Option Pricing

Unit 3-Topic 8
 Introduction
 Time to expiry, exercise price, spot price etc. affects the option price.

 Two models of pricing

(1) Binomial Option Pricing Model (BOPM).

(2) Black-Scholes Model (BSM).

2 By Prof.Rugved Shivgan
 (1) Binomial Option Pricing Model (BOPM)

 The binomial option pricing model is a discrete time model i.e. time is broken down
into discreet bits and only at these time points the model is applied.

 The binomial option pricing model assumes that the underlying asset price (say, stock
price) follows a binomial process i.e. at a given discreet point in time there would e two
possibilities. The stock price will either move up or move down. It is not known whether
the stock price will move up or move down, however, the percent by which it may move
up or move down is assumed as known.

 This can be viewed in the form of Binomial Tree,

3 By Prof.Rugved Shivgan
 Bionomial Model Notations
 t = time period

 0 signifying starting period and 1, 2, ... signifying = subsequent time till expiration.

 X = Exercise Price

 So = Stock price at the beginning (at the time of valuation)

 u = Percentage of upswing in So

 d = Percentage of downswing in So

 Stu = Subsequent period Stock price, if there is upswing = So x(1+ u)

 Std =Subsequent period Stock price, if there is downswing = So x(1+d)

 r=risk-free interest rate

 p = probability of upswing = r — d / u — d

 1-p = probability of downswing

4 By Prof.Rugved Shivgan
 Assumptions of Binomial Model
(1) The current underlying asset (stock) price can only take two possible values i.e. upward
(St u) or downward (St d).

(2) The financial markets are perfect and competitive i.e.

(a) No transaction cost, no taxes, and no margin requirements.

(b) It is possible to predict (r), (u) and (d)
(c) Risk-free interest rate is the only prevailing interest rate in the markets. Thus lending &
borrowing by investors are at risk-free interest rate.
(d) Underlying assets are divisible and thus tradable in fraction.

(3) The value of (1+r) is greater than d, but smaller than u i.e. u < 1+r < d, so that there is
no arbitrage possibility.

(4) The investors want to maximize their wealth.

5 By Prof.Rugved Shivgan
 Single Period Binomial Model:
 The single period binomial option model implies that the stock price will either
move up or down only once by the date of the expiration of the option.

 Thus, the single period binomial model is also known as a one-step binomial model.

Multi Period Binomial Model:

 In reality the underlying asset price moves up or down in two or more period.
Thus, the binomial model can be extended to any number of periods. This is
referred to as Multi Period Binomial Model.

6 By Prof.Rugved Shivgan
 (2) Black-Scholes Model (BSM).

 Binomial option pricing model has certain limitations in terms of computation. BOPM
assumes only two possible prices in subsequent period. Further when number of period
increases the computational procedure becomes complex and time consuming.

 The Black-Scholes Mode (BSM), on the other hand, is a continuous time model. In
various studies it has been observed that if sufficiently long periods are taken the results
of BOPM matches with BSM results. But in this case the BOPM computations become
lengthy and tedious.

7 By Prof.Rugved Shivgan
 Assumptions of Black-Scholes Model (BSM).

(1) Interest Rate is, (a) Risk-free interest rates. (b) It remains constant during the option
contract period. (c) It is same for all expiry dates.

(2) Financial markets are efficient. There are no transaction costs and taxes are absent.

(3) Short selling of stocks is permitted. The proceeds from short selling are available to
investors for use.

(4) Trading in stocks is continuous and stocks are divisible.

(5) No possibility of riskless arbitroge.

(6) Stocks do not pay dividend during the option contract period. (This assumption was
subsequently removed)

8 By Prof.Rugved Shivgan
 (7) The stock returns are, (a) Continuously compounding and (b) Follows a normal
distribution (i.e. distribution of stock prices are log normal)

(8) The volatility of the stock is known and remains constant during the contract period.

(9) The stock price follows a Geometric Brownian Motion. In simple words, stock returns
are normal and stationary.

9 By Prof.Rugved Shivgan
  The input variables of BSM model are:

(1) So = Current Stock Price

(2) X = Exercise Price

(3) Sigma = Annual Volatility i.e. Standard Deviation of log returns denoted by Greek small
letter sigma

(4) r = Risk-free interest rate

(5) t = Remaining time to expiry

(6) N = Cumulative Standard Normal Distribution

(7) e = Exponential term, i.e. = 2.71828

10 By Prof.Rugved Shivgan
11 By Prof.Rugved Shivgan
 THANK YOU

12 By Prof.Rugved Shivgan