Two Marks questions:

1. What is Black and Sholes model?

Ans. The Black and Scholes Model is used in options pricing to

determine whether a particular option should be selling at a price
other than the one at which it currently trades. This model also
shows for valuing European call and put option on a non-
dividend-paying stock.

2. What is volatility?

Ans. Volatility of a stock is a measure of our uncertainty about

the returns provided by the stock. Stocks typically have volatility
between 20% and 50% It can be defined as the SD of the return
provided by the stock in the 1 year when the return is expressed
using continuous compounding.

3. Which are the five measure points taken into consideration to

calculate premiums?

Ans. The model is for mathematically pricing options. This model

takes into account the strike price, the time until the expiration
date, the price of the underlying asset, and the standard
deviation of the underlying asset's return. And it assumes that
the No dividends are paid out on the underlying stock during the
option life

Five marks questions:

1. What are the assumptions, advantages and disadvantage of

Black and Sholes model?

Ans. The Assumptions Underlying the Model

  No dividends are paid out on the underlying stock during
the option life.

 The option can only be exercised at expiry (European

characteristics)

 Efficient markets (Market movements cannot be predicted)

 Commissions are non-existent

 Interest rates do not change over the life of the option (and
are known)

 Stock returns follow a lognormal distribution

Advantages:

 The main advantage of the Black-Scholes model is speed --

it lets you calculate a very large number of option prices in
a very short time.

Disadvantages:

 It cannot be used to accurately price options with an

American-style exercise as it only calculates the option price
at one point in time -- at expiration.

 It does not consider the steps along the way where there
could be the possibility of early exercise of an American
option.

2. Explain

i. European option

ii. American option

iii. Formula for Put option premium

 iv. Who introduced Black and scholes and when

v. Expiration date

Ans.

i. European option : The contract which is exercise only on the

expiration date is known as European option

ii. American option: The contract which can be excised at any

time up to the expiration date is known as American option.

iii. Formula for Put option premium : P = Xe-rt N(-d2) – S0N(-d1)

iv. Expiration date: The date in the contract is known as

Expiration date.
i. Ten Marks questions:

1. Calculate both call and put options premium using the data
given below: Consider an option on a non – dividend paying
stock when the stock price is $30, the excise price is $29, the
risk – free interest rate is 5%, the volatility is 25% per annum,
and the maturity is 4 months.

Solution: Here S=$30, X = $29, r = 5% = 0.05,v = 25% = 0.25

and t = 4months = 0.33

Formulas for put and call option premium calculation:

c = S N(d1)- Xe-rt N(d2)

P = Xe-rt N(-d2) – S0N(-d1)

Terms calculated:

d1 = ln(S/X) + (r + v2/2)t

= ln(30/29) + (0.05 + .252/2)0.33

0.1436

=0.03390 + (0.08125)0.33
0.1436

=0.03390 + 0.0268125
0.1436

= 0.4228

d2 = d1 -

= 0.4228 - 0.1436
= 0.2792
 Xe-rt = 29e -0.05*0.33

=29*0.9836
=28.5254

For Call Option Premium:

N(0.4228) =N(0.42) + 0.28[N(0.43) – N(0.42)]

=0.6628 + 0.28[0.6664 – 0.6628]
=0.663808

N(0.2792) = N(0.27) + 0.92[N(0.28) – N(0.27)]

=0.6064 + 0.92[0.6103 – 0.6064]
=0.609988
Substitute the above calculated terms i.e., Xe-rt , d1, d2, N
values:

c = S N(d1)- Xe-rt N(d2)

=30N(0.4228) - 28.5254 N(0.2792)
=30 * 0.663808 – 28.5254 * 0.609988
= 2.5141

For Put Option Premium:

P = Xe-rt N(-d2) – S0N(-d1)

= 28.5254 N(- 0.2792) - 30N(- 0.4228)

N(-0.4228) =N(-0.42) - 0.28[N(-0.42) – N(-0.43)]

=0.3372 - 0.28[0.3372 – 0.3336 ]
=0.336192

N(-0.2792) = N(-0.27) - 0.92[N(-0.27) – N(-0.28)]

=0.3936 - 0.92[0.3936 – 0.3897]
=0.390012
 Substitute the above calculated terms i.e., Xe-rt , d1, d2 and N
values:

P = Xe-rt N(-d2) – S0N(-d1)

= 28.5254 N(- 0.2792) - 30N(- 0.4228)
= 28.5254*0.390012 – 30 * 0.336192
=1.0395