15

Chapter
Option Valuation

Fundamentals
of Investments
Valuation & Management
second edition
Charles J. Corrado Bradford D. Jordan

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

 15 - 2

Just What is an Option Worth?

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 15 - 3

Option Valuation
Our goal in this chapter is to discuss stock option
prices. We will look at the fundamental
Goal relationship between call and put option prices and
stock prices. Then we will discuss the Black-
Scholes-Merton option pricing model.

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 15 - 4

Put-Call Parity
Put-call parity
The difference between a call option price and a put option
price for European-style options with the same strike price
and expiration date is equal to the difference between the
underlying stock price and the discounted strike price.

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 15 - 5

Put-Call Parity

 rT
C  P  S  Ke
C = call option price
P = put option price
S = current stock price
K = option strike price
r = risk-free interest rate
T = time remaining until option
expiration
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 15 - 6

Put-Call Parity
 Put-call parity is based on the fundamental
principle of finance stating that two securities
with the same riskless payoff on the same
future date must have the same price.
 Suppose we create the following portfolio:
 Buy 100 shares of stock X.
 Write one stock X call option contract.

 Buy one stock X put option contract.

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 15 - 7

Put-Call Parity

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 15 - 8

Put-Call Parity
 Since the payoff for the portfolio is always
equal to the strike price, it is risk-free, and
therefore comparable to a U.S. T-bill.
 So, cost of portfolio = discounted strike price
S + P – C = Ke–rT
 C – P = S – Ke–rT
 If the stock pays a dividend before option
expiration, then C – P = S – Ke–rT – PV(D),
where PV(D) represents the present value of the
dividend payment.
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 15 - 9

Work the Web

 To learn more about trading options,

see:
http://www.ino.com
http://www.optionetics.com

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 15 - 10

The Black-Scholes-Merton Option Pricing Model

 Option pricing theory made a great leap

forward in the early 1970s with the
development of the Black-Scholes option
pricing model by Fischer Black and Myron
Scholes.
 Recognizing the important theoretical
contributions by Robert Merton, many finance
professionals refer to an extended version of
the model as the Black-Scholes-Merton option
pricing model.
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 15 - 11

The Black-Scholes-Merton Option Pricing Model

 The Black-Scholes-Merton option pricing model

states the value of a stock option as a function of
six input factors:
 S, the current price of the underlying stock
 y, the dividend yield of the underlying stock
 K, the strike price specified in the option contract
 r, the risk-free interest rate over the life of the option
contract
 T, the time remaining until the option contract expires
 , the price volatility of the underlying stock
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 15 - 12

The Black-Scholes-Merton Option Pricing Model

 The price of a call option on a single share of
common stock, C = Se–yTN(d1) – Ke–rTN(d2)
 The price of a put option on a share of common
stock, P = Ke–rTN(–d2) – Se–yTN(–d1)

where
d1 

ln S K   r  y  σ 2 T 2

σ T
d 2  d1  σ T
N(x) denotes the standard normal probability
of the value of x
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 15 - 13

The Black-Scholes-Merton Option Pricing Model

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 15 - 14

Work the Web

 To learn more about the Black-

Scholes-Merton formula, see:
http://www.jeresearch.com

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 15 - 15

Varying the Option Price Input Values

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 15 - 16

Varying the Underlying Stock Price

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 15 - 17

Varying the Time to Option Expiration

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 15 - 18

Varying the Volatility of the Stock Price

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 15 - 19

Varying the Interest Rate

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 15 - 20

Work the Web

 For option trading strategies and

more, see:
http://www.numa.com

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 15 - 21

Measuring the Impact of Input Changes

 Delta measures the dollar impact of a change
in the underlying stock price on the value of a
stock option.
Call option delta = e–yTN(d1) > 0
Put option delta = –e–yTN(–d1) < 0
 A $1 change in the stock price causes an
option price to change by approximately delta
dollars.

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 15 - 22

Measuring the Impact of Input Changes

 Eta measures the percentage impact of a
change in the underlying stock price on the
value of a stock option.
Call option eta = e–yTN(d1)S/C > 1
Put option eta = –e–yTN(–d1)S/P < –1
 A 1% change in the stock price causes an
option price to change by approximately eta%.

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 15 - 23

Measuring the Impact of Input Changes

 Vega measures the impact of a change in stock
price volatility on the value of a stock option.
 Vega is the same for both call and put options.
Vega = Se–yTn(d1)T > 0
where n(x) represents a standard normal density
 A 1% change in sigma changes an option price
by approximately the amount vega.

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 15 - 24

Measuring the Impact of Input Changes

 Gamma measures delta sensitivity to a stock
price change. A $1 stock price change causes
delta to change by approximately the amount
gamma.
 Theta measures option price sensitivity to a
change in time remaining until option
expiration. A one-day change causes the
option price to change by approximately the
amount theta.
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 15 - 25

Measuring the Impact of Input Changes

 Rho measures option price sensitivity to a
change in the interest rate. A 1% interest rate
change causes the option price to change by
approximately the amount rho.

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 15 - 26

Implied Standard Deviations

 Of the six input factors for the Black-Scholes-
Merton stock option pricing model, only the
stock price volatility is not directly observable.
 A stock price volatility estimated from an
option price is called an implied standard
deviation (ISD) or implied volatility (IVOL).
 Calculating an implied volatility requires that
all input factors (except sigma) and either a
call or put option price be known.
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 15 - 27

Implied Standard Deviations

 Sigma can be found by trial and error, or by
using the following formula, which yields
accurate implied volatility values as long as
the stock price is not too far from the strike
price of the option contract.

2π T  YX  Y  X  Y  X 
2 2 
σ C  C    
YX  2  2  π 
 
Y  Se  yT X  Ke  rT
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 15 - 28

Work the Web

 For applications of implied volatility,

see:
http://www.ivolatility.com

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 15 - 29

Hedging a Portfolio with Index Options

 Many institutional money managers make
some use of stock index options to hedge the
equity portfolios they manage.
 To form an effective hedge, the number of
option contracts needed =
Portfolio beta  Portfolio value .

Option delta  Option contract value

 Note that regular rebalancing is needed to
maintain an effective hedge over time.
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 15 - 30

Work the Web

 For stock option reports, see:

http://www.aantix.com

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 15 - 31

Implied Volatility Skews

 Volatility skews (or volatility smiles) describe
the relationship between implied volatilities
and strike prices for options.
 Recall that implied volatility is often used to
estimate a stock’s price volatility over the period
remaining until option expiration.

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 15 - 32

Implied Volatility Skews

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 15 - 33

Implied Volatility Skews

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 15 - 34

Implied Volatility Skews

 Logically, there can be only one stock price
volatility, since price volatility is a property of
the underlying stock.
 However, volatility skews do exist. There is
widespread agreement that the major cause
factor is stochastic volatility.
 Stochastic volatility is the phenomenon of
stock price volatility changing randomly over
time.
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 15 - 35

Implied Volatility Skews

 The Black-Scholes-Merton option pricing
model assumes that stock price volatility is
constant over the life of the option.
 Nevertheless, the simplicity of the model
makes it an excellent tool. Furthermore, the
model yields accurate option prices for options
with strike prices close to the current stock
price.

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 15 - 36

Work the Web

 For volatility summaries, see:

http://www.pmpublishing.com

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 15 - 37

Chapter Review
 Put-Call Parity
 The Black-Scholes-Merton Option Pricing
Model

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 15 - 38

Chapter Review
 Varying the Option Price Input Values
 Varying the Underlying Stock Price
 Varying the Option’s Strike Price

 Varying the Time Remaining until Option

Expiration
 Varying the Volatility of the Stock Price

 Varying the Interest Rate

 Varying the Dividend Yield

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 15 - 39

Chapter Review
 Measuring the Impact of Input Changes on
Option Prices
 Interpreting Option Deltas
 Interpreting Option Etas

 Interpreting Option Vegas

 Interpreting an Option’s Gamma, Theta, and Rho

 Implied Standard Deviations

 Hedging a Stock Portfolio with Stock Index
Options
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 15 - 40

Chapter Review
 Implied Volatility Skews

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