Option Pricing

Teaching Agenda
✓ Put Call Parity Concept
✓ Discrete-time Option Pricing – Binomial Model
◼ Assumption
◼ One-Step Binomial Model
➢ Riskless Portfolio concept and Option price computation
✓ Binomial Model Generalisation (Cox, Ross and Rubinstein)
➢ Binomial Model Parameter
➢ Determination of p, u and d
➢ Multi-steps Tree and Option price computation
✓ 2 Steps Binomial Model – Example walkthrough
✓ 3 Steps Binomial Model – Example walkthrough
✓ Continuous-time Option Pricing – Black Scholes Model
◼ Assumption & Limitation
◼ Example
✓ Convergence of Binomial model to Black-Scholes model
✓ Volatility
◼ Types of Volatility
◼ Example walkthrough

Recommended Reference
Options, Futures, And Other Derivatives, Chapter - Binomial trees, The Black-Scholes-Merton Model
2
Put Call Parity Relationship
◼ The arbitrage relationship which links European options markets to cash
markets.
C = Call premium
P = Put premium
X = Option strike price
T = Time to maturity
ST = Stock price at maturity (or forward price)

◼ Alternative 1: C + long Bond PV(X)

➢ Buy 1 Call (C) with strike X and long Bond at PV of strike X.

At maturity T, the portfolio value are

ST < = X ST > X
Long Call 0 ST - X
Long Bond PV (X) X X
Portfolio Value at T X ST
3
Put Call Parity Relationship (Cont)
◼ Alternative 2: P + S0
➢ Long Put (P) with strike X and long Physical Stock at S0

At maturity T, the portfolio value are:

ST < = X ST > X
Long Put X - ST 0
S0 ST ST
Portfolio Value at T X ST
◼ Both alternatives have same portfolio value at maturity T
◼ Therefore, to avoid arbitrage at T0, C + long Bond PV (X) = P + S0 ;
where long Bond PV (X) = X e –rT
C + X e –rT = P + S0
or C = P + S0 - X e –rT
or P = C - S0 + X e –rT
◼ This equation is called Put-Call Parity
◼ If this relationship is mispriced, it presents an arbitrage opportunity
4
Put Call Parity Example – No Arbitrage case
Put-Call Parity Example
= P + 0− ^(− )
Put-Call Parity Theoretical Option Price Calculation
S0 $110 If Put 2.00 (Actual)
X $100 Then Call 14.47 (Theoretical)
r 2.50%
T 1

Assume the Current Option Market Price

Put $2.00
Call $14.47 ** at Put-Call Parity

Portfolio Value today (at T0) Portfolio Value at T (option expiry) Arbitrage Opportunties
Current Stock Price ST < = X ST = X ST > X Arbitrage Opportunties ST < = X ST = X ST > X
Alternative 1 - Long Call + Long Bond @ PV(X) if ST = 95.00 100.00 105.00 if ST = 95.00 100.00 105.00
A1 Value at T0 -112.00 -112.00 -112.00
Buy 1 Call -14.47 Exercise Call 0.00 0.00 5.00 A2 Value at T0 -112.00 -112.00 -112.00
Long Bond @ PV(X) -97.53 Bond Redemption @X 100.00 100.00 100.00 Net P&L at T0 (Long A1+Short A2) 0.00 0.00 0.00
A1 Value at T0 -112.00 A1 Value at T 100.00 100.00 105.00
A1 Value at T 100.00 100.00 105.00
Alternative 2 - Long Put + Long Stock A2 Value at T 100.00 100.00 105.00
Net P&L at T (Long A1+Short A2) 0.00 0.00 0.00
Long 1 Put -2.00 Exercise Put 5.00 0.00 0.00
Long Stock -110.00 Sell Stock / Deliver vs Put 95.00 100.00 105.00 Arbitrage P&L (Long A1 + Short A2) 0.00 0.00 0.00
A2 Value at T0 -112.00 A2 Value at T 100.00 100.00 105.00

Portfolio Value Gap at T0 0.00 A1 - A2 Portfolio Value Gap at T 0.00 0.00 0.00

5
Put Call Parity Example – Arbitrage case
Put-Call Parity Example
= P + 0− ^(− )
Put-Call Parity Theoretical Option Price Calculation
S0 $110 If Put 2.00 (Actual)
X $100 Then Call 14.47 (Theoretical)
r 2.50%
T 1

Assume the Current Option Market Price

Put $2.00
Call $10.00 ** Call is under valued

Portfolio Value today (at T0) Portfolio Value at T (option expiry) Arbitrage Opportunties
Current Stock Price ST < = X ST = X ST > X Arbitrage Opportunties ST < = X ST = X ST > X
Alternative 1 - Long Call + Long Bond @ PV(X) if ST = 95.00 100.00 105.00 if ST = 95.00 100.00 105.00
A1 Value at T0 -107.53 -107.53 -107.53
Buy 1 Call -10.00 Exercise Call 0.00 0.00 5.00 A2 Value at T0 -112.00 -112.00 -112.00
Long Bond @ PV(X) -97.53 Bond Redemption @X 100.00 100.00 100.00 Net P&L at T0 (Long A1+Short A2) 4.47 4.47 4.47
A1 Value at T0 -107.53 A1 Value at T 100.00 100.00 105.00
A1 Value at T 100.00 100.00 105.00
Alternative 2 - Long Put + Long Stock A2 Value at T 100.00 100.00 105.00
Net P&L at T (Long A1+Short A2) 0.00 0.00 0.00
Long 1 Put -2.00 Exercise Put 5.00 0.00 0.00
Long Stock -110.00 Sell Stock / Deliver vs Put 95.00 100.00 105.00 Arbitrage P&L (Long A1 + Short A2) 4.47 4.47 4.47
A2 Value at T0 -112.00 A2 Value at T 100.00 100.00 105.00

Portfolio Value Gap at T0 4.47 A1 - A2 Portfolio Value Gap at T 0.00 0.00 0.00

6
Put Call Parity Example – Arbitrage case
How it works in practice?
Put-Call Parity Example

=P + 0− ^(− )

S $110 Put-Call Parity Theoretical Option Price Calculation

X $100 if Put $2.00 (Actual)
r 2.50% then Call $14.47 (Theoretical)
T 1

Assume the Current Market Option Price as follows:

Put $2.00
Call $10.00 ** Call is under-valued
** Arbirtrage exist when the call is undervalued and/or the put is overvalued

A) Construct an Arbitrage Strategy in practice

1. buying the call (long call)
2. selling the put (short put)
3. selling 1 share S short at 110
4. buying $97.53 bond at PV(X) with yield r

B) Net Arbitrage Profit & Loss Evaluation

Portfolio at T0 Portfolio at T
Current Stock Price ST < = X ST = X ST > X
Proceed if ST = 95.00 100.00 105.00
Buy 1 call -10.00 Exercise call 0.00 0.00 5.00
Short 1 put 2.00 Deliver shares to settle short put -5.00 0.00 0.00
Sell 1 share 110.00 Buy back 1 share at market price -95.00 -100.00 -105.00
Buy bond @PV(X) -97.53 Receive cash from bond redemption 100.00 100.00 100.00
Total Proceed 4.47 Total Proceed 0.00 0.00 0.00

7
Discrete-Time Option Pricing
Binomial Model

◼ Popular Technique for Pricing an Option or other

Derivative
◼ Possible paths followed by underlying asset’s price
◼ Risk-Neutral Valuation
◼ Cox, Ross and Rubinstein [CRR 1979]

8
Assumption – Binomial Model
◼ The stock price follows a random walk
◼ In each time step, it has a certain probability of moving up or down by a
certain amount
◼ This is assumed that investors are risk-neutral (i.e. investor is indifferent
about risk preference)
◼ In the risk-neutral portfolio (i.e. the hedged portfolio with combination of
option and stock), the risk-neutral assumption simplify the option
valuation,
➢ Arbitrage opportunities do not exist

➢ the return it earns must equal the risk-free interest rate (hence,
discount rate used for expected payoff of an option is the risk-free
interest rate)
➢ the value of the hedged portfolio is the same and are independent of
risk preferences (i.e. regardless of underlying stock price move up or
down)
9
 One-Step Binomial Model
Example
3-month European call option on the stock has a strike price of $21
The current stock price is $20, risk free rate = 12% per annum

At the end of 3 month, the stock price is anticipated to be either $22 or $18
Hence,
If stock price = $22, option price = $1
If stock price = $18, option price = $0

Stock Price Option Price

Today at the end of 3 month Today at the end of 3 month
Option price = $1
Stock price = $22 Max (22-21,0)

Option price Call option price at

Stock price = $20 at T0 = ? maturity :
Max (S-X,0)

Stock price = $18 Option price = $0

Max (18-21,0)

10
To Create the Riskless Portfolio
Construct the risk-neutral hedged portfolio
Long : Δ share (where Δ is hedge ratio)
Short : 1 call option (- + = -)
The portfolio is riskless if the value of Δ is chosen such that the
final portfolio value is the same for either rise / fall in stock
price
Portfolio value when stock ↑ $22 : 22 Δ – 1
Portfolio value when stock ↓ $18 : 18 Δ
Hence, 22 Δ – 1 = 18 Δ
Δ = 0.25
A risk-neutral portfolio is therefore:
Long: 0.25 shares
Short : 1 option
11
Option Price
What is the portfolio value at option expiry (in 3 months) ?
If stock price ↑ $22 : 22 Δ – 1 = 22 x 0.25 – 1 = 4.5
If stock price ↓ $18 : 18 Δ = 18 x 0.25 = 4.5
◼ The portfolio value at option expiry is the same regardless of
stock price up or down at option expiry.
◼ Risk-neutral portfolio, in the absence of arbitrage opportunities,
must earn the risk-free rate: Risk-neutral portfolio
Portfolio value at T3m
Long 0.25 stock
Short 1 Call Stock price = $22
Portfolio value at T0 = PV of portfolio value at T3m Call Option price = 1

Portfolio value at To Portfolio value = 4.5

PV of portfolio value at T0 with risk free rate 12% p.a.
is 4.5 e -0.12 X 0.25 = 4.367 Stock price = $20
Call Option Price ?

The portfolio value at T0 is 4.367, hence Portfolio value = 4.367

20 x 0.25 – Option Price = 4.367 Stock price = $18

Call Option price = 0

Option Price = 0.633 Portfolio value = 4.5

12
Binomial Model Parameter
Input parameter
S = Current Stock Price
X = Stock Call Option Strike/Exercise Price
T = Option life expiration in year
σ = Volatility
r = Risk free interest rate (with continuous compounding)
n = no. of steps in bonomial tree

Intermediate calculated parameter

p = Risk neutral probability of up jump size
u = Up jump size (e.g. ΔS = 10%, u = 1.10)
d = Down jump size
∆t = period interval in each binomial nodes
=T/n

To estimate
f = Current option price

13
Generalization
In One-step model ... T = Δt
Current Up at T Down at T
Stock Price S Su Sd

Derivative Price f fu fd

Current T0 Expiry T Su − f u = Sd − f d

Su
fu − f d
fu
=
S Su − Sd
f
Sd
fd
where ∆ is Hedge Ratio

14
Derivative Price
r = risk - free interest rate
(
PV of portfolio = Su − f
u
)e − rT

(
Thus, S − f = Su − f
u
)e − rT

f = e − rT pf + (1 − p) f 
u d

e rT − d
where p=
u−d
15
 Determination of p, u and d
To generalise in multi-step model...
p, u and d must give the correct values for
mean and variance of stock price change during each step Δt
Sert = pSu + (1 − p) Sd
2 2 rt
S e  2 t
(e − 1) = pS 2u 2 + (1 − p) S 2 d 2 − S 2  pu + (1 − p)d  2

1
u= condition by Cox, Ross and Rubinstein
d
e rt − d
p= u = e t d = e − t
u−d
16
Multi-steps Tree – Stock Price Projection
Time to maturity = T

Time per step = Δt Time per step = Δt Time per step = Δt Time per step = Δt

Su3 Su4
Su2
Su Su Su2
S
S Sd S
Sd
Sd2
Sd2
Sd3

Sd4 17
Working Backwards - Option values

◼ Option values are evaluated by starting at the

end of the tree (Time T)
◼ Option value at time (T-Δt ) is the expected
value at time T discounted at risk-free rate r for
a time period Δt

** Please practice using the Excel model provided

18
Example – 2 Steps Models
Current share price = $70
Call option strike price = 80
Risk free rate = 12%
(with continuous compounding)
Option life to maturity = 3 month
Stock price volatility = 20%
What is the Call option price ?
$0.21

If Put option strike price = 80

What is the Put option price ?
$7.85

Put Call Parity Holds?

C – P = S – Xe-rT
C-P = $0.21 - $7.85 = -$7.64
S – Xe-rT = $70 - 80e-(0.12*3/12)= -$7.64
19
 Example – 3 Steps Trees
Current share price = $70
Call option strike price = 80
Risk free rate = 12%
(with continuous compounding)
Option life to maturity = 3 month
Stock price volatility = 20%
What is the Call option price ?
$0.59

If Put option strike price = 80

What is the Put option price ?
$8.23
Put Call Parity Holds?
C – P = S – Xe-rT
C-P = $0.59 - $8.23 = -$7.64
S – Xe-rT = $70 - 80e-(0.12*3/12)= -$7.64
20
Example – 3 Steps Trees
If Put option strike price = 80

What is the Put option price for American Option ?

$10

21
Continuous-time Option Pricing
Black-Scholes Model for underlying securities pay no
dividend Expected Value of S if S > X at
Expiration (i.e. in-the-money)
(expectations taken using Present Value of
𝑆0: Current stock price risk-neutral probabilities) Cost of
𝑋: Option strike price Investment
𝑇: time to expiration (in year)
𝑟: continuous compounding interest rate
𝜎: volatility
Risk-Neutral Probability of S > X
at Expiration (i.e. in the money)
European call price 𝐶 = 𝑆0𝑁(𝑑1 ) − 𝑋𝑒 −𝑟𝑇 𝑁(𝑑2 )

European put price 𝑃 = −𝑆0𝑁(−𝑑1 ) + 𝑋𝑒 −𝑟𝑇 𝑁(−𝑑2 )

𝑤ℎ𝑒𝑟𝑒:
𝑆 𝜎2
𝐿𝑁 0 + (𝑟 + )𝑇
𝑋 2
𝑑1 =
𝜎 𝑇
𝑆0 𝜎2
𝐿𝑁 + (𝑟 − )𝑇
𝑋 2
𝑑2 = = 𝑑1 − 𝜎 𝑇
𝜎 𝑇
𝑁(𝑑) = standard normal cumulative probability distribution at d1 and d2
N(d1) = the delta of an option
N(d2) = probability that the option will be exercised (i.e. in the money)

22
Assumption - Black-Scholes Model
◼ The underlying price follows a geometric lognormal
diffusion process
◼ The risk free rate is known and constant
◼ The volatility of the underlying asset is known and
constant
◼ there are no taxes and transaction costs
◼ there are no cash flows on the underlying
◼ the options are European
Limitation of Black-Scholes Model
◼ The log-normal assumption does not capture extreme
movements such as stock market crashes.
◼ Volatility and interest rate are not constant throughout the
option’s life in practice
◼ The model is very sensitive to the value of volatility which is
difficult to estimate
◼ The model normally uses historic volatility for the option
price for a future period
◼ Application to non-traded assets is questionable (e.g.
employee stock options)
Example
Continue the example from Binomial Model, the input parameter are:
Initial Stock Price = 70 (S)
Interest rate with continuous compounding = 12% (r)
volatility (%) = 20% (σ)
Time to expiration = 3 months (T)
Strike Price = 80 (X)
Day count convention = Act / 360

The Call Option Price = 0.5735

The Put Option Price = 8.2092

Using Black-Shole Model, the input parameter are:

N(d1) = -0.9853
N(d2) = -1.0853

The Put-Call Parity holds?

25
 Example (Cont’d)
Black-Scholes Model (for non-dividend paying stock) For N(d), you can obtain the value using
Excel function

NORM.S.DIST(z,cumulative)

Option Input This returns the standard normal

S Spot Price 70.00 distribution (has a mean of zero and a
X Strike Price 80.00 standard deviation of one).
Maturity (time to maturity in days) 90 Use this function in place of a table of
r Interest Rate (risk free) - continuous 12.00% standard normal curve areas.
σ Volatilty 20.00%
d Dividend 0.00%
N(d1) = NORM.S.DIST(-0.9853,TRUE) =
0.16223
N(d2) = NORM.S.DIST(-1.0853,TRUE) =
0.13889

Calculations N(-d1) = NORM.S.DIST(0.9853,TRUE) =

T Maturity (time to maturity in years) 0.2500 Use 360 days for 1 year 0.83777
Interest Rate (Continuous Compounding) 0.1200 N(-d2) = NORM.S.DIST(1.0853,TRUE) =
d_1 -0.9853 0.86111
d_2 -1.0853
Call = So N(d1) – X e^-rt N(d2)
Option Output = (70 x 0.16223) – [(80 e ^(12%x0.25))
Call Premium 0.5735 x 0.13889]
Put Premium 8.2092 = 0.5735

Put = - So N(-d1) + X e^-rt N(-d2)

Put Call Parity - Validation = (-70 x 0.83777) + [(80
Call 0.57 0.57 C e^(12%x0.25)) x 0.86111]
Put 8.21 = 8.2092
Stock 70
Xe-rT 77.6356 0.57 P + S - Xe-rT ** The result may have slight margin of
difference due to rounding of actual figures
P-C Parity Checking 0.00 displayed above.
26
Convergence of Binomial model to Black-
Scholes model
◼ For a given period to the option expiry, a binomial
model will converge to Black-Scholes Model as the
number of branches increases, the possible
binomial up and down movements in the price must
be chosen to suit the parameters assumed by the
Black-Scholes model
Binomial Model Black-Scholes Model
2-Step 3-Step
Call $0.21 $0.59 $0.57
Put $7.85 $8.23 $8.21

27
Volatility
◼ To measure the degree to which the price of an underlying
asset fluctuate over time
◼ the uncertainty about the future stock price
◼ This is the only variable that cannot be directly observed and
easily obtained
◼ Different volatility estimate will result in different option price
◼ This is important inputs to price of option, why?
➢ expectations about future prices movement
➢ liquidity
➢ volatility tends to revert to mean over time

28
Types of Volatility
Historical Volatility
◼ actual volatility during a specified time period from past historical
data
Future Volatility
◼ actual volatility from present to option expiration

Implied Volatility
◼ computed from available option price at a particular point in time

◼ Can be worked backwards to infer the volatility by setting the Black-

Sholes price equal to the market price
Forecasted Volatility
◼ Estimate of future volatility based on pre-defined model

29
Example
n


Observed 1
Month
Price (S t )
Xt
Volatility  = ( xt − x ) 2
0 100
n −1 t =1
1 102 0.019803 0.000123
2 99 -0.029853 0.001486 St = observed stock price at time period t
3 97 -0.020409 0.000847 Xt = LN (relative price change) = LN (St / St-1)
4 89 -0.086075 0.008982 n = no. of Xt observation in the sample period
5 103 0.146093 0.018878
6 104 0.009662 0.000001 Monthly variance is
7 102 -0.019418 0.000790 σ2 = 0.037639 / (12-1)
8 99 -0.029853 0.001486 = 0.003422
9 104 0.049271 0.001646 Monthly standard deviation (i.e. monthly volatility)
10 102 -0.019418 0.000790 σ = √ 0.003422 = 0.058495 = 5.85%
11 105 0.028988 0.000412 The monthly historical volatility estimate is 5.85%
12 111 0.055570 0.002197
Annualized standard deviation (i.e. annualized volatility)
Σ Xt 0.104360 conversion
= AVERAGE(Xt) = (ΣXt ) / n 0.008697 σ a = σ t* √ T
where
σ t = standard deviation of observed price frequency
0.037639
T = observed price frequency per year

Hence, σ a = 0.058495 x √ 12 = 0.2026

The annualized historical volatility estimate is 20.26%
30