Put-Call Parity

• Put option value can be computed using put-call parity

• A Fiduciary Call (long call, plus an investment in a zero-coupon bond
with a face value equal to the strike price) is equal to the value of
Protective Put (Long Stock and Long Put)
• Stock + Put = Call + PV(ZCB)
• S0 + P0 = C0 + PV(X)
 Put-Call Parity - Assumptions

• Derives relationship only for European options

• Call and Put have same strike price – X
• All the instruments have the same time to maturity – T
• Stock pays no dividend
 Binomial Model Assumptions
• There are two (and only two) possible prices (security prices follow a
stationary binomial stochastic process) for the underlying asset on the next
date. The underlying price will either:
• Increase by a factor of U% (Uptick)
• Decrease by a factor of D% (Downtick)
• The uncertainty is that we do not know which of the two prices will be realized.

• No Arbitrage opportunity exits

• No dividends

• The one-period interest rate, r, is constant over the life of the option (r% per period)

• Markets are perfect (no commissions, bid-ask spreads, taxes, etc.)

Risk-Neutral Valuation
• Important principle used in the valuation of derivatives is risk-neutral valuation

• This means that when valuing a derivative we can make assumption that investors are risk-
neutral which means that they do not increase the expected return they require, from an investment, to
compensate for increased risk.

• A risk neutral world has 2 features that simplify pricing of derivatives:

 Expected return on a stock (or any investment) is the risk free rate of return
 Discounted rate used for the expected payoff on an option is the risk free rate

• Binomial trees illustrate the general result that to value a derivative we can assume that the
expected return on the underlying asset is the risk-free rate and discount at the risk-free rate

• This is known as using risk-neutral valuation

• In risk neutral world, expected share price at time T is : E(ST) = S0erT

 Generalization
• Notations:
S0 = Stock price
X = Strike Price
C = Call option price
T = time of option
S0u= up level for stock price where u > 1
Cu = payoff from option when stock price rises to S0u
S0d = down level for stock price where d < 1
Cd = payoff from option when stock price goes down to S0d
 Generalization

A derivative lasts for time T and is dependent

on a stock
S0u
Cu
S0
C S0d
Cd
Generalization
• The value of a derivative is its expected payoff in a risk-neutral world
discounted at the risk-free rate

S0u
p Cu
S0
C 1–p S0d
Cd
e rT  d
p
• C = [ pCu + (1 – p)Cd ]e–rT where ud

• It is natural to interpret p and 1-p as probabilities of up and down

movements.
A Simple Binomial Model

• A stock price is currently Rs.20

• At the end of three months it will be either Rs.22 or
Rs.18
• The situation can be represented by the following
diagram:
Stock Price = Rs.22

Stock price = Rs.20

Stock Price = Rs.18
A Simple Binomial Model – contd.
• A 3-month European call option on the stock has a strike
price of Rs.21.
• The possible values of this call option in three months
time is shown below.
• We need to find the price of option now.
• The situation is represented below:

Stock Price = Rs.22

Option Payoff =Rs.1
Stock price = Rs.20
Option Price=?
Stock Price = Rs.18
Option Payoff = Rs.0
 Original Example Revisited: Risk Neutral
Valuation
S0u = 22 Time period 3 months = 0.25 years
p Cu = 1 Risk free interest rate = 12% per annum
S0
C (1 – S0d = 18
p)
Cd = 0

• Expected return on the stock in a risk neutral world must be the risk free rate of 12%
• Thus p would satisfy the condition : 22p +18 (1-p) = 20e0.12*(3/12) so p= 0.65
• At the end of 3 months, call option has 0.6523 probability of being worth 1 and 0.3477 (1-0.6523)
probability of being worth zero.
• Expected Value of call at time T = 0.65*1 + 0.35*0 = 0.65
• In risk neutral world, this would be discounted at risk free rate to give the value of the option is = 0.6523e–
0.12*0.25
= Rs. 0.633
Valuing options – Binomial tree approach
• Simplified formulas:
• Probability of up move = (rf – low)/(hi-low)
• Where rf = amount due to risk free on Re 1
• high = up side on fluctuation on Re 1
• low = down side on fluctuation on Re 1
• How to find upside and downside?

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Valuing options – Binomial tree approach
• Assume that
• Absolute values of upside and downside are the same
• Upside / downside is equal to the observed volatility
• For example,
• observed volatility in Nifty is 10.76% p.a.
• Balance period till expiry : 17 days
• Volatility for the balance period = 10.76% * sqrt(17/365) = 2.32%
• Upside on current market price of Rs 100 : Rs 102.32
• Downside on current market price of Rs 100 : Rs 97.68
• If risk free rate is 6% p.a. , risk free price after 17 days
= 100 + 100 * (6%*17/365) = 100.28

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Steps for solving under Binomial Method
• State the given data – Current price of the underlying; % of up-move; % of down-
move; Strike price; Maturity period; Risk-free rate
• Find out the range of the underlying prices from the current levels at the end of the
given period
• Using the expected price movements of the underlying, find out the payoffs for the
Option by comparing with the Strike price
• Find out the Probability of Up-move (use the formula in Slide 8)
• Find out the Probability of Down-move (1 – prob. of up move)
• Find out Expected Payoffs of the option (probability * option payoff)
• Discount the expected payoffs using the risk-free rate
• You get the Price / Premium of that specific Option contract
Q1.

Calculate the value today of a one-year Call option on a

stock that has an exercise price of Rs. 30. Assume that
Discreet / Periodic Compounded Risk-free rate is 7%.
Current value of stock is Rs. 30
Stock Price either rises to Rs. 40 or falls to Rs. 22.50
Q2.

Calculate the value today of a one-year Call option on a

stock that has an exercise price of Rs. 250. Assume that
Discreet / Periodic Compounded Risk-free rate is 9%.
Current value of stock is Rs. 300
Up / Down Move – 20% of market price
Q3.

Calculate the value today of a one-year Put option on a

stock that has an exercise price of Rs. 30. Assume that
Discreet / Periodic Compounded Risk-free rate is 7%.
Current value of stock is Rs. 30
Size of an up-move is 1.333
Size of an down-move is 0.75
Q4.

Suppose you own a stock currently priced at Rs. 50 and

that a two-year European Call option on the stock is
available with a strike price of Rs. 45. The size of an
up-move is 1.25 and the size of down-move is 0.80. The
discreet compounding risk-free rate per period is 7%.
Compute the value of call option using a two-period
Binomial model
Q5
• A stock price is currently $50. It is known that at the end of six
months it will be either $60 or $42. The risk-free rate of interest with
continuous compounding is 12% per annum. Calculate the value of a
six-month European call option on the stock with an exercise price of
$48.
Q5 (Solution)

• Suppose that p is the probability of an upward stock price movement

in a risk neutral world.
• Then, p = (e0.12*0.5 – 0.84)/(1.2 – 0.84)
= 0.6161
• The expected value of option in a risk-neutral world is:
C = e–0.12*0.5 (0.6161*12 + 0.3839*0) = 6.96
Example 6 (solve on the basis of Slide 8 & 9)
• Given
• CMP : 100
• Observed volatility : 12% p.a.
• Time till expiry : 20 days
• Risk free rate : 5% p.a.
• Estimate
• Price of at-the-money European call
• Price of at-the-money European put
• Using one step binomial

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Example 6
• Step 1 : Compute price using risk free rate of 5% p.a.
• Current market price = Rs 100
• Tenor = 20 days = 20/365 year
• Risk free price (Rf) = 100 * ( 1 + 5% * 20/365)
• = 100.274

3 digits after decimal point are shown for this example only for the illustrative purposes.
It is not necessary to show more than two digits

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Example 6
• Step 2 : Calculate hi and low prices using the given
volatility rate of 12% p.a.
 hi price =
current market price *
(1+ volatility rate p.a. * sqrt( number of days to
expiry / 365))
= 100 * ( 1 + 12% * sqrt ( 20/365))
= 102.809
 low price =
current market price *
(1- volatility rate p.a. * sqrt( number of days to
expiry / 365))
= 100 * ( 1 - 12% * sqrt ( 20/365))
= 97.191

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Example 6
• Step 3 : Calculate probability of up move
• p = ( Rf – low) / ( hi – low)
• = (100.274 - 97.191)/(102.809 - 97.191)
• = 0.55

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Example 6
• Step 4 : Calculate expected value of call option price today
• call option payoff on hi price = 102.809 - 100 = 2.809
• Probability : 0.55
• call option payoff on low price = 0, as low price of 97.191 is below the strike
of 100
• Probability : 0.45
• Expected payoff on the call option at expiry
• 0.55 * 2.809 + 0.45 * 0 = 1.545
• Present value of the expected payoff is the expected price of call option =
1.545 / ( 1 + .05 * 20/365) = 1.541

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Example 6
• Step 5 : Calculate expected value of put option price today
• put option payoff on hi price = 0, price of 102.809 is above the strike of 100
• Probability : 0.55
• put option payoff on low price = 100 – 97.191 = 2.809
• Probability : 0.45
• Expected payoff on the call option at expiry
• 0.55 * 0 + 0.45 * 2.809 = 1.264
• Present value of the expected payoff is the expected price of call option =
1.264 / ( 1 + .05 * 20/365) = 1.261

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