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# Advanced Derivatives Course Chapter 8

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03/18/2014

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76
Week 8: Black-Scholes Equation For Financial
Derivatives
Lecture VII.1 Risk-Free Portfolio

Perhaps some of you have become desperate and frustrated because of somewhat heavy mathematical stuff we have encountered up to this moment. Now all your efforts are going to be rewarded. The goal of the next two lectures is to see how bits and pieces of math we have been hard learning in the previous lectures are beautifully combined in to the famous Black-Scholes model. This week is probably the most important in this course.

Although financial derivatives are centuries old, until recently pricing some of them had been a pure guesswork. The breakthrough came in the early seventies when Fisher Black, Myron Scholes, with help from a third, Robert Merton, developed an algorithm to do it instead. Their work swiftly became important, because demand for options and derivatives in general soared in the 1970s. That was partly because the breakdown of the Bretton Woods exchange-rate regime, and two oil-price shocks, led to huge swings in the prices of financial assets. It may also have reflected growing market sophistication. This course is evidence to the latter.

As we all already know financial derivatives are deals written on other securities (bonds, shares, etc.) In most of the cases1 these contracts have a specific termination date \u2013 the expiry time, which we denoted as T. At the expiration time, the option should depend only on the value of the underlying assetS(T) and the timeT . The value of the option at timeT is calledpayoff and this can be represented as a functionV(S(T),T), which is known exactly at timeT. For example, for a European callV(S(T),T)= max(S(T)-E,0).

For timest other thanT (that is,t<T), the value of the derivative can be presented as a
functionV(S(t),t). As time changes fromt tot+dt, the price of the option also changes from
V(S(t),t) to V(S(t),t)+dV(S(t),t). This change in the derivative value is what a derivative

desk would like to know. However, at times other than expiration, the explicit form of the functionV(S(t),t) is not at all obvious and, as we will see, needs to be found via a quite sophisticated analysis.

Apart from some simple observations, which we discussed in the earlier lectures, it appears
to be difficult to say anything more specific on the precise form of the functionV(S(t),t).
1 In the future lectures we will be discussing exotic derivatives, which do not have a specific expiration time.
These derivatives are in perpetuity.
77
Remarkably, those simple properties of calls and puts can be exploited to construct a very
special portfolio2. We shall denote the value of this portfolio as\u03a0.
: One long option position and a short position in some quantity\u2206 of the
underlying:
\u03a0 = V(S,t)- \u2206\u00b7S.

The first term on the right-hand side is the option position and the second term is the asset position. Notice the minus sign in front of the second term indicating that the asset is a short position. For the time being,\u2206 is an unspecified coefficient, which we will determine in a moment.

Now we make a crucial assumption that the underlying asset,S, follows a geometric
Brownian motion:
dS = \u00ec Sdt + \u00f3SdW.

A natural question to ask is how the value of the portfolio changes from timet tot+dt? Since both the option value and the asset price will change, we have to use the chain rule to find the change in the portfolio value:

d\u03a0 = dV(S,t) -\u2206\u00b7 dS.

The important point to be made is that the coefficient\u2206 in the above formula has not changed during the time stepdt. Intuitively, this is because the values ofV(S(t),t) andS change unexpectedly and when we set up the portfolio we could not anticipate these changes. This is why we still have the same quantity of the underlying at the momentt+dt. The above definition of the infinitesimal increment of the value of the portfolio, based on practical experience, is consistent with the mathematical definition of the Ito integral. Indeed, we can write the following logical statement:

\u222b
\u222b
+
+
\u2206
\u2212
=
\u03a0
=
\u03a0
\u2212
+
\u03a0
=
\u03a0
dt
t
t
dt
t
t
dS
dV
d
t
dt
t
d
).
(
)
(
)
(

Now, if you check your lecture notes with the definition of the Ito integral, you can clearly see that the coefficient\u2206 must be a non-anticipating function. As a matter of fact, all stochastic differential equations are understood with respect to the Ito integral. The sole reason for studying the Ito integral is to make sense out of stochastic differential equations.

In finance, the given portfolio is called a self-financed portfolio which means that once set it changes its value without any external injections of cash. This requirement also leads to the above formula for the change in the portfolio value. Indeed, the above mentioned portfolio can also be presented as follows

2 Do you remember, one of your computer exercises was to analyse a portfolio insensitive to the volatility?
78
,
B
S
V
B
\u2206
\u2212
\u2206
\u2212
=
\u03c0
whereB is a bond and\u2206B is the size of our short position in the bond. Our original portfolio
\u03a0 is presented as\u03c0 + \u2206BB. When time t changes to t + dt our positions \u2206and \u2206Bmay

change as well. However, if our portfolio is self-financed than the change in the share position must be equal to the opposite change in the bond position, so that the combination of the two vanishes:

.
0
=
\u22c5
\u2206
+
\u22c5
\u2206
B
d
S
d
B
In other words, when we sell bonds, we simultaneously buy shares and vice versa. This
equation gives rise to the above presented formula for the change in the portfolio value:
.
dS
dV
d
\u2206
\u2212
=
\u03a0Ito\u2019s Lemma
Since the option price,V(S(t),t), is a function of both t
he share and time, the changed V(S,t)
is also determined by using the chain rule and the Taylor expansion:
dV(S,t) = Vtdt + VSdS +(1/2)VSSd2S.
Note that we expandedV to the second order ind S. Now remember that the share follows
geometric Brownian motion. Therefore, in the third term on the right-hand side we have
d2S =(\u00ec Sdt + \u00f3SdW)2 = \u00f32S2d2W.

Here we have dropped all terms withd2t anddtdW, because they can be considered as negligible for infinitesimally small dt anddW. However,d2W is not negligible as we have shown in the previous lectures. In fact, we have established that in the mean square limit sense, we can use the magic formula

d2W = dt.
Thus, we arrive at the conclusion that
d2S = \u00f32S2dt.
Correspondingly for the increment of the option value we obtain the following formula
dV(S,t) =[Vt+ \u00ec SVS +(1/2)VSS \u00f32S2]dt + \u00f3SVSdW.

This is the Ito formula and the stochastic version of the chain rule used in derivation of the Ito formula is known as Ito\u2019s lemma. It plays a crucial role in option pricing. In situations where one has to apply the Ito formula, one will in general be given a stochastic differential equation that drives the process, like eq. (11). In a sense, the Ito formula can be seen as a vehicle that takes the SDE forS(t) and determines the SDE that corresponds toV(S(t),t).