Option Valuation

Chapter 21
Intrinsic and Time Value

intrinsic value of in-the-money options = the
payoff that could be obtained from the
immediate exercise of the option

for a call option: stock price – exercise price

for a put option: exercise price – stock price

the intrinsic value for out-the-money or at-the-

money options is equal to 0

time value of an option = difference between
actual call price and intrinsic value

as time approaches expiration date, time value
goes to zero
21-2
Determinants of Option Values

Call Put
Stock price + –
Exercise price – +
Volatility of stock price + +
Time to expiration + +
Interest rate + –
Dividend rate of stock – +

21-3
Binomial Option Pricing

consider a stock that currently sells at S0

the price an either increase by a factor u or fall
by a factor d (probabilities are irrelevant)

consider a call with exercise price X such that
dS0 < X < uS0

hence, the evolution of the price and of the call
option value is
uS0 Cu = (uS0 – X)
S0 C
dS0 Cd = 0

21-4
Binomial Option Pricing (cont.)

now, consider the payoff from writing one call
option and buying H shares of the stock, where
Cu − Cd uS0 − X
H= =
uS0 − dS0 uS 0 − dS0

the value of this investment at expiration is
Up Down
Payoff of stock HuS0 HdS0
Payoff of calls –(uS0 – X) 0
Total payoff HdS0 HdS0

21-5
Binomial Option Pricing (cont.)

hence, we obtained a risk-free investment with
end value HdS0

arbitrage argument: the current value of this
investment should be equal to its present
discounted value using the risk-free rate

H is called the hedge ratio (the ratio of the
range of call option payoffs and the range of
the stock price)

the argument is based on perfect hedging, or
replication (the payoff of the investment
replicates a risk-free bond)
21-6
Binomial Option Pricing – Algorithm
1. given the end of period stock prices, uS0 and
dS0, calculate the payoffs of the call option,
Cu and Cd
2. find the hedge ratio H = (Cu – Cd)/(uS0 – dS0)
3. calculate HdS0, the end-of-year certain value
of the portfolio including H shares of the
stock and one written call
4. find the present value of HdS0, given the
riskfree interest rate r
5. calculate the price of the call using the
arbitrage argument:
HS0 – C = PV(HdS0) 21-7
Binomial Option Pricing – Example

S0 = 100 1. uS0 = 150, dS0 = 75

d = .75 Cu = uS0 – X = 30, Cd = 0

u = 1.5 2. H = (Cu – Cd) / (uS0 – dS0) = 0.4

X = 120 3. HdS0 = 30

r = 5% 4. PV(HdS0) = HdS0 / (1 + r) = 28.57
5. HS0 = 0.4 ⋅ 100 = 40
C = HS0 – PV(HdS0) = 11.43

21-8
Generalized Binomial Option Pricing

the binomial model can be expanded to more
than one period

in this case, we would need to find the
hedging ratio H at every node in the tree

thus, we can construct, at each point in time, a
perfectly hedged portfolio – dynamic hedging

some of the nodes will be shared by different
branches (e.g., the “up and down” scenario
would yield the same price as the “down and
up” scenario)

although numerous and tedious calculations,
can “easily” program into a computer 21-9
Black-Scholes Valuation Model

Assumptions

European call option

underlying asset does not pay dividends until
expiration date

both the (riskfree) interest rate r and the
variance of the return on the stock σ2 are
constant

stock prices are continuous (no sudden jumps)

21-10
Black-Scholes Valuation Model (cont.)

Formula

the current price of the call option is
C0 = S0 N(d1) – X e–rT N(d2)
where:

S0 is the current price of the stock

X is the exercise price

T is the time until maturity of option (in years)

e = 2.71828 is the base of the natural logarithm

N(⋅) is the probability from a standard normal
distribution

ln(S 0 / X ) + (r + σ 2 / 2)T

d1 = and d 2 = d1 − σ T
σ T
21-11
Black-Scholes Formula – Example

S0 = 100

X = 95

r = 10% per year

T = 0.25 years (one quarter)

σ = 0.50 (50% per year)
ln(100 / 95) + (0.10 + 0.52 / 2)0.25

d1 = = 0.43
0.5 0.25

d 2 = 0.43 − 0.5 0.25 = 0.18

N(d1) = N(0.43) = 0.6664, N(d2) = N(0.18) = 0.5714

C0 = 100 ⋅ 0.6664 – 95 ⋅ e–0.10 ⋅ 0.25 ⋅ 0.5714 = $13.70
21-12
Black-Scholes Formula – Put Options

to find the value of a European put option, we
can use the put-call parity theorem:
P0 = C0 – S0 + PV(X)
where the present value of X is calculated in
continuous time:
PV(X) = X e–rT

this yields the formula:
P0 = X e–rT [1 – N(d2)] – S0 [1 – N(d1)]

21-13
Implied Volatility

the Black-Scholes formula is based on four
observed variables (S0, X , T and r) and one
unobserved variable (σ)

we can estimate σ from historical data

alternatively, we can calculate the value of σ
that equates the Black-Scholes value of a call
to the observed value of a call  implied
volatility

investors would buy the call option if they think
the actual standard deviation of the stock is
higher than the implied volatility
21-14
Delta

the delta of an option is the change in the
price of an option due to a $1 increase in the
stock price

it summarizes the exposure to stock price risk

it is the same as the hedge ratio in the
binomial model

for a call option, delta = N(d1) > 0

for a put option, delta = N(d1) – 1 < 0

21-15