Unit-5

Introduction to Options Valuation

Prepared By-
Dr. Meera Hirapurkar
• Option valuation means we are calculating the
present value of the options (call or put) that
we are buying for the future purpose.
 Options Pricing
• To deal in options market, it is important to
know how the options are priced or valued.
• There are 2 reasons for it.
• First to see whether the existing options
premium quoted in the market are correct,
and second, to identify profitable trading and
arbitrage opportunities.
The determinants of Option Prices
• Before discussing the option pricing models, let us
see which factors influence the option pricing. 6
important factors are-
1. Current price of the option
2. Strike price of the option
3. Time to expiration of the option
4. Expected price volatility of the stock
5. Risk free interest rate
6. anticipated cash payments on the stock
 There are 3 Models to calculate value of
option

3 Models

1. Binomial Model

Put Call Parity

Black Scholes Model
Risk Neutral probability Approach (Imp) Delta hedging or Risk Free portfolio approach Theorom
Replicating(PCP)
portfolio Approach
Assumptions of Binomial Tree
 BINOMIAL MODEL
(Risk Neutral Probability Approach)

-Binomial Model is based on 2

assumptions only- either the price
of the stock will increase at the
maturity or it will decrease.
-Us and ds are these prices notified
as per ICAI.
Explaining with example
Valuation for Call Option
When rate is 8% pa compounded semi-
annually
When rate is 8% pa compounded Annually
Valuation for Put Option
 The Black-Scholes Options Pricing Model

• The B-S option pricing model is probably the most

commonly used option pricing model in finance.
• It was developed by Fisher Black and Myron Scholes.
• The reason for popularity of the Model is that it allows
for an analytical solution. It means that there is a
formula into which certain values are input and from
which an option price is forthcoming.
• However, this formula when programmed into a
computer, it can produce results (option price) within
seconds.
Assumptions underlying Black-Scholes Model

1. Stock price behavior corresponds to the log normal

distribution.
2. There are no transaction costs or taxes.
3. All securities/stocks are perfectly divisible.
4. No dividend payments on stock during the life of the
option.
5. There are no riskless arbitrage opportunities.
6. Stock trading is continuous.
7. Investors can borrow and lend at the same risk free rate
of interest.
THANK YOU