Continuous time models

Derivatives 1, professor Alexei Zhdanov

Fall 2010

Handout 6

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Risk-Neutral Valuation
Theorem (Girsanov). Let W (t), 0 ≤ t ≤ T , be a Brownian
motion on a probability space (Ω, F, P) and let F(t) be a filtration
for this Brownian motion. Let Θ(t) be an adapted process. Define

Zt Zt
1
Z(t) = exp{− Θ(u)dW (u) − Θ2 (u)du},
2
0 0
Zt
W
f (t) = W (t) + Θ(u)du,
0

and assume that

Zt
E Θ2 (u)Z 2 (u)du < ∞.
0

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Risk-Neutral Valuation

Set Z = Z(t). Then EZ = 1 and under the probability measure P

e
given by Z
P(A) =
e Z(w)dP (w) for all A ⊂ F
A

the process W
f (t) is a Brownian motion.
Translation:
For a ”well-behaved” function Θ(t) one can change the probability
measure such that W f (t) becomes a Brownian motion under the
new measure P. In other words, by changing the probability
e
measure one can change the drift of the Brownian motion:
dW
f (t) = dW (t) + Θ(t)dt

Proof: See Professor Michael Rockinger

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Stock prices under the Risk-Neutral Measure

Let W (t), 0 ≤ t ≤ T , be a Brownian motion on a probability

space (Ω, F, P). Consider a stock price process whose differential is
dS(t) = µS(t)dt + σS(t)dW (t), 0 ≤ t ≤ T.
Then
d(e−rt S(t)) = e−rt dS(t) − re−rt S(t)dt =
e−rt [(µ − r)S(t)dt + σS(t)dW (t)] (1)
Let us choose
µ−r
Θ(t) =
σ
so
d(e−rt S(t)) = σS(t)e−rt [Θdt + dW (t)]
Choose probability measure Q such that W f (t) = W (t) + Θt is a
Brownian motion under Q (and dW f (t) = dW (t) + Θdt)
Then discounted the stock price is a martingale under Q and we
can call Q the Risk-Neutral measure 4 / 54
Portfolio values under the Risk-Neutral Measure
Consider an agent who begins with initial wealth X(0) and at each
t, 0 ≤ t ≤ T , holds ∆(t) shares of the stock, investing/borrowing
the rest of his wealth in the risk-free asset. Then
dX(t) = ∆(t)dS(t) + r(X(t) − ∆(t)S(t))dt =
∆(t)((µ − r)S(t)dt + σS(t)dW (t)) + rX(t)dt
Then discounted portfolio value is

d(e−rt X(t)) = e−rt dX(t) − re−rt X(t)dt =

e−rt [∆(t)((µ − r)S(t)dt + ∆(t)σS(t)dW (t) + rX(t)]dt
− re−rt X(t)dt =
e−rt ∆(t)((µ − r)S(t)dt + σS(t)dW (t)) =
e−rt ∆(t)σS(t)[Θdt + dW (t)] = e−rt ∆(t)σS(t)dW
f (t)

Therefore, self-financing portfolios are martingales under the

Risk-Neutral measure.
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Risk-Neutral Valuation

But we have seen that we can replicate the payoff of a derivative

by constructing a self-financing portfolio. Therefore, discounted
prices of derivative securities are martingales under Q and the price
of a derivative with a payoff D(T ) at maturity is

D(t) = E Q [e−r(T −t) D(T )|Ft ]

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Risk-Neutral Valuation

Using the RN valuation formula is in many cases easier than

solving the Black-Scholes PDE directly. Let us see if we can
get the Black-Scholes formula this way.
Under the RN measure Q the price ST is
1 2 )T +σW 1 2 )T −σ
√
ST = S0 e(r− 2 σ T
= S0 e(r− 2 σ TY

where Y = − W
√T .
T
Therefore
1 2
√
c(t, S0 ) = EQ [e−rT (S0 e(r− 2 σ )T −σ T Y − K)+ |Ft ] =
Z ∞ √
1 1 2 Y2
√ e−rT (S0 e(r− 2 σ )T −σ T Y − K)+ e− 2 dY
2π −∞

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Risk-Neutral Valuation
1 2 )T −σ
√
Note that S0 e(r− 2 σ TY
− K > 0 iff
log(S0 /K) + (r − 21 σ 2 )T
Y < d2 = √
σ T
So we have:

c(t, S0 ) =
Z d2 √
1 1 2 Y2
√ e−rT (S0 e(r− 2 σ )T −σ T Y − K)e− 2 dY =
2π −∞
Z d2 √
1 1 2 Y2
√ (S0 e− 2 σ T −σ T Y − 2 )dY −
2π −∞
Z d2
Y2
−rT
Ke e− 2 dY =
−∞
S0 N (d1 ) − Ke−rT N (d2 )

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Some basic extensions

Binary option
Also called digital options
Pay a fixed amount (e.g. $1) if the price of the underlying is
above/below the strike.
Pricing
D(K) = e−rT N (d2 )
Why?

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Some basic extensions
Gap option
Option with payment triggers that differ from their strikes.
E.g. C(K1 , K2 ) pays ST − K1 if ST > K2
Not really an option
Pricing: a gap option is a European option, struck at the
trigger, plus a binary, also struck at the trigger
So the call price is
c(K1 , K2 ) = S0 N (d1 ) − K2 e−rT N (d2 )+
(K2 − K1 )e−rT N (d2 ) =
S0 N (d1 ) − K1 e−rT N (d2 )
where
log(S0 /K2 ) + (r + 12 σ 2 )T
d1 = √
σ T
log(S0 /K2 ) + (r − 12 σ 2 )T
d2 = √
σ T
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Some basic extensions

Options on futures
Options on futures are options that cost nothing to exercise,
written on futures.
The strike refers to the futures price of the delivered futures
contract
An option is initiated at t, and expires at te = t + T in the
future, on or before the futures maturity at td = te + τ. I.e. at
te , if exercised, the contract delivers a futures contract for
τ −ahead delivery of the underlying
The call gives the owner the right to a long futures contract
(with a futures price equal to the strike)
The put gives the owner the right to a short

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Some basic extensions

Pricing
At exercise the futures contract is marked to market. The
owner can then close it out for free
The payoff at maturity (te )

C(K, te ) = (Fte ,τ − K)+ = (Ste erτ − K)+ =

erτ (Ste − Ke−rτ )+

This looks like erτ calls struck at Ke−rτ . Can use

Black-Scholes!
h i
c(K, 0) = erτ S0 N (d1 ) − Ke−r(T +τ ) N (d2 ) =
erτ S0 N (d1 ) − Ke−rT N (d2 ) =
e−rT [F0,T +τ N (d1 ) − N (d2 )]

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Some basic extensions

where

log(S0 /Ke−rτ ) + (r + 12 σ 2 )T
d1 = √ =
σ T
log(S0 er(τ +T ) /K) + 21 σ 2 T
√ =
σ T
log(F0,T +τ /K) + 12 σ 2 T
√
σ T
√
d2 = d1 − σ T

This is Black’s formula for options on futures.

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Some basic extensions

Chooser option
A chooser option gives its holder the right at time t0 to choose
to own either the call or the put
”Simple chooser” - the strikes aned maturities of the call and
the put are the same
At time t0 the value of the chooser option is

D(t0 ) = max(c(t0 , K, T ), p(t0 , K, T )) =

c(t0 , K, T ) + (p(t0 , K, T ) − c(t0 , K, T ))+ =
 +
c(t0 , K, T ) + e−r(T −t0 ) K − S(t0 )

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Some basic extensions

The price at time 0 is

D(0) = EQ [e−rt0 D(t0 )|F0 ] =

EQ [e−rt0 EQ [e−r(T −t0 ) (S(T ) − K)+ |Ft0 ]|F0 ]+
 +
Q −rt0 −r(T −t0 )
+ E [e e K − S(t0 ) ] =
c(0, K, T ) + p(0, e−r(T −t0 ) K, t0 )

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Some basic extensions

Option on S 2
What is the price of a security that pays ST2 at maturity?
Can use risk-neutral valuation:

D(t) = EtQ [e−r(T −t) D(T )] =

 2  
ST ST
log 2 log
St2 e−r(T −t) EtQ [e St
] = St2 e−r(T −t) EtQ [e St
]

Fact: if X is Normal with mean µ and variance σ 2 , then

1 2
E(eX ) = eµ+ 2 σ . But

σ2
log(ST ) = log(St ) + (r − )(T − t) + σ(WT − Wt )
2
Therefore,
2 )(T −t)
D(t) = St2 e(r+σ

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Limitations of Black-Scholes and empirical evidence

Does the market price of an option always equal the

Black-Scholes price?
All inputs for the Black-Scholes formula are observable
(S, K, T, and r) except for volatility σ.
Volatility has to be estimated. Using, for example, historical
volatility
Option prices are directly observable. So we can solve for σ
b
that solves

cBS (S, K, T, r, σ
b) = cmkt (S, K, T, r)

This is so-called option implied volatility

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Limitations of Black-Scholes and empirical evidence

Note that implied volatilities of calls and puts with the same
strikes and times to maturity are equal. Why?
Start with the put-call parity for the Black-Scholes model

pBS + S = cBS + Ke−rT

The put-call parity also holds for the market prices

pmkt + S = cmkt + Ke−rT

Therefore,
pBS − pmkt = cBS − cmkt

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Limitations of Black-Scholes and empirical evidence

Example. A European call option on a certain stock has a

strike price of $30, a time to maturity of 1 year, and an
implied volatility of 30%. A European put option on the same
stock has a strike price of $30, a time to maturity of 1 year,
and an implied volatility of 33%. What is the arbitrage
opportunity open to the trader? Does the arbitrage work only
when the lognormal assumption underlying Black-Scholes
holds?
How does the implied volatility provide a test for
Black-Scholes?
Black-Scholes assumes constant volatility. Then we should see
the same implied volatility across different strikes and across
different maturities
Prior to the 1987 crash the Black-Scholes model did very well

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Limitations of Black-Scholes and empirical evidence
The implied volatilities from S&P 500 index options with 5
months to maturity used to look like

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Limitations of Black-Scholes and empirical evidence

Since the crash, the implied volatilities look like a ”smirk”

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Limitations of Black-Scholes and empirical evidence

For individual stocks, the pattern looks more like a ”smile” -

both corners turn up
OTM puts have higher implied volatilities. That is, if we use
the implied volatility of the ATM option, then OTM puts are
”overpriced”.
So ITM calls are also overpriced. Why?

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The reasons behind Black-Scholes’ failure

Let us review the assumptions behind Black-Scholes

1 The stock price is lognormally distributed
2 Stock prices are continuous and do not jump
3 Volatility of stock returns σ is constant
4 The continuously compounded risk-free rate is constant over
time
5 Marktes are perfect (costless trades and short sales,
borrowning rates = lending rates, etc.)
6 Continuous trading is possible

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The reasons behind Black-Scholes’ failure

Costly trades. Then we do not get a no-arbtrage price, but

get no-arbitrage bounds
Discontinuous stock price dynamics. Stock prices don’t
change continuously. There is some probability of downward
jumps.
Stochastic volatility. Even if prices are continuous,
Black-Scholes may misprice because volatility is not constant.
But it is not enough that volatility is time-varying. To
generate higher OTM put prices we need volatility to be
negatively correlated with stock prices

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American Derivatives

Definition. A stopping time τ is a random variable taking

values in [0, ∞] and satisfying

{τ ≤ t} = {ω ∈ Ω; τ (ω) ≤ t} ∈ F(t) for all t ≥ 0

Example - First passage time of a continuous process. Let

X(t) be an adapted process with continuous paths, let m be a
number, and set

τm = min{t ≥ 0; X(t) = m}

If X(t) never reaches m, then we interpret τm to be ∞.

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Perpetual American Put

Let us consider a perpetual American put (that has no

expiration date).
Definition. Let T be the set of all stopping times. The price
of the perpetual American put is defined as

p(S(0)) = maxEQ [e−rτ (K − S(τ ))]

τ ∈T

In the event that τ = ∞ we interpret e−rτ (K − S(τ )) to be

zero.
Because every date is like any other date, it is reasonable to
expect that the optimal exercise policy depends only on the
value of S(t) and not on the time variable t.

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Perpetual American Put

Therefore, the optimal exercise policy is of the form “exercise

the put as soon as S(t) falls to the level L∗ .
We have two questions to answer:
1 What is the value of L∗ ?
2 What is the value of the put?

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Perpetual American Put
In the continuation region (values of S for which it is not
optimal to exercise)
EQ (dp(S(t))) = rp(S(t))dt
Use Ito’s lemma:
f (t) + 1 σ 2 S(t)pss dt + pt dt)
EQ (ps rS(t)dt + ps σS(t)dW
2
= rp(S(t))dt
or
1
ps rS(t) + σ 2 S 2 (t)pss = rp(S(t))
2
This is an ordinary differential equation. Let us try a solution
of the form p = AS(t)β . Then
1
βr + σ 2 β(β − 1) − r = 0
2
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Perpetual American Put
There are two roots of this quadratic equation:
2r
β1 = 1 and β2 = −
σ2
and the general solution is
2r
p = AS(t) + BS − σ2 (t)
The boundary conditions are:
p(L∗ ) = K − L, lim p(x) = 0
x→∞

Therefore 2r
A = 0, B = (K − L)L σ2
and  − 2r2
2r
− 2r2 S σ
p = (K − L)L σ2 S σ = (K − L)
L
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Perpetual American Put

We want to maximize the value of the put, therefore

2r
L∗ = K≤K
2r + σ 2
and the value of the put option in the “continuation region” is
 2r2
σ2

2r σ 2r+σ 2 2r
p(S(t)) = K σ2 (S(t))− σ2
2r + σ 2 2r + σ 2

In the “exercise region” the price of the put is

p(S(t)) = K − S(t)

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Smooth-pasting conditions

Another way to find the value of the option is to use so-called

“smooth-pasting” condition, that requires the first derivative
of the value function to be continuous.

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Smooth-pasting conditions

Therefore, the optimal exercise policy is determined by the

following two conditions:
1 Value-matching
p(L∗ ) = K − L∗
2 Smooth-pasting
∂p(S)
|S=L∗ = −1
∂S

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Derivation of the put value by replicating portfolio

Under the original probability measure the price process is

dS(t)
= µS(t) + σS(t)dW (t)
dt
Consider the following portfolio:
1 Hold one put option p(S(t))
2 Short ∂p(S) ∂p(S)
∂S shares (or buy − ∂S shares)

The value of your portfolio is

∂p(S)
p(S(t)) − S(t)
∂S

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Derivation of the put value by replicating portfolio

The total return from holding this portfolio is

dp(S(t)) − ps (S(t))dS(t) =
1
ps dS + σ 2 S 2 pss dt − ps dS
2
This portfolio is risk-free, therefore
1 2 2
σ S pss dt = r(p − ps S)dt
2
and we get the same ODE in the continuation region as before

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Discounted American derivatives are supermartingales

In the continuation region

1
ps rS(t) + σ 2 S 2 (t)pss − rp(S(t)) = 0
2
In the exercise region
1
ps rS(t) + σ 2 S 2 (t)pss − rp(S(t)) = −rK
2

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Discounted American derivatives are supermartingales

Theorem. The discounted process e−rt pL∗ (S(t)) is a

supermartingale under the risk-neutral measure Q. The
stopped process e−r(t∧τL∗ ) pL∗ (S((t ∧ τL∗ )) is a martingale.
Proof. Let p = pL∗ (S(t))

d[e−rt pL∗ (S(t))] =

1
e−rt [−rp + rS(t)ps + σ 2 S 2 (t)pss ]dt+
2
e−rt σS(t)ps dW
f (t)

Therefore

d[e−rt pL∗ (S(t))] =

− e−rt rK1{S(t)<L∗ } + e−rt σS(t)ps dW
f (t)

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Discounted American derivatives are supermartingales

Because the dt term is less than or equal to zero, e−rt pL∗ (S(t)) is
a supermartingale.
If S(t) > L∗ then prior to τL∗ the dt term is zero, and therefore
e−r(t∧τL∗ ) pL∗ (S((t ∧ τL∗ )) is a martingale. Indeed,

e−r(t∧τL∗ ) pL∗ (S((t ∧ τL∗ )) =

Z t∧τL∗
pL∗ (0) + e−ru σS(u)ps dW
f (u)
0

It is an Ito integral and therefore a martingale.

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Discounted American derivatives are supermartingales

Discounted European options are martingales under the

risk-neutral measure
Discounted American options are martingales up to the time
they should be exercised. If they are not exercise when they
should be they tend downwards.
Since a martingale is a special case of a supermartingale,
discounted American option prices are supermartingales

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Finite expiration American put

Now in the continuation region

f (t) + 1 σ 2 S(t)pss dt + pt dt)

EQ (ps rS(t)dt + ps σS(t)dW
2
= rp(S(t), t)dt

or
1
ps rS(t) + σ 2 S 2 (t)pss + pt = rp
2

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Finite expiration American put

This a partial differential equation which has to be solved

numerically
The boundary conditions are

p|L(T −t) = K − L(T − t)

∂p
| = −1
∂S L(T −t)
p(S(T ), T ) = (K − S(T ))+
and
lim p(S, t) = 0
S→∞

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Perpetual American call

Consider a perpetual American call option on a stock with a

constant dividend yield α
We can derive its value using either the risk-neutral or the
replicating portfolio approach
Let us use the replicating portfolio approach
Consider the following portfolio:
1 Hold one call option c(S(t))
2 Short ∂c(S)
∂S shares

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Perpetual American call

The value of your portfolio is

∂c(S)
c(S(t)) − S(t)
∂S
The total return from holding this portfolio is

dc(S(t)) − cs (S(t))dS(t) − cs (S(t))S(t)αdt =

1
cs dS + σ 2 S 2 css dt − cs dS − cs Sαdt
2
This portfolio is risk-free, therefore
1 2 2
σ S css dt − cs Sαdt = r(c − cs S)dt
2
or
1 2 2
σ S css dt + cs S(r − α)dt − rc = 0
2
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Perpetual American call
Need to solve this ODE subject to the boundary conditions:
c(0) = 0
c(L∗ ) = L∗ − K
∂c(S)
|S=L∗ = 1
∂S
The general solution is AS(t)β1 + BS(t)β2 where β1 and β2
are the two roots of the following quadratic equation:
1 2
σ β(β − 1) + β(r − α) − r = 0
2
or r
1 r−α r−α 1 2r
β1 = − 2
+ [ 2 − ]2 + 2 > 0
2 σ σ 2 σ
r
1 r−α r−α 1 2r
β1 = − 2
− [ 2 − ]2 + 2 < 0
2 σ σ 2 σ
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Perpetual American call
Using the boundary conditions, we get
B=0
β1
L∗ = K
β1 − 1
and the value of the call is
 β1
S
c(S) = (L∗ − K)
L∗
Note that if α → 0, then β1 → 1 and
L∗ → ∞
so it is not optimal to exercise a call on a non-dividend paying
In this case the value of the call
c(S) → S
stock before maturity.
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Finite maturity American call

The corresponding PDE is

1 2 2
σ S css dt + cs S(r − α)dt − rc = 0
2
Must be solved subject to the following boundary conditions.
The boundary conditions are

c|L(T −t) = L(T − t) − K

∂c
| =1
∂S L(T −t)
c(S(T ), T ) = (S(T ) − K)+
and
c(0, t) = 0

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Application to credit risk - Merton’s model (1973)

Consider a single firm, and suppose that the market value of

the firm’s assets under the risk-neutral measure is given by
dAt
= rAt dt + σAt dWt
dt
Assume that there are no taxes and no bankruptcy costs so
that the Modigliani and Miller theorem holds
For simplicity, assume that the firm produces no cash flow
before some fixed horizon T (when the debt matures)

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Application to credit risk - Merton’s model (1973)

The owners of the firm have chosen a very simple capital

structure:
Common equity
Zero coupon debt with face value L maturing at time T
In the absence of corporate taxes and bankruptcy costs, the value
of the firm equals the sum of debt and equity values

At = Et + Dt

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Application to credit risk - Merton’s model (1973)

The payoff to the claimholders of the firm (shareholders and

debtholders) depends on the value of the firm’s assets at
maturity of the debt
If AT ≥ L at maturity then
Debtholders receive the face value of debt DT = L
Shareholders receive the residual payoff: ET = AT − L ≥ 0
If AT ≤ L at maturity then
Debtholders receive AT
Shareholders receive nothing

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Application to credit risk - Merton’s model (1973)

Therefore,

DT = min(AT , L) = L − max(L − AT , 0)

ET = max(AT − L, 0) = (AT − L)+

This shows that
Equity is a call options on the firm’s assets (with a strike equal
to the face value of debt)
Defaultable debt is equivalent to default-free debt minus put
on the firms asset

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Application to credit risk - Merton’s model (1973)
We can use the Black-Scholes formula to price debt and equity
The value of equity is

Et = EQ [e−r(T −t) (AT − L)+ |Ft ] =

At N (d1 ) − Le−r(T −t) N (d2 )
where
log(At /L) + (r + 12 σ 2 )(T − t)
d1 = p
σ (T − t)
log(At /L) + (r − 12 σ 2 )(T − t)
d2 = p
σ (T − t)
The value of debt is
Dt = At − Et = At (1 − N (d1 )) + Le−r(T −t) N (d2 ) =
At N (−d1 ) + Le−r(T −t) N (d2 )
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Application to credit risk - Merton’s model (1973)

Lets use the following parameter values: r = 5%,

T = 1, L = 72.
The value of equity is

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Application to credit risk - Merton’s model (1973)

And the value of debt

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Application to credit risk - Merton’s model (1973)

Defaultable spot rate:

Dt = e−Rd (T −t)

Inverting this relation, we get

 
1 Dt
Rd (t, T ) = log =
t−T L
 
1 At
log N (−d1 ) + e−r(T −t) N (d2 )
t−T L

As the maturity shortens, the spot rate converges to

The default free rate if At ≥ L (probability of default is zero)
Infinity if At < L (probability of default is one)

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Application to credit risk - Merton’s model (1973)

The credit spread is the difference between the defaultable

spot rate and the risk-free rate:

CS = Rd (t, T ) − r =
 
1 At
log N (−d1 ) + N (d2 )
t−T Le−r(T −t)

Example - what is the credit spread on the firm’s debt if the

value of the firm’s assets A0 = 100, the face value of debt
L = 30, the volatility of the value of the assets σ = 25% and
the risk-free interest rate r = 5%? What is the value of the
debt?

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