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David Dubofsky and 18-13
Thomas W. Miller, Jr.
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?
David Dubofsky and 18-14
Thomas W. Miller, Jr.
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.
David Dubofsky and 18-15
Thomas W. Miller, Jr.
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
David Dubofsky and 18-16
Thomas W. Miller, Jr.
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
David Dubofsky and 18-17
Thomas W. Miller, Jr.
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.
David Dubofsky and 18-18
Thomas W. Miller, Jr.
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
X
S
ln
X
S
ln IV
2
2 1
+
|
.
|
\
|
+
|
.
|
\
|
+ =
David Dubofsky and 18-21
Thomas W. Miller, Jr.
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.
David Dubofsky and 18-22
Thomas W. Miller, Jr.
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
)
David Dubofsky and 18-23
Thomas W. Miller, Jr.
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
+ =
=
=
dlnS
2
+
|
|
.
|
\
|
=
David Dubofsky and 18-34
Thomas W. Miller, Jr.
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
David Dubofsky and 18-35
Thomas W. Miller, Jr.
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%
David Dubofsky and 18-36
Thomas W. Miller, Jr.
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:
David Dubofsky and 18-37
Thomas W. Miller, Jr.
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
David Dubofsky and 18-38
Thomas W. Miller, Jr.
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
)
David Dubofsky and 18-39
Thomas W. Miller, Jr.
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.
David Dubofsky and 18-40
Thomas W. Miller, Jr.
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
David Dubofsky and 18-41
Thomas W. Miller, Jr.
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
David Dubofsky and 18-42
Thomas W. Miller, Jr.
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%.