Option Fundamentals

Payoff Diagrams – These are the basic building blocks of financial engineering.
They represent the payoffs or terminal values of various investment choices.
We shall assume that the maturity value of the bond is $X, the exercise price.

Long (Buy) Positions Short (Sell) Positions

+S
Stock

∆W

∆W
-S

∆S ∆S

+C
Call

∆W

∆W

-C

∆S ∆S

+P
Put

∆W

∆W

-P

∆S ∆S

+B
Bond

∆W

∆W

-B

∆S ∆S
Payoff Positions – The algebra of the payoffs is shown in the table below. The
exercise price of the options will be defined as $X and we shall assume that the
maturity value of the bond is $X

Stock Price S C P B
S>X S S–X nil X
S<X S nil X–S X

Financial Alchemy – What happens when we combine some of these

investments

Buy a Share and a Put (S+P) Buy a Bond and a Call (B+C)
∆W

∆W
+S +B
+P +C
S+P B+C

∆S ∆S

Notice that these have the same pattern of payoffs, given the change in the
underlying stock price. The payoffs are:

S+P B+C
S>X S: S B: X
P: 0 C: S–X
Total S Total S
S<X S: S B: X
P: X–S C: 0
Total X Total X

With options, it is possible to create a risk free payoff:

 S+P–C
S: S
P: 0
S>X -C: – (S – X)
Total X
∆W

S: S
+S P: X–S
+P
S<X -C: 0
-C
S+P-C Total X
∆S

Note that this creates a risk free payoff, which is always $X. Therefore, we can
create a risk-free security by buying a stock, buying a put option with an exercise
price of $X and selling (or writing) a call option with an exercise price of $X.

Binomial Pricing

Let’s assume that we have a stock currently selling for $40 and there is an at-the-
money option that expires in 6 months, ½ a year. The risk free rate is 4.04% or
2% over the six-month time horizon. We shall assume that the outcomes are
binary, that is that the stock can either rise 25% or fall 20%. Note that these two
rates imply terminal values that are the multiplicative inverse of each other,
(1+25%) = 1/(1-20%). Thus the terminal values for the stock can be either $32 or
$50. We shall examine two strategies to allow us to work toward pricing the
option.

Strategy #1 – Buy a Call

P6 = 40(1-20%) = $32 P6 = 40(1+25%) = $50
Call Value nil 50 – 40 = $10

Strategy #2 – Buy 5/9s of a share and take out a risk-free loan with a repayment
of $17.777… The loan is ($17.777…)/(1.02) = 17.42919…
P6 = 40(1-20%) = $32 P6 = 40(1+25%) = $50
Stock Value $32 x (5/9) = $17.777… $50 x (5/9) = $27.777…
Loan Repayment ($17.777…) ($17.777…)
Total nil $10

Notice that these two strategies have identical payoffs, meaning that the two
strategies must have the same value:

C = (5/9)(40) – 17.42919… = $4.793…

Where did the 5/9s come from?

This is the “Delta” (∆) of the option. It is also known as the hedge ratio.

Spread of Options Values 10.00 − 0 10.00 5

∆= = = =
Spread of Share Values 50.00 − 32.00 18.00 9

Where did the $17.777… come from?

It is the difference between the in-the-money share payoff (5/9 x $50 = 27.777…)
and the option payoff ($10.00). The amount borrowed is the present value,
discounted at the risk-free rate of interest.

Based on what we have seen with creating risk free payoffs, the option value that
we obtained, $4.793…, is a fair value. Any other price would create arbitrage
opportunities.

Risk Neutral Valuation

Let’s take another approach, and assume that investors do not care about risk.
Since we demonstrated that we could create risk-free payoffs using options, this
approach is not much of a stretch.

Since investors are indifferent about risk, the return expected on the stock over
the next six months is 2%. Let’s compute the risk-neutral probability that the
stock will rise (PU):

E(r ) = 2% = (PU )(25%) + (1 − PU )(− 20%)

⇒ 2% = (25%)(PU ) + (20%)(PU ) − (20%)
⇒ 22% = (45%)(PU )
⇒ (PU ) = (22%) (45%) = 0.48888...

Let’s apply this probability to the option payoff or terminal value:

Probability Terminal Value Cross-Product

0.4888… $10.00 4.888…
0.5111… 0.00 0.00
Total 4.888…

This is the expected value of the option at the maturity. The present value of this
is $4.888…/1.02 = $4.793…, the same value that we had before.

The general formula to get this risk-neutral probability of an upside price

movement is:
 r −D
PU = , where r is the risk free return to the maturity of the option.
U−D

Put Option Valuation

Strategy #1 – Buy a Put

P6 = 40(1-20%) = $32 P6 = 40(1+25%) = $50
Put Value 40 – 32 = $8 nil

Strategy #2 – Sell 4/9s of a share and lend $21.786… as a risk-free loan with a
repayment of $22.222…
P6 = 40(1-20%) = $32 P6 = 40(1+25%) = $50
Stock Value $32 x (-4/9) = ($14.22…) $50 x (-4/9) = ($22.22…)
Loan Repayment ($22.222…) ($22.222…)
Total $8 Nil

Notice that these two strategies have identical payoffs, meaning that the two
strategies must have the same value:

P = (-4/9)(40) + 21.786… = $4.0087…

Using Risk Neutral Valuation:

Probability Terminal Value Cross-Product

0.4888… $0.00 0.00
0.5111… 8.00 4.0888…
Total 4.0888…

This is the expected value of the option at the maturity. The present value of this
is $4.0888…/1.02 = $4.0087…, which is the same value.

Put-Call Parity

Recall that:

S+P=B+C
and B = Xe-rT
S + P = Xe-rT + C
P = C – S + Xe-rT

In our example:

P = $4.793… – 30.00 + (30.00)-0.02

= $4.0087…
General Form of Put-Call Parity

C – P = S – Xe-rT

Generalizing Binomial Option Pricing

We assumed that there were only two terminal values of the stock in the future,
S(1+U) and S(1+D). To make this more realistic, we split the time preiods into
smaller fractions of the year and adjust the u = (1 + U) and d = (1 + D)
movements accordingly. As an intermediate step the binomial lattice would
look like this:

Su10
9
Su

Su8 Sdu9

Su7 Sdu8
6 7
Su Sdu Sd2u8
5 6 2 7
Su Sdu Sd u

Su4 Sdu5 Sd2u6 Sd3u7

3 4 2 5 3 6
Su Sdu Sd u Sd u

Su2 Sdu3 Sd2u4 Sd3u5 Sd4u6

Su Sdu2 Sd2u3 Sd3u4 Sd4u5

2 2 3 3 4 4
S Sud Sd u Sd u Sd u Sd5u5
2 3 2 4 3 5 4
Sd Sd u Sd u Sd u Sd u

Sd2 Sd3u Sd4u2 Sd5u3 Sd6u4

3 4 5 2 6 3
Sd Sd u Sd u Sd u

Sd4 Sd5u Sd6u2 Sd7u3

Sd5 Sd6u Sd7u2

6 7
Sd Sd u Sd8u2
7 8
Sd Sd u

Sd8 Sd9u
9
Sd

Sd10

As the time intervals or steps get smaller and the ending points become
continuous, we have the familiar situations of the binomial approaching the
normal. The difference here is that the probabilities are not symmetrical and the
distribution of ending prices is actually the lognormal.

To determine the appropriate values of U and D (or u and d) we need the

following relationships:

1 + U = u = e σT
1 + D = d = 1/ u

Applying this to our example:

 1.25 = e σ 0.5

ln(1.25) = σ 0.5
ln(1.25) 0.22314...
σ= = = 0.31557... ≅ 31.56%
0.5 0.70710...

This means that the values of u = 25% and d = -20% correspond to an annual
standard deviation of 31.56%.

In our example, if we wanted to create the a binomial lattice with six, one-month
steps, the values that we would use would be:

1 + U ≡ u = e (0.3156 ) 1 12
= 1.09537...
1 + D ≡ d = 1/ u = 0.9129...
or
U = 9.537...%
D = −8.70...%

Black-Scholes Option Pricing Model

C = S ⋅ N(d1 ) − Xe −rT ⋅ N(d2 )

 S  σ T
2
 S  σ T
2
ln  + ln  −
Xe −rT  Xe −rT  2
d1 = 
2 d2 =  Brealey and Myers Notation
σ T σ T
 S   S 
ln −rT 
ln 
 Xe  σ T  Xe −rT  σ T
= + = −
σ T 2 σ T 2
S σ2T S σ2T
ln  + rf T + ln  + rf T − Standard Textbook Notation
X 2
=  
X 2 =  
σ T σ T
= d1 − σ T
Applying the Black-Scholes to the example:

 40 
ln 
 40e −0.02  0.3156 0.5
d1 = + = 0.2012
0.3156 0.5 2
d2 = 0.2012 − 0.3156 0.5 = −0.02194

Using the NORMSDIST Excel function:

N(d1) = 0.5797, N(d2) = 0.4912

C = 40(0.5797) – 40e-0.02(0.4912) = 23.189 – 19.261 = $3.928