Valuation of Options

Prof Mahesh Kumar

Amity Business School
Introduction
 There are number of models for valuation of
options.
 The most important ones are:
1. The Binomial Option Pricing Model
2. Black-Scholes Option Pricing Model
 The difference in the two models of option
valuation stems basically from the
assumptions made about how prices change
over time.
Introduction
 Binomial model assumes that percentage change in
share prices follow binomial distribution, the Black
Scholes model is based on the assumption that it
follows a log normal distribution.
 Both the above models are in respect of the European
call options.
 Since it never pays to exercise an American call option
before its expiration if the stock involved would not pay
dividend before the expiration date or if the call is
dividend protected. Thus, an American call, which
satisfies this condition, will be just like an European call
and evaluated in a similar manner
The Binomial Option Pricing Model
 This model is based on the assumption that if
a share price is observed at the start and end
of period of time, it will take one of the two
values at the end of that period i.e., the model
assumes that the share price will either
increase to a given higher price or decrease to
a given lower price.
 Although this may seem an extreme
simplification, it allows us to come closer to
understanding more complicated and realistic
models.
The Binomial Option Pricing Model
 Suppose the stock sell at S0= Rs.100 and the price will
either increase by a factor of u=2 to Rs.200 (u stands
for ‘up’) or fall by a factor of d=0.5 to Rs.50 (d stands
for ‘down’) by year end. A call option on the stock might
specify the exercise price of Rs.125 and a time to
expiration of 1 year. The interest rate is 8%. At the
year end, the payoff to the holder of the call option will
be either zero, if the stock price falls or Rs.75, if the
stock price goes to Rs.200.
 These possibilities are illustrated by the following value
‘trees’
200 75
100 C
50 0
The Binomial Option Pricing Model
 Now if we compare the pay off of the call to that of a
portfolio consisting of one share of the stock and borrowing
of Rs.46.30 at the interest rate of 8%. The payoff of this
portfolio depends on the price at the year end.
Value of the stock at year end Rs.50 Rs.200
- Repayment of loan with int. - Rs.50 -Rs.50
Total 0 Rs.150
 We know the cash outlay to establish the portfolio is
Rs.53.70: Rs.100 for the stock less Rs.46.30 proceeds from
borrowing. Therefore the portfolio’s value tree is:
150
53.70
0
The Binomial Option Pricing Model
 The payoff from this portfolio is exactly twice that of call
option for either value of the stock price. In other
words, two call options will exactly replicate the payoff
to the portfolio; it follows that two call options should
have the same price as the cost of establishing the
portfolio. Hence the two calls should sell for the same
price as the ‘replicating portfolio’. Therefore 2C=53.70
or each call should sell at C=Rs.26.85
 Thus given the stock price, exercise price, interest rate
and volatility of the stock prices (as represented by the
magnitude of the up or down movements), we can
derive the fair value of the call option.
The Binomial Option Pricing Model
 This valuation approach relies heavily on the notion of
replication. With only two possible end-of-year values of the
stock, the payoff of the leverages stock portfolio replicate the
payoffs to two call options therefore command the same
market price. This notion of replication is behind most option
pricing formulas. For complex price distribution for stocks, the
replication technique is corresponding more complex, but the
principle remains the same.
 One way to view the role of replication is to note that, using
the numbers assumed for this example, a portfolio made up of
one share of stock and two call options written is perfectly
hedged. Its year end value is independent of the ultimate
stock price.
Stock Value Rs.50 Rs.200
-Obligation from 2 calls written -0 -Rs.150
Total Rs.50 Rs.50
The Binomial Option Pricing Model
 The investor has formed a risk less portfolio, with a
payout of Rs.50. Its value must be the recent
value of Rs.50 or Rs.50/1.08=Rs.46.30 or C=26.85
 The hedge locks in the end-of-year payout, which
can be discounted using the risk free interest rate.
 To find the value of the option in terms of the
value of the stock, we do not know either the
option’s or stock’s beta or expected rate of return.
 With a hedged position, the final stock price does
not affect the investor’s payoff, so the stock’s risk
and return parameters have no bearing.
The Binomial Option Pricing Model
 The hedge ratio of this example is one share of
stock to two calls i.e. for every call option
written, one half share of stock must be held
in the portfolio to hedge away the risk.
 Hedge ratio is thus the ratio of the range of
the values of the option to those of the stock
across the two possible outcomes.
The Binomial Option Pricing Model
 The stock, which originally sells for S0= Rs.100, will be worth
either d*Rs.100=Rs.50 or u*Rs.100=Rs.200 for a range of
Rs.150
 If the stock price increase, the call will be worth Cu=Rs.75
whereas if the stock price decreases, the call will be worth
Cd=0, for a range of Rs.75
 The ratio of ranges, 75/150, is one half, which is the hedge
ratio we have established.
 Thus we can generalize the hedge ratio for other two-state
option problem as
H= Cu - Cd
uS0-dS0
Where Cu and Cd refers to the call option’s value when the
stock prices goes up or down respectively and uS0 and dS0 are
the stock prices in two states.
The Binomial Option Pricing Model
 Hedge ratio, H, is the ratio of the swings in the
possible end-of-period values of the option
and the stock.
 If the investor writes one option and holds H
shares of stock, the value of the portfolio will
be unaffected by the stock price.
 In this case option pricing is simply setting the
value of hedged portfolio equal to the present
value of the known payoff.
The Binomial Option Pricing Model
 Using our example, the option pricing technique would
proceed as follows:
1. Given the possible end-of-year stock prices uS0=Rs.200
and dS0= Rs.50 and the exercise price is Rs.125,
calculate Cu=Rs.75 and Cd=0 The stock price range is
Rs.150 while option price range is Rs.75
2. Find that the hedge ratio of 75/150=0.5
3. Find that the portfolio made up of 0.5 share with one
written option would have an year end value of Rs.50
with certainty.
4. Show that the present value of Rs.25 with a 1 year
interest rate of 8% is Rs.23.15
5. Set the value of the hedged position to the present
value of certain payoff.
0.5S0-C =Rs.23.15; 50-C=Rs.23.15; C=Rs.26.85
The Binomial Option Pricing Model
 If the option was overpriced, say selling at Rs.30 then investor
can make arbitrage profits by following the strategy as given
below:
Cash flow in 1 year for
for each possible stock price
Int Cash Flow S1=50 S1=200
1. Write 2 options Rs.60 0 -Rs.150
2. Purchase 1 sh. –Rs.100 Rs.50 Rs.200
3. Borrow Rs.40 Rs.40 -Rs.43.20 -Rs.43.20
At 8% int.
Repay in 1 year
Total 0 Rs.6.80 Rs.6.80
Although the initial investment is zero, the payoff in one year
is positive and risk less.
The Binomial Option Pricing Model
 If the option was under priced, say selling at Rs.24 then
investor can make arbitrage profits by following the strategy
as given below:
Cash flow in 1 year for
for each possible stock price
Int Cash Flow S1=50 S1=200
1. Buy 2 options -Rs.48 0 Rs.150
2. Short 1 sh. Rs.100 -Rs.50 - Rs.200
3. Invest Rs.52 -Rs.52 Rs.56.16 Rs.56.16
At 8% int.
Repay in 1 year
Total 0 Rs.6.16 Rs.6.16
The Binomial Option Pricing Model
 It is worth noting that the present value of the profit to
the arbitrage strategy as discussed equals twice the
amount by which the option is overpriced. The present
value of risk free profit of Rs.6.80 at an 8% interest
rate is Rs.6.30.
 With two options written in the strategy above, this
translates to a profit of Rs.3.15 per option, exactly the
amount by which option is over priced: Rs.30 versus
the fair value of Rs.26.85
The Binomial Option Pricing Model
 Let us examine a portfolio consisting of a long position in H
shares and a short position in one option.
S0u
cu
S0
c
S0d
cd
 If there is an upward movement in the stock price, the value of
the portfolio at the end of the life of the option is:
S0H-cu
 If there is an downward movement in the stock price, the value
of the portfolio at the end of the life of the option is:
S0H-cd
 The Binomial Option Pricing Model
 The portfolio is risk less if the value of H is close so that the final value of
the portfolio is same for both the alternatives.
 This means
S0uH-cu=S0dH-cd
H= cu-cd
S0u-S0d
 If we denote risk free interest by r, the present value of portfolio is
(S0uH-cu)e-rT
 The cost of setting up the portfolio is
S0H-c
 It follows that
S0H-c=(S0uH-cu)e-rT
c= S0H-(S0uH-cu)e-rT
c = e-rT [pcu+(1-p)cd]
where p=erT -d
u-d
The Binomial Option Pricing Model
 In the example we had taken u=2, d=0.5,
r=8% T=1 years, cu=75,cd=0
p=e0.08*1-0.5 = 1.08329-0.5 =0.38886
2-0.5 1.5
c= e-0.08*1[0.38886*75+(1-0.38886)*0]
= 0.92312(0.38886*75)= Rs.26.85
Generalizing the Two-State Approach
 To start, suppose we were to break up the year into two
6-mth segments. Here we suppose stock price S0=100
and it can increase 10% (i.e. u=1.10) or decrease 5%
(i.e. d=0.95). The possible paths over the course of the
year
121
110
100 104.50
95
90.25
 The mid range value of 104.50 can be attained by two
paths: an increase of 10% followed by decrease of 5%,
or a decrease of 5% followed by a 10% increase.
Generalizing the Two-State Approach
 The three possible end-of-year values for the stock and
therefore for the option is:
Cuu
Cu
C Cud
Cd
Cdd
 From the above we could value Cu from the knowledge
of Cuu and Cud, then value Cd from the knowledge of Cdu
and Cdd and finally the value of C from the knowledge of
Cu and Cd
 The above interval of 1 year can be broken into four 3
month units or 12 1-month units or 365 1-day each
units
The Binomial Option Pricing Model
 Example: Suppose the risk free interest rate is 5% per 6 month
period and wish to value a call option with exercise price Rs.110
on the stock with value S0=100 u=1.10 d=0.95
 The call can rise to the expiration date with value of Cuu =Rs.11
(since the stock price is u*u*S0= Rs.121)
 The call can fall to the expiration date value of Cud =0 (since at
this point stock price is u*d*S0= Rs.104.50 which is less than
the exercise price i.e. Rs.110).
 Thus the hedge ratio at this point is
H=Cuu -Cud = Rs.11-0 = 2
uuS0-udS0 121-104.50 3
Thus the following portfolio will be worth Rs.209 at the option
expiration regardless of the ultimate stock price.
The Binomial Option Pricing Model
t=0 udS0=104.50 uuS0=Rs.121
Buy 2 shares at Rs.209 Rs.242
price uS0=Rs.110
Write 3 calls at 0 -33
price Cu
Total Payoff Rs.209 Rs.209
The portfolio must have a current market value equal to the present value
of Rs.209
2*110-3Cu= Rs.209/1.05= Rs.199.047, therefore Cu=6.984
Next we find the value of Cd. This value is zero because if we reach this
point (corresponding to stock price of Rs.95), the stock price will be either
Rs.104.50 or Rs.90.25; in either case, the option will expire out of the
money.
The Binomial Option Pricing Model
 Now we calculate the value of C.
Cu-Cd=6.984-0=6.984
uS0-dS0= Rs.110-Rs.95= Rs.15
H=6.984/15=0.4656

Action today (time=0) Value in Next Pd as function of Stock Price

dS0=Rs.95 uS0= Rs.110
Buy 0.4656 shares at 44.232 51.216
price S0= Rs.100
Write one call option at 0 -6.984
price C0
Total Payoff 44.232 44.232
The portfolio must have a market value of Rs.44.232
PV of Rs.44.232 at 5% rate of return = Rs.44.232/1.05=Rs.42.126
0.4656*100-C0= Rs.42.126;C0= Rs.46.56-42.126=4.434
The Binomial Option Pricing Model
 As we break the year into progressively finer sub intervals, the range
of possible year end stock prices expands and, in fact, will ultimately
take a familiar bell-shaped distribution. The event tree for the stock
for a period with three sub intervals can be shown as:
u3S0
u2S0
uS0 u2dS0
S0 udS0
ds0 ud2S0
d2S0
d3S0
 From the above we notice that
i. As the number of sub interval increases, the number of possible stock
prices also increases.
ii. Extreme events such as u3S0 and d3S0 are relatively rare as they
require either three consecutive increases or decreases in three sub
intervals. More moderate or mid range value like u2dS0 are more likely.
The Binomial Option Pricing Model
 The probability of each outcome is described by the binomial
distribution, and this multi period approach to option pricing
is called the binomial model.
 Let us take the example of stock price movements over three
period and let S0= Rs.100, u=1.05 and d=0.97
Cuuu
Cuu
Cu Cuud
C Cud
Cd Cudd
Cdd
Cddd
The Binomial Option Pricing Model
 There are eight possible combinations for the stock
price movements in three period: uuu, uud, udu, duu,
udd, dud, ddu and ddd. Each has probability 1/8.
Therefore the probability distribution of stock prices at
the end of the last interval would be:
Event Prob. Final Stock Prices
3 up movements 1/8 100*(1.05)3=115.76
2 up and 1 down 3/8 100*1.052*0.97=106.94
1 up and 2 down 3/8 100*1.05*0.972=98.79
3 down movements 1/8 100*(0.97)3=91.27
 From the above it can be seen that the mid range
values are three times as likely to occur as the extreme
values.
The Binomial Option Pricing Model
 If we keep on sub dividing the interval in which stock
prices are posited to move up and down the possible
stock price movement within that time interval would
be correspondingly small and would resemble lognormal
distribution.
 At any node, one still could set up a portfolio that would
be perfectly hedged over the next tiny time interval.
 By continuously revising the hedge position, the
portfolio would remain hedged and would earn a
riskless rate of return over each interval. This is called
dynamic hedging, the continued updating of the hedge
ratios as the time passes.
Black Scholes Option Valuation
 An option pricing formula is far easier to use
than the complex algorithm involved in
binomial model.
 Fischer Black, Myron Scholes & Robert C
Merton provided a workable option pricing
model which is popularly known as Black
Scholes formula.
 Scholes and Merton shared the 1997 Nobel
Prize in Economics for their accomplishment.
 Black Scholes Option Valuation
 The Black Scholes formula for the prices of European calls and puts on non-
dividend paying stocks are:
c=S0N(d1)-Xe-rT N(d2)
p=Xe-rT N(-d2)-S0N(-d1)
Where d1=ln(S0/X)+(r+σ 2/2)T
σ (T)1/2
d2=ln(S0/X)+(r-σ 2/2)T = d1- σ (T)1/2
σ (T)1/2
Where c=current call option value
p=current put option value
N(d)=the probability that a random draw from a standard normal distribution will be less
than d
e=2.71828, the base of natural log function
r=risk free interest rate (annualized continuously compounded rate on a safe asset with
the same maturity as the expiration of the option, which is distinguished from rf, the
discrete period interest rate.
T=time to maturity of options in years.
ln=Natural logarithm function
σ = Standard deviation of annualized continuously compounded rate of return on the
stock.
Black Scholes Option Valuation
 From the above formula it can be seen that
the option value does not depend on the
expected rate of return on the stock. In a
sense, this information is already built into the
formula with the inclusion of stock price, which
itself depends on the stock’s risk and return
characteristics.
 A full proof of the Black Scholes formula is
beyond the scope of this course but we can
explain it at a somewhat intuitive level.
Black Scholes Option Valuation
 N(d) terms can loosely taken as risk-adjusted
probabilities that the call option will expire in the
money.
 First if we assume N(d) are close to 1.0, that is, when
there is high probability that the option will be
exercised. Then the value of call option is S0-Xe-rT, which
is what we called earlier the adjusted intrinsic value S0-
PV(X). This makes sense, if exercise is certain, we have
a claim on a stock with a current value S0 and an
obligation with present value PV(X), or with continuous
compounding, Xe-rT
 Second, if we assume N(d) terms are close to zero,
meaning the option certainly will not be exercised. Thus
the equation confirms that the call is worth nothing.
Black Scholes Option Valuation
 For middle range values of N(d) between 0 and 1, Black
Scholes equation tells us that the call value can be
viewed as the present value of the call’s potential pay
off adjusting for the probability of in-the-money
expiration.
 How do the N(d) terms serve as risk adjusted
probabilities? In the Black Scholes formula ln(S0/X)
which appears in the numerator of d1 and d2 is
approximately the percentage amount by which the
option is currently in or out of the money.
 Example if S0=105 and X=100, the call option is 5% in the
money and ln(105/100)=0.049
 Similarly if S0=95 then option is 5% out of the money and
ln(95/100)=-0.051
Black Scholes Option Valuation
 The denominator σ (T)1/2, adjusts the amount
by which the option is in or out of the money
for the volatility of the stock price over the
remaining life of the option.
 An option in the money by a given percent is
more likely to stay in the money if both stock
price volatility and time to maturity are small.
 Therefore N(d1) and N(d2) increase with the
probability that the option will expire in the
money.
Black Scholes Option Valuation
 S0=100, X=95, r=0.10(10% p.a.), T=0.25 (3mths.)
Standard deviation=0.50% (50% per year)
d1=ln(100/95)+ [0.10+0.52/2].025 = 0.43

0.5(0.25)1/2
d2=0.43-0.5(0.25)1/2=0.18
N(0.43)=0.6664 N(0.18)=0.5714
C=100*0.6664-95e-0.10*0.25*0.5714
=66.64-52.94=13.70
Assumptions Black Scholes Option Formula
 Following are the assumptions in the formula
underlying Black Scholes Option pricing model:
1. The stock will pay no dividend until after the
option expiration date.
2. Both the interest rate, r, and the variance rate,
σ , of the stock are constant.
3. Stock prices are continuous, meaning that
sudden extreme jumps such as those in
aftermath of a takeover attempt are ruled out.
Assumptions Black Scholes Option Formula
 Variants of Black Scholes have been developed to deal
some of these limitations.
 Four of the five variables- S0, X, T, r- are straight
forward. The stock price, exercise price and time of
maturity are readily determined. The interest rate used
is the money market rate for a maturity equal to that of
the option and the dividend payout is reasonably
predictable, at least over short horizons. Standard
deviation, the last input is estimated from historical
data.
 The discrepancies between an option price and its Black
Scholes value are simply artifacts of error in the
estimation of the stock’s volatility.
Assumptions Black Scholes Option Formula
 Market participants often give the option valuation
problem a different twist. Rather than calculating the
Black Scholes option value for a given stock’s standard
deviation, they ask instead: What standard deviation
would be necessary for the option price that I observe
to be consistent with the Black Scholes formula? This is
called implied volatility of the option, the volatility level
for the stock that the option price implies.
 Through implied volatility investors can judge whether
they think the actual stock standard deviation exceeds
the implied volatility. If it does, the option is considered
a good buy; if actual volatility seems greater than the
implied volatility, its fair price would exceed observed
price.
Assumptions Black Scholes Option Formula
 The option with the higher implied volatility would be
considered relatively expensive, because a higher
standard deviation is required to justify its price.
 The analyst might consider buying an option with the
lower implied volatility and writing the option with the
higher implied volatility.
Dividends and Call Option Valuations
 In case of dividend paying stocks, the Black Scholes
formula is adjusted by replacing S0 with S0-
PV(dividends).
 Suppose the underlying asset pays a continuous flow of
income. This might be a reasonable assumption for
options on stock indexes, where different stocks in the
index pay dividends on different days, so that the
dividend income arrives in more or less continuous flow.
If the dividend yield, denoted ‘d’ is constant then value
of S0 is replaced by S0e-dt in the original formula.
 The above approximation is good for European call
option.
Dividends and Call Option Valuations
 Example: Suppose that a stock selling at Rs.20 will pay a
Re.1 dividend in four months whereas the call option on
the stock expires in 6 months. The effective annual interest
rate is 10% so that the present value of the dividend is
Rs.1/(1.10)1/3= Rs.0.97. Black suggests that we can
compute the option value in one of the two ways:
1. Apply the Black Scholes formula assuming early exercise,
thus using the actual stock price of Rs.20 and a time to
expiration of 4 months. (the time until dividend payment).
2. Apply the Black Scholes formula assuming no early
exercise, using the dividend adjusted stock price of Rs.20-
Re.0.97 = Rs.19.03 and a time to expiration of 6 months.
Dividends and Call Option Valuations
 The greater of the two values is the estimate of the option
value. In other words, the so called pseudo-American call
option value is maximum of the value derived by assuming
that the option will be held until expiration and the value
derived by assuming that the option will be exercised just
before an ex-dividend date.
Hedge Ratios and Black Scholes Formula
 The call option position is more sensitive to swings in
stock’s price that is the all-stock position.
 To quantify these sensitivities hedge ratios are used.
 An option’s hedge ratio is the change in the price of an
option for a Re.1 increase in the stock price.
 A call option, therefore has a positive hedge ratio and
put option a negative hedge ratio.
 The hedge ratio is commonly called the option’s delta.
 If we plot a graph of the option value as a function of
the stock value, hedge ratio is simply the slope of the
value curve evaluated at the current stock price.
Hedge Ratios and Black Scholes Formula
 If the hedge ratio of a stock at S0=120 is say 0.60, it
implies that as the stock increase in value by Re.1, the
option value increase by approximately Re.0.60.
 For every call option written, 0.60 shares of the stock
would be needed to hedge the investor’s portfolio.
 Example: If one writes 10 options and holds 6 shares of
stock, according to hedge ratio of 0.60, a Re.1 increase
in stock price will result in a gain of Rs.6 on the stock
holding whereas the loss on the 10 options written will
be 10*0.60= Rs.6 The stock price movement leaves
total wealth unaltered, which is what hedged position is
intended to do.
Hedge Ratios and Black Scholes Formula
 Black Scholes hedge ratios are easy to compute. The
hedge ratio for a call is N(d1) , whereas the hedge ratio
for put is N(d1)-1
 Although rupee movements in option prices are less
than the rupee movements in the stock price, the rate
of return volatility of options remain greater that the
stock return volatility because options sell at lower
price.
Hedge Ratios and Black Scholes Formula
 In our example, with the stock selling at Rs.120 and the
hedge ratio of 0.6, an option with exercise price Rs.120
may sell for Rs.5
 If the stock price increases to Rs.121, the call price
would be expected to increase by Re.0.60 to Rs.5.60.
The percentage increase in the option value is
Rs.0.60/5=12% however, the stock price increase is
only Re1/120=0.83%. The ratio of percentage change
is 12/0.83=14.4%. That is for every 1% increase in the
stock price, the option price increases by 14.4%. This
ratio, the percentage change in option price per
percentage change in stock price, is called the option
elasticity.
Hedge Ratios and Black Scholes Formula
 When you establish a position in stocks and options that
is hedged with respect to fluctuations in the price of the
underlying asset, your portfolio is said to be delta
neutral, meaning that the portfolio has no tendency to
either increase or decrease in value when the stock
price fluctuates.
 Portfolio insurance can be obtained by purchasing a
protective put option on an equity position. When the
appropriate put is not traded, portfolio insurance entails
a dynamic hedging strategy when a fraction of the
equity portfolio equal to the desired put option’s delta is
sold and put in riskless securities.