Chapter 21 – Option Valuation
CHAPTER TWENTY-ONE
OPTION VALUATION
CHAPTER OVERVIEW
This chapter discusses factors affecting the value of an option, determination of option pricing in a two–
LEARNING OBJECTIVES
After studying this chapter, the student should have an understanding of the factors affecting option
PRESENTATION OF MATERIAL
21.1 Option Valuation: Introduction
The concept of an option’s intrinsic value was developed in Chapter 20. Section 21.1 describes the
concept of time value of an option building on intrinsic value. A graph that compares the intrinsic and
time value of a call option is displayed in Figure 21.1.
21.2 Restrictions on Option Values
The value of levered equity gives the lower bound for option value. The value of the option cannot
exceed the value of stock. This places the upper bound on option price.
21.3 Binomial Option Pricing
This section presents binomial pricing examples based on the example that is developed in the text. The
example assumes the stock is currently priced at $100 and will have a value of either $120 or $90 at the
Chapter 21 – Option Valuation
21-2
21.4 Black-Scholes Option Valuation
The Black-Scholes Option Pricing Model is developed here. It is recommended that students work
through the examples provided manually at least once before using the Excel application (described
below). The Excel spreadsheet that calculates option value is very helpful in using the Black-Scholes
Option Model.
in the text, the put would have a value of $6.35.
21.5 Using the Black-Scholes Formula
The appropriate hedge ratio is the options delta which is the slope of the option price at the current stock
price. An overview of the concept of portfolio insurance is presented here. The basic concept involves
the purchase of protective puts. Purchase of protective puts is a straight forward in concept but there are
21.6 Empirical Evidence on Option Pricing
Evidence offered by vast numbers of studies show that for the most part that Black-Scholes does a good
Chapter 21 – Option Valuation
Excel Model
The Black-Scholes Option Pricing Model is available in a spreadsheet at the Online Learning Center