Chapter 5

Option Pricing

1 © 2004 South-Western Publishing

 Outline
 Introduction
 A brief history of options pricing
 Arbitrage and option pricing
 Intuition into Black-Scholes

2
 Introduction
 Option pricing developments are among the
most important in the field of finance during
the last 30 years

 The backbone of option pricing is the

Black-Scholes model

3
 Introduction (cont’d)
 The Black-Scholes model:
C  SN (d1 )  Ke  rt N (d 2 )
where
S   
2
ln    r  t
K  2 
d1 
 t
and
d 2  d1   t
4
 A Brief History of Options
Pricing: The Early Work
 Charles Castelli wrote The Theory of
Options in Stocks and Shares (1877)
– Explained the hedging and speculation aspects
of options

 Louis Bachelier wrote Theorie de la

Speculation (1900)
– The first research that sought to value derivative
assets

5
 A Brief History of Options Pricing:
The Middle Years

 Rebirth of option pricing in the 1950s and

1960s
– Paul Samuelson wrote Brownian Motion in the
Stock Market (1955)
– Richard Kruizenga wrote Put and Call Options:
A Theoretical and Market Analysis (1956)
– James Boness wrote A Theory and
Measurement of Stock Option Value (1962)

6
 A Brief History of Options Pricing:
The Present

 The Black-Scholes option pricing model

(BSOPM) was developed in 1973
– An improved version of the Boness model
– Most other option pricing models are modest
variations of the BSOPM

7
 Arbitrage and Option Pricing
 Introduction
 Free lunches
 The theory of put/call parity
 The binomial option pricing model
 Put pricing in the presence of call options
 Binomial put pricing
 Binomial pricing with asymmetric branches
 The effect of time
8
 Arbitrage and Option Pricing
(cont’d)
 The effect of volatility
 Multiperiod binomial option pricing
 Option pricing with continuous
compounding
 Risk neutrality and implied branch
probabilities
 Extension to two periods

9
 Arbitrage and Option Pricing
(cont’d)
 Recombining binomial trees
 Binomial pricing with lognormal returns
 Multiperiod binomial put pricing
 Exploiting arbitrage
 American versus European option pricing
 European put pricing and time value

10
 Introduction
 Finance is sometimes called “the study of
arbitrage”
– Arbitrage is the existence of a riskless profit

 Finance theory does not say that arbitrage

will never appear
– Arbitrage opportunities will be short-lived

11
 Free Lunches
 The apparent mispricing may be so small
that it is not worth the effort
– E.g., pennies on the sidewalk

 Arbitrage opportunities may be out of reach

because of an impediment
– E.g., trade restrictions

12
 Free Lunches (cont’d)

A University Example

A few years ago, a bookstore at a university was

having a sale and offered a particular book title for
$10.00. Another bookstore at the same university
had a buy-back offer for the same book for $10.50.

13
 Free Lunches (cont’d)
 Modern option pricing techniques are
based on arbitrage principles
– In a well-functioning marketplace, equivalent
assets should sell for the same price (law of one
price)
– Put/call parity

14
 The Theory of Put/Call Parity
 Introduction
 Covered call and short put
 Covered call and long put
 No arbitrage relationships
 Variable definitions
 The put/call parity relationship

15
 Introduction
 For a given underlying asset, the following
factors form an interrelated complex:
– Call price
– Put price
– Stock price and
– Interest rate

16
 Covered Call and Short Put
 The profit/loss diagram for a covered call
and for a short put are essentially equal
Covered call Short put

17
 Covered Call and Long Put
 A riskless position results if you combine a
covered call and a long put
Covered call Long put Riskless position

+ =

18
 Covered Call and Long Put
 Riskless investments should earn the
riskless rate of interest

 If an investor can own a stock, write a call,

and buy a put and make a profit, arbitrage is
present

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 No Arbitrage Relationships
 The covered call and long put position has
the following characteristics:
– One cash inflow from writing the call (C)
– Two cash outflows from paying for the put (P)
and paying interest on the bank loan (Sr)
– The principal of the loan (S) comes in but is
immediately spent to buy the stock
– The interest on the bank loan is paid in the
future

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 No Arbitrage Relationships
(cont’d)
 If there is no arbitrage, then:

Sr
S S C P 0
(1  r )
Sr
CP 0
(1  r )
Sr
CP
(1  r )
21
 No Arbitrage Relationships
(cont’d)
 If there is no arbitrage, then:
CP r
 r
S (1  r )
– The call premium should exceed the put premium by
about the riskless rate of interest
– The difference will be greater as:
 The stock price increases
 Interest rates increase
 The time to expiration increases

22
 Variable Definitions
C = call premium
P = put premium
S0 = current stock price
S1 = stock price at option expiration
K = option striking price
R = riskless interest rate
t = time until option expiration

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 The Put/Call Parity Relationship
 We now know how the call prices, put
prices, the stock price, and the riskless
interest rate are related:

K
C  P  S0 
(1  r ) t

24
 The Put/Call Parity Relationship
(cont’d)

Equilibrium Stock Price Example

You have the following information:

 Call price = $3.5
 Put price = $1
 Striking price = $75
 Riskless interest rate = 5%
 Time until option expiration = 32 days

If there are no arbitrage opportunities, what is the equilibrium

stock price?
25
 The Put/Call Parity Relationship
(cont’d)

Equilibrium Stock Price Example (cont’d)

Using the put/call parity relationship to solve for

the stock price:
K
S0  C  P 
(1  r )t
$75.00
 $3.50  $1.00  32
(1.05) 365
 $77.18
26
 The Put/Call Parity Relationship
(cont’d)
 To understand why the law of one price must hold,
consider the following information:

C = $4.75
P = $3
S0 = $50
K = $50
R = 6.00%
t = 6 months

27
 The Put/Call Parity Relationship
(cont’d)

 Based on the provided information, the put

value should be:

P = $4.75 - $50 + $50/(1.06)0.5 = $3.31

– The actual call price ($4.75) is too high or the

put price ($3) is too low

28
 The Put/Call Parity Relationship
(cont’d)

 To exploit the arbitrage, arbitrageurs would:

– Write 1 call @ $4.75
– Buy 1 put @ $3
– Buy a share of stock at $50
– Borrow $48.56 at 6.00% for 6 months
 These actions result in a profit of $0.31 at
option expiration irrespective of the stock
price at option expiration

29
 The Put/Call Parity Relationship
(cont’d)
Stock Price at Option Expiration

$0 $50 $100

From call 4.75 4.75 (45.25)

From put 47.00 (3.00) (3.00)

From loan (1.44) (1.44) (1.44)

From stock (50.00) 0.00 50.00

Total $0.31 $0.31 $0.31

30
 The Binomial Option Pricing
Model
 Assume the following:
– U.S. government securities yield 10% next year
– Stock XYZ currently sells for $75 per share
– There are no transaction costs or taxes
– There are two possible stock prices in one year

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

$100

$75
$50

Today One Year Later

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 The Binomial Option Pricing
Model (cont’d)
 A call option on XYZ stock is available that
gives its owner the right to purchase XYZ
stock in one year for $75
– If the stock price is $100, the option will be
worth $25
– If the stock price is $50, the option will be worth
$0
 What should be the price of this option?

33
 The Binomial Option Pricing
Model (cont’d)
 We can construct a portfolio of stock and
options such that the portfolio has the
same value regardless of the stock price
after one year
– Buy the stock and write N call options

34
 The Binomial Option Pricing
Model (cont’d)
 Possible portfolio values:

$100 - $25N

$75 – (N)($C)

$50

Today One Year Later

35
 The Binomial Option Pricing
Model (cont’d)
 We can solve for N such that the portfolio
value in one year must be $50:

$100  $25 N  $50

N 2

36
 The Binomial Option Pricing
Model (cont’d)
 If we buy one share of stock today and write
two calls, we know the portfolio will be
worth $50 in one year
– The future value is known and riskless and must
earn the riskless rate of interest (10%)
 The portfolio must be worth $45.45 today

37
 The Binomial Option Pricing
Model (cont’d)
 Assuming no arbitrage exists:
$75  2C  $45.45
C  $14.77
 The option must sell for $14.77!

38
 The Binomial Option Pricing
Model (cont’d)
 The option value is independent of the
probabilities associated with the future
stock price

 The price of an option is independent of the

expected return on the stock

39
 Put Pricing in the Presence of
Call Options
 In an arbitrage-free world, the put option
cannot also sell for $14.77; If it did, an
astute arbitrageur would:
 Buy a 75 call
 Write a 75 put
 Sell the stock short
 Invest $68.18 in T-bills
 These actions result in a cash flow of $6.82
today and a cash flow of $0 at option
expiration
40
 Put Pricing in the Presence of
Call Options
Portfolio Value at Option
Activity Cash Flow Expiration
Today Price = $100 Price = $50

Buy 75 call -$14.77 $25 0

Write 75 put +14.77 0 -$25
Sell stock short +75.00 -100 -50
Invest $68.18 in -68.18 75.00 75.00
T-bills
Total $6.82 $0.00 $0.00
41
 Binomial Put Pricing
 Priced analogously to calls

 You can combine puts with stock so that

the future value of the portfolio is known
– Assume a value of $100

42
 Binomial Put Pricing (cont’d)
 Possible portfolio values:

$100

$75

$50 + N($75 - $50)

Today One Year Later

43
 Binomial Put Pricing (cont’d)
 A portfolio composed of one share of stock
and two puts will grow risklessly to $100
after one year

$75  2 P  $90.91
P  $7.95

44
 Binomial Pricing With
Asymmetric Branches
 The size of the up movement does not have
to be equal to the size of the decline
– E.g., the stock will either rise by $25 or fall by
$15
 The logic remains the same:
– First, determine the number of options
– Second, solve for the option price

45
 The Effect of Time
 More time until expiration means a higher
option value

46
 The Effect of Volatility
 Higher volatility means a higher option
price for both call and put options
– Explains why options on Internet stocks have a
higher premium than those for retail firms

47
 Multiperiod Binomial Option Pricing

 In reality, prices change in the marketplace

minute by minute and option values change
accordingly

 The logic of binomial pricing can be easily

extended to a multiperiod setting using the
recursive methods of solving for the option
value

48
 Option Pricing With Continuous
Compounding

 Continuous compounding is an
assumption of the Black-Scholes model

 Using continuous compounding to

revalue the call option from the previous
example:
($75  2C )(e.10 )  $50.00
C  $14.88
49
 Risk Neutrality and Implied Branch
Probabilities

 Risk neutrality is an assumption of the

Black-Scholes model

 For binomial pricing, this implies that

the option premium contains an implied
probability of the stock rising

50
 Risk Neutrality and Implied Branch
Probabilities (cont’d)
 Assume the following:
– An investor is risk-neutral
– He can invest funds risk free over one year at a
continuously compounded rate of 10%
– The stock either rises by 33.33% or falls 33.33% in
one year

 After one year, one dollar will be worth $1.00 x

e.10 = $1.1052 for an effective annual return of
10.52%

51
 Risk Neutrality and Implied Branch
Probabilities (cont’d)

 A risk-neutral investor would be

indifferent between investing in the
riskless rate and investing in the stock if
it also had an expected return of 10.52%

 We can determine the branch

probabilities that make the stock have a
return of 10.52%

52
 Risk Neutrality and Implied Branch
Probabilities (cont’d)
 Define the following:
– U = 1 + percentage increase if the stock
goes up
– D = 1 – percentage decrease if the stock
goes down
– Pup = probability that the stock goes up
– Pdown = probability that the stock goes down
– ert = continuously compounded interest rate
factor

53
 Risk Neutrality and Implied Branch
Probabilities (cont’d)

 The average stock return is the

weighted average of the two possible
price movements:
 P U   (P
up down D )  e rt

e rt  D
Pup 
U D
1.1052  0.6667
Pup 
1.3333  0.6667
Pup  65.78%
Pdown  1  0.6578  34.22%
54
 Risk Neutrality and Implied Branch
Probabilities (cont’d)

 If the stock goes up, the call will have an

intrinsic value of $100 - $75 = $25
 If the stock goes down, the call will be
worthless

 The expected value of the call in one

year is:
(0.6578  $25)  (0.3422  $0)  $16.45

55
 Risk Neutrality and Implied Branch
Probabilities (cont’d)

 Discounted back to today, the value of

the call today is:
$16.45 / 1.1052  $14.88

56
 Extension to Two Periods

 Assume two periods, each one year

long, with the stock either rising or
falling by 33.33% in each period

 What is the equilibrium value of a two-

year European call shown on the next
slide?

57
 Extension to Two Periods (cont’d)

$133.33 (UU)

$100
$66.67
$75 (UD = DU)
$50
$33.33 (DD)
Today One Year Later Two Years Later
58
 Extension to Two Periods (cont’d)

 The option only winds up in the money

when the stock advances twice (UU)
– There is a 65.78% probability that the call is
worth $58.33 and a 34.22% probability that
the call is worthless
(0.6578  $58.33)  (0.3422  $0)  $38.37
$38.37 / 1.1052  $34.72

59
 Extension to Two Periods (cont’d)

 There is a 65.78% probability that the

call is worth $34.72 in one year and a
34.22% probability that the call is
worthless in one year
– The expected value of the call in one year is:
(0.6578  $34.72)  (0.3422  $0)  $22.84
$22.84 / 1.1052  $20.66

60
 Extension to Two Periods (cont’d)

$58.33 (UU)

$34.72
$0 (UD = DU)
$20.66
$0
$0 (DD)
Today One Year Later Two Years Later
61
 Recombining Binomial Trees

 If trees are recombining, this means that

the up-down path and the down-up path
both lead to the same point, but not
necessarily the starting point

 To return to the initial price, the size of

the up jump must be the reciprocal of
the size of the down jump

62
 Binomial Pricing with Lognormal
Returns

 Black-Scholes assumes that security

prices follow a lognormal distribution
– With lognormal returns, the size of the
upward movement U equals:
 t
e
– The probability of an up movement is:
e t  D
Pup 
U D

63
 Multiperiod Binomial Put Pricing

 To solve for the value of a put using

binomial logic, just change the terminal
intrinsic values and work backward just
as with call pricing

 The branch probabilities do not change

64
 Exploiting Arbitrage

Arbitrage Example

Binomial pricing results in a call price of $28.11 and a put

price of $2.23. The interest rate is 10%, the stock price is $75,
and the striking price of the call and the put is $60. The
expiration date is in two years.

What actions could an arbitrageur take to make a riskless

profit if the call is actually selling for $29.00?

65
 Exploiting Arbitrage (cont’d)

Arbitrage Example (cont’d)

Since the call is overvalued, and arbitrageur would want to

write the call, buy the put, buy the stock, and borrow the
present value of the striking price, resulting in the following
cash flow today:

Write 1 call $29.00

Buy 1 put ($2.23)
Buy 1 share ($75.00)
Borrow $60e-(.10)(2) $49.12
$0.89
66
 Exploiting Arbitrage (cont’d)

Arbitrage Example (cont’d)

The value of the portfolio in two years will be worthless,

regardless of the path the stock takes over the two-year
period.

67
 American Versus European Option
Pricing
 With an American option, the intrinsic
value is a sure thing
 With a European option, the intrinsic
value is currently unattainable and may
disappear before you can get at it

 An American option should be worth

more than a European option

68
 European Put Pricing and Time
Value
 With a European put, the longer the option’s
life, the longer you must wait to see sales
proceeds
 More time means greater potential dispersion
in underlying asset values, and this pushes up
the put value

 A European put’s value with respect to time

until expiration is indeterminate

69
 European Put Pricing and Time
Value (cont’d)

 Often, an out-of-the-money put will

increase in value with more time

 Often, an in-the-money put decreases in

value for more distant expirations

70
 Intuition Into Black-Scholes
 Continuous time and multiple periods

71
 Continuous Time and Multiple
Periods
 Future security prices are not limited to only two
values
– There are theoretically an infinite number of future
states of the world
 Requires continuous time calculus (BSOPM)

 The pricing logic remains:

– A risk less investment should earn the riskless rate of
interest

72