Chapter 15 BSM

3/6/2019
Options, Futures, and Other Derivatives

Tenth Edition
Chapter 15
The Black-Scholes-
Merton Model
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Kiyosi Ito
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Black-Scholes-Merton
The Stock Price Assumption

• Consider a stock whose price is S.
• In a short period of time of length Dt, the return on the stock is
normally distributed:
DS
S

  Dt ,  2 Dt 
where  is expected return and  is volatility.
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The Lognormal Property

• It follows from this assumption that
 2  
ln S T  ln S 0      T ,  2T 

 2  
or
  2  
ln S T   ln S 0     T ,  2 T 

  2  
• Since the logarithm of ST is normal, ST is lognormally distributed
The Lognormal Distribution
E ( ST )  S0 eT
2
var ( ST )  S0 e2T (e T  1)
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Continuously Compounded Return

If x is the realized continuously compound return
S T  S 0 e xT
1 S
x = ln T
T S0
 2 2 
x      , 
 2 T 
The Expected Return

• The expected value of the stock price is S0eT
• The expected return on the stock is
  – 2/2not 
 This is because
ln[ E ( ST / S 0 )] and E[ln(ST / S 0 )]
are not the same.
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µ and µ−σ2/2
•  is the expected return in a very short time, Dt, expressed with a
compounding frequency of Dt
•  −2/2 is the expected return in a long period of time expressed with
continuous compounding (or, to a good approximation, with
compounding frequency of Dt)
Mutual Fund Returns

• Suppose that returns in successive years are 15%, 20%, 30%, −20%
and 25% (ann. comp.)
• The arithmetic mean of the returns is 14%
• The returned that would actually be earned over the five years (the
geometric mean) is 12.4% (ann. comp.)
• The arithmetic mean of 14% is analogous to 
• The geometric mean of 12.4% is analogous to  −2/2
(1.15*1.20*1.30*0.8*1.25)^1/5 -1 = 12.4%
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volitility is always annual unless otherwise mentioned. Volatility = Sigma

The Volatility
• The volatility is the standard deviation of the continuously
compounded rate of return in 1 year
• The standard deviation of the return in a short time period time Dt is
approximately  Dt
• If a stock price is $50 and its volatility is 25% per year what is the
standard deviation of the price change in one day?
Estimating Volatility from Historical

Data
1. Take observations S0, S1, . . . , Sn at intervals of t years (e.g. for
weekly data t = 1/52)
2. Calculate the continuously compounded return in each interval as:
 S 
ui  ln i 
 Si 1 
3. Calculate the standard deviation, s, of the ui´s

s
4. The historical volatility estimate is: ˆ 

5. The standard error of this estimate is 𝜎 / 2𝑛
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Nature of Volatility
• Volatility is usually much greater when the market is open (i.e. the
asset is trading) than when it is closed
• For this reason time is usually measured in “trading days” not calendar
days when options are valued
• It is assumed that there are 252 trading days in one year for most
assets
Example
• Suppose it is April 1 and an option lasts to April 30 so that the
number of days remaining is 30 calendar days or 22 trading days
• The time to maturity would be assumed to be 22/252 = 0.0873 years
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The Concepts Underlying Black-Scholes-

Merton
• The option price and the stock price depend on the same underlying
source of uncertainty Delta Z
• We can form a portfolio consisting of the stock and the option which
eliminates this source of uncertainty
• The portfolio is instantaneously riskless and must instantaneously
earn the risk-free rate
• This leads to the Black-Scholes-Merton differential equation
The Derivation of the Black-Scholes-

Merton Differential Equation
DS  S Dt  S Dz
 ƒ ƒ 2ƒ 2 2  ƒ
Dƒ   S  ½  S Dt  S Dz
 S t S
2
S 
We set up a portfolio consisting of

 1: derivative
ƒ
+ : shares
S
This gets rid of the dependence on Dz.
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Merton Differential Equation (2 of 3)
The value of the portfolio, , is given by

ƒ
  ƒ  S
S
The change in its value in time Dt is given by
ƒ
D  Dƒ  DS
S

Merton Differential Equation (3 of 3)
The return on the portfolio must be the risk - free
rate. Hence
D  r D t
f  f 
- Df  DS  r   f  S  Dt
S  S 
We substitute for Dƒ and DS in this equation
to get the Black - Scholes differenti al equation
ƒ ƒ 2 2  ƒ
2
 rS ½ σ S  rƒ
t S  S2
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The Differential Equation

• Any security whose price is dependent on the stock price satisfies the
differential equation
• The particular security being valued is determined by the boundary
conditions of the differential equation
• In a forward contract the boundary condition is ƒ = S – K when t =T
• The solution to the equation is ƒ = S – K e–r (T –t)
The Black-Scholes-Merton Formulas for

Options
c  S 0 N (d1 )  K e  rT N (d 2 )
p  K e  rT N (d 2 )  S 0 N (d1 )
ln( S 0 / K )  (r   2 / 2)T
where d1 
 T
ln( S 0 / K )  (r   2 / 2)T
d2   d1   T
 T
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The N(x) Function

• N(x) is the probability that a normally distributed variable with a mean
of zero and a standard deviation of 1 is less than x
• See tables at the end of the book
Properties of Black-Scholes Formula

• As S0 becomes very large c tends to S0 – Ke-rT and p tends to zero
• As S0 becomes very small c tends to zero and p tends to Ke-rT – S0
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Understanding Black-Scholes

c  erT N (d2 ) S0erT N d1  N d2   K 
erT : Present value factor
N (d2 ) : Probability of exercise
S0erT N (d1 )/N (d2 ) : Expectedstockpricein a risk - neutralworld
if optionis exercised
K : Strikepricepaidif optionis exercised
Risk-Neutral Valuation
• The variable µ does not appear in the Black-Scholes-Merton
differential equation
• The equation is independent of all variables affected by risk
preference
• The solution to the differential equation is therefore the same in a
risk-free world as it is in the real world
• This leads to the principle of risk-neutral valuation
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Applying Risk-Neutral Valuation

1. Assume that the expected return from the stock price is the risk-free
rate (𝜇 = 𝑟)
2. Calculate the expected payoff from the option
3. Discount at the risk-free rate
Valuing a Forward Contract with Risk-

Neutral Valuation
• Payoff is ST – K
• Expected payoff in a risk-neutral world is S0erT – K
• Present value of expected payoff is
e-rT[S0erT – K] = S0 – Ke-rT
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Implied Volatility
• The implied volatility of an option is the volatility for which the Black-
Scholes-Merton price equals the market price
• There is a one-to-one correspondence between prices and implied
volatilities
• Traders and brokers often quote implied volatilities rather than dollar
prices
Dividends
• European options on dividend-paying stocks are valued by
substituting the stock price less the present value of dividends into
Black-Scholes
• Only dividends with ex-dividend dates during life of option should be
included
• The “dividend” should be the expected reduction in the stock price
expected
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Black’s Approximation for Dealing with

Dividends in American Call Options
Set the American price equal to the maximum of two European prices:
1. The 1st European price is for an option maturing at the same time
as the American option
2. The 2nd European price is for an option maturing just before the
final ex-dividend date
15

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3/6/2019

Options, Futures, and Other Derivatives

The Stock Price Assumption

The Lognormal Property

• Since the logarithm of ST is normal, ST is lognormally distributed

The Lognormal Distribution

Continuously Compounded Return

The Expected Return

ln[ E ( ST / S 0 )] and E[ln(ST / S 0 )]

are not the same.

Mutual Fund Returns

volitility is always annual unless otherwise mentioned. Volatility = Sigma

Estimating Volatility from Historical

3. Calculate the standard deviation, s, of the ui´s

5. The standard error of this estimate is 𝜎 / 2𝑛

The Concepts Underlying Black-Scholes-

The Derivation of the Black-Scholes-

We set up a portfolio consisting of

The Derivation of the Black-Scholes-

The value of the portfolio, , is given by

The Derivation of the Black-Scholes-

The Differential Equation

• The solution to the equation is ƒ = S – K e–r (T –t)

The Black-Scholes-Merton Formulas for

The N(x) Function

• See tables at the end of the book

Properties of Black-Scholes Formula

Applying Risk-Neutral Valuation

Valuing a Forward Contract with Risk-

Black’s Approximation for Dealing with

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