Finance 2 (6012B0457Y)

Prof. Arnoud Boot

University of Amsterdam – Finance Group
THURSDAY MARCH 12, 2024

Week 6: Lecture 1 = Concepts and Theory

Options: pricing and applications

• Key invention for financial markets (how to prize

financial options), but also important applications
for real decisions!

Fisher Black had died

too early: Black and
Scholes option pricing
model most famous

2
Real decisions: Capital budgeting and (real)
options

3
Valuation revisited, need to think about real
options
• In text: what is strategic value of project?
 What is problem with NPV analysis?
 NPV cannot (or barely) capture the value of real options
• What does this sequencing of investments in small
biotech companies mean?
 These investments give you the right, not the obligation to
make further investments (call option): you buy the right to
stay in the game…;
 This is just one example of a real option application. More
in next lecture (Week 6: Lecture 2 – applications)
• Strong similarities with financial options. Those we
look at today.
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Outline
Lecture 1: Financial Options (Chapters 20+21)
1. Basics of Options (chapter 20)
Option Terminology
Options Payoffs at Expiration
Combinations of Options
Put-Call Parity
2. Option Pricing (chapter 21)
The Binomial Option Pricing Model
Black Scholes Model
Factors affecting Option Prices

Next lecture:
Week 6, Lecture 2: Real Options (Chapter 22)
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Options: Basics

• Financial option: a contract that gives its owner

the right (but not the obligation) to purchase or
sell a financial asset (that is traded on financial
markets) at a fixed price
 Call option: option that gives its owner the right to buy
 Put option: option that gives its owner the right to sell a
particular asset
• Real option: underlying value (the particular
asset) is a real investment, i.e. a business
decision. Key: the asset is not traded in the
financial markets
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Options: Contract features

• Exercising an option
 When a holder of an option enforces the agreement
and buys or sells a share of stock at the agreed-
upon price
• Strike price (exercise price)
 The price at which an option holder buys or sells a
share of stock when the option is exercised
• Expiration date
 The last date on which an option holder has the right to
exercise the option

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Option holders versus option writers
• The option buyer (holder)
 Holds the right to exercise the option and has a long
position in the contract

• The option seller (writer)

 Sells (or writes) the option and has a short position in the
contract
 Because the long side has the option to exercise, the
short side (option seller/writer) has an obligation to fulfill
the contract if it is exercised
• Option market is a zero sum market: against every
buyer is a seller.
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Option holders versus option writers:
rights versus obligations

Position Buyer of option Seller of option

(Holder) (Writer)
Type (Long position) (Short position)
Call option Right to buy Obligation to
underlying sell underlying

Put option Right to sell Obligation to

underlying buy underlying

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Options: Other contract features and
terminology
• Right to exercise early?
 American Option: Options that allow their holders to exercise the
option on any date up to, and including, the expiration date
 European Option: Options that allow their holders to exercise the
option only on the expiration date
• In/at/out of the money:
 In-the-money: Option whose value if immediately exercised would
be positive
 At-the-money: Option whose exercise price is equal to the current
stock price
 Out-of-the-money: Option whose value if immediately exercised
would be negative
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 Why would someone invest in options? And
why write an option?
For option holder (long position):
•Hedge
 To reduce risk by holding position that negatively correlates
with some risk exposure coming from the business

•Speculate
 When investors use options to place a bet on the direction
in which they believe the market is likely to move

Option writer: receives a premium upfront. This might give

a profit if the option expires without being exercised, or is
exercised with only marginal payoff to the holder ex post
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 Value of a Call Option at expiration
• Payoff of a Long Call Option at expiration
C  max (S  K , 0)
S: stock price at expiration
K : exercise price (e.g. $20)
C: value of the call

Assume at expiration:
S=10 or S=30. What is the
value of the call option?
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 Value of a Put Option at expiration

• Payoff of a Long Put Option at expiration:

P  max (K  S , 0)
S: stock price at expiration
K: exercise price (e.g. $20)
P: value of the put option

Assume at expiration:
S=10 or S=30. What is the
value of the put option?

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 Value of a short Call Option at expiration

• An investor that sells

(=short) a call option
has an obligation to
sell when the option
holder wants to
exercise

• Payoff at expiration of a
short call option:
Payoff  C   max(S  K ,0)

What is the payoff of the option for the seller of the

call option when S=10 or S=30?
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 Value of a short Put Option at expiration

• An investor, who sells

(writes) a put option
has the obligation to
buy the stock once
the option holder wants
to exercise the option
• Payoff at expiration of
the short put option:

Payoff  P   max( K  S ,0)

What is the payoff of the option for the seller of the
put option when S=10 or S=30?
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 Why would anyone write an option?
• Option premium: price paid to the option writer when
the option contract is signed (price reflects value of the
option):
 If the option is not exercised  profit to the option writer is
positive; or even when exercised with small gain to the holder
Profit diagram of a short call option
say K = $60 and option price = $5.15
total profit ($)

Break even
5.15

Share Price ($)

60 65.15

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Combinations of Options: Protective Put
Protective Put: Buy a stock and take a long position in a
European put option on the stock with K=$45

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Strategy to replicate the Protective Put.
Replication strategy: purchase a risk-free bond with
repayment $45 (i.e. lend money) and take a long position in
an European call option on the stock with K=$45

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We now have discovered the Put-Call Parity
• Two different portfolio’s give identical payoffs:
 Purchase the stock and an European put
 Purchase a bond and an European call

• Both positions provide exactly the same payoff  and thus

must have the same price: Law of One Price!

20-19
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 Understanding the Put-Call Parity
Therefore, S + P = PV(K) + C, where,
PV(K) is the present value of the payment on the bond
 To be precise: PV(K) is the present value of zero coupon bond with face
value K, and
K = strike price of the option
C = call price (European)
P = put price (European), with same exercise price and maturity
S = stock price

Observe:
•The put-call parity could be rewritten as C = S – PV(K) + P
 In words: a call option is a levered position in the stock, S - PV(K), plus a
protective put P
•Formula assumes that no dividends are being paid. See eq. 20.4 for
formula with dividends
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Put-Call Parity: more observations and an
example
• While we just tried to give an interpretation to the expression C
= S – PV(K) + P, it is somewhat loose. Later in this lecture we
derive the value of the call option C without having to know the
value of the put option P (see later this lecture)
 Law of one price will play an important role!
• Example: assume you want to buy a one-year call and put option
• The strike price for each is $25
• The current share price is $21.87
• The risk-free rate is 5.5%
• The price of each call is $2.85 (note, in this example we know the call)

 Question: Using put-call parity, what should be the price of

each put?
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Example: Put-Call Parity (cont’d)

• Solution
 Put-Call Parity states:
S  P  PV (K )  C
$25
$21.87  P   $2.85
1.055
P  $4.68

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Price bounds of a call

The bounds on the value of holding a long position in a call

option (American options)

Upper bound: stock price

Option
Price point 3

point 2 Lower bound

(Intrinsic Value):
Max {S-K, 0}

point 1

Stock Price {$} 23

Time value of options:
• Time Value: The difference between an option’s price and its
intrinsic value. American option cannot have a negative time value
 Note: European options could have negative time value if there are dividends
(i.e. early exercise might be desirable just before ex-dividend date, but not
possible with European option)
• Time value of a long position in a (American) call option:
Option
Price

Time value

Stock Price

• When time to maturity decreases, the time value of the option

decreases and the value approaches the intrinsic value
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 Chapter 21: Option Valuation
Binomial Option Pricing Model
• A technique for pricing options based on the assumption that
each period, the stock’s return can take on only two values
(i.e. move to ‘up’ or ‘down’ state)

• Example:
 A European call option expires in one period and has an exercise
price of $50 (K=$50)
 The stock price today is $50, and no dividends (S = $50)
 In one period, the stock price will either rise by $10 or fall by $10
 The one-period risk-free rate is 6%

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Binomial Option Pricing Model
• The payoffs on the stock, bond or call option can be
summarized in a binomial tree:

Time

• The key exercise is now to find a replicating portfolio

consisting of stocks (shares) and risk-free bonds that has
identical payoffs as the call option: thus a payoff of 10 if
S↑ = 10, and 0 if S↓ = 0
 A portfolio with the same payoffs must have the same price
 the Law of One Price again
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 Binomial Option Pricing Model (cont'd)
• Let’s define:
number of shares of stock purchased
B= initial investment in bonds

• We need to match the payoffs using the replicating portfolio

In the up state: payoff of the call option equals $10, thus
60  1.06 B  10
In the down state, payoff of the call option equals $0, thus
40  1.06 B  0
Two equations, with two unknowns: can be solved!

• Solving the equations gives: = 0.5 and B = –18.867

(borrow $18.87 and buy ½ a share).
Note both can be negative: < 0 is short selling the shares, and B<0 implies
borrowing money (risk free)
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Binomial Option Pricing Model (cont’d-2)

• The price of the call option today must equal the current
market value of the replicating portfolio (Law of One
Price).
• The value of the portfolio today is the value of 0.5 shares
at the current share price of $50, less the amount
borrowed
50  B  50(0.5)  18.87  6.13
 This is the price of the call option
 Note that by using the Law of One Price, we are able to
solve for the price of the option without knowing the
probabilities of the states in the binomial tree

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 The Binomial Pricing Formula: General
formulation
Having seen the example, let’s now give the pricing
formula (in symbols)
•Given the above assumptions, the binomial tree would
look like:

•The payoffs of the replicating portfolios could be

written as: S u   (1  r f ) B  C u and S d   (1  r f ) B  C d

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The Binomial Pricing Formula: General
formulation (cont'd)
• Solving the two replicating portfolio equations, we
get: Cu  Cd Cd  S d 
  and B 
Su  S d 1  rf
• And hence, the value of the option today (time 0) is:
C  S  B
 with the values for and B defined above
• Note =could be interpreted as the sensitivity of the
option’s value to changes in the stock price
 The value of is always less than 1. Why?
 Why is the option value less sensitive than the stock
value?
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The Black-Scholes option pricing model

• Black-Scholes Option Pricing Model

 A technique for pricing European-style options when the
stock can be traded continuously
• It can be derived from the Binomial Option Pricing Model by
allowing the length of each period to shrink to zero and letting
the number of periods grow infinitely large
 Key feature: arbitrage
• The inventors (Nobel Prize to Scholes and Merton) realized
that an option is a derivative security and can be
approximated/represented by its underlying securities (i.e.
again via replicating portfolio!)

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The Black-Scholes formula

• Black-Scholes price of a call option on a non-

dividend-paying stock
C  S  N (d1 )  PV (K )  N (d 2 )
 Where S is the current price of the stock, K is
the exercise price, and N(d) is the cumulative
normal distribution
• Cumulative normal distribution
 The probability that an outcome from a standard normal
distribution will be below a certain value

 And, see next slide

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The Black-Scholes formula (cont'd)

ln[S / PV (K )]  T
d1   and d 2  d1   T
 T 2

 Where  is the annual volatility in the underlying

security (‘stock’), and T is the number of years left to
expiration

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Normal Distribution

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The Black-Scholes formula (cont'd)

• Note: only five inputs are needed for the Black-

Scholes formula
 Stock price
 Strike price
 Exercise date
 Risk-free rate
 Volatility of the stock

35
Option prices and the exercise date
 For American options, the longer the time to the exercise
date, the more valuable the option
• An American option with a later exercise date cannot be worth
less than an otherwise identical American option with an earlier
exercise date
• However, an European option with a later exercise date can be
worth less than an otherwise identical European option with an
earlier exercise date. WHY? [Dividends!]
 Unless there are intermediate payments on the underlying
security (‘stock’), early exercise of a call option is not
optimal
• A put option is different (why wait if option is deep in-the-
money, and you can obtain the strike price today? Gain is time
value of money, while deep-in-the-money will unlikely make
regret exercising it)
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 Option prices and volatility
• The value of an option increases with the volatility of the stock
 The option holder is facing the full upside potential and has no downside risk
• Example: consider the following two stocks with the same expected
value tomorrow, but different volatilities

• Stock 1: low volatility: • Stock 2: high volatility:

 Stock price now is 40.
 At t+1 stock price can go up
to 50 or down to 30.
• Consider a call option with
K = 40:
 Payoff if S↑= 50-40=10
 Payoff if S↓=0
 Stock price is now 40
 At t+1 stock price can go up
to 80 or down to 0.
• Consider a call option with
K = 40:
 Payoff if S↑= 80-40=40
 Payoff if S↓=0

Which option do you prefer? Option on Stock 2! 37

 Factors affecting option prices
• Value of a Call option
Increases if:
 Exercise price ↓
 Stock Value ↑
 Volatility of the underlying
stock ↑
 Time to exercise date ↑
(American options)
 Time to exercise date ↑
(European call options on
non-dividend paying stock)
• With dividends you may want
early exercise, favoring American
options
• Value of a Put option
Increases if:
 Exercise price ↑
 Stock Value ↓
 Volatility of the underlying stock ↑
 Time to exercise date ↑ (American
options)
 American put options may
optimally be exercised early!
• Getting exercise price early gives you extra
time value of money. This effect might be
dominant if option is deep in the money (i.e.
low probability that you regret exercising it)
• Note, dividends make early exercise less
valuable!
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What did we learn?
• Thorough understanding of financial options
• Basics of getting to valuation models
• Importance of replicating portfolios and Law of
One Price
• Some very preliminary intuition about real options

Next lecture:
Week 6, Lecture 2: Real Options (Chapter 22)

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APPENDIX

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Risk Neutral probabilities (RNP)
• Alternative to binomial model
• You determine not true probabilities but derive the
probabilities from prices assuming investors to be risk
neutral
• Value of option is expected present value of pay offs
of option with these risk neutral probabilities and at
the risk free rate
• With RNP up 0.65, price of a call in the example
above:
10(0.65)  0(1  0.65)
 6.13
1.06
• See next how to derive RNP
41
Risk-Neutral Probabilities Model

• Use same binomial model

• Assume a world where all market participants are risk

neutral:
 The value of the asset today is the expected value of
the asset tomorrow, discounted at the risk free rate.

• Example Risk neutral probabilities model:

 The stock price today is equal to $50.
 In one period it will either go up by $10 or go down by $10.
 The one-period risk-free rate of interest is 6%.

• What are the (quasi) probabilities of S=60 or S=40 at

period 2 to justify a stock price of $50 today?
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A Risk-Neutral Two-State Model (cont'd)

• If  is the risk neutral probability that the stock

price will increase, then (1 – ) is the risk neutral
probability that it will go down.
 The value of the stock today (S) must equal the
PV(Expected price next period) discounted at rf.
60   40(1   )
50 
1.06

 Solving for  yields  = .65

  is the risk neutral probability.
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A Risk-Neutral Two-State Model (cont’d 2)

• The call option will be worth either $0 or $10 at

expiration. The present value of the expected
payouts, using this risk-neutral probability, is:
10(0.65)  0(1  0.65)
 6.13
1.06

• This is the same value as with the Binomial

Option Pricing Model!
• Binomial Option Pricing model works for any set
of risk preferences : also risk averse investors.
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Implications of the Risk-Neutral World

• In the hypothetical risk-neutral world: investors do

not require compensation for risk.
 In the real world, investors are risk averse and require a
positive risk premium to compensate for risk.

• In other words,  is not the actual probability of

the stock price increasing.
 Rather, it represents how the actual probability would
have to be adjusted to keep the stock price the same in
a risk-neutral world.
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Risk-Neutral Probabilities Model: getting
to a formula
• Consider again the general binomial stock
price tree.

• Compute the risk-neutral probability that makes

the stock’s expected return equal to the risk-free
interest rate:
 Su  (1   )Sd
 1  rf
S
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Risk-Neutral Probabilities Model: Formula

• Solving for the risk-neutral probability  yields:

(1  rf )S  S d
 
Su  S d

• The value of the option can be calculated by computing its

expected payoff using the risk-neutral probabilities, and
discount the expected payoff at the risk-free interest rate.
  Cu  1    Cd
C
1  rf

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