Option Pricing

Rachidi Kotchoni

December 12, 2017

Rachidi Kotchoni () Option Pricing December 12, 2017 1 / 22

Options
De…nition

A "put option" entitles its holder with the right - not the obligation -
to sell a security at a pre-arranged price up to or at a given maturity.
A "call option" entitles its holder with the right - not the obligation -
to buy a security at a pre-arranged price up to or at a given maturity.
American option: may be exercised at any date between the creation of
the option and its maturity date
European option: may be exercised only at the maturity date

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Options
Terminology

Underlying asset: security to which the option applies

Exercising of the option: buying or selling the underlying asset as a
implication of the option contract.
Pre-arranged transaction price: strike price (K)
Maturity: date after which the option expires (T)

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European Put

Let St be the price of a stock.

Consider a European put option (written on this stock) with strike K
and maturity T
If on the maturity date, ST > K , then it is not a good idea to
exercise the option
Selling the stock brings a cash ‡ow of K while its value ST is higher.
In this case, the net cash ‡ow generated by the put option is 0.
If on the maturity date, ST < K , then the option should be exercised
Selling the stock brings a cash ‡ow of K while its price ST is lower.
In this case, the net cash ‡ow generated by the put option is K ST .
Hence, the cash ‡ow generated by a put option is

max (K ST , 0 )

Rachidi Kotchoni () Option Pricing December 12, 2017 4 / 22

European Call

Now, consider a European call option (written on the previous stock)

with strike K and maturity T
If on the maturity date, ST < K , then it is not a good idea to
exercise the option
Buying the stock costs K while its value ST is lower.
In this case, the net cash ‡ow generated by the put option is 0.
If on the maturity date, ST > K , then the option should be exercised
Buying the stock costs only K while its value ST is higher.
In this case, the net cash ‡ow generated by the put option is ST K.
Hence, the cash ‡ow generated by a call option is

max (ST K , 0)

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Option Price
The standard formula still holds

In principle, the price of the option at t = 0 can be obtained as the

expected cash ‡ow discounted at a risk adjusted discount rate (e r)
For a call option:
1
C0 = E [max (ST K , 0)] ,
(1 + er )T
For a put option:
1
P0 = E [max (K ST , 0)] .
(1 + er )T

Other formulas are more intuitive in the context of option pricing.

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Option Price
Risk neutral distribution

At t = 0, the option price can equivalently be obtained as the risk

neutral expectation of cash ‡ows discounted at the risk free rate (r )
For a call option:
1
C0 = E [max (ST K , 0)] ,
(1 + r )T
For a put option:
1
P0 = E [max (K ST , 0)] .
(1 + r )T

E [] is an expected value with respect to a distribution that is

obtained after appying a distorsion to the true physical distribution of
ST
The distorted distribution is called "risk neutral distribution"
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Binomial Price Model

A binomial price model assumes that at each date, the price can
either go up by a factor 1 + u or down by a factor 1 d, where u > 0
and d 2 (0, 1) are positive
The probability of an upward move is π
Consider a European call option with maturity T = 1 and strike price
K
Assume that the risk free rate is r
If S0 denotes the price at t = 0, then
S1 = S0 (1 + u ) if the price goes up at t = 1
S1 = S0 (1 d ) if the price goes down at t = 1
It is assumed that

S0 ( 1 d ) < K < S0 (1 + u ) and

r < u

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Binomial Price Model
Stock price

Binomial Tree

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Binomial Price Model
Cash ‡ows

The cash ‡ow of the option is

max (S1 K , 0)

Hence, the possible cash ‡ow scenarios for the call options are
S0 (1 + u ) K if the price goes up at t = 1
0 if the price goes down at t = 1

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Binomial Price Model

Cash ‡ows from the option

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Binomial Price Model
No-arbitrage Pricing

Let us try to reproduce the payo¤s of the option by buying n stocks

and by investing an amount B in a risk free asset at t = 0.
At t = 0, the value of this portfolio is

V0 = nS0 + B

At t = 1, we have
V1 = nS1 + B (1 + r )
We want the value of this portfolio replicate the payo¤s of the option.
Hence:

nS0 (1 + u ) + B (1 + r ) = S0 (1 + u ) K
nS0 (1 d ) + B (1 + r ) = 0

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Binomial Price Model
No-arbitrage Pricing

Taking the di¤erence between the two equations yields:

nS0 (u + d ) = S0 ( 1 + u ) K
S0 ( 1 + u ) K
) n =
S0 ( u + d )

The second equation implies:

nS0 (1 d )
B =
1+r
S0 ( 1 d ) ( 1 + u ) ( 1 d) K
=
(u + d ) (1 + r )
The replicating portfolio is a portfolio of n stocks and amount B
invested in a risk free asset.

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Binomial Price Model
No-arbitrage Pricing

No-arbitrage pricing:
If the replicating portfolio has the same payo¤s as the option, it must
be the case that their values at t = 0 are equal. Otherwise, there will
be an opportunity of arbitrage.
Hence, the value of the option at t = 0 is:

C 0 = n S0 + B
S0 ( 1 + u ) K S0 ( 1 d ) ( 1 + u ) ( 1 d) K
= S0
S0 ( u + d ) (u + d ) (1 + r )
1 [ S0 ( 1 + u ) K ] ( r + d )
=
1+r u+d
Interesting to note that the option price does not depend on the
actual probability that the price will go up.

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Risk Neutral Probability

r +d
If we de…ne π = u +d 2 (0, 1), then we note that:

[ S0 ( 1 + u ) K] π + 0 (1 π )
C0 =
1+r
E [max (S1 K , 0)]
=
1+r
π is the risk neutral probability that the stock price will go up at
t = 1.
The option price is therefore the risk neutral expectation of cash ‡ows
discounted at the risk free rate.

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State Price Density

π can be expressed as a deformation of π

π
π = π
π
1 π
1 π = (1 π)
1 π
π
The ratio of the risk neutral and the physical probability, π and
1 π
1 π , is called the state price density.

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Stochastic discount factor

The option price can be expressed as:

C 0 = [ S0 ( 1 + u ) K] π mu
+0 (1 π ) md ,
= E [max (S1 K , 0) m1 ]

where m1 is a stochastic discount factor with two possible values:

π
mu = and
π (1 + r )
1 π
md =
(1 π ) (1 + r )

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Multi-period maturity
Recombining trees

These pricing formulas can be generalized to a multi-period setting.

Assume that the stock price evolves according to the binomial model
From t=0 and t=2, four scenarios are possible:
an "up" at t=1 followed by an "up" at t=2:

S2 = S0 (1 + u )2

an "up" at t=1 followed by a "down" at t=2:

S2 = S0 ( 1 + u ) ( 1 d)

a "down" at t=1 followed by an "up" at t=2:

S2 = S0 ( 1 d ) (1 + u )

a "down" at t=1 followed by a "down" at t=2:

S2 = S0 ( 1 d )2

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Options with multi-period maturity
Recombining trees

An "up" followed by a "down" leads to the same price as a "down"

followed by an "up" at t = 2.
Therefore, there are two possible ways to get S2 = S0 (1 d ) (1 + u )
and one possible ways to observe each of the other outcomes.
The tree is said to be recombining if an upward movement o¤sets a
downward movement, that is:

(1 d ) (1 + u ) = 1,
u
so that d = 1 +u

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Multi-period maturity
Example for t=2

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Multi-period maturity

Consider a call option with maturity T

Between t=0 and t=1, the price may go "up" k times and down
T k times. Therefore, the possible values for ST are:

ST = S0 ( 1 + u ) k ( 1 d )T k

Hence, the possible values for the option’s cash ‡ows are
h i
max S0 (1 + u )k (1 d )T k K , 0

The number of possibilities to observe k "ups" and T k "downs" is:

T T!
CTk = =
k k!(T k )!

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Multi-period maturity

The option price is given by

1
C0 = E [max (ST K , 0)] ,
(1 + r )T

where E [] is the expectation under the risk neutral distribution.

Under the risk neutral distribution, the probability of an "up" is
π = ur + d
+d . Hence, the probability of k "ups" and T k "downs" is

CTk π k (1 π )T k

Finally:
T
CTk π k (1 π )T k h i
C0 = ∑ (1 + r )T
max S0 (1 + u )k (1 d )T k
K, 0
k =0

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