UNIVERSITY OF ZIMBABWE

Course: Introduction to Financial Mathematics/HMTH216

Selected Questions And Their Solutions

Title: Binomial and Black-Scholes-Merton Option Pricing Models

Author

Ivan Tadiwanashe Chuma

Lecturer

Registration Number

Revised: July 20, 2021

 Option Pricing Models

QUESTION 1

By using a one step binomial model and the replicating portfolio Π = ∆S − N B, where ∆ is the number of
shares, and N is the number of bonds B, show that the value of an European call option is

C0 = e−rT [pCu + (1 − p)Cd ];

erT − d
where p = , is the upstate risk neutral probability, r is the risk-free interest rate with continuous
u−d
compounding, T is the maturity time, Cu is the payoff from the option if the stock price moves up, Cd is
the payoff from the option if the stock price moves down.
Hint: In our notes interest rate r > 0 was assumed in such a way that a $ invested in the money market at
time t = 0 will be $(1 + r) at time t = 1. Here assume interest rate to be continuously compounded. [15]

SOLUTION

We assume that the interest rate is continuously compounded and the stock does not pay any dividends.
Also, stock price movements should not give rise to arbitrage opportunities that is,

0 < d < erT < u

Note that this case is a one period Binomial model.

We are given the replicating portfolio Π = ∆S − N B where 1 bond cost 1 currency unit i.e B = 1.
Now, we form the following portfolio:
• Buy ∆ shares of stock
• Borrow N currency units at risk-free rate (equivalently, short sell N zero-coupon risk-free bonds with
current price of N currency units and face value N erT paid at the end of the period)
Remark 1. This portfolio is called a replicating portfolio because borrowing N bonds at N currency units
and buying ∆ shares of stock creates a payoff similiar to that of a call option in this case.

Stock and call option price dynamics for one-step Binomial model

uS
p

Stock price = S

(1
−
p)
dS

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 Option Pricing Models

Cu = ∆uS − N erT
p

C0 = ∆S − N

(1
−
p)
Cd = ∆dS − N erT

Let S be the stock price today. From the above one-step Binomial trees we obtained

Cu = ∆uS − N erT (1)

Cd = ∆dS − N erT (2)

Using (1) to find ∆, we have

Cu + N erT
∆= (3)
uS
Substituting ∆ from (3) into (2) yields

(Cu + N erT )d
Cd = − N erT
u
(Cu + N erT )d
N erT = − Cd
u
N uerT = dCu + dN erT − uCd
N (uerT − derT ) = dCu − uCd
 
−rT dCu − uCd
⇒N =e (4)
u−d

Substituting the value of N from (4) into (3) yields

 h i
−uCd
Cu + e−rT dCuu−d erT
∆=
h uSi
dCu −uCd
Cu + u−d
=
uS
uCu − dCu + dCu − uCd
=
uS(u − d)
u(Cu − Cd )
=
u(uS − dS)
Cu − Cd
=
uS − dS

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 Option Pricing Models

Thus in summary we have ∆ and N as

Cu − Cd
∆=
uS −dS 
−rT dCu − uCd
N =e
u−d

Remark 2. A call option has been replicated by assuming a long position in the underlying stock and a
short position in the bonds.
Thus the portfolio value at inception is given by

C0 = ∆S − N

Now, substituting ∆ and N into the above formula yields

   
Cu − Cd dCu − uCd
C0 = S − e−rT
uS − dS u−d
 rT
u − erT
   
−rT e −d
=e Cu + Cd
u−d u−d
= e−rT [pCu + (1 − p)Cd ],

where

erT − d u − erT
p= and 1 − p =
u−d u−d

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 Option Pricing Models

QUESTION 2

(a) The classical Black-Scholes market is a financial market that maybe represented using a system of
stochastic differential equations

dX0 (t) = rX0 (t)dt; X0 (0) = 1,

dX1 (t) = µX1 (t)dt + σX1 (t)dB(t); X1 (0) = x > 0,

where r is the interest rate for the safe asset, X0 (t) is the unit price of the riskless asset, X1 (t) is the
unit price of the risky asset, µ is the measure of the mean return of thr risky asset, σ is the measure
of the volatilty of the asset returns and Bt is a 1-dimensional Brownian motion.
(i) Express the Black-Scholes market in explicit form. [15]
(ii) Find the normalisation of the market. [3]
(b) State any four assumptions adopted in the derivation of the Black-Scholes option pricing model. [2]
(c) Show that the Black-Scholes-Merton partial differential equation which models the dynamics of the
price of the European call option C = C(t, St ) with regard to changes in time and changes in the
underlying asset price is given by

∂C 1 ∂2C ∂C
+ σ 2 St2 2 + rSt − rC = 0,
∂t 2 ∂S ∂S
where r is the risk free interest rate. [10]

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 Option Pricing Models

SOLUTION

(a) (i) The first differential equation is given by

dX0 (t) = rX0 (t)dt

has a deterministic variable only which is time t. Hence dividing throughout by X0 (t) yields

dX0 (t)
= rdt
X0 (t)

Now, the implied integral equation is given by

Z t Z t
dX0 (u)
= rdu
0 X0 (u) 0
ln X0 (u)|t0 = ru|t0
ln X0 (t) − ln X0 (0) = rt
ln X0 (t) − ln (1) = rt since X0 (0) = 1
ln X0 (t) = rt
⇒ X0 (t) = ert

The second stochastic differential equation is given by

dX1 (t) = µX1 (t)dt + σX1 (t)dB(t); X1 (0) = x > 0

Dividing throughout by X1 (t) yields

dX1 (t)
= µdt + σdB(t)
X1 (t)

Now, the implied integral equation is given by

Z t Z t Z t
dX1 (u)
= µdu + σdB(u)
0 X1 (u) 0 0

Remark 3. The integral on the LHS of the implied integral equation is a stochastic process and
hence cannot be evaluated using deterministic calculus. The first integral on the RHS has no
stochastic terms hence can be evaluated using deterministic calculus. The second integral on the
RHS contain a stochastic term, but the coefficient of dB(u) is a time-invariant constant hence
the integral can be evaluated using deterministic calculus. Thus
Z t
dX1 (u)
= µu|t0 + σB(u)|t0
0 X1 (u)
Z t
dX1 (u)
= µt + σB(t) since B(0) = 0
0 X1 (u)

Now to evaluate the following stochastic integral note that

Z t
dX1 (u)
6= ln X1 (u)|t0
0 X1 (u)

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 Option Pricing Models

and we have to define Yu as follows

Yu = ln X1 (u)

Applying Ito’s Lemma on Yu yields

∂Yu 1 ∂ 2 Yu
dYu = dX1 (u) + dX 2 (u)
∂X1 (u) 2 ∂X12 (u) 1

Integrating both sides from 0 to t yields

t t Z t
1 ∂ 2 Yu
Z Z
∂Yu 2
dYu = dX1 (u) + 2 (u) dX1 (u)
0 0 ∂X1 (u) 0 2 ∂X 1
Z t Z t
1 1 2
Yt − Y0 = dX1 (u) − 2 (u) dX1 (u)
0 X1 (u) 0 2X 1

Recall we are given the geometric Brownian motion(GBM) stochastic differential equation

dX1 (u) = µX1 (u)du + σX1 (u)dB(u); X1 (0) = x > 0

2
⇒ dX12 (u) = (µX1 (u)du + σX1 (u)dB(u))
= µ2 X12 (u)du2 + 2µσX12 dudB(u) + σ 2 X12 dB 2 (u)

Now, take note of the following (you just need to know only, not necessary to reproduce in the
exam)

du2
du2 = o(du) = lim =0
du→0 du

dB 2 (u) = E[B(u + du) − B(u)]2

= V[B(u + du) − B(u)]
= du since B(u + du) − B(u) ∼ N (0, du)
dudB(u)
dudB(u) = o(du) = lim
du→0 du
3
du 2
= lim since dB 2 (u) = du
du→0 du
=0

Hence

dX12 (u) = σ 2 X12 dB 2 (u) = σ 2 X12 du

Remark 4. A function g(u) = o(du) if as du → 0, g(u) tends to zero faster than du itself, that
is
g(u)
lim =0
du→0 du

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 Option Pricing Models

Thus
Z t Z t
1 1
Yt − Y0 = dX1 (u) − σ 2 X12 (u)du
0 X1 (u) 0 2X12 (u)
t Z t
σ2
Z
1
= dX1 (u) − du
0 X1 (u) 0 2
Z t
1 σ2
= dX1 (u) − t
0 X1 (u) 2
Z t 2
1 σ
⇒ dX1 (u) = Yt − Y0 + t
0 X1 (u) 2
σ2
= ln X1 (t) − ln X1 (0) + t
2
σ2
 
X1 (t)
= ln + t
X1 (0) 2

Hence the stochastic integral

t
σ2
Z  
dX1 (u) X1 (t)
= ln + t (1)
0 X1 (u) X1 (0) 2

Recall that
Z t
dX1 (u)
= µt + σB(t) (2)
0 X1 (u)

Substituting (1) into (2) we get

σ2
 
X1 (t)
ln + t = µt + σB(t)
X1 (0) 2
σ2
   
X1 (t)
ln = µ− t + σB(t)
X1 (0) 2

Taking natural logarithms on both sides yields

σ2
  
X1 (t)
= exp µ− t + σB(t)
X1 (0) 2
σ2
  
X1 (t) = X1 (0) exp µ− t + σB(t)
2
σ2
  
= x exp µ− t + σB(t) since X1 (0) = x > 0
2

Thus the values of X0 (t) and X1 (t) are given by

X0 (t) = ert
σ2
  
X1 (t) = x exp µ− t + σB(t)
2

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 Option Pricing Models

Hence the Black-Scholes market in explicit form is given by

 
X0 (t)
X(t) =
X1 (t)
ert
" #
= n 2
o
x exp µ − σ2 t + σB(t)

(ii) In order to find the normalisation of the market we have to divide X(t) = (X0 (t), X1 (t)) by the
arbitrage free unit price of the riskless asset (since it does not have any stochastic component)
which in this case is X0 (t). That is the normalised market denoted by X(t)e = (Xe0 (t), X
e1 (t)) is
given by

e0 (t) = X0 (t)
X
X0 (t)
=1

e1 (t) = X1 (t)
X
X0 (t)
= X1 (t)e−rt
σ2
  
= x exp µ− t + σB(t) e−rt
2
σ2
  
= x exp µ− − r t + σB(t)
2

Hence the normalisation of the market is given by

" #
Xe0 (t)
X(t)
e = e
X1 (t)
" #
1
= n
σ2
 o
x exp µ − 2 − r t + σB(t)

Remark 5. Note that the normalised market X(t)

e = (X
e0 (t), X
e1 (t)) is a martingale with respect
to its natural filtration.

QUESTION 3: STOCHASTIC INTEGRALS

Show that
(a)
Z t Z t
udBu = tBt − Bu du
0 0

(b)
Z t Z t
1
Bu2 dBu = Bt3 − Bu du
0 3 0

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 Option Pricing Models

SOLUTION

(a) Note that the stochastic integral

Z t
udBu 6= uBu |t0
0

Now, define Yu as follows

Yu = uBu

Applying Ito’s Lemma on Yu yields

∂Yu ∂Yu 1 ∂ 2 Yu 2
dYu = du + dBu + dBu
∂u ∂Bu 2 ∂Bu2
dYu = Bu du + udBu

Integrating both sides from 0 to t yields

Z t Z t Z t
dYu = Bu du + udBu
0 0 0
Z t Z t
Yt − Y0 = Bu du + udBu
0 0
Z t Z t
tBt = Bu du + udBu
0 0

Rt
Making 0 udBu the subject yields
Z t Z t
udBu = tBt − Bu du
0 0

(b) Note that the stochastic integral

t
t
Bu3 
Z
Bu2 dBu 6 =
0 3 0

Now, define Yu as follows

Bu3
Yu =
3

Applying Ito’s Lemma on Yu yields

∂Yu 1 ∂ 2 Yu 2
dYu = dBu + dBu
∂Bu 2 ∂Bu2
1
dYu = Bu2 dBu + 2Bu du since dBu2 = du
2
dYu = Bu2 dBu + Bu du

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 Option Pricing Models

Integrating both sides from 0 to t yields

Z t Z t Z t
dYu = Bu2 dBu + Bu du
0 0 0
Z t Z t
Yt − Y0 = Bu2 dBu + Bu du
0 0
t t
Bt3
Z Z
= Bu2 dBu + Bu du since B0 = 0
3 0 0

Rt
Making 0 Bu2 dBu the subject yields

t t
B3
Z Z
Bu2 dBu = t − Bu du
0 3 0

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