F INANCIAL R ISK M ANAGEMENT

O PTION P RICING
L ECTURE 9
Angelo Luisi —
[email protected]
O VERVIEW

1 BINOMIAL TREES

2 BLACK-SCHOLES-MERTON MODEL

3 QUESTIONS?

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D ISCOUNTING C ASH F LOWS

Fair value price of any financial instrument equals discounted expected

cash flows:
Bond (1
P0 = C 1 e − r × 1 + C2e − r × 2 + · · · + (CT + FV ) e − r )

Problem with using this approach when valuing Derivatives,

The cash flows are uncertain and derived from another asset
How do we value Options?

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O PTION P RICING

Two different approaches

1 Binomial Option trees
2 Black-Scholes-Merton model
Both start with modeling the price process of the underlying (in our
case, stocks) Once the value of the underlying is known, infer the
value of the call/put option

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BINOMIAL TREES
B INOMIAL TREE - NO ARBITRAGE
ARGUMENT
Example
S0 = $20
In three months, either
1 $22
2 $18
Risk-free rate = 4% per
annum

Question: Evaluate a 3-month call option with K

= $21
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B INOMIAL
TREE - NO ARBITRAGE
ARGUMENT
Call option payoffs depending on future
stock price

Idea: Set up a portfolio of the stock and the option in a way that there is no
uncertainty about the value of the portfolio
⇒ Because the portfolio has no risk, the return earned must equal the risk-free
rate

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B INOMIAL TREE - N O ARBITRAGE
ARGUMENT
Consider the following portfolio
1 Long position in ∆ shares of the stock
2 Short position in one call option
Calculate the value of ∆ that makes the portfolio
risk-less
1 If the stock price moves to $22
Value of the shares is $ 22 ∆
Value of the option is $1
2 If the stock price moves to
$18 Value of the shares
is $ 18 ∆ Value of the
option is $0
22∆ −1= (2
18∆ )

⇒ ∆ = 0.25 (3
)
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B INOMIAL TREE - N O ARBITRAGE
ARGUMENT
Therefore, the risk-less portfolio is,
1 Long 0.25 shares
2 Short 1 option
Why?
1 If the stock price moves to $22
Value of the portfolio 22 × 0.25 − 1
= 4.5
2 If the stock price moves to $18
Value of the portfolio 18 × 0.25 =
4.5
(4
4.5e −0.04×3/12 = 4.455
Risk-less portfolio earns the risk-free
rate )
Denote by f the option
price
20 × 0.25 − f = 5 (5
−f )

5 − f = 4.455 (6
)
f =
0.545 (710 /
) 36
B INOMIAL
TREE - NO ARBITRAGE
ARGUMENT
A Generalization

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36
B INOMIAL TREE - NO ARBITRAGE AND R ISK N EUTRAL
ARGUMENT
A Generalization
S0∆ − f = (S0u∆ − fu ) e − r T (or, equivalently, S0∆ − f = (S0d ∆ −
fd ) e − r T ) Substituting the value of ∆ derived

f = [pfu + ( 1 − (8
p) fd ]eerT− −
rT )
d
p= (9
u− )
d
p can be easily interpreted as the Risk-neutral probabilities of upstate and
downstate

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B INOMIAL
TREE - R ISK NEUTRAL
ARGUMENT

When the probability of an up and down movements are p and 1 − p, the

rT
expected stock price at time T is S0 e
This shows that the stock price earns the risk free rate
Binomial trees illustrate the general result that to value a derivative we can
assume that the expected return on the underlying asset is the risk-free rate
and discount at the risk-free rate
This is known as using risk-neutral valuation

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36
B INOMIAL TREE - R ISK NEUTRAL
ARGUMENT
Example
S0 = $20
In three months, either
1 $22
2 $18
Risk-free rate = 4% per
annum

Question: Evaluate a 3-month call option with K

= $21
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36
B INOMIAL TREE - R ISK NEUTRAL
ARGUMENT
Call option payoffs depending on future
stock price

Idea: Define p as the probability of an upward movement in a risk-neutral world

⇒ The value of the derivative is the expected payoff in a risk-neutral world
discounted at the
risk-free
rate
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36
B INOMIALTREE - R ISK NEUTRAL
ARGUMENT
Remember: p is the probability that gives a return on the stock equal to the
risk-free rate,
(10
20e 0.04×0.25 = 22p + 18( 1 − p ) )

Therefore, p = 0.5503

e− 0.04× 0.25(0.5503 × 1 + 0.4497 × 0 ) = (11

0.545 )
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M ULTISTEP EXAMPLE

K = 21, r = 4 % , each time step is 3

months
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M ULTISTEP EXAMPLE

Value at node B: e− 0.04× 0.25(0.5503 × 3.2 + 0.44970) =

1.7433 Value at node A: e− 0.04× 0.25(0.5503× 1.7433 +
0.44970) = 0.9497 18 /
36
M ULTISTEP EXAMPLE : P UT O PTIONS

K = 52, r = 5 % , time step 1 year

u = 72/60 = 1.2, d = 48/60 = 0.8 (the assumption is that the stock either
goes up by 20 % or down by 20 %
0.05× 1
p = e 1.2−−
0.
0.8
=
0.62828 19 /
36
M ULTISTEP EXAMPLE : A MERICAN OPTION

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36
V ALUES FOR u AND d

Which values to choose for u and d ?

Cox et al. (1979) show that optimal values of u and d can be calculated from the
volatility of the underlying stock

√
u = eσ ∆t (12
)
1 √
d = u = e −σ ∆t
(13
)
σ is the volatility of the underlying, ∆t is the time step
(expressed in years)

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36
BLACK-SCHOLES-MERTON MODEL
BSM M ODEL

The Black-Scholes-Merton model features the same ingredients

It relies on a hedging
portfolio The hedging
portfolio has no risk
→ same payoff in every
state of the world
The Black-Scholes-Merton
model makes some different
assumptions
Binomial trees have two
outcomes and a discrete
time step
The BSM models the underlying as a continuum of outcomes (log-normal
distribution) in continuous time (also called Wiener or Ito process)
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BSM M ODEL
Stocks feature a specific price distribution (log-
normal) Therefore, logarithmic returns are
normally distributed

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36
BSM M ODEL

Similarly to Binomial tree, assume that,

The option and stock prices depend on the same underlying source of
uncertainty Form a portfolio consisting of the stock and the option which
eliminates this source of uncertainty (dynamic hedging)
→ ∆ shares, short 1 option
Since the value of the portfolio is risk-less, it must earn the risk free rate
(risk neutral argument!)

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36
BSM M ODEL

How the formula came about -

https://www.dailymotion.com/video/x225si7
c = S0 N ( d1 ) − Ke −rT N ( d2 ) (14
)
p = Ke N (−d2 )
−rT
−
(15
S0 N (−d1 )
)
ln ( S0 /K ) + (r +
d1 = (16
σ2 / 2 ) T √ )
σ T
ln ( S0 /K ) + (r − √
d2 = = d1 − σ (17
σ2 / 2 ) T √ T )
σ T

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36
BSM M ODEL
The function N ( x ) is the cumulative probability distribution function for a
variable with a standard normal distribution
It is the probability that a variable with a standard normal distribution will be
less than x
Use critical values of the standard normal distribution

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36
BSM M ODEL

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36
BSM M ODEL

Deconstruct the formula

c = S0 N ( d1 ) − Ke −rT
N ( d2 )

Based on a portfolio of ∆ shares and short 1

option Interpretation
N ( d1 ) is ∆
N ( d 2 ) is the probability that the option will
be exercised

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36
BSM M ODEL

From Put-Call parity, the price of a put option is,

p = Ke −rT N (−d2 ) −
S0 N (−d1 )

Interpretation
N (−d1 ) is −∆
N (− d 2 ) is the probability that the option will not be
exercised

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BSM M ODEL

Properties,
As S0 becomes large
⇒ Call price goes up, put price goes
down As S0 becomes very small
⇒ Call price goes down, put price
goes up
As volatility becomes very large
⇒ Both call and put prices
go up As T becomes very
large
⇒ Call price goes up, put
price goes down (risk
neutrality)

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I MPLIED V OLATILITY
The implied volatility of an option is the volatility for which the Black-Scholes-
Merton price equals the market price
There is a one-to-one correspondence between prices and implied
volatilities Traders and brokers often quote implied volatilities
rather than dollar prices

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B INOMIAL TREES VS BSM
M ODEL
Both methods rely on hedging strategy
As you increase the number of steps in binomial trees, the option price converges
to the BSM price

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36
QUESTIONS?
B IBLIOGRAPHY

Cox, J. C., S. A. Ross, and M. Rubinstein (1979). Option pricing: A simplified approach.
Journal of Financial Economics 7 (3), 229–263.

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F INANCIAL R ISK M ANAGEMENT

O PTION P RICING
L ECTURE 9
Angelo Luisi —
[email protected]