MATHEMATICAL ANALYSIS OF BLACK-SCHOLES

EQUATION AND THE RELATIONSHIP BETWEEN

RISK FREE INTEREST RATE AND OPTION VALUE

Abstract
This paper will deal with the derivation of Black-Scholes equation and then it will study the effect
of varying risk free interest rate on option value by using various numerical techniques.

Hrishabh Khakurel
Hrishabh.khakurel@mavs.uta.edu

MATHEMATICAL ANALYSIS OF BLACK-SCHOLES EQUATION AND THE

RELATIONSHIP BETWEEN RISK FREE INTEREST RATE AND OPTION VALUE

Introduction
Black-Scholes equation is a Partial Differentiated Equation (PDE) that is used to in the
financial world to determine the theoretical price of European Put and Call options. Utilization of
the Black-Scholes model allows to perfectly hedge the option by buying and selling the option
by eliminating risk. It was introduced in 1973 by Fischer Black, Myron Scholes and Robert
Merton. Scholes and Merton were awarded with the 1997 Nobel Prize in Economics. The BlackScholes equation is given below

=0

Here,
V=Option value
S= Spot price of the underlying asset
T=time
=Volatility
r= risk free interest rate

There are two types of option: Call and Put. Call is the right to buy a stock for a given price within a
given period of time and put is the right to sell a stock for a given price within a given period of time. We
will deal with only the call option.

Derivation
Let S(t) be the asset price and V(S,t) be the option price. We make the assumption that S
is lognormal. Then we can apply the simple Brownian motion form.
= +
Here is the drift and is the volatility.
We assume that our position has long option and a short asset. And we can hedge asset price with
option price. Let be our position and is the hedge factor. We are trying to hedge the change in
asset price against the option price. That means we want our position to stay the same. To achieve
this we have to hedge in every time step. Thus, this is a dynamic hedge. Then,
= V-S

Taking differentiation on both sides,

d = dV-dS
Now we use Itos lemma. Itos lemma gives us,

1 2 2 2
=
+
+

2
2
Using above equations we can have,
=

1
2
+
+ 2 2 2

= (

1
2
) + ( + 2 2 2 )

In the above equation ( ) is the random part which we will set to zero (0) by choosing

= .
= (

1 2 2 2
+
)
2
2

We know use the no arbitrage argument which states that if cash flow are known then they have
to be equal. Let r be the riskless interest rate. Then mathematically,
d = rdt=r(V-S)dt
Using above equations we can compute,

1
2

( + 2 2 2 ) = (rV r
S)dt
2

1 2 2 2

( +
)
=
rV

r
S
2
2

Interpretation
We can represent the equation as

=0

The right hand side involves the riskless return from long position in the derivative and a
short position consisting of

shares of the underlying. The left hand side consists of the change

in derivative value due to time increasing which called theta and a term involving the second
spatial derivative gamma. Thus the equation implies that the riskless return by holding an option
is equal to the sum of change in derivative value due to time increasing which called theta and a
term involving the second spatial derivative gamma.

Solving Black-Scholes equation:

The Black-Scholes equation with its boundary condition can be solved by using standard
methods of numerical analysis. We will study the call option of Black-Scholes equation. I will be
using Mathematica to solve the differential equation.
The Boundary Conditions for Call Option are given below:
V(S, T) = max[S-K, 0]
V (, t)
V (0, t) 0
Here, K=Strike Price (price that determines the utilization of option)
We will study the effects of varying the risk free interest rate on the option value.
We will be using the following values for our calculations:
Volatility () = 0.5
Strike price (K) = 10
We will be using various values for the risk free interest rate to study its effect on the Black-Scholes
model.
Varying the interest rate(r):
Case 1: r=0.07

As we can see the computation gives us a 3 dimensional price floor. By using this price floor
we can determine the various option value (V) for selected values of time and Spot price of
underlying asset S The following examples are given to find the option value at fixed T and S.
When S=20 and t=0
V=2.81428
When S=22 and t= 0.5
V=2.27462
When S= 25 and t=1
V=0
When S=25, t=0 (Practical maximum Value)
V=5.6871
When S=25, t=-1
V=8.68895
Case 2: r= 1

As we can see, in this price floor, the part after the diagonal starts increasing and reaches only
one maximum point at S=25 and t=0. At full maturity and highest value of S, utilization of our
option will not give any profit to us. We will now see some specific points in the price floor.
When S=10 and t=0
V=2.32384
When S=20 and t=0.5
V=5.59304
When S=22 and t =0.7

V=4.365
When V= 25 and t=0 (Maximum value)
V=15.8656
We can see that the final option value is higher than in the previous case. Thus, the option value
increases with the increase in our risk less interest rate. This is a common phenomenon in actual
financial markets (higher interest yields higher profit).

Case 3: r= 2.5

When the interest rate is increased to 2.5 we can see that V starts increasing earlier than in
previous cases and it also reaches a higher value. In the S-V plane V starts increasing as early as
S=2. The maximum value is nearly 21.5694 which is higher than previous cases which also
strengthens the fact that the option value increases with riskless rate interest rate.
Here are some specific values
When S=10, t=0
V= 7.88258
When S=20, t=0.5
V=13.4501
When S=22, t= 0.7
V=12.0649
When S=25, t=0 (Maximum Value)
V=21.5694

Here are some other cases where we increase the riskless interest rate.
r= 3.5

r=5

The analysis of this graph is similar to the previous cases.

Conclusion
From all these cases we can easily deduce that the option value increases with the riskless
interest rate. As you can see when T is the highest, the value of V is 0. Hence selling the option
at that time is worthless. Thus, one must sell the option when T=0, that is at full maturity of the
option. The use of numerical methods to solve a Partial Differential equation is one of the many
ways to study this phenomenon. We can also do similar analysis for the relationship between
volatility and strike price with the option vale. Furthermore this method can be extended for both
the call option and put option. Among the many utilizations of PDEs in econometrics to study
various phenomenon in the financial world, this is one of the common uses.

References
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May 2016.
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5. Heimer, Thomas, and Sebastian Arend. "The Genesis of the Black-Scholes Option
Pricing Formula." Frankfurt School Working Paper Series 98. Web.