Week 3 - Option Valuation

Review from Lecture 2: Introduction to Options

● Two main types of option contracts: call and put options
○ Options incorporate leverage
● Option strategies: Combine many calls and puts as if they were lego bricks, and you can
get whatever pattern you want!
● The put-call parity theorem relates the prices of put and call options

Arbitrage and Option Pricing

● How can we calculate the value (price) of an option?
○ Options derive their value from the underlying asset
○ We could determine the option prices by means of an arbitrage portfolio
○ This arbitrage portfolio will only involve the underlying asset and the risk-free
asset
○ Unlike the put-call parity formula in which we need the price of either C or P
● Challenges with using this arbitrage-portfolio for option pricing:
○ We can create such an arbitrage-portfolio only for a specific set of circumstances
○ The arbitrage-portfolio has to be dynamic: a different moneyness will require a
different portfolio
○ The remaining time to maturity (expiry) also matters: it affects the probability to
end up in-the-money
● Two components of option value:
○ Intrinsic value
○ Time value

Two Components of Option Value: Intrinsic and Time Value

● Intrinsic value: the value an option
would have if it were exercised
immediately (intrinsic value resembles
the payoff pattern of an option):
○ Call option: S – X
○ Put option: X – S
● Time value: the value of an option
created by the chances that the price of
the underlying asset (and the
moneyness) will change between the
present moment and expiration

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 ○ Time value is a type of volatility value and moves with time
○ Captures the chance of an increasing intrinsic value in the future
○ This is more important than a potential decrease, as options are asymmetric
instruments: the upside is unlimited, the downside is not (assuming a long
position / option holder)
○ The time value changes for different levels of moneyness

Determinants of Option Value

Notes: This table assumes ceteris paribus relations (only one variable changes, the others remain
constant).
* The value of an American put option always increases if the time to expiration increases. The
relation is a little bit ambiguous for European put options as longer time to expiration reduces the
present value of exercise price

Bounds on Option Value

● Lower Bound: The value of an option cannot be negative
○ The option does not need to be exercised, so it cannot impose any liability on its
holder.
○ Intrinsic value will be zero if an option is not in-the-money, but time value must
be positive.
○ With the passage of time, we benefit more from the upside than the downside, so
time value must always be positive
○ Example, for a call option C is greater than the maximum of either 0 or S 0 −
PV(X) − PV(Dividend), since time value is a positive amount on top of the
discounted intrinsic value
● Upper Bound: The value of a call option cannot exceed the price of the underlying asset;
The value of a put option cannot exceed the strike price of a stock
○ The combination of time and intrinsic value cannot exceed the value of the
underlying asset (for a call)
○ If we have the right to buy something at 20, while the current price is 50, that
right cannot be worth 50 or more. Otherwise exercising that right would by

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 definition be unprofitable. The option has to be cheaper, it pays the same or less
than the stock, never more
● These option bounds apply also to puts through the put-call parity formula

Two-State Option Pricing Using Arbitrage (1)

● Simplified example:
○ A stock 𝑆 that can only produce two results: up or down,
with a known percentage (or amount), and with equal
probability
○ A call option with strike price of 𝑋 = 21. What is the value
of 𝐶?
● We can use arbitrage to construct a portfolio that mimics the
payoffs of the option, and therefore produces not just a bound, but
an option value.

Two-State Option Pricing Using Arbitrage (2)

● Simplified example:
○ A stock 𝑆 that can only produce two results: up or
down, with a known percentage (or amount), and with
equal probability
○ A call option with strike price of 𝑋 = 21. What is the
value of 𝐶?
● We can replicate this option payoff pattern:
○ Invest $5 in 0.25 shares (0.25×20), and we have this
payoff profile:
■ Up: 0.25×22 = 5.50
■ Down: 0.25×18 = 4.50
● Finance the investment by borrowing the present value of
4.50:
○ Up: 0.25×22 − 4.50 = 1.00
○ Down: 0.25×18 − 4.50 = 0.00
● The call option payoff is the same as the payoff of borrowing the PV(4.50) and buying
0.25 shares
○ The portfolio is perfectly hedged: in both cases we earn 1 if the option ends up
in-the-money, and 0 if it does not.
○ The price of one call option has to be 𝐶 = 5 − 𝑃𝑉(4.50)

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Two-State Option Pricing Using Arbitrage (3)
● Simplified example:
○ A stock 𝑆 that can only produce two results: up or down, with a known percentage
(or amount), and with equal probability
○ A call option with strike price of 𝑋 = 21
○ What is the value of 𝐶?
● We can replicate this option payoff pattern:
○ The call option payoff is the same as the payoff of
borrowing the PV(4.50) and buying 0.25 shares
■ The price of one call option has to be 𝐶 = 5 −
𝑃𝑉(4.50)
■ Arbitrage will prevent the price of the call to
differ from that of 0.25 share and a loan that is
worth 4.5 at maturity
■ With a risk-free rate at 1% for the time till
maturity, that would be 𝐶 = 0.25×20 − (4.5/1.01)
= 5.000 − 4.455 = 0.545
■ The option price depends on the stock price,
strike price, interest rate, volatility of the stock
(spread between up and down movements)

Binomial Trees
● This setup is called a binomial tree
○ The calculations are simple but many; the true value lies in using computer code
for this
○ This also makes the assumption that there are just 2 possible outcomes redundant
● Implications of arbitrage pricing using binomial trees:
○ To find the value of the option in terms of the value of the stock, we do not need
to know either the option’s or the stock’s beta or expected rate of return
● But two issues remain:
○ How did we arrive at the 0.25 share ratio? (The amount in the risk-free asset was
derived from the value of the share*0.25 that needed to be brought down to 0)
○ How are we going to make this realistic? Asset prices can move in all sorts of
ways, we cannot just assume two possible outcomes

Binomial Trees: Hedge Ratio (Delta)

● The answer to the first issue is that we need the hedge ratio (also called delta). For a
portfolio replicating an option there is a formula for this, which requires us to adopt the
following notation:

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 ○ 𝑢 – the fraction of the original value we will get if the share goes up, if it goes
from 20 to 22, u = 1.10
○ 𝑑 – the fraction of the value we will have left if the share goes down, if it goes
from 20 to 18, d = 0.90
○ 𝐶u – the payoff (or value if we are before the expiration date) of the call if the
value of the underlying asset goes up
○ Cd – the payoff of the call if the value of the underlying asset goes down
● The hedge ratio is then:

● In our example:

Binomial Trees: Option Values

● This can then be transformed into a formula for the value of a call:

● To estimate put value we can use the put-call parity and transformations:

Binomial Trees: Realistic Multiperiod Models (1)

● The problem with these formulae is that they depend on u and d. These parameters only
make sense in a two-possibilities setting
● However, we can create more realism by assuming multiple periods
○ While we still assume that in a single period, only uS and dS are the possible
outcomes, we have a lot more variation over the entire tree

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Binomial Trees: Realistic Multiperiod Models (2)
● We can make the periods arbitrarily small:
○ More periods fill the time till expiration, so a richer variation in possible
outcomes is considered
○ We need to adjust the values of u and d, to make sure they fit the movement of the
underlying asset in a single (shorter) period
○ The proportional difference between 𝑢 and 𝑑 increases with both annualized
volatility as well as the length of the subperiod: higher 𝜎 and longer holding
periods make future stock prices more uncertain
● Example with a 1-year option on a stock with volatility of 30%:

Binomial Trees: Realistic Multiperiod Models (3)

● With enough periods, and the right values for u and d, we could in fact mimic the entire
return distribution of the underlying asset
● Converges towards lognormal distribution
● This is how more exotic options are priced in practice

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Part 2: Option Valuation Using Black-Scholes
Black-Scholes Option Valuation vs. Binomial Trees
● The binomial model is extremely flexible but requires a super-computer and programing
in order to use it for actual trading
● Black-Scholes model makes some mild assumptions and is able to price a normal
(European) call or put:
○ Replaces the assumptions from the binomial tree, which become trivial with
enough periods
○ We can assume that the number of periods goes to infinity, and the underlying
asset has a lognormal return distribution. In that case, we can use the
Black-Scholes formula to price an option
○ Myron Scholes got the Nobel prize in 1997, in large part for this work
○ Fischer Black died 2 years before, and the Nobel prize is not awarded
posthumously

Black-Scholes Pricing Formula (1)

● How does it work?
● Roughly speaking, the Black-Scholes formula works by assigning a probability to the
chance of the option ending up in the money
● This is the reason why we need the lognormal return distribution. § We then get the
following formula:

● Where, 𝑵 (𝒅𝟏) and 𝑵 (𝒅𝟐) are the probabilities that a random draw from a normal
distribution will be less than (𝒅𝟏) or (𝒅𝟐)
○ Note that this also has a relation to the hedge ratio!
● The risk-free interest rate 𝑟0 has to be annualized, based on continuous compounding

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 ○ For this calculation, use a risk-free instrument with the same maturity as the
option (as there might be a non- flat yield curve)
● 𝑇 is the time to maturity of the option, expressed in years
● 𝜎 is the standard deviation of the stock, also annualized

Black-Scholes Pricing Formula: Intuition Behind 𝑁(d1) and N(d2)

Obtain N(d1) and N(d2) from Tables of Cumulative Normal Distribution

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Example Using Black-Scholes Pricing Formula

Practical Applications of Option Valuation

1. Extensions of Black-Scholes formula
2. Practical applications: Implied volatility and volatility smiles
3. Hedging strategies and option Greeks

Extensions: Dividends and Option Value

● Black-Scholes pricing formula assumes a call option, no dividends, and no early exercise
○ The Black-Scholes formula can be transformed through put-call parity to price put
options
● What if the stock is paying a predictable dividend?
○ The Black-Scholes formula can be adjusted to price European options on stocks
paying dividends before expiration, provided the dividends are known
○ If dividends are known, they are risk-free
○ If the dividends are not known, but predictable, you can run a simulation
● However, the Black-Scholes formula performs worse for options on stocks with high
dividend payouts. A binomial tree (with lots of periods) often works better

Extensions: Early Exercise Rights and Option Value

● The Black-Scholes formula is designed to price European options which cannot be
exercised early
● What about American options which can be exercised early?
○ Options are almost always worth more alive than exercised. Early exercise
sacrifices the time-value of an option
○ In the vast majority of cases, it is more profitable to sell an option rather than to
exercise it

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 ○ If early exercise is not profitable, American options will be worth the same as
European style options. (Like American and European call options on a
non-dividend-paying stock.)
● As there is positive time value at any point, you are better off keeping the option in all
but two cases:
○ American calls on stocks where a big dividend is approaching: it may be optimal
to exercise of a call just before the stock goes ex-dividend (pays out); We would
have to compare the loss in intrinsic value with the loss in terms of time value
○ American puts on stocks that are nearly worthless: it may be optimal to exercise a
put if the firm is (nearly) bankrupt and the time value is less than the time-value
of X (reinvesting X for interest, depends on the risk-free rate)
● As there is always a small chance you can end up in either situation, American options
are worth more in general, but the difference is often tiny
○ Per asset there is usually just one type of option traded on the exchanges

Practical Matters: Black-Scholes Pricing Formula and Implied Volatility

● Black-Scholes pricing formula:

● Four parameters are known: S0, X, rf, and T

● But 𝝈 is not directly observable and needs to be estimated using historical data
○ Extensions of Black-Scholes model that allow stock volatility to evolve randomly
or model jumps
● Traders in practice assume take the prices of put and call options as given (observed
liquid trading on exchange), reverse the formula and estimate the implied volatility

Practical Matters: Implied Volatility and VIX

● This implied volatility is a measure of expected risk
○ Contrary to measuring risk as historical variance, it looks at what the markets
expect as the variance in the coming period
● Practical applications: an index of implied volatilities can serve as an indication of how
serious markets take potential unrest
○ VIX index, based on implied volatility of S&P500 index options with T = 30 days
○ Investor fear gauge
○ Trade on VIX using futures

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Practical Matters: Volatility Smile (1)
● If the Black-Scholes formula would be a good description of reality, every option series
(combination of strike and maturity) would give the same implied volatility
○ This result does not hold exactly in practice
● We see the following patterns:
○ Empirical tests show that implied volatility actually falls as exercise price
increases
○ Sometimes implied volatility is higher for both extremes: far in-the-money and
far-out-of-the- money options
○ The first situation is known as a volatility smirk, the second as the volatility smile

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Practical Matters: Volatility Smile (2)
● Is this a mispricing?
○ The discrepancies are not going away
○ We need to look for something more fundamental:
● The pattern suggests that the assumptions behind Black-Scholes formula are not accurate
○ Volatility smirk or smile may be due to fears of a market crash, or at least a
different assumption regarding the underlying return distribution (that is directly
linked to the volatility) than is made in the B-S model
● Practitioners prefer the binomial tree approach because it is more flexible in tackling
these issues

Hedging and Greeks: Intuition Behind Black-Scholes Pricing Formula

● Black-Scholes formula

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Hedging and Greeks: Delta Hedging
● Delta hedging:
○ Call option: ∂C/∂S = Δ = N(d1)
○ Put option: Δ = N(d1) – 1
○ We are back to the hedge ratio.
● Delta is the hedge ratio:
○ A call option has a positive delta
○ A put option has a negative delta
● Note: all these derivatives, except gamma, are used to create linear approximations
○ Those will be valid only over a limited range
○ None of these derivatives are constant

Hedging and Greeks: Example of Portfolio Delta

● In practice, many option strategies require holding a portfolio of options
● Suppose you implement a bullish spread strategy:
○ Buy two call options with 𝑋 = 20
○ Sell two call options with 𝑋 = 22
○ Other data: 𝑆0 = 18, 𝑟f = 1%, 𝑇 = 0.5 and 𝜎 = 35%
○ What is the delta of your portfolio of options?
● Black-Scholes option values and deltas:
○ The price of one option with 𝑋 = 20 is 𝐶 = 1.07 and the ∆= 𝑁 (𝑑1) = 0.3891
○ The price of one option with 𝑋 = 22 is 𝐶 = 0.60 and the ∆= 𝑁 (𝑑2) = 0.2524
● The portfolio delta is a weighted average of all options included in the portfolio:
○ Portfolio delta = +2×0.3891 − 2×0.2524 = 0.2734
○ If 𝑆" increases from $18 to $18.1, the value of your portfolio of options will
increase by $0.027

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Hedging Using The Greeks
● In practice, estimating and hedging the exposure using only delta is not enough
● If you want to hedge a portfolio that does not move in exactly the same way as the
underlying asset of the options, you would be well advised to check all the Greeks
○ It is possible that the quality of your hedge deteriorates if the inputs change
● Where ∆𝑺 denotes the change in the share price, ∆𝝈 the change in volatility, et

● Ideally, your hedge is delta-neutral, gamma-neutral, vega-neutral etc

○ That means the delta (etc.) of your portfolio (initial position + hedge) is zero
○ In practice, that ideal will never be reached
○ If you are hedging (or speculating), you determine the Greeks for the entire
portfolio simply by adding them; this works as long as the underlying asset is the
same
○ If you speculate using options, each Greek represents a risk (or exposure to
changes in the parameters)

Conclusion
● Derivatives are very versatile tools, both for hedging and speculation:
○ They can be used to create very precise investment strategies
● Derivatives also tend to embody a lot of leverage:
○ Warren Buffet’s characterization of derivatives as “Financial weapons of mass
destruction” is mainly based on this feature
○ Many regulators (AFM in the Netherlands) try to prevent retail investors from
using derivatives
● However, as with any tool, it is how you use it: with proper knowledge of its features,
and above all its pricing, a derivative provides a valuable addition to the portfolio
● Derivatives can create a risk-return trade-off pattern that matches our preferences,
something any investor would appreciate:
○ As is shown by the enormous volumes (in the trillions) of traded derivatives

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