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INVESTMENTS, Fourth Canadian Edition

Chapter 18
Option Valuation

Slide 18-1

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INVESTMENTS, Fourth Canadian Edition

Chapter Summary
Objective: To discuss factors that affect option prices and to present quantitative option pricing models.

Factors influencing option values Black-Scholes option valuation Using the Black-Scholes formula Binomial Option Pricing

Slide 18-2

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INVESTMENTS, Fourth Canadian Edition

Option Values
Intrinsic value - profit that could be made if the option was immediately exercised

Call: stock price - exercise price Put: exercise price - stock price

Time value - the difference between the option price and the intrinsic value

Slide 18-3

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INVESTMENTS, Fourth Canadian Edition

Time Value of Options: Call

Option value

Value of Call
Time value X
Slide 18-4

Intrinsic Value

Stock Price
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INVESTMENTS, Fourth Canadian Edition

Factors Influencing Option Values: Calls

Factor Stock price Exercise price Volatility of stock price Time to expiration Interest rate Dividend Rate Effect on value increases decreases increases increases increases decreases

Slide 18-5

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INVESTMENTS, Fourth Canadian Edition

Restrictions on Option Value: Call

Value cannot be negative Value cannot exceed the stock value Value of the call must be greater than the value of levered equity
C > S0 - ( X + D ) / ( 1 + R f )T C > S0 - PV ( X ) - PV ( D )

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INVESTMENTS, Fourth Canadian Edition

Allowable Range for Call

Call Value

Lower Bound = S0 - PV (X) - PV (D) S0

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PV (X) + PV (D)
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Kane Marcus Perrakis

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INVESTMENTS, Fourth Canadian Edition

Summary Reminder
Objective: To discuss factors that affect option prices and to present quantitative option pricing models.

Factors influencing option values Black-Scholes option valuation Using the Black-Scholes formula Binomial Option Pricing

Slide 18-8

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INVESTMENTS, Fourth Canadian Edition

Black-Scholes Option Valuation

Co = SoN(d1) - Xe-rTN(d2) d1 = [ln(So/X) + (r + 2/2)T] / (T1/2) d2 = d1 + (T1/2)
where,
Co = Current call option value So = Current stock price N(d) = probability that a random draw from a normal distribution will be less than d
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INVESTMENTS, Fourth Canadian Edition

Black-Scholes Option Valuation (contd)

X = Exercise price e = 2.71828, the base of the natural log r = Risk-free interest rate (annualizes 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 annualized continuously compounded rate of return on the stock
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INVESTMENTS, Fourth Canadian Edition

Call Option Example

So = 100 r = .10 = .50 X = 95 T = .25 (quarter)
2

d1

ln(100 / 95) (.10 .5 / 2) .25 .5 .25

.43

d2 .43 .5 .25 .18

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INVESTMENTS, Fourth Canadian Edition

Probabilities from Normal Distribution

N (.43) = .6664
Table 18.2 d .42 .43 .44
Slide 18-12

N(d) .6628 .6664 Interpolation .6700

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INVESTMENTS, Fourth Canadian Edition

Probabilities from Normal Distribution

N (.18) = .5714
Table 18.2 d .16 .18 .20
Slide 18-13

N(d) .5636 .5714 .5793

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INVESTMENTS, Fourth Canadian Edition

Call Option Value

Co = SoN(d1) - Xe-rTN(d2) Co = 100 x .6664 (95 e-.10 X .25) x .5714 Co = 13.70
Implied Volatility Using Black-Scholes and the actual price of the option, solve for volatility. Is the implied volatility consistent with the stock?
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INVESTMENTS, Fourth Canadian Edition

Put Value using Black-Scholes

P = Xe-rT [1-N(d2)] - S0 [1-N(d1)] Using the sample call data S = 100 r = .10 X = 95 g = .5 T = .25 P= 95e-10x.25(1-.5714)-100(1-.6664)=6.35

Slide 18-15

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INVESTMENTS, Fourth Canadian Edition

Put Option Valuation: Using Put-Call Parity

P = C + PV (X) - So = C + Xe-rT - So Using the example data C = 13.70 X = 95 S = 100 r = .10 T = .25 P = 13.70 + 95 e -.10 x .25 - 100 P = 6.35
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INVESTMENTS, Fourth Canadian Edition

Adjusting the Black-Scholes Model for Dividends

The call option formula applies to stocks that pay dividends One approach is to replace the stock price with a dividend adjusted stock price

Replace S0 with S0 - PV (Dividends)

Slide 18-17

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INVESTMENTS, Fourth Canadian Edition

Summary Reminder
Objective: To discuss factors that affect option prices and to present quantitative option pricing models.

Factors influencing option values Black-Scholes option valuation Using the Black-Scholes formula Binomial Option Pricing

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INVESTMENTS, Fourth Canadian Edition

Using the Black-Scholes Formula

Hedging: Hedge ratio or delta

The number of stocks required to hedge against the price risk of holding one option Call = N (d1) Put = N (d1) - 1 Percentage change in the options value given a 1% change in the value of the underlying stock
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Option Elasticity

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INVESTMENTS, Fourth Canadian Edition

Portfolio Insurance - Protecting Against Declines in Stock Value

Buying Puts - results in downside protection with unlimited upside potential Limitations

Tracking errors if indexes are used for the puts Maturity of puts may be too short Hedge ratios or deltas change as stock values change
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INVESTMENTS, Fourth Canadian Edition

Hedging Bets on Mispriced Options

Option value is positively related to volatility If an investor believes that the volatility that is implied in an options price is too low, a profitable trade is possible Profit must be hedged against a decline in the value of the stock Performance depends on option price relative to the implied volatility
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INVESTMENTS, Fourth Canadian Edition

Hedging and Delta

The appropriate hedge will depend on the delta. Recall the delta is the change in the value of the option relative to the change in the value of the stock.

Change in the value of the option Delta change in the value of the stock
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INVESTMENTS, Fourth Canadian Edition

Mispriced Option: Text Example

Implied volatility Investor believes volatility should Option maturity Put price P Exercise price and stock price = 33% = 35% = 60 days = $4.495 = $90

Risk-free rate r
Delta
Slide 18-23

= 4%
= -.453
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INVESTMENTS, Fourth Canadian Edition

Hedged Put Portfolio

Cost to establish the hedged position

1000 put options at $4.495 / option
453 shares at $90 / share Total outlay

$ 4,495
40,770 45,265

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INVESTMENTS, Fourth Canadian Edition

Profit Position on Hedged Put Portfolio

Value of put as function of stock price: implied volatility = 35% Stock Price 89 90 Put Price $5.254 $4.785 Profit/loss per put .759 .290

91 $4.347 (.148)

Value of and profit on hedged portfolio Stock Price 89 90 91 Value of 1,000 puts $ 5,254 $ 4,785 $ 4,347 Value of 453 shares 40,317 40,770 41,223 Total 45,571 45,555 45,570 Profit 306 290 305
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Kane Marcus Perrakis

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INVESTMENTS, Fourth Canadian Edition

Summary Reminder
Objective: To discuss factors that affect option prices and to present quantitative option pricing models.

Factors influencing option values Black-Scholes option valuation Using the Black-Scholes formula Binomial Option Pricing

Slide 18-26

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INVESTMENTS, Fourth Canadian Edition

Binomial Option Pricing: Text Example

200
100 50 C 0

75

Stock Price

Call Option Value X = 125

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INVESTMENTS, Fourth Canadian Edition

Binomial Option Pricing: Text Example

Alternative Portfolio Buy 1 share of stock at $100 Borrow $46.30 (8% Rate) 53.70 Net outlay $53.70 Payoff Value of Stock 50 200 Repay loan - 50 -50 Net Payoff 0 150

150

0 Payoff Structure is exactly 2 times the Call

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INVESTMENTS, Fourth Canadian Edition

Binomial Option Pricing: Text Example

150
53.70 0 2C = $53.70 C = $26.85
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75

C
0

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INVESTMENTS, Fourth Canadian Edition

Another View of Replication of Payoffs and Option Values

Alternative Portfolio - one share of stock and 2 calls written (X = 125) Portfolio is perfectly hedged

Stock Value Call Obligation Net payoff

50 0 50

200 -150 50

Hence 100 - 2C = 46.30 or C = 26.85

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Generalizing the Two-State Approach

Assume that we can break the year into two six-month segments In each six-month segment the stock could increase by 10% or decrease by 5% Assume the stock is initially selling at 100 Possible outcomes

Increase by 10% twice Decrease by 5% twice Increase once and decrease once (2 paths)
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Generalizing the Two-State Approach

121 110 100 95 104.50

90.25

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Expanding to Consider Three Intervals

Assume that we can break the year into three intervals For each interval the stock could increase by 5% or decrease by 3% Assume the stock is initially selling at 100

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Expanding to Consider Three Intervals

S+++ S++ S+ S SS+S+-S-S--S++-

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Possible Outcomes with Three Intervals

Event 3 up 2 up 1 down 1 up 2 down 3 down Probability 1/8 3/8 3/8 1/8 100 (1.05)3 Stock Price =115.76

100 (1.05)2 (.97) =106.94 100 (1.05) (.97)2 = 98.79 100 (.97)3 = 91.27

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INVESTMENTS, Fourth Canadian Edition

Multinomial Option Pricing

Incomplete markets

If the stock return has more than two possible outcomes it is not possible to replicate the option with a portfolio containing the stock and the riskless asset Markets are incomplete when there are fewer assets than there are states of the world (here possible stock outcomes) No single option price can be then derived by arbitrage methods alone Only upper and lower bounds exist on option prices, within which the true option price lies An appropriate pair of such bounds converges to the Black-Scholes price at the limit
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