2/23/2024

Options - Model 2

 The Black-Scholes-Merton model is unambiguously the best

known model of option pricing.

 It is also one of the most widely used: it is the benchmark

model for pricing options on

Equities
Stock indices
Currencies
Futures (the "Black model")

 The Black model is also commonly used to price some

interest-rate derivatives such as caps and floors.

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 Technically, the BSM model is more complex than the

binomial or other lattice models.
The BSM model is a continuous-time model: prices in the
model are allowed to change continuously rather than at
discrete points in time as in the binomial model.

 Unlike the binomial or other lattice models, option prices in

the BSM model can be expressed in closed-form, i.e., as
particular explicit functions of the parameters.
This makes computing option prices very easy
Developing and verifying the intuition about option pricing
and hedging behavior is made easier
It also makes computing option sensitivities very easy

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As in all option pricing models, the principal

assumption of Black-Scholes-Merton concerns the
evolution of the stock price.
Under their assumptions, Returns on the stock
follow a log-normal distribution

The Log-Normal Assumption

The log-normal assumption says that the (natural)

log of returns is normally distributed: if S0 denotes
the current price, and St the price t years from the
present, then

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Lognormal density function

What does mu=0.10 mean?

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The number σ is called the volatility of the stock.

The BSM model takes this volatility to be a
constant. In principle, this volatility can be
estimated in two ways:
From historical data. (This is called historical
volatility.)
From options prices. (This is called implied
volatility.)

How do you compute this volatility from past data?

LN distn and simple returns

 Suppose returns are lognormal over a one-year horizon with

µ = 0.10 and σ = 0.40
 Over the one-year horizon, this means:
Expected log-returns: 10%
Variance of log-returns: 16%
 What is the mean and variance of simple one year returns?

Upshot: Don’t use log returns and simple returns

interchangeably.

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Normal distn is one of the easiest distn to work

with and is a good approximation for most data.

Almost all properties of the normal can be carried

forward to the lognormal.

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BSM option pricing model

The model assumes that this price evolves

according to a geometric Brownian motion.
What is a "geometric Brownian motion?“
First, Returns on the stock follow a log-normal
distribution
The same structure holds at multiple time scales

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Variables

 0 : current date
 T : Maturity date (So time-left-to-maturity is also T )
 K : strike price of option.

 S0 : current price of stock.

 ST : stock price at T.
 µ, σ : Expected return and volatility of stock (annualized).
 r : risk-free rate of interest.
 C , P : Prices of call and put (European only).

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Assumptions

The risk-free interest rate r and volatility σ is constant.

(Since we are in a continuous-time world, the interest rate is
also expressed in continuously-compounded terms.)
No dividends during the life of the option. (We will drop this
later.)
The options are European in style.

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BSM formula

The call-pricing formula in the Black-Scholes model is

C = S0 · N (d1) − e −rT K · N (d2)

where N (·) is the cumulative standard normal distribution [N (x) is the

probability under a standard normal distribution of an observation less
than or equal to x ], and

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 The price of a put in the Black-Scholes model is given by

P = [PV (K ) × N (−d2)] − [S0 × N (−d1)],

where d1 and d2 are as defined earlier.

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Plot of Call and Put option prices (BSM)

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BSM formula gives us a great deal more than just

the option prices - it gives us the complete
replicating portfolios for the call and the put, at any
point in time.

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 Two features of the Black-Scholes formulae:

Option prices only depend on five variables: S0, K, r, T, and
σ (two market variables, two contract variables and one —
the volatility σ, which is not directly observable)
In particular, option prices do not depend on expected
stock returns, which are difficult to estimate.

 How can this formula be used by the seller of the option, say
a call option on a particular stock?

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No. of time steps and option price

No. of steps Option price

1 14.2507
2 12.3197
3 13.6709
5 13.5154
10 13.0638
20 13.1660
50 13.2280
100 13.2488
125 13.2796
150 13.2558

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Binomial model becomes more realistic and the

option prices become more stable!

Working with the formula

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An option is said to be at-the-money-forward

(ATMF) if the strike price equals the forward price
on the stock for that maturity.
Does the Black Scholes price for an ATMF Call have
a simpler formula?
What is special about this strike price?

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A stock is currently trading at ₹500. Under the Black-

Scholes model, where the expected log returns and
volatility for the stock are 12% p.a. and 35% p.a.
respectively, find the price x such that there is a 99%
chance that the stock price after 1 month will stay
above x.

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