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Probabilities
Tom Smith
November 4, 2011
dW N (0, t)
The second term contains a Weiner process, dW , which is normally dis-
tributed with a mean of zero and a variance equal to the time elapsed. The
first 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 2 G 2
G G G
dG = + a+ b dt + bdW (2)
t X 2 X 2 X
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
1
dln(S) = 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
distributed with mean ( q 21 2 )t and variance 2 t.
1 2 2
ln(St ) ln(S0 ) N ( q )t, t
2
The logarithm of the stock price itself is equivalent to the change plus the
logarithm of the starting stock price.
1
ln(St ) N 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.
1 2
St = S0 e(q 2 )t+W
(3)
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 .
1 2 V 2 2
V V V
dV = + ( 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
P =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 posi-
tion 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.
1 2 V 2 2
V V V V
dP = + ( q)S + S dt+ SdW ((q)Sdt+SdW +qSdt)
t S 2 S 2 S S
The value of the dividends and the amount the dividends reduce the stock
price directly offset each other of course.
1 2 V 2 2
V V V V
dP = + ( q)S + S dt + SdW (Sdt + SdW )
t S 2 S 2 S S
2
1 2 V 2 2
V V
dP = qS + S dt
t S 2 S 2
Since the terms containing dW cancel each other, there is no random com-
ponent 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.
1 2 V 2 2
V V
dP = qS + S dt = rP dt
t S 2 S 2
Subbing in equation 4 for P .
1 2 V 2 2
V V V
qS + S =r V S
t S 2 S 2 S
And then rearranging gives the formula below.
V 1 2 V 2 2 V
+ S + (r q)S = rV (5)
t 2 S 2 S
This equation is known as the Black-Scholes partial differential equation.
The price of any derivative that does not create an arbitrage opportunity must
satisfy this equation.
3
1 2
ST = S0 e(q 2 )T +W
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 .
1 2
ST = S0 e(rq 2 )T +WQ
We can now derive an important property of the stock price under Q. Re-
calling 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
1 2 1 2
erT EQ [S0 e(rq 2 )T +WQ
] = erT S0 EQ [e(rq 2 )T +WQ
]=
2
1
)T + 21 2 T
erT S0 e(rq 2 = 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 indifferent to risk. If investors were completely indifferent to risk
than the price of any asset would just be the discounted expected value of its
future payoff. 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 find the current price
of an option by calculating its discounted expected value under Q. That is
exactly what we do in the following steps.
y N (0, 1)
1 2
c0 = erT EQ [max(S0 e(rq 2 )T +y T
K, 0)]
Our integral is now just a function of y multiplied by its distribution, which
is a standard normal.
y 2
e
Z
2
rT (rq 12 2 )T +y T
c0 = e max(S0 e K, 0)
2
Because the payoff of the call is 0 for all stock prices below K it will have
no effect 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 define 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 .
1 2
S0 e(rq 2 )T +yK T
=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.
ln( SK0 ) (r q 21 2 )T
yK =
T
We can now change the integral so that it starts at yK and drop the max()
function.
y 2
e
Z
2
rT (rq 12 2 )T +y T
c0 = e (S0 e K)
yK 2
5
Next we will split the two terms within the integrand into two different
parts. The first 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.
y 2 y 2
e e
Z Z
2 2
rT (rq 12 2 )T +y T rT
c0 = e S0 e e K
yK 2 yK 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 infinity. This
is equal to 1 N (yK ), which by the symmetry of the standard normal around
zero is equal to N (yk ).
y 2
e
Z
2
rT (rq 21 2 )T +y T
c0 = e S0 e erT KN (yK )
yK 2
In the first 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.
2
1 2
T y2
e(rq 2 )T +y
Z
rT
c0 = e S0 erT KN (yK )
yK 2
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.
1 2
Z 2 (y 2y T + 2 T )+(rq)T
rT e
c0 = e S0 erT KN (yK )
yK 2
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 con-
tinuous dividend.
Inside the integral we complete the square on the exponential,
leaving (y T )2 .
1
Z 2 (y T )2
qT e
c0 = e S0 erT KN (yK )
yK 2
Then define x = y T , and sub this into theintegral. The starting value
of the integral is also adjusted from yK to yK T .
Z x
e 2
c0 = eqT S0 erT KN (yK )
yK T 2
The integral is now just a standard normal
evaluated from yK T to
infinity. 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 definition for yK .
! !
ln( SK0 ) (r q 12 2 )T ln( K ) (r q 21 2 )T
c0 = e qT
S0 N + T erT KN S0
T T
! !
qT ln( SK0 ) + (r q 21 2 )T 2 T rT ln( SK0 ) + (r q 21 2 )T
c0 = e S0 N + e KN
T T T
6
This leaves the standard Black-Scholes equation for a call option, with a
continuous dividend.
! !
qT ln( SK0 ) + (r q + 21 2 )T rT ln( SK0 ) + (r q 21 2 )T
c0 = e S0 N e KN
T T
Deriving the result for a put option can be done by a the same method.
ln( SK0 ) + (r q + 12 2 )T
d1 =
T
ln( SK0 ) + (r q 21 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 0 (x) is the standard
normal probability distribution function.
c d1 d2
= eqT N (d1 ) + eqT S0 N 0 (d1 ) erT KN 0 (d2 ) (6)
S S S
As an aside, we have to solve for d
S . First we rearrange the formula for d1
1
to isolate the relevant terms, and then differentiate. The solution is the same
for d
S .
2
ln(S0 ) ln(K) (r q + 21 2 )T
d1 = +
T T T
d1 d2 1
= = (7)
S S S0 T
As another aside we will rearrange N 0 (d2 ) into a more useful formula.
1 2
e 2 d2
N 0 (d2 ) =
2
7
Using the fact that d2 = d1 T , we can substitute for d2 .
1
2 (d1 T )2
e
=
2
2
Next we multiply out (d1 T ) .
1 2
2 (d1 2d1 T + 2 T )
e
=
2
1
Then multiply through 2 .
1 2
2 d1 +d1 T 21 2 T
e
=
2
Then seperate out all three terms in the exponential.
1 2
e 2 d1 1 2
= ed1 T e 2 T
2
The first exponential is just equal to N 0 (d1 ) and in the second exponential
we will sub in the formula for d1 .
!
S0
ln( )+(rq+ 1 2 )T
K 2 T
T 1 2
0
= N (d1 )e e 2 T
The T terms in the second exponential cancel out, leaving only the nu-
merator of d1 .
S0 2
)T ) 12 2 T
= N 0 (d1 )e(ln( K )+(rq+ 2
1
e
The 12 2 T terms cancel out. And the exponential of ln( SK0 ) is just equal to
the ratio SK0 .
S0 (rq)T
N 0 (d2 ) = N 0 (d1 )
e (8)
K
This leaves a more useful formula for N 0 (d2 ). Next we sub our results for
N (d2 ) and d
0
S into equation 6.
1
c 1 S 1
= eqT N (d1 ) + eqT S0 N 0 (d1 ) erT KN 0 (d1 ) 0 e(rq)T
S S0 T K 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
= eqT N (d1 ) + eqT S0 N 0 (d1 ) N 0 (d1 )S0 eqT
S S0 T S0 T
This leaves the same expressions in the second and third terms, so they
cancel, leaving only the first term.
c
= eqT N (d1 ) (9)
S
5.1.2 Gamma
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 ).
8
2 c d1
2
= eqT N 0 (d1 )
S S
d1
Subbing in equation 7 for S .
2 c 1
= eqT N 0 (d1 )
S 2 S0 T
This can be more simply written as below.
2 c eqT
2
= N 0 (d1 ) (10)
S S0 T
5.1.3 Theta
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 find 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.
c d1 d2
= qeqT S0 N (d1 ) + eqT S0 N 0 (d1 ) + rerT KN (d2 ) erT KN 0 (d2 )
T T T
Subbing our result for N 0 (d2 ) (equation 8) into the fourth term.
c d1 S0 d2
= qeqT S0 N (d1 )+eqT S0 N 0 (d1 ) +rerT KN (d2 )erT KN 0 (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 0 (d1 ) +rerT KN (d2 )N 0 (d1 )S0 eqT
T T T
The second and fourth terms are now almost the same, we can factor out
eqT S0 N 0 (d1 ) from both of them.
c d1 d2
= qeqT S0 N (d1 ) + eqT S0 N 0 (d1 ) + rerT KN (d2 ) (11)
T T T
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.
ln SK0 (r + 12 2 )T
d1 = +
T T
Next we take the derivative.
ln SK0 (r + 12 2 )
d1
= 3 +
T 2T 2 2 T
The result for d2 is very similar.
9
ln SK0 (r 12 2 )
d2
= 3 +
T 2T 2 2 T
d1 d2
Now we sub our equations for T and T into equation 11.
! !!
S0 S0
(r + 12 2 ) (r 12 2 )
c ln ln
=eqT S0 N 0 (d1 ) K
3 + K
3 +
T 2T 2 2 T 2T 2 2 T
+ rerT KN (d2 ) qeqT S0 N (d1 )
1 2
The two terms in the brackets nearly cancel out, except for the 2 terms
which sum together.
c 2
= eqT S0 N 0 (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 0
= 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.
c eqT S0 0
= N (d1 ) rerT KN (d2 ) + qeqT S0 N (d1 ) (13)
t 2 T
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.
10
ln( SK0 ) + (r q + 12 2 )T
d1 =
T
We then rearrange d1 into a more useful form.
! !!
c ln( SK0 ) + (r q)T T ln( SK0 ) + (r q)T T
= eqT S0 N 0 (d1 ) +
2
T 2 2
T 2
T
The two terms in brackets mostly cancel out, except for the terms, which
2
simplify to just T .
c
= eqT S0 N 0 (d1 ) T
This leaves our final expression for Vega.
5.2.2 Rho
Rho is the derivative with respect to the risk-free interest rate. We start with
the pricing formula for a call.
c d1 d2
= eqT S0 N 0 (d1 ) erT KN 0 (d2 ) (T )erT KN (d2 )
r r r
We then sub in our expression for N 0 (d2 ), equation 8.
c d1 S0 d2
= eqT S0 N 0 (d1 ) erT KN 0 (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 0 (d1 ) N 0 (d1 )S0 eqT + T erT KN (d2 )
r r r
We can now factor eqT S0 N 0 (d1 ) out of the first two terms.
c qT 0 d1 d2
=e S0 N (d1 ) + T erT KN (d2 ) (15)
r r r
11
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.
ln S0 1 2
rT T
d1 = K + 2
T T T
The T in the second two terms cancel.
ln SK0
r T T
d1 = +
T 2
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 qT 0 T T
=e S0 N (d1 ) + T erT KN (d2 )
r
The first term collapses to zero, leaving only the second term, which is our
formula for Rho.
c
= T erT KN (d2 )
r
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.
c eqT S0 0
= N (d1 ) rerT KN (d2 ) + qeqT S0 N (d1 )
t 2 T
Equation 10, Gamma:
2 c eqT
= N 0 (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 first.
qT
c 1 e 0 c
+ N (d1 ) 2 S 2 + (r q)S = rc
t 2 S0 T S
In the Gamma term the S and in the numerator and denominator cancel.
c eqT S 0 c
+ N (d1 ) + (r q)S = rc
t 2 T S
12
Next we will sub in Theta for the first term.
eqT S0 0
qT
rT qT e S 0 c
N (d1 ) re KN (d2 ) + qe S0 N (d1 ) + N (d1 )+(rq)S = rc
2 T 2 T S
The second term in the brackets cancels with the q term multiplied by the
Delta.
13