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FinanceQ&A LibraryBelow is part of the response you provided to a question I previously asked. I was wondering if you could explain more thoroughly the explanation you provided about the cash flows at time of expiration. I'm not totally understanding that portion of your response. Thanks.Cash flows at t = 0 i.e. today = Cash flows from short selling 1 call option + cash flow from buying 1 stock = +C - S = C - S > 0 as C > SCash flows at the time of expiration = 0.If option gets excercised, you offer the stock you hold to the buyer of the call option, thus there is no cash flow involved.If option is not excercised by the buyer, then there is no cash flows anyway.Question

Asked Jun 17, 2019

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Below is part of the response you provided to a question I previously asked. I was wondering if you could explain more thoroughly the explanation you provided about the cash flows at time of expiration. I'm not totally understanding that portion of your response. Thanks.

Cash flows at t = 0 i.e. today = Cash flows from short selling 1 call option + cash flow from buying 1 stock = +C - S = C - S > 0 as C > S

Cash flows at the time of expiration = 0.

- If option gets excercised, you offer the stock you hold to the buyer of the call option, thus there is no cash flow involved.
- If option is not excercised by the buyer, then there is no cash flows anyway.

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Step 1

Since yoiu have asked further explanation on cash flow at the time of expiration, I assume that you have understood the cash flows at t = 0 i.e. today = Cash flows from short selling 1 call option + cash flow from buying 1 stock = +C - S = C - S > 0 as C > S

Step 2

Now, let's come to the point in time when call option expires. There are two possibilities:

Possibility 1: At the time of expiration the stock price, S_{t} is higher than the strike price, K

- The call option will get exercized by the buyer of the call option.
- Since buyer has excercized the call option, you as a seller, is liable to sell him the stock at exercise price K
- You then recall that you already hold one stock in your replicating portfolio. Hence, you offer the stock that you have and the buyer pays you K.
- Hence, there is no cash outlfow for you. You get an inflow of K.

Step 3

Possibility 2: At the time of expiration the stock price, St is lower than the strike price, K

- The call option will not get exercized by the buyer of the call option.
- Since buyer has not excercized ...

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