Chapter 16

Option Valuation

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 Option Valuation

“I have compared the results of observation with those of

theory . . . to show that the market, unwittingly, obeys a law
which governs it, the law of probability.”

–Louis Bachelier

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 Learning Objectives

Make sure the price is right by making sure

that you have a good understanding of:

1. How to price options using the one-period and two-period

binomial models.

2. How to price options using the Black-Scholes model.

3. How to hedge a stock portfolio using options.

4. The workings of employee stock options.

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 Option Valuation

 Our goal in this chapter is to discuss how to calculate

stock option prices.

 We will discuss many details of the very famous Black-

Scholes option pricing model.

 We will discuss "implied volatility," which is the market’s

forward-looking uncertainty gauge.

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 Just What is an Option Worth?

 In truth, this question is difficult to answer.

 At expiration, an option is worth its intrinsic value.

 Before expiration, put-call parity allows us to price options. But,

 To calculate the price of a call, we need to know the put price.
 To calculate the price of a put, we need to know the call price.

 So, we want to know the value of a call option:

 Before expiration
and
 Without knowing the price of the put

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 A Simple Model to Value
Options Before Expiration, I.
 Suppose we want to know the price of a call option with
 One year to maturity.
 A $110 exercise price.
 A current stock price of $108.
 A one-year risk-free rate, r, of 10 percent.

 We know (somehow) that the stock price will be $130 or $115 in one year.
 The stock price in one year is still uncertain.
 We know that the stock price is going to be $130 or $115 (but no other values).
 We do not need to know the probabilities of these two values.

 Therefore, we know the call option value at expiration will be:

 $130 – $110 = $20
or
 $115 - $110 = $5

 This call option is certain to finish in the money.


6 A similar put option is certain to finish
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 A Simple Model to Value
Options Before Expiration, II.
 If you know the price of a similar put, you can use put-call parity to price a
call option before it expires.

C - P  S 0 - K/(1  r)T
C - 0  $108  $110/(1.10 )
C  $108 - $100  $8.

 The chosen pair of stock prices guarantees that the call option finishes in the
money.
 Suppose, however, we want to allow the call option to expire in the money
OR out of the money.
 How do we proceed in this case? Well, we need a different option pricing
model.
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 The One-Period Binomial Option Pricing
Model—The Assumptions
 Suppose the stock price today is S, and the stock pays no dividends.

 We assume that the stock price in one period is either S × u or S × d,

where:
 u (for “up” factor) is bigger than 1
 and d (for “down” factor) is less than 1

 Suppose the stock price today is $100, and u = 1.1 and d = 0.95.
 The stock price in one period will either be
 $100 × 1.1 = $110
or
 $100 × 0.95 = $95.

 What is the call price today, if:

 K = 100
 R = 3%
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 The One-Period Binomial Option
Pricing Model—The Setup

 Consider the following portfolio:

 Buy a fractional share of the underlying asset--this fraction is represented

by the Greek letter, D (Delta)
 Sell one call option
 Finance the difference by borrowing the amount:
DS – C

 Key Question: What is the value of this portfolio today and

at option expiration?

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 The Value of this Portfolio
(long D Shares and short one call) is:
Important: DS is NOT the change in S.
Rather, it is a dollar amount, DS.

DS×u - Cu
Cu and Cd : The intrinsic value of the call
if the stock price increases to S×u or
DS - C decreases to S×d, respectively.

DS×d - Cd

Portfolio Value Today Portfolio Value At Expiration

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 To Calculate Today’s Call Price, C:
 A Brilliant Insight: There is one combination of a fractional
share and one call that makes this portfolio risk-less.

 That is, the portfolio will have the same value when the underlying
asset increases as it does when the underlying asset decreases in value.

 The portfolio is riskless if: DSu – Cu = DSd – Cd

 We know all values in this equation today, except D.

 S = $100; Su = $110; Sd = $95
 Cu = MAX(Su – K, 0) = MAX($110 – 100,0) = $10.
 Cd = MAX(Sd – K, 0) = MAX($95 – 100,0) = $0.

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 Therefore, Our First Step is to Calculate D

To make the portfolio riskless:

DSu – Cu = DSd – Cd

DSu – DSd = Cu – Cd

D(Su – Sd) = Cu – Cd,

Therefore, we can calculate D:

D = (Cu – Cd) / (Su – Sd)

D = (10 – 0) / 110 – 95
D = 10 / 15
D = 2 / 3.
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 Sidebar: What is D?

 D, delta, is the riskless hedge ratio, a proportion.

 D, delta, is the fractional share amount needed to

hedge one call.

 Therefore, the number of calls to hedge one share is

1/D.

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 The One-Period Binomial Option
Pricing Model—The Formula
 A riskless portfolio today should be worth (DS – C)(1+r) in
one period.

 So, (DS – C)(1+r) = DSu – Cu (which equals DSd – Cd because

we chose the “correct” D).
( S - C)(1 r)  Su - Cu
 Solving the equation above for C: ΔS(1  r)  C(1  r)  ΔSu  Cu
ΔS(1  r)  ΔSu  C(1  r)  Cu
ΔS(1  r  u)  C(1  r)  Cu
ΔS(1  r  u)  Cu  C(1  r)
ΔS(1  r  u)  Cu
C
1 r

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 Now We Can Calculate the Call Price, C

C
ΔS(1  r  u)  Cu What is the price of a similar put?
1 r

(2/3)($100 )(1  .03  1.10)  $10 Using Put-Call Parity:

C
1  .03
P  S  C  K/(1  r)
($200/3)( .07)  $10 P  $100  $5.18  $100/1.03
C
1  .03 P  $5.18  $100/1.03  100
P  $2.27.
$5.33
C  $5.18
1.03 Why can we use
Put-Call Parity?

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 The Two-Period Binomial
Option Pricing Model
 Suppose there are two periods to expiration instead of one. What do
we do in this case?

 It turns out that we repeat much of the process we used in the one-
period binomial option pricing model.

 This method can be used to price:

 European call options.
 European put options.
 American calls and puts (with a modification to allow for early exercise).
 An exotic array of options (with the appropriate modifications).

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 The Method

We can find binomial option prices for two (or more) periods by
using the following five steps:

1. Build a price “tree” for stock prices through time.

2. Use the intrinsic value formula to calculate the possible option values at
expiration.

3. Calculate the fractional share needed to form each riskless portfolio at the
next-to-last date.

4. Calculate all possible option prices at the next-to-last date.

5. Repeat this process by working back to today.

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 The Binomial Option Pricing
Model with Many Periods

When there are more

than two periods, nothing
really changes—we just
keep working on back to
today.

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 What Happens When the Number
of Periods Gets Really, Really Big?

 We can always use a computer to handle this situation.

 However, for European options on non-dividend paying stocks,

the binomial method converges to the Black-Scholes option
pricing formula.

 To calculate the prices of many other types of options, however,

we still need to use a computer (and methods similar in spirit to
the binomial method).

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 The Black-Scholes
Option Pricing Model

 The Black-Scholes option pricing model allows us to calculate

the price of a call option before maturity (and, no put price is
needed).
 Dates from the early 1970s
 Created by Professors Fischer Black and Myron Scholes
 Made option pricing much easier—The CBOE was launched soon after
the Black-Scholes model appeared.

 The Black-Scholes option pricing model calculates the price of

European options on non-dividend paying stocks.

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 The Black-Scholes
Option Pricing Model
The Black-Scholes option pricing model says the value
of a stock option with European-style exercise
is determined by five factors:

 S, the current price of the underlying stock.

 K, the strike price specified in the option contract.

 r, the risk-free interest rate over the life of the option contract.

 T, the time remaining until the option contract expires.

 , (sigma) which is the price volatility of the underlying stock.

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 The Black-Scholes
Option Pricing Formula
 The price of a call option on a single share of common
stock is: C = SN(d1) – Ke–rTN(d2)

 The price of a put option on a single share of common

stock is: P = Ke–rTN(–d2) – SN(–d1)
d1 and d2 are calculated using these two formulas:

ln S K   r  σ 2 2  T
d1 
σ T
d2  d1  σ T

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 Formula Details
 In the Black-Scholes formula, three common functions are used to
price call and put option prices:

 e-rt, or exp(-rt), is the natural exponent of the value of –rt (in common
terms, it is a discount factor)

 ln(S/K) is the natural log of the "moneyness" term, S/K.

 N(d1) and N(d2) denotes the standard normal probability for the
values of d1 and d2.

 In addition, the formula makes use of the fact that:

N(-d1) = 1 - N(d1)
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 Example: Computing Prices
for Call and Put Options
 Suppose you are given the following inputs:

S = $50
K = $45
T = 3 months (or 0.25 years)
s = 25% (stock volatility)
r = 6%

 What is the price of a call option and a put option, using the
Black-Scholes option pricing formula?

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 We Begin by Calculating d1 and d2

d1 
  
ln S K   r  σ 2 2 T ln 50 45  0.06  0.252 2  0.25


σ T 0.25 0.25

0.10536  0.09125  0.25


0.125

 1.02538

d2  d1  σ T  1.02538  0.25 0.25  0.90038

Now, we must compute N(d1) and N(d2). That is,

the standard normal probabilities.

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Using the =NORMSDIST(x) Function in Excel

 If we use =NORMSDIST(1.02538), we obtain 0.84741.

 If we use =NORMSDIST(0.90038), we obtain 0.81604.

 Let’s make use of the fact N(-d1) = 1 - N(d1).

N(-1.02538) = 1 – N(1.02538) = 1 – 0.84741 = 0.15259.

N(-0.90038) = 1 – N(0.90038) = 1 – 0.81604 = 0.18396.

 We now have all the information needed to price the call and
the put.

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 The Call Price and the Put Price:

 Call Price = SN(d1) – Ke–rTN(d2)

= $50 x 0.84741 – 45 x e-(0.06)(0.25) x 0.81604

= 50 x 0.84741 – 45 x 0.98511 x 0.81604

= $6.195.

 Put Price = Ke–rTN(–d2) – SN(–d1)

= $45 x e-(0.06)(0.25) x 0.18396 – 50 x 0.15259

= 45 x 0.98511 x 0.18396 – 50 x 0.15259

= $0.525.

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 We can Verify Our Results
Using Put-Call Parity Equation

Recall: The options must have European-style exercise.

C  P  S  Ke rT

$6.195  $0.525  50  45e (0.060.25)

$5.67  $50  $44.33

Verified.

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 Valuing the Options Using Excel

Stock Price: 50.00 Stock: 50.00

Strike Price: 45.00 Discounted Strike: 44.33
Volatility (%): 25.00
Tim e (in years): 0.2500
Riskless Rate (%): 6.00

d(1): 1.02538
N(d1): 0.84741 N(-d1): 0.15259

d(2): 0.90038
N(d2): 0.81604 N(-d2): 0.18396

Call Price: $ 6.195

Put Price: $ 0.525

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Using a Web-based Option Calculator
www.option-price.com

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 Varying the Option Price Input Values
 An important goal of this chapter is to show how an option
price changes when only one of the five inputs changes.
 The table below summarizes these effects (for options with
European-style exercise).

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 Varying the Underlying Stock Price

Changes in the stock price has a big effect on option prices.

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 Varying the Time Remaining
Until Option Expiration

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Varying the Volatility of the Stock Price

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 Varying the Interest Rate

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 Calculating the Impact of Stock Price
Changes on Option Prices
 Option traders must know how changes in input prices affect
the value of the options that are in their portfolio.

 An important effect on option prices is how changes in the

stock price affects option prices.

 The street name for this effect is “Delta.”

 The other inputs also affect the option price, but we will
concentrate on Delta.

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 Calculating Delta
 Delta measures the dollar impact of a change in the
underlying stock price on the value of a stock option.

Call option delta = N(d1) > 0

Put option delta = –N(–d1) < 0

 A $1 change in the stock price causes an option price to

change by approximately delta dollars.

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Example: Calculating Delta with Excel

Stock Price: 50.00 Stock: 50.00

Strike Price: 45.00 Discounted Strike: 44.33
Volatility (%): 25.00
Time (in years): 0.2500
Riskless Rate (%): 6.00

d(1): 1.0254
N(d1): 0.84741 N(-d1): 0.15259
Call Delta: 0.84741

d(2): 0.90038
N(d2): 0.81604 N(-d2): 0.18396
Put Delta: -0.15259

Call Price: $ 6.195

Put Price: $ 0.525

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 The "Delta" Prediction:
 The call delta value of 0.8474 predicts that if the stock price
decreases by $1, the call option price will decrease by $0.85.
 If the stock price is $49, the call option value is $5.368—an actual
decrease of about $0.83.
 How well does Delta predict if the stock price changes by $0.25?

 The put delta value of -0.1526 predicts that if the stock price
decreases by $1, the put option price will increase by $0.15.
 If the stock price is $49, the put option value is $0.698—an actual
increase of about $0.17.
 How well does Delta predict if the stock price changes by $0.25?

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 Hedging with Stock Options
 You own 1,000 shares of XYZ stock AND you want protection from a price decline.

 Let’s use stock and option information from before—in particular, the “delta
prediction” to help us hedge.

 You want changes in the value of your XYZ shares to be offset by the value of
your options position. That is:

[Change in value of stock portfolio]  [Change in value of options]  0

[Change in stock price  shares held]  [Option Delta  Change in stock price  number of options]  0

or, by dividing by " Change in stock price" and rearranging :

Number of options  - Shares held / Option Delta

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Hedging Using Call Options—The Prediction

 Using a Delta of 0.8474:

Number of options  - Shares held / Option Delta

Number of options  - 1,000 / 0.8474  - 1,180.08

- 1,180.08 / 100  - 12.

Because each option contract is on 100 shares, you should write 12 call options
contracts with a $45 strike to hedge your stock.

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Hedging Using Call Options—The Results
 Suppose XYZ Shares fall by $1—so, you lose $1,000.

 What about the value of your option position?

 At the new XYZ stock price of $49, each call option is now worth $5.37—a
decrease of $.83 for each call ($83 per contract).
 Because you wrote 12 call option contracts at $6.20 (rounded), your call
option gain was $996 = ($6.20 - $5.37) ×12 ×100.

 Your call option gain nearly offsets your loss of $1,000.

 Why is it not exact?

 Call Delta falls when the stock price falls.
 Therefore, you did not sell quite enough call options.
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 Hedging Using Put Options—The Prediction

 Using a Delta of -0.1526:

Number of options  - Shares held / Option Delta

Number of options  - 1,000 / - 0.1526  6,553.08

6,553.08 / 100  66.

Because each option contract is for 100 shares, you should buy 66 put options
with a strike of $45 to hedge your stock.

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Hedging Using Put Options—The Results
 Suppose XYZ Shares fall by $1—so, you lose $1,000.

 What about the value of your option position?

 At the new XYZ stock price of $49, each put option is now worth $.70—an
increase of $.17 for each put ($17 per contract).
 Because you bought 66 put option contracts at $.53 (rounded), your put option
gain was $1,122 = ($.70 - $.53) × 66 ×100.

 Your put option gain more than offsets your loss of $1,000.

 Why is it not exact?

 Put Delta also falls (gets more negative) when the stock price falls.
 Therefore, you bought too many put options—this error is more severe the lower
the value of the put delta.
 To get closer: Use a put with a strike closer to at-the-money.
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 Hedging a Portfolio with Index Options

 Many institutional money managers use stock index options to hedge

the equity portfolios they manage.
 To form an effective hedge, the number of option contracts needed
can be calculated with this formula:
Portfolio Beta  Portfolio Value
Number of Option Contracts  
Option Delta  Index Value  100

 Regular rebalancing is needed to maintain an effective hedge over

time. Why? Well, over time:
 Underlying Value Changes
 Option Delta Changes
 Portfolio Value Changes
 Portfolio Beta Changes
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 Example: Calculating the Number of Option
Contracts Needed to Hedge an Equity Portfolio
 Your $10,000,000 portfolio has a beta of 1.00.
 You decide to hedge the value of this portfolio with the sale of
call options.
 The call options have a delta of 0.579
 The value of the index is 2,046.

Portfolio Beta  Portfolio Value

Number of Option Contracts  -
Option Delta  Index Value  100

1.00  10,000,000
  8 4
0.579  2,046  100

So, you sell 84 call options.

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 Implied Standard Deviations
 Of the five input factors for the Black-Scholes option pricing
model, only the stock price volatility is not directly
observable.

 A stock price volatility estimated from an option price is

called an implied standard deviation (ISD) or implied
volatility (IVOL).

 Calculating an implied volatility requires:

 All other input factors
and
 Either a call or put option price
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 CBOE Implied Volatilities for Stock Indexes
 The CBOE publishes data for three implied volatility indexes:
 S&P 500 Index Option Volatility, ticker symbol VIX
 S&P 100 Index Option Volatility, ticker symbol VXO
 NASDAQ 100 Index Option Volatility, ticker symbol VXN

 The VIX, VXO, and VXN indexes are estimates of expected market
volatility.
 The VIX was once known as the “investor fear gauge.”
 This name stems from the belief that the VIX reflects investors’ collective prediction of near-term
market volatility, or risk.
 Generally, the VIX increases during times of high financial stress and decreases during times of low
financial stress.
 Some investors use the VIX as a buy-sell indicator.
 The market saying is: “When the VIX is high, it’s time to buy; when the VIX is
low, it’s time to go!”

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 Employee Stock Options, ESOs

 Essentially, an employee stock option is a call option that

a firm grants (i.e., gives) to employees.
 ESOs allow employees to buy shares of stock in the company.
 Giving stock options to employees is a widespread practice.

 Because you might soon be an ESO holder, an

understanding of ESOs is important.

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 Features of ESOs
 ESOs have features that ordinary call options do not have.
 The details vary by firm, but:
 The life of the ESO is generally 10 years.
 ESOs cannot be sold.
 ESOs have a “vesting” period of about 3 years.
 Employees cannot exercise their ESOs until they have worked for the
company for this vesting period.
 If an employee leaves the company before the ESOs are “vested," the
employees lose the ESOs.
 If an employee stays for the vesting period, the ESOs can be exercised any
time over the remaining life of the ESO.

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 Why are ESOs Granted?

 Owners of a corporation (i.e., the stockholders) have a basic

problem. How do they get their employees to make
decisions that help the stock price increase?

 ESOs are a powerful motivator, because payoffs to options

can be large.
 High stock prices: ESO holders gain and shareholders gain.
 Low stock prices: ESO holders loose and so do shareholders.

 ESOs have no upfront costs to the company.

 ESOs can be viewed as a substitute for ordinary wages.
 Therefore, ESOs are helpful in recruiting employees.
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 ESO Repricing
 ESOs are generally issued exactly “at the money.”
 Intrinsic value is zero.
 There is no value from immediate exercise.
 But, the ESO is still valuable.

 If the stock price falls after the ESO is granted, the ESO is said
to be “underwater.”

 Occasionally, companies will lower the strike prices of ESOs

that are “underwater.”
 This practice is called “restriking” or “repricing.”
 This practice is controversial.
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 ESO Repricing Controversy
 PRO: Once an ESO is “underwater,” it loses its ability to
motivate employees.
 Employees realize that there is only a small chance for a payoff from
their ESOs.
 Employees may leave for other companies where they get “fresh”
options.

 CON: Lowering a strike price is a reward for failing.

 After all, decisions by employees made the stock price fall.
 If employees know that ESOs will be repriced, the ESOs loose their
ability to motivate employees.

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 ESOs Today

 Most companies award ESOs on a regular basis.

 Quarterly
 Annually

 Therefore, employees will always have some “at the money”

options.

 Regular grants of ESOs mean that employees always have

some “unvested” ESOs—giving them the added incentive to
remain with the company.

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 Valuing Employee Stock Options, I.

 Companies issuing ESOs must report estimates of the value of

these ESOs.

 The Black-Scholes-Merton formula is widely used for this

purpose.
 A modified version of the Black-Scholes model.
 The Black-Scholes-Merton model allows for dividends.
 In this model, the price of a call option on a single share of common stock is:

C = Se–yTN(d1) – Ke–rTN(d2), where “y” is the dividend yield.

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 Valuing Employee Stock Options, II.
 d1 and d2 are calculated using these two formulas:

 In December 2002, the Coca-Cola Co. granted ESOs with a stated

life of 15 years.

 However, to allow for the fact that ESOs are often exercised before
maturity, Coca-Cola also used a life of 6 years to value these ESOs.

d1 

ln S K   r  y  σ 2 2 T 
σ T

d2  d1  σ T

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 Example: Valuing Coca-Cola
ESOs Using Excel
Stock Price: 44.55 Stock Price: 44.55
Discounted Stock: 35.10 Discounted Stock: 40.23

Strike Price: 44.66 Strike Price: 44.66

Discounted Strike: 19.13 Discounted Strike: 36.41

Volatility (%): 25.53 Volatility (%): 30.20

Time (in years): 15 Time (in years): 6
Riskless Rate (%): 5.65 Riskless Rate (%): 3.40
Dividend Yield (%): 1.59 Dividend Yield (%): 1.70

d(1): 1.10792 d(1): 0.50458

N(d1): 0.86605 N(d1): 0.69307

d(2): 0.11915 d(2): -0.23517

N(d2): 0.54742 N(d2): 0.40704

Call Price: $ 19.92 Call Price: $ 13.06

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 Summary: Coca-Cola
Employee Stock Options

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 Useful Websites

 www.cboe.com (the most extensive website for options)

 www.option-price.com (for “everything about options”)
 www.ivolatility.com (for applications of implied volatility)
 jmdinvestments.blogspot.com (reference for current
financial information)
 www.ino.com (see the Web Center for Options)

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 Chapter Review, I.

 A Simple Model to Value Options Before Expiration

 The One-Period Binomial Option Pricing Model

 The Two-Period Binomial Option Pricing Model

 The Binomial Option Pricing Model with Many Periods

 The Black-Scholes Option Pricing Model

 Varying the Option Price Input Values

 Varying the Underlying Stock Price
 Varying the Time Remaining until Option Expiration
 Varying the Volatility of the Stock Price
 Varying the Interest Rate

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 Chapter Review, II.

 Calculating and Interpreting Option Deltas

 Hedging with Stock Options

 Hedging Using Call Options
 Hedging Using Put Options

 Hedging a Stock Portfolio with Stock Index Options

 Implied Standard Deviations

 Employee Stock Options (ESOs)

 Features
 Repricing
 Valuing (using the Black-Scholes-Merton Formula)

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