Sir, could you clarify for me what exactly an option buyer is paying? Is he or she paying a premium? Is premium the amount calculated using option pricing model? Are options traded on values calculated using the formula or premium? Could you explain with an example?

The amount you pay to buy the option is the premium and is determined by the Black Scholes formula. You pay the premium whether or not you later exercise the option.
I work through examples in this and the second lecture.

The premium is another word for the price at which the option is traded.
(Don’t confuse the word with the other use of the word ‘premium’ in other contexts – it is not a premium in the sense of it being extra over and above something else 🙂 )

The above is only relevant for share options – real options are not traded, and foreign currency options have a different formula (testing on the formula for these options is no longer in the syllabus).

Am I right to assume that in the case of put option, a shareholder already has a certain amount of shares and as a result, opts for buying a put option so that he or she can sell at a fixed rate?

As far as the exam is concerned – yes. Yes is the likely reason for buying put options. You are worried that the price of the shares will fall and therefore if the price does fall then you have the right to sell them at the fixed price. (But if the price of the shares rises, then you would not use the option but could sell the shares at the higher price.)

Sir I was doing ‘Q59 UNIGLOW from Kaplan kit sep14 to aug15 edition’ on option pricing.
It is not difficult question but I just need to understand one point.
In answer it says we can use Delta to construct delta hedge and in order to protect against a fall in Uniglow’s share price, the easiest hegde would be to write (sell) options on Uniglow’s shares. (I am protecting the investment of my company in Uniglow’s shares).
So my question whether the option we sell is call or put option?

We sell a call option (you could achieve the same ‘protection’ by buying a put option, but in the exam you always sell a call to create a delta hedge, unless told otherwise).

I do explain the reasoning behind this in the lectures.

i still can’t figure out how you reached the figure of 0.045 while calculating d1 (0.1+0.5*0.4^2)0.25 . My answer is 0.105 i’m really confused please help..

Because that is was comes out of the equations!!!!

The price of the share in 3 months could obviously be anything. However it is more likely that it will be less than 1.80 than more than 1.80, so the people selling the options will want to charge more for a put option because they are more likely to have to pay out on it.

(and don’t ask me why the price is more likely to be less than 1.80 than more!! That is down to the statistics why is how the derived the formulae, and I have certainly no intention of going through their proof 🙂 )

Not all scientific calculators are the same – there are two different ways that they work. If yours does not have a +/- button then it uses a different logic, and you will have to look in the instruction book how to do it.

Sir,
In Example % while calculating value of call option on the third step u used e raised to power -.04… aint that wrong as time is .25 and r is .1 when we multiply that it comes to .025.. :O
dont know how u came to to .04 :O
waiting for ur reply
thanks

I assume you were happy in arriving at the figure of -0.6886 for D1 (the workings are at the end of the lecture notes as well).

We look up 0.69 in the tables (we can only look up for 2 decimal places, so 0.6886 becomes 0.69). So do this you look along the 0.6 row and as you move through the columns it gives the figure for 0.60, 0.61, 0.62 and so on. We want 0.69 and so it is the 0.6 row and the 0.09 column, and the figure from the tables is 0.2549.

Because D1 is negative, we subtract then 0.2549 away from 0.5.
(Had it been positive, as D2 is, then we would add 0.5). This rule is given at the bottom of the tables.

You should be able to follow the rest of the answer at the back of the Lecture Notes.

(How did you manage to sort out the first four examples, but not example 5? :-))

John i have this question. it concerns calculatind d1 if a questions is given n i calculate d1 and a figure say 1.2812 and i then round it to 1.28 and another candidate calculates his and round it to 1.3. these two answers will give different values for N(d1) which will lead to a different value for a call option. will the two of us have all the marks. I am asking because when calculating the figure for natual log of Pa/Pe due to rounding candidates will have different answers
thank you

Firstly most if not all of the marks are for proving you understand what is happening rather than for the final answer.
Secondly, when rounding you should really round to the number of decimals needed for the tables, so why round to 1.3 when the tables allow you to look up 1.28 🙂

I am sorry, but you can only download the course notes – the lectures can only be watched online.
It is the only way that we can keep this website free of charge.

If it was a call option exercisable immediately, then the option gives you the right to buy a share at a fixed price.

So, for example, if the current share price is $4.00 and you could buy an option giving you the right to buy the share at an exercise price of $3.70, then you could buy the share for $3.70 and immediately sell it for $0.30.
Nobody is going to give you that right free! You would be prepared to pay $0.30 for the option. Then you could use it and buy a share for $3.70. You have then spent $4.00 in total and you own a share worth $4.00 🙂

(But of course, that is only if the option were exercisable immediately. In practice the option will be the right to buy a share at a fixed price on a future date, and to get the value of that we need to use all the formulae.)

This is invaluable! I have a scientific calculator and i had no idea how all this buttons worked ln and e* now you have educated me on the standard normal distribution table! whew u saved me a head ache. for a while there when i saw the formulae i imagened it must be some enginering formulae forgotten on P4 paper by error!

It means this paper should have more calculations and less writing , how then are we expected to mix the two?! I mean just one question on options is enough to give one a head ache. God have mercy on us!

But Thank God for Opentuition iam confident iam finalising and passing this June 2013 exams. Watch this space i will update u all. John you are our guardian angel!

Example 4. When the lecturer was doing the call option formula, he made a mistake and put t=.4 when it should be .25… so answer is actually 4cents and not 5cents…. whew

Isn’t it possible to incorporate video speed controls within the player? It would really help since some may never have enough time to watch at the normal speed. I would request you to consider takling to the company providing the streaming and update if possible.

It seems the tutor made an error in the lecture (example 5 around 53:01) where he says the ‘t’ in e^-rt is 0.4 instead of 0.25 (3months).

But if you look at page 144 in the OT notes, the answer to example 5 in chapter 13 (share options and option pricing) shows the correct figure, t = 0.25.

Brilliant lecture, I’ve picked up a lot more from here than I did in class! Thank you!

Olivia says

Hi, in the final part of example 5 when working out the Put option you have calculated it saying that t=0.4 but t=.25??

John Moffat says

Thanks – I must re-record the lecture.

However the answer in the lecture notes is correct.

Amer says

Sir, could you clarify for me what exactly an option buyer is paying? Is he or she paying a premium? Is premium the amount calculated using option pricing model? Are options traded on values calculated using the formula or premium? Could you explain with an example?

Thank you.

John Moffat says

The amount you pay to buy the option is the premium and is determined by the Black Scholes formula. You pay the premium whether or not you later exercise the option.

I work through examples in this and the second lecture.

Amer says

So options are traded on the premium values?

John Moffat says

The premium is another word for the price at which the option is traded.

(Don’t confuse the word with the other use of the word ‘premium’ in other contexts – it is not a premium in the sense of it being extra over and above something else 🙂 )

The above is only relevant for share options – real options are not traded, and foreign currency options have a different formula (testing on the formula for these options is no longer in the syllabus).

Amer says

Am I right to assume that in the case of put option, a shareholder already has a certain amount of shares and as a result, opts for buying a put option so that he or she can sell at a fixed rate?

Thank You!

John Moffat says

As far as the exam is concerned – yes. Yes is the likely reason for buying put options. You are worried that the price of the shares will fall and therefore if the price does fall then you have the right to sell them at the fixed price. (But if the price of the shares rises, then you would not use the option but could sell the shares at the higher price.)

Amer says

Thank you, Mr Moffat. 🙂

John Moffat says

You are welcome 🙂

Nicholas says

Fantastic lecture Sir!

John Moffat says

Thank you 🙂

IQ says

A very basic question: Value of an option is basically the premium payable right?

John Moffat says

Yes 🙂

sunday says

Thanks alot

alpha2006 says

Hello sir…

am confused, why do u said the call option is cheaper than the put option in this case?

the call option 5cent n the put option 28cent

John Moffat says

The prices of the two options depend on how likely they are to end up being exercised.

saan says

@ Sir John Moffat,

Sir I was doing ‘Q59 UNIGLOW from Kaplan kit sep14 to aug15 edition’ on option pricing.

It is not difficult question but I just need to understand one point.

In answer it says we can use Delta to construct delta hedge and in order to protect against a fall in Uniglow’s share price, the easiest hegde would be to write (sell) options on Uniglow’s shares. (I am protecting the investment of my company in Uniglow’s shares).

So my question whether the option we sell is call or put option?

John Moffat says

We sell a call option (you could achieve the same ‘protection’ by buying a put option, but in the exam you always sell a call to create a delta hedge, unless told otherwise).

I do explain the reasoning behind this in the lectures.

saan says

Thank you very much sir.

John Moffat says

You are welcome 🙂

Vione says

thank you. incredible lecture

John Moffat says

Thank you for the comment 🙂

accafreak91 says

i still can’t figure out how you reached the figure of 0.045 while calculating d1 (0.1+0.5*0.4^2)0.25 . My answer is 0.105 i’m really confused please help..

John Moffat says

(0.1 + 0.5 x 0.4 x 0.4) x 0.25 = (0.1 + 0.08) x 0.25 = 0.18 x 0.25 = 0.045

accafreak91 says

thank you so much looks like my calculator had issues

John Moffat says

You are welcome 🙂

sogan0 says

on example 5 why is the put option more epensive than call option?

John Moffat says

Because that is was comes out of the equations!!!!

The price of the share in 3 months could obviously be anything. However it is more likely that it will be less than 1.80 than more than 1.80, so the people selling the options will want to charge more for a put option because they are more likely to have to pay out on it.

(and don’t ask me why the price is more likely to be less than 1.80 than more!! That is down to the statistics why is how the derived the formulae, and I have certainly no intention of going through their proof 🙂 )

kash says

am unable to calculator the figure for e.

I have a scientific one with e and ln.

which key to press for +-

John Moffat says

Not all scientific calculators are the same – there are two different ways that they work. If yours does not have a +/- button then it uses a different logic, and you will have to look in the instruction book how to do it.

waqas says

Sir,

In Example % while calculating value of call option on the third step u used e raised to power -.04… aint that wrong as time is .25 and r is .1 when we multiply that it comes to .025.. :O

dont know how u came to to .04 :O

waiting for ur reply

thanks

waqas says

example 5

John Moffat says

You are correct – it should be 0.025 (and the final answer should be 4c).

I will re-record the lecture.

waqas says

thanks 🙂

braske77 says

Please leave it like it is, makes us think, not just silly writing all down 🙂

John Moffat says

Good point Braske77 (and thank you 🙂 )

sogan0 says

Im gettign lost in example 5 on the calculation of p on the e to the power of -0.04 what is the e value is it 2.7183

John Moffat says

Yes it is – and you must have a calculator with an ‘e’ button on it 🙂

sogan0 says

found the e button thanx

sogan0 says

Hi Tutor

Please give me an example on how to use the distribution table i got lost in Example 5 on the column 0.09 why that column?

John Moffat says

I assume you were happy in arriving at the figure of -0.6886 for D1 (the workings are at the end of the lecture notes as well).

We look up 0.69 in the tables (we can only look up for 2 decimal places, so 0.6886 becomes 0.69). So do this you look along the 0.6 row and as you move through the columns it gives the figure for 0.60, 0.61, 0.62 and so on. We want 0.69 and so it is the 0.6 row and the 0.09 column, and the figure from the tables is 0.2549.

Because D1 is negative, we subtract then 0.2549 away from 0.5.

(Had it been positive, as D2 is, then we would add 0.5). This rule is given at the bottom of the tables.

You should be able to follow the rest of the answer at the back of the Lecture Notes.

(How did you manage to sort out the first four examples, but not example 5? :-))

sogan0 says

i only started practicing exmaple 5 then i got lost. Many thanx for your advice

questforknowledge says

John i have this question. it concerns calculatind d1 if a questions is given n i calculate d1 and a figure say 1.2812 and i then round it to 1.28 and another candidate calculates his and round it to 1.3. these two answers will give different values for N(d1) which will lead to a different value for a call option. will the two of us have all the marks. I am asking because when calculating the figure for natual log of Pa/Pe due to rounding candidates will have different answers

thank you

John Moffat says

Two things.

Firstly most if not all of the marks are for proving you understand what is happening rather than for the final answer.

Secondly, when rounding you should really round to the number of decimals needed for the tables, so why round to 1.3 when the tables allow you to look up 1.28 🙂

mustafabilalqari says

How can I Have Lectures of Business Valuation

John Moffat says

There are no lectures yet on business valuation.

ALI says

How can i download this?or this is only for watching?

John Moffat says

I am sorry, but you can only download the course notes – the lectures can only be watched online.

It is the only way that we can keep this website free of charge.

ALI says

Can u provide me solution of paper strategic financial management 3.7 of december 2006 of ACCA………?

John Moffat says

I don’t think that I have it any longer – I will check later.

Do remember that the examiner (and the syllabus) has changed twice since then.

ALI says

okk,,,..

NEENA says

sir in example you taken t as 0.4 in formula of call option and put option i guess thats a mistake it should be 0.25 right?

NEENA says

i mean example 5.

John Moffat says

I have watched my lecture again, and it seems that I have taken ‘t’ as 0.25 correctly (it is ‘s’ that is 0.4).

You can of course check the answer at the back of the Course Notes. I think it is correct.

Lidia says

Dear John, it seems when calculating ‘-rt’ in example 6 (52,48 minute of the lecture and so on) you’ve multiplied 0,1 (r) by 0,4 instead of 0,25 (t)….

John Moffat says

Ooops – you are correct.

Sorry 🙁

sakura69 says

Thanks John!

ruth12 says

These are very well explained lectures and are a great help. Thank you sir and Open Tuition.

toobaalvi says

I have a very basic ques.. But its really confusing me. why the value of option is share price – excercise price?

John Moffat says

If it was a call option exercisable immediately, then the option gives you the right to buy a share at a fixed price.

So, for example, if the current share price is $4.00 and you could buy an option giving you the right to buy the share at an exercise price of $3.70, then you could buy the share for $3.70 and immediately sell it for $0.30.

Nobody is going to give you that right free! You would be prepared to pay $0.30 for the option. Then you could use it and buy a share for $3.70. You have then spent $4.00 in total and you own a share worth $4.00 🙂

(But of course, that is only if the option were exercisable immediately. In practice the option will be the right to buy a share at a fixed price on a future date, and to get the value of that we need to use all the formulae.)

tinashe says

thank u!

tinashe says

thank you

tinashe says

John you are God sent! what will we do without you and opentuition?!

Thank you so much for teaching me how to get more value using a scientific calculator!

tinashe says

This is invaluable! I have a scientific calculator and i had no idea how all this buttons worked ln and e* now you have educated me on the standard normal distribution table! whew u saved me a head ache. for a while there when i saw the formulae i imagened it must be some enginering formulae forgotten on P4 paper by error!

It means this paper should have more calculations and less writing , how then are we expected to mix the two?! I mean just one question on options is enough to give one a head ache. God have mercy on us!

But Thank God for Opentuition iam confident iam finalising and passing this June 2013 exams. Watch this space i will update u all. John you are our guardian angel!

tiffany2012 says

Example 4. When the lecturer was doing the call option formula, he made a mistake and put t=.4 when it should be .25… so answer is actually 4cents and not 5cents…. whew

bmparadzi says

Thank you very much for an invaluable lecture! You are brilliant, concise and straight to the point! Really appreciate the assistance.

coolsara says

invaluable ?

louis06111 says

You do help clarify all these complicated issues.

Thank you for all ur effort.

Benefit a lot

dladla says

please verify that on the last question,the “T” you used is annual and not adjusted for 3 months as it should be 0.25 and not 0.4.

John Moffat says

@dladla, You are correct – sorry. I used the correct T for calculating d1 and d2, but then made a mistake in the equation for c.

You can see the correct answer at the back of the Course Notes.

diana2010 says

gr8 lectures

thank you

diana2010 says

I have failed to view the lectures.

they are not running. Please help

admin says

Try another browser

pwyc says

thanks, i know how to use the formulaes ald…

mathiot says

Excellent lectures

Rejoyce says

Wonderful lecture. I picked up a great deal! Keep it up

kerry says

great explanation here!

rajad2010 says

@admin

Isn’t it possible to incorporate video speed controls within the player? It would really help since some may never have enough time to watch at the normal speed. I would request you to consider takling to the company providing the streaming and update if possible.

Thank you.

nausheenmoeen says

pls fix the techinal problem of this lecture i am reling on it its not running after 15 mins.

nausheenmoeen says

the lecture is not running after 15 mins

tosin says

my calculator isgivig wrong answer on the In(pa/pe) maybe im getting it wrong. whos is there to help me???

viviankyc82 says

thanks a lot…i didnt look at the answer in the notes just checked my answer against the video 😀 thanks a lot

John Moffat says

Thanks for your comments.

You are correct that it is e^-0.025, but that is what is in the answer to example 5 in the notes. I think the answer is correct.

viviankyc82 says

Also, thanks everything for putting these valuable lectures online, is even better and more thorough than Kaplan!! 😀

viviankyc82 says

i think the example 5 is wrong when working the call & put option, my e^-rt is actually e^-0.1*0.25; i.e. e^-0.025 or have i missed something? thanks

freshmint says

It seems the tutor made an error in the lecture (example 5 around 53:01) where he says the ‘t’ in e^-rt is 0.4 instead of 0.25 (3months).

But if you look at page 144 in the OT notes, the answer to example 5 in chapter 13 (share options and option pricing) shows the correct figure, t = 0.25.

Brilliant lecture, I’ve picked up a lot more from here than I did in class! Thank you!