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THE BLACK-SCHOLES OPTION-PRICING MODEL

Fischer Black and Myron Scholes had one of the last centurys most revealing insights
about pricing in financial markets. In 1973, they published an article1 outlining the first practical
theoretical model to price options. Their Black-Scholes model harnessed arbitrage forces that
ensure that two ways to create the same ultimate payoff will be priced the same in wellfunctioning financial markets. The models novel assumption was that an investor who wrote a
call option and simultaneously bought a certain number of shares in the underlying asset could
create a riskless cash payoff. Because the investor could also create risk-free payoffs using riskfree bonds, arbitrage forces would ensure that the risk-free-rate bond return would also apply to
the riskless payoff involving the shares and call option. Once this was established, Black and
Scholes could derive a practical way to estimate the value of the option based on variables that
could be observed or reasonably estimated.
This note discusses the economics underlying the Black-Scholes model and then applies
the model to the pricing of call options. We pay particular attention to procedures for estimating
the potential for stock-price changes, as these possible movements are the key driver of option
value.

The Underlying Economics

To illustrate the underlying economics of the Black-Scholes model, consider a simple
example. Suppose the shares of XYZ are currently trading at $105 a share. You are offered a
European call option with an exercise price of $100 and time to maturity of one year. How much
should you be willing to pay for this option? First, we need some assumption about how the
stock price will move. Lets make the simplifying assumption that the stock price will be either
$115 or $95 at the end of one year.

Black and Scholes ultimately received the Nobel Prize in Economics for their work, which first appeared in
The Pricing of Options and Corporate Liabilities, Journal of Political Economy (1973).
This note was prepared by Professors Robert Conroy and Robert Harris. It was written as a basis for class discussion
rather than to illustrate effective or ineffective handling of an administrative situation. Copyright 2007 by the
University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an
e-mail to [email protected]. No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying,
recording, or otherwisewithout the permission of the Darden School Foundation.

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Price Today

Price in One Year

115
or
95

105

The value of the call option one year from now depends on the stock price then, as the chart
below shows:
Price Today

Call price = ?

Call Value in One Year

Max(115 100, 0) = 15
or
Max(95 100, 0) = 0

Assume you buy H shares of the stock and write one call option. Your combined payoff in one
year will be H times the share price plus your payoff on the option. Note that when you write the
call option, your payoff is negative when the stock price increases and zero when the stock
dropsexactly the mirror image of payoffs to an option buyer. Your outlay today is the cost of
buying the shares minus the proceeds of selling (writing) the call.
Price Today
Buy H shares of stock
Write 1 call

Value in One Year

Combined payoff

H 115 15
or
H 95 0

H 105 Call

If we choose H carefully, we can make the payoff in one year the same regardless of what
happens to the stock price. In financial jargon, we create a riskless hedge position. To do this, we
choose H so that the payoff is the same regardless of the share price:
H 115 15 = H 95 0
or

H=

15 0
15
=
= .75
115 95 20

The payoff from doing this is determined below:

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Price Today
Buy H shares of stock
Write 1 call

Value in One Year

Combined payoff

.75 115 15 = 71.25

or
.75 95 0 = 71.25

.75 105 Call

If we buy .75 shares and write one call, the payoff in one year is $71.25 regardless of the share
price. We have created a riskless payoff! Because the combination of buying H = .75 shares of
stock and writing one call option is a riskless investment, arbitrage in markets will ensure that
this combination is priced to earn the risk-free rate of return. If the risk-free rate is 6%, Rf = 6%,
then the value of the call can be determined as follows:

(.75 105 Call ) e R 1 = 71.25 , or

f

(.75 105 Call ) = 71.25 e R 1 , and

f

Call = .75 105 71.25 e

R f 1

= 78.75 71.25 e .061 = 11.65

In essence, we have simply backed out what the value of the call option has to be for the riskless
hedge position to earn a risk-free rate of return. Any other value for the call option would allow
investors to profit from riskless arbitrage in the market.
While Black and Scholes incorporate a more complex treatment of stock-price
movement, our simple example captures the essence of their model. Valuing options is done by
setting up a riskless hedge and then discounting the payoff at the risk-free rate to determine the
options value.
Looking at our example, intuition suggests that five things matter in pricing call options:
1. The underlying asset value, UAV: the stock price, in this case ($105).
2. The exercise price of the option, X: we determined the payoff at maturity with this.
3. The time to maturity, T: we use this as the time period to discount the riskless payoff.
4. The risk-free rate, Rf: we use this as the discount rate to discount the riskless payoff.
5. The potential for stock-price movement over time: this is the 115 and 95. Note that if we
made this wider (say, 120 and 90), the call option would be worth more. As it turns out,

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this potential price movement is critical to options pricing and the Black-Scholes model2
as that movement will drive the ultimate payoffs of the call option.
In many practical applications, we often measure this potential for price fluctuation using the
volatility of the stock price. Volatility is just a statistical measure of how much the stock price
can change over a period of time. Typically, volatility is expressed on an annual basis. A stock
with a high volatility has the expectation that the stock price will change a great deal in a year.
Conversely, a stock with a low volatility has an expectation of a small change in stock price. The
stock price can go up or down, but what is important is the size of the potential price changes.
For example, a stock with a price of $50 and a volatility3 of .20 has a 67% probability that the
stock price one year from today will be between $60 and $40. Correspondingly, if the volatility
were .50, there would be a 67% probability that the stock price would be between $75 and $25.
As we lengthen an options maturity, the annual volatility has even more time to work. As a
result, a two-year option on a stock would be exposed to higher chances of wide stock-price
movements prior to maturity than would a 90-day option on the same stock.

The Specifics of the Black-Scholes Model

The Black-Scholes model requires exactly the five inputs discussed above, together with
some statistics. In terms of notation, let call be the value of a European call. In markets, this
value would be the call premium or price that the buyer pays the seller to acquire the option. The
Black-Scholes model states the following:
Call = UAV N (d1 ) X N (d 2 ) e
where

ln UAV
d1 =

)+ R

R f T

1 2
T
2

d 2 = d1 T
2

See the Appendix. In the Black-Scholes model, we would use volatility as the estimate of price movements.
For the example used above, the price movements over the year would be equivalent to a volatility of .105.
3
The convention is to express volatility in terms of annualized percentage rates of return. Thus, a volatility of
.20 (i.e., 20%) means that the standard deviation around the mean expected return for the stock is 20%. For
simplicity, the example has assumed away the effects of the stocks expected return over the year and just focused
on the deviation from that. The point is that the higher the volatility, the more likely it is that the future stock price
may take on high and low values. One must also be careful in assessing how volatility works over time because
random movements up and down can cancel each other out. As it turns out, a typical assumption is that one days
stock-price movement tells us nothing about the movement on the next day. Such statistical independence would
mean that the volatility experienced over four years is less than four times the annualized volatility. Specifically, if
we assume independence, volatility goes up with the square root of time, so four years of volatility will be only
twice the annualized volatility number.

-5UAV
X
T
Rf

=
=
=
=
=

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Underlying asset value, or stock price, in this case

Exercise price
Time to maturity, in years
Risk-free rate (continuous compounding)
volatility

N(.) is the cumulative standard normal density function. In essence, the density function allows
the model to deal with the nature of how a stock price might change over time. The exponential,
e, is used to implement the assumption of a continuously compounded risk-free interest rate.
In using the Black-Scholes model, the first four inputs are relatively straightforward; they
are either stated in the option contract (X and T) or are outcomes of traded prices in financial
markets (stock price and risk-free rate). The remaining issue is how to measure potential
movements in the stock price over time. In their model, Black and Scholes assumed that stock
prices follow a lognormal distribution over time. In this case, what determines how much the
stock price can change over time is the volatility, , which is calculated as the standard deviation
of the log of stock-price relatives.4 Essentially, this is the standard deviation of returns for the
stock. The convention is to express the volatility on an annualized basis.
Like almost any other statistical parameter, we can estimate the standard deviation or
volatility using observed data. Exhibit 1 shows five years of price data5 for Cisco Systems. What
we are interested in is the standard deviation of the log of the price relatives. Exhibit 1 shows the
calculation of the standard deviation of the log of the price relatives using monthly data. The
monthly standard deviation of the log relatives is .1219. As we noted before, the convention is to
express volatility on an annualized basis. To do this, we multiply the monthly standard deviation
by the square root6 of 12. For Cisco, this results in a volatility of .4223.

Applying the Model to Value a Call Option

Now suppose we were offered a European call option on Cisco where the exercise price
is $15 and the time to maturity is nine months. Currently, Cisco is trading at $17.48 a share, and
the risk-free rate for a maturity of nine months is 5% (continuously compounded). We can use
the Black-Scholes model (in Excel) to price this call option. The only input we are missing for
the Black-Scholes model is volatility. If we assume the last five years are representative of the

The log of price relatives = ln t . In continuous time, Pt is (Pt1 )(er), where r is the stocks continuous
Pt 1

rate of return. The law of exponents shows the log of price relatives is then just equal to r.
5
Note that we are using prices labeled adjusted prices. These are prices adjusted for stock splits and stock
dividends. When using price data, it is important to adjust for stock splits and stock dividends. Stock-price changes
caused by these events are not part of the volatility of the underlying asset.
6
Note that if we had a weekly standard deviation, W, we would convert it to an annualized value by
multiplying it by the square root of the number of weeks in a year (52), assuming weekly returns are independent.

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volatility for the next eight months, we can use the annualized volatility estimate of .4223
calculated in Exhibit 1.
Using the five inputs in the Excel-based model results in a call value of $4.135, as shown
below:
Underlying asset value (UAV, or stock price)
Exercise price (X)
Time to maturity (T, in years)
Risk-free rate (Rf continuously compounded)
Volatility ( annualized)

=
=
=
=
=

$17.48
$15.00
.75 years (9 months)
5%
.4223

Black-Scholes call value

$4.135

Estimating Volatility in Practice

In applying options pricing, volatility is almost always the most difficult input to
estimate. There are two basic approaches to estimating volatility for a particular stock. One way
is to use historical data to estimate the volatility for a future time period. In doing this, we are
assuming that the past is a good estimate of the future. This is the approach we used in the above
example. There, we used the historical volatility in Exhibit 1 to estimate the volatility.7
The second alternative is to use market prices for call options and the options-pricing
model to infer a volatility. Such a volatility estimate is referred to as an implied volatility. For
example, suppose we knew that a call option on Cisco with an exercise price of $15.00 and a
maturity of six months was trading at a price of $3.574. We can use the Black-Scholes model to
find the implied volatility for Cisco.
The inputs would be as follows:
Underlying asset value (stock price)
Exercise price (strike price)
Time to maturity (in years)
Risk-free rate (continuously compounded)
Volatility (annualized)

=
=
=
=
=

$17.48
$15.00
6 months (.5 years)
5%
?

Black-Scholes call value

$3.574

Note that in Exhibit 1, volatility is also estimated using simple percentage changes or monthly returns. The
result is quite similar to that obtained using the log relatives, which is technically appropriate given continuous
compounding. Because the results are so close, a common practice is to use percentage changes to calculate
volatility.

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The volatility that results8 in a call price of $3.574 is .400. This volatility estimate could
then be used to price other options on Cisco or on any underlying asset that was assumed to have
the same volatility as Cisco stock.
Implied volatilities have the advantage of capturing forward-looking expectations. The
calls market price used to estimate implied volatility is, after all, based on the market
expectation of the stocks future. The disadvantage of implied volatilities is that any error in the
pricing model used will affect the volatility estimate. While the Black-Scholes model works well
for many options, there are situations where even more advanced pricing models are needed.
Whatever method we use, our goal is to estimate the volatility for a future time period.
Here, we have a historical estimate of .4223 and an implied volatility of .400. These numbers are
quite close and thus the choice does not make a big difference. In other circumstances, they
could be quite different and the choice would matter. The choice then must be made based on
what you believe is the best estimate for the future time period under consideration.

Summary

The Black-Scholes model is the most widely used technique to price European call
options. Using only five inputs, the model offers a practical way to price options:
UAV
X
T
Rf

=
=
=
=
=

Underlying asset value (or stock price, in this case)

Exercise price
Time to maturity, in years
Risk-free rate (continuous compounding)
Volatility

While the first four inputs are relatively straightforward to estimate, volatility requires more
attention. Volatility captures the potential price movement of a stock and is a key driver of
option value. In practice, future volatility can be estimated one of two ways. If we think future
volatility will be similar to past volatility, we can use the volatility of past stock returns.
Alternatively, we can look at the volatilities implied in the prices of options that are currently
being traded. A number of financial services provide volatility estimates for a range of stocks.

We can find the volatility either through a trial-and-error process or through the use of the goal-seek function
in Excel.

UVA-F-1522

-8Exhibit 1
THE BLACK-SCHOLES OPTION-PRICING MODEL

Date
8/1/2001
9/1/2001
10/1/2001
11/1/2001
12/1/2001
1/1/2002
2/1/2002
3/1/2002
4/1/2002
5/1/2002
6/1/2002
7/1/2002
8/1/2002
9/1/2002
10/1/2002
11/1/2002
12/1/2002
1/1/2003
2/1/2003
3/1/2003
4/1/2003
5/1/2003
6/1/2003
7/1/2003
8/1/2003
9/1/2003
10/1/2003
11/1/2003
12/1/2003
1/1/2004
2/1/2004
3/1/2004
4/1/2004
5/1/2004
6/1/2004
7/1/2004
8/1/2004
9/1/2004
10/1/2004
11/1/2004

Cisco Stock Prices

Log Relative1
Adjusted Price
20.30
16.33
0.2176
11.90
0.3165
17.66
0.3948
19.86
0.1174
18.11
0.0922
19.21
0.0590
15.00
0.2474
17.52
0.1553
13.70
0.2459
15.33
0.1124
13.09
0.1580
12.10
0.0786
13.82
0.1329
10.94
0.2337
11.61
0.0594
15.06
0.2602
13.10
0.1395
13.48
0.0286
13.72
0.0176
12.98
0.0554
15.12
0.1526
16.80
0.1054
17.24
0.0259
19.15
0.1051
19.14
0.0005
20.20
0.0539
21.71
0.0721
23.18
0.0655
24.23
0.0443
26.20
0.0782
23.53
0.1075
23.74
0.0089
21.12
0.1169
22.24
0.0517
23.11
0.0384
21.24
0.0844
19.09
0.1067
18.93
0.0084
19.26
0.0173

% Change2
0.1956
0.2713
0.4840
0.1246
0.0881
0.0607
0.2192
0.1680
0.2180
0.1190
0.1461
0.0756
0.1421
0.2084
0.0612
0.2972
0.1302
0.0290
0.0178
0.0539
0.1649
0.1111
0.0262
0.1108
0.0005
0.0554
0.0748
0.0677
0.0453
0.0813
0.1019
0.0089
0.1104
0.0530
0.0391
0.0809
0.1012
0.0084
0.0174

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-9Exhibit 1 (continued)

Log
Relative1
0.0088
0.0636
0.0354
0.0114
0.0252
0.1292
0.0337
0.0141
0.0873
0.0051
0.0148
0.0119
0.0328
0.0818
0.1253
0.0249
0.0296
0.0222
0.0247
0.1347

%
Change2
0.0089
0.0616
0.0347
0.0114
0.0249
0.1379
0.0331
0.0142
0.0836
0.0051
0.0147
0.0120
0.0322
0.0853
0.1335
0.0252
0.0292
0.0219
0.0244
0.1260

Monthly standard deviation M

Annualized volatility

0.1219

0.1242

A = M 12

0.4223

0.4302

Date
1/1/2005
2/1/2005
3/1/2005
4/1/2005
5/1/2005
6/1/2005
7/1/2005
8/1/2005
9/1/2005
10/1/2005
11/1/2005
12/1/2005
1/1/2006
2/1/2006
3/1/2006
4/1/2006
5/1/2006
6/1/2006
7/1/2006
8/1/2006

The log relative is ln t

Pt 1

% change is

Pt
1
Pt 1

Adjusted Price
19.32
18.13
17.50
17.70
17.26
19.64
18.99
19.26
17.65
17.74
17.48
17.69
17.12
18.58
21.06
21.59
20.96
20.50
20.00
17.48

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-10Appendix
THE BLACK-SCHOLES OPTION-PRICING MODEL

The value of the call option one year from now depends on the stock price.
Price Today
Call price = ?

Price in One Year

Max(120 100, 0) = 20
or
Max(90 100, 0) = 0

Assume you buy H shares of the stock and write one call option.
Price Today
Buy H shares of stock
Write 1 call

Price in One Year

Combined payoff
H 120 20
or
H 90 0

H 105 Call

H 120 20 = H 90 0
or
H = (20 0)/(120 90) = .67
Price Today
Buy H shares of stock
Write 1 call
.67 105 Call

Price in One Year

Combined payoff
.67 120 20 = 60.00
or
.67 90 0 = 60.00

If we buy .67 shares and write one call, the payoff in one year is $60.00 regardless of the share
price.
(.67 105 Call ) e R f 1 = 60.00 , or

(.67 105 Call ) = 60.00 e R 1 , and

f

Call = .67 105 60.00 e .061 = 13.49