 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
C  SN ( d1 )  Ke  RT N ( d 2 )
where
 S   2 
ln  
 R 
T
 K  2 
d1 
 T
and
d 2  d1   T
 Strike price
 Time until expiration
 Stock price
 Volatility
 Dividends
 Risk-free interest rate
 The lower the strike price for a given stock,
the more the option should be worth
◦ Because a call option lets you buy at a
predetermined striking price

C  SN ( d1 )  Ke  RT N ( d 2 )
where
 S   2 
ln  
 R 
T
K  2 
d1 
 T
and
d 2  d1   T
The longer the time until expiration, the more the
option is worth
◦ The option premium increases for more distant
expirations for puts and calls

C  SN ( d1 )  Ke  RT N ( d 2 )
where
 S   2 
ln  
 R 
T
K  2 
d1 
 T
and
d 2  d1   T
 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

C  SN ( d1 )  Ke  RT N ( d 2 )
where
 S   2 
ln  
 R 
T
K  2 
d1 
 T
and
d 2  d1   T
 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

C  SN ( d1 )  Ke  RT N ( d 2 )
where
 S   2 
ln  
 R 
T
K  2 
d1 
 T
and
d 2  d1   T
 A company that pays a large dividend will
have a smaller option premium than a
company with a lower dividend, everything
else being equal
◦ Listed options do not adjust for cash dividends
◦ The stock price falls on the ex-dividend date
 The higher the risk-free interest rate, the
higher the option premium, everything else
being equal
◦ A higher “discount rate” means that the call
premium must rise for the put/call parity equation
to hold
C  SN ( d1 )  Ke  RT N ( d 2 )
where
 S   2 
ln  
 R 
T
K  2 
d1 
 T
and
d 2  d1   T
 Assumptions of the Black and Scholes Model:

1) The stock pays no dividends during the option's

life

Most companies pay dividends to their share holders,

so this might seem a serious limitation to the model
considering the observation that higher dividend
yields elicit lower call premiums. A common way of
adjusting the model for this situation is to subtract
the discounted value of a future dividend from the
stock price.
 Assumptions of the Black and Scholes Model:

2) European exercise terms are used

European exercise terms dictate that the option can only
be exercised on the expiration date.
American exercise term allow the option to be exercised
at any time during the life of the option, making american
options more valuable due to their greater flexibility.
This limitation is not a major concern because very few
calls are ever exercised before the last few days of their
life. This is true because when you exercise a call early,
you forfeit the remaining time value on the call and collect
the intrinsic value. Towards the end of the life of a call,
the remaining time value is very small, but the intrinsic
value is the same.
3) Markets are efficient

This assumption suggests that people cannot

consistently predict the direction of the market or an
individual stock. The market operates continuously with
share prices following a continuous Itô process. To
understand what a continuous Itô process is, you must
first know that a Markov process is "one where the
observation in time period t depends only on the
preceding observation." An Itô process is simply a
Markov process in continuous time. If you were to draw
a continuous process you would do so without picking
the pen up from the piece of paper.
4) No commissions are charged

Usually market participants do have to pay a

commission to buy or sell options. Even floor
traders pay some kind of fee, but it is usually very
small. The fees that Individual investor's pay is
more substantial and can often distort the output
of the model.
 5) Interest rates remain constant and known
 The Black and Scholes model uses the risk-free rate
to represent this constant and known rate
 In reality there is no such thing as the risk-free rate,
but the discount rate on Government Treasury Bills with
30 days left until maturity is usually used to represent it
 During periods of rapidly changing interest rates, these
30 day rates are often subject to change, thereby
violating one of the assumptions of the model
 6) Returns are lognormally distributed
 A variable that has a lognormal distribution can take
any value between zero and infinity.
 Unlike the normal distribution, it is skewed so that the
mean, median, and mode are all different.
 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
 Valuing a Microsoft Call Example

We would like to value a MSFT OCT 70 call.

Microsoft closed at $70.75 on August 23 (58 days
before option expiration). Microsoft pays no
dividends.

We need the interest rate and the stock volatility to

value the call.
 Valuing a Microsoft Call Example (cont’d)

Consulting the “Money Rate” section of the Wall

Street Journal, we find a T-bill rate with about 58
days to maturity to be 6.10%.

To determine the volatility of returns, we need to

take the logarithm of returns and determine their
volatility. Assume we find the annual standard
deviation of MSFT returns to be 0.5671.
 Valuing a Microsoft Call
Example (cont’d) Using the BSOPM:

S   2 
ln     R  T
K   2 
d1 
 T
 70 .75   . 56712

ln     .0610  0.1589
 70   2 
  .2032
.5671 .1589
 Valuing a Microsoft Call Example (cont’d)

Using the BSOPM (cont’d):

d 2  d1   T
 .2032  .2261  .0229
 Valuing a Microsoft Call Example (cont’d)

Using normal probability tables, we find:

N (.2032)  .5805
N (.0029)  .4909
 Valuing a Microsoft Call Example (cont’d)

The value of the MSFT OCT 70 call is:

C  SN (d1 )  Ke RT N (d 2 )
 (.0610)(.1589)
 70.75(.5805)  70e (.4909)
 $7.04
 Valuing a Microsoft Call Example (cont’d)

The call actually sold for $4.88.

The only thing that could be wrong in our

calculation is the volatility estimate. This is because
we need the volatility estimate over the option’s
life, which we cannot observe.
 (a) long position in a stock combined with
short position in a call; (Covered call writing)
 (b) short position in a stock combined with
long position in a call;
 (c) long position in a put combined with long
position in a stock; (Protective Put)
 (d) short position in a put combined with
short position in a stock.
 A spread trading strategy involves taking a position
in two or more options of the same type (i.e., two
or more calls or two or more puts).

 Bull Spreads
can be created by buying a European call option on
a stock with a certain strike price and selling a
European call option on the same stock with a
higher strike price. Both options have the same
expiration date.
Buying a European call
option on a stock with a
certain strike price and
selling a European call
option on the same stock
with a higher strike price.
The profit from the whole
strategy is the sum of the
profits given by the dashed
lines and is indicated by
the solid line. Because a
call price always decreases
as the strike price
increases, the value of the
option sold is always less
than the value of the
option bought. A bull
spread, when created from
calls, therefore requires an
initial investment.
Bull spreads can also be created by buying a European put with
a low strike price and selling a European put with a high strike
price.
An investor who enters
into a bull spread is
hoping that the stock
price will increase. By
contrast, an investor
who enters into a bear
spread is hoping that
the stock price will
decline.

Bear spreads can be

created by buying a
European put with
one strike price and
selling a European
put with another
strike price.
Bear spreads can be created by buying a call with a high
strike price and selling a call with a low strike price.
 A box spread is a combination of a bull call spread with strike
prices K1 and K2 and a bear put spread with the same two
strike prices.

 The payoff from a box spread is always K2 - K1.

 The value of a box spread is therefore always the present
value of this payoff or

Payoff from a box spread

The value of a box spread
If it has a different value there is an arbitrage opportunity.

If the market price of the box spread is too low, it is profitable to buy the
box. This involves buying a call with strike price K1, buying a put with
strike price K2, selling a call with strike price K2, and selling a put with
strike price K1.

If the market price of the box spread is too high, it is profitable to sell
the box. This involves buying a call with strike price K2, buying a put
with strike price K1, selling a call with strike price K1, and selling a put
with strike price K2.
A butterfly spread involves positions in
options with three different strike
prices. It can be created by buying a
European call option with a relatively
low strike price K1, buying a European
call option with a relatively high strike
price K3, and selling two European call
options with a strike price K2 that is
halfway between K1 and K3.
Generally, K2 is close to the current
stock price.