OPTIONS

Derivatives
When price of one security is derived from another
security it is called as Derivative
Such value can be derived from Stocks, Bonds,
Commodities, Currency Exchange Rates, Interest Rates
etc.
Common Example
Futures
Options
Swaps
Options
What is an Option?
A type of contract between two investors where one grants the
other right (not the obligation) to buy or sell a specific asset in the
future at a predetermined price
The option buyer is buying the right to buy or sell the
underlying asset at some future date
The option seller is selling the right to buy or sell the
underlying asset at some future date
Participants in Derivatives
Derivatives are used for
Hedging
Speculation/Investment
Arbitrage
Participants in Derivatives - Hedging
If someone bears an economic risk and uses the
derivative market to reduce the risk, the person is a
hedger
Hedging is a prudent business practice; today a
prudent manager has an obligation to understand
and apply risk management techniques including the
use of derivatives
Participants in Derivatives - Speculation
A person or firm who accepts the risk the hedger
does not want to take is a speculator
Speculators believe the potential return outweighs the
risk
The primary purpose of derivatives markets is not
speculation. Rather, they permit or enable the transfer
of risk between market participants as they desire
Participants in Derivatives - Arbitrage
Arbitrage is the existence of a riskless profit
Arbitrage opportunities are quickly exploited and
eliminated in efficient markets
Arbitrage then contributes to the efficiency of markets
Participants in Derivatives - Arbitrage
Persons actively engaged in seeking out minor pricing
discrepancies are called arbitrageurs
Arbitrageurs keep prices in the marketplace efficient
An efficient market is one in which securities are priced in
accordance with their perceived level of risk and their
potential return
The pricing of options incorporates this concept of
arbitrage
Types of Options
Call Option
Put Option
Call Option Put Option
Option Buyer
(Long)
Buys the right to buy the
underlying asset at the
Strike Price
Buys the right to sell the
underlying asset at the
Strike Price
Option Seller
(Short)
Has the obligation to sell
the underlying asset to the
option holder at the Strike
Price
Has the obligation to buy
the underlying asset from
the option holder at the
Strike Price
Options Agreement Specification
Type of Option Call / Put
Underlying Security (S) e.g. RELIANCE
Time to Expiry (t) Time at/before which option will
be valid. After passage of this option agreement will
expire
Strike Price (X) Reference price using which payoff
for option will be calculated
Call Option Payoffs at Expiry
For Call Option Buyers (Long)
Call Option Payoff = max(0, S-X)
Net Call Option Payoff = max(0, S-X) Option Price
Put Option Payoffs at Expiry
For Put Option Buyers (Long)
Put Option Payoff = max(0, X-S)
Net Put Option Payoff = max(0, X-S) Option Price
Fair Value of a Choice
E.g. We are tossing a fair coin (equal probability of
head/tail). You will get Rs. 10 if its head and Rs. 0 if it is
tails. How much are you willing to pay for this game?
Probability 0.5 0.5
Payoff 10 0
Fair Price = (0.5*10) + (0.5*0) = 5
Pay <5 to play this game
BINOMIAL OPTION
PRICING MODEL (BOPM)
Binomial Pricing Model
If we know stock prices at expiry then we can calculate fair
price of the option
We start with a single period.
Then, we stitch single period together to form Multi-period
Binomial Option Pricing Tree
Binomial Pricing Model Assumptions
There are two (and only two) possible prices for the underlying asset on
the next date. The underlying price will either:
Increase by a factor of u% (an uptick)
Decrease by a factor of d% (a downtick)
The uncertainty is that we do not know which of the two prices will be
realized.
No dividends.
The one-period interest rate, r, is constant over the life of the option (r%
per period).
Markets are perfect (no commissions, bid-ask spreads, taxes, price
pressure, etc.)
Stock Pricing Process
Time T is the expiration day of a call option. Time T-1 is one
period prior to expiration.
Suppose that S
T-1
= 800, u = 25% and d = -10%. What
are S
T,u
and S
T,d
?
S
T,d
= (1+d)S
T-1
S
T,u
= (1+u)S
T-1
S
T-1
800
S
T,u
= ______
S
T,d
= ______
Stock Pricing Process
Time T is the expiration day of a call option. Time T-1 is one
period prior to expiration.
Suppose that S
T-1
= 800, u = 25% and d = -10%. What
are S
T,u
and S
T,d
?
S
T,d
= (1+d)S
T-1
S
T,u
= (1+u)S
T-1
S
T-1
800
S
T,u
= _1000_
S
T,d
= _720__
Option Pricing Process (Call)
Suppose that K = 900. What are C
T,u
and C
T,d
?
C
T,d
= max(0, S
T,d
-K) = max(0,(1+d)S
T-1
-K)
C
T,u
= max(0, S
T,u
-K) = max(0,(1+u)S
T-1
-K)
C
T-1
C
T-1
C
T,u
= _ __
C
T,d
= _____
Option Pricing Process (Call)
Suppose that K = 900. What are C
T,u
and C
T,d
?
C
T,d
= max(0, S
T,d
-K) = max(0,(1+d)S
T-1
-K)
C
T,u
= max(0, S
T,u
-K) = max(0,(1+u)S
T-1
-K)
C
T-1
C
T-1
C
T,u
= _100__
C
T,d
= __0___
How to find price of this option?
Equivalent Portfolio
Assume that we have another portfolio consisting of
shares and Rs. B as borrowed cash.
We also assume that r is risk free interest rate from
period T-1 to T.
(1+d)S
T-1
+ (1+r)B = S
T,d
+ (1+r)B
(1+u)S
T-1
+ (1+r)B = S
T,u
+ (1+r)B
S
T-1
+B
Portfolio
at time T-1
Portfolio
at expiry
Equivalent Portfolio
If at expiry the portfolio value is equal to call option
payoff, then we can find out call value today
(1+d)S
T-1
+ (1+r)B = S
T,d
+ (1+r)B
(1+u)S
T-1
+ (1+r)B = S
T,u
+ (1+r)B
S
T-1
+B
Portfolio
at time T-1
Portfolio
at expiry
Equivalent Portfolio
Set the payoff of equivalent portfolio to option
payoff
Solve for these two equations with two unknowns
and S
T-1
(1+u)S
T-1
+ (1+r)B = C
T,u
(1+d)S
T-1
+ (1+r)B = C
T,d
Known values
u = 20%
d = -10%
r = 10%
C
T,u
= 100
C
T,d
= 0
Equivalent Portfolio
If two assets offer the same payoffs at time T, then they
must be priced the same at time T-1.
Here, we have set the problem up so that the equivalent
portfolio offers the same payoffs as the call.
Hence the calls value at time T-1 must equal the $ amount
invested in the equivalent portfolio.
C
T-1
= S
T-1
+ B
Equivalent Portfolio Solution

r) d)(1 (u
d)C (1 u)C (1
B
S S
C C
d)S (u
C C

u T, d T,
d T, u T,
d T, u T,
1 T
d T, u T,
+
+ +
=

C
T-1
= S
T-1
+ B
Equivalent Portfolio Solution Simplification
d u
r u
p) (1 and
d u
d r
p
where,

r) (1
p)C (1 pC
C
or,
r) (1
C
d u
r u
C
d u
d r
C
d T, u T,
1 T
d T, u T,
1 T

=
+
+
=
+

r) (1
p)C (1 pC
C
d u
+
+
=
In general,
Our example
u = 25%, d = -10%, r = 10%, Cu = 100, Cd = 0
p = (0.1 (-0.1)) / (0.25 - (-0.1)) = 0.57143
C = ((0.57143)*(100) + (1- 0.57143)*0) / (1+0.1)
= 51.95
So fair value for Call option in this case will be 51.95
What if the call price is greater or less than 51.95?
Interpreting p
p is the probability of an uptick in a risk-neutral world.
In a risk-neutral world, all assets (including the stock and
the option) will be priced to provide the same riskless rate
of return, r.
In our example, if p is the probability of an uptick then
S
T-1
= [(0.57143)(1000) + (1- 0.57143)(720)]/1.1= 800
That is, the stock is priced to provide the same riskless
rate of return as the call option
Then why do people trade derivatives?
Interpreting
Delta, , is the riskless hedge ratio; 0 <
c
< 1.
Delta, , is the number of shares needed to hedge one
call. I.e., if you are long one call, you can hedge your risk
by selling shares of stock.
Therefore, the number of calls to hedge one share is 1/.
I.e., if you own 100 shares of stock, then sell 1/ calls to
hedge your position. Equivalently, buy shares of stock
and write one call.
In continuous time, = C/S = the change in the value
of a call caused by a (small) change in the price of the
underlying asset.
Then why do people trade derivatives?
Two Period Binomial Model
S
T,dd
= (1+d)
2
S
T-2
S
T,uu
= (1+u)
2
S
T-2
S
T-1,u
= (1+u)S
T-2
S
T,ud
= (1+u)(1+d)S
T-2
S
T-1,d
= (1+d)S
T-2
S
T-2
C
T,dd
= max[0,(1+d)
2
S
T-2
- K]
C
T,uu
= max[0,(1+u)
2
S
T-2
- K]
C
T-1,u
C
T,ud
= max[0,(1+u)(1+d)S
T-2
- K]
C
T-1,d
C
T-2
Two Period Binomial Model Example
S
T,dd
= 648
S
T,uu
= 1250
S
T-1,u
= 1000
S
T-1,d
= 720
S
T-2
= 800
C
T,dd
= 0
C
T,uu
= _______
C
T-1,u
= ____
C
T,ud
= 50
C
T-1,d
= 20.41
C
T-2
S
T,ud
= 900
Two Period Binomial Model Equivalent Portfolio
= 1
B = -809.524
= 0.1984
B = -122.449
= 0.6074
B = -397.057
T-2 T-1
Note that as S rises, also rises. As S declines, so does .
Note that the equivalent portfolio is self financing. This means that the
cost of any purchase of shares (due to a rise in ) is accompanied by an
equivalent increase in required borrowing (B becomes more negative).
Any sale of shares (due to a decline in ) is accompanied by an
equivalent decrease in required borrowing (B becomes less negative).
n Period Binomial Model
In general, the n-period model is:

=


+ +

+
=
n
a j
n T
j n j j n j
n
K] S d) (1 u) [(1 p) (1 p
j
n
r) (1
1
C
Where a in the summation is the minimum number of up-ticks so that the
call finishes in-the-money.
Suppose the Number of Periods Approaches
Infinity
S
T
In the limit, that is, as N gets large, and if u and d are consistent
with generating a lognormal distribution for S
T
, then the BOPM
converges to the Black-Scholes Option Pricing Model
Binomial Put Pricing
S
T,u
= (1+u)S
T-1
S
T-1
S
T,d
= (1+d)S
T-1
P
T,u
= max(0,K-S
T,u
) = max(0,K-(1+u)S
T-1
)
P
T-1
P
T,d
= max(0,K-S
T,d
) = max(0,K-(1+d)S
T-1
)
(1+u)S
T-1
+ (1+r)B = S
T,u
+ (1+r)B = P
T,u
S
T-1
+B
(1+d)S
T-1
+ (1+r)B = S
T,d
+ (1+r)B = P
T,d
Binomial Put Pricing
P
T-1
= S
T-1
+ B
d u
d u d u
S S
P P
d)S (u
P P

=
r) d)(1 (u
d)P (1 u)P (1
B
u d
+
+ +
=
Where:
-1 <
p
<0
A put is can be replicated by selling shares of stock short, and
lending $B. and B change as time passes and as S changes.
Thus, the equivalent portfolio must be adjusted as time passes.
B >0
Binomial Put Pricing
r) (1
p)P (1 pP
P
d u
+
+
=
d u
r u
p) (1 and
d u
d r
p

=
Where:
Simple vs. Continuous Compounding
Calculate yearly 10% simple interest rate on 50
Interest = 50 * (1+10%) = 55
What if, interest is paid twice half yearly
Interest = 50 * (1 + 5%) * (1+ 5%) = 55.125
What if, interest is paid four times in a year
Interest = 50 * (1 + 2.5%)
4
= 55.19064
What if, interest is calculated on continuous basis
Interest = 50 * e
10%*1
= 55.25855
Simple vs. Continuous Compounding
We mostly use continuous compounding in Finance.
Formula for continuous compounding is
P * e
rT
= F
where, P Present Value
e Constant
r Continuous Interest Rate
T Time
F Future Value
How to calculate Present Value from Future Value?
European vs. American Option
European Option
can only be exercised on the expiry date
Indian stock exchanges options are european options
There is a simple equation with a closed-form solution
that can be used to evaluate option price easily
American Option
can be exercised at any time up to and including
expiry date
They are mostly traded OTC
No standardized approach to price american option
We will only talk about European Options
Bounds for Option Price Upper Bounds for Call
Call option gives the holder right to buy one share
of a stock for a certain price.
No matter what happens, the option can never be
worth more than the stock.
Hence, C S
0
What if C > S
0
?
Bounds for Option Price Upper Bounds for Call
Call option gives the holder right to buy one share
of a stock for a certain price.
No matter what happens, the option can never be
worth more than the stock.
Hence, C S
0
What if C > S
0
?
e.g. S
0
= 40, C=50, K=20
At time 0, you sell the call at 50 and buy stock at 40. You
are left with 10
At expiry, 1) if call is in the money then option will be
exercised
2) if call is out of the money then call is
worthless. Sell stock and keep money.
Bounds for Option Price Upper Bounds for Put
At expiry, the put option can not be worth more
than K. (Why? Stock price can minimum go to 0)
So, put option can not be worth more than present
value of K
Hence, P Ke
-rT
What if P > Ke
-rT
?
Bounds for Option Price Upper Bounds for Put
At expiry, the put option can not be worth more
than K. (Why? Stock price can minimum go to 0)
So, put option can not be worth more than present
value of K
Hence, P Ke
-rT
What if P > Ke
-rT
?
At time 0, Sell the put and invest P at risk free interest rate
At expiry, maximum value for Put will be K and invested
money will be greater than K
Bounds for Option Price Lower Bounds for Call
Lower bound for a call option is
C max(S
0
- Ke
-rT
, 0)
Verify if breach of this condition results in an arbitrage
e.g. S
0
= 20, K = 18, r = 10%, T = 1, C = 3
Bounds for Option Price Lower Bounds for Put
Lower bound for a put option is
P max(Ke
-rT
- S
0
, 0)
Verify if breach of this condition results in an arbitrage
e.g. S
0
= 37, K = 40, r = 5%, T = 0.5, P = 1
Put-Call Parity Payoff at time T
Put-Call Parity is the relationship between prices of
Call and Put options that have same strike price and
maturity.
Consider 2 portfolios as below,
Portfolio A Portfolio B
One European Call Option
Zero coupon bond that
provides a payoff of K at time T
One European Put Option
One share of Stock
Put-Call Parity Payoff at maturity
Portfolio A Portfolio B
At time 0
One European Call Option
Zero coupon bond that
provides a payoff of K at time T
One European Put Option
One share of Stock
At Expiry
If S
T
> K
Call Option = S
T
- K
Zero Coupon Bond = K
Total = S
T
Put Option = 0
One Share = S
T
Total = S
T
If S
T
< K
Call Option = 0
Zero Coupon Bond = K
Total = K
Put Option = K - S
T
One Share = S
T
Total = K
Put-Call Parity Payoff at maturity
Put-Call Parity
If two portfolios have same payoff at expiry then
the price of two portfolio should be same
Hence put-call parity,
C + Ke
-rT
= P + S
0
Options Moneyness
Option Premium is the amount of money option
buyer pays to the option writer to buy the option
contract
Option premium is split into two components
Intrinsic Value
Time Value
Options Moneyness Intrinsic Value
Intrinsic Value option is calculated as if option would
have exercised today
It is defined as the difference between the options
strike price (X) and stock current price (CP)
For Call, Intrinsic Value = max(0, CP X)
For Put, Intrinsic Value = max(0, X CP)
Intrinsic value depends on moneyness of the option
Intrinsic value can not be negative
Options Moneyness
The concept of moneyness describes whether an
option is in-, out-, at-, or in-the-money by examining
the position of strike vs. existing market price of the
option's underlying security.
In terms of moneyness, option can be classified as
In the Money (ITM)
Deep In the Money
Out of the Money (OTM)
At the Money (ATM)
Options Moneyness - ITM
Any option that has positive intrinsic value is said to
be In the Money (ITM)
Options Moneyness Deep ITM
These options represent a larger spread between the
strike and market price of an underlying security.
They trade at or near to their actual intrinsic values
This is because options with a significant amount of
intrinsic value built in have a very low chance of
expiring worthless.
Thus investing in the Deep ITM option is similar to
investing in the underlying asset, except the option
holder will have the benefits of lower capital outlay,
limited risk and leverage.
Options Moneyness OTM
When intrinsic value of an option is 0, it is called as
Out of the Money (OTM) option
Options Moneyness ATM
An option is said to be At the Money (ATM) when
the strike price of a call or put is equal to the
underlying asset.
Practically, the strike price
which is closest to the
underlying price is said to be
ATM strike
Call Option Price
Variation of Price of call option with the stock price.
Curve moves in the direction of the arrows when
there is an increase in the interest rate, time to
maturity or stock price volatility.
BLACK SCHOLES OPTION
PRICING MODEL (BSOPM)
Continuous Time Option Pricing Model
Assumptions of Black Scholes Option Pricing Model
No transaction cost
No taxes
Unrestricted short-selling of stock, with full use of short-
sale proceeds
Shares are infinitely divisible
Constant riskless interest rate for borrowing/lending
No Dividends
European Option
Continuous Trading
Derivation of Black Scholes Pricing
Specify a process that the stock price will follow (i.e.,
all possible paths)
Construct a riskless portfolio of:
Long Call
Short D Shares
As delta changes (because time passes and/or S
changes), one must maintain this risk-free portfolio
over time
This is accomplished by purchasing or selling the
appropriate number of shares.
Lognormal Distribution
Black Scholes Option Pricing Model assumes that the
stock prices follow Geometric Brownian Motion
In turn, this implies that the distribution of the returns of
the stock, at any future date, will be lognormally
distributed
Lognormal returns are realistic for two reasons
If returns are lognormally distributed, then the lowest
possible return in any period is -100%
lognormal returns distributions are positively skewed, that
is skewed to the right.
Thus stock returns distribution would have a minimum return
of -100% and a maximum return can go beyond 100%
Lognormal Distribution Price Changes
E S S e
S S e e
T
T
T
T T
( )
( ) ( )
=
=
0
0
2
2
2
1

var

Black Scholes Option Formula For Call
( ) ( )
2
rT
1
d N Ke d SN C

=
where N(d
i
) = the cumulative standard normal distribution function, evaluated at d
i
,
and:
T
/2)T (r ln(S/K)
d
2
1
+ +
=
T d d
1 2
=
N(-d
i
) = 1-N(d
i
)
Black Scholes Option Formula Example
S = 92
K = 95
T = 50 days (50/365 year = 0.137 year)
r = 7% (per annum)
= 35% (per annum)
What is the value of the call?
Black Scholes Option Formula Example
Calculation
Calculate the PV of the Strike Price:
Ke
-rT
= 95e
(-0.07)(50/365)
= (95)(0.9905) = 94.093.
Calculate d
1
and d
2
:
0.137 0.35
.137 0.1225/2)0 (0.07 ln(92/95)
T
/2)T (r ln(S/K)
d
2
1
+ +
=
+ +
=
0.1089
0.12955
0.01798 0.03209
701) (0.35)(0.3
0.01798 ) ln(0.96842
=
+
=
+
=
d
2
= d
1
T
.5
= -0.1089 (0.35)(0.137)
.5
= -0.2385
Black Scholes Option Formula Example
Calculation
Calculating N(d1) and N(d2)
Standard Normal Probability Tables
Excel Function NORMSDIST
N(-0.1089) = 0.4566; N(-0.2385) = 0.4058.
Black Scholes Option Formula Example
Calculation
Solving for Call Value
C = S N(d
1
) Ke
-rT
N(d
2
)
= (92)(0.4566) (94.0934)(0.4058)
= 3.8307.
Applying Put-Call Parity, the put price is:
P = C S + Ke
-rT
= 3.8307 92 + 94.0934
= 5.92.
Black Scholes Option Formula For Put
( ) ( )
1 2
rT
d - SN - d - N Ke P

=
where N(d
i
) = the cumulative standard normal distribution function, evaluated at d
i
,
and:
T
/2)T (r ln(S/K)
d
2
1
+ +
=
T d d
1 2
=
N(-d
i
) = 1-N(d
i
)
Binomial and Black Scholes Model
Note the analogous structures of the BOPM and the
BSOPM:
C = S + B (0< <1; B < 0)
C = SN(d
1
) Ke
-rT
N(d
2
)
= N(d
1
)
B = -Ke
-rT
N(d
2
)
Binomial and Black Scholes Model
The BOPM actually becomes the BSOPM as the number of
periods approaches , and the length of each period
approaches 0.
In addition, there is a relationship between u and d, and , so
that the stock will follow a Geometric Brownian Motion. If you
carve T years into n periods, then:
n
T

0.5 0.5 q
equal must q, uptick, an of y probabilit the and,
1 e d
1 e u
T/n
T/n
+ =
=
=

Black Scholes Model - Volatility

Volatility is the key to pricing options.
Believing that an option is undervalued is tantamount
to believing that the volatility of the rate of return on
the stock will be less than what the market believes
and vice versa.
We will be learning more about volatility later
Thanks
Q&A