Introduction

Black-Scholes-Merton Differential Equation

Risk-Neutral Valuation
Applications

Derivatives and Risk Management

Lecture 10: The Black-Scholes-Merton Model

Søren Hesel

Department of Business and Management

Fall 2022

Søren Hesel DRM

 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

Outline

1 Introduction

2 Black-Scholes-Merton Differential Equation

3 Risk-Neutral Valuation

4 Applications

Søren Hesel DRM

 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

From last time

• Stock prices using Itô processes

▶ Geometric Brownian motion
▶ Log of the process is normally distributed
• Using Itô’s lemma to manipulate Itô processes
• Today, we consider the returns of the process
• Black-Scholes differential equation
• Risk-Neutral valuation

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

The Stock Price Assumption

• Consider a stock whose price is S

• In a short period of time of length ∆t, the return on the stock is
normally distributed:

∆S
≈ Φ µ∆t, σ2 ∆t ,


S
where µ is the expected return and σ is the volatility
• The Lognormal Property:

ln(St ) − ln(S0 ) ≈ Φ (µ − σ2 /2)T, σ2 T

• Since the logarithm of ST is normal, ST is log-normally distributed

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

The Lognormal Distribution and continuous

compounded return

E (ST ) = S0 exp(µT)
Var (ST ) = S02 exp(2µT) exp(σ2 T) − 1

The Expected Return:
• The expected value of the
stock price is S0 exp(µT)
• If x is the realized • The expected return on the
continuously compounded stock is µ − σ2 /2 and not µ,
return because
 
1 ST ln (E(ST /S0 )) ̸= E (ln(ST /S0 ))
ST = S0 exp(xT) ⇔ x = ln
T S0
2 2


⇒ x ≈ Φ µ − σ /2, σ

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

µ − σ2 /2 and µ

µ expected return in ∆t ≈ 0, expressed with a

compounding frequency of ∆t
µ − σ2 /2 the expected return in a long period of time expressed
with continuous compounding (or, to a good
approximation, with a compounding frequency of ∆t)
• Example: Suppose that returns in successive years are 15%,
20%, 30%, −20% and 25% (ann. comp.)
▶ The arithmetic mean of the returns is 14% is analogous to µ
▶ The returned that would actually be earned over the five years (the
geometric mean) is 12.4% (ann. comp.) (analogous to µ − σ2 /2)
Q
▶ Geometric average: ( ni (1 + ri ))1/n − 1

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

The Volatility

• Standard deviation of the continuously compounded rate of

return in 1 year
• The standard deviation √ of the return in a short time period time
∆t is approximately σ ∆t
• Estimating Volatility from Historical Data:
1 Take observations S0 , S1 , . . . , Sn at intervals of t years (e.g. for
weekly data τ = 1/52)
2 Calculate
 the  continuously compounded return in each interval as:
ui = ln SS−i
i−1
3 Calculate the standard deviation, s, of the √ui ’s
4 The historical volatility estimate is σ̂ = s τ

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

Nature of Volatility

• Volatility is usually much greater when the market is open (i.e.

the asset is trading) than when it is closed
• For this reason time is usually measured in “trading days” not
calendar days when options are valued
• It is assumed that there are 252 trading days in one year for most
assets
• Example: Suppose it is April 1 and an option lasts to April 30 so
that the number of days remaining is 30 calendar days or 22
trading days
• The time to maturity would be assumed to be 22/252 = 0.0873
years

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

The Concepts Underlying Black-Scholes-Merton

• The option price and the stock price depend on the same
underlying source of uncertainty
• We can form a portfolio consisting of the stock and the option
which eliminates this source of uncertainty
• The portfolio is instantaneously riskless and must
instantaneously earn the risk-free rate
• This leads to the Black-Scholes-Merton differential equation

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

The Derivation of the Black-Scholes-Merton

Differential Equation I
From stochastic calculus

dS = µSdt + σSdzt
1 ∂2 f 2 2
 
∂f ∂f ∂f
df = µS + + 2
σ S dt + σdzt
∂S ∂t 2 ∂S ∂S

• ∂f
We set the portfolio consist of -1 derivatives and + ∂S shares.
• Thus, we get rid of the dependence of dz.
• ∂f
The value of the portfolio, Π, is given by Π = −f + ∂S S
• The change in its value in time dt is given by
∂f
dΠ = −df + dS
∂S
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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

The Derivation of the Black-Scholes-Merton

Differential Equation II

• The return over a short period, ∆t, on the portfolio must be the
risk-free rate. Hence

∆Π = rΠ∆t
 
∂f ∂f
−∆f + ∆S = r −f + S ∆t
∂S ∂S
• We substitute ∆f and ∆S in this equation to get the
Black-Scholes differential equation:

∂f ∂f 1 ∂2 f
− + rS + σ2 S2 2 = rf
∂t ∂S 2 ∂S

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

The Differential Equation

• Any security whose price is dependent on the stock price
satisfies the differential equation
• The particular security being valued is determined by the
boundary conditions of the differential equation
• In a forward contract the boundary condition is f = S − K when
t=T
• The solution to the equation is

f = S − K exp(−r(T − t))

• For a perpetual derivative there is no dependence on time and

the differential equation becomes

∂f 1 ∂2 f
rS + σ2 S2 2 = rf
∂S 2 ∂S

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

The Black-Scholes-Merton Formulas for Options

c = S0 N(d1 ) − Ke−rT N(d2 )

p = Ke−rT N(−d2 ) − S0 N(−d1 )

where
ln(S0 /K) + (r + σ2 /2)T
d1 = √
σ T
ln(S0 /K) + (r − σ2 /2)T √
d2 = √ = d1 − σ T
σ T
and
• N(x) is the probability that a standard normally distributed
variable is less than x

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

Properties of Black-Scholes Formula

• As S0 becomes very large c tends to S0 − K exp(−rT) and p tends

to zero
• As S0 becomes very small c tends to zero and p tends to
K exp(−rT) − S0
• What happens as σ becomes very large?
• What happens as T becomes very large?

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

Understanding Black-Scholes

 
N(d1 )
c = e−rT N(d2 ) S0 erT −K
N(d2 )

e−rT Discount rate

N(d2 ) Probability of exercise
N(d1 )
erT N(d 2)
Expected percentage increase in stock price if option is
exercised
K Strike price paid if option is exercised

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

Risk-Neutral Valuation

• The variable µ does not appear in the Black-Scholes-Merton

differential equation
• The equation is independent of all variables affected by risk
preference
• The solution to the differential equation is therefore the same in a
risk-free world as it is in the real world
• This leads to the principle of risk-neutral valuation
Applying Risk-Neutral Valuation:
1 Assume that the expected return from the stock price is the
risk-free rate
2 Calculate the expected payoff from the option
3 Discount at the risk-free rate

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

Valuing a Forward Contract with Risk-Neutral Valuation

• Payoff is ST − K
• Expected payoff in a risk-neutral world is S0 exp(rT) − K
• Present value of expected payoff is

exp(−rT) (S0 exp(rT) − K) = S0 − K exp(−rT)

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

Proving Black-Scholes-Merton Using Risk-Neutral

Valuation I

Black-Scholes value can also be written:

Z∞
c = exp(−rT) max(ST − K, 0)g(ST )dST ,
K

g(ST ) probability density function for the lognormal

distribution of ST in a risk-neutral world
ln(ST ) ∼ Φ(m, s2 )

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

Proving Black-Scholes-Merton Using Risk-Neutral

Valuation II

√
m = ln(S0 ) + (r − σ2 /2)T, s=σ T
We substitute
ln(ST ) − m
Q=
s
such that
Z∞
c = exp(−rT) max(exp(Qs + m) − K, 0)h(Q)dQ,
(ln(K)−m)/s

where h is the probability density function for a standard normal.

Evaluating the integral leads to the BSM result.

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

Implied Volatility
• The implied volatility of an option is the volatility for which the
Black-Scholes-Merton price equals the market price
• There is a one-to-one correspondence between prices and
implied volatilities
• Traders and brokers often quote implied volatilities rather than
dollar prices
• The VIX S&P500 Volatility Index:

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

Dividends

• European options on dividend-paying stocks are valued by

substituting the stock price less the present value of dividends
into Black-Scholes
• Only dividends with ex-dividend dates during life of option should
be included
• The “dividend” should be the expected reduction in the stock
price expected

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

Exercising American Calls

• An American call on a non-dividend-paying stock should never

be exercised early
• An American call on a dividend-paying stock should only ever be
exercised immediately prior to an ex-dividend date
• Suppose dividend dates are at times t1 , t2 , . . . , t,n .
Early exercise is sometimes optimal at time ti if the dividend at
that time is greater than

K (1 − exp(−r(ti+1 − ti )))

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

Pricing american calls

Black’s Approximation with Dividends in American Call Options:

• Set the American price equal to the maximum of two European
prices:
1 The 1st European price is for an option maturing at the same
time as the American option
2 The 2nd European price is for an option maturing just before the
final ex-dividend date

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

Valuing European Index Options

BS formula with dividend yields

• Set S0 = current index level

• Set F0 = futures or forward index price for a contract maturing at
the same time as the option
• Set q = av. dividend yield expected during the life of the option

⇒ c = e−rT (F0 N(d1 ) − KN(d2 ))

where

F0 = S0 e(r−q)T
ln(F0 /K) + σ2 T/2 √
d1 = √ , d2 = d1 − σ T
σ T

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

Implied Forward Prices and Dividend Yields

• From European calls and puts with the same strike price and
time to maturity

c − p + Ke−rT
 
rT 1
F0 = K + (c − p)e , q = ln
T S0
• These formulas allow term structures of forward prices and
dividend yields to be estimated
• OTC European options are typically valued using the forward
prices (Estimates of q are not then required)
• American options require the dividend yield term structure

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

The Binomial Model

• In a risk-neutral world the asset price grows at r − q rather than

at r when there is a dividend yield at rate q
• The probability, p, of an up movement must therefore satisfy

e(r−q)T − d
pS0 u + (1 − p)S0 d = S0 e(r−q)T , where p =
u−d

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

Currency Options

• Currency options trade on NASDAQ OMX

• There also exists a very active over-the-counter (OTC) market
• Currency options are used by corporations to buy insurance
when they have an FX exposure

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 Introduction
Black-Scholes-Merton Differential Equation
Risk-Neutral Valuation
Applications

Valuing European Currency Options

• A foreign currency is an asset that provides a yield equal to rf

• We can use the formula for an option on a stock paying a
dividend yield
S0 current exchange rate
q foreign currency interest rate, rf
Formulas for European Currency Options

c = S0 e−rf T N(d1 ) − Ke−rT N(d2 )

where
ln(S0 /K) + (r − rf + σ2 /2)T ln(S0 /K) + (r − rf − σ2 /2)T
d1 = √ , d2 = √
σ T σ T

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