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VALUATION

OUTLINE

• Terminology

• Option Payoffs

• Black-Scholes Model

• Binomial Model

TERMINOLOGY

• CALL AND PUT OPTIONS

• OPTION HOLDER AND OPTIONS WRITER

• EXERCISE PRICE OR STRIKING PRICE

• EXPIRATION DATE OR MATURITY DATE

• EUROPEAN OPTION AND AMERICAN OPTION

• EXCHANGE-TRADED OPTIONS AND OTC OPTIONS

• AT THE MONEY, IN THE MONEY, AND OUT OF THE

MONEY OPTIONS

• INTRINSIC VALUE OF AN OPTION

• TIME VALUE OF AN OPTION

OPTION PAYOFFS

PAYOFF OF A CALL OPTION

PAYOFF OF A

CALL OPTION

PAYOFF OF A

PUT OPTION

PAYOFFS TO THE SELLER OF OPTIONS

PAYOFF

E

STOCK PRICE

PAYOFF

E

STOCK PRICE

OPTIONS

BUYER/HOLDER SELLER/WRITER

OBLIGATIONS NO OBLIGATIONS OBLIGATIONS-NO RIGHTS

CALL RIGHT TO BUY/TO GO OBLIGATION TO SELL/GO

LONG SHORT ON EXERCISE

PUT RIGHT TO SELL/ TO OBLIGATION TO BUY/GO

GO SHORT LONG ON EXERCISE

PREMIUM PAID RECEIVED

EXERCISE BUYER’S DECISION SELLER CANNOT

INFLUENCE

MAX. LOSS COST OF PREMUIM UNLIMITED LOSSES

POSSIBLE

MAX. GAIN UNLIMITED PROFITS PRICE OF PREMIUM

POSSIBLE

CLOSING • EXERCISE • ASSIGNMENT ON OPTION

POSITION OF • OFFSET BY SELLING • OFFSET BY BUYING BACK

EXCHANGE OPTION IN MARKET OPTION IN MARKET

TRADED • LET OPTION MARKET • OPTION EXPIRES AND KEEP

WORTHLESS THE FULL PREMIUM

FACTORS DETERMINING

THE OPTION VALUE

• EXERCISE PRICE

• EXPIRATION DATE

• STOCK PRICE

• INTEREST RATE

C0 = f [S0 , E, 2, t , rf ]

+ - + + +

BLACK - SCHOLES MODEL

E

C0 = S0 N (d1) - N (d2)

ert

N (d) = VALUE OF THE CUMULATIVE

NORMAL DENSITY FUNCTION

S0 1

ln E + r + 2 2 t

d1 =

t

d2 = d1 - t

r = CONTINUOUSLY COMPOUNDED RISK - FREE

ANNUAL INTEREST RATE

= STANDARD DEVIATION OF THE CONTINUOUSLY

COMPOUNDED ANNUAL RATE OF RETURN ON

THE STOCK

BLACK - SCHOLES MODEL

ILLUSTRATION

S0 = RS.60 E = RS.56 = 0.30

t = 0.5 r = 0.14

STEP 1 : CALCULATE d1 AND d2

S0 2

ln E + r + 2 t

d1 =

t

.068 993 + 0.0925

= = 0.7614

0.2121

d2 = d1 - t

= 0.7614 - 0.2121 = 0.5493

STEP 2 : N (d1) = N (0.7614) = 0.7768

N (d2) = N (0.5493) = 0.7086

STEP 3 : E 56

= = RS. 52.21

ert e0.14 x 0.5

STEP 4 : C0 = RS. 60 x 0.7768 - RS. 52.21 x 0.7086

= 46.61 - 37.00 = 9.61

ASSUMPTIONS

• THE STOCK PRICE IS CONTINUOUS AND IS

DISTRIBUTED LOGNORMALLY

• THERE ARE NO TRANSACTION COSTS AND

TAXES

• THERE ARE NO RESTRICTIONS ON OR

PENALTIES FOR SHORT SELLING

• THE STOCK PAYS NO DIVIDEND

• THE RISK-FREE INTEREST RATE IS KNOWN AND

CONSTANT

SUMMING UP

• An option gives its owner the right to buy or sell an asset on or before

a given date at a specified price. An option that gives the right to buy

is called a call option; an option that gives the right to sell is called a

put option.

• A European option can be exercised only on the expiration date

whereas an American option can be exercised on or before the

expiration date.

• The payoff of a call option on an equity stock just before expiration is

equal to:

Stock Exercise

Max price - price, 0

equal to:

Exercise Stock

Max

price - price, 0

• Puts and calls represent basic options. They serve as building blocks

for developing more complex options. For example, if you buy a stock

along with a put option on it (exercisable at price E), your payoff will

be E if the price of the stock (S1) is less than E; otherwise your payoff

will be S1.

• A complex combination consisting of (i) buying a stock, (ii) buying a

put option on that stock, and (iii) borrowing an amount equal to the

exercise price, has a payoff that is identical to the payoff from buying

a call option. This equivalence is referred to as the put-call parity

theorem.

• The value of a call option is a function of five variables: (i) price of the

underlying asset, (ii) exercise price, (iii) variability of return, (iv) time

left to expiration, and (v) risk-free interest rate.

• The value of a call option as per the binomial model is equal to the

value of the hedge portfolio (consisting of equity and borrowing) that

has a payoff identical to that of the call option.

• The value of a call option as per the Black and Scholes model is:

E

C0 = S0 N (d1) - N (d2)

ert

PUT CALL PARITY THEOREM - 1

position (S1) position (P1)

E-

Stock Stock

E price (S1) E price (S1)

(S1)

Value of borrow position (-E) E Buy a put

(P1)

E Combination

(buy a call)

C1= S1+ P1-E

Stock price (S1) 0 E Stock price (S1)

Borrow (-E)

-E --------------------------------------- -E

PUT CALL PARITY THEOREM - 2

OPTION

P1 = MAX [(E - S1 ), 0]

S1 = TERMINAL VALUE

E = AMOUNT BORROWED

C1 = S1 + P1 - E

OPTION VALUE : BOUNDS

FOR THE VALUE OF CALL OPTION

CALL OPTION BOUND (S0) BOUND ( S0 – E)

STOCK PRICE

0 E

BINOMIAL MODEL

OPTION EQUIVALENT METHOD – 1

• S CAN TAKE TWO POSSIBLE VALUES NEXT YEAR, uS OR

dS (uS > dS)

• B CAN BE BORROWED .. OR LENT AT A RATE OF r, THE

RISK-FREE RATE .. (1 + r) = R

•d < R > u

• E IS THE EXERCISE PRICE

Cu = MAX (u S - E, 0)

Cd = MAX (dS - E, 0)

BINOMIAL MODEL : OPTION EQUIVALENT

METHOD - 2

PORTFOLIO

SHARES OF THE STOCK AND B RUPEES OF BORROWING

STOCK PRICE RISES : uS - RB = Cu

STOCK PRICE FALLS : dS - RB = Cd

Cu - Cd SPREAD OF POSSIBLE OPTION PRICE

= =

S (u - d) SPREAD OF POSSIBLE SHARE PRICES

dCu - uCd

B =

(u - d) R

SINCE THE PORTFOLIO (CONSISTING OF SHARES AND B

DEBT) HAS THE SAME PAYOFF AS THAT OF A CALL OPTION,

THE VALUE OF THE CALL OPTION IS

C = S - B

ILLUSTRATION

S = 200, u = 1.4, d = 0.9

E = 220, r = 0.10, R = 1.10

Cu = MAX (u S - E, 0) = MAX (280 - 220, 0) = 60

Cd = MAX (dS - E, 0) = MAX (180 - 220, 0) = 0

Cu - Cd 60

= = = 0.6

(u - d) S 0.5 (200)

dCu - uCd 0.9 (60)

B = = = 98.18

(u - d) R 0.5 (1.10)

0.6 OF A SHARE + 98.18 BORROWING … 98.18 (1.10) = 108 REPAYT

PORTFOLIO CALL OPTION

WHEN u OCCURS 1.4 x 200 x 0.6 - 108 = 60 Cu = 60

WHEN d OCCURS 0.9 x 200 x 0.6 - 108 = 0 Cd = 0

C = S - B = 0.6 x 200 - 98.18 = 21.82

BINOMIAL MODEL RISK-NEUTRAL METHOD

CALL OPTION WITHOUT KNOWING ANYTHING

ABOUT THE ATTITUDE OF INVESTORS TOWARD

RISK. THIS SUGGESTS … ALTERNATIVE METHOD …

RISK-NEUTRAL VALUATION METHOD

1. CALCUL ATE THE PROBABILITY OF RISE IN A

RISK NEUTRAL WORLD

2. CALCULATE THE EXPECTED FUTURE VALUE ..

OPTION

3. CONVERT .. IT INTO ITS PRESENT VALUE USING

THE RISK-FREE RATE

PIONEER STOCK

1. PROBABILITY OF RISE IN A RISK-NEUTRAL WORLD

RISE 40% TO 280

FALL 10% TO 180

EXPECTED

RETURN = [PROB OF RISE x 40%] + [(1 - PROB OF RISE) x - 10%]

= 10% p = 0.4

2. EXPECTED FUTURE VALUE OF THE OPTION

STOCK PRICE Cu = RS. 60

STOCK PRICE Cd = RS. 0

0.4 x RS. 60 + 0.6 x RS. 0 = RS. 24

3. PRESENT VALUE OF THE OPTION

RS. 24

= RS. 21.82

1.10

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