15.

401 Recitation

5: Options
Learning Objectives

 R i off Concepts
Review C t
o Payoff profile
o Put‐call parityy
o Valuation of options

o Binomial tree
 Examples
o Payoff replication
o Arboreal Corporation

2010 / Yichuan Liu 2

Review: elements of a call/put option
 Type:
o Call: holder has the right but not the obligation to buy

o Put: holder has the right but not the obligation to sell
 Q
Quantity
tit off the
th underlying
d l i asset:
t
o Usually one share of stock with current price S
 Strike/exercise price (K)
 Expiration date (T)
 Style:
o European: can only be exercised at T
o American: can be exercised at any time between 0 and T.

2010 / Yichuan Liu 3

Review: payoff profile

Call Put

Payoff Payoff
Long

45° 45°
K Asset Price K Asset Price

K 45° Asset Price 45° K Asset Price

Short

Payoff Payoff

2010 / Yichuan Liu 4

Review: payoff profile
 The payoff of a portfolio of options is the sum of

payoffs of the individual components:
1 put 1 call Straddle

+ =

K1 K1 K1

1 call @ K1 ‐2 call @ K1 1 call @ K3 Butterfly spread

+ + =

K1 K2 K3 K1 K2 K3

2010 / Yichuan Liu 5

Review: put‐call parity
 Two portfolios with identical payoffs
1 call @ K Bond w/ FV=K
Portfolio 1

+ K =

K K

1 put @ K 1 stock
olio 2
Portfo

+ =

K K

2010 / Yichuan Liu 6

Review: put‐call parity
 No arbitrage implies that the two portfolios must

have the same cost:
 PV K   P  S
C 
C
K
C   P  S

1  r T

 This is the put‐call parity.

 Note: the call and put must have the same exercise
 exercise

price (K).

2010 / Yichuan Liu 7

Review: value of an option

Value of call Value of put

Strike p
price ((K)) Decrease Increase
Pricce of options

Price of underlying Increase Decrease

asset (S)
Volatility of the Increase Increase
underlying asset (σ)
Maturity (T) Increase Increase
Price of underlying asset Interest rate (r) Increase Decrease

2010 / Yichuan Liu 8

Review: binomial tree
 Idea: if there are only two states of the world next

period, we can price options given the underlying
asset and a risk‐free asset (“bond”) by replication:

Underlying Asset Bond Call

p Su
S
B Cu
S B/(1+r) C

1‐p Sd
B Cd

2010 / Yichuan Liu 9

Review: binomial tree

 Replication:
CF at t = 0 CF at t=1 CF at t=1

(“up” state) (“down” state)

A shares of underlying asset ‐A x S A x Su A x Sd
Bond (FV=B) ‐ B/(1+r) B B

Total ‐A
A x S ‐ B/(1+r) A x Su + B A x Sd + B
Replication = ‐C = Cu = Cd

o A = ( C u – C d ) / ( Su – Sd )
o B = C u – A x Su
o C = A x S + B/(1+r)
2010 / Yichuan Liu 10
Review: binomial tree
 Equivalently, we can solve for the risk
 risk‐neutral
neutral
probability, q:
qSu  1 q S d
q
S
S 
1 r
 Then,
qCu  1 q Cd
C
1 r

 Note: q is not related to the state probability p. In

fact,, p is not used in the pricing
g of C.
2010 / Yichuan Liu 11
Example 1: payoff replication
 How would you replicate the following payoff profile
using only call and put options?
a)

10 15 25 30
b)
8

8 12 16 20
2010 / Yichuan Liu 12
Example 1: payoff replication
 Answer:
a) Long 1 call (K=10)

Short 1 call (K=15)

Sh t 1 callll (K
Short (K=25)

Long 1 call (K=30)

b) Long 1 put (K=8)

Short 1 call (K=8)

Long 2 calls (K=12)

Short 1 call (K=20)

(K 20)

2010 / Yichuan Liu 13

Example 2: Arboreal Corporation
 Arboreal Corporations stock price is currently $102.

At the end of 3 months it will be either $120 or $90.
The 3‐month spot rate is 2%. What is the value of a
3‐month European call option with a strike price of
$110?
Stock Call
$120 $10
$102 C
$90 $0

2010 / Yichuan Liu 14

Example 2: Arboreal Corporation
 The call can be replicated with:
o Long 1/3 stock: costs $34
o Short bond with FV=30: costs ‐$30/(1+2%) = ‐$29.41

 Th price
The i off th
the callll mustt b

be
C  34  29.41  $4.59
 Alternatively, we can solve for the risk
Alternatively risk‐neutral
neutral
probability: 120q  901 q 
 102  q  0.468
1 2%
 The price of the call is then
100.468  01 0.468
C  $4.59
$4 59
2010 / Yichuan Liu
1 2% 15
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15.401 Finance Theory I

Fall 2008

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