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Theorem 1: Suppose Y = ln X is a normal distribution with mean m and variance v, then X has mean exp( m + v /2 ) Proof: The density function of Y= ln X
= Note that the integral inside is just the density function of a normal random variable with mean (m-v) and variance v. By definition, the integral evaluates to be 1.
is given by
If form a portfolio P
Since the portfolio has no risk, by no arbitrage, it must earn the risk free rate,
Therefore we have
To solve this PDE, we need the Feynman-Kac theorem: Assume that f is a solution to the boundary value problem:
Since the last term involves only second order terms only,
Integrating from 0 to T
Since the integral is a limiting sum of independent Brownian motions increments, i.e. =0 it is zero. Recall that W has independent and stationary increment with a zero mean, i.e. is normally distributed with zero mean. 3
End of Proof.
By the Feynman Kac Theorem, the solution to the Black Scholes PDE is given by
Where S follows
has a normal distribution with mean 0, and variance T, and variance , let g(X) be the density function of X.
Theorem 3: if ln(X) is a normal distributed random variable and the standard deviation is , then
Where
Define . Q is a standard normal random variable with mean 0 and standard deviation 1. Hence the density function of Q is given by
Since
Or
Note that the last expression is nothing more than the density function of a normal random variable with mean and variance 1, i.e.
End of Proof. Since 1, has a normal distribution with mean and variance , from theorem
Applying Theorem 3,
Final Exam question 1: Question 1 (total: 25%) Prove the Black Scholes formula a) (2%) If the price of a stock follows the SDE
b) (5%) derive the Black Scholes PDE. c) (5%) State and prove the Feynman Kac theorem. d) (5%) If Y=ln X is a normal distribution with mean m and variance v, show that the mean of X is exp(m +v/2) e) (8%) By applying the Feynman Kac theorem to the Black Scholes PDE, derive the equation you state in part a)