Chapter 6

The Black-Scholes
Option Pricing
Model

1 2004 South-Western Publishing

 Outline
Introduction
The Black-Scholes option pricing model
Calculating Black-Scholes prices from
historical data
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

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

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 The Model (contd)
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

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

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 Striking Price
Thelower 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

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 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

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 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

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 Volatility
Thegreater 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

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 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

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 Risk-Free Interest Rate
Thehigher 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

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

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 The Stock Pays no Dividends
During the Options Life
Ifyou 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

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 The Stock Pays no Dividends
During the Options Life (contd)

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
Few options are exercised early due to time
value

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 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

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

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 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

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

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 Calculating Black-Scholes
Prices from Historical Data
Tocalculate 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

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 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.
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 Calculating Black-Scholes
Prices from Historical Data

Valuing a Microsoft Call Example (contd)

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 (contd)

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 (contd)

Using the BSOPM (contd):

d 2 d1 T
.2032 .2261 .0229

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 Calculating Black-Scholes
Prices from Historical Data

Valuing a Microsoft Call Example (contd)

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 (contd)

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 (contd)

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
options life, which we cannot observe.
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 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 )

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 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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