7.

2 VALUATION OF CONTINGENT
CLAIMS
7.2.a.b.e.(i) BINOMIAL MODEL: VALUATION OF CALLS

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7.2.a.b.e.(ii) BINOMIAL MODEL: VALUATION OF PUTS

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7.2.c ARBITRAGE INVOLVING OPTIONS

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7.2.d BINOMIAL MODEL: VALUING INTEREST RATE OPTIONS

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7.2.f ASSUMPTIONS OF THE BLACK-SCHOLES-MERTON (BSM) MODEL

The BSM model is used to find the fair value for option contracts. This valuation is based on the
following assumptions:

1. The price of the underlying asset follows a geometric Brownian motion. In other words, the
price of the underlying asset is log-normally distributed, with zero as its minimum value and
positive infinity as its maximum value. With that being the case, the natural logarithm of the
underlying asset’s return is normally distributed. To illustrate, suppose that the price of the
underlying asset appreciates from $100 to $108. While the discrete return is 8%, the
continuously compounded rate of return is found as follows: LN(1.08) = 7.696%.
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So while the price may be log-normally distributed (i.e. its values ranging from 0 to positive
infinity), its continuously compounded rate of return is normally distributed (i.e. its values
ranging from negative infinity to positive infinity).

2. The risk free rate is known and is constant throughout the term of the option. As well, funds
may be borrowed or lend at this risk free rate.

3. The variance of the underlying asset’s price is known and is constant throughout the term of
the option.

4. There are no taxes or transaction costs, nor are there any restrictions on short selling.

5. The underlying asset is liquid (therefore a trade would not be able to impact its price).

6. There are no arbitrage opportunities be available.

7. If the underlying asset does generate a yield (income), it would be known in advance and
would remain constant throughout the term of the option.

8. Trading is continuous (i.e. the underlying asset is tradeable at any point in time). As well, the
underlying price moves in a continuous fashion. For example, upon the release of good news, the
stock price would move up one penny at time (rather than jump instantly) to its new intrinsic
value.

9. The option is European (i.e. it may only be exercised upon expiry). Consequently, the BSM
model may not be used to price American options (which are exercisable at any time before the
expiry date). American options are instead valued using binomial models, which provide the
framework to determine if the option would be exercised at each node during the term of the
option.

Since these assumptions must hold in order for the values generated by the BSM model to
become accurate, these assumptions may also be viewed as the model’s limitations.

7.2.g.h(i) BLACK SCHOLES MERTON (BSM) OPTION VALUATION MODEL

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7.2.g.h(ii) APPLICATIONS OF THE BLACK SCHOLES MERTON (BSM) MODEL

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7.2.i BLACK MODEL: VALUATION OF OPTION ON FUTURES

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7.2.j(i) BLACK MODEL: VALUING INTEREST RATE OPTIONS

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7.2.j(ii) BLACK MODEL: VALUATION OF SWAPTIONS

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7.2.k(i).l OPTION GREEK: CALL DELTA

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7.2.k(ii).l OPTION GREEK: PUT DELTA

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7.2.k(iii).m OPTION GREEK: GAMMA

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7.2.k(iv) OPTION GREEK: THETA

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7.2.k(v) OPTION GREEK: VEGA

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7.2.k(vi) OPTION GREEK: RHO

7.2.k(vii) OPTION GREEKS: SUMMARY

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7.2.n IMPLIED VOLATILITY

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