Factors affecting option pricing, Put Call Parity, Option Greeks, Style of Option

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