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Option Valuation II

Milind Shrikhande

Valuation of Options

Arbitrage Restrictions on the Values of

Options

Quantitative Pricing Models

Binomial model

A formula in the simple case

An algorithm in the general

Assumptions:

A single period

possible values

risk free interest rate, no taxes

Example

The stock price

Assume S= $50,

u= 10% and d= (-3%)

Su=$55

Su=S(1+u)

S=$50

Sd=S(1+d)

Sd=$48.5

Example

The call option price

Assume X= $50,

T= 1 year (expiration)

Cu= $5

= Max{55-50,0}

Cu= Max{Su-X,0}

C

Cd= Max{Sd-X,0}

Cd= $0

= Max{48.5-50,0}

Example

The bond price

Assume r= 6%

$1.06

(1+r)

$1

(1+r)

$1.06

Replicating Portfolio

At time t=0, we can create a portfolio of N shares of

the stock and an investment of B dollars in the riskfree bond. The payoff of the portfolio will replicate

the t=1 payoffs of the call option:

N$55 + B$1.06 = $5

N$48.5 + B$1.06 = $0

Obviously, this portfolio should also have the same

price as the call option at t=0:

N$50 + B$1 = C

We get N=0.7692, B=(-35.1959) and the call option price is C=$3.2656.

A Different Replication

The price of $1 in the

up state:

down state:

$0

$1

qd

qu

$0

$1

State Prices

We can replicate the t=1 payoffs of the stock and

the bond using the state prices:

qu$55 + qd$48.5 = $50

qu$1.06 + qd$1.06 = $1

Obviously, once we solve for the two state prices

we can price any other asset in that economy. In

particular we can price the call option:

qu$5 + qd$0 = C

We get qu=0.6531, qd =0.2903 and the call option price is C=$3.2656.

Example

The put option price

Assume X= $50,

T= 1 year (expiration)

Pu= $0

= Max{50-55,0}

Pu= Max{X-Su,0}

P

Pd= Max{X-Sd,0}

Pd= $1.5

= Max{50-48.5,0}

State Prices

We can replicate the t=1 payoffs of the stock and

the bond using the state prices:

qu$55 + qd$48.5 = $50

qu$1.06 + qd$1.06 = $1

But the assets are exactly the same and so are the

state prices. The put option price is:

qu$0 + qd$1.5 = P

We get qu=0.6531, qd =0.2903 and the put option price is P=$0.4354.

Assume that the current stock price is $50,

each period.

The one period risk-free interest rate is

6%.

What is the price of a European call option

and expiration in two periods?

S= $50, u= 10% and d= (-3%)

Suu=$60.5

Su=$55

Sud=Sdu=$53.35

S=$50

Sd=$48.5

Sdd=$47.05

r= 6% (for each period)

$1.1236

$1.06

$1.1236

$1

$1.06

$1.1236

X= $50 and T= 2 periods

Cuu=Max{60.5-50,0}=$10.5

Cu

Cud=Max{53.35-50,0}=$3.35

C

Cd

Cdd=Max{47.05-50,0}=$0

We can replicate the t=1 payoffs of the stock and the bond

using the state prices:

qu$55 + qd$48.5 = $50

qu$1.06 + qd$1.06 = $1

Note that if u, d and r are the same, our solution for the

state prices will not change (regardless of the price levels

of the stock and the bond):

quS(1+u) + qdS (1+d) = S

qu (1+r)t + qd (1+r)t = (1+r)(t-1)

Therefore, we can use the same state-prices in every part

of the tree.

qu= 0.6531 and qd= 0.2903

Cuu=$10.5

Cu

Cud=$3.35

C

Cd

Cdd=$0

Cu = 0.6531*$10.5 + 0.2903*$3.35 = $7.83

Cd = 0.6531*$3.35 + 0.2903*$0.00 = $2.19

C = 0.6531*$7.83 + 0.2903*$2.19 = $5.75

What is the price of a European put option on

expiration in two periods?

expiration in two periods?

expiration in two periods?

European put option - use the tree or the

put-call parity

What is the price of an American call

American put option use the tree

qu= 0.6531 and qd= 0.2903

Puu=$0

Pu

Pud=$0

P

Pd

Pdd=$2.955

Pu = 0.6531*$0 + 0.2903*$0 = $0

Pd = 0.6531*$0 + 0.2903*$2.955 = $0.858

PEU = 0.6531*$0 + 0.2903*$0.858 = $0.249

qu= 0.6531 and qd= 0.2903

Puu=$0

Pu

Pud=$0

PAm

Pd

Pdd=$2.955

Note that at time t=1 the option buyer will

decide whether to exercise the option or

keep it till expiration.

If the payoff from immediate exercise is

higher than the option value the optimal

strategy is to exercise:

If Max{ X-Su,0 } > Pu(European) => Exercise

qu= 0.6531 and qd= 0.2903

Puu=$0

Pu

Pud=$0

P

Pd

Pdd=$2.955

Pu = Max{ 0.6531*0 + 0.2903*0 , 50-55 } = $0

Pd = Max{ 0.6531*0 + 0.2903*2.955 , 50-48.5 } = 50-48.5 = $1.5

PAm = Max{ 0.6531*0 + 0.2903*1.5 , 50-50 } = $0.4354 > $0.2490 = PEu

of Call and Put Options

Variable

S stock price

Increase

Decrease

X exercise price

Decrease

Increase

Increase

T time to expiration

Increase

Increase

Decrease

Increase

Black-Scholes Model

Developed around 1970

Closed form, analytical pricing model

An equation

Can be calculated easily and quickly (using a

computer or even a calculator)

The limit of the binomial model if we are making the

number of periods infinitely large and every period

very small continuous time

Crucial assumptions

The risk free interest rate and the stock price volatility

are constant over the life of the option.

Black-Scholes Model

C S N (d1 ) Xe rT N (d 2 )

Where

1 2

S

ln T r

X

2

d1

,

T

d 2 d1 T

C call premium

S stock price

X exercise price

T time to expiration

r the interest rate

std of stock returns

ln(z) natural log of z

e-rT exp{-rT} = (2.7183)-rT

N(z) standard normal

cumulative probability

pdf(z)

N(z)

z=0

Black-Scholes example

C S N (d1 ) Xe rT N (d 2 )

Where

1 2

S

ln T r

X

2

d1

,

T

d 2 d1 T

C?

S $47.50

X $50

T 0.25 years

r 0.05 (5% annual rate

compounded

continuously)

Black-Scholes Example

d1 (0.1836)

N (d1 ) 0.4272

d 2 (0.3336)

N (d 2 ) 0.3693

and

C $2.0526

C?

S $47.50

X $50

T 0.25 years

r 0.05 (5% annual rate

compounded

continuously)

Black-Scholes Model

Continuous time and therefore continuous

compounding

N(d) loosely speaking, N(d) is the risk

adjusted probability that the call option

will expire in the money (check the pricing

for the extreme cases: 0 and 1)

ln(S/X) approximately, a percentage

measure of option moneyness

Black-Scholes Model

P Xe rT 1 N (d 2 ) S 1 N (d1 ) P Put premium

Where

1 2

S

ln T r

X

2

d1

,

T

d 2 d1 T

S stock price

X exercise price

T time to expiration

r the interest rate

std of stock returns

ln(z) natural log of z

e-rT exp{-rT} = (2.7183)-rT

N(z) standard normal

cumulative

probability

Black-Scholes Example

d1 (0.1836)

N (d1 ) 0.4272

d 2 (0.3336)

N (d 2 ) 0.3693

and

P $3.9315

P?

S $47.50

X $50

T 0.25 years

r 0.05 (5% annual rate

compounded

continuously)

The continuous time version (continuous

compounding):

C PV ( X ) S P

C Xe

rT

SP

$2.0526 $50e

0.050.25

? $47.5 $3.9315

One approach:

Calculate an estimate of the volatility using the

historical stock returns and plug it in the option

formula to get pricing

Est ( )

1 n

2

returnt average return

n 1 t 1

Where

returnt ln

St

St 1

Another approach:

Calculate the stock return volatility implied by

the option price observed in the market

(a trial and error algorithm)

C S N (d1 ) Xe rT N (d 2 )

Where

1 2

S

ln T r

X

2

d1

T

and d 2 d1 T

Let 1 < 2 be two possible, yet different return volatilities;

C1, C2 be the appropriate call option prices; and

P1, P2 be the appropriate put option prices.

We assume that the options are European, on the same

stock S that pays no dividends, with the same expiration date

T.

Note that our estimate of the stock return volatility changes.

The two different prices are of the same option, and can not

exist at the same time!

Then,

C1 C2 and

P 1 P2

C S N (d1 ) Xe rT N (d 2 )

Where

1 2

S

ln T r

X

2

d1

,

T

d 2 d1 T

C $2.5

S $47.50

X $50

T 0.25 years

r 0.05 (5% annual rate

compounded

continuously)

d1 (0.1836)

N (d1 ) 0.4272

d 2 (0.3336)

N (d 2 ) 0.3693

and

C $2.0526

C?

S $47.50

X $50

T 0.25 years

r 0.05 (5% annual rate

compounded

continuously)

C S N (d1 ) Xe rT N (d 2 )

Where

1 2

S

ln T r

X

2

d1

,

T

d 2 d1 T

S $47.50

X $50

T 0.25 years

r 0.05 (5% annual rate

compounded

continuously)

d1 (0.0940)

N (d1 ) 0.4626

d 2 (0.2940)

N (d 2 ) 0.3844

and

C $2.9911

C?

S $47.50

X $50

T 0.25 years

r 0.05 (5% annual rate

compounded

continuously)

d1 (0.1342)

N (d1 ) 0.4466

d 2 (0.3092)

N (d 2 ) 0.3786

and

C $2.5205

C?

S $47.50

X $50

T 0.25 years

r 0.05 (5% annual rate

compounded

continuously)

Options can be used to guarantee minimum

returns from an investment in stocks.

Purchasing portfolio insurance (protective put

strategy):

Long one stock;

Buy a put option on one stock;

If no put option exists, use a stock and

a bond to replicate the put option payoffs.

You decide to invest in one share of General Pills (GP)

stock, which is currently traded for $56. The stock pays no

dividends.

You worry that the stocks price may decline and decide to

purchase a European put option on GPs stock. The put

allows you to sell the stock at the end of one year for $50.

If the std of the stock price is =0.3 (30%) and rf=0.08 (8%

compounded continuously), what is the price of the put

option?

What is the CF from your strategy at time t=0?

What is the CF at time t=1 as a function of 0<S T<100?

What if there is no put option on the stock that

you wish to insure? - Use the B&S formula to

replicate the protective put strategy.

What is your insurance strategy?

What is the CF from your strategy at time t=0?

Suppose that one week later, the price of the

stock increased to $60, what is the value of the

stocks and bonds in your portfolio?

How should you rebalance the portfolio to keep

the insurance?

The B&S formula for the put option:

-P = -Xe-rT[1-N(d2)]+S[1-N(d1)]

Therefore the insurance strategy (Original

portfolio + synthetic put) is:

Long one share of stock

Long X[1-N(d2)] bonds

Short [1-N(d1)] stocks

The total time t=0 CF of the protective put

(insured portfolio) is:

CF0 = -S0-P0

= -S0-Xe-rT[1-N(d2)]+S0[1-N(d1)]

= -S0[N(d1)] -Xe-rT[1-N(d2)]

And the proportion invested in the stock is:

wstock=-S0[N(d1)] /{-S0[N(d1)] -Xe-rT[1-N(d2)]}

The proportion invested in the stock is:

wstock = S0[N(d1)] /{S0[N(d1)] +Xe-rT[1-N(d2)]}

Or, if we remember the original (protective

put) strategy:

wstock = S0[N(d1)] /{S0 + P0}

Finally, the proportion invested in the bond is:

wbond = 1-wstock

Say you invest $1,000 in the portfolio today (t=0)

Time t = 0:

wstock= 560.7865/(56+2.38) = 75.45%

Stock value = 0.7545*$1,000 = $754.5

Bond value = 0.2455 *$1,000 = $245.5

End of week 1 (we assumed that the stock price increased

to $60):

Stock value = ($60/$56)$754.5 = $808.39

Bond value = $245.5e0.08(1/52) = $245.88

Portfolio value = $808.39+$245.88 = $1,054.27

Now you have a $1,054.27 portfolio

Time t = 1 (beginning of week 2):

wstock= 600.8476/(60+1.63) = 82.53%

Stock value = 0.8253*$1,054.27 = $870.06

Bond value = 0.1747 *$1,054.27 = $184.21

I.e. you should rebalance your portfolio (increase the

proportion of stocks to 82.53% and decrease the proportion

of bonds to 17.47%).

Why should we rebalance the portfolio? Should we

rebalance the portfolio if we use the protective put strategy

with a real put option?

Practice Problems

BKM Ch. 21: 7-10, 17,18

Practice set: 36-42.

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