Diffusion and Black-Scholes Pricing Formula Wikipedia
Diffusion and Black-Scholes Pricing Formula Wikipedia
Diffusion and Black-Scholes Pricing Formula Wikipedia
Black–Scholes 1
Black–Scholes
The Black–Scholes model (pronounced English pronunciation: /ˌblæk ˈʃoʊlz/[1] ) is a mathematical description of
financial markets and derivative investment instruments. The model develops partial differential equations whose
solution, the Black–Scholes formula, is widely used in the pricing of European-style options.
The model was first articulated by Fischer Black and Myron Scholes in their 1973 paper, "The Pricing of Options
and Corporate Liabilities." The foundation for their research relied on work developed by scholars such as Jack L.
Treynor, Paul Samuelson, A. James Boness, Sheen T. Kassouf, and Edward O. Thorp.[2] The fundamental insight of
Black–Scholes is that the option is implicitly priced if the stock is traded. Robert C. Merton was the first to publish a
paper expanding the mathematical understanding of the options pricing model and coined the term Black–Scholes
options pricing model.
Merton and Scholes received the 1997 Nobel Prize in Economics (The Sveriges Riksbank Prize in Economic
Sciences in Memory of Alfred Nobel) for their work. Though ineligible for the prize because of his death in 1995,
Black was mentioned as a contributor by the Swedish academy.[3]
Model assumptions
The Black–Scholes model of the market for a particular equity makes the following explicit assumptions:
• It is possible to borrow and lend cash at a known constant risk-free interest rate.
• The stock price follows a geometric Brownian motion with constant drift and volatility.
• There are no transaction costs, taxes or bid-ask spread.
• The underlying security does not pay a dividend.[4]
• All securities are infinitely divisible (i.e., it is possible to buy any fraction of a share).
• There are no restrictions on short selling.
• There is no arbitrage opportunity.
From these conditions in the market for an equity (and for an option on the equity), the authors show that "it is
possible to create a hedged position, consisting of a long position in the stock and a short position in [calls on the
same stock], whose value will not depend on the price of the stock."[5]
Several of these assumptions of the original model have been removed in subsequent extensions of the model.
Modern versions account for changing interest rates (Merton, 1976), transaction costs and taxes (Ingersoll, 1976),
and dividend payout (Merton, 1973).
Notation
Let
, be the price of the stock (please note as below).
, the price of a derivative as a function of time and stock price.
the price of a European call option and the price of a European put option.
, the strike of the option.
, the annualized risk-free interest rate, continuously compounded.
, the drift rate of , annualized.
, the volatility of the stock's returns; this is the square root of the quadratic variation of the stock's log price
process.
, a time in years; we generally use: now=0, expiry=T.
, the value of a portfolio.
Black–Scholes 2
Mathematical model
Per the model assumptions above, we assume that the price of the
underlying asset (typically a stock) follows a geometric Brownian
motion. That is,
where is Brownian—the term here stands in for any and all sources of uncertainty in the price history of
the stock.
The payoff of an option at maturity is known. To find its value at an earlier time we need to know how
evolves as a function of and . By Itō's lemma for two variables we have
Now consider a trading strategy under which one holds a single option and continuously trades in the stock to hold
shares. At time , the value of these holdings will be
The composition of this portfolio, called the delta-hedge portfolio, will vary from time-step to time-step. Let
denote the accumulated profit or loss from following this strategy. Then over the time period , the
instantaneous profit or loss is
This equation contains no term. That is, it is entirely riskless (delta neutral). Black and Scholes reason that
under their ideal conditions, the rate of return on this portfolio must be equal at all times to the rate of return on any
other riskless instrument; otherwise, there would be opportunities for arbitrage. Now assuming the risk-free rate of
return is we must have over the time period
Black–Scholes 3
If we now substitute in for and identify left and right hand side of the equation we obtain the celebrated
Black–Scholes second order partial differential equation (PDE):
With the assumptions of the Black–Scholes model, this second order partial differential equation holds whenever
is twice differentiable with respect to and once with respect to .
Other derivations
Above we used the method of arbitrage-free pricing ("delta-hedging") to derive some PDE governing option prices
given the Black–Scholes model. It is also possible to use a risk-neutrality argument. This latter method gives the
price as the expectation of the option payoff under a particular probability measure, called the risk-neutral measure,
which differs from the real world measure.
Black–Scholes formula
The Black Scholes formula calculates the price of European put and
call options. It can be obtained by solving the Black–Scholes partial
differential equation.
The value of a call option for a non-dividend paying underlying stock
in terms of the Black–Scholes parameters is:
Also,
Interpretation
The terms are the probabilities of the option expiring in-the-money under the equivalent
exponential martingale probability measure (numéraire=stock) and the equivalent martingale probability measure
(numéraire=risk free asset), respectively. The equivalent martingale probability measure is also called the
risk-neutral probability measure. Note that both of these are probabilities in a measure theoretic sense, and neither of
these is the true probability of expiring in-the-money under the real probability measure. To calculate the probability
under the real ("physical") probability measure, additional information is required—the drift term in the physical
measure, or equivalently, the market price of risk.
Derivation
We now show how to get from the general Black–Scholes PDE to a specific valuation for an option. Consider as an
example the Black–Scholes price of a call option, for which the PDE above has boundary conditions
The last condition gives the value of the option at the time that the option matures. The solution of the PDE gives the
value of the option at any earlier time, . To solve the PDE we transform the equation into a
diffusion equation which may be solved using standard methods. To this end we introduce the change-of-variable
transformation
where
Reverting to the original set of variables yields the above stated solution to the Black–Scholes equation.
Black–Scholes 5
Greeks
The Greeks under Black–Scholes are given in closed form, below:
delta
gamma
vega
theta
rho
Note that the gamma and vega formulas are the same for calls and puts. This can be seen directly from put-call
parity.
In practice, some sensitivities are usually quoted in scaled-down terms, to match the scale of likely changes in the
parameters. For example, rho is often reported divided by 10,000 (1bp rate change), vega by 100 (1 vol point
change), and theta by 365 or 252 (1 day decay based on either calendar days or trading days per year).
where now
Therefore,
Black–Scholes 6
Exactly the same formula is used to price options on foreign exchange rates, except that now q plays the role of the
foreign risk-free interest rate and S is the spot exchange rate. This is the Garman-Kohlhagen model (1983).
where now
Black–Scholes in practice
The Black–Scholes model disagrees with reality in a number of ways,
some significant. It is widely employed as a useful approximation, but
proper application requires understanding its limitations – blindly
following the model exposes the user to unexpected risk.
Among the most significant limitations are:
• the underestimation of extreme moves, yielding tail risk, which can
be hedged with out-of-the-money options;
• the assumption of instant, cost-less trading, yielding liquidity risk,
which is difficult to hedge;
• the assumption of a stationary process, yielding volatility risk,
which can be hedged with volatility hedging;
• the assumption of continuous time and continuous trading, yielding
gap risk, which can be hedged with Gamma hedging.
In short, while in the Black–Scholes model one can perfectly hedge
options by simply Delta hedging, in practice there are many other
The normality assumption of the Black–Scholes
sources of risk.
model does not capture extreme movements such
Results using the Black–Scholes model differ from real world prices as stock market crashes.
Nevertheless, Black–Scholes pricing is widely used in practice,[6] for it is easy to calculate and explicitly models the
relationship of all the variables. It is a useful approximation, particularly when analyzing the directionality that
Black–Scholes 7
prices move when crossing critical points. It is used both as a quoting convention and a basis for more refined
models. Although volatility is not constant, results from the model are often useful in practice and helpful in setting
up hedges in the correct proportions to minimize risk. Even when the results are not completely accurate, they serve
as a first approximation to which adjustments can be made.
One reason for the popularity of the Black–Scholes model is that it is robust in that it can be adjusted to deal with
some of its failures. Rather than considering some parameters (such as volatility or interest rates) as constant, one
considers them as variables, and thus added sources of risk. This is reflected in the Greeks (the change in option
value for a change in these parameters, or equivalently the partial derivatives with respect to these variables), and
hedging these Greeks mitigates the risk caused by the non-constant nature of these parameters. Other defects cannot
be mitigated by modifying the model, however, notably tail risk and liquidity risk, and these are instead managed
outside the model, chiefly by minimizing these risks and by stress testing.
Additionally, rather than assuming a volatility a priori and computing prices from it, one can use the model to solve
for volatility, which gives the implied volatility of an option at given prices, durations and exercise prices. Solving
for volatility over a given set of durations and strike prices one can construct an implied volatility surface. In this
application of the Black–Scholes model, a coordinate transformation from the price domain to the volatility domain
is obtained. Rather than quoting option prices in terms of dollars per unit (which are hard to compare across strikes
and tenors), option prices can thus be quoted in terms of implied volatility, which leads to trading of volatility in
option markets.
is a normal random variable with mean and variance . It follows that the mean of is
If then
Now let
and use the corollary to the lemma to verify the statement above about the mean of . Define
Remarks on notation
The reader is warned of the inconsistent notation that appears in this article. Thus the letter is used as:
(1) a constant denoting the current price of the stock
(2) a real variable denoting the price at an arbitrary time
(3) a random variable denoting the price at maturity
(4) a stochastic process denoting the price at an arbitrary time
It is also used in the meaning of (4) with a subscript denoting time, but here the subscript is merely a mnemonic.
In the partial derivatives, the letters in the numerators and denominators are, of course, real variables, and the partial
derivatives themselves are, initially, real functions of real variables. But after the substitution of a stochastic process
for one of the arguments they become stochastic processes.
The Black–Scholes PDE is, initially, a statement about the stochastic process , but when is reinterpreted as a
real variable, it becomes an ordinary PDE. It is only then that we can ask about its solution.
The parameter that appears in the discrete-dividend model and the elementary derivation is not the same as the
parameter that appears elsewhere in the article. For the relationship between them see Geometric Brownian
motion.
Black–Scholes 10
Criticism
Espen Gaarder Haug and Nassim Nicholas Taleb argue that the Black–Scholes model merely recast existing widely
used models in terms of practically impossible "dynamic hedging" rather than "risk," to make them more compatible
with mainstream neoclassical economic theory.[8]
Jean-Philippe Bouchaud argues: 'Reliance on models based on incorrect axioms has clear and large effects. The
Black–Scholes model[9] , for example, which was invented in 1973 to price options, is still used extensively. But it
assumes that the probability of extreme price changes is negligible, when in reality, stock prices are much jerkier
than this. Twenty years ago, unwarranted use of the model spiralled into the worldwide October 1987 crash; the Dow
Jones index dropped 23% in a single day, dwarfing recent market hiccups.
Notes
[1] http:/ / www. merriam-webster. com/ dictionary/ scholes
[2] Nassim Taleb and Espen Gaarder Haug: "Why We Have Never Used the Black-Scholes-Merton Option Pricing Formula" link (http:/ / papers.
ssrn. com/ sol3/ papers. cfm?abstract_id=1012075)
[3] Nobel prize foundation, 1997 Press release (http:/ / nobelprize. org/ nobel_prizes/ economics/ laureates/ 1997/ press. html)
[4] Although the original model assumed no dividends, trivial extensions to the model can accommodate a continuous dividend yield factor.
[5] Black, Fischer;. "The Pricing of Options and Corporate Liabilities". Journal of Political Economy 81 (3): 637–654.
[6] http:/ / www. wilmott. com/ blogs/ paul/ index. cfm/ 2008/ 4/ 29/ Science-in-Finance-IX-In-defence-of-Black-Scholes-and-Merton
[7] R Rebonato: Volatility and correlation in the pricing of equity, FX and interest-rate options (1999)
[8] http:/ / papers. ssrn. com/ sol3/ papers. cfm?abstract_id=1012075
[9] Jean-Philippe Bouchaud (Capital Fund Management, physic professor at École Polytechnique): Economics needs a scientific revolution,
NATURE|Vol 455|30 Oct 2008 OPINION ESSAY p. 1181
References
Primary references
• Black, Fischer; Myron Scholes (1973). "The Pricing of Options and Corporate Liabilities". Journal of Political
Economy 81 (3): 637–654. doi:10.1086/260062. (http://links.jstor.org/sici?sici=0022-3808(197305/
06)81:3<637:TPOOAC>2.0.CO;2-P) (Black and Scholes' original paper.)
• Merton, Robert C. (1973). "Theory of Rational Option Pricing" (http://jstor.org/stable/3003143). Bell Journal
of Economics and Management Science (The RAND Corporation) 4 (1): 141–183. doi:10.2307/3003143. (http://
links.jstor.org/sici?sici=0005-8556(197321)4:1<141:TOROP>2.0.CO;2-0&origin=repec)
• Hull, John C. (1997). Options, Futures, and Other Derivatives. Prentice Hall. ISBN 0-13-601589-1.
Further reading
• Haug, E. G (2007). "Option Pricing and Hedging from Theory to Practice". Derivatives: Models on Models.
Wiley. ISBN 9780470013229. The book gives a series of historical references supporting the theory that option
traders use much more robust hedging and pricing principles than the Black, Scholes and Merton model.
• Triana, Pablo (2009). Lecturing Birds on Flying: Can Mathematical Theories Destroy the Financial Markets?.
Wiley. ISBN 9780470406755. The book takes a critical look at the Black, Scholes and Merton model.
External links
Computer implementations
• Black–Scholes in Multiple Languages (http://www.espenhaug.com/black_scholes.html), espenhaug.com
Historical
• Trillion Dollar Bet (http://www.pbs.org/wgbh/nova/stockmarket/)—Companion Web site to a Nova episode
originally broadcast on February 8, 2000. "The film tells the fascinating story of the invention of the Black-Scholes
Formula, a mathematical Holy Grail that forever altered the world of finance and earned its creators the 1997
Nobel Prize in Economics."
• BBC Horizon (http://www.bbc.co.uk/science/horizon/1999/midas.shtml) A TV-programme on the so-called
Midas formula and the bankruptcy of Long-Term Capital Management (LTCM)
Article Sources and Contributors 13
License
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