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Liuren Wu
Zicklin School of Business, Baruch College
Options Markets
Liuren Wu (Baruch)
Payoffs
Options Markets
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A call option gives the holder the right to buy a security. The payoff is
(ST K )+ when exercised at maturity.
A put option gives the holder the right to sell a security. The payoff is
(K ST )+ when exercised at maturity.
Liuren Wu (Baruch)
Payoffs
Options Markets
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More terminologies
Moneyness: the strike relative to the spot/forward level
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More terminologies
The value of an option is determined by
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Out-of-the-money options do not have intrinsic value, but they have time
value.
Time value is determined by time to maturity of the option and the
dynamics of the underlying security.
Generically, we can decompose the value of each option into two
components:
option value = intrinsic value + time value.
Liuren Wu (Baruch)
Payoffs
Options Markets
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Stocks (OMON)
Stock indices
Index return variance (new)
Exchange rate (XOPT)
Futures
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Payoffs
Options Markets
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Expiration date (T )
Strike price (K )
European or American
Call or Put (option class)
OTC options (such as OTC options on currencies) are quoted differently.
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Payoffs
Options Markets
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Liuren Wu (Baruch)
Payoffs
Options Markets
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Liuren Wu (Baruch)
Payoffs
Options Markets
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New developments:
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Margins
A total of 100% of the proceeds of the sale plus 10% of the underlying
share price.
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Payoffs
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Liuren Wu (Baruch)
Payoffs
Options Markets
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Whats your payoff and P&L if the index level reaches 100, 90, or 80 at
the expiry date T ?
If you write this option and have sold it to the exchange, what does your
terminal payoff look like?
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Whats your payoff and P&L if the index level reaches 100, 90, or 80 at
the expiry date T ?
Liuren Wu (Baruch)
Payoffs
Options Markets
12 / 34
30
30
20
20
10
10
20
10
20
70
80
90
100
Spot at expiry, ST
110
30
60
120
30
30
20
20
30
60
10
10
10
20
30
60
70
80
90
100
Spot at expiry, ST
110
120
70
80
90
100
Spot at expiry, ST
110
120
10
10
20
70
80
90
100
Spot at expiry, ST
110
120
30
60
Long a call pays off, (ST K ) , bets on index price going up.
Shorting a call bets on index price going down.
Liuren Wu (Baruch)
Payoffs
Options Markets
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Liuren Wu (Baruch)
Payoffs
Options Markets
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Long a put option pays off, (K ST )+ , and bets on the underlying currency
(pound) depreciates.
Shorting a put option bets on pound appreciates.
How does it differ from betting using forwards?
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Payoffs
Options Markets
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0.5
0.5
0.4
0.4
0.3
0.3
0.2
0.1
0
0.1
0.2
0.1
0
0.1
0.2
0.3
0.3
0.4
0.4
0.5
1
0.5
1.2
1.4
1.6
Spot at expiry, ST
1.8
0.5
0.5
0.4
0.4
0.3
0.3
0.2
0.2
0.1
0
0.1
0.2
1.8
1.2
1.4
1.6
Spot at expiry, ST
1.8
0.1
0
0.1
0.2
0.3
0.4
0.4
1.4
1.6
Spot at expiry, ST
0.2
0.3
0.5
1.2
0.5
1.2
Liuren Wu (Baruch)
1.4
1.6
Spot at expiry, ST
1.8
Payoffs
Options Markets
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120
15
115
10
10
110
105
100
95
10
10
90
15
15
20
80
85
90
95
100
105
Spot at expiry, ST
110
115
20
80
120
85
85
90
95
100
105
Spot at expiry, ST
110
115
80
80
120
20
20
80
15
15
85
10
10
90
105
10
110
15
15
85
90
95
100
105
Spot at expiry, ST
Liuren Wu (Baruch)
110
115
120
20
80
90
95
100
105
Spot at expiry, ST
110
115
120
95
100
105
Spot at expiry, ST
110
115
120
100
10
20
80
85
95
Payoff
Payoff
Payoff
20
15
Payoff
20
Payoff
Payoff
115
85
90
95
100
105
Spot at expiry, ST
Payoffs
110
115
120
120
80
85
90
Options Markets
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Put-call conversions
Plot the payoff function of the following combinations of calls/puts and forwards
at the same strike K and maturity T .
1
Liuren Wu (Baruch)
Payoffs
Options Markets
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15
15
15
10
10
10
Payoff
20
10
10
10
15
15
20
80
85
90
95
100
105
Spot at expiry, ST
110
115
20
80
120
15
85
90
95
100
105
Spot at expiry, ST
110
115
20
80
120
15
15
15
10
10
10
Payoff
20
0
5
10
10
10
15
15
90
95
100
105
Spot at expiry, ST
110
115
120
20
80
95
100
105
Spot at expiry, ST
110
115
120
110
115
120
85
90
20
20
80
85
20
Payoff
Payoff
20
Payoff
Payoff
1
20
15
85
90
95
100
105
Spot at expiry, ST
110
115
120
20
80
85
90
95
100
105
Spot at expiry, ST
The dash and dotted lines are payoffs for the two composition instruments.
The solid lines are payoffs of the target.
Liuren Wu (Baruch)
Payoffs
Options Markets
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Liuren Wu (Baruch)
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pt = e r (T t) (K Ft,T )+ + TVt .
Call and put at the same maturity & strike (T , K ) have the same time.
Most option pricing models only deal with the time value, and take the
forward (financing) and hence intrinsic value as given (starting point).
To estimate these option pricing models, one only needs to use the time
value at each (T , K ), which is the out-of-the-money option (call when
Ft < K and put otherwise).
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Liuren Wu (Baruch)
Payoffs
Options Markets
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Liuren Wu (Baruch)
Payoffs
Options Markets
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Payoff
5
0
5
10
15
20
80
85
90
95
100
105
Spot at expiry, ST
110
115
120
Can you generate the above payoff structure (solid blue line)
using (in addition to cash/bond):
two calls
two puts
a call, a put, and a stock/forward
Who wants this type of payoff structure?
Liuren Wu (Baruch)
Payoffs
Options Markets
23 / 34
30
20
20
25
15
15
20
10
15
10
10
15
10
20
15
25
85
90
95
100
105
Spot at expiry, ST
Liuren Wu (Baruch)
110
115
120
20
80
10
Payoff
Payoff
Payoff
30
80
0
5
10
15
20
85
90
95
100
105
Spot at expiry, ST
Payoffs
110
115
120
25
80
85
90
95
100
105
Spot at expiry, ST
110
115
120
Options Markets
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Payoffs
Options Markets
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Starting from the right side of the payoff graph at the highest strike
under which there is a slope change. Let this strike be K1 .
Liuren Wu (Baruch)
Payoffs
Options Markets
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Payoff
5
0
5
10
15
20
80
85
90
95
100
105
Spot at expiry, ST
110
115
120
How many (at minimum) options do you need to replicate the bear spread?
Do the exercise, get familiar with the replication.
Who wants a bear spread?
Liuren Wu (Baruch)
Payoffs
Options Markets
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Example: Straddle
30
25
20
Payoff
15
10
5
0
5
10
80
85
90
95
100
105
Spot at expiry, ST
110
115
120
How many (at minimum) options do you need to replicate the straddle?
Do the exercise, get familiar with the replication.
Who wants long/short a straddle?
Liuren Wu (Baruch)
Payoffs
Options Markets
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Example: Strangle
40
35
Payoff
30
25
20
15
10
80
85
90
95
100
105
Spot at expiry, ST
110
115
120
How many (at minimum) options do you need to replicate the strangle?
Do the exercise, get familiar with the replication.
Who wants long/short a strangle?
Liuren Wu (Baruch)
Payoffs
Options Markets
29 / 34
Payoff
10
5
0
5
10
15
20
80
85
90
95
100
105
Spot at expiry, ST
110
115
120
How many (at minimum) options do you need to replicate the butterfly
spread?
Do the exercise, get familiar with the replication.
Who wants long/short a butterfly spread?
Liuren Wu (Baruch)
Payoffs
Options Markets
30 / 34
10
10
Payoff
Payoff
8
10
80
8
85
90
95
100
105
Spot at expiry, ST
110
115
120
10
80
85
90
95
100
105
Spot at expiry, ST
110
115
120
How many (at minimum) options do you need to replicate the risk reversal?
Do the exercise, get familiar with the replication.
Who wants long/short a risk reversal?
Liuren Wu (Baruch)
Payoffs
Options Markets
31 / 34
Payoff
250
200
150
100
50
0
80
85
90
95
100
105
Spot at expiry, ST
110
115
120
Liuren Wu (Baruch)
Payoffs
Options Markets
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f (Ft )
bonds
+f(0 (Ft )(ST Ft )
forwards
)
R Ft 00
+
(K
)(K
S
)
dK
f
T
+ R0 00
OTM options
f (K )(ST K )+ dK
Ft
Payoffs
Options Markets
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Replication applications
Replicate the return variance swap using options and futures.
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Information
Information
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Information
about
about
about
about
Examples:
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Payoffs
Options Markets
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