Black Scholes Model

David Dubofsky and 18-1
Thomas W. Miller, Jr.

Chapter 18
Continuous Time Option Pricing Models
Assumptions of the Black-Scholes Option Pricing Model (BSOPM):
No taxes
No transactions costs
Unrestricted short-selling of stock, with full use of short-sale proceeds
Shares are infinitely divisible
Constant riskless interest rate for borrowing/lending
No dividends
European options (or American calls on non-dividend paying stocks)
Continuous trading
The stock price evolves via a specific process through time (more on
this later.)
Derivation of the BSOPM
Specify a process that the stock price will follow (i.e., all
possible paths)

Construct a riskless portfolio of:
Long Call
Short A Shares
(or, long A Shares and write one call, or long 1 share and write 1/A
calls)

As delta changes (because time passes and/or S changes), one
must maintain this risk-free portfolio over time

This is accomplished by purchasing or selling the appropriate
number of shares.
The BSOPM Formula
( ) ( )
2
rT
1
d N Ke d SN C

=
where N(d
i
) = the cumulative standard normal distribution
function, evaluated at d
i
, and:
T
/2)T (r ln(S/K)
d
2
1
+ +
=
T d d
1 2
=
N(-d
i
) = 1-N(d
i
)
The Standard Normal Curve
The standard normal curve is a member of the family of normal curves
with = 0.0 and o = 1.0. The X-axis on a standard normal curve is often
relabeled and called Z scores.

The area under the curve equals 1.0.

The cumulative probability measures the area to the left of a value of Z.
E.g., N(0) = Prob(Z) < 0.0 = 0.50, because the normal distribution is
symmetric.
The Standard Normal Curve
The area between Z-scores of -1.00 and +1.00 is 0.68 or 68%.

The area between Z-scores of -1.96 and +1.96 is 0.95 or 95%.
Note also that the area
to the left of Z = -1
equals the area to the
right of Z = 1. This
holds for any Z.
What is the area
in each tail? What
is N(1.96)? What
is N(-1.96)?
What is N(1)?
What is N(-1)?
Cumulative Normal Table
(Pages 560-561)
Cumulative Probability for the Standard Normal Distribution
2nd digit of Z
z 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
-1.3 0.0968 0.0951 0.0934 0.0918 0.0901 0.0885 0.0869 0.0853 0.0838 0.0823
1.3 0.9032 0.9049 0.9066 0.9082 0.9099 0.9115 0.9131 0.9147 0.9162 0.9177
N(-d) = 1-N(d)
N(-1.34) = 1-N(1.34)
Example Calculation of the BSOPM Value
S = $92
K = $95
T = 50 days (50/365 year = 0.137 year)
r = 7% (per annum)
o = 35% (per annum)

What is the value of the call?

Solving for the Call Price, I.
Calculate the PV of the Strike Price:

Ke
-rT
= 95e
(-0.07)(50/365)
= (95)(0.9905) = $94.093.

Calculate d
1
and d
2
:

0.137 0.35
.137 0.1225/2)0 (0.07 ln(92/95)
T
/2)T (r ln(S/K)
d
2
1
+ +
=
+ +
=
0.1089
0.12955
0.01798 0.03209
701) (0.35)(0.3
0.01798 ) ln(0.96842
=
+
=
+
=
d
2
= d
1
T
.5
= -0.1089 (0.35)(0.137)
.5
= -0.2385
Solving for N(d
1
) and N(d
2
)
Choices:
Standard Normal Probability Tables (pp. 560-561)

Excel Function NORMSDIST

N(-0.1089) = 0.4566; N(-0.2385) = 0.4058.

There are several approximations; e.g. the one in fn 8 (pg.
549) is accurate to 0.01 if 0 < d < 2.20:

N(d) ~ 0.5 + (d)(4.4-d)/10
N(0.1089) ~ 0.5 + (0.1089)(4.4-0.1089)/10 = 0.5467
Thus, N(-0.1089) ~ 0.4533
Solving for the Call Value
C = S N(d
1
) Ke
-rT
N(d
2
)

= (92)(0.4566) (94.0934)(0.4058)

= $3.8307.

Applying Put-Call Parity, the put price is:

P = C S + Ke
-rT
= 3.8307 92 + 94.0934 = $5.92.
Lognormal Distribution
The BSOPM assumes that the stock price follows a Geometric
Brownian Motion (see
http://www.stat.umn.edu/~charlie/Stoch/brown.html for a
depiction of Brownian Motion).
In turn, this implies that the distribution of the returns of the stock,
at any future date, will be lognormally distributed.
Lognormal returns are realistic for two reasons:
if returns are lognormally distributed, then the lowest possible return in
any period is -100%.
lognormal returns distributions are "positively skewed," that is, skewed to
the right.

Thus, a realistic depiction of a stock's returns distribution would have
a minimum return of -100% and a maximum return well beyond
100%. This is particularly important if T is long.
The Lognormal Distribution

E S S e
S S e e
T
T
T
T T
( )
( ) ( )
=
=
0
0
2
2
2
1

var
o
BSOPM Properties and Questions
What happens to the Black-Scholes call price when the call gets
deep-deep-deep in the money?

How about the corresponding put price in the case above? [Can
you verify this using put-call parity?]

Suppose o gets very, very close to zero. What happens to the
call price? What happens to the put price?
Hint: Suppose the stock price will not change from time 0 to time T.
How much are you willing to pay for an out of the money option?
An in the money option?

Volatility
Volatility is the key to pricing options.

Believing that an option is undervalued is tantamount to
believing that the volatility of the rate of return on the stock will
be less than what the market believes.

The volatility is the standard deviation of the continuously
compounded rate of return of the stock, per year.
Estimating Volatility from
Historical Data
1. Take observations S
0
, S
1
, . . . , S
n
at intervals of t (fractional
years); e.g., t = 1/52 if we are dealing with weeks; t = 1/12 if we
are dealing with months.
2. Define the continuously compounded return as:

3. Calculate the average rate of return
4. Calculate the standard deviation, o , of the r
i
s
5. Annualize the computed o (see next slide).
|
|
.
|
\
|
=
1 i
i
i
S
S
ln r
; on an ex-div day:
|
|
.
|
\
|
+
=
1 i
i
i
S
div S
ln r
Annualizing Volatility
Volatility is usually much greater when the market is open (i.e. the
asset is trading) than when it is closed.
For this reason, when valuing options, time is usually measured in
trading days not calendar days.
The general convention is to use 252 trading days per year. What is
most important is to be consistent.
252
day trading per annual
=
52
weekly annual
=
12
monthly annual
=
Note that
yr
>
mo
>
week
>
day

Implied Volatility
The implied volatility of an option is the volatility for which the
BSOPM value equals the market price.
The is a one-to-one correspondence between prices and implied
volatilities.
Traders and brokers often quote implied volatilities rather than
dollar prices.
Note that the volatility is assumed to be the same across strikes,
but it often is not. In practice, there is a volatility smile, where
implied volatility is often u-shaped when plotted as a function
of the strike price.
Using Observed Call (or Put) Option Prices
to Estimate Implied Volatility
Take the observed option price as given.
Plug C, S, K, r, T into the BSOPM (or other model).
Solving o (this is the tricky part) requires either an iterative
technique, or using one of several approximations.

The Iterative Way:
Plug S, K, r, T, and into the BSOPM.
Calculate (theoretical value)
Compare (theoretical) to C (the actual call price).
If they are really close, stop. If not, change the value of
and start over again.
o

Volatility Smiles
In this table, the option premium column is the average bid-ask price for June 2000 S&P 500 Index call and put options at the
close of trading on May 16, 2000. The May 16, 2000 closing S&P 500 Index level was 1466.04, a riskless interest rate of 5.75%,
an estimated dividend yield of 1.5%, and T = 0.08493 year.
call price put price
Strike Call price Call IV with o = 0.22 Put Price Put IV with o = 0.22
1225 1.5625 0.336 0.054
1250 2.34375 0.3283 0.153
1275 2.625 0.3021 0.39
1300 3.8125 0.292 0.904
1325 5.75 0.2855 1.919
1350 129.5 0.2834 124.335 8.25 0.2762 3.753
1375 107.625 0.2689 102.51 11.375 0.2641 6.809
1400 86.625 0.2534 82.353 14.875 0.2463 11.533
1425 67.625 0.2423 64.288 20.0625 0.2315 18.35
1450 50.6875 0.2324 48.648 29 0.2285 27.592
1475 35.625 0.2201 35.612 38.625 0.2152 39.437
1500 22.5 0.2036 25.178 50.875 0.2016 53.885
1525 14 0.1982 17.173 66.75 0.1923 70.762
1550 7.875 0.1912 11.291 85.375 0.1826 89.761
1575 4.375 0.1896 7.154 106.875 0.1788 110.505
1600 2.28125 0.1881 4.367 129.5 0.1668 132.6
1625 1.21875 0.1897 2.569 153.375 0.1512 155.684
1650 0.625 0.1912 1.457
Graphing Implied Volatility versus Strike (S = 1466):

Using the call data:
= 2.17;
1
= -4.47;
2
= 2.52; R
2
= 0.988

Volatility Smiles
0
0.1
0.2
0.3
0.4
1200 1400 1600
Strike Price
I
m
p
l
i
e
d

V
o
l
a
t
i
l
i
t
y
Call IV
Put IV
X
S
ln
X
S
ln IV
2
2 1
+
|
.
|
\
|
+
|
.
|
\
|
+ =
Dividends

European options on dividend-paying stocks are valued by substituting the
stock price less the present value of dividends into Black-Scholes.

Also use S
*
when computing d
1
and d
2
.
Only dividends with ex-dividend dates during life of option should be
included.
The dividend should be the expected reduction in the stock price
expected.
For continuous dividends, use S
*
= Se
-dT
, where d is the annual constant
dividend yield, and T is in years.
*
0
-r T
C = S N(d ) - Ke N(d )
1 2
Where: S
*
= S PV(divs) between today and T.
The BOPM and the BSOPM, I.
Note the analogous structures of the BOPM and the
BSOPM:
C = S + B (0< <1; B < 0)

C = SN(d
1
) Ke
-rT
N(d
2
)

= N(d
1
)
B = -Ke
-rT
N(d
2
)
The BOPM and the BSOPM, II.

The BOPM actually becomes the BSOPM as the number of
periods approaches , and the length of each period
approaches 0.
In addition, there is a relationship between u and d, and , so
that the stock will follow a Geometric Brownian Motion. If you
carve T years into n periods, then:
n
T
0.5 0.5 q
equal must q, uptick, an of y probabilit the and,
1 e d
1 e u
T/n
T/n
+ =
=
=

The BOPM and the BSOPM: An Example
T = 7 months = 0.5833, and n = 7.
Let = 14% and = 0.40
Then choosing the following u, d, and q will make the stock follow
the right process for making the BOPM and BSOPM consistent:
0.5505 0.0833
0.40
0.14
0.5 0.5 q
equal must q, uptick, an of y probabilit the and,
0.10905 1 e d
0.1224 1 e u
0.833 0.40
0.0833 0.40
= + =
= =
= =

Generalizing the BSOPM
It is important to understand that many option pricing models are
related.

For example, you will see that many exotic options (see chap. 20)
use parts of the BSOPM.

The BSOPM itself, however, can be generalized to encapsulate
several important pricing models.

All that is needed is to change things a bit by adding a new term,
denoted by b.
The Generalized Model Can Price
European Options on:
1. Non-dividend paying stocks [Black and Scholes (1973)]

2. Options on stocks (or stock indices) that pay a continuous dividend
[Merton (1973)]

3. Currency options [Garman and Kohlhagen (1983)]

4. Options on futures [Black (1976)]
The Generalized Formulae are:
( )
( ) ( )
b-r T
-rT
gen 1 2
C = Se N d - Ke N d
( )
( )
( )
b-r T
-rT
gen 2 1
P = Ke N -d - Se N -d
o
o
+ +
=
2
1
ln(S/K) (b /2)T
d
T
o
o
o
+
= =
2
2 1
ln(S/K) (b /2)T
d d T
T
By Altering the b term in These Equations,
Four Option-Pricing Models Emerge.
By Setting: Yields this European Option Pricing Model:

b = r Stock option model, i.e., the BSOPM

b = r - d Stock option model with continuous
dividend yield, d (see section 18.5.2)

b = r r
f
Currency option model where r
f
is the
foreign risk-free rate

b = 0 Futures option model

American Options

It is computationally difficult to value an American
option (a call on a dividend paying stock, or any put).
Methods:
Pseudo-American Model (Sect. 18.10.1)
BOPM (Sects. 17.3.3, 17.4)
Numerical methods
Approximations
Of course, computer programs are most often used.
Some Extra Slides on this Material
Note: In some chapters, we try to include some extra slides in
an effort to allow for a deeper (or different) treatment of the
material in the chapter.

If you have created some slides that you would like to share with
the community of educators that use our book, please send
them to us!
The Stock Price Process, I.
The percent change in the stock prices does not
depend on the price of the stock.

Over a small interval, the size of the change in the
stock price is small (i.e., no jumps)

Over a single period, there are only TWO possible
outcomes.
The Stock Price Process, II.
Consider a stock whose current price is S

In a short period of time of length At, the change in the stock price is
assumed to be normal with mean of S At and standard deviation,

is expected return and o is volatility

t S
That is, the Black-Scholes-Merton model
assumes that the stock price, S, follows a
Geometric Brownian motion through time:

o
o
= +
= +

dS Sdt Sdz
dS
dt dz
S
dz dt
2
dlnS
2
+
|
|
.
|
\
|
=
The Discrete-Time Process

o
+A +A
A
= A + A
| |
A
= =
|
\ .
A =
A A
S
t z
S
S
ln
S
a unit of time
z = a nor mally distr ibuted r andom var iable
with a mean of zer o, and a var iance of t
z = is distr ibuted nor mally, with E( z) = 0, and V
t t t t t
t t
S S S
S S
t
A A AR( z)= t
Example:
Suppose At is one day.
A stock has an expected return of = 0.0005 per day.
NB: (1.0005)
365
1 = 0.20016, 20%
The standard deviation of the stock's daily return distribution is
0.0261725
NB: This is a variance of 0.000685
Annualized Variance: (365)(0.000685) = 0.250025
Annualized STDEV:
(0.250025)
0.5
= 0.500025, or 50%
(0.0261725)(365)
0.5
= 0.500025, or 50%
Example, II.
Then, the return generating process is such that
each day, the return consists of:
a non-stochastic component, 0.0005 or 0.05%
a random component consisting of:
The stock's daily standard deviation times the realization
of Az,
Az is drawn from a normal probability distribution with a
mean of zero and a variance of one.
Then, we can create the following table:
The First 10 Days of a Stochastic
Process Creating Stock Returns:

NON-STOCHASTIC STOCHASTIC S(T)=S(T-1)[1.0+R]
TREND PRICE COMPONENT R = At + oAz
DAY Az S(T)=S(T-1)[1.00050] (0.0261725)Az At = 1 DAY
0 1.000000 1.000000
1 -2.48007 1.000500 -0.064910 0.935590
2 -0.87537 1.001000 -0.022911 0.914623
3 -0.80587 1.001501 -0.021092 0.895789
4 -1.03927 1.002002 -0.027200 0.871871
5 0.10523 1.002503 0.002754 0.874709
6 0.66993 1.003004 0.017534 0.890483
7 -0.21137 1.003505 -0.005532 0.886002
8 2.19733 1.004007 0.057510 0.937398
9 -0.82807 1.004509 -0.021673 0.917551
10 0.58783 1.005011 0.015385 0.932126
The Result (Multiplying by 100):

A Graph of a Stock Price Following a
Geometric Brownian Motion Process
80.000
90.000
100.000
110.000
1 6 11 16 21 26 31 36 41 46 51 56 61
Day
P
r
i
c
e

(
t
i
m
e
s

1
0
0
)
Risk-Neutral Valuation
The variable does not appear in the Black-Scholes equation.
The equation is independent of all variables affected by risk preference.
The solution to the differential equation is therefore the same in a risk-
free world as it is in the real world.
This leads to the principle of risk-neutral valuation.

Applying Risk-Neutral Valuation:

1. Assume that the expected return from the stock price is the risk-free
rate.
2. Calculate the expected payoff from the option.
3. Discount at the risk-free rate.
Two Simple and Accurate Approximations
for Estimating Implied Volatility
1. Brenner-Subramanyam formula. Suppose:

t
o
=
~
t hen,
2
T
r T
S Ke
C
S
2. Corrado and Miller Quadratic formula.

t
o
t
o
| |
|
\ .
> ~
| |
|
\ .
s ~
2
8
If :
3
2
8
If :
3
r T
r T
r T
r T
r T
r T
S Ke
C
S Ke
T S Ke
S Ke
C
S Ke
T Ke S
Lets Have a Horse Race
Data: S = 54, K = 55, C = 1.4375, 29 days to expiration (T=29/365), r =
3%. We can verify:

The actual ISD is 30.06%.

Brenner-Subramanyam estimated ISD is 23.67%.

Corrado-Miller estimated ISD is 30.09%.

Black Scholes Model

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