MScFE 622 Continuous-time Stochastic Processes - Module 5: Problem Set

Compiled Notes
Module 5
MScFE 622
Continuous-time Stochastic
Processes

Revised: 07/07/2020
MScFE 622 Continuous-time Stochastic Processes − Notes Module 5

Module 5: The Black-Scholes Model

Contents
Unit 1: An Introduction to the Black-Scholes Model 3

Unit 2: Pricing Options 5

Unit 3: Hedging 7

Unit 4: Generalized Black-Scholes 9

Problem Set 11

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MScFE 622 Continuous-time Stochastic Processes − Summary Module 5

Summary
This Module introduces an important example of a complete market model: the Black-Scholes Model.
The module begins by describing the Black-Scholes model with one risky asset and one riskless bank
account that grows at a constant, continuously compounded rate of interest. Then, the module
shows how to price both vanilla and exotic derivatives in this simple model, as well as how to derive
the Black-Scholes partial differential equation. The module concludes by discussing the multi-asset
generalization of the Black-Scholes model.

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MScFE 622 Continuous-time Stochastic Processes − Notes (1) Module 5: Unit 1

Unit 1: An Introduction to the Black-Scholes Model

• The Black-Scholes Model is an important example of a complete market model. We will begin
with the simple model consisting of one stock S and a riskless bank account B. We will define
all stochastic processes on a fixed time horizon [0, T ], where T > 0.

• First fix a filtered probability space (Ω, F, F, P) and a Brownian motion W . We assume that
F = FW and F = FT . In this model, the stochastic processes S and B satisfy the following
SDEs:
dSt = St (µ dt + σ dWt ) , dBt = rBt dt,
where µ ∈ R, σ > 0 and r > 0 are constants. Here r is the constant continuously compounded
risk-free rate.

• Solving both SDEs we obtain:

1 2
St = S0 e(µ− 2 σ )t+σWt , Bt = B0 ert .

• We now turn to the discounted assets (1, X), where X = S/B. By Ito’s lemma, the SDE for
X is
dXt = Xt ((µ − r) dt + σ dWt ) .

• To find an ELMM for this model, we will need a powerful result known as Girsanov’s theorem.
To motivate this result, let Z be a standard normal random variable (Z ∼ N (0, 1)) on (Ω, F, P)
and µ be a real number. Define a new probability measure P∗ on (Ω, F) by
dP∗ 1 2
:= eµZ− 2 µ .
dP
Then P∗ is a probability measure that is equivalent to P. Furthermore, the moment generating
function of Z under P∗ is given by
 
∗ αZ µZ− 12 µ2 1 2 1 2
αZ
= e− 2 µ E e(α+µ)Z = eαµ+ 2 α ,



E e =E e e

which is the moment generating function of a N (µ, 1) random variable. Thus, by choosing µ
we can create a probability measure that “shifts” the mean of Z (from 0 to µ) but keeps the
variance the same.

• Girsanov’s Theorem does something similar with Brownian motions. We will let ||x|| denote
the Euclidean norm of a vector x in Rd .


Theorem 1 (Girsanov’s Theorem). Let (Ω, F, F, P) be a filtered space and W = W 1 , . . . , W d
be a d-dimensional Brownian motion on this space. Let γ = (γ1 , . . . , γd ) be a vector of progres-
sive processes satisfying
Z T 
i 2


P γs ds < ∞ = 1, i = 1, . . . , d.
0

Define the continuous local martingale Z by

d Z
!
t Z t
X 1 2
Zt := exp γsi dWsi − ||γs || ds .
i=1 0 2 0

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MScFE 622 Continuous-time Stochastic Processes − Notes (1) Module 5: Unit 1

Assume that Z is a martingale and define a new probability measure P∗ by

dP∗
= ZT .
dP
 
Then the process W̃ = W̃ 1 , . . . , W̃ d defined by
Z t
i i
W̃t := Wt − γsi ds
0
∗
is a d-dimensional Brownian motion on (Ω, F, F, P ).
• We can now apply Girsanov’s theorem to find an ELMM for X above. Let γ be a one-
dimensional process such that Z T 
2
P γs ds < ∞ = 1.
0
Define Z by
t
1 t 2
Z Z 
Zt := exp γs dWs − γ ds .
0 2 0 s
Then Z = {Zt : 0 ≤ t ≤ T } is a UI martingale with E(Zt ) = 1 for every 0 ≤ t ≤ T and we can
therefore define a measure P∗ on (Ω, F) by
dP∗
:= ZT .
dP
Then the process W̃ defined by Z t
W̃t := Wt − γs ds
0
is a Brownian motion with respect to P∗ . Now we can rewrite the SDE for X in terms of W̃ as
 
dXt = Xt ((µ − r) dt + σ dWt ) = Xt (µ − r) dt + σ dW̃t + σγt dt
 
= Xt (µ − r + σγt ) dt + σ dW̃t .
Hence, for X to be a P∗ local martingale, we need to choose
µ−r
γt = − .
σ
The quantity (µ − r)/σ is often called the market price of risk.
• So let us pick γt = −(µ − r)/σ. Then the SDE for X is
dXt = Xt σ dW̃t ,
a local martingale under P∗ (in fact, X is a true martingale, so P∗ is a martingale measure).
We can therefore conclude that this model satisfies NFLVR by the first fundamental theorem
of asset pricing.
• Now we move on to uniqueness of the measure. By the martingale representation of Bronwian
motion, we observe that X satisfies PRP with respect to P∗ , hence the market is complete and
the ELMM measure is unique.
• Using these results, we can then price any contingent claim H using the formula
π (H) = E∗ e−rT H .

We will go through some examples in the next sections.

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MScFE 622 Continuous-time Stochastic Processes − Notes (2) Module 5: Unit 2

Unit 2: Pricing Options

• In this section we illustrate how to price a call option and a put option using the Black-Scholes
model.
• First, we consider a call option on S with a strike price K. This is a derivative whose payoff is
H = (ST − K)+ .
Under the ELMM P∗ , the dynamics of X are
dXt = Xt σ dW̃t ,
where W̃ is a P∗ -Brownian motion. Hence the dynamics of S are
 
dSt = St r dt + σ dW̃t .

Solving this yields

1 2
St = S0 e(r− 2 σ )t+σW̃t .
• We now calculate the price of H.
 + 
1 2
π (H) = E ∗
e −rT
(ST − K) +

=e −rT
E ∗
(ST − K) +

=e −rT ∗
E S0 e(r− 2 σ )T +σW̃T − K
Z ∞ √
 1 1 2
+
S0 e(r− 2 σ )T +σ
1 2
−rT
=e √ e− 2 z dz, Tz
−K
−∞ 2π
∗ ∗
where we have used the fact that PW̃ = P√T Z , where Z ∼ N (0, 1). To evaluate this integral,
T
we note that the integrand is only non-zero when
1 2
√
S0 e(r− 2 σ )T +σ Tz
> K,
which is equivalent to  
K
− r − 12 σ 2 T


ln S0
z> √ =: −d2 .
σ T
Hence, Z ∞  √  1
1 2
S0 e(r− 2 σ )T +σ
1 2
−rT
π (H) = e Tz
− K √ e− 2 z dz
−d2 2π
= S0 Φ(d1 ) − Ke−rT Φ(d2 )
after completing the square, where
√
d1 := d2 + σ T
and Φ is (as usual) the standard normal CDF.
• In general, if 0 ≤ t ≤ T , then the price of H at time t is
E∗ e−r(T −t) (ST − K)+ |Ft = St Φ (d1 (t)) − Ke−r(T −t) Φ(d2 (t)),

where
St
+ (r + 12 σ 2 )(T − t) √


ln K
d1 (t) = √ and d2 (t) = d1 (t) − σ T − t.
σ T −t
Note that di (0) = di for i = 1, 2.

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MScFE 622 Continuous-time Stochastic Processes − Notes (2) Module 5: Unit 2

• We now price a put option. For that, note that

(
ST − K ST > K
(ST − K)+ − (K − ST )+ = = ST − K.
ST − K ST ≤ K

Therefore, the put option price (πP ) is related to the call option price (πC ) by the equation

πC − πP = E∗ e−rT (ST − K) = S0 − Ke−rT .

This relationship is called the put-call parity.

• Now let us consider some non-vanilla options. First we price a digital (binary) option that pays
1 if the terminal stock price value exceeds a pre-specified threshold K > 0 and 0 otherwise. This
option is sometimes called a cash-or-nothing call and has a payoff HC that can be represented
as
HC = I{ST >K} .
The price of this derivative is given by

E∗ e−rT I{ST >K} = e−rT P∗ (ST > K) = e−rT (1 − Φ(−d2 )) = e−rT Φ(d2 ).

• Now we consider an asset-or-nothing call, whose payoff is

HA = ST I{ST >K} .

This is a derivative whose payoff at maturity is equal to the value of the stock price (ST ) if the
stock price is greater than K and zero otherwise. Its price is given by

E∗ e−rT HA = e−rT E∗ ST I{ST >K} = S0 Φ(d1 ),

through a similar calculation to the call option price.

• Note that the payoff of a call option H is related to the digital options above by

H = HA − KHC ,

hence the relationship between the prices too.

• Finally we mention that there are put option equivalents of these. Define them yourself and
find their prices.

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MScFE 622 Continuous-time Stochastic Processes − Notes (3) Module 5: Unit 3

Unit 3: Hedging
• In this section we derive the hedging formula in the Black-Scholes model and also derive the
Black-Scholes PDE.
• Consider an option whose payoff H is of the form H = h(ST ) for some Borel measurable
function h : R → R. We want to find a trading strategy (v0 , ϕ) such that VT ((v0 , ϕ)) = H.
• We will first find a trading strategy in the discounted assets (1, X) that replicates the discounted
derivative H̃ := e−rT H = e−rT h(erT XT ) = g(XT ) and then show that the same strategy applied
to the original assets (B, S) replicates H.
• Consider the martingale M = {Mt : 0 ≤ t ≤ T } defined by Mt := E∗ (g(XT )|Ft ). Since X is a
Markov process, we have
Mt = E∗ (g(XT )|Ft ) = E∗ (g(XT )|Xt ) ,
hence by the Doob-Dynkin theorem, there exists a function F : [0, ∞) × R → R such that
Mt = F (t, Xt ).
By Ito’s lemma, we have
1 ∂ 2F ∂ 2F
 
∂F ∂F ∂F 1 ∂F
dMt = dt + dXt + dhXit = + σ 2 Xt2 2 dt + σXt dWt ,
∂t ∂x 2 ∂x2 ∂t 2 ∂x ∂x
hence
∂F 1 2 2 ∂ 2F
+ σ Xt =0
∂t 2 ∂x2
since M is a martingale.
• Thus, since MT = F (T, XT ) = g(XT ) = H̃, we have
  Z T ∂F
∗
H̃ = E H̃ + dXt ,
0 ∂x
   
which means that E∗ H̃ , ϕ where

∂F
ϕt := (t, Xt )
∂x
is a replicating strategy for H̃. The corresponding holding in the riskless asset B is
ηt = F (t, Xt ) − ϕt Xt .

• Now we show that the same strategy – applied to (B, S) instead of (1, X) – replicates H as
well. Let V be the value of this strategy. Then
VT = ηT BT + ϕT ST = (F (T, XT ) − ϕT XT ) BT + ϕT ST = BT F (T, XT ) = H̃BT = H.
It also follows that e−rt Vt = F (t, Xt ), hence Vt = ert F (t, Xt ) = ert F (t, St e−rt ) =: V (t, St ) for
some function V : [0, ∞) × R → R. Using the chain rule we see that
∂F ∂V
= .
∂Xt ∂St

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MScFE 622 Continuous-time Stochastic Processes − Notes (3) Module 5: Unit 3

Hence, since F satisfies the PDE

∂F 1 ∂ 2F
+ σ 2 Xt2 = 0,
∂t 2 ∂Xt2

then V (t, St ) satisfies the PDE

∂V 1 ∂ 2V ∂V
+ σ 2 St2 2 + rSt − rV (t, St ) = 0,
∂t 2 ∂St ∂St

together with the boundary condition V (T, ST ) = h(ST ). This equation is the celebrated
Black-Scholes PDE.

• Let H be a call option with strike K. We know that for this derivative,

V (t, St ) = St Φ (d1 (t)) − Ke−r(T −t) Φ(d2 (t)),

where
St
+ (r + 12 σ 2 )(T − t) √


ln K
d1 (t) = √ and d2 (t) = d1 (t) − σ T − t.
σ T −t
The hedging strategy ϕ is given by
∂V
ϕt = = Φ(d1 (t)).
∂St
Check this as an exercise.

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MScFE 622 Continuous-time Stochastic Processes − Notes (4) Module 5: Unit 4

Unit 4: Generalized Black-Scholes

• We now extend the Black-Scholes model to multiple assets.


• Consider d > 1 assets S = S 1 , . . . , S d whose prices evolve according to the following SDEs
m
!
X
dSti = Sti µi dt + σij dWtj i = 1, . . . , d.
j=1

where µi , σij are constants and W = (W 1 , . . . , W m ) is an m-dimensional Brownian motion

process (hW i , W j it = δij t).

• These SDEs can also be written succinctly as

dSt = St (µ dt + σ dWt )

for appropriately defined matrices µ and σ.

• We will assume that F = FW and F = FT .

• We now attempt to find an ELMM in this model by applying Girsanov’s theorem. Let γ =
(γ 1 , . . . , γ m ) be a W -integrable vector process so that the positive local martingale E ((γ • W ))
is a true martingale. Define the measure P∗ by
m Z T Z T !
dP∗ X 1
:= E ((γ • W ))T = exp γsi dWsi − ||γs ||2 ds .
dP i=1 0
2 0

 
Then W̃ = W̃ 1 , . . . , W̃ m is an m-dimensional Brownian motion with respect to P∗ , where
Z t
W̃ti := Wti − γsi ds, i = 1, . . . , m.
0

• Substituting these equations to the SDEs for the discounted asset Xt = e−rt St , we get
m
! m
! m
!
X X X
dXti = Xti (µi − r) dt + σij dWtj = Sti µi − r + γtj σij dt + σij dW̃tj .
j=1 j=1 j=1

So, for P∗ to be an ELMM, we need to choose γ so that

m
X
µi − r + γtj σij = 0 i = 1, . . . , d.
j=1

This system of equations can have no solutions, a unique solutions or infinitely many solutions,
depending on the relationship between m, d, r, σij , and µi .

• Let us look at a concrete example. Consider two stocks S and U whose prices have the following
dynamics   
p
dSt = St µS dt + σS ρ dWt1 + 1 − ρ2 dWt2

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MScFE 622 Continuous-time Stochastic Processes − Notes (4) Module 5: Unit 4

and
dUt = Ut µU dt + σU dWt1 ,

where W 1 and W 2 are independent Brownian motion processes and µS , µU , σS , σU , ρ are all
constants with |ρ| < 1. Define a new process W 3 by
Z t Z tp p
3 1
Wt := ρ dWs + 1 − ρ2 dWs2 = ρWt1 + 1 − ρ2 Wt2 .
0 0

Then W is also a Brownian motion process, with hW 3 , W 1 it = ρt, and the pair of SDEs can
3

be rewritten as
dSt = St µS dt + σS dWt3 and dUt = Ut µU dt + σU dWt1 .

• To find an ELMM for (S, U ), we have to solve the following system of equations
p
µS − r + γt1 σS ρ + γt2 σS 1 − ρ2 = 0
µU − r + γt1 σU = 0
for γt1 and γt2 , which can easily be seen to have a unique solution.
• Under the unque ELMM P∗ , the dynamics of S and U are given by
  p 
dSt = St r dt + σS ρ dW̃t1 + 1 − ρ2 dW̃t2
and  
dUt = Ut r dt + σU dW̃t1 ,
where W̃ i i = 1, 2 are P∗ Brownian motions.
• We again define a third P∗ Brownian motion W̃ 3 as
Z t Z tp p
3 1
W̃t := ρ dW̃s + 1 − ρ2 dW̃s2 = ρW̃t1 + 1 − ρ2 W̃t2
0 0
and rewrite the SDE for S as
 
dSt = St r dt + σS dW̃t3 .

• Now, let us price options on this model. First, options that depend only on one asset can be
priced using exactly the formulae from the one-dimensional model. We consider the following
exchange option whose payoff H is
H = max {ST − UT , 0} .
This is an option to exchange one asset for another at maturity. To price this option, we first
solve the SDEs for S and U to get
1 2 1 2
ST = S0 e(r− 2 σS )T +σS W̃T and UT = U0 e(r− 2 σU )T +σU W̃T .
3 1

Then by writing H = max {ST /UT − 1, 0} and considering the process V = S/U , one can use
a modified version of the one-dimensional Black-Scholes call option pricing formula derived in
the previous sections to get
π(H) = S0 Φ(d1 ) − U0 Φ(d2 ),
where  
S0
ln U0
+ 12 σ 2 T √ q
d1 = √ , d2 = d1 − σ T and σ := σS2 + σU2 − 2ρσS σU .
σ T

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MScFE 622 Continuous-time Stochastic Processes − Problem Set Module 5

Problem Set

Problem 1. Consider the BS model with µ = 0.1, r = 0.06, and σ = 0.25. Then B12 is equal
to:

Solution: First fix a filtered probability space (Ω, F, F, P) and a Brownian motion W . We
assume that F = FW and F = FT . In this model, the stochastic processes S and B satisfy the
following SDEs:
dSt = St (µ dt + σ dWt ) , dBt = rBt dt,
where µ ∈ R, σ > 0 and r > 0 are constants. Here r is the constant continuously compounded
risk-free rate.

Solving both SDEs we obtain:

1 2
St = S0 e(µ− 2 σ )t+σWt , Bt = B0 ert .

Thus, we just have to substitute in Bt as follows:

B12 = B0 er∗12 = B0 e0.06∗12 = B0 e0.72

Problem 2. Consider the BS model with S0 = 100, µ = 0.1, r = 0.06, T = 1 and σ = 0.25.
The price of a call option with strike price K = 110 is:

Solution: Following the lecture notes, the call price is defined as:

E∗ e−r(T −t) (ST − K)+ |Ft = St Φ (d1 (t)) − Ke−r(T −t) Φ(d2 (t)),

where
St
+ (r + 12 σ 2 )(T − t) √


ln K
d1 (t) = √ and d2 (t) = d1 (t) − σ T − t.
σ T −t
Note that di (0) = di for i = 1, 2. Applying the above equations to our case,

100
+ (0.06 + 12 0.252 )(1) √


ln 110
d1 (t) = √ = −0.0162407 and d2 (t) = d1 (t) − 0.25 1 = −0.2662407
0.25 1
Finally, we apply (for t = 0)

E∗ e−r(T −t) (ST − K)+ |Ft = St Φ (d1 (t)) − Ke−r(T −t) Φ(d2 (t)) = 8.42966

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MScFE 622 Continuous-time Stochastic Processes − Problem Set Module 5

Problem 3. Consider the BS model with S0.5 = 112, µ = 0.2, r = 0.04, T = 1 and σ = 0.30.
Consider a call option with a strike price of K = 100 and its corresponding hedging strategy
(v0 , ϕ). Then ϕ0.5 is equal to:

Solution: Let H be a call option with strike K. We know that for this derivative,

V (t, St ) = St Φ (d1 (t)) − Ke−r(T −t) Φ(d2 (t)),

where
St
+ (r + 12 σ 2 )(T − t) √


ln K
d1 (t) = √ and d2 (t) = d1 (t) − σ T − t.
σ T −t
The hedging strategy ϕ is given by
∂V
ϕt = = Φ(d1 (t)).
∂St

In our case, d1 is equal to,

St
+ (r + 12 σ 2 )(T − t) 112
+ (0.04 + 12 0.32 )(0.5)



ln K
ln 100
d1 (0.5) = √ = √ = 0.734583
σ T −t 0.3 0.5
and,

∂V
ϕ0.5 = = Φ(d1 (0.5)) = 0.76870
∂St

Problem 4. Consider the BS model with S0.5 = 108, µ = 0.1, r = 0.06, T = 1 and σ = 0.25.
The price of an asset-or-nothing call option with strike price K = 110 at time 0.5 is

Solution: This is a derivative whose payoff at maturity is equal to the value of the stock price
(ST ) if the stock price is greater than K and zero otherwise. Its price is given by

C = S0 ∗ Φ(d1 ),

Where,

St
+ (r + 12 σ 2 )(T − t) 108
+ (0.06 + 21 0.252 )(0.5)



ln K
ln 110
d1 (0.5) = √ = √ = 0.154296
σ T −t 0.25 0.5
and,

C0.5 = S0.5 ∗ Φ(d1 ) = 108 ∗ Φ(0.154296) = 60.6217

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MScFE 622 Continuous-time Stochastic Processes − Problem Set Module 5

Problem 5. Consider the BS model with S0 = 120, µ = 0.2, r = 0.04, T = 1 and σ = 0.30.
Compute the price of a derivative with payoff H = max {ST , 80}.

Solution: First of all, we have to notice that the payoff H = max {ST , 80} is equivalent to:

H = max {ST , 80} = 80 + max {ST − 80, 0}

Where the payoff max {ST − 80, 0} represent a call option with strike 80. The call option price
today is equal to (applying Black-Scholes): 44. Therefore, the price of the payoff should be
equal to:

P rice = 80 ∗ e−0.04∗1 + 44 = 120.86

Which is the solution that we were looking for.

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