Stochastic Processes and their Applications to Mathematical Finance

Sean Fanning Jay Parekh

August 17, 2004

Contents
1 Introduction 2 Financial Background 2.1 Options . . . . . . . . . . . . . . . . . . . 2.1.1 Basics . . . . . . . . . . . . . . . . 2.1.2 Stocks: the Underlying Asset . . . 2.1.3 Payos . . . . . . . . . . . . . . . . 2.1.4 Financial Leverage . . . . . . . . . 2.1.5 Trading Strategies: Option Spreads 2.2 Arbitrage . . . . . . . . . . . . . . . . . . 3 Stochastic Processes 3.1 Brownian Motion . . . . . . 3.1.1 Denition . . . . . . 3.1.2 History . . . . . . . . 3.2 Geometric Brownian Motion 3.2.1 Denition . . . . . . 3.2.2 A Better Model . . . 3 4 4 4 4 5 6 7 9 10 10 10 11 11 11 12 13 13 13 14 16 16 16 17 17 18 19 19

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

4 Stochastic Calculus 4.1 Stochastic Integrals . . . . . . . . . . . 4.1.1 Introduction . . . . . . . . . . . 4.1.2 Example . . . . . . . . . . . . . 4.2 Itos Formula: A Stochastic Chain Rule 4.2.1 Motivation by Taylor Expansion 4.2.2 Formal Itos Formula . . . . . . 5 The 5.1 5.2 5.3 5.4 Black-Scholes Formula Deriving the Black-Scholes Feynman-Kac Theorem . . Exact Solution . . . . . . History . . . . . . . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

. . . . . .

Formula . . . . . . . . . . . . . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

6 Numerical Solutions 6.1 Monte Carlo Method . . 6.1.1 Overview . . . . 6.1.2 Example . . . . . 6.2 Euler-Maruyama Method

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

. . . .

20 20 20 21 21 23 24 24 24 25 26 26 27 27 27 28 30

7 Application: 3M Company 7.1 Estimating the Parameters . . . . . . . . . 7.2 The Application: The Black-Scholes Price Price . . . . . . . . . . . . . . . . . . . . . 7.2.1 Introduction . . . . . . . . . . . . . 7.2.2 Implied Volatility . . . . . . . . . . 8 Appendix: Code 8.1 Payo Diagrams . . . . . 8.2 Brownian Motion . . . . 8.3 Monte Carlo Simulation 8.4 Euler-Maruyama Payo 8.5 Pricing European Call . 9 References

. . vs. . . . . . .

. . . The . . . . . . . . .

. . . True . . . . . . . . .

. . . . . Market . . . . . . . . . . . . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

. . . . .

Chapter 1 Introduction
Worldwide, there is an estimated $10,000 billion gross in the derivative market. This paper provides a brief overview of options and the stochastic processes used to model them. We assume the reader has a general understanding of probability, calculus, and dierential equations. We do not assume the reader has prior knowledge about options, stochastic processes, or stochastic calculus. We begin with a brief background on basic nancial concepts, with an emphasis on options. We then cover Brownian Motion and Geometric Brownian Motion, the latter of which we will use as a model for stock prices. It then becomes necessary to introduce stochastic calculus concepts. Using the stochastic calculus, we procede to the Black-Scholes Formula, which is used to price options. Then using the Feynman-Kac Theorem, we relate the Black-Scholes partial differential equation to a stochastic diential equation. Basic numerical methods for solving the stochastic dierential equation are introduced. MATLAB code for the numerical methods is supplemented. We conclude with an application to the real-world stock data of 3M Company. We would like to thank Professors Jerey Cooper and Kyoung-Sook Moon for their instruction, guidance, and time as well as the University of Maryland Math Department for sponsoring this project.

Chapter 2 Financial Background

2.1
2.1.1

Options
Basics

An option is a contract that gives the purchaser the right to buy or sell a specied number of shares of an underlying asset at a xed price on a specied future date. There is no obligation to exercise the option. In our case, we will discuss options whose underlying asset is a publicly traded stock. The price at which the buyer of an option agrees to buy or sell an option, if he or she so chooses, is called the strike price. It is denoted as K . The time at which the option expires is called expiry, denoted as T . Options can be classied as either call or put options. A call option gives the purchaser the right to buy a security. A put option gives the purchaser the right to sell a security. Generally, one option corresponds to the purchase or sale of 100 shares of stock. There are many types of options. Two specic types are European and American options. A European option gives the purchaser the right to buy or sell stock only upon expiry of the option. Alternatively, an American option gives the purchaser the right to buy or sell stock at any time between purchase and expiry. In this paper, we will only consider European options.

2.1.2

Stocks: the Underlying Asset

A stock represents ownership in a company. By purchasing stock, an investor is putting a claim on a companys assets and earnings. A shareholder purchases stock because he or she expects to receive compensation in the form of either dividends1 or capital gains2 .
We will not take into account dividends when considering the pricing of options. A capital gain is the prot resulting in an increase in stock price, between the time of purchase and the time of sale.
2 1

Stocks are traded on an exchange or market, where buyers and sellers are linked together. Stock prices are determined by supply and demand. If investors feel strongly about a stock, they will demand more shares, causing the stock price to increase. Company earnings play a major role in investor demand. Many other factors, like speculation, news events, and dividend payouts, also drive stock prices. However, there is no single parameter responsible for changes in stock price. Often, it is the case that investors buy or sell stock based on feelings. Because of this, there is an inherent randomness to the stock market. Mathematically, this randomness can be addressed with stochastic processes.

2.1.3

Payos
Payoff for a European Call Option 20

18

16

14

12 Payoff

10

10

15

20 Stock Price

25

30

35

40

Figure 2.1: Payo for a European call option with strike price $20 The payo3 from purchasing a European call option can be represented by the following function: C = max(S (T ) K, 0) That is, if the stock price at time T is greater than the strike price, the option will be exercised. The purchaser can buy a stock for K < S (T ) and immediately sell it for S (T ), thus earning a payo of S (T ) K . If, however, the stock price upon expiry is less than the strike price, the option will not be exercised. If it
It should be noted that there is a dierence between payo and prot. Prot takes into account the transaction costs associated with buying an option. Payo treats these transaction costs as sunk costs.
3

were, the payo would be negative; the investor chooses a zero payo rather than a negative payo. The payo from a European put can be represented by the following function: P = max(K S (T ), 0) If the stock price at time T is less than the strike price, the owner of a put will exercise the option, agreeing to sell the specied shares at the price K . The payo from this transaction will be the dierence of K S (T ). Stock can be bought for S (T ) and sold for K , where S (T ) < K . If S (T ) > K , then the put will not be exercised; doing so would result in a negative payo.
Payoff for a European Put Option 20

18

16

14

12 Payoff

10

10

15

20 Stock Price

25

30

35

40

Figure 2.2: Payo for a Eurpean put option with strike price $20

2.1.4

Financial Leverage

By purchasing stock through the use of options, an investor is taking advantage of nancial leverage. By purchasing a stocks option, there is more potential prot and loss. Consider the following example: An investor purchases 100 call options with strike price $5. This gives the investor the right to buy 10,000 shares of stock. Upon expiry, the price of the stock is $10. The market value of the stock is $100,000. If the options are exercised, they will cost the investor $50,000. Therefore, the investor will earn a $50,000 prot. Now suppose the stock price increases by 50% to $15. The market value of the stock is now $150,000, but the cost of exercising the options is the same, 6

$50,000. The prot is now $100,000; a 50% increase in stock price leads to a 100% increase in prot.

2.1.5

Trading Strategies: Option Spreads

An option spread involves buying or selling two or more options on the same stock. Spreads allow the investor to limit risk and prot under certain expected conditions. We will describe a straddle, a strangle, and a buttery spread. Straddle A long straddle involves buying a call and put option with the same strike price on the same stock. A long straddle is ideal for a volatile stock; the investor prots when the stock goes up or down drastically. A short straddle involves selling a call and put with the same strike on the same stock. It gives a prot only when the stock price does not change greatly. A long straddle has a limited loss and an unlimited prot. A short straddle has an ulimited loss and a limited prot.
Payoff for a Long Straddle 20

18

16

14

12 Payoff

10

10

15

20 Stock Price

25

30

35

40

Figure 2.3: Payo for a long straddle

Strangle A strangle involves the same strategy as a straddle, except that the strike prices for the call and put are not equal. The strike for the call is greater than the strike for the put. For a long strangle, a drastic change (either positive or negative) in stock price results in a prot. However, the change in stock price must be greater for a long strangle than for a long straddle.

Payoff for a Long Strangle 10

6 Payoff

10

15 Stock Price

20

25

30

Figure 2.4: Payo for a long strangle

Buttery Spread A buttery spread (using call options) involves purchasing four calls. One call is purchased with a low strike price and another with a higher strike price. Then two call options are sold with a strike price inbetween the long options. The buttery spread is protable when the stock price does not change drastically or remains close to the strike prices of the two short calls. In addition, there is a limited loss to this strategy. The buttery spread can also be formed with put options (protable with a volatile stock).
Payoff for a Butterfly Spread 10

6 Payoff

10

15

20 Stock Price

25

30

35

40

Figure 2.5: Payo for a Buttery Spread of Call Options

2.2

Arbitrage

In deriving a model for the pricing of options, an important assumption is made regarding arbitrage. Arbitrage is the ability to buy an asset in one market and instantaneously sell it in another market for a prot. Arbitrage is possible when one of the following three conditions is not met: 1. The Law of One Price: any given asset must trade at the same price on any market 2. Two assets with identical cash ows must trade at the same price 3. An asset with a known future price must trade at its risk-free discounted price today

Chapter 3 Stochastic Processes

3.1 Brownian Motion
1

0.5

W(t)

0.5

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

Figure 3.1: A random Brownian Motion along the time interval [0, 1]

3.1.1

Denition

Denition: Brownian Motion. A Brownian Motion W (t, ) is a function W : [0, ] R, where represents the set of outcomes in a probability space, satisfying the following three conditions: 1. With probabilty 1, W (0) = 0 and the mapping t W (t, ) is almost surely continuous

10

2. For 0 s < t T , W (t) W (s) N (0, t s) where N is the normal Gaussian distribution, with mean 0 and variance t s. 3. For 0 s < t < u < v T , the increments W (t) W (s) and W (v ) W (u) are independent for all s, t, u, v [0, T ]

3.1.2

History

The long studied model known as Brownian Motion, also known as a Wiener Process, is named after the English botanist Robert Brown. In 1827, Brown described the unusual motion exhibited by a small particle totally immersed in a liquid or a gas. In 1900, the French mathemetician Bachelier independently introduced Brownian motion to model the price movements of stocks and commodities. In 1905, Albert Einstein was able to explain this motion mathematically. He assumed that the immersed particle was continuously bombarded by molecules of the surrounding medium. In a series of papers originating in 1918, Norbert Wiener provided a mathematically concise denition and other mathematical properties of Brownian Motion.

3.2
3.2.1

Geometric Brownian Motion

Denition

Denition: Geometric Brownian Motion. A Geometric Brownian Motion is an almost surely continuous time stochastic process S (t) that solves the stochastic dierential equation dS (t) = Sdt + SdW (t) where dW (t) is a Brownian Motion and the constants and represent drift and volatility, respectively. The equation has solution S (t) = S (0)e( 2
1 2 )t+W (t)

A variant of Brownian Motion, Geometric Brownian Motion (GBM) is lognormally distributed; it takes on only nonnegative values. The random variable S (t) ln( S ) is normally distributed with mean ( 1 2 )t and variance 2 t. Future (0) 2 changes in value are independent of past changes in value.

11

3.2.2

A Better Model

When using a Brownian Motion to describe stock prices, two major aws arise. First, a Brownian Motion could become negative. Stock prices, however, are never negative. Second, a Brownian Motion assumes the price dierence, regardless of the initial price, follows the same normal distribution. In the case of stocks, the probability that a stock would drop from say $100 to $90 (a 10% change) is not the same as if the stock were to drop from $50 to $40 (a 20% change). The Brownian Motion model assigns these two events equal probability. Because a Geometric Brownian Motion is nonnegative, it provides for a more realistic model of stock prices. Also, the GBM model considers the ratio of stock prices to have the same normal distribution. Therefore, the percentage change in price as opposed to the absolute change in price is modelled.

12

Chapter 4 Stochastic Calculus

4.1
4.1.1

Stochastic Integrals
Introduction

A bounded, smooth function f : [a, b] R is said to be integrable provided that there is exactly one number A such that L(f, P ) A U (f, P ), where P is a partition of the interval [a, b], L(f, P ) is the lower Darboux sum, and U (f, P ) is the upper Darboux sum. b This denes the integral a f A, which can be approximated by using Riemann sums.
N 1 b

f (tn )(tn+1 tn ) A =
n=0 N 1 a

f
b

(4.1)

f(
n=0

tn+1 + tn )(tn+1 tn ) A = 2

f
a

(4.2)

The sum (4.1) is the lefthand sum and the sum (4.2) is the midpoint sum. As b the number of partitions goes to innity, both sums approximate a f as A. Now consider the case of a stochastic function W (t) and its integral 0 W (t)dW (t). b This stochastic integral can be approximated in the same manner a f was approximated by (4.1) and (4.2). However, the approximations resulting from a lefthand sum and a midpoint sum on a stochastic function are not equivalent; the lefthand sum results in the Ito Integral while the midpoint sum results in the Stratonovich Integral. We will concern ourselves with the Ito Integral.
T

13

4.1.2

Example
T

Consider the stochastic integral W (t)dW (t).

0

(4.3)

Also, recall from the denition of a Brownian Motion that E [W (t) W (s)] = 0 E [(W (t) W (s))2 ] = t s for all t > s [0, T ]. Ito Integral The Ito Integral of (4.3) is the limiting case of the lefthand sum
N 1

Sn =
n=0

W (tn )(W (tn+1 ) W (tn )).

(4.4)

The Riemann sum (4.4) can be rewritten as 1 Sn = 2

N 1

1 (W (tn+1 ) W (tn ) ) 2 n=0

2 2

N 1

(W (tn+1 ) W (tn ))2 .

n=0

(4.5)

The rst sum telescopes to W (T )2 W (0)2 = W (T )2 , since W (0) = 0 from the denition of Brownian Motion. Now (4.5) becomes 1 1 Sn = W (T )2 2 2
N 1

(W (tn+1 ) W (tn ))2 .

n=0

(4.6)

Let us now focus on the second sum, the quadratic variation :

N 1

QV =
n=0

(W (tn+1 ) W (tn ))2 .

For any partition, the expected value

N 1 N 1

E [QV ] =
n=0

E [(W (tn+1 ) W (tn ))2 ] =

n=0

(tn+1 tn )

= T

14

and E [S n ] = 1 1 (E [W (T )2 ] T ) = (T T ) 2 2 = 0.

It can be shown that the sum QV tends to T , in the L()2 sense. If t W (t, ) were a smooth function, we would have
N 1

QV =
n=0

W (n )2 (tn+1 tn ) C tT,

which would tend to zero as t 0. In conclusion, in L()2 , the Ito Integral

T 0

1 W (t)dW (t) = lim Sn = (W (T )2 T ) t0 2

T

and E[
0

W (t)dW (t)] = lim E [Sn ] = 0.

t0

OPTIONAL: The Stratonovich Integral Let us now see what happens when the integral (4.3) is approximated by the midpoint sum N 1 W (tn+1 ) + W (tn ) ( )(W (tn+1 ) W (tn )). (4.7) 2 n=0 (4.7) can be rewritten as 1 2
N 1

1 (W (tn+1 )2 W (tn )2 ) = W (T )2 2 n=0

(4.8)

The expected value of (4.8) is 1 T E [W (T )2 ] = . 2 2 Therefore, in L2 (),

T

W (t)dW (t) =
0

1 W (T )2 2 T 2

with
T

E[
0

W (t)dW (t)] =
T 0

when using the midpoint sum. This is

W (t)dW (t) in the Stratonovich sense.

15

4.2
4.2.1

Itos Formula: A Stochastic Chain Rule

Motivation by Taylor Expansion

Given a function f (t, S (t)), where S (t) solves the stochastic dierential equation dS = Sdt + SdW , we must nd a formula for determining df . Let us apply a Taylor Expansion 1 to f (t, S (t)), disregarding the fact that S (t) is stochastic: 1 1 df = ft dt + fS dS + ftt dt2 + fSS dS 2 + ftS dtdS + . . . 2 2 where . . . represents higher order terms. Proposition 1. dS dt as dt 0 in the L2 sense Making use of this proposition results in 1 1 df = ft dt + fS dt + ftt dt2 + fSS dt + ftS dt3/2 + . . . 2 2 Because dt 0, dt2 and dt3/2 can be eliminated: a number less than the absolute value of one raised to an exponent greater than one is smaller than the original number (n < n, for n < |1| and > 1). This also means that the higher order terms can be eliminated; they all contain a dt term. Therefore, 1 df = ft dt + fS dS + fSS dt 2 1 = ft dt + fS (Sdt + SdW ) + fSS dt 2 1 = (ft + SfS + fSS )dt + SfS dW 2 (4.9) is Itos Formula applied to f (t, S (t)).

(4.9)

4.2.2

Formal Itos Formula

dX (t) = a(X, t)dt + b(X, t)dW (t)

Itos Formula. Let X (t) solve the stochastic dierential equation

and let f (X (t), t) be C 2 . Then 1 df (X (t), t) = (a(X, t)fX + ft + b2 (X, t)fXX )dt + b(X, t)fX dW (t) 2
1

NOTATION:

f t

f f ft , t2 ftt , tS ftS , etc . . .

16

Chapter 5 The Black-Scholes Formula

5.1 Deriving the Black-Scholes Formula

Let f (t, S (t)) represent the value of a European call option on a stock S . Let S follow the stochastic dierential equation dS = Sdt + SdW with constants equal to the drift and equal to the volatility. dW follows a Brownian Motion. Our goal is to construct a portfolio that replicates a European call option. If we can price the replicating portfolio, then we can also price the option. To construct the replicating portfolio , consider a short position in the call option, f , (t) shares of stock S , and (t) shares of a risk-free bond B . Therefore, = f + (t)S + (t)B (5.1) ASSUMPTIONS: f (t, S (t)) represents the value of a European call option. S follows a Geometric Brownian Motion. That is, dS = Sdt + SdW , where W is a Brownian Motion and the constants and represent drift and volatility, respectively. The risk-free bond B grows at the rate dB = rBdt, where r is the risk-free interest rate. There is no arbitrage. The portfolio is self-nancing.

17

Now dierentiating (5.1) with respect to t gives d = df + (t)dS + Sd(t) + (t)dB + Bd (t) + ddS (5.2)

The self-nancing assumption says that changes in the value of the portfolio are not caused by changes in the number of shares or bonds. Rather, changes in the value of are caused only by changes in the value of S , r, and f . This means that (5.2) can be re-written as d = df + (t)dS + (t)dB Now applying Itos Formula to f (t, S (t)) gives 1 df = (ft + SfS + 2 S 2 fSS )dt + SfS dW 2 Substituting this result and dS and dB into (5.3) gives 1 d = (ft SfS 2 S 2 fSS +(t)S + (t)rB )dt +((t)S SfS )dW (5.4) 2 Choose (t) = fS . This eliminates the stochastic element, dW . Now (5.4) becomes 1 d = (ft SfS 2 S 2 fSS + SfS + (t)rB )dt (5.5) 2 Since there is no arbitrage, the portfolio must grow by the rate of d = rdt = r(f + fS + (t)B )dt. Substituting into (5.5) yields 1 ft + 2 S 2 fSS + rSfS rf = 0 2 (5.6) (5.3)

(5.6) is the BLACK-SCHOLES PDE, with nal condition f (T, S ) = (S K )+

5.2

Feynman-Kac Theorem

Feynman-Kac Theorem. Let a, b, and g be smooth, bounded functions. Let X solve the stochastic dierential equation dX (t) = a(t, X (t))dt + b(t, X (t))dW (t) and let u(x, t) = E [g (X (T ))|X (t) = x] Then u is a solution of 1 ut + aux + b2 uxx = 0 2 u(x, T ) = g (x) for t < T . 18

The Feynman-Kac Theorem provides a way of relating the Black-Scholes partial dierential equation with a stochastic dierential equation. The SDE is independent of the drift parameter. The PDE 1 ft + 2 S 2 fSS + rSfS rf = 0 (5.7) 2 with nal condition f (T, S ) = max(S (T ) K, 0) and the SDE f (t, S (t)) = E [er(T t) max(S (T ) K, 0)] with dS = rSdt + SdW are equivalent. Finite dierence or nite element methods can be used with (5.7), while (5.8) is ideal for the Monte Carlo Simulation. (5.8)

5.3

Exact Solution
C (S, t) = S (1 ) Ker(T t) (2 )

Exact Solution. The Black-Scholes PDE (5.7) has exact solution

where 1 2
S ) + (r + ln( K = T S ln( K ) + (r = T 1 2 )(T 2

t)

t 1 2 )(T t) 2 t

and represents the Gaussian CDF.

5.4

History

In 1973, Myron Scholes and Fisher Black derived the Black-Scholes formula. Their work was built upon the earlier research of Paul Samuelson and Robert Merton. The Black-Scholes formula revolutionized the trading of options. It gives investors a mathematical approach to pricing options, as opposed to guessing. It assumes that the stock or underlying asset follows a random walk with constant drift and volatility, there are no arbitrage opportunities, stock trading is continuous, there are no dividends, there are no transaction costs, stocks are perfectly divisible (can buy a fraction of a stock), and the stock can be sold short. Not all of these assumptions are realistic, especially the assumption that a stock has constant volatility. However, Black-Scholes is still useful. 19

Chapter 6 Numerical Solutions

6.1
6.1.1

Monte Carlo Method

Overview

In mathematics, generally speaking, a problem is given, a formulation of the problem is made, then solved analytically or numerically. In a Monte Carlo simulation the opposite occurs. A mathematical problem is given and then solved by constructing a game of chance that in some way leads to an approximate solution to the given problem. We have previously stated that the expected value of the solution of the SDE stock model is equivalent to the solution of the Black-Scholes PDE, by the Feynman-Kac Theorem. A Monte Carlo Simulation can be used with this SDE model. In many of the problems where the Monte Carlo simulation is applicable, there is already an element of chance built into the system. In our case, the element of chance is the volatility of the movement of the stock price. The various possibilites of Monte Carlo simulations began to be studied in the 1940s.

20

6.1.2

Example

The following gure is an example, using MATLAB, of a Monte Carlo Simulation:

4 mean of 1000 paths 5 individual paths 3.5

2.5

U(t)
2

1.5

0.5

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

Figure 6.1: Monte Carlo Simulation along 1000 discretized Brownian paths of GBM In this example we evaluate the stock model function U (t, S (t)) along 1000 discretized Brownian paths. The expected value of this solution can be seen as the center line with a smooth appearence. Notice that although U (t, S (t)) is nonsmooth along the individual paths, the expected value of the solution appears to be smooth. This can be established by noting that the properties of the Brownian motion require the expected value of S (t) to be zero. Therefore, the expected value of U (t, S (t)) is solely dependent on the drift and not the volatility. In this example, the expected value turns out to be e9/8t .

6.2

Euler-Maruyama Method

The Euler-Maruyama Method is an extension of the Euler Method. The Euler Method, also known as the tangent line method, originated in 1758. It computes an approximation to a deterministic dierential equation along a set of time values. The Euler-Maruyama Method computes an approximation to stochastic dierential equations. It can be stated as follows:
t t

X (t) = X0 +
0

f (X (S ))dS +
0

g (X (S ))dW (S )

for 0 t T . 21

Let us take a look at Figure 6.2. The black line represents the true solution and the x-line represents the Euler-Maruyama approximated solution. The true solution and Euler-Maruyama approximated solution were computed along 1000 discretized Brownian paths for dierent initial values, ranging from 70 to 95. The strike price (K ) was set at 82.96, the interest rate (r) at 10.8%, the time (T ) at .2 years, and volatility ( ) at .1195.
Price of European Call Option 9

6 Expected Value

0 70

75

80 Initial Value S(0)

85

90

95

Figure 6.2: Euler-Maruyama Approximated Payo Diagram for a European Call

Notice that the graph in Figure 6.2 resembles the call payo graph shown in Figure 6.2. The computed graphs curve begins to rise slightly before the strike price of 82.96, which diers from the previously shown payo graph. This dierence can be explained by the fact that our computed graph is for the expected value of the payo at the initial time, while the previously shown payo graph was drawn at the expiration date. Given any set of initial values (time, interest rate, strike price and volatility), our code can compute the expected value or price of the option under the set of Black-Scholes assumptions.

22

Chapter 7 Application: 3M Company

3M COMPANY 100

90

80

70

60

50

40

30

200

400

600

800

1000

1200

1400

Figure 7.1: 3M Comany: 5 Year Chart of Daily Closing Prices As a real world application, we have taken ve years of historical data from the 3M Company (NYSE symbol MMM) to estimate the parameters for the stochastic Black-Scholes model. Using numerical methods, we wanted to see how close our model predicted the price of an option with respect to the real option. The model used is the result of the Feynman-Kac Theorem (5.8), as applied to the Black-Scholes deterministic PDE. f (t, S (t)) = E [er(T t) max(S (T ) K, 0)] dS = Srdt + SdW

23

7.1

Estimating the Parameters

For our model, which is independent of drift , it was only necessary to estimate the volatility . However, even though it was unnecessary, we estimated . To estimate the parameters, ve years of historical daily closing prices were collected for MMM. Next, the daily percentage change in stock price was computed. This was done in the following manner: i = ln( Si ) Si1

where Si is the closing price on day i and i is the daily change in closing price. Next, the sample standard deviation of the i terms was calculated: 1 N 1
N

Sdaily =

( i )2
i=1

This gives an estimate for the daily volatility, but we are interested in the yearly volatility. Since there are 252 trading days in a year, multiplying Sdaily by 252 will give us our yearly volatility estimate: = 252 N 1
N

( i )2
i=1

To estimate , we can calculate the sample mean and multiply by 252: 1 N

N

i
1

The risk-free rate r can be approximated by the interest rate for 3 month Treasury Bonds. Using our historical data, our calculations resulted in the following estimates: r = .108 = 0.007528 = .1195

7.2
7.2.1

The Application: The Black-Scholes Price vs. The True Market Price
Introduction

In reality, the Black-Scholes model is based upon several unrealistic assumptions. These assumptions include continuity of stock price, no transaction costs, and 24

most importantly, constant volatility. In the real market, stocks often change in their volatilities. For example, the airline industry is more volatile when gas prices increase. A well-known discrepency arises between the market price of options and the computed BlackScholes price. This discrepency can be better accounted for when using a stochastic volatility model. It is important to note that there is no generally accepted stochastic volatility model.

7.2.2

Implied Volatility

Implied volatility is the volatility that when substituted into the Black-Scholes Formula produces the actual market price of an option. In Figure 7.2, the computed Black-Scholes price can be seen as the straight black line, the true market price as the x-line, and the implied volatility as the dashed-line.
Price and Implied Volatility of a European Call Option 18

16

14

Price or Implied Volatility

12

10

0 70

75

80 Strike Price

85

90

95

Figure 7.2: Implied Volatility

Notice that the implied volatility is not constant; it increases the further away from the strike price (82.96). This smile-eect gives rise to what is known as the Smile Curve. Intuitively, a stock with a higher volatility is harder to predict. Therefore, the stocks option requires a higher premium due to the increased stock volatility.

25

Chapter 8 Appendix: Code

8.1 Payo Diagrams

clear all; close all; syms k k_0 d k_01; k = 20; k_0=10; k_2=30; d=.01; %EURO CALL s=0:d:k; y=0; AXIS([0 40 -5 40]); AXIS manual; plot(s,y, k*) hold on; s=k:d:2*k; y=s-k; plot(s,y,k*) title(Payoff for a European Call Option); hold off; pause; %EURO PUT s=0:d:k; y=k-s; plot(s,y,k*); hold on; s=k:d:2*k; y=0; plot(s,y,k*); title(Payoff for a European Put Option); hold off; pause; %EURO STRADDLE s=0:d:k; y=k-s; plot(s,y,k*); hold on; s=k:d:2*k; y=s-k; plot(s,y,k*); title(Payoff for a Long Straddle); hold off; pause; %EURO STRANGLE s=0:d:k_0; y=k_0-s; plot(s,y, k*); hold on; s=k_0:d:k; y=0; plot(s,y, k*); s=k:d:k+k_0; y=s-k; plot(s,y,k*); hold off; title(Payoff for a Long Strangle); pause; %BUTTERFLY SPREAD s=0:d:k_0; y=0; plot(s,y,k*); hold on; s=k_0:d:k; y=s-k_0; plot(s,y,k*); s=k:d:k_2; y=s-k_0-2*s+2*k; plot(s,y,k*); s=k_2:d:k_2+k_0; y=0; plot(s,y, k*); title(Payoff for a Butterfly Spread);

26

8.2
%BPATH2

Brownian Motion
Brownian path simulation: vectorized % set the state of randn

randn(state,500) T = 1; N = 500; dt = T/N; dW = sqrt(dt)*randn(1,N); W = cumsum(dW);

% increments % cumulative sum

plot([0:dt:T],[0,W], k-) % plot W against t xlabel(t,FontSize,16) ylabel(W(t),FontSize,16,Rotation,0)

8.3
%BPATH3

Monte Carlo Simulation

Function along a Brownian path % set the state of randn

randn(state,0) T = 1; N = 500; dt = T/N; t = [dt:dt:1];

M = 1000; % M paths simultaneously dW = sqrt(dt)*randn(M,N); % increments W = cumsum(dW,2); % cumulative sum U = exp(repmat(t,[M 1]) + 0.5*W); Umean = mean(U); plot([0,t],[1,Umean],k x), hold on % plot mean over M paths plot([0,t],[ones(5,1),U(1:5,:)],k-), hold off % plot 5 individual paths xlabel(t,FontSize,16) ylabel(U(t),FontSize,16,Rotation,0,HorizontalAlignment,right) legend(mean of 1000 paths,5 individual paths,2) averr = norm((Umean - exp(9*t/8)),inf) % sample error

8.4

Euler-Maruyama Payo

% Sean and Jay % Expected Value of a European Call Option % makes the graph that looks like the call payoff graph randn(state,100) % set seed for psuedorandom number generator

% problem parameters vol = 0.1195; r = 0.108; XzeroStart = 65; K = 82.96; M = 1000; T = .2; N = 2^8; dt = T/N; t = [dt:dt:T]; R = 4; Dt = R*dt; L = N/R; for i = 1:11 Xzero = XzeroStart + 2.5*(i-1); dW = sqrt(dt)*randn(M,N); W = cumsum(dW,2); %loop runs throough different initial values %increment inital value % Brownian increment % discretized Brownian path

27

Xtrue = Xzero*exp((r-0.5*vol^2)*repmat(t, [M 1])+vol*W); XendTrue = Xtrue(1:M,N)-K; % true solution based off Black-Scholes Gtrue = exp(-r*T)*max(XendTrue,0); % defines funtion max(X-K, 0) MeanGtrue(i) = mean(Gtrue); % expected value of G Xem = zeros(M,L); Xtemp = repmat(Xzero, [M 1]); for j = 1:L Winc = sum(dW(1:M,R*(j-1)+1:R*j),2); Xtemp = Xtemp + r*repmat(Dt, [M 1]).*Xtemp + vol*Winc.*Xtemp; Xem(1:M,j) = Xtemp; end XendEm = Xem(1:M,L)-K; GEm = exp(-r*T)*max(XendEm, 0); MeanGEm(i) = mean(GEm); end plot([70:2.5:95],MeanGtrue, k-), hold on plot([70:2.5:95],MeanGEm, k--*), hold off title(Price of European Call Option); xlabel(Initial Value S(0)); ylabel(Expected Value);

8.5

Pricing European Call

% Sean and Jay % Expected Value of a European Call Option randn(state,300) % set seed for psuedorandom number generator

% problem parameters vol = 0.1195; r = 0.108; Xzero = 82.96; KStart = 70; M = 10^4; N = 2^8; T = .2; %8/3/04 thru 10/15/04 = 73/365 dt = T/N; t = [dt:dt:T]; dW = sqrt(dt)*randn(M,N); % Brownian increment W = cumsum(dW,2); % discretized Brownian path %true market 3M option data taken 8/03/04 Cobs = [12.5 9 4.6 2 .55 .2]; plot([70:5:95],Cobs, k--*), hold on %initialized variables Ivol = [0 0 0 0 0 0]; min = [100 100 100 100 100 100]; ivolatility = [0 0 0 0 0 0]; MeanGtrue = [0 0 0 0 0 0]; diff = [0 0 0 0 0 0];

for i = 1:6 K = KStart + 5*(i-1);

%loop runs through different strike values %increment strike value

28

Xtrue = Xzero*exp((r-0.5*vol^2)*repmat(t, [M 1])+vol*W); XendTrue = Xtrue(1:M,N)-K; % true solution based off Black-Scholes Gtrue = exp(-r*T)*max(XendTrue,0); % defines funtion max(X-K, 0) MeanGtrue(i) = mean(Gtrue); % expected value of G diff(i) = MeanGtrue(i) - Cobs(i); count = 0; value = MeanGtrue(i); done = 1; temp = 100; while done == 1 count = count + 1; Ivol(i) = Ivol(i) + .01; Itrue = Xzero*exp((r-0.5*Ivol(i)^2)*repmat(t, [M 1])+Ivol(i)*W); IendTrue = Itrue(1:M,N)-K; % true solution based off Black-Scholes Ihold = exp(-r*T)*max(IendTrue,0); % defines funtion max(X-K, 0) value = mean(Ihold); % expected value of G temp = abs(value - Cobs(i)); if temp < min(i) min(i) = temp; ivolatility(i) = count; else done = 1; %as vol increases so does the mean %therefore if not closer to true value heading further from true value end if count == 100 done = 0; end end end diff min ivolatility plot([70:5:95],ivolatility,k-.) plot([70:5:95],MeanGtrue, k), hold off title(Price and Implied Volatility of a European Call Option); xlabel(Strike Price); ylabel(Price or Implied Volatility);

29

Chapter 9 References
1. Fitzpatrick, Patrick M., Advanced Calculus: A Course in Mathematical Analysis, PWS Publishing Company, 1996. 2. Goodman, J., Moon, K.S., Szepessy, A., Tempone, R., Zouraris, G., Stochastic and Partial Dierential Equations with Adapted Numerics, 2004. 3. Higham, Desmond J., An Algorithmic Introduction to Numerical Simulation of Stochastic Dierential Equations, Society for Industrial and Applied Mathematics, 2003. 4. Hull, John C., Options, Futures, and Other Derivatives: Fifth Edition, Pearson Education, Inc., 2003. 5. Ross, Sheldon M., An Elementary Introduction to Mathematical Finance: Options and Other Topics Second Edition, Cambridge University Press, 2003.

30