INTDERIV Ch19 Lecture PDF

Derivatives.
27-03-2017
An Introduction to Derivative Securities, Financial Markets, and Risk Management

© Jarrow and Chatterjea 2013
 This chapter presents the Black–Scholes–Merton
(BSM) option pricing model (OPM).
◦ First, we consider some applications and uses.
◦ Next, we provide a brief history of the model.
◦ We describe the model’s assumptions, present the Black–
Scholes formula for valuing European options, and
discuss the theory underlying the model’s structures.
◦ We discuss how to gather the model’s inputs.
◦ Finally, we show how to extend the BSM model to adjust
for dividends and to price foreign-currency options. We
also discuss the pricing of American options.
◦ An insert presents a bird’s-eye view of exotic options.
Chapter 19, Slide 2

© Jarrow-Chatterjea 2013
 The Black–Scholes–Merton model has several
useful characteristics.
◦ It is intuitive and easy to understand.
◦ It is easier to handle than the binomial model, for which
you must decide on U, D, and the number of periods.
◦ Applying the BSM model’s analytical hedge ratios and
Greeks is more convenient than computing numerical
derivatives.
◦ Despite its simplicity, the model can be made to work,
even though some of its assumptions fail to hold.
◦ The BSM model is a building block for more complex
option pricing models.
Chapter 19, Slide 3

 Late 1960s: Fischer Black, Myron Scholes, and Robert
Merton worked on the option pricing problem.
◦ Black applied the capital asset pricing model to value options
and derived a partial differential equation that implicitly
solved the option’s value.
◦ He teamed up with Scholes to solve the equation and derive
the formula that bears their names.
◦ Merton pioneered the use of stochastic calculus to tackle a
variety of problems, including portfolio theory and option
valuation.
 He also showed Black and Scholes a critical step—how to derive
their partial differential equation using a perfectly hedged
portfolio consisting of the stock and the option.
Chapter 19, Slide 4

 1973: After initial rejections, Black and Scholes’s
article was published in the Journal of Political
Economy. Merton’s article was published in the
Bell Journal of Economics and Management
Science.
 The Black–Scholes and Merton papers deeply

influenced both academics and practice.
 1997: Merton and Scholes won the Bank of

Sweden Prize in Economic Sciences in Memory of
Alfred Nobel (aka the Nobel Prize in Economics).
Chapter 19, Slide 5

A1. No market frictions.
 We assume that trading involves no market frictions.
Moreover, assets are perfectly divisible.
◦ This assumption creates a benchmark model.
◦ It is a reasonable approximation for many institutional traders.
◦ Political changes, regulatory changes, and the IT revolution
have substantially reduced market frictions.
A2. No credit risk.

 This is the risk that the counterparty will fail to
perform on an obligation.
◦ This is a reasonable assumption for exchange-traded
derivatives.
◦ OTC derivatives may use collaterals to lower credit risks.
Chapter 19, Slide 6

A3. Competitive and well-functioning markets.
 In a competitive market, traders’ purchases or
sales have no impact on the market price; they act
as price takers.
 In a well-functioning market, traders agree on

zero- probability events. Price bubbles are absent.
◦ Pricing securities when counterparties have market
power and traders can manipulate prices invalidates the
pricing methodology.
Chapter 19, Slide 7

A3. Competitive and well-functioning markets
(cont’d)
◦ If traders disagree on zero-probability events, then they
cannot come to a consensus regarding what they
consider an arbitrage opportunity.
 This lack of consensus destroys our key tool for proving
results (see assumption A5).
◦ A price bubble occurs when an asset’s price deviates from
its fundamental value.
 The fundamental value is the present value of an asset’s
future cash flows—that is, the price paid if, after purchase,
you have to hold the asset forever.
◦ Bubbles invalidate our option-pricing methodology (see
Extension 19.1).
Chapter 19, Slide 8
 Bubbles are a thorn in the side of policy makers, a
source of problems for asset holders, an opportunity
for hedge fund managers, and a hot research area for
academics.
 If assumption A3 fails and a bubble occurs, then many

results of option pricing theory no longer hold.
◦ Fortunately, in the BSM model, assumption A8 (that stock
prices follow a lognormal distribution) excludes bubbles.
 If you believe that stock price bubbles are present,

modify the lognormal distribution assumption.
◦ The BSM model no longer applies.
Chapter 19, Slide 9

 In a market with no arbitrage opportunities or
dominated assets, asset price bubbles occur only
when the market is incomplete.
◦ Most option pricing theories assume a complete market,
which excludes bubbles.
 But how do you price options when asset price

bubbles occur in an incomplete market?
◦ Two common alternative pricing approaches are:
(1) using indifference- or utility-based pricing
(2) identifying the risk-neutral probabilities from traded
derivatives
Chapter 19, Slide 10

 Exact hedging is no longer possible:
◦ We cannot price by synthetic construction.
◦ Risk-neutral valuation may still apply.
 Research suggests that in the presence of

bubbles:
◦ Put–call parity holds for European options.
◦ Risk-neutral valuation:
 Works for put prices because it has a bounded payout
 Does not work for call prices: if the underling asset has a
price bubble, so does the call
◦ Forwards and futures inherit the underlying’s price
bubble.
◦ Futures prices can have their own price bubbles.

A4. No intermediate cash flows
 For now, we can assume that the underlying asset
has no CFs over the option’s life.
 Later, we will relax this assumption.
A5. No arbitrage opportunities

 This is self-explanatory.

A6. No interest rate uncertainty
 We assume that interest rates are constant across
time.
◦ This assumption works only for short-lived options
whose underlying assets’ prices are not interest rates.
◦ It does not work well for long-dated options whose
underlying assets’ prices are correlated with interest rate
changes, such as long-term options on foreign currencies.
 Next, we introduce two assumptions that are

crucial for developing the BSM model.

 A7. Trading takes place continuously over time.
This assumption gives a realistic description of
transacting actively traded stocks.
 A8. The stock price follows a lognormal

probability distribution.
 This assumption means that the continuously

compounded returns on the stock follow a normal
distribution. We approach this assumption by:
◦ plotting diagrams
◦ adding more structure to the concept of the continuously
compounded rate of return

 Assumption A8: Lognormal probability distribution
(cont’d)
 Figure 19.1 shows stock price evolution under discrete and

continuous time trading.
◦ First figure: Single period binomial case
 Trivially reject this price path and the model as unreasonable.
◦ Second figure: Multiperiod binomial evolution
 It may also be trivially rejected as unreasonable. It starts
looking like a stock price path if the time step shrinks to zero.
◦ Third figure: Stock price path for the lognormal
distribution Cannot trivally reject this as unreasonable—a
rejection requires the use of formal statistical procedures.
 This is the first real or realistic stock price evolution that we
have considered.

 Assumption A8: Lognormal probability
distribution (cont’d)
 Result 2.1c considered continuously compounded

growth. Similarly, for a stock
S(T) = S(0)eyT (19.1)
◦ where S(T) and S(0) are the stock prices at times T and 0,
respectively, and y is the continuously compounded rate
of return on the stock per year
 But the stock price return is not risk free.

 Assumption A8: Lognormal probability distribution (cont’d)
 We need a model that

◦ generates prices that look like the stock price patterns
observed in financial markets
◦ never allows stock prices to be negative
◦ allows stock price returns to be positive, zero, or negative (as
you find in the markets)
◦ is mathematically tractable
 Samuelson, Merton, and others did this by introducing a

geometric Brownian motion.
◦ This modification gives us a structure similar to expression
(19.1).

 Assumption A8: Lognormal probability distribution
(cont’d)
 Geometric Brownian motion assumes that y is normally

distributed with mean ( – 2/2)T and standard deviation
T. This is expressed as
σ2
μT  T σ T z
S (T )  S (0)e 2
where
◦  is the expected return on the stock per year
◦  is the standard deviation or volatility of the stock’s return per
year
◦ z is a standard normal random variable with mean 0 and variance
1 with the probability density function
 The original proof of the BSM model utilizes the idea of
hedging an option position with an opposing stock trade
(see Figure 19.2).
Step 1
 The call prices and the underlying stock price move
together.
 The call value is a function of the underlying stock price. It
also depends on time.
Step 2
 A long call and a short stock position must move in
opposite directions. This creates a partial hedge.

Step 3
For each long call, short-sell a fraction of a stock to
make it a perfect hedge.
◦ For any movement in the stock price, the change in the call
value exactly offsets the change in the short stock position.
The perfectly hedged portfolio uniquely identifies the

option’s arbitrage-free price.
◦ This happens because the hedged portfolio requires a known
initial investment, and it is riskless over the next time period.
To avoid arbitrage, it must earn the risk-free rate.
◦ The equation implied by this restriction is a partial differential
equation. Solve this equation to get the option’s price.

 The replication argument utilizes the hedge ratio, the so-
called holy grail of option pricing.
 Jarrow notes:
◦ “The idea of constructing a perfectly hedged portfolio is the key
insight of the Black–Merton–Scholes model, more important than
the valuation formula itself.
◦ “Indeed, if one considers the meaning of a perfectly hedged
portfolio, it becomes apparent that it implies that a position in the
stock and the riskless asset can be created that exactly duplicates
the changes in value to the call option.”
 The creation of synthetic options is the basis for most OPMs

and will be applied throughout this textbook.

 The European call price is:
c = SN(d1) – Ke-rTN(d2) … (19.4a)
where
◦S  S(0) is today’s spot price
◦N(…) is the cumulative standard normal distribution
function which has mean 0 and standard deviation 1
S  σ2 
log     r  T
K  2 
d1 
σ T
d 2  d1  σ T

 The European call price (cont’d):
◦ K is the strike price
◦ r is the continuously compounded risk-free interest rate
per year
◦ T is the time to maturity measured in years (because time 0
is today, T is also the option’s expiration date)
◦  is the stock return’s volatility per year, which is the
square root of the stock return’s instantaneous variance
 The European put price is given by

p = Ke–rTN(–d2) – SN(–d1) (19.4b)

 The call’s value depends on:
◦ the stock price (S)
◦ the strike price (K)
◦ the time to maturity (T)
◦ the riskless interest rate (r)
◦ the stock return’s volatility ()
 The call’s value does not depend on the stock’s

expected return ().
 This omission exception is significant.

 The expected return is the most difficult input to
estimate.
◦ Estimating  is equivalent to estimating the stock’s risk
premium. There is no consensus on how to estimate this.
◦ Had the option’s value depended on , we would not have
applied the formula.
 Because the option value does not depend on , two

traders who agree on (S, K, T, r, ) but disagree on  will
still agree on the call’s value.
◦ If the traders disagree on , they probably will disagree on S.
◦ But if they agree on S, regardless of their views of , they agree
on the call’s value.

 Recall the binomial option pricing data from chapter
18:
◦ YBM’s current stock price S is $100.
◦ Strike price K is $110.
◦ Time to maturity T is 1 year.
◦ Volatility  of the stock’s return is 0.142470 per year.
◦ The risk-free interest rate r is 5 percent per year.
 Compute d1 and Sd2:  σ2 

log     r  T
K  2 
d1 
σ T
d 2  d1  σ T

 The cumulative normal distribution function
values are:
◦ N( d1 )
◦ N( d2 )
 The zero-coupon bond price:

B = e–rT
 The European call price:

c = SN(d1) – Ke–rTN(d2)

 For European puts, we need:
◦ N(–d1)
◦ N(–d2)
 The European put price:

p = Ke–rTN(–d2) – SN(–d1)
 Double-check computations by applying put-call

parity:
p = c + Ke–rT – S

 In an arbitrage-free market, pseudo-probabilities exist such
that
S(t) = Eπ[S(T)]e–r(T–t)
where π(z) are the pseudo-probabilities.
◦ Adjustment for risk occurs with the pseudo-probabilities
in the expectation.
◦ The discount rate is the riskless rate, which is not risk
adjusted.
 Equivalently, S(t)/ert = Eπ[S(T)/erT]

◦ The stock price, normalized by the price of a money
market account, is a martingale under the pseudo-
probabilities. Hence the name martingale probabilities.

 Under the lognormal distribution assumption, the
market is complete, and risk-neutral valuation
holds. π
c  E max[ 0,S (T )  K ]e  rT
 Evaluating the expectation:

c  E π S (T ) S (T )  K e  rT Pr obπ {S (T )  K }
 K Pr obπ S (T )  K e  rT
 We can show that on the right-hand side

◦ The first expression equals SN(d1)
◦ The second expression equals Ke–TN(d2)
 The first term in the BSM formula, S(0)N(d1), can
be interpreted as the discounted expected stock
price at maturity, given that it ends up in-the-
money multiplied by the probability of being in-
the-money.
 The second term in the BSM formula, KN(d2)e–rT,

can be interpreted as the discounted strike price
(Ke–rT) times the pseudo-probability of ending up
in-the-money, that is, N(d2) = Probπ{S(T)  K}

 Note that π(z) > 0 if and only if q(z) > 0
◦ That is, the actual and pseudo-probabilities must agree
on zero-probability events.
 This implies: π(z) = (z)q(z)

where
θ2
 θz μr 
φ( z )  e 2
0 and θ    T
 σ 
 The quantity (z) represents an adjustment for
risk, and  is the stock’s risk premium.

 Greeks help us understand how the Black–Scholes–
Merton model price changes when inputs change.
◦ Take partial derivatives of the BSM formula (given in
Result [19.1]) with respect to S, T, r, and  (see Table
19.1).
 Delta measures the change in the option’s value

when there is a small change in the underlying stock
price. A call’s delta
 c Change in the value of the call
Delta    N (d1 ) (19.10a)
 S Change in the value of the stock
◦ Delta, the hedge ratio, lies between 0 and 1.
◦ The put’s delta is similarly defined.

 Gamma gives the sensitivity of the delta to changes in the
underlying stock price.
◦ Gamma is given by the second partial derivative of the
BSM call price formula:
 (Delta) Change in the delta

Gamma  
S Change in the value of the stock
 2c 1
  N ' (d1 )  0 (19.10b)
S 2
Sσ T
◦ where N( . ) is the standard normal distribution function.
Other symbols are defined in Result 19.1.
◦ Gamma shows that as the stock price increases, the delta
increases.
◦ Gamma for a call and gamma for a put have the same
value.

 Recall the BOP data (see Example 19.1):
◦ S = $100
◦ K = $110
◦ T = 1 year
◦  = 0.142470 per year
◦ r = 0.05 per year
 From Example 19.1:

◦ d1 = –0.2468
o Then:
◦ For the call, deltaC = N(d1) = 0.4025
◦ For the put, deltaP = –N(–d1) = –0.5975
 From expression (19.10b), we get

◦ Gamma = N(d1)/(ST) = 0.0272

 Table 19.2 reports deltas and gammas for calls and
puts.
◦ Column 1 reports stock prices S at $5 intervals ranging
from $50 to $150.
◦ Columns 2 and 3 report deltas for calls and puts. They are
plotted against S in Figure 19.3A.
◦ Column 4 reports gamma values. They are the same for
both calls and puts. They are plotted against S in Figure
19.3B.

 Examining the Greek values in Table 19.1 suggests
that:
◦ The call’s theta is negative. As time passes, the call
becomes less valuable. The variance of the stock’s return
decreases but the PV of the strike (which is the cost of
exercising the option) increases.
◦ The put’s theta has an ambiguous sign. The first effect is
similar to that of a call, but the second effect has the
opposite sign.

 Greek values in Table 19.1 (cont’d):
◦ Vega has a positive sign. As the volatility increases, the
value of the option increases. Traders view options as
volatility bets.
◦ Rho is positive for a European call. As the interest rate
increases, PV of strike that may be paid goes down, which
increases a European call value.
◦ Rho is negative for a European put, where an opposite
argument is given.

 Greeks are useful for understanding the sensitivity
of option values to changes in the inputs.
 Greeks are also used for hedging option price risks

caused by changes in these parameters.
◦ Delta and gamma hedging are valid procedures when the
BSM assumptions are satisfied (see chapter 20).
◦ Even if the BSM assumptions are valid, rho hedging
(which has been largely abandoned) and vega hedging
(which also should disappear but persists in many
institutions) have serious conceptual problems.

 In the derivation of the BSM model, assumption
A3, the competitive markets assumption, is
crucial.
◦ A competitive market is one in which traders’ trades do
not affect the stock price.
◦ When this assumption is relaxed and traders’ trades
change the price, stock market manipulation is possible.
 In a market that can be manipulated, the BSM

model is no longer valid.
◦ We can illustrate this with a simple example.

 A European call option has inputs (S[t], K, T, r, ).
 The stock price has evolved across time as graphed

(see Figure 19.4).
 Currently we are standing at time T – e for a small e > 0

where the stock price is out-of-the-money, that is,
S(T – e) < K
 The BSM formula can show that the value of the call
and its delta are approximately zero, that is,
c ~ 0 and delta ~ 0

 Suppose that trades can change the stock price.
◦ The competitive market assumption (A3) is violated.
 A manipulator purchases a large quantity of the stock’s

shares to make the price jump to S* > K.
 The true price of the call and its delta are easily seen to be:
c = S* – K and delta = 1
◦ This is very different from values predicted by the BSM model.
◦ If a risk manager had applied the BSM model to hedge an
option position using a delta value near zero, he would have
lost significant wealth due to the market manipulator’s actions.

 The current method for pricing options assumes that
there are no price bubbles and no market
manipulation.
◦ If either of these assumptions does not hold, then pricing
and hedging in these models do not apply.
 Implication 1: When trading options by applying these

models, you must monitor market conditions to
ensure that these assumptions are approximately true.
◦ If they are approximately true, the models will work well.
◦ If they are false, do not use the model!
 Implication 2: Models are a useful tool, but they can be

applied wrongly if they are not understood.
 Most inputs of the BSM formula are easily
obtained.
◦ The strike price and time to maturity are specified in the
option contract.
◦ For actively traded stocks, use the last transaction price.
For less liquid stocks, use the average of the bid and ask
prices.
◦ The risk-free interest rate comes from Treasury security
prices.
 Use the Treasury bill that matures closest to the option’s
expiration date.
 Take the average of the bid and ask yields, and compute the
T-bill price.
 Solve for the continuously compounded annual interest rate
r.
 Volatility is the hardest input to estimate. We apply either:
◦ an explicit method using statistical methods and past
price data, called the historical volatility; or
◦ an implicit method using option market prices, called the
implied volatility
 Historical volatility, an estimate of the volatility, is the

stock return’s sample standard deviation. We can use other
estimators as well.
◦ The historical volatility estimation uses actual stock price
realizations that are generated from the actual
probability distribution.
◦ Estimates of  and  are obtained under the actual
probability q.

Data
 Table 19.3 reports closing stock prices for Your
Beloved Machines Corp. (YBM).
◦ Column 1 is labeled Week(t). There are (n + 1) = 17
observations corresponding to seventeen consecutive
weeks, where t runs from week 0 to week t = 16.
◦ Column 2 records weekly closing prices for YBM.
The Price Relative

◦ Column 3 reports price relatives of YBM: S(t)/S(t – 1),
where S(t) is week t’s closing price.
◦ When we compute the difference, the first observation is
lost. We now have n = 16 data points.

Logarithm of the Price Relative
 Column 4 records natural logarithm of the price
relative, log[S(t)/S(t – 1)], which we write as x(t).
Computing the Sample Variance

 Excel: If the data are input into a spreadsheet or other
computer program, the sample variance is computed
in one step.
◦ Running Excel command VARA over the sixteen observations in
cells D4 to D19 gives VARA(D4:D19) = 0.000390218

Computing the Sample Variance (cont’d)
 Hand calculations:
◦ Compute the sample mean:
1 T
μ̂   x(t )
T t 1
◦ Column 5 presents the deviations of the x(t)’s values
from the mean, which we square, and then compute the
average of these squared deviations using (n – 1) = 15 in
the denominator to get the sample variance:
1 T
σ̂  2
 x (t )  μ̂ 2
T  1 t 1

Computing the Annualized Volatility
 Convert the weekly sample variance to the annualized
variance by multiplying it by the number of weeks:
σ̂ 2Annual  σ̂ 2Week (Number of weeks)
Converting to Annualized Figures

 Suppose you compute the volatility using daily data.
◦ On the basis of empirical studies, annualize using 250
trading days (instead of all 365 days in the year).
σ̂ 2Annual  σ̂Week
2
(250)

 How many observations should you use?
◦ More observations will give a more accurate estimation.
◦ But a long time series of data may not be stationary. Also,
a long time series may not contain relevant information
about the current probability distribution.
◦ Daily data for a year is a reasonable choice.
 How long should the time interval be between

stock price observations?
◦ If observations are collected at short intervals, then
market frictions and market microstructure issues can
have a significant impact on the estimate.
◦ Daily or weekly intervals have fewer of these problems.

 Implied volatility IV is determined by solving the
equation
cMarket = BSM(Imp) (19.11)
 Use (S, K, r, T) and cMarket as inputs and then

compute  by solving this equation.
◦ This is an example of calibration, whereby we estimate a
parameter from a model by using market prices as inputs
rather than outputs.
◦ Calibration (and implicit volatilities) can easily be applied
incorrectly. The next chapter elaborates on this issue.

When the dividend date and dollar dividend are known:
 Replace the actual stock price with the current stock price
minus the present value of all the dividends paid over the
option’s life.
 Run the BSM model with this modified stock price. Result
19.1 becomes
c = [S – PV(dividends)]N(d1) – Ke–rTN(d2) (19.12)
where
 S  PV ( dividends )   σ 2

log     r  T
 K   2 
d1  and d 2  d1  σ T
σ T
When the dividend rate is known:
 Proceed as before, but here we perform fractional
reduction (e–T). Result 19.1 becomes
c = e–TSN(d1) – Ke–rTN(d2) (19.13a)
p = Ke–rTN(–d2) – e–TSN(–d1) (19.13b)
Where  is the dividend yield,

S  σ2 
log     r  δ  T
K  2 
d1  and d 2  d1  σ T
σ T

Data
 Consider the data from chapter 12:
◦ INDY index’s current level I = 1,000
◦ r = 6 percent per year
◦  = 0.02 or 2 percent per year
European Call Price

 A European call on INDY with strike price K =
1,100 matures after T = 1 year.
◦ The index’s return volatility  is 0.142470 per year.
◦ The call payoff on the maturity date is 100[S(T) – 1,100]
dollars if it ends in-the-money but is zero otherwise.
◦ 100 is the contract multiplier.

 The call is valued using expression (19.13a), as
follows: S
   σ2 
log     r  δ  T
K  2 
d1 
σ T
d 2  d1  σ T
 The cumulative standard normal distribution function

values are:
◦ N( d1 )
◦ N( d2 )

 Zero-coupon bond price B = e–rT
 PV of dividend yield e–T
 European call price for the index option is

c = e–TSN(d1) – Ke–rTN(d2)
 Multiplying this by the contract multiplier 100

gives the call’s price:

Data
 We use the data from chapter 12:
◦ Today’s spot exchange rate SA is $2 per pound sterling.
◦ Continuously compounded annual risk-free interest rates are:
◦ r = 6 percent in the United States (domestic)
◦ rE =  = 4 percent in the United Kingdom (foreign)
European Call Price

 A European call on pound sterling with strike price K = $2.10
matures after T = 1 year.
◦ The pound’s volatility  is 0.10 per year.
◦ The call payoff at maturity is 100[S(T) – 2.10] dollars if it ends
in-the-money but is zero otherwise.
◦ 100 is the contract multiplier.

 The call is valued using expression (19.13a), as
follows: S
 A  σ2 
log     r  δ  T
K   2 
d1 
σ T
d 2  d1  σ T
 The cumulative standard normal distribution function

values are:
◦ N( d1 )
◦ N( d2 )

 Zero-coupon bond price B = e–rT
 PV of dividend yield e–T
 European call price for the index option is

c = e–TSN(d1) – Ke–rTN(d2)
 Multiplying this by the contract multiplier 100

gives the call’s price:

 The BSM formula and its dividend modifications
hold only for European options.
◦ American options are more valuable than European
options because of an early exercise premium.
◦ We cannot obtain formulas for American calls except in
some very special cases.
◦ No closed-form solutions have been found for pricing
American puts.
◦ To price American options in practice, we need to turn to
numerical procedures.

 The multiperiod binomial model is an important
tool for approximating American call and put
values in the BSM model as well.
◦ This approach works well, but the computations can be
time consuming.
 Other numerical procedures for pricing American

options are available. They belong to two
categories:
◦ methods that numerically solve a partial differential
equation (pde)
◦ methods that approximate the stock price evolution

 Methods that numerically solve the partial
differential equation (pde) implied by the option’s
price:
◦ To solve pdes, we can employ numerical techniques like
finite difference methods and numerical integration.
 Methods that approximate the stock price

evolution to compute the option’s risk-neutral
value (a discounted expectation):
◦ To compute discounted expectations, the binomial model
and Monte Carlo simulation techniques are useful.

 Additional comments and discussions


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Derivatives.

An Introduction to Derivative Securities, Financial Markets, and Risk Management

Chapter 19, Slide 2

Chapter 19, Slide 3

Chapter 19, Slide 4

 The Black–Scholes and Merton papers deeply

 1997: Merton and Scholes won the Bank of

Chapter 19, Slide 5

A2. No credit risk.

Chapter 19, Slide 6

 In a well-functioning market, traders agree on

Chapter 19, Slide 7

 If assumption A3 fails and a bubble occurs, then many

 If you believe that stock price bubbles are present,

Chapter 19, Slide 9

 But how do you price options when asset price

Chapter 19, Slide 10

 Research suggests that in the presence of

Chapter 19, Slide 11

 Later, we will relax this assumption.

A5. No arbitrage opportunities

Chapter 19, Slide 12

 Next, we introduce two assumptions that are

Chapter 19, Slide 13

 A8. The stock price follows a lognormal

 This assumption means that the continuously

Chapter 19, Slide 14

 Figure 19.1 shows stock price evolution under discrete and

Chapter 19, Slide 15

 Result 2.1c considered continuously compounded

Chapter 19, Slide 17

 We need a model that

 Samuelson, Merton, and others did this by introducing a

Chapter 19, Slide 18

 Geometric Brownian motion assumes that y is normally

Chapter 19, Slide 20

The perfectly hedged portfolio uniquely identifies the

Chapter 19, Slide 21

 The creation of synthetic options is the basis for most OPMs

Chapter 19, Slide 23

Chapter 19, Slide 24

 The European put price is given by

Chapter 19, Slide 25

 The call’s value does not depend on the stock’s

 This omission exception is significant.

Chapter 19, Slide 26

 Because the option value does not depend on , two

Chapter 19, Slide 27

 Compute d1 and Sd2:  σ2 

Chapter 19, Slide 28

 The zero-coupon bond price:

 The European call price:

Chapter 19, Slide 29

 The European put price:

 Double-check computations by applying put-call

Chapter 19, Slide 30

 Equivalently, S(t)/ert = Eπ[S(T)/erT]

Chapter 19, Slide 31

 Evaluating the expectation:

 We can show that on the right-hand side

 The second term in the BSM formula, KN(d2)e–rT,

Chapter 19, Slide 33

 This implies: π(z) = (z)q(z)