Option Price Calculation

The price of an option contract is the premium that is acceptable to the seller of the option.
The seller decides about this with the assumption and calculation that the seller will have no profitno loss by accepting this premium to bear the risk of an option contract.

Binomial Model of Calculating Option Price

One-step Binomial Method Option equivalent method Risk neutral method

Two-step Binomial Method

Risk neutral method

Binomial Model
Binomial method is based on the fundamental that price of the underlying share can either increase or decrease in the future in comparison to current spot price.

One-step Binomial Process Under this model, one-time step is considered for calculating the price of option:
Option equivalent method Risk neutral method

Option equivalent method

The option equivalent method assumes that the outcomes for a particular share on which an option contract has been written can result into either a high value or low value.

Option equivalent method is based on the concept of hedge ratio, hedge ratio implies that the seller of the option should have position in the underlying asset equal to the hedge ratio for the quantity for which option

Price of a call option

Option equivalent method assumes that the outcome for a particular share on which an option contract has been written, can result into any two values, i.e., high value or low value, depending on the movement of spot price likely to take place during the time duration of option contract. Steps taken to calculate the price of call option:
Estimate highest value of call assuming that the spot price of underlying asset on the expiration date will increase to a certain level in future.

Price of a call option

Estimate lowest value of call assuming that spot price of underlying asset on the expiration date will decrease to a certain level in future.

Calculation of hedge ratio symbolized as [h] or

By hedge ratio, we mean a ratio of difference between the highest and the lowest value of call option and the difference of the maximum and minimum price of underlying share.

Price of a call option

Estimating funds to be borrowed at present to create a hedge portfolio

Calculation of price of call using formula

Risk neutral method

Risk neutral method assumes that investors expect returns from an investment at least equal to the risk-free interest rate. Steps taken to calculate value of a call option:
Estimate highest value of call assuming that the spot price of underlying asset on the expiration date will increase to a certain level in future.

Risk neutral method

Estimate lowest value of call assuming that spot price of underlying asset on the expiration date will decrease to a certain level in future.

Risk neutral method (Cont.)

Estimate the probability of increase in the spot price of underlying shares on the expiration date

 Calculate expected future value of the call option with the help of probability

Calculate present value of call: Done by discounting the future value of call as calculated in the previous step.

Price of a Put Option

Once we have calculated price of call option it is much easier to calculate the price of put option. The formula is as follows:

Two-step binomial process

Under this model, two-time steps are considered for calculating the price of the option. It is perceived that price of the underlying share has a probability of rise or fall during each of the two successive time periods. Price can be calculated by using Risk neutral method

Black and Scholes Model for Option Price Calculation

This model of option price/value calculation is based on the fundamental that in the future, the price of the underlying asset will either increase or decrease as compared to the spot price of the underlying asset. This model has the following assumptions: The call option for which value is being calculated in European style Price of the underlying share change continuously Share price has a log normal distribution Transaction costs and taxes do not exist No restriction on short selling Funds can be borrowed at risk-free rate of return to create risk neutral portfolio During the time period to maturity of the call option, dividend is not declared by the company

Steps taken to calculate the price of the option

Calculation of d1

Steps taken to calculate the price of the option

Calculation of d2.

Steps taken to calculate the price of the option (Cont.)

Application of the formula to calculate value/price of call option

Value/Price of a put option

The price so calculated is called equilibrium price and it is expected to be maintained because of the arbitrage process. It is the arbitrage process, which forces it to be maintained.

Valuation Mechanism for Futures Contract In a market, there is always a difference between the spot price of the share and price of the same share for a futures contract. Difference is on account of many factors expectation about the future market trends, i.e., bullish or bearish, expected performance of the company, rate of interest, inflation rate, market imperfections, carrying cost, volatility of the share prices, time till expiration and others. All these factors have a collective influence in deciding the futures price. A model called COST OF CARRY MODEL has been developed to estimate futures price.

The Cost of Carry Model

Cost of carry model takes into consideration the spot price and the effective cost of carrying the hedge position in underlying asset. Assumptions
The price of the underlying share change continuously Transaction costs and taxes do not exist No restriction on short selling Funds can be borrowed at risk-free rate of return to create risk neutral portfolio i.e. zero cash flow portfolio. During the time period to maturity of the call option, dividend is not declared by the company; even if it is declared, it can be adjusted in the formula.

Futures price

Price of futures contract