BLACK AND SCHOLES

Technique to option pricing Model

Mahesh Sharma - 278 Nitin Divakar - 216

FEATURES OF OPTION TECHNIQUE

Complex : Modern option pricing techniques are often considered among the most mathematically complex of all applied areas of finance. Accuracy : Financial analysts have reached the point where they are able to calculate, with alarming accuracy, the value of a stock option. Improved Version : Model is actually an improved version of a previous model developed by A. James Boness in his Ph.D. dissertation at the University of Chicago.

HISTORY
The 1st person to find a mathematical approach for the valuation of option was Mr. Louis Bachelier in 1900 Formula for option pricing was found in 1970 by Myron Scholes and Fisher Black. Famously known as Black-Scholes formula Types of Option American Options European Options Asian Options

ASSUMPTIONS OF THE BLACK AND SCHOLES MODEL

The stock pays no dividends during the option's life European exercise terms are used Markets are efficient No commissions are charged Interest rates remain constant and known Returns are lognormally distributed Returns are lognormally distributed

CALCULATION OF PREMIUM
Formula : Call Option Premium C = SN(d1) X N(d2) e^(-rt)
Where : C = price of Call Option S = Strike Price of Underlying Stock X = Exercise Price of Stock r = Risk Free Interest Rate t = time until expiration in year N () = Area under the normal Curve d1 = {ln(S/X) + [r + (SD)^2/2]^t}/SD(t)^1/2 d2 = d1 SD (t)^1/2 SD= Standard Deviation

CALCULATION OF PREMIUM
Formula : Put Option Premium
P = X N(-d2) e^(-rt)- SN(-d1)
Where : P = price of Put Option S = Strike Price of Underlying Stock X Exercise Price of Stock r = Risk Free Interest Rate t = time until expiration in year N () = Area under the normal Curve d1 = {ln(S/X) + [r + (SD)^2/2]^t}/SD(t)^1/2 d2 = d1 SD (t)^1/2 SD= Standard Deviation