4.

Option pricing models under the Black-

Scholes framework
Riskless hedging principle
Writer of a call option hedges his exposure by holding certain units
of the underlying asset in order to create a riskless portfolio.
In an ecient market with no riskless arbitrage opportunity, a riskless
portfolio must earn rate of return equals the riskless interest rate.
1
Dynamic replication strategy
How to replicate an option dynamically by a portfolio of the riskless
asset in the form of money market account and the risky underlying
asset?
The cost of constructing the replicating portfolio gives the fair price
of an option.
Risk neutrality argument
The two tradeable securities, option and asset, are hedgeable with
each other. Hedgeable securities should have the same market price
of risk.
2
Black-Scholes assumptions on the nancial market
(i) Trading takes place continuously in time.
(ii) The riskless interest rate r is known and constant over time.
(iii) The asset pays no dividend.
(iv) There are no transaction costs in buying or selling the asset or
the option, and no taxes.
(v) The assets are perfectly divisible.
(vi) There are no penalties to short selling and the full use of pro-
ceeds is permitted.
(vii) There are no arbitrage opportunities.
3
The stochastic process of the asset price S is assumed to follow the
Geometric Brownian motion
dS
S
= dt + dZ.
Consider a portfolio which involves short selling of one unit of a
European call option and long holding of units of the underlying
asset. The value of the portfolio is given by
= c +S,
where c = c(S, t) denotes the call price.
Since both c and are random variables, we apply the Ito lemma
to compute their stochastic dierentials as follows:
dc =
c
t
dt +
c
S
dS +

2
2
S
2

2
c
S
2
dt
4
d = dc + dS
=
_

c
t

2
2
S
2

2
c
S
2
_
dt +
_

c
S
_
dS
=
_

c
t

2
2
S
2

2
c
S
2
+
_

c
S
_
S
_
dt +
_

c
S
_
S dZ.
Why the dierential Sd does not enter into d? By virtue of
the assumption of following a self-nancing trading strategy, the
contribution to d due to Sd is oset by the accompanying pur-
chase/sale of units of options.
5
If we choose =
c
S
, then the portfolio becomes a riskless hedge in-
stantaneously
_
since
c
S
changes continuously with time
_
. By virtue
of no arbitrage, the hedged portfolio should earn the riskless in-
terest rate.
By setting d = rdt
d =
_

c
t

2
2
S
2

2
c
S
2
_
dt = rdt = r
_
c +S
c
S
_
dt.
Black-Scholes equation:
c
t
+

2
2
S
2

2
c
S
2
+rS
c
S
rc = 0.
Terminal payo: c(S, T) = max(S X, 0).
The parameter (expected rate of return) does not appear in the
governing equation and the auxiliary condition.
6
5 parameters in the option model: S, T, X, r and ; only is
unobservable.
Deciencies in the model
1. Geometric Brownian motion assumption? Actual asset price
dynamics is much more complicated.
2. Continuous hedging at all times
trading usually involves transaction costs.
3. Interest rate should be stochastic instead of deterministic.
7
Dynamic replication strategy (Mertons approach)
Q
S
(t) = number of units of asset
Q
V
(t) = number of units of option
M
S
(t) = dollar value of Q
S
(t) units of asset
M
V
(t) = dollar value of Q
V
(t) units of option
M(t) = value of riskless asset invested in money market account
Construction of a self-nancing and dynamically hedged portfo-
lio containing risky asset, option and riskless asset.
8
Dynamic replication: Composition is allowed to change at all
times in the replication process.
The self-nancing portfolio is set up with zero initial net invest-
ment cost and no additional funds added or withdrawn after-
wards.
The zero net investment condition at time t is
(t) = M
S
(t) +M
V
(t) +M(t)
= Q
S
(t)S +Q
V
(t)V +M(t) = 0.
Dierential of option value V :
dV =
V
t
dt +
V
S
dS +

2
2
S
2

2
V
S
2
dt
=
_
V
t
+S
V
S
+

2
2
S
2

2
V
S
2
_
dt +S
V
S
dZ.
9
Formally, we write
dV
V
=
V
dt +
V
dZ
where

V
=
V
t
+S
V
S
+

2
2
S
2

2
V
S
2
V
and
V
=
S
V
S
V
.
d(t) = [Q
S
(t) dS +Q
V
(t) dV +rM(t) dt]
+[SdQ
S
(t) +V dQ
S
(t) +dM(t)]
. .
zero due to self-nancing trading strategy
10
The instantaneous portfolio return d(t) can be expressed in terms
of M
S
(t) and M
V
(t) as follows:
d(t) = Q
S
(t) dS +Q
V
(t) dV +rM(t) dt
= M
S
(t)
dS
S
+M
V
(t)
dV
V
+rM(t) dt
= [( r)M
S
(t) +(
V
r)M
V
(t)] dt
+ [M
S
(t) +
V
M
V
(t)] dZ.
We then choose M
S
(t) and M
V
(t) such that the stochastic term
becomes zero.
From the relation:
M
S
(t) +
V
M
V
(t) = SQ
S
(t) +
S
V
S
V
V Q
V
(t) = 0,
we obtain
Q
S
(t)
Q
V
(t)
=
V
S
.
11
Taking the choice of Q
V
(t) = 1, and knowing
0 = (t) = V +S +M(t)
we obtain
V = S +M(t), where =
V
S
.
Since the replicating portfolio is self-nancing and replicates the
terminal payo, by virtue of no-arbitrage argument, the initial cost
of setting up this replicating portfolio of risky asset and riskless asset
must be equal to the value of the option being replicated.
12
The dynamic replicating portfolio is riskless and requires no net
investment, so d(t) = 0.
0 = [( r)M
S
(t) +(
V
r)M
V
(t)] dt.
Putting
Q
S
(t)
Q
V
(T)
=
V
S
, we obtain
( r)S
V
S
= (
V
r)V.
Replacing
V
by
_
V
t
+S
V
S
+

2
2
S
2

2
V
S
2
_ _
V , we obtain the Black-
Scholes equation
V
t
+

2
2
S
2

2
V
S
2
+rS
V
S
rV = 0.
13
Alternative perspective on risk neutral valuation
From
V
=
V
t
+S
V
S
+

2
2
S
2

2
V
S
2
V
, we obtain
V
t
+

2
2
S
2

2
V
S
2
+S
V
S

V
V = 0.
We need to calibrate the parameters and
V
, or nd some other
means to avoid such nuisance.
Combining
V
=
S
V
S
V
and ( r)S
V
S
= (
V
r)V , we obtain

V
r

V
. .

V
=
r

. .

S
Black-Scholes equation.
14
The market price of risk is the rate of extra return above r per
unit risk.
Two hedgeable securities should have the same market price of
risk.
The Black-Scholes equation can be obtained by setting =

V
= r (implying zero market price of risk).
In the world of zero market price of risk, investors are said to be
risk neutral since they do not demand extra returns on holding
risky assets.
Option valuation can be performed in the risk neutral world by
articially taking the expected rate of returns of the asset and
option to be r.
15
Arguments of risk neutrality
We nd the price of a derivative relative to that of the underlying
asset mathematical relationship between the prices is invariant
to the risk preference.
Be careful that the actual rate of return of the underlying as-
set would aect the asset price and thus indirectly aects the
absolute derivative price.
We simply use the convenience of risk neutrality to arrive at the
mathematical relationship but actual risk neutrality behaviors of
the investors are not necessary in the derivation of option prices.
16
How we came up with the option formula? Black (1989)
It started with tinkering and ended with delayed recognition.
The expected return on a warrant should depend on the risk of
the warrant in the same way that a common stocks expected
return depends on its risk.
I spent many, many days trying to nd the solution to that (dif-
ferential) equation. I have a PhD in applied mathematics, but
had never spent much time on dierential equations, so I didnt
know the standard methods used to solve problems like that. I
have an A.B. in physics, but I didnt recognize the equation as
a version of the heat equation, which has well-known solutions.
17
Continuous time securities model
Uncertainty in the nancial market is modeled by the ltered
probability space (, F, (F
t
)
0tT
, P), where is a sample space,
F is a -algebra on , P is a probability measure on (, F), F
t
is the ltration and F
T
= F.
There are M + 1 securities whose price processes are modeled
by adapted stochastic processes S
m
(t), m = 0, 1, , M.
We dene h
m
(t) to be the number of units of the m
th
security
held in the portfolio.
The trading strategy H(t) is the vector stochastic process (h
0
(t)
h
1
(t) h
M
(t))
T
, where H(t) is a (M+1)-dimensional predictable
process since the portfolio composition is determined by the in-
vestor based on the information available before time t.
18
The value process associated with a trading strategy H(t) is
dened by
V (t) =
M

m=0
h
m
(t)S
m
(t), 0 t T,
and the gain process G(t) is given by
G(t) =
M

m=0
_
t
0
h
m
(u) dS
m
(u), 0 t T.
Similar to that in discrete models, H(t) is self-nancing if and
only if
V (t) = V (0) +G(t).
19
We use S
0
(t) to denote the money market account process that
grows at the riskless interest rate r(t), that is,
dS
0
(t) = r(t)S
0
(t) dt.
The discounted security price process S

m
(t) is dened as
S

m
(t) = S
m
(t)/S
0
(t), m = 1, 2, , M.
The discounted value process V

(t) is dened by dividing V (t)

by S
0
(t). The discounted gain process G

(t) is dened by
G

(t) = V

(t) V

(0).
20
No-arbitrage principle and equivalent martingale measure
A self-nancing trading strategy H represents an arbitrage op-
portunity if and only if (i) G

(T) 0 and (ii) E

P
G

(T) > 0 where

P is the actual probability measure of the states of occurrence
associated with the securities model.
A probability measure Q on the space (, F) is said to be an
equivalent martingale measure if it satises
(i) Q is equivalent to P, that is, both P and Q have the same
null set;
(ii) the discounted security price processes S

m
(t), m = 1, 2, , M
are martingales under Q, that is,
E
Q
[S

m
(u)|F
t
] = S

m
(t), for all 0 t u T.
21
Theorem
Let Y be an attainable contingent claim generated by some trading
strategy H and assume that an equivalent martingale measure Q
exists, then for each time t, 0 t T, the arbitrage price of Y is
given by
V (t; H) = S
0
(t)E
Q
_
Y
S
0
(T)

F
t
_
.
The validity of the Theorem is readily seen if we consider the dis-
counted value process V

(t; H) to be a martingale under Q. This

leads to
V (t; H) = S
0
(t)V

(t; H) = S
0
(t)E
Q
[V

(T; H)|F
t
].
Furthermore, by observing that V

(T; H) = Y/S
0
(T), so the risk
neutral valuation formula follows.
22
Change of numeraire
The choice of S
0
(t) as the numeraire is not unique in order that
the risk neutral valuation formula holds.
Let N(t) be a numeraire whereby we have the existence of an
equivalent probability measure Q
N
such that all security prices
discounted with respect to N(t) are Q
N
-martingale. In addition,
if a contingent claim Y is attainable under (S
0
(t), Q), then it is
also attainable under (N(t), Q
N
).
23
The arbitrage price of any security given by the risk neutral valuation
formula under both measures should agree. We then have
S
0
(t)E
Q
_
Y
S
0
(T)

F
t
_
= N(t)E
Q
N
_
Y
N(T)

F
t
_
.
To eect the change of measure from Q
N
to Q, we multiply
Y
N(T)
by the Radon-Nikodym derivative so that
S
0
(t)E
Q
_
Y
S
0
(T)

F
t
_
= N(t)E
Q
_
Y
N(T)
dQ
N
dQ

F
t
_
.
By comparing like terms, we obtain
dQ
N
dQ
=
N(T)
N(t)
_
S
0
(T)
S
0
(t)
.
24
Black-Scholes model revisited
The price processes of S(t) and M(t) are governed by
dS(t)
S(t)
= dt + dZ
dM(t) = rM(t) dt.
The price process of S

(t) = S(t)/M(t) becomes

dS

(t)
S

(t)
= ( r)dt + dZ.
We would like to nd the equivalent martingale measure Q such
that the discounted asset price S

is Q-martingale. By the Girsanov

Theorem, suppose we choose (t) in the Radon-Nikodym derivative
such that
(t) =
r

,
then

Z is a Brownian motion under the probability measure Q and
d

Z = dZ +
r

dt.
25
Under the Q-measure, the process of S

(t) now becomes

dS

(t)
S

(t)
= d

Z,
hence S

(t) is Q-martingale. The asset price S(t) under the Q-

measure is governed by
dS(t)
S(t)
= r dt + d

Z.
When the money market account is used as the numeraire, the cor-
responding equivalent martingale measure is called the risk neutral
measure and the drift rate of S under the Q-measure is called the
risk neutral drift rate.
26
The arbitrage price of a derivative is given by
V (S, t) = e
r(Tt)
E
t,S
Q
[h(S
T
)]
where E
t,S
Q
is the expectation under the risk neutral measure Q
conditional on the ltration F
t
and S
t
= S. By the Feynman-Kac
representation formula, the governing equation of V (S, t) is given
by
V
t
+

2
2
S
2

2
V
S
2
+rS
V
S
rV = 0.
Consider the European call option whose terminal payo is max(S
T

X, 0). The call price c(S, t) is given by

c(S, t) = e
r(Tt)
E
Q
[max(S
T
X, 0)]
= e
r(Tt)
{E
Q
[S
T
1
{S
T
X}
] XE
Q
[1
{S
T
X}
]}.
27
Exchange rate process under domestic risk neutral measure
Consider a foreign currency option whose payo function de-
pends on the exchange rate F, which is dened to be the do-
mestic currency price of one unit of foreign currency.
Let M
d
and M
f
denote the money market account process in
the domestic market and foreign market, respectively. The pro-
cesses of M
d
(t), M
f
(t) and F(t) are governed by
dM
d
(t) = rM
d
(t) dt, dM
f
(t) = r
f
M
f
(t) dt,
dF(t)
F(t)
= dt + dZ
F
,
where r and r
f
denote the riskless domestic and foreign interest
rates, respectively.
28
We may treat the domestic money market account and the for-
eign money market account in domestic dollars (whose value
is given by FM
f
) as traded securities in the domestic currency
world.
With reference to the domestic equivalent martingale measure,
M
d
is used as the numeraire.
By Itos lemma, the relative price process X(t) = F(t)M
f
(t)/M
d
(t)
is governed by
dX(t)
X(t)
= (r
f
r +) dt + dZ
F
.
29
With the choice of = (r
f
r +)/ in the Girsanov Theorem,
we dene
dZ
d
= dZ
F
+ dt,
where Z
d
is a Brownian process under Q
d
.
Under the domestic equivalent martingale measure Q
d
, the pro-
cess of X now becomes
dX(t)
X(t)
= dZ
d
so that X is Q
d
-martingale.
The exchange rate process F under the Q
d
-measure is given by
dF(t)
F(t)
= (r r
f
) dt + dZ
d
.
The risk neutral drift rate of F under Q
d
is found to be r r
f
.
30
Recall that the Black-Scholes equation for a European vanilla call
option takes the form
c

=

2
2
S
2

2
c
S
2
+rS
c
S
rc, 0 < S < , > 0, = T t.
Initial condition (payo at expiry)
c(S, 0) = max(S X, 0), X is the strike price.
Using the transformation: y = lnS and c(y, ) = e
r
w(y, ), the
Black-Scholes equation is transformed into
w

=

2
2

2
w
y
2
+
_
r

2
2
_
w
y
, < y < , > 0.
The initial condition for the model now becomes
w(y, 0) = max(e
y
X, 0).
31
Green function approach
The innite domain Green function is known to be
(y, ) =
1

2
exp
_
_

[y +(r

2
2
)]
2
2
2

_
_
.
Here, (y, ) satises the initial condition:
lim
0
+
(y, ) = (y),
where (y) is the Dirac function representing a unit impulse at the
origin.
The initial condition can be expressed as
w(y, 0) =
_

w(, 0)(y ) d,
so that w(y, 0) can be considered as the superposition of impulses
with varying magnitude w(, 0) ranging from to .
32
Since the Black-Scholes equation is linear, the response in po-
sition y and at time to expiry due to an impulse of magnitude
w(, 0) in position at = 0 is given by w(, 0)(y , ).
From the principle of superposition for a linear dierential equa-
tion, the solution is obtained by summing up the responses due
to these impulses.
c(y, ) = e
r
w(y, )
= e
r
_

w(, 0) (y , ) d
= e
r
_

lnX
(e

X)
1

2
exp
_
_

[y +(r

2
2
) ]
2
2
2

_
_
d.
33
Note that
_

lnX
e

2
exp
_
_

[y +(r

2
2
) ]
2
2
2

_
_
d
= exp(y +r)
_

lnX
1

2
exp
_
_
_
_
_

_
y +
_
r +

2
2
_

_
2
2
2

_
_
_
_
_
d
= e
r
SN
_
_
ln
S
X
+(r +

2
2
)

_
_
, y = lnS;
_

lnX
1

2
exp
_
_

[y +(r

2
2
) ]
2
2
2

_
_
d
= N
_
_
y +(r

2
2
) lnX

_
_
= N
_
_
ln
S
X
+(r

2
2
)

_
_
, y = lnS.
34
Hence, the price formula of the European call option is found to be
c(S, ) = SN(d
1
) Xe
r
N(d
2
),
where
d
1
=
ln
S
X
+(r +

2
2
)

, d
2
= d
1

.
The call value lies within the bounds
max(S Xe
r
, 0) c(S, ) S, S 0, 0,
35
36
c(S, ) = e
r
E
Q
[(S
T
X)1
{S
T
X}
]
= e
r
_

0
max(S
T
X, 0)(S
T
, T; S, t) dS
T
.
Under the risk neutral measure,
ln
S
T
S
=
_
r

2
2
_
+

Z()
so that ln
S
T
S
is normally distributed with mean
_
r

2
2
_
and
variance
2
, = T t.
From the density function of a normal random variable, the
transition density function is given by
(S
T
, T; S, t) =
1
S
T

2
exp
_
_
_
_
_

_
ln
S
T
S

_
r

2
2
_

_
2
2
2

_
_
_
_
_
.
37
If we compare the price formula with the expectation representation
we deduce that
N(d
2
) = E
Q
[1
{S
T
X}
] = Q[S
T
X]
SN(d
1
) = e
r
E
Q
[S
T
1
{S
T
X}
].
N(d
2
) is recognized as the probability under the risk neutral
measure Q that the call expires in-the-money, so Xe
r
N(d
2
)
represents the present value of the risk neutral expectation of
payment paid by the option holder at expiry.
SN(d
1
) is the discounted risk neutral expectation of the terminal
asset price conditional on the call being in-the-money at expiry.
38
Delta - derivative with respect to asset price

c
=
c
S
= N(d
1
) +S
1

2
e

d
2
1
2
d
1
S
Xe
r
1

2
e

d
2
2
2
d
2
S
= N(d
1
) +
1

2
[e

d
2
1
2
e
(r+ln
S
X
)
e

d
2
2
2
]
= N(d
1
) > 0.
Knowing that a European call can be replicated by units of asset
and riskless asset in the form of money market account, the factor
N(d
1
) in front of S in the call price formula thus gives the hedge
ratio .
39

c
is an increasing function of S since

S
N(d
1
) is always posi-
tive. Also, the value of
c
is bounded between 0 and 1.
The curve of
c
against S changes concavity at
S
c
= X exp
_

_
r +
3
2
2
_

_
so that the curve is concave upward for 0 S < S
c
and concave
downward for S
c
< S < .
lim

c
S
= 1 for all values of S,
while
lim
0
+
c
S
=
_

_
1 if S > X
1
2
if S = X
0 if S < X
.
40
Variation of the delta of the European call value with respect to the
asset price S. The curve changes concavity at S = Xe

_
r+
3
2
2
_

.
41
Variation of the delta of the European call value with respect to
time to expiry . The delta value always tends to one from below
when the time to expiry tends to innity. The delta value tends to
dierent asymptotic limits as time comes close to expiry, depending
on the moneyness of the option.
42
Continuous dividend yield models
Let q denote the constant continuous dividend yield, that is, the
holder receives dividend of amount equal to qS dt within the interval
dt. The asset price dynamics is assumed to follow the Geometric
Brownian Motion
dS
S
= dt + dZ.
We form a riskless hedging portfolio by short selling one unit of the
European call and long holding units of the underlying asset. The
dierential of the portfolio value is given by
43
d = dc + dS +qS dt
=
_

c
t

2
2
S
2

2
c
S
2
+qS
_
dt +
_

c
S
_
dS.
The last term qS dt is the wealth added to the portfolio due to
the dividend payment received. By choosing =
c
S
, we obtain a
riskless hedge for the portfolio. The hedged portfolio should earn
the riskless interest rate.
We then have
d =
_

c
t

2
2
S
2

2
c
S
2
+qS
c
S
_
dt = r
_
c +S
c
S
_
dt,
which leads to
c

=

2
2
S
2

2
c
S
2
+(r q)S
c
S
rc, = T t, 0 < S < , > 0.
44
Martingale pricing approach
Suppose all the dividend yields received are used to purchase addi-
tional units of asset, then the wealth process of holding one unit of
asset initially is given by

S
t
= e
qt
S
t
,
where e
qt
represents the growth factor in the number of units. The
wealth process

S
t
follows
d

S
t

S
t
= ( +q) dt + dZ.
We would like to nd the equivalent risk neutral measure Q under
which the discounted wealth process

S

t
is Q-martingale. We choose
(t) in the Radon-Nikodym derivative to be
(t) =
+q r

.
45
Now

Z is Brownian process under Q and
d

Z = dZ +
+q r

dt.
Also,

S

t
becomes Q-martingale since
d

t
= d

Z.
The asset price S
t
under the equivalent risk neutral measure Q be-
comes
dS
t
S
t
= (r q) dt + d

Z.
Hence, the risk neutral drift rate of S
t
is r q.
Analogy with foreign currency options
The continuous yield model is also applicable to options on foreign
currencies where the continuous dividend yield can be considered as
the yield due to the interest earned by the foreign currency at the
foreign interest rate r
f
.
46
Call and put price formulas
The price of a European call option on a continuous dividend paying
asset can be obtained by changing S to Se
q
in the price formula.
This rule of transformation is justied since the drift rate of the
dividend yield paying asset under the risk neutral measure is r q.
Now, the European call price formula with continuous dividend yield
q is found to be
c = Se
q
N(

d
1
) Xe
r
N(

d
2
),
where

d
1
=
ln
S
X
+(r q +

2
2
)

,

d
2
=

d
1

.
47
Similarly, the European put formula with continuous dividend yield
q can be deduced from the Black-Scholes put price formula to be
p = Xe
r
N(

d
2
) Se
q
N(

d
1
).
The new put and call prices satisfy the put-call parity relation
p = c Se
q
+Xe
r
.
Furthermore, the following put-call symmetry relation can also be
deduced from the above call and put price formulas
c(S, ; X, r, q) = p(X, ; S, q, r),
48
The put price formula can be obtained from the corresponding
call price formula by interchanging S with X and r with q in the
formula. Recall that a call option entitles its holder the right to
exchange the riskless asset for the risky asset, and vice versa for
a put option. The dividend yield earned from the risky asset is
q while that from the riskless asset is r.
If we interchange the roles of the riskless asset and risky asset
in a call option, the call becomes a put option, thus giving the
justication for the put-call symmetry relation.
49
Time dependent parameters
Suppose the model parameters become deterministic functions of
time, the Black-Scholes equation has to be modied as follows
V

=

2
()
2
S
2

2
V
S
2
+[r()q()] S
V
S
r()V, 0 < S < , > 0,
where V is the price of the derivative security.
When we apply the following transformations: y = lnS and w =
e
_

0
r(u) du
V , then
w

=

2
()
2

2
w
y
2
+
_
r() q()

2
()
2
_
w
y
.
Consider the following form of the fundamental solution
f(y, ) =
1
_
2s()
exp
_

[y +e()]
2
2s()
_
,
50
it can be shown that f(y, ) satises the parabolic equation
f

=
1
2
s

()

2
f
y
2
+e

()
f
y
.
Suppose we let
s() =
_

0

2
(u) du
e() =
_

0
[r(u) q(u)] du
s()
2
,
one can deduce that the fundamental solution is given by
(y, ) =
1
_
2
_

0

2
(u) du
exp
_
_
_
{y +
_

0
[r(u) q(u)

2
(u)
2
] du}
2
2
_

0

2
(u) du
_
_
_.
Given the initial condition w(y, 0), the solution can be expressed as
w(y, ) =
_

w(, 0) (y , ) d.
51
Note that the time dependency of the coecients r(), q() and

2
() will not aect the spatial integration with respect to . We
make the following substitutions in the option price formulas
r is replaced by
1

_

0
r(u) du
q is replaced by
1

_

0
q(u) du

2
is replaced by
1

_

0

2
(u) du.
For example, the European call price formula is modied as follows:
c = Se

0
q(u) du
N(

d
1
) Xe

0
r(u) du
N(

d
2
)
where

d
1
=
ln
S
X
+
_

0
[r(u) q(u) +

2
(u)
2
] du
_
_

0

2
(u) du
,

d
2
=

d
1

_

0

2
(u) du.
52
Implied volatilities
The only unobservable parameter in the Black-Scholes formulas is
the volatility value, . By inputting an estimated volatility value, we
obtain the option price. Conversely, given the market price of an
option, we can back out the corresponding Black-Scholes implied
volatiltiy.
Several implied volatility values obtained simultaneously from
dierent options (varying strikes and maturities) on the same
underlying asset provide the market view about the volatility of
the stochastic movement of the asset price.
Given the market prices of European call options with dierent
maturities (all have the strike prices of 105, current asset price
is 106.25 and short-term interest rate over the period is at at
5.6%).
maturity 1-month 3-month 7-month
Value 3.50 5.76 7.97
Implied volatility 21.2% 30.5% 19.4%
53
Time dependent volatility
The Black-Scholes formulas remain valid for time dependent volatil-
ity except that

1
T t
_
T
t
()
2
d is used to replace .
How to obtain (t) given the implied volatility measured at time t

of a European option expiring at time t. Now

imp
(t

, t) =

1
t t

_
t
t

()
2
d
so that
_
t
t

()
2
d =
2
imp
(t

, t)(t t

).
Dierentiate with respect to t, we obtain
(t) =

imp
(t

, t)
2
+2(t t

)
imp
(t

, t)

imp
(t

, t)
t
.
54
Practically, we do not have a continuous dierentiable implied volatil-
ity function
imp
(t

, t), but rather implied volatilities are available at

discrete instants t
i
. Suppose we assume (t) to be piecewise con-
stant over (t
i1
, t
i
), then
(t
i
t

)
2
imp
(t

, t
i
) (t
i1
t

)
2
imp
(t

, t
i1
)
=
_
t
i
t
i1

2
() d =
2
(t)(t
i
t
i1
), t
i1
< t < t
i
,
(t) =

_
(t
i
t

)
2
imp
(t

, t
i1
) (t
i1
t

)
2
imp
(t

, t
i1
)
t
i
t
i1
, t
i1
< t < t
i
.
55
Quanto-prewashing techniques
1. Consider two assets whose dynamics follow the lognormal pro-
cesses
df
f
=
f
dt +
f
dZ
f
dg
g
=
g
dt +
g
dZ
g
.
By the Ito Lemma
d(fg)
fg
= (
f
+
g
+
f

g
) dt + dZ
where
2
=
2
f
+
2
g
+2
f

g
;
d(f/g)
f/g
= (
f

g

g
+
2
g
) dt +

dZ
where

2
=
2
f
+
2
g
2
f

g
.
56
Proof
d(fg) = f dg +g df +
f

g
fg dt
. .
arising from dfdg and
observing dZ
f
dZ
g
= dt
d(fg)
fg
=
dg
g
+
df
f
+
f

g
dt
= (
f
+g +
f

g
) dt +
f
dZ
f
+
g
dZ
g
. (1)
Observe that the sum of two Brownian processes remains to be
Brownian. Recall the formula
VAR(X +Y ) = VAR(X) +VAR(Y ) +2COV(X, Y ).
Hence, the sum of
f
dZ
f
+
g
dZ
g
can be expressed as dZ, where

2
=
2
f
+
2
g
+2
f

g
.
57
d
_
1
g
_
=
dg
g
2
+
2
g
3
dg
2
2
; (2)
d
_
1
g
_
1
g
=
g
dt +
2
g
dt
g
dZ
g
. (3)
Replacing g by 1/g in formula (1), we obtain
d(f/g)
f/g
= (
f

g

g
+
2
g
) dt +
f
dZ
f

g
dZ
g
. (4)
Recall the formula: VAR(XY ) = VAR(X)+VAR(Y )2COV(X, Y ).
The sum of
f
dZ
f

g
dZ
y
can be expressed as

dZ, where

2
=
2
f
+
2
g
2
f

g
.
58
2.
S = foreign asset price in foreign currency
F = exchange rate
= domestic currency price of one unit of foreign currency
S

= FS = foreign asset price in domestic currency

q = dividend yield of the asset.
Under the domestic risk neutral measure Q
d
, the risk neutral
drift rate of S

and F are

d
S

= r
d
q and
d
F
= r
d
r
f
.
Under the foreign Q
f
, the risk neutral drift rate for S and 1/F
are

f
S
= r
f
q and
f
1/F
= r
f
r
d
.
59
Quanto prewashing is to nd
d
S
, that is, the risk neutral drift rate
of the price of the asset in foreign currency under Q
d
.
Recall the formula:

d
S

=
d
FS
=
d
F
+
d
S
+
F

S
where the dynamics of S and F under Q
d
are
dS
S
=
d
S
dt +
S
dZ
d
S
dF
F
=
d
F
dt +
F
dZ
d
F
,
where Z
d
S
and Z
d
F
are Q
d
-Brownian process.
60
We obtain

d
S
=
d
S

d
F

F

S
= (r
d
q) (r
d
r
f
)
F

S
= (r
f
q)
F

S
.
Comparing with
f
S
= r
f
q and
d
S
, there is an extra term
F

S
.
The risk neutral drift rate of the asset is changed by the amount

S
when the risk neutral measure is changed from the foreign
currency world to the domestic currency world.
61
Siegels paradox
Given that the price dynamics of F under Q
d
is
dF
F
= (r
d
r
f
) dt +
F
dZ
d
,
then the process for 1/F is
d(1/F)
1/F
= (r
f
r
d
+
2
F
) dt
F
dZ
d
.
This is seen as a puzzle to many people since the risk neutral drift
rate for 1/F should be r
f
r
d
instead of r
f
r
d
+
2
F
.
We observe directly from the above SDEs that

F
=
1/F
and
F,1/F
= 1.
62
An interesting application of Siegels paradox
Suppose the terminal payo of an exchange rate option is F
T
1
{F
T
>K}
.
Let V
d
(F, t) denote the value of the option in the domestic currency
world. Dene
V
f
(F
t
, t) = V
d
(F
t
, t)/F
t
,
so that the terminal payo of the exchange rate option in foreign
currency world is 1
{F
T
>K}
. Now
V
f
(F, t) = e
r
f
(Tt)
E
Q
f
t
[1
{F
T
>K}
|F
t
= F].
63
From
d
1/F
=
f
1/F
+
2
F
and observing
F
=
1/F
, we deduce that

f
F
=
d
F
+
2
F
.
This is easily seen if we interchange the foreign and domestic cur-
rency worlds. We obtain
V
d
(F, t) = FV
f
(F, t) = e
r
f
(Tt)
FN(d)
where
d =
ln
F
K
+
_

f
F

2
F
2
_

=
ln
F
K
+
_
r
d
r
f
+

2
F
2
_

.
64
Foreign exchange options
Under the domestic risk neutral measure Q
d
, the exchange rate
process follows
dF
F
= (r
d
r
f
) dt +
F
dZ
F
.
Suppose the terminal payo is max(F
T
X
d
, 0), then the price of
the exchange rate call option is
V (F, ) = Fe
r
f

N(d
1
) X
d
e
r
d

N(d
2
),
where
d
1
=
ln
F
X
d
+
_
r
d
r
f
+

2
F
2
_

, d
2
= d
1

.
65
Equity options with exchange rate risk exposure
Quanto options are contingent claims whose payo is determined
by a nancial price or index in one currency but the actual payout
is done in another currency.
1. Foreign equity call struck in foreign currency
c
1
(S
T
, F, 0) = F
T
max(S
T
X
f
, 0).
2. Foreign equity call struck in domestic currency
c
2
(S
T
, F, 0) = max(F
T
S
T
X
d
, 0).
3. Foreign exchange rate foreign equity call
c
3
(S
T
, F, 0) = F
0
max(S
T
X
f
, 0).
66
Under the domestic risk neutral measure Q
d
dS
S
=
d
S
dt +
S
dZ
S
dF
F
=
d
F
dt +
F
dZ
F
S

= FS = asset price in domestic currency

dS

=
d
S

dt +
S
dZ
S
.
where Z
S
, Z
F
, and Z
S
are all Q
d
-Brownian processes.
By Itos lemma,

d
S

=
d
S
+
d
F
+
SF

2
S

=
2
S
+
2
F
+2
SF

F
.
Under the risk neutral measures,

d
S

= r
d
q,
d
F
= r
d
r
f
,
f
S
= r
f
q,

d
S
=
d
S

d
F

SF

F
= r
f
q
SF

F
=
f
S

SF

F
.
67
1. Dene
c
1
(S, F, )/F =

c
1
(S, ) so that

c
1
(S, 0) = max(S X
f
, 0).
This call option behaves like the usual vanilla call option in the
foreign currency world so that

c
1
(S, 0) = Se
q
N(d
(1)
1
) X
f
e
r
f

N(d
(1)
2
)
where
d
(1)
1
=
ln
S
X
f
+
_

f
S
+

2
S
2
_

, d
(1)
2
= d
(1)
1

S

.
68
2. c
2
(S, F, 0) = max(S

T
X
d
, 0)
c
2
(S, F, ) = S

e
q
N(d
(2)
1
) X
d
e
r
d

N(d
(2)
2
)
where
d
(2)
1
=
ln
S

X
d
+
_

d
S

+

2
S

2
_

, d
(2)
2
= d
(2)
1

2
S

=
2
S
+
2
F
+2
SF

F
.
69
3. For c
3
(S, 0) = F
0
max(S
T
X
f
, 0), the payo is denominated in
the domestic currency world, so the risk neutral drift rate is of
the stock price
d
S
. The call price is
c
3
(S, ) = F
0
e
r
d

[Se

d
S

N(d
(3)
1
) X
f
N(d
(3)
2
)]
where
d
(3)
1
=
ln
S
X
f
+
_

d
S
+

2
S
2
_

, d
(3)
2
= d
(3)
1

S

.
The price formula does not depend on the exchange rate F since
the exchange rate has been chosen to be the xed value F
0
.
The currency exposure is reected through the dependence on

F
and correlation coecient
SF
.
70
Digital quanto option relating 3 currency worlds
F
S\U
= SGD currency price of one unit of USD currency
F
H\S
= HKD currency price of one unit of SGD currency
Digital quanto option payo: pay one HKD if F
S\U
is above
some strike level K.
We may interest F
S\U
as the price process of a tradeable asset
in SGD. The dynamics is governed by
dF
S\U
F
S\U
= (r
SGD
r
USD
) dt +
F
S\U
dZ
S
F
S\U
.
71
Given
S
F
S\U
= r
SGD
r
USD
, how to nd
H
F
S\U
, which is the risk
neutral drift rate of the SGD asset denominated in Hong Kong
dollar?
By the quanto-prewashing technique

H
F
S\U
=
S
F
S\U

F
S\U

F
H\S
.
Digital option value = E
Q
H
t
_
1
{F
S\U
>K}
_
= N(d)
where
d =
ln
F
S\U
K
+
_
_

H
F
S\U

2
F
S\U
2
_
_

F
S\U

.
72
Exchange options
Exchange asset 2 for asset 1 so that the terminal payo is
V (S
1
, S
2
, 0) = max(S
1
S
2
, 0).
Assume
dS
1
S
1
=
S
1
dt +
1
dZ
1
,
S
1
= r q
1
,
dS
2
S
2
=
S
2
dt +
2
dZ
2
,
S
2
= r q
2
.
Dene S =
S
1
S
2
,

2
S
=
2
1
2
12

2
+
2
2
. Write
V (S
1
, S
2
, 0)
S
2
= max
_
S
1
S
2
1, 0
_
.
V (S
1
, S
2
, ) = e
r
_
S
1
e

S
1

N(d
1
) S
2
e

S
2

N(d
2
)
_
, where
d
1
=
ln
S
1
S
2
+
_
_

S
1

S
2
_
+

2
S
2
_

, d
2
= d
1

.
73
Hints on the proof of the price formula
Under the risk neutral measure
dS
S
= (
S
1

S
2

12

2
+
2
2
) dt +
1
dZ
1

2
dZ
2
.
It is convenient to use S
2
(t)e
q
2
t
as numeraire, where
S
2
(t) = S
2
(0)e
_

S
2

2
2
2
_
t+
2
Z
2
(t)
or
S
2
(t)e
q
2
t
S
2
(0)
e
rt
= e

2
2
2
t+
2
Z
2
(t)
.
We can take =
2
in Girsanov Theorem so that
S
2
(t)e
q
2
t
S
2
(0)
e
rt
= e

1
2

2
2
t+
2
Z
2
(t)
=
dQ

dQ
.
74
We then have d

Z
2
= dZ
2

2
dt where d

Z
2
is under Q

. In a similar
manner, we obtain
d

Z
1
= dZ
1

12

2
dt.
Putting everything together,
dS
S
= (
S
1

S
2
) dt +(
1
d

Z
1

2
d

Z
2
)
and

1
d

Z
1

2
d

Z
2
=

d

Z
where

2
=
2
1
+
2
2
2
12

2
.
75
Use of the exchange option formula to price quanto options
Consider
C
2
(S, F, 0) = F max(S X, 0) = max(S

XF, 0)
C
4
(S, F, 0) = S max(F X, 0) = max(S

XS, 0)
where S

= FS. Both can be considered as exchange options.

Though an exchange option appears to be a two-state option, it
can be reduced to an one-state pricing model when the similarity
variable S =
S
1
S
2
is dened. Similarly, the two-state quanto options
can be reduced to one-state pricing models.
76
For valuation of C
4
(S, F, ), we consider the similarity variable
S

S
=
F. Note that

d
S

=
d
S
+
d
F
+
SF

F
,

=
F
,
and the corresponding dierence in the risk neutral drift rates in Q
d
is

d
S

d
S
=
d
F
+
SF

F
= r
d
r
f
+
SF

F
.
77