CHAPTER TWENTY-ONE

OPTION VALUATION

CHAPTER OVERVIEW
This chapter discusses factors affecting the value of an option, determination of option pricing in a two-
state world (binomial option pricing), hedge ratios, and the Black-Scholes option-pricing model.
Portfolio insurance techniques are also discussed. The chapter presents hedging applications related to
mispriced options and concludes with a discussion of the empirical evidence of option pricing.

LEARNING OBJECTIVES
After studying this chapter, the student should have an understanding of the factors affecting option
prices. Students will be able to compute option prices in the two-scenario model of the economy
(binomial option pricing), compute the Black Scholes value of an option, compute hedge ratios, apply
delta neutral hedging and construct portfolio insurance strategies using option hedge ratios.

PRESENTATION OF MATERIAL
21.1 Option Valuation: Introduction
The concept of an option’s intrinsic value was developed in Chapter 20. Section 21.1 describes the
concept of time value of an option building on intrinsic value. A graph that compares the intrinsic and
time value of a call option is displayed in Figure 21.1.

The discussion then turns to the factors that will have influence on the value of a call option. The
relationship between the first two factors determines the intrinsic value. Other factors constant, the higher
the stock price the higher will be the value of the call. Other factors constant, the higher the exercise
price the lower will be the value of the call. Options on stocks with greater volatility will be more
valuable than options on lower volatility stocks. The payoffs from the call are not symmetric. The upside
potential is greater with higher volatility stocks but the downside loss potential does not increase
proportionately. The longer the time to expiration, the greater will be the option price. Higher interest
rates, holding other factors constant, will increase a call option’s value. Higher interest rates will lower
the present value of the exercise price. Higher interest rates may also reduce the stock price. Generally,
higher dividend payouts will limit the ability of a firm to grow. Other factors constant, higher dividends
will reduce the value of the option. Table 21.1 summarizes these determinants or relationships.

Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
21.2 Restrictions on Option Values
The value of levered equity gives the lower bound for option value. The value of the option cannot
exceed the value of stock. This places the upper bound on option price. This section presents a
discussion on early exercise of an American option and if it makes sense (e.g., an American Put). Figure
21.2 demonstrates graphically the range of prices that is ruled out by the upper and lower bounds for the
value of a call option. Figure 21.3 graphically presents the call option value as a function of the current
stock price. In Figure 21.4, Panel A illustrates the value of an American put option as a function of the
current stock price while Panel B provides the European put as a contrast.

21.3 Binomial Option Pricing

This section presents binomial pricing examples based on the example that is developed in the text. The
example assumes the stock is currently priced at $100 and will have a value of either $120 or $90 at the
end of the period. A call that has an exercise price of $110 will be worth $0 or $10 at the end of the
period. With a 10% interest rate, an alternative portfolio can be developed by borrowing $81.82 and
investing $18.18 to buy one share of stock for $100. The payoff for such a strategy would be $0 or $30.
This payoff is the same as the payoff for three calls and must be priced accordingly. With the conditions
that we have assumed the price of the call would equal $6.06. Finally, the concept of adding more sub-
periods to the binomial model adds greater precision in estimating values. This section provides a few
different examples that can be discussed to illustrate the points in this section. Example 21.1 works
through a binomial option pricing, while Example 21.2 provides a working example of calibrating u and d
to stock volatility. Example 21.3 continues the previous example by increasing the number of sub-
periods. The section ends with Figure 21.5, illustrating probability distributions for final stock prices
through different subintervals.

21.4 Black-Scholes Option Valuation

Section 21.4 develops the Black-Scholes Option Pricing Model, summarized in Equation 21.1. It is
recommended that students work through the examples provided manually at least once before using the
Excel application (described below). The Excel spreadsheet that calculates option value is very helpful in
using the Black-Scholes Option Model. Students may need a refresher on cumulative distributions.
Figure 21.6 illustrates a standard normal curve and Example 21.4 provides an example of the Black-
Scholes Valuation formula. Table 21.2 presenting the cumulative normal distribution may also be helpful
for this discussion.

Given the option price that is observed in the market, it is possible to calculate the volatility that is
implied by the option. The implied volatility can then be compared to the estimated volatility of the
stock. If the implied volatility is higher than the estimated volatility for the stock, the option price would
be considered too high. Spreadsheet 21.1 shows example calculations using an Excel spreadsheet and
Figure 21.7 shows how to use the Goal Seek function in Excel to compute an implied volatility. If the

Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
implied volatility is lower than the estimated volatility of the stock, the option price would be too low.
Option prices are sensitive to changes in expected volatility. Figure 21.8 shows the implied volatility of
the S&P 500. The spikes in implied volatility are present with major news events.

The Black-Scholes formula must be adjusted with stocks that pay dividends. Modify it by replacing the
stock price with the difference between the stock price and the present value of expected dividends.

This section concludes with put option pricing derived from the put-call parity theorem. For Example
21.5, in the text, the put would have a value of $6.35.

21.5 Using the Black-Scholes Formula

The appropriate hedge ratio is the options delta which is the slope of the option price at the current stock
price. An overview of the concept of portfolio insurance is presented here. The basic concept involves
the purchase of protective puts. Purchase of protective puts is a straight forward in concept but there are
some limitations to the implementation of portfolio insurance. Since indexes are commonly used for the
puts, tracking errors are possible. The maturities of the puts are often too short. Even if the portfolio of
stocks remains constant, the deltas change as the stock prices change. Figure 21.9 graphically presents
call option value and hedge ratio.

The chapter presents a few examples using hedging with option prices. Example 21.6 works through a
hedge ratio example and 21.7 a synthetic protective put options example. The examples are built from
expected option mispricing based on the volatility that is implied in the option price. Since option values
are positively related to volatility, if an investor believes the implied volatility is incorrect, then the
investor can trade on the perceived mispricing. The hedge that is used for an example is designed to take
advantage of the option mispricing but to avoid the risk associated with changes in the price of the
underlying stock. Figure 21.10 presents profit on an at-the-money protective put strategy, while Figure
21.11 illustrates deltas change as the stock price fluctuates.

The profit positions from the hedged transaction shows that the profit (loss) position on the options is
subject to changes in the underlying stock price. The hedged transaction results in positive profit even
when the stock price changes causing a change in the option value. The overall profit on the position
depends on the correct assessment of the volatility. The option prices in the example adjust to the
expected volatility level. Figure 21.12 shows that futures sold far below the stock index level on day
recorded.

This section also tackles the relationship between options and the Financial Crisis of 2008-2009. Merton
shows how option pricing models can provide insight. Figure 21.13 illustrates the value of a put option on
the value of the implicit put option in a loan guarantee. Figure 21.14 uses the Black-Scholes model to plot
call option elasticity as a function of the value of the underlying stock. The key to understanding his

Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.
argument is to remember that when banks lend to or buy the debt of firms with limited liability, they
implicitly write a put option to the borrower (see Chapter 20, Section 20.5). The section concludes with a
discussion of hedging bets on mispriced options. Example 21.8 illustrates a speculating on Mispriced
options and Table 21.3 profit on hedged put portfolio. Finally Table 21.4 shows the option prices at 30%
volatility in Panel B and Panel C shows the values of your position for various stock prices.

21.6 Empirical Evidence on Option Pricing

Evidence offered by vast numbers of studies show that for the most part that Black-Scholes does a good
job in pricing options. The major limitation that has appeared is the inconsistency of implied volatility.
If the model were exact, expected volatility would be constant across exercise price. As depicted in
Figure 21.15, the implied volatility is not constant.

Excel Model
The Black-Scholes Option Pricing Model is available in a spreadsheet at the Online Learning Center
(www.mhhe.com/bkm). The model is setup to allow students to assess the sensitivity of the factors that
affect option pricing. The model can be used to examine the implied volatility for sets of options as well.

Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent
of McGraw-Hill Education.