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Chapter
13
The Black-Scholes-Merton
SOLUTIONS
Problem 13.1.
Model
TO QUESTIONS
AND PROBLEMS
The Black-Scholes option pricing model assumes that the probability distribution of the stock price in I year (or at any other future time) is lognormal. It assumes that the continuously compounded rate of return on the stock during the year is normally distributed. Problem 13.2. The standard deviation of the percentage price change in time f..t is (5v;Ij where (5.is the
volatility. In this problem (5 = 0.3 and, assuming 252 trading days in one year, f..t = 1/252 = 0.004 so that (5v;Ij
Problem 13.3. The price of an option or other derivative when expressed in terms of the price of the underlying stock is independent of risk preferences. Options therefore have the same value in a risk-neutral world as they do in the real world. We may therefore assume that the world is risk neutral for the purposes of valuing options. This simplifies the analysis. In a riskneutral world all securities have an expected return equal to risk-free interest rate. Also, in a risk-neutral world, the appropriate discount rate to use for expected future cash flows is the risk-free interest rate. Problem 13.4.
In this case So
= 50,
= 50, r = O. I,
(5
= 0.3,
dl =
d2 = d1 - 0.3vO.25
= 0.0917
= 50 x 0.4634e-0.lxO.25 - 50
or $2.37.
= 2.37
----
83 Problem 13.5.
In this case we must subtract the present value of the dividend from the stock price before using Black-Scholes. Hence the appropriate value of So is So = 50As before K
1.50e-O.\667xO.1
= 48.52
In this case = 0.0414
= 50, r = 0.1,
d 1=
(J
= 50 x 0.5432e-0.lxO.25 -48.52
or $3.03. Problem 13.6.
x 0.4835
= 3.03
The implied volatility is the volatility that makes the Black-Scholes price of an option equal to its market price. It is calculated using an iterative procedure. Problem 13.7. In this case J1 = 0.15 and (J
= 0.25.
0.15 -
0.252
0.25
'
J2
I.e., (jJ(0.11875,0.1768)
The expected value of the return is 11.875% per annum and the standard deviation is 17.68% per annum. Problem 13.8. (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 InST 0352 (jJ(In38+ (0.16 - ~ )0.5, 0.35v(5) 2
rv
.
84
Model
3.689 - 3.687
0.247
From normal distribution tables N(0.008) 0.5032 so that the required probability 0.4968. In general the required probability is N((h). (See Problem 13.22).
(b) In this case the required probability $40 in six months' time. It is
)= =
1- N(0.008) is
= 0.5032
')
and
- 1.96aVT
a-') InSo + (J.1- -)T 2 95% confidence intervals for ST are therefore
+ J.96aVT
e InSo+(,u-a2/2)T -1.96aVT
and
elnSo+(,u-a2 /2)T + J.96aVT
I.e.
Soe(,u-a2 /2)T - J.96aVT
and
Soe(,u-a2 /2)T + 1.96aVT
Problem 13.10. The statement is misleading in that a certain sum of money, say $ J000, when invested for 10 years in the fund would have realized a return (with annual compounding) of less than 20% per annum. The average of the returns realized in each year is always greater than the return pcr annum (with annual compounding) realized over 10 years. The first is an arithmetic average of the returns In each year; the second is a geometric average of these returns.
.
85
Problem 13.11.
(a) At time t, the expected value oflnST is, from equation (\3.3)
(J-
InS+(,u--)(T-t) 2
In a risk-neutral world the expected value of InSr is therefore: InS + (r - - ) (T - t) 2 Using risk-neutral valuation the value of the security at time tis:
(J-
e-,(T-'j
(b) If: .f
= e-,(T-'j [Ins + (r -
~2 )(T - t)]
(J2 . 2
-e-r(T-t)(r--
as -
S
e-r(T -t) S2
a2f as2
(J-
=re-,(T-'j [Ins+(r-
~2)(T-t)]
= rf
Hence equation (13.16) is satisfied.
.
86 Chapter 13. The Black-Scholes-Merton Model
Problem 13.12.
This problem is related to Problem 12.10. (a) If C(S,t) obtain
') hI + rIm + -(rhl1(l12
I )SII-2 where hI = dh/dt. Substituting intodC/dS = the Black-Scholes and d2C/dS2 equation we differential = hl1(l1I
I)
= hlSII,
hI1SII-],
= rh
(b) The derivative is worth SII equation is therefore h(T, T) (c) The equation
h(t, T) = eIO.S(J"211(1I-])+r(II-I)I(T-I)
satisfies the boundary condition since it collapses to h = 1 when t = T. It can also be shown that it satisfies the differential equation in (a). Alternatively we can solve the
differential equation in (a) directly. The differential equation can be written hI 1 - - -r(n-1)--(rl1(n-l) h 2
')
= [-r(n
1 ') k ~ [r(n - 1)+ 2:cr-n(n- 1)]T so that 1 1nh = [r(n - 1)+ -cr-n(n - 1)](T- t)
')
or
h(t, T) = eIO.5(J"2n(II-I)+r(n-I)I(T-I)
cr = 0.30 and T
= 0.25.
=0.5365
.
+(0.12+0.32/2)0.25
"
87
= 52 x 0.7042 = 5.06
or $5.06. Problem 13.14. In this case So = 69, K
d 1=
50e-0.03 x 0.6504
= 70, r = 0.05,
= 0.5.
= 0.1666
d2 = dl -0.35J<f5 = -0.0809
The price of the European put is
- 69N( -0.1666) 70e-0.025 x 0.5323 - 69 x 004338 = 70e-0.05XO.5N(0.0809)
= 6040
or $6040.
Problem 13.15.
Using the notation of Section 13.12, DJ = D2 = 1, K(l - e-r(T-t2)) 1.07, and K( 1 - e-r(t2-tl)) = 65( 1- e-o.J XO.25)= 1.60. Since
Dl <K(I-e-r(T-t2))
= 65(1
- e-0.JXO.J667) =
and D2 < K(1- e-r(t2-tl)) It is never optimal to exercise the call option early. DerivaGem shows that the value of the option is 10.94. Problem 13.16. In the case c = 2.5, So = 15, K = 13, T = 0.25, r = 0.05. The implied volatility must be calculated using an iterative procedure. A volatility of 0.2 (or 20% per annum) gives c = 2.20. A volatility of 0.3 gives c = 2.32. A volatility of 004 gives c = 2.507. A volatility of 0.39 gives c = 20487. By interpolation the
.
88
Model
Problem 13.17. (a) Since N(x) is the cumulative probability that a variable with a standardized normal distribution wilI be less than x, N' (x) is the probability density function for a standardized normal distribution, that is,
I N'(x) = -e-2 J2ii ,2
(b)
N'(dd =N'(d2+avT-t)
=v5
d~
2
= N'(d,)exp [-ad,~
Because
d?
- ~a'(T -t)]
-=
In(S/ K) + (r -
a2
/2) (T - t)
avff=t =
Ke-r(T-t)
it follows that
I? exp -ad2VT-t-"2(r(T-t) [
= Ke-r(T-I)N'(d2)
0
In ~ + (r+ T) (T - t)
avT - t
T )(T 0
t)
avT - t 1
as = SaJT -t
Similarly
d?
-=
In S - InK + (r - a,,2) - t) - (T
avT -t
ad2 1 as SavT -t
and
Therefore:
ad)
'>
dd2 as
as -
J.
.
89 (d) c
= SN(dl)
ac
From (b):
SN1 (dl) at = at
adl
at
SN'(dI) Hence
= Ke-r(T-I)N'(d2)
Since
ac
-rKe-1 at =
.(T
( at
adl -
ad.,
=at )
dl -d2
= a~
a
1~
Hence
(e) From differentiating the BJack-Scholes formula for a call price we obtain
ac
(d7 )
ad2
- dS
ac
(f) Differentiating the result in (e) and using the result in (c), we obtain
a2c
aS2
= N' (d I )
=N'(dl)
adl as Sa
T- t
- +rS-
ac at
= r[SN(dl) = rc
formula This shows that the Black-Scholes Black~Scholes differential equation.
.
90 Chapter 13. The Black-Scholes-Merton Model
(g) Consider what happens in the formula for c in part (d) as t approaches T. If S > K, dl and d2 tend to infinity and N(dI) and N((h) tend to I. If S < K, dl and d2 tend to zero. It follows that the formula for c tends to max(S - K, 0).
Problem 13.18.
From the Black-Scholes equations
- SoN( -dl)
+ So
N( -dl)
Also: c + Ke-rT = SoN(dl) - Ke-rT N(d2) + Ke-rT Because I - N(d2) = N( -d2), this is also Ke-rT N( -d2) + SoN(dJ) The Black-Scholes equations are therefore consistent with put-call parity.
Rroblem 13.19.
This problem naturally leads on to the material in Chapter 16 on volatility smiles. Using
DerivaGem we obtain the following table of implied volatilities:
Strike Price ($) 45 50 55
12 34.02 32.03 30.45 The option prices are not exactly consistent with Black-Scholes. If they were, the implied volatilities would be all the same. We usually find in practice that low strike price options on a stock have significantly higher implied volatilities than high strike price options on the same stock.
Problem 13.20. Black's approach in effect assumes that the holder of option must decide at time zero whether it is a European option maturing at time tn (the final ex-dividend date) or a European option maturing at time T. In fact the holder of the option has more flexibility than this. The holder
can choose to exercise at time tn if the stock price at that time is above some level but not otherwise. Furthennore, if the option is not exercised at time tn, it can still be exercised at
time T.>
.
91
It appears from this argument that Black's approach understates the true option value. However, the way in which volatility is applied can lead to Black's approach overstating the option value. Black applies the volatility to the option price. The binomial model, as we will see in Chapter 17, applies the volatility to the stock price less the present value of the dividend. This issue is also discussed in Example 13.9. Problem 13.21.
I
= D2 = 1.50,
tl
= 0.3333,
t2
= 0.8333,
K [1-e-r(T-t2)]
= 55(I-e-O.08xOAI67) = 1.80
Hence
D2 < K [1-e-r(T-t2)]
Also: K [1-e-r(12-IJ)]
= 55(1-e-0.08xO.5)
= 2.16
Hence:
D) < K [1 - e-r(t2-ld] It follows from the conditions established in Section 13.12 that the option should never be
1.5e-0.3333xO.08
1.5e-0.8333xO.08
2.864
The option can be valued using the European pricing formula with:
So
= 50 -
2.864
= 47.136,
K=55,
(J
dl -
_In(47.136/55)+(0.08+0.252/2)1.25
. - - 00
54 5
= 0.4783,
N(d2)
= 0.3692
= 4.17
or $4.17.
'>
.
92
Model
Problem 13.22. The probability that the call option will be exercised is the probability that ST > K where ST is the stock price at time T. In a risk neutral world /2)T, (JVT] The probability that ST > K is the same as the probability that InST > InK. This is I -N InK -lnSo - (r- (J2/2)T
[
(JVf
]
(J2
=N
In (So/ K) + (r - (J2/2)T
[
(JVf
]
= N(d2)
The expected value at time T in a risk neutral world of a derivative security which pays off $100 when ST > K is therefore IOON(d2) From risk neutral valuation the value of the security at time t is
IOOe-rT N(d2)
Problem 13.23.
2 ') If 1= s-_r / 0- then
aI
aS2
s-2r/o-2-1 as = - (J2
2r
a21
al at =0
( )(
(J2
2r
2r
(J2
+1
S-2r/o-2-2
at
I
aI
+r S
aI
a2
This shows that the Black-Scholes equation is satisfied. S-2r/o-2 could therefore be the price of a traded security. Problem 13.24. The answer is no. If markets are efficient they have already taken potential dilution into account in determining the stock price. This argument is explained in Business Snapshot 13.3.
93
Problem 13.25.
I
ffhe Black-Scholes price of the option is given by setting So = 50, K = 50, r = 0.05, 0.25, ~nd T = 5. It is 16.252. From an analysis similar to that in Section 13.10 the cost=to the ~ompany of the options is 10 x 16.252= 12.5 10+3 or about $12.5 per option. The total cost is therefore 3 million times this or $37.5 million. If :themarket perceives no benefits from the options the stock price will fall by $3.75.
(j