Financial Management

Lecture 7: Option Valuation II

Professor Andrea Vedolin

ETH Zürich
 Today

Binomial Option Pricing Model: A Summary

Black-Scholes Option Pricing Model

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 Binomial Option Pricing Model: A Summary

The replicating portfolio (∆, B) is such that the payoffs of the portfolio are
equal to the payoffs of the option next period in any state:

∆ × Su + B × (1 + rf ) = Cu
∆ × Sd + B × (1 + rf ) = Cd

Solving this system of 2 equations in 2 unknowns yields:

Cu − Cd Cd − Sd ∆
∆= and B=
Su − Sd 1 + rf
Therefore, the option price in the binomial model is given by:

C =∆×S +B
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 Binomial Option Pricing Model: A Summary

In a multiperiod model:
any option can be perfectly replicated (at any point in time!) by
constructing and rebalancing over time a portfolio of only 2 assets:
I the underlying stock
I a risk-free bond
the resulting dynamic trading strategy is “self-financing” ⇒ after the
initial cost, no more money is need to rebalance the portfolio
the initial price of the option is equal to initial cost of the replicating portfolio:
C0 = ∆0 × S0 + B0
the price of the option at any point in time is equal to the value of the
replicating portfolio at that point in time:
Ct = ∆t × St + Bt
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 Black-Scholes Option Pricing Model

The Black-Scholes Option Pricing Model can be obtained by:

1. considering the Binomial Option Pricing Model

2. allowing the length of each period to shrink to zero
3. letting the number of periods grow infinitely large

What do we need to know to be able to use the B-S formula?

Stock price (today): St

Strike price (in future): K
Time to the expiration date: T − t
Risk-free interest rate (annualized): rf
Volatility of the stock return (annualized): σ

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 Black-Scholes Option Pricing Model

B-S Price of a European Call Option on a Non-Dividend-Paying Stock:

Ct = ∆t × St + Bt

where

∆t = N(d1 )
Bt = −PVt (K ) × N(d2 )

N(d) is the cumulative distribution function (CDF) of a standard normal

distribution: it represents the probability that an outcome from a standard normal
distribution will be below the value d. In the B-S formula:
√
 
ln PVSt (K
t
) σ T −t √
d1 = √ + , d2 = d1 − σ T − t
σ T −t 2

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 Black-Scholes Option Pricing Model
Standard Normal Distribution:

N(d) = cumulative distribution function (CDF)

N(d) = probability that an outcome will be below the value d
N(d) = area under the standard normal distribution to the left of the value d
N(d) = the shaded are in the figure
Since N(d) is a probability ⇒ 0 6 N(d) 6 1 for any value d
In Excel N(d) is calculated using the function NORMSDIST(d)

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 Black-Scholes Model: Example 1
JetBlue Airways does not pay dividends. Using the data in the Table below,
compare the price on July 24, 2009, for the December 2009 American call option
on JetBlue with a strike price go $6 to the price predicted by the Black-Scholes
formula. Assume that the volatility of JetBlue is 65% per year and that the
risk-free rate is 1% per year.

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 Black-Scholes Model: Example 1
Let’s first identify the input of the B-S formula:

JetBlue stock price: St = $5.03

Strike price of the call: K = $6
Time to the expiration date: there are 148 days left until expiration. Since
the unit of time is 1 year, T − t = 148/365 = 0.4055
Risk-free rate: rf = 1%
Volatility of the stock: σ = 65%

√ √
   
St 5.03
ln σ T −t ln 6/(1.01)
PVt (K ) 0.4055 0.65 0.4055
d1 = √ + = √ + = −0.209
σ T −t 2 0.65 0.4055 2

√ √
d2 = d1 − σ T − t = −0.209 − 0.65 0.4055 = −0.623

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 Black-Scholes Model: Example 1

Substituting d1 and d2 in the B-S formula:

Ct = N(d1 ) × St − PVt (K ) × N(d2 )

 
6
= N(−0.209) × 5.03 − × N(−0.623)
(1.01)0.4055
= 0.417 × 5.03 − 5.976 × 0.267
= $0.50

The Black-Scholes price for this option seems quite accurate since it is in between
the bid and the ask prices, $0.45 and $0.55, respectively. Given that there are no
dividends the Eurpean call option price from the Black-Scholes model fits well the
American option value for JetBlue on the CBOE.

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 Black-Scholes Model: Example 1

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 Black-Scholes Option Pricing Model

B-S Price of a European Put Option on a Non-Dividend-Paying Stock:

Using the Put-Call-Parity:

Pt = Ct + PVt (K ) − St
 
= N(d1 ) × St − PVt (K ) × N(d2 ) +PVt (K ) − St
| {z }
B-S price of a European call option

= PVt (K )[1 − N(d2 )] − St [1 − N(d1 )]

Therefore, Pt = ∆t × St + Bt , where

∆t = −[1 − N(d1 )]
Bt = PVt (K )[1 − N(d2 )]

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 Black-Scholes Option Pricing Model
B-S Price of a European Put Option on a Non-Dividend-Paying Stock:

Example: Black-Scholes Value on July 24, 2009 of the January 2010 $5.00
Put on JetBlue Stock

Note: the Time Value of the Put = (Price − Intrinsic Value) can be negative
if the strike price is high and the put option is sufficiently deep in-the-money

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 Dividend-Paying Stock
If PVt (Div ) is the present value of any dividends paid prior to the expiration
of the option, then Stx denotes the price of the stock excluding any dividends:

Stx = St − PVt (Div )

Special case: the stock will pay a dividend that is proportional to its stock
price at the time the dividend is paid. If q is the stock’s (compounded)
dividend yield until the expiration date, then:

Stx = St /(1 + q)

Because a European call option is the right to buy the stock without
receiving these dividends (between t and T ), its price can be computed by
using the Black-Scholes formula with Stx in place of St .
√ !
ln (Stx /PVt (K )) σ T − t  √ 
Ct = N √ + Stx − PVt (K )N d1 − σ T − t
σ T −t 2
| {z }
=d1

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 Implied Volatility
Of the five required inputs in the Black-Scholes formula, only σ is not
observable directly

Practitioners use two strategies to estimate the value of σ:

1. use historical data to compute historical volatility
2. use option prices to “back out” the implied volatility

Implied Volatility: the volatility of an asset’s returns that is consistent with the
quoted price of an option on the asset.

To “back out” the implied volatility, we would need to solve numerically the
following equation for σ:
√ !
ln (Stx /PVt (K )) σ T − t  √ 
Ct = N √ + Stx − PVt (K )N d1 − σ T − t
σ T −t 2
| {z }
=d1

In Excel you can use the SOLVER tool

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 Factors Affecting Option Prices
Call Price Ct Put Price Pt

Stock Price St + −

Strike Price K − +

Time to Expiration T − t + +

Risk-Free Rate rf + −

Stock Volatility σ + +

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 Risk-Neutral Probabilities
Interesting and clever way to use direct pricing instead of the replicating
portfolio strategy

The idea:

We pretend that we live in a risk-neutral world, that is a world in which we

(market participants) do not care about risk
Since we do not care about risk, the appropriate discount rate is always the
risk-free rate
In order to be able to do this (use always rf for any securities, projects...), we
need to change the probabilities of the possible states
expected value of future payoffs
computed with different probabilities
z }| {
E∗ t [Payoff OptionT ]
Price Optiont =
(1 + rf )T −t

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 Risk-Neutral Probabilities

How do we change the probabilities in order to use rf ?

We extract them from market prices of well-known risky securities:

Let π and ρ denote the real and the risk-neutral probabilities associated with
the state up, respectively. Then, the price of the stock today is given by

π × Su + (1 − π) × Sd ρ × Su + (1 − ρ) × Sd
S= ∗
=
(1 + r ) (1 + rf )
| {z } | {z }
we do not know either π or r ∗ we do not know only ρ

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 Risk-Neutral Probabilities
Therefore,

We solve for ρ the following linear equation:

S(1 + rf ) = ρ × Su + (1 − ρ) × Sd
⇓
S(1 + rf ) − Sd
ρ=
Su − Sd

The price of any options (actually any contingent claim!) can be

computed using the Direct Pricing where:

expected future cash flows are computed using the risk-neutral probability ρ
expected future cash flows are discounted using the risk-free rate rf

ρ × Cu + (1 − ρ) × Cd
C=
(1 + rf )

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 Risk-Neutral Valuation: Example 1
If probability is p = 75% to move up and risk premium is RP = 4%, then

p × Su + (1 − p) × Sd 0.75 × 60 + 0.25 × 40
S= = = 50
1 + rf + RP 1.06 + 0.04
For option valuation, we determine first the risk-neutral probability:

S(1 + rf ) − Sd 50(1.06) − 40
ρ= = = 0.65
Su − Sd 60 − 40
Second, we determine the expected present value using the risk-free rate rf

ρ × Cu + (1 − ρ) × Cd 0.65 × 10 + 0.35 × 0
C= = = 6.13
(1 + rf ) 1.06

Similarly, the put option value can be obtained as follows:

ρ × Pu + (1 − ρ) × Pd 0.65 × 0 + 0.35 × 10
P= = = 3.30
(1 + rf ) 1.06

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 Next Class...

Next week, we will begin the material on “Real Options”

If you like, read Chapter 22

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