Principles of Option Pricing

RAVICHANDRAN
 Notation
• So, ST = price of the underlying asset at time 0 (today)
and time T (expiration)
• K = exercise price
• r = risk-free rate
• T = time to expiration, equal to number of days to
expiration divided by 365
• co, cT = price of European call today and at expiration
• Co, CT = price of American call today and at expiration
• po, pT = price of European put today and at expiration
• Po, PT = price of American put today and at expiration
 Call Option worth
• An option's value at expiration is called its payoff
• At expiration, a call option is worth either zero or
the difference between the underlying
• price and the exercise price, whichever is
greater:
• cT = Max (ST - K ,0)
• CT = Max (ST - K ,0)
• Note that at expiration, a European option and an
American option have the same payoff because
they are equivalent instruments at that point.
 Put Option worth
• At expiration, a put option is worth either
zero or the difference between the exercise
• price and the underlying price, whichever
is greater:
• pT = Max ( K- ST ,0)
• PT = Max ( K- ST ,0)
 Intrinsic value:

• Intrinsic value:
• For a call option equals the stock price
minus the striking price
• For a put option equals the striking
price minus the stock price
The value Max(O,ST - K) for calls or
Max(0,K - ST) for puts is also called the
option's intrinsic value or exercise
value.
 Intrinsic Value
• The difference between the market price of
the option and its intrinsic value is called its
time value or speculative value.
• At expiration, of course, the time value is
zero.
 Options ITM, ATM, OTM
• In-the-Money Option
• One that would lead to positive cash flows to the
holder if it were exercised immediately
• At-the-Money Option
• One that would lead to zero cash flows to the holder if
it were exercised immediately
• Out-of-the Money Option
• One that would lead to negative cash flows to the
holder if it were exercised immediately
• In-Money Calls and Puts
• Call is in the money if S > K
• Put is in the money if K > S
• Out of Money Calls and Puts
• Call is out of money if S < K
• Put is out of money if K < S
 Option Boundaries

• Minimum and Maximum Values

• Minimum Value :

• The maximum value of a call is the current value

of the underlying:

• A call is a means of buying the underlying. It would

not make sense to pay more for the right to buy the
underlying than the value of the underlying itself.
 Boundaries to option prices: Call options.

At expiration:
C = max[0, (ST -K)]
Before expiration
Upper bound:
A call cannot sell for more than the stock: C < S
and c < S
Lower bound:
C > = max[0, (S -K)]
c > = max[0, (S -Ke-rT )]
 Boundaries to option prices:
Put options.

At expiration:
P = max[0, (K -ST)]

Before expiration
Upper bound:
A put cannot sell for more than the stock: P < S and p < S

Lower bound:
P > = max[0, (K - S)]
p >= max(Ke-rT - S, 0)
 Concept of Intrinsic Value
Concept of Intrinsic Value :
• Intrinsic Value (IV) is the value of call
holder receives while exercising the option.
So IV is positive for In-the-Money calls and
Zero at-the-Money and Out-of-Money calls.
• S0= 125 , K =120 IV=5
• S0 = 120, K =120 IV=0
• S0 = 1118, K =120 IV=0
 Concept of time value decay
• As expiration approaches (i.e., short time remaining for
an option), the call price loses its time value “time value
decay”.
• At expiration, the call price curve collapses onto the
intrinsic value  time value goes to zero at expiration
• As an option moves closer to expiration, its time value
decreases
• Time value decay
• An option is a wasting asset
• Everything else being equal, the value of an option
declines over time
 Interest Rates and Calls
• A call option is a deferred substitute for the
purchase of the stock of the stock
• If the stock price is expected to rise, the investor
can either choose to buy the stock or buy the
call.
• Buying the call will cost far less than
purchasing the stock. Invest the difference in
risk-free bonds.
• If rates rise, the combination of calls and risk-free
bonds will be more attractive
 THE EXPECTED RETURN
• The expected return, , required by
investors from a stock depends on the
riskiness of the stock.
• The higher the risk, the higher the
expected return.
• It also depends on the level of interest
rates in the economy.
• The higher the level of interest rates, the
higher the expected return required on any
given stock.
 VOLATILITY
• The volatility, sigma, of a stock is a
measure of our uncertainty about the
returns provided by the stock.
• Stocks typically have a volatility between
15% and 60%.
• Volatility of a stock price can be defined as
the standard deviation of the return
provided by the stock in 1 year when the
return is expressed using continuous
compounding.
 Volatility and Call Options
• Volatility gives rise to risk and need to buy
insurance
• Greater volatility increases the gains on
the call if the stock price rises big time, and
Zero downside risk if the stock price
declines big time
 Effect of Stock Volatility –Call
Option Pricing
• The higher the volatility of the underlying
stocks, the higher the price of a call
• Intuition If the stock price increases, the
gains on the call increase.
• If the stock price decreases it does not
matter, since the potential loss on the call
is limited.
 Strike Price and Option Pricing
• Lower Strike Calls
• Higher Strike Puts
• Must Be More Expensive
Summary of Variables Affecting
Call and Put Prices
 Determinants of the
Option Premium
• Market factors
• Accounting factors

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 Market Factors
• Striking price
• For a call option, the lower the striking price,
the higher the option premium

• Time to expiration
• For both calls and puts, the longer the time to
expiration, the higher the option premium

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 Market Factors (cont’d)
• Current stock price
• The higher the stock price, the higher the call
option premium and the lower the put option
premium

• Volatility of the underlying stock

• The great the volatility, the higher the call and
put option premium

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 Market Factors (cont’d)
• Dividend yield on the underlying stock
• Companies with high dividend yields have a
smaller call option premium than companies
with low dividend yields

• Risk-free interest rate

• The higher the risk-free rate, the higher the
call option premium

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 Accounting Factors
• Stock splits:
• The OCC will make the following adjustments:
• The striking price is reduced by the split ratio
• The number of options is increased by the split
ratio

• For odd-lot generating splits:

• The striking price is reduced by the split ratio
• The number of shares covered by your options is
increased by the split ratio

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Option Prices
Option Pricing Models
Option Pricing Models
The Greeks
Delta Definition