Scribd
Upload
36 views

DM9 Circulation

The document discusses valuation of options using option pricing models. It introduces key concepts like no arbitrage, risk neutral world used in option pricing. Historical models like binomial and Black-Scholes models are explained. Black-Scholes model uses geometric Brownian motion and risk neutral valuation to price options. The document also discusses Cox-Ross-Rubenstein binomial model and applications and complications of option pricing models.

Uploaded by

Naman Jain
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
36 views

DM9 Circulation

The document discusses valuation of options using option pricing models. It introduces key concepts like no arbitrage, risk neutral world used in option pricing. Historical models like binomial and Black-Scholes models are explained. Black-Scholes model uses geometric Brownian motion and risk neutral valuation to price options. The document also discusses Cox-Ross-Rubenstein binomial model and applications and complications of option pricing models.

Uploaded by

Naman Jain
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 60

VALUATION OF OPTIONS: OPTION

PRICING MODELS

12th August, 2020


Session 9
SESSION PLAN
▷ INTRODUCTION TO OPTION PRICING
INTUITIVE UNDERSTANDING

▷ CRITICAL CONCEPTS

▷ HISTORICAL BACKGROUND OPTION PRICING


▷ OPTION PRICING MODELS
NO ARBITRAGE
RISK NEUTRAL WORLD
COX, ROSS AND RUBENSTEIN 1979

▷ APPLICATIONS
▷ COMPLICATIONS
INTRODUCTION
FACTORS IN OPTION PRICE

1. THE CURRENT STOCK PRICE, S(0)


2. THE STRIKE PRICE, K
3. THE TIME TO EXPIRY, T
4. THE VOLATILITY OF THE STOCK PRICE, σ
5. THE RISK FREE RATE, r
6. THE DIVIDENDS THAT ARE EXPECTED TO BE
PAID DURING THE CONTRACT LIFE, d
EQUITY AS OPTIONS ?

▷ ARE STOCKS OPTIONS ?

EQUITY MAX [0,V-B]


V - B + MAX[ 0, B-V]

DEBT = MIN [V, B]


= B- MAX[ 0, B-V]

V = D +E
CRITICAL CONCEPTS
CONCEPTS
▷ BERNOULLI TRIAL: Y/N

DISCRETE PROBABILITY DISTRIBUTION OF A RANDOM


VARIABLE THAT 1 PROBABILTY P AND 0 WITH 1-P

▷ MARKOV PROCESS
STOCHASTIC PROCESS WHERE ONLY CURRENT VALUE IS
RELEVANT FOR PREDICTING THE FUTURE
CONCEPTS
▷ WIENER PROCESS

TYPE OF MARKOV WHEREIN MEAN CHANGE OF 0 AND VARIANCE


OF 1.0 PER YEAR. IN PHYSICS TO DESCRIBE THE MOTION OF A
PARTICLE THAT IS SUBJECT TO LARGE NO. OF SMALL
MOLECULAR SHOCKS ALSO BROWNIAN MOTION
FROM POLLEN GRAINS SUSPENDED IN WATER
CONCEPTS
▷ MARTINGALES

▷ In probability theory, a martingale is a sequence of random variables (i.e., a 


stochastic process) for which, at a particular time, the conditional expectation of the next
value in the sequence, given all prior values, is equal to the present value.

• An unbiased random walk (in any number of dimensions) is an


example of a martingale.

• A gambler's fortune (capital) is a martingale if all the betting


games which the gambler plays are fair. To be more specific:
suppose Xn is a gambler's fortune after n tosses of a fair coin,
where the gambler wins $1 if the coin comes up heads and loses
$1 if it's tails. The gambler's conditional expected fortune after
the next trial, given the history, is equal to their present fortune.
This sequence is thus a martingale.
LOGNORMAL PROPERTY
A BRIEF HISTORY OF OPTION
PRICING
HISTORICAL BACKGROUND
▷ EARLIEST MODELS OF ASSET PRICES
▷ NOTION OF “FAIR GAME”
▷ THE MARTINGALE

▷ CARDANO (c 1565) Liber De Ludo Aleae

The Most fundamental principle of all gambling is simply equal


conditions, e.g. of opponents, of bystanders, of money, of situations, of the dice
box and of the die itself. To the extent you depart from equality, if it is in your
opponent’s favour, you are a fool and if it is in your favour, you are unjust.

PRECURSOR TO THE RANDOM WALK


HISTORICAL BACKGROUND

▷ BASCHILIER WAS THE FIRST TO BRING HEAT


CONDUCTION TO OPTION PRICING AS PART OF
Ph.D THESIS IN 1900 AT PARIS IN FRANCE.
HISTORICAL BACKGROUND
▷ KRUEIZENGA (1956) MIT, SAMUELSON
“Put and Call Options: A Theoretical and Market Analysis

▷ SPRENKLE (1961) YALE, TOBIN


“Warrant Prices as indicators of Expectations and Preferences”
SUBSEQUENT PRICING ATTEMPTS
▷ SAMUELSON (1965)
“Rational Theory of Warrant Pricing”

▷ SAMUELSON AND MERTON (1969)


“A Complete Model of Warrant Pricing that Maximizes Utility”.

▷ BLACK AND SCHOLES (1973)


CONSTRUCT PORTFOLIO OF OPTION AND STOCK
ELIMINATE MARKET RISK
REMAINING RISK IS INCONSEQUENTIAL
EXPECTED RETURNS GIVEN BY CAPM
OPTION PRICING MODELS
“
▷ BLACK SCHOLES GIVES ME A BETTER METHOD OF VALUATION
THAN I WOULD OTHERWISE HAVE, BUT IT IS NOT GOD’S TRUTH.
IF WE TRY TO USE THE MODEL AS BOOKIES, WE’D GO BROKE. IT
IS LIKE SAYING THAT BECAUASE YOU HAVE JUST LEARNT IN
HIGH SCHOOL PHYSICS THAT THE ANGLE OF INCIDENCE
EQUALS THE ANGLE OF REFLECTION, YOU ARE READY TO GO TO
POOL HALL AND CHALLENGE LANNY THE LOCAL HUSTLER.
LENNY WILL CLEAN YOU OUT, EVEN THOUGH HE DOES’NT
KNOW WHAT PHYSICS IS”

▷ MYRON SCHOLES
MODELS

1. NO ARBITRAGE WORLD

2. RISK NEUTRAL WORLD

3. COX, ROSS AND RUBENSTEIN (1979)


NO ARBITRAGE WORLD: MODEL 1
ONE STEP BINOMIAL MODEL
▷ EXAMPLE 13.1

STOCK PRICE = Rs. 20


3 MONTHS HENCE = Rs. 18 or 22

C(0) = ??
S(0) = 20
STRIKE PRICE = 21

TWO SECURITIES (CALL AND STOCK) AND TWO POSSIBLE


OUTCOMES.
IT IS SETTING UP RISKLESS PORTFOLIO.

PORTFOLIO A: LONG POSITION IN Δ SHARES +


SHORT 1 CALL
ONE STEP BINOMIAL MODEL
▷ CALCULATE Δ THAT MAKES IT RISKLESS:
▷ TWO SITUATIONS UP AND DOWN
22 Δ - 1 = 18 Δ (CALL 0)
4Δ = 1
Δ = 0.25

LONG 0.25 SHARES AND SHORT 1 CALL OPTION

IRRESPECTIVE OF THE PRICE MOVEMENT THE VALUE OF


THE PORTFOLIO IS THE SAME THAT IS 4.50.
RISKLESS PORTFOLIO SHOULD EARN RISK FREE RATE
IF ASSUMING RISK FREE RATE 4%

PV OF PORTFOLIO IS 4.50 e^-rt = 4.455


CONTD.

ALSO CALLED PORTFOLIO REPLICATION

▷ STOCK PRICE IS 20
▷ SUPPOSE CALL OPTION PRICE IS f
▷ PORTFOLIO VALUE TODAY IS

20* 0.25 – f = 5 –f
or
5-f = 4.455 (PV OF THE PORTFOLIO)
f = 0.545
GENERALISATION NO ARBITRAGE
▷ STOCK PRICE IS S(0)
▷ OPTION PRICE = f
▷ EXPIRY = T

▷ PRICE CAN MOVE UP S(0)u where u>1


▷ PRICE MOVE DOWN S(0)d where d<1
▷ INCREASE IS u-1, DECREASE IS 1-d

▷ Payoff on option on stock up is f(u)


▷ Payoff on option on stock down is f(d)
GENERALISATION
EARLIER EXAMPLE
EXPECTED STOCK RETURN

▷ IRRELEVANT AS NOT VALUING OPTION IN


ABSOLUTE TERMS RATHER IN TERMS OF
UNDERLYING STOCK. PROBABILITY OF
FUTURE UP DOWN MOVEMENT IS
INCORPORATED IN STOCK PRICE.
RISK NEUTRAL VALUATION: MODEL 2
RISK NEUTRAL WORLD

INVESTORS ARE RISK NEUTRAL

▷ 2 ASSUMPTIONS

▷ THE EXPECTED RETURN ON A STOCK OR


INVESTMENT IS RISK FREE RATE

▷ THE DISCOUNT RATE USED FOR THE


EXPECTED PAY-OFF ON AN OPTION IS THE
RISK FREE RATE
TWO STEP BINOMIAL MODEL

▷ CONSIDER SITUATION 2

STOCK PRICE = Rs. 20


TWO TIME STEPS= INCREASE 10% 3
MONTHS DECREASE 10%
CALL STRIKE PRICE= Rs. 21
RISK FREE RATE 4% P.A.

C(0) = ??
S(0) = 20

IT IS SETTING UP RISKLESS PORTFOLIO


RISK NEUTRAL VALUATION
A GENERALISATION
THERE ARE 2 WAYS BS MODEL IS
DERIVED
BLACK-SCHOLES-MERTON
▷ MODEL 1

ALLOWING NUMBER OF TIME STEPS IN A BINOMIAL TREE TO


REACH INFINITY

▷ MODEL 2

USING THE PDE


BLACK SCHOLES MERTON

▷ ASSUMPTIONS

▷ STOCK PRICES FOLLOW GEOMETRIC


BROWNIAN MOTION
▷ SHORT SELLING PERMITTED
▷ NO TRANSACTION COST/TAXES
▷ NO DIVIDENDS
▷ NO RISKLESS ARBITRAGE
▷ SECURITY TRADING IS CONTINUOUS
▷ RISK FREE RATE IS r AND IS CONSTANT
NOTATIONS
▷ VARIABLES
STOCK PRICE = S(0)
TIME STEPS = n
STRIKE PRICE=K
OPTION LIFE =T ( DAYS MATURITY/252)
EACH STEP LENGTH = T/n
UPWARD MOVEMENT=j
DOWNWARDS MOVEMENT= n-j
FINAL STOCK PRICE = S(0)(u)^j(d)^n-j

u and d are proportional up or down movements


BLACK-SCHOLES MODEL
Call Value of Opportunity cost
 
price upside potential of invested funds

X
C  S  N (d1 )  rt  N (d 2 )
e

Where C: current price of a call option


S: current market price of the underlying stock
X: exercise price
r: risk free rate
t: time until expiration
N(d1) and N (d2) : cumulative density functions for d1 and d2

d1 
 
ln  S X   r  0.5 2 t d 2  d1   t
 t
Example
Current stock price: 50 exercise price : 55
Risk free rate: 6.25% time to expiration: 6 months
Volatility: 40% What is the call price?
Solution

ln  50 55   0.0625  0.5  0.4 2   0.5 d 2  0.0851  0.4 0.5


d1 
0.4 0.5  0.3679
 0.0953  0.0713
  0.0851
0.2828

N(d1) = 0.4661 N(d2) = 0.3564

X
Call price  S  N (d1 )   N (d 2 )
e rt
55
 50[0.4661]  ( 0.0625)( 0.5) [0.3564]  $4.30
e
PROPERTIES OF BSM
▷WHEN S(0) IS VERY LARGE, CALL IS LIKELY TO
BE EXERCISED. IN THIS CASE THIS IS LIKE A
FORWARD CONTRACT WITH DELIVERY PRICE
K; C = S(0) - Kе-Rt, N (d1) and N(d2) BECOME
CLOSE TO 1,

▷SIMILARLY PUT OPTION BECOMES 0 AS N(-d1)


and N(-d2) ARE CLOSE TO 0

▷WHEN VOLATILITY σ APPROACHES 0, d1 and d2


APPROACH ∞, so that N(d1) and N(d2) approach 1,
call price close to 0
EXAMPLE
▷STOCK PRICE 6 MONTH FROM EXPIRATION IS
42, EXERCISE PRICE 40, r= 10%, σ =20%, USING
BSM FIND CALL AND PUT PRICE
BLACK-SCHOLES MODEL PDE
SIMPLE NO ARBITRAGE MODEL:
COX, ROSS AND RUBENSTEIN
BINOMIAL OPTION PRICING MODEL

▷ COX, ROSS AND RUBENSTEIN (1979)

▷ ASSUMPTIONS

2 PERIOD STOCK
1 PERIOD CALL OPTION ON STOCK ABC
CURRENT PRICE S(0)
STRIKE PRICE K
OPTION EXPIRES TOMORROW C(1)= MAX(S(1)-K,0)
WHAT IS TODAY’S OPTION PRICE C(0)

0__________________________1
S(0), C(0)= ??? C(1)= MAX(S(1)-K,0)
VALUATION OF OPTION

▷ NEXT PERIOD USE BERNOULLI TRIAL


S(0) → S(1)

S(1)

C(1)
FACTORS IN VALUATION
▷ C(0) SHOULD DEPEND ON

PARAMETERS S(0), K, u, d, p, r

▷ CONSIDER A PORTFOLIO OF STOCKS


AND BONDS TODAY

ΔSHARE OF STOCK RS. B OF BONDS


TOTAL COST TODAY OR V(0) = S(0)*Δ + B
PAYOFF TOMORROW= V(1)= u S(0) Δ + rB = C(u)
d S(0) Δ + rB = C(d)
FACTORS IN VALUATION
▷ CHOOSE Δ AND B SO THAT IT SATISFIES THE
CONDITION
FINAL VALUATION
GENERALISATION
APPLICATIONS OF BS MODEL
▷ VALUING EQUITY

▷ VALUING BONDS

▷ VALUING LOAN GUARANTEES

▷ VALUING SUBORDIATED DEBT

▷ VALUING EQUITY-LINKED DEBT

▷ DESIGNING SECURITIES

▷ ASSESSING CAPITAL INVESTMENTS


COMPLICATIONS

▷ NO DIVIDENDS

▷ EUROPEAN OPTIONS ONLY

▷ NO COSTLY FRICTIONS LIKE TRXN,


TURNOVER, TAXES ETC.

▷ INTEREST RATES AND VOLATILITY IS


ASSUMED TO BE CONSTANT
“
▷ UNDERSTANDING PRICING IN THE
COMPLEX WORLD FROM MODELS BUILT
ON SIMPLISTIC ASSUMPTIONS IS
WONDERFUL AND COUNTER-INTUITIVE
Thanks for Your time
and Attention!
FINAL VALUATION

You might also like