MINERVA UNIVERSITY B111 Financial Planning, Budgeting, and Modeling 1

Note on Option Pricing

John Percival and Wayne Chang
Edits from the B111 Teaching Team
Last modified: July 2021

Instructions: Follow each situation in this sheet. The sheet also contains optional exercises
to better learn the material (copy the sheet to make changes). Study each optional exercise.
Solutions are provided here.

What is an Option?
Derivatives are contracts written between a buyer and a seller to exchange the
underlying financial asset at a pre-specified future date and price. One of many types of
financial derivatives is options. An option is a right, but not the obligation, to buy or sell the
underlying asset at a future pre-specified date (expiration date) and price (strike or exercise
price).

There are two basic types of financial options, namely the call option and put option. A
call option gives the right, but not the obligation, to buy the underlying financial asset while a put
option gives the right, but not the obligation, to sell the underlying financial instrument. The
option buyer (holder) buys the option from the option seller (writer) at a given premium. The
buyer (holder) of an option is said to have a long position. The seller (writer) of an option is said
to have a short position.

A call option is said to be out-of-money when the price of the underlying asset is less
than the strike price and in-the-money when the price of the underlying asset is greater than the
strike price. Conversely, a put option is said to be in-the-money when the price of the underlying
asset is less than the strike price and out-of-money when the price of the underlying asset is
greater than the strike price. When the price of the underlying asset is equal to the strike price
then both call and put options will be at-the-money.

Options can either be exercised at any time during the contract period or at the maturity
date of the contract period. The former type is called an American option, and the latter is called
a European option. All the calculations below assume the option in question is a European
option.

What is a Call Option’s Value?

Call options provide its holders the right but not the obligation to purchase shares of
stock at a pre-specified exercise price (also called the strike price) at a pre-specified future date.
Options are valuable because on the future date, if the stock’s market price exceeds the strike
price the option holder can buy the stock at the cheaper strike price and immediately profit by
selling the stock at the higher market price. On the other hand, on that future date, if the market
price is lower than the strike price, the owner simply lets the option expire without exercising it
(remember that the option owner has the right but not the obligation to buy). After all, it makes
no sense to buy at the higher strike price when you can buy at the lower market price. In this
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case, the option expires worthless but at no cost to its owner (except for the fixed premium that
the owner initially paid to own the option before knowing how the stock will turn out).

Call options are called out-of-the-money (in-the-money) when it’s strike price is less
(greater) than the price of the underlying asset. Call options are called at-the-money when it’s
strike price is equal to the price of the underlying asset.

Determining the value of a call option is very challenging and in fact, was an unsolved
problem for the centuries that options were used before modern financial economists finally
cracked the problem. In this write-up, we will discuss the elegant solution and intuition for how
call options can indeed be priced.

Example with 2 Dates

To make this more concrete, consider a simple example with two dates. There is a
market in which only one company has issued shares of common stock. At Date 0, the stock is
selling for $60 per share. Investors believe that at Date 1, there are two possible things that can
happen. The stock price can increase to $75 with probability 80%, or the stock price can
decrease to $45 with probability 20%. In this simplistic example, there are only 2 possible
outcomes, and we know what the exact probabilities are. You can think about these two
possible outcomes as reflecting a good state of the economy with a strong stock market and a
bad state of the economy with a weak stock market.

Source and Additional Exercises

We can easily solve for the stock’s probability-weighted expected value at Date 1:
E[Value of stock @ t=1] = 80%($75) + 20%($45) = $69

The expected return of shareholders (r) is then:

E[R] = E[1+r] = ($69/$60) = 1.15
E[r] = 15%

Note that you can also calculate the expected return of shareholders (r) as the
probability-weighted return of the stock at Date 1:
MINERVA UNIVERSITY B111 Financial Planning, Budgeting, and Modeling 3

E[R of stock @ t=1] = 80% ($75/$60) + 20% ($45/$60) = 1.15

E[r of stock @ t=1] = 15%
Assume that there are also risk-free bonds that pay $100 at Date 1, which includes a
10% return for investing in the bond at Date 0. This means the price of the bond at Date 0 is
$90.91 (=$100 / (1+10%)). Since the bond is risk-free, the Date 1 payoff must be the same
regardless of the state of the world.

In addition, there is a call option on the stock with an exercise price of $55 at Date 1. This
means the option owner can choose to buy the stock for $55 no matter what the actual stock
price is at Date 1. If the stock ends up higher at $75, it makes sense to exercise the option and
buy the stock for $55. The payoff from the call option is then $20 (= $75 - $55), or the difference
between the stock price and the exercise price. This payoff exists because the option holder can
immediately sell the stock at $75 after exercising the option. On the other hand, the call option
payoff when the stock price is below the exercise price is $0 since the option would never be
exercised. Why buy the stock at $55 when you can get it at the prevailing market price of $45?
MINERVA UNIVERSITY B111 Financial Planning, Budgeting, and Modeling 4

Source and Additional Exercises

So what is the value of a call option at Date 0? We can solve for the expected payoff
from the option at Date 1:

80%($20) + 20%($0) = $16

The value of the call option at Date 0 should then simply be the discounted present
value of the future payoff. But then, what is the right discount rate to apply? Assuming the stock
is efficiently priced (i.e. 0 NPV at Date 0), its discount rate would just equal its expected return of
15%. If so, the financial market is saying that a 15% discount rate is enough to capture the risk
of investing in the stock (which translates to a 5% market premium given the 10% risk-free rate).
However, the risk of the option is different from the stock so we cannot apply the 15% discount
rate to the option. The call option is much riskier, offering an all-or-nothing outcome, while the
stock at least retains most of its value even in the unfortunate downstate. Obviously, the
risk-free rate of 10% is not appropriate for the option’s discount rate either. Finally, we cannot
solve for the option’s beta and apply the CAPM. We do not know the option’s starting value and
thus cannot solve for the returns that are necessary for obtaining beta.
For many years, options were traded in financial markets. However, it was not clear how
investors can determine their values since traditional valuation tools did not work. Finally, three
finance professors, namely Fischer Black, Myron Scholes, and Robert Merton developed an
intriguing process to determine an option’s value without the need of the correct discount rate, in
other words without the need to know investors’ attitude towards risk, and without the need to
know the probability of the occurrence of different states. Their approach that solved the
problem was later awarded by Nobel Prizes (here is an article explaining why this approach
deserved the Nobel Prize).
They employed the process of arbitrage and the principle of one price to solve the
problem. In an efficient market, two assets with identical risk and future cash flows should
always sell at the same price. If they do not, investors would buy the cheaper asset and sell the
more expensive asset (“buy low, sell high”). They would make money each time they did so until
the two assets’ prices converged. In an efficient market where many investors are doing this, the
convergence process should happen quickly as the cheaper asset will be quickly bid up while
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the more expensive one will be quickly sold down. This process is called arbitrage, and the
Black-Scholes option pricing model uses this idea to value options.
If there were an asset with the same future cash flows as the call option and if we knew
the value of that asset, then by arbitrage, the call option should have that same value too. In the
previous example, we know the value of the stock and risk-free bond at Date 0. If we can create
a portfolio with a combination of stock and bonds that exactly mirror the options’ cash flows, we
would know that portfolio’s value and thus pin down the option’s value at Date 0 too. Therefore,
all we need to do is to figure out the correct replicating portfolio of stocks and bonds that
exactly mirror option payoffs at Date 1.
Returning to our previous example, with two possible outcomes of the call option, we can
have a portfolio composed of two assets (how much (underlying) stock to hold, S, and how
much bond to hold, B, at Date 0) that replicates Date 1 option payoffs (cash flows) in the
up-state and in the down-state. Given this setup, we can obtain a unique solution for S and B.

Up-state equation: $20 = ($75)S + ($100)B

Down-state equation: $0 = ($45)S + ($100)B

Solving for S and B is straightforward. We can subtract the two equations which eliminates B
and isolates S. Once we solve for S, we can plug it into the up-state equation to solve for B.

($20 - $0) = ($75 - $45)S + ($100 - $100)B

S = $20 / $30 = 2/3

$20 = ($75)(2/3) + ($100)B

B = ($20 - ($75)(2/3))/$100 = -0.3

+2/3 shares of the common stock and -0.3 bonds is the only combination that works and
is the unique solution for our replicating portfolio. What does -0.3 bonds mean? A positive
holding of the risk-free bond is essentially saving at the risk-free rate while a negative holding of
the risk-free bond is essentially borrowing at the risk-free rate. Therefore, at Date 0, the
replicating portfolio borrows money and uses it to partially fund purchasing of the stock. At Date
1, this replicating portfolio will then pay off $20 in the up-state and $0 in the down-state, exactly
the same as the call option.

We can now determine the value of the call option at Date 0 by simply calculating the
value of the replicating portfolio at Date 0:

Call Value = (Stock value)(Stock shares) + (Bond value)(Bond shares)

$12.73 = ($60)(2/3) + ($90.91)(-.3)

That’s it. We’ve solved for the value of the call option! To summarize our steps:

1) Find the replicating portfolio by matching its Date 1 payoffs to the call option payoffs.
2) The replicating portfolio has a unique solution as long as the number of assets (e.g. 2: Stock,
Bond) is the same as the number of possible future states (e.g. 2: up-state, down-state).
3) Given this unique solution, calculate the replicating portfolio’s value at Date 0.
4) By arbitrage, the call option’s value must equal this replicating portfolio’s value.
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Now that we know the correct value for the option, we can also determine its appropriate
discount rate. We know that the option’s expected value at Date 1 is the $16 we previously
obtained and after discounting, much equal the option’s Date 0 value of $12.73:
E[R of the Call] = E[1+r] = $16/$12.73 = 1.26
E[r] = 26%

Unsurprisingly, the option’s appropriate discount rate of 26% is much higher than the
stock’s discount rate of 15% since the option is much riskier because in the down-state one can
lose everything.

Extending the Example to 3 Dates

We can expand our simple example to 3 dates (instead of 2) to see what happens.
Suppose we go back one period earlier and look at the current stock price and possible future
stock prices. We are still assuming that we have a call option that can be exercised in Date 1
with a $55 strike price. We’ve just solved for what the call option would be worth in the Date 0
up branch ($12.73), and we can easily determine what it’ll be worth in the Date 0 bottom branch
($0 since it will for sure expire worthless in Date1). We can solve for the option’s price in Date -1
given these two call prices in Date 0 by using the exact same replicating portfolio approach as
before.

Thus:
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Source and Additional Exercises

Again, we use 2 equations with 2 unknowns but this time with the payoff of the option at Date 0
being its value at Date 0. The stock and bond prices are now all based on Date 0 as well:

Up-state equation: $12.73 = ($60)S + ($90.91)B

Down-state equation: $0 = ($36)S + ($90.91)B

S = 0.53
B = -0.21

Value of portfolio = C = ($48)(0.53) + ($90.91/1.1)(-0.21) = $8.10

This setup where there are two possible future outcomes at every point in time and with
a convergence of outcomes in the up-then-down and the down-then-up states (e.g. middle node
at Date 1) is called a binomial model. A binomial model ensures that we only need 2 assets to
always be able to recreate possible call option payoffs, regardless of which Date or node we find
ourselves in. Starting at Date -1, we hold the 0.53 stock and -0.21 bond portfolio worth $8.10. At
Date 0, if we are in the up-state, our portfolio is now exactly worth $12.73. We can now trade
and alter our portfolio to the previously calculated 2/3 stock and -0.3 bond portfolio that’s worth
exactly $12.73 too (such no money needs to be added). This new portfolio is then ready for
what can happen at Date 1 since it can replicate exactly the up-then-up state as well as the
up-then-down state. On the other hand, if at Date 0 we are in the down-state, the original $8.10
portfolio now has a $0 value and cannot afford any stocks or bonds. But that’s ok because both
the down-then-up and down-then-down states require $0 payoff too so holding a $0 portfolio can
replicate these two possible outcomes in Date 1 regardless. You can imagine that this model
can be expanded to as many periods as necessary. During each period, we just need to
recalculate our replicating portfolio and shift our stock/bond portfolio accordingly. But no matter
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what state we are in, we should always have just enough assets to do so without needing
additional cash.

The Black-Scholes Model

This logic of the replicating portfolio using a binomial model setup is the justification
behind the Black-Scholes Option Pricing Model. On the surface, the binomial model is not
realistic. After all, there are many possible future states of the world, not just two. However, as
we make the intervals shorter and increase the number of periods, we can approximate reality.
At any given second, a stock can move up or down by a certain amount. As long as we can
trade during every second, we can continuously readjust the replicating portfolio to reflect the
new outcomes at every second. At the limit with an infinite number of periods, we arrive at the
Black-Scholes model. You do not need to understand the model’s equation, but it is included
below because of its historical significance. Interestingly, the original paper explaining the model
had trouble being published because the results were so unintuitive.

Black-Scholes Option Pricing Model:

−𝑟𝑡
For Call option value 𝐶 = (𝑆)𝑁(𝑑1) − (𝐾𝑒 )𝑁(𝑑2)
−𝑟𝑡
For Put option value 𝑃 = (𝐾𝑒 )𝑁(− 𝑑2) − (𝑆)𝑁(− 𝑑1)

where
S is the stock price at Date 0
K is the strike price at maturity
t is the time to maturity (in years)
r is the risk-free rate (continuous compounding)
−𝑟𝑡
𝑒 is the time value of money (continuous discounting)
N() is the standard normal cumulative distribution function

2
𝑆 σ
𝑙𝑛( 𝐾 )+(𝑟+ 2
)𝑡
𝑑1 =
σ 𝑡

𝑑2 = 𝑑1 − σ 𝑡

σis the stock’s volatility.

The values of both N(d1) and N(d2) are between 0 and 1. A closer look at the above call (put)
option value formula reveals the portfolio that replicates the payoffs of the corresponding call
(put) option. Accordingly, N(d1) is the amount of underlying stock bought (long position) and
−𝑟𝑡
(𝐾𝑒 )𝑁(𝑑2) is the magnitude borrowed via the bond sold (short position) to finance the long
stock position.

This was a breakthrough discovery by the Nobel Prize winners. Not only did they
demonstrate how to value an option but at the same time, they gave birth to the financial
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engineering industry. Even if there exists no call option in the markets, this approach of the
replicating portfolio can create it by using the right mixture of stock and bonds. In fact, the
approach is not limited to just creating options. Specify any possible future payoff you may
desire, and the replicating portfolio approach can create it while telling you its fair value today.
This ability to create any desired financial security is what is called financial engineering. Even if
an asset does not currently exist, we can create it using existing assets.

FAQs

If you can only win with an option, what wouldn’t everyone want one?
If the option were free, it’s true that you would always want to own it. At worst, you don’t
exercise it so there’s no loss to you. But there could be outcomes where the option delivers a
positive payoff. Since an option is indeed valuable, it does not come for free. Before the option
can be exercised, an investor must pay a premium to own the option. Indeed, what we
calculated above for the value of the call option is what a fair premium for the option would be.

What is the relationship between the value of a call option and a put option?
When both the call and the put option are contracts written on the same underlying stock
(S) at the same strike price (X) with the same expiration date (T), the put-call parity can be
written as
P+S = C+PV(X)
where
P is the price of a European put option
C is the price of a European call option
PV(X) is the present value of the strike price X, in other words X discounted from the value of
the expiration date T at the risk-free rate.

What does a call option (holder’s) payoff diagram look like?

Remember that holder of a call option is the buyer of the stock. Looking at a call option
(holder’s) payoff diagram can be quite useful. A payoff diagram expresses, on the x-axis, the
price of the option’s underlying stock at the option’s maturity, and on the y-axis, how much the
option will consequently be worth. In the diagram below, we assume a call option with a strike
price X.
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Assume that the strike price is $55. If at maturity, the stock were trading at $55, the
option is worth $0. You could exercise the option to buy at the strike price of $55 but that is no
different then simply buying the stock at its prevailing market price (also $55). You are not better
off. On the other hand, if the stock price were $56, the option would be worth $1. You would
exercise the option and buy at $55 while immediately selling it at the $56 market price to make a
$1 profit. Similarly, given a $57 stock price, the call option payoff would be $2. This is why the
payoff diagram depicts an upward sloping 45-degree line. Every dollar increase in the stock
price leads to a dollar increase in the payoff value.

What does a put option (holder’s) payoff diagram look like?

Remember that holder of a put option is the seller of the stock. In a similar vein, the put
option (holder’s) payoff diagram would look like the following diagram.

How does market volatility affect the value of an option?

Unlike other assets, an option’s value increases as volatility risk increases. In the original
first example, an increase in the stock’s volatility can be modelled by increasing the payoff of the
up-state and decreasing the payoff of the down-state (while holding the stock’s expected value
constant). If so, the same call option will now have a bigger payoff in the upstate (since the
strike price has not changed) while the payoff in the downstate remains at $0 (the option still
won’t be exercised). In other words, the upstate potential return increases while the downside
risk is always capped at $0. This clearly increases the value of the call option.