Day 11 Financial Options

Example Volatility Discrete dividends Continuous dividend yield Summing up
Financial Options
António Barbosa
(antonio.barbosa@iscte-iul.pt)
Day 11: 11/Oct/23
António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 1 / 35

Outline
1 Example
2 Volatility
3 Discrete dividends
4 Continuous dividend yield
5 Summing up

Outline
1 Example
2 Volatility
5 Summing up

Example (1/7)
Let’s revisit Example 1 of Day 07
Example 1: pricing a put option with Black-Scholes model

Consider the following European put option: maturity in 3 months,
strike of 5€, underlying asset is Cimpor shares (no dividends paid in
the next 3 months), contract size is 100. Cimpor’s spot price is 4.6€
and its volatility is 25%. The 3-month risk-free rate is 1%.
1. Price this put using the Black-Scholes formula

2. Describe the replicating strategy for this option today
When we used the binomial model, the answer to these questions

were:
p0 = 0.502€ × 100 = 50.02€
∆ = −0.709 × 100 = −70.9 and B0 = 3.763€ × 100 = 376.3€
Example (2/7)
The model parameters are
T = 0.25, K = 5, S0 = 4.6, σ = 0.25, r = 0.01
We start by computing d2 and d1

2
2

ln SK0 + r − σ2 T ln 4.6
5 + 0.01 − 0.25
2 × 0.25
d2 = √ = √ = −0.7096
σ T 0.25 0.25
√ √
d1 = d2 + σ T = −0.7096 + 0.25 0.25 = −0.5846

Example (3/7)
Next, we look on the tables for the values closest to N (−d1 ) and
N (−d2 ) and interpolate them
N (0.59) − N (0.58)
N (−d1 ) = N (0.5846) = N (0.58) + (0.5846 − 0.58)
0.59 − 0.58
0.7224 − 0.719
= 0.719 + (0.5846 − 0.58) = 0.7206
0.59 − 0.58
N (0.71) − N (0.7)
N (−d2 ) = N (0.7096) = N (0.7) + (0.7096 − 0.7)
0.71 − 0.7
0.7611 − 0.758
= 0.758 + (0.7096 − 0.7) = 0.7610
0.71 − 0.7

Example (4/7)

Example (5/7)
Finally, we plug everything into the Black-Scholes formula
p0 = −S0 N (−d1 ) + Ke−rT N (−d2 )
= −4.6 × 0.7206 + 5e−0.01×0.25 × 0.7610
= 0.4807
The price of the put is then
0.4807€ × 100 = 48.07€
The replicating portfolio is
∆ = −N (−d1 ) × 100 = −0.7206 × 100 = −72.06
B0 = Ke−rT N (−d2 ) × 100 = 5e−0.01×0.25 × 0.7610 × 100 = 379.55€
By the way, the risk-neutral probability of exercising this option at
expiration is
N (−d2 ) = 0.7610 = 76.1%
Example (6/7)
Now, suppose the stock price 0.125 years from today is 5.025€
this corresponds to the price after one up move when we used the
binomial model on Day 07
If you compute the price of the put in this scenario using the
Black-Scholes formula using these parameters
T = 0.25 − 0.125 = 0.125, K = 5, S0 = 5.025, σ = 0.25, r = 0.01
you obtain
p0.125 = 0.1614€ × 100 = 16.14€
But the value of the replicating portfolio is
∆ × 5.025€ + B0 e0.01×0.125
= −72.06 × 5.025€ + 379.55€ × e0.01×0.125
= 17.92€

Example (7/7)
Shouldn’t these values coincide?

yes and no
supposedly yes, because this was supposed to be the replicating
portfolio
but in fact no, because a lot of time has elapsed and the stock
price has changed substantially, which means this is no longer the
replicating portfolio
The Black-Scholes model assumes that the replicating portfolio is
continuously adjusted, that is, after a very short time interval
and after a very small change in the price of the underlying asset
in practice, even daily adjustments on the replicating portfolio
might not be frequent enough
To work around this problem, we will have to hedge not only the
delta (as we are doing here), but other greeks, a topic that will be
covered in the coming weeks
Outline
1 Example
2 Volatility
5 Summing up

Volatility estimation (1/3)
All parameters needed to use the Black-Scholes formula are

readily observable, except for the annualized volatility of the
underlying asset’s rate of return σ
K and the expiration date, from which you compute T , are
written on the option contract
S0 can be observed in the market
r can also be observed in the market, being the risk-free rate of
return with a maturity T (or close to it)
To use the Black-Scholes formula we will need to estimate σ


Recall that assuming a GBM as the stock price process (and working
with real-world probabilities) we have
√

2
µ− σ2 t+σ t
St = S0 e
and so the underlying asset’s log return is
σ2 √ σ2

St 2
ln = µ− t + σ t ∼ N µ− t, σ t
S0 2 2
Therefore, σ 2 t is the variance of log returns that are computed over
time intervals of t years
The most basic way to estimate σ is to use a sample of n historical log
returns over a time interval ∆t (for example, one day), and compute its
sample variance
n 2
1 X2 S0−(i−1)∆t
Sample variance ≡ σ̂ ∆t = ln − µ̂
n − 1 i=1 S0−i∆t
n
1X S0−(i−1)∆t
µ̂ = ln
n i=1 S0−i∆t
Our estimate for σ is then

v
u 1 Pn ln S0−(i−1)∆t − µ̂ 2
u h i
r
Sample variance t n−1 i=1 S0−i∆t
σ̂ = =
∆t ∆t
For example, if we use daily returns then ∆t = 250

1
(assuming 250
trading days per year) and the volatility estimate is given by
σ̂ = Sample variance × 250

p
This is a backward looking estimate, because it uses historical

data to estimate σ
In the Risk Management course we will see more sophisticated
ways of estimating volatility (e.g. EWMA, GARCH)
Implied volatility (1/6)
Alternatively, we can estimate σ by using market prices on

European options and “inverting” the Black-Scholes formula
unfortunately the Black-Scholes formula cannot be literally
inverted to obtain an algebraic expression for σ as a function of
the other parameters plus the option price
but we can use numerical methods (for example Excel’s solver) to
solve for σ
Doing so we obtain the implied volatility, the volatility that is
implied by the current option price observed on the market and
by the Black-Scholes model
the implied volatility we obtain assumes that the price we use is a
fair price (not the case if the option has low liquidity, that is,
trades infrequently)
and that the Black-Scholes model is correct (which it is not)

This implied volatility can then be used as an input in the

Black-Scholes formula to price other options:
with the same underlying asset (obvious)
with the same, or approximate expiration date (kind of obvious)
with an approximate strike price (not obvious at all)
The expiration dates must be close because option prices depend
on the volatility only during the life of the option
i.e. we should use a different σ to price options with different T
if we use 3-month options to obtain the implied volatility, this is
the volatility expected by the market for the next 3 months
(remember, this is a forward looking estimate)
but to price a 1-year option we need an estimate of the volatility
over the next year, not just over the next 3 months

However, the strikes shouldn’t matter: we use the same σ to price

all options with the same underlying asset and T , regardless of
the strike
But indeed it matters because the Black-Scholes model is not
correct:
in particular, log returns usually have a distribution with fatter
tails than the normal distribution that is assumed by the
Black-Scholes model (in other words, the log returns are not
normally distributed)
this means that extreme returns are more likely to be observed
than what a normal distribution assumes
as a result, implied volatilities are usually larger for high and low
strikes (volatility smile)

For this reason, we should price options with implied volatilities

obtained from options with approximate strikes (in addition to
maturity)
This is known as:
“Using the wrong number on the wrong formula to get the

right price.”

To understand how the underestimation of the likelihood of

extreme returns generate the volatility smile, consider a deep
OTM call option:
the value of this option depends exclusively on the likelihood of an
extreme positive return occurring during the next T years
since the real distribution has fatter tails that the normal
distribution assumed by the Black-Scholes model, for the same
volatility on both distributions (real vs assumed by the model) the
Black-Scholes underestimates the probability of such an extreme
return occurring and so underestimates the option price
but we are asking the Black-Scholes model to tell us what is the
volatility that is needed to justify the market price (which
obviously depends on the real distribution); the answer will be an
overestimated volatility

In the case of a (near) ATM call option, the value of the option
no longer depends exclusively on the occurrence of an extreme
positive return and so the implied volatility is less overestimated
or even underestimated
The implied volatility from calls and puts is the same:
therefore the implied volatility of a deep ITM put (which
corresponds to the implied volatility of a deep OTM call) is
overestimated
similarly, the implied volatility of a deep ITM call (which
corresponds to the implied volatility of a deep OTM put) is also
overestimated
And this is how we end up with a volatility smile

Volatility smile

Volatility skew
You’ll get a volatility skew if on top of fat tails, the real distribution is
not symmetric as assumed in the Black-Scholes model
Outline
1 Example
2 Volatility
5 Summing up

Adjustment to the Black-Scholes formula
With a small adjustment, we can use the Black-Scholes formula

to price European options on an underlying asset that pays
discrete dividends during the life of the option
The adjustment is the same we used in the binomial model
assume that the price S0 has two components
one is deterministic, corresponding to the known dividends to be
paid during the life of the option, P V (D)
the remainder is stochastic (S0∗ )
that is,
S0 = S0∗ + P V (D)
The adjustment consists in using just the stochastic part of the
price (S0∗ ) in the Black-Scholes formula instead of the full price
(S0 )

Example (1/3)
Let’s revisit Example 1 and introduce some dividends
Example 2: pricing a put option with Black-Scholes model

Consider the following European put option: maturity in 3 months,
strike of 5€, underlying asset is Cimpor shares, contract size is 100.
Cimpor’s spot price is 4.6€, its volatility is 25%, and it will pay a
dividend of 0.2 in 2 months. The 3-month risk-free rate is 1%.
Price this put using the Black-Scholes formula.

Example (2/3)
The present value of all dividends to be paid during the life of the
option is
2
P V (D) = 0.2e−0.01× 12 = 0.1997
and so
S0∗ = S0 − P V (D) = 4.6 − 0.1997 = 4.4003
The model parameters are
T = 0.25, K = 5, S0∗ = 4.4003, σ = 0.25, r = 0.01
We start by computing d2 and d1

∗

S0 σ2 4.4003 2
+ 0.01 − 0.25

ln K
+ r− 2
T ln 5 2
× 0.25
d2 = √ = √ = −1.0646
σ T 0.25 0.25
√ √
d1 = d2 + σ T = −1.0646 + 0.25 0.25 = −0.9396

Example (3/3)
Next, we look up on the tables the values closest to N (−d1 ) and
N (−d2 ) and interpolate them
The end result is
N (−d1 ) = N (0.9396) = 0.8263
N (−d2 ) = N (1.0646) = 0.8565
Plugging everything into the Black-Scholes formula,
p0 = −S0∗ N (−d1 ) + Ke−rT N (−d2 )
= −4.4003 × 0.8263 + 5e−0.01×0.25 × 0.8565
= 0.6358
The price of the put is then
0.6358€ × 100 = 63.58€
Without dividends it was 48.07€ (dividends increase the value of a put
option)
Outline
1 Example
2 Volatility
5 Summing up

Merton’s Model (1/5)
The adjustment to the Black-Scholes model to accommodate an

underlying asset paying a continuous dividend yield q has a
name: Merton’s model
As we know, a dividend payment pushes the price of the
underlying asset down
Therefore, a dividend yield q decreases the drift of the price by q
if the drift is µ in the absence of the dividend yield
it is µ − q if it has a dividend yield q

Therefore, the stock price process is now
dSt = (µ − q) St dt + σSt dZt
in the real world, and
dSt = (r − q) St dt + σSt dZt
in the risk-neutral world

From this Geometric Brownian Motion we obtain the distribution
for St as being
√
2
σ2

r−q− σ2 t+σ t 2
St = S0 e ∼ LN ln S0 + r − q − t, σ t
2


As before, the price of the call option is determined as
c0 = e−rT EQ [ (ST − K) IST >K | F0 ]
You can see that we have r − q instead of r everywhere except when we
are discounting the expected payoff of the call (we still discount it at
the risk-free interest rate r)
Therefore,
c0 = e−rT EQ [ (ST − K) IST >K | F0 ]
h i
= e−rT S0 e(r−q)T N (d1 ) − KN (d2 )
= S0 e−qT N (d1 ) − Ke−rT N (d2 )
where
2
−qT

S0 σ2
+ r −q − σ2 T ln S0 eK

ln K
+ r− 2
T
d2 = √ = √
σ T σ T
√
d1 = d2 + σ T
As you can see, the Merton’s formula is just the Black-Scholes

formula with S0 e−qT instead of S0
obviously, when q = 0 we are back to the Black-Scholes model
It is easy to see why this is so:
if with the dividend yield the price grows from S0 to ST
without the dividend yield the price would grow faster, from S0 to
ST eqT or, it could start from S0 e−qT and it would still be able to
grow to ST

Similarly, the formula for the price of a put is
p0 = e−rT EQ [ max (K − ST , 0)| F0 ]

= −S0 e−qT N (−d1 ) + Ke−rT N (−d2 )
This formula can be obtained either by solving the expectation,

or by using the put-call parity, which is now
c0 + Ke−rT = p0 + S0 e−qT

Outline
1 Example
2 Volatility
5 Summing up

Summing up
If the underlying asset pays discrete dividends during the life of

the option we use S0∗ = S0 − P V (D) instead of S0 in the
Black-Scholes and put-call parity formulas
If the underlying asset pays a continuous dividend-yield we use
S0 e−qT instead of S0 in the Black-Scholes and put-call parity
formulas
It can’t get any easier than this!

Day 11 Financial Options

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Day 11 Financial Options

Uploaded by

Copyright:

Available Formats

Example Volatility Discrete dividends Continuous dividend yield Summing up

Day 11: 11/Oct/23

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 1 / 35

4 Continuous dividend yield

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 2 / 35

4 Continuous dividend yield

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 3 / 35

Example 1: pricing a put option with Black-Scholes model

1. Price this put using the Black-Scholes formula

When we used the binomial model, the answer to these questions

The model parameters are

T = 0.25, K = 5, S0 = 4.6, σ = 0.25, r = 0.01

We start by computing d2 and d1

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 5 / 35

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 6 / 35

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 7 / 35

T = 0.25 − 0.125 = 0.125, K = 5, S0 = 5.025, σ = 0.25, r = 0.01

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 9 / 35

Shouldn’t these values coincide?

4 Continuous dividend yield

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 11 / 35

Volatility estimation (1/3)

All parameters needed to use the Black-Scholes formula are

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 12 / 35

Volatility estimation (2/3)

Volatility estimation (3/3)

Our estimate for σ is then

For example, if we use daily returns then ∆t = 250

σ̂ = Sample variance × 250

This is a backward looking estimate, because it uses historical

Implied volatility (1/6)

Alternatively, we can estimate σ by using market prices on

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 15 / 35

Implied volatility (2/6)

This implied volatility can then be used as an input in the

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 16 / 35

Implied volatility (3/6)

However, the strikes shouldn’t matter: we use the same σ to price

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 17 / 35

Implied volatility (4/6)

For this reason, we should price options with implied volatilities

“Using the wrong number on the wrong formula to get the

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 18 / 35

Implied volatility (5/6)

To understand how the underestimation of the likelihood of

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 19 / 35

Implied volatility (6/6)

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 20 / 35

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 21 / 35

4 Continuous dividend yield

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 23 / 35

Adjustment to the Black-Scholes formula

With a small adjustment, we can use the Black-Scholes formula

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 24 / 35

Let’s revisit Example 1 and introduce some dividends

Example 2: pricing a put option with Black-Scholes model

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 25 / 35

T = 0.25, K = 5, S0∗ = 4.4003, σ = 0.25, r = 0.01

We start by computing d2 and d1

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 26 / 35

4 Continuous dividend yield

António Barbosa (ISCTE IBS) Financial Options Day 11: 11/Oct/23 28 / 35

Merton’s Model (1/5)

The adjustment to the Black-Scholes model to accommodate an