SOA UNIVERSITY

NAME : GYANABRATA MOHAPATRA

REGESTRATION NO : 2161301176
Subject: Financial Derivetives

ASSIGNMENT
Case study & QUIZ
SUBMMITED TO : BHABANI SHANKAR ROUT SIR
Define Black Scholes Model for Option Pricing. (Case Study)
The Black-Scholes model, also known as the Black-Scholes-Merton (BSM)
model, is one of the most important concepts in modern financial theory. This
mathematical equation estimates the theoretical value of derivatives based on
other investment instruments, taking into account the impact of time and other
risk factors. Developed in 1973, it is still regarded as one of the best ways for
pricing an options contract.
How the Black-Scholes Model Works
Black-Scholes posits that instruments, such as stock shares or futures contracts,
will have a lognormal distribution of prices following a random walk with constant
drift and volatility. Using this assumption and factoring in other important
variables, the equation derives the price of a European-style call option.

The Black-Scholes equation requires five variables. These inputs are volatility,
the price of the underlying asset, the strike price of the option, the time until
expiration of the option, and the risk-free interest rate. With these variables, it is
theoretically possible for options sellers to set rational prices for the options that
they are selling.

Furthermore, the model predicts that the price of heavily traded assets follows a
geometric Brownian motion with constant drift and volatility. W hen applied to a
stock option, the model incorporates the constant price variation of the stock, the
time value of money, the option's strike price, and the time to the option's expiry.

Black-Scholes Assumptions
The Black-Scholes model makes certain assumptions:

 No dividends are paid out during the life of the option.

 Markets are random (i.e., market movements cannot be predicted).
 There are no transaction costs in buying the option.
 The risk-free rate and volatility of the underlying asset are known and
constant.
 The returns of the underlying asset are normally distributed.
 The option is European and can only be exercised at expiration.

While the original Black-Scholes model didn't consider the effects of dividends
paid during the life of the option, the model is frequently adapted to account for
dividends by determining the ex-dividend date value of the underlying stock. The
model is also modified by many option-selling market makers to account for the
effect of options that can be exercised before expiration.
Black-Scholes Model For Option
Pricing Explained
The Black-Scholes Model was developed by economists Fischer Black and
Myron Scholes in 1973. The Black-Scholes model works on five input
variables: underlying asset’s price, strike price, risk-free rate, volatility,
and expiration time.

It is a mathematical model that utilizes a partial differential equation to

calculate the price of options. This partial differential is known as the
Black-Scholes equation. Banks and financial institutions use this model
for evaluating European options. The primary objective behind the
model is to hedge options in a portfolio and eliminate the risk factor.

Fischer Black and Myron Scholes met at the Massachusetts Institute of

Technology (MIT) and started a partnership that lasted 25 years. Their
pricing model completely revolutionized technical investing. Black and
Scholes won the Nobel prize for their contribution in 1997.

Black and Scholes assume there are no market arbitrage opportunities or

riskless profits. This is why the model receives criticism. In real-world
scenarios, volatility is not constant across time; transaction costs exist.
Real-world data depicts that price returns tend to have
a skewed distribution; prices fall much faster than they rise.

At the beginning of the 20th century, French mathematician Louis

Bachelier made an analogy between Brownian motion and the movement
of financial assets in his Theory of Speculation. The Black-Scholes theory
incorporates this assumption.

Formula
The Black-Scholes model formula is as follows:

The above equation determines the stock options price over time.

The following formula computes the price of a call option C:

Here,

The following formula computes the price of a put option P:

 In this equation, N equals the cumulative distribution function of the
standard normal distribution. It represents a standard normal
distribution with mean = 0 and standard deviation = 1

 T-t refers to the maturity period (in years).

 St is the underlying asset’s spot price.
 K denotes the strike price.
 r represents the risk-free rate.
 Ó symbolizes the underlying assets’ return volatility.

Example
Now, let us look at a Black-Scholes model example to understand
calculations.

To estimate the value of a call option for Apple (AAPL), the following
formula is used:

Here,

On October 17, 2022, the call option for Apple’s stock ($AAPL) was priced
at S = $138.38 (on NASDAQ).

We multiply the current price by 1.2 to determine an exercise price 20%

higher than the current stock trading price of X = $166.05.
Further, we take a 101-day expiration period (ends January 25, 2023) and
consider a risk-free interest instrument, $USGG10YR, that pays 2.12%
currently. It is a US 10-year government bond.

Therefore, the values are as follows:

S = 138.38 (Stock Price)

X = 166.05 (Trading Price)

(T-t) = 101 (Expiration Period)

r = 0.0212. (Risk-Free Rate)

The only parameter missing is the stock volatility estimation. It can be

determined using historical prices. If the resulting value, σ, varies between
0 and 1, it represents the market’s implied stock volatility.

The stock’s fair price helps traders hedge their portfolios; they eliminate
the risks.

2. Why Financialization is important in Commodity Derivatives Market?

(Assignment)
Financial derivatives are financial instruments that are linked to a specific financial
instrument or indicator or commodity, and through which specific financial risks can be
traded in financial markets in their own right.

Financial derivatives are financial instruments that are linked to a specific financial
instrument or indicator or commodity, and through which specific financial risks can
be traded in financial markets in their own right. Transactions in financial derivatives
should be treated as separate transactions rather than as integral parts of the value of
underlying transactions to which they may be linked. The value of a financial
derivative derives from the price of an underlying item, such as an asset or index.
Unlike debt instruments, no principal amount is advanced to be repaid and no
investment income accrues. Financial derivatives are used for a number of purposes
including risk management, hedging, arbitrage between markets, and speculation.

Financial derivatives enable parties to trade specific financial risks (such as interest
rate risk, currency, equity and commodity price risk, and credit risk, etc.) to other
entities who are more willing, or better suited, to take or manage these risks—
typically, but not always, without trading in a primary asset or commodity. The risk
embodied in a derivatives contract can be traded either by trading the contract itself,
such as with options, or by creating a new contract which embodies risk characteristics
that match, in a countervailing manner, those of the existing contract owned. This
latter is termed offsetability, and occurs in forward markets. Offsetability means that it
will often be possible to eliminate the risk associated with the derivative by creating a
new, but "reverse", contract that has characteristics that countervail the risk of the first
derivative. Buying the new derivative is the functional equivalent of selling the first
derivative, as the result is the elimination of risk. The ability to replace the risk on the
market is therefore considered the equivalent of tradability in demonstrating value.
The outlay that would be required to replace the existing derivative contract represents
its value—actual offsetting is not required to demonstrate value.

Financial derivatives contracts are usually settled by net payments of cash. This often
occurs before maturity for exchange traded contracts such as commodity futures. Cash
settlement is a logical consequence of the use of financial derivatives to trade risk
independently of ownership of an underlying item. However, some financial derivative
contracts, particularly involving foreign currency, are associated with transactions in the
underlying item.

What Are the Main Functions of Financial Markets?

Financial markets exist for several reasons, but the most fundamental function is
to allow for the efficient allocation of capital and assets in a financial economy.
By allowing a free market for the flow of capital, financial obligations, and money
the financial markets make the global economy run more smoothly while also
allowing investors to participate in capital gains over time.

Why Are Financial Markets Important?

Without financial markets, capital could not be allocated efficiently, and
economic activity such as commerce and trade, investments, and growth
opportunities would be greatly diminished.

3. Describe different hedging strategies to mitigate unsystematic risk? (Quiz)

Unsystematic risk is the risk that is unique to a specific company or industry.

It's also known as nonsystematic risk, specific risk, diversifiable risk, or
residual risk. In the context of an investment portfolio, unsystematic risk can
be reduced through diversification—while systematic risk is the risk that's
inherent in the market.
Types of Unsystematic Risk
Business Risk
Both internal and external issues may cause business risk. Internal risks are tied
to operational efficiencies. For example, management failing to take out a patent
to protect a new product would be an internal risk, as it may result in the loss of
competitive advantage. The Food and Drug Administration (FDA) banning a
specific drug that a company sells is an example of external business risk.

Financial Risk
Financial risk relates to the capital structure of a company. A company needs to
have an optimal level of debt and equity to continue to grow and meet its
financial obligations. A weak capital structure may lead to inconsistent earnings
and cash flow that could prevent a company from trading.

Operational Risk
Operational risks can result from unforeseen or negligent events, such as a
breakdown in the supply chain or a critical error being overlooked in the
manufacturing process. A security breach could expose confidential information
about customers or other types of key proprietary data to criminals.

Operational risk is tied to operations and the potential for failed systems or
policies. These are the risks for day-to-day operations and can result from
breakdowns in internal procedures, whether tied to systems or employees.

Strategic Risk
A strategic risk may occur if a business gets stuck selling goods or services in a
dying industry without a solid plan to evolve the company's offerings. A company
may also encounter this risk by entering into a flawed partnership with another
firm or competitor that hurts their future prospects for growth.

Legal and Regulatory Risk

Legal and regulatory risk is the risk that a change in laws or regulations will hurt
a business. These changes can increase operational costs or introduce legal
hurdles. More drastic legal or regulation changes can even stop a business from
operating altogether. Other types of legal risk can include errors in agreements
or violations of laws.

Understanding Unsystematic Risk

Unsystematic risk can be described as the uncertainty inherent in a
company or industry investment. Examples of unsystematic
risk include a new competitor in the marketplace with the potential
to take significant market share from the company invested in, a
regulatory change (which could drive down company sales), a shift
in management, or a product recall.

While investors may be able to anticipate some sources of

unsystematic risk, it is nearly impossible to be aware of all risks. For
instance, an investor in healthcare stocks may be aware that a
major shift in health policy is on the horizon, but may not fully know
the particulars of the new laws and how companies and consumers
will respond.

Other examples of unsystematic risks may include strikes,

outcomes of legal proceedings, or natural disasters. This risk is also
known as a diversifiable risk since it can be eliminated by
sufficiently diversifying a portfolio. There isn't a formula for
calculating unsystematic risk; instead, it must be extrapolated by
subtracting the systematic risk from the total risk.