Financial Engineering & Risk Management

MFIM 7111

Tamirat Temesgen (PhD)

Addis Ababa University

School of Comerce

November 14, 2023

 Table of Contents

1 The Black-Scholes-Merton Model

Lognormal Property of Stock Prices
The Distribution of the rate of return
The Expected Return
The Volatility
The Idea Underlying The Black-Scholes-Merton Differential
Equation
The Derivation of the Black-Scholes-Merton Differential Equations
Risk-Neutral Valuation
Black-Scholes-Merton Pricing Formulas
Options on Stock Indices and Currencies
Options on Assets Providing a Known Yield
Valuation of European Stock Index Options
Valuation of European Currency Options
The Black-Scholes-Merton Model

The Stock Price Assumption

Consider a stock whose price is S

In a short period of time of length ∆t, the return on the stock is
normally distributed:
∆S
∼ ϕ µ∆t, σ 2 ∆t


S
where µ is expected return and σ is volatility
The Black-Scholes-Merton Model
Lognormal Property of Stock Prices

The Log-normal Property

Recall that the log of a stock price G = ln S satisfies the stochastic

differential equation,

σ2
 
dG = d ln S = µ − dt + σdW
2

It follows that
σ2
  
2
ln ST − ln S0 ∼ ϕ µ− T, σ T
2
or
σ2
   
2
ln ST ∼ ϕ ln S0 + µ − T, σ T
2
Since the logarithm of ST is normal, ST is lognormally distributed
The Black-Scholes-Merton Model
Lognormal Property of Stock Prices

µ : Expected return in a short period of time (annualized)

σ : Volatility of the stock price.
 
σ2
The mean of ln ST is ln S0 + µ − 2 T
√
the standard deviation of ln ST is σ T .
The Black-Scholes-Merton Model
Lognormal Property of Stock Prices

Remark 1
Recall the 68 − 95 − 99.7 rule:

P(µ − 1σ ≤ X ≤ µ + 1σ) ≈ 68.27%

P(µ − 2σ ≤ X ≤ µ + 2σ) ≈ 95.45%
P(µ − 3σ ≤ X ≤ µ + 3σ) ≈ 99.73%
P(µ − 1.96σ ≤ X ≤ µ + 1.96σ) ≈ 95%
The Black-Scholes-Merton Model
Lognormal Property of Stock Prices

For the case X = ln ST , with 95% confidence level,

σ2 √ σ2 √
   
ln S0 + µ − T −1.96σ T ≤ ln ST ≤ ln S0 + µ − T +1.96σ T
2 2
or  2
 √  2
 √
ln S0 + µ− σ2 T −1.96σ T ln S0 + µ− σ2 T +1.96σ T
e ≤ ST ≤ e
The Black-Scholes-Merton Model
Lognormal Property of Stock Prices

Example 1
Consider a stock with:
initial price, S0 = $40,
expected return µ = 0.16 per annum,
volatility σ = 20% per annum
Then the probability distribution of the stock price ST in 6 months’ time
T = 0.5 is given by

ln ST ∼ ϕ[ln 40 + (0.16 − 0.22 /2) × 0.5, 0.22 × 0.5]

ln ST ∼ ϕ(3.759, 0.002)

with 95% confidence,

e3.759−1.96×0.141 ≤ ST ≤ e3.759+1.96×0.141

or
32.55 ≤ ST ≤ 56.56
The Black-Scholes-Merton Model
Lognormal Property of Stock Prices

The Lognormal Distribution

0.25

0.20

0.15

0.10

0.05

0 2 4 6 8 10

E(ST ) = S0 eµT
2
Var(ST ) = S02 e2µT (eσ T
− 1)
The Black-Scholes-Merton Model
Lognormal Property of Stock Prices

Example 2
Consider a stock where:
Current price S0 = $20
Expected return µ = 20% per annum
Volatility σ = 40% per annum.
Find the expected stock price, and the variance of the stock price, in 1
year
The Black-Scholes-Merton Model
The Distribution of the rate of return

Continuously Compounded Return

If x is the realized continuously compounded return between 0 and T ,
then

ST = S0 exT
1 ST
x = ln
T S
 0 2 2
σ σ
x∼ϕ µ− ,
2 T

Remark 2
the continuously compounded rate of return per annum is normally
2
distributed with mean µ − σ2 and standard deviation √σT
T → ∞ =⇒ standard deviation of x declines. i.e, we are more
certain about the average return over long period of time.
The Black-Scholes-Merton Model
The Expected Return

The Expected Return

The expected value of the stock price is E(ST ) = S0 eµT .

σ2
The expected return on the stock is µ − 2 not µ.
This is because ln[E( SST0 )] and E[ln( SST0 )] are not the same. What is
the fault on the following arguments:

E(ST ) = S0 eµT (1)

ln(E(ST )) = ln(S0 ) + µT (2)
ln(E(ST )) − E(ln(S0 )) = µT (3)
E(ln((ST )) − E(ln(S0 )) = µT (4)
1 ST
E( ln( )) = µ (5)
T S0

which leads to E(x) = µ (wrong!)

The Black-Scholes-Merton Model
The Expected Return

σ2
µ and µ − 2

µ is the expected return in a very short time, ∆t, expressed with a

compounding frequency of ∆t.
2
µ − σ2 is the expected return in a long period of time expressed with
continuous compounding.
The Black-Scholes-Merton Model
The Volatility

The Volatility

The volatility is the standard deviation of the continuously

compounded rate of return in 1 year
The standard deviation
√ of the return in a short time period time ∆t
is approximately σ ∆t

Example 3
If a stock price is $50 and its volatility is 25% per year what is the
standard deviation of the price change in one day?
The Black-Scholes-Merton Model
The Volatility

Estimating Volatility form Historical Data

1 Take observations S0 , S1 , . . . , Sn at intervals of τ years (e.g. for

1
weakly data τ = 52 )
2 Calculate the continuously compounded return in each intervals as:
 
Si
ui = ln
Si−1
3 Calculate the standard deviation, s, of the u′i s
4 The historical volatility estimate is: σ̂ = √s
τ
The Black-Scholes-Merton Model
The Volatility

Nature of Volatility

Volatility is usually much greater when the market is open (i.e. the
asset is trading) than when it is closed
For this reason time is usually measured in “trading days” not
calendar days when options are valued
It is assumed that there are 252 trading days in one year for most
assets
The Black-Scholes-Merton Model
The Volatility

Example 4
Suppose it is April 1 and an option lasts to April 30 so that the
number of days remaining is 30 calendar days or 22 trading days
The time to maturity would be assumed to be 22/252 = 0.0873
years
The Black-Scholes-Merton Model
The Idea Underlying The Black-Scholes-Merton Differential Equation

The Concepts Underlying Black-Scholes-Merton

The option price and the stock price depend on the same underlying
source of uncertainty
We can form a portfolio consisting of the stock and the option
which eliminates this source of uncertainty
The portfolio is instantaneously riskless and must instantaneously
earn the risk-free rate
This leads to the Black-Scholes-Merton differential equation
The Black-Scholes-Merton Model
The Idea Underlying The Black-Scholes-Merton Differential Equation

Assumptions

The assumptions we use to derive the BSM differential equations are as

follows:
1 The stock price follows the process, dS = µSdt + σSdW
2 The short selling of securities with full use of proceeds is permitted.
3 There are no transaction cost or taxes. All securities are perfectly
divisible.
4 There are no dividends during the life of the derivative.
5 There are no riskless arbitrage opportunities.
6 Security trading is continuous.
7 The risk-free rate of interest, r, is constant and the same for all
maturities.
The Black-Scholes-Merton Model
The Derivation of the Black-Scholes-Merton Differential Equations

The Derivation of the BSM Differential Equations

The stock price process

dS = µSdt + σSdW,

in discrete form,
∆S = µS∆t + σS∆W (6)
Let f = f (S, t) be the price of a call option or other derivative
contingent on S, then applying Ito’s formula and the discrete version
gives,

1 ∂2f 2 2
 
∂f ∂f ∂f
∆f = µS + + σ S ∆t + σS∆W (7)
∂S ∂t 2 ∂S 2 ∂S
The Black-Scholes-Merton Model
The Derivation of the Black-Scholes-Merton Differential Equations

We set up a portfolio consisting of

−1 : derivative
∂f
+ : shares
∂S
This gets rid of the dependence on ∆W.
The value of the portfolio, Π, is given by
∂f
Π = −f + S (8)
∂S
The change in its value in time ∆t is given by
∂f
∆Π = −∆f + ∆S (9)
∂S
The Black-Scholes-Merton Model
The Derivation of the Black-Scholes-Merton Differential Equations

... Cont’d

Substituting equations (6) and (7) into equation (9) gives,

1 ∂2f 2 2
 
∂f
∆Π = − − σ S ∆t (10)
∂t 2 ∂S 2

The return on the portfolio must be the risk-free rate. Hence

∆Π = rΠ∆t (11)

Substituting from equation (8) and (10) into (11), we obtain the
Black-Scholes differential equation:

∂f ∂f 1 ∂2f
+ rS + σ 2 S 2 2 = rf (12)
∂t ∂S 2 ∂S
The Black-Scholes-Merton Model
The Derivation of the Black-Scholes-Merton Differential Equations

The Differential Equation

Any security whose price is dependent on the stock price satisfies the
differential equation.
The particular security being valued is determined by the boundary
conditions of the differential equation
In the case of a European call option, the key boundary conditions is,

f = max(S − K, 0), when t = T

In the case of a European put option, it is

f = max(K − S, 0), when t = T

The Black-Scholes-Merton Model
The Derivation of the Black-Scholes-Merton Differential Equations

Example 5
A forward contract on a non-dividend paying stock is a derivative
dependent on the stock. It should satisfy equation (12). In a forward
contract the boundary condition is f = S–K when t = T . We know
that the the value of the forward contract is

f = S–Ke–r(T –t)

where K is the delivery price. This means that

∂f ∂f ∂2f
= −rKe−r(T −t) , = 1, =0
∂t ∂S ∂S 2
When these are substituted into the left-hand side of equation (12), we
obtain
−rKe−r(T −t) + rS
This equals rf , showing that equation (12) is indeed satisfied.
The Black-Scholes-Merton Model
Risk-Neutral Valuation

Risk-Neutral Valuation

The variable µ does not appear in the Black-Scholes-Merton

differential equation
The equation is independent of all variables affected by risk
preference
The solution to the differential equation is therefore the same in a
risk-free world as it is in the real world
This leads to the principle of risk-neutral valuation
The Black-Scholes-Merton Model
Risk-Neutral Valuation

Applying Risk-Neutral Valuation

1 Assume that the expected return from the stock price is the risk-free
rate
2 Calculate the expected payoff form the option
3 Discount at the risk-free rate
The Black-Scholes-Merton Model
Risk-Neutral Valuation

Valuing a Forward Contract with Risk-Neutral Valuation

Payoff is ST − K
The value of the forward contract at time zero is

f = e−rT Ê(ST − K) = e−rT Ê(ST ) − Ke−rT

where Ê denotes the expected value in a risk-neutral world

The expected return µ on the stock becomes r in a risk-neutral
world.
Hence Ê(ST ) = S0 erT
Present value of exacted payoff is

e−rT [S0 erT − K] = S0 − Ke−rT

The Black-Scholes-Merton Model
Black-Scholes-Merton Pricing Formulas

The BSM Formulas of Options

Solutions of the differential equation (12) are Black-Scholes-Merton

formulas for the prices of European call and put options:

c = S0 N (d1 ) − Ke−rT N (d2 )

p = Ke−rT N (−d2 ) − S0 N (−d1 )

where
ln(S0 /K) + (r + σ 2 /2)T
d1 = √
σ T
ln(S0 /K) + (r − σ 2 /2)T √
d2 = √ = d1 − σ T
σ T
The Black-Scholes-Merton Model
Black-Scholes-Merton Pricing Formulas

The N (x) Function

N (x) is the probability that a normally distributed variable with a

mean of zero and a standard deviation of 1 is less than x.
Normal Distrib tion PDF with Area Shaded
0.40

0.35

0.30

0.25
PDF

0.20

0.15

0.10

0.05
PDF
0.00 Area nder PDF (-4 to 1)
−4 −3 −2 −1 0 1 2 3 4
X
The Black-Scholes-Merton Model
Black-Scholes-Merton Pricing Formulas

Understanding N (d1 ) and N (d2 )

c = e−rT N (d2 ) S0 erT N (d1 )/N (d2 ) − K

 

e−rT : Present value factor

N (d2 ) : Is the probability that a call option will be exercised in a
risk-neutral world
S0 erT N (d1 )/N (d2 ) : Expected stock price in a risk-neutral world if
options is exercised .
K : Strike price paid if option is exercised
The Black-Scholes-Merton Model
Black-Scholes-Merton Pricing Formulas

Properties of Black-Scholes Formula

As S0 becomes very large c tends to S0 − Ke−rT and p tends to zero

As S0 becomes very small c tends to zero and p tends to
Ke−rT − S0
What happen as σ becomes very large?
What happen as T becomes very large?
The Black-Scholes-Merton Model
Black-Scholes-Merton Pricing Formulas

The differential equation (12) gives the call and put prices at a general
time t.

c(t) = SN (d1 ) − Ke−r(T −t) N (d2 )

p(t) = Ke−r(T −t) N (−d2 ) − SN (−d1 )

where
ln(S/K) + (r + σ 2 /2)(T − t)
d1 = √
σ T −t
ln(S/K) + (r − σ 2 /2)(T − t) √
d2 = √ = d1 − σ T − t
σ T −t
The Black-Scholes-Merton Model
Black-Scholes-Merton Pricing Formulas

Proving BSM Using Risk-Neutral Valuation

Z ∞
c = e−rT max(ST − K, 0)g(ST )dST
K

where g(ST ) is the probability density function for the lognormal

distribution of ST in a risk-neutral world. ln ST is ϕ(m, s2 ) where
√
m = ln S0 + (r − σ 2 /2)T s = σ T

We substitute
ln ST − m
A=
s
so that
Z∞
−rT
c=e max(eQs+m − K, 0)h(Q)dQ
(ln K−m)/s

where h is the probability density function for a standard normal

Evaluating the integral leads to the BSM result.
The Black-Scholes-Merton Model
Options on Stock Indices and Currencies

Index Options

Option contracts based on a benchmark index.

No actual stocks are bought or sold.
The most popular underlying indices in the U.S are:
the S&P 100 Index (OEX and XEO),
the S&P 500 Index (SPX),
the Dow Jones Index (DJX) and
the Nasdaq 100 Index (NDX).
Most of the contracts are European. An exception is the OEX
contract on the S&P 100, which is American.
One contact is usually to buy or sell 100 times the index at the
specified strike price.
The Black-Scholes-Merton Model
Options on Stock Indices and Currencies

Example 6
Consider a call option on an index with a strike price of 880
Suppose 1 contract is exercised when the index level is 900
What is the payoff?
(900 − 880) × 100 = 2, 000
The Black-Scholes-Merton Model
Options on Stock Indices and Currencies

Currency Options

Currency options trade on NASDAQ OMX in US.

There also exists a very active over-the-counter (OTC) market.
Currency options are used by corporations to buy insurance when
they have an FX exposure.

Example 7
An a European call option is a contract that gives the holder the right to
buy on million euros with U.S dollars at an exchange rate of 1.1000 U.S
dollars per euro. If the actual exchange rate at the maturity of the option
is 1.1500, the payoff is

1, 000, 000 × (1.1500 − 1.1000) = $50, 000

The Black-Scholes-Merton Model
Options on Assets Providing a Known Yield

Options on Assets Providing a Known Yield

If, with a dividend yield of q, the stock price grows from S0 to ST ,

then in the absence of dividends it would grows form S0 to S0 eqT .
Alternatively, in the absence of dividends it would grow form S0 e−qT
to ST
We get the same probability distribution for the asset price at time
T in each of the following two cases:
1 The stock starts at price S0 and provides a dividend yield at a rate q.
2 The stock starts at price S0 e–qT and provides no dividends.
Rule: When valuing a European options lasting for time T on a
stock paying a known dividend yield at rate q, we reduce the current
stock price from S0 to S0 e–qT and value the option as though the
stock pays no dividends.
The Black-Scholes-Merton Model
Options on Assets Providing a Known Yield

Put-Call Parity

The put-call parity for on option on a stock paying a dividend yield at

rate q:
c + Ke−rT = p + S0 e−qT . (13)
The Black-Scholes-Merton Model
Options on Assets Providing a Known Yield

Pricing Formulas
By replacing S0 by S0 e−qT in the BSM formulas, we obtain the prices,

c = S0 e−qT N (d1 ) − Ke−rT N (d2 ) (14)

−rT −qT
p = Ke N (−d2 ) − S0 e N (−d1 ). (15)

Since,
S0 e−qT S0
= ln ln− qT,
K K
it follows that d1 and d2 are given by

ln(S0 /K) + (r − q + σ 2 /2)T

d1 = √
σ T
ln(S0 /K) + (r − q − σ 2 /2)T √
d2 = √ = d1 − σ T .
σ T
The Black-Scholes-Merton Model
Options on Assets Providing a Known Yield

Differential Equation and Risk-Neutral Valuation

The results in equations (14) and (15) are also the analytical
solution for the following differential equation obtained when
including the dividend yield q in the BS differential equation (12),

∂f ∂f 1 ∂2f
+ (r − q)S + σ 2 S 2 2 = rf (16)
∂t ∂S 2 ∂S
In a risk-neutral world, the total return form the stock must be r.
The dividends provide a return of q.
The expecte growth rate in the stock price must therefore be r − q
It follows that the risk-neutral process for the stock price is

dS = (r − q)Sdt + σSdW
The Black-Scholes-Merton Model
Valuation of European Stock Index Options

Example 8
Consider a European call option on an index that is two months from
maturity. The current value of the index is 930, the exercise price is 900,
the risk-free interest rate is 8% per annum, and the volatility of the index
is 20% per annum. Dividend yield of 0.2% and 0.3% (expressed with
continuous compounding) are expected in the first month and the second
month, respectively. In this case S0 = 930, K = 900, r = 0.08, σ = 0.2,
and T = 2/12. The total dividend yield during the option’s life is
0.2% + 0.3% = 0.5%. This corresponds to 3% per annum. Hence,
q = 0.03 and
The Black-Scholes-Merton Model
Valuation of European Stock Index Options

ln( 930 2
900 ) + (0.08 − 0.03 + 0.2 /2) × 2/12
d1 = p = 0.5444
0.2 2/12
d2 = 0.4628

N (d1 ) = 0.7069, N (d2 ) = 0.6782

so the call price, c, is

c = 930 × 0.7069e−0.03×2/12 − 900 × 0.6782e−0.03×2/12 = 51.83

One contract, if on 100 times the index, would cost $5, 183.
The Black-Scholes-Merton Model
Valuation of European Currency Options

Valuation of European Currency Options

To value currency option, we define S0 as the spot exchange rate.

A foreign currency is analogous to a stock paying a known dividend
yield.
The owner of foreign currency receives a yield equal to the risk-free
interest rate rf , in the foreign currency.
Replacing q with rf , provides the put-call parity for European
currency options:

c + Ke−rT = p + S0 e−rf T , (17)

The Black-Scholes-Merton Model
Valuation of European Currency Options

the pricing formulas for European currency options,

c = S0 e−rf T N (d1 ) − Ke−rT N (d2 ) (18)

−rT −rf T
p = Ke N (−d2 ) − S0 e N (−d1 ) (19)

where
ln(S0 /K) + (r − rf + σ 2 /2)T
d1 = √
σ T
ln(S0 /K) + (r − rf − σ 2 /2)T √
d2 = √ = d1 − σ T
σ T
Both the domestic interest rate, r, and the foreign interest rate, rf , are
the rate for a maturity T
The Black-Scholes-Merton Model
Valuation of European Currency Options

Using Forward Exchange Rates

Since banks and other financial institutions trade forward contracts on
foreign exchange rates actively, forward exchange rates are often used for
valuing options. The forward exchange rate, F0 , for maturity T is given
by
F0 = S0 e(r−rf )T
This relationship allows equation (18) and (19) to be simplified to

c = e−rT [F0 N (d1 ) − KN (d2 )] (20)

−rT
p=e [KN (−d2 ) − F0 N (−d1 )] (21)

where
ln(F0 /K) + σ 2 T /2
d1 = √
σ T
ln(F0 /K) + −σ 2 T /2 √
d2 = √ = d1 − σ T
σ T
The Black-Scholes-Merton Model
Valuation of European Currency Options

Remark 3
A European option on the spot price of any asset can be valued in terms
of the price of a forward or futures contract on the asset using the
equations (20) and (21). The maturity of the forward or the futures
contract must be the same as the maturity of the European option.
For further reading: (Hull, 2021, Chapter 15, 17)
Choe, G. H. et al. (2016). Stochastic analysis for finance with
simulations. Springer.
Hull, J. C. (2021). Options futures and other derivatives. Pearson
Education India.