Valuing Stock Options: The

BlackScholes Model

Chapter 12.
Lecture Notes # 9
Lecture Notes#9 The Black-Scholes Model 2
Outline
1. Introduction
2. Option Prices in the Black-Scholes Model
3. Plotting Option Prices
4. Dividends in the BlackScholes Model
5. Options on Indices & Currencies
6. Implied Volatility
Lecture Notes#9 The Black-Scholes Model 3
1. Introduction
The BlackScholes model is unambiguously the
best known model of option pricing.
Also one of the most widely used: forms the
benchmark model for pricing options on
Equities.
Stock indices.
Currencies.
Futures.

Moreover, it forms the basis of the Black model that
is commonly used to price some interest-rate
derivatives such as caps and floors.

Lecture Notes#9 The Black-Scholes Model 4
Introduction (Contd)
Technically, the Black-Scholes model is much more
complex than the Binomial model.

The Black-Scholes model assumes time is continuous.

Thus, all returns, interest rates, etc are quoted in
continuously-compounded terms.

Moreover, prices in the model are allowed to change
continuously.

Modeling the continuous evolution of uncertainty requires
the use of very sophisticated mathematics, including
techniques drawn from the field of stochastic calculus.
Lecture Notes#9 The Black-Scholes Model 5
Introduction (Contd)
What is gained by all this sophistication?

Option prices in the Black-Scholes model can be expressed in
closed-form, i.e., as particular explicit functions of the
parameters.

This makes computing option prices very easy.

More importantly, it makes computing option sensitivities very
easy.

These sensitivities are much more difficult to compute in the
binomial model.

Lecture Notes#9 The Black-Scholes Model 6
Main Assumptions of the Model
The Black-Scholes model involves three main
assumptions:

1. Time is continuous. In particular:
Asset prices change continuously, not at discrete points in
time like the binomial model.
All returns (including interest rates) are quoted in continuously
compounded terms.

2. The risk-free rate of interest, denoted r, is constant.

3. The price of the risky asset (which we continue to call a
stock) evolves according to a geometric Brownian
motion.

Lecture Notes#9 The Black-Scholes Model 7
Main Assumptions of the Model (Contd)
What is a geometric Brownian motion?
Essentially, two conditions must be satisfied:

1. Returns on the stock over any period are log-normally distributed:
if S denotes the current stock price, and S
T
the price at a future
time t, then



The parameters and are assumed constant.

2. Stock prices must evolve smoothly: they cannot jump (the market
cannot gap).

( )
2
ln ,
T
S
N t t
S
o
| |
~
|
\ .
Lecture Notes#9 The Black-Scholes Model 8
Main Assumptions of the Model (Contd)
These assumptions appear unreasonably restrictive:
Volatility of markets is typically not constant over time.
Market prices do sometimes jump.
In particular, the no-jumps assumption appears to rule out
dividends.
Dividends (and similar predictable jumps) are
actually easily handled by the model as we will see
later.
The other issues are more problematic, and not
easily resolved.
Lecture Notes#9 The Black-Scholes Model 9
Order of Analysis
We proceed in the following order:

1. Basic Black-Scholes model: European
options/no dividends.
2. Extension to dividends.
3. Options on indices and currencies.
4. Implied volatility and the volatility smile or
skew.

Lecture Notes#9 The Black-Scholes Model 10
2. Option Prices in the Black-Scholes
Model
Option prices in the BlackScholes model may be
recovered using either of the procedures we
examined in the Binomial model:
Using a replicating/riskless hedge portfolio.
Using risk-neutral pricing methods.

Both methods are significantly more technically
complex than in the Binomial model.

We focus here on the final option prices that result
and the intuitive content of these prices.

Lecture Notes#9 The Black-Scholes Model 11
Notations
t: current time.

T: Horizon of the model. (So time-left-to-maturity: T t)

K: strike price of option.

S
t
: current price of stock.

S
T
: stock price at T.

, : Expected return and volatility of stock (annualized).

r: risk-free rate of interest.

C, P: Prices of call and put (European only).

Lecture Notes#9 The Black-Scholes Model 12
Call Option Prices in the BlackScholes
Model
We have seen that, in general, to replicate a
call, we must
Take a long position in
c
units of the underlying,
and
Borrow B
c
at the risk-free rate.

In notational terms, we can express this as:
C =
c
S
t
B
c
.
Lecture Notes#9 The Black-Scholes Model 13
Call Prices in the BlackScholes Model
(Contd)
In general,
c
and B
c
will depend on many factors including

1. Depth-in-the-money of the option. For example,
c
increases
from near-zero for deep OTM options to near unity for deep ITM
options.
2. Volatility of the underlying. For deep ITM call, delta will
decrease as volatility increases. For deep OTM call, delta will
increase as volatility increases.
3. Time-to-maturity of the option. OTM call with very short time to
maturity will have delta close to zero. Same call with longer
maturity will have larger delta.
4. Interest rate. Higher interest rate moves the call more into-the-
money, raising its delta.

Complex nature of dependencies make closed-forms hard to
obtain in general.

Lecture Notes#9 The Black-Scholes Model 14
Call Prices in the BlackScholes Model
(Contd)
Near-unique feature of BlackScholes: precise expressions
for
c
and B
c
!








N(): cumulative standard normal distribution: N(x) is the
probability under a standard normal distribution of an
observation less than or equal to x.

t T d
t T
t T r K S
d
t T
t T r K S
d
d N K e B
d N
t
t
t T r
c
c
=

+
=

+ +
=
=
= A

o
o
o
o
o
1 2
1
2
) (
1
) )( 2 /
2
( ) / ln(

) )( 2 /
2
( ) / ln(
where
) ( .
) (
Lecture Notes#9 The Black-Scholes Model 15
Call Prices in the BlackScholes Model
(Contd)
Thus, we have




This is the BlackScholes formula for a call option
on a non-dividend paying stock.

The proof is technically involved and needs some
knowledge of stochastic calculus.
) ( . . ) (
2
) (
1
d N K e d N S C
t T r
t

=
Lecture Notes#9 The Black-Scholes Model 16
Notice the similarity to the binomial
pricing:
* *
* *
n n
k k k k
n n
k k k k
1 1
( ) ( )
1 1
= ( ) ( )
k n k
n n
k n k
n n
C k u d S K k
R R
C S k u d K k
R R

= =

= =
| | | |
(
=
| |

\ . \ .
| | | |
(

| |

\ . \ .


) ( . . ) (
2
) (
1
d N K e d N S C
t T r
t

=
Lecture Notes#9 The Black-Scholes Model 17
Call Prices in the BlackScholes Model
(Contd)
However, these closed-forms do have the intuitive
properties we expect:

For example: behavior of the delta as depth-in-the-
money changes.
For deep OTM options (S << K):
c
0.
For deep ITM options (S >> K):
c
+1.

c
increases as S increases.

Similarly, at a more complex level:
For deep OTM calls:
c
increases as increases.
For deep ITM calls:
c
decreases as increases.
Lecture Notes#9 The Black-Scholes Model 18
Put Option Prices in the BlackScholes
Model
Recall that to replicate a put in general, we must
Take a short position in |
p
| units of the underlying, and
Lend B
p
at the risk-free rate.

Thus, in general, we can write the price of the put as
P = B
p
+ S
t
.
p


The Black-Scholes formula identifies the exact composition of p
and Bp:

p
= N(d
1
) B
p
= PV (K)N(d
2
)

where N(), d
1
, and d
2
are all as defined above.

Lecture Notes#9 The Black-Scholes Model 19
Put Prices in the BlackScholes Model
(Contd)
Therefore, the price of the put is given by

P = PV (K) N(d
2
) S
t
N(d
1
)

This is the Black-Scholes formula for a European put option.

Equivalently, since N(x) + N(x) = 1 for any x, we can also write

P = S
t
[N(d
1
) 1] + PV (K) [1 N(d
2
)]

Of course, the put price may also be recovered from the call
price using put-call parity.
Lecture Notes#9 The Black-Scholes Model 20
Black-Scholes via Risk-Neutral
Probabilities
Alternative way to derive BlackScholes formulae: use risk-
neutral probabilities.

To identify option prices in this approach: take expectation of
terminal payoffs under the risk-neutral probability measure and
discount at the risk-free rate.

The terminal payoffs of a call option with strike K are given by
max{S
t
K, 0}.

Therefore, the arbitrage-free price of the call option is given by
C = e
r(T-t)
E
t

[max{S
t
K, 0}]
where E
t

[] denotes timet expectations under the risk-neutral
measure.

Lecture Notes#9 The Black-Scholes Model 21
Black-Scholes via Risk-Neutral Probs
(Contd)
Equivalently, this expression may be written as

C = e
r(T-t)
E
t

[S
t
K || S
T
K]

Splitting up the expectation, we have

C = e
r(T-t)
E
t

[S
t
|| S
T
K] - e
r(T-t)
E
t

[ K || S
T
K]

From this to the BlackScholes formula is simply a
matter of grinding through the expectations, which
are tedious, but not otherwise difficult.
Lecture Notes#9 The Black-Scholes Model 22
Black-Scholes via Risk-Neutral Probs
(Contd)
Specifically, it can be shown that

e
r(T-t)
E
t

[S
t
|| S
T
K] = S
t
N(d
1
)

e
rT
E
t

[ K || S
T
K] = e
r(T-t)
K. N(d
2
)

Note, in particular, that N(d
2
) is the risk-
neutral probability that the option finishes in-
the-money (i.e., that S
T
K).

Lecture Notes#9 The Black-Scholes Model 23
Remarks
Two remarkable features of the BlackScholes formulae:
Option prices only depend on five variables: S, K, r, T, and .
Of these five variables, only onethe volatility is not directly
observable.

This makes the model easy to implement in practice.

Closed-form expressions exist in the Black-Scholes framework
only for European-style options.
For example, closed-forms do not exist for American put options.
However, it is possible to obtain closed-form solutions for certain
classes of exotic options (such as compound options or barrier
options).
Lecture Notes#9 The Black-Scholes Model 24
Plotting Option Prices (Contd)
Assume the following:
The strike price is K = 100.
The time-to-maturity is T t = 0.5 years.
The annualized volatility of the stock price is 20% ( =
0.20).
The risk-free interest rate is r=5%.

What is the price of call option using B-S formula at:
At S = 72, the call is deep OTM, while the put is deep
ITM.


Lecture Notes#9 The Black-Scholes Model 25
1
2 1
( )
1 2
2
ln( / ) ( / 2)( )
where
ln(72/100) (0.05 0.04/ 2)(0.5)
= 3.3382
0.2* 0.5
3.3382 (0.2* 0.5) 3.4382
( ) . . ( )
= 72*N( 3.3382)
t
r T t
t
S K r T t
d
T t
d d T t
C S N d e K N d
e
o
o
o

+ +
= =

+ +
=
= = =
=

0.05*0.5
0.05*0.5
1 2
0.05*0.5
*100* ( 3.4382)
= 72*0.000422 *100*0.000293 0.0018
[ ( ) - 1] ( ) [1 - ( )]
72*[0.000422 1] *100*[1 0.000293] $25.5328
t
N
e
P S N d PV K N d
P e

=
= +
= + =
Lecture Notes#9 The Black-Scholes Model 26
Table for N(x) when 0 X
x 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0 0.5 0.504 0.508 0.512 0.516 0.5199 0.5239 0.5279 0.5319 0.5359
0.1 0.5398 0.5438 0.5478 0.5517 0.5557 0.5596 0.5636 0.5675 0.5714 0.5753
0.2 0.5793 0.5832 0.5871 0.591 0.5948 0.5987 0.6026 0.6064 0.6103 0.6141
: : : : : : : : : : :
Table for N(x) when X 0
x 0 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0 0.5 0.496 0.492 0.488 0.484 0.4801 0.4761 0.4721 0.4681 0.4641
-0.1 0.4602 0.4562 0.4522 0.4483 0.4443 0.4404 0.4364 0.4325 0.4286 0.4247
-0.2 0.4207 0.4168 0.4129 0.409 0.4052 0.4013 0.3974 0.3936 0.3897 0.3859
: : : : : : : : : : :
: : : : : : : : : : :
-3.4 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0003 0.0002
( 3.4382) ( 3.43) 0.82[ ( 3.43) ( 3.44)]
0.0003 0.82[0.0003 0.0003]
N N N N ~
~
Lecture Notes#9 The Black-Scholes Model 27
Plotting Option Prices (Contd)
Four parameters are held fixed in the figure:
The strike price is K = 100.
The time-to-maturity is T t = 0.5 years.
The annualized volatility of the stock price is 20% ( = 0.20).
The risk-free interest rate is r=5%.

The figures plot call and put prices as S varies from 72 to 128.
At S = 72, the call is deep OTM, while the put is deep ITM.
At S = 128, the call is deep ITM, while the put is deep OTM.

Observe non-linear reaction of option prices to changes in stock
price.
Evident visually in the curvature of the option prices as S varies.
Can also be directly checked using the numbers.

Lecture Notes#9 The Black-Scholes Model 28
Lecture Notes#9 The Black-Scholes Model 29
4. Dividends in the BlackScholes Model
There are two possibilities to be considered here:
Discrete (lumpy) dividends of sizes D
1
,D
2
, . . . at times T
1
,
T
2
, . . . During the life of the option.
A continuous dividend yield at rate m.

The two have different technical implications and
need to be handled differently.
In particular, lumpy dividends cause a discontinuity in the
stock price, but a continuous dividend yield will not.

We consider lumpy dividends first.

Lecture Notes#9 The Black-Scholes Model 30
Lumpy Dividends in the BlackScholes
Model
For simplicity, we consider the case of a single dividend D at time T
D
, t
< T
D
< T.

Let PV (D) denote the present value at t of an amount D receivable at
T
D
.

Then, the stock price S
t
at time t can be regarded as composed of two
components:
A riskless component of PV (D).
A risky component of S
t
PV (D).

Only the risky component is relevant for pricing options.

Therefore, call can be priced simply by replacing the term S
t
in the
BlackScholes formula by (S
t
PV (D)).

Lecture Notes#9 The Black-Scholes Model 31
Lumpy Dividends in the BlackScholes
Model, contd
1
( )
2
1
2 1
( )
. ( )
2
ln(( ( )) / ) ( / 2)( )
where
2
ln(( ( )) / ) ( / 2)( )

c
r T t
c
t
t
N d
B e K N d
S PV D K r T t
d
T t
S PV D K r T t
d d T t
T t
o
o
o
o
o

A =
=
+ +
=

+
= =

( )
1 2
( ( )) ( ) . . ( )
r T t
t
C S PV D N d e K N d

=
P = (S
t
-- PV(D)) [N(d
1
) 1] + PV (K) [1 N(d
2
)]
Lecture Notes#9 The Black-Scholes Model 32
Lumpy Dividends (Contd)
The figure on the next page illustrates the impact of dividends on
Black-Scholes prices.

It considers the same range of parameter values as the earlier
plot, and compares option prices under three dividend levels:
Low: D = 0.
Medium: D = 2.
High: D = 5.

The timing of the dividend payment is assumed to be 3 months
(i.e., the halfway point of the option life).


Lecture Notes#9 The Black-Scholes Model 33
Lecture Notes#9 The Black-Scholes Model 34
Lumpy Dividends (Contd)
Note that dividends lower call prices and raise put
prices.
This is intuitive: dividends lower the price of the underlying.
Thus, they push OTM calls further OTM, and make ITM
calls less ITM.

The impact is:
Maximal for deep ITM options (nearly one-for-one).
Least for deep OTM options (near zero).
Lecture Notes#9 The Black-Scholes Model 35
Continuous Dividend Yields in the
BlackScholes Model
Suppose the stock pays a continuous dividend yield at rate m.

Compare two stocks that are identical except:
Stock 1: Continuous dividend yield at rate m.
Stock 2: No dividend payments.

Stock 1 will clearly grow at a rate m slower than Stock 2.

Thus, under the following conditions, the prices of the two stocks will
be identical at time T:
Current price of Stock 1: S
t.

Current price of Stock 2: e
m(Tt)
S
t
.

Lecture Notes#9 The Black-Scholes Model 36
Continuous Dividend Yields (Contd)
Therefore, it must also be that the following options have the same
payoffs at T (and, hence the same price today):
A Tmaturity European option on Stock 1 written at t when
the stock price is S
t
.
A Tmaturity European option on Stock 2 written at t when
the stock price is e
m(Tt)
S
t.


The second option is a European option on a non-dividend paying
stock.

The price of this option can be found from the BlackScholes
formula by using e
m(Tt)
S
t.
for the current stock price.

Lecture Notes#9 The Black-Scholes Model 37
Continuous Dividend Yields (Contd)
t T d
t T
t T m r K S
d
t T
t T m r K S
d
d N S e d N K e P
d N K e d N S e C
t
t
t
t T m t T r
t T r
t
t T m
=

+
=

+ +
=
=
=


o
o
o
o
o
1 2
1
1
) (
2
) ( *
2
) (
1
) ( *
) )( 2 /
2
( ) / ln(

) )( 2 /
2
( ) / ln(
where
) ( . - ) ( .
) ( . ) ( .
: prices opion Resulting
Lecture Notes#9 The Black-Scholes Model 38
Continuous Dividend Yields (Contd)

The following figure illustrates the impact of a continuous dividend yield.

It considers the same range of parameter values as the earlier plots,
and compares option prices under three dividend yield levels:
Low: m = 0.
Medium: m = 0.025 (i.e., a 2.5% annualized yield).
High: m = 0.10 (i.e., a 10% annualized yield).

The higher the yield, the lower the growth rate of the stock price.

Thus, higher m implies lower call prices and higher put prices.

Again: impact is maximal for deep ITM options and least for deep OTM
options.

Lecture Notes#9 The Black-Scholes Model 39
m
m
m
m
m
m
Lecture Notes#9 The Black-Scholes Model 40
Options on Indices & Currencies
Using the Black-Scholes formula adjusted for
a continuous dividend yield, we can extend
the pricing formulae to also cover:

Stock indices.

Currencies (sometimes called the Garman-
Kohlhagen model).
Lecture Notes#9 The Black-Scholes Model 41
Options on Indices
Many exchange-traded options exist on stock indices.

Both European- and American-style index options exist.
S&P 500 index options: European
S&P 100 index options: American

Like index futures, index options are also cash settled. If S
T
is the
index level at close of the trading day, then at maturity:

Holder of call receives max{S
T
K, 0}
Holder of put receives max{K S
T
, 0}
Lecture Notes#9 The Black-Scholes Model 42
Index Options (Contd)
An index can be treated as an asset paying a continuous dividend
yield.

Therefore, the earlier formula can be used with m denoting the yield
on the index.

This results in:
t T d
t T
t T m r K S
d
t T
t T m r K S
d
d N S e d N K e P
d N K e d N S e C
t
t
t
t T m t T r
t T r
t
t T m
=

+
=

+ +
=
=
=


o
o
o
o
o
* *
*
1
) (
2
) ( *
2
) (
1
) ( *
1 2
1
) )( 2 /
2
( ) / ln(

) )( 2 /
2
( ) / ln(
where
) ( . - ) ( .
) ( . ) ( .
Lecture Notes#9 The Black-Scholes Model 43
Options on Currency
Options on foreign currencies are traded on the
Philadelphia Exchange and on the OTC market.

The underlying asset here is the foreign currency.
Thus, the underlying is an interest-paying asset.
Let r
f
denote the (continuously-compounded) interest rate
on foreign currency.

Note an important symmetry:
A call option to purchase DM with $ at a given exchange
rate is a put option to sell $ for DM at that rate.

Lecture Notes#9 The Black-Scholes Model 44
Currency Options (Contd)
Foreign currency = asset with a continuous dividend yield.

Earlier formulae apply with m replaced by r
f
and S = exchange rate.

This results in:

t T d
t T
t T r r K S
d
t T
t T r r K S
d
d N S e d N K e P
d N K e d N S e C
f t
f t
t
t T r
t T r
t T r
t
t T r
f
f
=

+
=

+ +
=
=
=




o
o
o
o
o
* *
*
1
) (
2
) ( *
2
) (
1
) (
*
1 2
1
) )( 2 /
2
( ) / ln(

) )( 2 /
2
( ) / ln(
where
) ( . - ) ( .
) ( . ) ( .
Lecture Notes#9 The Black-Scholes Model 45
6. Implied Volatility
Given an option price, one can ask the question:
what level of volatility is implied by the observed
price?

This level is the implied volatility.

Formally, implied volatility is the volatility level that
would make observed option prices consistent with
the Black-Scholes formula, given values for the
other parameters.
Lecture Notes#9 The Black-Scholes Model 46
Implied Volatility (Contd)
For example, suppose we are looking at a call on a non-dividend-
paying stock.
Let K and T t denote the calls strike and time-to-maturity, and
let C be the calls price.
Let S
t
be the stock price and r the interest rate.
Then, the implied volatility is the unique level for which
C
bs
(S, K, T t, r, ) = C ,
where C
bs
is the Black-Scholes call option pricing formula.

Note that implied volatility is uniquely defined since C
bs
is strictly
increasing in .
Lecture Notes#9 The Black-Scholes Model 47
Implied Volatility (Contd)
Implied volatility represents the markets
perception of volatility anticipated over the
options lifetime.

Implied volatility is thus forward looking.

In contrast, historical volatility is backward
looking.

Lecture Notes#9 The Black-Scholes Model 48
The Volatility Smile/Skew
In theory, any option (any K or T) may be used for measuring
implied volatility.

Thus, if we fix maturity and plot implied volatilities against strike
prices, the plot should be a flat line.

In practice, in equity markets, implied volatilities for low strikes
(corresponding to out-of-the-money puts) are typically much
higher than implied volatilities for ATM (At-of-the-money)
options.

This is the volatility skew.
In currency markets: volatility smile.

Lecture Notes#9 The Black-Scholes Model 49
The Source of the Volatility Skew
The Black-Scholes model assumes log-returns are normally
distributed.

However, in every financial market, extreme observations are far
more likely than predicted by the log-normal distribution.

Extreme observations = observations in the tail of the distribution.
Empirical distributions exhibit fat tails or leptokurtosis.

Moreover, empirical log-returns distributions are often skewed, in
contrast to the normal distribution underlying BlackScholes.

50
Normal versus non-normal
distribution
0
1% of the normal distribution
normal distribution
actual distribution
1% of the actual
distribution
Underestimation of risk
Lecture Notes#9 The Black-Scholes Model 51
Source of the Volatility Skew (Contd)
Fat tails Black-Scholes model with a constant volatility will
underprice out-of-the-money puts relative to those at-the-
money.

Thus, in practice, when the Black-Scholes model is used for
pricing OTM puts, a higher volatility is used than that used for
ATM options.

This is inconsistent, of course.

However, it is a quick-fix that generates the necessary extra
weight in the tails to raise the option price.

Lecture Notes#9 The Black-Scholes Model 52
Information in the Volatility Smile/Skew
The volatility skew is evidence not only that the lognormal model
is not a completely accurate description of reality but also that
the market recognizes this shortcoming.

As such, there is valuable information in the smile/skew
concerning the actual (more accurately, the markets
expectation) of the return distribution:

For example:
More symmetric smile Less skewed distribution.
Flatter smile/skew Smaller kurtosis.

Lecture Notes#9 The Black-Scholes Model 53
Generalizing Black-Scholes
Obvious question: why not generalize the log-normal
distribution?

Indeed, there may even be a natural generalization.

The Black-Scholes model makes two uncomfortable
assumptions:
No jumps.
Constant volatility.

If jumps are added to the log-normal model or if volatility is
allowed to be stochastic, the model will exhibit fat tails and even
skewness.

Lecture Notes#9 The Black-Scholes Model 54
Generalizing Black-Scholes (Contd)
So why dont we just do this?

Tremendously increased complexity.
Jumps & stochastic volatility have very different
dynamic implications.
Reality is more complex than either model
(indeed, substantially so).

Ultimately: better to use a simple model with
known shortcomings?