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Summary
Prof. Preeti Kumari
Definitions and Preliminaries
! An option is a financial security that gives the holder the
right
to buy or sell a specified quantity of a specified asset at a specified
price on or before a specified date.
Buy = Call option. Sell = Put option
On/before: American. Only on: European
Specified price = Strike or exercise price
Specified date = Maturity or expiration date
Buyer = holder = long position
Seller = writer = short position
Options as Insurance
! Options provide financial insurance.
The option holder has the right, bit not the obligation, to
participate in the specified trade.
! Example: Consider holding a put option on Cisco stock with
a strike of $25. (Ciscos current price: $26.75.)
The put provides a holder of the stock with protection against the
price falling below $25.
! What about a call with a strike of (say) $27.50?
The call provides a buyer with protection against the price
increasing above $25.
The Option Premium
! The writer of the option provides this insurance to the
holder.
! In exchange, writer receives an upfront fee called the option
price or the option premium.
! Key question we examine: How is this price determined?
What factors matter?
The question is how much this premium
is going to be?

! The Basic Idea
! We are trying to find the value today of a contract whose ultimate value
depends on the value of the Microsoft stock price in one years time.
! The contract has different values depending on whether that stock price
goes up or goes down.
! So intuitively we are going to need some measure, or measures, of the
probabilities of the stock price ending up at various values after one
year.
! If we have that it may be possible to apply an expected value
calculation to get to a price for the contract.
Volatility

! Option values depend on volatility. The amount of volatility anticipated
over an options life is a central determinant of option values
! Technically volatility is defined as the annualized standard deviation of
the return on an asset They are expressed as percentages.
! However, its easier to think of it intuitively as the amount that the price
will swing around in a given period. Stocks with a high level of
uncertainty surrounding them will have high volatilities. An example
currently might be the stock of small Russian oil companies. Stocks that
are relatively stable (e.g. Microsoft) will have lower volatilities.
! Long option positions increase in value when volatility goes up and
decrease in value when volatility goes down.
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Volatility
! Why does volatility affect the price of an option? Astock that has a high
volatility is more likely to swing around, and hence more likely to have a very high
value or very low value at maturity. Astock with a low volatility is more likely to be
close to its current value at maturity.
! Now if the stock price at maturity is below our strike price we dont care if its just
slightly below or massively below. In both cases we dont exercise the option and dont
make any money.
! But if the share price at maturity is above our strike we really want it to be as far above
the strike as is possible, since we make more money the higher the volume is.
! So an option with a high volatility is more likely to make us lots of money if the price
goes up, but wont lose us lots of money even if the price goes down hugely.
! As a result options with high volatility are more valuable than options with low
volatility.
Time Value of Money

! If I receive a cash flow of $1,000,000 in one years time then that is worth LESS to me than if I
receive $1,000,000 today. This is intuitively obvious if you consider that if I receive $1,000,000 today I can
buy a government bond and earn interest on it for a year. At the end of the year Ill have more than
$1,000,000.
! The difference between the two values clearly depends on the interest rate that I can get over the year. If I
can get an interest rate of i% then at the end of the year my $1,000,000 will be worth $1,000,000 x (1+i%).
Equally if I am due to receive $1,000,000 x (1+i%) in a years time, I can say that that is worth $1,000,000
to me today. If I receive $1,000,000 in a years time that is worth $1,000,000 / (1+i%) to me today.

! In general if I am going to receive $y in a years time I can say that that is worth y / (1+i%) to me today. In
this case we call the 1/(1+i%) a discount factor. Its what we discount (multiply) the future cash flow by
to get its current value.
! if r is our continuously compounded interest rate for a period of T years then the discount factor will be
Exp rT.
Option pricing notation (repeat)
S = The underlying stock (or asset) price
X = The exercise, or strike, price, at which the asset can be
purchased or sold
t = The time to expiration, expressed in years
! = The volatility of the underlying asset, equal to the square
root of the variance of the asset's rate of return over a very
short time interval
r =The risk-free rate of interest over the life of the option
More option pricing notation
! c is the value of a call option.
c is a function of S, X, t, !, and r, and is expressed as c
(S,X,t,!,r).
! p is the value of a put option.
p is a function of S, X, t, !, and r, and is expressed as p
(S,X,t,!,r)
PutCall Parity
! One of the most important results in all of option
pricing theory.
! It relates the prices of otherwise identical European puts and
! calls:
P + S = C + PV(K).
! Put-call parity is proved by comparing two portfolios and
showing that they have the same payoffs at maturity.
Portfolio A Long stock, long put with strike K and maturity T.
Portfolio B Long call with strike K and maturity T, investment of
PV(K) for maturity at T.
Two specific binomial option pricing
approaches
! The replicating portfolio approach
Price the option by pricing a portfolio of stock and bonds with
identical cash flows
! The risk-neutral approach
Probabilities of future up or down movements of the stock do not
affect option prices (such probabilities already are incorporated
into the price of the stock)
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Overview of binomial option pricing
! Goal: Find exact formula for value of the option before expiration
! Binomial tree: Diagram that represents different possible paths a
stock price might follow over the life of an option


C
C
u
C
d
t = 0
t = 1
Replicating portfolio approach

If =
Payoff of
replicating
portfolio
Payoff of
option
They must cost the same today .
Options and Replication

! As with all derivatives, the basic idea behind pricing options
is replication: we look to create identical payoffs to the
options using
Long/short positions in the underlying secutiy.
Default-risk-free investment/borrowing.
! Once we have a portfolio that replicates the option, the cost
of the option must be equal to the cost of replicating (or
synthesizing)
Pricing Options by Replication (Contd)

! As we have just seen, volatility is a primary determinant of option
value, so we cannot price options without first modelling volatility.
! More generally, we need to model uncertainty in the evolution of the
price of the underlying security.
! It is this dimension that makes option pricing more complex than
forward pricing.
! It is also on this dimension that different option pricing models
make different assumptions:
Discrete (lattice) models: e.g., the binomial.
Continuous models: e.g., Black-Scholes.
Pricing Options by Replication (Contd)

! Once we have a model of prices evolution, options can be priced by
replication:
Identify option payoffs at maturity.
Set up a portfolio to replicate these payoffs.
Value the portfolio and hence price the option.
! The replication process can be technically involved; we illustrate it
using a simple examplea one-period binomial model.
! From the example, we draw inferences about the replication process in
general, and, in particular, about the behavior of the option delta.
! Using the intuition gained here, we examine the Black-Scholes model.
Numerical example
! Consider a stock that is currently priced at $100 and will either be $110 or $90 at the end of one
year



! The one-period risk-free rate is 6%. A$1 investment in a bond pays off:




S
u
=110
S
d
=90
S =100
1.06
1.06
B=1
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Stock and bond replication
! We can replicate the payoffs of the call option by buying
shares of the stock and selling the risk-free bond
! Step 1: Find the replicating portfolio
": the number of shares
B: the price of the bond (amount borrowed TODAY)

Value of replicating portfolio = " S - B
! Option delta= spread of possible option prices/spread
of possible share prices
! Amount of bank loan:
=((.5) x 90) - 0)/1.06
= ((.5) 110 - 10)/1.06
= 42.45
! Therefore, the replicating portfolio consists of:
Buying 1/2 share of stock
Selling the risk-free bond (that is, borrowing) in the amount of
$42.45 at t=0
Check that we have replicated the option
payoff

Path of stock price:



The value of the portfolio (at t = 1):

Up state: Down state:
Portfolio
u
= " S
u
- 1.06 B Portfolio
d
= " S
d
- 1.06 B

= .5 (110) - (1.06)(42.45) = .5 (90) - (1.06)(42.45)
= 10 = 0
S
u
=110
S
d
=90
S =100
Find the option value
! Because the replicating portfolio and the call option have
identical payoffs, by the no-arbitrage principle, they must have
the same cost today
! The current value of the portfolio (at t = 0) is:
Portfolio = " S - B

= .5 (100) - 42.45
= 7.55
! The current value of the call is $7.55.

What is " (delta)?
! ! is the number of shares needed to replicate the call option
! It is the spread of option prices relative to the spread of stock prices
! Also known as the hedge ratio:

! With this definition of ", we only need to find B to find the calls price:
d u
d u
S S
c c
!
!
= "
C = " S B
The Option Delta
! The delta of an option is the number of units of the
underlying security that must be used to replicate the option.
! As such, the delta measures the riskiness of the option in
terms of the underlying.
! For example: if the delta of an option is (say) +0.60, then,
the risk in the option position is the same as the risk in
being long 0.60 units of the underlying security.
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! Replicating portfolio Package of assets whose return
exactly replicate those of an option.
! Hedge ratio (delta, option delta) The number of shares to
buy for each option sold to create a safe position; more
generally, the number of units of an asset that should be
bought to hedge one unit of a liability.
Another example: Hershey Foods option
! Hershey Foods, Inc. stock is currently priced at $68 and will
rise by 25% or fall by 20% over the next period. Exercise
price $65. The interest rate is 2.5% over the next period


Summary of replicating portfolio
approach
Step 1: Set up binomial trees for the stock and option path prices.
Step 2: Using terminal stock and option prices, find option delta:


Step 3: Find B (the amount borrowed) by setting the terminal payoff of
the replicating portfolio equal to the terminal payoff of the option:

Step 4: Using option " and B, calculate the price of call:
d u
d u
S S
c c
!
!
= "
C = " S - B
" S
d
- (1+r) B = C
d
Calculating the put option value
! !S - B = p
! In the down state: !S
d
- B(1+r) = p
d

! ! = (p
u
- p
d
)/(S
u
- S
d
) = (0-10)/(110-90) = -0.5
! Using the down state to calculate B:
-0.5 (90) - (1.06) B = 10
B = -51.89
! Now calculate p:
p = -0.5 (100) - (-51.89) = 1.89
Put-call parity
! Verify that put-call parity holds


C = P + S PV(X)
P = C S + PV(X)
= 7.55 100 + (100 / 1.06)
= 1.89
The risk-neutral pricing
method
Two ways of pricing options





In the risk-neutral world:
Investors are indifferent to risk
The expected return of a stock is equal to the risk-free rate
We can find the risk-neutral probabilities of up or down movements in stock prices
Stock and bond replication Risk-neutral valuation
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Risk-Neutral Valuation

! Indifference to risk
! Arbitrage Opportunity- buying from a market and selling in
another market. It makes a riskless profit.
! The expected return must be equal to the real option and the
riskless option
Risk-Neutral Pricing
! An alternative approach to identifying the fair value of an option is
to use the models risk-neutral (or risk-adjusted) probabilities.
! This approach is guaranteed to give the same answer as replication,
but is computationally a lot simpler.
! Pricing follows a three-step procedure.
Identify the models risk-neutral probability.
Take expectations of the options payoffs under the risk-neutral probability.
Discount these expectations back to the present at the risk-free rate.
! The number obtained in Step 3 is the fair value of the option.
The Risk-Neutral Probability
! The risk-neutral probability is that probability under which expected
returns on all the models assets are the same.
! For example, the binomial model has two assets: the stock which
returns u or d, and the risk-free asset which returns R. (R = 1+ the
risk-free interest rate.)
! If q and 1 " q denote, respectively, the risk-neutral probabilities of
state u and state d, then q must satisfy
q # u + (1 " q) # d = R.
! This means the risk-neutral probability in the binomial model is
q = R " d/ u " d

Risk-Neutral Pricing: An Example
! Consider the one-period binomial example in which u = 1.10, d =
0.90, and R = 1.02.
In this case, q = 1.02 " 0.90/ 1.10 " 0.90 = 0.60.
! Therefore, the expected payoffs of the call under the risk-neutral
probability is
(0.60)(10) + (0.40)(0) = 6.
! Discounting these payoffs back to the present at the risk-free rate
results in 6/ 1.02 = 5.88
Risk-Neutral Pricing: A Second Example

! Now consider pricing the put with strike K = 100.
! The expected payoff from the put at maturity is
(0.60)(0) + (0.40)(10) = 4.
! Discounting this back to the present at the risk-free rate, we
! Obtain
4/ 1.02 = 3.92,
! As these examples show, risk-neutral pricing is
computationally much simpler than replication
! If the investors are risk-neutral, the expected value of the option
is:
[Probability of rise x increase] + [(1 - probability of rise) x
0]
And the current value of the call is:
(Expected future value)/(1 + interest rate)
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Back to the Hersheys example
! Hershey stock is currently priced at $68
and will rise by 25% or fall by 20% over
the next period: Exercise price=$65
! What are the risk-neutral probabilities?
! Price of call using risk-neutral valuation

! Consider a European call option on a Microsoft share (the asset), with a strike
of 30 (the predetermined price) and maturity of one year from today (the
predetermined date). If I pay to enter into this contract I have the right but not
the obligation to buy one share at 30 in a years time. Whether I actually
exercise my right clearly depends on the share price in the market at that date:
If the share price is above 30, say at 35,
If the share price is 40
If the share price is below 30, say at 25
Black-Scholes

! The easiest way to understand the Black-Scholes formula intuitively is to consider what happens
if we exercise the option. This has two parts:
! i) Value of the Cash to Buy the Option

! Firstly, if the option is exercised we pay the strike price (30 in our example). We pay the strike
price only if the underlying stock price is above the strike at maturity. So to work out the
expected value of this we need the probability simply that the stock price is above the strike at
maturity. Lets call this probability N(d2), and the strike price K. Then the expected value of this
is just KN(d2). What N() means, and the value of d2, will be discussed later.
! KN(d2) is the value of the cash flow at maturity. To get the value of this cash flow today we
need to discount it, and the discount factor is
! So the value of the cash to buy the option today is K N(d2)

! ii) Value of the Stock Received if any
! Secondly, if the option is exercised we get a unit of the stock. This is
clearly worth whatever the stock price is in the market at maturity.
But this again only happens if the underlying stock price is above the
strike at maturity.
! It turns out that the expected value of this valued as at today is
proportional to S, the stock price today, and can be written as SN
(d1). That is to say, SN(d1) is the expected value of something that is
equal to the final stock price if the final stock price is above the
strike, and equal to zero if the final stock price is below the strike.
The Formula
! Finally, note that if I have bought the call I am paying the cash amount in i) above and receiving the value
of the stock ii). So we can say that the value, c, of a European call option on a non-dividend paying stock
is:
! d1 and d2
! whilst these formulas are complicated, you can just plug in the underlying values and get a
result:
! Here sigma ($) is volatility.