EFB344 Risk Management

and Derivatives
Lecture 8:
Options 1, Introduction and
Binomial Option Pricing
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Unit Outline
Week 1: Introduction to Risk, Risk Management and Derivatives
Week 2: Financial Statistics
Week 3: Value-at-Risk 1
Week 4: No Classes Ekka Public Holiday
Week 5: Value-at-Risk 2
Week 6: Forwards and Futures 1
Week 7: Forwards and Futures 2
Week 8: Mid-Semester Exam
Week 9: Forward Rate Agreements (FRAs) and Swaps
Week 10: Reflective Practice and Options 1 (intro and binomial
model)
Week 11: Options 2 (Black-Scholes model)
Week 12: Options 3 (trading strategies and risk management)
Week 13: Derivative Disasters
Week 14: Revision
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Lecture Content
Options
Option Valuation

Expectation Pricing
Replicating Portfolios
One-Step Binomial Model
Two-Step Binomial Model
Determining Up and Down Movements
Increasing the Time Steps

Readings:
Hull et al. (2014), Ch. 1: 1.5 1.6, Ch. 9 (skim) and Ch. 12.
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Options

Long Call

0
X

Payof

Payof

An option is the right (but not the obligation) for the

option buyer to force a transaction to occur at some
time in the future on terms and conditions agreed upon
now.

ST

Long Put
Where:
- X is the exercise price
Note:
- Call price (C) and Put price
(P) > 0

0
X

ST

Options
Some History
First traded in the 18th century, which is the same century
that Captain Cook sailed on the Endeavour (was on a
journey to witness the transit of Venus in 1769).
A colourful history then ensued.
First key option exchange, Chicago Board Options Exchange
(part of CBOT) was established in 1973.
Black, F. and Scholes, M. (1973) "The Pricing of Options and
Corporate Liabilities". Journal of Political Economy 81 (3):
637654.
Options first traded on the ASX in 1976.
Robert Merton and Myron Scholes awarded the Nobel Prize
in Economics in 1997. Unfortunately, Fischer Black died in
1995 and the Nobel Prize is not awarded posthumously.
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Options
Terminologies:

Call: right to buy

Put: right to sell
Buyer: buys the option
Writer: sells the option
Exercise: the option buyer enforcing their right to buy or sell
Exercise Price:
the price at which the option buyer transacts
Premium: amount paid by buyer to acquire the option
Intrinsic Value:maximum of the payof from exercising option now
and 0.
Time Value: diference between premium and intrinsic value
Maturity Date:
last day on which option can be exercised
American: option that can be exercised at any time up to an
including the expiration date
European: option that can only be exercised on expiration
date

Options
It is September 2014, CBA stocks trade for $77.83 and a
18 December 2014 CBA Call Option with an exercise price
of $75.00 trades for $4.13 on the ASX.
What do we know?

Buyer would pay the writer $4.13 and acquires the right to buy
The option expires on 18 December 2014 .
If exercised, the buyer will pay the writer $75.00 per share.
The option has an intrinsic value of $2.83 and a time-value of
$1.30.

What else could we know?

ASX options are American options, so can be exercised on any day
up to and including the expiration date.
The contract size is for 100 stocks.
The writer of the option must maintain a margin account. The
buyer does not need to maintain a margin account as the
premium, which they have already paid, is the most they can lose.7

Options
Written CBA Call

Return

Payof
Profit

Return

Bought CBA Call

Gains
unbounded
0
X = 75

ST

0
X = 75

ST
Losses
unbounded
Profit
Payof

The payof line shows the intrinsic value of the option. Options with positive
intrinsic value are referred to as in-the-money options while those with a 0
intrinsic value because ST < X are referred to as out-of-the-money options.
When ST = X, these are at-the-money options.
e buyer, the profit line is the payof line less the premium (they pay the premium
e seller, it is the payof line plus the premium (they receive the premium). 8

Options

Return

Profit

Written CBA Put

Return

Payof

Bought CBA Put

Gains
bounded
X = 75

ST

Losses
bounded

X = 75

ST

Profit
Payof

The most the buyer can lose is the premium. Given that they have already
paid the premium,
they do not pose a credit risk to the exchanges clearinghouse. However, the
writer of the option is a credit risk given that their potential losses have not
occurred. Hence, the writer
y, note whatever the buyer gains the writer loses, and vice versa.
must maintain a margin account or post collateral to cover their position.9

Options
Additional Information
Exchanges place limits on the amount of options one can trade.
ASX is an electronic exchange.
Market makers provide bid and ofer prices. In doing so, they
attempt to make the spread between bid and ofer.
A commission is paid on the purchase and on the sale (or
execution) of the option.
A naked option is where the investor does not have an ofsetting
position in the underlying. For the writer of naked options, the
margin is:
Call: the greater of 100% of the premium plus 20% of the share price less the
amount the option is out-of-the-money or 100% of the premium plus 10% of
the share price.
Put: the greater of 100% of the premium plus 20% of the share price less the
amount the option is out-of-the-money or 100% of the premium plus 10% of
the exercise price.

Warrants are options. Warrants issued by a company on its own

stock will result in the company issuing more of its own stock if
the warrant is exercised.
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Option Valuation
Modern
finance theory provides several

approaches for calculating the value of an asset.

1. Expectation Pricing (pricing the asset directly):

2. Risk Neutral Pricing (pricing with a replicating

portfolio)

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Option Valuation
A stock that currently sells for $20 (S0) will either move up to
$22 (Su) or down to $18 (Sd) in the next three months.
Assuming that the probability of the price increase is 70%
(pu), and
rf = 12% p.a., what is the value of a European call option on
this stock if the call has an exercise price of $21?
pu = 0.7

Su = 22
fu = 1

S0 =
20
pd = 0.3

Sd = 18
fd = 0

Where fu and fd are the options payofs for the up and down movement
respectively, f = max(0, X-S)

12

Expectation Pricing
Options
expected total return, , is

where: is the total risk-free return

is the total return on the underlying stock
is the options elasticity that measure the
percentage
change in the options value for a 1%
change in the
underlying

where: is the stock price and is the value of the option

13

Expectation Pricing

and
Options expected payof:

Stocks expected return

Option Elasticity:

14

Expectation Pricing
The
price of the options is

Heres the problem. For

multi-level trees, which
are more realistic, the
rate at which the
expected cash flows are
discounted varies through
the tree, which is difficult
to manage and
computationally
inconvenient. Therefore,
this approach is not used.
15

Replicating Portfolios
Derivative payofs can be replicated with a
portfolio of the underlying asset and bond or the
underlying asset and a related option.
Then, by replicating the options payofs and
setting up a riskless portfolio (cash flows are
known), the option can be valued under an
arbitrage argument.
Su = 22
Example
fu = 1

S0 =
20
Sd = 18
fd = 0

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Replicating Portfolios
Long Stocks and Long of Riskless Bond to generate payofs of
the call

Example, solve for and by simultaneous equations (were not doing

it)

Therefore, long 0.25 stocks and short 4.367 bonds generate payofs
of 1 and 0 if the stock price increases to 22 or decreases to 18,
17
respectively.

Replicating Portfolios
The replicating portfolio matches the payofs of the call

Outlay at 0

Payoff at T

x 20 +

0.25 x 22 4.367e0.03 =
1.00

x 20 +

0.25 x 18 4.367e0.03 =
Therefore its value must = f under0.00
arbitrage arguments.

The problem here is that were solving with simultaneous

equations, which is fine, but theres an easier and more
intuitive way

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Replicating Portfolios
Long Stocks and Short the Call such that the payof is

the same whether the stock price increases or

decreases.

Solving for in example

Outlay at 0

Payoff at T

x 20 f

0.25 x 22 1 = 4.50

x 20 f

0.25 x 18 0 = 4.50

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Replicating Portfolios
Therefore, under arbitrage arguments, option value, , should
be

Example:

Because this approach uses , it is referred to as the deltahedging approach. That is, (delta) is the number of stocks
required to hedge a short option position in the option.
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One-Step Binomial Model

Initial stock price, S0
Price can
increase by a factor u, where u > 1
decrease by a factor d, where d < 1 and d = 2 - u

S0u
fu
S0

f
S0d
fd

PV of riskless portfolio,
P0

21

One-Step Binomial Model

Continuing
with

Substitute for ,

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One-Step Binomial Model

Example

S0u = 20(1.1) =
22
fu = 1

20
f
S0d = 20(0.9) =
18
f =0
d

Surprisingly, this answer

does not depend on the
probability of the stock
price increasing or
decreasing. These
probabilities have been
already incorporated into
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One-Step Binomial Model

Risk Neutral Valuation
Investors are risk neutral (they do not increase their
required expected return to compensate for increased
risk) when valuing derivatives.
While options are risky, the formula for pricing options
remains the same. This is due to the fact that as
investors become more risk averse it is the stock price
that declines.
In risk neutral world
The expected return on a stock is the risk-free rate
The discount rate for pricing options is the risk-free rate

Despite the risk neutral assumption, pricing the option

under risk neutrality gives the right option price.
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One-Step Binomial Model

From

We interpret as the probability of an up movement,

which implies that is the probability of a down
movement.
From this, states that the value of the option is the
expected option payof discounted by the risk-free rate.
Note that these are risk neutral probabilities and are
not the probabilities of up and down movements in the
real world.
As mentioned in the last slide, risk neutral pricing gives
the correct valuation and it is much more convenient
than real world pricing because the discount rate for
all assets = r.
For more detail, refer to Hull et al. (2014) pp. 269-271.
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Two-Step Binomial Model

S0uu
S0u
fu
S0
f
S0d

fuu

S0ud = S0du
fud =
fdu

fd
S0dd
fdd
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Two-Step Binomial Model

Example:

and

24.2
22

fuu

fu
20

19.8

fud

18
fd

16.2
fdd

To value the
option, we
start by
looking at the
payofs at the
terminal
nodes: the
nodes at
maturity.
f = max(0,S-X)

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Two-Step Binomial Model

Example,

24.2

22

fuu =
3.2

max(0, 24.2 - 21)

fu
19.8

20
f
18

fud = 0

max(0, 19.8 - 21)

fd
Obviously fd =
0

16.2
fdd =
0

max(0, 16.2 - 21)

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Two-Step Binomial Model

Example,

24.2

22

fuu =
3.2

fu
19.8

20
f
18
fd =
0

fud = 0

16.2
fdd =
0

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Two-Step Binomial Model

Example,

24.2

22

20
f

fu =
2.03
18
fd =
0

fuu =
3.2

19.8
fud = 0

16.2
fdd =
0

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Two-Step Binomial Model

and
S0uu
S0u
fu
S0
f
S0d

fuu

S0ud = S0du
fud =
fdu

fd
S0dd
fdd

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Two-Step Binomial Model

60

72

max(0, X - S)

fuu = 0

max(0, 52 - 72)

fu
48

50
f
40

fud = 4

max(0, 52 - 48)

fd

32
fdd =
20

max(0, 52 - 32)
32

Two-Step Binomial Model

72

60

fuu = 0

fu
50

48

fud = 4

40

fd
32

fdd =
20
33

Two-Step Binomial Model

72

60

50
f

fu =
1.41
40

fuu = 0

48
fud = 4

fd = 9.46
32
fdd =
20
34

Two-Step Binomial Model

American options can be exercised any time up to
expiry.
For example, it turns out that we should exercise
72
the put early if the price drops to 40.
60

50

fu =
1.41

f
40

fuu = 0

48
fud = 4

fd = 9.46
max(0, X S) =
12

32
fdd =

35

Two-Step Binomial Model

72

60

50

fu =
1.41

f
40

fuu = 0

48
fud = 4

fd = 12
32
fdd =
20

36

Determining u and d
To
determine the actual up and down movement
factors, and respectively, we can employ volatility

A more detailed explanation of these formulas is

provided in the next lecture, but just note that S 0ud =
S0du = S0u/u = S0. As such, there is not an excessive
number of nodes to value the option over; especially
for multi-period binomials.
37

Determining u and d

S0 = 50
and a Put (American) with X = 52, = 0.30, =1 and r = 0.05

91.11

50
f=
7.43

67.4
9
fu =
0.93
37.0
4
fd =
14.96

fuu = 0

50
fud = 2

27.44
fdd = 24.56
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Increasing the time steps

In practice, a binomial models will general have

around 30 or more time steps.

As the number of time-steps increases, approaches 0.
We still use the approaches presented earlier, but
recognise that there will be a lot of calculations to
perform
Refer to tutorial
Do it in Excel
You will do it in your assignment

Note also, that as approaches 0, the price given by the

binomial model approaches that of the Black-Scholes
option pricing formula that we discuss next week.
39