MSM3G11/MSM4G11

Mathematical Finance
These lecture notes follow the recommended text of Wilmott, Howison and Dewynne. It
is recommended that students purchase this textbook. This book contains many more
details and examples of great interest, aimed at the audience of this module.
As already noted this module assumes no previous knowledge of mathematical nance.
The objective is for students to gain a fundamental understanding of the concepts un-
derpinning mathematical nance and to be able to apply the appropriate mathematical
tools derived in this course.
1 Introduction
It is virtually impossible not to notice that the current nancial world is in absolute
turmoil: major banks, insurance companies, investment houses, etc., are collapsing, re-
structuring, struggling, merging . . . . The projected job losses in the nance sector in the
UK are estimated to be in the 10s to 100s of thousands. What has gone wrong?
This course is meant to be an introduction to mathematical nance and the simplest
possible nancial models will be discussed. The recent troubles in the worlds nancial
markets are beyond the scope of this module, and indeed, beyond the scope of most
advanced nancial theory. Research into more sophisticated models of mathematical
nance is likely to be a signicant growth area in the future.
1.1 Stocks, shares and equities
The terms stocks, shares and equities essentially mean the same thing and are used
interchangeably. Suppose company XYZ wishes to raise money to build a new factory.
XYZ thinks that it will be able to make a prot by building the new factory (and then
selling whatever it is that is produced in the factory). XYZ then sells shares in itself
to investors, in order to nance the new factory. The investors, or shareholders, then
share the ownership of the company, based upon the number of shares that each investor
owns. If XYZ then makes a prot, it can choose to pay a dividend to shareholders, or it
may choose to invest the prot in some other way. If company XYZ is then subsequently
sold, the proceeds from the sale is then split amongst the shareholders (according to the
number of shares that they own). If XYZ is sold its net worth is equal to the sum of all of
its assets (e.g.. property, inventory, IPR, etc.) minus the sum of all of its liabilities (e.g..
outstanding loans, deferred tax payments, pension plan commitments, etc.). If there are
n outstanding shares in the company XYZ then the value V of share can be approximated
as
V
1
n
(AL) + D
1
where A represents the sum of all assets of XYZ, L represents the sum of all liabilities
of XYZ and D represents a contribution due to the expected dividend per share that
will be paid out by XYZ. Clearly V should increase if the expected dividends from XYZ
increase. Similarly, V should increase if the dierence (A L) increases. The diculty
with actually assigning a value to V is that dierent people may have dierent opinions
about the values of A, L and D. (Why might this be the case?).
The actual value of a share is determined when the buyer of a share, and the seller of
a share, agree a sale price. (In reality most shares are bought and sold by an intermediary
known as a stockbroker. The seller agrees to sell at the bid price, and the buyer agrees
to buy at the ask price. The ask price is always greater than the bid price, and the
stockbroker makes a commission of ask price - bid price for each share sold. During
the rst term of this module we will ignore the eects of commission charges and assume
that the ask price and the bid price are equal. The eects of commission will be discussed
in the second term of this module). The buyer of a share hopes that the value of the
share will increase and/or to receive dividend payments such that their investment is
worthwhile. The seller of a share wishes to release the value of their investment, either
to make further investments, or to fund other expenditures (e.g. a new car, a holiday,
retirement, education, etc.). The value of a share is only determined when a buyer and a
seller agree a sale price. The value of stocks listed in the news media and online reect
the most recent sale price agreed between a buyer and a seller, or, the last sale priced
agreed at the end of a business day.
1.2 Supply and Demand
Ultimately, the value of shares are determined by the laws of supply and demand. Suppose
there are a large number of investors who feel that purchasing shares in company XYZ
is a good investment (i.e. demand is high), but there are relatively few people willing to
sell these shares (i.e. supply is low). In this case the sellers are at liberty to increase the
price at which they are willing to sell their shares since the shares are in high demand.
Conversely if a large number of investors feel that shares in XYZ are a poor investment
and they all attempt to sell their shares then supply will be high. If there are relatively
few investors wanting to buy these shares (i.e. demand is low) then buyers can agree to
buy these shares at a lower price. Since the value of a share is only determined when it is
bought and sold, the value will be determined when there is a balance between supply and
demand. In particular the share price must be suciently high that the seller is willing
to sell while simultaneously being sucient low that the buyer is willing to buy.
1.3 Long selling and short selling
The term long is used to refer to assets that you actually own. For example if you are long
10 shares in company XYZ you own 10 shares in this company. The term short refers
to assets that you do not actually own, but that you are willing to trade in. The practice
of short selling has frequently been in the news in the recent months and weeks, and it
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refers to selling shares that you do not actually own. Laws which allow for short selling
are currently being examined very closely. When you short sell, you sell (at the current
market value) shares which you do not actually own. At some specied, or unspecied
time in the future, you are then obliged to purchase the shares at the new market value.
When you short sell, you are taking the position that the value of the share will fall in the
future, and you will thus make a prot. If the value of the share increases in the future
and you are obliged to purchase the shares which you originally short sold, you will make
a loss.
The practice of short selling relies on the existence of a stockbroker with many clients.
Suppose client A wishes to short sell 10 shares in company XYZ, and client B owns 10
shares in this company. The stockbroker, assuming he trusts client A, can then sell client
Bs shares in XYZ subject to client A agreeing to return these shares to client B at some
point in the future. Any dividends that are paid out on shares in XYZ in the intervening
period must be paid directly from client A to client B. If at any time client B actually
wishes to sell his shares in XYZ, then client A is immediately obliged to purchase the
shares that he originally short sold. In reality the stockbroker will have many clients
with shares in company XYZ, and if client B wishes to sell his shares in XYZ that were
originally sold by client A, then client A can then borrow shares in XYZ from client C,
and so on. If the stockbroker runs out of additional clients with shares in XYZ, then client
A is short-squeezed and he must immediately buy the shares at the prevailing market
value.
The reason short selling has been in the news recently is directly related to the laws
of supply and demand. People short sell shares because they feel that the price of the
share will fall in the future. If a large number of shares are short sold (thus articially
increasing the supply of shares) it is possible that the market will respond by decreasing
the value of the shares and subsequently yield a prot to the short seller. Of course if
demand outstrips supply, than the short seller will make a loss.
(Question: Do you think short selling caused the collapse of HBOS? No doubt this
will be the topic of many PhD theses and research papers in the future.)
1.4 Arbitrage
One of the most important concepts in Mathematical Finance is that of arbitrage. This
term is used to mean that it is impossible to make an instantaneous risk-free prot.
More accurately, the concept of arbitrage demands that opportunities to make risk-free
prots will vanish quickly due to the market forces of supply and demand. As an example,
suppose that the shares of company XYZ are traded in pounds sterling on the London
Stock Exchange and in American dollars on the New York Stock Exchange and that the
shares traded on these two stock exchanges are identical (i.e. oer the same dividends,
same ownership rights, same voting rights, etc., and can be sold freely on either market
regardless of where they were purchased from). Further suppose that the exchange rate
between pound sterling and the American dollar is 1 = $2. What would happen if the
price of a share in XYZ was $2.00 in New York, and 1.10 in London? Ignoring the eects
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of commission charges and any tax implications, the prudent investor would buy shares
in XYZ in New York and then immediately sell them in London gaining an instantaneous
10 pence prot per share. Presumably there are many prudent investors out there and
they will buy as many shares in XYZ in New York as possible, and then instantly sell
them in London. The large demand to buy XYZ on the New York stock exchange will
drive the price of XYZ up in New York. The large supply of XYZ which are being sold in
London will drive down the price of XYZ in London. Very quickly, the laws of supply and
demand will ensure that the eective price of XYZ is the same on both stock markets.
An important point is that the nancial institutions with access to the lowest commission
costs, are also the ones trying to take advantage of arbitrage opportunities. The more that
these institutions compete with each other to take advantage of an arbitrage opportunity,
the faster that opportunity vanishes.
1.5 Risk
In mathematical nance the term risk specically refers to uncertainty. The value of
a nancial investment may go up as well as down (as we are constantly reminded by
the Financial Services Authority). Each individual investor must evaluate the risks of
each individual investment and make their investment decisions accordingly. High risk
investments are expected to have the potential to earn a great deal of money for the
investor, but they also have the potential to lose a great deal of money for the investor.
Conversely low risk investments are expected to earn a lower amount of money, but they
also have a lower potential of losing money. Nothing is certain in the nancial market
(certainly within the current nancial market) and what constitutes a high risk or a low
risk opportunity is ultimately reected in the price agreed to between the buyer and seller
of any nancial product.
In nancial theory there are dierent types of risk. The term specic risk refers
to the risk associated with investing in a specic company. The term non-specic risk
refers to the risk associated with investing in a particular market as a whole. For example,
there is a non-specic risk at the moment associated with investing in the Aviation sector
(on a global scale all Airlines are faced with high fuel costs at present, and there is no
particular reason to assume any one airline should perform better or worse than any other
airline ... there is a risk associated with investing in airlines, but that risk is faced by
the sector as a whole). On the other hand, there may be a specic risk associated with
investing in Quantus Airlines (in the past couple of months they have been involved in
several serious safety incidents). The Aviation sector seems risky on the whole at the
moment, but, if you choose to invest in an airline that out performs its competitors in
the current nancial situation, than you are likely to make a prot in the long term.
Current investors in Quantus may be willing to sell on the cheap at the moment because
of future safety concerns (or more likely the view of the market on future safety concerns).
Ultimately, market forces will reect the value of a share in a company quoted on a stock
exchange. People who feel that there is a strong risk that the company will decrease in
value will sell their shares and drive the value of the share down. People who feel that it
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is worth the risk to invest in the company will buy shares and then drive the value of the
share up. Market forces ultimately will determine the value of a share.
1.6 Risk-free investments and arbitrage
Most nancial models assume the (theoretical) existence of risk-free investments which
give a guaranteed return. In this course we will assume that money deposited in a sound
bank which earns interest at a rate r is a risk-free investment. (Is this true in the current
nancial climate?) If I represents the amount of money deposited in the bank, r represents
the interest rate (which is continuously compounded) and t represents time, then the value
of the risk free investment varies as
dI
dt
= rI. (1)
This is a separable rst order dierential equation and it can easily be solved according
to the appropriate initial conditions. Suppose that at time t = t
o
an amount I = I
o
is
invested and further suppose that the interest rate r is constant. We thus obtain
I(t) = I
o
e
r(tto)
(2)
At a later time t = T the value of our investment is simply I(T) = I
o
e
r(Tto)
. The increase
in the value of our risk-free investment (i.e. our risk free prot) is
P
rf
= I(T) I(t
o
) = I
o
e
r(Tto)
I
o
= I
o
_
e
r(Tto)
1
_
(3)
Note, if this investment is risk-free to the investor depositing the money, it is also risk-
free to the bank. The risk-free cost (to the bank) of borrowing an amount I
o
at time
t
0
and repaying the loan at time T is simply P
rf
above. It is a risk-free cost since the
bank knows its liabilities at time t = T exactly, when it agrees to the investment at
time t = t
o
. In reality, depositing money in a bank is not risk-free (What happens if the
bank goes bankrupt? How much of your investment is secure?) Banks would also claim
that loaning money is never risk-free (what happens if the client cannot repay the loan?).
Nevertheless, the concept of a risk-free investment is central to Financial Mathematical
modelling. In an ideal economy, market forces will determine the appropriate rates of
interest for borrowing and depositing.
Now that we have dened a risk-free investment, we can re-examine the concept of
arbitrage which states that it is impossible to make an instantaneously risk free prot.
Interest earned on a bank deposit is risk free but it is not instantaneous, since interest is
earned over the time period T t
o
. Now suppose there exists an investment opportunity
which costs C = I
o
at time t = t
o
and is guaranteed (so that there is no risk whatsoever)
to have a return at time t = T of I
T
so the net prot P
hypothetical
from this hypothetical
investment is
P
hypothetical
= I
T
I
o
(4)
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The relevant question is whether or not you should invest in this hypothetical, risk-free
investment. If
P
hypothetical
< P
rf
(5)
you should denitely not invest, since you can make more money simply by depositing
your money in the bank. If
P
hypothetical
> P
rf
(6)
you should denitely invest. The optimal strategy would be to borrow the amount I
o
from
a bank, at a known risk-free cost of P
rf
and then instantaneously purchase the hypothetical
investment to yield an instantaneous risk-free prot of P
hypothetical
P
rf
. This prot will
only be realized at time t = T, but you know instantaneously at time t = t
0
that you
will yield this prot (with no risk whatsoever). Clearly you, and all sensible investors
will try to borrow as much money as possible, so that you can immediately invest in our
hypothetical investment. According to the laws of supply and demand this will increase
the rate of interest and thus increase your cost P
rf
of borrowing, and it will also increase
the cost of the hypothetical investment, thus decreasing the return on your investment
P
hypothetical
. Ultimately market forces will ensure that the guaranteed prot from our
hypothetical investment will balance the prot that could be obtained by depositing our
money in the bank.
The principle of arbitrage is eected by friction factors such as commission costs, the
fact that banks have dierent interest rates for borrowing and lending, and possible tax
implications of dierent investment opportunities, but in general it is sound. Market
forces are such that possibilities to make instantaneous risk free prots can only exist for
a very short time. Remember, there are a great deal of investors who are continuously
searching for opportunities to make risk-free prots.
1.7 Hedging
Other than depositing money in a bank (or investing in similar products) the concept
of arbitrage argues that other investment opportunities cannot be risk-free. There are
certainly investment opportunities that have the potential to earn a greater possible return
than by simply depositing your money in a bank, but there is also the risk that you will
have a smaller return or even lose your money altogether. The term hedging is used
to refer to investment strategies that are designed to reduce or minimise the risk to a
portfolio of investments. Hedging may result in smaller overall prots, but hopefully it
will also reduce the likelihood of large losses.
One hedging strategy is to invest in negatively correlated market sectors. Suppose
you believe that investing in shares in the aviation sector is risky because of high fuel
costs. One possible strategy might be to also invest in shares in the Oil sector. If one of
your investments falls in value, it is likely that the other investment will rise in value. If
you have the right balance of shares in the two sectors, it is possible to remove a large
component of the risk in your total portfolio. Determining the optimal balance of shares
in various market sectors is obviously the challenge.
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There also hedging strategies that are based on investing in nancial products intrin-
sically related to the same shares. These products, known as nancial options or nancial
derivatives, are the primary subject of this course. We shall learn how to assign a value
to these nancial products, and how to combine them to reduce the level of risk
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2 What are Financial Options?
Financial options (also known as nancial derivatives) are investment products which are
based on a contract between two parties which places options and obligations to each of
the parties to either buy or sell shares in a specied company at a specied price in the
future. Financial options were originally (and can still be) contracts agreed to between
two interested parties (often negotiated through an intermediary). Today options are
openly traded on various stock markets and can be bought and sold by interested investors.
Options can be used to either speculate (i.e. bet on the future performance of a particular
stock) or as a tool for hedging (reducing the risk associated with a nancial portfolio).
There are many dierent types of options and we shall begin by looking at the simplest.
2.1 European Call Option
The simplest type of option is the European Call Option (often called a vanilla call or
European vanilla call ... why vanilla? This option is as simple as they come!). This is a
contract with the following conditions:
At a certain time in the future, called the expiry date or expiration date, the holder
of the option may choose to purchase a certain specied asset, called the underlying asset
or the underlying (e.g. a share in a company, or currency, or a commodity etc), for a
certain price known as the exercise price or strike price. The holder of the option has the
right to buy the underlying on the expiry date, but they do not have to, which is why it
is called an option. The other party to the contract, called the writer, has an obligation:
they must sell the asset to the holder for the strike price on the expiry date if the holder
chooses to buy it. When the contract is started, the holder pays the writer a fee for this
contract (usually via some middleman at the futures and options market) i.e. the holder
buys the option from the writer. Moreover, the options contract can be traded at any
point up to the expiry date e.g. if you buy the option from the holder then you become
the holder. Throughout this term we will assume that there are no commission charges
associated with the buying or selling of options, or the subsequent purchase and sale of
the underlying.
Note: if the underlying is a share of a company, the option has nothing to
do with that company. The option is a contract between two parties (often
large companies, investment rms, banks, etc.) about the option of buying a
share in that company. If the option is bought/sold on the open market than
the holder need not know the identity of the writer. The volume of trading
in options in an underlying share can often exceed the volume of trading in
the underlying shares themself.
Further Note: European options are traded all over the world and the
designation European specically refers to the options as described above
where the option/obligation to buy/sell shares is based on the value of the
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underlying share at a specic time (which is typically just after the close of
the markets on the expiry date). There are also American options which
will be described later on in this term, and Asian options which will be
discussed during term 2 of this module. Again the terminology is used to
refer to specic aspects of the contract between the writer and holder of the
option, and these options can be traded worldwide. Presumably the terms
European, American and Asian refer to where these types of options were
rst introduced, or, where they are most popularly traded.
Example: Today the share price of Johnson Matthey PLC is 1677 pence. I buy a
European call option today where the underlying is one share of Johnson Matthey PLC.
The expiry date is 1st December and the exercise price is 1700 pence. It costs me 20
pence to buy the option from the writer. I am the holder of the option.
(a) Suppose on 1st December that the share price is 1742 pence. I then as the holder
of the option have the right to buy a share of Johnson Matthey PLC for 1700 pence which
is actually worth 1742 pence. So I may buy the share from the writer for 1700 pence (this
is called exercising the option), and if I choose, I could immediately sell that share on the
stock exchange for 1742 pence, making an immediate prot of 1742-1700=42 pence. But
it cost me 20 pence to buy the option in the rst place, hence I make an overall prot of
42-20=22 pence.
(b) Suppose instead on 1st December that the share price is 1689 pence. I then as
the holder of the option have the right to buy a share of Johnson Matthey PLC for 1700
pence which is actually worth only 1689 pence. Hence I choose not to use the option
to buy the share, and hence the option has become worthless. Hence I make an overall
loss on this deal of 20 pence, which was the price that the option originally cost me to buy.
Notice that the overall prot or loss is a large percentage of the original cost of enter-
ing into the contract in the rst place. So in case (a), I make an overall prot of 22/20 x
100% = 110% on my original investment. In case (b), I lose all my original investment,
and so I make a 100% loss on my original investment.
In contrast, suppose I didnt buy the option today, but I instead bought one share
of Johnson Matthey PLC today. That would have cost me 1677 pence. In case (a), the
share would have risen to 1742 pence, giving me an overall prot of 1742-1677=65 pence
by the 1st December. This is an overall prot of 65/1677 x 100%=3.88%. In case (b), the
share would have risen to 1689 pence, giving me an overall prot of 1689-1677=12 pence.
This is an overall prot of 12/1677 x 100%=0.72% of my original investment.
Hence in case (a), if I had bought the option I get a 110% prot on my investment,
while if I had bought the share I would have instead received a 3.88% prot on my in-
vestment.
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In case (b), if I had bought the option, I would have had a 100% loss on my original
investment, while if I had bought the share then I would have instead received a 0.72%
prot on my investment.
This eect is called gearing. It means if you invest a certain sum of money in options,
then the potential prots or losses are much greater than if you invested the same amount
of money on shares. Imagine this eect when we are not dealing with pence, but instead
with hundreds of millions of pounds. Throughout this course you must try to think
of things in terms of investments made by large banks / investment rms who will be
investing large quantities of money and who have the capacity to expose themselves to
larger levels of risk. The laws of supply and demand will not be eected by one individual
investor buying one call option for one share. It is the large investors who ultimately
inuence the market.
Example: Consider the previous example from the point of view of the writer of the
option instead. Today the writer receives 20 pence when writing the option. In case (a),
the holder forces the writer to sell a share for 1700 pence, which is actually worth 1742
pence, on 1st December. Hence the writer makes a loss at that point of 1742-1700=42
pence. But the writer originally received 20 pence when writing the option, and hence
the writer makes an overall loss of 42-20=22 pence.
In case (b), the holder does not exercise the option, and hence the writer has made
an overall prot of 20 pence.
Note: The above examples have introduced the mechanics of buying/selling
and choosing or otherwise to exercise a European vanilla call option, but note
that the cost/value of the option was specied. One of the primary objectives
of this course is to examine how the cost/value of an option can be determined
so that it correctly reects the risk which is being assumed by both parties to
the contract.
2.2 European Put Option
The next simplest type of option is the European Put Option (often called a vanilla put
or European vanilla put). This is a contract with the following conditions:
At a certain time in the future, called the expiry date or expiration date, the holder
of the option may choose to sell a certain specied asset, called the underlying asset or
the underlying (e.g. a share in a company, or currency, or a commodity etc), for a certain
price known as the exercise price or strike price. The holder of the option has the right
to sell the underlying on the expiry date, but they dont have to. The other party to the
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contract, called the writer, has an obligation: they must buy the asset from the holder for
the strike price on the expiry date if the holder chooses to sell it. When the contract is
started, the holder pays the writer a fee for this contract i.e. the holder buys the option
from the writer. Moreover, the options contract can be traded at any point up to the
expiry date e.g. if you buy the option from the holder then you become the holder.
2.3 Exercising options
The holder of a call option is said to be in the money on the expiry date if the share
price on the expiry date of the option is greater than the strike price. The holder can then
immediately realize his/her prot by buying shares from the writer at the strike price and
then selling these shares on the open market. Alternatively, the holder may choose to
purchase the shares at the strike price and then retain them as part of their investment
portfolio. Dierent investors will have dierent investment strategies depending on their
current feelings of the nancial market. If the holder of a call option is in the money,
it is sometimes possible for the writer to pay the holder the net dierence between the
share price at expiry and the strike price, instead of the holder actually going through
the act of purchasing and immediately selling shares. This of course will depend on the
ner details of the option contract.
2.4 What is the value/cost of an option?
Suppose you are interested in buying a call option. How much should you pay? There
are certain things that are known. You purchase a call option because you expect the
share price S on the expiry date to be greater than the exercise price E. This denitely
means that the cost of a call option should be inversely related to the exercise price (i.e.
the lower the exercise price, the higher the cost of the option). The share price S on
the expiry date is not known, but, the share price at the time the option is purchased is
known, and this should presumably inuence the price of the option (a call option to buy
a share with a current market value of 1000 pence should presumably be more expensive
than a share with a current market value of 100 pence). Further, the price of the option
should depend on the current (and projected) rate of interest (instead of investing in the
option, the holder can choose to make a risk free prot by depositing money in the bank),
as well as the time until the expiry date (which not only eects the amount of risk free
interest that can be earned, but, also inuences the risk/uncertainty associated with the
unknown share price at the expiry date).
Consider the following scenarios. On January 1st you purchase a European vanilla
call option for shares in XYZ at a cost of 100 pence with an expiry date of September 1st
and an exercise price of 1000 pence. Todays date is August 1st (one month before the
expiry date). What do you do if:
(a) The current share price is 1200 pence and another investor oers to buy your call
option for 10, 50, 100, 200, 300, . . . pence, or,
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(b) The current share price is 800 pence and another investor oers to buy your call
option for 5, 10, 50, 100, 200, . . . pence?
In case (a) you are in the money if the share price of XYZ is the same on the expiry
date as it is on August 1. In case (b) you are out of the money if the share price of XYZ
is the same on the expiry date as it is on August 1. In either case the option can only be
exercised (if at all) on the expiry date. The value of XYZ might rise or fall in value in
the next month and dierent investors might have dierent views on this. In case (a) you
may be willing to accept an oer of 200 pence for your option since this would guarantee
you a prot of 100 pence on your original investment. This might be a good decision if
you think the value of XYZ is going to fall in the next month. Alternatively, you may
still think that the price of XYZ is going to rise, but, you choose to sell on August 1st
since you are happy to settle for a known prot (you may need this money immediately
to pay o an imminent liability, or you may feel that you can use this money to invest in
an even more lucrative venture). In case (b) you can choose to hold on to your option in
the hope that the value of XYZ will rise above the exercise price, or, you choose to sell
the option to minimise your losses. The purchaser of the option in case (b) may well be
taking a large risk, so, he/she is unlikely to oer too high of a price for the option.
The key point is that both the buyer and seller of an option are subject to risk since the
value of XYZ on the expiry date is not known. The buyer and the seller of an option have
to agree a sale price for the option, so, the sale price is to a certain extent determined by
the laws of supply and demand. Nevertheless, we have to assume that both the buyer and
the seller are prudent. Using the theory of mathematical nance it is possible to determine
(estimate) the cost/value of an option that fairly reects the risk to both parties. The
buyer and the seller may have dierent estimates, but, at the very least, mathematical
nance can be used as a starting point for the negotiation of the sale price.
2.5 Pay-o functions and pay-o diagrams
So far we have dealt with hypothetical data with regards to the cost of options and the
prots that can be realized on the expiry date of the option. Let us consider a real world
example. This example is based on the FT-SE index on 4 February 1993 as reported
in the recommended text of Wilmott, Howison and Dewynne (1995). The FT-SE index
represents a weighted average of the London Stock exchange and holders/writers of call
Exercise Price 2650 2700 2750 2800 2850 2900 2950 3000
Cost of Call 233 183 135 89 50 24 9 3
Table 1: The cost of European Call Options on the FT-SE index on 4 February 1993 with
an expiry date of 14 February 1993. The index value on 4 February 1993 was 2872 pence.
12
options on the FT-SE index either hope that the index will go above/below the exercise
price of the call option respectively. On 4 February 1993, the value of one share in the
FT-SE index was 2872 pence. Table 1 lists the cost of purchasing European call options
on February 4 for dierent exercise prices with a known expiry date of 14 February 1993.
The option price is plotted versus the exercise price in Figure 1. Also plotted in Figure
1, as a solid line, is the hypothetical value of the option (share value at expiry minus
exercise price) assuming that the share value on the expiry date is the same as it is on 4
February 1993. Observe that the cost of purchasing a call option today exceeds the return
that would be achieved if the underlying value of the share in question has the same value
on the expiry as it has on the day the call option was sold. This is perfectly consistent
with the presumption that purchasers of call options feel that the share price will increase
in value (or more specically, above the strike price) by the expiry date. Note that call
options can be bought and sold for strike prices above or below the current value of the
underlying share and the buyer of a call option is specically making an investment based
on a specied exercise price.
2650 2700 2750 2800 2850 2900 2950 3000
Excercise Price
0
100
200
300
C
a
l
l

P
r
i
c
e
Figure 1: The price of FT-SE index call options versus exercise price on 4 February 1993.
The data plotted in Figure 1 is based on information that is known today as opposed
13
to information that is known at the expiry date. In particular the price of an option is
plotted versus the exercise price. Once an investor has purchased an option the exercise
price is xed, and it is more important to know the value of the option as a function of
the unknown value of the underlying at the expiry date.
European vanilla call
The European vanilla call option can be characterised by its pay-o function. This
is the function, of the underlying share price S, which gives a formula for the immediate
prot to the holder of the option at the expiry date. For a European vanilla call, we have
seen that the holder only chooses to exercise the option (i.e. to buy the underlying share
from the writer) if the share price S of the underlying is greater than the strike price E
on the expiry date. If this is the case (i.e. S > E) then it is possible for the holder to buy
the underlying from the writer at price E (the strike price) and to sell it immediately on
the stock exchange for the share price S, making an immediate prot of S E.
However, if S < E, then the holder will choose not to exercise the option (i.e. why
buy a share for price E when the holder can get it more cheaply on the stock exchange for
price S). Therefore, if S < E, then the immediate prot is 0 to the holder of the option
since the option has become worthless.
So, ignoring the fee paid by the holder for the call option in the rst place, the
immediate prot on the expiry date for the holder is equal to S E if S > E, and equal
to 0 if S < E. This is called the pay-o function of the option. So the pay-o function
for a European vanilla call is
S E, when S > E,
0, when S < E.
This can be written in a simplied form as
max(S E, 0),
where max is a dened as the function which chooses the maximum of the two numbers
in the brackets.
Therefore, we say that the pay-o function of a European vanilla call is equal to
max(S E, 0). If we sketch a graph of max(S E, 0) on the vertical axis, and the share
price S on the horizontal axis, then this is called the pay-o diagram. (See Figure 2.)
The overall prot on the deal for the holder of the option equals the pay-o minus the
original cost that the holder paid for the option.
European vanilla put
We can repeat the above to work out the pay-o function for a European vanilla put.
For this option, if S > E on the expiry date, then the holder may sell the underlying to
14
0
S
C
E
Figure 2: The pay-o diagram for a European call option.
the writer for price E when in fact the underlying is worth S. The holder would have
to be crazy to do so, and hence the option is not exercised if S > E and the immediate
prot, or pay-o, to the holder equals 0.
If S < E on the expiry date, then the holder may sell the underlying to the writer
for price E when in fact the underlying is worth S. This is a good deal for the holder,
and hence the option will be exercised. Then the immediate prot for the holder (i.e. the
pay-o) equals E S.
So the pay-o function for a European vanilla put is
0, when S > E,
E S, when S < E.
This can be written in a simplied form as
max(E S, 0).
15
Again a pay-o diagram can be sketched. (See Figure 3.)
0
P
S
E
Figure 3: The pay-o diagram for a European put option.
Other European options (binaries or digitals)
Investors buy and sell call and put options because they have a certain view on the
future price of the underlying. Vanilla calls and puts represent the simplest possible type
of options. Options can be used to hedge against uncertainty or to speculate, and we
can now dene some of the most common types of European options by using the pay-o
function.
16
Cash-or-nothing call: pay-o equals
BH(S E),
where B is a constant (a sum of money). The function H is the Heaviside step function.
It is dened as
H(x) = 1 if x > 0,
H(x) = 0, if x < 0.
Therefore, the cash-or-nothing call has pay-o equal to
B if S > E,
0 if S < E.
Bullish vertical spread: pay-o equals
max(S E
1
, 0) max(S E
2
, 0),
where E
2
> E
1
, so that there are two dierent strike prices on this option (E
1
and E
2
).
Supershare: pay-o equals
1
d
(H(S E) H(S E d)) ,
where d is some constant.
Asset-or-nothing call: pay-o equals
SH(S E).
Straddle: pay-o equals
max(S E, 0) + max(E S, 0).
From these denitions you should be able to draw the pay-o function for these more
intricate options. Also, you may wish to look at the various recommended textbooks for
denitions of other common European options.
17
3 Random walk model of asset prices
The term asset is used to collectively refer to stocks, commodities (such as gold, oil,
wheat, etc.), options, currency, etc. The goal of this course is not to explicitly predict
how asset prices will vary as a function of time. If this were possible, the wise investor
would keep it a secret, and happily make as much money as they could regardless of the
overall market performance. In reality, it is not possible to predict with certainty, how
asset prices will vary as a function of time. Figure 4 shows the closing value of the FT-SE
100 stock index on trading days between 1 April 2008 and 21 October 2008. Over this
time period the general market trend is downwards, but there is considerable variability:
on some days the market goes up on some days it goes down. The overall trend in the
data in Figure 4 is for the stock index to go downwards, but on any given day it seems
impossible to predict whether the index is going to go up or go down. In essence there are
random variations which combine with the overall market trend to determine the index
as a function of time. One data point is plotted for each trading day in Figure 4. Similar
uctuations would also be seen if we plotted the index value with a much shorter time
interval (for example once every minute over the course of a trading day). These random
uctuations appear to be an inherent characteristic of asset values. In section 1.2 it was
argued that the value of an asset is determined by the market forces of supply and demand
and that the ultimate value is the price agreed by the buyer and the seller. The random
uctuations are the results of dierent buyer/seller pairs having slight dierences in their
view of the the asset value.
The model we will use in this course is given by the following stochastic dierential
equation
dS = S (dX + dt) . (7)
Here dS is the change in the asset price (i.e. share price) in a small time step dt. Also, S
is the current asset price, is a measure of the average rate of growth of the asset price
(known as the drift), is called the volatility of the share (which measures the standard
deviation of any random variation in the share price), and dX is a random number taken
from a normal distribution. The mean of the normal distribution that dX is taken from
is equal to zero and the variance of the normal distribution is equal to dt. Since the
variance is equal to dt, then the standard deviation is equal to

dt. Therefore, we can

write dX =

dt where is a random number taken from a normal distribution with

mean zero and standard deviation equal to one.
Therefore, the above model describes how the asset price S, changes from S to S+dS,
during a time step from t to t + dt. We will ultimately examine this model in the limit
dt 0.
Note that if = 0 then the above equation simplies to
dS = Sdt. (8)
Therefore, using separation of variables,
_
dS
S
=
_
dt.
18
0 50 100 150
Time (days since 1 April 2008)
3000
4000
5000
6000
7000
F
T

S
E

1
0
0

I
n
d
e
x
Figure 4: Closing values of the FT-SE 100 index call between 1 April 2008 and 21 October 2008
Therefore,
ln S = t + c,
where c is a constant of integration. Therefore,
S = S
o
e
(tto)
,
where the initial condition S = S
o
at time t = t
o
is used. This equation is formally
equivalent to the case of money earning continuously compounded interest in a bank.
For the case of bank interest, however, the interest rate r is always positive. The drift
coecient in equation (8) can be either positive, negative, or even zero. Therefore, we
see that measures the non-random increase in the share price if > 0 (or non-random
decrease in the share price if < 0). Of course, the case with = 0 is not realistic, since
the share price S varies randomly.
Example: Suppose S = 10, t = 1, = 0.1, = 0.01 and dt = 0.01. Then dX
must be a random number selected from a normal distribution of mean 0 and standard
19
deviation equal to 0.1. Of course dX is random and cannot be predicted, but suppose it
was equal to 0.03. (Note that dX could be anything since it is random; this is just an
example of a number it could be!) Then dS = S (dX + dt), which in this case gives
dS = 0.031. So in this time step, t increases from 1 to 1+dt = 1.01, and S increases from
10 to 10 + dS = 10.031.
For the next time step, we now have S = 10.031, t = 1.01, = 0.1, = 0.01 and dt =
0.01. Again dX is a random number selected from a normal distribution of mean 0 and
standard deviation equal to 0.1. Once again dX cannot be predicted because it is random.
But suppose the next value for dX was equal to 0.02. Then dS = S (dX + dt),
which in this case gives dS = 0.0190589. So in this time step, t increases from 1.01 to
1 + dt = 1.02, and S changes from 10.031 to 10.031 + dS = 10.0119411. etc.
The repeated iteration of equation (7) to calculate the value S(t
new
) = S(t
old
) + dS
where t
new
= t
old
+dt is known as a random walk. Since dX is a random variable, repeated
independent walks starting from the same initial position will likely give dierent predicted
values of S at any later time. Thus, equation (7) cannot be used to make predictions
about future asset values. Nevertheless by performing many repeated random walks, it
is possible to make some qualitative statements. Consider the following simple MatLAB
program:
s(1) = 100
mu = 0.1
sigma = 0.01
dt = 1/365
for i = 1:365
dX = randn*sqrt(t);
dS = s(i)*(mu*dt + sigma*dX);
s(i+1) = s(i)+dS;
end
plot(s)
In the above we are assuming that time is measured in years and dt = 1/365 represents
one day. The value of and are specied, as is the value of S on day 1. We have
explicitly assumed that dX =

t where is a normal random variable with mean zero

and standard deviation one. In MatLAB we use the in-built function randn to calculate
the required values of at each iteration. After 365 days (one year) we then plot S as a
function of time. Using this program we can then easily perform repeated random walks
to determine the inuence of varying the various parameters.
Figures 5, 6 and 7 show repeated random walks for dierent values of . In each case
we start with S = 100 and we perform 365 time steps with dt = 1/365. The drift rate is
held xed at = 0.1. In Figure 5 we have set = 0.01, in Figure 6 we have set = 0.1
and in Figure 7 we have set = 0.3. The solid lines in these gures represent the repeated
random walk. The dotted line (which is the same in all gures) represents the exponential
growth that would be expected if = 0. Observe in Figure 5 that when is relatively
small (in this case = 0.01) the dierent realizations of the random walk all lie close to
20
0.0 100.0 200.0 300.0 400.0
Time (days)
50.0
75.0
100.0
125.0
150.0
S
Figure 5: Random walks using equation (10) with = 0.01.
exponential growth curve. As is increased to 0.1 in Figure 6 and to 0.3 in Figure 7 we
see that the dierent realizations of the random walk start to strongly diverge from each
other. In some cases the random walk greatly exceeds the expected exponential growth
due to drift along, and in some cases the random walk falls well below. The volatility of
an aspect is a direct measure of risk. The larger the volatility, the greater the uncertainty
of the investment. From these gures it is clear that high risk investments can lead to
much greater earnings than low risk investments, but they can also lead to much greater
losses. These gures certainly indicate that when the volatility is large, it is impossible
to make predictions about asset values in the future.
This module assumes that asset values can be modelled using the stochastic dierential
equation (7). The results of gures 5-7 clearly show the eects of randomness, thus
indicating that this equation cannot be used to make predictions about future asset values.
Why then is this equation so important? First, in a statistical sense, it has been shown
that equation (7) generally does a very good job of modelling the historical data of most
asset prices (better agreement is achieved for stocks, options and commodities, than for
currencies). Second, and more signicantly, we can use equation (7) as the foundation for
21
0.0 100.0 200.0 300.0 400.0
Time (days)
50.0
75.0
100.0
125.0
150.0
S
Figure 6: Random walks using equation (10) with = 0.1.
more sophisticated models, and these models can be used to completely eliminate risk.
The formation of these models is the primary goal of this module. Before, we proceed to
examining these more sophisticated models, we rst note that equation (7) requires the
specication of two fundamental parameters and . These parameters will depend on
the particular asset which is being modelled, and they can be estimated by looking at the
historic data of the asset prices. In particular, suppose that we know the value of S at
n + 1 discrete, and equally spaced, points in time, which we denote by S
o
, S
1
, S
2
, . . . , S
n
with the subscripts denoting sequential points in time. Assuming that dX is normally
distributed then we estimate
m =
1
ndt
n1

i=0
S
i+1
S
i
S
i
and

2

2
=
1
(n 1)dt
n1

i=0
_
S
i+1
S
i
S
i
mdt
_
2
(9)
22
0.0 100.0 200.0 300.0 400.0
Time (days)
50.0
75.0
100.0
125.0
150.0
S
Figure 7: Random walks using equation (10) with = 0.3.
The accuracy of these estimates will depend on the number of points in the time series,
as well as the size of the time step dt. It has been assumed that and in equation (7)
are constant, but, in reality these parameters will be slowly varying functions of time.
23
3.1 The size of random uctuations
The starting point for our modelling of asset prices is the stochastic dierential equation
dS = S (dX + dt) . (10)
The drift term dt corresponds to the deterministic rise or fall in the value of S with
time in the absence of any random uctuations. The dX term accounts for the inuence
of random uctuations. The relevant question is Which is more important?: the deter-
ministic drift of S with respect to time, or the inuence of random uctuations. This
question is relatively straightforward to answer. If dt >> dX then deterministic forces
will dominate. If dX >> dt then random uctuations will dominate. If the terms
dt and dX are approximately of the same magnitude, then, the value of the asset S
will depend on both deterministic and random forces. Historical evidence suggests that
stock prices are indeed determined by a combination of deterministic and random forces
and thus we would like to have an appropriate balance in the sizes of the dt term and
the dX term. Moreover, we would like the parameter to uniquely characterise the
deterministic drift (growth or fall) of S and to uniquely characterise the inuence of
random uctuations. Ultimately this means that we will need to comment on the relative
size of dt versus dX in order to ensure that equation (10) is a realistic model of the time
evolution of asset prices.
In the previous section we made the statement that dX can be modelled as a normally
distributed random variable with zero mean and variance equal to dt (i.e. dX =

dt
where is a random variable from a standardised normal distribution with mean 0 and
variance 1). This is indeed the appropriate choice of scaling for dX as a function of dt,
but it is instructive to try to convince ourselves, why this scaling is appropriate. In this
section we will use computer simulations to justify this scaling. In the following section
we will use more rigorous mathematical methods to justify this scaling. The key point
is that if we can successfully argue that dX is proportional to

dt, then we can convert

the stochastic dierential equation (10) for S into a fully deterministic equation (i.e. the
Black Scholes equation).
Our objective is to use equation (10) to perform a large sequence of random walks
and then to compare these random walks to each other in order to see if any meaningful
information can be obtained. In particular, we shall keep and xed and iterate
equation (10) from some initial time t = t
0
until some nal time t = t
1
by performing
n iterations with xed dt = (t
1
t
0
)/n. Because equation (10) can be seen as a leading
order Taylor series expansion for S as a function of time, we expect that our results will
become most meaningful in the limit as dt 0 (or n ). In equation (10) we will set
dX = dt
k
(11)
where is a random variable from a standardised normal distribution with mean 0 and
variance 1, and we will then examine the inuence of varying k for values of k > 0.
The following MatLAB program can be easily modied to perform our comparison:
24
s(1) = 100
mu = 0.1
sigma = 0.3
n = 100000
dt = 1/n
k = 0.5
for j = 1:500 % perform 500 random walks
for i = 1:n
dX = randn*dt^k;
dS = s(i)*(mu*dt + sigma*dX);
s(i+1) = s(i)+dS;
end
ss(j) = s(n+1) % save the final value of each random walk
end
plot(ss)
The above program was used to integrate from t = 0 to t = 1 using a time-step of
dt = 10
5
with = 0.1 and = 0.3 xed for dierent values of k. Figures 8, 9 and 10
show results for k = 1, k = 1/2 and k = 1/4 respectively. In each case, 500 separate
random walks were performed assuming an initial value of S(0) = 100, and the value of
S at time t = 1 is then plotted. Since we are interested in the limit where dt << 1 it
follows that dt
1
<< dt
1/2
<< dt
1/4
. Consequently, it would be expected that the results
for k = 1 will be least inuenced by the eects of random uctuations, while the results
for k = 1/4 will be most strongly inuenced. This is indeed the case. Figure 8 shows that
when k = 1, the share price at time t = 1 is virtually deterministic and independent of
random uctuations. We consider this an unsatisfactory outcome since we would expect
random uctuations to play an important role in determining the value of S. For the case
of k = 1/4 in Figure 10, we also obtain unsatisfactory results with the value of S varying
from approximately 0, to essentially innity. Thus, for k = 1/4, we cannot say anything
meaningful about the predicted value of S at time t = 1. The case of k = 1/2 shown
in Figure 9, is however, satisfactory. The results certainly show the inuence of random
uctuations, and while each individual random walk is just as likely as any other, we can
with a certain level of condence make meaningful predictions about the value of S at
time t = 1. For example we can state that there is a 60% (estimated) chance that the
value of S at time t = 1 will lie in the interval 100 < S < 150. Further random walks can
be performed for dierent values of k, and in the limit as dt 0 it would be observed
that all results for k > 1/2 are similar (and thus unsatisfactory) to those in Figure 8
and results for k < 1/2 are similar (and thus unsatisfactory) to those in Figure 10. The
distinguished limit of k = 1/2 in equation (11) is the only admissible value in order for
25
0.0 100.0 200.0 300.0 400.0 500.0
Walk number
109.0
110.0
111.0
112.0
S
Figure 8: A sequence of random walks using equation (10) with dX = dt.
equation (10) to meaningfully model the variation of stock prices.
3.2 Black-Scholes equation: derivation (part 1)
The rest of this module is concerned with how to work out how much to pay for an option,
or how much to sell it for if it is to be traded prior to the expiry date. We shall derive the
Black-Scholes equation, which will be the basis of all such calculations. We will derive
the fair price for an option, though a trader will always try to do better than that! This
equation gives the basis for all trading in options and is used extensively in all Investment
Banks.
In the derivation of the Black-Scholes equation we will consider holding a portfolio
made up of one option (it can be a call or a put, or in fact any type of option) which has
value V , plus lots of the underlying share S. Thus the portfolio that we hold has total
value where
= V + S,
26
0.0 100.0 200.0 300.0 400.0 500.0
Walk number
0.0
100.0
200.0
300.0
S
Figure 9: A sequence of random walks using equation (10) with dX = dt
1/2
.
i.e. equals the total value of the portfolio, V equals the value of the option, S equals
the value of the underlying share, and is the number of shares in the portfolio. e.g.
a portfolio like this might consist of one European Call Option where the underlying is
Rolls Royce plus lots of Rolls Royce shares where is a constant.
The value of the option V will vary with time t and also with the underlying share
price S. Thus V = V (S, t). The equation that we will derive below will be valid for any
function V which is a function of S where S is determined by the lognormal random walk
given by equation (10) and time t. Strictly speaking V does not have to represent the
value of an option, but this is a helpful starting point.
The following derivation is mathematically informal. See the recommended textbooks
for notes on how to make the following mathematical argument more rigorous.
We consider a small time step dt over which the time varies from t to t + dt, and the
underlying share price varies from S to S +dS. During this small time interval, the value
of the option will vary from V to V + dV , where
dV = V (S + dS, t + dt) V (S, t).
27
0.0 100.0 200.0 300.0 400.0 500.0
Walk number
0.0
5000.0
10000.0
15000.0
20000.0
S
Figure 10: A sequence of random walks using equation (10) with dX = dt
1/4
.
We take to be constant over the time step t to t +dt, but may vary from one time
step to another.
We can use Taylors theorem (it is called Itos Lemma in the case of using an expansion
with a random variable) to nd
V (S + dS, t + dt) = V (S, t) + dS
V
S
+ dt
V
t
+
1
2
dS
2

2
V
S
2
+ dSdt

2
V
St
+
1
2
dt
2

2
V
t
2
+ ...
where the derivatives are all evaluated at (S, t). This is just the standard formula for
Taylors theorem in two variables. Rearranging slightly gives
V (S + dS, t + dt) V (S, t) = dS
V
S
+ dt
V
t
+
1
2
dS
2

2
V
S
2
+ dSdt

2
V
St
+
1
2
dt
2

2
V
t
2
+ ...
But dV = V (S + dS, t + dt) V (S, t), therefore
dV = dS
V
S
+ dt
V
t
+
1
2
dS
2

2
V
S
2
+ dSdt

2
V
St
+
1
2
dt
2

2
V
t
2
+ ...
28
But dS = S (dX + dt). Substituting this into the above equation gives
dV = S (dX + dt)
V
S
+ dt
V
t
+
1
2
(S (dX + dt))
2

2
V
S
2
+S (dX + dt) dt

2
V
St
+
1
2
dt
2

2
V
t
2
+ ...
Rearranging gives
dV = SdX
V
S
+ dt
_
S
V
S
+
V
t
_
+
1
2
(dX)
2
S
2

2
V
S
2
+dtdX
_
S
2

2
V
S
2
+ S

2
V
St
_
+
1
2
dt
2
_
S
2

2
V
S
2
+ 2S

2
V
St
+

2
V
t
2
_
+ ...
But from the previous section, we know we can write dX =

dt where is a random
number taken from a normal distribution with mean zero and standard deviation equal
to one. Hence, for dt small, even though dX is random, we know the size of dX will be of
the order of

dt i.e. dX is proportional to

dt. Using this we can examine the relative

size of terms in the above equation when dt is small. Retaining terms only up to the size
of the order of dt, gives
dV = SdX
V
S
+ dt
_
S
V
S
+
V
t
_
+
1
2
(dX)
2
S
2

2
V
S
2
+ ...
All higher-order terms (denoted by +...) will be smaller and hence we will neglect. (These
neglected terms are of size (dt)
3/2
and smaller, where dt is small.)
But = V + S. Therefore
d = dV + dS.
Using the above formula for dV , as well as dS = S (dX + dt), gives
d = SdX
V
S
+ dt
_
S
V
S
+
V
t
_
+
1
2
(dX)
2
S
2

2
V
S
2
+ ... + S (dX + dt)
Rearranging gives
d = SdX
_
V
S
+
_
+ dt
_
S
V
S
+
V
t
+ S
_
+
1
2
(dX)
2
S
2

2
V
S
2
+ ...
Justication that (dX)
2
can be replaced by dt
29
As a rule of thumb, we can replace (dX)
2
by dt in all such equations whenever we see
it, and this will give the correct result when used. We now give an informal demonstration
of this fact. We consider a typical time interval that we wish to solve the option problem
for and denote this as a time interval from 0 to t. We break this time interval up into n
equal time steps each of time dt, where n is some integer. We consider the time at each
time step to be t
j
where
t
j
=
jt
n
,
where j is an integer which varies from 1 to n. Note that when j = n then jt/n = t i.e.
the end of that time interval. We choose
dt =
t
n
,
so that each time step is of length dt as required. i.e.
t
1
=
t
n
, t
2
=
2t
n
= t
1
+ dt, t
3
=
3t
n
= t
2
+ dt, ..., t
n
= t.
We let dX (t
j
) correspond to the value of the random variable at time t
j
. We let dX (t
j
)
be a random variable selected from a normal distribution with mean zero and variance
equal to dt (i.e. standard deviation equal to

dt).
If dX is a random variable selected from a normal distribution with mean zero and
variance equal to dt, then we dene the quantity expectation of the random function
g (dX) as
E [g(dX)] =
_

g(x)f(x)dx,
where
f(x) =
1

2dt
exp
_

x
2
2dt
_
.
(Those students who have taken modules in Statistics will recognise this, but it doesnt
matter if you dont. We dont need to consider at all what the expectation corresponds
to - we may think of it as just being an integral. In fact, f(x) is the probability density
function of the normal distribution with mean zero and variance equal to dt, and the
expectation tells us the mean of the resulting function.)
We use this denition to calculate
E
_
_
_
n

j=1
(dX (t
j
))
2
t
_
2
_
_
.
This equals
E
_
_
_
n

j=1
(dX (t
j
))
2
_
2
2t
n

j=1
(dX (t
j
))
2
+ t
2
_
_
30
by multiplying out the brackets. This equals
nE
_
(dX)
4

+ n(n 1)
_
E
_
(dX)
2
_
2
2tnE
_
(dX)
2

+ t
2
E [1] .
This is because each dX (t
j
) comes from the same normal distribution for every value
of j i.e. E
_
(dX (t
j
))
2

= E
_
(dX (t
i
))
2

for all integers i and j; also E

_
(dX (t
j
))
4

=
E
_
(dX (t
i
))
4

for all integers i and j.

The rst two terms in the above equation come from the term
_
n

j=1
(dX (t
j
))
2
_
2
.
When squaring this and expanding out the brackets, we get n terms of the form
(dX (t
j
))
4
,
which has given us the nE
_
(dX)
4

term above, and we get n(n 1) terms of the form

(dX (t
j
))
2
(dX (t
i
))
2
where i = j, which gives us the n(n 1)
_
E
_
(dX)
2
_
2
term in the above equation.
In doing this we have written E
_
(dX)
4

= E
_
(dX(t
j
))
4

for all j, and E

_
(dX)
2

=
E
_
(dX(t
j
))
2

for all j. Also note that we have used

E
_
(dX(t
j
))
2
(dX(t
i
))
2

= E
_
(dX(t
j
))
2

E
_
(dX(t
i
))
2

=
_
E
_
(dX)
2
_
2
which can be proved using the fact the the random numbers dX(t
i
) and dX(t
j
) are selected
at dierent times (i.e. at times t
i
and t
j
) and hence are independent from each other.
To explain the above steps in more detail, we will consider the following simple case
when n = 3. Then
E
_
_
_
3

j=1
(dX (t
j
))
2
_
2
2t
3

j=1
(dX (t
j
))
2
+ t
2
_
_
equals
E
_
_
(dX(t
1
))
2
+ (dX(t
2
))
2
+ (dX(t
3
))
2
_
2
2t
_
(dX(t
1
))
2
+ (dX(t
2
))
2
+ (dX(t
3
))
2
_
+ t
2
_
.
This equals
E
_
(dX(t
1
))
4
+ (dX(t
2
))
4
+ (dX(t
3
))
4
+ 2(dX(t
1
))
2
(dX(t
2
))
2
+ 2(dX(t
1
))
2
(dX(t
3
))
2
+2(dX(t
2
))
2
(dX(t
3
))
2
2t
_
(dX(t
1
))
2
+ (dX(t
2
))
2
+ (dX(t
3
))
2
_
+ t
2

.
31
This equals
3E
_
(dX)
4

+ 6
_
E
_
(dX)
2
_
2
6tE
_
(dX)
2

+ t
2
E [1] .
We note that this is of the correct form for n = 3. This can then be generalised for all n
in this manner.
We now evaluate our expression
nE
_
(dX)
4

+ n(n 1)
_
E
_
(dX)
2
_
2
2tnE
_
(dX)
2

+ t
2
E [1] .
To do this we note that
E [1] =
_

f(x)dx = 1,
E
_
(dX)
2

=
_

x
2
f(x)dx = dt,
and
E
_
(dX)
4

=
_

x
4
f(x)dx = 3 (dt)
2
,
using integration by parts.
Substituting these results into the above formula gives that
E
_
_
_
n

j=1
(dX (t
j
))
2
t
_
2
_
_
= n
_
3 (dt)
2
_
+ n(n 1) (dt)
2
2tn(dt) + t
2
.
But dt = t/n, so
E
_
_
_
n

j=1
(dX (t
j
))
2
t
_
2
_
_
= n
_
3
_
t
n
_
2
_
+ n(n 1)
_
t
n
_
2
2tn
_
t
n
_
+ t
2
=
2t
2
n
.
We let n in the above expression. Therefore
E
_
_
_
n

j=1
(dX (t
j
))
2
t
_
2
_
_
=
2t
2
n
0
as n . Since the left-hand side of the above expression corresponds to an integral
over the square of a quantity, the only way that this integral can be zero, in the limit of
n , is if
n

j=1
(dX (t
j
))
2
= t
32
as n . This is called the mean square limit.
We now dene the stochastic integral as
_
t
0
h(t)dX = lim
n
n

j=1
h(t
j
)dX(t
j
)
for a function h(t). While this looks complicated, it isnt. It just says that we can think
of the integral on the left-hand side as an innite sum of lots of very small areas under
the curve.
Therefore,
lim
n
n

j=1
(dX(t
j
))
2
=
_
t
0
(dX)
2
,
by choosing h(t) to be equal to dX(t). Therefore,
_
t
0
(dX)
2
= t.
We can rewrite this equation as
_
t
0
(dX)
2
=
_
t
0
dt.
Therefore,
_
t
0
_
(dX)
2
dt
_
= 0.
Therefore, (dX)
2
is equal to dt when written under an integral.
We now return to the equation
d = SdX
_
V
S
+
_
+ dt
_
S
V
S
+
V
t
+ S
_
+
1
2
(dX)
2
S
2

2
V
S
2
+ ...
and integrate throughout from 0 to t giving
_
t
0
d =
_
t
0
_
SdX
_
V
S
+
_
+ dt
_
S
V
S
+
V
t
+ S
_
+
1
2
(dX)
2
S
2

2
V
S
2
+ ...
_
We can replace (dX)
2
in this integral with dt. Therefore,
_
t
0
d =
_
t
0
_
SdX
_
V
S
+
_
+ dt
_
S
V
S
+
V
t
+ S
_
+
1
2
dtS
2

2
V
S
2
+ ...
_
Hence, removing the integral, we get
d = SdX
_
V
S
+
_
+ dt
_
S
V
S
+
V
t
+ S
_
+
1
2
dtS
2

2
V
S
2
+ ...
Thus we have simply replaced (dX)
2
in the equation by dt. The above justication of
this has been rather informal. For more details see Paul Wilmott Introduces Quantitative
Finance pages 119 to 137.
33
3.3 Black-Scholes equation: derivation (part 2)
So we can simply replace (dX)
2
by dt, as demonstrated in the previous section.
Therefore, by collecting together the dt terms, we get
d = SdX
_
V
S
+
_
+ dt
_
S
V
S
+
V
t
+ S +
1
2
S
2

2
V
S
2
_
+ ...
So far we have not chosen . If we choose
=
V
S
,
then
d = dt
_
V
t
+
1
2
S
2

2
V
S
2
_
+ ...
Remember that the neglected terms, denoted by +..., are of size (dt)
3/2
or smaller.
Dividing through by dt gives
d
dt
=
V
t
+
1
2
S
2

2
V
S
2
+ ...
Therefore, the neglected terms, denoted by +..., are now of size (dt)
1/2
or smaller.
Taking the limit dt 0, we see that all the extra terms, denoted by +... in the
previous equation, all tend to zero, since the largest of them are proportional to (dt)
1/2
,
and (dt)
1/2
0 as dt 0. Hence
d
dt
=
V
t
+
1
2
S
2

2
V
S
2
.
This is remarkable, since we have eliminated all the random dXs from the above equa-
tion. Thus if we know the right-hand side at any time step, then varies in a non-random
way according to the above equation over that time step.
Before we proceed further, lets summarise what we have shown so far. We have shown
that a portfolio = V + S has a non-random evolution over a time-step dt given by
d
dt
=
1
2

2
S
2

2
V
S
2
+
V
t
where the value of the option is V (S, t), S is the value of the underlying and t is time.
We also take E to be the strike price, to be the volatility, r to be the interest rate, and
T to be the expiry time. The above equation requires us to choose
=
V
S
.
34
Note that this is often instead re-written as = V S with
=
V
S
,
so that
= .
Either way, this is commonly called a Delta Hedging strategy.
Now if the money is instead invested in a bank then it would increase by
d
dt
= r
over the same time period, according to our interest rate equation. If these two equations
for d/dt are not equal to each other, then it would be possible to make a risk free prot
i.e. it would be possible to borrow from the bank and invest in the portfolio, or sell the
portfolio and put the money in the bank (depending on which expression for d/dt is the
greater), making a risk free prot which is not subject to any random eects. This is not
considered possible, since the stock market would automatically adjust the value of the
underlying S by increasing or decreasing its value to remove this possibility of risk free
investment. This is called the principle of no arbitrage. This says that there is no such
thing as a risk free prot; or that the stock exchange acts by continuously repositioning
the price of shares S to remove any risk free prot. There are traders on the Stock
Exchange who look for arbitrage opportunities, where risk free prots can be made, but
these opportunities close up very quickly if they ever form. Prices on the stock market
eectively move continuously to prevent arbitrage (i.e. preventing risk free prot).
Therefore, by the principle of no arbitrage, these two expressions for d/dt must be
equal to each other, and hence we have
d
dt
=
1
2

2
S
2

2
V
S
2
+
V
t
= r.
But = V S. Therefore
1
2

2
S
2

2
V
S
2
+
V
t
= r (V S) ,
where
=
V
S
.
Rearranging this gives the Black-Scholes equation
1
2

2
S
2

2
V
S
2
+
V
t
rV + rS
V
S
= 0.
This is a partial dierential equation for the value of the option V (S, t).
35
3.4 Black Scholes equation: brief discussion
Note that even though we have considered a Delta Hedging strategy (i.e. = V S
where = V/S) in the derivation of the Black-Scholes equation, the Black-Scholes
equation is independent of . Therefore it is a valid equation for V even if the portfolio
you own is not this Delta Hedging portfolio e.g. this equation for V is valid even if you
just own one option of value V and do not own any shares in the underlying; or, in fact,
if you own any other portfolio containing V . This equation will always describe V (S, t).
The Black-Scholes equation can be solved to nd the value of the option V at time
t when the value of the underlying S is known. The value of S varies randomly though,
and V is dependent on S. But since we always know the value of the underlying S at the
current time, this equation tells us the value of the option V at that time. The equation
also tells us how future values of V will vary with the share price S of the underlying.
As a bi-product of the previous derivation of the Black-Scholes equation, we have also
shown that the Delta-Hedging portfolio = V S is a risk free investment, with value
varying according to
d
dt
= r.
For this we must repeatedly change so that it equals V/S, by buying or selling shares
in the underlying. Note that needs to be a constant over each time-step (since was
assumed constant over a time step in the derivation and = ). Therefore, you would
tend to update the value of on a regular basis e.g. on a daily basis. This is called
dynamic hedging. Also, note that is called the Delta of the portfolio.
Also note that the Black-Scholes equation is independent of the drift , and also in-
dependent of the random variable dX.
3.5 Solution of the Black-Scholes equation for European options
The Black-Scholes equation can be simplied. Substitute
V = Eu (x, ) exp
_

(k 1) x
2

(k + 1)
2

4
_
(where S = Ee
x
, t = T 2/
2
and k = 2r/
2
) into the Black-Scholes equation. This
can then be rearranged to show that u (x, ) satises the diusion equation i.e.
u

=

2
u
x
2
.
(Try this: Problem sheet 4. Question 1. Warning: very lengthy calculation!)
Note that the share price 0 S < . Therefore < x < since S = Ee
x
. Also,
the Black-Scholes equation is valid for t T, since we only want to solve the equation for
36
the times before the expiry date (t < T) and at the expiry date (t = T). Therefore we
wish to solve the diusion equation for 0 since t = T 2/
2
.
The diusion equation has the solution
u =
1
2

u
0
(s) exp
_

1
4
(x s)
2
_
ds
where u = u
0
(x) at = 0. (Show this: Problem sheet 4. Question 3.) Therefore the Black-
Scholes equation can be solved by just doing an integral! (But only for European options:
later in this module we will look at American options which are more complicated.)
Usually this integral must be solved numerically (e.g. trapezium rule or Simpsons rule).
The function u = u
0
(s) is found from the pay-o function for the European option.
(See Problem sheet 4. Question 2.) This can be done as follows:
If the pay-o function for an option is g(S) where S is the value of the underlying,
then V = g(S) when t = T since T is the time of expiry (the expiry date) i.e. the pay-o
function is just the value of the option at the expiry time. But when t = T then = 0
since t = T 2/
2
. Therefore the pay-o function g(S) satises the equation
V (S, T) = g(S) = Eu(x, 0) exp
_

1
2
(k 1)x
_
since
V (S, t) = Eu (x, ) exp
_

(k 1) x
2

(k + 1)
2

4
_
(i.e. we have put = 0 and t = T into the above formula).
But u(x, 0) = u
0
(x) since u = u
0
(x) at = 0. Therefore,
g(S) = Eu
0
(x) exp
_

1
2
(k 1)x
_
.
Therefore, rearranging this expression gives
u
0
(x) =
g(S = Ee
x
)
E
exp
_
1
2
(k 1)x
_
where g(S) is the pay-o function, and since S = Ee
x
. Therefore
u
0
(s) =
g(S = Ee
s
)
E
exp
_
1
2
(k 1)s
_
.
Example.
For a European vanilla call g(S) = max(S E, 0) since this is the pay-o function.
Therefore for a European vanilla call
u
0
(x) =
max(Ee
x
E, 0)
E
exp
_
1
2
(k 1)x
_
37
since S = Ee
x
. Therefore, replacing x with s gives
u
0
(s) =
max(Ee
s
E, 0)
E
exp
_
1
2
(k 1)s
_
.
Simplifying gives
u
0
(s) = max(e
s
1, 0) exp
_
1
2
(k 1)s
_
,
or equivalently
u
0
(s) = max
_
exp
_
1
2
(k + 1)s
_
exp
_
1
2
(k 1)s
_
, 0
_
by multiplying through by the exponential.
Therefore the value of a European vanilla call can be found from calculating
u =
1
2

max
_
exp
_
1
2
(k + 1)s
_
exp
_
1
2
(k 1)s
_
, 0
_
exp
_

1
4
(x s)
2
_
ds
(which can be solved numerically), and then substituting that result for u into
V = Eu (x, ) exp
_

(k 1) x
2

(k + 1)
2

4
_
gives the value of the option V .
Alternately the above integral can be rearranged into the form
V = SN(d
1
) E exp(r(T t))N(d
2
) (see problem sheet 4, question 3) where
N(q) =
1

2
_
q

exp
_

1
2
s
2
_
ds,
d
1
=
log(S/E) + (r +
2
/2)(T t)

T t
and
d
2
=
log(S/E) + (r
2
/2)(T t)

T t
.
Here log is the natural logarithm, or equivalently ln.
The above expression in terms of N(d
1
) and N(d
2
) is a common way of rewriting the
integral.
38
4 Solving The Black-Scholes Equation
The Black-Scholes equation can be used to model the value of a portfolio of the form
(t) = V (S, t) + (t)S(t). (12)
Here, V (S, t) refers to the value of any nancial product that depends only on the current
value of some underlying stock S, where it is assumed that S follows a lognormal walk of
the form described in section 3. The Black-Scholes Equation is given by
1
2

2
S
2

2
V
S
2
+
V
t
rV + rS
V
S
= 0. (13)
This is a partial dierential equation for the value of the option V (S, t). It has been
derived under the assumption that there are no commission costs and that a portfolio
at time t will have the same expected rate of return as investing your money in a bank
with interest rate r at time t if you instantaneously choose the value of =
V
S

t
. The
correct choice of to ensure that a portfolio of the form equation (12) is risk-free is known
as delta-hedging. Equation (13) is valid for modelling the current value of V (S, t) even
if delta-hedging is not used: if this were not true prudent investors could make a risk free
prot by investing/trading in V . Market forces will ensure that equation (13) represents
the current value of V (S, t).
Most nancial products are sold via an intermediary. If we assume that the value of a
nancial product V is correctly identied via the Black Scholes equations, the intermediary
will purchase from the seller at a price of V C
seller
and then sell to the ultimate buyer
for a price of V + C
buyer
. The intermediary makes a small (or large) prot from both
the buyer and the seller. The commission need not be the same for either the buyer
or the seller, but irregardless, the dierence between what you pay/receive to buy/sell
V , and the solution to equation (13) can be thought of as commission. Equation (13)
is appropriate since there are large nancial institutions that can buy and/or sell large
quantities of V and S for
It must be stressed that equation (13) is strictly valid if
(a) the interest rate r is assumed to be constant,
(b) the underlying stock S does not pay out dividends, and
(c) the volatility is assumed to be constant and known.
Equation (13) can be modied to account for variations of r as a function of time and to
account for the payments of dividends (as will be shown later in this module). Equation
(13) can also be modied to account for variations of the volatility with time (as will
also be shown later in this module). Of assumptions (a)-(c) above, it is assumption (c)
which is perhaps the most most challenging. The volatility can be estimated today using
historical data via equation (9) from Section 3. Dierent investors will choose to estimate
using dierent values of n and dt and these dierences will eect the prediction of .
39
Thus dierent investors may agree that equation (13) is the appropriate mathematical
model for V but they may disagree on the actual value of V if they cannot agree on the
appropriate value of . As already noted, the drift coecient does not appear in the
Black-Scholes equation (13). Correctly estimating the current and future value of is
thus incredibly important.
4.1 Boundary/nal conditions
Equation (13) is a second order partial dierential equation which can be used to model V
as a function of S and t. This equation involves a second derivative with respect to S and
a rst derivative with respect to t. Without going into the full details of the properties
of partial dierential equations we must provide two independent boundary conditions
(specifying either V or
V
dS
either as constants or a function of t at the boundary points
a = a(t) and b = b(t), and one condition of the form V (S, T) = V(S) for some specied (or
to be determined) value of T. The Black-Scholes equations are used to give the value of a
nancial product at the current time t given some known information at some future time
T. The Black-Scholes equations are then integrated backwards in time from the specied
nal conditions. For European vanilla calls and puts, the exact solution to the Black-
Scholes equation is known as previously discussed. For more complicated options, the
Black-Scholes equations will have to be solved numerically, and the numerical solution
will depend vitally on the appropriate boundary/nal conditions. When developing a
numerical method it is clear that the semi-analytical solutions for European calls and
puts should be considered as appropriate test cases.
4.2 Boundary and nal conditions for European vanilla call and
put options
We have seen that at expiry (i.e. at t = T), the value of the option V equals the pay-o
function.
In this section we derive boundary conditions on the European vanilla call and Euro-
pean vanilla put which will be useful later on in the module.
European vanilla call
From now on, we write the value of the European vanilla call as C(S, t) instead of
V (S, t). Therefore, C(S, t) satises the Black-Scholes equation, namely
1
2

2
S
2

2
C
S
2
+
C
t
rC + rS
C
S
= 0.
Also, at expiry, at t = T, C(S, t) equals the pay-o function. Therefore,
C(S, T) = max(S E, 0).
40
We also need to work out boundary conditions at S = 0 and also for S .
We note that when the underlying share becomes worthless (i.e. S = 0) then the
stochastic dierential equation dS = S (dX + dt) implies that dS = 0. If dS = 0 then
S = constant. Hence once S = 0 then S becomes equal to a constant for all subsequent
times. Hence once S = 0 then S remains equal to zero for all subsequent times. Therefore,
once S = 0 then the underlying remains at zero for all subsequent times and hence is equal
to zero at expiry, and so the pay-o equals zero. The call option is worthless since it gives
the holder of the option the right to buy a worthless share for the strike price E, which
clearly would not be exercised. Therefore the call option has zero value. In other words,
C(0, t) = 0.
As the price of the underlying tends to innity (i.e. as S ), then the European
call option will certainly be exercised. This of course gives the right for the holder to
buy the underlying for the strike price E when the underlying is actually worth S .
Therefore the price of the option is just equal to the price of the underlying since the
option will certainly be exercised. Therefore,
C S
as S .
European vanilla put
From now on, we write the value of the European vanilla put as P(S, t) instead of
V (S, t). Therefore, P(S, t) satises the Black-Scholes equation, namely
1
2

2
S
2

2
P
S
2
+
P
t
rP + rS
P
S
= 0.
Also, at expiry, at t = T, P(S, t) equals the pay-o function. Therefore,
P(S, T) = max(E S, 0).
We also need to work out boundary conditions at S = 0 and also for S .
We note that when the underlying share becomes worthless (i.e. S = 0) then the
stochastic dierential equation dS = S (dX + dt) implies that dS = 0. If dS = 0 then
S = constant. Hence once S = 0 then S becomes equal to a constant for all subsequent
times. Hence once S = 0 then S remains equal to zero for all subsequent times. Therefore,
once S = 0 then the underlying remains at zero for all subsequent times and hence is equal
to zero at expiry, and so the pay-o equals E (since the pay-o equals max(E S, 0)).
The put option gives the holder of the option the right to sell a worthless share for the
strike price E, which clearly would be exercised since this is an excellent deal for the
holder of the option, making an immediate prot of E. Therefore, if ever S = 0 then we
know that the pay-o for the put is certainly going to be equal to E at time T. To nd
41
the value of P for times t < T for S = 0 then we need to solve the Black-Scholes equation
for S = 0 subject to this condition at t = T. Substituting S = 0 into the Black-Scholes
equation gives
P
t
rP = 0.
This is just the same equation that we solved for money growing in a bank with constant
interest rates. It has the general solution
P = Ae
rt
,
where A is a constant of integration. But P = E when t = T, and so
E = Ae
rT
.
Solving this gives
A = Ee
rT
.
Therefore, when S = 0,
P = Ee
r(tT)
.
Or equivalently,
P(0, t) = Ee
r(Tt)
,
as it is often written. This is the boundary condition on P at S = 0 for all t T.
Finally, as S , the option will certainly not be exercised (why sell a share that is
worth for price E?), and so obviously,
P(S, t) 0
as S .
It is important that you know these boundary conditions for C and P at t = T, at
S = 0 and at S = .
4.3 Put-call parity for European options
Consider the portfolio V = S +P C where S is the underlying, P is a European vanilla
put and C is a European vanilla call. (This is often called long one asset, long one put
and short one call - the long refers to a +, the short refers to a -.)
At expiry, the pay-o equals S + max(E S, 0) max(S E, 0). If S E then this
pay-o function equals S + 0 (S E) = E. If S E then this pay-o function equals
S +(E S) 0 = E. Therefore, the pay-o equals E for this portfolio for all values of S.
42
Therefore the value of this portfolio is independent of S. Let the value of this portfolio
equal V . Then V = V (t) since its value has been shown to be independent of S.
Substitute V (t) into the Black-Scholes equation. This gives
dV
dt
rV = 0.
Using separation of variables this has the solution
V = Ae
rt
,
where A is a constant. But when t = T (at expiry), V = E (from the above argument
that the pay-o always equals E). Therefore substituting this into the solution of the
dierential equation gives E = Ae
rT
. Therefore A = Ee
rT
. Therefore the value of this
portfolio is
V = Ee
r(tT)
.
Therefore
S + P C = Ee
r(tT)
. (14)
Therefore this combination of a share, put and (short) a call produces a guaranteed risk-
free investment (i.e. hedging). This formula is called put-call parity.
Compare this form of hedging, with a guaranteed risk free investment, to the delta
hedging strategy discussed earlier. Note in both cases the overall value of the portfolio
grows according to the dierential equation d/dt = r, or equivalently dV/dt = rV
(since we have used dierent notation for the total value of the portfolio in each case i.e.
or V ). With delta hedging the number of shares in the underlying must continually
be updated to ensure the portfolio is risk free. Using put-call parity the portfolio is
theoretically risk free from the instant it is purchased.
It must be stressed that put-call parity and delta hedging are not practical investment
strategies: if you want a guaranteed return equivalent to the rate of interest (without
having to pay commission charges) then you should put your money in the bank. These
strategies may however become practical if you think you can predict future changes in r
and more accurately than other investors.
43
4.4 Dividends
If a company makes an overall prot it can choose to invest some/all of this money for the
future (perhaps by building a new factory so that the company can expand, or by putting
the money in the bank or some other type of investment, to cover potential losses in the
future) or it can pay some/all of this money to its shareholders in the form of dividends.
Some investors purchase shares in a company in the hope of making a steady income in
the form of dividends. Indeed if a company is known to regularly pay out dividends, then
it is likely that more people will want to purchases shares in that company, and by the
laws of supply and demand, this should in the long term boost the value of the share price.
When a company pays out dividends, this will have an immediate eect on the underlying
share price. Let S(t) represent the value of the underlying share price and suppose the
company pays a dividend D at time t = t
d
. Then by using arbitrage considerations
S(t
+
d
) = S(t

d
) D
where t

d
refers to the time immediately before t
d
and where t
+
d
refers to the time imme-
diately after t
d
(i.e. the share price must drop by exactly the amount D). If this were
not the case it would be possible to make an instantaneous risk free prot by purchasing
shares just before the dividend is paid out, collecting the dividend and then immediately
selling the shares. The principle of arbitrage will ensure that the share price after the
dividend is paid automatically reects the dividend payment.
4.4.1 Continuous Dividends
The simplest way to model dividends is to assume that they are paid out continuously
as a function of time. This is a good model for index options and for currency options
(i.e. when the underlying is an index such as FTSE, or when the underlying is a foreign
currency).
Suppose in a time dt the underlying pays out a dividend D
0
Sdt where D
0
is a constant
called the dividend yield, continuous dividend yield or constant dividend yield. (In fact
this can easily be generalised so that D
0
becomes a time-dependent function.)
The derivation of the Black-Scholes equation is identical, except that
dS = SdX + ( D
0
) Sdt.
The D
0
Sdt simply accounts for the continuous reduction in share value due to the
dividend payment (i.e. arbitrage requirement). The share price is still modelled by using
a lognormal random walk but the deterministic term is changed by replacing the drift
by D
0
.
The other change in the derivation of the Black-Scholes equation is that
d = dV + dS + D
0
Sdt
since in our portfolio (that we consider in the derivation of the Black-Scholes equation)
we hold lots of the shares, and each share generates a dividend payment equal to D
0
Sdt.
44
Following through the derivation with these minor changes, ultimately gives us the
revised version of the Black-Scholes equation:
1
2

2
S
2

2
V
S
2
+
V
t
rV + (r D
0
) S
V
S
= 0.
This equation looks very similar to the original Black-Scholes equation, and it is left
as a exercise to show that this equation can indeed be transformed into the Black-Scholes
equation. The of a portfolio which pays continuous dividends is the same as the for
the case of no dividends.
4.4.2 Discrete Dividends
A dividend D paid out on an asset S is usually dened in terms of a dividend yield by
D = d
y
S where 0 d
y
< 1. Suppose the dividend is is paid at time t
d
then the jump
condition for S is
S(t
+
d
) = (1 d
y
)S(t

d
).
Our goal is to determine the value V (S, t) of an option assuming there is one discrete
dividend paid out on the underlying at time t
d
with t < t
d
< T. The holder of the option
does not receive the dividend so even though S is discontinuous at time t
d
the value of
the option will remain continuous with a matching condition V (S(t

d
), t

d
) = V (S(t
+
d
), t
+
d
)
or
V (S(t

d
), t

d
) = V ((1 d
y
)S(t

d
), t
+
d
). (15)
To determine the value of the option we then
1) Integrate the Black Scholes equation backwards in time from the expiry time T until
time t
+
d
using the payo function as the initial condition.
2) At time t
+
d
use the matching condition (15) to determine the appropriate initial
condition for t

d
.
3) Integrate the Black Scholes equation backwards in time from time t

d
until time t
using this new initial condition.
Thus if a discrete dividend is paid out we essentially have solve the Black Scholes equations
twice.
If our option is a European Vanilla call with exercise price E it can be shown that
the value C
d
(S, t; E) (where the subscript d is used to denote that the underlying share
pays one discrete dividend) of the option is
C
d
(S, t) = (1 d
y
)C
_
S, t;
E
1 d
y
_
(See exercise sheet 4, question 8). Thus C
d
(S, t) is equal to (1 d
y
) times the equivalent
call option of a non-dividend paying share with exercise price E/(1 d
y
). Clearly this
shows that the value of a call option on a dividend paying share is less than the call option
of an otherwise equivalent non-dividend paying share. This is reasonable since we know
that the eect of paying a dividend is to reduce the value of S.
45
4.5 Forward Contracts and Futures
A forward contract is an agreement between two parties where one agrees to buy a specied
asset from the other for a specied price, known as the forward price, on a specied date
in the future, known as the delivery date or maturity date. Note this is dierent to an
option, since there is no element of choice involved on the delivery date. i.e. the holder
of the forward contract must buy the asset on the delivery date for the forward price.
A forward contract is also dierent from an option contract in that no money exchanges
hands until delivery. It therefore costs nothing to enter into a forward contract. An
example of a forward contract is one company agreeing to buy a certain number of barrels
of crude oil for a specied price at a specied time in the future. The company is happy
because they can be assured of delivery of the oil at the specied time at a xed and
known cost. The oil producer is happy because they have a guaranteed buyer for their
product.
A futures contract, or future, is a forward contract which may be traded on an ex-
change. For example if you own a forward contract which allows you to purchase a barrel
of oil in one years time at say 100 US dollars, this contract has a certain value. If the
price of oil is expected to be 200 US dollars per barrel in one years time, there will be
many people who would be willing to buy your forward contract (i.e. when you trade a
forward contract it is called a future).
It is straight-forward to value a forward contract or future. Let T be the delivery date
and let the underlying asset have value S (which will be a function of time t). Also let the
forward price be F, and the bank interest rate be r. Consider the person who is short the
contract (i.e. the person who must deliver the asset on the delivery date). This person
could if they wanted borrow an amount S when the contract begins, and use this to buy
the asset which will also have price S. The money received at time t = T, which is equal
to F, could be used to pay o the loan. The loan will cost
Se
r(Tt)
.
The above expression must equal F. If it does not, then it would be possible to make
a risk free prot or risk free loss on the transaction by borrowing from the bank to buy
futures. Therefore,
F = Se
r(Tt)
where S is the value of the underlying share at time t.
See problem sheet 4, question 9, to work out if someone makes a prot or loss from
buying a future contract.
Options on Futures
It is possible to buy an option where the underlying is a future. We have already
discussed how the value of an option V (S, t) can be derived using the Black Scholes
46
equation. In this case we wish to determine the value of an option of the form V (F, t)
where F = Se
r(Tt)
. To do this we simply use the chain rule to calculate
V (S, t)
S
=
V (F, t)
F
F
S
and
V (S, t)
t
=
V (F, t)
F
F
t
+
V (F, t)
t
and then substitute into the Black Scholes equation to obtain
V
t
+
1
2

2
F
2

2
V
F
2
rV = 0.
See exercise sheet 4, question 10.
47
5 American options
A European option is purchased at time t (today) and is exercised at time T (the expiry
date) where t < T and the return from a European option is given by its associated pay-o
function. American options have the same pay-o function as European options, but, they
have the additional property that the American option can be exercised at any time t
e
between t and T (i.e., t t
e
T). The ability to exercise the option at any time between
the time of purchase and the expiry time certainly oers an advantage to the holder
of an American option. The extra exibility of an American option suggests that they
oer extra value to the holder of these options and should then cost at least as much, or
more, than the equivalent European option (alternatively, the writer of the option should
demand a return that is no less than the equivalent from a European option). Also, the
fact that American options can be exercised early suggests that there exists an optimal
time at which to exercise the option. In general this optimal time cannot be determined
analytically.
The opportunity to exercise an American option at any time certainly implies that an
American option should not cost less than a European option. In many (most) cases an
American option will cost more than the corresponding European option. Indeed, simple
arbitrage arguments suggest that an American option should never have a lower value
than the corresponding European option.
5.1 American vanilla put options
In this case the payo function is simply P = max(ES, 0). To repeat, American options
have the important dierence to European options that they may be exercised at any time
up to the expiry date. Thus the holder of an American vanilla put option may do one of
two things:
1. Retain the option up until the expiry date. On the expiry date (t = T), the pay-o
will then be max(ES, 0) which is the same pay-o as for a European vanilla put. (Note
the E S part of the pay-o function corresponds to the holder choosing to exercise the
option on the expiry date i.e. selling the underlying for strike price E even though it is
only worth S. The 0 part of the pay-o function corresponds to the holder not choosing
to exercise the option on the expiry date. The holder exercises the option on the expiry
date if E S > 0. This is all identical to the European option.)
or
2. Exercise the option early at any time t < T (this is called early exercise). Then
the pay-o equals E S. (This is not possible with a European option.) In this case the
holder choose to sell the underlying for price E even though it is only worth S.
48
We identify a boundary
S = S
f
(t)
which is the value of S at which the American vanilla put should be exercised. This is
called the optimal exercise price (or optimal exercise boundary). This is a time-dependent
function which needs to be determined, with the properties:
1. For S > S
f
(t), the option is held onto.
2. For S < S
f
(t), the option is exercised early.
5.2 Derivation of the model for an American vanilla put
Looking at the graph of the value of a European vanilla put P plotted against S (see Figure
11), we see that there are values of S where P is below the pay-o function max(ES, 0),
and values of S where P is above the the pay-o function. Suppose S lies in the range on
this graph where 0 < P < max(E S, 0) = E S. Now if this was instead an American
option, then we could buy the option (an American vanilla put) for price P and at the
same time buy the underlying asset for price S. Because it is an American option we
could immediately exercise the option (early exercise) by selling the asset S for the strike
price E. We would therefore make an immediate risk free prot equal to E S P > 0
since P < E S. This must be impossible by the principle of no-arbitrage since this
would be a guaranteed risk free prot. Therefore the value of an American vanilla put
must be dierent to the value of a European vanilla put. By making sure that the above
argument can never hold, we have a condition for American vanilla puts:
P(S, t) max(E S, 0)
for all time t. This condition means that the above argument can never hold and prevents
risk free prots (which are clearly impossible).
From the above argument, we see that for low values of S the American vanilla put
should be exercised early. For larger values of S the American vanilla put should not be
exercised early. Therefore we identify a boundary
S = S
f
(t)
which is the value of S at which the American vanilla put should be exercised. This is
called the optimal exercise price (or optimal exercise boundary). This is a time-dependent
function which needs to be determined, with the properties:
1. For S > S
f
(t), the option is held onto. Hence P max(E S, 0) in this case and
P satises the Black-Scholes equation as usual.
49
S
f
(t) E
E
European put option
before expiry date
payoff
function
American put option before
expiry date
optimal
S
P
exercise price
Figure 11: The pay-o of a Vanilla put with Excercise price E and the corresponding values of
the European and American Vanilla put options at some time t.
2. For S < S
f
(t), the option is exercised early. Here P = E S.
What boundary conditions need to be applied at S = S
f
(t)? Firstly we need P =
max(E S
f
(t), 0) at S = S
f
(t). This makes sure that P is a continuous function. Since
P = E S for S < S
f
(t), this simplies to P = E S
f
(t) at S = S
f
(t).
We also need to determine an extra condition at S = S
f
(t) so that we have an equation
for S
f
(t). Let
P
S
=
at S = S
f
(t) where is some constant to be determined. What does equal?
We note that as we decrease the value of S
f
(t) decreases. This is because we know
that the Black-Scholes equation for a vanilla put produces monotonic decreasing functions
50
for P (i.e. P decreases as S increases). Since S
f
(t) is the optimal exercise boundary, we
wish to make the pay-o at early exercise as great as possible. Therefore we choose S
f
(t)
in order to maximise E S at S = S
f
(t) i.e. we must choose the lowest value of S
f
(t)
which is possible. Therefore we must choose the smallest value of possible. We also note
that we cannot choose < 1 or else the value of the American vanilla put P < E S
for values of S immediately above S = S
f
(t). (This is because the derivative of E S
with respect to S equals 1.) Therefore the smallest value of that we can choose is
= 1. Therefore we have the boundary condition
P
S
= 1
at S = S
f
(t). This just says that the derivative of P with respect to S is continuous at
S = S
f
(t) since P = E S for S < S
f
(t).
To complete the formulation of an American vanilla put we consider what happens
to the Black-Scholes equation for S < S
f
(t). Here the option would be exercised early
with pay-o equal to E S. The derivation of the Black-Scholes equation is identical in
this case until we get to the arbitrage argument towards the end of the derivation. In
this case we can only say that the return from the portfolio cannot be greater than the
return from a bank deposit, but not the other way around. (The reverse argument does
not hold since the option has already been exercised once early exercise has occurred for
S < S
f
(t).) Therefore the argument in the derivation of the Black-Scholes equation in
this case produces
d
dt
=
1
2

2
S
2

2
P
S
2
+
P
t
for a portfolio = P S with
=
P
S
.
This cannot be greater than the money invested in a bank, therefore
d
dt
r,
giving
1
2

2
S
2

2
P
S
2
+
P
t
r 0.
Therefore in this case we have
1
2

2
S
2

2
P
S
2
+
P
t
rP + rS
P
S
0
for S < S
f
(t). It is straight-forward to verify that this condition holds. If we substitute
P = E S into the previous equation we get
1
2

2
S
2

2
P
S
2
+
P
t
rP + rS
P
S
= r(E S) rS = rE < 0.
51
Therefore, we can in fact see that we have a less than sign (<) rather than a less than
or equal to sign () in the above condition since the strike price E > 0 and the bank
interest rate r > 0.
Finally we note that we have the same boundary condition as before as S for a
vanilla put i.e. P 0 as S . This condition holds for both a European vanilla put
and an American vanilla put.
This completes the formulation of the model.
Model for an American vanilla put
In summary, for an American vanilla put, we have the equations (which must be solved
numerically to obtain P(S, t) and S
f
(t)):
For S < S
f
(t):
P = E S
and
1
2

2
S
2

2
P
S
2
+
P
t
rP + rS
P
S
< 0.
For S > S
f
(t):
P max(E S, 0)
and
1
2

2
S
2

2
P
S
2
+
P
t
rP + rS
P
S
= 0.
At S = S
f
(t):
P = E S
f
(t)
and
P
S
= 1
At S = :
P = 0.
52
At t = T:
P = max(E S, 0).
(The previous equation is just the pay-o function at expiry.)
In fact, the inequality for S < S
f
(t) is automatically satised since P = E S here.
(Exercise)
5.3 Rewriting the model for an American vanilla put
This model can be transformed just as in the case of a European option, using
P = Eu (x, ) exp
_

(k 1) x
2

(k + 1)
2

4
_
where S = Ee
x
, t = T 2/
2
and k = 2r/
2
. The optimal exercise boundary becomes
transformed to x = x
f
(). Then for x > x
f
(), the Black-Scholes equation becomes
transformed to the diusion equation
u

=

2
u
x
2
as before.
We need to transform the function max(E S, 0) using this transformation. Then at
pay-o, or at early exercise,
P = max(E S, 0) = max(E Ee
x
, 0).
Let u(x, ) = g(x, ) here. Then
g(x, ) =
max(E Ee
x
, 0)
E
exp
_
(k 1) x
2
+
(k + 1)
2

4
_
,
using the above equation relating P and u. This simplies to
g(x, ) = max(1 e
x
, 0) exp
_
(k 1) x
2
+
(k + 1)
2

4
_
,
which in turn simplies to
g(x, ) = exp
_
(k + 1)
2

4
_
max
_
exp
_
(k 1) x
2
_
exp
_
(k + 1) x
2
_
, 0
_
.
53
Therefore, we can now write down the transformed equations for an American vanilla
put (which must be solved numerically to obtain u(x, ) and x
f
()):
For x < x
f
():
u(x, ) = g(x, )
and

2
u
x
2

u

< 0.
(Exercise: substitute u(x, ) = g(x, ) into the left-hand side of the above inequality and
show that it is always negative.)
For x x
f
():
u(x, ) g(x, )
and

2
u
x
2
=
u

.
At x = x
f
(): u and u/x are both continuous. (This comes immediately from the
condition that P and P/S are both continuous at S = S
f
(t).)
At x = : u = 0.
At = 0:
u (x, 0) = g(x, 0) = max
_
exp
_
(k 1) x
2
_
exp
_
(k + 1) x
2
_
, 0
_
,
which is the transformed pay-o function at expiry.
5.4 Linear complementarity form
The above problem can be written in linear complementarity form, by multiplying both
sides of the diusion equation by u g. This gives the formulation
_

2
u
x
2

u

_
(u(x, ) g(x, )) = 0,
54

2
u
x
2

u

0,
u(x, ) g(x, ) 0,
with the initial condition
u (x, 0) = g(x, 0) = max
_
exp
_
(k 1) x
2
_
exp
_
(k + 1) x
2
_
, 0
_
,
and the boundary conditions u g as x for all , along with the conditions that
u and u/x are both continuous for all > 0.
(Note that u g as x was always satised automatically in the previous
formulation. But now, in linear complementarity form, we must additionally apply this
boundary condition too.)
There are two possibilities in this formulation. One in which it is optimal to exercise
the option early i.e. where u = g; and the situation where it is not optimal to exercise
the option early i.e. where u > g. In this second case, u satises the diusion equation.
The main advantage of this linear complementarity form is that it has removed the
optimal exercise boundary x = x
f
() from the above formulation, making the equations
easier to solve.
Once the above equations in linear complementarity form have been solved, then the
optimal exercise boundary x = x
f
() can be determined afterwards from that solution
using the conditions:
1.
u (x
f
(), ) = g (x
f
(), ) ,
and
2.
u(x, ) > g(x, )
for all x > x
f
().
These two conditions enable us to determine x
f
() from the solution for u(x, ) once
u(x, ) has been obtained.
55
5.5 American calls, the eect of dividends and perpetual Amer-
ican options
Above we have analyzed the American Vanilla put option in great detail. In the following
subsections we will examine American Vanilla call options, the eect of continuous divi-
dends on the pricing of American options and perpetual American options. A perpetual
American option is an American option with expiry date T = . In section 6 below we
will summarize all of the nancial models that are relevant to this module.
5.5.1 American Vanilla call options
Recall that put options are essentially a bet on stock prices falling and call options are
a bet on stock prices rising. Above we have discussed that an American put option
should be excercised if the share price falls below some threshold value S
f
(t). Below this
threshold the value of the put option is exactly equal to the payo function, and the
Black Scholes equation contains a < 0 instead of an =0. Above this threshold, the put
option is greater than or equal to the pay-o function and the Black Scholes equations are
satised exactly. For American call options the opposite is true. The option should only
be excercised if the underlying share price rises above some threshold value S
f
(t), and
above this share price the Black Scholes equation contains a < 0 inequality. Also, above
this threshold, the value of an American Vanilla call option is exactly equal to the pay-o
function. Below this threshold value, the call option should not be excercised early, and
the option price is greater than the pay-o function and the Black Scholes equation is
statised exactly.
The complete formulation for an American Vanilla call option is as follows:
For S > S
f
(t):
C = S E
and
1
2

2
S
2

2
C
S
2
+
C
t
rC + rS
C
S
< 0.
For S < S
f
(t):
C max(S E, 0)
and
1
2

2
S
2

2
C
S
2
+
C
t
rC + rS
C
S
= 0.
56
At S = S
f
(t):
C = S
f
(t) E
and
C
S
= 1
At S = 0:
C = 0.
At t = T:
C = max(S E, 0).
Here r, , E and T are constants. It is necessary to nd C(S, t) for 0 S S
f
(t) and
for < t T. It is also necessary to nd S
f
(t) for < t T.
In fact, it is easy to argue that an American Vanilla call should not be excercised early
(i.e. an American Vanilla call should have the same value of a European Vanilla call,
since the optimal exercise boundary is S
f
(t) ).
For example, consider the American vanilla call option with value C(S, t). Also con-
sider the portfolio = C S + E exp (r (t T)). (a) If this option is exercised early,
show that < 0 at this time of early exercise. (b) If the option is not exercised early
then show that = 0 at expiry if S E. (c) If the option is not exercised early then
show that 0 at expiry if S E. (d) Use your results to parts (a)-(c) to explain why
American vanilla calls are usually not exercised early. (Hence this question shows that an
American vanilla call and a European vanilla call, on the same underlying, with the same
expiry date, and with the same strike price, always have the same value.)
5.5.2 The eect of continuous dividends
The eect of dividends with constant yield can be incorporated into the pricing of Ameri-
can options in exactly the same way as for European options as discussed in section 4.4.1.
All of the equations remain the same except that the coecient multiplying the S
V
S
is
changed from r to r D
0
where r is the interest rate and D
0
is the dividend yield. All
boundary and matching conditions remain the same as for the corresponding American
Vanilla options.
57
5.5.3 Perpetual American options
Perpetual American options are the same as regular American options except that the
expiry time is T = . In reality these options are not traded on any major stock exchange,
but they are useful in that they provide analyitical solutions that can be tested against
the corresponding American option with a nite expiry date. Perpetual options are not
traded because it is impossible to accurately predict how r, , D
0
vary as a function of
time. Also, who would take the risk of the underlying company or the writer of the option
going out of business before the option can be optimally excercised.
The value of a perpetual American option should depend on the value of the underlying
today, but not on time itself. If the underlying has the same value today as it had
yesterday, the perpetual option should have the same value since in both cases, there is
still an innite time available to excercise the option. In this sense perpetual American
options should be thought as the steady state solutions to the corresponding American
option with nite time to expiry. In the mathematical model all

t
terms are set equal to
zero, and S
f
(t) is replaced by S
f
= constant.
58
6 Summary of main nancial models
The following gives a summary of the main mathematical models considered in this mod-
ule including all of the appropriate boundary conditions (and matching conditions in the
case of American options).
European vanilla call without dividends
The value of the option C(S, t) satises
1
2

2
S
2

2
C
S
2
+
C
t
rC + rS
C
S
= 0,
subject to
C(S, T) = max(S E, 0),
C(0, t) = 0
and
C(S, t) S
as S . Here r, , E and T are constants. It is necessary to nd C(S, t) for 0 S <
and for < t T.
European vanilla call with a constant dividend yield
The value of the option C(S, t) satises
1
2

2
S
2

2
C
S
2
+
C
t
rC + (r D
0
) S
C
S
= 0,
subject to
C(S, T) = max(S E, 0),
C(0, t) = 0
and
C(S, t) S exp (D
0
(T t))
as S . Here D
0
, r, , E and T are constants. It is necessary to nd C(S, t) for
0 S < and for < t T.
59
European vanilla put without dividends
The value of the option P(S, t) satises
1
2

2
S
2

2
P
S
2
+
P
t
rP + rS
P
S
= 0,
subject to
P(S, T) = max(E S, 0),
P(0, t) = E exp (r (T t))
and
P(S, t) 0
as S . Here r, , E and T are constants. It is necessary to nd P(S, t) for 0 S <
and for < t T.
European vanilla put with a constant dividend yield
The value of the option P(S, t) satises
1
2

2
S
2

2
P
S
2
+
P
t
rP + (r D
0
)S
P
S
= 0,
subject to
P(S, T) = max(E S, 0),
P(0, t) = E exp (r (T t))
and
P(S, t) 0
as S . Here r, , D
0
, E and T are constants. It is necessary to nd P(S, t) for
0 S < and for < t T.
American vanilla put without dividends
For S < S
f
(t):
P = E S
60
and
1
2

2
S
2

2
P
S
2
+
P
t
rP + rS
P
S
< 0.
For S > S
f
(t):
P max(E S, 0)
and
1
2

2
S
2

2
P
S
2
+
P
t
rP + rS
P
S
= 0.
At S = S
f
(t):
P = E S
f
(t)
and
P
S
= 1
At S = :
P = 0.
At t = T:
P = max(E S, 0).
Here r, , E and T are constants. It is necessary to nd P(S, t) for S
f
(t) S < and
for < t T. It is also necessary to nd S
f
(t) for < t T.
American vanilla put with a constant dividend yield
For S < S
f
(t):
P = E S
and
1
2

2
S
2

2
P
S
2
+
P
t
rP + (r D
0
) S
P
S
< 0.
61
For S > S
f
(t):
P max(E S, 0)
and
1
2

2
S
2

2
P
S
2
+
P
t
rP + (r D
0
) S
P
S
= 0.
At S = S
f
(t):
P = E S
f
(t)
and
P
S
= 1
At S = :
P = 0.
At t = T:
P = max(E S, 0).
Here r, , D
0
, E and T are constants. It is necessary to nd P(S, t) for S
f
(t) S <
and for < t T. It is also necessary to nd S
f
(t) for < t T.
American vanilla call without dividends
We can prove that this always has the same value as the European vanilla call without
dividends.
American vanilla call with a constant dividend yield
For S > S
f
(t):
C = S E
and
1
2

2
S
2

2
C
S
2
+
C
t
rC + (r D
0
) S
C
S
< 0.
62
For S < S
f
(t):
C max(S E, 0)
and
1
2

2
S
2

2
C
S
2
+
C
t
rC + (r D
0
) S
C
S
= 0.
At S = S
f
(t):
C = S
f
(t) E
and
C
S
= 1
At S = 0:
C = 0.
At t = T:
C = max(S E, 0).
Here r, , D
0
, E and T are constants. It is necessary to nd C(S, t) for 0 S S
f
(t)
and for < t T. It is also necessary to nd S
f
(t) for < t T.
American vanilla put without dividends in linear complementarity form
Solve for u(x, ):
_

2
u
x
2

u

_
(u(x, ) g(x, )) = 0,

2
u
x
2

u

0,
u(x, ) g(x, ) 0,
with the initial condition
u (x, 0) = g(x, 0) = max
_
exp
_
(k 1) x
2
_
exp
_
(k + 1) x
2
_
, 0
_
,
63
and the boundary conditions u g as x for all , along with the conditions that
u and u/x are both continuous for all > 0.
Here
g(x, ) = exp
_
(k + 1)
2

4
_
max
_
exp
_
(k 1) x
2
_
exp
_
(k + 1) x
2
_
, 0
_
,
and k is a given constant. The above problem must be solved to obtain u(x, ) for all
< x < and for 0.
Once the above equations in linear complementarity form have been solved, then the
optimal exercise boundary x = x
f
() can be determined from that solution using the
conditions:
1.
u (x
f
(), ) = g (x
f
(), ) ,
and
2.
u(x, ) > g(x, )
for all x > x
f
().
These two conditions enable us to determine x
f
() from the solution for u(x, ), and
x
f
() must be found for all 0.
American perpetual vanilla put without dividends
For S < S
f
:
P = E S
and
1
2

2
S
2
d
2
P
dS
2
rP + rS
dP
dS
< 0.
For S > S
f
:
P max(E S, 0)
and
1
2

2
S
2
d
2
P
dS
2
rP + rS
dP
dS
= 0.
64
At S = S
f
:
P = E S
f
and
dP
dS
= 1
At S = :
P = 0.
Here r, and E are constants. It is necessary to nd P(S) for S
f
S < . It is also
necessary to nd the value of the constant S
f
.
American perpetual vanilla put with a constant dividend yield
For S < S
f
:
P = E S
and
1
2

2
S
2
d
2
P
dS
2
rP + (r D
0
)S
dP
dS
< 0.
For S > S
f
:
P max(E S, 0)
and
1
2

2
S
2
d
2
P
dS
2
rP + (r D
0
)S
dP
dS
= 0.
At S = S
f
:
P = E S
f
and
dP
dS
= 1
65
At S = :
P = 0.
Here r, , D
0
and E are constants. It is necessary to nd P(S) for S
f
S < . It
is also necessary to nd the value of the constant S
f
.
American perpetual vanilla call with a constant dividend yield
For S > S
f
:
C = S E
and
1
2

2
S
2
d
2
C
dS
2
rC + (r D
0
) S
dC
dS
< 0.
For S < S
f
:
C max(S E, 0)
and
1
2

2
S
2
d
2
C
dS
2
rC + (r D
0
) S
dC
dS
= 0.
At S = S
f
:
C = S
f
E
and
dC
dS
= 1
At S = 0:
C = 0.
Here r, , D
0
and E are constants. It is necessary to nd C(S) for 0 S S
f
. It is
also necessary to nd the value of the constant S
f
.
66
7 Numerical Methods
In this course we are interested in determining the value of options on nancial products
using the Black Scholes equation
1
2

2
S
2

2
V
S
2
+
V
t
rV + rS
V
S
= 0. (16)
This partial dierential equation must be solved according to the appropriate boundary
conditions, and the pay-o function which serves as a nal condition. We have seen in
section 3.5 how the change of variables
V = Eu (x, ) exp
_

(k 1) x
2

(k + 1)
2

4
_
(where S = Ee
x
, t = T 2/
2
and k = 2r/
2
) can transform equation (16) into the
much simpler diusion equation
u

=

2
u
x
2
. (17)
We have seen in section 3.5 that equation (17) can be solved in terms of an integral
formulation to give
u(x, ) =
1
2

u
0
(s) exp
_

1
4
(x s)
2
_
ds
where u
0
(x) = u(x, 0). Integral solutions of this type are appropriate for European options
where there is no opportunity for early exercise of the option. For American (and other
non-European options) integral solutions do not exist. In this section we will discuss the
solution to equation (16) and its equivalent (17) by using numerical methods to solve the
underyling partial dierential equations. The numerical methods that we shall develop
are important because they will help us to determine the value of European as well as
non-European options.
(As an aside, it must be stated that in practice not all methods that are used to value
nancial options are based on the Black Scholes Equation. Nevertheless, the numerical
solution approach to the Black Scholes equation provides a sound foundation for one of
the most used alternative approaches ... this will become apparent next term.)
Similar numerical techniques exist for solving equation (16) and (17), so which of these
two equations should we solve? As a matter of practical interest equation (17) involves
only 2 terms while equation (16) involves 4 terms, thus it would seem more ecient to
solve (17) numerically. Consequently, we will be focussing on the numerical solution of
(17) below. The relative ease of solving equation (17) with regards to solving our desired
equation (16) does have its drawbacks. First, equation (17) is only strictly true if r and
are constant with time, while the numerical solution of equation (16) will instantly
incorporate the time variation of these parameters. Second, a solution to equation (17)
67
which is constructed at equally spaced points in x will not correspond to a solution at
equally spaced points in S. This will be highlighted below.
Once we determine the solution u to equation (17) as a function of (x, ) we can
determine the corresponding solution V to equation (16) as a function of (S, t) using the
transformation
V (S, t) = E
1
2
(1+k)
S
1
2
(1k)
e

1
8
(k+1)
2

2
(Tt)
u(x = log(S/E), =
2
(T t)/2).
7.1 Approach to numerical solutions
This course is meant to be an introduction to Mathematical Finance, and correspondingly
our treatment of the numerical solution of the diusion equation should be considered
merely as an introduction as well. Students taking the MSc in Finance and MSci stu-
dents have the opportunity to take the course Computational Methods and Frontiers
(MSM4A10) which will expose them to considerably more sophisticated numerical meth-
ods. Our goal will be to develop numerical solutions to the Black Scholes equation (or
more particularly its equivalent, equation (17)) which are relatively easy to implement,
but which are also suciently accurate for our purposes. Question: How accurately do we
need to solve the Black Scholes equation? Why might people determine dierent values
of the same option? The methods that we will learn in this course are denitely not the
most ecient methods, but, with the speed of modern computers, the methods taught will
only require a matter of seconds to solve the one-dimensional diusion problem which is
of interest. The emphasis therefore will be on the correct understanding of the underlying
numerical method.
7.2 Finite dierence approximations
There are many numerical methods that are appropriate for solving equation (17). We
consider the nite dierence approach which is very closely related to the theory of Taylor
series. We suppose that the function f(z) is suciently smooth and we write
f(z+dz) = f(z)+dzf

(z)+
1
2!
dz
2
f

(z)+
1
3!
dz
3
f

(z)+ +
1
(n 1)!
dz
n1
f
(n1)
(z)+R
n
()
(18)
where
R
n
() =
dz
n
n!
f
(n)
()
is known as the remainder term. Equation (18) is exact, however, it depends on the
unknown which lies in the range z z +dz. Typically we disregard the error term
and use the Order notation O(dz
n
) to denote the magnitude of the lowest order term
which is omitted. For example, we can write
f(z + dz) = f(z) + O(dz),
f(z + dz) = f(z) + dzf

(z) + O(dz
2
),
68
f(z + dz) = f(z) + dzf

(z) +
1
2
dz
2
f

(z) + O(dz
3
),
etc. Similarly we can write
f(z dz) = f(z) + O(dz),
f(z dz) = f(z) dzf

(z) + O(dz
2
),
f(z dz) = f(z) dzf

(z) +
1
2
dz
2
f

(z) + O(dz
3
),
etc. The order notation is used to represent the size of the error in an approximation.
Provided dz is suciently small, the error of an approximation which is of O(dz
n
) will be
reduce by a factor of 2
n
if dz is reduced by a factor of 2.
Combining the above approximations we obtain
f

(z) =
f(z + dz) f(z)
dz
+ O(dz) (19)
which is known as the rst order forward nite dierence approximation to f

(z),
f

(z) =
f(z) f(z dz)
dz
+ O(dz) (20)
which is known as the rst order backward nite dierence approximation to f

(z), and
f

(z) =
f(z + dz) f(z dz)
2dz
+ O(dz
2
) (21)
which is known as the second order central nite dierence approximation to f

(z). Figure
12 illustrates these dierent approximations. Furthermore we can write
f

(z) =
f(z + dz) 2f(z) + f(z dz)
dz
2
+ O(dz
2
) (22)
which is known as the second order central nite dierence approximation to f

(z).
(Aside: physically the diusion equation can be thought of as a smoothing operator
and discontinuities in the initial conditions will be instantaneously smoothed out ... any
solution to the diusion problem can be written in terms of its Taylor series approximation.
Also, while the above approximations have been formulated for functions of one variable,
the results carry forward in a straightforward manner to functions of multiple variables).
7.3 Numerical Grid
Our goal is to solve the diusion equation (17) to determine u as a function of x and
subject to the appropriate initial conditions and boundary conditions. We do this by
discretising our spatial and temporal domain. Recall that in our Black-Scholes problem
0 S < where we have used the scaling S = Ee
x
. This means that our x variable
69
z-dz z+dz z
f(z)
central
forward
backward
Figure 12: Forward, backward and central dierence approximations to f

(z).
ranges from < x < . In our numerical approximation we will truncate this innite
range to x

< x < x
+
where x

and x
+
are choosen to be appropriately large positive
numbers (i.e. the values of x

and x
+
must be increased until the nal solution is in-
sensitive to the choice of these values). The procedure that we use is to choose positive
numbers N

and N
+
and a grid size dx and we discretize our x-domain as
x
i
= i dx for N

i N
+
Our temporal domain ranges from 0
max
. Typically for equation (16) we are
interested in solutions over the range 0 t T so we can choose
max
=
2
T/2. We then
discretize our temporal domain as

j
= j d for 0 j j
max
where j
max
=
max
/d. Finally we describe our discrete approximation to u(x, ) as
u
i,j
= u(x
i
,
j
)
Our numerical grid is then as illustrated in Figure 13.
70
x

Figure 13: Discrete grid used to the diusion equation.

Our procedure is then to apply the appropriate initial conditions along the line j = 0
and the appropriate boundary conditions along i = N

and i = N
+
. We will then
develop a numerical procedure that will allow us to determine the solution along the
line j = 1 using the information along line j = 0, and then progressively work our way
upwards. Our solution approach will only require that information is known along line j
in order to determine information along line j +1, however more sophisticated techniques
may require information from previous iterations. We will examine both explicit and
implicit techniques, terms which will be dened below.
Note: Since we are using uniform grid spacing in x, the result is that our solution will
not be uniformly spaced in our variable of interest S = Ee
x
(see Figure 14). Provided dx
is suciently small this should not be a serious issue, however, care will be required when
interpolating between our tabulated values of V (S, t) if we require V at a value that does
not correspond to a grid point x.
71
1.0 0.5 0.0 0.5 1.0
x
0
1
2
3
S
/
E
Figure 14: The eect of constant grid spacing in x for S = Ee
x
.
72
7.4 Explicit nite dierence solution of the diusion Equation
In this section our goal is to develop a simple algorithm for the numerical solution of the
diusion equation
u

=

2
u
x
2
subject to the boundary conditions
u(x

, ) = u

()
at the boundary x = x

and
u(x
+
, ) = u
+
()
at the boundary x = x
+
. The initial conditions are
u(x, 0) = u
0
(x)
for x

x x
+
. Using our discretised numerical grid these conditions become
u
N

,j
= u

(
j
), u
N
+
,j
= u
+
(
j
)
for all time steps j 0 and
u
i,0
= u
0
(x
i
)
for all N

i N
+
.
We discretize the diusion equation (17) using
u

(x
i
,
j
)
=
u
i,j+1
u
i,j
d
+ O(d)
(where the O(d) term is the error in the approximation) and

2
u
x
2

(x
i
,
j
)
=
u
i+1,j
2u
i,j
+ u
i1,j
dx
2
+ O(dx
2
)
(where the O(dx
2
) term is the error in the approximation). Combining the above two
equations (and omitting the error terms) we arrive at
u
i,j+1
u
i,j
d
=
u
i+1,j
2u
i,j
+ u
i1,j
dx
2
which can be re-written as
u
i,j+1
= u
i,j
+
d
dx
2
(u
i+1,j
2u
i,j
+ u
i1,j
)
or
u
i,j+1
= u
i1,j
+ (1 2)u
i,j
+ u
i+1,j
(23)
73
where
=
d
dx
2
. (24)
Equation (23) is the simplest possible example of an EXPLICIT nite dierence ap-
proximation to the diusion equation (17). Equation (23) is termed EXPLICIT since all
discrete values of u at time step j +1 can be determined explicitly in terms of the known
values of u at time step j. The value in equation (24) places an important restriction
on the size of the timestep d in comparison to the size of dx. This will be emphasized
below.
With known boundary and initial conditions equation (23) leads naturally to an algo-
rithm that can be applied to solve the one dimensional diusion equation (17):
1) Set up numerical grid with x
i
= i dx for N

i N
+
and
j
= j d for
0 j j
max
where j
max
=
max
/d.
2) Apply the initial conditions u
i,0
= u
0
(x
i
) for all N

i N
+
.
3) For all 1 j j
max
do
3a) Apply boundary conditions u
N

,j
= u

(
j
), u
N
+
,j
= u
+
(
j
)
3b) Update all interior values of u
i,j
For all N

+ 1 < i < N
+
1 do
u
i,j+1
= u
i1,j
+ (1 2)u
i,j
+ u
i+1,j
where = d/dx
2
4) Output nal results at time =
max
5) End
In the limit as dx 0 (with appropriate values of d) the above algorithm will converge
to the solution to equation (17) subject to the stated initial and boundary conditions.
The choice of dx and d will depend on the required accuracy and the computational
resources available.
7.4.1 Numerical example and stability
In order to understand the above algorithm consider the following example. Solve
u

=

2
u
x
2
over 1 x 1 for 0 t 1 subject to u(1, ) = 1, u(1, ) = 1 for 0 and
u(x, 0) = x
3
for 1 x 1. Consider a spacing of dx = 0.1 and determine solutions for
(a) d = 0.001 and (b) d = 0.01.
74
In both cases our x-domain is broken into 20 subintervals with x
i
= 0.1 i for 10
i 10. The initial conditions are simply u
i,0
= x
3
i
and the boundary conditions are simply
u
10,j
= 1 and u
10,j
= 1 for all j.
For case (a) we have d = 0.001 which gives = d/dx
2
= 0.1. The results of
applying our nite dierence algorithm to this problem are shown in gure 15 at times
= 0 (our initial condition), = 0.1, 0.2, . . . , 1.0 =
max
(our nal time). It is observed
that our initially smooth x
3
prole for u is attening out, and is approaching the line
u = x. (Indeed in can be shown that u x as for this diusion problem.) If we
wished to check the accuracy of our numerical solution, we would have to decrease our
value of dx while keeping our value of = d/dx
2
xed, and then compare our results.
1.0 0.5 0.0 0.5 1.0
x
1.5
1.0
0.5
0.0
0.5
1.0
1.5
u
Figure 15: Explicit nite dierence approximation to the diusion equation with dx = 0.1 and
d = 0.001. Solid line (initial conditions), dotted lines = 0.1, 0.2, . . . 1.0.
For case (b) we have d = 0.01 which gives = 1 and we plot our results in gure 16 at
times = 0, d, 2d, 3d, . . . , 10d. The results for case (b) are generated using the exact
same algorithm as for case (a), but it is clear from inspecting Figure 16 that the results
for case (b) are non-physical, with a zig-zag pattern of increasing amplitude appearing in
the numerical results. After a small number of additional time steps these zig-zags will
75
actually diverge to innity. What has gone wrong? The answer to this question is that
the explicit nite dierence scheme described above is only stable for suciently small
values of . In particular it can be shown that the explicit nite dierence scheme given
by equation (23) is only stable if
0
1
2
. (25)
We will not prove this stability criterion in this course, but we will note that equation
(25) does impose a severe restriction on the time-step size of our explicit nite-dierence
approximation. Additionally, it can be shown that for dx xed, the optimal choice of is

opt
=
1
6
.
This choice of and hence d will reduce the overall discretization error of the numerical
method.
1.0 0.5 0.0 0.5 1.0
x
1.5
1.0
0.5
0.0
0.5
1.0
1.5
u
Figure 16: Explicit nite dierence approximation to the diusion equation with dx = 0.1 and
d = 0.01. Solid line (initial conditions), dotted lines = d, 2d, . . . , 10d.
76
7.4.2 Interpretation on stability
Our explicit nite dierence approximation to the diusion equation
u
i,j+1
= u
i1,j
+ (1 2)u
i,j
+ u
i+1,j
can be interpreted as a random walk on a regular grid. Suppose u
i,j
represents the
probability of a marker being at spatial position i at time step j. The above equation can
be interpretated as a random walk where the marker (a) moves from position i at time
step j to position i 1 at time step j + 1 with probability , (b) remains at position i
at time step j +1 with probability 1 2, or (c) moves from position i at time step j to
position i + 1 at time step j + 1 with probability . For each each of the above random
walks to be viable we require 0 1 and 0 1 2 1 which is precisely the
criterion given by equation (25).
7.4.3 The European vanilla call
In section 7.4.1 we looked at the solution of a very simple diusion problem using the
explicit nite dierence scheme and we identied the stability constraint given by equation
(25). In this section we will use our explicit time-stepping algorithm to determine the
value of a European vanilla call option We must solve
u

=

2
u
x
2
subject to u = u
0
(x) at = 0, where
u
0
(x) = max
_
exp
_
1
2
(k + 1)x
_
exp
_
1
2
(k 1)x
_
, 0
_
.
To implement a numerical solution, we will need to rewrite the problem on a nite
domain in x, so that we solve for x

< x < x
+
, where x

and x
+
are both large
and positive, instead of an innite domain. To do this, we need to determine boundary
conditions at x = x
+
and at x = x

. Remember that the value of the European call

option C(S, t), when written in the original notation, satises (i) C = 0 at S = 0, and (ii)
C = S at S = . Using (i), when S = 0, x = and when C = 0 then u = 0, since
C = Eu (x, ) exp
_

(k 1) x
2

(k + 1)
2

4
_
and S = Ee
x
. Therefore, on a nite domain we approximate (i) as u = 0 at x = x

where x

is large and positive.

For boundary condition (ii),
C = S = Ee
x
= Eu (x, ) exp
_

(k 1) x
2

(k + 1)
2

4
_
77
at S = i.e. at x = . Solving the above equation gives
u = exp
_
(k + 1) x
2
+
(k + 1)
2

4
_
at x = . This becomes
u = exp
_
(k + 1) x
+
2
+
(k + 1)
2

4
_
at x = x
+
on a nite domain.
Thus in discretized form with x
i
= i dx for N

i N
+
and
j
= j d for
0 j j
max
the boundary conditions become
u
N

,j
= 0
for all j, and
u
N
+
,j
= exp
_
(k + 1) x
+
2
+
(k + 1)
2
jd
4
_
for all j. Note in particular that the boundary condition at i = N
+
is a function of the
time step j. The initial conditions become
u
i,0
= max
_
exp
_
1
2
(k + 1)idx
_
exp
_
1
2
(k 1)idx
_
, 0
_
,
for all i.
Example Question.
Solve the European vanilla call using explicit nite dierences when x
+
= x

= 10,
dx = 0.1, d = 0.001, N
+
= N

= 100 and k = 1.4. Calculate (i) u

1,0
, (ii) u
0,0
, (iii) u
1,0
,
(iv) u
0,1
, (v) u
100,0
, (vi) u
100,0
. Gives your results correct to 4 signicant gures.
Solution.
(i) To nd u
n,0
we use the formula
u
n,0
= max
_
exp
_
1
2
(k + 1)ndx
_
exp
_
1
2
(k 1)ndx
_
, 0
_
,
for all n.
Let n = 1. This gives u
1,0
= 0.1073.
(ii) Using the same method as in part (i), but with n = 0, gives u
0,0
= 0.
(iii) Using the same method as in part (i), but with n = 1, gives u
1,0
= 0.
78
(iv) Use the formula
u
n,m+1
= u
n,m
+
d
(dx)
2
(u
n+1,m
+ u
n1,m
2u
n,m
) ,
with n = 0 and m = 0. This gives
u
0,1
= u
0,0
+
d
(dx)
2
(u
1,0
+ u
1,0
2u
0,0
) = 0.01073.
(v) Use the formula
u
N
+
,m
= exp
_
(k + 1) x
+
2
+
(k + 1)
2
md
4
_
for all m. Choose m = 0. This gives u
100,0
= 162800 correct to 4 signicant gures.
(vi) Use the formula u
N

,m
= 0 for all m. Choose m = 0. This gives u
100,0
= 0.
79
7.5 Implicit Finite Dierence Solution for the Diusion Equa-
tion
In this section we will develop an IMPLICIT approach to the solution of the diusion
equation
u

=

2
u
x
2
subject to the boundary conditions
u(x

, ) = u

()
at the boundary x = x

and
u(x
+
, ) = u
+
()
at the boundary x = x
+
. The initial conditions are
u(x, 0) = u
0
(x)
for x

x x
+
. We use the same numerical grid as in the previous section and these
boundary and initial conditions are
u
N

,j
= u

(
j
), u
N
+
,j
= u
+
(
j
)
for all time steps j 0 and
u
i,0
= u
0
(x
i
)
for all N

i N
+
.
We discretize the diusion equation (17) using
u

(x
i
,
j+1
)
=
u
i,j+1
u
i,j
d
+ O(d)
(where the O(d) term is the error in the approximation) and

2
u
x
2

(x
i
,
j+1
)
=
u
i+1,j+1
2u
i,j+1
+ u
i1,j+1
dx
2
+ O(dx
2
)
(where the O(dx
2
) term is the error in the approximation). The important distinction
between this implicit method and the explicit method discussed previously is that the
time derivative is written as a backwards dierence when evaluated at time
j+1
and the
spatial derivative

2
u
x
2
is also evaluted at time
j+1
.
Combining the above two equations (and omitting the error terms) we arrive at
u
i,j+1
u
i,j
d
=
u
i+1,j+1
2u
i,j+1
+ u
i1,j+1
dx
2
.
This equation can be manipulated to give
u
i1,j+1
+ (1 + 2)u
i,j+1
u
i+1,j+1
= u
i,j
(26)
80
where as above
=
d
dx
2
.
It will not be shown here, but, the numerical method given by equation (26) is stable
for all values of d > 0. Thus the implicit method is not restricted by the time-stepping
contraint d < dx
2
/2 associated with the explicit method. In practice this means that
the value of d for the implicit method can be chosen to ensure the necessary level of
accuracy, as opposed to ensuring numerical stability. The truncation error associated with
the backwards dierence method is O(d). The goal is to choose d small enough that
the error associated with the method is acceptably small, while choosing d suciently
large so that only a small number of time steps are required to integrate from = 0 to
=
max
.
Note the distinction between the explicit nite dierence formula given by equation
(23) and the implicit formula given by equation (26). For the explicit case u
i,j+1
is
determined explictly in terms of the known values of u
i,j
at the previous timestep. For
the implicit case the unknown u
i,j+1
depends on the unknowns u
i1,j+1
and u
i+1,j+1
.
Equation (26) represents a set of coupled linear equations. In matrix format we can write
equation (26) as
Au = b (27)
where
A =
_

_
1 0 0 0 0 0 0 0 0 0
0 1 + 2 0 0 0 0 0 0 0
0 1 + 2 0 0 0 0 0 0
0 0 1 + 2 0 0 0 0 0
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
0 0 0 0 0 1 + 2 0 0
0 0 0 0 0 0 1 + 2 0
0 0 0 0 0 0 0 1 + 2 0
0 0 0 0 0 0 0 0 0 1
_

_
, (28)
u =
_

_
u
N

,j+1
u
N

+1,j+1
.
.
.
u
0,j+1
.
.
.
u
N
+
1,j+1
u
N
+
,j+1
_

_
,
81
and
b =
_

_
u

(
j+1
)
u
N

+1,j
+ u

(
j+1
)
u
N

+2,j
u
N

+3,j
.
.
.
u
N
+
3,j
u
N
+
2,j
u
N
+
1,j
+ u
+
(
j+1
)
u
+
(
j+1
)
_

_
.
Equation (27) can be solved to give u = A
1
b since it can be shown that the matrix A
in equation (28) is always invertible. This, however, is not the most ecient way of solving
equation (27). When the size of the matix A in equation (27) is large, matrix inversion is
prohibitively expensive. An ecient alternative is to use an iterative approach. Equation
(26) is re-written as
u
i,j+1
=
1
1 + 2
(u
i,j
+ (u
i1,j+1
+ u
i+1,j+1
))
for N

+1 < i < N
+
1 with u
N

,j+1
and u
N
+
,j+1
given by the appropriate boundary
conditions. All we have done here is to isolate the value of u
i,j+1
. We then introduce the
iterative approximation
u
k+1
i,j+1
=
1
1 + 2
_
u
i,j
+ (u
k
i1,j+1
+ u
k
i+1,j+1
)
_
(29)
where u
k
i,j+1
represents the approximate value of u
i,j+1
at the k
th
step of the iteration.
The iteration is initialized by setting u
0
i,j+1
= u
i,j
(i.e. by using the value of u from the
previous timestep), and it is continued until
Error =
N
+

i=N

(u
k+1
i,j+1
u
k
i,j+1
)
2
becomes suciently small. The iterative procedure given by equation (29) is known as the
Jacobi method. It is known to converge for all values of > 0. A signicant improvement
is given by
u
k+1
i,j+1
=
1
1 + 2
_
u
i,j
+ (u
k+1
i1,j+1
+ u
k
i+1,j+1
)
_
(30)
for N

+1 < i < N
+
1 with u
N

,j+1
and u
N
+
,j+1
given by the appropriate boundary
conditions. Equation (30) is known as the Gauss-Seidl method and it diers from the
Jacobi method in that all of the guesses on the right hand side are based on the most
recently calculated value (i.e. the value of u
i1,j+1
is approximated by the most recent
information at iteration k + 1, as opposed to the old information at iteration k.)
82
It should be noted that equation (27) can also be solved using the matrix method of
LU decomposition. While this method is beyond the scope of this course, it is extremely
ecient since it exploits the tridiagonal nature of the matrix A in equation (28). Since
the matrix A in equation (28) is constant as a function of time the LU decomposition of
A only needs to be calculated once.
7.6 Comparison between Explicit and Implicit Methods
There are many dierent numerical methods that can be used to solve the one-dimensional
diusion equation (and hence the Black Scholes equation). In this course we have discussed
the forwards dierence explicit method and the backwards dierence implicit method. The
explicit method is very easy to implement since the values of u at time step j + 1 only
depend on the values of u at time step j. Thus the explicit method provides a simple
formula that can be used to march the diusion equation forwards in time. This simplicity
of the explicit method must be balanced by the stability constraints of the explicit method
which require = d/dx
2
< 1/2. This imposes a very serious timestep restriction on the
explicit method. This timestep restriction is not required for numerical accuracy, it is
required to ensure that the numerical method remains stable. On the other hand, the
implicit method is stable for any choice of d > 0, and the size of the timestep can be
chosen to be as large as possible to ensure that the method can march forward in time
eciently, while still being small enough to retain the neccesary accuracy. The implicit
method however requires more work per timestep since at each timestep a set of coupled
linear equations need to be solved. That said, accurate and ecient algorithms exist for
solving the coupled linear equations associated with implicit methods.
Overall, a comparison between explicit and implicit methods, comes down to a com-
parision between the relative ease of implementation, and the relative computational
eciency. The explicit method is much easier to implement, but a properly implemented
implicit method will be more ecient (i.e. less computer eort will be required to inte-
grate the diusion equation forwards in time from = 0 to =
max
). For novices, the
explicit method is recommended. In practice implicit methods are the norm. In either
case, the user is required to validate their numerical implementation against known test
cases. For the Black Scholes equation, the obvious test case is the value of a European
vanilla put or call. The appropriate values of x

, x
+
, dx and d can be determined by
comparison with known results.
7.7 Numerical Methods for American options
The distinction between American options and European options is that with American
options there is the opportunity of early excercise. Since this opportunity exists, the
relevant question is when should an American option be excercised early? In this section
we shall discuss the numerical solution of the Black Scholes equation for American options.
We will consider the case of using the explicit nite dierence method to determine the
value of an American Vanilla put. This explicit method can be easily altered to determine
83
the value of any American option. Alternatively, the implicit methods discussed above
can be easily manipulated to determine the value of American options.
To determine the value of an American vanilla put we must solve the equations
_

2
u
x
2

u

_
(u(x, ) g(x, )) = 0,

2
u
x
2

u

0,
u(x, ) g(x, ) 0,
with the initial condition
u (x, 0) = g(x, 0) = max
_
exp
_
(k 1) x
2
_
exp
_
(k + 1) x
2
_
, 0
_
,
and the boundary conditions u g as x for all , along with the conditions that
u and u/x are both continuous for all > 0. Here (for an American put option)
g(x, ) = exp
_
(k + 1)
2

4
_
max
_
exp
_
(k 1) x
2
_
exp
_
(k + 1) x
2
_
, 0
_
.
It is noted that g(x, ) is simply the re-scaled value of the pay-o function as varies.
To implement a numerical solution, we will need to rewrite the problem on a nite
domain in x, so that we solve for x

< x < x
+
, where x

and x
+
are both large and
positive, instead of an innite domain.
The boundary conditions u g as x for all , are then replaced by u = g at
x = x
+
and at x = x

for all .
We use exactly the same equations as for a European vanilla put i.e.
u
i,j+1
= u
i,j
+
d
(dx)
2
(u
i+1,j
+ u
i1,j
2u
i,j
) ,
with the initial condition u
i,0
= g(idx, 0), and boundary conditions u
N

,j
= g(x

, jd)
and u
N
+
,j
= g(x
+
, jd).
There is just the extra constraint that
u(x, ) g(x, ) 0,
which becomes
u
i,j
g
i,j
for all i and j where g
i,j
= g (idx, jd).
84
Therefore we modify our numerical algorithm as follows:
We use the same set of equations and the same algorithm as for the European vanilla
put, but after calculating each value of u
i,j
we check to see if u
i,j
g
i,j
. If this condition
is satised then we leave u
i,j
unchanged. If however we calculate a value of u
i,j
such that
u
i,j
< g
i,j
then we immediately replace that value of u
i,j
with g
i,j
. That is, if we calculate
u
i,j
< g
i,j
for any i or j in our algorithm, then we immediately instead choose u
i,j
so that
u
i,j
= g
i,j
.
Therefore we are guaranteed that either u satises the diusion equation (i.e.
2
u/x
2
=
u/), or that u = g for all x and . Therefore the equation
_

2
u
x
2

u

_
(u(x, ) g(x, )) = 0
must be satised for all x and .
The algorithm for American options therefore becomes
1) Set up numerical grid with x
i
= i dx for N

i N
+
and
j
= j d for
0 j j
max
where j
max
=
max
/d.
2) Apply the initial conditions u
i,0
= u
0
(x
i
) for all N

i N
+
and g
i,0
= g(x
i
, 0)
for all N

i N
+
3) For all 1 j j
max
do
3a) Apply boundary conditions u
N

,j
= u

(
j
), u
N
+
,j
= u
+
(
j
)
3b) Update the scaled payo function g
i,j
= g(x
i
,
j
)
3c) Update all interior values of u
i,j
For all N

+ 1 < i < N
+
1 calculate
y
i,j+1
= u
i1,j
+ (1 2)u
i,j
+ u
i+1,j
where = d/dx
2
.
Then set
u
i,j+1
= max(y
i,j+1
, g
i,j+1
).
4) Output nal results at time =
max
5) End
The value of the optimal excercise boundary is then determined by comparing the value
of x
f
at which g
i,j
and u
i,j
dier.
85
7.7.1 Numerical example of vanilla puts
(a) Solve the European vanilla put using explicit nite dierences when x
+
= x

= 10,
dx = 0.1, d = 0.001, N
+
= N

= 100, = 0.4, r = 0.01 and E = 10. Calculate u

0,1
.
Give your result correct to 4 signicant gures.
(b) Repeat part (a) for an American vanilla put.
(c) Repeat part (a) for u
10,1
for a European vanilla put.
(d) Repeat part (a) for u
10,1
for an American vanilla put.
Solution
(a) Using u
i,0
= g(idx, 0) gives u
1,0
= 0.0994183613 (using i = 1), u
1,0
= 0 (using
i = 1), and u
0,0
= 0 (using i = 0). Using the formula
u
i,j+1
= u
i,j
+
d
(dx)
2
(u
i+1,j
+ u
i1,j
2u
i,j
)
with i = 0 and j = 0 then gives u
0,1
= 0.009942 correct to 4 signicant gures.
(b) For the American vanilla put, the rst part of this question is the same as part (a)
initially, giving u
0,1
= 0.009942. Using g
i,j
= g (idx, jd) gives g
0,1
= 0. This is less than
u
0,1
. Therefore we leave u
0,1
unchanged. Therefore u
0,1
= 0.009942 correct to 4 signicant
gures.
(c) Following the same method as in part (a) gives u
10,1
= 0.9792 for the European
vanilla put. (Note. To calculate this it is necessary to rst calculate u
11,0
, u
10,0
and
u
9,0
, and then use these results to nd u
10,1
.)
(d) For the American vanilla put, the rst part of this question is the same as part (c)
initially, giving u
10,1
= 0.9792. We then calculate g
10,1
= 0.9794. This is greater than
u
10,1
= 0.9792. Therefore we set u
10,1
= g
10,1
= 0.9794 for the American vanilla put.
Please see the excercise sheets and previous exams for further examples.
7.7.2 A computer example of American vanilla puts
The algorithm derived above to calculate the value of American vanilla puts for the
specic case of E = 10, r = 0.1, = 0.25. The value of the put versus S is plotted
in Figure 17. The solid line represents the pay-o function which is equal to the value
of the put at time = 0. The bold dashed line corresponds the value of the perpetual
American put, and the thin solid lines correpsond to the value of the American put for
= 0.05, 0.1, 0.15, 0.2, 0.25. Note that as increases, the value of the American put
rapidly approaches the value of the perpetual American put which is given by
P
perp
= (E S
f
)(S
f
/S)
k
for S > S
f
and
P
perp
= E S
86
for S S
f
where k = 2r/
2
and
S
f
=
E
1 + 1/k
.
0.0 5.0 10.0 15.0 20.0
S
0.0
2.0
4.0
6.0
8.0
10.0
P
Figure 17: The value of an American vanilla put for E = 10, r = 0.1 and = 0.25 as a function
of =
2
(T t)/2.
Plotted in Figure 18 is the optimal excercise boundary S
f
as a function of . Note that
as increases, S
f
rapidly approaches the constant value S
f
E/(1 +1/k) of a perpetual
American vanilla put.
7.7.3 Summary of American option calculations
Therefore we now have an algorithm for solving all American option problems. Depending
upon the type of option, we can choose the function g(x, ). e.g.
g(x, ) = exp
_
(k + 1)
2

4
_
max
_
exp
_
(k + 1) x
2
_
exp
_
(k 1) x
2
_
, 0
_
,
87
0.00 0.05 0.10 0.15 0.20 0.25

7.0
8.0
9.0
10.0
S
f
Figure 18: The optimal excercise boundary for an American vanilla put as a function of =

2
(T t)/2 when E = 10, r = 0.1 and = 0.25.
for a vanilla call, and
g(x, ) = exp
_
(k + 1)
2

4
_
max
_
exp
_
(k 1) x
2
_
exp
_
(k + 1) x
2
_
, 0
_
for a vanilla put.
We can follow the same nite dierence procedure for other American options. Only
the function g(x, ) will change in each case. For example, what is g(x, ) for an American
cash-or-nothing call? See problem sheet 5.
88
8 Course Summary
The following fundamental ideas and concepts have been introduced this term. They will
be used and expanded upon next term to provide a strong foundation for mathematical
nance.
Shares, dividends, supply and demand
Short-selling
Options
Risk Free Investment
Arbitrage
Lognormal random walk
Black Scholes Equation
89
Transformation from Black Scholes to Diusion Equation
Integral solution
The eect of dividends
Futures and Forwards
American options and optional early excercise
Numerical Methods for the Solution of the Black Scholes Equation
90