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Deriving Black-Scholes by Risk Neutral Probabilities

Tom Smith November 4, 2011

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1.1

Assuming the Stock Price Process


The Stock Price

The rst step in deriving the Black-Scholes Formula is making an assumption about how the stock price behaves. We assume that the stock price follows a stochastic process. It has an average annual growth rate of , pays a continuous dividend yield of q and has an annual standard deviation of . The formula for this process is given below. dS = ( q )Sdt + SdW dW N (0, t) The second term contains a Weiner process, dW , which is normally distributed with a mean of zero and a variance equal to the time elapsed. The rst term, containg the average annual growth rate and the dividend rate, is completely deterministic. It increases at a constant and known rate as time passes. The second term is random because of the underlying Weiner process. We must assume that , q and are all constant. For deriving Black-Scholes, they cannot vary over the life of the option. (1)

1.2

Itos Lemma

In this section well review the denition of Itos Lemma, which we will then apply to our stock price process in the next section. Itos Lemma is a formula that gives the process for any function of an underlying stochastic process. Take a continuous stochastic process, X , where W is a Brownian Motion, a and b are variables that can be functions of X and t. dX = a(X, t)dt + b(X, t)dW The process for any function of X , called G here, is given by Itos Lemma. dG = G G 1 2 G 2 G + a+ b dt + bdW t X 2 X 2 X (2)

This function describes the relationship between the process of any arbitrary function of a stochastic process, and its underlying process. We will apply this result to the natural logarithm of the stock price to show that the stock is a Geometric Brownian Motion. We will then also apply it to the stock itself to relate the process of an option to its underlying stock.

1.3

The Stock as a Geometric Brownian Motion

Below we take the natural logarithm of the process that we have already assumed for the stock price, equation 1, and use Itos Lemma to nd its process. dln(S ) = 0+ 1 1 1 2 2 1 ( q ) + S dt + SdW S 2 S2 S 1

dln(S ) =

1 q 2 dt + dW 2

This implies that the logarithm of the stock follows a Brownian Motion. The change in the logarithm of the stock from time 0 to time t is normally 1 2 distributed with mean ( q 2 )t and variance 2 t. ln(St ) ln(S0 ) N 1 ( q 2 )t, 2 t 2

The logarithm of the stock price itself is equivalent to the change plus the logarithm of the starting stock price. ln(St ) N 1 ln(S0 ) + ( q 2 )t, 2 t 2

Since the logarithm of the stock follows a Brownian Motion, the stock itself follows a Geometric Brownian Motion. This is simply the exponential of the formula above. St = S0 e(q 2
1 2

)t+W

(3)

Deriving the Black-Scholes PDE

In this section we derive the Black-Scholes partial dierential equation. This result will give some conditions that a derivative price will have to satisfy and it justies our use of risk neutral probabilities. We start with the stock price process, which we have assumed in equation 1. dS = ( q )Sdt + SdW Let V be the value of an arbitrary derivative on the stock; we apply Itos Lemma to the stock price process to derive a process for V . dV = V V 1 2 V 2 2 V + ( q )S + S dt + SdW t S 2 S 2 S

If we build a portfolio, P , of one derivative, V , and an amount of shares V equivalent to X , its value would be equal to the formula below. V S (4) X The process for the value of this portfolio is given below. The extra term occuring along with the stock price process, qSdt, is included because any position in the stock, long or short, would include receiving or paying the dividends the stock pays. The formula we derived earlier, equation 3, describes the stock price but not the value of owning the stock. If you own the stock you will also receive the dividends, so this must be included in the formula below. P =V V V 1 2 V 2 2 V V + ( q )S + S dt+ SdW ((q )Sdt+SdW +qSdt) t S 2 S 2 S S

dP =

The value of the dividends and the amount the dividends reduce the stock price directly oset each other of course. V V 1 2 V 2 2 V V + ( q )S + S dt + SdW (Sdt + SdW ) t S 2 S 2 S S

dP =

Collecting the terms that cancel, gives the following.

dP =

V V 1 2 V 2 2 S dt qS + t S 2 S 2

Since the terms containing dW cancel each other, there is no random component in the value of the portfolio; it is completely deterministic. Since it is completely determinsitic it must earn the risk free rate, otherwise there would be an arbitrage opportunity. It is only completely deterministic for an instant; as time passes or the stock price changes V S will change, which will require an adjustment to the number of shares in the portfolio. But as long as it is instantaneously risk free, it must earn the risk-free rate for that instant. Earning the risk-free rate r, on the value of the portfolio P , for an instant in time, is equal to rP dt. The process for the portfolio is given below. dP = V 1 2 V 2 2 V S dt = rP dt qS + t S 2 S 2

Subbing in equation 4 for P . V V 1 2 V 2 2 V S =r V qS + S t S 2 S 2 S And then rearranging gives the formula below. 1 2 V 2 2 V V S + ( r q )S + = rV (5) t 2 S 2 S This equation is known as the Black-Scholes partial dierential equation. The price of any derivative that does not create an arbitrage opportunity must satisfy this equation.

2.1

The Black-Scholes PDE and Risk Neutral Valuation

A very useful result of this equation is that it does not contain , the expected drift rate of the stock. The expected drift rate of the stock is the return that investors require as compensation for holding a risky asset. The value of will depend on investors risk preferences. If investors are very risk averse, then will have to be high. Because an arbitrage free price for an arbitrary derivative need only satisfy equation 5, and this equation does not depend on investors risk preferences, we can calculate the price of the derivative making any assumptions about their risk preferences that we like. We could assume that investors are very risk averse and that must be very high. Or we could assume that investors are risk loving and that is negative, since if investors were risk loving they would be willing to pay to take risk, they love it so much. The easiest assumption to work with is that investors are risk neutral. If investors are risk neutral, they do not care about the variance of potential outcomes, they only care about their expected value. For example, they would be indierent between receiving $5 with certainty and a gamble that pays either nothing or $10 with equal probabilities. This is equivalent to assuming that the utility curve of every investor is an upward sloping straight line. Since investors only care about the expected value of an asset when we assume they are risk neutral, we can price any asset as the discounted expected value of its payos. The variability of those payos is irrelevant. And since the value of the derivative is not dependent on our choice of risk preferences, if we can solve for its value under one assumption about risk preferences, that solution will be equally valid for all other possible risk preferences. This is the pricing approach that we follow in the next section.

Changing to Risk Neutral Probabilities

Beginning with the assumed process for the stock price.

ST = S0 e(q 2 S0 is the current stock price

)T +W

ST is the stock price after an amount of time T has passed T is the time to the maturity of the option is the average annual return of the stock, and is constant q is the continuous dividend payout rate of the stock, and is constant is the annual volatility of returns, and is constant W is a Weiner process, with mean of zero and variance equal to the time elapsed We dene a new process WQ that is based on our original Brownian motion but also contains a drift term. According to Girsanovs theorem there exists a probability measure, which we will call Q, under which WQ is a Brownian motion, even though it has a drift component. r T We can rearrange our denition for WQ and sub into the stock price process. WQ = W + W = WQ ST = S0 e(q 2
1 2

r T

r )T + (WQ T)

After collecting terms the expected drift rate of the stock disappears and is replaced by the risk free rate. The original Brownian motion underlying the price, W is replaced by WQ . ST = S0 e(rq 2
1 2

)T +WQ

We can now derive an important property of the stock price under Q. Recalling that the terms in the exponential are normally distributed under Q as shown below, we calculate the discounted expected value of the stock price, applying the formula for the expected value of the exponential of a normally distributed variable. 1 1 (r q 2 )T + WQ N ((r q 2 )T, 2 T ) 2 2 erT EQ [S0 e(rq 2
1 2

)T +WQ
2

] = erT S0 EQ [e(rq 2

)T +WQ

]=

erT S0 e(rq 2

1 2 )T + 2 T

= erT S0 e(rq)T = eqT S0

This result shows that the discounted expected value of the stock price is equal to the current stock price, decreased by the value of the dividends the stock will pay between now and the time T . This would also be the case if investors were indierent to risk. If investors were completely indierent to risk than the price of any asset would just be the discounted expected value of its future payo. We have shown that this is the case under the probability measure Q, which is why we call Q the risk neutral probability measure. You can also interpret this result as follows; if investors were risk neutral, all assets would just earn the risk free rate, since investors do not need any extra return to convince them to hold risky assets. So the current price of the stock would be equal to the discounted expected future value of the stock. We have shown that under the Q measure, the current stock price does equal its discounted future value. This implies that if investors were risk neutral, they 4

would have to be applying this probability measure to all of the future potential outcomes for the stock, to arrive at the current price. Since we have shown that using the Q measure is the same as pretending that investors are risk neutral, we can use this measure to nd the current price of an option by calculating its discounted expected value under Q. That is exactly what we do in the following steps.

Applying Risk Neutral Probabilities to a Call Option

Equating the current price of a European call option to the discounted expected payo of the call, where the expectation is taken under the Q measure, gives the formula below. c0 = erT EQ [max(ST K, 0)] We can then sub into this formula our expression for the stock price. c0 = erT EQ [max(S0 e(rq 2
1 2

)T +WQ

K, 0)]

Let us also dene a new variable y , which has a standard normal distribution. Because WQ is normally distributed with a variance equal to T , we can replace it with a standard normal scaled by a coecient of T . WQ = y T y N (0, 1) c0 = erT EQ [max(S0 e(rq 2
1 2

)T +y T

K, 0)]

Our integral is now just a function of y multiplied by its distribution, which is a standard normal.

c0 = e

rT

max(S0 e

2 (r q 1 2 )T +y T

e K, 0)

y 2 2

Because the payo of the call is 0 for all stock prices below K it will have no eect on the expected value, so we can take the integral for only the values of the stock price where ST > K . Since we are not integrating over the stock price directly but over y , we need to dene yK as the value of y where ST is equal to K , as shown below. We set the formula for the stock price equal to K , and set y equal to yK . S0 e(rq 2
1 2

)T +yK

=K

Taking the natural logarithm of both sides and moving over the stock price. 1 K (r q 2 )T + yK T = ln( ) 2 S0 Then rearranging the rest of the equation. yK =
K 1 2 ln( S ) (r q 2 )T 0 T

We can now change the integral so that it starts at yK and drop the max() function.

c0 = e

rT yK

(S0 e

2 ( r q 1 2 )T +y T

e K)

y 2 2

Next we will split the two terms within the integrand into two dierent parts. The rst term being a function of the stock price and the second being a function of the strike. The discounting factor, erT , applies to both of them.
2 (r q 1 2 )T +y T

c0 = e

rT yK

S0 e

y 2 2

rT yK

e K

y 2 2

Since K is a constant it can come outside of the integral, this leaves nothing but a standard normal inside the integral, evaluated from yK to innity. This is equal to 1 N (yK ), which by the symmetry of the standard normal around zero is equal to N (yk ).

c0 = e

rT yK

S0 e

1 2 (r q 2 )T +y T

y 2 2

erT KN (yK )

In the rst term, S0 is just a constant so it can come outside of the integral. We will then combine the exponential terms of the stock price and of standard normal distribution.

c0 = e

rT

S0
yK

e(rq 2 )T +y 2

Ty 2

erT KN (yK )

Within the exponential we then combine the terms containing y and , isolating (r q )T . This leaves one set of terms, y 2 2y T + 2 T , on which we can easily complete the square.

c0 = e

rT

S0
yK

1 2 2 (y 2y

T + 2 T )+(r q )T

erT KN (yK )

The exponential of (r q )T is a constant that can come outside of the integral. The rT term cancels with the discounting factor, leaving only the continuous dividend. Inside the integral we complete the square on the exponential, leaving (y T )2 .

c0 = e

qT

S0
yK

1 2 (y

T )2

erT KN (yK )

Then dene x = y T , and sub this into the integral. The starting value of the integral is also adjusted from yK to yK T .

c0 = eqT S0

The integral is now just a standard normal evaluated from yK T to innity. This is equal to 1 N (yK T ), which by the symmetry of the standard normal around zero is equal to N ((yK T )). c0 = eqT S0 N ((yK T )) erT KN (yK ) Substituting in our earlier denition for yK .
K 2 ln( S ) (r q 1 2 )T 0 + T erT KN T K 1 2 ln( S ) (r q 2 )T 0 T

yK T

e 2 erT KN (yK ) 2

c0 = eqT S0 N

In the stike term, simply multiply the negative coecient through the nu merator. In the stock price term, multiply and divide T by T , then add 2 to 1 2 T in the numerator.
1 2 0 ln( S 2 T K ) + ( r q 2 )T + T T 1 2 0 ln( S K ) + (r q 2 )T T

c0 = eqT S0 N

erT KN

This leaves the standard Black-Scholes equation for a call option, with a continuous dividend.
1 2 0 ln( S K ) + ( r q + 2 )T T 1 2 0 ln( S K ) + (r q 2 )T T

c0 = eqT S0 N

erT KN

Deriving the result for a put option can be done by a the same method.

Deriving the Greeks

The Greeks, the partial derviatives of the Black-Scholes formula to all of its inputs, are informally divided into two categories; the (actual) Greeks and the Bastard Greeks. The Bastard Greeks are the partial derivatives with respect to the interest rate (Rho) and volatility (Vega). These are called the Bastard Greeks because they are technically invalid. In deriving the Black-Scholes formula we had to assume that both the interest rate and the volatility were both constant over the life of the option. These assumptions are essential for deriving the formula; it is then inconsistent to take the derivatives with respect to these values, since the derivatives assume that the values can vary. However since interest rates and volaitilities do vary in the real world, these values are relevant for practical purposes. For the other greeks, Delta, Gamma and Theta, they are perfectly consistent with the assumptions of the model. We calculate all of the Greeks for a European call option with dividends, similar methods could be applied for a put option.

5.1
5.1.1

The Greeks
Delta

The Delta is the rst derivative with respect to the underlying stock price. We start with the pricing formula for a call option. c0 = eqT S0 N (d1 ) erT KN (d2 )
1 2 0 ln( S K ) + (r q + 2 )T T

d1 =

1 2 0 ln( S K ) + ( r q 2 )T d2 = d1 T = T

Taking the derivative uses the product rule and chain rule on the stock price term, and uses the chain rule on the strike price term. N (x) is the standard normal probability distribution function. c d1 d2 = eqT N (d1 ) + eqT S0 N (d1 ) erT KN (d2 ) S S S (6)

1 As an aside, we have to solve for d S . First we rearrange the formula for d1 to isolate the relevant terms, and then dierentiate. The solution is the same 2 for d S .

d1 =

1 2 )T ln(S0 ) ln(K ) (r q + 2 + T T T

d1 d2 1 = = S S S0 T As another aside we will rearrange N (d2 ) into a more useful formula. e 2 d2 N (d2 ) = 2 7
1 2

(7)

Using the fact that d2 = d1 T , we can substitute for d2 . = e


1 2 (d1

T )2

Next we multiply out (d1 T ) . = Then multiply through e


1 2 2 (d1 2d1

T + 2 T )

1 2 .

1 2 2 d1 +d1

1 2 T2 T

Then seperate out all three terms in the exponential.


1 2 e 2 d1 = ed1 T e 2 T 2
1 2

The rst exponential is just equal to N (d1 ) and in the second exponential we will sub in the formula for d1 .
ln( S0 )+(r q + 1 2 )T K 2 T

The T terms in the second exponential cancel out, leaving only the numerator of d1 . = N (d1 )e(ln( K )+(rq+ 2
1 S0 2 2 )T ) 1 2 T

= N (d1 )e

e 2

S0 2 The 1 2 T terms cancel out. And the exponential of ln( K ) is just equal to S0 the ratio K .

S0 (rq)T e (8) K This leaves a more useful formula for N (d2 ). Next we sub our results for 1 N (d2 ) and d S into equation 6. N (d2 ) = N (d1 ) c 1 S 1 erT KN (d1 ) 0 e(rq)T = eqT N (d1 ) + eqT S0 N (d1 ) S K S0 T S0 T In the last term K in the numerator and denominator cancel out, as do the exponentials of rT and rT . c 1 1 N (d1 )S0 eqT = eqT N (d1 ) + eqT S0 N (d1 ) S S0 T S0 T This leaves the same expressions in the second and third terms, so they cancel, leaving only the rst term. c = eqT N (d1 ) S 5.1.2 Gamma (9)

Gamma is the second derivative with respect to the stock price. To calculate it we begin with the formula for the delta, equation 9. c = eqT N (d1 ) S Applying the chain rule to N (d1 ).

d1 2 c = eqT N (d1 ) 2 S S Subbing in equation 7 for


d1 S .

1 2 c = eqT N (d1 ) S 2 S0 T This can be more simply written as below. 2 c eqT N (d1 ) = 2 S S0 T 5.1.3 Theta (10)

Theta is the derivative of the option price with respect to time. An index of time does not actually apper in the pricing formula, rather the time to maturity in fractions of a year. Because the change in time is always constant, so as time passes the time to maturity changes by the same amount, the change in price as time passes is just the negative of the change in price as time to maturity increases. This means we can nd the derivative of the option price with respect to the time to maturity, and then the theta is just the negative of that. This is the method we follow below. We start with the standard call option formula. c0 = eqT S0 N (d1 ) erT KN (d2 ) Taking the derivative with respect to the time to maturity requires applying the product rule and the chain rule to the stock and strike terms, leaving four terms in the derivative. d1 d2 c = qeqT S0 N (d1 ) + eqT S0 N (d1 ) + rerT KN (d2 ) erT KN (d2 ) T T T Subbing our result for N (d2 ) (equation 8) into the fourth term. d1 S0 c d2 = qeqT S0 N (d1 )+eqT S0 N (d1 ) +rerT KN (d2 )erT KN (d1 ) e(rq)T T T K T In the fourth term the K in the numerator and denominator cancel, as do the exponentials of rT and rT . c d1 d2 = qeqT S0 N (d1 )+ eqT S0 N (d1 ) + rerT KN (d2 ) N (d1 )S0 eqT T T T The second and fourth terms are now almost the same, we can factor out eqT S0 N (d1 ) from both of them. c = qeqT S0 N (d1 ) + eqT S0 N (d1 ) T d1 d2 T T + rerT KN (d2 ) (11)

We now have to take the derivative of d1 with respect to the time to maturity. First we rearrange the expression for d1 into something more useful. d1 = ln
S0 K + T 2 (r + 1 2 )T T

Next we take the derivative.


2 0 ln S (r + 1 d1 K 2 ) = + 3 T 2 T 2T 2 The result for d2 is very similar.

2 0 ln S (r 1 d2 K 2 ) = + 3 T 2 T 2T 2

Now we sub our equations for c =eqT S0 N (d1 ) T + re


rT

d1 T

and

d2 T

into equation 11. ln 2T


S0 K
3 2

ln 2T

S0 K
3 2

2 (r + 1 2 ) 2 T

2 (r 1 2 ) 2 T

KN (d2 ) qe

qT

S0 N (d1 )
1 2 2

The two terms in the brackets nearly cancel out, except for the which sum together.

terms

c 2 = eqT S0 N (d1 ) + rerT KN (d2 ) qeqT S0 N (d1 ) T 2 T The in the numerator and denominator cancel out and it can be rearranged for simplicity, as below. c eqT S0 = N (d1 ) + rerT KN (d2 ) qeqT S0 N (d1 ) (12) T 2 T The equation above is the derivative with respect to the time to maturity T . Theta, the derivative with respect to time itself, t, is simply the negative of this. eqT S0 c = N (d1 ) rerT KN (d2 ) + qeqT S0 N (d1 ) t 2 T (13)

5.2

The Bastard Greeks

As described above Vega and Rho can be called the Bastard Greeks since they are not entirely valid, since deriving the Black-Scholes formula requires the assumption that both the volatility and the interest rate are constant over the life of the option. Since these derivatives are of immense practical concern we still calculate them. 5.2.1 Vega

Vega is the derivative with respect to the stocks volatility. We start with the standard pricing formula for a call option. c0 = eqT S0 N (d1 ) erT KN (d2 ) Taking the derivative requires applying the chain rule to both terms. c d1 d2 = eqT S0 N (d1 ) erT KN (d2 ) Then we sub in our expression for N (d2 ), equation 8. c d1 S0 d2 = eqT S0 N (d1 ) erT KN (d1 ) e(rq)T K The K in the numerator and denominator of the second term cancel, as do the exponentials of rT and rT . d1 d2 c = eqT S0 N (d1 ) N (d1 )S0 eqT We can now factor eqT S0 N (d1 ) out of both terms. c = eqT S0 N (d1 ) Now we must solve for
d1 ,

d1 d2

(14)

starting from d1 . 10

d1 =

1 2 0 ln( S K ) + (r q + 2 )T T

We then rearrange d1 into a more useful form. d1 =


1 2 0 ln( S T K )(r q )T + 2 T T

The in the numerator and denominator of the second term cancel. 0 ln( S T K )(r q )T d1 = + 2 T And then we take the derivative. 0 ln( S d1 T K ) + ( r q )T + = 2 2 T The result for d2 is very similar. 0 ln( S d2 T K ) + ( r q )T = 2 2 T We then sub these formulas into equation 14. c = eqT S0 N (d1 ) 0 ln( S T K ) + (r q )T + 2 2 T 0 ln( S T K ) + ( r q )T 2 2 T
T 2

The two terms in brackets mostly cancel out, except for the simplify to just T . c = eqT S0 N (d1 ) T This leaves our nal expression for Vega. 5.2.2 Rho

terms, which

Rho is the derivative with respect to the risk-free interest rate. We start with the pricing formula for a call. c0 = eqT S0 N (d1 ) erT KN (d2 ) Taking the derivative requires applying the chain rule to the rst term, and the product rule and chain rule to the second term. c d1 d2 = eqT S0 N (d1 ) erT KN (d2 ) (T )erT KN (d2 ) r r r We then sub in our expression for N (d2 ), equation 8. d1 S0 d2 c = eqT S0 N (d1 ) erT KN (d1 ) e(rq)T + T erT KN (d2 ) r r K r In the second term the K in the numerator and denominator cancel, as do the exponentials of rT and rT . c d1 d2 = eqT S0 N (d1 ) N (d1 )S0 eqT + T erT KN (d2 ) r r r We can now factor eqT S0 N (d1 ) out of the rst two terms. c = eqT S0 N (d1 ) r d1 d2 r r 11 + T erT KN (d2 ) (15)

Now we have to take the derivative of d1 with respect to r. We start by rearranging the formula for d1 into a more useful form. d1 = ln
S0 1 2 T rT K + 2 T T T

The T in the second two terms cancel. 0 ln S T r T K d1 = + 2 T Then taking the derivative leaves only one term. The result is the same for
d2 r .

d1 d2 T = = r r Subbing this result into equation 15. c = eqT S0 N (d1 ) r T T + T erT KN (d2 )

The rst term collapses to zero, leaving only the second term, which is our formula for Rho. c = T erT KN (d2 ) r

Showing the Black-Schole PDE holds for a Call Option

Previously we derived the Black-Scholes PDE and stated that the price of any derivative that does not create an arbitrage opportunity must satisfy this equation. Using the the Greeks for a call option, we will now show that the BlackScholes pricing formula for a call option satises this equation. First we restate equation 5 in terms of the call price. c 1 2 c 2 2 c + S + ( r q )S = rc t 2 S 2 S Next, we will review the three Greeks that we will need to use. Equation 13, Theta: c eqT S0 = N (d1 ) rerT KN (d2 ) + qeqT S0 N (d1 ) t 2 T Equation 10, Gamma: 2 c eqT N (d1 ) = S 2 S0 T Equation 9, Delta: c = eqT N (d1 ) S We now have to sub all of these Greeks into the Black-Scholes PDE. To make it easier to follow we will sub in Gamma rst. c 1 + t 2 eqT c N (d1 ) 2 S 2 + (r q )S = rc S S0 T

In the Gamma term the S and in the numerator and denominator cancel. c eqT S c + N (d1 ) + (r q )S = rc t S 2 T 12

Next we will sub in Theta for the rst term. eqT S0 eqT S c N (d1 ) rerT KN (d2 ) + qeqT S0 N (d1 ) + N (d1 )+(rq )S = rc S 2 T 2 T

The rst term of Theta cancels with the Gamma term. rerT KN (d2 ) + qeqT S0 N (d1 ) + (r q )S Now we will sub in Delta. rerT KN (d2 ) + qeqT S0 N (d1 ) + (r q )SeqT N (d1 ) = rc The second term in the brackets cancels with the q term multiplied by the Delta. rerT KN (d2 ) + rSeqT N (d1 ) = rc Rearranging and factoring out r from both terms. r(SeqT N (d1 ) erT KN (d2 )) = rc This shows that the Black-Scholes PDE holds for the Black-Scholes pricing formula for a call option. c = rc S

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