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14 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Combinations of Put, Call and Share
Straddle: Combining Call and Put at Same
Exercise Price
Strips and Straps
Strangle: Combining Call and Put at Different
Exercise Prices
Spread: Combining Put and Call at Different
Exercise Prices
Spread: Combining the Long and Short
Options
Collars
15 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Factors Determining Option Value
1. Exercise price and the share (underlying asset)
price
2. Volatility of returns on share
3. Time to expiration
4. Interest rates
16 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Limitations of DCF Approach
The DCF approach does not work for options
because of the difficulty in determining the
required rate of return of an option. Options
are derivative securities. Their risk is
derived from the risk of the underlying
security. The market value of a share
continuously changes. Consequently, the
required rate of return to a stock option is
also continuously changing. Therefore, it is
not feasible to value options using the DCF
technique.
17 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Model for Option Valuation
Simple binomial tree approach to option
valuation.
Black-Scholes option valuation model.
18 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Simple Binomial Tree Approach
Sell a call option on the share. We can create
a portfolio of certain number of shares (let us
call it delta, A) and one call option by going
long on shares and short on options that
there is no uncertainty of the value of portfolio
at the end of one year.
Formula for determining the option delta,
represented by symbol A, can be written as
follows:
Option Delta = Difference in option Values /
Difference in Share Prices.
19 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Simple Binomial Tree Approach
The value of portfolio at the end of one year
remains same irrespective of the increase or
decrease in the share price.
Since it is a risk-less portfolio, we can use the
risk-free rate as the discount rate:
PV of Portfolio = Value of Portfolio at end of year /
Discount rate
20 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Simple Binomial Tree Approach
Since the current price of share is S, the value
of the call option can be found out as follows:
Value of a call option = No. of Shares (A) Spot
Price PV of Portfolio
The value of the call option will remain the same
irrespective of any probabilities of increase or
decrease in the share price. This is so because
the option is valued in terms of the price of the
underlying share, and the share price already
includes the probabilities of its rise or fall.
21 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Risk Neutrality
Investors are risk-neutral. They would simply
expect a risk-free rate of return. In our
example, the share price could rise by 100 per
cent (from Rs 150 to Rs 300) or it could fall by
33.3 per cent (from Rs 150 to Rs 100). Under
these situations, a risk-neutral investors return
from the investment in the share is given in
box.
22 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Risk Neutrality
We can utilise this information to determine the
value of the call option at the end of the year. The
call option is worth Rs 100 when the share price
increases to Rs 300, and its worth is zero if the
share price declines. We can thus calculate the
value of the call option at the end of one year as
given below:
Value of call option at the end of the period
= 0.325 100 + (1 0.352) 0 = Rs 32.50
Current value of the call option
= 32.5/1.1 = Rs 29.55
Expected return (probability of price increase) percentage increase in price
(1 probability of price increase) percentage decrease in price risk-free rate
100 (1 ) ( 33.33) 10
0.325
p p
p
=
+ =
= + =
=
23 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Black and Scholes Model for Option
Valuation
The BS model is based on the following
assumptions:
The rates of return on a share are log
normally distributed.
The value of the share (the underlying asset)
and the risk-free rate are constant during the
life of the option.
The market is efficient and there are no
transaction costs and taxes.
There is no dividend to be paid on the share
during the life of the option.
24 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Black and Scholes Model for Option
Valuation
The BS model is as follows:
where
C
0
= the current value of call option
S
0
= the current market value of the share
E = the exercise price
e = 2.7183, the exponential constant
r
f
= the risk-free rate of interest
t = the time to expiration (in years)
N(d
1
) = the cumulative normal probability density
function
0 0 1 2
( ) ( )
f
r t
C S N d Ee N d
=
25 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Black and Scholes Model for Option
Valuation
where
ln = the natural logarithm;
= the standard deviation;
2
= variance of the continuously
compounded annual return on the share.
2
1
2 1
ln( / ) / 2
f
S E r t
d
t
d d t
o
o
o
( + +
=
=
26 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Features of BS Model
BlackScholes model has two features-
The parameters of the model, except the share
price volatility, are contained in the agreement
between the option buyer and seller.
In spite of its unrealistic assumptions, the
model is able to predict the true price of option
reasonably well.
The model is applicable to both European
and American options with a few adjustments.
27 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Options Delta or Hedge Ratio
The hedge ratio is a tool that enables us to
summarise the overall exposure of portfolios of
options with various exercise prices and
maturity periods.
An options hedge ratio is the change in the
option price for a Re 1 increase in the share
price.
A call option has a positive hedge ratio and a
put option has a negative hedge ratio.
Under the BlackScholes option valuation
formula, the hedge ratio of a call option is
N (d
1
) and the hedge ratio for a put is N (d
1
) 1.
28 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Dividend-Paying Share Option
We can use slightly modified
BS model for this purpose. The share price
will go down by an amount reflecting the
payment of dividend. As a consequence, the
value of a call option will decrease and the
value of a put option will increase.
We also need to adjust the volatility in case of
a dividend-paying share since in the BS
model it is the volatility of the risky part of the
share price. This is generally ignored in
practice.
29 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Ordinary Share as an Option
The limited liability feature provides an
opportunity to the shareholders to default on
a debt.
The debt-holders are the sellers of call option
to the shareholders. The amount of debt to be
repaid is the exercise price and the maturity
of debt is the time to expiration.
The shareholders option can be interpreted
as a put option. The shareholders can sell
(hand-over) the firm to the debt-holders at
zero exercise price if they do not want to
make the payment that is due.