FIN 635

Lecture Notes 6
Options Markets

Main Topics
1. Definition: Options
2. Payoff Diagrams
3. Put-Call Parity
4. Stock Price Simulation
5. Binomial Option Pricing Model
6. Black-Scholes Option Pricing Model

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 1
Options

An option is a financial security whose value is derived from the value(s) of other underlying
(financial or non-financial) securities. Thus, options are known as derivatives. Alternatively,
you can think of options as securities that yield a positive payoff when an event (or, a set of
events) occurs. Thus, they are also known as contingent claims.

European
Options (the option can only be
exercised at the expiration
date.)
Call Put
(an option to buy) (an option to sell)
American
(the option can be
exercised at any time)

• Options can be written on any stochastic/random variable: stocks, stock indexes (e.g.,
SP500, currencies, commodity prices, weather, etc.

• Options allow investors to hold a leveraged position (⇒ it is riskier than the underlying
security).

• However, it can be used as a very effective risk management (or hedging) tool when
combined with other securities.
Leveraged ⇒ if the value of the underlying security changed by $X, the value of
the option changes by $KX where K > 1.
Hedging tool ⇒ it reduces the risk of the portfolio.

• An option is said to be in the money if it is expected to yield a positive payoff. The option is
likely to be exercised.
• Out of money option: will not exercise the option since the payoff would be negative.
• At the money option: the payoff from the option = 0. Indifferent about exercising the option.

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 2
Payoff Diagrams
How can we characterize an option? Need 4 variables.
X: exercise or strike price of an option.
T: expiration or maturity date.
ST: price of the underlying security (e.g., a stock) at the expiration date.
f: premium or purchase price of an option.

Call Option
Net Option Payoff

call writer
f
Payoff to a call holder
= ST – X, if ST > 0 0
= 0, if ST ≤ X call holder
–f

Net payoff (or profit)

= ST – X – f, if ST > 0
X Stock price
= –f, if ST ≤ 0 Strike Price at expiration
date (ST)

If you are writing a call option (i.e., taking a short position), the payoffs would just be opposite.

Net payoff to a call writer = f + X – ST, if ST > 0

= f, if ST ≤ 0.

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 3
 Put Option

Net Option Payoff

Put Holder:
Payoff = 0, if ST > 0
X–f
= X – ST, if ST ≤ X. Put
f Writer
Net Payoff = – f, if ST < 0
= X – ST – f, if ST ≤ 0. 0
Put
–f Holder
–X+f

ST
The payoffs to a put writer would just be opposite.

Now, let us look at the payoffs from various combinations.

Protective Put

• A combination of a put option and a stock.

• Guarantees a minimum payoff equal to the strike price (X) of the put option. Net minimum
payoff = X – f.

ST > X (Up) ST = Sup 0

ST = Sdown X – ST
ST ≤ X (Down)
Stock Price Stock Put
at Expiration

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 4
The payoffs of the protective put in the 2 states are:

ST + 0 = ST if ST > X

ST + (X – ST) = X if ST ≤ X

⇒ Minimum payoff = X.

The payoff diagram for a protective put:

Option Payoff
f = price of the protective put
= S0 + fput

S0: current stock price

Total fput: price of the put option
X
X–f Net

X ST

Other possibilities combinations:

Covered call: Buy stock, sell call.
Straddle: Call option + put option
Strip: Call option + 2 put option
Strap: 2 Call option + put option
Spreads: Multiple call/put options with different exercise prices or expiration dates.
Example: Collar (payoff between two bounds): hold call (strike = X1) and
write a call (strike X2), X2 > X1.

You must know how to draw the payoff diagrams for these option strategies. Please see the text
for additional details.

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 5
Put-Call Parity
What should be the relation between put and call prices?

To answer this question, we will manufacture the payoffs of a protective put (which contains a put
option) using a call option and other securities. We will use the no arbitrage condition to relate
the prices.

Consider a protective put option:

Payoff = ST if ST > X
=X if ST ≤ X (provides a lower bound on the payoff).

Cost of the protective put = S0 + P (using the no arbitrage condition).

Current stock price Current price of the put option.

Now, consider a call option:

Payoff = ST – X if ST > X
= 0 if ST ≤ X

By adding X to the payoffs in the two states, we can replicate the payoff of the protective put.
In practice, this can be done by buying a riskless bond with a face value of X.

The payoffs of a bond + call portfolio would be:

Payoff = ST – X + X = ST if ST > X
= 0 +X = X if ST ≤ X

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 6
Cost of this portfolio (if no arbitrage condition holds)

X
=C+ rf: riskfree interest rate
(1 + r f )
T

Price of the call option Bond price

With continuous compounding, the price/cost will be:

X
=C+ rf
= C + Xe−rfT
e T

If two portfolios yield similar payoffs, then they must trade at equal prices. An arbitrage
opportunity will exist if the prices are not equal. In the current context, this means:

S0 + P = C + Xe−rfT

Price of the Price of the bond-call

protective put portfolio.
Memorize this!!!!

This is the put-call parity relation. It is another manifestation of the no arbitrage condition.

If a stock pays dividends, the put-call parity relation is slightly different:

S0 – PV(D) + P = C + X e−rfT

Present value of future dividend payment of D.

The put-call relation can be used to find the price of the call option if the price of the put option
is known and vise versa.

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 7
Stock Price Simulation
Consider a stock XYZ with an expected (or mean) annual return of 15% and an annualized
standard deviation of 30%.
μ = 0.15, σ = 0.30.
Assume a time interval of a week, i.e., Δt = 1/52 year = 0.0192 year.

The stock price process can be written as:

∆S
= 0.15∆t + 0.30ε ∆t
S
S is the stock price, ΔS is the change in the stock price, and ε is a random variable (mean is zero,
standard deviation is one).

Suppose the initial stock price is $50.

Stock Price Paths

58

56

54

52
Stock Price

50

48

46

44

42
0 10 20 30 40 50 60
Time

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 8
 58

56

54

52
Stock Price

50

48

46

44
0 10 20 30 40 50 60
Time

50

48

46

44
Stock Price

42

40

38

36

34
0 10 20 30 40 50 60
Time

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 9
 80

75

70

65
Stock Price

60

55

50

45
0 10 20 30 40 50 60
Time

70

65

60
Stock Price

55

50

45
0 10 20 30 40 50 60
Time

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 10
 120

110

100

90

80
Stock Price

70

60

50

40

30

20
0 10 20 30 40 50 60
Time

160

140

120

100
Stock Price

80

60

40

20
0 10 20 30 40 50 60
Time

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 11
Stock Price Distribution (Stock Price After One Year)

µ = 58.390, Mdn = 55.791, σ = 17.847

6

4
Percent of Cases

0
20 40 60 80 100 120 140
Final Price

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 12
Higher Volatility

500

450

400

350

300
Stock Price

250

200

150

100

50

0
0 10 20 30 40 50 60
Time

µ = 58.451, Mdn = 48.510, σ = 37.621

8

6
Percent of Investors

0
0 50 100 150 200 250
M-Score

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 13
Lower Volatility

75

70

65

60
Stock Price

55

50

45

40
0 10 20 30 40 50 60
Time

µ = 57.930, Mdn = 57.581, σ = 5.833

5

4.5

3.5
Percent of Cases

2.5

1.5

0.5

0
40 45 50 55 60 65 70 75
Final Stock Price

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 14
Skewness (Generated using “Jumps”)
µ = 71.390, Mdn = 57.747, σ = 60.071
20

18

16

14
Percent of Cases

12

10

0
0 50 100 150 200 250 300 350 400 450
Final Stock Price

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 15
Computer Program used the Generate the Price Paths
%
% ClassGenerateStockPrices.m
% Generate stock prices using a simple model.
%
% AK, February 2008

% PARAMETERS
Nperiods = 52; % number of periods (in weeks)
Sinit = 50; % initial stock price
mu = 0.15; % expected returns (annual)
sigma = 0.30; % annualized standard deviation
Niter = 1000; % number of price paths to generate
% Skewness parameters
GenerateSkew = 1; JumpProb = 0.0025; JumpSize = 50;

DeltaT = 1/Nperiods; % time increment (unit is week)

S = zeros(Nperiods,Niter); S(1,:) = Sinit;

for i = 1:Niter
for j = 2:Nperiods
% STEP 1: Get a random number (from a normal distribution with
% mean of 0 and std dev of 1)
RandVar = randn;

% STEP 2: Generate the stock price change

DelS = S(j-1,i)*(mu*DeltaT + sigma*RandVar*(DeltaT^0.5));

% Check if there is a "jump" (to generate skewness)

if GenerateSkew == 1
newrand = rand;
if newrand <= JumpProb
DelS = JumpSize*abs(DelS);
end;
end;

% STEP 3: Add it to the previous stock price and generate a new

% stock price
S(j,i) = S(j-1,i) + DelS;
end;
end;

% PLOT
clf; plot(S,'b'); grid on; hold on;
xlabel('Time'); ylabel('Stock Price'); axis([0 60 0 500]);
figure; fndHist(S(Nperiods,:)');

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 16
 Option Pricing I: One-Step Binomial Model

Main Topics
1. Binomial Model for Stock Prices
2. Risk Neutral Probabilities
3. One-Step Binomial Option Pricing Model
4. Examples

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 Option Pricing Part II

Main Topics
1. Two Step Binomial Model
2. Extensions of Two Step Binomial Model
3. Several Examples
4. Binomial Model in Practice
5. Pricing of American Options using Two-Step Binomial Model
6. Risk Neutral Valuation Principle
7. Black-Scholes Option Pricing Model

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 26
Two-Step Binomial Model

The stock price at the current instant (t = 0) is S. In the next two periods, it may go up or down.

We have an option (f) whose value is determined by the prices of the underlying security S.

What is the price of the option? i.e., f = ?

Main idea: Apply the one-step binomial tree procedure twice.

fup
p Suu fuu
Sup
S p ! 1-p
f=? p ! Sud = Sdu fud = fdu
1-p !
Sdn Sdd fdd
fdn 1-p

Stock Payoffs Option Payoffs

(Gross) (Gross)

T = 2⋅∆T
The total time to expiration (e.g., 6 months) is divided into two sub-periods

Sup = uS Suu = uSup = u(uS) = u2S

Sdn = dS Sdd = dSdn = d(dS) = d2S

fup = ? fdn = ? Sud = Sdu = u(dS) = udS

or
d(uS)

The option values at the end of the second sub-period:

fuu, fud = fdu, fdd = ?.

These must be computed based on the properties of the option.

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 27
Let us focus on the second step of the tree and compute fu and fd.

Applying the one-step binomial formula to the top sub-tree:

p fuu

f u = e − r⋅∆T [p ⋅ f uu + (1 − p)f ud ] fu

1-p fud

∆T

Note:

• r is the risk-free interest rate for the sub-period ∆T.

• p is the risk neutral probability.

e r⋅∆T − d
p=
u−d

Similarly, applying the one-step binomial formula to bottom sub-tree:

p fud

f d = e − r⋅∆T [p ⋅ f ud + (1 − p)f dd ] fu

1-p fdd

∆T

Now, we will apply the one-step binomial formula to the first time-step:

p fu

f = e − r⋅∆T [p ⋅ f u + (1 − p)f d ] f

1-p fd

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 28
Substitute the values of fu and fd in this equation.

f = e − r⋅∆T [p ⋅ {e − r⋅∆T (p ⋅ f uu + (1 − p) ⋅ f ud )}
+ (1 − p){e −r⋅∆T (p ⋅ f ud + (1 − p)f dd )}]

⇒ f = e −2 r⋅∆T [p 2 f uu + 2p(1 − p) ⋅ f ud + (1 − p) 2 f dd ] Must know this!

Current Discount Expected future

Option term payoffs
Price (discount at
the risk-free rate)

Discounted present value

of
expected future cash flow

Reduced form representation

fuu
p2
f 2p(1-p) fud

(1-p)2 fdd

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 29
Example

S = 50
u = 1.2
d = 0.8
r = 5% (per period)

What is the price of a put-option with a strike price of $52 (X = 52)?

Use the 2-step binomial option pricing model.

Compute the risk-neutral probability first.

e r⋅∆T − d e 0.05 x1 − 0.8

p= = = 0.6282.
u −d 1.2 − 0.8

Next, draw the two-step binomial tree.

Sup = uS
= 1.2 x 50
= 60 Suu = uSup = 1.2 Sup = 1.2 x 60 = 72
Sup 0.6282
0.6282 !
S=50 0.3718
f=? 0.6282 ! Sud = Sdu = dSup = 0.8 x 60 = 48
0.3718 ! 0.3718
Sdn
= dS Sdd = dSdn = 0.8 x 40 = 32
= 0.8 x 50
= 40
Stock Payoffs

Given these stock payoffs, we can compute the payoffs from the put option.

72 fuu = 0 0
(0.6282)2
2(0.3718)(0.6282)
50 48 fud = 52 – 48 = 4 4
f
(0.3718)2 32 fdd = 52 – 32 = 20 20
Stock payoffs
Option payoffs

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 30
f = e −0.05 x 2 [(0.6282) 2 x 0 + 2(0.3718)(0.6282)(4) + (0.3718) 2 (20)]

= $4.19 Current price

of the put option

Instead of using the two-step binomial option pricing formula, you could have used the one-step
model twice.

f up = e −0.05 x1 [p ⋅ f uu + (1 − p)f ud ]

= e −0.05 [0.6282(0) + (0.3718)(4)] = 1.41

f dn = e −0.05 x1 [p ⋅ f ud + (1 − p)f dd ]

= e −0.05 [0.6282(4) + (0.3718)(20)] = 9.46

Finally,

[
f = e −0.05 x1 p ⋅ f up + (1 − p)f dn ]
= e −0.05 [0.6282(1.41) + (0.3718)(9.46)]

= $4.19 (as before!)

What would happen if u and d are different in the two sub-periods?

fup
Sup
Suu fuu Suu = u1u2S
p1 ! 1-p2
! Sud fud Sud = u1d2S
S p2 ! Sdu fdu Sdu = d1u2S
1-p1 !
Sdn Sdd fdd Sdd = d1d2S
fdn 1-p2

 u1  u2 
d  d 
 1  2

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 31
In this case:

• Sud ≠ Sdu Sud = u1d2S Sdu = d1u2S

• The risk-neutral probabilities will be different in the two sub-periods.

e r⋅∆T − d1 e r⋅∆T − d 2
p1 = p2 =
u 1 − d1 u2 − d2

The option pricing formula would be:

f = e − r⋅( 2 ∆T ) [p1p 2 f uu + p1 (1 − p 2 )f ud + p 2 (1 − p1 )f du + (1 − p1 )(1 − p 2 )f dd ]

It is easy to remember the formula if you understand its basic structure.

Example

S = 50
u1 = 1.2 d1 = 0.8
u2 = 1.1 d2 = 0.9
r = 5% (per year)

What is the price of a put option with a strike price of $60 (X = 60)?

Sup = 1.2 x 50 = 60 Suu = 1.1 x 60 = 66 fuu = 0

!
! Sud = 0.9 x 60 = 54 fud = 6
S = 50 ! Sdu = 1.1 x 40 = 44 fdu = 16
!
Sdn Sdd = 0.9 x 40 = 36 fdd = 24
= 0.8 x 50
= 40
Stock Option
payoffs payoffs

e 0.025 − 0.8 e 0.025 − 0.9

p1 = = 0.562 p2 = = 0.623
1.2 − 0.8 1.1 − 0.9

1 – p1 = 1 – 0.562 = 0.438 1 – p2 = 1 – 0.623 = 0.377

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 32
Price of the put option

= e −0.05 [(0.562)(0.623)(0) + (0.562)(0.377)(6) + (0.438)(0.623)(16) + (0.438)(0.377)(24)]

= 0.9512 x 9.60

= $9.13

Let us examine another extension of the two-step Binomial model.

u
•   is state-dependent.
d 

• The interest rate changes: r1 during the first sub-period.

r2 during the second sub-period.

p2 Suu fuu
fup
Sup  u2 
 
p1  d2  Sud fud
S
f=?
Sdu fdu
p3
1-p1

 u1   u3 
   
 d1  1-p3  d3 
Sdd fdd
∆T ∆T

T
Interest Interest
Rate = r1 Rate = r2

S = 50
u1 = 1.2 d1 = 0.8
u2 = 1.3 d2 = 0.9
u3 = 1.1 d3 = 0.7
r1 = 5% per year r2 = 3% per year
T = 1 year.

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 33
What is the price of a put option with a strike price of $60 (X = 60)?

The first thing you should note is that the risk-neutral probability will be different for each sub-
tree.

e r1∆T − d1 e r2∆T − d 2 e r3∆T − d 3

p1 = p2 = p3 =
u1 − d1 u2 − d 2 u3 − d 3

1
Let us leave r1 in its annual unit. Then, ΔT = .
2

e 0.05 / 2 − 0.8
∴ p1 = = 0.563 1 - p1 = 0.437
1.2 − 0.8

Similarly,

e 0.03 / 2 − 0.9
p2 = = 0.288 1 – p2 = 0.712
1.3 − 0.9

e 0.03 / 2 − 0.7
p3 = = 0.788 1 – p3 = 0.212
1.1 − 0.7

The stock prices can be computed in a simple manner.

Sup = u1S Sdn = d1S

Suu = u2(Sup) = u2 (u1S) = u1u2S

Sud = d2(Sup) = d2 (u1S) = u1d2S

Sdu = u3(Sdn) = u3 (d1S) = d1u3S

Sdd = d3(Sdn) = d3 (d1S) = d1d3S

Sup = 1.2 x 50 = 60 Sdn = 0.8 x 50 = 40

Suu = 1.2 x 1.3 x 50 = 78 Sdu = 0.8 x 1.1 x 50 = 44
Sud = 1.2 x 0.9 x 50 = 54 Sdd = 0.8 x 0.7 x 50 = 28

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 34
The Binomial tree can be drawn with all the numbers.
fup =? 78
0.288 0 fuu
6

6 fud
0.563 0.712
50 54
f=? 16 fdu
0.788 44
0.437
0.212
32 fdd
40
28
fdn =? Put option
Stock payoffs
payoffs (X = 60)

Let us compute fup and fdn now.

16
0
0.788
0.288

fup fdn

0.212
0.712 32
6
Int. rate = r2 = 3% p.a. Int. rate = r2 = 3% p.a.

fup = e-0.03 x ½ [0.288 x 0 + 0.712 x 6] fdn = e-0.03 x ½[0.788 x 16 + 0.212 x 32]

= 0.9851 x 4.272 = 0.9851 x 19.392
= 4.21 = 19.10

Finally, we can compute f.

fup = 4.21

0.563

0.437
fdn = 19.10
Interest rate = r1 = 5% p.a.

f = e -0.05/2 [0.563 x 4.21 + 0.437 x 19.10]

= 0.9753 x 10.717

⇒ f = $10.45 Current price of the put option.

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 35
Binomial Model in Practice

In practice, the life of the option is divided into 25-50 steps.

The stock price volatility (σ) is used to compute u and d.

u = eσ ∆T
d = e −σ ∆T

Note that d = 1/u.

Example:
T = 1 year.
Number of steps = 25. ΔT = 1/25.
Stock volatility, σ = 40% per year.
r = 5% per year.

u = eσ ∆T
= e 0.40 1 / 25
= 1.083
d = e −σ ∆T
= e −0.40 1 / 25
= 0.923

Alternatively, you can use d = 1/u = 1/1.083 = 0.923.

e r ⋅∆T − d e 0.05 x (1 / 25) − 0.923
p= = = 0.494.
u−d 1.083 − 0.923

All the remaining calculations do not change.

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 36
Pricing American Options using the Binomial Model

The two-step binomial model can be used the price American options.

Basic Idea:
• At each node, examine whether the option will be exercised or not.
• Replace the value of the option at the node by the exercise value if the option will be
exercised.
• Price the option using the revised node values.

Consider the two-step binomial model. Let EV be the exercise value and PV be the present value
of the future option payoffs at a given node.
fup = max(EVup, PVup)
fdn = max(EVdn, PVdn)
where, as before:
PVup = e − r ⋅∆T [ p ⋅ f uu + (1 − p ) f ud ]

PVdn = e − r ⋅∆T [ p ⋅ f ud + (1 − p ) f dd ]
Note that in the case of European options, fup = PVup and fdn = PVdn.

Example
S = 50
u = 1.2
d = 0.8
r = 5% (per period)

What is the price of an American put-option with a strike price of $52 (X = 52)? Use the 2-step
binomial option pricing model.

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 37
The current price of an European put option with these characteristics is $4.19 (see the two-step
binomial example).
The risk-neutral probability is:

e r⋅∆T − d e 0.05 x1 − 0.8

p= = = 0.6282.
u −d 1.2 − 0.8

The stock and the option payoffs are:

72 fuu = 0 0

S = 50 48 fud = 52 – 48 = 4 4
f=?
32 fdd = 52 – 32 = 20 20
t=0 Stock payoffs
Put option payoffs

PVup = e −0.05 x1 [ p ⋅ f uu + (1 − p ) f ud ] = e −0.05 [0.6282(0) + (0.3718)(4)] = 1.41

PVdn = e −0.05 x1 [ p ⋅ f ud + (1 − p ) f dd ] = e −0.05 [0.6282(4) + (0.3718)(20)] = 9.46

Exercise decision at the UP node:

• The stock price is above the strike price and the option will not be exercised.
Thus, EVup = 0.
fup = max(0, 1.41) = 1.41. Option will not be exercised.

Exercise decision at the DN node:

• The stock price is below the strike price and the option will be exercised.
Thus, EVdn = 52 – 40 = 12.
fdn = max(12, 9.46) = 12. Option will be exercised.

Finally,

[
f = e −0.05 x1 p ⋅ f up + (1 − p)f dn ] = e −0.05 [0.6282(1.41) + (0.3718)(12)]

= 0.9512 x 5.35 = $5.09

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 38
Compare this with the price an European put option = $4.19. The American option has a higher
price.

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 39
Risk Neutral Valuation Principle

This is another interpretation of the no arbitrage based pricing principle.

Basic Idea:
• Compute risk neutral probabilities.
• In the risk neutral world, the expected return from all traded securities is the risk free rate
of return. In other words, the growth rates of all securities would be equal to the risk free
rate.

Growth Rate of Stock Prices

The expected stock price at the expiration date T is:
E(ST) = p Sup + (1– p) Sdn
= puS + (1– p) dS
= puS + dS – pdS
= dS + (u – d) pS
Substitute the value of the risk neutral probability p computed earlier (using the no arbitrage
principle):
e rT − d
E ( S T ) = dS + (u − d ) S = dS + Se rT − dS = Se rT
(u − d )
Thus, the stock price grows at the risk free rate. We can write:
E(ST) = p Sup + (1– p) Sdn = SerT

Given the equivalence between the no arbitrage and risk neutral valuation principles, this
equation can be used to compute the risk neutral probability p.

The risk neutral principle can be used to price any option. For instance, an option must also
grow at the risk free rate. Thus:
p fup + (1– p) fdn = ferT

And as before, we get the option pricing formula:

f = e–rT [p fup + (1– p) fdn]

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 40
The Black-Scholes Model
The model is a more refined version of the Binomial option pricing formula.
• divides the time-interval into infinitesimally small parts;
• computes the intermediate option prices using the Binomial model in each of these small
time-intervals;
• formulates the option-pricing formula as a partial differential equation, which can be
solved quite easily.

We will only look at the final solution of the partial differential equation.

Assumptions:
(i) Risk free rate (r) and stock volatility (σ2) remain constant.
(ii) Dividend payments are constant.

Call Option (Informal derivation)

Consider a regular call option.

If the option is guaranteed to expire “in the money”, the gross option payoff = ST – X
ST − X
The price of the option today, C0 =
e rT
ST X X
= rT
− rT = S 0 − rT
e e e
(S0 = current stock price = discounted present value of payoff ST)

Note: We are using the riskfree rate for discounting because we are in a risk-neutral world.

If the stock pays dividends at a continuous rate δ , then the current price of the stock would be
lower. The price of the option today would be:
S0 X
⇒ C0 = δT
− rT = S 0 e −δT − Xe − rT
e e

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 41
If there is a probability p that the option will expire “in the money” and it will be exercised, then
(1–p) is the probability that the option will expire “out of money” and will not be exercised.

∴ C0 = p [S0e–δT – Xe –rT] + (1–p).0

= S0e –δT.p – Xe –rT.p.

In the Black-Scholes formula, p is derived in a complicated manner. Furthermore, different

probabilities are associated with S and X.

⇒ C0 = p1 (S0e –δT) – p2 (Xe –rT)

In this equation, p1 = N(d1) and p2 = N(d2).

N(d): Cumulative probability distribution for a variable that has a normal distribution
(Mean = 0, Std Deviation = 1).
N(d1): the hedge ratio.
N(d2): the probability that the option will be exercised.

C0 = S0e –δT N(d1) – Xe –rT N(d2)

This is the Black-Scholes formula for pricing an European call option.

S   σ2 
ln o  +  r − δ + T
X   2 
d1 =
σ T

 So   σ2 
ln  +  r − δ − T
X   2 
d2 = d1 – σ T =
σ T

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 42
So = current stock price
X = strike price
r = riskfree interest rate
δ = dividend yield
σ = standard deviation of stock returns
T = time to expiration.
ln: national logarithm.
N(d): normal distribution
(area to the left of d). N(d) ≤ 1

N(d) d

To compute the price of a put option, you should first calculate C0 using the Black-Scholes
formula. Then, use the put call parity:

S0 + P0 = C0 + Xe –rT
⇒ P0 = C0 + Xe –rT – S0.

Example:
Compute the price of a call option.

S0 = 100
X = 95
r = 10% per year (= 0.10)
T = 3 months (= 0.25 year) All variables are in annual units.
σ = 50% per year (= 0.50)

δ is not given ⇒ δ = 0., i.e., the stock does not pay dividends.

 100   0.50 2 
ln  +  0.10 − 0 + (0.25)
 95   2 
d1 = = 0.43
0.50 0.25

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 43
 (
d 2 = d1 − σ T = 0.43 − (0.50 ) 0.25 = 0.18 )

N (d1 ) = N (0.43) = 0.6664

using normal distribution tables.
N (d 2 ) = N (0.18) = 0.5714
This information will be provided to you!

C0 = S o e −δT N (d1 ) − Xe − rT N (d 2 )

= (100 x 1 x 0.6664) – (95 x e-0.10 x 0.25 x 0.5714)

= 66.64 – 52.94 = $13.70 (price of a call option with a strike price of 95).

Price of a put option:

S0 + P0 = C0 + Xe –rT

⇒ P0 = C0 + Xe –rT – S0
= 13.70 + (95 x e –0.12 x 0.25) – 100
= 13.70 + 92.19 – 100 = $21.51 (price of the put option with a strike price of 95).

Comparison with the One-Step Binomial Pricing Model

T = 0.25.
Number of steps = 1. ΔT = T/1 = 0.25.

u = eσ ∆T
= e 0.50 0.25
= 1.284
d = e −σ ∆T
= e −0.50 0.25
= 0.779

Alternatively, you can use d = 1/u = 1/1.284 = 0.779.

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 44
The risk neutral probability is:

e r ⋅∆T − d e 0.10 x ( 0.25) − 0.779

p= = = 0.488.
u−d 1.284 − 0.779

Sup = uS = 1.284 x 100 = 128.40.

Sdn = dS = 0.779 x 100 = 77.88.

Given these stock payoffs, the option payoffs are:

fup = Sup – X = 128.40 – 95 = 33.40.
fup = 0 since the option will not be exercised.

The current price of the option is given by:

f = e–0.10 x 0.25 [0.494 x 33.40 + (1– 0.494) x 0]
= 0.975 x 16.50
= $16.09.

FIN 635, Lecture Notes, Kumar, Spring 2024 Lecture Notes 6, Page 45