How to Derive Black-Scholes Equation Correctly?

Peter P. Carr1

Banc of America Securities

9 West 57th Street, 40th Floor

New York, NY 10019

and

Akash Bandyopadhyay2

Loomis Laboratory of Physics

University of Illinois at Urbana-Champaign

1110 West Green Street

Urbana, IL 61801

Abstract

This paper points out the mathematical deficiencies in the derivation of the Black-

Scholes partial differential equation as found in many MBA level textbooks. In addition to

correcting the analysis, we present a financial justification for Black and Scholes original

hedging arguments.

1
E.Mail: pcarr@bofasecurities.com, (212) 583-8529 (Voice), (212) 583-8569 (FAX)
2
E.Mail: akash@physics.uiuc.edu, (217) 332-2465 (Voice), (217) 333-9819 (FAX)

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I. Introduction

The Black-Scholes-Merton [1,2] analysis is the central tool for pricing and hedging

options and other derivative securities. Many option pricing textbooks aimed at MBA's

derive the Black-Scholes partial differential equation (pde) in a mathematically

inconsistent manner [3,4,5,6]. The mathematically correct evaluation of the total

derivative of their hedged portfolio renders the portfolio neither riskless nor self-financing.

Such inconsistencies make it difficult for mathematically inclined newcomers to

appreciate the derivation of the central tenet of derivative pricing theory.

There are now many good derivations of the Black-Scholes equation [7,8,9].

While mathematically rigorous, these derivations generally do not focus on explaining the

financial insights behind the great success of Black-Scholes-Merton theory. The purpose

of this paper is three-fold. First, to re-construct Black-Scholes analysis in a

mathematically sound fashion from Merton’s self-financing portfolio. It is done in the

next section. Second, in section III, we pinpoint the mathematical and financial problems

in the original derivation which is blindly repeated with meaningless or no arguments in

several textbooks. Third, in section IV, we present a financial justification for Black and

Scholes original hedging technique. We believe that Black and Scholes original thoughts

were more on financial perspectives of option valuation than on precise mathematical

analysis of portfolios.

II. Mathematical Foundation to Black-Scholes Analysis

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 The existence of self-financing continuous trading strategy, and the existence of

an unique riskfree interest rate in the market are the two fundamental building blocks of

the Black-Scholes-Merton analysis. Uniqueness of riskfree interest rate is a consequence

of the absence of arbitrage opportunity in the market. It states that all riskless assets obey

the same deterministic price process. Any riskfree portfolio can be replicated by the

riskless asset under this condition. To quantify the ideas, let us assume the standard

continuous time price processes for a risky asset S t (stock), its dividend Dt , and the

riskfree asset Bt (zero coupon bond):

[ ]
dS t = µ ( S t , t ) − δ( S t , t ) St dt + σ ( St , t )St dWt , S 0 > 0, µ > 0, t ≥ 0; (2.1a)

dDt = δ( S t , t )S t dt, D0 ≥ 0, δ ≥ 0, t ≥ 0; (2.1b)

dBt = r ( Bt , t )Bt dt , B0 ≥ 0, r ≥ 0, t ≥ 0; (2.1c)

where µ ( St , t ) and σ ( St , t ) are the expected rate of return and volatility respectively. The

unique riskfree interest rate is r ( B t , t ) , and δ( St , t ) is the dividend yield on the stock. Wt

is a Wiener process. We assume that the time t value of a path-independent derivative

security Vt is a C 2 ,1 ( ℜ + × [0, T ]) function V ( S t , t ) . Its payoff is given by a continuous

deterministic terminal boundary condition:

V ( S T , T ) = g( S T ), ST ∈ ℜ + , T > 0. (2.2)

Consider the value of a self-financing portfolio Π t at time t ∈ [0, T ] consisting of

α t ≠ 0 derivative securities, ∆ t shares of stock and β t bonds:

Π t = α tVt + ∆ t St + β t Bt , Π 0 ≥ 0, t ∈ [0, T ]; (2.3a)

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 t t t t
Πt = Π0+ ∫α u dVu + ∫ ∆ u dS u + ∫∆ u dDu + ∫β u dBu , Π 0 ≥ 0, t ∈ [0, T ]. (2.3b)
0 0 0 0

The differential form of the self-financing condition (2.3b) sets a constraint on the trading

strategy ( α t , ∆ t , β t ) :

dα t (V t + dVt ) + d∆ t ( St + dS t ) + dβ t ( Bt + dB t ) = ∆ t dDt , t ∈ [0, T ]. (2.4)

It allows the following formula for the dynamics of this self-financing portfolio:

dΠ t = α t dVt + ∆ t ( dSt + δS t dt) + β t dB t , t ∈ [0, T ]. (2.5)

It is crucial to realize that eqn. (2.5) cannot be obtained without the self-financing

condition (2.4).

Applying It⊥ ’s lemma to Vt = V ( St , t ) and setting the hedge ratio

∆t ∂V
= − ∀ t ∈ [0, T ] we find:
αt ∂S t

 ∂V 1 2 ∂ V
2
∂V 
dΠ t =  α t + α tσ 2 St − α t δS t + β t rB t  dt , t ∈ [0, T ]. (2.6)
 ∂t 2 ∂ St
2
∂ St 

Uniqueness of riskfree interest rate means that this riskless portfolio can be replicated by a

bond position. Therefore:

dΠ t = rΠ t dt, Π 0 ≥ 0, t ∈ [0, T ]. (2.7)

Equating the last two equations we obtain the Black-Scholes pde:

∂V 1 2 2 ∂ 2V ∂V
+ σ St + ( r − δ)St − rV = 0, St ∈ ℜ + , t ∈ [0, T ]. (2.8)
∂t 2 ∂S t
2
∂S t

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 It is important to notice that the self-financing condition and the hedge ratio set

two constraints on the trading strategy ( α t , ∆ t , β t ) ∀ t ∈ [0, T ]. Therefore only one

portfolio weight can be chosen arbitrarily. Once a portfolio weight is fixed for its life, the

other two weights are uniquely determined from the hedge ratio, self-financing condition

(2.4), initial value of the portfolio Π 0 , and the terminal boundary condition on the

derivative security (2.2). Since dynamic trading strategies in derivatives are expansive in

practice, without any loss of generality we set α t = − 1 ∀ t ∈ [0, T ] in the subsequent

analysis.

The standard hedging argument given in Black and Scholes paper [1], and in many

MBA level textbooks [3,4,5,6] over-constrain the portfolio by fixing two portfolio weights

for its life. In the next section we will see that this is the root of the inconsistencies in the

traditional analysis [7]. In section IV, we discuss a method to circumvent this problem.

III. Problems in Black-Scholes Analysis

The hedging argument given in Black and Scholes paper [1] fixed the number of

shares of stock held at one and varied the number of call options written. Since dynamic

trading strategies in options are expensive in practice, the usual textbook derivation

instead fixes the number of options written at one and then varies the number of shares of

stock held long. Both derivations assume that there is no riskfree asset in the portfolio for

its life. Without loss of generality, let us focus on the textbook derivation. Thus, consider

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the value of a portfolio at t ≥ 0 consisting of one written derivative security Vt and ∆ t

shares of dividend-free stock held long:

Ht = − Vt + ∆ t S t , t ∈ [0, T ]. (3.1)

Following the Black-Scholes derivation, textbooks generally offer that the total derivative

of the portfolio is given by:

dHt = − dVt + ∆ t dS t , t ∈ [0, T ]. (3.2)

∂V
Applying It⊥ ’s lemma, and blindly substituting the hedge ratio ∆ t = ∀ t ∈ [0, T ]
∂S t

yields:

 ∂V 1 2 2 ∂2V 
dH t =  − − σ St  dt , t ∈ [0, T ]. (3.3)
 ∂t 2 ∂S t 
2

It thus appears that the differential change in value of this portfolio is deterministic and

therefore riskless, and hence it is claimed that from the absence of arbitrage:

dH t = rHt dt , H0 ≥ 0, t ≥ 0. (3.4)

Setting expressions (3.3) and (3.4) equal to each other yields the Black-Scholes pde (2.8)

at δ = 0 . This analysis suffers from two major drawbacks. It is a great favor of luck that

the following two inconsistencies exactly cancel each other, and thereby one gets the right

partial differential equation for the valuation of derivative securities [10].

Mathematical Problem : The total derivative of the portfolio was computed in a

meaningless manner. While:

d ( ∆ t S t ) = d∆ t S t + ∆ t dS t + d∆ t dS t ∀ t ∈ [0, T ]; (3.5)

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this analysis assumes:

d ( ∆ t S t ) = ∆ t dS t ∀ t ∈ [0, T ]; (3.6)

which, in fact, demands ∆ t = constant ∀ t ∈ [0, T ] -- a direct contradiction to the

∂V
definition of hedge ratio as ∆ t = ∀ t ∈ [0, T ]. The portfolio was constructed by
∂S t

helding two portfolio weights constant for its life, namely α t = − 1 and β t = 0

∀ t ∈ [0, T ]. Since ∆ t is not a constant, it violates the self-financing condition (2.4).

Therefore, the traditional hedge portfolio is in fact a non-self-financing position.

Financial Problem : Riskfree price process (2.1c) has been applied to a portfolio whose

strictly correct differential change in value is not deterministic. Since ∆ t randomly

changes with time, the traditional hedge portfolio is a risky position.

The derivation becomes much worse for dividend paying stocks where the text

books usually offer dH t = − dVt + ∆ t ( dSt + dDt ), t ∈ [0, T ] from eqn. (3.1). In the next

section we discuss a method to circumvent these problems.

IV. Financial Foundation to Black-Scholes Analysis

The proof given in the Back-Scholes paper [1] can be made strictly correct simply

by replacing the mathematical operation of taking a total derivative with the financial

operation of computing the “gain” on a portfolio. We believe that Black and Scholes did

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not wanted to compute the total derivative of the hedged portfolio consisting options and

stock. Instead, they were interested in the financial gain on the hedged portfolio.

Consider the value of a portfolio H t at time t consisting of one written derivative

security and ∆ t shares of stock held long:

Ht = − Vt + ∆ t S t , t ∈ [0, T ]. (4.1)

We define the financial gain on the portfolio H t at time t as:

t t
g( H t ) = ∫− dVu + ∫∆ ( dS u u + δSu du) ∀ t ∈ [0, T ]. (4.2)
0 0

Applying It⊥ ’s lemma on Vu = V ( S u , u) , and hedging the portfolio by setting

∂V
∆u = ∀ u ∈ [0, t ] yields:
∂S u

t
 ∂V 1 2 2 ∂ 2V ∂V 
g( H t ) = ∫ − ∂u − 2 σ Su ∂S 2 + δSu ∂Su du ∀ t ∈ [0, T ]. (4.3)
0  u 

Since this financial gain is deterministic for all time t ∈ [0, T ], absence of arbitrage

requires that it be the same as the interest gain on a dynamic position Bt = B ( S t , t ) in the

riskless asset chosen so as to finance all trades in the derivative and the stock:

t
 ∂V 
g( Bt ) = ∫r − V + Su  du ∀ t ∈ [0, T ]. (4.4)
∂S u 
u
0

Equating the financial gains (4.3) and (4.4) then leads to the Black-Scholes pde (2.9).

Given the non-self-financing portfolio H t , we can always construct the following

self-financing riskless portfolio:

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 Π t = α t H t , α t ≠ 0 ∀ t ∈ [0, T ]; (4.5a)

− dα t ( Vt + dVt ) + d ( α t ∆ t )( S t + dSt ) = α t ∆ t dDt , t ∈ [0, T ]; (4.5b)

dΠ t = rΠ t dt, t ∈ [0, T ]. (4.5c)

Thus, financial gain on H t is a self-financing trading strategy on a multiplicative portfolio.

This idea of financial gain justifies the original hedging argument proposed by

Black and Scholes [1] and reproduced in many textbooks [3,4,5,6]. Equations (4.5a,b,c)

illustrates that Black-Scholes portfolio can be dynamically modified to a self-financing

strategy, which provides a solid foundation to the long debated analysis.

It is worth noting that the portfolio consisting of the option and stock is not self-

financing. Similarly, positions in the riskless asset are not self-financing. Nonetheless, by

showing that the trading gains between two non-self-financing strategies are always equal

under no arbitrage, the value of the derivative security can be determined.

V. Conclusion

We discussed several financial and mathematical issues for basic option pricing

theory in continuous time. These fundamental points are often overlooked in MBA level

treatments. Our analysis provides a rigorous foundation to Black and Scholes original

hedging arguments from the perspective of financial gain on an arbitrary portfolio.

More than twenty five years has passed since Black, Scholes, and Merton

developed the present theoretical framework of option valuation. At present, the

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derivatives business has become a more than US$15 trillion market. Unfortunately, many

subtle issues at the theoretical foundation of option valuation are still not well-explained

clearly in standard business school literature. We believe that this paper will provide some

insight on the deep question, “Why does the Black-Scholes-Merton analysis work?”

ACKNOWLEDGMENT

Akash would like to thank Prof. Yoshi Oono for his tremendous support. His

work is supported by National Science Foundation grant NSF-DMR99-70690.

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