Ch.

21 Valuing Options
-- Show how the five variables discussed in the last chapter can be combined into an exact optionvaluation model. -- two models: 1) the binomial model 2) the Black-Scholes formula

21-1 A Simple Option-Valuation Model

-- why discounted cash flow wont work for options DCF method: Figure out expected cash flows and discounted them at the opportunity cost of capital. Unfortunately, finding the opportunity cost of capital is impossible for options, because the risk of an option changes every time the stock price moves [and it also changes over time even with the stock price constant]. features of the risk for options: 1) When you buy a call, you are taking a position in the stock but putting up less of your own money than if you had bought the stock directly (levered investment in the stock). => An option is always riskier than the underlying stock. 2) How much riskier an option is depends on the stock price relative to the exercise price. A call option that is in the money is safer than one that is out of the money. => A stock price increase raises the options price and reduces its risk, and vice versa. That is why the expected rate of return investors demand from an option changes every time the stock price changes. -- constructing option equivalents from common stocks and borrowing: breakthrough by Black and Scholes (1973): Set up an option equivalent whose net costs equal the value of the option.

 a simple example: a 6-month call option on AOL with K = $55, S0 = $55, rf = 4%, and future stock price: ST % ----------------------------------------$73.33 33.33 41.25 -25 => ST payoff to the call -----------------------------------------------------$73.33 $18.33 41.25 0

a levered investment in the stock: Buy 0.5714 AOL shares and borrow $23.11 from the bank, spread .of . possible.option. prices 18.33 0 18.33 = where 0.5714 = = , spread .of . possible.share. prices 73.33 41.25 32.08 23.11 = PV(payoffs from the 0.5714 shares payoffs from the option) = PV($73.33 0.5714 - $18.33) = $23.57/(1+0.02) a note: Also, 2.11 = PV(41.25 0.5714 - $18.33) = $23.57/(1+0.02). Payoffs from the levered investment: ST = 41.25 ST = 73.33 ----------------------------------------------------------------------------------------------------------0.5714 shares $23.57 $41.90 repayment of loan + interest -23.57 -23.57 total payoff $0 $18.33 Therefore, both investments must have the same value (at time t = 0): value of call = value of levered investment = value of 0.5714 shares - $23.11 bank loan = $55 0.5714 - $23.11 = $8.32 hedge ratio or option delta = spread .of . possible.option. prices spread .of . possible.share. prices

-- risk-neutral method:
market equilibrium and investors attitudes to risk The call option on AOL in the example above must sell for $8.32. Otherwise, there will be a money machine. For example, the option price C0 > $8.32. Then, we can make profits by selling the option (short) and buying the option equivalent (i.e., selling the option, buying 0.5714 shares of stock, and borrowing $23.11). => $8.32 must be the option equilibrium price regardless of investors attitudes to risk. suggestion: We can pretend that all investors are indifferent about risk (risk neutral) and use the risk-free rate as the discount rate to calculate the option value. => the expected return on AOL stock and the option = rf (4%) option value = PV(expected cash flow) the expected return on AOL stock over the future 6 months: p 33.33% + (1-p) (-25%) = 4%, where p = the probability of rise => p = 46.3% => expected value of the option at expiration = 0.463 $16.25 + 0.537 $0 = $8.49 => current value of the option = $8.49/1.02 = $8.32 [i.e., C0 = Ct/(1+rf)t] a note: footnote 5

-- valuing the AOL put option

payoffs to the put at expiration: K = $55, S0 = $55, rf = 4% ST payoff to the call -----------------------------------------------------$73.33 $18.33 41.25 0 the option equivalent: Sell 0.4286 AOL shares and lend $30.81.
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where delta of put =

spread .of . possible.option. prices 0 13.75 = = -0.4286 spread .of . possible.share. prices 73.33 41.25

= delta of call 1, amount of lending = PV(value of 0.4286 shares) = PV($73.33 0.4286) = PV($31.43) = $31.43/1.02 = $30.81 It is the PV of the money that you lay out at the end of 6 months to buy the 0.4286 shares back when you have sold short. payoffs to the option equivalent at expiration: ST = 41.25 ST = 73.33 ----------------------------------------------------------------------------------------------------------sale of 0.3286 shares -$17.68 -$31.43 repayment of loan + interest +31.43 -31.43 total payoff $13.75 $0 Therefore, current value of the put = -0.4286 $55 + $30.81 = $7.24

-- valuing the put option by the risk-neutral method

the expected future value of the put in a risk-neutral world = p 0 + (1-p) 13.75 = 0.463 0 + 0.537 13.75 = $7.38 => the current value of the put = (expected future value)/(1 + interest rate) = $7.38/1.02 = $7.24

-- the put-call parity

S + P = PV(K) + C => P = PV(K) + C S = 55/1.02 + 8.32 55 = $7.24 a note: When all the valuation parameters are identical (the same stock price, exercise price, time to expiration, and the risk-free rate) and the exercise price equals the current stock price, the call option will have greater value than the put option.

21-2 The Binomial Method for Valuing Options

-- the binomial method

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There are several ways to find the replicating package of investments in stock and loan that will exactly replicate the payoffs from the option. The example in the last section is known as the binomial method. The method starts by reducing the possible changes in the next periods share price to two, an up move and a down move. This simplification is OK if the time period is very short, so that a large number of small moves is accumulated over the life of the option.

--

Figure 21-1: the possible 6-month price changes assuming the stock makes a single up or down move each 6 months (a), each 3 months (b), or each week (c)

We could continue in this way to chop the period into shorter and shorter intervals, until eventually we could reach a situation in which the stock price is changing continuously and there is a continuum of possible future stock prices.

-- the two-stage binomial method

We can still replicate the call by a levered investment in the stock, but we need to adjust the degree of the leverage at each stage. possible future prices (Figure 21-2): now (t=0) month 3 (t=0.25) month 6 (t=0.5) $55.00 (C0) $44.88 (C12) $36.62 (0) $55.00 (0) $67.43 (C11) $82.67 ($27.67)

notes: 1) The number in parentheses are possible call values at each date (at the end of each stage). 2) In each 3-month period, the price will either rise by 22.6% or fall by 18.4%. 3) K = $55 and rf = 4% option value in month 3 (at t = 0.25): 1) C11 $55.00 (0) $67.43 (C11) $82.67 ($27.67)
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27.67 0 = 1.0 82.67 55.00 borrowed money = PV($82.67 1 - $27.67) = PV($55) option delta = => payoffs to the levered position at expiration: ST = 55.00 ST = 82.67 ----------------------------------------------------------------------------------------------------------buying 1.0 share $55.00 $82.67 repayment of loan + interest -55.00 -55.00 total payoff $0 $27.67 => value of call at month 3: C11 = $67.43 - $55/1.01 = $12.97 2) C12 When the stock price is $44.88 at t = 0.25, the most that you can hope is that the share price will recover to $55.00. => C11 = $0.00 option value today (C0): $44.88 ($0) $55.00 (C0) $67.43 ($12.97)

67.43 44.88 = 0.575 12.97 0 borrow money = PV($67.43 0.575 - $12.97) = PV($25.81) option delta = => payoffs to the levered position: ST = 44.88 ST = 67.43 ----------------------------------------------------------------------------------------------------------buying 0.575 shares $25.81 $38.78 repayment of loan + interest -25.81 -25.81 total payoff $0 $12.97 => value of call at t = 0: C0 = 0.575 $55.00 $25.81/1.01 = $6.07

-- the general binomial method

Table 21-1: Chop the period into smaller and smaller intervals
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change per interval (%) estimated intervals in a year (1/h) upside downside option value 2 +33.3 -25.0 $8.32 4 +22.6 -18.4 6.07 12 +12.4 -11.1 6.65 52 +5.8 -5.5 6.75 Black-Scholes value = $6.78 formula that relates the up and down changes to the STD of stock returns: 1 + upside change = u = e h 1 + downside change = d = 1/u where e = base for the natural logarithms 2.718 = STD of annualized continuously compounded rate of return h = interval as fraction of a year examples: = 40.69% 1) h = 0.5 => u = e 0.4069 0.5 = 1.333, d = 1/u = 0.75 2) h = 0.25 => u = e 0.4069 0.25 = 1.226, d = 1/u = 0.816

Supplements to the General Binomial Method

-- the
21-3 The Black-Scholes Formula

-- continuous-time model: If we continue to divide the options life into a larger and larger number
of increasingly small subperiods, we could eventually reach the situation where there is a continuum of possible stock price changes at maturity.

-- distribution of stock price changes:

As the options life is divided into more and more subperiods, the distribution of possible stock price changes approaches a lognormal distribution (Figure 21-4).
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The lognormal distribution has one good commonsense feature: It recognizes the fact that the stock price can never fall by more than 100%, but that there some, perhaps small, chance that it could rise by much more than 100%.

-- adjusting the degree of leverage

Subdividing the option life into independently small slices does not affect the principle of option valuation. We could still replicate the call option by a levered investment in the stock, but we need to adjust the degree of leverage continuously as time went by.

-- Black-Scholes formula
Black and Scholes (1973) derive a formula when there is an infinite number of subperiods. the formula: value of call = [ delta share price ] [bank loan] = [N(d1) S] [N(d2) PV(K)]

where d1 = ln[ S / PV ( K )] / T + T / 2 d2 = d1 - T N(d) = cumulative normal probability density function K = exercise price of option; PV(K) is calculated by discounting at the risk-free rate, i.e., K e r f T T = number of periods to exercise date S = price of stock now = STD per period of continuously compounded rate of return on stock The formula has the same properties that we identified earlier: C / S > 0 , C / K < 0 , C / r f > 0 , C / T > 0 , C / > 0 , and so on.

-- Using the Black-Scholes Formula

The STD is the only input used by the formula that is not readily available from the data. estimating STD:
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Suppose that you have collected Intel weekly closing prices for the period from July 1994 to June 1995 and dividend (cash and stock) data: t St 18 50 19 51 20 21 49.5 48 22 49 23 25 24 27

Date t = 20 is the ex-dividend date for cash dividend of $1.00. Date t = 23 is the ex-right data for stock split 2-for-1. The STD can be calculated by using the following table: Closing Price S1 S2 . St . S52 Rt = St/ St-1 S2/ S1 . St/ St-1 . S52/ S51 ln(Rt) ln(R2) . . . ln(R52) ln(Rt) u ln(R2) u . . . ln(R52) u
t

(ln(Rt) u)2 (ln(R2) u)2 . . . (ln(R52) u)2

ln(R )
t=2

52

(ln( R
2

52

) u) 2

u = ln( R t ) / 51
2

52

ln(Rt) is the instantaneous rate of return per period of time.

2 1/ 2 The estimated STD of the rate of return is [ (ln( R t ) u) / 51] . 2 52

Notice that to calculate Rt, we have to adjust for cash dividends and stock splits: t St/ St-1 19 51/50 20 (49.5+1)/51 21 48/49.5 22 49/48 23 (2x25)/49 24 27/25

-- the Black-Scholes formula and the binomial method

The B-S formulas assumption of a continuum of possible outcomes is more realistic than the limited number of outcomes assumed in the binomial method. The formula is also more accurate and quicker to use than the binomial method. However, there are circumstances in which you cannot use the B-S formula but the binomial method
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will give you a good measure of the options value (e.g., American calls on dividend-paying stocks).

-- using the B-S formula to estimate volatility (implied volatility)

implied volatility: the underlying assets volatility implied by the option price. It shows what the option price is telling us about the market assessment of the underlying assets volatility. Given the option market price C*, C* = f(S, T, K, rf, ) => = *. examples: 1) S&Ps 100-share index = 575 a six-month at-the-money call option = 42 => STD of index returns = 23% a year 2) Figure 21-6

21-4 The Option Values at A Glance

-- valuation methods extended to American options and to stocks that pay dividends -- American calls no dividends:
In the absence of dividends, the value of a call option increases with time to maturity. Also, by holding on the option, we earn interest on the exercise money. => An American call should not be exercised before maturity. => The value of the call is the same as that of a European call.

-- American puts no dividends:

It can sometimes pay to exercise an American put before maturity to reinvest the exercise price. one extreme case: Immediately after you buy an American put, the stock price falls (and is close) to zero. Since it cannot become more valuable, it is better to exercise the put and invest the exercise money. The American put is always more valuable than a European put. In the extreme example, the difference equals to the PV of the interest earned on the exercise price. In all other cases, the difference is less. valuation: We can use the step-by-step binomial method as long as we check at each point (node) whether the option is worth more dead than alive and then use the higher of the two
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values.

-- European calls on dividend-paying stock:

The option holder is not entitled to dividends. => When using the B-S model to value, we should reduce the price of the stock by the PV of the dividends paid before the options maturity. example: foreign currency When you buy foreign currency, you can invest it to earn interest. But if you own an option to buy foreign currency, you miss out this income. => Valuing an option to buy foreign currency, you need to deduct the PV of the foreign interest from the currency price of the currency. (See footnote 13.)

-- American calls on dividend-paying stocks:

trade-off: 1) By holding onto the option, we not only keep our option open but also earn interest on the exercise money. 2) By exercising early (just before the ex-dividend date), we gain the dividend income. rule: If the dividend is sufficiently large, we might want to capture it by exercising the option just before the ex-dividend date. valuation: Use the step-by-step binomial method. Check at each stage to see whether the option is more valuable if exercised just before the ex-dividend date than if held for at least one more period. example: S0 = $100, T = 2 years, u = 1.25, d = 0.80, Div = $20 paid in the end of year 1, K = $70, r = 12%.

1) stock prices now (t = 0)

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$100

year 1 (t = 1)

$80 60 $48 $75 $84

$125 with dividend 105 ex-dividend $131.25

year (t = 2) 2) option prices now year 1 year 2

C0 C11 $0 $5 C12 $14 $61.25

C11: option value if held onto = (0.71x5 + 0.29x0)/1.12 = $3.18 option value if exercised early = 80 70 = $10.00 C12: option value if held onto = (0.71x61.25 + 0.29x14)/1.12 = $42.45 option value if exercised early = 125 70 = $55 C0: option value = (0.71x55 + 0.29x10)/1.12 = $37.50 a note: The risk-neutral probability of a rise in value is given by p = [(1+r) d]/(u d) = 0.71.

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