Options 1

OPTIONS
Introduction
• A derivative is a financial instrument whose value is
derived from the value of some underlying asset.
• A call option gives one the right to buy an asset at
the exercise or strike price.
• A put option gives one the right to sell the asset at
the exercise price.
Options 2

• An option has an exercise date, also called the

strike date, maturity, or expiration date.
• American options can be exercised at any time up
to their exercise date.
• European options can be exercised only at their
exercise date.
Options 3

• Complex types of derivatives cannot be priced by a

simple formula such as the Black-Scholes formula.
• In this chapter:
– heuristic derivation of Black-Scholes formula
Options 4

Why do companies purchase options and other

derivatives?
Answer: to manage risk
In 2000 Annual Report, the Coca Cola Company wrote:
• Our company uses derivative financial instruments
primarily to reduce our exposure to adverse
fluctuations in interest rates and foreign exchange
rates and, to a lesser extent, adverse fluctuations in
commodity prices and other market risks.
Options 5

• We do not enter into derivative finanicial instruments

for trading purposes.
• As a matter of policy, all our derivative positions are
used to reduce risk by hedging an underlying
economic exposure.
Options 6

• Because of the high correlation between the hedging

instrument and the underlying exposure, fluctuations
in the value of the instruments are generally offset by
reciprocal changes in the value of the underlying
exposure.
• The derivatives we use are straightforward
instruments with liquid markets.
Derivatives can and have been used to speculate.
• But that should not be their primary purpose.
Options 7

Call options
Suppose you purchased a European call on 100 shares of
Stock A with exercise price of $70.
• At expiration, suppose Stock A is selling at $73.
• The option allows you to purchase the 100 shares for
$70 and to immediately sell them for $73.
– gain of $300.
• Net profit isn’t $300 since you paid for the option.
• If the option cost $2/share, then you paid $200
Options 8

• Moreover, you paid the $200 up front but only got the
$300 at the expiration date.
• Suppose expiration date was 3 months after purchase
and r is 6% per annum or 1.5% for 3 months.
• The dollar value of your net profit is

exp(−.015)300 − 200 = 95.53

at t = 0 and is

300 − exp(.015)200 = 96.98

at t = T .
Options 9

• We will use the notation (x)+ = x if x > 0 and = 0 if

x ≤ 0.
• With this notation, the value of a call at exercise date
is
(ST − K)+ ,
where K is the strike price and ST is stock’s price on
the exercise date, T .
Options 10

• A call is not exercised if strike price is greater than

stock price.
• If a call is not exercised, then one loses the cost of
buying the option.
• One can lose money on an option even if it is
exercised.
– In example, if Stock A were selling for $71 at T ,
then one would exercise and gain $100.
– This is less than the $200 paid for the option.
Options 11

The law of one price

• “Law of one price”
– if two financial instruments have exactly the same
payoffs, then they will have the same price.
• This principle is used to price options.
• Find a portfolio or a self-financing trading strategy
with a known price and same payoffs as the
option in all situations.
– Price of the option is the same as the portfolio or
trading strategy.
– “Self-financing” means requires only an initial
investment and no money is withdrawn
Options 12

• Example:
– Company A sells at $100/share.
– r is 6% compounded annually.
– Consider futures contract obliging party 1 to sell
to party 2 one share a year from now at price P .
∗ No money changes hands now.
– What is the fair market price P ?
• Not an option – sale must take place.
• Should P depend on expected price of company A in
one year?
– NO!!!
Options 13

• Consider the following strategy.

– Party 1 can borrow $100 and buy one share now.
– A year from now Party 1 sells the share for P
dollars
– Pays back $106.
– The profit is P − 106.
– Therefore, P should be $106.
• Consider what would happen if P were not $106:
– Any other value of P besides $106 would lead to
unlimited risk-free profits.
– Market would immediately correct.
Options 14

Arbitrage
Arbitrage means a guaranteed risk-free profit with no
invested capital.
• In other words, arbitrage is a “free lunch.”
• The arbitrage price of a security is the price that
guarantees no arbitrage opportunities.
• The law of one price is equivalent the market being
free of arbitrage.
• The price of $106 that we just derived is the arbitrage
price.
Options 15

Time value of money and present value

“Time is money”
• A dollar a year from now is worth less than a dollar
now.
• We must be able to convert future values to their
present values, or vice versa.
– Example: The arbitrage enforced future price of
a stock is the present price converted into a “future
value”.
Options 16

• Let r be the risk-free annual interest rate.

• “present value” of $D one year from now is
$D/(1 + r) (simple interest) or $D exp(−r)
(continuous compounding).
• Thus, $D now is worth $(1+r)D dollars a year from
now without compounding, or ${exp(r)} D dollars
under continuous compounding.
• When $D is a future cash flow, then its present value
is also called a discounted value and r is the
discount rate.
Options 17

• Distinction between simple interest and compounding

is not essential
– an interest rate of r without compounding is
equivalent to an interest rate of r0 with
continuously compounding where

1 + r = exp(r0 )

so that

r = exp(r0 ) − 1 or r0 = log(1 + r).

• We will work with both simple and compound

interest, whichever is most convenient.
Options 18

• Examples
– If r = 5%, then r0 = log(1.05) = .0488 or 4.88%.
– If r0 = 4%, then r = exp(.04) − 1 = 1.0408 − 1 or
4.08%.
– In general, r > r0
• Occasionally, we make the unrealistic assumption that
r = 0.
– This allows us to focus on other concepts.
Options 19

Pricing calls — a simple binomial example

Suppose stock is selling for $80.
• At the end of one time period it can either have
– increased to $100 or
– decreased to $60.
• What is the current value of a call with strike price =
$80 and T = 1?
Options 20

• At T = 1, call option will be worth

– $20 ($100 − $80) if the stock has gone up
– $0 dollars if the stock has gone down.
• However, the question is “what is the option worth
now?”
Options 21

Stock Option
20
100

80 ?

60 0

Given: exercise price = 80

hedge ratio = 1/2
buy 1/2 share
borrow $30
initial value of portfolio = (1/2)(8) − 30 = $10

Example of one-step binomial option pricing.

Options 22

• The current value of the option depends only on r.

• Start with r = 0.
• The value of the option is $10.
• How did I get this value?
Options 23

Consider the following investment strategy.

• Borrow $30 and buy one-half of a share of stock.
• The cost upfront is $40 − $30 = $10.
• If stock up, then portfolio worth 100/2 − 30 = 20
(same as option).
• If stock down, then portfolio worth 60/2 − 30 = 0
(same as option).
• By law of one price:
present value of the call
= present value of the portfolio = $10.
Options 24

Let’s summarize what we have done.

• We have found a portfolio of stock and risk-free that
replicates the call option.
• The current value of the portfolio is easy.
• And, the option must have the same value.
Options 25

Suppose we have just sold a call option.

• By purchasing this portfolio we have hedged the
option.
• By hedging is meant that we have eliminated all risk:
– the net return of selling the option and purchasing
the portfolio is exactly 0, no matter what.
Options 26

How did I know that the portfolio should be 1/2 share of

stock and −$30 in cash?
• The “volatility” of one share of the stock is $100 −
$60 = $40.
• The volatility of the option is $20 − $0 = $20.
• The ratio of volatilities is 1/2 (called the hedge
ratio).
• Portfolio must have same volatility as option
– so portfolio must have one-half share.
Options 27

Stock Option
20
100

80 ?

60 0

Given: exercise price = 80

hedge ratio = 1/2
buy 1/2 share
borrow $30
initial value of portfolio = (1/2)(8) − 30 = $10

Example of one-step binomial option pricing.

Options 28

Key point: The number of shares in the portfolio must

equal
volatility of option
hedge ratio = .
volatility of stock

• So now we know why the portfolio holds 1/2 share.

• How was it determined that $30 should be borrowed?
– If stock down, portfolio worth $30 minus amount
borrowed and option worth $0.
– Thus, the amount borrowed is $30.
Options 29

Key point: When stock down

value of portfolio = value of the option.
• Alternatively, when stock up
value of portfolio = value of the option.
• So $50 minus the amount borrowed = $20.
Options 30

Stock Option
20
100

80 ?

60 0

Given: exercise price = 80

hedge ratio = 1/2
buy 1/2 share
borrow $30
initial value of portfolio = (1/2)(8) − 30 = $10

Example of one-step binomial option pricing.

Options 31

Suppose interest rate is 10%.

• Then borrow $30/(1.1) = $27.27 so amount owed
after one year is $30.
– Cost of portfolio is 40 − 30/1.1 = $12.7273.
– So value of option is $12.7273 if the risk-free rate is
10%.
• Higher than when the risk-free rate is 0, because the
initial borrowing is more expensive.
Options 32

Here’s how to valuate one-step binomial options for other

values of the parameters. Suppose
• current price is s1
• after one time period the stock either
– goes up to s3 , or
– down to s2
• strike price is K
• risk-free rate is r
Options 33

• s2 < K < s3 , so the option is exercised if and only if

the stock goes up.
– This is a reasonable assumption for the following
reasons:
– If s2 < s3 ≤ K, then the option will never be
exercised
∗ its price must be 0
– If K ≤ s2 < s3 , then the option will always be
exercised
∗ it is a futures contract.
Options 34

• Therefore, the hedge ratio is

s3 − K
δ= . (1)
s3 − s2
• This is the number of shares purchased
– cost is δ s1
Options 35

• amount borrowed is
δs2
, (2)
1+r
and
• amount paid back will be δs2 .
• price of the option (cost of portfolio) is
½ ¾ ½ ¾
s2 s3 − K s2
δ s1 − = s1 − . (3)
1+r s3 − s2 1+r
Options 36

• If the stock goes up, then

– the option is worth (s3 − K)
– the portfolio is also worth (s3 − K).
• If the stock goes down, both the option and the
portfolio are worth 0.
Thus, the portfolio does replicate the option.
Options 37

Example In the example analyzed before,

• s1 = 80
• s3 = 100
• s2 = 60
• K = 80
Therefore,
100 − 80 1
δ= = .
100 − 60 2
The price of the option is
½ ¾
1 60
80 − ,
2 1+r
which is $10 if r = 0 and $12.7273 if r = 0.1.
Options 38

The amount borrowed is

δs2 (1/2)60 30
= = ,
1+r 1+r 1+r
which is
• $30 if r = 0
• $27.27 if r = .1
Options 39

Two-step binomial option pricing

Options 40

• A one-step binomial model may be reasonable for

very short maturities.
• For longer maturities, multiple-step models needed.
• A multiple-step model can be analyzed by doing the
individual steps going backwards in time.
Options 41

• Where we are headed eventually: As the number

of steps increases and the holding period decreases
accordingly
– stock price follows a geometric Brownian motion
– price of option converges to Black-Scholes formula
Options 42

Stock Option
100 20

90 ?
80 80 ? 0

70 ?
60 0

Exercise price = $80

Two-step binomial model for option pricing.
Options 43

Assume r = 0 for now.

Using the pricing principles just developed and working
backwards, we can fill in the question marks:
Options 44

Stock Option
100 20D
1 share
borrow $80
90 10 B
1/2 share
borrow $35
80 80 5 A 0E

70 0 C
0 shares
borrow $0
60 0F

Exercise price = $80

Pricing the option by backwards induction.
Options 45

Let’s show that our trading strategy is self-financing.

• To do this we need to show that we invest no money
other than the initial $5.
• Suppose that the stock is up on the first step, so we
are at node B. Then our portfolio is worth $90/2 −
$35 or $10.
• At this point we borrow $45 and buy another
half-share for $45; this is self-financing.
• If the stock is down on the first step, we sell the half
share of stock for $35 and buy off our debt; again the
step is self-financing.
Options 46

Arbitrage pricing by expectation

Options are priced by arbitrage,
• The expected value of the option is not relevant.
• In fact, we have not even considered the up and down
probabilities.
Options 47

However, there is a remarkable result showing that

arbitrage pricing can be done using expectations.
• There exists probabilities of the stock moving up and
down such that the arbitrage price is equal to the
expected value.
• Whether these are the “true” probabilities is
irrelevant.
• These probabilities do give the correct arbitrage price.
– In fact, they are the easiest means for computing
arbitrage derived prices.
Options 48

• Let “now” be time 0 and “one-step ahead” be time 1.

• Present value of $D dollars at time 1 is $D/(1 + r).
• Let f (2) = 0 and f (3) = s3 − K be the values of
option if stock moves up or down.
Options 49

• There is a value of q between 0 and 1, such that the

present value of the option is
1
{qf (3) + (1 − q)f (2)}. (4)
1+r
(4) is the present value of the expectation of the
option at time 1 when q is up probability.
Options 50

How do we find this magical value of q?

• q must satisfy
½ ¾
1 s3 − K s2
{qf (3) + (1 − q)f (2)} = s1 − .
1+r s3 − s2 1+r
• Substituting f (2) = 0 and f (3) = s3 − K into
equation and solving for q:
(1 + r)s1 − s2
q= .
s3 − s2
Options 51

From previous slide:

(1 + r)s1 − s2
q= . (5)
s3 − s2
• We want q to be between 0 and 1.
• From (5) one can see that 0 ≤ q ≤ 1 if
s2 ≤ (1 + r)s1 ≤ s3 .
Options 52

• s2 ≤ (1 + r)s1 ≤ s3 is required for market to be

arbitrage-free.
• If we invest s1 in a risk-free asset at time 0, then
value of our holdings at time 1 will be (1 + r)s1 .
• If we invest s1 in stock, then value of our holdings at
time 1 will be either s2 or s3 .
• If s2 ≤ (1 + r)s1 ≤ s3 were not true, then there would
be an arbitrage opportunity.
Options 53

• For example, if (1 + r)s1 < s2 ≤ s3 , then could borrow

at rate r and invest in stock
– at t = 1 we pay back (1 + r)s1 and receive at least
s2 > (1 + r)s1 .
• Thus, the requirement that the market be
arbitrage-free ensures that 0 ≤ q ≤ 1.
Options 54

A general binomial tree model

Consider a possibility non-recombinant tree as seen in
the following figure.
Options 55

q(3)
3
1−q(3)
q(1) 6

1−q(1) 5
q(2)
2

1−q(2)

Two-step non-recombinant tree.

Options 56

Assume that:
• At the jth node the stock is worth sj and the option
is worth f (j).
• The jth node leads to either the 2j + 1th node or the
2jth node after one time “tick.”
• The actual time between ticks is δt.
• Interest is compounded continuously at a fixed rate r
so that B0 dollars now is worth exp(rn δt)B0 dollars
after n time ticks.
Options 57

Then at node j:
• The value of the option is
n o
f (j) = exp(−r δt) qj f (2j + 1) + (1 − qj )f (2j) .

where
• The arbitrage determined qj is
er δt sj − s2j
qj = . (6)
s2j+1 − s2j
• The number of shares of stock to be holding is
f (2j + 1) − f (2j)
φj = = hedge ratio.
s2j+1 − s2j
Options 58

• Denote the amount of capital to hold in the risk-free

asset by ψj .
– typically ψj is negative because money has been
borrowed.
• Since portfolio replicates option, f (j) = sj φj + ψj .
• Therefore,
ψj = {f (j) − φj sj }. (7)
(ψj changes in value to er δt {f (j) − φj sj } after one
time tick).
• The probability of any path is product of qj ’s along
the path.
Options 59

An example
The tree for the previous example is shown in the next
figure.
• Because r = 0 and stock moves up or down same
amount ($10), the qj all equal 1/2.
• It follows from
er δt sj − s2j
qj = .
s2j+1 − s2j
that whenever r = 0 and the up moves = s2j+1 − sj
and down moves = sj − s2j , are length, then qj = 1/2
for all j.
Options 60

20
7
100

.5
10
3
90 .5
0
6
.5 80
5
1
80 0
.5
5
0 80
.5
2
70
.5

0
4
60
Options 61

• The probability of each full path from node 1 to one

of nodes 4, 5, 6, or 7 is 1/4.
• Given the values of the option at nodes 4, 5, 6, and 7,
it is easy to compute the expectations of the option’s
value at other nodes.
• The path probabilities are independent of the exercise
price, since they depend only on the prices of stock at
the nodes and on r. Therefore, it is easy to price
options with other exercise prices.
Options 62

Exercise
Assuming the same stock price process as in the figure,
price the call option with an exercise price of $70.

Answer:
• Given this exercise price, it is clear that the option is
worth $0, $10, $10, and $30 dollars at nodes 4, 5, 6,
and 7, respectively.
• Then we can use expectation to find that the option
is worth $5 and $20 at nodes 2 and 3, respectively.
• Therefore, the option’s value at node 1 is $12.50; this
is the price of the option.
Options 63

Martingales
Martingale: probability model for a fair game, that is, a
game where the expected changes in one’s fortune are
always zero.
• More formally, . . . , Y0 , Y1 , Y2 , . . . is a martingale if

E(Yt+1 |Yt , . . . , Y1 ) = Yt

for all t.
– In most cases that we will study
E(Yt+1 |Yt , . . . , Y1 ) = E(Yt+1 |Yt ) (Markov)
Options 64

Example
On each toss of a fair coin we wager half of our fortune
on heads.
• Our fortune at time t is Yt .
• We win or loss Yt /2 with probability 1/2.
• Our fortune at time t + 1 is either Yt /2 or (3/2)Yt ,
each with probability 1/2.
• Therefore,
E{Yt+1 |Yt } = (1/2)(Yt /2) + (1/2)(3/2)Yt = Yt .
– our sequence of fortunes is a martingale.
Options 65

Let Pt , t = 0, 1, . . . be the stock price at the end of the

tth step.
• Then Pt∗ := exp(−rt δt)Pt is the discounted price
process.
Options 66

Key fact: Under the {qj } probabilities, the discounted

price process Pt∗ is a martingale.
• Recall:
er δt sj − s2j
qj = .
s2j+1 − s2j
• To see that Pt∗ is a martingale, we calculate using the
definition (6) of qj :

E(Pt+1 |Pt = sj ) = qj s2j+1 + (1 − qj )s2j

= s2j + qj (s2j+1 − s2j )

= s2j + {exp(r δt)sj − s2j } = exp(r δt)sj .
• This holds for all values of sj .
Options 67

• Therefore,

E(Pt+1 |Pt ) = exp(r δt)Pt ,

so that

E{exp(−r(t + 1) δt)Pt+1 |Pt )} = exp(−rt δt)Pt ,

or
∗
E(Pt+1 |Pt∗ ) = Pt∗ .
• This shows that Pt∗ is a martingale.
Options 68

Martingale or risk-neutral measure

Any set of path probabilities, {pj }, is called a measure
of the process.
• The measure {qj } is called
– the martingale measure
– or the risk-neutral measure.
• We will also call {qj } the risk-neutral path
probabilities.
Options 69

The risk-neutral world

• If all investors were risk-neutral, that is, indifferent to
risk, then
– there would be no risk premiums
– and all expected asset prices would rise at the
risk-free rate.
• Therefore, all asset prices discounted at the risk-free
rate would be martingales.
– We know that we do not live in such a risk-free
world
– But expectations with respect to a risk-neutral
model give arbitrage-free prices.
Options 70

Example
It was argued that if a stock is selling at $100/share and
r is 6%, then the correct (= arbitrage-free) future price
of a share one year from now is $106.
• We can now calculate this value using the risk-neutral
measure
– in the risk-neutral world, the expected stock price
will increase to exactly $106 one year from now.
Options 71

Trees to random walks to Brownian motion

Getting more realistic
Binomial trees are useful because they illustrate several
important concepts, in particular:
• arbitrage pricing
• self-financing trading strategies
• hedging
• computation of arbitrage prices using the risk-neutral
measure
Options 72

However, binomial trees are not realistic:

• Stock prices are continuous, or at least approximately
continuous.
• This lack of realism can be alleviated by increasing
the number of steps.
• One can increase the number of steps without limit to
derive the Black-Scholes formula.
• The present section will get us closer to that goal.
Options 73

A three-step binomial tree

The next figure is a three-step tree where at each step
the stock price either goes up $10 or down $10.
• Assume that the risk-free rate is r = 0.
• Strike price = $80
Options 74

50
All q’s are 1/2 130
40
120
30 30
110 110
21.25
20
100 100

12.5 10
90 90

5
80

0
70

t=0 t=1 t=2 t=3

Options 75

• Pt is stock price at time t

• Risk-neutral path probabilities are each 1/2
• Using risk neutral probabilities Pt is a stochastic
process,
• Pt+1 equals Pt ± $10 — process is a random walk.
Options 76

• We have

Pt = P0 + ($10){2(W1 + · · · + Wt ) − t} (8)

where
– W1 , · · · , W3 are independent
– and Wt equal 0 or 1, each with probability 1/2.
• If Wt is 1, then
– 2Wt − 1 = 1 so price jumps up $10.
• If Wt is 0, then
– 2Wt − 1 = −1 so the price jumps down $10.
Options 77

The random sum W1 + · · · + Wt is Binomial(t, 1/2)

• mean = t/2 (using formula: np)
• variance = t/4. (using formula: np(1 − p))

The value of the call option is

E{(P3 − K)+ } (9)
where
• x+ equals x if x ≥ 0
• and equals 0 otherwise.
The expectation in (9) is with respect to the risk-neutral
probabilities.
Options 78

Since W1 + W2 + W3 is Binomial(3, 1/2)

• it equals 0, 1, 2, or 3 with probabilities 1/8, 3/8, 3/8,
and 1/8, respectively. Using formula:
µ ¶
n
px (1 − p)n−x
x
• Therefore,
·
1
E{(P3 − K)+ } = {P0 − 30 − K + (20)(0)}+
8
+ 3{P0 − 30 − K + (20)(1)}+
+ 3{P0 − 30 − K + (20)(2)}+
¸
+ {P0 − 30 − K + (20)(3)}+ .
Options 79

Examples
If P0 = 100 and K = 80,
• then P0 − 30 − K = −10
• and
1n
E{(P3 − K)+ } = (−10 + 0)+ + 3(−10 + 20)+
8
o
+ 3 (−10 + 40)+ + (−10 + 60)+
1 170
+ (0 + 30 + 90 + 50) = = 21.25
8 8
as seen in previous figure, which is shown again on the
next page.
Options 80

50
All q’s are 1/2 130
40
120
30 30
110 110
21.25
20
100 100

12.5 10
90 90

5
80

0
70

t=0 t=1 t=2 t=3

Options 81

Similarly, if P0 = 100 and K = 100,

• then P0 − 30 − K = −30
• and
1n
E{(P3 − K)+ } = (−30 + 0)+ + 3(−30 + 20)+
8
o
+ 3 (−30 + 40)+ + (−30 + 60)+
1 60
= (0 + 0 + 30 + 30) = = 7.5
8 8
Options 82

More time steps

Let’s consider a call option with T = 1.
• Take time interval [0, 1]
– divide into n steps,
– each of length 1/n.
√
• Suppose that stock price goes up or down σ/ n at
each step.
Options 83

• Then after m steps (0 ≤ m ≤ n)

– t = m/n
– price is
σ
Pm/n = P0 + √ {2(W1 + · · · + Wm ) − m}.
n
Options 84

From last slide:

σ
Pm/n = P0 + √ {2(W1 + · · · + Wm ) − m}.
n

Since, W1 + · · · + Wm is Binomial(m, 1/2)

E(Pt |P0 ) = P0 .

and
4σ 2 m m 2
Var(Pt |P0 ) = = σ = tσ 2 .
n 4 n
By the CLT, as n → ∞, Pt converges to N (P0 , tσ 2 ).
Options 85

K = exercise price.
• Value of option is expectation with respect to
risk-neutral measure of present value at expiration.
• Therefore, as the number of steps goes to ∞, price of
option converges to

E{(P0 + σZ − K)+ } (10)

where
– Z is N (0, 1)
– so that P1 = P0 + σZ is N (P0 , σ 2 ).
Options 86

• Pt is a discrete time stochastic process

– since t = 0, 1/n, 2/n, . . . , (n − 1)/n, 1.
• In fact, Pt is a random walk.
• As n → ∞, Pt becomes a continuous time stochastic
process.
• Limit process is called Brownian motion.
Options 87

Brownian motion
Brownian motion is the limit of random walks as the
frequency of steps increases.
Bt starting at B0 = 0 has the following properties:
1. E(Bt ) = 0 for all t.
2. Var(Bt ) = tσ 2 for all t.
3. If t1 < t2 < t3 < t4 , then Bt2 − Bt1 and Bt4 − Bt3 are
independent.
4. Bt is normally distributed for any t.
Options 88

Geometric Brownian motion & Black-Scholes

√
s exp(µ/n ± σ/ n) = (sup , sdown ).

s exp(r/n) − sdown
q =
sup − sdown
√
exp(r/n) − exp(µ/n − σ/ n)
= √ √
exp(µ/n + σ/ n) − exp(µ/n − σ/ n)
µ 2
¶
1 µ − r + σ /2
≈ 1− √ .
2 σ n
( m
)
σ X
Pt = Pm/n = P0 exp µt + √ (2Wi − 1) .
n i=1
Options 89

Wi is either 0 or 1 (so 2Wi − 1 = ±1)

( m
)
σ X σm(2q − 1)
E √ 2Wi − 1 = √
n i=1 n
µ 2
¶
σ r − µ − σ /2
≈√ m √
n σ n
µ 2
¶
σ m
= r−µ− = t(r − µ − σ 2 /2).
2 n
( m
)
σ X 4σ 2 mq(1 − q)
Var √ 2Wi − 1 = ≈ tσ 2 ,
n i=1 n
since q → 1/2 as n → ∞.
Options 90

In the risk-neutral world

Pt ≈ P0 exp{(r − σ 2 /2)t + σBt }. (11)

(11) does NOT depend on µ, only on σ. Payoff at time T

is
£ 2
¤
P0 exp{(r − σ /2)T + σBT } − K + . (12)
√
Since BT ∼ N (0, T ), we can write BT = T Z where
Z ∼ N (0, 1).
The discounted value of (12) is
· ½ 2 ¾ ¸
σ T √
P0 exp − + σ T Z − exp(−rT )K . (13)
2 +
Options 91

From previous slide:

Discounted value is
· ½ 2 ¾ ¸
σ T √
P0 exp − + σ T Z − exp(−rT )K .
2 +

Therefore, call price is

Z · ½ 2
√
¾ ¸
σ T
C= P0 exp − + σ T z − exp(−rT )K φ(z)dz,
2 +
Options 92

Computing integral leads to:

Black-Scholes formula

C = Φ(d1 )S0 − Φ(d2 )K exp(−rT )

where Φ is the standard normal CDF,

log(S0 /K) + (r + σ 2 /2)T √
d1 = √ , and d2 = d1 − σ T .
σ T
Options 93

Example
S0 = 100, K = 90, σ = .4, r = .1, and T = .25.
Then
log(100/90) + {.1 + (.4)2 /2}(.25)
d1 = √ = 0.7518
.4 .25
and
√
d2 = d1 − .4 .25 = .5518.
Then Φ(d1 ) = .7739 and Φ(d2 ) = .7095.
Also, exp(−rT ) = exp{(.1)(.25)} = .9753.
Therefore,
C = (100)(.7739) − (90)(.9753)(.7095) = 15.1.
Options 94

How does the option price depend on the inputs?

The next figure shows the variation in the price of a call
option as the parameters change.
• The baseline values of the parameters are
– S0 = 100,
– K = 100 exp(rT ),
– T = .25,
– r = .06,
– and σ = .1.
Options 95

The exercise price K and initial price S0 have been

chosen so that if invested at the risk-free rate, S0 would
increase to K at expiration time.
• There is nothing special about this choice of S0 and
K.
• In each of the subplots in the figure, one of the
parameters is varied while the others are held at
baseline.
Options 96

4 15 15

3
Price of call

Price of call

Price of call
10 10
2
5 5
1

0 0 0
0 0.1 0.2 90 100 110 90 100 110
σ K S0

3 1.5

2.5
Price of call

Price of call

1
2
0.5
1.5

1 0
0 0.04 0.08 0.12 0 0.04 0.08 0.12
r T
Options 97

Example — GE
• This information was taken from The Wall Street
Journal, February 14, 2001
• GE closed at $47.16 on February 13, so we use
S0 = 47.16.
• 3-month T-bill rate was 4.91%.
– r = 0.0491/253 = .00019470, assuming a return on
the 253 trading days per year.
• T = 3 for options expiring in February.
• An option expiring in March had T = 23
• For June, T = 23 + (21)(3)
• For September, T = 23 + (6)(21).
Options 98

K Month of T (in Actual B&S calculated price Implied

Expiration days) Price σ = .0176 σ = .025 Volatility
35 Sep 149 14.90 13.40 14.03 .0320
40 Sep 149 10.80 9.22 10.37 .0275
42.50 Mar 23 5.30 5.03 5.38 .0235
45 Feb 3 2.40 2.22 2.32 .0290
45 Mar 23 3.40 3.00 3.57 .0228
50 Feb 3 0.10 0.016 0.09 .0258
50 Mar 23 0.90 0.64 1.23 .0209
50 Sep 149 4.70 3.42 5.12 .0232
55 Mar 23 0.20 0.06 0.28 .0223
55 Jun 86 1.30 0.92 2.00 .0204

Actual prices and prices determined by the Black-Scholes formula for

options on February 13, 2001. K is the exercise price. T is the maturity.
Options 99

Early exercise of calls is never optimal

Example: first option in table

• strike price is 35
• closing price of GE was 47.16
• if the option had been exercised: $(47.16 − 35)=
$12.16
• selling on the market for $14.90 that day.
• gain $(14.90 − 12.16) = $2.74 more by selling
Options 100

Implied volatility
Implied volatility is the amount of volatility the market
believes to exist currently.

In the following figure

• The price was $5.30 on February 13, 2001.
• The implied volatility in figure is 0.0235.
• Determined by MATLAB’s interpolation function
interp1.m.
Options 101

5.5

5.4

5.3
price

5.2

5.1

4.9
0.015 0.02 0.025 0.03
sigma

Calculating the volatility implied by the option

with an exercise price of $42.50 expiring in March
2001.
Options 102

Volatility Smiles and Polynomial Regression

Superscript “c” means center, e.g., K c = K − K.

Initial model:

Vi = β0 + β1 Kic + β2 (Kic )2 + β3 Tic + β5 (Tic )2 + β6 Kic Tic + ²i ,

Final model:

Vi = β0 + β1 Kic + β2 (Kic )2 + β3 Tic + β5 (Tic )2 + β6 (Tic )3 + ²i ,

Options 103

data ImpVol ;
infile ’C:\book\sas\ImpVolRegData.txt’ ;
input K T ImpVol ;
T = T - 63.040 ;
K = K - 46.7500 ;
T2 = T*T ;
K2 = K*K ;
KT = K*T ;
K3 = K*K*K ;
T3 = T*T*T ;
run ;
Options 104

proc reg;
model ImpVol = K T T2 K2 KT K3 T3/
selection=rsquare adjrsq cp best=2 ;
run ;
Options 105

The REG Procedure

Dependent Variable: ImpVol
R-Square Selection Method
Number in Adjusted
Model R-Square R-Square C(p) Variables in Model

1 0.6498 0.6060 62.3013 K3

1 0.6262 0.5794 66.9068 K
----------------------------------------------------------------
2 0.7065 0.6226 53.2406 K T2
2 0.6970 0.6104 55.0917 T2 K3
----------------------------------------------------------------
3 0.8602 0.7903 25.2674 T2 K3 T3
3 0.8426 0.7639 28.6927 K T2 T3
----------------------------------------------------------------
4 0.9760 0.9568 4.6809 K T2 K2 T3 min C_P but no T term
4 0.9138 0.8449 16.8072 K T T2 K2
----------------------------------------------------------------
5 0.9833 0.9624 5.2588 K T T2 K2 T3 model used
5 0.9827 0.9611 5.3713 K T2 K2 K3 T3
----------------------------------------------------------------
6 0.9884 0.9653 6.2568 K T2 K2 KT K3 T3
6 0.9878 0.9635 6.3729 K T T2 K2 K3 T3
----------------------------------------------------------------
7 0.9897 0.9539 8.0000 K T T2 K2 KT K3 T3
Options 106

0.03

0.028

0.026
implied volatility

0.024

0.022

0.02

0.018
35 40 45 50 55
exercise price

K varies with T fixed at mean

Options 107

0.028

0.027

0.026

0.025
implied volatility

0.024

0.023

0.022

0.021

0.02

0.019
0 50 100 150
maturity

T varies with K fixed at mean

Options 108

0.04

0.035
implied volatility

0.03

0.025

0.02

0.015
150
100 55
50
50 45
40
maturity 0 35
exercise price

T and K both vary

Options 109

−3
x 10
1.5
SE of implied volatility

0.5

0
150
100 55
50
50 45
40
maturity 0 35
exercise price

Standard error surface

Options 110

Puts
In this example, European and American puts do NOT
have the same price at all nodes.
• The continuously compounded rate is r = 0.05.
• K = 110
• In this example
exp(.05) − .8
q= = .6282.
1.2 − .8
Options 111

0
6
144
4.91

11.65
3
(13.54) 120
14
1 5
24.63 96
100 (30)
2
80 46
4
64

Pricing a put option. Amercian put in

parentheses when it differs from European put.
Options 112

• At node 2 the European option is worth

(.6282)(14) + (1 − .6282)(46) = $24.63.

The American option can be exercised to earn $(110

− 80) = $30.
– Thus, at node 2 the European option is worth
$24.63 but the American option is worth $30.
• The price of the European put at node 1 is

e−.05 {(q)(4.91) + (1 − q)(24.63)} = 11.65.

Options 113

• At node 1, the American option is worth

e−.05 {q ∗ 4.91 + (1 − q) ∗ 30} = 13.65,

which is more than $11.65.

• The American option should NOT be exercised early
at node 1
– would earn only $10.
• American option is worth more than European at
node 1 because the American can be exercised early
at node 2 should the stock move down at node 1.
Options 114

Why are puts different than calls?

• A put increases in value as the stock price decreases.
• As the stock price decreases, the size of further price
changes also decreases.
• At the point of diminishing returns, it is better to
exercise the option and invest the profits in a risk-free
asset.
• With calls, everything is reversed.
Options 115

Put-call parity
• Put price and call price with same K and T are
related:
P = C + e−rT K − S0 .
• Consider
– first portfolio holds one call and Ke−rT dollars in
the risk-free asset
– second portfolio holds a put and one share of stock.
• same payoff — K or ST , whichever is larger
• Thus,
C + e−rT K = P + S0 ,
Options 116

From previous slide:

P = C + e−rT K − S0 , (14)

• (14) holds only for European options

– American puts are worth more than European
puts, so the left hand side of (14) is larger for
American than for European puts.
Options 117

The evolution of option prices

• t = 0 is when the option was written
• t = T is the expiration date
• 0<t<T
• Black-Scholes formula can be used to find the option
price at t —
– S0 in the formula set equal to St
– T in the formula set equal to T − t
Options 118

110

stock price
100

90
0 0.2 0.4 0.6 0.8 1

10
call price

0
0 0.2 0.4 0.6 0.8 1
put price

0
0 0.2 0.4 0.6 0.8 1
time

Evolution of option prices. T = 1, σ = .1, r = .06,

S0 = 100, and K = 100 for both put and call. Blue
and red are two simulations.
Options 119

The “Greeks”
110

stock price
100

90
0 0.2 0.4 0.6 0.8 1

10
call price

0
0 0.2 0.4 0.6 0.8 1
put price

0
0 0.2 0.4 0.6 0.8 1
time

Evolution of option prices. T = 1, σ = .1, r = .06,

S0 = 100, and K = 100 for both put and call.
Options 120

60

50

40
call return / stock return
30

20

10

−10

−20

−30
0 0.2 0.4 0.6 0.8 1
time

Ratio of log return on a call to log return on the

underlying stock. Uses blue simulation.
Options 121

C(S, T, t, K, σ, r) = price of an option

∂
∆= C(S, T, t, K, σ, r) “Delta”
∂S
∂
Θ = C(S, T, t, K, σ, r) “Theta”
∂t
∂
R= C(S, T, t, K, σ, r) “Rho”
∂r
∂
V= C(S, T, t, K, σ, r) “Vega”
∂σ
Options 122

Use of ∆:

change in price of option ≈ ∆ × change in price of asset.

Or, using math notation,

Ptoption − Pt−1
option
= ∆(Ptasset − Pt−1
asset
)

Therefore,
à !
Ptoption
− Pt−1 option asset
Pt−1 Ptasset − Pt−1asset

option
=∆ option asset
Pt−1 Pt−1 Pt−1
Options 123

From last slide:

à !
Ptoption− Pt−1 option asset
Pt−1 Ptasset − Pt−1asset

option
=∆ option asset
Pt−1 Pt−1 Pt−1

Define: Ã !
asset
Pt−1
L=∆ option
Pt−1
Then:

return on option ≈ L × return on asset

and

µoption ≈ L × µasset and σ option ≈ L × σ asset

Options 124

Recall Black-Scholes formula

C = Φ(d1 )S0 − Φ(d2 )K exp(−rT )

By differentiating the Black-Scholes formula for a call:

∆ = Φ(d1 )
Options 125

Example:
• T = 1, σ = 0.1, r = 0.06, S0 = 100, and K = 100
• At t = 0
– C(100, 1, 0, 100, 0.1, 0.06) = 7.46
– d1 = 0.65
– ∆ = Φ(0.65) = 0.742
• revenue from call option on one share = 0.742 times
the revenue from one share
• return on call is L = (0.742)(100)/7.46 = 9.95 times
return on the stock
Options 126

60

50

40

call return / stock return

30

20

10

−10

−20

−30
0 0.2 0.4 0.6 0.8 1
time

Ratio of log return on a call to log return on the

underlying stock

9.95 does not include the effect of t changing (by one unit). This
effect is approximately
∂
Θ = C(S, T, t, K, σ, r)
∂t