Options Valuation within Market Uncertainty :

Options Valuation
The value of an option is determined using option valuation models. These models can figure out the
current value using certain inputs and can also calculate the hypothetical value based on changes of the
different inputs into the model.

The Black-Scholes model and the Cox, Ross and Rubinstein binomial model are the primary pricing
models used to value of an options. Both models are based on the same theoretical foundations
and assumptions (such as the geometric Brownian motion theory of stock price behaviour and
risk-neutral valuation). However, there are also some important differences between the two
models and these are highlighted below.
The Black-Scholes Model
The Black-Scholes model was the first formula that was able to accurately determine the value of an option.
The formula was created by Fischer Black and Myron Scholes and was one of the biggest breakthroughs in
the history of theoretical finance. Their ground-breaking work led to a Nobel Prize in Economics in 1997 for
Myron Scholes and Robert Merton, who was the first to publish a paper about Black-Scholes

The Black-Scholes model is used to calculate a theoretical call price (ignoring dividends paid during
the life of the option) using the five key determinants of an option's price: stock price, strike price,
volatility, time to expiration, and short-term (risk free) interest rate.
The original formula for calculating the theoretical option price (OP) is as follows:

Where:

The variables are:

S = stock price
X = strike price
t = time remaining until expiration, expressed as a percent of a year
r = current continuously compounded risk-free interest rate
v = annual volatility of stock price (the standard deviation of the short-term returns over one

year).
ln = natural logarithm
N(x) = standard normal cumulative distribution function
e = the exponential function

The Binomial Model

The binomial model was first proposed by Cox, Ross and Rubinstein (1979). The binomial option pricing

model uses an iterative procedure, allowing for the specification of nodes, or points in time,
during the time span between the valuation date and the option's expiration date.

The model reduces possibilities of price changes, removes the possibility for arbitrage, assumes a
perfectly efficient market, and shortens the duration of the option. Under these simplifications, it
is able to provide a mathematical valuation of the option at each point in time specified.
The binomial pricing model traces the evolution of the option's key underlying variables in discrete-time.
This is done by means of a binomial lattice (tree), for a number of time steps between the valuation and
expiration dates. Each node in the lattice represents a possible price of the underlying at a given point in
time.

Valuation is performed iteratively, starting at each of the final nodes (those that may be reached
at the time of expiration), and then working backwards through the tree towards the first node
(valuation date). The value computed at each stage is the value of the option at that point in time.
Option valuation using this method is, as described, a three-step process:
1. price tree generation,
2. calculation of option value at each final node,
3. sequential calculation of the option value at each preceding node.
STEP 1: Create the binomial price tree
The tree of prices is produced by working forward from valuation date to expiration.
At each step, it is assumed that the underlying instrument will move up or down by a specific
factor (u or d) per step of the tree (where, by definition, 1 and 0 d 1). So, if S is the current
price, then in the next period the price will either be S up = S . or S down = S . d .
The up and down factors are calculated using the underlying volatility, , and the time duration of
a step, t, measured in years (using the day count convention of the underlying instrument). From
the condition that the variance of the log of the price is 2t, we have:

The above is the original Cox, Ross, & Rubinstein (CRR) method; there are other techniques for
generating the lattice, such as "the equal probabilities" tree. The Trinomial tree is a similar model,
allowing for an up, down or stable path.
The CRR method ensures that the tree is recombinant, i.e. if the underlying asset moves up and
then down (u,d), the price will be the same as if it had moved down and then up (d,u) here the
two paths merge or recombine. This property reduces the number of tree nodes, and thus
accelerates the computation of the option price.
This property also allows that the value of the underlying asset at each node can be calculated
directly via formula, and does not require that the tree be built first. The node-value will be:

Where Nu is the number of up ticks and Nd is the number of down ticks.

STEP 2: Find Option value at each final node

At each final node of the tree i.e. at expiration of the option the option value is simply its
intrinsic, or exercise, value.
Max [ (Sn K), 0 ], for a call option
Max [ (K Sn), 0 ], for a put option:

Where K is the strike price and Sn is the spot price of the underlying asset at the nth period.

STEP 3: Find Option value at earlier nodes

Once the above step is complete, the option value is then found for each node, starting at the
penultimate time step, and working back to the first node of the tree (the valuation date) where
the calculated result is the value of the option.
In overview: the binomial value is found at each node, using the risk neutrality assumption; see
Risk neutral valuation. If exercise is permitted at the node, then the model takes the greater of
binomial and exercise value at the node.
The steps are as follows:
(1) Under the risk neutrality assumption, today's fair price of a derivative is equal to the expected
value of its future payoff discounted by the risk free rate. Therefore, expected value is calculated
using the option values from the later two nodes (Option up and Option down) weighted by their
respective probabilitiesprobability p of an up move in the underlying, and probability (1-p)

of a down move. The expected value is then discounted at r, the risk free rate corresponding to
the life of the option.
The following formula to compute the expectation value is applied at each node:
Binomial Value = [ p Option up + (1-p) Option down] exp (- r t), or

where
is the option's value for the

node at time ,

is chosen such that the related binomial distribution simulates the

geometric Brownian motion of the underlying stock with parameters r and ,
q is the dividend yield of the underlying corresponding to the life of the option. It follows that in a
risk-neutral world futures price should have an expected growth rate of zero and therefore we can
consider q = r for futures.
Note that for p to be in the interval (0,1) the following condition on t has to be satisfied
.
(Note that the alternative valuation approach, arbitrage-free pricing, yields identical results; see
delta-hedging.)

(2) This result is the Binomial Value. It represents the fair price of the derivative at a particular
point in time (i.e. at each node), given the evolution in the price of the underlying to that point. It
is the value of the option if it were to be heldas opposed to exercised at that point.
(3) Depending on the style of the option, evaluate the possibility of early exercise at each node: if
(1) the option can be exercised, and (2) the exercise value exceeds the Binomial Value, then (3) the
value at the node is the exercise value.

Metode Monte Carlo

A Monte Carlo method is a technique that involves using random numbers and probability to
solve problems. The term Monte Carlo Method was coined by S. Ulam and Nicholas Metropolis in
reference to games of chance, a popular attraction in Monte Carlo, Monaco (Hoffman, 1998;
Metropolis and Ulam, 1949).
The Monte Carlo method is just one of many methods for analyzing uncertainty propagation, where the
goal is to determine how random variation, lack of knowledge, or error affects the sensitivity, performance,
or reliability of the system that is being modeled. Monte Carlo simulation is categorized as a sampling

method because the inputs are randomly generated from probability distributions to simulate the process
of sampling from an actual population. So, we try to choose a distribution for the inputs that most closely
matches data we already have, or best represents our current state of knowledge. The data generated from
the simulation can be represented as probability distributions (or histograms) or converted to error bars,
reliability predictions, tolerance zones, and confidence intervals. (See Figure 2).

Uncertainty Propagation

Figure 2: Schematic showing the principal of stochastic uncertainty propagation. (The basic
principle behind Monte Carlo simulation.)
If you have made it this far, congratulations! Now for the fun part! The steps in Monte Carlo
simulation corresponding to the uncertainty propagation shown in Figure 2 are fairly simple, and
can be easily implemented in Excel for simple models. All we need to do is follow the five simple
steps listed below:
Step 1: Create a parametric model, y = f(x1, x2, ..., xq).
Step 2: Generate a set of random inputs, xi1, xi2, ..., xiq.
Step 3: Evaluate the model and store the results as yi.
Step 4: Repeat steps 2 and 3 for i = 1 to n.
Step 5: Analyze the results using histograms, summary statistics, confidence intervals, etc.