Option valuation Black Scholes

Black-Scholes Option Valuation

Co = SoN(d1) - Xe-rTN(d2)
d1 = [ln(So/X) + (r + 2/2)T] / (T1/2)
d2 = d1 + (T1/2)
where,
Co = Current call option value
So = Current stock price
N(d) = probability that a random draw from a normal
distribution will be less than d
 Black-Scholes Option Valuation
(cont)

X = Exercise price
e = 2.71828, the base of the natural log
r = Risk-free interest rate (annualizes continuously
compounded with the same maturity as the option)
T = time to maturity of the option in years
ln = Natural log function
Standard deviation of annualized continuously
compounded rate of return on the stock
 Call Option Example

So = 100 X = 95
r = .10 T = .25 (quarter)
= .50

ln(100 / 95)  (. 10  .52 / 2)  .25

d1   .43
.5 .25

d 2  . 43  . 5 . 25  . 18
Probabilities for Normal Distribution

From the Excel function NORMSDIST we

find

N (.43) = .6664

N(.18) = .5714
• Note when the N(d) terms are close to one
then the option will be exercised –i.e. In the
money.
• If N(d) is close to 0 then it will not.
• Values in between represents the call option’s
present value potential payoff.
• If stock prices increase so do N(d1)and N(d2)
indicating a higher probability of exercise.
 Call Option Value

Co = SoN(d1) - Xe-rTN(d2)
Co = 100 x .6664 – (95 e-.10 X .25) x .5714
Co = 13.70
Implied Volatility
• Using Black-Scholes and the actual price of
the option, solve for volatility.
• Is the implied volatility consistent with the
historical volatility of the stock?
• Hedge ratios in Black Scholes

• N(d) is the hedge ratio for the call and N(d)-1

is the hedge ratio of the put.
• The call hedge is positive and < 1
• The put is negative and absolute value < 1
 Using the Black-Scholes Formula
Hedging: Hedge ratio or delta
The number of stocks required to hedge against
the price risk of holding one option
Call = N (d1)
Put = N (d1) - 1
Option Elasticity
Percentage change in the option’s value given a
1% change in the value of the underlying stock
Call Option Value and Hedge Ratio
Hedge Ratios Change as the Stock Price
Fluctuates
 Hedging On Mispriced Options

Option value is positively related to volatility:

• If an investor believes that the volatility that is
implied in an option’s price is too low, a
profitable trade is possible
 Using the Black-Scholes Formula
Hedging: Hedge ratio or delta
The number of stocks required to hedge against
the price risk of holding one option
Call = N (d1)
Put = N (d1) - 1
Option Elasticity
Percentage change in the option’s value given a
1% change in the value of the underlying stock
Call Option Value and Hedge Ratio
Hedge Ratios Change as the Stock Price
Fluctuates
 Example of option elasticity
Suppose Stock is at 120, Hedge is .6 , Strike (X)
is 120, call is 5.
• St =121 so the stock increased 1 dollar the call
will increase .60 to 5.60
• .60/5.00 =12% but 1/120 = .83%
• Elasticity: 12/.83 = 14.4% that is ; for every
1% increase in the stock the option increases
14.4%.
 Hedging On Mispriced Options

Option value is positively related to volatility:

• If an investor believes that the volatility that is
implied in an option’s price is too low, a
profitable trade is possible
• Performance depends on option price relative
to the implied volatility