Option Pricing I

Introduction to Options
In day-to-day usage, to have an option is to have some
flexibility and to have a choice.
In finance, an option refers to a financial contract that
gives you a choice.
A call option is a typical example of an option. What is
a call option on a stock?
A call option on a stock is the right to buy the stock at a
pre-specified price (the options exercise price) on a
pre-specified date (the options maturity date). We refer
to such an option more formally as a European option.
European Call Options
If ST represents stock price on date T and X
represents the exercise price of a European
call option, when would it pay to exercise it?
Of course, when the stock price ST > X.
On the other hand, the option would be
useless if ST X.
We can graph the value of an option as
follows:
European Call Options
Call Price (C)

C f S , X ,s , rf , T
Max(0, ST - X)

X Stock Price (ST)

Comparative Static Results

C f S , X ,s , rf , T
It is clear that as S increases, so does C, the value of a
call option. An option is said to be in the money if S > X.
Ceteris paribus, as X increases, C decreases.
What is the effect of s increasing?
C increases.
More the time to expiration, more the worth of a call.
The effect of the riskfree rate is more complex, but can
be shown to be positive.
 Early Exercise of a Call Option
By definition, an American call option can be exercised
early.
Consider a non-dividend paying stock. Early exercise of
an American call option on the stock is undesirable.
Why?
Two adages you might have heard:
An option is always worth more alive than dead.
Always exercise your options as late as possible.
The rule breaks down for a dividend-paying stock.
 Put Options
A European put option is a right to sell stock at a
pre-specified price (called the options exercise
price) on a pre-specified date (called the options
maturity date).
If the right of exercise extends to dates prior to the
maturity date, we have an American put option.
The value of a put option satisfies P > Max(0, X -
S).
Let us next examine the relation between P and S.
Put Option Value
Put Price (P)

P f S , X ,s , rf , T
Max(0, X - ST)

X Stock Price (ST)

Some Option Strategies
C C

X S X S

Buying a call Writing a call

Some Option Strategies
P P

X S X S

Buying a put Writing a put

The Bull Spread
C

X1 X2 S

Buy the low exercise price call

and
sell the high exercise price call
The Bear Spread
C

X1 X2 S

Sell the low exercise price call

and
buy the high exercise price call
Put-Call Parity
Puts and calls can be mimicked by combinations of
the underlying stock and the riskfree asset.
Of course, an interesting question then is, why do we
need puts and calls to complete the market? The
answer will start to emerge soon.
A well known result that relates a put and a call to the
underlying stock and the riskfree asset, is called the
put-call parity result.
The result also illustrates the no-arbitrage types of
arguments that pervade option pricing.
Put-Call Parity
r f t
S P C X e

Consider the following two options:

a call option on stock S with exercise price X, and
a put option on stock S with exercise price X.

The put-call parity result states that buying the

underlying stock, buying the put option and
selling the call option provides a perfect hedge.
Put-Call Parity

Current value ST X ST > X

Buy stock -S ST ST
Buy put -P X - ST 0
Sell call C 0 -( ST - X )
Portfolio -S - P + C X X

r f t
Therefore, S P C X e
Put-Call Parity

Current value ST X ST > X

Buy stock -S ST ST
Buy put -P X - ST 0
Sell call C 0 -( ST - X )
Portfolio -S - P + C X X

r f t
Therefore, S P C X e
Put-Call Parity

Current value ST X ST > X

Buy stock -S ST ST
Buy put -P X - ST 0
Sell call C 0 -( ST - X )
Portfolio -S - P + C X X

r f t
Therefore, S P C X e
Put-Call Parity

Current value ST X ST > X

Buy stock -S ST ST
Buy put -P X - ST 0
Sell call C 0 -( ST - X )
Portfolio -S - P + C X X

r f t
Therefore, S P C X e
Put-Call Parity

Current value ST X ST > X

Buy stock -S ST ST
Buy put -P X - ST 0
Sell call C 0 -( ST - X )
Portfolio -S - P + C X X

r f t
Therefore, S P C X e
Put-Call Parity

Current value ST X ST > X

Buy stock -S ST ST
Buy put -P X - ST 0
Sell call C 0 -( ST - X )
Portfolio -S - P + C X X

r f t
Therefore, S P C X e