Option Valuations

Introduction
An option gives its owner the right to buy or sell an underlying asset on or before a given date at a fixed price. An option is a special contract under which the option owner enjoys the right to buy or sell something without the obligation to do so. There can be as many different option contracts as the number of items to buy or sell. Stock options, commodity options, foreign exchange options and interest rate options are traded on and off organized exchanges across the globe. Option belongs to a broader class of assets called contingent claims. A contingent claim is an asset whose payoff in future depends (or is contingent upon) on the outcome of some uncertain event.
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How Options Work - Terminologies

The option to buy is a call option (or just call) and the option to sell is a put option (or just put) The option holder is the buyer of the option and the option writer is the seller of the option. The fixed price at which the option holder can buy and/or sell the underlying asset is called the exercise price or striking price. The date when the option expires or matures is referred to as the expiration date or maturity date. After the expiration date, option is worthless. The act of buying or selling the underlying asset as per the option contract is called exercising the option. A European option can be exercised only on expiration date whereas an American option can be exercised on or before the expiration date. Options traded on an exchange are called exchange-traded options and options not traded on an exchange is called over-the-counter options. (OTC Options)
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How options work

Options are said to be at the money (ATM) or in the money (ITM) or out of the money (OTM) as shown below:
Call option ATM ITM OTM Exercise Price = Market Price Exercise Price < Market Price Exercise Price > Market Price
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Put option Exercise Price = Market Price Exercise Price > Market Price Exercise Price < Market Price
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Contd
Exchange-traded options are standardized in terms of quantity, trading cycle, expiration date, strike prices, type of option and mode of settlement. The value of an option, if it were to expire immediately, is called its intrinsic value. The excess of the market price of any option over its intrinsic value is called time value of option.
Suppose the market price of a share is Rs 260, the exercise price of a call option on the share is Rs 250, and market price of the call option is Rs 15. In this case, the intrinsic value of the option is (Rs 260-Rs 250) = Rs 10 And the Time value of option is (Rs 15-Rs 10) = Rs 5
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Options and their Payoffs just before Expiration

Payoff of a Call option buyer:
The payoff of the call option (C) just before expiration depends on the relationship between the stock price (S1 ) and the exercise price (E). Formally C = S1 - E, ..if S1 > E C = 0, .if S1 E

i.e. C = Max (S1 - E, 0) When S1 E, the call is said to be Out of Money and is worthless When S1 > E, the call is said to be In The Money and its value is S1 - E
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ContdPayoff of a call option buyer

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Payoff of a Put Option Buyer

The payoff of the put option (P) just before expiration depends on the relationship between the stock price (S1 ) and the exercise price (E). Formally
P = E S1 , P = 0, ..if S1 < E .if S1 E

i.e. P = Max (E S1, 0) When S1 E, the call is said to be Out of Money and is worthless When S1 < E, the call is said to be In The Money and its value is E - S1
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Contd..Payoff of Put option buyer

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Sellers Payoff in Call Option

A writer of a call option collects the option premium from the buyer(holder) of the option. In return, he is obliged to deliver the shares, should be option buyer exercise the option. If S1 E, on the expiration date, the option holder will not exercise the option, and option writer s liability is nil. If S1 > E, the option holder will exercise the option. Hence the option writer looses S1 - E
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Contd..Sellers payoff in Call Option

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Sellers Payoff in Put Option

In this case also, the seller charges option premium from the buyer. If S1 E, the holder of the put option will no exercise the option. Hence, the option writer s liability is nil. If S1 < E, the holder of the put option will exercise the option. Hence the option writer looses E S1
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ContdSellers Payoff in Put Option

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Payoffs of buyer, when premium p is included

Payoff of call option buyer:
C = S1 - (E + p), C = - p, ..if S1 > E + p .if S1 E + p

i.e. C = Max [S1 - (E + p), 0] Payoff of a put option buyer: P = E (S1 + p), ..if S1 < E - p P = -p, ..if S1 E - p i.e. P = Max [E (S1 + p), 0]
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Boundaries of Option Values

The minimum value at which a call option sells before expiration, say at tme zero, is Max (S0 - E, 0). This means that C0 , the value of call option, can never fall below zero (this happens when S0 < E ) Also, the value of a call option cannot fall below (S0 - E) (This happens when S0 > E) Example:
Consider a call with E = 150, S0 = 250 and C0 = 75. In this case, it pays an investor to buy the call option for 75, exercise it for 150, and finally sell the stock for 250. By doing so, he earns a profit of: (S0 - [C0 + E]) = 250 (75+150) = 25 This profit, reflecting arbitrage profits, comes without incurring any risk or cost. Such a profit cannot occur in a well functioning financial market. Hence, in such a market C0 cannot sell for less than (S0 E)

This is the lower limit for option price.

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ContdBoundaries of Option Values

What is the upper limit of option price ? A call option entitles the holder to buy the underlying stock on payment of a certain exercise price. Hence, its value cannot be greater than that of the underlying stock. If it were so, the investor would be better off by buying the stock directly.
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ContdBoundaries of Option Values

The price of call option must fall in the region : Max (S0 - E, 0) e C0 e S0
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Factors Determining Call Option Values

1. Exercise Price 2. Expiration Date 3. Stock Price 4. Stock Price Variability 5. Interest Rate
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1. Exercise Price
Higher the E, lower the value of the call option Value of call option can never be negative, regardless of how high the E is set. It has a positive value if there is some possibility that stock price will be higher than the exercise price before the expiration date.
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2. Expiration Date
Longer the time to expiration date, the more valuable the call option. The two year call obviously is more valuable than the one year call because it gives its holder one more year within which it can be exercised.
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3. Stock Price

Value of call option increases with the stock price.

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4. Variability of the Stock Price

A call option has value when there is a possibility that the stock price exceeds price before the expiration date. Higher the variability of stock price, the greater the likelihood that the stock price will exceed the exercise price and higher will be the probability that the value of call option will rise.
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4. contd

Call option on high variance stock A is more valuable than on stock B. This is so because the holder of a call option gains when the stock price exceeds the exercise price and does not loose when the stock price is less than the exercise price.
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5. Interest Rate
When you buy a call option, you do not pay the exercise price until you decide to exercise the call option. Put differently, the payment, if any, is made in future. The higher the interest rate, the greater the benefit will be from the delayed payment and vice versa. So the value of call option is positively related to interest rate.
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Functional Relationship

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Binomial Model of Option Valuation (2-stage)

DCF Technique cannot be used in option valuation:
Because it is difficult to estimate the expected cash flows It is impossible to determine the opportunity cost of capital (discount rate)
Because risk of an option is virtually indeterminate as it changes everytime the stock price varies

Fisher Blacm and Myron Scholes publised their model in 1973 The basic idea underlying their model is to set up a portfolio which imitates the call option in its payoff. The cost of such a portfolio, which is readily observed, must represent the value of the call option.
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Contd..
Assumptions:
The stock, currently selling for S, can take two possible values next year, uS or dS (uS>dS), where,
u = percentage factor of increase in price of stock d = percentage factor of decrease in price of stock

An amount of B can be borrowed or lent at a rate of r, the risk-free rate. The interest factor (1+r) may be represented as R The value of R is greater than d but smaller than u (d< R < u) The excercise price is E
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Contd
The value of call option, just before expiration, if the stock price goes up to uS, is Cu = Max (uS E, 0) The value of call option, just before expiration, if the stock price goes down to dS is Cd = Max (dS E, 0) Set up a portfolio consisting of sharesof stock and B rupees of borrowing. Such that, the payoff of the portfolio is identical to that of a call option at time 1
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Contd
If Stock price rises: uS RB = Cu If Stock price falls: dS RB = Cd Solving these two equations, we get

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Contd
Since the portfolio (consisting of shares and B debt) has the same payoff as that of a call option, the value of the call option is C= S B

This is called Option Equivalent Method of finding out the value of Call option.
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Illustration
Consider the following data for Pioneer s Stock:

Given above data, we can get the values of

and B

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Contd
Thus the portfolio consists of 0.6 of a share plus a borrowing of 98.18 (entailing payment of 98.18 x 1.10 = 108 after one year). The identity of the payoffs of the portfolio and call option are shown below:

The value of call option is:

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Risk Neutral Valuation

Assumption: Investors are risk-netural (indifferent to risk) Method:
Calculate the expected future value of the option Convert it into its present value by using risk-free rate.

Expected return on Pioneer s Stock = 10% Since Pioneer s stock can either rise by 40% to Rs 280 or fall by 10% to Rs 180, we can calculate the probability of a price rise in the hypothetical risk neutral world. Expected Return = [Prise x 0.40] + [ (1- Prise ) x -0.10] = 10% Risk netural probabilty of rise = 0.40
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Contd
We know that if the stock price rises, the call option has a value of Rs 60 and if the stock price falls the call option has a value 0. Hence, if investors are risk-neutral, the call option has an expected future value of: [Prise x Rs 60] + [ (1- Prise ) x Rs 0] = [0.40 x Rs 60] + [ 0.60 x Rs 0] = Rs 24 The current value of the call option is the present value of expected future value:

Not surprisingly, this is exactly the answer we got by using option equivalent method. S.B.Khatri - kcm

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Contd
Thus, we have two ways of calculating the value of the option in the binomial world.
Option Equivalent Method:
Find a portfolio of shares and loan that imitates the option in its payoff. Since the two alternatives have identical payoffs in the future, they must command the same price today.

Risk Neutral Method:

Assume that investors are risk-neutral, so that the expected return on the stock is the same as the interest rate. Calculate the expected future value of the option and discount it at the risk-free interest rate.
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Application - Example
A stock is currently selling for Rs 60. The call option on the stock exercisable a year from now at an exercise price of Rs 55 is currently selling for Rs 15. The risk-free interest rate is 12%. The stock price can either rise or fall after a rise. It can fall by 30%. By what percent it can rise ?

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Solution
According to the binomial model

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Contd
In the problem the following are given: S = Rs 60, E = Rs 55, C = Rs 15, R = 1.12, d =0.7 Cd = Max (0.7x60 55, 0) = 0 Since, C = Rs 15, (uS-E) has to be positive

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Contd

Multiplying both sides by (u-0.7), we get

Solving this for u, we get u =1.35 So the stock can rise by 35%
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Example 2
ABC Company s share price is now Rs. 60. One year from now; it will be either Rs 75 with probability 0.70 or Rs 50 with probability 0.30. A one year European call option on the stock with exercise price of Rs. 65 exists. The risk free rate is 5%. i) Compute hedge ratio and the value of your hedged position under each possible outcome? ii) Compute the value of the call option at present
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Solution
Given:
S = Rs 60 u = Rs 75/60 = 1.25 d = Rs 50/60 = 0.83 Prise = 0.70, Pfall = 0.30 E = Rs 65 r = 0.05, R = 1.05

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Contd
Compute hedge ratio and the value of your hedged position under each possible outcome?

Cu = Max (1.25x60 65, 0) = 10 Cd = Max (0.83x60 65,0) = 0

10  0 - d (! ! ! 0.40 (u - d) 60(1.25  0.83) d u - u d 0.83 v 10  1.25 v 0 B! ! ! 18.82 (u  d ) R (1.25  0.83) v 1.05
u

Hence the hedge ratio is 0.40. The equivalent portfolio would consist 0.40 number of shares and borrowing Rs 18.82.
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Contd
Value of Hedged Position Portfolio When u occurs (when price rises) When d occurs (when price falls) 0.4 x 1.25 x 60 18.82 x 1.05 = 10.24 0.4 x 0.83 x 60 18.82 x 1.05 = 0.16 Call Option Cu = 10 Cd = 0

ii) Compute the value of the call option at present Value of Call option at present is:

C ! (S  B ! 0.4 v 60 - 18.82 ! 5.18

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Exercise 3
Alpha company s equity is currently selling for Rs 100 per share. In a year from now, it can rise to Rs 150 or fall to Rs 90. The interest rate is 15%. What is the value of a call option on Alpha Company s equity as per the Binomial model if the exercise price is Rs 100?

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Solution

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Exercise 4
Beta Company s equity is currently selling for Rs 60. In a year from now, it can rise or fall. On the downside, it may fall to Rs 45. The call option on Beta s equity has a value of Rs 5. If the interest rate is 16%, to what level would Beta s equity rise on the upside assuming that the exercise price is Rs 60 ?

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Solution

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Black and Scholes Model

Two state binomial model was based on the assumption that there was two possible values for the stock price at the end of one year. If the price of the stock changes continuously, the task of forming equivalent portfolio with be daunting one. Black and Scholes model calculates the value of such portfolio.
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Contd

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Assumptions
The call option is European Option The stock price is continuous and distributed log-normally 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.
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Application - Example
Price of stock now = Rs 60 Exercise price = Rs 56 Standard deviation of continuously compounded annual returns = 0.3 Years to maturity = 0.5 Interest rate per annum = 0.14

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Step 1 Calculate d1 and d2

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Step 2 Find N(d1 ) and N(d2 )

They represent the probabilities that a random variable that has a standardized normal distribution will assume values less than d1 and d2. The simples way to find N(d1 ) and N(d2 ) is to use the Excel function NORMDIST.
N(d1 ) = N (0.7614) = 0.7768 N(d2 ) = N (0.5493) = 0.7086
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Step 3 Estimate the PV of E

Step 4 Plug the numbers in model to find C0

C0 = Rs 60 x 0.7768 Rs 52.21 x 0.7086 = Rs 9.61

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Replicating Portfolio

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Investment Strategies involving Options

Option Strategies

Spread
A spread investment strategy involves taking a position in two or more options of the same type, which can be either two or more calls or two or more puts.

Bull Spreads
A spread, which is designed to earn profits for the investor in case of a price rise, is known as bull spread. A bull spread using call options can be created by buying a call option with a lower strike price and selling a call option with a higher strike price. However, it is important to note that both options must have the same expiration date.
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Example
An investor buys one June call option on a share of Philips at a premium of Rs 58 per share and a strike price of Rs.270 (E1). He also sells one June call option on a share of Philips at a premium of Rs. 8 and a strike price of Rs. 350 (E2). The payoff table shows the fluctuations in net profit with the change in spot prices.
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S 240 260 270 280 300 320 340 350 360

E1 270 270 270 270 270 270 270 270 270

E2 350 350 350 350 350 350 350 350 350

p 50 50 50 50 50 50 50 50 50

Payoff 0 0 0 10 30 50 70 80 80

Net Profit -50 -50 -50 -40 -20 0 20 30 30

Payoff is (E2 E1) when S u E2 Payoff is (S E1) when E1 < S < E2 Payoff is 0 when S e E1

Net Profit = Payoff - p

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A bull-spread strategy limits both the investor's upside potential as well as the downward risk. It is a conservative strategy adopted by investors who eel that the market is more likely to rise than all, but wish to limit their downside risk. A bull spread can also be created using put options where a put is bought at a lower strike price and sold at a higher strike price. In this case, the upside potential is limited to the amount o net option premium while the downside risk is limited to the di erence between the strike price and the net option premium.
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Bear Spread
A spread designed in such a way so as to yield pro it even i the price alls is known as the bear spread. A bear spread using call options can be created by buying a call option with a higher strike price and selling a call option with a lower strike price. Both options have the same expiration date. A bear spread created by using calls involves an initial cash in low since the value o the option sold is always greater than the value o the option bought, since the call price i.e. premium always decreases as exercise/strike price increases.
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Example
An investor buys one October call option on a share of ABB at a premium of Rs. 12 per share. The strike price is Rs.350 (E2). He also sells an October call option on a share of ABB at a premium of Rs. 71 and a strike price of Rs. 270 (E1). The payoff table shows the fluctuations of net profit with a change in the spot price.
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S 240 260 270 280 300 320 340 350 360

E1 270 270 270 270 270 270 270 270 270

E2 350 350 350 350 350 350 350 350 350

p 59 59 59 59 59 59 59 59 59

Payoff Net Profit 0 0 0 -10 -30 -50 -70 -80 -80 59 59 59 49 29 9 -11 -21 -21

Payoff is -(E2 E1) when S u E2 Payoff is -(S E1) when E1 < S < E2, Payoff is (0) when S e E1 Net Profit = p + Payoff because p is cash inflow
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Similar to the bull spread, a bear spread strategy limits both the upside potential as well as the downward risk. Investors adopt this strategy when they eel that the market will not rise and they want to limit their downside risk. A bear spread can also be created using put options by buying a put with a higher strike price and selling a put with a lower strike price, but using puts will involve an initial investment. In this case, the upside potential is limited to the di erence between the strike prices and the net option premium while the downside risk is limited to the amount o net option premium.
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Butterfly Spread
A butter ly spread is an option strategy involving our options o the same type, having the same expiration date but three di erent exercise prices. A butter ly spread can be created by buying an option each at two extreme strike prices ( 1 and 3) and selling two options with a strike price ( 2), which is hal way between 1 and 3. The strike price should be so chosen that 1 < E2 < E3. Generally, E2 should be close to the prevalent market price.
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Example
An investor buys two arch call options on shares o Reliance, one at a premium o Rs. 25 per share with a strike price o Rs.200 (E1) and the other at a premium o Rs. 15 per share with a strike price o Rs. 300 (E3). The investor also sells two arch call options at a premium o Rs. 17 per share with a strike price o Rs. 250 (E2). The payo table o a butter ly spread using calls will be:

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S 180 200 220 240 250 260 280 300 320

E1 200 200 200 200 200 200 200 200 200

E2 250 250 250 250 250 250 250 250 250

E3 300 300 300 300 300 300 300 300 300

p 6 6 6 6 6 6 6 6 6

Payoff Net Profit 0 0 20 40 50 40 20 0 0 -6 -6 14 34 44 34 14 -6 -6

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In the case o a butter ly spread using calls, the payo will be:
From Call From Two From Call bought at E1 Calls sold at E2 bought at E3 0 S E1 S E1 S E1 0 0 - 2 * (S E2) - 2 * (S E2) 0 0 0 S E3

Payoff when, S E1 E1 S E2 E2 S E3 S E3

Total Payoff 0 S E1 E3 S 0

* These payoffs will hold true only when E2 is halfway between E1 and E3

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Investors adopt the butter ly spread strategy when they are certain that the prices will luctuate signi icantly and want to limit their downside risk. This strategy limits both the upside potential as well as the downside risk. The upside potential is limited to the di erence between (the middle exercise price and the lower exercise price) less the net option premium while the downside risk is limited to the amount o net option premium paid to create the spread.
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THE END

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