OPTIONS PRICING

The Basics
Options
 Options Contract – Derivative
Instrument.
 Used for Hedging.
 Has speculative appeal as a leveraging
instrument.
 Options Contract
 Two parties to an options contract: the
buyer and the writer (or seller).
 The buyer of the options contract has the
right but not the obligation to buy (or sell)
the underlying asset from (to) the writer at
a specified price within a specified period of
time (or at a specified date).
 In return, the buyer pays a premium (or
options price).
 Options Contract
 The specified price – strike price, exercise
price.
 The specified date – expiration date,
maturity date.
 When the option grants the buyer the right
to buy, then it is called a call option.
 When the option grants the buyer the right
to sell, then it is called a put option.
Example 1
Anil K. owns a luxury apartment down
Bannerghatta road which is currently
worth Rs. 20 lakhs. Ashish B., who rents
this apartment buys a European call with
a strike price of Rs. 20 lakhs and with an
expiration date three months from now.
For this option, Ashish pays a premium of
Rs. 1.5 lakhs.
Example 1 Continued..
 What happens if, three months from
now, the market price goes up to Rs. 30
lakhs?
 What happens if, three months from
now, the market price goes down to Rs.
15 lakhs?
Call Options – Buyer’s
Perspective
C C: Intrinsic Value of Option
K: Strike Price
S: Market Price

K S
Call Options – Seller’s
Perspective
C C: Intrinsic Value of Option
K: Strike Price
S: Market Price

K S
Example 2
Shakil, a fruit wholesaler goes long on a
put option for 1000 Kilos of premium
Langda mangoes (assuming that such
an options market is in existence). The
expiration date is 1 month from now.
The strike price is Rs. 10/Kilo. For this
option he pays a premium of Rs. 250.
Example 2 continued..
 What happens when the wholesale
price becomes Rs. 8/Kilo?
 What happens when the price rises to
Rs. 12/Kilo?
Put Options-Buyer’s
Perspective
C C: Intrinsic Value of Option
K: Strike Price
K S: Market Price

K S
Put Options-Writer’s
Perspective
C C: Intrinsic Value of Option
K: Strike Price
S: Market Price

K S
Options vs. Futures
Contract
 In futures, equal and opposite
obligation on both parties. In options,
the obligation lies only with the seller.
 In futures, buyer and seller face
symmetric risk. In options, the buyer
simply risks losing his/her premium,
while the reward can be unlimited.
Opposite is true for the seller.
 Example 3
Pyara Singh expects to harvest a 1000 Kilos
of Langda mangoes a month from now. To
hedge against a possible downturn in
prices, he takes a long position on put
option with a strike price of Rs 10000, and
an expiration date a month from today. For
this option he pays a premium of Rs. 300.
Example 3 continued..
 What would his returns look like as a
function of the market price of
mangoes?
 If he were to take a short position on a
futures contract for 1000 Kilos of
mangoes with a futures price of Rs.
10000, what would his returns look
like?
 Example 4:
Shirin Patel, CFO, Malgudi Tiffin Room
(MTR Sweets) needs a delivery of 10 tons
of sugar on August 27th, 2001. To hedge
against a possible price rise she goes long
on a call option with a strike price of Rs.
10000/ton. The expiration date is one
month from today. She pays an option
premium of Rs. 5000. What do her
payoffs(costs) look like?
 Pricing of Options
 Options Price (Premium) = Intrinsic Value
+ Time Value.
 Intrinsic Value = Max (0,S-K) {for a Call},
= Max (0,K-S) {for a Put}.
 Time Value: Reflects the expectation that
favorable changes in the
market price will
increase the value of option
beyond the intrinsic value.
 Pricing of Call Options
12

10 Options
Price
8

6
Intrinsic
4 Value

0
0 5 10 15 20
 Pricing of Put Options
12

10

0
0 5 10 15 20
 Factors Affecting Price
 Current Price of Asset (S).
 Strike Price (K).
 Time to expiration of option.
 Expected price volatility (s).
 Short-term, risk-free interest rate (r).

Surprising Result! Growth rate of asset

price does not affect Options Price.
 Binomial Options Theory –
Single Period
t=0 t=Dt
S: Price of Asset at t=0.
u: Factor of increase in Price after 1 time
period.
d: Factor of decrease in Price after 1 time
period.
p: Probability of increase in Price after 1 time
period.
 Binomial Options Theory –
Single Period
uS (p)

dS (1-p)

r: Risk Free Rate,

R = 1 + r.

Assume that,
u > R > d > 0.
 Binomial Options Theory –
Single Period
We now match the returns of a portfolio
consisting of Rs. x worth of asset (stocks)
and Rs. b worth of risk-free securities to that
of a call option on the same asset (stocks).
ux
Max(uS-K)
x
C
dx
Rb Max(dS-K)
b

Rb
 Binomial Options Theory –
Single Period
 After 1 time period, the returns of the Call
option are either, Cu = Max {uS-K,0}, or Cd =
Max {dS-K,0}.
 After 1 time period, the returns of the
matching portfolio are either, (ux + Rb), or
(dx + Rb).
 It is always possible to find an appropriate
mix of x and b so that the returns are
matched.
 Example 5
Yasmin buys one Call option on a stock
whose current price S = Rs. 100. The stock’s
upturn factor u = 1.051, and it’s downturn
factor d = 0.951. Let R = 1.02, and the strike
price K = Rs. 102.
 What are the returns of the the option after

1 time period?
 If x = Rs. 31 and b = - Rs. 28.9 what are the

returns of the matched portfolio?

 Example Continued..
Suppose that the strike price K = Rs. 90.0.
 What are the returns of the the option
after 1 time period?
 Can you determine the values of x and b

so that the returns of the portfolio match

those of the call option?
 Binomial Options Theory –
Single Period
 In general, to match the returns:
ux + Rb = Cu ,
dx + Rb = Cd .
 Hence,
C u  Cd
x
ud
and uC d  dC u
b
R(u  d )
Binomial Options Theory –
Single Period
 The value of the portfolio:
C u  Cd uC d  dC u
x  b 
ud R( u  d )
1 Rd u R
 ( Cu  Cd )
R ud ud
Binomial Options Theory –
Single Period
 By the no-arbitrage principle,
C = x + b.
From our example, when K = 102, C = ?

 Therefore,
1 Rd u R
C ( Cu  Cd )
R ud ud
 Binomial Options Theory –
Single Period
1 Rd u R
C ( Cu  Cd )
R ud ud
Rd
Let, q
ud
u R
Then, 1 q  ,
ud
and 0 < q < 1.
 Binomial Options Theory –
Single Period
 q – risk-neutral probability
 Observe that
qu + (1-q)d = R.
 In general,
E[C(T)] = qCu + (1-q)Cd
C(T-1) = 1/R*E[C(T)]
 The option pricing formula is independent
of p.
Multi-period Options
Call Options:

Cu Cuu= Max (u2S-K,0)

C Cud = Max (udS-K,0)

Cd
Cdd = Max (d2S-K, 0)
Multi-period Options
1
C u  (qC uu  (1  q)C ud )
R

1
Cd  (qC ud  (1  q)Cdd )
R

1
C  (qC u  (1  q )Cd )
R