Professional Documents
Culture Documents
Chapter 21
Chapter 21
Introduction
We examine two model used to price options:
1. Binomial method
2. Black-Scholes method
If that is true, then it must be the case that the option value is exactly the
same as the cost of the so-called replicating strategy. If it is not, to exploit,
buy the cheap one and sell the expensive one (arbitrage).
Assume that a stock price can take only two possible values at option
expiration: The stock will either increase to a given higher price or
decrease to a given lower price.
If these two portfolio provide the same pay-off they in the future. They
should be cost the same to establish.
A call option on the stock might specify At year-end, the payoff to the holder of the
an exercise price of X=$110 and a time to call option will be either zero, if the stock
expiration of 1 year. falls, or $10, if the stock price goes to $120.
Suppose the stock now sells at S0=$100,
These possibilities are illustrated by the
and the price will
following value trees:
either increase by a factor of u=1.20
to Su =$120
or fall by a factor of d = 0.9 to SD
=$90 by year-end.
u is called up factor and d is called down
factor. u and d depends on volatility and
times interval (more to say).
The interest rate is 10%.
The payoff of this portfolio is exactly three times that of the call option for either
value of the stock price.
In other words, three call options will exactly replicate the payoff to the portfolio;
it follows that three call options should have the same price as the cost of
establishing the portfolio.
Hence the three calls should sell for the same price as this replicating portfolio.
Therefore, 3C=$18.18 or each call should sell at C= $6.06.
We can generalize the hedge ratio for other two-state option problems as:
where Cu or Cd refers to the call options value when the stock goes up or down,
respectively, and uS0 and dS0 are the stock prices in the two states.
The hedge ratio, H, is the ratio of the swings in the possible end-of-period values
of the option and the stock.
If the investor writes one option and holds H shares of stock, the value of the
portfolio will be unaffected by the stock price.
A Risk-Neutral Shortcut
In a risk-neutral economy, investors would not demand risk premiums and
would therefore value all assets by discounting expected payoffs at the risk-
free rate of interest. Therefore, a call option would be valued at the risk-free
rate:
C=E(CF)/(1+rf )
Because there are no risk premiums, the stocks expected rate of return must
equal the risk-free rate.
A Risk-Neutral Shortcut
We call p a risk-neutral probability to distinguish it from the true, or
objective, probability.
To illustrate, in our two-state example at the beginning of Section 21.2,
we had u = 1.2, d = .9, and rf = .10. Given these values,
p =(1 + .10 - .9)/(1.2 - .9)=2/3.
We find the present value of the option payoff using the risk-neutral
probability and discount at the risk-free interest rate:
C=E(CF)/(1+rf)=[pCu+(1-p)Cd ]/(1+rf )=[2/3x10 + 1/3x0]/1.10=6.06
Assuming both N (d) terms are close to 1, that is, when there is a very high
probability the option will be exercised. Then the call option value is equal
to S0 - Xe -rT , which is the adjusted intrinsic value, S0 -PV(X ).
Assuming the N (d) terms are close to zero, meaning the option almost
certainly will not be exercised. Then the equation confirms that the call is
worth nothing.
For example, if S0 = 105 and X = 100, the option is 5% in the money, and
ln(105/100) = 0.049. Similarly, if S0 = 95, the option is 5% out of the
money, and ln(95/100) = - 0.051.
At the same time, some regular empirical failures of the model have
been noted.
The market might price these options as though there is a bigger chance
of a large drop in the stock price than would be suggested by the Black-
Scholes assumptions.