Put-Call Parity

• Put option value can be computed using put-call parity

• A Fiduciary Call (long call, plus an investment in a zero-coupon bond with

a face value equal to the strike price) is equal to the value of Protective
Put (Long Stock and Long Put)

• Stock + Put = Call + PV(ZCB)

• S0 + P0 = C0 + PV(X)
 Put-Call Parity - Assumptions

• Derives relationship only for European options

• Call and Put have same strike price – X

• All the instruments have the same time to maturity – T

• Stock pays no dividend

 Put - Call Parity
• Consider Two scenarios – where ST is greater than X and where ST is
less than X [S0 + P0 = C0 + PV(X)]

ST > X ST < X
Equation Portfolio Payoff Payoff
LHS Stock S S
Put 0 X-S
Total S X
RHS Zero-coupon Bond X X
Call S-X 0
Total S X
 Binomial Model Assumptions
• There are two (and only two) possible prices (security prices follow a stationary
binomial stochastic process) for the underlying asset on the next date. The
underlying price will either:
• Increase by a factor of U% (Uptick)
• Decrease by a factor of D% (Downtick)

• The uncertainty is that we do not know which of the two prices will be realized.

• No Arbitrage opportunity exits

• No dividends

• The one-period interest rate, r, is constant over the life of the option (r% per period)

• Markets are perfect (no commissions, bid-ask spreads, taxes, etc.)

 Risk-Neutral Valuation
• Important principle used in the valuation of derivatives is risk-neutral valuation

• This means that when valuing a derivative we can make assumption that investors are risk-neutral
which means that they do not increase the expected return they require, from an investment, to
compensate for increased risk

• A risk neutral world has 2 features that simplify pricing of derivatives:

 Expected return on a stock (or any investment) is the risk-free rate of return
 Discounted rate used for the expected payoff on an option is the risk-free rate

• Binomial trees illustrate the general result that to value a derivative we can assume that the expected
return on the underlying asset is the risk-free rate and discount at the risk-free rate

• This is known as using risk-neutral valuation

• In risk neutral world, expected share price at time T is : E(S T) = S0erT

 Generalization
• Notations:

S0 = Stock price

X = Strike Price

C = Call option price

T = time of option expiration

S0u= up level for stock price where u > 1

Cu = payoff from option when stock price rises to S0u

S0d = down level for stock price where d < 1

Cd = payoff from option when stock price goes down to S0d

 Generalization

A derivative lasts for time T and is dependent on a stock

S0u
Cu
S0
C S0d
Cd
 Generalization
• The value of a derivative is its expected payoff in a risk-neutral world discounted
at the risk-free rate

S0u
p Cu
S0
C 1–p S0d
Cd
e rT  d
p
• C = [ pCu + (1 – p)Cd ]e–rT where ud

• It is natural to interpret p and 1-p as probabilities of up and down movements.

 A Simple Binomial Model

• A stock price is currently INR 20

• At the end of three months it will be either INR 22 or INR 18

• The situation can be represented by the following diagram:

Stock Price = INR 22

Stock price = INR 20

Stock Price = INR 18
 A Simple Binomial Model – contd.
• A 3-month European call option on the stock has a strike price of INR 21
• The possible values of this call option in three months time is shown below.
• We need to find the price of option now.
• The situation is represented below:

Stock Price = INR 22

Option Payoff =INR 1
Stock price = INR 20
Option Price=?
Stock Price = INR 18
Option Payoff = INR 0
 Original Example Revisited: Risk Neutral Valuation
S0u = 22 Time period 3 months = 0.25 years
p Cu = 1 Risk free interest rate = 12% per annum
S0 = 20
C (1 – S0d = 18
p)
Cd = 0

• Expected return on the stock in a risk neutral world must be the risk free rate of 12%
• Thus p would satisfy the condition : 22p +18 (1-p) = 20e0.12*(3/12) so p = 0.6523
• At the end of 3 months, call option has 0.6523 probability of being worth 1 and 0.3477 (1-
0.6523) probability of being worth zero.
• Expected Value of call at time T = 0.6523*1 + 0.3477*0 = 0.6523
• In risk neutral world, this would be discounted at risk free rate to give the value of the option
is = 0.6523e–0.12*0.25 = INR 0.633
 Valuing options – Binomial tree approach

Questions?
• Probability of up move = (rf – low) / (hi-low)

• Where rf = amount due to risk free on INR 1

• high = up side on fluctuation on INR 1

• low = down side on fluctuation on INR 1

• Probability of Down move = 1 – probability of up move

• How to find upside and downside?

12
 Steps for solving under Binomial Method
• State the given data – Current price of the underlying; % of up-move; % of down-
move; Strike price; Maturity period; Risk-free rate
• Find out the range of the underlying prices from the current levels at the end of the
given period
• Using the expected price movements of the underlying, find out the payoffs for the
Option by comparing with the Strike price
• Find out the Probability of Up-move (use the formula in Slide 7)
• Find out the Probability of Down-move (1 – prob. of up move)
• Find out Expected Payoffs of the option (probability * option payoff)
• Discount the expected payoffs using the risk-free rate
• You get the Price / Premium of that specific Option contract
 Valuing options – Binomial tree approach

• Assume that
• Absolute values of upside and downside are the same
• Upside / downside is equal to the observed volatility
• For example,
• observed volatility in Nifty is 10.76% p.a.
• Balance period till expiry: 17 days
• Volatility for the balance period = 10.76% * sqrt(17/365) = 2.32%
• Upside on current market price of INR 100 : INR 102.32
• Downside on current market price of INR 100 : INR 97.68
• If risk free rate is 6% p.a., risk free price after 17 days
= 100 + 100 * (6%*17/365) = 100.28
14
Q1.

Calculate the value today of a one-year Call option on a stock that has
an exercise price of INR 30. Assume that Discreet / Periodic
Compounded Risk-free rate is 7%.
Current value of stock is INR 30
Stock Price either rises to INR 40 or falls to INR 22.50
Q2.

Calculate the value today of a one-year Call option on a stock that has
an exercise price of INR 250. Assume that Discreet / Periodic
Compounded Risk-free rate is 9%.
Current value of stock is INR 300
Up / Down Move – 20% of market price
Q3.

Calculate the value today of a one-year Put option on a stock that has
an exercise price of INR 30. Assume that Discreet / Periodic
Compounded Risk-free rate is 7%.
Current value of stock is INR 30
Size of an up-move is 1.333
Size of an down-move is 0.75
Q4.

Suppose you own a stock currently priced at INR 50 and that a two-
year European Call option on the stock is available with a strike price
of INR 45. The size of an up-move is 1.25 and the size of down-move
is 0.80. The discreet compounding risk-free rate per period is 7%.
Compute the value of call option using a two-period Binomial model
Q5

A stock price is currently $50. It is known that at the end of six months
it will be either $60 or $42. The risk-free rate of interest with
continuous compounding is 12% per annum. Calculate the value of
a six-month European call option on the stock with an exercise price
of $48.
Q5 (Solution)

• Suppose that p is the probability of an upward stock price movement

in a risk neutral world.

• Then, p = (e0.12*0.5 – 0.84)/(1.2 – 0.84)

= 0.6161

• The expected value of option in a risk-neutral world is:

C = e–0.12*0.5 (0.6161*12 + 0.3839*0) = 6.96

 Example 6
(solve on the basis of Slide 7 & 12)

• Given
• CMP : 100
• Observed volatility : 12% p.a.
• Time till expiry : 20 days
• Risk free rate : 5% p.a.
• Estimate Using one step binomial
• Price of at-the-money European call
• Price of at-the-money European put
25
Example 6

• Step 1 : Compute price using risk free rate of 5% p.a.

• Current market price = INR 100
• Tenor = 20 days = 20/365 year
• Risk free price (Rf) = 100 * (1 + 5% * 20/365)

= 100.274

26
Example 6
• Step 2 : Calculate hi and low prices using the given
volatility rate of 12% p.a.
 hi price =
current market price *
(1+ volatility rate p.a. * sqrt (number of days to expiry / 365))
= 100 * (1 + 12% * sqrt (20/365))
= 102.809
 low price =
current market price *
(1- volatility rate p.a. * sqrt (number of days to expiry / 365))
= 100 * (1 - 12% * sqrt (20/365))
= 97.191

27
Example 6

• Step 3 : Calculate probability of up move

• p = ( Rf – low) / ( hi – low)
• = (100.274 - 97.191) / (102.809 - 97.191)
• = 0.55

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Example 6
• Step 4 : Calculate expected value of call option price today

• call option payoff on hi price = 102.809 - 100 = 2.809

• Probability : 0.55

• call option payoff on low price = 0, as low price of 97.191 is below the strike of 100

• Probability : 0.45

• Expected payoff on the call option at expiry

• 0.55 * 2.809 + 0.45 * 0 = 1.545

• Present value of the expected payoff is the expected price of call option =

• 1.545 / ( 1 + .05 * 20/365) = 1.541

29
Example 6
• Step 5 : Calculate expected value of put option price today

• put option payoff on hi price = 0, price of 102.809 is above the strike of 100

• Probability : 0.55

• put option payoff on low price = 100 – 97.191 = 2.809

• Probability : 0.45

• Expected payoff on the call option at expiry

• (0.55 * 0) + (0.45 * 2.809) = 1.264

• Present value of the expected payoff is the expected price of call option =

• 1.264 / ( 1 + .05 * 20/365) = 1.261

30