Option Pricing Models Option pricing basically involves determining the appropriate premium for an option available at given

strike price. The most widely practiced option pricing models are: (i) lack and !choles option pricing model and (ii) inomial option pricing model (i) Black and Scholes option pricing model This model is by far the most widely used model in options market to determine the price of a call and put options. The model was initially developed by "ischer lack and Myron !choles in #$%& and introduce to the academicians and traders and investors through well recogni'ed article (The Pricing of Options and )orporate *iabilities+ in The ,ournal of Political -conomy in May that year. "ollowing loosely on the Ph... thesis written by ,ames oness at /niversity of )hicago0 lack and !choles developed an analytical model now known as lack and !choles Model. The model is designed to use for pricing -uropean options0 though it was further modified by other researchers to apply to 1merican options also. 1ssumptions of the Model The model works within the framework of following assumptions: (i) 2o dividends are paid out on the underlying stock during the life of the option contract. (ii) The option can only be e3ercised at the e3piry (thus -uropean option) (iii) Market movements cannot be predicted. 4n other words stock markets are efficient. (iv) Transaction costs such as commission0 ta3es do not e3ist. (v) 4nvestors can borrow or lend at same risk free rate of interest. This interest rate is known to investors and do not change over the life of option contract. (vi) !tock market returns follow log normal distribution. 5hile all the above assumptions are simpler to understand0 the last one on log normal distribution of stock market returns can be understood as follows. 1 log normal distribution is different from the normal distribution or bell shaped curve. 1 log normal distribution has longer right tail which implies that stock price distribution is between 'ero and infinity. This in other words means that stock prices cannot be negative and have upward bias representing the fact that a stock price can only drop by #667 but can rise by more than #667. The Model efore we define the model let us understand the basic inputs that go into the model. These are: ! 8 /nderlying stock price 9 8 !trike price r 8 :isk free interest rate ; 8 <olatility of stock measured as standard deviation of returns over # year t 8 Time to maturity 5e can now define the lack and !choles Option price model as under:

"or )all Option: ) = !N(d1) > 9e(8rt)N (d2) "or Put Option: P = 9e(8rt)N(-d2) > !N(-d1) 4n the above formulae0 e is the e3ponential function and N(d1) and N(d2) are the cumulative normal distribution function for d1 and d2 which are defined as under: d1 = ln(!?9) @ (r@ ;A?A)t ; t d2 = d1 8 ;t (4n the above ln stands for natural logarithm). One of the key concepts of the option pricing using above model is the risk8neutral valuation of derivatives. This in simple words means that the price of an option is independent of the risk preferences of investors. 4t thus means that all the derivatives can be valued by assuming that the return from their underlying assets is the risk free rate. 1dvantages of the Model: The main advantage of ! Model is the speed. 4t lets you calculate a very large number of option prices in a very short time. *imitations of the Model: (i) 4t cannot be used to accurately price 1merican options as it only calculates option price at one point in timeB ie e3piration. 1ll e3change traded stocks have 1merican options and therefore this is a significant limitation. 1lthough various adCustments are made to the basic ! Model to use it for calculating price of 1merican options (for eg. "ischer lack Pseudo8 1merican method)0 these only work well within certain limits and they do not really work well for put options. (ii) 4n practice0 stock returns are not found to follow the assumption of log normal distribution. The stock returns are distributed with high freDuency of high returns and high freDuency of low returns thus resulting in fatter right and left tails for return distribution. <ariations to basic ! Model: 1s discussed before0 the basic ! model can be used to determine option price of only -uropean style and not the 1merican style. "urther0 the above model is applicable only for non8dividend paying stock. <arious modifications have been made in the basic ! model to account for these important and practical reDuirements. !ome of them are discussed as below: (i) "or dividend paying stock. To use the ! model for pricing options on dividend paying stock0 an adCustment of the remaining present value of dividends receivable prior to e3piry of option is necessary. This can be understood using the simple discounted dividend model of eDuity valuation. The dividend discount model says that the value of eDuity share is nothing but present value of all the future e3pected dividends on the stock. Thus0 if option on such stock is available for a particular period0 the present value of dividend receivable before the e3piry of the option should be deducted from the current market price of the stock.

(ii) 1merican style options .elta 1 by8product of the ! model is the calculation of the delta 8 the degree to which an option price will move given a small change in the price of underlying stock. "or eg.0 an option with a delta of 6.E will move by 6.E paise for every # paise of movement in the underlying stock. 1 deeply out8of8the money call will have a delta very close to 'eroB a deeply in8the8 money call will have a delta very close to #. )all deltas are positive and Put deltas are negative0 reflecting the fact that the put option price and the underlying stock price are inversely related. Put delta = )all delta > #. The delta is often called Fedge :atio. 4t helps you to know the number of shares reDuired to create a riskless portfolio. 4f for eg.0 you have sold E calls0 then E multiplied by .elta will give you the number of shares reDuired to create riskless portfolio. 4t is a portfolio whose value will remain the same whether the stock price rose by a small amount or fell down by a small amount. Gamma 4t measures how Duickly the delta changes for the small change in the underlying stock price. Gamma should be kept as small as possible meaning that the option price should change as slowly as possible against change in the price of underlying stock. 4f Gamma is too large0 then maintaining a proper hedge ratio becomes very difficult since a small change in underlying stock price can change the option price significantly thus reDuiring you to adCust the number of shares reDuired for creating riskless portfolio. Gamma of underlying asset is by definition 'ero. Therefore0 buying more shares or selling shares does not bring about any change in Gamma of the portfolio. 1dCusting of Gamma is thus done using options and not the underlying stocks. <ega 4t measures the change in option price to one percentage change in volatility. <ega is also used for hedging. Theta The change in option price given one day decrease in time to e3piration is called Theta. :ho The change in option price given one percentage change in risk free rate of interest. (ii) The Binomial option pricing model This is yet another techniDue of determining option price. The inomial option pricing model computes the option price using binomial tree which basically represents different paths that might be followed by the stock price during the life of the option. The model given by )o30 :oss and :ubinstein in #$%$ breaks down the time to e3piration into potentially very large number of time intervals or steps. 1 tree of stock prices is initially produced working forward from the present to e3piration. 1t each

step it is assumed that the stock price will move up or down by an amount calculated using volatility and time to e3piration. !ince the price is assumed to move either up or down it gives rise to binomial distribution (ie only two movements). 1ssumptions of the Model (i) There are no transaction costs. (ii) There is no risk of default by counterparty to option contract. (iii) Markets are competitive and investors do not influence prices but rather act as takers of prices. (iv) There are no arbitrage opportunities. (v) There is no interest rate uncertainty.