0 chapters 14/15 – part 1 options: basic concepts l options l call options l put options l selling...
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1
Chapters 14/15 – Part 1Options: Basic Concepts
Options Call Options Put Options Selling Options Reading The Wall Street Journal Combinations of Options Valuing Options An Option‑Pricing Formula Investment in Real Projects and Options Summary and Conclusions
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2
Options Contracts: Preliminaries
Option Definition. Calls versus Puts Call options Put options. Exercising the Option Strike Price or Exercise Price Expiration Date European versus American options
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3
Options Contracts: Preliminaries
Intrinsic Value Speculative Value
Option Premium =
Intrinsic Value
Speculative Value
+
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4
Value of an Option at Expiration
Impact of leverage…
Stock price is $50. Buy 100 shares
Call strike is $50, price is $10. Buy 1 contract.
Put strike is $50, price is $10. Buy 1 contract.
=====================
C = S – E
P = E - S
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Call Option Payoffs
-20
100908070600 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
Op
tio
n p
ayo
ffs
($)
Write a call
Buy a call
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6
Put Option Payoffs
Write a put
Buy a put
-20
0
-40
20
0
-60
40
60
Op
tio
n p
ayo
ffs
($)
Stock price ($)
1009080706010 20 30 40 50
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7
Call Option Payoffs
-20
100908070600 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
Op
tio
n p
ayo
ffs
($)
Buy a call
Exercise price = $50
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8
Call Option Payoffs
-20
100908070600 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
Op
tio
n p
ayo
ffs
($)
Write a call
Exercise price = $50
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Call Option Profits
-20
100908070600 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
Op
tio
n p
rofi
ts (
$)
Write a call
Buy a call
Exercise price = $50; option premium = $10
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Put Option Payoffs
-20
100908070600 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
Op
tio
n p
ayo
ffs
($)
Buy a put
Exercise price = $50
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Put Option Payoffs
-20
100908070600 10 20 30 40 50
-40
20
0
-60
40
60
Op
tio
n p
ayo
ffs
($)
write a put
Exercise price = $50
Stock price ($)
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Put Option Profits
-20
100908070600 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
Op
tio
n p
rofi
ts (
$)
Buy a put
Write a put
Exercise price = $50; option premium = $10
10
-10
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Selling Options – Writing Options
The seller (or writer) of an option has an obligation.
The purchaser of an option has an option.
-20
100908070600 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
Op
tio
n p
rofi
ts (
$)
Buy a put
Write a put
10
-10
-20
100908070600 10 20 30 40 50
-40
20
0
-60
40
60
Stock price ($)
Op
tio
n p
rofi
ts (
$)
Write a call
Buy a call
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Call Option Payoffs at Expiration (Δ exercise)
Stock price ($)
100908070600 10 20 30 40 50
Buy a call
20
10
40
30
0
50
60
Op
tio
n p
ayo
ffs
($)
E=50E=0
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Option Pricing Bounds at Expiration
Upper bounds Call Options Put Options
Lower Bounds Call option intrinsic value = max [0, S - E] Put option intrinsic value = max [0, E - S]
In-the-money / Out-of-the-money Time premium/time decay At expiration, an American call option is worth
the same as a European option with the same characteristics.
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Reading The Wall Street Journal
Option/Strike Exp. Vol. Last Vol. LastIBM 130 Oct 364 15¼ 107 5¼138¼ 130 Jan 112 19½ 420 9¼138¼ 135 Jul 2365 4¾ 2431 13/16
138¼ 135 Aug 1231 9¼ 94 5½138¼ 140 Jul 1826 1¾ 427 2¾138¼ 140 Aug 2193 6½ 58 7½
--Put----Call--
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Valuing Options
The last section concerned itself with the value of an option at expiration.
This section considers the value of an option prior to the expiration date.
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Option Value Determinants
Call Put1. Exercise price2. Stock price 3. Interest rate 4. Volatility in the stock price 5. Expiration date
The value of a call option C0 must fall within
max (S0 – E, 0) < C0 < S0.
The precise position will depend on these factors.
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Varying Option Input Values
Stock price: Call: as stock price increases call option price
increases Put: as stock price increases put option price
decreases
Strike price: Call: as strike price increases call option price
decreases Put: as strike price increases put option price
increases
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Varying Option Input Values
Time until expiration: Call & Put: as time to expiration increases call and put
option price increase
Volatility: Call & Put: as volatility increases call & put value
increase
Risk-free rate: Call: as the risk-free rate increases call option price
increases Put: as the risk-free rate increases put option price
decreases
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Figure 15.1. Put and Call Option Prices
0
5
10
15
20
25
Stock Price ($)
Op
tio
n P
rice
($) Call PricePut Price
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Figure 15.2. Option Prices and Time to Expiration
0
5
10
15
20
25
30
35
0 3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60
Time to Expiration (months)
Op
tio
n P
rice
($)
Call Price
Put Price
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Figure 15.3. Option Prices and Sigma
0
5
10
15
20
25
Sigma (%)
Op
tio
n P
rice
($)
Call Price
Put Price
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Figure 15.4. Options Prices and Interest Rates
0
1
2
3
4
5
6
7
8
9
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Interest Rate (%)
Op
tio
n P
rice
($)
Call Price
Put Price
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Option Value Determinants
Call Put1. Exercise price – +2. Stock price + –3. Interest rate + –4. Volatility in the stock price + +5. Expiration date + +
The value of a call option C0 must fall within
max (S0 – E, 0) < C0 < S0.
The precise position will depend on these factors.
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Market Value, Time Value and Intrinsic Value for an American Call
CaT > Max[ST - E, 0]Profit
lossE ST
Market Value
Intrinsic value
S T - E
Time value
Out-of-the-money In-the-money
S T
The value of a call option C0 must fall within max (S0 – E, 0) < C0 < S0.
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Combinations of Options
Puts and calls can serve as the building blocks for more complex option contracts.
If you understand this, you can become a financial engineer, tailoring the risk-return profile to meet your client’s needs.
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Protective Put Strategy: Buy a Put and Buy the Underlying Stock: Payoffs at Expiration
Buy a put with an exercise price of $50
Buy the stock
Protective Put strategy has downside protection and upside potential
$50
$0
$50
Value at expiration
Value of stock at
expiration
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Protective Put Strategy Profits
Buy a put with exercise price of $50 for $10
Buy the stock at $40
$40
Protective Put strategy has
downside protection and upside potential
$40
$0
-$40
$50
Value at expiration
Value of stock at
expiration
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Covered Call Strategy
Sell a call with exercise price of $50 for $10
Buy the stock at $40
$40
Covered call
$40
$0
-$40
$10
-$30
$30 $50
Value of stock at expiration
Value at expiration
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Long Straddle: Buy a Call and a Put
Buy a put with an exercise price of
$50 for $10$40
A Long Straddle only makes money if the stock price moves $20 away from $50.
$40
$0
-$20$50
Buy a call with an exercise price of $50 for $10
-$10
$30
$60$30 $70
Value of stock at
expiration
Value at expiration
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Short Straddle: Sell a Call and a Put
Sell a put with exercise price of$50 for $10
$40
A Short Straddle only loses money if the stock price moves $20 away from $50.
-$40
$0
-$30$50
Sell a call with an exercise price of $50 for $10
$10
$20
$60$30 $70
Value of stock at expiration
Value at expiration
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Put-Call Parity
TreECPS
TreECPS
Buy the stock, buy a put, and write a call; the sum ofwhich equals the strike price discounted at the risk-free rate
C = Call option price P = Put option priceS = Current stock price E = Option strike pricer = Risk-free rate T = Time until option
expiration
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Put-Call ParityBuy Stock & Buy Put
Share Price
Pos
itio
n V
alue
Combination: Long Stock & Long Put
Long Put
Long Stock
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Put-Call ParityBuy Call & Buy Zero Coupon Risk-Free Bond @ Exercise Price
Long Bond
Share Price
Pos
itio
n V
alue
Combination: Long Stock & Long Bond
Long Call
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Put-Call Parity
Share Price
Pos
itio
n V
alue Combination:
Long Stock & Long Put
Long Put
Long Stock
Share Price
Pos
itio
n V
alue
Combination: Long Stock & Long Bond
Long Call
Long Bond
TreECPS In market equilibrium, it must be the case that option prices are set such that:
Otherwise, riskless portfolios with positive payoffs exist.
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The Black-Scholes Model
Value of a stock option is a function of 6 input factors:1. Current price of underlying stock.2. Strike price specified in the option contract.3. Risk-free interest rate over the life of the contract.4. Time remaining until the option contract expires.5. Price volatility of the underlying stock.
The price of a call option equals:
)()( 21 dNeEdNSC Tr
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Black-Scholes Model
Where the inputs are:S = Current stock priceE = Option strike pricer = Risk-free interest rateT = Time remaining until option expiration = Sigma, representing stock price volatility,
standard deviation
)()( 21 dNeEdNSC Tr
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Black-Scholes Model
)()( 21 dNeEdNSC Tr
Where d1 and d2 equal:
T
TrES
d2
2
1
2ln
Tdd 212
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40
Black-Scholes Models
ESC
SEP
Also, remember at expiration:
Remembering put-call parity, the value of a put,given the value of a call equals:
TreECPS TreESCP
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41
The Black-Scholes Model
Find the value of a six-month call option on the Microsoft with an exercise price of $150
The current value of a share of Microsoft is $160The interest rate available in the U.S. is r = 5%.The option maturity is 6 months (half of a year).The standard deviation of the underlying asset is
30% per annum.Before we start, note that the intrinsic value of the
option is $10—our answer must be at least that amount.
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42
The Black-Scholes Model
Then d2,
T
TσrESd
)5.()/ln( 2
1
First calculate d1 and d2
Tdd 12
5282.05.30.0
5).)30.0(5.05(.)150/160ln( 2
1
d
31602.05.30.052815.02 d
Assume S = $160, X = $150, T = 6 months, r = 5%, and = 30%, calculate the value of a call.
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43
The Black-Scholes Model
N(d1) = N(0.52815) = 0.7013
N(d2) = N(0.31602) = 0.62401
5282.01 d
31602.02 d
)N()N( 210 dEedSC rT
92.20$
62401.01507013.0160$
0
5.05.0
C
eC
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Assume S = $50, X = $45, T = 6 months, r = 10%, and = 28%, calculate the value of a call and a put.
12514550328 500100 .$$$.$ ).(. eP
328754045812050 500100 .$).().( ).(. eC
8840
500280
5002280
1004550
2
1 ...
..
.ln
d
686050028088402 .... d
From a standard normal probability table, look up N(d1) = 0.812 and N(d2) = 0.754 (or use Excel’s “normsdist” function)
Another Black-Scholes Example
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Real Options
Real estate developer buys 70 acres in a rural area. He plans on building a subdivision when the population from the city expands this direction. If growth is less than anticipated, the developer thinks he can sell the land to a country club to build a golf course on the property.
The development option is a ______ option. The golf course option is a _______ option. How would these real options change the standard
NPV analysis?
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46
Collar: Buy a Put, Buy the Stock, Sell the Call
Buy a put with exercise price of $50 for $0.67
Buy the stock at $80
$80
$49.33
$0
-$80
$50
Value at expiration
Value of stock at
expiration
$120
Sell a call with exercise price of $120 for $2.76
$2.76
-$27.91
$42.11
Collar
$0.67
NTS