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Principles of Finance
BS 2100
Derivative Securities II
Pete Hahn
Faculty of Finance
Room 5012
Cass Building
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Topics Covered
Review of Derivatives I

Simple Option Valuation Model
Binomial Model (Concept Only)
Black-Scholes Formula
Black Scholes in Action
Option Values at a Glance
Real Options
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Option Valuation Methods
Colgate call options have an exercise price
of $80. (K is normally 100 shares)
Case 1

Stock price falls to $60

Option value = $0
Case 2

Stock price rises to $106.67

Option value = $26.67
Interest rates are 5% p.a., and our option expires in 6 months
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Option Valuation Methods
(Leveraged Purchase)
Assume you buy 4/7 of the value of the Colgate
exercise price ($45.71) and you borrow $33.45.

Value of Call = 80 x (4/7) 33.45 = $12.26
Well see where the 4/7 comes from in a minute
33.45 = ((4/7)*60-0)/1.025 also
33.45 = ((4/7)*106.67-26.67)/1.025 [5% interest p.a.]
Case I & II Prices
Case I & II Values
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Option Valuation Methods
Since the Colgate call option is equal to a
leveraged position in 4/7 shares, the option
delta can be computed as follows.



7
4
67 . 46
67 . 26
60 67 . 106
0 67 . 26
prices share possible of spread
prices option possible of spread
Delta Option
= =

=
=
Option Valuation Methods
(Leveraged Purchase)
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Option Valuation Methods
If we are risk neutral, the expected return on Colgate
call options is 2.5%. Accordingly, we can determine the
probability of a rise in the stock price as follows.
| | ( ) | |
.471 rise of y Probabilit
.025 Retrun Expected
) 25 ( rise of y probabilit 1 33.33 rise of y probabilit Retrun Expected
=
=
+ =
Risk-free rate
=106.67/80 =(80-60)/80
This tests theory, we are rarely risk neutral and would likely
want a higher expected return and probability. Based on our 2
possibilities we assume a rise 47% likely.
Option Valuation Methods
(Probability)
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Option Valuation Method
The Colgate option can then be valued
based on the following method.
| | ( ) | |
57 . 12 $
) 0 529 (. ) 67 . 26 471 (.
0 rise of y probabilit 1 67 . 26 rise of y probabilit ue Option val
=
+ =
+ =
12.57/1.025=12.26
12.26= 80 (4/7) 33.45
Option Valuation Methods
(Probability)
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Binomial Pricing Model
) (
) (
up y Probabilit
d u
d a
p

= =
p =1 down y Probabilit
year of % as interval time = A =
=
=
=

t h
e u
e d
e a
h
h
rh
o
o
The prior examples can be generalized as binomial models and
shown as follows. They are based upon options following a type
of decision tree or two direction probability.
a= interest rate
u= upside change
d= downside change
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40.37




32.10

36

37 . 40 1215 . 1 36
1 0
=
=
U
P U P
Binomial Pricing
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Binomial Model
The price of an option, using the Binomial method, is significantly
impacted by the time intervals selected. The Colgate example
illustrates this fact.
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Option Value
Components of the Option Price

1 - Underlying stock price
2 - Striking or Exercise price
3 - Volatility of the stock returns (standard deviation of
annual returns)
4 - Time to option expiration
5 - Time value of money (discount rate)
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Option Value
| | | | ) ( ) ( ) (
2 1
EX PV d N P d N O
C
=
Black-Scholes Option Pricing Model
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O
C
- Call Option Price
P

- Stock Price
N(d
1
) - Cumulative normal density function of (d
1
)
PV(EX) - Present Value of Strike or Exercise price
N(d
2
) - Cumulative normal density function of (d
2
)
r - discount rate (risk free rate)
t - time to maturity of option (as % of year)
v - volatility - annualized standard deviation of daily returns
| | | | ) ( ) ( ) (
2 1
EX PV d N P d N O
C
=
Black-Scholes Option Pricing Model
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| | | | ) ( ) ( ) (
2 1
EX PV d N P d N O
C
=
Black-Scholes Option Pricing
Model
( )
rt
e EX EX PV

= ) (
factor discount g compoundin continuous
1
= =

rt
rt
e
e
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N(d
1
)=
t v
t r
d
v
EX
P
) ( ) ln(
2
1
2
+ +
=
Black-Scholes Option Pricing Model
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Cumulative Normal Density Function
t v
t r
d
v
EX
P
) ( ) ln(
2
1
2
+ +
=
t v d d =
1 2
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Call Option
2297 .
1
= d
t v
t r
d
v
EX
P
) ( ) ln(
2
1
2
+ +
=
5908 . ) (
1
= d N
Example - Colgate
What is the price of a call option given the following?
P = 80 r = 5% v = .4068
EX = 80 t = 180 days / 365
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d N(d) d N(d) d N(d)
-1.95 0.0256 0.05 0.5199 2.1 0.9821
-1.9 0.0287 0.1 0.5398 2.15 0.9842
-1.85 0.0322 0.15 0.5596 2.2 0.9861
-1.8 0.0359 0.2 0.5793 2.25 0.9878
-1.75 0.0401 0.25 0.5987 2.3 0.9893
-1.7 0.0446 0.3 0.6179 2.35 0.9906
-1.65 0.0495 0.35 0.6368 2.4 0.9918
Normal Distribution
d1 = .2297 N(d1) = .5908
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.50
.59
0.0
1.0
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Call Option
4769 . 5231 . 1 ) (
0580 .
2
2
1 2
= =
=
=
d N
d
t v d d
Example - Colgate
What is the price of a call option given the following?
P = 80 r = 5% v = .4068
EX = 80 t = 180 days / 365
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Call Option
| | | |
| | | |
05 . 10 $
) 80 ( 4769 . 80 5908 .
) ( ) ( ) (
) 5 )(. 05 (.
2 1
=
=
=

C
C
rt
C
O
e O
e EX d N P d N O
Example - Colgate
What is the price of a call option given the following?
P = 80 r = 5% v = .4068
EX = 80 t = 180 days / 365
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Call Option
3070 .
1
= d
t v
t r
d
v
EX
P
) ( ) ln(
2
1
2
+ +
=
3794 . 6206 . 1 ) (
1
= = d N
Example
What is the price of a call option given the following?
P = 36 r = 10% v = .40
EX = 40 t = 90 days / 365
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Call Option
3065 . 6935 . 1 ) (
5056 .
2
2
1 2
= =
=
=
d N
d
t v d d
Example
What is the price of a call option given the following?
P = 36 r = 10% v = .40
EX = 40 t = 90 days / 365
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Call Option
| | | |
| | | |
70 . 1 $
) 40 ( 3065 . 36 3794 .
) ( ) ( ) (
) 2466 )(. 10 (.
2 1
=
=
=

C
C
rt
C
O
e O
e EX d N P d N O
Example
What is the price of a call option given the following?
P = 36 r = 10% v = .40
EX = 40 t = 90 days / 365
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Example
What is the price of a call option given the following?
P = 36 r = 10% v = .40
EX = 40 t = 90 days / 365
Binomial price = $1.51
Black Scholes price = $1.70
The limited number of binomial outcomes produces the
difference. As the number of binomial outcomes is expanded,
the price will approach, but not necessarily equal, the Black
Scholes price.
Binomial vs. Black Scholes
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How estimated call price changes as
number of binomial steps increases
No. of steps Estimated value
1 48.1
2 41.0
3 42.1
5 41.8
10 41.4
50 40.3
100 40.6
Black-Scholes 40.5
Binomial vs. Black Scholes
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Dilution
Nq N
NqEX V
+
+
= exercise after Price Share
V = Value of all shares prior, N = Outstanding shares, P = Price
NqEX = Exercise Price x New Shares Issued
Nq = New Shares Issued
For a company that sold call options
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Topics Covered
Simple Option Valuation Model
Binomial Model (Concept Only)
Black-Scholes Formula
Black Scholes in Action
Option Values at a Glance
Real vs Financial Options


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See you at the review session