Appendix 27A: An Alternative Method to Derive The Black-Scholes Option Pricing Model (Related to...
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Transcript of Appendix 27A: An Alternative Method to Derive The Black-Scholes Option Pricing Model (Related to...
Appendix 27A:An Alternative
Method to Derive The Black-Scholes
Option Pricing Model
(Related to 27.5)
ByCheng Few LeeJoseph Finnerty
John LeeAlice C Lee
Donald Wort
• Perhaps it is unclear why it is assumed that investors have risk-neutral preferences when the usual assumption in finance courses is that investors are risk averse.
• It is feasible to make this simplistic assumption because investors are able to create riskless portfolios by combining call options with their underlying securities.
• Since the creation of a riskless hedge places no restrictions on investor preferences other than nonsatiation, the valuation of the option and its underlying asset will be independent of investor risk preferences.
• Therefore, a call option will trade at the same price in risk-neutral economy as it will in a risk-averse or risk-preferent economy.
Appendix 27A: An Alternative Method to Derive The Black-Scholes Option Pricing Model
2
Appendix 27A.1: Assumptions and
the Present Value of the Expected
Terminal Option Price
ByCheng Few LeeJoseph Finnerty
John LeeAlice C Lee
Donald Wort
• In the risk-neutral assumptions of Cox and Ross (1976) and Rubinstein (1976), today’s option price can be determined by discounting the expected value of the terminal option price by the riskless rate of interest.
• Today’s call option price is:(27A.1)
• where
Appendix 27A.1: Assumptions and the Present Value of the Expected Terminal Option Price
exp Max ,0tC rt S X
the market value of the call option;
riskless rate of interest;
time to expiration;
the market value of the underlying stock at time ; and
exercise or striking price.t
C
r
t
S t
X
4
• Assuming that the call option expires in the money, then the present value of the expected terminal option is equal to the present value of the difference between the expected terminal stock price and the exercise price as:
(27A.2)
where is the log-normal density function of• To evaluate the integral in (27A.2), rewrite it as the difference between
two integrals:(27A.3)
Appendix 27A.1: Assumptions and the Present Value of the Expected Terminal Option Price
th StS
exp ,0
exp
t
t t tx
C rt E Max S X
rt S X h S dS
exp
exp exp 1
t t t t tx x
x t
C rt S h S dS X h S dS
E S rt X rt H X
the partial expectation of , truncated from below at ; andx t tE S S x the probability that tH X S X
5
• The terminal stock price can be rewritten as the product of the current price and the t-period log-normally distributed price ratio. So, Equation (27A.3) can also be rewritten as:
(27A.4)
where
Appendix 27A.1: Assumptions and the Present Value of the Expected Terminal Option Price
exp
exp exp 1
t t t t t
x s x s
tx S
S S dS S dSC rt S g X g
S S S S S
S XS rt E X rt G
S S
log normal density function of ;
the partial expextation of , truncated from below at ;
the probability that .
tt
tx S t
t
Sg S SS
SE S S x S
S
XG S S X S
S
6
Appendix 27A.2: Present Value of the Partial Expectation
of the Terminal Stock Price
ByCheng Few LeeJoseph Finnerty
John LeeAlice C Lee
Donald Wort
Appendix 27A.2: Present Value of the Partial Expectation of the Terminal Stock Price
• The right-hand side of Equation (27A.4) is evaluated by considering the two integrals separately.
• The first integral, , can be solved by assuming the return on the underlying stock follows a stationary random walk:
(27A.5)
• Following Garven (1986), it can be transformed into a density function of a normally distributed variable according to the relationship as:
(27A.6)
exp x S tS rt E S S
exptS KtS
ln tS KtS
Kt exptS S Kt
t tS Sg f KtS S
8
Appendix 27A.2: Present Value of the Partial Expectation of the Terminal Stock Price• These transformations allow the first integral in Equation
(27A.4) to be rewritten as:
• Substitution yields:
(27A.7)• Equation (27A.7)’s integrand can be simplified by adding the
terms in the two exponents, multiplying and dividing the result by
ln
exp exp exp tx S x S
SS rt E S rt f Kt Kt t dK
S
1 2 22 2122 expK K Kf Kt t Kt t
1 22
2 212ln
exp exp 2
exp exp
tx S K
K Kx S
SS rt E S rt t
S
Kt Kt t t t dK
212exp K t
9
Appendix 27A.2: Present Value of the Partial Expectation of the Terminal Stock Price
First, expand the term and factor out t so that:
Next, factor out t so:
Now combine the two exponents:
Now, multiply and divide this result by to get:
Next, rearrange and combine terms to get:
(27A.8)
2
KKt t
2 212exp exp K KKt Kt t t
2 2 212exp exp 2 K K KKt t K K
2 2 2 212exp ( 2 2 )K K K Kt K K K
212exp K t
2 2 2 4 4 212exp ( 2 2 )K K K K K Kt K K K
22 4 2 212
22 2 21 1
22
exp 2
exp exp
K K K K K K
K K K K K
t K
t Kt t t
10
Appendix 27A.2: Present Value of the Partial Expectation of the Terminal Stock PriceIn Equation (27A.8),Therefore, Equation (27A.7) becomes:
(27A.9)
• Since the equilibrium rate of return in a risk-neutral economy is the riskless rate:
• So Equation (27A.9) becomes(27A.10)
212exp K K tt E S S
21 22 2 212ln
exp
exp 2 exp ( ) exp
tx S
tK K K Kx S
SS rt E
S
SS E rt t Kt Kt t t
S
exp exp exptSS E rt S rt rt SS
21 22 2 212ln
exp
2 exp
tx S
K K K Kx S
SS rt E
S
S t Kt t t t dK
11
Appendix 27A.2: Present Value of the Partial Expectation of the Terminal Stock Price• To complete the simplification of this part of the Black–Scholes
formula, define a standard normal random variable y:
• The lower limit of integration becomes:
• Further simplify the integrand by noting that the assumption of a risk-neural economy implies:
• Hence,
2 2 1 2K K Ky Kt t t
2 1 2 ,K K KKt t t y 1 2 Kt dK t dy
2 1 2ln K K Kx S t t
212exp exp ,K K t rt 21
2K K t rt
2 21 12 2K K Kt r t
12
Appendix 27A.2: Present Value of the Partial Expectation of the Terminal Stock Price• The lower limit of integration is now:
• Substituting this into Equation (27A.10) and making the transformation to y yields:
• Since y is a standard normal random variable (distribution is symmetric around zero) the limits of integration can be exchanged:
(27A.11)
2 1 2112ln K KS x r t t d
1
2 1 212 exp exp 2 t
x S d
SS rt E S y dy
S
1 1 2212
1
exp exp 2
dt
x S
SS rt E S y dy
S
S N d
13
Appendix 27A.3: Present Value of the Exercise Price under
Uncertainty
ByCheng Few LeeJoseph Finnerty
John LeeAlice C Lee
Donald Wort
Appendix 27A.3: Present Value of the Exercise Price under Uncertainty• Start by making the logarithmic transformation:
• The differential can be written as:
• Therefore,
(27A.12)
• The integrand is now simplified by following the same procedure used in simplifying the previous integral. Define a standard normal random variable Z:
ln tS KtS
exp tSd Kt t dKS
ln
1 2 22 212ln
exp 1 exp
exp 2 exp
X S
K K KX S
X rt G X S X rt f Kt t dK
X rt t Kt t t t dK
1 2K
K
Kt tZ
t
15
Appendix 27A.3: Present Value of the Exercise Price under Uncertainty• Making the transformation from Kt to Z means the lower
limit of integration becomes:
• Again, note that the assumption of a risk-neutral economy implies:
• Taking the natural logarithm of both sides yields:
• Therefore, the lower limit of integration becomes:
1 2
ln K
K
X S t
t
212exp expK K t rt
212 ,K K t rt 21
2K Kt r t
21
2 1 21 21 2
ln K
KK
S x r td t d
t
16
(27A.13)
• Substituting, Equations (27A.11) and (27A.13) into Equation (27A.4) completes the derivation of the Black–Scholes formula:
(27A.14)
• This appendix provides a simple derivation of the Black–Scholes call-option pricing formula.
• Under an assumption of risk neutrality the Black–Scholes formula was derived using only differential and integral calculus and a basic knowledge of normal and log-normal distributions.
Appendix 27A.3: Present Value of the Exercise Price under Uncertainty• Substitution yields:
2
2
1 2212
1 22122
exp 1 exp exp 2
exp exp 2 exp
d
d
x rt G X S x rt Z dZ
x rt Z dZ x rt N d
1 2 exp C S N d X rt N d
17