Modification of Black-Scholes Model: 7.1 Dividend

Download as pdf or txt
Download as pdf or txt
You are on page 1of 9

CHAPTER 7.

MODIFICATION OF BLACK-SCHOLES MODEL

78

Chapter 7

Modification of Black-Scholes
model
7.1
7.1.1

Dividend
Continuous dividend yield model

Let q denote the constant continuous dividend yield which is known.1 In other
words, the holder receives a dividend, qSdt, within the time interval dt. The share
value is lowered after the dividend payout so that the expected rate of return
of a share becomes q by the continuous dividend yield q. The geometric
Brownian motion model becomes
dS
= ( q)dt + dZ
S
1

(7.1)

The continuous yield model is extremely useful to options on foreign currencies where the

continuous dividend yield can be considered as the yield due to the interest earned by the foreign
currency at the foreign interest rate rf . In the pricing model for a foreign currency call option,
we can simply set q = rf . S is the domestic currency price of a unit of foreign currency and the
exchange rate is assumed to follow the lognormal diffusion process. The model in this section
applied to the currency option, assumes that both the domestic and foreign interest rates are
constant.

CHAPTER 7. MODIFICATION OF BLACK-SCHOLES MODEL

79

By having number of the share, a share holder gains a dividend, (qdt)S. The
value of a portfolio
1
+

call option
underlying shares

is = c + S. The differential of the value of the portfolio is


d = dc + dS + qSdt
=

c 2 2 c
c
S 2 2 + qS dt +
t
2
S
S


dS

(7.2)

where Eq.(5.1) has been used.


The portfolio becomes non-stochastic by choosing =

c
S .

The portfolio is

then risk-free and should earn the risk-free interest rate, r. Thus
d =

c
c 2 2 c
S 2 2 + qS
t
2
S
S

c
dt = r c + S
S


dt

(7.3)

By rearranging the equation above, we have the modified form of the BlackScholes equation:
c 2 2 2 c
c
+ S
+ (r q)S
rc = 0
2
t
2
S
S

(7.4)

Solving the equation, we find the call value


c = Seq N (d1 ) Xer N (d2 ),

(7.5)

where = T t is the remaining time to mature and


ln S + (r q +

d1 = X

2
2 )

, d2 = d1

(7.6)

Similarly, the value of a put option is


p = Xer N (d2 ) Seq N (d1 ).

(7.7)

The put call parity can be derived using Eqs.(7.5) and (7.7),
p = c Seq + Xer ,

(7.8)

and the following put-call symmetry relation,


c(S, ; X, r, q) = p(X, ; S, q, r).

(7.9)

CHAPTER 7. MODIFICATION OF BLACK-SCHOLES MODEL

7.1.2

80

Discrete dividend

Suppose the underlying asset pays N discrete dividends at known payments dates
t1 , t2 , , tN of amounts D1 , D2 , , DN , respectively. If the actual amounts of
dividends and ex-dividend dates are known then we can assume that the asset
price is composed of two components:
risk-free component that will be used to pay the known dividends during
the life of the option.
risky component which follows a stochastic process.
The risk-free component is taken to be the present value of all future dividends
discounted at the risk-free interest rate. The value of the risky component St is
St = St D1 er1 D2 er2 DN erN for t < t1
St = St D2 er2 DN erN for t1 < t < t2

St = St

for t > tN

(7.10)

where i = ti t. The volatility of the risky component is customarily taken as


the volatility of the whole asset price multiplied by the factor St /(St D), where
D is the present value of the future discrete dividends.

7.2

Time dependent parameters

The parameters, , r, q, are normally time-dependent. Suppose these parameters


are known functions of time, Eq.(7.4) becomes
c
2 ( ) 2 2 c
c
=
S
+ [r( ) q( )]S
r( )c, = T t.
2

2
S
S

(7.11)

81

CHAPTER 7. MODIFICATION OF BLACK-SCHOLES MODEL


R

Introducing a new parameter, y = ln S, Eq.(7.11) is for w = exp[


"

w
2 ( ) 2 w
2 ( ) w
=
+
r(
)

q(
)

2 y 2
2
y

r( )d ]c,
(7.12)

Its fundamental solution is

{y +
1
(y, ) = q R
exp
2
2 0 (u)du

[r(u) q(u)
R
2 0 2 (u)du

2 (u)
2
2 ]du}

(7.13)

The solution of Eq.(7.12)is

w(y, ) =

w(, 0)(y , )d

(7.14)

which gives the call value




c = SN (d1 ) exp

q(u)du XN (d2 ) exp

r(u)du

(7.15)

where
d1 =

1
qR

d2 = d1

7.3

2 (u)du
sZ

S
ln
+
X

"

2 (u)
r(u) q(u) +
du
2

2 (u)du.

(7.16)

Transaction costs

There have been continual efforts to construct hedging strategies that best replicate the payoffs of derivative securities in the presence of transaction costs. The
transaction cost occurs in buying and selling. Suppose that the transaction cost
is proportional to the amount of money involved in the transaction and the rate
of proportion is k2 . For buying (+) or selling (-) of || shares at the price S, the
transaction cost is k2 ||S.

Let us consider a portfolio of number of shares and B dollars in a risk-free


account whose value is
= S + B

(7.17)

CHAPTER 7. MODIFICATION OF BLACK-SCHOLES MODEL

82

Let , S, be the change in , S and in time t, respectively. From


Eq.(7.17)
k
= S + rt B ||S,
2

(7.18)

Let f (S, t) denote the value of the option which is replicated by the above portfolio, i.e., f = . Using Itos lemma,
f
f =
S +
S

f
2 2 f
+ S2 2
t
2
S

t.

(7.19)

Because f = , f = . From Eqs.(7.18) and (7.19),


=
k
rBt ||S =
2

f
S
!
f
2 2 2f
+ S
t.
t
2
S 2

(7.20)
(7.21)

Using Eq.(7.20) and the fact f = S + B, we get


B=f
Leland2 found that

where Le =

q 
2

f
S.
S

(7.22)

2f
k
2


S||
Le S 2 2 t,
S
2
2

(7.23)

is called the Leland number.

Using Eqs.(7.22) and (7.23), Eq.(7.21) is written as


2f
f
2 2f
2
f


+ S 2 2 + Le S 2 2 + rS
rf = 0
S
t
2
S
2
S

(7.24)

which can be rearranged as follows

2 2f
f
+ S 2 2 + rS
rf = 0,
t
2
S
S

(7.25)

with the modified volatility,

2 = 2 [1 + Le sign()] , =
2

2f
S 2

(7.26)

H.E. Leland, Option pricing and replication with transaction costs, Journal of Finance,

vol. 40 (1985) p.1283-p.1301

CHAPTER 7. MODIFICATION OF BLACK-SCHOLES MODEL

83

This form resembles the Black-Scholes equation.


Eq.(7.26) can be a problem because the modified volatility
2 can become
negative when < 0 and Le > 1. However, as we discussed earlier, is positive
for a simple European call and put options. Assuming
2 positive, we can solve
Eq.(7.26) as we solve the Black-Scholes equation with the modified volatility
.

7.4

Futures options

Options of futures contracts are traded on many different exchanges, as some


examples are shown in Table 7.1. The futures options require the delivery of an
underlying futures contract when exercised.
If a call futures option is exercised, the holder acquires
a long position in the underlying futures contract + cash
( = current futures price - strike price)
If a put futures option is exercised, the holder acquires
a short position in the underlying futures contract + cash
( = strike price - current futures price)
Example
The strike price of an April futures call option on 1,000 tones of copper is
1, 200 per ton. On the expiration date (say, March) of the option, the spot
copper futures price is 1, 300 per ton. The holder of the call option then receives 100, 000(= 1, 000 (1, 300 1, 200)) plus a long position in a futures
contract to buy 1,000 tonnes of copper on the April delivery date.
The maturity date of the options contract is generally on or a few days before
the earliest delivery date of the underlying futures contract.

Why are futures options popular?

84

CHAPTER 7. MODIFICATION OF BLACK-SCHOLES MODEL

Table 7.1: Some examples of futures options.

(NYMEX: New York Mercantile Exchange, LME:

London Metal Exchange, CME: Chicago Mercantile Exchange.)

Futures options

Exchanges

Treasury-bond futures

CBOT

Crude oil futures

NYMEX

Copper futures

LME

Cattle live futures

CME

For most commodities, it is more convenient to deliver futures contract on


the asset rather than the asset itself. Example: crude oil.
In most circumstances, the underlying futures contract is closed out prior
to delivery. Futures options are therefore settled in cash, which particularly appeals to investors with limited capital because less amount of initial
capital is needed.
Futures options facilitate hedging, arbitrage and speculation, which makes
the markets more efficient.
Transaction costs for futures options are normally smaller than those for
spot options.

7.4.1

Black equation for futures option

The time-dependence of a futures price is the same as that of the underlying asset.
Thus we suppose the futures price F follows the geometric Brownian motion:
dF
= F dt + F dZ
F

(7.27)

where F and F are, respectively, the constant expected rate of return and the
constant volatility, and dZ is the standard Wiener process. By Itos lemma, the
volatility of the futures price is given by
F =

1
F

S
= Ser =
F
S
F

(7.28)

CHAPTER 7. MODIFICATION OF BLACK-SCHOLES MODEL

85

where is the volatility for the underlying asset. From Itos lemma,
df =

f
f
1 2f 2 2
f
F F +
+
F dt +
F dZ
2
F
t
2 F
F

(7.29)

where f is the value of the derivative. For the case of a call option f = c and for
the case of a put option f = p.
Consider a portfolio composed of
1
f
+
F

derivative
number of futures contracts

The value, , of the portfolio is


= f,

(7.30)

at the opening of the contract because it costs nothing to enter into a futures
contract. Let d, df and dF be their changes of , f and F in time dt. In time
dt, the holder of the portfolio earns capital gains equal to df from the derivative
and income of

f
F dF

from the futures contract. The change, d, of the wealth

of the portfolio in time dt is


d =

f
dF df
F

(7.31)

Substituting Eqs.(7.27) and (7.29) into Eq.(7.31) we find the change in wealth
!

f
1 2f 2 2
d =

F dt
t
2 F 2

(7.32)

which is non-stochastic and risk-free. Therefore the portfolio should give the
risk-free rate of return, r:
d = rdt.

(7.33)

We find the Black equation for futures derivatives by using Eqs.(7.30), (7.32) and
(7.33):
f
1 2f 2 2
+
F = rf.
t
2 F 2
This has the same form as Eq.(7.4) with q = r.

(7.34)

CHAPTER 7. MODIFICATION OF BLACK-SCHOLES MODEL

86

By solving the Black equation (7.34) for futures call and put options, we obtain
c = er [F N (d1 ) XN (d2 )]
p = er [XN (d2 ) F N (d1 )]
where
1
d1 =

F
2
ln
+
X
2

, d2 = d1 .

(7.35)

(7.36)

We can easily derive the following put-call parity.


p + F er = c + Xer .

(7.37)

You might also like