P A R T V I Options, Futures, and Other Derivatives

Sometimes, it is easier to work with a put option valuation formula directly. If we sub
stitute the Black-Scholes formula for a call in Equation 21.2, we obtain the value of a European put option as

P = Xe−rT 1 − N(d2) − S01 − N(d1) (21.3)

Example 21.5 Black-Scholes Put Valuation

Using data from Example . (C = $., X = $, S

= $, r = ., σ = ., and

T = .), Equation . implies that a European put option on that stock with identical
exercise price and time to expiration is worth

$e−.× .( − .) − $( − .) = $.

Notice that this value is consistent with put-call parity:

P = C + PV(X) − S = . + e−.× . − = .

As we noted traders can do, we might then compare this formula value to the actual put price
as one step in formulating a trading strategy.

Dividends and Put Option Valuation

Equation 21.2 and Equation 21.3 are valid for European puts on non-dividend-paying stocks. As we did for call options, if the
underlying asset pays a dividend, we can find European put values by substituting S0 − PV(Div) for S0. Cell E7 in Spreadsheet
21.1 allows for a continuous dividend flow with a dividend yield of δ. In that case S0 −
PV(Div) = S0e−δT.
However, listed put options on stocks are American options that offer the opportunity of early exercise, and we have seen that
the right to exercise puts early can turn out to be valuable. This means that an American put option must be worth more than the
cor
responding European option. Therefore, Equation 21.2 and Equation 21.3 describe only the lower bound on the true value of the
American put. However, in many applications the approximation is very accurate.

21.5 Using the Black-Scholes Formula

Hedge Ratios and the Black-Scholes Formula
In Chapter 20, we considered two investments in FinCorp stock: 100 shares or 1,000 call options. We saw that the call option
position was more sensitive to swings in the stock price than was the all-stock position. To analyze the overall exposure to a
stock price more precisely, however, it is necessary to quantify these relative sensitivities. We can summa
rize the overall exposure of portfolios of options with various exercise prices and times to expiration using the hedge ratio, the
change in option price for a $1 increase in the stock price. A call option, therefore, has a positive hedge ratio and a put option a
negative hedge ratio. The hedge ratio is commonly called the option’s delta.
C H A P T E R Option Valuation
If you were to graph the option value as a
function of the stock value, as we have done
for a call option in Figure 21.9, the hedge
ratio is simply the slope of the curve evalu
ated at the current stock price. For 40
example,
C)
suppose the slope of the curve at S0 = $120 Value of a

Call (

equals .60. As the stock increases in value by

$1, the option increases by approximately
$.60, as the figure shows.
For every call option written, .60 Slope = 0.6
share of stock would be needed to
hedge the investor’s portfolio. If one
writes 10 options and holds six
S0
shares of stock, according to the
120
hedge ratio of .6, a $1 increase in
20 0
stock price will result in a gain of $6
on the stock holdings, whereas the
loss on the 10 options written will
be 10 × $.60, an equivalent $6. The
stock price

Figure 21.9 Call option value and hedge ratio

movement leaves total wealth unaltered, which
is what a hedged position is intended to do.
Black-Scholes hedge ratios are particularly
easy to compute. The hedge ratio for a call is N(d1), whereas the hedge ratio for a put is
N(d1) − 1. We defined N(d1) as part of the Black-Scholes formula in Equation 21.1. Recall
that N(d) stands for the area under the standard normal curve up to d. Therefore, the call
option hedge ratio must be positive and less than 1.0, whereas the put option hedge ratio
is negative and of smaller absolute value than 1.0.
Figure 21.9 verifies that the slope of the call option valuation function is less than 1.0,
approaching 1.0 only as the stock price becomes much greater than the exercise price.
This tells us that option values change less than one-for-one with changes in stock
prices. Why should this be? Suppose an option is so far in the money that you are
absolutely certain it will be exercised. In that case, every dollar increase in the stock price
would increase the option value by $1. But if there is a reasonable chance the call option
will expire out of the money, even after a moderate stock price gain, a $1 increase in the
stock price will not nec
essarily increase the ultimate payoff to the call; therefore, the call price will not respond
by a full dollar.
The fact that hedge ratios are less than 1.0 does not contradict our earlier observa tion
that options offer leverage and disproportionate sensitivity to stock price movements.
Although dollar movements in option prices are less than dollar movements in the stock
price, the rate of return volatility of options remains greater than stock return volatility
because options sell at lower prices. In our example, with the stock selling at $120, and a
hedge ratio of .6, an option with exercise price $120 may sell for $5. If the stock price
increases to $121, the call price would be expected to increase by only $.60, to $5.60.
The percentage increase in the option value is $.60/$5.00 = 12%, however, whereas the
stock price increase is only $1/$120 = .83%. The ratio of the percentage changes is
12%/.83% = 14.4. For every 1% increase in the stock price, the option price increases by
14.4%. This ratio, the percentage change in option price per percentage change in stock
price, is called the option elasticity.
The hedge ratio is an essential tool in portfolio management and control. An example
will show why.
 eXcel APPLICATIONS: Black-Scholes Option Valuation ABCD

EF GH I J

T he spreadsheet below can be used to determine option

of calls while the second workbook presents similar analysis for

values using the Black-Scholes model. The inputs are the
puts. You can find these spreadsheets in Connect or through
stock price, standard deviation, expiration of the your course instructor.
option, exer
cise price, risk-free rate, and dividend yield. The call option
is valued using Equation ., and the put is valued using
Excel Questions
Equation .. For both calls and puts, the dividend-adjusted
. Find the value of the call and put options using the
Black-Scholes formula substitutes Se−δT for S, as outlined in
parameters given in this box but changing the standard
Section .. The model also calculates the intrinsic and time
value for both puts and calls. deviation to .. What happens to the value of each option?
Further, the model presents sensitivity analysis using the
. What is implied volatility if the call option is selling for $?
one-way data table. The first workbook presents the analysis

K
LM
N

N(d2) 0.42314 0.30 7.61 0.300 7.61

Chapter - Black-Scholes Option Pricing LEGE 2 2

Call Valuation & Call Time Premiums Enter Black-Scholes call value $6.9999 0.33 8.31 0.325 8.31
2 7 7

Value ca Black-Scholes put value $8.8967 0.35 9.02 0.350 9.02

0 2 2
See co
0.38 9.72 0.375 9.72
6 6
Standard deviation (σ) 0.27830

0.40 10.42 0.400 10.42

Variance (annual, σ2) 0.07745 Call 9 9

Time to expiration (years, 0.50 Standar Optio Standar 0.43 11.13 0.425 11.13
T) d n d $0.0000 2 2
0

Risk-free rate (annual, r) 6.00% Deviati Value Deviatio

on n
Time value of call 6.99992 0.45 11.83 0.450 11.83
Current stock price (S0) $100.00 7.00 4 4
0
0.48 12.53 0.475 12.53
Exercise price (X) $105.00 0.15 3.38 0.150 6 6
8
Intrinsic value of put $5.00 0.50 13.23 0.500 13.23
Dividend yield (annual, δ) 0.00% 0.18 4.08 0.175 000 6 6
9
3.89670
0.20 4.79 0.200
2

d1 0.00290 0.23 5.49 0.225

95 7

d2 -0.1938 0.25 6.20 0.250

78 2

N(d1) 0.50116 0.28 6.90 0.275

7
 Example 21.6 Hedge Ratios
Consider two portfolios, one holding FinCorp calls and shares of FinCorp and the other holding
shares of FinCorp. Which portfolio has greater dollar exposure to FinCorp price movements? You
can answer this question easily by using the hedge ratio.
Each option changes in value by H dollars for each dollar change in stock price, where H
stands for the hedge ratio. Thus, if H equals ., the options are equivalent to . × = shares in terms of the
response of their market value to FinCorp stock price movements. The first portfolio has less dollar
sensitivity to stock price change because the share
equivalents of the options plus the shares actually held are less than the shares held in the
second portfolio.
This is not to say, however, that the first portfolio is less sensitive to the stock’s rate of return.
As we noted in discussing option elasticities, the first portfolio may have lower total value than the
second, so despite its lower sensitivity in terms of dollar value, it might have greater rate of return
sensitivity.