Professional Documents
Culture Documents
Options
Road Map
Main Issues
• Introduction to Options
• Use of Options
• Qualitative Properties of Options
• Binomial Pricing Model
• Risk-Neutral Valuation
• Black-Scholes Formula
6-2 Options Chapter 6
Contents
1 Introduction to Options . . . . . . . . . . . . . . . . . . . . 6-3
1.1 Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-3
1.2 Option Payoff . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-4
1.3 Corporate Securities as Options . . . . . . . . . . . . . . . . . . . 6-8
2 Use of Options . . . . . . . . . . . . . . . . . . . . . . . . . 6-10
3 Properties of Options . . . . . . . . . . . . . . . . . . . . . . 6-11
4 Determinants of Option Value . . . . . . . . . . . . . . . . . 6-17
5 Binomial Option Pricing Model . . . . . . . . . . . . . . . . 6-18
5.1 One-period Option Pricing . . . . . . . . . . . . . . . . . . . . . 6-19
5.2 Two-period Option Pricing . . . . . . . . . . . . . . . . . . . . . 6-21
5.3 Lessons from the Binomial Model . . . . . . . . . . . . . . . . . . 6-25
5.4 Criticisms of the Binomial Model . . . . . . . . . . . . . . . . . . 6-26
6 “Risk-Neutral” Pricing: A Shortcut . . . . . . . . . . . . . . 6-27
6.1 State Prices and Risk-Neutral Probabilities . . . . . . . . . . . . . 6-27
6.2 Principle of Risk-Neutral Pricing . . . . . . . . . . . . . . . . . . 6-32
7 General Binomial Pricing Formula . . . . . . . . . . . . . . . 6-33
8 Black-Scholes Option Pricing Formula . . . . . . . . . . . . . 6-36
9 Appendix: Black-Scholes Formula . . . . . . . . . . . . . . . 6-38
10 Homework . . . . . . . . . . . . . . . . . . . . . . . . . . . 6-39
1 Introduction to Options
1.1 Definitions
Option types:
Exercise styles:
• European or American.
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-4 Options Chapter 6
Note:
• Sometimes, it is positive.
100 100 @
@
@
@
@
@
- @ -
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-6 Options Chapter 6
Payoff
100 6 a
a
a
a
a
a
a
a
a
0 aa a a a a a a a a a a
a a a a a a a a a a a a a a a a a a
-
or
ST = $105.025.
Payoff of
a straddle
6
100 @@
@
@
@
@
@
@ -
Asset
100 price
Example. The underlying asset and the bond (with face value
$100) have the following payoff diagram:
Payoff of Payoff of
asset bond
6 6
100 100
- -
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-8 Options Chapter 6
• Firm B’s bond has a face value of $50. Thus default is likely.
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-10 Options Chapter 6
2 Use of Options
Hedging Downside while Keeping Upside.
The put option allows one to hedge the downside risk of an asset.
Payoff of Payoff of
asset & put asset + put
6 6
Payoff of Payoff of
a call a put
6 6
100 100 @
@
@
@
@
@
- @ -
Asset
100 Asset 100 price
price
3 Properties of Options
For convenience, we refer to the underlying asset as stock. It
could also be a bond, foreign currency or some other asset.
Notation:
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-12 Options Chapter 6
Price Bounds
3. C ≥ S − KB (assuming no dividends).
Strategy (a): Buy a call
Strategy (b): Buy a share of stock by borrowing K .
The payoff of strategy (a) dominates that of strategy (b):
Payoff
6 b
b
b
b
b
b
b
b
call b
b
-
b
b
b
b KB ST
b
b
b
b strategy (b)
b
b
Since C ≥ 0, we have
C ≥ max[S −KB, 0].
Option
price
6
lower
upper option bound
price
bound
KB Stock price
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-14 Options Chapter 6
Put-Call Parity
Since the two portfolios have identical payoffs, they must have
the same value:
C + K/(1 + r)T = P + S.
c(S, K, T ) = C(S, K, T ).
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-16 Options Chapter 6
Effect of Dividends
1. With dividends,
max[S −KB −PV (D), 0] ≤ C ≤ S.
2. strike price K
3. time to maturity T
4. interest rate r
5. dividends D
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-18 Options Chapter 6
uT S
uT −1 dS
u2 S ..
.
uS
duS uj dT −j S
S ···
udS uj−1 dT −j+1 S
dS ..
d2 S .
udT −1 S
dT S
75 1.1
50 1
25 1.1
25
C0
0
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-20 Options Chapter 6
25a + 1.1b = 0.
That is
Now we generalize the above example when there are two periods
to go: period 1 and period 2. The stock price process is:
112.5
75
37.5
S =50
37.5
25
12.5
Cuu = 62.5
Cu
Cud = 0
C
Cdu = 0
Cd
Cdd = 0
where
• the terminal value of the call is known, and
• Cu and Cd denote the option value next period when the stock
price goes up and goes down, respectively.
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-22 Options Chapter 6
37.5a + 1.1b = 0.
• Thus, Cu = 34.075.
Cu = 34.075
C0
Cd = 0
25a + 1.1b = 0.
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-24 Options Chapter 6
112.5
75 [62.5]
[(0.833,−28.4); 34.075] 37.5
[0]
50
[(0.6815,−15.48); 18.59]
37.5
25 [0]
[(0,0); 0] 12.5
[0]
“Play Forward” —
Thus
• No early exercise.
• Replicating strategy gives payoffs identical to those of the call.
• Initial cost of the replicating strategy must equal the call price.
• interest rate
• strike price
• time to maturity.
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-26 Options Chapter 6
• Price takes more than two possible values over a given period.
Response:
• For a small enough trading period, price may not move a lot.
But over many periods, price can move a lot.
CFu
CFd
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-28 Options Chapter 6
1 0
φu φd
0 1
1 R−d 1 u−R
φu = and φd = .
R u−d R u−d
uS = 75
S0 = 50
dS = 25
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-30 Options Chapter 6
u2 S = 112.5
uS = 75
udS = 37.5
S = 50
duS = 37.5
dS = 25
d2 S = 12.5
E∗ [CF 2 ]
PV0 =
(1+r)2
112.5 112.5
75
37.5 75
S = 50
37.5 50
25
12.5 50
• If your firm has sold one of these contracts, how do you hedge
the risk exposure to changes in stock price? — an exercise.
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-32 Options Chapter 6
Caveats:
• The risk preferences and true probabilities are all rolled into
one set of probabilities — the risk-adjusted probabilities.
uT S
uT −1 dS
u2 S
..
uS .
duS uj dT −j S
S ···
udS uj−1 dT −j+1 S
dS
d2 S
..
.
udT −1 S
dT S
The risk neutral probabilities for the two branches at each node
is
R−d u−R
q= and 1−q = .
u−d u−d
1 j
PV(CF ) = T q (1−q)T −j CF (ω).
R ω
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-34 Options Chapter 6
Its price is
T
1 T!
C= q j (1−q)T −j max[uj dT −j S − K, 0] .
RT j!(T −j)!
j=0
max[un dT −j S − K, 0] = 0.
• For all j ≥ n
max[ua dT −j S − K, 0] = un dT −j S − K.
• Then
T
T! uj dT −j
C(S, K, T ) = S q j (1 − q)T −j
j!(T −j)! RT
j=n
T
T!
−KR−T q j (1 − q)T −j .
j!(T −j)!
j=n
Let
R−d
q= and q = (u/R)q
u−d
and
T
T!
Φ[n; T, q ] = q j (1−q )T −j
j!(T −j)!
j=n
T
T!
Φ[n; T, q] = q j (1−q)T −j
j!(T −j)!
j=n
Then, we have
where
ln(K/SdT )
n = smallest nonnegative integer greater than .
ln(u/d)
If n > T , C(S, K, T ) = 0.
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-36 Options Chapter 6
where
• x is defined by
ln S/KR−T 1 √
x= √ + σ T
σ T 2
• T is in units of a year
Then
30
− 365
ln 50/50(1.05895)
1 30 = 0.0977
x = + (0.3) 365
(0.3) 30 2
365
30
− 365 30
C = 50N (0.0977) − 50(1.05895) N 0.0977−0.3 365
= 50(0.53890) − 50(0.99530)(0.50468)
= 1.83.
c Jiang Wang Fall 2003 15.407 Lecture Notes
6-38 Options Chapter 6
Let T be the length of a given time horizon. Divide it into n steps and the
step size is h = T /n. Suppose that the stock price process is described by a
n-step binomial tree over the time from 0 to T . Let the up-step be u and the
down-step be d as before and the corresponding probabilities be p and 1 − p,
respectively. Choose u, d and p such that
√ √ 1 1
u = eσ T /n , d = e−σ T /n , and p = + (µ/σ) T /n.
2 2
It can be shown that for any t (0 ≤ t ≤ T ), for n very large (thus step-size h
very small)
E [ln (St /S0 )] = µt; Var [ln (St /S0 )] = σ 2 t.
Thus, µ gives the expected rate of return on the stock and σ gives the volatility.
where
ln S/ KR−T 1 √
x= √ + σ T.
σ T 2
10 Homework
Readings:
• BM Chapters 20.
Assignment:
• Problem Set 5.
c Jiang Wang Fall 2003 15.407 Lecture Notes