BlackScholes

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The BlackScholes model (pronounced /blk olz/[1]) or BlackScholes-Merton is a mathematical model of a financial market containing certain derivative investment instruments. From the model, one can deduce the BlackScholes formula, which gives the price of European-style options. The formula led to a boom in options trading and the creation of the Chicago Board Options Exchange[dubious discuss]. lt is widely used by options market participants.[2]:751 Many empirical tests have shown the BlackScholes price is fairly close to the observed prices, although there are well-known discrepancies such as the option smile.[2]:770-771 The model was first articulated by Fischer Black and Myron Scholes in their 1973 paper, The Pricing of Options and Corporate Liabilities. They derived a partial differential equation, now called theBlackScholes equation, which governs the price of the option over time. The key idea behind the derivation was to hedge perfectly the option by buying and selling the underlying asset in just the right way and consequently "eliminate risk". This hedge is called delta hedging and is the basis of more complicated hedging strategies such as those engaged in by Wall Street investment banks. The hedge implies there is only one right price for the option and it is given by the BlackScholes formula. Robert C. Merton was the first to publish a paper expanding the mathematical understanding of the options pricing model and coined the term BlackScholes options pricing model. Merton and Scholes received the 1997 Nobel Prize in Economics (The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel) for their work. Though ineligible for the prize because of his death in 1995, Black was mentioned as a contributor by the Swedish academy.[3]

Contents
[hide]

1 Assumptions 2 Notation 3 The BlackScholes equation

o

3.1 Derivation

4 BlackScholes formula
o o

4.1 Interpretation 4.2 Derivation

4.2.1 Other derivations

5 The Greeks 6 Extensions of the model

o o

6.1 Instruments paying continuous yield dividends 6.2 Instruments paying discrete proportional dividends

7 BlackScholes in practice
o o o o

7.1 The volatility smile 7.2 Valuing bond options 7.3 Interest rate curve 7.4 Short stock rate

8 Criticism 9 Remarks on notation 10 See also 11 Notes 12 References

o o o

12.1 Primary references 12.2 Historical and sociological aspects 12.3 Further reading

13 External links
o o o o o

13.1 Discussion of the model 13.2 Derivation and solution 13.3 Revisiting the model 13.4 Computer implementations 13.5 Historical

[edit]Assumptions
The BlackScholes model of the market for a particular stock makes the following explicit assumptions:

There is no arbitrage opportunity (i.e., there is no way to make a riskless profit). It is possible to borrow and lend cash at a known constant risk-free interest rate. It is possible to buy and sell any amount, even fractional, of stock (this includes short selling). The above transactions do not incur any fees or costs (i.e., frictionless market). The stock price follows a geometric Brownian motion with constant drift and volatility. The underlying security does not pay a dividend.[4]

From these assumptions, Black and Scholes showed that it is possible to create a hedged position, consisting of a long position in the stock and a short position in the option, whose value will not depend on the price of the stock.[5] Several of these assumptions of the original model have been removed in subsequent extensions of the model. Modern versions account for changing interest rates (Merton, 1976)[citation needed],transaction costs and taxes (Ingersoll, 1976)[citation needed], and dividend payout.[6]

[edit]Notation
Let , be the price of the stock (please note as below). , the price of a derivative as a function of time and stock price. the price of a European call option and , the strike of the option. , the annualized risk-free interest rate, continuously compounded. , the drift rate of , annualized. the price of a European put option.

, the volatility of the stock's returns; this is the square root of the quadratic variation of the stock's log price process. , a time in years; we generally use: now=0, expiry=T. , the value of a portfolio. Finally we will use which denotes the standard

normal cumulative distribution function,

. which denotes the standard normal probability density function,

[edit]The

BlackScholes equation

Simulated Geometric Brownian Motions with Parameters from Market Data

As above, the BlackScholes equation is a partial differential equation, which describes the price of the option over time. The key idea behind the equation is that one can perfectly hedge the option by buying and selling the underlying asset in just the right way and consequently eliminate risk". This hedge, in turn, implies that there is only one right price for the option, as returned by the Black Scholes formula given in the next section. The Equation:

[edit]Derivation
The following derivation is given in Hull's Options, Futures, and Other Derivatives.[7]:287288 That, in turn, is based on the classic argument in the original Black Scholes paper. Per the model assumptions above, the price of the underlying asset (typically a stock) follows a geometric Brownian motion. That is,

where W is Brownian motion. Note that W, and consequently its infinitesimal increment dW, represents the only source of uncertainty in the price history of the stock. Intuitively, W(t) is a

process that jiggles up and down in such a random way that its expected change over any time interval is 0. (In addition, its variance over time T is equal to T); a good discrete analogue for W is a simple random walk. Thus the above equation states that the infinitesimal rate of return on the stock has an expected value of dt and a variance of The payoff of an option .

at maturity is

known. To find its value at an earlier time we need to know how evolves as a function of and .

By It's lemma for two variables we have

Now consider a certain portfolio, called the delta-hedge portfolio, consisting of being

short one option and long time

shares at

. The value of these holdings is

Over the time period

, the

total profit or loss from changes in the values of the holdings is:

Now discretize the equations for dS/S and dV by replacing differentials with deltas:

and appropriately substitute them into the expression for :

Notice that the term has vanished. Thus uncertainty has been eliminated and the portfolio is effectively riskless. The rate of return on this portfolio must be equal to the rate of return on any other riskless instrument; otherwise, there would be opportunities for arbitrage. Now assuming the risk-free rate of return is we

must have over the time period

If we now equate our two formulas for we obtain:

Simplifying, we arrive at the celebrated BlackScholes

partial differential equation:

With the assumptio ns of the Black Scholes model, this second order partial differential equation holds for any type of option as long as its price function is twice differentia ble with respect to and

once with respect to .

Different pricing formulae

for various options will arise from the choice of payoff function at expiry and appropriat e boundary conditions.

[edit]Bl

ack Schol es form ula

Black Schol es Europ ean call option pricin

g surfac e
The Black Scholes formula calculates the price of Europe an put and call options. This price is consiste nt with the Black Scholes equation a s above; this follows since the formula can be obtained b y solving the equation for the correspon ding terminal and

boundary conditions. The value of a call option for a nondividend paying underlying stock in terms of the Black Scholes parameter s is:

The price of a corres pondi ng pu t option base d on pu t-call parity is:

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