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Sumit Gulati
Intrinsic Value:-The payoff the holder gets by exercising the option 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} For put option: Max {(X-S),0} The value of call option can never fall below its intrinsic value.For example a call for exercise price of Rs 80 on the underlying stock currently trading at Rs 100 would haveintrinsic value 20.This would be the minimum price at which the call would sell.Any price less than Rs 20 presents an opportunity to make immediate profit without taking any risk.If one buys a call at Rs 19(less than Rs 20) and exercises it immediately, the cash outflow would be Rs 99.But the holder can sell the acquired stock at Rs 100 gaining Re 1 immediately.
Time value:-It is the excess of actual value over intrinsic value. Time value= Actual Price-Intrinsic value
Boundary condition is generally used to calculate the miximum and minimum values of an option.The boundary condition tell that the price of an option should not exceed a particular amount or should not be minimum than a particular amout so calculated. For call option Maximum price of the call option , Minimum price of the call option Where
Cmax= S or C S
, Cmin=S-Xe-rt or c s Xe -rt
For put option A put option as we know is right to sell the underslying security at exercise price X. so the max value to pay is X or Maximum price of the put option
Pmax= Xe
rt
Pmin=Xe-rt -s
Call option with higher strike price would be priced lower than the one with lower strike price. Strike price A B 90 101 call price/premium 25 28
Buyer of call A= 90 Net cash flow Final position of portfolio price (condition) Spot < 90 90< spot< 101 Spot> 101 Cash flow 3 Always positive ( 11+3) 14
-25 3
Status Both call are worthless Call A is ITM and Call B is Worthless Both call are exercised A=(102-90), B=(101-102)
Difference in call or put price can t exceed the difference in strike price Strike price A B 95 101 call price/premium 25 34
Arbitrage opportunity Action Seller of call B =101 Buyer of call A= 95 Net cash flow Final position of portfolio price (condition) Spot < 95 95< spot< 101 Spot> 101 Cash flow 9 Always positive ( 6+9) 15 Status Both call are worthless Call A is ITM and Call B is Worthless Both call are exercised A=(102-95), B=(101-102) Cash flow 34 -25 9
Arbitrage opportunity
Action Seller of put B =101 Buyer of put A= 95 Net cash flow Final position of portfolio price (condition) Spot > 101 95> spot> 101 Spot> 95 Cash flow 9 Always positive ( -6+9) 3
Status Both put are worthless Put B is ITM and Call A is Worthless Both put are exercised A=(95-87), B=(87-101)
Call or put with longer time to maturity must be priced higher than the one with shorter time to maturity. Strike price 65 Action Seller of call with X= 65 ,T=3 m. Buyer of call with X= 65, T= 6m. Net cash flow call t=3 month 22 Cash flow 22 -20 2 call t= 6 month 20
After 3 months (Final position of portfolio ) Price (condition) Spot <65 Spot>65 Cash flow 2 (5+2) 7 Status Call of 3m is worthless Call of 3 month is exercised (70-65)
For put Strike price 65 Action put t=3 month 22 Cash flow put t= 6 month 20
Seller of put with X= 65,T=3 m. Buyer of put with X= 65, T= 6m. Net cash flow After 3 months (Final position of portfolio ) Price (condition) Spot >65 Spot<65 Cash flow 2 (5+2) 7
22 -20 2
Higher the exercise price more valuable is put. Strike price A B Action Seller of the put A=70 Buyer of the put B= 80 Net cash flow Final position of portfolio Price (condition) Spot< 70 70< spot<80 Spot >80 Cash flow (10+3) 13 Always positive 3 Status Both put are ITM A=(65-70),B=(80-65) Put B is ITM of put a is worthless Both put are worth less 70 80 put price/premium 23 20 cash flow 23 -20 3
Example for put call parity Let us take a example and form a portfolio having under mentioned security Buy 1 stock Sell a call for X=100 ,maturity t ,premium p Buy a put for x=100 maturity t premium p
If we examine the position fo this portfolio under various prices of the underlying asset at the time of expiration (from 0 to 200) the total value of the portfolio will remain 100 at all price level. We can also say that: 1. An investor can borrow an amout 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. This portfolio can be said to be equivalent to a bond which matures to the value equal to that of exercise price and whose maturity coincides with the expiry of options.
s-c+p= PV OF X=X/(1+R)=Xe-rt
Pa ca+X.e-rt-s
C+Xe-rt= p+s-De-rt