MATHEMATICAL MODELS IN FINANCE ACTS 467

Mini-Thesis: ACTUARIAL SCIENCE (IV)

TOPIC:

OPTION PRICE SENSITIVITY ANALYSIS (a Black- Scholes model approach)

October, 2012

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This mini thesis (report) is submitted in fulfillment of our assignment in the Mathematical Model in Finance (ACTS 467) Class (lesson 2), based on Option price and its sensitivity to some factors.

PRESENTED TO Dr. LORD MENSAH (Lecturer, Mathematical Model in Finance)

PRESENTED BY

Elaine Ablorh Quarcoo (3961809) Norman Adu Bamfo (3962109) Benneth Kweku Koufie (3967009) Francis Kuditcher ( 3967209)

DECLARATION We humbly declare this report is a true reflection of data for CALBANKs monthly stock prices (2007 to 2010) loaded (from actuarial class e mail) on due provision by Lecturer: Dr. Lord Mensah.
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ABSTRACT

This work is designed to actualize the factors that affect the pricing of options (call and put). An assessment of this nature is done by a data set obtained on monthly CALBANK stock prices from 2007 to 2010. Applying the Black Scholes Pricing Model (Formular), highlights how variations in some factors such as Volatility ( standard deviation), strike price, stock price, time to expiration and even dividend pay outs affect the valuation or the pricing of options.

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TABLE OF CONTENT

I.

Declaration

II. III. IV. V. VI. VII.

Abstract.. Introduction Methodology.. Application of Method.. Results .. Conclusion .

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INTRODUCTION
OPTIONS (CALL AND PUT)

An option is a typical example of a derivative (securities that get their value from the price of other securities). Options are traded both on exchanges and in the over-thecounter market. There are two basic types of options. A call option gives the holder the right to buy the underlying asset by a certain date for a certain price. A put option gives the holder the right to sell the underlying asset by a certain date for a certain price. The price in the contract is known as the exercise price or strike price; the date in the contract is known as the expiration date or maturity. American options can be exercised at any time up to the expiration date. European options can be exercised only on the expiration date itself.

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OPTION PRICING/ VALUATION

In many ways, options are just like any other investment in that you need to understand what determines their price in order to use them to take advantage of moves the market. A stock investor who is interested in using options to capture a potential move in a stock must understand how options are priced. Besides the underlying price of the stock, the key determinates of the price of an option are its intrinsic value - the amount by which the strike price of an option is in-the-money - and its time value.

DETERMINANTS OF OPTION PRICING

Five main factors may influence the price of an option, also called the premium:

The strike price of the option The market price of the underlying asset Volatility, the price uncertainty of the underlying asset Remaining life (the time length until the expiry date) The interest of a loan with a term similar to the options remaining life

If there are payments attached to the underlying asset during the life of the contract, e.g. share dividend, the expected size and time of payment will also have an impact on pricing.

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The strike price of an option

The price of an option is naturally related to the strike price. A lower strike price implies that the buyer of a call option is willing to pay more to acquire the option. Similarly, a higher strike price will cause the price of a put option to rise since the buyer of the right to sell the underlying shares may sell at a higher price.

The price of the underlying asset

The option price depends on the market price of the underlying asset. If the price of the underlying asset increases, the premium of a call option will rise and the premium of a put option will fall. If the price of the underlying asset drops, the premium of a put option will rise and the premium of a call option will fall.

Volatility

Volatility expresses the expectations to fluctuations in the price of the underlying asset. The volatility has an influence on the value of an option because it is one of the factors that determine the probability to what extent the option will end in the money, and thus the size of payoff at expiry; The higher the volatility, the higher the value of the option price. The option price will therefore rise if the volatility of the underlying assets market price increases.

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Interest rates

Buying a call option may be considered as an alternative to buying the underlying asset. The purchase of a call option postpones the investment until the options expiry date, and the excess liquidity can be placed on the money market. For that reason the seller of a call option will naturally demand payment for having to finance the underlying asset during the life of the option. A higher interest rate will therefore imply a higher price on call options. The same applies to put options, the price of which will accordingly drop as interest rates go up. The interest rate level of both call and put options is, however, quite low.

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METHODOLOGY

There are several options pricing models (methods) that use these parameters (the determinants) to determine the fair market value of the option. The Binomial Option Pricing, Black - Scholes Pricing Model etc. Of these, the Black-Scholes model is the most widely used.

In finance, the Binomial Options Pricing Model (BOPM) provides a generalizable numerical method for the valuation of options. The binomial model was first proposed by Cox, Ross and Rubinstein (1979). Essentially, the model uses a discrete-time (lattice based) model of the varying price over time of the underlying financial instrument. In general, binomial options pricing models do not have closed-form solutions.

Valuation is performed iteratively, starting at each of the final nodes (those that may be reached at the time of expiration), and then working backwards through the tree towards the first node (valuation date). The value computed at each stage is the value of the option at that point in time.

Option valuation using this method is, as described, a three-step process:

1. price tree generation, 2. calculation of option value at each final node, 3. sequential calculation of the option value at each preceding node
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The tree of prices is produced by working forward from valuation date to expiration.At each step, it is assumed that the underlying instrument will move up or down by a specific factor (u or d) per step of the tree (where, by definition, u 1 and 0 < d 1).

So, if S is the current price, then in the next period the price will either;

S up = S .u or Sdown = S.d

THE BLACK SCHOLES PRICING MODEL The Black Scholes Model is one of the most important concepts in modern financial theory. It was developed in 1973 by Fisher Black, Robert Merton and Myron Scholes and is still widely used today, and regarded as one of the best ways of determining fair prices of options. The model assumes that the price of heavily traded assets follow a geometric Brownian motion with constant drift and volatility. When applied to a stock option, the model incorporates the constant price variation of the stock, the time value of money, the option's strike price and the time to the options expiry. This is known as the Black-Scholes-Merton Model.

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ASSUMPTIONS

Markets are efficient

This assumption suggests that people cannot consistently predict the direction of the market or an individual stock. The market operates continuously with share prices following a continuous It process. An It process is simply a Markov process in continuous time.

No commissions are charged Usually market participants do have to pay a commission to buy or sell options. Even floor traders pay some kind of fee, but it is usually very small. The fees that Individual investor's pay is more substantial and can often distort the output of the model

Returns are log normally distributed This assumption suggests, returns on the underlying stock are normally distributed, which is reasonable for most assets that offer options.

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LIMITATIONS

The stock pays no dividends during the option's life

Most companies pay dividends to their shareholders, so this might seem a serious limitation to the model considering the observation that higher dividend yields elicit lower call premiums. A common way of adjusting the model for this situation is to subtract the discounted value of a future dividend from the stock price.

Only European exercise terms are used

European exercise terms dictate that the option can only be exercised on the expiration date. American exercise term allow the option to be exercised at any time during the life of the option, making American options more valuable due to their greater flexibility. However, this limitation is not a major concern because very few calls are ever exercised before the last few days of their life. This is true because when you exercise a call early, you forfeit the remaining time value on the call and collect the intrinsic value. Towards the end of the life of a call, the remaining time value is very small, but the intrinsic value is the same.

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FORMULAE

ON CALL OPTION Co = So N(d1) - X N(d2) )

d1 = [ln (So/X) + (r + /2) T] / ( d2 = d1 - ( )

ON PUT OPTION P=X N(d2)) - So ( 1 - N(d1)) )

d1 = [ln (So/X) + (r + /2) T] / ( d2 = d1 - ( )

Alternative: Using put call parity: P = Co + X

OPTION (CALL OR PUT) MODELLED ON DIVIDEND Replace the stock price with a dividend adjusted stock price. So with So PV (DIVIDEND) Or So with So( ,where d = dividend

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Where: Co = Current call option value So = Current stock price N(d) = probability that a random draw from a normal distribution will be less d. X = Exercise price e = 2.71828, the base of the natural log r = Risk-free interest rate (annualized, continuously compounded with the same maturity as the option) T = time to maturity of the option in years LN = Natural log function = Standard deviation of the stock

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THE BLACK SCHOLES MODEL COMPUTED IN EXCEL ON CALBANK STOCKS

We considered the Black Scholes Formular as the ideal approach for the assessment of how the price of the option ( call and put ) on CALBANKs stock ( 2007 to 2010 ) is sensitive to factors such as time to maturity, the volatility of the option, the risk free rate, stock price, exercise or strike price and even dividend pay-out. A spreadsheet (Microsoft Office Excel application) was used to diagnose the model to seek out the effects of the determinant factors aforementioned.

Table 1.0 below shows the distribution of stock prices on CALBANK stocks and the corresponding Treasury bill on due dates.
monthly return(m) -0.039002268 0.100047192 0.072501073 0.048 0.038167939 0.177573529 0.061504839 0.007352941

DATE 2007 Jan Feb Mar Apr May Jun Jul Aug Sep

CALBANK STOCK 0.2205 0.2119 0.2331 0.2500 0.2620 0.272 0.3203 0.34 0.3425

T-bills 0.007599202 0.007501389 0.0074964 0.007520577 0.007518658 0.007553186 0.007627951 0.007654774 0.007971086

LN (1+m) -0.03978323 0.095353081 0.069993372 0.046883586 0.037457563 0.16345599 0.059687561 0.00732604 Page 15

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2008

2009

2010

Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

0.3515 0.4152 0.442 0.506 0.700 0.700 0.620 0.660 0.700 0.700 0.700 0.690 0.670 0.600 0.600 0.600 0.450 0.340 0.300 0.260 0.200 0.220 0.250 0.240 0.220 0.200 0.200 0.200 0.170 0.190 0.230 0.280 0.270 0.260 0.300 0.290 0.280 0.300 0.310

0.008201035 0.008228834 0.008305713 0.008349452 0.00842661 0.008825426 0.010061599 0.011757428 0.013502762 0.016472541 0.017533092 0.017528274 0.017574725 0.017563373 0.017573005 0.017581605 0.01794516 0.018171359 0.018202115 0.018255743 0.018277253 0.018303537 0.018301148 0.018282374 0.018051997 0.016969025 0.01472062 0.013184043 0.011667985 0.010430344 0.01002651 0.0098561 0.009811202 0.009749807 0.009623893 0.009513201 0.009463252 NaN NaN

0.026277372 0.181223329 0.064547206 0.14479638 0.383399209 0 -0.114285714 0.064516129 0.060606061 0 0 -0.014285714 -0.028985507 -0.104477612 0 0 -0.25 -0.244444444 -0.117647059 -0.133333333 -0.230769231 0.1 0.136363636 -0.04 -0.083333333 -0.090909091 0 0 -0.15 0.117647059 0.210526316 0.217391304 -0.035714286 -0.037037037 0.153846154 -0.033333333 -0.034482759 0.071428571 0.033333333

0.025938054 0.166550621 0.06254955 0.135226787 0.324543666 0 -0.121360857 0.062520357 0.0588405 0 0 -0.014388737 -0.029413885 -0.110348057 0 0 -0.287682072 -0.280301965 -0.125163143 -0.143100844 -0.262364264 0.09531018 0.127833372 -0.040821995 -0.087011377 -0.09531018 0 0 -0.162518929 0.111225635 0.191055237 0.196710294 -0.036367644 -0.037740328 0.143100844 -0.033901552 -0.03509132 0.068992871 0.032789823

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The generation of monthly returns and the LN (1+M) column Monthly Return This is measured by accounting for the rate of change in the stock prices over time. In Table 1.0 We found the difference between the current and the previous stock price as a rate on the current price. Monthly return = (CT - CT- 1)/ CT- 1 The LN (1+M) This is the natural log of an increased value of +1 on the monthly return. LN (1+M) = LN (1+ (CT - CT- 1)/ CT- 1)

Evaluation for input (Monthly and Annual Volatility) (

This is calculated by using the STDEV function in excel on the LN (1+M); Such as: = STDEV (LN (1+M)), where LN (1+M) are the range of values in table 1.0. Monthly Volatility = 0.122811668

Aftermath, we estimated annual volatility by multiplying the monthly volatility with .Such as: = SQRT (STDEV (LN (1+M)) Annual Volatility = 0.425432096
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Evaluation for input (Risk Free Rate) (

This also calculated by finding the average on the T-bill for the period (2007 to 2010). Such as: = AVERAGE (RANGE OF VALUES ON T.BILL) in excel Risk Free Rate = 0.012494247

SUMMARY OF ALL INPUTS FOR THE MODEL

Volatility (

) = 0.425432096

Strike Price (X) = 0.35 Stock Price (S0) = 0.37 Time or duration of the option contract (T) = 3 years Risk Free Rate = 0.012494247

OUTPUT OF THE MODEL: THE CALL PRICE AND THE PUT PRICE ON CALL OPTION d1 = [ln (0.37/0.35) + (0.01249 + 0.425432/2) T] / (0.42542 * d2 = 0.49471588 - (0.4252* ) = - 0.242154123 N(-0.242154123) = 0.118842455 ) = 0.494715882

Co = 0.37* N (0.494715882) (0.35)

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ON PUT OPTION P = (0.35) N(-0.242154123) - 0.37* N (0.494715882) = 0.08596632

SUMMARY OF ALL OUTPUTS OF THE MODEL Call value = 0.118842455 Put value = 0.08596632

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STOCK PRICE CALL PRICE PUT PRICE D1 D2 N(D1) N(D2) 0.37 0.118842455 0.08596632 0.494715882 -0.2421541 0.6896 0.40433 0.38 0.125802223 0.082926087 0.530907133 -0.2059629 0.702258 0.41841 0.39 0.4 0.41 0.132885756 0.140087573 0.147402428 0.080009621 0.077211438 0.074526293 0.566158244 0.600516825 0.634026959 -0.1707118 0.714357 0.432225 -0.1363532 0.725919 0.445771 -0.102843 0.736968 0.459044

INTERPRETATION OF RESULTS

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CONCLUSION

REFERENCES Dr. Lord Mensah, (2012), lecture notes on option markets and option valuation. Hull J.C. - Options, Futures, and Other Derivatives - 5th Edition BodieKaneMarcus ( The McGraw-Hill ) Investments, Fifth Edition

http://www.investopedia.com/articles/optioninvestor/07/options_beat_market.asp#ixzz28FYYpb lX

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