PRICING OF OPTIONS

CHAPTER 13

BINOMIAL TREES
A Simple Binomial Model

A stock price is currently $20

In 3 months it will be either $22 or $18

Stock Price = $22

Stock price = $20
Stock Price = $18
A Call Option
A 3-month call option on the stock has a strike
price of 21.

Stock Price = $22

Option Price = $1
Stock price = $20
Option Price=?
Stock Price = $18
Option Price = $0
Setting Up a Riskless Portfolio
For a portfolio that is long D shares and a
short 1 call option values are

22D – 1

18D

Portfolio is riskless when 22D – 1 = 18D

or D = 0.25
Valuing the Portfolio (Risk-Free Rate is 12%)
The riskless portfolio is:
long 0.25 shares
short 1 call option
The value of the portfolio in 3 months is
22 ×0.25 – 1 = 4.50, (or 18 x 0.25 = 4.50)
The value of the portfolio today is
4.5e–0.12×0.25 = 4.3670
Valuing the Option
The portfolio that is
long 0.25 shares
short 1 option
is worth 4.367
The value of the shares is
5.000 (= 0.25 × 20 )
The value of the option is therefore
0.633 ( as 5.000 – 0.633 = 4.367 )
Generalization
A derivative lasts for time T and is dependent
on a stock
S0u
ƒu
S0
ƒ
S0d
ƒd
Generalization (continued)
Value of a portfolio that is long D shares and short 1
derivative: S uD – ƒ
0 u

S0dD – ƒd

The portfolio is riskless when S0uD – ƒu = S0dD – ƒd or

ƒu − f d
D=
S 0u − S 0 d
Generalization (continued)

Value of the portfolio at time T is S0uD – ƒu

Value of the portfolio today is (S0uD – ƒu)e–rT
Another expression for the portfolio value
today is S0D – f
Hence
S0D – f= (S0uD – ƒu)e–rT

ƒ = S0D – (S0uD – ƒu )e–rT

Generalization (continued)

Substituting for D we obtain

ƒ = [ pƒu + (1 – p)ƒd ]e–rT

where
e rT − d
p=
u−d
p as a Probability
It is natural to interpret p and 1-p as probabilities of up
and down movements
The value of a derivative is then its expected payoff in
a risk-neutral world discounted at the risk-free rate
S0u
ƒu
S0
ƒ
S0d
ƒd
Risk-Neutral Valuation
When the probability of an up and down movements
are p and 1-p the expected stock price at time T is S0erT
This shows that the stock price earns the risk-free rate
Binomial trees illustrate the general result that to value
a derivative we can assume that the expected return on
the underlying asset is the risk-free rate and discount at
the risk-free rate
This is known as using risk-neutral valuation
Risk-Neutral Probability
Original Example Revisited
S0u = 22
ƒu = 1
S0=20
ƒ
S0d = 18
ƒd = 0

p is the probability that gives a return on the stock equal to the

risk-free rate:
20e 0.12 ×0.25 = 22p + 18(1 – p ) so that p = 0.6523
Alternatively:
e rT − d e 0.120.25 − 0.9
p= = = 0.6523
u−d 1.1 − 0.9
Valuing the Option Using Risk-Neutral
Valuation
S0u = 22
ƒu = 1
S0=20
ƒ
S0d = 18
ƒd = 0

The value of the option is

e–0.12×0.25 (0.6523×1 + 0.3477×0)
= 0.633
Irrelevance of Stock’s Expected Return

When we are valuing an option in terms of the price

of the underlying asset, the probability of up and
down movements in the real world are irrelevant

This is an example of a more general result stating

that the expected return on the underlying asset in
the real world is irrelevant
A Two-Step Example
24.2
22

20 19.8

18
16.2
K=21, r = 12%
Each time step is 3 months
Valuing a Call Option
24.2
3.2
22
B
20 2.0257 19.8
1.2823 A 0.0
18

0.0 16.2
0.0
Value at node B
= e–0.12×0.25(0.6523×3.2 + 0.3477×0) = 2.0257
Value at node A
= e–0.12×0.25(0.6523×2.0257 + 0.3477×0) = 1.2823
A Put Option Example
72
0
60
50 1.4147 48
4.1923 4
40
9.4636 32
20

K = 52, time step =1yr

r = 5%, u =1.2, d = 0.8, p = 0.6282
What Happens When the Put
Option is American
72
0
60

50 1.4147 48
5.0894 4
40
The American feature C
increases the value at node 12.0 32
C from 9.4636 to 12.0000. 20

This increases the value of

the option from 4.1923 to
5.0894.
Delta
Delta (D) is the ratio of the change in the
price of a stock option to the change in
the price of the underlying stock

The value of D varies from node to node

Different Delta
24.2
3.2
22
B
20 2.0257 19.8
1.2823 A 0.0
18

0.0 16.2
0.0
Choosing u and d
One way of matching the volatility is to set

u = es Dt

d = 1 u = e −s Dt

where s is the volatility and Dt is the length of

the time step. This is the approach used by
Cox, Ross, and Rubinstein (1979)
Girsanov’s Theorem
Volatility is the same in the real world and the
risk-neutral world

We can therefore measure volatility in the

real world and use it to build a tree for the
asset in the risk-neutral world
Assets Other than Non-Dividend
Paying Stocks
For options on stock indices, currencies and
futures the basic procedure for constructing
the tree is the same except for the calculation
of p
The Probability of an Up Move
a−d
p=
u−d

a = e rDt for a nondividen d paying stock

a = e ( r − q ) Dt for a stock index wher e q is the dividend

yield on the index

( r − r ) Dt
a=e f for a currency w here r f is the foreign
risk - free rate

a = 1 for a futures contract

 CHAPTER 15

THE BLACK-SCHOLES-
MERTON MODEL
The Stock Price Assumption
Consider a stock whose price is S
In a short period of time of length Dt, the
return on the stock is normally distributed:
DS
S
(
  mDt, s 2 Dt )
where m is expected return on stock per
year and s is volatility of the stock per year
The Lognormal Property
It follows from this assumption that
 s2  
ln S T − ln S 0    m − T , s T 
2

 2  
or
  s2  

ln S T    ln S 0 +  m −  T, s T
2

  2  

Since the logarithm of ST is normal, ST is

lognormally distributed
The Lognormal Distribution

E ( ST ) = S0 e mT
2 2 mT s2T
var ( ST ) = S0 e (e − 1)
Continuously Compounded Return

If x is the realized continuously compounded

return
S T = S 0 e xT
1 ST
x = ln
T S0
 s2 s2 
x    m − , 

 2 T 
The Expected Return
The expected value of the stock price is S0emT
The expected return on the stock is
m – s 2/2 not m
m is the expected return in a very short time, Dt, expressed
with a compounding frequency of Dt

m −s2/2 is the expected return in a long period of time

expressed with continuous compounding (or, to a good
approximation, with a compounding frequency of Dt)
Mutual Fund Returns (Business Snapshot 15.1)
Suppose that returns in successive years are 15%,
20%, 30%, −20% and 25% (ann. comp.)
The arithmetic mean of the returns is 14%
The return that would actually be earned over the five
years (the geometric mean) is 12.4% (ann. comp.)
The arithmetic mean of 14% is analogous to m
The geometric mean of 12.4% is analogous to m−s2/2
• $100 x 1.145 = $192.54
• Actually, $100x1.15x1.2x1.3x0.8x1.25 = $179.40
• $100 x (1+r)5 = $179.40 ➔ r = 12.4%
 The Volatility
The volatility is the standard deviation of the
continuously compounded rate of return in 1
year
The standard deviation of the return in a short
time period time Dt is approximately s Dt
If a stock price is $50 and its volatility is 25%
per year what is the standard deviation of the
price change in one day?
Standard normal distribution
Estimating Volatility from Historical Data

1. Take observations S0, S1, . . . , Sn at intervals of t

years (e.g. for weekly data t = 1/52)
2. Calculate the continuously compounded return in
each interval as:  Si 
u i = ln  
 S i −1 

3. Calculate the standard deviation, s , of the ui´s

s
4. The historical volatility estimate is: s =
ˆ
t
Example: Calculating Apple’s standard deviation
Nature of Volatility (Business Snapshot 15.2)
Volatility is usually much greater when the
market is open (i.e. the asset is trading) than
when it is closed
For this reason time is usually measured in
“trading days” not calendar days when
options are valued
It is assumed that there are 252 trading days
in one year for most assets
Example
Suppose it is April 1 and an option lasts to
April 30 so that the number of days remaining
is 30 calendar days or 22 trading days
The time to maturity would be assumed to be
22/252 = 0.0873 years
The Concepts Underlying Black-
Scholes-Merton
The option price and the stock price depend on the
same underlying source of uncertainty
We can form a portfolio consisting of the stock and
the option which eliminates this source of uncertainty
The portfolio is instantaneously riskless and must
instantaneously earn the risk-free rate
This leads to the Black-Scholes-Merton differential
equation
The Derivation of the Black-Scholes-
Merton Differential Equation
D S = mS D t + s S D z
 ƒ ƒ 2ƒ 2 2  ƒ
Dƒ =  mS + +½ s S  Dt +
 sS D z
 S t S S
2


W e set up a portfolio consisting of

− 1: derivative
ƒ
+ : shares
S
This gets rid of the dependence on Dz.
The Derivation of the Black-Scholes-Merton
Differential Equation continued

The value of the portfolio, , is given by

ƒ
 = −ƒ + S
S
The change in its value in tim e D t is given by
ƒ
D = − D ƒ + DS
S
The Derivation of the Black-Scholes-Merton
Differential Equation continued

The return on the portfolio must be the risk - free

rate. Hence
D = r Dt
f  f 
- Df + DS = r  − f + S  Dt
S  S 
W e substitute for Dƒ and DS in this equation
to get the Black - Scholes differenti al equation :
ƒ ƒ  2
ƒ
+ rS +½ σ S 2 2
= rƒ
t S S 2
The Differential Equation
Any security whose price is dependent on the
stock price satisfies the differential equation
The particular security being valued is
determined by the boundary conditions of the
differential equation
In a forward contract the boundary condition is
ƒ = S – K when t =T
The solution to the equation is
ƒ = S – K e–r (T –t)
The Black-Scholes-Merton
Formulas for Options
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 + s 2 / 2)T
where d1 =
s T
ln( S 0 / K ) + ( r − s 2 / 2)T
d2 = = d1 − s T
s T
The N(x) Function
N(x) is the probability that a normally distributed
variable with a mean of zero and a standard deviation
of 1 is less than x

See tables at the end of the book

Properties of Black-Scholes Formula

As S0 becomes very large c tends to S0 – Ke-rT

and p tends to zero

As S0 becomes very small c tends to zero and

p tends to Ke-rT – S0
Understanding Black-Scholes
c = e N (d )(S e N (d ) N (d ) − K )
− rT
2 0
rT
1 2

e − rT : Discount rate
N (d 2 ) : Probability of exercise
e rT N (d1 )/N (d 2 ) : Expected percentage increase in stock
price if option is exercised
K: Strike price paid if option is exercised
Risk-Neutral Valuation
The variable m does not appear in the Black-
Scholes-Merton differential equation
The equation is independent of all variables affected
by risk preference
The solution to the differential equation is therefore
the same in a risk-free world as it is in the real world
This leads to the principle of risk-neutral valuation
Applying Risk-Neutral Valuation

1. Assume that the expected return from the stock

price is the risk-free rate

2. Calculate the expected payoff from the option

3. Discount at the risk-free rate

Implied Volatility
The implied volatility of an option is the
volatility for which the Black-Scholes-Merton
price equals the market price
There is a one-to-one correspondence
between prices and implied volatilities
Traders and brokers often quote implied
volatilities rather than dollar prices
The VIX S&P500 Volatility Index

Chapter 26 explains how the index is calculated

Example:
Calculate the price of a three-month European
put option on a non-dividend-paying stock
with a strike price of $50 when the current
stock price is $50, the risk-free interest rate is
10% per annum, and the volatility is 30% per
annum.
𝑁 −0.2417
= 𝑁 −0.24 − 0.17 × 𝑁 −0.24 − 𝑁 −0.25
= 0.4052 − 0.17 × 0.4052 − 0.4013 = 0.4045

𝑁 −0.0917
= 𝑁 −0.09 − 0.17 × 𝑁 −0.09 − 𝑁 −0.10
= 0.4641 − 0.17 × 0.4641 − 0.4602 = 0.4634

56