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# Option Valuation Models

Section 1:
Put Call Parity

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What is Put Call Parity ?
Put Call Parity
Relationship between
The price of the European call option (C)
the price of the European put option (P)
of the same strike price (K)
At Maturity Date (T)

Mathematical Equation
C-P = Spot Price (S)- Present Value of Strike Price (PV of K)

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Nifty Put of the strike price 5200 & has sold call of Nifty 5200 strike.Logic behind Put Call Parity For a given underlying. e. (Assured Pay in equal to 5200) Case 1 (Expiry= CMP) Case 2 (Expiry > CMP) Case 3 (Expiry < CMP) Total Payoff on Short Assured Pay Call in Nifty on Expiry Payoff on Long Put 5200 0 0 5200 5500 0 -300 5200 4900 300 0 52004 . Investor holds Nifty Future @ 5200.g. Consider a portfolio of Long Future. Long Put & Short Call (only condition being Call & Put must of the same strike price) Such a portfolio will assure the holder pay in equal to the strike price irrespective of the level of expiry.

g.Logic behind Put Call Parity For a given underlying. Consider a portfolio of Short Future. Short Put & Long Call (only condition being Call & Put must of the same strike price) Such a portfolio will assure the holder pay out equal to the strike price irrespective of the level of expiry. Investor has sold Nifty Future @ 5200 & Nifty Put of the strike price 5200 & has bought call of Nifty 5200 strike. (Assured Pay out equal to 5200) Case 1 (Expiry= CMP) Case 2 (Expiry > CMP) Case 3 (Expiry < CMP) Total Payoff on Long Assured Pay Call out Nifty on Expiry Payoff on Short Put -5200 0 0 -5200 -5500 0 +300 -5200 -4900 -300 0 -52005 . e.

Mathematics behind Put. (Detailed Example will be discussed in Class) 6 .Call Parity Consider 2 Portfolios Portfolio A Portfolio B Underlying Stock (S) Cash Equivalent to PV of K Put option of the same stock /index of some strike price (P) Call option of the same stock/index of some strike price strike same as put (C) If the above 2 portfolio's are not equal trader can have arbitrage opportunities.

As the above portfolio will be get a pay in equal to strike price irrespective of where the spot is on Expiry. If the portfolio A is greater than portfolio B then Traders can create Synthetic Long by Selling Put. As the above portfolio will have to make a pay out equal to strike price irrespective of where the spot is on Expiry.Execution behind Put.Call Parity Synthetic Short 1. If the portfolio B is greater than portfolio A then Traders can create Synthetic Short by Buying Put. Buying Future & Selling Call. (Detailed Example will be discussed in Class) 7 . 2. Synthetic Long 1. Selling Future & Buying Call. 2.

Section 2: Options Pricing Models .

The consequent argument is that since the portfolio has no risk it must earn returns equal to risk free rate.Binomial Tree Assumptions 1. 3. There are no arbitrage opportunities in this case. One can set a portfolio of the stocks & options in such a way that one can counterbalance the impact of another. 9 . 2.

(i. 1.1000 2.1050. Stock Price can either move up or down by the end of the month but the value of the portfolio must remain same. Spot Price – Rs.) 10 . 3. We have portfolio of Long ∆ no of shares of Reliance & Short one call option.One step Binomial Model (Example) Objective  To value European Call option at the end of one month to buy Reliance at Rs. ∆ should be such that portfolio is made risk free.e.

50 11 .1000∆ .0)= 50 Value of the portfolio in that case = 1100∆. Value of Call Option = MAX(1100-1050.1100 at the end of the month.One step Binomial Model (Example) The mathematics to calculate ∆ Existing Value of the portfolio.C Case I Reliance goes up to Rs.

0)= 0 Value of the portfolio in that case =900∆ Both these Portfolios must be equal as per our assumptions. Value of Call Option = MAX(900-1050.25 12 .e. So. ∆ = 0.50=900∆ i.900 at the end of the month. 1100∆.One step Binomial Model (Example) Case II Reliance goes down to Rs.

4 (For more details refer excel) 13 .225.C =250-C  Therefore C = 26.  The value of the same portfolio today will be = 225*exp^ (.1000∆ .One step Binomial Model (Example)  So.C= 1000*0.5% per annum 1/12 is a multiplier for 1 month. 223.6  Existing Value of the portfolio.25.r*1/12)    Where r is risk free rate. So today's value of the portfolio will be Rs. Let us assume it to be 7. Regardless of Price Movement the Value of the portfolio at the end of the month is Rs.

T  In T. 14 .S  Call Option Price – C  Time to expiry.  Portfolio consists of Long ∆ shares & short 1 Call option. S can move to Su or Sd such that u>1 & d<1.  Proportionate Increase will be u-1 or decrease will be 1-d.Generalisation  Let us assume Spot Price.  Risk free rate is represented by r.

rT)  Cost of Setting up Portfolio (II) S∆.e.C 15 .Cd ∆ (Delta)= (Cu-Cd)/ (Su-Sd).Cu)* e( .Generalisation  Value of the portfolio in case Price moves up to Su.   Present value of the Portfolio ( I )  (Su∆.  Su∆. i. Delta is rate or the ratio of change in option price as a function of change in Spot Price.   Sd∆.Cu Value of the portfolio in case Price moves down to Sd.

δT = Total time T No.rT)  Substituting for ∆ we get. C= S∆.d)/ (u-d)  (III) (IV) Where.rT) = S∆. of Stages 16 .(Su∆-Cu) )* e( .e.σ *sqrt (δT )) Also.  (Su∆. u= e^(σ *sqrt (δT )) d = e^(.Cu)* e( .Generalisation  Equating (I) & (II) we get.C  i.  C = e(-rT) *(p Cu+(1-p)*Cd) Where P= (e^(rT).

Conclusion  Options are always valued in terms of the price of the underlying stock & not in absolute terms.  Rate of return used for all the calculations is risk free rate.Important Learning's from the expression Observations  The option pricing formula does not involve the probabilities of the stock prices moving up or down as per their risky returns. 17 .  Future up or down price movements are already incorporated in the price of the option.

Risk Neutral Valuation Risk Neutral World A world where investors are assumed to require no extra return on average for bearing risk. Risk Neutral Valuation The valuation of an option assuming the world is risk neutral. Risk Neutral valuation gives the correct price for the option in all worlds. 18 . not just in risk neutral world.

E(S)= p Su+ (1-p) Sd 19 . p Cu+(1-p)*Cd Where p= probability of up movement 1-p = probability of down movement Now let us look at expected returns from the stock.Risk Neutral Valuation Explanation From expression (III) in previous slide value of the call option is nothing but the present value of expression.

e. we get E(S)= S* e^(rT) The above expression shows on an average return on stock equals risk free rate. E(S)= p S(u-d)+Sd Substituting for p. 20 .Risk Neutral Valuation i.

Real world vs. expected  A position in Call option is riskier than position in stock. 21 . Risk Neutral Valuation solves this problem so that all securities are discounted at Risk free rate.  So the discounting for the option needs to be more than what it is for underlying.  However. Risk Neutral world  It is not easy to know the correct discount rate to apply to the payoff in the real world.

More the number of iterations we do we get an answer close to the answer we get using Black.Two Step Binomial Trees  Here We extent Binomial Tree to 2 steps  Objective is to calculate option price at initial node.Scholes Model. 22 .  This can be done by repeatedly doing exercise we did in one step binomial tree.

Section 3: Black –Scholes Model 23 .

24 .Behaviour of Stock Prices Any variable whose value changes over time in an uncertain way is said to follow a Stochastic Process.Variable can only take value amongst fixed set of values. Continuous time – Variable can change at any time Stochastic Process can be Continuous Variable or Discrete Variable. Discrete Variable.Variable can change only at fixed points of time. Stochastic Process can be Continuous Time or Discrete Time. Discrete time. Continuous Variable – Variable can take any value.

25 .e. multiple of 5 paisa) Prices change only when the exchanges are open. stock prices are restricted to discrete values (i. In realty.Behaviour of Stock Prices Stock Prices follow Continuous Time & Continuous Variable process.

only The Markov Process implies that the probability distribution of the price at any particular future time is not dependent on the particular path followed by the price in the past. 26 .Behaviour of Stock Prices Markov Process A Markov process is a particular type of stochastic process where the present value is relevant for predicting the future.

So whatever price movement that has to happen will happen immediately.Behaviour of Stock Prices Weak Form of Market (WFME) Efficiency As per WFME the present price of stock contains all the information carried in the record of the past prices. As per WFME . 27 . Technical analyst can not make above average returns just by observing historical price charts because there is competition in the market place & there are many investors & traders who observe the price movements closely.

It can be represented by (Mean. for µ =0.e.3σ Covers 99. σ =1 28 .3% Of The Curve +/.1 σ Covers 68.4% Of The Curve +/.σ) Where µ = Mean.7% of the Curve The function N(x) is the cumulative probability distribution function for standardized normal distribution.Normal Distribution The standard Bell-Shaped distribution of Statistics. φ(µ.e.2σ Covers 95. +/. Standard Deviation) i. σ = Standard Deviation about the Mean Key Property of the Normal distribution. i.

A variable that has a lognormal distribution can take any value from ‘0’ to α. Even though stock returns can be negative Stock prices can never be negative hence stock prices are said to follow a lognormal distribution.Lognormal Distribution A Variable has a Log-normal distribution when the logarithm of the variable has a normal distribution. 29 .

σ * Sqrt(T) 30 .Black-Scholes Pricing Formulas C= S * N(d1) – K e^(-rT) * N (d2) P= K e^(-rT) * N (-d2) – S * N(-d1) Where. d1 =[ In(S/K) + (r +σ^2/2)*T] / [σ * Sqrt(T)] d2 =[ In(S/K) + (r -σ^2/2)*T] / [σ * Sqrt(T)] = d1.

Variables in the Formula C= European Call option Price P= European Put option Price S= Spot Price at time t=0 K= Strike Price r= Continuously compounded risk-free rate σ = Stock Price Volatility T= Time to Maturity of the Option 31 .

Significance of N(d1) & N(d2) Let us look at the B&S formula C= S * N(d1) – K e^(-rT) * N (d2) In a certain world investors knows that a call will finish out of money hence the value of call will be 0. You just need to multiply this by N(d1) & N(d2) and get the B&S model. The term N (d1)= Hedge Ratio or Delta (∆) N (d2)= Probability that option would end up in the money 32 .K exp(-RT) Compare this with the B& S formula. If investors knew that a call would finish “ in the money”. the value of the call at expiration would be = St.K Its value today would be =( St-K)exp(-rT) Co= So.

Section 4: Implied Volatilities 33 .

Scholes Model is the volatility of the stock price (σ). Typical volatilities of the stocks are in the range of 20% to 40% per annum 34 . σ is the volatility which is implied by the option price hence it is known as Implied Volatility. So. It is not possible to invert the Black-Scholes Model so as to calculate σ as a function of other variables.Implied Volatility The only variable that can not be directly observed in the Black. Traders typically take observations for 20-24 previous trading days estimate historical volatility of the daily returns from the underlying.

The volatility for low strike price options is significantly higher as compared to high strike price options.Volatility Smile The variation of Implied Volatility as a function of Strike price is known as Volatility Smile. Deeply OTM puts or Deeply ITM calls will have more σ as compared to Deeply ITM puts or Deeply OTM calls. i. The volatility decreases as the Strike Price Increases.e. 35 . Volatility Smile is also referred as Volatility Skew in case of Equity Options.

At Lower Strike Prices company’s equity declines in value. 36 . the company’s leverage increases & hence the Risk & consequently the volatility It is natural for people to assume that after one crash there will be another crash.Explanation for Volatility Smile The only logical explanation given for the smile is leverage. It gets reflected in option prices.

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