Lecture 16 Flashcards
Intrinsic value
Profit that could be made if the option was immediately exercised
Intrinsic value of call =
Stock price - exercise price
Intrinsic value of put =
Exercise price - stock price
Time value =
Difference between actual call price and intrinsic value
Value of call option if > stock price increases
Increases
Value of call option if > exercise price increases
Falls
Value of call option if > volatility increases
Increases
Value of call option if > time to expiration increases
Increases
Value of call option if > interest rate increases
Increases
Value of call option if > dividend payouts increase
Falls
Black-Scholes model
Model of price variation over time of financial instruments such as stocks that can be used to determine the price of a European call option
Black-Scholes model states
The price of heavily traded assets follows a geometric Brownian motion with constant drift and volatility
When applied to a stock option, the Black-Scholes model incorporates
The constant price variation of the stock, the time value of money, the option’s strike price, and the time to the option’s expiry
Black-Scholes model assumes (3)
- No dividends are paid
- Interest rate and variance rate are constant
- Stock prices are continuous
N(d) =
The normal distribution of d
If N(d) is close to 1.0
High probability the option will be exercised
If N(d) is close to 0
The option is unlikely to be exercised > the call is worth nothing
If N(d) is in the middle range between 0-1
Call value is viewed as the present value of the call’s potential payoff, adjusting for the probability of the in-the-money expiration
Implied volatility
That value of the volatility of the underlying instrument which, when input in an option pricing model (such as Black–Scholes) will return a theoretical value equal to the current market price of the option.
If actual stock standard deviation exceeds the implied volatility
Option is considered a good buy > fair price exceeds observed price
Black-Scholes model with dividends
Replace the stock price with the dividend adjusted stock price
