Product of BM

Geometric Brownian Motion
Product of Geometric Brownian Motion Processes

(continued)
Consider the geometric Brownian motion process

Y (t) eX(t)
X(t) is a (, ) Brownian motion.
As Y /X = Y and 2 Y /X 2 = Y , Itos formula (51)

on p. 453 implies

dY
= + 2 /2 dt + dW.
Y
Note that
Y
Z
The annualized instantaneous rate of return is + 2 /2

not .
c
2005
Prof. Yuh-Dauh Lyuu, National Taiwan University
The product of two (or more) correlated geometric

Brownian motion processes thus remains geometric
Brownian motion.
Page 459

a b2 /2 dt + b dWY ,

= exp f g 2 /2 dt + g dWZ ,

= exp a + f b2 + g 2 /2 dt + b dWY + g dWZ .
= exp
c
2005
Page 461

Let
dY /Y
= a dt + b dWY ,
dZ/Z
= f dt + g dWZ .

(concluded)
ln U is Brownian motion with a mean equal to the sum
of the means of ln Y and ln Z.
Consider the Ito process U Y Z.

Apply Itos lemma (Theorem 18 on p. 457):
dU
Z dY + Y dZ + dY dZ
ZY (a dt + b dWY ) + Y Z(f dt + g dWZ )
This holds even if Y and Z are correlated.

Finally, ln Y and ln Z have correlation .
+Y Z(a dt + b dWY )(f dt + g dWZ )

=
U (a + f + bg) dt + U b dWY + U g dWZ .
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2005
Page 460
c
2005
Page 462
Ornstein-Uhlenbeck Process
The Ornstein-Uhlenbeck process:
Quotients of Geometric Brownian Motion Processes
dX = X dt + dW,
Suppose Y and Z are drawn from p. 460.
where , 0.
Let U Y /Z.
It is known that
We now show that
dU
= (a f + g 2 bg) dt + b dWY g dWZ .
U
E[ X(t) ]
Var[ X(t) ]
Cov[ X(s), X(t) ]
(52)
Keep in mind that dWY and dWZ have correlation .
(tt0 )
E[ x0 ],

2
2(tt0 )
2(tt0 )
1e
+e
Var[ x0 ],
2
i
2 (ts) h
e
1 e2(st0 )
2
+e(t+s2t0 ) Var[ x0 ],
for t0 s t and X(t0 ) = x0 .
c
2005
Page 463
Quotients of Geometric Brownian Motion Processes

(concluded)
X(t) is normally distributed if x0 is a constant or

normally distributed.
dU
=
=
(1/Z) dY (Y /Z ) dZ (1/Z ) dY dZ + (Y /Z ) (dZ)
(1/Z)(aY dt + bY dWY ) (Y /Z 2 )(f Z dt + gZ dWZ )

(1/Z 2 )(bgY Z dt) + (Y /Z 3 )(g 2 Z 2 dt)
U (a dt + b dWY ) U (f dt + g dWZ )
E[ x0 ] = x0 and Var[ x0 ] = 0 if x0 is a constant.

The Ornstein-Uhlenbeck process has the following mean
reversion property.
When X < 0, it is pulled toward zero again.
U (a f + g 2 bg) dt + U b dWY U g dWZ .
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2005
X is said to be a normal process.
When X > 0, X is pulled X toward zero.
U (bg dt) + U (g 2 dt)
Page 465
Ornstein-Uhlenbeck Process (continued)
The multidimensional Itos lemma (Theorem 18 on

p. 457) can be employed to show that
2
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2005
Page 464
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2005
Page 466
Interest Rate Modelsa

Ornstein-Uhlenbeck Process (continued)
Suppose the short rate r follows process

dr = (r, t) dt + (r, t) dW .
Another version:
Let P (r, t, T ) denote the price at time t of a

zero-coupon bond that pays one dollar at time T .
dX = ( X) dt + dW,
where 0.
Write its dynamics as
Given X(t0 ) = x0 , a constant, it is known that

E[ X(t) ] =
Var[ X(t) ] =
(tt0 )
+ (x0 ) e
,
i
2 h
1 e2(tt0 ) ,
2
dP
= p dt + p dW.
P
(53)
The expected instantaneous rate of return on a

(T t)-year zero-coupon bond is p .
The instantaneous variance is p2 .
for t0 t.
a Merton
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2005
Page 467
(1970).
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2005
Interest Rate Models (continued)
Ornstein-Uhlenbeck Process (concluded)
Surely P (r, T, T ) = 1 for any T .
The mean and standard deviation are roughly and
/ 2 , respectively.
By Itos lemma (Theorem 17 on p. 455),
For large t, the probability of X < 0 is extremely

unlikely in any finite time interval when > 0 is large
relative to / 2 (say > 4/ 2).
dP
=
=
The process is mean-reverting.
X tends to move toward .
Useful for modeling term structure, stock price

volatility, and stock price return.
c
2005
Page 469
Page 468
P
P
1 2P
dT +
dr +
(dr)2
T
r
2 r2
P
P
dt +
[ (r, t) dt + (r, t) dW ]
T
r
1 2P
+
[ (r, t) dt + (r, t) dW ]2
2 r2

P
P
(r, t)2 2 P
dt
+ (r, t)
+
T
r
2
r2
P
+(r, t)
dW.
r
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2005
Page 470
Interest Rate Models (concluded)

Hence,
P
P
(r, t)2 2 P
+ (r, t)
+
T
r
2
r 2
P
(r, t)
r
= P p , (54)
= P p .
I have hardly met a mathematician

who was capable of reasoning.
Plato (428 B.C.347 B.C.)
Models with the short rate as the only explanatory

variable are called short rate models.
c
2005
Page 471
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2005
Page 473
Toward the Black-Scholes Differential Equation

The price of any derivative on a non-dividend-paying
stock must satisfy a partial differential equation.
The key step is recognizing that the same random
process drives both securities.
Continuous-Time Derivatives Pricing
As their prices are perfectly correlated, we figure out the

amount of stock such that the gain from it offsets
exactly the loss from the derivative.
The removal of uncertainty forces the portfolios return
to be the riskless rate.
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2005
Page 472
c
2005
Page 474
Assumptions
Black-Scholes Differential Equation (continued)
The stock price follows dS = S dt + S dW .
The change in the value of the portfolio at time dt is
There are no dividends.
d = dC +
Trading is continuous, and short selling is allowed.

There are no transactions costs or taxes.
Substitute the formulas for dC and dS into the partial

differential equation to yield

C
1
2C
dt.
d =
2 S 2
t
2
S 2
All securities are infinitely divisible.

The term structure of riskless rates is flat at r.
There is unlimited riskless borrowing and lending.
As this equation does not involve dW , the portfolio is

riskless during dt time: d = r dt.
t is the current time, T is the expiration time, and

T t.
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Page 475
Black-Scholes Differential Equation
c
2005
Page 477
Black-Scholes Differential Equation (concluded)
Let C be the price of a derivative on S.

From Itos lemma (p. 455),

C
C
C
1 2 2 2C
dt + S
dC = S
+
+ S
dW.
S
t
2
S 2
S
The same W drives both C and S.
Short one derivative and long C/S shares of stock
(call it ).
By construction,
So
C
1
2C
+ 2 S 2
t
2
S 2

C
dt = r C S
dt.
S
Equate the terms to finally obtain

C
C
1
2C
+ rS
+ 2 S 2
= rC.
t
S
2
S 2
When there is a dividend yield q,
C
C
1
2C
+ (r q) S
+ 2 S 2
= rC.
t
S
2
S 2
= C + S(C/S).
c
2005
C
dS.
S
Page 476
c
2005
Page 478
PDEs for Asian Options (continued)
Rephrase
The Black-Scholes differential equation can be expressed
in terms of sensitivity numbers,
+ rS +
1 2 2
S = rC.
2
(55)
Identity (55) leads to an alternative way of computing

numerically from and .
When a portfolio is delta-neutral,
+
1 2 2
S = rC.
2
The two-dimensional PDE produces algorithms similar

to that on pp. 316ff.
But one-dimensional PDEs are available for Asian
options.a
For example, Vecer (2001) derives the following PDE for
Asian calls:
2

1 Tt z 2 2 u
u
t
u
+r 1 z
+
=0
t
T
z
2
z 2
with the terminal condition u(T, z) = max(z, 0).
A definite relation thus exists between and .
c
2005
a Rogers
Page 479
and Shi (1995), Ve

cer (2001), and Dubois and Leli`
evre (2005).
c
2005
Page 481
PDEs for Asian Options

Add the new variable A(t)
Rt
0
S(u) du.
PDEs for Asian Options (concluded)
Then the value V of the Asian option satisfies this

two-dimensional PDE:a
For Asian puts:

u
t
u
+r
1z
+
t
T
z
V
V
1
2V
V
+ rS
+ 2 S 2
+S
= rV.
2
t
S
2
S
A
The terminal conditions are

A
V (T, S, A) = max
X, 0
T

A
V (T, S, A) = max X , 0
T
a Kemna
t
T
1z
2
2
2 2 u
=0
z 2
with the same terminal condition.

for call,
One-dimensional PDEs lead to highly efficient numerical

methods.
for put.
and Vorst (1990).
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2005
Page 480
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2005
Page 482
Exchange Optionsa
A correlation option has value dependent on multiple
assets.
Pricing of Exchange Options
An exchange option is a correlation option.

It gives the holder the right to exchange one asset for
another.
Assume that the two underlying assets do not pay

dividends and that their prices follow
dS1
S1
dS2
S2
Its value at expiration is thus

max(S2 (T ) S1 (T ), 0),
where S1 (T ) and S2 (T ) denote the prices of the two
assets at expiration.
a Margrabe
= 1 dt + 1 dW1 ,
= 2 dt + 2 dW2 ,
where is the correlation between dW1 and dW2 .
(1978).
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Page 483
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Page 485
Pricing of Exchange Options (concluded)

The option value at time t is
Exchange Options (concluded)
V (S1 , S2 , t) = S2 N (x) S1 N (x T t),
The payoff implies two ways of looking at the option.
It is a call on asset 2 with a strike price equal to the

future price of asset 1.
It is a put on asset 1 with a strike price equal to the
future value of asset 2.
where
x
2
ln(S2 /S1 ) + ( 2 /2)(T t)
,
T t
12 21 2 + 22 .
(56)
This is called Margrabes formula.
c
2005
Page 484
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2005
Page 486
Derivation of Margrabes Formula

Observe first that V (x, y, t) is homogeneous of degree
one in x and y.
That is, V (S1 , S2 , t) = V (S1 , S2 , t).
Derivation of Margrabes Formula (continued)

The interest rate on a riskless loan denominated in asset
1 is zero in a perfect market.
An exchange option based on times the prices of

the two assets is thus equal in value to original
exchange options.
Intuitively, this is true because of
max(S2 (T ) S1 (T ), 0) = max(S2 (T ) S1 (T ), 0)
A lender of one unit of asset 1 demands one unit of

asset 1 back as repayment of principal.
The option to exchange asset 1 for asset 2 is a call on
asset 2 with a strike price equal to unity and the interest
rate equal to zero.
and the perfect market assumption.
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2005
Page 487
c
2005
Derivation of Margrabes Formula (concluded)
Derivation of Margrabes Formula (continued)

The price of asset 2 relative to asset 1 is S S2 /S1 .
p
The diffusion of dS/S is 12 21 2 + 22 by Eq. (52)
on p. 463 (proving Eq. (56) on p. 486).
Hence, the option sells for
So the Black-Scholes formula applies:

V (S1 , S2 , t)
S1
= V (1, S, t)
= SN (x) 1 e0(T t) N (x T t),
where
V (S1 , S2 , t)/S1 = V (1, S2 /S1 , t)

x
with asset 1 as the numeraire.
c
2005
Page 489
Page 488
ln(S/1) + (0 + 2 /2)(T t)
ln(S2 /S1 ) + ( 2 /2)(T t)
=
.
T t
T t
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2005
Page 490
Margrabes Formula with Dividends
Options on Foreign Currencies and Assets (concluded)
Margrabes formula is not much more complicated if Si

pays out a continuous dividend yield of qi , i = 1, 2.
So S(t) follows the geometric Brownian motion process,
Simply replace each occurrence of Si with Si eqi (T t)

to obtain
V (S1 , S2 , t)
S2 eq2 (T t) N (x)
(57)
S1 eq1 (T t) N (x T t),
x
2
dS
= (r rf ) dt + s dWs (t),
S
in a risk-neutral economy.
The foreign asset will be assumed to pay a continuous
dividend yield of qf , and its price follows
dGf
= (f qf ) dt + f dWf (t)
Gf
ln(S2 /S1 ) + (q1 q2 + 2 /2)(T t)
,
T t
12 21 2 + 22 .
in foreign currency.
is the correlation between dWs and dWf .
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Page 491
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2005
Options on Foreign Currencies and Assets
Inverse Exchange Rates
Correlation options involving foreign currencies and

assets can be analyzed either take place in the domestic
market or the foreign market before being converted
back into the domestic currency.
In the following, S(t) denotes the spot exchange rate in
terms of the domestic value of one unit of foreign
currency.
We knew from p. 305 that foreign currency is analogous
to a stock paying a continuous dividend yield equal to
the foreign riskless interest rate rf in foreign currency.
c
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Page 493
Page 492
Suppose we have to work with the inverse of the

exchange rate, Y 1/S, instead of S.
Because the option payoff is a function of Y ; or
Because the parameters for Y are quoted in the

markets but not S.
Y follows
dY
= (r rf s2 ) dt s dWs (t)
Y
by Eq. (52) on p. 463.
c
2005
Page 494
Inverse Exchange Rates (concluded)
Foreign Equity Options (concluded)
Hence the volatility of Y equals that of S.
If a simulation of S gives wildly different sample

volatilities for S and Y , you probably forgot to take
logarithms before calculating the standard deviations.
The correlation between Y and Gf equals
E[ (Y s dWs )(Gf f dWf ) ]

E[ (Y s dWs )2 ]E[ (Gf f dWf )2 ]
They will fetch SCf and SPf , respectively, in domestic

currency.
E[ dWs dWf ]
=
E[ dWs2 ]E[ dWf2 ]
These options are called foreign equity options struck in

foreign currency.
as the correlation between S and Gf is .
c
2005
Similarly, a European option on the foreign asset Gf

with the terminal payoff S(T ) max(Xf Gf (T ), 0) is
worth
Pf = Xf erf N (x + f ) Gf eqf N (x)
Page 495
c
2005
Page 497
Foreign Domestic Options

Foreign Equity Options
Foreign equity options fundamentally involve values in

the foreign currency.
From Eq. (26) on p. 255, a European option on the

foreign asset Gf with the terminal payoff
S(T ) max(Gf (T ) Xf , 0) is worth
Cf = Gf eqf N (x) Xf erf N (x f )
A foreign equity call may allow the holder to participate

in a foreign market rally.
But the profits can be wiped out if the foreign currency
depreciates against the domestic currency.
Above,
x
What is really needed is a call in domestic currency with

a payoff of max(S(T ) Gf (T ) X, 0).
ln(Gf /Xf ) + (rf qf + f2 /2)
.
f
For foreign equity options, the strike price in

domestic currency is the uncertain S(T ) Xf .
Xf is the strike price in foreign currency.
This is called a foreign domestic option.
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Page 496
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2005
Page 498
Pricing of Foreign Domestic Options
Cross-Currency Options
To foreign investors, this call is an option to exchange

X units of domestic currency (foreign currency to them)
for one share of foreign asset (domestic asset to them).
It is an exchange option, that is.
By Eq. (57) on p. 491, its price in foreign currency equals
An option to buy 100 yen at a strike price of 1.18

Canadian dollars provides one example.
X r
e
N (x ),
S
ln(Gf S/X) + (r qf + 2 /2)
Usually, a third currency, the U.S. dollar, is involved

because of the lack of relevant exchange-traded options
for the two currencies in question (yen and Canadian
dollars in the above example).
s2 + 2s f + f2 .
So the notations below will be slightly different.
Gf eqf N (x)
x
A cross-currency option is an option in which the

currency of the strike price is different from the currency
in which the underlying asset is denominated.
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Page 499
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2005
Page 501
Cross-Currency Options (continued)

Pricing of Foreign Domestic Options (concluded)
The domestic price is therefore
Both SA and SC are in U.S. dollars, say.
C = SGf eqf N (x) Xer N (x ).
If S is the price of the foreign asset as measured in

currency C, then we have the triangular arbitrage
S = SA /SC .a
Similarly, a put has a price of
P = Xer N (x + ) SGf eqf N (x).
c
2005
Let SA denote the price of the foreign asset and SC the

price of currency C that the strike price X is based on.
a Triangular
arbitrage had been known for centuries.

tesquieus The Spirit of Laws.
Page 500
c
2005
See Mon-
Page 502
Quanto Options (continued)
Cross-Currency Options (concluded)
b f in a risk-neutral economy follows

The process U SG
Assume SA and SC follow the geometric Brownian

motion processes dSA /SA = A dt + A dWA and
dSC /SC = C dt + C dWC , respectively.
dU
= (rf qf s f ) dt + f dW
U
in domestic currency.
Parameters A , C , and can be inferred from

exchange-traded options.
Hence, it can be treated as a stock paying a continuous

dividend yield of q r rf + qf + s f .
By an exercise in the text,

dS
2
= (A C + C
A C ) dt + A dWA C dWC ,
S
where is the correlation between dWA and dWC .
The volatility of dS/S is hence
2
(A
2A C +
Page 503
Quanto Options
Consider a call with a terminal payoff
Sb max(Gf (T ) Xf , 0) in domestic currency, where Sb
is a constant.
b
This amounts to fixing the exchange rate to S.
= Sb (Gf eq N (x) Xf er N (x f ))
= Sb (Xf er N (x + f ) Gf eq N (x))
where x
ln(Gf /Xf )+(rq+f2 /2)
.
f
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2005
Page 505
Quanto Options (concluded)

In general, a quanto derivative has nominal payments in
the foreign currency which are converted into the
domestic currency at a fixed exchange rate.
A cross-rate swap, for example, is like a currency swap
except that the foreign currency payments are converted
into the domestic currency at a fixed exchange rate.
For instance, a call on the Nikkei 225 futures, if it

existed, fits this framework with Sb = 5 and Gf
denoting the futures price.
Quanto derivatives form a rapidly growing segment of

international financial markets.
A guaranteed exchange rate option is called a quanto

option or simply a quanto.
c
2005
Apply Eq. (26) on p. 255 to obtain

P
2 1/2
C
) .
c
2005
(58)
Page 504
c
2005
Page 506

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Geometric Brownian Motion

Product of Geometric Brownian Motion Processes

Consider the geometric Brownian motion process

As Y /X = Y and 2 Y /X 2 = Y , Itos formula (51)

The annualized instantaneous rate of return is + 2 /2

The product of two (or more) correlated geometric

Product of Geometric Brownian Motion Processes

Product of Geometric Brownian Motion Processes

Consider the Ito process U Y Z.

ZY (a dt + b dWY ) + Y Z(f dt + g dWZ )

This holds even if Y and Z are correlated.

+Y Z(a dt + b dWY )(f dt + g dWZ )

U (a + f + bg) dt + U b dWY + U g dWZ .

Quotients of Geometric Brownian Motion Processes

Suppose Y and Z are drawn from p. 460.

We now show that

Cov[ X(s), X(t) ]

Keep in mind that dWY and dWZ have correlation .

for t0 s t and X(t0 ) = x0 .

Quotients of Geometric Brownian Motion Processes

X(t) is normally distributed if x0 is a constant or

(1/Z) dY (Y /Z ) dZ (1/Z ) dY dZ + (Y /Z ) (dZ)

(1/Z)(aY dt + bY dWY ) (Y /Z 2 )(f Z dt + gZ dWZ )

E[ x0 ] = x0 and Var[ x0 ] = 0 if x0 is a constant.

U (a f + g 2 bg) dt + U b dWY U g dWZ .

X is said to be a normal process.

When X > 0, X is pulled X toward zero.

U (bg dt) + U (g 2 dt)

Ornstein-Uhlenbeck Process (continued)

The multidimensional Itos lemma (Theorem 18 on

Interest Rate Modelsa

Suppose the short rate r follows process

Let P (r, t, T ) denote the price at time t of a

Write its dynamics as

Given X(t0 ) = x0 , a constant, it is known that

The expected instantaneous rate of return on a

Interest Rate Models (continued)

Ornstein-Uhlenbeck Process (concluded)

Surely P (r, T, T ) = 1 for any T .

The mean and standard deviation are roughly and

By Itos lemma (Theorem 17 on p. 455),

For large t, the probability of X < 0 is extremely

relative to / 2 (say > 4/ 2).

The process is mean-reverting.

X tends to move toward .

Useful for modeling term structure, stock price

Interest Rate Models (concluded)

I have hardly met a mathematician

Models with the short rate as the only explanatory

Toward the Black-Scholes Differential Equation

Continuous-Time Derivatives Pricing

As their prices are perfectly correlated, we figure out the

Black-Scholes Differential Equation (continued)

The stock price follows dS = S dt + S dW .

The change in the value of the portfolio at time dt is

There are no dividends.

Trading is continuous, and short selling is allowed.

Substitute the formulas for dC and dS into the partial

All securities are infinitely divisible.