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:

An exploration into financial mathematics, partial

differential equations, probability, and statistics

Edward Quinlan

April 4, 2007

Math 257, Section 201

Dr. Alexei Cheviakov

The Black-Scholes Equation:

An exploration into financial mathematics, partial

differential equations, probability, and statistics

Mathematical finance is a rich field of study within applied mathematics, focusing specifically

on financial markets. The work of mathematical finance is essentially built upon the theoretical studies

of financial economics. Using a wide range of mathematical tools, models are constructed that

determine derivatives (some form of asset related to a commodity, not the commodity itself) pricing,

based upon a pre-defined set of rules, in order to maximize profit and minimize risk. The purpose of

this paper is the analyze one such model, known as the Black-Scholes equation, a partial differential

equation (PDE) which is based upon the fundamentals of Black-Scholes theory. Its purpose is to

analyze options pricing, an option defined as being a contract for a derivative used in trade.

The math behind the equation was set down by Robert C. Merton, who built on work done by

Fischer Black and Myron Scholes in 1973, and generalized their work to apply to such things as

mortgages and student loans. Merton was the first to coin the term “Black-Scholes” options pricing

model, ironic since the model does not bear his name. For the sake of accuracy and simplicity, the

theory, and subsequent equation will be referred to as the BSM theory, or Black-Scholes-Merton theory.

The BSM theory and equation are based upon a few primary assumptions.

i. It is possible to short sell (purchase, then quickly sell) the underlying stock.

ii. There are no arbitrage opportunities, that is, chances to benefit from price discrepancies in other

markets, local or otherwise.

iii. Trading in the stock is continuous.

iv. There are no transaction costs or taxes, that is, no money is lost in research, legal confirmation

in the execution of a deal, etc., or in the taxes that might be associated with such actions.

v. All securities (a non-unique negotiable interest representing financial value) are perfectly

divisible (e.g. it is possible to buy 1/100th of a share).

vi. It is possible to borrow and lend cash at a constant risk-free interest rate.

Without delving into great detail, with respect to the derivation, it is possible to develop the

following stochastic

1

differential equation (SDE), where S

t

is the price of the underlying instrument

2

, μ

is the percentage drift of the system, σ is the percentage volatility – also known as the statistical

deviation – and finally W

t

which is a stochastic process:

dS

t

=uS

t

dt+c S

t

dW

t

From this, it is possible to construct the following PDE, using various statistical and

probabilistic theorems and lemmas that are beyond the scope of this course, let alone this paper, which

is at the core of BSM theory:

6V

6t

+

1

2

c

2

S

2 6

2

V

6S

2

+r S

6V

6 S

−rV =0

Where V is the value of the option, at a given time t, with an underlying stock value of S, and

all other variables are the same as stated before.

1 In probability, a stochastic process is a process that can be described by a probability distribution

2 An asset, bank of assets, even another derivative, upon which the price of the derivative is dependent upon

The equation contains one forcing term, rV, making it a non-homogeneous equation, and is

solved as if it were a heat equation. By simple substitution, it is possible to convert the BSM equation

into the form of the heat equation. First, the following mixed initial conditions are applied to the

system:

V ¦ 0,t )=0 for all t

V ¦ S , t )≈S as S - ∞

V ¦ S , T )=max ¦S−K , 0)

We consider the pricing of a “call option”, S, a contract between two parties where the buyer of

the option has the right, but not the obligation to buy an agreed quantity of a particular commodity or

financial instrument, at a specific time, T years in the future, for a given price, the strike price, K. The

buyer must pay a fee, called a premium, for this right. The constant interest rate is r, and the volatility

is σ as before. To transform the equation into a diffusion equation, a form of the heat equation, we use

the following change-of-variable substitutions:

x=ln¦ S/ K)+

¦

r−c

2

2

)

¦T −t )

t=T −t

u=V e

r t

We then see that the BSM equation then becomes:

6u

6t

=

c

2

2

6

2

u

6 x

2

Solving for u, then substituting back in for u, x, and τ, we obtain the value of a call option, in

terms of BSM parameters:

V ¦ S , t )=S 1¦ d

1

)−K e

−r ¦T−t )

1¦d

2

)

where

d

1

=

ln ¦S / K)+¦r+c

2

/ 2)¦T−t )

c.¦T−t )

d

2

=d

1

−c.¦T−t )

Using analysis on the coefficients of the second order linear equation, before transforming it, we

can determine that the BSM equation is parabolic. We use the following conditions, the requirement

for a second order PDE to be parabolic:

Au

xx

+2Bu

xy

+Cu

yy

+Du

x

+Eu

y

+F=0

Z=

∣

A B

B C

∣

=0

By rearranging the given form of the BSM equation above, taking note of the coefficients, and

finally performing the determinant of the Z matrix, we obtain:

6V

6t

+

1

2

c

2

S

2

6

2

V

6 S

2

+r S

6V

6 S

−rV=0

V

t

+

1

2

c

2

S

2

V

tt

+rSV

S

−rV =0

0⋅V

SS

+2⋅0⋅V

St

+

1

2

c

2

S

2

V

tt

+rSV

S

+V

t

=rV

A=0, B=0, C=

1

2

c

2

S

2

Z=

∣

A B

B C

∣

=

∣

0 0

0

1

2

c

2

S

2

∣

=0⋅

1

2

c

2

S

2

−0⋅0=0

Thus, we have analytically determined that the BSM equation is a parabolic second order linear

non-homogenous partial differential equation.

The BSM equation, and BSM theory as a whole, has been incredibly valuable to the field of

financial mathematics, and was one of the first theories to begin a revolution in the manner in which

business was conducted in stock markets. It is the hope of this author that a greater understanding of

the underlying principles behind BSM theory, and perhaps a bit of finance theory, has been learned.

Also, too, it is hoped that a greater appreciation for mathematical modeling of systems has been

reached. A unique feature of financial modeling is that it is attempting to model a system that is

entirely man-made, whereas many other mathematical models strive to estimate natural phenomena,

from the flow of fluids, to the vibration of strings. While it is true that financial systems depend upon

real-world phenomena, in terms of the trade of goods and services, they are removed from these

systems, isolated in computer systems and stock markets. Yet, regardless of this, it is still possible to

predict factors of the system. Such is the beauty of math.

Bibliography

Various authors; Black-Scholes article on Wikipedia; http://en.wikipedia.org/wiki/Black-Scholes

Provided general information on the equation, and the theory behind the equation, as well as the method

of solution. General background information on finance theory was also garnered from links provided by the

article.

Polyanin, Andrei Dmtrievich; Various articles on PDEs; http://eqworld.ipmnet.ru/en/pde-en.htm

Site assisted with developing a greater understanding of the material, as well as having numerous

examples of different classifications of systems. Also provided background for the commentary on the parabolic

property of the PDE analyzed in the essay.

http://en.wikipedia.org/wiki/Heat_equation

Provided information on different forms of the heat equation than were covered in class, as well as

material on diffusion equation.

http://www.britannica.com/eb/article-9110824/Robert-C-Merton

Source for background information on Merton, as well as details on publication dates of the papers by

Black and Scholes, which Merton drew from in the writing of BSM theory.

it is possible to buy 1/100th of a share). which is at the core of BSM theory: V 1 2 2 V V S r S −rV =0 2 t 2 S S Where V is the value of the option. Trading in the stock is continuous. μ is the percentage drift of the system. 1 In probability. at a given time t. no money is lost in research. it is possible to construct the following PDE. It is possible to short sell (purchase. who built on work done by Fischer Black and Myron Scholes in 1973. the theory. and subsequent equation will be referred to as the BSM theory. i. All securities (a non-unique negotiable interest representing financial value) are perfectly divisible (e. The purpose of this paper is the analyze one such model. bank of assets. that is. probability. not the commodity itself) pricing. focusing specifically on financial markets. Merton. There are no arbitrage opportunities.g. and statistics Mathematical finance is a rich field of study within applied mathematics. with respect to the derivation. The math behind the equation was set down by Robert C. or Black-Scholes-Merton theory. local or otherwise. using various statistical and probabilistic theorems and lemmas that are beyond the scope of this course. where St is the price of the underlying instrument2. iii. even another derivative. partial differential equations. v. σ is the percentage volatility – also known as the statistical deviation – and finally Wt which is a stochastic process: dS t = S t dt S t dW t From this. a stochastic process is a process that can be described by a probability distribution 2 An asset.The Black-Scholes Equation: An exploration into financial mathematics. or in the taxes that might be associated with such actions. known as the Black-Scholes equation. based upon a pre-defined set of rules. ironic since the model does not bear his name. let alone this paper. vi. Using a wide range of mathematical tools. ii. upon which the price of the derivative is dependent upon 2 . chances to benefit from price discrepancies in other markets. models are constructed that determine derivatives (some form of asset related to a commodity. that is. with an underlying stock value of S. in order to maximize profit and minimize risk. The BSM theory and equation are based upon a few primary assumptions. a partial differential equation (PDE) which is based upon the fundamentals of Black-Scholes theory. For the sake of accuracy and simplicity. legal confirmation in the execution of a deal.. it is possible to develop the following stochastic1 differential equation (SDE). The work of mathematical finance is essentially built upon the theoretical studies of financial economics. Its purpose is to analyze options pricing. an option defined as being a contract for a derivative used in trade. and all other variables are the same as stated before. and generalized their work to apply to such things as mortgages and student loans. iv. Merton was the first to coin the term “Black-Scholes” options pricing model. etc. Without delving into great detail. There are no transaction costs or taxes. then quickly sell) the underlying stock. It is possible to borrow and lend cash at a constant risk-free interest rate.

the strike price. the requirement for a second order PDE to be parabolic: Au xx 2Bu xy Cu yy Dux Eu y F =0 Z = A B =0 B C ∣ ∣ By rearranging the given form of the BSM equation above. rV. a form of the heat equation. We use the following conditions. before transforming it. making it a non-homogeneous equation. The constant interest rate is r. and τ. The buyer must pay a fee. but not the obligation to buy an agreed quantity of a particular commodity or financial instrument. S. we can determine that the BSM equation is parabolic.The equation contains one forcing term. T years in the future. a contract between two parties where the buyer of the option has the right. we use the following change-of-variable substitutions: r − 2 x=ln S / K T −t 2 =T −t u=V e r We then see that the BSM equation then becomes: u 2 2 u = 2 x2 Solving for u. at a specific time. then substituting back in for u.t =0 for all t V S . K. taking note of the coefficients. the following mixed initial conditions are applied to the system: V 0. for a given price. called a premium. and is solved as if it were a heat equation. for this right. we obtain the value of a call option. x. and the volatility is σ as before. First. T =max S −K . and . in terms of BSM parameters: V S . 0 We consider the pricing of a “call option”. To transform the equation into a diffusion equation. t=S d 1− K e−r T −t d 2 where ln S / K r 2 /2T −t d 1= T −t d 2=d 1− T −t Using analysis on the coefficients of the second order linear equation. t≈S as S ∞ V S . it is possible to convert the BSM equation into the form of the heat equation. By simple substitution.

Such is the beauty of math. they are removed from these systems. The BSM equation. we have analytically determined that the BSM equation is a parabolic second order linear non-homogenous partial differential equation. in terms of the trade of goods and services. to the vibration of strings. B=0. regardless of this. and was one of the first theories to begin a revolution in the manner in which business was conducted in stock markets. has been learned. it is hoped that a greater appreciation for mathematical modeling of systems has been reached. It is the hope of this author that a greater understanding of the underlying principles behind BSM theory.finally performing the determinant of the Z matrix. whereas many other mathematical models strive to estimate natural phenomena. and BSM theory as a whole. we obtain: V 1 2 2 2V V S r S −rV =0 2 t 2 S S 1 V t 2 S 2 V tt rSV S −rV =0 2 1 0⋅V SS 2⋅0⋅V St 2 S 2 V tt rSV S V t =rV 2 1 A=0. and perhaps a bit of finance theory. While it is true that financial systems depend upon real-world phenomena. Also. A unique feature of financial modeling is that it is attempting to model a system that is entirely man-made. too. C = 2 S 2 2 0 0 1 2 2 Z= A B = 1 2 2 =0⋅ S −0⋅0=0 S B C 0 2 2 ∣ ∣∣ ∣ Thus. it is still possible to predict factors of the system. has been incredibly valuable to the field of financial mathematics. isolated in computer systems and stock markets. Yet. from the flow of fluids. .

Polyanin. Black-Scholes article on Wikipedia. General background information on finance theory was also garnered from links provided by the article. http://www.wikipedia. . Andrei Dmtrievich. and the theory behind the equation.htm Site assisted with developing a greater understanding of the material. as well as the method of solution. as well as material on diffusion equation.com/eb/article-9110824/Robert-C-Merton Source for background information on Merton. Various articles on PDEs. as well as having numerous examples of different classifications of systems. Also provided background for the commentary on the parabolic property of the PDE analyzed in the essay. http://eqworld.Bibliography Various authors.wikipedia.ipmnet. as well as details on publication dates of the papers by Black and Scholes. http://en.britannica.org/wiki/Black-Scholes Provided general information on the equation.ru/en/pde-en. which Merton drew from in the writing of BSM theory. http://en.org/wiki/Heat_equation Provided information on different forms of the heat equation than were covered in class.

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