3.3.3 Properties of Options

3. Properties of Options

3.1 Six Factors

$S_0$: current stock price.

$X$: strike price of the option.

$T$: time to expiration of the option.

$r$: short-term risk-free interest rate over $T$.

$D$: present value of the dividend of the underlying stock.

$\sigma$: expected volatility of stock prices over $T$.

Summary of the effect on the price of a stock option of increasing one variable while holding all others factors constant.

Factor	European Call	European Put	Amercian Call	Amercian Put
$S$	+	-	+	-
$X$	-	+	-	+
$T$	?	?	+	+
$\sigma$	+	+	+	+
$r$	+	-	+	-
$D$	-	+	-	+

3.2 Early Exercise

3.2.1 Early Exercise for American Call and Put Options

Underlying stock without dividends

Call options: it is never optimal to exercise early an Amercian call on a non-dividend paying stock.

Put options: it may be optimal to exercise early an Amercian put on a non-dividend paying stock

Underlying stock with dividends ($D_n$) paid at time $t_n$

Call options: it more likely an Amercian call option will be exercised early. Early exercise will be optimal when
$$D_n>X(1-e^{-r(T-t_n)})$$

Put options: it less likely that an Amercian put option will be exercised early. Early exercise will be optimal when
$$D_n<X(1-e^{-r(T-t_n)})$$

3.2.2 Early Exercise for American Call Options

The call option on no-dividends paying underlying should not be exercised before maturity if interest rates are positive.

Early exercising call option would yield a profit equal to intrinsic value. However, selling the option yields a profit of the intrinsic value plus time value.

Deep-ITM call option with dividends may be early exercised. Exercising the option before an ex-dividend date would be the optimal decision.

3.2.3 Early Exercise for American Put Options

The decision to exercise an American put option without dividends is therefore a trade-off between:

• Receiving the strike price early so it can be invested to earn
  interest.
• Benefiting from the optionality in circumstances where the stock price moves above the strike price.

In general, early exercising becomes less attractive to the holder of a put option when:

• Stock price increases
• Interest rate decreases
• Time to maturity increases
• Dividends expected during the life of the option increase.

3.3 Upper&Lower Bounds of Value

Upper and lower bonds without dividend

Option Type	Max	Min
European Call	$S_0$	$\text{Max}(S_0-X{e}^{-rT},0)$
American Call	$S_0$	$\text{Max}(S_0-X{e}^{-rT},0)$
European Put	$X{e}^{-rT}$	$\text{Max}(X{e}^{-rT}-S_0,0)$
Amercian Put	$X$	$\text{Max}(X-S_0,0)$

Upper and lower bonds with dividend

Option Type	Max	Min
European Call	$S_0$	$\text{Max}(S_0-\text{PVD}-X{e}^{-rT},0)$
American Call	$S_0$	- -
European Put	$X{e}^{-rT}$	$\text{Max}(X{e}^{-rT}+\text{PVD}-S_0,0)$
Amercian Put	$X$	- -

3.4 Put-Call Parity

3.4.1 Definition

The relationship between the price of a European call option and that of a European put option with the same strike price and time to maturity.

Portfolio A: a European call option $c_0$ and an amount of cash equals to $PV(X)=X{e}^{-rT}$

Portfolio B: a European put option $p_0$ and one share $S_0$.

At maturity

$$p+S_T=c+X{e}^{-rT}$$

Arbitrage opportunities exist when put-call parity does not hold.

3.4.2 Parity Relationship at Maturity

$S_T>X$, Call will be ITM & Put will be OTM.

$S_T<X$, Call will be OTM & Put will be ITM.

3.4.3 Synthetic Equivalencies

The put-call parity can be rearranged to create synthetic equivalencies. Note: the term “+” means long and “-” means short.

Synthetic call: $c=S+p-X{e}^{-rT}$

Synthetic put: $p=c+X{e}^{-rT}-S$

Synthetic stock: $S=c+X{e}^{-rT}-p$

Synthetic bond: $X{e}^{-rT}=p+S-c$

3.4.4 Put-Call Parity with Dividends

When the underlying asset provide dividends, the parity formula can be derived from portfolio.

Portfolio A: a European call option $c_0$ and an amount of cash equals to $X{e}^{-rT}+\text{PV}(\text{Div})$

Portfolio B: a European put option $p_0$ and one share $S_0$.

$$p+S_T=c+X{e}^{-rT}+\text{PV}(\text{Div})$$

3.4.5 Put-Call Parity with American Options

The inequality relationship between the price of an American call option and that of an American put option with the same strike price and time to maturity is as follow:
$$S_0-X⩽C_0-P_0⩽S_0-X{e}^{-rT}$$