OPTIONS and FUTURES

Lecture 4: The Black-Scholes model

Philip H. Dybvig
Washington University in Saint Louis
Black-Scholes option pricing model
Lognormal price process
Call price
Put price
Using Black-Scholes
Copyright c Philip H. Dybvig 2004
Continuous-Time Option Pricing
We have been using the binomial option pricing model of Cox, Ross, and Rubin-
stein [1979]. In this lecture, we go back to the original modern option pricing
model of Black and Scholes [1973]. The mathematical underpinnings of the
Black-Scholes model would take a couple of semesters to develop in any formal
way, but we can discuss the intuition by viewing it as the limit of the binomial
model as the time between trades becomes small.
Black, Fischer, and Myron Scholes (1973) The Pricing of Options and Corporate
Liabilities Journal of Political Economy 81, 637654
Cox, John C., Stephen A. Ross, and Mark Rubinstein (1979) Option Pricing: A
Simplied Approach Journal of Financial Economics 7, 229263
2
Lognormal stock price process
The stock price process in the Black-Scholes model is lognormal, that is, given the
price at any time, the logarithm of the price at a later time is normally distributed.
(Recall that the normal distribution is the familiar bell curve from statistics.) It
is also known how to do option pricing for a continuous-time model with normally
distributed prices, but the lognormal model is more reasonable because stocks
have limited liability and cannot go negative. In the basic Black-Scholes model
there are no dividends. Over a short period of time, the mean rate of return is
per unit time and the variance is
2
per unit time. For s < t, the expected
return over the time interval [s, t] is approximately (t s):
E
_

_
S
t
S
s
S
s
_

_ (t s)
and the variance is approximately
2
(t s):
E
_

_
_
_
_
S
t
S
s
S
s
(t s)
_
_
_
2
_

_

2
(t s).
(Note: (t s) is not exactly the correct mean. However, this does not mat-
ter since the squared mean is much smaller than the variance over small time
intervals. In fact, it would not matter if we didnt subtract the mean at all.)
3
Binomial approximates lognormal when time increment is small
stock price
p
r
o
b
a
b
i
l
i
t
y

d
e
n
s
i
t
y
4
Black-Scholes call option pricing formula
The Black-Scholes call price is
C(S, T) = SN(x
1
) BN(x
2
),
where N() is the cumulative normal distribution function, T is time-to-maturity,
B is the bond price Xe
r
f
T
,
x
1
=
log(S/B)

T
+
1
2

T,
and
x
2
=
log(S/B)

T

1
2

T.
Note that the Black-Scholes option price does not depend on the mean return of
the stock. This is because the change to risk-neutral probabilities changes the
mean but not the variance. Note that these prices are for European options on
stocks paying no dividends.
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BlackScholes Call Price
stock price
c
a
l
l

o
p
t
i
o
n

p
r
i
c
e
T=0.00
T=0.25
T=0.50
T=1.00
6
Intuition: gamblers rule

When a call option ends in the money at maturity T periods from now, its value
is S
T
X
T
, which has value S Xe
r
f
T
= S B in the notation above. If
the probability of exercise were and chosen independent of everything in the
economy, the option value would be S B. However, we can skew the odds
in our favor if we pick and choose when to exercise, which skews the probabilities:
SN(x
1
) BN(x
2
) where x
1
> x
2
. As maturity approaches, both probabilities
tend to 1 if the option is in the money or 0 if the option is out of the money. In
particular, if we look at x
1
and x
2
, they both go to + as the moneyness S/B
of the option increases or goes down to as the moneyness decreases. The
dierence between x
1
and x
2
is the greatest when volatility and time-to-maturity
are greatest.
*fanciful description due to Stephen Brown
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Where does Black-Scholes come from?
The Black-Scholes formula can be derived as the limit of the binomial pricing
formula as the time between trades shrinks, or directly in the continuous time
model using an arbitrage argument.
The option value is a function of the stock price and time, and the local movement
in the stock price can be computed using a result called It os lemma, which
is an extension of the chain rule from calculus. The standard version of the
chain rule does not work, because the stock price in the lognormal model is
not dierentiable (and cannot be or else stock price would be locally predictable
implying the existence of an arbitrage). Even if a function of the stock has zero
derivative at a point, its expected rate of increase can be positive due to the
volatility of local price movements.
Once It os lemma is used to calculate the local change in the option value in term
of derivatives of the function of stock price and time, absence of arbitrage implies
a restriction on the derivatives of the function (in economic terms, risk premium
is proportional to risk exposure), essentially similar to the per-period hedge in the
binomial model. The absence of arbitrage implies a dierential equation that is
solved subject to the boundary condition of the known option value at the end.
8
What are the two terms?
I am not sure it widely known, but the two terms in Black-Scholes call formula
are prices of digital options. The rst term SN(x
1
) is the price of a digital option
that pays one share of stock at maturity when the stock price exceeds X: this is
a digital option if we measure payos in terms of the stock price (this is called
using the stock as numeraire and is like a currency conversion). The second term
XN(x
2
) is the price of a short position in a digital option that pays X at
maturity when the stock price exceeds X.
There is a slightly mystical result that the two terms also represent the portfolio
we hold to replicate the option if we want to perform an arb. We can create
the call option payo at the end by holding SN(x
1
) long in stocks and BN(x
2
)
short in bonds (with trading to vary this continuously as time passes and the
stock price evolves).
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In-class exercise: Black-Scholes put price
Derive the Black-Scholes put price.
hint: Use the known form of the Black-Scholes call price (SN(x
1
) BN(x
2
))
and put-call parity (C + B = P + S).
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BlackScholes Put Price
stock price
p
u
t

o
p
t
i
o
n

p
r
i
c
e
T=0.00
T=0.25
T=0.50
T=1.00
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Using the Black-Scholes formula
The Black-Scholes model is usually the model of choice when working with a plain
vanilla European option pricing application. The binomial model is more exible
and is a better choice for inclusion of a nontrivial American feature, realistic
dividends, and other complications.
The simplest way to obtain the Black-Scholes call price is to use available tables,
a spreadsheet, or a nancial calculator. Or, compute the value directly using the
formula. The value of N() is available in tables or from the approximation in the
next slide. Be sure to use the natural logarithm function to compute log(S/B).
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Cumulative Normal Distribution Function
If you want to calculate the formula yourself, there are lots of good approxi-
mations to the cumulative normal distribution function. For example, you can
use the following procedure for x 0. For x 0, use the procedure on x
and the formula N(x) = 1 N(x). First compute t, dened by t 1/(1
0.33267x). Then use t and x to compute N(x) (0.4361836t 0.1201676t
2
+
0.937298t
3
) exp(x
2
/2)/

2, where 3.1415926535 is the familiar numeri-

cal constant.
If x very close to zero (say .25 < x < .25), as it will be for near-the-money
options at short maturities, N(x) .5+x/

2 .5+0.39894x. Consequently,
near-the-money call options are worth about
SB
2
+.4
S+B
2

T. This is a handy
approximation for a meeting or job interview where a quick approximate answer
is useful.
13
What interest rate to use
The original Black-Scholes derivation assumes that the interest rate is always
constant and is the same for all maturities. Of course, the riskless interest rate
is not constant, and bonds of dierent maturities have dierent yields.
In the Black-Scholes formula, the interest rate always appears in e
r
f

, which is
the price of a riskless pure discount bond with a face value of 1 and a maturity
periods from now. The generalizations of Black-Scholes suggest that we should
use the price of a discount bond maturing with the option and a face equal to
the strike price. Traditionally, prices of Treasury securities were used, but now
most practitioners use LIBOR instead as Treasuries are viewed as less liquid.
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What variance to use
The choice of variance estimate is even more important than the choice of interest
rate in most option pricing applications. Getting the variance wrong can have a
big impact on the computed price, and an equally big impact on the eectiveness
of a hedge. The two most common methods of determining the appropriate
variance are historical estimation and implied variance.
In the historical estimation approach, simply look at the variance of historical
returns and then adjust for the length of the time horizon. For technical reasons,
it is best to use log returns (that is, to compute the sample variance of log(1+
return)). Be sure that your returns are computed correctly, and that you have
adjusted properly for any dividends or stock splits. Weekly returns seem like an
ideal choice: longer returns give less accurate estimates and are more subject
to changes in variance over time, while shorter returns are more contaminated
by the bid-ask spread, liquidity distortions, and non-trading eects. After the
variance is computed, do the proper adjustment to convert to annual terms. For
example, a weekly variance of returns of .0032 corresponds to an annual variance
of 52 0.0032 0.16 or an annual standard deviation of

0.16 = 40%.
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What Variance to Use (continued)
The implied variance approach to computing variance is a way of reading market
participants assessment of variance. It requires there to be quoted prices available
for options on the stock on which the option is written, or for options on a related
instrument. The idea is to look at what variance (the implied variance) would
be consistent with the option prices you see in the market. In doing so, it is
important to get option and stock prices that are as nearly contemporaneous as
possible, which is particularly dicult if the stock or its options are thinly traded.
This approach is used mostly in active markets (for example, for stock index
futures). Practitioners often use implied variances as an indicator of the state of
these markets.
Of course, individual judgment also enters the equation. For example, if you
believe that historical variances were estimated on a particularly turbulent pe-
riod and that we are in a quieter period, then you should adjust the estimate
downward. Or, if you obtain an implied variance that doesnt seem sensible, you
should obviously consider whether the price quotes (and your calculations) are
reliable.
16
Warning: Black-Scholes is for underlying assets
Do not just plug in an interest rate, vol, or other number where the stock price
goes in Black-Scholes! If you make this common mistake, the result is nonsense
and any decisions based on this mistake are likely to cost you money. The Black-
Scholes model assumes in its derivation that we can set up a hedge by going long
or short the stock to enforce the pricing. However, there is no asset we can buy
today whose price today is the interest rate today and whose price tomorrow is
the interest rate tomorrow!
17
Wrap-up
Black-Scholes uses the same economics as the binomial model
continuous time with a lognormal price process
closed form solutions for European call and put prices
for the interest rate, use LIBOR
for the vol, used historical, implied vol, and/or your own judgment
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