The Pricing of Stock

Options Using Black-

Scholes

Chapter 12
Assumptions Underlying Black-
Scholes
We assume that stock prices follow a
random walk
Over a small time period ot,the change in
the stock price is oS. The return over time
ot is oS/S
This return is assumed to be normally
distributed with mean ot and standard
deviation
t o o
The Lognormal Property
These assumptions imply
ln S
T
is normally
distributed with mean:


and standard deviation:

Since the logarithm of S
T

is normal, S
T
is
lognormally distributed
ln ( / ) S T + o
2
2
T o
The Lognormal Property
continued
where | |m,s] is a normal distribution with
mean m and standard deviation s
If T=1 then ln(S
T
/S) is the continuously
compounded annual stock return.
| |
ln ( / ) ,
S
S
T T
T
~ | o o
2
2
The Lognormal Distribution

S
T
The Expected Return
Two possible definitions:
is the arithmetic average of the returns
realized in may short intervals of time
o
2
/2 is the expected continuously
compounded return realized over a
longer period of time
is an arithmetic average
o
2
/2 is a geometric average
Notice the geometric (compound) return
is less than the average with the
difference positively related to o

Expected Return
Suppose = 10 and o

=0. Then annual
compound return = 10%
Suppose = 10 and o

=5. Then annual
compound return
o
2
/2 = .1 (.05)(.05)/2
= 9.875%
Suppose = 10 and o

=20%. Then annual
compound return
o
2
/2 = .1 (.2)(.2)/2
= 8.0%
The Volatility
The volatility is the standard deviation of the
continuously compounded rate of return in 1 year
The standard deviation of the continuously
compounded return over T years:

If the volatility is 25% per year, what is the standard
deviation of the continuously weekly compounded
return?
It equals .25 times the square root of 1/52:
.0347 = 3.47%
o T
The Concepts Underlying
Black-Scholes
The option price & the stock price
depend on the same underlying source
of uncertainty
We can form a portfolio consisting of the
stock & the option which eliminates this
source of uncertainty
The portfolio is instantaneously riskless
& must instantaneously earn the risk-
free rate
Assumptions
Stock price follows lognormal model with
constant parameters
No transactions costs
No dividends
Trading is continuous
Investors can borrow or lend at a constant
risk-free rate
The Black-Scholes Formulas
c S N d X N d
p X N d S N d
rT
rT
d
S X r T
T
d
S X r T
T
d T
=
=

=
+ +
=
+
=
e
e
where

( ) ( )
( ) ( )
ln( / ) ( / )
ln( / ) ( / )
1 2
2 1
1
2
2
2
2
2
1
o
o
o
o
o
Properties of Black-Scholes
Formula

As S becomes very large c tends to S-Xe
-rT
and
p tends to zero

As S becomes very small c tends to zero and p
tends to Xe
-rT
-S
Put price can be determined from put-call parity:
p = c + Xe
-rT
-S
On a test I will give you the Black-Scholes
formula for call option. For a put you should use
put-call parity.
The N(x) Function
N(x) is the probability that a normally
distributed variable with a mean of zero
and a standard deviation of 1 is less than x
See tables at the end of the book
Applying Risk-Neutral Valuation
1. Assume that the expected return from
the stock price is the risk-free rate
2. Calculate the expected payoff from the
option
3. Discount at the risk-free rate
Implied Volatility
The volatility implied by a European option
price is the volatility which, when
substituted in the Black-Scholes, gives the
option price
In practice it must be found by a trial and
error iterative procedure
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
Causes of Volatility
To a large extent, volatility appears to be
caused by trading rather than by the
arrival of new information to the market
place
For this reason days when the exchange
are closed are usually ignored when
volatility is estimated and when it is used
to calculate option prices