Corporate Finance

Chapter No. 7 Option Valuation Summary

Submitted To: Prof. Dr. Usman Yousaf

Submitted By: Abdul Karim L1F10MSMG0065

University Of Central Punjab Lahore

When we say that option is prevailing it means that gives a buyer a right to sell or buy something at or before a future date at an agreed price an remember we are here talking about the right not obligation. Different terms are being used for the holder and seller of the option as long position and short position respectively and the asset under sale purchase is called the underlying asset. As options are about future price an date so we term it as the expiry date and the exercise price/ strike price. While having the option, we are actually receiving a valuable right in form of option so we are definitely going to pay against it to the person in the short position that is known as premium. There are two kinds of options A call Option (right to buy) A put Option (right to sell) Now discussing more about the expiration date value of an option, this again differs with the name European option (that does not pay dividends and can only be exercised on the expiry date), formula of this kind of option valuation at expiry date is V= max (market price-exercising price) This equation can only be interpreted in the terms that it cannot be negative; indirectly being given a negative answer means the value of an option is zero. Ultimately discussion turns toward the cost and benefit analysis of giving this right in form of gain or loss and that is much relevant to the premium paid for that option right. It can be Gain E>P Loss E< P Breakeven (E+P)

For the writer or the seller, unless the E (exercise price reaches to the maximum of the premium received and then starts decreasing) and for the investor unless E reaches to price maximum of the premium paid and then starts increasing. But that again depends upon the variations in the price change to the exercising time; we relate it with the concept of Volatility that is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices. An implied volatility is derived from the market price of a market traded derivative (in particular an option). It is common for discussions to talk about the volatility of a security's price, even while it is the returns' volatility that is being measured. It is used to quantify the risk of the financial instrument over the specified time period. Volatility is normally expressed in annualized terms, and it may either be an absolute number ($5) or a fraction of the mean (5%). The volatility has a positive relationship between worth of an option and outcomes. For a financial instrument whose price follows a Gaussian random walk, the width of the distribution increases as time increases? This is because there is an increasing probability that the instrument's price will be farther away from the initial price as time increases. However, rather than increase linearly, the volatility increases with the square-root of time as time increases, because some fluctuations are expected to cancel each other out, so the most likely deviation after twice the time will not be twice the distance from zero. Now to summarize the variables like stock volatility, time to expiration, interest rate and current stock price have the direct relationship with the increase in option value. The delta of an option is the sensitivity of an option price relative to changes in the price of the underlying asset. It tells option traders how fast the price of the option will change as the underlying stock/future moves. Option delta is represented as the price change given a 1 point move in the underlying asset and is usually displayed as a decimal value. Delta values range between 0 and 1 for call options and -1 to 0 for put options. Note -

some traders refer to the delta as a whole number between 0 to 100 for call options and -100 to 0 for put options. However, I will use the decimal version of -1 to 0 (puts) and 0 to 1 (calls) throughout this site. Whenever you are long a call option, your delta will always be a positive number between 0 and 1. When the underlying stock or futures contract increases in price, the value of your call option will also increase by the call options delta value. Conversely, when the underlying market price decreases the value of your call option will also decrease by the amount of the delta. Whereas Put options have negative deltas, which will range between -1 and 0. When the underlying market price increases the value of your put option will decreases by the amount of the delta value. Conversely, when the price of the underlying asset decreases, the value of the put option will increase by the amount of the delta value.

The Black-Scholes option valuation formula: The Black-Scholes option valuation formula attempts to calculate the fair economic value of an option for both buyer and seller, the price at which (exclusive of commissions) both a buyer and seller would, on average, break even if they repeated this trade many times. Thus, the calculated price does not favor either the buyer or seller, so it is a price they can agree on. In real world trading, it means that, on average, both the buyer and seller will lose money on the transaction, by the amount of the commissions they paid. The valuation model uses probability theory, discounted cash flows, and expected value calculations. The model assumes: 1. That the underlying stock price will fluctuate in the manner of a random walk. It will go up sometimes and down sometimes, with small moves in either direction being very likely and large moves in either direction being very unlikely.

2. That the actual direction the stock will move during the holding period is notpredictable, by anyone, using any prediction method. 3. That the volatility of a particular stock, the amount by which its price fluctuates during a given time interval, is a stable measurement for that stock. That is, one can expect that stock to exhibit the same volatility in the future that it has had in the past. (This assumption is often incorrect.) In comparing American and European options, we found that an American Option on a stock that pays a dividend may have less value than a European option on a stock that does not pay a dividend. Finally there are a number of options and applications additional to stock options. On the other side if we talk about the debt and other options, there are option on other securities other than stock option. Certain options are available and they are given below 1. Index option (a broad portfolio stock) 2. Debt option may be on actual debt instrument or on an interest rate futures contract) 3. Foreign currency option (written on a number of units of foreign currency options) In all subsequent discussion involving the principles of option we draw on the foundations of stock option concepts.