Objectives • Options – basic strategies – introduction to some pricing restrictions – introduction to binomial model 4/16/99 Options 1 Payoff Diagrams Payoff Long stock Stock Price Short stock 4/16/99 Options 2 1 European call Payoffs Long call Underlying price X 4/16/99 Options 3 European Put Options Payoff Long put Underlying Price 4/16/99 Options 4 2 Some strategies • • • • Naked Protective put Covered call Straddle 4/16/99 Options 5 Protective put • Purchase underlying security • Purchase put option, exercise price X Value Underlying Put Value of underlying X 4/16/99 Options 6 3 Algebraically Position ST <X Underlying 4/16/99 ST >X ST ST Put X- ST ST Net X ST Options 7 Why do this? 4/16/99 Options 8 4 Covered call • Purchase underlying • Write call option against it Underlying Position Value X Underlying 4/16/99 Options 9 Straddle • Buy put and call, both at the same strike Position Value Put 4/16/99 Call Options Underlying 10 5 Other spreads • combination of 2+ calls or puts, same asset with differing exercise prices or times to expiration – Vertical or money spread • Same maturity and different exercise price – Horizontal or time spread • different maturities 4/16/99 Options 11 Main Points • Lots of strategies possible • Options allow you to customize cash flows across states in the future... 4/16/99 Options 12 6 Put call parity • Relationship between price of European call and put • Independent of assumptions about randomness in underlying – stocks – indexes – bonds, currencies, etc. 4/16/99 Options 13 Final Payoffs: Long call and short put Position Value Underlying 4/16/99 Options 14 7 Arbitrage relationship 4/16/99 Options 15 Example • Stock price = $10 • maturity 1 year, interest rate 10% • exercise price = $9.90 – Put price = $1 – Call price ? 4/16/99 Options 16 8 Call price < stock price • Suppose stock price = 10, call price = 11, exercise price = 4 • Strategy: – purchase stock – short option 4/16/99 Options 17 Payoffs on strategy Item Long stock Today Maturity ST<4 ST ≥4 -$10 ST ST Short option +$11 0 4- ST Net ST 4 4/16/99 +$1 Options 18 9 American calls • Don’t exercise early without dividends 4/16/99 Options 19 Binomial Model • Workhorse model for derivatives valuation • Very flexible • Basic Assumption about stock price moves – binomial process for stock price: either goes up or down next period 4/16/99 Options 20 10 1 period example • S0=10, current stock price, r= 1.1=riskfree rate • probability stock increase = q=0.5 – u: multiplicative upward movement =2 – d: downward movement = 0.5 –u>r>d • Why? 4/16/99 Options 21 Stock price movements S1 = %&uS 'dS 0 0 = 2(10) = 20, = 0.5(10) = 5, probability = 0.5 probability = 0.5 uS0=20, prob 0.5 S0=10 dS0=5, prob 0.5 4/16/99 Options 22 11 Call option,X=10, 1 period maturity Stock Payoffs Call Payoffs 20 Max(20-10,0) =10 ? 10 5 4/16/99 Options Max(5-10,0) =0 23 Valuation • Basic idea: come up with strategy of stock and bonds with same payoff as option – arbitrage says: cost of strategy = cost of option • : number of shares, : number of bonds – ‘u’: 20+ 1.05=10 – ‘d’: 5+ 1.05=0 – Solving: = (2/3), 4/16/99 =-(2/3)(5/1.1) Options 24 12 Call value • Value of call=value of portfolio – (10)+ =(2/3)(10)-(2/3)(5/1.1)=3.64 4/16/99 Options 25 Implications • 2 states in future: needed 2 securities (stock and bond) to hedge/price option • Call = long stock and short bond: levered position in portfolio • What happened to probability of u and d? 4/16/99 Options 26 13 Recap • Pricing via replication • probabilities of up and down doesn’t matter! • Steps: – check if #securities ≥ # states – if so, match cash flows state by state 4/16/99 Options 27 Summary • Options – strategies – basic pricing restrictions – introduction to binomial model 4/16/99 Options 28 14 Next Time • Extend binomial model to deal with multiple periods • Applying model to portfolio strategies – Sharpe and Perold in readings packet 4/16/99 Options 29 15