Chapter 4: Principles of Option

Pricing
Well, it helps to look at derivatives like atoms. Split them one way and you
have heat and energy - useful stuff. Split them another way and you have a
bomb. You have to understand the subtleties.

Kate Jennings
Moral Hazard, Fourth Estate, 2002, p. 8

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Important Concepts in Chapter 3

Role of arbitrage in pricing options

Minimum value, maximum value, value at expiration and lower
bound of an option price
Effect of exercise price, time to expiration, risk-free rate and volatility
on an option price
Difference between prices of European and American options
Put-call parity

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Options Terminology

• Intrinsic value is the value realized from immediate exercise

• Call options: maximum (S0-x or 0)
• Put options: maximum (x-S0 or 0)
• Prior to option maturity, option premiums exceed intrinsic value
• Time value =Option price - Intrinsic value
• =seller compensation for risk

19-3
 Example 19-1
• The common stock of Teledyne trades on the NSYE. Teledyne has never paid
a cash dividend. The stock is relatively risky. Assume that Teledyne closed at
a price of $162. Hypothetical option quotes on Teledyne are as follows

• r =not traded ; s = no option offered

19-4
Example 19-1

• Based on the Teledyne data, answer the following questions:

• A. which calls are in the money?
• B. which puts are in the money?

19-5
Example 19-2

• Based on the Teledyne data, answer the following :

• a. Calculate the intrinsic value of the April 140 and the October 170
calls.
• b. Calculate the intrinsic value of the April 140 and the October 170
puts.

19-6
Example 19-12

• Assume that on February 10 Pfizer closes at $25.7 and that a March

call option with a strike price of 25 is available on that day for a price
of $1.15. this option is in the money because the stock price is
greater than the exercise price.
• Find the Intrinsic value of March 25 call

19-7
Example 19-13

• Assume that there is a Pfizer March put available on February 10

with a strike price of $ 27.5. the current market price of the stock is
$25.70. the price of the put on the day is $1.90
• Find the Intrinsic value of March 27.5 put

19-8
Example 19-14

• For the Pfizer option find the time value

19-9
Basic Notation and Terminology

• Symbols
• S0 (stock price)
• X (exercise price)
• T (time to expiration = (days until expiration)/365)
• r (see below)
• ST (stock price at expiration)
• C(S0,T,X), P(S0,T,X)

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 X
Basic Notation and Terminology (continued)
• Computation of risk-free rate (r)
• Date: May 14. Option expiration: May 21
• T-bill bid discount = 4.45, ask discount = 4.37

(4.57 %)

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 X
Basic Notation and Terminology (continued)
• Computation of risk-free rate (r)
• Date: May 14. Option expiration: May 21
• T-bill bid discount = 4.45, ask discount = 4.37
• Average T-bill discount = (4.45+4.37)/2 = 4.41
• T-bill price = 100 – 4.41(7/360) = 99.91425
• T-bill yield = (100/99.91425)(365/7) – 1 = 0.0457
• So 4.57 % is risk-free rate for options expiring May 21
• Other risk-free rates: 4.56 (June 18), 4.63 (July 16)

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 X
Problem 4-1
• Consider an option that expires in 68 days. The bid and ask discounts
on the Treasury bill maturing in 67 days are 8.24 and 8.20,
respectively . Find the approximate risk-free rate.

(0.0876)

Chance/Brooks An Introduction to Derivatives and Risk Management, 10th ed. Ch. 3: 13

 X
Principles of Call Option Pricing
• Minimum Value of a Call
• C(S0,T,X) 0 (for any call)
• For American calls:
• Ca(S0,T,X)  Max(0, S0 – X)
• Concept of intrinsic value: Max(0, S0 – X)
• Proof of intrinsic value rule for DCRB calls
• Concept of time value
• See Table 3.2 for time values of DCRB calls
• See Figure 3.1 for minimum values of calls

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Chance/Brooks
X An Introduction to Derivatives and Risk
Management, 10th ed.
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Chance/Brooks
X (Return to text slide 5)

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 X
Principles of Call Option Pricing (continued)

• Maximum Value of a Call

• C(S0,T,X) S0
• See Figure 3.2, which adds this to Figure 3.1
• Value of a Call at Expiration
• C(ST,0,X) = Max(0, ST – X)
• For American and European options
• See Figure 3.3

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 X
Principles of Call Option Pricing (continued)

• Effect of Time to Expiration

• Two American calls differing only by time to expiration, T1 and T2 where T1 <
T2.
• Ca(S0,T2,X)  Ca(S0,T1,X)
• Proof/intuition
• Deep in- and out-of-the-money
• Time value maximized when at-the-money
• Concept of time value decay
• See Figure 3.4 and Table 3.2
• Cannot be proven (yet) for European calls

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 X
Principles of Call Option Pricing (continued)

• Effect of Exercise Price

• Effect on Option Value
• Two European calls differing only by strikes of X 1 and X2. Which is greater, Ce(S0,T,X1) or
Ce(S0,T,X2)?
• Construct portfolios A and B. See Table 3.3.
• Portfolio A has non-negative payoff; therefore,
• Ce(S0,T,X1)  Ce(S0,T,X2)
• Intuition: show what happens if not true
• Prices of DCRB options conform

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 X
Principles of Call Option Pricing (continued)

• Effect of Exercise Price (continued)

• Limits on the Difference in Premiums
• Again, note Table 3.3. We must have
• (X2 – X1)(1+r)–T  Ce(S0,T,X1) – Ce(S0,T,X2)
• X2 – X1 Ce(S0,T,X1) – Ce(S0,T,X2)
• X2 – X1 Ca(S0,T,X1) – Ca(S0,T,X2)
• Implications
• See Table 3.4. Prices of DCRB options conform

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 X
Problem 15
• Examine the following pairs of calls, which differ only by exercise
price. Determine whether either of them violates the rules regarding
relationships between American options that differ only by exercise
price.
a. August 155 and 160
b. October 160 and 165

Chance/Brooks An Introduction to Derivatives and Risk Management, 10th ed. Ch. 3: 21

 X
Principles of Call Option Pricing (continued)

• Lower Bound of a European Call

• Construct portfolios A and B. See Table 3.5.
• B dominates A. This implies that (after rearranging)
• Ce(S0,T,X)  Max[0, S0 – X(1+r)–T]
• This is the lower bound for a European call
• See Figure 3.5 for the price curve for European calls
• Dividend adjustment: subtract present value of dividends from S 0; adjusted
stock price is S0´
• For foreign currency calls,
• Ce(S0,T,X)  Max[0, S0(1+)–T – X(1+r)–T]

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 X
Principles of Call Option Pricing (continued)

• American Call Versus European Call

• Ca(S0,T,X)  Ce(S0,T,X)
• But S0 – X(1+r)–T > S0 – X prior to expiration so
• Ca(S0,T,X)  Max(0, S0 – X(1+r)–T)
• Look at Table 3.6 for lower bounds of DCRB calls
• If there are no dividends on the stock, an American call will never be
exercised early. It will always be better to sell the call in the market.
• Intuition

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Problem 4-11
• The following option prices were observed for a stock on July 6 of a
particular year. The stock is priced at 165.13. The expirations are July 17,
October 16, and August 21. The risk-free rates are 0.0516, 0.0550,
and0.0588, respectively. Compute the intrinsic values, time values, and
lower bounds of the following calls. Identify any profit opportunities that
may exist. Treat these as American options
• a. July 160
• b. October 155
• c. August 170

Chance/Brooks An Introduction to Derivatives and Risk Management, 10th ed. Ch. 3: 24

 X
Principles of Put Option Pricing

• Minimum Value of a Put

• P(S0,T,X) 0 (for any put)
• For American puts:
• Pa(S0,T,X)  Max(0, X – S0)
• Concept of intrinsic value: Max(0, X – S0)
• Proof of intrinsic value rule for DCRB puts
• See Figure 3.6 for minimum values of puts

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 X
Principles of Put Option Pricing (continued)

• Maximum Value of a Put

• Pe(S0,T,X)  X(1+r)–T
• Pa(S0,T,X)  X
• Intuition
• See Figure 3.7, which adds this to Figure 3.6
• Value of a Put at Expiration
• P(ST,0,X) = Max(0, X – ST)
• For American and European options

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 X
Principles of Put Option Pricing (continued)

• Effect of Time to Expiration

• Two American puts differing only by time to expiration, T 1 and T2 where T1 <
T2.
• Pa(S0,T2,X)  Pa(S0,T1,X)

• Cannot be proven for European puts

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 X
Principles of Put Option Pricing (continued)

• Effect of Exercise Price

• Effect on Option Value
• Two European puts differing only by X 1 and X2. Which is greater, Pe(S0,T,X1) or
Pe(S0,T,X2)?
• Portfolio A has non-negative payoff; therefore,
• Pe(S0,T,X2)  Pe(S0,T,X1)

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 X
Principles of Put Option Pricing (continued)

• Effect of Exercise Price (continued)

• Limits on the Difference in Premiums
• Again, note Table 3.8. We must have
• (X2 – X1)(1+r)–T  Pe(S0,T,X2) – Pe(S0,T,X1)
• X2 – X1 Pe(S0,T,X2) – Pe(S0,T,X1)
• X2 – X1 Pa(S0,T,X2) – Pa(S0,T,X1)
• Example: See Table 3.9. Prices of DCRB options conform

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 X
Problem 16
• Examine the following pairs of puts, which differ only by exercise price.
Determine whether either of them violates the rules regarding
relationships between American options that differ only by exercise
price.
a.August 155 and 160
b.b. October 160 and 170
X2 – X1 Pa(S0,T,X2) – Pa(S0,T,X1)

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 X
Principles of Put Option Pricing (continued)

• Lower Bound of a European Put

• Construct portfolios A and B. See Table 3.10.
• A dominates B. This implies that (after rearranging)
• Pe(S0,T,X)  Max(0, X(1+r)–T – S0)
• This is the lower bound for a European put

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 X
Principles of Put Option Pricing (continued)

• American Put Versus European Put

• Pa(S0,T,X)  Pe(S0,T,X)
• Early Exercise of American Puts
• There is always a sufficiently low stock price that will make it optimal to
exercise an American put early.
• Dividends on the stock reduce the likelihood of early exercise.

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Problem 4-11
• The following option prices were observed for a stock on July 6 of a
particular year. The stock is priced at 165.13. The expirations are July 17,
October 16, and August 21. The risk-free rates are 0.0516, 0.0550,
and0.0588, respectively. Compute the intrinsic values, time values, and
lower bounds of the following puts. Identify any profit opportunities that
may exist. Treat these as American options
• a. July 165

Chance/Brooks An Introduction to Derivatives and Risk Management, 10th ed. Ch. 3: 33

 X
Problem 4-11
• The following option prices were observed for a stock on July 6 of a
particular year. The stock is priced at 165.13. The expirations are July 17,
October 16, and August 21. The risk-free rates are 0.0516, 0.0550,
and0.0588, respectively. Compute the intrinsic values, time values, and
lower bounds of the following puts. Identify any profit opportunities that
may exist. Treat these as American options
• b. October 160

Chance/Brooks An Introduction to Derivatives and Risk Management, 10th ed. Ch. 3: 34

Problem 4-11
• The following option prices were observed for a stock on July 6 of a
particular year. The stock is priced at 165.13. The expirations are July 17,
October 16, and August 21. The risk-free rates are 0.0516, 0.0550,
and0.0588, respectively. Compute the intrinsic values, time values, and
lower bounds of the following puts. Identify any profit opportunities that
may exist. Treat these as American options
• c. August 170

Chance/Brooks An Introduction to Derivatives and Risk Management, 10th ed. Ch. 3: 35

Principles of Put Option Pricing (continued)

• Put-Call Parity
• Form portfolios A and B where the options are European. See Table 3.11.
• The portfolios have the same outcomes at the options’ expiration. Thus, it
must be true that
• S0 + Pe(S0,T,X) = Ce(S0,T,X) + X(1+r)–T
• This is called put-call parity.
• It is important to see the alternative ways the equation can be arranged and their
interpretations.

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Principles of Put Option Pricing (continued)

 Put-call parity for American options can be stated only as inequalities:

 See Table 3.12 for put-call parity for DCRB options

 See Figure 3.11 for linkages between underlying asset, risk-free bond, call,
and put through put-call parity.

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Problem 13
• Check the following combinations of puts and calls and determine
whether they conform to the put–call parity rule for European
options. If you see any violations, suggest a strategy
• .a. July 155
• b. August 160
• c. October

Chance/Brooks An Introduction to Derivatives and Risk Management, 10th ed. Ch. 3: 38

Problem 13

• Repeat problem 13 using American put–callparity, but do not

suggest a strategy.

Chance/Brooks An Introduction to Derivatives and Risk Management, 10th ed. Ch. 3: 39

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