Financial Management

Lecture 6: Option Valuation I

Professor Andrea Vedolin

ETH Zürich
 Today

Main Ingredients for Option Valuation:

I Assumptions on the price movements of the underlying asset
I Replicating portfolio strategy vs Direct pricing
I The Law of One Price

Binomial Option Pricing: Single Period Model

Binomial Option Pricing: Multiperiod Period Model

Dynamic Trading Strategy

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 Price Dynamics of the Underlying Asset
The payoff of a generic option can be written as: Option PayoffT = f (ST )
For instance:
Call Put
PayoffT max(ST − K , 0) max(K − ST , 0)

Since the value of ST is unknown today, we need at least to know what are
the possible realizations of ST and the likelihood of these realizations
⇓

we need to impose some structure on the price dynamics of the underlying asset

We will explore two cases:

1. Binomial model: the price of the underlying asset can move only up or down
with probability p and (1 − p)
2. Black-Scholes model: the price of the underlying asset can assume any
positive (real) value with Log-Normal distribution

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 Replicating Portfolio vs Direct Pricing

Direct Pricing:

the price/value of any security must be equal to the discounted value of

future expected cash flows, discounted with the appropriate discount rate:

Et [Payoff OptionT ] Et [f (ST )]

Price Optiont = =
(1 + r ∗ )T −t (1 + r ∗ )T −t

ISSUE: What is the appropriate discount rate? It depends on how risky

the cash flows of the option are and on the attitude towards risk of the
market participants... Very difficult to estimate it!

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 Replicating Portfolio vs Direct Pricing

Replicating Portfolio Strategy:

instead of pricing the option directly, we can do it indirectly by constructing a

portfolio of well known assets (underlying stock and risk-free bond) such that:

Payoff PortfolioT = Payoff OptionT

Since the replicating portfolio and the option have the same cash-flows at
time T , by the Law of One Price, it must be that, for any t < T :

Price Optiont = Price Portfoliot

TODAY: we learn how to construct a replicating portfolio, that is how to

answer the following questions:
I how much of the underlying asset do we have to buy or sell?
I how much of the risk-free bond do we have to buy or sell?

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 Binomial Option Pricing Model
Assumption: at the end of next period the stock price has only 2 possible values

A useful representation: The Binomial Tree

Note: at the end of next period the risk-free bond will always have the same
value regardless the realization of the stock price in the two states (up and down)

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 Single Period Binomial Model: Example 1

A European call option expires in one period and has an exercise price of $50
The stock price today is equal to $50 and the stock pays no dividends
In one period, the stock price will either rise by $10 or fall by $10
The one-period risk-free rate is 6%

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 Single Period Binomial Model: Example 1
How to construct a replicating portfolio for the call option?

Let ∆ be the number of shares of stock purchased, and let B be the initial
investment in bonds (or equivalently the number of bonds purchased)
To create a call option using the stock and the bond, the value of the
portfolio consisting of the stock and bond (the replicating portfolio) must
match the value of the option in every possible state (up and down)
In the up state the value of the portfolio must be equal to 10:

up : ∆ × 60 + B × (1 + 6%) = 10

In the down state the value of the portfolio must be equal to 0:

down : ∆ × 40 + B × (1 + 6%) = 0

The replicating portfolio (∆, B) is given by the solution of a system of 2

linear equations in 2 unknowns

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 Single Period Binomial Model: Example 1
A simple way to solve the system of linear equations:

∆ × 60 + B × (1 + 6%) = 10 (1)
∆ × 40 + B × (1 + 6%) = 0 (2)

Equation (1) - Equation (2) delivers:

10
∆ × (60 − 40) + 0 = (10 − 0) ⇒ ∆ = = 0.5
20
Substituting ∆ = 0.5 into either Equation (1) or Equation (2) we obtain:

10 − (0.5 × 60)
0.5 × 60 + B × (1 + 6%) = 10 ⇒ B = = −18.87
(1 + 6%)

Therefore, the replicating portfolio is given by (∆, B) = (0.5, -18.87)

I Long 0.5 shares of stock
I Short $18.87 worth of bond (or borrow $18.87)

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 Single Period Binomial Model: Example 1

By the Law of One Price:

Price Option0 = Value Replicating Portfolio0

= ∆ × 50 + B
= 0.5 × 50 − 18.87
= $ 6.13

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 Single Period Binomial Model: Example 1

Note: with this pricing strategy we solved for the price of the option without
knowing the probabilities of the two states in the binomial tree.
Indeed, we did not need to compute any expected value of future cash flows! This
is a very important result in finance:

to price derivatives we do not need to estimate investor beliefs

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 The Binomial Pricing Formula

S is the current stock price

S will either go up to Su or go down to Sd next period
The risk-free rate is rf
Cu is the value of a generic option if the stock goes up and Cd is the value of
the option if the stock goes down

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 The Binomial Pricing Formula

The replicating portfolio (∆, B) is such that the payoffs of the portfolio are
equal to the payoffs of the option next period in any state:

∆ × Su + B × (1 + rf ) = Cu
∆ × Sd + B × (1 + rf ) = Cd

Solving this system of 2 equations in 2 unknowns yields:

Cu − Cd Cd − Sd ∆
∆= and B=
Su − Sd 1 + rf
Therefore, the option price in the binomial model is given by:

C =∆×S +B

It works for calls and for puts, because Cd and Cu are changed

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 Multiperiod Binomial Model
To calculate the value of an option in a multiperiod binomial tree:

we solve for the pricing of the option at any node of the binomial tree
we start at the end of the tree and work backwards

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 Multiperiod Binomial Model
To calculate the value of an option in a multiperiod binomial tree:

we solve for the pricing of the option at any node of the binomial tree
we start at the end of the tree and work backwards

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 Multiperiod Binomial Model
To calculate the value of an option in a multiperiod binomial tree:

we solve for the pricing of the option at any node of the binomial tree
we start at the end of the tree and work backwards

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 Multiperiod Binomial Model
To calculate the value of an option in a multiperiod binomial tree:

we solve for the pricing of the option at any node of the binomial tree
we start at the end of the tree and work backwards

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 Multiperiod Binomial Model: Example 2

A European call option expires in two periods and has an exercise price of $50
The stock price today is equal to $40 and the stock pays no dividends
At the end of each period, the stock price will either rise by $10 or fall by $10
The one-period risk-free rate is 6%

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 Multiperiod Binomial Model: Example 2

Value of the option at time 1 in the up state:

If we are in the up state at time 1, the remaining part of the tree is:

Since this is the same problem we considered in Example 1, we conclude that:

C1u = $6.13 and (∆1u , B1u ) = (0.5, −18.87)

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 Multiperiod Binomial Model: Example 2

Value of the option at time 1 in the down state:

If we are in the down state at time 1, the remaining part of the tree is:

If we are in the down state at time 1, we know for sure that at time 2 any
possible payoff will be equal to 0. Therefore, we conclude that:

C1d = $0 and (∆1d , B1d ) = (0, 0)

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 Multiperiod Binomial Model: Example 2
Value of the option at time 0:

Given the value of the call option in either state at time 1 (which is indeed
the discounted value of expected future payoffs), we can consider the
binomial tree ONLY over the next period:

Using the Binomial Pricing Formula:

C1u − C1d 6.13 − 0
∆0 = = = 0.3065
S1u − S1d 50 − 30
C1d − S1d ∆0 0 − 30 × 0.3065
B0 = = = −8.67
1 + rf 1.06

Hence, (∆0 , B0 ) = (0.3065, −8.67) and C0 = ∆0 × S0 + B0 = $3.59

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 Multiperiod Binomial Model: Example 2
Replicating portfolio and Trading strategy:

How much of the underlying asset and of the bond do we have to buy or sell
at time 0? How much at time 1 in the upstate? And how much at at time 1
in the down state?

The price of the call option must be equal to the total cost of forming
and rebalancing the composition of the replicating portfolio over time.

Time 0: The total amount of share must be equal to ∆0 and the total
investment in the bond equal to B0 . Therefore, the trading at time 0 is given
by:

∆0 = 0.3065 (long 0.3065 shares of stock)

B0 = -$8.67 (borrow $8.67)

Cost of Trading0 = 0.3065 × $40 − $8.67 = $3.59

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 Multiperiod Binomial Model: Example 2

Time 1, up state: The total amount of share must be equal to ∆1u and the
total investment in the bond equal to B1u . Therefore, the trading in the up
state at time 1 is given by:

∆1u − ∆0 = 0.5 − 0.3065 = 0.1935 (long 0.1935 shares of stock)

B1u − B0 (1 + rf ) = −18.87 − (−8.67)(1.06) = -$9.67 (borrow $9.67)

Cost of Trading1u = 0.1935 × $50 − $9.67 = $0

Note: borrowing $9.67 can be seen as the net of:

i. repaying $8.67 plus interests = $8.67(1.06) = $9.20
ii. borrowing $18.87

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 Multiperiod Binomial Model: Example 2

Time 1, down state: The total amount of share must be equal to ∆1d and
the total investment in the bond equal to B1d . Therefore, the trading in the
down state at time 1 is given by:

∆1d − ∆0 = 0 − 0.3065 = -0.3065 (short 0.3065 shares of stock)

B1d − B0 (1 + rf ) = 0 − (−8.67)(1.06) = $9.20 (repay $9.20)

Cost of Trading1d = −0.3065 × $30 + $9.20 = $0

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 Multiperiod Binomial Model: Example 2

Summing all the costs,

C0 = Cost of Trading0 + Cost of Trading1u + Cost of Trading1d

= $3.59 + $0 + $0 = $3.59

We just showed that the dynamic trading strategy implemented to

replicate the option payoffs is “self-financing”: after the initial cost, no
more money is need to rebalance the portfolio.

Hence, the price of the option is equal ONLY to the initial cost of the
portfolio.
I Note that once we have passed 1u or 1d no more trading is required, because
we have targeted the option’s time 2 payoffs {10, 0} and {0, 0}, respectively.

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 Dynamic Trading Strategy

Very Important Result in Finance: An option payoff can be replicated by

dynamically trading in a portfolio of the underling stock and a risk-free bond.

Multiperiod binomial model ⇒ N states at the expiration date would

require N assets to construct a buy-and hold-replicating portfolio (that is a
portfolio which is not rebalanced overtime). For instance, for the case of 2
periods, we would need 4 assets:

However, if we can trade dynamically (in any period), 2 assets are enough!
Indeed, since we can rebalance the replicating portfolio at any point in time,
what matters is only the uncertainty over the next period.

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 Put Option Value: Example 1

Using the put-call parity for the put value:

50
P = C − S + PV (K ) = 6.13 − 50 + = 3.30
(1.06)1

Using the Binomial Pricing Formula for the put value:

Pu − Pd 0 − 10 10
∆= = =− = −0.5
Su − Sd 60 − 40 20
Pd − Sd ∆ 10 − 40 × (−0.5)
B= = = 28.30
1 + rf 1.06

Hence, (∆, B) = (−0.5, 28.30) and P = ∆ × S + B = $3.30

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 Next Class...

Next week, we finish the material on “Option Valuation” + Exercises

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