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Simon Léger April 09, 2006

Abstract

In this paper, we will try to give every known closed formula for options and also their proof(s). We are going to work under the Black Scholes equation for the diusion of the process.We will start with a classical call option, try to give a few proofs of its price and then move on to more complex products, such as binary options, quanto options. . .

1

. . . . . . . . 4 4 6 6 6 7 8 9 3 Binary Options 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 Direct calculation . . . . . . . . . . . . . . . . . . . 11 12 10 4 Quanto Options 2 . . . . . .1 Deriving the price of a call . . . . .1 Direct calculation . .2. .2 Transformation into heat equation . 2. 2. . . . 2. . . . . . . . . . . . . . . 2. . . . . . .2. . . . . . . . . .Contents 1 2 Framework Classic European Call 3 4 2. . . . . . . . . . . . . . .1. . . . . . . . . . . . .2. . . . . . . . . . . 2. . . .1 Deriving the Black-Scholes PDE . 11 3. . . . . . . .1 Introduction . . . . . 10 3. . . .4 Pricing a call again . . . . . . . . . . . . . .3 Solving the heat equation via Fourier transform 2. . .2 PDE approach . . .2. . .3 PDE approach . . . . . .2 Implied results . . . . . 2. . . . . . . . . . . . . . . . . . . . . .1. . . . . .

html. you can visit my website at http://homepages.edu/~sl1544/index.leger@nyu. This can be easily proved by seeing that if we assume the following equation : dSt = µ(t)St dt + σ (t)St dWt we still have. For those who are curious to know more about me. we just need to replace µ and σ with : µ = T 1 T t=0 µ(t)dt and σ = T 1 T t=0 σ 2 (t)dt. the integral T σ (t)dWt is gaussian with mean zero and variance σ 2 (t)dt so we can replace our deterministic functions t=0 by the constants we gave. We assume that it obeys the following equation : dSt = µSt dt + σSt dWt As we are going to study rst only non path dependent options. this is the stock price. thanks to Itô lemma : T ST = S0 × exp t=0 µ(t)dt − 1 2 T T σ 2 (t)dt + t=0 T t=0 t=0 σ (t)dWt Since σ (t) is deterministic.edu. We will not assume in this paper any kind of more complex diusion equations such as stochastic volatility. we can assume that the drift and the volatility are deterministic functions of time since we just then need to replace the constants by their integrals over the period considered.Introduction This article has not only the ambition to contain most of the known closed formulas for options. Indeed. local volatility. We call the underlying St which is a function of time. We are now ready to start pricing our 3 . 1 Framework As we mentioned. but also to give their proof and even their proofs when available. You can also contact me by email at simon. We will assume a quite general framework since we are just assuming the Black Scholes diusion equation for the process as well as deterministic drifts and volatilities.nyu. It will then be useful for students or just curious mathematicians to remember how to nd the price of such options which is often the starting point of the pricing of more complex options. if we consider an option with maturity T . jump processes since it is beyond the scope of this article. we are going to price some path independent options.

1. X > ln S : 0 C (K ) = e−rT ∞ K ln S 0 e− 2σ2 T dX (S0 eX − K ) √ 2π (X −α)2 We can now split this computation into two integrals.rst option.1 Deriving the price of a call A european call means that the payo can only be exercised at maturity T .1 Classic European Call Direct calculation 2.e. but we will try to give a few proofs of the known closed form price. 0). let us write ST = 2 S0 eX where X is a gaussian variable with mean α = (r − 1 2 σ )T and variance σ 2 T . We will rst see the classic call european type option. Indeed. since the payo is K strictly positive only when S0 eX > K i. Then : C (K ) = e−rT e− 2σ2 T (S0 eX − K )+ √ dX 2π −∞ ∞ (X −α)2 and we can rewrite this with an indicatrice function. his payo is : [ST − K ]+ = max(ST − K. we use the solution of the Black-Scholes equation : ST = S0 × e(r− 2 σ 1 2 )T +σW T We can now price this call using the fact that its price is the discounted expected payo under the risk-neutral measure : C (K ) = EQ [e−rT (ST − K )+ ] We can now work out this calculation since r is a constant here (we replaced the deterministic function of time by its integral). the rst one being : ∞ I1 = K ln S 0 e− 2σ2 T S0 eX √ dX 2π (X −α)2 and the second one : ∞ I2 = K ln S 0 e− 2σ2 T K √ dX 2π (X −α)2 4 . 2 2. To price it.

The second one is easier. We can now replace our α to simplify the expression : ∞ I1 = S0 e 0 − 2 2 (X −(r + σ 2 T )) 2σ 2 T √ K ln S 2π e 2ασ 2 T 2σ 2 T e σ2 T 2 2 dX ∞ = S0 e 0 − 2 2 (X −(r + σ 2 T )) 2 2σ T √ K ln S 2π eα+ σ2 T 2 dX We now let u be u = 2 X −(r + σ T )) √2 σ T such that : e− 2 rT √ e dX 2π u2 ∞ I1 = S0 2 ln K −(r + σ 2 T) S0 √ σ T = S0 erT (1 − N (−d1 )) = S0 erT N (d1 ) where : −d1 = d1 = K − (r + ln S 0 √ σ T 0 ln S r+ K +( √ σ T σ2 2 )T σ2 2 )T 5 . let us set u = ∞ X√ −α σ T : u2 I2 = K ln K −α S0 √ σ T e− 2 √ dX 2π = K (1 − N (−d2 )) = K (N (d2 ) where : −d2 = d2 = K ln S −α 0 √ σ T 0 ln S r− K +( √ σ T σ2 2 )T We can now work out the other integral : ∞ I1 = S0 e K ln S 0 − Xe √ (X −α)2 2σ 2 T 2π dX α2 ( α +σ 2 T ) 2 2σ 2 T ∞ I1 = S0 e− 0 (X −(α+σ 2 T ))2 2σ 2 T √ K ln S 2π e− 2σ2 T e dX by developing the square in the exponential and recomposing it by adding the eX inside.

d2 . One should here wonder why we did not derive φ.1 Deriving the Black-Scholes PDE We are going to derive the Black-Scholes PDE by considering a hedging strategy. we will now try to get the same results by solving the Black-Scholes PDE. We consider now a portfolio Π where we are long a call and short φ shares of stocks : Π = C − φs. The argument in the original paper is that the number of shares hold is instantaneously constant. 2. which 6 .1. 2. the results are : (we are not going to do these very boring calculations here.2 Implied results We can derive the put price the same way or just by using the call-put parity : Ct − Pt = St − Ke−rT which leads us to : P (K ) = Ke−rT N (−d2 ) − S0 N (−d1 ) From these equations. but please be careful when you do them since for exemple the delta can not be computed just by saying that the payo is linear in S0 since S0 occurs also in the d1 .2.2 Puts N (d1 ) φ(d1 ) √ Sσ (T ) (d1 )σ √ − Sφ 2 (T ) N (d1 ) − 1 Sφ(d1 ) (T ) Sφ(d1 )σ + rKe−rT N (−d2 ) 2) − √ 2 (T ) − rKe−rT N (d 2) KT e−rT N (d −KT e−rT N (−d2 ) PDE approach We derived the price of a call by direct calculation. ) Calls delta gamma vega theta rho 2. since this is to my sense the most intuitive way. maturing at T . We have the nal condition : C (s. Let C (s. . . t) be the price of a call at time t. We consider now the dierence in the portfolio value for an arbitrary small time spent : dΠ = dC − φds.We can now combine our two results to get our option price : C (K ) = e−rT S0 erT N (d1 ) − K N (d2 ) such that : C (K ) = S0 N (d1 ) − Ke−rT N (d2 ) which is our call price. we can calculate the greeks by deriving the prices. T ) = [s − K ]+ .

We can now apply Ito's lemma to get : dΠ = dC − φds = = ∂C ∂C 1 ∂2C 2 2 dt + ds + σ s dt − φds ∂t ∂s 2 ∂s2 1 ∂C 1 ∂2C 2 2 ∂C − φ (r + σ 2 )sdt + + σ s dt + ∂s 2 ∂t 2 ∂s2 ∂C − φ σsdW ∂s We know that the choice of φ that makes our portfolio deterministic is φ = ∂C ∂s but here we have a proof of this. τ ) 7 .is not very rigorous but true. T ) = Kv (x. a non arbitrage relation implies that it grows at the risk free rate : dΠ = rΠdt which gives us : ∂C 1 ∂2C 2 2 + σ s dt = r(C − φs)dt ∂t 2 ∂s2 which is the Black Scholes PDE that we can rewrite as : ∂C ∂C 1 ∂2C 2 2 +r s+ σ s = rC ∂t ∂s 2 ∂s2 We are now ready to transform our PDE into the heat equation. t) : ∂V ∂V 1 ∂2V 2 2 +r s+ σ s = rV ∂t ∂s 2 ∂s2 For a call. With this φ our portfolio now satises : 2 dΠ = dC − φds = ∂C 1∂ C 2 2 + σ s dt ∂t 2 ∂s2 As our portfolio is now deterministic. T ) = max(ST − K. t) = 0 V (0. because we can not anticipate the change in s. 0) Let us now change the variables such that : x S = Ke 2τ t=T −σ 2 V (S.2 Transformation into heat equation Let us rewrite this equation for any claim V (S. t) → S as S → ∞ V (S.2. 2. our PDE has the following boundary conditions : ∀t V (0. The way Peter Carr goes around this problem is to say that we are not actually interested in the dierentiation but in the gain of our portfolio which is given by ∆Π = ∆C − φ∆s since the number of shares hold is constant during this period of time.

and where we set c = σ 2 . 0). 0) = max e 2 (c+1)x − e 2 (c−1)x . We still have our initial condition which is now : u0 (x) = u(x. T ) = max(ST − K.2.3 Solving the heat equation via Fourier transform 1 1 This is a very easy way to solve our heat equation. 0) = max(ex − 1. Our equation now becomes : ∂u ∂2u = ∂τ ∂x2 which is exactly the heat equation.And we can use the chain rules to transform our equation : ∂V ∂t ∂V ∂S ∂2V ∂S 2 ∂v ∂tau Kσ 2 ∂v =− ∂τ ∂t 2 ∂τ ∂v dx K ∂v = K = ∂x dS S ∂x ∂ ∂V ∂ K ∂v = = ∂S ∂S ∂S S ∂x K ∂v K ∂ 2 v dx K ∂v K ∂2v = − 2 + = − + S ∂x S ∂x2 dS S 2 ∂x S ∂x2 = K Now. The terminal condition can now be seen as an initial condition : V (S. 8 . τ ) = u ˆ0 (ω )e−ω τ where u ˆ0 = u ˆ(x. 0) becomes v (x. ∞[ and τ > 0. τ ) = e− 2 (c−1)x− 4 (c+1) τ u(x. Let us call u ˆ = F (u) the Fourier transform of u : 1 u ˆ= √ 2π ∞ −∞ u(x)e−iωx dx We can now take the Fourier transform of our equation : F (uτ ) = F (uxx ) 2 which gives u ˆτ = −ω 2 u ˆ and the solution is : u ˆ(ω. τ ) 1 1 2 which is a common method to parabolic equations. 0). If we make another transformation : v (x. 0 2. we can substitute this into the Black-Scholes PDE and what do we get ? ∂v ∂2v ∂v = + (c − 1) − kv ∂t ∂x2 ∂x 2r for x ∈] − ∞.

2.Before going further we need some properties of the Fourier transform : F F 1 √ 2π ∞ x2 1 √ e− 4τ 2τ = e−ω 2τ f (y )g (x − y )dy −∞ ˆ(ω )ˆ = f g (ω ) and we can now go back to our original problem with the following inverse Fourier transform : u(x. τ ) = F −1 (ˆ u) = F −1 u ˆ0 (ω )e−ω = 2. τ ) = 1 √ 2 πτ 1 √ = 2 πτ 1 √ = 2 πτ = I1 − I2 ∞ −∞ ∞ −∞ ∞ 0 u0 (y )e− 1 (x−y )2 4τ dy 1 (x−y )2 4τ max(e 2 (c+1)y − e 2 (c−1)y . Let us work a little on I1 : I1 = = = 1 √ 2 πτ 1 √ 2 πτ 1 √ 2 πτ ∞ 0 ∞ 0 ∞ x+(c+1)τ √ 2τ 1 (c+1)x+ 1 (c+1)2 τ 2 4 e− e− y 2 −2xy +x2 −2(c+1)τ y 4τ (y −(x+(c+1)τ ))2 4τ dy (x+(c+1)τ )2 4τ e− 4τ e x(c+1) 2 x2 dy e− u2 2 √ 2τ e e 4 (c+1) τ dy 1 2 = N (d1 )e 9 .4 Pricing a call again 2τ (x−y )2 4τ 1 √ 2 πτ ∞ −∞ u0 (y )e− dy We can now plug that into our previous equations and we can work out the price of our call : u(x. 0)e− (e 2 (c+1)y − e 2 (c−1)y )e− 1 1 (x−y )2 4τ dy dy where : 1 I1 = √ 2 πτ ∞ 0 e 2 (c+1)y e− 1 (x−y )2 4τ dy and I2 is the same after replacing c + 1 with c − 1.

1 Binary Options Introduction We are now going to price a binary. τ ) = ex N (d1 ) − e−cτ N (d2 ) and : C (S. t) = S N (d1 ) − Ke−r(T −t) N (d2 ) where : d1 = = = √ 1 x √ + (c + 1) 2τ 2 2τ S ln( K ) 1 2r + σ 2 √ + σ2 σ T −t 2 0 r+ ln S K +( √ σ T √ σ T −t σ2 2 )T and : ln S0 + (r − √ d2 = K σ T σ2 2 )T And we nally found back our Black-Scholes price which is nice. T ) = 1 if ST ≥ K 0 if ST < K 10 .after setting u = y −(x+(c+1)τ ) √ 2τ and where : √ x 1 d1 = √ + (c + 1) 2τ 2 2τ We now need to substitute these terms to get our result as a function of our initial parameters : v (x. which is not more dicult than the price of a call option. it is even easier. 3 3. t) = K × σ2 2r S × N (d1 ) − Ke σ2 × 2 (T −t) N (d2 ) K which gives us : C (S. or digital. The payo of a binary option is a Heaviside function : C d (ST . call options.

t) and where : σ2 2 )T 0 ln S r− K +( √ σ T Then the price of our binary option is : C d (St . t) = e−r(T −t) N (d2 ) 3. We follow the K then u0 (x) = K 1x>0 e same calculation as before : u(x. which is now easier than before since we have already derived most of the formulas. τ ) = = = = = 1 √ 2 πτ 1 √ 2 πτ 1 √ 2 πτ 1 √ 2 πτ ∞ −∞ u0 (y )e− ∞ 1 (x−y )2 4τ dy dy (y −(x+(c−1)τ ))2 4τ 1 K 1 K 1 K e 2 (c−1)y e− e 4τ e x2 (x−y )2 4τ 0 ∞ 0 ∞ − x+(c−1)τ √ 2τ (x+(c−1)τ )2 4τ e− dy 2τ dy e 4 (c−1) τ e 2 (c−1)x e− 1 2 1 u2 2 √ 1 1 1 2 (1 − N (−d2 ))e 4 (c−1) τ e 2 (c−1)x K such that : 11 . 1) because Wt d2 = N (0.2 Direct calculation Again. the price of our option is the discounted expected payo under the risk-neutral probability : C d (St . t) = EQ [e−r(T −t) 1ST ≥K ] = e−r(T −t) PQ (ST ≥ K ) such that we just need to work out one probability computation : PQ (ST ≥ K ) = PQ ln( = P Q St σ2 ) + (r − )(T − t) + σ (WT − Wt ) > 1 K 2 2 t r− σ ln( S K)+( 2 )(T − t) √ X>− σ T −t = 1 − N (−d2 ) = ∈ where X N (0.3. but the nal payo 1ST >K 1 (c−1)x 1 t 2 is now 1x>0 since x = ln S .3 PDE approach We can also work out the price of this option by our PDE approach. We start from the solution of the heat equation.

t) = e−r(T −t) N (d2 ) and once again we found our price with the PDE method. so our result is just the discounted riskneutral probability that our stock ends above K at time T . Let us note that we could have guessed this result before since N (d2 ) is the probability that the option is in the money. 4 Quanto Options Conclusion 12 . τ ) = 1 N (d2 )e−cτ K and : C d (St .v (x.

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