Lec1 2e

ACTSC 970: Lectures #1-2e
1
Notes: This slide combines Lec1-2.pdf slide with Introduction to Finance:
Lecture #1 Of Finance Notes, under the sub-section of Background Notes,
Undergraduate Level, both of which are available on this course website

Description of a Basic Financial Model

Financial Markets

A financial market is a place (or, more precisely, market) where financial assets,
such as stocks, bonds, foreign currency, etc. are being traded.

We distinguish between
- basic assets
- contingent claims, also called derivatives or options

Basic assets are those involved with actual ownership of wealth and promise of
earnings

2
Contingent claims are contracts for future exchanges of money and assets,
whose payoffs to the parties entering the contract are contingent upon (that is,
are derived from) the values of basic assets

A contingent claim, whose payoff depends wholly on the value of an asset, is
said to be written on that asset

In this case, the asset is called the underlying asset or simply the underlying

Contingent claims can also be written on commodities instead of being written
on financial assets

In this case it is necessary to include the commodity in the financial market

A defining feature of any financial markets is risk

Risk comes to be prominent because we do not know, and cannot predict,
exactly the future prices of financial assets
3

It is in this sense that we say that the return on investments in financial assets is
uncertain

We refer to this uncertainty as risk

We will use the word risk" only in this general sense in this course

Financial Model

Next we establish the basic elements of a financial model and introduce the
notation we will use for the model

Definition: A market (or economy) has p tradable assets, labeled 1,2,,p

Then a financial model typically contains the following elements:

4
(1)Trading times:

T t t t
n
= < < < = ... 0
1 0

where

{ }
n
t t t ,..., ,
1 0
= t in discrete-time, finite-horizon case

or

] , 0 [ T = t in continuous-time, finite-horizon case, where T is called a terminal
date or maturity

We treat t = 0 as the present time when we enter the market

When we set { }
n
t t t ,..., ,
1 0
= t , we say that the model is an n-period model

5
(2) Sample (or state) space: { }
m
e e ,...,
1
= O

Each O e e represents a state or condition of the market (or economy),

ie, the elements
m
e e ,...,
1
of this set label all of the possible future states of the
market admitted by the model

It is at this point that we need to introduce risk

We do not know the future state of the market

That is, we do not know its prices and factors affecting its prices

It is the task of the model to list the possibilities

At this point, avid students of probability theory, seeing the notation, O, would
immediately be looking next for a probability measure on subsets of O. But we
have not introduced this concept yet!
6

Indeed we start the course with the study of the finite-state case, where
{ }
m
e e ,...,
1
= O is a finite set and we have a finite-state model ) ( < m

Note that, at this stage, we have not placed any probabilities on these outcomes
as part of the model (as for instance done in Bass (2003) notes)

But it is easy to imagine that there is a probabilistic idea lurking in the
background of our discussion

That is, we assume that every one of the states in O has a positive probability to
occur

Dare I say, that it does not make too much sense to put a state in the model if the
state cannot possibly happen!

We will in later part of the course introduce uncountably infinite O to support
continuous-state models
7
Then, for reasons we hope will become apparent at that time, we will have to
introduce probability measure explicitly into our discussion

(3) Price Functions (or Price Processes):

For each asset i, where p i ,..., 2 , 1 = , the model specifies a price function or price
process

{ } ) , ( ,..., ), , (
1
e e t S t S
p
; t e t ; O e e

We state the above succinctly as

e ) , ( e t S
i

to give us the price of asset i at time t when the market is in state e

Since we treat t =0 as the present time when we are able to observe the prices,
we assume that
8

p i S S
i i
,...., 1 ); 0 ( ) , 0 ( = = e

is deterministic, in the sense that prices are independent of O e e at t=0

(4) We also assume that the market has a bank account or money market fund
or bond:

0 ) , ( > e t B ) , ( e t and
0
) , 0 ( B B = e

which are risk free

That is, we assume that ) ( ) , ( t B t B = e O e e

Examples: Let
k k
t t t = A
+1
be a time step. Often we choose

9
A +
= A +
A
) (
) ( ) 1 (
) (
t B e
or t B t r
t t B
t r

This is simple compounding or continuous compounding, and r is the riskfree
interest rate, where r>0.

We typically assume that ) (t B is one of ) , ( e t S
i
by setting ) ( ) , (
1
t B t S e

Portfolio Processes (Trading Strategies)

Definition: A portfolio process (or trading strategy) is a list of the amounts of
shares held by an investor in each asset i=1,,p, at each time t e t in each
market state O e e :
10

e ) , ( ),..., , (
1
e | e | t t
p
, ) , ( e t in O t

So, given p assets, we can represent a portfolio by

( )
p
p
t t t e = u
*
1
) , ( ),..., , ( ) , ( e | e | e

where ) , ( e | t
i
is the number of units of asset i held by the investor and *
denotes a transpose , i.e.,

( )
|
|
|
.
|
\
|
=
) , (
) , (
) , ( ),..., , (
1
*
1
e |
e |
e | e |
t
t
t t
p
p

A portfolio value process is the total value of the portfolio at each
O et e) , (t :
11

=
=
P
i
i i
t S t t
1
) , ( ) , ( ) , ( e e | e t
( )
|
|
|
.
|
\
|
=
) , (
...
) , (
) , ( ),..., , (
1
1
e
e
e | e |
t S
t S
t t
p
p

) , ( ) , (
*
e e t A t u =

I often write the last expression as

) , ( ) , ( ) , ( e e e t t A t t - u =

where *-* is an dot (or inner) product operator (Note: Given any two column
vectors, their dot product is obtained by multiplying the transpose of one
vector (which is a row vector) with the other (column) vector, resulting in a
1 1 scalar quantity)
12

At t=0, we have ) 0 ( ) , 0 (
i i
| e | = that is, at the time the investor enters the
market, the number of units of asset i held by her is not a function of the state
of the market, O e e

This means that the trading strategy is assumed to be known at t=0

In a similar fashion, we also assume that the portfolio (as a whole) at time
1
t t =
is not a function of the state of the market:

) 0 ( ) , (
1
u = u e t

i.e.
p i t
i i
,..., 1 ) 0 ( ) , (
1
= = | e |

13
where ) , ( e | t
i
is the # shares of the i
th
security held by the investor

Next it is possible to buy a negative number of shares of a stock

This is equivalent to selling shares of a stock you do not have and, therefore, is
called selling short, i.e.,

If 0 <
i
| : the investor shorts asset i

If 0 >
i
| : the investor longs asset i
Arbitrage

*********************Start of Preliminary Discussion****************

An arbitrage is a portfolio that earns a riskfree profit simply by cross trading
several assets in a market

14
To say that a portfolio is riskfree is to say that a profit, or at least no loss, is
achieved regardless of the state of the market

The basic assumption of the markets is that they do not allow for arbitrage

Note for now that no-arbitrage assumption, under certain right conditions,
imposes unique prices on contingent claims

*********************End of Preliminary Discussion****************

Below we give a formulation for the one-period, finite-state model

That is, consider a model with

- a finite number of states of the market: { }
m
e e ,...,
1
= O
- p tradable assets
- lasting for only one period:

15
n=1: 0
0
= t and T t =
1

(often we assume that 1 = At with T=1)

Definition: An arbitrage is a trading strategy ) ,..., (
1
*
p
| | = u , such that

(a) 0 ) 0 ( ) 0 ( < - u t A and 0 ) , ( ) , ( . > - u e t e T T A for all e

or

(b) 0 ) 0 ( ) 0 ( = - u t A and 0 ) , ( ) , ( > - u e t e T T A O e e and
0 ) ' , ( > e t T for some O e ' e

The owner of such a portfolio begins at time t=0 with zero or negative wealth,
but ends up with non-negative or positive wealth whatever the state of the
market

16
Example: Suppose that we are given

0
) 1 ( ) ( B rT T B + =
0 1
) 0 ( ) , ( B B t S = e
) , ( ) , (
2
e e t S t S =

That is, we have a bank account, one stock, and two states for the market:
} , {
2 1
e e = O where u
1
e to represent the up movement in the market and
d
2
e to represent the down movement in the market

At 0
0
= t , we have a single stock whose price is
0
) , 0 ( S S = e

After one time unit, T t =
1
, the stock price will be

= =
= =
=
down for dS d T S
up for uS u T S
T S
e
e
e
0
0
) , (
) , (
) , (
17

Instead of purchasing shares in the stock, we can also put our money in the bank
or money market funds or bonds to earn risk-free interest at rate r,
0
) 1 ( ) ( B rT T B + =

Assume that ) 1 , 1 ( , 0 , 0
0
> < < < > u d u d S and 0
0
> B

Claim: the market is arbitrage free u rT d < + <1 , where ) 0 ( / ) ( 1 B T B rT = +

Proof: we show and leave : as an exercise

Suppose that u d rT < s + 1

Then we get an arbitrage by borrowing at r and investing in S

Suppose that rT u d + s < 1

Then we get an arbitrage by selling S short and investing at r
18

Formal Proof: Suppose that u d rT < s + 1

Then

|
|
.
|
\
|
=
|
|
.
|
\
|
= u
0
0
2
1
B
S
|
|
, |
.
|
\
|
=
|
|
.
|
\
|
=
) , (
) (
) , (
) , (
) , (
2
1
e e
e
e
t S
t B
t S
t S
t A

At : 0 = t
|
|
.
|
\
|
|
|
.
|
\
|
=
|
|
.
|
\
|
-
|
|
.
|
\
|
= - u =
0
0
*
0
0
0
0
0
0
) 0 ( ) 0 (
S
B
B
S
S
B
B
S
A t

( ) 0
0 0 0 0
0
0
0 0
= + =
|
|
.
|
\
|
= B S B S
S
B
B S

19
At : T t = |
.
|
\
|
+
-
|
|
.
|
\
|
= |
.
|
\
|
-
|
|
.
|
\
|
= - u =
) , (
) 1 (
) , (
) (
) , ( ) , (
0
0
0
0
0
e e
e e t
T S
rT B
B
S
T S
T B
B
S
T A T

where we have two states to consider:

:
1
u = e
0 ) ) 1 ( (
) 1 (
) , (
) 1 (
) , (
0 0
0
0
0
0 0
0
0
> + + =
|
|
.
|
\
|
+
-
|
|
.
|
\
|
= |
.
|
\
|
+
-
|
|
.
|
\
|
= u rT S B
uS
rT B
B
S
u T S
rT B
B
S
u T t

since we assume that , 0
0
> S 0
0
> B , and u d rT < s + 1 u rT + + < ) 1 ( 0
:
2
d = e

0 ] ) 1 ( [
) 1 (
) , (
) 1 (
) , (
0 0
0
0
0
0 0
0
0
> + + =
|
|
.
|
\
|
+
-
|
|
.
|
\
|
= |
.
|
\
|
+
-
|
|
.
|
\
|
= d rT S B
dS
rT B
B
S
d T S
rT B
B
S
d T t

since we assume that , 0
0
> S 0
0
> B , and u d rT < s + 1 d rT + + s ) 1 ( 0
20

So, from the Definition for Arbitrage, we conclude that there is an arbitrage in
the market

Similarly we can show that there is an arbitrage in the market if rT u d + s < 1 .

In the case of continuous compounding, we can show that there is no arbitrage
in the market u e d
rT
< < , where
0
/ ) ( B T B e
rT
=

Some Simple Derivative Securities

*********************Start of Preliminary Discussion****************

What is a forward contract?
21

In a forward contract, party a, agrees at time zero to purchase from party b an
agreed upon amount of an asset or commodity for a predetermined price K per
unit and a predetermined time T

Party a has a long position in the contract

Party b has a short position

The contract obligates each party to fulfill the agreement at time T, no matter
what the state of the market is
The price K is delivery price and the time T is delivery time (or maturity)

Let the market price of the commodity on which the contract is written be
denoted ) , ( e t S - this is called spot price

A key feature of a forward contract is that no money or goods are exchanged
at time zero, only at the delivery time, T
22

The payoff per unit of commodity to party a is

K T S T FC = ) , ( : ) , ( e e O e e

where ) , ( e T S is the underlying

This is because, party a purchases each unit of commodity for price K, but on
the market that unit is worth ) , ( e T S

So, if the spot price is higher, party a could realize an immediate gain at time
T by selling off the asset or commodity bought for price K

The party may want to take a long position in a forward contract to protect
against the risk of a rise in price of the asset or commodity that they need to
buy at a later date

Short positions protect against any price decreases
23

********************End of Preliminary Discussion******************
Examples:

(1) Forward Contract: defined by payoff

K T S T FC = ) , ( : ) , ( e e O e e

where K=delivery price, T=maturity, and ) , ( e T S =the underlying

(2) Consider an option to buy one share of the stock at time T at price K

K is some time also called the strike price

Let ) , ( e T S be the price of the stock at time T and in state e

If K T S < ) , ( e , then the option is worthless at time T

24
If K T S > ) , ( e , we can exercise the option at time T by buying the stock at price
K, immediately turning around and selling the stock for price ) , ( e T S and, in the
process, earning a healthy profit of K T S ) , ( e

So the value of the option at time T is

( )
+
= K T S T C ) , ( : ) , ( e e

where ( )
+
K T S ) , ( e { } 0 , ) , ( max K T S e

That is,

( )
+
= K T S T C ) , ( : ) , ( e e

is a payoff function for a call option (European style)

25
(3) Similarly, ( )
+
= ) , ( : ) , ( e e T S K T P

is a payoff function for a put option (European style)

The principal question to be answered is: what is the value of the option at time
0? In other words, how much should we pay for, say (as in (1), a European call
option with strike price K?

As a note for now, (2) and (3) are somewhat complicated to deal with as we will
see later on in this course

******************Start of Preliminary Discussion******************

Next, suppose that, at time t=0, we enter into a contract with party b to purchase
a unit of asset at time T for delivery price K.

Question: What should be the price of this contract?
26

We will assume that the asset price is ) , ( e t S

The basic market will consist of this asset and a risk-free bank account with
simple return at interest rate r

The price vector is given by:

|
.
|
\
|
+
= |
.
|
\
|
+
= |
.
|
\
|
=
) , (
) 1 (
) , (
) 1 (
) , (
) (
) , (
0
e e e
e
t S
rT
t S
B rT
t S
t B
t A

The pay-off of the contract is

K T S ) , ( e

27
as explained earlier

Next consider a portfolio

|
|
.
|
\
|
+
= u

1
) 1 (
1
rT K

that consists of borrowing
1
) 1 (

+ rT K at the risk free rate, r, and owning one
share of asset

The total value of this portfolio at time T is simply

) , ( ) , ( e e t T A T - u =
|
.
|
\
|
+
-
|
|
.
|
\
|
+
=

) , (
) 1 (
1
) 1 (
1
e t S
rT
rT K

28
|
.
|
\
|
+
+ =

) , (
) 1 (
) 1 , ) 1 ( (
1
e t S
rT
rT K
K T S = ) , ( e

The above result is expected given that at time T we will owe K to the lender of
cash and own one share of asset

This value is exactly equal to the pay-off of the proposed contract

For this reason u is called a replicating portfolio for the contract

The value of the replicating portfolio at time t=0 is:

|
.
|
\
|
-
|
|
.
|
\
| +
= - u =

) 0 (
1
1
) 1 (
) 0 ( ) 0 (
1
S
rT K
A t

29
|
.
|
\
|
+ =

) 0 (
1
) 1 , ) 1 ( (
1
S
rT K

1
) 1 ( ) 0 (

+ = rT K S

The claim is that this value must be the price of the contract at time t=0 if
there is to be no arbitrage

Briefly the justification for this claim is rooted in the argument that both the
contract and the portfolio u have the same pay-off. Therefore, at t=0, they must
be worth the same. Otherwise by trading in the contract and the portfolio
simultaneously, we could earn a riskfree profit

Let us firm up this argument a little bit

Let us use the notation ) , ( e t FC for the price (value) of the contract and add the
contract to the market
30

There are only two relevant times to consider the price:

- price FC(0) at time t=0
- price FC(T) at the delivery time t=T

But the value FC(T) must equal the pay-off:

K T S T FC = ) , ( ) , ( e e O e e

Next we consider an augmented price vector

|
|
|
.
|
\
|
+
=
|
|
|
.
|
\
|
=
) , (
) , (
1
) , (
) , (
) (
) , (
e
e
e
e e
t FC
t S
rt
t FC
t S
t B
t A

Assume that
31

K rT S K
T B
B
S FC
1
) 1 ( ) 0 (
) (
) 0 (
) 0 ( ) 0 (

+ = =

We will show that there is an arbitrage

Since in this situation the contract price is lower than the value of the replicating
portfolio, the arbitrage consists of going long in a contract and short in the
replicating portfolio
This is given by the following augmented portfolio:

|
|
|
|
.
|
\
|
+
= u

1
1
) 1 (
1
rT K

Thus, in this portfolio, we borrow a unit of asset, invest
1
) 1 (

+ rT K at the risk
free rate, and own a contract
32

Its total value of this portfolio at time 0 is thus given by:

) 0 ( ) 0 ( A - u = t

|
|
|
.
|
\
|
-
|
|
|
|
.
|
\
|
+
=

) 0 (
) 0 (
1
1
1
) 1 (
1
FC
S
rT K

|
|
|
.
|
\
|
+ =

) 0 (
) 0 (
1
) 1 , 1 , ) 1 ( (
1
FC
S rT K

0 ) 0 ( ) 0 ( ) 1 (
1
< + + =

FC S rT K

However, its total value at time T is:

33
|
|
|
.
|
\
|
+
-
|
|
|
|
.
|
\
|
+
= - u =

) , (
) , (
) 1 (
1
1
) 1 (
) , ( ) , (
1
e
e e e t
T FC
T S
rT rT K
T A T

|
|
|
.
|
\
|
+
+ =

) , (
) , (
) 1 (
) 1 , 1 , ) 1 ( (
1
e
e
T FC
T S
rT
rT K

0 ) , ( ) , ( = + = e e T FC T S K

Thus, u is an arbitrage in the sense defined earlier

Similarly we can show that

1
) 1 ( ) 0 ( ) 0 (

+ > rT K S FC

34
leads to an arbitrage opportunity

This suggests that the only price that does not lead to an arbitrage is given by:

1
) 1 ( ) 0 ( ) 0 (

+ = rT K S FC

The result we have obtained can now be used to deduce the no-arbitrage
delivery price of a forward contract, because in a forward contract, no money is
exchanged at time 0, i.e. the value of the contract to both parties at time 0 is
zero

The above argument suggests that we need to insist that

FC(0) =0

and since
1
) 1 ( ) 0 ( ) 0 (

+ = rT K S FC , we have

35
) 0 ( : ) 0 ( ) 1 ( ) 0 (
) 0 (
) (
F S rT S
B
T B
K = + = =

This is what we call a forward price

The arbitrage argument given above is essentially that given in Hull, but fancied
up a bit with our notation

We also can arrive at the forward price more directly, as in Hull (through a set
of reasonings):

- Suppose that delivery price is ) 0 ( ) 1 ( S rT K + <

- Then we borrow one unit of asset at time 0, sell it and invest the proceeds
S(0) at the risk-free interest rate

- At the same time, we enter the forward contract which requires no money

36
- Then at time T, the initial investment yields ) 0 ( ) 1 ( S rT +

- We take K of this, buy the asset using the contract and return it to the lender

- Since ) 0 ( ) 1 ( S rT K + < , we will have gained K S rT + ) 0 ( ) 1 ( from these
transactions and, hence, will have managed an arbitrage

Observe that this argument requires that we must be able to borrow the asset

Similar reasoning shows that we can also make an arbitrage if ) 0 ( ) 1 ( S rT K + >

*******************End of Preliminary Discussion*******************

Back to the Lec1-2.pdf slide to collect the results:

Claim: no-arbitrage price is given

37
K
T B
B
S FC
) (
) 0 (
) 0 ( ) 0 ( =

where
1
) 1 (
) (
) 0 (

+ = rT
T B
B
(or
rT
e
in the case of continuous compounding)

Proof:

Suppose that K
T B
B
S FC
) (
) 0 (
) 0 ( ) 0 ( <

Assume that B(0)=1 and B(T)=1+rT

Then we choose

38
|
|
|
.
|
\
|
+
= u

1
1
) 1 (
1
rT K
,
|
|
|
.
|
\
|
=
) , (
) , (
) (
) , (
e
e e
t FC
t S
t B
t A

So we have

|
|
|
.
|
\
|
-
|
|
|
|
.
|
\
|
+
= - u =

) , (
) , (
) (
1
1
) 1 (
) , ( ) , (
1
e
e e e t
t FC
t S
t B rT K
t A t

) , ( ) , ( ) ( ) 1 (
1
e e t FC t S t B rT K + + =

and, hence,

0 ) 0 ( ) 0 ( ) 1 ( ) 0 (
1
< + + =

FC S rT K t - by assumption

39
) , ( ) , ( ) ( ) 1 ( ) , (
1
e e e t T FC T S T B rT K T + + =

0 ) , ( ) , ( = + = e e T FC T S K - by definition

there is an arbitrage in the market

Similarly, we can show that there is arbitrage in the market if
K
T B
B
S FC
) (
) 0 (
) 0 ( ) 0 ( >

Since in a forward contract, no money is exchanged at time 0, the value of the
contract to both parties at time 0 is zero

Thus, we need to have FC(0) = 0, and because
) (
) 0 (
) 0 ( ) 0 (
T B
B
K S FC = , we have
that

40
) 0 (
) (
) 0 (
B
T B
S K =

This is a forward price, denoted as ) 0 ( F

To summarize our discussion,

Definition: A forward price, F(0), of an asset S is the delivery price K, such that
FC(0)=0, i.e.,

) 0 ( : ) 0 (
) 0 (
) (
F S
B
T B
K = =

No-arbitrage Pricing and Replicating Portfolios

41
Note: The logic of pricing by applying the no arbitrage argument when there is a
replicating portfolio extends to the general one-period, finite-state model

Consider a one-period model

Recall that in this model we are given

- A price vector ) 0 ( A for the prices of p tradable assets at time 0
- State space { }
m
e e ,...,
1
= O
- Price vectors ) , ( e T A for the prices at time T for each of the states

A contingent claim is a function ) , ( e T V O e e that gives the pay-off for each
possible state

Question: What is V(0)=?

A portfolio ( )
*
1
,...,
p
| | = u is a replicating portfolio for the derivative security if
42

) , ( ) , ( e e T A T V - u = O e e

If the contingent claim is added to the market as another security, an arbitrage
opportunity will arise unless the price ) 0 ( V of the security at time T is the value
of the replicating portfolio at time 0
That is,

) 0 ( ) 0 ( A V - u =

To sum up the discussion,

Claim: If the market { } V S S
p
, ,..,
1
is arbitrage free, then

) 0 ( ) 0 ( A V - u =

Proof: The proof steps follow those of the proof steps used for the forward
contract
43

The next topic is the Binomial Tree model

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ACTSC 970: Lectures #1-2e

in the case of continuous compounding)

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