FINA2322EFG Tutorial 10
THE UNIVERSITY OF HONG KONG
FACULTY OF BUSINESS AND ECONOMICS
FINA2322EFG DERIVATIVES
SECOND SEMESTER, 2021-2022
Tutorial 10 Black-Scholes Option Pricing Model
The Black-Scholes Formula
Where
Black-Scholes Assumptions
Assumptions about stock return distribution
The continuously compounded returns on the stock are normally distributed and
The volatility of continuously compounded returns is known and constant
Future dividends are known, either as dollar amount or as a fixed dividend yield
Assumptions about economic environment
The risk-free rate is known and constant
There are no transaction costs or taxes
It is possible to short-sell costlessly and to borrow at the risk-free rate
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FINA2322EFG Tutorial 10
Option Greeks
Option Greeks describe how inputs of Black-Scholes pricing formula changes the value
of the option
Option Greek Definition Effect on Call option Effect on Put option
Change in option price when
Delta Stock price increase by $1
Vega Volatility increases by 1% Always positive
Vega is the same for both call and put
Theta Time to maturity decreases Generally negative, namely time to maturity decreases
by 1 day will decrease the option value.
Exceptional example: deep ITM put or deep ITM Call
with high dividend potential positive theta
Rho Interest rate increases by 1% Call: Positive Put: Negative
Magnitude of Rho becomes larger when time to
maturity increases and when call option become more
ITM
Psi Increase in dividend yield of Call: Negative Put: Positive
1% Magnitude of Psi becomes larger when time to
maturity increases
Gamma Change in delta when stock Positive
price increases by $1 Gamma is the same for both call and put
Other forms of Black-Scholes
For currency/other assets:
Where
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Dollar risk of option
Delta tells how much the option price will change when stock price increases by $1. This
is called the dollar risk of the option (relative to the stock).
When the change is large, delta approximation is not good enough, so the approximate
change would be:
Where is the dollar change in stock price.
Option elasticity
Option elasticity tells the percentage change of the option price when stock price
increases by 1%. This is called the percentage risk of the option.
For call option, option elasticity is greater than or equal to 1.
For put option, option elasticity is smaller than or equal to 0.
Volatility of option
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Implied Volatility
- Implied Volatility means that you calculate volatility by inputting option prices into
the Black-Scholes model.
- A good pricing model should give the same implied volatility from different sets of
observed market value of option.
- In reality, volatility of in, at, and out-of-the-money options are generally different
resulting in the volatility skew (volatility smile).
- For European options with same strike and time to maturity, the implied volatilities
must be the same for call and put because of put-call parity.
Delta-Hedging
Using stocks to offset the risk of the option risk-free return will be earned.
Long call exposure: sell delta unit of stock
Long put exposure: buy delta unit of stock
This is called a delta neutral position, for option buyer, the gamma is still positive.
Drawback: borrow money to buy stocks (financing cost), potential negative theta (i.e. as
time pass, option value decreases, although sometimes theta could be positive)
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Question 1
Suppose S=40, K=40, annualized volatility = 0.3, r=0.08, time to maturity = 91/365. The
stock pays no dividend.
(a) What is the value of the European call option?
(b) When there is a 0.75 increase in stock price, what is the option value calculated
based on delta approximation?
(c) What is the actual increase in option value? Did you underestimate or
overestimate the option value in part (a)?
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(d) Suppose a market maker sells 100 call options (when S=40) and hedge it by
buying stocks.
i. How much stock should he buy? How much in total did he pay for his
portfolio?
ii. Suppose the overnight financing charge is 8% p.a. and after 1 day, the
stock price becomes 40.5. What is the profit or losses of the market
maker?
iii. Re-do part (ii) with a stock price of 45.
iv. Re-do part (ii) with a stock price of 39.75
v. Re-do part (ii) with a stock price of 38
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(e) Suppose the overnight financing charge is 8% p.a. and after 30 days, the stock
price becomes 38. What is the profit or losses of the market maker?
Question 2
Suppose the current exchange rate between HKD and JPY is HKD 0.073 per yen. Find
out the price of a European put option with a strike price of 0.075, a time to maturity of 1
year. The annualized volatility of the exchange rate is 20%. The continuously
compounded risk-free interest rate of HKD is 0.75% p.a. and that of JPY is 0.7% p.a..
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Options are convex?
