Partial Differential Equations in Option Pricing

Jean-Pierre Fouque
University of California Santa Barbara

Special Semester on Stochastics with Emphasis on Finance

Tutorial
September 5, 2008
RICAM, Linz, Austria

1
PART 1: Review of the
Black-Scholes Theory of Derivative Pricing
1.1 Market Model
One riskless asset (savings account):

dβt = rβt dt, (1)

where r ≥ 0 is the instantaneous interest rate.

Setting β0 = 1, we have βt = ert for t ≥ 0.
The price Xt of the other asset, the risky stock or stock index,
evolves according to the
stochastic differential equation

dXt = µXt dt + σXt dWt , (2)

where µ is a constant mean return rate, σ > 0 is a constant

volatility and (Wt )t≥0 is a standard Brownian motion.

2
Risky Asset Price Model
Differential form:
dXt
= µdt + σdWt (3)
Xt
Integral form:
Z t Z t
Xt = X0 + µ Xs ds + σ Xs dWs (4)
0 0

General class of stochastic differential equations driven by a

Brownian motion:

dXt = µ(t, Xt )dt + σ(t, Xt )dWt , (5)

or in integral form
Z t Z t
Xt = X0 + µ(s, Xs )ds + σ(s, Xs )dWs . (6)
0 0

3
Itô’s formula in differential form:
′ 1 ′′
dg(Wt ) = g (Wt )dWt + g (Wt )dt. (7)
2
More generally, when Xt satisfies

dXt = µ(t, Xt )dt + σ(t, Xt )dWt ,

and g depends also on t, one has

∂g ∂g 1 ∂2g
dg(t, Xt ) = (t, Xt )dt + (t, Xt )dXt + (t, Xt )dhXit , (8)
∂t ∂x 2 ∂x2
Rt 2
where hXit = 0 σ (s, Xs )ds is the quadratic variation of the
martingale part of Xt .
In terms of dt and dWt the formula is
 2

∂g ∂g 1 2 ∂ g ∂g
dg(t, Xt ) = + µ(t, Xt ) + σ (t, Xt ) 2 dt + σ(t, Xt ) dWt , (9)
∂t ∂x 2 ∂x ∂x
where all the partial derivatives of g are evaluated at (t, Xt ).

4
Application to the discounted price g(t, Xt ) = e−rt Xt

d (e−rt Xt ) = −re−rt Xt dt + e−rt dXt

= e−rt (−rXt + µ(t, Xt )) dt + e−rt σ(t, Xt )dWt (10)
= (µ − r) (e−rt Xt ) dt + σ (e−rt Xt ) dWt .

e t = e−rt Xt satisfies the same equation as

The discounted price X
Xt where the return µ has been replaced by µ − r:
e t = (µ − r)X
dX e t dt + σ X
e t dWt . (11)

Integration by parts formula

d(Xt Yt ) = Xt dYt + Yt dXt + dhX, Y it , (12)

where the covariation (also called “bracket”) of X and Y is given by

dhX, Y it = σX (t, Xt )σY (t, Yt )dt.

5
Lognormal Risky Asset Price

dXt = Xt (µdt + σdWt )

gives by Itô’s formula

 
1 2
d log Xt = µ − σ dt + σdWt −→
2
 
1
log Xt = log X0 + µ − σ 2 t + σWt −→
2
 
1
Xt = X0 exp (µ − σ 2 )t + σWt . (13)
2
The return Xt /X0 is lognormal and the process (Xt ) is called a
geometric Brownian motion. which can also be obtained as a
diffusion limit of binomial tree models which arise when the
Brownian motion is approximated by a random walk.

6
 108

106

Stock Price Xt
104

102

100

98

96

94
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5
Time t

Figure 1: A sample path of a geometric Brownian motion, with µ = 0.15,

σ = 0.1 and X0 = 95. It exhibits the “average growth plus noise” behavior
we expect from this model of asset prices.

7
1.2 Replicating Strategies
The Black-Scholes-Merton analysis of a European style derivative
yields an explicit trading strategy in the underlying risky asset and
riskless bond whose terminal payoff is equal to the payoff h(XT ) of
the derivative at maturity, no matter what path the stock price
takes. This replicating strategy is a dynamic hedging strategy since
it involves continuous trading, where to hedge means to eliminate
risk. The essential step in the Black-Scholes methodology is the
construction of this replicating strategy and arguing, based on
no-arbitrage, that the value of the replicating portfolio at time t is
the fair price of the derivative. We develop this idea now.

8
Replicating Self-Financing Portfolios
We consider a European style derivative with payoff h(XT ).
Assume that the stock price (Xt ) follows the geometric Brownian
motion model.
A trading strategy is a pair (at , bt ) of adapted processes specifying
the number of units held at time t of the underlying asset and the
riskless bond, respectively.
nR o RT
T 2
We suppose that IE 0 at dt and 0 |bt |dt are finite so that the
stochastic integral involving (at ) and the usual integral involving
(bt ) are well-defined.
The value at time t of this portfolio is at Xt + bt ert . It will
replicate the derivative at maturity if its value at time T is almost
surely equal to the payoff:

aT XT + bT erT = h(XT ) (14)

9
In addition, this portfolio is to be self-financing,
rt


d at Xt + bt e = at dXt + rbt ert dt, (15)
which implies the self-financing property
Xt dat + ert dbt + dha, Xit = 0. (16)
In integral form:
Z t Z t
at Xt + bt ert = a0 X0 + b0 + as dXs + rbs ers ds , 0 ≤ t ≤ T.
0 0

In discrete time:
atn Xtn+1 + btn ertn+1 = atn+1 Xtn+1 + btn+1 ertn+1 −→

rtn+1

rtn


atn+1 Xtn+1 + btn+1 e − atn Xtn + bn e

rtn+1 rtn


= atn Xtn+1 − Xtn + btn e −e ,
which in continuous time becomes (15).

10
The Black-Scholes Partial Differential Equation
Assume that the price of a European-style contract with payoff
h(XT ) is given by P(t, XT ) where the pricing function P(t, x) is to
be determined.
Cconstruct a self-financing portfolio (at , bt ) that will replicate
the derivative at maturity (14).
The no-arbitrage condition requires that
at Xt + bt ert = P(t, Xt ) , for any 0 ≤ t ≤ T . (17)

Differentiating (17) and using the self-financing property (15) on

the left-hand side, Itô’s formula (9) on the right-hand side and
equation (2), we obtain
rt


at µXt + bt re dt + at σXt dWt (18)
 2

∂P ∂P 1 2 2 ∂ P ∂P
= + µXt + σ Xt 2
dt + σX t dWt
∂t ∂x 2 ∂x ∂x

11
Eliminating risk (or equating the dWt terms) gives
∂P
at = (t, Xt ). (19)
∂x
From (17) we get

bt = (P(t, Xt ) − at Xt ) e−rt . (20)

Equating the dt terms in (18) gives

 
∂P ∂P 1 2 2 ∂ 2 P
r P − Xt = + σ Xt , (21)
∂x ∂t 2 ∂x2
which needs to be satisfied for any stock price Xt .
Note that µ disappeared!

12
P (t, x) is the solution of the Black-Scholes PDE

LBS (σ)P = 0, (22)

where the Black-Scholes operator is defined by

 
∂ 1 2 2 ∂2 ∂
LBS (σ) = + σ x 2
+r x −· . (23)
∂t 2 ∂x ∂x
Equation (22) is to be solved backward in time with the terminal
condition P (T, x) = h(x), on the upper half-plane x > 0.
Knowing P , the portfolio (at , bt ) is uniquely determined by
(19) and (20).
at is the “Delta” of the portfolio.
Only the volatility σ is needed.

13
The Black-Scholes Formula
For European call options the Black-Scholes PDE (22) is solved
with the final condition h(x) = (x − K)+ . There is a closed-form
solution known as the Black-Scholes formula:

CBS (t, x; K, T; σ) = xN(d1 ) − Ke−r(T−t) N(d2 ), (24)

1 2


log(x/K) + r + 2σ (T − t)
d1 = √ , (25)
σ T −t
√
d2 = d1 − σ T − t, (26)
Z z
1 −y 2 /2
N (z) = √ e dy. (27)
2π −∞

(By direct check or probabilistic derivation later)

∂CBS
The Delta hedging ratio at for a call is given by ∂x = N(d1 ).

14
 45
40
Call Option Price

35
30
25
20
15
10 Payoff (x − K)+
t = 0 price
5
0
60 70 80 90 100 110 120 130 140
Current Stock Price x
Figure 2: Black-Scholes call option price CBS (0, x; 100, 0.5; 10%) at time
t = 0, with K = 100, T = 0.5, σ = 0.1 and r = 0.04.
15
European put options
We have the put-call parity relation

CBS (t, Xt ) − PBS (t, Xt ) = Xt − Ke−r(T−t) , (28)

between put and call options with the same maturity and strike
price.
This is a model-free relationship that follows from simple
no-arbitrage arguments. If, for instance, the left side is smaller than
the right side then buying a call and selling a put and one unit of the
stock, and investing the difference in the bond, creates a profit no matter
what the stock price does.

Under the lognormal model, this relationship can be checked directly since
the difference CBS − PBS satisfies the PDE (22) with the final condition
h(x) = x − K. This problem has the unique simple solution
x − Ke−r(T −t) .

16
Using the Black-Scholes formula (24) for CBS and the put-call
parity relation (28), we deduce the following explicit formula for
the price of a European put option:

PBS (t, x) = Ke−r(T−t) N(−d2 ) − xN(−d1 ) , (29)

where d1 , d2 and N are as in (25), (79) and (27) respectively.

Other types of options do not lead in general to such explicit
formulas. Determining their prices requires solving numerically the
Black-Scholes PDE (22) with appropriate boundary conditions.
Nevertheless probabilistic representations can be obtained as
explained in the following section. In particular American options
lead to free-boundary value problems associated with equation (22).

17
 40
35
Put Option Price

30
25
20
15 Payoff (K − x)+
10
5 t = 0 price
0
60 70 80 90 100 110 120 130 140
Current Stock Price x
Figure 3: Black-Scholes put option price PBS (0, x; 100, 0.5; 10%) at time
t = 0, with K = 100, T = 0.5, σ = 0.1 and r = 0.04.
18
The Greeks:

∂CBS
“Delta” : ∆BS = = N(d1 ) (30)
∂x
2
∂ 2 CBS ∂∆BS e−d1 /2
“Gamma” : ΓBS = = = p (31)
∂x2 ∂x xσ 2π(T − t)

−d2
√
∂CBS xe 1 /2 T−t
“Vega” : VBS = = √ (32)
∂σ 2π
The sensitivities with respect to time to maturity T − t and short
rate r are respectively named the “Theta” and the “Rho”.
In the general case of an European derivative whose price satisfies
the Black-Scholes PDE (22) with a terminal condition
P (T, x) = h(x), there are simple and important relations between
some of the Greeks −→

19
For instance, differentiating with respect to σ leads to the following
equation for the Vega:
2
2∂ P
LBS (σ)V + σx 2
= 0, (33)
∂x
with a zero terminal condition.
One can easily check that the Black-Scholes operator LBS (σ)
2 2 2 2 ∂2P
commutes with x ∂ /∂x , and therefore that (T − t)σx ∂x2
satisfies equation (33). If the second derivative with respect to x
remains bounded as t → T , this solution satisfies the zero terminal
condition, and we obtain the following relation between the Vega
and the Gamma
2
∂P 2∂ P
= (T − t)σx 2
. (34)
∂σ ∂x
In the case of a call option this relation can be directly obtained from
(31) and (32).

20
Using the same argument, by differentiating the Black-Scholes
equation with respect to r, one can obtain the relation between
the Rho and the Delta:
 
∂P ∂P
= (T − t) x −P . (35)
∂r ∂x

Note that these relations may not be satisfied by

more complex derivatives involving additional
boundary conditions, such as barrier options for
instance.

21
1.3 Risk-Neutral Pricing
Unless µ = r, the expected value under the objective probability IP
of the discounted payoff of a derivative (??) would lead to an
opportunity for arbitrage. This is closely related to the fact that
ft = e−rt Xt is not a martingale since,
the discounted price X
from (11),
dXft = (µ − r)X ft dt + σ X
ft dWt , (36)
which contains a non zero drift term if µ 6= r.
The main result we want to build in this section is that there is a
unique probability measure IP ⋆ equivalent to IP such that,
ft is a martingale
under this probability, (i) the discounted price X
and (ii) the expected value under IP ⋆ of the discounted payoff of a
derivative gives its no-arbitrage price. Such a probability
measure describing a risk-neutral world is called an Equivalent
Martingale Measure.

22
Equivalent Martingale Measure
In order to find a probability measure under which the discounted
price Xft is a martingale, we rewrite (36) in such a way that the
drift term is “absorbed” in the martingale term:
   
f f µ−r
dXt = σ Xt dWt + dt .
σ

µ−r
θ= (37)
σ
is called the market price of asset risk, and we define
Z t
Wt⋆ = Wt + θds = Wt + θt, (38)
0

so that
ft = σ X
dX ft dW⋆ . (39)
t

23
Using characteristic functions, it is easy to check that
 
θ 1
ξT = exp −θWT − θ 2 T , (40)
2
has an IP -expected value equal to 1 (Cameron-Martin formula).
It has a conditional expectation with respect to Ft given by
 
θ 1
IE{ξT | Ft } = exp −θWt − θ2 t = ξtθ , for 0 ≤ t ≤ T ,
2
which defines a martingale denoted by (ξtθ )0≤t≤T .
IP ⋆ is the equivalent measure to IP (they have the same null sets), which
has the density ξTθ with respect to IP :

dIP⋆ = ξT
θ
dIP, (41)

or denoting by IE ⋆ {·} the expectation with respect to IP ⋆ , for any

integrable random variable Z we have

IE⋆ {Z} = IE{ξT

θ
Z}.

24
For any adapted and integrable process (Zt ),

⋆ 1
IE {Zt | Fs } = θ IE{ξtθ Zt | Fs }, (42)
ξs

for any 0 ≤ s ≤ t ≤ T . The process (ξtθ )0≤t≤T is called the

Radon-Nikodym density .
The main result of this section asserts that the process
(Wt⋆ ) given by (38) is a standard Brownian motion under
the probability IP ⋆ .
This result in its full generality (when θ is an adapted stochastic
process) is known as Girsanov’s Theorem.
In our simple case (θ constant), it is easily derived as follows:

25
 n o 1 n θ iu(Wt⋆ −Ws⋆ ) o
⋆ iu(Wt⋆ −Ws⋆ )
IE e | Fs = IE ξt e | Fs
ξsθ
1 2
n 1 2
o
= eθWs + 2 θ s IE e−θWt − 2 θ t eiu(Wt −Ws +θ(t−s)) | Fs
1 2
n o
= e( 2
− θ +iuθ )(t−s)
IE ei(u+iθ)(Wt −Ws )
| Fs
2
( − 21 θ 2 +iuθ )(t−s) − (u+iθ)2 (t−s)
= e e
u2 (t−s)
−
= e 2 .

26
Self-Financing Portfolios

Vt = at Xt + bt ert .

The self-financing property (15), namely dVt = at dXt + rbt ert dt,
ft = e−rt Vt , is a
implies that the discounted value of the portfolio, V
martingale under the risk-neutral probability IP ⋆ . This essential
property of self-financing portfolios is obtained as follows:

dVet = −re−rt Vt dt + e−rt dVt

= −re−rt (at Xt + bt ert )dt + e−rt (at dXt + rbt ert dt)
= −re−rt at Xt dt + e−rt at dXt
= at d(e−rt Xt )
ft
= at dX
ft dWt⋆
= σat X (by (39)), (43)

27
Connection between martingales and no-arbitrage
Suppose that (at , bt )0≤t≤T is a self-financing arbitrage strategy
such that

VT ≥ erT V0 (IP-a.s.), (44)

IP{VT > erT V0 } > 0, (45)

so that the strategy never makes less than money in the bank and
there is some chance of making more. But

IE⋆ {e−rT VT } = V0

by the martingale property, so (44) and (45) cannot hold.

This is because IP and IP ⋆ are equivalent and so (44) and (45) also
hold with IP replaced by IP ⋆ .

28
Risk-Neutral Valuation
Let (at , bt ) be a self-financing portfolio replicating the European
style derivative with nonnegative square integrable payoff H:

aT XT + bT erT = H. (46)

This includes European calls and puts or more general standard

European derivatives for which H = h(XT ), as well as other European
style exotic derivatives presented in Section 1.2.3.

On one hand, a no-arbitrage argument shows that the price at

time t of this derivative should be the value Vt of this portfolio.
On the other hand the discounted values (Vet ) of this portfolio form
a martingale under the risk-neutral probability IP ⋆ :
n o
Vft = IE⋆ V gT | Ft −→

29
 n o
Vt = IE⋆ e−r(T−t) H | Ft , (47)

after reintroducing the discounting factor and using the replicating

property (46).
Alternatively, given the risk-neutral valuation formula (47),
we can find a self-financing replicating portfolio for the payoff H.
The existence of such a portfolio is guaranteed by an application of
the martingale representation theorem: for 0 ≤ t ≤ T
⋆
 −rT
Mt = IE e H | Ft ,

defines a square integrable martingale under IP ⋆ with respect to

the filtration (Ft ), which is also the natural filtration of the
Brownian motion W ⋆ .

30
The representation theorem says that any such martingale is a
stochastic integral with respect to W ⋆ , so that
Z t

IE⋆ e−rT H | Ft = M0 + ηs dWs⋆ ,
0
nR o
⋆ T
where (ηt ) is some adapted process with IE 0
ηt2 dt finite.

By defining at = ηt /(σ X ft ) and bt = Mt − at Xft , we construct a

portfolio (at , bt ), which is shown to be self-financing by checking
that its discounted value is the martingale Mt and using the
characterization (43) obtained in Section 1.4.2.
Its value at time T is erT MT = H and therefore it is a replicating
portfolio.

31
Using the Markov Property
For a standard European derivative with payoff H = h(XT ) the
Markov property of (Xt ) says that conditioning with respect
to the past Ft is the same as conditioning with respect to
Xt , so that the risk-neutral pricing formula becomes
n o
Vt = IE⋆ e−r(T−t) h(XT ) | Xt .

We will come back to this property in the next Section.

Denoting by P (t, x) the price of this derivative at time t for an
observed stock price Xt = x, we obtain the pricing formula
n o
P(t, x) = IE⋆ e−r(T−t) h(XT ) | Xt = x . (48)

If we compare this formula (at time t = 0) with (??), the naive pricing a
standard European derivative, we see that the essential step is to replace
the “objective world” IP by the “risk-neutral world” IP ⋆ in order to
obtain the fair no-arbitrage price.

32
Solving the SDE (2) from t to T starting from x gives
 2

σ
XT = x exp (µ − )(T − t) + σ(WT − Wt ) . (49)
2
Using (38), this formula can be rewritten in terms of (Wt⋆ ) as
 2

σ ⋆
XT = x exp (r − )(T − t) + σ(WT − Wt⋆ ) .
2
As (Wt⋆ ) is a standard Brownian motion under the risk-neutral
probability IP ⋆ , the increment WT⋆ − Wt⋆ is N (0, T − t)-distributed,
and (48) gives the Gaussian integral
Z +∞  
1 −r(T −t)
2
(r− σ2 )(T −t)+σz
2
− 2(Tz −t)
P (t, x) = p e h xe e dz. (50)
2π(T − t) −∞

33
In the case of a European call option, h(x) = (x − K)+ , this
integral reduces to the Black-Scholes formula (24) obtained in
Section 1.3.4, as the following computation shows:
Z +∞ −rτ Z +∞
x −
(z−στ )2 Ke − z2
P(t, x) = √ e 2τ dz − √ e 2τ dz,
2πτ z⋆ 2πτ z⋆
where τ = T − t and z ⋆ is defined by
 
1
x exp (r − σ 2 )τ + σz⋆ = K.
2
We then set
z ⋆ − στ z⋆
√ = −d1 , √ = −d2 ,
τ τ
which coincide with the definitions (25) and (79) of d1 and d2 . The
Black-Scholes formula (24) follows by introducing the normal
cumulative distribution function N given by (27).

34
Binary or digital options
It pays at time T a fixed amount (say one), if XT ≥ K, and
nothing otherwise. The corresponding discontinuous payoff
function is simply h(x) = 1{x≥K} . Its value at time t is given by
(48), which, in this case, becomes
Z +∞
e−rτ z2
− 2τ
Pdigital (t, x) = √ e dz = e−rτ N(d2 ). (51)
2πτ z⋆

The two approaches developed in Sections “PDE” and “risk-neutral

valuation” should give the same fair price to the same derivative.
This is indeed the case, and is the content of the following section,
where we explain that a formula like (48) is just a probabilistic
representation of the solution of a partial differential equation like
(22).

35
1.4 Risk-Neutral Expectations and PDEs
We denote by (Xt,x
s )s≥t the solution of the SDE (5) starting from x
at time t:
Z s Z s
Xt,x
s =x+ µ(u, Xt,x
u )du + σ(u, Xt,x
u )dWu ,
t t

and we assume enough regularity in the coefficients µ and σ for

(Xst,x ) to be jointly continuous in the three variables (t, x, s). The
flow property for deterministic differential equations can be
extended to stochastic differential equations like (5); it says that, in
order to compute the solution at time s > t starting at time 0 from
point x, one can use
t,Xt0,x
x −→ Xt0,x −→ Xs = Xs0,x (IP-a.s.). (52)
In other words, one can solve the equation from 0 to t, starting from x, to
obtain Xt0,x . Then we solve the equation from t to s, starting from Xt0,x .
This is the same as solving the equation from 0 to s, starting from x.

36
The Markov property is a consequence and can be stated as
follows:

IE {h(Xs ) | Ft } = IE h(Xt,x
s ) |x=Xt , (53)

which is what we have used with s = T to derive (48).

Observe that the discounting factor could be pulled out of the
conditional expection since the interest rate is constant (not random).

In the time homogeneous case (µ and σ independent of time) we

further have
 n o
0,x
IE h(Xt,x
s ) = IE h(Xs−t ) ,

which could have been used with s = T to derive (50) since WT⋆ −t
is N (0, T − t)-distributed.

37
Infinitesimal Generators and Associated Martingales
Consider first a time homogeneous diffusion process (Xt ), solution
of the SDE
dXt = µ(Xt )dt + σ(Xt )dWt . (54)
Let g be a twice continuously differentiable function of the variable
x with bounded derivatives, and define the differential operator
L acting on g according to
1 2
Lg(x) = σ (x)g′′ (x) + µ(x)g′ (x). (55)
2
In terms of L, Itô’s formula (9) gives
dg(Xt ) = Lg(Xt )dt + g′ (Xt )σ(Xt )dWt −→
Z t
Mt = g(Xt ) − Lg(Xs )ds, (56)
0

defines a martingale.
38
Consequently, if X0 = x, we obtain
Z t 
IE{g(Xt )} = g(x) + IE Lg(Xs )ds .
0

Under the assumptions made on the coefficients µ and σ and on the

function g, the Lebesgue dominated convergence theorem is
applicable and gives
d IE{g(Xt )} − g(x)
IE{g(Xt )}|t=0 = lim
dt t↓0 t
 Z t 
1
= lim IE Lg(Xs )ds = Lg(x).
t↓0 t 0
The differential operator L given by (55) is called the
infinitesimal generator of the Markov process (Xt ).

39
For nonhomogeneous diffusions (σ(t, x), µ(t, x)) and functions
g(t, x) which depend also on time, (56) can be generalized by using
the full Itô formula (9) to yield the martingale
Z t 
∂g
Mt = g(t, Xt ) − + Ls g (s, Xs )ds, (57)
0 ∂t
where the infinitesimal generator Lt is defined by
1 2 ∂2 ∂
Lt = σ (t, x) 2 + µ(t, x) , (58)
2 ∂x ∂x
and g is any smooth and bounded function.
Finally we incorporate
Rt a discounting factor by computing the
− r(s,Xs )ds
differential of e 0 g(t, Xt ) and obtaining the martingales
Rt Z t Rs  
− r(s,Xs )ds − r(u,Xu )du ∂g
Mt = e 0 g(t, Xt ) − e 0 + Ls g − rg ds, (59)
0 ∂t
which introduces the potential term −rg.

40
Conditional Expectations and Parabolic PDEs
Suppose that u(t, x) is a solution of the PDE
∂u 1 2 ∂ 2u ∂u
+ σ (t, x) 2 + µ(t, x) − ru = 0, (60)
∂t 2 ∂x ∂x
with the final condition u(T, x) = h(x) and assume that it is
regular enough to apply Itô’s formula (9). Using (59) we deduce
that Mt = e−rt u(t, Xt ) is a martingale when Lt , given by (58), is
the infinitesimal generator of the process (Xt ) - in other words,
when µ and σ are the drift and diffusion coefficients of (Xt ).
The martingale property for times t and T reads
IE{MT | Ft } = Mt which can be rewritten as
n o
u(t, Xt ) = IE e−r(T−t) h(XT ) | Ft ,

since u(T, XT ) = h(XT ) according to the final condition.

41
Using the Markov property (53), we deduce the following
probabilistic representation of the solution u:
n o
u(t, x) = IE e−r(T−t) h(Xt,x
T ) , (61)

which may also be written as

n o n o
−r(T−t) −r(T−t)
u(t, x) = IE e h(XT ) | Xt = x or u(t, x) = IEt,x e h(XT )

If r depends on t andx, the discounting factor becomes

RT
exp − t r(s, Xs )ds .
The representation (61) is then called the Feynman-Kac formula.

42
Application to the Black-Scholes PDE
When µ(t, x) = rx and σ(t, x) = σx in the SDE (60), we have the
Black-Scholes PDE (22) for the option price P (t, x) on the
domain {x > 0}, since
∂
LBS = + L − r,
∂t
where L is the infinitesimal generator of the geometric Brownian
motion X. The non-ellipticity

σ 2 (t, x) = σ 2 x2 (62)

can be dealt with by the change of variable P (t, x) = u(t, y = log x)

where equation (22) becomes
2
 
∂u 1 2 ∂ u 1 2 ∂u
+ σ + r− σ − ru = 0, (63)
∂t 2 ∂y2 2 ∂y
to be solved for 0 ≤ t ≤ T , y ∈ IR with u(T, y) = h(ey ).

43
1.5 American Options and Free-boundary
Problems
Optimal Stopping
⋆

P(0, x) = sup IE e−rτ h(Xτ ) ,
τ ≤T

is the price of the derivative at time t = 0, when X0 = x and where

the supremum is taken over all the possible stopping times less
that the expiration date T . This formula can be generalized to get
the price of American derivatives at any time t before expiration T :
n
o
⋆
P(t, x) = sup IE e−r(τ −t) h Xt,x τ , (64)
t≤τ ≤T

where (Xst,x )s≥t is the stock price starting at time t from the
observed price x.
τ =t −→ P (t, x) ≥ h(x)
t=T −→ P (T, x) = h(x)

44
Because an American derivative gives its holder more rights than the
corresponding European derivative, the price of the American is always
greater than or equal to the price of the European derivative which has
the same payoff function and the same expiration date.
This can be seen by choosing τ = T in (64).
The supremum in (64) is reached at the optimal stopping time,
τ ⋆ = τ ⋆ (t) = inf {t ≤ s ≤ T , P(s, Xs ) = h(Xs )} , (65)
s

the first time after t that the price of the derivative drops down to
its payoff. In order to determine τ ⋆ , one must first compute the
price. In terms of PDEs, this leads to a so-called free-boundary
value problem. To illustrate, we consider the case of an American
put option.
It can be shown by a no-arbitrage argument that, for nonnegative interest
rates and no dividend paid, the price of an American call option is the
same as its corresponding European option.

45
The price of an American put option
n
o
a ⋆ −r(τ −t) t,x +
P (t, x) = sup IE e K − Xτ ,
t≤τ ≤T

is in general strictly higher than the price of the corresponding

European put option which has been obtained in closed-form (29).
In fact, we saw in Figure 3 that the Black-Scholes European put
option pricing function crosses below the payoff “ramp” function
(K − x)+ for small enough x. This violates P (t, x) ≥ h(x), so the
European formula for a put cannot also give the price of the
American contract, as is the case for call options.

46
Free-Boundary Value Problems
Pricing functions for American derivatives satisfy partial
differential inequalities. For the nonnegative payoff function h, the
price of the corresponding American derivative is the solution of
the following linear complementarity problem:

P ≥ h
LBS (σ)P ≤ 0 (66)
(h − P)LBS (σ)P = 0, (67)

to be solved in {(t, x) : 0 ≤ t ≤ T, x > 0} with the final condition

P(T, x) = h(x).
The second inequality is linked to the supermartingale property
of e−rt P (t, Xt ) through (59) applied to g = P.
To see that the price (64) is solution of the differential inequalities
−→

47
For any stopping time t ≤ τ ≤ T we have
Z τ  
∂
e−rτ P (τ, Xτt,x ) = e−rt P (t, x) + e−rs + L − r P (s, Xst,x )ds
t ∂t
Z τ
−rs t,x ∂P
+ e σXs (s, Xst,x )dWs⋆ .
t ∂t
The integrand of the Riemann integral is nonpositive by (67) and,
since τ is bounded, the expectation of the martingale term is zero
by Doob’s optional stopping theorem. This leads to
n o
⋆
IE e−r(τ −t) P(τ, Xt,x
τ ) ≤ P(t, x),

and, using the first inequality in (67),

n o
⋆
IE e−r(τ −t) h(Xt,xτ ) ≤ P(t, x).

It is easy to see now that if τ = τ ⋆ , then we have equalities throughout.

This verifies that if (67) has a solution to which Itô’s formula can be
applied then it is the American derivative price (64).

48
In the case of the American put option there is an increasing
function x⋆ (t) - the free boundary - such that, at time t,
P(t, x) = K − x for x < x⋆ (t)
LBS (σ)P = 0 for x > x⋆ (t), (68)
with
P(T, x) = (K − x)+ (69)
x⋆ (T) = K. (70)
∂P
In addition, P and ∂x are continuous across the boundary x⋆ (t), so
that
P(t, x⋆ (t)) = K − x⋆ (t), (71)
∂P
(t, x⋆ (t)) = −1. (72)
∂x
The exercise boundary x⋆ (t) separates the hold region, where the
option is not exercised, from the exercise region, where it is:
49
 1
P (T, x) = (K − x)+ K
0.9
0.8 EXERCISE HOLD
0.7
P =K −x LBS (σ)P = 0
0.6
P > (K − x)+
Time t

0.5
0.4
x⋆ (t)
0.3 P (t, x⋆ (t)) = (K − x⋆ (t))+
∂P ⋆
0.2
∂x (t, x (t)) = −1
0.1
0
50 60 70 80 90 100 110 120
Stock Price x
Figure 4: The American put problem for P (t, x) and x⋆ (t), with LBS (σ)
defined in (23).
50
 1
K
0.9
0.8
0.7
0.6 τ⋆
Time t

0.5
0.4
x⋆ (t) Xt
0.3
0.2
0.1
0
50 60 70 80 90 100 110 120
Stock Price
Figure 5: Optimal exercise time τ ⋆ along a sample path for an American
put option.
51
1.6 Path-Dependent Derivatives
In order to price path-dependent derivatives, one has to compute
the expectations of their discounted payoffs with respect to the
risk-neutral probability. Here are some examples.
Barrier Options
A down-and-out call option (European style) is an example of a
barrier option:
n o
+
P(0, x) = IE⋆ e−rT (XT − K) 1{inf 0≤t≤T Xt >B} | X0 = x .

The price at time t < T of this option is given by

n o
⋆ −r(T−t) +
Pt = IE e (XT − K) 1{inf 0≤s≤T Xs >B} | Ft
n o
+
= 1{inf 0≤s≤t Xs >B} IE⋆ e−r(T−t) (XT − K) 1{inf t≤s≤T Xs >B} | Ft
= 1{inf 0≤s≤t Xs >B} u(t, Xt ), by the Markov property. (73)

52
These expectations can be computed by using classical results on the
joint probability distribution of the Brownian motion and its minimum,
obtained by the reflection principal.
Alternatively, the function u(t, x) given by (73) satisfies the following
boundary value problem on {x > B}:

LBS (σ)u = 0
u(t, B) = 0
u(T, x) = (x − K)+ .

The method of images leads to a formula for u(t, x):

 x 1− 2r2  2

σ B
u(t, x) = uBS (t, x) − uBS t, , (74)
B x
where uBS (t, x) is the Black-Scholes price of the European derivative
with payoff function h(x) = (x − K)+ 1{x>B} . In the case B ≤ K, where
the knock-out barrier is below the call strike, uBS (t, x) is simply the
price CBS (t, x) of a call option given by the Black-Scholes formula (24).

53
Lookback Options
We consider for instance a floating strike lookback put which pays
the difference JT − XT where JT is the running maximum
Jt = sup0≤s≤t Xs .
⋆
 −rT
P(0, x) = IE e (JT − XT ) | X0 = x
  
1 2
= xe−rT IE⋆ sup e(r− 2 σ )t+σWt − x,
0≤t≤T

by using the martingale property of the discounted stock price

under the risk neutral probability IP ⋆ , and the explicit form of Xt .
Again, by using log-variables and a change of measure, these
expectations can be reduced to integrals involving the joint
distribution of a driftless Brownian motion and its running
maximum.

54
The PDE approach:
The price P(t, x, J) of this option satisfies the problem

LBS (σ)P = 0 in x < J and t < T

∂P
(t, J, J) = 0
∂J
P(T, x, J) = J − x.

The boundary condition at J = x expresses the fact that the price of

the lookback option for Xt = Jt is insensitive to small changes in Jt
because the realized maximum at time T is larger than the realized
maximum at time t with probability one.

55
The problem of finding P(t, x, J) can be reduced to a one (space)
dimensional boundary value problem with the following similarity
reduction: ξ = x/J, and P(t, x, J) = JQ(t, ξ), leading to
 2

σ
P(t, x, J) = − x + x 1 + N(d7 )
2r
 2  1− 2r2

σ x
+ Je−r(T−t) N(d5 ) −
σ
N(d6 ) (75)
2r J
where
1 2

1 2


log(J/x) − r − 2σ (T − t) log(x/J) − r − 2σ (T − t)
d5 = √ , d6 = √ ,
σ T −t σ T −t

1 2


log(x/J) + r + 2σ (T − t)
d7 = √ .
σ T −t

56
Forward-Start Options (“Cliquets”)
A typical forward-start option is a call option maturing at time T such
that the strike price is set equal to XT1 at time T1 < T .
Its payoff at maturity T is given by h = (XT − XT1 )+ .
If T1 ≤ t ≤ T , the contract is simply a call option with K = XT1 .

When t < T1 < T2 , which is the case when the contract is initiated, its
price at time t is given by P (t, Xt ) where
n o
P (t, x) = IE ⋆ e−r(T −t) (XT − XT1 )+ | Xt = x
n n o o
⋆ −r(T1 −t) ⋆ −r(T −T1 ) +
= IE e IE e (XT − XT1 ) | FT1 | Xt = x
n o
⋆ −r(T1 −t)
= IE e CBS (T1 , XT1 ; T, K = XT1 ) | Xt = x
n   o
= IE ⋆ e−r(T1 −t) XT1 N (d¯1 ) − e−r(T −T1 ) N (d¯2 ) | Xt = x ,

57
where d¯1 and d¯2 are given here by
 √  √
1 T − T1 1 T − T1
d¯1 = r + σ 2 , d¯2 = r − σ2 ,
2 σ 2 σ
because the underlying call option is computed at the
money K = XT1 .
We then deduce
  n o
⋆
P(t, x) = N(d̄1 ) − e−r(T−T1 ) N(d̄2 ) IE e−r(T1 −t) XT1 | Xt = x
 
−r(T−T1 )
= x N(d̄1 ) − e N(d̄2 ) , (76)

by using the martingale property of the discounted stock

price under the risk neutral probability IP ⋆ .

58
Compound Options
Example of a call-on-call option. For t < T1 < T , at time T1 ,
the maturity time of the option, the payoff is given by

h(CBS (T1 , XT1 ; K, T)) = (CBS (T1 , XT1 ; K, T) − K1 )+ .

The price at time t of this call-on-call is given by

n o
+
P (t, x) = IE ⋆ e−r(T1 −t) (CBS (T1 , XT1 ; K, T ) − K1 ) | Xt = x (77)
n o
⋆
= IE e−r(T1 −t) (CBS (T1 , XT1 ; K, T ) − K1 ) 1{XT1 ≥x1 } | Xt = x ,

where x1 is defined by CBS (T1 , x1 ; K, T) = K1 .

Explicit formulas can be obtained by using the bivariate normal
distribution.

59
Asian Options
As an example we consider an Asian (European style)
average-strike option whose payoff is given by a function of the
stock price at maturity and of the arithmetically-averaged stock
price before maturity like in an average strike call option (??). One
can introduce the integral process
Z t
It = Xs ds,
0

and redo the replicating strategies analysis or the risk-neutral

valuation argument for the pair of processes (Xt , It ). Observe that
(It ) does not introduce new risk or, in other words, there is no new
Brownian motion in the equation dIt = Xt dt.

60
Using a two-dimensional version of Itô’s formula presented in
the following section, one can deduce the PDE
 
∂P 1 2 2 ∂ 2 P ∂P ∂P
+ σ x 2
+r x −P +x = 0, (78)
∂t 2 ∂x ∂x ∂I
to be solved, for instance, with the final condition
P(T, x, I) = (x − TI )+ , in order to obtain the price P(t, Xt , It ) of
an arithmetic-average strike call option at time t. This is solved
numerically in most examples (see the notes for a dimension
reduction technique).
Note that geometric-average Asian options are much simpler since
log prices are added leading to Gaussian random variables.

61
First Passage Structural Approach to Default
Credit risk. We consider here the problem of pricing a defaultable
zero-coupon bond which pays a fixed amount (say $1) at maturity T
unless default occurs, in which case it is worth nothing. In other
words we consider the simple case of no recovery in case of default.
Merton’s Approach
In the Merton’s approach, the underlying Xt follows a geometric
Brownian motion, and default occurs if XT < B for some
threshold value B. In this case the price at time t of the
defaultable bond is simply the price of a European digital option
which pays one if XT exceeds the threshold and zero otherwise, as
in (51). Assuming that the underlying is tradable and the risk free
interest rate r is constant, by no-arbitrage argument, the price of
this option is explicitly given by ud (t, Xt ) where −→

62
 n o
d ⋆ −r(T −t)
u (t, x) = IE e 1XT >B | Xt = x

= e−r(T −t) IP ⋆ {XT > B | Xt = x}

 2
  
σ B
= e−r(T −t) IP ⋆ r− (T − t) + σ(WT⋆ − Wt⋆ ) > log
2 x

 2
 
x
W⋆ − W⋆ log B + r − σ2 (T − t) 
= e−r(T −t) IP ⋆ √T t
>− √
 T −t σ T −t 

= e−rτ N (d2 (τ )), (108)

with the usual notation τ = T − t and the distance to default:

 2

x
log B + r − σ2 τ
d2 (τ ) = √ . (109)
σ τ

63
The First Passage Model
In the first passage structural approach, default occurs if Xt goes
below B at some time before maturity. In this extended
Merton, or Black and Cox model, the payoff is

h(X) = 1{inf 0≤s≤T Xs >B} .

The defaultable bond can then be viewed as a path-dependent

derivative. Its value at time t ≤ T , denoted by PB (t, T), is given by
n o
PB (t, T) = IE⋆ e−r(T−t) 1{inf 0≤s≤T Xs >B} | Ft (110)
−r(T−t) ⋆

= 1{inf 0≤s≤t Xs >B} e IE 1{inf t≤s≤T Xs >B} | Ft .

Indeed PB (t, T) = 0 if the asset price has reached B before time t,

which is reflected by the factor 1{inf 0≤s≤t Xs >B} .

64
Introducing the default time τt defined by

τt = inf{s ≥ t, Xs ≤ B},

one has

⋆
IE 1{inf t≤s≤T Xs >B} | Ft = IP⋆ {τt > T | Ft },

which shows that the problem reduces to the characterization of

the distribution of default times. Observe that the default time τt is
a predictable stopping time, in the sense that it can be announced
by an increasing sequence of stopping times. For instance one can
(n)
consider the sequence (τt ) defined by
(n)
τt = inf{s ≥ t, Xs ≤ B + 1/n}.

These stopping times are illustrated in Figure 6:

65
B+1/n

(n)
t τ τ T
t t

Figure 6: The cartoon shows a sample trajectory of the geometric Brown-

(n)
ian motion Xt , and the corresponding values of the first hitting times τt
and τt after t of the levels B + 1/n and B.

66
An alternative intensity based approach to default consists in
introducing default times which are unpredictable.
In the first passage model, a defaultable zero-coupon bond is in
fact a binary down-an-out barrier option where the barrier
level and the strike price coincide. From a probabilistic point of
view, we have
⋆

IE 1{inf t≤s≤T Xs >B} | Ft
  2
   
⋆ σ ⋆ ⋆ B
= IP inf (r − )(s − t) + σ(Ws − Wt ) > log | Xt = x ,
t≤s≤T 2 x
which can be computed by using the distribution of the minimum
of a (non standard) Brownian motion. From the point of view of
PDEs, we have
n o
IE⋆ e−r(T−t) 1{inf t≤s≤T Xs >B} | Ft = u(t, Xt ),

67
where u(t, x) is the solution of the following problem

LBS (σ)u = 0 on x > B, t < T (111)

u(t, B) = 0 for any t ≤ T
u(T, x) = 1 for x > B,

which is to be solved for x > B. This problem can be solved by

introducing the corresponding European digital option which pays
$1 at maturity if XT > B and nothing otherwise. Its price at time
t < T is given by ud (t, Xt ) computed explicitly in (79).
The function ud (t, x) is the solution to the PDE

LBS (σ)ud = 0 on x > 0, t < T (112)

ud (T, x) = 1 for x > B, and 0 otherwise.

68
By using the method of images, the solution u(t, x) can be written
 x 1− 2r2  2

B
u(t, x) = ud (t, x) − ud t,
σ
. (113)
B x

Combining with the formula for ud (t, x), we get

  x 1− 2r2 
u(t, x) = e−r(T−t) N(d+ −
σ
2 (T − t)) − N(d2 (T − t)) , (114)
B
where we denote

 2

x σ
± log B + r− 2 τ
d±
2 (τ ) = √ . (115)
σ τ

69
The yield spread Y(0, T) at time zero is defined by

−Y(0,T)T PB (0, T)
e = , (116)
P(0, T)

where P(0, T) = e−rT is the default free zero-coupon bond

price. In other words, r + Y(0, T) is the effective rate of return
over the period (0, T ), where the spread Y (0, T ) is due to the
default risk.
The price of the defaultable bond is given by PB (0, T) = u(0, x)
given in (114),
leading to the explicit formula for the yield spread
   
1 x 1− 2r
σ2


Y(0, T) = − log N (d2 (T)) − N d−
2 (T) . (117)
T B

70
 450

400

350

300

Yield spread in basis points

250

200

150

100

50

0
−1 0 1 2
10 10 10 10
Time to maturity in years

Figure 7: The figure shows the sensitivity of the yield spread curve to the
volatility level. The ratio of the initial value to the default level x/B is set
to 1.3, the interest rate r is 6% and the curves increase with the values of
σ: 10%, 11%, 12% and 13%. Time to maturity is in unit of years and
plotted on the log scale and the yield spread is quoted in basis points.

71
 450

400

350

300

Yield spread in basis points

250

200

150

100

50

0
−1 0 1 2
10 10 10 10
Time to maturity in years

Figure 8: This figure shows the sensitivity of the yield spread to

the leverage level. The volatility level is set to 10%, the interest
rate is 6%. The curves increases with the decreasing ratios x/B:
(1.3, 1.275, 1.25, 1.225, 1.2).

72
1.8 Multidimensional Stochastic Calculus
Multidimensional Itô’s Formula
We consider the generalization of the SDEs (5) to the case of
systems of such equations:
d
X
dXit = µi (t, Xt )dt + σi,j (t, Xt )dWtj , i = 1, · · · , d, (118)
j=1

where Wtj , j = 1, · · · , d, are d independent standard

Brownian motions, and

Xt = (X1t , · · · , Xd
t ),

is a d-dimensional process.
We assume that the functions µi (t, x) and σi,j (t, x) are smooth and at
most linearly growing at infinity, so that this system has a unique solution
adapted to the filtration (Ft ) generated by the Brownian motions (Wtj ).

73
We now consider real processes of the form f (t, Xt ) where the real
function f (t, x) is smooth on IR+ × IRd (for instance continuously
differentiable with respect to t, and twice continuously differentiable in
the x-variable). The d-dimensional Itô’s formula can then be
written:
d
X ∂f
∂f i
df (t, Xt ) = (t, Xt )dt + (t, X t )dX t
∂t ∂xi
i=1
d
1 X ∂2f i j
+ (t, X t )dhX , X it , (119)
2 ∂xi ∂xj
i,j=1

where
d
X
dhXi , Xj it = σik (t, Xt )σjk (t, Xt )dt
k=1

= (σσ T )i,j (t, Xt )dt, (120)

74
Cross-variation rules
dht, Wtj i = dhWtj , ti = 0,
dhWti , Wtj i = dhWtj , Wti i = 0 for i 6= j,
dhWti , Wti i = dt.
Formula (119) can then be rewritten:
 
Xd X d 2
∂f ∂f 1 ∂ f
df (t, Xt ) =  + µi i + (σσ )i,j i j  dt
T
∂t ∂x 2 ∂x ∂x
i=1 i,j=1
 
Xd d
∂f X j
+ i
σ i,j dW t , (121)
∂x
i=1 j=1

where the partial derivatives of f and the coefficients µ and σ are

evaluated at (t, Xt ).

75
Girsanov Theorem
In Section 1.4.1 we have used a change of probability measure so
that the one-dimensional process Wt⋆ = Wt + θt becomes a
standard Brownian motion under the new probability IP⋆ . We now
give a multidimensional version of this result in the case where θ
may also be a stochastic process. To simplify the presentation we
assume that the d-dimensional process (θt ) is of the form
(θj (Xt ), j = 1, · · · , d) where the functions θj (x) are bounded (see
the notes for less restrictive conditions such as Novikov condition).
Generalizing (40), we define the real process (ξtθ )0≤t≤T by:
 
Xd  Z t Z t 
1
ξtθ = exp − θj (Xs )dWsj + θj2 (Xs )ds  , (122)
0 2 0
j=i

76
 d
X
dξtθ = −ξtθ θj (Xt )dWtj .
j=1

and therefore (ξtθ ) is a martingale.

We then define, on FT , the probability IP⋆ by dIP⋆ = ξT
θ
dIP.
Girsanov Theorem states that the processes
(Wtj⋆ )0≤t≤T , j = 1, · · · , d, defined by
Z t
Wtj⋆ = Wtj + θj (Xs )ds, j = 1, · · · , d, (123)
0

are independent standard Brownian motions under IP ⋆ .

See the notes for a justification using the martingale property of (ξtθ−iu ),
and the characterization of independent standard Brownian motions by
conditional characteristic functions.

77
Feynman-Kac Formula
The infinitesimal generator of the (possibly non-homogeneous)
Markovian process X = (X 1 , · · · , X d ), introduced in (118), is given
by
d
X d
∂ 1 X ∂ 2
Lt = µi (t, x) i + (σσ T )i,j (t, x) i j .
∂x 2 ∂x ∂x
i=1 i,j=1

If r(t, x) is a function on IR+ × IRd (for instance bounded), then

the function u(t, x) defined by
 RT 
− r(s,Xs )ds
u(t, x) = IE e t h(XT ) | Xt = x ,

satisfies the PDE

∂u
+ Lt u − ru = 0,
∂t
with the terminal condition u(T, x) = h(x) (a call for instance).

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Such parabolic PDEs with an additional source are also
important, If the function g(t, x) is, for instance, bounded, then
the backward problem
∂v
+ Lt v − rv + g = 0
∂t
v(T, x) = h(x),

admits the solution

( R Z Rs )
T T
− r(s,Xs )ds − r(u,Xu )du
v(t, x) = IE e t h(XT ) + e t g(s, Xs )ds | Xt = x
t

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Two Fundamental Questions:
1. Is the Geometric Brownian motion
under IP a good model for returns?
⋆
2. Under IP does it predict prices of
traded options?
Possible generalizations: local volatility,
stochastic volatility, jumps,...

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 0.4

0.35
9 Feb, 2000

0.3 Skew

0.25

Implied Volatility

0.2

0.15 Excess kurtosis

Historical Volatility
0.1

0.05

0
0.8 0.85 0.9 0.95 1 1.05 1.1
Moneyness K/x

Figure 9: S&P 500 Implied Volatility Curve as a function of moneyness

from S&P 500 index options on February 9, 2000. The current index value
is x = 1411.71 and the options have over two months to maturity. This is
typically described as a downward sloping skew.

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