Options Pricing Models

Option Pricing Models

Option Pricing Model is a mathematical formula or a computational procedure to determine the theoretical value of the option. Basically there are two approaches for valuation of Options: Binomial Option Pricing Model,which is more of a computational procedure, and Black-Scholes Option Pricing Model, which is a mathematical formula.

Options Pricing Model

Black-Scholes Option Pricing Model

Fischer Black and Myron Scholes, professors at MIT, developed an option pricing model which was published in Journal of Political Economy in 1973. At the same time, another professor at MIT, Robert Merton was also working on option pricing. His findings were published in Bell Journal of Economics & Management Science in 1973. Merton however, did not receive much credit as Black & Scholes, whose name became permanently associated with the model. Black left MIT to work for Goldman Sachs in 1983 and later died in 1995 . In 1997, the Nobel Prize for Economic Science was awarded to Myron Scholes & Robert Merton, while recognising Blacks contribution.
Options Pricing Model

Fischer Black

Myron Scholes

Robert Merton

Black-Scholes Option Pricing Model Assumptions: Stock returns follow Lognormal distribution No transaction fees and taxes. No dividends during the life of the option. Trading in securities is on continuous basis The options are European Short-term risk-free interest rate rf and Volatility of Log return on the stock is constant.
Options Pricing Model

Stock Prices
3 0 0 0 .0 0

2 5 0 0 .0 0

s2 0 0 0 . 0 0 e c i r P _ l 1 5 0 0 .0 0 C e u l a V1 0 0 0 .0 0

5 0 0 .0 0

0 .0 0 0 1 J A N 2 0 0 1 0 6 A P R 2 0 0 1 1 1 J U L 2 0 0 1 1 6 O C T 2 0 0 1 2 3 J A N 2 0 0 2 2 9 A P R 2 0 0 2 3 1 J U L 2 0 0 2 0 7 N O V 2 0 0 2 1 1 F E B 2 0 0 3 2 1 M A Y 2 0 0 3 2 2 A U G 2 0 0 3 2 1 N O V 2 0 0 3 2 7 F E B 2 0 0 4 0 3 J U N 2 0 0 4 0 3 S E P 2 0 0 4 0 9 D E C 2 0 0 4 1 5 M A R 2 0 0 5 1 6 J U N 2 0 0 5 2 1 S E P 2 0 0 5 2 7 D E C 2 0 0 5 0 4 A P R 2 0 0 6 0 7 J U L 2 0 0 6 1 1 O C T 2 0 0 6 1 6 J A N 2 0 0 7 2 5 A P R 2 0 0 7 3 0 J U L 2 0 0 7 0 1 N O V 2 0 0 7

D a te
Options Pricing Model

Log Normal Stock Returns

500

400

y300 c n e u q e r F
200

100

Mean = 0.1183 Std. Dev. = 2.22395 N = 1,751 0 -30.00 -20.00 -10.00 0.00 10.00

LogR eturns
Options Pricing Model

Stock Prices

300

y c n2 0 0 e u q e r F

100

M e a n = 7 1 4.9 8 8 6 S td . D e v . = 5 6 7 . 9 6 1 1 2 N = 1 ,7 5 2 0 5 00 .0 0 1 0 0 0 .0 0 1 5 0 0 . 00 2 0 0 0 .0 0 2 5 00 .0 0 3 0 0 0 .0 0

C l _ P r ic e s

Options Pricing Model

BSOPM
The Black-Scholes formula is:

c = SoN(d1) Xe rft N(d2) and p = Xe rft N(-d2) SoN(-d1)

where,

d1 = ln(So/X) + (rf + 2/2)t t rf = Risk-Free Interest Rate d2 = d1 - t = annualised Volatility (Std Dev) t = Time to expiration of option c = European CALL price N(d1) & N(d2) = Cumulative p = European PUT price Normal probabilities So = Stock Price X = Exercise Price
Options Pricing Model

BSOPM - Illustration

Stock Price Exercise Price Time to expiration Risk-free interest rate Std. Deviation

S X T r sd
d1 d2 -d1 -d2 Xe

42.00 40.00 0.50 10.00% 20.00%

5 Step Process Calculate d1 Calculate d2 Find N(d1) Find N(d2) Plug-in the values
0.7791 0.7349 0.2209 0.2651

0.7693 N(d1) 0.6278 N(d2) -0.7693 N(-d1) -0.6278 N(-d2) 38.049

c p
Options Pricing Model

4.7594 0.8086

-rT