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Topic 12 OptionValuation

# Topic 12 OptionValuation - Topic12 Option Valuation FIN...

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Topic12: Option Valuation FIN 4504 Aaron Gubin

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2 Introduction We are trying to compute what an option should sell for. What factors determine option prices? Effect on option price Effect on call Effect on put 1. Current stock price (S t ) 1. Exercise price (X) 1. Volatility of the stock (σ) 1. Time to expiration (T) Increase Decrease Decrease Increase Increase Increase Increase Increase
3 Option Values Intrinsic value - profit that could be made if the option was immediately exercised Call: stock price - exercise price Put: exercise price - stock price Time value - the difference between the option price and the intrinsic value

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4 Time Value of Options: Call Option value X Stock Price Value of Call Intrinsic Value Time value
5 Binomial Option Pricing We assume that the underlying stock can only take 2 values at the end of each time period. Example: S 0 = \$100 S U = \$110 S D = \$85 p 1-p t = 0 t = 3 months

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6 Binomial Option Pricing What is the payoff to a call option with strike price of \$105, expiring in three months? S 0 = \$100 S U = \$110 S D = \$85 p 1-p t = 0 t = 3 months C 0 C U = \$ 5 C D = 0 p 1-p t = 0 t = 3 months
7 Binomial Option Pricing Consider this portfolio:

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