Hedging
This article will examine the effect that stock price, exercise price, volatility, time interest and dividend rate has on the value of call/put options. Hedging is like insurance to an investor in the financial market. By hedging, an investor is insuring themselves against a negative event. It doesn’t prevent the event from happening, but it does lessen the impact. To do this, an investor needs to invest in two securities with negative correlations which will reduce their potential loss. By hedging, the investor is also reducing their potential profits. It’s important that an investor weighs the benefits with the costs involved with hedging.
Option Contracts and the Black-Scholes Formula
Options are contracts that give the purchaser the “right” to buy or sell an underlying asset at a certain fixed price. The holder has the right, but not the obligation, to buy or sell the underlying asset. If he chooses to buy or sell the option, the option is said to have been exercised. The difference between the options payoff and the cost of purchasing the call is the call options profit. The key is to determine how much an option is worth. The Black-Scholes formula is a mathematical equation that is used to determine the value of a call or put option.
The Black-Scholes option pricing model generates values fairly close to prices at which options trade. It assumes risk-free interest rates and stock price volatility. It also assumes that there will be no extreme jumps in stock prices. This pricing model was derived from a need to find a workable option pricing model. The Black-Scholes formula is a model of varying prices over time of a financial instrument. It can’t model the real world exactly because one of the parameters of the model is not a constant. Time to maturity, strike price, risk-free rate and current underlying price are constant. The implied volatility is not.
Six Inputs Affecting the Black-Scholes Formula
There are six factors that affect the value of a call option. They are: stock price, exercise price, volatility of the stock price, time to expiration, interest rate, and the dividend rate of stock. As a stock price increases, the call option will increase because the option is approaching the adjusted intrinsic value (i.e. the payoff if exercised immediately). If the stock price decreases, the immediate exercise of the stock would not be profitable.
The call option value increases as the volatility of the stock prices increases (i.e. the unpredictable changes in the underlying asset). This happens because of the limited loss an option holder can suffer. No matter how much the stock price decreases, the option holder is limited in how much they can lose. Obviously, good stock performance can increase the option payoff but moderate or even really bad performance can’t take the payoff below a certain number. The greater the volatility of the underlying stock, the more likely the option will become more valuable.
The longer the time until the option expires, the higher the value of the call option. The more time available, the more likely future events could affect prices. It works in the same fashion as volatility. As time increases, the option increases because the present value of the exercise price decreases. It is more likely that the stock prices will change making the option more valuable.
The higher the dividend yield on a stock price, the more the potential payoff from a call option is decreased. As the dividend increases the growth rate of the stock decreases and the potential payoff from the call option also decreases. The lower the exercise price, the more valuable the option becomes. The owner can buy more stock at lower prices which increases their chance of making a profit.
Conclusion
The concept of options has existed since the beginning of investments. It wasn’t until the Black-Scholes pricing model was introduced in 1973 that a framework for pricing options became available. Although the model required assumptions, it still went a long way in mathematically measuring what was once thought to be random and unobservable behavior, of stocks. Black and Scholes method allowed investors to “know” in advance the price one should charge for an option. Hedging is always an “uncertain undertaking” and involves risk, but methods like the Black-Scholes pricing model allow hedging to become more predictable.
Jan Tucker - Jan has a PhD in Business Management and combines her 20+ years experience in Higher Education and Business Administration to offer a ...
