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As delta changes (because time passes and/or S changes), one must maintain this risk-free portfolio over time This is accomplished by purchasing or selling the appropriate number of shares.
David Dubofsky and 18-2 Thomas W. Miller, Jr.
K
rT
ln( /K) (r T
2
/2)T
N(- i) = 1-N( i)
-1.3
0.0968
0.0951
0.0934
0.0918
0.0901
0.0885
0.0869
0.0853
0.0838
0.0823
1.3
0.9032
0.9049
0.9066
0.9082
0.9099
0.9115
0.9131
0.9147
0.9162
0.9177
N(-d) = 1-N(d)
N(-1.34) = 1-N(1.34)
/2)T
Lognormal Distribution
The BSOPM assumes that the stock price follows a Geometric Brownian Motion (see http://www.stat.umn.edu/~charlie/Stoch/brown.html for a depiction of Brownian Motion). In turn, this implies that the distribution of the returns of the stock, at any future date, will be lognormally distributed. Lognormal returns are realistic for two reasons:
if returns are lognormally distributed, then the lowest possible return in any period is -100%. lognormal returns distributions are "positively skewed," that is, skewed to the right.
Thus, a realistic depiction of a stock's returns distribution would have a minimum return of -100% and a maximum return well beyond 100%. This is particularly important if T is long.
David Dubofsky and 18-11 Thomas W. Miller, Jr.
E ( ST ) ! S0 eQT var ( ST ) ! S0 e
2 2 QT
(e
W 2T
1)
David Dubofsky and 18-12 Thomas W. Miller, Jr.
Volatility
Volatility is the key to pricing options. Believing that an option is undervalued is tantamount to believing that the volatility of the rate of return on the stock will be less than what the market believes. The volatility is the standard deviation of the continuously compounded rate of return of the stock, per year.
S div ri ! ln i S i1
3. Calculate the average rate of return 4. Calculate the standard deviation, W , of the ris 5. Annualize the computed W (see next slide).
Annualizing Volatility
Volatility is usually much greater when the market is open (i.e. the asset is trading) than when it is closed. For this reason, when valuing options, time is usually measured in trading days not calendar days. The general convention is to use 252 trading days per year. What is most important is to be consistent.
annual
!
!
v 252
annual
weekly
v 52
annual
!
yr
mont ly
v 12
>
week
Note t at
>
mo
>
day
Implied Volatility
The implied volatility of an option is the volatility for which the BSOPM value 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. Note that the volatility is assumed to be the same across strikes, but it often is not. In practice, there is a volatility smile, where implied volatility is often u-shaped when plotted as a function of the strike price.
Using Observed Call (or Put) Option Prices to Estimate Implied Volatility
Take the observed option price as given. Plug C, S, , r, T into the BSOPM (or other model). Solving Wthis is the tricky part) requires either an iterative technique, or using one of several approximations. The Iterative Way:
Plug S, , r, T, and W into the BSOPM. (theoretical value) Calculate W Compare c (theoretical) to C (the actual call price). If they are really close, stop. If not, change the value of and start over again.
Volatility Smiles
In this table, the option premium column is the average bid-ask price for June 2000 S&P 500 Index call and put options at the close of trading on May 16, 2000. The May 16, 2000 closing S&P 500 Index level was 1466.04, a riskless interest rate of 5.75%, an estimated dividend yield of 1.5%, and T = 0.08493 year.
Strike
Call price
Call IV
1225 1250 1275 1300 1325 1350 1375 1400 1425 1450 1475 1500 1525 1550 1575 1600 1625 1650
129.5 107.625 86.625 67.625 50.6875 35.625 22.5 14 7.875 4.375 2.28125 1.21875 0.625
0.2834 0.2689 0.2534 0.2423 0.2324 0.2201 0.2036 0.1982 0.1912 0.1896 0.1881 0.1897 0.1912
124.335 102.51 82.353 64.288 48.648 35.612 25.178 17.173 11.291 7.154 4.367 2.569 1.457
Put Price Put IV 1.5625 0.336 2.34375 0.3283 2.625 0.3021 3.8125 0.292 5.75 0.2855 8.25 0.2762 11.375 0.2641 14.875 0.2463 20.0625 0.2315 29 0.2285 38.625 0.2152 50.875 0.2016 66.75 0.1923 85.375 0.1826 106.875 0.1788 129.5 0.1668 153.375 0.1512
put price with W = 0.22 0.054 0.153 0.39 0.904 1.919 3.753 6.809 11.533 18.35 27.592 39.437 53.885 70.762 89.761 110.505 132.6 155.684
David Dubofsky and 18-19 Thomas W. Miller, Jr.
Volatility Smiles
Implied Volatilit 0 .4 0. 0 .2 0 .1 0 1200 1400 Strike Price 1600 a ll IV ut IV
S S IV ! 1ln 2ln X X
Using the call data: = 2.17; 1 = -4.47;
2
= 2.52; R2 = 0.988
Dividends
European options on dividend-paying stocks are valued by substituting the stock price less the present value of dividends into Black-Scholes.
C = S 0 N (d 1 ) - K e
-r T
N (d 2 )
u!e
T/n
1
! 0. 0.
T n
David Dubofsky and 18-23 Thomas W. Miller, Jr.
u ! e 0.40 d ! e 0.40
0.0833 0.833
1 ! 0.1224 1 ! 0.10 05
and, the probabilit y of an uptick, q, must equal 0.14 0.0833 ! 0.5505 q ! 0.5 0.5 0.40
David Dubofsky and 18-24 Thomas W. Miller, Jr.
3. 4.
-r
Pg n
!
-r
b-r
ln( / ) (b W / )
ln( / ) (b W / ) W
W
b = r rf
b=0
American Options
It is computationally difficult to value an American option (a call on a dividend paying stock, or any put). Methods:
Pseudo-American Model (Sect. 18.10.1) BOPM (Sects. 17.3.3, 17.4) Numerical methods Approximations
That is, the Black-Scholes-Merton model assumes that the stock price, S, follows a Geometric Brownian motion through time:
dS dS S ! QS dt W S dz
! Qdt W dz
2 dt dz dlnS ! 2
is istribut
Example:
Suppose (t is one day. A stock has an expected return of Q= 0.0005 per day. NB: (1.0005)365 1 = 0.20016, 20% The standard deviation of the stock's daily return distribution is 0.0261725 NB: This is a variance of 0.000685 Annualized Variance: (365)(0.000685) = 0.250025 Annualized STDEV: (0.250025)0.5 = 0.500025, or 50% (0.0261725)(365)0.5 = 0.500025, or 50%
Example, II.
Then, the return generating process is such that each day, the return consists of:
a non-stochastic component, 0.0005 or 0.05% a random component consisting of: The stock's daily standard deviation times the realization of (z, (z is drawn from a normal probability distribution with a mean of zero and a variance of one.
Risk-Neutral Valuation
The variable Q does not appear in the Black-Scholes equation. The equation is independent of all variables affected by risk preference. The solution to the differential equation is therefore the same in a riskfree world as it is in the real world. This leads to the principle of risk-neutral valuation.
S ! Ke r th n,
W}
T C S
If S " Ke rT : W }
If S e Ke rT : W }
S Ke rT C 2 8T T 3Ke rT S