Three Derivations of the Black Scholes PDE

by Fabrice Douglas Rouah

www.FRouah.com
www.Volopta.com
In this Note we derive the Black Scholes PDE for an option \ , given by
0\
0t
+
1
2
o
2
o
2
0
2
\
0o
2
+ro
0\
0o
r\ = 0. (1)
We derive the Black-Scholes PDE in 3 ways.
1. By a hedging argument. This is the original derivation of Black and
Scholes [1].
2. By a replicating portfolio. This is a generalization of the rst approach.
3. By the Capital Asset Pricing Model. This is an alternate derivation
proposed by Black and Scholes.
To derive the PDE we assume that there exists three instruments
1. A riskless bond 1 that evolves in accordance with the process d1 = r1dt
where r is the risk-free rate.
2. An underlying security which evolves in accordance with the Ito process
do = jodt +ood\.
3. A option \ written on the underlying security which, by Itos Lemma,
evolves in accordance with the process
d\ =

0\
0t
+jo
0\
0o
+
1
2
o
2
o
2
0
2
\
0o
2

dt +

oo
0\
do

d\. (2)
We have written o = o(t). 1 = 1(t). \ = \ (t) and d\ = d\(t) for
notional convenience. We also assume the portfolios are self-nancing, which
implies that changes in portfolio value are due to changes in the value of the
three instruments, and nothing else. Under this setup, any of the instruments
can be replicated by forming a replicating portfolio of the other two instruments,
using the correct weights.
1 Derivation of PDE by Hedging Argument
We set up a self-nancing portfolio that is comprised of one option and an
amount of the underlying stock, such that the portfolio is riskless, i.e., that
is insensitive to changes in the price of the security. Hence the value of the
1
portfolio at time t is (t) = \ (t) + o(t). The self-nancing assumption (see
Section 2.1) imples that d = d\ + do so we can write
d = d\ + do (3)
=

0\
0t
+jo
0\
0o
+
1
2
o
2
o
2
0
2
\
0o
2
+ jo

dt +

oo
0\
0o
+ oo

d\.
The portfolio must have two features. The rst feature is that it must be
riskless, which implies that the second term involving the Brownian motion
d\ is zero so that =
@V
dS
. Substituting in Equation (3) implies that the
portfolio follows the process
d =

0\
0t
+
1
2
o
2
o
2
0
2
\
0o
2

dt.
The second feature is that the portfolio must earn the risk free rate. This
implies that the diusion of the riskless portfolio is d = rdt. Hence we can
write
d = rdt

0\
0t
+
1
2
o
2
o
2
0
2
\
0o
2

dt = r

\
0\
0o
o

dt
Dropping the dt term from both sides and re-arranging yields the PDE in Equa-
tion (1). The proportion of shares to be held, , is delta, also called the hedge
ratio. The derivation stipulates that in order to hedge the single option, we
need to hold shares of the stock. This is the principle behind delta hedging.
1.1 Original Derivation by Black and Scholes
In their paper, Black and Scholes [1] set up a portfolio that is slightly dierent:
it is comprised of one share and 1 shares of the option. Hence, they dene
their portfolio to be (t) = 0\ (t) +o(t). Similarly to Equation (3) they obtain
d = 0d\ +do (4)
=

0
0\
0t
+0jo
0\
0o
+
1
2
0o
2
o
2
0
2
\
0o
2
+jo

dt +

0oo
0\
0o
+oo

d\
In order for the portfolio to be riskless, they set 0 =

@V
@S

1
. Substitute
into Equation (4), equate with d = rdt = r [0\ +o] dt and drop the term
involving jo to obtain

0
0\
0t
+
1
2
0o
2
o
2
0
2
\
0o
2

dt = r [0\ +o] dt.

Now drop dt from both sides and divide by 0 to produce
0\
0t
+
1
2
o
2
o
2
0
2
\
0o
2
= r\ ro
0\
0o
.
Re-arranging terms produces the Black-Scholes PDE in Equation (1).
2
2 Derivation of PDE Using Pricing by Arbitrage
Pricing by arbitrage means in a complete market, all derivatives can be expressed
in terms of a self-nancing replicating strategy, and that this replicating strategy
is unique. With this replicating strategy we can set up a replicating portfolio
and use a risk neutral measure to calculate the value of the derivative.
2.1 Self Financing Trading Strategy
Given assets with values 7
1
(t). . 7
N
(t) at time t, a trading strategy is a -
dimensional stochastic process a
1
(t). . a
N
(t) that represents the allocations
into the assets at time t. The time-t value of the of the portfolio is (t) =

N
i=1
a
i
(t)7
i
(t). The trading strategy is self-nancing if the change in the
value of the portfolio is due only to changes in the value of the assets and not
to inows or outows of funds. This implies the strategy is self-nancing if
d(t) = d

i=1
a
i
(t)7
i
(t)

.
in other words, if
(t) = (0) +
N

i=1

t
0
a
i
(n)d7
i
(n).
In the case of two assets the portfolio value is (t) = a(t)7
1
(t) +/(t)7
2
(t) and
the strategy (a. /) is self-nancing if d(t) = a(t)d7
1
(t) +/(t)d7
2
(t).
2.2 Arbitrage Opportunity
An arbitrage opportunity is a self-nancing trading strategy that produces the
following properties on the portfolio value:
(t) 0
Pr [(T) 0] = 1.
This implies that the initial value of the portfolio (at time zero) is zero or
negative, and the value of the portfolio at time T will be greater than zero with
absolute certainty. This means that we start with a portfolio with zero value,
or with debt (negative value). At some future time we have positive wealth,
and since the strategy is self-nancing, no funds are required to produce this
wealth. This is a "free lunch."
2.3 Derivatives and Replication
The payo \ (T) at time T of a derivative is a function of a risky asset. To
rule out arbitrage we identify a self-nancing trading strategy that produces
the same payo as the derivative, so that (T) = \ (T). The trading strategy
3
is then a replicating strategy and the portfolio is a replicating portfolio. If a
replicating strategy exists the derivative is attainable, and if all derivatives are
attainable the economy is complete.
In the absence of arbitrage the trading strategy produces a unique value
for the value \ (T) of the derivative, otherwise an arbitrage opportunity would
exist. Not only that, at every time t the value of the derivative, \ (t) must
be equal to the value of the replicating strategy, (t), so that (t) = \ (t).
Otherwise an arbitrage opportunity exists. Indeed, if \ (t) < (t) you could
buy the derivative, sell the replicating strategy, and lock in an instant prot.
At time T both assets would have equal value ((T) = \ (T)) and the value
of the bought derivative would cover the sold strategy. If \ (t) (t) you
could sell the derivative, buy the replicating strategy, and end up with the same
outcome at time T. The technique of determining the value of a derivative by
using a replicating portfolio is called pricing by arbitrage.
2.4 Derivation of the PDE by Replication
To replicate the derivative \ we form a self-nancing portfolio with the stock o
and the bond 1 in the right proportion. Hence we need to use the replicating
strategy (a(t). /(t)) to form the replicating portfolio \ (t) = a(t)o(t) +/(t)1(t)
and determine the value of (a(t). /(t)). The self-nancing assumption means
that
d\ = ado +/d1
where a = a(t) and / = /(t). Substituting for d\ from Equation (2) and for
d1 and do produces

0\
dt
+jo
0\
do
+
1
2
o
2
o
2
0
2
\
0o
2

dt +

oo
0\
do

d\ (5)
= (ajo +/r1)dt +aood\
Equating coecients for d\ implies that a =
@V
@S
. Substituting in Equation
(5) produces
0\
dt
+
1
2
o
2
o
2
0
2
\
0o
2
= /r1
= /r

\ ao
/

= r\ ro
0\
0o
.
Re-arranging terms produces the Black Scholes PDE in Equation (1).
4
2.4.1 Interpreting the Replicating Portfolio
The time-t Black-Scholes price of a call with time to maturity t = T t and
strike 1 when the spot price is o is
\ (o
t
. 1. T) = o(d
1
) 1c
r
(d
2
) (6)
= ao +/1
where
d
1
=
log
S
K
+ (r +

2
2
)t
o
p
t
and d
2
= d
1
o
p
t. It is easy to show, by dierentiating the right-hand side
of Equation (6), that a =
@V
@S
= (d
1
). Since (d
1
) 0 this implies that the
replicating portfolio is long the stock, and since (d
1
) < 1 the dollar amount of
the long position is less than o, the spot price. Furthermore, since
/1 = 1c
r
(d
2
).
the replicating portfolio is short the bond. Finally, since c
r
(d
2
) < 1, the
dollar amount of the short position is less than 1, the strike price.
2.5 Replicating the Security
In the original Black-Scholes derivation of Section (1) we are in fact replicating
the bond 1 with the option \ and the security o. In the arbitrage derivation
of Section (2.4) we are replicating the option with the security and the bond.
We can also replicate the security with the bond and the option, and obtain the
Black-Scholes PDE. We form the portfolio o = 1 + c\ where c needs to be
determined. Applying the self-nancing assumption implies that
do = d1 +cd\
so we can write
jodt +ood\ = r1dt +c

0\
dt
+jo
0\
do
+
1
2
o
2
o
2
0
2
\
0o
2

dt (7)
+c

oo
0\
do

d\.
This implies that c =

@V
dS

1
. We can write Equation (7) as
jodt = r1dt +

0\
do

0\
dt
+jo
0\
do
+
1
2
o
2
o
2
0
2
\
0o
2

dt
Drop the dt terms from both sides, substitute 1 = o \

@V
dS

1
to obtain
jo = r

o
\
@V
dS

0\
do

0\
dt
+jo
0\
do
+
1
2
o
2
o
2
0
2
\
0o
2

5
so that
jo
0\
do
= ro
0\
do
r\ +

0\
dt
+jo
0\
do
+
1
2
o
2
o
2
0
2
\
0o
2

.
Cancelling terms and rearranging yields the PDE in Equation (1).
3 Derivation Using the CAPM
This derivation is included in the original derivation of the PDE by Black and
Scholes [1].
3.1 The CAPM
The Capital Asset Pricing Model (CAPM) stipulates that the expected return
of a security i in excess of the risk-free rate is
1 [r
i
] r =
i
(1 [r
M
] r)
where r
i
is the return on the asset, r is the risk-free rate, r
M
is the return on
the market, and

i
=
Co [r
i
. r
M
]
\ ar [r
M
]
is the securitys beta.
3.2 The CAPM for the Assets
In the time increment dt the expected stock price return, 1 [r
S
dt] is 1

dSt
St

,
where o
t
follows the diusion do
t
= ro
t
dt + oo
t
d\
t
. The expected return is
therefore
1

do
t
o
t

= rdt +
S
(1 [r
M
] r) dt. (8)
Similarly, the expected return on the derivative, 1 [r
V
dt] is 1

dVt
Vt

, where \
t
follows the diusion in (2), is
1

d\
t
\
t

= rdt +
V
(1 [r
M
] r) dt. (9)
3.3 The Black-Scholes PDE from the CAPM
The derivative follows the diusion
d\
t
=
0\
0t
dt +
0\
0t
do +
1
2
0
2
\
0o
2
(do)
2
6
Divide by \
t
on both sides to obtain
d\
t
\
t
=
1
\
t

0\
0t
+
1
2
o
2
o
2
t
0
2
\
0o
2

dt +
0\
0o
do
t
o
t
o
t
\
t
.
which is
r
V
dt =
1
\
t

0\
0t
+
1
2
o
2
o
2
t
0
2
\
0o
2

dt +
0\
0o
o
t
\
t
r
S
dt. (10)
Drop dt from both sides and take the covariance of r
V
and r
M
, noting that only
the second term on the right-hand side of Equation (10) is stochastic
Co [r
V
. r
M
] =
0\
0o
o
t
\
t
Co [r
S
. r
M
] .
This implies the following relationship between the beta of the derivative,
V
,
and the beta of the stock,
S

V
=

0\
0o
o
t
\
t

S
.
This is Equation (15) of Black and Scholes [1]. Multiply Equation (9) by \
t
to
obtain
1 [d\
t
] = r\
t
dt +\
t

V
(1 [r
M
] r) dt (11)
= r\
t
dt +
0\
0o
o
t

S
(1 [r
M
] r) dt.
This is Equation (18) of Black and Scholes [1]. Take expectations of the second
line of Equation (2), and substitute for 1 [do
t
] from Equation (8)
1 [d\
t
] =
0\
0t
dt +
0\
0o
[ro
t
dt +o
t

S
(1 [r
M
r]) dt] +
1
2
0
2
\
0o
2
o
2
o
2
dt. (12)
Equate Equations (11) and (12), and drop dt from both sides. The term
involving
S
cancels and we are left with the PDE in Equation (1)
0\
0t
+ro
t
0\
0o
+
1
2
o
2
o
2
t
0
2
\
0o
2
r\
t
= 0.
References
[1] Black, F., and M. Scholes (1973). "The Pricing of Options and Corporate
Liabilities." Journal of Political Economy, Vol 81, No. 3, pp. 637-654.
7