Black-Scholes - Wikipedia, the free encyclopedia http://en.wikipedia.

org/wiki/Black-Scholes

Black-Scholes
From Wikipedia, the free encyclopedia.

The Black-Scholes model, often simply called Black-Scholes, is a model of the varying price over time of financial
instruments, and in particular stocks. The Black-Scholes formula is a mathematical formula for the theoretical value of
European put and call stock options that may be derived from the assumptions of the model. The equation was derived by
Fischer Black and Myron Scholes; the paper that contains the result was published in 1973. They built on earlier research
by Paul Samuelson and Robert Merton. The fundamental insight of Black and Scholes was that the call option is
implicitly priced if the stock is traded. The use of the Black-Scholes model and formula is pervasive in financial markets.
Merton and Scholes received the 1997 Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel for their
work (Black was ineligible, having died in 1995).

Contents
1 The model
2 Black-Scholes in practice
3 The formula
4 Extensions of the formula
5 Formula derivation
5.1 Elementary derivation
5.2 The Black-Scholes PDE
5.3 From the general Black-Scholes PDE to a specific valuation
5.4 Other derivations
6 See also
7 References
8 External links

The model
The key assumptions of the Black-Scholes model are:

The price of the underlying instrument is a geometric Brownian motion, in particular with constant drift and
volatility.
It is possible to short sell the underlying stock.
There are no riskless arbitrage opportunities.
Trading in the stock is continuous.
There are no transaction costs or taxes.
All securities are perfectly divisible (e.g. it is possible to buy 1/100th of a share).
The risk-free interest rate is constant, and the same for all maturity dates.

Black-Scholes in practice
The use of the Black-Scholes formula is pervasive in the markets. In fact the model has become such an integral part of
market conventions that it is common practice for the implied volatility rather than the price of an instrument to be quoted.
(All the parameters in the model other than the volatility - that is the time to maturity, the strike, the risk-free rate, and the
current underlying price - are unequivocally observable. This means there is one-to-one relationship between the option
price and the volatility.) Traders prefer to think in terms of volatility as it allows them to evaluate and compare options of
different maturities, strikes, and so on.

1 of 8 9/1/2005 6:49 PM
Black-Scholes - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Black-Scholes

However, the Black-Scholes model can not be modelling the real world exactly. If the Black-Scholes model held, then the
implied volatility of an option on a particular stock would be constant, even as the strike and maturity varied, and roughly
equal to the historic volatility. In practice, the volatility surface (the two-dimensional graph of implied volatility against
strike and maturity) is not flat. In fact, in a typical market, the graph of strike against implied volatility for a fixed maturity
is typically smile-shaped (see volatility smile). That is, at-the-money (the option for which the underlying price and strike
co-incide) the implied volatility is lowest; out-of-the-money or in-the-money the implied volatility tends to be different,
usually higher on the put side (low strikes), and call side (high strikes). Furthermore all implied volatilities on the surface
tend to be higher than historic volatility.

In fact the volatility surface of a given underlying instrument depends on, among other things, its historical distribution
and is constantly re-shaping as investors, market-makers, and arbitrageurs re-evaluate the probability of the underlying
instrument reaching a given strike and the risk-reward (including factors related to liquidity) associated to it.

Black-Scholes cannot be applied directly to bond securities because of the pull-to-par problem. As the bond reaches its
maturity date, all of the prices involved with the bond become known, thereby decreasing its volatility, and the simple
Black-Scholes model does not reflect this process. A large number of extensions to Black-Scholes, beginning with the
Black model, have been used to deal with this phenomenon.

The formula
The above lead to the following formula for the price of a call on a stock currently trading at price S, where the option has
an exercise price of K, i.e. the right to buy a share at price K, at T years in the future. The constant interest rate is r and the
constant stock volatility is σ.

where

Here N is the cumulative normal distribution function.

The price of a put option may be computed from this by put-call parity and simplifies to

The Greeks under the Black-Scholes model are also easy to calculate.

Extensions of the formula

The above option pricing formula is used for pricing European put and call options on non-dividend paying stocks. The
Black-Scholes model may be easily extended to options on instruments paying dividends. For options on indexes (such as
the FTSE) where each of 100 constituent companies may pay a dividend twice a year and so there is a payment nearly
every business day, it is reasonable to assume that the dividends are paid continuously. The dividend payment paid over
the time period [t,t + dt] is then modelled as

for some constant q. Under this formulation the arbitrage-free price implied by the Black-Scholes model can be shown to
be

2 of 8 9/1/2005 6:49 PM
Black-Scholes - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Black-Scholes

where now

is the modified forward price that occurs in the terms d1 and d2:

Exactly the same formula is used to price options on foreign exchange rates, except now q plays the role of the foreign
risk-free interest rate and S is the spot exchange rate. This is the Garman-Kohlhagen model (1983).

It is also possible to extend the Black-Scholes framework to options on instruments paying discrete dividends. This is
useful when the option is struck on a single stock. A typical model is to assume that a proportion δ of the stock price is
paid out at pre-determined times T1,T2,.... The price of a stock is then modelled as

where n(t) is the number of dividends that have been paid by time t. The price of a call option on such a stock is again

where now

is the forward price for the dividend paying stock.

American options are more difficult to value, and a choice of models is available (for example Whaley, binomial options
model).

Formula derivation
Elementary derivation

Let S0 be the current price of the underlying stock and S the price when the option matures at time T. Then S0 is known,
but S is a random variable. Assume that

is a normal random variable with mean µT and variance σ2T. It follows that the mean of S is

for some constant r (independent of T), which may be readily identified with the interest rate. Define the value of the
option as the present value of the expected payoff. For a call option with exercise price K this is

3 of 8 9/1/2005 6:49 PM
Black-Scholes - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Black-Scholes

The derivation of the formula for C is facilitated by the following lemma: Let Z be a standard normal random variable and
let b be an extended real number. Define

If a is a positive real number, then

where N is the normal distribution function. As a special case, we have

Now let

and use the corollary to the lemma to verify the statement above about the mean of S. Define

and observe that

for some b. Define

and observe that

The rest of the calculation is straightforward.

The Black-Scholes PDE

In this section we derive the partial differential equation (PDE) at the heart of the Black-Scholes model via a no-arbitrage
or delta-hedging argument; for the underlying logic, see the discussion at rational pricing. The presentation given here is
informal and we do not worry about the validity of moving between dt meaning an small increment in time and dt as a

4 of 8 9/1/2005 6:49 PM
Black-Scholes - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Black-Scholes

derivative.

As in the model assumptions above we assume that the underlying (typically the stock) follows a geometric Brownian
motion. That is,

where Wt is Brownian. Now let V be some sort of option on S - mathematically V is a function of S and t. V(S,t) is the
value of the option at time t if the price of the underlying stock at time t is S. The value of the option at the time that the
option matures is known. To determine its value at an earlier time we need to know how the value evolves as we go
backward in time. By Itō's lemma for two variables we have

Now consider a portfolio

consisting of one unit of the option V and −∂V/∂S units of the underlying stock. The composition of this portfolio, called
the delta-hedge portfolio, will vary from time-step to time-step. Now consider the change in return

of the portfolio. By substituting in the equations above we get

This equation contains no dW term. That is, it is entirely riskless. Thus, assuming no arbitrage (and also no transaction
costs and infinite supply and demand) the rate of return on this portfolio must be equal to the rate of return on any other
riskless instrument. Now assuming the risk-free rate of return is r we must have over the time period [t,t + dt]

If we now substitute in for Π and divide through by dt we obtain the Black-Scholes PDE:

This is the law of evolution of the value of the option. With the assumptions of the Black-Scholes model, this equation
holds whenever V has two derivatives with respect to S and one with respect to t.

From the general Black-Scholes PDE to a specific valuation

We now show how to get from the general Black-Scholes PDE to a specific valuation for this option. Consider as an
example the Black-Scholes price of a call on a stock currently trading at price S. The option has an exercise price of K, i.e.
the right to buy a share at price K, at T years in the future. The constant interest rate is r and the constant stock volatility is

5 of 8 9/1/2005 6:49 PM
Black-Scholes - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Black-Scholes

σ (all as at top). Now, for a call option the PDE above has boundary conditions:

for all t

as

The last condition gives the value of the option at the time that the option matures. The solution of the PDE gives the
value of the option at any earlier time. In order to solve the PDE we transform the equation into a standard diffusion
equation which may be solved using standard methods. To this end set

x such that

τ such that

v(x,τ) such that

Thus our Black-Scholes PDE becomes

where c = 2r / σ2. The terminal condition V(S,T) = max(S − K,0) now becomes an initial condition v(x,0) = max(ex − 1,0).
If we now make a further transformation such that

then

a standard diffusion equation as desired. Our initial condition has translated to

Using the standard method for solving a diffusion equation we have:

where u0 is the initial condition defined in the line above. This integral may be further transformed until we obtain:

where

6 of 8 9/1/2005 6:49 PM
Black-Scholes - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Black-Scholes

and I2 is identical to I1 except that c + 1 is replaced by c − 1 everywhere.

Substituting for u, v, x, and τ, we finally obtain the value of a call option in terms of the Black-Scholes parameters:

where

As before, N is the cumulative normal distribution function.

The formula for the price of a put option follows from this via put-call parity.

Other derivations

Above we used the method of arbitrage-free pricing ("delta-hedging") to derive a PDE governing option prices given the
Black-Scholes model. It is also possible to use a risk-neutrality argument. This latter method gives the price as the
expectation of the option payoff under a particular probability measure, called the risk-neutral measure, which differs
from the real world measure.

See also
Binomial options model, which is a method of calculating option prices.
Black model, a variant of the Black-Scholes option pricing model.
Financial mathematics, which contains a list of related articles.

References
Black, F., and M. Scholes. "The Pricing of Options and Corporate Liabilities." Journal of Political Economy, 81
(1973), 637-654. Black and Scholes' original paper.
Merton, Robert C. "Theory of rational option pricing." Bell Journal of Economics and Management Science, 4 (1)
(1973), 141-183.

External links
The Black Scholes Option Pricing Model
Option pricing theory (http://www.riskglossary.com/link/option_pricing_theory.htm) , links to more detailed
articles on specific models, riskglossary.com
The Black & Scholes Model (http://www.global-derivatives.com/options/black-scholes.php) ,
global-derivatives.com
Options pricing using the Black-Scholes Model
(http://www.finance24.com/register/help/mmx_school/displayarticlewide.asp?ArticleID=271869) , The
Investment Analysts Society of South Africa
The Black Scholes Option Pricing Model
(http://www.ftsmodules.com/public/texts/optiontutor/eappch6.htm) , optiontutor
Black, Merton and Scholes: Their work and its consequences

7 of 8 9/1/2005 6:49 PM
Black-Scholes - Wikipedia, the free encyclopedia http://en.wikipedia.org/wiki/Black-Scholes

(http://www.mayin.org/ajayshah/PDFDOCS/Shah1997_bms.pdf) , by Ajay Shah

(http://www.mayin.org/ajayshah)

Variations on the model

Options on non-dividend-paying stocks (Black Scholes)
(http://www.riskglossary.com/articles/black_scholes_1973.htm) , riskglossary.com
Options on stock indexes and continuous dividend-paying stocks
(http://www.riskglossary.com/articles/merton_1973.htm) , riskglossary.com
Foreign exchange options (http://www.riskglossary.com/articles/garman_kohlhagen_1983.htm) ,
riskglossary.com
Options on forwards (the Black model) (http://www.riskglossary.com/articles/black_1976.htm) ,
riskglossary.com

Derivations
The risk neutrality derivation of the Black-Scholes Equation
(http://www.quantnotes.com/fundamentals/options/riskneutrality.htm) , quantnotes.com
Arbitrage-free pricing derivation of the Black-Scholes Equation
(http://www.quantnotes.com/fundamentals/options/black-scholes.htm) , quantnotes.com, or an alternative
treatment (http://www.sjsu.edu/faculty/watkins/blacksch.htm) , Prof. Thayer Watkins
Solving the Black-Scholes Equation (http://www.quantnotes.com/fundamentals/options/solvingbs.htm) ,
quantnotes.com
Solution of the Black Scholes Equation Using the Green's Function
(http://www.physics.uci.edu/%7Esilverma/bseqn/bs/bs.html) , Prof. Dennis Silverman

Tests of the Model

Anomalies in option pricing: the Black-Scholes model revisited
(http://www.findarticles.com/p/articles/mi_m3937/is_1996_March-April/ai_18367627) , New England
Economic Review, March-April, 1996

Online calculators
Black-Scholes Pricing Analysis (http://www.hoadley.net/options/optiongraphs.aspx) - including dividends
(http://www.hoadley.net/options/optiongraphs.aspx?divs=Y) , hoadley.net

Computer Programming Implementations

Black-Scholes in Multiple Languages (http://www.espenhaug.com/black_scholes.html) ,
www.espenhaug.com

Historical
The Sveriges Riksbank (Bank of Sweden) Prize in Economic Sciences in Memory of Alfred Nobel for 1997
(http://www.nobel.se/economics/laureates/1997/press.html)
Trillion Dollar Bet (http://www.pbs.org/wgbh/nova/stockmarket/) - Companion Web site to a Nova episode
originally broadcast on February 8, 2000. "The film tells the fascinating story of the invention of the
Black-Scholes Formula, a mathematical Holy Grail that forever altered the world of finance and earned its
creators the 1997 Nobel Prize in Economics."

Retrieved from "http://en.wikipedia.org/wiki/Black-Scholes"

Categories: Financial mathematics | Stock market | Equations | Finance theories | Derivatives

This page was last modified 14:25, 23 August 2005.

All text is available under the terms of the GNU Free Documentation License (see Copyrights for
details).

8 of 8 9/1/2005 6:49 PM