Option Pricing

Call Option  The right but not the obligation to buy a particular asset at an exercise price

Put Option  The right but not an obligation to sell a particular asset at an exercise price

VALUE OF an OPTION= Intrinsic value + time Value

Determinants of CALL Option Prices

Increase In Value of a Call Value of a Put

Pa= price of underlying Share Price Increase Decrease

Pe = Exercise price Exercise Price Decrease Increase

Time= t ( in years) Time to Expiry Increase Decrease

S=standard deviation Volatility Increase Decrease

( in decimal )
Risk free rate = Rf ( in Interest Rate Increase Decrease
decimal
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 Option Pricing
THE BLACK SCHOLES MODEL

THE Black-Scholes model values options before the expiry date and takes account of all the determinants
that effect the value of option

Value of a Call Option = Pa N (d1) – Pe N (d2) e ^-rt

Where d1 = In(Pa/Pe) + (r + 0.5s^2) t / S√T

d2 = d1 – S √T

Pa = Current Price of a underlying asset

Pe = Exercise Price

r= Risk Free Rate

t = time until expiry of options in years

s = Volatility of the share price

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 THE BLACK SCHOLES MODEL
Option Pricing
Value of a Call Option = Pa N (d1) – Pe N (d2) e ^-rt

Example :

The current share price of TYZ Co = $120

The exercise price = $100
The risk free interest rate = 12%
Standard deviation of return on the shares = 40%
Time to Expiry = 3 months

Calculate the value of call option

Solution:
d1 = In (120/100) + (0.12 + 0.5 x 0.4^2)0.25 / 0.4 √0.25 = 1.16
d2 = 1.16 - 0.4 √0.25 = 0.96
Value of Call Option = 120 x 0.8770 – 100 x 0.8315 x 2.71828 ^ (- 0.12 x 0.25)
N (d1) = 0.5 + 0.3770 = 0.8770
N (d2) = 0.5 + 0.3315 = 0.8315
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 Option Pricing
THE BLACK SCHOLES MODEL
THE Black-Scholes model values options before the expiry date and takes account of all the determinants
that effect the value of option

Value of a PUT option = c – Pa + Pe x e^-rt

Step 1 : Value the corresponding call option using Black Scholes Model
Step 2 : Calculate the value of a put option using the above formula
Assumptions and Limitations

• No Transaction Costs or taxes

• Options are European calls

• Investor can borrow at the risk-free rate

• Risk free rate and share price volatility is constant over the period

• No dividends before expiration

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 Option Pricing
American Call Options
If no dividends are payable before the option expiry date, the American call option will be
worth the same as European Call Option

Where dividends are payable before Expiry Date

Calculate the ‘ Dividend adjusted share price ‘

• Deduct the present value of dividends to be paid from current Share Price
• Pa, becomes Pa – PV (dividends) in Black Scholes Model.
• Pa adjusted = Pa – Dividend × e-(rt)

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