The Black-Scholes-Merton
Model
Chapter 13
1 C. Hull 2013
Fundamentals of Futures and Options Markets, 8th Ed, Ch 13, Copyright John
The Black-Scholes-Merton
Random Walk Assumption
Consider
ln S 0 ( 2 / 2)T
Fundamentals of Futures and Options Markets, 8th Ed, Ch 13, Copyright John3C. Hull
2013
ln ST ln S 0 ( 2)T , T
2
or
ST
2
2
ln
( 2)T , T
S0
E ( ST ) S0 e T
2 2 T
var ( ST ) S0 e
(e
2T
1)
Fundamentals of Futures and Options Markets, 8th Ed, Ch 13, Copyright John5C. Hull
2013
Fundamentals of Futures and Options Markets, 8th Ed, Ch 13, Copyright John6C. Hull
2013
Suppose
Fundamentals of Futures and Options Markets, 8th Ed, Ch 13, Copyright John7C. Hull
2013
The Volatility
The volatility is the standard deviation of the
continuously compounded rate of return in 1
year
The standard deviation of the return in time
t is t
If a stock price is $50 and its volatility is 25%
per year what is the standard deviation of
the price change in one day?
Fundamentals of Futures and Options Markets, 8th Ed, Ch 13, Copyright John8C. Hull
2013
Nature of Volatility
Volatility
Fundamentals of Futures and Options Markets, 8th Ed, Ch 13, Copyright John9C. Hull
2013
uiln Si1
s
3.
4.
Fundamentals of Futures and Options Markets, 8th Ed, Ch 13, Copyright John10
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Fundamentals of Futures and Options Markets, 8th Ed, Ch 13, Copyright John11
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c S 0 N (d1 ) K e
rT
N (d 2 )
p K e rT N (d 2 ) S 0 N (d1 )
2
ln( S 0 / K ) (r / 2)T
where d1
T
ln( S 0 / K ) (r 2 / 2)T
d2
d1 T
T
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Fundamentals of Futures and Options Markets, 8th Ed, Ch 13, Copyright John14
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Risk-Neutral Valuation
The variable does not appear in the BlackScholes equation
The equation is independent of all variables
affected by risk preference
This is consistent with the risk-neutral
valuation principle
Fundamentals of Futures and Options Markets, 8th Ed, Ch 13, Copyright John15
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2.
3.
Fundamentals of Futures and Options Markets, 8th Ed, Ch 13, Copyright John16
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is ST K
Expected
S0erT K
Present
Fundamentals of Futures and Options Markets, 8th Ed, Ch 13, Copyright John17
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Implied Volatility
The
Fundamentals of Futures and Options Markets, 8th Ed, Ch 13, Copyright John19
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Dividends
European options on dividend-paying stocks
are valued by substituting the stock price less
the present value of dividends into the BlackScholes-Merton formula
Only dividends with ex-dividend dates during
life of option should be included
The dividend should be the expected
reduction in the stock price on the exdividend date
Fundamentals of Futures and Options Markets, 8th Ed, Ch 13, Copyright John20
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American Calls
An American call on a non-dividend-paying
stock should never be exercised early
An American call on a dividend-paying stock
should only ever be exercised immediately
prior to an ex-dividend date
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1.
2.
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