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# EC3314 Financial

Economics

Spring Lecture 9
Option Valuation

Outline
The Binomial Method of option valuation
The Black-Scholes Model of option valuation
The Replication Method of option valuation

## Spring Lecture 9 - Option Valuation

Generalization
Let S0 be the price of a stock today
Let f be the price of the option on the stock
Let T be the lifetime of the option, during

## Move up by u to S0u, u > 1

Move down by d to S0d, d < 1
Risk Free Rate of interest is r

## Percentage increase in stock price when

there is an up movement is u 1
Percentage decrease in stock price when
there is a down movement is 1 d
Spring Lecture 9 - Option Valuation

Generalization
Call payoff from option following an up

movement is fu
Call payoff from option following a down

movement is fd
Imagine a hedged portfolio that is long in

## shares and short in one call option.

Then, equating values of the portfolio:
S 0u f u = S 0d f d
= (fu fd)/(S0u S0d) = (fu fd)/S0(u d)
Spring Lecture 9 - Option Valuation

Generalization
S0u
fu
S0u fu

S0
f

S0d
fd

S0 f

S0d fd

## Spring Lecture 9 - Option Valuation

Generalization
If the risk free rate of interest is r, then the PV

of the portfolio is
(S0u fu) e-rT [Or (S0d fd) e-rT]
The cost of setting up the portfolio is S0 f
As they must be equal:
(S0u fu) e-rT = S0 f
f = S0(1 ue-rT) + fue-rT
But = (fu fd)/S0(u d)
Spring Lecture 9 - Option Valuation

Generalization

fu fd
S0 1 ue rT fu e rT
f
S0 (u d)

fu fd 1 ue rT fu e rT u d
f
u d
fu fu de rT fd fd ue rT
f
u d
fe

rT

rT
e rTfu fu d e rTfd fd u
d fd u e rT
rT fu e

d
u

## Spring Lecture 9 - Option Valuation

Generalization

rT
rT

f
e

f
u

e
rT u
d
fe

u d

Let

e rT d
p,
ud
Then
u e rT
1 p
ud
f e rT pfu 1 p fd
Spring Lecture 9 - Option Valuation

Generalization
From the previous weeks example: u=1.1,

## d=0.9, r=0.12, T=0.25, fu=1, fd=0,

p = (e0.12x0.25 0.9)/(1.1 0.9) = 0.6523
f = 0.63
Note that we dont need to know the

## probabilities of the up and down movements

in stock price
in the new stock price
Spring Lecture 9 - Option Valuation

Risk-Neutral Valuation

## We only need to assume NO ARBITRAGE

Interpret p as the probability of an up movement
(1 p) as the probability of a down movement
Then expected payoff from option at T is

f = pfu + (1-p)fd
For PV of f, discount at the risk free rate.
Since S grows at risk free rate too
This means that we are in a risk neutral world
Everyone is indifferent to risk
Spring Lecture 9 - Option Valuation

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## Two-Step Binomial Pricing

S0 = 20, K = 21, u = 1.1, d = 0.9, r = 0.12, T = 0.25
24.2
22
S0 =20

19.8
18
16.2

11

## Two-Step Binomial Pricing

Call Values
S0 = 20, K = 21, u = 1.1, d = 0.9, r = 0.12, T = 0.25
24.2 D
fuu =3.2
22
S0 =20

B
19.8
fud = 0 E

18

C
16.2
fdd =0

12

Call Values
24.2
fuu =3.2
22
fu = 2.0257

19.8
fud = 0

## Working backwards from Nodes D and E to find call value at

Node B
fu = e-rT [pfu + (1-p) fd] = 2.0257
Where p = (e

0.12x0.25

13

## Two-Step Binomial Pricing

Call Values
Similarly, work out call value at Node C to

obtain fd = 0

19.8
fud =0
18
fd = 0

C
16.2
fdd = 0

## f = e-rT [pfu + (1-p) fd] = 1.2823

Spring Lecture 9 - Option Valuation

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## Two-Step Binomial Pricing

Put Values
Put Option: K = 52, r = 0.05 per six months period,

Maturity = 1 year

72
fuu =0

60
A
S0 =50
f = 4.1923

fu =1.415

48
fud = 4

40
fd=9.464

32
fdd =20 F
Spring Lecture 9 - Option Valuation

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## Two-Step Binomial Pricing

Valuing an American Put
Assume that K = 52, r = 0.05 per period, Maturity =1 year, So =

50

72
fuu =0

60
A
S0 =50
f = 4.1923

fu =1.415

48
fud = 4

40
fd=9.464

32
fdd =20 F
Spring Lecture 9 - Option Valuation

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## Two-Step Binomial Pricing

Valuing an American Put
However for an American put, recall that the

## put can be exercised anytime.

The procedure is modified: at each
intermediate (earlier) node (here, at B and C),
test whether early exercise is optimal
The value of the option at intermediate nodes
is the greater of
The value obtained for f
The payoff from early exercise

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## Two-Step Binomial Pricing

Valuing an American Put
Assume that K = 52, r=0.05 per period, Maturity =1 year, So = 50

## and two periods:

72
fuu =0

60
fu =1.415

S0 =50
f=?

Early exercise:
Max[52 60, 0]
=0

48
fud = 4

40
fd=9.464
Early exercise:
Max[52 40, 0]
= 12
Spring Lecture 9 - Option Valuation

32
fdd =20 F
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## Two-Step Binomial Pricing

Valuing an American Put
Clearly at Nodes D, E and F, the values of fuu, fud,

## and fdd are the same as for the European put.

At the intermediate Node B, early exercise is not

## optimal, so we use fu = 1.415

At Node C, early exercise is optimal as it gives us

## a payoff of 12, which is superior to fd = 9.464

So the value of the put at C is 12
Value of put at Node A =

## (0.6282 x 1.415 + 0.3718 x 12) x e-0.05 x 1 = 5.089

Spring Lecture 9 - Option Valuation

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## Volatility of underlying asset

Volatility can be important
Assume that Expected Return on stock is

## and its volatility is

Cox, Ross and Rubinstein (1979), propose
that u and d are chosen so that they match
Specifically,

u e T
1

d e
u

T
Spring Lecture 9 - Option Valuation

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## The Probability of an Up Move

p
ud
a e rt for a nondividen d paying stock
a e ( r q ) t for a stock index wher e q is the dividend
yield on the index
a e

( r r f ) t

## risk - free rate

a 1 for a futures contract
Spring Lecture 9 - Option Valuation

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## The Black-Scholes Option Valuation

Multi-Step Binomial Pricing
Co = SoN(d1) Xe-rTN(d2)
ln S 0 X r 2 2 T
d1
T
d 2 d1 T

ln S 0 X r 2 2 T

T
where
Co = Current call option value, So = Current stock price
N(d) = probability that a random draw from a normal distribution will
be less than d
Spring Lecture 9 - Option Valuation

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## The Black-Scholes Option Valuation

X = Exercise price (or Strike Price)
e = 2.71828, the base of the natural log
r = Risk-free interest rate (annualizes continuously
compounded with the same maturity as the option)
T = Time to maturity of the option in years
ln = Natural log function
Standard deviation of annualized continuously
compounded rate of return on the stock
No dividends are being paid by the underlying stock.
Spring Lecture 9 - Option Valuation

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## The Black-Scholes Option Valuation

For a European put option on nondividend paying stock,

p Xe

rT

N d 2 S0 N d1

24

## standardized normal distribution

It is the probability that a variable with a
standard normal distribution , (0,1) will be
less than x

x
Spring Lecture 9 - Option Valuation

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## N(x) and Cumulative Probability Density Function

Co = SoN(d1) Xe-rTN(d2)

## = e-rT [SoN(d1) erT XN(d2) ]

N(d2) is the probability that the option will be

## exercised in a risk neutral

XN(d2) is the strike price times the probability
that the strike price will be paid
S0N(d1)erT is the expected value of a variable
that equals ST if ST > X and is 0 otherwise in a
risk-neutral world.
Spring Lecture 9 - Option Valuation

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Illustrated Example
The price of a stock today is 42, and there is a

## European Call option on the stock with exercise price

of 40. This option matures in 6 months. The risk free
rate is 10% p.a. and the volatility is given as 20% p.a.
Calculate c
d1 = 0.7693, d2= 0.6278
From the Standard NCDF Table,
N(d1) = N(0.7693)

## = N(0.76) + 0.93x[N(0.77) N(0.76)]

= 0.7764 + 0.93(0.7794 0.7764) = 0.7791
Spring Lecture 9 - Option Valuation

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Illustrated Example
d1 = 0.7693, d2= 0.6278
From the Standard NCDF Table,
N(d1) = N(0.7693) = 0.7791
N(d2) = N(0.6278) = 0.7349
c = 42 x 0.7791 42 x e-0.05 x 0.7349 = 4.76

## Spring Lecture 9 - Option Valuation

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Replication Method
An Intuitive Method

## of an option to the change in the price of the

underlying stock
Sometimes also called the hedge ratio H

## Spring Lecture 9 - Option Valuation

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Replication Method
An Intuitive Method

22

20

18

## The call can take values of 1 and 0

H = 0.25
For perfect hedge,
For each option, there should be 0.25 stocks
OR for each share, there should be 4 options
Let us create a portfolio with 1 long stock and

4 short calls

## Spring Lecture 9 - Option Valuation

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Replication Method
An Intuitive Method

## short four calls

Portfolio is perfectly hedged:

Up
Down

Stock Value 22 18

Call Obligation -4
0

Net payoff
18 18
PV of 18 @ 12% p.a. for 3 months is 17.468
Hence now, 20 - 4C = 17.468 or C = 0.63
Spring Lecture 9 - Option Valuation

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Replication Method
An Intuitive Method

## Suppose we look at two periods, each of 3

months
Then we know that in the last period, stock
can takes prices of 24.2, 19.8, 19.8 and 16.2
So the Call can take values of 3.2, 0, 0 and 0
For Node B, H = (3.2 0)/(24.2 19.8)
=0.727 (Hedge ratio changes at each node)
This means that for a perfect hedge, for each
call written, buy 0.727 of the stock
Spring Lecture 9 - Option Valuation

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## Two-Step Binomial Pricing

Call Values
S0 = 20, K = 21, u = 1.1, d = 0.9, r = 0.12, T = 0.25
24.2 D
fuu =3.2
22
S0 =20

B
19.8
fud = 0 E

18

C
16.2
fdd =0

## Spring Lecture 9 - Option Valuation

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Replication Method
An Intuitive Method

Up
Down

14.4

## Call Obligation -3.2

0

Net payoff
14.4
14.4
PV of 14.4 @ 12% p.a. for 3 months is
13.974
Hence @ Node B, 22 *0.727 c = 13.974 or
c = 2.03

## Spring Lecture 9 - Option Valuation

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Replication Method
An Intuitive Method

## (Hedge ratio changes at each node)

This means that a portfolio of 0 share will
replicate the payoff of the call (which expires)
Value of Call at Node C is c = 0
At Node A, H = (2.0256 0)/(22 18) = 0.506
(Hedge ratio changes yet again)

## Spring Lecture 9 - Option Valuation

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Replication Method
An Intuitive Method

Up
Down

## Call Obligation -2.026

0

Net payoff
9.11 5 9.115
PV of 9.115 @ 12% p.a. for 3 months is 8.845
Hence @ Node A, 20 *0.506 c = 8.845 or c
= 1.28

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