1 Deriving the Black-Scholes Formula

1.1 Call Option

For a European call option, the potential cash-ows at time t with occur if S
t
> K
1. Receive a stock worth S
t
with probability Pr(S
t
> K)
2. Pay K with probability Pr(S
t
> K)
E(call payo) = Pr(S
t
> K) [E(S
t
| S
t
> K) K]
PV
0
[E(call payo)] = e
t
Pr(S
t
> K) [E(S
t
| S
t
> K) K]
1.2 Put Option
For a European put option, the potential cash-ows at time t with occur if S
t
> K
1. Receive K with probability Pr(S
t
< K)
2. Pay (buy a stock worth) S
t
with probability Pr(S
t
< K)
E(put payo) = Pr(S
t
< K) [K E(S
t
| S
t
< K)]
PV
0
[E(put payo)] = e
t
Pr(S
t
< K) [K E(S
t
| S
t
< K)]
1.3 Lognormal Model
In order to develop the Black-Scholes formula, we need to know the following quantities
1. Pr(S
t
> K)
2. E(S
t
|S
t
> K)
Let A be the normally distributed random variable for the stock return.
S
t
= S
0
e
At
where A N(,
2
).
S
t
/S
0
LN(m = ( 1/2
2
)t, v =

t).
1
These parameters are chosen s.t. E(S
t
/S
0
) = e
()t
where is the capital gains rate.
We can see that this is true since E(S
t
/S
0
) = e
m+1/2v
2
= e
(1/2
2
)t+1/2
2
t
= e
()t
For t = 1 the volatility of the stock return equals to the volatility of ln(S
t
/S
0
)
Otherwise, the volatility of ln(S
t
/S
0
) must be adjusted for time, so v =

t
Pr(S
t
< K) = Pr(S
t
/S
0
< K/S
0
)
= Pr(ln(S
t
/S
0
) < ln(K/S
0
))
Since ln(S
t
/S
0
) Normal(m, v
2
), then (ln(S
t
/S
0
) m)/v = Z N(0, 1) where Z is the
standard normal random variable. Therefore,
Pr(S
t
< K) = Pr(Z <
ln(K/S
0
) m
v
)
= Pr(Z < d
2
)
= N(d
2
)
where d
2
=
ln(S
0
/K)+m
v
=
ln(S
0
/k)+(1/2
2
)

t
Since Pr(S
t
< K) = N(d
2
) then
Pr(S
t
> K) = N(d
2
)
To nd E(S
t
| S
t
< K) we use the following formula
E(S
t
| S
t
< K) = PE(S
t
| S
t
< K)/ Pr(S
t
< K)
where PE is the partial expectation from S
t
= 0 to S
t
= K. Note that
PE(S
t
/S
0
| S
t
/S
0
< K/S
0
) = E(S
t
/S
0
)N((ln(K/S
0
) mv
2
)/v)
We can calculate PE(S
t
| S
t
/S
0
< K/S
0
) = S
0
(PE(S
t
/S
0
| S
t
/S
0
< K/S
0
)). This simplies
as follows
PE(S
t
| S
t
< K) = PE(S
t
| S
t
/S
0
< K/S
0
)
= S
0
(PE(S
t
/S
0
| S
t
/S
0
< K/S
0
))
= S
0
E(S
t
/S
0
)N((ln(K/S
0
) mv
2
)/v)
= S
0
e
m+1/2v
2
N((ln(K/S
0
) ( 1/2
2
)t
2
t)/(

t))
= S
0
e
()t
N((ln(K/S
0
) ( + 1/2
2
)t)/(

t))
= S
0
e
()t
N(d
1
)
2
where d
1
=
ln(S
0
/k)+(+1/2
2
)

t
. Notice that d
2
= d
1

t
Since E(S
t
) = PE(S
t
| S
t
> K) + PE(S
t
| S
t
< K) then
PE(S
t
| S
t
> K) = E(S
t
) PE(S
t
| S
t
< K)
= S
0
e
()t
S
0
e
()t
N(d
1
)
= S
0
e
()t
(1 N(d
1
))
= S
0
e
()t
N(d
1
)
Which leads to the following formulas
E(S
t
| S
t
< K) = (S
0
e
()t
N(d
1
))/N(d
2
)
E(S
t
| S
t
> K) = (S
0
e
()t
N(d
1
))/N(d
2
)
1.4 The Black-Scholes Formula
Substituting in the formulas derived above, we nd that for a European call option
E(call payo) = Pr(S
t
> K) [E(S
t
| S
t
> K) K]
= N(d
2
)((S
0
e
()t
N(d
1
))/N(d
2
) K)
= S
0
e
()t
N(d
1
) KN(d
2
)
PV
0
[E(call payo)] = e
t
(S
0
e
()t
N(d
1
) KN(d
2
))
= S
0
e
t
N(d
1
) Ke
t
N(d
2
)
So, for a European call option,
C = S
0
e
t
N(d
1
) Ke
t
N(d
2
) (1.1)
Similarly, substituting in the formulas derived above, we nd that, for a European put option
E(put payo) = Pr(S
t
< K) [K E(S
t
| S
t
< K)]
= N(d
2
)(K (S
0
e
()t
N(d
1
))/N(d
2
))
= KN(d
2
) S
0
e
()t
N(d
1
)
PV
0
[E(call payo)] = e
t
(KN(d
2
) S
0
e
()t
N(d
1
))
= Ke
t
N(d
2
) S
0
e
t
N(d
1
)
3
So, for a European put option,
P = Ke
t
N(d
2
) S
0
e
t
N(d
1
) (1.2)
4