Option Pricing Models

By Vaibhav Kabra
M.F.S.M, F.R.M.

Binomial Model

Binomial Model
A stock is currently at $100. We are interested in valuing an European call option to buy the stock at the strike price of $102.

This option will have one of the 2 values at the end of 3 months i.e. At the end of 3 months, the stock will either be at $105 or $ 95. If the stock price rises to $ 105, the value of the call option will be $ 3, if the stock price goes down to $95, the value of the call option will be zero.

Binomial Model
We calculate the value of that makes the portfolio risk less The portfolio is risk less if the value of is chosen so that the final value of the portfolio is same for both alternatives If the stock price moves up from $100 to $105, the value of shares is 105 and the value of the option is $3 Therefore the total value of the portfolio is (105 3) If the stock price moves down from $100 to $95, the value of shares is $95 and the value of the option is $0 Therefore the total value of the portfolio is (95 )

 The portfolio is risk less if the value of is chosen so that the final value of the portfolio is same for both alternatives Therefore 105 3 = 95 105 -95 =3 =3/10 =0.3

A risk less portfolio is therefore Long : 0.3 Shares Short : 1 call option
If the stock price moves up to $105 , the value of the portfolio is (105 * 0.3) 3 = 28.5 If the stock price moves down to $ 95 , the value of portfolio is 95 * 0.3 = 28.5

Binomial Model

Risk less portfolios must, in the absence of arbitrage opportunities, earn the risk free rate of interest If the risk free rate is 10% per annum, the value of the portfolio today must be present value of 28.5 28.5 * e-0.10*(3/12) = 27.79 The value of the portfolio today is 100 * c =100 * 0.3 c Hence, 100 * 0.3 c = 27.79 c = 30 27.79 c = 2.21

In the absence of arbitrage opportunities, the current value of the call option must be $2.21.

Binomial Model
In the absence of arbitrage opportunities, the current value of the call option must be $2.21. If the value of the option were more than $ 2.21, the portfolio would cost less than 27.79 to set up and would earn more than the risk free rate If the value of the option were less than $ 2.21, shorting the portfolio would provide a way of borrowing money at less than the risk free rate

Binomial ModelA Generalization

Consider the stock Price is S0 An option on the stock whose price is f We suppose than the option lasts for time T The stock price can either move up from S0 to S0u . (u >1) The stock price can either move down from S0 to S0d . (d <1) If the stock price moves up to S0u, we suppose that the pay off from the option is fu If the stock price moves down to S0d, we suppose that the pay off from the option is fd

Binomial ModelA Generalization

The portfolio consists of a long position in shares and a short position in one call option We calculate the value of that will make the portfolio risk less If there is an up movement in the stock price, the value of the portfolio at the end of the life of the option is (S0 u fu) If there is a down movement in the stock price, the value of the portfolio at the end of the life of the option is (S0 d fd) For a risk less portfolio both should be equal. (S0 u fu) = (S0 d fd) (S0 u S0 d) = (fu fd) = (fu fd) / (S0 u S0 d)

As per the equation, is the ratio of the change in the option price to the change in the stock price.

Binomial ModelA Generalization

The portfolio is risk less and must earn the risk free interest rate If the risk free interest rate is denoted by r , the present value of the portfolio is (S0u fu) e-rT The cost of setting the portfolio is (S0 - f) (S0 - f) = (S0u fu) e-rT f = S0 S0u e-rT + fu e-rT f = S0(1 u e-rT) + fu e-rT Substituting for We get, f = e-rT [p fu + (1-p) fd] p = (erT d) / (u - d)
*** Please refer your note books for the entire proof

Risk Neutral Valuation

p is the probability of an upward movement 1-p is the probability of downward movement The expected payoff from the option is [p fu + (1-p) fd] The expected payoff from the option today is obtained by discounting it by risk free rate f = e-rT [p fu + (1-p) fd] The expected stock price at time T , E(ST) E(ST) = p S0 u + (1-p) S0 d = p S0 u + S0 d - p S0 d = p S0 (u d) + S0 d = S0 (u d) ( erT d) / (u d) + S0d = S0 erT S0d + S0d E(ST) = S0 erT Hence the stock price grows on average at the risk free rate. Setting the probability of up movement equal to p, is therefore equivalent to assuming that the return on the stock equal to the risk free rate

Risk Neutral Valuation -Formulae to Remember

Term Symbol Formula

Size of up move

e T

Size of down move

d Pu

e - T = 1/eT = 1/u (erT d) / (u - d)

Probability of up move

Probability of down move

Pd

1 - Pu

Concept Checkers
The stock price of Shah Inc. is $100. The annual S.D. is 15%. Continuously Compounded Risk Free rate is 15% p.a. Compute the value of 6 month European call option with a strike price of $ 100 using a one period Binomial Model.

*** Refer your notebooks for solution

Two step Binomial Model

Concept Checker
The stock price of Shah Inc. is $100. The annual S.D. is 15%. Continuously Compounded Risk Free rate is 15% p.a. Compute the value of I year European CALL option with a strike price of $ 100 using a two period Binomial Model.

*** Refer your notebooks for solution

Concept Checker
The stock price of Shah Inc. is $100. The annual S.D. is 15%. Continuously Compounded Risk Free rate is 15% p.a. Compute the value of I year European PUT option with a strike price of $ 100 using a two period Binomial Model.

*** Refer your notebooks for solution

American Options
Valuing American Options using Binomial Model The Binomial Model is also well suited for handling American Style options At any point in the Binomial tree, we can see whether the calculated value of the option is exceeded by its value if exercised early If the payoff from early exercise (the intrinsic value of the option ) is greater than the options value (the present value of the expected payoff at the end of the second period) then it optimal to exercise early . If early exercise is optimal, we replace the calculated value with the exercise value

Concept Checker
The stock price of Shah Inc. is $100. The annual S.D. is 15%. Continuously Compounded Risk Free rate is 15% p.a. Compute the value of I year American CALL option with a strike price of $ 88 using a one period Binomial Model.

*** Refer your notebooks for solution

Impact of Dividends
When dividends are to be considered then there is a minor change in the formula of probability up move. The formula for Pu becomes Pu = (e(r-q)T d) / (u d) where q is the dividend yield Up and down movement factors remains the same.

Black- Scholes - Merton Model

Black- Scholes - Merton Model

In the binomial model, we divided an options life into a given number of periods. Suppose we are pricing a one year option. If we use only one binomial period, it will give us only two prices for the underlying, and we are unlikely to get a very good result.

If we use two binomial periods, we will have three prices for the underlying at expiration. This result would probably be better but still not very good.

But as we shorten the length of intervals and increase the number of periods, there will be more branches to consider and hence the result should become more accurate. Increasing the number of periods by considering arbitrarily small length of intervals, we are moving from discrete time to continuous time.

Black- Scholes - Merton Model

Black- Scholes - Merton Model for option valuation is a continuous time model. The Binomial model converges to this continuous time model as we make the time periods arbitrarily small.

Black- Scholes - Merton Model Assumptions

1. The Underlying Price follows a Geometric Lognormal Diffusion Process
The underlying price follows a lognormal probability distribution as it evolves through time. A lognormal probability distribution is one in which the log return is normally distributed. For e.g., if a stock moves from 100 to 110, the return is 10 % but the log return is ln(1.10) = 0.0953 or 9.53%. Log returns are often called continuously compounded returns. The lognormal distribution is skewed, reaching further out to the right and truncated on the left side, reflecting the limitation that an asset cannot be worth less than zero.

Black- Scholes - Merton Model Assumptions

1. The Underlying Price follows a Geometric Lognormal Diffusion Process

ln (ST / S0) ~ N [( 2/2)T , T)] ln ST ~ N [ ln S0 + ( 2/2)T , T)]

where:

ST = stock price at time T S0 = stock price at time 0 = expected return on the stock per year = volatility of the stock price per year N [m , s] = normal distribution with mean = m and standard deviation = s

Black- Scholes - Merton Model Assumptions

1. The Underlying Price follows a Geometric Lognormal Diffusion Process

ln (ST / S0) ~ N [( 2/2)T , T)]

Dividing the mean and standard deviation by T, results in a continuously compounded annual return of a stock price. The continuously compounded annual returns are normally distributed with a
Mean of ( 2/2) Standard deviation of / T

Black- Scholes - Merton Model Assumptions

Expected Value:
Using the properties of a lognormal distribution, we can show that the expected value of ST, E(ST) is

E(ST) = S0 eT

Black- Scholes - Merton Model Assumptions

Expected Annual Return = Mean Return = ( 2/2) The difference between the Expected Annual Return on the stock, and the mean return ( 2/2), is closely related to the difference between the arithmetic mean and the geometric mean. The mean return will always be slightly less than the expected return, just as the geometric return will always be slightly less than the arithmetic return. Using a Geometric Return produces a more accurate representation of portfolio returns.

Black- Scholes - Merton Model Assumptions

2. The Risk Free Rate is constant and known The Black- Scholes - Merton Model does not allow interest rates to be random. Generally, we assume that the risk free rate is constant.

Black- Scholes - Merton Model Assumptions

3.

The volatility of the underlying asset is constant and known

The volatility of the underlying asset, specified in the form of standard deviation of the log return, is assumed to be known at all times and does not change over the life of the option. In reality, volatility is definitely not known and must be estimated and obtained from some other source. In addition, volatility is generally not constant. Obviously the stock market is more volatile at some times than at others. Nonetheless, this assumption is very critical for this model.

Black- Scholes - Merton Model Assumptions

4. There are no Taxes or Transaction Costs
Taxes and Transaction Costs greatly complicate our models and keep us from seeing the essential financial principles involved in the models.

Black- Scholes - Merton Model Assumptions

5. There are no Cash flows on the underlying
The basic form of Black- Scholes - Merton Model makes the assumption that the underlying asset pays no coupons, dividends or and other cash flows. However, this assumption can be relaxed and will be discussed in the later sections.

Black- Scholes - Merton Model Assumptions

6. The Options are European
The Black- Scholes - Merton Model does not price American Options. Users of the model must keep this in mind, or they may badly misprice these options. For pricing American options, the best approach is the binomial model with a large number of time periods.

Black- Scholes - Merton Model Formulae

The Black Scholes Merton formulae for the prices of call and put options are c = S0 N(d1) X e rcT N(d2) p = X ercT[1 - N(d2)] - S0 [1 - N(d1)] where

d1 = ln(S0 / X) + [rc + 2/2)]T / ( T)

d2 = d1 - T

Black- Scholes - Merton Model Formulae

= the annualized standard deviation of the continuously compounded return on the stock rc = the continuously compounded risk free rate of return T = time to maturity S0 = Stock or Asset Price X = Strike or Exercise Price N ( ) = Cumulative Normal Probability

Black- Scholes - Merton Model Formulae

Note: If you are given any one of the prices, then the other one need not be substituted in the BSM Formula. The other option price can be calculated by using the put-call parity equation. For e.g. if the call price is known, then the put value can be found by simply substituting the values in the put-call parity equation p = c S + X e rt Similarly, if the put price is known, then the call value can be found by simply substituting the values in the put-call parity equation c = p + S - X e -rt

Black- Scholes - Merton Model Concept Checker

S0 = $100 X = $95 T = 3 months rc = 4% = 15% Calculate the call and put option value using the Black Scholes Merton Model

*** Refer your notebooks for solution

Black- Scholes - Merton Model with Dividends

Since the Black Scholes Merton Model is in continuous time, in practice S0 e qT is substituted for S0 in the BSM formula, where q is equal to the continuously compounded rate of dividend payment.

The asset price is discounted by a greater amount to account for the greater amount of cash flows.
Cash flows will increase put values and decrease call values

Black- Scholes - Merton Model Concept Checker

S0 = $100 X = $95 T = 3 months rc = 4% = 15% q = 3% Calculate the call and put option value using the Black Scholes Merton Model

*** Refer your notebooks for solution

Historical Volatility
1. 2. 3. Volatility is one of the important variable in the BSM model and is unobservable. The steps in computing historical volatility for use as an input in the BSM continuous time options pricing model are: Convert a time series of N prices to returns Ri = Pi Pi-1 / Pi-1 , i= 1 to N Convert the returns to continuously compounded returns Ric = ln (1+Ri), i= 1 to N Calculate the Variance and Standard Deviation of the continuously compounded returns 2 = (Ric - Ri)2 / (N-1) and = 2

Historical Volatility Calculation

R1 = P1 P0 / P0 = 15% R2 = P2 P1 / P1 = 20% R3 = P3 P2 / P2 = 14% R4 = P4 P3 / P3 = 13% R5 = P5 P4 / P4 = 18% R = 16%
2 = (R1-R)2 + (R2 R)2 + (R3 R)2 + (R4 R)2 + (R5 R)2 / (N-1) 2 = (1 + 16 + 4 + 9 + 4) / 4 ; 2 = 8.5 and = 2.92

Implied Volatility
The one parameter in the BSM model that can not be directly observed is the volatility of the stock price. In the previous slide, we observed how volatility is obtained from Historical Prices. Historical data can serve as a basis for what volatility might be going forward, but is not always representative of the current market. In practice, traders usually work with Implied Volatilities. These are the volatilities implied by option prices observed in the market.

To illustrate how implied volatility is calculated, suppose that the value of a European Call on a non dividend paying stock is 1.875 when S0 = 21, K = 20, r = 0.1, and T = 0.25. The implied volatility is the value of that , when substituted in the BSM equation gives c = 1.875.

Implied Volatility
Unfortunately it is not possible to invert equation so that is expressed as a function of S0, K, r, T and c. i.e. Volatility enters in the equation in a complex way, and there is no closed form solution for the volatility that will satisfy the equation. Thus, by setting the BSM price equal to the market price, we can work backwards to infer the volatility. Hence an iterative search procedure can be used to find the implied volatility.

For e.g. we can start by trying = 0.20. This gives the value c = 1.76, which is too low. Option value and volatility are positively correlated i.e. c is an increasing function of . Hence a higher value of is required here
We can try a value of 0.30 for . This gives the value of call = 2.10, which is too high and means that should lie between 0.2 and 0.3. The value of 0.25 for also proves to be high. Hence should lie between 0.2 and 0.25. The correct value for the call price is obtained at = 0.235 or 23.5%

Option Greeks

Naked and Covered Call

A naked position occurs when one party sells a call option without owning the underlying asset. A covered position occurs when the party selling a call option owns the underlying asset A firm sells 1,000 call options S0 = $100 and X = $105 Option premium received = $10 per option A naked position would generate $10,000 in revenue, if the stock price remains below $105 If at expiration, S0 = 106, then loss on the written call = $1,000 and profit reduces to $9,000 If at expiration, S0 = 110, then loss on the written call = $5,000 and profit reduces to $5,000 If at expiration, S0 = 125, then loss on the written call = $20,000 and loss = $10,000

Naked and Covered Call

Therefore, the maximum potential gain is capped at the level of the premium received, whereas the potential loss from a naked written position is unlimited. With a Covered Call, the firm already owns 1000 shares of the underlying stock, so if the stock price rises above $105 and the option is exercised, the firm will sell shares that it already owns. For e.g. if the stock is bought at $105 If at expiration, S0 = 106, then loss on the written call = $1,000 but there is a gain of $1000 on the underlying stock. Therefore the revenue of $10,000 on the option premium is saved. If at expiration, S0 = 125, then loss on the written call = $20,000 but there is a gain of $20,000 on the underlying stock. Therefore the revenue of $10,000 on the option premium is saved. However, if the stock price reduces to $50, then there is a loss of 55,000 on the stock and a net loss of 45,000

Stop Loss Strategy

Stop Loss Strategies with Call options are designed to limit the losses associated with short option positions, especially the call writers. Hold naked Call Position when the option is out of the money Hold Covered Call position (buy the underlying) when the call is in the money Sell the asset as soon as the option goes out of the money ( the stock price is below the strike price) This approach is very simplistic, however, the transaction costs are very high and there is great price uncertainty as well.

Option Delta
Delta ( )gives the relationship between option price and the underlying price. Delta ( )of an option is the ratio of the change in the option price(c or p) to the change in the underlying price (S). Delta = Change in Option Price / Change in the underlying price = (c / S) . for Call Options = (p / S) . for Put Options

Delta is the slope of the call option pricing function at the current stock price

Option Delta
A Delta of 0.8 means that the option price will change by $0.8 for every $1 change in the underlying price To completely hedge a long stock or a short call position, an investor must purchase the number of shares of stock equal to delta times the number of options sold.

For e.g. If an investor is short 1000 call options, then he needs to buy 800 shares of the underlying stock. Now if the underlying price rises by $1, the value of sold options decreases $800 but there is corresponding increase in the stock price by $800.

Option Delta
Call Deltas range from 0 to 1. i.e. the delta will increase towards 1 as the underlying price moves up and will decrease towards 0 as the underlying price moves down. Call Deltas range from 0 to -1. i.e. the delta will decrease towards -1 as the underlying price moves down and will increase towards 0 as the underlying price moves up. Delta of an at the money call is +0.5 whereas Delta of an at the money put is -0.5

Option Delta
Deltas European call non dividend paying stock European call dividend paying stock European put non dividend paying stock European put dividend paying stock Formula N ( d1 ) e q T *N( d1) N ( d1 ) 1 e q T *[ N ( d1) 1]

Forward contract
Forward contract (dividend paying stock) Futures contract Futures contract ( dividend paying stock)

1
e q T e rt e (r q )t

Dynamic aspect of Delta hedging

Delta is constantly changing which means that delta hedging is a dynamic process. In fact Delta hedging is also referred to as dynamic hedging. In theory, the delta is changing continuously and the hedge should be adjusted continuously to maintain a delta neutral position, i.e. the investor will need to either purchase or sell the underlying asset depending on the new delta. However the continuous adjustment is not possible in reality. When the hedge is not adjusted continuously, we are admitting the possibility of much larger moves in the price of the underlying.

Portfolio Delta (P)

The delta of a portfolio of options on a single underlying asset can be calculated as the weighted average delta of each option position in the portfolio: Portfolio Delta = P = wi i where wi = Portfolio weight of each option position i = Delta of each option position Therefore, portfolio delta represents the expected change of the overall option portfolio value given a small change in the price of the underlying asset.

Option Vega ()
Vega () is option prices sensitivity to volatility changes in the underlying stock Vega () is positive for both, calls and puts, meaning that if the volatility increases, both call and put prices increase. Vega () of 0.5 means that if volatility increases by $1, options price will increase by $0.5 Vega () is maximum when Options are At- the Money Deep In The Money and Deep Out of The Money options have very little sensitivity to changes in volatility thus small Vega() i.e. Vega() is close to zero.

Option Rho ()
Rho () is option prices sensitivity to the changes in the Risk free rate Equity Options are less sensitive to changes in interest rates as they are to changes in other variables like volatility and stock prices. Rho () is a much important risk factor for fixed income derivatives. In The Money calls and puts are more sensitive to interest rate changes than Out of The Money options

Increase in rates cause larger increases for in the money calls versus out of the money calls
Increase in rates cause larger decreases for in the money puts versus out of the money puts

Option Theta ()
Theta, () , measures the options sensitivity to a decrease in time to expiration. It is the rate of change of the option price with respect to the passage of time with all else remaining the same. Theta () is sometimes referred to as the time decay of the portfolio. Theta () is usually negative for an option. This is because, the option price decreases as time moves forward all else remaining constant. Both call and put values decrease as the time to expiration decreases. Theta () is most pronounced when option is at- the money especially nearer to the expiration. For some cases, European put options can increase in value as the time to expiration decreases, i.e. it has a positive Theta (). This occurs when the put is deep in the money, the volatility is low, the interest rate is high and the time to expiration is low. Most of the time, option prices are higher the longer the time to expiration.

Option Gamma ()
Gamma is the rate of change of delta with respect to the price of the underlying asset. It is the second order partial derivative with respect to the asset price

= 2c / S2
2c = second partial derivative of call price S2 = second partial derivative of stock price
Gamma is Maximum when Option is At the Money When option is Deep in the Money or Out of Money there is little effect on gamma

Option Gamma ()
Large Gamma implies that Delta is changing rapidly. Small Gamma Implies that Delta is changing slowly Since Gamma represents the curvature component of the call price function not accounted for by delta, it can be used to minimize the hedging error associated with the linear relationship to represent the curvature of the call price function Delta hedging will help for small changes in stock price but for large changes in stock price the portfolio has to be gamma hedged Thus we should not only create a delta neutral position, but also we need to create a gamma neutral position Underlying assets have linear payoffs and thus cant be used for gamma hedging , we use options (non linear pay offs) to create gamma neutral positions

Option Gamma ()

If a delta-neutral portfolio has a gamma of (P) and a traded option has a gamma of (T). To make the portfolio and gamma neutral the position in the traded option necessary is

- (P / T)

Option Gamma () - Gamma Hedging:

An existing short position is delta neutral but has a Gamma of 4000(negative because we are short the options). Also, there exists a traded option with a delta of 0.7 and a gamma of 1.60. Create a Gamma Neutral Position. We need to buy options as we are currently short options , in order to gamma hedge our position Options to buy = ( 4000) / 1.60 = 2500 Thus buy 2500 options to be gamma neutral But this changes our delta neutral position ( We added 2500 more options) thus we will need to sell (delta * options added) of underlying stock to maintain original delta hedge position Thus sell (2500 * 0.7) 1750 underlying stock to maintain original delta hedge position In this way a Gamma Neutral position is created.

r = + r S + (1/2) 2 S2

Relationship Among Delta, Theta and Gamma

where r = risk-free rate = Price of the Option = options theta = options delta = options Gamma 2 = underlying stocks variance For delta neutral position the above equation reduces to

r = + (1/2) 2 S2

Thank You !