Chapter 14

Options, Futures, And Other
Derivatives
† Options, Futures, and Other Derivatives, 8th Edition, Copyright © John C. Hull
Chapter 14
The Black-Scholes-Merton
Model
Chapter 14
The Black-Scholes-Merton Model
Lognormal Property of Stock Prices

(1) Let us consider a stock price S in which µ and σ are defined as
µ : Expected return on stock per year
σ : Volatility of the stock price per year.
(2) The return of the stock price in time ∆t is normally
distributed with mean µ∆t and variance σ 2 ∆t, so that
∆S
∼ φ(µ∆t, σ 2 ∆t).
S
Chapter 14

(3) The stock price under the geometric Brownian motion implies
that
σ2

2
ln ST − ln S0 ∼ φ µ − T,σ T
2
and
σ2

2
ln ST ∼ φ ln S0 + µ − T,σ T .
2
(4) Since ln ST is normally distributed, ST has a lognormal
distribution.
Chapter 14

(5) The lognormal probability density function f (x; µ, σ) is given
by
1 (ln x−µ)2
f (x; µ, σ) = √ e − 2σ2 for x > 0.
x 2πσ 2
(6) The expected value and the variance of the stock price are
E (ST ) = S0 e µT
and 2
Var (ST ) = S02 e 2µT e σ T − 1 ,
respectively.
Chapter 14
Lognormal Distribution
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
0 1 2 3 4 5 6 7 8 9 10
Figure: The plot of the lognormal probability density function associated

with the standard normal distribution.
Chapter 14
The Distribution of the Rate of Return

(1) Let x be the continuously compounded rate of return per
annum given by
ST = S0 e xT
1 ST
⇒ x = ln .
T S0
(2) The continuously compounded rate of return x is normally
distributed with
σ2
2
σ
x ∼φ µ− , .
2 T
Chapter 14
The Expected Return

(1) The expected value of the stock price ST is
E (ST ) = S0 e µT .
The expected return of the stock price is µ.

(2) The mean of the continuously compounded rate of return x is
σ2
E (x) = µ − ,
2
which is called the expected continuously compounded
return on the stock price.
Chapter 14
The Expected Return

(3) For a very short time ∆t, the average of the return on the
stock is close to µ since
∆S
∼ φ(µ∆t, σ 2 ∆t).
S
(2) The expected return over the whole period expressed with a
2
compounding interval of ∆t is close to µ − σ2 .
Chapter 14
Mutual Fund Returns
Figure: Options, Futures, And Other Derivatives, Eight Edition, John C.

Hull, Pearson
Chapter 14
Mutual Fund Returns

(1) Suppose that returns in successive years are 15%, 20%, 30%,
−20%, and 25% (ann. comp.).
(2) The arithmetic mean of the returns is 14%.
(3) The returned that would actually be earned over the five years
(the geometric mean) is 12.4% (ann. comp.).
(4) The arithmetic mean of 14% is analogous to µ.
σ2
(5) The geometric mean of 12.4% is analogous to µ − 2 .
Chapter 14
The Volatility
(1) The volatility is the standard deviation of the continuously
compounded rate of return in 1 year.
(2) The standard deviation of the
√ return in a short time period
time ∆t is approximately σ ∆t.
(3) If a stock price is $50 and its volatility is 25% per year, what
is the standard deviation of the price change in one day?
Chapter 14
Estimating Volatility from Historical

Data
(1) Take observations S0 , S1 , . . . , Sn at intervals of τ years (e.g.
for weekly data τ = 1/52).
(2) Calculate the continuously compounded return in each
interval as
Si
ui = ln .
Si−1
(3) Calculate the standard deviation s of the values ui .
(4) The historical volatility estimate is
s
σ̂ = √ .
τ
Chapter 14
Nature of Volatility
(1) Volatility is usually much greater when the market is open
(i.e. the asset is trading) than when it is closed.
(2) For this reason time is usually measured in “trading days” not
calendar days when options are valued.
(3) It is assumed that there are 252 trading days in one year for
most assets.
Chapter 14
Example
(1) Suppose it is April 1 and an option lasts to April 30 so that
the number of days remaining is 30 calendar days or 22
trading days.
(2) The time to maturity would be assumed to be
22/252 = 0.0873 years.
Chapter 14
The Concepts of the Underlying

Black-Scholes-Merton Model
(1) The option price and the stock price depend on the same
underlying source of uncertainty.
(2) We can form a portfolio consisting of the stock and the option
which eliminates this source of uncertainty.
(3) The portfolio is instantaneously riskless and must
instantaneously earn the risk-free rate.
(4) This leads to the Black-Scholes-Merton differential equation.
Chapter 14
The Derivation of the Black-Scholes

Differential Equation
∆S = µS∆t + σS∆z,
1 2 2 ∂2f

∂f ∂f ∂f
∆f = µS + + σ S 2
∆t + σS ∆z.
∂S ∂t 2 ∂S ∂S
We set up a portfolio consisting of
−1 : derivative
∂f
+ : shares.
∂S
This gets rid of the dependence on ∆z.
Chapter 14

Differential Equation (cont’d)
The value of the portfolio Π is given by
∂f
Π = −f + S.
∂S
The change in its value in time ∆t is given by
∂f
∆Π = −∆f + ∆S.
∂S
Chapter 14

The return on the portfolio must be the risk-free rate. Hence
∆Π = r Π∆t
and
∂f ∂f
−∆f + ∆S = r −f + S ∆t.
∂S ∂S
We substitute for ∆f and ∆S in this equation to get the
Black-Scholes differential equation
∂f 1 ∂2f ∂f
+ σ 2 S 2 2 + rS − rf = 0.
∂t 2 ∂S ∂S
Chapter 14

Chapter 14
The Differential Equation

(1) Any security whose price is dependent on the stock price
satisfies the differential equation.
(2) The particular security being valued is determined by the
boundary conditions of the differential equation.
(3) In a forward contract the boundary condition is f = S − K
when t = T .
(4) The solution to the equation is
f = S − Ke −r (T −t) .
Chapter 14
The Black-Scholes-Merton Formulas
The price c of a European call and the price p of a European put
are
c = S0 e −dT N(d1 ) − Ke −rT N(d2 )

p = Ke −rT N(−d2 ) − S0 e −dT N(−d1 ),
where N(x) is the cumulative density function for a standardized

normal distribution and the parameters d1 and d2 are given by
ln(S0 /K ) + (r − d + σ 2 /2)T
d1 = √
σ T
ln(S0 /K ) + (r − d − σ 2 /2)T √
d2 = √ = d1 − σ T .
σ T
Chapter 14
The N(x) Function
N(x) is the probability that a normally distributed variable with a
mean of zero and a standard deviation of 1 is less than x.
Figure: Options, Futures, And Other Derivatives, Eight Edition, John C.

Hull, Pearson
Chapter 14
Properties of Black-Scholes Formula

(1) As S0 becomes very large c tends to S0 − Ke −rT and p tends
to zero.
(2) As S0 becomes very small c tends to zero and p tends to
Ke −rT − S0 .
(3) What happens as σ becomes very large?
(4) What happens as T becomes very large?
Chapter 14
Risk-Neutral Valuation
(1) The variable µ does not appear in the Black-Scholes-Merton
differential equation.
(2) The equation is independent of all variables affected by risk
preference.
(3) The solution to the differential equation is therefore the same
in a risk-free world as it is in the real world.
(4) This leads to the principle of risk-neutral valuation.
Chapter 14
Applying Risk-Neutral Valuation

(1) Assume that the expected return from the stock price is the
risk-free rate.
(2) Calculate the expected payoff from the option.
(3) Discount at the risk-free rate.
Chapter 14
Valuing a Forward Contract with

Risk-Neutral Valuation
(1) Payoff is ST − K .
(2) Expected payoff in a risk-neutral world is S0 e rT − K .
(3) Present value of expected payoff is

e −rT S0 e rT − K = S0 − Ke −rT .

Chapter 14

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Options, Futures, And Other

Lognormal Property of Stock Prices

Lognormal Property of Stock Prices

Lognormal Property of Stock Prices

Figure: The plot of the lognormal probability density function associated

The Distribution of the Rate of Return

The Expected Return

The expected return of the stock price is µ.

The Expected Return

Figure: Options, Futures, And Other Derivatives, Eight Edition, John C.

Mutual Fund Returns

Estimating Volatility from Historical

The Concepts of the Underlying

The Derivation of the Black-Scholes

We set up a portfolio consisting of

The Derivation of the Black-Scholes

The Derivation of the Black-Scholes

The Derivation of the Black-Scholes

The Differential Equation

c = S0 e −dT N(d1 ) − Ke −rT N(d2 )

where N(x) is the cumulative density function for a standardized

Figure: Options, Futures, And Other Derivatives, Eight Edition, John C.

Properties of Black-Scholes Formula

Applying Risk-Neutral Valuation

Valuing a Forward Contract with

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