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## Black-ScholesTheBlack-Scholes model, often simply Black-Scholes, is a model of the varying price over time of financial instruments, and in particular stocks. The Black-Scholes formula is a mathematical formula for the theoretical value of European put and call stock options that may be derived from the assumptions of the model. The equation was derived by Fisher Black and Myron Scholes; the paper that contains the result was published in 1973. They built on earlier research by Paul Samuelson and Robert Merton. The fundamental insight of Black and Scholes was that the call option is implicitly priced if the stock is traded. The use of the Black-Scholes model and formula is pervasive in financial markets.
## The modelThe key assumptions of the Black-Scholes model are: - The price of the underlying instrument is a geometric Brownian motion, in particular with constant drift and volatility.
- It is possible to short sell the underlying stock.
- There are no riskless arbitrage opportunities.
- Trading in the stock is continuous.
- There are no transaction costs.
- All securities are perfect divisible (e.g. it is possible to buy 1/100th of a share).
- The risk free interest rate is constant, and the same for all maturity dates.
## The formula
The above lead to the following formula for the price of a call on a stock currently trading at price
- .
*N*is the cumulative Normal distribution function.
## Extensions of the formulaThe above option pricing formula is used for pricing European put and call options on non-dividend paying stocks. The Black-Scholes model may be easily extended to options on instruments paying dividends. For options on indexes (such as the FTSE) where each of 100 constituent companies may pay a dividend twice a year and so there is a payment nearly every business day, it is reasonable to assume that the dividends are paid continuously. The dividend payment paid over the time period is then modelled as
q. Under this formulation the arbitrage-free price under the Black-Scholes model can be shown to be
Exactly the same formula is used to price options on foreign exchange rates, except now q plays the role of the foreign risk-free interest rate and S is the spot exchange rate. This is the It is also possible to extend the Black-Scholes framework to options on instruments paying discrete dividends. This is useful when the option is struck on a single stock. A typical model is to assume that a proportion of the stock price is paid out at pre-determined times . The price of a stock is then modelled as
American options are more difficult to value, and a choice of models is available (for example Whaley, binomial options model). ## Formula derivationIn this section we derive the partial differential equation (PDE) at the heart of the Black-Scholes model via a no-arbitrage or delta-hedging argument. The presentation given here is informal and we do not worry about the validity of moving between dt meaning an small increment in time and dt as a derivative. As in the model assumptions above we assume that the underlying (typically the stock) follows a geometric Brownian motion. That is,
Black-Scholes PDE
We now show how to get from the general Black-Scholes PDE to a specific valuation for this option. Consider as an example the Black-Scholes price of a call on a stock currently trading at price
- for all t
- as
_{0} is the initial condition defined in the line above. This integral may be further transformed until we obtain:
Substituting v for u and the V for v, we finally obtain the value of a call option in terms of the Black-Scholes parameters:
- .
*N*is the cumulative Normal distribution function.
Above we used the method of arbitrage-free pricing ("delta-hedging") to derive a PDE governing option prices given the Black-Scholes model. It is also possible to use a risk neutrality argument. This latter method gives the price as the expectation of the option payoff under a particular probability measure, called the risk-neutral measure, which differs from the real world measure.
- The risk neutrality argument:
- Arbitrage-free pricing:
- Detailed solutions of the Black-Scholes equation or a further treatment.
## Black-Scholes in practice
The use of the Black-Scholes formula is pervasive in the markets. In fact the model has become such an integral part of market conventions that it is common practice for the implied volatility rather than the price of an instrument to be quoted. (All the parameters in the model However, the Black-Scholes model can not be modelling the real world completely accurately. If the Black-Scholes model held, then the implied volatility of an option on a particular stock would be constant, even as the strike and maturity varied. In practice, the volatility surface (the two-dimensional graph of implied volatility against strike and maturity ) is not flat. In fact, in a typical market, the graph of strike against implied volatility for a fixed maturity is typically smile-shaped (see volatility smile). That is, at-the-money (the option for which the underlying price and strike co-incide) the implied volatility is lowest; out-of-the-money or in-the-money the implied volatility tends to be higher. The reason for this smile is still the subject of much speculation and research. A prominent proposed explanation is that the market in options away from the money is less liquid than at-the-money: traders demand a premium for these options because they know it may be more difficult to reverse an option position in illiquid markets. This view is consistent with the fact the smile was first observed shortly after the stock market crash of 1987. Before this crash, the first and most severe since the introduction of options, the Black-Scholes was more widely trusted. ## See also- Binomial options model, which is able to handle a variety of conditions for which Black-Scholes cannot be applied.
- Black model a variant (and more general form) of the Black-Scholes option pricing model.
- Financial mathematics, which contains a list of related articles.
## External links and references- Black, F. and M. Scholes, "The Pricing of Options and Corporate Liabilities" Journal of Political Economy 81, 1973, 637-654. Black and Scholes' original paper.
- Merton, Robert C., "Theory of rational option pricing", Bell Journal of Economics and Management Science 4 (1), 1973, 141-183.
- Trillion Dollar Bet - Companion Web site to a Nova episode originally broadcast on February 8, 2000.
*"The film tells the fascinating story of the invention of the Black-Scholes Formula, a mathematical Holy Grail that forever altered the world of finance and earned its creators the 1997 Nobel Prize in Economics."* - The Sveriges Riksbank (Bank of Sweden) Prize in Economic Sciences in Memory of Alfred Nobel for 1997
- Options pricing using the Black-Scholes Model, Investment Basics: XLII., The Investment Analysts Society of South Africa
- The Black Scholes Option Pricing Model, optiontutor
- Generalized Black-Scholes Calculator, Written by Espen Gaarder Haug (himself) 1998
- Further information on pricing options on continuous dividend-paying stocks
- Further information on pricing options on foreign exchange options.
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