Lesson 5 Option Investments Cover image Part 2: Option Valuation (Textbook chapter 21) Thanh Trúc – TCNH – UEL 5.2-1 Outline Option valuation: Introduction Restriction on option values Binomial option pricing Black-Scholes option valuation Cover image 5.2- 2 Option valuation: Introduction Cover image 5.2- 3 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. Cover image 5.2- 4 Figure 21.1 Call Option Value before Expiration Cover image 5.2- 5 Table 21.1 Determinants of Call Option Values Cover image 5.2- 6 Restrictions on Option Value Cover image 5.2- 7 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 > S0 - ( X + D ) / ( 1 + Rf )T C > S0 - PV ( X ) - PV ( D ) Cover image 5.2- 8 Figure 21.2 Range of Possible Call Option Values Cover image 5.2- 9 Figure 21.3 Call Option Value as a Function of the Current Stock Price Cover image 5.2- 10 Figure 21.4 Put Option Values as a Function of the Current Stock Price Cover image 5.2- 11 Binomial Option Pricing Cover image 5.2- 12 Binomial Option Pricing: Text Example Page 735/1041 Cover image 5.2- 13 Binomial Option Pricing: Text Example 120 100 C 90 Stock Price Cover image 10 0 Call Option Value X = 110 5.2- 14 Binomial Option Pricing: Text Example Alternative Portfolio Buy 1 share of stock at $100 Borrow $81.82 (10% Rate) 18.18 Net outlay $18.18 Payoff Value of Stock 90 120 Repay loan - 90 - 90 Net Payoff 0 30 Cover image 30 0 Payoff Structure is exactly 3 times the Call 5.2- 15 Binomial Option Pricing: Text Example 30 30 18.18 C 0 0 3C = $18.18 C = $6.06 Cover image 5.2- 16 Replication of Payoffs and Option Values Alternative Portfolio - one share of stock and 3 calls written (X = 110) Portfolio is perfectly hedged Stock Value 90 120 Call Obligation 0 -30 Net payoff 90 90 Hence 100 - 3C = 81.82 or C = 6.06 Cover image 5.2- 17 Why three call option?-The hedge ratio Cover image 5.2- 18 Why three call option?-The hedge ratio Cover image 5.2- 19 Arbitrage if the option is mispriced Cover image What if the option is underpriced? Reverse the arbitrage strategy 5.2- 20 Generalizing the Two-State Approach Assume that we can break the year into two sixmonth 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). Cover image 5.2- 21 Generalizing the Two-State Approach 121 110 104.50 100 95 90.25 Cover image 5.2- 22 Generalizing the Two-State Approach Example: page 738/1041 Cover image 5.2- 23 Generalizing the Two-State Approach Example: page 738/1041 Cover image 5.2- 24 Generalizing the Two-State Approach Example: page 738/1041 Cover image 5.2- 25 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. Cover image 5.2- 26 Expanding to Consider Three Intervals S+++ S++ S++- S+ S+- S S+-SS-S--- Cover image 5.2- 27 Possible Outcomes with Three Intervals Event Cover image Probability Stock Price 3 up 1/8 100 (1.05)3 =115.76 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 = 91.27 5.2- 28 Valuation of Put option Excersice 9,10: page 766,767/1041 Cover image 5.2- 29 Valuation of Put option Range of stock price: 80 – 130; range of Put option value 0 – 30 The hedge ratio = (30 – 0)/(130 – 80) = 3/5 The strategy: Buy 3 stocks at price of $100 and buy 5 put options The payoffs: Initial CFs S = 80 S = 130 Three stocks -300 240 390 5 put options -5P 150 0 300 + 5P 390 390 The value of the Portfolio = 390/1.1 = 354.545 = 300 + 5P P = (354.545 – 300)/5 = $10.91 Put – Call Parity: S0 + P = PV(X) + C C = S0 + P – PV(X) = 100 + 10.91 – 110/1.1 = $10.91 Cover image 5.2- 30 Figure 21.5 Probability Distributions Cover image 5.2- 31 Black-Scholes Option Valuation Cover image 5.2- 32 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 dist. will be less than d. Cover image 5.2- 33 Black-Scholes Option Valuation 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 cont. compounded rate of return on the stock Cover image 5.2- 34 Figure 21.6 A Standard Normal Curve Cover image 5.2- 35 Call Option Example So = 100 r = .10 X = 95 T = .25 (quarter) = .50 d1 = [ln(100/95) + (.10+(5 2/2))] / (5 .251/2) = .43 d2 = .43 + ((5.251/2) = .18 Cover image 5.2- 36 Probabilities from Normal Dist N (.43) = .6664 Table 21.2 Cover image d .42 N(d) .6628 .43 .44 .6664 Interpolation .6700 5.2- 37 Probabilities from Normal Dist. N (.18) = .5714 Table 21.2 Cover image d .16 N(d) .5636 .18 .20 .5714 .5793 5.2- 38 Table 21.2 Cumulative Normal Distribution Cover image 5.2- 39 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? Cover image 5.2- 40 Spreadsheet 21.1 Spreadsheet to Calculate Black-Scholes Option Values Cover image 5.2- 41 Figure 21.7 Using Goal Seek to Find Implied Volatility Cover image 5.2- 42 Figure 21.8 Implied Volatility of the S&P 500 Cover image 5.2- 43 Black-Scholes Model with 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. Replace S0 with S0 - PV (Dividends) Cover image 5.2- 44 Put Value Using Black-Scholes P = Xe-rT [1-N(d2)] - S0 [1-N(d1)] Using the sample call data S = 100 r = .10 X = 95 g = .5 T = .25 95e-10x.25(1-.5714)-100(1-.6664) = 6.35 Cover image 5.2- 45 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 Cover image 5.2- 46 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 Percentage change in the option’s value given a 1% change in the value of the underlying stock. Cover image 5.2- 47 Figure 21.9 Call Option Value and Hedge Ratio Cover image 5.2- 48 Portfolio Insurance Buying Puts - results in downside protection with unlimited upside potential. Limitations – 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. Cover image 5.2- 49 Figure 21.10 Profit on a Protective Put Strategy Cover image 5.2- 50 Figure 21.11 Hedge Ratios Change as the Stock Price Fluctuates Cover image 5.2- 51 Figure 21.12 S&P 500 Cash-to-Futures Spread in Points at 15 Minute Intervals Cover image 5.2- 52 Hedging On Mispriced Options Option value is positively related to volatility: If an investor believes that the volatility that is implied in an option’s 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. Cover image 5.2- 53 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. Delta = Change in the value of the option Change of the value of the stock Cover image 5.2- 54 Mispriced Option: Text Example Implied volatility = 33% Investor believes volatility should = 35% Cover image Option maturity = 60 days Put price P = $4.495 Exercise price and stock price = $90 Risk-free rate r = 4% Delta = -.453 5.2- 55 Table 21.3 Profit on a Hedged Put Portfolio Cover image 5.2- 56 Table 21.4 Profits on Delta-Neutral Options Portfolio Cover image 5.2- 57 Figure 21.13 Implied Volatility of the S&P 500 Index as a Function of Exercise Price Cover image 5.2- 58