Derivatives (ECONM3017)

Lecture Nine: Options IV

(The Black-Scholes-Merton Model)

Nick Taylor
nick.taylor@bristol.ac.uk

University of Bristol

Derivatives Lecture Nine 1 / 37

Table of contents

1 Learning Outcomes
2 General Information
3 The BSM Differential Equation
4 The BSM Formula
5 Adjustments
6 Hedging Using Options
7 Volatility
8 Summary
9 Reading

Derivatives Lecture Nine 2 / 37

Learning Outcomes

At the end of this lecture you will be able to:

1 Derive the Black-Scholes-Merton differential equation.
2 Understand the concept of risk-neutral valuation.
3 Use the Black-Scholes-Merton option pricing model.
4 Use derivatives to hedge long and short positions.
5 Differentiate between the different risks faced when taking option positions.
6 Appreciate the importance of implied volatility.

Derivatives Lecture Nine 3 / 37

General Information

Defining Features
The Black-Scholes-Merton differential equation (BSM differential
equation henceforth) is an equation that must be satisfied by the price
of any derivative dependent on a non-dividend paying stock.
The derivation involves setting up a risk-free portfolio consisting of a
position in the derivative and a position in the stock.
The return on this portfolio must be the risk-free rate – this insight
ultimately leads to the BSM differential equation.

Derivatives Lecture Nine 4 / 37

General Information (cont.)

Assumptions
Stock prices follow geometric Brownian Motion.
Short selling is allowed.
No transaction costs or taxes.
No dividends.
No arbitrage opportunities.
Trading is continuous.
Risk-free rate is constant and equal across maturities.

Derivatives Lecture Nine 5 / 37

The BSM Differential Equation

Derivation of the BSM Differential Equation

Assume that stock prices evolve as follows (geometric Brownian motion):

dS = µSdt + σSdz.

Moreover, the price of any security whose price (f ) depends on S will follow
the Itô process,

1 ∂2f
 
∂f ∂f 2 ∂f
df = µS + + (σS) dt + σSdz,
∂S ∂t 2 ∂S 2 ∂S

where all previous notation is maintained.

Derivatives Lecture Nine 6 / 37

The BSM Differential Equation (cont.)

Derivation of the BSM Differential Equation (cont.)

Discrete versions of the previous two equations are given by

∆S = µS∆t + σS∆z,

and
1 ∂2f
 
∂f ∂f 2 ∂f
∆f = µS + + (σS) ∆t + σS∆z,
∂S ∂t 2 ∂S 2 ∂S
respectively.

Derivatives Lecture Nine 7 / 37

The BSM Differential Equation (cont.)

Derivation of the BSM Differential Equation (cont.)

As the same Wiener process (uncertainty) underlies the stock and the
derivative then it is possible to eliminate this process (uncertainty) by taking
(and combining) certain positions in the two securities. The positions are:

− 1 unit of the derivative security,

∂f
units of the underlying stock.
∂S
These positions imply that the portfolio values (and changes thereof) will be

∂f ∂f
Π = −f + S, ∆Π = −∆f + ∆S,
∂S ∂S
where the change in the portfolio value is measured over the period ∆t.

Derivatives Lecture Nine 8 / 37

The BSM Differential Equation (cont.)

Derivation of the BSM Differential Equation (cont.)

Substituting in the expressions for ∆f and ∆S into the expression for ∆Π,
∂f
∆Π = −∆f + ∆S,
∂S
1 ∂2f
 
∂f ∂f 2 ∂f ∂f
=− µS + + (σS) ∆t − σS∆z + (µS∆t + σS∆z) .
∂S ∂t 2 ∂S 2 ∂S ∂S | {z }
| {z } ∆S
∆f

Rearranging (and cancelling out terms),

1 ∂2f
   
∂f  ∂f ∂f ∂f ∂f
(σS)2 − µS ∆t + − ZσS + ZσS ∆z,
 Z Z
=− µS + + 2
∂S ∂t 2 ∂S ∂S
 ∂S Z ∂S Z
1 ∂2f
 
∂f
=− + 2
(σS)2 ∆t.
∂t 2 ∂S

Derivatives Lecture Nine 9 / 37

The BSM Differential Equation (cont.)

Derivation of the BSM Differential Equation (cont.)

As the constructed portfolio is risk-free (i.e., no z’s), then the return on this
portfolio must also be risk-free. Therefore,

∆Π = r Π∆t,

where r is the risk-free rate. Substituting in the expressions for Π and ∆Π

we obtain
1 ∂2f
   
∂f ∂f
+ 2
(σS)2 ∆t = r f − S ∆t.
∂t 2 ∂S ∂S
| {z } | {z }
∆Π Π

Rearranging leads to the BSM differential equation,

∂f ∂f 1 2 2 ∂2f
+ rS + σ S = rf .
∂t ∂S 2 ∂S 2

Derivatives Lecture Nine 10 / 37

The BSM Differential Equation (cont.)

Derivation of the BSM Differential Equation (cont.)

The BSM differential equation can be solved subject to certain boundary
conditions. We are interested in solving the equation in the presence of the
following boundary conditions:

European Call : f = max(S − K , 0), when t = T ,

and

European Put : f = max(K − S, 0), when t = T .

where previous notation is maintained.

Derivatives Lecture Nine 11 / 37

The BSM Formula

Risk-Neutral Valuation
The BSM differential equation does not contain variables that are
affected by investors’ risk preferences.
It follows that any set of risk preferences can be used when evaluating
f.
The very simple assumption that all investors are risk-neutral can be
made.
It follows that the expected return on all investment assets is the
risk-free rate.
Under risk-neutral valuation, solutions obtained are valid in all worlds
(not just the risk-neutral world).

Derivatives Lecture Nine 12 / 37

The BSM Formula (cont.)

The BSM Pricing Formula

The BSM formula (aka Black-Scholes model) for the price of a European
call on a non-dividend paying stock is

c = SN(d1 ) − Ke −rT N(d2 ),

where
ln(S/K ) + (r + σ 2 /2)T
d1 = √ ,
σ T
ln(S/K ) + (r − σ 2 /2)T √
d2 = √ = d1 − σ T ,
σ T
where N(.) is the cumulative probability distribution function for a
standardised normal distribution.

Derivatives Lecture Nine 13 / 37

The BSM Formula (cont.)

The BSM Pricing Formula (cont.)

Moreover, the BSM formula for the price of a European put on non-dividend
paying stock is
p = Ke −rT N(−d2 ) − SN(−d1 ),
where all previous notation is maintained.

Example
Consider a European call option on a stock with a strike price of $40 and six
months to maturity. The current stock price is $42, the volatility of stock
returns is 20% per annum, and the risk-free rate is 10%. The d1 and d2
parameter values are given by

ln(42/40) + ((0.1 + 0.22 /2) × 0.5)

d1 = √ = 0.7693,
0.2 0.5
ln(42/40) + ((0.1 − 0.22 /2) × 0.5)
d2 = √ = 0.6278.
0.2 0.5

Derivatives Lecture Nine 14 / 37

The BSM Formula (cont.)

The BSM Pricing Formula (cont.)

Example (cont.)
Thus, the theoretical price of a European call is

c = 42 N(0.7693) − 40e −0.10×0.5 N(0.6278) = $4.76,

where N(0.7693) = 0.7791 and N(0.6278) = 0.7349. Furthermore, the

theoretical price of a European put with the same variables is given by

p = 40e −0.10×0.5 N(−0.6278) + 42 N(−0.7693) = $0.81,

where N(−0.7693) = 1 − 0.7791 = 0.2209 and

N(−0.6278) = 1 − 0.7349 = 0.2651.

Derivatives Lecture Nine 15 / 37

Adjustments

Dividends
European Options
Use the BSM formula with the present value of dividends removed
from the current stock price: thus,

c = S a N(d1 ) − Ke −rT N(d2 ), p = Ke −rT N(−d2 ) − S a N(−d1 ),

with
ln(S a /K ) + (r + σ 2 /2)T √
d1 = √ , d2 = d1 − σ T ,
σ T
where S a = S − D, and D is the present value of dividends paid during
the life of the option (with the risk-free rate used to discount
dividends).
Important Note: if the underlying pays
a dividend yield q (e.g., stock indices)
then S a = Se −qT .

Derivatives Lecture Nine 16 / 37

Adjustments (cont.)

Dividends (cont.)
European Options (cont.)

Example
Consider a six-month maturity European call option on a stock with expected
dividends of $0.50 each paid in two and five months. The current stock price
and the strike price are both $40, the annualised volatility is 30%, and the
risk-free rate is 9%. The present value of dividends, and adjusted stock price,
will be

D = 0.5e −0.09×2/12 + 0.5e −0.09×5/12 = 0.9741, S a = 40 − 0.9741 = 39.0259.

Substituting into the adjusted BSM formula gives d1 and d2 values of

ln(39.0259/40) + ((0.09 + 0.32 /2) × 0.5)

d1 = √ = 0.2017,
0.3 0.5
√
d2 = 0.2017 − 0.3 0.5 = −0.0104.

Derivatives Lecture Nine 17 / 37

Adjustments (cont.)

Dividends (cont.)
European Options (cont.)

Example (cont.)
Using the above values, the theoretical call price can be calculated as follows:

c = 39.0259 N(0.2017) − 40e −0.09×0.5 N(−0.0104),

= (39.0259 × 0.5800) − 40e −0.09×0.5 0.4959 = 3.67,

or $3.67. A similar methodology can be used to price European put options.

Derivatives Lecture Nine 18 / 37

Adjustments (cont.)

Dividends (cont.)
American Options
It is only optimal to exercise an American call option immediately
before the stock goes ex-dividend. This (partly) motivates Black’s
approximation methodology. Black’s approximation involves two steps:
1 Calculate the prices of European options that mature at time T and tn
(where tn is the final ex-dividend date before the maturity of the
option).
2 Set the American call price equal to the greater of the two.

Note: The European option prices

used in Black’s approximation must
make use of stock prices with the
present value of dividends removed.

Derivatives Lecture Nine 19 / 37

Adjustments (cont.)

Futures Options
A futures option gives the owner the right (not obligation) to enter into a
futures contract at a certain futures price by a certain date. We use Black’s
model for valuing these options. The formula is

c = e −rT (FN(d1 ) − KN(d2 )), p = e −rT (KN(−d2 ) − FN(−d1 )),

with
ln(F /K ) + (σ 2 /2)T √
d1 = √ , d2 = d1 − σ T ,
σ T
where F is the current futures price, and σ is the volatility of the futures
price.
Note: When the cost of carry and the
convenience yield are functions only of
time, the volatility of the futures price
equals the volatility of the underlying
asset.

Derivatives Lecture Nine 20 / 37

Adjustments (cont.)

Futures Options (cont.)

Example
Consider a European put futures option on a commodity. The time to the
option’s maturity is 4 months, the current futures price is $20, the exercise price
is $20, the risk-free interest rate is 9% per annum, and the volatility of the
futures price is 25% per annum. In this case, as ln(F /K ) = 0 we have
√
σ T
d1 = = 0.07216, N(−d1 ) = 0.4712,
2
√
σ T
d2 = − = −0.07216 N(−d2 ) = 0.5288,
2

and the put price p is given by

p = e −0.09×4/12 (20 × 0.5288 − 20 × 0.4712) = 1.12,

or $1.12.

Derivatives Lecture Nine 21 / 37

Hedging Using Options

Delta
Delta (∆) is defined as the rate of change of the option price with respect to
the underlying asset; specifically,
∂c
∆=
,
∂S
where all previous notation is maintained.
Delta Hedging
This involves maintaining a delta neutral portfolio, in turn, achieved by
purchasing ∆ shares for every one share contained in the option position.
European Call Delta: for a European call on a non-dividend paying
stock ∆ = N(d1 ), where N(.) is the cumulative density function for a
standard normal distribution.
European Put Delta: for a European put on a non-dividend paying
stock ∆ = N(d1 ) − 1.

Derivatives Lecture Nine 22 / 37

Hedging Using Options (cont.)

Delta Hedging (cont.)

Example
A bank has sold for $300000 a European call option on 100000 shares of a
non-dividend paying stock. Furthermore, assume that the current stock price is
$49, the strike price is $50, the risk-free rate is 5% per annum, the stock return
volatility is 20% per annum, the time to maturity is 20 weeks (0.3846 years),
and the expected return on the stock is 13% per annum. Using this information
we have

ln(49/50) + ((0.05 + 0.22 /2) × 0.3846)

d1 = √ = 0.0542.
0.2 × 0.3836

Thus, the delta is N(d1 ) or 0.522. When the stock price changes by ∆S, the
option price changes by 0.522∆S.

Derivatives Lecture Nine 23 / 37

Hedging Using Options (cont.)

Delta Hedging (cont.)

Note that:
As delta changes over time, the investor’s position remains delta
neutral for only a relatively short period of time.
Consequently, the hedge has to be frequently adjusted or rebalanced.
When hedges are rebalanced the process is referred to as dynamic
hedging (as opposed to static hedging).

Derivatives Lecture Nine 24 / 37

Hedging Using Options (cont.)

Gamma
The gamma (Γ) of a portfolio of options on an underlying asset is the rate
of change of the portfolio’s delta with respect to the price of the underlying
asset. It is given by
∂2Π
Γ= ,
∂S 2
where Π is the value of the portfolio of options.

Derivatives Lecture Nine 25 / 37

Hedging Using Options (cont.)

Gamma (cont.)
Note that:
If gamma is small (large) then delta changes slowly (rapidly), and
hence infrequent (frequent) adjustments are required to keep a
portfolio delta neutral.
Gamma is greatest for options that are close to the money.
Gamma addresses delta hedging errors caused by curvature in the
relationship between call premia and the underlying asset price.

Derivatives Lecture Nine 26 / 37

Hedging Using Options (cont.)

Gamma (cont.)
The difference between C 0 and C 00 in the following diagram leads to hedging
error. The size of this error is measured by gamma.

Source: Chapter 17, Hull (2008).

Derivatives Lecture Nine 27 / 37

Hedging Using Options (cont.)

Gamma (cont.)
For a European call or put option on a non-dividend paying stock, gamma is
given by
N 0 (d1 )
Γ= √ ,
Sσ T
where all previous notation is maintained.

Example (cont.)
Using the parameters in the above example, the option’s gamma is given by

N 0 (0.0542)
Γ= √ = 0.066.
49 × 0.2 × 0.3846

Thus, when the stock price changes by ∆S, the delta of the option changes by
0.066 × ∆S.

Derivatives Lecture Nine 28 / 37

Hedging Using Options (cont.)

Vega
Vega (ν) is the rate of change of the value of a derivatives portfolio with
respect to volatility.
Theta
The theta (Θ) of a portfolio of options is the rate of change of the value of
the portfolio with respect to time (all other things remaining equal).
Rho
The rho (ρ) of a portfolio of options is the rate of change of the value of the
portfolio with respect to the interest rate.

Derivatives Lecture Nine 29 / 37

Hedging Using Options (cont.)

Managing Delta, Gamma and Vega Risk

Note that:
Delta risk (i.e., changes in delta over time) can be eliminated by
altering the position taken in the underlying asset.
By contrast, gamma and vega risk can only be eliminated via use of
positions in ‘other’ derivatives.

Derivatives Lecture Nine 30 / 37

Hedging Using Options (cont.)

The Realities of Hedging

In a perfect world, portfolios would be frequently rebalanced such that all
Greeks equalled zero. However, in reality:
Traders usually ensure that their portfolios are delta-neutral at least
once a day.
When possible, gamma and vega risk is reduced (by rarely eliminated).
The larger the portfolio, the less expensive hedging becomes
(economies of scale).

Derivatives Lecture Nine 31 / 37

Volatility

Implied Volatility
Some facts:
Volatility is the only parameter in the BSM pricing formula that cannot
be directly observed.
Traders often make use of volatilities implied by observed option prices
(and the BSM pricing formula) – referred to as implied volatilities.
Implied volatilities are used to monitor the market’s opinion about
future volatility.
The SPX VIX index is an index of the implied volatility of 30-day
options on the S&P 500 calculated using a range of calls and puts.

Derivatives Lecture Nine 32 / 37

Volatility (cont.)

Implied Volatility (cont.)

Example
Let c = 1.875, S = 21, K = 20, r = 0.1, and T = 0.25. Implied volatility is the
measure of σ that generates a BSM-calculated value for c equal to 1.875. By
iterative search (analytical solutions are not available):

σ = 0.2 ⇒ c ∗ = 1.76,
σ = 0.3 ⇒ c ∗ = 2.10,
σ = 0.25 ⇒ c ∗ > 1.875,
σ = 0.235 ⇒ c ∗ = 1.875.

Thus, the implied volatility is 0.235 (or 23.5%).

Derivatives Lecture Nine 33 / 37

Volatility (cont.)

Volatility Smiles
A plot of the implied volatility of an option as a function of its strike price
should be flat if the option pricing model is accurate. However, such plots
reveal volatility smiles or volatility skews.
Foreign Currency Options
Observation: implied volatility is lower for at-the-money options than
for in-the-money and out-of-the-money options, i.e., volatility smiles.
Reason: exchange rates are not unconditionally lognormally distributed
(time-varying volatility, jumps).

Derivatives Lecture Nine 34 / 37

Volatility (cont.)

Volatility Smiles (cont.)

Equity Options
Observation: since 1987, implied volatility falls as the strike price
increases, i.e., volatility skews.
Reason: equity returns are not unconditionally lognormally distributed
(leverage) .

Volatility Term Structure

A plot of the implied volatility of an option as a function of its maturity.
This does not have to be flat; indeed, empirically it is upward sloping when
short-term volatility is low (i.e., markets expect volatility to rise in the
future), and downward sloping when short-term volatility is high (i.e.,
markets expect volatility to fall in the future).

Derivatives Lecture Nine 35 / 37

Summary

The BSM Differential Equation

Derivation by construction of a risk-free portfolio (hence risk-neutral
valuation).
The BSM Formula
European calls and puts (with and without dividends), plus Black’s
approximation for American calls with dividends.
Hedging Using Options
Basic hedging strategies, dynamic hedging, and the Greeks.
Volatility
Implied volatility, volatility smiles, and volatility skews.

Derivatives Lecture Nine 36 / 37

Reading

Essential Reading
Chapters 15, 17, 18, 19, and 20, Hull (2015).
Further Reading
Ederington, L., and W. Guan, 2002, Why are those options smiling?, Journal
of Derivatives 10, 9–34.

Derivatives Lecture Nine 37 / 37