Module 3: Black-Scholes Formula

Introduction to B-S formulas Greek Letters and Elasticity

Binary Options (all-or-nothing options) Let V be the price of a derivative, then

Consider the prepaid forward prices and the quantities ∂V ∂2V ∂∆ ∂V
d1 and d2 : ∆= ; Γ= 2
= ; θ=
∂S ∂ S ∂S ∂t
P
Ft,T (k) = ke−r(T −t) ; P
Ft,T (S) = St e−δ(T −t) ∂V ∂V ∂V
υ= ; ψ= ; ρ=
∂σ ∂δ ∂r
   
1 St 1 2 Relation between Delta, Gamma, and Theta
d1 = √ ln + (r − δ + σ )(T − t)
σ T −t k 2 Recalling the Black-Scholes equation:
∂V ∂V 1 ∂2V
"
P
! # + (r − δ)S + σ 2 S 2 2 = rV
1 Ft,T (S) 1 ∂t ∂S 2 ∂ S
= √ ln P
+ σ 2 (T − t)
σ T −t Ft,T (k) 2 then
1
θ + (r − δ)S∆ + σ 2 S 2 Γ = rV
√ 2
d2 = d1 − σ T − t ∆call = e−δ(T −t) N (d1 )

Cash-or-Nothing call ∆put = −e−δ(T −t) N (−d1 )

Payoff= I(ST > k)
Γcall = Γput > 0
That’s why calls and puts are called convex de-
Time-t Price: e−r(T −t) N (d2 ) = Ft,T
P
(1)N (d2 )
rivatives.
Cash-or-Nothing put ∆call − ∆put = e−δ(T −t)

Payoff= I(ST < k) θcall − θput = δSe−δ(T −t) − rke−r(T −t)

Time-t Price: e−r(T −t) N (−d2 ) = Ft,T
P
(1)N (−d2 )
θcall(δ=0) < 0
Asset-or-nothing call
υcall = υput > 0
Payoff= ST I(ST > k)
ψcall < 0, ψput > 0
Time-t Price: St e−δ(T −t) N (d1 ) = Ft,T
P
(S)N (d1 )
ρcall > 0, ρput < 0
Asset-or-nothing put
Suppose that at time t, the price of the derivative is
Payoff= ST I(ST < k)
V (S, t), then:
Time-t Price:St e−δ(T −t) N (−d1 ) = Ft,T
P
(S)N (−d1 ) 
∂

1 ∂2
 
V (S+ε, t) ≈ V (S, t)+ V (S, t) ε+ 2S
V (S, t) ε2
Black-Scholes formulas ∂S 2 ∂
Delta Approximation:
call(St , k, T ) = St e−δ(T −t) N (d1 ) − ke−r(T −t) N (d2 ) V (S + ε, t) ≈ V (S, t) + ∆(S, t)ε
Delta-Gamma Approximation:
P P
= Ft,T (S)N (d1 ) − Ft,T (k)N (d2 ) V (S + ε, t) ≈ V (S, t) + ∆(S, t)ε + 21 Γ(S, t)ε2
Delta-Gamma-Theta Approximation:
put(St , k, T ) = ke−r(T −t) N (−d2 ) − St e−δ(T −t) N (−d1 ) V (St+h , t + h) ≈ V (St , t) + ∆ε + 12 Γε2 + θh
Mean Return and Volatility of a Derivative
= P
Ft,T (k)N (−d2 ) − P
Ft,T (S)N (−d1 ) Elasticity of a Derivative:
S ∂V ∆
Ω := =S
V ∂S V

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 Module 3: Black-Scholes Formula

Recalling that under B − S framework: If ε := Sud − S0

dSt 1
= (α − δ)dt + σdZt θ(S0 , 0) ≈ [C(Sud , 2h) − ε∆(S0 , 0)
St 2h 
1
If we set: − ε2 Γ(S0 , 0) − C(S0 , 0)
2
dV (St , t)
= mV dt + sV dZt
V (St , t) Risk Management Techniques
We have:
Let X and Y be two risky assets:
mV = Ωα + (1 − Ω)r derivative’s instantaneous expected return
dXt dYt
S∆ = mX dt + sX dZt ; = mY dt + sY dZt
sV = σ = Ωσ derivative’s instantaneous volatility Xt Yt
V
If we have 1 unit of X at time t, to hedge the risk,
Ω is a measure of leverage because if |Ω| > 1 then we must purchase Nt = − sX Xt units of Y and hold a
|sV | > σ, and hence the option is riskier than the un- sY Yt
derlying asset. cash position of W t = −Xt − Nt Yt .

∂V /V Hence Xt + Nt Yt + Wt = 0, i.e., (Xt , Nt Yt , Wt ) is a

Ω=
∂S/S riskless and, therefore, costless portfolio.
percentage change in derivative price
= Delta-hedging a portfolio:
percentage change in stock price
If Xt = V (St , t) a derivative on S and Yt = St , then
Properties of Elasticity of Calls and Puts
Nt = −∆ , Wt = −V + St ∆
Ωcall > 1 This means that a call is a levered in-
vestment in the underlying stock and is always (⇒ P &Lt = V (St , t) + Nt St + Wt = 0)
riskier than the stock.
Ωput < 0, because ∆put ≤ 0 Understanding the profit from a Hedged Port-
folio:
The magnitude of Ω increases with the time to
expiration.
At t + h the P &L of the derivative position and the
The magnitude of Ω increases when the option hedged portfolio is
becomes ITM.
P &Lt+h = V (St+h , t + h) + Nt eδh St+h + Wt erh
If we have a portfolio P with n derivatives written on
n
X (Suppose δ = 0, ε = St+h − St , h small
the same underlying stock S, P = wi Vi
i=1 1
P &Lt+h ≈ V (St , t) + ∆ε + Γε2 + θh + Nt St+h + Wt (1 + rh)
n   2
X Vi S 1
⇒ ΩP = wi Ωi ΩP = ∆ P = Γ(St+h − St )2 + θh + rhWt (1)
i=1
P P 2
1 
2

n = Γ [St+h − St ] h − σ 2 St2
X 2
Note that ΩP 6= wi Ωi
i=1 (1) shows why the fluctuation in the value of a hedged
Greek Letters for Binomial Trees portfolio is typically small.)
Cu − Cd
∆(S0 , h) = e−δh If P &Lt+h > 0 we said we have a self-financing si-
Su − Sd
tuation
∆(Su , h) − ∆(Sd , h)
Γ(Sh , h) =
Su − Sd

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 Module 3: Black-Scholes Formula

Self-financing Delta-hedged Portfolio: Estimation of Volatilities and Ex-

pected Rates of Appreciation
Suppose δ = 0, then

P &Lt+h > 0 ⇔ The implied volatility is the volatility implied by

√ √ the market price, V , of an option, i.e., the value σ that
St (1 − σ h) < St+h < St (1 + σ h) for Γ < 0 gives V when it is substituted into the Black-Scholes
√ √
St+h < St (1 − σ h) or St+h > St (1 + σ h) formula.
for Γ > 0
√
±St σ h is one standard deviation move of the stock For ATM options with r = δ we have
price.
1 √
d1 = −d2 = σ T
Rebalancing the Hedge Portfolio 2

Consider a time-t portfolio Pt on a derivative and

The historical volatility may be regarded as an
its hedge portfolio. Let Pt,t+h be the new value of Pt
estimate of volatility from historical stock prices.
at t + h, and Pt+h be the rebalanced portfolio then we
{St0 , St1 , ..., Stn }
have:
Pt = V (St , t) + Nt St + Wt = 0 If we let h = ti − ti−1 , then the annual historical vola-
δh rh tility is
Pt,t+h = V (St+h , t + h) + Nt e St+h + Wt e = P &Lt+h √
Pt+h = V (St+h , t + h) + Nt+h St+h + Wt+h = 0 σ̂ = su / h
⇒ Pt,t+h − Pt+h = P &Lt+h

where
= Nt+h St+h − Nt eδh St+h + Wt+h − Wt erh


n
1X
Notice that the rebalancing entails a cost which is s2u = (ui − ū)2
n i=1
exactly the profit from the hedge.
   
Boyle-Emanuel Formula Sti 1 Stn
ui = ln ; ū = ln
Sti−1 n St0
The frequency of rebalancing is strongly related to
the variation in the value of a delta-hedged portfolio,
whose relationship is modeled by the next formula: We can estimate the expected rate of appreciation by
noticing that
1 2 2 2


V ar(P &Lt+h ) ≈ Γ(St , t)σ hSt ˆ 1 ū
2 α − δ − σ2 =
2 h
Gamma Neutrality

A portfolio with a zero gamma is called gamma-neutral Q-Q plot (Normal probability plot)
2
position, since ΓS = ∂∂2 S S = 0, to adjust the gamma
of a portfolio, we must make use of instruments such
as options that are not linearly dependent on the un- It is a plot xi vs. zi , where
derlying asset.
xi is the i − th order statistic of a set of n obser-
vations.
i−1/2
zi = N −1 (qi ) where qi = n

If the underlying distribution is normal, then the points

on a normal probability plot should roughly lie on a
straight line.