Black-Scholes Pricing

& Related Models

Option Valuation
Black and Scholes
Call Pricing
Put-Call Parity
Variations
Option Pricing: Calls
Black-Scholes Model:
C S N d X e
rT
N d
d
S
X
r T
T
d d T
N d
=

=

(
+ +
|
\

|
.
|
|
=
=

Probabilty of Exercise
( ) ( )
ln
( )
1 2
1
2
2
2 1
o
o
o
C = Call
S = Stock Price
N = Cumulative Normal
Distrib. Operator
X = Exercise Price
e = 2.71.....
r = risk-free rate
T = time to expiry
= Volatility
o
Call Option Pricing Example
IBM is trading for $75. Historically, the volatility is 20% (o). A call
is available with an exercise of $70, an expiry of 6 months, and
the risk free rate is 4%.
ln(75/70) + (.04 + (.2)
2
/2)(6/12)
d
1
= -------------------------------------------- = .70, N(d
1
) = .7580
.2 * (6/12)
1/2

d
2
= .70 - [ .2 * (6/12)
1/2
] = .56, N(d
2
) = .7123

C = $75 (.7580) - 70 e
-.04(6/12)
(.7123) = $7.98

Intrinsic Value = $5, Time Value = $2.98
Put Option Pricing
Put priced through
Put-Call Parity:
Put Price = Call Price + X e
-rT
- S
From Last Example of IBM Call:

Put = $7.98 + 70 e
-.04(6/12)
- 75
= $1.59
Intrinsic Value = $0, Time Value = $1.59
) ( ) (
1 2
d SN d N Xe P
rT
- - - =
-
(or : )
Black-Scholes Variants
Options on Stocks with Dividends
Futures Options
(Option that delivers a maturing futures)
Blacks Call Model (Black (1976))
Put/Call Parity
Options on Foreign Currency
In text (Pg. 375-376, but not reqd)
Delivers spot exchange, not forward!
The Stock Pays no Dividends
During the Options Life
If you apply the BSOPM to two
securities, one with no dividends and
the other with a dividend yield, the
model will predict the same call
premium
Robert Merton developed a simple
extension to the BSOPM to account
for the payment of dividends
The Stock Pays Dividends During
the Options Life (contd)
Adjust the BSOPM by following (o=continuous dividend yield):
T d d
T
T o R
X
S
d
d N Xe d SN e C
RT oT
o
o
o
=
|
|
.
|


\
|
+ +
|
.
|

\
|
=
=

*
1
*
2
2
*
1
*
2
*
1
*
and
2
ln
where
) ( ) (
Futures Option Pricing Model
Blacks futures option pricing model
for European call options:



| |
T a b
T
T
K
F
a
b KN a FN e C
RT
o
o
o
=
+
|
.
|

\
|
=
=

and
2
ln
where
) ( ) (
2
Futures Option Pricing Model
(contd)
Blacks futures option pricing model
for European put options:


Alternatively, value the put option
using put/call parity:






| | ) ( ) ( a FN b KN e P
RT
=

) ( K F e C P
RT
=

Assumptions of the Black-
Scholes Model
European exercise style
Markets are efficient
No transaction costs
The stock pays no dividends during
the options life (Merton model)
Interest rates and volatility remain
constant, but are unknown

Interest Rates Remain Constant
There is no real riskfree interest
rate
Often use the closest T-bill rate to
expiry
Calculating
Volatility Estimates
from Historical Data:
S, R, T that just was, and o as standard deviation of
historical returns from some arbitrary past period
from Actual Data:
S, R, T that just was, and o implied from pricing of
nearest at-the-money option (termed implied
volatility).
Intro to Implied Volatility
Instead of solving for the call
premium, assume the market-
determined call premium is correct
Then solve for the volatility that
makes the equation hold
This value is called the implied
volatility
Calculating Implied Volatility
Setup spreadsheet for pricing at-the-
money call option.
Input actual price.
Run SOLVER to equate actual and
calculated price by varying o.
Volatility Smiles
Volatility smiles are in contradiction
to the BSOPM, which assumes
constant volatility across all strike
prices
When you plot implied volatility
against striking prices, the resulting
graph often looks like a smile
Volatility Smiles (contd)
Volatility Smile
Microsoft August 2000
0
10
20
30
40
50
60
40 45 50 55 60 65 70 75 80 85 90 95 100 105
Striking Price
I
m
p
l
i
e
d

V
o
l
a
t
i
l
i
t
y

(
%
)
Current Stock
Price
Problems Using the Black-
Scholes Model
Does not work well with options that are deep-in-
the-money or substantially out-of-the-money

Produces biased values for very low or very high
volatility stocks
Increases as the time until expiration increases

May yield unreasonable values when an option
has only a few days of life remaining