1 Stochastic Differential Equations and the Black-Scholes

PDE

– Derivation of the BS PDE via Ito calculus

Motivations:

1. Ito calculus provides us an elegant tool to deal with many financial derivative problems,
e.g., the meaning of hedging in continuous time can be easily clarified
2. PDE methods lead to efficient computational methods analytically and numerically,
e.g., trinomial tree method is merely a numerical method for solving these PDE’s

1.1 Brownian Motion

Binomial models gives rise to a lognormal stock price dynamics, i.e.,

S (t2 )
log is a Gaussian random variable with
S (t1 )
mean µ (t2 − t1 ) and variance σ 2 (t2 − t1 )

Consider the following limit process:

As
∆t → 0, xn → x (t)
then x (t) is a stochastic process, i.e., a time-dependent random variable.

1
1.1.1 Brownian Motion W (t) :

Brownain motion W (t):

1. W (t2 ) − W (t1 ) is a Gaussian random variable with mean 0 and variance t2 − t1 .

2. Distinct intervals give rise to independent random variables, i.e.,

W (t2 ) − W (t1 ) and W (t4 ) − W (t3 ) are statistically independent

if the intervals [t1 , t2 ] and [t3 , t4 ] do not overlap.

3. W (0) = 0

Note that

1. These properties determine a unique stochastic process, i.e.,

Given any t1 , t2 , · · · tn ∀n, then

P (W (t1 )) , P (W (t2 )) , · · · , P (W (tn ))

P (W (ti ) , W (tj )) , · · · ∀i, j
P (W (ti ) , W (tj ) , W (tk )) , · · · ∀i, j, k
···
P (W (t1 ) , W (t2 ) , · · · W (tn ))

are specified.

2. Any realization:
t 7−→ W (t)
is continuous but nowhere differentiable since
¯ ¯
¯ ∆W ¯ ∆t1/2 1
E¯¯ ¯∼ ∼ as ∆t → 0
∆t ¯ ∆t ∆t1/2

2
 3. Define

∆W = W (t2 ) − W (t1 )
∆t = t2 − t1
E [|∆W n |] = Cn |∆t|n/2 , n = 1, 2, · · ·

and

E [∆W ] = 0
£ ¤
E (∆W )2 = ∆t
V ar [∆W ] = ∆t
£ ¤
V ar (∆W )2 = 2 (∆t)2

the last of which can be seen as follows:

£ ¤ £ ¤ £ ¤2
V ar (∆W )2 = E (∆W )4 − E (∆W )2
= 3 (∆t)2 − (∆t)2
= 2 (∆t)2

Note that (∆W )2 has mean ∆t and variance (∆t)2 . Since this variance/mean → 0 as
∆t → 0, (∆W )2 looks more and more "deterministic" as ∆t → 0. In the limit, we can
express this fact by
(dW (t))2 = dt
which has a strong ramification for the derivation of Ito formula later.

4. Stock price dynamis can be written as

S (t)
log = µt + σW (t)
S (0)
=⇒
S (t) = S (0) eµt+σW (t)

1.2 Stochastic Differential Eqautions and Ito’s Lemma

1.2.1 Deterministic Setting

Review: An ODE is (
dy
= f (y, t)
dt (1)
y (0) = y0

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 Eq. (1) can be viewed as the limit of finiite difference equation:

∆y = f (y, t) ∆t

i.e.,
y ((k + 1) δt) − y (kδt) = f (y (kδt) , kδt) δt
which is Taylor expansion, formally, we write this as

dy = f (y, t) dt

Next, if we know dy = f (y, t) dt, what ODE does z = A (y (t)) satisfy? This is answered by
the chain rule:
dz dA dy dA
= = f (y, t)
dt dy dt dy
i.e.,
dz = A0 f (y, t) dt
where
dA
A0 ≡
dy
Again, this can be viewed as the Taylor expansion:

∆z = z (t + ∆t) − z (t)
= A (y (t) + ∆y) − A (y (t))
= A0 (y) ∆y + O (∆y)2
= A0 (y) f (y, t) ∆t + O (∆t)2

if
(∆y)2 ≤ c (∆t)2 .

1.2.2 Stochastic Setting

Now we turn to the stochastic setting:

1. dy = σdW , by this short hand, we mean:

Z t
y (t) = y (0) + σ dW
0
= y (0) + σW (t)

since W (0) = 0.

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2. dy = g (t) dW, we mean Z t
y (t) = y (0) + g (s) dW (s)
0
Rt
the question here is what is 0 g (s) dW (s)? This is defined as

Z t X
g (s) dW (s) = lim g (τ i ) (W (τ i+1 ) − W (τ i ))
0 ∆τ →0

3. dy = g (W, t) dW is interpreted as
Z t
y (t) = y (0) + g (W (s) , s) dW (s)
0
Rt
where the integral 0 g (W (s) , s) dW (s) is defiend as the limit:
Z t X
g (W (s) , s) dW (s) = lim g (W (τ i ) , τ i ) (W (τ i+1 ) − W (τ i )) .
0 ∆τ →0

It is crucial that the dependence of g on the discrete time is the beginning point of
the interval [τ i , τ i+1 ] and W is incremented forward – Unlike the deterministicRcase,
where the limit do not depend on the choice of discrete time between g and f for gdf,
in the stochastic setting, the limit
X
lim g (W (τ 0i ) , τ 0i ) (W (τ i+1 ) − W (τ i )) ,
∆τ →0
where
τ 0i ≡ τ i + λ (τ i+1 − τ i ) ,
depends on λ. This leads to the concept of nonanticipatoriness, i.e., g (W (τ i ) , τ i ) does
not contain the information of dW = W (τ i+1 ) − W (τ i ) .
4. For any g (W (s) , s) , we have
Z t
E g (W (s) , s) dW (s) = 0
0
This can be easily seen as follows:
Z t X
E g (W (s) , s) dW (s) = lim E [g (W (τ i ) , τ i ) (W (τ i+1 ) − W (τ i ))]
0
X
= lim E [g (W (τ i ) , τ i )] E [(W (τ i+1 ) − W (τ i ))]
( due to nonanticipatoriness, g (W, s) and dW are independent)
X
= lim E [g (W (τ i ) , τ i )] · 0
= 0 for any g (W, s)

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 5. The convergence we discussed above is the so-called mean-square convergence, i.e.,
£ ¤
lim E (Xn − X)2 = 0
n→∞

6. Adding a drift, we have

dy = µ (t) dt + σ (t) dW
which is merely a shorthand for
Z t Z t
y (t) = y (0) + µ (s) ds + σ (s) dW (s)
0 0

1.2.3 Ito’s Lemma

Now we are ready to answer the following question: If

dy = fdt + gdW

and
z = A (y)
what is the stochastic differential equation that z satisfies? Different fromt the answer we
gave in the deterministic setting, the answer is given by the famous Ito’s Lemma:
1
dz = A0 (y) dy + A00 (y) g 2 dt
µ 2 ¶
1 00
= A (y) f + A (y) g dt + A0 (y) gdW.
0 2
2
This can be heuristically justified as follows:
Taylor expansion of A (y) is
1
∆A = A0 (y) dy + A00 (y) (∆y)2 + error of order |∆y|3
2
1
= A0 (y) (g∆W + f ∆t) + A00 (y) g2 (∆W )2
2
+ error of order |∆y| , |∆W | ∆t, |∆t|2
3

Note that
£ ¤
E (∆W )2 = ∆t
E [|∆W |] ∼ ∆t1/2

therefore,
|∆W | |∆t| ∼ ∆t3/2
To order O (∆t) , we have
1
dA = A0 (y) (gdW + f dt) + A00 (y) g2 (dW )2
2
6
 £ ¤
Since, E (∆W )2 = ∆t, and (∆W )2 behaves more and more “deterministic” – like ∆t, as
∆t → 0. In the mean-square sense, it turns out that we can replaced (dW )2 by dt in the
expression, leading to
µ ¶
1 00
dA = A (y) f + A (y) g dt + A0 (y) gdW.
0 2
2

A more general form of Ito’s lemma is

z = A (y, t) ,
dy = fdt + gdW,
∂A ∂A 1 ∂2A 2
dz = dy + dt + g dt
∂y ∂t 2 ∂y 2
µ ¶
∂A ∂A 1 2 ∂2A ∂A
= + f+ g dt + gdW
∂t ∂y 2 ∂y 2 ∂y

Common rules for computation:

£ ¤
1. E (∆W )2 is replaced by dt;

2. Order count:
n
(∆W )n ∼ ∆t 2
We have the following nemonic form of Ito’s formula:
For
dy = f (t, y) dt + g (t, y) dW
and z = A (y, t) , we have

∂A ∂A 1 ∂2A
dz = dt + dy + (dy)2
∂t ∂y 2 ∂x2
with the replacement rule:

(dt)2 = 0
dtdW = 0
(dW )2 = dt

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1.2.4 Examples:
1. Find the SDE for stock price process if S = S0 ey and

dy = µdt + σdW

Since

y = y0 + µt + σW (t)
St = S0 eµt+σW (t) , S0 = ey0

∂S 1 ∂ 2S 2
dS = dy + σ dt
∂y 2 ∂y 2
S0 y 2
= S0 ey (µdt + σdW ) + e σ dt
2
1
= S (µdt + σdW ) + σ 2 Sdt
2
µ ¶
dS 1
∴ = µ + σ 2 dt + σdW
S 2
which is called a geometric Brownian motion. Note that for a stock price satisfying
the risk-neutral process, we have

St = S0 e(r− 2 σ )t+σW (t)

1 2

therefore,
µ ¶
dS 1 2 1 2
= r − σ + σ dt + σdW
S 2 2
= rdt + σdW

2. Find the SDE for the forward price if

µ ¶
1 2
dS = S µ + σ dt + σSdW
2

Since
F = Ser(T −t) , t<T

∂F ∂F 1 ∂2F
∴ dF = dS + dt + (Sσ)2 dW
∂S ∂t 2 ∂S 2
= er(T −t) dS − rSer(T −t) dt + 0 · dt
dS ¡ ¢
= Ser(T −t) − r er(T −t) dt
·µ S ¶ ¸
1 2
= F µ + σ dt + σdW − rF dt
2

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 Hence, µ ¶
1 2
dF = µ − r + σ F dt + σF dW
2
which is also a geometric Brownian motion.
Note that different books have different notational convenctions, e.g., Hull’s book uses
dS = µSdt + σSdW. Don’t copy formulas with checking the convenction.
£ ¤
3. Compute E eαW (t)
Z (t) ≡ eαW (t)
1
dZ (t) = α2 eαW (t) dt + αeαW (t) dW
2
therefore, Z (t) satisfies the SDE:
1
dZ (t) = α2 Z (t) dt + αZ (t) dW (t) with Z (0) = 1
2
or Z t Z t
1
Z (t) = 1 + α2 Z (s) ds + α Z (s) dW (s)
2 0 0

m (t) ≡ E [Z (t)]
therefore, Z t
1
m = 1 + α2 m (s) ds
2 0
i.e.,
dm 1 2
= α m, with m (0) = 1
dt 2
=⇒ £ ¤ 1 2
E eαW (t) = E [Z (t)] = m (t) = e 2 α t

1.3 The Black-Scholes PDE

The Black-Scholes PDE is
∂V 1 2 2 ∂2V ∂V
+ σ S 2
+ rS − rV = 0,
∂t 2 ∂S ∂S
where
V = V (S (t) , t) – the value of a contingent claim at time t,
describes the time dynamics of the value of a contingent claim. The BS PDE is solved with
the following final condition:
V (S (T ) , T ) = f (ST )
where f (ST ) is the payoff of the contingent claim at maturiy T.

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 Since we know a European option with payoff f (ST ) has the value at time t :
Z ∞
2
[x−(r− 12 σ2 )(T −t)]
−r(T −t) x 1 −
V (S (t) , t) = e f (S0 e ) p e 2σ 2 (T −t) dx
2
2πσ (T − t)
−∞

it must satisfy the BS PDE.

Note that

1. The BS integral formula is the continuous-time limit analogue of summing over all
paths
2. Solving the BS PDE is the continuous-time analogue of working backward through the
tree by starting from the final data

1.3.1 Derivation
Now we derive the BS PDE using Ito’s lemma. The central idea involved is a heding strategy
– which, of course, implies that our contingent claim is replicatable, as a consequence of
the completeness of the Black-Scholes market (a deep result beyond our course).
Consider the hedging portfolio:
at time t, Π = V − ∆S,
where ∆ is the number of shares of stock in this portfolio. At time t + dt, the increment of
the value of the portfolio is
dΠ = Π (t + dt) − Π (t)
= [V (t + dt) − ∆S (t + dt)] − [V (t) − ∆S (t)]
⇑ ⇑
the number of shares are fixed from t to t + dt
· − ∆dS
= dV ¸
∂V ∂V 1 ∂2V 2 2
= dS + dt + σ S dt − ∆dS
∂S ∂t 2 ∂S 2
µ µ ¶ ¶
1 2
∵ dS = S µ + σ dt + σSdW
2
µ ¶ µ ¶µ ¶
∂V ∂V 1 2
= − ∆ σSdW + −∆ µ + σ dt
∂S ∂S 2
µ 2
¶
∂V 1∂ V 2 2
+ + σ S dt
∂t 2 ∂S 2
Note that the number of shares of the stock in this portfolio is not changed from time t to
time t + dt since no trading is involved. To remove uncertainty, i.e, eliminating dW, we
choose
∂V
∆=
∂S
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This leads to µ ¶
∂V 1 ∂2V 2 2
dΠ = dV − ∆dS = + σ S dt
∂t 2 ∂S 2
i.e., the changing of the value of the portfolio is deterministic – there is no risk invoved in
this portfolio, then the no-arbitrage principle demands that a deterministic return must be
at the risk-free rate, therefore,

dΠ = rΠdt
∂V
= r (V − ∆S) dt with ∆ =
∂S
which yields µ ¶ µ ¶
∂V 1 ∂2V 2 2 ∂V
+ σ S dt = r V − S dt
∂t 2 ∂S 2 ∂S
i.e.,
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS − rV = 0,
∂t 2 ∂S ∂S
which is the Black-Scholes PDE.
Note that ∆ = ∂V ∂S
, the number of shares in the hedging portfolio, is consistent with
waht we already know in the ∆-hedging strategy, i.e., the number of share is the ratio of the
change of the option value to the change of the stock price.

1.3.2 The solution of BS PDE and the risk-neutral pricing formula

Now we prove that the solution of the BS PDE gives our risk-neutral pricing formula:

V = V (St , t) = e−r(T −t) E [f (ST )]

with the risk-neutral process:

ST = St e(r− 2 σ )(T −t)+σ(W (T )−W (t))

1 2

Note that this process satisfies

dSt = rSt dt + σSt dWt , t≤T

Define
U (S, t) = er(T −t) V (S, t)

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i.e., to remove the discount factor from the expression of V (S, t) . Applying Ito’s formula:
∂U ∂U 1 ∂2U 2 2
dU = dS + dt + σ S dt
∂S ∂t 2 ∂S 2
∂V
= er(T −t) dS + (−r) er(T −t) V dt
∂S
∂V 1 ∂2V
+er(T −t) dt + er(T −t) 2 σ 2 S 2 dt
∂t 2 ∂S
(∵ dS = rSdt + σSdW for risk-neutral process)
 

 


· 2
¸ 

r(T −t) ∂V ∂V 1 ∂ V 2 2 ∂V
= e −rV + + rS + σ S dt + σS dW

 ∂t ∂S 2 ∂S 2 ∂S 


 | {z } 

=0 (∵ BS PDE=0, i.e., V is a solutionof it)

therefore,
∂V
dU = er(T −t) σS dW
∂S
∂U
= σS dW
∂S
i.e., the normalized V, U, is a martingale. Hence,
Z t0
0 ∂V
U (t ) − U (t) = er(T −τ ) σS (τ ) (S (τ ) , τ ) dW (τ ), t0 > t
t ∂S
| {z }
an Ito integral, whose expectation vanishes

therefore,
E (U (t0 )) = E (U (t)) (2)
For t0 = T, we have then
E (U (t0 )) = E (U (T ))
µ ¶
using the final data for BS pde :
U (T ) = er(T −T ) V (T ) = f (ST )
= E (f (ST ))
Moreover, since U (t) is deterministically known with certainty at time t, we have
E (U (t)) = U (t)
= er(T −t) V (S (t) , t)
therefore, from Eq. (2) , we obtain
er(T −t) V (S (t) , t) = E (f (ST ))
i.e.,
V = e−r(T −t) E (f (ST ))
Note that

12
1. the expectation is taken with respect to a Brownian motion dW , under this brownian
motion, the stock price is dS = rSdt + σSdW – the risk-neutral process – is used in
derivation, thus
E (·) = ERN (·)

2. Tradeable derivatives

(a) Any solution of the BS PDE is a theoretical price of a derivative that can be
traded without arbitrage.
(b) If a price V (St , t) does not satisfy the BS PDE, then, it cannot be a price of some
derivative in the absence of arbitrage.
e.g.,
i. V = eS , this V does not satisfy the BS pde (verify this!), then V = eS cannot
be the price of some derivative without arbitrage. In other words, it cannot
be replicated with a self-financing portfolio.
e(σ −2r)(T −t)
2

ii. satisfies the BS pde (verify this!), then it can be a price of some
S
1
derivative (i.e, the payoff is at maturity t = T.)
ST

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