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EFB344 Risk Management

and Derivatives
Lecture 9:
Options 2, Black-ScholesMerton Option Pricing Model
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Unit Outline
Week 1: Introduction to Risk, Risk Management and Derivatives
Week 2: Financial Statistics
Week 3: Value-at-Risk 1
Week 4: No Classes Ekka Public Holiday
Week 5: Value-at-Risk 2
Week 6: Forwards and Futures 1
Week 7: Forwards and Futures 2
Week 8: Mid-Semester Exam
Week 9: Forward Rate Agreements (FRAs) and Swaps
Week 10: Reflective Practice and Options 1 (intro and binomial model)
Week 11: Options 2 (Black-Scholes-Merton model)
Week 12: Options 3 (trading strategies and risk management)
Week 13: Derivative Disasters
Week 14: Revision
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Lecture Content
Review of the Binomial Model
Price Process
Black-Scholes-Merton Model

Assumptions
Call pricing formulas
Put pricing formulas
Factors affecting option value
Implied Volatility
Dividends

Readings:
Hull et al. (2014), Ch. 13
3

and

Review of the Binomial


Model
72
60

fuu = 0

fu
48

50
f

fud = 4
40
fd
32

To value the
option, we
start by
looking at the
payoffs at the
terminal
nodes.

fdd =
20
4

Review of the Binomial


Model
and
72

60

fuu = 0

fu
48

50
f

fud = 4

40
fd
32

fdd =
20
5

Review of the Binomial


Model
and

72

60

50

fu =
1.41

f
40
fd =
9.46
fd = 12
Early exercise of American Put Option

fuu = 0

48
fud = 4

32
fdd =
20

Price Process

Where: is the change in the stocks price over a
short
period of time, . Therefore, is the
percentage
change in the stock price.
indicates the normal distribution.
and are the expected return, , and
variance, , of the stock returns scaled for time,
Recall that volatility scales .

Price Process
Based on some assumptions (e.g. prices follow a generalised
Weiner process) and some math (Itos lemma), which are
beyond the scope of this unit, it can be shown that the
continuously compounded return is normally distributed with
a mean of and a standard deviation of , where is the mean
of the simple returns measured over .

and

Therefore, given that the log of a random variable is


normally distributed, it can be shown that the random
variable, , is log-normally distributed.

Price Process
Simulation:

Price Process
If the random variable is log-normally distributed
then
the log of the random variable will have a normal distribution.

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Price Process
S = 10,000
5000

3000

4500
2500

4000
3500

3000
2500

2000

1500

2000
1000

1500
1000

500

500
0

50

100

150

200

250

300

350

0
2.5

3.5

4.5

5.5

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Price Process

Simulation
Statistics

r = ln(St/St-1)

R = (St St1)/St-1

Mean (p.a)

9.93%

11.94%

Standard
Deviation (p.a)

20.04%

20.05%

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Price Process
Properties
of the log of price

From the 100 simulations:


expected ln(ST) = 4.083 and stdev of ln(ST) = 0.398

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Black-Scholes-Merton Model
Assumptions
1. Stock prices are log-normally distributed with a
constant mean and volatility.
2. No transaction costs or taxes, and assets are
perfectly divisible.
3. No dividends on the stock during the life of the
option.
4. No riskless arbitrage opportunities.
5. Security trading is continuous.
6. Investors can borrow and lend at the risk-free rate
of return.
7. The short-term risk-free rate, r, is constant.
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Black-Scholes-Merton Model
No-Arbitrage
As per last weeks lecture, an investor can establish a position in
the option and delta () stocks such that they establish a
portfolio with a certain (riskless) payoff.
Why?
Both stock and option are affected by the stocks price movements.
In a short period of time, the change in the stocks price is perfectly
correlated with the change in the options price (positively for the
call and negatively for the put).
Therefore, a portfolio where the gain in the stock is offset by the loss
in the option (and vice versa) is established to generate at riskless
return.
For the call, it is short the call and long delta of the stock.
For the put, it is long the put and long delta of the stock.

Note that the portfolio remains riskless for a very short period
because the delta changes as the stock price changes. Therefore,
the portfolio (option and delta the stock) requires rebalancing with
every price movement.

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Black-Scholes-Merton Model
Pricing a European Call with an exercise price of on a
non-dividend paying stock
Note that the derivation of these formulas is beyond the
scope of this unit. One can refer to Hull (2002), Options,
Futures and Other Derivatives 5ed, or a later edition, for
the derivation good luck

where:

is the cumulative density function of the

standard normal distribution.


is the risk-free rate of return.

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Black-Scholes-Merton Model
Cumulative Normal Density Function

This integral is calculated


numerically,
with normal tables or in excel
(=normsdist(z))

x < 0, N(x) < 0.5

Tables provided with text report


probabilities for x-values to two decima
N(0) = 0.5
places. These tables will be provided in
the final exam. When we use them, we
x > 0, N(x) > 0.5 will simply round d1 and d2 to two
decimal places
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Black-Scholes-Merton Model
Example:

1.Solve for d1 and d2

2.Compute N(d1) and N(d2) using tables

3.Price Call Option

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Black-Scholes-Merton Model
Pricing
a European Put with an exercise price of

on a non-dividend paying stock

where:

is the cumulative density function of the

standard normal distribution.


is the risk-free rate of return.

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Black-Scholes-Merton Model
Example:

1.Solve for d1 and d2

2.Compute N(-d1) and N(-d2) using tables

3.Price Put Option

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Black-Scholes-Merton Model

Factors Affecting Option


Value

Impact of Calls

Impact on Puts

Current Share Price (S)

Positive

Negative

Exercise Price (K)

Negative

Positive

Term to Expiry (T)

Positive

Positive

Share Return Volatility


()

Positive

Positive

Risk-Free Rate (r)

Positive

Negative

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Black-Scholes-Merton Model

Factors Affecting Option


Value

Impact of Calls

Impact on Puts

Original Example:

4.74

0.81

Current Share Price


(S45)

7.28

0.33

Exercise Price (K43)

2.90

1.81

Term to Expiry (T1)

6.84

1.03

Share Return Volatility


5.95
1.63
(0.3)
Note that when changing a variable all the other variables are held constant at
Risk-Free Rate (r0.15)
0.68
the value from the 5.57
original example.

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Black-Scholes-Merton Model
Implied Volatilities
The inputs for the Black-Scholes-Merton model discussed
thus far are all observable except volatility (). That is, we
observe S0, K, T and r but we must estimate .
One approach to estimating volatility is to use historical
information. This is what we did earlier in the semester.
An alternative approach to estimating volatility that is
forward looking is to use the option pricing model. If we
know the options price (c or p) and the value of the
observables (S0, K, T and r), we can solve for volatility ().
The approach we use to solve for volatility is trial-and-error.
That is, put in all the variables and change the volatility ()
until the models option equals the markets option price.

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Black-Scholes-Merton Model
Implied
Volatilities Example:

and there are no dividends between now and maturity

By trial-and-error, 0.135
Noting that this is CBA information from 19 Sept. 2014
When I used an EWMA model for the volatility of CBA
returns I got, 0.113
By 30 Sept. the EWMA volatility was
0.143

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Black-Scholes-Merton Model
Dividends

Most stocks pay dividends.


To date, the model used has been for non-dividing paying
stocks.
We know that at the ex-dividend date the share price should
fall by the amount of the dividend; at least theoretically.
How is the Black-Scholes-Merton model adjusted for
dividends?
Still working with a European option
Assume that dividends during the life of the option are known (certain)
S0 includes the risky component (future dividends past those we know)
and the riskless component (known dividends)
Therefore, we simply strip out the present value of the known
dividends from S0 such that

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Black-Scholes-Merton Model
Example: .

1.Calculate

2.Solve for d1 and d2

3.Compute N(d1) and N(d2) using tables

4.Price Call Option

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