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hull Ch 10

hull Ch 10

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SECONDEDITION
Options,
r--------t
Futures,andOtherDerivativeSecurities
JOHN
HULL
Universityo]Toronto
-PRENTICEHALL~ENGLEWOODCLIFFS,NEWJERSEY
07632
 
10
TheBlack-ScholesAnalysis
Intheearly1970s,BlackandScholesmadeamajorbreakthroughbyderivingadifferentialequationthatmustbesatisfiedbythepriceofanyderivativesecuritydependentonanon-dividend-payingstock.
I
TheyusedtheequationtoobtainvaluesforEuropeancallandputoptionsonthestock.InthischapterweexplaintheBlack-Scholesanalysis.WealsodiscussthepropertiesofthestochasticprocessforstockpricesdevelopedinChapter9andexplainapowerfultoolknownasrisk-neutralvaluation.Beforewestart,itisappropriatetomentiononepointconcerningthenotationthatwillbeused.WhenvaluingforwardcontractsinChapter3,noassumptionsweremadeaboutinterestratesandthevariable,
r,
wasusedtodenotetherisk-freerateofinterestforaninvestmentmaturingattime
T.
Inthischapterandthenextfewchapters,wecontinuetodenotetherisk-freeinterestrateby
1'.
However,exceptwhereotherwisestated,weassumethatinterestratesareconstantandthesameforallmaturities.InChapter17wewilldiscusshowthisconstantinterestrateassumptioncanberelaxed.
ISeeF.BlackandM.Scholes."ThePricingofOptionsandCorporateLiabilities."
Journalof
PoliticalEconomy,
81(May-June1973).637-54.
207
 
208
TheBlack-ScholesAnalysisChapter10
10.1ITO'SLEMMA
Thepriceofastockoptionisafunctionoftheunderlyingstock'spriceandtime.Moregenerally,wecansaythatthepriceofanyderivativesecurityisafunctionofthestochasticvariablesunderlyingthederivativesecurityandtime.Aseriousstudentofderivativesecuritiesmustthereforeacquiresomeunderstandingofthebehavioroffunctionsofstochasticvariables.Animportantresultinthisareawasdiscoveredbyamathematician,Ito,in
1951.
2
Itisknownas
Ito'slemma.
Supposethatthevalueofavariable
x
followsanItoprocess:
dx
=
a(x,t)dt
+
btx,
t)dz
(10.1)
where
dz
isaWienerprocessand
a
and
b
arefunctionsof
x
and
t.
Thevariable.1hasadriftrateof
a
andavariancerateof
b
2
Ito'slemmashowsthatafunction,G,of
x
and
t
followstheprocess
(aG
eo
I
a
2
G
2)
eo
dG=-a+-+--bdt+-bdzaxat
2
ax
2
ax
(10.2)
wherethe
dz
isthesameWienerprocessasinEquation(10.1).ThusGalsofollowsanItoprocess.Ithasadriftrateof
eoeo
I
a
2
G
b2
-a+-+--axat
2
ax
2
andavariancerateof
(aG)2
b
2
ax
AcompletelyrigorousproofofIto'slemmaisbeyondthescopeofthisbook.InAppendixlOAweshowthatthelemmacanbeviewedasanextensionofwell-knownresultsindifferentialcalculus.InChapter9wearguedthat
dS=j1,Sdt+aSdz
(10.3)
with
j1,
and
a
constantisareasonablemodelofstockpricemovements.FromIto'slemma,
it
followsthattheprocessfollowedbyafunction,G,ofSand
t
is
(eoec
I
a
2
G
22)
eo
dG
=
-agj1,S
+
at
+
2:
aS
2
a
S
dt
+
-agaS
dz
(10.4)
NotethatbothSandGareaffectedbythesameunderlyingsourceofuncertainty,
dz.
ThisprovestobeveryimportantinthederivationoftheBlack-Scholesresults.
2SeeK.Ito,"OnStochasticDifferentialEquations,"
Memoirs,AmericanMathematicalSociety,
no.4(1951),I-51.

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