Valuation: equivalent portfolio

• Current stock price $85

• Exercise Price=$85 (in the money)
• Maturity =6 months
• Risk free rate= 6%
• Two possibilities for the stock price in six
months:
– Either stock price falls (20%) to $68
– Or stock prices goes up (25%) to $106.25
– Pay offs from call option
• $0 if stock price=$68
• $21.25 if stock price=$106.25
Equivalent Portfolio: pay offs from owning
5/9 shares and borrowing of $36.86
S=$68 S=106.25

5/9 share $37.78 $59.03

Repayment of loan + interest -$37.78 -$37.78

Total pay off $0 $21.25

 Option equivalent

• Loan amount L=37.78/1.025

• The pay offs from portfolios (owning 5/9 shares
and borrowing $36.86 and one call option) are
the same.
• Value of call option= Value of 5/9 share- $36.86
bank loan.
• Hedge ratio: To replicate the call option, the
number of shares needed is called the option
Delta and is given by
– Change in option price/change in share price
– (21.25-0)/(106.25-68)=5/9
 Principle of arbitrage

• The option must sell for $10.36 if not risk free

arbitrage will take place.
• If option is trading at a higher price than $10.36
then an investor by buying 5/9 of the share and
selling call option and borrowing $36.78 will
make a certain profit without taking a risk. This
will lead to arbitrage till the price falls to $36.78.
• If the option is trading at less than $10.36, then
investor can make by selling 5/9 of share buying
a call and lending the balance.
• The option price is therefore independent of
investors attitude to risk.
 Valuing options

• Generally two approaches are used for

valuing options:
– Binomial method.
– Black and Scholes option pricing model.
 Upper and lower bounds to the call options

• Value of a call option cannot be negative.

• Value of a call option cannot be less than its
intrinsic value.
• The value of call option cannot be more than the
price of the underlying stock, because even if
the strike price is zero and maturity is infinite,
call price will be less than the stock price, as
stocks have voting rights.
• The call option should be trading at a higher
price than (S- PV of X), where S is the trading
price and X is the exercise price. The discount
rate is the risk free rate.
 Upper bounds and lower bounds

• Option price

C(S,X,T)
S (S-PV of X) S-X

Option price

Share price
Upper and lower bounds

CS
 r .T
PV ( X )  X .e
r  RiskFreeRate
C  (S  X )
 r .T
C  ( S  X .e )
Black and Scholes Model for option pricing

• Assumptions:
– Efficient market no transaction costs
– Short positions are possible
– Stock price is a random variable and follow a
log-normal distribution. Returns follow a
normal distribution.
– Risk free rate is non-random variable.
– Stocks pay no dividends.
 Black and Scholes Formula

 r .T
C  S .N (d1 )  X .e N (d 2 )
ln( S / X )  (r   / 2)T 2
d1 
 T
d 2  d1   T
 Black and Scholes Formula

• C= call option price

• S= share price
• X= exercise price
• r= risk free rate
• T= time to maturity in years
• Sigma= volatility
• Value of call option = (delta x share price) –
(bank loan)
• Delta= (change in option price) / (change in the
stock price)
Black and Scholes in the presence of
dividends

 .T  r .T
C  S .e N (d1 )  X .e N (d 2 )
ln(S / X )  (r     / 2)T 2
d1 
 T
d 2  d1   T
  DividendYi eld
 Volatility

• The volatility of a stock (sigma) is a measure of the

uncertainty of returns on the stock. More precisely, it is
the standard deviation provided by the stock returns in
one year when the returns are expressed in continuous
compounding.
• To estimate the volatility empirically, the stock price is
observed at fixed intervals of time usually daily. From
these observations the returns are calculated. The
returns are calculated based on continuous
compounding. These observations are then used to
calculate the standard deviation of returns. This is then
the basis for the annualized returns. This is called
historical estimation.
 Estimation of historical volatility

Day Stock Price Price Relative Si/S(i-1) Daily Returns

Ln(Si/Si-1)=ui

0 S0

1 S1 S1/S0 Ln(SI/S0)

i-1 S(i-1) Si-1/Si-2 Ln(Si-1/Si-2)

i Si Si/Si-1 Ln(Si/Si-1)

n Sn Sn/Sn-1 Ln(Sn/Sn-1)
 Historical Volatility

NumberOfObservations : n  1
Stock Pr iceAtTheEndOfPeriod ' i '  S i
LengthOfTi meInterval  
Since : S i  e ui .Si 1;ui  Continuous lyCompounded Re turn
1 n
Std .DevOf Re turns  s  
n  1 i 1
(ui  u ) 2
 Historical Volatility

1 1
s
n 1
 i n(n  1)  i
u 2
 ( u ) 2

Variable ' s '  EstimateOf ' 

  ( NumberOfTradingDays250  360)  (1 / 250  1 / 360)Yrs
Choo sin g ' n' Between  90 & 180 Days.
 Options and Risk

• Option holders and writers do not have

symmetrical risks.
• Downside risk of an option holder is limited
whereas the gains are theoretically unlimited (at
least in the case of a call).
• On the contrary the gains of a option writer is
limited whereas the losses can be unlimited.
• Option markets therefore require that the option
writers to maintain funds in a margin account.
 Margins in options markets

• When call put options are purchased, the option

price must be paid in full. Unlike stocks,
investors are not allowed to buy options on
margins.
• When an investor writes options, they are
required to maintain funds in Margin Account.
This is because the investor’s broker and the
exchange want to be satisfied that the investor
will not default.
• The size of the margin required depends on the
exchange and the circumstances.
 Margin accounts: example of writing naked
options.
• This means that option position is not combined with an
offsetting position in the underlying stock.
• If the option is in the money, the initial margin = 30% of
the value of the underlying stock + amount by which the
stock is in the money.
• If the stock is out of the money, the initial margin = 30%
of the value of the underlying stock – the amount by
which the option is out of the money.
• The option price received by the writer can be used
partially to fulfill this margin requirement.
• Each contract corresponds to 100 options.
 Margin requirement: put option

• Here the put option is out of the money.

• First part of the margin =$5040
• The amount by which it is out of the money =
$800.
• If the option price is $5, the additional margin
requirement would be = $5040 - $800 - $2000 =
$2240.
• A similar calculation is done everyday and the
account of the investor is debited or credited.
 Margin Accounts: Example of call option.

• Investor writes 4 naked call options. The option

price $ 5, the strike price is $ 40, the stock price
is $42.
• The stock is in the money.
• First part of the margin requirement =
30%X$42x400 = $5040.
• Second part of the margin requirement = $2x400
= $800.
• Additional margin requirement = $5040+$800-
$2000 =$3840.
 Options on Stock Indices

• Most Stock Markets trade options on stock indices. The

most popular are S&P 100 and S&P 500 which are
traded on the CBOE. The contract is to buy and sell 100
times the index at the specified index price. The
settlement is in cash rather than delivering the
underlying the index.
• One contract on S&P 100 at a strike price of 310. If it is
exercised when the index price is 340. The writer pays
the holder (340-310)x$100 = $3000.
• Some indices track the movement of a particular sector
(banking and finance, computer technology, utilities,
manufacturing etc).
• In Paris options are available on CAC40.
 Options on Stock Indices and Portfolio insurance

• Index options are used by portfolio managers to limit

their downside risks. They are also used to leverage
their performance.
• Consider the portfolio manager with a well diversified
portfolio. If Beta of the portfolio is close to one, it is likely
to mirror the market.
• Portfolio is worth $500,000. The index is 250.
• The portfolio manager wants to ensure that the portfolio
value does not drop below $480,000 in three months.
• If the contract is 100 times the index value, the portfolio
manager can buy 20 Put option contracts at a strike
price of 240, maturity 3 months.
 Portfolio Insurance: How it Works?

• Suppose the stock index falls to 225 in three

months. The portfolio value will be worth
$450,000. Which is a loss of $50000.
• Pay off from the index option = 20x(240-225)x
100= $30000.
• The total value of the portfolio will be = 450,000+
$30000= $480,000.
• The net value of the portfolio will be $480,000 –
Price paid for the put options.