Black Scholes Model

The Black Scholes Option Pricing Model
6-1
500
EC3605 Empirical Finance
1000
Chapter 6:
The Black Scholes Option Pricing
Model
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6-2
Differential Equation
A common model for stock prices is the geometric Brownian motion
dSt = St dt + St dWt
(6.1)
Equivalently returns follow general Brownian motion

dSt
= dt + dWt
St
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Drift reflects the current expectations of the returns.

Volatility reflects the standard deviation around that drift.
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6-3
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1000
The idea of Black-Scholes (BS) was to construct a portfolio from

stocks and bonds that yields the same return as a portfolio
consisting only of an option. This so called hedge portfolio has the
same cash flow in T as the option, and thus must have the same
price.
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6-4
In contrast to the hedge portfolios introduced in the first sections

of this class, the balance of stocks and calls is adapted
continuously.
We shall see that the relation
Value of hedge portfolio = Value of option portfolio
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yields a partial DEQ for the value of the call.
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6-5
Pricing a call option on a stock
There are two equivalent strategies:

1. Portfolio A: Call option with strike K and maturity T
Portfolio B: nt = n(St , t) stocks and mt = m(St , t) zero
bonds with nominal value BT = 1
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1000
2. Portfolio A: One stock and nt = n(St , t) calls short with

strike K and maturity T
Portfolio B: mt = m(St , t) zero bonds with nominal value
BT = 1
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6-6
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As the proof of the BS pricing formula is essential in the theory of

finance, we want to give three proofs of it. The first is more
lengthy but allows for a convenient understanding of the portfolio
adjustments. The second one is more condensed and more elegant.
With the result, it will be possible to value derivatives of arbitrary
payoff functions. A third proof is given in the technical appendix
using martingale techniques.
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6-7
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Proposition 6.1 (BS I) Let St be an asset governed by a

geometric Brownian motion, and let FI be a financial instrument
(derivative) on St expiring in T . Let T be the exercise time and
T = T if FI is not exercised. The value of FI at time t T is
given by the function F (St , t).
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6-8
1. There exists a portfolio in St and zero bonds Bt duplicating

FI , i.e. it generates the same payoff in T as FI and has the
same time T -value as FI .
2. The value F (S, t) fulfills the BS-DEQ:
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1000
F (S, t)
F (S, t) 1 2 2 2 F (S, t)
=0
rF (S, t) + bS
+ S
2
t
S
2
S
(6.2)
for t T ,
where b is cost of carry, r is risk free interest rate.
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6-9
Proof:
W.l.o.g. we assume that the object is a stock with continuous
dividend d and costs of carry b = r d.
We construct a (dynamic) hedge portfolio V consisting of
nt
= n(St , t)
stock
mt
= m(St , t)
bonds (with BT = 1)
such that the financial instrument F and the hedge portfolio have
the same value in T :
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V (ST , T ) = F (ST , T ).
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6-10
The value of hedge portfolio is

Vt = V (St , t) = nt St + mt Bt .
Here
Bt = BT e r (T t) = e r (tT )
How does it change in a small time interval dt?
dVt = Vt+dt Vt , dnt = nt+dt nt
dVt
= {nt+dt St+dt nt St }
(6.3)
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1000
+ {mt+dt Bt+dt mt Bt }
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6-11
Note that the first term equals:

nt+dt (St+dt St ) + nt+dt St nt St ={nt+dt nt }(St+dt St )
+ nt (St+dt St ) + {nt+dt nt }St

+ nt St nt St
which is just
dnt dSt + nt dSt + St dnt = dnt (dSt + St ) + nt dSt
Hence equation (6.3) can be written as :

(6.4)
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dVt = dnt (St + dSt ) + nt dSt + dmt (Bt + dBt ) + mt dBt .
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6-12
Apply now Itos Lemma

g
g
1 2g 2 2
dg (St , t) =
St dt
dt +
dSt +
2
t
S
2 S
to g = nt and g = mt .
Furthermore, use
(dSt )2 = (St dt + St dWt )2 = 2 St2 (dWt )2 = 2 St2 dt + O(dt)
dBt = rBt dt
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and exploit that dSt dt and (dt)2 are O(dt).
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dVt
nt
t dt
nt dSt +
+

nt
S dSt
mt
t dt
6-13
2n
1
t 2 2
2
2 S St dt
mt
S dSt
2m
St +
nt 2 2
S St dt+
1
t 2 2
2
2 S St dt
Bt + mt rBt dt
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1000
The assumption of no cash flow up to T means that all payments

and costs in dt (these are all terms in the above equation, except
nt dSt and mt rBt dt = mt dBt ) are neutralized by payments and
costs of the object i.e. d nt St dt = (r b)nt St dt.
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6-14
This yields:
nt (r b)St dt
mt
1 2 mt 2 2
dt +
dSt +
St dt Bt
t
S
2 S 2
m
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1000
nt
1 2 nt 2 2
nt 2 2
dt +
dSt +
St dt St +
St dt
2
t
S
2 S
S
n
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6-15
Insert dSt = St dt + St dWt and order stochastic (dW ) and

non-stochastic components (dt):
nt
1 2 nt 2 2
1 2 mt 2 2
nt 2 2 mt mt
+
St +
St +
+
St +
St St +
St Bt
t
S
2 S 2
S
t
S
2 S 2
o
n
mt
t
+nt (b r )St dt +
St +
Bt St dWt = 0
t
S
t
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n n
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6-16
It follows that the stochastic and riskless part of this equation

must equal zero:

2
nt
1 nt 2 2
nt 2 2
nt
+
St +
St
St St +
2
t
S
2 S
S

2
mt
1 mt 2 2
mt
St Bt + nt (b r )St
+
St +
+
2
t
S
2 S
= 0
and
nt
mt
St +
Bt = 0
S
S
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1000
(6.5)
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6-17
Combining equations we obtain:

1 2 nt 2 2
nt 2 2
+
St +
S
S
+
t
t
2
t
2 St
S
m
1 2 mt 2 2
t
St Bt + nt (b r )St = 0
+
t
2 S 2
n
(6.6)
Differentiate (6.5) w.r.t. S:

2 nt
2 mt
nt
St +
Bt =
2
2
S
S
S
(6.7)
Insert into equation (6.6):

nt
mt
1 nt 2 2
St +
Bt +
St + nt (b r )St = 0
t
t
2 S
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1000
(6.8)
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6-18
By definition of V we have:
mt
Vt
= Bt1 (Vt nt St )
= nt St + mt Bt
(6.9)
(6.10)
Differentiate w.r.t. t:
V

mt
n
t
= rBt1 (Vt nt St ) + Bt1
St
t
t
t
Insert into equation (6.8) and obtain:
(6.11)
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V
1 2 2 nt
St
+
+ nt bSt rVt = 0
2
S
t
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6-19
Differentiate (6.9) w.r.t. S and observe that Bt /S = 0:

V
mt
n
t
= Bt1
nt
St
S
S
S
This yields together with (6.5):
V
,
nt =
S
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which is the so called Delta. It yields the number of stocks in the

hedge portfolio.
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Since
6-20
Vt nt St
mt =
Bt
we may construct the desired duplication portfolio if we know

Vt = V (St , t).
Insert this into (6.11) and we obtain the DEQ of BS
V (S, t)
V (S, t) 1 2 2 2 V (S, t)
rV (S, t)+bS
+ S
= 0, (6.12)
2
t
S
2
S
The function V (St , t) follows this DEQ and has at time T the
same pay-off as the financial instrument F (ST , T ), i.e.
V (ST , T ) = F (ST , T ).
(6.13)
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0
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6-21
Check solution
The function VK ,T (St , ) = St e (br ) Ke r with = T t for
the value of a forward contract fulfills the DEQ (6.12) and satisfies
V (ST , 0) = ST K .
Check:
(6.14)
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V
= St e (br )(T t) (r b) Ke r (T t) r
t
2V
V
=0
= e (br )
2
S
S
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6-22
Plug into (6.12):

Se (br )(T t) (r b) Ke r (T t) r
rV + bSe (br ) + 0
= bSe (br ) rV +rV bSe (br ) = 0.
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When one tries to follow the hedging strategy in Proposition 6.1 in

practice, accumulating transaction costs may diminish the quality
of the hedge.
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6-23
FX Options
Investment in a foreign currency is comparable with a stock with
continuous dividend payments, that corresponds to the riskfree
interest rate rf in the foreign country. Under the assumption that
the FX rate follows a geometric Brownian motion, the value V of a
financial instrument also satisfies the BS DEQ (6.12) with d = rf
and b = r rf .
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Empirical observations indicate, however, that FX rates are not

very well described by geometric Brownian motion. BS option
theory should be applied carefully.
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6-24
Proposition 6.2 (BS II) Let the processes for a stock and a bond
be described by the following equations:
dSt
= St dt + St dWt
dBt
= rBt dt,
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then every financial instrument (derivative) of the form f (ST ) may

be duplicated by a dynamic portfolio Vt such that:
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6-25
1. the duplication portfolio has the same cash flow as f (ST ), i.e:
f (ST ) = VT = F (ST , T ),
(6.15)
2. a function F (S, t) exists, which fulfills Vt = F (St , t) and:
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F (S, t)
F (S, t) 1 2 2 2 F (S, t)
= 0,
rF (S, t) + rS
+ S
2
t
S
2
S
(6.16)
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6-26
Proof:
Let nt and mt describe the allocations in stock and bond. We look
for a self financing portfolio which replicates the claim f (ST ). Self
financing means that no funds are required after the initial
investment. If such a portfolio exists, then its initial value is the
unique price of the derivative.
The definition of the portfolio and the self financing condition
imply:
(6.17)
dVt = nt dSt + mt dBt = nt dSt + mt rBt dt
(6.18)
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V t = n t St + mt B t
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6-27
Assume now that Vt = F (St , t) for a sufficiently smooth function

F (, ), so that we can apply Ito calculus. Then:
2

1 F 2 2 F
F
St +
dSt +
dt. (6.19)
dVt = dF (St , t) =
2
S
2 S
t
By the self financing condition (6.18) we obtain:
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1000
F (St , t)
.
nt =
S
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6-28
Furthermore, from (6.17) we have:

F (St , t)
1
St Bt1 ,
mt = {F (St , t) nt St }Bt = F (St , t)
S
and from equation (6.18) we can rewrite the self financing
condition in the form:

F
F
dVt = dF (St , t) =
dSt + F
St rdt.
S
S
(6.20)
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Finally, equating (6.19) and (6.20) we obtain (6.16).
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6-29
A solution to the DEQ (6.16) with boundary condition (6.15)

provides a complete description to the price and hedging strategy
of a derivative f (ST ). It can be shown (homework) that the
solution takes the form:
Vt = F (St , t) = e r (T t)

x 2

Z +
e 2
1 2
dx,
f St exp T tx + r (T t)
2
2
whenever the above integral is finite.
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6-30
Black-Scholes (BS) Formula for European

Options
An American option can be exercised anytime till the expiration
date. A European option can only be exercised on the expiration
date.
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Theoretically and practically European options and American

options have different prices. This is because e.g. in case of a put
or in case of a call on dividend paying there is a positive probability
of exercising prior to expiration.
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6-31
Call prices
BS DEQ for a call C = V in (6.12)

C (S, t)
C (S, t)
1 2 2 2 C (S, t)
S
,0tT
=
rC bS
2
S
2
S
t
0<S <
(6.21)
C (S, T ) = max {0, S K } , 0 < S <
(6.22)
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C (0, t) = 0,
lim C (S, t) S = 0,
6-32
0 t T.
(6.23)
The first part in (6.23) follows from the fact that 0 is an absorbing
state for the geometric Brownian motion: St = 0, t < T , implies
ST = 0, and the call is not exercised.
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The second part in (6.23) can be motivated by the fact that the
probability for ST < K is small if St K in t already. Hence the
call is exercised and CT = ST K ST .
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6-33
Transformation of the BS DEQ:

There exists an analytic solution based on theory for parabolic
DEQ with boundary conditions. Multiply (6.21) with 22 and put
and = T t.
= 2r2 , = 2b
2
Moreover define:
g (u, v ),
with
v = ( 1)
2
S
u = ( 1) log + v
K
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C (S, T ) = e
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6-34
A transformed version of the DEQ is then:

g
2g
=
,
2
u
v
0 v ( 1)
2T
= v ,
(6.24)
< u < ,
with boundary conditions
def
g0 (u) = g (u, 0) = K max{0, e
u
1
1},
< u <
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Such DEQ occurs in physics (as the heat equation).
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6-35
The solution is:

g (u, v ) =
(u)2
1
g0 ()e 4v d
2 v
Transforming back yields:

C (S, T ) = e r g (u, v ) = e r
(u)2
1
g0 ()e 4v d
2 v
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6-36
By substituting = ( 1) log Ky , the boundary condition is in its

original form is recovered: max{0, y K }.
Replace (u, v ) by the corresponding expressions in S and :
C (S, ) = e
dy
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1000
1
max{0, y K } e
y 2
2
[log y (log S+(b 2 ) )]2
2 2
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6-37
Interpretation:
C (S, ) a discounted expectation of the payoff function
taken with respect to log-normal distribution, the risk neutral
distribution:
C (S, ) = e r E[max{0, S K }]
= e r E(S K )1(S > 0)1(S K > 0)

1
0
if S K > 0
if S K < 0
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1(S K > 0) =
(6.25)
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6-38
Why?
E [g (x)] =
g (x)f (x)dx
2
[log x{log St +(b 2 ) }2 ]
2 2
with f (x) =
e
2
and g (x) = max(0, x K )
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Where the expected value is calculated for a rv log Y N(

,
2)
2
2 = 2 .
with
= log St + (b 2 ) and
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6-39
We transform the formula for C (S, t) further:
(r b)
C (S, ) = e
S(y + ) e r K (y )
y=
log
S
K
+ (b
(6.26)
2
2 )
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Here describes the cdf of a standard normal rv.

Z y
Z y
2
2
1
1
z 2
z2
e dz.
e
dz =
(y ) =

2
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6-40
Interpretation of the BS formula:

C (S, ) = e
(r b)
S(y + ) e r K (y ),
(6.27)
the first term (S(y + ), for r = b) represents the value

of the stock in case the option is exercised for S > K .
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the second term e r K (y ) represents the discounted value

of the strike price.
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6-41
C
S,
where
Value of stock in hedge portfolio is C
S
S is the
hedge ratio. Differentiate (6.27) w.r.t. S: C
S = (y + ).
The first term stands for the capital invested in stock, the
second for the capital invested in zerobonds.
If S K then the value of C S e r K

If S = 0 then C (0, ) = 0.
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The value of a perpetual European put ( = ) is zero
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6-42
Put prices
With the help of the put-call parity

P(S, ) = C (S, ) Se (r b) + Ke r
(6.28)
the value of a European put option is given by:

P(S, ) = e
K (y ) e
(r b)
S(y )
(6.29)
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1000
SFEPutCall
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6-43
70
70
60
60
50
50
40
40
C(S,tau)
C(S,tau)
30
30
20
20
10
10
0
0
100
S
0
0
50
100
150
Figure 1: Black-Scholes prices for the European call option C (S, ) for
different values of times to maturity = 0.6 and r = 0.1 and strike price
K = 100. Left figure = 0.15, right figure = 0.3.
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1000
SFEbsprices
0
1000
2000
3000
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4000
6-44
Stock Price Path & Call Price Path ( = 0, 3)

140
St
120
100
0
0.2
0.4
0.6
0.8
0.6
0.8
C(S,t)
30
20
10
0
0
0.2
0.4
t
500
1000
Figure 2: Black-Scholes price C (S, ) as a function of St , which is modelled

as a geometric Brownian motion. Upper panel: sample path of the price
process of the underlying S, lower panel: Black-Scholes prices C (S, ) for
strike K = 100, r = 0.05 and expiry at T = 1 where the initial value of
SFEbsbm
the underlying is taken from the above sample path.
0
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6-45
Heat-transfer equation of physics

In physics, Greens function of heat equation for temperature G is:
1 2 2G
G
=
2 x 2
with boundary condition:
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1000
G (x, 0) = (x x0 )
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6-46
500
1000
Here, we seek the temperature distribution G (x, t; x0 ) in a one

dimension rod when t > 0. And with a Dirac delta function
(x x0 ) as an initial condition, which means that, the initial
temperature is infinitely large at the point x0 , and 0 at the other
point. The solution to this problem is the heat kernel (also called
Green funcion) to describe the change of heat distribution over
time.
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6-47
If we apply Greens formula which is given by:

(x x0 )2
}
G (x, ; x0 ) =
exp{
2
2
2
2
1
to the value of a European call C(S,t) satisfying following PDE:

C
1 2 2 2C
C
+ S
rC = 0
+ rS
2
t
2
S
S
(6.30)
and satisfying the final condition C (S, T ) = max(S K , 0), then

we get for the price of the call option:
C (S, ) =
log(S/K ) + (r +
log(S/K ) + (r
2
2 )
2
2 )
e r K
)
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1000
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6-48
Numerical Approximation
Important are good approximations to the normal cdf!
Edgeworth Expansion:
(a) (y ) 1 (a1 t + a2
t2
+ a3
1
t = 1+by
,
a1 = 0.17401209,
a3 = 0.373927817.
2 /2
3
y
t )e
,
with
b =
0.33267253,
a2 = 0.04793922,
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1000
The approximation error is independent of y and of order O(105 ).

SFENormalApprox1
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6-49
Edgeworth Expansion with higher accuracy:

(b) second approximation
2
(y ) 1 (a1 t + a2 t + a3 t + a4 t + a5 t )e
t
a1
a4
=
=
=
1
1+by ,
0.127414796,
0.726576013,
b
a2
a5
=
=
=
with
a3 = 0.71070687,
SFENormalApprox2
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1000
Error of approximation: O(107 )
0.231641888,
0.142248368,
0.530702714.
y 2 /2
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6-50
(c) another approximation is:

1
,
(y ) 1
2
3
4
5
8
2(a1 t + a2 t + a3 t + a4 t + a5 t )
a1 = 0.099792714,
a3 = 0.009699203,
a5 = 0.000581551.
a2 =
0.044320135,
a4 = 0.000098615,
SFENormalApprox3
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1000
Error of approximation: O(105 )
with
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6-51
(d) A Taylor expansion yields

(y )
=
1
1
+
2
2
y3
1!
21 3
y5
2!
22 5
X
1
1
y 2n+1
n
+
(1)
2
n! 2n (2n + 1)
2 n=0
y7
3!
23 7
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1000
Here the approximation error depends on the order of the

expansion.
SFENormalApprox4
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6-52
Comparison of Approximation
x
1.0000
1.1000
1.2000
1.3000
1.4000
1.5000
1.6000
1.7000
1.8000
1.9000
2.0000
approximation of normal distribution

norm-a
norm-b
norm-c
0.8413517179
0.8413447362
0.8413516627
0.8643435425
0.8643338948
0.8643375717
0.8849409364
0.8849302650
0.8849298369
0.9032095757
0.9031994476
0.9031951398
0.9192515822
0.9192432862
0.9192361959
0.9331983332
0.9331927690
0.9331845052
0.9452030611
0.9452007087
0.9451929907
0.9554336171
0.9554345667
0.9554288709
0.9640657107
0.9640697332
0.9640670474
0.9712768696
0.9712835061
0.9712842148
0.9772412821
0.9772499371
0.9772538334
norm-d
0.8413441191
0.8643341004
0.8849309179
0.9031993341
0.9192427095
0.9331930259
0.9452014728
0.9554342221
0.9640686479
0.9712839202
0.9772496294
iter
6
7
7
8
8
9
9
10
10
11
12
500
1000
Table 1: Several approximations to the normal distribution
1000
2000
3000
X
4000
6-53
Simulation
In many situations we are unable to compute the derivative price

analytically. The paths of the underlying need to be simulated.
The performance of these simulations depends decisively on the
quality of random numbers used.
500
1000
No random number generator in common software packages is

satisfactory in every respect.
1000
2000
3000
X
4000
6-54
Konrad Zuses Z3
500
1000
Figure 3: Konrad Zuse with a rebuilt Z3 in 1961
1000
2000
3000
X
4000
6-56
Linear congruent generator

Choose N0 (seed) with (a, b, M) define
Ni = (aNi1 + b)modM
(6.31)
Ui = Ni /M
(6.32)
Ui U[0, 1] pseudo random

Arrange the Ni in random vectors of m-triples
(Ni , Ni+1 , ..., Ni+m1 )
500
1000
Problem: (Ui , ..., Ui+m1 ) [0, 1] lie on a (m 1) dimensional

hyperplane.
0
1000
2000
3000
X
4000
6-57
Analysis for m = 2
Ni = (aNi1 + b) mod M = aNi1 + b kM
for kM aNi1 + b < (k + 1)M
For all z0 , z1 :
z0 Ni1 + z1 Ni
= z0 Ni1 + z1 (aNi1 + b kM)
500
1000
= Ni1 (z0 + az1 ) + z1 b z1 kM

z0 + az1
= M(Ni1
z1 k) + z1 b
M
Hence :
z0 Ui1 + z1 Ui = c + z1 bM 1 (6.33)
1000
2000
3000
X
4000
6-58
Example
Ni = 2Ni1 mod 11 a = 2, b = 0, M = 11
1
0.8
0.6
0.4
0.2
0
0
0.2
0.4
0.6
U
0.8
i-1
Figure 5: The scatterplot of Ui1 vs. Ui
SFErangen1
500
1000
The question is how to choose (a, b, M).
1000
2000
3000
X
4000
6-59
Example
Ni = 1229Ni1 mod 2048
1
0.8
0.6
0.4
0.2
0
0
0.2
0.4
0.6
0.8
i-1
500
1000
SFErangen2
1000
2000
3000
X
4000
6-60
A famous example is RANDU (the official IBM U[0, 1] generator

for years )
Ni = aNi1 mod M, a = 216 + 3, M = 231
Make a scatterplot and rotate:
1
0.5
0
1
1
0.5
0.5
0
Figure 7: The scatterplot of Ui2 vs. Ui1 vs. Ui
500
1000
SFErandu
1000
2000
3000
X
4000
6-61
Fibonacci generators
The Fibonacci sequences:
Ni+1 = Ni + Ni1 mod M
The ratio
of consecutive random numbers converges to the golden
ratio 1+2 5
lagged Fibonacci Ni+1 = Ni + Ni mod M
Example
Ui = (Ui17 Ui5 )
500
1000
if Ui < 0 then Ui = Ui + 1.0

0
1000
2000
3000
X
4000
6-62
Notre-Dame and the golden ratio
500
1000
Figure 8: Application of the golden ratio in the design of the cathedral

Notre-Dame in Paris.
1000
2000
3000
X
4000
6-63
Fibonacci generator
Repeat:
= Ui Uj
if < 0: = + 1
Ui =
i =i 1
j =j 1
if i = 0: i = 17
500
1000
if j = 0: j = 17
0
1000
2000
3000
X
4000
6-64
0.8
0.6
0.4
0.2
0
0
0.2
0.4
0.6
0.8
Ui-1
500
1000
SFEfibonacci
1000
2000
3000
X
4000
6-65
Inversion method
How to generate Xi F ?
Xi = F 1 (Ui )
Proof:

P(Xi x) = P F
(Ui ) x
= P {Ui F (x)}
= F (x)
500
1000
Problem : F 1 is often hard to calculate numerically.
1000
2000
3000
X
4000
6-66
Transformation methods
Example
Exponential distribution fY (y ) = e y I (y 0)
Define y = h(x) = 1 log x, x > 0
h1 (y ) = e y for y 0
Y
500
1000
X U[0, 1] leads to Y exp()

1 dh1 (y )
y

= e y
fY (y ) = fX h (y ) dy = ()e
1000
2000
3000
X
4000
6-67
Box-Muller method
Unit square S = [0, 1]2 , fX (x) = 1 uniform
y1 =
y2 =
h1 (x) =
det
x1
y1
x2
y1
x1
y2
x2
y2
500
1000
|Jacobian| =
p
2 log x1 cos 2x2 = h1 (x1 , x2 )
p
2 log x2 sin 2x2 = h2 (x1 , x2 )
1 2

2
x1 = exp 2 (y1 + y2 )
x2 = (2)1 arctan y2 /y1
!
1000
2000
3000
X
4000
6-68
Here:
x1
y1
x1
y2
x2
y1
x2
y2
1
= exp (y12 + y22 ) (y1 )
2

1 2
= exp (y1 + y22 ) (y2 )
2

1
1
y2
=
2 1 + y22 /y12 y12

1
1
1
=
2 1 + y22 /y12 y1

2
1
y2
1
1
1
1 2
2
|Jacobian| =
y2
exp (y1 + y2 )
y1
2
2
2
2
1 + y2 /y1 y1
1 + y22 /y12 y12

1
1
exp (y12 + y22 )
=
2
2

500
1000
Hence (Y1 , Y2 )> N(0, I2 )

0
1000
2000
3000
X
4000
6-69
Algorithm Box-Muller
1. U1 U[0, 1], U2 U[0, 1]
2. = 2U2 , = 2 log U1
3. Z1 = cos is N(0, 1)
Z2 = sin is N(0, 1)
500
1000
Variant of Marsaglia avoids the calculation of the trigonometric

functions.
1000
2000
3000
X
4000
6-70
Z2
-2
-4
-4
-2
0
Z1
Figure 10: The scatterplot of (Z1 , Z2 )
500
1000
SFEbmuller
1000
2000
3000
X
4000
6-71
Variant of Marsaglia Method

Generate V1 , V2 U[1, 1].
Accept (V1 , V2 )> if V12 + V22 < 1 ie. (V1 , V2 )> uniform
on a unit circle with density 1 .
The transformation

X1
X2
V12 + V22
2 1 arctan V
2 /V1
to S = [0, 1]2 gives (X1 , X2 )> U(S).

Since cos 2X1 =
V1
V12 +V22
and sin 2X2 =
V2
V12 +V22
hold, there
500
1000
arises no need for an evaluation of the trigonometric functions.

0
1000
2000
3000
X
4000
6-72
Marsaglia Method
500
1000
1. U1 , U2 U[0, 1], Vi = 2Ui 1

with W = V12 + V22 < 1
p
2. Z1 = V1 p2 log(W )/W N(0, 1)
Z2 = V2 2 log(W )/W N(0, 1)
1000
2000
3000
X
4000
6-73
Risk Management with hedge strategies

Example
current time t
term T
time of expiration T t
interest rate r
annual volatility of the stock
current stock price St
strike price K
6 weeks
26 weeks
20 weeks = 0.3846
0.05
0.20
98 EUR
100 EUR
500
1000
Table 2: data of example
1000
2000
3000
X
4000
6-74
A bank sells 100 000 calls on a dividend free asset for 600 000
EUR. BS option price is 480 119 EUR, which is approximately
480 000 EUR. Hence the bank has sold the call too expensive.
500
1000
SFEBSCopt2
1000
2000
3000
X
4000
6-75
Naked position
If ST rises to 120 EUR the call is exercised and the bank has to
deliver 100 000 shares at the strike price K = 100 EUR. In order
to cover the underlying position the bank has to buy 100 000
shares at the market price ST = 120 EUR.
The bank loses 100 000(ST K ) = 2 000 000 EUR. This is much
higher than the premium of 600 000 EUR, and the loss is
1 400 000 EUR.
500
1000
If ST < K the option will not be exercised. The bank has gained
600 000 EUR.
1000
2000
3000
X
4000
6-76
Covered position
Immediately after the sale of the call the bank buys 100 000 stock
at St = 98 EUR
100 000 St = 9 800 000 EUR
If ST > K the stock is delivered at K. Without considering interest
payments the gain is roughly 600 000 EUR from the sale of the
options.
500
1000
If ST < K , eg. ST = 80 EUR, the option will not be exercised.

The bank has to sell the stock at the market for 8 000 000 EUR.
The bank loses 2 000 000 EUR, which is again more than the gain
of 600 000 EUR from the sale of the options.
1000
2000
3000
X
4000
6-77
500
1000
Both risk management strategies are unsatisfying since the costs

vary between 0 and large values. According to BS the average cost
should be 480 000 EUR and a perfect hedge should eliminate the
randomness and should just create these costs.
1000
2000
3000
X
4000
6-78
Stop-Loss strategy
The bank that issues the calls

changes to a naked position
changes to a covered position
if
if
St < K
St > K ,
500
1000
i.e. the stocks to be delivered in case of exercise are bought as

soon as St is bigger than K .
1000
2000
3000
X
4000
6-79
All purchases after t > 0 are done at price K . In T either no

stocks (ST < K ) or stocks bought at K are hold. Hence costs of
this strategy occur only if S0 > K .
Cost of stop-loss strategy:
max {S0 K , 0} .
500
1000
The cost of hedging are therefore equal to the intrinsic value at

issuance. If interest rates were zero, it is clear that these cost are
smaller than the BS price C (S0 , T ). Arbitrage seems possible by
selling an option and hedging with the stop-loss strategy.
1000
2000
3000
X
4000
6-80
Problems of this strategy:

going short and long in the stocks creates transaction costs
the long position in stock before T creates losses in interest
in practice sales and purchases are not possible at price K .
When the stock increases the price is K + , when the stock
decreases the price is K , > 0
500
1000
in practice sales and acquisitions are done in t time units.

The bigger t, the bigger is and the smaller are transaction
costs.
1000
2000
3000
X
4000
6-81
Table 3, taken from Hull (2000), shows results of a simulation of

the stop-loss strategy with M = 1000 sample paths.
Costs m , m = 1, . . . , M are recorded and the variance
2
M
M
X
X
1
1
m
2 =
j
M
M
m=1
j=1
500
1000
is computed.
1000
2000
3000
X
4000
t (weeks)
L
5
1.02
4
0.93
6-82
2
0.82
1
0.77
1
2
0.76
1
4
0.76
Table 3: Performance of the stop loss strategy
We measure the risk from this strategy by dividing the standard

deviation of the costs by the call price:
q
2
L=
.
C (S0 , T )
500
1000
A perfect hedge has L = 0.
1000
2000
3000
X
4000
6-83
Delta Hedging
In order to reduce the risk associated with option trading more

complex hedging strategies than those considered so far are
applied.
500
1000
One possibility is to try to make the value of the portfolio for small
time intervals as insensitive as possible to small changes in the
price of the underlying stock. This is called delta hedging.
1000
2000
3000
X
4000
6-84
The Delta of a call (also called hedge ratio) is the derivative of the
option price wrt. the underlying
C
=
S
or
C
=
S
500
1000
The delta of a stock is = S/S = 1.
1000
2000
3000
X
4000
6-85
A forward contract on a dividend free stock has the forward price

V (St , ) = S K e r (see proposition 2.1), hence the Delta of
a forward contract is
= V /S = 1.
500
1000
Therefore stocks and forward contracts are interchangeable in

-hedging.
1000
2000
3000
X
4000
6-86
Example
A bank sells 2 000 calls at C = 10 EUR/stock with S0 = 100
EUR. Suppose the delta of the call is = 0.4. In order to delta
hedge the option position the bank buys 2 000 = 800 shares.
If e.g. the share price rises by S = 1 EUR, i.e. the total value of
shares held rises by 800 EUR, then the value of a call on 1 share
rises by C = S = 0.4 EUR. The total value of all calls sold
therefore rises by 800 EUR. Gains and losses are perfectly
balanced in this case.
500
1000
The whole portfolio has = 0, i.e. is a delta neutral position.
1000
2000
3000
X
4000
6-87
The delta neutral positions have only a short time horizon because
the Delta of an option depends, among others, on time and stock
price.
In practice, the portfolio has to be rebalanced frequently in order
to adapt to the changing environment.
Example
500
1000
Suppose that for the above example the stock rises to 110 EUR
and the delta changes to = 0.5. To obtain a delta neutral
position it is necessary to buy (0.5 0.4) 2 000 = 200 stocks.
1000
2000
3000
X
4000
6-88
Improving Risk Management: Delta Hedging

Delta Hedging is at the heart of the Black-Scholes proof
At t0 , sell a call and immediately buy stocks, i.e. make the
portfolio Delta-neutral
As changes with St , and , Delta-neutrality only holds
for a short period of time
To achieve perfect hedge: constant rebalancing, which is
called Dynamic Delta Hedging
500
1000
In contrast to Stop-Loss Strategy, the investor never stays

passive
1000
2000
3000
X
4000
6-89
Delta Hedging Logic
DELTA
1
80
85
90
95
100
105
The Logic of Delta Hedging
0
10
20
30
40
50
Step n
Figure 11: Logic of the Delta Hedging Strategy
500
1000
SFEDeltaHedgingLogic
0
1000
2000
3000
X
4000
6-90
Delta Hedging Dependencies

0.8
Delta vs S(t)
0.2
0.4
Delta
0.6
... : Delta with contant tau
90
95
100
105
S(t)
0.2
0.4
Delta
0.6
0.8
Delta over time
10
20
30
40
50
Step n
Figure 12: Dependence of Delta on Asset and Steps

500
1000
SFEDeltaHedgingLogic
0
1000
2000
3000
X
4000
6-91
Simulation: Parameters
Current time t
Maturity T
Time to maturity = T t
Continuous annual interest rate r
Annualized stock volatility
Current stock price St
Exercise price K
6 weeks
26 weeks
20 weeks = 0.3846
0.05
0.20
98 EUR
100 EUR
500
1000
Table 4: The parameters of the simulation
1000
2000
3000
X
4000
6-92
Simulation: Results I
The calculation of L, the remaining risk of the portfolio, as a
function of t yields:
t (weeks)
L
5
2.46
4
1.99
2
0.94
1
0.47
1/2
0.28
1/4
0.10
Table 5: Performance of the Delta Hedging Strategy
500
1000
SFEDeltaHedging
1000
2000
3000
X
4000
6-93
Simulation: Results II
Costs of Delta Hedging
1.5
0.5
90
100
Costs
Stockprice(t)
110
2.5
120
StockPaths with Strike Price
10
15
Steps (n)
20
25
30
Delta T (weeks)
Figure 13: Three stock paths and the cost function of all paths
500
1000
SFEDeltaHedging
0
1000
2000
3000
X
4000
6-94
Testing the Strategy: Does Delta Hedging

Eliminate Risk?
L 0 as t 0, the strategy constitutes a perfect hedge if

the portfolio is continuously rebalanced
500
1000
This is an intuitive result, and also one behind a derivation of

the Black-Scholes differential equation. It is similar to the
idea of a duplicating portfolio.
1000
2000
3000
X
4000
6-95
Assumptions and Drawdowns

Continuously rebalancing a portfolio is impossible
Extremely costly in terms of transaction costs
Trade-off must be decided upon by the book manager
Recall the formula for costs
L=
C (S0 , T )
500
1000
Is this the only measure of risk?
1000
2000
3000
X
4000
6-96
BS Delta
The BS formula was derived via a dynamic hedge portfolio
argument. The BS Delta is:
C
=
S
P
=
S
n (r b)
=
e
S(y + ) e r K (y )
S
= (y + )
= (y + ) 1,
where:
+ (b
2
2 )
500
1000
y=
log
S
K
1000
2000
3000
X
4000
6-97
Figure 14: Delta as function of stock prices (right axis) and time of expiration (left axis).
500
1000
SFEdelta
0
1000
2000
3000
X
4000
6-98
Properties of Delta:
For increasing S the approaches 1.
For decreasing S the approaches 0.
If the option is ITM, the writer of the option should cover the
risk by holding stocks in sufficient size.
If the option is OTM, the writer of the option does not need
to hold stocks in too large quantities.
500
1000
The probability that an OTM option will be exercised and an

ITM option will not be exercised at maturity increases with .
1000
2000
3000
X
4000
6-99
The following table shows the performance of the hedging as a

function of t. The limit t 0 yields the riskless BS portfolio
strategy
t (weeks)
L
5
0.43
4
0.39
2
0.26
1
0.19
1
2
0.14
1
4
0.09
Table 6: Performance of Delta hedging
Linearity
Portfolios are linear. If a portfolio consists of w1 , . . . , wm stocks
the delta of the portfolio is:
p =
m
X
wj j
500
1000
j=1
1000
2000
3000
X
4000
6-100
Example
A portfolio of USD FX options consists of
1. 200 000 bought calls (long position) with K = 1.70 EUR and
= 4 months. The delta is 1 = 0.54
2. 100 000 sold calls (short position) with K = 1.75 EUR and
3. 100 000 sold puts (short position) with K = 1.75 EUR and
The delta of the portfolio is
p = 200 000 1 100 000 2 100 000 3

= 111 000
500
1000
The portfolio is delta neutral when 111 000 USD are sold.
0
1000
2000
3000
X
4000
6-101
Gamma and Theta

Delta hedging: C is locally approximated by a linear function in S.
Should t not be short, this is not adequate any more. A more
accurate approximation can be considered.
Taylor expansion of C as a function of S and t:
= C (S + S, t + t) C (S, t)
C
1 2C
C
2
(S)
+ O(t)
S +
t +
=
2
S
t
2 S
S is of order t hence the dominant term is C S.

If we consider terms of order t:
1
C S + t + (S)2
2
500
1000
1000
2000
3000
X
4000
6-102
Again: C S + t + 12 (S)2
Here = C
t is the Theta and =
Theta is also called time decay.
2C
S 2
the Gamma of the option.
From BS formula:
S
= (y + ) rKe r (y )
2
and
1
(y + )
=
S
where
+ (b
2
2 )
500
1000
y=
log
S
K
1000
2000
3000
X
4000
6-103
Gamma hedging consists of buying or selling derivatives. However,

buying or selling further derivatives makes the portfolio value even
more sensitive to changes in the stock price.
500
1000
As delta is constant for stocks and futures: = 0. Therefore

stocks and future contracts can be used to make a gamma neutral
portfolio delta neutral.
1000
2000
3000
X
4000
6-104
Example
A portfolio of USD options and USD is neutral with
= 150 000. On the future market a USD-call with B = 0.52
and B = 1.20 is offered. The portfolio will be -neutral by adding
/B = 125 000 calls.
500
1000
The is now: 125 000 B = 65 000. The -neutral position

may be obtained by shorting 65 000 USD from the portfolio. This
will not change the .
1000
2000
3000
X
4000
6-105
Figure 15: Gamma as a function of stock price (right axis) and time of
expiration (left axis).
500
1000
SFEgamma
0
1000
2000
3000
X
4000
6-106
Figure 16: Theta as a function of stock price (right axis) and time of
expiration (left axis).
500
1000
SFEtheta
1000
2000
3000
X
4000
6-107
Time decay
If and are both zero the value of the portfolio changes
essentially with = C /t.
The parameter is for most options negative:
An option loses in value as it approaches the delivery date,
even if all other parameters remained constant.
From BS:
500
1000
1 2 2
rV = + S
2
where V is the value of the portfolio. Hence and are
related in a straightforward way. Consequently, can be used
instead of to gamma hedge a delta neutral portfolio.
1000
2000
3000
X
4000
6-108
Rho and Vega

The BS approach assumes constant volatility . Empirical evidence
shows that this assumption is questionable.
The Vega is:
C
V=
500
1000
Stock and futures have V = 0. Traded options have to be used to

vega hedge a portfolio. Since a vega neutral portfolio is not
necessarily delta neutral two distinct options have to be involved to
achieve simultaneously V = 0 and = 0.
0
1000
2000
3000
X
4000
BS yields:
6-109
V = S (y + )
500
1000
The Black Scholes formula was derived under the assumption of a

constant volatility. It is therefore actually not justified to compute
the derivative with respect to . However, the above formula for V
is quite similar to a equation following on from a more general
stochastic volatility model. The equation for V can be used as an
approximation to the real vega.
1000
2000
3000
X
4000
6-110
Figure 17: Vega as function of stock price (left axis) and time of expiration
(right axis).
500
1000
SFEvega
1000
2000
3000
X
4000
6-111
The Rho of an option is the derivative w.r.t. changes in the

interest rate:
C
=
r
BS yields for a call on a dividend free stock:
= K e r (y )
where
+ (b
2
2 )
500
1000
y=
log
S
K
1000
2000
3000
X
4000
6-112
Volga and Vanna

Volga and Vanna display the sensitivity of the volatility vega to
changes in this volatility and in the stock price.
Volga
Volga is defined as the second derivative of the option price with
respect to the volatility:
500
1000
2C
V
= 2 .
Volga =

The BS formula yields:
y (y + )

Volga = S
y + .
1000
2000
3000
X
4000
6-113
Figure 18: Volga as a function of stock price (right axis) and time to
maturity (left axis).
500
1000
SFEvolga
1000
2000
3000
X
4000
6-114
Vanna
500
1000
The effect of changes in the stock price S on the volatility vega is

given by vanna:
2C
V
=
.
Vanna =
S
S
Vanna, derived from the BS formula for a call option, is given by:
"
!r

1
y + .
Vanna =
+
1000
2000
3000
X
4000
6-115
Figure 19: Vanna as a function of stock price (right axis) and time to
maturity (left axis).
500
1000
SFEvanna
1000
2000
3000
X
4000
6-116
Historical and implied volatility

Historical volatility is an estimator for : S0 , . . . , Sn stock prices
at times 0, t, 2t, . . . , nt. Returns are
St
, t = 1, . . . , n
Rt = log
St1
independent normal rvs, if the stock is modelled as a geometric
Brownian motion.
Hence,
= Var(Rt ) = 2 t
n
X
1
(Rt Rn )2
v =
n1
(unbiased estimator of v)
t=1
500
Rn =
n
1 X
Rt
n
1000
t=1
1000
2000
3000
X
4000
6-117
The rv (n 1) v/v is 2n1 . Hence

#
2 $

v v
2
1
v
E
=
=
Var (n 1)
2
v
(n 1)
v
n1
p
2
since v = t:
= v/t (
is the estimator from the
sample)

1
E [
] = + O
n
it follows that the larger n the less the estimation will be biased
#
2 $

1
1
=
+O
E
2(n 1)
n
500
1000
(relative mean-squared error)

0
1000
2000
3000
X
4000
6-118
Choice of t:
500
1000
t corresponds to 1 day since in most cases one considers daily

quotations.
1
For calendar days t = 365
which however is not reasonable since
volatility decreases over weekends.
1
One better uses t = 252
since the number of trading days is
approximately 252.
1000
2000
3000
X
4000
6-119
Choice of n
500
1000
Theoretically
becomes more and more reliable. In practice
though is not constant. As a compromise one calculates
for
the last 90 or 180 days.
1000
2000
3000
X
4000
6-120
Implied volatility
The unknown parameter in the BS formula is the standard
deviation of the underlying stock. The implied volatility I is
often used as the estimate of the standard deviation, which is
calculated by:
S (y + I ) e r K (y ) = CB
with
y=

2
I
S
log + r
K
2
500
1000
Unfortunately this equation has no closed form solution which

means the equation must be solved numerically.
0
1000
2000
3000
X
4000
6-121
Figure 20: Implied Volatility of the DAX-Option on 29th of May 2005
500
1000
SFEVolSurfPlot
0
1000
2000
3000
X
4000
6-122
Example
Two options of a stock are on the market. One of them is ATM
and has I 1 = 0.25. The other is ITM and has I 2 = 0.21. ATM
the dependence of option price and volatility is very strong, i.e. the
market price of the first option tells us more about the , (I 1 is
the better approximation to ). In an approximation to the true
the first volatility should obtain higher weight. For example:
500
1000
= 0.8 I 1 + 0.2 I 2
1000
2000
3000
X
4000
6-123
Realized volatility
Let Yt = log St be the logarithmic stock price;

Rt = Y (t) Y {(t 1)}, t = 1, 2, ..., n the returns over .
The variance of Rt :
2 (u)du is the integrated variance
500
1000
V (t) =
Rt
Var(Rt ) = 2 (t).
1000
2000
3000
X
4000
6-124
Using the entire past of Y (t), estimate the integrated variance

V (t) by means of quadratic variation [Y ] (t):
{Y }t =
M
X
j=1
j
(t 1) +
M

2
(j 1)
,
Y (t 1) +
M
500
1000
M denotes intraday observations during each day for a 24-hour

market, daily realized volatility based on 5-minute underlying
returns is defined as the sum of 288 intra-day squared 5-minute
returns, taken day by day.
1000
2000
3000
X
4000

Black Scholes Model

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The Black Scholes Option Pricing Model

EC3605 Empirical Finance

The Black Scholes Option Pricing Model

Equivalently returns follow general Brownian motion

EC3605 Empirical Finance

Drift reflects the current expectations of the returns.

The Black Scholes Option Pricing Model

EC3605 Empirical Finance

The idea of Black-Scholes (BS) was to construct a portfolio from

The Black Scholes Option Pricing Model

In contrast to the hedge portfolios introduced in the first sections

EC3605 Empirical Finance

yields a partial DEQ for the value of the call.

The Black Scholes Option Pricing Model

Pricing a call option on a stock

There are two equivalent strategies:

EC3605 Empirical Finance

2. Portfolio A: One stock and nt = n(St , t) calls short with

The Black Scholes Option Pricing Model

EC3605 Empirical Finance

As the proof of the BS pricing formula is essential in the theory of

The Black Scholes Option Pricing Model

EC3605 Empirical Finance

Proposition 6.1 (BS I) Let St be an asset governed by a

The Black Scholes Option Pricing Model

1. There exists a portfolio in St and zero bonds Bt duplicating

EC3605 Empirical Finance

The Black Scholes Option Pricing Model

EC3605 Empirical Finance

The Black Scholes Option Pricing Model

The value of hedge portfolio is

EC3605 Empirical Finance

The Black Scholes Option Pricing Model

Note that the first term equals:

+ nt (St+dt St ) + {nt+dt nt }St

Hence equation (6.3) can be written as :

EC3605 Empirical Finance

dVt = dnt (St + dSt ) + nt dSt + dmt (Bt + dBt ) + mt dBt .

The Black Scholes Option Pricing Model

Apply now Itos Lemma

EC3605 Empirical Finance

and exploit that dSt dt and (dt)2 are O(dt).

The Black Scholes Option Pricing Model

EC3605 Empirical Finance

The assumption of no cash flow up to T means that all payments

The Black Scholes Option Pricing Model

EC3605 Empirical Finance

The Black Scholes Option Pricing Model

Insert dSt = St dt + St dWt and order stochastic (dW ) and

EC3605 Empirical Finance

The Black Scholes Option Pricing Model

It follows that the stochastic and riskless part of this equation

EC3605 Empirical Finance

The Black Scholes Option Pricing Model

Combining equations we obtain:

Differentiate (6.5) w.r.t. S:

Insert into equation (6.6):

EC3605 Empirical Finance

The Black Scholes Option Pricing Model

Insert into equation (6.8) and obtain:

EC3605 Empirical Finance

The Black Scholes Option Pricing Model

Differentiate (6.9) w.r.t. S and observe that Bt /S = 0:

This yields together with (6.5):