FIN4110

Options and Futures

S2-2023

Topic 6
Fundamentals of Option Pricing

Haifeng Wu
 Learning outcomes

1. Factors affecting the value of an option

2. Options arbitrage
3. Put-call parity
4. Lower & Upper bound for call and put options
5. Single step binomial trees options pricing model
6. Risk natural valuation
7. Multi steps binomial trees options pricing model
(call/put)
8. Binomial trees pricing model for American Options
Options - recap

◼ Options that give the right to buy the underlying are known as
call options
◼ Options that give the right to sell the underlying are known as put
options
◼ The holder of an option has a long position
◼ The issuer of an option has a short position
◼ People holds short call position means he has obligation to sell
the underlying at K if the call has been exercised
◼ People holds short put position means he has obligation to buy
the underlying at K if the put has been exercised
◼ Options that can only be exercised at a specific time-of-maturity,
T, are called European options
◼ Options that can be exercised at any time prior to T are called
American options
Options – markets and underlying assets
◼ Common underlying assets for options are
➢ Stocks (typically American options)
➢ Stock indices (typically European options)
➢ Foreign currencies
➢ Futures contracts (including futures written on commodities)

◼ Trading options is similar to trading futures

➢ Actual markets have bid-ask spreads
➢ Each trade has a fixed cost (commission)
➢ If you write a naked option you must post and maintain a margin
➢ The option is naked if you don’t hold the underlying asset
Option market conventions and terminology
◼ If the underlying asset is a stock the option is typically American
➢ We will typically be interested in European options
◼ Contracts expire the third Friday of each month
◼ Expiration days are typically within six months
◼ Strike prices are typically traded at intervals of $2.5, $5 or $25
(depending on the price of the underlying asset)
◼ Option contracts take “mechanical changes” of the stock price into
account
➢ If there is a stock split or stock dividend, the contracts are adjusted
accordingly (so we don’t have to worry about such events)
◼ The payoff of an option if it expired or is exercised today is called the
intrinsic value of the option
➢ If the intrinsic value is positive the option is said to be in-the-money
➢ If the spot price is equal to the strike price the option is said to be at-the-
money
➢ Other options are said to be out-of-the-money
Notations
Factors affecting the value of an option
Upper bounds on option prices

◼ American options are like European option but with more rights,
so it must be that
➢ ct ≤ Ct
➢ pt ≤ Pt

◼ In the best case scenario, call options are exercised and

converted into a stock (or whatever the underlying asset is), so:
➢ ct ≤ St
➢ Ct ≤ St

◼ In the best case scenario, put options are exercised and

converted into $K, so:
➢ Pt ≤ K
➢ pt ≤ Ke-r(T-t) (we get the money at time T)
Calls: an arbitrage opportunity?

◼ Suppose that

◼ Is there an arbitrage opportunity?

Call option: an arbitrage opportunity?
◼ We don’t have money
◼ Sell the stock now @ S0, and plan to buy it back in 1yr.
◼ In order to make sure you can but the stock at known price, you
buy the stock call option and its strike price is K=18 at cost c0=3
◼ Cash Flow at T0:
◼ 20-3=17
◼ Cash Flow at T1:
◼ Deposit the 17 in to a bank and earn 10% risk free rate, one year
later will get 17e(0.1)x1=18.79
◼ If ST>K, buy the stock @ K=18, free cash flow 18.79-18=0.79
◼ If ST<K, buy the stock back, make more money
◼ Yes, in both scenarios, you will make arbitrage profit,
◼ So the call option price c0=3 is not arbitrage free
Lower bound for calls (European, arbitrage
free)
◼ Portfolio A: one European call option plus a zero-coupon bond
provides a payoff of K at time T
◼ Portfolio B: one share of the stock
◼ At T, if ST>K, the call option will be exercised and portfolio A will
be worth ST, if ST<K, the call option will not be exercised and
Portfolio A will be only worth K, so at time T, portfolio A is worth
max(ST,K)

◼ Portfolio B will be worth ST at time T

◼ So the Portfolio A is always worth as much as, and can be worth
than Portfolio B at T
PV(portfolio A)≥PV(Portfolio B)

c+Ke-rT ≥S0
Lower bound for European call option prices
- no dividends
Puts: an arbitrage opportunity?

◼ Suppose that

◼ Is there an arbitrage opportunity?

Put option: an arbitrage opportunity?
◼ We don’t have money
◼ Borrow the amount of S0+p at T0, so we borrow 38 (37+1) from
bank
◼ Buy one share of the Stock and buy one put option with strike
price K
◼ Cash Flow at T0:
◼ 37+1=38
◼ Cash Flow at T1:
◼ Repayment of the loan 38e0.05x0.5=38.96
◼ If ST<K, sell the stock @ K=40, free cash flow 40-38.96=1.04
◼ If ST>K, sell the stock at market price, make more money
◼ Yes, in both scenarios, you will make arbitrage profit,
◼ So the put option price p0=1 is not arbitrage free
Lower bound for put (European, arbitrage free)
◼ Portfolio C: one European put option plus one share of the stock
◼ Portfolio D: a zero-coupon bond provides a payoff of K at time T\
◼ At T, if ST>K, the put option will not be exercised and portfolio C will
be worth ST, if ST<K, the put option will be exercised and Portfolio
C will be worth K, so at time T, portfolio A is worth
max(ST,K)

◼ Portfolio D will be worth K at time T

◼ So the Portfolio C is always worth as much as, and can be worth
than Portfolio D at T

PV(portfolio C)≥PV(Portfolio D)

p+S0 ≥ Ke-rT
Lower bound for European put option prices
- no dividends
Put-call parity: no dividends

◼ Consider the following 2 portfolios:

➢ Portfolio A: European call on a stock + zero-coupon bond

that pays K at time T

➢ Portfolio C: European put on the stock + the stock

Values of portfolios

c+Ke-rT=p+S0
Arbitrage opportunities

◼ Suppose that

◼ What are the arbitrage possibilities when

p = 2.25 ?
p=1?
Example-put overpriced

◼ Given c+Ke-rT=p+S0
◼ c+Ke-rT=3+30e-0.1x3/12=32.26
◼ p+S0=2.25+31=33.25
◼ Portfolio C>Portfolio A, Portfolio C is overpriced
◼ Buy Portfolio A, Sell Portfolio C
◼ Buying call option, selling put option, and selling the stock
◼ Cash flow at T0=-3+2.25+31=30.25
◼ Invest at risk free rate, T0.25=30.25e0.1x0.25=31.02
◼ At T=0.25, if ST>30, long call option will be exercised, if ST <30,
short put option will be exercised, in both case, ends up to buy
stock @ 30
◼ 31.02-30=1.02 Arbitrage Profit
Example-put underpriced

◼ Given c+Ke-rT=p+S0
◼ c+Ke-rT=3+30e-0.1x3/12=32.26
◼ p+S0=1+31=32
◼ Portfolio C<Portfolio A, Portfolio A is overpriced
◼ Buy Portfolio C, Sell Portfolio A
◼ Selling call option, borrow money to buy put option and the
stock
◼ Cash flow at T0=3-31-1=-29
◼ Borrow at risk free rate, T0.25=29e0.1x0.25=29.73
◼ At T=0.25, if ST>30, short call option will be exercised, if ST
<30, long put option will be exercised, in both case, ends up to
sell stock @ 30
◼ 30-29.73=0.27 Arbitrage Profit
Early exercise
◼ Usually there is some chance that an American option will be exercised
early
◼ An exception is an American call on a non-dividend paying stock
◼ This should never be exercised early
◼ For an American call option:
➢ S0 = 100; T = 0.25; K = 60; D = 0
➢ Should you exercise immediately?

◼ What should you do if

➢ You want to hold the stock for the next 3 months?
➢ ST>K, buy @K anyway, also earn interest on K. ST<K, better to wait
➢ You do not feel that the stock is worth holding for the next 3
months?
➢ Sell the option to someone whom want to buy the share
➢ Given
➢ C ≥S0-Ke-rT or C>S0-K
Bounds for European or American call options
Should puts be exercised early ?

◼ Are there any advantages to exercising an American put when

➢ S0= 60; T = 0.25; r=10% K = 100; D = 0

◼ Think about St,T>t>0=0

◼ The money K you received today is always better than you
receive later, you can earn interest on
◼ It is optimal to exercise the American Put option early, especially
when
➢ S0 decrease, r increase and volatility decrease.

◼ max(Ke-rT-S0,0）≤p≤Ke-rT
◼ max(K-S0)<P<K
Bounds for European and American put options
Binomial trees
◼ A useful and very popular and simple technique for pricing an
option involves constructing a binomial tree, i.e., a diagram
representing different possible paths for the stock price over the
life of an option.
◼ The underlying assumption is that the stock price follows a
random walk. This implies that in each time interval, the stock
price will move up or down by a certain amount with a certain
probability.
◼ Given the stock price movement in each time interval, the value of
option written on the stock can be computed at different point in
time and level of stock prices described in the tree.
◼ In the limit, as the time interval becomes smaller, this model
converges to the Black-Scholes-Merton model.
One-period binomial model
Pricing assumption

◼ We try to form a risk-free portfolio using the

stock and its derivative and then use the
value of the portfolio to price the derivative =>
No Arbitrage Pricing

◼ There is a risk neutral probability which can

be used to price any derivative by taking the
expected value of its cash flows discounted at
the risk-free rate => Risk Neutral Pricing
No-arbitrage pricing principle illustration:
stock price movement
◼ A stock price is currently $20

◼ In 3 months it will be either $22 or $18

Stock Price = $22

Stock price = $20
Stock Price = $18
A call option

◼ A 3-month call option on the stock has a strike price of 21

◼ How can we value the price of the call option?

Stock Price = $22

Option Price = $1
Stock price = $20
Option Price=?

Stock Price = $18

Option Price = $0
Thinking path

◼ First, establish a portfolio of stock and option such that

there is no uncertainty about the value of the portfolio in
the next period (i.e., at maturity in our example as it has
only one period.)

◼ Because the portfolio has no risk, it must earn the risk

free rate of return.

◼ From this we deduce the value of the portfolio today, and

hence the value of the option today.
Setting up a riskless portfolio

◼ For a portfolio that is long D shares and a short 1 call

option values are
22D – 1

18D
◼ Portfolio is riskless when 22 D – 1 = 18 D or D = 0.25
Deduce the value of the portfolio
◼ Regardless of how the stock price moves,
the portfolio is always worth 4.5 at maturity. This
means that there is no uncertainty with the value
of portfolio.
◼ Since the portfolio is riskless, it must earn the
riskless rate r; otherwise there would be an
arbitrage opportunity (why?)
◼ Assume that r = 12% (continuous compounding)
◼ Hence, the present value of the portfolio must be
-0.12 * 3/12
4.5 × e = 4.5/1.03045 = 4.367
Deduce the value of the call option
◼ The value of the portfolio today is also the sum of the
values of its components:
20 × 0.25 – c = 5 – c = 4.367

◼ This means that the call price (today) is

c = 5 – 4.367 = 0.633

◼ This is the call price in the absence of arbitrage

opportunities.
Arbitrage opportunities may occur

◼ If the option value exceeded 0.633, the portfolio

would cost less than 4.367 to construct but still
return 4.5 at maturity. Hence, the portfolio would
earn more than the risk-free rate. An arbitrager
would borrow at risk-free rate and buy the portfolio.

◼ Similarly, if the option value were less than 0.633,

shorting the portfolio would provide a way of
borrowing at less than the risk-free rate. An
arbitrager would simply short the portfolio and invest
the proceeds at the risk-free rate.
Generalization
◼ Consider a non-dividend-paying stock with current price S0 and
an option on this stock with the current price f
◼ Suppose that the stock price can either move up from S0 to a
new level S0u or down from S0 to a new level of S0d (u>1; d<1) at
time T
◼ If the stock price moves up to S0u the option payoff is fu
◼ If the stock price moves down to S0d, the payoff is fd

S0u
ƒu
S0
ƒ
S0d
ƒd
Generalization
Generalization
Generalization
◼ Value of the portfolio at time T is S0uD – ƒu

◼ Value of the portfolio today is (S0uD – ƒu)e–rT

◼ Another expression for the portfolio value today

is S0D – f

◼ Hence

ƒ = S0D – (S0uD – ƒu )e–rT

No arbitrage option price
◼ Let’s recall ƒu − fd
D=
S 0u − S 0 d

and ƒ = S0D – (S0uD – ƒu )e–rT

◼ Substituting for D we obtain

ƒ = [ pƒu + (1 – p)ƒd ]e–rT

◼ Where S0e − S0 d e − d
rT rT
p= =
S 0u − S 0 d u−d
p represents the probability
Risk-neutral pricing

◼ {p, 1-p} corresponds to a risk neutral probability

measure. This probability has nothing to do with
the “true” probability which we may or may not
know

− rT
◼ Then, f = [ pf u + (1 − p ) f d ]e represents the
expected value of the derivative’s payoffs
discounted at the risk-free rate under this “risk
neutral” probability {p, 1-p}.

◼ This is called the risk neutral valuation.

Risk neutral valuation
◼ Assumption of risk-neutral means: investors do not increase the
expected return they require from an investment to compensate
for increased risk.
◼ Risk Neutral has two features:
➢ The expected return on a stock (or other investment asset） is the
risk-free rate
➢ The discount rate used for the expected payoff on an option (or
other derivatives) is the risk-free rate
◼ When we are valuing an option in terms of the price of the
underlying asset, the probability of up and down movements in
the real world are irrelevant
◼ This is an example of a more general result stating that the
expected return on the underlying asset in the real world is
irrelevant
Call option revisit
Call option revisit
Multi-step binomial trees
◼ We can add more and more steps to the tree. To do this, we
assume that the risk-free rate, r, is constant, and that u and d are
constant throughout the tree.
◼ So, after one step, the stock price can take on values Su, or Sd;
after two steps, the values are Suu, Sud = Sdu, or Sdd, etc.
◼ Note that this model has the property that the tree is
recombining, in other words, because Sud = Sdu, “going up then
down” is the same as “going down then up”.
◼ Also, the risk-neutral probability of an “up move”, p, is then the
same at each node of the tree. We then calculate option prices
starting with the payoffs (at time T) and then moving backwards
through the tree, node by node, using our one-step procedure.
◼ The risk-neutral approach is easier to use here.
Multi-step binomial trees
A two-step example

◼ The stock’s current price is 50, the risk-free rate

is 10% per year (compounded continuously),
and there is a 2-month European call with an
exercise price of 51.

◼ Let’s use u = 1.07, and d = 0.93.

◼ Then, Su = 53.5, Sd = 46.5, and

Suu = 57.245, Sud = 49.755, Sdd = 43.245.
A two-step example
A two-step example

◼ Call value at maturity, using the call payoff:

fT = max{0, ST – K }.
◼ The values are fuu = Suu – K = 57.245 – 51 = 6.245, fud = 0,
and fdd = 0 .
◼ At t = 1 month, we can use risk-neutral pricing. Given that r
= 10% and ∆t = 1/12, so

e rDt − d e( 0.10)(1/12) − 0.93

p= = = 0.5598
u−d 1.07 − 0.93
1 − p = 0.4402
A two-step example
◼ We can evaluate the call at t =1 month:

f u = ( pf uu + (1 − p) f ud ) e − rDt
= (0.5598  6.245 + 0.4402  0) e −0.10 /12 = 3.4669
f d = ( pf ud + (1 − p) f dd ) e −rDt
= (0.5598  0 + 0.4402  0) e −0.10 /12 = 0

◼ Then at t = 0:

f = ( pf u + (1 − p) f d ) e − rDt
= (0.5598  3.4669 + 0.4402  0) e − 0.10 / 12
= 1.92
A two-step example

◼ We combine stock and option prices into a single

tree:
Hedge ratio Δ

◼ Let’s look at the hedge ratios for this problem.

◼ At t = 0, we have
fu − f d 3.4669 − 0
D= = = 0.4953
Su − Sd 53.5 − 46.5
◼ At t = 1/12, in the “up” state, we have
f uu − f ud 6.245 - 0
Du = = = 0.8338
Suu − Sud 57.245 - 49.755
◼ While in the “down” state, we have
f du − f dd 0−0
Dd = = =0
Sdu − Sdd 49.755 - 43.245
Hedge ratio Δ
◼ Hedge Ratio Δ of the stock options represents the ratio of the
change in the price of the stock option to the change in the price
of the stock.
◼ It is the number of units of the stock we shall hold for each option
on hand in order to create a riskless portfolio.
◼ The construction of the riskless portfolio is referred as delta
hedging.
◼ The delta of a call option is positive, and the delta of a put
option is negative.
◼ The hedge ratio changes from period to period. If we want to
hedge this option, we have to re-balance the portfolio each
period.
◼ For a call option, as the option goes deeper into money, the
hedge ratio approaches +1, while as the option goes deeper out
of money, the hedge ratio approaches 0.
Price an European put option
Example:
◼ The stock’s current price is 50, the risk-free rate is 10% per year (cc),
and now there is a 2-month European put with a exercise price of 51.
◼ Again, we use u = 1.07, and d = 0.93.
◼ We use the same tree for the stock prices as in the previous two-step
example.
◼ The put value at maturity is:
fT = Max 0, K − ST 
◼ The values are: fuu=0
fud=K–Sud=51 – 49.755=1.245,
fdd=51–43.245 = 7.755 (please calculate the Suu,Sud,Sdd by yourself)
◼ Because u, d, r and ∆t are the same, the risk-neutral probability is still
equal to:
p=0.5598 and 1–p=0.4402
Price an European put option

◼ We can calculate at t=1 month:

f u = ( pf uu + (1 − p) f ud ) e − rDt = 0.5435
f d = ( pf ud + (1 − p) f dd ) e −rDt = 4.0766

◼ Finally, we have the put price at t=0:

f = ( pf u + (1 − p) f d ) e − rDt
= (0.5598  0.5435 + 0.4402  4.0766) e −0.10 /12
= 2.08
American options and early exercise
◼ Let’s consider a one-step tree for an American put
option. As usual, let p be the risk-neutral probability
of an “up” state, and 1 – p be the risk-neutral
probability of a “down” state.
◼ Let fE represent the price of a European put, and fA
be the price of an American put. Here’s the tree:
American put option

◼ For a European option, we would simply use risk-neutral

pricing:

f =e
E − rDt
E (_ payoff _ ) = e
p − rDt p
E pf ( E
u + (1 − p) f E
d )
◼ We can think of this price as the value of the option if we
continue to hold it.

◼ For an American option, however, we have the possibility

of early exercise. If we exercise at time t=0, our payoff for
the put option is K–S.
American put option

◼ If we exercise at date 0, our payoff for the put

option is K–S. So, the price of the American
option is the maximum of these two values:

A

f = Max K − S , e − rDt
(pf A
u + (1 − p) f A
d )
◼ For a multi-period binomial tree, we make this
calculation at each node of the tree, and the price
of an American option will be at least as much as
its European equivalent.
Pricing American put option

◼ Let’s repeat the previous example but assume that the

option is an American put rather than a European option.
Recall the tree for the European put (K = $51)
Payoffs of the American put option
◼ What are the payoffs for the American put?

f A
u 
= Max K − Su, e − rDt
(
pf uu + (1 − p ) f
A A
ud )
= Max − 2.5, 0.5435 = 0.5435
f A
d  (
= Max K − Sd , e − rDt pf Aud + (1 − p) f A dd )
= Max 4.5, 4.0766 = 4.5  early exercise
◼ Why early exercise?
Return is more than risk-free rate.
The value of the American put
◼ Then, at initial date

f A = Max K − S , e − rDt ( pf A
u + (1 − p ) f
A
d )
= Max 1, 2.27 = 2.27

◼ Comparison of American and European puts

f A = 2.27
f E
= 2.0813

◼ Early exercise premium = 2.27 – 2.0813 = 0.1887

Binomial trees’ parameters
◼ Binomial trees are frequently used to approximate the
movements in the price of a stock or other asset
◼ RECALL: In each small interval of time the stock price is
assumed to move up by a proportional amount u or to move
down by a proportional amount d.
◼ How are we going to choose the parameters u and d?
◼ We choose the tree parameters u and d so that the tree gives
correct values for the mean & standard deviation of the stock
price changes in a risk-neutral world
erΔt = pu + (1– p)d
σ2Δt = pu2 + (1– p)d 2 – [pu + (1– p)d ]2
◼ A further condition often imposed is u=1/d
Binomial trees’ parameters
◼ For a small Δt, a solution to the equations is:
 Dt
u=e
− Dt
d =e
a−d
p=
u−d
r Dt
a=e
A binomial tree
Backwards induction & option on other assets
◼ We know the value of the option at the final nodes
◼ We work back through the tree using risk-neutral valuation to calculate the
value of the option at each node, testing for early exercise when
appropriate.
◼ One-Step Binomial Model
f = e − r(T-t)[pf u + ( 1 − p)f d )]
a−d
where p=
u−d

a = e rDt for a nondividen d paying stock

a = e ( r − q ) Dt for a stock index wher e q is the dividend

yield on the index

( r − r ) Dt
a=e f for a currency w here r f is the foreign
risk - free rate

a = 1 for a futures contract

In-class practice - 1
◼ Stock ABC has a current price of S = $50. We believe that in 3 months, the
price will either increase to $55 or decrease to $44. The risk-free rate is 7%
per year (compounded continuously). There is a European call option on this
stock with exercise price X = $48. The hedge ratio, Δ, and the risk-neutral
probability of an “up state”, p, are
a. Δ = 0.75, p = 0.5.
b. Δ = -0.75, p = 0.5.
c. Δ = 0.6364, p = 0.6259.
d. Δ = 0.6364, p = 1.0127.
e. None of the above

◼ Consider the same scenario above. There is a European put option on this
stock with exercise price X = $53. When you use Δ -hedging, the risk-free
payoff is equal to:
a. -28.5.
b. -31.5.
c. -45.0.
d. not enough information.
e. none of the above.
In-class practice - 2
In-class practice - 3
In-class practice - 4

Prove

the above equation holds.

Hint：
Thank You