Option Pricing and the Black -Scholes Model: A Lecture Notes for Master’s Level

Teaching Perspectives.

kapil Dev Subedi*

Introduction

The idea of options is certainly not new. Ancient Romans, Grecians, and Phoenicians (ancient civilization
centered in the north of ancient Canaan, with its heartland along the coastal regions of modern day
Lebanon, Syria and Israel) traded options against outgoing cargoes from their local seaports. When used
in relation to financial instruments, options are generally defined as a "contract between two parties in
which one party has the right but not the obligation to do something, usually to buy or sell some
underlying asset". Having rights without obligations has financial value, so option holders must purchase
these rights, making them assets. This asset derives their value from some other asset, so they are called
derivative assets. Call options are contracts giving the option holder the right to buy something, while put
options, and conversely entitle the holder to sell something. Payment for call and put options, takes the
form of a flat, up-front sum called a premium. Options can also be associated with bonds (i.e. convertible
bonds and callable bonds), where payment occurs in installments over the entire life of the bond.

The Black and Scholes Model:

The Black and Scholes Option Pricing Model didn't appear overnight, in fact, Fisher Black started out
working to create a valuation model for stock warrants. This work involved calculating a derivative to
measure how the discount rate of a warrant varies with time and stock price. The result of this calculation
held a striking resemblance to a well-known heat transfer equation. Soon after this discovery, Myron
Scholes joined Black and the result of their work is a startlingly accurate option pricing model. Black and
Scholes can't take all credit for their work; in fact their model is actually an improved version of a
previous model developed by A. James Boness in his Ph.D. dissertation at the University of Chicago.
Black and Scholes' improvements on the Boness model come in the form of a proof that the risk-free
interest rate is the correct discount factor, and with the absence of assumptions regarding investor's risk
preferences. The model is named after Fischer Black and Myron Scholes, who developed it in 1973.
Robert Merton also participated in this model creation, and this is why the model is sometimes referred to
as the Black-Scholes-Merton model. All three men were college professors working at both the university
of Chicago and MIT at that time.

The Black-Scholes option pricing formula is a pricing algorithm for European call options on stocks
without dividends. The formula was first published in 1973 by Fisher Black and Myron Scholes;however,
in the same year, Robert C. Merton provided extensions and an alternative derivation of the formula.
From the viewpoint of innovation theory, the Black-Scholes option pricing formula is of interest because
it constitutes a paradigm change. Before the publication of the formula, finance was dominated by the
paradigm of risk-based pricing models rooted in an equilibrium (neoclassic) thinking with the Capital
Asset Pricing Model (CAPM) being the most prominent example.

The Black-Scholes option pricing formula marks an important step towards contemporary finance with its
arbitrage-based pricing models and the related paradigm of arbitrage theory. The Black-Scholes option
pricing formula is the first and - perhaps - most important example of the class of arbitrage pricing
models. On the one hand, the formula is a scientific innovation; on the other hand, it should be clear that

*
Mr Subedi is the Member of Management Board Shaheed Smriti Multiple Campus, Tandi,
Chitwan
it is also an economic innovation: Using the Black-Scholes option pricing formula it was possible for the
first time to compare the price resulting from supply and demand with the analytical value of an option.
Therefore they were awarded the Nobel Prize of economics in 1997 for their dignified contribution in the
field of arbitrage pricing and for a new method to determine the value of derivatives.

The creative and invaluable contribution of Black and Scholes to option pricing theory was their
"tinkering"; starting from the CAPM, their thought process enrolled to recognizing that hedging must lead
to the risk-free interest rate replacing the stock's expected return. This allowed the Black-Scholes partial
differential equation to be derived and subsequently solved for the Black-Scholes option pricing formula.
Thereby, they laid the foundation for the first major application of Arbitrage Theory (Discounting).
Merton`s creative contributions consist of the idea of the arbitrage portfolio and the application of Itô-
Calculus, laying the rigorous foundation. The term "risk-neutral valuation" (See Hull, 2000, pp. 205) has
become the generic term for pricing via arbitrage portfolios. The crucial difference between the paradigm
of equilibrium models and the paradigm of arbitrage models is, (besides the more technical innovation of
using a different math in form of the Itô-Calculus), the fundamentally different assumptions used. In
equilibrium models (in general and especially in the CAPM), the user has to make assumptions about risk
preferences of individuals whose behavior must be modeled. Therefore, the CAPM always returns the
risk-return tradeoff: An investor will only accept a risky security if, and only if, he is adequately
compensated by a higher return. By contrast, the risk return tradeoff is irrelevant for arbitrage models
because the valuation is conducted on a risk-neutral basis (as the hedging portfolios are risk-free, they
must earn the risk-free rate). Therefore the Black-scholes option pricing is based upon the following
model.

In order to understand the model itself, we divide it into two parts. The first part, SN (d1), derives the
expected benefit from acquiring a stock outright. This is found by multiplying stock price [S] by the
change in the call premium with respect to a change in the underlying stock price [N (d1)]. The second
part of the model, Ke-rtN(d2), gives the present value of paying the exercise price on the expiration day.
The fair market value of the call option is then calculated by taking the difference between these two
parts.
How It Works? ; Example:

Let assume you would like to know the value of an option to purchase one share of Nepal Liver Limited
stock for Rs95. The current price of the shares is Rs100, and the option expires in three months (one-
quarter year). Assuming that the stock pays no dividends, the standard deviation of the stock returns is
50% per year, and the risk-free rate is 10% per year, we can calculate that the value of the option, even
though it is out of the money right now, is as follows:

d1 = [ln(100/95) + (.10 + .52/2).25]/ .5√.25 = .43

d2 = .43 - .5√.25 = .18
N(.43) = .6664
N(.18) = .5714

Thus, the value of the call options is:

C0 = 100 x .6664 - 95e-.10 x .25 x .5714 = 66.64 - 52.94 = Rs13.70

Note that this formula values a call option. The Black-Scholes model can be used to price other
derivatives, including puts. To value a put option (P), use the value of the call option to solve for
the value of the put option, as follows:

P = C0 + PV(K) - S0 = C0 + Ke-rT - S0 = 13.70 + 95e-.10 x .25 - 100 = Rs6.35

The basic mission of the Black-Scholes model is to calculate the probability that an option will expire in
the money. To do this, the model looks beyond the simple fact that the value of a call option increases
when the underlying stock price increases or when the exercise price decreases. Rather, the model assigns
value to an option by considering several other factors, including the volatility of Nepal Liver Limited
stock, the time left until the option expires, and interest rates. For example, if Nepal Liver Limited stock
is considerably volatile, there is more potential for the option to go in the money before it expires. Also,
the longer the investor has to exercise the option, the greater the chance that an option will go in the
money and the lower the present value of the exercise price. Higher interest rates raise the price of the
option because they lower the present value of the exercise price.

It is important to note that the Black-Scholes model is geared toward European options. American
options, which allow the owner to exercise at any point up to and including the expiration date, command
higher prices than European options, which allow the owner to exercise only on the expiration date. This
is because the American options essentially allow the investor several chances to capture profits, whereas
the European options allow the investor only one chance to capture profits.

Why it matters?

Empirical studies show that the Black-Scholes model is very predictive, meaning that it generates option
prices that are very close to the actual price at which the options trade. However, various studies show
that the model tends to overvalue deep out-of-the-money calls and undervalue deep in-the-money calls. It
also tends to misprice options that involve high-dividend stocks. Several of the models assumptions also
make it less than 100% accurate.

Assumptions;
1) The stock pays no dividends during the option's life

Most companies pay dividends to their share holders, so this might seem a serious limitation to the model
considering the observation that higher dividend yields elicit lower call premiums. A common way of
adjusting the model for this situation is to subtract the discounted value of a future dividend from the
stock price.

2) European exercise terms are used

European exercise terms dictate that the option can only be exercised on the expiration date. American
exercise term allow the option to be exercised at any time during the life of the option, making American
options more valuable due to their greater flexibility. This limitation is not a major concern because very
few calls are ever exercised before the last few days of their life. This is true because when you exercise a
call early, you forfeit the remaining time value on the call and collect the intrinsic value. Towards the end
of the life of a call, the remaining time value is very small, but the intrinsic value is the same.

3) Markets are efficient

This assumption suggests that people cannot consistently predict the direction of the market or an
individual stock. The market operates continuously with share prices following a continuous Itô process.
To understand what a continuous Itô process is, you must first know that a Markov process is "one where
the observation in time period t depends only on the preceding observation." An Itô process is simply a
Markov process in continuous time or Ito process is a stochastic process: a generalized Wiener process
with normally distributed jumps. If you were to draw a continuous process you would do so without
picking the pen up from the piece of paper.

4) No commissions are charged

Usually market participants do have to pay a commission to buy or sell options. Even floor traders pay
some kind of fee, but it is usually very small. The fees that Individual investor's pay is more substantial
and can often distort the output of the model.

5) Interest rates remain constant and known

The Black and Scholes model uses the risk-free rate to represent this constant and known rate. In reality
there is no such thing as the risk-free rate, but the discount rate on Government Treasury Bills with 30
days left until maturity is usually used to represent it. During periods of rapidly changing interest rates,
these 30 day rates are often subject to change, thereby violating one of the assumptions of the model.

6) Returns are log-normally distributed- This assumption suggests, returns on the underlying stock are
normally distributed, which is reasonable for most assets that offer options.

Conclusions;

Ultimately, however, the Black-Scholes model represents a major contribution to the efficiency of the
options and stock markets, and it is still one of the most widely used financial tools. Besides providing a
dependable way to price options, it helps investors understand how sensitive an option price is to stock
price movements. This in turn helps investors maximize the efficiency of their portfolios by giving them a
way to calculate hedge ratios and more efficiently implement portfolio insurance.
 Despite the tremendous efficiencies created by the Black-Scholes model, many financial theorists claim
the model’s introduction indirectly increased the volatility of the stock and options markets by
encouraging more trading (as investors sought to constantly fine-tune their hedge positions). Others claim
the model actually steadies the markets because of its ability to measure equilibrium pricing relationships.
When these relationships are violated, arbitrageurs are usually the first to discover and exploit mispriced
options.

References
Black, F., 1989. How we came up with the option formula. Journal of Portfolio Management, Volume 15,
No. 2, pp. 4-8.
Black, F., Jensen, M.C., Scholes, M., 1972. The Capital Asset Pricing Model: Some Empirical Tests,
Studies in the Theory of Capital Markets. Michael C. Jensen, ed., Praeger, New York, pp. 79-
121.
Black, F., Scholes, M., 1972. Valuation of Option Contracts and a Test of Market Efficiency. Journal of
Finance, Volume 27 (May), pp. 399-418.
Black, F., Scholes, M., 1973. The Pricing of Options and Corporate Liabilities. Journal of Political
Economy, May – June, pp. 637-654.
Dosi, G., et al., 1990. The nature of the innovative process. Technical Change and Economic Theory.
Printer Publishers Limited, S. 221-238.
Dunbar, N., 2001. Inventing Money. The story of Long-Term Capital Management and the legends
behind it, second ed. John Wiley & Sons, Ltd., Chichester, New York.
Hull, J.C., 2000. Options, Futures and Other Derivatives, fourth ed. Upper Saddle River, Prentice Hall,
New Jersey.
Scholes, M.S. 1998. Derivatives in a Dynamic Environment. American Economic Review, Volume 88,No.
3, pp. 350-370.
Shah, A., 1997. Black, Scholes and Merton: Their Work and Their Consequences. Economic and
Political Weekly, Volume 32, No. 52, pp.. 3337-3342.