Past exam of the mathematics course of the University of Cambridge / 2001 / iii / Paper 22 / 4

Assume $f\in C^{1,2}$ on positive prices before maturity and the usual local trading integrability. If its value is held in stock units ${\delta }_t$ and bank units ${\beta }_t$, thenfor a self-financing portfolio. The Itô formula diffusion coefficient is $\sigma S_t{f}_x$, so $\sigma S_t>0$ forces ${\delta }_t=f_x(S_t,t)$ and ${\beta }_t{B}_t=f-S_t{f}_x$. Equating drifts yieldsThe physical drift cancels, giving the Black-Scholes equationConversely, if the smooth function satisfies this equation, set $\delta =f_x$ and $\beta =(f-x{f}_x)/B$. Substituting into Itô formula gives exactly $df=\delta dS+\beta dB$, so these holdings are self-financing. This checks the holdings as well as the value equation; a partial differential equation solution does not justify arbitrary prescribed holdings. Appropriate admissibility and growth conditions are imposed when using it as an economic price.

For the logarithmic stock payoff, let $\tau =T-t$ and condition on $S_t=x$. Under the risk-neutral measure,The normal exponential moment $\mathbb{E}{e}^{uZ}=e^{u^2/2}$ and its derivative $\mathbb{E}[Z{e}^{uZ}]=u{e}^{u^2/2}$ giveThereforeThe option delta is the displayed stock holding. The bank account value is $f-S_t{f}_x=-S_t$, so ${\beta }_t=-S_t/B_t$. Directly, $f_{xx}=1/x$ and $f_t=-x(\rho +{\sigma }^2/2)$ verify the partial differential equation, while $f(x,T)=x\log x$ verifies the payoff. Lognormal moments give the required pricing integrability. Since $x\log x\ge -1/e$, the conditional price is bounded below over this finite horizon, so the resulting claim replication has the usual admissibility property.