Option pricing Model

1. Binomial Trees

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A Simple Binomial Model

A stock price is currently $20

In 3 months it will be either $22 or $18

Stock Price = $22

Stock price = $20
Stock Price = $18

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A Call Option (Figure 12.1, page 254)
A 3-month call option on the stock has a strike
price of 21.

Stock Price = $22

Option Price = $1
Stock price = $20
Option Price=?
Stock Price = $18
Option Price = $0

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Setting Up a Riskless Portfolio
For a portfolio that is long  shares and a
short 1 call option values are

22 – 1

18

Portfolio is riskless when 22 – 1 = 18

or  = 0.25
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Valuing the Portfolio
(Risk-Free Rate is 12%)
The riskless portfolio is:
long 0.25 shares
short 1 call option
The value of the portfolio in 3 months is
22 ×0.25 – 1 = 4.50
The value of the portfolio today is
4.5e–0.12×0.25 = 4.3670
0.25 là 3 tháng / 12 = 0.25

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Valuing the Option
The portfolio that is
long 0.25 shares
short 1 option
is worth 4.367
The value of the shares is
5.000 (= 0.25 × 20 )
The value of the option is therefore
0.633 ( 5.000 – 0.633 = 4.367 )

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Generalization (Figure 12.2, page 255)
A derivative lasts for time T and is dependent
on a stock
S0u
ƒu
S0
ƒ
S0d
ƒd
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Generalization (continued)
Value of a portfolio that is long  shares and short 1
derivative: S u – ƒ 0 u

S0d – ƒd

The portfolio is riskless when S0u – ƒu = S0d – ƒd or

ƒu − f d u luôn luôn >1,
=
S 0u − S 0 d d luôn luôn <1

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Generalization (continued)

Value of the portfolio at time T is S0u – ƒu

Value of the portfolio today is (S0u – ƒu)e–rT
Another expression for the portfolio value
today is S0 – f
Hence
ƒ = S0 – (S0u – ƒu )e–rT

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Generalization
(continued)

Substituting for  we obtain

ƒ = [ pƒu + (1 – p)ƒd ]e–rT

where
e rT − d
p=
u−d

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p as a Probability
It is natural to interpret p and 1-p as probabilities of up
and down movements
The value of a derivative is then its expected payoff in
a risk-neutral world discounted at the risk-free rate
S0u
ƒu
S0
ƒ
S0d
ƒd
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Risk-Neutral Valuation
When the probability of an up and down movements
are p and 1-p the expected stock price at time T is
S0erT
This shows that the stock price earns the risk-free
rate
Binomial trees illustrate the general result that to
value a derivative we can assume that the expected
return on the underlying asset is the risk-free rate and
discount at the risk-free rate
This is known as using risk-neutral valuation

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Original Example Revisited
S0u = 22
ƒu = 1
S0=20
ƒ
S0d = 18
ƒd = 0

p is the probability that gives a return on the stock equal to the

risk-free rate:
20e 0.12 ×0.25 = 22p + 18(1 – p ) so that p = 0.6523
Alternatively: 0.120.25
e −d e
rT
− 0 .9
p= = = 0.6523
u−d 1 .1 − 0 .9

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Valuing the Option Using Risk-Neutral
Valuation
S0u = 22
ƒu = 1
S0=20
ƒ
S0d = 18
ƒd = 0

The value of the option is

e–0.12×0.25 (0.6523×1 + 0.3477×0)
= 0.633

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Irrelevance of Stock’s Expected
Return
When we are valuing an option in terms of the price
of the underlying asset, the probability of up and
down movements in the real world are irrelevant
This is an example of a more general result stating
that the expected return on the underlying asset in
the real world is irrelevant

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A Two-Step Example
Figure 12.3, page 260

24.2
22

20 19.8

18
16.2
K=21, r = 12%
Each time step is 3 months

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Valuing a Call Option
Figure 12.4, page 260 24.2
3.2
22
B
20 2.0257 19.8
1.2823 A 0.0
18

0.0 16.2
0.0
Value at node B
= e–0.12×0.25(0.6523×3.2 + 0.3477×0) = 2.0257
Value at node A
= e–0.12×0.25(0.6523×2.0257 + 0.3477×0) = 1.2823
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A Put Option Example
Figure 12.7, page 263
72
0
60
50 1.4147 48
4.1923 4
40
9.4636 32
20

K = 52, time step =1yr

r = 5%, u =1.32, d = 0.8, p = 0.6282

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What Happens When the Put
Option is American (Figure 12.8, page 264)
72
Ko có thi 0
60

50 1.4147 48
5.0894 4
40
The American feature C
increases the value at node 12.0 32
C from 9.4636 to 12.0000. 20

This increases the value of

the option from 4.1923 to
5.0894.
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Delta
Delta () is the ratio of the change in the
price of a stock option to the change in
the price of the underlying stock
The value of  varies from node to node

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Choosing u and d
One way of matching the volatility is to set

u = e t

d = 1 u = e − t

where  is the volatility and t is the length of

the time step. This is the approach used by
Cox, Ross, and Rubinstein

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Girsanov’s Theorem
Volatility is the same in the real world and the
risk-neutral world
We can therefore measure volatility in the
real world and use it to build a tree for the an
asset in the risk-neutral world

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Assets Other than Non-Dividend
Paying Stocks
For options on stock indices, currencies and
futures the basic procedure for constructing
the tree is the same except for the calculation
of p

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The Probability of an Up Move
a−d
p=
u−d

a = e rt for a nondividen d paying stock

a = e ( r − q ) t for a stock index where q is the dividend

yield on the index

( r − r ) t
a=e f for a currency where r f is the foreign
risk - free rate

a = 1 for a futures contract

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THE BLACK – SCHOLES – MERTON
MODEL

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Option-pricing Model

Black-Scholes Model (1973)

The pricing remains the same - construct a hedge
portfolio comprising a long position in stock and a
short position in a zero-coupond bond.
The portfolio has the value at any point of time will
always be equal to the option’s price at that time.
When the option’s price differs from the hedge
portfolio’s value, then what is going to happen?

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The Stock Price Assumption
Consider a stock whose price is S
In a short period of time of length t, the
return on the stock is normally distributed:
S
S
(
  t ,  2 t )
where  is expected return and  is
volatility

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The Lognormal Property
(Equations 14.2 and 14.3, page 300)

It follows from this assumption that

 2  
ln S T − ln S 0     − T ,  T 
2

 2  
or
  2  

ln S T   ln S 0 +   − T,  T
2

  2  

Since the logarithm of ST is normal, ST is

lognormally distributed

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The Lognormal Distribution

E ( ST ) = S0 e T
2 2 T 2T
var ( ST ) = S0 e (e − 1)

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Continuously Compounded
Return (Equations 14.6 and 14.7, page 302)
If x is the realized continuously compounded
return
S T = S 0 e xT
1 ST
x = ln
T S0
 2 2 
x     − , 

 2 T 

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The Expected Return
The expected value of the stock price is S0eT
The expected return on the stock is
 –   not 

This is because
ln[ E ( ST / S 0 )] and E[ln(ST / S 0 )]
are not the same

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 and  − 
 is the expected return in a very short time,
t, expressed with a compounding frequency
of t
 −/2 is the expected return in a long period
of time expressed with continuous
compounding (or, to a good approximation,
with a compounding frequency of t)

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Mutual Fund Returns (See Business
Snapshot 14.1 on page 304)

Suppose that returns in successive years are 15%,

20%, 30%, −20% and 25% (ann. comp.)
The arithmetic mean of the returns is 14%
The returned that would actually be earned over the
five years (the geometric mean) is 12.4% (ann.
comp.)
The arithmetic mean of 14% is analogous to 
The geometric mean of 12.4% is analogous to −/2

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The Volatility
The volatility is the standard deviation of
the continuously compounded rate of
return in 1 year
The standard deviation of the return in a
short time period time t is
approximately  t
If a stock price is $50 and its volatility is
25% per year what is the standard
deviation of the price change in one day?
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 Estimating Volatility from Historical
Data (page 304-306)
1. Take observations S0, S1, . . . , Sn at intervals
of  years (e.g. for weekly data  = 1/52)
2. Calculate the continuously compounded
return in each interval as:
 Si 
ui = ln 
 Si −1 

3. Calculate the standard deviation, s , of the

ui´s
s
4. The historical volatility estimate is:  =
ˆ


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Nature of Volatility
Volatility is usually much greater when the
market is open (i.e. the asset is trading) than
when it is closed
For this reason time is usually measured in
“trading days” not calendar days when
options are valued
It is assumed that there are 252 trading days
in one year for most assets
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Example
Suppose it is April 1 and an option lasts to
April 30 so that the number of days remaining
is 30 calendar days or 22 trading days
The time to maturity would be assumed to be
22/252 = 0.0873 years

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The Concepts Underlying Black-
Scholes-Merton
The option price and the stock price depend on the
same underlying source of uncertainty
We can form a portfolio consisting of the stock and
the option which eliminates this source of uncertainty
The portfolio is instantaneously riskless and must
instantaneously earn the risk-free rate
This leads to the Black-Scholes-Merton differential
equation

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The Derivation of the Black-Scholes
Differential Equation
S = S t + S z
 ƒ ƒ 2ƒ 2 2  ƒ
ƒ =  S + +½  S t +
 S z
 S t S S
2


We set up a portfolio consisting of

− 1: derivative
ƒ
+ : shares
S
This gets rid of the dependence on z.

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The Derivation of the Black-Scholes
Differential Equation continued

The value of the portfolio, , is given by

ƒ
 = −ƒ + S
S
The change in its value in time t is given by
ƒ
 = − ƒ + S
S

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The Derivation of the Black-Scholes
Differential Equation continued
The return on the portfolio must be the risk - free
rate. Hence
 = r t
f  f 
- f + S = r  − f + S t
S  S 
We substitute for ƒ and S in this equation
to get the Black - Scholes differenti al equation :
ƒ ƒ  2
ƒ
+ rS + ½ σ 2S 2 = rƒ
t S S 2

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The Differential Equation
Any security whose price is dependent on the
stock price satisfies the differential equation
The particular security being valued is
determined by the boundary conditions of the
differential equation
In a forward contract the boundary condition is
ƒ = S – K when t =T
The solution to the equation is
ƒ = S – K e–r (T – t )
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The Black-Scholes-Merton
Formulas (See pages 313-315)
c = S 0 N (d1 ) − K e − rT N (d 2 )
p = K e − rT N (−d 2 ) − S 0 N (−d1 )
2
ln( S 0 / K ) + (r +  / 2)T
where d1 =
 T
2
ln( S 0 / K ) + (r −  / 2)T
d2 = = d1 −  T
 T
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The N(x) Function
N(x) is the probability that a normally distributed
variable with a mean of zero and a standard deviation
of 1 is less than x

See tables at the end of the book

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Properties of Black-Scholes Formula

As S0 becomes very large c tends to S0 – Ke-rT

and p tends to zero
As S0 becomes very small c tends to zero and
p tends to Ke-rT – S0
What happens as  becomes very large?
What happens as T becomes very large?

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Risk-Neutral Valuation
The variable  does not appear in the Black-
Scholes-Merton differential equation
The equation is independent of all variables
affected by risk preference
The solution to the differential equation is
therefore the same in a risk-free world as it
is in the real world
This leads to the principle of risk-neutral
valuation
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Applying Risk-Neutral Valuation

1. Assume that the expected return

from the stock price is the risk-free
rate
2. Calculate the expected payoff from
the option
3. Discount at the risk-free rate

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Valuing a Forward Contract with
Risk-Neutral Valuation
Payoff is ST – K
Expected payoff in a risk-neutral world is
S0erT – K
Present value of expected payoff is
e-rT[S0erT – K]=S0 – Ke-rT

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Implied Volatility
The implied volatility of an option is the
volatility for which the Black-Scholes price
equals the market price
There is a one-to-one correspondence
between prices and implied volatilities
Traders and brokers often quote implied
volatilities rather than dollar prices

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The Impact of Dilution
After the options have been issued it is not
necessary to take account of dilution when
they are valued
Before they are issued we can calculate the
cost of each option as N/(N+M) times the
price of a regular option with the same terms
where N is the number of existing shares and
M is the number of new shares that will be
created if exercise takes place

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Dividends
European options on dividend-paying stocks
are valued by substituting the stock price less
the present value of dividends into Black-
Scholes
Only dividends with ex-dividend dates during
life of option should be included
The “dividend” should be the expected
reduction in the stock price expected
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American Calls
An American call on a non-dividend-paying
stock should never be exercised early
An American call on a dividend-paying
stock should only ever be exercised
immediately prior to an ex-dividend date
Suppose dividend dates are at times t1, t2,
…tn. Early exercise is sometimes optimal at
time ti if the dividend at that time is greater
than K [1 − e − r (ti+1 −ti ) ]
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Summary:
The BSOPM formular for option pricing is given:

53
B-S Assumption and Limitation

Frictionless markets

The asset pays zero dividends

The option is European style

Asset prices follow a geometric Brownian

motion

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