The Black-Scholes-Merton Model

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Normal (Gaussian) Distribution Probability Density 0.5 0. 0.15 0.1 0.05 0 1.1 1 0.9 0.8 0.7 0.6? 0.5 0.4 0.3 0. 0.1 0 3.6 5. 6.8 8.4 10 11.6 13. 14.8 16.4 18 Cumulative Probability Slide 13 in this slide set was corrected (d 1 was set up wrong, although the solution was correct) and this was reposted on Monday, February 18 at 9:45 AM. The Black-Scholes-Merton Model... pricing options and calculating some Greeks 019 Gary R. Evans. This slide set by Gary R. Evans is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License.

Conceptually calculating what a 110 OTM call option should be worth if the present price of the stock is 100... 9.00 8.00 7.00 6.00 5.00 4.00 (1) We know how to calculate the probability that the price will be above 100. () What, though, will be the value of that domain?... in 16 days. 1.0 1.00 0.80 0.60 3.00 0.40.00 1.00 0.0 0.00 8 85 88 91 94 97 100 103 106 109 11 115 118 11 0.00

Remembering from our homework... Standard normal density function The cumulative distribution is integrating from left to right π = 0.11675 We did this integration and subtracted it from 1! If SS = ln P str Psto σ d π SS itm = 1-4 (SNDF) dr Negative values 1.1914 Positive values

... and knowing this will come in handy when we look at Black-Scholes-Merton: This has a negative value when done this way (for an OTM option).. π = 0.11675 If SS = ln P sto Pstr σ d BSM does this integration for the same problem! then π itm = SS 4 (SNDF) dr -1.1914

How Black-Scholes-Merton works... The Black-Scholes-Merton model is used to price European options (which assumes that they must be held to expiration) and related custom derivatives. It takes into account that you have the option of investing in an asset earning the risk-free interest rate. It acknowledges that the option price is purely a function of the volatility of the stock's price (the higher the volatility the higher the premium on the option). Black-Scholes-Merton treats a call option as a forward contract to deliver stock at a contractual price, which is, of course, the strike price.

The Essence of the Black-Scholes Approach Only volatility matters, the mu (drift) is not important. The option's premium will suffer from time decay as we approach expiration (Theta in the European model). The stock's underlying volatility contributes to the option's premium (Vega). The sensitivity of the option to a change in the stock's value (Delta) and the rate of that sensitivity (Gamma) is important [these variables are represented mathematically in the Black-Scholes DE]. Option values arise from arbitrage opportunities in a world where you have a risk-free choice.

The BSM Model: European Options C SN( d ) Ke N( d ) 1 r t 365 C = theoretical call value S = current stock price N = standard normal probability distribution integrated to point d x. t = days until expiration K = option strike price r = risk free interest rate daily stock volatility d d 1 ln ln d d t 1 S K r 365 t S K r 365 t t t Note: Hull's version (13.0) uses annual volatility. Note the difference.

Breaking this down... C SN( d ) Ke N( d ) 1 r t 365 This term discounts the price of the stock at which you will have the right to buy it (the strike price) back to its present value using the risk-free interest rate. Let's assume in the next slide that r = 0. d 1 ln S K r 365 t t Dividing by this term (the standard deviation of stock's daily volatility adjusted for time) turns the distribution into a standard normal distribution with a standard deviation of 1.

... or simplifying it some (r is zero) This is the absolute log growth spread between the strike price and the stock price. We are calculating the cumulative probability to this standard normal point. CP d 1 SP ln d STR SP STR 1 d This normalizes it to standard normal (the numerator is now number of standard deviations. ).... assume that r is 0 and t is 1: μ is zero so this is the log-normal zero mean adjustment

What role is being played by half variance?? Let s look at this simplified where we have a call at the money exactly, with these assumptions, assuming r = 0: 1.. d 1 = ln Sto Str + σ t ln 100 100 = 0 σ t Stock price = 100 Strike price = 110 100 Sigma = 0.00 days = 16 3. d 1 = σ t σ t 4. d 1 = σ t

In this example, we are pricing a call that is expiring in 16 days. The price of the stock is $100 and the call strike price is $100. Because BSM does not allow drift, the expected value of the stock in 16 days is $100. If you own this call, you have the right to buy the stock for $100 in 16 days, no matter what the price. Why does this have any value at all?

σ t + σ t σ t This spread is what gives the ATM option value... and it is equal to the duration-volatility adjusted random draw.

An example (back to the full model)... Consider an otm option with 16 days to expiration. The strike price is 110 and the price of the stock is 100 and the stock has an daily volatility of 0.0. Assume an interest rate of 0.01 (1% annual). The set-up for d1 was incorrect in the original slide posted.. this is correct and consistent with the Jupyter Notebook black_scholes_merton_logical.ipynb d 1 = ln 100/110 + 0.01 365 + 0.0 16 0.0 16 = 1.1459 d = d 1 0.0 16 = 1.59 C = 100csnd 1.1459 110e 0.01 16 365 csnd 1.59 = 0.4841

Using the BSM Model There are variations of the Black-Scholes model that prices for dividend payments (within the option period). See Hull section 13.1 to see how that is done (easy to understand). However, because of what is said below, you really can't use BSM to estimate values of options for dividend-paying American stocks There is no easy estimator for American options prices, but as Hull points out in chapter 9 section 9.5, with the exception of exercising a call option just prior to an exdividend date, "it is never optimal to exercise an American call option on a nondividend paying stock before the expiration date." The BSM model can be used to estimate "implied volatility". To do this, however, given an actual option value, you have to iterate to find the volatility solution (see Hull's discussion of this in 13.1). This procedure is easy to program and not very timeconsuming in even an Excel version of the model. For those of you interest in another elegant implied volatility model, see Hull's discussion of the IVF model in 6.3. There you will see a role played by delta and vega, but again you would have to iterate to get the value of the sensitivity of the call to the strike price.

Doing this in Python for a Call

Doing this in Python for a Put.. a couple of important sign changes.

Calculating implied volatility with B/S: d 1 ln SP STR Very easy to do: Once Black-Scholes is structured, you can use an iterative technique to solve for σ. Name: Date: Gary R. Evans October 7, 011 Put Option Implicit Daily Volatility (IDV) Calculator Stock Symbol: DIA Price: 11.60 Month: Dec Put Strike: 10.00 Price: 3.50 Expiration date: 1/17/011 Interest rate: 0.0100 Days to maturity today: Days to maturity override: Implied daily volatility: One-day time decay: Version 3.4 Aug 16, 011 51 51 0.0145 0.045 Calculate

Notational differences: Call Put