# CHAPTER 21: OPTION VALUATION

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1 CHAPTER 21: OPTION VALUATION PROBLEM SETS 1. The value of a put option also increases with the volatility of the stock. We see this from the put-call parity theorem as follows: P = C S + PV(X) + PV(Dividends) Given a value for S and a risk-free interest rate, then, if C increases because of an increase in volatility, P must also increase in order to maintain the equality of the parity relationship. 2. A \$1 increase in a call option s exercise price would lead to a decrease in the option s value of less than \$1. The change in the call price would equal \$1 only if: (i) there were a 1% probability that the call would be exercised, and (ii) the interest rate were zero. 3. Holding firm-specific risk constant, higher beta implies higher total stock volatility. Therefore, the value of the put option increases as beta increases. 4. Holding beta constant, the stock with a lot of firm-specific risk has higher total volatility. The option on the stock with higher firm-specific risk is worth more. 5. A call option with a high exercise price has a lower hedge ratio. This call option is less in the money. Both d 1 and N(d 1 ) are lower when X is higher. 6. a. Put A must be written on the stock with the lower price. Otherwise, given the lower volatility of Stock A, Put A would sell for less than Put B. b. Put B must be written on the stock with the lower price. This would explain its higher price. c. Call B must have the lower time to expiration. Despite the higher price of Stock B, Call B is cheaper than Call A. This can be explained by a lower time to expiration. d. Call B must be written on the stock with higher volatility. This would explain its higher price. e. Call A must be written on the stock with higher volatility. This would explain its higher price. 21-1

2 7. Exercise Price Hedge Ratio 12 /3 =. 11 1/3 = /3 = /3 = 1. As the option becomes more in the money, the hedge ratio increases to a maximum of S d 1 N(d 1 ) a. us = 13 P u = ds = 8 P d = 3 The hedge ratio is: H = P us u P d ds 3 = = 5 b. S = 8 S = 13 Buy 3 shares Buy 5 puts 15 Total Present value = \$39/1.1 = \$ c. The portfolio cost is: 3S + 5P = 3 + 5P The value of the portfolio is: \$ Therefore: P = \$54.545/5 = \$

3 C 1. The hedge ratio for the call is: H = us u Cd ds S = 8 S = 13 Buy 2 shares Write 5 calls -1 Total Present value = \$16/1.1 = \$ The portfolio cost is: 2S 5C = \$2 5C The value of the portfolio is: \$ Therefore: C = \$54.545/5 = \$1.91 Does P = C + PV(X) S? 1.91 = /1.1 1 = = 13 8 = d 1 =.3182 N(d 1 ) =.6248 d 2 =.354 N(d 2) =.4859 Xe r T = C = \$ P = \$5.69 This value is derived from our Black-Scholes spreadsheet, but note that we could have derived the value from put-call parity: P = C + PV(X) S = \$ \$47.56 \$5 = \$ a. C falls to \$ b. C falls to \$ c. C falls to \$6.778 d. C rises to \$ e. C rises to \$

4 14. According to the Black-Scholes model, the call option should be priced at: [\$55 N(d 1 )] [5 N(d 2)] = (\$55.6) (\$5.5) = \$8 Since the option actually sells for more than \$8, implied volatility is greater than A straddle is a call and a put. The Black-Scholes value would be: C + P = S N(d 1 ) Xe rt N(d 2) + Xe rt [1 N(d 2)] S [1 N(d 1 )] = S [2N(d 1 ) 1] + Xe rt [1 2N(d 2)] On the Excel spreadsheet (Spreadsheet 21.1), the valuation formula would be: B5*(2*E4 1) + B6*EXP( B4*B3)*(1 2*E5) 16. The rate of return of a call option on a long-term Treasury bond should be more sensitive to changes in interest rates than is the rate of return of the underlying bond. The option elasticity exceeds 1.. In other words, the option is effectively a levered investment and the rate of return on the option is more sensitive to interest rate swings. 17. Implied volatility has increased. If not, the call price would have fallen as a result of the decrease in stock price. 18. Implied volatility has increased. If not, the put price would have fallen as a result of the decreased time to expiration. 19. The hedge ratio approaches one. As S increases, the probability of exercise approaches 1.. N(d 1 ) approaches The hedge ratio approaches 1.. As S decreases, the probability of exercise approaches 1. [N(d 1 ) 1] approaches 1 as N(d 1 ) approaches. 21. A straddle is a call and a put. The hedge ratio of the straddle is the sum of the hedge ratios of the individual options:.4 + (.6) =

5 22. a. The spreadsheet appears as follows: INPUTS OUTPUTS Standard deviation (annual).3213 d1.89 Expiration (in years).5 d Risk-free rate (annual).5 N(d1).536 Stock Price 1 N(d2).4136 Exercise price 15 B/S call value 8. Dividend yield (annual) B/S put value The standard deviation is:.3213 b. The spreadsheet below shows the standard deviation has increased to:.3568 INPUTS OUTPUTS Standard deviation (annual).3568 d1.318 Expiration (in years).5 d Risk-free rate (annual).5 N(d1).5127 Stock Price 1 N(d2).4128 Exercise price 15 B/S call value 9. Dividend yield (annual) B/S put value Implied volatility has increased because the value of an option increases with greater volatility. c. Implied volatility increases to.487 when expiration decreases to four months. The shorter expiration decreases the value of the option; therefore, in order for the option price to remain unchanged at \$8, implied volatility must increase. INPUTS OUTPUTS Standard deviation (annual).487 d Expiration (in years) d Risk-free rate (annual).5 N(d1).4928 Stock Price 1 N(d2).3997 Exercise price 15 B/S call value 8.1 Dividend yield (annual) B/S put value d. Implied volatility decreases to.246 when exercise price decreases to \$1. The decrease in exercise price increases the value of the call, so that, in order to the option price to remain at \$8, implied volatility decreases. INPUTS OUTPUTS Standard deviation (annual).246 d1.232 Expiration (in years).5 d2.619 Risk-free rate (annual).5 N(d1).5917 Stock Price 1 N(d2).5247 Exercise price 1 B/S call value 8.1 Dividend yield (annual) B/S put value

6 e. The decrease in stock price decreases the value of the call. In order for the option price to remain at \$8, implied volatility increases. INPUTS OUTPUTS Standard deviation (annual).3566 d Expiration (in years).5 d Risk-free rate (annual).5 N(d1).487 Stock Price 98 N(d2).3819 Exercise price 15 B/S call value 8. Dividend yield (annual) B/S put value a. The delta of the collar is calculated as follows: Position Delta Buy stock 1. Buy put, X = \$45 N(d 1 ) 1 =.4 Write call, X = \$55 N(d 1 ) =.35 Total.25 If the stock price increases by \$1, then the value of the collar increases by \$.25. The stock will be worth \$1 more, the loss on the purchased put will be \$.4, and the call written represents a liability that increases by \$.35. b. If S becomes very large, then the delta of the collar approaches zero. Both N(d 1 ) terms approach 1. Intuitively, for very large stock prices, the value of the portfolio is simply the (present value of the) exercise price of the call, and is unaffected by small changes in the stock price. As S approaches zero, the delta also approaches zero: both N(d 1 ) terms approach. For very small stock prices, the value of the portfolio is simply the (present value of the) exercise price of the put, and is unaffected by small changes in the stock price. 24. Put X Delta A 1.1 B 2.5 C a. Choice A: Calls have higher elasticity than shares. For equal dollar investments, a call s capital gain potential is greater than that of the underlying stock. b. Choice B: Calls have hedge ratios less than 1., so the shares have higher profit potential. For an equal number of shares controlled, the dollar exposure of the shares is greater than that of the calls, and the profit potential is therefore greater. 21-6

7 26. a. us = 11 P u = ds = 9 P d = 1 Pu Pd 1 1 The hedge ratio is: H = = = us ds A portfolio comprised of one share and two puts provides a guaranteed payoff of \$11, with present value: \$11/1.5 = \$14.76 Therefore: S + 2P = \$14.76 \$1 + 2P = \$14.76 P = \$2.38 b. Cost of protective put portfolio = \$1 + \$2.38 = \$12.38 c. Our goal is a portfolio with the same exposure to the stock as the hypothetical protective put portfolio. Since the put s hedge ratio is.5, the portfolio consists of (1.5) =.5 shares of stock, which costs \$5, and the remaining funds (\$52.38) invested in T-bills, earning 5% interest. S = 9 S = 11 Buy.5 shares Invest in T-bills Total 1 11 This payoff is identical to that of the protective put portfolio. Thus, the stock plus bills strategy replicates both the cost and payoff of the protective put. 27. The put values in the second period are: P uu = P ud = P du = = 5.5 P dd = = To compute P u, first compute the hedge ratio: P H = uus uu P ud uds = =

8 Form a riskless portfolio by buying one share of stock and buying three puts. The cost of the portfolio is: S + 3P u = \$11 + 3P u The payoff for the riskless portfolio equals \$121: S = 14.5 S = 121 Buy 1 share Buy 3 puts Total Therefore, find the value of the put by solving: \$11 + 3P u = \$121/1.5 P u = \$1.746 To compute P d, compute the hedge ratio: Pdu Pdd H = = = 1. dus dds Form a riskless portfolio by buying one share and buying one put. The cost of the portfolio is: S + P d = \$95 + P d The payoff for the riskless portfolio equals \$11: S = 9.25 S = 14.5 Buy 1 share Buy 1 put Total Therefore, find the value of the put by solving: \$95 + P d = \$11/1.5 P d = \$9.762 To compute P, compute the hedge ratio: P H = us u Pd ds = = Form a riskless portfolio by buying.5344 of a share and buying one put. The cost of the portfolio is:.5344s + P = \$ P 21-8

9 The payoff for the riskless portfolio equals \$6.53: S = 95 S = 11 Buy.5344 share Buy 1 put Total Therefore, find the value of the put by solving: \$ P = \$6.53/1.5 P = \$4.28 Finally, we verify this result using put-call parity. Recall from Example 21.1 that: C = \$4.434 Put-call parity requires that: P = C + PV(X) S \$4.28 = \$ (\$11/1.5 2 ) \$1 Except for minor rounding error, put-call parity is satisfied. 28. If r =, then one should never exercise a put early. There is no time value cost to waiting to exercise, but there is a volatility benefit from waiting. To show this more rigorously, consider the following portfolio: lend \$X and short one share of stock. The cost to establish the portfolio is (X S ). The payoff at time T (with zero interest earnings on the loan) is (X S T). In contrast, a put option has a payoff at time T of (X S T) if that value is positive, and zero otherwise. The put s payoff is at least as large as the portfolio s, and therefore, the put must cost at least as much as the portfolio to purchase. Hence, P (X S ), and the put can be sold for more than the proceeds from immediate exercise. We conclude that it doesn t pay to exercise early. 29. a. Xe rt b. X c. d. e. It is optimal to exercise immediately a put on a stock whose price has fallen to zero. The value of the American put equals the exercise price. Any delay in exercise lowers value by the time value of money. 21-9

10 3. Step 1: Calculate the option values at expiration. The two possible stock prices and the corresponding call values are: us = 12 C u = 2 ds = 8 C d = Step 2: Calculate the hedge ratio. C u Cd 2 1 H = = = us ds Therefore, form a riskless portfolio by buying one share of stock and writing two calls. The cost of the portfolio is: S 2C = 1 2C Step 3: Show that the payoff for the riskless portfolio equals \$8: S = 8 S = 12 Buy 1 share 8 12 Write 2 calls -4 Total 8 8 Therefore, find the value of the call by solving: \$1 2C = \$8/1.1 C = \$ Notice that we did not use the probabilities of a stock price increase or decrease. These are not needed to value the call option. 31. The two possible stock prices and the corresponding call values are: us = 13 C u = 3 ds = 7 C d = C u Cd 3 1 The hedge ratio is: H = = = us ds Form a riskless portfolio by buying one share of stock and writing two calls. The cost of the portfolio is: S 2C = 1 2C The payoff for the riskless portfolio equals \$7: S = 7 S = 13 Buy 1 share 7 13 Write 2 calls -6 Total 7 7 Therefore, find the value of the call by solving: \$1 2C = \$7/1.1 C = \$ Here, the value of the call is greater than the value in the lower-volatility scenario. 21-1

11 32. The two possible stock prices and the corresponding put values are: us = 12 P u = ds = 8 P d = 2 Pu Pd 2 1 The hedge ratio is: H = = = us ds Form a riskless portfolio by buying one share of stock and buying two puts. The cost of the portfolio is: S + 2P = 1 + 2P The payoff for the riskless portfolio equals \$12: S = 8 S = 12 Buy 1 share 8 12 Buy 2 puts 4 Total Therefore, find the value of the put by solving: \$1 + 2P = \$12/1.1 P = \$4.545 According to put-call parity: P + S = C + PV(X) Our estimates of option value satisfy this relationship: \$ \$1 = \$ \$1/1.1 = \$ If we assume that the only possible exercise date is just prior to the ex-dividend date, then the relevant parameters for the Black-Scholes formula are: S = 6 r =.5% per month X = 55 σ = 7% T = 2 months In this case: C = \$6.4 If instead, one commits to foregoing early exercise, then we reduce the stock price by the present value of the dividends. Therefore, we use the following parameters: S = 6 2e (.5 2) = 58.2 r =.5% per month X = 55 σ = 7% T = 3 months In this case, C = \$5.5 The pseudo-american option value is the higher of these two values: \$

12 34. True. The call option has an elasticity greater than 1.. Therefore, the call s percentage rate of return is greater than that of the underlying stock. Hence the GM call responds more than proportionately when the GM stock price changes in response to broad market movements. Therefore, the beta of the GM call is greater than the beta of GM stock. 35. True. The elasticity of a call option is higher the more out of the money is the option. (Even though the delta of the call is lower, the value of the call is also lower. The proportional response of the call price to the stock price increases. You can confirm this with numerical examples.) Therefore, the rate of return of the call with the higher exercise price responds more sensitively to changes in the market index, and therefore it has the higher beta. 36. As the stock price increases, conversion becomes increasingly more assured. The hedge ratio approaches 1.. The price of the convertible bond will move one-for-one with changes in the price of the underlying stock. 37. Salomon believes that the market assessment of volatility is too high. Therefore, Salomon should sell options because the analysis suggests the options are overpriced with respect to true volatility. The delta of the call is.6, while that of the put is.6 1 =.4. Therefore, Salomon should sell puts and calls in the ratio of.6 to.4. For example, if Salomon sells 2 calls and 3 puts, the position will be delta neutral: Delta = (2.6) + [3 (.4)] = 38. If the stock market index increases 1%, the 1 million shares of stock on which the options are written would be expected to increase by:.75% \$5 1 million = \$37,5 The options would increase by: delta \$37,5 =.8 \$37,5 = \$3, In order to hedge your market exposure, you must sell \$3,, of the market index portfolio so that a 1% change in the index would result in a \$3, change in the value of the portfolio

13 39. S = 1; current value of portfolio X = 1; floor promised to clients (% return) σ =.25; volatility r =.5; risk-free rate T = 4 years; horizon of program a. Using the Black-Scholes formula, we find that: d 1 =.65, N(d 1 ) =.7422, d 2 =.15, N(d 2) =.5596 Put value = \$1.27 Therefore, total funds to be managed equals \$11.27 million: \$1 million portfolio value plus the \$1.27 million fee for the insurance program. The put delta is: N(d 1 ) 1 = =.2578 Therefore, sell off 25.78% of the equity portfolio, placing the remaining funds in T- bills. The amount of the portfolio in equity is therefore \$74.22 million, while the amount in T-bills is: \$11.27 million \$74.22 million = \$36.5 million b. At the new portfolio value, the put delta becomes:.2779 This means that you must reduce the delta of the portfolio by: =.21 You should sell an additional 2.1% of the equity position and use the proceeds to buy T-bills. Since the stock price is now at only 97% of its original value, you need to sell: \$97 million.21 = \$1.95 million of stock 4. Using the true volatility (32%) and time to expiration T =.25 years, the hedge ratio for Exxon is N(d 1 ) = Because you believe the calls are under-priced (selling at an implied volatility that is too low), you will buy calls and short.5567 shares for each call you buy. 41. The calls are cheap (implied σ =.3) and the puts are expensive (implied σ =.34). Therefore, buy calls and sell puts. Using the true volatility of σ =.32, the call delta is.5567 and the put delta is: =.4433 Therefore, for each call purchased, buy:.5567/.4433 = puts 21-13

14 42. a. To calculate the hedge ratio, suppose that the market index increases by 1%. Then the stock portfolio would be expected to increase by: 1% 1.5 = 1.5% or.15 \$1,25, = \$18,75 Given the option delta of.8, the option portfolio would increase by: \$18,75.8 = \$15, Salomon s liability from writing these options would increase by the same amount. The market index portfolio would increase in value by 1%. Therefore, Salomon Brothers should purchase \$1,5, of the market index portfolio in order to hedge its position so that a 1% change in the index would result in a \$15, change in the value of the portfolio. b. The delta of a put option is:.8 1 =.2 Therefore, for every 1% the market increases, the index will rise by 1 points and the value of the put option contract will change by: delta 1 contract multiplier = = \$2 Therefore, Salomon should write: \$12,/\$2 = 6 put contracts CFA PROBLEMS 1. Statement a: The hedge ratio (determining the number of futures contracts to sell) ought to be adjusted by the beta of the equity portfolio, which is 1.2. The correct hedge ratio would be: \$1 million β = 2, β = 2, 1.2 = 2,4 \$1 5 Statement b: The portfolio will be hedged, and should therefore earn the risk-free rate, not zero, as the consultant claims. Given a futures price of 1 and an equity price of 1, the rate of return over the 3-month period is: (1 99)/99 = 1.1% = approximately 4.1% annualized 2. a. The value of the call option is expected to decrease if the volatility of the underlying stock price decreases. The less volatile the underlying stock price, the less the chance of extreme price movements and the lower the probability that the option expires in the money. This makes the participation feature on the upside less valuable. The value of the call option is expected to increase if the time to expiration of the option increases. The longer the time to expiration, the greater the chance that the option will expire in the money resulting in an increase in the time premium component of the option s value

15 b. i. When European options are out of the money, investors are essentially saying that they are willing to pay a premium for the right, but not the obligation, to buy or sell the underlying asset. The out-of-the-money option has no intrinsic value, but, since options require little capital (just the premium paid) to obtain a relatively large potential payoff, investors are willing to pay that premium even if the option may expire worthless. The Black-Scholes model does not reflect investors demand for any premium above the time value of the option. Hence, if investors are willing to pay a premium for an out-of-the-money option above its time value, the Black-Scholes model does not value that excess premium. ii. With American options, investors have the right, but not the obligation, to exercise the option prior to expiration, even if they exercise for non-economic reasons. This increased flexibility associated with American options has some value but is not considered in the Black-Scholes model because the model only values options to their expiration date (European options). 3. a. American options should cost more (have a higher premium). American options give the investor greater flexibility than European options since the investor can choose whether to exercise early. When the stock pays a dividend, the option to exercise a call early can be valuable. But regardless of the dividend, a European option (put or call) never sells for more than an otherwise-identical American option. b. C = S + P PV(X) = \$43 + \$4 \$45/1.55 = \$4.346 Note: we assume that Abaco does not pay any dividends. c. i) An increase in short-term interest rate PV(exercise price) is lower, and call value increases. ii) An increase in stock price volatility the call value increases. iii) A decrease in time to option expiration the call value decreases. 4. a. The two possible values of the index in the first period are: us = = 6 ds =.8 5 = 4 The possible values of the index in the second period are: uus = (1.2) 2 5 = 72 uds = = 48 dus = = 48 dds = (.8) 2 5 =

16 b. The call values in the second period are: C uu = 72 6 = 12 C ud = C du = C dd = Since C ud = C du =, then C d =. To compute C u, first compute the hedge ratio: C uu C ud 12 1 H = = = uus uds Form a riskless portfolio by buying one share of stock and writing two calls. The cost of the portfolio is: S 2C u = \$6 2C u The payoff for the riskless portfolio equals \$48: S = 48 S = 72 Buy 1 share Write 2 calls -24 Total Therefore, find the value of the call by solving: \$6 2C u = \$48/1.6 C u = \$7.358 To compute C, compute the hedge ratio: C u Cd H = = =.3679 us ds 6 4 Form a riskless portfolio by buying.3679 of a share and writing one call. The cost of the portfolio is:.3679s C = \$ C The payoff for the riskless portfolio equals \$14.716: S = 4 S = 6 Buy.3679 share Write 1 call Total Therefore, find the value of the call by solving: \$ C = \$14.716/1.6 C = \$

17 c. The put values in the second period are: P uu = P ud = P du = 6 48 = 12 P dd = 6 32 = 28 To compute P u, first compute the hedge ratio: Puu Pud 12 1 H = = = uus uds Form a riskless portfolio by buying one share of stock and buying two puts. The cost of the portfolio is: S + 2P u = \$6 + 2P u The payoff for the riskless portfolio equals \$72: S = 48 S = 72 Buy 1 share Buy 2 puts 24 Total Therefore, find the value of the put by solving: \$6 + 2P u = \$72/1.6 P u = \$3.962 To compute P d, compute the hedge ratio: Pdu Pdd H = = = 1. dus dds Form a riskless portfolio by buying one share and buying one put. The cost of the portfolio is: S + P d = \$4 + P d The payoff for the riskless portfolio equals \$6: S = 32 S = 48 Buy 1 share Buy 1 put Total 6 6 Therefore, find the value of the put by solving: \$4 + P d = \$6/1.6 P d = \$16.64 To compute P, compute the hedge ratio: P H = us u Pd ds = =

18 Form a riskless portfolio by buying.6321 of a share and buying one put. The cost of the portfolio is:.6321s + P = \$ P The payoff for the riskless portfolio equals \$41.888: S = 4 S = 6 Buy.6321 share Buy 1 put Total Therefore, find the value of the put by solving: \$ P = \$41.888/1.6 P = \$7.912 d. According to put-call-parity: C = S + P PV(X) = \$5 + \$7.912 \$6/(1.6 2 ) = \$4.512 This is the value of the call calculated in part (b) above. 5. a. (i) Index increases to 142. The combined portfolio will suffer a loss. The written calls expire in the money; the protective put purchased expires worthless. Let s analyze the outcome on a per-share basis. The payout for each call option is \$52, for a total cash outflow of \$14. The stock is worth \$1,42. The portfolio will thus be worth: \$1,42 \$14 = \$1,298 The net cost of the portfolio when the option positions are established is: \$1,336 + \$16.1 (put) [2 \$8.6] (calls written) = \$1,334.9 (ii) Index remains at Both options expire out of the money. The portfolio will thus be worth \$1,336 (per share), compared to an initial cost 3 days earlier of \$1, The portfolio experiences a very small gain of \$1.1. (iii) Index declines to 127. The calls expire worthless. The portfolio will be worth \$1,33, the exercise price of the protective put. This represents a very small loss of \$4.9 compared to the initial cost 3 days earlier of \$1,334.9 b. (i) Index increases to 142. The delta of the call approaches 1. as the stock goes deep into the money, while expiration of the call approaches and exercise becomes essentially certain. The put delta approaches zero. (ii) Index remains at Both options expire out of the money. Delta of each approaches zero as expiration approaches and it becomes certain that the options will not be exercised. (iii) Index declines to 127. The call is out of the money as expiration approaches. Delta approaches zero. Conversely, the delta of the put approaches 1. as exercise becomes certain

19 c. The call sells at an implied volatility (11.%) that is less than recent historical volatility (12.%); the put sells at an implied volatility (14.%) that is greater than historical volatility. The call seems relatively cheap; the put seems expensive

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