Black-scholes

Black-Scholes

The basic starting point for the actual pricing of an

European option is the model developed by Fisher
Black, Myron Scholes, and Robert Merton.

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 Black-Scholes Assumptions

 The option being valued is a European Style option

 The risk-free interest rate is known and constant over the
life of the option
 The market is an efficient one
 Stock prices follow a lognormal distribution with m and s
constant.
 There are no transaction costs and there are no taxes
 The underlying security pays no dividends during the life
of the option

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 Black-Scholes Assumptions…

 There are no riskless arbitrage opportunities

 Security trading is continuous
 Investors can borrow and lend at the same risk free rate
 The volatility of the underlying instrument is known and is
constant over the life of the option.

4
 Black-Scholes Formula

Value of Call Option

= SN(d1)-Xe-rtN(d2)

ln( S )  (r  s )t
2
where d  X 2
s t
1

d 2  d1  s t
5
 Inputs You Will Need

S = Current value of underlying asset

X = Exercise price
t = life until expiration of option
r = riskless rate
s2 = variance
N(d ) = the standard normal cumulative distribution
function (the probability that a variable with a standard
normal distribution will be less than d)

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 Black Scholes (Intuition)

SN(d1) - Xe-rt N(d2)

The expected PV of cost Risk Neutral
Value of S of investment Probability of
if S > X S>X

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 Numerical

Use the following information to calculate the value a call on

the stock of XYZ company

Current price of the share = Rs 120

Exercise price of the option = Rs 115
Time period to expiration = 3 months
Standard Deviation = 60%
Riskless rate = 10%

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 Changes in the Value of the Option

The value of the option is dependent upon changes

in any of the inputs in the Black Scholes model.
The impact of a change in one of the inputs on
into the Black Scholes Equations to the value of
the option is measured by a group of variables
known as “the Greeks”
We will introduce them now and explore the
relationship between changes in each input and the
option value in depth later.

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 Option Pricing & Valuation

 current stock/index rate (S) – as S , Call  and Put 

 strike price (X) – as X , Call  and Put 
 time to expiration (T) – as T , both 
 volatility of the stock/index rate (s) – as s , both 
 interest rate (i) – as i, Call  and Put 
 interest rate (i) – as i , Call  and Put 

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 Extending Black Scholes to
Futures Options

 Black extended the original model to price options on

futures.
c  e  rt ( F0 N (d1 )  XN (d 2 ))
p  e  rt ( XN (d 2 )  F0 N (d1 ))

ln 
F0 
s T / 2

2

d1   X
d 2  d1  s T
s T

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 Derivatives of Black-Scholes Formulation

 Measures of sensitivity
 Mathematically obtained by differentiating the Black-
Scholes Formula for call and put options
 The derivatives include Delta, Gamma, Theta, Rho and
Vega
 Delta is the most important: help in managing the
portfolio consist of options (dynamic hedging)
 Delta provides multifold information

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 Delta of an Option

Delta is a measure of volatility of option prices

A measure of the likelihood that an option will be
in-the-money on the expiration day
Provides the hedge ratio
Delta of the option shows how the theoretical price
of the option will change with a small change in
the underlying asset.
change in price of call option
delta 
change in price of underlying asset
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 Delta

Delta can be found from the call price equation

as:

c
  N (d1 )
S
Using delta hedging for a short position in a
European call option would require keeping a long
position of N(d1) shares at any given time. (and
vice versa).

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 Delta Explanation

Delta will be between 0 and 1.

A 1 Rupee change in the price of the underlying

asset leads to a change of delta Rupee in the price
of the option.

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 Delta and Stock Price

Time value of Delta (and slope

Call option of tangent line)
S-X gets closer to 1
as the option
becomes more
In-the-money

X S
Delta (and slope of tangent line) gets closer to 0
as the option becomes more Out-of-the-money
 Delta vs. Share Price

1
Delta of Call Option
0.9

0.8

0.7

0.6
Delta

0.5

0.4

0.3

0.2

0.1

0
35 40 45 50 55 60 65 70
Spot Price
 Delta and Time to Maturity
X=50 r=0.05 s=0.2
1

0.9

0.8

0.7

0.6
Delta

3 months
0.5 1 year
3 years

0.4

0.3

0.2

0.1

0
35 40 45 50 55 60 65 70

Stock Price
 Delta and Moneyness
X=35 r=0.05 s=.2
1

0.9

0.8

0.7

0.6
Delta

0.5

0.4

0.3

0.2

0.1

0
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2

out-of-the money S=30 at-the-money S=35 in-the-money S=40

Time
 Delta of a put option
• A long position in a put option should be hedged
with a long position in the stock, (delta will be
negative).
• Delta for the put is given by N(d1) – 1
• Similar to call options, for deep in the money puts
(Asset price is less than exercise price) the value
of delta will be close to -1. For delta out of the
money puts the delta will be close to zero.
 Delta of an Option

A delta equal to 0.7 for a call implies that the call

premium would move up by 70 paise if stock price
move up by one rupee.
A delta equal to -0.8 for a put options means that
the put option premium will decline by 80 paise if
the underlying stock price rises by one rupee.
For call options having delta equal to 0.6443,
mean that there is nearly a 64.43% chance that the
stock price on the expiration day will be above the
option exercise price

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 Delta as Hedge Ratio

Delta indicates how many units of the option

contract are necessary to mimic the returns of the
underlying stock.
A delta equal to 0.6443 implies that for every call
option purchased, 0.6643 * lot size of the stock
should be sold short.
Or
If someone owned n number of shares of the
underlying stock, then writing 1/delta*(numbers
of lot) of call contracts would result in a
theoretically perfect hedge.
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 Gamma

Gamma measures the curvature of the theoretical

call option price line.

change in price of option

gamma 
Change in price of underlying asset

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 Gamma of an Option

The change in delta for a small change in the stock

price is called the options gamma
The gamma of call option is always equal to the
gamma of put option

 d12 / 2
Z (d1 ) e
Gamma = 
S 0s T S 0s 2T

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 Gamma Graphically
21 Gamma measures the amount of curvature
In the call price relationship, The reason the
portfolio Is not perfectly hedged is because delta
16
provides only a linear estimate of the call price
change. The hedge error is from the difference
11 between the estimate from delta and the actual
relationship
6
$

Delta is equal to the slope

of the line tangent to the
1 graph of the Options price
34 44 54 64
-4

-9
Spot Price
 Gamma
• If gamma is small it implies that delta changes slowly
which implies the cost to adjust the portfolio will be small.
• If gamma is large it implies that delta changes quickly and
the cost to keep a portfolio delta neutral will be large.
 Gamma and Stock Price
• The impact of gamma will be the largest when the stock
price is close to the exercise price.
• For deep in the money or deep out of the money call
options gamma will be relatively small.
 Gamma vs. Stock Price
X=50, r =0.05, s.2, t.5
0.07

0.06

0.05
Gamma

0.04

0.03

0.02

0.01

0
30 35 40 45 50 55 60 65 70

GAMMA Stock Price

 Gamma and Time to Maturity
• Gamma will be highest for at the money options close to
maturity.
• Gamma will be low for both in the money and out of the
money options that are close to maturity.
 Gamma vs Time to Maturity
X=35, r=0.05, s=.2
0.25

0.2

0.15
Gamma

0.1

0.05

0
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2

out-of-the money S=30 at-the-money S=35 in-the-money S=40 Time

 Theta
• Theta is generally negative for an option since as the time
to maturity decreases the value of the option becomes less
valuable. (Keeping everything else constant, as time passes
the value of the option decreases).
 Theta

Time decay of the option value (expressed in

years)
change in the price of option
theta 
decrease in time to expiration

 S 0 Z (d1 )s  rT
 Ee rN (d 2 )
Theta for Call = 2 T
 S 0 Z (d1 )s  rT
Theta for Put =
 Ee rN (d 2 )
2 T 32
 Theta
X=35, r=0.05, t=.5, s=.2
0
0 10 20 30 40 50 60 70

Stock Price
-0.5

-1

-1.5
Theta

-2

-2.5

-3

-3.5

-4
 Theta vs Time
X=35, s=.2, r=0.05
0.0
0 0.5 1 1.5 2 2.5 3

-1.0 Time

-2.0

-3.0

-4.0
Theta

-5.0

-6.0

-7.0

-8.0

-9.0

out-of-the money S=30 at-the-money S=35 in-the-money S=40

 Relationship between Delta, Theta and
Gamma
• From the derivation of the Black-Scholes Formula it can be
shown that:
1
(theta)  rS (delta)  ( Ss 2 )(Gamma)  r ( PortfolioValue )
2

• In a Delta Neutral portfolio delta =0 and the portfolio value

remains relatively constant. This implies that if Theta is
negative, Gamma needs to be of similar size and positive and
vice versa. Therefore Theta is often considered as a proxy for
Gamma.
 Vega (Kappa or Lambda)
• The rate of change of the option value with respect to the
volatility of the underlying asset is given by the Vega (also
sometimes called kappa)
• The Black Scholes Model assumes that volatility is constant, so
in theory this seems to be inconsistent with the model.
• However variations of the Black Scholes do allow for
stochastic volatility and their estimates of Vega are very close
to those form the Black Scholes model so it serves as an
approximation.
 Vega/Kappa/Lambda

Vega is always positive and identical for call and

put

Change in option Price

Vega 
Change in expected

Vega  S 0 T Z (d1 )
d12

2
e
where Z (d1 ) is 
2 37
 Vega
• Vega will be highest for options that are at
the money. As the option moves into or out
of the money the impact of a volatility
change is decreased.
 Rho
• The final measure is the change in the value of the option
with respect to the change in the interest rate.
• The interest rate has the smallest impact on the value of the
option. Therefore this is not used often in trading.
 Rho

Sensitivity of option value to interest rates

change in the price of option

Rho 
change in interest rate

 rT
Rho for Call = ETe N (d 2 )
 rT
Rho for Put =  ETe N (d 2 )
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Option Pricing & Valuation

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 Implied Volatility
• The one input in Black Scholes that cannot
be observed is volatility
• Implied volatility is calculated as the
volatility that would provide the observed
option price when used in the Black Scholes
equation
• The calculation needs to be done based
upon an iterative process, since the
volatility cannot be calculated directly.
Implied Volatility

Strike Price