Option

Pricing: A
Review

Rangarajan K.
Sundaram

Introduction Option Pricing: A Review

Pricing
Options by
Replication

The Option Rangarajan K. Sundaram

Delta

Option Pricing Stern School of Business

using
Risk-Neutral New York University
Probabilities

The
Black-Scholes
Invesco Great Wall Fund Management Co.
Model Shenzhen: June 14, 2008
Implied
Volatility
 Outline

Option
Pricing: A
Review

Rangarajan K. 1 Introduction
Sundaram

Introduction
2 Pricing Options by Replication
Pricing
Options by
Replication
3 The Option Delta
The Option
Delta

Option Pricing
using
4 Option Pricing using Risk-Neutral Probabilities
Risk-Neutral
Probabilities

The
5 The Black-Scholes Model
Black-Scholes
Model

Implied 6 Implied Volatility

Volatility
 Introduction

Option
Pricing: A
Review

Rangarajan K.
Sundaram
These notes review the principles underlying option pricing and
Introduction some of the key concepts.
Pricing
Options by One objective is to highlight the factors that affect option
Replication
prices, and to see how and why they matter.
The Option
Delta
We also discuss important concepts such as the option delta
Option Pricing
using
and its properties, implied volatility and the volatility skew.
Risk-Neutral
Probabilities For the most part, we focus on the Black-Scholes model, but as
The motivation and illustration, we also briefly examine the binomial
Black-Scholes
Model model.
Implied
Volatility
 Outline of Presentation

Option
Pricing: A
Review

Rangarajan K.
Sundaram
The material that follows is divided into six (unequal) parts:
Introduction

Pricing Options: Definitions, importance of volatility.

Options by
Replication Pricing of options by replication: Main ideas, a binomial
The Option example.
Delta The option delta: Definition, importance, behavior.
Option Pricing
using
Pricing of options using risk-neutral probabilities.
Risk-Neutral The Black-Scholes model: Assumptions, the formulae,
Probabilities
some intuition.
The
Black-Scholes Implied Volatility and the volatility skew/smile.
Model

Implied
Volatility
 Definitions and Preliminaries

Option
Pricing: A
Review

Rangarajan K.
Sundaram
An option is a financial security that gives the holder the right
Introduction
to buy or sell a specified quantity of a specified asset at a
Pricing
Options by specified price on or before a specified date.
Replication

The Option Buy = Call option. Sell = Put option

Delta On/before: American. Only on: European
Option Pricing
using
Specified price = Strike or exercise price
Risk-Neutral Specified date = Maturity or expiration date
Probabilities
Buyer = holder = long position
The
Black-Scholes Seller = writer = short position
Model

Implied
Volatility
 Options as Insurance

Option
Pricing: A
Review

Rangarajan K. Options provide financial insurance.

Sundaram

Introduction
The option holder has the right, bit not the obligation, to
Pricing
participate in the specified trade.
Options by
Replication Example: Consider holding a put option on Cisco stock with a
The Option strike of $25. (Cisco’s current price: $26.75.)
Delta

Option Pricing The put provides a holder of the stock with protection
using
Risk-Neutral against the price falling below $25.
Probabilities

The What about a call with a strike of (say) $27.50?

Black-Scholes
Model
The call provides a buyer with protection against the price
Implied
Volatility increasing above $25.
 The Option Premium

Option
Pricing: A
Review

Rangarajan K.
Sundaram

Introduction

Pricing The writer of the option provides this insurance to the holder.
Options by
Replication In exchange, writer receives an upfront fee called the option
The Option
Delta
price or the option premium.
Option Pricing Key question we examine: How is this price determined? What
using
Risk-Neutral factors matter?
Probabilities

The
Black-Scholes
Model

Implied
Volatility
 The Importance of Volatility: A Simple Example

Option
Pricing: A
Review Suppose current stock price is S = 100.
Rangarajan K.
Sundaram Consider two possible distributions for ST . In each case, suppose
that the “up” and ”down” moves each have probability 1/2.
Introduction

Pricing
Options by 120
Replication
110
The Option
Delta
100 100
Option Pricing
using
Risk-Neutral 90
Probabilities

The 80
Black-Scholes
Model

Implied Case 1: Low Vol Case 2: High Vol

Volatility

Same mean but second distribution is more volatile.

 Call Payoffs and Volatility

Option
Pricing: A
Review

Rangarajan K.
Consider a call with a strike of K = 100.
Sundaram
Payoffs from the call at maturity:
Introduction

Pricing 20
Options by
Replication

The Option
10
Delta

Option Pricing C C
using
Risk-Neutral
Probabilities 0 0
The
Black-Scholes
Model
Call Payoffs: Low Vol Call Payoffs: High Vol
Implied
Volatility
The second distribution for ST clearly yields superior payoffs.
 Put Payoffs and Volatility

Option
Pricing: A
Review Puts similarly benefit from volatility. Consider a put with a
Rangarajan K. strike of K = 100.
Sundaram

Introduction
Payoffs at maturity:
Pricing
Options by 0 0
Replication

The Option
Delta P P
Option Pricing
using 10
Risk-Neutral
Probabilities
20
The
Black-Scholes Put Payoffs: Low Vol Put Payoffs: High Vol
Model

Implied
Volatility Once again, the second distribution for ST clearly yields superior
payoffs.
 Options and Volatility (Cont’d)

Option
Pricing: A
Review

Rangarajan K.
In both cases, the superior payoffs from high volatility are a
Sundaram consequence of “optionality.”
Introduction A forward with a delivery price of K = 100 does not
Pricing similarly benefit from volatility.
Options by
Replication
Thus, all long option positions are also long volatility positions.
The Option
Delta That is, long option positions increase in value when
Option Pricing volatility goes up and decrease in value when volatility
using
Risk-Neutral goes down.
Probabilities

The
Of course, this means that all written option positions are
Black-Scholes short volatility positions.
Model

Implied Thus, the amount of volatility anticipated over an option’s life is

Volatility
a central determinant of option values.
 Put–Call Parity

Option
Pricing: A
Review

Rangarajan K. One of the most important results in all of option pricing theory.
Sundaram
It relates the prices of otherwise identical European puts and
Introduction
calls:
Pricing
Options by
Replication
P + S = C + PV (K ).
The Option
Delta

Option Pricing
Put-call parity is proved by comparing two portfolios and
using showing that they have the same payoffs at maturity.
Risk-Neutral
Probabilities
Portfolio A Long stock, long put with strike K and
The
Black-Scholes maturity T .
Model
Portfolio B Long call with strike K and maturity T ,
Implied investment of PV (K ) for maturity at T .
Volatility
 Options and Replication

Option
Pricing: A
Review

Rangarajan K.
Sundaram

As with all derivatives, the basic idea behind pricing options is

Introduction
replication: we look to create identical payoffs to the option’s
Pricing
Options by using
Replication

The Option Long/short positions in the underlying secutiy.

Delta
Default-risk-free investment/borrowing.
Option Pricing
using
Risk-Neutral Once we have a portfolio that replicates the option, the cost of
Probabilities the option must be equal to the cost of replicating (or
The “synthesizing”) it.
Black-Scholes
Model

Implied
Volatility
 Pricing Options by Replication (Cont’d)

Option
Pricing: A
Review

Rangarajan K. As we have just seen, volatility is a primary determinant of

Sundaram
option value, so we cannot price options without first modelling
Introduction volatility.
Pricing
Options by More generally, we need to model uncertainty in the evolution of
Replication
the price of the underlying security.
The Option
Delta It is this dimension that makes option pricing more complex
Option Pricing than forward pricing.
using
Risk-Neutral
Probabilities It is also on this dimension that different “option pricing”
The models make different assumptions:
Black-Scholes
Model
Discrete (“lattice”) models: e.g., the binomial.
Implied
Volatility
Continuous models: e.g., Black-Scholes.
 Pricing Options by Replication (Cont’d)

Option
Pricing: A
Review

Rangarajan K.
Once we have a model of prices evolution, options can be priced
Sundaram by replication:
Introduction
Identify option payoffs at maturity.
Pricing Set up a portfolio to replicate these payoffs.
Options by
Replication Value the portfolio and hence price the option.
The Option
Delta The replication process can be technically involved; we illustrate
Option Pricing it using a simple example—a one-period binomial model.
using
Risk-Neutral
Probabilities From the example, we draw inferences about the replication
The
process in general, and, in particular, about the behavior of the
Black-Scholes option delta.
Model

Implied Using the intuition gained here, we examine the Black-Scholes

Volatility
model.
 A Binomial Example

Option
Pricing: A
Review

Rangarajan K.
Sundaram
Consider a stock that is currently trading at S = 100.
Introduction

Pricing Suppose that one period from now, it will have one of two
Options by
Replication possible prices: either uS = 110 or dS = 90.
The Option
Delta
Suppose further that it is possible to borrow or lend over this
Option Pricing
period at an interest rate of 2%.
using
Risk-Neutral What should be the price of a call option that expires in one
Probabilities
period and has a strike price of K = 100? What about a similar
The
Black-Scholes
put option?
Model

Implied
Volatility
 Pricing the Call Option

Option
Pricing: A
Review

Rangarajan K.
Sundaram
We price the call in three steps:
Introduction

Pricing First, we identify its possible payoffs at maturity.

Options by
Replication Then, we set up a portfolio to replicate these payoffs.
The Option
Finally, we compute the cost of this replicating portfolio.
Delta

Option Pricing
Step 1 is simple: the call will be exercised if state u occurs, and
using not otherwise:
Risk-Neutral
Probabilities

The
Call payoff if uS = 10.
Black-Scholes Call payoff if dS = 0.
Model

Implied
Volatility
 The Call Pricing Problem

Option
Pricing: A
Review

Rangarajan K.
Sundaram

Introduction
110 1.02 10
Pricing
Options by
Replication
100 1 C
The Option
Delta

Option Pricing
99 1.02 0
using
Risk-Neutral
Stock Cash Call
Probabilities

The
Black-Scholes
Model

Implied
Volatility
 The Replicating Portfolio for the Call

Option
Pricing: A
Review

Rangarajan K.
Sundaram
To replicate the call, consider the following portfolio:
Introduction

Pricing ∆c units of stock.

Options by
Replication B units of lending/borrowing.
The Option
Delta Note that ∆c and B can be positive or negative.
Option Pricing
using ∆c > 0: we are buying the stock.
Risk-Neutral
Probabilities
∆c < 0: we are selling the stock.
The
B > 0: we are investing.
Black-Scholes B < 0: we are borrowing.
Model

Implied
Volatility
 The Replicating Portfolio for the Call

Option
Pricing: A
Review

Rangarajan K.
For the portfolio to replicate the call, we must have:
Sundaram
∆c · (110) + B · (1.02) = 10
Introduction

Pricing
Options by ∆c · (90) + B · (1.02) = 0
Replication

The Option
Delta Solving, we obtain:
Option Pricing
using ∆C = 0.50 B = −44.12.
Risk-Neutral
Probabilities
In words, the following portfolio perfectly replicates the call
The
Black-Scholes option:
Model

Implied A long position in 0.50 units of the stock.

Volatility
Borrowing of 44.12.
 Pricing the Call (Cont’d)

Option
Pricing: A
Review

Rangarajan K.
Sundaram
Cost of this portfolio: (0.50) · (100) − (44.12)(1) = 5.88.
Introduction

Pricing Since the portfolio perfectly replicates the call, we must have
Options by
Replication
C = 5.88.
The Option Any other price leads to arbitrage:
Delta

Option Pricing
using
If C > 5.88, we can sell the call and buy the replicating
Risk-Neutral portfolio.
Probabilities
If C < 5.88, we can buy the call and sell the replicating
The
Black-Scholes portfolio.
Model

Implied
Volatility
 Pricing the Put Option

Option
Pricing: A
Review

Rangarajan K.
Sundaram To replicate the put, consider the following portfolio:

Introduction ∆p units of stock.

Pricing B units of bond.
Options by
Replication
It can be shown that the replicating portfolio now involves a
The Option
Delta short position in the stock and investment:
Option Pricing
using ∆p = −0.50: a short position in 0.50 units of the stock.
Risk-Neutral B = +53.92: investment of 53.92.
Probabilities

The
Black-Scholes
As a consequence, the arbitrage-free price of the put is
Model

Implied (−0.50)(100) + 53.92 = 3.92.

Volatility
 Summary

Option
Pricing: A
Review Option prices depend on volatility.
Rangarajan K.
Sundaram Thus, option pricing models begin with a description of
volatility, or, more generally, of how the prices of the underlying
Introduction
evolves over time.
Pricing
Options by
Replication Given a model of price evolution, options may be priced by
The Option
replication.
Delta
Replicating a call involves a long position in the underlying
Option Pricing
using and borrowing.
Risk-Neutral
Probabilities Replicating a put involves a short position in the
The
underlying and investment.
Black-Scholes
Model A key step in the replication process is identification of the
Implied option delta, i.e., the size of the underlying position in the
Volatility
replicating portfolio. We turn to a more detailed examination of
the delta now.
 The Option Delta

Option
Pricing: A
Review

Rangarajan K.
Sundaram
The delta of an option is the number of units of the underlying
Introduction
security that must be used to replicate the option.
Pricing
Options by
Replication As such, the delta measures the “riskiness” of the option in
The Option
terms of the underlying.
Delta

Option Pricing
For example: if the delta of an option is (say) +0.60, then,
using roughly speaking, the risk in the option position is the same as
Risk-Neutral
Probabilities the risk in being long 0.60 units of the underlying security.
The
Black-Scholes
Why “roughly speaking?”
Model

Implied
Volatility
 The Delta in Hedging Option Risk

Option
Pricing: A
Review

Rangarajan K. The delta is central to pricing options by replication.

Sundaram

As a consequence, it is also central to hedging written option

Introduction
positions.
Pricing
Options by
Replication For example, suppose we have written a call whose delta is
The Option currently +0.70.
Delta
Then, the risk in the call is the same as the risk in a long
Option Pricing
using
position in 0.70 units of the underlying.
Risk-Neutral Since we are short the call, we are essentially short 0.70
Probabilities
units of the underlying.
The
Black-Scholes Thus, to hedge the position we simply buy 0.70 units of
Model
the underlying asset.
Implied
Volatility
This is delta hedging.
 The Delta in Aggregating Option Risk

Option
Pricing: A
Review

Rangarajan K.
Sundaram
The delta enables us to aggregate option risk (on a given
underlying) and express it in terms of the underlying.
Introduction

Pricing
For example, suppose we have a portfolio of stocks on IBM
Options by stock with possibly different strikes and maturities:
Replication

The Option Long 2000 calls (strike K1 , maturity T1 ), each with a delta
Delta
of +0.48.
Option Pricing
using Long 1000 puts (strike K2 , maturity T2 ), each with a delta
Risk-Neutral
Probabilities
of −0.55.
The
Short 1700 calls (strike K3 , maturity T3 ), each with a
Black-Scholes delta of +0.63.
Model

Implied What is the aggregate risk in this portfolio?

Volatility
 The Delta in Aggregating Option Risk

Option
Pricing: A
Review Each of the first group of options (the strike K1 , maturity T1
Rangarajan K. calls) is like being long 0.48 units of the stock.
Sundaram
Since the portfolio is long 2,000 of these calls, the aggregate
Introduction
position is akin to being long 2000 × 0.48 = 960 units of the
Pricing
Options by
stock.
Replication
Similarly, the second group of options (the strike K2 , maturity
The Option
Delta T2 puts) is akin to being short 1000 × 0.55 = 550 units of the
Option Pricing stock.
using
Risk-Neutral
Probabilities
The third group of options (the strike K3 , maturity T3 calls) is
akin to being short 1700 × 0.63 = 1071 units of the stock.
The
Black-Scholes
Model Thus, the aggregate position is: +960 − 550 − 1071 = −661 or
Implied a short position in 661 units of the stock.
Volatility
This can be delta hedged by taking an offsetting long position
in the stock.
 The Delta as a Sensitivity measure

Option
Pricing: A
Review

Rangarajan K.
Sundaram

Introduction The delta is also a sensitivity measure: it provides a snapshot

Pricing estimate of the dollar change in the value of a call for a given
Options by
Replication
change in the price of the underlying.
The Option For example, suppose the delta of a call is +0.50.
Delta

Option Pricing Then, holding the call is “like” holding +0.50 units of the stock.
using
Risk-Neutral
Probabilities
Thus, a change of $1 in the price of the stock will lead to a
The
change of +0.50 in the value of the call.
Black-Scholes
Model

Implied
Volatility
 The Sign of the Delta

Option
Pricing: A
Review

Rangarajan K.
Sundaram
In the binomial examples, the delta of the call was positive,
Introduction
while that of the put was negative.
Pricing
Options by These properties must always hold. That is:
Replication

The Option
Delta
A long call option position is qualitatively like a long
Option Pricing
position in the underlying security.
using A long put option position is qualitatively like a short
Risk-Neutral
Probabilities position in the underlying security.
The
Black-Scholes Why is this the case?
Model

Implied
Volatility
 Maximum Value of the Delta

Option
Pricing: A
Review

Rangarajan K.
Sundaram

Moreover, the delta of a call must always be less than +1.

Introduction

Pricing
Options by
The maximum gain in the call’s payoff per dollar increase
Replication in the price of the underlying is $1.
The Option Thus, we never need more than one unit of the underlying
Delta
in the replicating portfolio.
Option Pricing
using
Risk-Neutral Similarly, the delta of a put must always be greater than −1
Probabilities since the maximum loss on the put for a $1 increase in the
The
Black-Scholes
stock price is $1.
Model

Implied
Volatility
 Depth-in-the-Money (“Moneyness”) and the Delta

Option
Pricing: A
Review

Rangarajan K.
Sundaram
The delta of an option depends in a central way on the option’s
Introduction
depth-in-the-money.
Pricing
Options by Consider a call:
Replication

The Option If S  K (i.e., is very high relative to K ), the delta of a

Delta
call will be close to +1.
Option Pricing
using If S  K (i.e., is very small relative to K ), the delta of the
Risk-Neutral
Probabilities call will be close to zero.
The
In general, as the stock price increases, the delta of the
Black-Scholes call will increase from 0 to +1.
Model

Implied
Volatility
 Moneyness and Put Deltas

Option
Pricing: A
Review

Rangarajan K.
Sundaram

Introduction Now, consider a put.

Pricing
Options by
Replication
If S  K , the put is deep out-of-the-money. Its delta will
The Option
be close to zero.
Delta If S  K , the put is deep in-the-money. Its delta will be
Option Pricing close to −1.
using
Risk-Neutral In general, as the stock price increases, the delta of the
Probabilities put increases from −1 to 0.
The
Black-Scholes
Model

Implied
Volatility
 Moneyness and Option Deltas

Option
Pricing: A
Review

Rangarajan K.
Sundaram To summarize the dependence on moneyness:
Introduction
The delta of a deep out-of-the-money option is close to
Pricing
Options by zero.
Replication The absolute value of the delta of a deep in-the-money
The Option option is close to 1.
Delta
As the option moves from out-of-the-money to
Option Pricing
using in-the-money, the absolute value of the delta increases
Risk-Neutral
Probabilities from 0 towards 1.
The
Black-Scholes The behavior of the call and put deltas are illustrated in the
Model figure on the next page.
Implied
Volatility
 The Option Deltas

Option
Pricing: A
Review

Rangarajan K. 1
Sundaram
0.8

Introduction 0.6
Call Delta
Pricing Put Delta
0.4
Options by
Replication
Option Deltas

0.2
The Option Stock Prices
Delta 0
72 80 88 96 104 112 120 128
Option Pricing -0.2
using
Risk-Neutral
-0.4
Probabilities

The -0.6
Black-Scholes
Model -0.8

Implied -1
Volatility
 Implications for Replication/Hedging

Option
Pricing: A
Review

Rangarajan K.
Sundaram The option delta’s behavior has an important implication for
Introduction
option replication.
Pricing In pricing forwards, “buy-and-hold” strategies in the spot asset
Options by
Replication suffice to replicate the outcome of the forward contract.
The Option
Delta In contrast, since an option’s depth-in-the-money changes with
Option Pricing time, so will its delta. Thus, a static buy-and-hold strategy will
using
Risk-Neutral
not suffice to replicate an option.
Probabilities
Rather, one must use a dynamic replication strategy in which
The
Black-Scholes the holding of the underlying security is constantly adjusted to
Model
reflect the option’s changing delta.
Implied
Volatility
 Summary

Option
Pricing: A
Review

Rangarajan K.
Sundaram
The option delta measures the number of units of the
underlying that must be held in a replicating portfolio.
Introduction

Pricing
As such, the option delta plays many roles:
Options by
Replication Replication.
The Option (Delta-)Hedging.
Delta As a sensitivity measure.
Option Pricing
using The option delta depends on depth-in-the-money of the option:
Risk-Neutral
Probabilities
It is close to unity for deep in-the-money options.
The
Black-Scholes
It is close to zero for deep out-of-the-money options.
Model Thus, it offers an intuitive feel for the probability the
Implied option will finish in-the-money.
Volatility
 Risk-Neutral Pricing

Option
Pricing: A
Review

Rangarajan K. An alternative approach to identifying the fair value of an option

Sundaram
is to use the model’s risk-neutral (or risk-adjusted) probabilities.
Introduction
This approach is guaranteed to give the same answer as
Pricing
Options by replication, but is computationally a lot simpler.
Replication

The Option
Pricing follows a three-step procedure.
Delta

Option Pricing
Identify the model’s risk-neutral probability.
using Take expectations of the option’s payoffs under the
Risk-Neutral
Probabilities risk-neutral probability.
The Discount these expectations back to the present at the
Black-Scholes
Model risk-free rate.
Implied
Volatility The number obtained in Step 3 is the fair value of the option.
 The Risk-Neutral Probability

Option
Pricing: A
Review

Rangarajan K.
The risk-neutral probability is that probability under which
Sundaram expected returns on all the model’s assets are the same.
Introduction For example, the binomial model has two assets: the stock
Pricing which returns u or d, and the risk-free asset which returns R.
Options by
Replication (R = 1+ the risk-free interest rate.)
The Option
Delta If q and 1 − q denote, respectively, the risk-neutral probabilities
Option Pricing
of state u and state d, then q must satisfy
using
Risk-Neutral
Probabilities
q · u + (1 − q) · d = R.
The
Black-Scholes This means the risk-neutral probability in the binomial model is
Model

Implied R −d
Volatility q = .
u−d
 Risk-Neutral Pricing: An Example

Option
Pricing: A
Review
Consider the one-period binomial example in which u = 1.10,
Rangarajan K.
d = 0.90, and R = 1.02.
Sundaram
In this case,
Introduction
1.02 − 0.90
Pricing q = = 0.60.
Options by 1.10 − 0.90
Replication

The Option Therefore, the expected payoffs of the call under the risk-neutral
Delta probability is
Option Pricing
using
Risk-Neutral
(0.60)(10) + (0.40)(0) = 6.
Probabilities

The Discounting these payoffs back to the present at the risk-free

Black-Scholes rate results in
Model

Implied 6
Volatility = 5.88,
1.02
which is the same price for the option obtained by replication.
 Risk-Neutral Pricing: A Second Example

Option
Pricing: A
Review

Rangarajan K. Now consider pricing the put with strike K = 100.

Sundaram
The expected payoff from the put at maturity is
Introduction

Pricing (0.60)(0) + (0.40)(10) = 4.

Options by
Replication

The Option
Discounting this back to the present at the risk-free rate, we
Delta obtain
Option Pricing
using 4
Risk-Neutral = 3.92,
Probabilities 1.02
The which is the same price obtained via replication.
Black-Scholes
Model
As these examples show, risk-neutral pricing is computationally
Implied
Volatility much simpler than replication.
 The Balck-Scholes Model

Option
Pricing: A
Review

Rangarajan K.
Sundaram The Black–Scholes model is unambiguously the best known
model of option pricing.
Introduction

Pricing Also one of the most widely used: it is the benchmark model for
Options by
Replication
Equities.
The Option
Delta Stock indices.
Option Pricing Currencies.
using Futures.
Risk-Neutral
Probabilities

The
Moreover, it forms the basis of the Black model that is
Black-Scholes commonly used to price some interest-rate derivatives such as
Model
caps and floors.
Implied
Volatility
 The Black-Scholes Model (Cont’d)

Option
Pricing: A
Review

Rangarajan K. Technically, the Black-Scholes model is much more complex

Sundaram than discrete models like the binomial.
Introduction
In particular, it assumes continuous evolution of
Pricing
Options by
uncertainty.
Replication Pricing options in this framework requires the use of very
The Option sophisticated mathematics.
Delta

Option Pricing What is gained by all this sophistication?

using
Risk-Neutral
Probabilities Option prices in the Black-Scholes model can be expressed
The in closed-form, i.e., as particular explicit functions of the
Black-Scholes
Model parameters.
Implied This makes computing option prices and option
Volatility sensitivities very easy.
 Assumptions of the Model

Option
Pricing: A
Review

Rangarajan K.
Sundaram
The main assumption of the Black-Scholes model pertains to
Introduction the evolution of the stock price.
Pricing
Options by This price is taken to evolve according to a geometric
Replication
Brownian motion.
The Option
Delta
Shorn of technical details, this says essentially that two
Option Pricing
using
conditions must be met:
Risk-Neutral
Probabilities Returns on the stock have a lognormal distribution with
The constant volatility.
Black-Scholes Stock prices cannot jump (the market cannot “gap”).
Model

Implied
Volatility
 The Log-Normal Assumption

Option
Pricing: A
Review

Rangarajan K. The log-normal assumption says that the (natural) log of

Sundaram
returns is normally distributed: if S denotes the current price,
Introduction and St the price t years from the present, then
Pricing  
St
Options by
Replication ln ∼ N(µt, σ 2 t).
S
The Option
Delta
Mathematically, log-returns and continuously-compounded
Option Pricing
using
returns represent the same thing:
Risk-Neutral  
Probabilities St St
The
ln = x ⇔ = e x ⇔ St = Se x .
Black-Scholes
S S
Model

Implied
Thus, log-normality says that returns on the stock, expressed in
Volatility continuously-compounded terms, are normally distributed.
 Volatility

Option
Pricing: A
Review

Rangarajan K.
Sundaram
The number σ is called the volatility of the stock. Thus,
Introduction volatility in the Black-Scholes model refers to the standard
Pricing deviation of annual log-returns.
Options by
Replication
The Black-Scholes model takes this volatility to be a constant.
The Option
Delta
In principle, this volatility can be estimated in two ways:
Option Pricing
using
From historical data. (This is called historical volatility.)
Risk-Neutral From options prices. (This is called implied volatility.)
Probabilities

The We discuss the issue of volatility estimation in the last part of

Black-Scholes
Model this segment. For now, assume the level of volatility is known.
Implied
Volatility
 Is GBM a Reasonable Assumption?

Option
Pricing: A
Review

Rangarajan K.
Sundaram The log-normality and no-jumps conditions appear unreasonably
restrictive:
Introduction

Pricing
Options by
Volatility of markets is typically not constant over time.
Replication Market prices do sometimes “jump.”
The Option In particular, the no-jumps assumption appears to rule out
Delta
dividends.
Option Pricing
using
Risk-Neutral Dividends (and similar predictable jumps) are actually easily
Probabilities handled by the model.
The
Black-Scholes The other issues are more problematic, and not easily resolved.
Model
We discuss them in the last part of this presentation.
Implied
Volatility
 Option Prices in the Black-Scholes Model

Option
Pricing: A
Review

Rangarajan K.
Sundaram

Introduction Option prices in the Black–Scholes model may be recovered

Pricing using a replicating portfolio argument.
Options by
Replication
Of course, the construction—and maintenence—of a replicating
The Option
Delta
portfolio is significantly more technically complex here than in
Option Pricing
the binomial model.
using
Risk-Neutral We focus here instead on the final option prices that result and
Probabilities
the intuitive content of these prices.
The
Black-Scholes
Model

Implied
Volatility
 Notation

Option
Pricing: A
Review

Rangarajan K.
Sundaram t: current time.
Introduction T : Horizon of the model. (So time-left-to-maturity: T − t.)
Pricing
Options by K : strike price of option.
Replication

The Option St : current price of stock.

Delta

Option Pricing
ST : stock price at T .
using
Risk-Neutral µ, σ: Expected return and volatility of stock (annualized).
Probabilities

The r : risk-free rate of interest.

Black-Scholes
Model
C , P: Prices of call and put (European only).
Implied
Volatility
 Call Option Prices in the Black-Scholes Model

Option
Pricing: A
Review

Rangarajan K.
The call-pricing formula in the Black-Scholes model is
Sundaram

Introduction
C = St · N(d1 ) − e −r (T −t) K · N(d2 )
Pricing
Options by where N(·) is the cumulative standard normal distribution [N(x)
Replication
is the probability under a standard normal distribution of an
The Option
Delta observation less than or equal to x], and
Option Pricing    
using 1 St 1
Risk-Neutral d1 = √ ln + (r + σ 2 )(T − t)
Probabilities σ T −t K 2
The
Black-Scholes √
Model d2 = d1 − σ T − t
Implied
Volatility
This formula has a surprisingly simple interpretation.
 Call Prices and Replication

Option
Pricing: A
Review

Rangarajan K.
Sundaram To replicate a call in general, we must
Introduction
Take a long position in ∆c units of the underlying, and
Pricing
Options by
Borrow Bc at the risk-free rate.
Replication

The Option
The cost of this replicating portfolio—which is the call price—is
Delta

Option Pricing C = St · ∆c − Bc . (1)

using
Risk-Neutral
Probabilities The Black-Scholes formula has an identical structure: it too is
The of the form
Black-Scholes
Model
C = St × [Term 1] − [Term 2]. (2)
Implied
Volatility
 Call Prices and Replication (Cont’d)

Option
Pricing: A
Review

Rangarajan K.
Sundaram
Comparing these structures suggests that
Introduction

Pricing ∆c = N(d1 ). (3)

Options by
Replication

The Option
Bc = e −r (T −t) K · N(d2 ). (4)
Delta

Option Pricing This is exactly correct! The Black-Scholes formula is obtained

using
Risk-Neutral precisely by showing that the composition of the replicating
Probabilities
portfolio is (3)–(4) and substituting this into (1).
The
Black-Scholes In particular, N(d1 ) is just the delta of the call option.
Model

Implied
Volatility
 Put Option Prices in the Black–Scholes Model

Option
Pricing: A
Review

Rangarajan K. Recall that to replicate a put in general, we must

Sundaram

Introduction
Take a short position in |∆p | units of the underlying, and
Lend Bp at the risk-free rate.
Pricing
Options by
Replication Thus, in general, we can write the price of the put as
The Option
Delta P = Bp + St , ∆p (5)
Option Pricing
using
Risk-Neutral
The Black-Scholes formula identifies the exact composition of
Probabilities ∆p and Bp :
The
Black-Scholes
Model
∆p = −N(−d1 ) Bp = PV (K ) N(−d2 )
Implied
Volatility where N(·), d1 , and d2 are all as defined above.
 Put Prices in the Black–Scholes Model (Cont’d)

Option
Pricing: A
Review

Rangarajan K.
Sundaram
Therefore, the price of the put is given by
Introduction

Pricing P = PV (K ) · N(−d2 ) − St · N(−d1 ). (6)

Options by
Replication
Expression (6) is the Black-Scholes formula for a European put
The Option
Delta option.
Option Pricing
using
Equivalently, since N(x) + N(−x) = 1 for any x, we can also
Risk-Neutral write
Probabilities

The
Black-Scholes P = St · [N(d1 ) − 1] + PV (K ) · [1 − N(d2 )] (7)
Model

Implied
Volatility
 Black-Scholes via Risk-Neutral Probabilities

Option
Pricing: A
Review
Alternative way to derive Black–Scholes formulae: use
Rangarajan K.
Sundaram risk-neutral (or risk-adjusted) probabilities.
Introduction To identify option prices in this approach: take expectation of
Pricing terminal payoffs under the risk-neutral probability measure and
Options by discount at the risk-free rate.
Replication

The Option The terminal payofffs of a call option with strike K are given by
Delta

Option Pricing
using
max{ST − K , 0}.
Risk-Neutral
Probabilities Therefore, the arbitrage-free price of the call option is given by
The
Black-Scholes
Model
C = e −rT Et∗ [max{ST − K , 0}]
Implied
Volatility where Et∗ [·] denotes time–t expectations under the risk-neutral
measure.
 Black-Scholes via Risk-Neutral Probs (Cont’d)

Option
Pricing: A
Review

Rangarajan K.
Sundaram
Equivalently, this expression may be written as
Introduction

Pricing C = e −rT Et∗ [ST − K || ST ≥ K ]

Options by
Replication

The Option
Splitting up the expectation, we have
Delta

Option Pricing
C = e −rT Et∗ [ST || ST ≥ K ] − e −rT Et∗ [K || ST ≥ K ] .
using
Risk-Neutral
Probabilities
From this to the Black–Scholes formula is simply a matter of
The
grinding through the expectations, which are tedious, but not
Black-Scholes otherwise difficult.
Model

Implied
Volatility
 Black-Scholes via Risk-Neutral Probs (Cont’d)

Option
Pricing: A
Review

Rangarajan K.
Sundaram

Introduction Specifically, it can be shown that

Pricing
Options by
Replication
e −rT Et∗ [ST || ST ≥ K ] = St N(d1 )
The Option
Delta e −rT Et∗ [K || ST ≥ K ] = e −rT K N(d2 )
Option Pricing
using
Risk-Neutral In particular, N(d2 ) is the risk-neutral probability that the
Probabilities
option finishes in-the-money (i.e., that ST ≥ K ).
The
Black-Scholes
Model

Implied
Volatility
 Remarks on the Black-Scholes Formulae

Option
Pricing: A
Review

Rangarajan K.
Sundaram

Introduction
Two remarkable features of the Black–Scholes formulae:
Pricing
Options by
Replication Option prices only depend on five variables: S, K , r , T ,
The Option and σ.
Delta Of these five variables, only one—the volatility σ—is not
Option Pricing directly observable.
using
Risk-Neutral
Probabilities This makes the model easy to implement in practice.
The
Black-Scholes
Model

Implied
Volatility
 Remarks (Cont’d)

Option
Pricing: A
Review

Rangarajan K. It must also be stressed that these are arbitrage-free prices.

Sundaram

Introduction That is, they are based on construction of replicating

Pricing
portfolios that perfectly mimic option payoffs at maturity.
Options by Thus, if prices differ from these predicted levels, the
Replication
replicating portfolios can be used to create riskless profits.
The Option
Delta
The formulae can also be used to delta-hedge option positions.
Option Pricing
using
Risk-Neutral For example, suppose we have written a call option whose
Probabilities
current delta, using the Black-Scholes formula, is N(d1 ).
The
Black-Scholes To hedge this position, we take a long position in N(d1 )
Model units of the underlying.
Implied Of course, dynamic hedging is required.
Volatility
 Remarks (Cont’d)

Option
Pricing: A
Review

Rangarajan K.
Finally, it must be stressed again that closed-form expressions of
Sundaram this sort for option prices is a rare occurence.
Introduction
The particular advantage of having closed forms is that
Pricing
Options by
they make computation of option sensitivities (or option
Replication “greeks”) a simple task.
The Option
Delta Nonetheless, such closed-form expressions exist in the
Option Pricing Black-Scholes framework only for European-style options.
using
Risk-Neutral
Probabilities For example, closed-forms do not exist for American put
The options.
Black-Scholes
Model However, it is possible to obtain closed-form solutions for
Implied
certain classes of exotic options (such as compound
Volatility options or barrier options).
 Plotting Black-Scholes Option Prices

Option
Pricing: A
Review

Rangarajan K.
Sundaram
Closed-forms make it easy to compute option prices in the
Black-Scholes model:
Introduction

Pricing
1 Input values for St , K , r , T −t, and σ. √
2
Compute d1 = [ln(St /K √ ) + (r + σ /2)(T − t)]/[σ T − t].
Options by 2
Replication
3 Compute d2 = d1 − σ T − t.
The Option
Delta 4 Compute N(d1 ).
Option Pricing 5 Compute N(d2 ).
using
Risk-Neutral
6 Compute option prices.
Probabilities

The C = St N(d1 ) − e −r (T −t) K N(d2 )

Black-Scholes
Model

Implied P = e −r (T −t) K [1 − N(d2 )] − St [1 − N(d1 )]

Volatility
 Plotting Option Prices (Cont’d)

Option
Pricing: A
Review

Rangarajan K.
Sundaram
The following figure illustrates this procedure.

Introduction
Four parameters are held fixed in the figure:
Pricing
Options by K = 100, T − t = 0.50, σ = 0.20, r = 0.05
Replication

The Option The figures plot call and put prices as S varies from 72 to 128.
Delta

Option Pricing Observe non-linear reaction of option prices to changes in stock

using
Risk-Neutral
price.
Probabilities

The
For deep OTM options, slope ≈ 0.
Black-Scholes For deep ITM options, slope ≈1.
Model

Implied Of course, this slope is precisely the option delta!

Volatility
 Plotting Option Prices

Option
Pricing: A
Review

Rangarajan K.
Sundaram 25

Introduction
Call
Pricing 20
Options by Put
Replication
Option Values

15
The Option
Delta

Option Pricing 10
using
Risk-Neutral
Probabilities
5
The
Black-Scholes
Stock Prices
Model
0
Implied 70 80 90 100 110 120 130
Volatility
 Implied Voaltility

Option
Pricing: A
Review

Rangarajan K.
Sundaram

Introduction
Given an option price, one can ask the question: what level of
Pricing
Options by volatility is implied by the observed price?
Replication

The Option
This level is the implied volatility.
Delta

Option Pricing
Formally, implied volatility is the volatility level that would make
using observed option prices consistent with the Black-Scholes
Risk-Neutral
Probabilities formula, given values for the other parameters.
The
Black-Scholes
Model

Implied
Volatility
 Implied Volatility (Cont’d)

Option
Pricing: A
Review

Rangarajan K. For example, suppose we are looking at a call on a

Sundaram
non-dividend-paying stock.
Introduction
Let K and T −t denote the call’s strike and time-to-maturity,
Pricing
Options by and let C
b be the call’s price.
Replication

The Option
Let St be the stock price and r the interest rate.
Delta
Then, the implied volatility is the unique level σ for which
Option Pricing
using
Risk-Neutral C bs (S, K , T −t, r , σ) = C
b,
Probabilities

The
Black-Scholes
where C bs is the Black-Scholes call option pricing formula.
Model
Note that implied volatility is uniquely defined since C bs is
Implied
Volatility strictly increasing in σ.
 Implied Volatility (Cont’d)

Option
Pricing: A
Review

Rangarajan K.
Sundaram

Introduction

Pricing
Options by
Implied volatility represents the “market’s” perception of
Replication volatility anticipated over the option’s lifetime.
The Option
Delta Implied volatility is thus forward looking.
Option Pricing
using
In contrast, historical volatility is backward looking.
Risk-Neutral
Probabilities

The
Black-Scholes
Model

Implied
Volatility
 The Volatility Smile/Skew

Option
Pricing: A
Review
In theory, any option (any K or T ) may be used for measuring
Rangarajan K.
Sundaram implied volatility.
Introduction Thus, if we fix maturity and plot implied volatilities against
Pricing strike prices, the plot should be a flat line.
Options by
Replication In practice, in equity markets, implied volatilities for “low”
The Option strikes (corresponding to out-of-the-money puts) are typically
Delta
much higher than implied volatilties for ATM options. This is
Option Pricing
using the volatility skew.
Risk-Neutral
Probabilities In currency markets (and for many individual equities), the
The picture is more symmetric with way-from-the-money options
Black-Scholes
Model having higher implied volatilities than at-the-money options.
Implied This is the volatility smile.
Volatility
See the screenshots on the next 4 slides.
 S&P 500 Implied Voaltility Plot

Option
Pricing: A
Review

Rangarajan K.
Sundaram

Introduction

Pricing
Options by
Replication

The Option
Delta

Option Pricing
using
Risk-Neutral
Probabilities

The
Black-Scholes
Model

Implied
Volatility
 S&P 500 Implied Voaltility Plot

Option
Pricing: A
Review

Rangarajan K.
Sundaram

Introduction

Pricing
Options by
Replication

The Option
Delta

Option Pricing
using
Risk-Neutral
Probabilities

The
Black-Scholes
Model

Implied
Volatility
 USD-GBP Implied Volatility Plot

Option
Pricing: A
Review

Rangarajan K.
Sundaram

Introduction

Pricing
Options by
Replication

The Option
Delta

Option Pricing
using
Risk-Neutral
Probabilities

The
Black-Scholes
Model

Implied
Volatility
 USD-GBP Implied Volatility Plot

Option
Pricing: A
Review

Rangarajan K.
Sundaram

Introduction

Pricing
Options by
Replication

The Option
Delta

Option Pricing
using
Risk-Neutral
Probabilities

The
Black-Scholes
Model

Implied
Volatility
 The Source of the Volatility Skew

Option
Pricing: A
Review

Rangarajan K.
Sundaram Two sources are normally ascribed for the volatility skew.
Introduction
One is the returns distribution. The Black-Scholes model
Pricing
Options by
assumes log-returns are normally distributed.
Replication
However, in every financial market, extreme observations are far
The Option
Delta more likely than predicted by the log-normal distribution.
Option Pricing
using Extreme observations = observations in the tail of the
Risk-Neutral
Probabilities distribution.
The
Empirical distributions exhibit “fat tails” or leptokurtosis.
Black-Scholes
Model Empirical log-returns distributions are often also skewed.
Implied
Volatility
 Source of the Volatility Skew (Cont’d)

Option
Pricing: A
Review
Fat tails =⇒ Black-Scholes model with a constant volatility will
Rangarajan K.
Sundaram
underprice out-of-the-money puts relative to those at-the-money.

Introduction
Put differently, “correctly” priced out-of-the-money puts will
Pricing
reflect a higher implied volatility than at-themoney options.
Options by
Replication This is exactly the volatility skew! That is, the volatility skew is
The Option evidence not only that the lognormal model is not a fully
Delta
accurate description of reality but also that the market
Option Pricing
using
recognizes this shortcoming.
Risk-Neutral
Probabilities As such, there is valuable information in the smile/skew
The concerning the “actual” (more accurately, the market’s
Black-Scholes
Model expectation) of the return distribution. For instance:
Implied
Volatility More symmetric smile =⇒ Less skewed distribution.
Flatter smile/skew =⇒ Smaller kurtosis.
 Source of the Volatility Skew (Cont’d)

Option
Pricing: A
Review

Rangarajan K. The other reason commonly given for the volatility skew is that
Sundaram
the world as a whole is net long equities, and so there is a
Introduction positive net demand for protection in the form of puts.
Pricing
Options by This demand for protection, coupled with market frictions,
Replication raises the price of out-of-the-money puts relative to those
The Option at-the-money, and results in the volatility skew.
Delta

Option Pricing With currencies, on the other hand, there is greater symmetry
using
Risk-Neutral since the world is net long both currencies, so there is two-sided
Probabilities demand for protection.
The
Black-Scholes Implicit in this argument is Rubinstein’s notion of
Model
“crash-o-phobia,” fear of a sudden large downward jump in
Implied
Volatility prices.
 Generalizing Black-Scholes

Option
Pricing: A
Review

Rangarajan K.
Sundaram Obvious question: why not generalize the log-normal
distribution?
Introduction

Pricing Indeed, there may even be a “natural” generalization.

Options by
Replication The Black-Scholes model makes two uncomfortable
The Option assumptions:
Delta

Option Pricing
using
No jumps.
Risk-Neutral Constant volatility.
Probabilities

The If jumps are added to the log-normal model or if volatility is

Black-Scholes
Model allowed to be stochastic, the model will exhibit fat tails and
Implied even skewness.
Volatility
 Generalizing Black-Scholes (Cont’d)

Option
Pricing: A
Review So why don’t we just do this?
Rangarajan K.
Sundaram We can, but complexity increases (how many new
Introduction
parameters do we need to estimate?).
Pricing
Jumps & SV have very different dynamic implications.
Options by Reality is more complex than either model (indeed,
Replication
substantially so).
The Option
Delta
Ultimately: better to use a simple model with known
Option Pricing
using shortcomings?
Risk-Neutral
Probabilities On jumps vs stochastic volatility models, see
The
Black-Scholes Das, S.R. and R.K. Sundaram (1999) “Of Smiles and
Model
Smirks: A Term-Structure Perspective,” Journal of
Implied
Volatility Financial and Quantitative Analysis 34(2),
pp.211-239.