The Black Scholes model

1 The model
The Black-Scholes model for a stock price process is defined as
1 2
St = S0 e(µ− 2 σ )t+σWt
. (1)

where Wt is a standard Brownian motion. From Ito’s lemma, we have seen that St satisfies the SDE

dSt = St [µdt + σdWt ]

which is known as Geometric Brownian motion. µ is the drift of the process which describes the overall up-
ward/downward trend, and σ is the volatility, which describes its variability.

2 The stock price distribution under the Black-Scholes model

• Re-arranging (1) we see that

St 1
log St − log S0 = log = (µ − σ 2 )t + σWt .
S0 2

Thus we can calculate the distribution of log SS0t as

St 1
log ∼ N (µ − σ 2 )t, σ 2 t)
S0 2

or equivalently log St ∼ N (log S0 + (µ − 21 σ 2 )t, σ 2 t).

• We compute P(ST > K) as follows:

ST K
P(ST > K) = P(log > log )
S0 S0
log SST0 − (µ − 12 σ 2 )T log K
− (µ − 12 σ 2 )T
= P( √ > S0
√ )
σ T σ T
log SK0 − (µ − 12 σ 2 )T
= P(Z > √ )
σ T
= Φc (z)
ST
log K
−(µ− 12 σ 2 )T log −(µ− 12 σ 2 )T
where z = S0
√ , because Z = S0
√ is a standard N (0, 1) random variable, and Φc (x) =
∫ ∞ 1 −z2 /2 σ T σ T
√ e dz.
x 2π

• Example: set S = 1, K = 1.1, σ = .1, τ = .25, µ = .05. Then we have z = 1.681203596 and P(ST > K) = Φc (z) =
0.046361687633 (CHECK!). Use Normsdist(.) to calculate Φ and Φc in Excel.
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0.8 1.0 1.2 1.4

Figure 1: Here we have plotted the stock price density fSt (S) for σ = .1 and t = 1.

• Note that

P(St ≤ S) = P(log St ≤ log S) = F (log S)

where F is the distribution function of log S. Differentiating both sides with respect to S and using the chain
rule, we see that the density fSt (S) of St is given by

d 1 ′ 1
fSt (S) = P(St ≤ S) = F (log S) = fX (x)
dS S S t
where x = log S and fXt (x) is the density of Xt which is given by
(x−x0 −(µ− 1 σ 2 )t)2
1
e−
2
fXt (x) = √ 2σ 2 t (2)
2
2πσ t

so
[log S−log S0 −(µ− 1 σ 2 )t]2
1
e−
2
fSt (S) = √ 2σ 2 t .
S 2πσ 2 t
1
St has what is known as a lognormal distribution. Note the presence of the S pre-factor, and this pdf is only
defined for S > 0 because the stock price cannot go negative.
• fSt (S) is a probability density function and thus must integrate to 1, i.e.
∫ ∞
fSt (S)dS = 1 .
0
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1.0

0.8

0.6

0.4

0.2

0.5 1.0 1.5 2.0

Figure 2: Here we have plotted the “hockey stick” payoff max(S − K, 0).

3 The Black-Scholes PDE

A European call option is a contract which pays max(ST − K, 0) at the maturity time T in the future.

Suppose that f is the price of a call option or other derivative depending on St and t. We expect that f must be
some function f (S, t) of S and t, which we assume to be twice differentiable in S and once in t. Thus, by Ito’s lemma
we have
1
df = ft dt + fS dSt + fSS σ(St )2 dt
2
1 2
= (ft + µSt fS + σ fSS St2 )dt + fS St σdWt .
2
We now wish to hedge this option by selling ∆ = fS (St , t) units of stock. Thus the total portfolio value Π = f − ∆S
satisfies

dΠ = df − fS dSt
1
= (ft + µSt fS + σ 2 fSS St2 )dt + fS St σdWt − fS St (µdt + σdWt )
2
1
= (ft + σ 2 fSS St2 )dt .
2
But the change in the portfolio has no dW term, i.e. is riskless. Thus (in analogy with the binomial model) the
portfolio should earn the risk free rate, i.e.
1
ft + σ 2 fSS St2 = rΠ .
2
Substituting for Π and re-arranging, we obtain the celebrated Black-Scholes partial differential equation
1
ft + rSfS + σ 2 fSS S 2 = rf .
2
Note (as for the binomial model) that µ has disappeared, because we are computing f using a hedging argument
with S .

4 The Black-Scholes formula

• To solve the Black-Scholes PDE

1
ft + rSfS + σ 2 S 2 fSS = rf , (3)
2
we have to specify a boundary condition for the PDE at the time of maturity t = T .
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• For a European call option, the boundary condition at t = T is f (S, T ) = max(S − K, 0), because the call option
is worth max(S − K, 0) at expiry.
• It can be shown that there is a unique solution to the Black-Scholes PDE with this boundary condition, given
by the (Nobel prize winning) Black-Scholes formula
C(S, τ ) = SΦ(d1 ) − Ke−rτ Φ(d2 ) ,
where τ = T − t and
S
log+ (r + 21 σ 2 )τ
d1 = √K
,
σ τ
√
d2 = d1 − σ τ
∫x −z 2 /2
e√
where Φ(x) = −∞ 2π
is the standard cumulative Normal distribution function.

• If the Stock also pays a continuous dividend q, then the BS PDE becomes
1
ft + (r − q)SfS + σ 2 S 2 fSS = rf , (4)
2
and the formula has to be adjusted as follows
C(S, t) = SΦ(d1 ) − Ke−rτ Φ(d2 ) ,
log S
+(r−q+ 12 σ 2 )τ √
where d1 = K √
σ τ
, d2 = d1 − σ τ . We will not consider dividends on this course.

4.1 Numerical example

Assume current stock price is 1, volatility is .10 and interest rate is .05. Price a call option with strike 1.1 with maturity
1: take S = 1, K = 1.1, σ = .1, τ = 1, r = .05. Plugging these numbers into the BS formula we obtain
d1 = −0.403101798043249 ,
d2 = −0.503101798043249
and the call price
C = 0.021739503382137.
(the Excel sheet “BlackScholesModel.xls” on the course website implements this formula in Visual Basic.)

5 The Greeks
We can compute partial derivatives of the BS formula with respect to each of the parameters
∂C
∆ = = Φ(d1 ) > 0,
∂S
∂2C ∂∆ n(d1 )
Γ = 2
= = √ > 0,
∂S ∂S Sσ τ
∂C √
Λ = = Sn(d1 ) τ > 0 (5)
∂σ
where n(z) = √12π e−z /2 is the standard Normal density. ∆, Γ and Λ are known as the Delta, Gamma and Vega
2

respectively of the option. The proof of these expressions for the Greeks are very tedious and not examinable.

• Delta measures the responsiveness of the call option price to small changes in the underlying stock price.
• Vega measures the responsiveness of the call option price to small changes in the volatility.
• Gamma measures the responsiveness of the Delta to small changes in the underlying stock price.
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5.1 Numerical example

For the example above, we obtain ∆ = 0.343435379743, Γ = 3.677756432729 and Λ = 0.367811626137.

5.2 Calculating Greeks using finite differences

• We can also calculate Greeks numerically (rather than using the exact formulae in (5)). e.g. choose ∆S > 0
small. Then we can approximate ∆ as
1
∆ ≈ (C(S + ∆S, K, σ, T, r) − C(S, K, σ, T, r)).
∆S

• We get a better approximation if we use the following two-sided formula:

1
∆ ≈ (C(S + ∆S, K, σ, T, r) − C(S − ∆S, K, σ, T, r)).
2∆S
This is just the usual way in which we use finite differences to approximate a true derivative, by making a small
change to one variable.

• Similarly, we can approximate Λ as

1
Λ ≈ (C(S, K, σ + ∆σ, T, r) − C(S, K, σ − ∆σ, T, r))
2∆σ
and for Γ (which is a second derivative), we use
1
Γ ≈ (C(S + ∆S, K, σ, T, r) − 2C(S, K, σ, T, r) + C(S − ∆S, K, σ, T, r)).
(∆S)2

• These finite difference approximations converge to the true answers in (5) as ∆S or ∆σ tend to zero.

• Recall Taylor’s theorem for a differentiable function of one variable:

1
f (x + ∆x) ≈ f (x) + f ′ (x)∆x + f ′′ (x)(∆x)2 .
2
We can do the same thing for the Black-Scholes formula:
∂C 1 ∂2C
C(S + ∆S, K, σ, τ, r) ≈ C(S, K, σ, τ, r) + ∆S + (∆S)2
∂S 2 ∂S 2
1
= C(S) + ∆ · ∆S + Γ(∆S)2 .
2
This is the practical financial use of Delta and Gamma - we can approximate the new value of the Black Scholes
call price if the stock price moves from S to S + ∆S, if ∆S is small. We obtain a cruder approximation if we
ignore the Gamma term Γ.

6 Obtaining the Black-Scholes formula via risk neutral valuation

• It turns out that C(S, τ ) (the price of a call option under the Black-Scholes model) also has a probabilistic
representation
C(S, τ ) = e−rτ E(max(ST − K, 0) ,
where S follows the process
dSt = St [rdt + σdWt ] (6)
(this will be proved using the Feynman-Kac formula in the next set of notes). In words: the call price is the
discounted expected value of max(ST − K, 0) in the risk-neutral world where the drift is r − q. We refer to this
world as the risk neutral measure.
• Note that (6) this is the same as the Black-Scholes SDE dSt = St [µdt + σdW ], but the real-world µ has been
replaced by r − q.
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6.1 Put-Call parity

By considering both cases ST > K and ST < K we see that

max(ST − K, 0) + K = max(K − ST , 0) + ST . (7)

A portfolio of 1 call option and Ke−rT dollars will be equal in value to the left hand side at T . Similarly, a portfolio
of 1 put option and S0 shares will be equal in value to the right hand side at T . Thus we obtain the put-call parity:

C + Ke−rT = P + S0 .

6.2 Implied volatility

√
The Vega ∂C∂σ = Sn(d1 ) τ of a call option under Black-Scholes is positive, so C is montonically increasing as a function
of σ. Thus, given an observed call price C obs in the market, we can extract the unique σ value consistent with this
price by solving

C(S, K, σ̂, τ, r) = C obs . (8)

This σ is known as the implied volatility of the option, and is a very important concept in practice.