The Black-Scholes equation

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Some time ago, I wrote a short unpublished note (mostly for my own benefit) when I was trying to understand the derivation of the Black-Scholes equation in financial mathematics, which computes the price of various options under some assumptions on the underlying financial model.  In order to avoid issues relating to stochastic calculus, Itō’s formula, etc. I only considered a discrete model rather than a continuous one, which makes the mathematics much more elementary.  I was recently asked about this note, and decided that it would be worthwhile to expand it into a blog article here.  The emphasis here will be on the simplest models rather than the most realistic models, in order to emphasise the beautifully simple basic idea behind the derivation of this formula.

The basic type of problem that the Black-Scholes equation solves (in particular models) is the following.  One has an underlying financial instrument

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