Option Valuation
Option Values
Intrinsic value - profit that could be made if the
option was immediately exercised
– Call: stock price - exercise price
– Put: exercise price - stock price
Time value - the difference between the option
price and the intrinsic value
Call Option Value Before Expiration
Factors Influencing Option
Values: Calls
Factor Effect on value
Stock price increases
Exercise price decreases
Volatility of stock price increases
Time to expiration increases
Interest rate increases
Dividend Rate decreases
Binomial Option Pricing:
Text Example
200 75
100 C
50 0
Stock Price Call Option Value
X = 125
Binomial Option Pricing:
Text Example
Alternative Portfolio 150
Buy 1 share of stock at $100
Borrow $46.30 (8% Rate) 53.70
Net outlay $53.70
Payoff 0
Value of Stock 50 200
Payoff Structure
Repay loan - 50 -50 is exactly 2 times
Net Payoff 0 150 the Call
Binomial Option Pricing:
Text Example
150 75
53.70 C
0 0
2C = $53.70
C = $26.85
The Hedge Ratio
If the investor writes one option and holds H
shares of Stock the value of the portfolio will
be unaffected by the stock price.
Cu Cd
H
Su S d
In theprevious example :
75 0 1
H
200 50 2
Another View of Replication of
Payoffs and Option Values
Alternative Portfolio - one share of stock
and 2 calls written (X = 125)
Portfolio is perfectly hedged
Stock Value 50 200
Call Obligation 0 -150
Net payoff 50 50
PV of Net payoff 46.30.
Hence 100 - 2C = 46.30 or C = 26.85
Binomial Option Pricing:
Text Example
120
80 C
60
Stock Price Call Option Value
X = 100, r=5%
Generalizing the Two-State
Approach
121
110
100 104.50
95
90.25
Generalizing the Two-State
Approach
CU U
CU
C CU D
CD
CDD
Figure 15-2 Probability
Distributions
Black-Scholes Option
Valuation
Co = Soe-dTN(d1) - Xe-rTN(d2)
d1 = [ln(So/X) + (r – d + s2/2)T] / (s T1/2)
d2 = d1 - (s T1/2)
where
Co = Current call option value.
So = Current stock price
N(d) = probability that a random draw from a normal
dist. will be less than d.
Black-Scholes Option
Valuation
X = Exercise price.
d = Annual dividend yield of underlying stock
e = 2.71828, the base of the natural log
r = Risk-free interest rate (annualizes continuously
compounded with the same maturity as the option.
T = time to maturity of the option in years.
ln = Natural log function
s Standard deviation of annualized cont. compounded
rate of return on the stock
Figure 15-3 A Standard
Normal Curve
Call Option Example
So = 100 X = 95
r = .10 T = .25 (quarter)
s = .50 d = 0
d1 = [ln(100/95)+(.10-0+(.5 2/2))]/(.5 .251/2)
= .43
d2 = .43 - ((.5)( .25)1/2
= .18
Probabilities from Normal
Dist.
N (.43) = .6664
Table 17.2
d N(d)
.42 .6628
.43 .6664
.44 .6700
Probabilities from Normal
Dist.
N (.18) = .5714
Table 17.2
d N(d)
.16 .5636
.18 .5714
.20 .5793
Call Option Value
Co = Soe-dTN(d1) - Xe-rTN(d2)
Co = 100 X .6664 - 95 e- .10 X .25 X .5714
Co = 13.70
Implied Volatility
Using Black-Scholes and the actual price of the
option, solve for volatility.
Is the implied volatility consistent with the
stock?
Figure 15-4 Implied Volatility
of the S&P 500 (VIX Index)
Put-Call Parity Relationship
ST < X ST > X
Payoff for
Call Owned 0 ST - X
Payoff for
Put Written -( X -ST) 0
Total Payoff ST - X ST - X
Figure 15-5 The Payoff Pattern of a Long
Call – Short Put Position
Arbitrage & Put Call Parity
Since the payoff on a combination of a long
call and a short put are equivalent to
leveraged equity, the prices must be equal.
C - P = S0 - X / (1 + rf)T
If the prices are not equal arbitrage will be
possible
Put Call Parity –
Disequilibrium Example
Stock Price = 110 Call Price = 17
Put Price = 5 Risk Free = 5%
Maturity = .5 yr Exercise (X) = 105
C - P > S0 - X / (1 + rf)T
14- 5 > 110 - (105 e (-.05 x .5))
9 > 7.59
Since the leveraged equity is less expensive;
acquire the low cost alternative and sell the high cost
alternative
Intro to Finance Winter 2007
William Fuchs Put Option Value: Black-
Scholes
P=Xe-rT [1-N(d2)] - S0e-dT [1-N(d1)]
Using the sample data
P = $95e(-.10X.25)(1-.5714) - $100 (1-.6664)
P = $6.35
Intro to Finance Winter 2007
William Fuchs Put Option Valuation:
Using Put-Call Parity
P = C + PV (X) - So
= C + Xe-rT - So
Using the example data
C = 13.70 X = 95 S = 100
r = .10 T = .25
P = 13.70 + 95 e -.10 X .25 - 100
P = 6.35
Using the Black-Scholes
Formula
Hedging: Hedge ratio or delta
The number of stocks required to hedge against the price risk
of holding one option
Call = N (d1)
Put = N (d1) - 1
Option Elasticity
Percentage change in the option’s value given a 1%
change in the value of the underlying stock
Figure 15-6 Call Option Value
and Hedge Ratio
Portfolio Insurance –
Protecting Against Declines in Stock Value
Buying Puts - results in downside protection
with unlimited upside potential
Limitations
– Tracking errors if indexes are used for the puts
– Maturity of puts may be too short
– Hedge ratios or deltas change as stock values
change
Fig.15-7 Profit on a Protective
Put Strategy
Figure 15-8 Hedge-Ratios Change
as the Stock Price Fluctuates
Empirical Tests of Black-Scholes
Option Pricing
Implied volatility varies with exercise price
– Lower exercise price leads to higher option pricing
– If the model was complete implied variability should
be the same for different exercise prices
Figure 15-9 Implied Volatility
as a Function of Exercise Price
