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Unformatted text preview: Option Pricing I by Dr. Fernando Diz Elementary Pricing: Calls ❚ Suppose you own a call option on ABC stock with exercise price of E = $40.0 ❚ Suppose that at expiration ABC is trading at $35.0 ❚ What is the intrinsic value of the option? Elementary Pricing: Calls ❚ What transactions take place if you decide to exercise this option (not sell)? Elementary Pricing: Calls 1 . Advice your broker that you are exercising the option. 2. You pay $40.0 per share, and 3. You receive 100 shares of ABC stock. 4. You sell 100 shares of ABC at $35.0 ❚ What is your payoff after exercising? Elementary Pricing: Calls ❚ What would be the maximum amount an investor would pay for such an option at expiration? ❚ The call value will be zero at expiration if the intrinsic value of the option is negative! Elementary Pricing: Calls ❚ Suppose now ABC is trading at $45.0 a share at expiration. ❚ What is the intrinsic value? ❚ What would the CALL option at most be worth? Elementary Pricing: Calls ❚ At most $5.0 per share! Why? ❚ If I buy the option from you an instant before expiration, I can exercise it immediately. ❚ What would my profit be from doing this? Elementary Pricing: Calls 1. I buy the option at $5.0 per share. 2. I exercise it, so that I pay $40.0 per share and get a share of ABC. 3. I sell a share of ABC at $45.0. ❚ The profit is zero!!! Elementary Pricing: Calls ❚ Total cash flows from the transactions: Transaction Cash Flow Buy one call option @ $5.0 ($5.00) Buy one share of ABC @ $40.0 ($40.00) Sell one share of ABC @ $45.0 $45.00 NET CASH FLOW (profit) $0.00 Elementary Pricing: Calls ❚ What does it mean that I cannot make any profits from this strategy?...
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 Spring '07
 Yildary
 Options, Elementary Pricing

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