Published by the Press Syndicate of the University of Cambridge ‘The Pitt Building, Trumpington Street, Cambridge CB2 1RP 40 West 20th Street, New York, NY 10011-4211, USA. 10 Stamford Road, Oakleigh, Melbourne $166, Australia © Paul Wilmott, Sam Howison, Jeff Dewynne 1995 First Published 1905, Reprinted 1996 Printed in the United States of America Library of Congress cataloging-in-publication data available A catalogue record for this book is available from the British Library ISBN 0-521-49690-3 hardback ISBN 0-521~49789-2 paperbackContents Preface Part One: Basic Option Theory 1 An Introduction to Options and Markets 1.1 Introduction 1.2. What is an Option? 1.3 Reading the Financial Press 1.4 What are Options For? 1.5 Other Types of Option 1.6 Forward and Futures Contracts L7 Interest Rates and Present Value 2 Asset Price Random Walks 21 Introduction 2.2 A Simple Model for Asset Prices 23 It's Lemma 24 The Elimination of Randomness 3 The Black-Scholes Model 3.1 Introduction 3.2 Arbitrage 3.3 Option Values, Payofls and Strategies 3.4 Put-call Parity 3.5. The Black-Scholes Analysis 3.6 ‘The Black-Scholes Equation 3.7 Boundary and Final Conditions 3.8 The Black-Scholes Formula: 3.9 Hedging in Practice 3.10 Implied Volatility page ix 1B uM 1B 18 18 19 Py 30 33 33 33 35 40 a 44 48 51 524 Partial Differential Equations 4.1 Introduction 4.2. The Diffusion Equation 4.3 Initial and Boundary Conditions 4.4 Forward versus Backward 5 ‘The Black-Scholes Formule 5.1 Introduction 5.2 Similarity Solutions 5.3 An Initial Value Problem 54 The Formule Derived 5.5 Binary Options 5.6 Risk Neutrality 6 Variations on the Black-Scholes Model 6.1 Introduction 6.2 Options on Dividend-paying Assets 6.3 Forward and Futures Contracts 64 Options on Futures, 6.5 Time-dependent Parameters 7 American Options 7.1 Introduction 7.2. The Obstacle Problem 7.8 American Options as Free Boundary Problems 74 The American Put 7.5 Other American Options 7.6 Linear Complementarity Problems 7.7 The American Call with Dividends Part Two: Numerical Methods 8 Finite-difference Methods 8.1 Introduction 8.2 Finite difference Approximations 8.3. The Finite-difference Mesh 84 The Explicit Finite-difference Method 8.5. Implicit Finite-difference Methods 8.6 The Fully-implicit Method 8.7 The Crank-Nicolson Method 9 Methods for American Options 9.1 Introduction 9.2 Finite-difference Formulation Contents 58 58 59 66 68 na 7 1 6 76 81 83 90 90 90 98 100 101 106 106 108 109 110 4 15 121 133 135 135 136 138 139 ida 44 155 165 165 167