Derivatives

Chapter 12 The Black-Scholes Formula

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The Black-Scholes Formula

• In this chapter we present the Black-Scholes formula for pricing

European options
• Explain how it is used for different underlying assets
• Discuss the so-called option Greeks—delta, gamma, theta,
vega, rho, and psi—which measure the behavior of the option
price when inputs to the formula change.
• We also show how observed option prices can be used to infer
the market’s estimate of volatility.

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12.1 INTRODUCTION TO THE BLACK-SCHOLES
FORMULA

• Call Options
• Put Options
• When Is the Black-Scholes Formula Valid?

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Binomial Option Pricng
• When computing a binomial option price, we can vary the
number of binomial steps, holding fixed the time to expiration.
• Changing the number of steps changes the option price.
• Once the number of steps becomes great enough we appear to
approach a limiting value for the price.

• The Black-Scholes formula is a limiting case of the binomial

formula for the price of a European option.
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Call Options

• As with the binomial model, there are six inputs to the

Black-Scholes formula:
- S, the current price of the stock;
- K, the strike price of the option;
- σ, the volatility of the stock;
- r, the continuously compounded risk-free interest rate;
- T, the time to expiration;
- δ, the dividend yield on the stock.

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Call Options

• The Black-Scholes formula for a European call option on a stock

that pays dividends at the continuous rate δ is

C(S, K , σ, r , T , δ) = Se−δT N(d1 ) − Ke−rT N(d2 )

where
ln(S/K ) + (r − δ + 12 σ 2 )T
d1 = √
σ T
√
d2 = d1 − σ T
• The function N(x) in the Black-Scholes formula is the cumulative
standard normal distribution function (mean 0 and variance 1)

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Call Options

• How is the Black-Scholes formula related to the binomial pricing

forumla?
C(S, K , σ, r , T , δ) = ∆S + B

where
∆ = e−δT N(d1 )

B = −Ke−rT N(d2 )
• It can be shown that when the number of steps go to infinity, the
solution of ∆ and B of the binomial pricing formula converge to
the solution of the Black-Scholes formula

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Call Options
Example. (12.1) Let S = $41, K = $40, σ = 0.3, r = 8%, T = 0.25 (3
months), and δ = 0. What is the call option price?

ln(S/K ) + (r − δ + 12 σ 2 )T
d1 = √
σ T
2
ln( 41 0.3
40 ) + (0.08 − 0 + 2 ) × 0.25
= √
0.3 × 0.25
√ √
d2 = d1 − σ T = d1 − 0.3 × 0.25

C = Se−δT N(d1 ) − Ke−rT N(d2 )

= 41e−0×0.25 N(d1 ) − 40e−0.08×0.25 N(d2 )
= 3.399

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Put Options

• The pricing formula for a European put follows from put-call

parity:
P(S, K , σ, r , T , δ) = C(S, K , σ, r , T , δ) + Ke−rT − Se−δT

• Using the Black-Scholes equation for the call, we can also write
the put formula as

P(S, K , σ, r , T , δ) = Ke−rT N(−d2 ) − Se−δT N(−d1 )

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Put Options

Example. (12.2) Let S = $41, K = $40, σ = 0.3, r = 8%, T = 0.25 (3

months), and δ = 0. What is the put option price?
• Method 1 (formula):

P = Ke−rT N(−d2 ) − Se−δT N(−d1 )

= 40e−0.08×0.25 N(−d2 ) − 41e−0×0.25 N(−d1 )
= 1.607

• Method 2 (parity):

P = C − PV (F − K )
= 3.399 + 40e−0.08×0.25 − 41 = 1.607

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When Is the Black-Scholes Formula Valid?

• Assumptions about the distribution of the stock price

- Continuously compounded returns on the stock are normally
distributed and independent over time .
- The volatility of continuously compounded returns is known and
constant.
- Future dividends are known, either as a dollar amount or as a
fixed dividend yield.
• Assumptions about the economic environment
- The risk-free rate is known and constant.
- There are no transaction costs or taxes.
- It is possible to short-sell costlessly and to borrow at the risk-free
rate.
• Many of these assumptions can easily be relaxed

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12.2 APPLYING THE FORMULA TO OTHER ASSETS

• Options on Currencies

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Options on Currencies

• We can price an option on a currency by replacing the dividend

yield with the foreign interest rate
- the spot exchange rate is x
- the foreign currency interest rate is rf
C(x, K , σ, r , T , rf ) = xe−rf T N(d1 ) − Ke−rT N(d2 )

where
ln(x/K ) + (r − rf + 21 σ 2 )T
d1 = √
σ T
√
d2 = d1 − σ T
• The price of a European put follows from put-call parity:
P(x, K , σ, r , T , rf ) = C(x, K , σ, r , T , rf ) + Ke−rT − xe−rf T

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Options on Currencies

Example. (12.4) Suppose the spot exchange rate is x = 1.25

dollar/euro, K = $1.20, σ = 0.10, r = 1% (the dollar interest rate), T =
1, and rf = 3% (the euro-denominated interest rate).

0.12
ln( 1.25
1.2 ) + (0.01 − 0.03 + 2 )
d1 =
0.1
d2 = d1 − 0.1

C = 1.25e−0.03 N(d1 ) − 1.2e−0.01 N(d2 ) = 0.061407

• The price of a dollar-denominated euro call is $0.061407

• The price of a dollar-denominated euro put is $0.03641

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12.3 OPTION GREEKS

• Definition of the Greeks

• Greek Measures for Portfolios
• Option Elasticity

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Definition of the Greeks

• Option Greeks are formulas that express the change in the

option price when an input to the formula changes, taking as
fixed all the other inputs
• One important use of Greek measures is to assess risk
exposure

Example. A market-making bank with a portfolio of options would

want to understand its exposure to changes in stock prices, interest
rates, volatility, etc. An options investor would like to know how
interest rate changes and volatility changes affect profit and loss.
• Similar to DV01 and duration of Bonds (the change in the bond
price when yield changes)

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Delta

• Delta (∆) measures the option price change when the stock
price increases by $1.
∂C(S,K ,σ,r ,T ,δ)
- ∆= ∂S

• For a call option, delta is positive. As the stock price increases,

the call price increases.
• Delta for a put option is negative, so a stock price increase
reduces the put price.
• You can think of delta as the share-equivalent of the option.

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Delta

when maturity t increases, delta is larger, because

there are more volatility of option price chnge

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Delta
• How does delta change with moneyness?
- An in-the-money option will be more sensitive to the stock price
than an out-of-the-money option.
0(OTM) ≤ ∆ ≤ 1(ITM)

Example.
- If a call is deep in-the-money (i.e., the stock price is $60), it is
likely to be exercised and hence the option should behave much
like a leveraged position in a full share. Delta approaches 1 in this
case and the share-equivalent of the option is 1.
- If a call is out-of-the-money, it is unlikely to be exercised and the
option behaves like a position with very few shares. In this case
delta is approximately 0 and the share-equivalent is 0.
- An at-the-money option may or may not be exercised and, hence,
behaves like a position with between 0 and 1 share.
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 delta is always increasing, so gamma is also always increasing
Gamma
• Gamma (Γ) measures the change in delta when the stock price
increases by $1.
∂ 2 C(S,K ,σ,r ,T ,δ)
- Γ= ∂S 2
• Gamma is always positive for a call or put.

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Vega

• Vega measures the change in the option price when there is an

increase in volatility of 1 percentage point.
- “vega” and “volatility” share the same first letter
- vega = ∂C(S,K∂σ
,σ,r ,T ,δ)
vega is bigger for at-the money
• Vega is positive
- high volatility makes options more valuable
• How does vega change with moneyness?
- Vega tends to be greater for at-the-money options
- The exercise decisions of deep OTM and ITM options are less
affected by volatility

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Theta
• Theta (θ) measures the change in the option price when there is
a decrease in the time to maturity of 1 day.
- “theta” and “time” share the same first letter
,T −t,δ)
- θ = ∂C(S,K ,σ,r
∂t

theta is the slope of the curve

these are european options

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Theta
• Options generally—but not always—become less valuable as
time to expiration decreases.
- Some special cases (Ch 9).

call

put

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Rho

• Rho (ρ) measures the change in the option price when there is
an increase in the interest rate of 1 percentage point.
- interest rate “r” and “rho” share the same first letter
- ρ = ∂C(S,K∂r,σ,r ,T ,δ)
• Rho is positive for a call. I’m paying strike in call
- Exercising a call entails paying the fixed strike price to receive the
stock
- A higher interest rate reduces the present value of the strike.
• Rho is negative for a put. I’m getting strike in put
- z put entitles the owner to receive cash
- A higher interest rate reduces the present value of the cash.

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Psi
• Psi (Ψ) measures the change in the option price when there is
an increase in the continuous dividend yield of 1 percentage
point. you do not have stock, you only get stock but no dividend at maturity
∂C(S,K ,σ,r ,T ,δ)
- Ψ= ∂δ
• Psi is negative for a call.
- A call entitles the holder to receive the stock, but without receiving
the dividends paid on the stock prior to exercising the option.
- The present value of the stock to be received goes down when
the dividend yield goes up.
• Psi is positive for a put.
- A put entails an obligation to deliver the stock in the future in
exchange for cash.
- The present value of the stock to be delivered goes down when
the dividend yield goes up.
you hold stock and receieve dividend, so when dividend increases you fell good
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Rho and Psi

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Summary of Greeks

• How do European C(S, K , σ, r , T , δ) and P(S, K , σ, r , T , δ)

change with each input?

If the input increases

Input Greek Call price Put price

Spot Price S ∆ increase decrease

Strike Price K decrease increase
Volatility σ vega increase increase
Interest Rate r ρ increase decrease
Time to Expiration T θ generally increase generally increase
Dividend δ Ψ decrease increase

• “Increases” mean the greek is positive, except θ.

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Greek Measures for Portfolios

• The Greek measure of a portfolio is the sum of the Greeks of the

individual portfolio components.
• Thus, the risk of complicated option positions is easy to evaluate.
• For a portfolio containing N options with a single underlying
stock, where the quantity of each option is given by ni, we have
N
X
∆portfolio = ni ∆i
i=1

• The same relation holds true for the other Greeks as well.

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Greek Measures for Portfolios

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Option Elasticity

• An option is an alternative to investing in the stock.

• Delta tells us the dollar risk of the option relative to the stock
- If the stock price changes by $1, by how much does the option
price change?
• The option elasticity tells us the risk of the option relative to the
stock in percentage terms
- If the stock price changes by 1%, what is the percentage change
in the value of the option?

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Dollar Risk of the Option
• If the stock price changes by , the change in the option price is

Change in option price = Change in stock price×option delta

=×∆

Example. (12.7) Suppose that the stock price is S = $41, the strike
price is K = $40, volatility is σ = 0.30, the risk-free rate is r = 0.08, the
time to expiration is T = 1, and the dividend yield is δ = 0.
• The call price is $6.961.
• Delta is 0.6911.
• If we own options to buy 1000 shares of stock, the delta of the
position is 691.1 shares of stock
• If the stock price changes by $0.50, we expect an option price
change of approximately 1000 × ∆ × 0.50 = 345.55
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Percentage Risk of the Option
• The option elasticity computes the percentage change in the
option price relative to the percentage change in the stock price.
• The percentage change in the stock price is simply /S.
• The percentage change in the option price is the dollar change
in the option price divided by the option price: ∆/C
• The option elasticity is the ratio of these two: Ω = S∆/C
• The elasticity tells us the percentage change in the option for a
1% change in the stock.
- It is effectively a measure of the leverage implicit in the option.

Example. (12.8) In the previous example, the call elasticity is

41 × 0.6911
= 4.071
6.961

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Percentage Risk of the Option
• A call option is replicated by a levered investment in the stock.
• The implicit leverage in the option becomes greater as the option
is more out-of-the-money.

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The Volatility of an Option

• The volatility of an option is the elasticity times the volatility of

the stock
σoption = σstock × |Ω|
• |Ω| is the absolute value of Ω

Example. The stock volatility is σ = 0.30. Therefore, the option

volatility is

σoption = σstock × |Ω| = 0.30 × 4.071 = 1.22

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The Risk Premium and Beta of an Option

• Let α denote the expected rate of return on the stock, γ the

expected return on the option, and r the risk-free rate.
• The return on the option is a weighted average of the return on
the stock and the risk-free rate. borrow money to buy stock
so there is a leverage
∆S ∆S
γ= α + (1 − )r
C C
= Ωα + (1 − Ω)r

• The risk premium on the option equals the risk premium on the
stock times Ω. dS/C is the weight of stock in option
γ − r = (α − r ) × Ω

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The Sharpe Ratio of an Option

• The Sharpe ratio for any asset is the ratio of the risk premium to
volatility
• The risk premium on the option equals the risk premium on the
stock times Ω.
Ω(α − r ) α−r
Sharpe ratio = =
Ωσ σ
• The Sharpe ratio for a call equals the Sharpe ratio for the
underlying stock.
- leverage per se does not change the Sharpe ratio

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12.5 IMPLIED VOLATILITY

• Computing Implied Volatility

• Using Implied Volatility

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Implied Volatility
• How to measure future volatility?
- One approach is to compute historical volatility using the history
of returns (Ch 10). But expected future volatility can be different
from historical volatility.
• The option price should reveal the market’s expectations about
the future stock price distribution.
- An option market as the venue where volatility is traded and
revealed.
- Options are claims that investors use to hedge and speculate on
future values of the stock price.

Example. The price of a deep out-of-the-money put depends

upon the market’s assessment that the stock will decline enough
for the put to be valuable
• One way to extract information from an option price is by
computing the option’s implied volatility.
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Computing Implied Volatility

• The option’s implied volatility is the volatility that, when put into a
pricing formula, yields the observed option price
• To compute a Black-Scholes implied volatility, assume that we
observe the stock price S, strike price K, interest rate r, dividend
yield δ, and time to expiration T. The implied call volatility is the σ̂
that solves
Option Price = C(S, K , σ̂, r , T , δ)

• Any pricing model can be used to calculate an implied volatility,

but Black-Scholes implied volatilities are frequently used as
benchmarks.

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Computing Implied Volatility

• The volatility plots exhibit different patterns.

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Volatility Skew

• A difference in volatilities between in-the-money and

out-of-the-money options is referred to as volatility skew.
• A volatility smile is symmetric, with volatility lowest for
at-the-money options, and high for in-the-money and
out-of-the-money options.
• A lopsided smile is a “smirk”
• An upside-down smile would be a “frown.”

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Volatility Skew

• If the Black-Scholes model were literally true, implied volatilities

for a given underlying asset would be the same at all strike
prices and maturities.
• The existence of volatility skew suggests that the Black-Scholes
model and assumptions are not a perfect description of the
world.
• Several more complex models:
- the jump diffusion model: the underlying asset can jump
- the Heston model: the instantaneous volatility of the stock evolves
stochastically with the stock price

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VIX
• Chicago Board Options Exchange (CBOE) has reported an
index of implied volatility called the “VIX” (its ticker symbol).
• The CBOE reported implied volatility for the S&P 100 index,
computed from near-the-money options.
• It is commonly referred to as the fear index or the fear gauge.

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Using Implied Volatility
• Implied volatility is a standard descriptive measure with
important practical uses.
• If you need to price an option for which you cannot observe a
market price, you can use implied volatility to generate a price
consistent with the prices of traded options. Market-makers will
price options consistently with prices of similar options.
• Implied volatility is often used as a quick way to describe the
level of option prices on a given underlying asset: you could
quote option prices in terms of volatility, rather than as a dollar
price.
• Volatility skew provides a measure of the extent to which pricing
deviates from the assumptions underlying the Black-Scholes
model.
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A Case Study: HSBC Option

• Previously, we use the historical volatility

• Let’s use the implied volatility σ = 13.896%
• We obtain the price from the binomial model
Historical Vol Implied Vol

Two-period Binomial Tree 0.69 0.68

Multi-period Binomial Tree 0.64 0.62
Black-Scholes 0.62 0.62
Market Price 0.62

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