- CFA Exams
- 2016 Level II > Study Session 17. Derivative Investments: Options, Swaps, and Interest Rate and Credit Derivatives > Reading 49. Option Markets and Contracts
- 9. The effect of the underlying asset's cash flows

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**Subject 9. The effect of the underlying asset's cash flows**

Recall that:

- c
_{T}= Max {0, S_{T}- X} - p
_{T}= Max {0, X - S_{TM}}

Anything that affects the underlying price at expiration will affect the price of the option. For example, dividends that might be paid during the life of a stock option can obviously affect the stock price.

- We may regard a dividend as a repayment of a portion of the share's value to the shareholder.
- As such, we would expect the stock price to fall by the amount of the dividend payment.
- As a metaphor, we might think of the dividend on a stock as a leakage of value from the stock.

A drop in the underlying price due to a cash flow will have:

- An adverse effect on the price of a call.
- A beneficial effect on the price of a put.

To adjust for cash flows of the underlying, we will simply use S

_{0}- PV(CF, 0, T) in the Black-Scholes-Merton model instead of S_{0}, where PV(CF, 0, T) is the present value of the cash flows on the underlying over the life of the option.As an example, consider call and put options with a common exercise price of $100 and 150 days until expiration. Assume that the underlying stock trades for $102, and that you expect the stock to pay a $3 dividend in 90 days. The continuously compounded interest rate is 9%, and the standard deviation for the stock is 0.30.

The present value of the $3 dividend is: $3 e

^{-r (90/365)}= $2.93.According to this technique, we reduce the stock price now by the present value of the dividend, giving an adjusted stock price of $99.07. We then apply the Black-Scholes-Merton model in the usual way, except we use the adjusted stock price of $99.07 instead of the current price of $102. The following table shows the results of applying the adjusted and unadjusted models to the call and the put.

The difference in prices is substantial, amounting to almost 20%. Also, as we hypothesized, subtracting the present value of the dividends from the stock price reduces the value of the call and increases the value of the put.

#### Practice Question 1

Use the Black-Scholes-Merton model adjusted for cash flows on the underlying to calculate the price of a call option.The underlying price: 125.

The exercise price: 100.

The continuously compounded risk-free rate: 5.25%.

The time to expiration: 2 years.

Volatility: 0.3.

The continuously compounded dividend yield is 2%.Correct Answer: 36.38

Adjust the price of the underlying to S

_{0}= 125

^{e -0.02 (2.0)}= 120.1.

d

_{1}= {ln(120.1/100) + [0.0525 + (0.3)

^{2}/2] 2.0} / [0.3 (2.0)

^{1/2}] = 0.89132.

d

_{2}= 0.89132 - 0.3 (2.0)

^{1/2}= 0.4671.

N(d

_{1}) = N(0.89132) = 0.8133.

N(d

_{2}) = N(0.4671) = 0.6808.

c = 120.1 x 0.8133 - 100

^{e-0.0525 (2)}x 0.6808 = 36.38.

#### Practice Question 2

A put expires in 150 days and has an exercise price of $100. The underlying stock is worth $105 and has a standard deviation of 0.2. The continuously compounded risk-free rate is 5.5 %. Assume that the stock will pay a dividend of $3 on day 50. The price of the option should be:A. 3.19.

B. 7.44.

C. 2.10.Correct Answer: A

The present value of the $3 dividend is: $3 e ^{-0.055 (50/365)} = $2.98.

Adjust the price of the underlying to S

_{0}= 105 - 2.98 = $102.02.

d

_{1}= {ln(102.02 /100) + [0.055 + (0.2)

^{2}/2] (150/365)} / [0.2 (150/365)

^{1/2}] = 0.16.

d

_{2}= 0.16 - 0.2 (150/365)

^{1/2}= 0.03.

N(d

_{1}) = N(0.16) = 0.5636.

N(d

_{2}) = N(0.03) = 0.5120.

c = 102.02 x 0.5636 - 100

^{e-0.055 (150/365)}x 0.5120 = 7.44.

p = 100 x e

^{-0.055 (150/365)}x [1 - 0.5120] - 102.02 x [1 - 0.5636] = 3.19.

### Study notes from a previous year's CFA exam:

g. explain the effect of the underlying asset's cash flows on the price of an option;