Chapter 6

The Black-Scholes Option Pricing Model

2004 South-Western Publishing

Outline
     

Introduction The Black-Scholes option pricing model Calculating Black-Scholes prices from historical data Implied volatility Using Black-Scholes to solve for the put premium Problems using the Black-Scholes model

Introduction


The Black-Scholes option pricing model (BSOPM) has been one of the most important developments in finance in the last 50 years

Has provided a good understanding of what options should sell for Has made options more attractive to individual and institutional investors

The Black-Scholes Option Pricing Model

 

  

The model Development and assumptions of the model Determinants of the option premium Assumptions of the Black-Scholes model Intuition into the Black-Scholes model

The Model
C ! SN (d1 )  Ke  RT N (d 2 ) where W2 S T ln  R  2 K W T

d1 ! and

d 2 ! d1  W T

The Model (contd)



Variable definitions:
S K e R T W = = = = = = current stock price option strike price base of natural logarithms riskless interest rate time until option expiration standard deviation (sigma) of returns on the underlying security natural logarithm

ln = N(d1) and N(d2) = cumulative standard normal distribution functions

Development and Assumptions of the Model



Derivation from:

Physics Mathematical short cuts Arbitrage arguments

Fischer Black and Myron Scholes utilized the physics heat transfer equation to develop the BSOPM

Determinants of the Option Premium

     

Striking price Time until expiration Stock price Volatility Dividends Risk-free interest rate

Striking Price


The lower the striking price for a given stock, the more the option should be worth

Because a call option lets you buy at a predetermined striking price

Time Until Expiration



The longer the time until expiration, the more the option is worth

The option premium increases for more distant expirations for puts and calls

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Stock Price


The higher the stock price, the more a given call option is worth

A call option holder benefits from a rise in the stock price

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Volatility


The greater the price volatility, the more the option is worth

The volatility estimate sigma cannot be directly observed and must be estimated Volatility plays a major role in determining time value

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Dividends


A company that pays a large dividend will have a smaller option premium than a company with a lower dividend, everything else being equal

Listed options do not adjust for cash dividends The stock price falls on the ex-dividend date

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Risk-Free Interest Rate



The higher the risk-free interest rate, the higher the option premium, everything else being equal

A higher discount rate means that the call premium must rise for the put/call parity equation to hold

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Assumptions of the BlackScholes Model



    

The stock pays no dividends during the options life European exercise style Markets are efficient No transaction costs Interest rates remain constant Prices are lognormally distributed

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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

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The Stock Pays no Dividends During the Options Life (contd)

The Robert Miller Option Pricing Model
* C * ! e  dT SN (d1* )  Ke  RT N (d 2 )

where W2 S T ln  R  d  2 K d1* ! W T and

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* d 2 ! d1*  W T

European Exercise Style



A European option can only be exercised on the expiration date

American options are more valuable than European options Few options are exercised early due to time value

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Markets Are Efficient



The BSOPM assumes informational efficiency

People cannot predict the direction of the market or of an individual stock Put/call parity implies that you and everyone else will agree on the option premium, regardless of whether you are bullish or bearish

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No Transaction Costs


There are no commissions and bid-ask spreads

Not true Causes slightly different actual option prices for different market participants

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Interest Rates Remain Constant



There is no real riskfree interest rate

Often the 30-day T-bill rate is used Must look for ways to value options when the parameters of the traditional BSOPM are unknown or dynamic

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Prices Are Lognormally Distributed



The logarithms of the underlying security prices are normally distributed

A reasonable assumption for most assets on which options are available

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Intuition Into the Black-Scholes Model



The valuation equation has two parts

One gives a pseudo-probability weighted expected stock price (an inflow) One gives the time-value of money adjusted expected payment at exercise (an outflow)

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Intuition Into the Black-Scholes Model (contd)

C ! SN (d1 )

 Ke

 RT

N (d 2 )

Cash Inflow

Cash Outflow

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Intuition Into the Black-Scholes Model (contd)



The value of a call option is the difference between the expected benefit from acquiring the stock outright and paying the exercise price on expiration day

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Calculating Black-Scholes Prices from Historical Data



To calculate the theoretical value of a call option using the BSOPM, we need:

The stock price The option striking price The time until expiration The riskless interest rate The volatility of the stock

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Calculating Black-Scholes Prices from Historical Data

Valuing a Microsoft Call Example
We would like to value a MSFT OCT 70 call in the year 2000. Microsoft closed at $70.75 on August 23 (58 days before option expiration). Microsoft pays no dividends. We need the interest rate and the stock volatility to value the call.

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Calculating Black-Scholes Prices from Historical Data

Valuing a Microsoft Call Example (contd)
Consulting the Money Rate section of the Wall Street Journal, we find a T-bill rate with about 58 days to maturity to be 6.10%. To determine the volatility of returns, we need to take the logarithm of returns and determine their volatility. Assume we find the annual standard deviation of MSFT returns to be 0.5671.

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Calculating Black-Scholes Prices from Historical Data

Valuing a Microsoft Call Example (contd)
Using the BSOPM:
W2 S T ln  R  2 K d1 ! W T .56712 70.75 0.1589 ln  .0610  2 70 ! .2032 ! .5671 .1589

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Calculating Black-Scholes Prices from Historical Data

Valuing a Microsoft Call Example (contd)
Using the BSOPM (contd):

d 2 ! d1  W T ! .2032  .2261 ! .0229

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Calculating Black-Scholes Prices from Historical Data

Valuing a Microsoft Call Example (contd)
Using normal probability tables, we find:

N (.2032) ! .5805 N ( .0029) ! .4909

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Calculating Black-Scholes Prices from Historical Data

Valuing a Microsoft Call Example (contd)
The value of the MSFT OCT 70 call is:

C ! SN (d1 )  Ke ! $7.04
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 RT

N (d 2 )

! 70.75(.5805)  70e (.0610 )(.1589 ) (.4909)

Calculating Black-Scholes Prices from Historical Data

Valuing a Microsoft Call Example (contd)
The call actually sold for $4.88. The only thing that could be wrong in our calculation is the volatility estimate. This is because we need the volatility estimate over the options life, which we cannot observe.

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Implied Volatility
     

Introduction Calculating implied volatility An implied volatility heuristic Historical versus implied volatility Pricing in volatility units Volatility smiles

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Introduction


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

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Calculating Implied Volatility



Sigma cannot be conveniently isolated in the BSOPM

We must solve for sigma using trial and error

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Calculating Implied Volatility (contd)

Valuing a Microsoft Call Example (contd)
The implied volatility for the MSFT OCT 70 call is 35.75%, which is much lower than the 57% value calculated from the monthly returns over the last two years.

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An Implied Volatility Heuristic



For an exactly at-the-money call, the correct value of implied volatility is:

W implied

0.5(C  P ) 2T / T ! T K /(1  R )

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Historical Versus Implied Volatility



The volatility from a past series of prices is historical volatility Implied volatility gives an estimate of what the market thinks about likely volatility in the future

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Historical Versus Implied Volatility (contd)



Strong and Dickinson (1994) find

Clear evidence of a relation between the standard deviation of returns over the past month and the current level of implied volatility That the current level of implied volatility contains both an ex post component based on actual past volatility and an ex ante component based on the markets forecast of future variance

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Pricing in Volatility Units



You cannot directly compare the dollar cost of two different options because

Options have different degrees of moneyness A more distant expiration means more time value The levels of the stock prices are different

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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

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Volatility Smiles (contd)

Volatility Smile Microsoft August 2000
60 Current Stock Price

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Implied Volatility (%)

40

30

20

10

0 40 45 50 55 60 65 70 75 80 85 90 95 100 105

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Striking Price

Using Black-Scholes to Solve for the Put Premium



Can combine the BSOPM with put/call parity:

P ! Ke

 RT

N ( d 2 )  SN ( d1 )

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Problems Using the BlackScholes Model



Does not work well with options that are deep-in-the-money or substantially out-ofthe-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

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