Financial Derivatives and Partial Dierential Equations

Robert Almgren July, 2001

1. ASSETS AND DERIVATIVES. Assets of all sorts are traded in nancial markets: stocks and stock indices, foreign currencies, loan contracts with various interest rates, energy in many forms, agricultural products, precious metals, etc. The prices of these assets uctuate, sometimes wildly. As an example, Figure 1 shows the price of IBM stock within a single day. The picture would look more or less the same across a month, a year, or a decade, though the axis scales would be dierent. If you could anticipate the price uctutations to any signicant extent, then you could clearly make a great amount of money very quickly. The fact that many people are trying to do exactly that makes the uctuations essentially unpredictable for practical purposes. A fundamental principle of nance, the ecient market hypothesis [9] asserts that all information available to anyone anywhere is instantly expressed in the current price, as market participants race to be the rst to prot from new information. Thus successive price changes may be considered to be uncorrelated random variables, since they depend on as-yet unrevealed information. This principle is the subject of intensive analytical testing and some controversy [7], but is an excellent approximation for our purposes. Although the directions of the price motions are completely unpredictable, statistics can tell us a lot about their expected size. Figure 2 shows the distribution of percentage changes in IBM stock price across half hour time intervals. We can identify a typical size of the uctuations, about half of one percent in this example. Since the uctuations are uncorrelated and have mean near zero, this typical size is the single most important statistical quantity that we can extract from the price history. We may additionally ask about the form of this distribution, for example, whether or not it is a Gaussian. Again, this is the subject of active research [10].

To appear in American Mathematical Monthly

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Financial Derivatives and PDEs

95 94.5 94 93.5 93

10

12

14

16

Figure 1: Price of one share of IBM stock, on November 16, 1999; the xaxis is time of day. These are prices at which trades actually occured; this picture contains 5400 data points. The fastest oscillations, on scales of a few seconds, represent bounce between bid and ask prices. But complicated structure is clear on all higher scales, and continues across decades.

300 Number of events 250 200 150 100 50 0 0.02 0.01 0 0.01 Fractional price change 0.02

Figure 2: Fractional price change in IBM stock price across half-hour time intervals, for 1999 (about 3000 data values). Although the direction of the changes is unpredictable, we can still identify a characteristic size of the changes, about half a percent in this example.

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Financial Derivatives and PDEs

A derivative is an asset whose value depends on the price of some other asset, the underlying. Derivatives permit investors to customize their exposure to the market: they can speculate, hoping to win a large amount with a small initial investment, or hedge, investing in the new asset in order to oset risks they already have. Derivatives provide a rich means for market participants to exchange risk and thereby achieve their preferred prole of exposure to marketplace uctations. Many books explain the basics of derivatives [5] and the mathematical models for valuing them [13]. The simplest derivative is a forward or futures contract: a committment to buy a particular asset on a specied future expiration date T , for a specied strike price K. If at expiration the asset is trading in the marketplace for price S, then the holder of the contract makes a prot or loss of S K. Futures are widely used to take positions in assets that are not themselves easily traded, such as agricultural commodities. For example, a farmer may sell her crop as she plants it, thus guaranteeing her price before the objects being sold even exist. By selling the futures contract, the farmer acquires short exposure to the crop price, which hedges the long exposure she already has by her ownership of the crop. The speculator at the Chicago Mercantile Exchange who buys the contract hopes to make money if crop prices rise. An option gives the contract holder the decision whether or not to execute the nal transaction. A call option gives the holder the right to purchase the asset (from the counterparty) on date T for price K; a put option gives her the right to sell the asset on date T for price K. For a call option, the payo is thus (S) = max{S K, 0}, since the option holder will choose to exercise only if the market price S is greater than K; she can then turn around and sell the asset, pocketing a prot S K. Similarly, the payo of a put option is (S) = max{K S, 0}. In both cases, the option holder has the possibility of prot with no chance of loss; she must therefore pay something to acquire the contract. If you believe an asset will rise in price, then you may buy a call option to capture a very large potential gain with a small investment; however, if your belief is wrong then you may very easily lose your entire option investment. Options may also be used for hedging. For example, the Canadian Imperial Bank of Commerce oers an Index-Linked GIC that allows you to take advantage of increases in the value of the S&P/TSE 60 Index, but with no risk to your principal if the index declines. In eect, this is an investment in the index, combined with a put option to sell at the original value. Mortgages in the United States commonly combine a xed rate with a prepayment feature, which permits the borrower to take advantage of decreases in interest rates, while being protected against increases.

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Options trade in marketplaces, just like the assets on which they are based. Figure 3 shows market prices of 117 call and put options on IBM stock on the same day as in Figure 1. The expiration dates range from a few weeks to six months into the future (longer-term options also exist), and the strike prices of the options range over about a factor of two above and below the current stock price. The prices shown are daily closing values; throughout the day the options uctuate just as actively as the stock itself. The rst attempt to explain option prices was by Poincars student e Louis Bachelier in 1900 [1], [3]. He proposed that the correct value of an option was the expected value of its payos, and by introducing a specic probabilistic model for the underlying price motion, he was able to calculate this expectation and compare his results with market prices. In his formulation, the option holder and the writer both took on risk associated with uctuations about this mean value. The surprising fact is that, under suitable assumptions about the statistics of the asset price motion, the risk can be eliminated by following a suitable hedging strategy. The value of the option is then uniquely determined. Again, the value is obtained by computing an expectation, which can be carried out by solving a partial dierential equation, though the interpretation is quite dierent than in Bacheliers model. This observation in 1973 by Black, Scholes, and Merton [2], [11] led to the development of large options exchangesand to the 1997 Nobel Memorial Prize for Merton and Scholes. 2. EUROPEAN OPTION VALUATION. Let us consider an option, written on an underlying asseta stock, saythat trades in the market at price S(t). Some payo function (S) has been specied, which determines the value of the option at expiration t = T . For t < T , the option value V should depend on the underlying price S and on time t; in the hope (to be justied later) that these are the only relevant parameters, we denote the price as V (S, t). So far, we know only that V (S, T ) = (S). We assume that the option is European, meaning that it can be exercised only on the future date T ; thus any value it has for t < T comes from passively waiting to receive this possible payout. An American option can be exercised at any time up to and including T ; we consider options of this kind in Section 3. As time progresses, the value of the option changes, both because the expiration date approaches and because the stock price changes. Across a

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Financial Derivatives and PDEs

60 40 Calls 20 Apr 2000 0 60 80 100 120 140 160 K 60 40 Puts 20 0 Apr 2000 Jan 2000 Dec 1999 Nov 1999 T 140 100 120 K 160 Jan 2000 Dec 1999 Nov 1999 T

60

80

Figure 3: Options on IBM stock, closing prices on Nov. 16, 1999. The x-axis is the strike price K, at which the option holder may eventually buy or sell the stock; the dashed line at about 95 shows the closing price of the stock itself. The y-axis is the expiration date T . The z-axis is the price at which the option dened by parameters (K, T ) could be either bought or sold at the Chicago Board of Options Exchange. Call options are more valuable for lower strike prices, and conversely for puts. The Black-Scholes theory largely explains the structure of these prices.

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Financial Derivatives and PDEs

short time interval t, we may write V = Vt t + VS S +

1 2 VSS

S 2 +

(1)

in which the neglected terms are of size O( t2 , S t, S 3 ). It will be made clear later why we need to include the terms of size S 2 . To determine the option price, we construct a replicating portfolio. This will be a specic investment strategy, involving only the stock and a cash account, that will yield exactly the same eventual payo as the option in all possible future scenarios. Its present value must therefore be the same as the present value of the option, and if we can determine one we have the other. We thus dene a portfolio , consisting of D(S, t) shares of stock and a cash account with balance C. Both D and C can be positive or negative, corresponding to long or short positions. The value of this portfolio is (S, t) = D(S, t) S + C(S, t). The stock holdings D(S, t) are chosen by a specic rule (determined in what follows) depending on the underlying price and on time. The investor holding this portfolio is also exposed to risk as long as she holds a nonzero amount of stock. She could eliminate this risk by taking D = 0, but instead we are going to choose D so that the risks of the portfolio exactly match the risks of the option. We will then say that replicates V . The change in value of across time t is not determined by a passive expansion as in (1); rather, we follow the investing actions in detail. During the time interval t, the stock holding is held constant at D, and the value of changes only due to uctuations in the stock price S and due to interest paid on the cash balance: = D S + r C t. (2)

The interest payment rC t is approximate for small t, depending on whether interest is paid continuously or discretely, but the D S term is exact; there is no term S 2 . At the end of the time interval, before the start of the next interval, D is changed to respond to the new price S(t + t). The amount of money required for or generated by this rebalancing is withdrawn from or deposited into the cash account. Thus the total value does not change in this step, and (2) represents the entire change across the time t. We say that the portfolio is self-nancing, since no money is put in or taken out. Thus the dierence in value between the two portfolios changes by V = Vt rC t + VS D S +
1 2 VSS

S 2 + ,

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Financial Derivatives and PDEs

which depends on the unknown change S. But we can eliminate the rstorder dependence by choosing D(S, t) = VS (S, t). That is, if the investor is able to compute the function V (S, t), then she can compute its derivative with respect to S and articially implement a trading strategy that at rst order tracks the same risks. Assuming this strategy has been implemented, we then have V = Vt rC t +
1 2 VSS

S 2 + ,

(3)

where the higher-order terms in t and S are small if the time interval and the corresponding price changes are small. This change is still an uncertain quantity, since we do not know S 2 . However, we argued in the introduction that we know much more about the size of the changes S than about their direction. As a consequence, it may be that S 2 is eectively deterministic, as long as we average over enough small steps. Let us consider a time interval t that is small compared with the overall lifetime of the option, yet large compared with the time intervals t at which we are able to trade. Let us take t = N t, and denote the small price changes by Sj for j = 1, . . . , N . Now, for the rst time, we write down a specic probabilistic model for the price changes. We suppose that (4) Sj = a t + b t j , where a is the expected rate of change and b is an absolute volatility measuring the expected size of the motions. At each step, j is a random variable of mean zero and unit variance, and these variables are independent across successive steps. In general, a and b may depend on S and t, but for now they can be considered constant. When t is small, the stochastic process S(t) corresponding to the model (4) becomes a Brownian motion or Wiener process, although it was rst introduced by Bachelier for the purpose of option pricing. The Brownian motion model is extremely popular, not primarily because of statistical evidence, but because it is only with this model that we can determine option prices exactly. The accumulated change across the time interval t is
N

S =
j=1

Sj = a t + b t X,

1 X= N

j .
j=1

(5)

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Financial Derivatives and PDEs

By standard probability theory, since the j are independent, the random variable X has mean zero and unit variance; if N is large, then X has a Gaussian distribution. The resemblance between (4) and (5) is the reason for choosing the specic time scalings in (4): they are stable across dierent time scales. If the j have a Gaussian distribution, then the law is precisely the same on all time scales. As suggested above, the sum of the squares of price changes is much less random than the changes themselves. We readily calculate (Sj )2 = b2 t j2 + 2ab t3/2 j + a2 t2 , and nd that
N N N

(Sj )
j=1

1 = b t N
2

j2
j=1

+ 2ab(t)

3/2

1 N 3/2

j + a2 (t)2
j=1

1 N2

b t as N . The latter limit is a consequence of our assumption that the j are independent with unit variance. Thus our intuition was correct: although the square of change in price is random on any one step, when we average across a large number of steps, it becomes certain. Since we have eliminated the rst-order dependence on S by taking D = VS , the total accumulated change from (3) is now
N

=
j=1

j N

= =

Vt rC t + Vt rC +

1 2

VSS
j=1

(Sj )2 t.

1 2 2 b VSS

This expression has no randomness anywhere in it. By adjusting the holdings D(S, t) at every microscopic time interval to follow changes in price, we have replicated V . In this expression we have neglected the changes in VSS caused by changes in S from step 1 to N . It is not dicult to see that these are of higher order in S. In eect, we have just given a heuristic derivation of a result known as Its Lemma. o Since the dierence portfolio V is nonrisky, it must grow in value at exactly the same rate as as any risk-free bank account: V = r V t. (6)

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Financial Derivatives and PDEs

The reasoning is a classic application of lack of arbitrage: lack of possibility to make a prot without risk. If (V ) > r(V )t, then anyone could borrow money at rate r to acquire the portfolio V . Acquiring the portfolio means buying the option in the marketplace for V , shorting D shares of stock, and loaning out cash C. By holding the option for a time t, following the above hedging strategy, and selling at price V (t + t), the growth in value of the dierence portfolio is certain to more than cover the interest costs on the loan. Conversely, if (V ) < r(V )t, then the reverse strategy yields a risk-free prot. This strategy consists of selling the option in the marketplace for V , covering the risk by purchasing D shares of stock, and loaning out the cash left over at rate r. Recalling that V = V DS C and that D = VS , we obtain the general version of the Black-Scholes equation:
1 Vt + 2 b(S, t)2 VSS + rSVS rV = 0.

(7)

Note that the drift coecient a has disappeared, hence does not aect the value of the option. The only coecients that appear are b and r, the size of the motions and the risk-free interest rate, respectively. This partial dierential equation must be satised by the value of any derivative security depending on the asset S. The PDE (7) is linear: two options are worth twice as much as one option, and a portfolio consisting of two dierent options has value equal to the sum of the individual options. The PDE is backwards parabolic. Thus, terminal values V (S, T ) must be specied at some future time T , from which values V (S, t) can be determined for t < T . Typically, the value of an option is known at expiration, and this equation is solved to determine its values for earlier times. In addition, boundary conditions may arise from features of the option specication. The option price may also be calculated by probabilistic methods [6]. In this equivalent formulation, the discounted price process ert S(t) is shifted into the risk-free measure using the Girsanov theorem, so that it becomes a martingale. The option price V (S, t) is then the discounted expected value of the payo (S) in this measure, and the PDE (7) is obtained as the backwards evolution equation for the expectation. Our derivation has followed the original reasoning of Black and Scholes, although the probabilistic view is more modern and can more easily be extended to general market models. We have achieved the remarkable conclusion that the market value of the option V (S, t) is uniquely determined by its boundary conditions and

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10

by the parameters of the probabilistic model for the underlying asset price motion. Let us summarize the assumptions that went into this model: The asset S can be bought and sold. This is essential for us to construct a suitable hedging portfolio. Thus the model cannot be applied to risk factors that dont exist in a market. For example, home heating costs depend on outside temperature. You are at the mercy of this risk, unless you can nd a way to buy and sell temperature (this is now possible, precisely by using hedging portfolios composed of energy futures). Assets can be bought and sold with no transaction costs. In practice, trading costs are substantial, including both the bid-ask spread on small amounts and liquidity limits on large amounts. This constrains the frequency with which new values of D can be taken and means that risk cannot be eliminated completely. The market parameters r and b are known. The interest rate r is different for dierent investors (usually the rate taken is the overnight rate for short-term cash deposits between major banks), but does not have too large an eect on the result. However, the computed value V is very sensitive to the input value of b, and this value is very dicult to estimate empirically. In practice, option prices quoted on the exchanges are usually used to determine appropriate implied values for the parameters of the price process. The asset price follows a Brownian motion. This model follows from the assumptions that (a) price is a continuous function of time, (b) its increments are independent random variables, even when viewed on arbitrarily short time intervals, and (c) variance is nite and constant. As a consequence, the price changes S across intermediate time intervals have a Gaussian distribution. Although these assumptions are very plausible, the results are not consistent with empirical observations either of the asset prices themselves [10] or of option prices. Constructing improved models for asset price motion and for option pricing is a subject of active research. An especially popular choice is the lognormal model b(S, t) = S, so Sj = a(S, t) t + S j . That is, the percentage size of the random changes in S, rather than the absolute sizes, are assumed to be constant as S varies. The parameter is

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11

called the volatility, and T is the expected size of changes across a time interval T . For this model, the Black-Scholes equation is
1 Vt + 2 2 S 2 VSS + rSVS rV = 0.

This PDE has nonconstant coecients, depending on the independent variable S. At the edge S = 0 of the domain of solution, the coecients have a strange singularity. However, by changing the independent variable to x = log S, these diculties disappear and, with the aid of Greens functions, it is easy to construct exact solutions. These deliver the famous Black-Scholes formula for the price of a European call option: V (S, t; K, T ) = S N log(S/K) + r + 1 2 (T t) 2 T t Ker(T t) N log(S/K) + r 1 2 (T t) 2 T t ,

in which N () is the cumulative normal distribution 1 N (x) = 2

x

ey

2 /2

dy.

(Prices for put options can be determined in the same way, or by using the symmetry principle of put-call parity.) In Figure 4, the Black-Scholes solution is compared with the market prices of call options for a single expiration date T . The value of has been chosen to give a reasonable t over the whole range of strike prices K. A more detailed examination shows that the lognormal model with a constant value of simultaneously overprices at-the-money optionsthat is, with K near Sand underprices options at the endseither deep in the money or deep out of the money. This is an indication that the price process has fat tails: large changes are more frequent than would be predicted by extrapolation from the statistics of small changes. In fact, market practioners quote prices in terms of implied volatility: for each strike, the value of that gives the market option price. Nonetheless, this simple model does a remarkably good job of reproducing actual market behavior. 3. AMERICAN AND EXOTIC OPTIONS. The foregoing model may be extended in various ways, giving rise to a variety of interesting mathematical problems.

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Financial Derivatives and PDEs

12

40

Call option price

30

20 S

10

0 60

80

100 120 Strike price K

140

160

Figure 4: Comparison of Black-Scholes formula with IBM call option prices as in Figure 3 (Jan. 2000). Parameters are = 35% and r = 5% per year. Many real options have American features: at any time t before T , the option holder may choose to exercise the option and receive the payout (S, t) at that time. Mathematically, this adds a free boundary to the problem, corresponding to the optimal exercise strategy, and makes explicit solution impossible. In fact, equity options are generally American rather than European, so our description in Section 2 was slightly over-simplied. However, for a simple call option, it is never optimal to exercise early (you would incur interest costs by paying the strike price, unless the asset itself pays dividends), so our analysis was correct in that case. For put options, early exercise is important. Many options are complicated custom contracts traded privately over the counter between professional market participants; an immense variety of possible structures exists. Black-Scholes theory is used to determine model parameters from prices of exchange-traded vanilla options, then solved to quote prices for arbitrary exotics, and to determine optimal hedging strategies for reducing risk after the option contract has been written.

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Financial Derivatives and PDEs

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American options. Let us again suppose that the option price V (S, t) is a smooth function, and denote by V the change in value across a short time interval, V = V (t + t) V (t). Earlier, we argued that V was given by the expression on the right-hand side of (1). Now, however, the reasoning needs to be modied. We argued previously that (V ) = r(V )t, for if the equality were violated in either direction, there would be a strategy available to the option holder that would guarantee a prot. One side of that strategy depended on shorting the option. But for an American option, shorting it means giving the counterparty the decision whether to exercise, and it is unlikely that he will do it in a way that is optimal for the holder of the option. Thus (6) needs to be modied to V r V t, and the PDE (7) becomes
1 Vt + 2 b2 VSS + rSVS rV 0.

(8)

Of course, a partial dierential inequality is not sucient to determine V (S, t). The second piece of information needed is that V (S, t) (S, t), (9)

precisely because the option may be exercised at any time: if it ever happened that V < , then a risk-free prot could be made by purchasing the option for V and immediately exercising it to collect . One further statement is required to determine V uniquely. At each moment, the option value arises purely from the possibility either to exercise immediately or to hold and get the exercise value at a later time. This yields the third constraint: At each (S, t), at least one of (8) and (9) is an equality. (10)

The three pieces (8)(10) constitute a linear complementarity or obstacle problem [12]. The (S, t)-plane may be divided into two pieces, an exercise region in which (9) is an equality and a hold region in which (8) is an equality. Assuming everything is regular, the boundary between these regions is a curve S (t), the optimal exercise boundary. The option holder should exercise when the price S(t) crosses this level. The motion of the boundary can be modeled as a free boundary problem, mathematically similar to the Stefan problem of freezing/melting. Solutions may be obtained numerically by adding obstacle features to a nite-dierence code or by solving an integral equation for the motion of the boundary.

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14

Other exotics. Almost any contract between consenting parties that could possibly be written is probably being traded somewhere right now. Here is a brief list of possible extensions, any one of which may include American features as well. The payo function may have a more complicated form. For a digital option, (S) is a step function: it pays a xed amount if S > K at expiration, zero if S < K. By putting together piecewise linear payos, one obtains spreads, straddles, collars, etc. These are valued in the same way as the vanilla assets, namely, by solving the PDE with appropriate terminal data. A barrier option loses its value if the underlying asset price crosses a specied level (which may be either above or below the current price) at any time before expiration. It is valued by adding a homogeneous Dirichlet boundary condition to the diusion equation (7). Asian options depend in some way on a time average of the price. For example, one may have the right to acquire the asset for its average price over a specied time period. These are valued by adding an additional state variable. The option price V (S, I, t) also depends on the value of the running average I, and the Black-Scholes equation (7) becomes a degenerate diusion equation in two variables [13]. Lookback options depend on the maximum or minimum asset price in a time window and are priced by similar means. Multi-asset or rainbow options may give, for example, the right to acquire any one of a set of assets for a given price. They are valued by solving a diusion equation in as many variables as there are assets, with a diusivity matrix representing correlations among the price motions as well as their volatilities. In addition to changing the denition of the option, one may make the market model more realistic. For example, transaction costs are important in real life, preventing the hedging strategy of Section 2 from being implemented in continuous time. Finally, a more realistic statistical model may be used for the price process itself. Two prominent models for incorporating realistic statistics are stochastic volatility [4] and jump models such as variance gamma [8]. Both of these incorporate fat tails, hence are capable of correcting the systematic mispricings mentioned at the end of Section 2.

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Financial Derivatives and PDEs

15

In this note, we have reviewed the basic theory of pricing and hedging options, and a few of its extensions. Besides the practical importance of the calculations, the development of such quantitative models represents a real advance in our ability to think rationally about risk and hedging. Although the classical framework of Brownian motion and Black-Scholes hedging has been developed to a high degree of renement, there still remains a lot to do in the area of more realistic stochastic models, not to mention the connection of these ideas with traditionally less quantitative areas such as insurance and risk management. Acknowledgement This article is based on an MAA invited lecture at the Joint Mathematics Meetings in New Orleans, January 2001. The author would like to thank the MAA both for their invitation and for their support in completing the article. Robert Almgren is Associate Professor of Mathematics and Computer Science at the University of Toronto, where he teaches numerical methods for PDEs in the Mathematical Finance Program. His Ph.D. thesis in Applied and Computational Mathematics at Princeton University was on high-frequency asymptotics in reacting gas dynamics. He has since worked on free boundary problems in materials science and in uid dynamics, and on optimal trading strategies in nance. In good weather he soars crosscountry in his Pegasus sailplane. University of Toronto, Department of Mathematics, 100 St. George St., Toronto ON M5S 3G3, Canada. almgren@math.toronto.edu

Robert Almgren/July 2001 References

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