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The Black-Scholes Model

3.1 Introduction
We begin this chapter with a discussion of the concept of arbitrage, a concept which, in certain circu stances, allows us to establish precise relationships between prices and thence to deter ine the . We then discuss option strategies in general and use arbitrage, together with the odel for asset price o!e ents that we discussed in the pre!ious chapter, to deri!e the celebrated Black-Scholes differential e"uation for the price of the si plest options, the so-called #uropean !anilla options. We also discuss the boundar$ conditions to be satisfied b$ different t$pes of option, and we set the scene for the deri!ation of e%plicit solutions. This chapter is funda ental to the whole sub&ect of option pricing and should be read with care.

3.' (rbitrage
)ne of the funda ental concepts underl$ing the theor$ of financial deri!ati!e pricing and hedging is that of arbitrage. This can be loosel$ stated as *there+s no such thing as a free lunch.* More for all$, in financial ter s, there are ne!er an$ opportunities to ake an instantaneous risk-free profit. ,More correctl$, such opportunities cannot e%ist for a significant length of ti e before prices o!e to eli inate the .- The f inancial application of this principle leads to so e elegant odelling. (l ost all finance theor$, this book included, assu es the e%istence of risk-free in!est ents that gi!e a guaranteed returns with no chance
s (s e%plained in .hapter 1/ the return a!ailable a$ depend on the ti e for which the deposit is ade0 the different rates a!ailable for different periods reflect the possibilit$ that interest rates a$ change in the future. We need onl$ assu e that a known guaranteed short-ter return is alwa$s a!ailable.



The Black-Scholes Model

of default. ( good appro%i ation to such an in!est ent is a go!ern ent bond or a deposit in a sound bank. The greatest risk-free return that one can ake on a portfolio of assets is the sa e as the return if the e"ui!alent a ount of cash were placed in a bank. The ke$ words in the definition of arbitrage are 2instantaneous+ and 2risk-free+0 b$ in!esting in e"uities, sa$, one can probabl$ beat the bank, but this cannot be certain. If one wants a greater return then one ust accept a greater risk. Wh$ should this be so3 Suppose that an opportunit$ did e%ist to ake a guaranteed return of greater agnitude than fro a bank deposit. Suppose also that ost in!estors beha!e sensibl$. Would an$ sensible in!estor put one$ in the bank when putting it in the alternati!e in!est ent $ields a greater return3 )b!iousl$ not. Moreo!er, if he could also borrow one$ at less than the return on the alternati!e in!est ent then he should borrow as uch as possible fro the bank to in!est in the higher-$ielding opportunit$. In response to the pressure of suppl$ and de and we would e%pect the bank to raise its interest rates to attract one$ and4or the $ield fro the other in!est ent to drop. There is so e elasticit$ in this argu ent because of the presence of 2friction+ factors such as transaction costs, differences in borrowing and lending rates, proble s with li"uidit$, ta% laws, etc., but on the whole the principle is sound since the arket place is inhabited b$ arbitragers whose ,highl$ paid- &ob it is to seek out and e%ploit irregularities or ispricings such as the one we ha!e &ust illustrated. Technical 5oint6 7isk.
7isk is co onl$ described as being of two t$pes6 specific and non-

specific. ,The latter is also called

arket or s$ste atic risk.- Specific risk is

the co ponent of risk associated with a single asset ,or a sector of the

arket, for e%a ple che icals-, whereas non-specific risk is associated
with factors affecting the whole affect an indi!idual co arket. (n unstable anage ent would pan$ would pan$ but not the arket0 this co

show signs of specific risk, a highl$ !olatile share price perhaps. )n

the other hand the possibilit$ of a change in interest rates would be a non-specific risk, as such a change would affect the arket as a whole. It is often i portant to distinguish between these two t$pes of risk because of their beha!iour within a large portfolio ,a portfolio is a ter for a collection of in!est ents-. 5ro!ided one has a sensible definition of risk, it is possible to di!ersif$ awa$ specific risk b$ ha!ing a portfolio with a large nu ber of assets fro different sectors of the arket0 howe!er,
it is not possible to di!ersif$ awa$ non-specific risk. ,Market risk can

3.3 )ption 8alues, 5a$offs and Strategies

be eli inated fro a portfolio b$ taking opposite positions in two assets


which are highl$ negati!el$ correlated - as one increases in !alue the other decreases. This is not di!ersification but hedging, which is of the ut ost i portance in the anal$sis of deri!ati!es.- It is co onl$ said that specific risk is not rewarded, and that onl$ the taking of greater non-specific risk should be rewarded b$ a greater return. ( popular definition of the risk of a portfolio is the !ariance of the return. ( bank account which has a guaranteed return, at least in the short ter , has no !ariance and is thus ter ed riskless or risk-free. )n the other hand, a highl$ !olatile stock with a !er$ uncertain return and thus a large !ariance is a risk$ asset. This is the si plest and co onest definition of risk, but it does not take into account the distribution of the return, but rather onl$ one of its properties, the !ariance. Thus as uch weight is attached to the possibilit$ of a greater than e%pected return as to the possibilit$ of a less than e%pected return. )ther, ore sophisticated, definitions of risk a!oid this propert$ and attach different weights to different returns.

3.3 )ption 8alues, 5a$offs and Strategies

:ow we turn to option pricing. ;et us introduce so e si ple notation, which we use consistentl$ throughout the book. < We denote b$ 8 the !alue of an option0 when the distinction is i portant we use .,S, t- and 5,S, t- to denote a call and a put respecti!el$. This !alue is a function of the current !alue of the underl$ing asset, S, and ti e, t6 8 = 8,S,t-. The !alue of the option also depends on the following para eters6 < a, the !olatilit$ of the underl$ing asset0 < #, the-e%ercise price0 < T, the e%pir$0 < r, the interest rate. >irst, consider what happens &ust at the o ent of e%pir$ of a call option, that is, at ti e t = T. ( si ple arbitrage argu ent tells us its !alue at this special ti e. If S ? # at e%pir$, it akes financial sense to e%ercise the call option, handing o!er an a ount #, to obtain an asset worth S. The profit fro such a transaction is then S - #. )n the other hand, if S @ # at e%pir$, we should not e%ercise the option because we would ake a loss of #-S.


The Black-Scholes Model

)ption price 3BB


#%ercise price


>igure 3.1 The !alue of a call option at and before e%pir$ against e%ercise price0 option !alues fro >T-S# inde% option data.

In this case, the option e%pires worthless. Thus, the !alue of the call option at e%pir$ can be written as .,S,T- = a%,S - #, B-. ,3.1-

(s we get nearer to the e%pir$ date we can e%pect the !alue of our call option to approach ,3.1-. To confir this we reproduce in >igure 3.1 the figure fro .hapter 1 which co pares real >T-S# inde% call option data with the !alue of the option at e%pir$ for fi%ed S. In this f igure we show a%,S - #, B- as a function of # for fi%ed S , = 'C/'and superi pose the real data for 8 taken fro the >ebruar$ call option series. )bser!e that the real data is alwa$s &ust abo!e the predicted line. This reflects the fact that there is still so e ti e re aining before the option e%pires - there is potential left for the asset price to rise further, gi!ing the option e!en greater !alue. This difference between the option

3.3 )ption 8alues, 5a$offs and Strategies


>igure 3.' The pa$off diagra for a call, .,S,T-, and the option !alue, .,S, t-, prior to e%pir$, as functions of S.

!alue before and at e%pir$ is called the ti e !alue and the !alue at e%pir$ the intrinsic !alue.' If one owns an option with a gi!en e%ercise price, then one is less interested in how the option !alue !aries with e%ercise price than with how it !aries with asset price, S. In >igure 3.' we plot a%,S - #, Bas a function of S ,the bold line- and also the !alue of an option at so e ti e before e%pir$. The latter cur!e is &ust a sketch of a plausible for for the option !alue. >or the o ent the reader ust trust that the
!alue of the option before e%pir$ is of this for . ;ater in this chapter

we see how to deri!e e"uations and so eti es for ulae for such cur!es. The bold line, being the pa$off for the option at e%pir$, is called a pa$off diagra . The reader should be aware that so e authors use the ter 2pa$off diagra + or 2profit diagra + to ean the difference between the ter inal !alue of the contract ,our pa$off- and the original pre iu . We choose not to use this definition for two reasons. >irstl$,
' )ther i portant &argon is at-the- one$, which refers to that option whose e%ercise price is closest to the current !alue of the underl$ing asset, in-the- one$, which is a call ,put- whose e%ercise price is less ,greater- than the current asset price - so that the option !alue has a significant intrinsic co ponent - and outof-the- one$, which is a call or put with no intrinsic !alue.


The Black-Scholes Model

B B #

>igure 3.3 The pa$off diagra for a put, 5,S, T-, and the option !alue, 5,S, t-, prior to e%pir$, as functions of S.

the pre iu is paid at the start of the option contract and the return, if an$, onl$ co es at e%pir$. Secondl$, the pa$off diagra has a natural interpretation, as we see, as the final condition for a diffusion e"uation. It should now be clear that each option and portfolio of options has its own pa$off at e%pir$. (n argu ent si ilar to that gi!en abo!e for the !alue of a call at e%pir$ leads to the pa$off for a put option. (t e%pir$ it is worthless if S ? # but has the !alue # - S for S @ #. Thus the pa$off at e%pir$ for a put option is a%,# - S, B-. The pa$off diagra for a #uropean put is shown in >igure 3.3, where

the bold line shows the pa$off function

a%,# - S, B-. The other cur!e

is again a sketch of the option !alue prior to e%pir$. (lthough the ti e !alue of the call option of >igure 3.' is e!er$where positi!e, for the put the ti e !alue is negati!e for sufficientl$ s all S, where the option !alue falls below the pa$off. We return to this point later. (lthough the two ost basic structures for the pa$off are the call and the put, in principle there is no reason wh$ an option contract cannot be written with a ore general pa$off. (n e%a ple of another pa$off is shown in >igure 3.1. This pa$off can be written as

B3-1,S - #-,
where 3-l,.- ,is the Eea!iside function, which has !alue B when its argu ent is negati!e but is 1 otherwise. This option a$ be interpreted

3.3 )ption 8alues, 5a$offs and Strategies


B -1

>igure 3.1 The pa$off diagra on the asset price.

for a cash-or-nothing call, e"ui!alent to a bet

as a straight bet on the asset price0 it is called a cash-or-nothing call. )ptions with general pa$offs are usuall$ called binaries or digitals. B$ co bining calls and puts with !arious e%ercise prices one can construct portfolios with a great !ariet$ of pa$offs. >or e%a ple, we show in >igure 3.9 the pa$off for a 2bullish !ertical spread+, which is constructed b$ bu$ing one call option and writing one call option with the sa e e%pir$ date but a larger e%ercise price. This portfolio is called 2bullish+ because the in!estor profits fro a rise in the asset price, +!ertical+ because there are two different e%ercise prices in!ol!ed, and 2spread+ because it is ade up of the sa e t$pe of option, here calls. The pa$off function for this portfolio can be written as a%,S - #l, B- a%,S - #', B-

with #' ? #l. Man$ other portfolios can be constructed. So e e%a ples are 2co binations+, containing both calls and puts, and 2horiFontal+ or 2calendar+ spreads, containing options with different e%pir$ dates. )thers are gi!en in the e%ercises at the end of this chapter. The appeal of such strategies is in their abilit$ to redirect risk. In e%change for the pre iu - which is the a%i u possible loss and known fro the start - one can construct portfolios to benefit fro !irtuall$ an$ o!e in the underl$ing asset. If one has a !iew on the arket and this turns out to be correct then, as we ha!e seen, one can

1B 8

The Black-Scholes Mode

# -#-1


>igure 3.9. The pa$off diagra

for a bullish !ertical spread.

ake large profits fro asset.

relati!el$ s all

o!e ents in the underl$ing

3.1 5ut-call 5arit$

(lthough call and put options are superficiall$ different, in fact the$ can be co bined in such a wa$ that the$ are perfectl$ correlated. This is de onstrated b$ the following argu ent. Suppose that we are long one asset, long one put and short one call. The call and the put both ha!e the sa e e%pir$ date, T, and the sa e e%ercise price, #. Genote b$ E the !alue of this portfolio. We thus ha!e rI=SH5-., where 5 and . are the !alues of the put and the call respecti!el$. The pa$off for this portfolio at e%pir$ is S H This can be rewritten as SH,#-S--B=# if S@#, or a%,# - S, B- a%,S - #, B-.

SHB-,S-#-=# if S?#.
Whether S is greater or less than # at e%pir$ the pa$off is alwa$s the sa e, na el$ #.

3.9 The Black-Scholes (nal$sis :ow ask the "uestion < Eow uch would I pa$ for a portfolio that gi!es a guaranteed # at t = T3


This is, of course, the sa e "uestion that we asked in .hapter 1, and the answer is arri!ed at b$ discounting the final !alue of the portfolio. ,:ote that here we do ha!e to assu e the e%istence of a known risk-free interest rate o!er the lifeti e of the option.- Thus this portfolio is now worth #e-++,T-t- This e"uates the return fro the portfolio with the return fro a bank deposit. If this were not the case then arbitragers could ,and would- ake an instantaneous riskless profit6 b$ bu$ing and selling options and shares and at the sa e ti e borrowing or lending one$ in the correct proportions, the$ could lock in a profit toda$ with Fero pa$off in the future. Thus we conclude that

S H 5 - . = #e-r,T-t-


This relationship between the underl$ing asset and its options is called put-call parit$. It is an e%a ple of risk eli ination, achie!ed b$ carr$ing out one transaction in the asset and each of the options. In the ne%t section, we see that a ore sophisticated !ersion of this idea, in!ol!ing a continuous rebalancing, rather than the one-off transactions abo!e, allows us to !alue #uropean call and put options independentl$.

3.9 The Black-Scholes (nal$sis

Before describing the Black-Scholes anal$sis which leads to the !alue of an option we list the assu ptions that we ake for ost of the book. < The asset price follows the lognor al rando walk ,'.1-. )ther odels do e%ist, and in an$ cases it is possible to perfor the Black-Scholes anal$sis to deri!e a differential e"uation for the !alue of an option. #%plicit for ulae rarel$ e%ist for such odels. Eowe!er, this should not discourage their use, since an accurate nu erical solution is usuall$ "uite straightforward. < The risk-free interest rate r and the asset !olatilit$ a are known functions of ti e o!er the life of the option. )nl$ in .hapters 1/ and 1C do we drop the assu ption of deter inistic beha!iour of r0 there we odel interest rates b$ a stochastic differential e"uation.


The Black-Scholes Model

< There are no transaction costs associated with hedging a portfolio. In .hapter 1A we describe a odel which allows for transaction costs. < The underl$ing asset pa$s no di!idends during the life of the option. This assu ption can be dropped if the di!idends are known beforehand. The$ can be paid either at discrete inter!als or continuousl$ o!er the life of the option. We discuss this point further in .hapter A. < There are no arbitrage possibilities. The absence of arbitrage opportunities eans that all risk-free portfolios ust earn the sa e return. < Trading of the underl$ing asset can take place continuousl$. This is clearl$ an idealisation, and beco es i portant in the chapter on transaction costs, .hapter 1A. < Short selling is per itted and the assets are di!isible. We assu e that we can bu$ and sell an$ nu ber ,not necessaril$ an integer- of the underl$ing asset, and that we a$ sell assets that we do

not own.
Suppose that we ha!e an option whose !alue 8,S, t- depends onl$ on S and t. It is not necessar$ at this stage to specif$ whether 8 is a call or a put0 indeed, 8 can be the !alue of a whole portfolio of different options although for si plicit$ the reader can think of a si ple call or put. Ising Ito+s le a, e"uation ,'.C-, we can write

d8 JS

aS dK H

a'8 9 H 1A.'S'

C S' H at i dt.


This gi!es the rando walk followed b$ 8. :ote that we4 re"uire 8 to ha!e at least one t deri!ati!e and two S deri!ati!es. :ow construct a portfolio consisting of one option and a nu ber -B of the underl$ing asset. This nu ber is as $et unspecified. The !alue of this portfolio is II = 8 - (S. The &u p in the !alue of this portfolio in one ti e-step is ,3.1-

dlI=d8 - (dS.
Eere B is held fi%ed during the ti e-step0 if it were not then dII would contain ter s in dB. 5utting ,'.1-, ,3.3- and ,3.1- together, we find

3.9 The Black-Scholes (nal$sis that II follows the rando walk



= aS

,as - o- d% H ,+ISa8 as H 1,'S' asa'8 ' H at -,IoS- dt.

(s we de onstrated in Section '.1, we can eli inate the rando ponent in this rando walk b$ choosing B

co -




:ote that ( is the !alue of a84aS at the start of the ti e-step dt. This results in a portfolio whose incre ent is wholl$ deter inistic6

dII =

at H ''9' aS - dt.


We now appeal to the concepts of arbitrage and suppl$ and de and, with the assu ption of no transaction costs. The return on an a ount I I in!ested in riskless assets would see a growth of rII dt in a ti e dt. If the right-hand side of ,3./- were greater than this a ount, an arbitrager could ake a guaranteed riskless profit b$ borrowing an a ount II to in!est in the portfolio. The return for this risk-free strateg$ would be greater than the cost of borrowing. .on!ersel$, if the right-hand side of ,3./- were less than rII dt then the arbitrager would short the portfolio and in!est n in the bank. #ither wa$ the arbitrager would ake a riskless, no cost, instantaneous profit. The e%istence of such arbitragers with the abilit$ to trade at low cost ensures that the return on the portfolio and on the riskless account are ore or less e"ual. Thus, we ha!e

,3.CLa'S'a- dt. Substituting ,3.1- and ,3.A- into ,3.C- and di!iding throughout b$ dt we arri!e at a8 1 a8 a'8 - r8 = B. ,3.D'S' at as H a as+' H rS This is the Black-Scholes partial differential e"uation. With its e%tensions and !ariants, it pla$s the a&or role in the rest of the book. It is hard to o!ere phasise the fact that, under the assu ptions stated earlier, an$ deri!ati!e securit$ whose price depends onl$ on the current !alue of S and on t, and which is paid for up-front, ust satisf$ the Black-Scholes e"uation ,or a !ariant incorporating di!idends or ti edependent para eters-. Man$ see ingl$ co plicated option !aluation

rIldt =


wa$. It is also i portant to note, though, that

The Black-Scholes Model

an$ options, for e%a ple

proble s, such as e%otic options, beco e si ple when looked at in this ( erican options, ha!e !alues that depend on the histor$ of the asset
price as well as its present !alue. We see later how the$ fit into the Black-Scholes fra ework. Before o!ing on, we ake three re arks about the deri!ation we ha!e &ust seen. >irstl$, the delta, gi!en b$

a! M - as,
is the rate of change of the !alue of our option or portfolio of options with respect to S. It is of funda ental i portance in both theor$ and practice, and we return to it repeatedl$. It is a easure of the correlation between the o!e ents of the option or other deri!ati!e products and those of the underl$ing asset. Secondl$, the linear differential operator .BS gi!en b$ F .Bs =



has a financial interpretation as a easure of the difference between the return on a hedged option portfolio ,the first two ter s- and the return on a bank deposit ,the last two ter s-. (lthough this difference ust be identicall$ Fero for a #uropean option, in order to a!oid arbitrage, we see later that this need not be so for an ( erican option. Thirdl$, we note that the Black-Scholes e"uation ,3.D- does not contain the growth para eter M. In other words, the !alue of an option is independent of how rapidl$ or slowl$ an asset grows. The onl$ para eter fro the stochastic differential e"uation ,'.1- for the asset price that affects the option price is the !olatilit$, a. ( conse"uence of this is that two people a$ differ in their esti ates for $ $et still agree on the !alue of an option.

3.A The Black-Scholes #"uation

#"uation ,3.D- is the first partial differential e"uation that we ha!e deri!ed in this book. The theor$ and solution ethods for partial differential e"uations are discussed in depth in .hapters 1 and 90 ne!ertheless, we now introduce a few basic points in the theor$ so that the reader is aware of what we are tr$ing to achie!e. B$ deri!ing the partial differential e"uation for a "uantit$, such as an option price, we ha!e ade an enor ous step towards finding its !alue.

3.A The Black-Scholes #"uation


We hope to be able to find an e%pression for this !alue b$ sol!ing the

e"uation. So eti es this in!ol!es solution b$ nu erical eans if e%act for ulae cannot be found. Eowe!er, a partial differential e"uation on its own generall$ has an$ solutions0 for e%a ple, the !alues of puts, calls and S itself all satisf$ the Black-Scholes e"uation. The !alue of an option should be uni"ue ,otherwise, arbitrage possibilities would arise-, and so, to pin down the solution, we ust also i pose boundar$ conditions. ( boundar$ condition specifies the beha!iour of the re"uired solution at so e part of the solution do ain. The ost fre"uent t$pe of partial differential e"uation in financial proble s is the parabolic e"uation. ( parabolic e"uation for a function 8,S, t- is a specific relationship between 8 and its partial deri!ati!es with respect to the independent !ariables S and t. In the si plest case, the highest deri!ati!e with respect to S is a second deri!ati!e, and the highest deri!ati!e with respect to t is onl$ a first deri!ati!e. Thus ,3.Dco es into this categor$. If the e"uation is linear and the signs of these particular deri!ati!es are the sa e, when the$ appear on the sa e side of the e"uation, then the e"uation is called backward parabolic0 otherwise it is called forward parabolic. #"uation ,3.D- is backward parabolic. )nce we ha!e decided that our partial differential e"uation is of this parabolic t$pe we can ake general state ents about the sort of boundar$ conditions that lead to a uni"ue solution. T$picall$, we ust pose two conditions in S, which has the second deri!ati!e associated with it, but onl$ one in t. >or e%a ple we could specif$ that 8,S, t- = 8a,,t- on S = a and

8,S, t- = 8b,t- on S = b
where 8a and 8b are gi!en functions of t.

If the e"uation is of backward t$pe we condition such as

ust also i pose a 2final+

8,S, t- = 8T,S- on t = T where 8T is a known function. We then sol!e for 8 in the region t @ T. That is, we sol!e 2backwards in ti e+, hence the na e. If the e"uation is of forward t$pe we i pose an 2initial+ condition on t = B, sa$, and sol!e in t ? B, in the forward direction. )f course, we can change fro backward to forward b$ the si ple change of !ariables t+ = -t. This is wh$ both t$pes of e"uation are athe aticall$ e"ui!alent and it is


The Black-Scholes Model

co on to transfor backward e"uations into forward e"uations before an$ anal$sis. It is i portant to re e ber, howe!er, that the parabolic

e"uation cannot be sol!ed in the wrong direction0 that is, we should not
i pose initial conditions on a backward e"uation.

3./ Boundar$ and >inal .onditions for #uropean )ptions

Ea!ing deri!ed the Black-Scholes e"uation for the !alue of an option, we ust ne%t consider final and boundar$ conditions, for otherwise the partial differential e"uation does not ha!e a uni"ue solution. >or the o ent we restrict our attention to a #uropean call, with !alue now denoted b$ .,S, t-, with e%ercise price # and e%pir$ date T. The final condition, to be applied at t = T, co es fro the arbitrage argu ent described in Section 3.3. (t t = T, the !alue of a call is known with certaint$ to be the pa$off6

.,S, T- =

a%,S - #, B-.


This is the final condition for our partial differential e"uation. )ur 2spatial+ or asset-price boundar$ conditions are applied at Fero asset price, S = B, and as S -H oo. We can see fro ,'.1- that if S is e!er Fero then dS is also Fero and therefore S can ne!er change. This is the onl$ deter inistic case of the stochastic differential e"uation ,'.1-. If S = B at e%pir$ the pa$off is Fero. Thus the call option is worthless on S = B e!en if there is a long ti e to e%pir$. Eence on S = B we ha!e .,B, t- = B. ,3.11-

(s the asset price increases without bound it beco es e!er ore likel$ that the option will be e%ercised and the agnitude of the e%ercise price beco es less and less i portant. Thus as S -H oo the !alue of the option beco es that of the asset and we write .,S, t- + S as S -O oo. ,3.1'-

>or a #uropean call option, without the possibilit$ of earl$ e%ercise, ,3.D--,3.1'- can be sol!ed e%actl$ to gi!e the Black-Scholes !alue of a call option. We show how to do this in .hapter 9, and at the end of this section we "uote the results for a #uropean call and put. >or a put option, with !alue 5,S, t-, the final condition is the pa$off 5,S,T- = a%,# - S,B-. ,3.13-

3./ Boundar$ and >inal .onditions


We ha!e alread$ entioned that if S is e!er Fero then it ust re ain Fero. In this case the final pa$off for a put is known with certaint$ to be #. To deter ine 5,B, t- we si pl$ ha!e to calculate the present !alue of an a ount # recei!ed at ti e T. (ssu ing that interest rates are constant we find the boundar$ condition at S = B to be

5,B, t- = #e-r,T-t-.
More generall$, for a ti e-dependent interest rate we ha!e
5,B, t- = #e- f,-




(s S -1 oo the option is unlikel$ to be e%ercised and so 5,S, t- -H B as S -1 oo. ,3.19-

Technical 5oint6 Boundar$ .onditions at Infinit$.

We see later that we can transfor ,3.D- into an e"uation with constant coefficients b$ the change of !ariable S = #eF. The point S = B beco es % = -oo and S = oo beco es % = oo. (s we also see, a ph$sical analog$ to
the financial proble is the flow of heat in an infinite bar. .learl$, prescribing the te perature of the bar at % = Poo has no effect whatsoe!er

at finite !alues of % unless the te perature is highl$ singular there. If the te perature at infinit$ is well-beha!ed then the te perature in an$ f inite region of the bar is go!erned wholl$ b$ the initial data6 it cannot be influenced b$ the ends at infinit$. Since ost option proble s can be transfor ed into the diffusion e"uation it is also not strictl$ necessar$ to prescribe the boundar$ conditions at S = B and S = oo. We onl$ need to insist that the !alue of the option is not too singular. We can distinguish between < prescribing a boundar$ condition in order to

ake the solution uni"ue,

< deter ining the solution in the neighbourhood of the boundar$, perhaps to assist or check a nu erical solution. The boundar$ conditions ,3.11- and ,3.1'- contain ore infor ation than is strictl$ athe aticall$ necessar$ ,see Section 1.3.'-. :e!ertheless, the$ are financiall$ useful6 the$ tell us ore infor ation about the beha!iour of the option at certain special parts of the S-a%is and can be used to i pro!e the accurac$ of an$ nu erical ethod. It can be shown that an e!en ore accurate e%pression for the beha!iour of . as S oo
is .,S, t- - S - #e-r,T-t-. ,3.1A-

This is a si e%ercise price.

The Black-Scholes Model

ple correction to ,3.1'- which accounts for the discounted

Throughout the book we gi!e boundar$ conditions to show the local

beha!iour of the option price.

3.C The Black-Scholes >or

ulae for #uropean )ptions

Eere we "uote the e%act solution of the #uropean call option proble ,3.D--,3.1'- when the interest rate and !olatilit$ are constant0 in .hapter 9 we show how to deri!e it s$ste aticall$. In .hapter A we drop the constraint that r and a are constant and find ore general for ulae. When r and a are constant the e%act, e%plicit solution for the #uropean call is

.,S,t- = S:,dl- - #e-r,T-t-:,d'-,


where :,.- is the cu ulati!e distribution function for a standardised nor al rando !ariable, gi!en b$

:,%Eere dl and

' r Q




log,S4#- H ,r H La'-,T - t-

a T-t
d' - log,S4#- H ,r - 1B,'-,T - t-

a T-t
>or a put, i.e. ,3.D-, ,3.13-, ,3.11- and ,3.19-, the solution is 5,S, t- = #e-r,T-t-:,-d'- - S:,-dl-. It is eas$ to show that these satisf$ put-call parit$ ,3.'-. The delta for a #uropean call is ,3.1C-

-9 -S :,di-,
and for a put it is


aS :,di--1.
The latter follows fro the for er b$ put-call parit$.

3.C The Black-Scholes >or ulce


>igure 3.A The #uropean call !alue .,S, t- as a function of S for se!eral !alues of ti e to e%pir$0 r = B.1, or = B.', # = 1 and T - t = B, B.9, 1.B and 1.9.

B B #
>igure 3./ The #uropean put !alue 5,S, t- as a function of S for se!eral !alues of ti e to e%pir$0 r = B.1, or = B.', # = 1 and T - t = B, B.9, 1.B and 1.9.

)ther deri!ati!es of the option !alue ,with respect to S, t, r and acan pla$ i portant roles in hedging and are discussed briefl$ at the end of this chapter. In >igures 3.A and 3./ we show plots of the #uropean call and put !alues for se!eral ti es up to e%pir$. :ote how the cur!es approach the pa$off functions as t -H T. In >igure 3.C we show the #uropean call delta as a function of S, again for se!eral ti es up to e%pir$. The delta is alwa$s between Fero and one, and approaches a step function

9B (

The Black-Scholes Model

>igure 3.C The #uropean call delta as a function of S for se!eral !alues of ti e to e%pir$0 r = B.1, or = B.', # = 1 and T - t = B, B.9, 1.B and 1.9.

as t -? T. 7ecall that the writer of a call option will be re"uired to deli!er the asset if S ? # at e%pir$, and not otherwise. If he follows the delta-hedging strateg$, with a portfolio . - (S, he will auto aticall$ hold the correct a ount ,one or Fero- of the asset at e%pir$. This is to be e%pected, since delta-hedging is a risk-free strateg$ right up to e%pir$. If the option e%pires in-the- one$, the re"uired asset will ha!e been bought o!er the lifeti e of the option, firstl$ in setting up the initial hedge, and secondl$ in a series of transactions as S changes. The cost of these purchases and4or sales, less the e%ercise price #, is e%actl$ balanced b$ the initial pre iu and bank interest. .on!ersel$, if the option e%pires out-of-the- one$, the initial hedge is graduall$ sold. ,It should also be noted that if the !alues of the asset &ust before e%pir$ are close to #, the hedge a$ change fro nearl$ Fero to nearl$ one an$ ti es. This is awkward to handle in practice, since each transaction incurs costs. We discuss transaction costs further in .hapter 1A.#"uations ,3.1/- and ,3.1C- for the !alues of #uropean call and put options are interesting in that the$ contain the function for the cu ulati!e nor al distribution :,%-. Thus the !alue of an option is related to the probabilit$ densit$ function for the rando !ariable log S. It can be shown, and we discuss this in .hapter 9, that the !alue of an option has a natural interpretation as a certain discounted e%pected !alue of the pa$off at e%pir$. This leads to the sub&ect of the 2risk-neutral !aluation+ of contingent clai s, a phrase which is e%plained there.

3.D Eedging in 5ractice


3.D Eedging in 5ractice

Eedging is the reduction of the sensiti!it$ of a portfolio to the o!e-

ent of an underl$ing asset b$ taking opposite positions in different

f inancial instru ents. Two e%tre e cases ha!e been introduced abo!e0 in both cases the sensiti!it$ of the portfolio was reduced to Fero. The f irst e%a ple was in the de onstration of put-call parit$ for #uropean options and the second was in the Black-Scholes anal$sis with deltahedging. These are, howe!er, funda entall$ different hedging strategies. The for er in!ol!es a one-off transaction in three products ,a call, a put and the underl$ing-0 the resulting portfolio can then be left unattended with the riskless return locked in. The latter is a d$na ic strateg$0 the delta hedge is onl$ instantaneousl$ risk-free, and it re"uires a continuous rebalancing of the portfolio and the ratio of the holdings in the asset and the deri!ati!e product. The delta-hedge position ust be onitored continuall$, and in practice it can suffer fro losses due to the costs of transacting in the underl$ing. )ne use for delta-hedging is for the writer of an option who also wishes to co!er his position. If the writer can get a pre iu slightl$ abo!e the fair !alue for the option then he can trade in the underl$ing ,or a futures contract on the underl$ing, since this is usuall$ cheaper to trade in because the transaction costs are lower- to aintain a delta-neutral position until e%pir$. Since he charges ore for the option than it was theoreticall$ worth he akes a net profit without an$ risk - in theor$. This is onl$ a practical polic$ for those with access to the arkets at low dealing costs, such as arket akers. If the transaction costs are significant then the fre"uent rehedging necessar$ to aintain a deltaneutral position renders the polic$ i practical. We discuss this point further in .hapter 1A. The delta for a whole portfolio is the rate of change of the !alue of the portfolio with respect to changes in the underl$ing asset.3 Writing II for the !alue of the portfolio,


as O

Thus, when delta hedging between an option and an asset, the position taken is called 2delta-neutral+, since the sensiti!it$ of the hedged portfolio to asset price changes is instantaneousl$ Fero. >or a general portfolio
3 This definition, which is standard, is not "uite consistent with our pre!ious use of B and fl ,which is also standard-. There, B was the sensiti!it$ of a single option to asset price changes and fI was the hedged portfolio. There should be little risk of confusion.


The Black-Scholes Model

the aintenance of a delta-neutral position a$ re"uire a short position in the underl$ing asset. This entails the selling of assets which are not owned - so-called short selling. ( broker a$ re"uire a argin to co!er an$ o!e ents against the short seller but this argin usuall$ recei!es interest at the bank rate. There are ore sophisticated trading strategies than si ple deltahedging, and here we ention onl$ the basics. In delta-hedging the largest rando co ponent of the portfolio is eli inated. )ne can be ore subtle and hedge awa$ s aller order effects due, for instance, to the cur!ature ,the second deri!ati!e- of the portfolio !alue with respect to the underl$ing asset. This entails knowledge of the ga a of a portfolio, defined b$ a

r as
The deca$ of ti e !alue in a portfolio is represented b$ the theta, gi!en


ail an ao, ,

>inall$, sensiti!it$ to !olatilit$ is usuall$ called the !ega and is gi!en


and sensiti!it$ to interest rate is called rho, where


Eedging against an$ of these dependencies re"uires the use of another option as well as the asset itself. With a suitable balance of the underl$ing asset and other deri!ati!es, hedgers can eli inate the shortter dependence of the portfolio on o!e ents in ti e, asset price, !olatilit$ or interest rate.

3.1B I

plied 8olatilit$

We ha!e suggested in the abo!e odelling and anal$sis that the wa$ to use the Black-Scholes and other odels is to take para eter !alues estiated fro historical data, substitute the into a for ula ,or perhaps sol!e an e"uation nu ericall$-, and so deri!e the !alue for a deri!ati!e product. This is no longer the co onest use of option odels, at least not for the si plest options. This is partl$ because of difficult$ in easuring the !alue of the !olatilit$ of the underl$ing asset. Gespite

3.1B I plied 8olatilit$


our assu ption to the contrar$, it does not appear to be the case that !olatilit$ is constant for long periods of ti e. >urther ore, it is not ob!ious that the historic !olatilit$ is independent of the ti e series fro which it is calculated, nor that it accuratel$ predicts the future !olatilit$ that we re"uire, o!er the lifeti e of an option. ( direct easure ent of !olatilit$ is therefore difficult in practice. Eowe!er, despite these difficulties it is plainl$ true that option prices are "uoted in the arket. This suggests that, e!en if we do not know the !olatilit$, the arket 2knows+ it. Take the Black-Scholes for ula for a call, for e%a ple, and substitute in the interest rate, the price of the underl$ing, the e%ercise price and the ti e to e%pir$. (ll of these are !er$ si ple to easure and are either "uoted constantl$ or are def ined as part of the option contract. (ll that re ains is to specif$ the !olatilit$ and the option price follows. Since a call option price increases onotonicall$ with !olatilit$ ,this is eas$ to show fro the e%plicit forula and, as we ha!e alread$ entioned, is clear financiall$- there is a one-to-one correspondence between the !olatilit$ and the option price. Thus we could take the option price "uoted in the arket and, working backwards, deduce the arket+s opinion of the !alue for the !olatilit$ o!er the re aining life of the option. This !olatilit$, deri!ed fro the "uoted price for a single option, is called the i plied !olatilit$. There are ore ad!anced wa$s of calculating the arket !iew of !olatilit$ using ore than one option price. In particular, using option prices for a !ariet$ of e%pir$ dates one can, in principle, deduce the arket+s opinion of the future !alues for the !olatilit$ of the underl$ing ,the ter structure of !olatilit$-. )ne unusual feature of i plied !olatilit$ is that the i plied !olatilit$ does not appear to be constant across e%ercise prices. That is, if the !alue of the underl$ing, the interest rate and the ti e to e%pir$ are f i%ed, the prices of options across e%ercise prices should reflect a unifor !alue for the !olatilit$. In practice this is not the case and this highlights a flaw in so e part of the odel. ,(lso, puts and calls tend to gi!e slightl$ different i plied !olatilities.- Which part of the odel is inaccurate is the sub&ect of a great deal of acade ic research. We illustrate this effect in >igure 3.D, which shows the i plied !olatilities as a function of e%ercise price using the >T-S# inde% option data in >igure 1.1. )bser!e how the !olatilit$ of the options deepl$ in-the- one$ is greater than for those at-the- one$. This cur!e is traditionall$ called the 2s ile+, although depending on arket conditions it a$ be lopsided as in >igure 3.D, or e!en a 2frown+.

91 I plied

The Black-Scholes Model

B.3 -

B.' R R R


.urrent asset price


#%ercise price
>igure 3.D I plied !olatilities as a function of e%ercise price. Gata is taken fro >T-S# inde% option prices.

Technical 5oint6 Trading 8olatilit$. In practice !olatilit$ is not constant, nor is it predictable for ti escales of ore than a few onths. This, of course, li its the !alidit$ of an$ odel that assu es the contrar$. This proble a$ be reduced b$ pricing options using i plied !olatilit$ as described abo!e. Thus one trading strateg$ is to calculate i plied !olatilities fro prices of all options on the sa e underl$ing and the sa e e%pir$ date and then to bu$ the one with the lowest !olatilit$ and sell the one with the highest. The hope is then that the prices o!e so that i plied !olatilities beco e ore or less co parable and the portfolio akes a profit.
More sophisticated odelling in!ol!es describing !olatilit$ itself as a


!ariable satisf$ing so e stochastic differential e"uation. This results in a two-factor odel. If the !olatilit$ is rando then it is no longer possible to construct the perfect hedge, in which a portfolio grows b$ a deter inistic a ount, using the asset alone. Eowe!er, it is in principle possible to use other options, but the details are too co ple%
to go into here.



>urther 7eading
< .arefull$ read the original papers of Black S Scholes ,1D/3- and Mer-

ton ,1D/3-.
< .o pare the bino ial ethod for !aluing options with the differential e"uation approach. The bino ial ethod can be found in, for e%a ple, .o% S 7ubinstein ,1DC9-. We discuss it in .hapter 1B. < Qarrow S 7udd ,1DC3- and .o% S 7ubinstein ,1DC9- describe 2&u pdiffusion+ odels and 2constant elasticit$ of !ariance+ odels. In the for er the asset price rando walk need not be continuous but can ha!e rando discontinuous &u ps0 in the latter the !olatilit$ can be a function of S. < Eull ,1DD3- considers the esti ation of !olatilit$ using the i plied !olatilities of se!eral options. Eull S White ,1DC/- discuss the !ariation of !olatilit$ with ti e. < There has been a great deal of work done on testing the !alidit$ of the Black-Scholes for ulae in practice0 see Eull ,1DD3-. >or details of how the call option for ula stands up in practice see MacBeth S Mer!ille ,1D/D- and for a test of put-call parit$ see Tle kosk$ S 7esnick ,1D/D-. < Ue ill ,1DD'- gi!es a practical e%a ple illustrating the practical shortco ings of the purel$ theoretical approach to hedging. < More sophisticated hedging strategies are described in .o% S 7ubinstein ,1DC9-.

1. Toda$+s date is D Qanuar$ 'BBB and KVL+s share price stands at W1B. )n C :o!e ber 'BBB there is to be a 5residential election and $ou belie!e that, depending on who is elected, KVL+s share price will either rise
or fall b$ appro%i atel$ 1BX. .onstruct a portfolio of options which

will do well if $ou are correct. .alls and puts are a!ailable with e%pir$ dates in March, Qune, Septe ber, Gece ber and with strike prices of W1B plus or inus 9BY. Graw the pa$off diagra and describe the pa$off athe aticall$.
'. Graw the e%pir$ pa$off diagra s for each of the following portfolios6

,a- Short one share, long two calls with e%ercise price # ,this co bination is called a straddle-0

,b- ;ong one call and one put, both with e%ercise price # ,this is
also a straddle6 wh$3-0


The Black-Scholes Model

,c- ;ong one call and two puts, all with e%ercise price # ,a strip-0 ,d;ong one put and two calls, all with e%ercise price # ,a strap-0 ,e;ong one call with e%ercise price #l and one put with e%ercise price #'. .o pare the three cases #, ? #' ,known as a strangle-, #l = #' and #l @ #'.
,f- (s ,e- but also short one call and one put with e%ercise price #

,when #l @ # @ #', this is called a butterfl$ spread-. Ise the arket data of >igure 1.1 to calculate the cost of an e%a ple of each portfolio. What !iew about the arket does each strateg$


Show b$ substitution that two e%act solutions of the Black-Scholes e"uation ,3.D- are ,a- 8 ,S, t- = (S, ,b- 8,S,t- = (ert, where ( is an arbitrar$ constant. What do these solutions represent and what is the ( in each case3


Show that the for ulae ,3.1/- for a call and ,3.1C- for a put also satisf$ ,3.D- with the rele!ant boundar$ conditions ,one at each of S = B and S = oo- and final conditions at t = T. Show also that the$ satisf$ put-call parit$. Sketch the graphs of the ( for the #uropean call and put. Suppose that the asset price now is S = # ,each of these options is at-the- one$-. .on!ince $ourself that it is plausible that the delta-hedging strateg$ is
self-financing for each option, in the two cases that the option e%pires


in-the- one$ and out-of-the- one$0 look at the contract fro

of !iew of the writer.

the point


>ind the ost general solution of the Black-Scholes e"uation that has the special for ,a- 8 = 8,S-0 ,b- 8 =( ,t- B ,S-.
These are e%a ples of 2si ilarit$ solutions+, which are discussed further

in .hapter 9. Ti e-independent options as in ,a- are called perpetual



Ise arbitrage argu ents to pro!e the following si ple bounds on #uropean call options on an asset that pa$s no di!idends6 ,a- . @ S0

,b- . ? S - #e-r,T-t-0

#%ercises ,c- If two otherwise identical calls ha!e e%ercise prices #l and #' with #l @ #', then


B @.,S,t0#1--.,S,t0#'- @#'-#,0
,d- If two otherwise identical call options ha!e e%pir$ ti es Tl and
T' with TI @ T'i then

.,S,t0T&- @.,S,t0T'-.
Geri!e si ilar restrictions for put options.

C. D.

Geri!e e"uation ,3.1A-. Suppose that a share price S is currentl$ W1BB, and that to orrow it will be either W1B1, with probabilit$ p, or WDD, with probabilit$ 1 - p. ( call option, with !alue ., has e%ercise price W1BB. Set up a BlackScholes hedged portfolio and hence find the !alue of .. ,Ignore interest rates.:ow repeat the calculation for a cash-or-nothing call option with pa$off W1BB if the final asset price is abo!e W1BB, Fero otherwise. What difference do $ou notice3 This !er$ si ple discrete odel is the basis of the bino ial ethod, described in .hapter 1B.

5artial Gifferential #"uations

1.1 Introduction
The odelling of .hapter 3 cul inates in the for ulation of the pricing proble for a deri!ati!e product as a partial differential e"uation. We now take a break fro the financial odelling to discuss, in this and the ne%t chapter, so e of the theor$ behind such differential e"uations. In this chapter we describe the ele entar$ theor$ and the nature of boundar$ and initial conditions. In .hapter 9 we deri!e so e e%plicit solutions, including the original Black-Scholes for ulae. ;ater, in .hapter /, we describe in detail the special proble s arising when there are free boundaries. This chapter is of particular i portance when considering the !aluation of ( erican options. The stud$ of partial differential e"uations in co plete generalit$ is a !ast undertaking. >ortunatel$, howe!er, al ost all the partial differential e"uations encountered in financial applications belong to a uch ore anageable subset of the whole6 second order linear parabolic e"uations. These technical ter s are discussed below0 ore detailed treat ents of the areas be$ond the scope of this te%t are gi!en in so e of the references at the end of the chapter. We begin this chapter with a re!iew of second order linear parabolic e"uations6 their ph$sical interpretation, athe atical properties of their solutions, and techni"ues for obtaining e%plicit solutions to specific proble s. Then, we e%ploit this knowledge in the conte%t of financial odels to deri!e e%plicit solutions to so e option !aluation proble s, and we set the scene for the nu erical ethods of .hapters C and D. Before doing this, though, it is helpful to step back and consider in general ter s the "uestions we should ask when considering a partial


1.' The Giffusion #"uation


differential e"uation. Such "uestions usuall$ include an$ or all of the following6 < Goes the e"uation ake sense athe aticall$3 If it is to be sol!ed in a region, what ust we sa$ about the solution on the boundar$ of that region in order to obtain a well-posed proble , i.e. one whose solution e%ists, is uni"ue, and is, in so e sense, +well-beha!ed+3 Such specifications of the solution on the boundar$ are called boundar$ conditions or, if applied at a particular !alue of ti e, initial conditions or final conditions. The ter 2well-beha!ed+ used here is usuall$ taken to i pl$ that the solution depends continuousl$ on the initial and boundar$ conditions, so that s all changes in these conditions cannot induce large changes in the solution itself. Be$ond this, we also want to know what athe atical properties the solution ust or can ha!e. >or e%a ple, is it guaranteed to be s ooth or can it ha!e discontinuities3 < .an we de!elop anal$tical tools to sol!e the e"uation3 #%plicit solutions are useful both to illustrate the general beha!iour of the e"uation and for their application in practice. We note, though, that an$ e%plicit solutions a$ be so cu berso e as to be of less practical use than a well-designed nu erical appro%i ation. < Eow should we sol!e the e"uation nu ericall$, should this be necessar$3 What i plications do the athe atical properties of the solution ha!e for the nu erical ethod we choose3 (re there alternati!e for ulations, such as a change of !ariable or a weak state ent of the proble ,see .hapter /-, that lead to a better ,si pler, ore adaptable, ore accurate, ore robust, faster- nu erical sche e3 These ai s guide us in the sections to follow.

1.' The Giffusion #"uation

The heat or diffusion e"uations Cu

)r = a''


has been studied for nearl$ two centuries as a odel of the flow ,or diffusion- of heat in a continuous ediu . It is one of the ost successful
s We use % rather than S as the spatial independent !ariable because all our applications of the diffusion e"uation occur after a change of !ariable of the for S = #e%. We use r as the 2ti e+ !ariable rather than t for a si ilar reason0 the details are gi!en later.


5artial Gifferential #"uations

and widel$ used odels of applied athe atics, and a considerable bod$ of theor$ on its properties and solution is a!ailable. It is often helpful as a

guide to intuition to bear in

ind the ph$sical situations that lead

to the heat e"uation, and we ention the where!er it is appropriate. Thus, we recall that e"uation ,1.1- odels the diffusion of heat in one space di ension, where u,%, T- represents the te perature in a long, thin, unifor bar of aterial whose sides are perfectl$ insulated so that its te perature !aries onl$ with distance % along the bar and, of course,
with ti e T.

We begin with a list of so e of the ele entar$ properties of the diffusion e"uation. < It is a linear e"uation. That is, if ul and u' are solutions, then so is .1 I1 Hc'u' for an$ constants cl and c'. < It is a second order e"uation, since the highest order deri!ati!e occurring is the second, in the ter a'u4a%e. < It is a parabolic e"uation. Its characteristics are gi!en b$ T = constant. ,The ter s 2parabolic+ and 2characteristic+ are discussed further in Technical 5oint 1 at the end of this section.- Thus, inforation propagates along these lines in ,%, T- space, and if a change is ade to u at a particular point, for e%a ple on the boundar$ of the solution region, its effect is felt instantaneousl$ e!er$where else. < Uenerall$ speaking, its solutions are anal$tic functions of %. This eans that for each !alue of T greater than the initial ti e, u,%, Tregarded as a function of % has a con!ergent power series in ter s of % - %o for each %o awa$ fro spatial boundaries. >or practical purposes, for T ? B we can think of a solution of the diffusion e"uation as being as s ooth a function of % as we could e!er need, but discontinuities in ti e a$ be induced b$ the boundar$ conditions. This
is again a conse"uence of the fact that infor ation propagates with

infinite speed along the characteristics T = constant. >ro the ph$sical point of !iew, diffusion is a s oothing out process6 heat flows fro hot to cold and so e!ens out te perature differences. The properties abo!e go so e wa$ towards showing that solutions of the diffusion e"uation, which is a athe atical odel of the ph$sical process, ha!e the sa e tendenc$. (nticipating so e results fro Section 1.3, it can be shown further that e!en though the initial !alues of u a$ be rather irregular or &agged, for an$ T ? B the solution of the

1.' The Giffusion #"uation

initial !alue proble
.hu a' u


aT - C%' with initial data


u,%,B- = uB,%and u --? B as % - Poo

is anal$tic for all T ? B. This s oothness, which is characteristic of all ,forward- linear parabolic e"uations, is !er$ helpful when it co es to nu erical solution. (n illustration of all these points is the following special solution, which is deri!ed in Section 9.'6 uA,%+T' 84/ %' 41r - W @ % @ BB, T ? B. ,1.'-

>or T ? B this is a s ooth Uaussian cur!e, but at T = B it is 2e"ual+ to the delta function ,hence our notation-6 uA,%,B- = A,%-. (t r = B, uA,%,B- !anishes for % 91 B0 at % = B it is 2infinite+, but its integral is still 1. ,This is to be interpreted as follows6 since for all T ? B, f B ua ,%, T- d% = 1, the li it as T tends to Fero fro abo!e of the integral is still 1. >urther infor ation on delta functions is gi!en in Technical 5oint ' below.- We show uA ,%, T- in >igure 1.1 for se!eral !alues of T0 note how the cur!e beco es taller and narrower as T gets s aller. The delta function initial !alue for uA,%, T- sa$s that all the heat is
initiall$ concentrated at % = B. This function odels the e!olution of an

idealised 2hotspot+, a unit a ount of heat initiall$ concentrated into a single point, and it is called the funda ental solution of the diffusion e"uation. It also illustrates the infinite propagation speed entioned abo!e. (t T = B, the solution ,1.'- is Fero for all % B, but for an$ T ? B, howe!er s all, and an$ %, howe!er large, uA ,%, T- ? B6 the heat initiall$ concentrated at % = B i ediatel$ diffuses out to all !alues of %. :ote, though, that uA falls off !er$ rapidl$ as I%Q -? oo. >inall$, note that the right-hand side of e"uation ,1.'- is &ust the nor al distribution of probabilit$ theor$, with ean Fero and !ariance 'T. This solution of the diffusion e"uation can be interpreted as the

A' ub

5artial Gifferential #"uations

>igure 1.1. The funda ental solution of the diffusion e"uation.

probabilit$ densit$ function of the future position of a particle that follows a constant coefficient rando walk along the %-a%is. The delta function initial condition si pl $ sa$s that the particle is initiall$ known to be at the origin.
Technical 5oint 16 .haracteristics of Second )rder ;inear 5ar-

tial Gifferential #"uations. We can think of the characteristics of a second order linear e"uation as cur!es along which infor ation can propagate, or as cur!es across which discontinuities in the second deri!ati!es of u can occur. Suppose that u,%, r- satisfies the general second order linear e"uation



T H.,%+T-f/T'




Hd,%,T-a% He,%+T-CT Hf,%,T-uHg,%,T- =B.

The idea is to see whether the deri!ati!e ter s can be written in ter s
of directional deri!ati!es, so that the e"uation is partl$ like an ordinar$

differential e"uation along cur!es with these !ectors as tangents. These cur!es are the characteristics. If we write the as % = %,e-, T = T,e-, where is a para eter along the cur!es, then %,e- and T,10- satisf$
' '

a,%, T-


b,%, T- @

H c,%, T@


= B.

1.' The Giffusion #"uation


There now arises the "uestion whether this e"uation, regarded as a "uadratic in ,d%4d.-4,dT4@-, has two distinct real roots, two e"ual real roots, or no real roots at all. These cases correspond to the discri inant b' - 1ac being greater than Fero, Fero, or less than Fero. The first case, two real fa ilies of characteristics, is called h$perbolic, and is t$pical of wa!epropagation proble s. These do not often occur in finance. The second case, an e%act s"uare, is called parabolic0 the diffusion e"uation, which has b = c = B, is the si plest e%a ple. (ll the second order e"uations in this book are parabolic. The final case, with no real characteristics, is
called elliptic, and is t$pical of stead$-state proble s such as perpetual

options in


odels which are be$ond the scope of this book.

:ote that the definitions gi!en here are pointwise6 the h$perbolic4 parabolic4elliptic distinction is specified at each point. It is possible for an e"uation to change t$pe as a,%, T-, b,%, T- and c,%, T- !ar$, if the discri inant changes sign. In particular, the Black-Scholes e"uation ,in S and t rather than % and T-,

a! at

H 1 c$'s'


a'8 as'


is parabolic for S ? B ,it is in fact h$perbolic at S = B, where it reduces to an ordinar$ differential e"uation with characteristic S = B-. This fact has i portant financial i plications6 the line S = B is a barrier across which infor ation cannot cross. Technical 5oint '6 The Gelta >unction and the Eea!iside >unction. The Girac delta function, written C,%-, is not in fact a function in the nor al sense of the word, but is rather a 2generalised function+. >or technical reasons, its definition is as a linear ap, but it is reall$ oti!ated b$
the need for a athe atical description of the li it of a function whose

effect is confined to a s aller and s aller inter!al, but $et re ains finite. Suppose, for e%a ple, that I recei!e one$ at the rate f ,t- dt in a ti e dt where f is e"ual to the following function6 f,t14'#, Itl @ # B, Itl ?#.

This function is drawn in >igure 1.' for se!eral !alues of #. (s c gets s aller the graph beco es taller and narrower. It is clear that the total
pa$ ent is

Q MM f,t- dt


5artial Gifferential #"uations


>igure 1.'. Three

e bers of a li iting se"uence for the delta function.

and is e"ual to 1 independentl$ of #, but that for all t 91 B, f ,t- --f B as # --? B. The li iting 2function+ is Fero for all nonFero t, $et its integral is still 1Z This is an infor al wa$ of defining the delta function, A,t-6 it is the 2li it+ as # --f B of an$ one-para eter fa il$ of functions A,,t- with the
following properties6

< for each c, A#,t- is piecewise s ooth0 <

A# ,t- dt = 10 Af ,t- = B. c-B

< for each t 31 B, li

Such a se"uence of functions is called a delta se"uence. The function f ,tabo!e is one such0 another, which uses % as the independent !ariable' instead of t, is A ,%- =



With f replaced b$ t, this is the funda ental solution of the diffusion e"uation discussed abo!e. It is easil$ confir ed that the latter function has integral 1, and that, like f ,t-, for % [ B it tends to Fero as # -1 B, while for % = B its !alue increases without li it. This 2pointwise+ !iew of the delta function is rather hard to work with, since the functions A# beco e increasingl$ badl$ beha!ed near the origin as # --? B. Indeed, the li iting 2function+ is not a nor al function at all ,this is wh$ the ter 2generalised function+ is used-. Instead, we e%ploit '
Whether we use %, t or an$ other letter as the argu depends on the application we ha!e in ind. ent for the delta function


The Giffusion #"uation


the fact that integration s ooths out the bad beha!iour0 the integral of an$ e ber of a delta se"uence is well-beha!ed, being e"ual to 1. This idea oti!ates the definition of the delta function !ia its integral action6 for an$ s ooth function Y,%-, called a test function,

A ,%-),%- d% = li


A# ,%-cb,%- d%

,In fact, this defines the delta function as the continuous linear ap fro s ooth functions Y,%- to real nu bers that has the !alue B,B-, usuall$

written as ,A, B- = B,B-.It is apparent that for an$ a, b ? B, b A ,%-Y,%- d% = B,B-, and that for an$ %o,

f BB

A ,% - %o-o,%- d% = Y,%o-,

so ultipl$ing B b$ A,% - %o- and integrating 2picks out+ the !alue of " at %o. We also ha!e Q A ,s- ds = 1I ,%-,

where /-l,%- is the Eea!iside function, defined b$ 1 .on!ersel$, 1-l+,%- = A,%-.

The last pair of relations shows that the deri!ati!e of a function that

for%@B for%?B.

has a &u p discontinuit$ has a delta function co ponent at the sa e point, ultiplied b$ the agnitude of the &u p. This fact is often useful in the anal$sis of differential e"uations with discontinuous functions or
coefficients. We gi!e a si ple e%a ple.

Suppose that M,t- represents the a ount of one$ owned b$ a person who is initiall$ penniless, but at ti e t = to ? B recei!es an a ount GA. Then, clearl$,



forB@t@to fort ? to,


5artial Gifferential #"uations

and so M,t- satisfies the differential e"uation dM dt =GA9,t-to-. The discontinuit$ in M,t- gi!es a delta function in dM4dt at t = to. .on!ersel$, when we see a differential e"uation with a delta function on the right-hand side, there ust be a corresponding delta function in the highest order deri!ati!e on the left-hand side in order to aintain a balance. This in turn eans that the ne%t highest order deri!ati!e has a &u p discontinuit$ of agnitude e"ual to the coefficient of the delta function. These &u p conditions can be used to &oin together s ooth seg ents of the solution across discontinuities. The delta function in e%a ples like this can be ultiplied b$ a s ooth function of % or t, but care ust be taken to a!oid products like 9,%-D-l,%- or ,A,%--', for which no sensible definition can easil$ be gi!en.

1.3 Initial and Boundar$ .onditions

We now consider what initial and boundar$ conditions are appropriate for solutions of the diffusion e"uation, first in a finite region, then in an infinite one.

1.3.1 The Initial 8alue 5roble

Suppose we wish to sol!e au S = a'u4a%e in the finite inter!al -; @ % @ ; and for T ? B, representing heat flow in a bar of finite

4 T

on a >inite Inter!al

length ';.
)b!iousl$ we should specif$ the initial te perature u,%, B- = uo ,%- for -; @ % @ ;. With the heat flow analog$ in ind, it see s reasonable on ph$sical grounds that we ha!e enough infor ation to deter ine u,%, Tuni"uel$ if we specif$ either the te peratures at the ends of the bar or the heat flu%es at both ends, but not both. This turns out to be the case0 in fact both the following state ents of the proble can be shown to be well-posed6 ,i-

au C'u aT a%e

-; @ % @ ;, with u,%, B- = uo,%-,

u,-;, -r- = gN,T-, u,;,T- = gH ,T-0

1.3 Initial and Boundar$ .onditions



au aT

' ', a% -; @%@ ;, with u,%, B- = uo ,%-,

-+au,-;, T- = h-,T-,

a%,;,T- = hH,T-.

In the first case it is the te perature and in the second case the heat f lu%es that are specified at % = -; and % = ;.

1.3.' The Initial 8alue 5roble

on an Infinite Inter!al

Suppose now that we consider heat flow in a !er$ long bar, b$ taking the li it ; ---H oo in the e%a ple abo!e. When the bar is infinitel$ long, it is still i portant to sa$ how u beha!es at large distances, but we do not ha!e to be as precise in our specification of u at the 2boundaries+ % = PBB as we were in the finite case. There are so e technical difficulties here, associated with the notion of infinit$, but roughl$ speaking as long as u is not allowed to grow too fast, the solution e%ists, is uni"ue, and depends continuousl$ on the initial data uo,%-. To be specific, the solution to the initial !alue proble au
= a'u



-BB@K@BB, r?B,


with u,%,B- = uo,%-, where ,1.1-

,i,iiand lastl$ where

uo,%- is sufficientl$ well-beha!ed, li uo,%-e-1D%' = B I%I-.BB for an$ a ? B,


li u,%,T-e-1D%' = B I%I-.B

for an$ a ? B, T ? B,


is well-posed. The precise definition of the phrase 2sufficientl$ wellbeha!ed+ here is be$ond the scope of this book, but certainl$ an$ function that has no worse than a finite nu ber of &u p discontinuities is acceptable. We also note that although it is necessar$ to prescribe the


5artial Gifferential #"uations

beha!iour at infinit$, in practice the li itations abo!e are not too se!ere. (ll the initial !alue proble s in this book satisf$ the growth conditions "uite co fortabl$. We so eti es need to consider initial !alue proble s defined on a se i-infinite inter!al, for e%a ple in the anal$sis of barrier options. In this case we re"uire a co bination of the two sets of conditions abo!e. If, for e%a ple, we need to sol!e ,1.3- for B @ % @ oo, T ? B, then gi!en suff icientl$ s ooth initial data uo,%- for B @ % @ oo, a sufficientl$ s ooth boundar$ !alue at % = B, u,B, T- = go ,/-, and the growth conditions ,1.A-, ,1./- as % -O oo, the proble is well-posed.

1.1 >orward !ersus Backward

In all the abo!e we ha!e discussed the forward e"uation )n

a 'u
a$ ask, what is wrong with

)T - a%'+ with conditions gi!en at T = B. The reader the e"uation



,1.C%' ,with the sa e initial and boundar$ conditions-3 This e"uation ight, for e%a ple, arise if in a forward proble we had replaced -r b$ To - T for so e constant To, whereupon au4aT beco es -au4aT. It turns out that this backward proble is ill-posed6 for ost initial and boundar$ data the solution does not e%ist at all, and e!en if it does e%ist, it is likel$ to blow up ,for e%a ple, u a$ tend to oo- within a finite ti e. ( good e%a ple is the funda ental solution of the diffusion e"uation ,1.'-. (t ti e To this solution is e"ual to
1 e-%'41To


1r To

which is as s ooth and well-beha!ed as we could wish. If we use this function as our initial data uo,%- for e"uation ,1.C-, then the solution is u,%,T- = ' 1 ir,T) - Te-%'41,TB-T-

and this beco es singular ,blows up- at T = To, when it is e"ual to the delta function A,%-. Moreo!er, it cannot be continued be$ond this ti e ,at least, not as a 2nor al+ function-.



5h$sicall$ this distinction akes good sense. If the forward diffusion e"uation odels the e!olution of the te perature fro its initial !alues, the backward e"uation poses the "uestion of deter ining the te pera ture fro which the initial distribution could ha!e e!ol!ed0 this is clear fro the ti e-re!ersal argu ent abo!e. Since forward diffusion s ooths out &agged te perature distributions, backward diffusion akes s ooth initial data beco e ore &agged. (nother wa$ of seeing this is to note that under forward diffusion heat flows fro hot to cold, whereas under backward diffusion it flows fro cold to hot, and so the hot places beco e e!er hotter, leading to blow-up. There are, howe!er, so e well-posed proble s for e"uation ,1.C-0 in particular the final !alue proble for the backward diffusion e"uation is well-posed. Thus, we can sol!e ,1.C- for B @ T @ To with u,%, Togi!en. This is easil$ shown b$ con!erting ,1.C- to a forward proble b$ replacing T b$ To - T.

>urther 7eading
< >or further infor ation about first order partial differential e"uations and their solution see Willia s ,1DCB-, Strang ,1DCA-, Teener ,1DCCand Te!orkian ,1DDB-. < Three books de!oted wholl$ to the diffusion e"uation are those b$ .rank ,1DCD-, Eill S Gew$nne ,1DDB- and .arslaw S Qaeger ,1DCD-. < More details about delta functions, and about other generalised functions ,or 2distributions+- are gi!en b$ 7ichards S Voun ,1DDB-.

1. Show that the solution to the initial !alue proble is uni"ue pro!ided that it is sufficientl$ s ooth and deca$s sufficientl$ fast at infinit$, as follows6

Suppose that u1,%, T- and u' ,%, T- are both solutions to the initial !alue proble ,1.3--,1./-. Show that !,%,T- = u1-u' is also a solution of ,1.3- with !,%, B- = B. Show that if #,T- =

Q !' d%, BB
#,B- = B,

#,T- ? B,

and, b$ integrating b$ parts, that d# dr@B0

5artial Gifferential #"uations

thus #,r- = B, hence !,%, r- = B. :ote, though, that as $et we ha!e no guarantee that u,%, r- e%ists,
nor that the abo!e '. anipulations can be &ustified. Show that sin n% a-,''T is a solution of the forward diffusion e"uation, and that sin n% e/''T is a solution of the backward diffusion e"uation. :ow tr$ to sol!e the initial !alue proble for the forward and backward

e"uations in the inter!al -/r @ % @ Fr, with u = B on the boundaries and u,%, B- gi!en, b$ e%panding the solution in a >ourier series in % with coefficients depending on r. What difference do $ou see between the two proble s3 Which is well-posed3 ,The for er is useful for double knockout options0 see #%ercise 3 in .hapter 1'.3. 8erif$ that uA,%, r- does satisf$ the diffusion e"uation for r ? B.

The Black-Scholes >or ulae

9.1 Introduction
In this chapter we describe so e techni"ues for obtaining anal$tical solutions to diffusion e"uations in fi%ed do ains, where the spatial boundaries are known in ad!ance. >ree boundar$ proble s, in which the spatial boundaries !ar$ with ti e in an unknown anner, are discussed in .hapter /. We highlight in particular one ethod6 we discuss si ilarit$ solutions in so e detail. This ethod can $ield i portant infor ation about particular proble s with special initial and boundar$ !alues, and it is especiall$ useful for deter ining local beha!iour in space or in ti e. It is also useful in the conte%t of free boundar$ proble s, and in .hapter / we see an application to the local beha!iour of the free boundar$ for an ( erican call option near e%pir$. Be$ond this, though, we can also use si ilarit$ techni"ues to deri!e the funda ental solution of the diffusion e"uation, and fro this we can deduce the general solution for the initial-!alue proble on an infinite inter!al. This in turn leads i ediatel$ to the Black-Scholes for ulae for the !alues of #uropean call and put options. >inall$, we e%tend the ethod to so e options with ore general pa$offs, and we discuss the risk-neutral !aluation ethod.

9.' Si

ilarit$ Solutions

It a$ so eti es happen that the solution u,%,+r- of a partial differential e"uation, together with its initial and boundar$ conditions, depends onl$ on one special co bination of the two independent !ariables. In such cases, the proble can be reduced to an ordinar$ differential e"uation in which this co bination is the independent !ariable. The solution to this ordinar$ differential e"uation is called a si ilarit$ solution to the /1


The Black-Scholes >or ula

original partial differential e"uation. The athe atical reasons for the e%istence of this reduction are subtle and be$ond the scope of this book,

although the Technical 5oint at the end of this section, which deals
with the echanics of finding si ilarit$ solutions, does hint at the . We si pl$ gi!e two e%a ples here. #%a ple 1. Suppose that u,%, T- satisfies the following proble se i-infinite inter!al % ? B6 au a'u
aTa% - 8 K,

on the


with the initial condition u,%,B- = B, and a boundar$ condition at % = B, u,B, Twe also re"uire that u-OBas%-?oo. ,9.110 ,9.3,9.'-

These e"uations odel the e!olution of te perature in a long bar, initiall$ at Fero te perature, after the te perature at one end is suddenl$ raised to 1 and held there. >ollowing the argu ents suggested in the Technical 5oint below, we look for a solution in which u,%, T- depends onl$ on % and r through the co bination l0 = %4 f, so that u,%, r- = I,t0-. Gifferentiation shows that


'TSI ,-

and a'uN 1
a%' I*,B1


,9.1- shows that all the ter s in!ol!ing r on its own a$ be cancelled, and I,.- satisfies the second order ordinar$ differential e"uation I*HI.I, =B. >ro the initial and boundar$ conditions ,9.'--,9.1-, ,9.9-

d4dl0. Substitution into e"uation

9.' Si ilarit$ Solutions


I,)- = 1, I,oo- = B.


,The second of these incorporates both ,9.'- and ,9.1-, since as T -H B fro abo!e, L -? oo.Separating the !ariables, we find that

I+,- = .e-e'41
for so e constant .. Integrating,

I,L0- = .

Q e-D'41ds H G

where G is a further constant. (ppl$ing the boundar$ conditions ,9.A-, writing fo = f,/ - f , and using the standard result ' e-D 41ds ,


we find that

I,) =
that is, u,%,T- N
81N/Nr f BB

e- 9'41 ds-

Q e-D'41ds.


It is eas$ to !erif$ that this function does satisf$ the proble state ent ,9.1--,9.1-, so that the solution does indeed depend onl$ on %4.,fT-. #%a ple '. >or our second e%a ple we deri!e the funda ental solution uA,%, i--, which we introduced in .hapter 1. We again look for a solution of the diffusion e"uation that depends on % onl$ through the co bination
= %4 f, but now we tr$ the for

us,%,T- = T-14' IA,-.

The r-14' ter ultipl$ing IA ,.- is there to ensure that f BB u,%, rr- d% is constant for all r, which can be shown b$ direct calculation. ( co putation si ilar to the e%a ple abo!e shows that IA,L0- satisfies the ordinar$ differential e"uation

IA H ,L IA-+ = B.


The Black-Scholes >orrnul.#

The general solution of this, obtained b$ integrating twice, the second ti e with the help of the integrating factor e'41, is IA,- = .e-.'41 H G for constant . and G. .hoosing G = B and nor alising the solution b$ setting . = 14,' f-, so that f * ud% = 1, $ields the funda ental solution 1 41-r
uA,% T- =




as re"uired. The si ilarit$ solution techni"ue is rarel$ successful in sol!ing a co plete boundar$ !alue proble , because it re"uires such special s$ etries in the e"uation and the initial and boundar$ conditions. )n the other hand, it co es into its own in local anal$ses in space or in ti e, for e%a ple the initial otion of a free boundar$ in an ( erican option proble and the !alue of an at-the- one$ option shortl$ before e%ercise, which are hard to resol!e nu ericall$. Technical 5oint6 Uroup In!ariances and Si ilarit$ Solutions. The ke$ to the si ilarit$ solutions abo!e is that both the e"uations and the initial and boundar$ conditions are in!ariant under the scalings % -O (%, T (+/- for an$ real nu ber (. Such a scaling is called a one-para eter group of transfor ations. This in!ariance is readil$ !erified using the new !ariables K = (%, T = (+/-, whereupon u is easil$ seen to satisf$ au4aT = a'u4aK'. >urther ore, in #%a ple 1, the initial and boundar$ conditions beco e u,K, B- = B, u,B, T- = 1 for an$ (. :ow %4,4 = K4! is the onl$ co bination of K and T which is independent of (, and so the solution ust be a function of %44 onl$. It is essential that the e"uation, the boundar$ conditions and the initial
conditions should all be in!ariant under the scaling transfor ation for

the ethod to work. In #%a ple ', the function of r, in this case T-14', ultipl$ing IA,t0- is present because the diffusion e"uation, being linear,
is also in!ariant under the one-para eter group u +--f \u. ( good practi-

cal test for si ilarit$ solutions is to tr$ u = ra f ,%4/-B- in the hope that
% and T will re ain in the e"uations onl$ in the co bination A = %4Tp.

In #%a ple 1 abo!e, the result of doing this is a = B fro the boundar$ condition at % = B and ,B = F fro the diffusion e"uation, while in #%a ple ', a = -a because we want the integral of u,%, r- o!er % to be independent of T, and again J = 1 '

9.3 (n Initial 8alue 5roble


9.3 (n initial !alue proble

for the diffusion e"uation ,1.3--,1./-, in which we

The funda ental solution of the diffusion e"uation can be used to deri!e

an e%plicit solution to the initial !alue proble

ha!e to sol!e the diffusion e"uation for -oo @ % @ oo and T ? B, with arbitrar$ initial data u,%, B- = uo,%- and suitable growth conditions at % = Poo. The ke$ to the solution is the fact that we can write the initial data as uo,%- = f uo,.-b,. - %- dl0BB


where A,.- is the Girac delta function. We recall that the funda ental solution of the diffusion e"uation,
s ub,S,T41T

' !4/ r/t 1

has initial !alue uA,s,B- = A,s-. :ow note that because uA ,s - %, T- = uA ,% - s, T-,
IA ,S - K, /-- =


e-,s-%-'41T 1 /rT

is a solution of the diffusion e"uation using either s or % as the spatial independent !ariable, and its initial !alue is uA,s - %,B- = b,s - %-. Thus, for each s, the function
uo,s-ub,S - K, T-,

regarded as a function of % and T with s held fi%ed, satisfies the diffusion 4aT = a'u4a%e, and has initial data uo,s-b,s - %-. Because the diffusion e"uation is linear, we can superpose solutions of this for . Going so for all s b$ integrating fro s = -oo to s = oo, we obtain a further solution of the diffusion e"uation,
e"uation au

u,%,Twhich has initial data u,%,B- =

' T f uo,s-e-,%-s-'41Tds



uo,s-A,s - %- ds = uo,%-.


The Black-Scholes >or ul$

This, therefore, is the e%plicit solution of the initial !alue proble ,1.3,1./-. It can be shown ,#%ercise 1 of .hapter 1- that this solution is uni"ue. The deri!ation abo!e is not the onl$ wa$ of finding it6 the >ourier transfor is an alternati!e, but we do not describe it here ,see an$ of the books referred to in .hapter 1 for treat ents-. The solution ,9./- can be interpreted ph$sicall$ as follows. 7ecall that the funda ental solution of the diffusion e"uation describes the spreading out of a unit 2packet+ of heat which, at T = B, is all concentrated at the origin. Mathe aticall$, this 2packet+ is represented b$ a delta function. :ow i agine the initial te perature distribution uo,%as being ade up of an$ s all packets, the packet at % = s ha!ing agnitude uo,s- ds. #ach of these e!ol!es to gi!e a te perature distribution e"ual to the funda ental solution, ultiplied b$ uo,s- and with % replaced b$ % - s. Because the diffusion e"uation is linear, we obtain the whole te perature distribution b$ superposing ,adding- the e!olutions of these indi!idual packets0 in the li it, this su is replaced b$ the integral ,9./-.

9.1 The Black-Scholes >or

ulae Geri!ed

The Black-Scholes e"uation and boundar$ conditions for a #uropean call with !alue .,S, t- are, as described in Sections 3.9 and 3.A,
' at H Za+LS 9S

H rS

ac - r. = B,



.,B, t- = B,

.,S, t- - S asS -H oo,

.,S,T- =

a%,S - #,B-.

#"uation ,9.C- looks a little like the diffusion e"uation, but it has ore ter s, and each ti e . is differentiated with respect to S it is ultiplied b$ S, gi!ing nonconstant coefficients. (lso the e"uation is clearl$ in backward for , with final data gi!en at t = T. The first thing to do is to get rid of the awkward S and S' ter s ultipl$ing a.4aS and C'.4aS'. (t the sa e ti e we take the opportunit$ of aking the e"uation di ensionless, as defined in the Technical 5oint below, and we turn it into a forward e"uation. We set S = #e%, t = T - T4 ' J', . = #!,%, T-. ,9.D-

9.1 The >or ulr Geri!ed This results in the e"uation


a! a'! a! aT a%' H ,k - 1- a% - k!
where k = r4 a'. The initial condition beco es ' !,%, B- = a%,e% - 1, B-.


:otice in particular that this e"uation contains onl$ one di ensionless para eter, k = r4 a', although there are four di ensional para eters, #, T, a' and r, in the original state ent of the proble . There is in fact ' another, 'a'T, the di ensionless ti e to e%pir$, and these two are the onl$ genuinel$ independent para eters in the proble 0 the effect of all other factors is si pl$ brought in b$ in!erting the abo!e transfor ations, i.e. b$ a straightforward arith etical calculation. #"uation ,9.1B- now looks uch ore like a diffusion e"uation, and we can turn it into one b$ a si ple change of !ariable. If we tr$ putting
! = ea%H)ru,%,T-,

for so e constants a and 43 to be found, then differentiation gi!es

4&u H aT =

a'u H 'aa% H



H ,k - 1-

au H

TK I - ku.

We can obtain an e"uation with no u ter

b$ choosing

43=a'H,k-1-a-k, while the choice s eli inates the au4a% ter B = 'a H ,k - 1as well. These e"uations for ,kH1-'. aand 43 gi!e

a=-,k-1-, I3=-

! = e-',k-1-%-a,kH1-'Tu


au = a'u
aT a%'

for -oo@%@oo,r?B,

u,%,B- = uo,%- =



- e',k-1-%




The Black-Scholes >or ulae

This a$ see like a long wa$ to tra!el fro the original for ulation, but we ha!e reached the pa$off. The solution to the diffusion e"uation proble is &ust that gi!en in e"uation ,9./-6 u,%,


' /rT

BB uo,s-e-,%-




where uo,%- is gi!en b$ ,9.11-. It re ains to e!aluate the integral in ,9.1'-. It is con!enient to the change of !ariable %+ = ,s - %-4 'T, so that
u,%, r-


1 '/r



l.o,%+ e

'T H %-e-'%+'d%+




- 1',

e',k-1-,%H %4 'r-e- '



sa$. We e!aluate I1 b$ co pleting the s"uare in the e%ponent to get a standard integral6 I1 =

e 1 -,kH1-,%H%+



F 'r -


'r BB




,kH 1-'re-



e ' ,kH1-%H1,kH1-Fr foB





e '5dp'

e 1A ,kH 1-%H 1 ,kH1-'r:,d1-, ' where d1 and :,d1- = 1 ' // N % '/ H',kH1'/-,

Q e-'S'ds BB

rd l

is the cu ulati!e distribution function for the nor al distribution.

9.1 The >or ulee Geri!ed


The calculation of I' is identical to that of Il, e%cept that ,k H 1- is replaced b$ ,k - 1- throughout. ;astl$, we retrace our steps, writing !,% T- = e-





and then putting % = log,S4#-, r = reco!er

J',T - t- and . = #!,%,T-, to

.,S, t- = S:,dl- - #e-++,T-t-:,d'-,

where dl log,S4#- H ,r H !'-,T - t' a ,T - t- log,S4#- H ,r ' J'-,T - t-



,T - t-

The corresponding calculation for a #uropean put option follows si ilar lines. Its transfor ed pa$off is u,%, B- = a% ,e

' k-1-a N e',kHi-%, B- ,


and we can proceed as abo!e. Eowe!er, ha!ing e!aluated the call, a si pler wa$ is to use the put-call parit$ for ula . - 5 = S - #e-+,T-tfor the !alue 5 of a put gi!en the !alue of the call. This $ields 5,S,t- = #e-r,T-t-:,-d'- - S:,-di-, where we ha!e used the identit$ :,d- H :,-d- = 1. The deltas of call and put options are calculated b$ differentiation6 for the call,

ac as
:,dl- H S a :,dl- - #e-+ TS


:,dl- H S:+,dlas - #e-++,T-t-:I,d'- aad's

:,di- H ,S:+,dl- - #e-T,T-t-:+,d'-- 4 So T- --t :,di-,


The Black-Scholes >or ulae

since a rather painful calculation shows that S:+,dl- = #e-r,T-t-:+,d',di!ide both sides b$ :,d'- = ,14 '/r-e-,d' first-. Then, the delta for the put is

C5 :,di- - 1,


again using put-call parit$. These "uantities are !ital if an option posi-

tion is to be hedged correctl$.

So e co puter algebra packages offer a li ited range of financial routines. Maple, for e%a ple, has a Black-Scholes call co and. It has to be loaded b$ t$ping

and then the co



returns the Black-Scholes !alue of the call with e%ercise price #, ti e to e%pir$ T-t, current asset price S, interest rate r and !olatilit$ sig a. In this e%a ple the s$ bols ha!e to be replaced b$ their nu erical !alues, but the routine can also be used as a function. >or e%a ple, ?plot,blackscholes,1B,B.9,S,B.1,B.'-, S=B..'B-0 generates a plot of the call !alues for B @ S @ 'B, with the other para eters held fi%ed at the !alues indicated. )ther Maple features can also be used0 for e%a ple ?plot,diff,blackscholes,1B,B.9,S,B.1,B.'-,S-,S=B..'B-0 ?plot,diff,blackscholes,1B,B.9,S,B.1,B.'-,SW'-,S=B..'B-0 plot the delta and ga a respecti!el$. (lthough there is no separate put routine, it is eas$ to write one using the call routine and put-call parit$. Technical 5oint6 Gi ensionless 8ariables. The differential e"uations used to odel ph$sical and financial processes often contain an$ para eters0 these ight be aterial properties of the substances in!ol!ed, for e%a ple, ther al conducti!it$, or constants
of the underl$ing stochastic processes, such as their rate of return or

!olatilit$. (n earl$ step in

ost solutions is to scale the dependent and

9.9 Binar$ )ptions


independent !ariables with 2t$pical !alues+ in order to collect these para eters together as far as possible. Thus abo!e we scaled S and 8 with #, the onl$ a priori t$pical !alue a!ailable. (lthough S ight be easured in # ,or W, or GM, or an$ other units-, % has no units, and nor does !. This is i portant, since an e%pansion of the for es = 1H9H S'H< is eaningless if S is a di ensional "uantit$. ,:ote that an absolute F change in an asset !alue, dS, is di ensional, but that the relati!e change, dS4S, is not.Ea!ing carried out this scaling, we can collect the re aining para eters into di ensionless groups, also called di ensionless para eters. This scaling tells us the true nu ber of independent constants in the solution. If one of the resulting di ensionless para eters is !er$ large or !er$ s all, we a$ subse"uentl$ be able to e%ploit this fact to construct a useful appro%i ation to the solution. Such an appro%i ation is called an as$ ptotic e%pansion, and the theor$ of as$ ptotic anal$sis ai s to de!ise techni"ues for this kind of appro%i ation. It also ai s to anal$se the techni"ues in order to ake sure that we can be confident that the effects we ha!e neglected in aking the appro%i ation are genuinel$ uni portant. In the Black-Scholes e"uation, both r and o' ha!e units ,ti e--10 ,$ears--1 or ,da$s--1, for e%a ple. The "uantit$ k = r4 a' is a di en' sionless para eter. (nother is 'o'T, the di ensionless lifeti e. These are the onl$ di ensionless para eters in the basic proble for a #uropean call or put.

9.9 Binar$ )ptions

(lthough we discussed onl$ !anilla calls and puts in the pre!ious section, it was onl$ at the !er$ last stage that we needed to know which option we were dealing with. The function up,s- in e"uation ,9./- can clearl$ be the pa$off for an$ co bination of options6 the linearit$ of the Black-Scholes e"uation guarantees that we can !alue portfolios of options b$ superposition. In this wa$, we can !alue co binations such as straddles, strangles and so on. >urther ore, the pa$off need not be a f inite co bination of calls and puts6 we can consider an$ function of S that we wish. )ptions with pa$offs ore general than !anilla calls and puts are known as binar$ options or digital options. Suppose that the pa$off at ti e T is (,S-, and that the !alue of the option is 8,S,t-, so 8,S,T- = (,S-. We first work out the function uo,%- corresponding to (,S- after the transfor ations that we used


The Black-Scholes >or uli!

abo!e. That is, we set S = #er and then 8,S, t- = #ea%HJru,%, Tr-, where a, 3 and T ha!e their pre!ious eanings. >ro the pa$off,

8,S,T- = (,S- = #e+%uo,%-. Then, fro

e"uation ,9./- we ha!e a

for ula for u,%, rr-0 undoing the changes of !ariable leads to the e%plicit for ula (,Sl-e-,log,S+4S--,r- ' M'-,T-t--'4'!',T-t- dS+ S+ S ,9.1Afor 8,S,t-. This for ula ob!iousl$ includes !anilla calls and puts as particular cases. The delta is gi!en b$ the deri!ati!e of ,9.1A- with respect to S. In deri!ing ,9.1A-, we ha!e assu ed that a and r are constant and that the underl$ing pa$s no di!idends. The inclusion of a di!idend ter is not difficult, and if a or r is a known function of t J e

-t'ir,T - t- Q


then the

ethods described in .hapter A

a$ be applied to obtain e%act


for ulae. )ne particularl$ popular binar$ option has alread$ been the cash-or-nothing call, whose pa$off is

(,S- = Bh,S - #-.

This option can be interpreted as a si ple bet on the asset price0 if S ? # at e%pir$ the pa$off is B and otherwise it is Fero. ,More often, though, it is found as part of a 2structured product+ with conditions that allow for a fi%ed pa$ ent to be ade if an asset is abo!e a certain !alue on a certain date.- Its !alue is 8,S,t- = Be-r,T-t-:,d'-, where d' is as abo!e. (nother binar$ option, so eti es known as a supershare, has pa$off 14d if # @ S @ # H d at e%pir$ and Fero otherwise6

(,S- = d,/-^,S-#- -1-1,S-#-d-,in the li it d --0 B the pa$off beco es a delta function-. Its !aluation is left as an e%ercise. (lthough these options are eas$ to !alue using ,9.1A- the$ can present proble s in hedging near the ti e of e%pir$, caused b$ the discontinuities in the pa$off function. .onsider, for e%a ple, the difficulties associated with hedging a cash-or-nothing call with pa$off B/-1,S - #-. B$ differentiating /-1,S - #- with respect to S we see that as t -? T the delta of the option tends to the function Bb,S - #-. (wa$ fro S = # this

9.A 7isk :eutralit$


function is Fero, and therefore close to e%pir$ we e%pect that we should not ha!e to hedge the option. Eowe!er, if S is close to # near e%pir$

there is a high probabilit$ that the asset price will cross the !alue #,
perhaps an$ ti es, before e%pir$. #ach ti e this !alue is crossed the delta goes fro nearl$ Fero to !er$ large and back to nearl$ Fero. The Black-Scholes odel assu es that the option is continuousl$ hedged with a nu ber of assets e"ual to the delta0 this is clearl$ i practical if, at one o ent, the portfolio contains no assets, then is rehedged to contain a large nu ber of the assets onl$ for that position to be li"uidated shortl$ afterwards. Vet, if this rehedging is not done, the pa$off at e%pir$ is either Fero or B, and cannot be known for certain.+ It is therefore open to "uestion whether options with discontinuous pa$offs can be !alued according to the si ple Black-Scholes for ula ,9.1A-.

9.A 7isk :eutralit$
( rather different !iew of option !aluation fro that presented abo!e is the risk-neutral approach. This ste s fro the obser!ation that the growth rate p does not appear in the Black-Scholes e"uation ,3.D-. Therefore, although the !alue of an option depends on the standard de!iation of the asset price, it does not depend on its rate of growth. Indeed, different. in!estors a$ ha!e widel$ !ar$ing esti ates of the growth rate of a share $et still agree on the !alue of an option. Moreo!er,

the risk preferences of in!estors are irrele!ant6 because the risk inherent
in an option can all be hedged awa$, there is no return to be ade o!er and abo!e the risk-free return. Whether for !anilla options or other products, it is generall$ the case that if a portfolio can be constructed with a deri!ati!e product and the underl$ing asset in such a wa$ that the rando co ponent can be eli inated - as was the case in our deri!ation of the Black-Scholes e"uation in .hapter 3 - then the deri!ati!e product a$ be !alued as if all the rando walks in!ol!ed are risk-neutral. This eans that the drift ter in the stochastic differential e"uation for

the asset return ,for our e"uit$

odel, u- is replaced b$ r where!er it

appears. The option is then !alued b$ calculating the present !alue of its e%pected return at e%pir$ with this odification to the rando walk. The process works as follows. We begin b$ recalling that the present !alue of an$ a ount at ti e T is that a ount discounted b$ ultipl$ing b$ e-r,T-t- Then, we set up a risk-neutral world6 we pretend that the rando walk for the return on S has drift r instead of t. >ro this, we can calculate the probabilit$ densit$ function of future !alues of S6 we use e"uation ,'.1Bwith \ replaced b$ r. It is ost i portant to realise that the new probabilit$ densit$ function is not that of S. :e%t, we calculate the e%pected !alue of the pa$off (,S- using this probabilit$ densit$ function. That is, we ultipl$ (,S- b$ the risk-neutral probabilit$ densit$ function and inte-grate o!er all possible future !alues of the asset, fro Fero to infinit$. >inall$, we discount to get the present !alue of the option. The resulting for ula is, as before,

8,S,t- =

e -r,T-trc


'- ,T-t--'4'o',T-t-(,Si-


,9.1 ,-


This e%pression can be shown b$ direct differentiation to satisf$ e"uation ,3.D-. When the pa$off is si ple, it can be integrated e%plicitl$ to gi!e the Black-Scholes for ula for ,for e%a ple- a #uropean call option. The idea of replacing \ b$ r is !er$ elegant. It does, howe!er, ha!e so e a&or drawbacks. >irst, it re"uires us to know the probabilit$ densit$ function of the future asset !alues ,under the risk-neutral assu ption-. This is eas$ enough for our constant-coefficient rando walks, but if we want to use an$ ore co plicated odel, we ust first find the distribution before integrating to calculate the e%pected return. )ften, the calculation of the probabilit$ densit$ function in!ol!es sol!ing a par-

tial differential e"uation e"ui!alent to that satisfied b$ the option, and

the subse"uent integration ust in general be carried out nu ericall$ as
well. It is usuall$ "uicker to sol!e the option pricing e"uation directl$.

Moreo!er, when we co e to e%otic options or ( erican options, it is uch ore difficult to see how to i ple ent the risk-neutral approach, while ,as we show- the direct approach !ia the partial differential e"uation for the option can be e%tended in a clear-cut wa$. ( further drawback is that risk neutralit$ can lead to confusion. >or e%a ple, it is so eti es said that < *It can be shown that t = r,*

or that



< *The delta of an option is the probabilit$ that it will e%pire in the one$.*

Both of these state ents are wrong. If the first state ent were correct
then all assets would ha!e the sa e e%pected return as a bank deposit and no one would in!est in e"uities ,see the Technical 5oint on risk in .hapter '-. If p were e"ual to r then the second state ent would be correct. The probabilit$ that S ? # at t = T can be found b$ calculating the e%pected !alue of f,S - #-. This necessaril$ in!ol!es the para eter p.

>inall$, risk-neutralit$ is far fro

eas$ to grasp intuiti!el$, which

is perhaps the source of the confusion abo!e. The ke$ steps in the deri!ation of the Black-Scholes e"uation, na el$ no arbitrage and that risk-free portfolios earn the risk-free rate, are intuiti!el$ clear.

>urther 7eading
< >or a discussion of si ilarit$ solutions of the diffusion e"uation see

.rank ,1DCD- and Eill S Gew$nne ,1DDB-.

< The risk-neutral ethod is set out in the papers b$ .o% S 7oss ,1D/A-

and Earrison S 5liska ,1DC1-. >or so e details of option !aluation

under risk neutralit$, see Earrison S Treps ,1D/D- and Eull ,1DD3-.

1. >ind a si ilarit$ solution to the proble

aT - a%e+

au a'u

BB @%@BB, T?B,

u,%, B- = Ti,%-. Show that au4a% is the funda ental solution ub ,%, -r-, either b$ direct differentiation or b$ constructing the initial !alue proble that it satisfies. , '. Suppose that u,%, T- satisfies the following initial !alue proble
se i-infinite inter!al6

on a

aT =a%e



%?B, T?B,

CA with

The Black-Scholes >or ulc

u,%,B- = uo,%-, % ? B, u,),T- = B, T ? B.

Gefine a new function !,%, T- b$ reflection in the line % = B, so that !,%,T- = u,%,T- if % ? B,
!,%,T- = -u,-%,T- if % @ B.

Show that !,), r- = B, and use ,9./- to show that

u,% T- = L

// B


The function ultipl$ing uo,s- here is called the Ureen+s function for this initial-boundar$ !alue proble . This solution is applicable to barrier options. 3. >ind si ilarit$ solutions to
au a'u

or = a%e H >,%-, % ? B,

? B,

u,%, B- = B, % ? B, u,B, t- = B, r ? B.
in the two cases ,a- >,%- = %0 ,b- >,%- = 1.

#%tend case ,b- b$ letting u,B, r- = T. ( related si ilarit$ solution pla$s an i portant role in the free boundar$ proble s studied in .hapter /. 1. Suppose that a and b are constants. Show that the parabolic e"uation a,u


a%' H a
)n a'u
Tr = a%'

H bu

can alwa$s be reduced to the diffusion e"uation. Ise a change of ti e

!ariable to show that the sa e is true for the e"uation

where c,r- ? B. Suppose that J' and r in the Black-Scholes e"uation are both functions of t, but that r4B,' is constant. Geri!e the BlackScholes for ulae in this case. 9. Suppose that in the Black-Scholes e"uation, r,t- and B,' ,t- are both nonconstant but known functions of t. Show that the following procedure reduces the Black-Scholes e"uation to the diffusion e"uation.



,a- Set S = #e+, . = #! as before, and put t = T - t+ to get the



1 a





:ote that we ha!e not $et scaled ti e, but erel$ changed its origin. ,b- :ow introduce a new ti e !ariable T such that La',t+-dt+ = dT, i.e.

a',s- ds.


,See the pre!ious "uestion where this calculation is re"uested.This change of ti e !ariable a ounts to easuring ti e weighted b$ !olatilit$, so that the new 2ti e+ passes ore slowl$ when the !olatilit$ is high. The resulting e"uation is a!






where a,T- = r4

a' -1, b,T- = r4 a' ,note that the dependence ' of r and a' on T is obtained b$ substituting for t+ in ter s of f


b$ in!erting the change of !ariable abo!e-. ,c- Show ,or !erif$- that the general solution of the first order partial differential e"uation obtained fro the e"uation for ! b$ o itting
the ter a'!4a%e, na el$

aT =



a% - b,r-!,


!,%,T- = >,%

H (,T--e-B,Tl,

where d(4d+r = a,T- and dB4dT = b,1-, and >,.- is an arbitrar$


,d- :ow seek a solution to the full e"uation for ! in the for !,,T- = e-B,Ti8,%,T-, where % = % H (,+*r- is as abo!e. .hoose B,T- so that 8 satisfies the diffusion e"uation a8 a'8
aT a%'.

,e- What happens to the initial data under this series of transforations3


The Black-Scholes >or ula

See Earper ,1DD3- for further e%a ples of this ingenious procedure applied to other e"uations.


Show that e"uation ,9.1B- can also be reduced to the diffusion e"uation b$ writing
!,%, T- =

e- k/ 8 ,S, /--,

where 10=%H,k-1-T. What disad!antages /. ight there be to this change of !ariables3

If .,S, t- and 5,S, t- are the !alues of a #uropean call and put with the sa e e%ercise and e%pir$, show that . - 5 also satisfies the BlackScholes e"uation ,9.C-, with the particularl$ si ple final data . - 5 = S - # at t = T. Geduce fro the put-call parit$ theore that S #e-++,T-t- is also a solution0 interpret these results financiall$. Ise the e%plicit solution of the diffusion e"uation to deri!e the Black-


Scholes !alue for a #uropean put option without using put-call parit$. D. .alculate the ga options. a, theta, !ega and rho for #uropean call and put

1B. Ise Maple ,or an$ other co puter algebra package- to plot out the functions of #%ercise D. Ise the plot3d co and to generate threedi ensional plots of call and put options as functions of two !ariables,
for e%a ple, S and t or S and a.

11. What is the rando

walk followed b$ a #uropean call option3

1'. If u,%, B- in the initial !alue proble for the heat e"uation on an infinite inter!al ,e"uations ,1.3--,1./-- is positi!e, then so is u,%, r- for r ? B. Show this, and deduce that an$ option whose pa$off is positi!e alwa$s has a positi!e !alue. 13. .onsider the following initial !alue proble on an infinite inter!al6

aT =



with u,%, B- =B and u --? B as % -Poo.

It can be shown ,for e%a ple b$ the Ureen+s function representation of the solution- that if f ,%, T- ? B then u,%, T- ? B. Wh$ is this ph$sicall$ reasonable3 Ise this result to show that if ., ,S, t- and .',S, t- are the



!alues of two otherwise identical calls with different !olatilities B-1 and a' @ al, then .' @ .1. Is the sa e result true for puts3 11. In di ensional !ariables, heat conduction in a bar of length ; is odelled b$ )I C'I pc C/T k)KF for B @ K @ ;, where I,K, T- is the di ensional te perature, p is the densit$, c is the specific heat, and k is the ther al conducti!it$. Suppose also that I) is a t$pical !alue for te perature !ariations, either of the initial te perature IB,K-, or of the boundar$ !alues at K = B, ;0 ake the e"uation di ensionless. 19. What is the !alue of an option with pa$off /-1,#-S-3 What is the !alue of a supershare3 1A. The #uropean asset-or-nothing call pa$s S if S ? # at e%pir$, and nothing if S @ #. What is its !alue3 1/. What is the probabilit$ that a #uropean call will e%pire in-the- one$3 1C. (n option has a general pa$off (,S- at ti e T, and its !alue is 8 ,S, t-. Show how to s$nthesise it fro !anilla call options with !ar$ing e%ercise prices0 that is, how to find the 2densit$+ f ,#- of calls, with the sa e e%pir$ T, e%ercise price # and price .,S, t0 #-, such that 8,S, t- =

f ,#-.,S, t0 #- d#.B

8erif$ that $our answer is correct ,a- when (,S- = a%,S - #, B- ,a !anilla call-0 ,b- when (,S- = S. ,What is the s$nthesiFing portfolio here37epeat the e%ercise using cash-or-nothing calls as the basis.
1D. Suppose that #uropean calls of all e%ercise prices are a!ailable. 7egard-

ing S as fi%ed and # as !ariable, show that their price .,#, t- satisfies the partial differential e"uation


L or '#'

a# - r## = B.

'B. *If an asset has Fero !olatilit$, then its future path is deter inistic, and

specified co pletel$ b$ \. Therefore, we can calculate e%actl$ the !alue of a call option on the asset, and it too ust depend e%plicitl$ on (. Eowe!er, it is repeatedl$ stated abo!e that this is not the case.* Wh$ is this not a contradiction3

8ariations on the

Black-Scholes Model

A.1 Introduction We ha!e now co pleted the Black-Scholes anal$sis of !anilla #uropean
call and put options. (lthough the for ulae that we ha!e deri!ed are useful, there are an$ ore co plicated situations in which the$ are not ade"uate. This chapter is de!oted to a nu ber of straightforward e%tensions of the Black-Scholes anal$sis. We see how to incorporate di!idends, how to deal with forward and futures contracts, and how to put ti e-!ar$ing para eters into the Black-Scholes e"uation, but we still use straightforward calls and puts as the building blocks. ;ater chapters deal with ( erican and 2e%otic+ options which ha!e ore co ple% contract structures. There is one possible direction of generalisation that we do not discuss in this book6 we assu e that all our odels are dri!en b$ stochastic processes of the t$pe discussed pre!iousl$. We do not use odels that, for e%a ple, postulate so e essential nonlinearit$ in the underl$ing arkets, as ight be attributed to feedback fro deri!ati!es arkets into asset prices. (lthough there is so e e!idence that arkets are not as close to our odels as we would like, the Black-Scholes world is a good enough appro%i ation for ost purposes, both theoretical and practical.

A.' )ptions on Gi!idend-pa$ing (ssets

A.'.1 Gi!idend Structures Man$ assets, such as e"uities, pa$ out di!idends. These are pa$ ents to shareholders out of the profits ade b$ the co pan$ concerned, and the likel$ future di!idend strea of a co pan$ is reflected in toda$+s share price. The price of an option on an underl$ing asset that pa$s DB

A.' )ptions on Gi!idend-pa$ing (ssets di!idends is affected b$ the pa$ ents, so we BlackScholes anal$sis. ust

D1 odif$ the

When we

odel di!idend pa$ ents, we need to consider two issues6


< When, and how often, are di!idend pa$ ents < Eow large are the pa$ ents3

There are se!eral possible different structures for di!idend pa$ ents. Indi!idual co panies usuall$ ake two or four pa$ ents per $ear, which a$ need to be treated discretel$, but the large nu ber of di!idend pa$ ents on an inde% such as the SS5 9BB are so fre"uent that it a$ be best to regard the as a continuous pa$ ent rather than as a succession of discrete pa$ ents. (nother e%a ple where di!idends can be odelled as continuous is when the asset is a foreign currenc$, in which case the 2di!idend+ represents pa$ ents at the foreign interest rate ,we assu e for now that this is constant-. The a ounts paid as di!idends a$ be odelled as either deter inistic or stochastic. In this book we consider onl$ deter inistic di!idends, whose a ount and ti ing are known at the start of an option+s life. This is a reasonable assu ption, since an$ co panies endea!our to aintain a si ilar di!idend polic$ fro $ear to $ear.

A.'.' ( .onstant Gi!idend Vield ;et us consider the !er$ si plest pa$ ent structure. Suppose that in a ti e dt the underl$ing asset pa$s out a di!idend G)S dt where Go is a constant. This pa$ ent is independent of ti e e%cept through the dependence on S. The di!idend $ield is defined as the proportion of the asset price paid out per unit ti e in this wa$. Thus the di!idend G)S dt represents a constant and continuous di!idend $ield Go. This di!idend structure is a good odel for inde% options and for shortdated currenc$ options ,it is debatable whether ,'.1- is a good odel for currencies o!er long ti escales-. In the latter case Go = rf, the foreign interest rate. >irst, we consider the effect of the di!idend pa$ ents on the asset price. (rbitrage considerations show that in each ti e-step dt, the asset price ust fall b$ the a ount of the di!idend pa$ ent, Go dt, in addition to the usual fluctuations. It follows that the rando walk for the asset price ,'.1- is odified to

dS = oSdK H ,\ - Go-Sdt.



8ariations on the Black-Scholes Model

We ha!e seen that the Black-Scholes e"uation is unaffected b$ the coefficient of dt in the stochastic differential e"uation for S and so one ight e%pect the di!idend to ha!e no effect on the option price. This is not the case. We ha!e allowed for the effect of the di!idend pa$ ent on the asset price but not its effect on the !alue of our hedged portfolio. Since we recei!e G)S dt for e!er$ asset held and since we hold -B of the underl$ing, our portfolio changes b$ an a ount

- GBSB dt,
i.e. the di!idend our assets recei!e. Thus, we earlier dII to arri!e at

,A.'ust add ,A.'- to our

dII = d8 - ) dS - G)S) dt.

The anal$sis proceeds e%actl$ as before but with the addition of this new ter . We find that

at H L


>or a call option the final condition is still .,S,T- = a%,S - #, B-, and the boundar$ condition at S = B re ains as .,B, t- = B. The onl$ change to the boundar$ conditions when we use the odified BlackScholes e"uation ,A.3- is that .,S, t- N Se-Go,T-t- as S -? oo. ,A.1-


H ,r - Go-S



This is because in the li it S --? oo, the option beco es e"ui!alent to the asset but without its di!idend inco e. We could calculate the !alue of this option in the sa e wa$ as we did without di!idends6 that is, reduce e"uation ,A.3- to the diffusion e"uation and sol!e in the usual wa$. Eowe!er, it is "uicker to notice that we can ake the coefficients of S a.4aS and . in ,A.3- e"ual b$ setting .,S t- = e-Go,T-t-.i,S,tWe then see that .l ,S, t- satisfies the basic Black-Scholes e"uation ,3.Dwith r replaced b$ r - Go and with the sa e final !alue. The !alue of .1,S,t- is therefore &ust that of a nor al #uropean call with interest rate r - Go, and it is now straightforward to show that with di!idends, the !alue of a #uropean call option is .,S, t- = e-Go,T-t-S:,dio- - #e-r,T-t-:,d'B-,

A.' )ptions on Gi!idend-pa$ing (ssets


1.1 1.' --


>igure A.1 ( co parison of #uropean call option !alues with ,lower cur!eand without di!idends ,upper cur!e-. There are si% onths to e%pir$, # = 1, o = B.1 and r = B.1. The bold cur!e has Go = B.B/.

where dlo = log,S4#- H ,r - Go H 'o'-,T - t! T-t d'o = d1 - J T - t.

,(lternati!el$, we can use the !ariable Se Got0 the !alue of the call is the usual Black-Scholes !alue with S replaced b$ Se-Go,T-t-

throughout.In >igure A.1 we see the #uropean call option !alues as functions of S with si% onths to e%pir$, o< = B.1 and r = B.10 the top cur!e is the !alue of the option in the absence of di!idends, and the lower bold cur!e has a constant and continuous di!idend $ield Go = B.B/. >urther properties of options on assets with a continuous di!idend $ield are de!eloped in the e%ercises at the end of the chapter.

A.'.3 Giscrete Gi!idend 5a$


Suppose that our asset pa$s &ust one di!idend during the lifeti e of the option, at ti e t = td. (s abo!e, we shall consider onl$ the case in which the di!idend $ield is a known constant d$ ,ob!iousl$, B @ d$ @ 10 usuall$ it is a few percent at ost-. Thus, at ti e td, holders of the


8ariations on the Black-Scholes Model

asset recei!e a pa$ ent d$S, where S is the asset price &ust before the di!idend is paid. >irst, consider the effect of the di!idend pa$ ent on the asset price. Its !alue &ust before+ the di!idend date, at ti e to , cannot e"ual its !alue &ust after, at ti e t d . If it did, the strateg$ of bu$ing the asset i ediatel$ before td, collecting the di!idend, and selling straight awa$, would $ield a risk-free profit. It is clear that, in the absence of other factors such as ta%es, the asset price ust fall b$ e%actl$ the a ount of the di!idend pa$ ent. Thus,

S,td- = S,td- - d$S,td- = S,ta-,1 - d$-.


We now ha!e to incorporate this &u p into our odel for options. The ideas we present below are i portant not onl$ for discrete di!idends, but also for an$ e%otic options with discrete contract features. The$ should be read with care.

A.'.1 Qu p .onditions for Giscrete Gi!idends

We ha!e &ust seen that a discrete di!idend pa$ ent ine!itabl$ results in a &u p in the !alue of the underl$ing asset across the di!idend date. )ur ne%t task is to deter ine what effect the &u p has on the option price. This brings us to the sub&ect of &u p conditions. Qu p conditions arise when there is a discontinuous change in one of the independent !ariables affecting the !alue of a deri!ati!e securit$. Eere, the cause of a &u p is the discontinuous change in asset price due to the discrete pa$ ent of a di!idend, but later we shall deal with other causes in connection with e%otic options. The &u p condition relates the !alues of the option across the &u p0 in this case it relates the !alues of the option before and after the di!idend date. Qu p conditions a$ be deri!ed in two e"ui!alent wa$s. )ne ethod is !ia financial argu ents, and is based on arbitrage considerations. The other wa$ is a purel$ athe atical ethod, based on the anipulation of delta functions and first order h$perbolic partial differential e"uations. We present the financial argu ent here0 for the athe atical argu ents, see the Technical 5oint at the end of this section and )ption 5ricing. (wa$ fro the di!idend date the !alue of the option !aries because of the rando o!e ent of the asset price0 this !ariation is gradual in
We shall consistentl$ use the notation t- and tH to denote the before and &ust after ti e t. o ents &ust

A.' )ptions on Gi!idend-pa$ing (ssets ti e, since the


o!e ent of the asset price is continuous in ti e ,albeit

rando -. (cross the di!idend date, howe!er, the !alue of the asset
changes discontinuousl$. This change in asset price is gi!en b$ ,A.9-. :ow consider the effect of this discontinuous change in the asset !alue, S, on an option, with !alue 8,S, t-, contingent on that asset. To eli inate the sa e sort of arbitrage possibilities as those considered abo!e, the !alue of the option ust be continuous as a function of ti e across the di!idend date0 the !alue of the option is the sa e i ediatel$ before the di!idend date as it is i ediatel$ after ,recall that the holder of the option does not recei!e the di!idend-. Thus we arri!e at the &u p

8 ,S,td -, td-- = 8 ,S,t This &u p condition arises fro ,A.Ad -, td- . eli inating arbitrage possibilities for

an$ gi!en realisation of the asset and option !alues. That is, the option
!alue ust be continuous in ti e for an$ realisation of the asset+s rando walk. We ha!e &ust asserted that the option price is continuous in ti e, $et we ha!e called this a &u p condition, which i plies discontinuit$.

Eow can we reconcile these two state ents3

In this book, we anal$se option odels using partial differential e"uations with S and t as independent !ariables. We do this instead of thinking of S as a function of t, as is i plicit in ,A.A-, because we need to be able to consider all possible realisations of the asset+s rando walk. Bearing this in ind, let us now consider what happens to the option !alue across a di!idend date in a Black-Scholes odel. Since we regard S and t as independent !ariables in such a for ulation, it would see at first sight that this "uestion could be phrased as

< Eow does 8 change across a di!idend date for S fi%ed3

In fact, in an$ realisation, S would not be fi%ed across a di!idend date. The "uestion we ha!e &ust posed is not "uite appropriate to the proble , and it is better to ask < Eow does 8 change as a function of S across a di!idend date3 The answer is that 8 changes discontinuousl$ according to ,A.A- with S,t a- and S,td- related b$ ,A.9-. That is, we ha!e 8 ,S, td- = 8 ,S,1 - d$-, t ,A./d- .

This sa$s that the !alue of the option at asset !alue S i

ediatel$ before

the di!idend pa$ ent is the sa e as the !alue of the option i


8ariations on the Black-Scholes Model

after the di!idend pa$ ent, but at asset !alue S,1- d$-. Thus, for fi%ed S the !alue of the option changes discontinuousl$ across a di!idend date. Eowe!er, ,A./- is e"ui!alent to insisting that the option !alue is continuous in ti e for an$ realisation of the asset+s rando walk. It is certainl$ true that the holder of the option does not recei!e an$ benefit fro the di!idend pa$ ent, and so the option price ust reflect this forgone benefit. The fact that the option price is continuous for each realisation of the asset+s rando walk, e!en though the asset !alue is not, does not ean that the option !alue is unaffected b$ di!idend pa$ ents. The effect of the &u p condition ,A.A- is felt throughout the life of the option, propagated b$ the partial differential e"uation that go!erns its !alue.

>inall$, note that the delta of an option does change across a di!idend date. ( corresponding ad&ust ent portfolio. ust be ade to an$ hedged

A.'.9 The .all )ption with )ne Gi!idend 5a$


;et us now !alue a #uropean call with one di!idend pa$ ent, as abo!e. 7ecall how we sol!e in the absence of di!idends6 because the BlackScholes e"uation is backward parabolic, we work backwards fro e%pir$, when we know the !alue with certaint$. When a di!idend is paid, this idea is elaborated as follows6

< Sol!e the Black-Scholes e"uation back fro

e%pir$ until &ust after the

di!idend date ,i.e. until t = td < I ple ent the &u p condition ,A./- across t = td, to find the !alues at t=td0 < Sol!e the Black-Scholes e"uation backwards fro t = to , using these !alues as final data. In effect, we sol!e the Black-Scholes e"uation twice, once for T ? t ? td, and once for td ? t ? B ,the present da$-. The !alues at t = td are linked b$ ,A./-. ( !er$ si ilar structure e erges when we !alue certain e%otic options. ;et us write .d,S, t- for the !alue of our call option ,in the discussion abo!e, 8,S,t- can represent an$ di!idend-pa$ing deri!ati!e product-. ;et us also write .,S, t0 #- for the !alue of a !anilla #uropean call option with e%ercise price # ,the other para eters, r, a and T are understood-. >or ti es after the di!idend date, our option is identical to a !anilla call6

A.' )ptions on Gi!idend-pa$ing (ssets no ore di!idends will be paid. Thus,


.d,S, t- = .,S, t0 #- for td @ t @ T.

:ow we use ,A./-6


.d,S,1 - d$-,t d d 0 #-. ,A.C-

= .,S,1 - d$-, t

(t this point, we could use the !alues we ha!e &ust calculated in our for ula ,9.11- for solutions of the Black-Scholes e"uation. Eowe!er, there is a short cut. The call option in ,A.C- is e!aluated not at S, but at S,1 - d$-6 a unifor scaling of S b$ ,1 - d$-. ( unifor scaling of this kind lea!es the Black-Scholes e"uation in!ariant, and so .,S,1 d$-, t0 #is a solution, which is e"ual to our option !alue at t = to , and hence for all ti es before td. It onl$ re ains to identif$ .,S,1-d$-, t0 #-. (t e%pir$, this deri!ati!e product has !alue .,S,1 - d$-,T0 #= a%,S,1 - d$- - #, B,1 - d$a% ,S - #,1 - d$--1, B-.

Thus, it is the sa e as ,1 - d$- calls with e%ercise price #,1 - d$--1. >or ti es before td, our call has !alue

.d,S,t- = ,1 -d$-.,S,t0#,1 -d$:ote that the effect of the di!idend is to decrease the !alue of the call. This is reasonable because the option holder does not recei!e the di!idend, and the effect of the latter is to decrease S and hence the upside potential of the option. Technical 5oint6 .ontinuous and Giscrete Gi!idends Inified. In this Technical 5oint, we outline a wa$ to unif$ continuous and discrete di!idend pa$ ents. >or ore details, see )ption 5ricing. Suppose the di!idend structure is a "uite general function of S and t, G,S, t-. The constant-$ield case abo!e had G,S, t- = G)S, while in the discrete case,
G,S, t- = GoS9,t-td- for so e constant GA, which we relate to d, below.

(s abo!e, the stochastic differential e"uation ,'.1- describing the rando walk followed b$ the asset ust be odified for the di!idend pa$ ent, so that it beco es dS = o S dK H ,\S - G,S, t-- dt. ,A.D-


8ariations on the Black-Scholes Model

When the di!idend pa$ ent is discrete, this gi!es dS = oSdK H ,\S - G, SA ,t - td-- dt. Integrating across the di!idend date, we find that rs,t i dS = f t i

fS,t ,tZ-


41 ! dK H p dt - GA




t S,t - td- dt.

d differ onl$ infinitesi all$, the onl$ nonFero ter on the right-hand side is the one containing the delta function, and hence we obtain dS = log ,S,t -S S,td -

Since td and t

d - GA A ,t - td- dt = -GA.


Thus, for a discrete pa$ ent GASA,t - td-, the asset is discounted b$

conse"uentl$, GA = - log d$. ,Thus if a co pan$ pa$s out half of the asset price at ti e td, this discretel$ paid constant di!idend $ield gi!es e-G1 = 1 ,this is dr-, GA = log '.>or an$ gi!en realisation the !alue of the option is continuous, and
hence the appropriate &u p condition is

8 ,S,t
with S,t

d -, td-

= 8 ,S,td -, td -

d- and S,td- related b$ ,A.1B-.

A.3 >orward and >utures .ontracts

>orward and futures contracts are in so e wa$s easier to !alue than
options. This is because all the risk can be eli inated b$ a once-and-

for-all hedge at the beginning of the contract. (s a corollar$, the$ can be !alued independentl$ of an$ assu ptions about the beha!iour of the asset price, pro!ided onl$ that the future course of interest rates can be predicted. :e!ertheless, we prefer to discuss the here in the BlackScholes fra ework. We need onl$ anal$se the forward contract, since, as stated in .hapter 1, forward and futures prices are the sa e ,under so e not too restricti!e assu ptions-. 7ecall that the forward price is not set at one of a nu ber of fi%ed !alues for all contracts on the sa e asset with the sa e e%pir$. Instead, it is deter ined at the outset, indi!iduall$ for each

A.3 >orward and >utures .ontracts


contract. Suppose that the ti e at which the contract is agreed is t, and that the asset price at that ti e is S,t-. Genoting the forward price b$ >, we ust find a relationship between S,t- and > that will ensure fair !alue for both parties to the contract. We assu e that interest rates are constant o!er the duration of the contract. There are se!eral wa$s of deri!ing the forward price. We begin with one based on arbitrage. .onsider first the part$ who is short the contract, and so ust deli!er the asset at ti e T. (lthough he does not know at ti e t what the asset price will be at ti e T, this does not atter. Ee can satisf$ his part of the contract b$ borrowing an a ount S,t- when the contract begins, bu$ing the asset, and using the one$ recei!ed at e%ercise, >, to pa$ off the loan. (ssu ing that the risk-free interest rate r is constant, the loan will cost S,t-e++,T-t- The forward price ust therefore be gi!en b$ > = S,t-er,T-t,A.11-

If this were not so, there would be a risk-free profit or loss on the transaction, in contradiction to the absence of arbitrage. ( si ilar argu ent applies to the part$ who is long the contract, and $ields the sa e price. (nother wa$ of looking at this result is to notice that a long position in the forward contract is e"ui!alent to a long position in a #uropean call option and a short position in a put option, both with the sa e e%pir$ and e%ercise price as the forward contract. ,This is &ust a restate ent of the put-call parit$ result ,3.'-.- Since the forward contract has Fero !alue when it is set up ,no one$ changes hands-, the e%ercise price of the options, #, which is also e"ual to the forward price >, ust be such that S - #e-r,T-t- = B0 this gi!es ,A.11-. )ur final interpretation is perhaps the least ob!ious of the three, but it is a pointer to the wa$ in which we approach ore co plicated deri!ati!e products. It is not alwa$s possible to find a si ple 2financial+ solution, such as the one abo!e, based on the construction of an e"ui!alent portfolio ,here, the asset and a loan-, and so to build the answer out of products we know how to !alue. We step back to see that the forward contract is a deri!ati!e contract, albeit of a si ple for . Therefore, it ust satisf$ the Black-Scholes e"uation. The pa$off, at ti e T, is S->0 it is eas$ to find the solution at an$ earlier ti e t as S - >e-++,T-tSince the !alue of the contract is Fero when it is initiated, we arri!e at ,A.11-.


8ariations on the Black-Scholes Model

We also note that the !alue of a forward contract changes with ti e, because S changes. (t an$ ti e t+ between t and T, a part$ to a forward contract can lock in a profit ,or loss- b$ entering into the e"ual and opposite contract. The argu ent abo!e shows that the !alue then is

8,S, t+- = S,t+- - >e-r,T-t+- 0


when t+ = t the !alue is Fero, and when t+ = T it is the pa$off, S,T- - >. We ha!e so far assu ed that the asset in "uestion pa$s no di!idend.

If it pa$s a constant di!idend $ield Go, a si ple

odification to the

argu ent abo!e shows that the forward price is related to the current price b$

> = S,t-e,r-GB-,T-t-


,The proof of this is re"uested in the #%ercises.- In so e cases Go a$ be negati!e, an e%a ple being the cost of holding an asset such as gold, which has to be stored and insured.

A.1 )ptions on >utures Man$ options ha!e as their underl$ing asset not the cash product but rather the corresponding futures contract, which is often ore li"uid and in!ol!es lower transaction costs. )ptions on futures therefore ha!e a !alue that depends on > and t, i.e. of the for 8 ,>, t-. Since

> = Ser,T-twe can deri!e a partial differential e"uation for 8,>, t- fro the ordinar$ Black-Scholes e"uation ,written in ter s of S and t- !ia the change of !ariable rule. That is, we replace S b$ >e-r,T-t- throughout, and we replace

aS b$

a> a = er,T-t- a -S a> 1D a>

a a a> a a a at b$ at H at a> at - r> a>

a8 1 '

The result is

-r8=B. ,A.11-

at H'o >-

We can, of course, deri!e e"uation ,A.11- directl$, &ust as we deri!e the Black-Scholes e"uation. There is, though, a slight finesse in the

A.9 Ti e-dependent 5ara eters


argu ent. We take the usual hedged portfolio II = 8 - )>. :oting that the
!olatilit$ of > is also a ,see #%ercise D-, we ha!e that d>' = !'>'dt. Ito+s le a thus gi!es

d8 = I
and as e%pected, the choice neousl$ risk-free, so

H ''>'tD>'- dtH a>>8,d>, at



akes the portfolio instanta-

dII = ,D8 H 'a'>' C>' I dt.

:ow co es the subtlet$. We want to e"uate dE to the risk-free return on the portfolio. What we reall$ ean here is that if at ti e t we were to set up the portfolio, we should earn the risk-free rate on the one$ thus used. The cost of setting up the portfolio is &ust 8, since it costs nothing to enter into a futures contract. Therefore, dII = r8 dt, and we obtain e"uation ,A.11-. ,(t the corresponding point in the deri!ation of the Black-Scholes e"uation on an ordinar$ asset, we ha!e to trade in -( of the asset to set up the hedge, and this in!ol!es a cash flow.Since e"uation ,A.11- is identical to the Black-Scholes e"uation when the asset pa$s di!idends at a rate r, we can use the results obtained earlier to price specific contracts. >or e%a ple, the !alue of a #uropean call is easil$ found to be

.,>, t- = e-r,T-t- ,>:,dl- - #:,d'--,

where dl and d' are &ust as in the usual Black-Scholes for ulae ,9.11-, but with S replaced b$ >. The !aluation of the put and the put-call parit$ relationship are left as e%ercises, as is the case when the asset pa$s di!idends.

A.9 Ti

e-dependent para

eters in the Black-Scholes

e"uation In this section we show how to deri!e e%plicit for ulae for options with ti e-!ar$ing interest rate and !olatilit$. ( odel of this kind a$ be useful to so eone who has, for e%a ple, strong !iews about the likel$ future course of interest rates or !olatilit$. (lthough r,t- and !,t- !ar$, we ha!e to assu e that we know how the$ do so. 7ando !ariations in either para eter lead to uch ore co plicated two-factor odels0 in

1B' .hapter 1C we describe

8ariations on the Black-Scholes Model odels for con!ertible bonds, which are sub&ect

to both asset and interest rate risk.

The Black-Scholes e"uation ,3.D- re ains !alid e!en if we replace r and o, b$ r,t- and a,t-0 the argu ent goes through in the sa e wa$. >urther ore, we can still sol!e the e"uation in this far ore general situation. .onsidering the specific cases of calls and puts, the boundar$ and final conditions for these options re ain e%actl$ as before with one e%ception. Since r appears e%plicitl$ in ,3.11-, the boundar$ condition at S = B for the put, we ust be ore careful in deri!ing this condition. When r is a function of ti e the correct condition is

5,B, t- = #e f


Since the pa$off at e%pir$ is certainl$ # if S is Fero, the !alue of the put option on S = B the present !alue of the pa$off under non-constant interest rates. We can now deri!e e%plicit for ulae when both r and a are functions of ti e.' The e"uation to be sol!ed is a8


S = Sea,t8 = 8eo,t-


,A.19ake the

where we ha!e shown the dependence on t e%plicitl$. ;et us following substitutions6

t = $,t-,
where a, ,J and -$ are to be chosen carefull$ so as to eli inate all ti edependent coefficients fro ,A.19-. In these new !ariables ,A.19- beco es $,t-

a8 1

' ' B',8


at H'J,t- S aS' H,r,t-HA, ,t--Sas, -,r,t-HJ,t--8 = B,


where + = d4dt. :ow eli choosing

inate the coefficients of 8 and a8 4aS b$

a ,t- =

T t



3 4 ,t- =



' So e readers a$ ha!e alread$ deri!ed these for ulae b$ a different procedure, in #%ercise 9 at the end of .hapter 9.

A.9 Ti e-dependent 5ara eters and re o!e the re aining ti e dependence b$ setting



With these choices ,A.1A- beco es =

I',T- dT.


' S' aS


and has coefficients which are independent of ti e6 this e"uation contains no reference to r or I. If 8 ,S, t- is an$ solution of ,A.1/-, then the corresponding solution of ,A.1A-, in original !ariables, is 8 = e-J,t-8 ,Sea,t-, $,t-- . ,A.1C-

;et us now denote b$ 8BS an$ solution of the Black-Scholes e"uation

for constant r, c and Fero di!idends. In !iew of the abo!e, this solution
can be written in the for 8BS = e-+,T-t-8BS ,Se-+,T-t-, B1 ',T - t-,A.1D-

for so e function 8BS. B$ co paring ,A.1C- and ,A.1D- we see that to go fro an e%plicit solution of the Black-Scholes e"uation with constant r and or and Fero di!idends we si pl$ perfor the following substitutions6 < where!er we see r in the e%plicit for ula replace it b$ 1 T

T-t it
1 T-t


< where!er we see a' in the e%plicit for ula replace it b$

I',T- dT.

,:ote that these for ulae gi!e the a!erage, o!er the re aining lifeti e of the option, of the interest rate and s"uared !olatilit$ respecti!el$.- The reader should check carefull$ that this procedure gi!es a !alue that is a solution of the odified Black-Scholes e"uation ,A.19-, and that for a gi!en option such as a call, the pa$off condition is satisfied.

1B1 >urther 7eading

8ariations on the Black-Scholes Model

< >or the original deri!ation of the Black-Scholes for ulae with ti edependent para eters see Merton ,1D/3-. < In this book we ha!e assu ed that di!idends are known. >or a odel with stochastic di!idends see Ueske ,1D/C-. < Ue ill ,1DD'- discusses the practical i plications of discrete di!i-

dend pa$ ents.

1. What is the put-call parit$ relation for options on an asset that pa$s a

constant continuous di!idend $ield3 '. 3. What is the delta for the call option with continuous and constant di!idend $ield3 >ind a transfor ation that reduces the Black-Scholes e"uation with a constant continuous di!idend $ield to the diffusion e"uation. What is the transfor ed pa$off for a call3 Eow an$ di ensionless para eters are there in the proble 3 Show that the !alue of a #uropean call option on an asset that pa$s a
constant continuous di!idend $ield lies below the pa$off for large enough


!alues of S. Show also that the call on an asset with di!idends is less !aluable than the call on an asset without di!idends. 9. .alculate the !alue of a put option for both continuous and discrete di!idend $ields ,one pa$ ent-. What is the put-call parit$ relation in the latter case3 Go the di!idends increase or decrease the !alue of the put3 Wh$3 .alculate the !alue of a call on an asset that pa$s out two di!idends
during the lifeti e of the option. /. (nother odel for di!idend structures is to assu e that the di!idend


pa$ ent will be a fi%ed a ount G paid at ti e td. Work out the &u p condition for a deri!ati!e product, and calculate the !alue of a call and put. What possible disad!antages ight this odel ha!e3 C. Suppose that a forward contract had the additional condition that a pre iu L had to be paid on entering into the contract. Eow would the forward price be affected3 What is the rando walk followed b$ the futures price >3




1B. Geri!e the put-call parit$ result for the forward4futures price in the
. - 5 = ,> - #-e-r,T-t-

What is the corresponding !ersion when the asset pa$s a constant continuous di!idend $ield3 11. What is the forward price for an asset that pa$s a single di!idend

d,S,td- at ti

e td3

1'. (nal$se the range forward contract, which has the following features.

There are two e%ercise prices, #l and #', with #, @ #'. The holder of a long position ust purchase the asset for #l if at e%pir$ S @ #l, for S if #l @ S @ #', and for #' if S ? #'. The e%ercise prices are to be
chosen so that the initial cost is Fero.

13. What is the

odel for deri!ati!e products on an asset that pa$s a ti e-

!ar$ing di!idend $ield G,t-S3 Show how to incorporate this !ariation

into the ti e-dependent !ersion of the Black-Scholes odel described in Section A.90 how are the functions a,t-, ,3,t- and $,t- odified3