STOCHASTIC

MODELS IN FINANCE
MT-356
BLACK-SCHOLES OPTION PRICING
MODEL(OPM)

 The Black-Scholes option pricing model

(OPM), developed in 1973, helped give
rise to the rapid growth in options
trading.
 It is used to determine value of option.
 OPM ASSUMPTIONS
1. The stock underlying the call option
provides no dividends or other
distributions during the life of the option.
2. There are no transaction costs for
buying or selling either the stock or the
option.
3. The short-term, risk-free interest rate
is known and is constant during the life of
the option.
4. Any purchaser of a security may
borrow any fraction of the purchase price
at the short-term, risk-free interest rate.
5. Short selling is permitted, and the
short seller will receive immediately the
full cash proceeds of today’s price for a
security sold short.

Short Sellers borrow shares of stock that

they do not own(typically from their
broker’s account) and sell those shares at
current market price.
The goal is to re-buy those shares of
stock at a lower price in the future and
then return the borrowed shares to the
lender.
6. The call option can be exercised only
on its expiration date.

7. Trading in all securities takes place

continuously, and the stock price moves
randomly.
BLACK-SCHOLES OPTION PRICING
MODEL FORMULA
• VC = Current value of the call option.
• P = Current price of the underlying stock.
• N(di) = Probability that a deviation less than di will occur in a
standard normal distribution. Thus, N(d1) and N(d2) represent areas
under a standard normal distribution function.
• X = Strike price of the option.
• e ≈ 2.7183.
• rRF = Risk-free interest rate
• t = Time until the option expires (the option period).
• ln(P/X) = Natural logarithm of P/X.
• σ = Standard deviation of the rate of return on the stock.
BLACK-SCHOLES OPTION PRICING
MODEL
 The value of the option is a function of
five variables:
(1) P, the stock’s price;
(2) t, the option’s time to expiration;
(3) X, the strike price
(4) σ, the standard deviation of the
underlying stock
(5) rRF, the risk-free rate.
APPLICATION OF THE BLACK-SCHOLES
OPTION PRICING MODEL
 P = $40
 X = $35

 t = 6 months (0.5 years)

 rRF = 8 % = 0.080

 σ = 31.557% = 0.31557

d1=0.8892
d2=0.6661
Note: N(d1) and N(d2) represent areas
under a standard normal distribution
function.
VC= $7.39
THE FACTORS THAT AFFECT OPTION
PRICES
 For all stock prices, the option prices
are always above the exercise value. If
this were not true, then an investor
could purchase the option and
immediately exercise it for a quick
profit.
 When the stock price falls far below the
strike price, the option prices fall
toward zero. In other words, options
lose value as they become more and
more out of-the-money(X>P)
 For very high stock prices, options tend
to move up and down by about the
same amount as does the stock price.
 Option prices increase if the stock price
increases.
 The 1-year option always has a greater
value than the 6-month option, which
always has a greater value than the 3-
month option; thus, the longer an
option has until expiration, the greater
its value. This is because stock prices
move up on average, so a longer time
until expiration means a greater chance
for the option to be in the- money(X<P)
by its expiration date, making the
option more valuable.
 As volatility increases, so does the option price.
Therefore, the riskier the underlying security, the
more valuable the option.
As the risk-free rate increases, the value of the
option increases. The principal effect of an
increase in rRF is to reduce the present value of
the exercise price, which increases the current
value of the option.
ANSWERS:
1) N=0.60, V=$6.88
2) D1=0.4906, D2=-0.0044, V=$5.42