FINANCIAL ENGINEERING

OPTIONS
KRIPA SHANKER Ph D (Cornell)
FNAE, FIE(I), FITEE(I), LMISTE, LMIIIE, MORSI, MORSA, SMIIE

Visiting Faculty
Department of Mechanical Engineering
Indian Institute of Technology (BHU) Varanasi
Former Emeritus Fellow
Industrial and Management Engineering Department
Indian Institute of Technology Kanpur
Former Vice Chancellor, Uttar Pradesh Technical University Lucknow
Former Deputy Director, Indian Institute of Technology Kanpur
 Financial Engineering

VALUATION OF OPTIONS
OPTIONS
OPTIONS

Kripa Shanker Ph D (Cornell)

3
RE
CA
LL
OPTIONS
WHAT IS AN OPTION?
 A stock option is a derivative security, because
the value of the option is “derived” from the value
of the underlying common stock.
 There are two basic option types.
 Call options are options to buy the underlying
asset.
 Put options are options to sell the underlying
asset.
 Listed option contracts are standardized to
facilitate trading and price reporting.
 Listed stock options give the option holder the
right to buy or sell 100 shares of stock.
RE
CA
LL
OPTIONS
WHAT IS AN OPTION?
Definition: a type of legal contract between two
investors where one grants the other the right
(but not the obligation)to buy or sell a specific
asset at a preset price in the future.

 the option buyer is buying the right to

buy or sell the underlying asset at some
future date.
 the option writer is selling the right to
buy or sell the underlying asset at some
future date.
RE
CA
LL
OPTIONS
The minimum terms stipulated by stock option contracts
are:
• The identity of the underlying stock.
• The strike price, or exercise price.
• The option contract size.
• The option expiration date, or option
maturity.
• The option exercise style (American or
European).
• The delivery, or settlement, procedure.

The price of the option is called as Premium.

A list of available option contracts and their prices for a
particular security is known as an option chain.
 Notation
S = the price of the underlying asset (stock)
(we will refer to S0=S, St or ST)
C = the price of a call option (premium)
(we will refer to C0=C, Ct or CT)
X or K = the exercise or strike price
T = the expiration date
t = a time index
VALUATION OF OPTIONS
 VALUATION OF OPTIONS
VALUATION : AT EXPIRATION (E)
PAYOFF FOR A EUROPEAN CALL OPTION
FROM THE VIEW POINT OF BUYER (HOLDER)
VALUATION AT JUST
BEFORE EXPIRATION
Value
of Value of option
Option = max {0, (S-X)}
Exercise Price (X)
 When S ≤X, the call is Out-
of- Money and worthless.
 When S > X, the call is In-

the-Money and its value is

0 X
Stock Price (S) at E
Note : Payoff of a Call option is unbounded.
(S-X).
 The upward sloping line
represents the intrinsic
value of the option.
 VALUATION OF OPTIONS
VALUATION : AT EXPIRATION (E)
PAYOFF FOR A EUROPEAN PUT OPTION
FROM THE VIEW POINT OF BUYER (HOLDER)

VALUATION AT JUST
Value BEFORE EXPIRATION
of X Value of option
Option
= max {(X-S), 0}
Exercise Price (X)  When S < X, the Put has
value of (X-S) and is In-
the-Money.
 When S ≥ X, the put

0 X option is worthless and is

Stock Price (S) at E
Out -of -Money.

Note : Value of Put option is bounded.

 VALUATION OF OPTIONS
VALUATION : AT EXPIRATION (E)
PAYOFF FOR A EUROPEAN CALL OPTION
FROM THE VIEW POINT OF WRITER (SELLER)

Value Value
of Sell a of Sell a
Option Call Option Put

Exercise Price (X) Exercise Price (X)

0 X Stock Price (S) 0 X Stock Price (S)

-X
VALUATION OF OPTIONS
PROFIT = max (0, X-S) – PP
= max (-PP , X-S-PP)
PROFITS PROFITS

CALLS PUTS
Premium

Premium = Pc
S S
0
0

LOSSES LOSSES
VALUATION OF OPTIONS
FACTORS DETERMINING THE OPTION VALUES
 VALUATION OF OPTIONS
Combination
Payoff for a combination of
(i) buying a stock, and (ii) buying a put option on the stock

Payoffs just Before Expiration Date

If S < X If S > X
(1) Put Option X-S 0
+
(2) Equity stock S S

= Combination X S
 VALUATION OF OPTIONS
Combination
(i) buying a stock, and (ii) buying a put option on the stock
Value of Stock Value of Put
Position Buy Stock Position Buy Put

Stock Price (S) Stock Price (S)

X X
Value of a combination of
Stock and Put position

Buy Sock
+ Buy Put

Stock Price (S)

X
 VALUATION OF OPTIONS
Combination
Payoff for a combination of
(i) buying a stock, (ii) buying a put option, and (iii) borrow
an amount equal to exercise price
Payoffs just Before Expiration Date
If S < X If S > X
(1) Put Option X-S 0
+
(2) Equity stock S S
+
(3) Borrow an
amount X -X -X

Combination = 0 S-X
Buy a call option
 VALUATION OF OPTIONS
Combination
Value of Stock Value of Put
Position (S) Position (P)
Buy Put
Buy Stock

Stock Price (S) Stock Price (S)

X X
Value of Borrow Position Buy a Put Buy a Stock
(-X) Value of a combination
(P) (S)
{S+P-X} =
Borrow (-X) Buy a Call
X
Stock Price (S) X Stock Price (S)

Borrow (-X)
-X -X
 VALUATION OF OPTIONS
Combination
Payoff for a combination of
(i) buying a call option, (ii) selling a put option
{-max(0,(X-S), and (iii) lending an amount equal to exercise price (X)

Payoffs just Before Expiration Date

If S < X If S > X
(1) Buy a Call Option 0 S-X
+
(2) Sell a Put Option -(X-S) 0
+
(3) Lend an amount X X
X

Combination = S S
Underlying stock
 VALUATION OF OPTIONS
Value of Stock
Combination Value of Put
Position (C) Position (P) Sell a Put

Buy a Call
Stock Price (S)

{C-P+X} =
Stock
X Stock Price (S) S
Value of a combination =C-P+X
Value of Lend
Position (X) Lend (X)

Lend (X) Buy a Call

(C)

Stock Price (S) X Stock Price (S)

Sell a Put
X (P)
-X
VALUATION OF OPTIONS
Combination
Underlying
Buy a Call + Sell a Put + Lend X = Stock S

Underlying
Buy a Call Sell a Put Lend X Stock S
C + -P + dX =
S

1
d= discounting factor = (1  r ) T
F

Put –Call Parity

VALUATION OF OPTIONS

PUT-CALL PARITY
VALUATION OF OPTIONS
Combination
Underlying
Buy a Call + Sell a Put + Lend X = Stock S

Underlying
Buy a Call Sell a Put Lend X Stock S
C + -P + dX =
S

1
d= discounting factor = (1  r ) T
F

Put –Call Parity

 The Put-Call Parity
Compare the payoffs of the following strategies:
☺ Strategy I:
☺ Buy one call option (strike price = X, expiration= T)
☺ Buy one risk-free bond

(face value= X, maturity= T, return= rF)

☺ Strategy II
☺ Buy one share of stock
☺ Buy one put option (strike price = X, expiration= T)
 Strategy I – Portfolio Payoff
Stock Buy Buy All 30

price Call Bond (Portfolio)

25

0 0 20 20 20

15

5 0 20 20 10

5
10 0 20 20 0
0 5 10 15 20 25 30 35 40

15 0 20 20 -5

-10

20 0 20 20 -15

25 5 20 25
-20

-25

30 10 20 30 -30
 The Put-Call Parity
Compare the payoffs of the following strategies:
☺ Strategy I:
☺ Buy one call option (strike price = X, expiration= T)
☺ Buy one risk-free bond

(face value= X, maturity= T, return= rF)

☺ Strategy II
☺ Buy one share of stock
☺ Buy one put option (strike price = X, expiration= T)
 Strategy II – Portfolio Payoff
Stock Buy Buy All 30

price Stock Put (Portfolio)

25

0 0 20 20 20

15

5 5 15 20 10

5
10 10 10 20 0
0 5 10 15 20 25 30 35 40

15 15 5 20 -5

-10

20 20 0 20 -15

25 25 0 25
-20

-25

30 30 0 30 -30
 The Put-Call Parity
If two portfolios have the same payoffs in
every possible state and time in the future,
their prices must be equal:

XXX
X
X
C  S  P
CC(1  r ) T TTT  SS PP
CC  S  S
P P
(1
(1rfrf
(1  rf )))
(1  rf )
F T
 The Put-Call Parity
S<X S>X
Strategy I Call option ST–X 0
Zero-coupon bond X X
Total ST X
Strategy II Put option 0 X-ST
Share ST ST

X
Total ST X

C  X  S  P
CC  X TT  S  P
C  (1   
 rT
 Xe rf )
(1  rf ) 0
(1  rf )S  P
S  P T
 Put-Call Parity Relation
 Put option price – call option price =
present value of strike price + present
value of dividends – price of stock.
X
C S P
(1  rF ) T

X
P-C  S
(1  rF ) T
 Put-Call Parity Relation
 For European options, this formula must
hold (up to small deviations due to
transactions costs), otherwise there would
be arbitrage profit opportunities.
 Put-Call Parity
Stock + Put
Payoff Payoff
= X

X ST X ST

Call +Bond
Payoff Payoff
=
X

X ST X ST
 Put-Call Parity

Payoffs:
Stock + Put = Call + Bond

Prices:
Stock + Put = Call + Bond
Stock = Call – Put + Bond
S = C – P + PV(E)
 Put Call Parity Relation Derivation

45

40

35

30

25
Stock Price
Intrinsic Value Put
20
Intrinsic Value Call
Exercise Price
15

10

0
0 5 10 15 20 25 30 35 40 45

-5
Stock Price
 Limits on Option Prices
 Call should be worth more than intrinsic
value when out of the money
 Call should be worth more than intrinsic
value when in the money
 Call should never be worth more than the
stock price
 Exercise Price = 20, r=5%, T=1,sigma=.3

25

20

15
Call Price

Intrinsic Value of Call

10
Call Price (Black Scholes)

0
0 5 10 15 20 25 30 35 40 45

-5
Stock Price
 The Law of One Price
 If 2 securities/portfolios have the same payoff
then they must have the same price
 Why? Otherwise it would be possible to make an
arbitrage profit
 Sell the expensive portfolio, buy the cheap
portfolio
 The payoffs in the future cancel, but the
strategy generates a positive cash flow today
(a money machine)