MIT15 401F08 Rec05 PDF

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.

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

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

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

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).

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

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

 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)
 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.
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
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)

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

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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15.

2010 / Yichuan Liu 2

2010 / Yichuan Liu 3

K 45° Asset Price 45° K Asset Price

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

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 This is the put‐call parity.

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Value of call Value of put

Price of underlying Increase Decrease

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Underlying Asset Bond Call

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(“up” state) (“down” state)

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

Short 1 call (K=15)

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)

2010 / Yichuan Liu 13

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15.401 Finance Theory I

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