Part-01

Introduction to Options

1
Introduction
 Options contracts are by design different from
futures contracts.
 The buyer of an option is called a Long
 He has a right to transact
 The seller of the option is called the Short or the
Writer
 He has an obligation

2
Introduction (Cont…)
 So the long has the freedom to decide
whether or not he wishes to transact
 But if he chooses to exercise the short has no
choice but to carry out his part of the agreement.
 Thus an option is a Right for the Long
 And a Contingent Obligation for the Short

3
Introduction (Cont…)
 The buyer of an option may acquire the
right to buy the underlying asset
 Or the right to sell the underlying asset
 Consequently there are two types of
options
 Calls and Puts

4
Introduction (Cont…)
 An option may give the holder the right
to exercise
 At any point in time after the contract is
entered into
 Or only at the time of expiration of the
contract

5
Introduction (Cont…)
 Consequently there are two types of options
 European and American
 Most exchange traded options are American
 But European options are easier to value
 In India stock options as well as options on stock
indices are European
 If all other features are the same, an American
option will be more valuable than a corresponding
European option.

6
Exercise Price
 The price which a call holder has to pay
the writer per unit of the underlying
asset if the option is exercised.
 It is the price receivable by a put holder
per unit of the underlying asset if a put
is exercised.
 It is also known as the Strike Price.

7
Exercise Price (Cont…)
 The exercise price enters the picture
only if the option is exercised.
 Since the holder has a right and not an
obligation
 The option may or may not be exercised
 Which means that the exercise price may
or may not be paid/received.

8
Expiration Date

9
Expiration Date
 It is the point in time after which the contract
becomes void.
 It is the only point in time at which a
European option can be exercised
 It is the last point in time at which an
American option can be exercised
 It is also known as
 Exercise date
 Strike date
 Maturity date
10
Option Premium
 It is the price paid by the holder to the
writer at the outset, in order to acquire
the right to exercise.
 It is a sunk cost?
 If the holder were to subsequently choose
not to exercise, the premium cannot be
recovered.

11
Option Premium (Cont…)
 Why is a premium required?
 The buyer is acquiring a right from the
writer who is taking on a contingent
obligation.
 Nobody will ever give a right away for free.
 They have to be paid for in order to
acquire them.

12
Exercising Options

13
Exercising Options (Cont…)
 American options may be exercised
 Prior to expiration
 Or at expiration
 European options can be exercised only
at expiration

14
Exercising Options (Cont…)
 When a call is exercised
 The holder will receive a specified # of
shares per contract being exercised
 In return for a payment of $X per share
 When a put is exercised
 The holder will have to deliver the specified
# of shares per contract
 And will receive $X per share delivered

15
Illustration
 An investor buys a call on Reliance
expiring in December, with an exercise
price of Rs 1,260.
 The premium is Rs 20 per share.
 Option premiums are always quoted per
unit of the underlying asset.
 In this case, on a per share basis.

16
Exercising Options (Cont…)
 The contract size for stock options
contract in the U.S. is 100 shares.
 In India it varies from company to
company.
 For Reliance the lot size is 250 shares
 So as soon as the deal is struck:
 The buyer has to pay 250 x 20 = Rs 5000 to
the writer.

17
Exercising Options (Cont…)
 When will the right be exercised?
 Obviously only if the stock price at
expiration is greater than Rs 1260.
 Else it is better to let the option expire
worthless.

18
Sunk Costs

19
Sunk Cost
 Would it not make sense to exercise
only if the stock price is > than X + the
premium
 That is only if ST > 1260 + 20 = Rs 1280
 The answer is NO

20
Sunk Cost (Cont…)
 Assume that the terminal stock price is
Rs 1275.
 If the options are exercised the profit is:
  = (1275 – 1260)x250 – 5,000 = (1,250)
 If the options are not exercised the profit
will be (5000).

21
Sunk Cost (Cont…)
 It is better to lose Rs 1,250 than
Rs 5,000
 The maxim is that:
`Sunk Costs are Irrelevant’ while

taking investment decisions.

22
Exercising Puts
 What if the option were to be a put and
not a call?
 Obviously exercise would be profitable only
if ST < 1260.
 Else it is better to let the option expire
worthless.

23
Illustration
 Assume that the terminal stock price is
1150 and that the put premium is 75.
 The profit is:
 = (1260 – 1150)x 250 - 18750 = Rs 8,750

24
Payoffs and Profits - Symbolically
 For a call holder the payoff at expiration
is ST – X if ST > X or 0 if ST ≤ X
 Combining the two conditions the
payoff may be expressed as:
Max[0, ST – X]
 The profit = Max[0, ST – X] – Ct where Ct
is the premium paid at the time of
acquisition.
25
Payoff…(Cont…)
 What about the writer?
 Payoff = -Max[0, ST – X]
= Min[0, X – ST]
 Profit = Min[0, X – ST] + Ct

26
Observations
 The maximum profit for the call holder is
unlimited.
 The stock price at the time of exercise has no
upper limit.
 The maximum loss is limited to the premium
paid at the outset.
 For writers the situation is the reverse.
 The maximum loss is unlimited.
 The maximum profit is the premium received at
the outset.
27
Puts
 For a put holder the payoff is X – ST if
ST < X, else it is equal to 0.
 This can be represented as
Max[0,X - ST]
 The profit can be represented as:
 = Max[0, X – ST] – Pt where Pt is the
premium paid at the outset.
28
Puts (Cont…)
 From the writer’s standpoint the payoff
is:
-Max[0,X - ST] = Min[0, ST – X]
 The profit for the writer is:
Min[0, ST – X] + Pt

29
Observations
 For a put holder the maximum profit is
equal to the exercise price minus the
premium.
 This is because stocks have limited liability.
 Consequently the stock price cannot go
below zero.
 The maximum loss like in the case of
calls, is equal to the option premium.
30
Observations (Cont…)
 For a put writer:
 The maximum profit is equal to the
premium
 The maximum loss is equal to the exercise
price minus the premium.

31
Observations (Cont…)
 The maximum loss for an option holder
is the premium
 This is true for both calls and puts
 The maximum profit for an option
writer is the premium
 This is once again true for both calls and
puts

32
Zero Sum Games
 Thus both calls and puts may be said to
be Zero Sum Games.
 The holder’s profit is equal to the writer’s
loss and vice versa.

33
Moneyness
 Call Options:
 If St > X the call is In-the-money
 If St = X the call is At-the-money
 If St < X the call is Out-of-the money
 If St  X the call is Near-the-money

34
Illustration
 Stock is currently trading at Rs 500
 A call with an exercise price of Rs 500 will
be at-the-money.
 A call with an exercise price of Rs 450 will
be in-the-money
 A call with an exercise price of Rs 550 will
be out-of-the-money.

35
Moneyness (Cont…)
 Put Options:
 If St > X the put is Out-of-the-money
 If St = X the put is At-the-money
 If St < X the put is In-of-the money
 If St  X the put is Near-the-money

36
Illustration
 A stock is currently trading at Rs 500.
 A put with an exercise price of Rs 500 will
be at-the-money.
 A put with an exercise price of Rs 450 will
be out-of-the-money.
 A put with an exercise price of Rs 550 will
be in-the-money.

37
Conclusion
 A call will be exercised only if it is
in-the-money.
 A put too will be exercised only if it
happens to be In-the-money.

38
Arbitrage Free Conditions
 Certain relationships and conditions
must be satisfied if arbitrage is to be
ruled out.
 Violation of any of these conditions
would tantamount to the presence of an
arbitrage opportunity.

39
Manifestation of Arbitrage
 A strategy that yields a cash inflow at
certain points in time and a zero cash
flow at other points in time
 Is an ARBITRAGE Strategy
 Because it leads to non-negative returns
without requiring an investment
 An investment at some stage would have
shown up as a cash outflow

40
Non-Negative Premia
 The option price or premium cannot be
negative.
 What would a negative premium imply?
 It would mean that the writer is prepared
to pay the holder to buy the option.
 If so, the holder can acquire the option,
pocket the payment, and simply forget
about the contract.

41
Non-Negative Premia (Cont…)
 The reason he can be nonchalant is
because he need not worry about a
subsequent cash outflow.
 This is because an option is a right and not
an obligation and
 Consequently the holder cannot be forced
to exercise under adverse circumstances.

42
Properties of American
Options
 We will use the symbol CA,t to denote
the price of an American call option at
time t.
 The stock price at that time will be
denoted by St and the exercise price of
the option by X.
 We can state that
 CA,t  Max[0,(St – X)]
43
American Options (Cont…)
 Proof:
If (St – X) < 0, then all we can say is
that
CA,t  0, since the option premium
cannot be negative.
However, if (St – X) > 0, then
CA,t  St – X
44
American Options (Cont…)
 To prove this let us assume the
converse.
 Assume that CA,t < St – X > 0
 If so, an investor can buy an option and
immediately exercise it.

45
American Options (Cont…)
 He will make a profit given by:
 = St – X – CA,t
which is clearly an arbitrage profit,
because it is costless and risk-less.

46
Numerical Illustration
 Let the stock price be $105
 The premium of an American call with
an exercise price of $ 100 is 4.50
 An arbitrageur will buy a call and
immediately exercise it.
 His profit = 105 – 100 – 4.50 = $0.50 
$50 per contract

47
American Options (Cont…)
 Similarly, if we denote the premium for an
American put option at time t by PA,t then it
can be demonstrated that:
PA,t  Max[0,(X – St)]
 Once again PA,t > 0 if (X – St) < 0, because a
put option cannot have a negative premium.
 However if (X – St) > 0, then the put
premium must be greater than or equal to
this.
48
American Options (Cont…)
 Otherwise, an arbitrageur will simply
buy the put option and immediately
exercise it.

49
Illustration
 The stock price is $100
 An American put with X = $105 is
trading at $4.50
 An arbitrageur will buy the put and
immediately exercise
  = (105 -100) – 4.50 = $0.50  $50
per contract

50
Put-Call Parity

51
The Put-Call Parity Theorem
 What we are now going to demonstrate is a
condition that is valid for European options on
non-dividend paying stocks.
 By a non-dividend paying stock we mean a
stock that will not pay a dividend during the
life of the option.
 Analogous relationships can be derived for
European options paying one or more
dividends.
52
Illustration-1
 Stock price = $100
 X = $100
 Risk-less rate = 10% per annum
 Call premium (6M) = $8
 Put premium (6M) = $3

53
Illustration-1 (Cont…)
 CE,t – PE,t = 8 – 3 = 5
 St – PV(X) = 4.65
 So there is a violation of put-call parity
 LHS is higher than the RHS
 The possibilities are
 Call is overpriced
 Put is underpriced
 Stock is undervalued
54
Illustration-1 (Cont…)
 Strategy:
 Buy stock
 Sell call
 Buy put
 Borrow PV of X

55
Illustration-1 (Cont…)
 Initial inflow = -100 + 8 – 3 + 95.35
= 0.35
 Subsequent cash flows will be zero
irrespective of the stock price at
expiration.
 So clearly arbitrage is possible

56
Illustration-2
 Stock price = 100
 Exercise price = 100
 Call (6M) = 7
 Put (6M) = 3
 Risk-less rate = 10% per annum

57
Illustration-2 (Cont…)
 CE,t – PE,t = 7 – 3 = 4
 St – PV(X) = 4.65
 So there is a violation of Put-Call parity
 RHS is higher than the LHS
 The possibilities are:
 Call is underpriced
 Put is overpriced
 Stock is overpriced
58
Illustration-2 (Cont…)
 Strategy:
 Short sell the stock
 Buy call
 Sell put
 Lend PV of X

59
Illustration-2 (Cont…)
 Initial inflow = 100 – 7 + 3 – 95.35
= 0.65
 Subsequent cash flows will be zero
irrespective of the stock price at
expiration
 So this is clearly an arbitrage opportunity

60
Intrinsic Value & Time Value

61
Intrinsic Value & Time Value
 The intrinsic value of an option is equal
to the amount by which it is in the
money, if it is in the money, else it is
equal to zero.
 Therefore the intrinsic value of a call is:
 Max[0, (St – X)]
 While that of a put is:
 Max[0, (X – St)]
62
I.V & T.V (Cont…)
 The difference between an option’s
premium and its intrinsic value is called
the time value of the option, also
known as the speculative value of the
option.

63
Illustration
 Stock price = 100
 X = 97.50
 Call premium = 3.50
 I.V = 100 – 97.50 = 2.50
 T.V = 3.50 – 2.50 = 1.00

64
Illustration-2
 S = 100
 X = 97.50
 Put premium = 1.25
 I.V = 0 because the put is out of the
money
 T.V = 1.25

65
I.V and T.V (Cont…)
 From our earlier analysis, it is obvious
that both American calls and puts must
be worth at least their intrinsic values.
 Thus the Time Value of an American option
must be greater than or equal to ZERO
 This is true for calls as well as puts

66
I.V & T.V (Cont…)
 Thus American options will always have
a non-negative time value.
 What about European options? From
put-call parity for a non-dividend stock
we know that:

67
I.V & T.V (Cont…)
 Look at the RHS.
 The value of the put option will always
be greater than or equal to zero.
 The difference between the exercise
price and its present value will also be
non-negative.
 Thus if the option is in the money, its
time value will be non-negative.

68
I.V and T.V (Cont…)
 What if the option is out of the money?
 If so the entire premium is the time
value by definition, which has to be
non-negative since option premia
cannot be negative.
 Thus European calls on non-dividend
paying stocks will always have a non-
negative time value.
69
I.V & T.V (Cont…)
 What about European Puts? From put-
call parity:

70
I.V & T.V (Cont…)
 Once again, if the put is out of the
money, the entire premium is due to
the time value, which consequently has
to be non-negative.
 What if the option is in the money?
 If so, the intrinsic value will be positive.
 The call premium will be non-negative.
 The difference between the present
value of X and X, will be non-positive.
71
I.V & T.V (Cont…)
 So whether or not the time value is
negative would depend on which item
in the expression
 The call premium or the difference
between the present value of X and X
dominates
 Obviously, the lower the value of the call
premium, the lower will be the time value.

72
I.V & T.V (Cont…)
 For a given exercise price, the lower the
stock price the lower will be the call
premium.
 The lower the call premium the higher
will be the corresponding put premium.
 Thus the more out of the money the call is,
the lower will be the time value of the
European put.

73
I.V & T.V (Cont…)
 This implies that:
 Certain deep in the money European put
options can have a negative time value.
 It is not however necessary that all ITM
put options will have a negative time value

74
Option Premia at Expiration
 At expiration the time value of an
option must be zero.
 That is, the option premium must be
equal to its intrinsic value

75
At Expiration (Cont…)
 Consider call options which are in the
money
 Assume that the time value is positive,
that is, C > ST – X
 An arbitrageur will sell a call.
 If it is exercised the cash flow = C-ST-X
which by assumption is positive.
76
At Expiration (Cont…)
 The same holds true if the call is out of
the money and the time value is
positive.
 In this case the writer need not worry
about exercise

77
At Expiration…(Cont…)
 What if the time value is negative, that is C <
S–X
 An arbitrageur will buy the option and
immediately exercise.
 The cash flow is guaranteed to be positive
 Thus to rule out arbitrage an option must sell
for its intrinsic value at expiration
 The logic holds for puts too, whether
European or American

78
The Binomial Option Pricing Model
Part-04
The Binomial Model
 The first pricing model that we will
study is called the Binomial Option
Pricing Model (BOPM).
 This model assumes that given a value
for the stock price, at the end of the
next period, the price can either be up
by X% or down by Y%.
Binomial Model (Cont…)
 Since the stock price can take on only
one of two possible prices
subsequently, the name Binomial is
used to describe the process.
 We will first study the model using a
single time period.
 That is, we will assume that we are at
time T-1, and that the option will expire
at T.
The One Period Model
 Let the current stock price be S0.
 At the end of the period, the price ST
can be
The One Period Model
(Cont…)
One Period (Cont…)
 Y in this case is obviously a negative
number.
 The stock price tree may be depicted as
follows.
The Stock Price Tree
Binomial Model (Cont…)
 Now consider a European call option.
 We will denote the exercise price by E,
since X has already been used to
denote an up movement for the stock
price.
 In the case of the Binomial model, we
always start with the expiration time of
the option, since the payoffs at
expiration are readily identifiable.
Binomial (Cont…)
 We will then work backwards.
 Let us denote the call value if the upper
stock price is reached by Cu, and the
call value if the lower stock price is
reached by Cd.
 Cu = Max[0, uS0 – E]
 Cd = Max[0, dS0 – E]
Binomial (Cont…)
 Our objective is to find that value of the
call option one period earlier, that is
right now.
 We will denote this unknown value by
C0.
A Risk-less Portfolio
 In order to price the option, we will
consider the following investment
strategy.
 Let us buy  shares of stock and write
one call option.
 The current value of this portfolio is:
 S0 – C0.
 The negative sign in front of the
option value indicates a short
position.
Risk-less Portfolio (Cont…)
 In the up state, the portfolio will have a
value of: uS0 – Cu
 In the down state, the portfolio will
have a value of: dS0 – Cd
 Suppose we were to select  in such a
way that the value of this portfolio is
the same in both the up as well as the
down state?
Risk-less Portfolio (Cont…)

 Then this portfolio may be said to be

risk-less since there are only two
possible states of nature in the next
period.
 So if: uS0 – Cu = dS0 – Cd
Risk-less Portfolio (Cont…)
  is known as the hedge ratio.
 Since the portfolio is risk-less it
must earn the risk-less rate of
return.
 Let us define r as 1 + risk-less rate.
 If so:
 uS0 – Cu = dS0 – Cd = (S0 – C0)r
Risk-less Portfolio (Cont…)
 Substituting for , we get:
The Option Premium
 Let us denote (r-d)/(u-d) by p.
 Therefore, (u-r)/(u-d) = 1-p.
 We can then write C0 as:
The Option Premium (Cont…)
 This is the one period binomial option
pricing formula.
 p is known as the Risk Neutral
probability.
Parameters
 We have assumed that r, u, and d are
constant.
 This is not a necessary condition.
 That is
 The interest rate may vary from
period to period
 And the magnitude of price moves
may also differ from period to period.
Numerical Illustration
 Let the current stock price be 100 and
the exercise price of a call option be
100.
 Let there be a possibility of a 20% up
move in the next period and a 20%
down move in the next period.
 Let the risk-less rate be 5% per period.
 Therefore r = 1.05.
Illustration (Cont…)
 p = (1.05 - .8)/(1.2-.8) = .625
 1-p = .375
 Cu = Max[0, 120 – 100] = 20
 Cd = Max[0, 80 – 100] = 0
 C0 = .625x20 + .375x0
------------------------------------ = 11.9048
1.05
The Two-Period Situation
 Now let us extend the model to a case
where there are two periods to
expiration.
 That is, the option expires at T,
whereas we are standing at T-2.
 We will denote the current stock price
by S0
 The stock price tree can be depicted as
follows.
 The Stock Price Tree
uuS0

uS0

S0
udS0

dS0 ddS0

T-2 T-1 T
Two Periods (Cont…)
 Once again, we know the payoff from
the option at expiration.
 Let us go back one period, that is to
time
T-1.
 At this point in time the problem is
essentially a one-period problem, to
which we have a solution already.
 Two Periods (Cont…)
 Let us denote the option premia
corresponding to values of the stock at
time T, as Cuu, Cud, and Cdd.
 If so, then:
Two Periods (Cont…)
 Knowing Cu and Cd, we can work
backwards to get C0, using an iterative
process.
 This procedure can be extended to any
number of periods.
Numerical Illustration
 Let the current stock price be 100.
 Consider a call option with two periods
to expiration and an exercise price of
100.
 Assume that given a stock price, the
price next period can be 20% more or
20% less.
 Let the risk-less rate of interest be 5%.
 The stock price tree will look as follows.
 The Stock Price Tree
144

120

100
96

80 64

T-2 T-1 T
Illustration (Cont…)
 p = 0.625 and 1-p = .375.
 Cuu = Max[0, 144- 100] = 44
 Cud = Max[0, 96-100] = 0
 Cdd = Max[0,64-100] = 0
Illustration (Cont…)
Pricing European Puts
 We will illustrate the procedure for the
one period case.
 The procedure is similar to the one
used for call options.
 It can easily be extended to the multi-
period case.
European Puts (Cont…)
 Assume that we have a stock with a
price of S0, which can either go up to
uS0 or go down to dS0.
 Consider a one-period put option with
an exercise price of E.
 Pu = Max[0, E – uS0]
 Pd = Max[0, E – dS0]
 European Puts (Cont…)
 Using similar arguments, we can show that:

and
European Puts (Cont…)
 p and 1-p, have the same definitions as
before.
Numerical Illustration
 We will use the same data as before.
 That is: S0 = E = 100
 u = 1.20; d = 0.80; r = 1.05
 Pu = Max[0, 100 – 120] = 0
 Pd = Max[0,100 – 80] = 20
Illustration (Cont…)
American Options (Cont…)
 The major difference, is that, at each
node of the tree, we have to consider
as to whether the option will be
exercised (killed) or kept alive.
 In other words, we must compare the
payoff from exercising the option, to
the price given by the model if the
option is kept alive.
American Options (Cont…)
 If we find that at a particular node, the
option will be exercised early
 Then we should take the payoff from
early exercise while working
backwards to the previous node
 And not the value given by the model.
European versus American
Puts
 We will consider the same data used for
the earlier example.
 That is, the current stock price is equal
to the exercise price is equal to 100.
 Every period the stock price can
increase by 20% or decline by 20%.
 The riskless rate is 5%.
 The stock pays no dividends.
Puts (Cont…)
 Consider puts with 3 periods to
expiration.
 The stock price tree can be expressed
as follows.
Stock Price Tree
172.8

144

120
115.2
96
100

80
76.8
64
51.2
Valuing a European Put
European Put (Cont…)
Valuing an American Put
 In this case, at each node, we have to
compare the model value with the
intrinsic value of the option.
 The greater of the two values should be
used for subsequent calculations.
 At uuS0, the model value is zero and so
is the intrinsic value.
American Puts (Cont…)
 At udS0 the model price is 8.2857 and
the intrinsic value is 4.
 So we will take the model value.
 Thus Pu,T-1 is identical for both European
as well as American puts.
 At ddS0 the model price is 31.2381.
 The intrinsic value is however 36.
American Puts (Cont…)
 Therefore:
Pd,T-1 = .625 x 8.2857 + .375 x 36
-------------------------------
1.05

= 17.7891
American Puts (Cont…)
 At dS0, the intrinsic value is 20, which is
greater than 17.7891.
 Therefore:

P0 = .625 x 2.9592 + .375 x 20

----------------------- = 8.9043
1.05
American Puts (Cont…)
 Even at this last stage, the model value
must be compared with the intrinsic
value.
 In this case the intrinsic value is zero.
 So the option will be valued at 8.9043.
 Not surprisingly the American put is
valued at a higher premium than the
European put.
The Black-Scholes Model
The Black-Scholes Formula
 Black and Scholes obtained exact
formulae for pricing call and put options
on non-dividend paying stocks by
assuming that stock prices follow a
lognormal process.
Black-Scholes (Cont…)
 The formulae obtained by them are:
Black-Scholes (Cont…)
Black-Scholes (Cont…)
 And
Black-Scholes (Cont…)
 N(X) is the cumulative probability
distribution function for a standard
normal variable and
  is the standard deviation of the rate
of return on the stock.
Example
 Let the current stock price be $100
 Call and put options are available with X
= 100
 T-t = 6 months = 0.5 years
 Risk-less rate = 10% per annum
 Volatility is 30% per annum
 Thus r = 0.10 and  = 0.30
Example (Cont…)
Example (Cont…)
 N(d1) and N(d2) have to be calculated
using interpolation.
 N(.34) = 0.6331 and N(.35) = .6368
 So N(.3418) = .6338
 N(.12) = .5478 and N(.13) = .5517
 So N(.1297) = .5516
Example (Cont…)
Example (Cont…)
 N(-X) = 1- N(X)
 So N(-.1297) = 1-.5516 = .4484
 N(-.3418) = 1- .6338 = .3662
 So PE,t = 6.0331
Put-Call Parity
 The Black-Scholes formula satisfies put-
call parity.
Using the Binomial Model in
Practice
 While illustrating the binomial model we
chose the parameters u and d in a
rather arbitrary manner.
 In practice the parameters are chosen
in such a way that the moments of the
discrete time stock price process being
modeled
 Correspond to the moments of the
lognormal distribution
Method
 Given the current price St, the next
period price, ST, can be uSt or dSt.
 The expected value of ST given St is
 puSt + (1-p)dSt
 In a risk-neutral world:
 E(ST) = Ster(T-t)
Method (Cont…)
 If we equate the two we get
Method (Cont…)
 The approach entails specification of
the following values for u and d.

Obviously u is the reciprocal of d

Method (Cont…)
 The variance of the return is given by
Method (Cont…)
 It can be shown that the variance tends
towards 2(T-t) as T-t0.
Example
 A stock is currently priced at $100
 A call is available with X = 100 and 1-
year till expiration.
 The risk-less rate is 10% per annum
 Volatility is 30% per annum
 We will model the stock price process
as a two-period model
Example (Cont…)