University Zurich Department of Mathematics

Presentation

in Probability III

Topics:

Black-Scholes-Merton Equation

written by:

Domenique Schwestermann <domenique.schwestermann@uzh.ch> Andrea Malaguerra <andrea.malaguerra@uzh.ch>

presented at:

5th September 2011

Supervisors:

Prof. Dr. Ashkan Nikeghbali

Contents
1 Black-Scholes-Merton Equation 1.1 Evolution of Portfolio Value . . . . . . . . . . . 1.2 Evolution of Option Value . . . . . . . . . . . . 1.3 Equating the Evolutions . . . . . . . . . . . . . 1.4 Solution to the Black-Scholes-Merton Equation 2 Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 3 5 6 8 10

Black-Scholes-Merton Equation

We want to derive the Black-Scholes-Merton Equation, which prices an European call respectively put option. An European call option (usually denoted as c) gives the owner a right but no obligation to buy a stock at time T for a strike price K instead of the market price S(T ). Similarly, an European put option (usually denoted as p) gives the owner a right but no obligation to sell a stock at time T for a strike price K instead of the market price S(T ).

1.1

Evolution of Portfolio Value

Throughout this section, we will always consider an agent whose portfolio value is X(t) at time t. The portfolio contains a money market account paying a constant rate of interest r and a stock with stock price S(t) at time t, which follows a geometric Brownian motion, i.e. dS(t) = S(t)dt + S(t)dW (t) (1)

where W(t) is a Brownian motion adapted to some ltration F (t), t > 0. is the mean rate of return on the stock and is the volatility of the stock. We suppose that the agent holds (t) stocks at time t. (t) may be random, but must be adapted to the ltration F (t). The remainder of the portfolio value, X(T ) (t)S(t), is invested in the money market account. The dierential dX(t) contains two terms, the capital gain (t)dS(t) on the stock position and the interest earnings r(X(t) (t)S(t))dt on the cash position. Using equation (1), we get: dX(t) = (t)dS(t) + r(X(t) (t)S(t))dt = (t)(S(t)dt + S(t)dW (t)) + r(X(t) (t)S(t))dt = rX(t)dt + (t)( r)S(t)dt + (t)S(t)dW (t)

(2)

Those three terms can be interpreted as follows: i) r(X(t)dt: an average underlying rate of return r on the portfolio ii) (t)( r)S(t)dt: the mean rate of return on the stock is typically larger than the interest rate r, that is why r is called the risk premium for investing in the stock iii) (t)S(t)dW (t): a volatility term proportional to the size of the stock investment In nance, the concept of discounted prices plays a crucial role. If S(t) is the stock price at some future time t > 0, then today the value of S(t) is less than at time t. We denote todays value of S(t) by ert S(t) and call it the discounted stock price. Similarly, the discounted portfolio value is ert X(t). Theorem 1.1 (Ito-Doeblin formula for Brownian motion) Let f (t, x) be a function for which the partial derivatives ft (t, x), fx (t, x) and fxx (t, x) are dened and continuous, and let W (t) be a Brownian motion. Then, for every T 0: 1 df (t, W (t)) = ft (t, W (t))dt + fx (t, W (t))dW (t) + fxx (t, W (t))dW (t)dW (t) 2 1 = ft (t, W (t))dt + fx (t, W (t))dW (t) + fxx (t, W (t))dt 2 3

(3)

Proof of Theorem 1.1 See Bibliography [1] (Chapter 4.4)

Using this theorem with the function f (t, x) = ert x for the discounted stock price yields to: d(ert S(t)) = df (t, S(t)) 1 = ft (t, S(t))dt + fx (t, S(t))dS(t) + fxx (t, S(t))dS(t)dS(t) 2 rt rt = re S(t)dt + e dS(t) = rert S(t)dt + ert (S(t)dt + S(t)dW (t)) = ( r)ert S(t)dt + ert S(t)dW (t) and similarly the dierential of the discounted portfolio value: d(ert X(t)) = df (t, X(t)) 1 = ft (t, X(t))dt + fx (t, X(t))dX(t) + fxx (t, X(t))dX(t)dX(t) 2 = rert X(t)dt + ert dX(t) = rert X(t)dt + ert (rX(t)dt + (t)( r)S(t)dt + (t)S(t)dW (t)) = (t)( r)ert S(t)dt + (t)ert S(t)dW (t) = (t)d(ert S(t))

(4)

(5)

If we compare equation (1) and (4), we realise that the the mean rate of return is changed to the premium risk r. Equation (5) tells us that the change in the discounted portfolio value is only due to the change in the discounted stock price.

1.2

Evolution of Option Value

So far, we have seen how the stock price and the portfolio value is modelled. Our next goal is to nd an equation for the option price itself, in order to do that we consider an European call option. At the nal time T this option pays (S(T ) K)+ = c(T, S(T )). Before time T , the option price c(t, S(t)) typically depends on ve dierent parameters, namely the time t and the stock price S(t) at time t, which are variable and the xed parameters r (interest rate), (volatility of the stock) and K (strike price). Note that r and are not constant in fact, but option prices are usually modelled for a short time interval, which makes the assumption of constant interest rate and volatility reasonable. We are now ready to compute the dierential of c(t, S(t)). Remember that Brownian motion accumulates quadratic variation at rate one per unit time, i.e. dW (t)dW (t) = dt. Moreover the cross variation of W (t) with t and the quadratic variation t with itself are zero (dW (t)dt = 0, dtdt = 0). We again use the Ito-Doeblin formula:

1 dc(t, S(t)) = ct (t, S(t))dt + cx (t, S(t))dS(t) + cxx (t, S(t))dS(t)dS(t) 2 = ct (t, S(t))dt + cx (t, S(t))(S(t)dt + S(t)dW (t)) 1 + cxx (t, S(t))(S(t)dt + S(t)dW (t))(S(t)dt + S(t)dW (t)) 2 = ct (t, S(t))dt + cx (t, S(t))(S(t)dt + S(t)dW (t)) 1 + cxx (t, S(t)) 2 S 2 (t)dt 2 1 = ct (t, S(t)) + S(t)cx (t, S(t)) + 2 S 2 (t)cxx (t, S(t)) dt 2 + S(t)cx (t, S(t))dW (t)

(6)

We next compute the dierential of the discounted option price ert c(t, S(t)) with the help of the function f (t, x) = ert x: d(ert c(t, S(t))) = df (t, c(t, S(t))) = ft (t, c(t, S(t)))dt + fx (t, c(t, S(t)))dc(t, S(t)) 1 + fxx (t, c(t, S(t)))dc(t, S(t))dc(t, S(t)) 2 = rert c(t, S(t))dt + ert dc(t, S(t)) = ert rc(t, S(t)) + ct (t, S(t)) + S(t)cx (t, S(t)) 1 + 2 S 2 (t)cxx (t, S(t)) dt + ert S(t)cx (t, S(t))dW (t) 2

(7)

1.3

Equating the Evolutions

To nd a solution to the dierential of c(t, S(t)), we introduce the so called hedging strategy, where the discounted value of our portfolio (stocks and money market account) has to be equal to the discounted call price at each time t. In other words: ert X(t) = ert c(t, S(t)) t [0, T ) One way to insure this equality is to make sure that d(ert X(t)) = d(ert c(t, S(t))) t [0, T ) and X(0) = c(0, S(0)). Comparing (5) and (7), we see that (9) holds if and only if (t)( r)S(t)dt + (t)S(t)dW (t) 1 = rc(t, S(t)) + ct (t, S(t)) + S(t)cx (t, S(t)) + 2 S 2 (t)cxx (t, S(t)) dt 2 +S(t)cx (t, S(t))dW (t) We examine what is required in order for (10) to hold. We rst equate the dW (t) terms, which gives 5 (10) (9) (8)

(t) = cx (t, S(t)) t [0, T )

(11)

This is called the delta-hedging rule and cx (t, S(t)) is the delta of the option. In other words, the agent in this hedging strategy needs to hold cx (t, S(t)) stocks at each time prior to expiration. Hence, the delta of the option is equal to the partial derivative with respect to the stock price of the option value. We next equate the dt terms in (10), using (11), to obtain: ( r)S(t)cx (t, S(t)) = rc(t, S(t)) + ct (t, S(t)) + S(t)cx (t, S(t)) 1 + 2 S 2 (t)cxx (t, S(t)) t [0, T ) 2 After cancelling the term, we receive t [0, T ): 1 rc(t, S(t)) = ct (t, S(t)) + rS(t)cx (t, S(t)) + 2 S 2 (t)cxx (t, S(t)) 2 (13)

(12)

Equation (13) is the Black-Scholes-Merton partial dierential equation. In the following section we will assume S(t) non-random, which allows us to solve (13) by partial dierential equation methods. After that Andrea will present this solution based on probability theory.

1.4

Solution to the Black-Scholes-Merton Equation

If the initial stock price is positive, then the stock price is always positive, and it can take any positive value. If the initial stock price is zero, then subsequent stock prices are all zero. We cover both of this cases by asking (13) to hold for S(t) 0. If c(t, S(t)) is continuous and (13) holds t [0, T ), then it also holds for time T. Equation (13) is a partial dierential equation of the type called backward parabolic. For such an equation, in addition to the terminal condition c(T, S(T )) = (S(T ) K)+ , one needs boundary conditions at S(t) = 0 and S(t) = in order to determine the solution. The boundary condition at S(t) = 0 is obtained by substituting S(t) = 0 into (13), which then becomes: rc(t, 0) = ct (t, 0) and hence the solution is: c(t, 0) = ert c(0, 0) Substituting t = T into this equation and using the fact that c(T, 0) = (0 K)+ = 0, we see that c(0, 0) = 0 and: c(t, 0) = 0 t [0, T ] (15) (14)

The intuitive meaning of equation (15) is that the call price is always zero if the stock price is zero. No one wants to buy a call option with strike price K > 0 whose underlying stock cannot get any positive value. As S(t) , the function c(t, S(t)) grows without bound. One way to specify a boundary condition at S(t) for the European call is: limS(t) [c(t, S(t)) (S(t) er(T t) K)] = 0 t [0, T ] (16)

This equation also matches our intuition. If the stock price S(t) is large, then everyone wants to buy a call option with xed strike price K and hence the price of the call option c(t, S(t)) is large as well. Precisely, it is the dierence between the stock price and the discounted strike price K (i.e. er(T t) K). The solution to the Black-Scholes-Merton equation (13) with terminal condition c(T, S(T )) = (S(T ) K)+ and boundary conditions (15) and (16) is t [0, T ], S(t) > 0: c(t, S(t)) = S(t)N (d+ (T t, S(t))) Ker(T t) N (d (T t, S(t))) where S(t) 2 1 + (r ) , d (, S(t)) = log K 2 and N is the cumulative standard normal distribution 1 N (y) = 2
y

(17)

:= T t

(18)

z2

1 dz = 2

e 2 dz

z2

(19)

Sometimes equation (17) uses the following notation: 7

BSM (, S(t); K, r, ) = S(t)N (d+ (, S(t))) Ke r N (d (, S(t)))

(20)

which is called the Black-Scholes-Merton function with and S(t) denoting the time to expiration and the current stock price, respectively. K, r and are the strike price, the interest rate and the stock volatility, respectively. (17) is not dened for t = T and S(t) = 0. However the two limits are dened as limtT c(t, S(t)) = (S(T ) K)+ and limS(t)0 c(t, S(t)) = 0. This was one example how probability is applied in nance. European options are quite simple and basic. American options are little more dicult to nd an explicit formula for, because those options can be exercised at each time t [0, T ]. There are even more complicated options such as Asian options or exotic options in general, where probability plays a crucial role.

Bibliography

[1] Steven E. Shreve, Stochastic Calculus for Finance II: Continuous-Time Models, Springer Finance, 2004 [2] Ashkan Nikeghbali, Lecture: Probability III, 2011