Unit 4 option pricing
- 1. Unit: 4 OPTION PRICING Ms.Swathi J Assistant professor PES Institute of Advanced Management Studies, Shivamogga
- 2. Factor affecting Option Pricing: 1. Underlying Price 2. Expected Volatility 3. Strike Price 4. Time Until Expiration 5. Interest Rate 6. Dividends
- 3. 1. Underlying Price • The spot price of the underlying asset of a derivative. • Change in market price of an underlying security has direct effect on Option Price. That is the main theme for playing with Options for speculative traders. • When the market price of underlying security increases, the Call Options Premiums increase while the Put Options Premiums decrease. • On the other hand, when security price decreases, the Put Options Premiums increase while the Call Options Premiums decrease.
- 5. 2. Expected Volatility • Volatility measures the possible price fluctuations in a security. • Rise in Volatility leads to rise in Option Premiums. • The greater the expected volatility, the higher the option value.
- 6. 3. Strike Price • The price at which a specific derivative contract can be exercised. • Premiums increase as options become further in-the-money. • The premium generally decreases as the option becomes more out-of-the-money.
- 7. 4. Time Until Expiration • The time remaining until a financial contract expires. Also called time to maturity. • The longer the time until expiration, the higher the option price The shorter the time until expiration, the lower the option price
- 8. 5. Interest Rate • The interest rate in the economy increases, the expected return required by investors from the stock tends to increases.
- 9. 6. Dividends • Options do not receive dividends, so their value fluctuates when dividends are released. • When a company releases dividends, they have an ex-dividend date. • If you own the stock on that date, you will be awarded the dividend. Also on this date, the value of the stock will decrease by the amount of dividend. As dividends increase a put option's value also increases and a calls' value decreases.
- 11. EFFECT ON AN INCREASE OF FACTOR ON FACTOR CALL PRICE PUT PRICE Current price of the stock Increase Decrease Strike price Decrease Increase Time to expiration Increase Increase Volatility Increase Increase Interest rate Increase Decrease Dividend Decrease Increase
- 12. Put-Call Parity • Put-Call Parity is perhaps the most fundamental relationship in option pricing. • Put-Call Parity is generally used for options with European-style exercise. • Put-Call Parity states: the difference between the call price and the put price equals the difference between the stock price and the discounted strike price.
- 13. The Put-Call Parity Formula C-P = S-K/(1+r)t C is the call option price today S is the stock price today r is the risk-free interest rate P is the put option price today K is the strike price of the put and the call T is the time remaining until option expiration
- 14. SIP PEPSI BE COOL S P B C STOCK PRICE + PUT OPTION= BOND+CALL OPTION ASSUMPTIONS: • Works only on European option • Underlying asset is same in both call and put option. • Expiry of call same as put • Bond= PV of strike price @ risk free return • Strike price of call as same as put option
- 15. Eg: Strike price = X = Rs. 100 B = Rs. 100 S + P = B + C Protective put and Fiduciary call SPOT PRICE STOCK PRICE PUT OPTION BOND CALL OPTION 200 200 0 100 100 180 180 0 100 80 100 100 0 100 0 70 70 30 100 0 0 0 100 100 0
- 16. • When the stock price decreases value is equal to strike price. • When the stock price increases value is equal to stock price. • Protective put- when the price decreases right to sell at 100. • Fiduciary call- PV of rfr.
- 17. OPTION GREEKS • The GREEKS are measures of sensitivity. The question is how sensitive a position’s value is to changes in any of the variables that contribute to the position’s market value. These variables are: • S, K, T-t, r and . • Each one of the Greek measures indicates the change in the value of the position as a result of a “small” change in the corresponding variable.
- 18. • Parameters of SENSITIVITY • Delta = • Theta = • Gamma = • Vega = • Rho =
- 19. Style of the option European Option • A European call option is an option for the right to buy a stock or an index at a certain price ON a certain date. • The most index options traded in the U.S. are European style. • A European option is a version of an options contract that limits execution to its expiration date.
- 20. Style of the option European Option • The holder may only exercise their rights on the day of expiration. • European options normally trade over the counter. • A European call option gives the owner the liberty to acquire the underlying security at expiry. • A European put option allows the holder to sell the underlying security at expiry. • Expiration of these options happens on the last Thursday of every month.
- 21. Style of the option Bermudan Option • A Bermudan option is an option where the buyer has the right to exercise at a set (always discretely spaced) number of times. • It is a derivative instrument wherein the holder of the option has the right to exercise his option only on certain pre-defined dates occurring in regular intervals throughout the duration of the contract.
- 22. Style of the option Bermudan Option • Bermuda options are a hybrid of American and European options. • Bermuda options provide writers with more control over when the options can be exercised, while giving the buyer a contract that is less expensive than an American option, but not as restrictive as an European option.
- 23. Style of the option Bermudan Option • Bermuda options are typically less expensive than American options because of the larger premiums that American options demand due to their flexibility. • Bermuda option contracts are generally traded over the counter. • This option tends to be most frequently used with Forex and interest rate contracts