MATH3075/3975 Financial Mathematics

Tutorial 11: Solutions

Exercise 1 We consider the Black-Scholes model M = (B, S) with the initial stock price S0 = 9,
the continuously compounded interest rate r = 0.01 per annum and the stock price volatility σ = 0.1
per annum. Recall that dBt = rBt dt with B0 = 1 (equivalently, B(t, T ) = e−r(T −t) and


dSt = St r dt + σ dWt , S0 > 0,

where W is a standard Brownian motion under the martingale measure P.

e

(a) Using the Black-Scholes call option pricing formula

C0 = S0 N d+ (S0 , T ) − Ke−rT N d− (S0 , T )

we compute the price C0 of the European call option with strike price K = 10 and maturity
T = 5 years. We find that

d+ (S0 , T ) = −0.13578, d− (S0 , T ) = −0.35938

and thus C0 = 0.59285.

(b) Using the Black-Scholes put option pricing formula

P0 = Ke−rT N − d− (S0 , T ) − S0 N − d+ (S0 , T )

we find that the price P0 = 1.10514

(c) The put-call parity relationship holds since

C0 − P0 = 0.59285 − 1.10514 = −0.51229 = 9 − 10e−0.05 = S0 − Ke−rT .

(d) We now recompute the prices of call and put options for modified maturities T = 5 months
and T = 5 days.

– We note that 5 months is equivalent to T = 0.416667 and thus

d+ (S0 , T ) = −1.53541, d− (S0 , T ) = −1.59996.

Hence C0 = 0.015315 and P0 = 0.973735.

– We note that 5 days is equivalent to T = 0.013699 and thus

d+ (S0 , T ) = −8.98455, d− (S0 , T ) = −8.99615.

Hence C0 = 1.49E − 21 and P0 = 0.99863.

(e) The call option (respectively, put option) price decreases to zero (respectively, increases to
K − S0 = 1) when the time to maturity tends to zero. This is related to the fact that S0 < K
and thus for short maturities it is unlikely (respectively, very likely) that the call option
(respectively, put option) will be exercised at expiration.

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Exercise 2 Assume that the stock price S is governed under the martingale measure P
e by the
Black-Scholes stochastic differential equation


dSt = St r dt + σ dWt

where σ > 0 is a constant volatility and r is a constant short-term interest rate. Let 0 < L < K
be real numbers. We consider a path-independent contingent claim with the payoff X at maturity
date T > 0 given as

X = min |ST − K|, L .

(a) It is easy to sketch the profile of the payoff X as the function of the stock price ST . The
decomposition of X in terms of the payoffs of standard call and put options reads

X = L − CT (K − L) + 2CT (K) − CT (K + L).

Note that other decompositions are possible.

(b) The arbitrage price πt (X) satisfies, for every t ∈ [0, T ],

πt (X) = Le−r(T −t) − Ct (K − L) + 2Ct (K) − Ct (K + L).

(c) We will now find the limits of the arbitrage price lim L→0 π0 (X) and lim L→∞ π0 (X). We
observe the payoff X increases when L increases. Hence the price π0 (X) is also an increasing
function of L. Moreover,

lim π0 (X) = −C0 (K) + 2C0 (K) − C0 (K) = 0.

L→0

By analysing the payoff X when L tends to infinity (obviously, we no longer assume here that
the inequality L < K holds since K is fixed and L tends to infinity), we obtain

lim min |ST − K|, L = |ST − K| = (K − ST )+ + (ST − K)+ = PT (K) + CT (K)

L→∞

and thus
lim π0 (X) = P0 (K) + C0 (K).
L→∞

(d) To find the limit lim σ→∞ π0 (X), we observe that

lim d+ (S0 , T ) = ∞, lim d− (S0 , T ) = −∞,

σ→∞ σ→∞

so that


lim N d+ (S0 , T ) = 1, lim N d− (S0 , T ) = 0.
σ→∞ σ→∞

Hence the price of the call option satisfies, for all strikes K ∈ R+ ,

lim C0 (K) = S0 .
σ→∞

This in turn implies that lim σ→∞ π0 (X) = Le−rT = π0 (L).

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Exercise 3 We denote by v the Black-Scholes call option pricing, that is, the function v : R+ ×
[0, T ] → R such that Ct = v(St , t) for all t ∈ [0, T ].

(a) We need to show that, for every s ∈ R+ ,

lim v(s, t) = (s − K)+

t→T

For this purpose, we observe that d+ (s, K) and d− (s, K) tend to ∞ (respectively, −∞) when
t → T and s > K (respectively, s < K). Consequently, N (d+ (s, K)) and N (d− (s, K)) tend
to 1 (respectively, 0) when t → T and s > K (respectively, s < K). This in turn implies that
v(s, T ) tends to either s − K or 0 depending on whether s > K or s < K. The case when
s = K is also easy to analyse and to check that limt→T v(s, t) = 0 when s = K.
(b) (MATH3975) Observe that v(s, t) = c(s, T − t) where the function c is such that Ct =
c(St , T − t). Our goal is to check that the pricing function of the European call option satisfies
the Black-Scholes partial differential equation (PDE)
∂v 1 2 2 ∂ 2 v ∂v
+ σ s + rs − rv = 0, ∀ (s, t) ∈ (0, ∞) × (0, T ), (1)
∂t 2 ∂s2 ∂s
with the terminal condition v(s, T ) = (s − K)+ . Equivalently, the function c satisfies
∂c 1 2 2 ∂ 2 c ∂c
− + σ s 2
+ rs − rc = 0, ∀ (s, t) ∈ (0, ∞) × (0, T ),
∂t 2 ∂s ∂s
with the initial condition c(s, 0) = (s − K)+ . From the Black-Scholes theorem, we know that
v is given by the following expression

v(s, t) = sN (d+ (s, T − t)) − Ke−r(T −t) N (d− (s, T − t)). (2)

Straightforward computations show that the partial derivatives are:

vs (s, t) = N (d+ (s, T − t)),

n(d+ (s, T − t))
vss (s, t) = √ ,
σs T − t
σs
vt (s, t) = − √ n(d+ (s, T − t)) − Kre−r(T −t) N (d− (s, T − t))
2 T −t
where n(x) is the density function of the standard normal distribution. Hence
sσ
− √ n(d+ (s, T − t)) − Kre−r(T −t) N (d− (s, T − t))
2 T −t
1 n(d+ (s, T − t))
+ σ 2 s2 √ + rsN (d+ (s, T − t)) − rv(s, t) = 0
2 sσ T − t
where we have also used the equality (2).
It is worth noting that the pricing function w(s, t) = p(s, T − t) for the put option also
satisfies the Black-Scholes PDE but with the terminal condition w(s, T ) = (K − s)+ . This
can be checked either by computing directly the partial derivatives or by combining already
established PDE (1) with the put-call parity relationship, which reads

v(s, t) − w(s, t) = s − Ke−r(T −t) .

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Exercise 4 (MATH3975) We consider the stock price process S given by the Black and Scholes
model.
(a) We will first show that Sbt = e−rt St is a martingale with respect to the filtration F = (Ft )t≥0
generated by the stock price process S. We observe that this filtration is also generated by
W . Using the properties of the conditional expectation, we obtain, for all s ≤ t,
 1 2

EPe Sbt Fs = EPe Sbs eσ(Wt −Ws − 2 σ (t−s)) Fs

1 2
 
= Sbs e− 2 σ (t−s) EPe eσ(Wt −Ws ) | Fs
1 2
 
= Sbs e− 2 σ (t−s) EPe eσ(Wt −Ws ) | Fs
1 2
 
= Sbs e− 2 σ (t−s) EPe eσ(Wt −Ws )

where in the last equality we√ used the independence of increments of the Wiener process.
Recall also that Wt − Ws = t − s Z where Z ∼ N (0, 1), and thus
1 2 √
EPe Sbt | Fs = Sbs e− 2 σ (t−s) EPe eσ t−sZ .

It is known (and easy to check by integration) that if Z ∼ N (0, 1) then for any real number a
1 2
EPe eaZ = e 2 a .


(3)
√
By setting a = σ t − s, we obtain
1 2 1 2
EPe Sbt | Sbu , u ≤ s = Sbs e− 2 σ (t−s) e 2 σ (t−s) = Sbs ,

which shows that Sb is a martingale under P.

e

(b) To compute the expectation EPe (St ), we observe that

EPe (St ) = ert EPe (Sbt ) = ert EPe (Sb0 ) = ert Sb0 = ert S0 .
To compute the variance Var Pe (St ), we recall that
2
Var Pe (St ) = EPe (St2 ) − EPe (St )


where in turn
h 2
i
EPe (St2 ) = S02 e2rt EPe e2σWt −σ t
2
h 1
√ 2i
= S02 e2rt eσ t EPe e2σWt − 2 (2σ t)
2
h 1 2
i
= S02 e2rt eσ t EPe eaZ− 2 a
√
where we denote a = 2σ t and Z ∼ N (0, 1). Since (see (3))
h 1 2
i
EPe eaZ− 2 a = 1

we conclude that
2t
EPe (St2 ) = S02 e2rt eσ
and thus
2
Var Pe (St ) = S02 e2rt eσ t − 1 .