Hull OFOD11 PPT 11

Options, Futures, and Other Derivatives
Eleventh Edition
Chapter 11
Properties of Stock
Options
Copyright © 2022, 2018, 2012 Pearson Education, Inc. All Rights Reserved
Notation
c: European call option price
p: European put option price
S0 : Stock price today
S sub 0,
K: Strike price
T: Life of option
: Volatility of stock price
sigma,
C: American call option price

P: American put option price
ST : Stock price at option maturity
S sub T,
D: PV of dividends paid during life of option

r Risk-free rate for maturity T with cont. comp.
Effect of Variables on Option Pricing
(Table 11.1)
Variable c p C P
S0 + minus
+ minus
 
S sub 0
K minus
+ minus
+
T ? ? + +
 + + + +
 
sigma
r + minus
+ minus
D minus
+  minus
American vs European Options
An American option is worth at least as much as the
corresponding European option,
C c
P p
Calls: An Arbitrage Opportunity?
• Suppose that
c=3
S0  20
T=1
r = 10%
K = 18
D=0
• Is there an arbitrage opportunity?
Lower Bound for European Call Option
Prices; No Dividends (Equation 11.4)
c max(SO – Ke  rT , 0 )
Puts: An Arbitrage Opportunity?
• Suppose that
P=1
S0 37
T = 0.5
r = 5%
K = 40
D=0
• Is there an arbitrage opportunity?
Lower Bound for European Put Prices;
No Dividends (Equation 11.5)
p max(Ke  rT – S0 , 0)
Put-Call Parity: No Dividends
• Consider the following 2 portfolios:
– Portfolio A: European call on a stock + zero-coupon
bond that pays K at time T
– Portfolio C: European put on the stock + the stock
Values of Portfolios (Table 11.2)
Blank Blank
ST  K ST  K
S sub T is greater than K S sub T is less than K
Portfolio A Call option ST  k 0

S sub T minus k
Zero-coupon bond K K
Total K
S sub T
ST
Portfolio C Put Option 0 K  ST
K minus S sub T
Share ST ST
S sub T S sub T
Total ST K
S sub T
The Put-Call Parity Result (Equation 11.6)
• Both are worth max ST , K  at the maturity of the
options.
• They must therefore be worth the same today. This
means that
c  Ke  rT  p  S0
Arbitrage Opportunities
• Suppose that
c=3
S0  31
T = 0.25
r = 10%
K = 30
D=0
• What are the arbitrage possibilities when
P = 2.25 ?
P=1?
Early Exercise
• Usually there is some chance that an American option will
be exercised early.
• An exception is an American call on a non-dividend
paying stock.
• This should never be exercised early.
An Extreme Situation
• For an American call option:
S0 100; T 0.25; K 60; D 0
Should you exercise immediately?

• What should you do if:
– You want to hold the stock for the next 3 months?
– You do not feel that the stock is worth holding for the
next 3 months?
Reasons For Not Exercising a Call Early
(No Dividends)
• No income is sacrificed.
• You delay paying the strike price.
• Holding the call provides insurance against stock price
falling below strike price.
Bounds for European or American Call
Options (No Dividends) Figure 11.3
Should Puts Be Exercised Early?
Are there any advantages to exercising an American put
when:
S0 60;
T = 0.25;
r = 10%
K = 100;
D=0
Bounds for European and American Put
Options (No Dividends) Figure 11.4
The Impact of Dividends on Lower Bounds
to Option Prices (Equations 11.8 and 11.9)
 rT
c so  D  Ke
p D  Ke  rT  so
Extensions of Put–Call Parity
• American options: D = 0
S0  K  C  P  S0  Ke  rT
Equation 11.7
• European options: D  0
c  D  Ke  rT  p  S0
Equation 11.10
• American options: D  0
S0  D  K  C  P  S0  Ke  rT
Equation 11.11
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Options, Futures, and Other Derivatives

C: American call option price

D: PV of dividends paid during life of option

Portfolio A Call option ST  k 0

S0 100; T 0.25; K 60; D 0

Should you exercise immediately?

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