DERIVATION OF THE BLACK SCHOLES MODEL AND ITS IMPLICATIONS

UCSI UNIVERSITY
BY JEEVAN KUMAR & JACKSON TAM KONG WAI
B.SC. (HONS) ACTUARIAL SCIENCE

2013

ACKNOWLEDGEMENTS

First and foremost, we would like to express our sincerest acknowledgements and gratitude to our supervisor, Mr. Lim Fang Ching, for his guidance and support throughout the process of completing this research study. Mr. Lim showed his interest in the subject and his professionalism and also his patience while supervising us in this research paper. Without his supervision, this research would not have completed in such a timely and professional manner. We sincerely appreciate the guidance, encouragement and counsel that he gave to us. Next, we would like to thanks to our course mates who gave their hand to us when we meet some difficulties. Lastly, we would like to express our deepest acknowledgement to our parents who have been very supportive during our study in this course.

CONTENTS

1.0 Summary 1.1 General Introduction 1.2 Problem Statement 1.3 Research Objectives 1.4 Definition of Terms 2.0 Brief History of Options 2.1 Options Trading in Malaysia 3.0 Literature Review 3.1 Empirical Testing on Different Market 3.2 The Important Assumptions 3.3 The Advantages of Black Scholes Model 3.3.1 Implied Volatility 3.3.2 Volatility Smile 3.3.3 Volatility Skew 3.3.4 Implication of Volatility Skew for Option Pricing 3.4 Errors Implying towards the Black Scholes Model 3.5 Summary of Chapter 4.0 Methodology 4.1 Stochastic Differential Equation 4.1.1 Geometric Brownian Motion 4.2 Arbitrage 4.3 Self-Financing 4.4 Risk Neutral Valuation 4.5 Itos Lemma 4.6 Log normal Dynamics 4.7 Factors Affecting the Option Value 4.8 Black Scholes Model 4.8.1 American and European Options 4.8.2 American and European Calls 4.8.3 Solution of the Black Scholes Equation 4.8.4 Volatility 4.8.5 Historical/Empirical Method 4.8.6 Implied Volatility 4.9 Dividend Paying Stocks 4.9.1 Continuous Dividend Yield Model 4.10 Options on Futures 4.10.1 American Options on Futures 4.10.2 European Options on Futures 4.10.3 Put-Call Parity 4.10.4 Blacks Model 4.11 Binomial Model

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5.0 Findings and Analysis 6.0 Conclusion 6.1 Summary of Black Scholes Model 6.2 Volatility; Implied or Historical? 6.3 Risk Neutral Valuation 6.4 Advantages and Limitations 6.4.1 Limitation of Black Scholes Model 6.4.2 Other Similar Models to Black Scholes Model

58 60 60 61 62 63 63 65

7.0 References 8.0 Appendix 8.1 VBA Code of CRR Binomial Model in Excel 8.2 VBA Code of Black Scholes Model in Excel

66 68 68 70

1.0 Summary This present thesis The Derivation of Black Scholes Model aims at exploring and explaining the fundamental of Black Scholes Model and the various equations surrounding it. Throughout these derivations, core concepts in financial mathematics, such as Itos Lemma, arbitrage pricing, risk-neutral pricing and put-call parity are also presented. We will also introduce the immense effects and contributions of the model towards the economy, and the limitation of the Black Scholes Model that has brought many financial experts to question about its reliability. First and foremost, we will introduce the option background and point out the emergence and discussion of the research problem. In the end of this discussion a disposition of the entire process will be given. Later we will illustrate the general methodology applied in this work. The methodological design as well as methods of data collection will be discussed. Then finally the theoretical framework is presented later in the chapter where we provide more details about options and option trading, explain the origin of the Black-Scholes model, its input variables, restrictions and how it is applied. Furthermore, a summary covering the limitations of the Black-Scholes Model that results in financial crisis.

1.1 General Introduction Finance has become one of the most rapidly changing and fastest growing areas in the corporate business world. Because of this revolution, modern financial instruments have become extremely complex. Many new mathematical models have been derived but dismissed by many financial experts due to its poor applicability in the market. Some are essential to implement and price these new financial instruments. Basically, the world of corporate finance that was once controlled by the business students is now governed by mathematicians and computer scientists. Published in the Journal of Political Economy 1972, Black-Scholes Model is considered one of the biggest achiever in terms of approach and applicability. The model was developed during the early 1970s where economist Fisher Black, Myron Scholes, and Robert Merton derived the Black-Scholes option-pricing formula, which helps investors and speculators to deduce a value for call or put option. Scholes and Merton were later awarded the 1997 Nobel Prize in Economics for their contribution. Unfortunately Fisher Black died in 1995, or he would have also received the award. The Black-Scholes Model displayed the importance of Mathematics in the field of Finance and also let to the development and success of the new field of mathematical finance or financial engineering. Its biggest strength is the possibility of estimating market volatility of and underlying asset generally as a function of price and time without direct reference to specific investor characteristics like expected yield, risk aversion measures or utility functions, Besides, the model is capable of replicating itself or hedging i.e. an explicit trading strategy in underlying assets and risk-less bonds whose terminal payoff is equal to payoff of a derivative security at maturity. This means that basically an investor can continuously buy and sell derivatives by the strategy and never to incur any losses. This kind of strategy plays a part as insurance for loss in the sense that if loss is incurred in one part of the portfolio at payoff, the loss will be compensated from the gain on the other side of
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payoff. Normally referred to as dynamic hedging as it involves continuous hedging. These kind of trading strategies are normally automated. Their existence is assumed and challenged by arbitrage. An arbitrage assumes that as time goes on, money is only moved around and within the portfolio. No money is taken out or added to the portfolio almost behaves like selffinancing. Also Black-Scholes Model is built on Brownian motion which can be seen as continuous time limit of random walks. In order to answer the applicability and reliability of Black-Scholes Model, this paper focuses more on examining the use of Black-Scholes Model in the U.S. Stock Exchange Markets and some limitations of the model that has made investors question about its reliability. The empirical results shall serve as evidence to what extent the Black-Scholes Model has performed and contribute in the world of corporate finance.

1.2 Problem Statement It is assumed that the Black-Scholes Model made it possible for option traders to calculate their delta hedge and to price option. This statement is highly debatable as stocks are actively traded in the 17th century stated by Joseph De La Vega himself. Whats unique about the model is that the model claims to remove the necessity of risk-based drift from the underlying security, eventually to make the trade risk-neutral. But one does not require dynamic hedging as simple put-call parity can suffice. Basically options have deeper history than shown in the conventional literature. Forward contracts can be seen dating all the way back to Mesopotamian clay tablets dating around 1750 B.C. Gelderblom and Jonker showed that Amsterdam grain dealers had used options and forwards in the early 1550s. Early records also showed that in the late 1800 and early 1900, options were actively traded in London and New York, as well as Paris several other European exchanges. Option market it seems, were active and extremely sophisticated. Recently, the campaign against The Black-Scholes Model option pricing has raised many to question: Do we actually need the Black-Scholes Model in the first place? This is basically brief questions which critically claimed by many bankers and traders that actually cause the sudden evaporation of billions in investment funds. Black-Scholes Model was partially blamed for the subprime crisis. Essentially, the argument was raised blaming investors blindly fetch too much risk too eagerly, by having so much faith on the model. But many still oppose the argument and concluded that the model has nothing to do with todays subprime mortgage crisis. Basically, the model simply does not withstand or resists any wear or criticism. Financial prices tend to jump and bring about a volatility that is not constant. The key strategy behind the model is basically known as dynamic hedging, a mathematical formula for constructing a

portfolio made up of underlying assets and cash that will theoretically mirror the op tions value at any given time. Unfortunately, as much convincing the model has been, its application simply not feasible in the real world. Veteran traders and best-selling authors Nassim Taleb and Espen Haug criticize the model saying that: It was not used (even by those who think they have used it), it wasnt needed, and it wasnt original in the first place.

1.3 Research Objectives Main objective of this study is to derive and explain the birth of the model alongside with its contributions towards the world of corporate finance. The problems are addressed by performing empirical testing on the performance of Black-Scholes Model that commonly used for pricing options. The empirical study basically conducted to perform the usage of the model in real life stock exchange under the U.S. stock markets. Stocks under the U.S. markets will be randomly selected and calculated to derive an option price using the BlackScholes Model. Should the model perform poorly, this study will analyze all the side effects of the model and look into other alternatives if possible. A probable pricing bias includes stock strike price, time to maturity, volatility of respective underlying share, and risk free interest rate. Basically the model may over or under perform based on respective probable pricing biases.

1.4 Definition of Terms For the purpose of this study, the following terms need some clarification Option The right but not an obligation, to buy or sell something at some time in the future at a given price. Options are trading based on some underlying assets such as stocks, bonds and index funds. Currently, options are not available in Malaysia but they are available in the U.S. markets. Call Option The right but not an obligation to buy a particular good at an exercise price. Put Option The right but not an obligation to sell a particular good at an exercise price. Warrants A long term call options written on a specified number of ordinary shares by Issuer Company and traded on an organized exchange. Call Warrants A relatively new type of financial instrument introduced to the KLSE. A short-term call options (Not more than 2 years) that can be issued by a third party entity specified in the Security Commission guidelines based on existing shares. Futures Dealing in futures means having the right to buy or sell a financial instrument at an agreed price at a future date. In Malaysia, the popular futures product traded in the market are: KLCI Futures (FKLI) and Crude Palm Oil Futures (FCPO). In other countries, the future commodity market includes wheat, corn, soybeans, gold, silver, and so on. Exercise Price or Strike Price The fixed price at which the good may be bought or sold. American Option An option that can be exercised on any day up until the expiry date. Pseudo-American Option An option that can be exercised on a future specified date up to its expiry date.

European Option An option that can be exercised on the last day of the option. Premium The cost of an option

The General Market The Dow Jones Industrial Average (DJIA) It consists of 30 widely traded stocks such as Microsoft and Wal-Mart in the US. The Nasdaq Composite It is the house of most but not all the technology stocks in America. It has over 4000 innovative and fast growing high-tech companies. The Hang Seng Index (HSI) It consists of 33 blue chips stocks in Hong Kong stock market. The Straight Times Index (STI) STI also consists 30 widely traded stocks in Singapore. The Nikkei 225 Index (NI) This index consists of 225 top-tier Japanese companies in the Tokyo stock exchange. The FBM Kuala Lumpur Composite Index (KLCI) 30 blue chips stocks that are traded in Malaysia. The Future Kuala Lumpur Index (FKLI) The KL futures can act as a guide to where the KLCI is heading.

2.0 Brief History of option Options trading can be traced back to 332BC where during that time, a man known as Thales bought the rights to buy olive prior to a harvest, reaping a fortune. Options then turned up again during the tulip mania of 1636 where options on tulips were widely purchased in order to speculate on the rising price of tulips. At the end of the seventeenth century in London, a market was formed to trade in both call and put options. That was the first instance of trading both call and put options over an exchange. By 1872, Russel Sage introduced Over the Counter call and put options trading to the United States which was unstandardized and illiquid. The emergence of options trading today comes with the setting up of the Chicago Board of Options Exchange (CBOE) and the Options Clearing Corporation (OCC) in 1973 where standardized exchange traded call options were introduced. By 1977, put options were also introduced by the CBOE and since then, options trading took on the standardized exchange traded form that we are familiar with today.

2.1 Option Trading in Malaysia Options trading are relatively new in Malaysia. Bursa Malaysia Derivatives currently offers the trading of options contracts in Malaysia. An option is a financial derivative that derives its value from its underlying instrument. This could be in the form of a stock, stock indices, commodities, and debt instruments or futures contracts. For example, the options being offered by Bursa Malaysia Derivatives is an index option with the FBM KLCI as its underlying instrument. In Malaysia, FBM KLCI options is the only option being traded on Bursa Malaysia Derivatives and it is an option on FBM KLCI index, which can be thought of as the trading of a portfolio of shares that tracks our local

share market. However, as index options usually exclude dividend payments and voting rights, they are not considered an exact substitute for actual ownership of the shares. The FBM KLCI, the underlying asset for the FBM KLCI options, is the weighted average market capitalisation of 30 largest Malaysian companies listed on the Bursa Malaysia by full market capitalisation. To trade the option, bids and offers are entered into the automated system by exchange members and the transaction is executed when a match is made.

3.0 Literature Review A review of related literature is compiled to compare the knowledge of financial economists, compensation professionals, option traders, academics and other experts in the area of Black Scholes Model as to option pricing. The review will indeed serve as a path to compare and contrast the views of experts and eventually provide an abstract framework for the study.

The Model with hedging errors Throughout the research, Black Scholes Model is associated with hedging errors. The formula relates for a lag resulting from the non-simultaneous trading in the option and its underlying asset when implementing the hedging portfolio. The lags may largely affect problems of liquidity in the market place The extended Black Scholes model with lags and hedging errors, International Journal of Banking and Finance

Self-Financing? The Black Scholes Model is considered to be a self-full filling prophecy quoted by Cherian and Jarrow (1994). The formula basically relies on few unrealistic assumptions, which the primary assumption was the transaction cost that was thought to be zero. In reality, transaction cost cannot be avoided alongside with the volatility in the market. But yet option prices in the real world are remarkably close to those predicted by the model. One main possibility could be the mass use of this model by traders as a working assumption for their option pricing - Black, Merton and Scholes: Their work and its consequences

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Black Scholes Model revealed that, under certain assumption on the random sequence {Rt} and for a certain value of Xo, it is possible to find a policy such that Xt = St. The value Xo then regarded as a fair price for Po for option at time 0. Under these conditions, the contract is self-financing and risk free to the buyer and seller On the Structure of Proper BlackScholes Formulae, Journal of Applied Probability, Vol. 38, Probability, Statistics and Seismology (2001), pp. 243-248

The beginning of the model Black and Scholes model claimed that in many cases their famous model could be used as an approximation to give an estimate of the option value. The Chicago Board Options Exchange (CBOE), the first public options exchange, started trading in April 1973, and by 1975, traders on the CBOE were using the model to price and hedge their option positions. Ever since the model was widely introduced, thousands of traders and investors use the formula everyday, noted by the Nobel committee (Marsh & Kobayashi, 2000). Making it more simple and conventional, it was widely used in those personal computer days that Texas Instruments sold a handheld calculator specially programmed to produce Black-Scholes options prices and hedge ratios Application of Option Pricing Theory: Twenty Five Years Later In the Malaysian context, Malaysia Derivatives Exchange Bhd (MDEX) and KLSE-RIIAM Information System (KLSE-RIS) has inserted a Black-Scholes Option Pricing Model Calculator in their respective website for investors convenience in checking out BS price. KLOFFE (before MDEX) has become the first exchange to provide Black-Scholes Model calculator over internet in Southeast Asia, beginning 16th April 2001. Table below shows a list of local institutions that often apply the Black-Scholes Model to value Malaysian warrants and advise investors. The model brings forward a great impact to Malaysian equity
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warrant investors since it is widely used as equity warrant evaluator by local research institutions and securities firms.

List of Local Institutions/ Publications that Apply Black-Scholes Model

TA Securities Kenanga Research AmSecurities GK Goh Research AMS Research

RHB Research Institute Affin Securities iCapital.biz Malaysian Business Dynaquest's Monthly Digest

3.1 Empirical Testing on Different Markets There have been an enormous number of empirical tests on the Black-Scholes model. The size of the option market and especially the difference in size between the U.S., Japan as well as emerging markets in Asia, and Malaysia in particular is interesting from the viewpoint of researchers. Empirical researches on call options traded on developed market in the U.S. include Macbeth and Merville (1980), Rubinstein (1985), Lauterbach and Schultz (1990), Leonard and Solt (1990), and Hauser and Lauterbach (1997). Macbeth and Merville (1980) and Rubinstein (1985) reported actual call option prices on the U.S. market tend to trade above their Black-Scholes values when the options are out-of-the money and below their Black-Scholes values when the options are in-the-money.

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3.2 The Important Assumptions The Black Scholes Model has a huge breakthrough in the pricing of stock options. It had a huge influence on the way that traders price and hedge options (Hull, 2006). The Black Scholes Model is based on few simplified assumptions (Blacks & Scholes, 1973) First and foremost, stock price follows a random walk in continuous time with a variance rate proportional to the square of the stock price. Basically todays price will reflect corresponding to todays news and information in the stock market. Thus the distribution of possible stock price at the end of any finite interval is log-normal. The variance rate of return on the stock is constant. The short term interest rate is known and constant through time. The option is European, means it can only be exercised at maturity. The stocks pay no dividend or other distributions (The model was later adjusted) There are no transaction costs in buying or selling the stock or the option. It is possible to borrow any fraction of the price of a security to buy it or hold it, at the shortterm interest rate. There no penalties to short selling. A seller who does not own a security will simply accept the price of the security from the buyer, and will agree to settle with the buyer on some future date by paying him/her an amount equal to the price of the security on that date.

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3.3 The Advantages of Black Scholes Model Based on the these underlying assumptions, the BS model says that the price of an option is a function of the current stock price S, exercise price K, risk-free interest rate r, time to expiration t, stock price volatility . Therefore, the BS model requires little information to price options, and the computational demands of the model are quite modest. Derman and Kani (1994) assert that the main appeals of the BS model are its simplicity and ease of implementation.

3.3.1 Implied Volatility All parameters in the Black-Scholes model, except the volatility of stock price, can be directly observed from the market data and the terms specified by option contracts. Therefore, if market price for a particular option is available, the market-based estimate of the stock price volatility can be obtained by numerically inverting the BlackScholes formula, yielding the implied volatility (Huang and Chen, 2002). It is the implied volatility that makes the option value derived from the BS model equal to its market value (Chriss, 1996). If the BS model is correct, the implied volatility should provide a measure of the expected volatility of the underlying asset over the remaining life of the option contract (Chriss, 1996). Nowadays many traders quote options market prices in terms of the implied volatility (Derman and Kani, 1994).

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3.3.2 Volatility Smile The volatility smile is the way in which implied volatility varies with strike price for options of a fixed expiration. (Chriss,1996:341) Today the volatility smile has become a remedy of testing the validity of the Black Scholes model by seeing if the implied volatility is actually independent of strike price as assumed by the BS model (Chance, 2004b)

Implied Volatility Smile As mentioned earlier, the fundamental assumption going into the Black Scholes Model is that the stock prices move with the constant volatility, consequently the implied volatilities obtained by numerically inverting the Black Scholes formula should be exactly the same for options on the same underlying with the same maturities but with a different strike prices (Rubinstein, 1994). Therefore, if the Black Scholes model is correct, the implied volatility smile should be flat and basically this statement is supported by some empirical evidence. For example, Rubinstein in 1994 reported that, whole not strictly true, S&P 500 index options on the same underlying with the same underlying with the same maturity tended to have the same implied volatilities across different exercise price before 1987.
Figure 1: Implied Volatility Smile

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3.3.3 Volatility Skew Rubinstein (1994) later then discovers that in practice the flat volatility smile has been rarely observed since the stock market crash in October 1987. The graph of implied volatility as a function of strike price for the identical options has tended to depart from the flat volatility smile since the 1987 crash. As Chriss (1996: 328) states, implied volatilities change from strike to strike and from expiration to expiration, and there is a recognizable pattern for these changes. When first observed, the implied volatilities were u-shaped in equity market, giving appearance of a smile as exhibited in Figure 1. Hence this pattern was named volatility smile. The volatility is relatively low for at-the-money options and becomes progressively higher as an option moves either in-the-money or out-of-the-money (McDonald, 2006).

Figure 2: Volatility Skew

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3.3.4 Implications of volatility skew for option pricing Volatility skew implies that the Black Scholes formula frequently misprices the in-the-money and out-of-the-money options (Derman, 2004). Option values calculated by the Black Scholes model increases as volatilities of the underlying assets rises (Dupire, 1994). From other perspective point of view, options that are traded at a higher implied volatilities are more expensive, assuming all other things being equal (Huang and Chen, 2002). Due to the negative relationship between exercise price and implied volatility, the implied volatility rises as strike prices fall, and accordingly options values go up due to the increased implied volatility. When the level of the implied volatility is higher than the flat smile assumed by the Black Scholes model, the out-of-the-money puts are priced more expensive than the Black Scholes model predicts (Chriss, 1996). Conversely, implied volatilities drop as strike prices rise, consequently the option values goes down due to the decrease in volatility. Once the implied volatility fall below the flat smile assumed by the Black Scholes model, the out-of-the-money puts (and the in-the-money calls) are less expensive than the values arising from the Black Scholes model (Chriss, 1996).

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3.4 Errors implying towards the Black Scholes Model

The model assume constant volatility The most significant assumption is that volatility. Volatility is the measure of how much a stock can be expected to move in the near-term or short term, is a constant over time. While volatility can be relatively constant in very short term, it is never constant in longer term. Some advanced option valuation models substitute Black-Scholes constant volatility with stochastic-process generated estimates. The Black-Scholes model assumes that the underlying prices follow the geometric Brownian motion. The probability distribution of stock return is normally distributed and the stock price is independent of all the previous trading. In this case, each trade contributes to the overall volatility in the same way.

McDonald (2006) argues that the Black Scholes model fails to consider all of the factors that enter into the pricing of an option. This model only accounts for the stock price, the exercise price, time to expiration, the dividends, and the risk-free rate. Therefore, the implied volatility is more or less a catch, capturing whatever variables are missing and thus causing the model is improperly specified or blatantly wrong.

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According to Rubinstein (1994), the constant volatility Black-Scholes model will fail under any of the following five violations:

1. The local volatility of the underlying asset is a function of the concurrent underlying asset price or time. 2. T he local volatility of the underlying asset depends upon the prior path of the underlying asset price. 3. The local volatility of the underlying asset is a function of a state-variable which is not the concurrent underlying asset price or the prior path of the underlying asset price. 4. The underlying asset price changes with large jumps. 5. The market has imperfections such as significant transactions costs, restrictions on short selling, taxes, non-competitive pricing and etc.

Interest rates constant and known

Same as volatility, interest rates are also assumed to be constant in the Black-Scholes model. The Black-Scholes model uses the risk-free rate to represent this constant and known rate. In the real world, there is no such thing as a risk-free rate, but it is possible to use the U.S. Government Treasury Bills 30-day rate since the U. S. government is deemed to be credible enough. However, these treasury rates can change in times of increased volatility.

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Wrong assumption on return distribution

The Black-Scholes model assumes that the percentage changes in assets prices are log normally distributed (McDonald, 2006). However, the volatility smile (or skew) indicates that this assumption is not true. As Lekvin and Tiwari (2001) points out, logarithmic percentage changes in underlying prices follows non-normal distribution, leading to the existence of the volatility smile. Jackwerth and Rubinstein (1996) also believe that the Black-Scholes model fails to capture the true nature of stock return distribution which is characterized by excess kurtosis and negative skew.

There has been much literature documenting excess kurtosis and negative skew in stock return distribution. On the one hand, empirical evidence shows that, in equity markets, center peak of the stock return distribution is much higher, that is, the real return distribution has greater kurtosis than the lognormal distribution (Cox and Ross, 1976; Merton, 1976; Jarrow et al., 1977). On the other hand, large negative stock returns are much more common than large positive ones, so stock return distribution should be negatively skewed. This phenomenon is also called contemporaneous asymmetry. This negative skew, or contemporaneous asymmetry, reveals up clearly in the pattern of extreme moves in stock prices in the postwar period (Campbell and Hentschel, 1992). For example, of the five largest oneday movements in the S&P 500 index since World War II, four were declines in the index and only one was increase (Cutler et al., 1989). Ignoring asymmetries in return distributions, such us negative skew, can lead to underestimation of risk and thus the incorrect pricing of financial instruments such standardized option contracts.

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Several explanations for the excess kurtosis and asymmetry in stock returns have been provided. The first and perhaps most well- known explanation is the leverage effect (Christie, 1982). According to the leverage effect hypothesis, the drop in the market value of the firm following bad news increases the operating and financial leverage and thus increases the volatility of the subsequent returns. Financial leverage is measured by the ratio of debt to equity, referring to the extent that a firm is financed by borrowed funds (Brealey et al., 2006). It is used to measure the risk to shareholders arising from the firms capital structure. Firms with higher financial leverage may be at higher risk of bankruptcy due to the high level of borrowed funds in the firms capital structure, which increases the volatility of the stock return. As Christie (1982) points out, the volatility of stock return is an increasing function of financial leverage. Likewise, operating leverage refers to the division between fixed and variable costs. Firms with greater amount of fixed as opposed to variable costs are said to have high operating leverage (Brealey et al., 2006). It is not easy for these firms to reduce costs in response to falling sales. Hence, compared with firms with low fixed costs, these firms are facing relatively higher risk and accordingly the firms stock return is subject to higher volatility. Christie (1982) has found that stock volatility has strong positive relationship with operating leverage. All in all, the higher financial or operating leverage leads to the larger volatility of stock returns and thus higher risk, resulting in greater probability to earn negative returns and thereby making the return distribution negatively skewed (Lev, 1974). However, it has been contended that the leverage effect cannot fully explain the observed asymmetry in the stock return distribution. In particular, the leverage effect seems to be the case for daily or more frequent return data (Schwert, 1989).

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Pindyck (1984) claims that the volatility feedback theory can explain the negative skewness and excess kurtosis in stock return distribution as well. This theory relies first of all on the well-documented fact that the stock volatility is persistent (Pindyck, 1984). It seems plausible that changes in volatility have important effects on the stock returns (French el al., 1987). The increase in volatility makes the stock less attractive, and therefore pushes its price down. This hypothesis states that the significant news, good or bad, increases the volatility of a stock and hence its risk premium, which in turn magnifies negative returns and reduces positive returns (Campbell and Hentschell,1992).

To sum up, the arrivals of large piece of good or bad news increase the volatility of stocks and hence their risk premium. As a result, negative returns are magnified while positive returns are shrunk, leading to stock return distribution with excess kurtosis and negative skewness. However, Poterba and Summers (1986) question the plausibility of this volatility feedback hypothesis as volatility changes in the market generally are too short-lived to affect stock return distribution.

In addition, negative skew can also be explained by stochastic bubbles hypothesis (Blanchard and Watson, 1982). When stock market bubble takes place, the stocks are traded in high volume and prices are considerably overvalued. Consequently, the market bubbles are usually followed by a sudden drop in prices, known as market crash or bubble burst. The volatility is typically higher after the stock market falls than after it rises, resulting in higher risk in the market crash and hence more negative return. In one word, the stock return

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distribution with negative skewness might be generated by the popping of stochastic bubbles which creates substantial loss in the market.

Assumption on price movement The Black-Sholes model assumes that the prices of the underlying assets change smoothly with no jumps, but extreme stock movements are more common than would be expected from the log normally-distributed stock return as assumed by the Black Scholes model. Therefore, the Black Scholes model fails to capture the true nature of stock price movements which are observed to have discrete jumps. Price jumps always arise from the arrival of new information, such as takeover attempt, verdict in an important lawsuit, earnings announcement, and so on. The existence of large price movements leads to the excess kurtosis in the stock return distribution

Suppose a piece of important news due in a few days and the stock price is expected either to rise or to fall. Thus a single jump in stock price can be anticipated. According to Hull (2006: 384), in this case, The probability distribution of the stock price might consist of a mixture of two lognormal distributions, the first corresponding to favorable news, the second to unfavorable news. The true probability distribution is bimodal (certainly not lognormal). The situation is illustrated in figure 3. The solid line shows the mixtures of lognormal distribution for the stock price, which is the true return distribution. The dashed line demonstrates the lognormal distribution with the same mean and standard deviation as the true distribution. As can be seen, the true probability distribution has higher kurtosis than the lognormal distribution. Bollerslev

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(1987) asserts that large price movement is always followed by greater amount of gain or loss than usual, which can explain the excess kurtosis in the bimodal distribution.

Figure 3: Effect of a single large jump on return distribution

Source: Hull, J. (2006) Options, Futures and Other Derivatives. 6th ed. Upper Saddle River: Pearson/Prentice Hall. Pp.384

Wrong valuation of risk-neutral

The primary feature of Black-Scholes model is that the values of contingent claims do not depend upon investors risk preference. As Bodie et al. (2006) point out; the Black-Scholes model is based on the risk-neutral valuation and assumes that all the investors in such riskneutral world are indifferent to risk.

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Figure 4 illustrates that the observed volatility smile for equity options is downward sloping and thus deviates from the flat volatility smile. The negative volatility skew indicates that investors pay higher price for the options with low strike prices because they have higher implied volatility than suggested by the Black-Scholes model. As shown in the Figure 4, it is interesting that the pattern of negative volatility skew has existed only since the stock market crash of October 1987. Implied volatilities were much less dependent upon strike price prior to October 1987. This phenomenon led Rubinstein (1994) to argue that one reason for the volatility skew may be so-called crashophobia. That is, traders are concerned about the possibility of another market crash similar to the October 1987, and they price options like risk-averse investors. There is some empirical support for this explanation. Declines in the S&P 500 tend to be accompanied by a steepening of the volatility skew. When the S&P increases, the skew tends to become less steep (Hull, 2006: 381). In summary, traders are risk-averse, rather than risk-neutral.
Figure 4 Volatility skew for put option before and after 1987 crash

Implied Volatility %

Downward-slopping volatility skew Data from put price after 1987 crash

Flat volatility smile

Strike Price Source: The Sardonic Smirk: The Volatility Smile and the Asymmetry of Risk.

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For example, after 1987 crash, the out-of-the-money puts with lower strike prices have higher implied volatilities and thus higher option value than the prediction made by the Black Scholes model which assumes the flat volatility smile.

Existence of arbitrage opportunity The most popular explanation for the volatility smile to date is the erroneous assumption in the Black Scholes model regarding the log normally distributed return of underlying assets. Hence it is said that, if the implied volatilities were calculated by the correct option pricing model based on the right distributional assumptions, volatility smile would disappear and the implied volatility would become flat (Bates,1996; Jackwerth and Rubinstein, 1996). In fact, it is extremely difficult to derive the correct model because the arbitrage opportunities do exist in the real world and are very hard to be incorporated into the option pricing model (Das and Sundaram, 1999; Ederington and Guan, 2002). So the ideal assumption concerning no arbitrage activities in markets threatens the reliability of the Black Scholes model.

However, Ederington and Guan (2002) find that such trading strategy based on the Black Scholes volatility smile yields substantial returns. On the one hand, profits generated by such trading strategy should vary randomly around zero on the presumption that the true volatility smile is flat and the observed volatility skew arises from the erroneous distributional assumptions, but the actual profits vary roughly in line with the Black Scholes models
26

predictions (Ederington and Guan, 2002). Profits are high when the Black Scholes formula predicts they are high and low when Black Scholes model predicts they are low. This finding suggests that there are arbitrage activities in the markets. On the other hand, the trading profits are not as great as the Black Scholes formula predicts, suggesting that the true smile is indeed flatter than the observed volatility smile but not flat. Such divergence between the reality and theory may be due to deficiencies in the Black Scholes model, such as the erroneous assumptions that volatility is constant and that returns are log-normally distributed (Ederington and Guan, 2002: 10).

In addition, based on the Black Scholes model, an important relationship between the call value and put value can be derived as follows:

Where C and P denote the call and put option value respectively, K refers to the strike price, r is the risk-free interest rate, T represents the time to maturity and S0 stands for the current stock price.

The relationship is known as put-call parity. It shows that the value of European call with a certain strike price and expiration date can be deducted from the value of a European put with the same strike price and expiration date, and vice versa (Hull,2006). If the equation does not hold, there are arbitrage opportunities in the market. Unfortunately, numerical studies have reported that there are frequent and substantial violations of put-call parity involving

27

both overpricing and underpricing of calls or puts (Wilson and Fung, 1991; Kamara and Miller, 1995; Klemkosky and Resnick, 1979). Because the actual put or call prices do deviate from the parity price in the real world, opportunities exist for investors to set up a riskless arbitrage position and earn more than the risk-free rate of return (Klemkosky and Resnick, 1979). The worse is that, almost two thirds of these arbitrage activities result in loss (Kamara and Miller, 1995). Therefore, it can be said that the assumption of no-arbitrage opportunity is unrealistic and weakens to the accuracy of the option value calculated by the Black Scholes model.

The model only assumes for European Option The model only assumes European-style options which can only be exercised on the expiration date. Where else, American style options can be exercised at any time during the life of the option, making the American options more valuable due to their greater flexibility in exercising their maturity.

No commissions and transaction costs and liquidity of the market The Black-Scholes model assumes that there are no required fees for buying and selling options and stocks and no barriers for trading. This seems ridiculous because parameters such as this could not be avoided in the real world of market trading. Besides the model also assumes that the markets are perfectly liquid and it is possible to purchase or sell any amount of stock option or their fractions at any time given.

28

3.5 Summary of chapter The Black-Scholes formula, the most commonly used option pricing model today, follows some ideal assumptions. First, asset prices follow geometric Brownian motion with constant volatility and the asset returns are log normally distributed. Second, the Black-Scholes model is based on risk-neutral valuation, assuming that all the traders are indifferent to the risk. Last but not least, the Black-Scholes model assumes that the arbitrage opportunities do not exist in the real world.

Implied volatility can be obtained by numerically inverting the Black-Scholes formula. Since assumption of constant volatility goes into the Black Scholes model, the implied volatility should be the same for all options on the same underlying assets. In fact, implied volatilities for the equity options with the same expiration date but different strike prices consistently differ, often displaying a persistent negative skew pattern on a graph. The existence of volatility skew suggests that the Black-Scholes model is not a perfect measure to price option due to its unrealistic assumptions.

The most popular explanation for the existence of the volatility skew is that it is due to erroneous assumptions in the Black Scholes model regarding the constant volatility and the log normally distributed return. On the one hand, the local volatility of the underlying assets may be a function of state variables such as asset price, time, etc. And asset price do experience discrete jumps. So the assumption of constant volatility is unrealistic. On the other hand, empirical evidence shows that the true stock return distribution is characterized by excess kurtosis and negative skew, which can be explained by leverage effect, volatility

29

feedback hypothesis and stochastic bubbles hypothesis.

Moreover, traders are willing to invest in stock and simultaneously purchase put option on that stock as insurance against the stock price declines, which bids up the value of put options with lower strike price. In other words, investors have great fear of market crash stating they are risk-averse, rather than risk-neutral as assumed by the Black-Scholes model.

A complementary explanation for the volatility smile is that it is due to the failure of the noarbitrage assumption of the Black Scholes model. The trading strategies based on the volatility smile, namely, buying options at or near the bottom of the B-S smile and selling options at or near the top of the smile, do make profits. In addition, empirical evidence shows that there are substantial violations of the put-call parity in the real world, indicating that arbitrage opportunities exist for investors to earn riskless return.

30

4.0 Methodology 4.1 Stochastic Differential Equation A stochastic differential equation or SDE is a differential equation which one or more of terms is a stochastic process, hence resulting in a solution which itself a stochastic process. The SDEs capable of modeling the randomness of the underlying asset in financial derivatives. They are utilized throughout pricing derivative assets because they produce rather a conventional model on how an underlying assets price changes in respect to time. Basically, the randomness of the underlying instrument is essential, when traders have the desire to eliminate or take the risk, finally leading to the existence of derivative assets. Let be the price of a security. We would be interested to know , the next instants

incremental change in the security price. The dynamic behavior of the asset price in time interval can then be represented by the SDE, which is ( Where ) ( ) , )

is an innovation term in representing unpredictable events that occur during the , ( ) is the drift parameter and ( ) is the diffusion parameter

infinitesimal interval

which depend on the level of observed asset price stochastic environment as the evolution of the asset price

and on the time . SDEs are vital in at time contains uncertainty.

31

4.1.1 Geometric Brownian motion If ( ) is a Brownian motion with drift rate

( )

and variance rate

, the process * ( )

+ represents the geometric Brownian motion, or also known as the exponential

( )

Brownian motion, or the log normal diffusion. The mean is given by , ( )while the variance is , ( )( )

4.2 Arbitrage Arbitrage is a trading strategy that involves two or more securities being misplaced relative to each other to realize a profit without taking risk. In practice, arbitrage opportunity are normally rare, short-lived and therefore immaterial with respect to the volume of transactions. Therefore, the market seemingly does not allow risk free profits. The primary tools used to determine the fair price of a security or a derivative asset relies on no arbitrage principle. It is a fundamental assumption about the market. The no arbitrage principle is that a portfolio yielding a zero return in every possible scenario must have a zero present value. Any other value would imply arbitrage opportunities, which one can realize by shorting the portfolio if its value is positive and buying it if its value is negative. If one makes risk free profit in the market, then arbitrage opportunities do really exist and it implies that the economy is in state of disequilibrium. An economic disequilibrium is a situation in which there is a mispricing in the market and investors trade. Their trading

32

causes prices to change, moving them to new economic equilibrium. The mispricing is corrected by trading and arbitrage opportunities no longer exist.

4.3 Self-financing strategy This is a trading strategy in which the change in value of a portfolio is a result of a change in the value of the underlying asset and not due to the change in the portfolio structure. Lets just say that we have units of a stock and units of a bond , therefore the portfolios value is

This strategy is self-financing only if

and

. We therefore have

readjusted the portfolio while the prices have remained the same, and the total value has not changed.

4.4 Risk Neutral Valuation Basically is an assumption that the world is risk neutral while having the valuation of derivatives. A risk neutral world is where assets are valued solely in terms of their expected return. The return on all securities is the risk free interest rate all individuals are indifferent to risk. Thus the risk neutral valuation principle is rather vital in option pricing. Indeed it implies that all the expected return must be zero. Therefore, derivative prices are determined by the expected present value payoff. We make an assumption that the world is risk neutral state and the price obtained is correct, not just in a risk neutral world but also in the real world.
33

4.5 Itos Lemma In stochastic calculus, Itos lemma or Itos formula, is the extension of the chain rule of ordinary calculus and contributes a very vital role in mathematics. Speaking to the fact, the importance of Itos lemma in finance cannot be exaggerated widely. There are several versions of Itos lemma, but this paper focuses more on the Itos lemma on Brownian motion. Itos Lemma for Brownian motion Let ( ) be a function of t, which satisfies the stochastic differential equation

(
Where ( ) and (

) are deterministic functions of x and t, and z represents a standard

Brownian motion. Let ( ) be a twice continuously differentiable function of x and t. ( ) 0 ( ) ( ) 1 ( ) ( )

Here

means

means , and

means

Thus, the above formula actually referred to as Itos Lemma or Itos formula The non-rational derivation of the Itos lemma derived using the Taylors expansion to expand in the second order and replace with ( ) ( ) ,

( )
34

( ( ( ) )

) ( (

( )

) ( )

( ) )

( (

) ( )

Throughout the calculation, we just ignore the ( ) and with , then equation will be ( ) ( ) ( )

terms and later replace (

If a variable ( ) follows a geometric Brownian motion, it follows the stochastic differential equation of the form ( And the Itos lemma for function ( 0 ) as 1 )

Where

and

are constants. ) , then

If a stock price, S follows a random process in (4.3). Let (

(
35

Substituting (4.4) into (4.3), we eventually get ( ) . /

Judging from above,

is a Brownian motion with drift parameters .

/ and variance

Integrating the expression above from of the stock price. ( ) .

to , we extract an explicit formulation for the evolution

( )

( )

, ( )

( )-

And

,(

where

Therefore, the stock dynamics follows a lognormal distribution.

4.6 Lognormal Dynamics The rate of return of a stock can be presented as ( )

where

As time passes by an amount of down by a random amount of

, the rate of return changes by

, and also jumps up and

. By making the time interval smaller and smaller, as , the above equation

, the random process becomes a continuous process. Taking can be expressed as

36

We then denote the right hand side of (4.5) by ( ( ) , write )

The variable

is known as the drift rate.

as

Logarithm of

is normally distributed. Therefore, the distribution of

is lognormal. The

lognormal distribution implies the following advantages A lognormal distribution variable only takes on positive values , normal distribution which has both positive and negative values. It is mathematically amenable as we can derive solutions for values of options. It exhibits a skew with its mean and median. The stock dynamics will be treated as log normally distributed with specified mean and variance. ) compared to

4.7 Factors affecting the option value The primary determinants of an option are the current stock price , interest rate . Strike price , expiration date , stock price volatility , and the dividend expected during the life of

the option. It is also crucial to identify whether the option is an American or European style option.

37

Increase in , means a higher intrinsic value if the call was in the money and hence higher the premium, and vice versa for a put option.

Increase in

raises the intrinsic value of a put while lowering the intrinsic value of a call.

The longer the time spans of an option, the greater the chances that it will be possible to exercise the option profitably.

The higher the volatility, the greater the movement in the price of the underlying instrument, the more valuable the option is.

Dividend

payment reduces the , thus increasing the probability for a call option to be

out of money, making the option less valuable. The reverse applies to put option having to be in the money. The increase in interest rate reduces the present value of the exercise price for the option. A call option gives someone the right but not an obligation to buy a particular good at an exercise price and higher degree of discount means more valuable the right is. Similarly, for put option the right becomes less valuable due to the low interest rate.

Table 4.1: A summary of the general effect of each of the six variables Factor Strike Price, Spot Price, Interest Rate, Time to maturity, Volatility, Dividend, Call Option Decrease Increase Increase Increase Increase Decrease Put Option Increase Decrease Decrease Increase Increase Increase

38

4.8 Black Scholes Model In 1973, Fisher Black and Myron Scholes formulated and solved the partial differential equation governing the behavior of the contingent claims and this changed the general view of pricing derivatives as financial instruments Under the assumptions of lognormal dynamics of derivatives, Fisher Black and Myron Scholes together with Merton developed their European option pricing model. Under their model, they made a few assumptions Stock prices exhibit the following properties: Continuously compounded returns are normally distributed Volatility is constant Future dividends are known

No transaction costs of taxes. No risk free arbitrage opportunities exist. Risk free interest rate, is known and constant.

Short-selling is costless, and the interest rate on borrowing is the risk free rate. There are no restrictions on the amount of the underlying asset investors can hold.

39

Let a stock price follows ( where is the trend, is the volatility and follows a Wiener process. Now, suppose that ) is

the price of a call option and other derivative contingent on . The variable function of and . Hence, by Itos Lemma 0 The discrete versions of ( ) and ( ) are 1

must be some

( 0 The Wiener process of underlyings 1 (

) )

and

is the same and can be carried off by choosing an

appropriate portfolio of the stock and the derivatives. We therefore choose a portfolio of

We short one derivative and long an amount portfolio and we have

of shares. We then define

as the value of the

The change in

in the value of the portfolio in the interval

is given by

40

( Substituting ( ) into( , ), we eventually retrieve (

The portfolio is now risk less due to the elimination of the

term. The portfolio must then

earn a return similar to the other short term risk free securities. Therefore ( Where is the risk free interest rate. Substituting ( 0 1 , ) and ( ) into( ), we obtain ( ) )

Finally we have ( )

This is the famous Black-Scholes-Merton differential equation. Solving the partial differential equation in ( ) gives an analytical formula for pricing the

European style options. European options can only be exercised at the maturity date. The American style options can be exercised anytime up to the maturity date. Thus the analytical formula we will derive is not appropriate for pricing them due to this early exercise privilege.

41

4.8.1 American and European Options American options are almost similar to European options except that American option allows an early exercise privilege. Considering if we know the price of a European option, we can price the parallel American option by determining the impact of early exercise privilege. Therefore, the value of the right to exercise before expiration is also known as early exercise premium. Thus the American option must be worth at least as much as the European option. ( ( Where the American and European Puts The respective American and European lower boundary conditions that are determined by the free arbitrage free option prices are ( ( ) )
( )

) )

( (

) ) and ( )

The upper boundary conditions are ( ( ) )

( )

42

The price difference between American and European options hugely depends on the extent to which the option is in-the-money, the interest rate and the time remaining. The early exercise of an American put casts aside the value of waiting to see how stock prices evolve. For an American put on a dividend paying stock, the optimal time to exercise is basically immediately after the dividend payment. Dividend payment reduces the value of the stock and this forces the put further into-the-money. A put option when held in conjunction with the stock insures the holder against the stock price falling below the certain level. However, it may be optimal for investors to forgo this insurance and exercise early in order to realize the strike price immediately. But, it is also optimal to exercise a put before maturity date on a non-dividend paying stock.

4.8.2 American and European Calls For a non-dividend paying stock, early exercises is never optimal and the price of an American call holds the exact values as its European counterpart. The respective lower boundary and upper boundary conditions are given by ( and ( ) ( ) ( ) )
( )

If the underlying stock pays a dividend, it is rather wise to actually exercise early, and basically an American call can worth more than the European call. The early exercise should occur immediately before a dividend payment as a dividend payout lowers the current stock price and this in turn lowers the call intrinsic value.

43

The American call on a non-dividend paying stock should not be exercised early as the call option behaves like insurance to the holder against the stock price falling below the exercise price. This insurance fells when the option is exercised. The latter the strike price is paid out, the better for the option holders

4.8.3 Solution of the Black Scholes Equation The restriction here given here is ( ) ( ). The lower and upper boundary

is given by 4.20. These are the conditions needed to be satisfied by the PDE. Now let equation ( , where represents the expiration time and as the present time. The

) can be written as ( )

Let

( We now induct a new notation ( ) (

). Using the above equation of (4.22), the

Black Scholes PDE appears to be a diffusion equation , ( )

44

Apparently has a fundamental solution as a normal function

) ]

The solution to (4.23) is ( ) ( ) ( ) ( )

Using the payoff conditions and the fundamental solutions of equation (4.24), we derive

) ]

) ]

We then denote the distribution function for a normal variable by ( ), ( ) ( )

We later express equation (4.26) as ( ) ,

( ( )

where

/ . We now consider the second term in the right

hand side of (4.28). Let ( )

45

Then using equation (4.29), the

becomes ( )

given that the limits of (4.28) using (4.29) are

By changing the variable from

to , the second term of equation (4.28) becomes ( ) ( )

The integrand of the first term in (4.28) is expressed as 0

( )

1
)

,
, (

) -

) -

46

We therefore use the definition of A to have ( Introducing (4.33) and (4.34) into (4.28), the first term then becomes ,
, ( ) -

By changing the variables, we derive ( ) ( )

The equation (4.26) can be written as

( ) ( ) ( ) ( )

and finally it implies that ( Where

( ) ( )

and

We now have the Black Scholes formula for the price at time zero of a European call option on a non-dividend paying stock. We then can derive the European put option by using put call parity by . The European put therefore is given as ( ) ( ) ( )

47

The European put and call option mainly has grown its popularity throughout the world as its importance towards pricing an option has brought ease to many investors. Calculating the option prices requires parameters that can be observed from the market, but the volatility especially has been the talk of the town of many financial mathematicians as this parameter cannot be observed directly from the market. Therefore it becomes rather necessary to find appropriate methods in estimating the volatility.

4.8.4 Volatility Volatility is defined as the standard deviation measure of an assets potential deviating from its current price. Basically the definition is also close related to what we know as risk. The price volatility creates greater value for a given option, for the greater the volatility of the underlying, the greater the value of the option. Volatility is good for option holders but bad for financial assets holders due the fact that financial assets have both risks but option holders only enjoy the upside potential and not the downside risk. The fluctuation of price volatility in assets market is mainly caused by the release of information, the process of trading, and market making for financial instruments. Explaining further, information release can be divided into anticipated and unanticipated information. The volatility estimate is the measure of the uncertainty about the returns on the asset. When pricing an option, the volatility is assumed to be time homogeneous, where it is the same over the life of an asset and constant between the pricing date and expiry of the option. Basically, the two major approaches for the estimation of the volatility are the historical and implied volatility methods.
48

4.8.5 Historical/Empirical Method The method works on estimating the volatility by calculating the standard deviation if the logs of the price changes of a sample time series of historical data for the asset price. The daily return is given as ( ) to make it an

The variance is estimated by the sample variance, which is normalized by unbiased statistic , ( )]

The standard deviation computed equals to the daily volatility if daily data is used. Annual volatility is computed as refers to the annual volatility, is the daily volatility and the is the mean value of the

daily return. We take 252 days as the number of days traded in a year. If the asset pays dividends, the asset price sequence must later be adjusted to reflect the non-homogenous nature of the data series. Transition from cum dividend to ex dividend will affect the price of the assets. A dividend payment increases the return to be paid to the buyer. If the buyer has an asset that pays dividend, then the daily price return is restated as ,( ) -

49

4.8.6 Implied volatility The volatility of an underlying asset which when substituted into the Black Scholes model, gives a theoretical price close to the market price. The implied volatility is considered deficient as the options currently trading volatility is treated as being the true constant assets price volatility parameter. Besides, options with different strike prices and same maturity often demonstrate different implied volatilities, also known as volatility smile. Newton-Raphson method or any suitable numerical method is used to derive volatility with respect to the price of the option.

4.9 Dividend Paying Stock By modifying the Black Scholes model, we can derive a dividend paying model and study the effects of dividend on the value of European options.

4.9.1 Continuous Dividend Yield Model We let as the constant continuous dividend yield. The holder receives a dividend within

the time interval of

. The value of share later decrease after the payout of the dividend and so of a share becomes ( ). The geometric Brownian motion

the expected rate of return model in (4.7) becomes ( )

50

The modified PDE in (4.16) becomes ( ) ( )

Therefore, ( ( Where
( ) ( )

) )

( (

) )

( (

) )

and

The dividend payment reduces the stock price from from ( ).

and the risk free interest rate

4.10 Options on Futures Futures option is a contract that grants the holder the right, but not obligation, to buy or sell a futures contract at a fixed price or strike price, upon the specified expiration date.

4.10.1 American Options on Futures The minimum value of an American call and put futures is its intrinsic value. The respective call and put intrinsic values are

51

( P where (

) ) is the strike price. ( )

is the futures price and

4.10.2 European Options on Futures The lower boundary of a European call and put are respectively given by ,( ,( ) )
( )

( )

4.10.3 Put-Call Parity We construct two portfolios, A and B. Portfolio A will consist of a long futures and a long put on the futures. This can be referred to as a protective put, where it involves an investment strategy of the use of long position in a put and a stock to provide a minimum selling price for the stock. Portfolio B consists of a long call and long bond with the face value equal to the exercise price of the futures contract minus the futures price. The current value of portfolio A is protective put and that of portfolio B is ( )
( )

which is a

. Since the portfolio B acts like a

protective put too, then its current value will equal to the current value of portfolio A. We therefore say agree that ( )
( ) ( ) ( )

52

4.10.4 Blacks Model For futures and forward prices to be equal, we have to assume that the interest rates are nonstochastic. The modification of the Black Scholes model on a spot instrument gives us the European call option on futures as
( )

)-

The future price we have

takes the place of the stock price . For the European put options on futures,

)-

Where
( ) ( )

and

Risk free rate is ignored due to the fact that it captures the opportunity cost of funds tied up in stock. If the option is on futures contract, no funds are invested, thus no opportunity cost as the cost to carry is zero. The cost to carry refers to the cost in holding or storing an asset that consists of storage costs and interest lost on funds tied up. The dividend in the other does not show up because the futures itself captures all the effects of the dividend, so including the dividend would rather be unnecessary.

53

4.11 Binomial Model The model was first introduced by Cox, Ross and Rubinstein (CRR) in 1979 and assumes that the stock price movements were composed of large number of smaller binomial movements. Binomial models come in handy particularly when the holder decides to exercise early or prior to maturity as the model is able to accommodate complex options pricing difficulties. The binomial model reduces the possibilities of price changes, removes the possibility for arbitrage by assuming a perfectly efficient market, and also shortens the duration of the option. Under these simplifications, it is able to provide a mathematical valuation of the option at each point in time specified. Basically the model takes the risk neutral probabilities into approach. It only assumes the underlying price for stocks can either increase or decrease according to time until the option expires. First we divide the life time , where . Suppose that - of the option into time subintervals of length ,

is the stock price of the beginning of a given period of time.

Then the binomial model of price movements assumes that at the end of each period, the price will either go up by with probability or go down by . and all satisfying the risk neutral with probability ( ). The and

are the up and down factors with

Using the log normal distribution with the parameters , valuation, we have ( ( ) )

54

The variance therefore is , , [ This is then simplified into ( We assume , then

, , ] , -

Basically

is called the risk neutral probability. It ensures all bets are fair and no arbitrage is ( ) , where

available. The expectation of share price can be written as , is the price after one period.

The Cox, Ross and Rubinstein model contains Black Scholes analytical formula as the limiting case as the number of steps tends to infinity. The value of the call option at the first movement is given by

55

( (

) )

As for the risk neutral call option price at the present time is , ( ) ( )

Now we extend the model to 2 periods. At time stock movements will be represented by movement will be represented by ( ( ( The values of call option at time , , . ) ) ) are ( ( ) ) and

for two consecutive upward and downward . For one upward and one downward

For a dividend paying stock, the risk neutral probability will be adjusted as

56

Where the probability of stock prices increases varies with the level of the continuous dividend rate, .

57

5.0 Finding and Analysis The results for American and European options using the multi-step binomial model are compared to those prices obtained using the Black Scholes model.

Table 5.1 Comparison of the Multi Step Binomial and CRR Analytical formula to Black Schole ss value

Type of Option 100 European Call American Call European Put American Put 267.8332 267.8332 85.574 123.1602 500 267.619 267.619 85.3598 123.1959

N 1000 267.6261 267.6261 85.3669 123.1985 5000 267.6156 267.6156 85.3564 123.2018

BS Value

267.6184

85.3593

Based on the results obtained, we can conclude that the Black Scholes model can only be used to value American call options and put option given that early exercise is does not take place. The value of American put option is higher than the corresponding European put option due to the fact that we have early exercise premium. Sometimes the early exercise of the American put option can be optimal. Besides the American option on the dividend paying stock is always worth more than its European counterparts. A very deep-in-the money American option has a high early exercise premium. The premium of both the put and call option decreases as the option goes out-of-the money. The American and European call options are not worth as the same as it is optimal to exercise the American call early on a dividend paying stock. A deep-out-of-the money American and

58

European call and put options are worth the same. This is due to the fact that they might not be exercised early as they are worthless.

59

6.0 Conclusion 6.1 Summary of the Black Scholes Model Determining the value of derivatives had been a longstanding problem in finance for 70 years. In the early 1970s, Black and Scholes made a pioneering contribution to finance through the development of the Black Scholes model. The Black-Scholes formula is generally one of the most commonly used option pricing model today. It has a magnificent influence on the way that a trader price and hedge options today. This model basically relates the option value to five parameters, which are the risk-free interest rate, strike price, time to maturity, underlying asset price and the volatility of the underlying asset return. The Black-Scholes model is based on the following ideal assumptions: The underlying asset prices move with constant volatility. The underlying asset returns are normally distributed. All the traders are indifferent to the risk, that is, they are risk-neutral. There are no riskless arbitrage opportunities.

Because one fundamental assumption underlying the Black Scholes model is that the asset prices move with constant volatility, the implied volatilities obtained by numerically inverting the Black-Scholes formula should be exactly the same for options on the same underlying asset with different strike prices. Therefore, one way to test the validity of the Black Scholes model is to see whether the implied volatility for given underlying assets is constant across different strike prices.

60

6.2 Volatility; Implied or Historical? Volatility is generally the most critical parameter for option pricing because option prices are very sensitive to price changes and this parameter cannot be directly observed but can be estimated by various mathematical models. Whilst implied volatility is the volatility of the option implied by current market prices and is commonly used the argument that this is the "best" estimate. Skilled or professional options traders will not rely solely on implied volatility but will look behind the estimates to see the fluctuation that you would expect from historical and current volatilities, and hence whether the price of the options are supposed to be more expensive or cheaper than perhaps they should be. The implied volatility will give you the price of an option while historical volatility will give you an indication of its value. It's important to understand both parameters. Basically if your forecast of volatility based on historical prices that is greater than current the implied volatility ( options under valued) you might consider calling a straddle, and if your historical forecast is less than the implied volatility you might want to long a straddle. Implied Volatility Calculation of American and European options with and without dividends. Equally Weighted Historical Volatility Estimated using the historical prices, one or more high low, open and closing prices. Exponentially Weighted Historical Volatility Estimated using the EWMA (Exponentially Weighted Moving Average) or the GARCH (Generalized Autoregressive Conditional Heteroscedasticity) model.

61

Volatility Forecasting By applying the GRACH model, it helps you to predict how the volatility moves in the future.

6.3 Risk Neutral Valuation Does the Expected Stock Return Matters? Significantly, the expected rate of return of the stock is not one of the variables in the BlackScholes model or in any other model to evaluate an option price. The important implication here is that the value of an option is completely independent of the expected growth of the underlying asset and is therefore risk neutral. The fact that a prediction of the future price of the underlying asset is not necessary to value an option may appear to be counter intuitive, but it is proven correct over the years. Dynamically hedging a call using underlying asset prices generated from Monte Carlo simulation perhaps is the ideal way to stimulate this situation. Irrespective of the assumptions regarding stock price growth built into the Monte Carlo simulation the cost of hedging a call (i.e. dynamically maintaining a delta neutral position by buying & selling the underlying asset) will always be the same, and will be very close to the Black-Scholes value. Putting it another way, whether the stock price rises or falls after. For example, writing a call, it will always cost the same (providing volatility remains constant) to dynamically hedge the call and this cost, when discounted back to present value at the risk free rate, is very close to the Black-Scholes value. (http://www.hoadley.net/options/bs.htm) Therefore the price evaluated by Black Scholes model is nothing more than the amount an option writer would require as compensation for writing a call and hedging the risk. The main concept here actually states that the price of an option is rather independent of the risk preferences of

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investors which are called the Risk Neutral Valuation. It states that all derivatives can be valued by assuming the return from their underlying assets is the risk free rate.

6.4 Advantages and Limitations The main advantage of the Black-Scholes model is generally its speed of evaluating option prices. The model it lets you evaluate a very large number of option prices in a very short time period, making it easy for options traders to price options instantaneously. The biggest strength is the possibility of estimating market volatility of an underlying asset generally as a function of price and time without direct reference to specific investor characteristics like expected yield, risk aversion measure or utility functions. Secondly, the model also acts as a self-replicating strategy or hedging, meaning investors can continuously buy and sell derivatives by the strategy and never incur any losses. 6.4.1 Limitation of Black Scholes Model Despite its popularity and the wide spread use, the model was built under some non-real assumptions, and those assumptions are challenged by experts about its reliability throughout these years. Constant volatility Volatility can be constant over short term period but it is never constant in a longer term as large price changes tend to be followed large price changes, and vice versa. This trend leads to a property called the volatility clustering. While measures of volatilities are negatively correlated with the assets price returns (Leverage Effect), trading volumes in the other hand is positively correlated, thus making

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volatility to be unstable over time. Therefore, some advance option valuation models substitute the constant volatility under Black Scholes model with stochastic process generated estimates. The movement of stocks in the market Stocks moves randomly in the market, also known as random walk. The stock at time is independent to time (Martingale

Property of Brownian Motion). Stock prices are determined by many economic factors that cannot be assigned the same probability of price fluctuation in each period of time. Returns of log normally distributed underlying stock prices are normally distributed This assumptions is reasonable in the real world, though not fitting observed financial data accurately. Assets returns have a finite variance and semi heavy tails contrary to stable distributions like log normal with infinite variance and heavy tails (Clark, 1973). As time scale over which return of assets are calculated increases, the distribution of asset prices look more like the normal distribution with heavy tails despite the fact that autocorrelation of asset prices are often insignificant. Constant interest rates The interest rates are represented by the risk free rate, while there is no such thing as risk free rates but it is possible to use the Treasury Bills 30Day rate if the government is deemed to be credible. Yet so the treasury rates can fluctuate based on the increase of volatility. No commission and transaction costs The Black Scholes model assumes that there are no fees for buying and selling options, and also there are no barriers for trading. Basically this is not true as stock brokers charge rates based on spreads and other criteria.

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Only can be applied for European style options which can only be exercised on the expiration date American style options can be exercised any time during the life span of the option, making it more valuable than European style options due to their greater flexibility.

Markets are perfectly liquid The Black Scholes model allows the possibility to purchase and sell any amount of stock or options at any time. This is not possible as investors are limited by the amount of money they can invest, policies of the company and the permission or interest of the sellers to sell.

The huge advantage the Binomial model has over the Black Scholes model is that it can be used to price American options accurately. This is due to the fact that the Binomial model allows early exercises. The only disadvantage the model possesses is that the model is relatively slow; as the time expands the slower the calculation leads to a price for an option.

6.4.2 Other Similar Models to the Black Scholes Model The pricing of American options using analytical models are more unmanageable compared to European options. Throughout the years, many models have been developed to handle American options pricing in an efficient manner. The three most widely used models are:

Roll, Geske and Whaley analytic solution - The RGW formula can be used for pricing an American call on a stock paying discrete dividends.
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Black's approximation for American calls - Although the RGW formula is an analytic solution it involves solving equations iteratively and thus it is slower than Black-Scholes model. Black's approximation basically involves using the Black-Scholes model after making adjustments to the stock price and expiration date to take account of early exercise.

Barone-Adesi and Whaley quadratic approximation - An analytic solution for American puts and calls paying a continuous dividend. Like the RGW formula it involves solving equations iteratively so whilst it is much faster than the binomial model it is still much slower than Black-Scholes.

Many models have been proposed over the years, all attempting to actually mimic the characteristics of market fully. Generally saying, every aspect of the market cannot be considered in any fraction of time, as every factor capturing the price of a financial security cannot be captured mathematically. Finally, we can only attempt to capture most of the factors, as what is proposed by Levy models and other advance models.

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7.0 References 1. Lyuu Y. (2002). Financial Engineering and Computation: Principles, Mathematics, Algorithms. Cambridge University Press, UK. 2. Neftci S. (2000). An Introduction to the Mathematics of Financial Derivatives. Academic Press, Second Edition, New York. 3. Baz J. and Chacko G. (2004). Financial Derivatives: Pricing, Applications and Mathematics. Cambridge University Press, Cambridge 4. Black F. and Scholes M. (1973). The Pricing of Options and Corporate Liabilities. Journal of Political Economy, Vol.81 (3), 637-654. 5. Chance D. (1998). An Introduction to Derivatives. The Dryen Press, Fourth Edition, USA. 6. Hull J. (2003). Options, Futures and other Derivatives. Pearson Education Inc., fifth Edition, New Jersey 7. Das S. (1997). Risk Management and Financial Derivatives, A guide to the Mathematics. McGraw Hill, New York. 8. Wilmott P., Howison S. and Dewyne J. (1995). The Mathematics of Financial Derivatives. A Student Introduction. Cambridge University Press, Cambridge. 9. 10. Kolb R. (1999). Futures, Options and Swaps. Blackwell Publisher Ltd, Third Edition, UK Peter Carr, Liuren Wu, 2002. Time Change Levy Process and Option Pricing August 2002, Accessed 20.11.2010
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11.

Bryman, A. (2004) Social Research Methods. 2nd ed. Oxford: Oxford University Press.

12.

Campbell, J. and Hentschel, L. (1992) No News Is Good News: An Asymmetric Model Of Changing Volatility In Stock Returns. Journal of Financial Economics. 31 (3): 281-318. Chance, D (2004b). An Introduction to Derivatives & Risk Management. 6th ed. Ohio: Thomson/South-Western.

13.

14.

Cox, J. C., and Ross, S. A. (1976) The Valuation of Options for Alternative Stochastic Processes. Journal of Financial Economics. 4 (2): 145-166.

15.

French, K., Schwert, G. and Stambaugh, R. (1987) Expected Stock Returns And Volatility. Journal of Financial Economics. 19 (1): 3-29.

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8.0 Appendix 8.1 VBA code of CRR Binomial Model in Excel

'CallPutFlag - use "c" for call and "p" for put option 'S - spot price 'K - option strike 'T - option maturity 'r - risk free rate 'v - volatility 'ExerciseType - use "a" for American and "e" for european 'N - no of time steps for the binomial tree

Public Function CRR_Price(CallPutFlag, S, K, T, r, v, ExerciseType, N) As Double S0 = S If CallPutFlag = "c" Then CallPutFlag = 1 Else CallPutFlag = -1 End If dt = T / N u = Exp(v * dt ^ 0.5) 'size of up jump d = Exp(-v * dt ^ 0.5) 'size of down jump p1 = (u - Exp(r * dt)) / (u - d) 'probability of up jump p2 = 1 - p1 'probability of down jump ReDim Smat(1 To N + 1, 1 To N + 1) 'hlods stock prices Smat(1, 1) = S0 For i = 1 To UBound(Smat, 1) - 1 Smat(1, i + 1) = Smat(1, i) * Exp(v * dt ^ 0.5) For j = 2 To i + 1

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Smat(j, i + 1) = Smat(j - 1, i) * Exp(-v * dt ^ 0.5) Next j Next i

ReDim Cmat(1 To N + 1, 1 To N + 1)

For i = 1 To N + 1 Cmat(i, N + 1) = Application.Max(CallPutFlag * (Smat(i, N + 1) - K), 0) Next i For i = UBound(Smat, 2) - 1 To 1 Step -1 For j = 1 To i present_value = Exp(-r * dt) * (p2 * Cmat(j, i + 1) + p1 * Cmat(j + 1, i + 1)) immediate_val = CallPutFlag * (Smat(j, i) - K) If ExerciseType = "a" Then Cmat(j, i) = Application.Max(present_value, immediate_val) Else Cmat(j, i) = Application.Max(present_value, 0) End If Next j Next i CRR_Price = Cmat(1, 1) End Function

8.2 VBA code of The Black Scholes Model in Excel

Function Black_Scholes(ByVal S As Double, ByVal K As Double, ByVal r As Double, ByVal q As Double, ByVal t As Double, ByVal sigma As Double) As Double Dim d1 As Double

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Dim d2 As Double Dim a As Double Dim b_call As Double Dim b_put As Double Dim c As Double Dim call_price As Double Dim put_price As Double a = Log(S / K) b_call = (r - q + 0.5 * sigma ^ 2) * t b_put = (r - q - 0.5 * sigma ^ 2) * t c = sigma * Sqr(t) d1 = (a + b_call) / c d2 = (a + b_put) / c call_price = S * WorksheetFunction.NormsDist(d1) - K * Exp(-r * t) * WorksheetFunction.NormsDist(d2) put_price = K * Exp(-r * t) * WorksheetFunction.NormsDist(-d2) - S * WorksheetFunction.NormsDist(-d1) Black_Scholes = Array(call_price, put_price) End Function

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