THE BLACK-SCHOLES AND BINOMIAL

OPTION PRICING MODEL

INTRODUCTION
The Black-Scholes option pricing model (BSOPM) has been
one of the most important developments in finance in the last
50 years
Has provided a good understanding of what options should
sell for
Has made options more attractive to individual and
institutional investors

THE BLACK-SCHOLES OPTION PRICING MODEL

The model
Development and assumptions of the model
Determinants of the option premium
Assumptions of the Black-Scholes model
Intuition into the Black-Scholes model

THE MODEL

C SN (d1 ) Ke RT N (d 2 )
where

2
S
T
ln
R
2
K
d1
T
and
d 2 d1 T
4

THE MODEL (CONTD)

Variable definitions:
S =
current stock price
K =
option strike price
e =
base of natural logarithms
R =
riskless interest rate
T =
time until option expiration
=
standard deviation (sigma) of returns on
the underlying security
ln =
natural logarithm
N(d1) and
N(d2) = cumulative standard normal distribution
functions
5

DEVELOPMENT AND ASSUMPTIONS OF THE MODEL

Derivation from:
Physics
Mathematical short cuts
Arbitrage arguments
Fischer Black and Myron Scholes utilized the physics heat
transfer equation to develop the BSOPM

DETERMINANTS OF THE OPTION PREMIUM

Striking price
Time until expiration
Stock price
Volatility
Dividends
Risk-free interest rate

STRIKING PRICE
The lower the striking price for a given stock, the more the
option should be worth
Because a call option lets you buy at a predetermined
striking price

TIME UNTIL EXPIRATION

The longer the time until expiration, the more the option is
worth
The option premium increases for more distant expirations
for puts and calls

STOCK PRICE
The higher the stock price, the more a given call option is
worth
A call option holder benefits from a rise in the stock price

10

VOLATILITY
The greater the price volatility, the more the option is worth
The volatility estimate sigma cannot be directly observed
and must be estimated
Volatility plays a major role in determining time value

11

DIVIDENDS
A company that pays a large dividend will have a smaller
option premium than a company with a lower dividend,
everything else being equal

12

RISK-FREE INTEREST RATE

The higher the risk-free interest rate, the higher the option
premium, everything else being equal

13

ASSUMPTIONS OF THE BLACK-SCHOLES MODEL

The stock pays no dividends during the options life

European exercise style
Markets are efficient
No transaction costs
Interest rates remain constant
Prices are lognormally distributed

14

THE STOCK PAYS NO DIVIDENDS DURING THE

OPTIONS LIFE
If you apply the BSOPM to two securities, one with no
dividends and the other with a dividend yield, the model will
predict the same call premium
Robert Merton developed a simple extension to the BSOPM
to account for the payment of dividends

15

The Robert Miller Option Pricing Model

C * e dT SN (d1* ) Ke RT N (d 2* )
where

2
S
T
ln
R d
2
K
*
d1
T
and
d 2* d1* T

16

EUROPEAN EXERCISE STYLE

A European option can only be exercised on the expiration
date
American options are more valuable than European options
Few options are exercised early due to time value

17

MARKETS ARE EFFICIENT

The BSOPM assumes informational efficiency
People cannot predict the direction of the market or of an
individual stock
Put/call parity implies that you and everyone else will agree
on the option premium, regardless of whether you are
bullish or bearish.

18

NO TRANSACTION COSTS
There are no commissions and bid-ask spreads
Not true
Causes slightly different actual option prices for different
market participants

19

INTEREST RATES REMAIN CONSTANT

There is no real riskfree interest rate
Often the 30-day T-bill rate is used
Must look for ways to value options when the parameters of
the traditional BSOPM are unknown or dynamic

20

PRICES ARE LOGNORMALLY DISTRIBUTED

The logarithms of the underlying security prices are normally
distributed
A reasonable assumption for most assets on which options
are available

21

INTUITION INTO THE BLACK-SCHOLES MODEL

The valuation equation has two parts
One gives a pseudo-probability weighted expected stock
price (an inflow)
One gives the time-value of money adjusted expected
payment at exercise (an outflow)

22

INTUITION INTO THE BLACK-SCHOLES MODEL

(CONTD)

C SN (d1 )

Cash Inflow

Ke

RT

N (d 2 )

Cash Outflow

23

INTUITION INTO THE BLACK-SCHOLES MODEL

(CONTD)
The value of a call option is the difference between the
expected benefit from acquiring the stock outright and paying
the exercise price on expiration day

24

CALCULATING BLACK-SCHOLES PRICES FROM

HISTORICAL DATA
To calculate the theoretical value of a call option using the
BSOPM, we need:
The stock price
The option striking price
The time until expiration
The riskless interest rate
The volatility of the stock

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BINOMIAL OPTION PRICING MODEL

Assumptions:
A single period
Two dates: time t=0 and time t=1 (expiration)
The future (time 1) stock price has only two possible values
The price can go up or down
The perfect market assumptions
No transactions costs, borrowing and lending at the risk free
interest rate, no taxes
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BINOMIAL OPTION PRICING MODEL

EXAMPLE
The stock price

Assume S= $50,
u= 10% and d= (-3%)
Su=$55

Su=S(1+u)
S=$50

S
Sd=S(1+d)

Sd=$48.5

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BINOMIAL OPTION PRICING MODEL

EXAMPLE
The call option price

Cu= Max{SuX,0}
C
Cd= Max{SdX,0}

Assume X= $50,
T= 1 year (expiration)

Cu= $5
= Max{5550,0}
Cd= $0
= Max{48.550,0}
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BINOMIAL OPTION PRICING MODEL

EXAMPLE
The bond price

Assume r= 6%

$1.06

(1+r)
$1

1
(1+r)

$1.06

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REPLICATING PORTFOLIO
At time t=0, we can create a portfolio of N shares of the stock and an
investment of B dollars in the risk-free bond. The payoff of the
portfolio will replicate the t=1 payoffs of the call option:
N$55 + B$1.06 = $5
N$48.5 + B$1.06 = $0
Obviously, this portfolio should also have the same price as the call
option at t=0:
N$50 + B$1 = C
We get N=0.7692, B=(-35.1959) and the call option price is C=$3.2656.
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A DIFFERENT REPLICATION
The price of $1 in the up
state:

The price of $1 in the down

state:
$0

$1
qd

qu
$0

$1

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REPLICATING PORTFOLIOS USING THE STATE PRICES

We can replicate the t=1 payoffs of the stock and the bond using the
state prices:
qu$55 + qd$48.5 = $50
qu$1.06 + qd$1.06 = $1
once we solve for the two state prices we can price any other asset in
that economy. In particular, the call option:
qu$5 + qd$0 = C
We get qu=0.6531, qd =0.2903 and the call option price is C=$3.2656.
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BINOMIAL OPTION PRICING MODEL

EXAMPLE
The put option price

Pu= Max{XSu,0}
P
Pd= Max{XSd,0}

Assume X= $50,
T= 1 year (expiration)

Pu= $0
= Max{5055,0}
Pd= $1.5
= Max{5048.5,0}
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REPLICATING PORTFOLIOS USING THE STATE PRICES

We can replicate the t=1 payoffs of the stock and the bond using the
state prices:
qu$55 + qd$48.5 = $50
qu$1.06 + qd$1.06 = $1
But the assets are exactly the same and so are the state prices. The put
option price is:
qu$0 + qd$1.5 = P
We get qu=0.6531, qd =0.2903 and the put option price is P=$0.4354.
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TWO PERIOD EXAMPLE

Assume that the current stock price is $50, and it can either go
up 10% or down 3% in each period.
The one period risk-free interest rate is 6%.
What is the price of a European call option on that stock, with
an exercise price of $50 and expiration in two periods?

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THE STOCK PRICE

S= $50, u= 10% and d= (-3%)
Suu=$60.5
S=$50

Su=$5
5

Sud=Sdu=$53.35

Sd=$48.
5

Sdd=$47.05

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THE BOND PRICE

r= 6% (for each period)
$1.1236
$1.06
$
1

$1.1236
$1.06
$1.1236

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THE CALL OPTION PRICE

X= $50 and T= 2 periods

Cu
C
Cd

Cuu=Max{60.550,0}=$10.5
Cud=Max{53.3550,0}=$3.35
Cdd=Max{47.0550,0}=$0

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STATE PRICES IN THE TWO PERIOD TREE

We can replicate the t=1 payoffs of the stock and the bond using the
state prices:
qu$55 + qd$48.5 = $50
qu$1.06 + qd$1.06 = $1
Note that if u, d and r are the same, our solution for the state prices will
not change (regardless of the price levels of the stock and the bond):
quS(1+u) + qdS (1+d) = S
qu (1+r)t + qd (1+r)t = (1+r)(t-1)
Therefore, we can use the same state-prices in every part of the tree.
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THE CALL OPTION PRICE

qu= 0.6531 and qd= 0.2903
Cuu=$10.5
Cu
Cud=$3.35

C
Cd

Cdd=$0

Cu = 0.6531*$10.5 + 0.2903*$3.35 = $7.83

Cd = 0.6531*$3.35 + 0.2903*$0.00 = $2.19
C = 0.6531*$7.83 + 0.2903*$2.19 = $5.75

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TWO PERIOD EXAMPLE

What is the price of a European put option on that stock, with
an exercise price of $50 and expiration in two periods?
What is the price of an American call option on that stock,
with an exercise price of $50 and expiration in two periods?
What is the price of an American put option on that stock, with
an exercise price of $50 and expiration in two periods?

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TWO PERIOD EXAMPLE

European put option - use the tree or the put-call parity
What is the price of an American call option - if there are no
dividends
American put option use the tree

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THE EUROPEAN PUT OPTION PRICE

qu= 0.6531 and qd= 0.2903
Puu=$0
Pu
Pud=$0

P
Pd
Pu = 0.6531*$0 + 0.2903*$0 = $0

Pdd=$2.95
5

Pd = 0.6531*$0 + 0.2903*$2.955 = $0.858

PEU = 0.6531*$0 + 0.2903*$0.858 = $0.249

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THE AMERICAN PUT OPTION PRICE

qu= 0.6531 and qd= 0.2903
Puu=$0
Pu
Pud=$0

PAm
Pd

Pdd=$2.95
5

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AMERICAN PUT OPTION

Note that at time t=1 the option buyer will decide whether to
exercise the option or keep it till expiration.
If the payoff from immediate exercise is higher than the option
value the optimal strategy is to exercise:
If Max{ X-Su,0 } > Pu(European) => Exercise

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THE AMERICAN PUT OPTION PRICE

qu= 0.6531 and qd= 0.2903
Puu=$0
Pu
Pud=$0

P
Pd

Pdd=$2.95
5
Pu = Max{ 0.6531*0 + 0.2903*0 , 50-55 } = $0
Pd = Max{ 0.6531*0 + 0.2903*2.955 , 50-48.5 } = 50-48.5
=$1.5
P

= Max{ 0.6531*0 + 0.2903*1.5 , 50-50 } = $0.4354 >

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DETERMINANTS OF THE VALUES

OF CALL AND PUT OPTIONS

Variable

C Call Value P Put Value

S stock price

Increase

Decrease

X exercise price

Decrease

Increase

stock price volatility Increase

Increase

T time to expiration

Increase

Increase

r risk-free interest rate Increase

Decrease

Div dividend payouts Decrease

Increase
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