The BlackScholes

Model

Randomness matters in
nonlinearity
An call option with strike price of 10.
Suppose the expected value of a stock at
call options maturity is 10.
If the stock price has 50% chance of
ending at 11 and 50% chance of ending at
9, the expected payoff is 0.5.
If the stock price has 50% chance of
ending at 12 and 50% chance of ending at
8, the expected payoff is 1.

ds
rdt dz
s

Applying Itos Lemma, we can find

S S0e

1
( r 2 )t
z (t )
2

Therefore, the average rate of return is r0.5sigma^2. (But there could be problem
because of the last term.)

The history of option pricing models

1900, Bachelier, the purpose, risk
management
1950s, the discovery of Bacheliers work
1960s, Samuelsons formula, which
contains expected return
Thorp and Kassouf (1967): Beat the
market, long stock and short warrant
1973, Black and Scholes

The influence of Beat the Market

Practical experience is not merely the
ultimate test of ideas; it is also the ultimate
source. At their beginning, most ideas are
dimly perceived. Ideas are most clearly
viewed when presented as abstractions,
hence the common assumption that
academics --- who are proficient at
presenting and discussing abstractions --are the source of most ideas. (p. 6,
Treynor, 1973) (quoted in p. 49)

Why Black and Scholes

Jack Treynor, developed CAPM theory
CAPM theory: Risk and return is the same
thing
Black learned CAPM from Treynor. He
understood return can be dropped from
the formula

Fischer Black (1938 1995 )

Start undergraduate in physics

Transfer to computer science
Finish PhD in mathematics
Looking for something practical
Join ADL, meet Jack Treynor, learn finance and
economics
Developed Black-Scholes
Move to academia, in Chicago then to MIT
Return to industry at Goldman Sachs for the last
11 years of his life

 Fischer never took a course in either economics or

finance, so he never learned the way you were supposed
to do things. But that lack of training proved to be an
advantage, Treynor suggested, since the traditional
methods in those fields were better at producing
academic careers than new knowledge. Fischers
intellectual formation was instead in physics and
mathematics, and his success in finance came from
applying the methods of astrophysics. Lacking the ability
to run controlled experiments on the stars, the
astrophysist relies on careful observation and then
imagination to find the simplicity underlying apparent
complexity. In Fischers hands, the same habits of
research turned out to be effective for producing new
knowledge in finance. (p. 6)

 Both CAPM and Black-Scholes are thus much

simpler than the world they seek to illuminate,
but according to Fischer thats a good thing, not
a bad thing. In a world where nothing is
constant, complex models are inherently fragile,
and are prone to break down when you lean on
them too hard. Simple models are potentially
more robust, and easier to adapt as the world
changes. Fischer embraced simple models as
his anchor in the flux because he thought they
were more likely to survive Darwinian selection
as the system changes. (p. 14)

 John Cox, said it best, Fischer is the only

real genius Ive ever met in finance. Other
people, like Robert Merton or Stephen
Ross, are just very smart and quick, but
they think like me. Fischer came from
someplace else entirely. (p. 17)
Why Black is the only genius?
No one else can achieve the same level of
understanding?

 Fischers research was about developing clever

models ---insightful, elegant models that
changed the way we look at the world. They
have more in common with the models of
physics --- Newtons laws of motion, or
Maxwells equations --- than with the
econometric models --- lists of loosely
plausible explanatory variables --- that now
dominate the finance journals. (Treynor, 1996,
Remembering Fischer Black)

The objective of this course

We will learn Black-Scholes theory.
Then we will develop an economic theory
of life and social systems from basic
physical and economic principles.
We will show that the knowledge that
helps Black succeed will help everyone
succeed.
There is really no mystery.

Effect of Variables on Option

Pricing
Variable
S0
K
T

r
D

?
+
+

+?
+

+
+
+

+
+
+

The Concepts Underlying

Black-Scholes
The option price and the stock price depend on the
same underlying source of uncertainty
We can form a portfolio consisting of the stock and
the option which eliminates this source of uncertainty
The portfolio is instantaneously riskless and must
instantaneously earn the risk-free rate
This leads to the Black-Scholes differential equation

The Derivation of the BlackScholes Differential Equation

S S t S z

2 2 2

S
2 S t
S z
t
S
S
S

W e set up a portfolio consisting of

1 : derivative

+ : shares
S

The Derivation of the Black-Scholes

Differential Equation continued
The value of the portfolio is given by

S
S
The change in its value in time t is given by

S
S

The Derivation of the Black-Scholes

Differential Equation continued
The return on the portfolio must be the risk - free
rate. Hence
r t
We substitute for and S in these equations
to get the Black - Scholes differenti al equation :
2

2 2
rS
S
r
2
t
S
S

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
In a forward contract the boundary condition is
= S K when t =T
The solution to the equation is
= S K er (T t )

The payoff structure

When the contract matures, the payoff is

C ( S ,0) max(S K ,0)

Solving the equation with the end condition,
we obtain the Black-Scholes formula

The Black-Scholes Formulas

c S 0 N (d1 ) K e

rT

N (d 2 )

p K e rT N (d 2 ) S 0 N (d1 )
2
ln(S 0 / K ) (r / 2)T
where d1
T
ln(S 0 / K ) (r 2 / 2)T
d2
d1 T
T

The basic property of BlackSchoels formula

C S Ke

rT

Rearrangement of d1, d2
S
ln( rT )
1
Ke
d1
T
2
T
S
ln( rT )
1
Ke
d2
T
2
T

Properties of B-S formula

When S/Ke-rT increases, the chances of
exercising the call option increase, from
the formula, d1 and d2 increase and N(d1)
and N(d2) becomes closer to 1. That
means the uncertainty of not exercising
decreases.
When increase, d1 d2 increases,
which suggests N(d1) and N(d2) diverge.
This increase the value of the call option.

Similar properties for put options

rT

Ke
ln(
)
1
S
d2
T
2
T
rT
Ke
ln(
)
1
S
d1
T
2
T

Calculating option prices

The stock price is $42. The strike price for
a European call and put option on the
stock is $40. Both options expire in 6
months. The risk free interest is 6% per
annum and the volatility is 25% per
annum. What are the call and put prices?

Solution
S = 42, K = 40, r = 6%, =25%, T=0.5
ln( S 0 / K ) (r 2 / 2)T
d1
T

= 0.5341
ln( S 0 / K ) (r 2 / 2)T
d2
T

= 0.3573

Solution (continued)
c S 0 N (d1 ) K e

rT

N (d 2 )

=4.7144

pKe

rT

=1.5322

N (d 2 ) S 0 N (d1 )

The Volatility
The volatility of an asset is the standard
deviation of the continuously
compounded rate of return in 1 year
As an approximation it is the standard
deviation of the percentage change in the
asset price in 1 year

Estimating Volatility from

Historical Data
1. Take observations S0, S1, . . . , Sn at intervals of
years
2. Calculate the continuously compounded
return in each interval as:

Si

ui ln
S i 1

3. Calculate the standard deviation, s , of the uis

4. The historical volatility estimate is:

Implied Volatility
The implied volatility of an option is the
volatility for which the Black-Scholes price
equals the market price
The is a one-to-one correspondence
between prices and implied volatilities
Traders and brokers often quote implied
volatilities rather than dollar prices

Causes of Volatility
Volatility is usually much greater when the
market is open (i.e. the asset is trading)
than when it is closed
For this reason time is usually measured
in trading days not calendar days when
options are valued

Dividends
European options on dividend-paying
stocks are valued by substituting the stock
price less the present value of dividends
into Black-Scholes
Only dividends with ex-dividend dates
during life of option should be included
The dividend should be the expected
reduction in the stock price expected

Calculating option price with

dividends
Consider a European call option on a stock
when there are ex-dividend dates in two
months and five months. The dividend on
each ex-dividend date is expected to be
$0.50. The current share price is $30, the
exercise price is $30. The stock price
volatility is 25% per annum and the risk
free interest rate is 7%. The time to
maturity is 6 month. What is the value of
the call option?

Solution
The present value of the dividend is
0.5*exp (-2/12*7%)+0.5*exp(-5/12*7%)=0.9798

S=30-0.9798=29.0202, K =30, r=7%,

=25%, T=0.5
d1=0.0985
d2=-0.0782
c= 2.0682

Investment strategies and

outcomes
With options, we can develop many
different investment strategies that could
generate high rate of return in different
scenarios if we turn out to be right.
However, we could lose a lot when market
movement differ from our expectation.

Example
Four investors. Each with 10,000 dollar
initial wealth.
One traditional investor buys stock.
One is bullish and buys call option.
One is bearish and buy put option.
One believes market will be stable and
sells call and put options.

Parameters
S
K
R
T
sigma
d1
d2
c
p

20
20
0.03
0.5
0.3
0.1768
-0.035
1.8299
1.5321

 Number of call options the second

investor buys
10000/ 1.8299 = 5464.84

Number of put options the second investor

buys
10000/ 1.5321 = 6526.91

Final wealth for four investors with

different levels of final stock price.
Final stock price

20

15

30

10000

7500

15000

Second investor

54648.4

Third investor

32635

30000

-2635

-24648.4

First investor

Fourth investor

American Calls
An American call on a non-dividend-paying
stock should never be exercised early
Theoretically, what is the relation between an
American call and European call?
What are the market prices? Why?

An American call on a dividend-paying stock

should only ever be exercised immediately
prior to an ex-dividend date

Put-Call Parity; No Dividends

Consider the following 2 portfolios:
Portfolio A: European call on a stock + PV of the
strike price in cash
Portfolio C: European put on the stock + the stock
Both are worth MAX(ST , K ) at the maturity of the
options
They must therefore be worth the same today
This means that

c + Ke -rT = p + S0

An alternative way to derive PutCall Parity

From the Black-Scholes formula

C P SN (d ) Ke rT N (d ) {Ke rT N (d ) SN (d )}
1
2
2
1
S Ke rT

Arbitrage Opportunities
Suppose that
c =3

S0 = 31

T = 0.25
r = 10%
K =30
D=0
What are the arbitrage
possibilities when
p = 2.25 ?
p=1?

Application to corporate liabulities

Black, Fischer; Myron Scholes (1973).
"The Pricing of Options and Corporate
Liabilities

Put-Call parity and capital structure

Assume a company is financed by equity and a zero
coupon bond mature in year T and with a face value of
K. At the end of year T, the company needs to pay off
debt. If the company value is greater than K at that time,
the company will payoff debt. If the company value is
less than K, the company will default and let the bond
holder to take over the company. Hence the equity
holders are the call option holders on the companys
asset with strike price of K. The bond holders let equity
holders to have a put option on their asset with the strike
price of K. Hence the value of bond is

 Value of debt = K*exp(-rT) put

Asset value is equal to the value of
financing from equity and debt
Asset = call + K*exp(-rT) put
Rearrange the formula in a more familiar
manner
call + K*exp(-rT) = put + Asset

Example
A company has 3 million dollar asset, of
which 1 million is financed by equity and 2
million is finance with zero coupon bond
that matures in 5 years. Assume the risk
free rate is 7% and the volatility of the
company asset is 25% per annum. What
should the bond investor require for the
final repayment of the bond? What is the
interest rate on the debt?

equity financing

1million

debt financing

2million

total asset

3million

debt maturity

5years

risk free rate

volatility

7%
25%

S
K
R
T
sigma
c
p
value of debt
debt rate

3
3.253908
0.07
5
0.25
1
0.29299
2
0.097342

Discussion
From the option framework, the equity
price, as well as debt price, is determined
by the volatility of individual assets. From
CAPM framework, the equity price is
determined by the part of volatility that covary with the market. The inconsistency of
two approaches has not been resolved.

Homework1
The stock price is $50. The strike price for
a European call and put option on the
stock is $50. Both options expire in 9
months. The risk free interest is 6% per
annum and the volatility is 25% per
annum. If the stock doesnt distribute
dividend, what are the call and put prices?

Homework2
Three investors are bullish about Canadian stock market.
Each has ten thousand dollars to invest. Current level
of S&P/TSX Composite Index is 12000. The first
investor is a traditional one. She invests all her money
in an index fund. The second investor buys call options
with the strike price at 12000. The third investor is very
aggressive and invests all her money in call options
with strike price at 13000. Suppose both options will
mature in six months. The interest rate is 4% per
annum, compounded continuously. The implied
volatility of options is 15% per annum. For simplicity we
assume the dividend yield of the index is zero. If
S&P/TSX index ends up at 12000, 13500 and 15000
respectively after six months. What is the final wealth of
each investor? What conclusion can you draw from the
results?

Homework3
The price of a non-dividend paying stock
is $19 and the price of a 3 month
European call option on the stock with a
strike price of $20 is $1. The risk free rate
is 5% per annum. What is the price of a 3
month European put option with a strike
price of $20?

Homework4
A 6 month European call option on a
dividend paying stock is currently selling
for $5. The stock price is $64, the strike
price is $60. The risk free interest rate is
8% per annum for all maturities. What
opportunities are there for an arbitrageur?

Homework5
Use Excel to demonstrate how the change
of S, K, T, r and affect the price of call
and put options. If you dont know how to
use Excel to calculate Black-Scholes
option prices, go to COMM423 syllabus
page on my teaching website and click on
Option calculation Excel sheet

Homework6
A company has 3 million dollar asset, of
which 1 million is financed by equity and 2
million is finance with zero coupon bond
that matures in 10 years. Assume the risk
free rate is 7% and the volatility of the
company asset is 25% per annum. What
should the bond investor require for the
final repayment of the bond? What is the
interest rate on the debt? How about the
volatility of the company asset is 35%?

Homework 7
The stock prices of companies A, B are both at 10
dollars per share. Both companies provide their CEOs
with shares or options as part of their packages.
Company A provides its CEO 1 million shares. What is
the value of these shares? Company B provides its CEO
call options on 10 million shares with strike price at 10
dollars and a maturity of 5 years. Assume the risk free
rate is 2% per annum and the volatility is 25% per
annum. Please calculate the total value of the call
options. Is the value of the option provided to the CEO of
company B higher or lower than the value of shares
provided to the CEO of company A?