The Black-Scholes-Merton Model - Introduction

The Black-Scholes-Merton
Model - Introduction
Chapter 13
Options, Futures, and Other

Derivatives, 7th Edition, Copyright ©
John C. Hull 2008 1
The Stock Price Assumption
Consider a stock whose price is S

In a short period of time of length t,
the return on the stock is normally
distributed:
S
  t ,  2 t 
S
where  is expected return and  is

volatility
Options, Futures, and Other Derivatives, 7 th Edition, Copyright © John C. Hull 2008 2
The Lognormal Property
(Equations 13.2 and 13.3, page 278)
It follows from this assumption that

 2  
ln ST  ln S 0     T ,  T 
2
 2  
or
  2  

ln ST  ln S 0     
T,  T
2
  2  
Since the logarithm of ST is normal, ST is
lognormally distributed

John C. Hull 2008 3
The Lognormal Distribution
E ( ST )  S0 e T
2 2 T  2T
var ( ST )  S0 e (e  1)
John C. Hull 2008
Continuously Compounded
ReturnEquations 13.6 and 13.7), page 279)
If x is the continuously
compounded return
ST  S 0 e xT
1 ST
x = ln
T S0
   
2 2
x     , 
 2 T 
John C. Hull 2008 5
Projecting stock price range
 Consider a stock with a price of $40, an expected return of
16% per annum and a volatility of 20% per annum. The
probability distribution of the stock price ST in 6 months is
given by ln ST is normally distributed with a mean of
ln40 + (0.16 – 0.2X0.2/2) X 0.5 and variance of 0.2X0.2X0.5.
Thus ln ST is normally distributed with a mean of 3.759 and
variance of 0.02.
 There is a 95% probability that a normally distributed variable
has a value within 1.96 standard deviation of its mean. In this
case, the standard deviation is 0.141. So we can say with
95% confidence that ln ST is between 3.759 – 1.96X0.141 and
3.759 + 1.96 X 0.141. So we can say with 95% confidence
that the stock price lies between e3.759-1.96x0.141 and e3.759+1.96x0.141
that is, between $32.55 and $56.56 in 6 months time.
Estimating Volatility from
Historical Data (page 282-84)
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  deviation, s , of
3. Calculate the standard
the ui´s
4. The historical volatility estimate is:
s
ˆ 

John C. Hull 2008 7
Nature of Volatility
Volatilityis 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

John C. Hull 2008 8
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
John C. Hull 2008 9
The Derivation of the Black-Scholes
Differential Equation
S  S t  S z
 ƒ ƒ  ƒ 2 2
2
ƒ
ƒ   S   ½ 2  S t  S z
 S t S  S
W e set up a portfolio consisting of
 1 : derivative
ƒ
+ : shares
S

John C. Hull 2008 10
Differential Equation continued
The value of the portfolio  is given by

ƒ
  ƒ  S
S
The change in its value in time t is given by
ƒ
  ƒ  S
S

Differential Equation continued
The return on the portfolio must be the risk - free

rate. Hence
  r t
We substitute for Δƒ and S in these equations
to get the Black - Scholes differential equation :
ƒ ƒ  2
ƒ
 rS ½  S
2 2
 rƒ
t S S 2

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
ƒ = S – K when t =T
The solution to the equation is
ƒ = S – K e–r (T – t )

The Black-Scholes Formulas
(See pages 291-293)
c  S 0 N (d1 )  K e  rT N (d 2 )
p  K e  rT N (d 2 )  S 0 N (d1 )
ln( S 0 / K )  (r   2 / 2)T
where d1 
 T
2
ln( S 0 / K )  (r   / 2)T
d2   d1   T
 T
The N(x) Function
N(x) is the probability that a normally
distributed variable with a mean of zero and
a standard deviation of 1 is less than x
See tables at the end of the book

Properties of Black-Scholes Formula
As S0 becomes very large c tends to

S0 – Ke-rT and p tends to zero
As S0 becomes very small c tends to zero

and p tends to Ke-rT – S0

Risk-Neutral Valuation
The variable  does not appear in the
Black-Scholes equation
The equation is independent of all
variables affected by risk preference
The solution to the differential equation is
therefore the same in a risk-free world
as it is in the real world
This leads to the principle of risk-neutral
valuation

Applying Risk-Neutral
Valuation
(See appendix at the end of Chapter 13)
1. Assume that the expected return

from the stock price is the risk-free
rate
2. Calculate the expected payoff
from the option
3. Discount at the risk-free rate

Valuing a Forward Contract with
Risk-Neutral Valuation
Payoff is ST – K
Expected payoff in a risk-neutral world
is S0erT – K
Present value of expected payoff is
e-rT[S0erT – K]=S0 – Ke-rT

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 correspondence
between prices and implied volatilities
Traders and brokers often quote implied
volatilities rather than dollar prices

The VIX S&P500 Volatility Index
Chapter 24 explains how the index is calculated

An Issue of Warrants &
Executive Stock Options
 When a regular call option is exercised the stock that
is delivered must be purchased in the open market
 When a warrant or executive stock option is
exercised new Treasury stock is issued by the
company
 If little or no benefits are foreseen by the market the
stock price will reduce at the time the issue of is
announced.
 There is no further dilution (See Business Snapshot
13.3.)

The Impact of Dilution
After the options have been issued it is not
necessary to take account of dilution when
they are valued
Before they are issued we can calculate the
cost of each option as N/(N+M) times the
price of a regular option with the same
terms where N is the number of existing
shares and M is the number of new shares
that will be created if exercise takes place

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

American Calls
An American call on a non-dividend-paying
stock should never be exercised early
An American call on a dividend-paying
stock should only ever be exercised
immediately prior to an ex-dividend date
Suppose dividend dates are at times t1, t2,
…tn. Early exercise is sometimes optimal at
time ti if the dividend at that time is greater
than  r ( t t )
K [1  e i 1 i
]
Black’s Approximation for Dealing with
Dividends in American Call Options
Set the American price equal to the

maximum of two European prices:
1. The 1st European price is for an
option maturing at the same time as the
American option
2. The 2nd European price is for an
option maturing just before the final ex-
dividend date


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The Black-Scholes-Merton

Options, Futures, and Other

Consider a stock whose price is S

where  is expected return and  is

It follows from this assumption that

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

The value of the portfolio  is given by

Options, Futures, and Other

The return on the portfolio must be the risk - free

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

As S0 becomes very large c tends to

As S0 becomes very small c tends to zero

Options, Futures, and Other

Options, Futures, and Other

1. Assume that the expected return

Options, Futures, and Other

e-rT[S0erT – K]=S0 – Ke-rT

Options, Futures, and Other

Options, Futures, and Other

Chapter 24 explains how the index is calculated

Options, Futures, and Other

Options, Futures, and Other

Options, Futures, and Other

Set the American price equal to the

Options, Futures, and Other

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