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12
Chapter Twelve
The BlackScholes Model
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Chapter Outline
12.1 Log-Normal Property of Stock Prices
12.2 The distribution of the Rate of Return
12.3 The Expected Return
12.4 Volatility
12.5 Concepts Underlying the Black-Scholes-Merton
Differential Equation
12.6 Derivation of the Black-Scholes-Merton
Differential Equation
12.7 Risk Neutral Valuation
12.8 Black-Scholes Pricing Formulae
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Chapter Outline (continued)
12.9 Cumulative Normal Distribution Function
12.10 Warrants Issued by a company on its own Stock
12.11 Implied Volatilities
12.12 The Causes of Volatility
12.13 Dividends
12.14 Summary
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Prospectus:
In the early 1970s, Fischer Black, Myron
Scholes and Robert Merton made a major
breakthrough in the pricing of options.
In 1997, the importance of this work was
recognized with the Nobel Prize.

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12.1 Log-Normal Property of Stock Prices
This is fully developed in chapter 11.
Assume that percentage changes in stock price in a
short period of time are normally distributed.
Let:
: expected return on the stock
o: volatility on the stock
The mean of the percentage change in time ot is ot
The standard deviation of this percentage change is
t
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12.1 Log-Normal Property of Stock Prices
The percentage changes in stock price in a short
period of time are normally distributed:
) , (

t t
S
S
| ~
Where oS is the change in stock price in time ot, and
|(m,s) denotes a normal distribution with mean m
and standard deviation s.

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12.1 Log-Normal Property of Stock Prices
As shown in section 11.7, the model implies that
(

|
|
.
|

\
|
~ T T S S
T
,
2
ln ln
2
0
o
|
From this it follows that

(

|
|
.
|

\
|
~ T T
S
S
T
,
2
ln
2
0
o
|
and

(

|
|
.
|

\
|
+ ~ T T S S
T
,
2
ln ln
2
0
o
|
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12.1 Log-Normal Property of Stock Prices
The above equation shows that ln S
T
is normally
distributed.
This means that S
T
has a lognormal distribution.
A variable with this distribution can take any value
between zero and infinity.
(

|
|
.
|

\
|
+ ~ T T S S
T
,
2
ln ln
2
0
o
|
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Properties of the Log-Normal Distribution
A variable with this
distribution can take any
value between zero and
infinity.
0
Unlike a normal distributions, it is skewed so that the
mean, median, and mode are all different.
T
T
e S S E
0
) ( =
) 1 ( ) var(
2
2 2
0
=
T T
T
e e S S
o
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12.2 The Distribution of the Rate of Return
The lognormal property of stock prices can be used
to provide information on the probability
distribution of the continuously compounded rate of
return earned on a stock between time zero and T.
Define the continuously compounded rate of return
per annum realized between times zero and T as q.
It follows that

T
T
e S S
q
0
=
so that

0
ln
1
S
S
T
T
= q
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12.2 The Distribution of the Rate of Return
It follows from:
that

(

|
|
.
|

\
|
~ T T
S
S
T
,
2
ln
2
0
o
|
|
|
.
|

\
|
~
T

,
2
2
o
| q
Thus, the continuously compounded rate of
return per annum in normally distributed

2
2
o

and standard deviation
T

with mean
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12.3 The Expected Return
The expected return, , required by investors from a
stock depends on the riskiness of the stock.
The higher the risk, the higher , ceteris paribus.
also depends on interest rates in the economy
We could spend a lot of time on the determinants of
, but it turns out that the value of a stock option,
when expressed in terms of the value of the
underlying stock, does not depend on at all.
There is however, one aspect of that frequently
causes confusion and is worth explaining.
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A subtle but important difference
Shows that ot is the expected percentage change in
the stock price in a very short period of time o t .
This means that is the expected return in a very
short short period of time ot .
It is tempting to assume that is also the
continuously compounded return on the stock over a
relatively long period of time.
However, this is not the case.
) , (

t t
S
S
| ~
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A subtle but important difference
The continuously compounded return on the stock
over T years is:
0
ln
1
S
S
T
T
Equation (12.7):
|
|
.
|

\
|
~
T

,
2
2
o
| q
Shows that the expected value of this is
2
2
o

The distinction between and
is subtle but important.
2
2
o

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A subtle but important difference
Start with
Taking logarithms:
T
T
e S S E
0
) ( =
T S S E
T
+ = ) ln( )] ( ln[
0
Since ln is a nonlinear function,
)] [ln( )] ( ln[
T T
S E S E =
So we cannot say
T
S
S
E
T
= )] [ln(
0
In fact, we have:
T
S
S
E
T
< )] [ln(
0
So the expected return over the whole period T,
expressed with compounding ot, is close to
Not
2
2
o

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A subtle but important difference
For example, if your portfolio has had the
following returns over the last five years:
30%; 20%; 10%; 20%; 40%;
What is the expected return?
It can refer to
2
2
o

The above shows that a simple term like expected
return is ambiguous.
or

Unless otherwise stated will be expected return.
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12.4 Volatility
The volatility of a stock, o, is a measure of our
uncertainty about the returns.
Stocks typically have a volatility between 20% and
50%
|
|
.
|

\
|
~
T

,
2
2
o
| q
From

The volatility of a stock price can be defined as the
standard deviation of the return provided by the
stock in one year when the return is expressed using
continuous compounding.
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The Volatility
The volatility of an asset is the standard deviation
of the continuously compounded rate of return in 1
year
As an approximation it is the standard deviation of
the percentage change in the asset price in 1 year
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Estimating Volatility from Historical Data (page 239-41)
1. Take observations S
0
, S
1
, . . . , S
n
at intervals of t
years
2. Calculate the continuously compounded return in
each interval as:


3. Calculate the standard deviation, s , of the u
i
s
4. The historical volatility estimate is:
u
S
S
i
i
i
=
|
\

|
.
|

ln
1
t
= o
s

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12.5 Concepts Underlying the Black-
Scholes-Merton Differential Equation
The arguments are similar to the no-arbitrage
arguments we used to value stock options using
binomial valuation in Chapter 10.
Set up a riskless portfolio consisting of a position in
the derivative and a position in the stock.
In the absence of profitable arbitrage, the portfolio
must earn the risk-free rate, r.
This leads to the BlackScholesMerton differential
equation.
An important difference is the length of time that
the portfolio remains riskless.
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Assumptions
1. The stock price follows a lognormal process with
and o constant.
2. Short selling with full use of proceeds permitted.
3. No transactions costs or taxes.
4. No dividends during the life of the derivative.
5. No riskless arbitrage opportunities.
6. Security trading is continuous.
7. The risk-free rate, r, is constant and the same for
all maturities.
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12.6 Derivation of the Black-Scholes-
Merton Differential Equation
The stock price process we are using:
dS = Sdt + oSdz
Let f be the price of a call option or other derivative
contingent upon S. The variable f must be some
function of S and t. From Its lemma
Sdz
S
f
dt S
S
f
t
f
S
S
f
df o o
c
c
+
|
|
.
|

\
|
c
c
+
c
c
+
c
c
=
2 2
2
2
2
1
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12.6 Derivation of the Black-Scholes-
Merton Differential Equation
The appropriate portfolio is:
S
f
c
c
short one derivative and long shares
Define H as the value of the portfolio.
By definition,


S
S
f
f
c
c
+ = H
The change, oH, in the value of the portfolio in time ot


S
S
f
f o o o
c
c
+ = H
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12.6 Derivation of the Black-Scholes-
Merton Differential Equation
S
S
f
f o o o
c
c
+ = H
Substituting oS = Sot + oSoz and
z S
S
f
t S
S
f
t
f
S
S
f
f o o o o o
c
c
+
|
|
.
|

\
|
c
c
+
c
c
+
c
c
=
2 2
2
2
2
1
yields
t S
S
f
t
f
o o o
|
|
.
|

\
|
c
c

c
c
= H
2 2
2
2
2
1
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12.6 Derivation of the Black-Scholes-
Merton Differential Equation
Because oH does not involve oz, the portfolio must be
riskless during time ot.
The no-arbitrage condition is therefore:
oH = rHot
Substituting from above yields:
t S
S
f
t
f
o o o
|
|
.
|

\
|
c
c

c
c
= H
2 2
2
2
2
1
t S
S
f
f r t S
S
f
t
f
o o o o
|
.
|

\
|
c
c
+ =
|
|
.
|

\
|
c
c

c
c
= H
2 2
2
2
2
1
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12.6 Derivation of the Black-Scholes-
Merton Differential Equation
Its a short step to:
t S
S
f
f r t S
S
f
t
f
o o o o
|
.
|

\
|
c
c
+ =
|
|
.
|

\
|
c
c

c
c
= H
2 2
2
2
2
1
rf
S
f
S
S
f
rS
t
f
=
c
c
+
c
c
+
c
c
2
2
2 2
2
1
o
This is the BlackScholesMerton differential
equation. It has many solutions, corresponding to
the different derivatives that can be defined with S
as the underlying variable.
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12.6 Derivation of the Black-Scholes-
Merton Differential Equation
rf
S
f
S
S
f
rS
t
f
=
c
c
+
c
c
+
c
c
2
2
2 2
2
1
o
The particular solution that is obtained when the
equation is solved depends on the boundary
conditions that are used.
In the case of a European call, the key boundary
condition is:
f = max(S K, 0) when t = T
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Example
Consider a forward contract on a non-dividend
paying stock.
From chapter 3 we have
) ( t T r
Ke S f

=
1 =
c
c
S
f
) ( t T r
rKe
t
f

=
c
c
0
2
2
=
c
c
S
f
rf
S
f
S
S
f
rS
t
f
=
c
c
+
c
c
+
c
c
2
2
2 2
2
1
o
Clearly this satisfies the BlackScholesMerton
differential equation:
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12.7 Risk Neutral Valuation
Without a doubt, the single most important tool for
the analysis of derivatives.
Note that the BlackScholesMerton differential
equation does not involve any variable that is
affected by the risk preferences of investors.
The only variables are S
0
, T, o, and r.
So any set of risk preferences can be used when
evaluating f. Lets use risk neutrality.
Now we can calculate the value of any derivative by
discounting its expected payoff at the risk-free rate.
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Risk Neutral Valuation of Forwards
Consider a long forward contract that matures at time
T with delivery price K.
The payoff at maturity is S
T
K
The value of the forward contract is the expected
value at time T in a risk-neutral world discounted at
the risk-free rate.
f = e
rT
(S
T
K)
Since K is constant, f = e
rT
[(S
T
) K]
In a risk-neutral world, becomes r so (S
T
) = S
0
e
rT
We have f = S
0
K e
rT
which is the no-arbitrage
result we have from chapter 3.
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12.8 BlackScholes Pricing Formulae
The Black-Scholes formulae for the price of a
European call and a put written on a non-dividend
paying stock are:
) N( ) N(
2 1 0
d Ke d S c
rT
=

T
T

r K S
d
o
)
2
( ) / ln(
2
0
1
+ +
=
T d d o =
1 2
N(d) = Probability that a standardized, normally distributed,
random variable will be less than or equal to d.
) N( ) N(
1 0 2
d S d Ke p
rT
=

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A BlackScholes Example
Find the value of a six-month call option on the Microsoft with
an exercise price of $150
The current value of a share of Microsoft is $160
The interest rate available in the U.S. is r = 5%.
The option maturity is 6 months (half of a year).
The volatility of the underlying asset is 30% per annum.
Before we start, note that the intrinsic value of the option is
$10our answer must be at least that amount.
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A BlackScholes Example
Lets try our hand at using the model. If you have a calculator
handy, follow along.
Then,

T
T r E S
d
o
) 5 . ( ) / ln(
2
1
+ +
=
First calculate d
1
and d
2

31602 . 0 5 . 30 . 0 52815 . 0
1 2
= = = T d d o
5282 . 0
5 . 30 . 0
5 ). ) 30 . 0 ( 5 . 05 (. ) 150 / 160 ln(
2
1
=
+ +
= d
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A BlackScholes Example
N(d
1
) = N(0.52815) = 0.7013
N(d
2
) = N(0.31602) = 0.62401

5282 . 0
1
= d
31602 . 0
2
= d
) N( ) N(
2 1
d Ke d S c
rT
=

92 . 20 $
62401 . 0 150 7013 . 0 160 $
5 . 05 .
=
=

c
e c
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Assume S = $50, K = $45, T = 6 months, r = 10%,
and o = 28%, calculate the value of a call and a put.
125 . 1 $ 45 $ 50 $ 32 . 8 $
) 50 . 0 ( 10 . 0
= + =

e P
32 . 8 $ ) 754 . 0 ( 45 ) 812 . 0 ( 50
) 50 . 0 ( 10 . 0 ) 5 . 0 ( 0
= =

e e C
( )
884 . 0
50 . 0 28 . 0
50 . 0
2
28 . 0
0 10 . 0
45
50
ln
2
1
=
|
|
.
|

\
|
+ +
= d
686 . 0 50 . 0 28 . 0 884 . 0
2
= = d
From a standard normal probability table, look up N(d
1
) =
0.812 and N(d
2
) = 0.754 (or use Excels normsdist function)
Another BlackScholes Example
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12.8 BlackScholes Pricing Formulae
To provide intuition, rewrite the Black-Scholes call
formula as:
)] N( ) N( [
2 1 0
d K e d S e c
rT rT
=

N(d
2
) is the probability that the option will be
exercised in a risk-neutral world, so KN(d
2
) is the
expected value of the cost of exercise.
S
0
N(d
1
)e
rT
is the expected value of a variable that
equals S
T
if S
T
> K and is zero otherwise in a risk-
neutral world.
The present value at the risk-free rate is the value of a
call

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Properties of the BlackScholes Formulae
Consider what happens when S
T
becomes large.
The option is almost certain to finish in-the-money,
so the call becomes like a forward contract.
From chapter 3 we have
f = S
0
K e
rT

When S
0
becomes large, d
1
and d
2
become large, so
N(d
2
) and N(d
1
) become close to 1
The Black-Scholes call price reduces to the futures
price.

) N( ) N(
2 1 0
d Ke d S c
rT
=

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Properties of the BlackScholes Formulae
Consider what happens when o approaches zero.
Because the stock is riskless, S
T
= S
0
e
rT

At expiry, the payoff from the call will be
max(S
0
e
rT
K, 0)
If we discount at r
c = e
rT
max(S
0
e
rT
K, 0) = max(S
0
K e
rT
, 0)

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Properties of the BlackScholes Formulae
If S
0
> K e
rT
When o approaches zero, d
1
and d
2
tend
to +, so N(d
2
) and N(d
1
) become close to 1.
The BlackScholes call price is then:
S
0
K e
rT

If S
0
< K e
rT
When o approaches zero, d
1
and d
2
tend
to , so N(d
2
) and N(d
1
) become close to zero.
The BlackScholes call price is then
0
So, the BlackScholes value of a call when o
approaches zero
c = max(S
0
K e
rT
, 0)
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12.9 Cumulative Normal Distribution
Function
NORMSDIST in Excel rocks.
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12.10 Warrants Issued by a company
on its own Stock
There is a dilution effect.
We can use the Black-Scholes formula for the
value of a call if:
1. The stock price S
0
is replaced by S
0
+ (M/N)W
2. The volatility is the volatility of the equity (I.e. the
volatility of the shares plus the warrants, not just
the shares).
3. The formula is multiplied by N/(N + M)
)] N( ) N( ) [(
2 1 0
d Ke d W
N
M
S
M N
N
W
rT
+
+
=

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12.11 Implied Volatilities
These are the volatilities that are implied by the
observed prices of options in the market.
It is not possible to solve

For o
In practice, use goal seek in Excel.
Its best to use near-the-money options to estimate
volatility.
) N( ) N(
2 1 0
d Ke d S c
rT
=
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Implied Volatility
The implied volatility of an option is the volatility
for which the Black-Scholes price equals the market
price
The is a one-to-one correspondence between prices
and implied volatilities
Traders and brokers often quote implied volatilities
rather than dollar prices
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12.12 The Causes of Volatility
Trading itself can be said to be a cause.
When implied volatilities are calculated, the life of
an option should be measured in trading days.
Furthermore, if daily data are used to provide a
historical volatility estimate, day when the exchange
are closed should be ignored and the volatility per
annum should be calculated from the volatility per
trading day using this formula:

The normal assumption is that there are 252 trading
days per year.
annum per days trading of number day g per tradin y volatilit annum per volatility =
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Causes of Volatility
Volatility is usually much greater when the market
is open (i.e. the asset is trading) than when it is
closed
For this reason time is usually measured in trading
days not calendar days when options are valued
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Warrants & Dilution (pages 249-50)
When a regular call option is exercised the stock that
is delivered must be purchased in the open market
When a warrant is exercised new Treasury stock is
issued by the company
This will dilute the value of the existing stock
One valuation approach is to assume that all equity
(warrants + stock) follows geometric Brownian
motion
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12.13 Dividends
European options on dividend-paying stocks are
valued by substituting the stock price less the
present value of dividends into Black-Scholes
Only dividends with ex-dividend dates during life of
option should be included
The dividend should be the expected reduction in
the stock price anticipated.
Elton and Gruber estimate this as 72% of the
dividend.
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American Calls
An American call on a non-dividend-paying stock
should never be exercised early
An American call on a dividend-paying stock
should only ever be exercised immediately prior
to an ex-dividend date
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Blacks Approach to Dealing with
Dividends in American Call Options
Set the American price equal to the maximum
of two European prices:
1. The first European price is for an option
maturing at the same time as the American
option
2. The second European price is for an
option maturing just before the final ex-
dividend date
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Blacks Approach to Dealing with
Dividends in American Call Options
K
1
Buy a long-lived option strike K
1
for c
1
c
1
S
T
Set the American price equal to the maximum of two
European prices:
K
1
+ c
American
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12.14 Summary
This chapter covers important material:
The lognormality of stock prices
The calculation of volatility from historical data
Risk-neutral valuation
The Black-Scholes option pricing formulas
Implied volatilities
The impact of dividends