Page 120 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 8: Option Pricing

8.5 Keywords Notes

Intrinsic Value: The intrinsic value of a call option is that amount by which stock price exceeds
the strike price, whenever the option is in-the-money.

Option Price: The price of an option contract is that amount which is paid by the option buyer to
the option seller.
Put-call Parity: Put-call parity is a classic application of arbitrage-based pricing – it does not
instruct us on how to price either put or call options, but it gives us an iron law linking the two
prices.
Volatility: The volatility of a stock price represents the uncertainty attached to its future
movement.

8.6 Review Questions

1. Briefly discuss the factors affecting option value.
2. What are the basic principles of option valuation?
3. What do you understand by Put-Call parity?
4. Discuss the effect of a dividend payable on the underlying shares on the call and put
option prices.
5. What do you mean by 'binomial'? Explain with suitable example the application of
Binomial model for the valuation of options.
6. State the basic feature and assumptions of Black-Scholes Option Valuation.
7. Explain the Black-Scholes model for the valuation of European call option. How is this
different from valuation of put option?
8. Consider the following information with regard to a call option on the stock of XYZ
company.

Current price of the share, S = ` 120
0
Exercise price of the option, E = ` 115
Time period to expiration = 3 months. Thus, t = 0.25 years.
Standard deviation of the distribution of continuously compounded rates of return, = 0.6
Continuously compounded risk-free interest rate, r = 0.10

Calculate the value of the call option using Black-Scholes Model.
9. Using the Black-Scholes model, calculate the value of a European call option using the
following data:

Exercise price = ` 65, Stock price- ` 60, Time to Expiration = 6 months
Continuously compounded risk-free rate of return= 15 % p.a.
Variance of rate of return is 0.25.

10. TISCO shares is currently selling at ` 75. Assume that at the end of three months, it will be
either ` 90 or ` 60. The risk-free rate of return with continuous compounding is 10% p.a.
Calculate the value of a three-month European call option on TISCO share with exercise
price of ` 70.

LOVELY PROFESSIONAL UNIVERSITY 115