CHAPTER 9

OPTION
PRICING - I

Derivatives and Risk Management

Copyright © Oxford University Press By Rajiv Srivastava
 Options Pricing I

• Intrinsic Value and Time Value

• Boundary Conditions for Option Pricing
• Arbitrage Based Relationship for Option Pricing
• Put Call Parity

Derivatives and Risk Management Chapter 9 2

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Option Pricing
 Determination of option premium has been major area of
research. But there also exist simple arbitrage based rule which
explain a lot about the option price behaviour.
 Options are uneven contracts that gives right to one i.e. the
holder or buyer while binds the other party i.e. writer or seller
to a contract.
 Buyer can not enjoy the right free of cost else it becomes a lop-
sided contract.
 Buyer of the right has to induce the writer to confer such right on
him and undertake an obligation. The amount that is paid by the
buyer of the option to the writer is called premium.

Derivatives and Risk Management Chapter 9 3

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Intrinsic Value & Time Value
 The option premium consists of two components;
1. the intrinsic value, and
2. the time value
 Two important factors that determine the price are:
a. the extent to which the option is in-the-money, and
b. the chances that before expiry the option will become deeper
in-the-money or will turn into in-the-money if it is presently
out-of-the-money

Derivatives and Risk Management Chapter 9 4

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Intrinsic Value
 The value attached to the option if it is exercised now is called
the intrinsic value of the option. The difference between spot
price and exercise price will determine this value. The intrinsic
value is
 For call option : max {(S - X), 0}, and
 For put option : max {(X - S), 0}
 Intrinsic value cannot be negative.
 The least intrinsic value is for out-of-the-money option, which is
equal to zero.
 An option cannot sell below its intrinsic value.

Derivatives and Risk Management Chapter 9 5

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Time Value
 The time value is the excess of actual value over intrinsic value.
 The value attached to the chances that strike price will be pierced
in times to come before expiry is called the time value of an
option.
 Time value of an option = Actual Price – Intrinsic Value
 Time value cannot be negative. At best/worst it can have zero
value.
 Time value of the option is greatest for ATM options. The entire
premium paid for ATM options is attributable to the time value as
the intrinsic value of the option is zero.
Derivatives and Risk Management Chapter 9 6
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Example–Intrinsic and Time Value
 A 2-month call option on the Infosys with strike of Rs 2,100 is selling
for Rs140 when the share is trading at Rs 2,200. Find out the
following:
a) What is the intrinsic worth of the call option?
b) Why should one buy the call for a price in excess of intrinsic worth?
Solution
a) The intrinsic worth of the option is (S – X) = 2,200 – 2,100 = Rs. 100
b) The price of the option is Rs. 140 i.e. Rs. 40 more than the intrinsic
worth. This is the time value of the option and is paid because there are
chances that in next two months the price of Infosys may rise further
and holder stands to gain more than Rs. 100.
Derivatives and Risk Management Chapter 9 7
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 Boundary Conditions for Option Pricing

• Call Option
• Put Option
• Effects of Dividend
• Currency Options
• Options on Indices

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Boundary Conditions–Call Option
 Maximum value of the call option cannot exceed the value of the
asset itself on which the option is bought
Maximum Price of the call option, cmax = S or c ≤ S
 Similarly, the minimum price that a call option would sell for is
dependent upon its intrinsic value. If the option is maturing just
at the time of buying the time value of the option can be assumed
to be zero and it must sell for its intrinsic worth
 The minimum value of call is given by spot price less present
value of exercise price.
cmin = S – Xe-rt or c ≥ S – Xe-rt
Derivatives and Risk Management Chapter 9 9
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Boundary Conditions–Put Option
 Maximum value of a put option cannot exceed the exercise price.
 A put option is a right to sell the underlying asset at exercise
price X. Therefore the maximum value that one would pay to get
that right is X if it is to be exercised immediately
pmax = Xe-rt or pmax ≤ Xe-rt
 Intrinsic value is the amount of profit one would derive if the
option is exercised immediately. If it is to be paid at maturity the
difference of present value of exercise price and the spot price
provides the lower bound.
pmin = Xe-rt – S or pmin ≥ Xe-rt – S
Derivatives and Risk Management Chapter 9 10
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Dividend and Lower Bounds
 The effect of dividend on the prices of options can easily be
incorporated by adjusting the spot price for the dividend.
 In case dividend is payable within the expiry of the option the
spot price, S of the asset must be replaced by S – present value of
dividend.
 the lower bound of call and put prices respectively would stand
modified for dividend of D payable at t’ as follows:
 Lower bound for call on dividend paying stock
cmin ≥ S – Xe-rt– De-rt’
 Lower bound for put on dividend paying stock
pmin ≥ Xe-rt – S + De-rt’
Derivatives and Risk Management Chapter 9 11
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Lower Bounds - Currency Options
 The foreign currency is like dividend paying asset as the currency
can be invested to yield the risk free return in foreign currency.
 As we adjust the spot price with the present value of dividend the
lower bounds for options on foreign currencies can be adjusted
for the risk free interest rate in foreign currency, rf.
 The lower bounds for call and put on foreign currencies would be
cmin ≥ S e-rf t – Xe-r t
pmin ≥ Xe-r t – S . e-rf t

Derivatives and Risk Management Chapter 9 12

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Lower Bounds – Index Options
 In case of options on indices the situation is same as underlying
asset paying dividend.
 In case of indices the dividend, referred as dividend yield, d is
deemed to be paid continuously rather that at discrete intervals of
time.
 The lower bounds for call and put on indices would be
cmin ≥ S e-d t – Xe-r t
pmin ≥ Xe-r t – S . e-d t

Derivatives and Risk Management Chapter 9 13

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 Arbitrage Based Relationships of
Option Pricing

• Call options with Different Strikes

• Options with time to Maturity

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Arbitrage Based Pricing
 Lower bounds on option values are derived on the arguments of
arbitrage.
 Similarly, arbitrage would also determine the relative prices of
two or more options.
 The concept of arbitrage is central to price determination in
economics and finance as it makes
a) prices of different assets consistent with each other,
b) establish relationship between prices of different assets,
c) prices of the same asset to converge in different markets, and
d) help explain differential in prices in different markets and different
assets.
Derivatives and Risk Management Chapter 9 15
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Option Value and Strike Price
 Call with higher strike price would cost less than the call with
lower strike, and
 Put with lower strike price would cost less than the put with
higher strike.

Derivatives and Risk Management Chapter 9 16

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Option Value and Strike Price
 The call with strike price of Rs 460 is selling for Rs 5 while the
call with strike price of Rs 475 is selling for Rs 6. Both the calls
have same maturity. How can you benefit from the situations?
Solution
 Call with higher X is selling for more than the call with lower X.
By writing call with higher X one can earn premium that is lower
than what would be required for buying the call with lower X.
 The liability on account of call written would always be matched
by the asset one has with the call bought. If the call with higher X
is exercised the call with lower X too would be exercised.

Derivatives and Risk Management Chapter 9 17

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Option Value and Strike Price
 Difference in option premium of two options cannot exceed the
difference in their strike prices
 Options with more time to maturity would cost more than the
one with shorter maturity.
 Higher the Exercise Price More Valuable is Put

Derivatives and Risk Management Chapter 9 18

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 Put Call Parity
• Put Call Parity for European Options
• Implications
• American Call Vs European Call
• American Put Vs European Put
• Put Call Parity
• for American Options
• for Dividend Paying Assets
• for Currency Options

Derivatives and Risk Management Chapter 8 19

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Put Call Parity
 Put call parity establishes the relationship of call and put prices
for European options.
 The options must be on the same asset, with same strike price
and with same time to maturity.
 For the same underlying asset, same exercise price and same time
to expiry the call price would exceed the put price by the amount
of differential of spot price and the present value of the exercise
price.

Derivatives and Risk Management Chapter 9 20

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Put Call Parity
 An investor creates following portfolio:
 Goes long on a share
 Writes a call for X = 100 maturing at time ‘t’ and selling at ‘c’.
 Buys a put for X = 100 also maturing at time ‘t’ and selling at‘p’.

Value of the Portfolio of Stock, Short Call and Long Put at Expiration
Figures in Rs
Stock Price 0 50 75 100 125 150 200
Long Stock 0 50 75 100 125 150 200
Short Call at - - - - - 25 -50 -100
X = 100
Long Put at 100 50 25 - - - -
X = 100
Total Value of 100 100 100 100 100 100 100
the Portfolio

Derivatives and Risk Management Chapter 9 21

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Value of Portfolio

Put Call Parity - A Riskless Portfolio

Profit/Loss End Value of Portfolio = X

Long Stock
Short Call

X Stock Price

Long Put

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Outcome of the Portfolio
 With no uncertainty in the value of the portfolio at expiration we
can state the following:
1. An investor can borrow an amount equivalent to the present
value of exercise price to create the portfolio,
2. And since the value of the portfolio is certain at expiration date
the lenders would lend the money at risk free rate,
3. The portfolio can be funded by borrowing an amount equal to
the present value of the maturity amount of X, and
4. This portfolio can be said to be equivalent to a bond which
matures to the value equal to X and with maturity coinciding.
Derivatives and Risk Management Chapter 9 23
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Put Call Parity - Equation
 Initial cost of the portfolio of long stock, short call and long put
= Amount that can be borrowed at risk free rate
= Present value of the bond maturing to the exercise price
 If S is the current price of the share, c the call premium and p the
put premium, then
S-c+p = PV of X = X/(1+r)
= Xe-rt (for continuous compounding)
Or c – p = S – X e-rt
 If the put call parity does not hold it presents an arbitrage
opportunity by forming portfolios of call, put, bond and stock.
Derivatives and Risk Management Chapter 9 24
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Implications – Put Call Parity
 Put call parity also links the equity, bonds and derivative markets
for any inconsistent returns in any of them restoring the balance
among the three.
 Put call parity also helps synthesise the stock, call, put and bond
with the help of other three.
c + X e-rt = p + S

Call option Bond maturing to X Put option Stock

Derivatives and Risk Management Chapter 9 25

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American Vs European Call
 American call option is priced equal to European call.
 Though it seems that flexibility of American option should be
more valuable than the necessity of exercising on maturity.
 By exercising early one realizes only the intrinsic value and
foregoes time value.
 An option would always have some time value as long as there is
time left for its expiration.
 Selling a call is would fetch more value than exercising it, and
hence one would always sell rather than exercise, till maturity.
 Therefore American call would be priced same as European call.
Derivatives and Risk Management Chapter 9 26
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American Vs European Put
 The minimum value of European put is given by X e-rt – S.
 The intrinsic value of put is X – S.
 With positive rates of interest the minimum value of put would
be less than its intrinsic worth.
 For extreme case of stock price of zero, exercise of the put would
have payoff of X. One cannot get higher payoff than this. If one
waits further he only stands to lose. There are circumstances
when put option is more beneficial to exercise before maturity.
 Therefore, American put could be more valuable than European
put.
Derivatives and Risk Management Chapter 9 27
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Put Call Parity - American Options
 With American call valued same as European call, and American
put more valuable than the European put the put call parity
would not be an equality.
 For American option put call parity would following inequality:
pa ≥ p = c + X . e-rt - S
Since ca = c the put call parity for American options as below:
pa ≥ ca + X . e-rt - S

Derivatives and Risk Management Chapter 9 28

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Put Call Parity – With Dividend
 Put call parity for European option with the underlying paying
dividend before expiry of options is modified by the amount of
dividend.
 Put call parity for dividend paying stock with dividend of D at
time t’ would be:
c + X e-rt = p + S – D e-rt’
 Put call parity for dividend paying stock with continuous
dividend of q would be:
c + X e-rt = p + S e-qt

Derivatives and Risk Management Chapter 9 29

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Put Call Parity – Currency Options
 Put call relationship rests on the equivalency of portfolio a) call
option and bond that matures to X, with b) put option and c) the
underlying asset.
 For options on currencies the underlying asset is foreign
currency.
 The underlying asset, the foreign currency is like a dividend
paying asset that yields risk free interest in foreign currency, rf.
 Therefore today’s equivalent would be S e-rft. Therefore put call
parity for currency options would be
c + X e-rt = p + S e-rft
Derivatives and Risk Management Chapter 9 30
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