Lecture 10: Option Pricing

Readings:
Cochrane Chapter 17
Ingersoll Chapter 14
Cox, Ross & Rubinstein, Option Pricing: !i"pli#ied pproach,$ %ournal o#
&inancial 'cono"ics, 1(7(
Ross, Options and '##icienc),$ *%', 1(7+
1
Background
Options are side bets bet,een in-estors concerning the #uture price le-el o# an underl)ing
asset .,hich ,e ,ill re#er to as a stoc/ #or si"plicit)0 relati-e to a #ixed bench"ar/1 '-en
"ore generall), a bet about the #uture reali2ation o# a rando" outco"e .,eather01 s the)
are created ,hen t,o in-estors ta/e opposite sides o# the bet,$ the) are in 2ero net suppl)1
call option is a #inancial securit) ,hich gi-es its o,ner the right .but not the obligation0 to
bu) an underl)ing asset .stoc/0 #or a pre3speci#ied price .this is the #ixed bench"ar/ called
the stri/e or exercise price, k0 on .or be#ore0 the expiration date .T0 o# the option contract1
'uropean$ call option can be exercised onl) on the expiration date ,hereas an "erican
call can be exercised at an) ti"e up to and including the expiration date1
put option gi-es its o,ner the right .but not the obligation0 to sell an underl)ing asset at
the stri/e price on or be#ore the expiration o# the put option contract1
4i-en the transactional co"plexit) .at least #or the #irst ti"e )ou discuss options0 o# a call
option, ,e ,ill #irst identi#) se-eral rele-ant prices in the hopes o# a-oiding con#usion .,e
,ill concentrate our discussion on call options0:
c or c
t
is the current price5-alue o# the call option
c
T
is the pa)o##5-alue o# the call at the expiration date
s or s
t
is the current price5-alue o# the underl)ing asset
s
T
is the price5-alue o# the underl)ing asset at T
k is the contractuall) speci#ied stri/e price
!i"ilarl),
p or p
t
is the current price o# the put option
p
T
is the pa)o## o# the put at expiration
6he basic option pricing literature concentrates on #inding c
t
as a #unction o# s
t
and other
-ariables in a -ariet) o# circu"stances1
Payoffs at Expiration
call option has -alue to its o,ner at T onl) i# the price o# the underl)ing asset s
T
is abo-e
the stri/e price k1 6hus bu)ing a call is a bet the price ,ill end up abo-e this bench"ar/1 I#
it is, the pa)o## on the call is s
T


- k7 i# not the pa)o## is not s
T
- k .,hich is negati-e i# s
T
< k0
but rather 8 .because the o,ner has a choice, an option01 6he o,ner o# the option si"pl) lets
it expire unexercised ,hen the exercise -alue ,ould be negati-e1 9ote that the bu)er o# an
option purchases a choice .right0, the seller o# an option incurs an obligation1
2
:e ,rite the pa)o## o# the call option as:
"one)0 the o# .out
"one)0 .in the
8 k s
k s
if
if k s
c
T
T T
T
<

'

or, 0 8 , . k s Max c
T T

Once again, the o,ner o# a call option bene#its i# the price o# the underl)ing asset ends up
abo-e the stri/e price at the expiration o# the option1
3
4raphicall), on the expiration date;
Buy (Own) Sell (Write)
c
T
c
T
c
t
k s
T
s
T
-c
t
6he dotted line is the pro#it$ o# the position ,hich ,as co""onl) but incorrectl) exa"ined1
put option ,or/s in the opposite$ ,a)1 It allo,s )ou to sell #or k1 !o, )ou .the o,ner0
are interested in .are betting on0 states in ,hich the true price is lo, .lo,er than k01 9ote,
ho,e-er, that )ou do not ha-e the sa"e interest in a lo, price as does the seller o# a call
option1
k s
k s
if
if s k
p
T
T T
T
>

'

8
or, 0 8 , .
T T
s k Max p
Own Sell (Write)
p
T
p
T
k
p
t



k s
T
s
T


Put-Call Parity
6he la, o# one price allo,s us to #ind a particular relation bet,een the current -alue o# a put,
the current -alue o# a call, the current -alue o# the underl)ing stoc/, and a ris/ #ree bond<s
-alue1
Consider the #ollo,ing t,o strategies:
4
.10 =u) a call and ,rite .sell0 a put on the sa"e underl)ing, ,ith the sa"e stri/e price
k, and the sa"e expiration date T7
.>0 =u) the underl)ing stoc/ and borro, so )ou "ust pa)bac/ k at ti"e T1
5
6he ti"e T pa)o##s o# these > strategies as a #unction o# the price o# the underl)ing are:
.10 Call Put Portfolio (sum)
k s
T
k s
T
k s
T
-k -k
.>0 Stoc Borrow Portfolio (sum)
s
T
k s
T
k s
T
-k -k
9o,, since their #uture pa)o##s are e?ui-alent, c
T
- p
T
= s
T
k, in all states o# nature .note that
the onl) uncertaint) #or both positions concerns the #uture, ti"e T, price o# the underl)ing
stoc/0, their current prices "ust also be e?ual1
!o,
f
t t t
R
k
s p c
6hus,
f
t t t
R
k
s c p +
so ,e can #ind p
t
i# ,e /no, c
t
hence our concentration, as is traditional, on call options1
Restrictions on Option Prices:
Ingersoll presents se-eral results the "ore intuiti-e o# ,hich are replicated here these
illustrate so"e i"portant intuitions5#eatures o# option prices1
Proposition (1 "erican and 'uropean put and call option prices are al,a)s at least ,ea/l)
positi-e1 6his co"es #ro" the li"ited liabilit) o# the pa)o## e?uations #or options1
Proposition (! 6he #inal pa)o##s on options are ,ea/l) positi-e and as gi-en abo-e1 Options
are ne-er exercised out o# the "one) as the exercise decision is a choice o# the o,ner1
Proposition (" "erican calls and puts "ust al,a)s sell #or at least their exercise -alues,
k s c
t t

.exercise -alue$ not price$01 Other,ise an i""ediate arbitrage is a-ailable1
!
Proposition (# &or t,o "erican calls .puts0 ,ritten on the sa"e underl)ing ,ith the sa"e
stri/e price, the call .put0 ,ith the greater ti"e to "aturit) is at least as -aluable as the
shorter$ contract1 :ith a longer$ "erican contract, the o,ner can do all she could
,ith a shorter contract and "ore .i1e1 exercise be#ore, on, or a#ter the expiration o# the
shorter contract0, the current -alue o# the extra right "ust be ,ea/l) positi-e1
Proposition ($ n "erican call .put0 is ,orth at least as "uch as a 'uropean call .put0 ,ith
the sa"e characteristics1 gain, the added rights ha-e -alue1 @ere, the right is to
exercise not onl) at "aturit), but be#ore T as ,ell1
Proposition (% Call option -alues are non3increasing in the exercise price and put option
-alues are non3decreasing in the exercise price
Consider calls i# )ou ha-e t,o calls, one ,ith a lo, exercise price and one ,ith a high
exercise price, then ,hene-er the second can be pro#itabl) exercised, the #irst can also be
pro#itabl) exercised and #or a strictl) greater pa)o##1 lso, the #irst can be pro#itabl)
exercised in so"e states in ,hich the second ,ith the higher exercise price cannot be1
6he #irst call "ust ha-e a higher current -alue1
Early Exercise of &'erican Call Options
:e can sho, that one should ne-er exercise an "erican call option earl) i# the underl)ing
asset pa)s no di-idends1
&ro" the pa)o## e?uation ,e /no, that at expiration k s k s Max c
T T T
0 8 , . 1
6hus, the current price o# the call "ust satis#) the restriction
f
t t
R
k
s c
1 !ince the ris/
#ree rate is strictl) positi-e .and thus R
f
A 10
k s c
t t
>
1 .6he di##erence
8 0 . > k s c
t t
is
o#ten called the option$ -alue1 6he added -alue #ro" /eeping the option ali-e rather than
exercising it1 6his result strengthens Proposition B abo-e b) "a/ing the ine?ualit) strict10
6his sa)s: ,hat )ou get i# )ou exercise the call earl) is strictl) less than ,hat )ou get i# )ou
sell the call1 6his suggests that in si"ple situations, ,e can concentrate not onl) on calls but
'uropean calls1 CR&R consider "erican calls ,hich leads to so"e o# the co"plications1
Bino'ial Option Pricing Exa'ple (fro' CR(R: 3 6he ris/less hedge
:e could al,a)s proceed ,ith
C D
, T T t t
c m E c
, but it is instructi-e to go through a "ore
elaborate anal)sis1 In the end, o# course,
C D
, T T t t
c m E c
,ill hold1
!uppose the distribution o# the pa)o## on a stoc/ o-er the next period is gi-en b)
q
q
y probabilit
y probabilit
with
with
s
s
s

'

1 >E
188
E8
1
1
8
"
lso assu"e that R
f
F 11>E, k F E8 .call is currentl) at the money0, and T F 11
)*e +uestion of t*e day: ,*at is c
#
-
$
6o address this ?uestion ,e exa"ine a port#olio #or"ed b) selling B calls, bu)ing > shares o# the
underl)ing stoc/, and borro,ing G48 no, .so at T ,e pa) bac/ GE8 F G48 x R
f
01
Payoff .o/ if s
1
0 !$ if s
1
0 100
!ell B calls Bc
0
8 31E8
=u) > shares 3188 E8 >88
1 =orro, 48 3E8 3E8 1
)otal "c
#
- %0 0 0
!ince, in all$ states o# nature the pa)o## on the port#olio is 2ero .ris/less hedge0, its current price
"ust be 2ero b) the la, o# one price1 !o Bc
0
3 +8 F G8, or c
0
F G>81
lternati-el): replicating port#olio:
=u) > shares and borro, G48 .to again pa)bac/ GE80 and co"pare this to bu)ing B calls1
Payoff .o/ if s
1
0 !$ if s
1
0 100
.10 =u) > shares 3188 E8 >88
1 =orro, 48 3E8 3E8 1
)otal -%0 0 1$0
Payoff .o/ if s
1
0 !$ if s
1
0 100
.>0 =u) B calls -"c
#
0 1$0
6he la, o# one price again sa)s c
0
F G>8 .3Bc
0
F 3G+80 and here ,e see that an appropriatel)
le-ered position in the underl)ing .10 replicates the pa)o## on the call option .>01 Replicating the
pa)o## on the option is the approach used in the earl) option pricing literature1 6his i"plies that
the call option is redundant, i1e1, is alread) in the asset span1 Ross .1(7+0 loo/s at the use#ulness
o# call options ,hen this is not true1
)*e 1eneral Bino'ial 2or'ula:
ssu"e: 6he price o# the underl)ing stoc/ #ollo,s a "ultiplicati-e bino"ial process o-er
discrete periods1 6he gross return on the stoc/ can ha-e one o# t,o -alues u .#or up0 ,ith
probabilit) q and .#or do,n0 ,ith probabilit) ! - q1 !o, i# s is the current price o# the stoc/, its
distribution loo/s li/e:
q us
s
!-q s
lso, assu"e the periodic ris/ #ree rate is constant: R
f
A 1
:e re?uire
8 > > R u
f 1 :h)H
%
One Period &nalysis:
I# the call expires in one period, then its price process loo/s li/e:
0 8 , .
0 8 , .
0 .
0 .
0 1 .
0 .
k s Max
k us Max
s c
us c
q pr
q pr
c
c
c
T
T

'

9o,, as in the nu"erical exa"ple, #or" a port#olio containing shares o# stoc/ and the
.dollar0 a"ount = in ris/less bonds1 6he initial cost is " s + and its pa)o## distribution is:
" R s
" R us
q pr
q pr
" s
f
f
+
+

'

+
0 1 .
0 .
9o,, choose and = to replicate the pa)o## o# the call:
u f
c "R us +
and, f
c "R s +
!ol-e the abo-e to #ind:
8
0 .

s u
c c
s us
c c
u u
.explain0
8
0 . 0 .

,
_

k u
c uc
R
k
R u
c uc
"
u
f f
u

:ith and = chosen this ,a), ,e ha-e a replicating port#olio and c = s#" as long as this is
not less than s k1 I# this is less than s k, then c = s k .recall the "erican option can not sell
#or less than its exercise -alue or it ,ould represent an arbitrage opportunit)01
6hen, c " s + .unless this is less than s - k0
f
u u
R u
c uc
u
c c
0 .

f
u
f
R
c
u
R u
c
u
R
1
1
]
1

,
_

,
_

.again, or s - k0
6his is a ris/ neutral pricing e?uation ,here the ris/ neutral probabilities are gi-en b):
1#
u
R
p
f

I
u
R u
p
f

I 1
9ote that the ris/ neutral probabilities depend onl) on para"eters o# the stoc/ price process and
the ris/ #ree rate1 :e could also represent the pricing e?uation using state prices or a state price
densit) .or stochastic discount #actor0 b) adJusting #or the actual probabilities and ta/ing an
expectation:
C D
, T T t t
c m E c
1 *uestion: ,here is qH
11
&inall), c f u
R c p c p C I0 1 . I D +
f
R k s Max p k us Max p 0C 8 , . I0 1 . 0 8 , . I D +
.or s - k0
f
R k s p k us p 0C I0. 1 . 0 . I D +
1 > >
f f
R if k s R k s
as abo-e
9ote: A8 and =K8, so the replicating port#olio is again a le-ered position in the underl)ing1
is re#erred to as the delta$ o# the option the change in option -alue #or a gi-en change in
the price o# the underl)ing stoc/1 6he general #or" o# the pricing #or"ula is ti"es the current
price o# the underl)ing less the a"ount borro,ed .,hich ,e can represent as the present -alue o#
the exercise price ti"es so"e #actor0 necessar) to #or" the replicating port#olio1
)*e )/o-Period Pro3le'
u
$
s c
uu
=Max%u
$
s-k& 0'
q us c
u
s us and, c c
u
=Max%us-k& 0'
s c

!-q

$
s c

=Max%
$
s-k& 0'
4i-en ,hat ,e ha-e Just deri-ed and that, under our assu"ptions #or R
f
and the stoc/ price
process, the en-iron"ent does not change #ro" period to period, so ,e can auto"aticall) ,rite:
f u uu u
R c p c p c C I0 1 . I D +
and,
f u
R c p c p c C I0 1 . I D +
Care#ul, the #or"s are the sa"e but not e-er)thing is1 &or exa"ple, exa"ine the L at each node
o# the tree using a nu"erical exa"ple1
t ti"e 0 ,e could again #or" a port#olio o# shares and = in bonds to replicate the call -alue
c
u
i# s us or c

i# s s1 gain, the #or"s o# and = are unchanged but their -alues are not1
s u
c c
u
0 .

M 8
f
u
R u
c uc
"
0 .

N 8
!i"pl) substitute the ne, c
u
and c

#ro" abo-e to get the s#" representation #or the current

call price1 s be#ore, c = Max% s#"& s-k'1
lternati-el), ,e can again ,rite the current -alue o# the call as:
f u
R c p c p c C I0 1 . I D +
again, i# this is greater than s-k or it ,ill be s-k other,ise1
!ubstitution allo,s us to deri-e the ris/ neutral probabilit) representation o# the call price:
c
> > >
C I0 1 . I0 1 . I > I D
f u uu
R c p c p p c p + +
12
> > > > >
0C 8 , . I0 1 . 0 8 , . I0 1 . I > 0 8 , . I D
f
R k s Max p k us Max p p k s u Max p + +
,hich ,e can see is al,a)s greater than s-k using the sa"e process as ,as used abo-e1
)*e n period pro3le': =) extension .o# the last e?uation0 ,e can ,rite:
n
f
n
(
( n ( ( n (
R k s u Max p p
( n (
n
c
1
]
1

,
_

8
0 8 , . I0 1 . I
0O . O
O
9o,, let a be the s"allest non3negati-e integer such that ,ith a up "o-es and n-a do,n
"o-es the option #inishes in the "one):
k s u
a n a
>

6his can also be stated as a is the s"allest non3negati-e integer greater than
0 . 0 . u )n s k )n
n
1
I# a * n the option can ne-er be in the "one) prior to its expiration and c=01
I# 0 + a + n then #or all ( < a, 8 0 8 , .

k s u Max
( n (
and #or all
a (
,
k s u k s u Max
( n ( ( n (


0 8 , . so ,e can si"pli#) our #or"ula as:
c
n
f
n
a (
( n ( ( n (
R k s u p p
( n (
n
1
]
1

,
_

C D I0 1 . I
0O . O
O
Re,rite this as:
c
( )
1
]
1

,
_

1
1
]
1

,
_

,
_

( n (
n
a ( n
f
n
a ( n
f
( n (
( n (
p p
( n (
n
R
k
R
u
p p
( n (
n
s I0 1 . I
0O . O
O
I0 1 . I
0O . O
O
or,
IC , 7 D C I , 7 D p n a
R
k
p n a s c
n
f

:here:
u
R
p
f

I
I I p
R
u
p
f

,
_

, and
a the smallest non-ne,ati-e inte,er ,reater than
( ) ( )0 .

u
)n
s
k
)n
n
gain, " s c + ,here the <s are the complementary bino"ial distribution #unction the
probabilit) o# getting a or more u.s in n tries i# the probabilit) o# u is
I p
.or p/01
13
)*e Continuous )i'e Li'it:
@ere ,e let the n$ #ro" the n3period proble" get large1 In doing so, ,e ,ant to let the
length o# a period o# ti"e go to 2ero1 :e need to ta/e so"e care in doing this so that ,e
don<t ,ind up ,ith ridiculous para"eter -alues that sa) the stoc/ price is expected to change
b) >8P o-er an instant in ti"e rather than o-er a )ear<s ti"e1
Qet h represent the elapsed ti"e bet,een successi-e stoc/ price changes .this is ,hat ,e ,ill
let go to 2ero0, and let T be the #ixed length o# calendar ti"e to expiration .#ixed nu"ber o#
units$ o# ti"e0, and n is the nu"ber o# periods o# length h prior to expiration
0 . n T h so
1
:e ,ant to see ,hat happens as
n
or 1 8 h
:e #irst need to adJust R
f
1 R
f
is one plus the rate o# interest o-er a unit$ o# calendar ti"e, so
o-er T units,
T
f
R
is the ris/less return1
Renote b) f
R
S
one plus the ris/less rate o-er a period o# length h1 6hen, o-er the ti"e to
expiration there are n such periods1 !o,
n
f
R
S
is the total return until expiration .date T01
:e there#ore re?uire:
n
T
f f
T
f
n
f
R R so R R
S S
:e also need to adJust u and #or changing n as ,ell1
O-er each discrete period, in the n period "odel ,e assu"ed the stoc/ price ,ould
experience a one plus rate o# return o# u ,ith probabilit) q and ,ith probabilit) !-q1
It<s easier to ,or/ ,ith )n%u' or )n%' ,hich gi-es the continuousl) co"pounded rate o#
return o-er each period1 6he continuousl) co"pounded return is a bino"ial rando" -ariable
,ith reali2ation )n%u' ,ith probabilit) q and )n%' ,ith probabilit) %!-q' in each period1
O-er n periods the continuousl) co"pounded return is additi-e:
( ) ( ) 0 . 0 . 0 . 0 .
I
n)n

u
()n )n ( n u ()n
s
s
)n + +
,here ( is the .rando"0 nu"ber o# up "o-es .an up$ is a 10 in the n periods until expiration1
6hen,
14
( ) [ ] ( ) 0 . 0 .
I
n)n ( E

u
)n
s
s
)n E +
and,
( ) ( ) ( ) [ ] 0 .
I
>
( 0ar

u
)n
s
s
)n 0ar
6he expected outco"e #or each trial is q .the probabilit) o# an up$0, so in n trials
nq ( E 0 .
!ince the -ariance o# the outco"e o# each trial is 0 1 . 0 8 0. 1 . 0 1 .
> >
q q q q q q + so
0ar%('=nq%!-q'
!o,
( ) [ ] ( ) [ ] n n )n

u
q)n
s
s
)n E
S
0 .
I
+
( ) [ ] ( ) [ ] n n

u
)n q q
s
s
)n 0ar
>
>
S
0 1 .
I

I#
T
and T
>
are the e"pirical -alues o# the stoc/<s expected return and -ariance o-er the
ti"e until expiration .T periods till expiration ,ith as the expected return o-er each unit o#
ti"e and
>
the -ariance o-er each unit o# ti"e0, then ,e ,ant:
15
( ) [ ] T n )n

u
q)n + 0 . and
( ) [ ] T n

u
)n q q
>
>
0 1 .
as
n
6hese conditions ,ill #ollo, i# ,e de#ine:
n T
e u

n T
e

n
T
q

,
_

>
1
>
1
=) substitution )ou can see that #or an) n&
T n S
and ( ) [ ] T T
n
T
n
> > > >
S as n 1
!o, the "ean is correct #or all n and the -ariance con-erges in the li"it .as
n
01
Our n period option pricing #or"ula is:
IC , 7 D
S
C I , 7 D p n a R k p n a s c
n
f


!ince
T
f
n
f
R R

S
,
IC , 7 D C I , 7 D p n a kR p n a s c
T
f


,hich "eans the bino"ial "odel con-erges to the =lac/3!choles "odel, ,hich is ,ritten
0 . 0 . T x 1 kR x s1 c
T
f


,here T
T
kR s )n
x
T
f

>
1
0 5 .
+

, i#
0 . C I , 7 D x 1 p n a
and,
0 . IC , 7 D T x 1 p n a 1
nd the) do as sho,n b) the central li"it theore" results de-eloped in the paper1 9ote again
that the option price can be expressed as delta ti"es the stoc/ price less the a"ount that "ust be
borro,ed to replicate the option1
1!