(equation (1) above).
This underlying asset is usually assumed to be a share 1 Introduction
price, but can also be a commodity price or an exchange rate. Underlying
assets have an associated drift (µ) and volatility (σ), where the drift is the
expected percentage increase over a certain period of time and the volatility
is the measure of uncertainty of this return. For example, one would expect
a fledgling technology share to have a higher volatility than a blue-chip
company like AT&T.
Interest rates and the time value of money
The famous mantra from courses on economics and finance is ‘a dollar
today is worth more than a dollar tomorrow’, as it is possible to invest
your dollar in a risk-free investment, like a US government bond, today and
tomorrow it will be worth more than a dollar. There are a few possible
conventions as to how much money is worth after a certain amount of time.
Assume a time scale of 1 year, given a yearly interest rate, r, then if A is
invested today, at the end of the year it will be worth A(1 + r). However, if
it is invested for only 6 months at the same quoted yearly rate and the new
total is then invested for another 6 months we have a compounding process
such that after 1 year A will be worth A(1 + 2r )2 . This can be extended to
the continuously compounded case, which is used throughout this course, in
r m
which the money is reinvested m times giving A(1 + m ) after one year. As
r ∂t
m → ∞ then
(2)
m
(1 + )m → er .
Thus, an amount, A, invested at a continually compounded rate of r for t
years is worth Aert . This convention is used primarily because it makes the
mathematics far simpler than using the cumbersome discretely compounded
formula. This time value of money is mainly used in its inverted form to
determine what an expected amount in the future is worth today. This
is known as discounting. For example, if an investor is going to receive
$100 at some time in the future T then at an earlier time t it is worth
$100e−r(T −t) . For more realistic models, where the interest rate can be a
function of time, an amount A invested for t years is worth
r(t)dt
Rt
Ae 0 .
Interest rates and discounting is used extensively in developing option pric-
ing techniques.
1.3 Forwards and Futures
Although it is always possible to buy a share or commodity today or to
exchange currency at a particular rate, investors or companies often want to
arrange a deal for some time in the future. A forward contract is one in
which one party (in the long position) agrees to buy an underlying asset
at a certain price (the delivery price F ) at a certain future time, T . The
other party (in the short position) agrees to sell the asset at time T at
this price F .
5 4
1.1 Introduction
Mathematics has myriad applications in the world of finance and as
such the title of this module may be a little broader than what is actually
studied. The main focus of this course is on the financial instruments known
as options and, most importantly, how to calculate their value.
This proved to be a remarkably interesting problem both mathematically
and financially and one which took centuries to satisfactorily solve. The
earliest known use of options was by the Greek philosopher Thales in 600
B.C. who used them to make money from his predictions about the harvest,
in this example the price of olives is the underlying asset. Since then
options have been traded the world over although rarely in a regulated
manner and, until 1973, their values were primarily calculated by guesswork.
In 1973, Fischer Black and Myron Scholes, together with help from Bob
Merton derived the Black-Scholes partial differential equation which
describes the value of an option, V (which is dependent on the time since the
option had been sold, t, the value of the underlying asset, S, the interest rate,
r, and the volatility of the underlying asset, σ) together with an appropriate
set of boundary conditions, as follows
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS (1)
2 ∂S ∂S
− rV = 0.
This equation changed the face of option pricing, not only did it earn
Nobel prizes for Merton and Scholes in 1997 (Black having died in 1995)
but it paved the way for an explosion in the trading of options and other
derivative products (an option is a type of financial derivative and you’ll
see more about these shortly). The first organised options exchange also
opened in Chicago in 1973 and the volume of trade in options has increased
from 5.7m contracts in 1974, to a staggering 673m in 2000. This boom in
the, occasionally mathematically complex, derivatives markets has also led
to many investment banks actively recruiting skilled mathematicians and
physicists to help value such products.
1.2 Terminology
Derivatives
In a financial sense a derivative is a product whose value is derived from
the price or value of another product. This is normally an underlying asset,
such as a stock or share (Marks and Spencer shares, Parmalat shares etc.),
a commodity (oil, gold, tin etc.), an exchange rate (Euro to Sterling etc.).
The most common types of derivative products are forwards, futures and
options.
Underlying assets
Throughout this course we will be considering options on underlying
assets, the value of which is denoted by S in the Black-Scholes equation
 A futures contract is a standardised forward contract in that parties
can enter into long or short positions on an exchange where the delivery
prices and dates are set by the exchange. In a futures contract the opposing
PAYOFF
parties (long and short) do not necessarily know each other and so the
exchange ensures that the contracts are honoured.
Why would anyone want to use such a derivative?
Example 1.1 Suppose Ryanair know that on August 5th 2008 they will
have to pay an American supplier $1m and they want to hedge against
unfavourable exchange rate movements. On February 5th 2008 the bank is
offering a six month forward exchange rate of 0.8. Ryanair then take the
F ST
long position in the forward contract and on August 5th will buy $1m for
800,000 Euro. The bank has taken the short position and has agreed to sell
$1m for 800,000 Euro. Note that neither party pays anything to enter
into the contract.
Obviously in this example if in 6 months the dollar has strengthened
against the euro (i.e. the exchange rate is higher than 0.8) then Ryanair are
pleased because they have locked in a lower exchange rate. Obviously if the
reverse has happened (the exchange rate has dropped) then they will lose
out.
Figure 1: Payoff from the long position in a forward contract In general, if the underlying asset has value St at time t then the payoff
at the delivery time, T , to the party in the long position is
ST − F
where F is the delivery price. Similarly, for the party in the short position
the payoff is
F − ST
PAYOFF
It is simple to depict these payoffs graphically in figures 1 and 2.
The key thing here is that we have not yet determined what would be
a suitable choice of value for F ; this is discussed shortly after the definition
of an option.

F ST
Figure 2: Payoff from the short position in a forward contract
1.4 Options
In Example 1.1 if the dollar weakens against the euro, then Ryanair lose
out in the above forward contract. Ideally, they would like it so that if the
exchange rate drops then they can walk away from the contract and buy
their $1m for less than 800,000 Euro. This is exactly the freedom which
an option would give them, the would have the option of whether to take
the delivery price or to walk away and take the favourable current price.
Obviously, if the exchange rate has increased then they can still pay 800,000
Euro for their $1m. Crucially, unlike in forward contracts the party who
buys the option must pay some premium to obtain the option. The main
thrust of this course is to determine how much she should pay.
There are two principal types of options:
Definition (Call options) A call option gives the holder the right, but not
the obligation to buy the underlying, S, at a certain date, T , for a certain
price, known as the exercise (or strike) price, X.

7 6

PROFIT
95 105 S
−10
Figure 3: Profit/loss from purchasing one call option as in Example 1.2
Example 1.2 (Option payoff ) An investor buys a European Call option
to buy 100 Hewlett Packard shares with a strike price, X, of $95. The
current stock price is $100, the expiration date is 6 months and the cost of
the call option to buy one option is $10. Plot a graph of profit from buying
the option against underlying asset value in 6 months time.
If, at expiry, S < 95 the investor would choose not to exercise the option
as there is no point in buying the share for $95 when you can buy it on the
market for less. In this case the investor will have lost the cost of the options
($1000). If, at t = T , S > 95 then the options will be exercised, yielding
a profit of (S − 95) × 100 − 1000. The diagram below shows the profit at
expiry for different levels of the underlying S. Note that if 95 < S < 105
the investor has exercised the options but has still made a loss overall. See
figure 3 for the payoff from one option.
See Examples 1 for drawing payoff diagrams.
1.5 Why options?
Why is the options market such a big deal. Options appeal to three main
types of investors - hedgers, speculators and arbitrageurs.
1.5.1 Options for hedging
This was how we introduced the idea of forward and option contracts.
If a company or investor requires a certain amount of goods or currency
in a certain amount of time then options provide insurance for cases where
there are adverse market moves. It is sometimes possible to hedge against
movements in a market which will affect your business. As an example, if
9 8
Definition (Put options) A put option gives the holder the right, but not
the obligation to sell the underlying, S, at a certain date, T , for a certain
price, known as the exercise (or strike) price, X.
There are also two main genres of options:
Definition (European options) A European option can can only be ex-
ercised at the expiration date T .
Definition (American options) An American option can be exercised at
any time up to and including the expiry date, T .
There are also many exotic types of options such as Asian, Russian,
Parisian, Bermudan, Lookback, Barrier etc. which have different exercise
conditions and are not considered fully in this course. This course mainly
deals with the valuation of European options.
1.4.1 European Call Options
Denote the value of a European call option by C(S, t) where S is the
value of the underlying asset at time t. If the strike price of the option is
X then at the expiry of the option, t = T , the holder of the option has the
right, but not the obligation, to buy the underlying, of value S at t = T at
this price, X. Clearly if S > X then the holder of the option would exercise
the option and buy the underlying (worth S) for X. This would yield the
holder of the option a profit of S − X. If S ≤ X then there is no point in
exercising the option as the holder can buy the underlying on the market
for less than X.
Hence at expiry (t = T ) the value of the call option is
C(S, T ) = max(S − X, 0).
1.4.2 European Put Options
In a similar way to call options, denote the value of a put option by
P (S, t). Again the option has a strike price of X and at expiry the holder
of the option has the right, but not the obligation, to sell the underlying
asset at this price. With a put option at expiry (t = T ) S < X then the
holder of the option would exercise as she can sell the underlying for more
than she could on the market, and the option would then be worth X − S.
If, however, S > X the the holder of the options could sell the underlying
for more than X and thus it would not be worth exercising the option.
Hence, at t = T the value of a put option is
P (S, T ) = max(X − S, 0)
1.6.1 Introduction
Although we introduced the idea of making money from arbitrage op-
portunities one of the principles required for most of the option pricing
methodology of this course is that arbitrage opportunities do not exist, or
only appear for a very short time. Also associated with the concept of no
instantaneous risk-free profit is the idea of a risk-free rate. This is the rate
of return (or interest rate) that an investor receives upon making a risk-free
investment, such as investing in US treasury bonds.
1.6.2 Determining forward prices
To determine the correct delivery or forward price on a forward contract
it is necessary to invoke the ideas of no arbitrage and the risk-free rate.
Consider a forward contract to purchase IBM stock, which pays no divi-
dends, in three months time. Suppose that the current share price is $40
and the current risk-free rate is 5%, also assume that the current delivery
price is $43. Now if an arbitrageur is sharp then she can spot an arbitrage
opportunity here, she can borrow the $40 to buy a share today and go short
in the forward contract. In three months time she will sell the share for $43.
She can use this to pay off the loan which will have increased to just
40e0.05×3/12 = 40.5.
Hence, whatever happens she will have made a profit of
43 − 40.5 = 2.5.
NB. This collection of one or more products (in this case short on a forward
contract and owning a share) is known as a portfolio.
The principle of no arbitrage says that as soon as this opportunity arises
then people like our investor here will rush in to go short on forwards.
However, very few people will be willing to go long on forwards with such
a high delivery price, so very quickly the price will drop to a fair level and
arbitrage opportunities will vanish.
Finding this ‘fair price’ is simple for forward contracts. Let the current
underlying asset price be S, the risk-free rate be r, the time to expiry be
T and the delivery price F . We have shown that there are arbitrage op-
portunities if F > SerT and similarly (from Examples 1) it is possible to
show that there are arbitrage opportunities if F < SerT . Hence the correct
delivery price on a forward contract is
F = SerT
Note that this derivation does not assume or predict anything about the
movement of the underlying asset S but is able to predict a correct value
for the forward price. Unfortunately for options it is not this simple.
11
jet fuel goes up then it costs BA more money to run their aircraft, so if they
buy call options in jet fuel then if the price goes up then they make money to
offset their operating losses. If the price has gone down then they’re happy
because their operating costs are low.
1.5.2 Options for speculating
If an investor has a hunch about which way a market is moving then he
can obtain more leverage by using options. Consider the following example:
an investor feels that Barclays is likely to increase in value over the next
three months and has $5000 to invest. The current stock price is $20 and
call options are available for three months at the cost of $1. Consider two
possible alternatives, the stock price goes up to $35 or down to $15.
Table 1.1: profit and loss from the two dif-
ferent strategies when speculating on Barclays
stock
Stock price at expiry
Strategy $15 $35
Buy shares -$1250 $3750
Buy call options -$5000 $45000
Investing the $5000 in shares, enables the investor to buy 250 shares
at $20, so if the price drops to $15 then the shares are now worth $3750,
realising a loss of $1250, and if it increases to $35 then they’re worth $8750,
a profit of $3750.
However, the options provide far more leverage in that a small increase
or decrease in the underlying can realise big profits or losses. In this case
the $5000 buys 5000 call options with a strike price of $25. If the price goes
down to $15 then none of these would be exercised and the investor would
have lost their entire $5000. If, on the other hand, the price has gone up
to $35 then each of the options enables the investor to make a $10 profit,
meaning they would make 5000 × 10 = $50000 less the initial outlay of
$5000 which is a massive profit of $45000.
1.5.3 Options for arbitrage
The principle of arbitrage is an important one in option pricing theory
and will be defined and expanded more fully later. However, an arbitrage
opportunity is one in which it is possible to lock in a risk free profit. An
arbitrageur will look for anomalies in the market, which by definition, exist
for only short periods of time and lock in these profits. A good example is in
spread betting, if one book has the spread 8-10 and another 12-14 then you
can buy at 10 in the first and sell at 12 in the second and make a risk-free
profit.
1.6 No arbitrage principle
Definition (Arbitrage opportunity) An arbitrage opportunity is one in
which it is possible to make an instantaneous, risk free profit.
10
 The idea of a process randomly evolving without memory fits very nicely
into the theory of basic random processes. Markov processes are processes
which have no memory, in that whatever movement or information has oc-
curred before a certain time in the process, has no impact on where its next
movement will be.
Example 2.1 One of the simplest random processes, which also happens
to be Markovian, is the simple symmetric discrete random walk. Consider a
stochastic process, St starting from S0 = 0, at each point in time the change
in position of S call it ∆Si is given by
+1 with probability 12
∆Si =

−1 with probability 12
After n steps in this walk then the position of S is given by
n impossible to exercise early they must have the same value throughout the
Sn∆t = ∆Si
i=1
X
This is Markov because each movement is independent of what has occurred
before. Also, it so happens that, in this case, by the Central Limit Theorem
Sn∆t is Normally distributed
√ with a mean of 0 and a variance of n∆t (thus
a standard deviation of n∆t). In general if the variance of each of the
increments ∆Si is σ 2 then the variance of Sn∆t is σ 2 n∆t.
13
1.6.3 The put-call parity
There are a few relationships between option prices which we can de-
termine from basic no arbitrage arguments. One of the most useful is the
put-call parity which will eventually enable you to calculate the value of a
European put using the value of the call. Consider, two portfolios, A and B
which at t = 0 consist of the following:
• Portfolio A: A European call option, C(S, t), with exercise price X
and expiry date T ; and an amount of cash Xe−rT .
• Portfolio B: A European put option, P (S, t), with exercise price X
and expiry date T ; and one share in the underlying S.
At expiry, t = T , the portfolios both have value max(S, X) (for example in
portfolio A at expiry Π = max(S − X, 0) + X = max(S, X)) and so as it is
lifetime of the option. Hence we have the following relationship
C(S, t) + Xe−r(T −t) = P (S, t) + S. (3)
where t is the current time. It is possible to determine some fairly loose
bounds for European options using a similar approach (see examples sheet
2) but for accurate valuation it is necessary to model the movements of the
underlying asset.
2 Model of stock price movements
In order to value more complex products than forward and futures con-
tracts we will have to use stochastic processes in an attempt to accurately
mirror the real life movements of underlying asset prices. Fortunately, al-
though dealing with stochastic variables it is often possible to transform the
problem into a deterministic one. In this case it is achieved through the em-
ployment of Itô’s lemma, which can be seen to be the analogue of Taylor’s
theorem for stochastic calculus.
2.1 Efficient markets and Markovian processes
Most of modern option pricing theory is based on the efficient mar-
ket hypothesis. The hypothesis states that all the data available about a
particular company or commodity is reflected in the current price. So it
is impossible to gain an edge by having studied the historical data or by
examining in intricate detail company reports or the financial press. This
means that any movements in underlying price will be unpredictable (i.e.
random and without memory).
Obviously to come to such a conclusion empirical experiments will have
to be made to check that increments in stock prices are random. Unsurpris-
ingly this is the case although there is a lot of academic dispute about the
true efficiency of markets. In any case, for this course we will assume that
they are efficient.
12
where σ is just scaling the effect of Brownian motion. So, in this case over a 2.2 Brownian motion and the model of stock price movement
period of time dt the stock price increases from St by an amount µdt plus an
This discrete random walk is one possible way of modelling stock price
unknown amount σdW where dW is a Brownian motion. The distribution
movements. It is, however, very simplistic and only works for discrete time.
of the stock price increases, dS, is slightly different in this case
The latter of these problems can be easily overcome by using its continu-
E[dS] = E[µdt + σdW ] ous time analogue: Brownian motion, or as it’s sometimes referred to, the
= µdt + σE[dW ] Wiener process.
= µdt The stochastic model of Brownian motion was, obviously, defined to
mirror the movement of tiny particles in water but has applications in more
and similarly the variance is σ 2 dt as before. This is an improvement on fields than that, one being in option pricing theory. There is a lot of rig-
Brownian motion but still has the problem that there is nothing to prevent orous mathematics surrounding such processes but as regards this course a
St from dropping below zero. heuristic overview will be provided.
Definition (Brownian motion) A real valued stochastic process Wt is a
2.2.2 Geometric Brownian motion Brownian motion (or Wiener process) under a probability measure P if
To over come this adapt the above process ever so slightly to 1. For each t ≥ 0 and s > 0 the random variable Wt+s −Wt (often termed
dS = µSdt + σSdW. (5) dW ) is distributed Normally with mean 0 and variance s.

This is saying that both the deterministic and random terms are scaled
2. For each n and for any times 0 ≤ t0 ≤ t1 ≤ · · · ≤ tn the random
depending on the size of S at time t. The larger S is the bigger, on average,
variables {Wtr − Wtr−1 } are independent.
its movements are. This makes sense as a share with price $3 is more likely 3. W0 = 0 (this is merely a convention, it can start from any point).
to move by a cent than one worth 2c. More importantly, S ≥ 0 as as soon
as S = 0 then the process remains there as dS ≡ 0 4. Wt is continuous in t ≥ 0.
This process does not give rise to increments which are distributed Nor-
mally but rather ones which are distributed lognormally a point seen on This is basically just an extension of the discrete simple random walk to
Examples 2. continuous time. The change Wt+s − Wt over a very small period of time
dt is often denoted by dW and obviously is distributed accordingly(mean
of zero and variance of dt). Brownian motions obviously have very strange
3 Basics of Stochastic calculus and Itô’s lemma paths and, in fact, the expected length of path followed by W in a any time
interval is infinite, this will make calculus difficult on Brownian motions (see
The usual way of approximating derivatives is to use a Taylor expansion.
section 3)
Consider a function of the stock price f (S) and look at the change in value √
One way of understanding dW is to see it as ǫ dt where ǫ is distributed
of f over a small change in S, δS
normally with a mean of 0 and variance of 1. The standard Brownian motion
df 1 d2 f Wt will not model stock prices very well for two main reasons:
f (S + δS) = f (S) + δS + (δS)2 2 + O((δS)3 ). (6)
dS 2 dS • The general trend of stock prices is upwards whereas the expected
Usually, as δS → 0 then the (δS)2 term disappears enabling the usual movement of Brownian motion is to stay at the same level.
df
representation of dS as
• Stock prices cannot drop below 0 whereas Brownian motion can take
any real value.
lim
f (S + δS) − f (S)
δS→0 δS
2.2.1 Generalised Brownian motion
However in this case we have
The first of these concerns can be over come easily. On top of the random
dS 2 = µ2 S 2 dt2 + 2µσS 2 dtdW + σ 2 S 2 dW 2 increments generating by the Brownian motion term it is possible to add
in deterministic terms. When dealing with stock prices there is a general
but as dW is a random variable then it clearly has some variance hence upward drift, call this µ and so if the stock price is denoted by St then we
E[dW 2 ] ≥ 0, in fact E[dW 2 ] = dt and so this term will not disappear as have the following stochastic differential equation
dt → 0. This means that it is not possible to perform calculus on stochas-
tic variables in the same way as it is for deterministic variables. In order St+dt − St = dS = µdt + σdW (4)

15 14
 What is the importance of this result? Well it is clear that the option
price, or any derivative price, is a function of the underlying asset and time.
This above notation has enabled us to define the process followed by any
function of these variables (within very broad constraints). This is a crucial
building block for the derivation of the Black-Scholes partial differential
equation.
to overcome this we need to refer to the work of Japanese mathematician
Kiyoshi Itô.
There is a huge amount of theory behind Itô calculus but we shall refer
only to the main results and most of the explanation will, hence, be heuris-
tic. For a better treatment see the books by Neftci or, better, Etheridge,
alternatively attend other (probability) modules.
Itô’s Lemma: If we have the standard stochastic differential equation

dS = a(S, t)dt + b(S, t)dW

and F = f (S, t) then if f is twice continuously differentiable on [0, ∞) × R

then F is also a stochastic process given by

∂f ∂f 1 ∂2f ∂f
dF = a(S, t) + + b2 (S, t) 2 dt + b(S, t) dW (7)
∂S ∂t 2 ∂S ∂S
 

(Note: the process for S can also be described in its integral form
t t
S = S0 + a(S, s)ds + b(S, s)dW
Z Z

0 0

where again the problem in evaluation comes with the random dW term,
a problem which can be overcome by defining the Itô integral which is,
obviously, closely linked to Itô’s lemma.)
It is worth noting that if one assumes that as dt → 0, dW 2 → dt and
dtdW = o(dt) it is possible to obtain the above result from performing a
Taylor series in two dimensions (see examples sheet 2). So, as a rule of
thumb to arrive at Itô’s lemma assume that dW 2 → dt as dt → 0 a result
which does not take a great leap of faith to assume to be correct as we know
that E[dW 2 ] = dt.
Example 2.2 If dS = adt + bdW where a and b are constants then what
process is followed by G = S 2 ?
Well from Itô’s lemma
∂g ∂g 1 2 ∂ 2 g ∂g
dG = a + + b 2
dt + b dW
∂S ∂t 2 ∂S ∂S
 

∂f ∂ f 2 ∂f
and in this case f (S, t) = S 2 and so ∂S = 2S, ∂S 2 = 2 and ∂t = 0 thus the
process followed by G is as follows

dG = (2aS + b2 )dt + 2bSdW

In our particular case of stock price movements we have the particular

case where a(S, t) = µS and b(S, t) = σS and so the process followed by any
function (satisfying the Itô conditions), F = f (S, t) will be as follows:

∂f ∂f 1 ∂2f ∂f
dF = µS + + σ 2 S 2 2 dt + σS dW (8)
∂S ∂t 2 ∂S ∂S
 

17 16
 • σ is the volatility of the underlying asset or a measure of the uncer- 4 The Black-Scholes analysis
tainty of its movements. For example, a telecommunications startup
company’s shares will have a higher volatility than Tesco’s shares. 4.1 Converting a stochastic process to a deterministic one

• µ is the drift of the underlying asset.
• r is the risk-free interest rate, the return that you would receive from
a risk-free investment such as a government bond.
Black-Scholes assumptions:
• The underlying asset follows geometric Brownian motion (dS = µSdt+
σSdW ) with constant drift, µ and volatility σ. It is possible to have
the volatility dependent on time but more complicated models will
provide much more challenging problems.
• It is permitted to short sell the underlying asset, i.e. sell an asset that
you don’t actually own.
• There are no transaction costs, all securities are perfectly divisible and
trading takes place continuously.
• There are no dividends, or equivalent, paid out during the lifetime of
the option (this will be relaxed at a later date).
In the previous section we have defined a particular model for the move-
ment of stock prices. This is by no means the only possible process used for
underlying assets but is the one which is used for the Black-Scholes analysis,
which still remains the most popular model for practitioners. From here we
now proceed to derive the Black-Scholes PDE.
The main problem with the process followed by the function of S, F , is
that there is still a random term present which makes constructing a PDE
somewhat problematic. The solution to this is to create a new function g
which is completely deterministic. Consider a function
g = f − ∆S
where ∆ is an as yet unknown parameter which is constant across a time
period dt. In which case the change in the value of g over this period is
dg = df − ∆dS
and by substituting in the expressions for df and dS from equations (8) and
(5) we obtain

∂f 1 2 2 ∂2f ∂f
• There are no riskless arbitrage opportunities. Any that do exist exist
only for a very short period of time. dg = µS ∂S + ∂f
 
∂t + 2 σ S ∂S 2 dt + σS ∂S dW − ∆[µSdt + σSdW ]

∂f ∂f 1 2 2 ∂2f
= σS ∂S ∂t + 2 σ S ∂S 2 dt
• The risk free rate r is constant. This can also be trivially relaxed
     
− ∆ dW + µS ∂S − ∆ + ∂f
to let r be a function of time. In practice, especially for long-term
derivatives, the interest rate is itself modelled stochastically. Thus, if we choose
As the option price V (S, t) depends on the underlying asset, S, which follows ∂f
∆=
geometric Brownian motion ∂S
then the equation reduces to one which has only deterministic variables.
dS = µSdt + σSdW (9) This is the basis of the technique employed by Black and Scholes to derive
their PDE
and by Itô’s lemma we have
∂V ∂V 1 ∂2V ∂V 4.2 The Black-Scholes PDE
dV = µS + + σ 2 S 2 2 dt + σS dW (10)
∂S ∂t 2 ∂S ∂S
 

Notation:
Now construct a portfolio which consists of an option and short in ∆ of the
underlying. Π is defined to be the value of the portfolio where • S is the current value of the underlying asset, can also be denoted by
St especially in SDEs but the t is usually dropped.
Π = V − ∆S. (11)
• t is the time elapsed since the option was created and the option expires
Assume, across a time period dt, that the value of ∆ is held fixed giving at time T .
dΠ = dV − ∆dS, (12) • V (S, t) is the value of either a call or a put option.
and so, on substituting in the expressions for dV and dS in equations (9) • C(S, t) is the value of a call option.
and (10) we get
• P (S, t) is the value of a put option.
∂V ∂V ∂V 1 ∂2V
dΠ = σS + σ 2 S 2 2 dt (13)
∂S ∂S ∂t 2 ∂S
     
− ∆ dW + µS −∆ + • X is the exercise price of the option.

19 18
 • The linear operator The amount of the underlying which the holder of the portfolio is short
selling, ∆, has not yet been set. However, if ∆ is selected, as before, such
∂ 1 ∂2 ∂ that
= + σ 2 S 2 2 + rS ∂V
∂t 2 ∂S ∂S
LBS −r
∆= , (14)
∂S
is a measure of the difference between the return on the hedged port-
then the stochastic differential equation for dΠ becomes deterministic, as
folio (Π) which are the first two terms (see equation (15)) and the
the coefficient of the dW term is now identically zero. Thus this portfolio is
return on a bank deposit which are the last two terms. For a Euro-
perfectly hedged as it provides a guaranteed return over a designated time
pean option these will be the same, though they are not necessarily
period. Obviously, this assumes that it is possible to change the value of
for an American option.
∆ continuously, because as time evolves the value of ∂V∂S is changing. With
• For many types of options it is not possible to obtain closed-form this continuous rebalancing of the portfolio the expression for dΠ is now
analytic values but more often than not numerical procedures must
∂V 1 ∂2V
be employed. In this lecture course, though, emphasis will remain on dΠ = + σ 2 S 2 2 dt. (15)
∂t 2 ∂S
 

analytic solutions.
However, this portfolio is perfectly hedged, in that it yields a risk-less value
4.3 Aside - portfolios of options after any period of time t and, as such, should return the risk-free rate.
It is possible, see the many examples on Examples 3, to combine different Assuming no arbitrage then over a period of time, dt, and a constant risk-
options to achieve a desired payoff. free interest rate, r, the change in the portfolio is

Example (Bull spread): The portfolio consists of buying (long) one call dΠ = rΠdt.
option with exercise price X1 and writing (short) another call option with
the same expiry but a larger exercise price X2 . Thus, the portfolio, Π is of If it were the case that dΠ 6= rΠdt then one could make a risk-free profit by
value either borrowing Π from the bank and investing in the portfolio (dΠ > rΠdt),
Π = C(S, t; X1 ) − C(S, t; X2 ) or shorting the portfolio and investing the money in the bank (dΠ < rΠdt).
On replacing Π by its definition, equation (11), equation (15) is now
and the value of the portfolio (the payoff ) at expiry will be
∂V ∂V 1 ∂2V
dt = + σ 2 S 2 2 dt. (16)
∂S ∂t 2 ∂S
   
Π = max(S − X1 , 0) − max(S − X2 , 0) r V −S

and so the portfolio pays nothing for S < X1 , S − X1 for X1 < S < X2 On dividing equation (16) by dt one obtains
and X2 − X1 for S > X2 . This will be used by an investor who thinks
that the underlying asset will increase but is happy to take a known amount ∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS (17)
∂t 2 ∂S ∂S
− rV = 0.
(X2 − X1 ) if the increase is substantial - note that this makes the portfolio
cheaper than just a call option with exercise price X1 . See figure 4. which is the Nobel prize winning Black-Scholes partial differential equation.
Remarks:

• This equation defines the price of any derivative claim on an under-

lying asset which follows geometric Brownian motion. The boundary
conditions will determine which type of derivative we are evaluating.

• This is a backwards parabolic partial differential equation, a class of

equations about which a lot more will be said below.

• Notice that by setting up the portfolio Π using what is known as the

Delta Hedge the Black Scholes equation does not depend on the drift
term µ in any way. The only parameter which needs to be empirically
estimated is σ.

• The Delta (∆) which is the rate of change of the derivative with respect
to the underlying asset is a very important value.

21 20
 Π
difference between the two types is that forwards equations require initial
conditions, whilst backwards equations require final conditions.
Note how these requirements are consistent with the individual nature
of the problems. When valuing options, we know the value at expiry (or
the final time) and so it makes sense that this problem gives rise to a back-
wards parabolic type. The heat conduction (or diffusion) equation requires
X2 − X 1
a known distribution of heat on a bar (or equivalent system) at t = 0 and
then models how the heat distribution evolves as time moves forwards. As
such the system requires initial conditions - thus is a forwards parabolic
type.
It is essential to always solve parabolic equations ‘in the correct direction’.

4.4.2 Characteristics X1 X2 S

The classification of PDEs in the above section is closely related to the

notion of characteristics. Characteristics are families of curves along which Figure 4: Payoff from a bull vertical for underlying asset, S.
information moves or across which discontinuities may occur. The trick is
to attempt to write the derivative terms in the PDE in terms of directional
derivatives reducing the equation to one which behaves like an ODE along 4.4 Formulating the mathematical problem
these characteristic curves.
4.4.1 Classifying the PDE
Definition (Characteristic curve) A curve Γ is a characteristic for a
general second order PDE if, for a general PDE in x and t, For there to be no arbitrage, the option value obtained from the Black-
Scholes PDE must provide a unique option price. Later it will be shown
that, given suitable boundary conditions, this is indeed the case. First, in
√
∂t
=0
b ± b2 − 4ac
∂x
−
2a order to determine the type of boundary conditions required it is necessary
to find out some general information about the PDE itself.
along Γ. We know that in general a PDE with solution u(x, t) of the form
Clearly the value of b2 − 4ac will be important in determining the char-
acteristic curves. In the parabolic case there is just one real valued solution auxx + buxt + cutt + dux + eut + f u = g (18)
giving
∂t b is classified depending on the sign of b2 − 4ac as follows:
= .
∂x 2a • If b2 − 4ac < 0 then the equation is elliptic.
In the case of the heat conduction equation where b = 0 then this reduces
to • If b2 − 4ac = 0 then the equation is parabolic.
∂t
=0
∂x • If b2 − 4ac > 0 then the equation is hyperbolic.
giving characteristic curves along t = C where C is a constant. The most commonly seen parabolic equation is the diffusion or heat equation

4.4.3 Boundary conditions for the Black-Scholes equation ∂2u ∂u

Returning to the Black-Scholes equation, for each particular type of op-
tion we will require the following boundary conditions:
V (S, t) = Va (t) on S = a
V (S, t) = Vb (t) on S = b
V (S, t) = VT (S) on t = T
where Va (t) and Vb (t) are known functions of time and VT (S) is, correspond-
ingly, a known function of the underlying asset price. To demonstrate how to
=
∂x2 ∂t
which typically models the evolution of heat along a bar. As they are second
order in x and only first order in t parabolic equations usually require two
boundary conditions in x (or S in the Black-Scholes case) and just the one
in t. It is important to notice here that in the heat conduction equation
the ∂u/∂t term is of a different sign from that in the Black-Scholes equation
(17). This is because the heat conduction equation is a forwards parabolic
equation whilst the Black-Scholes equation is backwards parabolic. The

23 22
European put option, P(S,t):
The case for a put option is far more straightforward. Again determining
the final condition is trivial as a result of the discussion in Chapter 1, so we
have
(22)
P (S, T ) = max(X − S, 0).
The conditions for particular values of S are extensions of the above
arguments for calls, only more routine. When S = 0 at a particular time
then by the nature of the underlying process then it will stay at 0 until
expiry. Hence the put option will definitely be exercised and thus worth
X − 0 = X at expiry. A guaranteed amount of money, in this case X, to be
received at time T is worth Xe−r(T −t) at time t and hence
P (0, t) = Xe−r(T −t) (23)
As S becomes very large then the put options will certainly not be exercised
as S will be much larger than the exercise price X and so
P (S, t) → 0 as S → ∞. (24)
As before the most important conditions are the final ones, but the other
conditions are essential for numerical schemes as well as giving us more
information about the option prices.
Cash-or-nothing options:
Cash-or-nothing call (put) options (denoted CC(S, t) or CP (S, t)) are
options where, at expiry, if the underlying asset price is above (below) a cer-
tain strike price, X, then the holder receives a pre-designated cash amount
A, whereas if it is below (above) this amount the holder receives nothing.
Hence at expiry, t = T , the final condition for a cash-or-nothing call is
CC(S, T ) = AH(S − X)
where H(.) is known as the Heaviside function. The Heaviside function
is defined as follows
0 if x < 0
1

H(x) =
if x ≥ 0
and will be important when solving PDEs later in the course. Cash-or-
nothing options are a special type of option in that their payoff is completely
discontinuous yet it is still possible to find an option value for them.
do this for different types of options we’ll consider three cases: the standard
European call and put options and a cash-or-nothing call option.
European call option, C(S,t):
The most straightforward of the conditions to determine is the final
condition C(S, t = T ) as this is the known payoff for the call option,
(max(S − X, 0)), hence
C(S, T ) = max(S − X, 0). (19)
The conditions for specific values of S are also reasonably straightforward.
Note that from the process followed by S, namely
dS = µSdt + σSdW
if S = 0 then dS = 0 and , hence, the underlying asset remains at 0 from
then on. Hence for a call option, however small the strike price X is, this
scenario will always result in the option being worthless, hence
C(0, t) = 0 (20)
For large S the situation is not as clear and there are three standard conven-
tions (of which two are provided here for brevity). As S → ∞ then clearly
the call option is more and more likely to be exercised and in comparison to
the size of S, X will be small and so one can simply use
C(S, t) → S as S → ∞.
However, the S boundary conditions are more important when dealing with
numerical procedures where a large, but finite, limit is put on S (Smax say).
In which case, more accurate conditions are required. One possibility is to
assume that the option will be exercised at expiry, receiving S plus whatever
else contributes to the option’s value as time moves backwards. In this way
write the option price for a particular high value of S as
C(S, t) = S + f (t)
on substituting into the Black-Scholes equation (17) we’re left with
df
dt + rS + −r(S + f (t)) = 0
df
dt = rf (t)

which on solving gives

4.5 Analytic solutions to the Black-Scholes equation f (t) = Aert
The next chapter of the course will deal with solving the heat conduction substituting in the known time constraint from (19) we get
or diffusion equation and how to adapt these techniques to solve the Black-
Scholes equation for some standard option pricing problems. Before doing A = −Xe−rT
that we will study the analytic solutions to the valuation problems and a
few more key features of options. and so the boundary condition for large S is

C(S, t) → S − Xe−r(T −t) as S → ∞. (21)

25 24
Similarly N (d2 ) = .0295 The Black-Scholes formulae for the price of European call and put
Leads to C = .0060. options are as follows:
Put can be calculated similarly - but best to use put-call parity:
C(S, t) = SN (d1 ) − Xe−r(T −t) N (d2 ) (25)
P = C − S + Xe−r(T −t) .
P (S, t) = Xe −r(T −t)
N (−d2 ) − SN (−d1 ) (26)
and this leads to P = 0.8725.
where
4.6 Delta hedging and the other hedge parameters log(S/X) + (r + 12 σ 2 )(T − t)
d1 = √
A tedious, yet straightforward, calculation (see example sheet 6) will σ T −t
show that using the known expressions for the values of call and put options, log(S/X) + (r − 12 σ 2 )(T − t)
that they have the following ∆’s d2 = √ .
σ T −t
∂C (27)
∆C = = N (d1 )
∂S
and x
∂P 1 1 2
∆P = e− 2 s ds (28)
∂S
= N (d1 ) − 1 N (x) = √
Z

2π −∞
What does this mean? During the lifetime of the option ∆ varies between 0
which we recognise as the cumulative distribution function for a Normal
for out of the money calls (puts) and 1 (−1) for in the money calls (puts) and
distribution. Note that these expressions satisfy the put call parity and so
very close to T there is in fact a step function between these two extremes.
by calculating one it is routine to calculate the other, also note that the
The ∆ simply approximates the rate of change of the option price wrt the
boundary conditions at S = 0 and S → ∞ are satisfied.
underlying asset and so any slight movement in the option price value will
For those students interested in probability it may be worth noting that
be offset by a roughly equivalent movement in ∆ of the underlying. Clearly
N (d2 ) is the probability that the option will be exercised, i.e. S > X at
the portfolio will have to be rebalanced as regularly as possible to have a
expiry. SN (d1 ) is the current value of a variable that equals ST at t = T if
perfect hedge. In practise the number of times a portfolio can be hedged
ST > X and is zero otherwise.
will be limited by transaction costs.
So, what does a graph of underlying asset against option price looks
For example, looking at the graph for the value of a cash-or-nothing
like as time moves backwards from expiry? As one would expect from a
call option we immediately see a problem with the delta-hedging strategy
PDE which is a close relative of the diffusion equation, the payoff function
underlying the Black-Scholes analysis. If ∆ is ∂C/∂S then as t → T then
max(S − X, 0) gradually diffuses out as time moves backwards. The same
is also true for a cash or nothing option even though the payoff is in fact
the ∆ ranges from 0 away from S = X to approaching ∞ close to S = X.
Thus as the underlying asset price moves, huge amounts of the underlying
discontinuous.
will have to be bought and sold to keep the portfolio properly hedged.
There are ways of hedging away other risks, not just those to do with Example
the movement of the asset price. There are hedge parameters (also known
as, somewhat loosely, as The Greeks) for each of the principle parameters The price of an asset (today) is £5. Find the value of a put and a call
in the Black-Scholes model, namely: option, both with an exercise price of £6, and both with expiration dates in
9 months time. The risk-free interest rate is 3% per annum (fixed) and the
1
• The sensitivity to the decay of time of any option V is known as the
theta and is defined as volatility (constant) is 10% per (annum) 2 .
∂V
Θ=
∂t Solution
• The sensitivity to the volatility is known as the vega and is defined
as
r = .03, T − t = 0.75, σ = .1, S = 5, X = 6.
∂V Using the formulae.d1 = −1.8021, d2 = −1.8888
V=
∂σ Then
• The sensitivity to interest rates is known as rho and, unsurprisingly N (d1 ) = N (−1.8021) = N (−1.80) − .21[N (−1.80) − N (−1.81)]
to be
∂V = 0.0359 − .21 × (0.0359 − 0.0351)
ρ=
∂r = 0.0357

27 26
 • It is a second order linear PDE, as such if u1 and u2 are solutions then • Finally, the sensitivity of the ∆ to the underlying asset is known as
so is a1 u1 + a2 u2 for any constants a1 , a2 gamma and is defined as follows

• It is a parabolic equation and it’s characteristics are simply along the ∂2V
lines τ = c (where c is a constant) which means that this is where infor- Γ=
∂S 2
mation propagates along. So any change in the boundary conditions
is felt along these lines. Often these hedge parameters are used to see what would happen if there
was a small change in one of the parameters, this is important as both r
• The heat conduction equation generally has analytic solutions in x, and σ are not fixed or even time dependent in practice.
technically in that for τ > 0, u(x, τ ) has a convergent power series of
(x − x0 ) for x0 6= x.
4.7 Implied volatility
Crucially, the heat conduction (diffusion) equation is a smoothing out One of the most important parameters, and the only one which is very
process, and as such discontinuities in the boundary or initial (final) condi- difficult to know for definite is the volatility, σ. There are several conventions
tions can be catered for. Recall that in the Black-Scholes equation the final for calculating the volatility of an underlying asset. One would perhaps
conditions are often discontinuous. assume that the best way is to look at the volatility of past returns and use
Example By way of demonstration consider the following initial value prob- this as a decent guess as to what would happen in the future. However,
lem. another way is to assume that the Black-Scholes analysis is correct and use
∂u ∂2u the market prices for options to back-out the volatility, using a suitable
=
∂τ ∂x2 iterative procedure such as Newton-Raphson, the only unknown being σ
for τ > 0 and −∞ < x < ∞ where u(x, 0) = u0 (x) and u → 0 as x → ±∞. itself.
u(x, τ ) is analytic for τ > 0. Consider a special solution, about which more If one attempts this they will see a problem with the volatility. Depend-
is said later ing on how far in or out of the money the option is the volatility may well
1 2
u(x, τ ) = uδ (x, τ ) = √ e−x /4τ (29) not be constant for a given r, S, and t. So, not only is it dependent on
2 πτ time but also on the exercise and asset prices. Such a result is often termed
for −∞ < x < ∞ and τ > 0. Now we verify that this indeed satisfies the the volatility smile although many other shapes can be observed depending
PDE. on the market conditions such as a frown, wry smile etc. This is another
∂u 2
−x example of the faults in the Black-Scholes model.
∂x
= 3/2 √ e−x /4τ
4τ π
∂2u 2 x2 2
−1 5 Solving the heat conduction and Black-Scholes
∂x2
= 3/2 √ e−x /4τ + 5/2 √ e−x /4τ
4τ π 8τ π
equations
∂u −1 2 x2 2

∂τ
= 3/2 √ e−x /4τ + 5/2 √ e−x /4τ .
4τ π 8τ π The PDE which defines the price of a derivative is now known to be
a second-order parabolic equation, in the majority of cases this equation
So, this is a solution which is well behaved except at one instance, the initial is also a linear one. This chapter is concerned with the nature of these
point in time τ = 0. At this point when x 6= 0 then uδ (x, 0) = 0 but at equations, focusing attention on the heat conduction equation and then
x = 0 it has infinite value. This clearly has discontinuous initial conditions extending to the Black-Scholes equation itself.
yet gives rise to a, reasonably, well behaved solution.
What more can we say about this special solution to the heat conduction
5.1 Properties of the Heat conduction equation
equation? Well,
∞
uδ (x, τ )dx = 1, ∀τ. The heat conduction equation takes the form
Z

−∞
∂u ∂2u
This function has all of the heat initially (τ = 0) concentrated at x = 0 and =
∂τ ∂x2
then this immediately dissipates out as for any τ > 0, uδ (x, τ ) > 0 for all
values of x. where τ is the time and x is the spatial variable, it normally models the flow
Finally note the close similarity between the probability density function of heat or its diffusion and has been extensively studied over the years. Its
2 2
for the Normal distribution ( σ√12π e−(x−µ) /2σ ) and the value of uδ (x, τ ). fundamental properties are as follows
Clearly it is the same only with a mean(µ) of zero and a variance (σ 2 ) of 2τ .

29 28
 0.9
Note that the specific solution to the heat conduction equation uδ satisfies
the above constraints with τ replaced by ǫ. The best way to look at the 0.8 τ = 0.1

delta function is to only consider its integral which we know to be 1 and

0.7
which smooths out the function’s bad behaviour, especially when x = 0 and
ǫ → 0 (of τ → 0). 0.6

When concentrating on the integral form we can see the delta function
0.5
as a test function, in that

uδ (x, τ )
0.4

δ(x)φ(x)dx = lim δǫ (x)φ(x)dx

ǫ→0 0.3
Z ∞ Z ∞

−∞ −∞

0.2
= lim δǫ (x)φ(x)dx + δǫ (x)φ(x)dx + δǫ (x)φ(x)dx
ǫ→0
Z −ǫ Z ǫ Z ∞ 

ǫ
0.1

= lim φ(0) δǫ (x)dx

ǫ→0 0
 −∞ Z ǫ  −ǫ

−ǫ -10 -5 0 5 10
= φ(0) x

Figure 5: A graphical representation of uδ (x, τ ) for τ = 0.1, 0.2, 0.3, . . . , 1.

In fact, for any a, b > 0
b
δ(x)φ(x)dx = φ(0)
As such it is possible to interpret this particular solution as the probability
Z

−a
density function of the future position of a particle following a Brownian
and, as importantly, for any x0 √
motion ( 2dW ) along the x-axis, with the particle starting at the origin.

δ(x − x0 )φ(x)dx = φ(x0 ) 5.2 The Dirac delta function

Z ∞

−∞
The function uδ (x, τ ) when τ = 0 is one representation of the (Dirac)
and so integrating picks out the value of φ at x0 , the reason why δ(x) is also
delta function which is not a function in the normal sense but is known as
known as a test function.
a generalised function. It’s definition is as a linear map representing the
Other properties concern its links with the Heaviside function as
limit of a function whose effect is confined to a smaller and smaller interval
but remains finite.
An informal definition is to consider a function
δ(s)ds = H(x)
Z x

−∞

and conversely, f (x) =

1/2ǫ, |x| ≤ ǫ
0,


H′ (x) = δ(x) |x| > ǫ

where, as before and as ǫ → 0 the graph becomes taller and narrower but at all points
0 if x < 0
1

H(x) =
if x ≥ 0 f (x)dx = 1
Z ∞

−∞

regardless of the value of ǫ although for all x 6= 0, f (x) → 0 as ǫ → 0. In

general the delta function δ(x) is the limit as ǫ → 0 of any one-parameter
family of functions δǫ with the following properties

• for each ǫ, δǫ (x) is piecewise smooth;

• −∞ δǫ (x)dx = 1;
R∞

• for each x 6= 0, limǫ→0 δǫ (x) = 0.

31 30
5.3 Transforming the Black-Scholes equation
Consider the Black-Scholes equation
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS
∂t 2 ∂S ∂S
− rV = 0

make the following three substitutions

S
S = Xex (or x = log ) 1
X
τ σ2 2ε
τ=
2
t = T − 1 2 (or (T − t))
2σ
V = Xv(x, τ ) (30)

thus
∂V ∂v dτ ∂v σ2 Xσ 2 ∂v
= X
∂t ∂τ dt ∂τ 2 2 ∂τ
=X .− =−
∂V ∂v dx ∂v 1 ∂v
= X =X = e−x x
∂S ∂x 2ε
∂2V ∂ ∂V e−x ∂ ∂v ∂v e−2x ∂ 2 v ∂v
= = e−x = e =
e−x −x ∂ 2 v
∂S 2 ∂S ∂S X ∂x ∂x X ∂x 2 ∂x X ∂x 2 ∂x
 dS  ∂x S  ∂x     
− e−x −
Figure 6: The epsilon representation of δ(x) which is the limit as ǫ → 0.
which leads to
∂v ∂2v ∂v
=
∂τ ∂x2 ∂x
+ (k − 1) − kv
where
r
k= 1 2 H(x)
2σ
∂v
Now attempt to remove the ∂x and v terms by introducing the substitution
H’(x) = 0
v(x, τ ) = eαx+βτ u(x, τ )
1
where α and β are constants to be determined, this gives
∂v ∂u
8

= βeαx+βτ u + eαx+βτ H’(x) =

∂τ ∂τ
∂v ∂u
= αeαx+βτ u + eαx+βτ
∂x ∂x x
∂2v ∂u ∂2u H’(x) = 0
= α2 eαx+βτ u + 2αeαx+βτ + eαx+βτ 2
∂x2 ∂x ∂x
which gives
∂u ∂u ∂ 2 u ∂u
βu + = α2 u + 2α
∂τ ∂x ∂x ∂x
 
+ 2 + (k − 1) αu + − ku

∂v
to remove the ∂x and v terms we require
1 Figure 7: Demonstration that H ′ (x) = δ(x).
2
α = − (k − 1)
1
4
β = − (k + 1)2 .

33 32
5.4 Similarity solutions to the Heat conduction equation Thus,
1 1 2
V (S, t) = Xe− 2 (k−1)x− 4 (k+1) τ u(x, τ ) (31)
Explanation is first by way of two examples
Example 5.1: Suppose that u(x, τ ) satisfies the heat conduction equation and
∂u ∂2u
=
−∞ < x < ∞
∂u ∂2u ∂τ ∂x2 τ >0
= , x, τ > 0
∂τ ∂x2 To transform the final conditions, or the payoff from the option we have for
a call option
with the following boundary conditions
V (S, T ) = max(S − X, 0)
u(x, τ = 0) = 0 (34) so, from the definition of x, τ and v(x, τ ) in (30)
u(x = 0, τ ) = 1 (35)
u(x, τ ) → 0 as x→∞ (36) Xv(x, 0) = max(Xex − X, 0)

i.e. the bar initially has heat zero and then immediately the heat at one end or
is raised to 1 and kept there. v(x, 0) = max(ex − 1, 0)
√
Seek a solution of the form u(x, τ ) = U (ξ) where ξ = x/ τ on substitu- and so, from (31)
tion
∂u dU ∂ξ 1 dU 1 1
= (32)
∂τ dξ ∂τ 2 dξ
= − xτ −3/2
 
u(x, 0) = u0 (x) = max e 2 (k+1)x − e 2 (k−1)x , 0
∂u dU ∂ξ dU
= = τ −1/2 and similarly for a put option
∂x dξ ∂x dξ
and 1 1
∂2u d dU d2 U (33)
 
u(x, 0) = u0 (x) = max e 2 (k−1)x − e 2 (k+1)x , 0
= τ −1/2 τ −1/2 = τ −1 2
∂x2 dξ dξ dξ
 

√ As such the Black-Scholes equation has been converted to the heat conduc-
and so, replacing x/ τ by ξ and multiplying by τ gives the ODE
tion equation for −∞ < x < ∞ and, for European call and put options,
d2 U 1 dU initial condition u0 (x) from (32) and (33) above. If we can determine a pro-
+ ξ =0 cedure for valuing the initial value problem for the heat conduction equation
dξ 2 2 dξ
we’ll be able to determine the correct values for call and put options.
the boundary conditions become

U (0) = 1

and
U (∞) = 0
with this second condition catering for both the initial condition and u(x, τ ) →
0 as x → ∞. Integrating the ODE once gives
dU 2
= Ce−ξ /4
dξ

(C constant) and on solving gives

ξ
2 /4
U (ξ) = C e−s ds + D
Z

(D constant). Upon substituting the boundary conditions, first U (0) = 1

gives
1=D

35 34
which says that the solution must decay faster than 1/ξ as ξ gets very big (or and then U (∞) = 0 gives
alternatively u(x, τ ) = o(1/x) as |x| → ∞). On transforming the derivatives ∞
2 /4
we get 0=C e−s ds + 1
Z

0
∂u 1 dU 1 1 1 dU
∂τ 2 dξ 2 2 2 dξ but we know that
= − τ −3/2 U + τ −1/2 . − xτ −3/2 = − τ −3/2 U − ξτ −3/2
∞
2 /4 √
∂u dU ∂ξ dU e−s ds = π
Z

= τ −1/2 = τ −1 0
∂x dξ ∂x dξ
thus
and √
∂2u d dU d2 U −1 = C π
2
= τ −1/2 τ −1 = τ −3/2 2
∂x dξ dξ dξ
 

Thus,
ξ
which gives 1 2 /4
e−s ds + 1
d2 U 1 dU 1 π
U (ξ) = − √
Z

0
+ ξ + U =0
dξ 2 2 dξ 2 but
or ξ ∞ ∞
2
d U d 1 = −
Z Z Z

+ ξU = 0. 0 0 ξ
dξ 2 dξ 2
 

hence
Integrating both sides wrt ξ gives 1 ∞
2 /4
∞
2 /4
e−s e−s ds + 1
dU 1 π
Z 
U (ξ) = − √ ds −
Z

0 ξ
+ ξU = C
dξ 2 or
1 2
where C is a constant. Now as ξ → ∞, U = o(1/ξ) so the LHS is o(1) thus
π

U (ξ) = − √ − e−s /4 ds − 1 + 1
 Z ∞

this constant C = 0. So then on solving the ODE ξ

2 /4
so
U (ξ) = Ae−ξ , 1 ∞
2 /4
U (ξ) = √ e−s ds
π
Z

ξ
where A is a constant. Putting in the condition we have
and on replacing ξ by its definition we get
2
A τ −1/2 e−x /4τ dx = 1
1 2
Z ∞

−∞
u(x, τ ) = √ e−s /4 ds
Z ∞
√ √
however, set x′ = x/ τ and we get dx = τ dx′ and the equation becomes π x/√τ

′2 The key trick being that to solve the equation we replace two variables (x
A e−x /4 dx′ = 1
and τ ) by just one (ξ) and then the problem reduces to an ODE. Even more
Z ∞

−∞

and so using the usual result

useful is the next example, for −∞ < x < ∞.
√ Example 5.2: Consider the following equation for u(x, τ )
2A π = 1
thus ∂u ∂2u
= ,
−∞ < x < ∞
1 ∂τ ∂x2 τ >0
A= √
2 π
where
and so, ∞
1 2 u(x, τ )dx = k, ∀τ where k is a constant.
Z

u(x, τ ) = τ −1/2
√ e−x /4τ −∞
2 π
 

or Choosing the normalised case where k = 1 we search for a solution of the

1 2
√
u(x, τ ) = √ e−x /4τ form u(x, τ ) = τ −1/2 U (ξ) where ξ = x/ τ . The other boundary condition
2 πτ is a somewhat odd one but is that as |ξ| → ∞ then
which is precisely the special solution uδ from section 5.1, equation 29.
2 U (ξ) = o(1/ξ)
[Note: The derivation in Wilmott where he states that U (ξ) = Ce−ξ /4 + D
is wrong.]

37 36
which is still a solution to the heat conduction equation with either s or x
as the spatial independent variable and it has initial value
uδ (s − x, 0) = δ(s − x).
Now comes the important bit, hence, for each s the function
u0 (s)uδ (s − x, τ )
as a function of x and τ with s held fixed, satisfies the heat conduction
equation as u0 (s) is simply a constant. Now using the fact that the diffusion
equation is linear we can add together linear combinations of these solutions
for any s all the way from −∞ to ∞ and obtain another solution to the heat
conduction equation, namely
1 2
u(x, τ ) = √ u0 (s)e−(x−s) /4τ ds
Z ∞
5.4.1 How similarity solutions work
The reason why the above similarity solution worked was because the
governing equations and the boundary conditions do not change under the
scalings x → λx and τ → λ2 τ , where λ ∈ R. In particular consider new
variables x∗ = λx and τ ∗ = λ2 τ , these clearly satisfy the heat-conduction
equation and in Example 5.1 the boundary conditions become u(x∗ , 0) = 0
and u(0, τ ∗ ) = 1 for any λ.
Combining these two results to get a variable
√ which is independent of λ
√
the only possible combination is x/ τ = x∗ / τ ∗ . Hence the solution to the
√
problem must be a function of x/ τ only.
Similarity solutions only work in special cases where all the boundary
and initial conditions are invariant under the scaling transformation. It is
also possible to multiply U (ξ) by a function of τ as in Example 5.2 because
as the heat-conduction equation is linear it is invariant under the scaling

2 πτ −∞
u → µu.
and the initial data is In general with similarity solutions a good practical test to see if they’ll
∞ work is to search for a solution of the form u = τ α U (xτ β ) in the hope that
u(x, 0) = u0 (s)δ(s − x)ds = u0 (x). the PDE will reduce to an ODE in ξ = xτ β and the boundary conditions will
Z

−∞
be satisfied. For the heat conduction equation then in all cases β = −1/2
What does all this mean? Well, this solution satisfies the heat conduction but the value of α will be dependent on the specific boundary conditions.
equation for all x and for τ > 0 and is also satisfies the initial conditions for For example in 5.1 α = 0 because of the condition at x = 0 and, in Example
all initial conditions u0 (x). It is also possible to show that this solution is 5.2, α = −1/2 to remove τ from the integral condition.
unique (see Examples 5). Hence we have found the general solution.
5.5 General solution to the Heat-Conduction equation initial
5.6 Pricing European call and put options value problem
We now know the general solution to the initial value problem for the Searching for a solution to the initial value problem in which we have to
heat conduction equation, where u(x, 0) = u0 (x) for τ > 0 and −∞ < x < solve
∂u ∂2u
= ,
∞, namely −∞ < x < ∞
1 2 ∂τ ∂x2 τ >0
u(x, τ ) = √ u0 (s)e−(x−s) /4τ ds.
Z ∞

with initial data u(x, 0) = u0 (x) and there are suitable growth conditions at
2 πτ −∞
2
We start by valuing a European call option but the procedure is similar for |x| → ∞ (usually lim|x|→∞ u(x, τ )e−ax = 0 for a > 0 and τ > 0).
a put option. In section 5.3 we transformed the European call option pricing The key to the formulation is the delta function, δ(x) as we can write
problem to the following system the initial conditions as
∂u ∂2u
= ,
−∞ < x < ∞
τ >0 u0 (x) =
∂τ ∂x2
u0 (ξ)δ(ξ − x)dξ
Z ∞

−∞

where we recall that the fundamental solution to the initial value problem from 5.2
1 1
is
2
 
u(x, 0) = u0 (x) = max e 2 (k+1)x − e 2 (k−1)x , 0 .
1
uδ (s, τ ) = √ e−s /4τ
By using the known general solution to this problem we have 2 πτ
1 1 1 2 and has initial value uδ (s, 0) = δ(s). Noting that because uδ (s − x, τ ) =
u(x, τ ) = √

max[e 2 (k+1)s − e 2 (k−1)s , 0]e−(x−s) /4τ ds
Z ∞

2 πτ −∞ uδ (x − s, τ ) we have
1 2
but u0 (x) = 0 for x < 0 hence
2 πτ
uδ (s − x, τ ) = √ e−(s−x) /4τ
1 1 1 2
u(x, τ ) = √

[e 2 (k+1)s − e 2 (k−1)s ]e−(x−s) /4τ ds.
Z ∞

2 πτ 0

39 38
where We make another change of variable, define
log(S/X) + (r + 12 σ 2 )(T − t) s−x
d1 = x′ = √ .
2τ
√
σ T −t
1 1 1
√ √
2
(k+1)(x′ 2τ +x)− 21 x′2 2
(k−1)(x′ 2τ +x)− 12 x′2
log(S/X) + (r − 21 σ 2 )(T − t)
d2 = √ . u(x, τ ) = √ { dx′ − dx′ }.
Z ∞ Z ∞
σ T −t √ e √ e
2π −x/ 2τ −x/ 2τ

The European put can be valued in a similar manner or, more easily, by Completing the square and removing the terms not dependent on x′ yields
use of the put-call parity, equation. Either approach yields the following 1 1 2τ
e 2 (k+1)x+ 4 (k+1) 1 ′ 1
∞ √
expression for its value, P (S, t) 2τ )2
u(x, τ ) = √ e− 2 (x − 2 (k+1) dx′
Z
√
2π −x/ 2τ
1 1 2τ
e 2 (k−1)x+ 4 (k−1) 1 ′ 1
P (S, t) = Xe−r(T −t) N (−d2 ) − SN (−d1 ). ∞ √
2τ )2
− √ e− 2 (x − 2 (k−1) dx′
Z
√
(To use put-call parity note that N (x) + N (−x) = 1). 2π −x/ 2τ
= I1 − I2 (37)

Noting that the expression for the cumulative Normal distribution is as

follows
1 1 2
N (x) = √ e− 2 s ds
Z x

2π −∞
we transform the dependent variable, x′ , once again to
1 √
2
x1 = x′ − (k + 1) 2τ

and
1 √
2
x2 = x′ − (k − 1) 2τ

in I1 and I2 respectively and then

1 1 2 1 1 2
u(x, τ ) = e 2 (k+1)x+ 4 (k+1) τ N (d1 ) − e 2 (k−1)x+ 4 (k−1) τ N (d2 )

where
x 1 √
d1 = √ + (k + 1) 2τ
2τ 2
x 1 √
d2 =
2
√ + (k − 1) 2τ .
2τ
Transforming the variables back using the usual definitions
1 1 2
V (S, t) = Xe− 2 (k−1)x− 4 (k+1) τ u(x, τ )
S
x = log
X
 

σ2
τ =
2
(T − t)
2r
k =
σ2
gives the following expression for the value of the European call option

C(S, t) = V (S, t) = SN (d1 ) − Xe−r(T −t) N (d2 ),

41 40
leads to a deterministic result, to which we can apply the usual no-arbitrage 6 Options on assets paying dividends
argument, i.e.
6.1 Introduction
∂V ∂2V ∂V
dΠ = dt The majority of companies who have issued shares pay out dividends of
∂t ∂S ∂S
dt + 12 σ 2 S 2 2 dt − DS
= rΠdt some form another, fortunately it is relatively easy to incorporate dividend
∂V payments into the option pricing methodology. Of even greater use is that
)dt the methods used for pricing options on dividend paying stocks can be rou-
∂S
= r(V − S
tinely extended to deal with other, analogous, problems such as options on
which gives the following PDE foreign currency where the dividend becomes the foreign risk-free interest
rate and options on commodities where the dividend becomes minus the
∂V 1 ∂2V ∂V
(38) cost of carry.
∂t 2 ∂S ∂S
+ σ 2 S 2 2 + (r − D)S − rV = 0.
There are two main ways of modelling dividend payments: as continuous
The standard Black-Scholes equation derived earlier in the course is just a and as discrete.
special case of this equation for the case when D = 0. Valuing European
call and put options is reasonably straightforward, the main difference being 6.2 Continuous constant dividend yield
that r is replaced by r − D but only in the coefficient of the ∂C/∂S. To
account for this slight difference introduce This is the simplest payment structure, assume that over a period of
time dt the underlying asset pays out a dividend DSdt in that D is the
V (S, t) = e−D(T −t) V1 (S, t) proportion of the value of the asset paid out over this period of time. D
is considered to be constant and independent of t though the size of the
so that we now have dividend will obviously depend on S which is dependent on t.
How does this affect our model? By using arbitrage arguments (see
∂V1 1 2 2 ∂ 2 V1 ∂V1
+ σ S Examples 1) a payment of dividends results in the underlying asset price
∂t 2 ∂S 2 ∂S
+ (r − D)S − (r − D)V1 = 0
dropping by the value of the dividend. Hence with a continuous dividend
which is the Black-Scholes equation only with r replaced by r − D and with the stochastic process is given by
the same final conditions. As such
dS = (µ − D)Sdt + σSdW.
C(S, t) = e−D(T −t) SN (d10 ) − Xe−r(T −t) N (d20 )
To derive the governing PDE a similar process is followed but although the
where portfolio is still
Π = V − ∆S
log(S/X) + (r − D + 12 σ 2 )(T − t)
d10 = √ in this case
σ T −t
dΠ = dV − ∆(dS + DSdt)
log(S/X) + (r − D − 12 σ 2 )(T − t)
d20 = .
as the holder of the portfolio receives the dividend as well. Proceeding as
√
σ T −t
for the non-dividend case
6.3 Discrete dividend payments
∂V ∂V ∂2V
dV = dt + dS + 12 σ 2 S 2 2 dt,
When considering options where the underlying is a stock then a more ∂t ∂S ∂S
realistic model is to treat dividends as being paid at discrete points in time.
and so
This is because most companies pay out their dividends periodically, every
quarter, every six months, every year etc. ∂V ∂V ∂2V
dΠ = dt + (
Assume, as a starting point, that just one dividend payment is made ∂t ∂S ∂S
− ∆) [(µ − D)Sdt + σSdW ] − ∆DSdt + 12 σ 2 S 2 2 dt.
during the lifetime of the option. Assume that this is paid at time td and
Setting
can be expressed as a percentage of the level of the underlying, i.e. as dy S ∂V
∆=
∂S
where 0 ≤ dy < 1. Thus the holder of the asset receives a payment of dy S at
td where S is the asset price prior to the dividend payment. How does this
affect the asset price? By the usual arbitrage arguments if t− d is the time

43 42
 We can simplify the methodology slightly by the following procedure: immediately before the dividend is paid and t+
d is the time immediately after
we have
Let C(S, t) be the standard European call option and Cd (S, t) be an
option on an underlying asset paying discrete payments. If there is just one S(t+ − −
d ) = S(td ) − dy S(td )
payment at td then from above we have
d)
= (1 − dy )S(t−
Cd (S, t) = C(S, t; X), t+
d ≤t<T
+ where S(t) is the value of the underlying asset at time t. There is a jump
Cd (S, t−
d ) = Cd (S(1 − dy ), td ) in the value of S, in that the value of the underlying asset is discontinuous
= C(S(1 − dy ), t+
d ; X). across the dividend date. What effect will this have on the option price?
Again in order to eliminate any possible arbitrage opportunities, the
For t < t−
d there is a shortcut to using the BSE. Prior to the dividend value of the option must be continuous as a function of time across the
payment the value of the call option is just subject to a scaling in S, i.e dividend date. In which case the value of the option immediately before the
S 7→ S(1 − dy ) as such C(S(1 − dy ), t; X) still satisfies the Black-Scholes dividend payment must be the same as the value immediately after (recall
equation. As this is equal to the value of Cd (S, t) at td then the two are also that the owner of the option does not receive the dividend) thus
equivalent for t < td . Thus if we can find the value of C(S(1 − dy ), t; X)
then we’ll know the value of Cd for t < td and hence for all t. + +
V (S(t− −
d ), td ) = V (S(td ), td ).
At expiry,
This brings to light something interesting in the relationship between S
C(S(1 − dy ), T ; X) = max(S(1 − dy ) − X, 0) and t. In the Black-Scholes methodology S and t are considered to be
X independent variables although S is clearly dependent on t, this is possible
, 0)
as we consider every possible value of S at a particular point in time, rather
= (1 − dy ) max(S −
1 − dy
than just one. This is because given the random movement of stock prices,
which is the same as (1 −dy ) calls with an exercise price of X/(1−dy ), hence S can take any value.
we now know the value of the call option for 0 ≤ t < td , which is As S is not fixed across the dividend date, in fact we know that S(t+ d)=
X (1−dy )S(t−d ) then there is no contradiction in the above relationship between
). +
Cd (S, t) = (1 − dy )C(S, t; V (t−
d ) and V (td ), as we have
1 − dy
+
In conclusion V (S, t−
d ) = V (S(1 − dy ), td ).

X So the option value is continuous across the dividend date even if the value
y .
(1 − dy )C(S, t; 1−d ) for 0 ≤ t < td
Cd (S, t) = of the underlying is discontinuous and the relationship is given above.


C(S, t; X) for td ≤ t < T

which can be valued using the standard option pricing formulae. 6.3.1 Example: pricing a European call option when there is one
Remark: Note that if the underlying asset pays a dividend then this dividend payment
decreases the value of the call option, since the holder of the the option does As usual we work back from the known conditions at expiry to derive
not receive the dividend yet a dividend payment reduces the value of the the option value at a previous time. Moving backwards from expiry to just
underlying asset. Correspondingly the value of a put option increases when after the dividend payment time, namely t+
d . At the dividend payment date
dividends are paid. we implement the jump condition
+
C(S, t−
7 American Options d ) = C(S(1 − dy ), td ).

then value the option back to any desired time t using these option values
American options are options which can be exercised at any time to
as new final conditions. Essentially you have to solve the Black Scholes
equation twice
receive S − X or X − S for call and put options respectively. Unfortunately
this gives rise to a non-linear problem and as such it is not possible in
general to derive explicit formulae like those for European options. • Once for T > t > td with C(S, T ) = max(S − X, 0).

d)
• Once for td > t > 0 with C(S, td ) = C(S(1 − dy ), t+

45 44
 96 7.1 American put options
The first problem is to decide at which values of S and t it is optimal
94
to exercise. To consider the problem, treat the American put option as a
European put option with the extra early exercise feature. At expiry the
92
early exercise condition has no effect, as the value of the American put,
P (S, t), is given by
90 P = PBS (S, t) P (S, T ) = max(X − S, 0).
Moving back from expiry there will, however, be certain values of S for

S
88
which
86
X − S > PBS (S, t)
where PBS (S, t) is the value of the European put option derived from the
84 Black-Scholes PDE. In this case the holder of the option would exercise their
S = Sf (t) right and receive X − S. The major problem is to locate the value of S at
82 P =X −S which it becomes optimal to exercise the option, if we call this value Sf (t)
then we have
80
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 P (S, t) =
X − S for S ≤ Sf (t)


T −t PBS (S, t) for S > Sf (t).

This is known as a free boundary problem and they are very difficult to solve.
Figure 8: The position of Sf (t) and the valuation regions for an American
More formally when pricing American options the Black-Scholes equation
put option.
becomes an inequality, which is an equality when it is optimal to hold the
option:
7.2 American call options
∂P 1 ∂2P ∂P
+ σ 2 S 2 2 + rS
If the underlying asset pays no dividends then pricing an American call ∂t 2 ∂S ∂S
Sf (t) < S < ∞ : P > X − S, − rP = 0,
option is remarkably simple. Recall that these options can be described as and an inequality when it is optimal to exercise
a European call with the added feature that it is possible to exercise at any
∂P 1 ∂2P ∂P
time to receive S − X. However, consider a portfolio + σ 2 S 2 2 + rS
∂t 2 ∂S ∂S
0 ≤ S < Sf (t) : P = X − S, − rP < 0.

Π=S−C The boundary conditions are as follows:

where C is a European call option, so at expiry P (S, T ) = max(X − S, 0),

P (Sf (t), t) = X − Sf (t),
as
Π = S − max(S − X, 0) ≤ X
P (S, t) → 0 S → ∞.
hence, for t < T where the first and third are as for a European put option but the second
S − C ≤ Xe−r(T −t) is one of the conditions on the free boundary, Sf (t). There is another, less
or obvious condition at S = Sf (t), known as the smooth pasting condition
C ≥ S − Xe−r(T −t) ≥ S − X which ensures that the ∆ (= ∂P/∂S) is smooth across the early exercise
boundary, namely
thus it is never optimal to early exercise this American call option and ∂P
so the price is the same as for a European call option. This is not the case ∂S
(Sf (t), t) = −1.
when the underlying asset is paying continuous dividends as one can observe If this were not the case then there are arbitrage possibilities (see the expla-
from the option profiles in figures 9 and 10. In the continuous dividend case nation in Wilmott, Howison and Dewynne, 1995, p. 110-111)
the problem becomes similar to that for the American put, with analogous
boundary conditions.

∂C 1 2 2 ∂ 2 C ∂C In general, numerical methods must be used to price American put op-

0 < S < Sf (t) : + σ S tions. There is one exception though and that is the perpetual case.
∂t 2 ∂S 2 ∂S
C > S −X, +(r −D)S −rC = 0,

47 46
 35

30

25

20

C(S,t)
15

10
t=0
80
5

70 t=T

0
60 75 80 85 90 95 100 105 110 115 120 125
S

50 Figure 9: The value of C(S, t) at t = 0, t = T /2 and t = T on a non-dividend

paying asset - note how the value of C(S, t) does not drop below S − X.

C(S, t)
40

and an equality when it is optimal to exercise

30

∂C 1 2 2 ∂ 2 C ∂C
C = S−X, + σ S +(r−D)S
20 ∂t 2 ∂S 2 ∂S
Sf (t) < S < ∞ : −rC < 0.

The boundary conditions are as follows:

10

C(S, T ) = max(S − X, 0),

0
70 80 90 100 110 120 130 140 150 160 170 180 C(Sf (t), t) = Sf (t) − X,
S
C(0, t) = 0.
Figure 10: The value of C(S, t) at t = 0, t = T /2 and t = T on a dividend
and there is also an equivalent smooth pasting condition:
paying asset - note how the value of C(S, t) can drop below S − X.
∂C
(Sf (t), t) = 1.
∂S

49 48