Chapter 12: Basic option theory

Investment Science
D.G. Luenberger
Before we talk about options

 This course so far has dealt with deterministic cash

flows and single-period random cash flows.
 Now we’d like to deal with random flows at each of
several time points, i.e., multiple random cash flows.
 Multiple random cash flow theories are generally
very difficult. Here, we’d like to focus on a special
case: derivatives, i.e., those assets whose cash
flows are functionally related to other assets whose
price characteristics are assumed to be known.
 Options are an important category of derivatives.
Option, I

 An option is the right, but not the obligation, to buy (or sell) an
underlying asset under specified terms. Usually there are a
specified price, called strike price or exercise price (K), and a
specified period of time, called maturity (T) or expiration date,
over which the option is valid.
 An option is a derivative because whose cash flows are related
to the cash flows of the underlying asset.
 If the option holder actually does buy and sell the underlying
asset, the option holder is said to exercise the option.
 The market price of an option is called premium.
Option, II

 An option that gives the right to purchase (sell) the

underlying asset is called a call (put) option.
 An American option allows exercise at any time
before and including the expiration date.
 An European option allows exercise only on the
expiration date. In this course, we will focus on
European options because their pricing is easier.
 The underlying assets of options can be financial
securities, such as IBM shares or S&P 100 Index, or
physical assets, such as wheat or corn.
Option, III

 Many options are traded on open markets. Thus,

their premiums are established in the market and
observable.
 Options are wonderful instruments for managing
business and investment risk, i.e., hedging.
 Options can be particularly speculative because of
their built-in leverages. For example, if you are very
sure that IBM’s share price will go up, betting $1 on
IBM call options may generate a much higher return
than betting $1 on IBM shares.
Notation

 S: the price of the underlying asset.

 C: the value of the call option.
 P: the value of the put option.
Value of call option at expiration
Value of put option at expiration
Value of option at expiration

 The value of the call at expiration: C = max (0, S –

K).
 The call option is in the money, at the money, or out
of money, depending on whether S > K, S = K, or S
< K, respectively.
 The value of the put at expiration: P = max (0, K –
S).
 The put option is in the money, at the money, or out
of money, depending on whether S < K, S = K, or S
> K, respectively.
11.1 Binomial model, PP. 297-299

 A binomial model can be a single-period model or a

multiple-period model.
 A basic period length can be a week, a month, a
year, etc.
 If the price of an asset is known at the beginning of a
period, say S, the price of the asst at the end of the
period is one of only two possible values, S*u and
S*d, where u > 1 > d > 0. S*u (S*d) is expected to
happen with probability p (1 – p).
 That is, we have uncertainty, but in the form of two
possible values.
Binomial model

Binomial lattice

S*u*u*u
S*u*u
S*u S*u*u*d
S S*u*d
S*d S*u*d*d
S*d*d
S*d*d*d

Time 0 Time 1 Time 2 Time 3

Calibration, I

 Binomial models provide an uncertain structure for us to model

the underlying asset’s price dynamics.
 This modeling is necessary because option value is a function
of the underlying asset’s price dynamics.
 Thus, to obtain accurate valuation for an option, we need to do
a good job on modeling the underlying asset’s price dynamics.
 That is, we need to choose binomial parameters, i.e., p, u, and
d, carefully such that the binomial-based price dynamics is
consistent with the observable (historical) price characteristics,
e.g., average return and standard deviation, of the underlying
asset.
Calibration, II

 Let v be the expected (average) annual return of the

underlying asset, v = E [ln(ST /S0 )], say 12%.
 Let  be the yearly standard deviation of the
underlying asset, 2 = var [ln(ST /S0 )], say 15%.
 Note that 12% return and 15% standard deviation
are about the kind of numbers that you would expect
from a typical S&P 500 stock.
 Now we need to define the period length relative to a
year. If we define a period as a week, a period
length of t is 1/52.
Calibration, III

 Then, the binomial parameters can be selected as:

 p = ½ + ½ *(v / )* (t)1/2.
 u = e * (t)1/2.
 d = 1/u.
 e is exponential and has a value of 2.7183.
 With these choices, the binomial model will closely
match the values of v and  (see pp. 313-315 for the
proof).
Calibration, IV

v std p u d del-t
0.12 0.15 0.5555 1.021 0.97941 0.01923

After 4 weeks
108.677
106.4
104.25 104.248
102.1 102.1
100 100 100
97.941 97.94
95.925 95.9251
93.95
92.0162
1-period binomial option theory, I

 We assume that it is possible to borrow or

lend at the risk-free rate, r.
 Let R = 1 + r, and u > R > d.
 Suppose that there is a call option on the
underlying asset with strike price K and
expiration at the end of the single period.
 Let Cu (Cd) be the value of the call at
expiration.
3 related lattices

If up If down
S*u
S
S*d Cu
C
R Cd
1
R

Time 0 Time 1 Time 0 Time 1

No-arbitrage

 The key to price the call option at time 0 is to form a portfolio at

time 0: (1) the portfolio consists of the underlying asset and the
risk-free asset, (2) the portfolio’s value at time 1 is equal to the
value of the call at time 1, regardless whether it is up or down.
 This portfolio is called a replicating portfolio: x dollar worth of
the underlying asset and b dollar worth of the risk-free asset.
 No-arbitrage: because the replicating portfolio and the call yield
the value at time 1 regardless what might happen, the value of
the replicating portfolio and the call at time 0 must be the same.
 That is, x + b = C.
Outcome matching

 The value of the replicating portfolio equals

to the value of the call at time 1 when it is up:
u * x + R * b = Cu.
 The value of the replicating portfolio equals
to the value of the call at time 1 when it is
down: d * x + R * b = Cd.
 Solve for x and b from the two equations.
1-period binomial Solution

 x = (Cu – Cd) / (u – d).

 b = (u * Cd – d * Cu) / (R * (u – d)).
 Based on no-arbitrage, we know that C = x + b.
 C = (Cu – Cd) / (u – d) + (u * Cd – d * Cu) / (R * (u –
d)).
 After some algebras, we have C = (1/R) * [q * Cu +
(1 – q) * Cd], where q = (R – d) / (u – d).
 Note that p is not in the pricing equation because no
trade-off among probabilistic events is made.
1-month IBM call option, I

 Consider IBM with a volatility of its logarithm

of  = 20%. The current price of IBM is $62.
A call option on IBM has an expiration date 1
month from now and a strike price of $60.
The current interest rate is 10%,
compounded monthly. Suppose that IBM will
not pay dividends.
1-month IBM call option, II

std u d del-t R q interest rate

0.2 1.0594 0.9439 0.0833 1.0083 0.5577 0.1

stock call K
65.685 5.6849 60
62 3.1443
58.522 0

Time 0 Time 1 Time 1 Time 0

When no information about v and 

 If we have a primitive binomial problem in which we

have no information on expected return and
standard deviation, we then must know the two
possible outcomes.
 Example: suppose the market price of a stock is $50.
The two possible outcomes for the stock price is
either $60 or $40 in a year.
 A call option with a one-year expiration and a $50
exercise price.
 Interest rate is 5%.
Duplicating portfolio

 We need to duplicate the call with the

strategy of buying stocks and borrowing
monies.
 The duplicating strategy is to buy ½ share of
the stock and borrow $19.05. Why this
particular combination? We will talk about
this later.
When the stock price is up

 When the stock price is up, the payoff of

buying a call is $10 ($60 - $50).
 When the stock price is up, the payoff the
duplicating strategy is also $10. The sum of
the following two positions is $10 ($30 - $20):
(1) buying ½ share: ½ * $60 = $30, and (2)
borrowing $19.05 at 5%: -$19.05 * 1.05 = -
$20.
When the stock price is down

 When the stock price is down, the payoff of

buying a call is $0.
 When the stock price is down, the payoff the
duplicating strategy is also $0. The sum of
the following two positions is $0 ($20 - $20):
(1) buying ½ share: ½ * $40 = $20, and (2)
borrowing $19.05 at 5%: -$19.05 * 1.05 = -
$20.
No arbitrage

 The call and the duplicating strategy generate

identical payoffs at the end of the year.
 No arbitrage principle implies that the current market
price of the call equals to the current market price of
the duplicating position.
 The market price of the duplicating position is $5.95
($25 - $19.05). Buying ½ share costs $25 (1/2 *
$50).
 The call price is $5.95.
Why ½ share?

 The duplicating portfolio was given to be

buying ½ share and borrowing $19.05
earlier.
 Why ½ share? This amount is called the
delta of the call.
 Delta = swing of the call / swing of the stock
= ($10 - $0) / ($60 - $40) = ½.
Why borrowing $19.05?

 Buying ½ share gives us either $30 or $20 at

expiration, which is exactly $20 higher than the
payoffs of the call, $10 and $0, respectively.
 To duplicate the position, we thus need to borrow a
dollar amount such that we will need to pay back
exactly $20.
 Given the future value is $20, the interest rate is 5%,
and the number of the time period is 1, we have the
present value to be $19.05 (use your financial
calculator).
Multiple-period pricing

 The usefulness of single-period binomial

pricing is that it can be applied to multiple-
period problems in a straightforward manner.
 That is, the single period pricing, C = (1/R) *
[q * Cu + (1 – q) * Cd], is repeated at every
node of the lattice, starting from the final time
period and working backward toward the
initial time.
5-month IBM call option, I
std u d del-t R q K
0.2 1.05943 0.9439 0.08333 1.00833 0.5577 60

Stock 82.749
78.1067
73.7249 73.7249
69.5889 69.5889
65.6849 65.6849 65.6849
62 62 62
58.5218 58.5218 58.5218
55.2387 55.2387
52.1398 52.1398
49.2147
46.4538

Time 0 Time 1 Time 2 Time 3 Time 4 Time 5

5-month IBM call option, II

std u d del-t R q K
0.2 1.05943 0.9439 0.08333 1.00833 0.5577 60
Stock Call
82.749 22.749
18.6026
73.7249 13.7249 14.7125
10.0848 11.189
65.6849 5.68495 6.95701 8.210984
3.14428 4.61068 5.84508
58.5218 0 1.73907 2.972037
0 0.96186
52.1398 0 0
0
46.4538 0

Time 5 Time5 Time4 Time3 Time2 Time1 Time0

1-month vs. 5-month

 The call price for 1-month IBM call is $3.14. The call
price for 5-month IBM call is $5.85.
 Holding other factors constant, the longer the
maturity, the higher the call premium.
 The reason for this is that additional time allows for a
greater chance for the stock to rise in value,
increasing the final payoff of the call option.
 See Figure 12.3, p. 324.
 Along the same line of seasoning, the higher the
standard deviation, the higher the call premium. You
should verify this numerically.
How about put option pricing?

 So far, we have focused on call pricing.

 The reason for this is that for European options one
can calculate the value of a put option, P, based on
value the call option, C, when they have the same
strike price and maturity.
 P = C – S + df * K, where df is risk-free discount
factor.
 This relationship is called the put-call parity.
Put option pricing

 Consider a GM call option and a GM put

option, both have 3 months to expiration and
the same strike price, $35. The current price
of GM shares is $37.78. The call premium is
$4.25. The interest rate is 5.5%, so over 3
months, the discount factor is 0.986 (= 1 / (1
+ 0.055/4).
 P = C – S + df * K = 4.25 – 37.78 + 0.986 *
35 = $1.00.
Options are interesting and important

 A combination of options can lead to a

unique payoff structure that otherwise would
not be possible.
 Options make it happen!
 Example: a butterfly spread, p. 325.
 Question: who would hold a butterfly spread?