Principles of Option Pricing

By: Ajay Mishra JSSGIW faculty of Management, Bhopal

Principles of Option Pricing

Arbitrage opportunities are quickly eliminated by investors.

(lets see examples)

Situation (1)

Suppose in a game you draw a ball from a box known to contain three black and three white balls. If you draw a black ball you receive nothing. If you draw a white ball you receive Rs. 10. Will you Play?

Situation (1)

As no entree fee is mentioned , most people will play. You incur no cash outlay up front and have the opportunity to earn Rs. 10. Of course this opportunity is too good, but no one will offer you such option without charging any entry fee. (lets play another one)

Situation (2)

Now suppose that a fair fee to play Game I is Rs.4 And for a game II the person offers you to pay Rs. 20 if you draw a white ball and nothing if you draw a black ball. Will the entry fee be higher or lower?

Situation (2)

If u draw a black ball you receive the same payoff as in game I but if you draw a white ball you receive a higher payoff.
You should be willing to pay more to play game II because these payoffs dominate those of game I.

From these simple games and opportunities it is easy to see some basic principles of how rational people behave when they faced with risky situations. The collective behaviour of rational investors operates in an identical manner to determine the fundamental principles of option pricing.

Basic Terminology in Option Pricing

The following symbols are used further: S = Stock price today X = Exercise Price. T = Time to expiration r = Risk free rate S = Stock price at options expiration; after the passage of a period of time of legth T

Basic Terminology in Option Pricing

C(S,T,X) = Price of a call option in which the stock price is S, the time to expiration is T, and the exercise price is X.
P(S,T,X) = Price of a put option in which the stock price is S the time to expiration is T and the exercise price is X.

Basic Terminology in Option Pricing

Ca(S,T,X) = American Call Ce(S,T,X) = European Call If there is no a or e subscript, the call can be either American or a European Call. In the case where two options differ only by exercise price, the notation C(S,T,X1) and C(S,T,X2) will identify the prices of the calls with X1 less than X2.

Basic Terminology in Option Pricing

Always a the subscript of the lower exercise price is smaller than the higher exercise price. In the case where two options differ only by time to expiration will be T1 and T2, where T1< T2. Identical adjustments will be made for put option prices.

Time to expiration

The time to expiration is expressed as a decimal friction of a year. For example if the current date is April 9 and the options expiration date is July 18. We count the number of days between these two dates. That would be : April= 21, May =31, June = 30 and July = 18 . Total 100 days. The time to expiration would be 100/365 = 0.274

Dividend

For most of the examples we shall assume that the stock pays no dividends. If during the life of the option, the stock pays a dividends of D1, D2.. And so forth, then we can make a simple adjustment and obtain a similar adjustment and obtain similar results. To do so we simply subtract the present value of the dividends.

Risk free rate of return r

It is the rate earned on a riskless investment. An example of such an investment is a treasury bill. T-bills pay interest not through coupons but by selling at a discount. The T-bill is purchased at less than face value. The difference between the purchase price and the face value is called the discount. The discount is the profit earned by the bill holder.

Risk free rate of return r

The rate of return on a T-bill of comparable maturity would be a proxy for the risk free of return. All T-bills mature on Thursday because most exchanged traded option expire on Fridays. There is always a T-bill maturing the day before expiration.

Risk free rate of return r

Bid and Ask discounts for several T bills for the business day of May 14 of particular year are as follows. Maturity Bid Ask 5/20 4.45 4.37 6/17 4.41 4.37 7/15 4.47 4.43

Bid and Ask figures are the discount quoted by dealers trading in T-bills

Risk free rate of return r

With first T-bill case if we take expiration date May 21. To find the T-bill rate we use the average of the bid and ask discount. Which is (4.45+4.37)/2=4.41 Then we find the discount from par value as4.41(7/360)= 0.08575, using the fact that the option has seven days until the maturity Thus the price is 100-0.08575= 99.91425

Risk free rate of return r

The yield on our T-bill is based on the assumption of buying it at 99.91425 and holding for seven days, at which time it will be worth of 100. This is a return of (100=99.91425)/99.91425=1.000858 Suppose we repeat this transaction every seven days for a full year, the return would be: ((1.000858)^365/7)-1 = 0.0457 Which can be taken as risk free rate of return.

Principles of call option pricing

Minimum Value of a call

Maximum Value of Call

Value of a Call at Expiration.

Minimum Value of a Call

The below given is one example option data for a stock for the date may 14. Try to find out the intinsic value and time values for the call. Assuming the current stock price is 125.94 and Expirations : May 21, June 18, July 16
CALL Exercise Price 120 125 130 May 8.75 5.75 3.6 June 15.4 13.5 11.35 July 20.9 18.6 16.4 PUT May 2.75 4.6 7.35 June 9.25 11.5 14.25 July 13.65 16.6 19.65

Minimum value of a Call

A Call is an instrument with limited liability. If the call holder sees that it is advantageous to exercise he it, the call will be exercised. If exercising it will decrease the call holders wealth he will not exercise it. The option cannot have negative value, because the holder cannot be forced to exercise it. Therefore, C(S,T,X)>= 0

Minimum value of a Call

For an American Call it will be Ca(S,T,X)>= Max(0, S-X) Max(0, S-X) means take the maximum value of two arguments, zero or S-X The minimum value of an option is called its intrinsic value some time referred to as parity value, parity or exercise value. Intrinsic value, which is positive for in the money calls and zero for out of the money calls.

Minimum value of a Call

Intrinsic Values and Time Values of a given Call

Time Value May 2.81

Exercise Price 120

Intrinsic Value 5.94

June 9.46

July 14.96

125
130

0.94
0.00

4.81
3.60

12.56
11.35

17.66
16.40

Minimum value of a Call

To check the intrinsic value rule we take the June 120 Call. The stock price is 125.94 and the exercise price is 120. Taking Max(0, 125.94-120) = 5.94 Now what would happen if the call were priced at less than 5.94 , say Rs. 3

Minimum value of a Call

An option trader could buy the call for Rs.3, Exercise it You can purchase the stock for Rs. 120 and then sell the stock for Rs. 125.94. This arbitrage would provide a risk less profit of Rs.2.94 All investors would do it, which would drive up the option price When the price of the option reached Rs.5.94, the transaction would no longer be profitable.

Minimum value of a Call

What if the exercise price exceeds the stock price ? Do it with exercise price = 130 Max(0, 125.94-130) = 0 Then minimum value be zero Now check at all the given calls.

Minimum value of a Call

The calls with an exercise price of Rs. 125 have a minimum values Max(0,125.94-125) = 0.94 and are priced at no less than 0.94.

The calls with an exercise price of 130 have a minimum value of Max(0, 125.94-130) = 0 Al those option obviously have nonnegative values

Minimum Value of a call

The intrinsic value concept applies only to an American call, because a European call can be exercised only the expiration day. The price of an American call normally exceeds its intrinsic value. The difference between the price and the intrinsic value is called the time value or speculative value of the call. Which is defined as Ca(S,T,X)-Max(0,S-X)

Minimum value of a call

The time value refers what traders are willing to pay for the uncertainty of the underlying stock. Time values increase with the time of expiration

Minimum value of a European call

(a) European

Call Price

Stock Price (S)

The call price lies in a shaded area . The European call price lies in the entire area.

Minimum value of a American call

(b) American

Call Price

Max(0,S-X)

X
Stock Price (S)

The American call price lies in a smaller area. This does not mean that the American call price is less than the European call price but only that its range of possible values is narrower.

Maximum Value of a call

C(S,T,X)S The most one can expect to gain from the call is the stocks value less than the exercise price. Even if the exercise price were zero, No one would pay more for the call than for the stock. However, one call that is worth the stock price is one with an infinite maturity.

Minimum and maximum values of a European call

(a) European

Call Price

0
Stock Price (S)

The call price lies in a shaded area . The European call price lies in the entire area.

Minimum and maximum values of an American call

(b) American

Call Price

Max(0,S-X)

X
Stock Price (S)

The call price lies in a shaded area . The European call price lies in the entire area.

Value of a Call at Expiration C(St,0,X) = Max (0,St-X

The prospect of future stock price increases is irrelevant to the price of the expiring option, which will be simply its intrinsic value. At expiration an American option and a European option are identical Instruments. Therefore this rule holds for both the options.

The value of a Call at Expiration.

Call Price

C(ST,0,X)

Max(0,St-X)
0

X
Stock Price at Expiration (St)

*Because of the transaction cost of exercising the option, it could be worth

slightly less than the intrinsic value.

Effect of time to Expiration.

Consider two American Calls that differ only in their time to expiration so their price will be as follows : (1) Ca(S,T1X) (2) Ca(S,T2X) (T2 is greater than T1 ) Now think which of these two option will have a greater value?

Effect of time to Expiration.

Suppose that today is the expiration day of the shorter lived option. The stock price is the value of the expiring option is : Max (0, ST1-X). The second option has a time to expiration of T2-T1. Its minimum value is MAX(0,St1-X). Thus when the shorter lived option expires, its value is the minimum value of the longer lived one.

References:

Don M. Chance, Derivatives and Risk Management Basics, India edition. John C. Hull and Sankarshan Basu, Options, Futures, and Other Derivatives seventh edition. http://content.icicidirect.com/learning/universi ty.htm