DerivativesChapter.ppt

MFIN6003 Derivative Securities Faculty of Business and Economics University of Hong Kong Dr. Huiyan Qiu Chapter Outline Introduction to the Black-Scholes formula for pricing European options Applying the formula to other underlying assets Options Greeks: the change in the option price when an input to the formula changes Profit diagram before maturity Implied volatility The Black-Scholes Formula The Black-Scholes option pricing model assumes that the terminal distribution of the stock price is described by a lognormal distribution That is, the logarithms of stock price follows a normal distribution The value of the call option at time to expiration is The Black-Scholes Formula Discounting the expected value of the option using the risk-free rate of interest gives the risk neutral pricing formula Call Options: where and Example: Option Pricing Consider the European call option on the stock of XYZ we discussed in chapter 10. Current stock price S0 = $41 Strike Price K = $40 The volatility of the stock ? = 30% The continuously compounded risk-free interest rate r = 8% The option expires in one year T = 1 XYZ does not pay dividends δ = 0 Using Binomial Pricing Model Consider one year as one period, we found that the option price is $7.8391. (Refer to slides 10-21, 10-22, and 10-23.) Dividing one year into three periods, we found that the option price is $7.074. (Refer to slides 10-30, 10-31, and 10-32.) Using different number n of periods, we have Using Black-Scholes Formula Binomial Pricing Model and BS Formula The binomial tree approximates a lognormal distribution as n goes to infinite The Black-Scholes option pricing model assumes that the terminal distribution of the stock price is described by a lognormal distribution In binomial pricing model, as n goes to infinite, we have the limiting value for the option price which is also given by the Black-Scholes formula. The B-S model is a limiting case of the binomial formula for the price of a Europe