P1.T3. Hull, Chapter 10. Bionic Turtle FRM Video Tutorials. By: David Harper CFA, FRM, CIPM

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1 P1.T3. Hull, Chapter 1 Bionic Turtle FRM Video Tutorials By: David Harper CFA, FRM, CIPM Note: This tutorial is for paid members only. You know who you are. Anybody else is using an illegal copy and also violates GARP s ethical standards. 1

2 Agenda Hull, Options, Futures, and Other Derivatives, 8th Edition Chapter 1: Properties of Stock options 2

3 Related Learning Spreadsheets Workbook Exam Relevance (XLS not topic) T3. Hull. 1.Options High 1.Put-call parity Note: If you are unable to view the content within this document we recommend the following: MAC Users: The built-in pdf reader will not display our non-standard fonts. Please use adobe s pdf reader ( PC Users: We recommend you use the foxit pdf reader ( or adobe s pdf reader ( Mobile and Tablet users: We recommend you use the foxit pdf reader app or the adobe pdf reader app. All of these products are free. We apologize for any inconvenience. If you have any additional problems, please Suzanne at suzanne@bionicturtle.com. 3

4 Hull, Chapter 1: Properties of Stock Options 4

5 Identify the six factors that affect an option's price for both European and American options. Directional Impact of Each Input on Call or Put Factor Symbol Call Put Stock price ( ) S + - Strike price ( ) X - + Time to expire ( ) T + (American) (European) Volatility ( ) + + Risk-free rate ( ) r + - Div. yield ( ) D (American) (European) 1 2 c S N( d ) Ke N( d ) 5

6 Identify, interpret and compute upper and lower bounds for option prices. Upper Bounds c S C S p X P X Lower bound for European CALL non-dividend paying stock: c max( S Ke,) Lower bound for European PUT on non-dividend paying stock: p max( Ke S,) 6

7 Explain put call parity c Ke p S c p Ke S 7

8 Explain put call parity Call (c) $1 Bond (K) $1 c Ke p S c p S Put (p) $1 Stock (S ) $1 Ke Stock increases to $13. Call (c) $3 Put (p) $ Bond (K) $1 Stock (S ) $13 Both portfolios = $13 8

9 Explain put call parity c Ke p S Call (c) $1 Bond (K) $1 Put (p) $1 Stock (S ) $1 Stock decreases to $7. Call (c) $ Put (p) $3 Bond (K) $1 Stock (S ) $7 Both portfolios = $1 9

10 Explain put call parity Ex 1.1 Ex 1.2 Stock $51. $38. Strike $5. $4. Riskfree rate 12% 1% T.5.25 Volatility 2% 2% Scenarios (Future Payoffs) Stock goes up to $6 $45 Long call + lend strike $6. $45. Protective put $6. $45. Stock goes down to $4 $35 Long call + lend strike $5. $4. Protective put $5. $4. Lower Bound, Call $3.91 -$1.1 Lower Bound, Put -$3.91 $1.1 d1.64 (.21) d2.49 (.31) Call (c) $5.15 $1.8 Put (p) $1.24 $2.9 Put-Call Parity Discounted Strike $47.9 $39.1 Long call $5.15 $1.8 c + K*EXP[-rT] $52.24 $4.9 Stock $51. $38. Long put $1.24 $2.9 S + p $52.24 $4.9 1

11 the value of a European and American option, respectively. c Ke p S c p S Ke S K C P S Ke 11

12 Explain the early exercise features of American call and put options American option: can be exercised before expiration (early exercise) A European option can only be exercised on the expiration date itself Value [American option] Value [European option] 12

13 Explain the early exercise features of American call and put options on a non dividend paying stock and the price effect early exercise may have. When is it optimal to exercise early (an American option)? Without Dividends Call Call without dividends: Never early Put Put without dividends: Often Early With Dividends Call with dividends: immediately before exdividend Put with dividends: Often Early 13

14 and the price effect early exercise may have. (From a mathematical standpoint) It is never optimal to early exercise an American call option on a non-dividend paying stock. But it can be optimal to early exercise an American put In general, we can say that for an American put, the early exercise becomes more attractive as: Stock price (S ) decreases, Risk-free (r) rate increases, and/or Volatility ( ) decreases. 14

15 Discuss the effects dividends have on the put call parity, the bounds of put and call option prices, and on the early exercise feature of American options. Put call parity applies to European options (note the use of small c and small p in the equation). Add Dividends Where D is the present value of dividends during the life of the option: c Ke p S c D Ke p S 15

16 Discuss the effects dividends have on the put call parity, the bounds of put and call option prices, and on the early exercise feature of American options. The difference between an American call and an American put (C P) is bounded by the following: S K C P S Ke S D K C P S Ke 16

17 End of P1.T3. Hull, Chapter 1 Visit us on the 17