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# Upper and lower bounds on options

#### wrongsaidfred

##### Member
Hi David,

According to Hull, dividends play a role in determining the lower bounds of options prices, but that does not appear in your video. If a question like this arises and the stock provides dividends, should we go by what Hull says?

I also have notes from a class I took that says dividends play a role in the upper bounds of option prices.

It states c (or C) < S-D and p<X*e^-rt+D and P<X+D.

Are these valid or necessary to use on the exam?

Thanks,
Mike

#### David Harper CFA FRM

##### David Harper CFA FRM
Staff member
Subscriber
Hi Mike,

Maybe they should be in my video (dividend's impact is assigned: "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."). Actually, I wish i did have the dividends impact in put-call parity, that really should be in the videos.

It is good to know. Again, "necessary" is impossible to answer given GARP's approach (many AIMs will never be asked). But I regret not addressing this AIM more specifically as this could be tested

I've got:

lower bounds (Hull 9.5 & 9.6)
European c >= S - D - K*exp(-rT)
European p>= D + K*exp(-rT) - S

Put call parity: c + D + K *exp(-rT) = p + S (Hull 9.7)

(
Hull 9.8 is very low testability and not worth the trouble, IMO:
American style with dividends put call parity:
S - D - K <= C- P < S - K *exp(-rT)
)

Thanks, David

#### wrongsaidfred

##### Member

Can I scrap the upper bound effects since I do not see them in Hull anywhere?

I know that there is no way for you to know what is "necessary". All I meant is that it is an extra step that may or may not be necessary in order to get the correct answer.

Thanks again,
Mike

#### David Harper CFA FRM

##### David Harper CFA FRM
Staff member
Subscriber
Hi Mike,

Oh, right, sorry, you have upper bounds. Yes, I agree that upper bounds, with dividends, aren't useful (they have no direct reference in the assigned Hull).

Re: as an extra step: I think what is "in bounds" is the a dividend-paying stock. While low probability exam-wise with respect to lower bound, it has appeared in put call parity (pretty sure that was a question last year or the year before) and possibly with BSM (pricing).

You may note that in all of this cases you can pretty much use this rule: dividends tend to reduce the stock price. So, if you replace (S) with (S-D):

works for lower bound Euro call: replace S - K * exp(-rT) with (S-D) - K*exp(-rT) --> c >= (S-D - K*exp(-rT)
works for lower bound Euro put: replace K * exp(-rT) - S with K*exp(-rT) - (S-D) --> p >= K*exp(-rT) - S +D
put call parity: replace c + K*exp(-rT) = p + S with c + K*exp(-rT) = p + (S - D) --> c + D + K*exp(-rT) = p + D

I hope that helps, David

#### bpdulog

##### Active Member
Hi,

We are not provided with lower bounds on American options in the study notes so I'd like to know what they are?

#### David Harper CFA FRM

##### David Harper CFA FRM
Staff member
Subscriber
Hi @bpdulog See below (from John Hull's OFOD), outlined in red. I agree that I should include this in the next revision. Thanks!

#### luccacerf

##### New Member
Hi @David Harper CFA FRM the upper bound of european put is p<=Xe(-rt) not p<=X. I've noticed this trick error on your notes because there is a question on frm pratice exame (P1.82) that requires this knowledge.

#### gprisby

##### Active Member
Thought I would add to this thread, as I don't see anything on American lower bounds. Question 180.5 also quizzes the American lower bound and I applied the Euro calculation and got it wrong. Let me provide some screenshots to detail my confusion.

Notes I have don't provide lower bound on American options. I also couldn't readily find it in the GARP text book I have...

Question:

180.5. What is the lower bound for the price of a nine (9)-month American PUT option on a non-dividend-paying stock when the stock price is $14.00, the strike price is$20.00, and the risk-free interest rate is 4.0% per annum?

a) zero (0)
b) $5.22 c)$5.41
d) $6.00 Answer.... I discounted the strike and got it wrong! 180.5. D.$6.00
For a European put, the lower bound is p >= K*exp(-rT) - S(0), but

#### San955

##### New Member
Hi @David Harper CFA FRM thank you for your answer! I found out that I should not read the vertical lines from left to right, because at first sight it seems confusing why upper bound is on the left and the lower bound is on the right. Could you give some logic explanation? Also, could I add up one more question why American call option is not optimal to be exercised if interest rates are zero (Hull solution is not much understandable?)

#### David Harper CFA FRM

##### David Harper CFA FRM
Staff member
Subscriber
Hi @San955 Sorry, I don't follow you re the bounds. I drew the green arrow to emphasize a vertical perspective: if you pick a stock price, that is S(0) on the X-axis, then look at the vertical line, the upper bound S(0) is higher than the lower bound. Per the math.

In regard to, why American call option is not optimal to be exercised if interest rates are zero? I'm tired (very long day) so maybe I'm mistaken, but this is not true. Please see https://www.bionicturtle.com/forum/threads/lower-bounds-on-dividend-paying-options.10667/post-52014 It is desirable to early exercise if the PV of dividend is greater than the value of waiting given by K-K*exp(-rT); if the Rf = 0, then the value of waiting is zero; the strike price is the same tomorrow/later as today. For any given dividend (which entices the EE), zero Rf makes early exercise more desirable. Thanks,

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