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Black Scholes

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12 views14 pages

Black Scholes

Uploaded by

messymissyher
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Black-Scholes Option

Pricing
Introduction-Black-Scholes Option Pricing

The Black–Scholes–Merton differential equation is an equation that must be


satisfied by the price of any derivative dependent on a non-dividend-paying stock.

They involve setting up a riskless portfolio consisting of a position in the derivative


and a position in the stock. In the absence of arbitrage opportunities, the return
from the portfolio must be the risk-free interest rate, r. This leads to the Black-
Scholes-Merton differential equation.
The reason a riskless portfolio can be set up is that the stock price and the
derivative price are both affected by the same underlying source of uncertainty:
stock price movements. In any short period of time, the price of the derivative is
perfectly correlated with the price of the underlying stock.

When an appropriate portfolio of the stock and the derivative is established, the
gain or loss from the stock position always offsets the gain or loss from the
derivative position so that the overall value of the portfolio at the end of the short
period of time is known with certainty.
There is one important difference between the Black–Scholes–Merton analysis
and binomial model. In Black–Scholes–Merton, the position in the stock and the
derivative is riskless for only a very short period of time. (Theoretically, it remains
riskless only for an instantaneously short period of time.) To remain riskless, it
must be adjusted, or rebalanced, frequently.
Stock Price behavior and log normal distribution
Consider the case of a call option written on a stock with an exercise price of K
expiring in T years. If the stock is currently selling at S0, the call will have a positive
value only if the stock price at expiry (St) is more than K. If we can find out the
probability of the various prices that a stock can have at time T, we can then
calculate the value of the call. This requires knowledge about how the stock price
evolves.

Researchers have devoted considerable time in order to find a suitable probability


distribution of stock prices, and the lognormal distribution has been accepted as a
suitable probability distribution for stock prices.
If a variable follows a lognormal distribution, then the natural logarithm of the
variable will have a normal distribution. Normal distribution for stock prices is not
tenable, as a normal distribution assumes both positive and negative values,
whereas stock prices can never be negative. That is why a lognormal distribution
is chosen. If stock prices are lognormally distributed, then the natural logarithm of
the stock prices will follow a normal distribution.
Assumptions
1. The stock price behaviour corresponds to the lognormal model.
2. There are no transaction costs or taxes, and all securities are infinitely
divisible. Thus, an investor can purchase or sell any fraction of the underlying
security or options without paying any commission or taxes on the gains.
3. There are no dividends on the stock during the life of the option. Thus, the
Black–Scholes analysis applies only to non-dividend-paying stocks. This
formula can be modified to take dividends into account.
4. There are no riskless arbitrage opportunities.
5. Security trading is continuous. This means that the underlying security as well
as the options and the risk-less security are traded every instant.
6. Investors can borrow as well as lend at the same risk-free rate of interest, and
the short-term risk-free rate of interest, r, is constant.
c = S0N(d1)) - Ke-rTN(d2)...................................................................(1)

p = Ke-rTN(-d2) - S0N(-d1).................................................................(2)

Where,

S0= stock price

K= strike price

r = risk free rate of interest

T = time to maturity
Procedure
1. Start with calculation of d1
a. Work out ln (S0/K)

c. Find 𝜎√T
b. Calculate (r + σ2/ 2)

d. Compute d1
2. Calculate d2
3. Find cumulative normal distribution values
4. Now calculate the price of the option by substituting the respective values in
equation 1
Problem
The current price of a stock is Rs. 90 per share. The risk-free interest rate is 8%
(annualized, continuous compounding). If the volatility of the stock is 23% p.a.,
what is the price of the Rs. 80 call option expiring in 6 months?

KUMAR, S.S.S. FINANCIAL DERIVATIVES (Kindle Locations 6743-6745). PHI


Learning. Kindle Edition.
Problem
Using the information provided in the previous example, find the price of a put
option.

KUMAR, S.S.S. FINANCIAL DERIVATIVES (Kindle Location 6760). PHI Learning.


Kindle Edition.
Option Greeks
Option price is a function of the five factors, namely, current market price, exercise
price, time to expiry, interest rates and volatility, changes in these parameters will
have an influence on the option prices. The affects, both in direction as well as in
magnitude, are captured by partial derivatives that are generally denoted by the
Greek alphabets. Hence these are also known as option greeks.

KUMAR, S.S.S. FINANCIAL DERIVATIVES (Kindle Locations 7368-7372). PHI


Learning. Kindle Edition.
1. Delta: It is a measure of the change in option price for a small change in the
spot price of the underlying asset. Delta describes the extend of change

2. Gamma: It portrays the change in delta for a change in the underlying asset’s
price. Gamma describes the pace of change

3. Theta: This captures the change in option prices due to elapsing of time. Theta
measures the rate at which the option loses its value.

4. Vega: It depicts the changes in option price for a change in implied volatility.

5. Rho: This denotes the change in option price for a unit change in interest rates.

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