The Black-Scholes Model

Liuren Wu

Options Markets

(Hull chapter: 12, 13, 14)

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The Black-Scholes-Merton (BSM) model

Black and Scholes (1973) and Merton (1973) derive option prices under the
following assumption on the stock price dynamics,

dSt = St dt + St dWt (explained later)

The binomial model: Discrete states and discrete time (The number of
possible stock prices and time steps are both finite).
The BSM model: Continuous states (stock price can be anything between 0
and ) and continuous time (time goes continuously).
Scholes and Merton won Nobel price. Black passed away.
BSM proposed the model for stock option pricing. Later, the model has
been extended/twisted to price currency options (Garman&Kohlhagen) and
options on futures (Black).
I treat all these variations as the same concept and call them
indiscriminately the BSM model (combine chapters 13&14).

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Primer on continuous time process
dSt = St dt + St dWt

The driver of the process is Wt , a Brownian motion, or a Wiener process.

The process Wt generates a random variable that is normally distributed
with mean 0 and variance t, (0, t). (Also referred to as Gaussian.)
The process is made of independent normal increments dWt (0, dt).
d is the continuous time limit of the discrete time dierence ().
t denotes a finite time step (say, 3 months), dt denotes an extremely
thin slice of time (smaller than 1 milisecond).
It is so thin that it is often referred to as instantaneous.
Similarly, dWt = Wt+dt Wt denotes the instantaneous increment
(change) of a Brownian motion.

By extension, increments over non-overlapping time periods are

independent: For (t1 > t2 > t3 ), (Wt3 Wt2 ) (0, t3 t2 ) is independent
of (Wt2 Wt1 ) (0, t2 t1 ).

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Properties of a normally distributed random variable

dSt = St dt + St dWt

If X (0, 1), then a + bX (a, b 2 ).

If y (m, V ), then a + by (a + bm, b 2 V ).
Since dWt (0, dt), the instantaneous price change
dSt = St dt + St dWt (St dt, 2 St2 dt).
The instantaneous return dS
S = dt + dWt (dt, 2 dt).
Under the BSM model, is the annualized mean of the instantaneous
return instantaneous mean return.
2 is the annualized variance of the instantaneous return
instantaneous return variance.
is the annualized standard deviation of the instantaneous return
instantaneous return volatility.

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Geometric Brownian motion
dSt /St = dt + dWt

The stock price is said to follow a geometric Brownian motion.

is often referred to as the drift, and the diusion of the process.
Instantaneously, the stock price change is normally distributed,
(St dt, 2 St2 dt).
Over longer horizons, the price change is lognormally distributed.
The log return (continuous compounded return) is normally distributed over
all horizons:
( )
d ln St = 12 2 dt + dWt . (By Itos lemma)
d ln St (dt 12 2 dt, 2 dt).
ln St (ln S0((+ t 12) 2 t, 2 t). )
ln ST /St 12 2 (T t), 2 (T t) .
1 2
Integral form: St = S0 e t 2 t+Wt
, ln St = ln S0 + t 12 2 t + Wt

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Simulate 100 stock price sample paths
dSt = St dt + St dWt , = 10%, = 20%, S0 = 100, t = 1.
0.05 200

0.04
180
0.03
160
0.02
Daily returns

Stock price
0.01 140

0 120

0.01
100
0.02
80
0.03

0.04 60
0 50 100 150 200 250 300 0 50 100 150 200 250 300
Days days

Stock with the return process: d ln St = ( 12 2 )dt + dWt .

Discretize to daily intervals dt t = 1/252.
Draw standard normal random variables (100 252) (0, 1).

Convert them into daily log returns: Rd = ( 12 2 )t + t.
252
Rd
Convert returns into stock price sample paths: St = S0 e d=1 .

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The key idea behind BSM

The option price and the stock price depend on the same underlying source
of uncertainty.
The Brownian motion dynamics imply that if we slice the time thin enough
(dt), it behaves like a binominal tree.
Reversely, if we cut t small enough and add enough time steps, the
binomial tree converges to the distribution behavior of the geometric
Brownian motion.
Under this thin slice of time interval, we can combine the option with
the stock to form a riskfree portfolio.
Recall our hedging argument: Choose such that f S is riskfree.
The portfolio is riskless (under this thin slice of time interval) and must
earn the riskfree rate.
Magic: does not matter for this portfolio and hence does not matter
for the option valuation. Only matters.
We do not need to worry about risk and risk premium if we can hedge
away the risk completely.

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Partial dierential equation

The hedging argument mathematically leads to the following partial

dierential equation:

f f 1 2f
+ (r q)S + 2 S 2 2 = rf
t S 2 S

At nowhere do we see . The only free parameter is (as in the

binominal model).

Solving this PDE, subject to the terminal payo condition of the derivative
(e.g., fT = (ST K )+ for a European call option), BSM can derive
analytical formulas for call and put option value.

Similar formula had been derived before based on distributional

(normal return) argument, but (risk premium) was still in.
The realization that option valuation does not depend on is big.
Plus, it provides a way to hedge the option position.

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The BSM formulae

ct = St e q(T t) N(d1 ) Ke r (T t) N(d2 ),

pt = St e q(T t) N(d1 ) + Ke r (T t) N(d2 ),
where
ln(St /K )+(r q)(T t)+ 12 2 (T t)
d1 = ,
T t
ln(St /K )+(r q)(T t) 21 2 (T t)
d2 =
T t
= d1 T t.
Black derived a variant of the formula for futures (which I like better):

ct = e r (T t) [Ft N(d1 ) KN(d2 )],

ln(Ft /K ) 12 2 (T t)
with d1,2 = .
T t

Recall: Ft = St e (r q)(T t) . Use forward price Ft to accommodate various

carrying costs/benefits.
Once I know call value, I can obtain put value via put-call parity:
ct pt = e r (T t) [Ft Kt ].

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Cumulative normal distribution

ln(Ft /K ) 21 2 (T t)
ct = e r (T t) [Ft N(d1 ) KN(d2 )] , d1,2 =
T t
N(x) denotes the cumulative normal distribution, which measures the
probability that a normally distributed variable with a mean of zero and a
standard deviation of 1 ((0, 1)) is less than x.
See tables at the end of the book for its values.
Most software packages (including excel) has ecient ways to computing
this function.
Properties of the BSM formula:
As St becomes very large or K becomes very small, ln(Ft /K ) ,
N(d1 ) = N(d2 ) = 1. ct = e r (T t) [Ft K ] .
Similarly, as St becomes very small or K becomes very large,
ln(Ft /K ) , N(d1 ) = N(d2 ) = 1. pt = e r (T t) [Ft + K ].

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Options on what?

Why does it matter?

As long as we assume that the underlying security price follows a geometric
Brownian motion, we can use (some versions) of the BSM formula to price
European options.
Dividends, foreign interest rates, and other types of carrying costs may
complicate the pricing formula a little bit.
A simpler approach: Assume that the underlying futures/forwards price (of
the same maturity of course) process follows a geometric Brownian motion.
Then, as long as we observe the forward price (or we can derive the forward
price), we do not need to worry about dividends or foreign interest rates
They are all accounted for in the forward pricing.
Know how to price a forward, and use the Black formula.

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Implied volatility
ln(Ft /K ) 21 2 (T t)
ct = e r (T t) [Ft N(d1 ) KN(d2 )] , d1,2 =
T t
Since Ft (or St ) is observable from the underlying stock or futures market,
(K , t, T ) are specified in the contract. The only unknown (and hence free)
parameter is .
We can estimate from time series return. (standard deviation calculation).
Alternatively, we can choose to match the observed option price
implied volatility (IV).
There is a one-to-one, monotonic correspondence between prices and
implied volatilities.
As long as the option price does not allow arbitrage against cash, there
exists a solution for a positive implied volatility that can match the
price.
Traders and brokers often quote implied volatilities rather than dollar prices.
More stable; more informative; excludes arbitrage
The BSM model says that IV = . In reality, the implied volatility calculated
from dierent options (across strikes, maturities, dates) are usually dierent.
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Violations of BSM assumptions
The BSM model says that IV = . In reality, the implied volatility calculated
from dierent options (across strikes, maturities, dates) are usually dierent.
These dierence indicates that in reality the security price dynamics dier
from the BSM assumptions:
Jumps: BSM assume that the security price moves by a small amount
(diusion) over a short time interval. In reality, sometimes the market can
jump by a large amount in an instant.
With jumps, returns are no longer normally distributed, but tend to
have fatter tails, and sometimes can be asymmetric (skewed).
Implied volatility at dierent strikes will be dierent.
Stochastic volatility: The volatility of a security is not constant, but varies
randomly over time, and can be correlated with the return move.
Implied volatilities will change over time.
Stochastic volatility also induces return non-normality.
Correlation between return and volatility induces return distribution
asymmetry.
Second-generation models can accommodate all these features.
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Implied volatility smiles and skews
AMD: 17Jan2006 SPX: 17Jan2006 GBPUSD
0.75 0.22 9.8

0.7 0.2 9.6

9.4

Average implied volatility

0.65 0.18 More skews than smiles
Shortterm smile 9.2
Implied Volatility

Implied Volatility
0.6 0.16

9
0.55 0.14

8.8
0.5 Longterm skew 0.12
8.6
0.45 0.1
8.4
Maturities: 32 95 186 368 732 Maturities: 32 60 151 242 333 704

0.4 0.08
3 2.5 2 1.5 1 0.5 0 0.5 1 1.5 2 3 2.5 2 1.5 1 0.5 0 0.5 1 1.5 2 8.2
10 20 30 40 50 60 70 80 90
Moneyness= ln(K/F


)
Moneyness= ln(K/F


)
Put delta

Plots of option implied volatilities across dierent strikes at the same

maturity often show a smile or skew pattern, reflecting deviations from the
return normality assumption.
A smile implies that the probability of reaching the tails of the distribution is
higher than that from a normal distribution. Fat tails, or (formally)
leptokurtosis.
A negative skew implies that the probability of downward movements is
higher than that from a normal distribution. Negative skewness in the
distribution.
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Stochastic volatility on stock indexes and currencies
SPX: Implied Volatility Level FTS: Implied Volatility Level
0.5 0.55

0.5
0.45
0.45
0.4
0.4
Implied Volatility

Implied Volatility
0.35
0.35

0.3 0.3

0.25
0.25
0.2
0.2
0.15
0.15
0.1

0.1 0.05
96 97 98 99 00 01 02 03 96 97 98 99 00 01 02 03

JPYUSD GBPUSD
28
12
26
24 11

22 10
Implied volatility

Implied volatility
20
9
18

16 8

14 7
12
6
10
8 5

1997 1998 1999 2000 2001 2002 2003 2004 1997 1998 1999 2000 2001 2002 2003 2004

At the-money option implied volatilities vary strongly over time, higher during
crises and recessions.
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Stochastic skewness on stock indexes and currencies

Implied volatility spread between 80% and 120% strikes

SPX: Implied Volatility Skew FTS: Implied Volatility Skew
0.4 0.4
Implied Volatility Difference, 80%120%

Implied Volatility Difference, 80%120%

0.35 0.35

0.3
0.3
0.25
0.25
0.2
0.2
0.15
0.15
0.1

0.1 0.05

0.05 0
96 97 98 99 00 01 02 03 96 97 98 99 00 01 02 03

10-delta call minis 10-delta put implied volatility

JPYUSD GBPUSD

50
10
40

30 5
RR10 and BF10

RR10 and BF10

20 0

10
5
0
10
10

20 15
1997 1998 1999 2000 2001 2002 2003 2004 1997 1998 1999 2000 2001 2002 2003 2004

Return skewness also varies over time.

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Summary

Understand the basic properties of normally distributed random variables.

Map a stochastic process to a random variable.
Understand the link between BSM and the binomial model.
Memorize the BSM formula (any version).
Understand forward pricing and link option pricing to forward pricing.
Can go back and forth with the put-call parity conditions, lower and upper
bounds, either in forward or in spot notation.
Understand the general implications of the implied volatility plots.

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