Pricing of options

Keyuri Halari (M-15-18)

Nikhil Kadam (M-15-27)
Piyush Patil (M-15-44)
 What is an option ?
An option is a contract that gives
the buyer the right, but not the
obligation, to buy or sell an
underlyingasset at a specific
price on or before a certain date.
An option, just like a stock or
bond, is asecurity.
Options are of 2 types:
ACALLgives the holder the right to buy
an asset at a certain price within a
specific period of time. Calls are similar to
having along positionon a stock. Buyers
of calls hope that the stock will increase
substantially before the option expires.
APUTgives the holder the right to sell an
asset at a certain price within a specific
period of time. Puts are very similar to
having ashort positionon a stock. Buyers
of puts hope that the price of the stock
will fall before the option expires.
 Terminologies used
Strike price
Premium
In-the-money
Out-the-money
At-the-money
 Pricing of an Option
The price, or cost, of an option is an amount of money
known as the premium. The buyer pays
thispremiumto the seller in exchange for the right
granted by the option.
For example, a buyer might pay a seller for the right to
purchase 100 shares of stock XYZ at a strike price of
Rs. 600 on or before December 22. If the position
becomes profitable, the buyer will decide to exercise
the option; if it does not become profitable, the buyer
will let the option expire worthless. The buyer pays the
premium so that he or she has the "option" or the
choice to exercise or allow the option to expire
worthless.

Premiums are priced per share.

 Factors affecting pricing of an
Option
There are 5 major factors that affect
the pricing of an option:
SPOT PRICE OF UNDERLYING ASSET
TIME
IMPACT OF VOLATILITY
DISTANCE OF STRIKE PRICE FROM
SPOT PRICE (Market movement or
price movement of an underlying
asset)
RISK FREE RATE OF RETURN
 SPOT PRICE
Aspot price is thecurrent pricein the
marketplace at which a given asset
such as a security, commodity or
currency can be bought or sold for
immediate delivery. While spot prices
are specific to both time and place, in
a global economy the spot price of
most securities or commodities tends
to be fairly uniform worldwide.
 TIME
The longer an option has until
expiration, the greater the chance
that it will end upin-the-money, or
profitable. As expiration approaches,
the option's time value decreases.

The longer the time until expiration,

the higher the option price
The shorter the time until expiration,
the lower the option price
 IMPACT OF VOLATILITY
Volatilityin market also affects
the price of options
If the market is volatile the price will
be high
If the market is less volatile the price
will be low
DISTANCE OF STRIKE FROM SPOT
The distance of the Strike price
from the spot price will also affect
the option price
For a Call Option If the distance is
more of strike price from the spot
price in the money, the Price
increases.
For a Call Option If the distance is
more of strike price from the spot
price out of the money the Price
decreases.
 RISK FREE RATE OF
RETURN
The risk-free rate of returnis the theoreticalrate
of returnof an investment with zero risk. The
risk-free rate represents the interest an investor
would expect from an absolutely risk-free
investment over a specified period of time.
In theory, the risk-free rate is the minimum
return an investor expects for any investment
because he will not accept additional risk unless
the potential rate of return is greater than the
risk-free rate.
 Valuation of option
Valuation i.e., the premium
payable is dependent upon
several factors. Two most
important components
Intrinsic Value
Time Value
Intrinsic value- The value attached
to the option if it is exercised now is
called the intrinsic value of the
option, the difference between spot
price and exercise price will
determine this value.

Time Value- Any premium that is in

excess of the options intrinsic value is
referred to as time value of the
option. It is a difference of actual
price and intrinsic value.
 Boundary Conditions for Call
Option Pricing
Maximum price of the option
cannot exceed the price of the
asset itself.
Price <= Spot price
Similarly the minimum price the
call option would sell for is the
intrinsic value of the option
adjusted for the present value of
the option
Price >= Spot Xe-rt
 Boundary Conditions for Put
option pricing
The Maximum price of the put
option cannot be more than its
exercise price
Price <= Strike price * e-rt
The minimum price that a put
option would sell for is its intrinsic
value
Price >= Strike price-rt Spot price
 Pricing Models :The Black-
Scholes Model

The Black-Scholes model is used to calculate a theoretical call

price (ignoring dividends paid during the life of the option) using
the five key determinants of an option's price: stock price, strike
price, volatility, time to expiration, and short-term (risk free)
interest rate.
The original formula for calculating the theoretical option price is
as follows:

Call Price= 2)

Where:-

or
The
variables are:

S = stock price

X = strike price

t = time remaining until expiration, expressed as a

percent of a year

r = current continuously compounded risk-free interest

rate

= annual volatility of stock price (the standard deviation

of the short-term returns over one year).

ln = natural logarithm

N(x) = standard normal cumulative distribution function

e = the exponential function

 Advantages and
Limitations
Advantage: The main advantage of the Black-
Scholes model is speed -- it lets you calculate a
very large number of option prices in a very
short time.

Limitation: The Black-Scholes model has one

major limitation: it cannot be used to
accurately price options with an American-
style exercise as it only calculates the option
price at one point in time
http://www.business-standard.co
m/article/markets/sebi-may-allo
w-options-in-select-commodities
-116050301004_1.html