The Black and Scholes Model:

The Black and Scholes Option Pricing Model didn't appear overnight, in fact, Fisher Black
started out working to create a valuation model for stock warrants. This work involved
calculating a derivative to measure how the discount rate of a warrant varies with time and stock
price. The result of this calculation held a striking resemblance to a well-known heat transfer
equation. Soon after this discovery, Myron Scholes joined Black and the result of their work is a
startlingly accurate option pricing model. Black and Scholes can't take all credit for their work,
in fact their model is actually an improved version of a previous model developed by A. James
Boness in his Ph.D. dissertation at the University of Chicago. Black and Scholes' improvements
on the Boness model come in the form of a proof that the risk-free interest rate is the correct
discount factor, and with the absence of assumptions regarding investor's risk preferences.

d1 = In (S/K) + (r + 0.5 SD2) t

SD t

d2 = d1 SD t
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In order to understand the model itself, formula is divided it into two parts. The first part,
SN(d1), derives the expected benefit from acquiring a stock outright. This is found by
multiplying stock price [S] by the change in the call premium with respect to a change in the
underlying stock price [N(d1)]. The second part of the model, Ke(-rt)N(d2), gives the present
value of paying the exercise price on the expiration day. The fair market value of the call option
is then calculated by taking the difference between these two parts.
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.
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 It process. To understand what a continuous It
process is, you must first know that a Markov process is "one where the observation in
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time period t depends only on the preceding observation." An It 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 riskfree 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 U.S. 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 normally distributed: This assumption suggests, returns on the underlying
stock are normally distributed, which is reasonable for most assets that offer options.
With these assumptions holding, suppose there is a derivative security also trading in this market.
We specify that this security will have a certain payoff at a specified date in the future, depending
on the value(s) taken by the stock up to that date. It is a surprising fact that the derivative's price
is completely determined at the current time, even though we do not know what path the stock
price will take in the future. For the special case of a European call or put option, Black and
Scholes showed that "it is possible to create a hedged position, consisting of a long position in
the stock and a short position in the option, whose value will not depend on the price of the
stock". Their dynamic hedging strategy led to a partial differential equation which governed the
price of the option. Its solution is given by the BlackScholes formula.

Results using the BlackScholes model differ from real world prices because of simplifying
assumptions of the model. One significant limitation is that in reality security prices do not
follow a strict stationary log-normal process, nor is the risk-free interest actually known (and is
not constant over time). The variance has been observed to be non-constant leading to models
such as GARCH to model volatility changes. Pricing discrepancies between empirical and the
BlackScholes model have long been observed in options that are far out-of-the-money,
corresponding to extreme price changes; such events would be very rare if returns were lognormally distributed, but are observed much more often in practice.
The formula shows the time left until expiration has a direct positive relationship to the value of
a call or put option. In other words, the more time that is left before expiration, the higher the
expected price will be. Options with 60 days left until expiration will have a higher price than
options that only has 30 days left. This is because the more time that is left, the more of a chance
the underlying stock price will move. But here is what you really need to understand--every
minute that goes by, the cheaper the option price will become. Think of it this way. As time ticks
by and as the days tick by, all things being equal, an option with 60 days left will lose about
1/60th of its value tomorrow when it only has 59 days left. That may not seem like a lot, but
when we get to expiration week and as Monday changes to Tuesday, options lose 1/5 of their
value. As Tuesday slips into Wednesday of expiration week, options lose 1/4 of their value, etc.
so you must be careful! While nothing is certain in the stock market, there is always one thing
that is certain--time ticks by and options lose their value day by day. Please note: Don't take me
literally here as the formula for this "time decay" is more complicated than that. It actually
indicates that the "time decay" accelerates as you get closer to expiration, but I hope you get the
point.
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The formula suggests the historical volatility of the stock also has a direct correlation to the
option's price. By volatility we mean the daily change in a stock's price from one day to the next.
The more a stock price fluctuates within a day and from day to day, then the more volatile the
stock. The more volatile the stock price, the higher the Model will calculate the value of its
options. Think of stocks that are in industries like utilities that pay a high dividend and have been
long-term, consistent performers. Their prices go up steadily as the market moves, and they
move small percentage points by week. But if you compare those utility stocks' price movements
with bio-tech stocks or technology stocks, whose prices swing up and down a few dollars per
day, you will know what volatility is. Obviously a stock whose price swings up and down $5 a
week has a greater chance of going up $5 then a stocks whose price swings up and down $1 per
week. This volatility can be calculated as the variance of the prices over the last 60 days, or 90
days, or 180 days. This becomes one of the weaknesses of the model since past results don't
always predict future performance. Stocks are often volatile immediately after an earnings
release, or after a major press release.
One of the attractive features of the BlackScholes model is that the parameters in the model
other than the volatility (the time to maturity, the strike, the risk-free interest rate, and the current
underlying price) are unequivocally observable. All other things being equal, an option's
theoretical value is a monotonic increasing function of implied volatility.
By computing the implied volatility for traded options with different strikes and maturities, the
BlackScholes model can be tested. If the BlackScholes model held, then the implied volatility
for a particular stock would be the same for all strikes and maturities. In practice, the volatility
surface (the 3D graph of implied volatility against strike and maturity) is not flat.

The typical shape of the implied volatility curve for a given maturity depends on the underlying
instrument. Equities tend to have skewed curves: compared to at-the-money, implied volatility is
substantially higher for low strikes, and slightly lower for high strikes. Currencies tend to have
more symmetrical curves, with implied volatility lowest at-the-money, and higher volatilities in
both wings. Commodities often have the reverse behavior to equities, with higher implied
volatility for higher strikes.
There are variations of the Black-Scholes model those prices for dividend payments (within the
option period). However, because of what is said below, you really can't use Black- Scholes to
estimate values of options for dividend-paying American stocks There is no easy estimator for
American options prices, with the exception of exercising a call option just prior to an exdividend date, "it is never optimal to exercise an American call option on a non dividend paying
stock before the expiration date." The Black-Scholes model can be used to estimate "implied
volatility". To do this, however, given an actual option value, you have to iterate to find the
volatility solution. This procedure is easy to program and not very time-consuming in even an
Excel version of the model. For those of you interest in another elegant implied volatility model.
There you will see a role played by delta and Vega, but again you would have to iterate to get the
value of the sensitivity of the call to the strike price.
Advantages of Black and Scholes Model
Easy to calculate: A useful approximation, particularly when analyzing the direction in which
prices move when crossing critical points a robust basis for more refined models reversible, as
the model's original output, price, can be used as an input and one of the other variables solved
for; the implied volatility calculated in this way is often used to quote option prices.

Useful approximation: although volatility is not constant, results from the model are often
helpful in setting up hedges in the correct proportions to minimize risk. Even when the results
are not completely accurate, they serve as a first approximation to which adjustments can be
made.
Basis for more refined models: The BlackScholes model is robust in that it can be adjusted to
deal with some of its failures. Rather than considering some parameters (such as volatility or
interest rates) as constant, one considers them as variables, and thus added sources of risk. This is
reflected in the Greeks (the change in option value for a change in these parameters, or
equivalently the partial derivatives with respect to these variables), and hedging these Greeks
mitigates the risk caused by the non-constant nature of these parameters. Other defects cannot be
mitigated by modifying the model, however, notably tail risk and liquidity risk, and these are
instead managed outside the model, chiefly by minimizing these risks and by stress testing.
Explicit modeling: this feature means that, rather than assuming a volatility a priori and
computing prices from it, one can use the model to solve for volatility, which gives the implied
volatility of an option at given prices, durations and exercise prices. Solving for volatility over a
given set of durations and strike prices one can construct an implied volatility surface. In this
application of the BlackScholes model, a coordinate transformation from the price domain to
the volatility domain is obtained. Rather than quoting option prices in terms of dollars per unit
(which are hard to compare across strikes and tenors), option prices can thus be quoted in terms
of implied volatility, which leads to trading of volatility in option markets.

Bibliography
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Internet:
http://bradley.bradley.edu/~arr/bsm/pg04.html
http://www.call-options.com/definition/black-scholes.html
www.wikipedia.com