Aswath Damodaran 1

SESSION 9: OPTION PRICING

BASICS
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 The ingredients that make an “option”
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¨ An option provides the holder with the right to buy

or sell a specified quantity of an underlying asset at
a fixed price (called a strike price or an exercise
price) at or before the expiration date of the option.
¨ There has to be a clearly defined underlying asset
whose value changes over time in unpredictable
ways.
¨ The payoffs on this asset (real option) have to be
contingent on an specified event occurring within a
finite period.

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 A Call Option
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¨ A call option gives you the right to buy an underlying

asset at a fixed price (called a strike or an exercise
price).
¨ That right may extend over the life of the option
(American option) or may apply only at the end of
the period (European option).

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 Payoff Diagram on a Call
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Net Payoff
on Call

Strike
Price

Price of underlying asset

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 A Put Option
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¨ A put option gives you the right to sell an underlying

asset at a fixed price (called a strike or an exercise
price).
¨ That right may extend over the life of the option
(American option) or may apply only at the end of
the period (European option).

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 Payoff Diagram on Put Option
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Net Payoff
On Put

Strike
Price
Price of underlying asset

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 Determinants of option value
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¨ Variables Relating to Underlying Asset

¤ Value of Underlying Asset; as this value increases, the right to buy at a fixed price
(calls) will become more valuable and the right to sell at a fixed price (puts) will
become less valuable.
¤ Variance in that value; as the variance increases, both calls and puts will become
more valuable because all options have limited downside and depend upon price
volatility for upside.
¤ Expected dividends on the asset, which are likely to reduce the price appreciation
component of the asset, reducing the value of calls and increasing the value of
puts.
¨ Variables Relating to Option
¤ Strike Price of Options; the right to buy (sell) at a fixed price becomes more (less)
valuable at a lower price.
¤ Life of the Option; both calls and puts benefit from a longer life.
¨ Level of Interest Rates; as rates increase, the right to buy (sell) at a fixed
price in the future becomes more (less) valuable.

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 The essence of option pricing models: The
Replicating portfolio & Arbitrage
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¨ Replicating portfolio: Option pricing models are built on

the presumption that you can create a combination of
the underlying assets and a risk free investment (lending
or borrowing) that has exactly the same cash flows as
the option being valued. For this to occur,
¤ The underlying asset is traded - this yield not only observable
prices and volatility as inputs to option pricing models but allows
for the possibility of creating replicating portfolios
¤ An active marketplace exists for the option itself.
¤ You can borrow and lend money at the risk free rate.
¤ Arbitrage: If the replicating portfolio has the same cash
flows as the option, they have to be valued (priced) the
same.

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 Creating a replicating portfolio
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¨ The objective in creating a replicating portfolio is to

use a combination of riskfree borrowing/lending and
the underlying asset to create the same cashflows as
the option being valued.
¤ Call = Borrowing + Buying D of the Underlying Stock
¤ Put = Selling Short D on Underlying Asset + Lending
¤ The number of shares bought or sold is called the option
delta.
¨ The principles of arbitrage then apply, and the value
of the option has to be equal to the value of the
replicating portfolio.
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 The Binomial Option Pricing Model
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Stock
Price Call
100 D - 1.11 B = 60 100 60
Option Details 50 D - 1.11 B = 10
D = 1, B = 36.04
K = $ 40 Call = 1 * 70 - 36.04 = 33.96
t=2
r = 11%

70 D - 1.11 B = 33.96 Call = 33.96

35 D - 1.11 B = 4.99 70
D = 0.8278, B = 21.61
Call = 0.8278 * 50 - 21.61 = 19.42

50
50 10
Call = 19.42

35
Call = 4.99

50 D - 1.11 B = 10
25 D - 1.11 B = 0
D = 0.4, B = 9.01
Call = 0.4 * 35 - 9.01 = 4.99

25 0

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 The Limiting Distributions….
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¨ As the time interval is shortened, the limiting

distribution, as t -> 0, can take one of two forms.
¤ If as t -> 0, price changes become smaller, the limiting
distribution is the normal distribution and the price process is a
continuous one.
¤ If as t->0, price changes remain large, the limiting distribution is
the poisson distribution, i.e., a distribution that allows for price
jumps.
¨ The Black-Scholes model applies when the limiting
distribution is the normal distribution , and explicitly
assumes that the price process is continuous and that
there are no jumps in asset prices.

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 Black and Scholes to the rescue
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¨ The version of the model presented by Black and Scholes

was designed to value European options, which were
dividend-protected.
¨ The value of a call option in the Black-Scholes model can
be written as a function of the following variables:
¤ S = Current value of the underlying asset
¤ K = Strike price of the option
¤ t = Life to expiration of the option
¤ r = Riskless interest rate corresponding to the life of the option
¤ s2 = Variance in the ln(value) of the underlying asset

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 The Black Scholes Model
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Value of call = S N (d1) - K e-rt N(d2)

where ! S# σ2
ln" + (r + )t
K$ 2
d1 =
σ t

d2 = d1 - s √t
¨ The replicating portfolio is embedded in the Black-
Scholes model. To replicate this call, you would need
to
¤ Buy N(d1) shares of stock; N(d1) is called the option delta
¤ Borrow K e-rt N(d2)

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 The Normal Distribution
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d N(d) d N(d) d N(d)

-3.00 0.0013 -1.00 0.1587 1.05 0.8531
-2.95 0.0016 -0.95 0.1711 1.10 0.8643
-2.90 0.0019 -0.90 0.1841 1.15 0.8749
-2.85 0.0022 -0.85 0.1977 1.20 0.8849
-2.80 0.0026 -0.80 0.2119 1.25 0.8944
-2.75 0.0030 -0.75 0.2266 1.30 0.9032
-2.70 0.0035 -0.70 0.2420 1.35 0.9115
-2.65 0.0040 -0.65 0.2578 1.40 0.9192
-2.60 0.0047 -0.60 0.2743 1.45 0.9265
N(d 1) -2.55 0.0054 -0.55 0.2912 1.50 0.9332
-2.50 0.0062 -0.50 0.3085 1.55 0.9394
-2.45 0.0071 -0.45 0.3264 1.60 0.9452
-2.40 0.0082 -0.40 0.3446 1.65 0.9505
-2.35 0.0094 -0.35 0.3632 1.70 0.9554
-2.30 0.0107 -0.30 0.3821 1.75 0.9599
-2.25 0.0122 -0.25 0.4013 1.80 0.9641
-2.20 0.0139 -0.20 0.4207 1.85 0.9678
-2.15 0.0158 -0.15 0.4404 1.90 0.9713
-2.10 0.0179 -0.10 0.4602 1.95 0.9744
-2.05 0.0202 -0.05 0.4801 2.00 0.9772
-2.00 0.0228 0.00 0.5000 2.05 0.9798
-1.95 0.0256 0.05 0.5199 2.10 0.9821
-1.90 0.0287 0.10 0.5398 2.15 0.9842
-1.85 0.0322 0.15 0.5596 2.20 0.9861
-1.80 0.0359 0.20 0.5793 2.25 0.9878
-1.75 0.0401 0.25 0.5987 2.30 0.9893
-1.70 0.0446 0.30 0.6179 2.35 0.9906
-1.65 0.0495 0.35 0.6368 2.40 0.9918
d1 -1.60 0.0548 0.40 0.6554 2.45 0.9929
-1.55 0.0606 0.45 0.6736 2.50 0.9938
-1.50 0.0668 0.50 0.6915 2.55 0.9946
-1.45 0.0735 0.55 0.7088 2.60 0.9953
-1.40 0.0808 0.60 0.7257 2.65 0.9960
-1.35 0.0885 0.65 0.7422 2.70 0.9965
-1.30 0.0968 0.70 0.7580 2.75 0.9970
-1.25 0.1056 0.75 0.7734 2.80 0.9974
-1.20 0.1151 0.80 0.7881 2.85 0.9978
-1.15 0.1251 0.85 0.8023 2.90 0.9981
-1.10 0.1357 0.90 0.8159 2.95 0.9984
-1.05 0.1469 0.95 0.8289 3.00 0.9987
-1.00 0.1587 1.00 0.8413

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 Adjusting for Dividends
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¨ If the dividend yield (y = dividends/ Current value of the

asset) of the underlying asset is expected to remain
unchanged during the life of the option, the Black-Scholes
model can be modified to take dividends into account.
Call value = S e-yt N(d1) - K e-rt N(d2)
where,
! S# σ2
ln" $ + (r - y + )t
K 2
d1 =
σ t

d2 = d1 - s √t
¨ The value of a put can also be derived from put-call parity (an
arbitrage condition):
Put value = K e-rt (1-N(d2)) - S e-yt (1-N(d1))

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 Choice of Option Pricing Models
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¨ Some practitioners who use option pricing models to

value options argue for the binomial model over the
Black-Scholes and justify this choice by noting that
¤ Early exercise is the rule rather than the exception with
real options
¤ Underlying asset values are generally discontinous.

¤ In practice, deriving the end nodes in a binomial tree

is difficult to do. You can use the variance of an asset
to create a synthetic binomial tree but the value that
you then get will be very similar to the Black Scholes
model value.
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