CHAPTER 5

OPTION MARKETS:
INTRODUCTION & VALUATION
PART B: OPTION VALUATION

McGraw-Hill/Irwin Copyright © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
 INTRODUCTION
Intrinsic and time value:
– The value S0 - X is sometimes called the intrinsic value of
in-the-money call options. For out of the money and at
the money, the intrinsic value is zero.
– The difference between the actual call price and the intrinsic
value is commonly called the time value of the option
– Most of an option’s time value typically is a type of “volatility
value.”
– As the stock price gets ever larger, the option value
approaches the “adjusted” intrinsic value, the stock price
minus the present value of the exercise price, S0 - PV( X ).

1-2
 INTRODUCTION
Determinants of option values:
– There is six factors that should affect the
value of a call option: the stock price, the
exercise price, the volatility of the stock price,
the time to expiration, the interest rate, and
the dividend rate of the stock

1-3
 INTRODUCTION
Determinants of call option values
The Value of a Call Option
(if it increases)

Stock price, S Increases

Exercise price, X Decreases

Volatility, σ Increases

Time to expiration, T Increases

Interest rate, rf Increases

Dividend payouts Decreases

1-4
RESTRICTION ON OPTION
VALUES
The value of a call option cannot be
negative. Thus, the option will command a
positive price.
Suppose the stock will pay dividend D just
before the expiration date. The value of the
call must be greater than S0 – PV(X) –PV(D)
or C ≥ max (0, S0 – (X+D)/(1+rf)T)
The upper bound of the option value is the
stock price: C ≤ S0

1-5
 RESTRICTION ON OPTION
VALUES
Early Exercise and Dividends:
– A call option holder who wants to close out that
position has two choices: exercise the call or sell it
– For an option on non-dividend stock, C ≥ S t – PV(X)
> St – X. Thus, sell the call is worth more than
exercise it. In other words, calls on non-dividend-
paying stocks are “worth more alive than dead.”
– We therefore conclude that the values of otherwise
identical American and European call options on
stocks paying no dividends are equal

1-6
RESTRICTION ON OPTION
VALUES
Early Exercise of American Puts
For American put options, the optimality of
early exercise is most definitely a
possibility
Thus, the American put must be worth
more than European put.

1-7
BINOMIAL OPTION PRICING
Two-State Option Pricing:
– Assume that a stock price can take only two possible
values at option expiration: The stock will either increase
to a given higher price or decrease to a given lower price
– Suppose the stock now sells at S0 = $100, and the price
will either increase by a factor of u = 1.20 to $120 ( u
stands for “up”) or fall by a factor of d = 0.9 to $90 ( d
stands for “down”) by year-end. A call option on the stock
with an exercise price of $110 and a time to expiration of 1
year. The interest rate is 10%. At year-end, the payoff to
the holder of the call option will be either 0 or $10

1-8
BINOMIAL OPTION PRICING
120 10

100 C

90 0

Compare the payoff of the call to that of a portfolio

consisting of one share of the stock and borrowing of
$81.82 at the interest rate of 10%. The payoff of this
portfolio is 0 or $30. The initial cash outlay to establish
this portfolio is $18.18
30

18.18

0
1-9
BINOMIAL OPTION PRICING
We can see that the payoff of this portfolio is exactly three
times that of the call option. Hence the three calls should
sell for the same price as this replicating portfolio.
3C = $18.18 => C = $6.06
We can form a riskless portfolio with a stock and writing 3
calls. This portfolio will have the payoff is $90 regardless
the price is up to $120 or down to $90. The present value of
the payoff is $81.82. Thus, the value of the portfolio, which
equals $100 from the stock held long, minus 3 C from the
three calls written, should equal 81.82. This is called
perfect hedge approach
100 – 3C = $81.82 => C = $6.06

1-10
BINOMIAL OPTION PRICING
The hedge ratio for other two-state option problems is:

H=

The hedge ratio of above example is 1/3. It can be

interpreted as for every call option written, one-third
share of stock must be held in the portfolio to hedge
away risk
What if the option is overpriced, perhaps selling for
$6.50

1-11
BINOMIAL OPTION PRICING
Generalizing the Two-State Approach:
– Suppose we were to break up the year into two 6-month
segments, and over each half-year segment the stock
price could take on two values: increase 10% (i.e., u 1.10)
or decrease 5% (i.e., d .95)

121 Cuu

Cu
110
104.5 C Cud
100
Cd
95
Cdd
90.25
1-12
BINOMIAL OPTION PRICING
The probability of each outcome is
described by the binomial distribution, and
this multiperiod approach to option pricing
is therefore called the binomial model

1-13
BLACK – SCHOLES OPTION
VALUATION
Black – Scholes formula:
– Two more assumptions: both the risk-free
interest rate and stock price volatility are
constant over the life of the option.
– The Black – Scholes pricing formula is:
C = S0N(d1) – Xe-rTN(d2)
Where,

1-14
 BLACK – SCHOLES OPTION
VALUATION
 C0: Current call option value.
 S0: Current stock price.
 N(d): The probability that a random draw from a
standard normal distribution will be less than d.
 X: Exercise price.
 r: Risk-free interest rate
 T : Time to expiration of option, in years.
 σ: Standard deviation of the annualized continuously
compounded rate of return of the stock.

1-15
BLACK – SCHOLES OPTION
VALUATION
Some of the important assumptions
underlying the formula are the following:
1. The stock will pay no dividends until after the
option expiration date.
2. Both the interest rate, r, and variance rate, σ2 ,
of the stock are constant
3. Stock prices are continuous, meaning that
sudden extreme jumps such as those in the
aftermath of an announcement of a takeover
attempt are ruled out.

1-16
BLACK – SCHOLES OPTION
VALUATION
The standard deviation of the stock return, is not
directly observable. It must be estimated from
historical data, from scenario analysis, or from
the prices of other options.
Implied volatility of the option is the volatility
level for the stock implied by the option price
If actual stock standard deviation exceeds the
implied volatility, the observed price is lower
than the fair price and vice versa.

1-17
BLACK – SCHOLES OPTION
VALUATION
Dividends and Call Option Valuation:
The payment of dividends raises the possibility of early
exercise
We can replace S0 by S0 – PV(dividend). If the dividend
yield is constant, δ, S0 – PV(Dividend) will be S0(1 –
eδT).
The so-called pseudo-American call option value is
the maximum of the value derived by assuming
that the option will be held until expiration and the
value derived by assuming that the option will be
exercised just before an ex-dividend date

1-18
BLACK – SCHOLES OPTION
VALUATION
Put Option Valuation:
If we use put-call parity to subtitute to
the B-S model for call option, the B-S
model for put option will be
P = Xe-rT (1 - N(d2)) - S0N(d1)

1-19