Bodie Essentials of Investments 12e Chapter 16 PPT

Chapter
Option Valuation
16
Bodie, Kane, and Marcus
Essentials of Investments
12th Edition
16.1 Option Valuation: Introduction
• Intrinsic Value
• Stock price minus exercise price, or profit that
could be attained by immediate exercise of in-
the-money call option
• Time Value
• Difference between option’s price and intrinsic
value
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16.1 Option Valuation: Introduction
• Determinants of Option Value

• Stock price
• Exercise price
• Volatility of price
• Time to expiration
• Interest rate
• Dividend rate
Figure 16.1 Call Option Value before Expiration
Table 16.1 Determinants of Call Option Values
16.2 Binomial Option Pricing
• Two-State Option Pricing
• Assume stock price can take one of two values
• Increase by u = 1.2, or fall by d = .9
• Compare payoff to one share of stock,
borrowing of $81.82 10% interest
• Outlay is $18.18; payoff is three times call

option
• Portfolio of one share and three call options is
perfectly hedged
•
• Hedge ratio for two-state option
Cu  Cd
H
uS0  dS0
• Generalizing the Two-State Approach
• Break up year into two intervals
• Subdivide further using the same pattern
Figure 16.2A Probability Distributions for Final Stock Price,
Three Subintervals
Figure 16.2B Probability Distributions for Final Stock Price, Six
Subintervals
Figure 16.2C Probability Distributions for Final Stock Price, 20
Subintervals
16.3 Black-Scholes Option Valuation
• Black-Scholes Pricing Formula Inputs
• Let
• 𝐶0 = Current call option value
• 𝑆0 = Current stock price
• e = Base of natural log function, roughly 2.71828
• δ = Annual dividend yield of underlying stock
• N(di) = Probability of random draw < di
• X = Exercise price
• Black-Scholes Pricing Formula Inputs

• Let
• r = Risk-free interest rate
• T = Time until expiration
• ln = Natural logarithm
• σ = Standard deviation of annualized continuously
compounded rate of return (RoR)
• Black-Scholes Pricing Formula
C0  S0 e  T N (d1 )  Xe  rT N (d 2 )
where
ln( S0 / X )  (r     2 / 2)T
d1 
 T
d 2  d1   T
Figure 16.3 Standard Normal Probability Function
Spreadsheet 16.1 Black-Scholes Call Option Values
• Implied volatility
• Standard deviation of stock returns consistent with
option’s market value
Figure 16.5 Implied Volatility of S&P 500
• Put-Call Parity Relationship

• Represents relationship between European put
and call prices:
C  P  S0  Xe  rT
• Extension for European call options on
dividend-paying stocks
P  C  S0  PV ( X )  PV (dividends)
Figure 16.6 Payoff-Pattern of Long Call–Short Put Position
Table 16.3 Arbitrage Strategy
• Put Option Valuation

• Black-Sholes formula for European put option
 rT  T
P  Xe [1  N (d 2 )]  S0e [1  N (d1 )]
16.4 Using the Black-Scholes Formula
• Hedge Ratios and Black-Scholes Formula

• Hedge ratio or delta
• Number of shares required to hedge price risk of
holding one option
• Option elasticity
• Percentage increase in option’s value given 1%
increase in value of underlying security
Figure 16.7 Call Option Value and Hedge Ratio
• Portfolio Insurance
• Portfolio strategies that limit investment losses
while maintaining upside potential
• Dynamic hedging
• Constant updating of hedge positions as market
conditions change
Figure 16.8 Profit on Protective Put Strategy
Figure 16.9 Hedge Ratios Change as Stock Price Fluctuates
• Option Pricing and the Crisis of 2008-2009
• When banks buy debt with limited liability, they
implicitly write put option to borrower
Figure 16.10 Risky Loan
Figure 16.11 Value of Implicit Put Option on Loan Guarantee as
% of Face Value of Debt
Figure 16.12 Implied Volatility

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Chapter

• Determinants of Option Value

• Outlay is $18.18; payoff is three times call

• Hedge ratio for two-state option

• Subdivide further using the same pattern

• Black-Scholes Pricing Formula Inputs

• Black-Scholes Pricing Formula

• Put-Call Parity Relationship

• Put Option Valuation

• Hedge Ratios and Black-Scholes Formula

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