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Black Scholes Model

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19 views19 pages

Black Scholes Model

Uploaded by

Apeksha Sharma
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Valuation of Options

Black Scholes Model


&
Binomial Model
Black Scholes Model (BSMOP)
• The Black-Scholes model, also known as the Black-Scholes-Merton
(BSM) model, is one of the most important concepts in modern financial
theory.
• Developed in 1973 by Fischer Black, Robert Merton, and Myron Scholes,
the Black-Scholes model was the first widely used mathematical
method to calculate the theoretical value of an option contract, using
current stock prices, expected dividends, the option's strike price,
expected interest rates, time to expiration, and expected volatility.
• In 1997, Scholes and Merton were awarded the Nobel Memorial Prize in
Economic Sciences for their work in finding "a new method to
determine the value of derivatives."
Assumptions
• No dividends are paid out during the life of the option.
• Markets are random (i.e., market movements cannot be predicted).
• There are no transaction costs in buying the option.
• The risk-free rate and volatility of the underlying asset are known
and constant.
• The returns of the underlying asset are normally distributed.
• The option is European and can only be exercised at expiration.
Black-Scholes Model
• In 1973, Fisher Black and Myron Scholes propounded a model for
valuation of options. According to the Black and Scholes formulation,
the value of a call option is calculated as follows:
C = current value of the option
r = continuously compounded risk-free rate of interest
S0 = current price of the stock
E = exercise price of the option
t = time remaining before the expiration date (expressed as a
fraction of a year)
s = standard deviation of the continuously compounded
annual rate of return
ln(S0/E) = natural logarithm of (S0/E)
N(d ) = value of the cumulative normal distribution evaluated at d
Problem 1
• Consider the following information with regard to a call option on the
stock of ABC company.
Current price of the share, S0 = Rs 120
Exercise price of the option, E = Rs 115
Time period to expiration = 3 months. Thus, t = 3/12 = 0.25 years
Standard deviation of the distribution of continuously compounded
rates of return, s = 0.6
Continuously compounded riskfree interest rate, r = 0.10
S0 = Rs 120, E = Rs 115,
t=0.25, Sd= 0.6, r=0.10
• D1 = ln (120/115) + (0.10 + 0.5X0.6^2)*0.25
• 0.6 * 0.5

• = ln (1.043) + 0.07 / 0.3 = .112/0.3 = 0.37

• D2 = ln (120/115) + (0.10 - 0.5X0.6^2)*0.25


• 0.6 * 0.5

• = 0.07
• Nd1 = 0.6443
• Nd2 = 0.5279

• C = 120 x 0.6443 – 115 e-(0.1 * 0.25) X (0.5279)


• = 77.316 – 115 x 0.9753 x 0.5279
• = 77.316 – 59.20
• = 18.11
• P = C + E e-rt – S0

• = 18.11 + 115 x e-(0.1 * 0.25) – 120


• = 10.27

P = E e-rt N (-d2) – S0 N(-d1)


Options Greeks
• Delta
• Gamma
• Theta
• Vega
• Rho
Delta
• Delta is the amount an option price is expected to move based on a
$1 change in the underlying stock.

• Deltas are interpreted as (i) a measure of volatility, ii) a measure of


the likelihood that an option will be in-the-money on the expiration
day, and (iii) a hedge ratio.
The Formulae

Delta  N ( d1 )s only
a ll
rc
Fo

Delta  N ( d1 )  1 ly
o n
uts
rP
Fo
12
Gamma
• Gamma is the rate that delta will change based on a $1 change in the
stock price. So if delta is the “speed” at which option prices change,
you can think of gamma as the “acceleration.” Options with the
highest gamma are the most responsive to changes in the price of the
underlying stock.
Theta
• Time decay, or theta, is enemy
number one for the option
buyer. On the other hand, it’s
usually the option seller’s best
friend. Theta is the amount the
price of calls and puts will
decrease (at least in theory) for
a one-day change in the time to
expiration.
Rho
• That’s the amount an option value will change in theory based on a
one percentage-point change in interest rates.
Vega
• Vega is the amount call and put prices will change, in theory, for a
corresponding one-point change in implied volatility.
Binomial Model
• The current price of a share is Rs. 50, and it is believed that at the end if one month the price will be either
Rs.55 or Rs.45. What will European call options with an exercise price.
i = 1 + Plus risk free rate
d = S1/S0 when the stork price decreases (S1 < S0) = 45/50 = 0.9
u = S1/S0 when the stock price Increases (S1 > S0) = 55/50 = 1.1
Cu = (the vlaue of call option if S1 > S0 = S1 - E = 55 - 53 = Rs.2
Cd = (the value of call option if S1 < S0 = Max (S1 - E, 0)

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