Derivatives Assignment: Submitted By: Yash Ahuja Roll No-22 Pgdm-Finance

DERIVATIVES
ASSIGNMENT
“OPTION PRICING- BLACK-SCHOLES MODEL”
Submitted By:
Yash Ahuja
Roll no-22
PGDM-
Finance
Introduction
The Black-Scholes model and the Binomial model are the primary options pricing models Both
models are based on the same theoretical foundations and assumptions (such as the geometric
Brownian motion theory of stock price behavior and risk-neutral valuation). However, there are
also some important differences between the two models and these are highlighted below.
The Black-Scholes Model
The Black-Scholes model is used to calculate a theoretical call price (ignoring dividends paid
during the life of the option) using the five key determinants of an option's price: stock price,
strike price, volatility, time to expiration, and short-term (risk free) interest rate.
The original formula for calculating the theoretical option price (OP) is as follows:
Where:
The variables are:
S = stock price
X = strike price
t = time remaining until expiration, expressed as a percent of a year
r = current continuously compounded risk-free interest rate
v = annual volatility of stock price (the standard deviation of the short-term returns over one
year).
ln = natural logarithm
N(x) = standard normal cumulative distribution function
e = the exponential function
Example:
Calculate the value of a call option and put option for the following contract:
Stock Price (S) = 100
Exercise Price (K) = 105
Risk-free, continuously compounded interest Rate (r) = 0.10 (10%)
Time to expiration (T-t) = 3 month = 0.25 years
Standard deviation (s) = 0.30 per year
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. This
restriction has been removed in later extensions of the model.
 The price follows a Geometric Brownian motion with constant drift and volatility. It
follows from this that the return is a Normal distribution (Then the underlying is a Log-
normal distribution). This often implies the validity of the efficient-market hypothesis.
 There are no transaction costs or taxes.
 The stock does not pay a dividend
 All securities are perfectly 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.
 Options use the European exercise terms, which dictate that options may only be
exercised on the day of expiration.
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.
Several of these assumptions of the original model have been removed in subsequent extensions
of the model. Modern versions account for changing interest rates transaction costs and taxes
and dividend payout.
Advantages & Limitations
Advantage: The main advantage of the Black-Scholes model is speed -- it lets you calculate a
very large number of option prices in a very short time.
Limitation: The Black-Scholes model has one major limitation: it cannot be used to accurately
price options with an American-style exercise as it only calculates the option price at one point
in time --at expiration. It does not consider the steps along the way where there could be the
possibility of early exercise of an American option.
As all exchange traded equity options have American-style exercise (ie they can be exercised at
any time as opposed to European options which can only be exercised at expiration) this is a
significant limitation.
The exception to this is an American call on a non-dividend paying asset. In this case the call is
always worth the same as its European equivalent as there is never any advantage in exercising
early.
Various adjustments are sometimes made to the Black-Scholes price to enable it to approximate
American option prices (eg the Fischer Black Pseudo-American method) but these only work
well within certain limits and they don't really work well for puts.

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DERIVATIVES

“OPTION PRICING- BLACK-SCHOLES MODEL”

The Black-Scholes Model

The variables are:

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