Week 3 Options II
Determinant of Option Price
When you long a call option
100
Volatility helps (Buy volatility) Bullish
Time hurts (Buy time)
80
60 PROFIT/LOSS
40
20
0 0 20 40 60 80 100 120 140 160 180 200
Downside protected = buy insurance
-20
UNDERLYING PRICE AT MATURITY
Premium of call = Intrinsic value + Time value
3
Determinants
Determinant Current spot Strike E pir! #ol $nterest rate %term& $nterest rate'Di(i)en) %commo)it!& " " European Call European American Put Call American Put
+inomial Option Pricin, -o)el
1-Period Binomial
Suppose asset price in 1-!ear time follo.s t/is possi0le pat/1
! = #$= #!$ !! "! = #D = #! D
./ere 2 3 up factor an) D 3 )o.n factor An) a 41 0on) /as t/e follo.in, possi0le pat/ %15r& 3 61
%!& %!&
6
A call option of e ercise price 3 100 .ill /a(e t/e follo.in, pat/1
'$=(a) (!* #$+,) = '! 'D=(a) (!* #D+,) = ! ! + !! = !
8o )etermine t/e price of t/e call to)a!9 .e construct a portfolio so t/at its (alue e:uals to C2 if t/e un)erl!in, asset rises to S2 an) e:uals to CD if t/e un)erl!in, asset rises to SD;; 8/e portfolio consists of
units of the underlyin- asset with value = # B units of bonds with value = B Total portfolio value = # + B
8o replicate9 t/e portfolio (alue must e:ual to t/e (alue of call option ./en e pires1
' $ = ! = # $ + %!&B = ! + %!&B
'!
' D = ! = # D + %!&B = "! + %!&B
=it/ t.o e:uations an) t.o unkno.ns9 .e can fin)1 ! + %!&B = !
"! + %!&B = ! 4e find 3 = !%0 and B = + ./%.0/12
<
8o a(oi) ar0itra,e9 to)a!9 t/e portfolio (alue must e:ual to t/e (alue of t/e call1
Total portfolio value = # + B = !%0 !! + ./%.0/12 = 5%0.5 = ' !
8/at is to sa!9 if .e 0u! 0;* s/ares of t/e un)erl!in, asset an) 0orro. 442;4*2839 .e replicate t/e call option ,i(en t/e asset price pat/;
10
Generalize the 1-Period Model
and B can be found usin- the followin- formula 3 '$ CD = #$ #D # $ ' D CU S D B= 7R #$ #D where 6 = + r = Delta or hed-e ratio
11
1-Period Model for Currenc
>i(en t/e >+P'2SD 1-perio) tree9 .e can map t/e tree for call %?31;4*&1 # = # $ = %01"
$ !
'$ = ma)8!* %01" + %.09 = !% 2" #! = %.0 '!=: #$= #!$ = %/0! 'D = ma)8!* %/0! + %.09 = !
Assume + as t/e 0orro.in, in 2S4 %)omestic currenc!&; @or 419 it .ill ,ro. to 1;0416; @or >+P19 it .ill ,ro. to 1;063<; $nterest rate is 6 f;
12
6eplicatin, t/e call usin, t/e spot an) t.o mone! markets9 .e s/oul) ,et1 ' $ = !% 2" = #$ + %!. &B = %!&2" %01" + %!. &B
' D = ! = #D + %!. &B = %!&2" %/0! + %!. &B
Sol(in, t/e unkno.n9 .e ,et1
= !%2105 B = !%."/"
An) t/e call price is1
' ! = %.0 + B = !%2105 %.0 !%."/" = ;!%!&&1
13
Multi-period Model
E c/an,e rate pat/ an) call pat/1
C2*2 S 2* 2 C* S* C! S! C2*
C *! S *!
C2 * / S 2* /
$sin- bac<ward induction* we can solve for '!
S 2* C2 * ! S 2* !
t!
t/
t2
14
Generalized Model !Co"-#oss#u$instein Model%
=rowin- the tree with 3 $p factor = $ = e
(rd r f !%0 / ) h + h (rd r f !%0 / ) h h
Down factor = D = e
where h = interval in year* e- & months = !%0
=iven the specification of the tree* it can be shown that there e)ists an uni>ue probability called ris<+neutral probability that can be used to solve the price of the option today3
Rd ( h) 6is< + neutral probability = p = where R( h) = + r R f ( h) D U D
1*
&-Period Model
C * = @ p C / * / + ( p ) C / * ? 7 R ( h)
C*
p
C/* / = ma)(S /* / K *!)
p
S /* /
S*
C! S!
p
C/* = ma)(S /* K *!) S /*
p
C *! S *!
p
C * ! = @ p C / * + ( p ) C / * ! ? 7 R ( h)
C/* ! = ma)(S /* ! K *!) S /* !
16
C! = @ p C * + ( p ) C * ! ? 7 R ( h )
Wh Binomial Model'
$f .e carefull! c/oose t/e 2 an) D9 t/e 0inomial mo)el pro)uces t/e same result of +lack-Sc/oles; +lack-Sc/oles can onl! price European option; =it/ +inomial mo)el9 at eac/ no)e9 earl! e ercise can 0e e amine) an) /ence pro)uce result for American option; $t is a numerical mo)el an) itAs fle i0le to /an)le e otic option;
17
