Chapter 9 Properties of

Stock Options

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Options, Futures, and Other Derivatives 9.1
by John C. Hull
 Notation

• c : European call option • C :American Call option

price price
• p : European put option • P : American Put option
price price
• S0 : Stock price today • ST :Stock price at option
• K :Strike price maturity
• T : Life of option • D: Present value of
• : Volatility of stock dividends during option’s life
price • r : Risk-free rate for
maturity T with cont comp
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John C. Hull
 Factors affecting option prices

• There are six factors affecting the price of a stock option:

• 1. The current stock price S0
• 2. The strike price, K
• 3. The time to expiration, T
• The volatility of the stock price, σ
• The risk free interest rate, r
• The dividends expected during the life of the option

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Options, Futures, and Other Derivatives 9.3
by John C. Hull
 Stock price and strike price

• Call option payoff will be the amount by

which the stock price exceeds the strike price
 Call option is more valuable as stock price
increases and less valuable as the strike price
increases.
• It is opposite to put option

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John C. Hull
 Time to maturity

• Both put and call American options become

more valuable as the time to expiration increases
as the owner of the long life option has all the
exercise opportunities open to the owner of the
short life option and more.
• Although European put and call options usually
become more valuable as the time to expiration
increase, it is not always the case of existing
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Options, Futures, and Other Derivatives 9.5
by John C. Hull
 Volatility
• As volatility increases, the chance that the
stock will do very well of very poorly
increase.
• The owner of options has benefit of favorable
price movement but has limited downside risk
in the event of unfavorable one.
• So value of both calls and puts therefore
increase as volatility increases.
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by John C. Hull
 Risk free interest rate
• Risk free rate increase the expected return
required by investors from the stock (Increase
So).
• It also reduces the future cash flow received
by the holder of the option (Decrease PV of
K).
• Thus, it increases the value of call options and
decrease the value of put.
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Options, Futures, and Other Derivatives 9.7
by John C. Hull
 Amount of future dividends

• Dividends have the effect of reducing the

stock price on the ex dividend date.
• This is bad news for the value of call options
and good news for the value of put options

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Options, Futures, and Other Derivatives 9.8
by John C. Hull
Effect of Variables on Option Pricing

Variable c p C P
S0 + – + –
K – +? – +
T ? + +
σ + + + +
r + – + –
D – + – +
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John C. Hull
American vs European Options

An American option is worth at

least as much as the
corresponding European option
C ≥c
P≥p

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John C. Hull
Upper and lower bounds for option prices

• Upper bounds
Upper bound for call options is stock price. If these relationship
were not true, an arbitrageur could make a riskless profit by
buying a stock and selling the call option.
C ≤ S0 and c ≤ S0
The upper bound for put option is K. For European options, we
know that at maturity the option cannot be worth more than K.
If this were not true, an arbitrageur could make a riskless profit
by writing the option and investing the proceeds of the sale at
the risk free rate.
P ≤ K and p ≤ Ke-rT
9.11
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Lower bound for Calls on Non-dividend-paying
stocks

A lower bound for the price of a European call

option on a non-dividend-paying stock is
S0 – Ke-rT
Because the worst that can happen to a call
option is that it expires worthless, its value
cannot be negative. This means that c ≥ 0
Therefore:
c ≥ max(S0 – Ke-rT, 0)
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 Lower bound for call options
An Arbitrage Opportunity?

• Suppose that
c=3 S0 = 20
T=1 r = 10%
K = 18 D=0

• Is there an arbitrage opportunity?

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John C. Hull
 Lower Bound for European Put Prices; No
Dividends

For the put options that pay no dividend, the lower

bound is
p  Ke -rT–S0
Because the worst that can happen to a put option is that
it expires worthless, its value cannot be negative. This
means that
p  max(Ke -rT–S0, 0)

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Options, Futures, and Other Derivatives 9.14
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Puts: An Arbitrage Opportunity?

• Suppose that
p =1 S0 = 37 T =
0.5 r =5%
K = 40 D =0

• Is there an arbitrage
opportunity?
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 Put-Call Parity; No Dividends
• Consider the following 2 portfolios:
– Portfolio A: European call on a stock + PV of the strike
price in cash
– Portfolio C: European put on the stock + the stock

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 Put-Call Parity; No Dividends

• Both are worth max(ST , K ) at the maturity of

the options
• They must therefore be worth the same today.
This means that

c + Ke -rT = p + S0
This relationship is called the put-call parity
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Options, Futures, and Other Derivatives 9.17
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Arbitrage Opportunities
• Suppose that
c =3 S0 = 31
T = 0.25 r = 10%
K =30 D=0
• What are the arbitrage
possibilities when p
= 2.25 ? p=1?
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John C. Hull
 Early Exercise

• Usually there is some chance that an

American option will be exercised early
• An exception is an American call on a
non-dividend paying stock
• This should never be exercised early

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John C. Hull
 An Extreme Situation

• For an American call option:

S0 = 100; T = 0.25; K = 60; D = 0
Should you exercise immediately?
• What should you do if
you want to hold the stock for the next 3 months?
you do not feel that the stock is worth holding for
the next 3 months?

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John C. Hull
Reasons For Not Exercising a Call Early (No
Dividends)

• No income is sacrificed
• Payment of the strike price is delayed
• Holding the call provides insurance
against stock price falling below strike
price

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John C. Hull
 Should Puts Be Exercised
Early ?

Are there any advantages to

exercising an American put when

S0 = 60; T = 0.25; r=10%

K = 100; D = 0

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John C. Hull
The Impact of Dividends on Lower Bounds to
Option Prices

 rT
c  S 0  D  Ke
 rT
p  D  Ke  S0

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John C. Hull
 Extensions of Put-Call Parity

• American options; D = 0
S0 - K < C - P < S0 - Ke -rT

• European options; D > 0

c + D + Ke -rT = p + S0

• American options; D > 0

S0 - D - K < C - P < S0 - Ke -rT

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Options, Futures, and Other Derivatives by 9.24
John C. Hull