1

Options and Futures

Note # 7
November 2011
The Black Scholes Option Pricing Formula
1. The Behavior of Stock Prices
What are desirable properties of a process for stock
price?
(i) random (stochastic)
(ii) reflects the level of market efficiency
(iii) has an expected upward trend
(iv) has volatility proportional to time horizon
(v) cannot go below zero
The assumed process will be referred to as the
stochastic processfor stock price.
1.1. The Markov Property
Stock price process depends on the stocks current
value, not past value.
Price history is irrelevant. =Weak-form efficiency.
Price distribution at any time is independent of past
path.
By extension, changes in stock price depend only
on the current price. independent AS's.
1.2. Brownian Motion
A variable z follows a Brownian motion if:
(i) Az =c where c ~ |(0,1); and
(ii) the values of Az for any two At's are independent (i.e.
Markov)
t A
It follows that for a short time period, At:
(i) E[Az] =0.
(ii) Var[Az] =At.
What about the change during a longer time period,
T?
[z(T) z(0)] ~ |(0, ) T
2
1.3. The Price Process for Non-Dividend-Paying
Stocks
A variable S follows a geometric Brownian motion
process if:
AS =S At +oS Az (discrete)
= At +o Az
dS =S dt +oS dz (continuous)
= dt +o dz
S
S A
S
dS
Change =expected drift term +random term where:
dt =a very small interval of time (an instant)
dS =change in stock price by the end of dt.
=expected return p.a. on the stock
o =volatility of the stock price
dz =the random term =c where c ~ | (0,1). dt
Note the following:
(i) dS is random through the term dz 1
st
property.
(ii) dS depends on current price, S, not past prices as dzs
are not correlated with one another. 2
nd
property.
(iii) E (dS) =S dt 3
rd
property
(iv) Var (dS) =o
2
S
2
dt. 4
th
property.
(v) If S =0, dS =0. 5
th
property
In other words,
E ( ) = dt
Var ( ) =o
2
dt Std ( ) =o .
Ex. Consider a non-dividend-paying stock whose = 12% p.a.
and o =30% p.a. Its price process is:
S
dS
S
dS
S
dS
dt
It can be shown that under GBM, stock price at any
future time has a lognormal distribution.
ln S
T
~ | (ln S +( )T, o ).
Ex. The prob dist of the above stock in a weeks time is:
2
2
o
T
Aside Lognormal Distribution
A variable has a lognormal distribution if its natural
log is normally distributed.
Ex. y has a lognormal dist. if ln y ~ | (-,+).
A lognormallydistributed variable can only take on
positive values.
3
It can also be shown that:
(i) E (S
T
) =Se
T
(ii) Var (S
T
) = ( ) 1
2
2 2

T T
e e S
o
Ex. For the above stock,
END ASIDE
2. The Price Process for Options on Non-
Dividend-Paying Stocks
With the assumed price process for a stock, we can
derive the price process for any derivatives on that
stock.
Itos Lemma (modified version):
If S follows a Geometric Brownian Motion, then f(S) also
follows a GBM, with different parameters for and o.
Since c =f (S), we can use Itos Lemma to derive
the price process for option:
df =
=[-] dt +[+] dz.
Sdz
S
f
dt S
S
f
t
f
S
S
f
o o
c
c
+
|
|
.
|

\
|
c
c
+
c
c
+
c
c
2 2
2
2
2
1
Note that:
- The option price process consists of a non-random term
and a random term.
- The random term consists of the same dz term as in the
stock price process. The randomness of option price
comes solely from the randomness of stock price.
3. The Black-Scholes Option Pricing formula
With this insight, Black and Scholes developed an
option pricing formula.
Assumptions underlying Black-Scholes:
- Options are European.
- Stock price follows a GBM with and o constant. (i.e. Price
is lognormallydistributed).
- No transaction costs or taxes
- No arbitrage opportunities
4
- Borrow or lend at the same risk-free rate
- The risk-free rate, r, is constant and the same for all
maturities.
- No dividends during the life of the options
- Stock trading is continuous.
Based on the price processes of stock and option,
what about a portfolio of:
- Short 1 unit of option; and
- Long unit of stock.
Cost of this port based on its composition = S f.
S
f
c
c
S
f
c
c
Payoff of this port after a small interval, dt,
=Stock payoff Option payoff
= [S dt +oS dz]
=- No dz term risk-free.
S
f
c
c
(
(

c
c
+
|
|
.
|

\
|
c
c
+
c
c
+
c
c
Sdz
S
f
dt S
S
f
t
f
S
S
f
o o
2 2
2
2
2
1
dt S
S
f
t
f
|
|
.
|

\
|
c
c
+
c
c
2 2
2
2
2
1
o
By holding option and stock in the right proportion, a
risk-free port is created.
Cost of port based on composition = S f
Risk-free payoff =[ S f ] r dt.
S
f
c
c
S
f
c
c
Therefore,
- = [ S f ] r dt.
Or,
B-S PDE.
dt S
S
f
t
f
|
|
.
|

\
|
c
c
+
c
c
2 2
2
2
2
1
o
S
f
c
c
.
2
1
2
2
2 2
rf
S
f
S
S
f
rS
t
f
=
c
c
+
c
c
+
c
c
o
Note that the B-S PDE has to be satisfied by all
derivatives, f, whose value depends on S.
We can solve the PDE to come up with a pricing
formula by specifying boundary conditions; e.g.,
- c s S
- c =max{0, S
T
- K) at maturity
5
B-S obtained:
c =SN(d
1
) Ke
-rT
N(d
2
)
p =Ke
-rT
N(-d
2
) SN(-d
1
)
where
d
1
=
d
2
=d
1
o .
.
) 2 / ( ) / ln(
2
T
T r K S
o
o + +
T
N (y) =cumulative probability function of a standard
normal random variable. y ~ | (0,1).
N (-y) =1 - N (y).
Ex. Consider a stock whose S is $30 and o is 20% p.a. The
r
f
is 10% p.a. What are the prices of a 6-month European
call and a 3-month European put on this stock where K of
both options is $31?
S =30; K =31; r =0.1; o =0.2; T =0.5 (call), 0.25 (put).
3.1. Properties of the B-S prices
Do the B-S prices conform to our understanding of
how the factors (S, K, T, r, o) affect option prices?
3.2. Hedge Ratio in the B-S Framework
Note that to construct a risk-free port, a short option
is paired with unit of stock.
So, is the hedge ratio in the B-S framework.
S
f
c
c
S
f
c
c
It can be shown that:
- for call, =N (d
1
) >0.
- for put, = - N (-d
1
) =N (d
1
) 1<0.
Ex. In the above example, the starting hedge ratio for the call
is 0.576, and the starting hedge ratio for the put is 0.511.
S
f
c
c
S
f
c
c
Note that the port will remain risk-free for only during
dt. After that, a new hedge ratio is needed.
requires continual changes in stock position.
Well need a new hedge ratio even when stock price
does not change.
Banks and market makers use this rebalancing
technique when quoting option prices. Usually, the
frequency is one day.
6
3.3. Risk-Neutral Valuation
Recall from the Binomial model that we can value
options as if we were risk-neutral.
Risk-neutral investors expect a risk-free return on all
investments.
We can price options as if we were risk-neutral
because we can mathematically construct the risk-
neutral probabilities.
In the risk-neutral framework, the expected return of
any asset under these prob is the risk-free rate.
We can do the same in the B-S framework by
assuming that the stocks expected return is the risk-
free rate:
dS =rS dt +oS dz
Then, we:
(i) calculate the E(payoff) of the option given the
lognormal dist of the stock price; and
(ii) discount the E(payoff) by the risk-free rate. will
get the same B-S pricing formula.
3.4. Binomial VS. B-S
If we keep increasing the #of periods under the
Binomial model, the price process will converge to
the GBM. Binomial price ~ B-S price.
Generally, convergence occurs around 100 periods.
3.5. Options on Dividend-Paying Stocks
Assume that future dividends can be correctly
predicted.
- This is reasonable for short-life options.
- For long-life options, it is more realistic to assume that the
dividend yield is known.
3.6.1. European Options
The B-S is still correct if the PV of dividends is
subtracted from the current stock prices.
Ex. Consider the above 6-m European call. Suppose:
Div 1 =$0.25 in 2 months
Div 2 =$0.25 in 5 months
7
3.6.2. American Options
We will separate our discussion between calls and
puts.
For American call options on dividend-paying stocks,
early exercise is possible.
- We cannot apply the original B-S formula directly.
- We have to use an approximation technique.
The approximation technique involves:
1. Determine if early exercise can be completelyruled
out.
2. If so, the call price will equal the European call price
with the original maturity but with the stock price
reduced by the PVs of all dividends during the
option's life.
3. If not, repeat the calculation in step 2. Also, calculate
the price of a European call with maturity date on
each of the ex-dividend dates (on which early
exercise cannot be ruled out) but with the stock price
reduced by the PVs of all dividends up to that date.
The highest of these prices is the approximated price
for the American call.
Ex. Consider a 6-month American call on a stock whose S is $20
and o is 20% p.a. The is 10% p.a. The call's K is $18. The r
f
rate is 6% p.a. Suppose there will be two dividends during the
option's life. The first dividend is $0.25 with an ex-dividend date
in 2 months, while the second is $0.25 with an ex-dividend date
in 5 months.
For American puts, they will be exercised whenever
they are sufficiently deep in the money.
- The price drop just after the stock goes ex-dividend
increases the likelihood.
There are some approximation techniques to use,
but it is better to use the binomial framework to
value American puts.