The Black-Scholes-Merton

Model
Chapter 13
1
B-S-M model is used to determine the
option price of any underlying stock. They
believed that stock follow a random walk.

Proportional changes in the stock
price(relative return) in a short period of
time is normally distributed and stock price
at any future time is lognormal distributed.
2
The Black-Scholes-Merton Model
Stock return have log normal
distribution
Determine the price change over an period not at
the end of period.
Stock price follow random walk, next movement of
price is completely independent of past prices.
For longer horizon, there can be upward and
downward movement but not hold for very small
period like daily or hourly periods. pure random
Returns are measured by price relative; ratio of the
price at two successive time intervals rather than
absolute value. To measure it, we need to assume
continuous compounding and we take natural log.
Options, Futures, and Other
Derivatives, 7th Edition, Copyright
John C. Hull 2008 3
Options, Futures, and Other Derivatives, 7
th
Edition, Copyright John C. Hull 2008 4
The Stock Price Assumption
Consider a stock whose price is S
In a short period of time of length At,
the return on the stock is normally
distributed:


where is expected return and o is
volatility

( ) t t
S
S
A o A | ~
A
2
,
Stock return have log normal
distribution
We consider the distribution of the logarithm of the
return relative rather than the distribution of stock
price?
We know stock price cant not be negative. Minimum
value is 0 and loss cant exceed 100%. So assuming
stock price normally distributed will consider
negative value also which is simply wrong.
A log normal distribution fits the description as it
consider only positive value. So as an alternative we
may imagine the distribution of log return. If log
return are ND, then distribution of the stock price will
be log normal.
5
6
The Lognormal Property

It follows from this assumption that







Since the logarithm of S
T
is normal, S
T
is
lognormally distributed
,
2
ln ln
or
,
2
ln ln
2
2
0
2
2
0
(

|
|
.
|

\
|
+ ~
(

|
|
.
|

\
|
~
T T S S
T T S S
T
T
o
o
|
o
o
|

Options, Futures, and Other
Derivatives, 7th Edition, Copyright
John C. Hull 2008 7
The Lognormal Distribution

E S S e
S S e e
T
T
T
T T
( )
( ) ( )
=
=
0
0
2
2
2
1

var

o

Assumptions of the Black and
Scholes Model:

The stock pays no dividends during the option's life
European exercise terms are used means option can
only be exercised on the expiration date
Markets are efficient suggests that people cannot
consistently predict the direction of the market or an
individual stock.
Interest rates remain constant and known
Returns are lognormally distributed. this assumption
suggests, returns on the underlying stock are normally
distributed, which is reasonable for most assets that
offer options.



9
Continuously Compounded Return
(Equations 13.6 and 13.7), page 279)

If x is the continuously compounded return.
10
,
2
ln
1
=

2 2
0
0
|
|
.
|

\
|
~
=
T
x
S
S
T
x
e S S
T
xT
T
o o
|
11
The Concepts Underlying Black-
Scholes
The option price and the stock price depend
on the same underlying source of uncertainty
We can form a portfolio consisting of the
stock and the option which eliminates this
source of uncertainty
The portfolio is instantaneously riskless and
must instantaneously earn the risk-free rate
12
The Black-Scholes Formulas
(See pages 291-293)
T d
T
T r K S
d
T
T r K S
d
d N S d N e K p
d N e K d N S c
rT
rT
o
o
o
o
o
=
+
=
+ +
=
=
=

1
0
2
0
1
1 0 2
2 1 0
) 2 /
2
( ) / ln(

) 2 /
2
( ) / ln(
where
) ( ) (
) ( ) (
13
The N(x) Function
N(d1) is the probability that the expected value in
risk neutral world, using the risk-free interest
rate, of the expected asset price at expiration St
at time T. It is the delta of the option which
represents the fraction of stock bought for each
call written. Fraction of stock owned.
N(d2) is the strike price times the probability that
the strike price will be paid in a risk neutral
world. It is the probability of call becoming ITM
that is spot price exceeding the strike price. The
expected value of cash outflow is
) ( X
2
d N e K
rT
14
Properties of Black-Scholes Formula

As S
0
becomes very large c tends to
S
0
Ke
-rT
and p tends to zero
As S
0
becomes very small c tends to zero
and p tends to Ke
-rT
S
0

When volatility approaches zero, d1 and d2
tends to infinite and standard normal
become 1
15
Implied Volatility
The implied volatility of an option is the volatility for which the
Black-Scholes price equals the market price. This is the volatility
implied by an option price observed in the market.
Implied volatility shows the markets opinion of the stocks potential
moves, but it doesnt forecast direction. If the implied volatility is
high, the market thinks the stock has potential for large price
swings in either direction, just as low IV implies the stock will not
move as much by option expiration.
Composite implied volatility for the stock is calculated by taking a
suitable weighted average of the individual implied volatility of
various options
Since most option trading volume usually occurs in at-the-money
(ATM) options, these are the contracts generally used to calculate
IV. Once we know the price of the ATM options, we can use an
options pricing model and a little algebra to solve for the implied
volatility.


Options, Futures, and Other
Derivatives, 7th Edition, Copyright
John C. Hull 2008 16

Options, Futures, and Other
Derivatives, 7th Edition, Copyright
John C. Hull 2008 17
18
Dividends
The dividend should be the expected reduction in
the stock price and call option price expected

European options on dividend-paying stocks are
valued by substituting the stock price less the
present value of dividends into Black-Scholes

The stocks price goes down by an amount
reflecting the dividend per share. The effect of this
is to reduce the value of calls and to increase the
value of puts.
19
Dividends
Adjusting stock price with the dividend would result
in . q is dividend yield (compounding basis)
T d
T
T q r K S
d
T
T q r K S
d
d N S d N e K p
d N e K d N S c
rT
rT
o
o
o
o
o
=
+
=
+ +
=
=
=

1
0
2
0
1
1
qt -
0 2
2 1
-qt
0
) 2 /
2
( ) / ln(

) 2 /
2
( ) / ln(
where
) ( e ) (
) ( ) ( e
-qt
0
e S
20
American Calls
An American call on a non-dividend-paying
stock should never be exercised early
An American call on a dividend-paying
stock should only ever be exercised
immediately prior to an ex-dividend date
Suppose dividend dates are at times t
1
, t
2
,
t
n
. Early exercise is sometimes optimal at
time t
i
if the dividend at that time is greater
than

] 1 [
) (
1 i i
t t r
e K

+