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Option Pricing
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December 11, 2019

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 1. Introduction

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An option is a contract giving the buyer the right, but not
the obligation, to buy (call) or sell (put) the underlying as-
Title Page set at a specific price on or before a certain date.
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Options are known as derivatives because they derive their
JJ II value from an underlying asset.
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European call option on stock with strike K and expiration
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T : Holder can buy one share of stock for price K at time T .
Go Back Payoff is (ST − K)+ .
Colab link for payoff function
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 Fundamental Theorem

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If there is no arbitrage and r is the interest rate, then there
exists measure (called a risk-neutral measure Q) such that
Title Page the price of the call option is
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EQ e−rT (ST − K)+ . (1)
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In fact the first fundamental theorem of asset pricing asserts
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that a market is arbitrage free iff there exists a risk neutral
Page 3 of 30 measure. The latter is defined as a measure that is equiva-
lent to the physical measure under which discounted prices
Go Back of all traded assets are martingales.
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HW: Show that C + e−rT K < S0 admits arbitrage. Here
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C is the price at time 0 of a European CALL option with
Quit strike K maturity T . The price of the underlying STOCK
at time 0 is S0 and the risk free interest rate is r. Trading
is allowed at times 0 and T in STOCK, BOND and CALL.
 Black-Scholes set-up

The dynamics of the underlying asset is represented by the

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geometric Brownian motion
Title Page dSt = µSt dt + σSt dBt
Contents while interest rates follow the following non-stochastic dif-
ferential equation
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dRt = rRt dt.
J I Here Bt is standard Brownian motion. This allows the ex-
plicit solution
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St = S0 exp (µ − σ 2 /2)t + σBt .

(2)
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Let C(t, x) be the function that describes the price of a
Full Screen contingent claim. Then, C(t, x) solves the following (non-
stochastic) partial differential equation:
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1
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rC(x, t) = Ct (x, t) + rxCx (x, t) + σ 2 x2 Cxx (x, t).
2
This is obtained from Ito calculus and the first fundamental
theorem.
 Under the risk neutral measure, µ = r.

2 /2
Home Page HW: Show this using EQ (e−rt St = S0 and mgf(u)=eu for
a standard normal random variable.
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Contents Under the Black Scholes set-up, the price of Call option is
JJ II S0 Φ(d1 ) − Ke−rT Φ(d2 )
J I 2
√
where d1 = (log(S
√ 0 /K) + (r + σ /2)T )/(σ T)
Page 5 of 30 and d2 = d1 − σ T .
Φ is the standard normal cdf.
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Full Screen HW: Show this using (2), (1) and µ = r.

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simulation
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 Examples of Options

American option can be exercised at any time before the

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A basket option is an option on the weighted average of sev-

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eral underlyings.
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A lookback option is a path dependent option where the
option owner has the right to buy (sell) the underlying in-
Page 6 of 30 strument at its lowest (highest) price over some preceding
period.
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Full Screen An Asian option is an option where the payoff is not de-
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termined by the underlying price at maturity but by the
average underlying price over some pre-set period of time.
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A barrier option involves a mechanism where if a ’limit price’

is crossed by the underlying, the option either can be exer-
cised or can no longer be exercised.
 2. The Greeks

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Delta is the amount an option price is expected to move
based on a $1 change in the underlying stock. Calls have
Title Page positive delta, between 0 and 1. That means if the stock
price goes up and no other pricing variables change, the
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price for the call will go up. Puts have a negative delta,
JJ II between 0 and -1.
Colab link for computing Theta with Centered differencing
J I and Richarson’s extrapolation
Page 7 of 30

Delta is also important in Hedging as it equals the num-

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ber of shares of stock to hold in a replicating self financing
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 Gamma is the second-derivative of the option price with
respect to the stock price. Gamma indicates the amount
the delta would change given a unit move in the underlying
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security.
Title Page Theta is the amount the price of calls and puts will decrease
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(at least in theory) for a one-day change in the time to expi-
ration. Each moment that passes causes some of the option’s
JJ II time value to “melt away.” So theta is usually positive.
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 Vega is the amount call and put prices will change for a unit
change in volatility. Typically, as volatility increases, the
value of options will increase. That’s because an increase in
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volatility suggests an increased range of potential movement
Title Page for the stock.

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HW:
√ Show that for European CALL option “vega” equals
JJ II S0 T φ(d1 ), where φ is the normal pdf.
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These relations are also called sensitivities.
Page 9 of 30

Go Back Colab link for plotting option price vrs volatility. Also all
Greeks using R function.
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 3. Volatility

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The σ in the option price is the variance/volatility of the
stock price.
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Contents The value of σ obtained by inverting the observed option

price is called the Implied Volatility.
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J I The variance of stock price obtained from observed stock

prices is Realized Volatility.
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Go Back The difference is called Market Price of risk. This is

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generally positive, that is the observed price of option es-
timates volatility more than it is in the stock prices. This
Close is the price that the option market demands for providing
protection against extreme movements of the stock.
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 Compute Implied Vol

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1. Compute implied volatility by bisection method

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2. General Newton-Raphson update

Contents x1 = x0 − f (x0 )/f 0 (x0 ). (3)

JJ II This amounts to approximating the function as being

linear and using the root of the approximation as the
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updated guess. This is a faster root-finding algorithm
Page 11 of 30 than bisection.
Write the program in R for computing implied volatil-
Go Back ity using Newton Raphson method.
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guess=guess-call/vega
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3. A similar idea that does not require the computa-

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tion of derivative is to keep track of two most recent
(x,f(x)) and use the difference quotient. Write the pro-
gram in R for computing implied volatility using Se-
cant method.
 vega=(call-prior_call)/(guess-prior_guess)

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 The values of implied volatility obtained by inverting op-
tions of different maturities and strikes are not same. One
observes low IV when K is close to S0 and higher values far
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away, leading to the nomenclature of IV Smile.
Title Page These are often combined to form a single index, the most
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common measure being the VIX followed by CBOE.
Relevance of Options
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J I 1. Trade options to protect yourself against extreme move-

ments of the market.
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2. Use option prices to estimate the distribution and dy-

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namics of the underlying stock price process.
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3. Use option price together with stock price to estimate
Close the market price of risk.

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 4. Solution of PDEs for American
options
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Black-Scholes PDE was stated as

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1
Contents rC(x, t) = Ct (x, t)+rxCx (x, t)+ σ 2 x2 Cxx (x, t). (x, t) ∈ D,
2
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(4)
where t is a time variable, x is a state variable, and C(x, t)
J I is an unknown function.
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Note that with a change of variables this is same as the heat
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∂u ∂ 2u
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∂t ∂x
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 To find a well-defined solution, we need to impose the final
condition
C(x, T ) = CT (x)
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and, if D = [a, b]X[0, T ], the boundary conditions
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C(a, t) = ga (t) and C(b, t) = gb (t)

Contents

JJ II where CT , ga , gb are continuous functions.

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The diffusion equation (4) with the initial condition (4) and
Page 15 of 30 the boundary conditions (4) is well-posed, i.e. there exists a
unique solution that depends continuously on u0 , ga and gb .
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 Grid Points

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To find a numerical solution to equation (4) with finite dif-
ference methods, we first need to define a set of grid points
Title Page in the domain D as follows:
Choose a state step size ∆x = (b − a)/M
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and a time step size ∆t = T /N (M and N are an integers).
JJ II

J I Draw a set of horizontal and vertical lines across D, and get

all intersection points (xj , ti ), or simply (j, i),
Page 16 of 30 where xj = a + j∆x, j = 0, · · · , M
and ti = i∆t, i = 0, 1, · · · , N
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 Finite Differences

2
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The partial derivatives Cx := ∂C
∂x
and Cxx := ∂∂xC2 are always
approximated by central difference quotients, i.e.
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i i i
Cj+1 − Cj−1 Cj+1 − 2Cji + Cj−1
i
Contents Cx ≈ and Cxx ≈
2∆x (∆x)2
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at a grid point (j, i). Here Cji = C(xj , ti ). Depending on how
J I Ct is approximated, we have three basic schemes: explicit,
implicit, and Crank–Nicolson schemes.
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 Explicit Scheme

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If Ct is approximated by a backward difference quotient

Title Page Cji − Cji−1

Ct ≈
∆t
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at (j, i), then the corresponding difference equation to (4)

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at grid point (j, i) is
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Cji−1 = A(j)(Cj−1
i
+ B(j)Cji + C(j)Cj−1
i
,
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rx σ 2 x2
where A(j) = ∆t(− 2∆x + 2(∆x)2
).
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σ 2 x2
B(j) = 1 − ∆t(r + (∆x)2
)
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σ x 2
C(j) = ∆t( 2∆x + 2(∆x)2
).
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The difference equations 4 together with terminal and bound-
ary conditions can be solved explicitly, starting from the end
time T and going backwards. Colab link for explicit scheme
 American Option

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For an American option, if the price of Put option at any
point of time is lower than the value( (K − S)+ ), then one
Title Page can buy the put and execute at once to make guaranteed
profit. This is an arbitrage situation.
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JJ II So we need to introduce the extra condition that at every

J I step, P ≥ (K − S)+ .

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It can be shown that this is indeed a sufficient condition.
Go Back Colab link for pricing American option using explicit scheme

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 Implicit Scheme

If Ct is approximated by a forward difference quotient

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Cji+1 − Cji
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Ct ≈
∆t
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at (j, i), then the corresponding difference equation to (4)
JJ II at grid point (j, i) is
J I i
D(j)(Cj+1 i
+ E(j)Cji + F (j)Cj−1 = Cji+1 ,
Page 20 of 30 In matrix form
 
Go Back F (1) G(1)
 E(2) F (2) G(2) 
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 C = b.
 
 .. ..
 . . 
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E(M ) F (M )
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Since the matrix is in tri-diagonal form, the difference equa-
tions (4), together with the initial and boundary conditions
as before, can be solved using the Crout algorithm or the
SOR algorithm.
 Crank–Nicolson Scheme

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The Crank–Nicolson scheme is the average of the explicit
scheme at (j, i) and the implicit scheme at (j, i + 1). The
Title Page resulting difference equation is
!
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Cji+1 − Cji i
Cj−1 − 2Cji + Cj+1
i i+1
Cj−1 − 2Cji+1 + Cj+1
i+1
= σ 2 x2 +
JJ II ∆t (2∆x)2 (∆x)2
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The difference equations (4), together with the initial and
Page 21 of 30 boundary conditions as before, can be solved using Crout
algorithm or SOR algorithm.
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 Local Truncation Errors

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These are measures of the error by which the exact solution
of a differential equation does not satisfy the difference equa-
Title Page tion at the grid points and are obtained by substituting the
exact solution of the continuous problem into the numerical
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scheme.
JJ II

J I A necessary condition for the convergence of the numerical

solutions to the continuous solution is that the local trunca-
Page 22 of 30 tion error tends to zero as the step size goes to zero. In this
case the method is said to be consistent. It can be shown
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that all three methods are consistent. The explicit and
Full Screen implicit schemes have local truncation errors O(∆t, (∆x)2 ),
while that of the Crank–Nicolson scheme is O((∆t)2 , (∆x)2 ).
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 Stability

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A scheme is stable if roundoff errors are not amplified in the
calculations.
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Contents The Fourier method can be used to check if a scheme is sta-

ble following von Neumann stability condition.
JJ II

J I It can be shown that the explicit scheme is stable if and

∆t
only if λ = (∆x) 2 ≤ 1/2, called conditionally stable, and
Page 23 of 30
the implicit and Crank–Nicolson schemes are stable for any
Go Back values of λ, called unconditionally stable.

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 5. Pricing Path dependent Options

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The payoff depends on the entire path of the underlying and
not only the value at the point of execution.
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Contents One way is through simulation of the entire path multiple

times.
JJ II
RT
J I Payoff of Asian Option is ( T1 0
St dt − K)+ .
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Discretize the time and approximate by ( n1 ni=1 Sti/n −K)+ ,
P
Go Back compute this over M realizations of the path and take aver-
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age.
Colab link for pricing Asian option by simulating path and
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discretizing time. Then pricing using various approxima-
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Advisable to parallelize over the different paths.
 Why does averaging work

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Consider the problem of estimating an expectation α=E[f (U )],
with U uniformly distributed between 0 and 1.
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Contents Suppose we have a mechanism for drawing points U1 , U2 , · · ·

independently and uniformly from [0, 1].
JJ II

J I Evaluating the function f at n of these random points and

averaging the results produces the Monte Carlo estimate
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n
Go Back 1X
α̂n = f (Ui ).
n i=1
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If f is integrable over [0, 1] then, by the strong law of large
numbers,
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α̂n → α with probability 1 as n → ∞.
 If f is in fact square integrable and we set
Z 1
2
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σf = (f (x) − α)2 dx
0
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then by the Central Limit Theorem, the error α̂n − α in the
Contents Monte Carlo estimate is approximately normally
√ distributed
with mean 0 and standard deviation σf / n, the quality of
JJ II this approximation improving with increasing n.
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The parameter σf would typically be unknown in a setting
Page 26 of 30
in which α is unknown, but it can be estimated using the
Go Back sample standard deviation
n
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s2f = (f (Ui ) − α̂)2 .
n − 1 i=1
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Quit Thus, from the function values f (U1 ), · · · , f (Un ) we obtain

not only an estimate of α but also a measure of the error in
this estimate.
 √
The form of the standard error σf / n is a central feature
of the Monte Carlo method.
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In contrast, the error in the simple trapezoidal rule is O(n−2 ),
Title Page at least for twice continuously differentiable f .
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Monte Carlo is generally not a competitive method for cal-

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culating one-dimensional integrals.
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Page 27 of 30
The value of Monte Carlo as a computational tool lies in the
fact that its O(n−1/2 ) convergence rate is not restricted to
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 The problem is now to generate random vectors (SiT /n , i =
1, · · · , n) where S follows geometric Brownian motion
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dSt = µSt dt + σSt dBt
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Brownian motion is a process starting at zero with contin-
Contents uous paths and independent normal increments with mean
zero and variance equal to the time interval.
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BiT /n − B(i−1)T /n ∼ N (0, T /n) and independent over all i.
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p
Page 28 of 30 Hence BiT /n = B(i − 1)T /n + T /nZi where Z1 , · · · , Zn
are iid standard normal.
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p
Full Screen From (2), SiT /n = S(i−1)T /n exp((µ − σ 2 /2)T /n + σ T /nZi ).
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 Barrier option

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A barrier option is “knocked out” if the underlying asset
crosses a prespecified level.
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Contents For instance, a down-and-out call with barrier b, strike K,

and expiration T has payoff 1τ (b) > T (S(T ) − K)+, where
JJ II τ (b) = inf t : S(t) < b is the first time the price of the un-
J I derlying asset drops below b.

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A down-and-in call gets “knocked in” only when the under-
Go Back lying asset crosses the barrier. Up-and-out and up-and-in
calls and puts are defined analogously.
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Close These are discretely monitored if t ∈ 0 ≤ t1 < · · · < tn ≤ T .

They can be priced by simulation through sampling of
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S(t1 ), · · · , S(tn ), S(T ).
 Lookback options

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Lookback puts and calls expiring at tn have payoffs

Title Page (maxi=1,··· ,n S(ti ) − S(tn ))

Contents and
(S(Tn ) − mini=1,··· ,n S(ti ))
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respectively.
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Page 30 of 30 A lookback call, for example, may be viewed as the profit

from buying at the lowest price over t1 , · · · , tn and selling at
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the final price S(tn ).
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Continuously monitored versions of these options are defined
by taking the maximum or minimum over an interval rather
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Both lookback and barrier options can be valued by simula-

tion of the entire path.