MScFE 622 Continuous-time Stochastic Processes – Video Transcripts Module 5

Video Transcripts
Module 5
MScFE 622
Continuous-time Stochastic
Processes

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Revised: 07/07/2020
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MScFE 622 Continuous-time Stochastic Processes – Video Transcripts Module 5

Table of Contents

Unit 1: An Introduction to the Black-Scholes Model.................. 3

Unit 2: Pricing Options ..................................................................... 5
Unit 3: Pricing a Digital Option ....................................................... 7
Unit 4: Generalized Black-Scholes ................................................. 9

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MScFE 622 Continuous-time Stochastic Processes – Video Transcript (Lecture 1) Module 5: Unit 1

Unit 1: An Introduction to the Black-Scholes Model

Girsanov’s Theorem
Hi, in this video we introduce the Black-Scholes model and illustrate how to apply Girsanov’s
theorem to finding an ELMM in this model.

So, the one-dimensional Black-Scholes model says that the undiscounted stock price, 𝑆, evolves
according to the following stochastic differential equation:

𝑑𝑆! = 𝑆! (𝑀𝑑𝑡 + 𝜎𝑑𝑊! )

"!
If we take the discounted stock price, which is , where 𝑟 is the constant risk-free rate, then the
# "!

stochastic differential of 𝑋! will be equal to 𝑋! ((𝜇 − 𝑟) 𝑑𝑡 + 𝜎𝑑𝑊! ). So, we are just removing 𝑟 from
the drift itself. 𝑊 is the Brownian motion and we will assume that the probability space contains
this Brownian motion, 𝑊. Written in full:

𝑑𝑆! = 𝑆! (𝑀𝑑𝑡 + 𝜎𝑑𝑊! )

𝑆! 𝑆!
𝑋! = = $!
𝐵! 𝑒

𝑑𝑋! = 𝑋! 3(𝜇 − 𝑟)𝑑𝑡 + 𝜎 𝑑𝑊! 4

Now, we want to find a ELMM for this model and we are going to apply Girsanov’s theorem to do
that.

Girsanov’s theorem says that if we have a new probability measure, let’s call it ℙ∗ , that is
equivalent to ℙ and has the following Radon-Nikodym derivative, or density with respect to ℙ,
& $ &
(# )*# & ∫' (#% )+ 7! , which equals 𝑊! plus ∫! 𝜃+ 𝑑𝑠, is a
𝑒 & ∫( % , then, this new stochastic process, 𝑊 ,

ℙ∗ Brownian motion. Written in full:

𝑑ℙ∗ & - & %

= 𝑒 & ∫( () )*) &. ∫' (# )+
𝑑ℙ

!
7! = 𝑊! + ; 𝜃+ 𝑑𝑠
𝑊
,

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MScFE 622 Continuous-time Stochastic Processes – Video Transcript (Lecture 1) Module 5: Unit 1

So, 𝑊 itself, the original Brownian motion, need not be a Brownian motion under this new
probability measure, ℙ∗ , but Girsanov’s theorem gives us a way of transforming the old Brownian
7! .
motion into a new Brownian motion, 𝑊

Now, we want to try and choose this stochastic process, 𝜃, such that this new measure that we get,
ℙ∗ , makes the discounted stock price, 𝑋, a local martingale. So, in other words, it does not have any
drift in its term.

7! . We will get:
So, let’s express this Brownian motion, 𝑊, in terms of 𝑊

7! − 𝜃! 𝑑𝑡4=
𝑑𝑋! = 𝑋! <(𝜇 − 𝑟)𝑑𝑡 + 𝜎3𝑑𝑊

which simplifies to

7! =
𝑋! <(𝜇 − 𝑟 − 𝜎𝜃! )𝑑𝑡 + 𝜎𝑑𝑊

We want to choose 𝜃! so that the equation above is driftless and it is clear that we have to make
/&$
sure that the above is 0. So, we need 𝜇 − 𝑟 − 𝜎𝜃! = 0, which implies that 𝜃! should be equal to 0
.

In other words, it’s independent of 𝑡 itself.

Therefore, the Radon-Nikodym derivative corresponding to any ELMM is given by:

𝑑ℙ∗ /&$ - /&$ %

= 𝑒 & 0 * & &. 1 0 2 3
𝑑ℙ

after evaluating the corresponding integral. So, that is the Radon-Nikodym derivative and, with
that probability measure, the discounted stock price is a local martingale. Hence, this is an ELMM.
As we can see, it is unique — there is no other value of 𝜃! that will make this a local martingale.

Now that we have looked at Girsanov’s theorem, in the next video, we are going to price a call
option in the Black-Scholes model.

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MScFE 622 Continuous-time Stochastic Processes – Video Transcript (Lecture 2) Module 5: Unit 2

Unit 2: Pricing Options

Pricing a Call Option

Hi, in this video we derive the price of a call option in the Black-Scholes model.

Consider a European call option whose payoff, 𝐻, is given by (𝑆3 − 𝐾)4 , so the positive part of 𝑆3 −
𝐾.

We are assuming the one-dimensional version of the Black-Scholes model, in the sense that the
stock price, under the real-world probability measure, evolves according to the following
stochastic differential equation when 𝑊 is a Brownian motion:

𝑑𝑆! = 𝑆! (𝜇𝑑𝑡 + 𝜎𝑑𝑊! )

In the last video, we showed how to find an ELMM, and, in that case, the stock price will have the
following stochastic differential equation:

7! )
𝑑𝑆! = 𝑆! (𝑟𝑑𝑡 + 𝜎𝑑𝑊

7 is a Brownian motion under the ELMM ℙ∗ .

where, 𝑊

To calculate the price of 𝐻, we have to find the expected value under ℙ∗ of the discounted value of
𝐻, which is shown by:

- % 4
5&
𝐸 ∗ = B𝑒 &$3 C𝑆, 𝑒 1$&.0 2340*
− 𝐾D E

7 3 , which has a normal

Now, the above is an expectation and the only random variable is 𝑊
distribution with mean 0 and variance 𝑇. So, we can express this in terms of a standard normal
random variable, which we write as:

- % 4
𝑒 &$3 𝐸 ∗ BC𝑆, 𝑒 1$&.0 2340√37
− 𝐾D E

where 𝑍 has a standard normal distribution.

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MScFE 622 Continuous-time Stochastic Processes – Video Transcript (Lecture 2) Module 5: Unit 2

This can be rewritten as:

8 - %
𝑒 &$3 ; (𝑆, 𝑒 1$&.0 2340√37
− 𝐾)4
&8

which we multiply by the density of 𝓏, (𝓏 is standard normal), so, written in full, that will give us:

8 7%
- % 1
𝑒 &$3 ; (𝑆, 𝑒 1$&.0
2340√37
− 𝐾)4 𝑒 & . 𝑑𝓏
&8 √2𝜋

To evaluate this expectation, we must just find the region where this is positive, because this is 0
when 𝐾 is greater than this quantity here, and evaluate the integral over that region, which, as
shown in the notes, gives us:

𝑆, 𝛷(𝑑- ) − 𝑒 $3 𝐾𝛷(𝑑. )

In the above equation:

• 𝛷 is the CDF of a standard normal,

%
) $,
9: 1 (24<$4 =3
+ %
• 𝑑- = 0√3
, and

• 𝑑. = 𝑑- − 𝜎√𝑇

So, that’s the expression for 𝑑- and 𝑑. , which gives us the price of the call option at time 0.

Now that we have priced a call option, in the next video, we are going to look at how to price a
digital option.

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MScFE 622 Continuous-time Stochastic Processes – Video Transcript (Lecture 3) Module 5: Unit 3

Unit 3: Pricing a Digital Option

Hi, in this video we introduce a digital option and show how to price it in the Black-Scholes model.

A digital option is a derivative whose payoff is of the following form: 𝐻 = 𝐼{"& ?@} . So it pays the
value 1 if 𝑆3 is greater than 𝐾 and 0 otherwise. This is the indicator.

We can draw it in a diagram, where the x-axis is 𝑆3 and the y-axis is 𝐻. When 𝑆3 is less than 𝐾, the
option pays the value 0 and, as soon as 𝑆3 is greater than 𝐾, it pays the value 1. In comparison to a
call option, on the other hand, it pays the value 0 when 𝑆3 is less than 𝐾 and it pays 𝑆3 minus 𝐾
when 𝑆3 is greater than 𝐾.

To find the price of 𝐻, we have to find the expected value under a risk-neutral measure of the
discounted derivative 𝐻; or the discounted payoff of 𝐻, which is equal to:

𝐸 ∗ (𝑒 &$3 𝐻) = 𝑒 &$3 𝐸 ∗ (𝐻)

We can simplify this to: 𝑒 &$3 𝐸 ∗ (𝐼{"& ?@} ) under the risk-neutral measure.

Note that the expected value of an indicator is just the probability of the set itself. So, the risk-
neutral probability when 𝑆3 is greater than 𝐾 is equal to:

𝑒 &$3 ℙ∗ (𝑆3 > 𝐾)

Now, 𝑆3 is equal to 𝑆, under the risk-neutral measure, as follows:

- % 5&
𝑆3 = 𝑆, 𝑒 1$&.0 2340*

Therefore, if you substitute that, we get:

- % 5&
𝑆3 > 𝐾 ⟺ 𝑆, 𝑒 1$&.0 2340*
>𝐾

which is equal to, taking the second part of the equation, dividing by 𝑆, and taking the logarithms,

1 𝐾
7 3 > 𝐼𝑛 C D
C𝑟 − 𝜎 . D 𝑇 + 𝜎𝑊
2 𝑆,

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MScFE 622 Continuous-time Stochastic Processes – Video Transcript (Lecture 3) Module 5: Unit 3

This can be further simplified to:

𝐾 1
7 3 > 𝐼𝑛 C D − C𝑟 − 𝜎 . D 𝑇
𝜎𝑊
𝑆, 2

We then divide by 𝜎 root 𝑇, because this is a normal random variable. So, if we replace this with
this, we get:

𝐾 1
𝐼𝑛 <𝑆 = − <𝑟 − 2 𝜎 . = 𝑇
,
ℙ∗ (𝑆3 > 𝐾) = ℙ∗ R𝑍 > S
𝜎√𝑇

because of the standard deviation of the beginning point.

This is equal to:

𝐾 1
𝐼𝑛 <𝑆 = − <𝑟 − 2 𝜎 . = 𝑇
,
1 − ℙ∗ R𝑍 < S
𝜎√𝑇

And, using the properties of the standard normal distribution, we see that this is equal to:

1 − 𝛷(−𝑑. ) = 𝛷(𝑑. )

where 𝑑. was calculated in the previous video.

Now that we have looked at the price of a digital option, in the next video we’re going to look at
the general Black-Scholes model.

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MScFE 622 Continuous-time Stochastic Processes – Video Transcript (Lecture 4) Module 5: Unit 4

Unit 4: Generalized Black-Scholes

Hi, in this video we introduce a multidimensional version of the Black-Scholes model.

Recall that the one-dimensional Black-Scholes model says that the stock price evolves according
to the following geometric Brownian motion:

𝑑𝑆! = 𝑆! (𝜇𝑑𝑡 + 𝜎𝑑𝑊! )

where 𝜇 and 𝜎 are constants and 𝑊 is a Brownian motion.

We now want to generalize this to the case where, instead of one stock or risky asset, 𝑠, we have 𝑑
of them, where 𝑑 is finite but greater than or equal to 2, in this case. Written in full:

𝑠3𝑠- , … , 𝑠 ) 4 𝑑 ≥ 2

The Black-Scholes analog of that model still uses something similar to geometric Brownian motion,
then. What we need is a vector of Brownian motion. In other words, we need 𝑚-dimensional
Brownian motion processes from 𝑊 - up to 𝑊 B , which are independent. The covariation between
them is as follows:
〈𝑊 C , 𝑊D 〉! = 𝛿CD!

This means that it is 𝑡 if 𝑖 is equal to 𝑗, and 0 otherwise.

The multidimensional Black-Scholes model says that the stock prices of 𝑆- up to 𝑆 ) all evolve
according to the following SDEs: 𝑑𝑆!C is equal to 𝑆!C times 𝜇C 𝑑𝑡 - where each stock has its own drift -
plus, and then in volatility terms, just a combination of the Brownian motion processes, which are
the sum from 𝑗 = 1 up to 𝑚 of 𝜎CD 𝑑𝑊D ! . That is the stochastic differential equation when 𝑖 = 1 up
to 𝑑. Written in full:
B
C C
𝑑𝑆! = 𝑆! ]𝜇C 𝑑𝑡 + ^ 𝜎CD 𝑑𝑊D ! _
DE-

We normally write this in vector notation as:

𝑑𝑆! = 𝑆! 𝜇𝑑𝑡 + 𝜎𝑑𝑊!

where these are now matrices instead of vectors themselves.

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MScFE 622 Continuous-time Stochastic Processes – Video Transcript (Lecture 4) Module 5: Unit 4

This model is guaranteed to have an ELMM if 𝑚 is greater than or equal to 𝑑. There are cases when
𝑚 is less than 𝑑 and there is no ELMM.

The model is complete - in other words, there is only one ELMM that is guaranteed if 𝑚 = 𝑑. Of
course, there are cases where this doesn’t hold and the model is still complete, but we won’t
explore those cases.

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