A Simple Binomial Model

A stock price is currently $20 In three months it will be either $22 or $18
Stock Price = $22 Stock price = $20 Stock Price = $18

A Call Option
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

Setting Up a Riskless Portfolio

Consider the Portfolio: short 1 call option long shares

22 1

Portfolio is riskless when 22 1 = 18 or

= 0.25
18

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 220.25 1 = 4.50 The value of the portfolio today is 4.5e 0.120.25 = 4.3670

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 (= 0.2520 ) The value of the option is therefore 0.633 (= 5.000 4.367 )

Generalization
A derivative lasts for time T and is dependent on a stock Su u Sd d

Generalization
(continued)
Consider the portfolio that is long shares and short 1 derivative Su u The portfolio is riskless when Su u Sd = d Sd d or

u f d = Su Sd

Generalization
(continued) Value of the portfolio at time T is Su u Value of the portfolio today is (Su u )erT Another expression for the portfolio value today is S f Hence = S (Su u )erT

Generalization
(continued) Substituting for we obtain
= [ p u + (1 p )d ]erT

where

e d p= u d
rT

Risk-Neutral Valuation
= [ p u + (1 p )d ]e-rT The variables p and (1 p ) can be interpreted as the riskneutral probabilities of up and down movements The value of a derivative is its expected payoff in a riskneutral world discounted at the risk-free rate

p
(1 p)

Su u Sd d

Irrelevance of Stocks Expected Return

When we are valuing an option in terms of the underlying stock the expected return on the stock is irrelevant

Original Example Revisited

p

Su = 22 u = 1

S Since p is a risk-neutral probability Sd = 18 (1 20e0.12 0.25 = 22pp+ 18(1 p ); p = 0.6523 d =0 ) Alternatively, we can use the formula

e rT d e 0.120.25 0.9 p= = = 0.6523 u d 1.1 0.9

Valuing the Option

23 5 6 . 0

Su = 22 u = 1

The value of is e0.120.25 [0.65231 + 0.34770] = 0.633

0.34 77 the option

Sd = 18 d = 0

A Two-Step Example
24.2 22 20 Each time step is 3 months 18 19.8 16.2

Valuing a Call Option

D

22

24.2 3.2

19.8 20 2.0257 A E 0.0 1.2823 18 Value at node B = e0.12 C 0.25(0.65233.2 + 0.34770)0.0 = 2.0257 16.2 Value at node A F0.12 =e 0.0 0.25(0.65232.0257 + 0.34770) = 1.2823

A Put Option Example; X=52

D
60 72 0

B
50

48

A
40

E C
32

A Put Option Example; X=52

D
60 72 0

B
50 4.1923

1.4147 40

E C F

48 4

9.4636

32 20

What Happens When an Option is American

D
60 72 0

B
50

48

A
40

E C
32

What Happens When an Option is American

D
60 72 0

B
50 5.0894

1.4147 40 12.0

E C F

48 4

32 20

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

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

where is the volatility and t is the length of the time step. This is the approach used by Cox, Ross, and Rubinstein

d = e

The Black-Scholes Random Walk Assumption

Consider a stock whose price is S In a short period of time of length t the change in the stock price is assumed to be normal with mean St and standard deviation S t is expected return and is volatility

The Lognormal Property

These assumptions imply ln ST is normally distributed with mean:

ln S 0 + ( / 2)T
2

and standard deviation:

Because the logarithm of ST is normal, ST is lognormally distributed

The Lognormal Property continued

ln S T ln S 0 + ( 2 2)T , T or ST ln = ( 2 2)T , T S0

where [m,s] is a normal distribution with mean m and standard deviation s

The Lognormal Distribution

E ( ST ) = S0 e T var ( ST ) = S0 e
2 2 T

(e

2T

1)

The Expected Return

The expected value of the stock price is S 0 e T The expected return on the stock with continuous compounding is 2/2 The arithmetic mean of the returns over short periods of length t is The geometric mean of these returns is 2/2

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 time t is 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?

Estimating Volatility from Historical Data

1. Take observations S0, S1, . . . , Sn at intervals of
years 2. Define the continuously compounded return as:
Si 3. Calculate the u standard deviation, s , of the ui s i = ln S i 1

4. The historical volatility estimate is:

Categorization of Stochastic Processes

Discrete time; discrete variable Discrete time; continuous variable Continuous time; discrete variable Continuous time; continuous variable

Modeling Stock Prices

We can use any of the four types of stochastic processes to model stock prices The continuous time, continuous variable process proves to be the most useful for the purposes of valuing derivative securities

Markov Processes (See pages 218-9)

In a Markov process future movements in a variable depend only on where we are, not the history of how we got where we are We will assume that stock prices follow Markov processes

Weak-Form Market Efficiency

The assertion is that it is impossible to produce consistently superior returns with a trading rule based on the past history of stock prices. In other words technical analysis does not work. A Markov process for stock prices is clearly consistent with weak-form market efficiency

Example of a Discrete Time Continuous Variable Model

A stock price is currently at $40 At the end of 1 year it is considered that it will have a probability distribution of (40,10) where (,) is a normal distribution with mean and standard deviation .

Questions
What is the probability distribution of the stock price at the end of 2 years? years? years? t years? Taking limits we have defined a continuous variable, continuous time process

Variances & Standard Deviations

In Markov processes changes in successive periods of time are independent This means that variances are additive Standard deviations are not additive

Variances & Standard Deviations

(continued) In our example it is correct to say that the variance is 100 per year. It is strictly speaking not correct to say that the standard deviation is 10 per year.

A Wiener Process
We consider a variable z whose value changes continuously The change in a small interval of time t is z The variable follows a Wiener process if 1. z = t where is a random drawing from (0,1) 2. The values of z for any 2 different (nonoverlapping) periods of time are independent

Ito Process
In an Ito process the drift rate and the variance rate are functions of time dx=a(x,t)dt+b(x,t)dz The discrete time equivalent

x = a ( x , t ) t + b( x , t ) t
is only true in the limit as t tends to zero

Itos Lemma
If we know the stochastic process followed by x, Itos lemma tells us the stochastic process followed by some function G (x, t ) Since a derivative security is a function of the price of the underlying & time, Itos lemma plays an important part in the analysis of derivative securities

Itos Lemma
From stock price process to derivative process Stock Price Process dx=a(x,t)dt+b(x,t)dz

Taking limits Substituting We obtain

G G 2G 2 dG = dx + dt + 2 b dt x t x dx = a dt + b dz G G 2G 2 G dG = a+ + 2 b dt + b dz t x x x This is Ito's Lemma

The Concepts Underlying BlackScholes

The option price & 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 differential equation

The Derivation of the Black-Scholes Differential Equation

1 of 3:

S = S t + S z
2 2 2 = S + + 2 S t + S z t S S S

We set up a portfolio consisting of 1: derivative + : shares S

The Derivation of the Black-Scholes Differential Equation

2 of 3:

The value of the portfolio is given by = + S S The change in its value in time t is given by = + S S

The Derivation of the Black-Scholes Differential Equation

3 of 3:

The return on the portfolio must be the risk - free rate. Hence = r t We substitute for and S in these equations to get the Black - Scholes differential equation: 2 2 + rS + S = r 2 t S S
2

The Black-Scholes Formulas

c = S 0 N ( d1 ) X e p= Xe
rT rT

N (d 2 )

N ( d 2 ) S 0 N ( d1 )

2 ln( S0 / X ) + (r + / 2)T where d1 = T 2 ln( S0 / X ) + (r / 2)T d2 = = d1 T T

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 Normal distribution tables

Properties of Black-Scholes Formula

As S0 becomes very large c tends to S Xe-rT and p tends to zero As S0 becomes very small c tends to zero and p tends to Xe-rT S

Risk-Neutral Valuation
The variable does not appear in the BlackScholes equation The equation is independent of all variables affected by risk preference This is consistent with the risk-neutral valuation principle

Applying Risk-Neutral Valuation

1. Assume that the expected return from an asset is the riskfree rate 2. Calculate the expected payoff from the derivative 3. Discount at the risk-free rate

Valuing a Forward Contract with Risk-Neutral Valuation

Payoff is ST K Expected payoff in a risk-neutral world is SerT K Present value of expected payoff is e-rT[SerT K]=S Ke-rT

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

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

Dividends
European options on dividend-paying stocks are valued by substituting the stock price less the present value of dividends into the Black-Scholes formula 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

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

Blacks Approach to Dealing with Dividends in American Call Options

Set the American price equal to the maximum of two European prices: 1. The 1st European price is for an option maturing at the same time as the American option 2. The 2nd European price is for an option maturing just before the final ex-dividend date