A proof of the Black and Scholes Formula

Claudio Pacati

May 30, 2012

Consider the Black and Scholes model, with a stock S and a bond B (the money market
account). Assuming the market to be perfect, it is known that there exists a martingale
measure Q such that for each t 0

dS(t) = rS(t) dt + S(t) dW (t) , (1)

dB(t) = rB(t) dt , (2)

where r (the risk-free rate) and (the stocks volatility) are constant and W is a Q-Wiener
process. Furthermore, given
T > 0 and a simple T -contingent claim X with contract
function , i.e. X = S(T ) , the Risk Neutral Valuation Theorem states that for any
t [0, T ], the market price of the contingent claim is given by the formula
"
#
(t, X) S(T )
= EQ | FTS , (3)
B(t) B(T )

where EQ denotes expectation with respect to measure Q and FtS is the sigma-algebra
generated by the knowledge of S(t) at time t.
The dynamics (1) shows that S is a log-normal process:

S(T ) = S(t) er(T t)+[W (T )W (t)] , (4)

where r = r 12 2 ; furthermore, by (2), B is a deterministic process:

B(T ) = B(t) er(T t) .

Hence equation (3) becomes

(t, X) = EQ S(T ) | FTS er(T t) .



(5)

Since the increment W (T ) W (t) in (4) is normally distributed under

Q, with zero
mean and variance T t, it can be written in the form W (T ) W (t) = Y T t, where Y
is a standard normal random variable under Q, with density
1 1 2
f (x) = e 2 x .
2
Equation (4) can be written in the form

S(T ) = S(t) er(T t)+ T t Y

and hence  
S(T ) = S(t) er(T t)+ T t Y

can be seen as a function of the random variable Y ; let us denote this function by (Y ).

1
 The expectation in the right-hand side of (5) is in fact an integral with respect to
measure Q:
Z + Z +
EQ S(T ) | FTS =


(Y ) d Q(Y ) = (y)f (y) dy . (6)

The calculation of right-most integral in (6) depends on the structure of the function
and hence on the contractual structure of the contingent claim.
Let us now assume X to be an European call option on S(T ), with strike price K. Then
h i+
S(T ) = [S(T ) K]+ (y) = S(t) er(T t)+ T t y K


and .

Notice that


S(T ) = 0 S(T ) K

and in the y-notation

K
log S(t) r(T t)
(y) = 0 y .
T t
Let us denote by
K
log S(t) r(T t)
y = .
T t

Hence (y) = 0 for y y and (y) = S(t) er(T t)+ T t y K for y > y . We can then
split the integral (6):
Z + Z y Z +
(y)f (y) dy = (y)f (y) dy + (y)f (y) dy
y
Z y Z +h i
= 0f (y) dy + S(t) er(T t)+ T t y
K f (y) dy
y
Z + 1
Z +
r(T t) 2 2 (T t)+ T t y
= S(t) e e f (y) dy K f (y) dy (7)
y y

For what about the second integral in (7), recall that f is the Q-density function of a
standard normal random variable and, in particular, it is symmetric. Hence
Z + Z y
f (y) dy = f (y) dy = Q(Y y ) = N(y ) , (8)
y

where N is the standard normal distribution function

Z x Z x
1 1 2
N(x) = f (x) dx = e 2 x dx .
2

For the first integral in (7), the integrand is

1 2 (T t)+
1 1 2
1 2 1 1
2
e 2 T t y
f (y) = e 2 + T t y+ 2 y = e 2 (y T t)
2 2

2

and it is the Q-density function g(y) of the normal random variable X = Y + T t.
Hence
Z +
Z y
12 2 (T t)+ T t y
e f (y) dy = 1 g(y) dy
y
= 1 Q(X y )
 
= 1 Q Y y T t
 
= 1 N y T t (9)
 
= N y + T t , (10)

where the equality from (9) to (10) is due to the symmetry of the standard normal distri-
bution.
Denote now by

log S(t)
K + (r + 1 2 )(T t)
d1 = y + T t = 2 ,
T t

log S(t)
K + (r 12 2 )(T t)
d2 = y = d1 T t = .
T t

By inserting (8) and (10) into (7) and using (6) we get
Z +
Q S
(y)f (y) dy = S(t) er(T t) N(d1 ) K N(d2 )


E S(T ) | FT =

and finally, by substituting this equation into (5), i.e. by discounting the expectation, we
get the Black and Scholes Formula for the call option

(t, X) = S(t) N(d1 ) K er(T t) N(d2 ) .