Lecture 7 - The Black-Scholes-Merton Model

Distribution of Stock Prices

A stock option pricing model must make some assumptions about how stock prices evolve over
time.

The Black–Scholes–Merton (BSM) model considers a non-dividend-paying stock and assumes

 the return on the stock in a very short period of time, ∆T, is normally distributed.
 the returns in two different non-overlapping periods are assumed to be independent.

Let µ be the expected return on the stock

Let σ be the volatility on the stock

Then the BSM assumption is that

The Log-Normal Distribution

Probability Density Function of a Log-Normal distribution

Properties of the log-normal distribution

A log-normally distributed variable can only take positive value.

A log-normal distribution is positively skewed.

The mean, median, and mode are all different.

The formulae for the mean and variance of Y ∼ LN(µ, σ2) are given by

Example 1: Consider a stock with an initial price of $40, an expected return of 16% per annum,
and a volatility of 20% per annum.

a) Calculate the mean and variance of the stock price after 6 months.
b) Calculate the probability that the stock after 6 months is higher than $45.
c) Construct a 95% confidence interval for the stock price after 6 months.
d) Construct a 95% confidence interval for the stock return after 6 months.

Answer:

S0 = 40 | µ = 0.16 | σ = 0.20

a) T = 6/12 = 0.5 (year)

S 0.5
LN((0.16 – 0.5 x 0.202) x 0.5, 0.202 x 0.5)
S0

S 0.5
LN(0.07, 0.02)
40

E(S0.5) = 40 x e0.07+0.5x0.02 = 40e0.08 = 43.331

Var(S0.5) = 402e2x0.07+0.02(e0.02 – 1) = 37.93

 b) P(S0.5 > 45) = P(
S 0.5 45
40 40
> ) = P(log(
S 0.5
40
45 ( )
) > log( )) = P(
40
log
S 0.5
40 >
45
−0.07 log ( )−0.07
40 )
√ 0.20 √0.20
= P(Z > –0.133) Z N(0,1)
= Φ (0.133) = 0.5517
c) The 95% CI for S0.5 [40e-0.207, 40e0.347] = [32.52,56.59]
S
d) log( 0.5 ) N(0.07,0.02)
40
S
 95% CI for log( 0.5 )
40
0.07 ± 1.96 x √ 0.20
[–0.207, 0.347]

Example 2: A stock price has an expected return of 16% and a volatility of 35%. The current
price is $38.

a) What is the probability that a European call option on the stock with an exercise price of
$40 and a maturity date in six months will be exercised?
b) What is the probability that a European put option on the stock with the same exercise
price and maturity will be exercised?

Answer:

S0 = 38 | µ = 0.16 | σ = 0.35

a) European call, K = 40, T = 0.5

ST K
S0 S0
ST
S0
K
P(ST > K) = P( > ) = P(log( ) > log( )) = P(
S0
log
( )(
ST
S0
1 2
− μ− σ T
2 ) >
σ √T
K
(
log ( )− μ− σ 2 T
S0
1
2 ) )
σ √T

= P(Z >
K
S0 (
log( )− μ− σ 2 T
1
2) ) = P(Z <
log( )(
S0
K
1 2
+ μ− σ T
2 ) ) = Φ(
log
S0
K ( )( 1 2
+ μ− σ T
2 ) )
σ √T σ √T σ √T

= Φ(
log( )(
38
40
1
2 )
+ 0.16− 0.35 2 ×0.5
) = Φ(−0.0078 ¿ = 0.50
0.35 √ 0.5

Volatility
The volatility of a stock, σ, is a measure of our uncertainty about the returns provided by the
stock.

Stocks typically have volatilities between 15% and 50%.

The volatility can be defined as the standard deviation of the return provided by the stock in
one year.

Example: The volatility of a stock price is 30% per annum. What is the standard deviation of the
percentage price change in one trading day?
0.30
= 0.018
√252
Estimation of volatility from historical data

A record of stock price movements can be used to estimate volatility.

The stock price is usually observed at fixed intervals of time.

We define:

 n + 1: Number of observations
 Si: Stock price at end of ith interval, where i = 0, 1, ..., n
 τ : Length of time interval in years

The log-return in the ith interval is

The sample standard deviation of the ui can be calculated as follows

The volatility σ can be estimated by

The standard error for σ^ is

Example: Suppose that observations on a stock price (in dollars) at the end of each of 15
consecutive weeks are as follows: 30.2, 32.0, 31.1, 30.1, 30.2, 30.3, 30.6, 33.0, 32.9, 33.0, 33.5,
33.5, 33.7, 33.5, 33.2.

a) Estimate the stock price volatility.

b) What is the standard error of your estimate?

Answer:

Assumptions underlying the BSM model

Stock price behavior corresponds to the log-normal model.

There are no transaction costs or taxes. All securities are perfectly divisible.

There are no dividends on the stock during the life of the option.

There are no risk-free arbitrage opportunities.

Security trading is continuous.

Investors can borrow or lend at the same risk-free rate of interest.

The short-term risk-free rate of interest is constant.

Key Ideas underlying BSM

The option price and the stock price depend on the same underlying source of uncertainty

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.

Black-Scholes Formula
Example: Consider an option on a non-dividend-paying stock when the stock price is $30, the
exercise price is $29, the risk-free interest rate is 5% per annum, the volatility is 25% per annum,
and the time to maturity is four months.

a) What is the price of the option if it is a European call?

b) What is the price of the option if it is an American call?
c) What is the price of the option if it is a European put?
d) Verify that put-call parity holds.

Answer:

S0 = 30 | K = 29 | r = 0.05 | σ = 0.25 | T = 4/12 = 1/3

a) d2 =
log ( )(
S0
K
1 2
+ r− σ T
2 ) =
log ( )(
30
29
1
+ 0.05− ×0.252 T
2 ) = 0.278
σ √T 0.25
√1
3

d1 = d2 + σ √ T = 0.278 + 0.25
√1
3
= 0.422

c = Φ(d1)S0 – Φ (d2)Ke-rT = Φ(0.422) x 30 – Φ(0.278) x 29e-0.05x1/3 = 0.6628 x 30 – 0.6103 x

29e-0.05x1/3 = 2.477
b) Since the stock pays no dividend, American call = 2.477
c) p = −Φ (– d1)S0 + Φ(– d2)Ke-rT = −Φ (–0.422) x 30 + Φ(–0.278) x 29e-0.05x1/3
= –(1 – 0.6628) x 30 + (1 – 0.6103) x 29e-0.05x1/3 = 0.999
Check: c – p = S0 – Ke-rT  2.477 – 0.999 = 30 – 29e-0.05x1/3
Properties of the Black-Scholes formula

As S0 becomes very large,

c → S0 − Ke−rT, p → 0.

As S0 becomes very small,

c → 0, p → Ke−rT − S0.

Example: What happens to c and p as

a) σ becomes very large?

b) T becomes very large?

Answer:

c = Φ(d1)S0 – Φ (d2)Ke-rT

p = −Φ (– d1)S0 + Φ(– d2)Ke-rT

d1 =
log ( SK )+(r + 12 σ ) T
0 2

σ √T

d2 = d1 – σ √ T

a) σ becomes very large

σ  ∞ : d1  ∞ => Φ (d1)  1

d2  −∞ => Φ(d2)  0

c  S0

σ  ∞ : d1  ∞ => Φ (–d1)  0

d2  −∞ => Φ(–d2)  1

p  Ke-rT

b) T becomes very large

T  ∞ : d1  ∞
1 1 1
d2  −∞ if r < σ2 | d2  ∞ if r > σ2 | d2  0 if r = σ2
2 2 2

c  S0 (for all cases)

p0

Understanding N(d1) or Φ(d1) and N(d2) or or Φ(d2)

Φ(d2) is the probability that a call option will be exercised in a risk-neutral world.

S0erTN(d1) is the expected stock price at maturity when stock prices less than the strike price are
counted as zero.

Thus, the formula for the European call option price is just the expected discounted payoff from
the call option in a risk-neutral world.

That is,

Risk-Neutral Valuation

Risk-neutral valuation is a very powerful tool because in a risk-neutral world two particularly
simple results hold:

 The expected return from all investment assets is the risk-free interest rate.
 The risk-free interest rate is the appropriate discount rate to apply to any expected
future cash flow.

Options and other derivatives can be valued using risk-neutral valuation.

The procedure is as follows

 Assume that the expected return from the underlying asset is the risk-free interest rate r.
 Calculate the expected payoff.
 Discount the expected payoff at the risk-free interest rate.

Applications of Risk-Neutral valuation

Consider the value of a forward contract on a non-dividend paying stock S with forward price K
which matures in T years.

The risk-free rate is r.

The payoff for the forward contract is ST – K

Thus, the value of the forward contract is

Implied Volatility

The implied volatility of an option is the volatility for which the Black-Scholes price equals the
market price.

The is a one-to-one correspondence between prices and implied volatilities.

Traders and brokers often quote implied volatilities rather than dollar prices.

Implied volatilities can be used to monitor the market’s opinion about the volatility of a
particular stock.

Whereas historical volatilities are "backward looking", implied volatilities are "forward looking".

The VIX Index

The CBOE publishes indices of implied volatility.

The most popular index, the SPX VIX, is an index of the implied volatility of 30-day options on
the S&P 500 calculated from a wide range of calls and puts.

An index value of 15 indicates that the calculated implied volatility of 30-day options on the S&P
500 is about 15%.

Trading in futures on the VIX started in 2004 and trading in options on the VIX started in 2006.

One contract is on 1,000 times the index.

Stocks paying discrete dividends

European options on dividend-paying stocks are valued by substituting the stock price less the
present value of dividends into the Black-Scholes formula.

Only dividends with ex-dividend dates during life of option should be included.

The "dividend" should be the expected reduction in the stock price on the ex-dividend date.

Example: Consider a European call option on a stock with ex-dividend dates in two months and
five months. The dividend on each ex-dividend date is expected to be $0.50. The current share
price is $40, the exercise price is $40, the stock price volatility is 30% per annum, the risk-free
rate of interest is 9% per annum, and the time to maturity is six months. Calculate the price of
this option.

Answer:

q = $0.50 at 2nd and 5th months | S0 = $40 | K = $40 | σ = 0.30 | r = 0.09| T = 0.5

PV of dividends: D = 0.5 x [e-0.09x9/12 + e-0.09x5/12] = $0.974

S0’ = S0 – D = 40 – 0.974 = $39.026

d1 =
log ( SK ' )+(r + 12 σ ) T = log ( 39.026
0 2
40 ) + (0.09+ 0.30 ) ×0.5
1
2
2

= 0.202
σ √T 0.30 √ 0.5

d2 = d1 – σ √ T = 0.202 – 0.30√ 0.5 = – 0.01

c = Φ(d1)S0 – Φ (d2)Ke-rT = Φ(0.202) x 39.026 – Φ(– 0.01) x 40e-0.09x0.5 = 0.5793 x 39.026 – 0.496 x
40e-0.09x0.5 = $3.64

Stocks paying known dividend yields

Suppose that the dividend yield per year is q.

The payment of a dividend yield at rate q causes the growth rate in the stock price to be
reduced by q.

When valuing a European option lasting for time T on a we reduce the current stock price from
S0 to S0e−qT and then value the option as though the stock pays no dividends.

Black-Scholes Formula for options on stock with known dividend yields

Example: Consider a European call option on an index that is two months from maturity. The
current value of the index is 930, the exercise price is 900, the risk-free interest rate is 8% per
annum, and the volatility of the index is 20% per annum. Dividend yields of 0.2% and 0.3% are
expected in the first month and the second month, respectively. Determine the price of one
contract if it is on 100 times the index.

Answer:
S0 = 930 | K = 900 | r = 0.08 | σ = 0.20

Dividends earned in 2 months = 0.2% + 0.3% = 0.5%

 Dividend yield rate for the 2-month period = 0.5% x 6 = 3% = q

d1 =
log( )(
S0
K
1 2
+ r− σ T
2 =
log
)
930
900 ( )(
1
+ 0.08− 0.022 ×
2
2
12
= 0.544
)
σ √T 0.20
2
12 √
d2 = d1 – σ √ T = 0.544 – 0.20
√ 2
12
= 0.463

c = Φ(d1)S0e-qT – Φ (d2)Ke-rT = Φ(0.544) x 930e-0.03x2/12 – Φ(0.463) x 900e-0.08x2/12 = 51.34