Qandeel Fatima Memon

INPUTS
Stock Price, S
Strike Price, K Dividends on Stock,

Annual Volatility,
Risk- free Rate, r Time to maturity, t

ASSUMPTIONS
Volatility is constant
No transaction costs or taxes Dividends are constant & known

Risk- free rate, r, is known & constant

Any amount can be short-sold or borrowed at r Returns on stock are normally distributed &

independent

Black- Scholes formula for Common Stock Options

Formula : d1 = LN(S/K) + (r- + 0.5(^2))*t

(t^0.5)
d2 = d1 - (t^0.5)

N(d1) is the probability taken from the Z- table by

seeing value of d1
N(d2) is probability taken by seeing value of d2 N(d2) is probability of the option being exercised in a

risk- neutral world

Calculating Value of Call & Put Options via Black- Scholes formula
C (S, K, , r, t, ) =

S*exp(-t)*N(d1) - K*exp(-rt)*N(d2) P (S, K, , r, t, ) = K*exp(-rt)*N(-d2) - S*exp(-t)*N(-d1)

1 1 N(-d2) = 1 - N(d2)
N(-d ) = 1 - N(d ) This can be verified by Put- Call Parity, which is:

P (S, K, , r, t, ) = C (S, K, , r, t, ) + K*exp(-rt) - S*exp(-t)

Example of Common Stock Options Pricing

Inputs:

S = 50, K = 52, = 0.04, = 0.4, r = 0.08, t=3/12= 0.25

d1 = LN(50/52) + (0.08- 0.04 + 0.5(0.4^2))*0.25

0.4(0.25^0.5)
d2 = -0.0461 0.4(0.25^0.5) d1 = -0.0461 , d2 = -0.2461
N(d1) = 0.4816, N(d2) = 0.4028

N(-d1) = 0.5184, N(-d2) = 0.5972

Example continued
C (S, K, , r, t, ) = 50*exp(-0.04*0.25)*0.4816

52*exp(-0.08*0.25)*0.4028 = 3.3102 P (S, K, , r, t, ) = 52*exp(-0.08*0.25)*0.5972 - 50*exp(0.04*0.25)*0.5184 = 4.7780

Verifying it with Put- Call Parity, P (S, K, , r, t, ) = 3.3102 + 52*exp(-0.08^0.25)

50*exp(-0.04^0.25) = 4.7780

Black- Scholes formula for Currency Options

Formula : d1 = LN(x/K) + (r- rf + 0.5(^2))*t

(t^0.5)
d2 = d1 - (t^0.5)

C (x, K, , r, t, rf) =

S*exp(-rf *t)*N(d1) - K*exp(-rt)*N(d2)

P (x, K, , r, t, rf ) =

K*exp(-rt)*N(-d2) - S*exp(-rf*t)*N(-d1)
This can be verified by Put- Call Parity, which is:

P (S, K, , r, t, rf ) = C (S, K, , r, t, rf ) + K*exp(-rt) - x*exp(-rft)

Black- Scholes formula for Options on Futures

Formula : d1 = LN(F/K) + 0.5(^2)*t

(t^0.5)
d2 = d1 - (t^0.5)

C (x, K, , r, t, rf) =

F*exp(-r*t)*N(d1) - K*exp(-rt)*N(d2)
P (x, K, , r, t, rf) =

K*exp(-rt)*N(-d2) - F*exp(-r*t)*N(-d1)
A put & a call option have same premium in this case

Advantages
option quickly Doesnt require sophisticated computer program for calculations Works on objective figures & not on human judgement

Limitations
assumptions, which may not always stand true Overprices options that are at the money Underprices options that are deep in the money or deep out of the money.

Gives theoretical value of Makes several

THANK YOU
Qandeel Fatima Memon

THANK YOU
Qandeel Fatima Memon