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5-2 Option’s strike price = $15; Exercise value = $22; Time value = $5;
V = ? P0 = ?
Using the Black-Scholes Option Pricing Model, you calculate the option’s value as:
Equalize the range to find the number of shares of stock: Option range / Stock range =
$5/$10 = 0.5.
With 0.5 shares, the stock’s payoff will be either $13 or $8. The portfolio’s payoff will
be $13 - $5 = $8, or $8 – 0 = $8.
The present value of $8 at the daily compounded risk-free rate is: PV = $8 / (1+
(0.05/365))365 = $7.610.
The option price is the current value of the stock in the portfolio minus the PV of the
payoff:
5-7 The stock’s range of payoffs in six months is $18 - $13 = $5. At expiration, the option
will be worth $18 - $14 = $4 if the stock price is $18, and zero if the stock price $13.
The range of payoffs for the stock option is $4 – 0 = $5.
Equalize the range to find the number of shares of stock: Option range / Stock range =
$4/$5 = 0.8.
With 0.8 shares, the stock’s payoff will be either 0.8($18) = $14.40 or 0.8($13) =
$10.40. The portfolio’s payoff will be $14.4 - $4 = $10.40, or $10.40 – 0 = $10.40.
The present value of $10.40 at the daily compounded risk-free rate is: PV = $10.40 /
(1+ (0.06/365))365/2 = $10.093.
The option price is the current value of the stock in the portfolio minus the PV of the
payoff:
Mini Case
c. Consider Triple Play’s call option with a $25 strike price. The following table
contains historical values for this option at different stock prices:
1. Create a table which shows (a) stock price, (b) strike price, (c) exercise value,
(d) option price, and (e) the time value, which is the option’s price less its
exercise value.
c. 2. What happens to the option’s time value as the stock price rises? Why?
Answer: As the table shows, the option’s time value declines as the stock price increases.
This is due to the declining degree of leverage provided by options as the underlying
stock prices increase, and to the greater loss potential of options at higher option
prices.
d. Consider a stock with a current price of P = $27. Suppose that over the next 6
months the stock price will either go up by a factor of 1.41 or down by a factor
of 0.71. Consider a call option on the stock with a strike price of $25 which
expires in 6 months. The risk-free rate is 6%.
1. Using the binomial model, what are the ending values of the stock price? What
are the payoffs of the call option?
d. 2. Suppose you write 1 call option and buy Ns shares of stock. How many shares
must you buy to create a portfolio with a riskless payoff (which is called a
hedge portfolio)? What is the payoff of the portfolio?
Answer:
Ns = Cu - Cd = 0.69153
P(u - d)
:
Stock price = P (u) = $38.07
Portfolio’s stock payoff: = P(u)(Ns) = $26.33
Subtract option's payoff: Cu = $13.07
Portfolio’s net payoff = P(u)Ns - Cu = $13.26
P = $27
Answer:
Answer: If you borrow an amount equal to the present value of the hedge portfolio’s
riskless payoff and purchase Ns shares of stock, the portfolio’s payoff’s will
replicate the call option’s payoffs.
The option’s value must be the same as the portfolio’s cost, otherwise you
would have an opportunity for arbitrage, which is a situation in which you
have none of your own money invested, you have no risk, yet you have a
positive cash flow. Arbitrage opportunities can’t exist long in a well
functioning economy, so the option’s price will be driven towards the cost of
the replicating portfolio.
e. In 1973, Fischer Black and Myron Scholes developed the Black-Scholes Option
Pricing Model (OPM).
• The stock underlying the call option provides no dividends during the life of the
option.
• No transactions costs are involved with the sale or purchase of either the stock
or the option.
• The short-term, risk-free interest rate is known and is constant during the life of
the option.
• Security buyers may borrow any fraction of the purchase price at the short-term,
risk-free rate.
• Security trading takes place in continuous time, and stock prices move randomly
in continuous time.
e. 2. Write out the three equations that constitute the model.
d2 = d1 - t .
Here,
VC = $27[N(d1)] - $25e-(0.06)(0.5)[N(d2)].
N(d2) = 0.5539.
Therefore,
VC = $27(0.6851) - $25e-(0.06(0.5)(0.5539)
=$5.06.
f. What impact does each of the following call option parameters have on the
value of a call option?
Answer: 1. The value of a call option increases (decreases) as the current stock price
increases (decreases).
2. As the strike price of the option increases (decreases), the value of the option
decreases (increases).
3. As the expiration date of the option is lengthened, the value of the option
increases. This is because the value of the option depends on the chance of a
stock price increase, and the longer the option period, the higher the stock price
can climb.
4. As the risk-free rate increases, the value of the option tends to increase as well.
Since increases in the risk-free rate tend to decrease the present value of the
option's strike price, they also tend to increase the current value of the option.
5. The greater the variance in the underlying stock price, the greater the possibility
that the stock's price will exceed the strike price of the option; thus, the more
valuable the option will be.