Dartmouth College, Fall 2017

Mathematical Finance I, Math 86 S. Nanda

Assignment 5 Due: Oct 30, 2017

You may discuss the problems and solutions with anyone but the work written up and
submitted must be done on your own. Justify every step. Draw pictures where it helps
to illustrate. Please write legibly.

1. Using the steps below we arrive at the solution of the Black - Scholes PDE:
∂V 1 ∂ 2V ∂V
+ σ 2 S 2 2 + rS − rV = 0 (1)
∂t 2 ∂S ∂S
for a european call (without dividends). We have one final condition V (S, T ) =
max(S−K, 0) and 2 boundary conditions V (0, t) = 0, limS→∞ V (S, t) = S, i.e V (S, t) ≈
S for large S.
2
(a) As a first step, let τ = σ2 (T − t), S = Kex . Set V (S, t) = Kν(x, τ ). K the
strike of the call option. Write equation (1) in the new variable ν(x, τ ) and get
an equation with constant co-efficients
∂ν ∂ 2ν ∂ν
= 2
+ (b − 1) − bν(x, τ ) (2)
∂τ ∂x ∂x
What is b when you do this calculation?
Write out the new initial condition. Note the system went from ∞ > S > 0 to
∞ > x > −∞.
(b) Simplify the new equation further by making the substitution ν(x, τ ) = eαx+βτ u(x, τ )
where α, β can be anything you choose. You will get an equation involving terms
for ux , uτ , u(x, τ ) and uxx . The coefficients are in terms of α, β and b. Choose
values for α and β so that you are left with an equation of the form
uτ = uxx (3)
Again write down the new initial condition i.e. u(x, 0). Note that u(x, 0) = 0 for
x ≤ 0. We will use this later.
Equation (3) is the standard heat equation.
(c) Check that the following conditions are satisfied for u.
2
lim|x|→∞ u(x, 0)e−ax = 0 for any a > 0 (4)
2
lim|x|→∞ u(x, τ )e−ax = 0 for any a > 0 (5)
The above correspond to boundary equations for the heat equation.

With conditions (4) and (5), the solution for the heat equation (3) is known to be
Z ∞
1 (x−y)2
u(x, τ ) = √ u(y, 0)e− 4τ dy (6)
2 πτ −∞
 (d) As a final step express the
√ solution as a normal density function. To do this do a
change of variable y = z 2τ + x, and re-write the integral. Note that u(x, 0) > 0
always. Use this to set the lower limit of integration. You will get the sum (or
difference) of two integrals. If you complete the square in the exponent term, the
integrand can be written in the form of a standard normal density function, after
another change of variable. Do this.
After unraveling all the change of variables we get the solution for call price:

VC (S, t) = SN (d1 ) − Ke−r(T −t) N (d2 ) (7)

ln(S/K)+(r+σ 2 /2)(T −t) ln(S/K)+(r−σ 2 /2)(T −t)
where d1 = √
σ T −t
and d2 = √
σ T −t

2. Use the Black-scholes call option formula to derive the Black-Scholes price of a european
put Vp (S, t).

3. Price a European put expiring in 3 months on a stock with spot price 40, Strike 40.
Risk free rate is 5% per annum and volatility 30% per annum.