Prof. Pankaj K.

Gupta
Effect of Variables on Option Pricing

Variable c p C P
S0 + – + –
K – +? – +
T ? + +
 + + + +
r + – + –
D – + – +
Properties of Stock Prices

E ( ST )  S0 eT
2 2 T 2T
var ( ST )  S0 e (e  1)
Binomial Model

ƒ = [ pƒu + (1 – p)ƒd ]e–rt

e rT  d
p
ud
Binomial Model Illustration
 Assume that spot rate of a stock is 20 and the stock can
move +10%(u) or –10%(d), and X=21, then
S 0  20 , t  3 m , S 0 u  22 , S 0 d  18

 Assuming that no arbitrage opportunities exists and the

value of the portfolio at the end of time period t is
certain so that its is able to generate a return equal to
risk free rate.
Binomial Model Illustration
22

20
18

In order to construct risk less portfolio, the ending value of

the portfolio should be same in both the situations.
 Binomial Model Illustration
 Position – Long Stock  and Short Call
 Portfolio Value = 22  and Value of the option = 1 if the
closing price is 22
 Portfolio Value = 18  if the closing price is 18
 22  - 1 = 18  ;  = 0.25
 If the closing price is 22 or 18 the value of the portfolio will
be 4.5
 Binomial Model Illustration
 Value of the portfolio today

0.12*3 / 12
4.5e  4.367
 If f is the option price the value of the portfolio today is
20*0.25-f = 5- f
 5-f = 4.367 ; f = 0.633
Practice Illustration
The stock price of Tata Motors is currently quoted at Rs. 400 in
the market. The market expectation about the stock is that its
value may increase or decrease by 10% in each of the next two
half-years. The return on the Government security being traded
in the market for same maturity is 5% p.a. The European call
option on Tata Motors stock with exercise price Rs.425 is
available in the market. You are required to calculate the value of
call option using two-step Binomial model.
Black-Scholes-Merton Model
 rT
c  S 0 N (d1 )  K e N (d 2 )
 rT
pKe N ( d 2 )  S 0 N ( d1 )
ln( S 0 / K )  (r   2 / 2)T
where d1 
 T
2
ln( S 0 / K )  (r   / 2)T
d2   d1   T
 T
Practice Illustration
IIM Exports Ltd. is currently trading at Rs. 47. The 6-month
call options for are available at a strike price of Rs. 50 The
volatility of the stock is 40% p.a. and risk free rate is 10%.
Compute the theoretical price using Black-Scholes model.
 Hedge Ratio
 Black Sholes Model – N(d1)
 Binomial Model Δ
Arbitrage Argument
A risk less arbitrage opportunity is one that without initial
investment, generates nonnegative returns under all
circumstances and positive returns under some
circumstances. In an efficient market, such opportunities
should not exist.
Relative Option Prices
An American call(put) with a longer time to expiration
cannot be worth less than an otherwise identical call
(put) with a shorter time to expiration.
A call(put) with a higher (lower) strike price cannot be
worth more than otherwise identical call(put) with a
lower(higher) strike price.
 Relative Option Prices
The difference in the value of two otherwise identical
options cannot be greater than the difference in their strike
prices.
A call is never worth more than the stock price, an
American put is never worth more than the strike price, and
a European put is never worth more than the present value
of the strike price.
Put-Call Parity
Consider a portfolio consisting of one short European Call,
one long European Put, one share of stock and a loan of
PV(Y). Assume that stock pays no dividends and the X and t
is same for both the options. The value of the portfolio is
C - P - S + PV(Y)
Put-Call Parity
If S>X, the call will be exercised and the amount received
i.e. X shall be used to pay the loan Y. The value of the
portfolio is therefore zero.
If S<X, the put will be exercised and the value of the
portfolio will again be zero.
Put-Call Parity
The arbitrage principle says that the value of the portfolio
be same as today. Therefore,
C - P - S + PV(Y) = 0
which implies that
C = P + S - PV(Y)
where PV(Y) = Ye -rt
 Early Exercise of American Call Options
An American call option must not be exercised early
because-
 No income is sacrificed
 Payment of the strike price is delayed
 Holding the call provides insurance against stock price falling
below strike price.
If the trader is convinced with the profit opportunity,
it is better to sell the option than to exercise it.
Early Exercise of American Put Options
If the put option is deep in the money the option must be
exercised because the profit can be invested to earn profit.
Also it guards against the risks if losing profit if the stick
prices go down.
 Implied Volatility
 The implied volatility of an option is the volatility for which
the Black-Scholes price equals the market price

 The is a one-to-one correspondence between prices and

implied volatilities.

 Traders and brokers often quote implied volatilities rather

than stock prices
 Volatility Smiles
 A volatility smile shows the variation of the implied volatility
with the strike price.

 The volatility smile should be the same whether calculated

from call options or put options.

 The volatility smile is a declining curve for equity assets.

 Volatility Term Structure
 This shows the variation of implied volatility with the time to
maturity of the option.

 The volatility term structure tends to be downward sloping

when volatility is high and upward sloping when it is low.
 Estimating Volatility
 Define n as the volatility per day between day n-1 and
day n, as estimated at end of day n-1 and Si as the value
of market variable at end of day i.
 Define ui= ln(Si/Si-1){continuously compounded return}
m
1
n 
2

m  1 i 1
( un i  u ) 2

m
1
u   un i
m i 1
Estimating Volatility Contd...
If  is the weight given to the current data


m
n
2
 i 1
 i u 2
n i

where
m


i 1
i 1
ARCH Model
In an ARCH(m) model we also assign some weight to the
long-run variance rate, VL:

  VL  i 1  i u n2i
2 m
n

where
m
   i  1
i 1
EWVA Model
 In an exponentially weighted moving average model, the
weights assigned to the u2 decline exponentially as we
move back through time
 This leads to

  
2
n
2
n 1  (1   )u 2
n 1
 EWVA Model Contd….
 Relatively little data needs to be stored

 We need only remember the current estimate of the variance

rate and the most recent observation on the market variable

 Tracks volatility changes

 Risk Metrics uses = 0.94 for daily volatility forecasting

EWVA Model Contd….
Assume that the most recent estimate of the daily volatility
of an asset is 1.5% and the price of the asset at the close of
the trading day yesterday was 30. Assume =0.94, compute
the new volatility if the assets now closes at 30.50
{1.5103%}
GARCH(1,1)
 In GARCH (1,1) we assign some weight to the long-run
average variance rate

  VL  u
2
n
2
n 1   2
n 1

Since weights must sum to 1

 GARCH(1,1) Contd...
Setting V the GARCH (1,1) model is

n
2
  u n 1
2
  n 1
2
and


VL 
1   
 GARCH(1,1) Contd...
If

vi   i ,
2
defined as
m 2


ui
{ ln(vi )  }
i 1 vi
GARCH(1,1) Illustration
If the Nifty closed yesterday at 1040 and the daily volatility
of the index was estimated as 1% per day at that time. The
parameters of GARCH(1,1) model are  =0.000002, =0.06
and =0.92. If the level of the index at the close of trading
today is 1.060, what is the new volatility estimate?{1.078%}

Daily Return = 1060-1040/1040=0.01923

Forecasting Volatility using GARCH(1,1)
k
E [ 2
nk ]  VL  (   ) (  VL ) 2
n
The parameters of GARCH(1,1) model are  =0.000004, =0.05 and
=0.92.What is the long run average volatility and what is the expected
volatility if the current volatility is 20% per year? VL = 0.0001333
n=0.2/SQRT252=0.0126

{SQRT0.0001471=0.0121}
Thank You