The Black- Scholes Formula

• Introduction to the Black-Scholes

formula
• Applying the formula to other assets
• Option greeks
• Delta-hedging
• Volatility

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 Binomial pricing

• Vary the number of binomial steps (think about the

multiperiod example), fix the expiration
• What if infinite number of steps?
• Black-Scholes formula is a limiting case of binomial
formula for the price of a European option

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 Black-Scholes Formula

• Consider an European call (or put) option written on a

stock
• Assume that the stock pays dividend at the continuous
rate δ
• Same notation as in the binomial pricing model

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 Black-Scholes Formula (cont’d)
• Call Option price

C(S, K, σ, r, T, δ) = Se−δT N (d1 ) − Ke−rT N (d2 )

• Put Option price

P (S, K, σ, r, T, δ) = Ke−rT N (−d2 ) − Se−δT N (−d1 )

∎ where
ln(S/K) + (r − δ + 21 σ 2 )T √
d1 = √ and d2 = d1 − σ T
σ T
• N (x) is the cumulative normal distribution, the
probability that a number randomly drawn from a
standard normal distribution will be less than x.
• Function “NormSDist” in Excel2007
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 Normal distribution
• N (x) is the cumulative normal distribution, the
probability that a number randomly drawn from a
standard normal distribution (mean is 0, std. dev. is 1)
will be less than x
(http://en.wikipedia.org/wiki/Cumulative distribution function).
• Normal distribution
http://en.wikipedia.org/wiki/Normal distribution
• For example,
• N(0)=0.5 chance of average: half
• N(1)=0.841345
• N(-1)=0.158655
• N(2)=0.97725
• N(-2)=0.02275
• N(1)-N(-1)=0.682 chance of falling within [-1,1]
around the mean
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 Normal distribution

Top panel: Area

under the normal
curve to the left of
0.3. Bottom
panel: Cumulative
normal
distribution. The
height at x = 0.3,
given by N(0.3), is
0.6179.

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 Black-Scholes (BS) Assumptions

• Assumptions about stock return distribution

• Continuously compounded returns on the stock are
normally distributed and independent over time (no
“jumps”)
• The volatility of continuously compounded returns is
known and constant
• Future dividends are known, either as dollar amount
or as a fixed dividend yield

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Black-Scholes (BS) Assumptions (cont’d)

• Assumptions about the economic environment

• The risk-free rate is known and constant
• There are no transaction costs or taxes
• It is possible to short-sell costlessly and to borrow at
the risk-free rate

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 Applying BS to Other Assets

• Call Options
p
C(F0,T (S), F0,T
p
(K), σ, T ) = F0,T
P
(S)N (d1 )−F0,T
P
(K)N (d2 )

• where
P
ln[F0,T (S)/F0,T
P
(K)] + 12 σ 2 T √
d1 = √ and d2 = d1 − σ T
σ T
and
P
F0,T (S) = Se−δT ; F0,T
P
(K) = Ke−rT

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 Applying BS to Other Assets (cont’d)

• Options on stocks with discrete dividends

• The prepaid forward price for stock with discrete
dividends is
P
F0,T (S) = S0 − PV0,T (Div)

• Example
• S = $41, K = $40, σ = 0.3, r = 8%, t = 0.25, Div =
$3 in one month
• The BS European call price is ?

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The BS European call price is ?

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What if dividends is zero?

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 Applying BS to Other Assets (cont’d)

• Options on currencies
• The prepaid forward price for the currency is

P
F0,T (x) = x0 e−rf T

• Where x is domestic spot rate and rf is foreign

interest rate
• Example
• x = $0.92/e, K = $0.9, σ = 0.10, r = 6%, T = 1,
and rf = 3.2%
• The dollar-denominated euro call price is ?
• The dollar-denominated euro put price is ?

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 Applying BS to Other Assets (cont’d)
• Options on futures
• The prepaid forward price for a futures contract is the
PV of the futures price. Therefore

C(F, K, σ, r, T ) = F e−rT N (d1 ) − Ke−rT N (d2 )

∎ where
ln(F /K) + 21 σ 2 T √
d1 = √ and d2 = d1 − σ T
σ T
• Example
• Suppose 1-yr. futures price for natural gas is
$2.10/MMBtu, r = 5.5%
• F = $2.10, K = $2.10, and δ = 5.5%
• If σ = 0.25, T = 1, call price = ? put price = ?

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 Option Greeks

• What happens to option price when one input changes?

• Delta (∆): change in option price when stock price
increases by $1
• Gamma (Γ): change in delta when stock price
increases by $1: positive for either long call or put
• Vega (Λ): change in option price when volatility
increases by 1%
• Theta (θ): change in option price when time to
maturity decreases by 1 day
• Rho (ρ): change in option price when interest rate
increases by 1%
• Psi (Ψ): change in the option price when there is an
increase in dividend yield of 1%

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 Option Greeks (cont’d)
• Delta (∆) is the change in option price when stock price
increases by $1
• How to find this out? We are thinking about

C(S + 1, K, σ, r, T, δ) − C(S, K, σ, r, T, δ)
S +1−S
• Formula for call delta: ∆call = e−δT N (d1 ) positive for
long call
• Formula for put delta: ∆put = −e−δT N (−d1 ) = ∆call − e−δT
negative for long put
• Greek measures for portfolios of n options each with
quantity wi , i = 1, 2, ...n.
• The Greek measure of a portfolio is weighted average
of Greeks of individual portfolio components
∆portfolio = ∑ni=1 wi ∆i
• The following graphs show long positions only
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 Option Greeks – Delta

● Deltas for European puts and calls with different times to

expiration; assume K = $40, σ = 30%, r = 8%, δ = 0.

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 Option Greeks – Gamma
● Gammas for European puts and calls with different times to
expiration; assume K = $40, σ = 30%, r = 8%, δ = 0. The
figures in the two panels are identical

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 Option Greeks – Vega
● Vegas for European puts and calls with different times to
expiration; assume K = $40, σ = 30%, r = 8%, δ = 0. The
figures in the two panels are identical

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 Option Greeks – Theta
● Panels (a) and (b) show the price as a function of time to
expiration for in-the-money, at-the-money, and
out-of-the-money calls and puts. Assume
K = $40, σ = 30%, r = 8%, δ = 0 (to be continued).

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 Option Greeks – Theta (Cont’d)
● Panels (c) and (d) show call and put thetas as a function of
the stock price for three different times to expiration. Assume
K = $40, σ = 30%, r = 8%, δ = 0.

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 Option Greeks – Rho

● Rhos for European puts and calls with different times to

expiration; assume K = $40, σ = 30%, r = 8%, δ = 0.

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 Option Greeks – Psi

● Psis for European puts and calls with different times to

expiration; assume K = $40, σ = 30%, r = 8%, δ = 0.

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 Option Greeks (cont’d)
∎ Greeks for the bull spread examined in Chapter 3, where
S = $40, σ = 0.3, r = 0.08, and T = 91 days, with a purchased
40-strike call (option 1) and a written 45-strike call (option 2).
The column titled “combined” is the difference between
column 1 and column 2.

40-strike call 45-strike call Combined

ωi 1 -1 –
Price 2.7804 0.9710 1.8094
Delta 0.5824 0.2815 0.3009
Gamma 0.0652 0.0563 0.0088
Vega 0.0780 0.0674 0.0106
Theta -0.0173 -0.0134 -0.0040
Rho 0.0511 0.0257 0.0255

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 Option elasticity

• Option elasticity (Ω)

• the if stock price changes by ε delta approximation
gives the approximate change in the option price:
ε×∆
• this works for small ε
• the if stock price changes by ε delta-gamma
approximation gives the approximate change in the
option price: ε × ∆ + 12 ε2 × Γ
• this works better when ε becomes larger

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 Option elasticity (cont’d)

• Option elasticity (Ω)

• Ω describes the risk of the option relative to the risk
of the stock in percentage terms: If stock price (S)
changes by 1%, what is the percent change in the
value of the option (C)?
change in C change in S×∆
% change in C S∆
Ω≡ = C
change in S
= C
change in S
=
% change in S S S
C

• S = $41, K = $40, σ = 0.30, r = 0.08, T = 1, δ = 0

• Elasticity for call:
Ω = S∆/C = $41 × 0.6911/$6.961 = 4.071
• Elasticity for put:
Ω = S∆/C = $41 × (−0.3089)/$2.886 = −4.389

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 Option elasticity (cont’d)

• Option elasticity (Ω) (cont’d)

• The volatility of an option σoption = σstock × ∣Ω∣
• The risk premium of an option γ − r = (α − r) × Ω
• The Sharpe ratio of an option
• Recall Sharpe ratio is the mean excess return
over its standard deviation
• Sharpe ratio for call = α−r
σ =Sharpe ratio for stock
• where ∣ . ∣ is the absolute value, γ: required
return on option, α: expected return on stock,
and r: risk-free rate

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 Option elasticity

● Elasticity for call and put options with different times to

expiration; assume K = $40, σ = 30%, r = 8%, δ = 0.

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 Delta-Hedging

• Market makers attempt to hedge in order to avoid the risk

from their arbitrary positions due to customer orders
• Market-makers can control risk by delta-hedging
• Delta-hedged positions should expect to earn risk-free
return

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 Delta-Hedging

• Delta hedging entails using the stock to offset the risk of

the option
• If you are a market maker, writing these options exposes
you to risk of the underlying, thus it is necessary to cover
the positions with stocks
• If you short a call, long stocks, if you short a put, short
stocks

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 Delta-Hedging (cont’d)

• Market-maker sells one option, and buys ∆ shares

• To self-finance, market-maker has to borrow money to
buy stocks
• Three sources of profit
• overnight gain on shares ∆t (St+1 − St ), less
• overnight change on the option Ct+1 − Ct , less
• interest rM Vt where M Vt = ∆t St − Ct is the market
value of the portfolio

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 Delta-Hedging (cont’d)

• Investor always has a positive gamma, but market-maker

always has a negative gamma (recall delta-gamma
approximation)
• Recall gamma is the same for both call and put
• Recall market-maker also has to borrow money to buy
stocks (financing cost)
• Still, source of market-maker profit to delta hedge a call:
positive theta – calls become less expensive with time.
This is called time decay.
• Therefore the matter is which effect is larger
• Again, zero sum game between an investor and a
market-maker

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 Delta-Hedging (cont’d)

Price and Greek

information for a call
option with Purchased Written
S = $40, K = $40, σ = Call price 2.7804 -2.7804
0.30, r = 0.08 Delta 0.5824 -0.5824
(continuously Gamma 0.0652 -0.0652
compounded), Theta -0.0173 0.0173
T − t = 91/365, and
δ = 0.

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 Delta-Hedging (cont’d)

• Delta-hedging for 2 days: (daily rebalancing and

marking-to-market):
• Day 0: Share price = $40, call price is $2.7804, and
∆ = 0.5824
• Sell call written on 100 shares for $278.04, and
buy 58.24 shares.
• Net investment:
(58.24 × $40) − $278.04 = $2051.56
• At 8%, overnight financing charge is
$0.45[= $2051.56 × (e0.08/365 − 1)]

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 Delta-Hedging

• Delta-hedging for 2 days: (daily rebalancing and

marking-to-market):
• Day 1: If share price = $40.5, call price is $3.0621,
and ∆ = 0.6142
• Overnight profit/loss:
($40.5 − $40)58.24 + ($2.7804 − $3.0621)100 −
$0.45 = $29.12 − $28.17 − $0.45 = $0.50
• Buy (0.6142 − 0.5824)100 = 3.18 additional
shares for $128.79 to rebalance

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 Delta-Hedging

• Delta-hedging for 2 days: (daily rebalancing and

marking-to-market):
• Day 2: If share price = $39.25, call price is $2.3282
• Overnight financing charge is
$0.48[= ($2051.56 + $128.79) × (e0.08/365 − 1)]
• Overnight profit/loss:
($39.25 − $40.5)61.42 + ($3.0621 − 2.3282)100 −
$0.48 = −$76.78 + $73.39 − $0.48 = −$3.87

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Overnight profit as a function of the stock price for a
delta-hedged market maker who has written a call. Bad:
gamma and interest expense. Good: theta.
Overnight Profit ($)

5
$0.50 Profit
0

-5

-10

-15

-20

-25 $40.50

-30

37 38 39 40 41 42 43
Stock Price ($)
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 Delta-Hedging (cont’d)

• What about put delta-hedging?

• Long a put, buy shares to delta hedge
• Write a put, sell shares to delta hedge
• Investor always has a positive gamma, but market-maker
always has a negative gamma (recall delta-gamma
approximation)
• The matter is how large the price change is
• Investor also has to borrow money to buy stocks
(financing cost)
• For investor, theta can be positive or negative. Positive
means the put option is more valuable

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 Implied Volatility

• Volatility is unobservable
• Choosing a volatility to use in pricing an option is difficult
but important
• One approach to obtaining a volatility is to use history of
returns
• However history is not a reliable guide to the future
• Alternatively, we can invert the Black-Scholes formula to
obtain option implied volatility

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 Implied Volatility (cont’d)

• The volatility of the returns consistent with observed

option prices and the pricing model (typically
Black-Scholes)
• One can use the implied volatility from an option
with an observable price to calculate the price of
another option on the same underlying asset
• Checking the uniformity of implied volatilities across
various options on the same underlying assets allows
one to verify the validity of the pricing model in
pricing those options

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 Implied Volatility (cont’d)

• The volatility of the returns consistent with observed

option prices and the pricing model (typically
Black-Scholes)
• In practice implied volatilities of in, at, and out-of-the
money options are generally different resulting in the
volatility skew
• Implied volatilities of puts and calls with same strike
and time to expiration must be the same if options
are European because of put-call parity

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 Implied Volatility (cont’d)

Black-Scholes
implied volatilities
for S&P 500
options, October
19, 2007, based
on midday option
prices from
www.cboe.com;
assumes S =
1508.08, r = 4.5%,
and δ = 0.02.

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