EC3314 Financial

Economics

Spring Lecture 9
Option Valuation

Outline
The Binomial Method of option valuation
The Black-Scholes Model of option valuation
The Replication Method of option valuation

extended over two periods

Spring Lecture 9 - Option Valuation

Generalization
Let S0 be the price of a stock today
Let f be the price of the option on the stock
Let T be the lifetime of the option, during

which time the stock can

Move up by u to S0u, u > 1

Move down by d to S0d, d < 1
Risk Free Rate of interest is r

Percentage increase in stock price when

there is an up movement is u 1
Percentage decrease in stock price when
there is a down movement is 1 d
Spring Lecture 9 - Option Valuation

Generalization
Call payoff from option following an up

movement is fu
Call payoff from option following a down

movement is fd
Imagine a hedged portfolio that is long in

shares and short in one call option.

Then, equating values of the portfolio:
S 0u f u = S 0d f d
= (fu fd)/(S0u S0d) = (fu fd)/S0(u d)
Spring Lecture 9 - Option Valuation

Generalization
S0u
fu
S0u fu

S0
f

S0d
fd

S0 f

S0d fd

Spring Lecture 9 - Option Valuation

Generalization
If the risk free rate of interest is r, then the PV

of the portfolio is
(S0u fu) e-rT [Or (S0d fd) e-rT]
The cost of setting up the portfolio is S0 f
As they must be equal:
(S0u fu) e-rT = S0 f
f = S0(1 ue-rT) + fue-rT
But = (fu fd)/S0(u d)
Spring Lecture 9 - Option Valuation

Generalization

fu fd
S0 1 ue rT fu e rT
f
S0 (u d)

fu fd 1 ue rT fu e rT u d
f
u d
fu fu de rT fd fd ue rT
f
u d
fe

rT

rT
e rTfu fu d e rTfd fd u
d fd u e rT
rT fu e

d
u

Spring Lecture 9 - Option Valuation

Generalization

rT
rT

f
e

f
u

e
rT u
d
fe

u d

Let

e rT d
p,
ud
Then
u e rT
1 p
ud
f e rT pfu 1 p fd
Spring Lecture 9 - Option Valuation

Generalization
From the previous weeks example: u=1.1,

d=0.9, r=0.12, T=0.25, fu=1, fd=0,

p = (e0.12x0.25 0.9)/(1.1 0.9) = 0.6523
f = 0.63
Note that we dont need to know the

probabilities of the up and down movements

in stock price
These probabilities are already incorporated
in the new stock price
Spring Lecture 9 - Option Valuation

Risk-Neutral Valuation

We only need to assume NO ARBITRAGE

Interpret p as the probability of an up movement
(1 p) as the probability of a down movement
Then expected payoff from option at T is

f = pfu + (1-p)fd
For PV of f, discount at the risk free rate.
Since S grows at risk free rate too
This means that we are in a risk neutral world
Everyone is indifferent to risk
Spring Lecture 9 - Option Valuation

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Two-Step Binomial Pricing

S0 = 20, K = 21, u = 1.1, d = 0.9, r = 0.12, T = 0.25
24.2
22
S0 =20

19.8
18
16.2

Spring Lecture 9 - Option Valuation

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Two-Step Binomial Pricing

Call Values
S0 = 20, K = 21, u = 1.1, d = 0.9, r = 0.12, T = 0.25
24.2 D
fuu =3.2
22
S0 =20

B
19.8
fud = 0 E

18

C
16.2
fdd =0

Spring Lecture 9 - Option Valuation

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Two-Step Binomial Pricing

Call Values
24.2
fuu =3.2
22
fu = 2.0257

19.8
fud = 0

Working backwards from Nodes D and E to find call value at

Node B
fu = e-rT [pfu + (1-p) fd] = 2.0257
Where p = (e

0.12x0.25

0.9)/(1.1 0.9) = 0.6523

Spring Lecture 9 - Option Valuation

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Two-Step Binomial Pricing

Call Values
Similarly, work out call value at Node C to

obtain fd = 0

19.8
fud =0
18
fd = 0

C
16.2
fdd = 0

At Node A, find the value of f as

f = e-rT [pfu + (1-p) fd] = 1.2823

Spring Lecture 9 - Option Valuation

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Two-Step Binomial Pricing

Put Values
Put Option: K = 52, r = 0.05 per six months period,

Maturity = 1 year

72
fuu =0

60
A
S0 =50
f = 4.1923

fu =1.415

48
fud = 4

40
fd=9.464

32
fdd =20 F
Spring Lecture 9 - Option Valuation

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Two-Step Binomial Pricing

Valuing an American Put
Assume that K = 52, r = 0.05 per period, Maturity =1 year, So =

50

72
fuu =0

60
A
S0 =50
f = 4.1923

fu =1.415

48
fud = 4

40
fd=9.464

32
fdd =20 F
Spring Lecture 9 - Option Valuation

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Two-Step Binomial Pricing

Valuing an American Put
However for an American put, recall that the

put can be exercised anytime.

The procedure is modified: at each
intermediate (earlier) node (here, at B and C),
test whether early exercise is optimal
The value of the option at intermediate nodes
is the greater of
The value obtained for f
The payoff from early exercise

Spring Lecture 9 - Option Valuation

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Two-Step Binomial Pricing

Valuing an American Put
Assume that K = 52, r=0.05 per period, Maturity =1 year, So = 50

and two periods:

72
fuu =0

60
fu =1.415

S0 =50
f=?

Early exercise:
Max[52 60, 0]
=0

48
fud = 4

40
fd=9.464
Early exercise:
Max[52 40, 0]
= 12
Spring Lecture 9 - Option Valuation

32
fdd =20 F
18

Two-Step Binomial Pricing

Valuing an American Put
Clearly at Nodes D, E and F, the values of fuu, fud,

and fdd are the same as for the European put.

At the intermediate Node B, early exercise is not

optimal, so we use fu = 1.415

At Node C, early exercise is optimal as it gives us

a payoff of 12, which is superior to fd = 9.464

So the value of the put at C is 12
Value of put at Node A =

(0.6282 x 1.415 + 0.3718 x 12) x e-0.05 x 1 = 5.089

Spring Lecture 9 - Option Valuation

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Volatility of underlying asset

Volatility can be important
Assume that Expected Return on stock is

and its volatility is

Cox, Ross and Rubinstein (1979), propose
that u and d are chosen so that they match
Specifically,

u e T
1

d e
u

T
Spring Lecture 9 - Option Valuation

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The Probability of an Up Move

ad
p
ud
a e rt for a nondividen d paying stock
a e ( r q ) t for a stock index wher e q is the dividend
yield on the index
a e

( r r f ) t

for a currency w here rf is the foreign

risk - free rate

a 1 for a futures contract
Spring Lecture 9 - Option Valuation

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The Black-Scholes Option Valuation

Multi-Step Binomial Pricing
Co = SoN(d1) Xe-rTN(d2)
ln S 0 X r 2 2 T
d1
T
d 2 d1 T

ln S 0 X r 2 2 T

T
where
Co = Current call option value, So = Current stock price
N(d) = probability that a random draw from a normal distribution will
be less than d
Spring Lecture 9 - Option Valuation

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The Black-Scholes Option Valuation

X = Exercise price (or Strike Price)
e = 2.71828, the base of the natural log
r = Risk-free interest rate (annualizes continuously
compounded with the same maturity as the option)
T = Time to maturity of the option in years
ln = Natural log function
Standard deviation of annualized continuously
compounded rate of return on the stock
No dividends are being paid by the underlying stock.
Spring Lecture 9 - Option Valuation

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The Black-Scholes Option Valuation

For a European put option on nondividend paying stock,

p Xe

rT

N d 2 S0 N d1

Spring Lecture 9 - Option Valuation

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N(x) and Cumulative Probability Density Function

The function N(x) is the cpdf for a

standardized normal distribution

It is the probability that a variable with a
standard normal distribution , (0,1) will be
less than x

x
Spring Lecture 9 - Option Valuation

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N(x) and Cumulative Probability Density Function

Co = SoN(d1) Xe-rTN(d2)

= e-rT [SoN(d1) erT XN(d2) ]

N(d2) is the probability that the option will be

exercised in a risk neutral

XN(d2) is the strike price times the probability
that the strike price will be paid
S0N(d1)erT is the expected value of a variable
that equals ST if ST > X and is 0 otherwise in a
risk-neutral world.
Spring Lecture 9 - Option Valuation

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Illustrated Example
The price of a stock today is 42, and there is a

European Call option on the stock with exercise price

of 40. This option matures in 6 months. The risk free
rate is 10% p.a. and the volatility is given as 20% p.a.
Calculate c
d1 = 0.7693, d2= 0.6278
From the Standard NCDF Table,
N(d1) = N(0.7693)

= N(0.76) + 0.93x[N(0.77) N(0.76)]

= 0.7764 + 0.93(0.7794 0.7764) = 0.7791
Spring Lecture 9 - Option Valuation

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Illustrated Example
d1 = 0.7693, d2= 0.6278
From the Standard NCDF Table,
N(d1) = N(0.7693) = 0.7791
N(d2) = N(0.6278) = 0.7349
c = 42 x 0.7791 42 x e-0.05 x 0.7349 = 4.76

Spring Lecture 9 - Option Valuation

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Replication Method
An Intuitive Method

Delta () is the ratio of the change in the price

of an option to the change in the price of the

underlying stock
Sometimes also called the hedge ratio H

The value of varies from node to node

Spring Lecture 9 - Option Valuation

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Replication Method
An Intuitive Method

Back to original example, with K = 21

22

20

18

The call can take values of 1 and 0

H = 0.25
For perfect hedge,
For each option, there should be 0.25 stocks
OR for each share, there should be 4 options
Let us create a portfolio with 1 long stock and

4 short calls

Spring Lecture 9 - Option Valuation

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Replication Method
An Intuitive Method

Alternative Portfolio Long one stock and

short four calls

Portfolio is perfectly hedged:

Up
Down

Stock Value 22 18

Call Obligation -4
0

Net payoff
18 18
PV of 18 @ 12% p.a. for 3 months is 17.468
Hence now, 20 - 4C = 17.468 or C = 0.63
Spring Lecture 9 - Option Valuation

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Replication Method
An Intuitive Method

Suppose we look at two periods, each of 3

months
Then we know that in the last period, stock
can takes prices of 24.2, 19.8, 19.8 and 16.2
So the Call can take values of 3.2, 0, 0 and 0
For Node B, H = (3.2 0)/(24.2 19.8)
=0.727 (Hedge ratio changes at each node)
This means that for a perfect hedge, for each
call written, buy 0.727 of the stock
Spring Lecture 9 - Option Valuation

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Two-Step Binomial Pricing

Call Values
S0 = 20, K = 21, u = 1.1, d = 0.9, r = 0.12, T = 0.25
24.2 D
fuu =3.2
22
S0 =20

B
19.8
fud = 0 E

18

C
16.2
fdd =0

Spring Lecture 9 - Option Valuation

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Replication Method
An Intuitive Method

Portfolio is perfectly hedged:

Up
Down

Stock Value 17.6

14.4

Call Obligation -3.2

0

Net payoff
14.4
14.4
PV of 14.4 @ 12% p.a. for 3 months is
13.974
Hence @ Node B, 22 *0.727 c = 13.974 or
c = 2.03

Spring Lecture 9 - Option Valuation

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Replication Method
An Intuitive Method

For Node C, H = (0 0)/(19.8 16.2) =0

(Hedge ratio changes at each node)

This means that a portfolio of 0 share will
replicate the payoff of the call (which expires)
Value of Call at Node C is c = 0
At Node A, H = (2.0256 0)/(22 18) = 0.506
(Hedge ratio changes yet again)

Spring Lecture 9 - Option Valuation

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Replication Method
An Intuitive Method

Portfolio is perfectly hedged:

Up
Down

Stock Value 11.14 1 9.115

Call Obligation -2.026

0

Net payoff
9.11 5 9.115
PV of 9.115 @ 12% p.a. for 3 months is 8.845
Hence @ Node A, 20 *0.506 c = 8.845 or c
= 1.28

Spring Lecture 9 - Option Valuation

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