Lecture 2: Option

valuation
preliminaries

J. R. Zhang

Call/Put Option
Payoff Diagram

Option
Lecture 2: Option valuation preliminaries Terminology

Option valuation
preliminaries
Time Value and
Zero-coupon Bond
J. R. Zhang Upper/Lower
bounds on Option
Values
Department of Computer Science
The University of Hong Kong

Comp 7405, 2014

 Lecture 2: Option
Outline valuation
preliminaries

J. R. Zhang

Call/Put Option
Payoff Diagram

Call/Put Option Payoff Diagram Option

Terminology

Option valuation
preliminaries
Option Terminology Time Value and
Zero-coupon Bond

Upper/Lower
bounds on Option
Values
Option valuation preliminaries
Time Value and Zero-coupon Bond

Upper/Lower bounds on Option Values

 Lecture 2: Option
Call/Put Option Payoff Diagram for Holder valuation
preliminaries

J. R. Zhang

Hockey Sticks Call/Put Option

Payoff Diagram
I At T , the call option payoff is max(S(T ) − K , 0). Option
Terminology
I At T , the put option payoff is max(K − S(T ), 0).
Option valuation
preliminaries
I The payoff diagrams can be plotted: Time Value and
Zero-coupon Bond

Upper/Lower
bounds on Option
Values

I Due to their shapes, they are often referred to as (ice)

hockey sticks.
 Lecture 2: Option
Option Terminology valuation
preliminaries
Let S(t) be the current asset price, K be the strike price. J. R. Zhang
I Intrinsic value: the maximum of zero and the value of
Call/Put Option
the option would have if it were exercised immediately. Payoff Diagram

( Option
Terminology
max(S(t) − K , 0), for a call option,
Intrinsic value = Option valuation
max(K − S(t), 0), for a put option. preliminaries
Time Value and
Zero-coupon Bond

I In the money option: Upper/Lower

bounds on Option
( Values
In the money call option : S(t) > K ,
In the money put option : S(t) < K .

I At the money option: S(t) = K ;

I Out of the money option:
(
Out of the money call option : S(t) < K ,
Out of the money put option : S(t) > K .
 Lecture 2: Option
Time Value valuation
preliminaries

I Cashflows (payments) taking place at different times J. R. Zhang

cannot be directly compared. Call/Put Option

I If I have $100 today, I can put it in an interest-bearing Payoff Diagram

Option
account, and the account will (typically) have more Terminology
than $100 in a year’s time. Option valuation
preliminaries
I For example, if the interest rate from the account is 1% Time Value and
Zero-coupon Bond
for 1-year deposit, I can receive $101 in a year. Upper/Lower
bounds on Option
I Mathematically, suppose an interest-bearing account Values
pays an annual interest rate of r compounding m
periods per year.
I It means the account gives m interest payments per
year, and each time the interest rate is mr .
I If we deposit some money D0 in this account, then in t
years, the money in this account is worth
 r mt
D(t) = D0 × 1 + (1)
m
 Lecture 2: Option
Present Value valuation
preliminaries

J. R. Zhang
I If the compounding frequency m −→ ∞, the interest
Call/Put Option
rate r is continuously compounded, and Payoff Diagram

Option
 r m Terminology
D(t) = D0 e rt , since lim 1 + = er (2)
m→∞ m Option valuation
preliminaries
Time Value and
I To receive money P from this account in t years, now Zero-coupon Bond

Upper/Lower
you need to deposit bounds on Option
Values

P(0) = Pe −rt . (3)

P0 is the present value of the payment P at time t.

I Transferring from P to Pe −rt is called discounting for
interest rate.
I To compare the payments happening at different times,
we need to look at their present values.
 Lecture 2: Option
Continuously Compounded Interest Rate valuation
preliminaries

J. R. Zhang

Call/Put Option
Payoff Diagram

I In this course, we always work with continuously Option

Terminology
compounded interest rates. Option valuation
preliminaries
I If D(t) grows at a continuously compounded interest Time Value and

rate r , that is, D(t) = e rt D(0). It is trivial to see that Zero-coupon Bond

Upper/Lower
bounds on Option
Values
dD(t) = rD(t)dt. (4)

I From (4), over a small time interval δt, we have

D(t+δt)−D(t) ≈ rD(t)δt =⇒ D(t+δt) ≈ D(t)(1+r δt).

 Lecture 2: Option
Zero-coupon Bond valuation
preliminaries

J. R. Zhang

Definition Call/Put Option

Payoff Diagram

I A zero-coupon bond is a contract that promises to pay Option

Terminology
a specified amount at some point in the future. Option valuation
preliminaries
I “Zero coupon” means the bond does not pay periodic Time Value and
Zero-coupon Bond
coupons. Upper/Lower
bounds on Option
I Putting money in an interest-bearing account (with no Values

possibility of early withdrawal) is equivalent to investing

it in zero-coupon bonds.
I For example, if a zero-coupon bond paying out $1 in a
year’s time costs $0.80 today, then my $100 will buy
125 of these bonds today. In one year they will pay out
$125.
 Lecture 2: Option
Zero-coupon Bond valuation
preliminaries

J. R. Zhang
Implied Interest Rate
Call/Put Option
Payoff Diagram
I Present (or future) value can be computed by using
Option
zero-coupon bonds. For example, if B0T is the price Terminology

today of a bond paying $1 at time T , then B0T is the Option valuation

preliminaries
present value of $1 at time T , and 1/B0T is the future Time Value and
Zero-coupon Bond
value at time T of $1 today. Upper/Lower
bounds on Option
I Given the present value of a zero-coupon bond, we can Values

calculate the implied continuously compounded interest

rate r .
I For a zero-coupon bond that pays BTT at maturity time
T , from Equations (2) and (3), we have

BTT
 
1
BTT = B0T e rT =⇒ r = ln (5)
T B0T
 Lecture 2: Option
Interest Rate valuation
preliminaries

J. R. Zhang

Risk-free Interest Rate Call/Put Option

Payoff Diagram
I In option valuation theory, there is an important term Option
Terminology
“risk-free interest rate”.
Option valuation
I It is essentially means the interest rate from a risk-free preliminaries
Time Value and
zero coupon bond. Here “risk-free” means the there is Zero-coupon Bond

no risk of financial loss from holding the bond. Upper/Lower

bounds on Option
Values
I In practice, the interest rate is actually a function of
time, so it is an interest rate curve, not a single number.
I Also it can be quite complicated to determine the risk
free interest rate, especially after the financial crisis.
I Nevertheless, in this course, we assume that the interest
rate is a flat number and that it can always be observed
from the market.
 Lecture 2: Option
Interest rate valuation
preliminaries

J. R. Zhang
In this course, we make the following assumptions about the
risk-free interest rate: Call/Put Option
Payoff Diagram
I the fixed interest rate r prevails whenever cash is lent or Option
Terminology
borrowed.
Option valuation
preliminaries
I the fixed interest rate r applies whatever amount of Time Value and
Zero-coupon Bond
cash is involved,
Upper/Lower
I the fixed interest rate r is always positive. bounds on Option
Values

With these assumptions, if somebody were to make you the

offer of
(a) $100e −rt immediately (time t = 0), or
(b) $100 at time t.
then you would regard both offers as being of equal value.
Similarly, a deal that is guaranteed to produce exactly $100
at time t is worth exactly $100e −rt at time zero.
 Lecture 2: Option
Short selling valuation
preliminaries

J. R. Zhang
Portfolio
Call/Put Option
We use the term portfolio to describe a combination of Payoff Diagram

(i) assets, Option

Terminology
(ii) options, and Option valuation
preliminaries
(iii) cash (invested in a bank). Time Value and
Zero-coupon Bond

We assume that it is possible to hold negative amounts of Upper/Lower

bounds on Option
each. Specifically, Values

I How to hold negative amount of cash? Easy! borrow

money from a bank!
I How to hold negative amount of options? Easy! write
an option!
I How to hold negative amount of assets? Sounds a bit
ridiculous! In practice, be implemented through short
selling.
 Lecture 2: Option
Short selling valuation
preliminaries

Definition J. R. Zhang

Short selling means you sell something you don’t really own. Call/Put Option
Payoff Diagram
To short sell an asset, you first borrow it from somebody
Option
who owns it, and later buy it back and return it. Terminology

Option valuation
preliminaries
Let S(t) denote the value of an asset at time t. We Time Value and
Zero-coupon Bond
I borrowed a share from somebody, and gained an Upper/Lower
amount S(t1 ) at time t = t1 from the short sale, bounds on Option
Values
I paid out an amount S(t2 ) at time t = t2 to buy back
the share, and returned it to the owner at t = t2 .
Then the overall profit/loss at time t = t2 from the short
selling is
PnL = e r (t2 −t1 ) S(t1 ) − S(t2 ). (6)
In this course, we assume that this is always possible, at no
cost, and that the short seller is free to choose when to buy
back and return the item.
 Lecture 2: Option
No arbitrage principle valuation
preliminaries

J. R. Zhang

Definition Call/Put Option

Payoff Diagram
I No arbitrage is one of the key principles on which Option
option valuation theory rests. There are different ways Terminology

Option valuation
to describe it, but the basic idea is the same. preliminaries
Time Value and
I Essentially, it means that one cannot make money for Zero-coupon Bond

nothing. No free lunch! Upper/Lower

bounds on Option
Values

An example
Let’s consider an example in foreign exchange.
I Suppose 1 pound (GBP) is worth 1.6 U.S. dollars and 1
U.S. dollar is worth 100 Japanese yen.
I How many yen is a pound worth? It has to be worth
exactly 160 yen. Why?
 Lecture 2: Option
No arbitrage principle: An Example valuation
preliminaries

J. R. Zhang
I If 1 pound is worth more than 160 yen, suppose we
Call/Put Option
start with 1 pound. We take the following actions: Payoff Diagram
I Sell this one pound for yen (> 160 yen), Option
Terminology
I Then sell these yen for dollars (> 1.6 dollars),
Option valuation
I Finally sell the dollars for pounds ( > 1 pound). preliminaries
I We end up more pounds than we started with. Time Value and
Zero-coupon Bond
I We keep on doing the same thing as long as we can. Upper/Lower
I This process is called taking advantage of an arbitrage bounds on Option
Values
opportunity.
I This process will cause the arbitrage opportunity
disappear due to supply and demand.
I Specifically, buying yen will drive the exchange rate
pound/yen down (i.e. 1 pound worth less yen), buying
dollars will drive the yen/dollar rate down, and so on.
I If 1 pound is worth less than 160 yen, we take the
opposite actions.
 Lecture 2: Option
No arbitrage principle valuation
preliminaries

J. R. Zhang

Call/Put Option
Payoff Diagram
I Due to the above actions from market participants, the Option
Terminology
arbitrage opportunity will be short-lived.
Option valuation
I In real market, arbitrage opportunities can exist but will preliminaries
Time Value and
generally be very small and disappear quickly. Zero-coupon Bond

Upper/Lower
I In the mathematical finance theory, it is therefore bounds on Option
Values
convenient to assume that there is no arbitrage.
I From another perspective, our job is to find the fair
price in an arbitrage-free market. If the observed price
from the market is not in agreement, then we know
there is an arbitrage opportunity to be exploited.
 Lecture 2: Option
Call-Put Parity valuation
preliminaries

J. R. Zhang

I A beautiful relationship between the value C0T of a Call/Put Option

Payoff Diagram
European call and the value P0T of a European put, Option
Terminology
with the same strike price K and expiry date T . Let r
Option valuation
be the risk-free rate and S(0) be the asset price now, preliminaries
Time Value and
then we have Zero-coupon Bond

Upper/Lower

C0T + Ke −rT = P0T + S(0)

bounds on Option
(7) Values

This equation is called call-put parity.

I The relationship doesn’t rely on assumptions on the
movement of the underlying asset.
I We apply the “no arbitrage” rule to derive the
relationship.
 Lecture 2: Option
Call-Put Parity valuation
preliminaries

Proof J. R. Zhang

I Consider two portfolios at time t = 0 Call/Put Option

Payoff Diagram
πA : one call option plus Ke −rT risk-free Option
zero-coupon bond, Terminology

Option valuation
πB : one put option plus one unit of the asset. preliminaries
Time Value and
I It is trivial to see that at time t = 0 Zero-coupon Bond

( Upper/Lower

πA is worth C0T + Ke −rT , bounds on Option

Values

πB is worth P0T + S(0).

I At the expiry date T , we have


Call option bond

 z }| { z}|{
π : max(S(T ) − K , 0) + K

= max(S(T ), K ),
A

 πB : max(K − S(T ), 0) + S(T ) = max(S(T ), K ).

 | {z } | {z }
Put option asset
 Lecture 2: Option
Call-Put Parity valuation
preliminaries

J. R. Zhang

Proof Call/Put Option

Payoff Diagram
I Since the two portfolios always give the same payoff at Option
time T , they must have the same value at time t = 0. Terminology

Otherwise, there would be arbitrage opportunities. Option valuation

preliminaries
Time Value and
I To see why, let’s first assume that πA is worth more Zero-coupon Bond

than πB , then we would sell πA and buy πB and we Upper/Lower

bounds on Option
would pocket some money πA − πB right away. At Values

maturity T , since the payout we receive from πB equals

the payout we give for πA , we do not gain or lose
anything.
I We have made some money without taking any risk!
I Similar argument applies if πB is worth more than πA .
I Hence C0T + Ke −rT = P0T + S(0).
 Lecture 2: Option
Upper/Lower bounds on Option Values valuation
preliminaries

J. R. Zhang
Bounds for Calls on Non-Dividend-Paying Stocks
Call/Put Option
Payoff Diagram
I C0T ≥ max(S(0) − Ke −rT , 0),
Option
I CT ≤ S(0). Terminology
0
Option valuation
preliminaries
To give an example, let’s prove the first inequality. Since the Time Value and
call option cannot have a negative value, we only need to Zero-coupon Bond

Upper/Lower
prove bounds on Option

C0T ≥ S(0) − Ke −rT .

Values

Proof
I Consider two portfolios at time t = 0,
πA : one call option plus Ke −rT risk-free
zero-coupon bond,
πB : one unit of the asset.
 Lecture 2: Option
Upper/Lower bounds on Option Values valuation
preliminaries

J. R. Zhang
Proof
Call/Put Option
Payoff Diagram
I At time t = 0
Option
( Terminology
πA is worth C0T + Ke −rT , Option valuation
preliminaries
πB is worth S(0). Time Value and
Zero-coupon Bond

Upper/Lower
I At the expiry date T , we have bounds on Option
Values
(
πA : max(S(T ), K ),
πB : S(T ).

I The payoff for πA is never less than the payoff for πB .

By “no arbitrage principle”, at time t = 0, the value of
πB is no less than the value of πB , which means
C0T + Ke −rT ≥ S(0) ⇒ C0T ≥ S(0) − Ke −rt .
 Lecture 2: Option
Upper/Lower bounds on Option Values valuation
preliminaries

Bounds for Puts on Non-Dividend-Paying Stocks J. R. Zhang

P0T ≥ max(Ke −rT − S(0), 0),

Call/Put Option
I Payoff Diagram

I P0T ≤ Ke −rT . Option

Terminology
I Prove these inequalities as exercises. Option valuation
preliminaries
Time Value and
Zero-coupon Bond

European Call Value and Maturity T Upper/Lower

bounds on Option
Values
I Consider two European call options with expiry dates
T1 and T2 , T2 > T1 . They have the same strike price
K . Then
C0T1 < C0T2
.
I Formally speaking, the time-zero value of a European
call option on a non-dividend-paying asset, C0T , is
non-decreasing as a function of the expiry date T .
 Lecture 2: Option
European Call Value and Maturity T valuation
preliminaries

Proof J. R. Zhang

Let’s look at what would happen at time t = T1 . Call/Put Option

Payoff Diagram
I At T1 , the stock price is S(T1 ).
Option
I The first option matures, and the payoff from it is Terminology

Option valuation
preliminaries
max(S(T1 ) − K , 0). Time Value and
Zero-coupon Bond

Upper/Lower
I The second option has not matured yet. Let’s denote bounds on Option
Values
its value by CTT12 .
I The second option can be seen as a new call option
starting from T1 and maturing at T2 with strike K . Its
time to maturity is T2 − T1 .
I From the upper bound on call option,

CTT12 ≥ max(S(T1 ) − Ke −r (T2 −T1 ) , 0)

> max(S(T1 ) − K , 0)
 Lecture 2: Option
European Call Value and Maturity T valuation
preliminaries

J. R. Zhang

Call/Put Option
Payoff Diagram

Proof (continued) Option

Terminology

Option valuation
I At T1 , the second option is definitely worth more than preliminaries
Time Value and
the first option. Zero-coupon Bond

Upper/Lower
I By no arbitrage principle, at t = 0, the second option bounds on Option
Values
must also be more valuable than the first one.
I The text book has a slightly more complicated proof
without using the upper bound result.
I Learn the proof yourself.
 Lecture 2: Option
No arbitrage Principle valuation
preliminaries

J. R. Zhang

Call/Put Option
Payoff Diagram
Let’s formalize our arguments used in the above proof and
Option
put them in a theorem. Terminology

Option valuation
Theorem preliminaries

If portfolios A and B are such that in every possible state of Time Value and
Zero-coupon Bond

the market at time T , portfolio A is worth at least as much Upper/Lower

bounds on Option
as portfolio B, then at any time t < T portfolio A is worth Values

at least as much as portfolio B.

If in addition, portfolio A is worth more than portfolio B in

some states of the market, then at any time t < T , portfolio
A is worth more than portfolio B.
 Lecture 2: Option
Forward Contract valuation
preliminaries

J. R. Zhang

I A forward contract is an agreement between two parties Call/Put Option

Payoff Diagram
to buy or sell an asset at a certain time in future Option
(delivery date/maturity) for a certain price (delivery Terminology

price). Option valuation

preliminaries
Time Value and
I It costs nothing for anyone to enter into a forward Zero-coupon Bond

contract, i.e. the price of the forward contract is zero. Upper/Lower

bounds on Option
Values
I The party who agrees to buy the underlying asset is
taking a long position; the other party who agrees to
sell the underlying asset is taking a short position.
I Forward contracts differ slightly from futures contracts,
which are normally traded on an exchange. Find out the
differences between forward contracts and futures
contracts yourself.
 Lecture 2: Option
Forward Contract valuation
preliminaries

J. R. Zhang
Example
On January 1, the forward price of one HSBC share is $90, Call/Put Option
Payoff Diagram
to be delivered in June. Contract size is 100 shares. If Option
investor ABC buys one such contract, she agrees to buy 100 Terminology

HSBC shares in June at a price of $90 per share. She is now Option valuation
preliminaries
taking a long position. Time Value and
Zero-coupon Bond

Scenario 1: Suppose that the share price of HSBC $90.5 in Upper/Lower

bounds on Option
June. Then ABC uses $9000 (= $90 × 100) to Values

buy 100 shares rather than using $9050

(= $90.5 × 100). The profit-and-loss (P/L) is
9050 − 9000 = $50.
Scenario 2: Suppose that the share price of HSBC is $80 in
June. Then ABC is obligated to use $9000 to
buy 100 shares rather than using $8000
(= $80 × 100). The P/L is
8000 − 9000 = −$1000.
 Lecture 2: Option
Fair Delivery Price valuation
preliminaries

J. R. Zhang
I A natural question is “how do we determine the delivery
Call/Put Option
price for expiry time T ?”. Payoff Diagram

I Let K be the delivery price of the forward contract, Option

Terminology
then the payoff at maturity T for a long position is Option valuation
preliminaries
Time Value and
S(T ) − K (8) Zero-coupon Bond

Upper/Lower
bounds on Option
I As mentioned before, it costs nothing for anyone to Values

enter into a forward contract, i.e., the initial value of a

forward contract at time t = 0 is always 0.
I It can be proved that, for non-dividend-paying stocks,
to make the forward contract have 0 value at t = 0, K
must satisfy
K = S(0)e rT , (9)
where r is the risk-free rate.