OPTION PRICING MODELS

Factors Affecting Option Premium/ Pricing

Spot Price of the Stock

Strike Price of the option

Time to expiration of the option

Expected price volatility of the

stock

Risk free interest rate

Anticipated cash payments on the

stock
Factors Affecting Option Premium/ Pricing

Factor Effect on Effect on

Increase in Current price of stock Call Put
1
Decrease in Current price of stock Call Put

Increase in Strike price Call Put

2
Decrease in Strike price Call Put

Increase in Time to expiration of option Call Put

3
Decrease in Time to expiration of option Call Put

Increase in Price volatility of the stock

4 Call Put
Decrease in Price volatility of the stock Call Put

Increase in Risk free interest rate

5 Call Put
Decrease in Risk free interest rate Call Put

Increase in Anticipated cash payments

6 Call Put
Decrease in Anticipated cash payments Call Put
 MODELS FOR OPTION PRICING
• BINOMIAL MODEL
- One Step Binomial Model
Option Equivalent method
Risk Neutral Method
- Two Step Binomial Model

• Black and Scholes Model

Introduction of BOPM

• The BOPM is a Discrete Time Model i.e., time is

divided into discrete bits and only at these time
points are Stock prices modeled.
• It assumes that the security prices obeys a
Binomial generating process i.e., at every point of
time there are exactly two possible states, stock
can move Up or Down.
• A priori it is not known which of the two states will
occur but the amount by which it can go Up or
Down is assumed as known.
 ASSUMPTIONS OF BINOMIAL MODEL
• Call and Put options are European Style
• The price of share changes continuously
• There are no transaction costs
• Taxes do not exist
• No restrictions on short selling, no margin
requirements
• Funds can be borrowed at risk free rate
• No Arbitrage opportunities
• Contract period is less than one year
 Option Equivalent method
• STEPS:
1.Estimate Highest value of Call Option: Cu=(Su-E,0)
2.Estimate Lowest value of Call Option: Cd=(Sd-E,0)
3.Calculation of Hedge Ratio: h or = Cu-Cd/ Su-Sd
4. Proportion of Spot price up to Spot price u= Su/S
4.Proportion of Spot price down to Spot price d= Sd/S
5.Estimation of cost of Funds to be borrowed to
create hedge portfolio: B= (dCu-uCd)/ (u-d) (1+r)t
6. Calculation of price of Call Option: C= h*S-B
7.Calculation of price of Put Option: P=C+E/ert -S
• Calculate Price of Put option assuming the
details given in Example 7.1:
P=C+E/ert-S
= 13.82+50/ e.12x.5-60
= 13.82+ 50/1.062-60
= 13.82+ 47.08-60
= 13.82- 12.92
P = 0.90 per share
• Current market price of shares of GMR is Rs.60 and a Call option
with exercise price of Rs.70 with 3 months to expiration is available.
It is expected that price of these shares at the end of 3 months from
now will be either Rs.94 or Rs.50 per share. If risk free rate of
interest is 18% per annum with simple compounding , find out the
Price of Call Option. Also calculate Price of Put option above details
are for Put Option.
Solution:
Cu= 94-70= 24
Cd= (50-70,0)= 0
h= 24-0/94-50= 0.5455
u= 94/60= 1.57
d= 50/60= 0.83
B= (0.83x24)(1.57x0)/(1.57-0.83)(1+.18).25 = 25.83
C= 0.5455x60- 25.83= 32.73-25.83= 6.9
P= 6.9+70/e.18x.25-60 = 6.9+70/1.046-60= 13.82
 Risk Neutral Method
• Steps:
1.Estimate Highest value of Call Option: Cu=(Su-E,0)
2.Estimate Lowest value of Call Option: Cd=(Sd,E,0)
3.Estimate the probability of increase and decrease in the
spot price: p and (1-p)
E(r)=(p x % increase)+ (1-p)x % decrease)
4. Price of Call Option C=Cu x p+ (Cd x (1-p)/ (1+r)t
5. Price of Put Option =C+E/ert-S

• * Use ert instead of (1+r)r for continuous compounding

• Spot price=90, Exercise Price=105, Expiration =6 months,
Increase in price by 50%, Decrease in price by 30%, Risk
free rate of return 9% with simple compounding.
Calculate price of Call and Put Option.
Spot 90 Increase by 50%= 90x50/100= 90+45=135
Spot 90 Decrease by 30%= 90x30/100= 90-27=63
Cu= 135-105= 30
Cd= (63-105,0)= 0
Estimation of Probability: .09=(p x.5)+(1-p) x -.3
.09=.5p -.3 +.3p
.09+.3= .5p+.3p
p= .39/.8= .4875
C= 30 x .4875+ 0 x .5125/(1.09).5
= 14.625/1.044= 14
P=C+E/ert-S
= 14+105/1.046-90
= 14+100.382-90
= 24.382
• Spot=Rs.20,Exercise Price Rs.22,Expiration 3months,
Increase and Decrease in Price by 20%, Risk free rate
of return 12% simple compounding. Calculate Price of
Call and Put Options.
Su= Spot Increases by 20%= 20x20/100= 20+4=24
Sd= Spot decreases by 20%= 20x20/100= 20-4= 16
Cu= Su-E = 24-22=2
Cd= (Sd-E,0) =(16-22,0)= 0
Estimation of Probability:
E(r)=(p x % increase)+ (1-p)x % decrease)
0.12= p x 0.20+ (1-p)-0.20
0.12= 0.20p-0.20+0.20p
0.12+0.20=0.20p+0.20p
0.32=0.40p
P=0.32/0.40
P= 0.80
Price of Call Option: C=Cu x p+ (Cd x (1-p)/ (1+r)t
C= 2 x 0.80+ 0 x 0.20/ (1+.12).25
C= 1.6/1.029= 1.55
Price of Put Option=C+E/ert-S
P= 1.55+22/e.12x.25- 20
P= 1.55+22/1.030-20
P= 1.55+21.36-20
P= 2.91
• Spot=Rs.200,Exercise Price Rs.220,Expiration 12
months, Increase in Price by 40% and Decrease in
Price by 10%, Risk free rate of return 10% simple
compounding. Calculate Price of Call and Put
Options using Option Equivalent Method and Risk
Neutral Method.
• Option Equivalent Method:
Su= Spot Increases by 40%= 200x40/100= 200+80=280
Sd= Spot decreases by 10%= 200x10/100= 200-20= 180
Cu= Su-E= 280-220=60
Cd= (Sd-E,0)=(180-220,0)= 0
h = Cu-Cd/ Su-Sd =60-0/280-180 = 60/100=0.60
u= Su/S = 280/200 =1.4
B= (dCu-uCd)/ (u-d) (1+r)t
B= (.9x60)-(1.4x0)/(1.4-.9)x(1.1)1
B= 54/.55= 98.18
Price of Call Option= h*S-B
C= .60x 200-98.18
C= 120-98.18
C= 21.82
Price of Put Option=C+E/ert –S
P= 21.82+220/e.1x1 -200
P= 21.82+220/1.105-200
P= 21.82+199.09-200
P= 20.91
• Risk Neutral method:
Su= Spot Increases by 40%= 200x40/100= 200+80=280
Sd= Spot decreases by 10%= 200x10/100= 200-20= 180
Cu= Su-E= 280-220=60
Cd= (Sd-E,0)=(180-220,0)= 0
Estimation of Probability:
E(r)=(p x % increase)+ (1-p)x % decrease)
0.10=p x 0.40+ (1-p)-0.10
0.10= 0.40p-0.10+0.10p
0.10+0.10= .40p+.10p
p= .20/.50= 0.40
Price of Call Option: C=Cu x p+ (Cd x (1-p)/ (1+r)t
C= 60 x .40+ (0 x (.6))/(1+.10)1
C= 24/1.1
C= 21.82
Price of Put Option=C+E/ert-S
P= 21.82+220/e.1x1-200
P= 21.82+220/1.105-200
P= 21.82+ 199.09-200
P= 20.91
Two Step Binomial process
• Spot price=100, Exercise price=100, Risk free rate of return 2%,
Price of the stock is likely to move up or down by 10% at the end of
each year for next two years. Using Two Step Binomial Model
calculate Call option Price at the end of One year and Now. Use
Option Equivalent Method and Risk Neutral methods:
• Option Equivalent Method:
Moving back one period:
Suu= Spot Increases by 10%= 100x10/100=
100+10=110x10/100=110+11=121
Sud/Sdu= 110x10/100=110-11=99 or 90x10/100=90+9=99
Sdd= Spot decreases by 10%= 100x10/100= 100-10= 90x10/100=90-
9=81
Cuu= Suu-E= 121-100=21
Cud= (Sud-E,0)=(99-100,0)= 0
h = Cuu-Cud/ Suu-Sud =21-0/121-99 = 21/22=0.9545
u= Suu/Su = 121/110 =1.1
B= (dCuu-uCud)/ (u-d) (1+r) t
B= (.9x21)-(1.1x0)/(1.1-.9)x(1.02) 1
B= 18.9/.204= 92.65
Price of Call Option= h*S-B
C= ..9545x 110-92.65
C= 104.995-92.65
C= 12.345 or 12.35
Moving back two periods: h = C-Cd/ Su-Sd
= 12.35-0/110-90=.6175
B= (dCu-uCd)/ (u-d) (1+r)t
= .9x12.35-1.1x0/(1.1-.9)(1.02)
=.90x12.35/.204= 11.115/.204=54.49
C=hxS-B= .6175x100-54.49
• Risk Neutral Method:
Moving back one period:
Suu= Spot Increases by 10%= 100x10/100=
100+10=110x10/100=110+11=121
Sud=110x10/100=110-11=99
Sdu= Spot decreases by 10%= 90x10/100= 90-10= 81
Cuu= Suu-E= 121-100=21
Cud= (Sud-E,0)=(99-100,0)= 0
Estimation of Probability= R-d/u-
d=1.02-.9/1.10-.9=.12/.20=.6
C=Cuu*p+ (1-p)Cud/1+r= 21*.6+
(1-.6)*0=12.6/1.02=12.35
Moving back two period= 12.35*.6+ (1-.6)0= 7.41/1.02=
A company’s stock is currently trading at 80. A two year
call option on the stock is available at an Exercise price of
75. The price of the stock during two years is likely to
move up or down by 10%. Risk free rate of return is 8%.
You are required to use Two Stage Binomial option price
model and calculate Call option price.
Estimation of Probability= R-d/u-d= 1.08-.90/1.1-.9=.9
Calculation of value of Call Option at Node B:
=Cuu*p+(1-p)Cud/1+r=
21.8*.9+(1-.9)4.2/1.08=19.62+.42/1.08=20.04/1.08=18.56
Calculation of value of Call at Node C=4.2*.9+1-
p*0/1.08=3.5
Calculation of Value of Call Option at Node A=
C= 18.56*.9+3.5*.1/1.08= 15.9
BLACK AND SCHOLES MODEL(B/S)
Assumptions:
1. Call and Put Options are European style
2. Price of underlying changes continuously
3. The share price has a log normal distribution
4. There are no transaction costs
5. Taxes do not exist
6. No restriction on short selling
7. Funds can be borrowed at risk free rate of
return
8. No dividend declared during the contract period
Factors Affecting Option Premium/ Pricing

Spot Price of the Stock

Strike Price of the option

Time to expiration of the option

Expected price volatility of the

stock

Risk free interest rate

Anticipated cash payments on the

stock
OPTION GREEKS/SENSITIVITY OF OPTIONS
DELTA:
• Delta represents the change in Option
Premium with respect to change in underlying
price.
• It is also known as hedge ratio
• Binomial Model Hedge Ratio = Cu-Cd/Su-Sd
• B/S model =
• Call option will have positive Delta whereas Put
Option will have negative Delta=d1-1
• It helps to manage the exposure of our option
THETA:
• Sensitivity of Option Premium with respect to time.
• Time value diminishes as maturity approaches &
becomes Zero
• Option premium increases with length of time to
maturity.
• The impact of change in time to maturity on the
value of option is represented by Theta θ.
• It is negative since with the passage of time, if the
time remaining for maturity decreases & theta also
decreases.
Theta θ= Change in premium
Change in time
GAMMA:
• The rate of change of the option’s Delta with respect to
the price of the underlying asset
• When the option is deep ITM or OTM, gamma is small: A
small gamma implies that delta is not very sensitive to the
changes in stock prices.
• When the option is near or at ATM, gamma is at its largest:
A large gamma for a given stock simply means that delta is
highly sensitive to changes in the stock prices around its
current level.
• Gamma calculations are most accurate for small changes in
the price of the underlying asset.
• Γ= Change Delta/ Change in the Price of underlying share
• The Gamma of a call option is always equal to the gamma
of put option and it can be either positive or negative.
VEGA:
• Vega is also referred as lambda or sigma.
• Vega may be defined as the rate of change of the
premium of options with respect to volatility of the
underlying asset.
• Volatility is defined as standard deviation of daily
percentage changes in underlying stock price.
• Vega=Change in premium/change in volatility(SD)
• If vega is high, then the option value is very sensitive to
change in volatility.
• Vega is always positive
• More the changes in spot prices, greater is the
uncertainty of exercise of an option and higher the
RHO AND PHI:
• The Rho may be defined as the rate of change in
the value of the options premium with respect
to the interest rate.
• It’s the expected change in the option premium
from a small change in the domestic interest rate

• Rho = Change in premium

Change in Domestic interest rate
• Rho is how much the price of an option change due
to a 1% move in interest rates.
• Phi
• In currency options we always have two interest
rates foreign interest rate and domestic
interest rate.

• When there is a change in the option value due

to change in the foreign interest rate, it is called
as Phi. Phi =Change in premium/Change in
foreign interest rate