Option Pricing Models

I. Binomial Model
II. Black-Scholes Model (Non-dividend paying European
Option)
A.Black-ScholesModelistheLimitoftheBinomialModel
B.Equations
C = S N(d1) - Xe-rT N(d2), where

d1 = [ln(S/X) + (r + 0.5S2)T]/ST

d2 = d1 - ST
N(d1), and N(d2) are cumulative normal probabilities of d1 and d2,
respectively.
 Factors that determine the option value
Underlying stock price
Exercise price
Time to expiration
Interest rate
Underlying stock volatility
Example : B-S Option Pricing
S = $98 ; X = $100
r = 0.05 (continuously compounded annual risk-free rate)
T = 0.25 (one quarter of a year)
S = 0.5 (Annual standard deviation of the continuously compounded stock
returns)
d1 = [ln(S/X) + (r + 0.5 S2)T]/ ST

= [ln(98/100) + (0.05 + 0.5(0.25))(0.25)] / 0.5(0.5)

= 0.0942
d2 = d1 - ST

= 0.0942 - (0.5) 0.25 = -0.1558

N(d1) = N(0.0942) N(0.09) = 0.5359
N(d2) = N(-0.1558) N(0.15) = 0.5596

N(-0.15) = 1 - 0.5596 = 0.4404

Excel: normsdist( )
N(d1) = N(0.0942) = 0.5375
N(d2) = N(-0.1558) = 0.4381

C = S N(d1) - Xe-rT N(d2)

= (98) (0.5375) - 100 e -0.05 (0.25) (0.4381)

= $9.41
OPTION CALCULATOR
B. Hedge Ratio

= C / S = N(d1)

III. More about the model inputs

A. Underlying stock price
B. Time to Expiration
C. The Risk-free Rate: continuously compounded
risk-free rate

D. Volatility

Expected Volatility

Proxy: Historical Volatility

 Variance of continuously compounded returns
1. Calculate continuously compounded returns: rS = ln(1+RS),

or, rs = ln(Pt/Pt-1)
2. Calculate standard deviation S

3. Annualized standard deviation

Example
CBOE Historical Volatility
F. Historical Volatility and Implied Volatility
represents expected volatility of the stock over the life of
the option.
Historical provides estimates of the future volatility.
Implied volatility is the markets estimates of the stock
volatility.
Option traders can compare their own expectations of future
price volatility with the implied price volatility. If these are
not consistent with one another, the option price may be
wrong.
 Estimation of implied volatility
IV. Relationship between Model Inputs and Call Price
A. Delta
= C / S = N(d1)

= f (T)
Delta is the hedge ratio
Position Delta the sum of the deltas

long 10,000 shares of stock, short 63 calls with = 0.377, long 134
puts with = -0.196
Position Delta = 10,000 (1) + (-63) (100) (0.377) + 134 (100) (-0.196)
= 4,998.5
Meaning: total portfolio is equivalent in market risk of 4,998 shares
of stocks
 B. Gamma
= / S

For stock-option hedgers, the value of measures

the extent to which a change in the stock price
will force a revision in the hedge ratio.

= f(S)
= f(T)

C. Rho
= C/ i

This is a liner relationship; the impact of changes in i

on changes in C normally is small.
D. Vega

= C/ s

= f (S)

E. Theta

= C/ T

Theta is a measurement of the rate of time value decay.

= f(S)
V. Put Option Pricing
A.Equations
P = -S [1-N(-d1)] + Xe-rT [1-N(-d2)], where

d1 = [ln(S/X) + (r + 0.5S2)T]/ST

d2 = d1 - ST
 Homework
1. Calculate B-S call price for INTC using Fridays closing stock price and a
X that is most close to S. (Use Excel, not manual calculation)
2. Calculate three implied volatility one near at-the-money call, one deep
out-of-the-money call, and one deep in-the-money call. Draw a diagram
relating these three implied volatility and option moneyness.
3. Calculate 6 Vegas assuming six different stock prices. Plot these six
Vegas against six stock prices.