Black and Scholes, 1973

See A bit Stochastic Calculus .

For,

$$ dS_t = \mu S_t \ dt +\sigma S_t \ dW_t $$

  • In calculating d f(S_t), we would get, (by Taylor Expansion)

$$ df(S_t) = \bigg( \frac{\partial f}{\partial t} + \frac{\partial f}{\partial S_t}\mu S_t +\frac{1}{2}\frac{\partial^2 f}{\partial S_t^2}\sigma^2 S_t^2 \bigg)dt + \frac{\partial f}{\partial S_t}\sigma S_t \ dW_t $$

  • A Special Form of f(\cdot) is f(S) = log(S),

$$ d\ log(S_t) = \bigg( \mu – \frac{1}{2}\sigma^2 \bigg)dt + \sigma \ dW_t $$


We get Y_t = log S_t is the price of a derivative security with respect to S_t and t and then,

$$ dY_t= \bigg( \frac{\partial Y_t}{\partial t} + \frac{\partial Y_t}{\partial S_t}\mu S_t +\frac{1}{2}\frac{\partial^2 Y_t}{\partial S_t^2}\sigma^2 S_t^2 \bigg)dt + \frac{\partial Y_t}{\partial S_t}\sigma S_t \ dW_t $$

Consider a portfolio \Pi is constructed with (1) short one derivative, and (2) long some fraction of stocks, \Delta, such that the portfolio is risk natural. (\Delta = \frac{\partial Y}{\partial S})

$$ \Pi_t = -Y +\Delta \ S_t $$

Differentiate it,

$$ d\Pi_t = -dY_t +\frac{dY}{dS}dS_t $$

Subtitute dY_t and dS_t into the above equation, we would then get the stochastic process of portfolio, by Ito’s Lemma.

$$ d\Pi_t =-\bigg( \frac{\partial Y}{\partial t} + \frac{1}{2}\frac{\partial^2 Y}{\partial S^2} \sigma^2 S_t^2 \bigg) dt $$

The diffusion term dW_t disappears, and that means the portfolio is riskless during the interval dt. Under a no arbitrage assumption, this portfolio can only earn the riskless return, r.

$$ d\Pi_t =r\Pi_t \ dt $$

  • Subtitute d\Pi_t and \Pi_t into, we would get the Partial Differential Equation (PDE) / Black-Scholes equation,

$$ – \bigg( \frac{\partial Y}{\partial t} + \frac{1}{2}\frac{\partial^2 Y}{\partial S^2} \sigma^2 S_t^2 \bigg) dt = r\bigg(- Y_t + \frac{\partial Y}{\partial S}S_t \bigg)dt $$

$$ rY_t = \frac{\partial Y}{\partial t} + \frac{1}{2}\frac{\partial^2 Y}{\partial S^2} \sigma^2 S_t^2 + \frac{\partial Y}{\partial S}S_t $$

Then, we guess (where U(.) is a function of S_t at time t=T),

$$ Y_t = e^{-r(T-t)} U(S_T) $$

For a European call with strike price, K, U(S_T) would be the payoff at maturity,

$$ U(S_T) = max( S – K , 0 ) $$

Finally, through a series of process to find a specific solution of the PDE, we can solve the value of call, (\Phi(\cdot) is the cumulative standard normal distribtion)

$$ c = S_t\Phi(d_1) – K e^{-r (T-t)}\Phi(d_2) $$

with,

$$ d_1 =\frac{ log(S_t/K) + (r-\frac{1}{2}\sigma^2)(T-t)}{\sigma \sqrt{T-t}} $$

$$ d_1 = \sigma \sqrt{T-t} $$