CHAPTER 4

Valuation of Options

Derivative Securities
Tunis Business School
 Study Objectives
1. Present the components of an Option Value.
2. Present the determinants of value of an Option.
3. Determine the value of an option through the Binomial model.
4. Find the value of an option through the “Black-Scholes Model”.
 Option Values

• Intrinsic value - profit that could be made if the

option was immediately exercised
– Call: stock price - exercise price
– Put: exercise price - stock price
• Time value - the difference between the option
price and the intrinsic value
Figure 21.1 Call Option Value
before Expiration
Table 21.1 Determinants of Call
Option Values
 Mono-period Binomial Model
The Spot price of the underlying asset (a stock
paying no dividend) can have at maturity (time 1)
only two possible outcomes:
S1u (in the case of occurrence of the “up” state)
and S1d (in the case of occurrence of the “down”
state).
 Binomial Option Pricing

u
S
1 C1u

S0 C0
d
S 1 C1d

Stock Price Call Option Value

Replication of Payoffs and Option
Values
The writer (seller) of an Option (a Call, for
example) can use the proceeds of the sale to
construct a hedging portfolio. This portfolio is
constructed through the investment in two
assets: the underlying stock and the risk-free
asset.
We have to invest a portion α (α>0 indicate a
purchase and α<0 indicates a sale)in the
underlying, and a sum β (β>0 indicates an
investment and β<0 indicates a borrowing) in the
risk-free asset.
Replication of Payoffs and Option
Values
The value of the hedging portfolio will be at time
0:
V0  S0  
The value of this portfolio at time 1 (maturity)
depends on the value of the underlying at
maturity. V  S   1  r 
1
u u
1

V0  S0  
V  S   1  r 
1
d d
1
Replication of Payoffs and Option
Values
The hedging portfolio must have the same payoff
as the option at maturity.

C  V  S   1  r 
u
1 1
u u
1

C  V  S   1  r 
1
d
1
d
1
d
Replication of Payoffs and Option
Values
The hedging parameters (α and β) will be:

C Cu
C d
 1
 1
S Su
1 S1
d

C  S
u u
 1 1
1 r
Replication of Payoffs and Option
Values
Using the optimal hedging value of α and β, we
obtain:
V0 
1
1 r
qC  1  q C 
u
1 1
d

with :
S 0 1  r   S d
q 1
S1  S1
u d

 
C1u  Max 0; S1u  K 
C1
d
 Max0; S 1
d
 K 
Replication of Payoffs and Option
Values
The hedging portfolio and the Call have the same
value at maturity. They must also have the same
value at time 0, otherwise arbitrage gains
become possible.

C0  V0
Replication of Payoffs and Option
Values
C0 
1
1 r

qC1u  1  q C1d 
Multiplica tiveModel :
1 r  d
q
ud
C1u  Max0; S 0u  K 
C1d  Max0; S 0 d  K 
With :
u0
0  d 1
Replication of Payoffs and Option
Values
We obtain similar formula for the Put:

P0 
1
1 r

qP1u  1  q P1d 
with :
S 0 1  r   Sd
q 1
S1  S1
u d

 
P1u  Max 0; K  S1u 
P1
d
 Max0; K  S 
1
d
 Exercise
A stock is worth initially on the spot market 100$. The
price of this stock follows a mono-period binomial
model with an increase factor u=1,1 and a decrease
factor d=0,9. The annual interest rate r=5%.
This stock is the underlying of a Call and a Put having
the same Strike price K=99$, the same maturity (1
period).
1- Find C0 and P0
2- Find the intrinsic value and the speculative
value of the Call and the Put at t=0.
3- Is the Call-Put parity verified?
4- Find the composition and the value of the
hedging portfolio of the Call and the Put.
Generalizing the Two-State Approach:
The Multi-period Binomial Model
This model is a simple extension of the mono-
period model. Instead of having a single period,
we will have N periods. In each period, the spot
price of the underlying follows a mono-period
binomial model having the same increase (u)
and decrease (d) factors.
 Construction of the tree u ... uu
S N
u ... u
….
S N 1
uu
S 2 S u ... ud
N

S1u .
S 2ud …. .
S0 .
d .
S1
dd d ... du
S 2 S N
…. d ... d
S N 1
S Nd ... dd
 Value of the Call u ... uu
C N
u ... u
….
C N 1
uu
C 2 C u ... ud
N

C1u .
C 2ud …. .
C0 .
d .
C 1
dd d ... du
C 2 C N
…. d ... d
C N 1
C Nd ... dd
 Value of the Call
The first step consists to compute the different
possible values of the Call at the maturity. At
maturity the speculative value is zero. The
entire value is due to the intrinsic component.
Hence:

C ......
N  
 Max 0; S ......
N K 
 Value of the Call
At the beginning of any period, the value of the
option is obtained through the following
formula:

C .....
i 
1
1 r

qCi 1  1  q Ci 1
..... u ..... d

 Example
Assume that we have two periods (N=2).
In each year (period) segment the stock could
increase by 10% or decrease by 5%
Assume the stock is initially selling at 100
Possible outcomes:
Increase by 10% twice
Decrease by 5% twice
Increase once and decrease once (2 paths)
What will be the value of a Call having this stock
as underlying and a strike price K=101 (risk-free
rate=2,5%)?
 Example (Continued)

121

110
104.50
100

95
90.25
 Example (Continued)
The 3 possible values of the Call at t=2:

 
C2uu  Max 0; S 2uu  K   Max0; 121  101  20
C2ud  Max0; S ud
2  K   Max0; 104,5  101  3,5
C2dd  Max0; S dd
2  K   Max0; 90,25  101  0
The increase and decrease factors are:
U=1,1 and d=0,95
1  r  d 1  0,025  0,95
q   0,5
ud 1,1  0,95
 Example (Continued)
The 2 possible values of the Call at t=1:

C 
u
1
1
1 r
 uu ud

qC2  1  q C2 
1
1,025
0,5x20  0,5x3,5  11,46

C1 
d 1
1 r
 ud

qC2  1  q C2 
dd 1
1,025
0,5x3,5  0,5x0  1,71
 Example (Continued)
The value of the Call at t=0:

C0 
1
1 r
 
qC1u  1  q C1d 
1
1,025
0,5 x11,46  0,5 x1,71  6,42
 Exercise
A stock is worth initially on the spot market 100$. The
price of this stock follows a two-period binomial model
with an increase factor u=1,1 and a decrease factor
d=0,9. The annual interest rate r=2%.
This stock is the underlying of a Call and a Put having
the same Strike price K=102$, the same maturity (2
periods).
1- Find C0 and P0
2- Find the intrinsic values and the speculative
values of the Call and the Put at t=0 and at t=1.
3- Is the Call-Put parity verified at t=0 and at t=1?
4- Find the compositions and the values of the
hedging portfolios of the Call and the Put at t=0 and at
t=1.
 Black-Scholes Option Valuation

Co = SoN(d1) - Xe-rTN(d2)
d1 = [ln(So/X) + (r + 2/2)T] / (T1/2)
d2 = d1 - (T1/2)
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
Black-Scholes Option Valuation Continued

X = Exercise 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 cont.
compounded rate of return on the stock
Figure 21.6 A Standard Normal Curve
 Call Option Example

So = 100 X = 95
r = .10 T = .25 (quarter)
 = .50
d1 = [ln(100/95) + (.10+(5 2/2)).25] / (5 .251/2)
= .43
d2 = .43 - ((5.251/2)
= .18
Probabilities from Normal Distribution

N (.43) = .6664
Table 21.2
d N(d)
.42 .6628
.43 .6664 Interpolation
.44 .6700
Probabilities from Normal Distribution
Continued
N (.18) = .5714
Table 21.2
d N(d)
.16 .5636
.18 .5714
.20 .5793
Table 21.2 Cumulative Normal Distribution
 Call Option Value

Co = SoN(d1) - Xe-rTN(d2)
Co = 100 X .6664 - 95 e- .10 X .25 X .5714
Co = 13.70
Implied Volatility
Using Black-Scholes and the actual price of
the option, solve for volatility.
Is the implied volatility consistent with the
stock?
 Put Value Using Black-Scholes

P = Xe-rT [1-N(d2)] - S0 [1-N(d1)]

Using the sample call data
S = 100 r = .10 X = 95 g = .5 T = .25
95e-10x.25(1-.5714)-100(1-.6664) = 6.35
Put Option Valuation: Using Put-Call Parity

P = C + PV (X) - So
= C + Xe-rT - So
Using the example data
C = 13.70 X = 95 S = 100
r = .10 T = .25
P = 13.70 + 95 e -.10 X .25 - 100
P = 6.35
Spreadsheet 21.1 Spreadsheet to Calculate
Black-Scholes Option Values