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Self-financing process: from discrete-time to

continuous-time

Let us first look at the discrete time version of a self-financing process. Denote
t0 < t1 < ... < tN , and the stock price Sti , and wealth Zti at time ti . Assume at
time ti , we hold ti stock until ti+1 , then Wti ti Sti is in the bank account.
We change the positions only at time ti , i = 0, 1, ..., N 1. So the profit/loss
during [ti , ti+1 ]

r (Zti ti Sti ) (ti+1 ti ) + ti Sti+1 Sti .

The accumulative profit/loss in [0, T ] is then
ZT Z0

N
1
X

r (Zti ti Sti ) (ti+1 ti ) + ti Sti+1 Sti

i=0
T

r (Z t St ) dt +
0

t dSt , as max |ti+1 ti | 0

i

r (Z t St ) dt +
0

Z
=

t (St dt + St dBt )
0

[rZ + ( r) t St ] dt +
0

t St dBt .
0

In differential form,
dZt = [rZ + ( r) t St ] dt + t St dBt .
This is the governing equation for a self-financing wealth process Zt : Note that
1) Zt is continuous;
2) The change of wealth is due to the change of asset prices, instead of the
change of the positions we take.

On the linkage between PDE and expectation

h
i
bt (X ST )+
E
h
i
bt Et+t (X ST )+
= E

f (St , t) =

bt [f (St+t , t + t)] ,
= E
b is the risk-neutral expectation. So,
where E
bt [f (St+t , t + t) f (St , t)]
E
"Z
#

Z t+t
t+t
f
f
1 2 2 2f
f
b
= Et
+ rS
+ S
dt +
S
dBt
t
2
S 2
S
S
t
t

0 =

"Z
bt
= E

t+t

It follows

"
bt
E

1
t

1
2f
f
f
+ 2 S 2 2 + rS
t
2
S
S

t+t

#
dt .

f
2f
1
f
+ 2 S 2 2 + rS
t
2
S
S

dt = 0

which yields by letting t 0

f
1
2f
f
+ 2 S 2 2 + rS
= 0.
t
2
S
S
Assume constant r. And consider
V (St , t)

h
i
bt er(T t) (X ST )+
= E
= er(T t) f (St , t)

or f (S, t) = er(T t) V (S, t). Then

f
S
f
t

2
V 2 f
r(T t) V
,
=
e
,
S S 2
S 2
V
= er(T t)
rer(T t) V.
t

= er(T t)

Substituting to the equation (1), we get the Black-Scholes equations.

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