Black Scholes

Tushar Jaruhar
Outline
• Introduction
• The Black-Scholes option pricing model
• Calculating Black-Scholes prices from historical data
• Implied volatility
• Using Black-Scholes to solve for the put premium
• Problems using the Black-Scholes model

2
Introduction
• The Black-Scholes option pricing model (BSOPM) has been one of
the most important developments in finance in the last 50 years
• Has provided a good understanding of what options should sell for
• Has made options more attractive to individual and institutional investors

3
The Black-Scholes Option Pricing Model
• The model
• Development and assumptions of the model
• Determinants of the option premium
• Assumptions of the Black-Scholes model
• Intuition into the Black-Scholes model

4
The Model

C = SN (d1 ) − Ke − RT N (d 2 )
where
S  2 
ln   +  R + T
K  2 
d1 =
 T
and
d 2 = d1 −  T

5
The Model (cont’d)
• Variable definitions:
S = current stock price
K = option strike price
e = base of natural logarithms
R = riskless interest rate
T = time until option expiration
 = standard deviation (sigma) of returns on the underlying security
ln = natural logarithm
N(d1) and
N(d2) = cumulative standard normal distribution functions

6
Development and Assumptions of the Model
• Derivation from:
• Physics
• Mathematical short cuts
• Arbitrage arguments

• Fischer Black and Myron Scholes utilized the physics heat transfer
equation to develop the BSOPM

7
Determinants of the Option Premium
• Striking price
• Time until expiration
• Stock price
• Volatility
• Dividends
• Risk-free interest rate

8
Striking Price
• The lower the striking price for a given stock, the more the option
should be worth
• Because a call option lets you buy at a predetermined striking price

9
Time Until Expiration
• The longer the time until expiration, the more the option is worth
• The option premium increases for more distant expirations for puts and calls

10
Stock Price
• The higher the stock price, the more a given call option is worth
• A call option holder benefits from a rise in the stock price

11
Volatility
• The greater the price volatility, the more the option is worth
• The volatility estimate sigma cannot be directly observed and must be
estimated
• Volatility plays a major role in determining time value

12
Dividends
• A company that pays a large dividend will have a smaller option
premium than a company with a lower dividend, everything else
being equal
• Listed options do not adjust for cash dividends
• The stock price falls on the ex-dividend date

13
Risk-Free Interest Rate
• The higher the risk-free interest rate, the higher the option
premium, everything else being equal
• A higher “discount rate” means that the call premium must rise for the
put/call parity equation to hold

14
Assumptions of the Black-Scholes Model
• The stock pays no dividends during the option’s life
• European exercise style
• Markets are efficient
• No transaction costs
• Interest rates remain constant
• Prices are lognormally distributed

15
The Stock Pays no Dividends During the Option’s
Life
• If you apply the BSOPM to two securities, one with no dividends
and the other with a dividend yield, the model will predict the same
call premium
• Robert Merton developed a simple extension to the BSOPM to account for
the payment of dividends

16
The Stock Pays no Dividends During the Option’s
Life (cont’d)

The Robert Miller Option Pricing Model

C * = e − dT SN (d1* ) − Ke − RT N (d 2* )
where
S  2 
ln   +  R − d + T
K  2 
d1 =
*

 T
and
d 2* = d1* −  T
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European Exercise Style
• A European option can only be exercised on the expiration date
• American options are more valuable than European options: For
an American call (on a stock without dividends), early
exercise is never optimal. The reason is that exercise requires payment of the
strike price X. By holding onto X until the expiration time, the option holder
saves the interest on X.
• Few options are exercised early due to time value

18
Markets Are Efficient
• The BSOPM assumes informational efficiency
• People cannot predict the direction of the market or of an individual stock
• Put/call parity implies that you and everyone else will agree on the option
premium, regardless of whether you are bullish or bearish

19
No Transaction Costs
• There are no commissions and bid-ask spreads
• Not true
• Causes slightly different actual option prices for different market
participants

20
Interest Rates Remain Constant
• There is no real “riskfree” interest rate
• Often the 30-day T-bill rate is used
• Must look for ways to value options when the parameters of the traditional
BSOPM are unknown or dynamic

21
Prices Are Lognormally Distributed
• The logarithms of the underlying security prices are normally
distributed
• A reasonable assumption for most assets on which options are available

22
Intuition Into the Black-Scholes Model
• The valuation equation has two parts
• One gives a “pseudo-probability” weighted expected stock price (an inflow)
• One gives the time-value of money adjusted expected payment at exercise
(an outflow)

23
Intuition Into the Black-Scholes Model (cont’d)

− RT
C = SN (d1 ) − Ke N (d 2 )

Cash Inflow Cash Outflow

24
Intuition Into the Black-Scholes Model (cont’d)
• The value of a call option is the difference between the expected
benefit from acquiring the stock outright and paying the exercise
price on expiration day

25
Calculating Black-Scholes Prices from Historical
Data
• To calculate the theoretical value of a call option using the BSOPM,
we need:
• The stock price
• The option striking price
• The time until expiration
• The riskless interest rate
• The volatility of the stock

26
Calculating Black-Scholes Prices from Historical
Data

Valuing a Microsoft Call Example

We would like to value a MSFT OCT 70 call in the year 2000.

Microsoft closed at $70.75 on August 23 (58 days before
option expiration). Microsoft pays no dividends.

We need the interest rate and the stock volatility to value

the call.

27
Calculating Black-Scholes Prices from Historical
Data

Valuing a Microsoft Call Example (cont’d)

Consulting the “Money Rate” section of the Wall Street

Journal, we find a T-bill rate with about 58 days to maturity
to be 6.10%.

To determine the volatility of returns, we need to take the

logarithm of returns and determine their volatility. Assume
we find the annual standard deviation of MSFT returns to
be 0.5671.
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Calculating Black-Scholes Prices from Historical
Data

Valuing a Microsoft Call Example (cont’d)

Using the BSOPM:

S  2 
ln   +  R + T
K  2 
d1 =
 T
 70.75   .56712 
ln   +  .0610 + 0.1589
 70   2 
= = .2032
.5671 .1589
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Calculating Black-Scholes Prices from Historical
Data

Valuing a Microsoft Call Example (cont’d)

Using the BSOPM (cont’d):

d 2 = d1 −  T
= .2032 − .2261 = −.0229

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Calculating Black-Scholes Prices from Historical
Data

Valuing a Microsoft Call Example (cont’d)

Using normal probability tables, we find:

N (.2032) = .5805
N (−.0029) = .4909

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Calculating Black-Scholes Prices from Historical
Data

Valuing a Microsoft Call Example (cont’d)

The value of the MSFT OCT 70 call is:

− RT
C = SN (d1 ) − Ke N (d 2 )
− (.0610 )(.1589 )
= 70.75(.5805) − 70e (.4909)
= $7.04
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Calculating Black-Scholes Prices from Historical
Data

Valuing a Microsoft Call Example (cont’d)

The call actually sold for $4.88.

The only thing that could be wrong in our calculation is the

volatility estimate. This is because we need the volatility
estimate over the option’s life, which we cannot observe.

33
Implied Volatility
• Introduction
• Calculating implied volatility
• An implied volatility heuristic
• Historical versus implied volatility
• Pricing in volatility units
• Volatility smiles

34
Introduction
• Instead of solving for the call premium, assume the market-
determined call premium is correct
• Then solve for the volatility that makes the equation hold
• This value is called the implied volatility

35
Calculating Implied Volatility
• Sigma cannot be conveniently isolated in the BSOPM
• We must solve for sigma using trial and error

36
Calculating Implied Volatility (cont’d)

Valuing a Microsoft Call Example (cont’d)

The implied volatility for the MSFT OCT 70 call is 35.75%,

which is much lower than the 57% value calculated from
the monthly returns over the last two years.

37
An Implied Volatility Heuristic
• For an exactly at-the-money call, the correct value of implied
volatility is:

0.5(C + P) 2 / T
 implied =
K /(1 + R) T

38
Historical Versus Implied Volatility
• The volatility from a past series of prices is historical volatility

• Implied volatility gives an estimate of what the market thinks about

likely volatility in the future

39
Historical Versus Implied Volatility (cont’d)
• Strong and Dickinson (1994) find
• Clear evidence of a relation between the standard deviation of returns over
the past month and the current level of implied volatility
• That the current level of implied volatility contains both an ex post
component based on actual past volatility and an ex ante component based
on the market’s forecast of future variance

40
Pricing in Volatility Units
• You cannot directly compare the dollar cost of two different options
because
• Options have different degrees of “moneyness”
• A more distant expiration means more time value
• The levels of the stock prices are different

41
Volatility Smiles
• Volatility smiles are in contradiction to the BSOPM, which assumes
constant volatility across all strike prices
• When you plot implied volatility against striking prices, the resulting graph
often looks like a smile

42
Volatility Smiles (cont’d)

Volatility Smile
Microsoft August 2000

60
Current Stock
Price
50
Implied Volatility (%)

40

30

20

10

0
40 45 50 55 60 65 70 75 80 85 90 95 100 105
Striking Price
43
Using Black-Scholes to Solve for the Put Premium
• Can combine the BSOPM with put/call parity:

− RT
P = Ke N (−d 2 ) − SN (−d1 )

44
Problems Using the Black-Scholes Model
• Does not work well with options that are deep-in-the-money or
substantially out-of-the-money
• Produces biased values for very low or very high volatility stocks
• Increases as the time until expiration increases
• May yield unreasonable values when an option has only a few days
of life remaining

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The Volatility
• The volatility is the standard deviation of
the continuously compounded rate of
return in 1 year
• The standard deviation of the return in a
short time period time Dt is
approximately  Dt
• If a stock price is $50 and its volatility is
25% per year what is the standard
deviation of the price change in one day?
 Estimating Volatility from Historical
Data
1. Take observations S0, S1, . . . , Sn at intervals
of t years (e.g. for weekly data t = 1/52)
2. Calculate the continuously compounded
return in each interval as:
 Si 
ui = ln 
 i −1 
S
3. Calculate the standard deviation, s , of the
ui´s
4. The historical volatility estimate is: ˆ = s
t
Nature of Volatility
• Volatility is usually much greater when the market is open (i.e.
the asset is trading) than when it is closed
• For this reason time is usually measured in “trading days” not
calendar days when options are valued
• It is assumed that there are 252 trading days in one year for
most assets
Example
• Suppose it is April 1 and an option lasts to April 30 so that the
number of days remaining is 30 calendar days or 22 trading
days
• The time to maturity would be assumed to be 22/252 = 0.0873
years
 The Concepts Underlying Black-Scholes-
Merton

• The option price and the stock price depend on the same underlying
source of uncertainty
• We can form a portfolio consisting of the stock and the option which
eliminates this source of uncertainty
• The portfolio is instantaneously riskless and must instantaneously earn
the risk-free rate
• This leads to the Black-Scholes-Merton differential equation
Problem
• The volatility of a stock price is 30% per annum (sigma). What is the
standard deviation of the percentage price change in one trading day?
• Delta Change in Volatility = Sigma * sqrt(delta time)
Solution

The standard deviation of the percentage price change in time Dt is  Dt where  is the
volatility. In this problem  = 03 and, assuming 252 trading days in one year,
Dt = 1  252 = 0004 so that  Dt = 03 0004 = 0019 or 1.9%.
Problem
• Calculate the price of a three-month European put option on a non-
dividend-paying stock with a strike price of $50 when the current
stock price is $50, the risk-free interest rate is 10% per annum, and
the volatility is 30% per annum.
Solution

In this case S0 = 50 , K = 50 , r = 01 ,  = 03 , T = 025 , and

ln(50  50) + (01 + 009  2)025
d1 = = 02417
03 025
d 2 = d1 − 03 025 = 00917
The European put price is
50 N (−00917)e−01025 − 50 N (−02417)

= 50  04634e−01025 − 50  04045 = 237

or $2.37.
Problem
• What difference does it make to your calculations in Problem if a
dividend of $1.50 is expected in two months?
Solution

In this case we must subtract the present value of the dividend from the stock price before
using Black–Scholes–Merton. Hence the appropriate value of S0 is
S0 = 50 − 150e−0166701 = 4852
As before K = 50 , r = 01 ,  = 03 , and T = 025 . In this case
ln(4852  50) + (01 + 009  2)025
d1 = = 00414
03 025
d 2 = d1 − 03 025 = −01086
The European put price is
50 N (01086)e−01025 − 4852 N (−00414)

= 50  05432e−01025 − 4852  04835 = 303

or $3.03.
Exam Preparation
• Compute the European Call option price for the same set of
conditions
Example
• A stock price is currently $40. It is known that at the end of one month
it will be either $42 or $38. The risk-free interest rate is 8% per annum
with continuous compounding. What is the value of a one-month
European call option with a strike price of $39?
Example

• A stock price is currently $50. It is known that at the end of six

months it will be either $45 or $55. The risk-free interest rate is 10%
per annum with continuous compounding. What is the value of a six-
month European put option with a strike price of $50?