Chapter 16

Option
Valuation

McGraw-Hill/Irwin
McGraw-Hill/Irwin

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2013
The McGraw-Hill
Companies,
Inc.
rights reserved.
reserved.
Copyright
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Outline
16.2 Binomial Op2on Pricing
16.3 Black-Scholes Op2on Valua2on
16.4 Using the Black-Scholes Formula (Dropped
from BF2201 Syllabus)

16-2

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The Binomial Model

Bi=two, nomial= terms (outcomes)

Stock XYZ is currently priced at S$100
In three months the stock price will either increase
to S$120 or decrease to S$90:
Stock Price = S$120
Stock price = S$100
Stock Price = S$90

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The Binomial Model

Stock XYZ is currently priced at S$100.
A 3-month call op:on on stock XYZ has a strike price of
$S110:

Stock Price = S$120
Option Payout = S$10
Stock price = S$100
Option Price=???

Stock Price = S$90

Option Payout = S$0

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16.2 Binomial Op2on Pricing

Stock price for XYZ can take one of two values
Increase by u = 1.2, or fall by d = .9





The binomial op2on pricing model makes an
assump2on that stock prices can either go up or
down by a xed amount.
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SeAng Up a Risk-free PorGolio

Consider the PorZolio:



Pay now:

Stock: 100

Call op2on: ???

Buy shares of XYZ

short 1 call op2on



Get in the future:


120 10







90 - 0

To VALUE this porZolio, nd so that the porZolio is riskless

(get the same amount in the future)
When does the porZolio become riskless?
PorZolio is riskless when 120 10 = 90 or = 1/3
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SeAng Up a Risk-free PorGolio

Consider the PorZolio: Buy shares of XYZ





short 1 call op2on

Pay now:



Get in the future:





120
10











90 - 0


When does the porZolio become riskless?
PorZolio is riskless when 120 10 = 90 or = 1/3

16-7

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SeAng Up a Risk-free PorGolio

Consider the PorZolio: Buy 1/3 shares of XYZ




short 1 call op2on

Pay now:



Get in the future:
Stock: 100 * (1/3) = 33.33


10
= 30
120*(1/3)
Call op2on: - C















*(1/3)
- 0 = 30
90

In the future, the porZolio produces a RISK-FREE payout of S

$30.
A porZolio of H shares of stock and short 1 call op:on is risk-
free.

16-8

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SeAng Up a Risk-free PorGolio

Pay now:


Stock: 100 * (1/3) = 33.33
Call op2on: - C

Get in the future:

120*(1/3)

10
= 30

90
*(1/3)
- 0 = 30

The value of the porZolio today is the present value of the

future payout. If the three month risk-free rate equals 10
percent:
Pay now:


= PV(Get in the future):
33.33 - C


= 30 / (1+0.1) -> C = 6.06

Calcula2ng call (or put) op2on prices this way is referred to as
16-9
Risk-Neutral Valua:on.
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16.2 Binomial Op:on Pricing

Risk-Neutral Valuation
1. Construct a portfolio with H shares and one short call that is
RISK-FREE.
H is referred to as the hedge ratio.
2. Value of portfolio today (from the previous example):
V0 = H*S0 C = (1/3)*100 C
3. Value of portfolio at expiration if stock goes UP:
Vu = H*u*S0 Cu = (1/3)*120 10 = (1/3)*1.2*100 10 =30
u = 1.2
4. Value of portfolio at expiration if stock goes DOWN:
Vd = H*d*S0 Cd = (1/3)*90 0 = (1/3)*0.9*100 = 30
d = 0.9
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16.2 Binomial Op:on Pricing

Risk-Neutral Valuation
Value of portfolio at expiration if stock goes UP equals the value
when the stock goes down goes down:
Vu = H*u*S0 Cu = 30 = H*d*S0 Cd =Vd
The hedge ratio, or number of shares purchased so that the
portfolio at expiration is risk free, is:

H=

Cu Cd
uS0 dS0

16-11
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16.2 Binomial Op:on Pricing

Risk-Neutral Shortcut
Since a hedged porZolio is riskless, and r is the risk-free
rate:


V0(1 + r) = Vu (or Vd)
and (HS0 C)(1 + r) = HuS0 Cu
Solving for C, we get
pCu + (1 p ) C d
1+ r

C=
where p =

This is the risk-neutral approach to op2on pricing, and we
call p a risk-neutral probability.
1+ r d
u d

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Q1. When the returns of an op2on and stock are perfectly

correlated as in a two-state binomial op2on model, the hedge
ra2o must be equal to the ra2o of ______.
1. the range of the op2on outcomes to
the range of the stock outcomes
2. the range of the stock outcomes to
the range of the op2on outcomes
3. the standard devia2on of the op2on
returns to the standard devia2on of
the stock returns
4. the standard devia2on of the stock
returns to the standard devia2on of
the op2on returns

0 of 40

16-13

Q2. The stock price of Ajax Inc. is currently $105. The stock
price a year from now will be either $130 or $90 with equal
probabili2es. The interest rate at which investors can borrow
is 10%. Using the binomial model, the value of a call op2on
with an exercise price of $110 and an expira2on date 1 year
from now should be worth __________ today.

1.
2.
3.
4.

$11.59
$15
$20
$40
0 of 40

16-14

16.2 Binomial Op:on Pricing

Before, the stock price can take one of two values at
the end of the year. This is clearly unrealis2c.
Subdivide year into two intervals:

Subdivide year into three intervals:

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16.2 Binomial Op2on Pricing

Generalizing the Two-State Approach

Subdivide further into four intervals:

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16.2 Binomial Op2on Pricing

Risk-Neutral Valuation in the Binomial Option Pricing Model:
When the number of time intervals until expiration INCREASES,
the amount of time between each interval DECREASES.
As the number of time intervals tend to infinity, the time between
each interval gets infinitesimally small.
At the limit, as the time between each interval gets
infinitesimally small, investors trade in continuous time.
The second approach to valuing option, the Black-Scholes
option pricing formula, assumes investors trade in continuous
time. In addition, (log) returns over each instant of time are
normally distributed.
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16.3 Black-Scholes Op:on Valua:on

The parameters in the Black and Scholes model
S0 : current stock price
K : the exercise price
T : the 2me to maturity
r : the risk free interest rate
: the vola2lity of the stock
: the stock dividend
All parameters are known except for the vola2lity of
the stock. This needs to be es2mated or implied from
market prices.
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16.3 Black-Scholes Op:on Valua:on

Black-Scholes Formula for European call op2on:
C0 = S 0 e T N (d1 ) Xe rT N (d 2 )
where
d1 =

ln

( )+ (r + )T
S0
X

2
2

d 2 = d1 T

Note: Will not ask you to calculate a price. You will learn
this in Deriva2ves. Instead, we will use the equa2on to
gain insight
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16.3 Black-Scholes Op2on Valua2on

Black-Scholes Pricing Formula

N(d) = Cumula2ve normal probability func2on

(Probability that a random draw from a standard
normal distribu2on will be less than d)

e = Base of natural log func2on, approximately

2.71828

ln(.) = Natural logarithm func2on

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Figure 16.3 Standard Normal Probability Func2on

16-21

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16-22

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Table 16.1 Determinants of call op2on values

16-23

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16.3 Black-Scholes Op2on Valua2on

Black-Scholes Pricing Formula
Implied vola2lity
Standard devia2on of stock returns consistent
with op2ons market value

Video (hqp://www.youtube.com/watch?v=VIHldsSmASU
5min)

Historical vola2lity is computed using historical

data.
Implied vola2lity is implied by the market price of
the op2on. It indirectly tells us what the market
expects the vola2lity to be.
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Table 16.1 Determinants of Call Op2on Values

16-25

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Figure 16.5 Implied Vola2lity of S&P 500

16-26

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Figure 16.4 Finding Implied Vola2lity

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