Determinants, linear equations and replicating portfolios

MA 343 Fall 2014

2-by-2 Determinants
A 2-by-2 determinant is a table of four numbers arranged in two rows and two columns.


2 1
 is a determinant with diagonal values 2, 4 and off-diagonal values 1, 3.
Example 1. 
3 4


2 5
 is a determinant with diagonal values 2, 1 and off-diagonal values 5, 4.
Example 2. 
4 1


a b
 is a determinant with diagonal values a, d and off-diagonal values b, c.
Example 3. 
c d
The value of a 2-by-2 determinant is the product of diagonal values minus the product of offdiagonal values.


2 1
 is 2 4 1 3 = 8 3 = 5.

Example 4. The value of the determinant 
3 4


2 5
 is 2 1 5 4 = 2 20 = 18.

Example 5. The value of the determinant 
4 1


a b
 is a d b c.

Example 6. The value of the determinant 
c d

Linear Equations
A linear equation in (x,y) is an equation of the form
ax + by = c,

a, b, c numbers

Example 7. 2x + 3y = 5 is a linear equation in (x,y).

Example 8. 2s + 3b = 5 is a linear equation in (s,b).
Example 9. 2 Bob + 3 Sally = 5 is a linear equation in (Bob,Sally).
A solution of a linear equation in (x,y) is a pair of numbers (x=number,y=another number)
that satisfy the equation.
Example 10. One (among many) solution to the equation 2x + 3y = 5 is (x=4,y=-1), since
replacing x with 4 and replacing y with -1 in the left hand side of the equation gives
2 4 + 3 (1) = 8 3 = 5
which is the value of the right hand side of the equation.
1

Note that there are other solutions to one equation in two unknowns.
A 2-by-2 system of linear equations in (x,y) is two linear equations in (x,y).
Example 11.
2x + 3y = 5
3x + y = 1
is a 2-by-2 system of linear equations in (x,y).
Example 12.
2s + 3b = 5
3s + b = 1
is a 2-by-2 system of linear equations in (s,b).
Example 13.
ax + by = c
dx + ey = f
a, b, c, d, e, f numbers
is a 2-by-2 system of linear equations in (x,y).
Note that each linear equation has a straight line as its graph.
The solution of a 2-by-2 system of linear equations in (x,y) is a pair of numbers (x = number,
y = another number) that satisfy both equations.
Example 14. The two linear equations
2x + y = 4
3x y = 1
has solution (x = 1, y = 2). This is verified by replacing x with 1 and y with 2 in the left hand side
of each equation, and verifying that the value computed is the same as the value on the right hand
side.
For the first equation,
2x + y = 2 1 + 1 2 = 4
which is the right hand side value of the first equation.
For the second equation,
3x y = 3 1 1 2 = 1
which is the right hand side value of the second equation.

Example 15. The two linear equations

3x y = 5
x + 2y = 4
has solution (x=2,y=1). This is verified by the following computation of the left hand sides of each
equation, which equal their right hand sides.
First equation left hand side value: 3 2 1 1 = 6 1 = 5
Second equation left hand side value: 1 2 + 2 1 = 2 + 2 = 4

Linear Equation Determinants

There are three determinants computed from the coefficients of a 2-by-2 system of linear equations
in (x,y). I have given them the names system determinant, x-determinant, and y-determinant.
System determinant
The system determinant of a 2-by-2 system of linear equations in (x,y) is the table of (x,y) coefficients.
Example 16. The system determinant of the two linear equations
2x + y = 4
3x y = 1

 
 
1 
2
1
. Note that the x coefficients are
, the y coefficients are
, and
1
3
1
 
4
the right hand side coefficients are
. The system determinant uses the x and y coefficients. It
1
does not use the right hand side coefficients.

2
is the determinant 
3

Example 17. The system determinant of the two linear equations in (x,y)
ax + by = c
dx + ey = f

a
is the determinant 
d


 
 
b
a
b
.
Note
that
the
x
coefficients
are
,
the
y
coefficients
are
, and
e
d
e
 
c
the right hand side coefficients are
.
f
x-determinant
The x-determinant of a 2-by-2 system of linear equations in (x,y) is the system determinant with
the x-coefficients (the first column in the system determinant) replaced by the right hand side
coefficients.
3

Example 18. Consider the two linear equations in (x,y):

2x + 3y = 5
3x + y = 1

2
The system determinant is 
3
 
5
. The x-determinant is the
1
 
5
hand side coefficients
:
1


 
3
2
.
The
x
coefficients
are
. The right hand side coefficients are
1
3
 
2
system determinant with the x coefficients
replaced by the right
3


5
x-determinant = 
1


3
1

Example 19. Consider the two linear equations in (s,b):

2s 4b = 7
s + 3b = 3


 
 2 4
2


, the s coefficients are
, and the right hand side coeffiThe system determinant is 
1 3 
1
 
7
cients are
. The s-determinant is the system determinant with the s coefficients replaced by the
3
right hand side coefficients.


7 4


s-determinant = 
3 3
y-determinant
The y-determinant of a 2-by-2 system of linear equations in (x,y) is the system determinant with
the y-coefficients (the second column in the system determinant) replaced by the right hand side
coefficients.
Example 20. Consider the two linear equations in (x,y):
2x + 3y = 5
3x + y = 1


 
2 3
. The y coefficients are 3 . The right hand side coefficients
The system determinant is 
3 1
1
 
 
5
3
are
. The y-determinant is the system determinant with the y coefficients
replaced by the
1
1
 
5
right hand side coefficients
:
1


2 5


y-determinant = 
3 1
4

Example 21. Consider the two linear equations in (s,b):

2s 4b = 7
s + 3b = 3


 
 2 4
, the b coefficients are 4 , and the right hand side coeffiThe system determinant is 
1 3 
3
 
7
cients are
. The b-determinant is the system determinant with the b coefficients replaced by the
3
right hand side coefficients.


 2 7

b-determinant = 
1 3
Example 22. Consider the two linear equations in (x,y):
ax + by = c


a
The system determinant is 
d

dx + ey = f

b
, the x-determinant is
e


c

f



a
b
and the y-determinant is 

d
e


c
.
f

Linear Equations Solution

The solution to a 2-by-2 system of linear equations in (x,y) can be computed by the following
formulas:
value of x-determinant
value of system determinant
value of y-determinant
y=
value of system determinant
x=

Example 23. Consider the following two linear equations in (x,y):

2x + y = 4

The value of
The value of
The value of
The solution

3x y = 1


2 1 

 = 2 (1) 3 (1) = 2 3 = 5.
the system determinant is 
3 1

4 1 
 = 4 (1) 1 (1) = 4 1 = 5.
the x-determinant is 

1
1


2 4
 = 2 (1) 3 (4) = 2 12 = 10.
the y-determinant is 
3 1
to this 2-by-2 system of linear equations is
x=

5
= 1,
5

y=

10
= 2.
5

Example 24. Consider the following two linear equations in (x,y):

3x y = 5

The value of
The value of
The value of
The solution

x + 2y = 4


3 1

 = 3 (2) 1 (1) = 6 + 1 = 7.
the system determinant is 

1
2


5 1
 = 5 (2) 4 (1) = 10 + 4 = 14.
the x-determinant is 

4 2
3 5
 = 3 (4) 5 (1) = 12 5 = 7.
the y-determinant is 
1 4
to this 2-by-2 system of linear equations is
x=

14
= 2,
7

y=

7
= 1.
7

Portfolio Value
We briefly review the computation of portfolio value. A portfolio will consist of s shares of stock
and b money market units. We will (eventually) denote the portfolio by (s, b) and the portfolio
value by V.
Example 25. Consider a market with stock share price of $120 and a money market unit price of
$110. A portfolio consisting of the purchase of three shares of stock and two money market units
has value 3 120 + 2 110 = 580. If we were to liquidate this portfolio, we would sell the three
shares of stock for 360 and sell (close our savings account) our two units of money market for
220, yielding a grand total of 580. In this example, s = 3 and b = 2.
Example 26. We keep the same stock share and money market unit prices. This time, a portfolio
consists of the purchase of three shares of stock and the shorting of two money market units. By the
short sale of two money market units, we mean that we give the bank our IOU and the bank gives
us a loan. The current unit money market price of 110 means that our IOU value of two units
is 2*110 = 220. Suppose we were to liquidate the portfolio. We would sell our three stock shares
for 3*120 = 360. But we would also need to close out our loan by repaying the loan amount of
2*110 = 220. The asset of 360 and the liability of 220 nets to 140, that is, our portfolio has value
3*120 - 2*110 = 360 - 220 = 140. In this example, s = 3 and b = 2.
Example 27. Let a share of stock have price $120 and a money market unit have price $110. A
portfolio of s shares of stock and b money market units has value V = 120s + 110b. s denotes the
quantity of stock shares, and b denotes the quantity of money market units.
Note that if either quantity is positive, then that asset was purchased. If either quantity is
negative, then that asset was short sold. Both s and b can be any number, positive or negative.
Example 28. Let a share of stock have price $80 and a money market unit have price $110. An
(s, b) portfolio has value V = 80s + 110b.

Replicating Portfolio Equations

There are two possible outcomes of our coin flip: H (head) and T (tail). To create a synthetic
option, our portfolio must match the option value in both outcomes.
6

Example 29 (European call option). Let (s, b) be a portfolio. Then,forour class example of a
20
European call option with strike price K = 100, the option payoffs were
. Our synthetic option
0
 
20
(our portfolio) must also have
as its payoffs (value), that is,
0
H outcome: 120s + 110b = 20
T outcome: 80s + 110b = 0
Example 30 (European put option). Let (s, b) be a portfolio. Then,forour class example of a
0
European put option with strike price K = 100, the option payoffs were
. Our synthetic option
20
 
0
(our portfolio) must also have
as its payoffs (value), that is,
20
H outcome: 120s + 110b = 0
T outcome: 80s + 110b = 20
Example 31 (Chooser option). Let (s, b) be a portfolio. Then,
 for our class example of a chooser
20
option with strike price K = 100, the option payoffs were
. Our synthetic option (our portfolio)
20
 
20
must also have
as its payoffs (value), that is,
20
H outcome: 120s + 110b = 20
T outcome: 80s + 110b = 20

Replicating Portfolio Solution

We can now apply our 2-by-2 system of linear equations solution to calculate replicating portfolios
(s, b).
Example 32 (European call option). The linear equations for replicating our European call option
are
H outcome: 120s + 110b = 20

The
The
The
The

T outcome: 80s + 110b = 0



120 110

 = 120 110 80 110 = 40 110.
system determinant value is 
80 110

20 110
 = 20 110 0 110 = 20 110.
s-determinant value is 

0
110


120 20
 = 120 0 80 20 = 80 20.
b-determinant value is 
80
0
solution is
1
80 20
4
20 110
= , b=
=
s=
40 110
2
40 110
11
7

Example 33 (European put option). The linear equations for replicating our European put option
are
H outcome: 120s + 110b = 0
T outcome: 80s + 110b = 20


120 110

 = 120 110 80 110 = 40 110.
The system determinant value is 

80
110


 0 110
 = 0 110 20 110 = 20 110.
The s-determinant value is 

20 110 
120 0 
 = 120 20 80 0 = 120 20.
The b-determinant value is 
80 20
The solution is
20 110
1
120 20
6
s=
= , b=
=
40 110
2
40 110
11
Example 34 (Chooser option). The linear equations for replicating our chooser option are
H outcome: 120s + 110b = 20
T outcome: 80s + 110b = 20


120 110
 = 120 110 80 110 = 40 110.

The system determinant value is 
80 110

20 110
 = 20 110 20 110 = 0.
The s-determinant value is 

20
110


120 20
 = 120 20 80 20 = 40 20.
The b-determinant value is 
80 20
The solution is
0
40 20
2
s=
= 0, b =
=
40 110
40 110
11
 
Cu
Example 35. Let C be an arbitrary option with payoffs
. The replicating portfolio (s, b) for
Cd
this option satisfies the two linear equations:
120s + 110b = Cu

The
The
The
The

80s + 110b = Cd


120 110
 = 40 110.
system determinant is 
80  110

C
110
s-determinant is  u
 = Cu 110 Cd 110 = (Cu Cd ) 110.
C
110
 d

120 Cu 

 = 120 Cd 80 Cu .
b determinant is 
80 Cd 
solution is
110 (Cu Cd )
Cu Cd
=
40 110
40
120Cd 80Cu
1
(3Cd 2Cu )
b=
=
40 110
110
s=

I leave it to the reader to check these two formulas by
replacing Cu with 20 and Cd with 0 to get
4
. Repeat for the European put option and
the European call option replicating portfolio 12 , 11
the chooser option.

Replicating Portfolio General Formulas

 
120
So far, we have fixed our primary asset prices: the stock payoffs are
, and the money market
80
 
110
unit payoffs are
. We can repeat the computations leading to the solution of the replicating
110
portfolio quantities (s, b) using symbols instead of numbers for our primary asset prices. We do
that now.
Let Su be the stock price on an H outcome; let Sd be the stock price on a T outcome.
Let Bu be the money market unit price on an H outcome; let Bd be the money market unit price
on a T outcome.
The portfolio V consisting of s shares of stock and b money market units will have the following
values:
On H outcome: V = Su s + Bu b
On T outcome: V = Sd s + Bd b
 
Cu
To replicate the option values
, the (s, b) must satisfy the two linear equations:
Cd
Su s + Bu b = Cu
Sd s + Bd b = Cd
The system determinant is

C
The s-determinant is  u
Cd
S
The b-determinant is  u
Sd
The solution is



Su Bu 


Sd Bd  = Su Bd Sd Bu .

Bu 
= Bd Cu Bu Cd .
Bd 
Cu 
= Su Cd Sd Cu .
Cd 
s=

Bd Cu Bu Cd
,
Su Bd Sd Bu

b=

Su Cd Sd Cu
Su Bd Sd Bu

These are the general formulas for the replicating portfolio (s, b).
Example 36. Our standard example has Su = 120, Sd = 80, Bu = Bd = 110.
For our European call option, we have Cu = 20, Cd = 0.
Substituting these values into the formulas gives us
s=

1
110 20 110 0
= ;
120 110 80 110
2

b=

120 0 80 20
4
=
120 110 80 110
11

I leave it to the reader to repeat this example for our European put option and our chooser option.