Derivatives and Financial Markets

TOPIC: Option Pricing—The Black-Scholes-Merton Model

READINGS: Fundamentals of Futures and Options Markets

Chapter 13, Sections 13.1, 13.3 - 13.8
Just understand qualitatively what the statistical distribution of the stock price means
(Section 13.1). You are not expected to memorize or re-derive any of the statistical
expressions in the text. You are expected to learn how to apply them to calculate option
prices.

ASSIGNMENT:
1. Program the Black/Scholes formulas (13.5) and (13.6) in Excel so that you can easily see
how option prices change with the inputs. Let your excel program calculate option prices
in steps, showing the values of N(d1) and N(d2) as an intermediate step. Keep in mind that
N(d) is the cumulative probability function for a standard normal distribution (i.e, normal
distribution with mean of 0 and standard deviation of 1). In excel, N(d) is obtained as
NORMSDIST(d) in older versions or NORM.S.DIST(d, cumulative) in recent versions.
Use the Black/Scholes model to price the following:
a. A European call with strike price $30 and maturity 3 months, when the current stock
price is $25 and the annual standard deviation of the stock’s return () is 40%. Three-
month Libor is 5% with continuous compounding. Make sure your excel model
shows the values of d1, d2, N(d1), and N(d2).
b. A European put on the same stock, with the same parameters as in part (a). Verify
that put-call parity holds.

2. Use the excel formulas you programmed above to check how changes in the parameters
(stock price, exercise price, maturity, stock return volatility, and interest rate) affect put
and call prices.

TEXTBOOK EXERCISES
Chapter 13: 13.1 and 13.4

© Walid Busaba, Ivey Business School, 2021