OPTIONS AND THEIR VALUATION

LEARNING OBJECTIVES:

By the end of this module, students should be able to:

• Define the key terms associated with options
• Show payoffs associated with call and put options
• Discuss factors that determine the value of options
• Explain the binomial model for option valuation
HOW OPTIONS WORK

• An option is a special contract under which the option owner enjoys the right to buy or sell
something without the obligation to do so. The following is special terminology associated with
options.
• The option to buy is a call option and the option to sell is a put option.
• The option holder is the buyer of the option and the option writer is the seller of the option.
• The exercise price or strike price is the fixed price at which the option holder can buy and / or
sell the underlying asset.
• The date when the option expires or matures is referred to as the expiration date or maturity
date.
• Exercising the option is the act of buying or selling the underlying asset as per option contract.
• A European option can be exercised only on the expiration date whereas an American option
can be exercised on or before the expiration date
• Exchange-traded options are traded on an exchange and options not traded
on an exchange are called over-the-counter options.
• Options are said to be at the money (ATM) or in the money (ITM) or out of
the money (OTM) as shown below:
Call option Put option
ATM Exercise price = market price Exercise price = Market price
ITM Exercise price ˂ Market price Exercise price ˃ Market price
OTM Exercise price ˃ Market price Exercise price ˂ Market price
The value of an option, if it were to expire immediately, is called its intrinsic value. The
excess of the market price of any option over its intrinsic value is called the time value of
the option.
Options and their Payoffs Just Before
Expiration
• Call Options: What is the payoff of a European call option? The payoff of the call option (C) just before
expiration depends on the relationship between the stock price (S1) and the exercise price (E). Formally
C = S1 – E if S1 ˃ E
C = 0 if S1 ≤ E
This means C = Max (S1 – E, 0) The diagram below shows the value of call option. When S1 ≤ E, the call is said
to be “out of the money” and is worthless. When S1 ˃ E, the call is said to be “in the money” and its value is S 1
– E.

Payoff of a call option

Exercise Price (E) Stock price

• Put Option: The opposite of a call option is a put option. While the call option
gives the holder the right to buy a stock at a fixed price, the put option gives the
holder the right to sell a stock at a fixed price.
• The payoff of a put option just before expiration depends on the relationship
between the exercise price (E) and the price of the underlying stock (S1). If S1 ≥ E,
the put option is worthless and is said to be “out of money”. Thus the payoff of a
put option just before expiration is: If S1˂ E If S1 ≥ E
Value of put option E – S1 0
Put differently, just before expiration the payoff of a put option is Max (E – S1, 0).
The diagram below plot the relationship between the underlying stock and the
payoff of the put option.
Continued………

• Payoff of a Put Option

Payoff of a put option

Exercise price (E) Stock price

Seller’s Position

• A writer of a call option collects the option premium from the buyer of the option. In
return he is obliged to deliver the shares, should the option buyer exercise the
option. If the stock price (S1) is less than the exercise price (E) on the expiration date,
the option holder will not exercise the option. In this case the, the option writer’s
liability is nil. On the other hand, if the stock price (S 1) is more than the exercise
price (E), the option holder will exercise the option. Hence the option writer loses S 1
– E.
• What is the position the seller of a put option? If the price of stock is equal to or
more than the exercise price, the holder of the put option will not exercise the
option. Hence the option writer's liability will be nil. On the other hand, if S 1 ˂ E, the
holder of the option will exercise the option. Hence the option writer loses E – S 1.
The diagram below shows the payoffs for “selling a call” and “selling a put” from the
sellers’ point of view.
Payoffs to the Seller of Options

• Payoff Payoff
•

E Stock price
E Stock price

(a) Sell a call (b) Sell a put

FACTORS DETERMINING OPTION VALUES

• Exercise Price: Other things being equal, the higher the exercise price the lower the value of the call
option. NB the value of a call price can never be negative, regardless of how the exercise price is set.
Further it has a positive value if there is some possibility that the stock price will be higher than the
exercise price before the expiration date.
• Expiration Date: Other things being equal, the longer the time to expiration date the more valuable
the call option.
• Stock Price: The value of a call option, other things being constant, increases with the stock price.
• Variability of the Stock Price: A call option has value when there is a possibility that the stock price
exceed the exercise price before expiration date. Other things being equal, the higher the variability
of the stock price, the greater the likelihood that the stock price will exceed the exercise price
• Interest Rate: When you buy a call option you do not pay the exercise price until you decide to
exercise the call option. Put differently, payment, if any, is made in future. the higher the interest
rate, the greater the benefit will be from delayed payment and vice versa.
BINOMIAL MODEL FOR OPTION VALUATION

• The following assumption are employed to develop the model:

The stock, currently selling for S, can take two possible values next
year, uS or dS (uS ˃ dS)
An amount of B can be borrowed or lent at a rate of r the risk-free
rate. The interest factor (1+r) may be represented, for sake of
simplicity, as R.
The value of R is greater than d, but smaller than u(d˂R˂u). This
condition ensures that there is no risk-free arbitrage opportunity.
The exercise price is E.
Continued……

• The value of the call option, just before expiration, if the stock goes up
to uS is : Cu = Max (uS –E, 0)
• Likewise, the value of the call option, just before expiration, if the stock
goes down to uS is : Cd = Max (dS – E, 0)
• Now let us set up a portfolio consisting of ∆ shares of the stock and B
dollars of borrowing. Since this portfolio is set up in such a way that it
has a payoff identical to that of a call option at time 1, the following
equations will be satisfied:
Stock price rises: ∆uS – RB = Cu
Stock price falls : ∆dS – RB = Cd
Continued……

• Solving the above equations for ∆ and B, we get:

∆ = Cu – Cd = Spread of possible option prices
S(u-d) Spread of possible share prices
B = dCu - uCd
(u – d)R
Since the portfolio has the same payoff as that of a call option, the value of the call option is: C = ∆S
–B
Example: Consider the following data for Pioneer’s stock
S = 200, u = 1,4, d =0,9
E = 220, r = 0,10, R = 1,10
Cu = Max (uS – E, 0) = Max (280-220, 0) = 60
Cd = Max (dS – E, 0) = Max (180 – 220, 0) = 0
Continued

• From the above data, we get the values of ∆ and B as follows:

∆ = CU – Cd = 60 =0,6
(u – d)S 0,5(200)
B = dCu – uCd = 0,9(60) = 98,18
(u – d)R 0,5(1,10)
Thus the portfolio consists of 0,6 of a share plus borrowing of 98,18. The identity of the payoffs
of the portfolio and call option is as follows:
Portfolio Call Option

When u occurs 1,4x200x0,6-108 = 60 Cu = 60

When d occurs 0,9x200x0,6-108=60 Cd = 0
Given the equivalence of the call option and the portfolio, the value of the call option is :
C = ∆S – B = 0,6x200-98,18 = 21,82
Risk – Neutral Valuation

• In this method it is assumed that investors are risk-neutral. If investors are risk-neutral, the
expected return on the equity of stock of Pioneer must be equal to the risk-free rate.
Expected return on Pioneer stock = 10%
Since Pioneer’s stock can either rise by 40% to 280 or fall by 10% to 180, we can calculate the
probability of a price rise in the hypothetical risk-neutral world.
Expected return = [Probability of rise x 40%] + [1 – Probability of rise) x -10%] = 10%
Therefore the probability of rise is 0,40. This is called the risk-neutral probability.
We know that if the stock price rises, the call option has a value of $0,60 and if the stock price
falls the call option has a value of $0. Hence if investors are risk-neutral, the call option has an
expected future value of:
Probability of rise x $0,60 + (1 – Probability of rise) x $0 = 0,40 x $0,60 + 0,60 x $0 = $24.
Continued………

• The current value of the call option is the present value of the expected future value:
Expected future value = $24,00 = $21,82
1 + Risk-rate (1,10)
Thus we have two ways of calculating the value of an option in the binomial world:
• Option Equivalent Method : Find a portfolio of shares and loan that imitates the
option in its payoff. Since the two alternatives have identical payoffs in the future,
they must command the same price today.
• Risk Neutral Method: Assume that investors are risk-neutral, so that the expected
return on the stock is the same as the risk-free interest rate. Calculate the expected
future value of the option and discount it at the risk-free interest rate.
BLACK AND SCHOLES MODEL

• Assumptions: the following are the assumptions underlying the Black-Scholes

model.
• The call option is the European option
• The stock price is continuous and is distributed lognormally
• There are no transaction costs and taxes
• There are no restrictions on or penalties for short selling
• The stock pays no dividend
• The risk-free interest rate is known and is constant
Continued………..

• The Black-Scholes formula says:

C0 = S0 N(d1) – E N(d2)
ert
Where C0 is the equilibrium value of a call option now, S0 is the price of the stock now,
E is the exercise price, e is the base of natural logarithm, r is the annualised
continuously compounded risk-free interest rate, t is the length of time in years to the
expiration date, and N(d) is the value of the cumulative normal density function
D1 = In(So/E) + (r +1/2σ²)t
σ√t
D2 = In(So/E) + (r – 1/2σ²)t = d1 - σ√t
σ√t
Continued…..

• Where In is the natural logarithm and σ is the standard deviation of the

continuously compounded annual rate of return on the stock.
• The formula has great appeal because four of the parameters, namely, So, E, r,
and t are observable. Only one of the parameters, namely, σ², has to be
estimated. Note that the value of a call option is affected by neither the risk
aversion of the investor nor the expected return on the stock.
• Example: Consider the following data for a certain stock:
Price of stock now = So = $60,00; Exercise price, E, = $56; Standard deviation of
continuously compounded annual returns = σ = 0,3; years to maturity = t = 0,5;
Interest rate per annum = 0,14.
Applying the Black-Scholes model involves the following steps:
Continued………

• Step 1: Calculate d1 and d2

d1 = In[So/E] + [r + σ²/2]t
σ√t
= 0,68993 + 0,0925 = 0,161493 = 0,7614
0,2121 0,2121
d2 = d1 - σ√t
= 0,7614 – 0,2121 = 0,5493
Continued………….

• Step 2: Find N(d1) and N(d2). These represent the probabilities that a
random variable that has a standardised normal distribution will assume
values less than d1 and d2
N(d1) = N(0,7614) = 0,7768
N(d2) = N(0,5493) = 0,7086
NB: Procedure in calculating N(0,7614)
1. 0,7614 lies between, 0,75 and 0,80 in the Normal Distribution tables.
2. According to the table, N(0,75) = 1 – 0,2264
= 0,7736 and N(0,80) = 1 – 0,2119=0,7881
Continued………….

3. For a difference 0f 0,05 (0,80 – 0,75) the cumulative probability

increases by 0,0145 (0,7881 – 0,7736)
4. The difference between 0,7614 and 0,75 is 0,114
5. So N(0,7614) = N(0,75) + 0,0114 x 0,0145 = 0,7736+0,0033
0,05
=0,7769
Continued…….

Step 3: Estimate the present value of the exercise price, using

continuous discounting principle:
E = $56 = $52,21
ert e0,14x0,5
Continued……………….

• Step 4: Plug the numbers obtained in the previous steps in the Black-
Scholes formula:
Co = $60 x 0,7768 - $52,21 x 0,7086
= $46,61 - $37,00 = $9,61
Practice Question

• The following information is available for the equity stock of Merlin

Limited:
So = $120,00, E = $110,00, rf = 0,12, σ = 0,40.

Required: Calculate the price of a 6 month call option as per the Black-
Scholes model.