Chapter 21: Option Valuation

Prepared by Cheng Savuth

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McGraw-Hill/Irwin
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Introduction
We examine two model used to price options:
1. Binomial method
2. Black-Scholes method

Both method is based on risk-neutral pricing, that is being able to perfectly

replicate the option payoffs with the underlying and risk-free bonds.

If that is true, then it must be the case that the option value is exactly the
same as the cost of the so-called replicating strategy. If it is not, to exploit,
buy the cheap one and sell the expensive one (arbitrage).

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Option Valuation: Intrinsic and Time Values

The value S0 - X is sometimes called the

intrinsic value of in-the-money call
options because it gives the payoff that
could be obtained by immediate exercise.
Intrinsic value = 0 for option is at or out-
of-the-money
Time value = actual option price
intrinsic value
As the stock price gets ever larger, the
option value approaches the adjusted
intrinsic value, the stock price minus the
present value of the exercise price, S0 -
PV(X ).
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Determinants of Option Values

We can identify at least six

factors that should affect the
value of a call option:
the stock price (+)
the exercise price (-)
the volatility of the stock
price (+)
the time to expiration (+),
the interest rate (+)
the dividend rate of the
stock (-)

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Binomial Option Pricing: Two-State Option Pricing

Assume that a stock price can take only two possible values at option
expiration: The stock will either increase to a given higher price or
decrease to a given lower price.

Based on this we can replicate two portfolio.

1. A call option on stock
2. A portfolio consisting of stock and bond (T-bill)

If these two portfolio provide the same pay-off they in the future. They
should be cost the same to establish.

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Binomial Option Pricing: Two-State Option Pricing

A call option on the stock might specify At year-end, the payoff to the holder of the
an exercise price of X=$110 and a time to call option will be either zero, if the stock
expiration of 1 year. falls, or $10, if the stock price goes to $120.
Suppose the stock now sells at S0=$100,
These possibilities are illustrated by the
and the price will
following value trees:
either increase by a factor of u=1.20
to Su =$120
or fall by a factor of d = 0.9 to SD
=$90 by year-end.
u is called up factor and d is called down
factor. u and d depends on volatility and
times interval (more to say).
The interest rate is 10%.

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Binomial Option Pricing: Two-State Option Pricing

We want to replicate of pay-off from We know the cash outlay to establish

call option by a portfolio consisting of the portfolio is $18.18 that is $100 for
one share of the stock and the stock, less the $81.82 proceeds
borrowing of $81.82 at the interest from borrowing. Therefore the
rate of 10% portfolios value tree is
Noted that $81.82 is the present value
of $90 (the lower price of stock, SD)
The payoff of this portfolio at year-
end:

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Binomial Option Pricing: Two-State Option Pricing

The payoff of this portfolio is exactly three times that of the call option for either
value of the stock price.

In other words, three call options will exactly replicate the payoff to the portfolio;
it follows that three call options should have the same price as the cost of
establishing the portfolio.

Hence the three calls should sell for the same price as this replicating portfolio.
Therefore, 3C=$18.18 or each call should sell at C= $6.06.

This valuation approach relies heavily on the notion of replication.

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Binomial Option Pricing: Two-State Option Pricing
One way to view the role of
replication is to note that, using
the numbers assumed for this
example, a portfolio made up
of
one share of stock and
three call options written is
perfectly hedged.
Its year-end value is
independent of the ultimate
stock price:
9
The investor has formed a riskless portfolio, with a
payout of $90. Its value must be the present value
of $90, or $90/1.10 = $81.82.
The value of the portfolio, which equals
$100 from the stock held long, and
minus 3C from the three calls written, should
equal $81.82.
Hence $100 - 3C= $81.82, or C = $6.06.
The ability to create a perfect hedge is the key to
this argument.
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Binomial Option Pricing: Two-State Option Pricing

We can generalize the hedge ratio for other two-state option problems as:

where Cu or Cd refers to the call options value when the stock goes up or down,
respectively, and uS0 and dS0 are the stock prices in the two states.
The hedge ratio, H, is the ratio of the swings in the possible end-of-period values
of the option and the stock.
If the investor writes one option and holds H shares of stock, the value of the
portfolio will be unaffected by the stock price.

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Binomial Option Pricing: Two-State Option Pricing

In this case, option pricing is easy: Simply set the value of the hedged portfolio equal to
the present value of the known payoff.
Using our example, the option-pricing technique would proceed as follows:
1. Given the possible end-of-year stock prices, uS0 =120 and dS0 =90, and the exercise
price of 110, calculate that Cu = 10 and Cd =0. The stock price range is 30, while the
option price range is 10.
2. Find that the hedge ratio of 10/30 = 13.
3. Find that a portfolio made up of 13 share with one written call option would have an
end-of-year value of $30 with certainty.
4. Show that the present value of $30 with a 1-year interest rate of 10% is $27.27.
5. Set the value of the hedged position to the present value of the certain payoff:
1/3S0 - C0 = $27.27 or $33.33 - C0 =$27.27
6. Solve for the calls value, C0 = $6.06.
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Binomial Option Pricing: Generalizing the Two-State

Approach

Although the two-state stock price model The probability of upward

seems simplistic, we can generalize it. can be calculated as follows:

To start, suppose we were to break up the

year into two half-year segment the stock
price could take on two values.

u and d should depend on that volatility.

Call your estimate of the standard
deviation.

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Binomial Option Pricing: Generalizing the Two-State

Approach

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Using methods similar to

those we followed above,
we could value Cu from
knowledge of Cuu and Cud
,then value Cd from
knowledge of Cdu and Cdd
, and finally value C from
knowledge of Cu and Cd .
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A Risk-Neutral Shortcut
In a risk-neutral economy, investors would not demand risk premiums and
would therefore value all assets by discounting expected payoffs at the risk-
free rate of interest. Therefore, a call option would be valued at the risk-free
rate:
C=E(CF)/(1+rf )
Because there are no risk premiums, the stocks expected rate of return must
equal the risk-free rate.

Call p the probability that the stock price increases.

Then: E(S) = p(uS) + (1 - p)dS = (1 + rf)S
This implies that p =(1 + rf d)/(u d)

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A Risk-Neutral Shortcut
We call p a risk-neutral probability to distinguish it from the true, or
objective, probability.
To illustrate, in our two-state example at the beginning of Section 21.2,
we had u = 1.2, d = .9, and rf = .10. Given these values,
p =(1 + .10 - .9)/(1.2 - .9)=2/3.
We find the present value of the option payoff using the risk-neutral
probability and discount at the risk-free interest rate:
C=E(CF)/(1+rf)=[pCu+(1-p)Cd ]/(1+rf )=[2/3x10 + 1/3x0]/1.10=6.06

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The Black-Scholes Formula

the Black-Scholes pricing formula for a call option is:

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The Black-Scholes Formula

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The Black-Scholes Formula

This version of the Black-Scholes formula is predicated on the

assumption that the stock pays no dividends.

Although you may find the Black-Scholes formula intimidating, we

can explain it at a somewhat intuitive level.

For middle-range values of N (d) between 0 and 1, Equation 21.1

tells us that the call value can be viewed as the present value of the
calls potential payoff adjusting for the probability of in-the-money
expiration.

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The Black-Scholes Formula

The trick is to view the N (d) terms (loosely) as risk-adjusted probabilities
that the call option will expire in the money.

Assuming both N (d) terms are close to 1, that is, when there is a very high
probability the option will be exercised. Then the call option value is equal
to S0 - Xe -rT , which is the adjusted intrinsic value, S0 -PV(X ).

Assuming the N (d) terms are close to zero, meaning the option almost
certainly will not be exercised. Then the equation confirms that the call is
worth nothing.

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The Black-Scholes Formula

ln( S0 / X ), which appears in the numerator of d1 and d2 , is approximately
the percentage amount by which the option is currently in or out of the
money.

For example, if S0 = 105 and X = 100, the option is 5% in the money, and
ln(105/100) = 0.049. Similarly, if S0 = 95, the option is 5% out of the
money, and ln(95/100) = - 0.051.

The denominator, T, adjusts the amount by which the option is in

or out of the money for the volatility of the stock price over the
remaining life of the option.

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The Black-Scholes Formula

The Black-Scholes valuation formula, as well as the implied volatility, is
easily calculated using an Excel spreadsheet like Spreadsheet 21.1 . The
model inputs are provided in

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The Black-Scholes Formula: Implied

Volatility

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Dividends and Call Option Valuation

Therefore, we would simply replace S0 with S0 - PV(dividends) or S0e- T in the
Black-Scholes formula.

Using the put-call parity theorem.

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Empirical Evidence on Option Pricing

For the most part, the results of the studies have been positive in that the
Black-Scholes model generates option values fairly close to the actual
prices at which options trade.

At the same time, some regular empirical failures of the model have
been noted.

The market might price these options as though there is a bigger chance
of a large drop in the stock price than would be suggested by the Black-
Scholes assumptions.

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