Black model

Overview

The Black model (also known as the Black-76 model) is a variant of the Black–Scholes option pricing model. Its primary applications are for pricing options on future contracts, bond options, interest rate cap and floors, and swaptions. It was first presented in a paper written by Fischer Black in 1976. It assumes that the relevant forward or futures price follows a log-normal distribution under a risk-neutral pricing measure and that the option payoff is discounted at a constant risk-free interest rate. In its standard form the model is used to price European call and put options on commodity futures, bond options, and interest rate caps and floors and swaptions.

Background and relation to the Black–Scholes model

In 1976 Black published an article titled The pricing of commodity contracts in the Journal of Financial Economics in which he adapted the Black–Scholes approach to European options on commodity futures. In this setting, the underlying economic quantity is a futures price or a forward price for delivery of a commodity at a future date, rather than the spot price of a traded share. The Black model keeps the main structural assumptions of the original Black–Scholes model. In particular, under a risk-neutral measure the relevant forward or futures price is modelled as a log-normal process with constant volatility. Standard relationships between spot and forward prices imply that the familiar Black–Scholes formula can be recovered from the Black model when the forward price is expressed in terms of the spot price and carrying costs. For this reason the Black model is often described as a version of Black–Scholes specialised to forwards and futures, and many derivations treat it as an application of the general Black–Scholes machinery rather than as a separate theory. Details of the Black–Scholes derivation are covered in the article on the Black–Scholes model. Options on forward rates, bond options, caps, floors and swaptions are frequently priced and quoted by assuming log-normal dynamics for the relevant forward or swap rate and then applying the Black formula. In this context the associated volatility parameter is usually reported as a Black implied volatility. The LIBOR market model extends the basic idea by specifying joint dynamics for a family of forward rates while retaining a Black-style formula for individual caplets, floorlets and swaptions.

The Black formula

Under the assumptions of the Black model, the arbitrage free price at time zero of a European call option on a futures contract can be written in terms of the current futures price and the risk-free discount factor. Let

F

{\displaystyle F}

denote the current futures price for delivery at time

T ′

{\displaystyle T'}

, let

K

{\displaystyle K}

be the strike price of the option, let

T ≤

T ′

{\displaystyle T\leq T'}

be the time to option expiry, let

r

{\displaystyle r}

be the continuously compounded risk-free interest rate, and let

σ

{\displaystyle \sigma }

be the volatility of the futures price, then:

Modelling assumptions

Under a risk-neutral pricing measure the futures or forward price process

(

F

t

)

0 ≤ t ≤ T

{\displaystyle (F_{t})_{0\leq t\leq T}}

is modelled as a geometric Brownian motion with constant volatility and zero drift. In differential form this can be written as

d

F

t

= σ

F

t

d

W

t

,

0 ≤ t ≤ T ,

{\displaystyle \mathrm {d} F_{t}=\sigma F_{t}\,\mathrm {d} W_{t},\quad 0\leq t\leq T,}

Derivation

Let

X

T

{\displaystyle X_{T}}

denote a payoff at time

T

{\displaystyle T}

. Under the risk-neutral measure the time zero price of this payoff is given by the discounted expectation

Price

0

=

e

− r T

E

[

X

T

] ,

{\displaystyle {\text{Price}}_{0}=e^{-rT}\mathbb {E} [X_{T}],}

where

Applications

The Black model is widely used for options on futures and forwards in commodity and fixed income markets.

Futures and commodity options

In commodity and financial futures markets the Black model underlies the pricing of exchange traded and over the counter options on futures. Examples include options on crude oil futures, metal futures and equity index futures. Exchanges and dealers often treat the volatility parameter in the Black formula as the primary quoted quantity and convert between option prices and so called Black implied volatilities when comparing contracts with different strikes and maturities. Volatility surfaces built from these implied volatilities provide a way to summarise option prices across a range of expiries and strike levels.

Caps, floors and bond options

In fixed income markets the Black framework is used for bond options and for caps and floors. A cap or floor can be decomposed into individual caplets or floorlets. Each component has a payoff that depends on a single forward interest rate over a specified accrual period. Under the assumption that the relevant forward rate is log-normal under an appropriate pricing measure each caplet or floorlet is valued by applying the Black formula to that forward rate and scaling by the notional and accrual factor. Market participants quote cap and floor prices in terms of Black implied volatilities for standard maturities and strike levels.

Swaptions and forward rate models

European swaptions are treated in a similar spirit. The underlying variable is a forward swap rate and prices for swaptions across different maturities and tenors are commonly quoted in terms of Black implied volatilities. In log-normal forward rate models the Black formula remains the basic building block for valuing individual caplets, floorlets and swaptions. The model specifies joint dynamics for a family of forward rates and is calibrated so that it reproduces observed Black or normal implied volatility surfaces used in swaption and cap markets.

Inflation-linked caps and floors on RPI for pension increases

In the United Kingdom many defined benefit pension schemes provide increases that are linked to the RPI or CPI, subject to an annual floor and cap, a structure known as limited price indexation and often written as LPI(

a

{\displaystyle a}

,

b

{\displaystyle b}

). A typical benefit might promise annual increases in line with RPI subject to a floor of

0 %

{\displaystyle 0\%}

and a cap of

5 %

{\displaystyle 5\%}

, denoted LPI(0,5). These guarantees can be valued or hedged using inflation derivatives such as RPI swaps and inflation caps and floors. For a single year let

I

{\displaystyle I}

denote the random annual RPI inflation rate expressed as a proportion. With a floor

a

{\displaystyle a}

and cap

b

Limitations and extensions

In liquid markets, option prices across strikes and maturities typically display volatility smiles and skews, so a single volatility parameter in the Black formula cannot reproduce the full implied volatility surface for caps, floors or swaptions. The log-normal specification also implies that forward rates, futures prices and swap rates remain strictly positive. In periods of very low or negative interest rates this conflicts with observed market behaviour and the standard Black formula can misprice options by assigning zero probability to negative outcomes that actually occur. To deal with this, practitioners often use shifted log-normal models or adopt a normal model such as the Bachelier model, which allows the underlying rate to take negative values. Local volatility and stochastic volatility models, including the SABR volatility model, are used to fit observed cap and swaption volatility smiles. Multi-factor term structure models such as the LIBOR market model specify joint dynamics for a family of forward rates and are calibrated so that their prices match the Black or normal implied volatilities quoted in the market.

See also

Financial mathematics Black–Scholes Description of applications Bond option § Valuation Futures contract § Options on futures Interest rate cap and floor § Black model Swaption § Valuation