Class6 X

Announcement Applications Option Pricing (Ch 17) Black-Scholes Equation
Financial Economics
Class 6
Steven Wei Ho
Department of Economics
Columbia University
March 2nd, 2020

Outline
1 Announcement
2 Applications
Pricing Kernel in Continuous Time (Ch 1.5)
3 Option Pricing (Ch 17)
Option Basics
Prices: One-Period Analysis
Practical Aspects of Option Investing
More Option Strategies
Arbitrage Bounds
4 Black-Scholes Equation
Option Value
Black-Scholes Differential Equation
Full Solution
Reminder
Proposal due tonight by 11.59pm to my email

The continuous-time analogue of pt = Et [mt+1 xt+1 ]

0 = Λt Dt dt + Et [d (Λt pt )]
∴ 0 = Λt Dt dt + Et [pt · dΛt + Λt · dpt + dpt · dΛt ]

h i
Divide both sides by pΛ ← 0 = Dt dt
pt + Et dΛt
Λt + dp dpt dΛt
pt + pt · Λt
t
dΛt

Recall from preivous class: rf ,t dt = −E Λt
h i h i h i
Dt dt dΛt dpt dpt
0= pt + Et Λt + Et pt + Et pt · dΛ
Λt
t
h i h i
Dt dt dpt dpt
0= pt − rf ,t dt + Et pt + Et pt · dΛ
Λt
t
h i h i
dpt dpt
Et pt + Dpt tdt = rf ,t dt − Et pt · dΛ
Λt
t
dΛt 1 dct2
From previous class: Λt = −δdt − γt dc
ct + 2 · ηt ·
t
ct2
h i h i
dpt dpt
Plug the above into Et pt + Dpt tdt = rf ,t dt − Et pt · dΛ
Λt
t
dct2
h i h i
dpt dpt 1
Et pt + Dpt tdt = rf ,t dt − Et pt · −δdt − γt dc
ct + 2 · ηt ·
t
ct2
h i h i
dpt dpt
Et pt + Dpt tdt = rf ,t dt + γt Et pt · dct
ct
h i h i
dpt dpt
Et pt + Dpt tdt − rf ,t dt = γt Et pt · dct
ct
Assets whose return covary more strongly with consumption gets higher
mean excess return
h i h i
dpt dpt
Et pt + Dpt tdt = rf ,t dt + γt Et pt · dct
ct
which is the analogue of :
E (Ri ) = Rf − Rf · cov (m, Ri )

h i
In Et dp
pt
t dΛt
· Λt , since the means are of order dt, there is no difference
between covariance and second moment
From before
h i h i
dpt dpt
Et pt + Dpt tdt − rf ,t dt = γt Et pt · dc
ct
t
Let µp = Et (dpt /pt ) , σp2 = Et (dpt /pt )2 , σc2 = Et (dct /ct )2 ,

h i h i
since correlation is no greater than 1:
µp + Dpt tdt − rf ,t dt ≤ γt σp σc
D d
µp + pt t −rf ,t dt
i.e. t
σp ≤ γt σc
Continuous-time analogue to:

| E (R)−R
σ(R) | ≤ γσ (ln (c))
f
Option Basics
Call option: gives owner the right, but not the obligation, to purchase the
underlying asset at a predetermined price (strike price or exercise price ) on
or before a predetermined expiration date
Put Option: gives owner the right, but not the obligation, to sell. . .
Vanilla exercise rights:
European option: can only be exercised on the expiration date
American option: can be exercised any time before as well as on the

expiration date
Non-Vanilla exercise rights:

Bermuda option: can only be exercised on a set of predetermined,
discretely-spaced dates (typically monthly)
Canary option: can be exercised on a set of predetermined dates

(typically quarterly), but not before a certain period has passed
(typically one-year)
Option Basics
Notations:
CT = max (ST − X , 0) PT = max (X − ST , 0)

ST − X , ST > X 0 , ST > X
Call payoff= Put payoff=
0 , ST ≤ X X − ST , ST ≤ X
Option Basics
Call Option Put Option

Market price > strike price in-the-money out-of-the money
Market price = strike price at-the-money at-the-money
Market price < strike price out-of-the money in-the-money
Hedge
To reduce risk by holding contracts or securities whose payoffs are
negatively correlated with some risk exposure
Speculate
When investors use contracts or securities to place a bet on the direction
in which they believe the market is likely to move
In summary
Long Position in an Option Contract: The value (payoff) of a call option
at expiration is C = max (ST − K , 0)
Long Position in an Option Contract: The value (payoff) of a put option
at expiration is P = max (K − ST , 0)
Although payouts on a long position in an option contract are never negative,
the profit from purchasing an option and holding it to expiration could be
negative because the payout at expiration might be less than the initial cost of
the option
Option Basics
The DJX index option contract is based on 1/100th (one-one-hundredth) of the

current value of the Dow Jones Industrial Average (DJIA)
You have decided to purchase 25 contracts of September 2016 put (1

contract=100 options) on the DJIA with an exercise price of $180
How much money will this purchase cost you?
Is this option in-the-money or out-of-the-money?
Solution:
The ask price is $6.35 per contract. The total cost is 25 × $6.35 × 100
= $15,875
Because the strike price ($180) exceeds the current price ($178.65), the
put option is in-the-money
The first two digits in the option name refer to the year of expiration. The
option name also includes the month of expiration, the strike or exercise price,
and the ticker symbol of the individual option
The first line of the left column is a call option with an exercise price of $70
that expires on the Saturday following the third Friday of July 2009 (July 18)
Consider the 09 August 80 call option on Amazon stock, the option costs $4.00 and expires in 45 days
Assume you choose to finance the purchase by borrowing $4.00 at an interest

rate of 3% per year
If the stock price at expiration is S, then the profit is the call payoff minus the
amount owed on the loan (shown in red): max (S − 80, 0) − 4.00 × 1.0345/365
Since 4 × 1.0345/365 = 4.01, you make a positive profit only if the stock price
exceeds $84.01
Because a short position in an option is the other side of a long position, the
profits from a short position in an option are just the negative of the profits of a
long position
Returns for Holding an Option to Expiration
The maximum loss on a purchased call option is 100% (when the option expires
worthless)
Out-of-the money call options are more likely to expire worthless, but if the
stock goes up sufficiently, it will also have a much higher return than an
in-the-money call option
Call options have more extreme returns than the stock itself
The maximum loss on a purchased put option is 100% (when the option expires
worthless)
Put options will have higher returns in states with low stock prices
Put options are generally not held as an investment, but rather as insurance to
hedge other risk in a portfolio
Option Basics
Writing (i.e., shorting or selling) options
Option Strategies: Portfolios of put and call options
Straddle strategy: Combine a put and call at the same strike price. It is a
bet on volatility.
This strategy pays off if the stock goes up or goes down
Loses money if the stock does not move
Option Basics
Protective Put : buy the stock and a put

Protect against down-side risk
Position ST < X ST > X
Underlying ST ST
Put X − ST 0
Net X ST
Option Basics
Covered call: own the stock and sell a call

can collect call premium
sacrifice up-side potential for somewhat higher profit [given the
collected call premium] in average/bad states of the world
Position ST < X ST > X

Underlying ST ST
Short Call 0 − (ST − X )
Net ST X
Prices: One-Period Analysis
The following two portfolios should have the same payoff

(1) Hold a call, write a put, same strike price
(2) Hold stock, promise to pay the strike price X
The payoffs are related by: CT − PT = ST − X , i.e. PT = CT − ST + X
Apply E (m·) to both sides, obtain put-call parity:
P = C − S + X /Rf
Average Option Returns
Expected Option Returns by Joshua D. Coval and Tyler Shumway
X-s denotes the % difference between the option’s strike price and the
underlying price
SPX returns are recorded in weekly percentage terms
Recall: Covered Call [i.e., Buy Write]: Sell (write) one call and Buy one share of
underlying stock
In general, what is the hypothetical performance of such a strategy?

Enter CBOE-BXM
The BXM is an index based on buying an S&P 500 stock index portfolio,
and "writing" (i.e. shorting or selling) the near-term S&P 500 Index call
option, generally on the third Friday of each month
The call option written will have about one month remaining to expiration
an exercise price slightly above the prevailing index level (i.e.,almost at
the money and slightly out of the money)
BXM vs S&P 500 (historical)
Since its 1986 inception, BXM has earned returns on par with the S&P 500 Index, but
with less volatility. The BXM tends to underperform the S&P 500 Index during
periods of sharply rising markets. In quiet market conditions, the BXM has the
potential to outperform the S&P 500 Index due to the premium collected on the sale
of the call option...This strategy is a potential solution for investors concerned about
reducing overall portfolio volatility. Source: Hewitt EnnisKnupp
Sharpe ratio=(Mean portfolio return−Risk-free rate)/Standard deviation of portfolio
return. It measures how much return you are compensated for taking on additional
risk (i.e., higher standard deviation). Highest Sharpe ratio=best return to risk ratio
What if you feel a bit more bullish?
The CBOE 2% OTM BuyWrite Index (BXY) is the index for you
Same as BXM, but write 2% out of the money (2% OTM) call options
E.g. if current S&P500 level is 100, write calls with strike 102
The Put Write Index (CBOE-PUT) can deliver an even higher Sharpe ratio
Short the closest out of the money put option on S&P500 index and
Invest K /(1 + r )T in Treasuries
Similar payoff profile to buy write (can you draw this?)
Is there money to be made here?

Sharpe ratios for the period January 1990 – March 2012
More Option Strategies
More strategies: Strips and Straps

1 Strip:Long two puts and one call
2 Strap: Long one put and two calls
Purpose? You know that price will move a lot in the near future and want
to ‘bet’ on one direction a little more than on the other
Your worst case is again that nothing happens (i.e. stock price at maturity
is very close to strike price)
Butterfly. The strategy involves
Buy one call at strike X-a (e.g. $50)
Sell two calls at strike X (e.g. $60)
Buy one call at strike X+a (e.g. $70)
Purpose: making money when the price of the underlying at maturity is right at
a target
Arbitrage Bounds
A > B, m > 0 → E (mA) > E (mB)
Recall that
CT = max (ST − X , 0)
CT ≥ 0 → C ≥ 0
CT ≥ ST − X → C ≥ S − X /Rf
CT ≤ ST → C ≤ S
Arbitrage Bounds
Early Exercise
Payoff CT = max (ST − X , 0) ≥ ST − X

Price C ≥ S − X /Rf
Rf > 1 S − X /Rf ≥ S −X
You should never exercise an American call option (on an

underlying stock which doesn’t pay dividend) early, in the
absence of dividend
S − X is what you get if you exercise now. The value of the
call is greater than this value because exercising early loses the
option value
Intrinsic value
Payoff that could be made if the option was immediately exercised
Call: stock price - exercise price
Put: exercise price - stock price
Time value
The difference between the option price and the intrinsic value
How do we price options?

Black-Scholes option pricing formula (Nobel Prize 1997)
We shall now use Black-Scholes eqution to price European options
Recall from earlier

dS
S = µdt + σdz
dΛt (µ−rf ,t )
Λt = −rf ,t · dt − σ · dzt
and, in the absence of dividends: 0 = Et [d (Λp)]
Guess that the solution for the call price is a function of stock price
and time to expiration:
C = C (S, t)
Use Ito’s lemma:

1
dC = Ct dt + CS dS + CSS dS 2
2
1 2 2
= Ct + CS Sµ + CSS S σ dt + CS Sσdz
2
Note: Ct here is a partial derivative, not call option value at time t

From previous slide:

dC = Ct + CS Sµ + 21 CSS S 2 σ 2 dt + CS Sσdz

dΛ
Λ = −r · dt − (µ−r )
σ · dz
Given Et (dΛ/Λ) = −rdt, plug in to the basic asset pricing equation [of
course the price of asset is C in this scenario]:
0 = Et [d (Λp)] = CEt (dΛ) + ΛEt (dC ) + Et (dΛ · dC )
0 = −Cr Λdt + ΛCt dt + ΛCS Sµdt + Λ · 12 CSS S 2 σ 2 dt−Λ (µ − r ) Cs Sdt
0 = −rC + Ct + CS Sµ + 12 CSS S 2 σ 2 − S (µ − r ) CS
0 = −rC + Ct + 21 CSS S 2 σ 2 + SrCS
This is the Black-Scholes differential equation for the option price

Black-Scholes differential equation

0 = −rC + Ct + 21 CSS S 2 σ 2 + SrCS
Using the boundary condition at expiration C (ST , T ) = max (ST − X , 0),

can easily obtain solution numerically by solving backwards:
∂C (S,t) ∂C (S,t) ∂ 2 C (S,t) 2 2

− ∂t = −rC (S, t) + Sr ∂S + 12 ∂S 2
S σ
Can solve for full analytical solution

guess-and-verify approach
Numerical solution through a grid (we will not do this):

1. At any point in time, you know the values of C (S, t) for all S, on a grid for S
2. Then, you can take the first and second derivatives with respect to S and
form the quantity on the right-hand side at each value of S
3. Now, you can find the option price at any value of S, one instant earlier in
time
Caveats on Black-Scholes Pricing:
The stock pays no dividends during the option’s life
No arbitrage
No fees/commissions
Interest rates remain constant and known
Returns are lognormally distributed

Full Solution
To price the option directly using the Discount Factor

C0 = E0 { ΛΛT0 max (ST − X , 0)} = ΛT
R
Λ0 max (ST − X , 0) df (ΛT , ST )
where ΛT and ST are solutions to
dS
= µdt + σdz
S
dΛ µ−r
= −rdt − dz
Λ σ
Solutions means finding the distribution of the random variables
ΛT , ST using information at time 0
Review, with the following specification:
dY
Y = µY dt + σY dz [Geometric Brownian motion]
dY 1 1 1 2

dln (Y ) = − dY 2 = µY − σY dt + σY dz
Y 2 Y2 2
σY2

ln (YT ) = ln (Y0 ) + µY − 2 T + σY (zT − z0 )
where zT − z0 is a normally distributed random variable with mean 0

variance T
Full Solution
dY
With Y = µY dt + σY dz
2

σY
ln (YT ) = ln (Y0 ) + µY − 2
T + σY (zT − z0 )
2

σY
E [ln (YT )] = ln (Y0 ) + µY − 2
T ; Var [ln (YT )] = σY2 T
zT −z0
Let ε = √ ∼ N (0, 1)
T
Apply to dS
S
= µdt + σdz
2
√
ln (ST ) = ln (S0 ) + µ − σ2 T +σ Tε
Apply to dΛ
Λ
= −rdt − µ−r
σ
dz
2 √
ln (ΛT ) = ln (Λ0 ) − [r + 12 µ−r
σ
]T − µ−r
σ
Tε
Full Solution
We can use the information on the joint distribution of ST and ΛT to evaluate:
Z ∞
ΛT
C0 = (ST − X ) df (ΛT , ST )
ST =X
Λ0
Z ∞
ΛT (ε)
= (ST (ε) − X ) df (ε)
ST =X
Λ0
Break up the integral to two parts:

ΛT (ε) ΛT (ε)
R∞ R∞
C0 = Λ0
ST (ε) df (ε) − Λ0
Xdf (ε)
ST =X ST =X
From earlier, we know that ΛT , ST are both exponential functions of ε

2
√
ln (ST ) = ln (S0 ) + µ − σ2 T +σ Tε
2 √
ln (ΛT ) = ln (Λ0 ) −[r + 21 µ−r
σ
]T − µ−r
σ
Tε
µ−r 2 µ−r √ 2 √

R∞ −[r + 21 ]T − σ Tε µ− σ2 T +σ T ε
C0 = e σ
S0 e f (ε) dε −
ST =X
µ−r 2 √

−[r + 12
µ−r
R∞ ]T − σ Tε
X e σ
f (ε) dε
ST =X
Full Solution
Z ∞ 2 √ 2
√
1 µ−r
]T − µ−r µ− σ2 T +σ T ε
C0 = e −[r + 2 ( σ ) σ Tε
S0 e f (ε) dε
ST =X
Z ∞ 2 √
1 µ−r
]T − µ−r
−X e −[r + 2 ( σ ) σ Tε
f (ε) dε
ST =X
Z ∞ 2 √
[µ−r − 12 σ 2 +( µ−r

σ ) ]T +(σ− µ−r
σ ) Tε
= S0 e f (ε) dε
S =X
ZT ∞ 2 √
1 µ−r
]T − µ−r
−X e −[r + 2 ( σ ) σ Tε
f (ε) dε
ST =X
1 2
Recall that ε = zT√−z0
∼ N (0, 1), thus f (ε) = √1 e − 2 ε
T 2π
Z ∞ 2 √
[µ−r − 21 σ 2 +( µ−r

]T +(σ− µ−r 1 1 2
σ ) σ ) Tε
C0 = S0 e √ e − 2 ε dε
S =X 2π
ZT ∞ 2 √
1 µ−r 1 1 2
]T − µ−r
−X e −[r + 2 ( σ ) σ Tε
√ e − 2 ε dε
ST =X 2π
Full Solution
Z ∞ 2 √
[µ−r − 12 σ 2 +( µ−r

1 ]T +(σ− µ−r 1 2
σ ) σ ) Tε −2ε
C0 = √ S0 e e dε
2π S =X
ZT ∞ 2 √
1 1 µ−r
]T − µ−r T ε − 12 ε2
−√ X e −[r + 2 ( σ ) σ e dε
2π ST =X
R∞ 1 2 µ−r 2 µ−r
√ 2
C0 = √1 S0
ST =X
e − 2 {[−2(µ−r )+σ +( σ ) ]T −2(σ− σ ) T ε+ε } dε −
2π
2 √
T ε+ε2

R∞ − 12 [( µ−r µ−r
σ ) ]T +2 σ
√1 Xe −rT e dε
2π ST =X
R∞ 1 µ−r
√ 2 µ−r
√ 2
C0 = √1 S0 e − 2 {[(σ− σ ) T ] −2(σ− σ ) T ε+ε } dε −
2π S T =X
R∞ 1 µ−r
√ 2
√1 Xe −rT
ST =X
e − 2 {( σ ) T +ε} dε
2π
R∞ 1 µ−r
√ 2
C0 = √1 S0
=X
e − 2 {−(σ− σ ) T +ε} dε −
2π S T
√
R∞ 1 µ−r 2
√1 e −rT X
ST =X
e − 2 {( σ ) T +ε} dε
2π

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Announcement Applications Option Pricing (Ch 17) Black-Scholes Equation

March 2nd, 2020

Proposal due tonight by 11.59pm to my email

Pricing Kernel in Continuous Time (Ch 1.5)

The continuous-time analogue of pt = Et [mt+1 xt+1 ]

∴ 0 = Λt Dt dt + Et [pt · dΛt + Λt · dpt + dpt · dΛt ]

Pricing Kernel in Continuous Time (Ch 1.5)

Pricing Kernel in Continuous Time (Ch 1.5)

which is the analogue of :

E (Ri ) = Rf − Rf · cov (m, Ri )

Pricing Kernel in Continuous Time (Ch 1.5)

Let µp = Et (dpt /pt ) , σp2 = Et (dpt /pt )2 , σc2 = Et (dct /ct )2 ,

since correlation is no greater than 1:

Continuous-time analogue to:

American option: can be exercised any time before as well as on the

Non-Vanilla exercise rights:

Canary option: can be exercised on a set of predetermined dates

CT = max (ST − X , 0) PT = max (X − ST , 0)

Call Option Put Option

The DJX index option contract is based on 1/100th (one-one-hundredth) of the

You have decided to purchase 25 contracts of September 2016 put (1

Assume you choose to finance the purchase by borrowing $4.00 at an interest

Writing (i.e., shorting or selling) options

Option Strategies: Portfolios of put and call options

Protective Put : buy the stock and a put

Covered call: own the stock and sell a call

Position ST < X ST > X

Prices: One-Period Analysis

The following two portfolios should have the same payoff

The payoffs are related by: CT − PT = ST − X , i.e. PT = CT − ST + X

Apply E (m·) to both sides, obtain put-call parity:

Practical Aspects of Option Investing

Average Option Returns

Expected Option Returns by Joshua D. Coval and Tyler Shumway

Practical Aspects of Option Investing

In general, what is the hypothetical performance of such a strategy?

Practical Aspects of Option Investing

Is there money to be made here?

More Option Strategies

More strategies: Strips and Straps

A > B, m > 0 → E (mA) > E (mB)

Payoff CT = max (ST − X , 0) ≥ ST − X

You should never exercise an American call option (on an

How do we price options?

Black-Scholes Differential Equation

Recall from earlier

Use Ito’s lemma:

Note: Ct here is a partial derivative, not call option value at time t

Black-Scholes Differential Equation

From previous slide:

0 = Et [d (Λp)] = CEt (dΛ) + ΛEt (dC ) + Et (dΛ · dC )

0 = −Cr Λdt + ΛCt dt + ΛCS Sµdt + Λ · 12 CSS S 2 σ 2 dt−Λ (µ − r ) Cs Sdt

0 = −rC + Ct + 21 CSS S 2 σ 2 + SrCS

This is the Black-Scholes differential equation for the option price

Black-Scholes Differential Equation

Black-Scholes differential equation

Using the boundary condition at expiration C (ST , T ) = max (ST − X , 0),

∂C (S,t) ∂C (S,t) ∂ 2 C (S,t) 2 2

Can solve for full analytical solution

Numerical solution through a grid (we will not do this):

Black-Scholes Differential Equation

Caveats on Black-Scholes Pricing:

The stock pays no dividends during the option’s life