STA 4186 L.

Ni

Chapter 12 The Black-Scholes Formula

12.1 Introduction
When computing a binomial option price, we can vary the number of binomial steps, hold-
ing fixed the time to expiration, which leads to different price. However, as the number of
steps approach to infinity, the price converges to limit, which is given by the Black-Scholes
formula. See Table 12.1 for an illustration.

Call options

C(S, K, σ, r, T, δ) = Se−δT N (d1 ) − Ke−rT N (d2 ),

where
ln(S/K) + (r − δ + σ 2 /2)T
d1 = √ ;
σ T
√
d2 = d1 − σ T .
N (x) is the cumulative normal distribution function. Example 12.1 shows one example.

Put options

P (S, K, σ, r, T, δ) = Ke−rT N (−d2 ) − Se−δT N (−d1 ).

Note: P = C + Ke−rT − Se−δT parity holds. Example 12.2 shows one example.

When is the Black-Scholes formula valid?

assumptions about the distribution of the stock price:
(1) continuously compounded returns on the stock are normally distributed and independent
over time (no jump!)
(2) volatility of the return is known and constant.
(3) future dividends are known, either as dollar amount or fixed dividend yield.
assumptions about the economic environment
(1) risk-free rate is known and constant.
(2) no transaction costs or taxes.
(3) possible to short-sell costlessly and to borrow at risk-free rate.

12.2 Applying the formula to other assets

We can rewrite
ln(Se−δT /Ke−rT ) + σ 2 T /2
d1 = √ .
σ T
Notice that the prepaid forward price for the stock and strike assets are
P
F0,T (S) = Se−δT ; F0,T
P
(K) = Ke−rT .

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We
√ can write the Black-Scholes formula entirely in terms of prepaid forward price and
σ T:
P
C(F0,T P
(S), F0,T P
(K), σ, T ) = F0,T (S)N (d1 ) − F0,T
P
(K)N (d2 )
P
ln[F0,T P
(S)/F0,T (K)] + 12 σ 2 T
d1 = √
σ T
√
d2 = d1 − σ T

where δ and r do not appear explicitly rather they are implicitly incorporated into the pre-
paid forward prices. To price options on underlying assets other assets other than stocks,
we can use above equation.

Options on stocks with discrete dividends

P
F0,T (S) = S0 − P V0,T (Div).
Example 12.3 shows an example.
Options on currencies
replace the dividend rate δ with the foreign interest rate rf . If the current spot price is x (in
domestic currency per unit of foreign currency) and F0,T P
(x) = xe−rf T . the Black-Scholes
formula (Garman-Kohlhagen model) becomes

C(x, K, σ, r, T, rf ) = xe−rf T N (d1 ) − Ke−rT N (d2 ),

√ √
where d1 = [ln(x/K) + (r − rf + σ 2 /2)T ]/(σ T ) and d2 = d1 − σ T . We also have the
parity
P = C + Ke−rT − xe−rf T .
Options on futures
the prepaid forward price for a futures contract is just eh present value of the futures price
with risk free rate.

C(F, K, σ, r, T, r) = F e−rT N (d1 ) − Ke−rT N (d2 ),

√ √
where d1 = [ln(F/K) + σ 2 T /2]/(σ T ) and d2 = d1 − σ T .

P = C + Ke−rT − F e−rf T .

12.3 Option Greeks

Definitions:
Delta (∆) measures the option price change when the stock price increases by $1. i.e. the
first derivative w.r.t S.
Gamma (Γ) measures the change in Delta when the stock price increases by $1. i.e. the
second derivative w.r.t S.

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Vega measures the option price change when there is an increase in volatility of one per-
centage point i.e. the first derivative w.r.t σ.
Theta (θ) measures the option price change when there is a decrease in the time to maturity
of 1 day, i.e. the first derivative w.r.t t.
Rho (ρ) measures the option price change when there is an increase in the interest rate of 1
percentage point (100 basis point), i.e. the first derivative w.r.t r.
Psi (Ψ) measures the option price change when there is an increase in the continuous divi-
dend yield of 1 percentage point (100 basis point), i.e. the first derivative w.r.t δ.

Delta
share-equivalent of the option. Figure 12.1 shows the behavior of the delta for calls. The
deeper in-the-money an option is, the higher the Delta is. As the time to expiration in-
creases, Delta is less at high stock prices and greater at low stock prices, i.e. the curve is
more flat.

Gamma
Gamma is always positive for a purchased call or put (convexity). Because of put-call par-
ity, gamma is the same for a European call and put with the same strike price and time to
expiration.

Vega
an increase in volatility raises the price of a call or put option. Vega is nonnegative. Be-
cause of put-call parity, vega, like gamma, is the same for calls and puts with same strikes
and maturities. common to express vega as the change in option price for a one percentage
point (0.01) change in volatility.

Theta
Options generally–but not always– become less valuable as time to expiration decreases.

Rho
Rho is positive for an ordinary stock call option, and is negative for a put.
Psi
Psi is negative for an ordinary stock call option and positive for puts.
Greek measures for portfolios
The Greek measure of∑ a portfolio is the sum of the Greeks of the individual portfolio com-
ponents. ∆portf olio = ni=1 ωi ∆i .

Option Elasticity
Option elasticity tells us the risk of the option relative to the stock in percentage terms: if
the stock price change by 1%, what is the percentage change in the value of the option?

Dollar risk of the option Suppose the stock price change by ϵ, see Example 12.7.

change in option price = change in stock price × option delta = ϵ × ∆.

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Percentage risk of the option

% change in option price ϵ∆/C S∆

Ω= = = .
% change in stock price ϵ/S C

For a call Ω ≥ 1, a call option is replicated by a levered investment in the stock. For a put,
Ω ≤ 0, replicating position for a put option involves shorting the stock. See Example 12.8.

Volatility of an option the volatility of an option is the elasticity times the volatility of the
stock: σoption = σstock × |Ω|.

Risk premium of an option at a point in time, the option is equivalent to a position in the
stock and in bonds; hence, the return on the option is a weighted average of the return on
the stock and the risk-free rate. Let α denote the expected rate of return on the stock, γ the
expected return on the option. we have
∆S ∆S
γ= α + (1 − )r = Ωα + (1 − Ω)r.
C(S) C(S)

In other words, γ −r = (α−r)×Ω, the risk premium on the option equals the risk premium
on the stock times Ω.

If the stock has a positive risk premium, then a call always has an expected return at
least as great as the stock (Ω ≥ 1) and that, other things equal, the expected return on an
option goes down as the stock price goes up (Ω decreasing as S goes up, see Figure 12.11).
The puts always has an expected return less than that of the stock (Ω negative).

α−r
Sharpe ratio of an option the ratio of the risk premium to volatility σ
. For a call,

Ω(α − r) α−r
Sharpe ratio f or call = = ,
|Ω|σ σ

the Sharpe ratio for a call equals the Sharpe ratio for the underlying stock.

Elasticity and risk premium of a portfolio the elasticity of a portfolio is the weighted
average of those of the portfolio components. Suppose there is a portfolio of n different
calls on the same underlying
∑n stock with ni units of ith call, which has value Ci and delta
∑ωi = ni Ci / j=1 nj Cj be the fraction of the portfolio invested in the ith call,
∆i . Let
where nj=1 nj Cj is the
∑ portfolio’s value. For $1 change in the stock price, the change in
the portfolio value is ni ∆i . The elasticity
∑ ∑
ni ∆i / nj Cj ∑ ni Ci S∆i ∑
n n
Ωportf olio = = (∑ ) = ωi Ω i .
1/S i=1
nj Cj Ci i=1

Therefore, the risk premium of the portfolio, γ − r = Ωportf olio (α − r).

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12.4 Profit diagrams before maturity

Purchased call option Table 12.3 shows the Black-Scholes value of a call option for five
different prices at four different time to expiration. Figure 12.12 shows the option premium
and Figure 12.13 shows the profit by holding for a certain period time.

In all cases, the slope of the call option graph is positive (a positive delta). In addition,
the slope becomes greater as the stock price increases (a positive gamma), i.e. the option
price is convex.

Calendar spreads the straddle, strangle, and butterfly spreads discussed in Chapter 3 are
options with the same time to expiration and different strikes. To speculate on volatility you
could also enter into a calendar spread, in which options you buy and sell have different
expiration dates. For example, if you speculate the XYZ stock will be unchanged over the
next 3 months. You may sell a 40-strike call with 91 days to expiration and buy a 40-strike
call with one year to expiration. See Figure 12.14. Connected with Figure 12.6 of theta
(i.e. 1st derivative w.r.t to t) around the $40, the 91-day call is more negative than for the
1-year call. Thus, if the stock price does not change over the course of 1 day, the position
will make money since the written option loses more value than the purchased option.