HMTH216 Lecture Notes

HMTH216 Introduction to Financial Mathematics
P. Sibanda
Room 236 New Wing

Department of Mathematics and Computational Sciences
Faculty of Science
University of Zimbabwe
April 27, 2021
P. Sibanda HMTH216 April 27, 2021 1 / 73

General Information
Topics to be covered:
Theory of Interest
Derivatives
Trading strategies involving options
Arbitrage
Binomial Option Pricing Model
Modelling Stock Price
The Black Scholes Model

Textbooks:
J. Robert Buchanan, An Undergraduate Introduction to Financial
Mathematics, 3rd edition, World Scientific, 2012.
J. Hull, Options, Futures and Other Derivatives, 7th Edition,
Prentice-Hall, 2008.
P. Wilmott, S. Howison and J. Dewynne, The Mathematics of
Financial Derivatives: A Student Introduction, Cambridge University
Press, 1995
Course work is the average of the tests: Weight 50%
Final Examination is 2hours long: Weight 50%

Topic 1: Theory of Interest
Money is the circulating medium of exchange as secured by the

government (and hence its citizens).
We define the time value of money using the interest rate i.e What is
the future value V (t) at time t = T of an amount P invested or
borrowed today at t = 0?
We define interest rate as a payment made in exchange for being in
debt to another party. Once you deposit money with a bank they owe
you the money back, so they are in debt to you and will pay you
interest in return. The rate part comes in the fact that it is expressed
as a % payment per an um.
It is interesting to note that if we have the option of receiving $100
today, or $100 a year from now, we will choose to get the money now.
There are several reasons for our choice to get the money
immediately.Give reasons why this is so.

In exchange for the temporary use of an investor’s money, a bank or
other financial institution agrees to pay interest, a percentage of the
amount invested, to the investor.
There are many different schemes for paying interest. We will
describe some of the most common types of interest and contrast
their differences.
The initially deposited amount which earns the interest will be called
the principal amount and will be denoted P.
The value of the investment at time t after accruing interest will be
denoted by V(t).
Interest rates will be denoted symbolically by r.
The time period of the deposit is t years.
In the case of compound interest, we will let n denote the number of
compounding periods per year.

Simple Interest
In general, the simple interest formula is given by
V (t) = P(1 + rt). (1)
This implies that the average account balance for the period of the
deposit is P and when the balance is withdrawn after the time period
t years, the principal amount P plus the interest earned Prt is
returned to the investor.
No interest is credited to the account until the time period has
elapsed.

Example
A person deposits $5, 000 in a bank account which pays 6% simple interest
per year. Find the value of his deposit after 4 years.
P= $5, 000
r=0.06
t= 4
The simple interest formula is given by
V (t) = P(1 + rt).
Therefore the value of his deposit after 4 years is
V = $5, 000(1 + 0.06 ∗ 4) = $6, 200.

Compound Interest
Whenever interest is allowed to earn interest itself, an investment is

said to earn compound interest.
We will let n denote the number of compounding periods per year.
For example for interest “compounded monthly” n = 12.
If the annual interest rate is r, then the interest rate per compounding
period is nr . Second, the elapsed time should be thought of as some
number of compounding periods rather than years. Thus, with n
compounding periods per year, the number of compounding periods
in t years is nt.
Therefore, the formula for compound interest is
r nt
V (t) = P 1 + (2)
n

Example
An investment earns 3% compounded monthly. Find the value of an initial
investment of $5, 000 after 6 years.
P= $5, 000
r=0.06
t= 4
n=12
The formula for compound interest is
r nt
V (t) = P 1 + (3)
n
Therefore the value of the initial investment after 4 years is
0.06 12×4
V = $5, 000 1 + ≈ $6, 352.45
12

Comparing the examples given above points us to the idea that compound
interest builds capital faster than simple interest as illustrated by the graph
below.

Continuously compounded Interest
Mathematically, when considering the effect on the compound

amount of more frequent compounding, we are contemplating a
limiting process.
In symbolic form we would like to find the compound amount V
which satisfies the equation
r nt
V (t) = lim P 1 + .
n→∞ n
Applying elementary calculus, we arrive at the formula for
continuously compounded interest,
V (t) = Pe rt.
This formula may seem familiar since it is often presented as

the exponential growth formula in elementary algebra,
precalculus, or calculus.
Example
Suppose an investment earns 6% interest computed continuously. If
$5,000 is invested what will be the value of the investment in 4 years?
P= $5,000
r=0.06
t=4
The formula for continuously compounded interest is
V (t) = Pe rt (4)
Therefore the value of the initial investment after 4 years is
V = $5, 000e 0.06×4 ≈ $6, 356.25

Comparing the examples shows that continuously compounded interest
build capital faster than compound interest as supported by the graph
below.

Present Value
Make own notes: Reference Text- J. Robert Buchanan

Rate of Return
Make own notes: Reference Text- J. Robert Buchanan.
Attempt Tutorial .

Topic 2: Derivatives
Financial markets are where financial contracts are bought and sold.
Markets act as the third party in all transactions. They do not set the
prices of things they merely allow the buyers and sellers to meet or
advertise products. They also perform the function of recording all
transactions and making that knowledge public, so that all
participants in the market can see the price at which things are sold.
Financial contract is a written agreement between two parties to
exchange payments according to some specified criteria. The two
parties are normally called the holder and seller.

Contractholder is normally the buyer of a contract, who pays money
at the beginning in exchange for receiving some payments at a later
date. Because payments may not always be positive a contract could
be free to enter at the start or even one where you pay to hold it.
Contractseller holds the opposite position to the holder, which
normally mean they receive money at the beginning in exchange for
giving out some payments at a later date

Definition
A derivative is a financial contract whose value at expiration date T
depends on the values of other underlying variables at time T.
Other names are financial derivative, derivative security, derivative product.

Types of derivatives
There are four basic types of derivative contracts, which are:

Option contacts
Forward contracts
Futures contracts
Swaps
A stock option, for example, is a derivative whose value is dependent on
the stock price.

Options
Definition
An option is a financial contract which gives the holder the right but not
the obligation to buy or sell an asset for an agreed upon price at some
time in the future.
European call option gives the holder the right (not obligation) to buy
underlying asset at a prescribed time T for a specified (strike) price K.
European put option gives its holder the right (not obligation) to sell
underlying asset at a prescribed time T for a specified (strike) price K.

Example
Consider a three-month European call option on a BP share with a strike
price K = 15 (T = 0.25). If you enter into this contract you have the right
but not the obligation to buy one share for K = 15 in a three months time.
Whether you exercise your right depends on the stock price in the market
at time T:
If the stock price is above $15, say $25, you can buy the share for $15,
If the stock price is below $15, there is no financial sense to buy it.
The option is worthless.

Option Positions

Payoff Diagrams

Profit vs Payoff diagram

Short selling
Definition
Short selling is the practice of selling assets that have been borrowed from
a broker with the intention of buying the same assets back at a later date
to return to the broker.
This technique is used by investors who try to profit from the falling price
of a stock.

Portfolios
Definition
A portfolio is a range of investments held by an individual. We assume
that portfolios may contain both positive and negative positions in stocks,
bonds, call and put options.
Mathematically we tend to denote portifolios as Π and your position in

each asset will be positive if you are holding it (long) and negative if you
are selling it (short).
Example
Π = 2S + 4C − 5P
This is a portfolio consisting of long position in two shares, long position

in four call options and short position in five put options.

Hedge
Remember that the price of taking a certain position will be related

to the likely payoffs i.e there is no easy way to make money on the
stock market.
If there is a large probability that there will be a negative payoff at
the end of the contract (you pay out money rather than receiving it)
then it is likely that the portfolio will be very cheap (or even negative
in price, so you receive money at the start) to set up.
The investor has to balance up the risk of winning and losing against
their view on the market. Setting up different portfolios will allow
them to maximise returns given what they think will happen in the
future.

There are two main concerns for an investor that is trading in the
market, that is profit and risk. When an investor buys or sells a
contract they either wish to increase their profit or hedge their risks.
If the investor wishes to make a profit, they will normally design a
portfolio with large positive payoffs that increases the risk.
If the investor wishes to hedge or reduce risk, they design or adapt
their existing portfolio so that both potential profit or losses are
lower. Hedge is something an investor does to reduce their risk. This
usually means that they are protecting themselves against a large
financial loss.
However in Financial Mathematics a reduction in risk might mean
that both large losses and profits are avoided, resulting in a less risky
portfolio.

One of the most common portfolios is the straddle and the value of
this portfolio is given by
Π(S, t) = C (S, t; K ) + P(S, t; K ) (5)
and therefore the payoff at maturity (t = T) is

K − S S < K (exercise put)
Π(S, T ) =
S − K K ≥ S (exercise call)
So this has large positive winnings if the stock price has a large
downward movement or if the stock has a large upward movement.
Given that the investor wins both ways, it follows that the cost of
setting up such a portfolio will be relatively high.

The opposite position of a short straddle is what you get if you sell
those same two options. We write the value of this portfolio as
Π(S, t) = −C (S, t; K ) − P(S, t; K ) (6)
At maturity we have

−(K − S) S < K (buyer exercises put)
Π(S, T ) =
−(S − K ) K ≥ S (buyer exercises call)
Now this contract has negative payoffs in all scenarios, so why would
you do it? Well if the payoff is always negative then the person you
sell it to will have to give you a lot of money at the start.
This means that you make money by hoping that there isn’t a large
movement up or down. As long as movements in stock price are small
you are able to charge enough at the start to still make a profit after
you have paid out any winnings at the end. This can be risky as you
tend to win small amounts very often but there is always a small
chance you might lose big and potentially go bankrupt i.e this a very
risky strategy!
Risk
A risky investment is one where the investment’s actual return will be

different than what is expected.
Risky investments may go up as well as down and they include the
possibility of losing.
If a financial contract that is trading in a market is risky, economic
theory tells us that different individuals will value that contract
differently according to their own current situation.
If for instance one investor is extremely rich, and another is extremely
poor, they will have a different view on an investment according to
what they feel as though they are able to lose.
The rich investor may feel they are able to gamble for a big win since
small losses won’t hurt them whereas the poor investor cannot take
risks in case they end up without enough money to pay the bills.

Risk free Investment
When dealing with contracts that make payments in the future there
is always a risk that you won’t get paid, even banks sometimes run
out of money!
In economics, we like to imagine that there does exist an investment
in the economy that is completely risk-free, and we can then use this
investment to compare against our options, portfolios etc.
An example is a Bond which is a contract that yields a known
amount F, called the face value, on a known time T, called the
maturity date. The authorised issuer (for example, government) owes
the holder a debt and is obliged to repay the face value at maturity
and may also make interest payments (the coupon). We will assume
in this course that the only bonds traded are those issued by
governments that can be assumed to be risk free.

The term B(t) will denote a risk free investment in government bonds.
The return on a risk free bond can be defined as
dB
= rdt
B
where r is the risk free interest rate.
Attempt Tutorial 2

Topic 3: Trading Strategies Involving Options
A combination is an option trading strategy that involves taking a position

in both calls and puts on the same stock. We will consider straddles and
strangles.
Definition
A long straddle is a combination which involves the purchase of a call and
a put on the same underlying asset with the same strike price and
expiration date.
-Refer to notes given in class for details.

Definition
A long strangle is a combination which involves the purchase of a put and
a call on the same underlying asset with the same expiration date and
different strike prices.
-Refer to notes given in class for details.

Reading Assignment
short straddle
short strangle
Attempt tutorial

Topic 4: Arbitrage
The key principle of financial mathematics is No Arbitrage Principle i.e

There are never opportunities to make risk-free profit.
Arbitrage opportunity arises when a zero initial investment Π0 = 0 is
identified that guarantees non-negative payoff in the future such that
ΠT = 0 with non-zero probability. Arbitrage opportunities may exist
in a real market.

Reading Assignment
Read and make own notes on

Put call parity
Upper and lower bounds on European Call and Put options

Topic 5: The Binomial Asset Pricing Model
The Binomial Asset Pricing Model is used to price options in discrete

time financial markets.
It can be used to price different assets but in this course we discuss it
in the context of pricing of options.
We start by deriving the one period version of the model.
Specifically we obtain the BAPM for the valuation of European call
options.

Derivation of the Model
It is assumed that there are only three assets available in the market and
these are:
(i) The riskless asset (bank account/ riskless bond) which offers an
interest rate r per period which is considered to be constant
throughout the life of the contract.
(ii) Stock
(iii) European Call Option written over the stock with exercise price K at
maturity time T.

Assumptions behind the model
The market is frictionless i.e There are no transaction costs on the

market, no commissions and taxes.
Investors are rational
Assets are infinitely divisible.
The price of the stock at time t is denoted by St and that of the call is Ct
, ∀t ∈ [0, T ].
Suppose that on the terminal date the economy may be in an upstate or
downstate.
We also suppose that that there exist two real numbers u and d such that
0 < d < 1 + r < u.

Price dynamics of the Stock
At initial time S = S0 and at maturity S = ST . Therefore in this case

uS0 = Su := ST ,u and similarly dS0 = Sd := ST ,d where uS0 (uSd ) is the
terminal price of the stock if there is an upstate (downstate).

The problem
The problem is to determine the price of the option at time 0, t = 0

i.e C0 .
We need a model that allows us to determine a fair price of the
option i.e a no arbitrage price for the call option.

Price dynamics of the call option price
At initial time C = C0 and at maturity C = CT . Therefore in this case

Cu := CT ,u = max{Su − K , 0} and similarly
Cd := CT ,d = max{Sd − K , 0} where Cu (Cd ) is the price of the
call option if the stock price increases (decreases).

The premium C0 (to be determined) is used to create a portfolio in
bonds and stocks.
Suppose we buy ∆ stocks and B bonds using the premium. (∆ and
B are known)
Initial Value of the portfolio assuming 1 bond cost 1 currency unit is
C0 = ∆S0 + B (7)
The value of the portfolio if there is an upstate is
Cu = ∆Su + (1 + r )B (8)
and if there is a downstate:
Cd = ∆Sd + (1 + r )B (9)

Solving 8 and 9 simultaneousy, we get:
Cu − Cd
∆= (10)
Su − Sd
and
1 u(Cu − Cd )
B= Cu − (11)
1+r u−d
The values of ∆ and B are used to compute the initial value of the
replicating portfolio.
∆ is called the hedge ratio and the portfolio is perfectly hedged when
∆Su − Cu = ∆Sd − Cd , (12)
that is to say, the portfolio is a replicating portfolio if the value of the

portfolio is the same in both future states of the economy.

That initial value of the replicating portfolio is the price of the
European call option at t = 0. Thus
1 h1 + r − d u − (1 + r ) i
C0 = Cu + Cd (13)
1+r u−d u−d
Equation 13 is the Binomial Option Pricing Model for the one period
market.

Risk neutral probabilities
1+r −d u−(1+r )
Setting p = u−d and q = u−d in 13, we have,
1 h i
C0 = pCu + qCd (14)
1+r
where p and q are called risk neutral probabilities.
p is the upstate risk neutral probability.
q is the down state risk neutral probability.
Note (verify) that p + q = 1.

Topic 6: Continuous Model for share Price
Our discrete models as in the previous chapter, are only a crude

approximation to the way in which stock markets actually move.
A better model would be one in which stock prices follow a stochastic
process.
Definition
A stochastic process is a mathematical model for the occurrence at each
moment after the initial time of a random phenomenon.

Firstly we note that the absolute change in the asset price is not by
itself a useful quantity.
So instead, with each change in asset price, we associate a return,
defined to be the change in in the price divided by the original value,
dS
.
S
Now suppose that at time t the asset price is St , let dt be a small
subsequent time interval during which St changes to St + dSt .
Note: We use the notation d· for the small change in any quantity over
this time interval when we intend to consider it as an infinitesmal change.
Now the question is how can we model the corresponding return on
dS
the asset, i.e, what is equal to?
S
The commonest model decomposes this return into two parts:

1. Deterministic part (µdt)
This models the return on money invested in a risk free bank account.
µ is a measure of the average rate of growth of the asset price, also
known as the drift.
In simple models, µ is taken to be a constant, in more complicated
models, it can be a fraction of S and t.

2. Undeterministic part (σdWt )
This models the random change in the asset price in response to

external effects such as unexpected news.
σ is a measure of the volatility (fluctuation) of the asset returns.
dW stands for ∆W = W (t + ∆t) − W (t).
W (t) is a Wiener process/Brownian motion.
Putting the two parts together we obtain the stochastic differential
equation
dSt = µSt dt + σSt dWt (15)
which is the equation for the stock price.

Note that if we want to make the model deterministic, we eliminate the
term involving dW (stochastic term) by taking σ = 0 such that
dSt
= µdt (16)
St
which is an o.d.e that we can solve to get [Integrate both sides from 0 to t]
St = S0 e µt (17)
Thus if σ = 0 the asset price is totally deterministic and we can predict

the future price of the asset with certainty.
The term dWt which contains the randomness that is certainly a feature
of asset pricing is known as a Wiener process denoted Wt or Brownian
motion denoted Bt which is an important example of a stochastic process
and has the following properties

Properties of the Wiener Process
(i) W (0) = 0
(ii) W (t) has continuous paths.
(iii) W (t) has independent increments i.e if u ≤ v ≤ s ≤ t then
W (t) − W (s) and W (v ) − W (u) are independent.
(iv) For any times 0 ≤ s ≤ t, W (t) − W (s) is normally distributed with
mean zero and variance t − s.

Ito’s Lemma is an identity used in Ito calculus to find the differential
of a time-dependent function of a stochastic process; it serves as the
stochastic calculus counterpart of the chain rule.
It is best understood using the Taylor series expansion of the function
up to its second derivatives and identifying the square of an increment
in the stochastic process with an increment in time.
Definition
Ito process: A stochastic process that can be written as
dXt = u dt + v dBt .

Definition
Ito’s Lemma: Suppose {Xt }t≥0 is an Ito process of the form
dXt = u dt + v dBt . Suppose g : [0, ∞) × < → < is a twice continuously
differentiable function and let Yt = g (t, Xt ). Then Yt is again an Ito
process and
∂g ∂g 1 ∂2g
dYt = (t, Xt ) dt + (t, Xt ) dXt + (t, Xt ).(dXt )2
∂t ∂x 2 ∂x 2
where (dXt )2 = dXt .dXt is computed according to the rules:
dt.dt = dXt .dt = dt.dXt = 0, dBt .dBt = dt.

Example
Solve the following equation
dXt = µXt dt + σXt dBt , X0 = x
where µ and σ are constants.

We have:
dXt = µXt dt + σXt dBt , X0 = x. (18)
The equation can be written as :
dXt
= µdt − σdBt .
Xt
Integrating from 0 to t :
Zt Zt Zt
dXs
= µds + σdBs
Xs
0 0 0
Zt Zt
=µ ds + σ dBs
0 0
= µs|t0 + σBs |t0
= µt + σBt − σB0 .
= µt + σBt
Therefore we have:
Zt
dXs
= µt + σBt (19)
Xs
0
Let g (t, x) = lnx x > 0.

We observe that g : (0, ∞) × < is twice continuously differentiable.
Therefore Yt = g (t, Xt ) = lnXt and
1 ∂2g
dYt = ∂g ∂g
∂t (t, Xt ) dt + ∂x (t, Xt ) dXt + 2 ∂x 2 (t, Xt ).(dXt )
2
= 0.dt + X1t .dXt + 12 (− X12 ).(dXt )2

t
dXt
= Xt − 12 . X12 .(µXt dt + σXt dBt )2
t
dXt
= Xt − 12 (µdt + σdBt )2
dXt
= Xt − 12 (µ2 (dt)2 + µσdt.dBt + σ 2 (dBt )2 )
dXt
= Xt − 12 (σ 2 dt)
dXt σ2
= Xt − 2 dt.

Thus :
σ2
dln(Xt ) = dXXt − 2 dt.
t
Integrating from 0 to t :
Rt Rt s σ2
Rt
d(lnXs ) = dX Xs − 2 dt
0 0 0
Rt dXs σ2
lnXs |t0 = Xs − 2 t
0
Rt dXs σ2
lnXt − lnX0 = Xs − 2 t
0
Rt σ2
ln[ XX0t ] = dXs
Xs − 2 t
0

Thus:
Zt
dXs Xt σ2
= ln[ ] + t. (20)
Xs X0 2
0
From (19) and (20) we have :

2
ln[ XX0t ] + σ2 t = µt + σBt .
σ2
ln[ Xxt ] = (µ − 2 )t + σBt .
σ2
Xt (µ− 2 )t+σBt
x =e .
2
(µ− σ2 )t+σBt
⇒ Xt = xe .

Example
Use Ito’s formula to write down the stochastic differential equation for Yt
where
t
(i) Yt =
Bt
(ii) Yt = 2 + t + e Bt

(ii) Yt = 2 + t + e Bt
g (t, x) = 2 + t + e x , (t, x) ∈ [0, ∞) × R
∂g ∂g
= 1, (t, Bt ) = 1
∂t ∂t
∂g ∂g
= ex , (t, Bt ) = e Bt
∂x ∂x
∂2g x ∂2g
= e (t, Bt ) = e Bt
∂x 2 ∂x 2
Therefore,
dYt = dt + e Bt dBt + 12 e Bt (dBt )2
= dt + e Bt dBt + 12 e Bt dt
= (1 + 12 e Bt )dt + e Bt dBt

Topic 7: The Black Scholes Model
We derive the Black-Scholes partial differential equation (BSPDE).

The derivation of this pde is based on the risk neutral valuation principle
which can be summarized as follows
(a) The writer of a call hedges his position or exposure by holding a
certain number of units of the underlying asset in order to create a
riskless portfolio.
(b) In an efficient market with no arbitrage opportunity a riskless portfolio
must earn a rate of return equal to the riskless interest rate i.e µ = r .

The replication strategy provides a mechanism for pricing an option.
The task of the option writer is to replicate an option dynamically by
a portfolio of the riskless asset available in the market and the risky
underlying asset.
The cost of constructing the replicating portfolio is considered to be
equivalent to the price of the call option.

Assumptions
The following assumptions are adopted in the derivation of the Black

Scholes Pricing Model
(i) Trading takes place continuously in time
(ii) The riskless interest rate, r is known and constant during the life of
the option
(iii) The underlying asset pays no dividents
(iv) The market is frictionless (no tax, no commissions etc)
(v) The assets are perfectly divisible
(vi) Short selling is permissible
(vii) There are no arbitrage opportunities in the market

Derivation of BSPDE
Three assets are available in the financial market and these are
riskless bond/bank account whose unit price A(t) = At at time t is
driven by the equation
dA(t) = rA(t)dt
risky asset/stock whose unit price S(t) = St = S at time t satisfies

the equation
dSt = µSt dt + σSt dBt
where µ, σ are constants and Bt is a 1-dimensional Brownian motion.
European call option written over the stock with price C = C (t, St ).

Consider a portfolio which involves writing a European call option and
buying ∆ units of the stock.
The value Π(t) = Π of the portfolio at time t is given by
Π(t) = C − ∆St
Since both C and Π are Ito processes we can differentiate as follows

∂C ∂C 1 ∂2C
dC = dt + dS + (dS)2
∂t ∂S 2 ∂S 2
∂C ∂C 1 ∂2C
= dt + (µSt dt + σSt dBt ) + (µSt dt + σSt dBt )2
∂t ∂S 2 ∂S 2
∂C ∂C 1 ∂2C 2 2
= dt + (µSt dt + σSt dBt ) + σ St dt
∂t ∂S 2 ∂S 2
∂C ∂C 1 ∂2C 2 2 ∂C
=( + µSt + σ St )dt + (σSt )dBt
∂t ∂S 2 ∂S 2 ∂S

Since Π = C − ∆S,
dΠ = dC − ∆dS
∂C ∂C 1 ∂ 2 C 2 2 ∂C
=( + µSt + σ St )dt + (σSt )dBt − ∆(µSt dt + σSt dBt )
∂t ∂S 2 ∂S 2 ∂S
∂C ∂C 2
1∂ C 2 2 ∂C
=( + µSt + 2
σ St − ∆µSt )dt + (σSt − ∆σSt )dBt
∂t ∂S 2 ∂S ∂S
∂C 2
1∂ C 2 2 ∂C ∂C
=( + 2
σ St + ( − ∆)µSt )dt + ( − ∆)σSt dBt
∂t 2 ∂S ∂S ∂S

Comment: The idea behind the Black Scholes analysis is to construct a
riskless portfolio in the underlying asset and the option. In order to
∂C
achieve this we chose ∆ = . By so doing we get
∂S
∂C 1 ∂2C 2 2
dΠ = ( + σ St )dt. (21)
∂t 2 ∂S 2
Now, since Π(t) is a riskless portfolio, it must earn the riskless interest
rate since there are no arbitrages in the economy.

It follows that Π(t) satisfies the equation
dΠ = r Π(t)dt
= r (C − ∆S)dt
∂C
= (rC − rS )dt
∂S
Comparing the two equations for dΠ we get
∂C 1 ∂2C ∂C
+ σ 2 St2 2 = rC − rS
∂t 2 ∂S ∂S
or
∂C 1 ∂2C ∂C
+ σ 2 St2 2 + rS − rC = 0
∂t 2 ∂S ∂S

This last equation is called a Black-Scholes partial differential equation
which models the dynamics of the European call with regard to changes in
time and in the underlying asset price.

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HMTH216 Introduction to Financial Mathematics

Room 236 New Wing

April 27, 2021

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Money is the circulating medium of exchange as secured by the

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In general, the simple interest formula is given by

V (t) = P(1 + rt). (1)

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V (t) = P(1 + rt).

Therefore the value of his deposit after 4 years is

V = $5, 000(1 + 0.06 ∗ 4) = $6, 200.

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Whenever interest is allowed to earn interest itself, an investment is

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Mathematically, when considering the effect on the compound

This formula may seem familiar since it is often presented as

Therefore the value of the initial investment after 4 years is

V = $5, 000e 0.06×4 ≈ $6, 356.25

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Make own notes: Reference Text- J. Robert Buchanan

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Make own notes: Reference Text- J. Robert Buchanan.

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Other names are financial derivative, derivative security, derivative product.

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There are four basic types of derivative contracts, which are:

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Mathematically we tend to denote portifolios as Π and your position in

This is a portfolio consisting of long position in two shares, long position

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Remember that the price of taking a certain position will be related

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Π(S, t) = C (S, t; K ) + P(S, t; K ) (5)

and therefore the payoff at maturity (t = T) is

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Π(S, t) = −C (S, t; K ) − P(S, t; K ) (6)

A risky investment is one where the investment’s actual return will be

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A combination is an option trading strategy that involves taking a position

-Refer to notes given in class for details.

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-Refer to notes given in class for details.

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