OPTIONS AND THEIR

VALUATION
 OUTLINE

• Terminology

• Option Payoffs

• Factors Determining Option Values

• Black-Scholes Model

• Binomial Model

• Put Call Parity Theorem

 TERMINOLOGY
• CALL AND PUT OPTIONS
• OPTION HOLDER AND OPTIONS WRITER
• EXERCISE PRICE OR STRIKING PRICE
• EXPIRATION DATE OR MATURITY DATE
• EUROPEAN OPTION AND AMERICAN OPTION
• EXCHANGE-TRADED OPTIONS AND OTC OPTIONS
• AT THE MONEY, IN THE MONEY, AND OUT OF THE
MONEY OPTIONS
• INTRINSIC VALUE OF AN OPTION
• TIME VALUE OF AN OPTION
 OPTION PAYOFFS
PAYOFF OF A CALL OPTION

PAYOFF OF A
CALL OPTION

E (EXERCISE PRICE) STOCK PRICE

PAY OFF OF A PUT OPTION

PAYOFF OF A
PUT OPTION

E (EXERCISE PRICE) STOCK PRICE

PAYOFFS TO THE SELLER OF OPTIONS
PAYOFF

E
STOCK PRICE

(a) SELL A CALL

PAYOFF

E
STOCK PRICE

(b) SELL A PUT

 OPTIONS
BUYER/HOLDER SELLER/WRITER

RIGHTS/ BUYERS HAVE RIGHTS- SELLERS HAVE ONLY

OBLIGATIONS NO OBLIGATIONS OBLIGATIONS-NO RIGHTS
CALL RIGHT TO BUY/TO GO OBLIGATION TO SELL/GO
LONG SHORT ON EXERCISE
PUT RIGHT TO SELL/ TO OBLIGATION TO BUY/GO
GO SHORT LONG ON EXERCISE
PREMIUM PAID RECEIVED
EXERCISE BUYER’S DECISION SELLER CANNOT
INFLUENCE
MAX. LOSS COST OF PREMUIM UNLIMITED LOSSES
POSSIBLE
MAX. GAIN UNLIMITED PROFITS PRICE OF PREMIUM
POSSIBLE
CLOSING • EXERCISE • ASSIGNMENT ON OPTION
POSITION OF • OFFSET BY SELLING • OFFSET BY BUYING BACK
EXCHANGE OPTION IN MARKET OPTION IN MARKET
TRADED • LET OPTION MARKET • OPTION EXPIRES AND
KEEP
 FACTORS DETERMINING
THE OPTION VALUE

• EXERCISE PRICE

• EXPIRATION DATE

• STOCK PRICE

• STOCK PRICE VARIABILITY

• INTEREST RATE
C0 = f [S0 , E, 2, t , rf ]
 BLACK - SCHOLES MODEL

C0 = S0 N (d1) - E e -r t N (d2)

N (d) = VALUE OF THE CUMULATIVE

NORMAL DENSITY FUNCTION
S0 1
ln E + r + 2 2 t
d1 =
t
d2 = d1 -   t
r = CONTINUOUSLY COMPOUNDED RISK - FREE
ANNUAL INTEREST RATE
 = STANDARD DEVIATION OF THE CONTINUOUSLY
COMPOUNDED ANNUAL RATE OF RETURN ON
 BLACK - SCHOLES MODEL
ILLUSTRATION
S0 = RS.60 E = RS.56  = 0.30
t = 0.5 r = 0.14
STEP 1 : CALCULATE d1 AND d2
S0 2
ln E + r + 2 t
d1 =
t
.068 993 + 0.0925
= = 0.7614
0.2121
d2 = d 1 -   t
= 0.7614 - 0.2121 = 0.5493
STEP 2 : N (d1) = N (0.7614) = 0.7768
N (d2) = N (0.5493) = 0.7086
STEP 3 :
E e -r t = 56 e - ( 0. 14 x 0.5 )
= RS. 52.21

STEP 4 : C0 = RS. 60 x 0.7768 - RS. 52.21 x 0.7086

= 46.61 - 37.00 = 9.61
 ASSUMPTIONS

• THE CALL OPTION IS THE EUROPEAN OPTION

• THE STOCK PRICE IS CONTINUOUS AND IS
DISTRIBUTED LOGNORMALLY
• THERE ARE NO TRANSACTION COSTS AND
TAXES
• THERE ARE NO RESTRICTIONS ON OR
PENALTIES FOR SHORT SELLING
• THE STOCK PAYS NO DIVIDEND
• THE RISK-FREE INTEREST RATE IS KNOWN AND

CONSTANT
 Boundaries within which the value of an
option falls

The minimum value at which a call option sells

before the expiration date is Max(0,So – E)

It means that Co, the value of a call option, can

never fall below zero( this happens when So < E)
 Boundaries within which the value of an
option falls
Co, the value of a call option, can never fall
below So – E ( this happens when So > E)
Eg : So = Rs.250, E = 150, Co = 75

Profit = 250 – (75 + 150) = Rs.25(Arbitrage profits)

Such an arbitrage profit can’t occur in a well

functioning financial market.

Hence in such a market, Co can’t sell for less than

Boundaries within which the value of an
option falls
What is the upper limit for the option price?

A call option entitles the holder to buy the

underlying stock at a certain exercise price.
Hence option’s value can’t be greater than
that of the underlying stock.
If it were so, the investor would be better off
by buying the stock directly.
 OPTION VALUE : BOUNDS

UPPER AND LOWER BOUNDS

FOR THE VALUE OF CALL OPTION
Max(So – E, 0) < Co < So

VALUE OF UPPER LOWER

CALL OPTION BOUND (S0) BOUND ( S0 – E)

STOCK PRICE
0 E
Theoretical value of a European Put Option

 Po = Ee-rt N(-d2) – SoN(-d1)

 Option Trading Strategies

 Long Calls: Hedging against price increase

 An investor short sold the shares of ABC
Ltd at Rs.327/- each and bought call
options on ABC Ltd at a strike price of
Rs.330/- per share at a premium of Rs.12
per option.
 Calculate his profit/loss position if maturity
price is a) Rs.300 b) Rs.350 c) Rs.320
 Option Trading Strategies

 Long Put : Hedging against price decline

 An investor holds a long position in the
shares of XYZ Ltd at Rs.396.20/- each and
bought put options on XYZ Ltd at a strike
price of Rs.380/- per share at a premium of
Rs.4.10 per option.
 Calculate his profit/loss position if maturity
price is a) Rs.450 b) Rs.330 c) Rs.400
 Option Trading Strategies
Straddle :Combining Call & Put at same exer.price
A straddle is a combined position created by the
simultaneous purchase ( or sale ) of a call and put
option with the same expiration date and the same
exercise price.

This strategy is used to take advantage of rising

prices and at the same time avoid the risk if price
falls.
 Option Trading Strategies
Straddle :Combining Call & Put at same exer.price
An investor simultaneously buys a call and put
option on ABC Ltd with the same expiration
date and a strike price of Rs.240. He pays
Rs.10 for the call and Rs.7 for the put.

Calculate profit or loss, if spot price is

a) Rs.223 b)257 c) 280 d) 200
 Option Trading Strategies

Strangle: Combining call and put at different exercise

prices
A strangle is a portfolio of a put and call option with the
same expiration date but with different exercise prices.

The investor will buy a call with an exercise price higher

than underlying share’s current price and a put with an
exercise price lower than underlying share’s current price

The effect of this strategy is similar to the effect of a

straddle except that the pay off range will be larger.