FINANCIAL ENGINEERING

OPTIONS
KRIPA SHANKER Ph D (Cornell)
FNAE, FIE(I), FITEE(I), LMISTE, LMIIIE, MORSI, MORSA, SMIIE

Visiting Faculty
Department of Mechanical Engineering
Indian Institute of Technology (BHU) Varanasi
Former Emeritus Fellow
Industrial and Management Engineering Department
Indian Institute of Technology Kanpur
Former Vice Chancellor, Uttar Pradesh Technical University Lucknow
Former Deputy Director, Indian Institute of Technology Kanpur
 Financial Engineering

PRICING OF OPTIONS
OPTIONS
OPTIONS

Black - Scholes Model

Kripa Shanker Ph D (Cornell)

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RE
CA
LL
OPTIONS
WHAT IS AN OPTION?
 A stock option is a derivative security, because
the value of the option is “derived” from the value
of the underlying common stock.
 There are two basic option types.
 Call options are options to buy the underlying
asset.
 Put options are options to sell the underlying
asset.
 Listed option contracts are standardized to
facilitate trading and price reporting.
 Listed stock options give the option holder the
right to buy or sell 100 shares of stock.
RE
CA
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OPTIONS
WHAT IS AN OPTION?
Definition: a type of legal contract between two
investors where one grants the other the right
(but not the obligation)to buy or sell a specific
asset at a preset price in the future.

 the option buyer is buying the right to

buy or sell the underlying asset at some
future date.
 the option writer is selling the right to
buy or sell the underlying asset at some
future date.
RE
CA
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OPTIONS
The minimum terms stipulated by stock option contracts
are:
• The identity of the underlying stock.
• The option contract size.
• The strike price, or exercise price.
• The option price (Premium)
• The option expiration date, or option
maturity.
• The option exercise style (American or
European).
• The delivery (or settlement) procedure.

A list of available option contracts and their prices for a

particular security is known as an option chain.
 OPTIONS
Notation
S = the price of the underlying asset
(stock)
(we will refer to S0=S, St or ST)
C = the price of a call option (premium)
(we will refer to C0=C, Ct or CT)
X or K = the exercise or strike price
T = the expiration date
t= a time index
 PRICING OF OPTIONS
Black - Scholes Model
Black-Scholes is a pricing model used to determine the fair price or theoretical value
for a call or a put option based on six variables such as volatility, type of option,
underlying stock price, time, strike price, and risk-free rate. The quantum of
speculation is more in case of stock market derivatives, and hence proper pricing of
options eliminates the opportunity for any arbitrage. There are two important models
for option pricing – Binomial Model and Black-Scholes Model. The model is used to
determine the price of a European call option, which simply means that the option
can only be exercised on the expiration date.

Black-Scholes pricing model is largely used by option traders who buy options that
are priced under the formula calculated value, and sell options that are priced
higher than the Black-Schole calculated value.
The Black-Scholes-Merton
Model
The Stock Price Assumption
 Consider a stock whose price is S
 In a short period of time of length Δt, the return on
the stock is normally distributed:
S
S

  t,  2t 
where μ is expected return and σ is volatility.
 The Black-Scholes-Merton
Model
The Lognormal Property
• It follows from this assumption that
 2  
ln S T  ln S 0      T ,  T 
2

 2  
or
  2  

ln S T   ln S 0     
T,  T
2

  2  
• Since the logarithm of ST is normal, ST is
lognormally distributed
The Black-Scholes-Merton
Model
The Lognormal Distribution

E ( ST )  S0 eT
2 2 T 2T
var ( ST )  S0 e (e  1)
The Black-Scholes-Merton
Model
Continuously Compounded Return
ST  S 0 exT

1 ST
x = ln
T S0
   
2 2
x     , 
 2 T 
 The Black-Scholes-Merton
Model
The Expected Return

• The expected value of the stock price is S0eμT

• The expected return on the stock is μ – σ2/2 not
μ

• This is because
ln[ E ( ST / S 0 )] and E[ln(ST / S0 )]
are not the same.
 The Black-Scholes-Merton
Model
μ and μ−σ2/2
Suppose we have daily data for a period of several
months
• μ is the average of the returns in each day
[=E(ΔS/S)]
• μ−σ2/2 is the expected return over the whole
period covered by the data measured with
continuous compounding (or daily compounding,
which is almost the same)
 Mutual Fund Returns

 Suppose that returns in successive years

are 15%, 20%, 30%, -20% and 25%
 The arithmetic mean of the returns is 14%
 The returned that would actually be
earned over the five years (the geometric
mean) is 12.4%

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 The Black-Scholes-Merton
Model
The Volatility
• The volatility is the standard deviation of the
continuously compounded rate of return in 1 year.
• The standard deviation of the return in time Δt is
• If a stock price is $50 and its volatility is 25% per
year
 what
t is the standard deviation of the price
change in one day?
 Estimating Volatility from
Historical Data
1. Take observations S0, S1, . . . , Sn at intervals of
t years
2. Calculate the continuously compounded return
in each interval as:
 Si 
ui  ln 
 Si 1 
3. Calculate the standard deviation, s , of the ui´s
4. The historical volatility estimate is: s
ˆ 

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 Estimating Volatility from
Historical Data
 Volatility is usually much greater when the
market is open (i.e. the asset is trading) than
when it is closed.
 For this reason time is usually measured in
“trading days” not calendar days when options
are valued.

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 The Black-Scholes-Merton
Model
The Concepts of the Model
• The option price and the stock price depend on
the same underlying source of uncertainty.
• We can form a portfolio consisting of the stock
and the option which eliminates this source of
uncertainty.
• The portfolio is instantaneously riskless and must
instantaneously earn the risk-free rate
• This leads to the Black-Scholes differential
equation.
The Derivation of the Black-Scholes Differential
Equation
S  S t  S z
 ƒ ƒ 2ƒ 2 2  ƒ
ƒ   S   ½ 2  S t  S z
 S t S  S
W e set up a portfolio consisting of
 1 : derivative
ƒ
+ : shares
S

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The Derivation of the Black-Scholes
Differential Equation

The value of the portfolio  is given by

ƒ
  ƒ  S
S
The change in its value in time t is given by
ƒ
   ƒ  S
S

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The Derivation of the Black-Scholes Differential
Equation

The returnon the portfoliomust be the risk - free

rate. Hence
  r t
We substitutefor Δƒ and S in these equations
to get the Black- Scholesdifferential equation:
ƒ ƒ  2
ƒ
 rS ½  S
2 2
 rƒ
t S S 2

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 The Differential Equation
 Any security whose price is dependent on the
stock price satisfies the differential equation
 The particular security being valued is
determined by the boundary conditions of the
differential equation
 In a forward contract the boundary condition is ƒ
= S – K when t =T
 The solution to the equation is
ƒ = S – K e–r (T – t )
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The Black-Scholes-Merton
Model
The Black-Scholes Formulas
rT
c  S0 N(d1) K e N(d2)
rT
p  K e N(d2) S0 N(d1)
2
ln(S0 / K) (r  / 2)T
whered1 
T
2
ln(S0 / K) (r  / 2)T
d2   d1  T
T 24
 The Black-Scholes-Merton
Model

N(x) Function

N(x) is the probability that a normally distributed

variable with a mean of zero and a standard
deviation of 1 is less than x

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 The Black-Scholes-Merton
Model
Properties of Black-Scholes Formula
 As S0 becomes very large c tends to
S0 – Ke-rT and p tends to zero

 As S0 becomes very small c tends to zero and p

tends to Ke-rT – S0

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 Risk-Neutral Valuation
 The variable m does not appear in
the Black-Scholes equation
 The equation is independent of all
variables affected by risk preference
 The solution to the differential
equation is therefore the same in
a risk-free world as it is in the real
world
 This leads to the principle of risk-
neutral valuation
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Applying Risk-Neutral Valuation

1. Assume that the expected

return from the stock price is
the risk-free rate
2. Calculate the expected payoff
from the option
3. Discount at the risk-free rate

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Valuing a Forward Contract with
Risk-Neutral Valuation
 Payoff is ST – K
 Expected payoff in a risk-neutral
world is S0erT – K
 Present value of expected payoff is
e-rT[S0erT – K]=S0 – Ke-rT

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 Implied Volatility
 The implied volatility of an option is the
volatility for which the Black-Scholes price
equals the market price
 There is a one-to-one correspondence
between prices and implied volatilities
 Traders and brokers often quote implied
volatilities rather than dollar prices

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The VIX S&P500 Volatility Index
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20

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10

0
Jan, 2004 Jan, 2005 Jan, 2006 Jan, 2007 Jan, 2008

Options, Futures, and Other

Derivatives, 7th Edition, Copyright
© John C. Hull 2008 31
An Issue of Warrants & Executive
Stock Options
 When a regular call option is exercised the stock that
is delivered must be purchased in the open market
 When a warrant or executive stock option is
exercised new Treasury stock is issued by the
company
 If little or no benefits are foreseen by the market the
stock price will reduce at the time the issue of is
announced.
 There is no further dilution (See Business Snapshot
13.3.)

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 The Impact of Dilution
 After the options have been issued it is
not necessary to take account of dilution
when they are valued
 Before they are issued we can calculate
the cost of each option as N/(N+M) times
the price of a regular option with the same
terms where N is the number of existing
shares and M is the number of new shares
that will be created if exercise takes place
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 Dividends
 European options on dividend-paying
stocks are valued by substituting the stock
price less the present value of dividends
into Black-Scholes
 Only dividends with ex-dividend dates
during life of option should be included
 The “dividend” should be the expected
reduction in the stock price expected
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 American Calls
 An American call on a non-dividend-paying stock
should never be exercised early
 An American call on a dividend-paying stock
should only ever be exercised immediately prior to
an ex-dividend date
 Suppose dividend dates are at times t1, t2, …tn.
Early exercise is sometimes optimal at time ti if the
dividend at that time is greater
r ( t t )
than
K [1  e i 1 i
]
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Black’s Approximation for Dealing with
Dividends in American Call Options
Set the American price equal to the
maximum of two European prices:
1. The 1st European price is for an
option maturing at the same time as
the American option
2. The 2nd European price is for an
option maturing just before the final
ex-dividend date

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