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Lecture 6.1 Optionsfinal
Lecture 6.1 Optionsfinal
Managerial Finance
NCCB5060/MBQCB821
Professor Mao Ye
Plans for Derivatives
• Options
• Futures
2
This Class: Option Basics
• Put-call parity
3
The Option Contract: Calls
• A call option gives its holder the right to buy an asset:
– At a pre-specified price, also called exercise or strike price
– On a future date, also called expiration date
– Example: the right to buy 1 share of Google at $1000 on May 1, 2023
4
The Option Contract: Puts
• A put option gives its holder the right to sell an asset:
– At the exercise or strike price
– On the expiration date
– Example: the right to sell 1 share of Google at $1,000 on May 1, 2023
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Premium of the Option: Example
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The Option Contract
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This Class: Option Basics
• Put-call parity
8
Profit and Loss on Buying a Call
• A January 2017 call on IBM with an exercise price of $130 was selling on December
2, 2016, for $2.18.
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Profit and Loss on Buying a Call
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Profit and Loss on Buying a Put
• Consider a January 2017 put on IBM with an exercise price of $130, selling on
December 2, 2016, for $4.79.
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Profit and Loss on Buying a Put
• Suppose IBM’s price at expiration is $123.
• Investor’s profit:
– $7.00 - $4.79 = $2.21
– Some people invest in options because it needs less investment ($7 vs $130)
– Some other people likes the leverage
• Return: $2.21/$4.79 = 46.1%
• Return is – 100% if IBM’s price increases above $130
• Higher risk, higher return
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Four Situations
Buyer Seller
Call • Call Holder (Buyer) • Call Writer (Seller)
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Two Strategies
• Exercise
• Walk Away
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Payoffs and Profits for the Call Holder
Notation
Stock Price = ST
Exercise Price = X
- (ST - X) if ST >X
0 if ST < X
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Payoffs and Profits for the Put Holder
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Payoffs and Profits for the Put Writer
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Bearish or Bullish?
• Bullish
– Buy call
– Write put
• Bearish
– Write call
– Buy put
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This Class: Option Basics
• Put-call parity
20
Valuation of Option: Example
115 5
100 C
95 0
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Binomial Option Pricing: Example
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Alternative Portfolio
Buy 1 share of stock at $100
Borrow $86.36 (10% Rate) 95/(1+10%) 13.64
Net outlay $13.64
Payoff in the future 0
Value of Stock 95 115
Payoff Structure
Repay loan -95 -95 is exactly 4 times
Net Payoff 0 20 the Call
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Binomial Option Pricing: No Arbitrage
20 20
13.64 4C
0 0
4C = $13.64
C = $3.41
Otherwise, there will be arbitrage opportunities!
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Another Way to Examine the Problem
•Risk-free asset
– Hence 100 - 4C = $95/(1+10%) = $86.36
– C = $3.41
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Hedge Ratio
•If the investor writes one option and holds H shares of stocks, the value of the portfolio
will not be affected by stock price
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Volatility and the Value of Call Option
A. Increases
B. Decreases
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Higher Volatility Increases Call Value
120 10
90 0
h𝑖𝑔h − 𝑣𝑜𝑙 𝐶 𝑢 −𝐶 𝑑 10 − 0 1
𝐻 = = =
𝑢 𝑆0 − 𝑑 𝑆0 120 − 90 3
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Higher Volatility Increases Call Value
120-90=30 30
90-90=0 0
•Alternative Portfolio
– Buy 1 share of Stock at 100
– Borrow $81.82 (10% interest Rate)
•Buy 3 contract of Call has the same payoff
– Net outlay $18.18 • = $18.18
• = 6.06
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Another Way to Examine the Problem
•Risk-free asset
– Hence 100 - 3C = $81.82 or C = $6.06 > $3.41
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Life Story
• Intuition: options protect you from bad performance and are profitable when
performance is good
– The worst thing you can get is 0 when things is really bad
– Option allows you to keep the upside
– The value of options increase with volatility
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Four Levels of Learning
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This Class: Option Basics
• Put-call parity
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Put-Call Parity
•Another application of no-arbitrage condition
– Financial assets with the same payoff should have the same price
•Call-plus-bills portfolio
– Buy call option with strike price X
– Buy treasury bills with face value equal to the strike price of the call
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Different Assets, Same Payoff
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Put-Call Parity
• The call-plus-bond portfolio (on the left) must cost the same as the stock-plus-put
portfolio (on the right):
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Put-Call Parity – Disequilibrium Example
𝑿 𝟏𝟎𝟓
𝑪+ 𝑻
=𝟏𝟕+ 𝟏
=𝟏𝟏𝟕
(𝟏+𝒓 𝒇 ) 𝟏.𝟎𝟓
Buy the low-cost alternative (115) and sell the high-cost
alternative (117)
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Arbitrage Strategy
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