Perrakis
Ryan
Option
Valuation
Slide 18-1
Perrakis
Ryan
Chapter Summary
Objective: To discuss factors that affect
option prices and to present quantitative
option pricing models.
Slide 18-2
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Ryan
Option Values
Intrinsic value - profit that could be
made if the option was immediately
exercised
Slide 18-3
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Value of
Call
Intrinsic Value
Time value
X
Slide 18-4
Stock Price
Copyright McGraw-Hill Ryerson Limited, 2003
Perrakis
Ryan
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
Perrakis
Ryan
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
Perrakis
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S
=
Up
p
er
bo
un
Call
Value
Lower Bound
= S0 - PV (X) - PV (D)
PV (X) + PV (D)
Slide 18-7
S0
Copyright McGraw-Hill Ryerson Limited, 2003
Perrakis
Ryan
Summary Reminder
Objective: To discuss factors that affect
option prices and to present quantitative
option pricing models.
Slide 18-8
Perrakis
Ryan
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
Perrakis
Ryan
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
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X = 95
r = .10
= .50
T = .25 (quarter)
d1
.43
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Probabilities from
Normal Distribution
N (.43) = .6664
Table 18.2
d N(d)
.42
.6628
.43 .6664 Interpolation
.44 .6700
Slide 18-12
Perrakis
Ryan
Probabilities from
Normal Distribution
N (.18) = .5714
Table 18.2
d N(d)
.16
.5636
.18 .5714
.20 .5793
Slide 18-13
Perrakis
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Perrakis
Ryan
X = 95
P= 95e-10x.25(1-.5714)-100(1-.6664)=6.35
Slide 18-15
Perrakis
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Perrakis
Ryan
Slide 18-17
Perrakis
Ryan
Summary Reminder
Objective: To discuss factors that affect
option prices and to present quantitative
option pricing models.
Slide 18-18
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Option Elasticity
Slide 18-19
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Slide 18-20
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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
Perrakis
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Perrakis
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Mispriced Option:
Text Example
Implied volatility
= 33%
= 35%
Option maturity
= 60 days
Put price P
= $4.495
= $90
Risk-free rate r
= 4%
Delta
= -.453
Slide 18-23
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Ryan
$ 4,495
40,770
Total outlay
45,265
Slide 18-24
Perrakis
Ryan
Perrakis
Ryan
Summary Reminder
Objective: To discuss factors that affect
option prices and to present quantitative
option pricing models.
Slide 18-26
Perrakis
Ryan
75
C
50
Stock Price
Slide 18-27
0
Call Option Value
X = 125
Copyright McGraw-Hill Ryerson Limited, 2003
Perrakis
Ryan
Slide 18-28
150
0
Payoff Structure
is exactly 2 times
the Call
Perrakis
Ryan
75
C
2C = $53.70
C = $26.85
Slide 18-29
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50
0
50
200
-150
50
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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
Slide 18-31
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Generalizing the
Two-State Approach
121
110
104.50
100
95
Slide 18-32
90.25
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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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Expanding to
Consider Three Intervals
S+++
S++
S++-
S+
S+-
S
S-
Slide 18-34
S+-S--
S---
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Probability
Stock Price
3 up
1/8
100 (1.05)3
2 up 1 down
3/8
1 up 2 down
3/8
3 down
1/8
100 (.97)3
Slide 18-35
=115.76
= 91.27
Perrakis
Ryan
Multinomial Option
Pricing
Incomplete markets
Slide 18-36