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A First Look at the Black-Scholes Equation

Primbs, MS&E 345

Background:
Derivative Security: A derivative (or derivative security) is a financial instrument whose value depends on the values of other, more basic underlying variables. ([Hull, 1999]). Example: European Call Option. The right, but not the obligation, to purchase a share of stock at a specified price K (the strike price), at a specified date T (the maturity date). Arbitrage: A riskless profit that involves no investment. (A free lunch)

Primbs, MS&E 345

Assumptions (to be used throughout most of the course)


There are no transaction costs (i.e. markets are frictionless) Trading may take place continuously There is no prohibition on short selling The risk free rate is the same for borrowing and lending Assets are perfectly divisible. These are the standard assumptions. When I deviate from them, I will mention it specifically, otherwise assume that they are always in force.
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The Set-up: Securities: Bond: Stock:


dB rBdt
dS Sdt Sdz
14

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Bond: -Deterministic -Exponential Growth -Continuous compounding

10

Bt B0 e rt

10

15

20

25

30

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40

45

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Primbs, MS&E 345

The Set-up: Securities: Bond: Stock:


dB rBdt
dS Sdt Sdz
8 7

Stock: -Geometric Brownian Motion -Log-Normal -Always positive

6 5 4 3

St S 0 e

( 1 2 ) t zt 2

2 1 0

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Primbs, MS&E 345

The Set-up: Securities: Bond: Stock:


dB rBdt
dS Sdt Sdz

Consider a derivative security whose price depends on St and t. We will call it: By Itos lemma:
dc (ct ScS 1 2 S 2 cSS )dt ScS dz 2

c( St , t )

Primbs, MS&E 345

Now we have 3 price processes:


dB rBdt dS Sdt Sdz dc (ct ScS 1 2 S 2 cSS )dt ScS dz 2

Bond: Stock: Derivative:

Here comes the Black-Scholes argument:


Lets form a portfolio using two of the assets, so that it looks exactly like the third.
Then this portfolio must have the same price as the third. We can choose any two assets for our portfolio. Lets choose the stock and derivative, and create a bond.

Primbs, MS&E 345

Now we have 3 price processes:


nothing dB rBdt dS Sdt Sdz dc (ct ScS 1 2 S 2 cSS )dt ScS dz 2

Bond: Stock: Derivative:

Our portfolio will consist of D shares of the stock and b of the derivative.

Pt D t S t b t ct
To create a bond, we can dynamically choose D and b so that the portfolio is riskless (i.e. dP has no dz term). Since this portfolio will be riskless, it must earn the same rate of return as the bond. Hence, we must have dP=rPdt. (Otherwise, we can arbitrage by shorting the one with the smaller return, and using that money to buy the one with the larger return). Lets perform these calculations...
Primbs, MS&E 345
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Now we have 3 price processes:


nothing dB rBdt dS Sdt Sdz dc (ct ScS 1 2 S 2 cSS )dt ScS dz 2

Bond: Stock: Derivative:

Our portfolio will consist of D shares of the stock and b of the derivative.

Pt D t S t b t ct
The first thing we need to do is compute dP and choose D and b to eliminate the dz term. To compute dP, we could use Itos lemma:

dP d (DS ) d ( bc) DdS SdD ... bdc cdb ...


But Wait!!!, We want out portfolio to be self financing. Lets think about this...
Primbs, MS&E 345
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Lets think about how a portfolio works:


Now your portfolio is worth

You purchase Dt shares of stock and bt of the derivative.

Pt dt D t St dt b t ct dt
If you want, you can rebalance your portfolio now. But if you dont add or take out any money, then

Your portfolio is worth Pt D t S t b t ct

dt period

Pt dt Dt St dt b t ct dt Dt dt St dt b t dt ct dt

So: dPt Pt dt Pt D t St dt b t ct dt (D t St b t ct )
D t ( St dt St ) b t (ct dt ct )

D t dSt b t dct
Primbs, MS&E 345
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Now we have 3 price processes:


nothing dB rBdt dS Sdt Sdz dc (ct ScS 1 2 S 2 cSS )dt ScS dz 2

Bond: Stock: Derivative:

Our portfolio will consist of D shares of the stock and b of the derivative. So, we have:

P DS bc
dP DdS bdc

The equation for dP is known as the self-financing constraint. As long as no money is added or taken from the portfolio, it will have the above dynamics.

Primbs, MS&E 345

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Now we have 3 price processes:


D + b
nothing dB rBdt dS Sdt Sdz dc (ct ScS 1 2 S 2 cSS )dt ScS dz 2

Bond: Stock: Derivative:

dP (DS b (ct ScS 1 2 S 2 cSS )) dt (DS b ScS )dz 2

DS b ScS 0
So, we have:

P DS bc
dP DdS bdc

D bcS
Substitute in

Lets do some portfolio algebra to compute dP. To make the portfolio riskless, eliminate the dz term

Primbs, MS&E 345

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Now we have 3 price processes:


D + b
nothing dB rBdt dS Sdt Sdz dc (ct ScS 1 2 S 2 cSS )dt ScS dz 2

Bond: Stock: Derivative:

dP b (ct 1 2 S 2 cSS )dt 2

nothing must look like the bond substitute P DS bc substitute

r (DS bc)dt rb (c cS S )dt


b (ct 1 2 S 2 cSS ) rb (c cS S ) 2
ct rScS 1 2 S 2 cSS rc 2

rPdt

D bcS

The Black-Scholes Equation

Primbs, MS&E 345

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Which derivative was this? If it was a European call option with strike K and maturity T:
c( S , T ) ( S K ) c(0, t ) 0

is the boundary condition.

If it was a European put option with strike K and maturity T:


c( S , T ) ( K S ) c(, t ) 0

is the boundary condition.

In general, the boundary condition determines which derivative it is.

Primbs, MS&E 345

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The Black-Scholes equation (European Call Option)

ct rScS 1 2 S 2 cSS rc 2
c( S , T ) ( S K )

c(0, t ) 0

Solution:
c( S , t ) SN (d1 ) Ke r (T t ) N (d 2 )
ln( S / K ) ( r 1 2 )(T t ) 2 d1 T t
d 2 d1 T t

where:

N () distribution function for a standard Normal (i.e. N(0,1))

We will derive this solution later in the course...


(If you like, you can verify it now.)
Primbs, MS&E 345
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Other properties of the Black-Scholes solution:

-It doesnt depend on the mean return of the stock, .


Risk Neutral Pricing. The solution can also be written as:
c( St , t ) e r (T t ) E[c( ST , T ) | St ]
where

dS rSdt Sdz

Not the true dynamics of the stock!

These are properties that we will understand later...


Primbs, MS&E 345
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This was our first look at the basic Black-Scholes argument.

Next, we will take a bit more abstract look at some of the basic arguments hidden in this derivation and see how far this approach can be generalized...

This will lead to a nice methodology for computing partial differential/difference equations for a surprisingly large number of derivative securities.

Primbs, MS&E 345

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References
Black, F. and M. Scholes, The pricing of options and corporate liabilities, Journal of Political Economy, 81, 637-659, 1973. Hull, J. Options, Futures, and Other Derivatives, 4th Ed. Prentice Hall, 2000.
Luenberger, D. G. Investment Science, Oxford Press, 1998.

Merton, R. C., Theory of rational option pricing, Bell Journal of Economics and Management Science, 4, 141-183, 1973.

Wilmott, P. Paul Wilmott on quantitative finance, Vol. 1 & 2, Wiley, 2000.

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