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4. The Black-Scholes Model
Binomial Approximation to Black-
Scholes model
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Introduction
Binomial model useful first step, but most models used in
practice use continuous-trading
Most models assume stock prices follow a lognormal
probability distribution.
Hence we show how a lognormal model can be obtained as
limit of binomial model as , the time between two trading-
dates tends to zero.
Binomial model remains useful even in practice:
It is easy to understand
It can approximate a lognormal distribution
Firms use it to value derivatives like American options.
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A Typical Stock Price Chart
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Why Lognormal?
A stock price evolution is usually very jagged, with
peaks and valleys, sometimes separated by trend-like
rises or declines.
Empirical studies show that stock returns over successive
intervals are approximately statistically independent of each
other (weak-form efficiency of markets) .
Over each interval, stock returns appear to be generated by
the same distribution.
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Lognormal Distribution of Returns
S(t) is stock price at date t. Let y
t
be the continuously
compounded return on the stock over the time interval
[t ,t], i.e.,
Note that is log-return over [t ,t]
Divide time horizon [0,T] into n intervals of length , where
T = n.
Write stock price at time T as
t
y
e t S t S ) ( ) ( =
( )
) 0 (
) 0 (
) (
) (
) 2 (
2
) (
) (
) (
) ( S
S
S
S
S
T S
T S
T S
T S
T S
(

= L
) ( ln ) ( ln = t S t S y
T
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Lognormal Distribution of Returns-2
Then
Let Y(T) = y

+ y
2
+ + y
T
+ y
T
.
Then Y(T) = ln[S(T)/S(0)] is the cont. compd. return
over the time horizon [0,T].
Y(T) is also the sum of the cont. compd. returns over n
intervals.
Continuously compounded returns are used because of this
linear relationship.
.
2
) 0 ( ) (
T T
y y y y
e S T S
+ + + +

=
L
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Why lognormal distributions?
4 Assumptions to determine stock price returns.
A1. Returns {y
t
} are independently distributed.
=> return (y
t
) over [t,t], is of no use in predicting return
(zy
+
) over the next interval.
A2. Returns {y
t
} are identically distributed.
=> return y
t
does not depend upon previous return y
t-
.
A1 and A2 implies that stock-returns follow a random
walk (like steps of a drunk).
Often associated with efficient market theory.
Random walk implies no particular probability distribution
for stock price changes
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Assumptions A3 & A4
Need 2 more assumptions, A3 and A4, to describe how
return changes as time interval gets smaller
A3. The expected continuously compounded return is E[y
t
] =
, where is expected cont. compd. return per unit time.
A4. The variance of the continuously compounded return is
var[y
t
] =
2
, where
2
is variance of cont. compounded return
per unit time.
Both expected return and variance of the return are proportional
to the length of the time interval.
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4 Assumptions Imply Lognormal
Recall the central limit theorem: the sum of centered
independent, identically distributed random variables
with finite variance converges to a normal distribution.
Hence the 4 assumptions imply that Y(T) =
ln[S(T)/S(0)] is normally distributed with
mean, E[Z(T)] = T
variance, var[Y(T)] =
2
T
This implies that stock price S(T)= S(0) exp(Y(T)) is
lognormally distributed.
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Normal Distribution for Z(T) &
Lognormal Distribution for S(T)
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Example: Lognormally Distributed
Stock Prices
Terminology: , the standard deviation of yearly log-
returns, is called volatility
Suppose
= 15% per year and volatility = 25% per year.
Continuously compounded return over a 2-year period
is normally distributed with mean of 15 2 = 30%
and volatility (= square root of variance) of 25 2 =
35.36 %.
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Recall: Multiperiod Binomial Model
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Recall: Stock Prices at Time T for a
Lattice with n Intervals
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Binomial Approximation to
Lognormal Distribution
One of several ways to choose binomial representation is
Satisfies assumptions A.1 - A.4, in particular.
E[Y(T)] = and var[Y(T)] =
2
.
is called drift (value to which stock return drifts before
shocked by + or -).
is called volatility (reflects size of random shocks in
stocks return as it moves through time).
| |

+
=
1/2.
1/2
) ( / ) ( ln
y probabilit with
y probabilit with
y t S t S
t


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Binomial Approximation to
Lognormal Distribution (contd)
Stock price at date t can be written as
Note that p stands for the real-world probabilities and
not for the martingale probabilities
Up and down factors are
( )
( )

+
=
1/2. exp
1/2 exp
) ( ) (
y probabilit with
y probabilit with
t S t S


( ) + = exp U
( ) = exp D
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Example: Binomial Lattice Approx.
to Lognormal Distr.
Expected return = 11% per year.
Volatility = 25% per year.
Time horizon = 1 year.
Initial stock price = $100
Part A
Divide 1 year into two 6-month intervals (number of
periods n = 2, length of each interval, = = 0.5)
Expected drift, = 0.11 0.5 = 0.055
Volatility over interval, = 0.25 0.5 = 0.1768
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Example Bin. Approx. to Lognormal - 2
One period cont. compounded returns are
The binomial model is
Part B: Divide 1 year into three 4-month subperiods
( n = 3, = 1/3). Then
Model with n = 3 approximates lognormal distribution better
than model with n = 2.

=
2 / 1 1218 . 0
2 / 1 2318 . 0
y probabilit with
y probabilit with
z
t

= +
. 2 / 1 0.8853
2 / 1 1.2609
) ( ) (
y probabilit with
y probabilit with
t S t S

= +
. 2 / 1 0.8979
2 / 1 1.1984
) ( ) (
y probabilit with
y probabilit with
t S t S
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Binomial Stock Price Lattices
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When Number of
Intervals Increases
As the number of intervals (n) increases, U decreases
toward 1 and D increases toward 1. Model becomes
closer to lognormal.
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Application to option pricing
Overview: The binomial approximation to lognormal
can be used for approximation of prices of derivatives
Convergence of model under real-world probabilities
implies convergence under martingale probabilities
In the limit we obtain celebrated Black-Scholes
formula
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Lattice Parameters
How to compute stocks expected return?
Under risk-neutral valuation, it equals (r -
2
/2)
So r and are the only 2 parameters needed.
For lognormal approx, we can use
and
As decreases to 0, approaches .
( ) | |
( ) | |

+
=
+


1 2 exp
2 exp
2
2
1
y probabilit with r
y probabilit with r
S S
t t
( ) ( ) | | ( ) ( ) | | = exp exp exp 2 exp
2
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Example
We begin with one period model, where is one year
Continuously compounded interest r = 0.06 or
6%.Volatility is 20% ( = 0.2).
1-Period Model (Time interval, = 1 year)
$1 after 1 year is R = exp(r) = exp(0.06 1) = 1.0618
U = exp{[0.06 (0.2)
2
/2] + 0.2} = 1.27124
D = exp{[0.06 (0.2)
2
/2] 0.2} = 0.85214.
= 0.5003.
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Computations for 2-Period Model
r = 0.06, = 0.2.
2-Period Model (Time interval, = year)
$1 after year is R = exp(0.06 0.5) = 1.0304
U = exp{[0.06 (0.2)
2
/2]0.5 + 0.2 0.5}
= 1.27124
D = exp{[0.06 (0.2)
2
/2]0.5 0.2 0.5}
= 0.85214
= (R-D)/(U-D)=0.5001.
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Convergence (S = 100, K = 110,
r = 0.06, = 0.2, T = 1 year)
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The Black-Scholes
Option Pricing Model
Calls boundary condition
Take expectation using eqv. mart. probabilities

<

=
. ) ( 0
) ( ) (
) (
K T S if
K T S if K T S
T c
) ( ) ( ) 0 ( ) exp(
] ) ( | ) ( [ )} ( {
T d KN d N S rT
K T S K T S E T c E

=
=
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The Black-Scholes European
Call Pricing Model (contd)
Discounting expected value using risk-free rate gives
Black-Scholes (BS) formula for pricing European call
options
where
B(0,T) = e
-rT
pays $1 at time T
N(.) is cumulative normal distribution function.
T T T KB S d / } 2 / )] , 0 ( / ) 0 ( {ln[
2
+
). ( ) , 0 ( ) ( ) 0 ( )} ( { ) , 0 ( ) 0 ( T d N T KB d N S T c E T B c

= =