Lecture 12
Sergei Fedotov
20912 - Introduction to Financial Mathematics
Sergei Fedotov (University of Manchester) 20912 2010 1/7
Lecture 12
1 Black-Scholes Model
2 Black-Scholes Equation
The Black-Scholes model for option pricing was developed by Fischer
Black, Myron Scholes in the early 1970s. This model is the most
important result in financial mathematics.
Sergei Fedotov (University of Manchester) 20912 2010 2/7
Black - Scholes model
The Black-Scholes model is used to calculate an option price using: stock
price S, strike price E , volatility σ, time to expiration T , and risk-free
interest rate r .
This model involves the following explicit assumptions:
• The stock price follows a Geometric Brownian motion with constant
expected return and volatility: dS = µSdt + σSdW . .
• No transaction costs.
Sergei Fedotov (University of Manchester) 20912 2010 3/7
Black - Scholes model
The Black-Scholes model is used to calculate an option price using: stock
price S, strike price E , volatility σ, time to expiration T , and risk-free
interest rate r .
This model involves the following explicit assumptions:
• The stock price follows a Geometric Brownian motion with constant
expected return and volatility: dS = µSdt + σSdW . .
• No transaction costs.
• The stock does not pay dividends.
• One can borrow and lend cash at a constant risk-free interest rate.
Sergei Fedotov (University of Manchester) 20912 2010 3/7
Black - Scholes model
The Black-Scholes model is used to calculate an option price using: stock
price S, strike price E , volatility σ, time to expiration T , and risk-free
interest rate r .
This model involves the following explicit assumptions:
• The stock price follows a Geometric Brownian motion with constant
expected return and volatility: dS = µSdt + σSdW . .
• No transaction costs.
• The stock does not pay dividends.
• One can borrow and lend cash at a constant risk-free interest rate.
• Securities are perfectly divisible (i.e. one can buy any fraction of a share
of stock).
Sergei Fedotov (University of Manchester) 20912 2010 3/7
Black - Scholes model
The Black-Scholes model is used to calculate an option price using: stock
price S, strike price E , volatility σ, time to expiration T , and risk-free
interest rate r .
This model involves the following explicit assumptions:
• The stock price follows a Geometric Brownian motion with constant
expected return and volatility: dS = µSdt + σSdW . .
• No transaction costs.
• The stock does not pay dividends.
• One can borrow and lend cash at a constant risk-free interest rate.
• Securities are perfectly divisible (i.e. one can buy any fraction of a share
of stock).
• No restrictions on short selling.
Sergei Fedotov (University of Manchester) 20912 2010 3/7
Basic Notation
We denote by V (S, t) the value of an option. We use the notations
C (S, t) and P(S, t) for call and put when the distinction is important.
Sergei Fedotov (University of Manchester) 20912 2010 4/7
Basic Notation
We denote by V (S, t) the value of an option. We use the notations
C (S, t) and P(S, t) for call and put when the distinction is important.
• The aim is to derive the famous Black-Scholes Equation:
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS − rV = 0.
∂t 2 ∂S ∂S
Sergei Fedotov (University of Manchester) 20912 2010 4/7
Basic Notation
We denote by V (S, t) the value of an option. We use the notations
C (S, t) and P(S, t) for call and put when the distinction is important.
• The aim is to derive the famous Black-Scholes Equation:
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS − rV = 0.
∂t 2 ∂S ∂S
Now, we set up a portfolio consisting of a long position in one option and
a short position in ∆ shares.
The value is Π = V − ∆S.
Sergei Fedotov (University of Manchester) 20912 2010 4/7
Basic Notation
We denote by V (S, t) the value of an option. We use the notations
C (S, t) and P(S, t) for call and put when the distinction is important.
• The aim is to derive the famous Black-Scholes Equation:
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS − rV = 0.
∂t 2 ∂S ∂S
Now, we set up a portfolio consisting of a long position in one option and
a short position in ∆ shares.
The value is Π = V − ∆S.
• Let us find the number of shares ∆ that makes this portfolio riskless.
Sergei Fedotov (University of Manchester) 20912 2010 4/7
Itô’s Lemma and Elimination of Risk
The change in the value of this portfolio in the time interval dt:
dΠ = dV − ∆dS, where dS = µSdt + σSdW .
Sergei Fedotov (University of Manchester) 20912 2010 5/7
Itô’s Lemma and Elimination of Risk
The change in the value of this portfolio in the time interval dt:
dΠ = dV − ∆dS, where dS = µSdt + σSdW .
Using Itô’s Lemma:
1 2 2 ∂2V
∂V ∂V ∂V
dV = + σ S 2
+ µS dt + σS dW ,
∂t 2 ∂S ∂S ∂S
Sergei Fedotov (University of Manchester) 20912 2010 5/7
Itô’s Lemma and Elimination of Risk
The change in the value of this portfolio in the time interval dt:
dΠ = dV − ∆dS, where dS = µSdt + σSdW .
Using Itô’s Lemma:
1 2 2 ∂2V
∂V ∂V ∂V
dV = + σ S 2
+ µS dt + σS dW ,
∂t 2 ∂S ∂S ∂S
we find
1 2 2 ∂2V
∂V ∂V ∂V
dΠ = + σ S + µS − µS∆ dt + σS − ∆σS dW .
∂t 2 ∂S 2 ∂S ∂S
The main question is how to eliminate the risk!!!
Sergei Fedotov (University of Manchester) 20912 2010 5/7
Itô’s Lemma and Elimination of Risk
The change in the value of this portfolio in the time interval dt:
dΠ = dV − ∆dS, where dS = µSdt + σSdW .
Using Itô’s Lemma:
1 2 2 ∂2V
∂V ∂V ∂V
dV = + σ S 2
+ µS dt + σS dW ,
∂t 2 ∂S ∂S ∂S
we find
1 2 2 ∂2V
∂V ∂V ∂V
dΠ = + σ S + µS − µS∆ dt + σS − ∆σS dW .
∂t 2 ∂S 2 ∂S ∂S
The main question is how to eliminate the risk!!!
∂V
We can eliminate the random component in dΠ by choosing ∆ = ∂S .
Sergei Fedotov (University of Manchester) 20912 2010 5/7
Black-Scholes Equation
This choice
results in a risk-free
portfolio Π = V − S ∂V
∂S whose increment
∂V 1 2 2∂ V 2
is dΠ = ∂t + 2 σ S ∂S 2 dt.
Sergei Fedotov (University of Manchester) 20912 2010 6/7
Black-Scholes Equation
This choice
results in a risk-free
portfolio Π = V − S ∂V
∂S whose increment
∂V 1 2 2∂ V 2
is dΠ = ∂t + 2 σ S ∂S 2 dt.
• No-Arbitrage Principle: the return from this portfolio must be rdt.
dΠ
Π = rdt
Sergei Fedotov (University of Manchester) 20912 2010 6/7
Black-Scholes Equation
This choice
results in a risk-free
portfolio Π = V − S ∂V
∂S whose increment
∂V 1 2 2∂ V 2
is dΠ = ∂t + 2 σ S ∂S 2 dt.
• No-Arbitrage Principle: the return from this portfolio must be rdt.
2V
dΠ
∂V
+ 12 σ2 S 2 ∂
∂t ∂S 2
Π = rdt or V −S ∂V
=r
∂S
Sergei Fedotov (University of Manchester) 20912 2010 6/7
Black-Scholes Equation
This choice
results in a risk-free
portfolio Π = V − S ∂V
∂S whose increment
∂V 1 2 2∂ V 2
is dΠ = ∂t + 2 σ S ∂S 2 dt.
• No-Arbitrage Principle: the return from this portfolio must be rdt.
2V
∂V
+ 12 σ2 S 2 ∂ 2
dΠ ∂S 2 ∂V
+ 12 σ 2 S 2 ∂∂SV2 = r V − S ∂V
∂t
Π = rdt or V −S ∂V
= r or ∂t ∂S .
∂S
Sergei Fedotov (University of Manchester) 20912 2010 6/7
Black-Scholes Equation
This choice
results in a risk-free
portfolio Π = V − S ∂V
∂S whose increment
∂V 1 2 2∂ V 2
is dΠ = ∂t + 2 σ S ∂S 2 dt.
• No-Arbitrage Principle: the return from this portfolio must be rdt.
2V
∂V
+ 12 σ2 S 2 ∂ 2
dΠ ∂S 2 ∂V
+ 12 σ 2 S 2 ∂∂SV2 = r V − S ∂V
∂t
Π = rdt or V −S ∂V
= r or ∂t ∂S .
∂S
Thus, we obtain the Black-Scholes PDE:
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS − rV = 0.
∂t 2 ∂S ∂S
Sergei Fedotov (University of Manchester) 20912 2010 6/7
Black-Scholes Equation
This choice
results in a risk-free
portfolio Π = V − S ∂V
∂S whose increment
∂V 1 2 2∂ V 2
is dΠ = ∂t + 2 σ S ∂S 2 dt.
• No-Arbitrage Principle: the return from this portfolio must be rdt.
2V
∂V
+ 12 σ2 S 2 ∂ 2
dΠ ∂S 2 ∂V
+ 12 σ 2 S 2 ∂∂SV2 = r V − S ∂V
∂t
Π = rdt or V −S ∂V
= r or ∂t ∂S .
∂S
Thus, we obtain the Black-Scholes PDE:
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS − rV = 0.
∂t 2 ∂S ∂S
Scholes received the 1997 Nobel Prize in Economics.
Sergei Fedotov (University of Manchester) 20912 2010 6/7
Black-Scholes Equation
This choice
results in a risk-free
portfolio Π = V − S ∂V
∂S whose increment
∂V 1 2 2∂ V 2
is dΠ = ∂t + 2 σ S ∂S 2 dt.
• No-Arbitrage Principle: the return from this portfolio must be rdt.
2V
∂V
+ 12 σ2 S 2 ∂ 2
dΠ ∂S 2 ∂V
+ 12 σ 2 S 2 ∂∂SV2 = r V − S ∂V
∂t
Π = rdt or V −S ∂V
= r or ∂t ∂S .
∂S
Thus, we obtain the Black-Scholes PDE:
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS − rV = 0.
∂t 2 ∂S ∂S
Scholes received the 1997 Nobel Prize in Economics. It was not awarded
to Black in 1997, because he died in 1995.
Sergei Fedotov (University of Manchester) 20912 2010 6/7
Black-Scholes Equation
This choice
results in a risk-free
portfolio Π = V − S ∂V
∂S whose increment
∂V 1 2 2∂ V 2
is dΠ = ∂t + 2 σ S ∂S 2 dt.
• No-Arbitrage Principle: the return from this portfolio must be rdt.
2V
∂V
+ 12 σ2 S 2 ∂ 2
dΠ ∂S 2 ∂V
+ 12 σ 2 S 2 ∂∂SV2 = r V − S ∂V
∂t
Π = rdt or V −S ∂V
= r or ∂t ∂S .
∂S
Thus, we obtain the Black-Scholes PDE:
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS − rV = 0.
∂t 2 ∂S ∂S
Scholes received the 1997 Nobel Prize in Economics. It was not awarded
to Black in 1997, because he died in 1995.
Black received a Ph.D. in applied mathematics from Harvard University.
Sergei Fedotov (University of Manchester) 20912 2010 6/7
The European call value C (S, t)
If PDE is of backward type, we must impose a final condition at t = T .
Sergei Fedotov (University of Manchester) 20912 2010 7/7
The European call value C (S, t)
If PDE is of backward type, we must impose a final condition at t = T .
For a call option, we have C (S, T ) = max(S − E , 0).
Sergei Fedotov (University of Manchester) 20912 2010 7/7
