BLACK SCHOLES MODEL

Saumya Goel 208 Rohit Solanki 218

INTRODUCTION
Discovered

in 1973

By Fischer Black and Myron Scholes

Mathematical Equation:

model of financial market

Gives theoretical estimate of

price of an option over time

Uses

Delta Hedging

ASSUMPTIONS
.
Stock pays no dividends Option can only be exercised upon expiration

Market direction cannot be predicted, hence "Random Walk. No commissions are charged in the transaction Interest rates remain constant
Stock returns are normally distributed, thus volatility is constant over time

GREEKS
Greeks
Delta (Spot Price S) Vega (Volatility ) Theta (Time to Expiration T) Rho (Risk Free Rate r) Gamma UA

Relationship with Option Price (V)

Call Premium Put Premium Vega of call & put are identical and positive Call and put lose value as expiration approaches Positive relation with call Negative relation with put Gamma of put and call are equal

EQUATION
c S 0 N (d1 ) X e rT N (d 2 ) p X e rT N (d 2 ) S 0 N (d1 ) ln(S 0 / X ) (r 2 / 2)T where d1 T ln(S 0 / X ) (r 2 / 2)T d2 d1 T T

Where, C = Call option price, P = Put option price S = Spot price of underlying asset X = Strike price of the option r = risk-free interest rate T t = Time to expiration expressed in years = Volatility of returns on the underlying asset N(d) = Cumulative standard normal distribution e = Exponential function (2.7183)

EXAMPLE

The stock price is $42. The strike price for a

European call and put option on the stock is $40. Both options expire in 6 months. The risk free interest is 6% per annum and the volatility is 25% per annum. What are the call and put prices?

EXAMPLE
S = 42, X = 40, r = 6%, =25%, T=0.5

ln(S 0 / X ) (r 2 / 2)T d1 T = 0.5341

ln(S 0 / X ) (r 2 / 2)T d2 T

= 0.3573

c S 0 N (d1 ) X e rT N (d 2 )
=4.7144

pX e

rT

=1.5322

N (d 2 ) S 0 N (d1 )

LIMITATIONS

Assumes that the risk-free rate and the stocks volatility are constant. Assumes that stock prices are continuous and that large changes (such as those seen after a merger announcement) dont occur. Assumes a stock pays no dividends until after expiration. Analysts can only estimate a stocks volatility instead of directly observing it, as they can for the other inputs. Tends to overvalue deep out-of-the-money calls and undervalue deep in-the-money calls. Tends to misprice options that involve high-dividend stocks. To deal with these limitations, a Black-Scholes variant known as ARCH, Autoregressive Conditional Heteroscedasticity, was developed. This variant replaces constant volatility with stochastic (random) volatility. A number of different models have been developed all incorporating ever more complex models of volatility. However, despite these known limitations, the classic Black-Scholes model is still the most popular with options traders today due to its simplicity.

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