# How to account for virtual arbitrage in the standard derivative pricing

## Appendix

In this appendix we give an informal derivation of the main equation (3) using the formalism of functional integrals.

We start with the Black-Scholes equation with the rate of return on the riskless portfolio $`VS\frac{V}{S}`$ given by $`r_0+x`$:

$$\frac{V}{t}+\frac{\sigma ^2S^2}{2}\frac{^2V}{S^2}+(r_0+x)S\frac{V}{S}(r_0+x)V=0,$$

$$V(S,t)|_{t=T}=\delta (SS^{}).$$

To simplify the calculation we change variables as $`\tau =Tt`$ and $`y=lnS`$ which casts the previous equations in the form:

$$\frac{V}{\tau }=\frac{\sigma ^2}{2}\frac{^2V}{y^2}+(r_0+x\frac{\sigma ^2}{2})\frac{V}{y}(r_0+x)V,$$

$$V(y,\tau )|_{\tau =0}=\frac{1}{y^{}}\delta (yy^{}).$$

The solution of the problem can be expressed as the following functional integral :

$$V(y,\tau )=\frac{1}{y^{}}DqD\frac{p}{2\pi }e^{_0^\tau \left(ip\dot{q}\frac{\sigma ^2}{2}p^2(r_0+x(\tau ))+i(r_0+x(\tau )\frac{\sigma ^2}{2})p\right)𝑑\tau }$$

with the boundary conditions $`q(0)=y^{}`$, $`q(\tau )=y`$. The functional integral form of the solution is extremely convenient for the purpose of averaging over trajectories $`x(\tau )`$ since it presents the dependence in explicit form. We, however, will use another trick. Let us first of all average the previous expression over realisations of the stochastic process $`x(\tau )`$ with fixed ends, i.e. when $`x(\tau )=x`$ and $`x(0)=0`$ (since there is no arbitrage at the expiration date of the contract and later). The probabilistic weight of a particular trajectory $`x(\tau )`$ for the Ornstein-Uhlenbeck process (1) is given by the expression

$$D\frac{\xi }{2\pi }e^{_0^\tau (i\xi \dot{x}\frac{\mathrm{\Sigma }^2}{2}\xi ^2i\lambda \xi x)𝑑\tau }$$

which leads to the following result for the conditional average value of the contract

$$\overline{V}(x,y,\tau )=\frac{1}{y^{}}DqD\frac{p}{2\pi }DxD\frac{\xi }{2\pi }e^{_0^\tau \left(i\xi \dot{x}+ip\dot{q}\frac{\sigma ^2}{2}p^2(r_0+x(\tau ))+i(r_0+x(\tau )\frac{\sigma ^2}{2})p\frac{\mathrm{\Sigma }^2}{2}\xi ^2i\lambda \xi x\right)𝑑\tau }$$

$$q(0)=y,q(\tau )=y^{},x(0)=0,x(\tau )=x.$$

Now, instead of evaluating these integrals, we find a partial differential equation for $`\overline{V}(x,y,\tau )`$ :

$$\frac{\overline{V}}{t}=\frac{\sigma ^2}{2}\frac{^2\overline{V}}{y^2}+(r_0+x\frac{\sigma ^2}{2})\frac{\overline{V}}{y}(r_0+x)\overline{V}+\frac{\mathrm{\Sigma }^2}{2}\frac{^2\overline{V}}{x^2}+\lambda \frac{x\overline{V}}{x},$$

with the initial conditions

$$\overline{V}(x,y,\tau )|_{\tau =0}=\frac{1}{y^{}}\delta (x).$$

Returning back to the initial variables $`t`$ and $`S`$ we obtain the problem (3)

$$\frac{\overline{V}}{t}+\frac{\sigma ^2S^2}{2}\frac{^2\overline{V}}{S^2}+(r_0+x)S\frac{\overline{V}(x,S,t)}{S}(r_0+x)\overline{V}+\frac{\mathrm{\Sigma }^2}{2}\frac{^2\overline{V}}{x^2}+\lambda \frac{x\overline{V}}{x}=0,$$

$$\overline{V}(x,S,t)|_{t=T}=\delta (x)\delta (SS^{}).$$

Integration of the solution over $`x`$ (to get the unconditional average) and the convolution with the final payoff complete the consideration.

In a similar way various generalizations of the equations can be derived. It is clear that the functional integral is a very convenient tool for such kind of manipulations. We would like to note however that the functional ingral formalism is full of subtlties which we have not emphasized here. It serves for fast derivation but not proving the results. The proof can be obtained in the routine framework of stochastic calculus.