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Derivative

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theoretical laboratory in which you can explore the likely

effect of possible causes. They give you a common

language with which to quantify and communicate your

feelings about value.

Emanuel Derman

The Journal of Derivatives, Winter, 2000, p. 64

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4-Period Binomial Tree

S 0u 4

S0u 3

S0u 2

S0u S0u S0u 2

S0

S0 S0d S0

S 0d

S0d 2

S 0d 2

S0d 3

S 0d 4

Chance/Brooks

5-Period Binomial Tree, u = 1.0235 d = 1/u = .9753

Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 4: 6

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Black-Scholes-Merton Model as the Limit of

the Binomial Model

Recall the binomial model and the notion of a dynamic

risk-free hedge in which no arbitrage opportunities are

available.

Consider the DCRB June 125 call option.

Figure 5.1, p. 127 shows the model price for an increasing

number of time steps.

The binomial model is in discrete time.

As you decrease the length of each time step, n increases to

infinity, and it converges to continuous time.

It’s like switching from periodic to continuous

compounding.

Assumptions of the Model

There are no taxes or transaction costs

The stock pays no dividends

The options are European

The risk-free rate and volatility of the log return on the stock are

constant throughout the option’s life

Stock prices behave randomly and evolve according to a

lognormal distribution.

Distribution of stock return is not symmetric because of

limited liability.

See Figure 5.2a, p. 130, 5.2b, p. 130 and 5.3, p. 131 for a look

at the notion of randomness.

A lognormal distribution means that the log (continuously

compounded) return is normally distributed.

See Figure 5.4, p. 132.

A Nobel Formula

The Black-Scholes-Merton Option Pricing Model (B-S-M OPM)

gives the correct formula for a European call with above

assumptions.

The model is derived with complex mathematics but is easily

understandable.

The formula is

C S0 N(d1 ) Xe rcT N(d 2 )

where

ln(S0 /X) (rc σ 2 /2)T

d1

σ T

d 2 d1 σ T

Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 5: 10

A Nobel Formula (continued)

where

SO = current stock price

X = exercise price

continuously compounded return on the stock

rc = continuously compounded annual risk-free rate

Interpretation of N(d1) and N(d2)

A Nobel Formula (continued)

The familiar normal, bell-shaped curve

(Figure 5.5, p. 134)

See Table 5.1, p. 135 for determining the normal

probability for d1 and d2.

This table gives you N(d1) and N(d2).

A Nobel Formula (continued)

A Numerical Example

Price the DCRB June 125 call

S0 = 125.94, X = 125, rc = ln(1.0456) = 0.0446,

T = 0.0959, s = 0.83.

See Table 5.2, p. 136 for calculations. C = $13.21.

Interpretation of B-S-M OPM Equation

N(d1) is the probability that the option will be exercised and ST

(payoff) will be received or collected on expiration date T

Expected payoff on expiration date T is

ST N(d1)

Present value of expected payoff today is

e –rcT ST N(d1) or ST e –rcT N(d1) or

SO N(d1)

N(d2) is the probability that the exercise price (cost) will be paid

on expiration date T when the option is exercised

Expected cost on expiration date T is

X N(d2)

Present value of expected cost today is

X e –rcT N(d2)

NPV = Payoff – Cost = S0 N(d1 ) Xe rcT N(d2 )

Interpretation of B-S-M OPM Equation

Characteristics of the Black-Scholes-Merton Formula

Interpretation of the Formula

The first term of the formula is the discounted expected

stock price at expiration, given that it exceeds the exercise

price multiplied by the probability [N(d1)] of the stock price

at expiration exceeding the exercise price.

The second term is the discounted exercise price times the

probability [N(d2)] that the exercise price will be paid.

N(d1) and N(d2) are transitional or pseudo-probabilities based

on no-arbitrage condition, also known as risk-neutral

probabilities.

They are not actual probabilities of stock price going up or

down.

Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 5: 17

Effect of Variables on Option Pricing

Variable Ce Pe Ca Pa

S0 + – + –

X – +? – +

T

s

? + +

+ + + +

r + – + –

D – + – +

Stock Price and Call Price

If S , then C .

This effect is called the Delta, which is given by N(d1).

Delta measures the change in call price for a very small change in the

stock price.

Delta = ΔC/ΔS; ΔC = Delta x ΔS

Call price after change in S = Current call price + ΔC

For DCRB June 125 call, S = 125.94 and delta = N(d1) = .5693

If S rises to $126.94, ΔC = .5693 x ( $126.94 - $125.94) ≈ $0.57

Stock Price and Call Price

Delta hedging/delta neutral:

holding shares of stock and selling calls to maintain

a risk-free position

The number of shares held per option sold is the

Delta, N(d1).

As the stock goes up/down by $1, the option goes

up/down by N(d1).

By holding N(d1) shares per call, the effects offset.

Black-Scholes-Merton Model When the Stock

Pays Dividends

Known Discrete Dividends

Assume a single dividend of Dt where the ex-dividend

date is time t during the option’s life.

Subtract present value of dividends from stock price.

Adjusted stock price, S, is inserted into the B-S-M

OPM:

S0 S0 D t e rc t

Black-Scholes-Merton Model When the Stock

Pays Dividends (continued)

Continuous Dividend Yield

Assume the stock pays dividends continuously at the

rate of .

Subtract present value of dividends from stock price.

Adjusted stock price, S, is inserted into the B-S model.

c T

S0 S0 e

Estimating the Volatility

Historical Volatility

This is the volatility over a recent time period.

Collect daily, weekly, or monthly returns on the stock.

Convert each return to its continuously compounded

equivalent by taking ln(1 + return).

Calculate variance.

Annualize by multiplying by 250 (daily returns), 52

(weekly returns) or 12 (monthly returns).

Take square root to calculate standard deviation.

Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 5: 24

Chance/Brooks An Introduction to Derivatives and Risk Management, 7th ed. Ch. 5: 25

Estimating the Volatility (continued)

Implied Volatility

This is the volatility implied when the market price of

the option is set to the model price.

Figure 5.17, p. 158 illustrates the procedure.

Substitute estimates of the volatility into the B-S-M

formula until the market price converges to the model

price. See Table 5.7, p. 159 for the implied volatilities

of the DCRB calls.

Estimating the Volatility (continued)

Implied Volatility (continued)

Interpreting the Implied Volatility

The relationship between the implied volatility and the time to

expiration is called the term structure of implied volatility.

See Figure 5.18, p. 160.

exercise price is called the volatility smile or volatility skew.

Figure 5.19, p. 161.

These volatilities are actually supposed to be the same.

month at-the-money options based on the S&P 100 (VIX) and

Nasdaq (VXN).

See Figure 5.20, p. 163.

Volatility Smile

Volatility Smile

Put Option Pricing Models

Restate put-call parity with continuous discounting

Pe ( S 0 , T , X ) C e (S0 , T, X) S 0 Xe rc T

B-S-M put option pricing model

P Xe rc T [1 N(d 2 )] S0 [1 N(d1 )]

N(d1) and N(d2) are the same as in the call model.

Put Option Pricing Models (continued)

Note calculation of put price:

P 125e (0.0446)0.0959 [1 0 .4670]

125.94[1 0 .5692] 12.08

exercise and, thus, is extremely biased here since the

American option price in the market is 11.50.

A binomial model would be necessary to get an accurate

price.

With n = 100, we obtained 12.11.

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