OPTION PRICING

Bhabani Shankar Parida

Product Specialist / WB - FMSD

John C. Hull, Options, Futures and Other Derivatives (6th Edition) New York: Prentice Hall

Ch-11

Binomial Trees
One-step Binomial
RiskNeutral Valuation
Two-step Binomial Trees
Matching Volatility with u and d

Ch-13

BlackScholes-Merton Model
Stock Price Properties
Volatility
BlackScholesMerton Differential Equation
BlackScholes Option Pricing Formulas
BlackScholesMerton
Risk-Neutral Valuation
Implied Volatilities

Hull, Chapter 9

Properties of Stock Options

Factors Affecting Option Prices
Upper and Lower Bounds for Options Prices
PutCall Parity

European and American Call Options

Dividends

Bhabani Shankar Parida

Product Specialist / Global Markets Risk Applications

6 Factors Affecting Option Prices

Notations:
So Current stock price
K
Strike price (aka, exercise price)
T
Time to expiration (aka, term)
ST Stock price at maturity
R
Continuously compounded risk-free interest rate
C
Value of American call option (option to buy one share)
P
Value of American put option (option to sell one share)
c
Value of European call option (option to buy one share)
p
Value of European put option (option to sell one share)
Factors Affecting Option Prices
Identify the six factors that affect an options price and discuss how the six factors affect an
options price for both European and American options.
In the chart below, we show the directional impact of each input on the value of a call or put:

Upper & Lower Bounds of Option Prices

Stock price: For a call option, a higher stock price implies greater intrinsic value

Strike price: For a call option, a higher strike price implies less intrinsic value

Time to expiration: For an American option (call or put), option value is an

increasing function with greater time to expiration. For a European option, while
typically value with increase with greater time to expiration, the timing of dividends
makes the relationship ambigious (on dividend payout, the stock tends to drop).

Volatility: Greater volatility increases the value of both a call and a put option

Risk-free rate: For a European call option, consider that the minimum value of an
option is the stock minus the discounted strike price. A higher riskfree rate implies a
lower discounted strike price; therefore, a higher riskfree rate increases the value of
the call option.

Dividend yield: As the option holder forgoes the dividend, a higher dividend
reduces the call options value.

Upper and Lower Bounds for Options Prices

Identify, interpret, and compute upper and lower bounds option pricing.

PutCall Parity
Explain putcall parity and calculate, using the putcall parity on a nondividendpaying stock, the value of
a European and American option, respectively
Putcall parity is based on a no-arbitrage argument; it can be shown that arbitrage opportunities exist if putcall
parity does not hold. Putcall parity is given by:

c + Ke^-rT = p + So
c = p Ke^-rT + So

Example Put Call Parity

Example
Assume we know the value of a European put is $2. The risk less rate is
5%. What is the value of a one-year call option where the strike (exercise)
price is $10 and the stock price is $10?

The early exercise features of American call and put options on a

nondividendpaying stock
American option: can be exercised before expiration (early exercise)
A European option can only be exercised on the expiration date itself
Value [American option] >= Value [European option]

Properties of Stock Options

(From a mathematical standpoint) It is never optimal to

early exercise an American call option on a nondividend paying stock.

But it can be optimal to early exercise an American put

In general, we can say that for an American put, the early

exercise becomes more attractive as:

Stock price (S0) increases,

Risk-free (r) rate increases, and/or
Volatility (sigma) decreases.

The effects dividends have on the putcall parity

Putcall parity applies to European options (note the use of small c and small
p in the equation).
An American call on a non-dividend paying stock must be worth at least its
European analogue
The difference between an American call and an American put (CP) is
bounded by the following:

Hull, Chapter 11

Binomial Trees
One-step Binomial
RiskNeutral Valuation
Two-step Binomial Trees
Matching Volatility with u and d

Bhabani Shankar Parida

Product Specialist / Global Markets Risk Applications

11

One Step BINOMIAL

Calculate, using the onestep and twostep binomial model, the value of a
European call or put option

One Step Binomial Method

Example
We are choosing n such that the final value of the
portfolio remains same for both alternatives.

Consider A portfolio of 1 long position in n shares

and 1 short position in 1 European Call Option.

Option Strike Price = $21

22n-1 = 18n
n = 0.25
A Riskless Portfolio is LONG 0.25 Shares + Short one
Option.

A Generalization

Consider A portfolio of 1 long position in n shares and 1

short position in 1 European Call Option.
Option Current Price =f

S0un fu = S0dn fd
n = ( fd fu ) / (S0u - S0d)

So Present Value of Portfolio = 4.5*e^(-0.12*3/12) = 4.367

Riskless portfolio must earn riskless interest rate in no

arbitrage situation.. Risk free Intt Rate = r
Present Value of Portfolio = (S0un fu)*e ^ (-rT)
Cost of setting up portfolio = S0n-f = (S0un fu)*e ^

Suppose the option price today is f then cost of setting up

portfolio = 20*0.25 f = 5-f = 4.367

(-rT)
=> f = Son(1-ue^-rT) + fu*e^-rT

Rf = 12% pa.

=> f =0.633

Risk Neutral Valuation

In a riskneutral world all individuals are indifferent to risk, and investors would require no
compensation for risk. The expected return on a stock would be the risk free rate:

The principle of riskneutral valuation says that we can generalize: when pricing an option under the
riskneutral assumption, our result will be accurate in the real world (i.e., where individuals are not
indifferent to risk).

Two-step Binomial Trees

Two Step Binomial Process

Here is the two-step binomial for a European call
option on a stock index (Asset = $800, Strike = $800,
Time = 0.25 years, Volatility = 20%, Riskless rate =
5%, and Dividend Yield = 2%)

Here is the two-step binomial for a European put

option (Asset = $50, Strike = $52, Time = 1.0 year,
Volatility = 30%, Riskless rate = 5%, and Dividend
Yield = 0%)

Two Step Binomial Process

Discuss how the binomial model
value converges as time periods
are added

The accuracy of the binomial is

partly a function of the number of
time periods modeled. Generally,
when less than forty or fifty time
periods are used, the value
produced by the binomial fluctuates
(i.e., up then down, then up, then
down). As the number of time
periods is increased, the value
converges toward a value. The
option is said to converge or
stabilize.

Assess the impact dividends have on the binomial model If the stock pays a known
dividend yield at rate (q), the probability (p) of an up movement is adjusted:

Two Step Binomial Process

Generalize the binomial model We have seen in the case of an European option on a stock, the
nodes value is the weighted, discounted value of the future nodes:
And that p, u, and d can be expressed as functions of volatility:

Options on currencies
Analogous to the adaptation of the cost of carry model to foreign exchange forwards, if (rf) is the
foreign risk-free rate, we can use:

Options on Futures
Since it costs nothing to take a long or short position in a futures contract, in a risk-neutral world the
futures price has an expected growth rate of zero. In this case, we can use:

Hull, Chapter 13
The BlackScholes-Merton Model

Stock Price Properties

Volatility

BlackScholesMerton Differential Equation

BlackScholes Option Pricing Formulas

Implied Volatilities
BlackScholesMerton
Risk-Neutral Valuation
Company Warrants

Bhabani Shankar Parida

Product Specialist / Global Markets Risk Applications

Hull Chapter 13. Black-Scholes-Merton

Hull Chapter 13. Black-Scholes-Merton

Lognormal property of stock prices, the distribution of rates of

return, and the calculation of expected return

Under GBM (a Weiner process), Periodic returns are normally

distributed

Price levels are log-normally distributed

Hull Chapter 13. Black-Scholes-Merton

Compute the realized return and historical volatility on a stock

Initial

Final
Arithmetic Avg.
Geometric Avg

$100.00
$115.00
$138.00
$179.40
$143.52
$179.40

Realized(continuous)

Period Return
15%
20%
30%
-20%
25%
14.00%
12.40%

$179.40

11.69%

$179.40

Assumptions underlying the Black-Scholes-Merton model

Stock price follows a Weiner process (a Markov stochastic process) with a

constant volatility

Price is lognormally distributed

No short selling is allowed

No transaction costs and no taxes; securities perfectly divisible (no friction)

No dividends

There are no (risk-less) arbitrage opportunities

Security trading is continuous (continuous trading)

The risk-free rate of interest is constant and the same for all maturities (constant
riskless rate)

Hull Chapter 13. Black-Scholes-Merton

Calculate the value of a European option using the BlackScholes-Merton model on non-dividend stock

Hull Chapter 13. Black-Scholes-Merton

EXAMPLE :
Calculate the value of a European
option using the Black-Scholes-Merton
model on non-dividend stock

So

10

d1

0.992

N(d1)
K

Stock price (S) is $10

Strike (K) is $9
Volatility ( ) is 20%
Term (t) is six months (0.5)
Riskless rate is 5%

0.839401
9

5%

0.5

d2

NORMSDIST(H21)

0.851

N(d2)

0.802615

NORMSDIST(H26)

1.348824

H20*H22-H23*EXP(-H24*H25)*H27

Implied Volatilities
Assume:
Stock price (S) is $10
Strike (K) is $10
Term (t) is six months (0.5)
Riskless rate is 5%
Call price is $1.25
$1.25 = Black-Scholes[ $10,$10,t=0.5 years, r = 5%, ]
= 0.405
Cannot be inverted,
needs iteration (goal seek)

Hull Chapter 13. Black-Scholes-Merton

Value of a European option using the Black-Scholes-Merton

model on dividend paying stock