StatisticsResearchLetters(SRL)Volume42015www.srljournal.

org
doi:10.14355/srl.2015.04.002

WhentheBlackscholesModelHitsZero?
FeranndoVadillo
DepartmentofAppliedMathematicsandStatisticsandOperationsResearch,UniversityoftheBasqueCountry
(UPV/EHU),Spain
fernando.vadillo@ehu.eus

Abstract
Inthisletterweresearchonthemeanextinctiontimewhichistheexpectedtimewhenthevalueoftheassetreachzerointhe
classicBlackSholesmodel.WeresolvethestationarybackwardKolmogorovequationandmakeadirectcomparisonbetween
ourpredictionsandthenumericalsimulationsofstochasticdifferentialequations.
Keywords
BlackscholesModel;Extinctiontime;StochasticDifferentialEquations;MonteCarlo

Introduction
ThefamousBlackSholesmodelwasthestartingpointofanewfinancialindustry,andithasbeenaveryimportant
pillarofoptionstradingsincethen.ThroughoutthisletterS(t)denotethevalueofanassetattimetthatmaytake
any nonnegative value. In the classic model for asset price behavior (see [3], and Chapters 6 and 7 of [7]), S (t)
followsageometricBrownianmotionsatisfyingalinearSDE:
dS(t)=S(t)dt+S(t)dW(t),(1)
whereandaretwononnegativeconstants,iscalledthedrift,andisthevolatilitythatquantifiestherisk.
Typical values for lie between 0.05 and 0.5, i.e., a volatility between 5% and 50%, and the drift parameter is
typicallybetween0.01and0.1.
It is possible to solve exactly (1) by means of Its formula with F(S, t) = ln(S ) (see for instance [1, 11, 8, 7]). Its
solutionis
S(t)=S(0)exp(t+W(t)),(2)
where=^2/2,anditsexpectationis
( S (t )) S (0)e Bt . (3)

Thereexisttwodifferentasymptoticbehaviors:

Therefore,accordingtothismodel,ifthevolatilityissufficientlylarge,theassetpricewilleventuallydecaytozero
with probability one, but without specifying how quickly it will do it depending on . In what follows, we are
interestedinCase(i).
LetTinf{t0:S(t)=0}betherandomvariablethatindicatestheextinctiontime,obviouslyTdependsonthe
initial population size and we denote this dependenceby TS(0), whereas the expectation time until extinction, or
mean extinctiontime, is S (0) = E(TS(0)). This mean extinctiontime satisfies the following boundary value
problem(BVP):

(4)

www.srljournal.orgStatisticsResearchLetters(SRL)Volume42015

(5)

supposingthatS(t)cannotexceedavalueM.Now,wehavealineardifferentialequationofvariablecoefficients;
afterthechangeofvariablez=lnsweobtain
(5)

with=^2/2>0,whoseexactsolutionis

orequivalenly

Nonetheless, it is evident that this last function cannot solve the boundary problem (4), because it is always
unbounded;therefore,(4)hasnosolution.Toavoidthisdifficulty,westudythetimeTatwhichS(T)= >0,i.e.,
wewillconsiderthemeanextinctiontimeforthenewstochasticvariableS(t)=S(t) .Thisvariablesatisfies

anditsmeanextinctiontime(s)=E(T)satisfies

(6)

supposing that S (t) cannot exceed a value M. We apply the change of variable z =ln( S~ + ) to this linear
differentialequationofvariablecoefficients,inordertoobtainagain(5).Inparticular,withoutloseofgenerality,
wetake =1,forwhichthesolution
(7)
solutionthattendsto(s)=ln(s+1)/||,asM,because<0and>0.
Ontheotherhand,asweannouncedintheintroduction,wehavesimulated(1)usingtheEulerMaruyamamethod
[9].Thealgorithmmaybedescribedasfollows:

StatisticsResearchLetters(SRL)Volume42015www.srljournal.org

InFigure1,wehaveplottedinblackthefunction(s)=ln(s+1)/||,for=0.01,=1.Theredcircleslocatedon
theblackcurvecorrespondtotheresultsfromAlgorithm1,executedwithtimestept=103,toleranceTol=1,
nrun=105and
S(0)=10,50,100,200,300,400.ObservethatwehavegivenToland thesamevalues,i.e.,Tol= =1,tomake
bothapproachescomparable;indeed,theirmatchingisobviousfromthefigure.

FIGURE1COMPARISONBETWEEN ( ~
s ) ln( ~
s 1) / (BLACKCURVE)VERSUSTHERESULTSFROMALGORITHM1(RED
CIRCLES).THEMATCHINGOFBOTHAPPROACHESISREMARKABLE.

Conclusions
The results obtained with both techniques are largely coincident, it is very important to underline that each
executionofAlgorithm1maytakeruntime(andithastoberepeatedagainforeachinitialvalue),whilefunction
(s)isexplicitlyknownforanypoint.
Moreover,whenstudyingarealmarketpricethevolatilityisnotconstantasassumedintheBlackScholesmodel,
butvaries.Inthisway,manyauthorshaveproposedthatthevolatilitiesshouldbemodeledbyastochasticprocess
[6]. As already commented in [4], the mean extinction time can also be computed by solving the stationary
backward Kolmogorov equations [2]. The equations are linear secondorderpartial differential equations with
variable coefficients and, therefore, it is impossible in general to find exact solutions, so we can only compute
numericalapproximations.
Ontheotherhand,recentresultsin[10]and[5]aboutconvergenceratesfortheapproximations
thesestochasticvolatilitymodels,inmyopinion,willallowtoestimateandcomparemeanextinctiontimeinthese
morecomplicatedstochasticmodels.
ACKNOWLEDGMENT

ThisworkwassupportedbyMEC(Spain),withtheprojectsMTM201453145PandbytheBasqueGovernment
withtheprojectITIT64113.
REFERENCES

[1]

E.Allen,ModelingwithItStochasticDifferentialEquations,Springer,2007.

[2]

L.J.S.Allen,AnIntroductiontoStochasticProcesseswithApplicationstoBiology,PersonPrenticeHall,2003.

[3]

F.BlackandM.Scholes,ThePrincingofOptionsandCorporateLiabilities,JournalofPoliticalyEconomy,81(1973),no.3,
637654,AccessonSeptember2012.

[4]

F. de la Hoz and F. Vadillo, A mean extinctiontime estimate for a stochastic LotkaVolterra predatorprey model,
AppliedMathematicsandComputation219,(2012),170179.

www.srljournal.orgStatisticsResearchLetters(SRL)Volume42015

[5]

S.Dereich,A.Neuenkirch,andL.Szpruch,AnEulertypeMethodfortheStrongApproximationoftheCoxIngersollRoss
Process,Proc.R.Soc.Lond.Ser.AMath.Phys.Eng.Sci.468(2012),no.2140,11051115.

[6]

J.P. Fouque, G. Papanicolaou, and R.K. Sircar, Derivatives in financial market with stochastic volatility Cambridge
UniversityPress,2000.

[7]

D.J.Higham,AnIntroductiontoFinancialOptionValuation,SIAM,2000.

[8]

F.C.Klebaner,IntroductiontoStochasticCalculuswithApplications,ImperialCollegePress,2005.

[9]

P.E.KloedenandE.Platen,NumericalSolutionofStochasticDifferentialEquations,CambridgeUniversityPress,1998.

[10] P. Kloeder and A. Neuenkirch, Convergence ofNumerical Methos for Stochastic Differential Eqautions in Mathematical
Finance. in Recent Developments in Computational Finance: Foundations, Algorithms and Applications, T. Gerstner and P.E.
Kloeden (Editors), vol. 14, Interdisciplinary Mathematical Sciences Series, Vol. 14, World Scientific Publishing Co. Inc,
Singapur,2013.
[11] B.ksendal,StochasticDifferentialEquations.AnIntroductionwithApplication.SixthEdition,Springer,2010.

10