Option Pricing Models

Option pricing theory has made vast strides

since 1972, when Black and Scholes published
their path-breaking paper providing a model for
valuing dividend-protected
European options. Black and Scholes used a
replicating portfolio a portfolio composed of
the underlying asset and the risk-free asset that
had the same cash flows as the option being
valued to come up with their final formulation.
While their derivation is mathematically
complicated, there is a simpler binomial model
for valuing options that draws on the same logic
also.

 The use of the BS model and formula is

reserved in financial markets.
ASSUMPTIONS:
1. The risk free interest rate exists and is
constant (over the life of the option),
and the same for all maturity dates.
2. The short selling of securities with full
use of proceeds is permitted.
3. There is no transaction cost and no
taxes. All securities are perfectly
divisible (ex: it is possible to buy
1/100th of a share)

4. There is no riskless arbitrage

opportunities ; security trading is
continuous.
5. The underlying security pays no
dividends during the life of the option. The
higher the yield of dividend, the lower the
call premium as thus, the market prices of
the calls are not likely to be the same.
6. The volatility of the underlying
instrument (may be the equity share or
the index) is known and constant over the
life of the option.

7. The distribution of the possible

share prices (or index levels) at the
end of a period of time is log (record)
normal or in other words, a shares
continuously compounded rate of
return follows a normal distribution.
8. The market is an efficient . This
implies that as a rule, the people
cannot predict the direction of the
market or any individual stock.

BLACK-SCHOLES EUROPEAN MODEL

The original BS option pricing model was
developed to value options primarily on
equities.
This model has a number of restrictive
assumptions including the limitations that
the underlying asset pays no dividends.
The model has since been modified to
value European options on dividend paying
equities, as well as on bonds, foreign
exchange, futures and commodities.
the formula as follows:-

If t is in years, the and r should also be expressed in annual

 Since the calculation of option price through

the BS formula involves many intermediary
computations, a systematic procedure may be
useful:
Step 1: work out In(S/K)
2/2)
Step 2: calculate (r+
Step 3 : find
t
Step 4 : compute TOTAL d1 from the equation
Step 5 : calculate TOTAL d2 from the equation
Step 6 : find cumulative normal distribution
values by using N(d) table.
Step 7: now calculate the price of the option
by substituting the respective values in
equation.

 Q. 1: S = 100; K = 100; T = 1 Yr ; r =
12%; volatility of the stock is 10%
p.a. Calculate the Call option price.

 Q.2: The current price of a stock is

Rs.90 per share. The risk-free
interest rate is 8% (annualized
continuous compounding). If the
volatility of the stock is 23% p.a.,
what is the price of the Rs.80 call
option expiring in 6 months.
i.e., S= 90 K=80 T = 6 months ; r =
8% and

= 23%

Put Option buying

A buyer of put option is bearish
on underlying stock.

PUT OPTION

A Put Option gives the holder the

right to sell an asset at a certain
price within a specific period of time.
Puts are very similar to having a
short position on a stock. Buyer of
puts hope that the price of the stock
will fall before the option expires.

PUT OPTION
The price of the European put option
can be computed using the following
formula:
P = K * e-rt * N(-d2) S N (-d1)
Where as the rTcall option is:
c S 0 N (d1 ) K e N (d 2 )
all the terms that appear in this
formula are as above only. But
N (-d2) same as = 1- N (d2)
N (-d1) Same as = 1- N (d1)

OPTION
PRICING
MODELS

BLACKSCHOLES
OPTION
MODEL
BINOMIAL
OPTION
MODEL

BINOMIAL OPTION PRICING MODEL

This model was advocated by COX, ROSS AND
RUBINSTEIN in 1979 and takes the form of binomial
model. This is also called as C-R-R MODEL.
This model is a discrete-time model, because it
breaks down the total time to expiration into potentially
a very large number of time intervals or steps.
These steps form a tree like format. At each step, it is
assumed that the price of the underlying asset say
stock will move up or down by an amount calculated
using volatility and time to expiry. Therefore this model
is based on constructing a binomial tree.
This is a tree which represents different possible paths
that might be followed by the stock price over the life
of the option.

 Initially, a tree of stock prices is drawn

showing the possible stock prices at
every point of time in a forward form
(left to right). This tree is commonly
known as Binomial Tree.
Next option prices at each step of the
tree are calculated working back from
expiry to present (right- to left).
The option prices at each step are
used to derive the option prices at
next step of the tree.

 This model will consider the time to expiry of an

option. Based on time it is divided in to three
models.

ONE-STEP
BINOMIAL
TREE
BOPM
(TYPES)

TWO-STEP
BINOMIAL
TREE
MULTI
PERIOD
BINOMIAL
TREE

ASSUMPTIONS
1. The current selling price of the stock (S) can
only take two possible values i.e., upper
value (Su) and a lower value (Sd).
2. There are no transaction costs, taxes or
margin requirements.
3. Market participants entail no counter party
risk. In other words, there is no risk of
default by the other party in the contract.
4. Markets are competitive. It means that
market participants act as price takers, and
not the makers.

5. There are no arbitrage

opportunities. Prices have adjusted
in such a way so that there are no
arbitrage opportunities in the
market.
6. The investors can lend or borrow at
the risk-less rate of interest,( r )
which is the only interest rate
prevailing.
7. The securities are tradable in

ONE STEP BINOMIAL TREE MODEL

Under this model the stock price will
move only two sides i.e., either up
side or down side in a given period.
(generally in three months).
Ex: A stock price is currently Rs.120
and it is known that after three
months it can either go up by 25% or
down by 20%

t = 0 (Today)

t = 1 (3-months)

150
120
96

TWO STEP BINOMIAL TREE

Under this model we will have one
more step apart of first step i.e., two
steps calculation will be there.
Ex: if we consider the above same
problem the construction of tree as
follows:

t = 0 (To day)

t = 1 (3 Months)

t = 2 (6 Months)

187.5
150
120

120
96

76.8

MULTI - PERIOD
BINOMIAL TREE
Under this model we will have one
more step apart of first & Second
step calculation, the step as
follows...
Ex: if we consider the above same
problem the construction of tree as
follows:

t=0

t=1

t=2

t= 3

234.37
187.5
150

150
120

120

96
96
76.8
61.44

 In the Binomial Tree the prices

changes at different points, Each
point where 2 lines meet is termed
as NODE. Which represents a
possible future price of the stock.
The tree is called as Binomial
because the spot price at every node
can either move up or down.

t=0

t=1

t=2

t= 3

G
D
H

B
E

C
F

STRIKE PRICE IS Rs.

t=0

t=1

t=2

t= 3
154.19

133.47
115.53

100

D
115.53

B
100

A
C
74.92

E
86.55

86.56

STRIKE PRICE IS Rs.105

64.85

t=0

t=1

t=2

t= 3
154.19

133.47
115.53

10.44

115.53

4.07
100

100

A
17.76

E
86.55

18.45
74.92

8.67
86.56

28.33

64.85
40.16

STRIKE PRICE IS Rs.105

 Some important characteristics are as

follows:1. Length of the time-interval remains
constant throughout the tree, i.e., if the
interval between the nodes is in
months, it will be months everywhere
and if it is in terms of years, it will years
everywhere.
2. Volatility remains constant throughout
the tree.
3. Change probability remains the same in
the entire tree.

Binomial Model system the following steps to be

followed:

Step 1 : finding the terminal values

with upper side and down side
variations.
Step 2: to find the terminal values,
we have to find the u value and d
value by using the formula.

ue

de

(T/n)

(T/n)

Step 3 : find the p value by using

the below formula.

d
u d

r*T / n

36

 Where :
u = probable up-swing
d = probable down-swing

= volatility (standard deviation)

p.a
r = Risk free return p.a.
T = Time to expiry of the option
n = Number of time steps

 The value of the options at different

nodes can be calculated by using the
following formula.
C = erT . p . Cu + (1 p) . Cd

 Ex: the spot price of the asset is Rs.100 and the

strike price of the stock is Rs.105 and an
annual volatility of 25%, assuming 5% risk free
interest rate, price the call option in three time
steps.
Ans: this question involves pricing the option in
three steps, i.e., we have to model the stock
price three times or once every four months.
First we have to determine the up factor and
the down factor which are related to volatility
by using the above FIRST TWO FORMULAS.

ue

(T/n)

ue

u e^

.25 (1/3)

(.25 ( (1/3) ))

=
1.1553
e = 2.7183
40

ue

(T/n)

ue

.25 (1/3)

=
1.1553

de

(T/n)

de

.25 (1/3)

=
0.8656
41

t=0

t=1

115.53
100

Su = 100 X 1.1553
= 115.53

t=2

t= 3

t=0

t=2

t=1

133.47
115.53
100

Su = 100 X 1.1553 = 115.53

Suu = 115.53 X 1.1553

= 133.47

t= 3

t=0

t=1

t=2

t= 3
154.19

133.47
115.53
100

Su = 100 X 1.1553
=
Suu115.53
= 115.53 X 1.1553 = 133.47

Suuu = 133.47 X 1.1553

= 154.19

t=0

t=1

t=2

t= 3
154.19

133.47
115.53
100
86.56

Sd = 100 X 0.8656 =
86.56

t=0

t=1

t=2

t= 3
154.19

133.47
115.53
100
86.56

Sd = 100 X 0.8656 = 86.56

Sdd = 86.56 X 0.8656

= 74.92

74.92

t=0

t=1

t=2

t= 3
154.19

133.47
115.53
100
86.56

Sd = 100 X 0.8656 = 86.56

Sdd = 86.56 X 0.8656 = 74.92

Sddd = 74.92 X
0.8656 = 64.85

74.92
64.85

t=0

t=1

t=2

t= 3
154.19

133.47

115.53
100

100
86.56

74.92

Su = 100 X 1.1553 = 115.53

Sud = 115.53 X 0.8656

= 100

64.85

t=0

t=1

t=2

t= 3
154.19

133.47
115.53

115.53
100

100
86.56

74.92

Su = 100 X 1.1553 = 115.53

Sud = 115.53 X 0.8656 = 100

Sudu = 100 X 1.1553 =

115.53

64.85

t=0

t=2

t=1

t= 3
154.19

133.47
115.53

115.53
100

100

86.55
86.56
74.92

Su = 100 X 1.1553 = 115.53

Sud = 115.53 X 0.8656 = 100

Sddu
Sudu = 100 X 1.1553 = 115.53

64.85

= 74.92 X 1.1553
= 86.55

d
u d

r *T / n

e
0.8656
p
0.5219
1.1553 0.8656
0.05 *1 / 3

51

t=0

t=1

t=2

t= 3

154.19
133.47

115.53

115.53
100

100

86.55
86.56
74.92

STRIKE PRICE IS Rs.105

64.85

Calculation of Option values

To construct the call option three period
binomial tree start the calculation from left to
right side.
Calculate the terminal value of the option. If
the stock price is Rs.154.19 upper value at
t = 3 upper option value is 154.20 105 =
49.19 .
and the t = 3 down option value is 115.53
105 = 10.53
Then, if the stock price is less than strike price
i.e., Rs.105 we have to consider the value =

t=0

t=1

t=2

t= 3

49.
19
10.
53
0
0

Cuuu (upper value) is 154.19 105

= Rs. 49.19

 Now the value of the other options at different

nodes can be calculated by using the following
formula.

C = er*T/n p . Cu + (1 p) . Cd
Cuu = e0.05 *1/3 0.5219 . 49.2 + (1 0.5219) .10.53
Cuu = 0.9834 25.677 + 0.4781 . 10.53
Cuu = 0.9834 25.677 + 5.03
Cuu = 0.9834 30.711

30.20

t=0

t=1

t=2

30.
20

t= 3

49.
19
10.
53
0
0

 Now the value of the other options at different

nodes can be calculated by using the following
formula.

C = er*T/n p . Cu + (1 p) . Cd
Cud = e0.05 *1/3 0.5219 . 10.53 + (1 0.5219) .0
Cud = 0.9834 5.495 + 0.4781 . 0
Cuu = 0.9834 5.495 + 0
Cud = 0.9834

5.495

5.40

t=0

t=1

t=2

30.
20
5.4
0
0

t= 3

49.
19
10.
53
0
0

 Now the value of the other options at different

nodes can be calculated by using the following
formula.

C = er*T/n p * Cu + (1 p) * Cd
Cu = e0.05 *1/3 0.5219 * 30.20 + (1 0.5219) 5.40
Cu = 0.9834 15.761 + 0.4781 * 5.40
Cu = 0.9834

15.761 + 2.581

Cu = 0.9834

18.34

18.03

t=0

t=1

18.
03

t=2

30.
20
5.4
0
0

t= 3

49.
19
10.
53
0
0

 Now the value of the other options at different

nodes can be calculated by using the following
formula.

C = er*T/n p * Cu + (1 p) * Cd
Cd = e0.05 *1/3 0.5219 * 5.40 + (1 0.5219) * 0
Cd = 0.9834 15.761 + 0.4781 * 0
Cd = 0.9834

2.818 + 0

Cd = 0.9834

2.818

2.77

t=0

t=1

18.
03
2.7
7

t=2

30.
20
5.4
0
0

t= 3

49.
19
10.
53
0
0

 Now the value of the other options at different nodes

can be calculated by using the following formula.

C = er*T/n p * Cu + (1 p) * Cd
Cd = e0.05 *1/3 0.5219 * 18.03 + (1 0.5219) * 2.77
Cd = 0.9834 9.40 + 0.4781 * 2.77
Cd = 0.9834

9.40 + 1.324

Cd = 0.9834

10.724

10.54

t=0

10.
54

t=1

18.
03
2.7
7

t=2

30.
20
5.4
0
0

t= 3

49.
19
10.
53
0
0

THE THREE PERIOD BINOMIAL TREE FOR A

CALL OPTION

t=0

t=1

t=2

t= 3

154.19
133.47

115.53

115.53
100

100

86.55
86.56
74.92

STRIKE PRICE IS Rs.105

64.85

Draw the Binomial Tree from the

following data and show the stock prices

Particula
rs

EUROPEAN
CALL OPTION

PUT OPTION

STOCK PRICE

100

100

STRIKE PRICE

120

80

MATURITY

1 YEAR

1 YEAR

SUB-PERIODS (t)

TWO

TWO

u FACTOR

1.40

1.40

d FACTOR

0.80

0.80

Ex: - Consider a three-step call option

under European method with the
following information:
Spot price = Rs.140
Exercise Price = Rs.150
Upper factor (u) = 1.25
Down factor (d) = 0.8
Risk free rate is 10%

 Calculate European Call Option and

Put Option from the given information
with 3 step method:
PARTICULARS

VALUES

STOCK PRICE

Rs.100

EXERCISE PRICE

Rs.90

Risk-Free interest Rate

(continuously
compounded)

8.00%

Volatility

50.00%

Maturity

1 year

Ex: - Consider a two-step put option

under European method with the
following information:
Spot price = Rs.100
Exercise Price = Rs.105
Time to expiry = 1 year
Risk free rate is 8%
Volatility is 25 %

EUROPEAN PUT OPTION

The binomial model can also be used
to price a put option in a similar way.
The following example shows pricing
of a European style put options
value at expiry.
This first initial option price tree
is as follows:

Calculation of put Option

values

To construct the put option three period

binomial tree
Then, if the stock price is greater than the
strike price i.e., Rs.105 we have to
consider the value = 0 at t=3

uuu option value and t=3 uud

value also 0.
And the below two terminal values of the
put option are Rs.105.00 86.55 = 18.45
and the t = 3 down option value is
105.00 64.85 = 40.15

t=1

t=0

t=2

t= 3

0
0
18.
45

Pddu
Rs.

40.
15
(down value) is 105 86.55 =

18.45

 Now the value of the other options at

different nodes can be calculated by using
the following formula.

Puu = er*T/n p * Pu + (1 p) * Pd
Puu = e0.05 *1/3 0.5219 * 0 + (1 0.5219) *
0
Puu = 0.9834 0
Puu = 0

t=0

t=1

t= 3

t=2

0
0
18.
45
40.
15
Puu (upper value) is

Rs.

 Now the value of the other options at different

nodes can be calculated by using the following
formula.

Pud = er*T/n p * Pu + (1 p) * Pd
Pud = e0.05 *1/3 0.5219 * 0 + (1 0.5219) * 18.45
Pud = 0.9834 0 + 0.4781 * 18.45
Pud = 0.9834

8.820

Pud = 0.9834

8.820

8.67

t=0

t=1

t= 3

t=2

0
0

8.6
7

18.
45
40.
15

Pud (upper down value) is

Rs.

8.67

 Now the value of the other options at different

nodes can be calculated by using the following
formula.

Pdd = er*T/n p * Pu + (1 p) * Pd
Pdd = e0.05 *1/3 0.5219 * 18.45 + (1 0.5219) *
40.15

Pdd = 0.9834 9.62 + 0.4781 * 40.15

Pdd = 0.9834 9.62 + 19.19
Pdd = 0.9834

28.815 = 28.33

t=0

t=1

t= 3

t=2

0
0

8.6
7

18.
45

28.
33
Pdd (down down value) is

40.
15
Rs.

28.33

Find the rest of put option

values

 Now the value of the other options at different

nodes can be calculated by using the following
formula.

Pdd = er*T/n p * Pu + (1 p) * Pd
Pdd = e0.05 *1/3 0.5219 * 18.45 + (1 0.5219) *
40.15

Pdd = 0.9834 9.62 + 0.4781 * 40.15

Pdd = 0.9834 9.62 + 19.19
Pdd = 0.9834

28.815 = 28.33

t=0

t=1

t=2

t= 3

0
4.0
7

8.6
7
28.
33

0
18.
45
40.
15

 Now the value of the other options at different

nodes can be calculated by using the following
formula.

Pdd = er*T/n p * Pu + (1 p) * Pd
Pdd = e0.05 *1/3 0.5219 * 18.45 + (1 0.5219) *
40.15

Pdd = 0.9834 9.62 + 0.4781 * 40.15

Pdd = 0.9834 9.62 + 19.19
Pdd = 0.9834

28.815 = 28.33

t=0

t=1

t=2

t= 3

0
4.0
7
17.
76

8.6
7
28.
33

0
18.
45
40.
15

 Now the value of the other options at different

nodes can be calculated by using the following
formula.

Pdd = er*T/n p * Pu + (1 p) * Pd
Pdd = e0.05 *1/3 0.5219 * 18.45 + (1 0.5219) *
40.15

Pdd = 0.9834 9.62 + 0.4781 * 40.15

Pdd = 0.9834 9.62 + 19.19
Pdd = 0.9834

28.815 = 28.33

t=0

t=1

t=2

t= 3

0
10.
44

4.0
7
17.
76

8.6
7
28.
33

0
18.
45
40.
15

t=0

t=1

t=2

t= 3
154.19

133.47
115.53

10.44

115.53

4.07
100

100

A
17.76

E
86.55

18.45
74.92

8.67
86.56

28.33

64.85
40.16

STRIKE PRICE IS Rs.105