Financial Markets

Valuation: idea
Properties of Black-Scholes financial market

MA322:Topic 3. Black-Scholes model

Valuation

Written by Albina Danilova

London School of Economics

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Albina Danilova Topic 3 1

 Financial Markets
Valuation: idea
Properties of Black-Scholes financial market

This lecture:

Financial Markets
Primary Assets
Derivatives
Self-financing Portfolios

Valuation: idea
No-arbitrage argument
Girsanov’s Theorem

Properties of Black-Scholes financial market

No arbitrage
Completeness
Pricing European contingent claims
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Albina Danilova Topic 3 2

 Financial Markets Primary Assets
Valuation: idea Derivatives
Properties of Black-Scholes financial market Self-financing Portfolios

Two types of assets can be traded: primary assets and derivatives.

• Primary assets are liquidly traded: an investor can invest in
these assets at any time, and at prices publicly quoted by the
market.
• No transaction costs..
• No feedback (prices do not react to trading activity).
• Buying assets: ⇒ Long position.
• Selling assets: ⇒ Short position.
• A derivative is an asset that yields its holder a payout that is a
functional of the underlying stock price process.

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Albina Danilova Topic 3 3

 Financial Markets Primary Assets
Valuation: idea Derivatives
Properties of Black-Scholes financial market Self-financing Portfolios

Asset structure

• Money market account:

dBt = Bt rdt; B0 = 1

m
Bt = e rt
• r ∈ R is interest rate, assumed to be a constant.
• Will be also refer to it as a ”bank account”.

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Albina Danilova Topic 3 4

 Financial Markets Primary Assets
Valuation: idea Derivatives
Properties of Black-Scholes financial market Self-financing Portfolios

Asset structure, ctd

• 1 risky asset:

dSt = St (µdt + σdWt ); S0 > 0

m
σ2
St = S0 e µt e σWt − 2
t
=: S0 e µt E(σ)t

• The constant µ is the drift or mean rate of return of the stock

price process,
• and the constant σ is the volatity of the stock price process.
• Note: the risky asset does not necessarily have to be a stock.
It could also be a currency, a commodity etc.
• Question: Why is S risky? beamer-LSE-

Albina Danilova Topic 3 5

 Financial Markets Primary Assets
Valuation: idea Derivatives
Properties of Black-Scholes financial market Self-financing Portfolios

Underlying probability structure

• Finite horizon [0, T ].

• Brownian motion W , 1 -dimensional.
• Information: filtration generated by W :
(Ft )t∈[0,T ] = {FtW : t ∈ [0, T ]}.
• ⇒ all information is generated by underlying shocks that drive
the economy.
• If we assume independence and unpredictability of the shocks
CLT will give BM.
• Filtered probability space (Ω, F, (Ft )t∈[0,T ] , P) - P is physical
measure.

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Albina Danilova Topic 3 6

 Financial Markets Primary Assets
Valuation: idea Derivatives
Properties of Black-Scholes financial market Self-financing Portfolios

Example: A European call option with maturity time T and strike

price K is a contract that gives its holder the right, but not the
obligation, to buy from the option’s writer one share of stock for K
at time T .
At maturity time T , shall the option holder exercise the option:
• if ST < K ?
• How much will she pay for the stock on the market?
• How much will she pay for the stock if she exercise the option?
• ⇒ Should not exercise the option ⇒ receives 0 payoff.
• if ST > K ?
• How much will she get from selling the stock on the market?
• How much will she pay for the stock if she exercises the
option?
• ⇒ Should exercise the option ⇒ receives ST − K payoff.
• Payoff HT given by HT = (ST − K )+ ≡ max {ST − K , 0} beamer-LSE-

Albina Danilova Topic 3 7

 Financial Markets Primary Assets
Valuation: idea Derivatives
Properties of Black-Scholes financial market Self-financing Portfolios

Example: A European put option with maturity time T and strike

price K is a contract that gives its holder the right, but not the
obligation, to sell to the option’s writer one share of stock for K at
time T .
At maturity time T , shall the option holder exercise the option:
• if ST > K ?
• How much will she get from selling the stock on the market?
• How much will she get from selling the stock if she exercises
the option?
• ⇒ Should not exercise the option ⇒ receives 0 payoff.
• if ST < K ?
• How much will she pay for the stock on the market?
• How much will she get from selling the stock if she exercises
the option?
• ⇒ Should exercise the option ⇒ receives K − ST payoff.
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• Payoff HT given by HT = (K − ST )+ ≡ max {K − ST , 0}

Albina Danilova Topic 3 8

 Financial Markets Primary Assets
Valuation: idea Derivatives
Properties of Black-Scholes financial market Self-financing Portfolios

Example: An American put option with maturity time T and

strike price K is a contract that gives its holder the right, but not
the obligation, to sell to the option’s writer one share of stock for
K at any time τ ≤ T that is at the discretion of the option’s
holder.
• Question: What is the payoff of such an option
mathematically?
• If the holder decides to exercise the option at time τ , then she
faces a payout equal to (K − Sτ )+ .
• Determining the time τ that is optimal for the holder to
exercise the option is a difficult mathematical problem.

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Albina Danilova Topic 3 9

 Financial Markets Primary Assets
Valuation: idea Derivatives
Properties of Black-Scholes financial market Self-financing Portfolios

Example: A down-and-out European call option with maturity

time T , strike price K , and knockout barrier b < S0 , where S0 is
the stock price at time 0 when the option is written, is a contract
like a European call option with the additional feature that the
contract is annulled on the event that the stock price process (St )
falls below the knockout barrier b at any time t ∈ [0, T ].
• Question: What is the payoff of such an option
mathematically?
• If the barrier is hit?
• If the barrier is not hit?
• if ST > K ?
• if ST < K ?
• The payoff HT is equal to (ST − K )+ 1 inf St >b } .
{ t∈[0,T ]

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Albina Danilova Topic 3 10

 Financial Markets Primary Assets
Valuation: idea Derivatives
Properties of Black-Scholes financial market Self-financing Portfolios

Example: An arithmetic-average Asian call option written at time

t with maturity time T > t and strike price K is the contract that
pays its holder the average, over the time interval [t, T ], stock
price minus the strike price K if this quantity is positive.
• Question: What is the payoff of such an option
mathematically?
• If the average is higher then K ?
• If the average is lower then K ?
 RT +
1
• The payoff HT is equal to T −t t
Su du − K .

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Albina Danilova Topic 3 11

 Financial Markets Primary Assets
Valuation: idea Derivatives
Properties of Black-Scholes financial market Self-financing Portfolios

Portfolio wealth

An investor:
• starts with an initial capital X0 ,
• invests at time t ≥ 0:
• Nt0 units of the money market account
• and Nt shares of stock.
• What is the portfolio’s total value Xt at time t?

Xt = Nt0 Bt + Nt St , (1)

• in particular,
X0 = N00 + N0 S0 .
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Albina Danilova Topic 3 12

 Financial Markets Primary Assets
Valuation: idea Derivatives
Properties of Black-Scholes financial market Self-financing Portfolios

Investor re-arranges the portfolio’s positions:

• at discrete times only,
• at no cost (no transaction cost).
• Xt− and Xt+ is the portfolio’s value just prior to and just
after the re-arrangement of its positions at time t,
• Question: What does self-financing mean?

Xt− = Xt+ .

• Portfolio’s positions change at times t and t + ∆t but not at

any intermediate time:

Xt+∆t − Xt = Nt0 (Bt+∆t − Bt ) + Nt (St+∆t − St ) . (2)

• ⇒ changes in a self-financing portfolio’s value are due to

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changes in the underlying asset prices but not to trading.

Albina Danilova Topic 3 13

 Financial Markets Primary Assets
Valuation: idea Derivatives
Properties of Black-Scholes financial market Self-financing Portfolios

Continuous time version of portfolio value evolution? Continuous

time analogue of (2)!

dXt = Nt0 dBt + Nt dSt

 
= rNt0 Bt + µNt St dt + σNt St dWt .

In view of (1) a self-financing portfolio’s value process should

satisfy

dXt = rXt dt + (µ − r )Nt St dt + σNt St dWt . (3)

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Albina Danilova Topic 3 14

 Financial Markets Primary Assets
Valuation: idea Derivatives
Properties of Black-Scholes financial market Self-financing Portfolios

• Define the portfolio process π by

π t = Nt S t ,
– is the amount of money invested in the stock at time t.
• Then (3) is equivalent to
Z t Z t Z t
Xt = X0 + r Xu du + (µ − r ) πu du + σ πu dWu . (4)
0 0 0
• Question: Solution to this equation?
 Z t Z t 
rt −ru −ru
Xt = e X0 + (µ − r ) e πu du + σ e πu dWu
0 0
 Z t Z t 
= Bt X0 + (µ − r ) Bu−1 πu du + σ Bu−1 πu dWu .
0 0
(5)
• Note: value process X is completely characterised by its initial
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endowment X0 and the portfolio process π.

Albina Danilova Topic 3 15
 Financial Markets
No-arbitrage argument
Valuation: idea
Girsanov’s Theorem
Properties of Black-Scholes financial market

Put-call parity

Example: (put-call parity of European options). Consider a

European call option and a European put option, both having the
same maturity T and strike price K , and we define, for t ∈ [0, T ]
• Ct – the price of the call option at time t,
• and Pt – the price of the put option at time t.
Note that

PT − CT − K + ST ≡ (K − ST )+ − (ST − K )+ − K + ST = 0,

Question: What can be said about the relationship between Pt

and St for t ∈ [0, T ]?

Pt = Ct + e −r (T −t) K − St . beamer-LSE-

Albina Danilova Topic 3 16

 Financial Markets
No-arbitrage argument
Valuation: idea
Girsanov’s Theorem
Properties of Black-Scholes financial market

What happens if the equality doesn’t hold?

Suppose Pt > Ct + e −r (T −t) K − St at some t ∈ [0, T ]. Enter the
following portfolio:
• sell one put option for Pt ,
• buy one call option for Ct ,
• invest an amount of e −r (T −t) K in thebanking account, and
• short-sell one share of stock for St .
• Collect Pt − Ct − e −r (T −t) K + St > 0 at time t
At the options’ maturity time T :
• pay to the put owner (K − ST )+ ,
• exercise the call if profitable, i.e., if K < ST ,
• retrieve all funds from the banking account, and
• buy back the short-sold share of stock.
• Payoff:
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−(K − ST )+ + (ST − K )+ + e r (T −t) e −r (T −t) K − ST = 0.

Albina Danilova Topic 3 17
 Financial Markets
No-arbitrage argument
Valuation: idea
Girsanov’s Theorem
Properties of Black-Scholes financial market

• Generally, suppose we know that there exists a portfolio such

that XTx ,π = HT
• What is the price of HT at t = 0?
• What is the price of HT at t?
• We have, due to (5):
" Z T #
1
HT = BT x + πv [(µ − r )dv + σdWv ]
0 Bv

• Holds for all realizations of randomness.

• Not affected by measure.

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Albina Danilova Topic 3 18

 Financial Markets
No-arbitrage argument
Valuation: idea
Girsanov’s Theorem
Properties of Black-Scholes financial market

Equivalent Martingale Measure

• Define
µ−r
,. ϑ= (6)
σ
• Consider the exponential martingale L given by

dLt = −ϑLt dWt , L0 = 1,

• Question: What is the solution of this equation?

1
 
Lt = exp − ϑ2 t − ϑWt .
2
• Define the risk-neutral or equivalent martingale probability
measure (EMM) QT on the measurable space (Ω, FT ) by
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QT (A) = EP [LT 1A ] , for A ∈ FT . (7)

Albina Danilova Topic 3 19

 Financial Markets
No-arbitrage argument
Valuation: idea
Girsanov’s Theorem
Properties of Black-Scholes financial market

Girsanov Theorem
Theorem: Under the measure Q the process (Wtϑ , t ∈ [0, T ])
given by
Wtϑ = ϑt + Wt ,
is an (Ft )-Brownian motion.
Moreover, for any Z ∈ FT and s ≤ T we have:

EP [LT Z |Fs ]
EQ [Z |Fs ] = (8)
Ls
Proof: First, let’s show (8). For any A ∈ Fs we have
" #
Q Q EP [LT Z |Fs ]
E [Z 1A ] = E [LT Z 1A ] = E [E [LT Z | Fs ] 1A ] = E 1A ,
Ls
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thus (8) holds by definition of conditional expectation.

Albina Danilova Topic 3 20
 Financial Markets
No-arbitrage argument
Valuation: idea
Girsanov’s Theorem
Properties of Black-Scholes financial market

Proof, ctd
Fix 0 ≥ t0 , . . . , ≤ tn ≤ T and let Xti = ϑti + Wti . We have:
Q[Xt1 − Xt0 ≤ x1 , . . . , Xtn − Xtn−1 ≤ xn ]
h i
= EP LT 1[Xt1 −Xt0 ≤x1 ,...,Xtn −Xtn−1 ≤xn ]
1
h 2 T −ϑW
i
= EP e − 2 ϑ T
1[Wt1 −Wt0 ≤x1 −ϑ(t1 −t0 ),...,Wtn −Wtn−1 ≤xn −ϑ(tn −tn−1 )]
z2
− i−ϑzi
Z x1 −ϑ(t1 −t0 ) Z xn −ϑ(tn −tn−1 ) n
− 21 ϑ2 T
Y e 2(ti −ti−1 )
= ... e p dzn . . . dz1
−∞ −∞ i=1 2π(ti − ti−1 )
(zi +ϑ(ti −ti−1 ))2
Z x1 −ϑ(t1 −t0 ) n
Z xn −ϑ(tn −tn−1 ) Y − 2(ti −ti−1 )
e
= ... p dzn . . . dz1
−∞ −∞ i=1 2π(ti − ti−1 )
y2
− 2(t i
Z x1 n
Z xn Y −t i−1 )
e i beamer-LSE-
= ... p dyn . . . dy1
−∞ −∞ i=1 2π(ti − ti−1 )
Albina Danilova Topic 3 21
 Financial Markets
No-arbitrage argument
Valuation: idea
Girsanov’s Theorem
Properties of Black-Scholes financial market

Theorem: In the Black and Scholes model the discounted stock

price process, (e −rt St )t∈[0,T ] , is (Ft ) martingale and the
discounted portfolio wealth process, (e −rt Xt )t∈[0,T ] , is is (Ft ) local
martingale under measure Q.
Proof: Using the integration by parts formula, we can calculate
d e −rt St = (µ − r ) e −rt St dt + σ e −rt St dWt

(6)
= σϑ e −rt St dt + σ e −rt St dWt

= σ e −rt St (dWt + ϑdt)

= σ e −rt St dWtϑ .

The solution of this equation is given by

1
 
−rt
e St = S0 exp − σ 2 t + σWtϑ , for t ∈ [0, T ]. (9)
2
Thus (e −rt St , t ∈ [0, T ]) is an (Ft )-martingale with respect to the
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probability measure Q.
Albina Danilova Topic 3 22
 Financial Markets
No-arbitrage argument
Valuation: idea
Girsanov’s Theorem
Properties of Black-Scholes financial market

Proof, ctd

Similarly, for a self-financing portfolio we have:

Z t Z t
(5)
e −rt Xt = X0 + (µ − r ) e −ru πu du + σ e −ru πu dWu
0 0
Z t Z t
(6)
= X0 + σϑ e −ru πu du + σ e −ru πu dWu
0 0
Z t
= X0 + σ e −ru πu (dWu + ϑ du)
0
Z t
= X0 + σ e −ru πu dWuϑ , for t ∈ [0, T ]. (10)
0

Thus, (e −rt Xt ) is an (Ft )-local martingale with respect to the

probability measure Q. beamer-LSE-

Albina Danilova Topic 3 23

 Financial Markets
No-arbitrage argument
Valuation: idea
Girsanov’s Theorem
Properties of Black-Scholes financial market

How to apply it here?

• We have:
Z T
HT 1
= X0 + πv [(µ − r )dv + σdWv ]
BT 0 Bv
Z T
1
= X0 + πv σdWvϑ
0 Bv

and W ϑ is ahBMi under measure Q.

• ⇒ X0 = EQ H P
BT = E [ξT HT ] where ξt =
T 1 dQ
Bt dP Ft is the
stochastic discount factor.

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Albina Danilova Topic 3 24

 Financial Markets
No-arbitrage argument
Valuation: idea
Girsanov’s Theorem
Properties of Black-Scholes financial market

Question: : What are the main 2 assumptions we used in the

argument?
1. No arbitrage: if portfolio has the same payoff as the
derivative, then the price of the derivative and the initial value
of the portfolio should be the same.
• Is it always true?
• Does our model allow for arbitrage?
2. Existence of portfolio such that XT = HT – completeness.
• For which random variables HT can we find such portfolio?

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Albina Danilova Topic 3 25

 Financial Markets No arbitrage
Valuation: idea Completeness
Properties of Black-Scholes financial market Pricing European contingent claims

Arbitrage

Definition: self-financing portfolio strategy is admissible if its

associated value process X is bounded from below by a constant,
which may depend on the portfolio itself.
Definition: A self-financing admissible portfolio presents arbitrage
opportunities if it starts with an initial endowment X0 = 0, and, for
some time T > 0, its value process X satisfies

XT ≥ 0, P-a.s., and
for some event A ∈ FT with P(A) > 0, XT (ω) > 0 for all ω ∈ A.
(11)

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Albina Danilova Topic 3 26

 Financial Markets No arbitrage
Valuation: idea Completeness
Properties of Black-Scholes financial market Pricing European contingent claims

Theorem: In the Black and Scholes model, there is no admissible

self-financing portfolio offering arbitrage opportunities.
Proof.
• Assume that there exists an arbitrage strategy π:
• admissible portfolio process π ,
• initial endowment X0 = 0,
• with associated self-financing portfolio wealth, X , satisfying

P (XT ≥ 0) = 1, and
for some event A ∈ FT with P(A) > 0, XT (ω) > 0 for all ω ∈ A.
(12)
for some T > 0
• Consider the risk-neutral measure Q defined by (7) above.
This measure is equivalent to the real-world probability
measure P, which means that, given any event C ∈ FT ,
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P(C ) = 0 ⇔ Q(C ) = 0 and P(C ) = 1 ⇔ Q(C ) = 1.

Albina Danilova Topic 3 27

 Financial Markets No arbitrage
Valuation: idea Completeness
Properties of Black-Scholes financial market Pricing European contingent claims

Proof, ctd
• This property and (12) imply that

Q (XT ≥ 0) = 1, and
for some event A ∈ FT with Q(A) > 0, XT (ω) > 0 for all ω ∈ A.
It follows that
EQ [XT ] > 0. (13)
• Dynamics of the discounted portfolio value process satisfy
Z t
e −rt Xt = σ e −rs πs dWsϑ .
0

• Since the portfolio strategy π is admissible, there exists a

constant K ≥ 0 such that e −rt Xt ≥ −K for all t ∈ [0, T ].
• Thus (e −rt Xt + K ) is a positive (Ft )-local martingale with beamer-LSE-

respect to the probability measure Q.

Albina Danilova Topic 3 28
 Financial Markets No arbitrage
Valuation: idea Completeness
Properties of Black-Scholes financial market Pricing European contingent claims

Proof, ctd

• Since positive local martingales are supermartingales,

(e −rt Xt + K ) is an (Ft )-supermartingale with respect to the
probability measure Q, and, therefore,
 h i 
EQ [XT ] = e rT EQ e −rT XT + K − K
 h i 
= e rT EQ EQ e −rT XT + K | F0

−K
 
≤ e rT EQ [X0 + K ] − K
= 0.

• However, this calculation contradicts (13), and the proof is

complete. beamer-LSE-

Albina Danilova Topic 3 29

 Financial Markets No arbitrage
Valuation: idea Completeness
Properties of Black-Scholes financial market Pricing European contingent claims

Definition: European contingent claim is a contract that yields a

payoff HT at its maturity time T > 0, where HT is an
FT -measurable random variable.
Definition: Consider a European contingent claim that yields the
payoff HT at its maturity T > 0, and suppose that there exists a
self-financing admissible portfolio strategy π ∗ that starts with an
initial endowment X0 and is such that its associated discounted
value process (e −rt Xt∗ ) is a martingale under equivalent martingale
measure Q and satisfies

XT∗ = HT , P-a.s.. (14)

Then, the no-arbitrage or rational price PtHT of the claim is given

by
PtHT = Xt∗ for all t ∈ [0, T ]. (15)
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We call πt∗ the claim’s hedging or replicating portfolio process.
Albina Danilova Topic 3 30
 Financial Markets No arbitrage
Valuation: idea Completeness
Properties of Black-Scholes financial market Pricing European contingent claims

Theorem: Consider a European contingent claim with payoff

HT ∈ L1 (Ω, FT , Q) bounded from below, where Q is the EMM
defined by (7). Then there exists a portfolio such that XT = HT .
Moreover, the no-arbitrage price of HT is given by
Bt P LT
 
PtHT = E HT | Ft
Lt BT
h i
= Bt EQ BT−1 HT | Ft , for t ∈ [0, T ].
Proof.
• Consider the (Ft , P)-martingale M defined by
LT HT
 
Mt = EP | Ft , for t ∈ [0, T ]. (16)
BT
• The martingale representation theorem yields that there exists
an adapted process K such that
 Z t
P LT HT

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Mt = E + Ks dWs for all t ≥ 0.
BT 0
Albina Danilova Topic 3 31
 Financial Markets No arbitrage
Valuation: idea Completeness
Properties of Black-Scholes financial market Pricing European contingent claims

Proof, ctd
• Combining this expression with the fact that

dL−1 2 −1 −1
t = ϑ Lt dt + ϑLt dWt ,

and the integration by parts formula, we can see that

Z t Z t
Mt LT HT ϑMs + Ks ϑMs + Ks
 
= EP + ϑ ds + dWs .
Lt BT 0 Ls 0 Ls
(17)
• Consider the self-financing portfolio strategy that:
• starts with an initial endowment
 
LT HT
X0 = EP
BT
• is defined by
Bt (ϑMt + Kt ) beamer-LSE-
πt∗ = . (18)
σLt
Albina Danilova Topic 3 32
 Financial Markets No arbitrage
Valuation: idea Completeness
Properties of Black-Scholes financial market Pricing European contingent claims

Proof, ctd

• In view of (5), we can see that the total value process X ∗ of

this portfolio satisfies

Xt∗
Z t Z t
LT HT ϑMs + Ks ϑMs + Ks
 
= EP + ϑ ds + dWs .
Bt BT 0 Ls 0 Ls
• Recalling the definition of M in (16) and comparing this
expression with (17), we can see that

Bt Mt Bt P LT HT
 
Xt∗ = = E | Ft for all t ∈ [0, T ]. (19)
Lt Lt BT
• In particular, for t = T we have XT∗ = HT , P-a.s., as required.
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Albina Danilova Topic 3 33

 Financial Markets No arbitrage
Valuation: idea Completeness
Properties of Black-Scholes financial market Pricing European contingent claims

Corollary.

In the Black and Scholes model, the no-arbitrage price process of a

European contingent claim that yields the payoff
F (ST ) ∈ L1 (Ω, FT , Q) at its maturity time T > 0 is given by
h i
F (ST )
Pt = EQ e −r (T −t) F (ST ) | Ft , for t ∈ [0, T ], (20)

where
dSt = rSt dt + σSt dWtϑ , (21)
and W ϑ is an (Ft )-Brownian motion under the risk-neutral
probability measure Q defined by (7).

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Albina Danilova Topic 3 34

 Financial Markets No arbitrage
Valuation: idea Completeness
Properties of Black-Scholes financial market Pricing European contingent claims

Example: Consider a European vanilla call option with maturity T

and strike price K . Its no-arbitrage price Ptvanilla call at time t is
given by

Ptvanilla call =e −r (T −t) EQ +

 
t (ST − K ) (22)
   
ln (St /K ) + r + 12 σ 2 (T − t)
= St Φ  √ 
σ T −t
   
ln (St /K ) + r − 12 σ 2 (T − t)
−r (T −t)
−e KΦ  √ .
σ T −t

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Albina Danilova Topic 3 35

 Financial Markets No arbitrage
Valuation: idea Completeness
Properties of Black-Scholes financial market Pricing European contingent claims

Arbitrage pricing:

• No arbitrage price in complete market model:

ξ T HT
h i  
PtHT = e (ert −rt
Xt ) = e E rt Q
e −rT
HT | Ft = E Q
| Ft
ξt
• State price density (Stochastic Discount Factor):

dQ
 
−rt
ξt = e LT where Lt = E | Ft
dP
• Pricing in complete markets is straightforward.
• Theoretical bond market consists of a continuum of assets.
• Realistic markets are generically incomplete:
• Price trajectories are discontinuous.
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• There are unspanned sources of risk.

Albina Danilova Topic 3 36