OPTIONS

Pricing Models

Option Value: Bounds

UPPER AND LOWER BOUNDS FOR THE VALUE OF CALL OPTION

VALUE OF CALL OPTION

UPPER BOUND (S0)

LOWER BOUND ( S0 E)

STOCK PRICE 0 E

Factors Determining The Option Value

EXERCISE PRICE EXPIRATION DATE STOCK PRICE STOCK PRICE VARIABILITY INTEREST RATE

C0 = f [S0 , E, 2, t , rf ] + - + + +

Binomial Model

Option Equivalent Method - 1

A SINGLE PERIOD BINOMIAL (OR 2 - STATE) MODEL

S CAN TAKE TWO POSSIBLE VALUES NEXT YEAR, uS OR dS (uS > dS)
B CAN BE BORROWED .. OR LENT AT A RATE OF r, THE RISK-FREE RATE .. (1 + r) = R d < R > u E IS THE EXERCISE PRICE

Cu = MAX (u S - E, 0)
Cd = MAX (dS - E, 0)

Binomial Model Option Equivalent Method - 1

PORTFOLIO SHARES OF THE STOCK AND B RUPEES OF BORROWING STOCK PRICE RISES : uS - RB = Cu STOCK PRICE FALLS : dS - RB = Cd = Cu - Cd = S (u - d) B = (u - d) R SPREAD OF POSSIBLE SHARE PRICES SPREAD OF POSSIBLE OPTION PRICE

dCu - uCd

SINCE THE PORTFOLIO (CONSISTING OF SHARES AND B DEBT) HAS THE SAME PAYOFF AS THAT OF A CALL OPTION, THE VALUE OF THE CALL OPTION IS C = S - B

Illustration
S = 200, u = 1.4, d = 0.9 E = 220, r = 0.10, R = 1.10 Cu = MAX (u S - E, 0) = MAX (280 - 220, 0) = 60 Cd = MAX (dS - E, 0) = MAX (180 - 220, 0) = 0 =

Cu - Cd
= (u - d) S dCu - uCd

60
= 0.6 0.5 (200) 0.9 (60) = = 98.18 0.5 (1.10)

B = (u - d) R

0.6 OF A SHARE + 98.18 BORROWING 98.18 (1.10) = 108 REPAYT PORTFOLIO WHEN u OCCURS WHEN d OCCURS 1.4 x 200 x 0.6 - 108 = 60 0.9 x 200 x 0.6 - 108 = 0 CALL OPTION Cu = 60 Cd = 0

C = S - B = 0.6 x 200 - 98.18 = 21.82

Binomial Model Risk-Neutral Method

WE ESTABLISHED THE EQUILIBRUIM PRICE OF THE CALL OPTION WITHOUT KNOWING ANYTHING ABOUT THE ATTITUDE OF INVESTORS TOWARD RISK. THIS SUGGESTS ALTERNATIVE METHOD RISK-NEUTRAL VALUATION METHOD 1. CALCUL ATE THE PROBABILITY OF RISE IN A RISK NEUTRAL WORLD 2. CALCULATE THE EXPECTED FUTURE VALUE .. OPTION 3. CONVERT .. IT INTO ITS PRESENT VALUE USING THE RISK-FREE RATE

Pioneer Stock
1. PROBABILITY OF RISE IN A RISK-NEUTRAL WORLD
RISE 40% TO 280 FALL 10% TO 180

EXPECTED RETURN = [PROB OF RISE x 40%] + [(1 - PROB OF RISE) x - 10%]

= 10% p = 0.4

2. EXPECTED FUTURE VALUE OF THE OPTION STOCK PRICE STOCK PRICE

Cu = RS. 60 Cd = RS. 0

0.4 x RS. 60 + 0.6 x RS. 0 = RS. 24

3. PRESENT VALUE OF THE OPTION RS. 24 = RS. 21.82 1.10

Black-Scholes Model
E
C0 = S0 N (d1) ert N (d) = VALUE OF THE CUMULATIVE NORMAL DENSITY FUNCTION ln S0 E + 1 r + 2 2 t t N (d2)

d1 =
d2 = d1 - t

r = CONTINUOUSLY COMPOUNDED RISK - FREE ANNUAL INTEREST RATE = STANDARD DEVIATION OF THE CONTINUOUSLY COMPOUNDED ANNUAL RATE OF RETURN ON THE STOCK

Black-Scholes Model
Illustration
S0 = RS.60 t = 0.5 E = RS.56 r = 0.14 = 0.30

STEP 1 : CALCULATE d1 AND d2 ln d1 =

S0 E

2 r + 2

t .068 993 + 0.0925

=
0.2121

= 0.7614

d2 = d1 - t = 0.7614 - 0.2121 = 0.5493 STEP 2 : STEP 3 : N (d1) = N (0.7614) = 0.7768 N (d2) = N (0.5493) = 0.7086 E = ert STEP 4 : e0.14 x 0.5 56 = RS. 52.21

C0 = RS. 60 x 0.7768 - RS. 52.21 x 0.7086 = 46.61 - 37.00 = 9.61

Assumptions
THE CALL OPTION IS THE EUROPEAN OPTION THE STOCK PRICE IS CONTINUOUS AND IS DISTRIBUTED LOGNORMALLY THERE ARE NO TRANSACTION COSTS AND TAXES

THERE ARE NO RESTRICTIONS ON OR PENALTIES FOR SHORT SELLING

THE STOCK PAYS NO DIVIDEND THE RISK-FREE INTEREST RATE IS KNOWN AND CONSTANT

Adjustment For Dividends Short-Term Options

ADJUSTED STOCK PRICE

= S = E

Divt (1 + r)t

VALUE OF CALL = S N (d1) -

N (d2)

ert
ln S E + t 2 r + 2 t

d1 =

Adjustment For Dividends 2 Long-Term Options

C = S e -yt N (d1) - E e -rt N (d2)

ln
d1 d2 =

S E

r-y +

2 2

t y - dividend yield

= d1 - t

THE ADJUSTMENT DISCOUNTS THE VALUE OF THE STOCK TO THE PRESENT AT THE DIVIDEND YIELD TO REFLECT THE EXPECTED DROP IN VALUE ON ACCOUNT OF THE DIVIDEND PAYMENS OFFSETS THE INTEREST RATE BY THE DIVIDEND YIELD TO REFLECT THE LOWER COST OF CARRYING THE STOCK

Put Call Parity - Revisited

JUST BEFORE EXPIRATION C1 = S1 + P1 - E S0 + P0 - E e -rt

IF THERE IS SOME TIME LEFT C0 =

THE ABOVE EQUATION CAN BE USED TO ESTABLISH THE PRICE OF A PUT OPTION & DETERMINE WHETHER THE PUT - CALL PARITY IS WORKING

SUMMING UP
An option gives its owner the right to buy or sell an asset on or before a given date at a specified price. An option that gives the right to buy is called a call option; an option that gives the right to sell is called a put option.
A European option can be exercised only on the expiration date whereas an American option can be exercised on or before the expiration date. The payoff of a call option on an equity stock just before

expiration is equal to:

Stock
Max

Exercise price, 0

price

 The payoff of a put option on an equity stock just before

expiration is equal to:

Exercise
Max

Stock price, 0

price

Puts and calls represent basic options. They serve as building blocks for developing more complex options. For example, if you buy a stock along with a put option on it (exercisable at price E), your payoff will be E if the price of the stock (S1) is less than E; otherwise your payoff will be S1.

A complex combination consisting of (i) buying a stock, (ii) buying a put option on that stock, and (iii) borrowing an amount equal to the exercise price, has a payoff from buying a call option. This equivalence is referred to as the put-call parity theorem.

 The value of a call option is a function of five variables: (i) price of the underlying asset, (ii) exercise price, (iii) variability
of return, (iv) time left to expiration, and (v) risk-free interest

rate.
The value of a call option as per the binomial model is equal to the value of the hedge portfolio (consisting of equity and

borrowing) that has a payoff identical to that of the call option.

The value of a call option as per the Black - Scholes model is:
E C0 = S0 N (d1) ert N (d2)