OPTIONS PRICING

The Basics

Options

Options Contract Derivative

Instrument.
Used for Hedging.
Has speculative appeal as a
leveraging instrument.

Options Contract

Two parties to an options contract: the

buyer and the writer (or seller).
The buyer of the options contract has the
right but not the obligation to buy (or
sell) the underlying asset from (to) the
writer at a specified price within a
specified period of time (or at a specified
date).
In return, the buyer pays a premium (or
options price).

Options Contract

The specified price strike price, exercise

price.
The specified date expiration date,
maturity date.
When the option grants the buyer the
right to buy, then it is called a call option.
When the option grants the buyer the
right to sell, then it is called a put option.

Example 1
Anil K. owns a luxury apartment down
Bannerghatta road which is currently
worth Rs. 20 lakhs. Ashish B., who
rents this apartment buys a European
call with a strike price of Rs. 20 lakhs
and with an expiration date three
months from now. For this option,
Ashish pays a premium of Rs. 1.5 lakhs.

Example 1 Continued..

What happens if, three months

from now, the market price goes
up to Rs. 30 lakhs?
What happens if, three months
from now, the market price goes
down to Rs. 15 lakhs?

Call Options Buyers

Perspective
C C: Intrinsic Value of Option
K: Strike Price
S: Market Price

Call Options Sellers

Perspective
C C: Intrinsic Value of Option
K: Strike Price
S: Market Price

Example 2
Shakil, a fruit wholesaler goes long on
a put option for 1000 Kilos of
premium Langda mangoes
(assuming that such an options
market is in existence). The
expiration date is 1 month from now.
The strike price is Rs. 10/Kilo. For this
option he pays a premium of Rs. 250.

Example 2 continued..

What happens when the wholesale

price becomes Rs. 8/Kilo?
What happens when the price rises
to Rs. 12/Kilo?

Put Options-Buyers
Perspective
C
K

C: Intrinsic Value of Option

K: Strike Price
S: Market Price

Put Options-Writers
Perspective
C

C: Intrinsic Value of Option

K: Strike Price
S: Market Price

Options vs. Futures

Contract

In futures, equal and opposite

obligation on both parties. In options,
the obligation lies only with the seller.
In futures, buyer and seller face
symmetric risk. In options, the buyer
simply risks losing his/her premium,
while the reward can be unlimited.
Opposite is true for the seller.

Example 3
Pyara Singh expects to harvest a 1000
Kilos of Langda mangoes a month from
now. To hedge against a possible downturn
in prices, he takes a long position on put
option with a strike price of Rs 10000, and
an expiration date a month from today. For
this option he pays a premium of Rs. 300.

Example 3 continued..

What would his returns look like as

a function of the market price of
mangoes?
If he were to take a short position
on a futures contract for 1000 Kilos
of mangoes with a futures price of
Rs. 10000, what would his returns
look like?

Example 4:
Shirin Patel, CFO, Malgudi Tiffin Room
(MTR Sweets) needs a delivery of 10
tons of sugar on August 27th, 2001. To
hedge against a possible price rise she
goes long on a call option with a strike
price of Rs. 10000/ton. The expiration
date is one month from today. She
pays an option premium of Rs. 5000.
What do her payoffs(costs) look like?

Pricing of Options

Options Price (Premium) = Intrinsic Value

+ Time Value.
Intrinsic Value = Max (0,S-K) {for a Call},
= Max (0,K-S) {for a Put}.
Time Value: Reflects the expectation that
favorable changes in the market
price will increase the
value of option
beyond the
intrinsic value.

Pricing of Call Options

12

Option
s Price

10
8
6

Intrinsic
Value

4
2
0
0

10

15

20

Pricing of Put Options

12
10
8
6
4
2
0
0

10

15

20

Factors Affecting Price

Current Price of Asset (S).

Strike Price (K).
Time to expiration of option.
Expected price volatility ().
Short-term, risk-free interest rate (r).

Surprising Result! Growth rate of asset

price does not affect Options Price.

Binomial Options
Theory Single Period
t=0
t=t
S: Price of Asset at t=0.
u: Factor of increase in Price after 1 time
period.
d: Factor of decrease in Price after 1 time
period.
p: Probability of increase in Price after 1
time period.

Binomial Options
Theory Single
Period
uS (p)
S
dS (1-p)

r: Risk Free Rate,

R = 1 + r.
Assume that,
u > R > d > 0.

Binomial Options
Theory Single Period

We now match the returns of a portfolio

consisting of Rs. x worth of asset
(stocks) and Rs. b worth of risk-free
securities to that of a call option on the
ux
same asset (stocks).
Max(uS-K)
x
Rb
b
Rb

dx

C
Max(dS-K)

Binomial Options
Theory Single Period

After 1 time period, the returns of the

Call option are either, Cu = Max {uS-K,0},
or Cd = Max {dS-K,0}.
After 1 time period, the returns of the
matching portfolio are either, (ux + Rb),
or (dx + Rb).
It is always possible to find an
appropriate mix of x and b so that the
returns are matched.

Example 5
Yasmin buys one Call option on a stock
whose current price S = Rs. 100. The
stocks upturn factor u = 1.051, and its
downturn factor d = 0.951. Let R = 1.02,
and the strike price K = Rs. 102.
What are the returns of the the option
after 1 time period?
If x = Rs. 31 and b = - Rs. 28.9 what are the
returns of the matched portfolio?

Example Continued..
Suppose that the strike price K = Rs.
90.0.
What are the returns of the the option
after 1 time period?
Can you determine the values of x and
b so that the returns of the portfolio
match those of the call option?

Binomial Options
Theory Single Period

In general, to match the returns:

ux + Rb = Cu ,
dx + Rb = Cd .

Hence,

and

Cu Cd
x
ud

uC d dC u
b
R( u d )

Binomial Options
Theory Single Period

The value of the portfolio:

C u C d uC d dC u
x b

ud
R(u d )
1 Rd
uR
(
Cu
Cd )
R ud
ud

Binomial Options
Theory Single Period
By the no-arbitrage principle,
C = x + b.
From our example, when K = 102, C
=?

Therefore,

1 Rd
u R
C (
Cu
Cd )
R ud
ud

Binomial Options
Theory Single Period
1 Rd
u R
C (
Cu
Cd )
R ud
ud

Rd
Let, q
ud
u R
Then, 1 q
,
ud
and 0 < q < 1.

Binomial Options
Theory Single Period

q risk-neutral probability
Observe that
qu + (1-q)d = R.
In general,
E[C(T)] = qCu + (1-q)Cd
C(T-1) = 1/R*E[C(T)]
The option pricing formula is
independent of p.

Multi-period Options
Call Options:
Cu
C

Cuu= Max (u2S-K,0)

Cud = Max (udS-K,0)

Cd

Cdd = Max (d2S-K, 0)

Multi-period Options
1
C u (qC uu (1 q )C ud )
R

1
C d (qC ud (1 q )C dd )
R
1
C (qC u (1 q )C d )
R