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18 Chapter model

Chapter 18. Derivatives and Risk Management

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This spreadsheet model focuses on option pricing and analysis.

OPTIONS (Section 18-3)

A call option allows an investor to buy shares of a stock at a specified price by/on a future date.
The writer of the call option holds a short position on the option, while the buyer holds a long
position. The price at which the stock may be purchased is called the strike, or exercise, price.

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A put option allows you to sell a stock at a specified price within some future period. If you believe
that the price of a stock is likely to fall, buying a put option allows you to turn a profit from that
decline. The profit or loss made on an option transaction is derived from what happens to the
value of the underlying asset; hence, options are derivative securities.
P = Price of the stock
X = Exercise price of the option, i.e., the price you must pay if you exercise the option and buy the
stock.

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FOR A CALL OPTION, AT EXPIRATION

The option is:
The investor makes (or loses):

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If P > X

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If P < = X

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If P < X

Exercised

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If P >= X

Allowed to expire

Exercised
Allowed to expire

FOR A PUT, AT EXPIRATION

The option is:

Makes difference between P

and X, minus the cost of the
call.
Loses the cost of the call.

The investor makes (or loses):

Makes the difference between
X and P, minus the cost of the
put.
Loses the cost of the put.

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A
EXAMPLE

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Suppose you decide to invest in options. You purchase a call option on ABC, Inc. with a strike
price of $80, paying $8.90. You also buy a put option on DEF Industries with a strike of $40, paying
$4.65. Finally, you buy a call on GHI Technologies with a strike price of $65, paying $1.20. At
expiration, ABC, DEF, and GHI have stock prices of $95.50, $36.25, and $63.75, respectively. The
three options were all purchased on the same day and they all expire on the same day. What is the
profit or loss on each option? What is the profit or loss of the entire investment portfolio?

At expiration, what is the profit/loss on each option?

Ends with
P>X

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Ends with P < X

Cost of the option

Strike price (X)
Initial value of the stock (P)

ABC
$8.90
$80.00
$95.50

DEF
$4.65
$40.00
$36.25

GHI
$1.20
$65.00
$63.75

Ending value of the option

Less cost of the option
Profit or loss on the option

$15.50
$8.90
$6.60

$3.75
$4.65
($0.90)

$0.00
$1.20
($1.20)

LOOKING AT THE INTRINSIC AND MARKET VALUES OF AN OPTION

At expiration a call option's value is simply the current price of the stock minus the strike price.
However, at any point prior to maturity, it is difficult to determine the value of an option, because
that value depends on several factors, especially the time to maturity and the stock's volatility.

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Space Technology Inc's (STI) stock is currently trading at $21. We will examine an option on STI's
stock (with a strike price of $20), and look at the option's value under different conditions. We
calculate the intrinsic value of the option by simply subtracting the strike price from the stock
price, if it exercised, or zero if it is not exercised. Once again, we use the MAX function. Assume
that the market values for the option were looked up in a newspaper. The last column represents
the difference between the market value and the intrinsic value of this option in these different
states of the world. We graphed these values below the table.

Price of
the stock
$0
$10
$20.00
$21.00
$22.00
$35.00
$42.00
$50.00
$73.00
$98.00

Strike
Price
$20.00
$20.00
$20.00
$20.00
$20.00
$20.00
$20.00
$20.00
$20.00
$20.00

Option Value
Intrinsic
Market
Value
Value
Premium
$0.00
$4.50
$4.50
$0.00
$6.00
$6.00
$0.00
$9.00
$9.00
$1.00
$9.75
$8.75
$2.00
$10.50
$8.50
$15.00
$21.00
$6.00
$22.00
$26.00
$4.00
$30.00
$32.00
$2.00
$53.00
$54.00
$1.00
$78.00
$78.50
$0.50

Intrinsic-vs-Market Value of Options

Option Value
$80.00
$70.00
$60.00
$50.00
$40.00
$30.00
$20.00
$10.00
$0.00
$0
$10

Intrinsic
Value

$20

$30

$40

$50

$60

$70

$80 $90 $100

Stock Price

This difference between the market and intrinsic values is the option's premium, and three factors
drive the premium: (1) the option's term to maturity, (2) the volatility of the stock's price, and (3) the
risk-free rate. The longer the time to maturity and the greater the stock's volatility, the higher the
premium, but the higher the risk-free rate, the lower the premium. The exact relationships are
discuss next, in the section on the Black-Scholes Option Pricing Model.

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THE BLACK-SCHOLES OPTION PRICING MODEL (OPM)

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In deriving this option pricing model, Black and Scholes made the following assumptions:

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(Section 18-5)

1. The stock underlying the call option provides no dividends or other

distributions during the life of the option.
2. There are no transaction costs for buying or selling either the stock or
the option.
3. The short-term, risk-free interest rate is known and is constant during
the life of the option.
4. Any purchaser of a security may borrow any fraction of the purchase
price at the short-term, risk-free interest rate.
5. Short selling is permitted, and the short seller will receive immediately
the full cash proceeds of today's price for a security sold short.
6. The call option can be exercised only on its expiration date.
7. Trading in all securities takes place continuously, and the stock price
moves randomly.
The derivation of the Black-Scholes model rests on the concept of a riskless hedge. By buying
shares of a stock and simultaneously selling call options on that stock, an investor can create a
risk-free investment position, where gains on the stock are exactly offset by losses on the option.
Ultimately, the Black-Scholes model utilizes these three formulas:
V =
d1 =
d2 =

P[ N (d1) ] Xe-rRF t [ N (d2) ]

{ ln (P/X) + [rRF + 2 /2) ] t } / (t1/2)
d1 (t 1 / 2)

In these equations, V is the value of the option. P is the current price of the stock. N(d 1) is the area
beneath the standard normal distribution corresponding to (d1). X is the strike price. rRF is the riskfree rate. t is the time to maturity. N(d2) is the area beneath the standard normal distribution
corresponding to (d2). , or sigma, is the volatility of the stock price, as measured by the standard
deviation.

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Looking at these equations we see that you must first solve d 1 and d2, after which you can value
the option.

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This model is widely used by option traders and is generally considered to be the standard for
option pricing. Many hand-held calculators and computer programs have this formula permanently
stored. We now use Excel to write a "program," if you will, for the Black-Scholes pricing model in
102 Excel. We will construct our "program" to price the option described in the text. The stock the
option is written on has a current market price of $21, the strike price is $21, the risk-free rate of
interest is 5%, time to maturity is 0.36 year, and the stock price's annual variance is 0.09. Using
this information, we will use the Black-Scholes model to value the option.

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104 First, we will lay out the input data given to us in the setup of the problem.
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P
$21
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X
$21
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t
0.36
108
rRF
5%
109
2

0.09
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112 Now, we will use the formula from above to solve for d 1.
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(d1) =
0.190 =(LN(C106/C107)+(C108+(C110/2))*C109)/((C110^0.5)*(C109^0.5))
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116 Having solved for d1, we will now use this value to find d2.
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(d2) =
0.010 =B114-(C110^0.5)*(C109^0.5)
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At this point, we have all of the necessary inputs for solving for the value of the call option. We will
use the formula for V from above to find the value. The only complication arises when entering
121 N(d1) and N(d2). Luckily, Excel is equipped with a function that can determine cumulative
probabilities of the normal distribution. This function is located in the list of statistical functions,
as "NORMDIST".
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By applying this method for cumulative distributions, we can solve for the option value using the
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formula above.
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V =

$1.687

=(C106*NORMDIST(B114,0,1,TRUE))-(C107*EXP(-C108*C109))*NORMDIST(B118,0,1,TRUE)

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We see that although the exercise value if executed now is $0, the actual market value of the option
would be $1.687.

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129 EFFECTS OF THE OPM FACTORS ON THE VALUE OF A CALL OPTION
130

Out of curiosity, we now examine the sensitivity of call option values to the five factors in the
131 Black-Scholes OPM. We will set up data tables for each factor to see how the call value changes if
the specified input changes by plus or minus 15% and 30% with the other factors held constant.
132 Stock Price
P
133 % change
-30%
$15
134
-15%
$18
135
0%
$21
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15%
$24
137
30%
$27
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140 Time to Maturity
t
141 % change
-30%
0.252
142
-15%
0.306
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0%
0.360
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15%
0.414
145
30%
0.468
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148 Stock's volitility
2
149 % change
-30%
0.063
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-15%
0.077
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0%
0.090
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15%
0.104
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30%
0.117
154

$1.687
0.0362
0.4121
1.6873
3.9448
6.7839

% Change

Strike Price

from base

% change

-98%
-76%
0%
134%
302%
% Change

$1.687
1.3884
1.5434
1.6873
1.8224
1.9503

from base

-18%
-9%
0%
8%
16%
% Change

$1.687
1.4455
1.5717
1.6873
1.7945
1.8949

from base

-14%
-7%
0%
6%
12%

-30%
-15%
0%
15%
30%

X
$15
$18
$21
$24
$27

Risk-free rate
r
% change
-30%
3.5%
-15%
4.3%
0%
5.0%
15%
5.8%
30%
6.5%

$1.687
6.5835
3.7539
1.6873
0.5959
0.1714

$1.687
1.6317
1.6593
1.6873
1.7155
1.7439

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OPM Factors Effect on Value of a Call Option

Option Value
7.0000
6.0000

Stoc k Pric e

5.0000

Exerc ise Pric e

4.0000

T ime to
maturity
Risk-free rate

3.0000

Varianc e

2.0000
1.0000
0.0000
-30%

-20%

-10%

0%

10%

20%

% Change

30%

From this graph, we see that by far the strongest influences on option's value are the stock price
and the exercise prices. Time to maturity, the risk-free rate, and volatility have only marginally
positive correlations with the value of the option. OF COURSE, AFTER THE OPTION HAS BEEN
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ISSUED, THE EXERCISE PRICE IS FIXED AND INVARIANT. THEREFORE, FOR EXISTING OPTIONS
THE FACTOR THAT REALLY DETERMINES THEIR VALUE, HENCE MONEY MADE OR LOST ON THE
OPTION, IS CHANGE IN THE STOCK'S PRICE.
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177 EXAMINING OPTIONS USING PAYOUT AND PROFIT DIAGRAMS

When thinking of a stock, the payout is an easy function to visualize. The payout you will receive
is simply price at which the stock is sold. However, options are different. In the case of a call
option, the payout is equal to the difference between the stock's price and the exercise price, if the
option is exercised. If the option is not exercised, the payout of the option is simply zero. For put
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options, the payouts are similar to call options, except the payout is the difference between
exercise price and the stock price. Naturally, an investor would not want to exercise an option
unless the exercise provided a payout greater than zero. For that reason, the payouts of call and
put options can be expressed as the following:
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Payout of a call =MAX(P-X,0)

Payout of a put =MAX(X-P,0)

Using these formulas for call and put options, we will now construct payout diagrams for two
hypothetical options on the same underlying stock. A call option with strike price of $20 and a put
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option with a strike price of $25. The first step in any option analysis is to determine the
appropriate payouts.
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XCALL =

XPUT =

$20
Call
$0
$0
$0
$0
$0
$5
$10
$15
$20

if P=
$0
$5
$10
$15
$20
$25
$30
$35
$40

if P=
$0
$5
$10
$15
$20
$25
$30
$35
$40

$25
Put
$25
$20
$15
$10
$5
$0
$0
$0
$0

Option Payout Diagrams

Option Payout
$30

Column C
Column G

$25
$20
$15
$10
$5
$0
$0

$5

$10

$15

$20

$25

$30

$35
$40
Stock Price

What would happen if you formed an option portfolio by buying both the put and the call? That
situation is shown below. You would have a large payoff from the put combined with zero on the
213 call if the stock price declined substantially and a large gain from the call and zero from the put if
the stock price rose sharply. If the stock price ended up in the range of $20 to $25, you would have
a net gain of $5.
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if P =
$0
$5
$10
$15
$20
$25
$30
$35
$40

Portfolio
Value =
$25
$20
$15
$10
$5
$5
$10
$15
$20

Portfolio Payout

Option Portfolio Payout

$30
$25
$20
$15
$10
$5
$0
$0

$5

$10

$15 Stock
$20Price$25

$30

$35

$40

From this diagram it would appear that forming the portfolio is a "win-win" strategy. By buying a
call option with a lower strike price than the put option on the same stock, we always have a
positive payout from the investment. However, there is a factor we have not considered. To this
point, we have failed to account for the price of purchasing the call and the put options in this
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scenario. Let us assume that the stock currently sells for $22. This means that both the put and
the call options are currently "in the money." Because of this, the call option is selling for $5, and
the put sells for $6.50. We will use all of this information to construct profit diagrams for this
option portfolio.

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234 C =
235 P =
236
237 if P=
$0
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$5
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$10
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$15
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$20
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$25
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$30
244
$35
245
$40
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247

$5
$6.50

$15
Option v alue

$10

Portfolio
$14
$9
$4
($2)
($7)
($7)
($2)
$4
$9

$5

$0
$0

$5

$10

$15

$20

$25

$30

$35

$40

($5)

($10)

This profit diagram shows us the downside risk to our investment strategy. This position is called
248 a "reverse straddle". For small movements in the stock price, there will be a loss on the
investment. However, for either large upward or downward swings, this portfolio will yield a profit.
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250 PROBLEM

Suppose, you are an investment broker. Your client wants to take five option positions on the
stock of Firm O. The stock is currently trading at $43.75. (1) He wants to buy a call option with a
strike price of $50 at an option price of $1.10. (2) He also wants to write a put option with a strike
251 of $40 at an option price of $2.25. (3) He also wants to buy a second call option with a strike of
$45, and an option price of $4.75. (4) He also wants to buy a put option with a strike of $45, and an
option price of $4.50. (5) Finally, he wants to write a call option with a strike price of $35, and an
option price of $14.25. Construct a profit diagram for this investment strategy.
252
253 First, lets lay out all of the information given to us in the problem.
254
$43.75
255 Stock Price
256
257 Call #1 (long)
Strike Price
$50.00
258
Option Price
$1.10
259
260 Put #1 (short)
Strike Price
261
Option Price
262

$40.00
$2.25

263 Call #2 (long)

Strike Price
264
Option Price
265

$45.00
$4.75

266 Put #2 (long)

Strike Price
267
Option Price
268

$45.00
$4.50

269 Call #3 (short)

Strike Price
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Option Price
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272

$35.00
$14.25

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Now, we construct formulas for each of the options that will give us the value of the option if it is
exercised at the current stock price.
position
long
short
long
long
short

Option
Call #1
Put #1
Call #2
Put #2
Call #3

Value
$0.00
$0.00
$0.00
$1.25
($8.75)

Using the payout values at the current price (calculated above), we now set up a data table for the
profits/losses from these options. We have also calculated the profits/losses from each of these
282
positions at the indicated set of stock prices. The final column to the right is merely the sum of the
profits/losses from each of the option positions.
283
Stock
Call #1
Put #1
Call #2
Put #2 Call #3
Portfolio
284
Price
($1.10)
$2.25
($4.75) ($3.25)
$5.50
285
$15.00
($1.10)
($22.75)
($4.75) $25.50
$14.25
$11.15
286
$20.00
($1.10)
($17.75)
($4.75) $20.50
$14.25
$11.15
287
$25.00
($1.10)
($12.75)
($4.75)
$15.50
$14.25
$11.15
288
$30.00
($1.10)
($7.75)
($4.75)
$10.50
$14.25
$11.15
289
$35.00
($1.10)
($2.75)
($4.75)
$5.50
$14.25
$11.15
290
$40.00
($1.10)
$2.25
($4.75)
$0.50
$9.25
$6.15
291
$45.00
($1.10)
$2.25
($4.75) ($4.50)
$4.25
($3.85)
292
$50.00
($1.10)
$2.25
$0.25
($4.50) ($0.75)
($3.85)
293
$55.00
$3.90
$2.25
$5.25
($4.50)
($5.75)
$1.15
294
$60.00
$8.90
$2.25
$10.25
($4.50) ($10.75)
$6.15
295
$65.00
$13.90
$2.25
$15.25
($4.50) ($15.75)
$11.15
296
297
298 Using this data, we can create a profit diagram for this option portfolio.
299
300
301
Portfolio Profit
302
$15.00
303
304
$10.00
305
306
$5.00
307
308
$0.00
309
$15.00 $20.00 $25.00 $30.00 $35.00 $40.00 $45.00 $50.00 $55.00 $60.00 $65.00
310
($5.00)
311
Stock Price
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313
314
315 The investor would make money if the stock sells sharply higher or lower than the
316 current price, but would lose if it remains in the $45 to $50 price range.

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1/06/09

3
Management
4
5
6
7

ecified price by/on a future date.

8 holds a long
, while the buyer
ed the strike, or exercise, price.
9

n some future period. If you believe

ws you to turn a profit from that
10
ved from what happens to the
urities.

11
12
ou exercise the option and buy the
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15
16
17
18
19
20
21
22
23
24

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25

ption on ABC, Inc. with a strike

ustries with a strike of $40, paying
price of $65, paying $1.20. At
26
25, and $63.75, respectively. The
xpire on the same day. What is the
ntire investment portfolio?
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28
29
30
31
32
33
34
35
36
37
38
39

he stock minus the strike price.

40 option, because
e the value of an
turity and the stock's volatility.
41

We will examine an option on STI's

under different conditions. We
the strike price from the stock
42function. Assume
e use the MAX
aper. The last column represents
of this option in these different

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45
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51
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61
62
63
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Intrinsic
Value 65
66
67
68
69
$80 $90 $100
70
Stock Price
71
72

ption's premium, and three factors

ility of the stock's price, and (3) the
73 the higher the
e stock's volatility,
m. The exact relationships are
g Model.
74

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76

77
he following assumptions:

dividends or other
78
79
g either the stock
80 or
81
d is constant during
82
83
on of the purchase
84
85
receive immediately
86
87
88
and the stock89
price
90
91

of a riskless hedge. By buying

t stock, an investor can create a
92
tly offset by losses on the option.
s:
93
94
95
96
97

price of the stock. N(d 1) is the area

X is the strike price. rRF is the riskstandard normal
98 distribution
price, as measured by the standard

99
nd d2, after which you can value
100
101

nsidered to be the standard for

ams have this formula permanently
he Black-Scholes pricing model in
102 The stock the
ribed in the text.
price is $21, the risk-free rate of
s annual variance is 0.09. Using
he option.

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104
105
106
107
108
109
110
111
112
113
C110^0.5)*(C109^0.5))
114
115
116
117
118
119
120

the value of the call option. We will

mplication arises when entering
an determine121
cumulative
in the list of statistical functions,

122
lve for the option value using the
123
124

*C109))*NORMDIST(B118,0,1,TRUE)
125

126
he actual market value of the option
127
128

I
129
130

alues to the five factors in the

o see how the131
call value changes if
the other factors held constant.
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134
135
136
137
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139
140
141
142
143
144
145
146
147
148
149
150
151
152
153
154

% Change
from base

290%
122%
0%
-65%
-90%
% Change
from base

-3%
-2%
0%
2%
3%

Option

ge

30%

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159
160
161
Stoc
k Pric e
162ise Pric e
Exerc
T ime
163to
maturity
164
Risk-free rate
165
Varianc e
166
167
168
169
170
171
172
173
174

option's value are the stock price

volatility have only marginally
AFTER THE OPTION HAS BEEN
175
REFORE, FOR EXISTING OPTIONS
E MONEY MADE OR LOST ON THE

176

I
177

alize. The payout you will receive

different. In the case of a call
price and the exercise price, if the
the option is simply zero. For put
178
ut is the difference between
not want to exercise an option
at reason, the payouts of call and

179
180
181
182

truct payout diagrams for two

n with strike price of $20 and a put
183
alysis is to determine the

184
185
186
187
188
189
190
191
192
193
194
195
196
197
198
199
C
200
201
G
202
203
204
205
206
207
208
209 $40
$30
$35
Stock210
Price
211
212

both the put and the call? That

he put combined with zero on the
m the call and213
zero from the put if
ange of $20 to $25, you would have

yout

$25

ce

$30

214
215
216
217
218
219
220
221
222
223
224
225
226
227
$35
228
229
230

$40

"win-win" strategy. By buying a

ame stock, we always have a
we have not considered. To this
call and the put options in this
231
This means that both the put and
he call option is selling for $5, and
struct profit diagrams for this

lue

$25

$30

232
233
234
235
236
237
238
239
240
241
$35
242
243
244
245
246
247

$40

nt strategy. This position is called

here will be a 248
loss on the
ngs, this portfolio will yield a profit.
249

I
250

ke five option positions on the

wants to buy a call option with a
to write a put option with a strike
251with a strike of
cond call option
option with a strike of $45, and an
with a strike price of $35, and an
ment strategy.
252
253
254
255
256
257
258
259
260
261
262
263
264
265
266
267
268
269
270
271
272

e us the value of the option if it is

273
274
275
276
277
278
279
280
281

we now set up a data table for the

profits/losses from each of these
282
to the right is merely the sum of the

283
284
285
286
287
288
289
290
291
292
293
294
295
296
297
298
299
300
301
302
303
304
305
306
307
308
309
$50.00 $55.00 310
$60.00 $65.00
311Price
Stock
312
313
314
r or lower than
the
315
316

SECTION 18-3
SOLUTIONS TO SELF-TEST QUESTIONS
4a. Underwater Technology stock is currently trading at $30 a share. A call
option on the stock with a $25 strike price currently sells for $12. What is
the exercise value of the call option?
Stock price
Strike price
Value of call option

Exercise value =
Exercise value =
Exercise value =

$30
$25
$12
Current
stock
price
$30
$5

Strike
price
$25

4b Underwater Technology stock is currently trading at $30 a share. A call

option on the stock with a $25 strike price currently sells for $12. What is
the premium of the call option?
Stock price
Strike price
Value of call option

Premium =
Premium =
Premium =

$30
$25
$12
Option
market
price
$12
$7

Exercise
value

$5

SECTION 18-5
SOLUTIONS TO SELF-TEST QUESTIONS
4. What is the value of a call option with these data: P = $25, X = $25, r RF =
8%, t = 0.5 (6 months), 2 = 0.09, N(d1) = 0.61586, and N(d2) = 0.53287?
P
X
rRF
t
2
N(d1)
N(d2)
V=
V=
V=
V=

$25
$25
8%
0.5
0.09
0.61586
0.53287

P[N(d1)]
$15.40
$15.40
$2.60

(
(

Xe-rRFt
$24.02
$12.80

[N(d2)] )

0.53287 )

SECTION 18-6
SOLUTIONS TO SELF-TEST QUESTIONS
5a. Suppose you buy a March futures contract on a hypothetical 15-year, 6% semiannual
coupon bond with a settlement price today of 109 9/32. You post the initial margin
required for this transaction ($2,430 per $100,000 contract). What nominal yield to
maturity is implied by the settlement price?
Years
No. of periods
Coupon rate
Face value
Settlement price
N
PMT
PV
FV
rd/2
rd

15
2
6%
$1,000
1.0928125
30
$30
$1,092.81
$1,000.00
2.55%
5.11%

5b. Suppose you buy a March futures contract on a hypothetical 15-year, 6% semiannual
coupon bond with a settlement price today of 109 9/32. You post the initial margin
required for this transaction ($2,430 per $100,000 contract). If interest rates fall to 4.5%,
what return would you earn on one futures contract?
Years
No. of periods
Coupon rate
Face value
rd
N
I/YR
PMT
FV
PV

15
2
6%
$1,000
4.50%
30
2.25%
$30
$1,000.00
$1,162.34

No. of contracts
Face value
Settlement price
MV
Margin

1
$100,000
1.0928125
1.1623400
$2,430

% Return =
% Return =
% Return =

[(MV
$6,952.75
186.12%

Settlement price)

$2,430

/
1

Margin]

5c. Suppose you buy a March futures contract on a hypothetical 15-year, 6% semiannual
coupon bond with a settlement price today of 109 9/32. You post the initial margin
required for this transaction ($2,430 per $100,000 contract). If interest rates rose to 5.5%,
what is the return on one futures contract?
Years
No. of periods
Coupon rate
Face value
rd
N
I/YR
PMT
FV
PV

15
2
6%
$1,000
5.50%
30
2.75%
$30
$1,000.00
$1,050.62

No. of contracts
Face value
Settlement price
MV
Margin

1
$100,000
1.0928125
1.0506233
$2,430

% Return =
% Return =
% Return =

[(MV
-$4,218.92
-273.62%

Settlement price)

$2,430

/
1

Margin]