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Chapter 18

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Option
Valuation

Slide 18-1

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Chapter Summary
Objective: To discuss factors that affect
option prices and to present quantitative
option pricing models.

Factors influencing option values


Black-Scholes option valuation
Using the Black-Scholes formula
Binomial Option Pricing

Slide 18-2

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Option Values
Intrinsic value - profit that could be
made if the option was immediately
exercised

Call: stock price - exercise price


Put: exercise price - stock price

Time value - the difference between the


option price and the intrinsic value

Slide 18-3

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Time Value of Options:


Call
Option
value

Value of
Call

Intrinsic Value

Time value
X
Slide 18-4

Stock Price
Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Factors Influencing
Option Values: Calls
Factor
Stock price
Exercise price
Volatility of stock price
Time to expiration
Interest rate
Dividend Rate
Slide 18-5

Effect on value
increases
decreases
increases
increases
increases
decreases
Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Restrictions on Option
Value: Call
Value cannot be negative
Value cannot exceed the stock value
Value of the call must be greater than
the value of levered equity
C > S 0 - ( X + D ) / ( 1 + R f )T
C > S0 - PV ( X ) - PV ( D )

Slide 18-6

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

S
=

Up
p

er

bo
un

Call
Value

Allowable Range for Call

Lower Bound
= S0 - PV (X) - PV (D)

PV (X) + PV (D)
Slide 18-7

S0
Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Summary Reminder
Objective: To discuss factors that affect
option prices and to present quantitative
option pricing models.

Factors influencing option values


Black-Scholes option valuation
Using the Black-Scholes formula
Binomial Option Pricing

Slide 18-8

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Black-Scholes Option
Valuation
Co = SoN(d1) - Xe-rTN(d2)
d1 = [ln(So/X) + (r + 2/2)T] / (T1/2)
d2 = d1 + (T1/2)
where,
Co = Current call option value
So = Current stock price
N(d) = probability that a random draw from a
normal distribution will be less than d
Slide 18-9

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Black-Scholes Option
Valuation (contd)
X = Exercise price
e = 2.71828, the base of the natural log
r = Risk-free interest rate (annualizes
continuously compounded with the same
maturity as the option)
T = time to maturity of the option in years
ln = Natural log function
Standard deviation of annualized
continuously compounded rate of return on
the stock
Slide 18-10

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Call Option Example


So = 100

X = 95

r = .10
= .50

T = .25 (quarter)

d1

ln(100 / 95) (.10 .52 / 2) .25


.5 .25

.43

d2 .43 .5 .25 .18


Slide 18-11

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Probabilities from
Normal Distribution
N (.43) = .6664
Table 18.2
d N(d)
.42
.6628
.43 .6664 Interpolation
.44 .6700
Slide 18-12

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Probabilities from
Normal Distribution
N (.18) = .5714
Table 18.2
d N(d)
.16
.5636
.18 .5714
.20 .5793
Slide 18-13

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Call Option Value


Co = SoN(d1) - Xe-rTN(d2)
Co = 100 x .6664 (95 e-.10 X .25) x .5714
Co = 13.70
Implied Volatility
Using Black-Scholes and the actual price
of the option, solve for volatility.
Is the implied volatility consistent with
the stock?
Slide 18-14

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Put Value using


Black-Scholes
P = Xe-rT [1-N(d2)] - S0 [1-N(d1)]
Using the sample call data
S = 100
r = .10
g = .5
T = .25

X = 95

P= 95e-10x.25(1-.5714)-100(1-.6664)=6.35

Slide 18-15

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Put Option Valuation:


Using Put-Call Parity
P = C + PV (X) - So
= C + Xe-rT - So
Using the example data
C = 13.70
X = 95
S = 100
r = .10
T = .25
P = 13.70 + 95 e -.10 x .25 - 100
P = 6.35
Slide 18-16

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Adjusting the Black-Scholes


Model for Dividends
The call option formula applies to stocks
that pay dividends
One approach is to replace the stock
price with a dividend adjusted stock
price

Slide 18-17

Replace S0 with S0 - PV (Dividends)

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Summary Reminder
Objective: To discuss factors that affect
option prices and to present quantitative
option pricing models.

Factors influencing option values


Black-Scholes option valuation
Using the Black-Scholes formula
Binomial Option Pricing

Slide 18-18

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Using the Black-Scholes


Formula
Hedging: Hedge ratio or delta

The number of stocks required to hedge


against the price risk of holding one option
Call = N (d1)
Put = N (d1) - 1

Option Elasticity

Slide 18-19

Percentage change in the options value given


a 1% change in the value of the underlying
stock
Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

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INVESTMENTS, Fourth Canadian Edition

Portfolio Insurance - Protecting


Against Declines in Stock Value
Buying Puts - results in downside
protection with unlimited upside
potential
Limitations

Slide 18-20

Tracking errors if indexes are used for the


puts
Maturity of puts may be too short
Hedge ratios or deltas change as stock
values change
Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Hedging Bets on
Mispriced Options
Option value is positively related to
volatility
If an investor believes that the volatility
that is implied in an options price is too
low, a profitable trade is possible
Profit must be hedged against a decline
in the value of the stock
Performance depends on option price
relative to the implied volatility
Slide 18-21

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Hedging and Delta


The appropriate hedge will depend on
the delta.
Recall the delta is the change in the
value of the option relative to the change
in the value of the stock.

Change in the value of the option


Delta
change in the value of the stock
Slide 18-22

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Mispriced Option:
Text Example
Implied volatility

= 33%

Investor believes volatility should

= 35%

Option maturity

= 60 days

Put price P

= $4.495

Exercise price and stock price

= $90

Risk-free rate r

= 4%

Delta

= -.453

Slide 18-23

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Hedged Put Portfolio

Cost to establish the hedged position


1000 put options at $4.495 / option

$ 4,495

453 shares at $90 / share

40,770

Total outlay

45,265

Slide 18-24

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Profit Position on Hedged


Put Portfolio
Value of put as function of stock price:
implied volatility = 35%
Stock Price
89
90
91
Put Price
$5.254
$4.785
$4.347
Profit/loss per put
.759
.290
(.148)
Value of and profit on hedged portfolio
Stock Price 89
90
91
Value of 1,000 puts $ 5,254
$ 4,785
$ 4,347
Value of 453 shares 40,317
40,770
41,223
Total
45,571
45,555
45,570
Profit 306
290
305
Slide 18-25

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Summary Reminder
Objective: To discuss factors that affect
option prices and to present quantitative
option pricing models.

Factors influencing option values


Black-Scholes option valuation
Using the Black-Scholes formula
Binomial Option Pricing

Slide 18-26

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Binomial Option Pricing:


Text Example
200
100

75
C

50

Stock Price

Slide 18-27

0
Call Option Value
X = 125
Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Binomial Option Pricing:


Text Example
Alternative Portfolio
Buy 1 share of stock at $100
Borrow $46.30 (8% Rate)
53.70
Net outlay $53.70
Payoff
Value of Stock 50 200
Repay loan
- 50 -50
Net Payoff
0 150

Slide 18-28

150

0
Payoff Structure
is exactly 2 times
the Call

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

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INVESTMENTS, Fourth Canadian Edition

Binomial Option Pricing:


Text Example
150
53.70

75
C

2C = $53.70
C = $26.85
Slide 18-29

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Another View of Replication


of Payoffs and Option Values
Alternative Portfolio - one share of stock
and 2 calls written (X = 125)
Portfolio is perfectly hedged
Stock Value
Call Obligation
Net payoff

50
0
50

200
-150
50

Hence 100 - 2C = 46.30 or C = 26.85


Slide 18-30

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

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INVESTMENTS, Fourth Canadian Edition

Generalizing the
Two-State Approach
Assume that we can break the year into
two six-month segments
In each six-month segment the stock could
increase by 10% or decrease by 5%
Assume the stock is initially selling at 100
Possible outcomes

Increase by 10% twice


Decrease by 5% twice
Increase once and decrease once (2 paths)

Slide 18-31

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

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INVESTMENTS, Fourth Canadian Edition

Generalizing the
Two-State Approach
121
110
104.50

100
95

Slide 18-32

90.25

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Expanding to
Consider Three Intervals
Assume that we can break the year into
three intervals
For each interval the stock could
increase by 5% or decrease by 3%
Assume the stock is initially selling at
100

Slide 18-33

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Bodie Kane Marcus

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Ryan

INVESTMENTS, Fourth Canadian Edition

Expanding to
Consider Three Intervals
S+++
S++
S++-

S+
S+-

S
S-

Slide 18-34

S+-S--

S---

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INVESTMENTS, Fourth Canadian Edition

Possible Outcomes with


Three Intervals
Event

Probability

Stock Price

3 up

1/8

100 (1.05)3

2 up 1 down

3/8

100 (1.05)2 (.97) =106.94

1 up 2 down

3/8

100 (1.05) (.97)2 = 98.79

3 down

1/8

100 (.97)3

Slide 18-35

=115.76

= 91.27

Copyright McGraw-Hill Ryerson Limited, 2003

Bodie Kane Marcus

Perrakis

Ryan

INVESTMENTS, Fourth Canadian Edition

Multinomial Option
Pricing
Incomplete markets

If the stock return has more than two possible outcomes


it is not possible to replicate the option with a portfolio
containing the stock and the riskless asset
Markets are incomplete when there are fewer assets than
there are states of the world (here possible stock
outcomes)
No single option price can be then derived by arbitrage
methods alone
Only upper and lower bounds exist on option prices,
within which the true option price lies
An appropriate pair of such bounds converges to the
Black-Scholes price at the limit

Slide 18-36

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