Black-Scholes Model

Prof.Shailesh Kulkarni
Notations used in the Black-Scholes
Model
 The Black-Scholes formula for option
pricing
Function N(x) is the
cumulative probability
distribution function for
a standardized normal
distribution.
In Excel we will use the
statistical function
“Norm.S.Dist” to
calculate the values of
N(d1) and N(d2)
Variables using in Black-Scholes
Formula
 Examples

• The stock price six 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 is 20% per annum. Calculate the price of
call and put option.
 Steps using Excel
• Calculate and

𝑑1=ln ¿ ¿
𝑑2 =ln ¿ ¿
S0 42
K 40
r 10%
σ 20%
t 0.50
d1 0.7693
d2 0.6278
Step 2 calculate the value of call
and put options
 Exercises
1. What is the price of a European call option on a non-dividend
paying stock when the stock price is $52, the strike price is $50, the
risk-free interest rate is 12% per annum, the volatility is 30% per
annum, and the time to maturity is 3 months.

2. What is the price of a European put option on a non-dividend

paying stock when the stock price is $69, the strike price is $70, the
risk-free interest rate is 5% per annum, the volatility is 35% per
annum, and the time to maturity is 6 months.
3. What is the price of an European put option on a non-dividend paying stock when
the stock price is $52, the strike price is $50, the risk-free interest rate is 5% p.a., the
volatility is 35% p.a. and time to maturity is 6 months?

4. At the close on 13th January 2025, the underlying price of Nifty was 23085.95. An
European Call option with a strike price of 23000 closed at 218.15 and with the same
strike price the put option was at 81.15. The expiry of the option is on 16 th January
2025. The daily returns for Nifty for the period between 1 st January 2025 to 13th
January 2025 was -2.81% with 17.44% volatility and a standard error of 1.30%. The risk
free interest rate is 6.36% p.a. Calculate the theoretical Call and Put option price using
Black-Scholes model and justify the current pricing of the call and put option. The excel
data in the next slide is calculation of Nifty daily returns.
 Date ClosePrice relative Daily return Square of daily return
01-Jan-25 23,742.90
02-Jan-25 24,188.65 1.018774034 0.018600 0.000346
03-Jan-25 24,004.75 0.992397261 -0.007632 0.000058
06-Jan-25 23,616.05 0.983807371 -0.016325 0.000267
07-Jan-25 23,707.90 1.003889304 0.003882 0.000015
08-Jan-25 23,688.95 0.999200688 -0.000800 0.000001
09-Jan-25 23,526.50 0.993142372 -0.006881 0.000047
10-Jan-25 23,431.50 0.995962 -0.004046 0.000016
13-Jan-25 23,085.95 0.985252758 -0.014857 0.000221

-2.81%

Standard Deviation 17.44%

Standard Error 1.30%
BLACK-SCHOLES MODEL FOR
DIVIDEND PAYING STOCKS

− 𝑟𝑡
𝑐=(𝑆 ¿ ¿ 0 − 𝐷 ×𝑒
−𝑟𝑡
)𝑁 ( 𝑑 1 ) −𝑘 𝑒 𝑁 (𝑑2 ) ¿
− 𝑟𝑡
𝑁 ( − 𝑑 2 ) −(𝑆 ¿ ¿ 0 − 𝐷 × 𝑒 ) 𝑁 (− 𝑑1 )¿
−𝑟𝑡
𝑝=𝑘𝑒
Lets deep dive into derivation of
Black-Scholes Model
 Brownian motion/Wiener process
• Brownian motion, any of various physical phenomena in which some
quantity is constantly undergoing small, random fluctuations.
 Wiener Process

1. We introduce the Wiener process, which is a particular type of

Markov stochastic process with-

• It has a mean change of zero

• Variance rate of 1.0 per year.

 Properties of Wiener process
Property 1: The change δz during a small period of time δt is
• A variable z follows a Wiener process if it has the following two properties:

δz=ϵ where ϵ is a random drawing from a standardised normal

distribution.
Property 2: The values of δz for any two different short intervals of
time δt are independent. It follows from the first property
that δz itself has a normal distribution with
Mean of δz=0
Standard deviation of δz=
Variance of δz=
The second property implies at z follows a Markov process
Generalised Wiener Process

Where, (which is also a constant)

+
Standard deviation
Variance of =
 The process for Stock prices

Earlier we discussed the Wiener process which assumed that the drift
rate was constant and had a constant variance rate. But this model fails
to capture an important aspect of stock prices which is the percentage
return required by an investor from a stock is independent of the stock’s
prices. This means that if investors require a return of 14% per annum
when the stock price is Rs.10, then they would also require a 14% p.a.
return when the stock price is Rs.50
• Therefore the constant drift rate assumption needs to be replaced by
constant expected return.
• Therefore, if S is the stock price at time t, the expected drift rate in S
should be assumed to be for some constant parameter µ.
• It follows that in a short interval of time which is , the expected
increase in S is The parameter of is expressed in decimal points,
which means 14% would be 0.14.
• If the volatility of the stock price is always zero the model implies that

Integrating between time zero and time T, we get

 Stock prices do exhibit volatility
• Since, stock prices do exhibit volatility, it should be assumed that
there variability of percentage return in a short period of time and is
indifferent to the stock prices.
• Thus, the standard deviation of the change in a short period of time

In a small time interval

 Example
• Consider a stock that pays no dividends, has a volatility of 30% pa and
provides an expected return of 15% pa with continuous
compounding. In this case
The process for the stock price is

Lets assume that S=$100 and time interval is 1 week or 0.0192 years (1/52)
• If S is the stock price at a particular time and is the increase in the
stock price in the next small time interval of time, then

Where is a random drawing from standardized normal distribution.

 Derivation of Black-Scholes-Merton
differential equation
Assumptions:
1. The stock price follows the wiener process developed earlier with
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 time 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 is the same for all
maturities.
We start the process by using derivation of stock prices developed
earlier.

Using discrete version,

If f is the price of the call option then the variable f must be some
function of S and t. Therefore,

The discrete version of the above equation becomes

 We can eliminate the wiener
process
• By choosing a portfolio of the stock and the derivative
The appropriate portfolio would be

It means that the holder of this portfolio is short one derivative and
long an amount shares. Let us define the portfolio as
The change in this is the change in the value of the
portfolio in the time interval

Since, and

We substitute the above two equations in

As stated in the assumptions earlier,
The portfolio must instantaneously earn the same rate of return as
other short-term risk-free securities, as earning anything more than this
would encourage arbitrageurs to make riskless profits by borrowing
money to buy the portfolio and vice-versa.
 and
We have
=
 Introduction to ITȎ’s LEMMA
• The price of a stock option is a function of the underlying stock’s price
and time.
Suppose a variable x follows ItȎ process

Where, dz is a wiener process and a and b are functions of x and t.

The variable x has a drift rate of a and a variance of b2
ItȎ lemma shows that a function G of x and t follows the process

Where the dz is the same wiener process

Thus, G also follows an ItȎ process, it has a drift rate of

And a variance rate of

 Deriving Black-Scholes formula
using Itố Lemma process
C = price of European Call option
S0= Present Underlying Stock price
T= Time to maturity
µ= mean growth rate
σ= Volatility of the stock
r = Continiously compounding risk free interest rate
Assumption:
1. S0 follows a geometric Brownian motion
2. µ, σ, r are not functions of time or S0 and therefore remain fixed for the
duration of the option’s lifetime.
C is a function of time t and the price of the asset S0 and therefore, we
use the notation,
c = f( S0,t) to represent the price of the option.

Since, the asset prices are modelled by geometric Brownian motion,

and µ, σ are constant
 Calculation of Probability that the
stock price will be above/below
strike price
• A stock price is currently $50. Assume that the expected return from
the stock is 18% and its volatility is 30%. What is the probability
distribution for the Stock price in two years? Calculate the mean and
Standard deviation of the distribution. Determine 95% confidence
intervals.
 Solution

The stock prices follow lognormal distribution. Given the stock price of $50, the expected return of

18% p.a and volatility of 30% p.a., the expected price and standard deviation of the stock after 2

years will be
0.18 × 2
𝑆 2=50 × 𝑒 =71.67

The standard deviation of the stock after 2 years will be

95% confidence interval for lognormal distribution is T

𝐼𝑛 (𝑆 𝑇 ) 𝑁 ¿ 𝐼𝑛(𝑆 𝑇 ) 𝑁 ( 4.1820 , 0.18)

Since, we know that there is a 95% probability that a Normal random
variable has a value within 1.96 standard deviations of its mean, we can say
that 95% of the time we will have:

In other words, there is a 95% probability, that the stock price in 2 years
will be between 28.5133 and 150.4496
 Binomial Tree
Assumption of Binomial tree: Arbitrage opportunity does not exist

Notations:
1) S0=Current price of the stock
2) f= Current price of the option on the stock
3) S0u= Uplevel of the stock where u>1
4) S0d = Down level of the stock where d<1
5) Percentage up move in the stock is u-1
6) Percentage down move in the stock is 1-d
7) ∆ is the number of shares in the stock to make the portfolio risk less
8) fu = Pay off from an up move = S0u-S0
9) fd= Pay off from a down move = S0-S0d or 0 which ever is applicable (depends on call or put)
----- Price of option with one step binomial tree
 Two Step Binomial Tree

Where ∆t= the length of the time step

2 step

3 step

You can extend this to many steps

 Matching Volatility with u and d

𝜎 √ ∆𝑡 −𝜎 √ ∆𝑡
𝑢=𝑒 𝑓 =𝑒 𝑎𝑛𝑑 𝑑=𝑒
− 2 𝑟 ∆ 𝑡
¿
 Options on Stocks paying
continuous dividend yield

Consider a stock paying a dividend yield of q and total returns including

dividend and capital gains in a risk neutral world is r.
Therefore, capital gains should be r-q.
Thus,

Therefore, if =Current stock price, its expected price after one time
step= which would be a result of
 Example
• A stock index is currently 810 and has volatility of 20% and a dividend
yield of 2%. The risk free rate is 5%. Calculate the value of 6 month
call option with strike price of 800 using 2 step tree.
 Key is to solve it step by step
• =

• =0 (since it becomes negative the payoff is zero)

• Now, solve the bracket first and then multiply by the outside value
• The value of the option is 53.9387
 Implied Volatility
The one parameter in the Black-Scholes-Merton pricing formulas that cannot be directly
observed is the volatility of the stock price. Traders usually work with what are known as implied
volatilities. These are the volatilities implied by option prices observed in the market.

• Implied volatilities are used to monitor the market's opinion about the volatility of a particular
stock. Whereas historical volatilities are backward looking, implied volatilities are forward
looking. Traders often quote the implied volatility of an option rather than its price. This is
convenient because the implied volatility tends to be less variable than the option price. The
implied volatilities of actively traded options on an asset are often used by traders to estimate
appropriate implied volatilities for other options on the asset.
 Underlying Nifty: 22547.55; Expiry Date: 27th February 2025
Date of capturing data: At the close of 25th February 2025
Strike Call Put Implied Volatility
Calculated
22500 101.65 34.10 17.78%
22000 566.30 2.95 66.40%

Calculate volatility if : The risk free interest rate for calculating implied volatility is 10% and
number of trading days is 246. Use both 365 and 246 to see the accuracy of the results

101.65 =22547.55 × ¿
Use EXCEL to calculate implied volatility