1

Whats an Option?
2
Option Positions
Long call
Long put
Short call
Short put
3
Long Call on eBay

Profit from buying one eBay European call option: option
price = $5, strike price = $100, option life = 2 months
30
20
10
0
-5
70 80 90 100
110 120 130
Profit ($)
Terminal
stock price ($)
4
Short Call on eBay

Profit from writing one eBay European call option: option
price = $5, strike price = $100
-30
-20
-10
0
5
70 80 90 100
110 120 130
Profit ($)
Terminal
stock price ($)
5
Long Put on IBM

Profit from buying an IBM European put option: option
price = $7, strike price = $70
30
20
10
0
-7
70 60 50 40 80 90 100
Profit ($)
Terminal
stock price ($)
6
Short Put on IBM

Profit from writing an IBM European put option: option
price = $7, strike price = $70
-30
-20
-10
7
0
70
60 50 40
80 90 100
Profit ($)
Terminal
stock price ($)
7
Payoffs from Options
What is the Option Position in Each Case?
K = Strike price, S
T
= Price of asset at maturity
Payoff Payoff
S
T
S
T
K
K
Payoff Payoff
S
T
S
T
K
K
Valuing Options
9
Topics Covered
Simple Option Valuation Model
Binomial Model
Black-Scholes Model
Black Scholes in Action
Option Values at a Glance

10
) (
) (
up y Probabilit
d u
d a
p

= =
Binomial Pricing
p =1 down y Probabilit
year of % as interval time = A =
=
=
=

t h
e u
e d
e a
h
h
rh
o
o
11
Example
Price = 36 o = .40 t = 90/365 A t = 30/365
Strike = 40 r = 10%
Binomial Pricing
a = 1.0083
u = 1.1215
d = .8917
Pu = .5075
Pd = .4925
12
40.37




32.10

36

37 . 40 1215 . 1 36
1 0
=
=
U
P U P
Binomial Pricing
13
40.37




32.10

36

37 . 40 1215 . 1 36
1 0
=
=
U
P U P
10 . 32 8917 . 36
1 0
=
=
D
P D P
Binomial Pricing
14
50.78 = price



40.37



32.10



25.52
45.28



36




28.62

40.37




32.10

36

1 +
=
t t
P U P
Binomial Pricing
15
50.78 = price
10.78 = intrinsic value

40.37
.37



32.10
0


25.52
0
45.28



36




28.62

36

40.37




32.10

Binomial Pricing
16
50.78 = price
10.78 = intrinsic value

40.37
.37



32.10
0


25.52
0
45.28
5.60


36




28.62

40.37



32.10

36

( ) ( ) | | ( )
t r
d d u u
e P U P O
A
+
The greater of
Binomial Pricing
17
50.78 = price
10.78 = intrinsic value

40.37
.37



32.10
0


25.52
0
45.28
5.60


36
.19



28.62
0
40.37
2.91


32.10
.10
36
1.51
( ) ( ) | | ( )
t r
d d u u
e P U P O
A
+
Binomial Pricing
18
Option Value
Components of the Option Price
1 - Underlying stock price
2 - Striking or Exercise price
3 - Volatility of the stock returns (standard deviation of
annual returns)
4 - Time to option expiration
5 - Time value of money (discount rate)
19
Option Value
Black-Scholes Option Pricing Model
| | | | ) ( ) ( ) (
2 1
EX PV d N P d N O
C
=
20
O
C
- Call Option Price
P

- Stock Price
N(d
1
) - Cumulative normal density function of (d
1
)
PV(EX) - Present Value of Strike or Exercise price
N(d
2
) - Cumulative normal density function of (d
2
)
r - discount rate (90 day comm paper rate or risk free rate)
t - time to maturity of option (as % of year)
v - volatility - annualized standard deviation of daily returns
Black-Scholes Option Pricing Model
| | | | ) ( ) ( ) (
2 1
EX PV d N P d N O
C
=
21
Black-Scholes Option Pricing Model
| | | | ) ( ) ( ) (
2 1
EX PV d N P d N O
C
=
( )
rt
e EX EX PV

= ) (
factor discount g compoundin continuous
1
= =

rt
rt
e
e
22
32 34 36 38 40
N(d
1
)=
Black-Scholes Option Pricing Model
t v
t r
d
v
EX
P
) ( ) ln(
2
1
2
+ +
=
23
Cumulative Normal Density Function
t v
t r
d
v
EX
P
) ( ) ln(
2
1
2
+ +
=
t v d d =
1 2
24
Call Option
3070 .
1
= d
t v
t r
d
v
EX
P
) ( ) ln(
2
1
2
+ +
=
Example
What is the price of a call option given the
following?
P = 36 r = 10% v = .40
EX = 40 t = 90 days / 365
3794 . 6206 . 1 ) (
1
= = d N
25
Call Option
3065 . 6935 . 1 ) (
5056 .
2
2
1 2
= =
=
=
d N
d
t v d d
Example
What is the price of a call option given the
following?
P = 36 r = 10% v = .40
EX = 40 t = 90 days / 365
26
Call Option
| | | |
| | | |
70 . 1 $
) 40 ( 3065 . 36 3794 .
) ( ) ( ) (
) 2466 )(. 10 (.
2 1
=
=
=

C
C
rt
C
O
e O
e EX d N P d N O
Example
What is the price of a call option given the
following?
P = 36 r = 10% v = .40
EX = 40 t = 90 days / 365
27
Expanding the binomial model to allow more
possible price changes
1 step 2 steps 4 steps
(2 outcomes) (3 outcomes) (5 outcomes)
etc. etc.
Binomial vs. Black Scholes
28
Binomial vs. Black Scholes
Example
What is the price of a call option given the
following?
P = 36 r = 10% v = .40
EX = 40 t = 90 days / 365
Binomial price = $1.51
Black Scholes price = $1.70

The limited number of binomial outcomes produces the
difference. As the number of binomial outcomes is expanded,
the price will approach, but not necessarily equal, the Black
Scholes price.
29
How estimated call price changes as
number of binomial steps increases
No. of steps Estimated value
1 48.1
2 41.0
3 42.1
5 41.8
10 41.4
50 40.3
100 40.6
Black-Scholes 40.5
Binomial vs. Black Scholes
30
Numericals
31
Numericals
32
Numericals
33
Numericals
34
Numericals
35
Numericals