Black-Scholes Option Pricing Model

Financial Derivatives
Continuous Time Option Pricing
Dr Eirini Konstantinid & Dr Ser-Huang Poon
(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 1 / 56

Outline
In the previous lecture, we priced options using discrete-time methods.

k Binomial trees.
In this lecture, we turn to continuous-time approaches.

k Black-Scholes-Merton model.
In the next lecture, we shall consider Greeks (partial derivatives of option

value wrt input parameters) and volatility smiles.

Outline
Video 1: Intended learning outcomes.
Video 1: Review of stochastic processes.

k Modelling stock prices using Wiener processes.
k Geometric Brownian Motion Process.
Video 2: Itô’s lemma.

k The log-normal property of stock prices.
Video 3: The Black-Scholes(-Merton) model.

k Deriving the Black-Scholes(-Metron) partial differential equation (p.d.e.).
k Practicing the Black-Scholes(-Merton) model.
k Stocks with & without dividends.
Video 4: Probability of ending up ITM.

k Risk-neutral and real world probability.
Intended learning outcomes
By the end of this lecture you should be able to :
Understand basic concepts on stochastic processes.
Discuss the appropriate modelling of stock prices.
Apply Itô’s lemma.
Discuss implications for the stock price (return) distribution.
Derive the Black-Scholes(-Merton) p.d.e..
Use and discuss the Black-Scholes(-Merton) model.
Derive, apply and discuss the probability to end up ITM.

Reading list
Hull (7th & 6th Edition): Chapter 12, 13 & 15.
Hull (8th Edition): Chapter 13, 14 & 16.
Hull (9th & 10th Edition): Chapter 14, 15 & 17.

Review of stochastic processes

Stochastic processes
Assumption: Stock prices evolve randomly over time.
k Stock prices incorporate expectations about the future.
k Hence, stock prices only change with news.
k News cannot be forecasted & arrives in a random fashion over time.
We hence model the stock price using a stochastic process.

k Stochastic process: Describes how a random variable evolves over time.
k They often include both a deterministic & a random component.
k They can be classified as discrete time or continuous time.
k They can also be classified as discrete variable or continuous variable.
Examples:
k Case 1: Each day a stock price increases by $1 with probability 30%, stays
the same with probability 50% & decreases by $1 with probability 20%.
k Case 2: Each day the stock price change is drawn from a normal
distribution with a specific mean & variance.
Markov processes
Markov processes depend only on the current level of the random variable
k Historical values are of no importance.
Do the following variables follow a Markov process?

k The temperature in London.
k The stock price of Barclay’s Bank.
Markov property of prices is consistent with weakly efficiency markets.
Weak-form of market efficiency.

k The spot price impounds all the information contained in past prices.
k Historical prices contain no info about future prices.
k Technical trading is therefore futile.
k Competition ensures that the markets are weakly efficient.
A good example of a Markov process is the random walk: yt = yt −1 + εt

Continuous-time stochastic process: The wiener process
Let N (µ, ν) denote a normal distribution with expectation µ & variance ν.
A random variable z follows a Wiener process if:

√
1 ∆z = ε ∆t, where ε ∼ N (0, 1).
2 ∆z for any two non-overlapping time periods are independent.
where ∆z is the change in z over a small time interval ∆t.
The Wiener process is a particular type of a Markov process.
The Wiener process is also referred to as Brownian motion.

The wiener process
From the definition of the Wiener process we can show that:
E (∆z ) = E (z (T ) − z (0)) = 0 and var (∆z ) = var (z (T ) − z (0)) = T
k Mean of (z(T) - z(0)):

E (z (T ) − z (0)) = E [∆z (1) + ∆z (2) + . . . + ∆z (T )]
= E [∆z (1)] + E [∆z (2)] + . . . + E [∆z (T )]
= 0 + 0 + . . . + 0 = 0.
k Variance of (z(T) - z(0)):

var (z (T ) − z (0)) = var [∆z (1) + ∆z (2) + . . . + ∆z (T )]
= var [∆z (1)] + var [∆z (2)] + . . . + var [∆z (T )]
= (1 − 0) + (2 − 1) + . . . + (T − (T − 1)) = T .
√
The standard deviation is the square root of the variance ( T ).
k Uncertainty is proportional to the square root of time.
The generalized wiener process
In a generalized Wiener process, the drift rate and the variance rate can
be set to any chosen constants (with the variance > 0).
k Drift rate: Mean change per unit of time for a stochastic process.
k Variance rate: Variance per unit of time for a stochastic process.
k Example of basic Wiener process ∆z: Drift = 0, Variance rate = 1.
The generalized Wiener process can be written as:
∆x = a∆t + b ∆z
√
= a∆t + b ε ∆t
where a is the mean change in x per time unit, and b2 is the variance of
the change per time unit.
If we let the time increment ∆t become smaller and smaller (i.e. ∆t → 0):
√
dx = adt + bdz ⇔ dx = adt + bε dt
The generalized wiener process: Sample path

Itô Process
Generalized Wiener process: dx = adt + bdz
Itô process: Obtained when a & b are deterministic functions of x and t.
dx = a(x , t )dt + b (x , t )dz
Both the expected drift rate & variance rate are liable to change over time.
The Itô process is a particular type of Markov process.

k The change in x at time t depends on the value of x at t (not on its history).

Why generalized wiener process is inappropriate for stocks
Do not use a generalized Wiener process to model stock prices.

k The stock price cannot become negative due to limited liability.
k The expected % change (i.e., return) should remain constant over time - not
the actual change.
k The variance of the actual change should depend on the stock price level
(greater price → greater variance).
The following Itô process, often referred to as Geometric Brownian motion

(GBM), makes more sense:
dS = µSdt + σSdz
where µ is the stock’s expected rate of return and σ is the volatility (i.e.
standard deviation) of the stock price.
√
The discrete-time equivalent is: ∆S = µS ∆t + σS ε ∆t

Simulating a Geometric Brownian Motion
We can sample random paths for the stock price (i.e., the GBM) by
sampling values for ε ∼ N (0, 1).
Suppose µ = 0.15, σ = 0.30, and ∆t = 1 week ( 52

1
= 0.0192 years):
√
∆S = µS ∆t + σS ε ∆t
√
⇒ ∆S = 0.15 S 0.0192 + 0.30 S ε 0.0192
⇒ ∆S = 0.00288 S + 0.0416 S ε
A stock price path is simulated by sampling repeatedly ε from N (0, 1).
Assume that the stock price at the begging of week 1 is $100.

k This implies that the stock price at the beginning of week 2 is 100 + ∆S.

Simulating A Geometric Brownian Motion (cont’d)
Assume that the stock price at the begging of week 1 is $100.

k This implies that the stock price at the beginning of week 2 is 100 + ∆S.
To calculate ∆S during week 1, we sample ε from N (0, 1).

k For instance, ε =0.52.
k ∆S = 0.00288 · 100 + 0.0416 · 100 · 0.52 = 2.45
k At the beginning of week 2 the stock price is: 100+2.45 = 102.45
The stock price at the beginning of week 3 is 102.45 + ∆S.

k Sample ε from N (0, 1). For instance, ε =1.44.
k ∆S = 0.00288 · 102.45 + 0.0416 · 102.45 · 1.44 = 6.43
k At the beginning of week 3 the stock price is: 102.45 + 6.43 = 108.88
. . . and so on . . .
Geometric Brownian Motion: One sample path

Geometric Brownian Motion: More than one sample paths

Itô’s lemma

Itô’s lemma
The stock options price is a function of the underlying stock’s price & time.
k What process does a function of the stock price follow?
Assume that x follows an Itô process: dx = a(x,t)dt+b(x,t)dz
Itô’s Lemma shows that a function G (x , t ) follows the process:
∂G 1 ∂2 G 2

∂G ∂G
dG = a+ + 2
b dt + bdz
∂x ∂t 2 ∂x ∂x

Itô’s lemma: Geometric Brownian Motion
If a stock price follows the GBM (dS = µSdt + σSdz) then G(S,t) follows:
∂G 1 ∂2 G 2 2

∂G ∂G
dG = µS + + 2
σ S dt + σSdz
∂S ∂t 2 ∂S ∂S
Example 1:
Apply Itô’s lemma when the stock price follows a GBM & G = lnS.
∂G 1 ∂2 G 1 ∂G
= , 2
= − 2, =0
∂S S ∂S S ∂t

1 1 2 2 1 1
dG = µS + 0 + − 2 σ S dt + σSdz
S 2 S S

1
= µ − σ2 dt + σdz
2
The lognormal property of stock prices
We have shown that:

1
dlnS = µ − σ2 dt + σdz
2
This means that:

σ2

lnST −lnS0 ∼ N µ− T , σ2 T
2
σ2

2
lnST ∼ N lnS0 + µ − T,σ T
2
Prices are lognormally distributed and continuously compounded returns

are normally distributed.
Itô’s lemma: Geometric Brownian Motion (cont’d)
∂G 1 ∂2 G 2 2

∂G ∂G
dG = µS + + σ S dt + σSdz
∂S ∂t 2 ∂S 2 ∂S
Example 2:
Apply Itô’s lemma to the price of a forward contract written on a
non-dividend paying stock: Ft ,T = St er (T −t )
∂F ∂2 F ∂F
= er (T −t ) , = 0, = −rSer (T −t )
∂S ∂S 2 ∂t
h i
dF = er (T −t ) µS − rSer (T −t ) + 0 dt + er (T −t ) σSdz
= [µF − rF ]dt + σFdz

= [µ − r ]Fdt + σFdz
Black-Scholes (-Merton) model

Towards the Black-Scholes(-Merton) formula
The price of an option is the discounted expected payoff.

k But it is difficult to determine the correct discount rate!
The idea behind the BS formula.

k The idea is identical to that underlying the binomial tree.
k Form a riskless portfolio (long in stocks & short in the option).
k Set the portfolio return over a short period of time equal to the risk-free rate
k This yields a partial differential equation (p.d.e.).

Deriving the Black-Scholes(-Merton) p.d.e.
Assume that stock price follows the Geometric Brownian Motion.

dS = µSdt + σSdz
Additional assumptions: (1) No transaction costs, (2) Continuous

trading, (3) Markets do not jump, and (4) Volatility is constant and known.
From Itô’s lemma, the option value f(S,t) follows the process:
2

∂f ∂f
df = ∂S µS + ∂t + 12 ∂∂Sf2 σ2 S 2 dt + ∂∂Sf σSdz
The discrete version of these equations is:

∆S = µS ∆t + σS ∆z (1)
∂f 1 ∂2 f 2 2

∂f ∂f
∆f = µS + + 2
σ S ∆t + σS ∆z (2)
∂S ∂t 2 ∂S ∂S
The replication portfolio
Buy δ units of the stock (S) and short one option (f).
We can set up a riskless portfolio because:

k The stock price & the option price are affected by the same underlying
source of uncertainty (i.e., stock price movements).
k Over a short period of time the stock price and the option price are perfectly
correlated.
k δ can be chosen so that the gain (loss) from the stock position is offset by
the loss (gain) from the option position.
The value of this portfolio is: Π = δS − f
The change in value of the portfolio over the time interval ∆t is:
∆Π = δ∆S − ∆f (3)

The replication portfolio (cont’d)
Substituting (1) and (2) into (3) we get:
∂f 1 ∂2 f 2 2

∂f ∂f
∆Π = δµS − µS − − σ S ∆t + δ − σS ∆ z (4)
∂S ∂t 2 ∂S 2 ∂S
∆z terms are responsible for the uncertainty in portfolio value.

∂f
k Choose δ = , so that the uncertainty terms cancel out!
∂S
Substituting δ = ∂∂Sf into (4) we get:

∂f 1 ∂2 f 2 2

∆Π = − − σ S ∆t (5)
∂t 2 ∂S 2
A risk-free portfolio must pay the risk-free rate:

∆Π = r Π∆t (6)
The replication portfolio (cont’d)
From (5) and (6) we have:

∂f 1 ∂2 f 2 2

− − σ S ∆t = r Π∆t
∂t 2 ∂S 2
∂f 1 ∂2 f 2 2
⇔ − − σ S = rΠ (7)
∂t 2 ∂S 2
2

Now substitute Π = ∂∂Sf S − f into (7): − ∂∂ft − 12 ∂∂Sf2 σ2 S 2 = r ∂f
∂S S − f
Re-arranging yields the p.d.e.:
∂f ∂f 1 ∂2 f
+ rS + σ2 S 2 2 = rf
∂t ∂S 2 ∂S
Note: As S and t change the δ = ∂∂Sf also changes.

k To keep the portfolio riskless we need to frequently rebalance it.
The Black-Scholes p.d.e. & risk-neutral valuation
Any security whose price is dependent on the stock price and time
satisfies the former p.d.e..
k The particular security being valued is determined using “boundary
conditions” (e.g., the payoffs at maturity).
The p.d.e. is independent of risk preferences.

k We have the risk free rate r and not the expected return on the stock µ.
k Any set of risk preferences can be used → risk-neutral investors.
k Risk neutral valuation.
Risk neutral valuation: A reminder

k We can treat all investors as if they are risk-neutral.
k The expected return on the stock is the risk-free rate.
k The price of the option is the expected payoff under the risk-neutral
probability measure discounted at the risk-free rate.

Risk-neutral valuation: European call price
Under risk-neutral valuation, all assets have a risk-neutral drift:
dS = rSdt + σSdZ
Consider a discounted call price, V = ce−rt , then through Ito’s lemma,:

∂V 1 2 2 ∂2 V

∂V ∂V
dV = + σS 2
+ rS dt + σS dZ
∂t 2 ∂S ∂S ∂S
1 2 2 ∂2 c

∂c ∂c ∂c
= − rc + σ S 2
+ rS dt + σS dZ
∂t 2 ∂S ∂S ∂S
which has exactly the same form as the Black-Scholes p.d.e..
Next from V = ce−rt ,

= V0 = E [VT ] = E e−rT cT

c0
= e−rT E [{max (ST − K , 0)}]
Z ∞
−rT
= e (ST − K ) dST (8)
K
The Black-Scholes formula (no dividends)
If the underlying asset pays no dividends, their solutions are:

k Call: c = S0 N (d1 ) − Ke−rT N (d2 )
k Put: p = Ke−rT N (−d2 ) − S0 N (−d1 )
ln(
S0 2
)+(r + σ2 )T ln(
S0 2
)+(r − σ2 )T √
with d1 = K √
σ T
and d2 = K √
σ T
= d1 − σ T
We can interpret N (d2 ) [N(−d2 )] as the risk-neutral probability of the call

[put] option ending up in-the-money.
k N (d2 ) [N (−d2 )] becomes a real-world probability when we swap r for µ.

The N(x) function
N (x ) is the probability that a normally distributed random variable with a

mean of 0 and a standard deviation of 1 is less than x:
No closed-form solution for N (x ), although there are several efficient

approximations (see Johnson and Kotz, 1974):
e2y
N (x ) ≈ , with y = 0.7988x (1 + 0.04417x 2 ).
1 + e2y
Use distribution tables to compute N (d1 ), N (d2 ), N (−d1 ), N (−d2 ).

Cumulative normal distribution table

Practicing the Black-Scholes model
Assume you have a non-dividend paying stock.

k The current stock price is 30 and its volatility is 25%.
What is the price of a European call written on the stock with strike price
K = 36 and time to maturity T = 16 months?
k The continuously-compounded risk-free rate is 2% p.a..
1 Calculate d1 and d2 :
2 2
ln( SK0 ) + (r + σ2 )T 30
ln( 36 ) + (0.02 + 0.25
2
) 16
12
d1 = √ = q = −0.39
σ T 0.25 1216
√
r
16
d2 = d1 − σ T = −0.39 − 0.25 = −0.68.
12

Practicing the Black-Scholes model (cont’d)
2 Look up N (d1 ) and N (d2 ) using a distribution table:

k N (−0.39) ≈ 0.34827
k N (−0.68) ≈ 0.24825
3 Plug into BS formula:
c = S0 N (d1 ) − Ke−rT N (d2 ))

= 30 · 0.34827 − 36 · e−0.02(16/12) 0.24825 = 1.75

Properties of the Black-Scholes formula
As S0 becomes very large, c tends to S0 − Ke−rT .

k The call option moves more and more into-the-money.
k We can be relatively certain that the call will be exercised.
k The call becomes similar to a forward contract (c → S0 − Ke−rT ).
k Note also that N (d1 ) → 1 and N (d2 ) → 1.
As S0 becomes very large, p tends to zero.

k The put option moves more and more out-of-the-money.
k We can be relatively certain that it will not be exercised.
k Note also that N (−d1 ) → 0 and N (−d2 ) → 0

Properties of the Black-Scholes formula (cont’d)
As σ becomes large, the values of calls and puts increase.

k Holders profit from the upside, but do not suffer from the downside.
∂c ∂p
k In fact, we could show that ∂σ > 0 and that ∂σ > 0.

O
k The amount of unit change is determined by vega v = ∂∂σ
As the time-to-maturity increases, the call option value converges to the

stock value, and the put option value converges to zero.

Dividends &
the Black-Scholes (-Merton) Model

The impact of dividends on Black-Scholes pricing
Dividends change the stock price distribution at maturity.

k In an efficient market, a $5 dividend per share drops the stock price by $5.
Dividend payouts can be modeled in two ways:

1 Continuous payouts occurring at a rate of q.
2 Discrete payouts occurring at specific points in time.
In each case, the dividend payouts shift downwards the distribution of the
stock price at maturity.
Instead of decreasing the stock value at the time dividends occur,

decrease the initial stock price by the value of the dividends.
1 Continuous payouts: S0 e−qT .
2 Discrete payouts: S0 − PV(Dividend payouts).

The Black-Scholes formula (continuous dividends)
If there are dividends, the BS formulae become:

Call: c = S0 e−qT N (d1 ) − Ke−rT N (d2 ) .
Put: p = Ke−rT N (−d2 ) − S0 e−qT N (−d1 ) .
ln(
S0 e−qT
+(r + σ2
2
)T ln(
S0 2
)+(r −q + σ2 )T √
with d1 = K √
σ T
= K √
σ T
and d2 = d1 − σ T .
Use these formulae to value European index options:

k Set S0 to current index level and q to average dividend yield.
We can also use them to value European currency options.

k Set S0 to the FX rate and q to the foreign interest rate.

Practicing the Black-Scholes model with dividends
Reconsider the previous example in the case where the stock pays
dividends.
k Stock: S0 = 30, σ = 25% and it pays a $2 dividend after ten months.
k European call: K = 36 and T = 16.

k Continuously-compounded risk-free rate: r = 2% p.a..
1 Calculate the present value (PV) of the dividend:
PV (Div ) = 2 · e−0.02(10/12) = 1.97
2 Calculate the "new" stock price: 30 − 1.97 = 28.03
3 Calculate d1 and d2 .
2
ln( S0K−D ) + (r + σ2 )T ln( 2836.03 ) + (0.02 + 0.5 · 0.252 ) 16
12
d1 = √ = q = −0.63.
σ T 0.25 1216
√
r
16
d2 = d1 − σ T = −0.63 − 0.25 = −0.92.
12
Practicing the Black-Scholes model with dividends (cont’d)
1 Look up N (d1 ) and N (d2 ) in the normal distribution tables.

k N (−0.63) ≈ 0.26435.
k N (−0.92) ≈ 0.17879
2 Plug into BS formula.
c = (S0 − D )N (d1 ) − Ke−rT N (d2 )

16
= 28.03 · 0.26435 − 36 · e−0.02( 12 ) 0.17879 = 1.14

Probability of ending up ITM

The lognormal risk-neutral distribution
Assume there are no dividends.
Using Itô’s lemma and assuming that dS = rSdt + σSdz and G = lnS, we
have shown that:

1 2 2
ln ST ∼ N ln S0 + r − σ T , σ T
2

Risk-neutral probability of European put ending up ITM
We have shown that: ln ST ∼ N ln S0 + r − 21 σ2 T , σ2 T

Hence:
Pr (ST < K ) = Pr (ln ST < ln K )
!
ln K − ln S0 − r − 21 σ2 T
= N √
σ T
!
ln SK0 + r − 21 σ2 T
= N − √
σ T
= N (−d2 )
We can interpret N (−d2 ) as the risk-neutral probability of the put option

ending up in-the-money (ITM).
k N (−d2 ) becomes a real-world probability when we replace r by µ.

Risk-neutral probability of European call ending up ITM
We have shown that: ln ST ∼ N ln S0 + r − 21 σ2 T , σ2 T

Hence:
Pr (ST > K ) = Pr (ln ST > ln K )

= 1 − Pr (ln S < ln K )
= 1 − N (−d2 )
= N ( d2 )
We can interpret N (d2 )as the risk-neutral probability of the call option
ending up in-the-money (ITM).
k N (d2 ) becomes a real-world probability when we replace r by µ.

Summary
In this lecture, we learned about valuing European call and put options
using continuous-time approaches.
We hence reviewed the following topics:

k Basic principles of stochastic processes.
k Replication portfolios in continuous-time.
k The Black-Scholes(-Merton) formula.
We shall next consider the Greeks (partial derivatives of option value with
respect to input parameters) and volatility smiles.

Appendix A:
Derivation of Itô’s Lemma
Not examinable!

Discretise a Diffusion Process
dx= adt + bdW

√
∆x = a ∆t + b ε ∆t
∆x 2 = b2 ε2 ∆t + higher order terms of ∆t
As ∆t is very small, order higher than 1 is ignore. Also, since ε ∼ N (0, 1),
=E (ε) 0
Var (ε) = 1
2
2
Var (ε) = E ε − [E (ε)] = 1
E ε2

= 1
∆x =
2
b 2 ∆t (9)

Taylor Series Expansion with Stochastic Time
If the price of a derivative, G, is a function of the price of only the underlying

asset x
∂G 1 ∂2 G
∆G = ∆x + ∆x 2 + · · ·
∂x 2 ∂x 2
When the price of a derivative, G (x , t ), is a function of the price of the

underlying asset x and time t, Taylor Series Expansion on G (x , t ) gives rise to
∂G ∂G 1 ∂2 G 1 ∂2 G 1 ∂2 G 2
∆G = ∆x + ∆t + ∆ x 2
+ ∆ x ∆ t + ∆t + · · ·
∂x ∂t 2 ∂x 2 2 ∂x ∂t 2 ∂t 2

Since ∆t is very small in the limit, higher order term of ∆t may be omitted
∂G ∂G 1 ∂2 G
∆G = ∆x + ∆t + ∆x 2
∂x ∂t 2 ∂x 2
From (9), ∆x 2 = b2 ∆t ,
∂G ∂G 1 ∂2 G 2
∆G = ∆x + ∆t + b ∆t
∂x ∂t 2 ∂x 2
As ∆t → 0, we get
∂G ∂G 1 ∂2 G 2
dG = dx + dt + b dt
∂x ∂t 2 ∂x 2
Substituting dx = adt + bdz, we get Itô’s lemma
∂G 1 ∂2 G 2

∂G ∂G
dG (x , t ) = a+ + 2
b dt + bdz
∂x ∂t 2 ∂x ∂x

Appendix B:
Some Notes on Calculus
Not examinable!

Differentiation
Constant
d
k =0
dx
Power
d
kx n = knx n−1
dx
Sum/difference
d d d
[f (x ) ± g (x )] = f (x ) ± g (x )
dx dx dx
Product
d d d
[f (x ) · g (x )] = f (x ) g (x ) + g (x ) f (x )
dx dx dx
Chain rule
z = f (y ) , and y = f (x )
dz dz dy
= ·
dx dy dx

Differentiation (cont’d)
Total differential, for z = f (x , y )
∂f ∂f
dz = dx + dy
∂x ∂y
Exponential and log
d
ex = ex
dx
d d
e f (x ) = e f (x ) f (x )
dx dx
d 1
ln x =
dx x
d 1 d
ln f (x ) = f (x )
dx f (x ) dx

Integration
Sum Z Z Z
[f (x ) + g (x )] dx = f (x ) dx + g (x ) dx
Multiple Z Z
K f (x ) dx = K f (x ) dx
Integral of normally distributed variable: If y ∼ N (µ, σ) and let

√
b = σ T − t, then
σ

µ−a
Z ∞
f (y ) dy = N
a σ
b

µ−a
Z ∞
1 2
ey f (y ) dy = N + σ eµ+ 2 σb
b
a σ
b

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Financial Derivatives

Continuous Time Option Pricing

Dr Eirini Konstantinid & Dr Ser-Huang Poon

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 1 / 56

In the previous lecture, we priced options using discrete-time methods.

In this lecture, we turn to continuous-time approaches.

In the next lecture, we shall consider Greeks (partial derivatives of option

(Dr Eirini Konstantinidi, AMBS) Financial Derivatives 2 / 56

Video 1: Intended learning outcomes.

Video 1: Review of stochastic processes.

Video 2: Itô’s lemma.

Video 3: The Black-Scholes(-Merton) model.

Video 4: Probability of ending up ITM.

By the end of this lecture you should be able to :

Understand basic concepts on stochastic processes.

Discuss the appropriate modelling of stock prices.

Apply Itô’s lemma.

Discuss implications for the stock price (return) distribution.

Derive the Black-Scholes(-Merton) p.d.e..

Use and discuss the Black-Scholes(-Merton) model.

Derive, apply and discuss the probability to end up ITM.

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Hull (7th & 6th Edition): Chapter 12, 13 & 15.

Hull (8th Edition): Chapter 13, 14 & 16.

Hull (9th & 10th Edition): Chapter 14, 15 & 17.

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We hence model the stock price using a stochastic process.

Do the following variables follow a Markov process?

Markov property of prices is consistent with weakly efficiency markets.

Weak-form of market efficiency.

A good example of a Markov process is the random walk: yt = yt −1 + εt

Let N (µ, ν) denote a normal distribution with expectation µ & variance ν.

A random variable z follows a Wiener process if:

The Wiener process is a particular type of a Markov process.

The Wiener process is also referred to as Brownian motion.

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k Mean of (z(T) - z(0)):

k Variance of (z(T) - z(0)):

The generalized Wiener process can be written as:

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Generalized Wiener process: dx = adt + bdz

Itô process: Obtained when a & b are deterministic functions of x and t.

dx = a(x , t )dt + b (x , t )dz

The Itô process is a particular type of Markov process.

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Do not use a generalized Wiener process to model stock prices.

The following Itô process, often referred to as Geometric Brownian motion

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Suppose µ = 0.15, σ = 0.30, and ∆t = 1 week ( 52

A stock price path is simulated by sampling repeatedly ε from N (0, 1).

Assume that the stock price at the begging of week 1 is $100.

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Assume that the stock price at the begging of week 1 is $100.

To calculate ∆S during week 1, we sample ε from N (0, 1).

The stock price at the beginning of week 3 is 102.45 + ∆S.

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Assume that x follows an Itô process: dx = a(x,t)dt+b(x,t)dz

Itô’s Lemma shows that a function G (x , t ) follows the process:

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We have shown that: