Market risk modelling - The Black

Scholes Equation
By: A V Vedpuriswar

Draws heavily from John C Hull, Options, Futures and Other

Derivatives and Neil A Chriss, Black Scholes and Beyond-
Option Pricing Models

October 31, 2010

Modelling asset price movements

To measure the market risk of an asset portfolio, we

should be able to model the price of the underlying.
The most celebrated modeling has been done for
stocks.
But this work can be extended to other asset classes
too.
Before we look at the modeling techniques, we need
to gain a basic understanding of stochastic processes.

2
Discrete and Continuous time Stochastic
processes

When the value of a variable changes over time in an

uncertain way, the variable follows a stochastic
process.
In a discrete time stochastic process, the value of the
variable changes only at certain fixed points in time.
In case of a continuous time stochastic process, the
changes can take place at any time.
Stochastic processes may involve discrete or
continuous variables.
The continuous variable continuous time stochastic
process is usually used for describing stock price
movements.

3
Markov Process

In a Markov process, the past cannot predict the

future.
Stock prices are usually assumed to follow a Markov
process.
All past data have been discounted by the current
stock price.
Suppose we have a coin tossing game.
For every head we gain $1 and for every tail, we lose
$1.
Then expected value of the gains after i tosses will be
zero.
For every toss, the expected value of the gains is zero.
4
Markov Process ( Contd)
Let Si denote the total amount of money we have
actually won up to and including the ith toss.
Then the expected value of Si is zero.
On the other hand, let us say we have already had 4
tosses and S4 is the total amount of money we have
actually won.
The expected value of the fifth toss is zero.
Thus the expected value after five tosses is nothing but
S 4.

That is no change is expected in the variable.

The expected value in future equals the current value.
This leads to the idea of Wiener process. 5
 Wiener Process
A Markov process with mean change = 0 and variance = 1
per year is called a Wiener process.
A variable z follows a Wiener process if the change z
during time t is given by z = t,
is a standard normal random variable(mean = 0, std
devn = 1)
The values of z for any two different short intervals of
time, t are independent.
Mean of z = 0
Variance of z = t or Standard deviation = t

6
Illustration

To illustrate, say a variable follows a Wiener process

and has an initial value of 30.
Where will it be at the end of one year?
The expected change in the value of the variable is 0.
The variable will be normally distributed with a mean
of 30 and a standard deviation of 1.0.
Where will it be at the end of 4 years?
At the end of 5 years, the mean will remain 30 but
the standard deviation will be 4 = 2.

7
Generalized Wiener Process

Here the mean does not remain constant.

Instead, it drifts at a constant rate.
This is unlike the basic Wiener process which has a
drift rate of 0 and variance of 1.
The generalized Wiener process can be written as:
dx = a dt + bdz
or dx = a dt + bt

8
Generalized Wiener Process (Continued)

Suppose the value of a variable is currently 40.

The drift rate is + 10 per year while the variance is 900
per year.
This means the expected change in the variable is 10 in a
year.
If we consider a period of 1 year the variable will be
normally distributed, with
mean of 40+10 = 50
std deviation of 30.

If we consider a period of 6 months, the variable will be

normally distributed with
mean of 40+5 = 45
std devn of 30.5 = 21.21.
9
 Problem

Variables X1 and X2 follow generalized Wiener

processes, with drift rates 1 and 2 and variances
21 and 22. What process does X1 + X2 follow if:

(a) the changes in X1 and X2 in any short interval of

time are uncorrelated?
(b) there is correlation between the changes in X 1
and X2 in any short time interval?

Ref : John C Hull, Options, Futures and Other Derivatives

10
 Solution
(a) Suppose that X1 and X2 equal a1 and a2 initially. After a time
period of length T, X 1 has the probability distribution

(a1 + 1T, 1T)

and X2 has a probability distribution

(a2 + 2T, 2T)

For independent normally distributed variables, mean and
variance can be added.
So .X1 + X2 has the probability distribution

a1 1T a2 2T , T T
2
1
2
2
=

a1 a2 ( 1 2 )T , ( 12T 22T )
S0 X1 + X2 follows a generalized wiener process with drift rate
1+ 2 and variance rate , 12 + 22 11
(b) In this case the change in the value of X1 + X2 in a short
interval of time t has the probability distribution:

( 1 2 )t , 12 22 2 1 2 )t
If 1, 2, 1, 2 and are all constant, the change in a longer
period of time T is

( 1 2 )T , 12 22 2 1 2 )T
The variable, X1 + X2, therefore follows a generalized Wiener
process with drift rate 1+ 2 and variance rate 12 + 22 +
2 1 2

12
 dz.
For the first four years, = 2 and = 4; for the next four
years = 3 and =5.
If the initial value of the variable is 5, what is the
probability distribution of the value of the variable at the
end of year 8?

The change in S during the first three years has the

probability distribution (2x4, 4x4) = ( 8, 8)
The change during the next three years has the probability
distribution (4x3, 5x4) = (12, 10)
The change during the six years is the sum of a variable
with probability distribution (8, 8) and a variable with
probability distribution (12, 10).
The probability distribution of the change is therefore:
= (8 +12, (64 + 100) ) = (20, 12.81 )
Since the initial value of the variable is 5, the probability
distribution at the end of the 8th year is (25, 12.81)
13
Ito Process
The generalised Wiener process needs to be modified
to make it useful for modelling stock prices.
An Ito process is nothing but a generalized Wiener
process.
Each of the parameters, a, b, in dx = a dt + bdz is a
function of the value of both the underlying variable x
and time, t.
Earlier a was a function only of t.
The expected drift rate and variance rate of an Ito
process are both liable to change over time.
x = a (x, t) t + b (x, t) t

14
Brownian Motion
In the coin tossing experiment, the expected winnings
after any number of tosses is just the amount we
already hold.
This is called the Martingale property.
The quadratic variation of a random walk is defined by
[(S1 S0)2 + (S2 S1)2 + + (Si Si-1)2]
For each toss, the outcome is + $1 or - $1. So each
of the terms in the bracket will be (1)2 or (-1)2 i.e.,
exactly equal to 1.
Since there are i terms within the square bracket, the
quadratic variation is nothing but i.

15
Brownian Motion ( Contd)

Let us now advance the discussion by bringing in the

time element.
Suppose we have n tosses in the allowed time, t.
We define the game in such a way that each time we
toss the coin, we may gain or lose an amount of
(t/n) .
Now each term in the small bracket is [(t/)n]2 or
t/n.
Since there are n tosses, the quadratic variation is
(t/n) (n) = t.
Thus the expected value of the pay off is zero and
that of the variance is t.
The limiting process as time steps go to zero is called
16
Brownian Motion

Wilmott has summarized the properties of Brownian

motion:
The increment scales with the square root of the
time step.
The paths are continuous.
The distribution follows the Markov property.
The quadratic variation is t.
Over finite time increments, ti-1 to ti, x(ti) x (ti-1) is
normally distributed with mean zero and variance (t i
ti-1).

17
 Geometric Brownian Motion
The most widely used model of stock price behaviour is
given by the equation:
ds/s = dt + dz
is the volatility of the stock price
is the expected return.
This model is called Geometric Brownian motion.
The first term on the right is the expected return and the
second is the stochastic component.
The return on a stock price between now and a short period
of time, t later is normally distributed with mean t and
std devn, t.
Over a long time, the return will be normally distributed
with mean, ( - 2/2) ( T) and standard deviation, T
18
Illustration
Suppose a stock has a volatility of 20% per annum
and provides an expected return of 15% per annum
with continuous compounding. If the time interval = 1
week = .0192 years and the initial stock price is 50,
what will be the process for a short period of time?
The process for the stock price can be written as:
ds/s = .15dt + .20dz
or s/s = .15 t + .20 z
or s/s = .15 t + .20 t
. s = 50 (.15 x .0192 + .20 .0192)
= .144 + 1.3856

19
Problem
Stock A and stock B both follow geometric Brownian
motion. Changes in any short interval of time are
uncorrelated with each other. Does the value of a portfolio
consisting of one of stock A and one of stock B follow
geometric Brownian motion?
Let SA, SB, A , B and A, B be stock price, expected return
and volatility for stocks A, B respectively..
Then SA = A SA t + ASAAt and SB = B SB t +
BSBBt

SA + SB = (A SA + BSB) t + (ASAA + BSBB)t

This cannot be written as
SA + SB = (SA + SB) t + (SA + SB) t
Hence the value of the portfolio does not follow GBM.
20

Ref : John C Hull, Options, Futures and Other Derivatives

Understanding Geometric Brownian Motion
To get a good intuitive understanding of Geometric
Brownian motion, we draw on the work of Neil A Chriss.
Consider a heavy particle suspended in a medium of
light particles.
These particles move around and crash into the heavy
article.
Each collision slightly displaces the heavy particle.
The direction and magnitude of this displacement is
random.
It is independent of other collisions.
Each collision is an independent, identically distributed
(i.i.d) random event.
21
Geometric Brownian Motion (Contd)
The stock price is equivalent to the heavy article.
Trades are equivalent to the light particles.
We can expect stock prices to change in proportion to
their size.
As the returns we expect do not change with the stock
prices.
Thus we would expect 20% return on Reliance shares
whether they are trading at Rs. 50 or Rs. 500.
So the expected price change will depend on the
current price of the stock.
So we write: s = S (dt + dz).
Because we scale by S, it is called Geometric Brownian
Motion. 22
The Short run

In the short run, the return of the stock price is

normally distributed.
The mean of the distribution is t.
The std devn is t.
is the instantaneous expected return.
is the instantaneous standard deviation.

23
The long run

In the long term, things are different.

Let S be the stock price at time, t.
Let be the instantaneous mean.
Let be the instantaneous standard deviation.
The return on S between now (time t) and future
time, T is normally distributed with a mean of (-2/2)
(T-t) and std devn of T-t.
Why do we write (-2/2) and not ?
What is the intuitive explanation?

24
Geometric Brownian Motion
We need to first understand that volatility tends to
depress the returns below what the short term returns
suggest.
Expected returns reduce because volatility jumps do not
cancel themselves.
A 5% jump multiplies the current stock price by 1.05; A
5% fall multiplies the amount by .95.
If a 5% jump is followed by a 5% fall or vice versa, the
stock price will reach 0.9975, not 1!
In general, if a positive return x is followed by a negative
return x, the price will reach (1+x) (1-x) = 1- x2
How do we estimate the value of x?
Consider a random variable x. We can calculate the
variance of x as follows: 25
2 = E [x2] {E[x]}2 = E [x2] (assuming E[x] = 0, ie.,
ups and downs in x cancel out)
Thus the expected value of x2 is the variance.
Amount by which the returns are depressed when a
positive movement of x is followed by an equal negative
movement is x2.
For two moves, the depression is x2.
So we could say that the average depression per move is
x2/2.
But the expected value of x2 is 2 .
So we can write 2 /2 as the expected value of the
amount by which the returns fall from the mean.
That is why we write (-2/2) and not .
26
A simple example to explain (-2/2)

Suppose the returns on a stock in 5 years are 10%,

15%, 20%, -15% and 25%.
Then the average return ( arithmetic mean) is 11%.
Expected returns = 1.115 = 1.685.
Actual returns = 1.1X1.15X1.2X0.85X1.25 =1.6129
Or Geometric mean = 1.1003
The geometric mean is less than the arithmetic mean.

27
Geometric Brownian Motion
Can we make some prediction about the kind of distribution followed by
the stock price under the assumption of a Geometric Brownian Motion?
Let us begin with the assumption that the stock returns are normally
distributed. 1 S T
ln
T t0 S t0
Annualised return from t0 to T =
ST = future price St0 = current price, T-t10 is expressed
1 in years.
lnST lnSt0
T t0 T t0
Annualised return = 1 1
lnST lnS t0
T t0 T t0
Let random variable X =
Let us define a 1new random variable
lnS t0
X+ T t0

The second term of the expression is a constant. So the basic

characteristics of the distribution are 1not affected. Only the mean
1
changes. lnS t
T t
lnST
T t0 0
0

Also X+ =
or (T-t0) X + ln St0 = ln ST

28
Geometric Brownian Motion

The mean return on S from time t to time T is (T-t) (r-2/2), while the std
devn is T-t
The return on S from time t to T = ln ST /St
The random variable is normally distributed with mean = 0 and std
devn = 1.
Suppose a call option on the stock with strike price, K is in the money at
expiration.
We want to estimate the probability of the stock price exceeding the
strike price.
ST K

ST/St K/St
/S ) ln
2
S 2
lln
n T (S ) (K/St)
K
(T
T tt )( r ln (T t )(r )
St 2 St 2

T t T t

29
Geometric Brownian Motion

St 2
ln (T t )(r ) 2
ST 2 St
ln (T t )(r (Taking
) the negative
K 2
T t T t

K S ST S
of both sides and noting thatln ST
ln t
K
ln
St
ln t
ST

The probability of the stock price exceeding the strike price can
be written as:
P (ST K) = N [ (l nS t / K (T t )( r 2
/ 2)
]
( T t )

We will see that this is N(d2 ) in the Black Scholes formula.

N(d2 ) is nothing but the probabiliy of the call option being in the
money at the time of expiration.

30
Geometric Brownian Motion : Concluding notes
This expression reminds us of the Black Scholes formula!
Indeed, GBM is central to Black Scholes pricing.
GBM assumes stock returns are normally distributed.
But empirical data reveals that large movements in stock price
are more likely than a normally distributed stock price model
suggests.
The likelihood of returns near the mean and of large returns is
greater than that predicted by GBM while other returns tend to
be less likely.
There is also evidence that monthly and quarterly volatilities are
higher than annual volatility.
Daily volatilities are lower than annual volatilities.
So stock returns do not scale as they are supposed to.

31
 Problem
A stock price follows geometric Brownian motion with
an expected return of 16% and a volatility of 35%.
The current price is $38.
(a) What is the probability that a European call option
on the stock with an exercise price of $40 and a
maturity date in 6 months will be exercised?
(b) What is the probability that a European put option
on the stock with the same exercise price and
maturity will be exercised?

Ref : John C Hull, Options, Futures and Other Derivatives

32
 Solution
(a) The required probability is the probability of the stock price
being above $40 in six months time. Suppose that the stock
price in six months is ST.

lnST ~ (ln38 + (0.16 0.352/2) 0.5, 0.350.5

i.e., lnST ~ (3.687, 0.247)

Since ln40 = 3.689, the required probability is
3.689 3.687
1 N 1 N (0.008)
0. 247
From normal distribution tables N(0.008) = 0.5032 so that the
required probability is 0.4968.
(b) In this case the required probability is the probability of the
stock price being less than $40 in six months time. It is
1 0.4968 = 0.5032

33
 Problem
An exchange rate is currently 0.8000. The annualised volatility of the
exchange rate is quoted as 12% and interest rates in the two countries
are the same. Using the log normal assumption, estimate the
probability that the exchange rate in 3 months will be

(a) less than 0.7000,

(b) between 0.7000 and 0.7500,

(c) between 0.7500 and 0.8000,

(d) between 0.8000 and 0.8500,

(e) between 0.8500 and 0.9000, and

(f) greater than 0.9000. Based on the volatility smile usually observed
in the market for exchange rates, which of these estimates would you
expect to be too low and which would you expect to be too high?
Ref : John C Hull, Options, Futures and Other Derivatives 34
 Solution
An exchange rate behaves like a stock that provides a dividend
yield equal to the foreign risk-free rate. Whereas the growth
rate in a non-dividend-paying stock in a risk-neutral world is r,
the growth rate in the exchange rate in a risk-neutral world is r
rf.
In this case the foreign risk-free rate equals the domestic risk-
free rate (r=rf).
The expected growth rate in the exchange rate is therefore
zero. If ST is the exchange rate at time T its probability
distribution is given by :
lnST~(lnS0 2T/2, T)

where S0 is the exchange rate at time zero and is the volatility

of the exchange rate. In this case S0 = 0.8000 and = 0.12 and
T = 0.25 so that lnST~(ln0.8 0.122 X 0.25/2, 0.120.25)

or lnST ~ (-0.2249, 0.06) 35

 Cont..
(a) In 0.70 = -03567. The probability that ST < 0.70 is the same
as the probability that lnST < -3567. It is

0.3567 0.2249
N
= N (-2.1955)
0.06

This is 1.41%
b) In 0.75 = -0.2877. The probability that ST < 0.75 is the same
as the probability that lnST < -0.2877. It is
0.2877= 0N.2249
(-1.0456)
N
0.06
This is 14.79%.
The probability that the exchange rate is between 0.70 and 0.75
is therefore 14.79 1.41 = 13.38%.
36
 Cont..
(c) In 0.80 = -0.2231. The probability that ST < 0.80 is the same
as the probability that lnST < -0.2231. It is

0.2231
= N (0.0300)
0.2249
N
0.06
This is 51.2%. The probability that exchange rate is between .75
and .80 is 51.20 14.79 = 36.41%.
(d) In 0.85 = -0.1625. The probability that ST < 0.85 is the same
as the probability that lnST < -0.1625. It is

0.1625
= N0.(1.0404)
2249
N
0.06

This is 85.09%.
The probability that the exchange rate is between 0.80 and 0.85
is therefore 85.09 51.20 = 33.89%
37
 Cont..
(e) In 0.90 = -0.1054. The probability that ST < 0.90 is the same
as the probability that lnST < -0.1054. It is
0.1054
= N0.(1.9931)
2249
N
0 .06

This is 97.69%. The probability that the exchange rate is

between 0.85 and 0.90 is therefore 97.69 85.09 = 12.60%.

(f) The probability that the exchange rate is greater than 0.90 is
100 97.69 = 2.31%.

38
Itos lemma
Let us move closer to the Black Scholes formula.
Black and Scholes formulated a partial differential equation
which they later solved, with the help of Merton by setting up
boundary conditions.
To understand the basis for their differential equation, we need to
appreciate Itos lemma.
Consider G, a function of x.
The change in G for a small change is x can be written as:
G
G = x
dx
We can understand this intuitively by stating that the change in
G is nothing but the rate of change with respect to x multiplied
by the change in x.
If we want a more precise estimate, we can use the Taylor series:
G = dG + 1 d 2G 1 d 3G
x 2 dx 2
(x) 2
3
( x ) 3
.....
dx 6 dx
Ref : John C Hull, Options, Futures and Other Derivatives
39
Itos lemma

Now suppose G is a function of two variables, x and t.

We will have to work with partial derivatives.
This means we must differentiate with respect to one variable at a time,
keeping the other variable constant. We could write:
G = G
x
G
t
dx dt
Again, if we want to get a more accurate estimate, we could use the
Taylor series:
G G 1 2G 2G 1 2G
G = x t (x)
2
(x)(t ) (t ) 2
x t 2 x 2
xdt 2 t 2

Suppose we have a variable x that follows the Ito process.

dx = a (x,t) dt+ b(x,t) dz
or x = a(x,t) t + b(x,t)t
or x = a t + b t
follows a standard normal distribution, with mean = 0 and standard
deviation = 1.
40
Itos lemma

We can write (x)2 = b22 t + other terms where the power of t is

higher.
If we ignore these terms assuming they are too small, we can write:
x2 = b22 t
All the other terms have t with power 2 or more. They can be ignored.
But x2 itself is big enough and cannot be ignored.
Let us now goG
back toGG and 1 write:
G
x t ( x ) 2

G = x t 2 x 2
But (x)2 = b22 t as we just saw a little earlier.
It can be shown (beyond the scope of this coverage) that the expected
value of 2 t is t, as t becomes very small.
Thus (x)2 = b2t

41
Itos lemma and GBM
But dx = a(x,t) dt + b(x,t) dz
So we can rewrite:
dG =
G G 1 2G 2
(adt bdz ) dt b dt
x t 2 x 2

=
G G 1 2G 2 G
(a b ) dt b dz
x t 2 x
This is called Itos lemma.
2
x

It is very much a type of generalised Weiner process.

Let us say the stock price is lognormally distributed.
If G=ln S and x= S we get :
ds = S dt + S dz; a = S and b = S
dG= { S /S + 0 - [-1/S2] 2 S2 }dt + [S/S ] dz
dG= ( - 2 /2) dt + dz

42
 Problem
Suppose that a stock price S follows geometric Brownian
motion with expected return and volatility : dS = Sdt
+ Sdz. What is the process followed by the variable S n?
If G(S,t) = Sn then G/S = nSn-1, and 2G/S2 = n(n-1)Sn-2.
Using Itos lemma: dG = [nG+ n(n-1) 2G]dt + nGdz
This shows that G = Sn follows geometric Brownian motion
where the expected return is n+ n(n-1) 2 and the volatility
is n.
The stock price S has an expected return of and the expected
value of ST is S0eT. 1 2
[ n n ( n1) ]T
n
The expected value of SnT is S e
0
2

Ref : John C Hull, Options, Futures and Other Derivatives 43

Itos lemma and Black Scholes
The Itos lemma is very useful when it comes to framing the
Black Scholes differential equation.
Let us assume that the stock price follows Geometric Brownian
motion, i.e., S = St + Sz
Let f be the price of a call option written on the stock whose price
is modeled as S.
f is a function of S and t.
or S = a (S,t) dt +b (S,t) dS.
Applying Itos lemma, we can relate the change in f to the
change in S .
Comparing with the general expression for Itos Lemma, we get:
G = f , a = S and b = S, 2x = S,
f f 1 f 2 2 f
or f s S t Sz
s t 2 S s
2

44
 The Black Scholes differential equation

Our aim is to create a risk free portfolio whose value does not depend on the
S, the stochastic variable.
Suppose we create a portfolio with a long position
f of shares and a short
position of one call option. s

The value of the portfolio will be

= -f + f S
s
(Value means the net positive investment made. So a purchase gets a plus
sign and a short sale gets a negative sign.)
We will see later that
f is nothing but delta and the technique used to
create a risk free portfolio
s is called delta hedging.
Change in the value of the portfolio will be:
= - f + s f
s
= -
f f 1 2 f 2 2 f f
s S t S z s
s t 2 s 2
s s

45
The Black Scholes differential equation

But s = St+Sz
f f 1 2 f 2 2 f f
or = - st t s t sz ( st sz )
s t 2 s 2 s s
f f 1 2 f 2 2 f f f
= - St t s t Sz st sz
s t 2 s 2
s s s
or = - f
t
1 2 f 2 2
s t
t 2 s 2
= - f 1 2 f 2 2
s t
t 2 s 2

This equation does not have a s term.

It is a riskless portfolio, with the stochastic or risky component having
been eliminated.
The total return depends only on the time. That means the return on the
portfolio is the same as that on other short term risk free securities.
Otherwise, arbitrage would be possible.
So we could write the change in value of the portfolio as:
= r t where r is the risk free rate. (Because this is a risk free
portfolio)
46
The Black Scholes differential equation
But = -f +f s
s
f 1 2 f 2 2
and ( s )t
t 2 s 2
or - f 1 2 f 2 2 =
s t

r f
f
s t
t 2 s
2
s
or f 1 2 f 2 2 f
rf s r s
t 2 s 2
s
or
f f 1 2 2 2 f
rf rs s
t s 2 s 2
This is the Black Scholes differential equation.
The portfolio used in deriving the Black Scholes differential equation is
riskless only for a very short period of
f time when is constant.
s
With change in stock price and passage of time,
f
can change.
s
So the portfolio will have to be continuously rebalanced to achieve what
is called a perfectly hedged or zero delta position.
This is also called dynamic hedging.
Solving the equation with appropriate boundary conditions gives us the
black Scholes formula.

47
 The Black Scholes formula
Let C be the value of the call, P that of the put, K the
strike price

C = S0 N(d1) Ke-rT N(d2)

d1 = [ln(S0/k) + (r+2/2)T] / T

d2 = [ln(S0/k) + (r-2/2)T] / T = d1 - T
As per put call parity,
C P = S0 Ke-rT

or P = C S0 + Ke-rT

= S0N(d1) Ke-rT N(d2) S0 + Ke-rT

= Ke-rT [1 N(d2)] + S0 [N (d1) 1]

= Ke-rT N(-d2) S0 N(-d1)

 Problem
What is the price of a European call option on a non-
dividend-paying stock when the stock price is $52, the
strike price is $50, the risk-free interest rate is 12% per
annum, the volatility is 30% per annum, and the time to
maturity is 3 months?
In this case S0 = 52, K = 50, r = 0.12, = 0.30 and T = 0.25
ln(52 / 50) (0.12 0.30 2 / 2)0.25
d1 0.5365
0.30 0.25

d 2 d1 0.30 0.25 0.3865

The price of the European call is

52N(0.5365) 50e-0.12x0.25N(0.3865)
= 52 x 0.7042 50e-0.03 x 0.6504
= $ 5.06
49
 Problem
A call has 91 days until it expires.The risk-free interest
rate is 8 percent/year. The strike price is 60.The stock
price is 64.The standard deviation of the stocks
monthly return is 0.144. Compute the value of the call.
What is the delta of the call?
The volatility of the stocks annual returns is .144 x12 .=.4988. t =
91/365 = 0249315.
ln( S / K ) (r 2 / 2)T ln(64 / 60) (0.08 1 2 0.248832)0.249315
d1 = 0.46374
T 0.49833 0.249315
N(d1) = 0.6786
d2 = d1 - T = 0.46374 0.498830.249315 = 0.46374 0.2491 =
0.2146
N(d2) = 0.5850
Ke-rT = (60) (e-0.019945) = (60) (0.98025) = 58.8151
C = SN(d1) Ke-rTN(d2) = 64(0.6786) 58.8151 (0.5850) = 9.0235
Options And Financial Futures:by
Dubofsky
50

 Problem
Use Black Scholes to value the following call option:
Stock price =$200, Strike price=$210,
Time to expiration =156 days, Risk-free interest rate
= 11%
Variance of monthly stock returns = 0.02
S = 200, K = 210, T = 156/365 = 0.4274 year
r = 0.11, = [12x0.02] = 0.489898 / year
ln(S / K ) (r 2 / 2)T ln(200 / 210) (0.11 0.12)0.4274
d1
T 0.320275

= 0.1546
51

Options And Financial Futures:by

Solution

N(d1) = 0.5614

d2 = d1 - T = 0.1546 0.3203 = - 0.1657

N(d2) = 0.4342
Ke-rT = 210e-(0.11)(0.4274) = (210)e-0.0470 =(210)(0.9541)
= 200.3556
C = SN(d1) - Ke-rTN(d2)
= (200) (0.5614) (200.3556) (0.4342)
= 25.2902
The equivalent portfolio consists of long 0.5614
shares of stock and borrowing $200.3556. 52
 Consider an American call option on a stock. The stock price is $50, the
time to maturity is 15 months, the risk-free rate of interest is 8% per
annum, the exercise price is $55, and the volatility is 25%. Dividends of
$1.50 are expected in 4 months and 10 months. Calculate the price of
the option.
The present value of the dividends is
1.5e-0.3333x0.08 + 1.5e-0.8333x0.08 = 2.864
The option can be valued using the European pricing formula with:
S0 = 50 2.864 = 47.136, K = 55, = 0.25, r = 0.08, T = 1.25

d1 = [{ln(47.136/55) + ( .08 + .0625/2)1.25}]/[.251.25] = -.0545

d2 = d1 0.25 1.25 = - 0.3340

N(d1) = 0.4783, N (d2) = 0.3692

and the call price is 47.136 x 0.4783 55e-0.08x1.25 x 0.3692 = 4.17

John C Hull, Options, Futures and Other Derivatives
53
 Problem
A company can buy an option for the delivery of 1 million
barrels of oil in 3 years at $25 per barrel. The 3-year
futures price of oil is $24 per barrel. The risk-free interest
rate is 5% per annum with continuous compounding and
the volatility of the futures price is 20% per annum. How
much is the option worth?.
The option can be valued using Blacks model. We use
futures/forward price, F0 instead of spot price, S0 of underlying.

F0 = 24, K = 25, r = 0.05, = 0.2, and T = 3. The value of a

option to purchase one ln(
barrelF 2
0 of oil atT$25
/ K ) / 2 is ln( F / K ) 2
T /2
d1 d2 0
T T
e-rT
[F0N(d1) KN(d2)],

d1 = 0.0554, d2 = -.2910, N(d1) = .52209 N(d2) = .

38553
F0N(d1) KN(d2) = 2.891, e-rT = 0.86
C =0.86 X 2.891 = 2.489
54

The
John C Hull, Options,
value Futures
of the and Other
option Derivatives
to purchase one million barrels is
 Problem
Use the Blacks model to value a 1-year European put option
on a 10-year bond. Assume that the current value of the
bond is $125, the strike price is $110, the 1-year interest
rate is 10% per annum, the bonds forward price volatility is
8% per annum, and the present value of the coupons to be
paid during the life of the option is $10.
In this case, F0 = (125 10)e0.1x1 = 127.09, K = 110, = 0.08, and
T = 1.0
d1 = {[ln(127.09/110) + .0064/2]}/.08 = 1.8456

d2 = d1 0.08 = 1.7656
The value of the option is
110e-0.1x1 N (-1.7656) 115N (-1.8456) = 0.12
Or $0.12
John C Hull, Options, Futures and Other Derivatives
55
 Problem
Calculate the value of a 4-year European call option on a bond that
will mature 5 years from today using Blacks model. The 5-year cash
bond price is $105, the cash price of a 4-year bond with the same
coupon is $102, the strike price is $100, the 4-year risk-free interest
rate is 10% per annum with continuous compounding, and the
volatility for the bond price in 4 years is 2% per annum.
We use Blacks formula.
The present value of the principal in the four year bond is 100e -4x0.1
= 67.032.
The present value of the coupons is, therefore, 102 67.032
= 34.968.
So forward price of the five-year bond is : (105 34.968)e4x0.1 =
104.475
F0 = 104.475, K = 100, r = 0.1, T = 4, and = 0.02.

d1 = ln [(104.475/100) + ..0004X4/2]/ [.02x 4] = 1.1144

dC
John 2 = d1 Options,
Hull, 0.024Futures
= 1.0744
and Other Derivatives
56

Price of the European call is e -0.1x4

[104.475N(1.1144) 100N(1.0744)]
 Problem
A companys stock price is $50. The company is considering
giving its employees at-the-money 5-year call options. The
stock price volatility is 25%, the 5-year risk-free rate is 5%
and the company does not pay dividends. Calculate the
value of the option.
d1 = { ln(50/50) + [.05+.0625 x 5 /2]} /[.25X5] = .3690,

N(d1 ) = .6439

d2 = .3690- . 25X5 = -.1900,

N(d2 )= .4247
e-rt = .7789, r = .05, t =5.
C = 50 x .6439- 50 x.7789x .4247 = 15.66

57
 Problem
A companys stock price is $50 and 10 million shares are
outstanding. The company is considering giving its
employees 3 million at-the-money 5-year call options.
Option exercises will be handled by issuing more shares.
Estimate the cost to the company of the employee stock
option issue. Asssume the value of an option is $ 15.66.
N = No. of existing shares, M, the no. of new options
The cost to the company of the option is[ NS + MK]/[N+M]
-K
= [Nx (S-K)]/(N+M) where, N=10, M=3, S-K = option value
= 15.66
= 10/[10+3} X 15.66 = $ 12.05 per option.
The total cost is therefore 3 million times this or $36.15
million.
58

John C Hull, Options, Futures and Other Derivatives