Module 4: Option Pricing

Put-Call Parity
Both portfolios are worth the same on
maturity expiration of options
Both are European options hence can
not be exercised before expiry date
Hence their value must be equal today
rT
Thus:
c Ke p S0
This is called Put-Call Parity. It provides
a basis for deriving the price of a call
from a put & vice versa, when strike
price & expiry date are same
2

Contents
Our focus will be on Stock Options
only because that is the typical
model applied for understanding
options
However the principles are
applicable with/without small
modifications, if required, to other
types of underlying assets also
3

Contents
Binomial model of Option
Pricing
Black-Scholes model of Option
Pricing
Related issues

Option Pricing Binomial Model for

European Options

Based on the concept of binomial trees

A binomial tree is a diagrammatic
representation of the various paths
that the price of the underlying stock
may follow during the lifetime of an
option
Underlying assumption: Stock price
follows a random walk
In each time interval there is a certain
probability that the stock price will
5

Binomial Model
No arbitrage argument: It is an
assumption that is made in order to
arrive at the equilibrium price of the
option. As long as there are arbitrage
opportunities there will be disequilibrium
in the options market & price will be
unstable.
Logic: A portfolio in the lines of a covered
call is set up with an investment horizon
equal to the maturity of the option. It
consists of a long position in some shares
& a short position in 1 call option. The
6

Binomial Model: Logic

The components of the portfolio are
likely to vary in value over time.
However it is constructed in a way so
as to keep the overall value of the
portfolio constant at maturity.
Because the portfolio value at maturity
is stable it is risk-free. Hence it must
earn a return equal to the risk-free
rate.
On this basis the value of the portfolio
7

Binomial Model: Logic

The value of the option is derived from
the cost of setting up the portfolio at
the inception.
Portfolio consists of a long position in
no. of shares & a short position in 1
European call option.
The stock price can have two possible
outcomes at maturity: it can move up
or down.
When the portfolio is designed to be
8

Binomial Model: Assumptions

No arbitrage assumption: Impact on
pricing
Perfect & competitive markets No
transaction costs, No margins, No
taxes, short sales are allowed, fractions
of securities can be traded, borrowing
& lending rates are same: Implies free
trading in all markets
Risk free interest rate, size of uptick &
size of downtick are known in every
9

Binomial Model: No Assumptions On

No assumption made on the

actual probabilities on the
uptick/downtick
No assumption made on
expected returns on the stock
No assumption made on the
investors degree of risk
aversion
10

Binomial Model: Notations

S0 : Spot price at time 0

f : Current price of call option
(European)
T : Time to expiration
u : Multiple by which the stock price
changes during T (u > 1) so that
ending price = S0u
d : Multiple by which the stock price
changes during T (d < 1) so that
ending price = S0d

11

Binomial Model
Let be the no. of shares in which long
position is taken
If the stock price increases at maturity
then portfolio value = S0u - fu
If the stock price decreases at maturity
then portfolio value = S0d - fd
The portfolio will be said to be risk-free
when its value at maturity is same in
f f

all conditions. Thus: SS0uu - Sfud = S0d - fd

OR
1.
u

12

Binomial Model
The portfolio is risk-free. Hence it must
earn risk-free rate of interest in order to
avoid arbitrage opportunities. Given the
(its
S 0upresent
f u )e rT
value of portfolio at maturity
value will be
Cost of setting up the
at
S 0 portfolio
f
inception:
In a no arbitrage
S0 f situation
( S0u f u )e rTthe
OR cost of
setting up must
be equal to the present
f S 0 (1 ue rT ) f u e rT
value of the value at maturity. Thus:

13

Binomial Model
S 0 f ( S0u f u )e rT OR
f S0 (1 ue rT ) f u e rT

When the expression for is substituted

rT
f

e
[ pf u (1 p) f d ]
we get:
rT
e
d
2.
where : p
ud
3.
Equations 2 & 3 are applicable for option
pricing when stock price follows one-period
binomial model.
The underlying principle is called Risk14

Binomial Model: Risk Neutral Valuation

Investors are assumed to be risk

neutral they are indifferent towards
risk; so they require NO
compensation for risk
Hence expected return on all
securities is the risk-free rate of
return
In a risk neutral world investors are
indifferent to the actual probabilities
of the stock price moving up/down
15

Binomial Model: Risk Neutral Valuation

The portfolio is designed to be riskfree the no. of shares is such that

the value of the portfolio remains the
same whether the stock moves up or
down
The terms p & (1 p) in equations 2
& 3 are not the true probabilities of
the up & down movements of the
stock
Rather they may be interpreted to be
16

Binomial Model: Risk Neutral Valuation

Thus the option price today is the

expected payoff from the option in
future, discounted back at the riskfree rate
The terms p and (1 p) when
interpreted to be the probabilities of
the stock price moving up/down in a
risk neutral world are called risk
neutral probabilities
It can be shown: with risk neutral
17

Binomial Model: Some Important Aspects

Stocks actual probabilities of up &

down movements in future are
irrelevant, and so is its expected
return in real world
Notwithstanding the real world
probabilities of up & down
movements in the stock price, in a
risk neutral framework the expected
return on the stock must be the riskfree rate the expected stock price
18

Binomial Model: Some Important Aspects

A position in an option is riskier than the
position in the underlying asset
Hence the discount rate to evaluate its
payoffs must be greater than the expected
return on the underlying asset in the real
world
However without knowing the options value
now the discount rate for option cannot be
known & without knowing the discount rate
its value now cannot be calculated
Valuing the option in a risk neutral
framework is easy because discount rate for
19

Binomial Model: Example

Current stock price: 20

Period: 3 months; Risk-free rate: 12%
After 3 months: price may be 22 or 18
Strike price of European call: 21
In order to construct a risk-free
portfolio the investor should be long on
how many shares?
What are the risk neutral probabilities
of the payoffs from the option when the
share price moves up or down?
What is the risk neutral price of the
20

Two Step Binomial Model

There are two consecutive periods
of time during which the share
price can consecutively change &
so can the option price
The option price at time 0 can be
arrived at in a stepwise manner
along the binomial tree using the
same procedure & formulae used
in case of one period binomial
model
21

Multi-Step Binomial Model

As the no. of steps/periods is
increased we get scenarios that tend
to be closer to reality
However such scenarios are too
complicated to be solved manually
Hence in real life the binomial model
can be applied only by software
The result will be more accurate than
the one period binomial model
22

Multi-Step Binomial Model

In both 2-step & multi-step binomial models
the expiry period of the option is broken
down into 2 or more sub-periods
So in the last nodes of the tree there are
multiple possible stock prices & option
payoffs & their probabilities joint
probabilities of the up & down movements of
stock price through various paths
So the expression of the expected payoff of
the option at the end of the last time step is
expanded because of the various possibilities
23

Binomial Model: Other Variants

a. Options on stocks paying

continuous dividends
b. Options on stock indices
c. Options on currencies
d. Options on futures

24

Binomial Model: Other Variants

a. Options on stocks paying

continuous dividend yield (q):
The binomial principle still
remains the same
In a risk neutral world the total
return to the stockholders from
dividends & capital gains will
be = Risk-free rate (r) which is
compounded continuously
25

Binomial Model: Other Variants

a. Options on stocks paying continuous
dividend yield (q):
The binomial pricing model for options
on stocks not paying any dividends uses
risk- free rate which is equivalent to the
capital gains yield in a risk neutral world
With zero dividends, total stock return
= capital gains yield = risk-free rate
The relevant discount rate is the capital
gains yield in zero dividends case
26

Binomial Model: Other Variants

a. Options on stocks paying continuous
dividend yield (q):
With known dividend yield the capital
gains yield will be = r q
Because the Total yield = Dividend yield
+ Capital Gains yield = Risk-free rate (r)
As dividends reduce the stock price it
will grow at the rate of: r q
Hence substitute r with r q in the
original binomial pricing model
27

Binomial Model: Other Variants

b. Options on stock indices:
Stock indices are assumed to provide
a known cumulative dividend yield q
(from the stocks comprising the
index)
Hence the binomial pricing of options
on stock indices is similar in principle
to the valuation of an option on a
stock paying known dividend yield
28

Binomial Model: Other Variants

c. Options on Currencies:
A foreign currency is an asset providing
a yield at the risk-free rate of interest
(rf ) in the foreign country
Hence the appropriate discount rate is
the domestic risk-free interest rate (r)
minus foreign risk-free interest rate: r rf
The model is similar to that of stocks
with known dividend yields & stock
indices
29

Binomial Model: Other Variants

d. Options on Futures:
There is no cost of entering into a
long or short position in a futures
In a risk neutral world the expected
growth rate of the price of a futures
contract should be zero
So the expected futures price at the
end of the time interval should be
that at time zero: pF0u + (1 p)F0d =
F0
30

Binomial Model: Other Variants

d. Options on Futures:

pF0u + (1 p)F0d = F0
Thus the risk neutral probability
of a up movement in the futures
price (p) will be:1 d
p

ud

31

Binomial Model: Critical Appraisal

The principal merit of the binomial

model is its flexibility
It can be used to evaluate a wide
variety of options including American
options
Major limitation: if we increase the
no. of time steps then the model will
require a very large no. of inputs
which can be handled only by a
computer
32

Binomial Model: Critical

Appraisal
The price process is discrete hence the riskneutral portfolio created will remain hedged
from risk only at discrete points of time
In reality the price process is continuous. So the
changes in between the discrete points of time
will cause volatility in the value of the portfolio
So in continuous price process the portfolio will
not remain risk-neutral at all points of time
This limitation is overcome by the Black-Scholes
model because it assumes continuous time

33

From Binomial To Black-Scholes Model (BSM)

Binomial model is a discrete time model
It allows for a time interval (t) between
price movements
If t tends to zero then in the limit two
types of distributions are possible
a. Normal if price changes tend to zero
as t tends to zero
b. Poisson if price changes remain large
as t tends to zero (allows for sudden
jumps)
34

From Binomial To Black-Scholes Model (BSM)

BSM explicitly assumes that the price

process is continuous
It uses normal distribution as the
limiting distribution as t tends to zero
Stock prices cannot assume ve
values because of limited liability of
shareholders hence cannot be
normally distributed
The distribution of natural log of stock
prices is assumed to be normal in BSM
35

From Binomial To Black-Scholes Model (BSM)

BSM is a special case of the Binomial

model
We reach the BSM from the binomial if we
reduce the time interval to extremely
short intervals such that in between time
0 (beginning) & time T (expiry) there are
infinite no. of time intervals, each one is
extremely short
This would happen if trading is a
continuous phenomenon for some
markets this assumption is close to reality
36

Black-Scholes Model (BSM)

Stock prices cannot be less than 0
(explained before) & stock returns
cannot be less than 100%
Hence the closely approximating
distribution for both stock prices &
stock returns is the lognormal
distribution
BSM is originally applicable to
European call options on stocks not
paying dividends

37

BSM: Assumptions
No dividends paid on the stock
No transaction costs
Risk-free interest rate is known & is
constant during the life of option
Short-selling of stock is allowed
Call can be exercised only on expiry
Stock prices change randomly & trading
takes place continuously
Stock prices & returns at any point of time
are best explained by lognormal distribution
38

BSM: Assumptions
Most of the assumptions of the BM
are present in the BSM
Two additional assumptions:
Trading is continuous this
happens when markets are always
open
The stock price behaviour over
time follows a stochastic process
called Geometric Brownian Motion
39

BSM: Assumptions
There are two critical assumptions: 1.
Evolution of stock prices over time follows
Geometric Brownian Motion; 2. At any point
of time the stock price & stock return are
lognormally distributed
The 1st assumption tells how the parameters
of the lognormal distribution in the 2nd
assumption will change over time
If stock returns are lognormally distributed
then ln(St / St-1) will be normally distributed.
ln(St / St-1) is the continuously compounded
return during 1 time interval (t-1 to t)
40

BSM: Reasonableness of Lognormality

If returns are lognormally distributed
then lowest possible return in any
period is -100% (whereas if returns are
normally distributed there is some
probability that returns will be less than
-100%)
Lognormal return distribution is skewed
to the right because while the lowest
return is -100%, there is no limit on the
highest return - hence right skewed
41

A. Lognormal Property of Stock Prices

Expected return () p.a. on stock &
volatility of returns () p.a. are known
Underlying assumption: Percentage
(Proportionate) changes in stock price in
a short time period are normally
distributed. This is related to the
Geometric Brownian Motion.
Due to Lognormal property of stock
prices ln(ST) is normally distributed with
mean & s.d. expressed in terms of S0 ,
&
42

A. Lognormal Property of Stock Prices

Underlying assumption: Percentage
(Proportionate) changes in stock price
in a short time period are normally
distributed: A1.S
( t , 2 t )
S distributed with
ln(ST) is normally
mean & s.d. expressed in terms of S0 ,
&
2
2
ln
S

ln
S

[(

)
T
,

T]
0
A2.
due
to
2
lognormality
2
ln ST [ln S 0 ( )T , 2T ]
or
A3.
2
T

43

A. Lognormal Property of Stock Prices

Calculate the 95% confidence

interval of the prices of a stock
after 6 months, given the
following data:
Current stock price: 40,
Expected return: 16% pa,
Volatility: 20% pa
44

B. Distribution of Continuously
Compounded Rate of Return
What is the Probability distribution of
continuously compounded rate of return pa
realised between time 0 & time T ? (Based on
Lognormal Property)
Different from because is A.M. of the annual
returns whereas continuously compounded
return is based on the G.M. of returns over very
small intervals of time between 0 & T
The above distribution is normal with mean &
s.d. expressed in terms of , & T
45

B. Distribution of Rate of Return

ST S 0 e

xT

1
ST
or x
ln
T
S0

From relationship A2 earlier it can be said:

x (

2
T
Thus as time T increases the standard
deviation of continuously compounded
return pa between times 0 & T declines

46

B. Distribution of Rate of Return

Calculate the 95% confidence
interval of average rate of return
(GM return) realised on a
continuously compounded basis
on a stock over a period of 3
years given the following data:
Expected return: 17% pa
Volatility: 20% pa
47

C. Volatility
Volatility () in stock returns (& hence
in stock price) is measured annually
can be estimated from the volatility
of the continuously compounded daily
returns i.e. volatility in log of daily
price relatives: ln(Si /Si-1)
s
relatives
If s = s.d of daily log price

then:
Estimated annual
volatility:

Standard error2nof estimate:

48

C. Volatility
Volatility () in stock returns (& hence
in stock price) is measured annually
Year is measured in trading days not in
calendar days. Hence 1 year = 252
trading days
If volatility is estimated on a daily basis:
Volatility p.a. Volatility per trading day 252

Life of an option (T in years) :

T

No. of trading days till option expiry

252
49

C. Volatility
Eg: The s.d of continuously
compounded daily returns is 1.216%.
Estimate the volatility of annual
returns and the standard error of
estimate; the s.d is estimated with 20
data points of daily returns. Assume 1
year = 252 trading days.

50

D. Basics of the BSM

The same source of uncertainty affects the
option price & the stock price
The value of a stock option expressed in terms
of the value of the underlying stock does not
depend on the expected return on the stock
A portfolio can be formed out of the option &
the stock such that the uncertainty is eliminated
The portfolio becomes risk-less for a very small
interval of time only
So the portfolio has to be rebalanced very
frequently in order to keep it risk-free in every
instant of time
51

The Black-Scholes-Merton Formulae

c S 0 N (d1 ) K e
pKe

rT

rT

N (d 2 )

N (d 2 ) S 0 N (d1 )

2
ln(S 0 / K ) (r / 2)T
where d1
T
2
ln(S 0 / K ) (r / 2)T
d2
d1 T
T
52

Black-Scholes Model: Numerical

Que: Calculate the price of a 3month European call option on a
non-dividend paying stock. The
strike price is INR 25 when the
current price is INR 25. The riskfree interest rate is 10% p.a. and
volatility is 30% p.a. What will be
the price of a put option?
53

BSM: Adjustment for Dividends

Known dividends
Known dividend yield

54

BSM: Adjustment for Known Dividends

Payment of dividends reduces the
stock price
Dividend payments tend to make call
options less valuable & put options
more valuable
So subtract the present value of the
expected dividends from current price
before inputting the same in the model
So in the BSM replace the factor S0 by:
S0 PV (Dividends)
55

BSM: Adjustment for Known Dividends

Another way of understanding this:

A stock price may be considered to be
the sum of two components: (a) a
Riskless component and (b) a Risky
component
The riskless component corresponds
with the known dividends
When there are no dividends the
current stock price is only the function
of the risky component
56

BSM: Adjustment for Known Dividends

When there are known dividends the riskless
component is the present value of all dividends
occurring during the life of the option
By the time the option expires all dividends
would have been paid hence there will be no
riskless component
So stock price after payment of dividends only
reflects the risky component
In present value terms: the present value of
risky component should be equal to stock price
at time 0 minus present value of dividends
57

BSM: Adjustment for Known Dividends

Que: Calculate the price of a

European Call option on a stock
which has ex-dividend dates in 2months and 5-months time. Each
time the dividend will be INR 0.50.
The current stock price is INR 40,
strike price is INR 40 & volatility is
30% p.a. The life of the option is 6
months & risk-free interest rate is
9%.
58

BSM: Adjustment for Known Dividend Yield

Limitation associated with the previous

approach is that if the option expiration
period is long then it is unrealistic to say
that dividends are known
A more realistic assumption is that
dividend yield (y = dividends / current
market price of the asset) is known &
shall remain constant during the life of
the option
Replace S0 by S0e-yT in the BS equations
59

BSM: Adjustment for Known Dividend Yield

The current stock price is multiplied

with a discount factor calculated on
the basis of the dividend yield to
account for the expected drop in
value from dividend payments
The interest rate is offset by the
dividend yield because the carrying
cost of the stock decreases due to
the dividend yield
60

BSM: Modified for Known Dividend Yield

c S0e

yT

pKe

N (d1 ) K e

rT

rT

N (d 2 ) S 0 e

N (d 2 )
yT

N (d1 )

2
ln(S 0 / K ) (r y / 2)T
where d1
T
2
ln(S 0 / K ) (r y / 2)T
d2
d1 T
T
61

BSM: Known Dividend Yield

Calculate the price of a European
Call option on a stock which
provides a continuous dividend
yield of 2.5%. The current stock
price is INR 50, strike price is INR
50 & volatility is 40% p.a. The life
of the option is 6 months & riskfree interest rate is 9%.
62