Probability and advanced statistics (by Sergio Ortobelli)

Black and Scholes and MonteCarlo generation

Suppose that the risk free asset evolve as the exponential law i.e.
t
r ( s ) ds

0
B (t ) B(0)e
Where B(t) is the price of a riskless asset at time t and r(t) is the infinitesimal
intensity of rate (force of interest).
That is equivalent to say that the risk free asset follows the differential
equation
dB (t ) r (t ) B (t )dt
(**)
Black and Scholes Theorem: If the log price follows a standard Brownian
motion with stochastic differential equation
d ln S (t ) ( S (t ), t )dt ( S (t ), t ) dW (t ) .
Assume that and are constant and the riskfree follows the exponential
financial law (**) with constant r(t)=r. Then, when no arbitrage
opportunities are allowed, the prices of an European call and an European

Probability and advanced statistics (by Sergio Ortobelli)

put at time t with exercise price K and maturity T are given respectively by
the formulas::
c( S (t ), t ) S (t ) N (d1 ) e r (T t ) KN (d 2 )
p ( S (t ), t ) e r (T t ) KN (d 2 ) S (t ) N ( d1 )
1
S (t )
1 2

where d1
ln K r 2 (T t ) ; d 2 d1 T t and
T t

N(.) is cumulative distribution of a Standard Normal N(0,1).

Example:
Determine the price of European call and put on the same underlying. Such
that S=25 euro, K=20 euro, r=4.5% yearly, 25% yearly, T=50 days.
25

1
1 2
d1
ln

0.045

0.25
50
/
250
...

20

2
0.25 50 / 250

d 2 d1 0.25 50 / 250 , N (d 2 ) ...N (d1 ) ...N ( d 2 ) ...N ( d1 ) ...

Probability and advanced statistics (by Sergio Ortobelli)

Thus
c( S (0),0) 25 N (d1 ) 20e 0.045*50 / 250 N (d 2 )
p ( S (t ), t ) e 0.045*50 / 250 20 N (d 2 ) 25 N ( d1 )
MonteCarlo simulation
To value the price today we can also use the fundamenthal theorem of
arbitrage. Under the hypothesis of B&S theorem the risk neutral measure is
unique (market is complete) and it is given by substituting the drift with
the riskless return r.
Thus, under the B&S hypothesis, we can evaluate any European contingent
claim at time t using the fundamental theorem of arbitrage and
f ( S (t ), t ) e r (T t ) E% f ( S (T ), T )
where the risk neutral measure implies practically that

Probability and advanced statistics (by Sergio Ortobelli)

ln S (T ) N ln S (t ) r 2 (T t ), T t
2

This fact suggests a practical way to value contingent claims that consists in
using some simulated log prices.
Montecarlo simulation for European options
Consider for example an European put evaluated at the maturity T that is
given by
p ( S (T ), T ) max( K S (T ),0)
Then the algorithm to determine the option price with Montecarlo
simulations use the law of large numbers and compute the mean under the
risk neutral measure:
1) Generate M random i.i.d. (independent identically distributed)
observations by using the Gaussian distribution Z i N (0, T t )

Probability and advanced statistics (by Sergio Ortobelli)

2) Compute the stochastic returns Yi (r 0.5 2 )(T t ) Z i

3) Compute the possible future prices Si (T ) S (t )eYi
4) Compute
the
final
payoff
pi ( Si (T ), T ) max( K Si (T ),0)

for

example

5) Compute the option price

p ( S (t ), t ) e

r ( T t )

1
M

p (S (T ),T )
i 1

of

put