Black Scholes Formula & The Greeks

Lorenzo Bretscher
Towards the Black-Scholes Formula

Cox, Ross and Rubinstein (1979), building on the fundamental idea of Sharpe
I suppose time to maturity is τ
I split up τ into n intervals of length ∆t = τ /n
I calculate option price in n -period binomial model
I let n → ∞, i.e., ∆t → 0
I keep the mean and standard deviation of the underlying asset return per unit
of time constant
I due to the Central Limit Theorem, binomial distributions of asset returns
converge to normal distributions

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The Black-Scholes Formula

Due to Black and Scholes (1973), Merton (1973)

r : continuously compounded rate of interest
σ : volatility of underlying asset
Φ : standard Normal distribution function The Black-Scholes Formula:

Ct = St Φ (d1 ) − e −r (T −t) K Φ (d2 )

with
S
+ r + σ 2 /2 (T − t)


log K
d1 = √
σ T −t
√
d2 = d1 − σ T − t

where Φ(d) = P(N(0, 1) ≤ d) is the cumulative standard normal distribution

function.

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The Black-Scholes Formula

Note that e −r (T −t) K = PV (K )

I At t, the call can be replicated by buying Φ (d1 ) shares, and shorting Φ (d2 )
bonds with face value K
I Equivalently, at t, the call can be hedged by selling Φ (d1 ) shares. This is the
option’s delta (equal to ∂C
∂S
)

Φ (d2 ) is the risk-neutral probability that the call expires in the money

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Advantages of Black-Scholes / Binomial Model

Advantages of Black-Scholes formula

I Simple closed form
I Can compute "the Greeks" in closed form: sensitivities of price C (S, τ ) to
changes of price in underlying asset (S), changes in time-to-expiry (τ ),
changes in volatility (σ), . . .
I Maps prices into volatilities, which may be easier to understand
Advantages of binomial model
I Flexible
I Can price American options, path-dependent options, options on
dividend-paying assets, ...

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Disadvantages of Black-Scholes / Binomial Model

You have to keep modifying your replicating portfolio as time evolves and you
move through the tree
Have to make an a priori assumption about what the tree looks like
This assumption can break down when you least want it to
Whereas, with static replication, you trade once and you’re done

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The Black-Scholes formula - Example #1

Consider a call with K = 110 and T − t = 1 year remaining till maturity, and
suppose that S = 100, σ = 20% per year, and rA = 6.18% (annual interest
rate, annually compounded)
The continuously compounded rate r corresponding to rA is log(1 + rA ) = 6%
To find C we follow these steps:
Step 1 Calculate d1 and d2 :
S
+ r + σ 2 /2 (T − t)


log K
d1 = √
σ T −t
100
log 110 + 0.06 + (0.2)2 /2
= = −0.0766
√ 0.2
d2 = d1 − σ T − t
= −0.0766 − 0.2 = −0.2766

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The Black-Scholes formula - Example #1 (Cont’d)

Step 2 Find Φ (d1 ) and Φ (d2 ). We can either use a normal distribution table or
the Excel function NORMSDIST

NORMSDIST(−0.0766) = 0.469

NORMSDIST(−0.2766) = 0.391

Step 3 Plug into the Black-Scholes formula

C = SΦ (d1 ) − e −r (T −t) K Φ (d2 )

= (100 × 0.469) − 110e −.06 × 0.391

= 6.39

Note how cheap the call is relative to the underlying stock. This is due to the
implicit leverage in the call
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The Black-Scholes formula - Extensions

Dividend-Paying Stock
Lumpy dividend payments: say PV(D) is the present value of all dividends between
t and T  √ 
C = [S − PV(D)] Φ (d1∗ ) − e −r (T −t) K Φ d1∗ − σ T − t
where
log ([S − PV(D)] /K ) + r + σ 2 /2 (T − t)


d1∗ = √
σ T −t
Continuous dividend payments: δ is the annualized continuous “dividend yield”
 √ 
C = e −δ(T −t) SΦ (d1∗ ) − e −r (T −t) K Φ d1∗ − σ T − t

where  
log e −δ(T −t) S/K + r + σ 2 /2 (T − t)


∗
d1 = √
σ T −t
Apply these formulae to stocks, indices, currencies, commodities ...
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The Black-Scholes formula - Extensions

Currency Options
The underlying is a foreign currency with S as the exchange rate (the price of
the foreign currency in terms of the domestic currency), and the “dividend
yield” is the foreign interest rate, rf :
 √ 
C = e −rf (T −t) SΦ (d1∗ ) − e −r (T −t) K Φ d1∗ − σ T − t

where
log (S/K ) + r − rf + σ 2 /2 (T − t)


d1∗ = √
σ T −t
Example: S = 0.61, K = 0.60, r = 5%, rf = 7%, σ = 12%, T − t = 0.25:
log (0.61/0.60) + 0.05 − 0.07 + 0.122 /2 × 0.25


d1∗ = √ = 0.0222
0.12 0.25
 √ 
C = 0.61e −0.07×0.25 Φ (0.0222) − 0.60e −0.05×0.25 Φ 0.0222 − 0.12 × 0.25
= 0.01796

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The “Greeks”

The partial derivatives of a financial derivative’s price with respect to its

arguments or parameters are called the “Greeks”

The Greeks
I measure the sensitivity of the price to these arguments or parameters
I are a useful guideline for hedging a position in the derivative

In what follows we will denote the derivative price by V

Unless otherwise said, the graphs are obtained with a strike assumed to be
K = 100, r = 0 = δ.

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The “Greeks”

Delta
The delta of a derivative tells us how much the value of the derivative will
change with a small change in the price of the underlying stock, other things
being equal:
∂V
∆=
∂S
∆ is also a hedge-ratio. In the B-S world
∆ (S, t) = Φ (d1 (S, t))
∆ can be identified directly from the B-S formula: to hedge one call, sell
Φ(d1 (S, t)) units of the underlying stock
Selling ∆ shares for every call gives us a position delta of 0. This is a
delta-neutral position
By put-call parity:
∆call = ∆put + 1
0 ≤ ∆call ≤ 1, −1 ≤ ∆put ≤ 0
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The “Greeks”

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Gamma
The gamma of a derivative measures by how much the delta will change for a
small change in the stock price, other things being equal:
∂∆
Γ=
∂S
∂2V
=
∂S 2
So if a call option has a gamma of .12, that means that if the underlying
stock moves by $1, the trader replicating the call needs to adjust his hedge
by buying or selling 12 shares for every option contract (assuming 100 shares
per option contract)
In the B-S world
1
Γ (S, t) = √ φ (d1 (S, t))
Sσ T − t
where φ is the standard normal density, φ(x) = Φ0 (x)
Γcall = Γput by put-call parity
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The “Greeks”

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The “Greeks”

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The “Greeks”

Gamma and Delta-Hedging

As the underlying stock price moves, the delta of a position changes. In order
to remain delta-neutral (or to keep delta below a target delta), it is necessary
to revise the position over time
Gamma is positive.
I When the stock goes up, ∆ goes up and hedging a long position in a call
requires an additional sale of stock.
I When the stock goes down, delta-hedging prescribes an additional purchase of
the stock
Since in practice it is not feasible to be continuously delta-hedged, a
reinforcing strategy is to select positions that, in addition to being close to
delta-neutral, have deltas that are relatively insensitive to movements in the
stock price, i.e. low gammas
A gamma-neutral position has a gamma of zero. To achieve gamma
neutrality, it necessary to use some other asset, as the
gamma of the stock itself is zero
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The “Greeks”

Vega
Vega, or V is the partial derivative of the option price with respect to the
volatility parameter, σ
In B-S, we have √
V = Sφ (d1 (S, t)) T −t
for both calls and puts, by put-call parity
Thus, V > 0. Hence, all else equal, there is a monotonic relationship between
σ and the B-S call price. In fact, option prices are typically quoted in terms
of “vol” rather than the cash price
For vanilla calls and puts, vega is a lot like gamma. Both are positive, highest
ATM, and very small for deep ITM or OTM options
I It is highest for ATM options as a small move in the underlying might decide
whether or not it is optimal to exercise the option.

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The “Greeks”

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The “Greeks”

Theta
Even if the stock price remains unchanged, as the maturity date approaches, the
mere passing of time creates profits or losses on option positions
We define an option’s theta as
∂V ∂V
Θ= =−
∂t ∂(T − t)
For calls in the B-S world, we have
Sσ
Θ = −re −r (T −t) K Φ (d2 ) − √ φ (d1 ) < 0
2 T −t
discount effect: The shorter the time to maturity, the less K is discounted. Hence,
more has to be paid to get the stock, and the call is worth less
volatility effect: The shorter the time to maturity, the lower is the variance of ST
given St , and hence the lower is the upside potential. This implies a lower value of
the call
For calls, theta is negative and highest (in absolute value) ATM. For puts, theta is
typically negative but can occasionally be positive
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The “Greeks”

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The “Greeks”

Rho
Rho measures the sensitivity of the B-S option price to a small change in the
interest rate, assumed to stay constant and known until the option’s maturity
The rho for a call and put in the B-S world are

ρcall = K (T − t) e −r (T −t) Φ ( d2 (S, t))

ρput = −K (T − t) e −r (T −t) Φ (−d2 (S, t))

For a call, rho is positive; for a put, it is negative

Everything else equal, a higher interest rate means that the cost K of
obtaining the stock at maturity is lower in present value terms, making the
call more valuable
The opposite is true for a put: the present value of the receipt K is lower
with a higher interest rate, meaning that the put effectively sells the
underlying for less
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The “Greeks”

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The “Greeks” - Summary

Signs of the “Greeks” for Plain Vanilla Options

Greeks Call Put

∂V
∆= ∂S
Positive Negative

∂2V
Γ= ∂S 2
Positive Positive

∂V
V= ∂σ
Positive Positive

∂V
Θ= ∂t
Negative +/−

∂V
ρ= ∂r
Positive Negative

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Conclusion

When the number of periods goes to infinity, the binomial model converges to the
famous Black-Scholes formula
In a Black-Scholes world, call prices depend on five quantities
I The current stock price
I The strike price
I The time to maturity
I The continuously-compounded riskless rate
I The stock’s volatility
The Black-Scholes model can easily be extended to deal with the underlying
stock paying dividends
The Black-Scholes model can also be used to price derivatives other than
calls and puts on stocks
The Greeks provide useful intuition about the underlying economics of option
pricing. They also allow derivatives traders to carefully immunize their
portfolio against changes in the key inputs to Black-Scholes
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