EUROPEAN JOURNAL OF PURE AND APPLIED MATHEMATICS

Vol. 17, No. 3, 2024, 2299-2310

ISSN 1307-5543 – ejpam.com
Published by New York Business Global

European Call Option under Stochastic Interest Rate in

a Fractional Brownian Motion with Transaction Cost
Felipe R. Sumalpong, Jr.1,∗ , Eric G. Lauron2
1
Department of Mathematics and Statistics, Faculty/Mindanao State University - Iligan
Institute of Technology, Iligan City, Philippines
2
J.H Cerilles State College - Dumingag Campus, Zamboanga del Sur, Philippines

Abstract. This paper deals on the valuation of European call option price in a stochastic environ-
ment by employing three factors which are the stochastic model of the asset value, the stochastic
interest rate and the transaction cost. We specify that our underlying asset and the stochastic in-
terest rate, particularly Hull-White model, follows a fractional Brownian Motion governed by Hurst
parameter H. We used the hedging and replicating technique to established the zero-coupon bond
on the European option. Finally, we give a closed-form formula of the European call option price.
2020 Mathematics Subject Classifications: 62P05, 97M30
Key Words and Phrases: European Call Option, Fractional Brownian Motion, Fractional Hull-
White Interest Rate Model, Transaction Cost, Hedging, Option Replication

1. Introduction

The study of option pricing can be traced back to the seminal papers of Black and
Scholes[1] and Merton[2]. The Black-Scholes-Merton(BSM) model is a known mathemat-
ical model to evaluate the price of the option that utilizes five inputs namely as: the asset
price, the strike price, the risk-free interest rates, time of expiration and the volatility.
The initial equation of the BSM model was published in 1973 on the paper “The Pricing
of Options and Corporate Liabilities” in Journal of Political Economy. By this model,
Black, Scholes and Merton received a Nobel prize in Economics in 1997.
However, there are several drawbacks of the BSM model such as the assumptions that
the interest rate and the volatility rate are constant over the period of the contract does
not fit the actual scenario of the market, transaction cost may not be avoided, and the
evolution of the asset price does not always obey a standard Brownian motion(H = 1/2)
for which Nualart[3] noted that for some stock process, the Hurst exponent H may not
∗
Corresponding author.
DOI: https://doi.org/10.29020/nybg.ejpam.v17i3.5107
Email addresses: felipejr.sumalpong@g.msuiit.edu.ph (F.Jr. Sumalpong),
eric.lauron@g.msuiit.edu.ph (E. Lauron)

https://www.ejpam.com 2299 © 2024 EJPAM All rights reserved.

F. Sumalpong, E. Lauron / Eur. J. Pure Appl. Math, 17 (3) (2024), 2299-2310 2300

be exactly 1/2 but greater than or equal to 1/2. Hence, the standard Brownian Motion
where H = 1/2 may not be a fitting stochastic process for some stock processes.
In this paper, we assumed that both the asset value and the interest rate follows the
fractional Brownian Motion. We specify that the asset value X(t) follows

dX(t) = r(t)X(t)dt + σX X(t)dB1H (t) (1)

and the interest rate r(t) follows the fractional Hull-White model

dr(t) = [θ(t) − ar(t)]dt + σr dB2H (t) (2)

where σX is the volatility of the asset price, σr is the volatility of the interest rate, and
B H is a fractional Brownian motion with Hurst parameter H.
With the transaction cost
Cost = cX(t)|v(t)| (3)
where c is a fixed proportion of the trading amount for the asset agreed between both
parties, and v(t) is the number of assets sold or bought, we formulate a European option
price model on par with the BSM model.
For simplicity, we assumed that the volatilities for both the asset price and the interest
rate are constant, no dividend and coupon payments, and we limit our analysis to European
options only.

2. Model Formulation

This section presents our assumptions for the computations of the option price. The
following assumptions are made:

1. Asset Price Model

The asset price X(t) follows a fractional Brownian motion given by

dX(t) = r(t)X(t)dt + σX X(t)dB1H (t) (4)

where r(t) is the total expected rate of return, σX is the volatility of the price and
B1H (t) is a fractional Brownian Motion with Hurst parameter H.

2. Interest Rate model

The risk-free interest rate r(t) follows a fractional Hull-White model given by

dr(t) = [θ(t) − ar(t)]dt + σr dB2H (t) (5)

where θ(t) is a deterministic function of time, a is constant, σr is the volatility of the

interest rate which is assumed to be constant and B2H (t) is a fractional Brownian
Motion with Hurst parameter H.
Under the fractional Brownian motion, the correlation coefficient between B1H (t)
F. Sumalpong, E. Lauron / Eur. J. Pure Appl. Math, 17 (3) (2024), 2299-2310 2301

and B2H (t) for t ≥ 0 is given by

Cov(B1H (t), B2H (t)) = ρ(dt)2H . (6)

Moreover, the following properties are applied to the fractional Brownian Motion:

E[dB H (t)] = 0, (7)

E[dtdB H (t)] = 0, (8)
E[dB1H (t)dB2H (t)] = ρdt 2H
, (9)
E[(dB (t)) ] = (dt)2H ,
H 2
(10)
2
E[(dt) ] = 0. (11)

Lemma 1. The zero-coupon bond model with the terminal condition P (r, t; T ) = 1
can derive the following formula

P (r, t; T ) = e−rB(t,T )−A(t,T ) , (12)

with
1h i
B(t, T ) = 1 − e−a(T −t)
a
Z T Z T 
1 2H 2 2
A(t, T ) = − θ(u)B(u, T )du + dt σr B (u, T )du
t 2 t

where σr is the volatility of the interest rate, θ(t) is a deterministic function of time,
and a is a constant assumed to be nonzero.

3. Transaction cost
Transaction cost is a fixed proportion c, depending on the individual investor, of the
trading amount for the asset. We have

Cost = cX(t)|v(t)|

where v(t) is the number of shares of the sold or bought at the price Xt . Specifically,
v(t) > 0 indicates a bought share while v(t) < 0 indicates a sold shares.

4. Portfolio
The portfolio is revised at time dt, where dt is a small time step from t to t + dt.

5. Expected return of the portfolio

The expected return of the portfolio Π(t) satisfies the equality

E[dΠ(t)] = r(t)Π(t)dt (13)

where r(t) is the interest rate.

F. Sumalpong, E. Lauron / Eur. J. Pure Appl. Math, 17 (3) (2024), 2299-2310 2302

From these assumptions, we can now begin to price the zero-coupon bond of the fractional
Hull-White which we will use to come up an option price.
Theorem 1. Under the fractional Hull-White Interest Rate Model, the zero-coupon bond
price P (r(t), t; T ) obeys the following equation:

∂P ∂P 1 ∂2P
+ [θ(t) − ar(t) − ψσr ] + (σr )2 (dt)2H−1 − rP = 0.
∂t ∂r 2 ∂r2
where r(t) is the interest rate under Hull-White model, θ(t) is a deterministic function
of time, a is constant, ψ is the market price of the risk with volatility σ and σr is the
volatility of the interest rate which is assumed to be constant.
Proof : The equation can be attained by constructing a deterministic hedged portfolio that
employs two coupon bonds P1 (t), P2 (t), that is,

Π(t) = P1 (t) − ∆P2 (t) (14)

with different maturity T1 and T2 respectively. We long one share of bond P1 (t) and short
∆ shares of P2 (t). Taking the derivative of Equation (14), we have

dΠ(t) = dP1 (t) − ∆dP2 (t). (15)

Applying Ito’s Lemma to the price function P (r(t), t; T ), the right-hand side of the equality
in Equation 15 becomes,

∂P1 ∂P1 1 ∂ 2 P1
dt + [θ(t) − ar(t)] dt + [θ(t) − ar(t)]2 (dt)2
∂t ∂r 2 ∂r2
∂P1 H ∂P1 H
+2[θ(t) − ar(t)]σr dtdB2H + (σr )2 (dB2H )2 + σr


dB2 − ∆σr dB2
∂r ∂r
1 ∂ 2 P2
 
∂P2 ∂P2
−∆ dt + [θ(t) − ar(t)] dt + [θ(t) − ar(t)]2 (dt)2
∂t ∂r 2 ∂r2

H 2 H 2
+ 2[θ(t) − ar(t)]σr dtdB2 + (σr ) (dB2 )

To eliminate the risk, take

∂P1 ∂P2
∆= / , (16)
∂r ∂r
∂P2
such that ∂r ̸= 0. Thus,

∂P1 ∂P1
dt + [θ(t) − ar(t)] dt + [θ(t) − ar(t)]2 (dt)2
∂t ∂r
∂ 2 P1 H
2
2 1 ∂ P1
+ [θ(t) − ar(t)]σr 2
dtdB 2 + (σ r ) 2
(dB2H )2
  ∂r 2 ∂r  
∂P1 ∂P2 ∂P2 ∂P2 ∂P1 ∂P2
− / dt − [θ(t) − ar(t)] / dt
∂r ∂r ∂t ∂r ∂r ∂r
F. Sumalpong, E. Lauron / Eur. J. Pure Appl. Math, 17 (3) (2024), 2299-2310 2303

1 ∂ 2 P2
 
∂P1 ∂P2
− / [θ(t) − ar(t)]2 (dt)2
2 ∂r2 ∂r ∂r
∂ 2 P2 ∂P1 ∂P2
 
− [θ(t) − ar(t)]σr / dtdB2H
∂r2 ∂r ∂r
2
 
2 1 ∂ P2 ∂P1 ∂P2
− (σr ) / (dB2H )2 .
2 ∂r2 ∂r ∂r

By non-arbitrage principle,

∂P1 ∂P1 1 ∂ 2 P1
+ [θ(t) − ar(t)] + (σr )2 2
(dt)2H−1 − rP1 (t)
∂t ∂r 2 ∂r
2
 
∂P1 ∂P2 ∂P2 ∂P2 2 1 ∂ P2 2H−1
= / + [θ(t) − ar(t)] + (σr ) (dt) − rP2 (t) .
∂r ∂r ∂t ∂r 2 ∂r2

This is one equation in two unknowns. However, the left-hand side is a function of T1
and the right-hand side is a function of T2 . The only way for this equality to be possible
is for both side to be independent of the maturity date. Thus dropping the subscripts of
P and introducing the market price of the risk ψ, we have
∂P 2
∂t + [θ(t) − ar(t)] ∂P 21 ∂ P
∂r + (σr ) 2 ∂r2 (dt)
2H−1 − rP (t)

∂P
= ψσr .
∂r

Simplifying this, the equation in the theorem can be arrived.

Theorem 2. If the number of assets traded during the time interval [t, dt] is v, then

r 2
∂2V

2
E[|v|] = (dt)H 2
σX X 2 (t)
π ∂X 2
2 !1
2
∂2V ∂2V ∂2V

+ σr2 + 2ρσX σr X(t)
∂r∂X ∂X 2 ∂r∂X

where V (t) is the option price, X(t) is the market price of the asset at time t, r(t) is
the interest rate that follows the fractional Hull-White model with Hurst parameter H,
σX is the volatility of the asset price, σr is the volatility of the interest rate and ρ is the
correlation coefficient between the interest rate and the asset price.

Proof : Suppose v is the number of asset traded during the time interval [t, dt]. At the
short time t, the number of assets hold is given by
∂V
∆1 = (X, r, t). (17)
∂X
F. Sumalpong, E. Lauron / Eur. J. Pure Appl. Math, 17 (3) (2024), 2299-2310 2304

After the time step dt, the number of assets held is

∂V
∆t+dt = (X + dt, r + dt, t + dt). (18)
∂X
Since the time step dt is assumed to be so small, we have

dX ≃ σX X(t)dB1H (t) (19)

and
dr ≃ σr dB2H . (20)
The number of assets traded v during the time interval [t, t + dt] given by

∂2V H ∂2V
v= σX X(t)dB1 (t) + σr dB2H (t) (21)
∂X 2 ∂r∂X
with mean
E[v] = 0, (22)
and variance
2 2
∂2V ∂2V
 
2 2
E[v ] = σX X 2 (t)(dt)2H + σr2 (dt)2H
∂X 2 ∂r∂X
∂2V ∂2V
+ 2ρσX σr X(t) (dt)2H .
∂X 2 ∂r∂X
If we let the variance of v to be β 2 , then we have E[v 2 ] = β 2 . Since v is normally
distributed, the probability density function of v is given as
2
1 −(v)
f (v) = √ e 2β2 . (23)
β 2π
Hence, we have
Z +∞
E[|v|] = |v|f (v)dv
−∞
Z +∞ 2
1 −(v)
= |v| √ e 2β2 dv
−∞ β 2π
−(v)2 −β 2 du
By letting u = 2β 2
, we have dv = v . Substituting we have
r " 2
2 ∂2V
E[|v|] = (dt)H × 2
σX X 2 (t)
π ∂X 2
F. Sumalpong, E. Lauron / Eur. J. Pure Appl. Math, 17 (3) (2024), 2299-2310 2305
2 #
∂2V ∂2V ∂2V

+ σr2 + 2ρσX σr X(t) .
∂r∂X ∂X 2 ∂r∂X

Theorem 3. Using the Hull-White Interest rate model and with transaction cost in a
fractional Brownian Motion, the value of the option is modeled as:

∂V 1 ∂2V 2 2 2H−1 1 ∂2V 2 ∂V

+ 2
σ X (X(t)) (dt) + 2
σr (dt)2H−1 + rX(t)
∂t 2 ∂X 2 ∂r ∂X
∂2V ∂V
+ σr σX X(t)ρ(t)(dt)2H−1 + [θ(t) − ar(t) − ψσr ]
∂X∂r " ∂r
r  2 2  2 2
2 H ∂ V 2 2 ∂ V
− rV (t) + cX(t) (dt) × 2
σX X (t) + σr2
π ∂X ∂r∂X
1
∂2V ∂2V 2
+2ρσX σr X(t) = 0.
∂X 2 ∂r∂X

where V (t) is the option price, X(t) is the market value of the asset at time t, r(t) is the
interest rate, σX is the volatility of the asset, σr is the volatility of the interest rate, c is
fixed proportion of the trading amount for the asset agreed by both parties, and H is the
Hurst parameter.

Proof : Let V (t) = V (t, X(t), r(t)) be the option price. Define the portfolio

Π(t) = V (t) − ∆1 X(t) − ∆2 P (t)

where ∆1 , ∆2 are the respective shares of the asset price X(t) and the zero-coupon bond
P (t).
The value of the change of portfolio at time [t, t + dt] with transaction cost is now

dΠ(t) = V (t) − ∆1 dX(t) − ∆2 dP (t) + c|v(t)|X(t).

Taking the expectation we have

E[dΠ(t)] = E [V (t)] − E [∆1 dX(t)] − E [∆2 dP (t)] + cX(t)E [|v(t)|] .

By non-arbitrage principle,

E [V (t)] − E [∆1 dX(t)] − E [∆2 dP (t)] − rV (t)dt + ∆1 rX(t)dt

+ ∆2 rP (t)dt + cX(t)E [|v(t)|] = 0

To eliminate the risk, take

∂V
∆1 = (24)
∂X
F. Sumalpong, E. Lauron / Eur. J. Pure Appl. Math, 17 (3) (2024), 2299-2310 2306

and
∂V ∂P
∆2 = / . (25)
∂r ∂r
Hence,

∂V 1 ∂2V 2 2 2H−1 1 ∂2V 2 ∂V

+ 2
σ X (X(t)) (dt) + 2
σr (dt)2H−1 + rX(t)
∂t 2 ∂X 2 ∂r ∂X
∂2V ∂V
+ σr σX X(t)ρ(t)(dt)2H−1 + [θ(t) − ar(t) − ψσr ]
∂X∂r ∂r
− rV (t) + cX(t)E [|v(t)|] = 0.

Employing the transaction cost, we have can derived the equation in the theorem.

3. The Model

Theorem 4. Based on the price model in Theorem 3 under a fractional Brownian motion,
the closed form formula for the European call option price is given by

VC (X, r, t) = XN (d1 ) − KP (r, t, T )N (d2 ) (26)

where

d1 = d2 + M
X
ln KP (r,t;T ) −M
d2 =
N
ˆ
σ = σX + σ22 B 2 + 2ρσX σ2 B
2 2

1 ∂P
B=
Pv∂r
u Z T" r #
1 2
(ds)2H−1 σˆ2 + c(ds)H−1
u
M = t2 σ̃ ds
t 2 π
v
u Z T" r #
u 1 2
N = t2 (ds)2H−1 σ̃ 2 + c(ds)H−1 σ̃ ds
t 2 π

Proof : Theorem 3 can be solved by the transformation of independent variables

X
y= (27)
P (r, t; T )

and a new unknown function denoted as

V (X, r, t)
V̂ (y, t) = . (28)
P (r, t; T )
F. Sumalpong, E. Lauron / Eur. J. Pure Appl. Math, 17 (3) (2024), 2299-2310 2307

We have the following computations,

∂V ∂P ∂ V̂ ∂P ∂ V̂
= V̂ +P −y ,
∂t ∂t ∂t ∂t ∂y
∂V ∂P ∂P ∂ V̂
= V̂ −y ,
∂r ∂r ∂r ∂r
∂V ∂ V̂
= ,
∂X ∂y
2
∂2V ∂2P ∂ V̂ ∂ 2 P 2

2 ∂ V̂ 1 ∂P
= V̂ − y − y ,
∂r2 ∂r2 ∂y ∂r2 ∂y 2 P ∂r
∂2V ∂ 2 V̂ 1 ∂P
= −y 2 ,
∂r∂X ∂y P ∂r
∂2V 1 ∂ 2 V̂
2
= .
∂X P ∂y 2
Substituting these equations gives,
" #" 2 #
2 V̂

∂ V̂ 1 2 ∂ 1 ∂P 2 ∂P
+ y (dt)2H−1 2 σX2
+ 2 (σr )2 − σr σX ρ(t)
∂t 2 ∂y P ∂r P ∂r
"
1 ∂P 2 2
r
2 V̂
 
2 2 H−1 ∂ 2
+ cy (dt) × σX + 2 σr
π ∂y 2 P ∂r
  1/2
1 ∂P
−2ρσX σr =0
P ∂r

Taking another transformation by letting

z = ln y.

Hence we have,
∂ V̂ ∂ V̂ 1
= (29)
∂y ∂z y
and
 2 !
∂ 2 V̂ 1 ∂ 2 V̂ ∂ V̂
= − .
∂y 2 y ∂z 2 ∂z

Furthermore, let B = P1 ∂P 2 2 2 2
∂r and σ̃ = σX + σr B + 2ρσX σr B.
Therefore, we have
" r # !
∂ V̂ 1 2H−1 2 H−1 2 ∂ 2 V̂ ∂ V̂
+ (dt) σ̃ + c(dt) × − =0
∂t 2 π ∂z 2 ∂z
F. Sumalpong, E. Lauron / Eur. J. Pure Appl. Math, 17 (3) (2024), 2299-2310 2308

Finally we take the following transformation. Let V̂ (z, t) = µ(η, τ ), where η = z + α(t)
and τ = γ(t). At the expiry date T of the contract, α(T ) = γ(t) = 0. So we have the
following calculations,
∂ V̂ ∂µ ′ ∂µ ′
= α (t) + γ (t) (30)
∂t ∂η ∂τ
and
∂ V̂ ∂µ
= , (31)
∂z ∂η
∂ 2 V̂ ∂2µ
= . (32)
∂z 2 ∂η 2
We let
1
α′ (t) = (dt)2H−1 σ̃ 2 + c(dt)H−1 (2/π)σ̃
p
2
and  
′ 1 2H−1 2 H−1
p
γ (t) = − (dt) σ̃ + c(dt) (2/π)σ̃ .
2
Substituting these, we have
 2 
∂µ ′ ∂µ ′ ′ ∂ µ ∂µ
α (t) + (−α (t)) + α (t) − = 0.
∂η ∂τ ∂η 2 ∂η

Hence, this can be reduced further to

∂µ ∂ 2 µ
− 2 =0 (33)
∂τ ∂η
with the initial condition
µ(η, T ) = (eη − K)+ . (34)
The solution for this equation is
Z +∞
1 2 /4τ
µ(η, τ ) = √ µ0 (ξ)e−(η−ξ) dξ (35)
2 πτ −∞

Now for eξ − K ≥ 0,
ξ ≥ ln K. (36)
Hence, the integration domain can be equivalently [−∞, ln K]. Hence, we can write the
solution as
Z +∞
1 2
µ(η, τ ) = √ (eξ − K)e−(η−ξ) /4τ dξ
2 πτ ln K
Z +∞ Z +∞
1 ξ −(η−ξ)2 /4τ 1 2
= √ e e dξ − √ Ke−(η−ξ) /4τ dξ
2 πτ ln K 2 πτ ln K
F. Sumalpong, E. Lauron / Eur. J. Pure Appl. Math, 17 (3) (2024), 2299-2310 2309
√
Let ξ = η + 2τ ω, then we can have
ξ−η
ω= √ (37)
2τ
and √
dξ = 2τ dω. (38)
Therefore,
Z η−ln
√K+2τ Z η−ln
√ K
1 2τ
− ζ2
2
1 2τ 2 /2
µ(η, τ ) = √ eη+τ e dζ − √ K e−ω dω.
2π −∞ 2π −∞

This can be written as

µ(η, τ ) = eη+τ N (d1 ) − KN (d2 ) (39)
where
η − ln K + 2τ
d1 = √ (40)
2τ
η − ln K
d2 = √ (41)
2τ
and Z d1
1 −1 2
ζ
N (d1 ) = √ e 2 dζ (42)
2π −∞
Z d2
1 −1 2
ω
N (d2 ) = √ e 2 dω. (43)
2π −∞
By inverse change of variables, the formula in the theorem can be derived.

Corollary 5. Without the transaction cost and under a fractional Brownian motion, the
closed form formula for the European call option price VC (X, r, t) is given by

VC (X, r, t) = X(t)N (d1 ) − KP (r, t, T )N (d2 ) (44)

where
s
Z T
d1 = d2 + σ̃ 2 (ds)2H ,
t
X 1 2 T 2H
R
ln KP (r,t;T ) − 2 σ̃ t (ds)
d2 = q R ,
T
σ̃ 2 t (ds)2H
σ˜2 = σX
2
+ σ22 B 2 + 2ρσX σ2 B,
1 ∂P
B= ,
P ∂r
REFERENCES 2310
Z d
1 −1 2
y
N (d) = √ e 2 dy.
2π −∞

4. Conclusion and Recommendations

This paper presents an extension of the BSM model for European call option introduced
by Black, Scholes and Merton by considering a stochastic rate under a fractional Brownian
Motion instead of a constant rate and adding a transaction cost. A closed-form formula for
European call option is derived under risk-neutral measure using replication techniques.
Also, the fractional Brownian motion employs the flexible dependence of the increments
of the evolution of the prices making it more closer to the real world scenario. For further
studies, a similar formula can be derived also that employs stochastic volatilities for both
asset value and interest rate. Moreover, this pricing can be extended further by considering
geometric fractional Brownian Motion.

References

[1] F Black and M Scholes. The pricing of options and corporate liabilities. Journal of
Political Economy, 81:637–654, 1973.

[2] R Merton. Theory of rational option pricing. Journal of Economics and Management
Science, 4:141–183, 1973.

[3] D Nualart. Fractional brownian motion: stochastic calculus and applications. European
Mathematical Society, 3:141–162, 2006.