MGMT 41150

Chapter 15
The Black-Scholes-Merton Model

Professor Boquist

November 2018 Chapter 15 – The Black-Scholes-Merton Model 1

 Option Pricing: Basic Idea
• We need to make some assumptions on how
stock prices move through time
– For example, normal distribution, binomial
distribution, etc.
• Since the option payoff depends on the stock
price and interest rates, the option price will
depend on those variables
• If we assume interest rates are constant, then
the option price depends only on the stock price
movements

November 2018 Chapter 15 – The Black-Scholes-Merton Model 2

 The Stock Price Assumption

• Consider a stock whose price is S

• In a short period of time of length ∆𝑡, the
return on the stock is normally distributed:
S
S

~  t ,  2 t 
where 𝜇 is expected return and 𝜎 is volatility

November 2018 Chapter 15 – The Black-Scholes-Merton Model 3

 The Lognormal Property

• It follows from this assumption that

 2  
ln ST  ln S0  ~     T ,  T 
2

 2  
or
  2  
ln ST ~  ln S 0     T ,  T 
2

  2  
• Since the logarithm of ST is normal, ST is
lognormally distributed

November 2018 Chapter 15 – The Black-Scholes-Merton Model 4

 The Lognormal Distribution

T
E ( ST )  S 0 e
2 2 T 2T
var ( ST )  S0 e (e  1)

November 2018 Chapter 15 – The Black-Scholes-Merton Model 5

 The Expected Return

• The expected value of the stock price is S0eT

• The expected return on the stock is
 –  2/2 not 

This is because

ln[ E ( ST / S 0 )]  E[ln(ST / S 0 )]

November 2018 Chapter 15 – The Black-Scholes-Merton Model 6

 The Expected Return

•  is the expected return in a very short time, t,

expressed with a compounding frequency of t
1 2
• 𝜇− 𝜎
is the expected return in a long period of time
2
expressed with continuous compounding (or, to a good
approximation, with a compounding frequency of t )

November 2018 Chapter 15 – The Black-Scholes-Merton Model 7

 Example: Mutual Fund Returns
• Suppose that returns in successive years are 15%,
20%, 30%, −20% and 25%
• The arithmetic mean of the returns is 14%
• The returned that would actually be earned over the
five years (the geometric mean) is 12.4% (with
annual compounding)
• The arithmetic mean of 14% is analogous to 
• The geometric mean of 12.4% is analogous to
−2/2
November 2018 Chapter 15 – The Black-Scholes-Merton Model 8
 Volatility
• The volatility is the standard deviation of the
continuously compounded rate of return in 1
year
• The standard deviation of the return in a short
time period ∆𝑡 is approximately σ ∗ ∆𝑡
• If a stock price is $60 and its volatility is 55%
per year what is the standard deviation of the
price change in one day?

November 2018 Chapter 15 – The Black-Scholes-Merton Model 9

 Estimating Volatility
1. Take stock price observations S0, S1, . . . , Sn at
intervals of τ years (e.g. for weekly data we
would use τ = 1/52)
2. Calculate the continuously compounded return
in each interval as:
 Si 
ui  ln 
 Si 1 

3. Calculate the standard deviation, s , of the ui´s

4. The historical volatility estimate is: ˆ  s


November 2018 Chapter 15 – The Black-Scholes-Merton Model 10

 Volatility Measurement
• Volatility is usually much greater when the
market is open (i.e. the asset is trading) than
when it is closed
• For this reason time is usually measured in
“trading days” not calendar days when options
are valued
• It is assumed that there are 252 trading days in
one year for most assets

November 2018 Chapter 15 – The Black-Scholes-Merton Model 11

 Example
• Suppose you have an option with 2 months until
expiration (61 calendar days)
• Assume there are 44 trading days during this
time window
• What should you use for T when you are valuing
this option?

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 Concepts Behind BSM Model
• The option price and the stock price depend on
the same underlying source of uncertainty
• We can form a portfolio consisting of the stock
and the option which eliminates this source of
uncertainty
• The portfolio is instantaneously riskless and
must instantaneously earn the risk-free rate
• This leads to the Black-Scholes-Merton
differential equation
November 2018 Chapter 15 – The Black-Scholes-Merton Model 13
 BSM Differential Equation
S  S t  S z
 ƒ ƒ  2ƒ 2 2  ƒ
ƒ   S   ½ 2  S t  S z
 S t S  S

We set up a portfolio consisting of

 1 : derivative
ƒ
+ : shares
S
This gets rid of the dependence on z.
November 2018 Chapter 15 – The Black-Scholes-Merton Model 14
 BSM Differential Equation

The value of the portfolio, , is given by

ƒ
  ƒ  S
S
The change in its value in time t is given by
ƒ
   ƒ  S
S

November 2018 Chapter 15 – The Black-Scholes-Merton Model 15

 BSM Differential Equation
The return on the portfolio must be the risk - free
rate. Hence
  r t
f  f 
- f  S  r   f  S t
S  S 
We substitute for ƒ and S in this equation
to get the Black - Scholes differenti al equation :
ƒ ƒ 2 2  ƒ
2
 rS ½ σ S  rƒ
t S S 2

November 2018 Chapter 15 – The Black-Scholes-Merton Model 16

 Using the Differential Equation
• Any security whose price is dependent on the
stock price satisfies the differential equation
• The particular security being valued is
determined by the boundary conditions of the
differential equation
• In a forward contract the boundary condition is
ƒ = S – K when t =T
• The solution to the equation is
ƒ = S – K e–r (T – t )
November 2018 Chapter 15 – The Black-Scholes-Merton Model 17
 BSM Formulas for Options
c  S 0 N (d1 )  K e  rT N (d 2 )
p  K e  rT N (d 2 )  S 0 N (d1 )

 S 0    
2
ln   r  T
 K   2 

where d1 
 T
 S 0    
2
ln   r  T
 K   2 

d2   d1   T
 T

November 2018 Chapter 15 – The Black-Scholes-Merton Model 18

 The N(x) Function
• N(x) is the probability that a normally
distributed variable with a mean of zero and a
standard deviation of 1 is less than x

• There are tables at the end of the book, or you

can use NORMSDIST(.) in Excel
November 2018 Chapter 15 – The Black-Scholes-Merton Model 19
 Option Example
• Suppose you have a call option on a stock that’s
currently $60 per share, with a strike price of
$65. It will expire in 6 months and the risk-free
rate is 4% (annualized, cont. compounded rate).
The annualized volatility is 47%.
• What is the option value?

November 2018 Chapter 15 – The Black-Scholes-Merton Model 20

 Understanding the BSM Model
 rT N d1  
ce  rT
N (d 2 ) S 0 e  K 
 N d 2  

e  rT : Discount rate
N (d 2 ) : Probability of exercise
e rT N (d1 )/N (d 2 ) : Expected percentage increase in stock
price if option is exercised
K: Strike price paid if option is exercised

November 2018 Chapter 15 – The Black-Scholes-Merton Model 21

 Risk-Neutral Valuation
• The variable  does not appear in the Black-
Scholes-Merton differential 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

November 2018 Chapter 15 – The Black-Scholes-Merton Model 22

 Applying Risk-Neutral Valuation
• First, assume that the expected return for the
stock price is the risk-free rate
• Then calculate the expected payoff from the
option
• Finally, discount at the risk-free rate

November 2018 Chapter 15 – The Black-Scholes-Merton Model 23

 Example: Forward Contract
• The payoff from a forward contract at time T is
given by: ST – K
• Thus, the expected payoff in a risk-neutral world
is: S0erT – K
• We can calculate the present value of the
expected payoff:
e-rT[S0erT – K] = S0 – Ke-rT

November 2018 Chapter 15 – The Black-Scholes-Merton Model 24

 Applying Risk-Neutral to BSM

c  e  rT  max( ST  K , 0) g ( ST )dST
0

where g(ST) is the probability density function for the lognormal

distribution of ST in a risk-neutral world. ln(ST) ~ j(m, s2) where

m  ln S 0  r   2 2 T  and s  T

We substitute ln ST  m
Q
s
so that

c  e rT (ln K  m ) / s
max(e Qs  m  K , 0)h(Q)dQ

where h(.) is the probability density function for a standard normal.

Evaluating the integral leads to the BSM result.

November 2018 Chapter 15 – The Black-Scholes-Merton Model 25

 Implied Volatility
• The implied volatility of an option is the
volatility for which the Black-Scholes-Merton
price equals the market price
• There is a one-to-one correspondence between
prices and implied volatilities
• Traders and brokers often quote implied
volatilities rather than dollar prices

November 2018 Chapter 15 – The Black-Scholes-Merton Model 26

 The Volatility Index (VIX)
• The VIX is an index that the CBOE created
which measures the implied volatility of S&P
500 options
• It is approximately 30 day implied volatility, in
other words it represents the volatility that
investors expect over the next month
• Sometimes called “the fear index”
• You can trade options and futures on the VIX
itself
November 2018 Chapter 15 – The Black-Scholes-Merton Model 27
 The Volatility Index (VIX)

November 2018 Chapter 15 – The Black-Scholes-Merton Model 28

 Understanding the BSM Model
• The equation for the BSM model has 5 inputs
– Current stock price
– Strike price
– Volatility
– Time to expiration
– Risk-free rate
• Let’s see how changes in these impact the option
value one at a time

November 2018 Chapter 15 – The Black-Scholes-Merton Model 29

 Changes in Stock Price
c  S 0 N d1   Ke  rT N d 2 
 S0  2  S0  2
ln   (r  )T ln   (r  )T
d1    , d2   
K 2 K 2
 T  T

• What happens to the call price, c, as S0 goes to

zero? As it goes to infinity?

November 2018 Chapter 15 – The Black-Scholes-Merton Model 30

 Changes in Stock Price
• Graphically:

November 2018 Chapter 15 – The Black-Scholes-Merton Model 31

 Changes in Strike Price
c  S 0 N d1   Ke  rT N d 2 
 S0  2  S0  2
ln   (r  )T ln   (r  )T
d1    , d2   
K 2 K 2
 T  T

• What happens to the call price, c, as K goes to

zero? As it goes to infinity?

November 2018 Chapter 15 – The Black-Scholes-Merton Model 32

 Changes in Strike Price
• Graphically:

November 2018 Chapter 15 – The Black-Scholes-Merton Model 33

 Changes in Volatility
c  S 0 N d1   Ke  rT N d 2 
 S0  2  S0  2
ln   (r  )T ln   (r  )T
d1    , d2   
K 2 K 2
 T  T

• What happens to the call price, c, as volatility

goes to zero (hint: it matters what the current
stock price is relative to K!)? As it goes to
infinity?

November 2018 Chapter 15 – The Black-Scholes-Merton Model 34

 Changes in Volatility
• Graphically:

November 2018 Chapter 15 – The Black-Scholes-Merton Model 35

 Changes in Time to Expiration
c  S 0 N d1   Ke  rT N d 2 
 S0  2  S0  2
ln   (r  )T ln   (r  )T
d1    , d2   
K 2 K 2
 T  T

• What happens to the call price, c, as T goes to

zero (hint: it matters what the current stock
price is relative to K!)? As it goes to infinity?

November 2018 Chapter 15 – The Black-Scholes-Merton Model 36

 Changes in Time to Expiration
• Graphically:

November 2018 Chapter 15 – The Black-Scholes-Merton Model 37

 Changes in the Risk-Free Rate
c  S 0 N d1   Ke  rT N d 2 
 S0  2  S0  2
ln   (r  )T ln   (r  )T
d1    , d2   
K 2 K 2
 T  T

• What happens to the call price, c, as the risk-free

rate, r, goes to infinity?
• (Note: no big result when r goes to zero)

November 2018 Chapter 15 – The Black-Scholes-Merton Model 38

 Changes in the Risk-Free Rate
• Graphically:

November 2018 Chapter 15 – The Black-Scholes-Merton Model 39

 Adding Dividends
• So far the BSM model we’ve used only works
for non-dividend paying stocks
• If the dividend is known, then it is easy to adjust
the model for this case:
– First, find the PV of all dividends between now and
the option expiration
– Subtract this PV(D) from the current stock price,
and use the BSM model as before

November 2018 Chapter 15 – The Black-Scholes-Merton Model 40

 Example
• Consider a European option on a stock which
will pay a $0.80 dividend in two months and five
months. The current share price is $50 and the
strike price is $45, the stock price volatility is
40% per annum, the risk free rate is 3% per
annum, and the time to expiration is six months.
• What is the BSM option value?

November 2018 Chapter 15 – The Black-Scholes-Merton Model 41

 Continuous Dividends
• If the dividends are continuous (dividend yield,
appropriate for a stock index), then we can
adjust the BSM model for this case:
– First, the share price today becomes:

PV [ E[ S (T )]]  e  *T S 0

– Use this instead of S0 in the BSM equations

November 2018 Chapter 15 – The Black-Scholes-Merton Model 42

 BSM With Continuous Dividends
• The BSM formula with continuous dividends:
c  e  *T S 0 N d1   Ke  rT N d 2 
 e  *T S 0   2 
ln    r  T
 K   2 
d1 
 T
 S0   2 
ln    r    T
K  2 

 T
d 2  d1   T
November 2018 Chapter 15 – The Black-Scholes-Merton Model 43
 Example
• Consider a European call option on the S&P
500 index which has two months until
expiration. The current value of the index is
2170, the exercise price is 2150, the risk-free rate
is 2% per annum, and the volatility of the index
is 20% per annum. Dividend yield is 3% per
annum.
• What is the BSM option value?

November 2018 Chapter 15 – The Black-Scholes-Merton Model 44

 American Options
• An American call option on a non-dividend
paying stock is the same as the European value
due to no early exercise
• If the stock pays a dividend D at time t1 (before
time T obviously), the American call will either
be exercised right before t1 or at expiration

November 2018 Chapter 15 – The Black-Scholes-Merton Model 45

 American Options
• Thus an American call option can be thought of
as the maximum of 2 European Calls:
– A European call that matures at time t1 on a stock
that does not pay the dividend
– A European call that matures at time T on a stock
that pays the dividend D at time t1

C A
 maxC E
( S 0 , t1 ), C ( S 0  PV ( D), T )
E


November 2018 Chapter 15 – The Black-Scholes-Merton Model 46

 American Options
• For an American Put option, there is no
analytical solution to adjust the model, so you
cannot use the Black-Scholes-Merton approach
• The Binomial Tree method is a very good way
to value these!

November 2018 Chapter 15 – The Black-Scholes-Merton Model 47

 Warrants and Executive Options
• When a regular call option is exercised, the stock
that is delivered must be purchased in the open
market
• When a warrant or executive stock option is
exercised, new Treasury stock is issued by the
company
• If little or no benefits are foreseen by the
market the stock price will drop at the time the
option grants are announced. (See Business
Snapshot 15.3 for an example)
November 2018 Chapter 15 – The Black-Scholes-Merton Model 48
 The Impact of Dilution
• After the options have been issued, it is not
necessary to take account of dilution when they
are valued
• Before they are issued we can calculate the cost
of each option as N/(N+M) times the price of a
regular option with the same terms where N is
the number of existing shares and M is the
number of new shares that will be created if
exercise takes place

November 2018 Chapter 15 – The Black-Scholes-Merton Model 49