A Complete Solution to the

Black-Scholes Option Pricing Formula∗

Ravi Shukla
Whitman School of Management
Syracuse University
Syracuse NY, 13244
315-443-3576
rkshukla@syr.edu
Michael J Tomas, III
Assistant Professor of Finance
School of Business Administration
University of Vermont
Burlington, VT 05405
802-656-8270
MTOMAS@bsad.uvm.edu
September 2006

∗ Please do not quote. Comments are welcome.

We are grateful to Raj Aggarwal, Fernando Diz, Tom Finucane, and Mark Holder for
providing valuable feedback.
 A Complete Solution to the
Black-Scholes Option Pricing Formula
Abstract
Option pricing theory is one of the major contributions of finance aca-
demics in the last thirty years. The early work of Black and Scholes (1972)
is now legendary. Nearly every textbook on option theory covers this work.
The textbooks derive the partial differential equation and present the so-
lution to the equation but do not provide the mathematical details of
the solution to the partial differential equation. In this paper we present
a complete solution that can be used as a pedagogical aid in classes on
derivatives, options and futures, or financial engineering.
 A Complete Solution to the
Black-Scholes Option Pricing Formula

1 Introduction
There has been a significant growth in the popularity of courses on derivatives
at college campuses. A major factor in this growth has been an increasing num-
ber of specialized programs in financial engineering, mathematical finance and
computational finance. As of June 2000, there were at least 37 such programs.
There has also been an increase in the use of derivative securities by market par-
ticipants in recent years. This attention to derivatives in the academic as well
as professional arena has resulted in a variety of texts discussing the theory and
practice of pricing these instruments. Cox and Rubinstein (1985), Hull (2000),
Jarrow and Turnbull (2000) and Neftci (2000) are representative examples.
Every textbook discusses the development of the enormously important work
of Black and Scholes (1972) since most option pricing models are based on this
work. The presentation, almost universally, consists of using arbitrage argu-
ments to derive the partial differential equation (PDE) and then presenting the
solution to the PDE under the appropriate initial and boundary conditions. The
textbooks and even the original Black-Scholes work, however, do not actually
derive the solution to the PDE. They make references to books on differen-
tial equations which provide the steps necessary to solve the equation. These
books also do not contain the direct solution to the PDE. The student is left to
construct the solution on his/her own.
One text, Shimko (1992), does present many steps based on the method of
Laplace transform and leads the reader from stochastic process to closed form
solution. However, many of the algebraic steps are missing. Here we present
the complete solution filling in all the necessary algebraic details.
We believe that this detailed solution will be a valuable resource to the
students of option pricing. Students in introductory courses on derivatives may
find it helpful in completing their understanding of the problem. It will help
the more advanced students in developing solutions to other derivative pricing
problems. For those students wishing to pursue careers in financial engineering
or financial modeling a working knowledge of financial mathematics is critical.
This exercise, developed around one of the foundations of option pricing theory
calls on students to engage in the detailed work necessary to solve a continuous
time finance problem. The benefit of working in the context of a familiar model
allows students to see the steps needed to derive this type of model.
This work can be used as a supplement to Shimko (1992), or as a stand-
alone presentation in classes on derivatives, options and futures, or financial
engineering involving a more mathematical treatment of the theory. There are
several potential classroom applications for this work:

1. An in class presentation delivered by the instructor,

1
 2. A solution to an out-of-class exercise, or
3. A handout for self-directed study.

2 The Partial Differential Equation

Assume that the stock price (S) follows a Geometric Brownian motion with
mean µ and variance σ 2 . t denotes time and z is a standard Weiner process:

dS = µSdt + σSdz (1)

Assume that the price of a European style call option (C) is a function of S
and t:
C = C(S, t) (2)
By Ito’s Lemma:
1
dC = CS dS + Ct dt + CSS dS 2 (3)
2
where CS and Ct are partial derivatives of C with respect to S and t, respectively
and CSS is the second partial derivative of C with respect to S.
Since,
dS 2 = σ 2 S 2 dz 2 = σ 2 S 2 dt (4)
we can write (3) as:
1
dC = CS dS + Ct dt + CSS σ 2 S 2 dt (5)
2
We can form a hedge portfolio by combining NS shares of stock and NC call
options. The value of the hedge portfolio (VH ) is given by:

V H = NS S + NC C (6)

Differentiating (6), we get:

dVH = NS dS + NC dC (7)

Substitute dC from (5) into (7):

 
1
dVH = NS dS + NC CS dS + Ct dt + CSS σ 2 S 2 dt (8)
2
Rearrange terms in (8) to get:
 
1
dVH = (NS + NC CS ) dS + NC Ct + NC CSS σ 2 S 2 dt (9)
2
A perfectly hedged portfolio should be risk free and earn a risk free rate.
Therefore,
dVH = rVH dt

2
 Substitute this dVH into (9):
 
1 2 2
rVH dt = (NS + NC CS ) dS + NC Ct + NC CSS σ S dt (10)
2
So NS + NC CS = 0 to make both sized of (10) deterministic. So that,
 
1
rVH dt = NC Ct + NC CSS σ 2 S 2 dt (11)
2
Dividing by dt and substituting (6) for VH
 
1
rNS S + rNC C = NC Ct + NC CSS σ 2 S 2 (12)
2
Rearranging and dividing by NC
NS 1
Ct = r S + rC − CSS σ 2 S 2 (13)
NC 2
Now we define τ = T − t where t is the chronological time, T is the time at
which the option matures, and τ is the time remaining to maturity. Then, Ct =
−1
−Cτ . Also, let NS = 1, then since NS + NC CS = 0, NC = C S
. Substituting for
Ct , NS , and NC and rearranging, we get:
1 2 2
σ S CSS + rSCS − rC − Cτ = 0 (14)
2
The initial and boundary conditions for (14) are

C(S, 0) = Max(S − E, 0) (14a)

C(0, τ ) = 0 (14b)

Initial condition (14a) specifies the option value upon maturity while boundary
condition (14b) states that the option is worthless when the stock price is zero.

3 The Laplace Transform

If we let g(S) = Lq [C(S, τ )], where Lq is the Laplace operator and g is the
Laplace transform with parameter q then Lq [Cτ (S, τ )] = qLq [C(S, τ )]−C(S, 0) =
qLq [C(S, τ )] − Max(S − E, 0)
Taking Laplace transform of equation (14) and using appropriate substitu-
tions, (14) becomes
1 2 2
σ S gSS + rSgS − rg − [qg − Max(S − E, 0)] = 0 (15)
2
Rearranging, we get
1 2 2
σ S gSS + rSgS − (r + q)g = −Max(S − E, 0) (16)
2

3
 We will have two equations for the Laplace transform g in equation (15).
One when S ≥ E and the other one when S ≤ E. The homogenous equation in
both cases is:
1 2 2
σ S gSS + rSgS − (r + q)g = 0 (17)
2
We will solve the homogeneous equation to get the general solution. For
S ≥ E case, we also have a particular solution because the differential equation
is nonhomogeneous.
Assume that the solution to (17) is of the form g = AS γ so gS = AγS γ−1
and gSS = A(γ 2 − γ)S γ−2 . Substituting into (17), we get:
1
A σ 2 S 2 (γ 2 − γ)S γ−2 + ArSγS γ−1 − A(r + q)S γ = 0 (18)
2
This can be factored as:
   
1 2 2 1
AS γ σ γ + r − σ 2 γ − (r + q) = 0 (19)
2 2

For a non trivial solution, A should be nonzero. Therefore, the terms in [· · ·]

must be zero. This leads to a quadratic equation whose roots are:

1 2

q
2
− r − 2σ ± r − 21 σ 2 + (2σ 2 )(r + q)
γ= (20)
σ2
Since we have two distinct roots, the solution to (17) is:

g = A 1 S γ1 + A 2 S γ2 (21)

where,
q
2
1 2
r − 12 σ 2


− r− 2σ + + 2σ 2 (r + q)
γ1 = (21a)
q σ2

2
− r − 21 σ 2 − r − 12 σ 2


+ 2σ 2 (r + q)
γ2 = (21b)
σ2
Note that γ1 ≥ 0 ≥ γ2 .
It will be useful to note that:
q
2
2 r − 12 σ 2 + 2σ 2 (r + q)
γ1 − γ2 = (21c)
σ 2q

2
− r + 12 σ 2 + r − 12 σ 2 + 2σ 2 (r + q)


γ1 − 1 = 2
(21d)
q σ
2
− r + 12 σ 2 − r − 12 σ 2 + 2σ 2 (r + q)


γ2 − 1 = (21e)
σ2

4
 For S ≤ E case, (21) is the complete solution. For the case S ≥ E, we must
solve for the particular solution as well. The equation for S ≥ E case is:
   
γ 1 2 2 1 2
AS σ γ + r − σ γ − (r + q) = −(S − E) (22)
2 2
Assume g = mS + n so gS = m and gSS = 0. Upon substitution, we get

rSm − (r + q)(mS + n) = −(S − E) (23)

Rearranging, we get:

−qSm − (r + q)n = −(S − E) (24)

or,
qSm + (r + q)n = S − E (25)
Matching the coefficients of terms with S and without S, we get
1 −E
m= and n=
q (r + q)
Therefore, for the case S ≥ E, the solution is:
S E
g = A 1 S γ1 + A 2 S γ2 + − (26)
q (r + q)
Recall that γ1 ≥ 0 ≥ γ2 . In the case of S ≥ E, A1 = 0 to ensure the
boundedness of the derivative gS . In the case of S ≤ E, A2 = 0 to ensure that
the option’s value approaches zero as the stock price goes to zero. The solutions
for the two cases (equations (21) and (26)), then reduce to:
S E
g(S ≥ E) = A 2 S γ2 + − (27a)
q (r + q)
g(S ≤ E) = A 1 S γ1 (27b)

We require the option pricing function to be continuous and differentiable at

the transition point S = E. Therefore, the values of the function and their first
derivatives from (27a) and (27b) must equal each other. These conditions can
be used to solve for A1 and A2 . The function values and derivatives at S = E
are:

E E
= A 2 E γ2 + −

g(S ≥ E) (28a)
E q (r + q)

= A 1 E γ1

g(S ≤ E) (28b)
E

1
g 0 (S ≥ E) = A2 γ2 E γ2 −1 +

(29a)
E q

g 0 (S ≤ E) = A1 γ1 E γ1 −1

(29b)
E

5
 

where  denotes the value at S = E.
E
By setting (28a)=(28b) and (29a)=(29b), we get two equations for the two
unknowns A1 , and A2 :
E E
A 2 E γ2 + − = A 1 E γ1 (30a)
q (r + q)
1
A2 γ2 E γ2 −1 + = A1 γ1 E γ1 −1 (30b)
q
γ1
Multiply (30a) by E and subtract (30b) from it to get:
γ1 γ1 1
A2 (γ1 − γ2 )E γ2 −1 + − − =0 (31)
q r+q q
Solving for A2 , we get:
E 1−γ2
 
γ1 (γ1 − 1)
A2 = − (32)
r+q q (γ1 − γ2 )
Substituting for A2 in (30b), we get A1 :
E 1−γ1
 
γ2 (γ2 − 1)
A1 = − (33)
r+q q (γ1 − γ2 )
Now we have solved for the Laplace transform g. The problem, therefore,
is reduced to taking the inverse Laplace transform of g. There are two g’s, one
for S ≥ E and the other for S ≤ E. The inverse Laplace transforms of both
are the same. We will take the inverse Laplace transform of (27b) which can be
written as,
E 1−γ1
 
γ2 (γ2 − 1)
g(S ≤ E) = − S γ1 (34)
q+r q (γ1 − γ2 )

4 The Inverse Laplace Transform

To get the solution to look like the familiar Black-Scholes formula, the following
Laplace transform is going to be useful:
√ 2
e−k q−f +a
  
fτ d + bτ 1 −ak
Lq e N √ = e p p
c τ 2 q − f + a2 (a + q − f + a2 )
√
where a = − c√b 2 , and k = − d c 2 , and b, c, d, and f are arbitrary constants.
Now, our efforts will be concentrated on rearranging (34) so that the useful
Laplace transform may be applied. First, we separate it out into two terms as:
γ2 E 1−γ1
S γ1 (34a)
q + r (γ1 − γ2 )
(γ2 − 1) E 1−γ1
− S γ1 (34b)
q (γ1 − γ2 )

6
 Performing some algebra on (34a) term, It can be written as:
     γ1
γ2 1 S
E (35)
q+r γ1 − γ2 E

Noting that   γ1
S
= eγ1 ln ( E )
S

E
and substituting for γ2 from (21b) and γ1 − γ2 from (21c), (35) can be written
as:
 p 2
 
(r− 21 σ2 )+ (r− 12 σ2 ) +2σ2 (r+q)
σ2 1  γ1 ln ( ES )
−E  e
 
 p
q+r 2
2 (r− 2 σ 2 ) +2σ 2 (r+q)
1

σ2
q (36)
1 2 1 2 2



Multiplying and dividing by − r − + r− +
2σ + q) and 2σ 2σ 2 (r
2 2
using the identity (x + y)(x − y) ≡ x − y , we get:
 
2 2
− r − 21 σ 2 + r − 12 σ 2 + 2σ 2 (r + q)



  1 γ ln ( S )
−E  q  q   e 1
2
E

1 2 2 1 2 2

1 2




(r + q) r − 2 σ 2
+ 2σ (r + q) − r − 2 σ + r − 2σ 2
+ 2σ (r + q)
(37)
This can be simplified to:
 
 1  1 γ ln ( S )
−E  q  q  2e
 1 E

1

2 2
r − 21 σ 2 + 2σ 2 (r + q) − r − 21 σ 2 + 1 2



r − 2σ 2
+ 2σ (r + q)
2σ 2

(38)
Substituting for γ1 from (21a) and using the identity ex+y ≡ ex ey , we get:
   p 2
 
−(r− 1 σ 2 )
2 (r− 12 σ2 ) +2σ2 (r+q)
σ2
ln ( S
E ) σ2
ln ( S
E )
 1 
2e e
 
−E 
 q  q 
2 2

 12 r − 21 σ 2 + 2σ 2 (r + q) − r − 21 σ 2 +



r − 12 σ 2 + 2σ 2 (r + q) 


2σ

(39)
This can be written as:
    √
q 2
 
−(r− 1 σ 2 ) √ ln ( S ) 2 (r− 12 σ2 ) +(r+q)
2 2 E
√ ln ( E
S
)
 1 σ 2 σ σ 2σ 2 
 2e e 
−E  r
 " r # (40)
2 2

 (r− 12 σ2 ) (r− σ )
1 2
(r− 12 σ2 )
−

2 + (r + q) √2 + 2 + (r + q)
2σ 2σ 2σ

7
 Equation (40) fits the useful form with b = r − 21 σ 2 , c = σ, d = ln E S



,
1 2 √ √
( r− σ ) ln ( S
) 2
and f = −r, so that a = − c√b 2 = − σ√2 2 and k = − d c 2 = − Eσ .
Taking the inverse Laplace transform of (40), we get our first term:
"
#
S
+ r − 12 σ 2 τ


−rτ ln E
−Ee N √ (I)
σ τ

Now, we’ll work on (34b) to get the second term. Write (34b) as:
   γ1 −1
(γ2 − 1) S S
− (41)
q γ1 − γ2 E
Noting that   γ1
S
= eγ1 ln ( E )
S

E
and substituting for γ1 − γ2 from (21c), (41) can be written as:
 
S (γ2 − 1)
e((γ1 −1) ln ( E ))
S
− p (42)
q 2
2 (r− 12 σ 2 ) +2σ 2 (r+q)
σ2

Substituting for γ2 − 1 from (21b), we get:

p
  −(r+ 12 σ2 )− (r− 12 σ2 )2 +2σ2 (r+q)
S
e((γ1 −1) ln ( E ))
S
σ2
− p (43)
q 2
2 (r− 12 σ 2 ) +2σ 2 (r+q)
σ2

which simplifies to,

q
2
r + 12 σ 2 + r − 12 σ 2 + 2σ 2 (r + q) 1 (γ −1) ln S
 
S
q e( 1 ( E )) (44)
q 1 2 2


2 2
r − 2σ + 2σ (r + q)

q
2
Multiplying and dividing (44) by − r + 12 σ 2 + r − 12 σ 2 + 2σ 2 (r + q)
and using the identity (x + y)(x − y) ≡ x2 − y 2 we get:

2
2
− r + 12 σ 2 + r − 12 σ 2 + 2σ 2 (r + q)
 
S 1
 e((γ1 −1) ln ( E ))
S

q 2
q q
2 2
r − 21 σ 2 + 2σ 2 (r + q) − r + 21 σ 2 + r − 12 σ 2 + 2σ 2 (r + q)

(45)
Expanding the numerator, we get −(r2 + σ 2 r + 14 σ 4 ) + (r2 − σ 2 r + 41 σ 4 ) +
2σ 2 r + 2σ 2 q = 2σ 2 q. So, we can write (45) as:
2σ 2 q
 
S 1
 e((γ1 −1) ln ( E ))
S

q 2
q q
2 2
r − 21 σ 2 + 2σ 2 (r + q) − r + 21 σ 2 + r − 12 σ 2 + 2σ 2 (r + q)

(46)

8
or,
1 1
 e((γ1 −1) ln ( E ))
S
S 
2
q
2 q
1 2
r − 12 σ 2 + 2σ 2 (r + q) − r + 21 σ 2 + r − 21 σ 2 + 2σ 2 (r + q)



2σ 2

(47)
Substituting for γ1 from (21d), doing some algebra, and using the identity
ex+y = ex ey , we get:
p 2


−(r+ 1 σ 2 )
 (r− 12 σ2 ) +2σ2 (r+q)
2 ln ( E )
S
σ2
ln (E)
S

1 σ2
2e e
Sr  q  (48)
2
(r− 12 σ2 ) −(r+ 12 σ 2 ) ( r− 12 σ 2 )
2σ 2 + (r + q) √
2σ
+ 2σ 2 + (r + q)

Doing some rearranging,

S √ √
  q 2
 
−(r+ 1 σ 2 ) ln ( E ) 2 (r− 12 σ2 ) +(r+q) ln ( ES ) 2
√2
σ 2 σ 2σ 2 σ
1
2e e
Sr  q  (49)
2
(r− 12 σ2 ) −(r+ 12 σ 2 ) (r− 12 σ2 )
2σ 2 + (r + q) √
2σ
+ 2σ 2 + (r + q)

Expanding the terms under the radical, we get:

r2 − σ 2 r + 41 σ 4
+r+q
2σ 2
r2 + σ 2 r + 41 σ 4
⇒ +q
2σ 2
(r + 21 σ 2 )2
⇒ +q
2σ 2
Making this substitution, and doing some rearranging, we get:
S √ √ q
   
−(r+ 1 σ 2 ) ln ( E ) 2 ln ( S ) 2
E (r+ 1 σ 2 )2
√2 2 +q
σ 2 σ σ 2σ 2
1
2e e
S q  q  (50)
(r+ 21 σ 2 )2 −(r+ 12 σ 2 ) (r+ 21 σ 2 )2
2σ 2 +q √
σ 2
+ 2σ 2 +q

Again, this matches our useful Laplace form with b = (r + 21 σ 2 ), c = σ, d =

√ √
S (r+ 1 σ 2 ) ln ( S ) 2
, and f = 0, so that a = − c√b 2 = − σ√2 2 and k = − d c 2 = − Eσ


ln E .
Taking the inverse Laplace transform of (50), we get our second term:
" #
S
+ (r + 12 σ 2 )τ


ln E
SN √ [II]
σ τ

9
 Combining the two terms [I] and [II], we get our solution:

C = SN (d1 ) − Ee−rτ N (d2 )

S
+ (r + 21 σ 2 )τ


ln E
where d1 = √
σ τ
S
+ r − 21 σ 2 τ



ln E
d2 = √
σ τ
√
= d1 − σ τ

5 Conclusion
In this work we present a complete solution to the Black-Scholes equation. This
work is appropriate for students in more advance classes in derivatives, options
and futures, or financial engineering in which there is a heavy reliance on con-
tinuous time financial mathematics.

References
Black, F. and M. Scholes, 1972, “The Pricing of Options and Corporate Liabil-
ities,” Journal of Political Economy (May), 231-236

Cox, J. C. and M. Rubinstein, 1985, Options Markets, Prentice Hall, Englewood

Cliffs, NJ.

Hull, J. C., 2000, Options, Futures and Other Derivatives, Fourth Edition, Pren-
tice Hall, Englewood Cliffs, NJ.

Jarrow, R. and S. Turnbull, 2000, Derivative Securities, Second Edition, South-

Western College Publishing, Cincinnati, OH.

Neftci, S., 2000, An Introduction to the Mathematics of Financial Derivatives,

Second Edition, Academic Press, San Diego, CA.

Shimko, D., 1992, Finance in Continuous Time, A Primer, Kolb Publishing,

Miami, FL.

10