ECO4108Z Futures, Options, Derivatives

Practice Question 9- Black Scholes
Question 1
The volatility of a stock price is 30% per annum. What is the standard deviation of the percentage
price change in one trading day?
The standard deviation of the percentage price change in time ∆t is σ ∆t where σ is the
volatility. In this problem σ = 0.3 and, assuming 252 trading days in one year, ∆t = 1 / 252 = 0.004
so that σ ∆t = 0.3 0.004 = 0.019 or 1.9%.
Question 2
Calculate the price of a three-month European put option on a non-dividend-paying stock with a strike
price of R50 when the current stock price is R50, the risk-free interest rate is 10% per annum, and the
volatility is 30% per annum.
In this case S0 = 50 , K = 50 , r = 0.1 , σ = 0.3 , T = 0.25 , and
ln(50 / 50) + (0.1 + 0.09 / 2)0.25

d1 = = 0.2417
0.3 0.25
d 2 = d1 − 0.3 0.25 = 0.0917
The European put price is
50 N (−0.0917)e −0.1×0.25 − 50 N (−0.2417)
= 50 × 0.4634e −0.1×0.25 − 50 × 0.4045 = 2.37

or R2.37.
Question 3
What is the price of a European call option on a non-dividend-paying stock when the stock price is
R52, the strike price is R50, the risk-free interest rate is 12% per annum, the volatility is 30% per
annum, and the time to maturity is three months?
In this case S0 = 52 , K = 50 , r = 0.12 , σ = 0.30 and T = 0.25 .
ln(52 / 50) + (0.12 + 0.32 / 2)0.25

d1 = = 0.5365
0.30 0.25
d 2 = d1 − 0.30 0.25 = 0.3865
The price of the European call is
52 N (0.5365) − 50e −0.12×0.25 N (0.3865)

= 52 × 0.7042 − 50e −0.03 × 0.6504
= 5.06
or R5.06.
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Multiple Choice
1. When the Black-Scholes-Merton and binomial tree models are used to value an option on a
non-dividend-paying stock, which of the following is true?
A. The binomial tree price converges to a price slightly above the Black-Scholes-Merton
price as the number of time steps is increased
B. The binomial tree price converges to a price slightly below the Black-Scholes-Merton
price as the number of time steps is increased
C. Either A or B can be true
D. The binomial tree price converges to the Black-Scholes-Merton price as the number
of time steps is increased
Answer: D
The binomial tree valuation method and the Black-Scholes-Merton formula are based on
the same set of assumptions. As the number of time steps is increased the answer given by
the binomial tree approach converges to the answer given by the Black-Scholes-Merton
formula.
2. When the non-dividend paying stock price is R20, the strike price is R20, the risk-free rate is
6%, the volatility is 20% and the time to maturity is 3 months which of the following is the
price of a European call option on the stock
A. 20N(0.1)-19.7N(0.2)
B. 20N(0.2)-19.7N(0.1)
C. 19.7N(0.2)-20N(0.1)
D. 19.7N(0.1)-20N(0.2)
Answer: B
The formula for the option price is

S 0 N (d 1 ) − Ke − rT N (d 2 )
ln(S 0 / K ) + (r + σ 2 / 2)T
d1 = and d 2 = d 1 − σ T
σ T
In this case S0 =K=20, r=0.06, =0.2, and T=0.25 so that Ke-rT=20e-0.06×0.25=19.7. Also
d1 = [ln(1)+(0.06+0.04/2)×0.25]/(0.2×0.5) =0.2 and d2=0.2 – 0.2×0.5=0.1.
B is therefore the correct answer.
3. When the non-dividend paying stock price is R20, the strike price is R20, the risk-free rate is
6%, the volatility is 20% and the time to maturity is 3 months which of the following is the
price of a European put option on the stock
A. 19.7N(-0.1)-20N(-0.2)
B. 20N(-0.1)-20N(-0.2)
C. 19.7N(-0.2)-20N(-0.1)
D. 20N(-0.2)-20N(-0.1)
Answer: A
The formula for the option price is

Ke − rT N (−d 2 ) − S 0 N (−d 1 )
ln(S 0 / K ) + (r + σ 2 / 2)T
d1 = and d 2 = d1 − σ T
σ T
In this case S0 = K =20, r = 0.06, =0.2, and T=0.25 so that Ke-rT=20e-0.06×0.25=19.7.
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Also
d1 = [ln(1)+(0.06+0.04/2)×0.25]/(0.2×0.5) =0.2 and d2=0.2 – 0.2×0.5=0.1.
A is therefore the correct answer.
4. A stock price is 20, 22, 19, 21, 24, and 24 on six successive Fridays. Which of the following
is closest to the volatility per annum estimated from this data?
A. 50%
B. 60%
C. 70%
D. 80%
Answer: D
The price relative for the first week is 22/20 or 1.1. The natural log of the price relative is
ln(1.1) or 0.09531. Similarly the ln of the price relatives for the other weeks are -0.1466,
0.1001, 0.1335, and 0. The standard deviation of 0.09531, -0.1466, 0.1001, 0.1335, and 0
is 0.1138. The volatility per week is therefore 11.38%. This corresponds to a volatility per
year of 0.1138 multiplied by the square root of 52 or about 82%. The answer is therefore
D.
NB: Normally in an exam you will be given the number of days per annum, as this
affects your final answer
5. The volatility of a stock is 18% per year. Which is closest to the volatility per month?
A. 1.5%
B. 3.0%
C. 5.2%
D. 6.3%
Answer: C
The volatility per month is the volatility per year multiplied by the square root of 1/12 .
The square root of 1/12 is 0.2887 and 18% multiplied by this is 5.2%.
6. A call option on a stock has a delta of 0.3. A trader has sold 1,000 options. What position
should the trader take to hedge the position?
A. Sell 300 shares
B. Buy 300 shares
C. Sell 700 shares
D. Buy 700 shares
Answer: B
When the stock price increases by a small amount, the option price increases by 30% of this
amount. The trader therefore has a hedged position if he or she buys 300 shares. For small
changes the gain or loss on the stock position is equal and opposite to the loss or gain on the
option position.
7. What does theta measure?

A. The rate of change of delta with the asset price
B. The rate of change of the portfolio value with the passage of time
C. The sensitivity of a portfolio value to interest rate changes
D. None of the above
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Answer: B
Theta measures the rate of change in the value of a portfolio with the passage of time.
8. Which of the following is true of a volatility smile?

A. Implied volatility is on the horizontal axis and strike price is on the vertical axis
B. Historical volatility is on the horizontal axis and strike price is on the vertical axis
C. Implied volatility is on the vertical axis and strike price is on the horizontal axis
D. Historical volatility is on the vertical axis and strike price is on the horizontal axis
Answer: C
A volatility smile shows implied volatility (which is on the vertical axis) as a function of the
strike price (which is on the horizontal axis).
9. Which of the following is true?

A. Volatility smile for European puts is the same as for European calls
B. Volatility smile for European puts is the same as for American puts
C. Volatility smile for European calls is the same as for American calls
D. Volatility smile for American puts is the same as for American calls
Answer: A
Put call parity shows that the volatility smile for European puts should be exactly the same as
that for European calls. The volatility smile for American options is usually close to but not
exactly the same as that for European options.
10. Which of the following is NOT true?

A. A volatility surface provides more information than a single volatility smile
B. A volatility surface is used to determine the implied volatility of an option that does
not trade actively
C. A volatility surface can be determined from a single volatility smile using
interpolation
D. A volatility surface incorporates information about options with different maturity
dates
Answer: C
A volatility surface requires a knowledge of how implied volatilities vary with option
maturity. C is therefore not true.
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Practice Question 9- Black Scholes

ln(50 / 50) + (0.1 + 0.09 / 2)0.25

50 N (−0.0917)e −0.1×0.25 − 50 N (−0.2417)

= 50 × 0.4634e −0.1×0.25 − 50 × 0.4045 = 2.37

In this case S0 = 52 , K = 50 , r = 0.12 , σ = 0.30 and T = 0.25 .

ln(52 / 50) + (0.12 + 0.32 / 2)0.25

52 N (0.5365) − 50e −0.12×0.25 N (0.3865)

The formula for the option price is

The formula for the option price is

7. What does theta measure?

8. Which of the following is true of a volatility smile?

9. Which of the following is true?

10. Which of the following is NOT true?

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