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Black and Scholes Model

The Black-Scholes model provides a formula for pricing options based on the stock price, exercise price, time to expiration, risk-free interest rate, and volatility. It assumes the risk-free rate and volatility are constant over time. Warrants are valued similarly but use total amounts instead of per-share to account for dilution from new shares issued upon exercise.

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136 views2 pages

Black and Scholes Model

The Black-Scholes model provides a formula for pricing options based on the stock price, exercise price, time to expiration, risk-free interest rate, and volatility. It assumes the risk-free rate and volatility are constant over time. Warrants are valued similarly but use total amounts instead of per-share to account for dilution from new shares issued upon exercise.

Uploaded by

Abhishek kumar jha
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Black-Scholes Option Pricing Formula

In their 1973 paper, The Pricing of Options and Corporate Liabilities, Fischer Black and
Myron Scholes published an option valuation formula that today is known as the Black-
Scholes model. It has become the standard method of pricing options.

The Black-Scholes formula calculates the price of a call option to be:

C  =  S N(d1)  -  X e-rT N(d2)

where

  C  =  price of the call option


  S  =  price of the underlying stock
  X  =  option exercise price
  r  =  risk-free interest rate
  T  =  current time until expiration
  N()  =  area under the normal curve
  d1  =  [ ln(S/X) + (r + σ2/2) T ] / σ T1/2
  d2  =  d1 - σ T1/2

Put-call parity requires that:

P  =  C  -  S + Xe-rT

Then the price of a put option is:

P  =  Xe-rT N(-d2)  -  S N(-d1)

Assumptions

The Black-Scholes model assumes that the option can be exercised only at expiration.
It requires that both the risk-free rate and the volatility of the underlying stock price
remain constant over the period of analysis. The model also assumes that the
underlying stock does not pay dividends; adjustments can be made to correct for such
distributions. For example, the present value of estimated dividends can be deducted
from the stock price in the model.

Warrant Pricing

Warrants are call options issued by a corporation. They tend to have longer durations
than do exchange-traded call options. Warrants can be valued by the Black-Scholes
model, but some modifications must be made to the parameters.

When warrants are exercised, the company typically issues new shares at the exercise
price to fill the order. The resulting increase in shares outstanding dilutes the share
value. If there were  n  shares outstanding, and  m  warrants are exercised,  α 
represents the percentage of the value of the firm that is represented by the warrants,
where

α  =  m / ( m + n )

When using the Black-Scholes model to value the warrants, it is worthwhile to use total
amounts instead of per share amounts in order to better account for the dilution. The
current share price  S  becomes the enterprise value (less debt) to be acquired by the
warrant holders. The exercise price is the total warrant exercise amount, adjusted for
the fact that in paying cash to the firm to exercise the warrants, the warrant holders in
effect are paying a portion of the cash, α, to themselves.

The inputs to the Black-Scholes model for both option pricing and warrant pricing are
outlined in the following table.

Black-Scholes Parameters for Pricing Options and Warrants

Input
Option Pricing Warrant Pricing
Parameter
S current share price α V, where V is enterprise value minus debt.
total warrant exercise amount multiplied
X exercise price per share
by (1 - α).
T current time to expiration average T for warrants
r interest rate interest rate
standard deviation of standard deviation for returns on enterprise
σ
stock return value, including warrants

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