Chapter 6: Option Pricing

Models:
The Black-Scholes-Merton
Model
Good theories, like Black-Scholes-Merton, provide a
theoretical laboratory in which you can explore the likely
effect of possible causes. They give you a common language
with which to quantify and communicate your feelings
about value.
Emanuel Derman
The Journal of Derivatives, Winter, 2000, p. 64

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Important Concepts in Chapter 5

• The Black-Scholes-Merton option pricing model

• The relationship of the model’s inputs to the option price
• How to adjust the model to accommodate dividends and put options
• The concepts of historical and implied volatility
• Hedging an option position

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Origins of the Black-Scholes-Merton
Formula
• Black, Scholes, Merton and the 1997 Nobel Prize

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 Assumptions of the Model
• Stock prices behave randomly and evolve according to a lognormal
distribution.
• See Figure 5.2a, 5.2b and 5.3 for a look at the notion of randomness.
• A lognormal distribution means that the log (continuously compounded)
return is normally distributed. See Figure 5.4.
• The risk-free rate and volatility of the log return on the stock are
constant throughout the option’s life
• There are no taxes or transaction costs
• The stock pays no dividends
• The options are European

An Introduction to Derivatives and Risk

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 A Nobel Formula
The Black-Scholes-Merton model gives the correct formula for a
European call under these assumptions.
The model is derived with complex mathematics but is easily
understandable. The formula is

C  S0 N(d1 )  Xe  rc T N(d 2 )
where
ln(S0 /X)  (rc  σ 2 /2)T
d1 
σ T
d 2  d1  σ T

An Introduction to Derivatives and Risk

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A Nobel Formula (continued)

• where
• N(d1), N(d2) = cumulative normal probability
•  = annualized standard deviation (volatility) of the continuously compounded return
on the stock
• rc = continuously compounded risk-free rate

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A Nobel Formula (continued)

• A Digression on Using the Normal Distribution

• The familiar normal, bell-shaped curve
(Figure 5.5)
• See Table 5.1 for determining the normal probability for d 1 and d2. This gives
you N(d1) and N(d2).

An Introduction to Derivatives and Risk

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 (Return to text slide)

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A Nobel Formula (continued)

• A Numerical Example
• Price the DCRB June 125 call
• S0 = 125.94, X = 125, rc = ln(1.0456) = 0.0446,
T = 0.0959,  = 0.83.
• See Table 5.2 for calculations. C = $13.21.
• Familiarize yourself with the accompanying software
• BlackScholesMertonBinomial10e.xlsm. Note the use of Excel’s =normsdist() function.
• BlackScholesMertonImpliedVolatility10e.xlsm. See Appendix.

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Example 2
• Use the Black-Scholes option pricing model to value the following
European call option on non-dividend paying stock. Be sure to state
the formula and provide sufficient information about the calculations
performed to arrive at the solution: current stock price :$30, Exercise
price: $40, time to expiration: 3 months, risk free interest rate: 5%
per year, and variance of annual stock returns: 0.25

Chance/Brooks An Introduction to Derivatives and Risk Management, 10th ed. Ch. 5: 10

Example 3
The following information is given about options on the stock of a certain
company.

S0 = 23 X = 20
rc = 0.09 T = 0.5
2 = 0.15

No dividends are expected.

What value does the Black-Scholes-Merton model predict for the call?

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