LECTURER:

BASIC OPTION VALUATION

DR. GARY TAN

BASIC OPTION VALUATION

BASIC OPTION VALUATION

 LEARNING OBJECTIVES
At the end of this Topic, students should be able to understand:
 standard option notations
 boundaries on option prices
 the factors determining option values
 put-call-parity
 elementary pricing of options

BASIC OPTION VALUATION 2

 STANDARD NOTATION
𝑆0 ~ stock price 𝑆𝑇 ~ stock price at expiration

D ~ Present value of dividends during option’s life

𝐶𝑎 ~ American Call 𝐶𝑒 ~ European Call

X ~ exercise price T ~ time to expiration

R ~ risk-free rate for maturity T with continuous compounding.

Usually use most liquid government short-term debt instrument

In Australia it is common to use Bank Bill Swap Reference Rate or short-term govt bond
futures.
• Technically, you should use a BBSRR with a duration close to that of the option contract. However, for the examples in this topic,
lets assume: BBSRR = 5%

BASIC OPTION VALUATION 3

CALL OPTION BOUNDARIES

 Absolute Minimum Value of a Call = $0

Ce(𝑆0 ,T,X)  Max{0, 𝑆0 -PV(X)}

Ca(𝑆0 ,T,X)  Max{0, 𝑆0 -X}

Intrinsic / Exercise/ Parity Value:

Call Price
S0-X if S0 > X
S0  X
S0 > X 0 if S0  X

X Stock Price (S0)

BASIC OPTION VALUATION 4

EXAMPLE OF ARBITRAGE

 Consider 2 portfolios’ payoff

𝑆𝑇 < X 𝑆𝑇  X
European Call 0 𝑆𝑇 – X
Bond worth X(1+r)-T X X

𝑆𝑇 < X 𝑆𝑇  X
Share 𝑆𝑇 𝑆𝑇

 As Portfolio A  Portfolio B then Ce + B  S

 Ce  𝑆0 -PV(X) or Ce  S - B

BASIC OPTION VALUATION 5

CALL OPTION BOUNDARIES

 Coy Jan Call Contract ($43.27, (14/365), $43.5) = $0.66

 Is this option in or out of the money?
 Instead of $43.27, let’s pretend S0 =$44.5
 Intrinsic Value = $1
 Else Arbitrage Profit exists!

 Why is the market price for Call = $0.66 and not $0?
 Time Value / Speculative Value ~ reflects uncertainty of stock price at
expiration
 The longer till expiration, the higher the time value
 Time Value = C(S0,T,X) - Max(0,S0-X) = $0.66 for Coy

BASIC OPTION VALUATION 6

CALL OPTION BOUNDARIES

 Absolute Maximum Value of a Call = $𝑆0

 C(𝑆0 ,T,X)  𝑆0
 If C = 𝑆0 then must have infinite maturity

Call Price S Call Price S

Stock Price (S0) Stock Price (S0)

BASIC OPTION VALUATION 7

CALL OPTION BOUNDARIES

 What is the value of an option at expiration?

C(𝑆𝑇 ,T,X) = Max(0, 𝑆𝑇 -X)

Call Price Max(0,ST-X)

X Stock Price at expiration (ST)

 Is this appropriate for both European and American Options?

BASIC OPTION VALUATION 8

FACTORS DETERMINING CALL OPTION VALUE

 The Effect of Time to Expiration

 Two American calls differing only by time to expiration, T1 and T2 where
T1 < T2.

 Ca2(S0,T2,X) ≥ Ca1(S0,T1,X)
 At T1 Ca1 = Max(0, S1 – X) whereas this will be the minimum for Ca2
 Due to Time value of the call option.
 Time value maximized when at-the-money
 Minimized when deep in-/out-of- the money.

 Time value decays closer to expiration

BASIC OPTION VALUATION 9
FACTORS DETERMINING CALL OPTION VALUE

Call Option Value Relative to Time

Call Price Max{(0,S0-PV(X)}

Max(0,S0-X)

Stock Price (S0)

BASIC OPTION VALUATION 10
FACTORS DETERMINING CALL OPTION VALUE

Example: BHP share options (S0 = $43.27)

Ceteris paribus, a call option is worth less when expiration is closer.

BASIC OPTION VALUATION 11
FACTORS DETERMINING CALL OPTION VALUE

 The Effect of Exercise Price

 Two European calls differing only by strikes of X1 and X2
(where X1 < X2).
 Which is greater, Ce1(S0,T,X1) or Ce2(S0,T,X2)?
 By how much?
 The difference in exercise prices will be greater than or equal to the
difference in call prices’ spread. See the following example.

BASIC OPTION VALUATION 12

 FACTORS DETERMINING CALL OPTION VALUE
 Consider 2 portfolios’ payoff

ST < X1 X1  ST < X2 X1 < X2  ST

A. Money spread
Buy Ce1(S0,T,X1) 0 ST – X1 ST– X1
Short Ce2(S0,T,X2) 0 0 -(ST – X2)
Sum: 0 ST – X1 X2 –X1

B. Buy Bond = PV(X2-X1) X2 –X1 X2 –X1 X2 –X1

 PV(X2-X1)  C1 –C2
 C2  C1 –B
BASIC OPTION VALUATION 13
FACTORS DETERMINING CALL OPTION VALUE

Example: BHP share options (S0 = $50.62)

Ceteris paribus, a call option is worth more the lower the exercise
price.

BASIC OPTION VALUATION 14

FACTORS DETERMINING CALL OPTION VALUE

 Limits on the Value Difference in Premiums

 We know that
 (X2 - X1)(1+r)-T ≥ Ce(S0,T,X1) - Ce(S0,T,X2)
 Therefore:
 X2 - X1 ≥ Ce(S0,T,X1) - Ce(S0,T,X2)

 X2 - X1 ≥ Ca(S0,T,X1) - Ca(S0,T,X2)

 The benefit from buying a call with a lower exercise price will not be greater than
the difference in exercise prices.

 Example: ANZ $16.00 call costs $0.52.

 Therefore, the maximum I would pay for an ANZ $15.50 call would be $0.52 + $0.50 = $1.02

 The mid-price of the Option is actually $0.78.

 As $1.02>$0.78 the value difference statement is true.

BASIC OPTION VALUATION 15

FACTORS DETERMINING CALL OPTION VALUE

 Effect of Dividend Payments

 With options pricing, we are NOT interested in the impact of a dividend
announcement, but rather the actual payment of the dividend.
 We state that once a stock goes Ex-dividend, the new stock value equals S0 – Div
 Prior to dividend being paid, S0’ = S0 – PV(Div)
 Therefore:
 S0 – PV(Div)  Ce(S0,T,X)  Max{0, S0 – PV(X) – PV(Div)}

 Example, assume dividend of $0.2 in two days

 $15.74 - PV($0.2)>

 ANZ Call($15.74, 0.2356, $16.00) >

 Max(0, $15.74 - $16.00(1.05)^-0.2356 - $0.2(1.05^-2/365))

BASIC OPTION VALUATION 16

FACTORS DETERMINING CALL OPTION VALUE

 The option to exercise early

 Are American calls worth more than European?
 Yes - if it is worthwhile to exercise (e.g. dividends)
 Ca(S0,T,X)  Ce(S0,T,X)
 Example, call may only be in the money when (S0 – X) and not when {[S0 – PV(Div)] - X}.
Better to exercise before dividend date.

 Would you ever exercise an American option early on a stock that does
not pay dividends?
 Exercise now you receive (S0 – X).
 However, value of call is intrinsic value PLUS time value!

BASIC OPTION VALUATION 17

FACTORS DETERMINING CALL OPTION VALUE

 Effect of Interest Rates

 Calls save you money
 Rather than buying stock, invest extra cash in term deposit.
 Higher r, the higher the value for a call.

BASIC OPTION VALUATION 18

FACTORS DETERMINING CALL OPTION VALUE

 Effect of Stock Volatility

 The higher , the higher the value of a call.
 Why?
 No downside risk.
 Maximum loss on a call?
 Maximum loss on a stock?

 Higher  increases chances of an out-of-money option to become in-

the-money.

BASIC OPTION VALUATION 19

PUTS

BASIC OPTION VALUATION 20

PUT OPTION BOUNDARIES

Absolute Minimum Value of a Put = $0

Pe(S0,T,X)  Max{0, PV(X) - S0}
Pa(S0,T,X)  Max{0, X - S0}

Put Price Intrinsic / Exercise/ Parity Value:

0 if S0  X
S<X S>X
X – S0 if S0 < X
Stock Price (S0) X

BASIC OPTION VALUATION 21

PUT OPTION BOUNDARIES

Example of Arbitrage
Consider 2 portfolios’ payoff
ST < X ST  X
A. Short European Put - (X- ST) 0
Bond worth X(1+r)-T X X

ST < X ST  X
B. Share ST ST

As Portfolio A  Portfolio B then PV(X) - Pe  S

Pe  PV(X) - S
BASIC OPTION VALUATION 22
PUT OPTION BOUNDARIES

 ANZ Jun Put Contract($15.74, (86/365), $16.0) = $0.60

 What is its intrinsic value?
 $0.26. This would have to be the minimum value for Pa

 What’s the minimum value for a Pe?

 {$16.00(1.05) –0.2356 - $15.74} ~ (PV(X)-S) = $0.077

 Why is Pa = $0.60 and not $0.26?

 Time Value / Speculative Value ~ reflects uncertainty of stock price at expiration
 The longer till expiration, the higher the time value
 Time Value = Pa(S0,T,X) - Max(0,X-S0) = $0.60 - $0.26 = $0.34

BASIC OPTION VALUATION 23

PUT OPTION BOUNDARIES

 Absolute Maximum Value of a Put = X

 Pe(S0,T,X)  PV(X)
 Pa(S0,T,X)  X

X for a Pa
Put Price
PV(X) for a Pe

Stock Price (S0)

BASIC OPTION VALUATION 24

PUT OPTION BOUNDARIES

 What is the value of an option at expiration?

 P(ST,T,X) = Max(0, X- ST)

Max(0,X -ST)
Put Price

Stock Price at expiration (ST)

 Is this appropriate for both European and American Options?

BASIC OPTION VALUATION 25

FACTORS DETERMINING PUT OPTION VALUE

 The Effect of Time to Expiration

 Two American puts differing only by time to expiration, T1 and T2
where T1 < T2.

 Pa2(S0,T2,X) ≥ Pa1(S0,T1,X)
 At T1 Pa1 = Max(0, X - S1) whereas this will be the minimum for Pa2
 Due to Time value of the put option.
 Time value maximized when at-the-money
 Minimized when deep in-/out-of the money.

 Time value decays closer to expiration

BASIC OPTION VALUATION 26

FACTORS DETERMINING PUT OPTION VALUE

American Put Option Value Relative to Time

Put Price
PV(X) As you reach the termination
date, the put price curve
approaches the intrinsic value.

Max(0,X – S0)

Stock Price (S0)

BASIC OPTION VALUATION 27
FACTORS DETERMINING PUT OPTION VALUE

Example: BHP share options (S0 = $50.62)

Ceteris paribus, an American put option is worth less when expiration

is closer.
BASIC OPTION VALUATION 28
FACTORS DETERMINING PUT OPTION VALUE

 The Effect of Exercise Price

 Two European puts differing only by strikes of X1 and X2
(where X1 < X2).
 Which is greater, Pe1(S0,T,X1) or Pe2(S0,T,X2)?
 Difference in put price will not be greater than the difference in the exercise
prices

BASIC OPTION VALUATION 29

 FACTORS DETERMINING PUT OPTION VALUE

Consider 2 portfolios’ payoff

ST < X1 X1  ST < X2 X1 < X2  ST
A. Money spread
Write Pe1(S0,T,X1) -X1 + ST 0 0
Take Pe2(S0,T,X2) X2 - ST X2-ST 0
Sum: X2 – X1 X2 - ST 0

B. Buy Bond = PV(X2-X1) X2 –X1 X2 –X1 X2 –X1

• Therefore, portfolio B  portfolio A

BASIC OPTION VALUATION 30

FACTORS DETERMINING PUT OPTION VALUE

Example: BHP share options (S0 = $50.62)

Ceteris paribus, a put option is worth less the lower the exercise price.

BASIC OPTION VALUATION 31

FACTORS DETERMINING PUT OPTION VALUE

 Limits on the Difference in Premiums

 We know that
 (X2 - X1)(1+r)-T ≥ Pe(S0,T,X2) - Pe(S0,T,X1)
 Therefore:
 X2 - X1 ≥ Pe(S0,T,X2) - Pe(S0,T,X1)
 X2 - X1 ≥ Pa(S0,T,X2) - Pa(S0,T,X1)
 The cost from buying a put with a higher exercise price will not be greater than the difference in exercise
prices.

 Example: ANZ $16.00 put costs $0.60. ANZ $15.50 put costs
$0.36. Therefore,
 (16 – 15.5) > (0.60 – 0.36)

BASIC OPTION VALUATION 32

FACTORS DETERMINING PUT OPTION VALUE

 Effect of Dividend Payments

 Stock Value now equals S0 – PV(Div)
 Therefore:
 PV(X)  Pe(S0,T,X)  Max{0, PV(X) – [S0 – PV(Div)]}

BASIC OPTION VALUATION 33

FACTORS DETERMINING PUT OPTION VALUE

 The option to exercise early

 Are American puts worth more than European?
 Pa(S0,T,X) ≥ Pe(S0,T,X)
 There is always a sufficiently low stock price that will make it optimal to exercise an
American put early.
 Dividends on the stock reduce the likelihood of early exercise.

BASIC OPTION VALUATION 34

FACTORS DETERMINING PUT OPTION VALUE

 Effect of Interest Rates

 Puts delay the sale of a stock
 Rather than selling stock now, you do so in the
future at a cost of r.
 Higher r, the lower the value for a put.

BASIC OPTION VALUATION 35

FACTORS DETERMINING PUT OPTION VALUE

 Effect of Stock Volatility

 The higher , the higher the value of a put.
 Why?
 No downside risk.
 Maximum loss on a put?
 Higher  increases chances of an out-of-money option to become in-the-
money.

BASIC OPTION VALUATION 36

PUT-CALL PARITY

Put-Call Parity

Call Put

Stock Risk-Free Bond

BASIC OPTION VALUATION 37

PUT-CALL PARITY

 Consider 2 portfolios, A & B

Payoff for A ST  X ST > X
Take European Put X – ST 0
Buy Share ST ST

Payoff for B ST  X ST > X

Take European Call 0 ST - X
Buy Bond worth X(1+r)-T X X

 S0 + Pe(S0,T,X) = Ce(S0,T,X) + X(1+r)-T

BASIC OPTION VALUATION 38

PUT-CALL PARITY

 Other common expressions:

 Pe(S0,T,X) = Ce(S0,T,X) + X(1+r)-T - S0
 S0 + Pe(S0,T,X) - X(1+r)-T = Ce(S0,T,X)
 What about American Options?
 Ca(Ś0, T, X) + X + PV(Div) ≥
 S0 + Pa(Ś0, T, X) ≥
 Ca(Ś0, T, X) + X(1+r)-T

BASIC OPTION VALUATION 39

PUT-CALL PARITY
 Example 1
 ANZ Put($15.74, (86/365), $16.0)  $0.60
 ANZ Call($15.74, (86/365), $16.0)  $0.52
 30 Day Bank Swap Rate = 5%
 Why is Put > Call price?
 Does Put-Call Parity hold?
 Call + Bond[$X]  Put + Share  Call + PV(Bond[$X])

 0.52 + 16  0.60 + 15.74  0.52 + 15.82

 16.52  16.34  16.34
 Even if the above does not hold:

 incorrect risk-free rate!

 no account for dividend payments!

BASIC OPTION VALUATION 40

PUT-CALL PARITY

 Example 2
 How would you show an at-the-money call option must be
worth more than an at-the-money put option on the same
stock with similar maturities (no dividends)?
 C = P + S - PV(X)
 As the options are at-the-money, S=X
C=P+r

BASIC OPTION VALUATION 41

ELEMENTARY PRICING OF A CALL

 The example below tries to look at a simple way we can price

options. To help us out, let’s make some assumptions:
1. A share is currently priced at $10
2. To make things simple, we assume that in one year the share will be worth
either $11 or $13
3. The risk free rate of interest (rf) is 12% per annum.
4. You can buy a call option that also expires in a year, with an exercise price of
$12

 What is the Price of the Call?

BASIC OPTION VALUATION 42
ELEMENTARY PRICING OF A CALL
 To solve this problem, lets try to replicate the payoff of a call by holding a portfolio of bonds and
stocks….

1. Buy a risk free asset worth the present value of the expected minimum share value in one year {$11} : 11/(1+rf) = $9.82
2. Now, our minimum payoff in one year’s time is $11
3. If, however, the share in one year is worth $13, the payoff of one call option is only $1 { $13 - $12 }
4. Therefore, buying 2 call options {payoff = $2} plus buying a risk free asset with a payoff of $11, will yield the same result as owning
the share

Share Value rf asset value Value of 2 Calls Total

$11 $11 $0 $11
$13 $11 $2 $13

 S0 = 2 * C0 + $11 / ( 1.12)
 C0 = $0.09

BASIC OPTION VALUATION 43