The Black-Scholes-Merton Formula and

Risk-Neutral Pricing
An Introduction to Mathematical Finance
Phillip Monin
Department of Mathematics
The University of Texas at Austin
Austin, TX 78712
pmonin@math.utexas.edu
March 31, 2010
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Derivatives are nancial weapons of mass destruction.
(Warren Buett, 2003)
Although the benets and costs of derivatives remain the
subject of spirited debate, the performance of the economy
and the nancial system in recent years suggests that those
benets have materially exceeded the costs.
(Alan Greenspan, 2003)
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Outline
Overview of Math Finance
Binomial Asset Pricing Model
Geometric Brownian Motion
The Black-Scholes-Merton Formula
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Outline
1 Overview of Math Finance
2 The Binomial Asset Pricing Model
3 Geometric Brownian Motion
4 The Black-Scholes-Merton Formula
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
History
1900: Bachelier - Brownian motion & stock prices
1950-60s: Markowitz and Sharpe - portfolio
optimization - risk/return tradeo
1970s: Black-Scholes, Merton - pricing options
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Mathematical Finance
risk-neutral pricing/ APT
utility maximization, duality methods
general equilibrium pricing
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
The Math in Math Finance
Real analysis and PDEs
Probability
Functional analysis
Stochastic analysis, SDEs
Convex duality
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Outline
1 Overview of Math Finance
2 The Binomial Asset Pricing Model
3 Geometric Brownian Motion
4 The Black-Scholes-Merton Formula
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
The Binomial Asset Pricing
Model: An Illustration of
Risk-Neutral Pricing
One period, no transactions costs, borrow/lend at same
rate r > 0
One riskless bond with price at time t denoted by B
t
One risky stock with price at time t denoted by S
t
.
S
1
(H) = uS
0
S
0
p
r
r
r
r
r
r
r
r
r
r
r
q=1p
L
L
L
L
L
L
L
L
L
L
L
S
1
(T) = dS
0
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Arbitrage
Arbitrage:
something for nothing: chance to make money with
no possible loss
real markets sometimes exhibit arbitrage, but this is
necessarily eeting; as soon as someone discovers it,
trading takes place that removes it.
In the binomial model, to preclude arbitrage, we must
assume
0 < d < 1 +r < u
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Why?
1 If d 1 +r
Start with nothing.
Borrow from bond to buy stock.
Money earned from stock at time one enough to pay
debt; positive probability of prot.
2 If u 1 +r
Start with nothing.
Short stock and buy bond.
Money earned from bond at time one enough to sell
stock; positive probability of prot.
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Financial Derivatives
A derivative is a nancial contract whose payout depends
on the value of some other (underlying) security.
A European call option: right, but not the obligation, to
buy one share of stock at time one for strike price K.
We shall assume that S
1
(T) < K < S
1
(H).
If we get a tail on the toss, the option expires worthless.
If we get a head on the coin toss, the option is
exercised and yields a prot of S
1
(H) K.
Thus the options payout is (S
1
K)
+
.
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Lets play a game
u = 2, d =
1
2
, r =
1
4
S
1
(H) = 8
S
0
= 4
p
q
q
q
q
q
q
q
q
q
q
q=1p
M
M
M
M
M
M
M
M
M
M
S
1
(T) = 2
B
0
= 1 B
1
= 1.25
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
You will buy the European call from me. The call has strike
K = 5 and so its payout looks like:
C
1
(H) = 3
C
0
=?
p
q
q
q
q
q
q
q
q
q
q
q=1p
M
M
M
M
M
M
M
M
M
M
C
1
(T) = 0
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
You will buy the European call from me. The call has strike
K = 5 and so its payout looks like:
C
1
(H) = 3
C
0
=?
p
q
q
q
q
q
q
q
q
q
q
q=1p
M
M
M
M
M
M
M
M
M
M
C
1
(T) = 0
How much will you pay me for this game?
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Replication
Suppose my initial wealth is X
0
= 1.20.
Buy
0
=
1
2
shares stock, which costs 2.
Only have 1.20, so borrow .80 at an interest rate of 25%.
If H, then stock position worth
1
2
8 = 4.
If T, then stock position worth
1
2
2 = 1.
At time one, owe 1 with certainty.
Therefore, total wealth at time one looks like
X
1
(H) = 3
X
0
= 1.20
p
o
o
o
o
o
o
o
o
o
o
o
q=1p
O
O
O
O
O
O
O
O
O
O
O
X
1
(T) = 0
regardless of what p and q are!
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
We have replicated the call option by investing in the stock
and the money market. This is the risk-neutral pricing or
arbitrage pricing theory approach. Why the names?
Since we have replicated the call with initial wealth
X
0
= 1.20, then the price of the call must be C
0
= 1.20 or
else there will be arbitrage.
1 If C
0
= 1.21, then I use 1.20 to replicate the call and
take 0.01 and put in the bond.
2 If C
0
= 1.19, then I buy the option and reverse the
replicating strategy: sell
1
2
shares stock short, receive
income of 2. Use 1.19 to buy the option, put .80 in
money market, and put 0.01 in another money market.
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Why is it called risk-neutral
pricing?
Let
p =
(1 +r) d
u d
> 0, q =
u (1 +r)
u d
= 1 p > 0
p + q = 1, and so we can regard them as probabilities.
Investors are neutral about risk:
S
0
=
1
1 +r
[ pS
1
(H) + qS
1
(T)]
Investors must be neutral about risk since they do not
require extra compensation to assume it, and are not
willing to pay for it.
Under these weights, we price by expectation:
C
0
=
1
1 +r
[ pC
1
(H) + qC
1
(T)]
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Hedging
So, how much do I put in the stock at time zero to replicate
the call?
One can show

0
=
C
1
(H) C
1
(T)
S
1
(H) S
1
(T)
the so called delta-hedging formula.
This tells me how much to invest in the stock to replicate
the call, that is, to hedge a short position in the call.
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Multi-period Binomial Model
Used in practice because with a sucient number of
periods, it provides a reasonably good, computationally
tractable approximation to continuous-time models.
Use backward induction.
Price by expectation using risk-neutral probabilities,
and hedge using delta-hedging formula.
In multi-period or continuous time setting, all discounted
portfolios are martingales under the risk-neutral measure,
which is sometimes called equivalent martingale
measure.
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Fundamental Theorem of Asset
Pricing (First part)
There is not always a unique risk-neutral measure. For a
given market, the set of EMMs is similar to the set of
solutions to linear systems.
Either
There is no risk-neutral measure.
There is a unique risk-neutral measure.
There are innitely many risk-neutral measures.
Theorem
No arbitrage there exists a risk-neutral measure
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Outline
1 Overview of Math Finance
2 The Binomial Asset Pricing Model
3 Geometric Brownian Motion
4 The Black-Scholes-Merton Formula
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Real data
Figure: Google price history3/26/10
Figure: Google price history4/09-3/10
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Paths of Geometric Brownian
Motion
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Geometric Brownian Motion
We say that {S
t
}
t0
follows a geometric Brownian
motion with drift and volatility , if for all t, s 0 the
random variable
S
t+s
S
t
is independent of all prices up to time t and if
log
_
S
t+s
S
t
_
is a normal random variable with mean t and variance t
2
.
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Geometric Brownian motion as a
limit of binomial models
Let > 0 be a small increment in time, and suppose that
every time units, the price of a security either goes up by
a factor u with probability p or goes down by a factor d with
probability 1 p where
u = e

, d = e

, p =
1
2
_
1 +

_
Proposition
As 0, the collection of prices becomes a geometric
Brownian motion.
Theorem (Central Limit Theorem)
{X
n
}
nN
sequence of iid random variables, and
S
n
=

n
i=1
X
i
. Then for large n, S
n
will approximately be
N(n, n
2
).
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Outline
1 Overview of Math Finance
2 The Binomial Asset Pricing Model
3 Geometric Brownian Motion
4 The Black-Scholes-Merton Formula
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
The Black-Scholes-Merton
Formula
Price a call with strike K and expiration T.
Interest rate r, compounded continuously.
Price of stock- GBM with volatility
2
Idea: nd risk-neutral price in n-periods, send n to innity
Approximate GBM (note no )
u = e

T/n
1 +
_
T/n +

2
T
2n
d = e

T/n
1
_
T/n +

2
T
2n
Let Y Binomial(n, p)
p =
1 +rT/n d
u d

1
2
+
r
_
T/n
2


_
T/n
4
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
The unique risk-neutral price for the n-period model is
C = (1 +rT/n)
n
E[(S
0
u
Y
d
nY
K)
+
]
= (1 +rT/n)
n
E
_
_
S
0
_
u
d
_
Y
d
n
K
_
+
_
= (1 +rT/n)
n
E[(S
0
e
2

T/n
Y e

nT
K)
+
]
= (1 +rT/n)
n
E[(S
0
e
W
K)
+
]
where
W = 2
_
T/nY

nT.
Y Binomial(n, p) implies Y N(np, np(1 p))
Linear combos of normals are normal, so W converges
to a normal too.
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Since E[Y ] = np,
E[W] = 2
_
T/nE[Y ]

nT
= 2
_
T/nnp

nT
= 2

nT(p 1/2)
2

nT
_
r
_
T/n
2


_
T/n
4
_
Moreover, Var(Y ) = np(1 p) and p 1/2 for large n, so we
have that
Var(W) = (2
_
T/n)
2
Var(Y )
= 4
2
Tp(1 p)

2
t
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Thus as n , the unique cost of the option that does not
result in an arbitrage when the underlying securitys price
follows a geo BM with volatility parameter is
C
0
= e
rT
E[(S
0
e
L
K)
+
]
where L N((r
2
/2)T,
2
T). Thus, we can derive the
Black-Scholes-Merton option pricing formula:
C
0
= S
0
() Ke
rt
(

T)
where
=
rT
2
T/2 log(K/S
0
)

T
and
(x) =
_
x

2
e
z
2
/2
dz
is the cumulative distribution function of the standard
normal random variable.
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
Using Girsanovs theorem, it can be shown that the
risk-neutral measure in this situation corresponds to the
stock following a GBM with and where
= r
2
/2.
Thus, the BSM formula is an example of risk-neutral pricing.
If C(S
0
, T, K) is the BSM valuation of the option then

0
=

S
0
C(S
0
, T, K) = () > 0
We can use this to construct hedges.
One can see that C is increasing in S
0
, T, , r and
decreasing in K.
is estimated from historical data.
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
In practice...
What if the real cost diers from the BSM price?
Probably not.
BSM assumes continuous trading in the stock, which is
impossible and expensive because of transactions costs.
Even if we assume our estimate of is very accurate, it
can change over the options life.
Our assumption that the stock follows a geometric BM
is only an approximation to reality. Many studies show
this not to be the case.
If you believe that GBM is a reasonable approximate model,
then BSM formula gives a reasonable option price. If the
price is signicantly above/below the market price, then a
strategy of buying/selling options and selling/buying stock
can be devised. Such a strategy, although not yielding a
certain win, can often yield a gain that has a positive
expected value along with a small variance.
B-S-M and
R-N
P. Monin
Overview of
Math
Finance
Bin. Asset
Pricing
Geometric
Brownian
Motion
The Black-
Scholes-
Merton
Formula
BSM used in practice, usually as a reference point.
Other limitations:
the underestimation of extreme moves
stationarity of the process, risk-free nonconstant &
must be estimated
continuous and frictionless trading
Thank you for your attention!
Feel free to email me at
pmonin@math.utexas.edu
for a set of references.