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Option Valuation II
Milind Shrikhande
Valuation of Options
Arbitrage Restrictions on the Values of
Options
Quantitative Pricing Models
Binomial model
A formula in the simple case
An algorithm in the general
possible values
Assume S= $50,
u= 10% and d= (-3%)
Su=$55
Su=S(1+u)
S=$50
Sd=S(1+d)
Sd=$48.5
Assume X= $50,
T= 1 year (expiration)
Cu= $5
= Max{55-50,0}
Cu= Max{Su-X,0}
C
Cd= Max{Sd-X,0}
Cd= $0
= Max{48.5-50,0}
Assume r= 6%
$1.06
(1+r)
$1
(1+r)
$1.06
Replicating Portfolio
At time t=0, we can create a portfolio of N shares of
the stock and an investment of B dollars in the riskfree bond. The payoff of the portfolio will replicate
the t=1 payoffs of the call option:
N$55 + B$1.06 = $5
N$48.5 + B$1.06 = $0
Obviously, this portfolio should also have the same
price as the call option at t=0:
N$50 + B$1 = C
We get N=0.7692, B=(-35.1959) and the call option price is C=$3.2656.
A Different Replication
The price of $1 in the
up state:
$1
qd
qu
$0
$1
Assume X= $50,
T= 1 year (expiration)
Pu= $0
= Max{50-55,0}
Pu= Max{X-Su,0}
P
Pd= Max{X-Sd,0}
Pd= $1.5
= Max{50-48.5,0}
6%.
What is the price of a European call option
S=$50
Sd=$48.5
Sdd=$47.05
$1
$1.06
$1.1236
C
Cd
Cdd=Max{47.05-50,0}=$0
C
Cd
Cdd=$0
Cu = 0.6531*$10.5 + 0.2903*$3.35 = $7.83
Cd = 0.6531*$3.35 + 0.2903*$0.00 = $2.19
C = 0.6531*$7.83 + 0.2903*$2.19 = $5.75
put-call parity
What is the price of an American call
P
Pd
Pdd=$2.955
Pu = 0.6531*$0 + 0.2903*$0 = $0
Pd = 0.6531*$0 + 0.2903*$2.955 = $0.858
PEU = 0.6531*$0 + 0.2903*$0.858 = $0.249
PAm
Pd
Pdd=$2.955
P
Pd
Pdd=$2.955
Pu = Max{ 0.6531*0 + 0.2903*0 , 50-55 } = $0
Pd = Max{ 0.6531*0 + 0.2903*2.955 , 50-48.5 } = 50-48.5 = $1.5
PAm = Max{ 0.6531*0 + 0.2903*1.5 , 50-50 } = $0.4354 > $0.2490 = PEu
S stock price
Increase
Decrease
X exercise price
Decrease
Increase
Increase
T time to expiration
Increase
Increase
Decrease
Increase
Black-Scholes Model
Developed around 1970
Closed form, analytical pricing model
An equation
Can be calculated easily and quickly (using a
computer or even a calculator)
The limit of the binomial model if we are making the
number of periods infinitely large and every period
very small continuous time
Crucial assumptions
The risk free interest rate and the stock price volatility
are constant over the life of the option.
Black-Scholes Model
C S N (d1 ) Xe rT N (d 2 )
Where
1 2
S
ln T r
X
2
d1
,
T
d 2 d1 T
C call premium
S stock price
X exercise price
T time to expiration
r the interest rate
std of stock returns
ln(z) natural log of z
e-rT exp{-rT} = (2.7183)-rT
N(z) standard normal
cumulative probability
N(z)
z=0
Black-Scholes example
C S N (d1 ) Xe rT N (d 2 )
Where
1 2
S
ln T r
X
2
d1
,
T
d 2 d1 T
C?
S $47.50
X $50
T 0.25 years
r 0.05 (5% annual rate
compounded
continuously)
Black-Scholes Example
d1 (0.1836)
N (d1 ) 0.4272
d 2 (0.3336)
N (d 2 ) 0.3693
and
C $2.0526
C?
S $47.50
X $50
T 0.25 years
r 0.05 (5% annual rate
compounded
continuously)
Black-Scholes Model
Continuous time and therefore continuous
compounding
N(d) loosely speaking, N(d) is the risk
adjusted probability that the call option
will expire in the money (check the pricing
for the extreme cases: 0 and 1)
ln(S/X) approximately, a percentage
measure of option moneyness
Black-Scholes Model
P Xe rT 1 N (d 2 ) S 1 N (d1 ) P Put premium
Where
1 2
S
ln T r
X
2
d1
,
T
d 2 d1 T
S stock price
X exercise price
T time to expiration
r the interest rate
std of stock returns
ln(z) natural log of z
e-rT exp{-rT} = (2.7183)-rT
N(z) standard normal
cumulative
probability
Black-Scholes Example
d1 (0.1836)
N (d1 ) 0.4272
d 2 (0.3336)
N (d 2 ) 0.3693
and
P $3.9315
P?
S $47.50
X $50
T 0.25 years
r 0.05 (5% annual rate
compounded
continuously)
C PV ( X ) S P
C Xe
rT
SP
$2.0526 $50e
0.050.25
? $47.5 $3.9315
1 n
2
returnt average return
n 1 t 1
Where
returnt ln
St
St 1
ln T r
X
2
d1
T
and d 2 d1 T
P 1 P2
ln T r
X
2
d1
,
T
d 2 d1 T
C $2.5
S $47.50
X $50
T 0.25 years
r 0.05 (5% annual rate
compounded
continuously)
C?
S $47.50
X $50
T 0.25 years
r 0.05 (5% annual rate
compounded
continuously)
ln T r
X
2
d1
,
T
d 2 d1 T
C?
S $47.50
X $50
T 0.25 years
r 0.05 (5% annual rate
compounded
continuously)
C?
S $47.50
X $50
T 0.25 years
r 0.05 (5% annual rate
compounded
continuously)
Practice Problems
BKM Ch. 21: 7-10, 17,18
Practice set: 36-42.