OPTIONS AND THEIR VALUATION

CHAPTER 7
 LEARNING OBJECTIVES
2

 Explainthe meaning of the term option

 Describe the types of options
 Discuss the implications of combinations of
options
 Highlight the factors that have an influence on the
valuation of options
 Develop a simple model of valuing options
 Show how the Black-Scholes model of option
valuation works
 Options
3

 Anoption is a contract that gives the holder a right,

without any obligation, to buy or sell an asset at an
agreed price on or before a specified period of time.

 The option to buy an asset is known as a call

option.

 The option to sell an asset is called a put option.

 Options
4

 Theprice at which option can be exercised is called

an exercise price or a strike price.

 The asset on which the put or call option is created

is referred to as the underlying asset.
 When an Option can be Exercised
5

 European option When an option is allowed to be

exercised only on the maturity date, it is called a
European option.

 American option When the option can be exercised

any time before its maturity, it is called an American
option.
 Possibilities of option holder exercising his
6
right
There are three possibilities:
 In-the-money: A put or a call option is in- the- money when it
is advantageous for the investor to exercise it.
 Out-of-the-money: A put or a call option is out-of-the-money
if it is not advantageous for the investor to exercise it.
 At-the-money: When the holder of a put or a call option does
not lose or gain whether or not he exercises his option, the
option is said to be at-the- money.
 Call Option
7

 Buy a call option

 You should exercise call option when:
• Share price at expiration > Exercise price.
 Do not exercise call option when:
• Share price at expiration < Exercise price.
 The value of the call option at expiration is:
• Value of call option at expiration = Maximum [Share price –
Exercise price, 0].
 The expression above indicates that the value of a call
option at expiration is the maximum of the share price
minus the exercise price or zero.
 The call buyer’s gain is call seller’s loss.
 Pay-off of a call option buyer
8
 Pay-off of a call option writer
9
 Call Premium
10

 The buyer of a call option must, pay an up-front

price, called call premium, to the call seller to buy
the option.

 The call premium is a cost to the option buyer and

a gain to the call seller.
 Example: Call Option Pay-off
11

 The share of Telco is selling for Rs 104. Radhey

Acharya buys a 3 months call option at a premium
of Rs 5. The exercise price is Rs 105. What is
Radhey’s pay-off if the share price is Rs 100, or Rs
105, or Rs 110, or Rs 115, or Rs 120 at the time the
option is exercised?
 Example : Pay-off of the call option buyer
12

The Call Option Holder's Pay-off at Pay-off of the call option buyer
Expiration
 Example: Pay-off of the call option seller
13

The Call Option Seller's Pay-off at Pay-off of the call option seller
Expiration
 Put Option
14

 Buy a put option

 Exercise the put option when:
• Exercise price > Share price at expiration.
 Do not exercise the put option when:
• Exercise price < Share price at expiration.
 The value or payoff of a put option at expiration will be:
• Value of put option at expiration = Maximum [Exercise price – Share
price at expiration, 0].
 The put option buyer’s gain is the seller’s loss.
 Example : Put Option Pay off
15

 An investor hopes that the price of BHEL’s share will fall after
three months. Therefore, he purchases a put option on BHEL’s
share with a maturity of three months at a premium of Rs 5.
The exercise price is Rs 30. The current market price of
BHEL’s share is Rs 28. How much is profit or loss of the put
buyer and the put seller if the price of the share at the time of
the maturity of the option turns out to be Rs 18, or Rs 25, or
Rs 28, or Rs 30, or Rs 40?
 16

Example
The Put Option Holder's Pay-off at Pay-off for a put option buyer
Expiration
 Example
17
The Put Option Seller's Pay-off at Pay-off for the put option seller
Expiration
 Options Trading in India
18

 The Security Exchange Board of India (SEBI) has

announced a list of 31 shares for the stock-based
option trading from July 2002. SEBI selected these
shares for option trading on the basis of the following
criteria:
Shares must be among the top 200 in terms of market
capitalisation and trading volume.

Shares must be traded in at least 90 per cent of the trading

days.
 Options Trading in India
19

The non-promoter holding should be at least 30 per cent and

the market capitalisation of free-float shares should be Rs 750
crore.

The six-month average trading volume in the share in the

underlying cash market should be a minimum of Rs 5 crore.

The ratio of daily volatility of the share vis-à-vis the daily

volatility of the index should not be more than four times at
any time during the previous six months.
 Options Trading in India
20

The minimum size of the contract is Rs 2 lakh. For the first six
months, there would be cash settlement in options contracts
and afterwards, there would be physical settlement. The
option sellers will have to pay the margin, but the buyers will
have to only pay the premium in advance. The stock
exchanges can set limits on exercise price.
 Index Options
21

 Index options are call or put options on the stock

market indices.

 InIndia, there are options on the Bombay Stock

Exchange (BSE)—Sensex and the National Stock
Exchange (NSE)—Nifty.
 Index Options
22

 The Sensex options are European-type options and expire on

the last Thursday of the contract month. The put and call index
option contracts with 1-month, 2-month and 3-month maturity
are available. The settlement is done in cash on a T + 1 basis
and the prices are based on expiration price as may be decided
by the Exchange. Option contracts will have a multiplier of
100.

 The multiplier for the NSE Nifty Options is 200 with a

minimum price change of Rs 10 (200  0.05).
 Combinations of Put, Call and Share
23

A share, a put and a call can be combined together

to create several pay-off opportunities. Some of
these combinations have significant implications.
They are:
 Long Position: A long position involves buying and
holding shares (or any other assets) to benefit from
capital gains and dividend. An investor may create a
long position in the shares of a firm. A long position
investment strategy is risky. The investor will incur
loss if the share price declines.
24

Example
 Suppose the current share price and the exercise
price to be Rs 100, and possible share prices at
expiration Rs 90 or Rs 110. The pay-off (value)
of a portfolio of a share (long) and a put (long) at
expiration is
Value of share

Current share
price

Share price
 Protective Put
25

Put option at-the-money is called a protective put

.The combination of a long position in the share
and a protective put helps to avoid the investor’s
risk when the share price falls.
Value of share
and put

Current share
price

Share price
Exerci se price
 Protective Put vs. Call
26

 The value of your portfolio of a share and a put at

expiration will always be greater than the value of a
call at expiration by the exercise price.

 At expiration, the position will be as follows:

Share price at expiration + Value of put at expiration = Value
of call at expiration + Exercise price
 Protective Put vs. Call
27
 Put-call Parity
28

 Suppose you buy a share (long position), buy a put (long position) and sell
a call (short). The current share price is Rs 100 and the exercise price of
put and call options is the same, that is, Rs 100. Both put and call options
are European type options and they will expire after three months. Let us
further assume that there are two possible share prices after three months:
Rs 110 or Rs 90. What is the value of your portfolio?

Value of a Portfolio of a Share and a Put Option

 Covered Call
29

 Naked option is a position where the option writer does not

hold a share in her portfolio that has a counterbalancing effect.

A covered call position is an investment in a share plus the

sale of a call on that share. The position is covered because the
investor holds a share against a possible obligation to deliver
the share. The total value or pay-off of a covered call at
expiration is the share price minus the value (pay-off) of the
call.
 Pay off of a covered call
30
 Combinations of Put, Call and Share
31

 Straddle: Combining Call and Put at Same

Exercise Price
 Strips and Straps
 Strangle: Combining Call and Put at Different
Exercise Prices
 Spread: Combining Put and Call at Different
Exercise Prices
 Spread: Combining the Long and Short Options
 Collars
 Pay offs : Straddle
32

Straddle Buyer Straddle Seller

 Pay offs: Strips and Straps
33

Strips Straps
 Strangle: Combining Call and Put at Different
34
Exercise Prices
 A strangleis a portfolio of a put and a call with the
same expiration date but with different exercise
prices. The investor will combine an out-of-the-
money call with an out-of-the-money put.
 Example
35

 Suppose the Telco share is currently selling for Rs 110. The

exercise prices for the Telco put and call are, respectively,
Rs 100 and Rs 105. What will be your pay-off if the price
of Telco’s share increases to Rs 120 in three months?
 You will forgo put option, but you will exercise call option.
So your pay-off will be the excess of the share price over
the call exercise price: Rs 120 – Rs 105 = Rs 15.
 If Telco’s share price falls to Rs 95, you will exercise put
option and pay-off will be the excess of exercise price over
the share price: Rs 100 – Rs 95 = Rs 5.
 Payoff from Strangle
36
 Spreads
37

A spread is a combination of a put and a call with

different exercise prices.
 Suppose that an investor buys simultaneously a 3-month
put option at an exercise price of Rs 95 and a call option at
an exercise price of Rs 105 on a company’s share. What
will be the investor’s positions if the share price is Rs 120?
How much will be the investor’s pay-off if the share price
is Rs 90?
 Pay off from Spread
38

Pay-off for a spread buyer Pay-off for a spread seller

 Types of Spreads
39

 The price spread or the vertical spread involves buying and

selling options for the same share and expiration date but
different strike (exercise) prices. For example, you may buy a
BPCL December option at a strike price of Rs 215 and sell a
BPCL December option at a strike price of Rs 210.

 The calendar spread or the horizontal spread involves

buying and selling options for the same share and strike price
but different expiration dates. For example, you may buy a
Tata Power December 2002 option at a strike price of Rs 95
and sell a Tata Power January option at a strike price of Rs 90.
 Bullish spread
40

An investor maybe expecting the price of an

underlying share to rise. But she may not like
to take higher risk. Therefore, she would buy
the higher-priced (premium) option on the
share and sell the lower-priced option on the
share.
41

Pay-off for a spread combining long position and short

position on a call
 Bearish spread
42

 An investor, who is expecting a share or index to fall, may

sell the higher-priced (premium) option and buy the lower-
priced option. For example, you may sell a BPCL December
option at Rs 10 (premium) with a strike price of Rs 210 and
buy a BPCL December option at Rs 5 (premium) with a strike
price of Rs 220.
 Butterfly Spread: Buying and Selling Calls
43

A long butterfly spread involves buying a call with a low

exercise price, buying a call with a high exercise price and
selling two calls with an exercise price in between the two.
Thus, there are three call contracts with different strike prices.

A short butterfly spread involves the opposite position; that

is, selling a call with a low exercise price, selling a call with a
high exercise price and buying two calls with an exercise price
in between the two.
44

Pay-off to a butterfly spread

 Collars
45

 A collar involves a strategy of limiting a portfolio’s

value between two bounds.
 It is a strategy that would let pay-off to range
within a band, irrespective of the price fluctuations
 Pay-off to a collar
46
 Factors Determining Option Value
47

1. Exercise price and the share (underlying asset)

price
2. Volatility of returns on share
3. Time to expiration
4. Interest rates
 Value of a call option
48
The value of the options will lie between Max and Min lines
 Exercise Price and Value of Underlying Asset
49

 Important determinants of options are the value of

the underlying asset and the exercise price.
 If the underlying asset were a share, the value of a
call option would increase as the share price
increases.
 The excess of the share price over the exercise
price is the value of the option at the expiration of
the option.
 Volatility of an Underlying Asset
50

 The option will be worthless if the share price

remains at strike price at maturity.
 It will be valuable if there are chances that the
share price may rise above the strike price.
 The probability of a higher price of the share
causes the option to be worth more.
 Example
51

 The figure below shows graphically the effect of the volatility of the underlying
asset on the value of a call option. The underlying assets in the example are share
of two companies—Brightways and Jyotipath. Both shares have same exercise
price and same expected value at expiration. However, Jyotipath’s share has more
risk since its prices have large variation. It also has higher chances of having higher
prices over a large area as compared to Brightways’ share. The greater is the risk of
the underlying asset, the greater is the value of an option.

Volatility of the share and the value of a call option

 Interest Rate
52

 The present value of the exercise price will depend on the

interest rate and the time until the expiration of the option.

 The value of a call option will increase with the rising interest
rate since the present value of the exercise price will fall.

 The effect is reversed in the case of a put option. The buyer of

a put option receives the exercise price and therefore, as the
interest rate increases, the value of the put option will decline.
 Time to Option Expiration
53

 The present value of the exercise price will be less if time to

expiration is longer and consequently, the value of the option
will be higher.

 Further,the possibility of share price increasing with volatility

increases if the time to expiration is longer.

 Longer is the time to expiration, higher is the possibility of the

option to be more in-the-money.
54

BINOMIAL MODEL FOR OPTION VALUATION

 Limitation of DCF Approach
55

 The DCF approach does not work for options

because of the difficulty in determining the
required rate of return of an option. Options are
derivative securities. Their risk is derived from the
risk of the underlying security. The market value of
a share continuously changes. Consequently, the
required rate of return to a stock option is also
continuously changing. Therefore, it is not feasible
to value options using the DCF technique.
 Model for Option Valuation
56

 Simple binomial tree approach to option valuation.

 Black-Scholes option valuation model.
 Simple Binomial Tree Approach
57

 Sell a call option on the share. We can create a

portfolio of certain number of shares (let us call it
delta, D) and one call option by going long on shares
and short on options that there is no uncertainty of
the value of portfolio at the end of one year.
 Formula for determining the option delta,
represented by symbol D, can be written as follows:
Option Delta = Difference in option Values /
Difference in Share Prices.
 Simple Binomial Tree Approach
58

 The value of portfolio at the end of one year

remains same irrespective of the increase or
decrease in the share price.
 Since it is a risk-less portfolio, we can use the risk-
free rate as the discount rate:
PV of Portfolio = Value of Portfolio at end of year /
Discount rate
 Simple Binomial Tree Approach
59

 Since the current price of share is S, the value of the

call option can be found out as follows:
Value of a call option = No. of Shares (D) Spot
Price – PV of Portfolio
 The value of the call option will remain the same
irrespective of any probabilities of increase or
decrease in the share price. This is so because the
option is valued in terms of the price of the
underlying share, and the share price already includes
the probabilities of its rise or fall.
 Risk Neutrality
60

 Investors are risk-neutral. They would simply expect a risk-

free rate of return.
 Black and Scholes Model for Option Valuation:
61
Assumptions
 The rates of return on a share are log normally
distributed.
 The value of the share (the underlying asset) and the
risk-free rate are constant during the life of the
option.
 The market is efficient and there are no transaction
costs and taxes.
 There is no dividend to be paid on the share during
the life of the option.
 Black and Scholes Model for Option Valuation
62

 The B–S model is as follows:

 rf t
C0  S0 N (d1 )  E e N (d 2 )
where
C0 = the current value of call option
S0 = the current market value of the share
E = the exercise price
e = 2.7183, the exponential constant
rf = the risk-free rate of interest
t = the time to expiration (in years)
N(d1) = the cumulative normal probability density
function
 Black and Scholes Model for Option Valuation
63

ln ( S / E )   rf   2 / 2  t
d1 
 t
d 2  d1   t

where
ln = the natural logarithm;
σ = the standard deviation;
σ2 = variance of the continuously
compounded annual return on the share.
 Features of B–S Model
64

 Black–Scholes model has two features-

 The parameters of the model, except the share price
volatility, are contained in the agreement between the
option buyer and seller.
 In spite of its unrealistic assumptions, the model is able
to predict the true price of option reasonably well.
 Themodel is applicable to both European and
American options with a few adjustments.
 Option’s Delta or Hedge Ratio
65

 The hedge ratio is a tool that enables us to summarise the

overall exposure of portfolios of options with various exercise
prices and maturity periods.

 An option’s hedge ratio is the change in the option price for a

Re 1 increase in the share price.

 A calloption has a positive hedge ratio and a put option has a

negative hedge ratio.

 Under the Black–Scholes option valuation formula, the hedge

ratio of a call option is N (d1) and the hedge ratio for a put is N
(d1) – 1.
 Example
66

 Rakesh Sharma is interested in writing a six-months call

option on L&T’s share. L&T’s share is currently selling
for Rs 120. The volatility (standard deviation) of the share
returns is estimated as 67 per cent. Rakesh would like the
exercise price to be Rs 120. The risk-free rate is assumed
to be 10 per cent. How much premium should Rakesh
charge for writing the call option?
 Example
67

 First we calculate d1 and d2

 Then, we obtain the values of N(d1) and N(d2) as follows:

 We obtain the call and put values as given below:

 Implied Volatility
68

 Implied volatility is the volatility that the option

price implies. An investor can compare the actual
and implied volatility. If the actual volatility is
higher than the implied volatility, the investor may
conclude that the option’s fair price is more than
the observed price.
 Dividend-Paying Share Option
69

 We can use slightly modified B–S model for this purpose. The
share price will go down by an amount reflecting the payment
of dividend. As a consequence, the value of a call option will
decrease and the value of a put option will increase.
 We also need to adjust the volatility in case of a dividend-
paying share since in the B–S model it is the volatility of the
risky part of the share price. This is generally ignored in
practice.
 Ordinary Share as an Option
70

 The limited liability feature provides an opportunity

to the shareholders to default on a debt.
 The debt-holders are the sellers of call option to the
shareholders. The amount of debt to be repaid is the
exercise price and the maturity of debt is the time
to expiration.
 The shareholders’ option can be interpreted as a put
option. The shareholders can sell (hand-over) the
firm to the debt-holders at zero exercise price if
they do not want to make the payment that is due.
 Example
71

 Excel Corporation is currently valued at Rs 250 crore. It

has an outstanding debt of Rs 100 crore with a maturity of
5 years. The volatility (standard deviation) of the Excel
share return is 60 per cent. The risk-free rate is 10 per
cent. What is the market value of Excel’s equity? What is
the current market value of its debt?
 Example
72

The market value of debt is : Market value of debt= Value of firm – value
of equity
= 250 – 200 = Rs 50 crore.