AN EMPIRICAL INVESTIGATION OF THE BLACK-SCHOLES (BS) MODEL IN PRICING THE STOCK CALL OPTIONS : (INDIAN BANKING SECTOR PERSPECTIVE)

Abstract

Derivatives are an important class of financial instruments that are central to today’s financial and trade markets. They offer various types of risk protection and allow innovative investment strategies. Derivatives markets have been in existence in India in some form or other for a long time. However, the ban on futures trading of many commodities was lifted starting in the early 2000s, and national electronic commodity exchanges were created. India’s tryst with derivatives began in 2000 when both the NSE and the BSE commenced trading in equity derivatives. In June 2000, index futures became the first type of derivate instruments to be launched in the Indian markets, followed by index options in June 2001, options in individual stocks in July 2001, and futures in single stock derivatives in November 2001. The turnover of derivatives on the NSE increased from Rs 23,654 million in 2000–2001 to Rs. 292,482,211 million in 2010–2011. Derivative products like index futures, stock futures, index options and stock options have become important instruments of price discovery, portfolio diversification and risk hedging in stock markets all over the world in recent times. An option is a financial instrument (Derivative) which gives holder of the option the right to do something, but holder does not have to exercise the right. The price of option is theoretically determined by many models like binomial method, Black –Scholes option pricing formula, put-call parity, Volatility jump model etc. out of which Black Scholes option pricing model is the most popular and widely used throughout the world. Black and Scholes developed closed-form formula to calculate the prices of European calls and puts, based on certain assumptions by showing how to hedge continuously the exposure on the short position of an option. Partial differential equation, derived by them, referred to as the Black–Scholes equation, governs the price of the option over time. Delhi School of Management, DTU Page vi This research, covering a period of five years from 2008 to 2012 gives the modern day perspective of Black Scholes implication on Call options pricing with sample covering the top 5 banks based on ET500 list of top 500 companies in India and compare it with the CNX Bank Nifty index that capture the movement of 12 most traded banks on NSE. This report covers some of the angles of an empirical study such as the sensitivity of the model to its variables, comparing the theoretical value of call option with the actual and understanding the deviation from the current market. Finally, this report tests the validity of the various assumptions of Black – Scholes model.