Option Valuation

Option Valuation
Copyright 2000 2006 Investment Analytics
Agenda
Lattice methods of valuation Binomial model Black Scholes Model Extensions to Black Scholes
Copyright 2000-2006 Investment Analytics
Option Valuation
Slide: 2
Why Valuation Models?

Pricing / Trading
Only know terminal payoff value Need to know interim value
Risk Management
A model will tell us how sensitive a derivative is to changes in market factors
Option Valuation
Slide: 3
Option Pricing
Option payoff depends on stock price Need to model stock prices
Binomial models Continuous time models
Option values depend on stock volatility
Option Valuation
Slide: 4
Binomial Model
Looks at stock price movement over small periods of time t Start with one period, t = 1
It turns out quite easy to determine option price in this case
Then many periods

Ultimately we can model infinite number of up/down movements This is continuous time
Copyright 2000-2006 Investment Analytics Option Valuation Slide: 5
Binomial Price Tree

Su
Sd
Usual to assume u > 1 > d

One-Period Model Example

S = 100, u = 2, d = 0.5
Su = 200 Sd = 50
Interest rate: 10%

Bond price 100 today, 110 in one period
Suppose call strike price is 100 What is price of call option?

One-Period Model
At Su
Stock worth 200 Option pays 100 Bond worth 110
At Sd
Stock worth 50 Option worth 0 Bond worth 110
Option Valuation
Slide: 8
One-Period Model
Up
Stock Bond Call 200 110 100
Down
50 110 0
But look at a portfolio of 0.6667 stocks and -0.30303 bonds: produces the same payoff as the call! UP: (0.6667*200) - (0.30303*110) = 100 Down: (0.6667*50) - (0.30303*110) = 0
Replication
The payoff of the call can be replicated
Using the stock and the bond, combined in a portfolio
The call and the portfolio must be worth the same

Because they have the same payoff
So we know the value of the call!

Because we know the value of the replicating portfolio In this case: C = (100*0.6667) - (0.30303*100) = $36.37
This tells us 2 things:

How to price the call How to create the call if it didnt exist
Option Valuation
Slide: 10
Replication - General Formula

In general, need to solve:
Cu = max{Su-X, 0} = nSu + m B(1 + rf) Cd =max{Sd-X,0} = nSd + m B(1 + rf) n = # stocks, m = #bonds
B(1 + rf) = value of bond at end of period
Solution:
n = (Cu-Cd)/(Su-Sd)
is also called the delta of the option, will see it again
m = [SuCd - SdCu]/[B(1 + rf) (Su-Sd)]

Risk Neutral Valuation

Define = (1 + rf) - d u-d Then S = Su + (1- )Sd (1 + rf) C = Cu + (1- )Cd (1 + rf)
Risk Neutral Probability

Interpretation:
is the risk-neutral probability S is the NPV of expected future stock cash flows C is the NPV of expected future option cash flows
Risk-Neutral:
Expected future cash flows are discounted using the risk-free rate: DF = 1 / (1 + rf) This is true in a risk-neutral world, where there is no premium for risk
Two Period Model

Extension of replication idea:
Must replicate dynamically
Work backwards Solve a sequence of 1period problems Su S Sd Sdd Sud Suu
Option Valuation
Slide: 14
Delta Hedging
We know how to value options Next: how to manage risk
Option Valuation
Slide: 15
Option Value & Stock Prices

Option value changes as stock moves:
Up move: call value increases, put value falls Down move: put value increases, call value falls
Delta measures sensitivity of option price to stock movements:

Delta = (Change in option price) (Change in stock price)
Option Valuation
Slide: 16
Rebalancing
Option deltas change as stock price moves
So, position deltas change too
Need to rebalance portfolio periodically to keep it delta neutral Example: Long 10 calls, delta = 5
Hedge this position by selling 5 stocks Now stock move up, and call delta increases to 0.6 Position delta is (10x0.6) - 5 = 1 Need to sell another stock to rebalance to delta neutral
Delta Hedging: General Case

Idea: Replicate an option position using stock and bonds Suppose we have 1 call and sell stock Need to solve:
- Su + Cu = Br - Sd + Cd = Br
Then = (Cu - Cd) / (Su - Sd)

The Black-Scholes Model

Can be viewed as limit of the binomial model
What happens as the time interval between up/down movements goes to zero.
Take a time period t, divide it into n intervals

Let = volatility of the stock
u = exp{t/n}, d = 1/u This value ensures process has correct volatility
Option Valuation
Slide: 19
Black-Scholes Model
In limit, stock price process has the following properties:
a) returns are normally distributed b) returns over different periods are independent c) stock prices over any interval are log-normally distributed
Formally, can be represented by a continuous time stochastic process
Option Valuation
Slide: 20
Continuous Time Random Walk Model

Stochastic Differential Equation
S is stock price is drift factor is stock volatility
dS = dt + dX S
X is Weiner Process
X = (t)1/2 is standardized Normal random variate
Black-Scholes Equation
Consider delta-hedged option portfolio
Must grow at risk free rate, else arbitrage
Leads to following relationship:
V 1 2 2 V V + S + rS = rV 2 S S t 2
2
Theta
Gamma
Option Valuation
Delta
Slide: 22
Black-Scholes Option Pricing

Solution of Black-Scholes equation:
C = SN ( d ) Xe N ( d )
rt 1 2
P = Xe N ( d ) SN ( d )
rt 2 1
ln( S / X ) + ( r + / 2 )t d = t d = d t
2 1 2 1
Option Valuation
Slide: 23
Properties of the Model

Call prices increase with S, r Put prices decrease S, r Both prices increase with volatility Value depends on time to maturity
Called time decay
Option Valuation
Slide: 24
Application
IBM Options
S = 107 1/2, strike = 105, Call option Expiration:
Sat after third Fri = July 20 0.137 years
Int rate: use 6.15% Volatility 30%
Option Valuation
Slide: 25
Option Calculator Pricing
Option Valuation
Slide: 26
Implied Volatility
Use quoted option price to back out volatility
Using Newton-Raphson or other iterative method
Volatility estimate implicit in option price

Assuming Black-Scholes model used
Markets estimate of future volatility

Over the life of the option May be higher or lower than historical volatility
Option prices often quoted in terms of implied volatility

Application: Implied Volatility

Sun Microsystems Options
S = 104, strike = 95 Option price $11.5 Expiration (Aug options):
0.08 years
Int rate: 6.15%
Implied Volatility: 53.29%

Option Calculator - Implied Vol
Option Valuation
Slide: 29
Black-Scholes Assumptions
Returns are normally distributed
In reality return distributions are non-Normal Can modify model to accommodate other forms of distribution (Student T, Pareto-Levy)
Zero transaction costs

Bid-Offer spreads and other costs can be factored in
Volatility is static
In fact volatility is stochastic Use GARCH & other stochastic volatility models
Limitations of Black Scholes

Stocks
Cannot handle dividends American options
Options on Futures
Assumes underlying is deliverable today
Foreign exchange
Two assets both paying dividend
Domestic and foreign risk free rate
Bonds
Bonds prices are constrained, unlike stocks
Validity of Black-Scholes Model

Can be extended quite easily
Asset classes
Dividends Foreign Exchange Futures
More realistic assumptions

E.g. stochastic volatility
Vanilla model is a benchmark

May not use it to value options, but use for reference quotes
Extensions of Black Scholes

Index Options
Options on e.g. the S&P500
European options, but with dividends
Mertons model
Extension of Black Scholes Underlying asset pays continuous dividends Good approximation for S&P500
not as good for smaller indices
Mertons Model
C = Se
qt
N ( d ) Xe
1
rt
N (d )
2
P = Xe rt N ( d 2 ) Se rt N ( d 1 ) ln( S / X ) + ( r q + d1 = t d
2 2
2 )t
= d
1
q: dividend yield Futures: q = r Currencies q = foreign interest rate

Option Valuation Slide: 34
Application to Index Options

S&P500 Index 1368.36 Yield: 2% June options (mature June 22) t = 0.06 Risk free rate: 6.15% 1375 call priced at 45.25 Option trading at implied vol. of 34.46%
Option Valuation
Slide: 35
Option Calculator: S&P500 Index Options
Option Valuation
Slide: 36
Foreign Exchange Options

Garman-Kohlhagen model
Identical to Mertons model q is foreign risk free rate Holding cost
h=r-q
Option Valuation
Slide: 37
Blacks Model
Simple extension of Black-Scholes
Originally developed for commodity futures Used to value caps and floors Let F = forward price, X = strike price Value of call option: C = e rt [ FN ( d ) XN ( d )]
1 2
ln( F / X ) + ( / 2 ) t d = t d = d t
2 1 2 1
Option Valuation
Slide: 38
Application to Caps
Example: 1-year cap
NP = notional principal Rj = reference rate at reset period j Rx = strike rate Then, get NP x Max{Rj - Rx,0} in arrears But this is an option on Rj, not Fj Use Fj as an estimator of Rj and apply Blacks model to Fj
Previously was a forward price, now a forward rate
Blacks Model for Caps

Payments: NP x Max{Rj - Rx,0} in arrears These are a series of options:
One for each Rj , the future spot interest rate Called caplets
Let Fj = forward rate from j to j+1 Value of caplet j:

Discount by (1+ Fj) as paid in arrears
C = NP x e-rt[FjN(d1) - RxN(d2)] / (1 + Fj)

Blacks Model - Example

8% cap on 3-m LIBOR (Rx = Strike = 8%)
Capped for period of 3m, in 1-years time f = 1-year forward rate for 3m LIBOR is 7% Rf = 1-year spot rate is 6.5% Yield volatility is 20% pa Blacks Model - Example Spreadsheet
See Excel workbook
Option Valuation
Slide: 41
Blacks Model - Example

Fwd Vol R C/P E/A HCost Strike Term f Rate C = BSOpt (8%, 1, 0, 7%, 20%, 6.5%, 0, 0, 0)
Holding Cost
Hcost = (Rf-d) for stocks, 0 for Futures
Cap Premium = 0.00211
Convert to %: C% = C x t / (1 + F * t)
0.00211 x 0.25 x 1 / (1 + 7% x 0.25) Cap Premium % = 0.0518% (5.18bp) So cost of capping $1000,000 loan would be $518
Blacks Model - Equivalent Formulation in Terms of Price

Cap = Put option on price
Equivalent of call option on rate
Useful if know price volatility rather than yield vol.
F = 1 / (1 + f x t) is forward price
F = 1 / (1 + 7% x 0.25) = 0.982801
X = 1/(1 + Rx x t) is strike price Require price volatility

Other parameters as before
X = 1 / (1 + 8% x 0.25) = 0.980392
Option Valuation
Slide: 43
Blacks Model - Price Example

Strike Term
C = BSOpt (.980392, 1, 0, 0.982801, 0.3702%, 6.5%, 1, 0, 0)
Fwd Price
Vol
Rf C/P E/A
Cap Premium % = 0.0518% (5.18bp)

So cost of capping $1000,000 loan would be $518
HCost
NOTE:
Premium already expressed as % of FV This time we are price a put option
Option Valuation
Slide: 44
Limitations of Blacks Model

Problems:
Unbiasedness: empirically false Option on Rj not same as option on Fj Discount rate: fixed - but Fj variable
Rates both stochastic and fixed!
If applied to prices the additional problem

Assumes prices can be any positive number But cant exceed value of future cash flows
Time Dependent Volatility

Black-Scholes still valid if is function of time t 1 2 Instead of , use: (t) = ( ) d
Fit (t) to implied volatilities of options of varying maturities
Option Valuation
Slide: 46
Stochastic Volatility
d = p(S, , t)dt + q(S, , t)dX
X is a Weiner process
Example: GARCH(1,1) model
t2+1 = + t2 + t2
{et}is a white noise process
Black-Scholes differential equation includes V extra terms:
( p q )
(S, s, t) is market price of volatility risk

Volatility Smiles & Surfaces

Implied volatilities of options with different strikes varies
Inconsistent with Black-Scholes Implies volatilities of OTM options typically greater than ATM options
Smile: Plot IV vs. Strike

Shows smile effect
Surface: Plot IV vs. Strike & Maturity

Volatility Smile Example
Option Valuation
Slide: 49
Volatility Surface Example
Option Valuation
Slide: 50
Lab: YAHOO
Construct implied volatility smile & surface
Option Valuation
Slide: 51
Solution: YAHOO
73% 73%
72%
72%
71%
71%
95 100 105 110 115 0.07 0.15 0.32 0.57
70%
Option Valuation
Slide: 52
Solution: YAHOO
73%
73%
72%
72%
71%
71% 95 100 105 0.32 110 0.15 115 0.07 70% 0.57
Option Valuation
Slide: 53
Non-Normal Models
Significant skewness and excess kurtosis in returns
Increases with sampling frequency Skewness = E[( X ) 3 ] / 3
0 for Normal distribution
Kurtosis
= E[( X ) 4 ] / 4
3 for Normal distribution
Option Valuation
Slide: 54
MOT 5-Minute Returns

MOT 5-Minute Returns
140 120 100 80 60 40 20 0 -2.00% -1.00% 0.00% 1.00% 2.00%
Kurtosis = 27.5
Option Valuation
Slide: 55
Impact on Options
Option Valuation
ATM / OTM options undervalued
Volatility Curve
Volatility curve smiles & skews
Risk Measurment
VaR Option Greeks
Modeling Non-Normality
Extreme value distributions
Models maximum values
Normal mixture models

Simulate market jumps
Option Valuation
Slide: 57
Extreme Value Distributions

Extreme value Mn
Mn = Max(X1, . . . , Xn) Standardized: Yn = (Mn n) / n
Generalized Extreme Value Distn

exp e y if = 0 F ( y) = exp (1 + y ) 1/ if 0, (1 + y ) > 0
Option Valuation
Slide: 58
Extreme Value Distributions

Gumbel: tail index = 0
Positive skew Exponential tails Normal or Lognormal returns
Weibull: tail index = <0

Uniform density in returns
Frechet: tail index = >0

Returns generated by GARCH, Student-t or stable Pareto
Gumbel Density
Gumbel
0.40 0.35 0.30 0.25 0.20 0.15 0.10 0.05 0.00 -1.0 -0.6 -0.2 0.2 0.6 1.0 1.4 1.8 2.2 2.6 3.0 3.4 3.8 4.2 4.6 5.0 5.4
Option Valuation
Slide: 60
Normal Mixtures
Weighted sum of two Normal processes
Low volatility High volatility (jumps)
g ( y ) = 1 ( y ) + (1 )2 ( y )
Option Valuation
Slide: 61
Moments of Normal Mixture

Mean
Weighted sum of means (zero)
Variance - weighted sum of variances M = i i2 Skewness zero 2 2 Kurtosis 3 4 /
Option Valuation
Slide: 62
Selecting Appropriate Mixtures

Three parameters
, 1 and 2 Need three equations to solve Match variance, kurtosis and sixth moment of empirical distribution
Option Valuation
Slide: 63
Applications
Option Pricing
Using MCS
Value at Risk
Improves measure of tail risk
Option Valuation
Slide: 64
Option Pricing with Kurtosis

Kurtosis will affect option value if present over life of option
Hence typically more relevant to shorter dated option
Option value is weighted sum of price under each density in mixture P = 1 f ( 1 ) + . .. + n f ( n )

f(i) is option price assuming normal distribution with volatility i NB: NOT price at volatility of mixture distribution
Option Pricing with Normal Mixture

45 day Call option
$105 strike, $100 stock
Normal mixture
Vol1 = 15% Vol2 = 30% Probability of jump = 0.5 Expected vol 22.5%
Option Valuation
Slide: 66
Normal Mixture Example

0.1400 0.1200
0.1000
0.0800
0.0600
0.0400
0.0200
0.0000 80 82 84 86 88 90 92 94 96 98 100 102 104 106 108 110 112 114 116 118 Strike
Option Valuation
Slide: 67
Jump Diffusion
Brownian Motion with jumps
dS = dt + dX + ( J 1)dq S
Poisson process
dq = 0 with probability (1-)dt dq = 1 with probability dt
is the inter-arrival time of jumps
Jump Diffusion Example

Jump Diffusion
160 140 120 100 80 60 40 20 0 0.0 0.9 1.7 2.6 3.5 4.3 5.2 6.0 6.9 7.8 8.6 9.5 10.3 11.2 12.1 12.9 13.8 14.6
Option Valuation
Slide: 69
Ito with Jump Diffusion

Hold portfolio
Option and of stock =V(S,t) - S
V 1 2 2 2V V dt + d = + S dS + (V ( JS , t ) V ( S , t ) ( J 1) S )dq t 2 S 2 S
If dq = 0 then = V/S eliminates risk If there is a jump the portfolio changes by an amount that cannot be hedged away
Option Valuation Slide: 70
Pricing with Jump Diffusion

Merton (1976):
if jump component is uncorrelated then jump risk should not be priced in
Since diversifiable
Option value is weighted sum of n BlackScholes values

Weights are probability of n jumps
1 t e ( t ) n VBS ( S , t ; n , rn ) n! n =1
Copyright 2000-2006 Investment Analytics Option Valuation
= (1 + E[ J 1])
Slide: 71
Jump Diffusion Option Pricing

Jump Diffusion vs Black-Scholes
60.0 50.0 40.0 30.0 20.0 10.0 0.0 60 70 80 90 100 110 120 130 140 BS JD
Option Valuation
Slide: 72
Summary: Option Valuation

Binomial
Option replication
Black-Scholes
Limiting case of binomial
Simple extensions
Merton Black
More complex extensions

Stochastic Volatility Extreme value Jump models
Option Valuation
Slide: 73

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Copyright 2000-2006 Investment Analytics

Why Valuation Models?

Copyright 2000-2006 Investment Analytics

Option values depend on stock volatility

Copyright 2000-2006 Investment Analytics

Then many periods

Binomial Price Tree

Usual to assume u > 1 > d

One-Period Model Example

Interest rate: 10%

Suppose call strike price is 100 What is price of call option?

Copyright 2000-2006 Investment Analytics

The call and the portfolio must be worth the same

So we know the value of the call!

This tells us 2 things:

Copyright 2000-2006 Investment Analytics

Replication - General Formula

m = [SuCd - SdCu]/[B(1 + rf) (Su-Sd)]

Risk Neutral Valuation

Risk Neutral Probability

Two Period Model

Copyright 2000-2006 Investment Analytics

Copyright 2000-2006 Investment Analytics

Option Value & Stock Prices

Delta measures sensitivity of option price to stock movements:

Copyright 2000-2006 Investment Analytics

Delta Hedging: General Case

Then = (Cu - Cd) / (Su - Sd)

The Black-Scholes Model

Take a time period t, divide it into n intervals

Copyright 2000-2006 Investment Analytics

Formally, can be represented by a continuous time stochastic process

Copyright 2000-2006 Investment Analytics

Continuous Time Random Walk Model

S is stock price is drift factor is stock volatility

Leads to following relationship:

Copyright 2000-2006 Investment Analytics

Black-Scholes Option Pricing

Copyright 2000-2006 Investment Analytics

Properties of the Model

Copyright 2000-2006 Investment Analytics

Int rate: use 6.15% Volatility 30%

Copyright 2000-2006 Investment Analytics

Option Calculator Pricing

Copyright 2000-2006 Investment Analytics

Volatility estimate implicit in option price

Markets estimate of future volatility

Option prices often quoted in terms of implied volatility

Application: Implied Volatility

Int rate: 6.15%

Implied Volatility: 53.29%

Option Calculator - Implied Vol

Copyright 2000-2006 Investment Analytics

Zero transaction costs

Limitations of Black Scholes

Validity of Black-Scholes Model

More realistic assumptions

Vanilla model is a benchmark

Extensions of Black Scholes

q: dividend yield Futures: q = r Currencies q = foreign interest rate

Copyright 2000-2006 Investment Analytics