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OPTIONS AND THEIR

VALUATION
OUTLINE

• Terminology

• Option Payoffs

• Factors Determining Option Values

• Black-Scholes Model

• Binomial Model

• Put Call Parity Theorem


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

E (EXERCISE PRICE) STOCK PRICE

PAY OFF OF A PUT OPTION


PAYOFF OF A
PUT OPTION

E (EXERCISE PRICE) STOCK PRICE


PAYOFFS TO THE SELLER OF OPTIONS
PAYOFF

E
STOCK PRICE

(a) SELL A CALL


PAYOFF

E
STOCK PRICE

(b) SELL A PUT


OPTIONS
BUYER/HOLDER SELLER/WRITER

RIGHTS/ BUYERS HAVE RIGHTS- SELLERS HAVE ONLY


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

• STOCK PRICE VARIABILITY

• 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 CALL OPTION IS THE EUROPEAN OPTION


• 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

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


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

Value of stock Buy stock Value of put Buy put


position (S1) position (P1)
E-

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

Value of combination Buy a stock


(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

IF C1 IS THE TERMINAL VALUE OF THE CALL


OPTION

C1 = MAX [(S1 - E), 0]


P1 = MAX [(E - S1 ), 0]
S1 = TERMINAL VALUE
E = AMOUNT BORROWED
C1 = S1 + P1 - E
OPTION VALUE : BOUNDS

UPPER AND LOWER BOUNDS


FOR THE VALUE OF CALL OPTION

VALUE OF UPPER LOWER


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

STOCK PRICE
0 E
BINOMIAL MODEL
OPTION EQUIVALENT METHOD – 1

A SINGLE PERIOD BINOMIAL (OR 2 - STATE) MODEL


• 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

WE ESTABLISHED THE EQUILIBRUIM PRICE OF THE


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