EXECUTIVE SUMMARY

Modern option pricing techniques are often considered among the most mathematically complex of all applied areas of finance. Financial analysts have reached the point where they are able to calculate, with alarming accuracy, the value of a stock option. Most of the models and techniques employed by today's analysts are rooted in a model developed by Fischer Black and Myron Scholes in 1973. This study examines the evolution of option pricing models leading up to and beyond Black and Scholes' model. The use of the Black-Scholes formula is pervasive in the markets. In fact the model has become such an integral part of market conventions that it is common practice for the implied volatility rather than the price of an instrument to be quoted. (All the parameters in the model other than the volatility - that is the time to maturity, the strike, the risk-free rate, and the current underlying price - are unequivocally observable. This means there is one-to-one relationship between the option price and the volatility.) Traders prefer to think in terms of volatility as it allows them to evaluate and compare options of different maturities, strikes, and so on. The work done by Black & Scholes in the 70's made way for further pricing of derivatives and in particular, exotic options. The Black-Scholes partial differential equation also enabled derivation of the 'Greeks of option pricing. The Black-Scholes model today is used in everyday pricing of options and futures and almost all formulas for pricing of exotic options such as barriers, compounds and Asian options take their foundation from the BlackScholes model.

TABLE OF CONTENTS
Abstract Introduction Option Pricing The Binomial Option Pricing Model The Black and Scholes Model S&P CNX Nifty Options Option Prices for S&P CNX Nifty Contracts Option Prices based on Historical Volatility Option Prices based on Implied Volatility Analysis Conclusion References Appendix 42 43 44 1 3 5 9 16 25

Introduction:
It was an ordinary autumn afternoon in Belmont, Mass. 1969, when Fischer Black, a 31 year old independent finance contractor, and Myron Scholes a 28 year old assistant professor of finance, at MIT hit upon an idea that would change financial history. Black had been working for Arthur D. Little in Cambridge, Mass., when he met a colleague who had devised a model for pricing securities and other assets. With his Harvard Ph.D. in applied mathematics just five years old, Black's interest was sparked. His colleague's model focused on stocks, so Black turned his attention to options, which were not widely traded at the time. By 1973, the tandem team of Fischer Black and Myron Scholes had written the first draft of a paper that outlined an analytic model that would determine the fair market value for European type call options on non-payout assets. They submitted their work to the Journal of Political Economy for publication, who promptly responded by rejecting their paper. Convinced that their ideas had merit, they sent a copy to the Review of Economics and Statistics, where it elicited the same response. After making some revisions based on extensive comments from Merton Miller (Nobel Laureate from the University of Chicago) and Eugene Fama, of the University of Chicago, they resubmitted their paper to the Journal of Political Economy, who finally accepted it. From the moment of its publication in 1973, the Black and Scholes Option Pricing Model has earned a position among the most widely accepted of all financial models.

What Is an Option?
The idea of options is certainly not new. Ancient Romans, Grecians, and Phoenicians traded options against outgoing cargoes from their local seaports. When used in relation to financial instruments, options are generally defined as a "contract between two parties in which one party has the right but not the obligation to do something, usually to buy or sell some underlying asset". Having rights without obligations has financial value, so option holders must purchase these rights, making them assets. This asset derives their value from some other asset, so they are called derivative assets. Call options are contracts giving the option holder the right to buy something, while put options, and conversely entitle the holder to sell 3

something. Payment for call and put options, takes the form of a flat, up-front sum called a premium. Options can also be associated with bonds (i.e. convertible bonds and callable bonds), where payment occurs in installments over the entire life of the bond, but this paper is only concerned with traditional put and call options.

Origins of Option Pricing Techniques:

Modern option pricing techniques, with roots in stochastic calculus, are often considered among the most mathematically complex of all applied areas of finance. These modern techniques derive their impetus from a formal history dating back to 1877, when Charles Castelli wrote a book entitled The Theory of Options in Stocks and Shares. Castelli's book introduced the public to the hedging and speculation aspects of options, but lacked any monumental theoretical base. Twenty three years later, Louis Bachelier offered the earliest known analytical valuation for options in his mathematics dissertation "Theorie de la Speculation" at the Sorbonne. He was on the right track, but he used a process to generate share price that allowed both negative security prices and option prices that exceeded the price of the underlying asset. Bachelier's work interested a professor at MIT named Paul Samuelson, who in 1955, wrote an unpublished paper entitled "Brownian Motion in the Stock Market". During that same year, Richard Kruizenga, one of Samuelson's students, cited Bachelier's work in his dissertation entitled "Put and Call Options: A Theoretical and Market Analysis". In 1962, another dissertation, this time by A. James Boness, focused on options. In his work, entitled "A Theory and Measurement of Stock Option Value", Boness developed a pricing model that made a significant theoretical jump from that of his predecessors. More significantly, his work served as a precursor to that of Fischer Black and Myron Scholes, who in 1973 introduced their landmark option pricing model.

OPTION PRICING

In general, the value of any asset is the present value of the expected cash flows on that asset. In this section, we will consider an exception to that rule when we will look at assets with two specific characteristics: They derive their value from the values of other assets. The cash flows on the assets are contingent on the occurrence of specific events. These assets are called options, and the present value of the expected cash flows on these assets will understate their true value. In this section, we will describe the cash flow characteristics of options, consider the factors that determine their value and examine how best to value them.

Cash Flows on Options

There are two types of options. A call option gives the buyer of the option the right to buy the underlying asset at a fixed price, whereas a put option gives the buyer the right to sell the underlying asset at a fixed price. In both cases, the fixed price at which the underlying asset can be bought or sold is called the strike or exercise price. To look at the payoffs on an option, consider first the case of a call option. When you buy the right to sell an asset at a fixed price, you want the price of the asset to increase above that fixed price. If it does, you make a profit, since you can buy at the fixed price and then sell at the much higher price; this profit has to be netted against the cost initially paid for the option. However, if the price of the asset decreases below the strike price, it does not make sense to exercise your right to buy the asset at a higher price. In this scenario, you lose what you originally paid for the option. Figure 1 summarizes the cash payoff at expiration to the buyer of a call option.

With a put option, you get the right to sell at a fixed price, and you want the price of the asset to decrease below the exercise price. If it does, you buy the asset at the exercise price and then sell it back at the current price, claiming the difference as a gross profit. When the initial cost of buying the option is netted against the gross profit, you arrive at an estimate of the net profit. If the value of the asset rises above the exercise price, you will not exercise the right to sell at a lower price. Instead, the option will be allowed to expire without being exercised, resulting in a net loss of the original price paid for the put option. Figure 2 summarizes the net payoff on buying a put option.

With both call and put options, the potential for profit to the buyer is significant, but the potential for loss is limited to the price paid for the option.

Determinants of Option Value

What is it that determines the value of an option? At one level, options have expected cash flows just like all other assets, and that may seem like good candidates for discounted cash flow valuation. The two key characteristics of options -- that they derive their value from some other traded asset, and the fact that their cash flows are contingent on the occurrence of a specific event -- does suggest an easier alternative. We can create a portfolio that has the same cash flows as the option being valued, by combining a position in the underlying asset with borrowing or lending. This portfolio is called a replicating portfolio and should cost the same amount as the option. The principle that two assets (the option and the replicating portfolio) with identical cash flows cannot sell at different prices is called the arbitrage principle. Options are assets that derive value from an underlying asset; increases in the value of the underlying asset will increase the value of the right to buy at a fixed price and reduce the value to sell that asset at a fixed price. On the other hand, increasing the strike price will reduce the value of calls and increase the value of puts. While calls and puts move in opposite directions when stock prices and strike prices are varied, they both increase in value as the life of the option and the variance in the underlying assets value increases. The reason for this is the fact that options have limited losses. Unlike traditional assets that tend to get less valuable as risk is increased, options become more valuable as the underlying asset becomes more volatile. This is so because the added variance cannot worsen the downside risk (you still cannot lose more than what you paid for the option) while making potential profits much higher. In addition, a longer life for the options just allows more time for both call and put options to appreciate in value. Since calls provide the right to buy the underlying asset at a fixed price, an increase in the value of the asset will increase the value of the calls. Puts, on the other hand, become less valuable as the value of the asset increase. The final two inputs that affect the value of the call and put options are the riskless interest rate and the expected dividends on the underlying asset. The buyers of call and put options usually pay the price of the option up front, and wait for the expiration day to exercise. There

is a present value effect associated with the fact that the promise to buy an asset for $ 1 million in 10 years is less onerous than paying it now. Thus, higher interest rates will generally increase the value of call options (by reducing the present value of the price on exercise) and decrease the value of put options (by decreasing the present value of the price received on exercise). The expected dividends paid by assets make them less valuable; thus, the call option on a stock that does not pay a dividend should be worth more than a call option on a stock that does pay a dividend. The reverse should be true for put options. A Simple Model for Valuing Options Almost all models developed to value options in the last three decades are based upon the notion of a replicating portfolio. The earliest derivation, by Black and Scholes, is mathematically complex, In this section; we consider the simplest replication model for valuing options the binomial model.

The Binomial Model

The binomial option pricing model is based upon a simple formulation for the asset price process in which the asset, in any time period, can move to one of two possible prices. The general formulation of a stock price process that follows the binomial is shown in Figure 3. Figure 3: General Formulation for Binomial Price Path

In this figure, S is the current stock price; the price moves up to Su with probability p and down to Sd with probability 1-p in any time period. For instance, if the stock price today is $ 100, u is 1.1 and d is 0.9, the stock price in the next period can either be $ 110 (if u is the outcome) and $ 90 (if d is the outcome).

Creating a Replicating Portfolio

The objective in creating a replicating portfolio is to use a combination of riskfree borrowing/lending and the underlying asset to create the same cash flows as the option being valued. In the case of the general formulation above, where stock prices can either move up to Su or down to Sd in any time period, the replicating portfolio for a call with a given strike price will involve borrowing $B and acquiring of the underlying asset. Of course, this formulation is of no use if we cannot determine how much we need to borrow and what s. i

There is a way, however, of identifying both variables. To do this, note that the value of this position has to be same as the value of the call no matter what the stock price does. Let us assume that the value of the call is Cu if the stock price goes to Su, and Cd if the stock price goes down to Sd. If we had borrowed $B and bought shares of stock with the money, the value of this position under the two scenarios would have been as follows:

Note that, in either case, we have to pay back the borrowing with interest. Since the position has to have the same cash flows as the call, we get Su - $ B (1+r) = Cu Sd - $ B (1+r) = Cd Solving for , We get = Number of units of the underlying asset bought = (Cu - Cd)/(Su - Sd) Where, Cu = Value of the call if the stock price is Su Cd = Value of the call if the stock price is Sd When there are multiple periods involved, we have to begin with the last period, where we know what the cash flows on the call will be, solve for the replicating portfolio and then estimate how much it would cost us to create this portfolio. We then use this value as the estimated value of the call and estimate the replicating portfolio in the previous period. We continue to do this until we get to the present. The replicating portfolio we obtain for the present can t be priced to yield a current value for the call. Value of the call = Current value of underlying asset * Option Delta - Borrowing needed to replicate the option

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An Example of Binomial valuation Assume that the objective is to value a call with a strike price of 50, which is expected to expire in two time periods, on an underlying asset whose price currently is 50 and is expected to follow a binomial process. Figure 4 illustrates the path of underlying asset prices and the value of the call (with a strike price of 50) at the expiration. Figure 4: Binomial Price Path

Note that since the call has a strike price of $ 50, the gross cash flows at expiration are as follows: If the stock price moves to $ 100: Cash flow on call = $ 100 - $ 50 = $ 50 If the stock price moves to $ 50: Cash flow on call = $ 50 - $ 50 = $ 0 If the stock price moves to $ 25: Cash flow on call = $ 0 (Option is not exercised). Now assume that the interest rate is 11%. In addition, define = Number of shares in the replicating portfolio B = Dollars of borrowing in replicating portfolio The objective, in this analysis, is to combine shares of stock and B dollars of borrowing to replicate the cash flows from the call with a strike price of $ 50.

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The first step in doing this is to start with the last period and work backwards. Consider, for instance, one possible outcome at t =1. The stock price has jumped to $ 70, and is poised to change again, either to $ 100 or $ 50. We know the cash flows on the call under either scenario, and we also have a replicating portfolio composed of shares of the underlying stock and $ B of borrowing. Writing out the cash flows on the replicating portfolio under both scenarios (stock price of $ 100 and $ 50), we get the replicating portfolios in figure 5: Figure 5: Replicating Portfolios when Price is $ 70

In other words, if the stock price is $70 at t=1, borrowing $45 and buying one share of the stock will give the same cash flows as buying the call. The value of the call at t=1, if the stock price is $70, should therefore be the cash flow associated with creating this replicating position and it can be estimated as follows: 70 - B = 70-45 = 25 The cost of creating this position is only $ 25, since $ 45 of the $ 70 is borrowed. This should also be the price of the call at t=1, if the stock price is $ 70. Consider now the other possible outcome at t=1, where the stock price is $ 35 and is poised to jump to either $ 50 or $ 25. Here again, the cash flows on the call can be estimated, as can the cash flows on the replicating portfolio composed of shares of stock and $B of borrowing. Figure 6 illustrates the replicating portfolio:

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Figure 6: Replicating Portfolio when Price is $ 35

Since the call is worth nothing, under either scenario, the replicating portfolio also is empty. The cash flow associated with creating this position is obviously zero, which becomes the value of the call at t=1, if the stock price is $ 35. We now have the value of the call under both outcomes at t=1; it is worth $ 25 if the stock price goes to $ 70 and $0 if it goes to $ 35. We now move back to today (t=0), and look at the cash flows on the replicating portfolio. Figure 7 summarizes the replicating portfolios as viewed from today: Figure 7: Replicating Portfolios for Call Value

Using the same process that we used in the previous step, we find that borrowing $22.5 and buying 5/7 of a share will provide the same cash flows as a call with a strike price of $50.

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The cost, to the investor, of borrowing $ 22.5 and buying 5/7 of a share at the current stock price of $ 50 yields: Cost of replicating position = 5/7 X $ 50 - $ 22.5 = $ 13.20 This should also be the value of the call.

More on the Determinants of Option Value The binomial model provides insight into the determinants of option value. The value of an option is determined not by the expected price of the asset but by its current price, which, of course, reflects expectations about the future. In fact, the probabilities that we provided in the description of the binomial process of up and down movements do not enter the option valuation process, though they do affect the underlying assets value. The reason for this is the fact that options derive their value from other assets, which are often traded. Consequently, the capacity investors possess to create positions that have the same cash flows as the call operates as a powerful mechanism controlling option prices. If the option value deviates from the value of the replicating portfolio, investors can create an arbitrage position, i.e., one that requires no investment, involves no risk, and delivers positive returns. The option value increases as the time to expiration is extended, as the price movements (u and d) increase, and as the interest rate increases. The second insight is that the greater the variance in prices in the underlying asset in this example, the more valuable the option becomes. Thus, increasing the up and down movements, in the illustration above, makes options more valuable. This occurs because of the fact that options do not have to be exercised if it is not in the holders best interests to do so. Thus, lowering the price in the worst case scenario to $ 10 from $ 25 does not, by itself, affect the gross cash flows on this call. On the other hand, increasing the price in the best case scenario to $ 150 from $ 100 benefits the call holder and makes the call more valuable.

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The binomial model is a useful model for illustrating the replicating portfolio and the effect of the different variables on call value. It is, however, a restrictive model, since asset prices in the real world seldom follow a binomial process. Even if they did, estimating all possible outcomes and drawing a binomial tree, as we have, can be an extraordinarily tedious exercise.

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The Black & Scholes Model

The Black and Scholes Option Pricing Model didn't appear overnight, in fact, Fisher Black started out working to create a valuation model for stock warrants. This work involved calculating a derivative to measure how the discount rate of a warrant varies with time and stock price. The result of this calculation held a striking resemblance to a well-known heat transfer equation. Soon after this discovery, Myron Scholes joined Black and the result of their work is a startlingly accurate option pricing model. Black and Scholes can't take all credit for their work, in fact their model is actually an improved version of a previous model developed by A. James Boness in his Ph.D. dissertation at the University of Chicago. Black and Scholes' improvements on the Boness model come in the form of a proof that the riskfree interest rate is the correct discount factor, and with the absence of assumptions regarding investor's risk preferences.

In order to understand the model itself, we divide it into two parts. The first part, SN(d1), derives the expected benefit from acquiring a stock outright. This is found by multiplying stock price [S] by the change in the call premium with respect to a change in the underlying 16

stock price [N(d1)]. The second part of the model, Ke(-rt)N(d2), gives the present value of paying the exercise price on the expiration day. The fair market value of the call option is then calculated by taking the difference between these two parts. Assumptions of the Black and Scholes Model: 1) The stock pays no dividends during the option's life Most companies pay dividends to their share holders, so this might seem a serious limitation to the model considering the observation that higher dividend yields elicit lower call premiums. A common way of adjusting the model for this situation is to subtract the discounted value of a future dividend from the stock price. 2) European exercise terms are used European exercise terms dictate that the option can only be exercised on the expiration date. American exercise term allow the option to be exercised at any time during the life of the option, making american options more valuable due to their greater flexibility. This limitation is not a major concern because very few calls are ever exercised before the last few days of their life. This is true because when you exercise a call early, you forfeit the remaining time value on the call and collect the intrinsic value. Towards the end of the life of a call, the remaining time value is very small, but the intrinsic value is the same. 3) Markets are efficient This assumption suggests that people cannot consistently predict the direction of the market or an individual stock. The market operates continuously with share prices following a continuous It process. To understand what a continuous It process is, you must first know that a Markov process is "one where the observation in time period t depends only on the preceding observation." An It process is simply a Markov process in continuous time. If you were to draw a continuous process you would do so without picking the pen up from the piece of paper.

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4) No commissions are charged Usually market participants do have to pay a commission to buy or sell options. Even floor traders pay some kind of fee, but it is usually very small. The fees that Individual investor's pay is more substantial and can often distort the output of the model. 5) Interest rates remain constant and known The Black and Scholes model uses the risk-free rate to represent this constant and known rate. In reality there is no such thing as the risk-free rate, but the discount rate on U.S. Government Treasury Bills with 30 days left until maturity is usually used to represent it. During periods of rapidly changing interest rates, these 30 day rates are often subject to change, thereby violating one of the assumptions of the model. 6) Returns are log normally distributed This assumption suggests, returns on the underlying stock are normally distributed, which is reasonable for most assets that offer options.

Term Used In Black and Scholes Model:

Delta:

Delta is a measure of the sensitivity the calculated option value has to small changes in the share price. Gamma:

Gamma is a measure of the calculated delta's sensitivity to small changes in share price. Theta: 18

Theta measures the calcualted option value's sensitivity to small changes in time till maturity. Vega:

Vega measures the calculated option value's sensitivity to small changes in volatility. Rho:

The work done by Black & Scholes in the 70's made way for further pricing of derivatives and in particular, exotic options. The Black-Scholes partial differential equation also enabled derivation of the 'Greeks of option pricing. The Black-Scholes model today is used in everyday pricing of options and futures and almost all formulas for pricing of exotic options such as barriers, compounds and Asian options take their foundation from the Black-Scholes model.

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Graphs of the Black and Scholes Model:

This following graphs show the relationship between a call's premium and the underlying stock's price. The first graph identifies the Intrinsic Value, Speculative Value, Maximum Value, and the Actual premium for a call.

The following 5 graphs show the impact of diminishing time remaining on a call with: S = $48 E = $50 r = 6% sigma = 40% Graph # 1, t = 3 months Graph # 2, t = 2 months Graph # 3, t = 1 month Graph # 4, t = .5 months Graph # 5, t = .25 months

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Graph #1

Graph #2

Graph #3

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Graph #4

Graph #5

Graphs # 6 - 9, show the effects of a changing Sigma on the relationship between Call premium and Security Price
S = $48 E = $50 r = 6% sigma = 40% Graph # 6, sigma = 80% Graph # 7, sigma = 40% Graph # 8, sigma = 20% Graph # 9, sigma = 10%

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Graph #6

Graph #7

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Graph #8

Graph #9

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S&P CNX Nifty Options

An option gives a person the right but not the obligation to buy or sell something. An option is a contract between two parties wherein the buyer receives a privilege for which he pays a fee (premium) and the seller accepts an obligation for which he receives a fee. The premium is the price negotiated and set when the option is bought or sold. A person who buys an option is said to be long in the option. A person who sells (or writes) an option is said to be short n the option. NSE introduced trading in index options on June 4, 2001. The options contracts are European style and cash settled and are based on the popular market benchmark S&P CNX Nifty index.

Contract Specifications
Security descriptor The security descriptor for the S&P CNX Nifty options contracts is: Market type: N Instrument Type: OPTIDX Underlying: NIFTY Expiry date: Date of contract expiry Option Type: CE/ PE Strike Price: Strike price for the contract Instrument type represents the instrument i.e. Options on Index. Underlying symbol denotes the underlying index, which is S&P CNX Nifty Expiry date identifies the date of expiry of the contract Option type identifies whether it is a call or a put option, CE - Call European, PE Put European

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Underlying Instrument The underlying index is S&P CNX NIFTY. Trading cycle S&P CNX Nifty options contracts have a maximum of 3-month trading cycle - the near month (one), the next month (two) and the far month (three). On expiry of the near month contract, new contracts are introduced at new strike prices for both call and put options, on the trading day following the expiry of the near month contract. The new contracts are introduced for three month duration. Expiry day

S&P CNX Nifty options contracts expire on the last Thursday of the expiry month. If the last Thursday is a trading holiday, the contracts expire on the previous trading day. Strike Price Intervals The number of contracts provided in options on NIFTY is related to the range in which previous days closing value of NIFTY falls as per the following table:

NIFTY Index Level upto 1500 >1500 upto 2000 >2000 upto 2500 >2500

Strike Interval 10 10 10 10

Scheme of strikes to be introduced (ITM-ATM-OTM) 3-1-3 5-1-5 7-1-7 9-1-9

New contracts with new strike prices for existing expiration date are introduced for trading on the next working day based on the previous day's close Nifty values, as and when

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required. In order to decide upon the at-the-money strike price, the Nifty closing value is rounded off to the nearest 10. The in-the-money strike price and the out-of-the-money strike price are based on the at-the-money strike price interval. Trading Parameters Contract size The value of the option contracts on Nifty may not be less than Rs. 2 lakhs at the time of introduction. The permitted lot size for futures contracts & options contracts shall be the same for a given underlying or such lot size as may be stipulated by the Exchange from time to time. Price steps The price step in respect of S&P CNX Nifty options contracts is Re.0.05. Base Prices Base price of the options contracts, on introduction of new contracts, would be the theoretical value of the options contract arrived at based on Black-Scholes model of calculation of options premiums. The options price for a Call, computed as per the following Black Scholes formula: C = S * N (d1) - X * e- rt * N (d2) and The price for a Put is: P = X * e- rt * N (-d2) - S * N (-d1) Where: d1 = [ln (S / X) + (r + 2 / 2) * t] / * sqrt(t)

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d2 = [ln (S / X) + (r - 2 / 2) * t] / * sqrt(t) = d1 - * sqrt(t) C = price of a call option P = price of a put option S = price of the underlying asset X = Strike price of the option r = rate of interest t = time to expiration = volatility of the underlying N represents a standard normal distribution with mean = 0 and standard deviation = 1 ln represents the natural logarithm of a number. Natural logarithms are based on the constant e. Rate of interest may be the relevant MIBOR rate or such other rate as may be specified. The base price of the contracts on subsequent trading days will be the daily close price of the options contracts. The closing price shall be calculated as follows:
If the contract is traded in the last half an hour, the closing price shall be the last half an hour weighted average price. If the contract is not traded in the last half an hour, but traded during any time of the day, then the closing price will be the last traded price (LTP) of the contract.

If the contract is not traded for the day, the base price of the contract for the next trading day shall be the theoretical price of the options contract arrived at based on Black-Scholes model of calculation of options premiums.

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Price bands
There are no day minimum/maximum price ranges applicable for options contracts. However, in order to prevent erroneous order entry, operating ranges and day minimum/maximum ranges for options contract are kept at 99% of the base price. In view of this, members will not be able to place orders at prices which are beyond 99% of the base price. Members desiring to place orders in option contracts beyond the day min-max range would be required to send a request to the Exchange. The base prices for option contracts may be modified, at the discretion of the Exchange, based on the request received from trading members.

Quantity freeze Order which may come to the exchange as a quantity freeze shall be based on the notional value of the contract of around Rs. 5 crores. In respect of orders which have come under quantity freeze, members would be required to confirm to the Exchange that there is no inadvertent error in the order entry and that the order is genuine. On such confirmation, the Exchange may approve such order. However, in exceptional cases, the Exchange may, at its discretion, not allow the orders that have come under quantity freeze for execution for any reason whatsoever including non-availability of turnover / exposure limits

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Order type/Order book/Order attributes Regular lot order Stop loss order Immediate or cancel Spread order

Option Prices Based on Historical Volatility

As on 17th Oct' 05 Current Index Value = 2485.15 Strike Price = 2400 Risk free rate = 6.70% Historical Volatility = 16% Expire on 27th Oct' 05

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Index Analysis
Index 2,323.7 3 2,336.4 4 2,349.1 5 2,361.8 6 2,374.5 8 2,387.2 9 2,400.0 0 2,412.7 1 2,425.4 2 2,438.1 4 2,450.8 5 2,463.5 6 2,476.2 7 Option Price 3.879 5.799 8.394 11.784 16.07 21.328 27.594 34.869 43.11 52.243 62.168 72.771 83.932 Time Value 3.879 5.799 8.394 11.784 16.07 21.328 27.594 22.157 17.686 14.107 11.32 9.211 7.66 Snapshot Price Delta Gamma Theta Vega Rho Elasticity Position Probability of closing ITM Calls 91.996 0.919 0.002 -0.888 0.653 0.601 24.83 ITM 91.50% Puts 2.445 -0.081 0.002 -0.448 0.653 -0.055 -82.25 OTM 8.50%

Call Option Price & Time Value by Index

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Strike Price = 2400 Index Analysis Index Option Price Time Value 2,267.89 7.118 7.118 2,289.91 10.697 10.697 2,311.93 15.524 15.524 2,333.95 21.803 21.803 2,355.96 29.698 29.698 2,377.98 39.317 39.317 2,400.00 50.7 50.7 2,422.02 63.817 41.799 2,444.04 78.571 34.535 2,466.05 94.813 28.759 2,488.07 112.359 24.288 2,510.09 131.006 20.917 2,532.11 150.551 18.444 Call Option Price & Time Value by Index

Expire on 24th Nov' 05

Snapshot Price Delta Gamma Theta Vega Rho Elasticity Position Probability of closing ITM

Calls 109.963 0.817 0.002 -0.859 1.934 1.582 18.46 ITM 80.40%

Puts 11.633 -0.183 0.002 -0.421 1.934 -0.379 -39.15 OTM 19.60%

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Strike Price = 2500 Index Analysis Index Option Price Time Value 2,420.5 4.041 4.041 5 2,433.7 6.041 6.041 9 2,447.0 8.744 8.744 3 2,460.2 7 12.275 12.275 2,473.5 2 16.74 16.74 2,486.7 6 22.216 22.216 2,500.0 0 28.744 28.744 2,513.2 4 36.322 23.08 2,526.4 8 44.906 18.423 2,539.7 3 54.42 14.695 2,552.9 7 64.759 11.792 2,566.2 1 75.803 9.595 2,579.4 5 87.429 7.979

Expire on 27th Oct' 05

Snapshot Price Delta Gamma Theta Vega Rho Elasticity Position Probability of closing ITM

Calls 21.495 0.443 0.006 -1.529 1.626 0.297 51.26 OTM 43.30 %

Puts 31.76 -0.557 0.006 -1.071 1.626 -0.386 -43.55 ITM 56.70%

Call Option Price & Time Value by Index

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Strike Price = 2500 Index Analysis Index Option Price Time Value 2,362.3 7.415 7.415 9 2,385.3 11.143 11.143 2 2,408.2 16.171 16.171 6 2,431.1 22.712 22.712 9 2,454.1 30.935 30.935 3 2,477.0 6 40.955 40.955 2,500.0 0 52.813 52.813 2,522.9 4 66.476 43.54 2,545.8 7 81.844 35.974 2,568.8 1 98.763 29.958 2,591.7 4 117.041 25.299 2,614.6 8 136.465 21.788 2,637.6 1 156.824 19.212

Expire on 24th Nov' 05

Snapshot Price Delta Gamma Theta Vega Rho Elasticity Position Probability of closing ITM

Calls 44.926 0.505 0.003 -0.986 2.842 1.002 27.95 OTM 48.70%

Puts 46.047 -0.495 0.003 -0.53 2.842 -1.041 -26.7 ITM 51.30%

Call Option Price & Time Value by Index

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Strike Price = 2600 Index Analysis Index Option Price Time Value 2,517.3 4.202 4.202 7 2,531.1 6.282 6.282 4 2,544.9 9.093 9.093 1 2,558.6 12.765 12.765 9 2,572.4 17.409 17.409 6 2,586.2 3 23.105 23.105 2,600.0 0 29.894 29.894 2,613.7 7 37.774 24.003 2,627.5 4 46.702 19.16 2,641.3 1 56.596 15.282 2,655.0 9 67.349 12.264 2,668.8 6 78.835 9.979 2,682.6 3 90.926 8.298

Expire on 27th Oct' 05

Snapshot Price Delta Gamma Theta Vega Rho Elasticity Position Probability of closing ITM

Calls 1.433 0.052 0.002 0.355 0.476 0.036 90.62 OTM 4.90 %

Puts 111.515 -0.948 0.002 0.121 0.476 -0.675 -21.12 ITM 95.10%

Call Option Price & Time Value by Index

35

Strike Price = 2600 Index Analysis Index Option Price Time Value 2,456.8 7.711 7.711 8 2,480.7 11.589 11.589 4 2,504.5 16.818 16.818 9 2,528.4 23.62 23.62 4 2,552.2 9 32.173 32.173 2,576.1 5 42.593 42.593 2,600.0 0 54.925 54.925 2,623.8 5 69.135 45.282 2,647.7 1 85.118 37.413 2,671.5 6 102.714 31.156 2,695.4 1 121.722 26.311 2,719.2 6 141.923 22.66 2,743.1 2 163.097 19.98

Expire on 24th Nov' 05

Snapshot Price Delta Gamma Theta Vega Rho Elasticity Position Probability of closing ITM

Calls 12.447 0.2 0.002 -0.62 2.039 0.403 39.91 OTM 18.70%

Puts 113.019 -0.8 0.002 -0.145 2.039 -1.721 -17.59 ITM 81.30%

Call Option Price & Time Value by Index

36

Strike Price = 2600 Index Analysis Index Option Price Time Value 2,415.2 10.34 10.34 4 2,446.0 15.598 15.598 3 2,476.8 3 22.679 22.679 2,507.6 2 31.863 31.863 2,538.4 1 43.366 43.366 2,569.2 1 57.316 57.316 2,600.0 0 73.744 73.744 2,630.7 9 92.581 61.787 2,661.5 9 113.668 52.08 2,692.3 8 136.779 44.398 2,723.1 7 161.648 38.473 2,753.9 7 187.988 34.02 2,784.7 6 215.519 30.757

Expire on 29th Dec' 05

Snapshot Price Delta Gamma Theta Vega Rho Elasticity Position Probability of closing ITM

Calls 24.944 0.282 0.002 -0.621 3.138 0.937 28.05 OTM 26.20%

Puts 116.04 -0.718 0.002 -0.148 3.138 -2.59 -15.39 ITM 73.80%

Call Option Price & Time Value by Index

37

Strike Price = 2700 Index Analysis Index Option Price Time Value 2,551.3 8.008 8.008 8 2,576.1 12.034 12.034 5 2,600.9 17.465 17.465 2 2,625.6 24.528 24.528 9 2,650.4 6 33.41 33.41 2,675.2 3 44.232 44.232 2,700.0 0 57.038 57.038 2,724.7 7 71.794 47.024 2,749.5 4 88.392 38.852 2,774.3 1 106.665 32.354 2,799.0 8 126.404 27.323 2,823.8 5 147.382 23.531 2,848.6 2 169.37 20.749

Expire on 24th Nov' 05

Snapshot Price Delta Gamma Theta Vega Rho Elasticity Position Probability of closing ITM

Calls 2.233 0.048 0.001 -0.207 0.774 0.098 53.41 OTM 4.40%

Puts 202.255 -0.952 0.001 0.286 0.774 -2.108 -11.7 ITM 95.60%

Call Option Price & Time Value by Index

38

Strike Price = 2700 Index Analysis Index Option Price Time Value 2,508.1 10.737 10.737 3 2,540.1 16.198 16.198 1 2,572.0 23.551 23.551 9 2,604.0 7 33.089 33.089 2,636.0 4 45.033 45.033 2,668.0 2 59.521 59.521 2,700.0 0 76.581 76.581 2,731.9 8 96.142 64.164 2,763.9 6 118.039 54.083 2,795.9 3 142.04 46.106 2,827.9 1 167.865 39.953 2,859.8 9 195.218 35.328 2,891.8 7 223.808 31.94

Expire on 29th Dec' 05

Snapshot Price Delta Gamma Theta Vega Rho Elasticity Position Probability of closing ITM

Calls 7.799 0.112 0.001 -0.328 1.835 0.378 35.71 OTM 10.10%

Puts 197.982 -0.888 0.001 0.163 1.835 -3.284 -11.15 ITM 89.90%

Call Option Price & Time Value by Index

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Implied Volatility
The Implied Volatility study uses the value of options on an underlying instrument to estimate the underlying instrument's volatility. To calculate the implied volatility you need to know the following information:

The price of the underlying instrument The market price of an option The strike price of an option The expiration date of an option The interest rate, if applicable

Finding out the Value of Call Option based on Implied Volatility Implied Volatility % 24.00 18.68 24.99

Strike Price 2400.00 2400.00 2500.00

Expiry Month Oct Nov Oct

Market Price of Call Options Rs. 98.75 115.00 36.10

Value of Call Option based on IV Rs. 102.07 134.10 39.40

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2500.00 2600.00 2600.00 2600.00 2700.00 2700.00

Nov Oct Nov Dec Nov Dec

69.70 10.55 37.55 80.00 18.45 41.00 27.01

24.79 27.53 26.86 32.24 28.03 29.26

76.00 10.00 37.94 61.55 16.60 34.34

Implied Volatility %

Implied Volatility is arrived based on the formula given below used in Excel Sheet:

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Analysis
Using the Black-Scholes formula with the option price known from market data, it is possible to solve for if all other parameters are known. bisection method or the Newton-Raphson method can be used. The implied volatility seems to be more closely related to the option strike price than the time to maturity. This illustrates the phenomenon of the volatility smile seen in market pricing of options. For the three option contracts with strike price of 2600 we take the average volatility. Linear interpolation is used for strike prices between those of the market priced options. It appears that estimates of based on historical data may be less appropriate for use in the option pricing formula when the strike price is significantly different from the current stock price. On the other hand, implied volatility values become suspect when extrapolating beyond the range of strike prices currently being traded in the market. Correct volatility values are likely to lie somewhere between the two. It is observed that the implied volatility of the option is rarely equal to and often persistently higher than the historical volatility of the underlying asset. And the implied volatilities differ significantly among options on the same underlying asset with different striking prices and expirations, which are often described as volatility smile, volatility smirk and volatility term structure. This discrepancy in the implied volatilities among the options on the same underlying asset is theoretically a risk less arbitrage opportunity. Since the volatility smile has been persistent with respect to all the solutions arrived from the BlackScholes PDE, it is conclusive that the option market is inefficient. The discrepancy is less in short term options to that of long term options. So, we can consider the Black-Scholes model as one of the viable models in arriving option prices, beyond market imperfection. In estimating the implied volatility, the solution is done by approximation. Trial and error in the spreadsheet, the

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CONCLUSION
The use of the Black-Scholes formula is pervasive in the markets. In fact the model has become such an integral part of market conventions that it is common practice for the implied volatility rather than the price of an instrument to be quoted. (All the parameters in the model other than the volatility - that is the time to maturity, the strike, the risk-free rate, and the current underlying price - are unequivocally observable. This means there is one-toone relationship between the option price and the volatility.) Traders prefer to think in terms of volatility as it allows them to evaluate and compare options of different maturities, strikes, and so on. It is observed from the calculations that the implied volatility of the option is rarely equal to and often persistently higher than the historical volatility of the underlying asset. And the implied volatilities differ significantly among options on the same underlying asset with different striking prices and expirations, which are often described as volatility smile, volatility smirk and volatility term structure. This discrepancy in the implied volatilities among the options on the same underlying asset is theoretically a risk less arbitrage opportunity. Since the volatility smile has been persistent with respect to all the solutions arrived from the Black-Scholes PDE, it is conclusive that the option market is inefficient. So, we can consider the Black-Scholes model as one of the viable models in arriving option prices, beyond market imperfection.

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REFERENCES

1. Black-Scholes Model is Right, Option Market is Inefficient: A Robust

Proof, by Chen Guo, Division of Banking & Finance, Nayang Business School, NTU pdf file

2. A power point presentation file on Option Pricing and Implied

Volatility from www.utstat.toronto.edu/pub/sam2/brov4.ppt

3. A power point presentation files on Options Pricing by Charles J

CORRADO and Bradlord D JORDAN.

4. Option Volatility & Pricing by Sheldon Natenberg

5.

www.hoadley.net

6. www.cboe.com

7. www.nseindia.com

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