Black-Scholes Option Valuation

In order to continue on and use the Black-Scholes

Option Valuation model we must assume that:
The risk free interest rate is constant over the life of the
option
Stock price volatility as measured by the stocks
standard deviation is constant over the life of the option

Using Black-Scholes we will also discuss the

Intrinsic Value of an option
Intrinsic value is the stock price minus the exercise
price or the profit that could be attained by immediate
exercise of an in-the-money call option
The actual value of an in-the-money call option will
approach the intrinsic value of the option as the stock
price increases
Intermediate Investm

Black-Scholes Option Valuation

The Black-Scholes formula in a world with no
dividends is
C0 = S0N(d1) Xe-rTN(d2)
Where:
N(d) is, loosely speaking, the probability thathte option
will expire in the money (cumulative Normal
distribution see pp. 552-3)
C0 is the current option value
e = 2.7128
d1 = ln(S0/X) + (rf + SD2/2)T ) / (SD * SQRT of T)
d2 = d1 (SD * SQRT T)
Intermediate Investm

Black-Scholes Option Valuation

Inputs needed to use B-S method are:

S0 = the current stock price

X = the exercise price
r = the risk free interest rate
T = Time to maturity
SD = stocks Standard Deviation

The first 4 variables can be known with certainty, while

standard deviation can be estimated based on historical
data. We have already used th e first 4 inputs in the
Binomial Pricing Model
Intermediate Investm

Black-Scholes Option Valuation

To review, N(d) is the probability that a random draw from
a normal distribution will be less than d in a cumulative
normal distribution, or loosely speaking, the probability
that the option will expire in the money
If both N(d) terms are close to 1, you can assume the
option will expire in the money and the call will be
exercised
In this case, C0 = S0 Xe-rT
If S0 X is the Intrinsic value, the above is the Adjusted
Intrinsic Value
If both N(d) terms are close to 0, then the value of C0 will
be 0
Intermediate Investm

Implied Volatility
B-S can be used to find the value of options
If we assume that B-S is an accurate method of
pricing options, we can also use B-S, given the
market price of the option, to predict the unknown
variable
Since Standard deviation can be estimated but not
known with certainty, B-S can be used to show the
underlying assumption regarding volatility that
must be used in the markets pricing of the option

Intermediate Investm

Black-Scholes Example
Given the following information, use BlackScholes to price the option:

Stock Price = $100.00

Exercise price = $95.00
Risk free rate = 10%
Dividend Yield = 0%
Time to expiration = 3 months
Standard deviation of stock = 50%

What is the value of d1? d2?

Intermediate Investm

Black-Scholes Example
Given the following information, use BlackScholes to price the option:

Stock Price = $14.00

Exercise price = $10.00
Risk free rate = 5%
Dividend Yield = 0%
Time to expiration = 6 months
Standard deviation of stock = 50%

What is the value of d1? d2?

Intermediate Investm

Using Black Scholes to Value a Put

In addition to Put-Call parity you can also use B-S
to value a Put

P = Xe-rT * [1-N(d2)] S0 * [1-N(d1)]

Intermediate Investm

Using Black Scholes to Value a Put - Example

Assume the following:

Time to maturity = 6 months

Standard deviation = 50% per year
Exercise price = $50
Stock price = $50
Risk free rate = 10%
Value of a call option = $8.13

Value the Put using Put-Call Parity

Value the Put using Black- Scholes
Intermediate Investm

Black-Scholes In-class Exercise

Consider the following:
On February 2, 1996 Microsoft stock closed at
$93/share
The one year T-bill rate was 4.82%
Standard deviation on the stock was approximately
32%

Use Black-Scholes to price both a put and a call

where:
Exercise price = $100
Maturity is April 1996 (77 days)
Intermediate Investm

10

Black-Scholes In-class Exercise

Consider the following:
On December 20, 1996 Compaq stock closed at
$76.75/share
The 6 month T-bill rate was 5.50%
Standard deviation on the stock was approximately
41%

Use Black-Scholes to price both a put and a call

where:
Exercise price = $75
Maturity is April 1997 (120 days)
Intermediate Investm

11

Review of Black-Scholes Assumptions and

Approach
Black-Scholes Assumptions are:
Perfect Capital Markets, no taxes, transaction costs etc.
Stock does not pay a dividend over the course of the
option (although the formula can be adjusted to include
dividends)
The Risk free rate and the variance of the stock are:
Constant
Completely predictable

Stock prices are continuous

Intermediate Investm

12

Review of Black-Scholes Assumptions and

Approach
The Black-Scholes approach is to:
Use a stock and bond to replicate eh value of the call
No arbitrage pricing
Formula is very well known and actually used

Intermediate Investm

13