CHAPTER 6.

ONE-ASSET EUROPEAN OPTIONS

62

Chapter 6

One-asset European options

6.1

Solution of the Black-Scholes equation

The Black-Scholes equation is written as

2 2 2 c
c
c
=
S
+ rS
rc
2

2
S
S

(6.1)

where = T t (T : expiration time, t: present time). We want to solve the

equation under the following condition
Payoff condition c(S, = 0) = max(S X, 0), X: strike price
Boundary conditions
1. The European call value is bounded by the asset value
c(S, ) S

(6.2)

2. The lower bound on the value of the European call is

c(S, ) max(S Xer , 0).

(6.3)

Taking y = ln S
c
S
2c
S 2

1 c
S y
1 c
1 2c
= 2
+ 2 2.
S y S y

(6.4)

CHAPTER 6. ONE-ASSET EUROPEAN OPTIONS

63

We introduce a new notation w(y, ) = e r c(y, ) then using Eqs.(6.4) the BlackScholes equation becomes a simple diffusion equation
w
2 2 w
2
=
+
r

2 y 2
2

w
y

(6.5)

whose fundamental solution is a normal function

1
[y + (r 2 /2) ]2
(y, ) =
exp
2 2
2

(6.6)

From the principle of superposition for a linear differential equation, the solution
to Eq.(6.5) is
w(y, ) =

w(, 0)(y , )d

(6.7)

Using the payoff condition and the fundamental solution (6.6),

w(y, ) =

[y + (r 2 /2) ]2
max(e X, 0) exp
2 2

[y + (r 2 /2) ]2
(e X) exp
2 2
ln X

d.

d
(6.8)

We denote the distribution function for a normal variable by N (x):

1
N (x) =
2

eq

2 /2

dq.

(6.9)

Then the last line in the right-hand side of Eq.(6.8) is

w(y, ) = er SN

ln(S/X) + (r + 2 /2)

XN

ln(S/X) + (r 2 /2)

c(S, ) = SN (d1 ) Xer N (d2 ),

where
d1 =

S
+ (r +
ln X

2
2 )

(6.10)

and d2 = d1 .

(6.11)

CHAPTER 6. ONE-ASSET EUROPEAN OPTIONS

64

From Eq.(6.8) to Eq.(6.10)

Eq.(6.8) can be written
w(y, ) =

X

2

( + A)2
e exp
2 2
ln X

( + A)2
exp
2 2
ln X

(6.12)

where A = y + (r 2 /2) = ln S + (r 2 /2) . Let us consider the

second term in the right-hand side. To convert this term to the form

(6.9), we take q = ( + A)/ . Then d and the limits of the integral

become
d

dq

= q =
ln X + A
ln X + ln S + (r 2 /2)

= ln X q =
=
d2


where ln X + ln S = ln S/X. Changing the variable from to q, the
second term of Eq.(6.12) becomes
X

d2

q2
X
e 2 dq =
2

d2

q2

e 2 dq = XN (d2 ).

(6.13)

The integrand of the first term

( + A)2
e exp
2 2

2 2(A + 2 ) + A2
= exp
2 2

2 2(A + 2 ) + (A + 2 )2 (A + 2 )2 + A2
= exp
2 2
[ (A + 2 )]2
1
+ 2 + A
= exp
2
2
2
= e

1 2
+A
2

[ (A + 2 )]2
exp
2 2

(6.14)

where using the definition of A

1

e2

2 +A

= ey+r
= Ser

(6.15)

CHAPTER 6. ONE-ASSET EUROPEAN OPTIONS

65

Inserting Eqs.(6.14) and (6.15) into the first term of (6.12), the first term
becomes
1

Ser
2

[ (A + 2 )]2
exp
2 2
ln X

(6.16)

Here we change the variable

t=

+ (A + 2 )

then
d
dt =

and the limits are converted to
= t =
ln X + A + 2

ln X + ln S + (r 2 /2)

+
=

ln S/X + (r 2 /2)

+
=

= d2 + = d 1

= ln X t =

(6.17)

The first term is thus written as

1
Ser
2

d1

t2

d1
t2
1
Ser
e 2 dt
2

= Ser N (d1 ).

e 2 dt =

(6.18)

This completes the step from Eq.(6.8) to Eq.(6.10)

This is the price formula of the European call option. This gives the optimum
price of an American call on a non-dividend paying asset.
Remarks
1. N (d2 ) may be regarded as the risk-neutral probability of the call option

CHAPTER 6. ONE-ASSET EUROPEAN OPTIONS

66

being in-the-money at expiry.

2. The first term in the right-hand side of Eq.(6.10) is the present value of the
risk-neutral expectation of the asset price at expiry conditional on the call
being in-the-money.
3. The second term is the present value of the risk-neutral expectation of the
payment made by the holder of the call option at expiry on exercising the
option.
Using the put-call parity we can find the value of a European put option:
p(S, ) = c(S, ) + Xer S
= Xer N (d2 ) SN (d1 ).

(6.19)

The European call price (6.10) is a decreasing function of the strike price which
can be proved:
c
X

S
X
d
d
2
2
ed1 /2 1 er d2 /2 2 er N (d2 )
X
X
2
2
r
= e N (d2 ) < 0.

(6.20)

Similarly, the fact that the European put price (6.19) is an increasing function of
the strike price whose proof is
p
X

c
+ er
X
= er [1 N (d2 )] > 0.

(6.21)

Example
Find the price for a European call option on a share with the spot price S = $53.
Assume the time to maturity = 6months, the strike price of the option X = $50,
the risk-free interest rate per annum r = 12% and the volatility = 30%.

CHAPTER 6. ONE-ASSET EUROPEAN OPTIONS

6.2

67

Risk management

A financial institution is always faced with the problem of managing its risk. The
financial institution can take a strategy to do nothing so it is completely exposed
to the risk. This is sometimes referred to as a naked position.
Example
Let us consider a financial institution that sold 1,000 European options on
100,000 shares of a non-dividend-paying stock. We assume that the option price
was 300 and the spot price of the stock 39, the strike price 40 and the
risk-free interest rate is 5% per annum and the time to maturity is 20 weeks.
If after 20 weeks the option is out-of-the money (for example, the stock price
is 30) then the financial institution makes a profit of 300, 000 (premium).
However, if the stock price is 50, the institution made a loss of 700, 000 =
1, 000, 000 300, 000.
The naked position may give the optimum profit but the financial institution
may also lose unlimited amount of money. Alternatively, the financial institution can adopt a covered position. This involves the financial institution longing
100,000 shares. The initial investment is
3, 900, 000 300, 000 = 3, 600, 000.
If the share price ST is 30, the portfolio is worth 3, 000, 000 at expiry. The
financial institution has lost 600, 000. If the share price S T is 50, the portfolio at expiry is worth 4, 000, 000. The covered position is not satisfactory in
reducing the risk.

6.2.1

Stop-loss strategy

Assume that a financial institution has written a call option. To hedge the
position, the institution buys an underlying stock as soon as its price rises above
the strike price, X, and sells as soon as it falls below X. The scheme is to ensure
that the institution owns the stock at time T if the option closes in the money

CHAPTER 6. ONE-ASSET EUROPEAN OPTIONS

68

and does not own it if the option closes out-of-the money. Ideally, the cost of
writing and hedging the option is
Q = max[S X, 0]

(6.22)

where S is the spot price of the underlying share when the option is written.
However there are three problems in the equation
1. It is impossible to buy and sell at exactly the same price X.
2. The cash flows to the hedger occur at different times and must be discounted.
3. The transaction cost has been ignored.

6.3

Delta hedging

The delta, , of a derivative is defined 1 as

=

f
,
S

(6.23)

where f is the value of a derivative. From the call price formula (6.10), the delta
for a call is
S
X
d2
d1
2
2
c = N (d1 ) + ed1 /2
er d2 /2
S
S
2
2
h
i
1
2
2
= N (d1 ) +
ed1 /2 e(r +ln S/X) ed2 /2
2
= N (d1 )

(6.24)

The delta for a call is always positive as N (d 1 ) > 0, which is easy to understand
because an increase in the asset price will increase the probability of a positive
terminal payoff. Using the put-call parity, the delta for a put is obtained as
p =
1

p
=
(c + Xer S) = N (d1 ) 1
S
S

(6.25)

A delta can be defined for any derivative as the rate of change of its price with respect to

the price of the underlying asset.

CHAPTER 6. ONE-ASSET EUROPEAN OPTIONS

69

which is always negative.

Deltas are closely related to the Black-Scholes analysis. We recall that Black
and Scholes formed a risk-neutral portfolio by shorting 1 option and longing
number of shares.
Properties
1. Call and put deltas are functions of S and so the delta hedging is timedependent. The investors position remains delta hedged for only a relatively short period of time.
2. The delta for a call is an increasing function of S as N (d 1 )/S is positive.
3. 0 < c < 1

6.3.1

Elasticity with respect to asset price

The elasticity, e, for a derivative is defined as

e=

f S
.
S f

(6.26)

The elasticity gives the measure of the percentage change in derivative price for
a unit percentage change in the asset price. For a call option, using Eqs.(6.10)
and (6.24) we find that
ec =

SN (d1 )
> 1.
SN (d1 ) Xer N (d2 )

(6.27)

This implies that a call option is riskier in percentage change than the underlying
asset. The elasticity is very high when the asset price is small (out-of-the-money)
and it decreases monotonically with the increase of the asset price. At a large S,
the elasticity tends asymptotically to one because c S as S .
For a put option, the elasticity is
ep =

p S
S p

which can be less than or greater than one.

(6.28)

CHAPTER 6. ONE-ASSET EUROPEAN OPTIONS

70

Theta
X
S

Figure 6.1: Variation of the theta for a European call option with respect to asset
price S. The asymtotic value K = rXe r .

6.4

Theta

The theta, , of a derivative security is the rate of change of the value of the
derivative with regard to time: =

f
t .

The theta for a call is

c
c
=
t

S
2
d1
X
2
d2
= ed1 /2
rXer N (d2 ) + er d2 /2

2
2
S d2 /2
=
e 1 rXer N (d2 ) < 0
2 2

c =

(6.29)

The negativity of c shows that as the time to maturity decreases, the option
tends to become less valuable. The time value decreases as time goes. The absolute value of the theta is greatest when the call option is at-the-money because
the option may become in-the-money or out-of-the-money at an instant later.
The absolute value of the theta is small when the option is sufficiently out-of-themoney because it will be quite unlikely for the option to become in-the-money at
a later time.

CHAPTER 6. ONE-ASSET EUROPEAN OPTIONS

71

The theta for a put is

2

p
c
Sed1 /2
p =
=
+ rXer =
+ rXer N (d2 ).

2
2

(6.30)

When the put is deep in-the-money, the theta is positive and the put value grows
as the time to expiration is lengthened. When the put is at-the-money or out-ofthe-money, the theta is negative.

6.5

Gamma

The gamma, , of the value of a derivative security is defined as the rate of change
of the delta with respect to the underlying asset S:
=

2f
S 2

(6.31)

The call and put options have the same gamma value
2

c = p =

ed1 /2

>0
S 2

(6.32)

The positivity explains why the curves of the option price functions against the
asset price are always concave upward.
large: is highly sensitive to the price of the underlying asset.
small: changes slowly with asset price so adjustments required to keep
a portfolio delta neutral can be made less frequently.
Using the definitions of , and , respectively, in Eqs.(6.23), (6.29) and
(6.31), the Black-Scholes equation (6.1) can be written as
1
+ rS + 2 S 2 = rc
2
1 2 2
+ S = r.
2

(6.33)

When = 0, the relation becomes

1
+ 2 S 2 = rc
2

(6.34)

CHAPTER 6. ONE-ASSET EUROPEAN OPTIONS

72

which shows that when is positive, tends to be negative and vice versa.
Using the Taylor series expansion,
d =

1 2 2
2
dS +
dt +
dS +
dSdt +
2
S
t
2 S
St

(6.35)

where, assuming -hedging,

c
=
= 0.
S
S

(6.36)

Taking dt small, we ignore that dt2 and higher terms. Thus the Taylor series
(6.35) becomes
1
d = dt + dS 2
2

(6.37)

is positive for a call and tends to be negative. The value of the portfolio
decreases if there is no change in S and vice versa.
When is negative for a put, tends to be positive. The value of the
portfolio increases if there is no change in S and vice versa.

6.6

Vega and Rho

Vega
In the derivation of the Black-Scholes equation, the volatility of the underlying
asset is assumed constant. In reality, however, the volatility changes over time.
The vega, V, is defined as the rate of change of the value of the derivative security
with respect to the volatility of the underlying asset. For a call and a put,
2

c
Sed1 /2 d1 Xer d2 /2 d2

=
Vc =

2
2

2
Sed1 /2 > 0
2

(6.38)

and
p
c

=
+
(Xer S) = Vc .
(6.39)

A European option (call or put) becomes more valuable with increasing volatility
Vp =

because of a chance for the option to end up in deep in-the-money. Of course,

there is a high chance for the option to end up in deep out-of-the-money. In this
case, the option is not exercised and the holder does not lose extra money.

CHAPTER 6. ONE-ASSET EUROPEAN OPTIONS

73

Rho
The rho, , is the rate of change of the value of the derivative security with
respect to the interest rate. The rhos of a call and a put are
2

Sed1 /2 d1
Xer d2 /2 d2
c

=
+ Xer N (d2 )
r
r
2 r
2
r
= Xe N (d2 ) > 0 for r > 0 and X > 0

c =

(6.40)

and
p =

p
= Xer N (d2 ) < 0
r

for r > 0 and X > 0.

(6.41)

The positiveness of the rho for a call means that a higher interest rate increases
the value of the call option. The negativeness of the rho for a put means that a
higher interest rate decreases the value of the put option.

6.7
6.7.1

Implied volatility
Newton-Raphson method

To plot the volatility smile we have to find the volatility as a function of moneyness. The option pricing formula (6.10) obtained by Black and Scholes is a
complicated function which cannot easily be inverted to a function (S t , X, r, T
t, c or p). In such the case, we first predict a value for the volatility. We find
the price of an option by substituting the predicted volatility into Eq.(6.10) and
compare it with the market price. If their difference can be tolerated, the predicted volatility is accepted as the market volatility. Otherwise, we have to
predict another volatility and repeat the procedure till the market option price
and the calculated option price are within the tolerable error range. In this type
of recursive method, how to correct the predicted values is an important point.
Two methods for recursive algorithm are commonly used: Bisection method
and Newton-Raphson method. The bisection method is simple and easy to understand but it takes long time to complete the procedure. The Newton-Raphson

CHAPTER 6. ONE-ASSET EUROPEAN OPTIONS

74

method is relatively difficult to understand but the result is obtained after a few
recursion.
The Newton-Raphson method requires the exact forms of functions c() and
its derivative c0 (). We sketch how to find the root 0 which gives the call value
c(0 ) in the market using the Newton-Raphson method.
1. Guess the behaviour of the function c() and select a reasonably accurate
value and call it the first trial value 1 .
2. Find the call price for 1 as substituting 1 into Eq.(6.10).
3. Compare c(0 ) and c(1 ). If they are not within the tolerable error range,
then we select the next trial volatility 2 as follows
2 =

c(0 ) c(1 )
+ 1 .
c0 (1 )

(6.42)

4. Compare c(0 ) and c(2 ). If the error cannot be tolerated, repeat the
procedure till we find i which gives c(i ) within the tolerable error range
of the market value c(0 ).
Why is the Newton-Raphson method powerful? To answer this question, let
us consider the Taylor expansion of c( 0 ) around 1 :
c(0 ) = c(1 ) + c0 (1 )(0 1 ) +

1 00
c (1 )(0 1 )2 + .
2!

(6.43)

To have the recursive method work, the second trial error 2 0 should be
smaller than the first trial error 1 0 . With use of Eq.(6.43) in Eq.(6.42), we
find that
2 0 =

1
1 00
c (1 )(0 1 )2 +
0
c (1 ) 2!


(6.44)

which shows that the Newton-Raphson method converges quadratically. Near

a root, the number of significant digits approximately doubles with each step.
This very strong convergence property makes Newton-Raphson the method of
choice for any function whose derivative can be evaluated efficiently, and whose

CHAPTER 6. ONE-ASSET EUROPEAN OPTIONS

75

derivative is continuous in the neighbourhood of a root. The first derivative of

the Black-Scholes call price with regard to the volatility is
1 2
1 2
1
c
ln(S/X) 1
ln(S/X) 1
X

= Se 2 d1
T + erT e 2 d2
T
+
+

2
2
2
2
2 T
2 T
(6.45)

which is continuous. In fact, the first-order derivative determines its tangential

line at a point. The first-order derivative of the call price with regard to the
volatility is the so-called vega of the option. 2

6.7.2

Volatility smile

Using the Newton-Raphson method, the implied volatility of each option contract
can computed. If the volatility is plotted against moneyness of the option, the
curve is typically convex in shape rather than a straight horizontal line as suggested by the simple Black-Scholes model. This is commonly called the volatility
smile which is shown in Fig.6.7.2

Black-Scholes assume that the volatility is constant but it varies with time. The option

price changes with the volatility as well as with time or with the underlying asset price. The
larger the volatility, the greater the option price is. This is similar to the time value of the
option, in other words, the option is more expensive as the time to mature is longer and the
volatility is larger. The volatility and the time to mature complement each other. This can be
seen in the Black-Scholes formula (5.4) where the volatility and the time to mature always go
together. The vega is to measure the change of the option price for the change of volatility. If
the vega is large, the option price is very sensitive to the change of the volatility. If the vega is
small a change in the volatility does not affect the option price much. The vega of a put option
is the same as the vega of a call option.

CHAPTER 6. ONE-ASSET EUROPEAN OPTIONS

Volatility

Moneyness

Figure 6.2: A typical volatility smile.

76