1. Jainendra Shandilya, CFA, CAIA
Derivatives-pricing
Jainendra Shandilya, CFA, CAIA 45

2. Pricing of futures contracts – when dividend yield is given45

3. Background of derivatives
Derivatives include forwards, futures, options and Swaps
While Forwards and Swaps are OTC products, Futures and Options are Exchange Traded Products.
Derivatives in India started in 2000 after amendment in SCRA – an act to regulate market during pre liberalization era.
Derivatives now in India is more popular than the cash market products for a number of reasons.
With commodity derivatives now being regulated by SEBI, this market is likely to grow and mature further down the line. 45

4. Futures price when dividends are received in future45

5. Option terms Call option Put Option European Option American Option
Exercise price(X)
In-the-Money Option (ITM)
At-the-Money Option (ATM)
Out-of-Money Option (OTM) 45

6. Put call parity(PCP)
In a typical case of buying put option one must have the underlying, hence that situation is
p+ S
In a typical case of a buyer buying call option, she must have the money to buy the underlying. That situation is
c+ X/(1+r)T
In a no arbitrage world, the value of both the bets should be equal
p+ S = c+ X/(1+r)T 45

7. Options
Options terminologies include call options, put options, European options, American options, ATM, ITM, OTM Options, Exercise Price, option premium, Exotic options(OTC options). Intrinsic value , time value. You should know all these terms.
Valuation of options
Binomial Options
We start with a call option. If the underlying goes up to S+, the call option will be worth c+. If the underlying goes down to S-, the option will be worth c-. We know that if the option is expiring, its value will be the intrinsic value. Thus, 45

8. One period binomial model
c+ = Max(0, S+ - X)
c- = Max(0, S- - X) 45

9. 45

10. Binomial option valuations
We identify a factor, ‘u’, as the up move in the underlying and ‘d’ as the down move
u=S+/S
d= S-/S
so that u and d represent 1 plus the rate of return if the underlying goes up and down, respectively. Thus, S+ = Su and S- = Sd. To avoid an obvious arbitrage opportunity, we require that 45

11. Binomial Options d<1+r<u
We assume that we have all information except for the current option price. In addition, we do not know in what direction the price of the underlying will move. We start by constructing an arbitrage portfolio consisting of one short call option. Let us now purchase an unspecified number of units of the underlying. Let that number be n. This n may be called the hedge ratio.
H+ = nS+ - c+
H- = nS- – c- 45

12. Binomial option pricing
Because we can choose the value of n, let us do so by setting H+ equal to H-. This specification means that regardless of which way the underlying moves, the portfolio value will be the same. Thus, the portfolio will be hedged. We do this by setting
H+ = H- , which means that 45

13. Value of n in binomial option formula45

14. Call option value in binomial model45

15. Value of Π in binomial model45

16. Example of binomial option pricing
Suppose the underlying is a non-dividend-paying stock currently valued at $50. It can either go up by 25 percent or go down by 20 percent. Thus, u = 1.25 and d = what is the value of call premium if the risk free rate is 7% ?
$7.01
Suppose the option is selling for $8. If the option should be selling for $7.01 and it is selling for $8, it is overpriced-a clear case of price not equaling value. What should you do as an investor?
Consider a one-period binomial model in which the underlying is at 65 and can go up 30 percent or down 22 percent. The risk-free rate is 8 percent. A. Determine the price of a European call option with exercise prices of 70. Assume that the call is selling for 9 in the market. Demonstrate how to execute an arbitrage transaction and calculate the rate of return. Use 10,000 call options. 45

17. Binomial Option Pricing Example..
We have u = 1.30 and d = = 0.78.
S+ = 65*1.30 = 84.50
S- = 65*0.78 = 50.70
Then find the option values at expiration, we use the following equations:
c+ = Max(0, S+ - X)
c- = Max(0, S- - X)
c+ = Max(0, – 70) = 14.50
c- = Max(0, S- - X) = 0 45

18. Option Pricing….. The risk-neutral probability is
Π = ( )/( ) =
and 1 - Π = The call's price today is
c= 7.75
For part B, we need the value of n for calls, and n is given as
= ( )/( ) =
The next question that you should ask is whether the call is overpriced or under- priced 45

19. Solution to Example….
The call is overpriced, so we should sell 10,000 call options and buy 4,290 units of the underlying.
Sell 10,000 calls at 9 and you get 90,000
Buy 4,290 units of the underlying at 65 =278,850
Net cash flow = 90, ,850 = - 188,850
So we invest 188,850. The value of this combination at expiration will be If ST = , we will get 4,290(84.50) - 10,000(14.50) = 217,505
If ST = 50.70, we will get 4,290(50.70) - 10,000(0) = 217,503
Thus, we receive a risk-free return almost twice the risk-free rate. We could borrow the initial outlay of $188,850 at the risk-free rate and capture a risk-free profit without any net investment of money. 45

20. Binomial put option pricing
Consider a one-period binomial model in which the underlying is at 65 and can go up 30 percent or down 22 percent. The risk-free rate is 8 percent. Determine the price of a European put option with exercise price of 70.
We have u = 1.30 and d = = 0.78.
S+ = S*u = 65*1.30 = 84.5
S- = S*d = 65*0.78 = 50.70
Then find the option values at expiration:
p+ = Max(0, ) = 0
p- = Max(0, ) = 19.30 45

21. The risk-neutral probability is π = (1.08 -.078)/(1.30-0.78) = 0.5769
and 1 - π = The put price today is
p= (0.5769* *19.30)/1.08
= 7.56 45

22. Exercise for class
Suppose a stock currently trades at a price of $150. The stock price can go up 33 percent or down 15 percent. The risk-free rate is 4.5 percent.
A. Use a one-period binomial model to calculate the price of a put option with exercise price of $150.
B. Suppose the put price is currently $14. Show how to execute an arbitrage transaction that will earn more than the risk-free rate. Use 10,000 put options.
C. Suppose the put price is currently $1 1. Show how to execute an arbitrage transactions that will earn more than the risk-free rate. Use 10,000 put options 45

23. Black Scholes Pricing Formulas45

24. Assumptions of the Black and Scholes Model
The underlying pays no dividends during the option's life
Option model is a European one.
Markets are efficient
No commissions are charged.
Interest rates remain constant and known
Returns are log normally distributed
Assumptions of the Black and Scholes Model 45

25. Black-Scholes Option Pricing formula45

26. Call option price and delta45

27. Put option price and delta45

28. Exercise on black sholes merton option pricing
Consider the following example. The underlying price is and has a volatility of The continuously compounded risk-free rate is 4.88 percent. The option expires in nine months; therefore, T = 9/12 = The exercise price is 50. what is the call price of this option?
First calculate d1 and d2 using the formula 45

29. Calculating Option Price
d1 =
d2 = – 0.35*( ) =
For our use, we will round off both d1 and d2 to two decimals and look up the table. So, we have d1 = 0.45 and d2 = 0.15
Hence, N(d1) =
And N(d2) =
Hence, c = 52.75*(0.6736) – 50* e *3/4 * (0.5596)
= , and the value of the put option on the same would be
p = 50* e *3/4 ( ) – 52.75*( ) = 45

30. Example on Option Pricing
Use the Black-Scholes-Merton model to calculate the prices of European call and put options on an asset priced at The exercise price is 65, the continuously compounded risk-free rate is 4 %, the options expire in 110 days, and the volatility is There are no cash flows on the underlying
The time to expiration will be T = 110/365 = Then d1 and d2 are
d1 =
d2 = – 0.38* = , Now calculate N(d1) and N(d2)
N(0.41) =
N(0.20) = , hence
c= 7.95 and p = 3.67 45

31. Effect of cash flow on option pricing
we subtract the present value of the dividends from the underlying price and use this adjusted price to obtain the boundary conditions or to price the options using put-call parity.
We do the same using the Black-Scholes-Merton model
For stocks, we used a continuously compounded dividend yield; for currencies, we used a continuously compounded interest rate. In the case of stocks, we let 6‘ represent the continuously compounded dividend rate. We use the stock price as
S0 e-∂T 45

32. Example
Use the Black-Scholes-Merton model adjusted for cash flows on the underlying to calculate the price of a call option in which the underlying is priced at 225, the exercise price is 200, the continuously compounded risk-free rate is 5.25%, the time to expiration is 3 years, and the volatility is The effect of cash flows on the underlying is indicated below for two alternative approaches:
A. The present value of the cash flows over the life of the option is
B. The continuously compounded dividend yield is 2.7 percent. 45

33. Call price in first case
Adjust the price of the underlying to So = = Then insert into the Black-Scholes-Merton formula as follows:
So = 225e-0.027(3) = , so then we have
d1=
d2=
N(0.84) =
N(0.58) =
c= and in the second case In second adjust the stock by the dividend paid, i.e. 45

34. Call price in second case
Hence, N(0.88) =
N(0.62) =
c= 43.06 45

35. Exercise for class
Consider an asset that trades at $100 today. Call and put options on this asset are available with an exercise price of $100. The options expire in 275 days, and the volatility is The continuously compounded risk-free rate is 3 percent.
A. Calculate the value of European call and put options using the Black-Scholes- Merton model. Assume that the present value of cash flows on the underlying asset over the life of the options is $4.25.
B. Calculate the value of European call and put options using the Black-Scholes- Merton model. Assume that the continuously compounded dividend yield is 1.5 percent. 45

36. Solution to exercise 45

37. Solution to Part b 45

38. Option Greeks – Measurement of Risk
Delta:
Delta is the sensitivity of an options price to a change in the price of underlying variable. It is calculated as percentage change in option price for a 1% change in the underlying asset price. It is also known as hedge ratio.
Gamma:
The Gamma is the change in the Delta with respect to change in the underlying asset price. 45

39. Option Greeks
Theta:
Theta is the sensitivity of the value of an option to changes in time, everything else remaining constant (spot, volatility, strike and interest rate and forward)
Vega:
Vega measures the sensitivity of the option price with respect to changes in volatility. Vega is thus the variation in percentage of the value of the option for a 1% change of implied volatility. Vega is large if the option has a long time to expiry or close to ATM 45

40. Option Greek…..
Rho:
The rho of a portfolio of options is the rate of change of the value of the portfolio with respect to the interest rate:
rho (call) = ∂π/∂r 45

41. Options Greek
Delta is the sensitivity of the option price to a change in the price of the underlying.
Gamma is a measure of how well the delta sensitivity measure will approximate the
option price's response to a change in the price of the underlying.
Rho is the sensitivity of the option price to the risk-free rate.
Theta is the rate at which the time value decays as the option approaches expiration.
Vega is the sensitivity of the option price to volatility. 45

42. Example on Option Greek
More formally, the delta is defined as
Delta = Change in option price/Change in underlying price
Consider the following example. The underlying price is and has a volatility of The continuously compounded risk-free rate is 4.88 percent. The option expires in nine months; therefore, T = 9/12 = The exercise price is 50, what is the value of the call option and the put option on the underlying?
First we calculate the values of d1 and d2: 45

43. Implied volatility
In a market in which options are traded actively, we can reasonably assume that the market price of the option is an accurate reflection of its true value. Thus, by setting the Black-Scholes-Merton price equal to the market price, we can work backwards to infer the volatility. This procedure enables us to determine the volatility that option traders are using to price the option. This volatility is called the implied volatility. 45

44. Monte carlo simulation method of option pricing
Monte Carlo Option Price is a method often used in Mathematical finance to calculate the value of an option with multiple sources of uncertainties and random features, such as changing interest rates, stock prices or exchange rates, etc. 45

45. Monte carlo option pricing
In the formula, the random terms on the right-hand side can be considered as shocks or disturbances that model functions in the stock price. After repeatedly simulating stock price trajectories and computing appropriate averages, it is possible to obtain estimates of the price of a European call option. 45

46. Questions for the class
In case you are bearish on market, which of the following options would you use?
A) Call option buy, b) Put option buy, c) sell call option, d) sell put option
A higher interest rate would lead to higher or lower price of call option and why?
A high volatility in the market will lead to higher call price or lower call price and why?
If delta of a call option is close to 1, what does it indicate?
A) the option is far out of money, b) the option is deep in the money, c) the option is at the money
If you have sold 400 call option of ICICI Bank and its delta is 0.35, how many shares would you need to own to hedge your position? A) 400, b) 140, c)1143, d) 200 45

47. Thank you. 45