OPTIONS

Overview of Lecture

Valuing Options

An Option Pricing Formula

The ‘Greeks’

Shares and Bonds as Options

Options and Corporate Decisions

 Options

An option is a contract
giving its owner the
right to buy or sell an Exercising the option Strike or exercise price
asset at a fixed price on
or before a given date.

American and European

Expiration date
options
 Call Options

There is no restriction on
A call option gives the
the kind of asset, but the
owner the right to buy an
most common ones traded
asset at a fixed price
on exchanges are options
during a particular period.
on shares and bonds.
 The Value of a Call Option at
Expiration
• A call option on Associated British Foods equity
enables an investor to buy 100 shares of
Associated British Foods on or before July 15 at
an exercise price of £7.00.
• Suppose the share price is £8.00 at expiration.
The buyer of the call option has the right to buy
the underlying shares at the exercise price of
£7.00. In other words, he has the right to exercise
the call.
• The value of this right is £1.00 (= £8.00 – £7.00)
on the expiration day.
The Value of a Call Option at
Expiration
 Example 1: Call Option
Payoffs
• Suppose Mr. Optimist holds a one-year call option on Agfa Gevaert. It
is a European call option and can be exercised at €1.80. Assume that
the expiration date has arrived. What is the value of the Agfa Gevaert
call option on the expiration date?
• If Agfa Gevaert is selling for €2.00 per share, Mr. Optimist can
exercise the optionpurchase Agfa Gevaert at £1.80and then
immediately sell the share at €2.00. Mr. Optimist will have made €.20
(= €2,00 – €1.80). Thus, the price of this call option must be €.20 at
expiration.
• Instead, assume that Agfa Gevaert is selling for €1.00 per share on
the expiration date. If Mr. Optimist still holds the call option, he will
throw it out. The value of the Agfa Gevaert call on the expiration date
will be zero in this case.
 Put Options

There is no restriction on
A put option gives the
the kind of asset, but the
owner the right to sell an
most common ones traded
asset at a fixed price
on exchanges are options
during a particular period.
on shares and bonds.
The Value of a Put Option at
Expiration
• Assume that the exercise price of the put is £50 and
the share price at expiration is £40. The owner of this
put option has the right to sell the share for more than
it is worth. That is, he can buy the share at the market
price of £40 and immediately sell it at the exercise
price of £50, generating a profit of £10 (= £50 – £40).
Thus, the value of the option at expiration must be
£10.
• Suppose that the equity at expiration is trading at £60.
The owner of the put would not want to exercise here.
That is, he will let the put option expire.
The Value of a Put Option at
Expiration
 Example 2: Put Option Payoffs
• Ms. Pessimist believes that Bayer AG will fall from its current
€42.00 share price. She buys a put. Her put option contract
gives her the right to sell a share of Bayer equity at €42.00
one year from now. If the price of Bayer is €44.00 on the
expiration date, she will tear up the put option contract
because it is worthless. That is, she will not want to sell
shares worth €44.00 for the exercise price of €42.00.
• On the other hand, if Bayer is selling for €40.00 on the
expiration date, she will exercise the option. In this case she
can buy a share of Bayer in the market for €40.00 and turn
around and sell the share at the exercise price of €42.00. Her
profit will be €2.00 (= €42.00 – €40.00). The value of the put
option on the expiration date therefore will be €2.00.
Option Quotes
 Why do we care about options?
• They can be used for both hedging and speculation.
• Hedging or Insurance: Suppose you own Microsoft
shares which is currently trading at £100 but you
expect the price to drop in the future.
• You can insure your losses by buying put option, with
an exercise price of, say, £80.
• Suppose that the price drops to £75. He could buy the
stock from the market at £75 and sell it for £80 and
recover £5 so that his pay-off is £80 and losses are
limited to £20 ( £100 - £80). Alternatively, he could sell
the put options for £5.
 Speculation
• Suppose Microsoft stock is selling at ce is £100
and a call with exercise price of £110 sells at £5 (
price of call option).
• Investor can buy 1000 options and if the price of
the Microsoft increase to £150 on the expiration
date, each option will be worth £40
and the return is £(40,000 – 5000)/£5000 = 700%.
• The return on stock is: with £5,000, the investor
could buy 50 shares and would realize £(150-
100)(50 shares)/£5000 = 50%.
 Speculation
• On the other hand, if the stock price increase
to £110, a stock holder will earn 10% but the
option holder will earn 0.
• Hence, options are high risk-high return assets
compared to stocks.
Option Quotes
 Put Call Parity
• The idea is: Prices of put options and call
options can not be independent.
• The arbitrage possibilities between various
portfolios bring them together.
• Consider two portfolios: A and B.
• Portfolio A: Buy the stock and buy a put.
• Portfolio B: Buy a call and invest the present
value of the exercise price.
 Put call Parity
Pay-off at the expiration date
S <(=)X S>X
• Portfolio A:
i. Buy the Stock: S S
ii. Buy the put : X-S 0

• Portfolio B
i. Buy one call 0 S-X
ii. Invest PV of X X
Exercise price:

Stock price at the expiration date = S and exercise price = X

Both portfolio A and B will earn the same return on the expiration date.
Hence, costs of buying them must be equal. Hence, the put-call parity.
 Put-Call Parity

Price of underlying Price of Price of Present value of

 = +
equity put call exercise price

Price of underlying Price of Price of Present value of

  +
equity call put exercise price
 Put Call Parity: An Example
• Nokia Oyj shares are selling for €10.95. A
three-month call option with an €10.95 strike
price goes for €0.35. The risk-free rate is .5
percent per month. What’s the value of a
three-month put option with a €10.95 strike
price?
Price of Price of underlying Price of Present value
=  +
put equity call of strike price
=  €10.95  €0.35  €10.95 / 1.0053
= €0.1873
Factors Determining Call Option
Values

Expiration
Exercise Price Share Price
Date

Underlying The Interest

Asset Volatility Rate
 The Value of an
American Call as a Function of the
Share Price
Option Value Determinants
 An Option Pricing Formula

Binomial Black-Scholes
Option Pricing Option Pricing
Formula Formula
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

t=0 t=1
Cu
C
Cd
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

t=0 t=1
Cu
C
Cd
Replicating portfolio approach
• Key assumption: No arbitrage
opportunities exist
Payoff of Payoff of
replicating option
If portfolio =

They must cost the same today .

 Numerical example
• Consider a stock that is currently priced at £100 and will either be £110 or £ 90 at the end of
one year.

Su =110
S =100
Sd =90
• The one-period risk-free rate is 6%. A $1 investment in a bond pays off:

1.06

B=1
1.06
(3.a) 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

Constructing the replicating portfolio

• Recall the path of the stock price:

Su =110
S =100
Sd =90
• Path of call price on above stock with X = $100:
Pay-off from Call option
Cu = max (0, Su – X) = 10

C = ??
Cd = max (0, Sd – X) = 0
• Path of replicating portfolio consisting of  shares of stock
and B in bonds:
 110  1.06 B
Cost=  100  B
 90  1.06 B

• Path of call price: Cu = 10

C = ??
• Choose  and B so that: Cd = 0

 110  1.06 B = 10

 90  1.06 B = 0
 Finding the exact ∆ and B
• Two equations, two unknowns:
 110  1.06 B = 10
 90  1.06 B = 0
• Solving these two equations yields:
 = 0.5
B = 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:

Su =110
S =100
Sd =90
The value of the portfolio (at t = 1):
Up state: Down state:
Portfoliou =  Su 1.06 B Portfoliod =  Sd 1.06 B
= .5 (110)  (1.06)(42.45) = .5 (90)  (1.06)(42.45)
= 10 =0
 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.
 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:
c u  cd

S u  Sd

Step 3: Find B (the amount borrowed) by setting the terminal

payoff of the replicating portfolio equal to the terminal payoff
of the option:
 Sd  (1+r) B = Cd

Step 4: Using option  and B, calculate the price of call:

C=SB
 The Black-Scholes Model

Rt
C  SN(d1 )  Ee N(d 2 )

d1  [ln(S/E ) + (R   /2)t ] /  t
2 2

d 2  d1   t
2
 Example 22.4: Black-Scholes
• Consider Private Equipment Company (PEC). On
October 4 of year 0, the PEC April 21 call option
(exercise price = £49) had a closing value of £4.
The equity itself was selling at £50. On October 4,
the option had 199 days to expiration (maturity
date = April 21, year 1). The annual risk-free
interest rate, continuously compounded, was 7
percent. The variance of Private Equipment
Corporation has been estimated to be .09 per
year.
• What is the value of the option?
 Example 22.4: Black-Scholes
 S 
d1  ln    ( R   /2)t 
2
 2t
 E 
  50  199  199
 ln    (.07  .09/2)   .09 
  49  365  365
 [.0202  .0627] / .2215  .3742
d 2  d1   2 t
 .1527
Example 22.4: Black-Scholes

N(d1) = N(.3742) = .6459

N(d2) = N(.1527) = .5607
 Cumulative Probabilities
of the Standard Normal
Distribution
 Example: Black-Scholes

C  S  [N(d1 )]  Ee Rt  [N(d 2 )]

 £50  [N(d1 )]  £49  e –.07(199/365) ]  N(d 2 )
 (£50  .6459)  (£49  .9626  .5607)
 £32.295  £26.447
 £5.85
 The Black-Scholes Model
Rt
C  S  N(d1 )  Ee N(d 2 )
• Value of call = Share price  Delta – Amount
borrowed
 The ‘Greeks’
• Rate of change in the value of an option with respect to a
Delta change in the underlying equity’s share price

• Rate of change in Delta with respect to a change in the

Gamma value of the underlying share price.

• Rate of change in the value of an option with respect to

Theta the change in time to maturity of the option

• Rate of change in an option’s value with respect to

Vega changes in its implied volatility