Академический Документы
Профессиональный Документы
Культура Документы
and Derivatives
Lecture 9:
Options 2, Black-ScholesMerton Option Pricing Model
1
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
2
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
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
60
fuu = 0
fu
48
50
f
fud = 4
40
fd
32
fdd =
20
5
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
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.
10
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
11
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%
12
Price Process
Properties
of the log of price
13
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.
14
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.
15
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:
16
Black-Scholes-Merton Model
Cumulative Normal Density Function
Black-Scholes-Merton Model
Example:
18
Black-Scholes-Merton Model
Pricing
a European Put with an exercise price of
where:
19
Black-Scholes-Merton Model
Example:
20
Black-Scholes-Merton Model
Impact of Calls
Impact on Puts
Positive
Negative
Negative
Positive
Positive
Positive
Positive
Positive
Positive
Negative
21
Black-Scholes-Merton Model
Impact of Calls
Impact on Puts
Original Example:
4.74
0.81
7.28
0.33
2.90
1.81
6.84
1.03
22
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.
23
Black-Scholes-Merton Model
Implied
Volatilities Example:
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
24
Black-Scholes-Merton Model
Dividends
25
Black-Scholes-Merton Model
Example: .
1.Calculate
26