Revisiting the Black-Scholes equation

Details Revisiting the Black-Scholes equation Revisiting the Black-Scholes equation

1998-05-10

arxiv.org/abs/cond-mat/9805115v1

Physics

Condensed Matter

Statistical Mechanics

12 pages, Revtex style

Scientific paper

In common finance literature, Black-Scholes partial differential equation of option pricing is usually derived with no-arbitrage principle. Considering an asset market, Merton applied the Hamilton-Jacobi-Bellman techniques of his continuous-time consumption-portfolio problem, deriving general equilibrium relationships among the securities in the asset market. In special case where the interest rate is constant, he rederived the Black-Scholes partial differential equation from the general equilibrium asset market. In this work, I follow Cox-Ingersoll-Ross formulation to consider an economy which includes (1) uncertain production processes, and (2) the random technology change. Assuming a random production stochastic process of constant drift and variance, and assuming a random technology change to follow a log normal process, the equilibrium point of this economy will lead to the Black-Scholes partial differential equation for option pricing.

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