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Financial Derivatives: Methods of valuation

# Financial Derivatives: Methods of valuation

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An essay for the 2011 Undergraduate Awards (Lecturer Nomination) Competition by Gerard Moran. It is nominated by Lecturer Michael Hayes of NUI Galway in the category of Business & Economics
An essay for the 2011 Undergraduate Awards (Lecturer Nomination) Competition by Gerard Moran. It is nominated by Lecturer Michael Hayes of NUI Galway in the category of Business & Economics

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01/02/2014

Financial Derivatives: Methods of valuation

Contents
1 Introduction 32 The Black-Scholes equation 4
2.1 Derivation of the Black-Scholes equation . . . . . . . . . . . . 42.2 Converting the Black-Scholes equationinto the Diusion equation . . . . . . . . . . . . . . . . . . . . 6
3 Greens Functions 10
3.1 Problems of the form:
L
[
u
(
x
)] =
(
x
) . . . . . . . . . . . . . . 103.2 Problems of the form:
L
[
u
(
x,t
)] = 0
,
with
u
(
x,
0) =
(
x
) . . . . . . . . . . . . . . . . . . . . . . . . 113.3 Deriviation of the Black-Scholes formula . . . . . . . . . . . . 12
4 The Martingale Approach 19
4.1 The Discrete Case (or ‘Binomial Model’) . . . . . . . . . . . . 194.2 The Derivative Pricing Formula . . . . . . . . . . . . . . . . . 234.3 The Continuous Case . . . . . . . . . . . . . . . . . . . . . . . 264.4 Example: European Put Option . . . . . . . . . . . . . . . . . 28
5 Numerical Methods 32
5.1 The Monte Carlo Technique . . . . . . . . . . . . . . . . . . . 325.2 Finite Dierence Methods . . . . . . . . . . . . . . . . . . . . 345.2.1 Explicit method . . . . . . . . . . . . . . . . . . . . . . 355.2.2 Implicit Method . . . . . . . . . . . . . . . . . . . . . . 405.3 The Binomial Options Pricing Model . . . . . . . . . . . . . . 43
6 Conclusion 48A Appendix 50
A.1 Maple code for Implicit Method . . . . . . . . . . . . . . . . . 50A.2 Python code for Binomial Options pricing model . . . . . . . . 51
References 53
2

1 Introduction
A ﬁnancial derivative is a ﬁnancial contract whose value depends on thevalues of other more basic assets. Derivatives are typically used to hedgerisk, but they may also be used for speculative purposes.This project derives and implements analytical and numerical methodsthat can be used to determine the price of a European option, one of themost basic and common ﬁnancial derivatives.European options are contracts that give the owner the right, but not theobligation, to buy or sell an asset at an agreed-upon price at maturity.‘European’ refers to the fact that the option is exercised at maturity,whereas, ‘American’ options can be exercised at any time up to maturity.Options that allow the owner to buy an asset are called call options andoptions that allow the owner to sell an asset are called put options. Theagreed upon price is called the strike price and will be denoted by the letter
.At the time of maturity, if the underlying asset’s price exceeds the strike price,the call option is worth the diﬀerence between the price of the underlyingand the strike price, otherwise it is worthless. Put options, since the owneris selling the asset, are worthless if the underlying has exceeded the strikeprice and worth the diﬀerence if the underlying is priced less than the strikeprice.Prior to the Black-Scholes model, it had proved diﬃcult to value options.The diﬃculty arises for determining the price before maturity.The Black-Scholes model was developed in 1973 by Fischer Black, RobertMerton and Myron Scholes. The model assumes that the price of theunderlying asset,
t
, follows a geometric Brownian motion (GBM). Thismeans that
t
is assumed to be a stochastic process that satisﬁesthe following stochastic diﬀerential equation
dS
t
=
µS
t
dt
+
σS
t
dZ
t
,
(1.1)where
µ
, a constant, is the drift rate of
t
;
σ
, a constant, is the volatility of
t
;
t
is Brownian motion; and a stochastic process is a sequence of randomvariables. The model develops a partial diﬀerential equation, known as theBlack-Scholes equation, which models the value of ﬁnancial derivatives. Thisequation is:
∂c∂t
+
rS ∂c∂S
+12
σ
2
2
∂
2
c∂S
2
=
rc,
(1.2)3