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CHAPTER 15
The Black-Scholes-Merton Model
Practice Questions
Problem 15.1.
What does the Black–Scholes–Merton stock option pricing model assume about the probability distribution of the stock price in one year? What does it assume about the probability distribution of the continuously compounded rate of return on the stock during the year?
The Black–Scholes–Merton option pricing model assumes that the probability distribution of the stock price in 1 year (or at any other future time) is lognormal. It assumes that the continuously compounded rate of return on the stock during the year is normally distributed.
Problem 15.2.
The volatility of a stock price is 30% per annum. What is the standard deviation of the percentage price change in one trading day?
The standard deviation of the percentage price change in time ?t is ?
where ? is
?tthe volatility. In this problem ? ? 0?3
?t
?t?t ? 1? 252 ? 0?004 so that ? ? 0?3 0?004 ? 0?019 or 1.9%.
?t
Problem 15.3.
Explain the principle of risk-neutral valuation.
The price of an option or other derivative when expressed in terms of the price of the underlying stock is independent of risk preferences. Options therefore have the same value in a risk-neutral world as they do in the real world. We may therefore assume that the world is risk neutral for the purposes of valuing options. This simplifies the analysis. In a risk-neutral world all securities have an expected return equal to risk-free interest rate. Also, in a
risk-neutral world, the appropriate discount rate to use for expected future cash flows is the risk-free interest rate.
Problem 15.4.
Calculate the price of a three-month European put option on a non-dividend-paying stock with a strike price of $50 when the current stock price is $50, the risk-free interest rate is 10% per annum, and the volatility is 30% per annum.
In this case S
0
? 50 , K ? 50 , r ? 0?1, ? ? 0?3, T ? 0?25 , and
d ? ln(50 ? 50) ? (0?1? 0?09 ? 2)0?25 ? 0?2417
1 0?3 0?25
d
2
The European put price
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