The Black-Scholes Option Pricing Model (BSOPM)

This Teaching Note supplements textbook Chapter 16

LEARNING OBJECTIVES CHAPTER OUTLINE

1. Study the Black-Scholes assumptions 15.1 BSOPM Assumptions
2. How to use the Black-Scholes call model 15.2 Valuing a Call Option
3. Analyze the component parts 15.3 Intrinsic Values & Time Values
4. Learn the Black-Scholes put model 15.4 Pricing Put Options
5. Research the underlying common factors 15.5 The Determinants of Put & Call Premiums
6. Discover an implicit relationship 15.6 Put-Call Parity
7. Consider summary and concluding remarks 15.7 The Bottom Line

In 1973 Fischer Black and Myron Scholes created the Nobel Prize winning Black-Scholes option

pricing model (BSOPM).1 The BSOPM includes a few complex equations. The function f in Eqn.(1)

characterizes the general form of the formula for the value of a call option, denoted C.

𝐶 = 𝑓(𝑠, 𝜎 2 , 𝑟, 𝒙, 𝑻) f represents the BSOPM for calls (1)

Table 1 defines five variables the BSOPM uses to explain call and put prices, and provides

hypothetical numbers that are used in computational examples below. Those not familiar with the

BSOPM are often surprised to see that the expected return of the underlying asset is not an

explanatory variable in Table 1.

TABLE 1 - Five Determinants of the Premiums (or Prices) for Put and Call Options
1. Price of underlying asset. The market price of an optioned share of stock, s = $60.
2. Variance of returns from the underlying asset, a measure of the stock’s riskiness; 𝜎 2 = .144.
3. The riskless (invariant) rate of interest, r = 7% = .07;
4. Exercise (Striking, Contract) price of a put or call option, x = $50 per share.
5. Fraction of year until the option expires, T = Four months = 0.3333 of one year

1 Fischer Black and Myron Scholes, “The Pricing of Options and Corporate Liabilities,” Journal of
Political Economy, May-June 1973, pages 637-659.

The Black-Scholes Option Pricing Model (BSOPM) – Page 1

The exercise price, x, and the fraction of year (time) until expiration, T, are bold-face type in

Eqns.(1) and (2) to emphasize that these two variables do not fluctuate like 𝑠, 𝜎 2 , and 𝑟. The values

of x and T never change during the option’s life.

The function g in Eqn.(2) represents the BSOPM formula for valuing put options, P.

𝑃 = 𝑔(𝑠, 𝜎 2 , 𝑟, 𝒙, 𝑻) g represents the BSOPM for puts (2)

Eqns.(1) and (2) employ the same five explanatory variables, but the functions f and g differ.

In 1979 John C. Cox, Steve A. Ross, and Mark Rubinstein (CRR) showed that a simple binomial

process can compute the prices of puts and calls.2 When the CRR binomial model is iterated over a

large number of time periods it converges to the BSOPM continuous time model. Thus, the BSOPM is

a special limiting case of the simpler CRR binomial model. This paper focuses on computing option

prices with the BSOPM and put-call parity.

Eqn.(3) defines a put-call parity equation that provides a simpler way to determine the cost of a

call (C) than solving the more complex Eqn.(1).

𝐶 = ℎ(𝑃, 𝑠, 𝑥, 𝑟) h represents the put-call parity formula for calls (3)

Eqn.(4) is another way to define put-call parity which sometimes provides a simpler way to

determine the price of a put (P) than solving the more complex Eqn.(2).

𝑃 = 𝑗(𝐶𝐶, , 𝑥, 𝑟) j represents the put-call parity formula for puts (4)

A put-call parity line is defined and illustrated later in this chapter, after the BSOPM is discussed.

1 BSOPM ASSUMPTIONS

2 John C. Cox, Steve A. Ross, and Mark Rubinstein (1979). "Option Pricing: A Simplified Approach,"
Journal of Financial Economics, Vol. 7, No. 3, pages 229-263.

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The BSOPM is based on four econometric assumptions.

A. The market price of the underlying asset (eg, stock prices) is lognormally distributed (as
illustrated in Figure 1A). This means the price of the underlying asset ranges from zero to positive
infinity.
B. The percentage changes in the market price (eg, holding period return, or HPR) of the underlying
asset over a short period of time are normally distributed (as illustrated in Figure 1B).
C. For simplicity, it is assumed that the underlying asset pays no cash dividends or interest.3
D. No opportunities exist to earn arbitrage profit from mispriced assets. In other words, we assume
supply equals demand so that a static equilibrium exists.

If a random variable (for example, a stock’s price) has a log-normal probability distribution, that

variable can only take on non-negative values (as illustrated in Figure 1A). If s is a random variable

that is log-normally distributed, then the asset’s returns, denoted R, will equal R = Log(𝑠) and R will

have a normal probability distribution (as illustrated in Figure 1B). Conversely, if R has a normal

probability distribution, then 𝑎ntiln(𝑅) = 𝑒 𝑅 = exp(𝑅) = 𝑠 will have a log-normal probability

distribution. In fact, stock prices are a random variable that is log-normally distributed because,

partially, the limited liability law makes negative stock prices illegal. Natural or naperian

logarithms have a base value of e = 2.718… [unlike the base 10 logs, denoted Log10(x)]. The natural

log of stock prices, Loge(s) = Ln(s), are distributed according to a normal (not log-normal)

probability distribution for either base 10 or base e logs.

If natural logarithms are used continuously compounded holding period returns (HPRs) can

easily be computed from a stock’s price relatives, (st/st-1). For example, if the price of a stock rises

from $100 to $110 (which is a 10 percent gain with no compounding) while the stock pays no cash

dividends, the continuously compounded HPR is 9.531 percent (not 10 percent), as shown in

Eqns.(5) and (5a). The HPRs in Eqns.(5) and (5a) are computed with base e logarithms (where e =

3 When the cash dividend yield, denoted y, is included in computing the price of a call, Eqn.(7) below
is modified to become: d1 ={ Ln(s/x) + [r – y +.5𝜎 2 ]T }/ [ơT.5]. See John Hull, Options, Futures, and
Other Derivatives, Eighth Edition, published by Prentice-Hall, 2012, pages 221-230.
The Black-Scholes Option Pricing Model (BSOPM) – Page 3
2.71828…), these logs are also called natural logs or Naperian logs and are commonly written in

either of two equivalent notations, Loge(x) = Ln(x).

Continuously compounded HPR = Loge(1 + HPR) = Ln(st/st-1) = Ln(st/st-1) = Ln(st) – Ln(st-1) (5)

9.531% = 0.09531 = Ln(1.1) = Ln($110/$100) = 4.70048 – 4.60517 = Ln($110) – Ln($100) (5a)

Continuously compounded HPRs are normally distributed, as shown in Figure 1B. Figures 1A and

1B contrast a log-normal distribution of stock prices and the resulting normal distribution of

continuously compounded holding period returns (HPRs).

----------------------------------------------- Top of Figure ----------------------------------------------------

FIGURE 1 – Contrasting the Log-Normal and Normal Probability Distributions

Figure 1A - Log-Normal Probability Distribution of A Stock’s Prices

Probability (s)
E(s)

0 $40 $80 $120

Price Per Share (s), $

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 Figure 1B - Normal Probability Distribution of a Stock’s HPRs
Probability(HPR)
E(HPR)

-20% -10% 0 10% 20% 30%

Holding Period Return (HPR) = 𝐿𝑛𝑒 (𝑠𝑡+1 /𝑠𝑡 )

----------------------------------------------- Bottom of Figure -----------------------------------------------------

2 VALUING A CALL OPTION

Eqn.(6) explains, with surprising accuracy (within pennies), the market-determined cost of a call (C)

option on a stock, a commodity, a diversified portfolio of stocks and commodities, or other market

asset.

𝐶 = 𝑠𝑁(𝑑1 ) − 𝑥𝑒 −𝑟𝑇 𝑁(𝑑2 ) (6)

where d1 and d2 are defined by Eqns.(7) and (8). Eqns.(7), (8) and (6) are evaluated below, in that

order, using the stock price data from Table 1 as the raw input data. The optioned stock’s standard

deviations of HPRs is denoted ơ, and the variance is 𝜎 2 . Eqns.(7) and (8) are used in the BSOPM call

pricing model and, also, in the BSOPM put pricing model.

Ln(s/x) + [r +.5𝜎 2 ]T
d1 = -------------------------------- (7)
ơT.5

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 .182322 + .047333 = .229654
d1 = ----------------------------------------- = 1.048275 (7a)
(.379473)(.577321) = .219078

The value for d2 is defined below.

d2 = d1 - ơT.5 (8)
= 1.048275 - .219078 = .82920 (8a)
Substituting the values from Eqns.(7a) and (8a) into Eqn.(6) yields BSOPM Eqn.(6a).

C = $60[N(1.048275)] - $50{𝑒 −.07(.3333)}[N(.82920)] (6)

= $60(.8527) - $50(.97693)(.7965) (6a)
= $12.2025 = Call premium
The three dashed curves in Figure 2 illustrate BSOPM call prices computed with Eqns.(6), (7) and (8)

for three calls on the same stock that have different expiration dates. As the call option’s expiration

date draws nearer, the pricing curve moves lower. The pricing curve keeps moving lower until, on

the expiration day, the pricing curve merges with the intrinsic (minimum value) value line.

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FIGURE 2 - Determinants of the Value of a Call Option Just Prior to Expiration
Call’s price, or, call premium, C ($)

Three option value

curves

Months
before
expiration:
8 Three time values
4
2
Intrinsic value
Exercise
price

Out of At the In the Deep in

the money mone the money
y
Market price of the underlying optioned stock, s
in $

INTRINSIC VALUES AND TIME VALUES

Table 2 defines the intrinsic values and time values of puts and calls from the perspectives of the

option buyer and the option writer.

TABLE 2 - Formulas for Options’ Intrinsic Values and Time Values, $

Call Call buyer, see Figure 2: Call writer or seller:
Intrinsic value of call: Max[(s-x),0] = Intrinsic value Min[(x-s),0] = Intrinsic value
Net intr. value of call: Max[(s-x),0]–premium Min[(x-s),0]+premium
Call’s time value: call’s premium - Max[(s-x),0] call’s premium - Min[(x-s),0]
Put Put buyer, see Figure 5: Put writer or seller:
Intrinsic value of put: Max[(x-s),0] = Intrinsic value Min[(s-x),0] = Intrinsic value
Net intr. value of put: Max[(x-s),0]-put premium Min[(s-x),0]+premium
Put’s time value: put premium - Max[(x-s),0] put premium - Min[(s-x),0]

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3A THE CUMULATIVE NORMAL-DENSITY FUNCTION AND VALUES FOR N(d)

N(d) gives the probability that a value of d or less will occur in a standard normal unit probability

distribution function (pdf) with a mean of zero and a standard deviation equal to unity. The

statistical convention for this pdf is: N(0,1). N(d), in the right-hand side of Figure 3B, illustrates the

value obtained from a unit normal cumulative density function (cdf) for an input with the value

of d. Figure 3 illustrates the cdf and the pdf from which it is derived. Table 3 displays selected

values for the unit normal cdf.4 If Figure 3B and Table 3 are extended to plus and minus infinity they

would contain the following three values of N(d): (A) from the far left side of the CDF in Figure 3B:

N(-∞) = 0, (B) from the center (mean value): N(0) = .5, and, (C) from the far right side: N(+∞) = 1.

FIGURE 3 – Probability Distribution Function (PDF) and Cumulative Density Function (CDF) for a
Unit Normal PDF with a Mean of Zero and a Standard Deviation Equal to Unity, N(0,1)5

Prob(d)

N(d)
Unit normal 1.0
probability
distribution Probability for a unit normal
function (pdf). .5 cumulative distribution
function (cdf).

0
d d
−3𝜎 −2𝜎 −1𝜎 0 +1𝜎 +2𝜎 +3𝜎

Fig. 3A. PDF Fig. 3B. CDF

4 The Microsoft Excel formula NORMSDIST(d) or NORM.S.DIST(d) can be used to compute the
exact probability, N(d), that a number selected randomly from a standard Normal probability
distribution will be less than d.
+∞ +∞
5 The integral of the pdf is the cdf: ∫−∞ 𝑝𝑑𝑓 = ∫−∞ 𝑓(𝑥)𝑑𝑥 = 𝐹(𝑥) = 𝑐𝑑𝑓.

The Black-Scholes Option Pricing Model (BSOPM) – Page 8

TABLE 3 – Values of N(d) for Given Input Values of d for a Unit Normal Cumulative
Distribution Function (CDF) with Zero Mean and Unit Variance, denoted N(0,1)
d N(d) d N(d) d N(d) d N(d) d N(d) d N(d)

–2.00 .0228 –1.00 .1587 .00 .5000 1.00 .8413 2.00 .9773
–2.95 .0016 –1.95 .0256 –.95 .1711 .05 .5199 1.05 .8531 2.05 .9798
–2.90 .0019 –1.90 .0287 –.90 .1841 .10 .5398 1.10 .8643 2.10 .9821
–2.85 .0022 –1.85 .0322 –.85 .1977 .15 .5596 1.15 .8749 2.15 .9842
–2.80 .0026 –1.80 .0359 –.80 .2119 .20 .5793 1.20 .8849 2.20 .9861
–2.75 .0030 –1.75 .0401 –.75 .2266 .25 .5987 1.25 .8944 2.25 .9878
–2.70 .0035 –1.70 .0446 –.70 .2420 .30 .6179 1.30 .9032 2.30 .9893
–2.65 .0040 –1.65 .0495 –.65 .2578 .35 .6368 1.35 .9115 2.35 .9906
–2.60 .0047 –1.60 .0548 –.60 .2743 .40 .6554 1.40 .9192 2.40 .9918
–2.55 .0054 –1.55 .0606 –.55 .2912 .45 .6736 1.45 .9265 2.45 .9929
–2.50 .0062 –1.50 .0668 –.50 .3085 .50 .6915 1.50 .9332 2.50 .9938
–2.45 .0071 –1.45 .0735 –.45 .3264 .55 .7088 1.55 .9394 2.55 .9946
–2.40 .0082 –1.40 .0808 –.40 .3446 .60 .7257 1.60 .9452 2.60 .9953
–2.35 .0094 –1.35 .0885 –.35 .3632 .65 .7422 1.65 .9505 2.65 .9960
–2.30 .0107 –1.30 .0968 –.30 .3821 .70 .7580 1.70 .9554 2.70 .9965
–2.25 .0122 –1.25 .1057 –.25 .4013 .75 .7734 1.75 .9599 2.75 .9970
–2.20 .0139 –1.20 .1151 –.20 .4207 .80 .7881 1.80 .9641 2.80 .9974
–2.15 .0158 –1.15 .1251 –.15 .4404 .85 .8023 1.85 .9678 2.85 .9978
–2.10 .0179 –1.10 .1357 –.10 .4602 .90 .8159 1.90 .9713 2.90 .9981
–2.05 .0202 –1.05 .1469 –.05 .4801 .95 .8289 1.95 .9744 2.95 .9984

Speaking intuitively, the values of the N(d) terms in Table 3 and in Eqn.(6) can be interpreted to

approximate the probabilities the call will be “in the money.” In other words, when the value of N(d)

is near one, it is likely the option will be profitable to exercise. Conversely, if the values of N(d) are

near zero, it is likely the option will not be profitable.

3B THE DELTA HEDGE RATIO

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An option’s hedge ratio is the ratio between of the change in an option’s value and the concurrent

change in the price of the underlying asset (eg, an optioned stock). Stated differently, the delta hedge

ratio equals the change in the option’s value that results from a one dollar change in the price of the

underlying stock. The option hedge ratio in Eqn.(9) is called the delta hedge ratio or simply delta.

N(d1) = d(C)/ds = Delta hedge ratio for a call > 0 (9)

= The slope of the dashed call pricing curve in Figure 4

Hedge ratios for call options are positive fractions with values between zero and one. Using the data

in Table 1, the hedge ratio equals N(d1) = 0.853 when the optioned stock’s price is $60; this value is

not depicted graphically in this paper. The hedge ratios for put options have negative values between

zero and minus one, N(d1) - 1 < 0. Thus, the hedge ratios for calls and puts move inversely.

FIGURE 4 – THE DELTA HEDGE RATIO EQUALS THE SLOPE OF A CALL PRICING CURVE
Call’s price, or, calls premium, c

Time value

Intrinsic value
Slope = .4 Exercise
price

Market price of underlying optioned asset, s dollars

The Black-Scholes Option Pricing Model (BSOPM) – Page 10

The value of the hedge ratio is: N(d1) = 0.4, at the tangency point in Figure 4 (which is above and

slightly to the left of the exercise price). The time value of an option achieves its greatest value at the

unmarked point, denoted N(d1) = 0.5, which is located directly above the call’s exercise price.

3C IMPLIED VOLATILITY

Some traders focus on the volatility, standard deviation, or variance of the optioned asset when using

the BSOPM.6 An option’s implied volatility equals the volatility of the optioned asset that is implied

by the BSOPM and the asset’s market price. A stock’s implied volatility is determined by inserting the

underlying stock’s market price into the BSOPM and, then, solving the BSOPM for the value of the

stock’s variance. For instance, the implied volatility of a call option on a stock is the volatility of the

underlying stock which, when input into the BSOPM call formula, will return a call value that equals

the call’s current market price. Volatility is one of the most important of the five input variables listed

in Table 1. If the BSOPM implies an unrealistic value for an optioned asset’s volatility, this suggests

either the optioned asset is mispriced or the statistical estimate of the volatility is inaccurate. In either

case, a serious option trader will investigate the possibility of a mis-priced option.

The ticker symbol VIX represents the Chicago Board of Trade’s (CBOE’s) Volatility Index. VIX

represents the market's expectation of the average volatility in the U.S. stock market during the

next 30 days. VIX is calculated from the implied volatilities computed from a wide variety of options

on the S&P 500 index. These volatilities are “forward looking” and are calculated from both calls

and puts on the S&P 500 index. VIX is a widely used measure of stock market risk and is often

referred to as a "fear gauge" for the average investor. Puts, calls, long futures and short futures

6 See Stan Beckers, “Standard Deviations Implied in Option Prices as Predictors of Future Stock
Price Volatility,” Journal of Banking and Finance, 1981, 5 (3): 363–381, doi:10.1016/0378-
4266(81)90032-7

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positions on VIX exist are and are actively traded.

4 PRICING PUT OPTIONS

Eqn.(10) displays the BSOPM that predicts put prices (P).

P = x𝑒 −𝑟𝑇 N(-d2) - sN(-d1) (10)

= $50𝑒 −.07(.3333)N(-.82913) - $60N(-1.048223) (10a)
= $50(.97693)(.204) - $60(.147) = $1.0876 = Put price (P) (10b)

The numerical values of N(d1) and N(d2) are taken from Tables 1 and 3 above, and the values of d1

and d2 are computed in Eqns.(7) and (8) above. The two curves in Figure 5 illustrate the ranges of

BSOPM put prices computed for the optioned stock data taken from Table 1 and used in Eqn.(10). As

the put’s expiration date draws nearer, the put pricing curve moves downward in Figure 5. The put

pricing curve keeps moving lower until, on the expiration day the put pricing curve converges with

the put’s intrinsic value line. The hedge ratio for a put option is a negative number, N(d1) - 1 < 0.

FIGURE 5 - PRICE DETERMINANTS FOR A PUT OPTION

5 DETERMINANTS OF CALL AND PUT PREMIUMS

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Table 4 shows the way the prices of puts and calls change in response to a change in value of one of

the explanatory variables.

TABLE 4 – DETERMINANTS OF OPTION PREMIUMS

Determinants of Option Impact on Put Premium Impact on the Cost of a
Premiums (P) Call (C)
The first two underlying determinants below vary positively with the values of both puts
and calls.
Time to option’s expiration, or Positive, 𝜕𝑃𝑃 > 0 𝜕𝐶𝐶
Positive, 𝜕𝐸𝑥𝑝𝑖𝑟𝑦 > 0
Expiry 𝜕𝐸𝑥𝑝𝑖𝑟𝑦

Variance or standard deviation Positive, 𝜕𝑃𝑃 > 0 Positive,

𝜕𝐶𝐶
>0
𝜕𝜎 𝜕𝜎
(𝜎 2 𝑜𝑟 𝜎) of the underlying
asset’s returns is a risk
measure.*
The underlying determinants below impact the values of the puts and calls in opposite
directions.
Market price or premium of 𝜕𝑃𝑃
Negative, 𝜕𝑠 < 0
𝜕𝐶𝐶
Sositive, 𝜕𝑠 > 0
the underlying asset, s
Exercise (striking, contract) Positive,
𝜕𝑃𝑃
>0 Negative,
𝜕𝐶𝐶
<0
𝜕𝑥 𝜕𝑥
srice of the option, x
Invariant interest rate, r *, is Negative,
𝜕𝑃𝑃
<0 Positive,
𝜕𝐶𝐶
>0
𝜕𝑟 𝜕𝑟
the riskless rate.
Cash dividend yield (y) for the Positive,
𝜕𝑃𝑃
>0 Negative,
𝜕𝐶𝐶
<0
𝜕𝑦 𝜕𝑦
underlying stock **
* The effects of standard deviation and the riskless interest rate are not visible in Figures 2,
3 and 5.
** Cash dividends are not an explanatory variable in the BSOPM, and their implications are
not visible in any of the Figures. But cash dividend payments change stock prices and the
prices of options on those stocks. See footnote 3 for more information about cash
dividends.

6 PUT-CALL PARITY

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The put-call parity formula is important for two reasons.7 First, it expedites finding deviations from

the Law of One Price for options. Remember, deviations from the Law of One Price create

opportunities to earn arbitrage (easy) profits. Second, the put-call parity formula provides a quick

and easy way to derive option premiums (prices) if the input data is available. The put-call parity

line is the straight line with a slope of 45 degrees (or, a slope of +1) illustrated in Figure 6.

FIGURE 6 – PUT-CALL PARITY LINE

𝑇ℎ𝑒 𝑝𝑢𝑡 − 𝑐𝑎𝑙𝑙 𝑝𝑎𝑟𝑖𝑡𝑦 𝑙𝑖𝑛𝑒 𝑖𝑠 𝑎 45° 𝑙𝑖𝑛𝑒

𝑡ℎ𝑎𝑡 ℎ𝑎𝑠 𝑎 𝑠𝑙𝑜𝑝𝑒 𝑜𝑓 + 1.

Sell calls, buy puts

Relative call prices, C/p

Sell puts, buy calls

Relative put prices, P/p

SUMMARY: The put-call parity line traces the parity relationship between the prices of puts and calls
that are priced correctly. The put-call parity line separates the over-priced options from the under-
priced options.

7 For a more detailed explanation of the put-call parity formula see John Hull, Options, Futures, and
Other Derivatives, Eighth Edition, published by Prentice-Hall, 2012, pages 221-224.

The Black-Scholes Option Pricing Model (BSOPM) – Page 14

Puts and calls on different underlying assets can all be graphed together in Figure 6, but every

option will probably not be positioned exactly on the put-call parity line because some are mis-

priced. Mispriced options will lay above or below the put-call parity line, the put-call parity line line

separates the under-priced from the over-priced options. Eqn.(11) formalizes the put-call parity

model. PV(x) denotes the present value of the exercise price, x.

C + PV(x) = P + s (11)
$12.203 + 50/(1+0.07)0.3333 = $1.088 + 60 (11a)
$12.203 + 48.885 = $1.088+60 = $61.088 (11b)

Put-call parity Eqn.(11) can be restated as Eqn.(12), which is an equivalent put-call parity equation.8

C = P + s – x/(1+r)T (12)
$12.203 = $1.088 + 60 – 50/(1+0.07)0.3333 (12a)
$12.203 = 1.088 + 60 – 48.885 (12b)

Dividing both sides of Eqn.(12) by the price of the underlying asset, s, restates the formula in terms

of relative call prices, C/s, and relative put prices, P/s, as shown in Eqn.(13). Eqn.(13) suggests

that for any given underlying asset, if all other factors are equal, call prices tend to exceed put prices

by 1 - x/s(1+r)T. Figure 6 illustrates the put-call parity line defined by Eqn.(13).

C/s = P/s + 1 - x/s(1+r)T (13)

0.203 = 1.088/60 + 1 – 50/60(1+0.07)0.3333 (13a)
0.203 = 0.018 + 1 – 0.815 (13b)
PUT PRICING: To determine the price of a put, the put-call parity line in Eqn.(11a) can also be

restated as Eqn.(14).

𝑃 = 𝐶 − 𝑠 + 𝑥/(1 + 𝑟)𝑇 (14)

$1.088 = 12.203 - 60 + 50(1+ 0.07)0.3333 (14a)
$1.088 = 12.203 - 60 + 48.885 (14b)

8 For the seminal work on put-call parity pricing see Hans R. Stoll, “The Relationship Between Put
and Call Prices,” Journal of Finance, 24, December 1969, pages 801-824.
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It is usually easier to use Eqn.(14) to determine the premium for a put option than to solve Eqns.(7),

(8) and (10), in that order. The formula for relative put prices, Eqn.(15), is derived by dividing both

sides of Eqn.(14) by the price of the optioned asset, s.

P/s = C/s – 1 + x/s(1+r)T (15)

0.018 = 12.203/60 - 1 + 50/60(1+0.07)0.3333 (15a)
0.018 = .203 - 1 + 0.815 (15b)

7 CONCLUSIONS

The Black-Scholes option pricing model is based on the realistic assumption that short-term

continuously compounded holding period returns (HPRs) are distributed according to a normal

probability distribution like the one in Figure 1B. This normal distribution of returns is derived

from asset prices that are log-normally distributed (see Figure 1A) by using the following

logarithmic transformation.

Continuously compounded HPR = Loge(1 + HPR)= Loge(st/st-1) = Ln(st/st-1) = Ln(st)–Ln(st-1) (5)

Modern option pricing theory has three main parts.

1. The call pricing equation, Eqn.(6),

2. The put pricing equation, Eqn.(10), and,
3. The put-call parity equations, Eqns.(12), (13), (14) and (15).
People who are unfamiliar with the Black-Scholes option pricing models often suspect intuitively that

the expected return of the underlying asset will be an important explanatory variable in determining

the prices of calls and puts. In fact, the expected return of the underlying asset is not an explanatory

variable. The Nobel Prize winning Black-Scholes put and call pricing equations both utilize the same

five explanatory variables.

A. The price of the optioned asset, s,

B. The risk of the underlying asset, 𝜎 2 ,
C. The riskless rate of interest, r,
D. The exercise price of the option, x, and,
E. The time until the option expires, T.

The Black-Scholes Option Pricing Model (BSOPM) – Page 16

Although the Black-Scholes call and put pricing models have fundamental common threads, the two

models differ significantly.

The put-call parity equations are simpler models than the Black-Scholes call and put pricing models.

The put-call parity equations can be stated two different ways, and the two equations below can

easily be derived from each other.

𝐶 = ℎ(𝑃, 𝑠, 𝑥, 𝑟) (3)

𝑃 = 𝑗(𝐶, 𝑠, 𝑥, 𝑟) (4)

The two put-call parity formulas utilize only four explanatory variables. In addition, the two put-call

parity line formulas can be easily restated in terms of relative call prices, C/s, and relative put

prices, P/s, to facilitate drawing the put-call parity line in Figure 6.

Table of Contents – Black-Scholes Option Pricing

The Black-Scholes Option Pricing Model (BSOPM) ............................................................................................ 1

𝐶 = 𝑓𝑠, 𝜎2, 𝑟, 𝒙, 𝑻 f represents the BSOPM for calls (1) ..................................................... 1
TABLE 1 - Five Determinants of the Premiums (or Prices) for Put and Call Options ......................... 1
𝑃 = 𝑔𝑠, 𝜎2, 𝑟, 𝒙, 𝑻 g represents the BSOPM for puts (2) ...................................................... 2
𝐶 = ℎ𝑃, 𝑠, 𝑥, 𝑟 h represents the put-call parity formula for calls (3) ............................. 2
𝑃 = 𝑗𝐶𝐶, , 𝑥, 𝑟 j represents the put-call parity formula for puts (4) ............................... 2
1 BSOPM ASSUMPTIONS ........................................................................................................................................ 2
Continuously compounded HPR = Loge(1 + HPR) = Ln(st/st-1) = Ln(st/st-1) = Ln(st) – Ln(st-1) (5) .......... 4
FIGURE 1 – Contrasting the Log-Normal and Normal Probability Distributions.................................. 4
2 VALUING A CALL OPTION ................................................................................................................................... 5
𝐶 = 𝑠𝑁𝑑1 − 𝑥𝑒 − 𝑟𝑇𝑁𝑑2 (6) ..................................................................... 5
d1 = -------------------------------- (7) ....................................................................................... 5
d2 = d1 - ơT.5 (8).......................................................................................................... 6

The Black-Scholes Option Pricing Model (BSOPM) – Page 17

 FIGURE 2 - Determinants of the Value of a Call Option Just Prior to Expiration ................................. 7
INTRINSIC VALUES AND TIME VALUES ................................................................................................................. 7
TABLE 2 - Formulas for Options’ Intrinsic Values and Time Values, $ ................................................... 7
3A THE CUMULATIVE NORMAL-DENSITY FUNCTION AND VALUES FOR N(d) .............................................. 8
TABLE 3 – Values of N(d) for Given Input Values of d for a Unit Normal Cumulative Distribution
Function (CDF) with Zero Mean and Unit Variance, denoted N(0,1) ...................................................... 9
3B THE DELTA HEDGE RATIO ............................................................................................................................. 9
N(d1) = d(C)/ds = Delta hedge ratio for a call > 0 (9)........................................................................... 10
FIGURE 4 – THE DELTA HEDGE RATIO EQUALS THE SLOPE OF A CALL PRICING CURVE .................. 10
3C IMPLIED VOLATILITY .................................................................................................................................... 11
P = x𝑒 − 𝑟𝑇N(-d2) - sN(-d1) (10) .......................................................................................... 12
= $50𝑒 − .07(.3333)N(-.82913) - $60N(-1.048223) (10a).................................................... 12
= $50(.97693)(.204) - $60(.147) = $1.0876 = Put price (P) (10b)..................................................... 12
FIGURE 5 - PRICE DETERMINANTS FOR A PUT OPTION ......................................................................... 12
5 DETERMINANTS OF CALL AND PUT PREMIUMS ........................................................................................... 12
TABLE 4 – DETERMINANTS OF OPTION PREMIUMS................................................................................. 13
6 PUT-CALL PARITY .............................................................................................................................................. 13
FIGURE 6 – PUT-CALL PARITY LINE ............................................................................................................. 14
C + PV(x) = P + s (11) ................................................................................... 15
$12.203 + 50/(1+0.07)0.3333 = $1.088 + 60 (11a) $12.203 + 48.885 = $1.088+60
= $61.088 (11b) 15
C = P + s – x/(1+r)T (12)........................................................................................................... 15
$12.203 = $1.088 + 60 – 50/(1+0.07)0.3333 (12a) $12.203 =
1.088 + 60 – 48.885 (12b) 15
C/s = P/s + 1 - x/s(1+r)T (13) .............................................................................................................. 15
𝑃 = 𝐶 − 𝑠 + 𝑥/(1 + 𝑟)𝑇 (14) ........................................................................................................ 15
$1.088 = 12.203 - 60 + 50(1+ 0.07)0.3333 (14a) $1.088 = 12.203 - 60 +
48.885 (14b)........................................................................................ 15
P/s = C/s – 1 + x/s(1+r)T (15) ........................................................................................................... 16
7 THE BOTTOM LINE ............................................................................................................................................ 16
𝐶 = ℎ𝑃, 𝑠, 𝑥, 𝑟 (3) .............................................................................................................................. 17
𝑃 = 𝑗𝐶, 𝑠, 𝑥, 𝑟 (4) ............................................................................................................................... 17

The Black-Scholes Option Pricing Model (BSOPM) – Page 18