Unit – 6 Option Pricing Model

Binomial Option Pricing Model

A useful and very popular technique for pricing an option involves constructing a
binomial tree. This is a diagram representing different possible paths that might be followed
by the stock price over the life of an option. The underlying assumption is that the stock price
follows a random walk. I n each time step, it has a certain probability of moving up and
moving down by a certain percentage amount. A binomial probability distribution is a
distribution in which there are two outcomes or states. The probability of an up or down
movement is governed by the binomial probability distribution. So this model is called
binomial model. It is also known as two state model. The assumptions of this model are:
a) The market is frictionless
b) Investors are price takers
c) Short selling is allowed with full use of the proceeds
d) Borrowing and lending at the risk free rate is permitted
e) Future stock prices will be two possible values
f) Options are European options.

The One Period Binomial Model

An option has a defined life typically expressed in days. It is assumed that option has
a one unit of time or life. This time period can be as short or as long as necessary. Now we
will assume that the options life is a single time period.
This option will have one of two value at the end of time. We set up a portfolio of the
stock and the option in such a way that there is no uncertainty about the value of the portfolio
at the end of period. So the portfolio has no risk, and the return an portfolio must equal to risk
free rate. There two securities (the stock and the option) and only two possible outcomes, it is
always possible to set up the riskless portfolio. The objective of this model is to derive a
formula for the theoretical fair value of the option. There are two methods:

22
Method – I Probability Distribution Method
Step 1: Create the Binomial Price Tree

Time ‘0’ Time ‘1’

Su =

So =

Sd =

Step 2: Find the Value of Option at Expiration

Cu = Max [Su – E,0]
Cd = Max [Sd – E,0]
Step 3: Find the Probability of Rise and Down
1+ r−d
Probability of rise (P) =
u−d

Probability of down (q) = 1 – P

Where,
S u−S0
u = Up factor = 1+
S0

Sd −S0
d = Down factor = 1−
S0

Step – 4: Find the Theoretical Fair Value of Call Option Today

P × Cu +q × cd
C 0=
1+r
P × Cu +(1−P)× cd
¿
1+ r
Where,
Su = Upper value of stock
Sd = Down value of stock
Cu = Upper value of option

23
 Cd = Down value of option

Another Method: Creation of Riskless Hedge Portfolio

Step 1: Same
Step 2: Same

Step 3: Find out the Hedge Ratio/Option Delta

Hedge ratio is also called option delta. It deals the proportionate relationship between
underlying asset and option write on this stock that established perfectively hedge position
and investor would earn equal to risk free rate. It can be calculated as follows:
Cu−Cd
Hedge ratio = Suppose
Su−S d

15−0 15 3
Hedge ratio = ¿ = Su = 50, Cu = 15, Sd = 30,
50−30 20 4
Cd = 0, E = 35
Decision: This hedge ratio implies that an investor can established perfectively hedge
position by purchase 3 stocks and writes 4 options on this stocks.
Calculation of initial investment ( if step 5 is required)
Purchase 3 stocks @ P0 = xxx
Sell 4 option @ C0 = xxx
Initial investment = xxx

Step 4: Show Combined Value of Hedge Position/Hedge Portfolio

A portfolio being hedged often used in the context of a long stock – short call or long
stock – long put in which hedge ratio is adjusted through time to produce a risk free portfolio.
Calculation of Value of Hedge Position
Ending stock price Value of stock Value of short call Value of portfolio
investment or terminal value

30 30 × 0.75 = 22.50 0×1=0 22.5

50 30 × 0.75 = 37.50 15 × 1 = 15 22.2

Decision: The value of combined hedged position is equal to Rs. 22.5 regardless of whether
stock price go up go down so it is a riskless hedge position or riskless portfolio.

24
Step 5: Value of Call Option Today
The binomial option pricing model is a tool to estimate the fair value of option. this
model assumes that the underlying stock does not pay cash dividend during the expiration of
option.
Initial investment (1+r) = Terminal value

Mispriced Option in One Period Binomial model

A riskless investment (or perfectively hedge portfolio) must earn a return equal to the risk
free rate. Thus, the portfolio’s value one period later should equal to its current value
compounded for one period at the risk free rate. If it does not, the portfolio will be incorrectly
valued (i.e. underpriced or overpriced) and there is arbitrage opportunity exist.
Overpriced
a) Market price > theoretical value = over priced
It call were overpriced, a riskless hedge ratio would generate excess return than risk
free rate. Then
buy stock
Arbitrager strategy, hedge ratio =
sell option
Initial Investment

Buy stock = – xx
Sell option = + xx

Outflow = Xx

Calculation of Terminal value like as above , then

( )
n
Terminal value
Rate of return = −1
Initial investment

Underpriced
b) Market price < theoretical value = under priced
sell stock
Arbitrager strategy, hedge ratio =
buy option

25
Initial Investment for Underpriced Case

Sell stock = + xx
Buy option = - xx

Inflow = xx

Calculation of Terminal value like as above and then

( )
n
Inflow
Rate of return = −1
Terminal value

= ……… %
Put Option Pricing
Probability Distribution Method
Step 1: Find out Two Possible Value of Option at Expiration
Pu = Max[E – Su, o) =
Pd = Max [E – Sd, o] =
Step 2: Find out Theoretical Fair Value of Put Option Today
P × P u+ q × Pd
Po =
1+r
Where,
1+ r−d
Probability (P) =
u−d

q=1–P

Portfolio Hedge Method

Step 1: Find out Two Possible Value of Option
Pu =
Pd =
Step 2: Find out the Hedge Ratio
P u−Pd 2
Hedge ratio (h) = =
S u−Sd 3

26
 This hedge ratio implies that the investors who want to make risk free portfolio should
purchase 2 stocks and purchase 3 puts option.

Calculation of initial investment ( if step 5 is required )

Purchase 2 stocks @ So = xxx
Purchase 3 put @ Po = xxx
Initial investment = xxx
Step 3: Calculation of Terminal Value of Portfolio
Stock price at Value of stock Value of long put Terminal value
expiration investment
A B C D=B+C

Step 4: Calculation of Value of Put Option Today

Initial investment (1+r) = terminal value

In case of put overprived and underpriced

i) Market price of put > theoretical value = overpriced = sell it

sell stock
Hedge ratio =
sell option

ii) Market price of put < theoretical value = buy it

buy stock
Hedge ratio =
buy option

Two Period Binomial Option Pricing Model

In the single period model, the stock price goes either up or down. Thus there are only
two possible future stock prices. To increase the degree of realism, we will now add another

27
period. This will increase number of possible outcomes at expiration. Thus, our model has
three time points today or time 0, time 1, time 2..

The path of the stock price and the corresponding call prices are explained as follows:

Su2=

Su=

S0 Sd=
=

Sd=

Sd2=

Cu2
=
Cu
=

C0= CUd
=

Cd
=
Cd2
=

Step 1: Find out the Stock Price at Expiration

Su2 =
Sud =
Sd2 =
Step 2: Find out the Possible Option Value at the End of Second Period

28
 Cu2 = Max (Su2 – E, 0) =
Cud = Max (Sud – E, 0) =
Cd2 = Max (Sd2 – E, 0) =
Step 3: Find put the Possible Option Value at the End of First Period
2
P × Cu +(1−P)×C u
Cu =
1+r
2
P × Cud +(1−P)× C d
Cd =
1+r
( 1+ r )−d
Where, P =
u−d

Step 4: Find Out the Option Value at Time ‘0’

P × Cu +(1−P)× Cd
C=
1+r
Or,
2 2 2 2
P C u + 2 P ( 1− p ) C ud+(1−P) Cd
C= 2
(1+r )

Hedge Portfolio
Here, we have not actually denied the formula by constructing a hedge portfolio. This
is possible only in case of single period but not in two period model. The hedge ratio is
constructed at their point initially and at the end of the first period; the stock price is either S u
or Sd.
Cu−Cd
Initial hedge ratio (h) =
Su−S d

Construct Portfolio and Find Value or Beg of Second Period

End of period Value of stock Value of short Combined value

stock price investment call of portfolio

Rate of return on portfolio = ( Initial investment )

Terminal value
−1

= …….. %

At the end of first period

29
Where Stock Price is Su
2
Cu −C ud
Hedge ratio = 2
Su −S ud

Construct Portfolio and Find Value

When Stock Price is Sd
2
Cud −Cd
Hedge ratio (h) = 2
Sud −S d

Construct a Hedge Portfolio

A Mispriced Call in the Two Period Model
If the call is mispriced at time zero, the law of one price is violated and an arbitrage
opportunity exists.
If call is underpriced

 Purchase call

 Sell shares

If call is overpriced

 Sell call

 Purchase shares

Two Period Binomial Model in Case of Put Options

Step 1: Find out the Stock Price

Su2=

Su=

S0 Sd=
=

Sd=

Sd2=

30
Step 2: Find Possible Put Option Value, at the end of Second Period
Pu2 = Max (E – Su2, 0)
Pud = Max (E – Sud, 0)
Pd2 = Max (E – Sd2, 0)

Step 3: Find possible Put Option Value at the end of First Period
2
P × P u +(1−P) × Pud
Pu =
1+r
2
P × P ud +(1−P) × Pd
Cd =
1+ r
( 1+ r )−d
Where, P =
u−d

Step 4: Find out the Option Value at Time ‘0’

P × P u+(1−P)× Pd
P=
1+ r
American Options in Binomial Model
An American option can be exercised at any time during its life. So at the end of first
period, the call is in the money then compare with intrinsic value call.
If intrinsic value is greater than calculated value (at the end of first period value) then
exercise it and replace the calculated value with intrinsic value for next step.
If intrinsic value is lower than calculated value then invester do not chose to exercise
it and it does not have any effect.
Dividends in Binomial Model
Binomial option pricing model can also be used to value options when underlying
stock pays dividends. In that condition, we use ex-dividend price in binomial formula.
Ex-dividend stock price (S0*) = S0 – D

The Block-Scholes-Metron: Option Pricing Models

Origin or the BSM Formula

31
 In the late 1960s. Fisher Black finished his doctorate in mathematics at Harvard and
he went to work as a management consulting firm in Boston. Black met a young MIT finance
professor named Myron Scholes, and the two began an interchange of ideas on how financial
markets worked.
Black and Scholes then began studying options, which at that time were traded only
on the OTC market. Black and Scholes took two approaches to finding the price. One
approach is capital asset pricing theory and another approach is stochastic model. They
obtained an equation using the first approach but the second approach is left. Black and
Scholes obtained the correct formula, using the first method but their finding were rejected by
two academic journals.
At the same time, another young financial economist at mit, Rebort Metron was also
working n option pricing, Metron discovered many of the arbitrage rules. In addition, Metron
more or less simultaneously derived the formula. After that both papers Black-Scholes and
Metron’s paper were published on the Bell Journals of Economics and Management Science.
Metron, however did not initially receive as much as credit as Black and Scholes, whose
Names become permanently associated with the model. The model has been one of the most
significant developments in the history of the pricing of financial instruments.
Assumptions of BSM
1. Only European options are considered i.e. exercised only at expiration.
2. There are not transaction cost and not taxes.
3. All securities are perfectively divisible (options & stocks)
4. The short term, risk free interest rate is known and is constant during the life of the
option.
5. The stocks pay no dividend.
6. No imperfections exist in writing an option or selling a stock short.
7. The variance of the return is constant over the life of the option construct and is
known to market participants.
8. Stock prices behave in a manner constant with a random walk in continuous time.
9. The probability distribution of stock returns over an instant of time is normal.
Black Scholes Option Pricing Model
The Black Scholes option pricing model based on the creation of a perfectively
hedged position so that the return will be equal to the risk free rate. The value of call option
according BSM is determined as follows:
C0 = S0 N(d1) – E e- rt N (d2)
Where,
C0 = Value of call option today

32
 S0 = Current stock price
E = Exercise price
N(d1) = Appropriate hedge ratio
e = Base of natural logarithm (2718282) (Shirt /n)
r = Risk free rate of return
t = Time to expiration
Calculation of N(d1)

Step 1: d1 =
¿n ( SE )+[r+ 0.5 σ ]×t
2

σ √t
Suppose: N(d1) = 0.38 implies that 0.38 unit of underlying assets should be purchased for
each unit of call sell.
Step 2: Referring Normal Probability Distribution Table, the value of d 1 lies between …….
and ……. and their corresponding tail value is
d1
Ld1 = Tail Value
Td1 =
Hd1 =
Where,
Td1 = True d1/Calculated d1
Ld1 = Lower d1
Hd1 = Higher d1
Step 3: By Interpolation Method
Td 1−Ld1
Tail value = TV Ld − ¿
1
Hd1− Ld1
N(d1) = Tail value (if – ve d1)
N (d1) = 1 – tail value (if + ve d1)
Calculation of N (d2)

Step 1: d2 = d1 - σ √ t
Step 2: Same
Step 3: Same
Where

33
 σ = Standard deviation or volatility of stock
σ2 = Variance of return on stock
ln = Natural logarithm
Note: Since d1 and d2 are negative value then do not subtract them from one but values are
positive then subtract from one to obtain value of N (d1) or N (d2).

Adjustment of Dividend
The BSM option pricing model assumes that the stock do not pay dividends during
the expiration of the option. But it does not always happen. If the company pays dividend it
should be adjusted in the current stock price. The adjustment takes place in following ways.
1) Known Discrete Dividends: The dividend is assumed to be known with certainty or paid
in fixed amount then the adjustment is to subtract the pv of dividend from stock price ad
use the adjusted stock price in formula.
New stock price after cash dividend (S*0) = S0 – D × e-rt
2) Known Continuous Dividend Yield: The dividend on the stock is to assume the
dividend is paid continuously at a known yield. This method assumes that dividend is
paid at a fixed rate continuously.
New stock price after dividend yield (S*0) = S0 × e-dt
Where d = Dividend Yield

Valuation of Put Option

The BSM option pricing model can be used to value put options based as the
principles of put call parity.
p = C + E e-r×t – S0
P0 = C + PV (E) – S0
Where
P = Value of put option
C = Value of call option
Calculation
Variables in the BSM Model
i) The Stock Price (S0): The higher stock price should lead to a higher call price and
lower the put option price.

34
ii) The Exercise Price (E) : A higher exercise price should lead to a lower call option
price but higher strike price increases the put option value.
iii) Time to Expiration (t): Other thing being equal, options with longer lives have
higher values for both of call and put option.
iv) The Volatility or Standard Deviation (σ): The higher volatility in stock price leads
higher value of both call and put options.
v) The Risk Free Rate (r): A higher risk free rate should lead to a higher value of call
option. but a higher risk free rate should lead to a lower value of put options.
vi) Cash Dividend (D): Other things being equal, the higher the dividend lower the value
of call and higher the value of put option.

35