You are on page 1of 31

Option Pricing and Implied Volatility

A Course 7 Common Core Case Study

1

Preliminary Information
• This case study will focus on the determination of the measure of volatility used when applying the Black-Scholes option pricing formula.

• Historical stock price data and current market prices for selected call option contracts are available.

2

Preliminary Information
• Two approaches to determining the stock price volatility will be considered: – estimation from historical stock prices – implied volatility from market option prices

3

Preliminary Information
• Skills and background needed: – standard deviation estimation – a spreadsheet program with standard normal distribution cdf calculation capability – Black-Scholes call option pricing formula, described in a report from an assistant

4

Background to the Problem
• Your employer is a company whose non-dividend paying stock trades actively on a major exchange.
• The company is considering offering a stock option purchase plan to its employees.

5

Background to the Problem
• The stock options may be regarded as a taxable benefit to the employees and as a deductible expense to the company and must be valued at fair market value.

6

Background to the Problem
• Currently traded call option contracts have a limited variety of strike prices and expiry dates and do not provide values for some combinations of strike prices and expiry dates being considered.

7

The Problem

• You are asked to develop valuations for call options on the company’s stock for a range of strike prices and expiry dates.

8

Information and Data

• The following information is available to you:
– a report from your assistant which summarizes the standard approach for pricing call options using the Black-Scholes option pricing model – the daily closing price of your company’s stock for the past year up to today’s closing price (in spreadsheet form)
9

Information and Data
– today’s (Aug. 12, 1998) closing prices for call options currently being traded in the options market – current Treasury Bill yields for 13 and 26 week T-Bills

10

Assistant’s Report
According to the Black-Scholes option pricing model, the appropriate price for a call option on a non-dividend paying stock is
C0  S 0 N (d 1 )  Xe  rT N (d 2 )

where and and where C0 S0 X r T 

d1 

ln( S 0 / X )  (r   2 / 2)T

 T
,

d 2  d1   T

Current option value Current stock price Exercise price Risk-free interest rate (annualized continuously compounded) Time to maturity or expiry of option in years Standard deviation of the annualized continuously compounded rate of return on the stock ln = Natural logarithm function e = 2.71828, the base of the natural logarithm function N(d) = P[ Z  d ] , where Z has a standard normal distribution

= = = = = =

11

Assistant’s Report
• All of the parameters in the formula are readily available except for . There are two approaches that can be taken to determine :
– it can be estimated from historical data – it can be estimated from prices of options currently traded in the market (the implied volatility)

12

Today’s Market Information
• Today’s closing stock price - 18.625

• Closing prices on all currently listed call option contracts –
Strike Price 15 17.5 20 20 20 20 22.5 Expiry Date Aug. 21, 1998 Aug. 21, 1998 Aug. 21, 1998 Sept. 18, 1998 Oct. 16, 1998 Jan. 15, 1999 Oct. 16, 1998 Market Price of Call Option 3.875 1.5 0.375 1 1.5625 2.75 0.875

13

Today’s Market Information
• Today’s Treasury Bill rates
13-week - 5.103% (nominal) 26-week - 5.238% (nominal)

14

Estimating  From Historical Data

The Solution

• From the spreadsheet of daily closing stock prices, we calculate the daily returns for the past year. The natural logs of successive daily returns are used to estimate  from historical data. The estimate obtained must be scaled up to an annual measure. Estimates are made using a range of historical periods ending today. The STDEV function in EXCEL can be used.
15

Historical Estimates of 

The Solution

• Estimated Volatility (Standard Deviation) • • • • • • 30-day 60-day 90-day 120-day 180-day 1-year 0.753168 0.625336 0.603594 0.653869 0.649999 0.728998
16

The Solution
Using The Black-Scholes Formula
• The quoted T-Bill rates are nominal rates that must be converted to annual continuously compounded rates. • The time to maturity T is measured as a fraction of a year the number of trading days to expiry as a fraction of 252 • A spreadsheet function such as NORMDIST in EXCEL can be used for the normal distribution cdf.
17

The Solution
Option Prices Based on Historical Estimates of  • Exercise Price of 12 • Expiry Date Price
– – – – – – 1 month 2 month 3 month 4 month 6 month 1 year 6.700 6.786 7.054 7.132 7.474 8.758

18

The Solution
Option Prices Based on Historical Estimates of  • Exercise Price of 15 • Expiry Date Price
– – – – – – 1 month 2 month 3 month 4 month 6 month 1 year 3.981 4.191 4.738 4.892 5.426 7.163

19

The Solution
Option Prices Based on Historical Estimates of  • Exercise Price of 18.625 • Expiry Date Price
– – – – – – 1 month 2 month 3 month 4 month 6 month 1 year 1.648 1.963 2.714 2.925 3.564 6.657

20

The Solution
Option Prices Based on Historical Estimates of  • Exercise Price of 22 • Expiry Date Price
– – – – – – 1 month 2 month 3 month 4 month 6 month 1 year .578 .837 1.531 1.741 2.400 4.555

21

The Solution
Option Prices Based on Historical Estimates of  • Exercise Price of 25 • Expiry Date Price
– – – – – – 1 month 2 month 3 month 4 month 6 month 1 year .197 .360 .894 1.077 1.670 3.784

22

Estimating  As The Implied Volatility

The Solution

• Using the Black-Scholes formula with the option price known from market data, it is possible to solve for  if all other parameters are known. The solution is done by approximation. Trial and error in the spreadsheet, the bisection method or the Newton-Raphson method can be used.
23

The Solution
Implied Volatility Calculations

Strike 15 17.5 20 20 20 20 22.5

Expiry 21/8/98 21/8/98 21/8/98 18/9/98 16/10/98 15/1/99 16/10/98

Implied  1.193 .664 .695 .644 .654 .650 .890

24

The Solution
Implied Volatility Used to Price Options

• The implied volatility seems to be more closely related to the option strike price than the time to maturity. This illustrates the phenomenon of the “volatility smile” seen in market pricing of options. For the four option contracts with strike price of 20 we take the average volatility. Linear interpolation is used for strike prices between those of the market priced options.
25

The Solution
Option Prices Based on Implied Volatility • Exercise Price of 12 • Expiry Date Price
– – – – – – 1 month 2 month 3 month 4 month 6 month 1 year 7.537 8.530 9.344 10.036 11.169 13.463

26

The Solution
Option Prices Based on Implied Volatility • Exercise Price of 15 • Expiry Date Price
– – – – – – 1 month 2 month 3 month 4 month 6 month 1 year 4.587 5.427 6.103 6.679 7.644 9.736

27

The Solution
Option Prices Based on Implied Volatility • Exercise Price of 18.625 • Expiry Date Price
– – – – – – 1 month 2 month 3 month 4 month 6 month 1 year 1.454 2.073 2.552 2.959 3.645 5.192

28

The Solution
Option Prices Based on Implied Volatility • Exercise Price of 22 • Expiry Date Price
– – – – – – 1 month 2 month 3 month 4 month 6 month 1 year .741 1.453 2.040 2.550 3.419 5.383

29

The Solution
Option Prices Based on Implied Volatility • Exercise Price of 25 • Expiry Date Price
– – – – – – 1 month 2 month 3 month 4 month 6 month 1 year .697 1.568 2.317 2.976 4.104 6.623

30

Conclusions
• It appears that estimates of  based on historical data may be less appropriate for use in the option pricing formula when the strike price is significantly different from the current stock price. On the other hand, implied volatility values become suspect when extrapolating beyond the range of strike prices currently being traded in the market. Correct volatility values are likely to lie somewhere between the two.
31