Turning Finance into Science:

Risk Management and the Black -

Scholes Options Pricing Model

Albert Kim
Mary Frauley
Writing for the Sciences
English ENG­LBE 09
Monday, May 1st 2000
 Recently, the people behind the famed Black - Scholes Options
Pricing Model received the Nobel Prize in Economics. Scientific
American delves into this form ula that has its share of praise,
and criticism

A New Breed of $cience

In recent years, a new discipline called financial engineering has emerged

in order to attem p t to under s t a n d finance using a scientific appro ac h.

Mathema ticians, physicists and trader s work together in this discipline in order

to incorpor a te the use of advanced mathe m a tics with everyday finance (Stix,

1998).

Although financial engineering deals with many aspects of finance, the

main application of this discipline is risk manage me n t within the stock market.

Regardless of what type of stock market transaction one perfor m s, risk is

always present. However, it is the manage m e n t of this risk that is studied by

these “financial engineers”. People need a fast and reliable way to calculate and

control the risk involved in all their stock trading.

This is where the Black- Scholes Option Pricing Model comes in. This

ideas behind this formula, created by Prof. Robert C. Merton, Prof. Myron S.

Scholes and the late Fisher Black, has been described by one economis t as “the

most successful theory not only in finance but in all of economics.” (Stix, 1998)

Options

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 The functioning of the Black- Scholes Model is based on the use of stock

option s. Stock options are a form of financial derivative (an item that is not a

stock in itself, but is an offshoot of one). It consists of a contract that gives

one the right, but not the obligation , to buy stocks later at a fixed price (known

as the exercise or strike price). The exercise price does not change, regardless

of all changes in the stock’s value. These options are purchase d at a fee

known as the premiu m.

To illustrate, let’s say someone obtained the option to purchase 100

shares a year from now (a date known as the call date) for $100 each. If the

stock were to rise to $120 by the call date, it would be feasible for this person

to exercise his / h e r option, because the shares would still only cost you $100,

even though they are worth $120.

However, if the value of the stock were $80 at the call date, then it

would not be feasible to purchase these shares, because you would be paying

$100 for shares that are worth $80 each (a loss of $20 a share). Thus, this

person probably would not exercise his / h e r option, and would only lose the

premiu m he / s he paid for the options a year ago.

Thus, stock options are a form of insurance policy. What makes stock

option s so appealing is that the purchaser knows that the limit of his / h e r

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losses can only be the premiu m price. However, there are no limits to his / h e r

gains, because the limit of the value of the stock is theoretically limitless

(Devlin, 1997).

The question is, what is the fair price for an option on a particular

stock? In other words, what is the option worth? When a stock has a call price

of $100 and a value of $120, the option is worth at least $20 ($120 - $100 =

$20). The value of the option clearly depen d s on the value of the stock. Thus,

if there were a formula that could tell you the fair price for an option while

taking into account all necessary factors, it would come of great use to the

financial world. This is what the Black- Scholes Options Pricing Model does.

The Math Behind It

Option pricing requires five inputs: the option’s exercise price, the time

to expiration, the price of the stock at the time of evaluation, current interest

rates and the volatility of the stock (Dammer s, 1998). The only unreliable

factor is the volatility of the stock. This number can be estima te d from

market data (Stix, 1998). The formula is as follows:

where the variable d is defined by:

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 According to this formula, the value of the option C, is given by the

difference between the expected share price (the first term) on the right - hand

side, and the expected cost (the second term) if the option is exercised. The

higher the current share price S, the higher the volatility of the share price

(Greek letter) sigma , the higher the interest rate r, the longer the time until the

call date t and the lower the strike price L, the higher the value of the option C

will be.

Limitations of the Model

As consistent as the model, there are limitations to the model. One

limitation is that it assu m es that the options can only be exercised on the call

date. In other words, it cannot be exercised earlier. This model involves

“European - Style” options, rather than “American - Style” options. “American -

Style” options can be exercised anytime (Dammers, 1998). American option s

are more flexible, thus more valuable. The model only takes European - style

option s into account. Thus, the model underes ti ma te s the value of option s.

Most options are not exercised until the call date anyways, but this law is not

written in stone.

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 Another limitation is that it assu me s that the interest rate (deter mine d

by the U.S. Governme n t) is known and will remain more - or - less constan t.

Many researcher s have conclude d that this is a safe assu m p tio n to make. But

there are times where the interest rate can change rapidly (Rubash, 1998), thus

putting the results of the model into question.

However, these limitatio ns are considere d insignificant, because they do

not affect the value of the option unless in extre me circums t a nc es (such as a

sud de n raise in interest rates or even a market crash).

The Birth of the Model

This formula did not create itself out of nowhere. Its roots lie deep in

the branches of mathe m a tics known as probability and statistics. The

combination of these two domains of mathe m a tics deals with the collection,

organiza tion, and analysis of numerical data in order to assist decision -

making. In short, statistics let you “predict the future”, not with 100%

accuracy, but well enough so that you can make a wise decision as to your next

course of action (Devlin, 1997).

It all starte d when Charles Castelli wrote a book called “The Theory of

Options in Stocks and Shares” in 1877. Castelli’s book was the first to deal

with the use of options. However, this book lacked the theoretical basis

needed for actual application (Rubash, 1998).

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 Twenty - three years later, a graduate stude nt by the name of Louis

Bachelier publishe d his thesis paper “La Théorie de la Spéculation” (The

Theory of Speculation) at the Sorbonne, in Paris (Rubash, 1998). In this paper,

Bachelier dealt with the “structur e of rando m n e s s” in the market. He

compare d the behavior of buyers and sellers to the rando m movemen t s of

particles suspe n d e d in fluids (NOVA Online, 2000). Remarkably, this paper

anticipate d key insights developed later on by famed physicist Albert Einstein

and future theories in the field of probability.

He created the first complete mathe m a tical model of options trading.

He believed the move men t s of stock prices were rando m and could never be

predicted, but risk could be managed (NOVA Online, 2000). He created a

formula that yielded an output that could help protect market investor s from

excessive risk by means of pricing options. However, this formula containe d

financially unrealistic assum p tion s, such as the existence of negative values

for stock prices and a zero interest rate (Stix, 1998). His paper was shelved

and went unnoticed for decades.

It wasn’t until 1955 that the idea of options pricing resurfaced, when a

profess o r at the Massachuset t s Institute of Technology name d Paul Samuelso n

browsed through the Sorbonne library. He began developing a formula of his

own. Other mathe m a ticians, such as Case Sprenkle and James Boness began

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toying with Bachelier’s ideas as well (Royal Swedish Academy of Sciences,

1997). But all of their efforts went fruitless.

A Revolution

Then in 1968, a 31- year - old indepen de n t finance contractor named

Fisher Black and a 28- year - old assistant profess or of finance at MIT name d

Myron Scholes (Rubash, 1998) began their work on options pricing. They were

dissatisfied with all the formulas that had preceded them, because they were

overly complicated and made assu m p tio n s that didn’t make sense. They

wanted to find a formula that would calculate the fair price of an option at any

mome n t in time just by knowing the current price of the stock, but they

could n’t see their way through the mass of equations they had inherited

(NOVA Online, 2000).

Then they decided to try somet hing different. They decided to strip

previously derived formulas to their bare - boned state. They dropp e d

everything that represent e d somet hing un - measur a ble (NOVA Online, 2000).

They were left with the vitals of calculating an option: the option’s exercise

price, the time to expiration, the price of the stock at the time of evaluation,

curren t interest rates and the volatility of the stock. But they were stuck with

one problem: one couldn’t measur e volatility, or in other words, risk.

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 So they decided if they couldn’t measur e the risk of an option, they

should make it less significant (NOVA Online, 2000). Their solution to this

proble m was to become of the most celebrate d discoveries of the 20th century.

The solution was rooted in the old gamblers’ practice of hedging. When one

makes a risky bet, one hedges his / h e r bet by also betting in the oppo site

direction.

To illustrate, let’s say one were to bet that the favored Detroit Red Wings

would beat the Colorado Avalanche in a 2nd round playoff series. If one

already bet $50 on the Red Wings, one would hedge that bet by betting $45 on

the Avalanche. Although Detroit is favored, by hedging this bet with a slightly

smaller bet on Colorado, we are protecting ourselves in the event of a

Colorad oa n upset. We minimize risk at the cost of lowering our possible

winnings. However, since Detroit is favored, the chances of winning $5 are

substan tial.

A more busines s - oriente d example would be as such: Let’s say a British

company is expecting to make several large payment s in US dollars in a few

mont h s. They can hedge against a huge drop in the Sterling Pound (thus

making it more expensive to buy US dollars) by purcha sing options for US

dollars on a foreign currencies market. Effective risk manage me n t requires

that such options be correctly priced (Royal Swedish Academy of Sciences,

1997).

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Fig 1: Hedging Cash Flows [Stix, G. (1998, May). A Calculus of Risk. Scientific American ,

p.94.]

To hedge against risks in changes in share price, the investor can buy

two options for every share he or she owns; the profit will then counter the

loss. Hedging creates a risk free portfolio (Stix, 1998). As the share price

changes over time, the investor must alter the composition of the portfolio,

the ratio of number of shares to the number of options, to ensure that the

holdings remain without risk (Stix, 1998).

They made up a theoretical portfolio of stocks and options. Whenever

either fluctuate d up or down, they tried to hedge against the moveme n t by

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making another move in the opposite direction. Their aim was to keep the

overall value of the portfolio in perfect balance. In other words, they tried to

minimize risk.

They discovered that they could indeed reduce risk by creating a balance

in which all moveme n t s in the markets cancelled each other out. Black and

Scholes had found a theoretical way to neutralize risk (NOVA Online, 2000).

With risk now virtually eliminate d from their equation, they had a

math e m a tical formula that could give them the price of any option. This was a

marvelous achieveme n t.

There was a practical problem with their formula. It assume d that

markets were always in equilibriu m, that supply equals dema n d (NOVA Online,

2000). They needed a way to instantly rebalance a portfolio of stocks and

option s to keep countering all their move men t s.

A Harvard graduate by the name of Robert Merton solved this problem

by introd ucing the notion of continuo u s time. This idea is rooted in rocket

science. A Japanese mathe m a tician by the name of Kiyosi Ito theorize d that

when you plot the trajectory of a rocket, knowing where the rocket was

second - by- second was not enough. You neede d to know where the rocket

was continuou sly. So he broke time down into infinitely small increme n t s,

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thus smoothe ning the graphing of its path out until it became a continu u m so

that the trajectory could be consta ntly update d (NOVA Online, 2000). Merton

applied this idea to the Black- Scholes model so that the value of an option

could be constantly recalculated and risk eliminate d continually (NOVA Online,

2000).

In 1997, Robert Merton and Myron Scholes were awarde d the Nobel

prize in economic sciences for their efforts. Their colleague Fisher Black had

unfort u na tely passed away in 1994. (Royal Swedish Academy of Sciences,

1997).

The History of the Model

In 1973, the Chicago Options Exchange was launche d, one month before

the Black- Scholes model was publishe d (Stix, 1998). When these three men

had published their paper in 1973 in the Journal of Political Economy, trader s,

acade mics and economis ts marveled at its overwhelming power, despite the

simple nature of its use.

Traders began using their ideas imme diately. Texas Instru m e n t s had

incorp o r ate d their formula into their latest calculator, annou ncing their

feature in the Wall Street Journal (Devlin, 1997). The options market exploded

soon after.

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 So overwhelming was the sudde n mass use of the Black- Scholes Model,

that when the stock market crashed in 1978, the influential business magazin e

Forbes put the blame squarely onto that one formula (Devlin, 1997).

According to Capital Market Risk Advisors, about 20 percent of the

$23.77 billion (US) in derivatives losses in the last decade are due to problem s

related to modeling (Stix, 1998). In 1997, however, model risk comprise d

nearly 40 percent of the $2.65 billion (US) in money lost.

Fig 2: Derivative s Losses [Stix, G. (1998, May). A Calculus of Risk. Scientific American , p.

95.]

At a conference in February 1998, an industry trade magazine called

Derivatives Strategy sponsore d a discussion group called “First Kill All the

Models”. (Stix, 1998) This group reflects the recent backlash against financial

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models. Many figures in the financial indus try question whether models can

match trader s’ skill and gut intuition about market dyna mics (Royal Swedish

Academy of Sciences, 1997).

Derivatives make the news because, like an airplane crash, their losses

can dramatic and chaotic. Enormou s losses by Proctor & Gamble and Gibson

Greetings and the bankr u p tcies of Barings Bank and Orange County, California

have been attribute d to the use of models (Stix, 1998).

Fig 3: Derivative s Debacles [Stix, G. (1998, May). A Calculus of Risk. Scientific American ,

pp. 91.]

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 However, Scholes says that it was not so much the formula itself that

caused these losses, rather its misuse by market traders. Every statistician

and mathe m a tician knows you cannot predict the future with 100% accuracy.

Laws as rigid as the laws of physics do not govern the market. Peter Fisher, a

New York economis t says: “Math doesn’t drive financial markets, people drive

financial markets, and people are not predictable. We do not yet have a

universal theory of huma n behavior or huma n motivation.” (NOVA Online,

2000)

It was not the model by itself that caused these losses, but the blind

faith that market trader s put into it. They all jumpe d at the pros pect of

making money without risk. However, this formula cannot eliminate risk, it

can only minimize it. Like many mathe m a tical models, it relies on imputs and

assu me s a functioning market. It is a powerful way to manage risk, but it’s not

a crystal ball. Scholes says this equation should be used as a tool for making

decisions, not a platfor m from which all decisions should be made (NOVA

Online, 2000).

Fisher says: “If a rando m bolt of lightning hits you when you’re

stan ding in the middle of the field, that feels like a rando m event. But if your

business is to stand in rando m fields during lightning stor m s, then you should

anticipate, perha p s a little more robustly, the risks you’re taking on.” (NOVA

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Online, 2000) This formula is a metho d to calculate these risks, not a risk

neutralizer.

“There is a danger of accepting models without carefully questioning

them,” says Joseph A. Langsa m, a former mathe m a tician who develops and

tests models for fixed - income securities at Morgan Stanley (Stix, 1998). Thus,

the Black- Scholes is not the culprit for all derivative losses, but trader s’ blind

faith in them.

Numbers vs. Instinct

Many traders still use the ideas behind the Black- Scholes Options

Pricing Model, if not the model itself. The funda m e n t al ideas behind the

equation forever changed the stock market. Today, trader s use many

principles of the Black- Scholes Model as guides through the treachero u s

waters of the stock market. For this, Scholes and Fisher became Nobel

laureates. But the lessons of putting all of one’s eggs in the same “Black -

Scholes Model” basket have been learned. One cannot blindly put all his / h e r

faith into the model and expect guarantee d financial success. Judgmen t is still

required.

Samuelson says: “There is a tempting and fatal fascination in

math e m a tics. Albert Einstein warned against it. He said elegance is for tailors,

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don’t believe in something because it’s a beautiful formula. There will always

be room for judgme n t.” (NOVA Online, 2000)

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 Reference s:
Dammer s, Jerry. (1998). “Option Pricing: The Concept & the Black- Scholes

Method” Valuemetrics, Inc. [Online] 4.9 (2000): Available URL:

http: / / w w w.value m e t rics.com / A r ticles / c o m p e n s a tio n%20article.ht ml

Devlin, Keith. (November 1997). “A Nobel Formula.” Mathema tical

Association of America. [Online] 4.9 (2000): Available URL:

http: / / w w w. m a a.org / d e vlin / d e vlin_11_97.ht ml

Hull, J.C. (1997). Options, Futures, and other Derivatives . New York:

Prentice Hall.

NOVA Online. (Feb 8 2000) “Trillion Dollar Bet”. Public Broadcasting

Syndicate Homepage. [Online] 4.9 (2000): Available URL:

http: / / w w w.pb s.org / w g b h / N OVA / t r a n sc ript s / 2 7 0 4 s t oc k m a r ke t.ht ml

Ross, Sheldon M. (1999). An Introduction to Mathe m atical Finance: Options

and other Topics . Cambridge, MA: Cambridge University Press.

Royal Swedish Academy of Sciences. (1997) “Additional backgrou n d

material on the Bank of Sweden Prize in Economic Sciences in Memory of Alfred

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Nobel 1997.” The Official Website of the Nobel Foundation [Online] 4.9 (2000):

Available URL: http: / / w w w.nobel.se / a n n o u n ce m e n t - 97/ecoback97.ht ml

Rubash, Kevin. (1998) “A Study of Option Pricing Models” Bradley

University. [Online] 4.9 (2000): Available URL: http: / / b r a dley.bradley.edu /%

7Earr / b s m / m o d e l.ht ml

Stix, G. (1998, May). A Calculus of Risk. Scientific American , pp. 90 - 98.

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