Effect of Variables on Option

Pricing

Variable c p C P
S0 + – + –
K – +? – +
T ? + +
σ + + + +
r + – + –
D – + – +
Option Valuation
Options Valuation
 Properties of Stock Prices

E ( ST ) = S0 eµT
2 2 µT σ2T
var ( ST ) = S0 e (e − 1)
 Binomial Model

ƒ = [ pƒu + (1 – p)ƒd ]e–rt

e rT − d
p=
u−d
 Binomial Model Illustration

• If spot rate is 20 and the stock can move

+10%(u) or –10%(d), and X=21, then
S 0 = 20, t = 3m, S 0u = 22, S 0 d = 18
• Assuming that no arbitrage opportunities
exists and the value of the portfolio at the
end of time period t is certain so that its is
able to generate a return equal to risk free
rate.
 Binomial Model Illustration

22

20
18

In order to construct risk less portfolio, the

ending value of the portfolio should be
same in both the situations.
 Binomial Model Illustration
• Position – Long Stock ∆ and Short Call
• Portfolio Value = 22 ∆ and Value of the
option = 1 if the closing price is 22
• Portfolio Value = 18 ∆ if the closing price is
18
• 22 ∆ - 1 = 18 ∆ ; ∆ = 0.25
• If the closing price is 22 or 18 the value of
the portfolio will be 4.5
 Binomial Model Illustration

• Value of the portfolio today

−0.12*3 / 12
4.5e = 4.367
• If f is the option price the value of the
portfolio today is 20*0.25-f = 5- f
• 5-f = 4.367 ; f = 0.633
 Practice Illustration
The stock price of Tata Motors is currently quoted at Rs.
400 in the market. The market expectation about the
stock is that its value may increase or decrease by 10%
in each of the next two half-years. The return on the
Government security being traded in the market for
same maturity is 5% p.a. The European call option on
Tata Motors stock with exercise price Rs.425 is available
in the market. You are required to calculate the value of
call option using two-step Binomial model.
 Black-Scholes-Merton Model

c = S 0 N (d1 ) − K e − rT N (d 2 )
p = K e − rT N (− d 2 ) − S 0 N (− d1 )
ln(S 0 / K ) + (r + σ 2 / 2)T
where d1 =
σ T
2
ln(S 0 / K ) + (r − σ / 2)T
d2 = = d1 − σ T
σ T
 Practice Illustration

Chinki Exports Ltd. is currently trading at

Rs. 47. The 6-month call options for are
available at a strike price of Rs. 50 The
volatility of the stock is 40% p.a. and risk
free rate is 10%. Compute the theoretical
price using Black-Scholes model and
estimate the gamma, Vega, theta and rho for
the call option.
 Arbitrage Argument

A risk less arbitrage opportunity is one that

without initial investment, generates
nonnegative returns under all circumstances
and positive returns under some
circumstances. In an efficient market, such
opportunities should not exist.
 Relative Option Prices

fAn American call(put) with a longer time to

expiration cannot be worth less than an
otherwise identical call (put) with a shorter
time to expiration.
fA call(put) with a higher (lower) strike
price cannot be worth more than otherwise
identical call(put) with a lower(higher)
strike price.
 Relative Option Prices

fThe difference in the value of two

otherwise identical options cannot be
greater than the difference in their strike
prices.
fA call is never worth more than the stock
price, an American put is never worth more
than the strike price, and a European put is
never worth more than the present value of
the strike price.
 Put-Call Parity

Consider a portfolio consisting of one short

European Call, one long European Put, one
share of stock and a loan of PV(Y). Assume
that stock pays no dividends and the X and t
is same for both the options. The value of
the portfolio is
C - P - S + PV(Y)
 Put-Call Parity

If S>X, the call will be exercised and the

amount received i.e. X shall be used to pay
the loan Y. The value of the portfolio is
therefore zero.
If S<X, the put will be exercised and the
value of the portfolio will again be zero.
 Put-Call Parity

The arbitrage principle says that the value

of the portfolio be same as today. Therefore,
C - P - S + PV(Y) = 0
which implies that
C = P + S - PV(Y)
where PV(Y) = Ye -rt
Early Exercise of American Call
Options
An American call option must not be
exercised early because-
• No income is sacrificed
• Payment of the strike price is delayed
• Holding the call provides insurance against stock price
falling below strike price.
If the trader is convinced with the profit
opportunity, it is better to sell the option than
to exercise it.
Early Exercise of American Put
Options

If the put option is deep in the money the

option must be exercised because the profit
can be invested to earn profit. Also it
guards against the risks if losing profit if
the stick prices go down.
 Implied Volatility

• The implied volatility of an option is the

volatility for which the Black-Scholes price
equals the market price
• The is a one-to-one correspondence
between prices and implied volatilities.
• Traders and brokers often quote implied
volatilities rather than stock prices
 Dividend Adjustments
• European options on dividend-paying
stocks are valued by substituting the stock
price less the present value of dividends into
Black-Scholes.
• Only dividends with ex-dividend dates
during life of option should be included.
• The “dividend” should be the expected
reduction in the stock price expected.
 American Calls

• An American call on a dividend-paying stock

should only ever be exercised immediately prior to
an ex-dividend date
• Suppose dividend dates are at times t1, t2, …tn.
Early exercise is sometimes optimal at time ti if
the dividend at that time is greater than
− r ( ti +1 −ti )
K [1 − e ]
Black -Sholes Approximation to
American Calls

Set the American price equal to the maximum of

two European prices:
1. The 1st European price is for an option
maturing at the same time as the American option.
2. The 2nd European price is for an option
maturing just before the final ex-dividend date.
 Volatility Smiles

• A volatility smile shows the variation of the

implied volatility with the strike price.
• The volatility smile should be the same
whether calculated from call options or put
options.
• The volatility smile is a declining curve for
equity assets.
 Volatility Term Structure

• This shows the variation of implied

volatility with the time to maturity of the
option.
• The volatility term structure tends to be
downward sloping when volatility is high
and upward sloping when it is low.
 Estimating Volatility
• Define σn as the volatility per day between day n-
1 and day n, as estimated at end of day n-1 and Si
as the value of market variable at end of day i.
• Define ui= ln(Si/Si-1){continuously compounded
return} m
1
σ =
2
n ∑
m − 1 i =1
( un −i − u ) 2

1 m
u = ∑ un −i
m i =1
 Estimating Volatility Contd...
If α is the weight given to the current data

∑
m
σ 2
n = i=1
α i u 2
n−i

where
m

∑i=1
α i = 1
 ARCH Model

In an ARCH(m) model we also assign some

weight to the long-run variance rate, VL:

∑ i =1 i n − i
m
σ = γV L +
2
n α u 2

where
m
γ+ ∑α
i =1
i =1
 EWVA Model

• In an exponentially weighted moving

average model, the weights assigned to the
u2 decline exponentially as we move back
through time
• This leads to
σ = λσ
2
n
2
n −1 + (1 − λ ) u 2
n −1
 EWVA Model Contd….
• Relatively little data needs to be stored
• We need only remember the current
estimate of the variance rate and the most
recent observation on the market variable
• Tracks volatility changes
• Risk Metrics uses λ = 0.94 for daily
volatility forecasting
 EWVA Model Contd….

Assume that the most recent estimate of the

daily volatility of an asset is 1.5% and the
price of the asset at the close of the trading
day yesterday was 30. Assume λ=0.94,
compute the new volatility if the assets now
closes at 30.50 {1.5103%}
 GARCH(1,1)

• In GARCH (1,1) we assign some weight to

the long-run average variance rate

σ = γV L + α u
2
n
2
n −1 + βσ 2
n −1

Since weights must sum to 1

γ + α + β =1
 GARCH(1,1) Contd...

Setting ω = γV the GARCH (1,1) model is

σ =ω +α
2
n
2
u n −1 + βσ 2
n −1

and
ω
VL =
1− α − β
 GARCH(1,1) Contd...

If
vi = σ 2
i , defined as
m 2
ui
∑
i =1
{− ln(vi ) −
vi
}
 GARCH(1,1) Illustration

If the Nifty closed yesterday at 1040 and the

daily volatility of the index was estimated
as 1% per day at that time. The parameters
of GARCH(1,1) model are ϖ =0.000002,
α=0.06 and β=0.92. If the level of the index
at the close of trading today is 1.060, what
is the new volatility estimate?{1.078%}
Daily Return = 1060-1040/1040=0.01923
 Forecasting Volatility using
GARCH(1,1)

E[ σ 2
n+k ] = VL + ( α + β) ( σ − VL ) k 2
n
The parameters of GARCH(1,1) model are ϖ =0.000004, α=0.05
and β=0.92.What is the long run average volatility and what is
the expected volatility if the current volatility is 20% per year?
VL = 0.0001333 σn=0.2/SQRT252=0.0126

{SQRT0.0001471=0.0121}