FINS 2624 Tutorial

Week 3 – Black Scholes Option Pricing Model

 Continuous Compounding

Continuous

Example: T=2 years, r = 5%, n=2 and PV = 100

0.05 2*2
With discrete compounding: FV = 100(1 + ) = 110.38
2

∗ 0.05
With continuous compounding: FV = 100(𝑒2 ) = 110.51
Factors affecting option prices
Factors (Increase) Call Option Put Option

Current Stock Price (S) Positive Negative

Exercise Price (X) Negative Positive

Risk Free rate (R) Positive Negative

Time to Maturity (T) Positive Positive

Stock Volatility (𝜎) Positive Positive

Black Scholes Formula
 The Black Scholes option pricing formula for a European call
option written on a non-dividend paying stock is:
C0= S0*N(d1) – X*e-rt *N(d2)
Notation Meaning
C Current price of call (suggested by the model)
S Current stock price
𝑆
D1 ln 𝑋 + 𝑟+0.5𝜎2 𝑇
D1 = 𝜎√𝑇
X Exercise price of the option
D2 D2 = D1- 𝜎√𝑇
r Annualised continuously compounded risk free rate
t Time to expiration in years
𝜎 Annualised standard deviation of continuously
compounded stock returns
Components of BSOPM – risk free
rate
 Bank bill is typically chosen as the risk free instrument
because:
◦ Little default risk as the return is guaranteed by the issuing bank
◦ Cost and terminal value are known at time of issuance if held to
maturity as it is a discount security
◦ Ideal to select a fixed income instrument with a maturity equal to
maturity of the option
◦ If not, short term instrument is used such as 90 day bank bill
 Remember to convert any short term interest rates to
annualised figures
Components of BSOPM – standard
deviation (Implied Volatility)
 𝜎 measures the volatility of the underlying stock
over the remaining life of the option
 The returns are continuously compounded
 Only part of BSOPM that is not directly
observable so must use a proxy
◦ Usually the historical standard deviation of the stock
returns
 Convert daily returns volatility to an annualised
figure:
𝜎 = 𝜎𝑑2 ∗ 260
 The volatility of the underlying stock is implied
through the market price of the option and the
BS formula
Components of BSOPM – time to
expiration
 Time to expiration is calculated as the
number of calendar days between the
valuation date and expiration date divided
by 365
 Expiry date is usually Thursday before the
last business Friday of the month
 E.g if option expires in 90 days, t=(90/365)
Components of BSOPM – N(d1)
𝑆
ln 𝑋 + 𝑟+0.5𝜎2 𝑇
D1 =
𝜎√𝑇
 N(x) is the cumulative probability of observing a value
that is equal to or less than x under the unit normal
distribution
 D1 and D2 measure the number of standard
deviations away from the mean of a unit normal
distribution
 N(d1) is the risk or time value adjusted probability
that the option will finish in the money and measures
how deep in the money the option will finish
 SN(d1) is the expected value of the stock that the
buyer of the call may receive on the expiration date if
the option is exercised
 D1 > D2 and therefore N(d1) > N(d2)
Components of BSOPM – N(d2)
D2 = D1- 𝜎√𝑇

 N(d2) measures the risk adjusted probability

that the call will finish in the money on the
expiration date
 X*e-rt *N(d2) is the expected value of the
exercise price that the buyer of a call option
may have to set aside at the time of
purchase to prepare for the potential
exercise of the option
Put-Call Parity
Consider two strategies At t=T ST < X ST > X
 Protective Put Stock ST ST
◦ Long a Put + Long a Share +Long Put X – ST 0
Total X ST

 Strategy 2 At t=T ST < X ST > X

◦ Long Call + Long Bond Call 0 ST – X

◦ Strike price X, Bond with +Bond X X

face value X Total X ST

Both strategies yield the same payoff!

Put option valuation using BSOPM
 Use put-call parity to create a no
arbitrage price for a European put option

P + S = C + PV(X)
P = C + PV(X) – S
P = C + Xe-rt – S0
P = Xe-rt [1-N(d2)]- S0[1-N(d1)]
P = Xe-rt [N(-d2)]- S0[N(-d1)]
Hedging using BSOPM
 Delta = change in value of option / change in value of
underlying stock
 Hedge ratio gives you number of stock/options to purchase
in order to limit losses
◦ Hedge ratio is based on sensitivity of option price to movements
in underlying stock price
 Delta=N(d1) for a call option and N(d1)-1 for a put option
 Portfolio is delta neutral if position is perfectly hedged by
purchasing shares/options
◦ Increased value of one asset perfectly offsets losses on another
 Delta is constantly changing as underlying stock price and
other factors change
◦ As option becomes more in the money, N(d1) increases and is
therefore more sensitive to changes in stock price
◦ Need to continually rebalance portfolio to remain delta neutral