Chapter 09

OPTION PRICING
CHAPTER 9
Chapter Objectives
This Chapter examines two commonly used option pricing models, the Binomial and
Black-Scholes option pricing models.
On completion of this chapter you should have a good understanding of determinants

of option values and explores the relationship among these determinants.
You should also have a good understanding of the logic of the two option pricing
models, pricing mechanics and the determinants of option values.
CHAPTER 9: Option Pricing Copyright 2017 by McGraw-Hill Education (Malaysia) Sdn. Bhd.
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Option Pricing - Introduction
An options value at maturity is very easily determined. Option value at expiration can
only take one of the following two values.
Value/price = O if the option is out-of-the-money at maturity
Value/price = Intrinsic value if the option is in-the-money at maturity
An option value at maturity is simply its intrinsic value.

If the option expires at or out-of-the-money, its intrinsic value is zero and the option is worthless.
If the option expires in-the-money, then its value at maturity equals its intrinsic value.
An options price before maturity arises from two sources: intrinsic value and time
value.
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Asset Valuation in Finance
The underlying logic of asset pricing in finance is that the value of an asset is
equivalent to the present value (PV) of future cash flows.
Asset valuation is easy when the future cash flows are either predetermined.
Though options too are a financial asset, future cash flows from options are
unpredictable and depend entirely on certain states of outcome.
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Asset Valuation in Finance
Prior to maturity, since the exercise price is known, the option value will depend on
the expected price of the underlying asset at option maturity.
This expected price would depend on the underlying assets current price (S0) and the
volatility of its price ().
The logic behind option pricing model is based on the fact that expected price
depends on the current price, volatility and the probability of directional movements.
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Binomial Option Pricing Model
The binomial option pricing model is based on the logic that the current value of the
option must equal the present value of the possible payoffs to the option at maturity.
The binomial option pricing model is a discrete time model, in that underlying asset
price changes at a given fixed time interval.
Illustration: Suppose we want to find the value of a European style call option on an
underlying stock which is currently selling at RM 10.00 with the following
assumptions:
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The call option on the stock has a RM 10 exercise price and one year maturity
The price of the underlying stock can only change in price once during the one year
The percentage change in the stocks price is 10%, that is, it can either go up or down
by a fixed 10%
The probability of an up or down movement is an equal 50%
The risk-free interest rate is 8% per annum
The possible stock and call values at maturity would be:
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At maturity in one year, the stocks price could either be 10% higher or lower.
The probabilities of each outcome occurring is 50% or 0.5.
Given this the call, denoted Ct now, would have a payoff of RM 1.00 (Stock price Exercise price) or
RM 0.
The call is only valuable if it ends in-the-money. Since the probability of the stock going up is 50%, the
RM 1.00 payoff from the call has a 50% probability.
Using Single Period Binomial Option Pricing Model the value of call is 46 sen.
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Holding all other assumptions constant, suppose we now allow the stocks price to
change twice within a year, i.e. once every 6 months. The stock price movement and
corresponding payoff would be:
The value of call using BOPM would be: 48.5 sen

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Suppose we now relax the periodic price change assumption and allow the stock price to change at 3
times a year.
The value of call using BOPM would be: 70 sen
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With increasing number of cycles, we observe from the earlier two calculations that BOPM becomes
very tedious to work with.
Two factors are evident from our calculations earlier. As we shorten the time interval over which stock
prices can change
The call value changes and tends to a higher value
The model becomes increasingly tedious/complicated.
Shorter price change intervals reflect reality and increases the accuracy.
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Probabilities & Volatility
In scenarios till now, probability has been assumed homogenous across all possibilities.
This may not be the case always, as a bullish opinion, would lead too higher weightage assigned to
positive outcomes.
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In scenarios till now, probability has been assumed homogenous across all possibilities.
This may not be the case always, as a bullish opinion, would lead too higher weightage assigned to
positive outcomes.
In a 3 period scenario where probability for the alternative paths are not equal anymore the value
of the call is different than equal probability weighted scenario.
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In earlier scenarios we had assumed that the underlying stock price would change by only 10%.
Suppose we now increase the volatility to 20%.
How would the call value change?
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In earlier scenarios we had assumed that the underlying stock price would change by only 10%.
Suppose we now increase the volatility to 20%.
How would the call value change?
With a doubling of volatility, the call option value goes from 70 sen to RM 1.37 which is almost
double.
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Pricing Put Options with BOPM
The logic of pricing put options is exactly the same as that of the valuation of calls.
In our earlier illustration, we assume a put option now instead of a call option.
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The logic of pricing put options is exactly the same as that of the valuation of calls.
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The value of an at-the-money put of RM 10.00 exercise price is 69 sen.
Volatility and Probability would impact the put option price in similar fashion as impact on call
options.
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The value of an at-the-money put of RM 10.00 exercise price is 69 sen.
Volatility and Probability would impact the put option price in similar fashion as impact on call
options.
With a doubling of stock price volatility, the value of the put increases from 69 sen in the base case
to RM 1.37.
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Black-Scholes Option Pricing Model
The BSOPM has applications in various areas beyond option pricing alone.
Its authors, Fisher Black and Myron Scholes, were awarded the Nobel Price for
Economics in 1995.
The biggest advantage of the BSOPM over other models is that the BSOPM provides a
closed-form solution to option pricing.
This model is in continuous time form, meaning, the time interval between underlying
asset price change is so small as to approach zero.
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Underlying Logic of BSOPM
Determining Option Pricing by Means of the Riskless Hedge Portfolio:
Illustration: Assume Syarikat ABCs stock is currently selling at RM 50.00. No dividends are
expected on the stock over the next 6 months. 3-month KLIBOR is at 6%. An European style call
option on the stock is available.
Assume the exercise price of the option is RM 50.00. Determine the payoff to the following
investment alternatives if
(a) Syarikat ABCs stock is at RM 55 at option expiration

(b) Syarikat ABCs stock is at RM 45 at option expiration.
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Determining Option Pricing by Means of the Riskless Hedge Portfolio
Investment Alternative 1: Leveraged Long Stock Position

Portfolio 1: Long 1 share of Syarikat ABC stock at RM 50.00 by borrowing the PV of RM 45 at 6% rf rate.
(We borrow the lower of the 2 possible prices. Note, we are assuming that the stock can only take on
one of the 2 prices at expiration).
Investment Alternative 2: Long Call Position

Portfolio 2: Long 2, 6-month, RM 50.00 call options on Syarikat ABC stock.
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Investment Alternative 1: Leveraged Long Stock Position

Portfolio 1: Long 1 share of Syarikat ABC stock at RM 50.00 by borrowing the PV of RM 45 at 6% rf rate.
(We borrow the lower of the 2 possible prices. Note, we are assuming that the stock can only take on
one of the 2 prices at expiration).
Investment Alternative 2: Long Call Position

Portfolio 2: Long 2, 6-month, RM 50.00 call options on Syarikat ABC stock.
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The payoff to both investment alternatives is exactly the same. The implications are:
If both alternatives have the same payoff, then in efficient markets they must have the same cost, i.e.
the net investment in each must be equal.
Since both portfolios provide the same payoff, it implies that the portfolios themselves must be similar.
Given implication 2, we should be able to construct a riskless hedge portfolio by combining the 2
alternative investments in an appropriate way.
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Going by implication 1, the value of the call option can be determined using the logic that since
both investment alternatives provide the same payoff, the net investment in Portfolio 1 must
equal the cost of buying the 2 call options in Portfolio 2.
The investor paid RM 50.00 for the stock but borrowed the PV of RM 45 which is RM 43.70, thus
the net investment (out of pocket cost) he made is
RM 50 RM 43.70 = RM 6.30.
This means that the cost of establishing portfolio 2 should also be RM 6.30. The correct price per
call option should therefore be RM 6.30/2 = RM 3.15
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The arrived call option price of RM 3.15 is on the given risk free rate of 6%.
There exists a positive correlation between interest rates and call option prices.
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Implication (3) states that if a long call position (Portfolio 2) is equivalent to levered stock position
(Portfolio 1), then a riskless hedged portfolio can be created by combining the two portfolios in an
appropriate way.
Its a riskless hedged portfolio since whether the underlying stock price increases (to RM 55) or
decreases (to RM 45), the cash flows all balance out.
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The fact that a riskless hedged portfolio can be created implies the price of the call option given
the underlying stock price, time to maturity and a risk free rate must equal to the RM 3.15 price
calculated earlier. Should the price be anything other than RM 3.15, riskless arbitrage profits can
be made.
Illustration: In case where call is mispriced at RM 3.50 instead of RM 3.15, the riskless arbitrage
profit will be as follows:
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Underlying Assumptions of the BSOPM:
1. Efficient markets with frictionless trading.
2. No transaction costs (the model ignores bid-ask spread, commissions etc).
3. Option has European style exercise.
4. The underlying stock will pay no dividends during the maturity of the option.
5. Underlying stock returns are log normally distributed (this means that the logarithmic stock returns are
normally distributed).
6. The risk-free interest rate remains unchanged over option maturity.
7. Underlying stock volatility is constant over option maturity.

Of these assumptions the last two of unchanged interest rates and constant volatility of the underlying asset
until option maturity are considered the most restrictive.
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BSOPM for a call option
The Black-Scholes option pricing model for a call option is as follows:
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Calculating option prices with the BSOPM is a 3-step process.
Calculate d1 and d2.
Using the cumulative normal distribution table, find the values of N(d1) and N(d2).
Plug the values into the model and solve.
Illustration
Suppose: Stock price, S0 = RM 11
Exercise price, k = RM 10
Interest rate, r = 0.10
Maturity, T = 90 days = 0.25
Standard deviation, = 0.5
What is the correct price of the call?

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What is the correct price of the call?
Decomposing the above call value of RM 1.77 into intrinsic and time values, the intrinsic value
here is RM 1.00 while the remainder 77 sen would constitute time value.
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Pricing Put Options
Though the Black-Scholes model was developed for pricing European call options, the model can
just as easily be used in valuing an European style put option.
The steps involved in valuation are similar to earlier steps for call options.
Illustration Continuing with the earlier example We computed the price of the call option in
above example to be RM 1.77.
The first two steps, (i) calculating d1, d2, and (ii) finding N(d1) and N(d2) are the same. However, a
small adjustment has to be made before we plug-in and solve for option value in step (iii). The
small adjustment is to convert N(d1) and N(d2) to N(d1) and N(d2).
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Pricing Put Options
Illustration
The Put Option price is RM 0.52 or 52 sen
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Valuing Call options on Stock Index Futures
Illustration:
Suppose: FBM KLCI Futures = 1830 points
Dividend yield = 7%
Risk-free rate = 3%
Volatility = 20%
What is the value of a 30 day Call option with a strike price of 1,800 points?
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Illustration continued...:
= 1830 * e -(rf-d) (t,T) = 1830 *e (.03-.07) (.0833)
= 1830 * 0.9917 = 1814.8 = 1815
d1 = {In (1815/1800) + [(0.03 + (.202/2)].0.833}/ 0.0577

d1 = [(0.0083) + (0.0042)] / 0.0577
d1 = 0.22 d2 = 0.22 0.0577 = 0.16
N(d1) = 0.59 N(d2) = 0.57
C = 1815 (.59) 1800 e (.03-.07) (.0833) (.57)
C= 1071 1786 (.57)
C = 1071 - 1018
C = 53
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Illustration continued:
Thus, the value of the call option on the index futures would be 53 points.
In Ringgit terms it would be 53 points X RM 50 = RM 2,650
The intrinsic value is 15 points x RM50 = RM750,
While the time value is RM 1,900
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Illustration continued:
Note that the Ringgit value of the contract is 1830 points x RM 50 = RM91,500
An investor buying the 30 day call option pays RM2,650 for the right to take a long position (buy)
the underlying futures contract on maturity day for RM 90,000.
Suppose the index futures contract on maturity day is at 1860 points. Since, the investors call
option is in the money it will be automatically exercised by the exchange and the profit of RM 3,000
{(1860 points-1800 points ) x RM 50} will be credited to his account. The same amount will be
debited from the option sellers margin account.
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Determinants of Option Prices
In BSOPM there are 5 input variables:
Stock/Underlying Asset Price:
The change in stock or underlying asset price is positively correlated to call values and negatively to puts.
This relationship between underlying asset price and option values are known as deltas.
Exercise Price:
The exercise price has a negative correlation with call options and a positive one with put options.
Raising the exercise price benefits put options but works against calls.
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Volatility:
Underlying asset price volatility has a positive correlation with both option prices.
The relationship between option value and underlying asset volatility known as vega.
Interest Rates:
The impact of interest rates on option values can be seen directly from the intrinsic value equations. An
increase in interest rates would increase call intrinsic value since the present value of the exercise price
would be lower.
In the case of put options, the effect is opposite; higher interest rates reduce the present value of
exercise price.
This relationship between interest rates and option values is termed rho.
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Time to Maturity:
The relationship between time to maturity and option values is termed theta.
Time to maturity is positively correlated with calls but has an ambiguous relationship to put values. This
is due to the opposite impact of time to maturity on the put intrinsic and time values.
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Illustration of Price Dynamics
The following tables show the computed Black-Scholes values for the FBM KLCI index
options.
The base case inputs for both the index call and put options used were: exercise price,
k = 720 points; volatility = 25%; rf interest rate = 5%; and maturity = 60 days
Relationships of Option prices, which are evident are:

Given the same spot value, call value decreases as exercise price increases but values increase.
For a given spot value, increasing volatility increases both and the call and put values.
Rising interest rates (last panel) increase call values but reduce put values for the same spot value.
Increasing maturity increases call and put value.
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Illustration of Price Dynamics
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Issues in Option Pricing
Dividends
Though the BSOPM assumes no dividend payments by the underlying stock, expected dividend
payments during the options life can be adjusted for by reducing the stock price used as input by
the present value of the expected dividend.
Option Deltas
When the price of the underlying asset changes, option values change with the relationship being
known as option delta.
An option delta has two common uses.

First, deltas can be used to determine the likely new price of an option given an expected finite change
in the underlying asset price.
Secondly deltas are used in determining hedge ratios. That is, the number of options needed to hedge
the underlying asset/stock.
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Option Deltas
Diagrammatically, option deltas are really the slope of the curve representing option value.
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Option Deltas
Diagrammatically, option deltas are really the slope of the curve representing option value.
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Hedge Ratios
The hedge ratio refers to the number of options needed to hedge each unit of the underlying
asset.
Delta provides estimates of the potential change in option value for small (finite) changes in
underlying stock price. However, delta itself, is dynamic. Thus, the hedge ratio changes as
underlying asset price changes. The number of options needed to hedge the underlying asset
changes as the asset price changes.
Estimating Volatility
Estimating the volatility input using past underlying price data gives us historical volatility.
In addition to historical volatility, there are at least two other commonly used volatility definitions,
these are expected or future volatility and implied volatility.
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Implied Volatility
Implied volatility is the volatility implied in an option price.
5 parameters go into the BSOPM to determine the option value. It is possible to work
out the sixth variable given any five variables.
Thus, given the four other input variables (s, k, r and T) and the call value, we can
derive the volatility estimate that justifies the given call value. This would be the
implied volatility.
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Implied Volatility
Implied volatility is the volatility implied in an option price.
There are two common uses of implied volatility in option trading.
First, traders can use implied volatility estimates to determine the expensiveness of an option
relative to other options.
Second common use of implied volatility is in determining option mispricing. A rule of thumb use by
traders is to compare implied volatility with actual or historical volatility.
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Estimating Historical Volatility
Volatility which is really dispersion around an expected/ mean return is measured
using standard deviation ().
The steps for estimating historical volatility are:

First determine the daily price relative given the daily prices.
Determine the logarithmic price relative, which is simply taking the natural log of each days price
relative.
Using these logarithmic price relatives, determine the mean or average price relative.
Using the mean PR, compute the square of the difference from the mean on a daily basis, i.e. [In PRt
Mean PR]2
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Volatility which is really dispersion around an expected/ mean return is measured
using standard deviation ().
The steps for estimating historical volatility are: (CONTD.)

The sum of these when divided by the number of observations less the degree of freedoms
(in this case only one, mean) gives us the variance.
Finally, by taking the square root of the variance we get the daily standard deviation
estimate.
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Illustration
Volatility Estimation for shares of Telekom Malaysia Bhd.
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Illustration
Volatility Estimation for shares of Telekom Malaysia Bhd.
The estimated daily volatility for Telekom Malaysia shares is 0.02464. Assuming 240 trading
days in a calendar year.
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Thank You

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OPTION PRICING

On completion of this chapter you should have a good understanding of determinants

An option value at maturity is simply its intrinsic value.

The value of call using BOPM would be: 48.5 sen

The value of call using BOPM would be: 70 sen

How would the call value change?

The value of an at-the-money put of RM 10.00 exercise price is 69 sen.

The value of an at-the-money put of RM 10.00 exercise price is 69 sen.

(a) Syarikat ABCs stock is at RM 55 at option expiration

Investment Alternative 1: Leveraged Long Stock Position

Investment Alternative 2: Long Call Position

Investment Alternative 1: Leveraged Long Stock Position

Investment Alternative 2: Long Call Position

2. No transaction costs (the model ignores bid-ask spread, commissions etc).

3. Option has European style exercise.

6. The risk-free interest rate remains unchanged over option maturity.

7. Underlying stock volatility is constant over option maturity.

What is the correct price of the call?

The Put Option price is RM 0.52 or 52 sen

= 1830 * 0.9917 = 1814.8 = 1815

d1 = {In (1815/1800) + [(0.03 + (.202/2)].0.833}/ 0.0577

d1 = 0.22 d2 = 0.22 0.0577 = 0.16

N(d1) = 0.59 N(d2) = 0.57

C = 1815 (.59) 1800 e (.03-.07) (.0833) (.57)

C= 1071 1786 (.57)

In Ringgit terms it would be 53 points X RM 50 = RM 2,650

The intrinsic value is 15 points x RM50 = RM750,

While the time value is RM 1,900

Relationships of Option prices, which are evident are:

An option delta has two common uses.

There are two common uses of implied volatility in option trading.

The steps for estimating historical volatility are:

The steps for estimating historical volatility are: (CONTD.)

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