10/11/2019

BSM formula gives us a great deal more than just

the option prices - it gives us the complete
Options - Model 2 replicating portfolios for the call and the put, at any
point in time.

1 2

Plot of Call and Put option prices (BSM)

Working with the formula

3 4

1
 10/11/2019

Call and Put deltas under BSM

An option is said to be at-the-money-forward

(ATMF) if the strike price equals the forward price
on the stock for that maturity.
What is the Black Scholes price for an ATMF Call?

5 6

Accommodating div yields in the BSM formula

 Some features of the Black-Scholes formulae: Appropriate for modeling options on stock indices
Option prices only depend on five variables: S0, K, r, T, and and currencies.
σ.
Two market variables, two contract variables and one — A simple adjustment: Replace S0 with e −δT S0
the volatility σ — is not directly observable.
throughout the formula, where δ is the dividend
In particular, option prices do not depend on expected
stock returns, which are difficult to estimate. yield for the underlying asset.
Why?
 How can this formula be used by the seller of the option, say
a call option on a particular stock?

7 8

2
 10/11/2019

IV

Consider a stock that pays dividends at a

continuous rate of δ.
Pricing options on currencies
A currency is just an asset with a continuous
dividend yield, with the interest rate on the
currency playing the role of the dividend yield in the
BSM formula.
 Given an option price, one can ask the question: what level
of volatility is implied by the observed price?
 This level is the implied volatility.
 Formally, implied volatility is the volatility level that would
make observed option prices consistent with the Black-
Scholes formula, given values for the other parameters.

9 10

 Two sources are normally ascribed for the volatility

smile/skew/smirk.
Let’s compute the IV for today morning’s market
prices at the NSE.  One is the returns distribution. The Black-Scholes model
assumes log-returns are normally distributed.
 However, in every financial market, extreme observations are
What do you observe?
far more likely than predicted by the log-normal distribution.
Extreme observations = observations in the tail of the
distribution.
Empirical distributions exhibit "fat tails" or leptokurtosis.
 Empirical log-returns distributions are often also skewed.

11 12