BLACK AND SCHOLES OPTION PRICING MODEL

Black-Scholes is a pricing model used to determine the fair price or theoretical value for a call
or a put option based on six variables such as volatility, type of option, underlying stock price,
time, strike price, and risk-free rate. The model was first articulated by Fischer Black and Myron
Scholes in 1973. The model is used to determine the price of a European call option, which
simply means that the option can only be exercised on the expiration date.
Black-Scholes pricing model is largely used by option traders who buy options that are priced
under the formula calculated value, and sell options that are priced higher than the Black-Schole
calculated value .

The formula for computing option price is as under :

Call Option Premium C = SN(d1) - Xe- rt N(d2)

Put Option Premium P = Xe–rT N (–d2) – S0 N (-d1)

d1 = [Ln (S / X) + (r + s2 / 2) X t] -------------------------------------- s Öt d2 = [Ln (S / X) + (r - s 2

/ 2) X t] --------------------------------------- s Öt

where,

C = price of a call option

P = price of a put option

S = price of the underlying asset

X = strike price of the option

r = rate of interest

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t = time to expiration

s = volatility of the underlying

N represents a standard normal distribution with mean = 0 and standard deviation = 1

Factors affecting call option

1. Spot market price-the higher the price of the underlying asset the greater the value of the call
option.
2. Exercise price- the lower the exercise price the greater the value of the call option
3. Time to expiration- the longer the time to expiration the higher the probability that the spot
price will exceed the exercise price and hence the option will have a greater value
4. Risk free rate- when an option contract is purchased the exercise price is not payable until
maturity. The higher the interest the lower the present value of the discounted exercise price. As
interest rates rise the value of the option will also increase.
5. The standard deviation of the returns /volatility in returns of underlying assets. The greater the
volatility in share prices the more likely that the exercise price will be exceeded hence the option
value will also increase.
6. Dividends- The price of a call option will normally fall with share price as share price goes
ex-dividend
7. Market trends- Strong market trends whether upward or downward moving generally offer
greater scope for making money through options.
Factors affecting put option

1. Spot market price; the higher the stock price the lower the value of a put option.
2. Exercise price; the higher the exercise price the higher the value of a put option.
3. Time to expiration of the underlying stock; the longer the time to expiration the higher
the value of a put option
4. Risk free rate; the higher the risk free rate the lower the value of a put option.

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 5. The standard deviation of the returns / volatility in returns of underlying assets; The
greater the volatility in share prices the more likely that the exercise price will be
exceeded hence the put option will also increase.

The Black-Scholes model makes certain assumptions:

 The option is European and can only be exercised at expiration.

 No dividends are paid out during the life of the option.

 Markets are efficient (i.e., market movements cannot be predicted).

 There are no transaction costs in buying the option..

Limitations of the Black-Scholes model

1. Volatility - a measure of how much a stock can be expected to move in the near
term is a constant over time. While volatility can be relatively constant in very short
term, it is never constant in longer term. Large price changes tend to be followed by
large price changes, and vice versa leading to a property called volatility clustering. But
measures of volatilities are negatively correlated with asset price returns (leverage
effect), while trading volumes or the number of trades are positively correlated, hence
volatility cannot be a constant over time . Some advanced option valuation models
substitute Black-Scholes's constant volatility with stochastic-process generated
estimates.
2. People cannot consistently predict the direction of the market or an individual
stock. It assumes stocks move in a manner referred to as a random walk. Random walk
means that at any given moment in time, the price of the underlying stock can go up or
down with the same probability. This is usually not true as stock prices are determined
by many economic factors that cannot be assigned the same probability in the way they
will affect the movement of stock prices. Also, the price of a stock in time t+1 is
independent from the price in time t (martingale property of Brownian motion).
3. Returns of log normally distributed underlying stock prices are normally
distributed. This assumption is reasonable in the real world, though not fitting observed
financial data accurately. Asset returns have a finite variance and semi-heavy tails
contrary to stable distributions like log normal with infinite variance and heavy tails
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 As the time scale over which return of assets are calculated increases, the
distribution of asset prices look more like the normal-distribution with heavy tails
despite the fact that autocorrelation of asset prices are often insignificant .
4. Interest rates are constant and known, just same like with the volatility. It uses
the risk-free rate to represent this constant and known rate. In the real world, there is no
such thing as a risk-free rate, but it is possible to use the U.S. Government Treasury
Bills 30-day rate since the U. S. government is deemed to be credible enough. However,
these treasury rates can change in times of increased volatility.
5. The underlying stock does not pay dividends during the option's life. In the real
world, most companies pay dividends to their shareholders. The basic Black-Scholes
model was later adjusted for dividends, so there is a workaround for this. This
assumption relates to the basic Black-Scholes formula. A common way of adjusting the
Black-Scholes model for dividends is to subtract the discounted value of a future
dividend from the stock price.
6. No commissions and transaction costs i.e. the model assumes that there are no fees
for buying and selling options and stocks and no barriers to trading. Usually not true as
stock brokers charge rates based on spreads and other criteria.
7. Assumes European-style options which can only be exercised on the expiration
date. American-style options can be exercised at any time during the life of the option,
making American options more valuable due to their greater flexibility.
8. Markets are perfectly liquid and it is possible to purchase or sell any amount of
stock or options or their fractions at any given time. This again is not plausible as
investors are limited by the amount of money they can invest, policies of their
companies and by the wish of sellers to sell. It may not be possible to sell fractions of
options as well.
The use of the Black and Scholes Model to value real options
The model is well suited for simple real options. The key input variables must however
be identified as follows:-
1. Exercise price; for most real options e.g. option to expand and option to delay, the
capital investment required can be substituted for exercise price. For an option to
abandon however the salvage value of abandonment can be treated as exercise price.
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 2. Share price; the value of the underlying asset is usually taken to be the present value
of the future cash flows from the project i.e. excluding initial outlay.
3. Time to expiry; this will be the length of time the project will last.
4. Volatility; this can be measured using the typical industry sector.
5. Risk free rate; this is also used when valuing real options. However specialists argue
that a higher rate should be used to reflect the extra risk when replacing the share
price with the present value of future cash flows.

INCREASING THE FIRM VALUE THROUGH RISK MANAGEMENT

Managers seeking to implement a risk management program must consider whether and to what
extent the risk management strategy attempts to evaluate the costs and benefits of the risks.

1.Risk management can reduce financial distress costs by reducing the firms total risk ,risk
management makes financial distress less likely to occur.

2.Risk management can reduce the risk faced by key undiversified investors. Another way that
risk management can add value is by lowering the risk faced by managers who have most of
their wealth invested in their company’s stock without the ability to diversify their holdings,
managers find that the value of their personal wealth fluctuates in tandem with their company’s
equity ,such fluctuations can have a negative impact on the firm value. Risk management
techniques can lower the risk faced by such managers.

3. Risk management can reduce taxes. risk management can also create value by reducing a
firms tax burden. A progressive tax system gives firms an incentive to smooth earnings to
minimize taxes and tax management enables such smoothing.

4.Risk management can reduce monitoring costs by improving performance evaluation. Risk
targeting can lower the cost of evaluating and monitoring corporate performance for investors,
creditors, customers and corporate boards of directors.

5.Risk management can provide internal funds for investors. if a company needs funding for a
potentially profitable project and issuing debt or equity is either impossible or too costly.
Management must fund the project internally or forego its .internal funding requires either a firm
stock piles cash or have a steady cash flow from other projects. By smoothing cashflow
volatility, risk management can help to ensure that the firm will be able to fund profitable
projects internally.