Lecture 15

Black-Scholes-Merton Model

Yicheng Zhu

8 Apr 2022

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Outline

1. Introduction

2. Black-Scholes-Merton Formula

3. Understanding the Black-Scholes-Merton Model

4. Other Approaches of Deriving Black-Scholes-Merton Formula

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Revisiting Multi-step Binomial Model

In previous lecture, we studied the two-step binomial tree model:

St+1 = 104.04
p = 60%

St+0.5 = 102
p = 60%

1 − p = 40%
St = 100 St+1 = 100
p = 60%

1 − p = 40%
St+0.5 = 98.04

1 − p = 40%
St+1 = 96.12

I We found that, for each node, the risk-neutral probability of going up is q = 49.5%.

I Then for a call option with strike K = 98 and maturity t + 1, we solve its time t price
by
I Solving its time t + 0.5 prices: 4 and 0.99, respectively.

I Solving its time t price: 2.48.

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Revisiting Multi-step Binomial Model (Cont’d)
St+1 = 104.04
p = 60%

St+0.5 = 102
p = 60%

1 − p = 40%
St = 100 St+1 = 100
p = 60%

1 − p = 40%
St+0.5 = 98.04

1 − p = 40%
St+1 = 96.12

I Consider time-t risk neutral probabilities of the terminal nodes.

I The probabilities are q 2 = 24.5%, 2 × q(1 − q) = 5 and (1 − q)2 = 25.5%.

I The time-t risk-neutral expectation of the payoff for call option is

6.04 × 24.5% + 2 × 50% + 0 × 25.5% = 2.48.

I When we solve for the payoff of the European options, we can consider the
risk-neutral probability of the terminal states directly.
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Outline

1. Introduction

2. Black-Scholes-Merton Formula

3. Understanding the Black-Scholes-Merton Model

4. Other Approaches of Deriving Black-Scholes-Merton Formula

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From Multi-step Binomial Tree to Black-Scholes-Merton Model (Cont’d)

In a Binomial Tree model, the movement of the stock price is a random walk: it moves up
and down proportionally. If we make the ‘steps’ smaller, at the continuous limit, the
random walk becomes a Brownian motion.
The Black-Scholes-Merton Model considers the limit case.

I Stock prices in Binomial Trees Model:

I Geometric random walk.
I Up or down proportionally.

I Stock prices in Black-Scholes-Merton Model:

I Geometric brownian motion.
I Up or down proportionally.

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Brownian Motion - Example

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Brownian Motion - Example

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Brownian Motion - Example

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Brownian Motion - Example

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From Multi-step Binomial Tree to Black-Scholes-Merton Model (Cont’d)

In previous lecture, we showed that the terminal value of the mult-step binomial tree
follows a log-normal distribution if we makes the size of ‘steps’ converge to zero.
I This limit is the case in Black-Scholes-Merton model, and as a result we say that the
terminal return of the stock in the model follows
 
ST 1
ln ∼ Normal(µ(T − t) − σ 2 (T − t), σ 2 (T − t)).
St 2
 h i
I µ: Annualized log expected return, or µ = 1
T −t
log E SSTt .

r h  S i
var log ST
t
I σ: Annualized standard deviation of log return, or σ = T −t
.

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From Multi-step Binomial Tree to Black-Scholes-Merton Model

However, knowing the distribution of terminal payoff does not help with pricing assets.

I We need the distribution of terminal payoff under risk-neutral probability.

I With some very complicated maths (Brownian motion...), it can be proved that the
distribution under risk-neutral probability is also log-normal with same volatility.

I In addition, the expected return of the asset must be risk-free return, or e r (T −t) .

I The distribution of the terminal prices of the asset under risk-neutral probability is
 
ST Q 1
ln ∼ Normal(r (T − t) − σ 2 (T − t), σ 2 (T − t)).
St 2

I This is the risk-neutral distribution of the asset under the famous

Black-Scholes-Merton model, a Nobel-Prize winning model.

I Interestingly, people have been trading options for many years before the model was
invented, and it turns out the model works very well in matching the prices of options.

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Option Prices under Black-Scholes-Merton Model

Now let’s try to solve for the prices of a European call option with strike price K , Ct .

I Risk-neutral pricing suggests that, the following must hold

C t = EQ
t [max(ST − K , 0)] Z (t, T )

= EQ
t [max(ST − K , 0)] e
−r (T −t)
.

Our next job is to solve the expectation. It turns out the solution is not that
complicated.

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Option Prices under Black-Scholes-Merton Model (Cont’d)

I We know that
 
ST q 1 2
ln ∼ Normal(r (T − t) − σ (T − t), σ 2 (T − t)).
St 2
S 
ln T −r (T −t)+ 1 σ 2 (T −t)
St 2
I Define z = − √
σ T −t
.

√
Q 1 2
I Then ∼ Normal(0, 1), ST = St e r (T −t)− 2 σ (T −t)−zσ T −t
.

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Option Prices under Black-Scholes-Merton Model (Cont’d)
Then we have

EQt [max(ST − K , 0)]

Z∞  √  1
1 2 1 2
= max St e r (T −t)− 2 σ (T −t)−zσ T −t − K , 0 √ e − 2 z dz
2π
−∞
St
ln + r − 1 σ 2 (T −t)
( )
K √2
σ T −t
√
Z  1 2
 1 1 2
= St e r (T −t)− 2 σ (T −t)−zσ T −t
−K √ e − 2 z dz
2π
−∞
St St
ln + r − 1 σ 2 (T −t)
( ) ln + r − 1 σ 2 (T −t)
( )
K √2 K √2
σ T −t σ T −t
√
Z Z
1 1 2 1 1 2
=St e r (T −t) √ e − 2 (z+σ T −t) dz − K √ e − 2 z dz
2π 2π
−∞ −∞
St St
ln + r + 1 σ 2 (T −t)
( ) ln + r − 1 σ 2 (T −t)
( )
K √2 K √2
σ T −t
Z σ T −t
Z
1 − 12 z 2 1 1 2
=St e r (T −t) √ e dz − K √ e − 2 z dz
2π 2π
−∞ −∞

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Call Option Prices under Black-Scholes-Merton Model (Cont’d)

As a result

EQ
t [max(ST − K , 0)] e
−r (T −t)

St St
ln + r + 1 σ 2 (T −t)
( ) ln + r − 1 σ 2 (T −t)
( )
K √2 K √2
σ T −t
Z σ T −t
Z
1 1 2 1 1 2
=St √ e − 2 z dz − Ke −r (T −t) √ e − 2 z dz
2π 2π
−∞ −∞

=St N (d1 ) − Ke −r (T −t) N (d2 ),

where
St
+ r + 12 σ 2 (T − t)


ln K
d1 = √
σ T −t
St
+ r − 12 σ 2 (T − t) √


ln K
d2 = √ = d1 − σ T − t.
σ T −t

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Black-Scholes-Merton Formula for Call Option
The result is the famous Black-Scholes-Merton Formula for call option prices.

I The options price is a function of

I St : spot price of the stock.

I K : strike price of the option.

I T − t: maturity.

I r : annualized continuously-compounded risk-free interest rate.

I σ: annualized standard deviation (volatility) of log returns.

Formally, we can write

C (St , K , T − t, r , σ) = St N (d1 ) − Ke −r (T −t) N (d2 ),

where
St
+ r + 12 σ 2 (T − t)


ln K
d1 = √
σ T −t
St
+ r − 12 σ 2 (T − t) √


ln K
d2 = √ = d1 − σ T − t.
σ T −t

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Black-Scholes-Merton Formula for Put Option

The corresponding put option price can be solved using put-call parity:

P(St , K , T − t, r , σ) − C (St , K , T − t, r , σ) = Ke −r (T −t) − St .

As a result,
P(St , K , T − t, r , σ) = Ke −r (T −t) N (−d2 ) − St N (−d1 ).

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Assumptions for Black-Scholes-Merton Model

Now that we have derived the prices of European call and put options under
Black-Scholes-Merton model, we can revisit some assumptions we implicitly used.

I Investors can freely trade the underlying asset.

I Transaction is free: no taxes or fees for transaction,

I No short sale restrictions.

I Etc....

I The return of the asset follows log-normal distribution.

I In fact, the path of the log price, or cumulative log return, is a Brownian motion.
(Beyond the scope of this class).

I With i.i.d assumption of return and other assumptions (very technical) this is always
true.

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Outline

1. Introduction

2. Black-Scholes-Merton Formula

3. Understanding the Black-Scholes-Merton Model

4. Other Approaches of Deriving Black-Scholes-Merton Formula

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Dynamic Replicating Portfolio under Black-Scholes-Merton Model

I In the Binomial Tree Model, we start with replication argument.

I Then we introduced risk-neutral probability, and stated that risk-neutral probability is

equivalent to absence of arbitrage.

I This implies that investor can always find a trading strategy, with dynamically
adjusting portfolio holding and self-financing, to replicate the payoff of the derivative
we want.

I The Black-Scholes-Merton Model, extends the replication argument under binomial

tree to continuous space, and suggests that a replication strategy could still be found.

I In addition, the strategy is self-financed, meaning that the initial cost of the strategy
is the price of the derivative.

I Under continuous-time, proving the existence of the model is already very hard, and
this is the contribution by Black and Scholes (JPE 1973).

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Intuitions behind Dynamic Replication

The Put Price Profile and the Replicating Portfolio

40
Put
Replicating Portfolio
35 Put Option pt

30

25
dollars

20

15
Put Option pt
Portfolio Pt
and Portfolio Pt
10 Increase by the Same
Amount

5 Stock
Declines

0
60 70 80 90 100 110 120 130 140 150 160
Stock S

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Black-Scholes-Merton Formula: Interpretation
The Black-Scholes-Merton formula expresses the option as a portfolio of stocks and
bonds. For a European call option:
I N (d1 ) is the number of shares we hold in the replicating portfolio today (at t), i.e.,
the ∆ of the call.

I In fact, we can show that:

∂Ct
∆c = = N (d1 ) > 0
∂St

I This means that, after 1 sec, no matter how the stock moves, the change in the call
option price will be ∆× change in stock price.

I After that, the ∆ changes (as d1 changes), and the investor needs to adjust the stock
holding to ensure that the replication portfolio follows the price of the call option.

I Ke −r (T −t) N (d2 ) is the initial borrowing in the replicating portfolio.

I The value of the call is again the cost of the replicating portfolio:

C (S, σ, r ; K , T − t) = ∆c × S − B = N (d1 )S − K e −r (T −t) N (d2 )

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Black-Scholes-Merton formula: Example

I Consider an at-the-money option: Current stock price St = 100, strike price K = 100,
interest rate r = 5%, maturity T − t = 1, return volatility σ = 30%
I We then have

St
+ (r + σ 2 /2)(T − t) ln 100 + (.05 + (0.30)2 /2) × 1



ln K 100
d1 = √ = √ = 0.3167
σ T −t 0.30 1
√ √
d2 = d1 − σ T − t = 0.3167 − .3 1 = 0.0167
I Therefore N (d1 ) = 0.62425 and N (d2 ) = 0.50665
I The value of the call option is

Ct = St N (d1 )−Ke −r (T −t) N (d2 ) = 100×0.62425−100×e .05×1 ×0.50665 = 14.2312

I The value of a put option can be computed from these data by recalling that

N (−d1 ) = 1 − N (d1 ) = 0.37575; N (−d2 ) = 1 − N (d2 ) = 0.49335

so that
Pt = Ke −r (T −t) N (−d2 ) − St N (−d1 ) = 9.3542

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Outline

1. Introduction

2. Black-Scholes-Merton Formula

3. Understanding the Black-Scholes-Merton Model

4. Other Approaches of Deriving Black-Scholes-Merton Formula

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Derivation Methods of BSM Formula

I In addition to what we have covered, there are other methods of deriving the BSM
formula.
I Cox-Ross-Rubinstein: Use a binomial tree and make the step size very small as the
number of steps n → +∞
I Black-Scholes: Derive a partial differential equation for the option price based on
dynamic hedging portfolios

I You do not need to know how to reproduce the derivations, but the intuition behind
them will be useful

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Method 1. The Binomial Tree

Suppose there is a one-step binomial tree between t and T .

i =0 i =1

ST ,u = St × (1 + u)
CT ,u = max(ST − K , 0) = ST − K
St
Ct = e −r ×(T −t) EQ [max(ST − K , 0)]
ST ,d = St × (1 + d)
CT ,d = max(ST − K , 0) = 0

I Consider i = 0 and i = 1 with ST ,u = St × (1 + u) and ST ,d = St × (1 + d)

I Assume the strike price of the option has ST ,u > K > ST ,d , so that the payoffs from
the tree above result

I Let q ∗ be the risk neutral probability of going up in the tree

St × e r (T −t) − ST ,d
q=
ST ,u − ST ,d

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Method 1. The Binomial Tree

I The price of the option at time t according to risk-neutral pricing is:

Ct = e −r (T −t) EQ [max(ST − K , 0)]

= e −r (T −t) × q ∗ × (ST ,u − K )
= St × e −r (T −t) × q × (1 + u) − e −r (T −t) × K × q
= St × N1 − e −r (T −t) × K × N2

where we define,

N1 = e −r (T −t) × q ∗ × (1 + u) and N2 = q ∗
I The similarity with the Black-Scholes-Merton formula is not coincidental

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

I Interpretation (other than hedging portfolio holdings):

I N2 (N (d2 )) risk neutral probability to be in the money at T

I N1 (N (d1 )) risk neutral present value of expected gross return conditional on exercise
at T

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Method 1. The Binomial Tree (n periods)
I For a large number of steps n:
Ct = e −r (T −t) EQ [max(ST − K , 0)]
n  
X n!
= e −rT (q ∗ ) (1 − q ∗ ) max(Sn,j − K , 0)
j n−j

j=0
j!(n − j)!

where Sn,j = St × (1 + u)j × (1 + d)n−j : n − j steps down, j steps up

I Let j ∗ be the smallest integer for which Sn,j ≥ K for j ≥ j ∗ , and Sn,j < K for j < j ∗
I Putting all together:
n  
X n!
Ct = e −r (T −t) (q ∗ ) (1 − q ∗ ) (Sn,j − K )
j n−j

j=j ∗
j!(n − j)!

= St × N1 − K × e −r (T −t) × N2
where
n
!
−r (T −t)
X n! ∗
j ∗
n−j (j) n−j
N1 = e q 1−q (1 + u) (1 + d)
j=j ∗
j!(n − j)!
n
!
X n! ∗
j ∗
n−j
N2 = q 1−q
j=j ∗
j!(n − j)!

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Method 1. The binomial tree (n → ∞)

I To match the log-normal model of BSM, we choose (see the previous lecture)
 p 
1 + u = exp σ (T − t)/n
 p 
1 + d = exp −σ (T − t)/n = 1/(1 + u)

I With these choices, it can be shown that, in the limit of n → ∞, we have

N1 → N (d1 ) and N2 → N (d2 )

So we have
C (St , K , T − t, r , σ) = St N (d1 ) − Ke −r (T −t) N (d2 )

I The interpretation of N (d1 ) and N (d2 ) are the same as the simple 1-period model

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Method 2. Black-Scholes PDE (Optional)

I To price an option with a binomial tree, we:

1. Calculate the stock price at every node
2. Calculate the payoff of the call at maturity
3. Working backward through the tree, use the call prices for the (k + 1)th period and the
risk-neutral probabilities to compute the prices for the kth period

I The Black-Scholes-Merton model works the same way:

1. Terminal Condition: Calculate the payoff of the call at maturity.
C (S, T ) = max[0, S − K ]
2. Moving Backwards: Calculate the value of the option at time t as a function of the
value of the option at time t + δ t, for all t.
I That is, determine the relation between C (S, t) and C (S + δS, t + δt) for all t.
I This is where the Black-Scholes partial differential equation comes in.

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Method 2. Black-Scholes PDE (Optional)
I Consider one branch of the tree with large n, so the time between periods,
h = (T − t)/n, is small:

t t +h

St+h,u = S × (1 + u)
S
St+h,d = S × (1 + d)

I The value of the call option at time t is:

C (S, t) = e −rh [q ∗ C ((1 + u)S, t + h) + (1 − q ∗ ) C ((1 + d)S, t + h)]

√ √
e rh −1−d
I Substituting using q ∗ = u−d
, u = eσ h
− 1, d = e −σ h
− 1 yields:
" √ # " √ #
−σ h
e rh − e σ
√
h eσ h
− e rh −σ
√
h rh
√ √ C (e S, t + h) + √ √ C (e S, t + h) − e C (S, t) = 0
eσ h − e −σ h eσ h − e −σ h

I We are not there yet. The goal is to drive h to 0

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Method 2. Black-Scholes PDE (Optional)
I When h is small, we can use the Taylor expansion to approximate C (S + δS, t + δt):

∂C ∂C 1 ∂2C
C (S + δS, t + δt) = C (S, t) + δS + δt + (δS)2 + · · · (1)
∂S ∂t 2 ∂S 2

I Next, express C ((1 + u)S, t + h) and C ((1 + d)S, t + h) according to (1), substitute
these expressions into the equation on the previous slide, simplify and drop all terms
smaller than h:
1 2 2 ∂2C ∂C ∂C
σ hS + rhS +h − rhC = 0
2 ∂S 2 ∂S ∂t
I Finally, dividing by h yields the Black-Scholes PDE:
1 2 2 ∂2C ∂C ∂C
σ S + rS + − rC = 0
2 ∂S 2 ∂S ∂t
with the additional constraints:
C (S, t)
C (S, T ) = max[0, S − K ], C (0, t) = 0 , lim =1
| {z } S→∞ S
0 is an absorbing boundary

I Turns out this is one of the “nice” PDEs that can be solved analytically
√
Note: Why did we keep the (δS)2 term in (1)? Because (δS)2 = (eσ h − 1)2 ≈ σ 2 h
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Conclusion

I What is Black-Scholes-Merton formula?

I How to derive the BSM formula?

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