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Options evaluation - Black-Scholes model vs. binomial options pricing model

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Year IX, No.12/2010 137

OPTIONS EVALUATION - BLACK-SCHOLES MODEL VS.

BINOMIAL OPTIONS PRICING MODEL
Prof. Ioan TRENCA, PhD
Assist. Prof. Maria-Miruna POCHEA, PhD Student
Lect. Angela-Maria FILIP, Phd
“Babeş-Bolyai University”, Cluj-Napoca

1. Introduction formula Black-Scholes-Merton is valid,

even if the dividend is stochastic. To do
A particularly important issue that this, they assumed that the present value
arises when it comes to options is fixing of future dividends is observable and a
their value. The emergence of forward contract can be obtained by
quantitative techniques that allow trading these accumulated dividends. To
operators to follow the evolution of obtain an explicit formula for determining
financial assets price has multiplied the the option price when the market is
transactions on futures markets. incomplete, Geske (1978) used the
Evaluation options theory has its CAPM (Capital Asset Pricing Model) to
roots in Bachelier's research (1900) who balance the risk premium in the
used Brownian motion to evaluate economy. From Black-Scholes-Merton
French options on government bonds. model, Lioui A. (2006) obtained new
Only in the early '70s options valuation formulas to evaluate options by
methods have begun to gain consistency considering the stochastic dividend yield.
by determining a formula for calculating Some of the hypotheses Black-Scholes-
the price of European options by Fischer Merton model are removed under the
Black and Myron Scholes. new approach.
Black and Scholes (1973) are the Unlike Black and Scholes who
pioneers in pricing option theory. They used the principle of continuous
started from the premise that if options valuation, Cox, Ross and Rubenstein
are properly evaluated, there can be designed the binomial model for
certainly no gain from the sale and calculating the price of an American
purchase of options and underlying option, based on the approximation of a
assets. Using this principle, they continuous process with a discreet one.
introduced a formula for determining the This model was presented in 1979 in
theoretical value of an option. This model Option Pricing: A Simplified Approach.
is the starting point for most further Model summary consists in simulation of
research. So Broadie, Detemple, Ghysels underlying asset price evolution by
and Torres (2000) determine the price of dividing the time to maturity in a certain
American options when the asset's number of short periods. Binomial
support provides a stochastic dividend method is useful and very popular for
yield. They show that an American option American call and put on a stock
is worth the sum of the European option providing dividends. The basic principle
premium and the premium for exercising of this model is that the underlying asset
the option before maturity. Chance, price can either increase or decrease in
Kumar and Rich (2002) provided the next period.
conditions under which the standard
138 Finance – Challenges of the Future

2. Black-Scholes formula for X – the strike price;

determining the price of European σ – the underlying assets volatility;
options r – the continously compounded risk-free
rate;
Black-Scholes model for T-t – the time to maturity of the option. T
determining the price of a European is the maturity, and t is the moment to
option is widely used in practice because maturity (at option issue t=0).
it requires knowledge of observable Previous formulas are used
parameters: the underlying asset price, when the underlying asset does not
the strike price, the time to maturity of the generate earnings. The amount of
option, the continously compounded risk- dividends generated by the underlying
free rate and a parameter to be asset of the option affects its price and,
estimated independently, the underlying accordingly, the option price. Thus, the
assets volatility. The model is based on a posting of dividends results in lower
set of assumptions of which the most premium for call options, and to increase
restrictive are: the underlying asset yield for the premium for put options. If the
are normally distributed, volatility remains underlying asset generates earnings,
constant throughout the life of the option, formulas for determining the price of an
there are no transaction costs and it can option are:
borrow money at the risk free rate.
Starting price evaluation model
c  S0eq(T t ) N (d1 )  Xer (T t ) N (d2 )
of European options by Black and
Scholes developed in the '70s, it was two p  S0eq(T t ) N (d1 )  Xer (T t ) N (d2 )
formulas for determining the price a
European call option (c) and a European
put option (p): where

c  S0 N (d1 )  Xer (T t ) N (d2 ) ln( S o X )  (r  q   2 / 2)(T  t )

d1 
p  S0 N (d1 )  Xe r (T t ) N (d 2 ) ,  T t
where
ln( S o X )  (r  q   2 / 2)(T  t )
ln( S o X )  (r   2 / 2)(T  t ) d2   d1   T  t
d1   T t
 T t ,
and q is the annual dividend yield if the
ln( S o X )  (r   2 / 2)(T  t ) underlying asset is a share or an index
d2   d1   T  t and the risk-free asset rate of foreign
 T t currency if the underlying asset is the
exchange rate.
The function N(x) is the Existence of an analytical
cumulative probability distribution solution for the price of a European
function for a standardized normal option allows analyzing how their prices
distribution. In other words, it is the respond to changes of variables and
probability that a variable with a standard parameters is determined. It's the Black-
normal distribution with average 0 and Scholes model assumptions, the
standard deviation 1. S0N(d1) is the variables: the underlying price (S) and
present value of the asset if the option is time to maturity (T-t) and the parameters:
 r (T  t ) the underlying assets volatility (σ), the
exercised, and Xe is the present
value of the strike price if the option is continously compounded risk-free rate (r)
exercised. and the strike price (X).
S0 – the stock price at time 0;
Year IX, No.12/2010 139

Options price response to the c

changes of these variables are virtually c   e q (T t ) N (d1 )
the sensitivity coefficients of the premium S
and main elements for measuring the risk p
that these financial assets involve and p   e q (T t ) [ N (d1 )  1]
are used to define practices cover such S
risks. In addition, the indicators facilitate Gamma (Γ) measures the delta
the development of cash flows generated sensitivity to changes in the underlying
by derivative in the underlying asset asset and it is represented
trading, technique which can be useful if mathematically as second derivative of
certain financial portfolio management option price to underlying price or first
strategies involve derivatives. order derivative of the delta to S. Gamma
Given the importance of knowing is identical for both call and the put option
the sensitivity indicators, we will continue and can be positive or negative. For a
this way of determining their values in European option on a non-dividend-
relation to different variables and their paying stock, it can be shown that:
use.  c  2 c N ' ( d1 )
Delta (Δ) is the most famous on c   2
Greek letters and it measures the option S S S T  t
price sensitivity to variations in the price  p  p
2
N ' ( d1 )
of the underlying asset. p   2 
Delta is calculated as the first S S S T  t
derivative of on option price to a change 1
1  x2
in the price of the underlying asset when where, N ' ( x )  e 2
the other parameters remain constant. 2
Practically, delta is the number of units of
the underlying asset we should hold for For a European call or put option
each option shorted in order to create a on an asset paying a continous dividend
riskless hedge. at rate q:
For a European option on a non-
dividend-paying stock, it can be shown
that: N ' ( d 1 ) * e  q (T  t )
c   p 
c S T  t
c   N (d1 )
S Geometric, gamma is the slope
p of the graph Δ = f(S) or convexity option
p   N ( d1 )  1 price to underlying price changes, was
S used to measure risk coverage, so the
The delta of a call option is risk position delta neutral.
always positive, that is to say, a variation Gamma presents values close to
in the price of the underlying asset zero when the option is out of the money
implies a variation, in the same direction, or in the money and the maximum value
in the price of the call option. On the when the option is at the money,
other hand, the value of a put option especially when the time to maturity is
decreases if the price of the underlying reduced.
asset increases, implying, therefore, a Theta (Θ) measures the option
negative delta. price change over time, while the other
For European options on an parameters are constant. To determine
asset paying a yield q, we have: the theta of a European option on a non-
dividend-paying stock, there are using
the following formulas:
140 Finance – Challenges of the Future

c N ' (d1 )
c    S  rXe r (T t ) N (d 2 )
 (T  t ) 2 T t
p N ' (d1 )e  q (T t )
c    S  qSN (d1 )e q (T t )  rXe r (T t ) N (d 2 )
(T  t ) 2 T t
For a European call or put option
on an asset paying a continous dividend
at rate q:
c N ' (d1 )e  q (T t )
c    S  qSN (d1 )e q (T t )  rXe r (T t ) N (d 2 )
(T  t ) 2 T t
p N ' (d1 )e  q (T t )
c    S  qSN (d1 )e q (T t )  rXe r (T t ) N (d 2 )
(T  t ) 2 T t
Theta is in most cases a
negative parameter, because as they c
approach maturity, option value tends to Kc   S (T  t ) N ' (d1 )e q (T t )
decrease. Exception to this observation 
are European put options on shares that
have a very strong position in the money, p
or call options in the money on Kp   S (T  t ) N ' (d1 )e q (T t )
currencies that have a very high interest

Vega is always a positive
rate.
coefficient and a higher value indicates a
Vega (K). Black-Scholes formula
high sensitivity to option volatility
has been demonstrated in the constant
changes. If vega has low volatility
volatility underlying assumption for the
changes, it will have a little impact on
time the option price is calculated. In
option price. Strong out or in the money
practice, volatility is a variable parameter,
options have a low vega, and the one at
which determines the option price
the money high, especially when maturity
changes. These changes are calculated
is delayed.
using vega which represents the first
Rho (Ρ) measures the sensitivity
derivative of an option value to volatility.
of the option value of interest rate and it
For a European option, a call or
is calculated as the first derivative of
a put, having an underlying asset that
option price to interest rate. For a
generates no gain, coefficient is given by
European option, a call or a put, having
the following formula:
an underlying asset that generates no
c
Kc   S (T  t ) N ' (d1 ) gain, the coefficient is given by the
 following formula:
p c
Kp   S (T  t ) N ' (d1 ) c   X (T  t )er (T t ) N (d 2 )
 r
For a European call or put p
option on an asset providing a dividend p    X (T  t )er (T t ) N (d 2 )
yield at rate q: r
The same formula applies if the
underlying European option generates
dividend.
Year IX, No.12/2010 141

Rho is always positive for a call 0.00591056, and put premium decrease
option, while for a put option the by 0.0210112.
coefficient is negative. Considering the coefficients
Example no. 1: Consider a delta, gamma and theta defined above,
European call option and a European put equation can be rewritten with the Black-
option on a stock that generate dividend Scholes partial differential according to
and it has the following characteristics: them. Thus, the relationship between
S=10 RON, E=11 RON, r=8.5%, σ=22%, delta, gamma and theta for a European
T=3 months, q=2%. option, in the Black-Scholes model
Applying the previous formulas, assumptions is:
we obtain: 1
Call premium=0.157455  c  rS c   2 S 2 c  rc
Put premium=0.976046 2
1
Determination of sensitivity  p  rS p   2 S 2 p  rp
coefficients of an option 2
In addition, it is noted that these
Call Put
indicators interact and may not be
Delta 0.252167 -0.7428446 regarded as separate entities.
Gamm 0.2895241 0.2895241 A higher volatility increases the
a
Vega 0.01592383 0.01592383 delta for out of the money and at the
money options and it brings down in the
Theta -0.002332 -0.0003694 money options, property resulting from
Rho 0.00591056 -0.0210112 delta to measure the probability of
Source: Own calculations using DerivaGem exercising the option. Changing the
gamma to the increased volatility is more
By the values of delta, it is noted pronounced for at the money options and
that an increase by one unit in spot price lower for those out of the money.
determines an increase by 0.252167
RON in the call premium and a reduction 3. A one-step binomial tree
by 0.7428446 RON in the put premium.
Gamma takes the value Consider a call option on a non-
0.2895241, which means that an dividend-paying stock. The assumptions
increase in the share price by 1 RON of the model are the same for the Black-
(from 10 to 11) will increase the option Scholes model, that the market id
value with 0.2895241 RON. efficient, there are no transaction costs
Vega is 0.01592383, which and no tax, securities are perfectly
means that if the underlying volatility divisible, short selling is allowed,
increase by one percentage point (from revenues generated by traded securities
22% to 23%), then both call and put are remunerated at the risk free rate, r,
premium will increase by 0.01592383. which is constant, volatility remains
Theta indicates the rate of constant throughout the life of the option.
change of the option premium with Add to this fact that the price of the
respect to the passage of time. The underlying asset follows a binomial
reduction of time to maturity by one day process in a time T, so this is the only
leads to a reduction by 0.002332 in call hypothesis on the evolution of the
premium and by 0.0003694 in put underlying asset price. So, if at the time 0
premium. the stock price is S, this can move up in
Rho shows that if the interest T by u times with probability p or to move
rate increase by one percentage point, down with probability 1-p. The process
then call premium increase by described is called the binomial
multiplicative process.
142 Finance – Challenges of the Future

The binomial model is based on follows that the present value of the
building a risk free rate portfolio with a portfolio is:
-0,06*3/12
short position in a call option and a long 3e =2,955
position in Δ shares. The value of the stock price
today is 10 RON. If we denote the option
A one-step binomial tree
price by f, then:
S 10x0,333-f=2,955
f=0,378
fu In conclusion, in the absence of
arbitrage opportunities, the current value
of the option must be 0,378 RON. If the
S value of the option were more than 0,378
f RON, the portfolio would cost less than
2,955 RON and would earn more than
the risk-free rate.
We can generalize the argument
d just presented by considering a stock
f whose current price is f. We denote with
Example no. 2: We propose to
evaluate an European call option with a T the maturity of the option and we
maturity of three months and the exercise suppose that during the life of the option
price of 11 RON. A stock price is the stock price can either moves down to
currently 10 RON. We suppose that at Sd or moves up to Su, where u>1 and
the end of three months the stock price d<1. The proportional increase in the
will be either 12 RON or 9 RON. If the stock price when is an up movement is u-
stock price turns out to be 12 RON, the 1, and the proportional decrease when
value of the option will be 1 RON. If the there is a down movement is 1-d. If the
stock price turns out to be 9 RON, the stock price moves up to Su,we suppose
value of the option will be zero. that the payoff from the option will be fu
Consider a portfolio consisting on and if the stock price moves down to Sd,
a short position in a call option and a long we suppose that the payoff from the
position in Δ shares. We calculate the option will be fd.
value of Δ that makes the portfolio We will calculate the value of Δ
riskless. If the stock price moves up from that makes the portfolio riskless. It
10 to 12 RON, the value of the option is follows that Δ can be chosen so that the
1RON, so that the total value of the final value of the portfolio be the same
portfolio is 12Δ-1. If the stock price whether the price of the underlying asset
moves down to 9 RON, the value of the increases or decreases during T.
portfolio will be 9Δ. The portfolio is fu - fd
SuΔ-fu =SdΔ-fd →Δ=
riskless if the value of Δ is chosen so S(u - d)
that the final value of the portfolio is the
In this case the portfolio is
same for both alternatives. This means
riskless and must earn the risk-free
12Δ-1=9Δ → Δ=0,333.
interest rate. The previous equation
The riskless portfolio contains 33
shows that Δ is the ratio of the change in
shares and one option. Whether the
the option price to the change in the
stock price moves up or down, the value
stock price as we move between the
of the portfolio is always 3 RON
nodes. If r is the risk-free rate, the
(12*0,333-1=9*0,33333≈3).
present value of the portfolios:
In the absence of arbitrage -rT
(SuΔ- fu)e
opportunities, riskles portfolios must earn
The cost of setting up the
the risk-free rate of interest. Suppose that
portfolio is SΔ- f.
the risk-free rate is 6% per annum. It
Year IX, No.12/2010 143

It follows that: 11=3.4. At nodes E and F, the option is

-rT
SΔ- f=(SuΔ- fu)e out of the money an its value is zero. At
-rT
f= SΔ-(SuΔ- fu)e node C, the option price is zero because
Substituting for Δ and simplifying, node C leads to either node E or node F
we obtain: and at both nodes the option price is
-rT
f= e [p fu+(1-p) fd] zero.
e rT  d We will calculate the option price
where p= at node B. We know that u=1.2, d=0.9,
ud r=0.06, T=0.25, so p=0.38371. It follows
In the numerical example that the value of the option at node B is
considered previously, u=1.2, d=0.9, -0.06x0.25
e [0.38371x3.4+(1-0.38371) x0]=1.285
r=0.06, T=0.25, fu=1, fd=0. It follows that:
e 0.06x0.25  0.9 It remains for us to calculate the
p= =0.38371 option price at node A. Thus the value of
1.2  0.9 the option is
-0.06x0.25
f=e [0.38371x1+(1-
e-0.06x0.25[0.38371x1.285+(1-0.38371) x0]=0.486
0.38371)x0]=0.378
The formula can be extended for
4. Generalized Binomial Model n periods using the same mechanism
with i up movements and n-i down
The one-step binomial tree cand movements of the stock price, for an
be exetended for a number of n periods, European call option being:
considering all possible states of the n
n!
stock price, with i up movements and n-i c= e -n rδt
 i!(n  i)! p (1-p)
i 0
i n-i
max(uid n-iS-X,0)
down movements.
The stock price is initially S, the In a similar manner, it can
risk-free rate is r, and the length of the calculate for an European put option:
time stept is δt years. Given the previous n
n!
results we obtain:
-rδt
p= e -n rδt
 i!(n  i)! p (1-p)
i 0
i n-i
max(X-uid n-iS,0)
fu= e [pfuu+(1-p)fud]
-rδt
fu= e [pfud+(1-p)fdd] Previous formula describe some
-rδt
f= e [pfu+(1-p)fd] widely used algorithms especially in the
Substituting the first two valuation of the options which offer
equations into the last, we have: exercise opportunities before the maturity
-2rδt 2 2
f=e [p fuu+2p(1-p)fud+(1-p) fdd] or whose underlying assets generate
Example no. 3: We consider the dividends.
call option with the same characteristics Essentially, after choosing the
as in the previous example. number of periods for dividing the option
life – usually 30 or more steps- it is built
14.4 the binomial network for the underlying
12 D3.4
B asset, following that the option price to be
1.285 10.8 determined little by little starting with the
A 10 E
0.486 9 0 final nodes of the network.
C Example no. 4: We consider an
0 8.1
F0 European call option with a maturity of
three months and the exercise price of 11
Our objective is to calculate the RON. A stock price is currently 10 RON,
option price at the initial node of the tree. the risk free-rate is 8% per annum, the
We begin by setting the option price at volatility is 22% per annum.
the final nodes. At node D the stock price The figure below illustrates the
is 14.4, and the option price is 14.4- binomial tree with 10 steps.
144 Finance – Challenges of the Future

Binomial tree with 10 steps for the underlying asset price and an European call option

Determination of sensitivity In the event that this period the

coefficients with binomial model can be underlying asset price, or the other
done by the transcription of definitions in parametters remain constant, the
dicrete form, considering the interval δt. coefficient can be approximated for the
Thus, it obtains for a call option: first two nodes:
f
 delta  f 21  f 20
S 
For the first step, the coefficient 2t
can be expressed as:
f f f
2f  vega K  
 gamma   
S 2 where f* is the value of the option
As we can see gamma can be for the volatility σ+δσ.
calculated with a delay of two periods δt
f f f
and for the first two periods its value can  rho P  
be approximated: r 
f 22  f 21 f 21  f 20 Estimation of sensitivity
 coefficients in the manner described
 Su 2
 S S  Sd 2 above is useful for following up hedging
Su 2  Sd 2 transactions, whose continuoully
sequence is not possible.
2 Example no. 5: We consider an
f
 theta   European call option with a maturity of
t three months and the exercise price of 11
RON. A stock price is currently 10 RON,
Year IX, No.12/2010 145

the risk free-rate is 8% per annum, the and in binomial version with 2, 10, 20, 30,
volatility is 22% per annum. 50, 100 steps.
Sensitivity coefficients have the
values below in Black-Scholes version

Calculation of sensitivity coefficients. Black-Scholes Model vs. Binomial Model

Black- Binomial Binomial Binomial Binomial Binomial Binomial
Sholes Model Model Model Model Model Model
Model n=2 n=10 n=20 n=30 n=50 n=100

Delta 0.264465 0.236763 0.260251 0.257564 0.262967 0.261829 0.263946

Gamma 0.297461 0.25986 0.302752 0.301808 0.298978 0.299448 0.29793

Vega 0.016360 0.021132 0.015410 0.019129 0.015711 0.016667 0.015817

Theta -0.00251 -0.00218 -0.00253 -0.00252 -0.00252 -0.00252 -0.00251

Rho 0.006193 0.005455 0.006156 0.006113 0.006235 0.006216 0.006264

Source: Own calculations using DerivaGem

It can be seen that the the the generally high leverage or sensitivity
differences are becoming smaller as the of derivatives value to the change of
number of steps increases. underlying asset value, a unique and yet
Similarly, sensitivity coefficients very important risk to options is the so-
can be calcaulated for a put option. called model risk that arises whenever
derivatives pricing and/or hedging
5. Conclusions strategies are based on a miss-specified
model.
Used both for hedging risks and Options prices, as those assets
for speculation, the options are found in that constitute their support, are affected
the portfolios of various institutions - from by several factors. Knowing these factors
hedge funds and financial institutions, and how they affect the value of options
corporations or individual investors. is essential to use as a tool for financial
Options have demonstrated risk management. Sensitivity coefficients
successfully their important role in the of the options premium measure the
financial markets. In an ideal setting, response of their price to each of the
derivatives pricing theory provides a factors influencing it, providing an image
framework in which the risks inherent to of the risk of a position on an option.
an option’s position can be minimized or The previous examples have
eliminated via a dynamic hedging shown that the difference in the
strategy. In practice, however, the calculation by the two models
effectiveness of such strategy can be of options price and their sensitivity
limited due to the lack of available coefficients disappear as the number of
hedging instruments and market binomial tree steps increases.
microstructure issues such as transaction
costs and market illiquidity. In addition to
 146 Finance – Challenges of the Future
REFERENCES

Black, F., Scholes, The pricing of options and corporate liabilities, Journal of Political
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