Principles &Pricing Models of

Option
Option Pricing: General Introduction
• Involves reasonably complex mathematics.
• What is a Model?
• Map; Simplifies the world keeping details what we need and excluding the
rest.
• Not a Perfect Representation of the Reality.
What to Look in a Model
• Have we used correct mathematical or statistical methods?
• Do the variables we have chosen on which to base our model make
sense?
• How should we interpret the results?
Choosing tools
• Fundamental understanding of the problem is required.
• Value of option is clearly related to the value of underlying.
• Natural way to price option- To Stimulate the underlying or Look at its
price distribution.
• Monte-Carlo or Tree Based Methods
• Black Scholes Merton Model
Using Suitable Variables
• Garbage in Garbage Out [ Experience is essential]
• Example
• Forecast a number of games a particular Nepal Football team will win next
season which consists of 82 games. What are the relevant variables ?

• Wins= 82X wins%+0XFG%+0XFT%

Binomial Option Pricing Model
• Key Characteristics of BOPM
• It models the life of the option as a number of discrete points in time. For
example an option that expires in one year:
• In a One period model: there are only two points- 0 and 1
• In a Two period model: there are three points- 0, 0.5 and 1
• In a three period model: there are four points-0, 0.33, 0.67 and 1
• In a Four period mode: there are five points- 0, 0.25, 0.5, 0.75 and 1
One Period Binomial Pricing Model
• Assumption Regarding Characteristics of Underlying Assets
• The price of underlying asset today is 𝑃0
• The price of underlying asset will either increase or decrease between today
and expiration date.
• If the underlying asset’s price increases it will increase by a factor U, where U
is a value greater than 1. Hence, it’s value will be 𝑃𝐻 = 𝑃0 × 𝑈
• If the underlying asset’s price decreases it will decrease by a factor D, where D
is a value less than 1. Hence, it’s value will be 𝑃𝐿 = 𝑃0 × 𝐷
• U and D are inverse to each other.
One Period Option Pricing Model
• Example
• Suppose $50 is the price of stock today. What will be the possible uptick price
and Downtick price of the stock if the possible price movement is 10%.
One Period Option Pricing Model
• Consider a Call Option
• Suppose a call option is created on the underlying assets, having strike price E
and expiration date T (or 1 Year).
• When the price of underlying asset increases in one year, the value of option
will be max[𝑃0 × 𝑈 − 𝐸, 0]
• When the price of underlying asset decreases in one year, the value of option
will be max[𝑃0 × 𝐷 − 𝐸, 0]
• Since one period option pricing model only models initiations and expiration,
there is no opportunity for early exercise. Therefore, Option must be
European style.
One Period Option Pricing Model
• Consider you purchase a call option on underlying asset A, which has
current market price $ 50, and Exercise price of the option is $ 49.
Calculate the possible payoffs for option on the expiration if expected
uptick in price of stock is 10%. And draw one period option pricing
model.
Solving for Valuation of Option at Initiation.
• Create a Portfolio Consisting of:
• A portion of underlying position .
• A Short Call.
• Step 1: Structure a portfolio so that it has the same payoff whether
underlying price increases or decreases.
• Step 2: Discount the portfolios pay off to the present using the risk
free rate.
• Step 3: The present value is the option value.
Step 1 Solving for portion of portfolio
• Identify the value of Alpha at which the pay off of portfolio are the
same.
• 𝛼𝑃0 𝑈 − max 𝑃0 𝑈 − 𝐸, 0 = 𝛼𝑃0 𝐷 − max[𝑃0 𝐷 − 𝐸, 0]
max 𝑃0 𝑈−𝐸,0 −max[𝑃0 𝐷−𝐸,0]
•𝛼=
𝑃0 (𝑈−𝐷)
Step 2: Discount the Portfolios Payoff
• PV=(𝛼𝑃0 𝑈 − max 𝑃0 𝑈 − 𝐸, 0 )𝑒 −𝑟𝑇/𝑛
• Where r= continuously compounding risk free rate
• n = number of periods associated with option pricing model. For one
period pricing model it is 1.
Step 3: Solve for the option Value
• The portfolio cost is associated with the cost for acquiring
𝛼 𝑢𝑛𝑖𝑡𝑠 𝑜𝑓 𝑆𝑡𝑜𝑐𝑘 𝑎𝑛𝑑 𝑐𝑎𝑠ℎ 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑓𝑟𝑜𝑚 𝑤𝑟𝑖𝑡𝑖𝑛𝑔 𝑎 𝑠ℎ𝑜𝑟𝑡 𝑐𝑎𝑙𝑙.
• Portfolio Cost=𝛼𝑃0 − 𝑐
• The cost of portfolio should be equal to its present value of payoff.
• We have
𝛼𝑃0 − 𝑐=(𝛼𝑃0 𝑈 − max 𝑃0 𝑈 − 𝐸, 0 )𝑒 −𝑟𝑇/𝑛
C= max 𝑃0 𝑈 − 𝐸, 0 𝑤 + max 𝑃0 𝐷 − 𝐸, 0 (1 − 𝑤) 𝑒 −𝑟𝑇/𝑛
Where,
𝑒 𝑟𝑇/𝑛 −𝐷
W=
𝑈−𝐷
Illustration
• Consider you purchase a call option on underlying asset A, which has
current market price $ 50, and Exercise price of the option is $ 49.
The underlying asset volatility is 9.531% and the maturity of the
option is 1 year. The risk free rate of return is 5%. Calculate the value
of Call Option considering one period binomial option pricing model.

• Consider you purchase a Put option on underlying asset B, which has

current market price $ 50, and Exercise price of the option is $ 50.
The underlying asset volatility is 9.531% and the maturity of the
option is 1 year. The risk free rate of return is 5%. Calculate the value
of Put Option considering one period binomial option pricing model.
Two Periods Binomial Pricing Models
• This Model Allows Three Points in Time:
• Initiation
• Mid-Point
• End-Point or Expiration
• Steps For Determining the Price of European Call Option
• Build the two period binomial tree.
• Identify the potential payoff at expiration.
• Calculate the midpoint node values
• Calculate the Option Value at initiation
Illustration
• Consider a call option with strike price of $ 21 and with 6 months
expiration. The stock price starts at $ 20 and the price may go up or
down by 10% in each of the two time steps during 6months.
Calculate the value of call option, assuming 12% per annum risk free
interest rate.
 Construction of Lattice
24.2

Vc2=$3.2
22

19.8
20
VC2=$0
VC0=$1.2823
18

VC1=$0
16.2

VC2=$0
Illustration
• Consider a European Style Put Option on an underlying asset of $ 25,
and exercise price of $ 26. The maturity period of the option is 1 year,
and the volatility of underlying asset is 10%. The risk free rate is 4%.
Calculate the value of Put Option today using the two period binomial
option pricing model.
 Construction of Lattice
30.25
Vp2=$0

27.5

Vp1=$0.4900 24.75
25
Vp2=$1.25
Vp0=$1.4603
22.5

Vp1=$2.9896
20.25
Vp2=$5.75
Binomial Pricing Model for American Options
• Consider a 2 year American put option with strike price of $ 52 on
stock whose current price is $ 50. There are two time steps of 1 year
and each time step the stock price either moves up or down by 20%.
The risk free interest rate is 5%. Calculate the value of American put
option
 D

72

B C=$0
60
E

48
A
50 C=$4
C
C0=$5.0894
Payoff= $2 40
Thus, C0=$5.0894 F
C=$9.4636
32
Payoff=$12
C=$20
Binomial Pricing Model for American Options
• Consider a 2 year American call option with strike price of $ 52 on
stock whose current price is $ 50. There are two time steps of 1 year
and each time step the stock price either moves up or down by 20%.
The risk free interest rate is 5%. Calculate the value of American put
option
 D

72

B C=$20
60
E

48
A
50 C=$0
C
C0=$7.1416
Payoff= ($2) 40
Thus, C0=$7.1416 F
C=$0
32
Payoff=($12)
C=$0
 Generalization
Given
Stock price(P0)
Uptick factor (U)
Downtick factor(D)
Risk free interest rate (r)
Length of time (∆t rather than T)
𝑒 𝑟∆𝑡 − 𝐷
𝑤=
𝑈−𝐷
• f=𝑒 −2𝑟∆𝑡 [𝑤 2 𝑓𝑢𝑢 + 2𝑤 1 − 𝑤 𝑓𝑢𝑑 + (1 − 𝑤)2 𝑓𝑑𝑑 ]
• Note:- 𝑓𝑢𝑢 , 𝑓𝑢𝑑 and 𝑓𝑑𝑑 are value of option at possible final stock
prices
Generalization
• Consider a 2-year European put with a strike price of $52 on a stock
whose current price is $50. We suppose that there are two time steps
of 1 year, and in each time step the stock price either moves up by
20% or moves down by 20%. We also suppose that the risk-free
interest rate is 5%. Calculate the value of option using generalization
formula.
Black Scholes Merton Pricing Model
• Breakthrough in Pricing European Stock Options.
• Invented by Fisher Black, Myron Scholes and Robert Merton in 1970s.
• Popularly known as Black Scholes Model.
• Gained popularity in pricing and hedging derivative
• Nobel prize in economics was awarded to this model and received by
Myron Scholes and Robert Merton in 1997, two years later of demise
of Fisher Black.
Assumptions of Black Scholes Option Model
• There are no transaction costs, and market allows short selling.
• Trading is continuous.
• The asset is non-dividend paying security.
• The interest rate during the life of the option is known and constant.
• The option can only be exercised on expiry.
Pricing Derivative Instruments Using the Black-
Scholes Model
• Calculate the price of a call option written with strike price $21 and a
maturity of three months written on a non-dividend-paying stock
whose current share price is $25 and whose implied volatility is 23
percent, given a short-term risk-free interest rate of 5 percent.

• Calculate the price of a put option on the same stock, given the same
risk free interest rate and same time to maturity.
Solving for BSOPM
Step 1: Assign Values for Relevant Variables
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑆𝑡𝑜𝑐𝑘 𝑃𝑟𝑖𝑐𝑒 (𝑃0 ) =$25
Exercise Price of Option (E)= $21
Risk free interest rate (r)= 5%
Time to maturity (t)= 3 months = 3/12 = 0.25
Volatility in stock price (𝜎) = 23%
Step 2: Calculation of Call option price using BSOPM
𝑓𝑐 =𝑃0 𝑁 𝑑1 − 𝐸𝑒 −𝑟𝑡 N(𝑑2 )
Where,
𝑁 𝑑1 =Cumulative probability from normal distribution of value obtained for
𝑑1
N(𝑑2 )=Cumulative probability from normal distribution of value obtained for
𝑑2
Solving for BSOPM
Calculation of Value of 𝑁 𝑑1 & N(𝑑2 )
𝑃 𝜎2
ln[ 𝐸0 ]+ 𝑟+ 2 𝑡
• 𝑑1 =
𝜎 𝑡
25 0.232
ln[ ]+ 0.05+ 0.25
21 2
𝑑1 = = 1.682313
0.23 0.25
𝑃 𝜎2
ln[ 0 ]+ 𝑟− 𝑡
𝐸 2
• 𝑑2 = = 𝑑1 -𝜎 𝑡
𝜎 𝑡
𝑑2 =1.682313-0.23 0.25 =1.567313
• Looking at normal probability distribution table the value 1.68 and
1.56 are found approximately 0.9535 and 0.9406
Solving for BSOPM
• Plugging value of 𝑁 𝑑1 & N(𝑑2 ) in equation of option value, we have
𝑓𝑐 =𝑃0 𝑁 𝑑1 − 𝐸𝑒 −𝑟𝑡 N(𝑑2 )
=25𝑁 1.682313 − 21𝑒 −0.05∗0.25 N(1.567313)
=25*0.9535-21*0.98757*0.9406
=23.8375-19.5072= $4.3303
Solving for BSOPM
• Calculation of Put option price using BSOPM

𝑓𝑝 =𝐸𝑒 −𝑟𝑡 N(−𝑑2 )-𝑃0 𝑁 −𝑑1

=21𝑒 −0.05∗0.25 (1-0.9406)-25(1-0.9535)= $0.06943
Alternatively
𝑓𝑝 =𝑓𝑐 − 𝑃0 +𝐸𝑒 −𝑟𝑡
=4.3303-25+21𝑒 −0.05∗0.25 = $0.06943
Solving BSOPM
• Calculate the price of a call option written with strike price $21 and a
maturity of six months written on a non-dividend-paying stock whose
current share price is $25 and whose implied volatility is 23 percent,
given a short-term risk-free interest rate of 5 percent. Compare the
result with the option premium calculate for previous example with 3
months expiration. Draw your conclusion in respect of change in time
to maturity.
Comments on B-S Model
• Major Critics on B-S model’s Assumptions
• Frictionless Market
• Constant Interest Rate
• Volatility of Price
• Limitation to European Exercise
Understanding the Greeks
• Why the Risk management for option is more complex than for
portfolio of other instrument?
• Option contract’s value rely on 5 factors [Asset’s price, Exercise Price,
Expiration, Interest Rate, Expected Dividend]
• Relationship between change in option value and key variables is not linear.
• What are the Greeks?
• Greeks are the derivatives of key variables of options.
• They are denoted by Greek letters.
• Most common Greeks are: Delta, Gamma, Theta, Vega or Kappa, Rho, Lamda
Understanding Risk less Hedge [Delta]
• In Black-Scholes equation, it is represented by the N(d1) term.
• Ratio of change in the price of the option to the change in the price of
the underlying stock.
• The number of underlying stock we should hold for each option
sorted in order to create a riskless portfolio.
• It’s value is positive for a call option whereas negative for put option.
∆𝑓
𝛿=
∆𝑃
• Mathematically, it is expressed as:
𝜕𝑓
𝛿=
𝜕𝑃
Understanding Risk less Hedge [Delta]
• Example:
• Consider a call option with strike price of $ 105 and with 6 months expiration. The
stock price starts at $ 100 and the price may go up or down by 10% in each of the
two time steps during 6months. The risk free interest rate is 12% per annum. You
initially sold 20 call option contracts on ABC stocks at $ 10 each option contract
• Required:-
• How would you create a riskless hedge?
• By writing 20 call option contracts, how many shares of ABC stocks would you go to
sell when they were exercised?
• What would be your profit or loss if stock price moved up to $ 110 during 6 months?
What would it be if price of stock moved down to $ 90?
• Would your riskless hedge ratio remain constant if stock price moved up to $ 110?
How would you maintain your riskless hedge?
• What conclusion will you draw from dynamism of hedge ratio?