The Black-Scholes-Merton Model

Md Mobashshir Hussain
The Stock Price Assumption
• Consider a stock whose price is S.
• In a short period of time of length Dt, the return on the stock is normally
distributed:

DS
S

  Dt ,  2 Dt 
where  is expected return and  is volatility.
The Lognormal Property
(Equations 15.2 and 15.3, page 320)
• It follows from this assumption that

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

• Since the logarithm of ST is normal, ST is lognormally distributed

The Lognormal Distribution

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

Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Continuously Compounded Return (Equations 15.6 and 15.7, page
322)
The lognormal property of stock prices can be used to provide information on the probability
distribution of the continuously compounded rate of return earned on a stock between times 0
and T. If we define the continuously compounded rate of return per annum realized between
times 0 and T as x, then
As T increases, the standard deviation of x declines.

S T  S 0 e xT
1 ST
x = ln
T S0
 2 2
x      , 
 2 T 

Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
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 )] and E[ln( ST / S 0 )]

are not the same.

µ and µ−σ2/2
•  is the expected return in a very short time, Dt, expressed with a compounding
frequency of Dt
•  −2/2 is the expected return in a long period of time expressed with
continuous compounding (or, to a good approximation, with compounding
frequency of Dt)
Mutual Fund Returns
(See Business Snapshot 15.1 on page 324)
• Suppose that returns in successive years are 15%, 20%, 30%, −20% and 25% (ann. comp.)
• 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%
(ann. comp.)
• The arithmetic mean of 14% is analogous to 
• The geometric mean of 12.4% is analogous to  −2/2
The 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
time Dt is approximately

 Dt

• If a stock price is $50 and its volatility is 25% per year what is
the standard deviation of the price change in one day? ( 0.79)
Estimating Volatility from Historical Data (page 324-326)
1. Take observations S0, S1, . . . , Sn at intervals of t years (e.g. for weekly data t = 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:
s
ˆ 


Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Nature of Volatility
(Business Snapshot 15.2, page 327)

• 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

Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Example
• Suppose it is April 1 and an option lasts to April 30 so that the
number of days remaining is 30 calendar days or 22 trading days
• The time to maturity would be assumed to be 22/252 = 0.0873 years
The Concepts Underlying Black-Scholes-Merton
• The option price and the stock price depend on the same underlying
source of uncertainty
• We can form a riskless portfolio consisting of the stock and the option
which eliminates this source of uncertainty ( stock price Move.)
• The portfolio is instantaneously riskless and must instantaneously
earn the risk-free rate r (In the absence of arbitrage opportunities)
and known with certinity
• This leads to the Black-Scholes-Merton differential equation
Assumptions

• 1.The stock price follows the process with µ and sigma constant.
• 2. The short selling of securities with full use of proceeds is permitted.
• 3. There are no transaction costs or taxes. All securities are perfectly
divisible.
• 4. There are no dividends during the life of the derivative.
• 5. There are no riskless arbitrage opportunities.
• 6. Security trading is continuous.
• 7. The risk-free rate of interest, r, is constant and the same for all
maturities
The Derivation of the Black-Scholes-Merton
Differential Equation (1 of 3)
D S  S D t  S D z
 ƒ ƒ  2ƒ 2 2  ƒ
D ƒ   S  ½  S  D t  S Dz
 S t S S
2


We set up a portfolio consisting of

 1 : derivative
ƒ
+ : shares
S
This gets rid of the dependence on D z .

Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
The Derivation of the Black-Scholes-Merton Differential
Equation (2 of 3)

The value of the portfolio, , is given by

ƒ
  ƒ  S
S
The change in its value in time Dt is given by
ƒ
D   Dƒ  DS
S

Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
The Derivation of the Black-Scholes-Merton
Differential Equation (3 of 3)
The return on the portfolio must be the risk - free
rate. Hence
D  r D t
f  f 
- Df  DS  r   f  S  Dt
S  S 
We substitute for Dƒ and DS in this equation
to get the Black - Scholes differenti al equation
ƒ ƒ 2 2  2
ƒ
 rS ½ σ S  rƒ
t S S 2

Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
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 European call option, the boundary condition is ƒ = S – K when t =T
• In the case of a European put option, it is f = K - S

• The solution to the equation is ƒ = S – K e–r (T – t )

Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Perpetual Derivative
• For a perpetual derivative there is no dependence on
time and the differential equation becomes
2
df 1 2 2 d f
rS   S 2
 rf
dS 2 dS
A derivative that pays off Q when S = H is worth QS/H
when S<H and when S>H. (These values satisfy
the differential equation and the boundary conditions)

Q S H  2 r /  2
The Black-Scholes-Merton Formulas for Options (See
pages 333-334)

 rT
c  S 0 N (d1 )  K e N (d 2 )
 rT
pKe N (d 2 )  S 0 N (d1 )
ln( S 0 / K )  (r   2 / 2)T
where d1 
 T
ln( S 0 / K )  (r   2 / 2)T
d2   d1   T
 T
The differential equation gives the call and put prices at a general time t. For example, the call
price that satisfies the differential equation is c and put price is p

Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
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, Excel function NORM.S.DIST(X,True)

• See tables at the end of the book

The stock price 6 months from the expiration of an option is $42, the exercise price
of the option is $40, the risk-free interest rate is 10% per annum, and the volatility.
Properties of Black-Scholes Formula

• As S0 becomes very large c tends to S0 – Ke-rT and p tends to zero

• As S0 becomes very small c tends to zero and p tends to Ke-rT – S0
• What happens as s becomes very large?
• What happens as T becomes very large?
Understanding Black-Scholes

c  erT N (d2 ) S0erT N d1  N d2   K 
erT : Present value factor
N (d2 ) : Probability of exercise
S0erT N (d1 )/N (d2 ) : Expectedstock pricein a risk - neutralworld
if optionis exercised
K : Strikepricepaid if optionis exercised

Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Risk-Neutral Valuation
• The variable µ ( expected Return) does not appear in the Black-
Scholes-Merton differential equation
• The equation is independent of all variables affected by risk
preference ( Stock price, time, stock price volatility, Rf)
• 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, r ( investor are risk neutral), they donot require any risk
premium to induce them to the risks.
2. Calculate the expected payoff from the option ( Cash flow)
3. Discount at the risk-free rate to get present value of cash flow
Valuing a Forward Contract with Risk-Neutral Valuation

• Consider a forward contracts on a non-dividend-paying stock. Consider a long

forward contract that matures at time T with delivery price, K. interest rates are
constant and equal to r. At Maturity,
• Payoff is ST – K
• Expected payoff in a risk-neutral world is S0erT – K
• Present value of expected payoff is
e-rT[S0erT – K] = S0 – Ke-rT
 Proving Black-Scholes-Merton Using Risk-Neutral Valuation
(Appendix to Chapter 15)


 rT
ce max( S T  K , 0 ) g ( S T ) dS T
K

where g(ST) is the probability density function for the lognormal distribution of ST
in a risk-neutral world. ln ST is j(m, s2) where

We substitute
mlnS0  r  2 T  2
 s  T
so that ln S  m
Q  T
s


 rT
ce max( e Qs  m  K , 0 ) h ( Q ) dQ
(ln K  m ) / s
where h is the probability density function for a standard normal. Evaluating the
integral leads to the BSM result.
Implied Volatility
• The one parameter in the Black–Scholes–Merton pricing formulas
that cannot be directly observed is the volatility of the stock price.
• we can estimate it from a history of the stock price.
• These are the volatilities implied by option prices observed in the
market.
• 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
Implied Volatility
The VIX S&P500 Volatility Index

The VIX Index The CBOE publishes indices of implied volatility. The most popular index, the SPX VIX, is an
index of the implied volatility of 30-day options on the S&P 500 calculated from a wide range of calls and
puts. It is sometimes referred to as the ‘‘fear factor.’’ An index value of 15 indicates that the implied
volatility of 30-day options on the S&P 500 is estimated as 15%. Trading in futures on the VIX started in
2004 and trading in options on the VIX started in 2006. India ( 2008)
Computation of India VIX- The variance for the near and mid month expiry computed separately are
interpolated to get a single variance value with a constant maturity of 30 days to expiration. The square
root of the computed variance value is multiplied by 100 to arrive at the India VIX value.
An Issue of Warrants and Executive Stock 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
reduce at the time the issue is announced.
• There is no further dilution (See Business Snapshot 15.3.)
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
Dividends

• European options on dividend-paying stocks are valued by

substituting the stock price less the present value of dividends into
Black-Scholes
• 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
American Calls

• An American call on a non-dividend-paying stock should never be

exercised early
• An American call on a dividend-paying stock should only ever be
exercised immediately prior to an ex-dividend date
• Suppose dividend dates are at times t1, t2,…tn. Early exercise is
sometimes optimal at time ti if the dividend at that time is greater
than
 r ( t i 1  t i )
D _ n  K [1  e ]
Black’s Approximation for Dealing with
Dividends in American Call Options
Black suggests an approximate procedure for taking account of early
exercise in call options. This involves calculating, as described earlier
in this section, the prices of European options that mature at times T
and tn, and then setting the American price equal to the greater of
the two.
Set the American price equal to the maximum of two European prices:
1. The 1st European price is for an option maturing at the same time
as the American option
2. The 2nd European price is for an option maturing just before the
final ex-dividend date