1. Option Pricing: basic principles
Definitions
Value bounds
Simple arbitrage relationships
Volatility as Source of Option Value
Finance 30233, Fall 2006
The Neeley School of Business
Texas Christian University
S. Mann
S. Mann, 2006

2. Call Option Valuation "Boundaries"
Value
Option value must be
within this region
Intrinsic Value -
Value of Immediate
exercise: S - K
K S (asset price)
Define:
C[S(0),T;K] =Value of American call option with strike K, expiration date T, and current underlying asset value S(0)
Result proof
1) C[0,T; K] = (trivial)
2) C[S(0),T;K]  max(0, S(0) -K) (limited liability)
3) C[S(0),T;K]  S(0) (trivial)
S. Mann, 2006

3. European Call lower bound (asset pays no dividend)
“Pure time value”:
K - B(0,T)K
Option
Value
Option value must be
within this region
Intrinsic value: S - K
KB(0,T) K S (asset price)
Define: c[S(0),T;K] =Value of European call (can be exercised only at expiration)
value at expiration
position cost now S(T) < K S(T) >K
A) long call + T-bill c[S(0),T;K] + KB(0,T) K S(T) B) long stock S(0) S(T) S(T)
position A dominates, so c[S(0),T;K] + KB(0,T)  S(0)
thus 4) c[S(0),T;K]  Max(0, S(0) - KB(0,T)
S. Mann, 2006

4. Example: Lower bound on European Call
“Pure time value”:
= $1.09
Option
Value
Option value must be
within this region
Intrinsic value:
=S(0) S (asset price)
Example: S(0) =$55. K=$50. T= 3 months. 3-month simple rate=8.9%.
B(0,3) = 1/(1+.089(3/12)) = KB(0,3) = 48.91
Lower bound is S(0) - KB(0,T) = = $6.09.
What if c = $4.00? Value at expiration
position cash flow now S(T)  $50 S(T) > $50
buy call - $ S(T) - $50
buy bill paying K
short stock S(T) S(T)
Total $ S(T) 
S. Mann, 2006

5. American and European calls on assets without dividends
5) American call is worth at least as much as European Call
C[S(0),T;K]  c[S(0),T;K] (proof trivial)
6) American call on asset without dividends will not be exercised early.
C[S(0),T;K] = c[S(0),T;K]
proof:
C[S(0),T;K]  c[S(0),T;K]  S(0) - KB(0,T)
so C[S(0),T;K]  S(0) - KB(0,T)  S(0) - K
and C[S(0),T;K]  S(0) - K
Call is: worth more alive than dead
Early exercise forfeits time value
7) longer maturity cannot have negative value: for T1 > T2:
C(S(0),T1;K)  C(S(0),T2;K)
S. Mann, 2006

6. Call Option Value Option Value lower bound 0 K S
No-arbitrage boundary:
C >= max (0, S - PV(K))
Intrinsic Value:
max (0, S-K)
lower bound
K S
S. Mann, 2006

7. Volatility Value : Call option
Low volatility asset
Call payoff
High volatility asset
K S(T) (asset value)
S. Mann, 2006

8. Volatility Value : Call option
Example:
Equally Likely "States of World"
"State of World" Expected
Position Bad Avg Good Value
Stock A
Stock B
Calls w/ strike=30:
Call on A:
Call on B:
S. Mann, 2006

9. Put Option Valuation "Boundaries"K
Option value must be
within this region
Option
Value
Intrinsic Value -
Value of Immediate
exercise: K - S
K S (asset price)
Define:
P[S(0),T;K] =Value of American put option with strike K, expiration date T, and current underlying asset value S(0)
Result proof
8) P[0,T; K] = K (trivial)
9) P[S(0),T;K]  max(0, K - S(0)) (limited liability)
10) P[S(0),T;K]  K (trivial)
S. Mann, 2006

10. European Put lower bound (asset pays no dividend)
KB(0,T)
Option
Value
Option value must be
within this region
Negative “Pure time value”: KB(0,T) - K
Intrinsic value: K - S
KB(0,T) K S(0)
Define: p[S(0),T;K] =Value of European put (can be exercised only at expiration)
value at expiration
position cost now S(T) < K S(T) >K
A) long put + stock p[S(0),T;K] + S(0) K S(T)
B) long T-bill KB(0,T) K K
position A dominates, so p[S(0),T;K] + S(0)  KB(0,T)
thus 11) p[S(0),T;K]  max (0, KB(0,T)- S(0))
S. Mann, 2006

11. American puts and early exercise
KB(0,T)
Option
Value
Option value must be
within this region
Negative “Pure time value”: KB(0,T) - K
Intrinsic value: K - S
KB(0,T) K S(0)
Define: P[S(0),T;K] =Value of American put (can be exercised at any time)
12) P[S(0),T;K]  p[S(0),T;K] (proof trivial)
However, it may be optimal to exercise a put prior to expiration (time value of money), hence American put price is not equal to European put price.
Example: K=$25, S(0) = $1, six-month simple rate is 9.5%.
Immediate exercise provides $24 ( (6/12)) = $25.14 > $25
S. Mann, 2006