Mathematical Methods for Financial Markets

by M. Jeanblanc, M. Yor and M. Chesney

Springer Verlag 2009, Chapter 2.
Denition 1.4.1.1
The continuous process X is said to be a standard Brownian motion, if:
1. The process X has stationary and independent increments
2. For any t > 0, the r.v. X
t
follows the N(0, t) law
3. X
0
= 0
2.3.1 The Model
The Black and Scholes model assumes that there is a riskless asset with interest
rate r and that the dynamics of the price of the underlying asset are
dS
t
= S
t
(dt + dB
t
)
under the historical probability P. Here, the risk-free rate r, the trend and the
volatility are supposed to be constant (note that, for valuation purposes, may
be an F-adapted process). In other words, the value at time t of the risky asset is
S
t
= S
0
exp(t +B
t

2
2
t).
Indeed, by applying Itos lemma to the function ln():
d ln(S
t
) =
1
S
t
dS
t
+
1
2
_

1
S
2
t
_

2
S
2
t
dt =
_


2
2
_
dt +B
t
Proposition 2.3.1.2
In the Black and Scholes model, there exists a unique e.m.m. Q, precisely Q|
F
t
=
exp(B
t

1
2

2
t)P|
F
t
where =
r

is the risk-premium. The risk-neutral dy-

namics of the asset are
dS
t
= S
t
(rdt + dW
t
)
where W is a Q-Brownian motion.
Theorem 2.3.2.1 Black and Scholes formula:
Let dS
t
= S
t
(dt + dB
t
) be the dynamics under the historical probability P of
the price of a risky asset and assume that the interest rate is a constant r. The
value at time t of a European call with maturity T and strike K is C
E
(x, t) where
C
E
(x, t) = xN
_
d
1
_
x
Ke
r(Tt)
, T t
__
(1)
Ke
r(Tt)
N
_
d
2
_
x
Ke
r(Tt)
, T t
__
1
where N(d
i
) =
_
d
i

2
e

1
2
y
2
dy for i = 1, 2
d
1
(y, u) =
1

2
u
ln(y) +
1
2

2
u, d
2
(y, u) = d
1
(y, u)

2
u,
where we have written

2
so that the formula does not depend on the sign of .
Proof:
Let (, ) be a replicating portfolio and
V
t
=
t
C
t
+
t
S
t
We assume that the value of this portfolio satises the self-nancing condition, i.e.,
dV
t
=
t
dC
t
+
t
dS
t
Then, assuming that C
t
is a smooth function of the underlying value and of time,
i.e., C
t
= C(S
t
, t), by relying on Itos lemma the dierential of V is obtained:
dV
t
=
t
(
x
CdS
t
+
t
Cdt +
1
2

2
S
2
t

xx
Cdt) +
t
dS
t
,
where
t
C (resp.
x
C ) is the derivative of C with respect to the second variable
(resp. the rst variable) and where all the functions C,
x
C, . . . are evaluated at
(S
t
, t). From
t
= (V
t

t
S
t
)/C
t
, we obtain
dV
t
= ((V
t

t
S
t
)(C
t
)
1

x
C +
t
)S
t
dB
t
(2)
+
_
V
t

t
S
t
C
t
_

t
C +
1
2

2
S
2
t

xx
C +S
t

x
C
_
+
t
S
t

_
dt.
If this replicating portfolio is risk-free, one has dV
t
= V
t
rdt: the martingale part
on the right-hand side vanishes, which implies

t
= (S
t

x
C C
t
)
1
V
t

x
C
and
V
t

t
S
t
C
t
_

t
C +
1
2

2
S
2
t

xx
C + S
t

x
C
_
+
t
S
t
= rV
t
. (3)
Using the fact that
t

x
C +
t
= 0, i.e.
(V
t

t
S
t
)(C
t
)
1

x
C +
t
= 0
we obtain that the term which contains , i.e.,
S
t
_
V
t
S
t
C
t

x
C +
t
_
2
vanishes. After simplications, we obtain
rC =
_
1 +
S
t

x
C
C S
t

x
C
__

t
C +
1
2

2
x
2

xx
C
_
(4)
=
C
C S
t

x
C
_

t
C +
1
2

2
x
2

xx
C
_
(5)
and therefore the PDE evaluation

t
C(x, t) + rx
x
C(x, t) +
1
2

2
x
2

xx
C(x, t)
= rC(x, t), x > 0, t [0, T[ (6)
is obtained. Now,

t
= V
t

x
C(S
x
C C
t
)
1
= V
0
N(d
1
)
Ke
rT
N(d
2
)
. (7)
Note that the hedging ratio is

t
=
x
C(S
t
, t) .
Reading carefully the Black and Scholes (1973) paper, The pricing of options and
corporate liabilities (Journal of Political Economy), it seems that the authors as-
sume that there exists a self-nancing strategy (1,
t
) such that dV
t
= rV
t
dt,
which is not true, and the portfolio with value C
t
+ S
t
N(d
1
) = Ke
r(Tt)
N(d
2
)
is not risk-free.
The solution of the PDE (eq. (6)) with terminal condition
C(x, T) = (x K)
+
is the Black-Scholes formula.
Final comment: Another way to nd the solution is to compute the conditional
expectation under the equivalent martingale measure of the discounted terminal
payo.
In a Black and Scholes model, the price of a European option is given by:
C
E
(S
0
, T) = E
Q
(e
rT
(S
T
K)1
{S
T
K}
) (8)
= E
Q
(e
rT
S
T
1
{S
T
K}
) e
rT
KQ(S
T
K). (9)
Hence, if k =
1

_
ln(K/x) (r
1
2

2
)T
_
, using the symmetry of the Gaussian law,
one obtains
Q(S
T
K) = Q(W
T
k) = Q(W
T
k) = N
_
d
2
_
x
Ke
rT
__
where the function d
2
is given in Theorem 2.3.2.1.
3
From the dynamics of S, one can write:
e
rT
E
Q
(S
T
1
{S
T
K}
) = S
0
E
Q
_
1
{W
T
k}
exp(

2
2
T + W
T
)
_
.
The process (exp(

2
2
t +W
t
), t 0) is a positive Q-martingale with expectation
equal to 1. Let us dene the probability Q

by its Radon-Nikod ym derivative with

respect to Q:
Q

|
F
t
= exp(

2
2
t + W
t
) Q|
F
t
.
Hence,
e
rT
E
Q
(S
T
1
{S
T
K}
) = S
0
Q

(W
T
k) .
Girsanovs theorem implies that the process (

W
t
= W
t
t, t 0) is a Q

-Brownian
motion. Therefore,
e
rT
E
Q
(S
T
1
{S
T
K}
) = S
0
Q

((W
T
T) k T) (10)
= S
0
Q

W
T
k + T
_
, (11)
i.e.,
e
rT
E
Q
(S
T
1
{S
T
K}
) = S
0
N
_
d
1
_
x
Ke
rT
__
.
The Greeks:
The greeks for a European call option are given by:
=
C
E
x
= N(d
1
) > 0
=

2
C
E
x
2
=
(d
1
)
x

T t
> 0
=
C
E
r
= K(T t)e
r(Tt)
N(d
2
) > 0
=
C
E
t
=
x(d
1
)
2

T t
rKe
r(Tt)
N(d
2
) < 0
V =
C
E

= x(d
1
)

T t > 0
where (x) =
1

2
e

x
2
2
is the density for a standard normal
random variable.
4