Fall 2011 The Black-Scholes-Merton Model Prof.

Page
BUSM 411: Derivatives and Fixed Income
14. The Black-Scholes-Merton Model
In the early 1970s, Fischer Black, Myron Scholes, and Robert Merton achieved a major
breakthrough in the pricing of European stock options.
The Black-Scholes-Merton model has had a huge inuence on the way traders price
and hedge derivatives
Previous researchers had made similar assumptions about the stock return distribution
and derived the expected payo of a European option, but it is dicult to know the
correct discount rate to apply to the expected payo.
The breakthrough was to set up a riskless portfolio consisting of a position in the stock
and the option, and arguing that the return of the portfolio over a short period of time.
This is similar to what we did in developing the binomial model, but more complicated
because the weights needed to form a riskless portfolio change continuously through
time.
14.1. The Black-Scholes-Merton Dierential Equation
Our objective is to nd an equation or formula for the price of an option as a function
of the price of the underlying asset and time.
The Black-Scholes-Merton dierential equation is an equation that must be satised
by the price of any derivative dependent on the price of a stock.
14.1.1 The idea behind the Black-Sholes-Merton dierential equation
We will derive the equation next, but rst give a preview of the arguments underlying
the approach
These are similar to the no-arbitrage arguments we used when introducing the binomial
model. They involve setting up a riskless portfolio consisting of a position in the
derivative and a position in the stock.
In the absence of arbitrage opportunities, the return on this portfolio must be equal
to the risk-free rate r.
The reason it is possible to set up a riskless portfolio is that the stock price and the
derivative price are both aected by the same underlying source of uncertainty: stock
price movements.
1
Fall 2011 The Black-Scholes-Merton Model Prof. Page
Thus, in any short period of time, the price of the derivative is perfectly correlated
with the price of the stock (that is, the change in the derivatives price is proportional
to the change in the stock price)
When an appropriate portfolio is chosen, the gain or loss from the stock position
perfectly osets the gain or loss from the derivatives position so that the value of the
portfolio at the end of a short period of time is known with certainty.
Example:
Suppose that at a particular point in time the relationship between a small change
in the stock price and the corresponding change in a European call option price
is given by
c = 0.4S
The riskless portfolio would thus consist of a long position in 0.4 shares of the
stock and short one call option.
What happens if the stock price increases by 10 cents?
The position in the stock and the derivative are riskless only for a very short period of
time. To remain riskless, it must be adjusted, or rebalanced, frequently.
Nevertheless, it remains true that the return on the riskless portfolio in any very short
period of time must be the risk-free rate. This is the key element of the Black-Scholes-
Merton analysis and leads to their pricing formulas.
Assumptions:
1. The stock price follows a geometric Brownian motion with constant and (well
discuss what this means in a moment)
2. Investors can short sell securities with full use of the proceeds
3. There are no transaction costs or taxes. All securities are perfectly divisible
4. There are no riskless arbitrage opportunities
5. Investors can trade securities continuously
6. The risk-free rate r is constant through time and the same for all maturities.
2
Fall 2011 The Black-Scholes-Merton Model Prof. Page
14.1.2 Model of stock price behavior
We assume that percentage changes in the stock price over a short period of time are
normally distributed
Dene
: Expected return on stock per year
: Volatility of the stock price per year
The mean of the return in time t is t, and the standard deviation of the return is

t, so that
S
S
(t,
2
t)
This means that the process the stock price follows over time is a geometric Brownian
motion, which we can write as
S
S
= t + z
or
S = St + Sz
If the stock pays continuous dividends, this becomes
S = ( )St + Sz
z is random variable that follows a Weiner process. This means that
1. The change z during a small period of time t is z =

t, where has a
standardized normal distribution (0, 1).
2. The values of z for any two short intervals of time, t, are independent
z is a random shock that occurs each period and is the underlying source of uncertainty
in the stock price process (Think about standardizing a normal random variable
this is essentially the reverse of that, where we take a draw from a standard normal
distribution each period and scale it to match the distribution of the stock return.)
In ordinary calculus, it is usual to proceed from small changes to the limit as the
changes become closer to zero. Similarly, in stochastic calculus we us the notation dz
to represent a Weiner process that has the properties above as t 0.
3
Fall 2011 The Black-Scholes-Merton Model Prof. Page
Thus, we can write the continuous process for the stock price as t 0 as
dS = ( )Sdt + Sdz
14.1.3 Derivation of the Black-Scholes-Merton dierential equation
We assume the stock price follow the stochastic process described above:
dS = Sdt + Sdz (1)
Suppose that f is the price of a call option (or some other derivative) contingent on
S. The variable f is a function of S and t, but we dont know what that function is
(that is what we are trying to gure out).
Itos lemma, sort of like the chain rule in ordinary calculus, tells us how to take the
derivative of a variable that is a function of another random variable and time (like f
is a function of S and t). By Itos lemma, we can write
df =

f
S
S +
f
t
+

2
f
S
2
1
2

2
S
2

dt +
f
S
Sdz (2)
Note that both dS, the change in stock price, and df, the change in the option price,
are driven by the same Weiner process dz. This means that we can form a portfolio
of the stock and the option that cancels out the Weiner process so that the portfolio
is riskless. Specically, we can form a portfolio that is short one option and long
f
S
shares of the stock.
Dene as the value of the portfolio. Thus
= f +
f
S
S (3)
and the instantaneous change in the value of the portfolio is
d = df +
f
S
dS (4)
Substituting equations (1) and (2) into equation (4) yields
d =

f
t


2
f
S
2
1
2

2
S
2

dt (5)
4
Fall 2011 The Black-Scholes-Merton Model Prof. Page
This expression does not involve dz, which implies that the portfolio is riskless. Thus,
it must earn the risk-free rate so that
d = rdt (6)
Substituting from equations (3) and (5) into (6), we obtain

f
t


2
f
S
2
1
2

2
S
2

dt = r(f +
f
S
S)dt
so that
f
t
+ rS
f
S
+
1
2

2
S
2

2
f
S
2
= rf (7)
If the stock pays continuous dividends, this becomes
f
t
+ (r )S
f
S
+
1
2

2
S
2

2
f
S
2
= rf
This is the Black-Scholes-Merton dierential equation. It has many solutions, corre-
sponding to all the dierent derivatives that can be dened with S as the underlying
asset.
We can solve the dierential equation to nd the function f corresponding to a specic
derivative contract by specifying boundary conditions. For example, in the case of a
European call option, the key boundary condition is
f = max(S K, 0) when t = T
Since we know the value of f at time t = T, we can use this to pin down the particular
solution to the dierential equation that gives us a general formula for the value of the
derivative as a function of S and t.
Example:
We can consider the example of a forward contract to conrm that it satises the
Black-Scholes-Merton dierential equation.
We already know that the value f of a forward contract at a general time t is
given by
f = S Ke
(r)(Tt)
5
Fall 2011 The Black-Scholes-Merton Model Prof. Page
where K is the delivery price. This means that
f
t
= rKe
(r)(Tt)
,
f
S
= 1,

2
f
S
2
= 0
Substituting these into the left-hand side of equation (7), we get
rKe
(r)(Tt)
+ rS
This equals rf, showing that equation (7) is indeed satised
14.2. Black-Scholes-Merton Formulas
The Black-Scholes-Merton Formulae for the prices of European call and put options
are:
c = S
0
e
T
N(d
1
) Ke
rT
N(d
2
) (8)
and
p = Ke
rT
N(d
2
) S
0
e
T
N(d
1
) (9)
where
d
1
=
ln(S
0
/K) + (r +
2
/2)T

T
and
d
2
=
ln(S
0
/K) + (r
2
/2)T

T
= d
1

T
The inputs are the current stock price (S
0
), the strike price (K), the volatility of the
stock price (), the continuously compounded risk-free interest rate (r), the time to
expiration (T), and the dividend yield () on the stock.
The function N(x) is the cumulative probability distribution function for a standard-
ized normal distribution. In other words, it is the probability that a variable with a
standard normal distribution, (0, 1), will be less than x.
14.3. Option Greeks
Given the formula for the option price, it is useful to think about how the option price
is aected by changes to the inputs of the formula.
In practice, the sensitivities of the Black-Scholes option price are represented by Greek
letters and known collectively as the option greeks
Delta ():
6
Fall 2011 The Black-Scholes-Merton Model Prof. Page
Sensitivity of the option price to a change in the underlying stock price
It is the derivative of the BSM formula with respect to S:
=
f
S
= e
T
N(d
1
)
Gamma ():
Sensitivity of the option Delta to a change in the underlying stock price
It is the second derivative of the BSM option pricing formula with respect to S:
Vega (not really a Greek letter):
Sensitivity of the option price to a change in volatility
Expressed as the change in option price when volatility increases by 1%
Theta ():
Sensitivity of the option price to a change in the time to maturity
Expressed as the change in option price when time to maturity decreases by 1 day
Rho ():
Sensitivity of the option price to a change in the risk-free rate
Expressed as the change in option price when interest rate increases by 1%
The Greek measure of a portfolio is weighted average of Greeks of individual portfolio
components. For example,

portfolio
=
n

i=1

i
14.4. Implied volatility
Volatility is unobservable
Choosing a volatility to use in pricing an option is dicult but important
One approach to obtaining a volatility is to use history of returns
However history is not a reliable guide to the future
Alternatively, we can invert the Black-Scholes formula to obtain option implied volatil-
ity
7
Fall 2011 The Black-Scholes-Merton Model Prof. Page
The volatility of the returns consistent with observed option prices and the pricing
model (typically Black-Scholes)
One can use the implied volatility from an option with an observable price to
calculate the price of another option on the same underlying asset
Checking the uniformity of implied volatilities across various options on the same
underlying assets allows one to verify the validity of the pricing model in pricing
those options
The volatility of the returns consistent with observed option prices and the pricing
model (typically Black-Scholes)
In practice implied volatilities of in, at, and out-of-the money options are generally
dierent resulting in the volatility skew
Implied volatilities of puts and calls with same strike and time to expiration must
be the same if options are European because of put-call parity
8