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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
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
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
Generalization
S0u
fu
S0u fu
S0
f
S0d
fd
S0 f
S0d fd
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
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,
Risk-Neutral Valuation
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
10
19.8
18
16.2
11
B
19.8
fud = 0 E
18
C
16.2
fdd =0
12
19.8
fud = 0
0.12x0.25
13
obtain fd = 0
19.8
fud =0
18
fd = 0
C
16.2
fdd = 0
14
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
15
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
16
17
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
18
19
u e T
1
d e
u
T
Spring Lecture 9 - Option Valuation
20
( r r f ) t
21
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
22
23
p Xe
rT
N d 2 S0 N d1
24
x
Spring Lecture 9 - Option Valuation
25
Co = SoN(d1) Xe-rTN(d2)
26
Illustrated Example
The price of a stock today is 42, and there is a
27
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
28
Replication Method
An Intuitive Method
29
Replication Method
An Intuitive Method
22
20
18
4 short calls
30
Replication Method
An Intuitive Method
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
31
Replication Method
An Intuitive Method
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
32
B
19.8
fud = 0 E
18
C
16.2
fdd =0
33
Replication Method
An Intuitive Method
Up
Down
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
34
Replication Method
An Intuitive Method
35
Replication Method
An Intuitive Method
Up
Down
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
36