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The Black-Scholes Equation in Finance
The Black-Scholes Equation in Finance
Equation in Finance
What we did:
Solution to Black-Scholes
Review of the One–Period
Mathematical Model
One–Period
Mathematical Model
P
N
Arbitrage
• The concept of arbitrage means an investor
can invest in a security at no risk and they
are guaranteed a positive profit in all future
states of the world.
• However, arbitrage does not exist in real-life
financial situations so the Arbitrage
Theorem states that a state-price vector the
cost to initiate a security is equivalent to
the pay-out matrix multiplied by the state-
price vector
P D
Arbitrage (cont.)
• In a one-period model, you can
calculate the current price of a
derivative by using the Risk Neutral
pricing Formula if you assume a few
things. The following should be
true:
• there are only two possible future states of
the world
• you have a three-asset market consisting of
a stock, a bond, and a derivative which has
just been introduced into the market.
Arbitrage (cont.)
• The Risk Neutral Pricing Formula is: V0 = e-rT(qV2+(1-q)V1) where
and
q
e S S
rT
0 1
S S 2 1
1- q
S e S
2
rT
0
S S 2 1
Risk Neutral Pricing
Formula Variables
• Note the following information in regard to the
previous equations:
• S0 = the current price of the stock
• V0 = the current price of the derivative
• e-rT = the discount factor of the bond with a
fixed interest rate and time
• S1 and S2 = the two projected future prices of
the stock
• V1 and V2 = the two projected future prices of
the derivative
Multi-Period Model and
Binomial Trees
Multi-Period Model
The one-period model easily
extends to a multi-period model.
Assumptions for simplicity:
- The interval from t = 0 to t = T is
S23 S34
S12
S22 S33
S S00 S32
S11
S21 S31
(t) t0 t1 t2 t3
Multi-Period Model and
Binomial Tree
If a derivative security enters our
market and we know all it’s values
at time tN, you can use the Risk
Neutral Pricing Formula:
V0 = e-rT(qV2 + (1-q)V1)
N
But we first need to define a
structure for our tree. We need to
define the following constants:
u, d, s, h, k
Multi-Period Model and
Binomial Tree
Let’s define the up (u) and down (d)
ratios as follows:
1 1
sk h sk - h
u e 2 de 2
Note:
u and d will be constant on the
entire tree
For each time step, a stock price
can either gain a fixed percentage
(u) or lose a fixed percentage (d)
Multi-Period Model and
Binomial Tree
In our u and d equations,
q e S S 0 1
and 1- q 2S e S 0
S S 2 1 S S
2 1
q ed
and 1- q e e
h / 2
ud h/2
e e
Multi-Period Model and
Binomial Tree
We can again rewrite the Risk
Neutral Pricing Formula as follows:
h+
Vi,j k O
h-
Vi+1,j
v 1 2 2 v
Vi , j V k k ...
t 2 t 2
v 1 2 2 v
Vi 1, j V h h ...
s 2 s 2
v 1 2 2 v
Vi 1, j 1 V h h ...
s 2 s 2
V 1 2 V 2
V
S rS rV 0
t 8 S 2
S
The Continuum Limit (cont.)
• We will now introduce a new parameter
called the volatility, denoted by .
• The volatility will replace a term in the
previous equation, namely
1 1 2
8 2
V 1 2 2 2V V
σ S rS rV
t 2 S 2
S
• Side condition: V(S,T) = (S), where
is the derivative contract
Solving the Black-Scholes
Equation
V 1 2 2 2V V
σ S rS rV
t 2 S 2
S
• Black-Scholes equation
– Partial differential equation
– Backwards parabolic
– Linear
– Variable coefficients
• Depend on the variable S
Solving PDEs
• Partial differential equations
– Generally difficult to solve
– Easiest PDEs to solve
• Linear
• Constant coefficients
• Black-Scholes equation
– Linear
– Variable coefficients
Obtaining Constant
Coefficients
• Perform a change of variables
– Done similar to the previous group
– Changing the variable S
• S only appears in pair with DV/DS
• Use logarithmic function for the change
– Changing the variable t
• Only done to simplify the form
Introduce a new function U
V S , t U x,
With variables x and
x ln S
T t
2
Change in function
notation
By the chain rule...
V 1 2 2 V 2
V
S rS rV
t 2 S 2
S
U 1 2 2 U
2
U
S rS r U
t 2 S 2
S
Calculate the partials
U U U
t
t
2
U U x U 1
S x S x S
2U 1 2U U
S 2 S2 x
2
x
Original
U 1 2U U
2S 2 S 2 rS rU
t 2 S
New
1 2U U
U 1 1 U
2
2
2
S 2 S 2 x 2 x rS
S x
rU
Simplification
U 1 1 2
U U 1 U
S 2 2 rS rU
2 2 2
2 S x x S x
U 1 2
U U U
2
2
2
r rU
2 x x x
U 1 2
U 1 2 U U
2
2
r rU
2 x 2
2 x x
Simplification
U 1 2 U
2
1 2 U
2
r rU
2 x 2
2 x
1 2
r
U 1 U
2
2 U r
2U
2 x 2
2
x
Equation Properties
• New PDE properties
– linear
– constant coefficients
• depend on the constants r and tau
– solvable with Green’s functions
Solution Using Green’s
functions
S 2
ln r T t
K 2
C S , t SN
T t
S 2
ln r T t
r T t K 2
Ke N
T t
Summary
Summary
Expansion of the Single-Period Model
into the Multi-Period Model