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John C. Hull, Options, Futures and Other Derivatives (6th Edition) New York: Prentice Hall
Ch-11
Binomial Trees
One-step Binomial
RiskNeutral Valuation
Two-step Binomial Trees
Matching Volatility with u and d
Ch-13
BlackScholes-Merton Model
Stock Price Properties
Volatility
BlackScholesMerton Differential Equation
BlackScholes Option Pricing Formulas
BlackScholesMerton
Risk-Neutral Valuation
Implied Volatilities
Hull, Chapter 9
Notations:
So Current stock price
K
Strike price (aka, exercise price)
T
Time to expiration (aka, term)
ST Stock price at maturity
R
Continuously compounded risk-free interest rate
C
Value of American call option (option to buy one share)
P
Value of American put option (option to sell one share)
c
Value of European call option (option to buy one share)
p
Value of European put option (option to sell one share)
Factors Affecting Option Prices
Identify the six factors that affect an options price and discuss how the six factors affect an
options price for both European and American options.
In the chart below, we show the directional impact of each input on the value of a call or put:
Stock price: For a call option, a higher stock price implies greater intrinsic value
Strike price: For a call option, a higher strike price implies less intrinsic value
Volatility: Greater volatility increases the value of both a call and a put option
Risk-free rate: For a European call option, consider that the minimum value of an
option is the stock minus the discounted strike price. A higher riskfree rate implies a
lower discounted strike price; therefore, a higher riskfree rate increases the value of
the call option.
Dividend yield: As the option holder forgoes the dividend, a higher dividend
reduces the call options value.
PutCall Parity
Explain putcall parity and calculate, using the putcall parity on a nondividendpaying stock, the value of
a European and American option, respectively
Putcall parity is based on a no-arbitrage argument; it can be shown that arbitrage opportunities exist if putcall
parity does not hold. Putcall parity is given by:
c + Ke^-rT = p + So
c = p Ke^-rT + So
Example
Assume we know the value of a European put is $2. The risk less rate is
5%. What is the value of a one-year call option where the strike (exercise)
price is $10 and the stock price is $10?
Putcall parity applies to European options (note the use of small c and small
p in the equation).
An American call on a non-dividend paying stock must be worth at least its
European analogue
The difference between an American call and an American put (CP) is
bounded by the following:
Hull, Chapter 11
Binomial Trees
One-step Binomial
RiskNeutral Valuation
Two-step Binomial Trees
Matching Volatility with u and d
11
Calculate, using the onestep and twostep binomial model, the value of a
European call or put option
22n-1 = 18n
n = 0.25
A Riskless Portfolio is LONG 0.25 Shares + Short one
Option.
A Generalization
S0un fu = S0dn fd
n = ( fd fu ) / (S0u - S0d)
(-rT)
=> f = Son(1-ue^-rT) + fu*e^-rT
Rf = 12% pa.
=> f =0.633
The principle of riskneutral valuation says that we can generalize: when pricing an option under the
riskneutral assumption, our result will be accurate in the real world (i.e., where individuals are not
indifferent to risk).
Assess the impact dividends have on the binomial model If the stock pays a known
dividend yield at rate (q), the probability (p) of an up movement is adjusted:
Options on currencies
Analogous to the adaptation of the cost of carry model to foreign exchange forwards, if (rf) is the
foreign risk-free rate, we can use:
Options on Futures
Since it costs nothing to take a long or short position in a futures contract, in a risk-neutral world the
futures price has an expected growth rate of zero. In this case, we can use:
Hull, Chapter 13
The BlackScholes-Merton Model
Implied Volatilities
BlackScholesMerton
Risk-Neutral Valuation
Company Warrants
Initial
Final
Arithmetic Avg.
Geometric Avg
$100.00
$115.00
$138.00
$179.40
$143.52
$179.40
Realized(continuous)
Period Return
15%
20%
30%
-20%
25%
14.00%
12.40%
$179.40
11.69%
$179.40
No dividends
The risk-free rate of interest is constant and the same for all maturities (constant
riskless rate)
Calculate the value of a European option using the BlackScholes-Merton model on non-dividend stock
EXAMPLE :
Calculate the value of a European
option using the Black-Scholes-Merton
model on non-dividend stock
So
10
d1
0.992
N(d1)
K
0.839401
9
5%
0.5
d2
NORMSDIST(H21)
0.851
N(d2)
0.802615
NORMSDIST(H26)
1.348824
H20*H22-H23*EXP(-H24*H25)*H27
Implied Volatilities
Assume:
Stock price (S) is $10
Strike (K) is $10
Term (t) is six months (0.5)
Riskless rate is 5%
Call price is $1.25
$1.25 = Black-Scholes[ $10,$10,t=0.5 years, r = 5%, ]
= 0.405
Cannot be inverted,
needs iteration (goal seek)