Review: Arbitrage-Free Pricing and Stochastic

Calculus

Leonid Kogan
MIT, Sloan

15.450, Fall 2010

c Leonid Kogan ( MIT, Sloan )

Review: Part I

15.450, Fall 2010

1 / 15

Discrete Models

Definitions of SPD () and risk-neutral probability (Q).

Absence of arbitrage is equivalent to existence of the SPD or a risk-neutral
probability:
"
"
#
#
Pt =

EPt

T
X
u
Du = EQ
t

t
u =t +1

T
X
Bt

u =t +1

Bu

Du

Price of risk: under Gaussian P and Q distributions,

P
Q
t = t + t

Log-normal model (discrete version of Black-Scholes):

t rt = t t

c Leonid Kogan ( MIT, Sloan )

Review: Part I

15.450, Fall 2010

2 / 15

Problem

Consider a 3-period model with t = 0, 1, 2, 3. There are a stock and a

risk-free asset. The initial stock price is $4 and the stock price doubles with
probability 2/3 and drops to one-half with probability 1/3 each period. The
risk-free rate is 1/4.
1
2

3
4

Compute the risk-neutral probability at each node.

Compute the Radon-Nikodym derivative (dQ/dP) of the risk-neutral measure
with respect to the physical measure at each node.
Compute the state-price density at each node.
Compare two assets, both with cash flows only at time 1. One pays (2, 1) in up
and down nodes, the other pays (3, 0). Which one has higher risk premium?

c Leonid Kogan ( MIT, Sloan )

Review: Part I

15.450, Fall 2010

3 / 15

Problem
A firm is considering a new project. Cash flows form an infinite stream
according to the distribution
Ct = a + brtM + t
rtM : market returns, IID, N(M , 2M ).
t : idiosyncratic shock, IID, N(0, 2 ).

Assume that CAPM holds, and the SDF is given by



t +1
2
r M M
= exp rf M M t
M
t
2
exp(rf ) 1 is the one-period risk-free rate.
1
2

Compute the present value of cash flows generated by this project.

What are the discount factors applied to expected cash flows from different
periods in the traditional DCF formula?

c Leonid Kogan ( MIT, Sloan )

Review: Part I

15.450, Fall 2010

4 / 15

Stochastic Calculus
Brownian motion, basic properties (IID Gaussian increments, continuous
trajectories, nowhere differentiable).
Quadratic variation. [Z ]T = T . Heuristically,

(dZt )2 = dt ,
Stochastic integral:

RT
0

dZt dt = o(dt )

t dZt . Basic properties.

Itos lemma:
df (t , Xt ) =

f (t , Xt )
f (t , Xt )
1 2 f (t , Xt )
dt +
dXt +
(dXt )2
t
Xt
2 Xt2

Multivariate Itos lemma.

df (t , Xt , Yt ) =

c Leonid Kogan ( MIT, Sloan )

f
f
f
dt +
dXt +
dYt +
t
Xt
Yt
1 2 f
1 2 f
2 f
2
2
(
dX
)
+
(
dY
)
+
dXt dYt
t
t
2 Xt2
2 Yt2
Xt Yt
Review: Part I

15.450, Fall 2010

5 / 15

Black-Scholes Model
Arbitrage-free pricing of options by replication.
European option with payoff H (ST ).
Replicating portfolio delta is

t =

f (t , St )
St

f (t , S )
f (t , S ) 1 2 2 2 f (t , S )
=0
+ rS
+ S
2
S 2
t
S
with the boundary condition f (T , S ) = H (S ).
r f (t , S ) +

Derive the B.-S. PDE using replication arguments:

df (t , St ) = t dSt + (f (t , St ) t St )r dt

c Leonid Kogan ( MIT, Sloan )

Review: Part I

15.450, Fall 2010

6 / 15

Problem

Your colleagues have developed a term structure model that they intend to
use for pricing of interest-rate sensitive securities. Their model is of the
following form: they fit the shape of the term structure using a parsimonious
closed-form description, and then describe the evolution of necessary
parameters. For example, one specification of the bond yields y is
yt = a +

xt
b+
dxt = (xt x ) dt + dZt
You suspect that this model implies arbitrage opportunities. How can you
convince your colleagues that this is the case?

c Leonid Kogan ( MIT, Sloan )

Review: Part I

15.450, Fall 2010

7 / 15

Solution
We want to show inconsistencies in returns on zero-coupon bonds of different maturities that lead to arbitrage.
Consider prices of bonds maturing at different dates. For maturity T ,

PtT = exp[ytT t (T t )] = exp a(T t )

(T t )
xt
b + (T t )

Compute bond returns. Let = T t. Using Itos formula,

dPtT
=
PtT

a+

(b +

)2

xt +

1
(xt x ) +
b+
2

b+

2

!
2

dt

b+

dZt

To avoid arbitrage, expected excess returns on bonds of different maturity have to satisfy a single-factor pricing
relation:
Risk Premium() = t
t
where
t is the diffusion coefficient of bond returns with maturity .
Interest rate is rt = yt0 = a + b1 xt , so our computation above yields


Risk Premium() =

(b +

)2

1
xt +
(xt x ) +
b
b+
2

b+

2

Risk premia implied by the model do not have a one-factor structure, and therefore one can construct an
explicit arbitrage trade.
c Leonid Kogan ( MIT, Sloan )

Review: Part I

15.450, Fall 2010

8 / 15

Solution
Consider two bonds with risk premia Risk Premiumi ,t , i = 1, 2 and diffusion
coefficients of returns i ,t . Assume that the risk premia do not have a
one-factor structure, and therefore we can find two bonds such that
Risk Premium1,t

1,t

>

Risk Premium2,t

2,t

1
1
Construct a portfolio with $1 total value,
1,t dollars in bond 1, 2,t dollars
in bond 2 and the rest in the short-term risk-free asset. The risk premium on
this portfolio is

Risk Premium1,t

1,t

Risk Premium2,t

2,t

>0

This is arbitrage, since the portfolio has no risk, and such risk-free excess
returns can be generated at all times.

c Leonid Kogan ( MIT, Sloan )

Review: Part I

15.450, Fall 2010

9 / 15

Pricing by Replication: Limitations

In many models one cannot derive a unique price for a derivative.

Term structure models, stochastic volatility.
Price assets relative to each other. Replication argument combined with
assumptions on prices of risk.
Alternatively, specify dynamics directly under Q.

c Leonid Kogan ( MIT, Sloan )

Review: Part I

15.450, Fall 2010

10 / 15

Risk-Neutral Pricing
General pricing formula

 ZT

exp
Pt = EQ
t

rs ds HT
t

Need to specify dynamics of the underlying under Q.

If underlying is a stock, only one way to do this: set expected return to r .
Q dynamics is related to P through price of risk
dZtP = t dt + dZtQ
Risk premium
EPt

c Leonid Kogan ( MIT, Sloan )

dSt
St


rt dt =

EPt

Review: Part I

dSt
St

EQ
t

dSt
St

15.450, Fall 2010

11 / 15

Problem
Suppose that uncertainty in the model is described by two independent
Brownian motions, Z1,t and Z2,t . Assume that there exists one risky asset,
paying no dividends, following the process
dSt
= (Xt ) dt + dZ1,t
St
where
dXt = Xt dt + dZ2,t
The risk-free interest rate is constant at r .
1
2
3

What is the price of risk of the Brownian motion Z1,t ?

Give an example of a valid SPD in this model.
Suppose that the price of risk of the second Brownian motion, Z2,t , is zero.
Characterize the SPD in this model.
Derive the price of a European Call option on the risky asset in this model, with
maturity T and strike price K .

c Leonid Kogan ( MIT, Sloan )

Review: Part I

15.450, Fall 2010

12 / 15

Risk-Neutral Pricing and PDEs

Derive a PDE on derivative prices using Itos lemma.
One-factor term structure model
EQ
t [df (t , rt )] = rt f (t , rt ) dt
Vasicek model:
drt = (rt r ) dt + dZtQ
f (t , rt ) must satisfy the PDE

f (t , r )
f (t , r ) 1 2 2 f (t , r )
(r r )
+
= rf (t , r )
t
r
2
r 2
with the boundary condition
f (T , r ) = 1
Expected bond returns satisfy
EPt
c Leonid Kogan ( MIT, Sloan )

dP (t , T )
P (t , T )

= (rt + Pt t ) dt

Review: Part I

15.450, Fall 2010

13 / 15

Problem
Suppose that, under P, the price of a stock paying no dividends follows
dSt
= (St ) dt + (St ) dZt
St
Assume that the SPD in this market satisfies
d t

t
1
2

= r dt t dZt

How does t relate to r , t , and t ?

Suppose that there exists a derivative asset with price C (t , St ). Derive the
instantaneous expected return on this derivative as a function of t and St .
Derive the PDE on the price of the derivative C (t , S ), assuming that its payoff is
given by H (ST ) at time T .
Suppose that there is another derivative trading, with a price D (t , St ) which does
not satisfy the PDE you have derived above. Construct a trading strategy
generating arbitrage profits using this derivative, the risk-free asset and the
stock.

c Leonid Kogan ( MIT, Sloan )

Review: Part I

15.450, Fall 2010

14 / 15

Monte Carlo Simulation

Random number generation: inverse transform, acceptance-rejection

method.
Variance reduction: antithetic variates, control variates.
Intuition behind control variates: carve out the part of the estimated moment
that is known in closed form, no need to estimate that by Monte Carlo.
Good control variates: highly correlated with the variable of interest,
expectation known in closed form.
Examples of control variates: stock price, payoff of similar option, etc.

c Leonid Kogan ( MIT, Sloan )

Review: Part I

15.450, Fall 2010

15 / 15

MIT OpenCourseWare
http://ocw.mit.edu

15.450 Analytics of Finance

Fall 2010

For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms .