BLACK-SCHOLES OPTIONS PRICING MODEL

Click to edit Master subtitle style

5/7/12

After completing the chapter, you should be able to calculate the fair value of an option and decide whether the market price of the option is high or low than the fair value.

5/7/12

BSOPM
BSOPM depends on the five factors to calculate the fair value of options. These are:
Stock Price (P0), Exercise (Strike) Price, Time to Expire (t) in years, Volatility () Risk Free Rate (kRF)

5/7/12

THE FORMULA UNDER BSOPM

Vc = P0 Nd1 X ekRFt Nd2

d1 = [ln P0/X + (kRF + 0.5 2)t] t

d2 = d1 - t

Vp = Vc -

X ekRFt

+ P0

5/7/12

Example Vc
Given, Stock Price (P0) Exercise Price (X) Volatility () Risk Free Rate = $62 = $60 = 32% = 4%

Time to Expiration (t) = 40 days

5/7/12

Solution
Step I: To calculate, Value of Call (Vc), first

we need to calculate d1 and d2

So
d1 = [ln P0/X + (kRF + 0.5 2)t] t

d1 = [ln 62/60 + (0.4 + 0.5(0.32)2 (40/365)] 0.32 (40/365) d1

= 0.404

d2 = d1 - t

5/7/12

Solution
Accordingly, d1 = 0.40 and d2 = 0.30 Step II: Find the value of d1 and d2 from the table showing Cumulative Area under Standard Normal Distribution Table

So, Nd1 = 0.6554 and Nd2 = 0.6179

Step III: Put various values into the Vc formulae Vc = P0 Nd1 X ekRFt Vc = 62 * 0.6554 (60/1.004389)* 0.6179 = 40.6348 59.7378*0.6179
5/7/12

Nd2

Solution Vp
Vc = P0 Nd1 X ekRFt Nd2

d1 = [ln P0/X + (kRF + 0.5 2)t] t

d2 = d1 - t

Vp = Vc -

X ekRFt

+ P0

5/7/12