Version 1/9/2001

FINANCIAL ENGINEERING: DERIVATIVES AND RISK MANAGEMENT (J. Wiley, 2001)

K. Cuthbertson and D. Nitzsche

LECTURE Options Pricing

Copyright K.Cuthbertson, D.Nitzsche. 1

Topics

Valuation and Pricing (Black Scholes) Speculation Delta Hedging

Copyright K.Cuthbertson, D.Nitzsche.

Valuation/Pricing of Options

Copyright K.Cuthbertson, D.Nitzsche.

T7.3 Price Quotes:Call Premia on BA: 27th July 2000 (pence) Strike Price K 360 390 ___ October 36.5 21.5 Expiry Month Jan 50 35.5 . April 57.5 44

Current Share Price, S = 376

How do the call premia vary with the time to maturity ? How do the call premia vary with the strike price? Could you make a profit from immediately exercising these options ? Oct 360 call: Intrinsic Value = $ amount if immediately exercised = 376-360 = St - K = 16 (In-the-money) So, Time Value = C - 41 = 20.5 (payment for possibility of price rise in the future
Copyright K.Cuthbertson, D.Nitzsche.

Value of Calls and Puts Prior to Expiry

Call Premium (price) C depends on: Put Premium (price) P depends on:

Time to maturity, T (+)

Time to maturity, T (+ or -)

Current Spot price, relative to strike price, S /K (+) Volatility spot price (+)

Current Spot price, relative to strike price, S /K Volatility spot price (+) (-)

Interest rate

r (+)

Interest rate

r (+ or - )
5

Copyright K.Cuthbertson, D.Nitzsche.

Black-Scholes (Merton)

PV = present value of the strike price = K e-rT

C S.N (d1 ) N (d 2 ).PV

ln( S / K ) ( r / 2)T d1 T
2

ln( S / K ) (r / 2)T d 2 d1 T T
2
Copyright K.Cuthbertson, D.Nitzsche. 6

Figure 21.5 : Black-Scholes

Call Premium
Value of call prior to expiry

Payoff from call at expiry

Ct

. BC=Time value .C
CD=Intrinsic value

C1= 10 C0= 9.6

A K
S0= 100 S1= 101

.D
St Stock Price

Copyright K.Cuthbertson, D.Nitzsche.

Black-Scholes
Key results are CALLS Call premium increases as stock price increases (but less than one-for-one) Call premium increases if the volatility of the stock increases PUTS Put premium falls as stock price increases (but less than one-for-one) Put premium increases if the volatility of the stock increases
Copyright K.Cuthbertson, D.Nitzsche.

Speculation with Options

Copyright K.Cuthbertson, D.Nitzsche.

Speculation with Options (Before Maturity)

Buy low and sell high Expect a bull market - then buy a call and close out the position before maturity

( that is, sell the call at a higher call premium)

Profit (before maturity) = C1 - C0 = 5.2 - 5.0 Your net position of zero is noted by the Clearing House which sends you the $0.2 (and cancels any delivery to you) Sell high and buy low Expect a bear market then sell a call at C0 = 10 and close out the position by buying back a call at C1 = 9.8 (prior to maturity)
Copyright K.Cuthbertson, D.Nitzsche. 10

Delta Hedging with Options

Copyright K.Cuthbertson, D.Nitzsche.

11

Delta Hedging with Options

Problem: You currently hold shares but you fear high volatility of stock prices over the next next month. You want to protect the current value of your stock position until the market returns to normal. Can you hedge your stock position using options ? A call option on the share is available with a delta of 0.4 which implies: When S increases by +$1 (e.g. from 100 to 101), then C increases by $0.4 (e.g. from 9.6 to 10)
Copyright K.Cuthbertson, D.Nitzsche. 12

Delta Hedging with Options Note:

The contract size for one call option contract is for 100 shares But the price of the call option C is quoted as if there was only one share underlying the option
(i.e. we need to multiply C by 100 to get the invoice price of the option)

Copyright K.Cuthbertson, D.Nitzsche.

13

DELTA OF A CALL Call Premium Payoff from call at expiry

Delta is the slope of this curve

Ct

. BC=Time value .C
CD=Intrinsic value

C1= 10 C0= 9.6

A K
S0= 100 S1= 101

.D
St Stock Price

Copyright K.Cuthbertson, D.Nitzsche.

Delta Hedging with Options

Consider the following portfolio
40-shares plus 1 written (sold) call option (at C0 = 10)

Suppose S falls by $1 over the next month

THEN fall in C is 0.4 ( = delta of the call) 9.6 So C falls to C1 =

To close out you must now buy back at C1 = 9.6 Loss on 40 shares = $40

Gain on initial written call = 100 (C0 - C1 )= 100(0.4)

= $40

DELTA HEDGING YOUR 40 SHARES WITH 1 WRITTEN CALL OPTION MEANS THAT THE VALUE OF YOUR POSITION WILL BE UNCHANGED.
Copyright K.Cuthbertson, D.Nitzsche. 15

Figure : Delta Hedging: Rebalancing Call Premium

D 0.5 B

D 0.4

.
0

100

110

Stock Price

As S changes then so does delta , so you have to rebalance your portfolio.

E.g. delta = 0.5, then hold 50 stocks for every written call.
Copyright K.Cuthbertson, D.Nitzsche.

END OF SLIDES

Copyright K.Cuthbertson, D.Nitzsche.

17

TAKE A BREAK

Copyright K.Cuthbertson, D.Nitzsche.

18