1

MS&E 408 Term Paper

May 29, 2008

On the Black-Scholes Equation: Various Derivations

Manabu Kishimoto



Abstract
One of the significant equations in financial mathematics is the Black-Scholes equation, a partial
differential equation that governs the value of financial derivatives, such as options. In this paper,
various derivations of the Black-Scholes equation are illustrated. Throughout these derivations,
core concepts in financial mathematics, such as Itos lemma, the replicating portfolio, the CAPM,
arbitrage pricing, risk-neutral pricing, and put-call parity, are presented. One of the great surprises
is the fact that the expected return of the underlying asset does not appear in the Black-Scholes
equation, which is discussed in this paper. Finally, we introduce the theoretical valuation formula
for a European call option case. This survey paper also provides examples of how the important
tools of financial mathematics are actually used.


Contents
1. Introduction
2. Preliminary: Itos Lemma
3. The Standard Derivation of the Black-Scholes Equation: Constructing a Replicating Portfolio
4. An Alternative Derivation 1: using the CAPM
5. An Alternative Derivation 2: using the Return Form of Arbitrage Pricing
6. An Alternative Derivation 3: using Risk-Neutral Pricing
7. Interpretation of the Black-Scholes Equation: Why Does the Expected Return Disappear?
8. The Black-Scholes Formula for a Call Option
9. Summary and Conclusion
References

2
1. Introduction

A derivative is a financial instrument whose value depends on (or is derived from) the values of
other, more basic, underlying assets. Financial derivatives, such as options, futures, and swaps of
financial assets play an important role in todays complex financial world. These financial
derivatives enable us to control risk; with the help of derivatives, we can speculate (take more
risk), or hedge (take less risk). Considering the importance of financial derivatives, a crucial
problem in finance is how to evaluate and price each financial derivative. Black and Scholes
(1973) discovered the partial differential equation which financial derivatives (the underlying
assets of which are stocks) have to satisfy; furthermore, they found the evaluation formula when
the financial derivative is a European call option. The partial differential equation is known as the
Black-Scholes equation, which is the focus of this paper. Scholes obtained a Nobel Prize for
economics in 1997 for this contribution (Black had died in 1995 and could not receive the prize
personally.).
In this paper, we explore various derivations of the Black-Scholes equation. In the
process, several core concepts in financial mathematics such as Itos lemma, the CAPM, arbitrage
pricing, risk-neutral pricing, and put-call parity, are introduced. One of the great surprises is the
fact that the expected return of the underlying asset does not appear in the Black-Scholes
equation. We also discuss this remarkable fact in this paper and provide an intuitive explanation.
Finally, we introduce the theoretical valuation formula for a European call option case.
As a result, we also obtain the theoretical valuation formulae for an American call option and a
European put option. Although the equation itself is known as the heat-transfer equation in
physics and the solution was already found in 1960s, it is worth deriving the solution in a much
more sophisticated way.


2. Preliminary: Itos Lemma

In stochastic calculus, Itos lemma (also known as Itos formula), an extension of the chain rule
of ordinary calculus, plays a very important role. In one stochastic differential equation class at
Stanford, the professor once said in his first lecture, In this class, everything comes from Itos
formula! The importance of Itos lemma in finance cannot be exaggerated. Although there are
several versions of Itos lemma, in this paper we only present Itos lemma for Brownian motion.
For other versions, especially Itos lemma for Poisson processes, see Primbs (2008).


3
Itos lemma for Brownian motion
Let x(t) be a function of t, which satisfies the stochastic differential equation
dz t x b dt t x a dx ) , ( ) , ( + = ,
where a(x,t) and b(x,t) are deterministic functions of x and t, and z represents a standard
Brownian motion.
Let f(x,t) be a twice continuously differentiable function of x and t. Then,
dz f t x b dt f t x b f t x a f t x df
x xx x t
) , ( ) ) , (
2
1
) , ( ( ) , (
2
+ + + = .
Here,
t
f means
t
f

,
x
f means
x
f

, and
xx
f means
2
2
x
f

.
(2.1) is referred to as Itos lemma (Itos formula).

The intuitive derivation of Itos lemma is as follows: first, use the Taylor expansion to expand df
in the second order and replace dx with dz t x b dt t x a ) , ( ) , ( + ,
dtdx f dx f dt f dx f dt f t x df
tx xx tt x t
+ + + + =
2 2
) (
2
1
) (
2
1
) , (
2 2
) ) , ( ) , ( (
2
1
) (
2
1
) ) , ( ) , ( ( dz t x b dt t x a f dt f dz t x b dt t x a f dt f
xx tt x t
+ + + + + =
) ) , ( ) , ( ( dz t x b dt t x a dt f
tx
+ + .
Throughout the calculation, ignore the
2
) (dt and dtdz terms, and replace
2
) (dz with dt (this is
the most crucial step), then, (2.2) will be
dt f t x b dz f t x b dt f t x a dt f
xx x x t
) , (
2
1
) , ( ) , (
2
+ + + =
dz f t x b dt f t x b f t x a f
x xx x t
) , ( ) ) , (
2
1
) , ( (
2
+ + + = .
The essential part of this intuitive derivation is to regard
2
) (dz as being dt. For a complete and
rigorous proof of Itos lemma, see ksendal (2003).


3. The Standard Derivation of the Black-Scholes Equation:
Constructing a Replicating Portfolio

The first step in deriving the Black-Scholes equation is to construct a replicating portfolio, which
consists of a risk-free bond and stock to mimic the payoffs of the given derivative. Before
moving on, we will describe the assumptions we use to derive the Black-Scholes equation.

(2.1)
(2.2)
4
Assumptions
The stock price follows a geometric Brownian motion process with u and constant.
The short selling of securities with the full use of proceeds is permitted.
There are no transactions costs or taxes. All securities are perfectly divisible.
There are no dividends during the life of the derivative.
There are no risk-free arbitrage opportunities.
Security trading is continuous.
The risk-free rate of interest, r, is constant and the same for all maturities.
1


The problem is stated as follows: let t be time and S
t
be the price of stock. Consider a derivative
security whose price depends on S and t. The price is a function of S and t, so we call it c(S, t) or
just c. Then, our task is to find the equation which c satisfies. We assume that there is a
risk-free bond B which earns a risk-free rate r. That is, the following holds:
Bond: rBdt dB = .
In addition, we assume that the stock price S
t
follows the geometric Brownian motion:
Stock: Sdz Sdt dS u + = .
Regarding the derivative c(S, t), by Itos lemma, the following holds:
Derivative: dz Sc dt c S Sc c dc
S SS S t
u + + + = )
2
1
(
2 2
.

Replicating the derivative with a stock and a bond
2

First, we form a portfolio using B and S so that the portfolio behaves exactly the same with c.
Lets consider that the portfolio G consists of x shares of the stock and y units of the bond,
yB xS G + = .
We want the portfolio to be self-financing, which means that no money is added or withdrawn.
Under this condition, the instantaneous gain in the value of the portfolio due to changes in
security prices, by (3.1) and (3.2), is
ydB xdS dG + =
) ( ) ( rBdt y Sdz Sdt x + + = u
Sdz x dt yrB S x u + + = ) ( .

In order to mimic c, c G = and dc dG = , that is, (3.5) must coincide with (3.3). Since dt and dz
are independent, the respective coefficients should be equal; otherwise, there will be an
opportunity for arbitrage. Therefore, we hope that the following equations will hold:

1
These assumptions are taken from Hull (2005) p.290.
2
This derivation is based on Luenberger (1997) p.354.
(3.1)
(3.2)
(3.3)
(3.4)
(3.5)
5
c yB xS = + ,
SS S t
c S Sc c yrB S x
2 2
2
1
u u + + = + ,
S
Sc S x = .
From (3.8),
S
c x = . Plugging this result into (3.6), we obtain
) (
1
S
Sc c
B
y = .
Plugging these results into (3.7), we finally obtain
rc c S rSc c
SS S t
= + +
2 2
2
1
.
This partial differential equation (3.9) is called the Black-Scholes equation.
In this derivation, we replicated the derivative with a stock and a bond. However, it is
also possible to derive the Black-Scholes equation by replicating the bond with a stock and a
derivative, or by replicating the stock with a bond and a derivative.

Replicating the bond with a stock and a derivative
3

Lets consider a portfolio that consists of shares of the stock and units of the derivative.
c S P + = .
Then, by the self-financing condition,
dc dS dP + = .
Plugging (3.2) and (3.3) into (3.11), we obtain
) )
2
1
(( ) (
2 2
dz Sc dt c S Sc c Sdz Sdt dP
S SS S t
u u + + + + + =
Sdz c dt c S Sc c S
S SS S t
u u ) ( ))
2
1
( (
2 2
+ + + + + = .
In order for P to replicate the bond, the dz term should disappear. That is,
S
c = .
Then, by plugging (3.13) into (3.12),
dt c S c dP
SS t
)
2
1
(
2 2
+ = .
On the other hand, since P earns a risk-free rate r, with (3.10) and (3.13),
rPdt dP =
dt c S r ) ( + =
dt Sc c r
S
) ( = .

3
This derivation is much more common than the first one; for example, see Hull (2005) pp.291-292.
(3.6)
(3.7)
(3.8)
(3.9)
(3.10)
(3.11)
(3.12)
(3.13)
(3.14)
(3.15)
6
Since we assume that there are no opportunities for arbitrage, (3.14) must coincide with (3.15).
Comparing (3.14) to (3.15), we obtain the Black-Scholes equation:
rc c S rSc c
SS S t
= + +
2 2
2
1
.

Replicating the stock with a bond and a derivative
4

Lets consider the portfolio consists of b units of the bond and units of the derivative
c bB Q + = .
Then, by the self-financing condition,
dc bdB dQ + = .
Plugging (3.1) and (3.3) into (3.17), we obtain
) )
2
1
((
2 2
dz Sc dt c S Sc c brBdt dQ
S SS S t
u + + + + =
dz Sc dt c S Sc c brB
S SS S t
u + + + + = ))
2
1
( (
2 2
.
In order for Q to replicate the stock, (3.18) should coincide with
Qdz Qdt u +
dz c bB dt c bB ) ( ) ( u + + + = .
That is, based on the no-arbitrage condition, we expect
) ( )
2
1
(
2 2
c bB c S Sc c brB
SS S t
u u + = + + +
and
) ( c bB Sc
S
+ = .
From (3.21), ) ( c Sc bB
S
= . By plugging this equation into (3.20),
c c Sc c S Sc c c Sc r
S SS S t S
u u u + = + + + ) ( )
2
1
( ) (
2 2
.
Notice that all u terms cancel out in (3.22). After rearranging and dividing both sides by ,
we obtain the Black-Scholes equation:
rc c S rSc c
SS S t
= + +
2 2
2
1
.

The essential part of these derivations is that if we have a stock, a bond, and a derivative, we can
replicate each of them by using the others. This methodology can also be used to develop a
hedging strategy.

4
This derivation is less common; I have never seen this approach used yet in the literature.
(3.16)
(3.17)
(3.18)
(3.19)
(3.20)
(3.21)
(3.22)
7
4. An Alternative Derivation 1: using the CAPM

There are many ways to derive the Black-Scholes equation. In this section, we derive it by using
the Capital Asset Pricing Model (CAPM). Lets begin by reviewing the CAPM, which was
developed primarily by Sharpe (1964), Lintner (1965), and Mossin (1966) and for which Sharpe
was awarded the 1990 Nobel Prize for economics. The CAPM claims that the expected return on
an asset is a linear function of its , which is defined as the covariance of the return on the asset
with the return on the market, divided by the variance of the return on the market.

The Capital Asset Pricing Model (CAPM)
5

If the market portfolio M is efficient, the expected return ) (
i
r E of any asset i satisfies
) ) ( ( ) ( r r E r r E
M i i
= ,
where
) (
) , (
M
M i
i
r Var
r r Cov
= and r represents the risk-free rate.

Lets continue to derive the Black-Scholes equation. First, we rearrange (3.3).
Since Sdz Sdt dS u + = ,
dz Sc dt c S Sc c dc
S SS S t
u + + + = )
2
1
(
2 2

can also be written as
dt c S c dS c dc
SS t S
)
2
1
(
2 2
+ + = .
Therefore,
dt c S c
c S
dS
c
Sc
c
dc
SS t
S
)
2
1
(
1
2 2
+ + = ,
and it follows that
|

\
|
=
|

\
|
M
S
M
r
S
dS
Cov
c
Sc
r
c
dc
Cov , , .

Thus, we have the following relation between the derivatives and the stocks :
6

S
S
c
c
Sc
= .

5
For the proof, see Luenberger (1997) pp.177-178.
6
The coefficient
c
Sc
S
can be interpreted as the elasticity of the derivative price with respect to the stock
price; it is the ratio of the percentage change in the derivative price to the percentage change in the stock price,
for small percentage changes.
(3.3)
(4.1)
(4.2)
(4.3)
(4.4)
(4.5)
8
On the other hand, the expected returns on the stock and the derivative, by CAPM, are,
dt r r E rdt
S
dS
E
S M
) ) ( ( + = |

\
|

dt r r E rdt
c
dc
E
c M
) ) ( ( + = |

\
|
.
Plugging (4.5) into (4.7) and multiplying both sides by c, it follows that
( ) dt Sc r r E rcdt dc E
S S M
) ) ( ( + = .
On the other hand, taking the expected value of Equation (4.2) and using (4.6), we obtain
dt c S c dt Sc r r E dt rSc dc E
SS t S S M S
)
2
1
( ) ) ( ( ) (
2 2
+ + + = .
Comparing (4.9) to (4.8),
dt Sc r r E rcdt dt c S c dt Sc r r E dt rSc
S S M SS t S S M S
) ) ( ( )
2
1
( ) ) ( (
2 2
+ = + + + .
After rearranging (4.10), we again obtain the Black-Scholes equation:
rc c S rSc c
SS S t
= + +
2 2
2
1
.

This derivation connects the two significant concepts in financial mathematics: the CAPM and
the Black-Scholes equation. This derivation first appeared in Black and Scholes original paper
(Black and Scholes (1973)). However, it is less commonly used because other derivations have
proven to be simpler and more useful.


5. An Alternative Derivation 2:
using the Return Form of Arbitrage Pricing

The return form of arbitrage pricing is a very powerful tool to evaluate the derivatives. Using this
tool, the Black-Scholes equation can easily be derived. In addition, this tool has a large range of
applications. For example, the Black-Scholes equation with a dividend case, which is not a
simple problem in the former setting, can be derived automatically. For the details of this section,
see Ross (1976) or Primbs (2008).

Suppose that we have the list of the returns of tradable assets that are driven by the factor dz
z d dt r
r r r r
+ = ,
where
n
r
r
;
n

r
;
m n

r
is a matrix, and
m
z d
r
is a vector which contains the
factors. We consider a portfolio of these assets, represented by a vector
n
x
r
. Then, the
(5.1)
(4.6)
(4.7)
(4.8)
(4.9)
(4.10)
9
necessary absence of the arbitrage condition can be written as
If 0 1 =
r
r
T
x (No cost) and 0 =
r r
T
x (No risk), then 0 =
r r
T
x (No return).

A useful necessary absence of the arbitrage condition (the Price APT equation)
A necessary and sufficient condition for the implication (5.2) to hold true is the existence of a
vector
1

+

m

r
, such that
[ 1
r

r
]
r
r
r
r
v
= + =
0
1

where

r
r
0

with
0
and
m

r
. (5.3) is called the Price APT equation.

Under this setting, deriving the partial differential equation for pricing derivative securities is
straightforward. To this end, we implement the following procedure:
(1) Determine the tradable assets;
(2) Write factor models for each asset, and construct a tradable table; and,
(3) Apply the Price APT equation and solve.

For example, when we consider a derivative on the stock, the tradable assets are the stock S, bond
B, and the derivative c. The equations we have seen before are the following:
Bond: rBdt dB =
Stock: Sdz Sdt dS u + =
Derivative: dz Sc dt c S Sc c dc
S SS S t
u + + + = )
2
1
(
2 2
.
These equations can be written as a factor model:
dz
c
Sc
dt
c S Sc c
c
r
c
dc
S
dS
B
dB
S
SS S t

\
|
+ +
=

u
u
0
2
1 1
2 2
.
(5.4) is the tradable table, which contains all of the information we need to apply the Price APT
equation. Applying the Price APT equation (5.3) to (5.4), we obtain
(5.2)
(5.3)
(3.1)
(3.2)
(3.3)
(5.4)
10

\
|
+ +
=

SS S t
S
c S Sc c
c
r
c
Sc
2 2
1 0
2
1 1
0
1
1
1
u
u

.
From the first and second equations in (5.5), we obtain
r =
0

and

r
=
1
.
Plugging (5.6) and (5.7) to the third equation in (5.5) yields
|

\
|
+ + =

+
SS S t
S
c S Sc c
c
r
c
Sc
r
2 2
2
1 1
u

u
.
Finally, we obtain the Black-Scholes equation:
rc c S rSc c
SS S t
= + +
2 2
2
1
.

Once we prepare factor models for the tradable assets, applying the Price APT equation is
straightforward. We can apply this methodology to various cases (See Primbs (2008)).


6. An Alternative Derivation 3: using Risk-Neutral Pricing

The derivation we introduce in this section is not totally independent of other derivations.
However, it illustrates the shortest way to obtain the Black-Scholes equation; it also tells us why
the right-hand side of the Black-Scholes equation is usually written as rc.
One of the most remarkable properties of the Black-Scholes equation is that all of the
variables that do appear in the equation are independent of risk preferences. In other words, the
equation does not involve the expected return, u , on the stock.
7
Once we assume this fact, we
can use risk-neutral pricing to derive the Black-Scholes equation with just a simple argument as
follows:
In a world where investors are risk-neutral, the expected return on all investment assets
is the risk-free rate of interest, r. Let Q be the risk-neutral probability measure. Then, under Q,
the dynamics of the stock are:

7
The argument of the risk preferences here is based on Hull (2005) pp.293-294.
(5.5)
(5.6)
(5.7)
11
Stock: Sdz rSdt dS + = .
Note that u in (3.2) is replaced with r. Then, by Itos lemma, we obtain
Derivative: dz Sc dt c S rSc c dc
S SS S t
+ + + = )
2
1
(
2 2
.
On the other hand, under Q, c should also earn the risk-free rate r; that is, the dt-term of dc must
coincide with rcdt. Therefore, with this fact and (6.2), it follows that
rc c S rSc c
SS S t
= + +
2 2
2
1
.
This is precisely the Black-Scholes equation. Now we can see that why the right-hand side of the
equation is usually written as rc.

Risk-neutral valuation
8

Consider a derivative that provides a payoff at one particular time. Under the risk-neutral
assumption (i.e. all investors are risk-neutral), the derivative can be valued with risk-neutral
valuation using the following the procedures:
(1) Assume that the expected return from the underlying asset is the risk-free interest rate, r
(i.e., assume that r = u );
(2) Calculate the expected payoff from the derivative; and,
(3) Discount the expected payoff at the risk-free interest rate r.

For example, the payoff of the European call option is given by
+
) ( K S
T
, where S
T
is the stock
price at expiration date T, and K is a strike price. Then, the value of the call option at time 0 can
be written as ] ) [( ) 0 , (
+
= K S E e S c
T
Q rT
, if we use the risk-neutral measure Q. To calculate this
expectation, see Section 8.


7. Interpretation of the Black-Scholes Equation:
Why Does the Expected Return Disappear?

One of the biggest surprises of the Black-Scholes equation is the fact that the expected return for
the underlying asset, and therefore, the expected return on the derivative itself, does not appear in
the equation. Black wrote in his memoir (Black (1989)), The warrant value did not depend on
the stocks expected return, or on any other assets expected return. That fascinated me.
9
(p.6)

8
This argument is based on Hull (2005) p.294.
9
A warrant is an option issued by a company or a financial institution. Call warrants are frequently issued by
companies on their own stock.
(6.1)
(6.2)
12
With respect to the option pricing formula, he wrote, First, we concentrated on the fact that the
option formula was going to depend on the underlying stocks volatility not on its expected
return. That meant that we could solve the problem using any expected return for the stock. (p.6)
Of course, if we take a closer look at the derivations of the Black-Scholes equation, the
expected return u disappears at a certain point in the calculation, and we can confirm that the
expected return is irrelevant to the present value of the derivative. However, is there any intuitive
explanation for this disappearance? There could be several explanations. One of them, using the
hedging argument, is as follows:
10
the irrelevance originates from the fact that investors can
construct hedged positions of the asset and the derivatives, such that the expected return of the
asset offsets itself, rendering the hedged position risk-free. Consequently, investors can value
derivatives as though they were indifferent to the risk of the derivative, even if they are truly
averse to the risk.


8. The Black-Scholes Formula for a Call Option

In this section, we will derive the Black-Scholes formula, which yields the theoretical value of a
call option
11
. An option is a security giving the buyer the right to buy or sell an asset, subject to
certain conditions, within a specified period of time. An American option is one that can be
exercised at any time up until the date the option expires. On the other hand, a European option
is one that can be exercised only on a specified future date. The price that is paid for the asset
when the option is exercised is called the strike price; the last day on which the option may be
exercised is called the expiration date.
First, we consider a European call option of a stock. A call option gives the right to
buy a single share of common stock. The payoff of the European call option is given by
+
) ( K S
T
, where S
T
is the stock price at expiration date T, and K is a strike price. From
risk-neutral valuation, using the risk-neutral measure Q, the value of the call option at time 0 is,

] ) [( ) 0 , (
+
= K S E e S c
T
Q rT
.
Since under Q,
Y T T r
T
e S S

+
=
)
2
(
0
2
, where S
0
is the stock price at time 0 and ) 1 , 0 ( ~ N Y , (8.1)
can be written as

10
This argument is based on Kritzman (2002) p.128.
11
This derivation is based on Dineen (2005) pp.230-231.
(8.1)
13

|
|

\
|
=
+
+

K e S E e S c
Y T T r
Q rT

)
2
(
0
2
) 0 , (

+
+

= dx e K e S e
x
x T T r
rT
2
)
2
(
0
2 2
2
1
) (

.
Since
0
)
2
(
0
2

+
K e S
x T T r

T r
x T
e
S
K
e
)
2
(
0
2

)
`

|
|

\
|

|
|

\
|
T r
S
K
T
x
2
ln
1
2
0

,
if we denote
)
`

|
|

\
|

|
|

\
|
= T r
S
K
T
T
2
ln
1
2
0
1

, we obtain

=
1
2 2
2
)
2
(
0
) (
2
) 0 , (
T
x
x T T r
rT
dx e K e S
e
S c

=
1 1
2 2
2
2 2
2
0
2 2
T T
x rT x
x T
T
dx e
Ke
dx e
e S

)) ( 1 (
2
1
) (
2
1
0
1
2
T N Ke dx e
S
rT
T
T x
=

)) ( 1 (
2
1
2
0
1
2
T N Ke dx e
S
rT
T T
y
=

(here, T x y = )
)) ( 1 ( )) ( 1 (
1 1 0
T N Ke T T N S
rT
=

,
where ds e x N
x s

=
2
2
2
1
) (

is the cumulative distribution function for the normal distribution.
(8.2)
(8.3)
14
Since
)
`

|
|

\
|
+ |

\
|
= T r
K
S
T
T T
2
ln
1
2
0
1

and the identity 1 ) ( ) ( = + x N x N , we have
|
|

\
|
)
`

|
|

\
|
+ + |

\
|
= = T r
K
S
T
N T T N T T N
2
ln
1
)) ( ( ) ( 1
2
0
1 1

.
Similarly,
|
|

\
|
)
`

|
|

\
|
+ |

\
|
= = T r
K
S
T
N T N T N
2
ln
1
) ( ) ( 1
2
0
1 1

.
Substituting (8.4) and (8.5) into (8.3), we obtain the Black-Scholes formula for a call option:
) ( ) ( ) 0 , (
2 1 0
d N Ke d N S S c
rT
= ,
where
T
T r
K
S
d

|
|

\
|
+ + |

\
|
=
2
ln
2
0
1
, T d d =
1 2
,
and ds e x N
x s

=
2
2
2
1
) (

is the cumulative distribution function for the normal distribution.

The above result (8.6) also indicates that the solution of the Black-Scholes partial differential
equation with the boundary condition
+
= ) ( ) , ( K S T S c
T

is given by (8.6). Note that all the parameters except for , the volatility of the underlying stock,
can be observed in the market. Regarding , we have to estimate it from historical market data
(historical volatility). Alternatively, if the price of the call option is available in the market, the
Black-Scholes formula can be used in reverse to solve for the market estimation of (implied
volatility
12
).
So far, we have discussed a European call option case. However, in fact, the value of an
American call option is exactly the same as that of a European call option (with the same
strike price and expiration date), if there are no dividends. In other words, for call options on a
stock that pays no dividends prior to expiration, early exercise of the option is never optimal.

12
For the calculation of the implied volatility, see Manaster and Koehler (1982).
(8.4)
(8.5)
(8.6)
15
Here, we provide a brief explanation for this. In this explanation, we use put-call parity
for European options.

Put-call parity
13

Let C and P be the prices of a European call and a European put, both with a strike price of K and
both defined on the same stock with price S. Put-call parity states that
S dK P C = + ,
where d is the discount factor to the expiration date.

With this parity, the above result can be explained as follows:
14
let C
A
be a price of an American
call option and C
E
be the price of a European call option with the same strike price K and the
same expiration date. Let P be the price of a European put option of the same kind. Let S be the
stock price. Then, by put-call parity, before the expiration date,
E A
C C
dK P S + = (by put-call parity)
K P S + > (because 1 < d )
K S > . (because 0 > P )

Since the right-hand side of (8.8) represents the call options payoff if it is exercised now, (8.8)
means that the early exercise of the call option is never optimal.

The Black-Scholes formula for a European put option
Put-call parity also yields the evaluation formula for a European put option. By (8.7),
0
S dK C P + = (S
0
means the stock price at time 0)
0 2 1 0
) ( ) ( S K e d N Ke d N S
rT rT
+ =


(because (8.6) and
rT
e d

= )
( ) ( ) ) ( 1 ) ( 1
1 0 2
d N S d N Ke
rT
=


) ( ) (
1 0 2
d N S d N Ke
rT
=

.
(because of the identity 1 ) ( ) ( = + x N x N )


13
In order to ensure that the put-call parity holds, note that a combination of a put, a call, and a risk-free loan
has a payoff identical to that of the underlying stock. See Luenberger (1997) p.326.
14
I first heard this explanation in MS&E245G: Finance for non-MBAs (Professor Adamati).
(8.7)
(8.8)
(8.9)
16
(8.9) is called the Black-Scholes formula for a European put option. Note that in the case of a
put option, even if there is no dividend, we cannot say that the early exercise of the option is
never optimal; the value of an American put option is higher than that of a European put option.
Unfortunately, there is no comparable explicit evaluation formula for an American put
option.

The history of option valuation
15

Finding a valuation formula for options had been a longstanding-problem until the early 1970s. In
1900, Bachelier derived the formula for assessing the value of stock options in his Ph.D. thesis.
However, the formula was based on unrealistic assumptions, such as a zero interest rate and a
process that allowed for a negative stock price.
Later, Sprenkle, Boness and Samuelson improved on Bacheliers formula. They assumed
that stock prices are log-normally distributed, which guarantees that the stock price is always
positive and allowed for a non-zero interest rate. Another assumption was that investors are
risk-averse and demand a risk premium in addition to the risk-free interest rate. In 1964, Boness
developed a formula, which still relied on an unknown interest rate, including compensation for
the risk associated with the stock.
Before 1973, the valuation approach was, basically, to determine the expected value of
an option at expiration and then to discount its value back to the time of the evaluation. The
difficulty in this approach was determining the discount rate; in other words, assigning a risk
premium was a tough problem, which was not successfully resolved at that time.
In 1973, Black and Scholes published the famous option pricing formula that now bears
their names (Black and Scholes (1973)). While working on their paper, they were strongly
influenced by Merton, who published an article that also included the option valuation formula
and various extensions (Merton (1973)). Black looks back on Mertons contribution as follows
(Black (1989)):

As we worked on the paper, we had long discussions with Robert Merton, who
was also working on option valuation. Merton made a number of suggestions that
improved our paper. In particular, he pointed out that if you assume continuous
trading in the option or the stock, you can maintain a hedged position between
them that is literally riskless. In the final version of the paper, we derived the
formula that way, because it seemed to be the most general derivation. (p.6)


15
This part is based on Royal Swedish Academy of Sciences (1997).
17
For his contribution, Merton also obtained the 1997 Nobel Prize for economics with
Scholes. Currently, the Black-Scholes equation is also known as the Black-Scholes-Merton
equation.


9. Summary and Conclusion

The Black-Scholes equation is a partial differential equation that governs the value of financial
derivatives. Determining the value of derivatives had been a longstanding-problem in finance for
70 years since 1900; in the early 1970s, Black and Scholes made a pioneering contribution to
finance by developing the Black-Scholes equation and the option valuation formula.
In this paper, several derivations of the Black-Scholes equation were discussed. The
standard derivation is to find the equation by constructing a replicating portfolio, which also
suggests a hedging strategy and give us an intuitive explanation of the fact that the equation, and,
thus, the value of the derivative, is irrelevant to the expected return on the underlying asset. We
also introduced the derivation using the CAPM, which appeared in the Black and Scholes
original paper (Black and Scholes (1973)). Another derivation utilizes the return form of arbitrage
pricing, first developed by Ross (1976). Although the argument is simple, this method is quite
powerful and has a wide range of applications.
Another powerful tool is risk-neutral valuation. Once we know that the value of the
derivative is irrelevant to the expected return on the underlying asset, we can solve the problem in
the risk-neutral world, a world in which all investment assets earn the risk-free rate r. The
derivation is quite simple; it also gives us insight into why the right-hand side of the
Black-Scholes equation is usually written as rc.
Thereafter, we also reviewed the Black-Scholes formula for a call option. Using put-call
parity, we know that the value of an American call option is exactly the same as that of a
European call option, provided there are no dividends. In addition, we obtain an evaluation
formula for a European put option.
This paper definitely enhanced my understanding of financial mathematics, since many
important concepts in financial mathematics are actually used throughout this paper. I really
thank Professor Jim Primbs for giving me the opportunity to take MS&E408: Directed Reading
and Research, and also for offering us wonderful lectures in MS&E345: Advanced Topics in
Financial Engineering. I also thank Dr. Carol Shabrami for giving me helpful comments in terms
of writing English.

18
References
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Political Economy, 81, no. 3, 637-654.

Black, F. (1989), How We Came Up with the Option Formula, The Journal of Portfolio
Management, 15, 4-8.

Dineen, S. (2005), Probability Theory in Finance: A Mathematical Guide to the Black-Scholes
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Hull, J.C. (2005), Options, Futures, and Other Derivative Securities, 6th ed., Prentice Hall.

Kritzman, M.P. (2002), Puzzles of Finance: Six Practical Problems and Their Remarkable
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Lintner, J. (1965), The Valuation of Risk Assets and the Selection of Risky Investment in Stock
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Manaster, S., and Koehler, G. (1982), The Calculation of Implied Variances from the
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19

Royal Swedish Academy of Sciences, (1997), Additional Background Material on the Bank of
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