SIQ3004

Mathematics of Financial Derivatives

Chapter 7: The Black-Scholes Formula

Lecturer: Dr. Koh You Beng

Institute of Mathematical Sciences

Faculty of Science
University of Malaya

March 17, 2020

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Outline

1 The Black- Scholes Formula

Introduction to Black-Scholes Formula
Applying the Formula to Other Assets
Option Greeks
Profit Diagrams Before Maturity
Implied Volatility

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Outline

1 The Black- Scholes Formula

Introduction to Black-Scholes Formula
Applying the Formula to Other Assets
Option Greeks
Profit Diagrams Before Maturity
Implied Volatility

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Black-Scholes Formula
I To introduce the Black-Scholes formula, we first return to the
binomial model
I Binomial option prices for different numbers of binomial steps. All
calculations assume that the stock price S = $41, the strike price
K = $40, volatility σ = 0.30, risk-free rate r = 0.08, time to expiration
T = 1, and dividend yield δ = 0.
Number of Steps (n) Binomial Call Price, C
1 7.839
4 7.160
10 7.065
50 6.969
500 6.960
∞ 6.961
I The last row reports the call option price if we were to use an infinite
number of steps.
I The Black-Scholes formula is a limiting case of the binomial
formula (infinitely many periods) for the price of a European option.

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Black-Scholes Formula
I Consider an European call (or put) option written on a stock.
I Assume that the stock pays dividend at the continuous rate δ.
I Call Option price

C (S , K , σ, r , T , δ) = Se −δT N (d1 ) − Ke −rT N (d2 )

I Put Option price

P (S , K , σ, r , T , δ) = Ke −rT N (−d2 ) − Se −δT N (−d1 )

where
S
+ r − δ + 21 σ 2 T √



ln K
d1 = √ and d2 = d1 − σ T .
σ T
 −δT 
ln Ke −rT + 21 σ 2 T
Se S
+ r − δ − 21 σ 2 T



ln K
= √ , and d2 = √
σ T σ T

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When Is the Black-Scholes Formula Valid?

I Assumptions about stock return distribution

I Continuously compounded returns on the stock are normally
distributed and independent over time (no “jumps”).
I The volatility of continuously compounded returns is known and
constant.
I Future dividends are known, either as dollar amount or as a fixed
dividend yield.
I Assumptions about the economic environment
I The risk-free rate is known and constant.
I There are no transaction costs or taxes.
I It is possible to short-sell costlessly and to borrow at the risk-free rate.

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Outline

1 The Black- Scholes Formula

Introduction to Black-Scholes Formula
Applying the Formula to Other Assets
Option Greeks
Profit Diagrams Before Maturity
Implied Volatility

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Applying the Formula to Other Assets
I The prepaid forward prices for the stock and strike asset are
P
F0,T (S ) = Se −δT and F0,T
P
(K ) = Ke −rT .
I We can write the Black-Scholes formula entirely in terms of prepaid
forward prices
P P P P


C F0,T (S ) , F0,T (K ) , σ, T = F0,T (S ) N (d1 ) − F0,T (K ) N (d2 )
(1)
 P (S )

F0,T
ln P (K )
F0,T
+ 21 σ 2 T
d1 = √
σ T
√
d2 = d1 − σ T
I This version of the formula is interesting because the dividend yield
and the interest rate do not appear explicitly; they are implicitly
incorporated into the prepaid forward prices.
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Options on Stocks with Discrete Dividends

I The prepaid forward price for stock with discrete dividends is

P
F0,T (S ) = S0 − PV0,T (Div)

I Examples 12.3, 12.1 and 12.2,

I S = $41, K = $40, σ = 0.3, r = 8%, t = 0.25, Div = $3 in one month.
I PV (Div) = $3e −0.08/12 = $2.98.
I Use $41– $2.98 = $38.02 as the stock price in BS formula.
I The BS European call price is $1.763.
I Compare this to European call on stock without dividends: $3.399.
I By put-call parity, the European put price without dividend is $1.607.

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Options on Currencies
I The prepaid forward price for the currency is
P
F0,T (x ) = x0 e −rf T ,

where x0 is domestic spot rate and rf is foreign interest rate

I The Black-Scholes formula becomes
C (x , K , σ, r , T , rf ) = xe −rf T N (d1 ) − Ke −rT N (d2 )
ln Kx + r − rf + 21 σ 2 T



d1 = √
σ T
√
d2 = d1 − σ T
I The price of a European currency put is obtained using parity:

P (x , K , σ, r , T , rf ) = C (x , K , σ, r , T , rf ) + Ke −rT − xe −rf T

I Example 12.4
I x0 = 1.25/€ , K = $1.20, σ = 0.10, r = 1%, T = 1, and rf = 3%
I The price of a dollar-denominated euro call is $0.061407.
I The price of a dollar-denominated euro put is $0.03641.
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Options on Futures

I The prepaid forward price for a futures contract is the PV of the

futures price. Therefore
C (F , K , σ, r , T , rf ) = Fe −rT N (d1 ) − Ke −rT N (d2 )
F

1 2
ln K + σ T
d1 = √ 2
σ T
√
d2 = d1 − σ T
I The price of a European currency put is obtained using parity:
P (x , K , σ, r , T , r ) = C (x , K , σ, r , T , r ) + Ke −rT − Fe −rT

I Example 12.5:
I Suppose 1-yr. futures price for natural gas is $6.50/MMBtu,r = 2%
I Therefore, F = $6.50, K = $6.50, and r = 2%
I If σ = 0.25, T = 1, call price = put price = $0.63379

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Outline

1 The Black- Scholes Formula

Introduction to Black-Scholes Formula
Applying the Formula to Other Assets
Option Greeks
Profit Diagrams Before Maturity
Implied Volatility

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Option Greeks
I Option Greeks are formulas that express the change in the option
price when an input to the formula changes, taking as fixed all the
other inputs.
I Delta (∆): measures the change in the option price for a $1 change in
the stock price:
∂C (S , K , σ, r , T − t, δ)
Call delta = = e −δ(T −t) N (d1 )
∂S
∂P (S , K , σ, r , T − t, δ)
Put delta = = −e −δ(T −t) N (−d1 )
∂S
I Gamma (Γ): measures the change in delta when the stock price
changes:
0
∂ 2 C (S , K , σ, r , T − t, δ) e −δ(T −t) N (d1 )
Call gamma = 2
= √
∂S Sσ T − t
∂ 2 P (S , K , σ, r , T − t, δ)
Put delta = = Call gamma
∂S 2

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Option Greeks
I Theta ( θ ): measures the change in the option price with respect to
calendar time (t), holding fixed time to expiration (T ):
∂C (S , K , σ, r , T − t, δ)
Call theta =
∂t
0
Ke −r (T −t) N (d2 ) σ
= δSe −δ(T −t) N (d1 ) − rKe −r (T −t) N (d2 ) − √
2 T −t
∂P (S , K , σ, r , T − t, δ)
Put delta =
∂t
= Call theta + rKe −r (T −t) − δSe −δ(T −t)
I If time to expiration is measured in years, theta will be the annualized
change in the option value. To obtain a per-day theta, divide by 365.
I Vega: measures the change in the option price when volatility
changes.
∂C (S , K , σ, r , T − t, δ) 0 √
Call vega = = Se −δ(T −t) N (d1 ) T − t
∂σ
∂P (S , K , σ, r , T − t, δ)
Put vega = = Call vega
∂σ
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Option Greeks
I Rho ( ρ ): is the partial derivative of the option price with respect to
the interest rate:
∂C (S , K , σ, r , T − t, δ)
Call rho = = (T − t) Ke −r (T −t) N (d2 )
∂r
∂P (S , K , σ, r , T − t, δ)
Put rho = = − (T − t) Ke −r (T −t) N (−d2 )
∂r
I Psi (Ψ): is the partial derivative of the option price with respect to
the continuous dividend yield:
∂C (S , K , σ, r , T − t, δ)
Call psi = = − (T − t) Se −δ(T −t) N (d1 )
∂δ
∂P (S , K , σ, r , T − t, δ)
Put psi = = (T − t) Se −δ(T −t) N (−d1 )
∂δ
I Note that the Greek for a written option is opposite in sign to that for
the same purchased option.
I Keep in mind that the Greek measures by assumption change only
one input at a time.
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 ∂C
Option Greeks: Delta, ∂S
Figure 12.1 represents the behavior of delta for European call (top graph) and put
(bottom graph) deltas for 40-strike options with differing times to expiration. Assumes
σ = 30%, r = 8%, and δ = 0.
I The figure illustrates that an in-the-money option (when ST > K for a call option) will
be more sensitive (high delta) to the stock price than an out-of-the-money option.
I Delta for a put option is negative, so a stock price increase reduces the put price.

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 ∂C
Option Greeks: Delta, ∂S
I Delta is also the sensitivity of the option price to a change in the
stock price
I Note that as time to expiration increases, the call delta is lower at
high stock prices and greater at low stock prices,
I reflects the fact that, for an option with greater time to expiration, the
likelihood is greater that an out-of- the-money option will eventually
become in-the-money, and the likelihood is greater that an
in-the-money option will eventually become out-of-the-money.
I The Black- Scholes formula both prices the option and also tells us
what position in the stock and borrowing is equivalent to the option.
I The formula for the call delta is
∆ = e −δT N (d1 )
I If we hold e −δT N (d1 ) shares and borrow Ke −rT N (d2 ) dollars, the
cost of this portfolio is
Se −δT N (d1 ) − Ke −rT N (d2 ) ,

Which is the Black-Scholes price.

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 ∂2C ∂C
Option Greeks: Gamma, ∂S 2 & Vega, ∂σ
Gamma (top panel) and vega (bottom panel) for 40-strike options with different times to
expiration. Assumes σ = 30%, r = 8%, and δ = 0.
Because of put-call parity, Gamma and vega are the same for calls and puts with the same strike
price and time to expiration.

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 ∂C
Option Greeks: Theta, ∂t
Figure 12.3 depicts call (top panel) and put (bottom panel) premiums for out-of-the-money,
at-the-money, and in-the-money options as a function of the time to expiration. Assumes
S = $40, σ = 30%, r = 8%, and δ = 0.

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 ∂C
Option Greeks: Theta, ∂t

Theta for calls (top panel) and puts (bottom panel) with different expirations at
different stock prices. Assumes K = $40, σ = 30%, r = 8%, and δ = 0.

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 ∂C ∂C
Option Greeks: Rho, ∂r and Psi, ∂δ
Rho (top panel) and psi (bottom panel) at different stock prices for call options with
different maturities. Assumes K = $40, σ = 30%, r = 8%, and δ = 0.

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Greek Measures for Portfolios
The Greek measure of a portfolio is the sum of the Greeks of the individual
portfolio components.
I For a portfolio containing N options with a single underlying stock,
where the quantity of each option is given by ni , we have
N
X
∆portfolio = ni ∆i .
i=1

The same relation holds true for the other Greeks as well.

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Option Elasticity
Elasticity measures the percentage sensitivity of the option relative to the
stock. The option elasticity computes the percentage change in the
option price relative to the percentage change in the stock price. It is
effectively a measure of the leverage implicit in the option.
I Dollar Risk of the Option.
I If the stock price changes by , the change in the option price is
change in option price = change in stock price × option delta
=×∆
I The percentage change in the stock price is

S
I The percentage change in the option price is the dollar change in
the option price, ∆, divided by the option price, C :
∆
C
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Option Elasticity: An Example
I The option elasticity, denoted by Ω, is the ratio of these two:
∆
% change in option price C ∆S S ∂C
Ω= =  = = ×
% change in stock price S C C ∂S
I Example 12.8
I Suppose S = $41.00, K = $40.00, σ = 0.30, r = 0.08, T = 1.00 years,
δ = 0.00.
I The option price is $6.961 and ∆ = 0.6911.
I Hence, the call elasticity is

$41 × 0.6911
Ω= = 4.071
$6.961
I The put has a price of $2.886 and ∆ = −0.3089;
I Hence, the elasticity is

$41 × (−0.3089)
Ω= = −4.389
$2.886

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Option Elasticity: Figure 12.6
Figure 12.6 shows the behavior of elasticity for a call, varying both the stock price and
time to expiration.
I The 3-month out-of-the-money calls have elasticities exceeding 8.
I For longer time-to-expiration options, elasticity is much less sensitive to the moneyness of
the option.
I Ω decreases as the stock (strike) price increases (decreases).

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Option Elasticity
I The volatility of an option is the elasticity times the volatility of the
stock:
σoption = σstock × |Ω| .
I The Risk Premium of an Option
I At a point in time, the option is equivalent to a position in the stock
and in bonds; hence, the return on the option is a weighted average of
the return on the stock and the risk-free rate,
 
∆S ∆S
γ= α+ 1− r
C (S ) C (S )

where α is the expected rate of return on the stock, γ is the expected

return on the option, and r is the risk-free rate.
I Thus, the risk premium on the option equals the risk premium on the
stock times Ω,
γ − r = (α − r ) × Ω.
I The Beta of an Option.
βoption = βstock × Ω.

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The Sharpe Ratio of an Option

I The Sharpe ratio for any asset is the ratio of the risk premium to
volatility:
risk premium α−r
Sharpe ratio = =
volatility σ
I The Sharpe ratio for a call

γ−r Ω (α − r ) α−r
Sharpe ratio for call = = = .
σoption Ωσ σ

Thus, the Sharpe ratio for a call equals the Sharpe ratio for the
underlying stock.
I Note that the option is always equivalent to a levered position in the
stock, and that leverage per se does not change the Sharpe ratio.

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The Elasticity and Risk Premium of a Portfolio
I The elasticity a portfolio.
I Suppose there is a portfolio of N calls with the same underlying stock,
where the i th call has value Ci and delta ∆i , and where
PN ni is the
quantity of the i th call. The portfolio value is then i=1 ni Ci . For a
$1 change in the stock price, the change in the portfolio value is
N
X
ni ∆i .
i=1

I The elasticity of the portfolio is the percentage change in the portfolio

divided by the percentage change in the stock,
PN
ni ∆i
Pi=1 N
! N
N
i=1 ni Ci
X ni Ci S ∆i X
Ωportfolio = 1 = PN = ωi Ωi
S i=1 i=1 ni Ci .
Ci i=1

where ωi is the fraction of the portfolio invested in option i . Hence, it

is the weighted average of the elasticities of the portfolio components.
I The risk premium of the portfolio, γ − r , is just the portfolio
elasticity times the risk premium on the stock, α − r :
γ − r = (α − r ) × Ωportfolio .

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Outline

1 The Black- Scholes Formula

Introduction to Black-Scholes Formula
Applying the Formula to Other Assets
Option Greeks
Profit Diagrams Before Maturity
Implied Volatility

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Purchased Call Option
I If we buy a call option and sell it prior to expiration, profit will depend
upon the changes in the stock price and time to expiration.

I We compute profit by subtracting from the value of the option at

each stock price the original cost of the position, plus interest.
I For example, if we buy a 1-year option and hold it for 9 months, the
resulting profit diagram is the payoff for a 3-month option less the
original cost plus interest of the 1-year option.
I The “held 9 months” line in the bottom panel of Figure 12.7 is thus the
“3 months” line from the top panel less $6.674 = $6.285e 0.08×0.75
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Purchased Call Option

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Calendar Spreads

I To speculate on volatility (straddle, strangle, butterfly spread: same

T but different K ) you could enter into a calendar spread, in which
the options you buy and sell have different expiration dates.
I Suppose you want to speculate that XYZ’s stock price will be
unchanged over the next 3 months.
I sell a call or put, in the hope that the stock price will remain
unchanged and you will earn the premium. The potential cost is that if
the option does move into the money, you can have a large loss.
I To protect, you can simultaneously buy a call option with the same
strike and greater time to expiration.
I For example, sell a 40-strike call with 91 days to expiration and buy a
40-strike call with 1 year to expiration.
I The profit diagram for this position for holding periods of 1 day, 45
days, and 91 days is displayed in Figure 12.8.

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Calendar Spreads

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Outline

1 The Black- Scholes Formula

Introduction to Black-Scholes Formula
Applying the Formula to Other Assets
Option Greeks
Profit Diagrams Before Maturity
Implied Volatility

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Implied Volatility

I Volatility is unobservable
I Option prices, particularly for near-the-money options, can be quite
sensitive to volatility
I One approach is to compute historical volatility using the history of
returns
I A problem with historical volatility is that expected future volatility can
be different from historical volatility.
I Alternatively, we can calculate implied volatility, which is the volatility
that, when put into a pricing formula (typically Black-Scholes), yields
the observed option price.

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Computing Implied Volatility

I To compute a Black-Scholes implied volatility, assume that we observe

the stock price S , strike price K , interest rate r , dividend yield δ, and
time to expiration T . The implied call volatility is the σ̂ that solves

Market option price = C (S , K , σ̂, r , T , δ)

I In practice implied volatilities of in-, at-, and out-of-the money

options are generally different
I A volatility smile refers to when volatility is symmetric, with volatility
lowest for at-the- money options, and high for in-the-money and
out-of-the-money options.
I A difference in volatilities between in-the-money and out-of-the-money
options is referred to as a volatility skew.

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Computing Implied Volatility

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Using Implied Volatility
I Some practical uses of implied volatility include
I Use the implied volatility from an option with an observable price to
calculate the price of another option on the same underlying asset
I Use implied volatility as a quick way to describe the level of options
prices on a given underlying asset: you could quote option prices in
terms of volatility, rather than as a dollar price
I Checking the uniformity of implied volatilities across various options on
the same underlying assets allows one to verify the validity of the
pricing model in pricing those options
I Another implied volatility measure that is widely cited is the risk
reversal, which is the difference between the implied volatilities of
out-of-the-money calls and puts, each with the same delta (most
commonly 0.25).
I A risk reversal is in effect a way to quote the price of a collar, which
entails buying an out-of-the-money put and selling an out-of-the-
money call, or vice versa.

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