Black-Scholes

Ser-Huang Poon

September 29, 2008

A European style call (put) option is a right, but not an obligation, to

purchase (sell) an asset at a strike price on option maturity date, T . An
American style option is a European option that can be exercised prior to
T.

1 Black-Scholes Model
The Black-Scholes formula below is for pricing European call and put op-
tions:

c = S0 N (d1 ) − Ke−rT N (d2 ) (1)

p = Ke−rT N (−d2 ) − S0 N (−d1 )
¡ ¢
ln (S0 /K) + r + 12 σ 2 T
d1 = √ (2)
σ T
√
d2 = d1 − σ T
Z d1
1 2
N (d1 ) = √ e−0.5z dz
2π −∞

where c (p) is the price of the European call (put), S0 is the current price of
the underlying assset, K is the strike or exercise price, r is the continuously
compounded risk free interest rate, T is the time to option maturity. N (d1 )
is the cumulativ probability distribution of a standard Normal distribution
for area below d1 , and N (−d1 ) = 1 − N (d1 ).
As T → 0,

d1 and d2 → ∞
N (d1 ) and N (d2 ) → 1
N (−d1 ) and N (−d2 ) → 0

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which means

c ≥ S0 − K, p≥0 for S0 > K (3)

c ≥ 0, p ≥ K − S0 for S0 < K. (4)

As σ → 0, again

N (d1 ) and N (d2 ) → 1,

N (−d1 ) and N (−d2 ) → 0.

This will lead to

c ≥ S0 − Ke−rT , and (5)

p ≥ Ke−rT − S0 . (6)

The boundary conditions (3), (4), (5) and (6) are the boundary conditions
for checking option prices before using them for empirical tests. These
conditions are not specific to Black-Scholes. Option with market prices
(transaction or quote) violating these boundary conditions should be dis-
carded.

1.1 The Black-Scholes assumptions

The key Black-Scholes assumptions are:

• The stock price follows a Geometric Brownian Motion with drift μ and
volatility σ
dS
= μ dt + σ dW (7)
S
where W is a Wiener process

• Short selling of the stock is allowed with full use of proceeds

• There are no taxes and transactions cost

• It is possible to lend/borrow at a risk-free interest rate

• All securities are infinitely divisible

• The underlying stock does not pay any dividend (cf. this assumption
can easily be extended to include dividend payments)

• There are no arbitrage opportunities (i.e. the market is in equilibrium)

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 • Continuous trading (so that rebalancing of portfolio is done instanta-
neously)

Empirical findings suggest that option pricing is not sensitive to the

assumption of a constant interest rate. There are now good approximating
solutions for pricing American style options that can be exercised early and
options that encounter dividend payments before option maturity. The
impact of stochastic volatility on option pricing is much more profound.
Apart from the constant volatility and the related GBM assumptions, the
violation of any of the remaining assumptions will result in the option price
being traded within a band instead of at the theoretical price.

2 Black-Scholes and no-arbitrage pricing

2.1 The stock price dynamics
The Black-Scholes model for pricing European equity options assumes stock
price has the following dynamics

dS = μSdt + σSdz , (8)

and for the growth rate on stock

dS
= μdt + σdz . (9)
S
From ito lemma, the logarithmic of stock price has the following dynamics
µ ¶
1 2
d ln S = μ − σ dt + σdz , (10)
2

which means that stock price has a lognormal distribution or the logarithm
of stock price has a normal distribution. In discrete time
µ ¶
1 2
d ln S = μ − σ dt + σdz
2
µ ¶
1 √
∆ ln S = μ − σ 2 ∆t + σ ε ∆t
2
∙µ ¶ ¸
1 2 √
ln ST − ln S0 ∼ N μ − σ T, σ T
2
∙ µ ¶ ¸
1 2 √
ln ST ∼ N ln S0 + μ − σ T, σ T . (11)
2

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2.2 Black-Scholes PDE
The derivation of the Black-Scholes partial differential equation is based
on the fundamental fact that the option price and the stock price depend
on the same underlying source of uncertainty. A portfolio can then be
created consisting of the stock and the option which eliminates this source
of uncertainty. Given that this portfolio is riskless and must therefore earn
the risk-free rate of return. Here is how the logic works:

∆S = μS∆t + σS∆z (12)

∙ ¸
∂f ∂f 1 ∂2f 2 2 ∂f
∆f = μS + + 2
σ S ∆t + σS∆z (13)
∂S ∂t 2 ∂S ∂S
∂f
We set up a hedged portfolio, Π, consisting of ∂S number of shares and short
one unit of the derivative security. The change in portfolio value is
∂f
∆Π = −∆f + ∆S
∙ ∂S ¸
∂f ∂f 1 ∂2f 2 2 ∂f
= − μS + + 2
σ S ∆t − σS∆z
∂S ∂t 2 ∂S ∂S
∂f ∂f
+ μS∆t + σS∆z
∂S
∙ ∂S ¸
∂f 1 ∂2f 2 2
= − + σ S ∆t
∂t 2 ∂S 2
Note that uncertainty due to ∆z is cancelled out and μ, the premium for risk
(returns on S), is also cancelled out. No only that ∆Π is has no uncertainty,
it is also preference free and not depend on μ, a parameter controlled by
investor’s risk aversion.
If the portfolio value is fully hedged, then no arbitrage implies that it
must earn only risk free rate of return

rΠ∆t = ∆Π
∂f
rΠ∆t = −∆f + ∆S
µ ¶ ∙ ∂S ¸
∂f ∂f ∂f 1 ∂2f 2 2 ∂f
r −f + S ∆t = − μS + + 2
σ S ∆t − σS∆z
∂S ∂S ∂t 2 ∂S ∂S
∂f
+ [μS∆t + σS∆z]
∂S
∂f ∂f ∂f 1 ∂2f 2 2
r (−f ) ∆t = −rS ∆t − μS∆t − ∆t − σ S ∆t
∂S ∂S ∂t 2 ∂S 2
∂f ∂f ∂f
− σS∆z + μS∆t + σS∆z
∂S ∂S ∂S

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and finally we get the well known Black-Scholes PDE

∂f ∂f 1 ∂2f 2 2
rf = rS + + σ S (14)
∂S ∂t 2 ∂S 2

2.3 Solving the PDE

There are many solutions to (14) correspond to different derivatives, f , with
underlying asset S. In another words, without further constraints, the PDE
in (14) does not have a unique solution. The particular security being valued
is determined by its boundary conditions of the differential equation. In
the case of an European call, the value at expiry c (S, T ) = max (S − E, 0)
serves as the final condition for the Black-Scholes PDE. Here, we show how
BS formula can be derived using the risk neutral valuation relationship. We
need the following facts:

(i) From (11), µ ¶

1 2
ln S ∼ N ln S0 + μ − σ , σ .
2
Under risk neutral valuation relationship, μ = r and
µ ¶
1 2
ln S ∼ N ln S0 + r − σ , σ .
2

(ii) If y is a normally distributed variable

Z ∞ µ ¶
y μy − a 1 2
e f (y) dy = N + σ y eμy + 2 σy .
a σy

(iii) From the definition of cumulative normal distribution

Z ∞ µ ¶ µ ¶
a − μy μy − a
f (y) dy = 1 − N =N
a σy σy

Now we are ready to solve the BS formular. First, the terminal value
of a call is

cT = E [max (S − K, 0)]
Z ∞
= (S − K) f (S) dS
K
Z ∞ Z ∞
ln S
= e f (ln S) d ln S − K f (ln S) d ln S.
ln K ln K

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Substituting facts (ii) and (iii) and using information from (i) to set
1
μy = ln S0 + r − σ 2
2
σy = σ
a = ln K

we get
à ! à !
ln S0 + r + 12 σ 2 − ln K ln S0 + r − 12 σ 2 − ln K
cT = S0 er N − KN
ln K ln K
= S0 er N (d1 ) − KN (d2 ) (15)

where
ln SK0 + r − 12 σ 2
d1 =
σ
d2 = d1 − σ.

The present value of the call option is derived by applying e−r to both
sides. The put option price can be derived using put-call parity or use the
same argument above. The σ in the above formular is volatility over the
option maturity. If we use σ as the annualised volatility then we replace σ
√
with σ T in the formula.
There are important insights from (15), all valid only in a “risk neutral”
world:

(i) N (d2 ) is the probability that the option will be exercise.

(ii) Alternatively, N (d2 ) is the probability that call finishes in the money.

(iii) XN (d2 ) is the expected payment.

(iv) S0 erT N (d1 ) is the expected value E [ST − X]+ , where E [·]+ is expec-
tation computed for positive values only.

(v) In another words, S0 erT N (d1 ) is the risk neutral expectation of ST ,

E Q [ST ] with ST > X.