Chapter 9

Option Pricing Model

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 Recall

 Option
A right to buy (or sell) an underlying asset.

 Strike price: E
 Maturity date: T
 Price of the underlying asset: S0 or ST

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 American Vs. European Option

 Option that can be exercised at any time until

expiration is called American Option.
 Option that can be exercised only at expiration
is called European Option.
 Then, what happens in price?
Price of American Option is greater or equal
to European Option.

3 © Kaji Dahal
 Price of Option at Maturity

 Payoff/Price of the call option at maturity:

C1  Max( ST  E,0)

 Payoff/Price of the put option at maturity:

P1  Max( E  ST ,0)

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 Asset Pricing Principle
 How to calculate the price of asset today?

Your Answer is
PV of future cash flow!
Call price should be the PV of C1

Similarly, put price should be PV of P1

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 Recall Time value of money

Today

C1 or P1 (future value)

Discounted to today

Price of Call/Put
(Present Value)

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 Binomial Option Pricing Model
(BOPM)

 Binomial option pricing is the formula to calculate the

price of option.

 BOPM is based on fundamental principles of PV

concept.

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 Assumption of BOPM

 The binomial option pricing model assumes

that the stock price can move up or down by a
specified amount in future.

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 One Period BOPM

 Assume that the whole life of option is one

period, no mater how long or how short it is.
From beginning to end life is always one period.
For example:
3 months maturity is one period
6 months maturity is one period
5 year maturity is ………………..

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 One Period BOPM
 Assume the following:
– Stock XYZ currently sells for Rs100 per share
– Time to maturity is one year.
– There are two possible stock prices in one year
and either will increase by 10% or down by 10%.
– Risk free rate is 8% p.a.

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 The Binomial Option Pricing
Model (cont’d)
 Possible states of the world:

Su = Rs110

S0=100
Sd = Rs90
0 1
One Period
Today One year Later
11 © Kaji Dahal
 Important !

 Up move factor (u) = 1+ %increase = 1.10

 Down move factor (d) = 1- %decrease= 0.90
 Thus,
Su = S0*u = 100*1.1 = Rs110
Sd = S0*d = 100*0.90 = Rs90
What is the probability (p) that stock price will
be SU?

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 Probability Determination

1 r  d
p
ud

r = risk free rate per period

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 Insert in same graph before

 Possible states of the world:

Su =110
p =0.90

S0=100
Sd= 90

Today One year Later

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 The Binomial Option Pricing
Model (cont’d)
 A call option on stock is available that gives
its owner the right to purchase at Rs100 in
one year.

 What should be the price of call option

today?

15 © Kaji Dahal
 Exercised value of call at maturity

If the stock price is Rs110, the call option will be

worth Rs…… i.e.
C1 = Max(ST –E, 0)
Cu = Max(Su –E, 0) = 10
– If the stock price is Rs90, the call option will be
worth Rs….. i.e.
C1 = Max(ST –E, 0)
Cd = Max(Sd – E, 0) = 0

16 © Kaji Dahal
  Possible states of the world:

Su= 110
p =0.90
Cu= 10
S0 =100
C0 =? Sd= 90
Cd = 0
Today One year Later
17 © Kaji Dahal
 Call Price (C0) is

p  Cu  (1  p )  Cd
C0  (1  r )1

0.9  10  0.10  0

1  0.08
C 0  Rs 8.33
18 © Kaji Dahal
 Quiz

 Chapter 9:
 Question no. 6.

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 Put price (P0)?

p  Pu  (1  p )  Pd
P0 
(1  r )1

Pu = Max (E – Su, 0)

Pd = Max (E – Sd, 0)

20 © Kaji Dahal
 Quiz

Q. No. 10

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 Important!

 If interest rate is continuously compounded

given in question. Replace 1+r with erT

 Also remember, T is always one in BOPM

and interest rate is periodic.

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 Two Periods BOPM

 We can divide whole life of option into two

periods in equal length.
 The option is priced by working backward through
the end.

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 Example 1

 Assume the following:

– Risk free rate is 8% p.a.
– Stock currently sells for Rs100 per share
– Life of option is 2 years
– There are two periods of one year.
 A call option on stock is available that gives its
owner the right to purchase at Rs100.
 Price of stock will increase by 10% and decrease
by 10% for both period.
 What should be the price of this option today?
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  Calculate first
Up move factor (u) = 1.1
Down move factor (d) = 0.90

Which are used for both periods.

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 Working process:

– Repeat much of the process used as in

one-period BOPM earlier

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 Extension to Two Periods (cont’d)

Suu =Rs121
Cuu = Max (Suu – E, 0)
= 21
17.5 Sud =99
S0 =Rs100 Cud =Max (Sud – E, 0)
0 =0
C0 = 14.58
Sd= 90 Sdd =Rs81
Cdd =Max (Sdd–E, 0)
Today 1 Year Later =0
2 Year Later
27 © Kaji Dahal
 Cu and Cd?

Cuu * p  Cud * (1  p )
Cu 
1  r 1

Cud * p  Cdd * (1  p )
Cd 
1  r 1

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 Quiz

 Chapter 9
 Q. No. 17

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 American Call valuation

 All process are same.

 But American Call can be exercised before
maturity if it is profitable.

 Note: to calculate the price of American call, we

need to calculate the price of European call first.

30 © Kaji Dahal
 American Call valuation (cont’d)

CuA = Max (Su – E, 0) Suu =Rs121

CdA = Max (Sd – E, 0) Cuu = Max (Suu – E, 0)
= Rs21
Sud =Rs99
S0 =Rs100 Cud = Max (Su – E, 0
=0
Sdd =Rs81
Cdd = Max (Sdd – E,
=0
Today 1 Year Later 2 Year Later
31 © Kaji Dahal
 Present value of American Call?

CuA * p  CdA * (1  p )
C0 A 
1  r 1

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 Fair price American Call?

Thus,
C0A = Rs14.58
If it is exercised immediately, Value is
= Max (S0 – E, 0) = 0
Therefore, Fair Price of American call is
C0A = Rs14.58

33 © Kaji Dahal
 Quiz

 Assume the following:

– Risk free rate is 8% p.a.
– Stock XYZ currently sells for Rs100 per share
– There are two steps of one year
 A put option on stock is available that gives its
owner the right to sale stock in one year for Rs100
 Price of stock will increase by 10% and decrease
by 15% for both period.
 What should be the price of American put today?

34 © Kaji Dahal
Synthetic Instrument
 Portfolio of security that duplicates the cash flow of other original
security.
Creation of synthetic instrument requires understanding of put call
parity model:
P0 + S0 = C0 + E (1+r)-T
Key of model
Where: P0 = Put price E = exercise price of call and put
S0 = current stock price Left hand side = right hand side
C0 = call price Assume E = Face value of zero coupon
E = Exercise price bond (M)
r = risk free rate Then E (1+r)-T = bond price today (B0)
T = time to maturity
Lets learn to create synthetic put
 P0 + S0 = C0 + E (1+r)-T
Positive sign means buy and negative sign means sell
Take all items to right hand side and let put only in left
hand side to create synthetic put
P0 = C0 + E (1+r)-T - S0
Thus,
Buying put is equivalent to :
Buying call, buying zero coupon bond and short selling
the stock today.
Right hand side will give payoff as buying put does.
Therefore right hand side is called synthetic put!
Example
 Put and call option are available on stock with an exercise
price of Rs80. Maturity period of option is one year and risk
free interest rate is 10% p.a. Both options are at the money
position. Stock price will rang from Rs80 to 100 interval of
Rs5 at expiry.
Required:
 Can you create synthetic put?
 Yes, we can do by buying call, buying zero coupon
bond and short selling the stock today.
 Prepare table showing that synthetic put gives same
value as actual put does at the end of one year.
Actual put and synthetic put table
 Can you create synthetic call?
We have

C0 = P0+ E (1+r)-T - S0

 Yes, we can do by buying put, buying stock and

selling the zero coupon bond today.
 Prepare table showing that synthetic call gives same
value as actual call does at the end of one year.
 Dividend Villain or Hero to stock
price?

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 When to exercise American
Option?

American Call with an Exercise price of Rs400

American Put with an exercise price of Rs Rs600

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 Example

Consider the two–period call option with the

exercise price of Rs 100. The current price
of underlying stock is Rs 100. The risk-
free interest rate is 7%. The current price
of stock will go up by 25% and decreases
by 20% each period. The stock pays the
dividend yield of 10% at the end of period
one.
Calculate American Call Price, C0A
42 © Kaji Dahal
 Suu =140.625
Su =125 Cuu = 40.625
C0E = 12.77 Less D = 12.5
S0 = 100 =112.5
Cu = 22.78 Sud =90
C0A = 14.02 CuA = 25 Cud = 0

Sd = 80
Less D =8
= 72 Sdd =57.60
Cd = 0
Cdd =0
CuA = 0
43 © Kaji Dahal
 Fair price American Call?

Thus,
C0A = Rs14.02
If it is exercised immediately, Value is
= Max (S0 – E, 0) = 0
Therefore, Fair Price of American call is
C0A = Rs14.02

44 © Kaji Dahal
 Try Q. No. 27

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 Hedge Portfolio
 We can construct a portfolio of stock and
options such that the portfolio has the
same value regardless of the stock price in
future.

Lets follow the steps for hedge portfolio.

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 Call and Stock Combination

Step 1: Hedge ratio (h) = Cu  Cd

Su  Sd
Hedge ratio (h) is the number of shares to
purchase @ S0 and sale of one call option
Thus;
Initial value (V0)= h*S0 – C0

47 © Kaji Dahal
 Cond.

Step 2: Calculation of Value of portfolio at expiry

(1) If stock price goes to Su
Vu = Su*h – Cu
(2) If stock price goes to Sd
Vd = Sd*h – Cd

Note: Vd = Vu
48 © Kaji Dahal
 Contd.

Step 3: Calculation of rate of return or call price

Vu or Vd
V0 
(1  r )1

 Note that rate of return will be equal to rate

given in question.

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 Example

Question no. 21

c. Rs2.84

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 e. Calculation of rate of return if call price is
Rs3.50 instead of 2.84.
New V0 = h*S0 – C0 = Rs9
New V0 = Vu or Vd
(1+r)1

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 Arbitrage Illustration

f. If market price of call is Rs2 instead of Rs2.84,

call is underpriced. So there is arbitrage
opportunity.
Strategies
Buy call -Rs2

Short sell h number of shares@S0 +Rs12.5

Net Cash flow Rs10.5
Invest Rs10.5 today @10% for one period.
52 © Kaji Dahal
 Result at expiry
1. If stock price is Su = Rs28.75
Collect investment Rs11.55
Exercise the call (Long call payoff) Rs3.75
Buy h number of shares @Su and refund -Rs14.375
Arbitrage profit Rs0.925

Try for Sd price.

53 © Kaji Dahal
 g. If price of call is Rs4, it is overpriced.
Strategies
Sell the call +Rs4
Buy h number of shares @S0 - Rs12.5
Net Cash flow -Rs8.50
Borrow Rs8.50 today @10 for one period.

54 © Kaji Dahal
 Result at expiry
1. If stock price is Su = Rs28.75
Exercise the call (short call payoff) -3.75
Pay loan -Rs9.35
Sell h number of shares @Su and refund +Rs14.375
Arbitrage profit Rs1.275
2. Try for Sd price.

55 © Kaji Dahal
 Hedge with stock and Put

 Step 1: Hedge ratio (h) = Pu  Pd

Su  Sd
Hedge ratio is the number of shares to purchase
@ S0 and purchase one put option.
Thus;
Initial value (V0)= h*S0 + P0

56 © Kaji Dahal
 Cond.

 Step 2: Calculation of Value of portfolio at

expiry
(1) If stock price goes to Su
Vu = Su*h + Pu
(2) If stock price goes to Sd
Vd = Sd*h + Pd
Note: Vd = Vu

57 © Kaji Dahal
 Contd.

 Step 3: Calculation of rate of return or put price

Vu or Vd
V0 
(1  r )1

 Note that rate of return will be equal to rate

given in question.

58 © Kaji Dahal
 Try Q. No. 22

59 © Kaji Dahal
 The Black-Scholes-Merton Model
(Ch 10)

ln( S0 / E )  ( r  .5σ 2 )T
d1 
 T
d 2  d1   T
 rT
C0  S0  N(d1 )  Ee  N(d2 )
60 © Kaji Dahal
 The Black-Scholes Model
E = Exercise price
T = Time to maturity in year
r= risk free rate p.a.
σ = standard deviation
S0 = current stock price
In = natural log
e = base of natural log
C0 = call price
d1 and d2 = indicators of cumulative probability
N(d1) & N(d2) = Normal cumulative probabilities

61 © Kaji Dahal
 The Black-Scholes Model

Find the value of a six-month call option on Microsoft with

an exercise price of Rs150.
The current value of a share of Microsoft is Rs160.
The interest rate available is r = 5% p. a.
The option maturity is six months (half of a year).
The volatility of the underlying asset is 30% per annum.

62 © Kaji Dahal
 The Black-Scholes Model
Let’s try our hand at using the model. If you have a
calculator handy, follow along.
First calculate d1 and d2
ln( S0 / E )  ( r  .5σ 2 )T
d1 
 T
ln( 160 / 150)  (.05  .5(0.30)2 ).5
d1   0.5280
0.30 .5
Then,
d 2  d1   T  0.5280  0.30 .5  0.3158
63 © Kaji Dahal
 Calculation of call Price

Referring cumulative normal probability table

d1  0.5280 N(d1) = N(0.53) = 0.7019
d 2  0.3158 N(d2) = N(0.32) = 0.6255
 rT
C0  S0  N(d1 )  Ee  N(d 2 )
.05.5
C0  Rs160  0.7019  150e  0.6255
C0  Rs 20.79

64 © Kaji Dahal
 Calculation of put price

Use put call- parity model as

P0 + S0 = C0 + E*e-r*T

65 © Kaji Dahal
 Note it

 If d1 and d2 are in negative

Eg.

N(d1) = N(-0.53) = 1 - 0.7019 = ……

66 © Kaji Dahal
 Test your knowledge

Variance is 64
How do you calculate fraction of variance 64?
SD = 8% 8/100 = 0.08
Thus, = 64/10000 = 0.0064

Test question no. 10

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 Calculation of adjusted stock price

A stock pays dividend of Rs5 after 6 months.

Current price of stock is Rs50. Calculate
adjusted stock price if interest rate is 10 p.a.
 S0  PV of D
*
S 0
 0.10*0.5
 50  5 * e
 Rs 45.24

Q. No. 24

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 Note

 If dividend yield (q) is given:

Adjusted stock price (S 0') = S0 * e-q*T
q = Annual dividend yield

Q. No. 25

69 © Kaji Dahal
 Currency Swap

 rfT
ln( S0 * e / E )  ( r  .5σ )T
2
d1 
 T
d 2  d1   T
 rfT  rT
C0  S0 * e  N(d1 )  Ee  N(d 2 )
70 © Kaji Dahal
 Option on foreign currency:
rf = foreign risk free rate
r = domestic risk free rate p.a.
S0 = current spot rate per unit of foreign currency
Foreign currency is stated in one unit.
Rs100 = $1
$2 = £1

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 Put Price?

Use put call- parity model for currency option

P0 + S0*e-rfT = C0 + E*e-rT

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 Concept Check

 Q. No. 40

73 © Kaji Dahal
 Useful Websites
 www.jeresearch.com (information on option formulas)
 www.option-price.com (for a free option price calculator)
 www.numa.com (for “everything about options”)
 www.wsj.com/free (option price quotes)
 www.ino.com (Web Center for Futures and Options)
 www.pmpublishing.com (free daily volatility summaries)
 www.ivolatility.com (for applications of implied volatility)

74 © Kaji Dahal
 THANK YOU

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