CHAPTER 5.

BLACK-SCHOLES EQUATION

59

Chapter 5

Black-Scholes equation
Options have the asymmetric profit/loss structure. The price of options rises
in volatile markets because options can pay out large amounts of money. The
possible loss is limited to the cost of the premium. The conceptual leap in the
Black-Scholes model is that traders are not estimating the price but are guessing
about how volatile the market would be in the future. Black and Scholes assumed
that the probability P (r) of the rate of return for a stock is normally-distributed
(Gaussian) with the mean same as the risk-free rate of return. Based on the
probability P (r), Black and Scholes formulated the option pricing. When it
was published in 1973 its impact on the financial markets was immediate and
unprecedented. Financial investors could use the option-pricing formula easily
just by punching in a few variables, including the stock price, risk-free rate of
return, options strike price and expiration date.
At the expense of simplicity in the formula, Black and Scholes assumed some
conditions on the financial market. The probability P (r) of the rate of return
is normally-distributed centred at the risk-free rate of return. The distribution
width depends on the volatility of the stock and the lapse of time. The volatility
and the risk-free rate of return are assumed constant. The assumptions were
There are no transaction costs or taxes.

CHAPTER 5. BLACK-SCHOLES EQUATION

60

There are no dividends during the life of the options.

There are no risk-free arbitrage opportunities.
Underlying asset trading is continuous and the change of its price is continuous.
The risk-free interest rate r is known and constant over time.

5.1

Black-Scholes equation

Under the effective market assumption Black and Scholes used the principle of
the hedge position, that is, when the option price is properly determined then it
should be possible to secure a return rate of a portfolio consisting of a short position in call options and a long position in its underlying asset. The Black-Scholes
formula determines the option price under the assumption that no transaction
costs are incurred, that funds can be borrowed or invested at a constant risk-free
rate, that trading is continuous, and that the distribution of the stocks logarithmic return is normal.
The evolution of the asset price S at time t is assumed to follow the Geometric
Brownian motion (4.38) with the constant expected rate of return and the
constant volatility . The price, c, of a call option is a function of its underlying
asset and time to mature; c = c(S, t). According to Itos lemma,
dc =

c 2 2 2 c
+ S
t
2
S 2

dt +

c
dS.
S

(5.1)

Consider a portfolio which involves short selling of one unit of a European call
option and long holding of units of the underlying asset. The value of the
portfolio is1
= c + S.
1

S in Eq.(5.1) is S. here is related to the delta hedging.

(5.2)

CHAPTER 5. BLACK-SCHOLES EQUATION

61

The infinitesimal change in is

d = dc
+ dS
#
"




c
c
c 2 2 2 c
= S
+

S
dt
+

SdZ. (5.3)
t
2
S 2
S
S
The last term in the right-hand side is the stochastic term which vanishes if
=

c
S .

Then the portfolio should earn the risk-free interest under the arbitrage-

free condition: d = rdt. Using this and Eq.(5.3), we obtain

c 2 2 2 c
c
+ S
+ rS
rc = 0.
t
2
S 2
S

(5.4)

which is the Black-Scholes equation. It is important to note that the risk preferences, , of the investors do not affect the option price and the option pricing
model involves five parameters: S, T, X, r and of which only is not an observable parameter.