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Black Scholes Merton

option pricing model


Amir Akbari
BSM Model
lognormal stock prices
(and some other
assumptions)

Myron Scholes & Fischer Black (1973)

Field of pricing formula


Financial for European
Engineering options

A. Akbari DERIVATIVE SECURITIES 2


BSM Model: Assumptions
No arbitrage opportunities.

Security trading is continuous.

The risk-free rate of interest, r, is constant.


Lognormal stock price distribution, with constant
Expected return of growth of stocks, , and its
variance, 2

~ , 2

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Assumptions
Other assumption, these are for simplicity and can be
relaxed:

Short selling is permitted.

No transaction costs or taxes.

All securities are perfectly divisible.

No dividends during the life of the derivative.

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Assumptions
Is the real world truly as simple?
Simple and obvious answer is NO.
Some assumptions are relax with later revisions of BSM
(more complex)

But, BSM model have some advantages:


Dynamic Trading and Delta Position
Importance of Volatility

A. Akbari DERIVATIVE SECURITIES 5


BSM Model: Price the Derivative

Do the same steps as Binomial Tree

1. Find out the payoffs at maturity

2. Get expected pay-off of derivative using RN


probability

3. Discount expected pay-off with riskless rate

A. Akbari DERIVATIVE SECURITIES 6


BSM Model: Option Prices
After extensive and ugly math, you get option
prices:

= 0 1 2
= 0 1 + (2 )
Where,
2 2
ln(0 ) + + 2 ln(0 )+
2
1 = 2 = = 1

A. Akbari DERIVATIVE SECURITIES 7


Option Prices

1. plug values of , , , , 0 in 1 and 2

2. Find them in the table

3. Get the option prices!

Note that is absent. Why?


Risk neutral investor only cares about not

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Option Prices: Numerical Example

Get ATM call option on Google stock

Current price: $700

Maturity = 6 month

Interest rate = 2%

Volatility = 30%

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Option Prices: Numerical Example

Get ATM call option on Google stock


Current price: $700 ln(700700)+
30%2 6
2%+ 2 12
1 = = 0.153
30% 6/12
Maturity = 6 month

Interest rate = 2%
2 = 0.153 30% 6/12 = -0.059
Volatility = 30%

6
2%12
= 700 0.153 700 0.059

= $ 62.38
A. Akbari DERIVATIVE SECURITIES 10
BSM and Risk Neutral Probability
Rewriting BSM formula we can find Risk Neutral
Probability from BSM:

Risk Neutral Prob( > ) = 2

Recall, Real world Probability is calculated from stock


2
distribution: ~ 0 + , 2
2

A. Akbari DERIVATIVE SECURITIES 14


BSM and Risk Neutral Probability
Analyzing the Call option Analyzing the Put option

Risk Neutral Probability Risk Neutral Probability

Prob( > ) = 2 Prob( < ) = 2

E | > = 2 E | < = 2

E | > = 0 1 E | < = 0 1

A. Akbari DERIVATIVE SECURITIES 20


BSM: Dynamic Replication
= 0 1 2
No arbitrage says:
If we buy 1 of the stock and
lend 2
We have a portfolio with the same price as a call option
We can synthetically replicate a call option
Note that
At each point, T, time to maturity reduces => 1 and 2
changes
So the trading weights changes (Dynamic Trading)

A. Akbari DERIVATIVE SECURITIES 21


Dynamic Replication

Dynamic Replication enables Market Makers to

increase the liquidity of options available in the

market, by dynamically trading the asset and

investing in the risk free market.

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Numerical Example

BMO is trading $42 and has volatility of 20% per


annum. Assume risk-free interest rate is 10% per
annum.

What is the price of a put option with exercise price


of $40 and maturity of 6 month? $0.79

But, You notice that a put option is selling $1.20.


How can you benefit from the mispricing?

A. Akbari DERIVATIVE SECURITIES 23


Numerical Example (Cont)

How can you benefit from the mispricing?

Put is traded expensive => Sell 1 put

Buy a synthetic put option (worth $0.79)


= 0 1 + (2 )

sell 0.22 share of BMO stock

Borrow $10.18

A. Akbari DERIVATIVE SECURITIES 24


Options and Dividends
Similar to the discussion on forward prices, with
dividend paying stocks substitute 0 with 0 .

we have:
= 0 1 2
= 0 1 + (2 )

2 2
ln(0 )
+ + 2 ln(0 ) + 2
1 = 2 =

A. Akbari DERIVATIVE SECURITIES 25


BSM Model and Volatility
= 0 1 2
2 2
ln(0 ) + + 2 ln(0 ) + 2
1 = 2 =

Previous Use historical volatility as an


Session estimate of get call price

BSM call price < Market prices. What the problem?


1)We do not observe , maybe we estimate it incorrectly.
2)Assumptions of BSM are not valid!
A. Akbari DERIVATIVE SECURITIES 26
BSM Model and Volatility
= 0 1 2
2 2
ln(0 ) + + 2 ln(0 ) + 2
1 = 2 =

This Use market option prices and get


Session implied volatility of the stock

BSM call price = Market prices.


BSM with what value of gives option prices equal
to the market price
A. Akbari DERIVATIVE SECURITIES 27
Implied Volatility

Implied Volatility Calculator:


http://www.option-price.com/implied-volatility.php
Insert call price (), Stock price (0 ), Strike price (), risk
free rate (), time to maturity ()
The calculator gives

Because of Call-Put parity Implied volatility from call


and put are the same (see the bonus slides)

A. Akbari DERIVATIVE SECURITIES 28


Implied Volatility

The implied volatility of an option is the volatility for


which the Black-Scholes price equals the market price

There is a one-to-one (and complex) correspondence


between prices and implied volatilities

Since, (risk averse) investors treat risk as costs, Traders


and brokers often quote implied volatilities rather than
dollar prices for the option.

A. Akbari DERIVATIVE SECURITIES 29


Implied Volatility: Forward Looking
This is a significant discovery! Extract stock volatility
from option prices

Implied Volatility is market belief about future!

It is forward looking measure as opposed to historical


volatility, which is backward looking

A. Akbari DERIVATIVE SECURITIES 30


VIX the fear factor
The VIX S&P500 Volatility Index

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Implied Volatility

BSM assumes a constant , but historical prices show


volatile periods as well as calm periods.
So, It is expected that for different horizons, T,
volatility change:
1 , 1 1
2 , 2 2
But the data show a bizarre behavior of options on
same maturity:
, 1 , 1 1
, 2 , 2 2 !!

A. Akbari DERIVATIVE SECURITIES 32


Implied Volatility: example

the relationship SPY Nov08 Options, 1:17 PM Oct 08, 2008


S=$99.63, T=30days, r(1-M LIBOR)=4.29%, q=2.18%
between Implied 70.00

60.00

Implied Volatility %
Volatility and strike 50.00

40.00

price for options on 30.00

20.00
S&P 500 (SPY) with a 10.00

certain maturity 0.00


80 84 88 92 96 100 104 108 112 116 120
K

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Volatility smile
Implied Volatility

Strike Price

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Historical Implied Volatility Patterns

Different underlying asset classes have different


Implied Volatility patterns:
Equity Index
Individual Stocks
Foreign Exchange
Commodities

These patterns relate to fundamentals of the assets


and might change in different periods.

A. Akbari DERIVATIVE SECURITIES 35


Smile Patterns: Equity Index

S&P 500 Index options: Since 87 crash, mostly


downward sloping
Lower Strike Price (K) seems
Implied Volatility

costlier for Equity Index Options


(higher risk)

Strike Price

A. Akbari DERIVATIVE SECURITIES 36


Smile Patterns: Equity Index

S&P 500 Index options: Since 87 crash, mostly


downward sloping
Implied Volatility

Strike Price

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Smile Patterns: Equity Index
Lower Strike Price (K) seems costlier for Equity Index
Options (higher risk)
Fear of very out of money put being exercised due to extreme
move

Negative Skewness of index return distribution

The left tail is heavier and the


right tail is less tick than the
lognormal distribution.
Possibly due to Crash-o-phobia!

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Smile Patterns: Individual Equity

Largely symmetric, minor curvature

One explanation:

Implied Volatility
volatility of a firm is more
related to its production
technology (unsystematic+
systematic) and
doesnt change very much
at a cross section of time
Strike Price

A. Akbari DERIVATIVE SECURITIES 39


Smile Patterns: Foreign Exchange

FX options: Symmetric

Fear of very out of money

Implied Volatility
put or call being exercised
due to moves in both
directions.
Currency crashes happen
on both sides, while for
equity is market crash on
the down side
Strike Price

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Smile Patterns: Foreign Exchange
Low and high Strike Prices (K) seem costlier for FX
Options (higher risk)
Excess Kurtosis in Distribution for Foreign Currency
Options

Both tails are heavier than


the lognormal distribution and it
peaks more.
Exchange rate exhibits jumps!

A. Akbari DERIVATIVE SECURITIES 41


Smile Patterns: Commodities

Some commodity options (like Gold): Upward sloping


smile sometimes

Implied Volatility
Positive skewness

Fly to Quality during bad


times. Crash-o-Phobia!

Strike Price

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Smile Patterns: Summary

stochastic
Jumps volatility

fatter tails
(excess
kurtosis)

Flat Large
smile smile

A. Akbari DERIVATIVE SECURITIES 43


Smile Patterns: Summary

Higher fear of
underlying
price drop

Negative
(left)
skewness

downward
sloping
smile

A. Akbari DERIVATIVE SECURITIES 44


Smile Patterns: Summary
upward
sloping
smile

Positive
(right)
skewness

Higher fear of
underlying
price growth

A. Akbari DERIVATIVE SECURITIES 45


Implied Volatility: Summary

BSM assumes volatility of stock is constant


over time; is not a function of time to
maturity or strike price.
Market Prices show that volatility changes
with and
Volatility is Cost, therefore Investors require
premium for bearing the cost

A. Akbari DERIVATIVE SECURITIES 46


BSM
details of the model
Bonus
BSM Model: Price the Derivative

1. Find out the payoffs

2. Develop riskless portfolio and Calculate Delta

3. Get expected pay-off of derivative using RN


probability

4. Discount expected pay-off with riskless rate

A. Akbari DERIVATIVE SECURITIES 48


BSM: Riskless portfolio and Delta
Portfolio of long shares, short 1 derivative

S 0 f S f

Su in
S0 u u fd df
millisec

Sd Su S d onds!
dS
d
d
rdt
rt

A. Akbari DERIVATIVE SECURITIES 49


BSM: Riskless portfolio and Delta
Portfolio of long shares, short 1 derivative

df d
S f rdt
dS

The change in its value in time dt is given by


d
d dS d
dS

We need & to calculate the price


A. Akbari DERIVATIVE SECURITIES 50
BSM: partial Derivatives &
is change in stock price (GBM)
dS RNmeasure
dt dz
S dS rS dt S dz

is change in derivative price (Ito Lemma)

d d d 2 2 2 d
d rS 2
S dt S dz
dS dt dS dS

*z is a random variable with zero mean and variance

A. Akbari DERIVATIVE SECURITIES 51


BSM: Partial Differential Equation (PDE)
Now we put back & S f

d d

rdt d r dt d
dS
dS d

df 1 d 2 f 2 2 df
2 S dt r f S dt
dS
2
dt dS

df df 1 2 2 d 2 f
rS 2 S 2
rf
dt dS dS

A. Akbari DERIVATIVE SECURITIES 52


BSM: The Differential Equation

Any security whose price is dependent on the stock


price satisfies the differential equation
The particular security being valued is determined by
the boundary conditions of the differential equation

E.g: forward contract:


boundary condition at = : =

The solution to the PDE at : = K er (T t)

A. Akbari DERIVATIVE SECURITIES 53


BSM: The Differential Equation

Any security whose price is dependent on the stock


price satisfies the differential equation
The particular security being valued is determined by
the boundary conditions of the differential equation

E.g: European call option:


> 0
boundary condition at = : =
0 < 0

The solution to the PDE: = 0 1 2

A. Akbari DERIVATIVE SECURITIES 54


BSM Model
Yet this is back-of-the-envelope calculation

Thats why you might consider masters in


finance!
A. Akbari DERIVATIVE SECURITIES 55
Implied Volatility and
Call Put Parity
Bonus Slides
Implied Volatility

What is the relationship of a Volatility Smile of


European Calls and Put?

they are the same!


why? Call-Put parity
= + 0

Put-call parity holds for market prices and for


BSM prices

A. Akbari DERIVATIVE SECURITIES 57


Implied Volatility: call or put?
Implied Volatility calculated from a European call
option should be the same as that calculated from a
European put option when both have the same strike
price and maturity
Call-Put parity
= 0 =
= 0

where is the call option price based on BSM formula and


is the observed market price for the call option. So, when
= the = . Therefore, =

A. Akbari DERIVATIVE SECURITIES 58


Any Questions?

A. Akbari DERIVATIVE SECURITIES 59


Next Class

Greeks

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References

Chapter 15 & 20: Options, Futures, and Other


Derivatives, 8th Edition, Copyright John C.
Hull 2012

A. Akbari DERIVATIVE SECURITIES 61

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