- Brownian Motion: (1) (0) = 0; (2) The graph is continuous; (3) the increment ~ 0, 0

< ; (4) two non-overlapping increments of () are independent.

!!! !

- (1) = min , ; (2) ! = ; (3) !"# ! = exp ! ;

(4) ! = 3 ! ; (5) + has the same distribution 0;
(6) = ! ! = ! = .
- Ito Formula: Let satisfies = , + , , then , satisfies
! ,
, = ! + , ! +
!! + , ! .
2
- Two- Dimensional Ito Formula: Let
= ! + !! ! + !" ! , and = ! + !" ! + !! ! , then
1 !
1 !
!
!
, , = ! + ! ! + ! ! + !!
+ !"
!! + !"
+ !!
!! + !! !" + !" !! !"
2
2
+ !! ! + !" ! ! + !" ! + !! ! ! .
- Let 0 = ! < ! < < ! = , where ! = /, then
!
!
1
1
(1) lim! !!!
= ! ! !;
= ! ! !
!!! ! !!! !
(2) lim!
- Show that
- Show that

!!!
!!!

!!!
!
!
!
!
=
!

!!! !
!

= !

= !

2
2
1 !
1
= ! + !
2
2

+!

, we let , = !

, we let , =
!

- Black-Scholes Differential Equation: ! + ! + ! ! ! !! = and = ! .

Proof: Set up a portfolio = + + . We want it to be self-financing, i.e. + + = 0.
Proof: = + + + + + = + + = + + .
!
Proof: By Ito Formula, = ! + ! + ! ! ! !! + ! = + . Because we are Proof:
approximating the option, thus = + + = 0; = .
Proof: = + + = + + + .
! !
Proof: Since is riskless, + = 0; ! ! = ! . and by no arbitrage assumption = = 0.
Proof: = + = 0 and the results follows.
! !
- For ! = !! with , 0 = , > 0; < < , = ! !!" exp ( ! /4) .
- For ! =
- For ! =

!!
!
!!

! !
exp ( ! /2 ! ) .
! ! !!"
! !
!!! !
exp !!! !
! ! !!"

!! with , 0 = , > 0; < < , =

!! with , 0 = , > 0; 0 < , =

0
where =
and 0, = 0.
< 0
- , = ! !! !!! ! ; , = !! !!! ! ! ;
=

!!

!
!
! !
! !!

; = !

!!!

0, = 0; , = !
0, = !! !!! ; , =
!"

log ! + ! !

!
!

for call

for put

Proof: (2) Let = , !"!!" to vanish and ! and make the coefficient of !! =
!!
!

!! ! +
!

!!
!

!!

! +

Proof: (1) where = ! !! ; = !!! +

!!
!

!!
!

!!!

, =
exp
2 !
! 2

Proof: (3) Note that

1

4
4 !
!
1

exp
4
4 !

exp

, 0

!!" !
!!" !

+ 2

2
+ 2

+ = !"!! !
+ = !"!! !

!!

+ = 0

; , 0 = !!" , 0 =

!"

; ! = ! + ; !" = ! ; !" = !" 1

Proof: (1) Let = log and = to constantize the coefficient.

!
!!
!!
Proof: (1) i.e. ! ! ! ! !! + = 0 with , 0 =
!
Proof: (1) !

!"

!
!

for call

for put

Proof: (3) For call,

!
exp
! ! !!"

, =

!!! !

!!" !

!! ! !

Proof: (3) where = !!

!!
!

and =

- For Dividend paying case: ! + ( )! +

then, , = !!
where ! = !
!!

!!!

- (1) !"! =

!!!
!

log ! + +

!!!

!"

!"

!! !!!

(3) !" =

> 0; !" = !!

! !

!"

!"

(7) !" = !!

!!!

!"

!!!

! !! !!! ! ! !!

!! !

(8) !! ! =

!" !!!

(9)

!!!

< 0

(Delta)
(Kappa)
(Rho)

> 0

!!!

!!!

1 !

< 0

1 !

< 0
(Vega)

> 0
!!!

!!

1 !

(7) When = 0,
(7) !" = !!

1 !

! < 0 !" = !!

! !!

!!!

!! !!!

!!

(6) !" = !" = !!

! !!

!!!

1 !

!"

!!!

!!!

!!!

! > 0 !" = !!

(5) !" = !!

!!"

; ! = ! .

!"

!"

!"

!!!

; ! ! = ! ! ! ! !!!

!!!

!!! !

!!

= and the boundary conditions are the same

! ; , = !!

! < 0; !" =

!"

(7) !" = !!

!!!

!!! !

and we get the result.

!
! ! !

!!
!

!"

(4) !" = !!
!"

!!

!!

!
exp
!"# ! !!"

!"
!" !!!
!! !!!

(2) !" =

! !!

!"! ! !!
! !!!

!! !

!!!

!"! !! !!!

!!

! !!!

1 !

!"

!!

!"! !! !!! ! ! !!
! !!!

< 0, !" = !!

!"

!"

!"

!"

; !" = !"

!!!

(Theta)

; !" = !"

1 !

!"! ! !!

! !!!

(Gamma)

= !! !

Variable

=
;

=
= ! ; =
; =
; =
Call
?

Put
?
!
!
(10) The
Black-Scholes differential equation becomes: = ! ! + .
(11) The Black-Scholes Analysis can be applied to general portfolio, i.e. we can have
!!

!!

+ ! ! + = . If it is already delta hedged, then + ! ! = and = + ! ! .

- Time-Varying of Black-Scholes Formula: The Black-Scholes Differential Equation for call option becomes
!"

+
!"

!! !

!! !

!
! !

!"

! !! ! + !" = 0, where , =

, (0 < ). Let

, = ! ! . ! = !! ! ! + ! !! ! ! ! !! ! ; ! = ! !! ! ; ! !! = ! !! !! !
!! !

with assumptions, the equation becomes ! + ! ! !! + + ! ! + ! = 0.

to vanish ! and . We choose ! + = 0; ! + = 0; where = = 0.
Thus we have =
! +

!!
!

!
!

, =

! !! = 0 with , = !

. The Black-Scholes Equation becomes

!

, =

. Also, let =

Then the equation becomes ! + ! ! !! = 0, with , =

! !

to eliminate ! .

where =

! !

Compare with the Black-Scholes Differential Equation ! + ! + ! ! ! !! = , put = 0, = 1 and thus

, = ! ! , where ! =
, =

! ! ! ! !"

where ! =

!
! !
!
!

!
!

! !"

!!!

! ! ! ! !"

log ! +

!
!

log ! + ! ; ! = ! .

! and , = !

!! !
!

; ! = !

!
!
!

! !"

! !

! !

!
!
!

! !"

- Call-Put-Parity the time varying case: , + ! ! ! ! !" = , + ! ! ! ! !" .

Proof: Let , = , , . Since , = ! ! = , so
!! !

! + ! ! !! + ! = 0 with , = . Let = . Then

! ! + = 0. So ! + = 0
and ! = 0 with = = 1. Then = !

!
!
!

! !"

, = !

!
!
!

! !"