Black Scholes Pricing

Methodology
Dr A Vinay Kumar
The What's?
What is Brownian Motion and Why is it
important for Option Pricing?
What is Ito Calculus and How was it used?
Noble formula, how does it work?
Whats the implied volatility puzzle?

Categorization of Stochastic
Processes
Discrete time; discrete variable
Discrete time; continuous variable
Continuous time; discrete variable
Continuous time; continuous variable
Modeling Stock Prices
We can use any of the four types of
stochastic processes to model stock
prices
The continuous time, continuous
variable process proves to be the most
useful for the purposes of valuing
derivatives
Markov Processes (See pages 216-
7)
In a Markov process future movements
in a variable depend only on where we
are, not the history of how we got
where we are
We assume that stock prices follow
Markov processes
A Wiener Process (See pages 218)
We consider a variable z whose value
changes continuously
The change in a small interval of time ot is
oz
The variable follows a Wiener process if
1.
2. The values of oz for any 2 different (non-
overlapping) periods of time are independent
(0,1) from drawing random a is where | c o c = o t z
Properties of a Wiener
Process
Mean of [z (T ) z (0)] is 0
Variance of [z (T ) z (0)] is T
Standard deviation of [z (T ) z (0)] is
T
Generalized Wiener Processes
(See page 220-2)
A Wiener process has a drift rate (i.e.
average change per unit time) of 0
and a variance rate of 1
In a generalized Wiener process the
drift rate and the variance rate
can be set equal to any chosen
constants
Generalized Wiener Processes
(continued)
Mean change in x in time T is aT
Variance of change in x in time T is b
2
T
Standard deviation of change in x in
time T is
t b t a x o c + o = o
b T
The Example Revisited
A stock price starts at 40 and has a probability
distribution of |(40,10) at the end of the year
If we assume the stochastic process is Markov
with no drift then the process is
dS = 10dz
If the stock price were expected to grow by $8
on average during the year, so that the year-
end distribution is |(48,10), the process is
dS = 8dt + 10dz
Why a Generalized Wiener
Process
is not Appropriate for Stocks
For a stock price we can conjecture that its
expected percentage change in a short period
of time remains constant, not its expected
absolute change in a short period of time
We can also conjecture that our uncertainty as
to the size of future stock price movements is
proportional to the level of the stock price
Ito Process (See pages 222)
In an Ito process the drift rate and the
variance rate are functions of time
dx=a(x,t)dt+b(x,t)dz
The discrete time equivalent

is only true in the limit as ot tends to
zero
t t x b t t x a x o c + o = o ) , ( ) , (
An Ito Process for Stock Prices
(See pages 222-3)


where is the expected return o is
the volatility.
The discrete time equivalent is
dS Sdt Sdz = + o
t S t S S o c o + o = o
Monte Carlo Simulation
We can sample random paths for the
stock price by sampling values for c
Suppose = 0.14, o= 0.20, and ot = 0.01,
then
c + = o S S S 02 . 0 0014 . 0
Monte Carlo Simulation One Path
(See Table 11.1)



Period
Stock Price at
Start of Period
Random
Sample for c
Change in Stock
Price, AS
0 20.000 0.52 0.236
1 20.236 1.44 0.611
2 20.847 -0.86 -0.329
3 20.518 1.46 0.628
4 21.146 -0.69 -0.262


Itos Lemma (See pages 226-227)
If we know the stochastic process
followed by x, Itos lemma tells us the
stochastic process followed by some
function G (x, t )
Since a derivative security is a function of
the price of the underlying and time, Itos
lemma plays an important part in the
analysis of derivative securities
The Stock Price Assumption
Consider a stock whose price is S
In a short period of time of length ot, the
return on the stock is normally distributed:


where is expected return and o is volatility

( ) t t
S
S
o o o | ~
o
,
The Lognormal Property
(Equations 12.2 and 12.3, page 235)
It follows from this assumption that





Since the logarithm of S
T
is normal, S
T
is
lognormally distributed
ln ln ,
ln ln ,
S S T T
S S T T
T
T
~
|
\

|
.
|

(
~ +
|
\

|
.
|

(
0
2
0
2
2
2
|
o
o
|
o
o

or

The Lognormal Distribution

E S S e
S S e e
T
T
T
T T
( )
( ) ( )
=
=
0
0
2
2
2
1

var

o
Continuously Compounded
Return, (Equations 12.6 and 12.7), page 236)
S S e
T
S
S
T
T
T
T
=
~
|
\

|
.
|
0
0
1
2

or
=
or

2
q
q
q |
o o
ln
,
The Expected Return
The expected value of the stock price is
S
0
e
T
The expected return on the stock is
o
2
/2


| |
| | =
o =
) / ( ln
2 / ) / ln(
0
2
0
S S E
S S E
T
T
The Volatility
The volatility of an asset is the standard
deviation of the continuously
compounded rate of return in 1 year
As an approximation it is the standard
deviation of the percentage change in the
asset price in 1 year
Estimating Volatility from
Historical Data (page 239-41)
1. Take observations S
0
, S
1
, . . . , S
n
at
intervals of t years
2. Calculate the continuously compounded
return in each interval as:


3. Calculate the standard deviation, s , of
the u
i
s
4. The historical volatility estimate is:
u
S
S
i
i
i
=
|
\

|
.
|

ln
1
t
= o
s

The Concepts Underlying

Black-Scholes
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 differential equation
Assumptions
Stock Prices follow GBM
Short selling of securities with full use of
proceeds is permitted
No transaction costs, taxes,
All securities are perfectly divisible
There are no dividends
No Arbitrage
Security trading is continuous
Risk free rate is constant and the same for all
maturities.
The Derivation of the Black-
Scholes Differential Equation
shares :

-
derivative : 1
of consisting portfolio a up set e W

2 2
2
2
S
z S
S
t S
S t
S
S
z S t S S
c
c
o o
c
c
o o
c
c
c
c

c
c
o
o o o o
+
+
|
|
.
|

\
|
+ + =
+ =
step time the during change nor did delta that Notice

by given is in time value its in change The

by given is portfolio the of value The
S
S
t
S
S
o
c
c
o o
o
c
c
+ = H
+ = H
H
The Derivation of the Black-Scholes
Differential Equation continued
The Derivation of the Black-Scholes
Differential Equation continued

: equation al differenti Scholes - Black the get to
equations these in and for substitute We

Hence rate.
free - risk the be must portfolio the on return The
r
S
S
S
rS
t
S
t r
=
c
c
o +
c
c
+
c
c
o o
o H = H o
2
2
2 2
Derivation

is therfore portfolio The

have we Ito From

2 2
2
2
2 2
2
2
S
S
t S
S
t
t
S
S
t S
S
t
t
S
S
o
c
c
o o
c
c
o
c
c
o
c
c
o
o o
c
c
o
c
c
o
c
c
o

|
|
.
|

\
|
+ + = H
|
|
.
|

\
|
+ + =
The deterministic terms and
random terms
All dt terms are deterministic and all ds
terms are random
To almost eliminate the randomness you
need choose
That what is delta hedging obviously it has
to be dynamic because asset price is
dynamic
S c
c
Principle of No arbitrage
( )


0

arbitrage create to going is rate other any

so rate free risk only earn to needs This

be to remains portfolio The

2 2
2
2
2 2
2
2
= + +
H = H
|
|
.
|

\
|
+ = H
rf
S
rS S
S t
t r
t S
S
t
t
c
c
o
c
c
c
c
o o
o o
c
c
o
c
c
o
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
= S K when t =T
The solution to the equation is
= S K e
r (T t )
Risk-Neutral Valuation
The variable does not appear in the Black-
Scholes 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
The Black-Scholes Formulas
(See pages 246-248)
T d
T
T r K S
d
T
T r K S
d
d N S d N e K p
d N e K d N S c
rT
rT
o =
o
o +
=
o
o + +
=
=
=

1
0
2
0
1
1 0 2
2 1 0
) 2 /
2
( ) / ln(
) 2 /
2
( ) / ln(
) ( ) (
) ( ) (

where


Implied Volatility
The implied volatility of an option is the
volatility for which the Black-Scholes price
equals the market price
The is a one-to-one correspondence
between prices and implied volatilities
Traders and brokers often quote implied
volatilities rather than dollar prices
Estimating the Volatility
(continued)
Implied Volatility
This is the volatility implied when the
market price of the option is set to the
model price.
Substitute estimates of the volatility into the
B-S formula until the market price
converges to the model price.
A short-cut for at-the-money options is
T (0.398)S
C

0
~ o
Estimating the Volatility
(continued)
Implied Volatility (continued)
Interpreting the Implied Volatility
The relationship between the implied volatility and the
time to expiration is called the term structure of implied
volatility.
The relationship between the implied volatility and the
exercise price is called the volatility smile or volatility
skew. These volatilities are actually supposed to be the
same. This effect is puzzling and has not been
adequately explained.
The CBOE has constructed indices of implied volatility of
one-month at-the-money options based on the S&P 100
(VIX) and Nasdaq (VXN).
Causes 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
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
Equity Options
Implied
Volatility
Strike
Price
The Volatility smirk for
Equity Options Possible biases in
BS Model.

If the BS model is
right we should have
had same IVS for all
moneyness and
maturity.
Low X:
ITM calls or
OTM puts
High X:
ITM puts or
OTM calls
The flat line is the BS
IV as it should be
The dark line is the IV
estimated from the market
data

ITM calls or
OTM puts
ITM puts or
OTM calls
The left tail is fatter and
the right tail is thinner
than the lognormal
distribution

Implied Risk neutral
distribution (IRND) is
more negatively skewed
and leptokurtic.
Biases in BS prices
Implied
Volatility
Strike
Price
The Volatility smirk for Equity Options
Low X:
ITM calls or OTM puts.
BS model under prices
High X:
ITM puts or OTM calls.
BS model over prices
The flat line is the BS
IV as it should be
The dark line is the IV
estimated from the market
data

Low X:
ITM calls or
OTM puts
High X:
ITM puts or
OTM calls
How about Foreign
Currency Options ?
Pricing Biases in B-S model
for equity options
Moneyness:
It under prices ITM ( OTM)
calls (puts) and over prices
deep OTM (ITM) calls (puts) .

Maturity:
Volatility smile becomes less
pronounced as option maturity
increases
It under (over) prices long
(short) maturity options
Market prices are higher
(lower) for long (short)
maturity options

Volatility
It under prices low volatility
stocks
It over prices high volatility
stocks


Further evidence of pricing biases
( Fleming, Dumas and Whaley JOF, 1997)
Stochastic Volatility
Heston (RFS, 1993)
Consider the following return and volatility risk
neutral processes:


The volatility process is the square root process of Cox,Ingersoll &
Ross (1985)
Price of volatility risk =

( ) dz V dt V dV
dw S dt S dS

k
ku
k
o |
+
|
.
|

\
|

+
+ =
+ =


( ) ( ) dV,dC/C Cov t V S = aversion risk relative , ,
Skewness and Kurtosis
Correlation controls the skewess of the risk
neutral distributions - important for pricing ITM
Vs. OTM options.

Volatility of Volatility controls the kurtosis of the
risk neutral distributions- important for pricing
ATM Vs. deep OTM options.

Characteristic Function
Approach
The new PDE involves both
delta, vega ( first order and
second order effects and cross
effects) and volatility risk
premium term .

Extra boundary conditions.

The risk neutral probability
function which is solution to
PDE does not have a closed
form.
However characteristic
functions exist that satisfy the
same PDE.

One should invert the
characteristic function to obtain
the desired probabilities
(numerical integrals).

Characteristic Function
Approach
Eq 10,17, 18 give the soln for European calls
Correlation in Hestons SV model
Nandi (JBF, 1998)
In order to estimate SV model besides the BS
inputs we need
( )
process SV of mean term long :
premium risk volatility :
process SV for reversion mean :
y volatilit of volatility :
parameter n correlatio :
, , , , : parameters model
u

ku k
t
v + +
IV Function Explanation
Shape of IV function:
Hedging Pressure
Net demand pressure
Why are those options smiling?
Ederington and Guan (JOD,
2000)
Two sources of the smile:
With respect to the underlying risk neutral
dynamics of the underlying asset
Violation of other assumptions such as
continuous trading and frictionless markets.

If BS Model is biased, trades based on
IV smile ( long options at the bottom of
the smile and short options at the top of
the smile ) would yield no profits, even
before transaction costs.

If BS Model is unbiased such trades
based on IV smile should yield profits.

IV smile
Trading on the smile
Follow the following strategy:
long options at the bottom of the smile and
short options at the top of the smile
Value of long portfolio/ Value of short
portfolio = 1
Portfolio is self financing
Delta and gamma hedge the portfolio

Data
S & P 500 index futures and futures options
IV ( Blacks model) based on near the money options
(OTM options Exclude).
No non-synchronous problem between two markets
Futures options:
Better liquidity and easy to trade than the spot.
Better arbitrage, hedging and market linkages
Lower transaction costs
Futures option pricing is independent of future dividends
Results
Trades based on IV smile ( long options at the
bottom of the smile and short options at the top
of the smile ) yield substantial profits, before
transaction costs.
So the BS Model is not completely biased.
i.e. BS formula is not completely wrong
i.e. Smile is not wholly caused by errors in the BS
formula

However that does not mean that the market is
inefficient.

Results
However the profits are spurious. The
profits drop once transaction costs are
considered.
The residual profits are also related to
imperfect delta-gamma hedging.

Results
If the Smile is not wholly caused by errors
in the BS formula, what causes it?:
Hedging in OTM puts (and hence ITM calls
through put-call parity)
The authors find support for the hedging
hypothesis:
IVs on low X options are relatively unrelated
to actual ex-post volatility than compared to
high X options

Net Buying Pressure and shape if IV
function
Bollen and Whaley (JOF, 2004)
Provide an explanation based on demand
and supply for different option series ( i.e
c(X,T) and p(X,T) ).
Under BS model, the supply curve for
each option series is a horizontal line
Option price is unaffected by demand
shifts for options
Market Maker
A market maker in option markets will not stand
ready to sell an unlimited number of contracts in
a particular option series.

As her position grows large and imbalanced, her
hedging costs and/or volatility risk exposure also
increases and he is forced to charge a higher
price.

With an upward sloping supply curve, differently
shaped IVF can be expected
Market Maker and upward sloping
Supply curve
If investor net (or excess) public demand for a particular
option series is to buy (sell) the option prices will be high
(low) and hence IV will be accordingly high (low).

In the case of S & P 500 index OTM puts, excess
demand can cause higher option prices.

The market makers need higher compensation towards
higher hedging costs and
exposure to volatility risk.
Net buying Pressure:
Defined as difference between:
buyer motivated contracts and
(trades executed at prices above prevailing bid-ask
prices)
seller motivated contacts
(trades executed at prices below prevailing bid-ask
prices)
traded each day.

The difference is multiplied by absolute value of
option delta to express demand in stock / index
equivalent units
Index Vs Stock options
Index markets:
Most of the trading is in puts
Buying pressure on Index put options leads to
the IVF being more negatively sloped.
Stock markets:
Most of the trading is in calls
Buying pressure on Equity calls options leads
to the IVF being less negatively sloped.


Delta Hedging
Delta hedging OTM Index puts leads to
significant profits compared to delta
hedging equity options.

Once the vega risk is factored in, the
excess profits are no longer significant.