Professional Documents
Culture Documents
Wim Schoutens
Leuven, 2004-2005
The aim of the course is to give a rigorous yet accessible introduction to the
We start with providing some background on the financial markets and the
main group of underlying assets, the markets where derivative securities are
traded and the financial agents involved in these activities. The fundamen-
cussing option pricing in the simplest idealised case: the Single-Period Market.
Next, we turn to Binomial tree models. Under these models we price European
and American options and discuss pricing methods for the more involved exotic
tence of equivalent martingale measures. We look when the models are complete,
look at them as limiting cases of discrete models. The discrete models will guide
Finance Course.
2
Contents
1 Derivative Background 1
1.1.4 Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.2 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
1.3.3 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . 28
1.3.4 Currencies . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
1
1.3.5 Commodities . . . . . . . . . . . . . . . . . . . . . . . . . 32
2 Binomial Trees 34
3.5.1 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
4 Exotic Options 82
2
4.4 Asian Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
6 Miscellaneous 132
3
Chapter 1
Derivative Background
A market typically consist out of a riskfree Bank account and some other risky
assets. On these basic instruments other financial contracts are written; these
financial contracts are so-called derivative securities. This text is on the (risk-
underlying assets, the related derivative securities, the markets where derivatives
securities are traded and the financial agents involved in these activities.
1
Stocks – Equity
The basis of modern economic life are companies owned by their shareholders;
the shares provide partial ownership of the company, pro rata with investment.
Shares have value, reflecting both the value of the company’s real assets and
the earning power of the company’s dividends. With publicly quoted companies,
shares are quoted and traded on the Stock Exchange. Stock is the generic term
for assets held in the form of shares. Stock markets date back to at least 1531,
when one was started in Antwerp, Belgium. Today there are over 150 stock
exchanges.
The value of some financial assets depends solely on the level of interest rates,
e.g. Treasury notes, municipal and corporate bonds. These are fixed-income
securities by which national, state and local governments and large companies
points in time, as well as the repayment of the principal at maturity of the secu-
rity. Interest rates themselves are notional assets, which cannot be delivered. A
1.1.2.
2
Currencies – Foreign Exchange
A foreign currency has the property that the holder of the currency can earn
interest at the risk-free interest rate prevailing in the foreign country. We thus
have to kind of interest rates, the domestic and the foreign interest rate.
Commodities
Commodities are a kind of physical products like gold, oil, cattle, fruit juice.
Trade in these assets can be for different purposes: for using them in the pro-
be used for hedging and speculation. Special care has to be taken with com-
modities because of storage costs (see Section 1.3.5) In Figure 1.1, one sees the
some prices (of the market on the 16th of October 2004) of (futures on) energy,
3
Figure 1.1: Commodities future prices on 16-10-2004
Miscellaneous
Indexes
4
derivative instruments on a particular asset in question are available and if the
correlation in movement between the index and the asset is significant. Further-
more, institutional funds (such as pension funds), which manage large diversi-
fied stock portfolios, try to mimic particular stock indices and use derivative on
In Figure 1.2, one sees the Belgian Bel-20 Index over a period of more than
4 years.
A new kind of index was generated with the Index of Catastrophe Losses
(CAT-index) by the Chicago Board of Trade (CBOT) lately. The growing num-
ber of huge natural disasters (such as hurricanes and earthquakes) has led the
insurance industry to try to find new ways of increasing its capacity to carry
risks. Currently investors are offered options on the CAT-index, thereby taking
5
in effect the position of traditional reinsurance.
Credit risk captures the risk on a financial loss that an institution incurs
when it lends money to another institution or person. This financial loss real-
izes whenever the borrower does not meet all of its obligations under its borrow-
ing contract. Because credit risk is so important for financial institutions the
banking world has developed instruments that allows them to evacuate credit
risk rather easily. The most commonly known and used example is the credit
contracts. This means that today I can buy protection on a bond and tomorrow
I can sell that same protection as easily as I bought it. Credit default swaps
work just as an insurance contract. The protection buyer (the insurance taker)
pays a fee and in exchange he gets reimbursed his losses if the company on which
In Figure 1.3, one sees credit default swap bid and offer rates for major
In the next Chapter we will start building models for the stock or asset price
available in all the later on encountered market models: the bank account. There
are two (quite related) regimes under which we will work: discrete or continuous
compounding. This has all to do with when and how frequently the interest
6
Figure 1.3: Credit Default Swap rates
gained on the invested money is paid out. Typically the discrete compounding
will be only used in discrete time models; the continuous compound can be used
annum. If the rate is compounded once per annum, the terminal value of the
investment is
A(1 + R)n .
We note that there is a difference. Indeed, take A = 100 euro and n = 1, when
7
the interest rate is 10 percent a year. The first regime leads to 110 euros after
one year. However, with quarterly payments (m = 4), i.e. with payments every
three month, we have after one year 100 × (1.0025)4 = 110.38 euros. In Figure
1.4 one sees the effect of increasing the compounding frequency from a yearly
110.5
110.4
end value
110.3
110.2
110.1
110
0 50 100 150 200 250 300 350
compounding frequency (m)
have
mn
R
lim A 1 + = A exp(nR).
m→∞ m
after n years. Note that it is because of the above discussion, important to state
8
(1 − exp(0.10))/100 = 10.517 percent annual compounding.
Throughout the text we will make use of a bank account on which we can
put money and borrow money on a fixed continuously compounded interest rate
r. This means that 1 euro on the bank account at time 0 will give rise to ert
euro on time t > 0. Similarly, if we borrow 1 euro now, we have to pay back ert
euro at time t > 0. Or equivalently, if we borrow now e−rt euro we have to pay
One euro on the bank account will grow over time; at some time t we denote
its value by B(t). Note thus that we set B(0) = 1. We call B = {B(t), t ≥ 0}
Related to all this is the time value of money. An investor will prefer 100 euro
in his pocket today to 100 euro in his pocket one year from now. The interest
paid on the riskless bank account expresses this. Using continuous compounding
with a rate r = 0.10, 100 euro is equivalent with 110.517 euros in one year. If
exp(−rT )X. 100 euro in one year is equivalent with 90.484 euros now. This
on the value of other more basic underlying securities. We adopt the more
precise definition:
9
at expiration date T (more briefly, expiry) is determined exactly by the price
Forwards and Futures, and Swaps. During this text we will mainly deal with
Options
An option is a financial instrument giving one the right but not the oblig-
price.
A lot of different type of options exists. We give here the basic types. Call
options give one the right to buy. Put options give one the right to sell. European
options give one the right to buy/sell on the specified date, the expiry date,
on when the option expires or matures. American options give one the right
minimum price over a period and barrier options, depend on some price level
The price at which the transaction to buy/sell the underlying assets (or
simply the underlying), on/by the expiry date (if exercised), is made is called
the exercise price or strike price. We usually use K for strike price, time t = 0,
for the initial time (when the contract between the buyer and the seller of the
10
option is struck), time t = T for the expiry or final time.
Consider, say, an European call option, with strike price K; write St for the
value (or price) of the underlying at time t. If St > K, the option is in the
option is out the money. This terminology is of course motivated by the payoff,
(more briefly written as (ST − K)+ ). This payoff function for K = 100 is
18
16
14
12
Payoff
10
0
80 85 90 95 100 105 110 115 120
stock price at maturity
There are two sides to every option contract. On one side there is the person
who has bought the option (the long position); on the other side you have the
11
person who has sold or written the option (the short poistion). The writer
In Figure 1.6, one can see that by investing in an option one can make huge
gains, but also if markets goes the opposite direction as anticipate, it is possible
Figure 1.6: Stock Prices and European Call Option at time t = 0 and t = T .
options on some stocks. Since then, the growth of options has been explosive.
Risk Magazine (12/1997) estimated $35 trillion as the gross figure for worldwide
In Figure 1.7, one sees some of the prices of call options written on the SP500-
index. The main aim of this text is to give a basic introduction to models for
12
Forwards, Futures
date T for a certain price K. It is usually between two large and sophisticated
age firms) and not traded on an exchange. The agents who agrees to buy the
underlying asset is said to have a long position, the other agent assumes a short
position. The payoff from a long position in a forward contract on one unit of
ST − K.
Compared with a call option with the same maturity and strike price K we see
that the investor now faces a downside risk, too. He has the obligation to buy
asset at a certain future date for a certain price. The difference is that futures
are traded. As such, the default risk is removed from the parties to the contract
Swaps
dates in the future, various financial assets (or cash flows) according to a pre-
arranged formula that depends on the value of one or more underlying assets.
Examples are currency swaps (exchange currencies) and interest-rate swaps (ex-
13
change of fixed for floating set of interest payments) and the nowadays popular
1.1.4 Markets
(strike price, maturity dates, size of contract, etc.). Examples are the Chicago
Exchange (LIFFE).
to each transaction. Its main task is to keep track of all the transactions that
take place during a day so it can calculate the net poistions of each of its
members.
OTC trading takes between various commercial and investments banks such
It is very important that the financial contract specifies in detail the exact nature
of the agreement between the two parties. It must specify the contract size (how
much of the asset will be delivered under one contract), where delivery will be
made, when exactly the delivery is made, etc. When the contract is traded at
14
an exchange, it should be made clear how prices will be quoted, when trade is
allowed, etc.
e.g. it is clear what a Japanese Yen is. When the asset is a commodity, there
may be quite a variation in the quality and it is important that the exchange
Most contracts are refered to by its delivery month and year. The contract
must specify in detail the period of that month when delivery can be made. For
some future the delivery period is the entire month. For other contract delivery
the exchange by a very detailed algorithm. It can be e.g. averages of the index
taken every five minutes during one hour, but also just the closing price of the
asset.
Other specification by the exchange deal with movement limits. Trade will be
halted if these limits are exceeded. The purpose of price limits is to prevent large
15
Hedgers
They use the market to insure themselves against adverse movements of prices,
Hedgers prefer to forgo the chance to make exceptional profits when future un-
loss.
Speculators
Speculators want to take a position in the market – they take the opposite
that a hedger, wishing to lay off risk, cannot do so unless someone is willing to
take it on.
making a profit: the underlying itself is irrelevant to the speculator, who is only
interested in the potential for possible profit that trade involving it may present.
Arbitrageurs
a security can be bought in New York at one price and sold at a slightly higher
price in London. The underlying concept of the here presented theory is the
16
1.1.7 Modelling Assumptions
We will discuss contingent claim pricing in an idealized case. We will not allow
market frictions; there is no default risk, agents are rational and there is no
• no transaction costs
• no bid/ask spread
• no taxes
• no margin requirements
• no transaction delays
its economic activity: death is part of life. Moreover those risks also appear
at the national level: quite apart from war, recent decades have seen default
17
of interest payments of international debt, or the threat of it (see for example
the 1998 Russian crisis). We ignore default risk for simplicity while developing
We assume financial agents to be price takers, not price makers. This implies
that even large amounts of trading in a security by one agent does not influence
the security’s price. Hence agents can buy or sell as much of any security as
To assume that market participants prefer more to less is a very weak as-
It is the basis for the arbitrage pricing technique that we shall develop, and we
1.2 Arbitrage
large quantities of riskless profit. This would, for instance, make it impossible
18
To explain the fundamental arguments of the arbitrage pricing technique we
financial assets are traded: (riskless) bonds B (bank account), stocks S and
European Call options C with strike K = 100 on the stock S. The investor may
invest today, time t = 0, in all three assets, leave his investment until time
t = T and gets his returns back then. We assume the option C expires at time
t = T . We assume the current prices (in euro, say) of the financial assets are
given by
and that at t = T there can be only two states of the world: an up-state with
euro prices
Now our investor has a starting capital of 25000 euro from which he buy the
following portfolio,
19
Depending of the state of the world at time t = T the value of his portfolio
will differ: In the up state the total value of his portfolio is 48750 euro:
TOTAL 48750
TOTAL 20000
Can the investor do better ? Let us consider the restructured portfolio with
We compute its return in the different possible states. In the up-state the total
20
value of his portfolio is again 48750 euro:
TOTAL 48750
and in the down-state his portfolio has again a value of 20000 euro:
Stock 70 × 75 5250
TOTAL 20000
We see that this portfolio generates the same time t = T return while costing
only 24600 euro now, a saving of 400 euro against the first portfolio. So the
investor should use the second portfolio and have a free lunch today!
In the above example the investor was able to restructure his portfolio, re-
ducing the current (t = 0) expenses without changing the return at the future
sibility in the above market situation, and the prices quoted are not arbitrage
prices. If we regard (as we shall do) the prices of the bond and the stock
(our underlying) as given, the option must be mispriced. Let us have a closer
look between the differences between Portfolio II, consisting of 11800 bonds, 70
stocks and 29 call options, in short (11800, 70, 290) and Portfolio I, of the form
21
(10000, 100, 250) The difference is the portfolio, Portfolio III say, of the form
So if you sell short 30 stocks, you will receive 3000 euro from which you
buy 40 options, put 1800 euro in your bank account and have a gastronomic
lunch of 400 euro. But what is the effect of doing that ? Let us consider the
consequences in the possible states of the world. We see in both cases that
the effects of the different positions of Portfolio III offset themselves: In the
up-state:
TOTAL 0
Call option 40 × 75 0
TOTAL 0
22
But clearly the portfolio generates an income at t = 0 of which you had a free
If we only look at the position in bonds and stocks, we can say that this
position covers us against possible price movements of the option, i.e. having
1800 euro in your bank account and being 30 stocks short has the opposite time
Let us emphasize that the above arguments were independent of the prefer-
on the value of options. In our analysis here we use non-dividend paying stocks
Next, we will deduce a fundamental relation between put and call options, the
so-called put-call parity. Suppose there is a stock (with value St at time t), with
European call and put options on it, with value Ct and Pt respectively at time
stock, one put and a short position in one call (the holder of the portfolio has
23
written the call); write Πt for the time t value of this portfolio. So
Πt = S t + P t − C t .
if ST ≥ K : ΠT = ST + 0 − (St − K) = K,
if ST ≤ K : ΠT = ST + (K − St ) − 0 = K.
Ke−r(T −t) in the bank at time t and do nothing (we assume continuously com-
pounded interest here). Under the assumption that the market is arbitrage-free
the value of the portfolio at time t must thus be Ke−r(T −t) , for it acts as a
synthetic bank account and any other price will offer arbitrage opportunities.
If the portfolio is offered for sale at time t too cheaply–at price Πt <
Ke−r(T −t) – we can buy it, borrow Ke−r(T −t) from the bank, and pocket a
positive profit Ke−r(T −t) − Πt > 0. At time T our portfolio yields K, while our
bank debt has grown to K. We clear our cash account – use the one to pay off
If on the other hand the portfolio is priced at time t at a too high price –
at price Πt > Ke−r(T −t) – we can do the exact opposite. We sell the portfolio
24
short – that is,we buy its negative: buy one call, write one put, sell short one
stock, for Πt and invest Ke−r(T −t) in the bank account, pocketing a positive
profit Πt − Ke−r(T −t) > 0. At time T , our bank deposit has grown to K, and
again we clear our cash account – use this to meet our obligation K on the
simply enter the current value of a given portfolio and then compute its value
in all possible states of the world when the portfolio is cashed in. In the case
ST < K ST ≥ K
Ke−r(T −t) − St
TOTAL 0 0
−Pt + Ct > 0
Thus the rational price for the portfolio at time t is exactly Ke−r(T −t). Any
other price presents arbitrageurs with an arbitrage opportunity (to make and
Proposition 1 We have the following put-call parity between the prices of the
underlying asset and its European call and put options with the same strike price
25
and maturity on stocks that pay no dividends:
St + Pt − Ct = Ke−r(T −t) .
The value of the portfolio above is the discounted value of the riskless equiv-
alent. This is a first glimpse at the central principle, or insight, of the entire
Next, we will deduce a fair price (based on the no-arbitrage assumption) for the
following forward contract: The contract states that party A (the buyer) must
buy from party B (the seller) the (non-dividend paying) stock at time T at the
you are party B, so you sold the forward contract and has received at time
To buy the stock you need S0 . You already have from the forward F = S0 −
exp(−rT )K and receives from your loan exp(−rT )K. So you spent all the
26
• long 1 stock.
• short 1 forward;
Look what happens at time T . You must deliver the stock to party A. You
give away your stock in your portfolio, for this you receive K. The forward
contract ends and you pay back your bank. You have to pay back the amount
exp(rT ) exp(−rT )K = K. This you can do exactly with the money you received
from party A. In the end everything is settled, you have no gain, no lost. Note
Note that any other price for the forward would have led to an arbitrage
situation. Indeed, suppose you received F̂ > F . Then by following the above
strategy you pocket at time t = 0 the difference F̂ − F > 0 which you can freely
spent. At time T you just close all the position as described above. Without
any initial investment and risk, you have then spent at time 0, F̂ − F > 0. This
is clearly an arbitrage opportunity (for party B). In case F̂ < F , party A con
set up a portfolio will always leads to an arbitrage opportunity (check this !).
K = exp(rT )S0 .
By doing this entering (in both ways: long or short) a forward contract is at
zero cost. For this reason, exp(rT )S0 is called the time T forward price of the
stock.
27
Finally, note that the put-call parity can be simply rewritten in terms of
the call price, the put price and the forward contract price as: C − P = F (all
derivatives have the same strike and time to maturity). From this one can see
that at the forward price of the stock, i.e. in case K = exp(rT )S0 and hence
1.3.3 Dividends
Up to now, we have assumed that the risky asset pays no dividends, however
in reality stocks can pay some dividend to the stock holders at some moments.
We assume that the amount and timing of the dividends during the live of an
option can be predicted with certainty. Moreover, we will assume that the stock
pays a continuous compound dividend yield at rate q per annum. Other ways
St = exp(−qt)S̄t ,
where S̄ is describing the stock prices behavior not taking into account divi-
dends. A stock which pays continuously dividends and an identical stock that
not pays dividends should provide the same overall return, i.e. dividends plus
capital gains. The payment of dividends causes the growth of the stock price to
28
then in absence of dividends it would grow from S0 to exp(qt)ST . Alternatively,
tation brings us to the fact that we get the same probability distribution for
the stock price at time T in the following cases: (1) The stock starts at S0
and pays a continuous dividend yield at rate q and (2) the stock starts at price
The put-call parity for a stock with dividend yield q can be obtained from the
St + Pt − Ct = K exp(−r(T − t)).
If we now take into account dividends, the change comes down to replacing St
t)) number of stocks, one put option and minus one call option. We reinvest
expiry date of the option we own one stock, one put and minus one call. The
value of the portfolio at that time thus always equals K. By the no-arbitrage
argument the time T value of the portfolio must equal K exp(−r(T − t)), the
If our asset is an index, the dividend yield is the (weighted) average of the
29
dividends yields on the stocks composing the index.In practice, the dividend
yield can be determined from the forward price of the asset. It is the agreement
to buy or sell an asset at a certain future time for a certain price, the delivery
price. At the time the contract is entered into, the delivery price is chosen so
that the value of the forward is zero. This means that it costs nothing to buy or
sell the contract. For an asset paying a continuous yield at rate q, the delivery
Assuming the short rate r and the delivery price of the forward as given, q can
easily be obtained.
1.3.4 Currencies
If the underlying is not a stock but a currency, we must take into account the
contract on the USD: you must buy N USD at some point in the future T for
What is the value of this future contract and for what value of K such that
the contract has a zero value (the forward price of the USD). It will turn out
now
K = exp((rd − rf )T )S0 .
30
Indeed, suppose K > exp((rd − rf )T )S0 . An investor can then do the following
• Use this cash to buy N × exp(−rf T ) USD and put this on an USD-
bankaccount at rate rf
Then the holding of the foreign currency grows to N because of the interest (rf )
earned. Under the terms of the contract this holding is exchanged for N × K
made at time T . In case K < exp((rd − rf )T )S0 you can the following
• Use this cash to buy N × S0 exp(−rf T ) EURD and put this on an EUR-
bankaccount at rate rd
to receive N USD and uses these dollars to pay the loan. In total you earned
31
1.3.5 Commodities
We now consider the cas of commodities. Important here is the impact of storage
costs. If the storage costs incurred at any time are proportional to the price of
F = S0 exp((r + u)T ),
where u is the storage costs per annum as a proportion of the spot price.
The relationship between all above future/forward prices and spot prices can be
summerized in terms of what is known as the cost of carry. This measures the
storage cost plus the interest that is paid to finance the asset less the income
earned on the asset. For a non-dividend paying stock, the cost of carry is r since
there are no storage costs and no income is earned; for a stock index, it is r − q
and so on.
Define the cost of carry as c. For an investment asset, the future price is
F = S0 exp(cT ).
32
Figure 1.7: Call options on S&P 500 Index
33
Chapter 2
Binomial Trees
Our aim here is to show in the simplest possible non-trivial model how the
Example
Let our financial market consist of two financial assets, a riskless bank account
(or bond) B and a risky stock S, with today’s price S0 = 20 euro. We look at
a single-period model and assume that starting from today (t = 0) the world
can only be in one of two states at time t = T : the stock price will either be
option to buy the stock for 21 euro at time t = T . At time t = T , this option
can have only two possible values. It will have value 1 euro, if the stock price
34
Figure 2.1: One-period binomial tree example
is 22 euro; if the stock price turns out to be 18 euro at time t = T , the value of
It turns out that we can price the option by the assumption that no arbitrage
opportunities exist. We set up a portfolio of the stock and the option in such a
way that there is no uncertainty about the value of the portfolio at the time of
expiry, t = T . We then argue that, because the portfolio has no risk, the return
earned on it must equal the risk-free interest rate of the bank account. This
enables us to work out the cost of setting up the portfolio and, therefore, the
option’s price.
a short position in one call option. We calculate the value of ∆ that makes the
portfolio riskless. If the stock price moves up from 20 to 22 euro, the value of
the shares is 22∆ and the value of the option is 1 euro, so that the total value
of the portfolio is 22∆ − 1 euro. If the stock price moves down from 20 to 18
euro, the value of the shares is 18∆ euro and the value of the option is zero, so
that the total value of the portfolio is 18∆ euro. The portfolio is riskless if the
35
value of ∆ is chosen so that the final value of the portfolio is the same for both
22∆ − 1 = 18∆
or
∆ = 0.25
• Short 1 option.
22 × 0.25 − 1 = 4.5.
If the stock price moves down to 18 euro, the value of the portfolio is
18 × 0.25 = 4.5.
Regardless of whether the stock price moves up or down, the value of the port-
folio is always 4.5 euro at the end of the life of the option.
risk free rate of interest. Suppose that in this case the risk-free rate is 12 percent
per annum and that T = 0.5, i.e. six months. It follows that the value of the
4.5e−0.12×0.5 = 4.238
36
The value of the stock today is known to be 20 euro. Suppose the option price
20 × 0.25 − f = 5 − f
It follows that
5 − f = 4.238
or
f = 0.762.
This shows that, in the absence of arbitrage opportunities, the current value of
the option must be 0.762. If the value of the option were more than 0.762 euro,
the portfolio would cost less than 4.238 euro to set up and would earn more than
the risk-free rate. If the value of the option were less than 0.762 euro, shorting
the portfolio would provide a way of borrowing money at less than the risk-free
rate.
In other words, if the value of the option were more than 0.762 euro, for
example 1 euro, you can borrow for example 42380 euro and buy 10000 times
10000(0.25 × 20 − 1) = 40000euro.
You pocket 2380 euro and after 6 months, you sell 10000 portfolio and cashes in
45000, because the value of one portfolio is always 4.5 euro. With this money
you pay back the bank for the money you borrowed plus the interests on it, i.e.
you pay the bank an amount of 42380 × e0.12×0.5 = 45000 euro. At the end
37
Figure 2.2: General one-period binomial tree
of all this you earned 2380 euro without taking any risk and without an initial
capital. If the value of the option were less than 0.762 euro, you do the opposite.
Generalization
suppose that the option lasts for time T and that during the life of the option
the stock can move up from S0 to a new level, S0 u or down from S0 to a new
level, S0 d (u > 1; 0 < d < 1). If the stock price moves up to S0 u, we suppose
that the payoff from the option is fu ; if the stock price moves down to S0 d, we
suppose the payoff from the option is fd . The situation is illustrated in Figure
2.2.
and a short position in one option. We calculate the value of ∆ that makes the
portfolio riskless. If there is an up movement in the stock price, the value of the
38
portfolio at the end of the life op the option is
S0 u∆ − fu .
S0 d∆ − fd .
S0 u∆ − fu = S0 d∆ − fd ,
or
fu − f d
∆= . (2.1)
S0 u − S 0 d
In this case, the portfolio is riskless and must earn the riskless interest
rate. If we denote the risk-free interest rate by r, the present value of the
portfolio is
S0 ∆ − f.
It follows that
(S0 u∆ − fu )e−rT = S0 ∆ − f,
or
f = S0 ∆ − (S0 u∆ − fu )e−rT .
39
Substituting from equation (2.1) for ∆ and simplifying, this equation reduces
to
where
erT − d
p= (2.3)
u−d
Remark 2 If we assume that u > erT , together with u > 1 and 0 < d < 1,
one can easily show that the value of p given in (2.3) satisfies 0 < p < 1. Note
that it is natural to assume that u > erT , because it means that after a time T ,
you can gain more (a factor u) by investing in the risky stocks, than you can
earn with a riskless investment in bond (a factor erT ). If this was not the case
no one would invest in stocks. Ofcourse, you can also lose money (d factior by
investing in stocks.
Remark 3 Equation (2.1) shows that ∆ is the ratio of the change in the option
Remark 4 The option pricing formula in (2.2) does not involve the probabili-
ties of the stock moving up or down. This is suprising and seems counterintu-
itive. The key reason is that the probabilities of future up or down movements
Risk-Neutral Valuation
40
interpret the variable p in Equation (2.2) as the probability of an up movement
in the stock price. The variable 1−p is then the probability of a down movement,
pfu + (1 − p)fd
is the expected payoff from the option. With this interpretation of p, Equation
(2.2) then states that the value of the option today is its expected future value
We now investigate the expected return from the stock when the probability
Ep [ST ], is given by
= pS0 (u − d) + S0 d.
showing that the stock price grows, on average, at the risk-free rate. Setting the
that the return on the stock equals the rsik-free rate. In a risk-neutral world
the expected return on all securities is the risk-free interest rate. Equation (2.4)
shows that we are assuming a risk-neutral world when we set the proability of
an up movement to p. Equation (2.2) shows that the value of the option is its
41
This result is an example of an important genereal principle in option pricing
the world is risk neutral when pricing options. The resulting option prices
are correct not just in a risk-neutral world, but in the real world as
well.
We now turn back to the numerical example in Figure 2.1 to illustrate that risk-
2.1, the stock price is currently 20 euro and will move either up to 22 euro or
down to 18 euro at the end of six months. The option considered is a European
call option with strike price of 21 euro and an expiration date in six months.
a risk-neutral world. (We know from the analysis given earlier in this section
that p is given by Equation (2.3). However, for the purpose of this illustration
return on the stock must be the risk-free rate of 12 percent. This means that p
must satisfy
or
20e0.12×0.5 − 18
p= = 0.8092
4
At the end of the six months, the call option has a 0.8092 probability of being
42
worth 1 euro and a 0.1908 probability of being worth zero. Its expected value
is, therefore,
0.8092e−0.12×0.5 = 0.7620
This is the same value as the value obtained earlier, illustrating that no-arbitrage
We can extend the analysis to a two-step binomial tree. The objective of the
analysis is to calculate the option price at the initial node of the tree. This can
We can first apply the analysis to a two-step binomial tree. Here the stock price
starts at 20 euro and in each of the two time steps may go up by 10 percent or
down by 10 percent. We suppose that each time step is six months long and
2.3 shows the tree with both the stock price and the option price at each node.
(The stock price is the upper number and the option price is the lower number.)
43
Figure 2.3: Two-period binomial tree example
The option prices at the final nodes of the tree are easily calculated. They are
the payoffs from the option. At node D, the stock price is 24.2 euro and the
option price is 24.2 − 21 = 3.2 euro; at nodes E and F, the option is out of the
At node C, the option price is zero, because node C leads to either node E
or node F and at both nodes the option price is zero. Next, we calculate the
r = 0.12, and T = 0.5 so that p = 0.8092. Equation (2.2) gives the value of the
option at node B as
focusing on the first step of the tree. We know that the value of the option at
node B is 2.4386 and that at node C it is zero. Equation (2.2), therefore, gives
44
Figure 2.4: General two-period binomial tree
We can generalize the case of two time steps by considering the situation in
Figure 2.4.
times its value or moves down to d times its value. The notation for the value
of the option is shown on the tree. For example, after two up movements, the
value of the option is fuu . We suppose that the risk-free interest rate is r and
45
Substituting the first two equations in the last one, we get
The variable p2 , 2p(1 − p), and (1 − p)2 are the probabilities that the upper,
middle, and lower final nodes will be reached. The option price is equal to
interest rate.
continues to hold. The option price is always equal to the present value (dis-
world.
a stock price, we choose the parameters u and d to match the volatility of the
stock price. To see how this is done, suppose that the expected return on a stock
in the real world is µ: The expected stock price at the end of the first time
the variance of the return in a short period of time of length ∆t. Suppose from
46
must therefore, have
or
(1 + µ∆t) − d
q= (2.9)
u−d
In order to match the real world stock price volatility we must therefore have
or equivalently
√
u = (1 + σ ∆t) (2.11)
√
d = (1 − σ ∆t) (2.12)
47
Indeed,
= −(µ∆t)2 + σ 2 ∆t
Another setting is
√
u = eσ ∆t
(2.13)
√
d = e−σ ∆t
, (2.14)
These are the values proposed by Cox, Ross and Rubinstein. Note that in both
cases the values of u and d are independent of µ, which implies that if we move
from the real world to the risk-neutral world the volatility on the stock remains
the same (at least in the limit as ∆t tends to zero). This is an illustration
from a world with one set of risk preferences to a world with another set of risk
preferences, the expected growth rates change, but their volatilities remain the
same. Moving from one set of risk preferences to another is sometimes referred
48
2.3 Binomial Trees
The above one- and two-steps binomial trees are very imprecise models of reality
and are used only for illustrative purposes. Clearly an analyst can expect to
the stock movements during the life of the option consist of one or two binomial
steps. When binomial trees are used in pratice, the life of the option is typically
divided into 30 or more time steps of length ∆t. In each time step there is
a binomial stock movement. With 30 time steps this means that 31 terminal
stock prices and 230 possible stock price paths are considered.
by dividing the life of the option into a large number of small intervals of length
∆t. We assume that in each time interval the stock price moves from its initial
value S to one of two new values Su and Sd. In general, u > 1 and 0 < d < 1.
The movement from S to Su is, therefore, an ”up” movement and the movement
is known as the risk-neutral valuation principle. This states that any security
which is dependent on a stock can be valued on the assumption that the world
is risk neutral. It means that for the purposes of valuing an option, we can
assume:
• The expected return from all traded securities is the risk-free interest rate.
49
• Future cash flows can be valued by discounting their expected values at
We make use of this when using a binomial tree. The tree is designed to represent
er∆t − d
p= .
u−d
√
u = eσ ∆t
√
d = e−σ ∆t
Figure 2.5 illustrates the tree of stock prices over 5 time periods that is
At time zero, the stock price S0 is known. At time ∆t there are two possible
stock prices, S0 u and S0 d; at time 2∆t, there are three possible stock prices,
S0 u2 , S0 ud, and S0 d2 ; and so on. In general, at time i∆t, i + 1 stock prices are
S0 uj di−j , j = 0, . . . , i.
European call and put options are evaluated by starting at the end of the tree
(time T ) and working backward. The value of the option is known at time T .
call option is worth max{ST − X, 0}, where ST is the stock price at time T and
50
Figure 2.5: General binomial tree for stock price
K is the strike price. Because a risk-neutral world is being assumed, the value
discounted at rate r for a time period ∆t. Similarly, the value at each node at
for a time period ∆t at rate r, and so on. Eventually, by working back through
all the nodes, the value of the option at time zero is obtained. This procedure
Another way of calculating the option prices is by directly taking the dis-
counted value of the expected payoff of the option in the risk-neutral world. For
example the European put, with strike price K and maturity T has a value:
N
X N
e−rT
max{K − S0 uj dN −j , 0}pj (1 − p)N −j
j=0 j
For more complex options, but where the payoff only depends on the final stock
price, i.e. the payoff is a function of ST , g(ST ) say, a similar expression can be
51
Figure 2.6: General binomial tree for stock price
where Ep denotes the expectation in the risk-neutral world, i.e. with a probabil-
52
2.3.2 American Options
to check at each node to see whether early exercise is preferable to holding the
option for a further time period ∆t. Eventually, again by working back through
all the nodes the value of the option at time zero is obtained.
when the current stock price is 50 euro, the strike price is also 50 euro, the risk-
free interest rate is 10 percent per annum, and the volatility is 40 percent per
annum. With our usual notation, this means that S0 = 50, K = 50, r = 0.10,
σ = 0.40, and T = 152/365 = 0.416. Suppose that we divide the life of the
option into five intervals of length one month (= 0.0833 year) for the purposes
∆t = 0.0833
√
u = eσ ∆t
= 1.1224
√
d = e−σ ∆t
= 0.8909
At each node there are two numbers. The top one shows the stock price
at the node; the lower one shows the value of the option at the node. The
53
Figure 2.7: Binomial tree for American put option
The option prices at the final nodes are calculated as max{K − ST , 0}. The
option prices at the penultimate nodes are calculated from the option prices at
the final nodes. First, we assume no exercise of the option at the nodes. This
means that the option price is calculated as the present value of the expected
option price one step later. For example at node C, the option price is calculated
as
54
whereas at node A it is calculated as
early exercise would give a value for the option of zero because both the stock
price and the strick price are 50 euro. Clearly it is best to wait. The correct
value for the option at node C is, therefore, 2.66 euro. At node A, it is a different
more than 9.90. If node A is reached, the option should therefore, be exercised
and the correct value for the option at node A is 10.31 euro.
Option prices at earlier nodes are calculated in a similar way. Note that it
is not always best to exercise an option early when it is in the money. Consider
if it is held, it is worth
The option should, therefore, not be exercised at this node, and the correct
Working back through the tree, we find the value of the option at the initial
node to be 4.49 euro. This is our numerical estimate for the option’s current
value. In practice, a smaller value of ∆t, and many more nodes, would be used.
It can be shown that with 30, 50, and 100 time steps we get values for the option
55
paying stock is divided into N subintervals of length ∆t. We will refer to the
jth node at time i∆t as the (i, j) node. Define fi,j as the value of the option
at the (i, j) node. The stock price at the (i, j) node is S0 uj di−j . Because the
that
There is a probability, p, of moving from the (i, j) node at time i∆t to the
value for fi,j must be compared with the option’s intrinsic value, and we obtain
Note that, because the calculations start at time T and work backward, the
value at time i∆t captures not only the effect of early exercise possibilities at
time i∆t, but also the effect of early exercise at subsequent times. In the limit as
∆t tends to zero, an exact value for the American put is obtained. In practice,
56
It is never optimal to exercise an American call option
We are now going to proof that for a non-dividend paying stock the price of a
European call and an American call are the same. This means that an early
first proof
with strike price K and time to expiry T , on a non-dividend paying stock with
Proof: That C ≥ 0 is obvious, otherwise ’buying’ the call would give a riskless
To prove the remaining lower bound, we setup an arbitrage table (Table 2.1)
for a portfolio, which has a positive current cash flow. This is clearly an arbitrage
Suppose now that the American call is exercised at some time t strictly less
than expiry T , i.e. t < T . The financial agent thereby realises a cash-flow
57
Portfolio Current cash flow Value at expiry
ST ≤ K ST > K
Buy 1 call −C 0 ST − K
Balance S − C − e−rT K ≥ 0 K − ST ≥ 0 0
St − K. From the above proposition we know that the value of the call must be
the call would have realised a higher cash-flow and the early exercise of the call
CA = C E
There are two reasons why an American call should not be exercised early.
• Insurance: An investor which holds the call option does not care if the
share price falls far below the strike price - he just discards the option -
but if he held the stock, he would. Thus the option insures the investor
against such a fall in stock price, and if he exercises early, he loses this
insurance.
• Interest on the strike price: When the holder exercises the option, he buys
the stock and pays the strike price, K. Early exercise at time t < T
58
deprives the holder of the interest on K between times t and T : the later
Notice how this changes when we consider American puts in place of calls:
The insurance aspect above still holds, but the interest aspect above is reversed
(the holder receives cash K at the exercise time, rather than paying it out).
By creating a tree with more and more time steps, that is by taking smaller and
smaller time-steps, we can get finer and finer graduations at the final stage and
value. Which limiting price we obtain will depend on how we make the tree
finer - this essentially comes down to assumptions we make about the random
Let us try to price an option with payoff function f (ST ) and we will refine
√
u = eσ ∆t
(2.16)
√
d = e−σ ∆t
. (2.17)
equals:
p
exp(rT ) − exp(−σ T /N )
pN = p p
exp(σ T /N − exp(−σ T /N))
59
Let us now investigate the risk-neutral limiting distribution of ST :
N
Y √ √ XN
ST = S 0 eZj σ T /N = S0 exp σ ∆t Zj ,
j=1 j=1
where Zj are independent random variables taking the values −1 and 1, with
In other words:
p N
X
log ST = log S0 + σ T /N Zj .
j=1
all with the same distribution as X of which the second moment is finite. Then
PN
j=1 −N E[X]
p →D N ,
N Var[X]
with N a standard Normal distributed variable (with mean zero and variance
equal to one).
We note that
E[Zj ] = 2pN − 1;
Var[Zj ] = 4pN (1 − pN ).
p
N E[Zj ] T /Nσ → (r − (1/2)σ 2 )T ;
q p √
Var[Zj ]N T /Nσ → σ T.
60
leads to
√
1 2
log ST →D log S0 + σ T N + r − σ T
2
when N → +∞. The distribution of the logarithm of the stock price thus follows
√
1 2
lim exp(−rT )EpN [g(ST )] = exp(−rT )E g S0 exp(σ T N + r − σ T .
N →∞ 2
In case of the European call option with strike K and time to maturity T , one
can with a little effort show that its initial price is given by:
where
σ2
ln(S0 /K) + (r + 2 )T
d1 = √ (2.18)
σ T
σ2 √
ln(S0 /K) + (r − 2 )T
d2 = √ = d1 − σ T (2.19)
σ T
and N (x) is the cumulative probability distribution function for a variable that
61
Chapter 3
Mathematical Finance in
Discrete Time
Any variable whose value changes over time in an uncertain way is said to
value of the variable can change only at certain fixed points in time, whereas
only certain discrete values are possible. Binomial tree models belong to the
62
In this chapter we study so-called finite markets, i.e. discrete-time models
of financial markets in which all relevant quantities take a finite number of val-
ues. We specify a time horizon T , which is the terminal date for all economic
activities considered. For a simple option pricing model the time horizon typi-
cally corresponds to the expiry date of the option. We thus work with a finite
probability space (Ω, P ), with a finite number |Ω| of possible outcomes ω, each
ourselves to the situation where agents take decisions on the basis of information
in the public domain, available to all. We shall further assume that information
Our financial market contains two financial assets. A risk-free asset (the
bond) with a deterministic price process Bi , and a risky assets with a stochastic
the bond) and Bi > 0; we say it is a numeraire. 1/Bi is called the discounting
factor at time i.
63
time: filtrations. The concept filtration is not that easy to understand. The full
theory will lead us too far. In order to clear this out a bit, we explain the idea
X which starts at some value, zero say. It will remain there until time t = 1,
value b. The process will stay at that value until time t = 2 at which it will
jump again with positive probability to two different values: c and d say if is
was at time t = 1 at a and f and g say if the process was at time t = 1 at state
b. From then on the process will stay in the same value. The universum of the
probability space consists of all possible paths the process can follow, i.e. all
In this situation we will take the following flow of information, i.e. filtrations:
Ft = {∅, Ω} 0 ≤ t < 1;
Ft = D(Ω) = F 2 ≤ t.
To each of the filtrations given above, we associate resp. the following par-
64
titions (i.e. the finest possible one) of Ω:
P0 = {Ω} 0 ≤ t < 1;
only know that some event ω ∗ ∈ Ω. At time point after t = 1 and strictly before
t = 2, i.e. 1 ≤ t < 2, we know to which state the process has jumped at time
belong, in other words we will know then the complete path of the process.
During the flow of time we thus learn about the partitions. Having the
of that time, the event ω ∗ is. The partitions become finer in each step and thus
clear that the price of the stock Si at time i (and i − 1, i − 2, ..., 0) is contained
in the information Fi .
65
it is G-measurable. So we have that Si is Fi -measurable. A stochastic process
process such that each ϕi is Fi−1 -adapted. Here βi , ζi denotes the numbers of
bonds ands stocks resp. held at time i and to be determined on the basis of
information available strictly before time i: Fi−1 ; i.e. the investor selects his
time i portfolio after observing the prices Si−1 . The components βi , ζi may
assume negative values as well as positive values, reflecting the fact that we
allow short sales and assume that the assets are perfectly divisible.
The value of the portfolio ϕ at time i, Viϕ = Vi , is called the wealth or value
Viϕ = Vi = βi Bi + ζi Si , i = 1, 2, . . . , T
Now βi Bi−1 + ζi Si−1 reflects the market value of the portfolio just after it
time i prices are observed, but before changes are made in the portfolio. Hence
is the change in the market value due to changes in security prices which occur
66
the gains process.
After the new prices (Bi , Si ) are quoted at time i, the investor adjusts his
portfolio from ϕi = (βi , ζi ) to ϕi+1 = (βi+1 , ζi+1 ). We do not allow him bringing
V0 = β 1 B 0 + ζ 1 S 0 , Vi = βi+1 Bi + ζi+1 Si , i = 1, . . . , T
To avoid negative wealth and unbounded short sales we also introduce the
The central principle in the Binomial tree models was the absence of arbitrage
opportunities, i.e. the absence of risk-free plans for making profits without any
investment. As mentioned there this principle is central for any market model,
our setting.
67
which produces a non-negative final value with probability one and has a postive
• X is F-adapted
Note that in a more general context a third condition is required: EQ [|Xi |] < ∞.
automatically satisfied.
EQ [Xi |Fj ] = Xj , 0 ≤ j ≤ i ≤ T.
will use the notation X̃ for the discounted version of the process X : X̃i =
Bi−1 Xi . For eaxmple, we will denote by S̃ the discounted stock price process :
S̃i = Bi−1 Si .
68
As a kind of example of the above concepts, we show the following proposit-
tion which we will later on need to prove one direction of the No-Arbitrage
Theorem.
= βi + ζi EP ∗ [Bi−1 Si )|Fi−1 ];
−1
= βi + ζi Bi−1 Si−1 ;
−1
= Bi−1 (βi Bi−1 + ζi Si−1 );
−1
= Bi−1 (βi−1 Bi−1 + ζi−1 Si−1 );
= Ṽi−1 ,
where the third line is because S̃ is a P ∗ -martingale and the fifth line is because
only if there exists an equivalent martingale measure for the discounted price
69
Proof : We only prove that P(S̃) 6= ∅ implies that the market is arbitrage-
free; the other direction can be proven using the Hahn-Banach theorem from
Functional Analysis.
EP ∗ [VTϕ ] = V0ϕ .
One can show that a security market which has no arbitrage opportunities
We now turn to the main underlying question of this text, namely the pricing
fashion.
claims by X .
70
We say that the claim is attainable if there exists an (admissible) self-
VTϕ = X.
We now return to the main question of the section: given a contingent claim
X, i.e. a cash-flow at time T , how can we determine its value (price) at time
i < T ? For attainable contingent claims this value should be given by the
value of any replicating strategy (perfect hedge) at time i, i.e. there should be
a unique value process (say ViX ) representing the time i value of the claim X.
The following proposition ensures that the value process of replicating strategies
VTϕ = VTψ = X
Viϕ = Viψ
contingent claim with time T to maturity. Then the arbitrage price process π iX ,
71
0 ≤ i ≤ T or simply the arbitrage price of X is given by the value process of
arbitrage valuation models, such as the Binomial tree models and the Black-
Scholes Model (see the next Chapters), depend on the idea that an option can
be perfectly hedged using the underlying risky asset and a risk-free asset.
the price of a contingent claim doesn’t require any specific preferences of the
agents other than that they prefer more to less, which rules out arbitrage. So,
the pricing formula for any attainable contingent claim must be independent
risk-neutral investors must price a contigent claim in the same manner. This
form the price of an attainable contingent claim is just the expected value of
Bi
πiX = EP ∗ [X|Fi ], i = 0, 1, . . . , T
BT
measure P ∗ .
72
Proof: Since we assume that the market is arbitrage-free there exists (at
S̃i . Furthermore because the claim is attainable there exists (at least) one
of ϕ = (βi , ζi )
= EP ∗ [Ṽiϕ − Ṽi−1
ϕ
|Fi−1 ]
= 0.
73
The last equality follows because S̃i = Bi−1 Si is P ∗ -martingale. So we have for
each i = 0, 1, . . . , T
πiX = Viϕ
= Bi Ṽiϕ
= Bi EP ∗ [ṼTϕ |Fi ]
The last section made clear that attainable contingent claims can be priced using
of the circumstances under which all contingent claims are attainable. This
would be a very desirable property of the market, because we would then have
solved the pricing question (at least for contingent claims) completely under
the assumption that the market is arbitrage free. Since contingent claims are
start with:
74
replicating strategy ϕ ∈ Φ such that VTϕ = X.
under which the discounted price process of the stock S̃i = Bi−1 Si is a martin-
gent claims can be replicated) if and only if there exists a unique equivalent
martingale measure.
So
75
Theorem 15 (Fundamental Theorem of Asset Pricing) In an arbitrage-
measures.
Assume now that the market is arbitrage-free and complete and let X ∈ X
then:
VTϕ = X
Bi
πiX = Viϕ = EP ∗ [X|Fi ], i = 0, 1, . . . , T
BT
and call πiX = Viϕ the the arbitrage price of the contingent claim X at time i.
For, if an investor sells the claim X at time i for πiX , he can follow strategy
ϕ to replicate X at time T and clear the claim; an investor selling this value
is perfectly hedged. To sell the claim for any other amount would provide an
know only:
• the filtration F,
• P ∗.
76
We do not need to know the underlying probability measure P (only its null
sets, to know what ’equivalent to P ’ means and actually in our finite model
Now pricing of contingent claims is our central task, and for pricing purposes
P ∗ is vital and P itself irrelevant. We thus may – and shall – focus attention
To summarize, we have:
market, arbitrage prices of contingent claims are their discounted expected values
3.5.1 Examples
We return to model given in Figure 2.2. There exists only two possible outcomes.
There is an upperstate u if price after one time step equals S1 = uS0 and a
cases the riskfree asset goes from 1 to a price b say (b is typically equal to
number 0 < P ({u}) < 1; we then have P ({d}) = 1 − P ({u}). In order that
EP ∗ [b−1 S1 |F0 ] = S0
77
or equivalently
b−d
p∗ = (3.2)
u−d
In order that this gives rise to a probability measure, we should have 0 < p∗ < 1,
if and only if (3.3) is satisfied. If (3.3) holds true, then there is a unique such
Note that (3.3) means that by investing in a stock one can have a bigger
return than the risk-free return (u > b), but also can have a greater loss (b > d).
Note also that one can easily show that the multi-period model of Section
78
Figure 3.1: The One-step Trinomial Model
In order to hedge or replicated this claim one has to solve the equations
ξuS0 + ηb = fu
ξdS0 + ηb = fd
Note that this system of equations has a unique solution if and only if
uS0 b
det 6= 0,
dS0 b
Suppose now the following one-step trinomial model: In one time step there
if the stock price changes to S1 = uS0 , a middle state m if the stock price after
one step is S1 = mS0 , and a down-state d if the stock price changes to S1 = dS0 ,
0 ≤ d < m < u: Ω = {u, m, d}. Again, in all cases the riskfree asset changes in
79
completely determined by two numbers 0 < P ({u}) < 1 and 0 < P ({m}) < 1;
0 < P ∗ ({u}) = p∗ < 1 and 0 < P ∗ ({m}) = q ∗ < 1, on Ω, it has to satisfy again
EP ∗ [b−1 S1 |F0 ] = S0
or equivalently
Unfortunately this equation has more than one solution as can be easily been
(b − d) − (m − d)q ∗
p∗ =
u−d
For every 0 < q ∗ < 1 there is a corresponding p∗ . If we then take also into
account that the values of p∗ and q ∗ must give rise to a probability distribution,
i.e. 0 < p∗ , q ∗ < 1 and p∗ + q ∗ < 1, there still are infinitely many solutions.
In conclusion there exist more then one martingale measure for the discounted
stock price. So the one-step trinomial model is arbitrage free, but is not com-
plete.
state and fd in the down state it can only be replicated if there exists a solution
80
to the equations
ξuS0 + ηb = fu
ξmS0 + ηb = fm
ξdS0 + ηb = fd
So only contingent claims which payoff function satisfies the above condition
81
Chapter 4
Exotic Options
Derivatives with more complicated payoffs than the standard European or Amer-
ican calls and puts are referred to as exotics options. Most exotics options are
traded in the OTC market and have been designed to meet particular needs of
investors.
In this chapter we describe different types of exotic options and discuss their
82
4.1 Monte Carlo Pricing
When the payoff depends on the path followed by the underlying variable S
in theory one has to consider every possible path. When using 30 time steps
in the Binomial tree model, there are about a billion different paths and one
has to relay on (Monte Carlo) simulations, which are computationally very time
3. Repeat steps one and two to get many sample values of the payoff from
4. Calculate the mean of the sample payoff to get an estimate of the expected
and our task has been to make optimal use of the information available to date.
For options, at expiry T the investor is in posssesion of the history of the price
evolution over time interval [0, T ] of the option’s life, and it may well be that
83
one could have been doing better. It is only natural to look back with regret.
If only one could buy at the low, and sell at the high ...
In order to provide some investor the right to do that lookback options were
created.
We write S for the stock price process and consider a time interval [0, T ].
{Xt , 0 ≤ t ≤ T } as
The two basic types of continuously montiored lookback options are the
LC cont (T ) = ST − mST ,
giving one the right to buy at the low over [0, T ], and the lookback put with
payoff
LP cont (T ) = MTS − ST ,
Consider an a partition of [0, T ] into n equal time intervals with size ∆t = T /n.
Write Si for the stock price value at time i∆t and MiS , mSi for its maximum
and minimum over [0, i∆t]. The discretely monitored versions payout
LC discr (T ) = Sn − mSn ,
and
LP discr (T ) = MnS − Sn ,
84
respectively.
put can be priced using binomial trees. Later, we will comment on the American
version. When exercised, this provides a payoff equal to the excess of the current
Set
MiS
Yi =
Si
and produce a binomial tree for the stock price (using the Cox-Ross-Rubenstein
setting). See the left tree in Figure 4.1. From this tree produce a corresponding
the first step, both the maximum and the stock price increase by a proportional
Continuing with these types of arguments, we produce the tree shown in Figure
4.1 (σ = 0.40, r = 0.10). The rules defining the geometry of the tree are
the probability of a up-movement in the stock. Note thus that p is also the
probability of a down-movement of Y .
We will use the Y -tree to value the lookback option in units of the stock
85
price (rather then in euros). In euros, the payoff from the option is
S n Yn − S n .
Yn − 1.
We roll back through the tree in the usual way, valuing a derivative that provides
this payoff except that we adjust for the differences in the stock prices (i.e. the
units of measurement) at the nodes. If fi,j is the value of the lookback at the
jth node at time iδt, and Yi,j is the value of Y at this node: Yi,j = uj , the
eur
fi,j = exp(−r∆t)((1 − p)fi+1,j+1 d + pfi+1,j−1 u),
in this equation. This takes into account that the stock price at node (i, j) is the
unit of measurement. The stock price at node (i + 1, j + 1), which was the unit
of measurement for fi+1,j+1 is d times the stock price at node (i, j). Similarly,
the stock price at node (i + 1, j − 1), which was the unit of measurement for
fi+1,j−1 is u times the stock price at node (i, j). When j = 0, the roll back
procedure gives
eur
fi,0 = exp(−r∆t)((1 − p)fi+1,1 d + pfi+1,0 u),
The tree is initialized at the final nodes with the boundary conditions
eur
fn,j = Yn,j − 1
eur
fn,0 = 0.
86
Figure 4.1: Lookback tree example
The tree (with 5 time steps) in the Figure 4.1 estimates the value of the
option at time zero (in stock price units) as 0.230 for the European version.
This means that the value of the option is 0.230 × S0 = 11.50 euros.
comparing the european price with the early exercise price (Yi,j − 1) and taking
amer
fi,j = max {Yi,j − 1, exp(−r∆t)((1 − p)fi+1,j+1 d + pfi+1,j−1 u)} , j≥1
amer
fi,0 = exp(−r∆t)((1 − p)fi+1,1 d + pfi+1,0 u),
87
the boundary conditions remain the same:
amer
fn,j = Yn,j − 1
amer
fn,0 = 0.
continuously montinored lookback options. It is quite well known that the tree-
values converge slowly to this value. This is due because, one is actually missing
all the situations where a maximum/minimum has been attained in between two
discrete montoring points and where the stock price has fallen/risen back before
The payoff of a barrier option depends on whether the price of the underlying
asset crosses a given threshold (the barrier) before maturity. The simplest bar-
rier options are “knock in” options which come into existence when the price of
the underlying asset touches the barrier and “knock-out” options which come
out of existence in that case. For example, an up-and-out call has the same
payoff as a regular plain vanilla call if the price of the underlying asset remains
below the barrier over the life of the option but becomes worthless as soon as
Let us denote with 1(A) the indicator function, which has a value 1 if A is
For single barrier options, we will focus on the following types of call options:
88
• The down-and-out barrier call is worthless unless its minimum remains
if its minimum went below some low barrier H. If this barrier was never
reached during the life-time of the option, the option is worthless. Its
• The up-and-in barrier call is worthless unless its maximum crossed some
• The up-and-out barrier call is worthless unless its maximum remains below
89
We note that the value, DIBC, of the down-and-in barrier call option with
barrier H and strike K plus the value, DOBC, of the down-and-out barrier
option with same barrier H and same strike K, is equal to the value C of the
vanilla call with strike K. The same is true for the up-and-out together with
the up-and-in:
The above options are so-called continuously monitored. Their value can
case.
These discretely monitored barrier options (of european and american type)
can again be priced using the binomial tree setup. For example an American
option except that, when we encounter a node below the barrier, we set the
and for i = n
fn,j = K − S0 uj dn−j if Sn ≥ H
fn,j = 0 if Sn < H
Similar schemes can be easily deduced for the other combinations. Unfortu-
nately, convergence of the price of the discretely monitored option to the price
90
of the continuouss is also here very slow when this approach is used. A large
reason for this is that the barrier being assumed by the tree is different fom the
true barrier. Define the inner barrier as the barrier formed by nodes on the side
of the true barrier (i.e., closer to the center of the tree) and the outer barrier
as the barrier formed by nodes just outside the true barrier (i.e., farther away
from the center of the tree). Figure 4.2 shows the inner and outer barrier for a
trinomial tree on the assumption the true barrier is horizontal. Figure 4.3 does
the same for a binomial tree. The usual tree calculations implicitly assume that
the outer barrier is the true barrier because the barrier conditions are first used
rolling back through the tree, two values of the derivative (for the nodes on
the inner barrier). The first one is obtained by assuming the inner barrier is
correct; the second one is obtained by assuming the outer barrier is correct. A
final estimate for the value of the derivative for the true barrier is then obtained
For example, suppose that at time i∆t, the true value barrier is 0.2 above the
inner barrier and 0.6 below the outer barrier and suppose further that the value
of the derivative on the inner barrier is zero if the inner barrier is assumed to be
correct and 1.6 if the outer barrier is assumed to be correct. The interpolated
value (for the inner barrier node) is then 0.4. Once we have adjusted the value
at the inner barrier node, we can roll back through the tree to obtain the initial
91
Figure 4.2: Trinomial tree: inner and outer barrier
92
Figure 4.3: Trinomial tree: inner and outer barrier
93
value of the derivative in the usual way.
call option with strike price K, maturity T and n averaging days 0 ≤ t1 < . . . <
tn ≤ T .
The american versions allows early exercise and in that case pays out the surplus
over the strike price K of the running average. For the put version just switch
Average price options are typically less expensive than regular options and are
arguably more appropriate than regular options for meeting some of investors
needs. Asian options are widely used in pratice - for instance, for oil and foreign
currencies. The averaging complicates the mathematics, but e.g., protects the
holder against speculative attemps to manipulate the asset price near expiry.
Assume for simplicity that t = 0 and that the averaging has not yet started.
Pn
First note, that for any K1 , . . . , Kn ≥ 0 with K = k=1 Kk , we have
n
!+ n
+ X
+
X
Stk − nK = (St1 − nK1 ) + · · · + (Stn − nKn ) ≤ (Stk − nKk ) .
k=1 k=1
94
Hence the intial price AAC0 (K, T )
!+
n
exp(−rT ) X
AAC0 (K, T ) = EP ∗ Stk − nK
F0
n
k=1
n
exp(−rT ) X h i
+
≤ EP ∗ (Stk − nKk ) F0
n
k=1
n
exp(−rT ) X
= exp(rtk )EC0 (κk , tk ), (4.2)
n
k=1
where EC0 (κk , tk ) denotes the price of a European call option at time 0 with
In terms of hedging, this means that we have the following static super-
hedging strategy: for each averaging day tk , buy exp(−r(T − tk ))/n European
call options at time t = 0 with strike κk and maturity tk and hold these until
Since the upper bound (4.2) holds for all combinations of κk ≥ 0 that satisfy
Pn
k=1 κk = nK, one still has the freedom to choose strike values.
the right-hand side of (4.2). This can be done using comonotonic theory, but
Next, we discuss the pricing of the European and American AAC using
binomial tree models. However, the procedure is not as simple as in the barrier
95
case and this because at each node we do not know the running average when
we reached that node. Typically, all different paths to reach the node lead to
different average prices, and the number of paths grow exponentially. Luckily,
the tree-approach can be extended to cope with this under certain circumstance.
single function of the path followed, namely the average stock price. We call
The trick is tp carry out, at each node, the calculations for a small number
of representative values of the path function. When the value of the derivative
is required for other values of the path function, we calculate it from the known
Suppose the initial stock price is 50, the strike price is 50, r = 0.10 and
the volatility is 0.40, and the time to maturity is one year. We use a tree with
20 time steps. The parameters describing the binomial tree parameters are
Figure 4.4 shows the calculations that are carried out in one small part of
the tree. Node X is the central node at time 0.2 year (at the end of the fourth
time step). Nodes Y and Z are the two nodes at time 0.25 years that are
reachable from node X. The stock price is X is 50. Forward induction shows
that the maximum average stock price achievable in reaching node X is 53.83.
The minimum is 46.65. (We include both the initial and final stock prices when
96
Figure 4.4: Part of tree for Asian option
one of the two nodes Y and Z. At node Y , the stock price is 54.68 and the
bounds for the average are 47.99 and 57.39. At node Z, the stock price is 45.72
and the bounds for the average stock price are 43.88 and 52.48.
be four equally spaced values at each node. This means that at node X, we
consider the averages 46.65, 49.04, 51.44, and 57.83. At node Y , we consider the
averages 47.99, 51.12, 54.26, and 57.39. At node Z, we consider the averages
43.88, 46.75, 49.61, and 52.48. We assume backward induction has already been
used to calculate the value of the option for each of the alternative valuesof the
average at node Y and Z. The values are shown in Figure 4.4. For exemple, at
97
node Y when the average is 51.12, the value of the option is 8.101.
Consider the calculation at node X for the case where the average is 51.44. If
the stock price moves up to node Y , the new average will be 5×51.44+54.68)/6 =
51.98. The value of the derivative at node Y for this average can be found by
interpolating between the values when the average is 51.12 and when it is 54.26.
It is
(51.98 − 51.12) × 8.635 + (54.26 − 51.98) × 8.101
= 8.247.
54.26 − 51.12
Similarly, if the stock price moves down to node Z, the new average will be
is 4.182. The value of the derivative at node X when the average is 51.44 is,
therefore,
The other values at node X are calculated similarly. Once the values at all
nodes at time 0.2 year have been calculated, we can move on to the nodes at
The value given by the full tree for the option at time zero is 7.17. As the
number of time steps and the number of averages considered at each node is
increased, the value of the option converges to the correct answer. With 60 time
steps and 100 averages at each node, the value of the option is 5.58. The true
A key advantage of the method here is that it can handle American options.
The calculations are as we have described them except that we test for early
98
exercise at each node for each of the alternative values of the path function at
the node.
The approach just described can be used in a wide range of different situa-
• the payoff from the derivative must depend on a single function, the path
• it must be possible to calculate the value of the path function at time t+∆t
from the value of this function at time t and the value of underlying asset
at time t + ∆t.
99
Chapter 5
Price Model
In the early 1970s, Fischer Black, Myron Scholes, and Robert Merton made
become known as the Black-Scholes model. The model has had huge influence
on the way that traders price and hedge options. In 1997, the importance of the
model was recognized when Myron Scholes and Robert Merton were awarded
the Nobel prize for economics. Sadly, Fischer Black died in 1995, otherwise he
also would undoubtedly have been one of the recipients of this prize.
This chapter shows how the Black-Scholes model for valuing European call
100
5.1 Continuous-Time Stochastic Processes
for stock prices. An understanding of this process is the first step to understand-
ing the pricing of options and other more complicated derivatives. It should
(often multiples of 0.01 euro) and changes can be observed only when the ex-
The underlying set-up is as in the discrete time case. We assume a fixed finite
available at time t, and the filtration F = (Ft ) represents the information flow
evolving with time.
We assume that the filtered probability space (Ω, FT , P, F) satisfies the ’usual
know which events are possible and which not, and b) (Ft ) is right-continuous,
101
for each t: thus Xt is known at time t.
5.1.2 Martingales
• X is F-adapted
A martingale is ’constant on average’, and models a fair game. This can be seen
from the third condition: the best forecast of the unobserved future value Xt
under a microscope in 1828 and 1829, and observed that they were in constant
rigorously for the first time. The resulting stochastic process is often called the
102
Definition 17 A stochastic process X = {Xt , t ≥ 0} is a standard Brownian
1. X0 = 0 a.s.
4. Xt+s −Xt is normally distributed with mean 0 and variance s: Xt+s −Xt ∼
N(0, s).
(W for Wiener).
Construction
No construction of Brownian motion is easy: one needs both some work and
Brownian motion with a simple symmetric random walk on the integers. More
√
Yk (t) = Zbktc / k,
103
where bxc is the integer part of x. Then from the Central Limit Theorem,
Yk (t) → Wt as k → ∞,
0.8
0.6
0.4
0.2
−0.2
−0.4
−0.6
−0.8
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Figure 5.2, one sees the random-walk approximation of the standard Brownian
motion. The process Yk = {Yk (t), t ≥ 0} is shown for k = 1 (i.e. the symmetric
the dynamic counterpart – where we work with evolution in time – of the uni-
statistics, science, economy etc. Both arise from the same source, the central
limit theorem. This says that when we average large numbers of independent
104
k=1 k=3
10 10
5 5
0 0
−5 −5
−10 −10
0 10 20 30 40 50 0 10 20 30 40 50
k=10 k=50
10 10
5 5
0 0
−5 −5
−10 −10
0 10 20 30 40 50 0 10 20 30 40 50
or Brownian motion in a dynamic context. What the central limit theory really
says is that, when what we observe is the result of a very large number of indi-
vidually very small influences, the normal distribution or Brownian motion will
Martingale Property
for all 0 ≤ s ≤ t,
105
We also mention that one has:
Path Properties
One can proof that Brownian motion has continuous paths, i.e. Wt is a continu-
ous function of t. However the paths of Brownian motion are very erratic. They
are for example nowhere differentiable. Moreover, one can prove also that the
paths of Brownian motion are of infinite variation, i.e. their variation is infinite
on every interval.
that
This result tells us that the Brownian path will keep oscillating between positive
Scaling Property
duce another Brownian motion. One of this is the scaling property which says
is a Brownian motion.
106
5.3 Itô’s Calculus
Stochastic integration was introduced by K. Itô in 1941, hence its name Itô
integrand and the integrator. We shall confine our attention here to the basic
val, the first thing to note is that stochastic integrals with respect to Brownian
motion, if they exist, must be quite different from the classical deterministic in-
tegrals. We take for granted Itô’s fundamental insight that stochastic integrals
We only show how these integrals can be defined for some simple integrands
X.
Indicators
If Xt = 1[a,b] (t), i.e. it equals 1 between a and b and is zero elsewhere, we define
R
XdW :
0 if t ≤ a
Z t
It (X) = Xs dWs = Wt − W a if a ≤ t ≤ b
0
Wb − W a
if t ≥ b
107
Simple deterministic functions
(|ξk | ≤ C for all k = 0, . . . , n for some C) and if Xt can be written in the form
n−1
X
Xt = ξ0 10 (t) + ξi 1(ti ,ti+1 ] (t), 0 ≤ t ≤ T.
i=0
Then if tk ≤ t ≤ tk+1 , k = 0, . . . , n − 1,
Z t k−1
X
It (X) = Xs dWs = ξi (Wti+1 − Wti ) + ξk (Wt − Wtk )
0 i=0
defined so far:
• It (X) is a martingale.
Rt
• Itô isometry: E[(It (X))2 ] = 0 E[(Xu )2 ]du.
Rt
The Itô isometry above suggests that 0
XdW should be defined only for processes
Rt
with 0 E[(Xu )2 ]du < ∞ for all t and this is indeed the case. Each such X may
108
the three above properties remain true. We will not include the technical and
detailed proofs of this procedure in this book. Note that one also can construct
a closely analogous theory for stochastic integrals with the Brownian integrator
The price of a stock option is a function of the underlying stock’s price and
time. More generally, we can say that the price of any derivative is a function of
the stochastic variables underlying the derivative and time. Therefore, we must
as Itô’s lemma.
once in its first argument (which will denote time), and twice in its second
∂F
Ft (t, x) = (t, x)
∂t
∂F
Fx (t, x) = (t, x)
∂x
∂2F
Fxx (t, x) = (t, x)
∂x2
t t t
1
Z Z Z
F (t, Wt )−F (s, Ws ) = Fx (u, Wu )dWu + Ft (u, Wu )du+ Fxx (u, Wu )du.
s s 2 s
109
or
1
dF = Fx dWt + Ft dt + Fxx dt.
2
for short.
Rt
As an application of Itô’s lemma we compute 0 Wu dWu by using F (t, x) =
x2 . Then
t t t
1
Z Z Z
Wt2 = W02 + 2Wu dWu + 2du = 2 Wu dWu + t.
0 2 0 0
So that
t
Wt2 t
Z
Wu dWu = −
0 2 2
Note the contrast with ordinary calculus ! Itô calculus requires the second term
Like with any ordinary and partial differential equations in a deterministic set-
ting (ODEs and PDEs), the two most basic questions are those of existence and
110
where the coefficients b and σ satisfy the following Lipschitz and growth condi-
tions
To see that the SDE (5.2) has a solution, we first define recursively
Z t Z t
(0) (n+1)
Xt = x, Xt =x+ b(u, Xu(n) )du + σ(u, Xu(n) )dWu .
s s
(n)
One can then prove that Xt converges (in some sense), to Xt say; Xt is the
Z t Z t
X0 = x, Xt = x + b(u, Xu )du + σ(u, Xu )dWu .
s s
The next result, which is an example for the rich interplay between probabil-
ity theory and analysis, links SDEs with PDEs. Suppose we consider a stochastic
Consider a function F (t, x) ∈ C 1,2 of it. Then we have the following extension
of Itô’s lemma:
Z t
F (t, Xt ) − F (s, Xs ) = σ(u, Xu )Fx (u, Xu )dWu + (5.3)
s
Z t
σ(u, Xu )2
Ft (u, Xu ) + µ(u, Xu )Fx (u, Xu ) + Fxx (u, Xu ) du.
s 2
111
Now suppose that F satisfies the PDE
(σ(t, x))2
Ft (t, x) + µ(t, x)Fx (t, x) + Fxx (t, x) = 0,
2
F (T, x) = h(x).
Z t
F (s, Xs ) = F (t, Xt ) − σ(u, Xu )Fx (u, Xu )dWu
s
Now that we have both Brownian motion W and Itô’s Lemma to hand, we can
introduce the most important stochastic process for us, a relative of Brownian
112
Suppose we wish to model the time evolution of a stock price St . Consider
how S will change in some small time interval from the present time t to a time
t + ∆t in the near future. Writing ∆St for the change St+∆t − St , the return on
to decompose into two components, a systematic part and a random part. The
representing the mean rate of the return of the stock. The random part could
plausibly be modeled by σ∆Wt , where ∆Wt represent the noise term driving the
stock price dynamics, and σ is a second parameter describing how much effect
the noise has – how much the stock price fluctuates. Thus σ governs how volatile
the price is, and is called the volatility of the stock. The role of the driving noise
σ2
St = S0 exp µ− t + σWt .
2
For, writing
σ2
f (t, x) = exp µ− t + σx
2
113
Itô’s lemma gives
δf δf 1 δ2 f
df (t, Wt ) = dt + dWt + dt
δt δx 2 δx2
σ2
1
= µ− f dt + σf dWt + σ 2 f dt
2 2
= f (µdt + σdWt )
σ2
log St = log S0 + µ − t + σWt
2
entails, are the basis for the Black-Scholes model for stock-price dynamics in
continuous time.
In Figure 5.3 one sees the realization of the geometric Brownian motion
based on the sample path of the standard Brownian motion of Figure ??.
We consider a frictionless security market in which two assets are traded con-
The first asset is one without risk (the bank account). Its price process is
114
Figure 5.3: Sample path of a geometric Brownian motion (S0 = 100, µ =
0.05, σ = 0.40)
Brownian motion:
σ2
St = S0 exp µ− t + σWt .
2
µ is reflecting the drift and σ models the volatility and are assumed to be
115
Our principle task will be the pricing and hedging of contingent claims, which
the contingent claims specify a stochastic cash-flow at time T and that they
may depend on the whole path of the underlying in [0, T ] – because FT contains
all information.
a trading strategy or dynamic portfolio process. The conditions ensure that the
Rt
stochastic integral 0
ξt dWt exists. Here βt denotes the money invested in the
riskless asset and ξt denotes the number of stocks held in the portfolio at time
t.
t, Ft− : the investor selects his time t portfolio just before the observation of the
116
The components of ϕt may assume negative as well as positive values, reflect-
ing the fact that we allow short sales and assume that the assets are perfectly
divisible.
Vt = Vtϕ = βt Bt + ξt St = βt ert + ξt St
The process Vtϕ is called the value process, or wealth process, of the trading
strategy ϕ.
Z t Z t
Gt = G ϕ
t = βu dBu + ξu dSu
0 0
fies
Vtϕ = V0ϕ + Gϕ
t for all t ∈ [0, T ].
The financial implications of the above equations are that all changes in the
Neutral Pricing
Next, we develop a pricing theory for contingent claims. Again the underlying
concept is the link between the no-arbitrage condition and certain probability
117
measures. We begin with
the broker from unbounded short sales. Using tame strategies the investor’s
wealth may never go negative at a time, even if he is able to cover his debt at
the final date. If we would later on allow non-tame strategies, one can show
large values of wealth starting with zero initial capital. Such strategies are
arbitrage opportunities.
118
(i) P ∗ is equivalent to P
As in the discrete case, one can prove that one can preclude arbitrage oppor-
is complete, in the restricted sense that for every contingent claim X satisfy-
Remark: Having seen the above results, a natural question is to ask whether
converse statements are also true. One has to put some further requirements
course be economically meaningful. A lot of effort has been put into solving this
question, and several alternatives have been proposed, but the details will lead
us to far. •
completeness means that a general contingent claim can not be perfectly hedged.
119
Most models are not complete, and most practitioners believe the actual market
way and this is not always clear. Actually, the market is choosing the martingale
In the Black-Scholes world however, one can prove (Girsanov Theorem) that
with coosing an appropriate one. It is not hard to see that under P ∗ , the stock
price process has the same volatility parameter σ, but the drift parameter µ is
σ2
St = S0 exp r− t + σWt .
2
Equivalent, we can say that under P ∗ our stock price process S = {St , 0 ≤ t ≤
This SDE tells us that in a risk-neutral world the total return from the stock
must be r.
Next, we will calculate European call option prices under this model.
If the payoff function is only depending on the time T value of the stock, i.e.
120
set for simplicity t = 0):
Take for example an European call on the stock (with price process S) with
strike K and maturity T (so G(ST ) = (ST − K)+ ). The Black-Scholes formulas
for the price C(K, T ) at time zero of this European call option on the stock
where
σ2
log(S0 /K) + (r + 2 )T
d1 = √ , (5.5)
σ T
σ2 √
log(S0 /K) + (r − 2 )T
d2 = √ = d1 − σ T , (5.6)
σ T
and N(x) is the cumulative probability distribution function for a variable that
From this, one can also easily (via the put-call parity) obtain the price
P (K, T ) of the European put option on the same stock with same strike K and
121
same maturity T :
For the call, the probability (under P ∗ ) of finishing in the money corresponds
with N(d2 ). Similarly, the delta (i.e. the change in the value of the option
compared with the change in the value of the underlying asset) of the option
Black-Scholes PDE
∂ ∂ 1 ∂2
F (t, s) + (r − q)s F (t, s) + σ 2 s2 2 F (t, s) − rF (t, s) = 0, (5.7)
∂t ∂s 2 ∂s
F (T, s) = G(s)
This will basically follow from the Feynman-Kac representation for Brownian
motion.
1
Ht (t, s) + rsHs (t, s) + σ 2 s2 Hss (t, s) = 0,
2
Then we know from the Feynman-Kac representation that H has the represen-
tation
122
Note that by the risk-neutral valuation principle
5.7.2 Hedging
σ2
!
ln(S0 /K) + (r + 2 )T
ξt = ∆call = N (d1 ) = N √
σ T
∆ is the rate of change of the option price with respect to the price of the
underlying asset. Suppose that the delta of a call option on as stock is 0.6. This
means that when the stock price changes by a small amount, the option price
changes by about 60 percent of that amount. Suppose further that the stock
price is 100 euro and the option price is 10 euro. Imagine an investor who has
sold 2000 option contracts – that is, options to buy 2000 shares. The investor’s
position could be hedged by buying 0.6 × 2000 = 1200 shares. The gain (loss)
on the option position would then tend to be offset by the loss (gain) on the
stock position. For example, if the stock goes up by 1 euro (producing a gain
of 1200 euro on the shares purchased), the option price will tend to go up by
123
0.6 × 1 = 0.60 euro (producing a loss of 2000 × 0.6 = 1200 euro on the options
written); if the stock price goes down by 1 euro (producing a loss of 1200 euro
on the stock position), the option price will tend to go down by 0.60 (producing
It is important to realize that, because delta changes (with time and stock
price movements), the investor’s position remains delta-hedged (or delta neu-
tral) for only a relatively short period of time. In order to have a perfect hedge,
the positions have to be adjusted continuously. In practice however one can only
an increase in the stock leads to an increase in delta, say from 0.60 to 0.65. An
extra of 0.05 × 2000 = 100 shares would then have to be purchased to maintain
the hedge.
Tables 5.1 and 5.2 provide two simulations of the operation of periodical
From this we can easily compute the initial value of the call: C = 2.40047;
and the delta which equals ∆ = 0.52160. This means that as soon as the option
for the total amount of 49 × 52160 = 2555840 euro. So we must borrow this
124
amount of 2555840 euro to buy 52160 shares. Because the interest rate is 0.05,
In Table 5.1, the stock price falls to 48.125 euro by the end of the first week.
shares must be sold to maintain the hedge. This realizes 6325×48.125 = 304391
cash and the cumulative borrowings at the end of week one are reduced to
2555840 − 304391 + 2459 = 2253908 euro. During the second week the stock
price reduces to 47.375 euro and the delta declines again; and so on. Towards the
end of the life of the option it becomes apparent that the option will be exercised
and the delta approaches 1. By week 20, therefore, the hedger has a fully covered
position. The hedger receives 5000000 euro for the stock held, so that the total
cost of writing the option and hedging it is 5000000 − 5263157 = 263157 euro.
Table 5.2 illustrates an alternative sequence of events such that the option closes
out of the money. As it becomes clearer that the option will not be exercised,
delta approaches zero. By week 20, the hedger has a naked position and has
In Table 5.1 and 5.2, the costs of hedging the option, when discounted to
the beginning of the period, i.e. 258145 and 251672 are close to but not exactly
125
Table 5.1: Hedging simulation; call option closes in the money
Table 5.2: Hedging simulation; call option closes out of the money
126
the same as the Black-Scholes price of 240047. If the hedging scheme worked
perfectly, the cost of hedging would, after discounting, be exactly equal to the
theoretical price of the option on every simulation. The reason that there is a
variation in the cost of delta hedging is that the hedge is rebalanced only once a
week. As rebalancing takes place more frequently, the uncertainty in the cost of
hedging is reduced. Of course the simulations above are idealized in that they
assume that the volatility and interest rate are constant and that there are no
transaction costs.
In Figure 5.4, one can see the underlying Standard Brownian Motion, the
related Geometric Brownian Motion, the option prices of a European call option
and the associated hedge over the one year life-time of the option (S0 = 100,
The Black-Scholes option values depend on the (current) stock price S, the
volatility σ, the time to maturity T , the interest rate r, and the strike price K.
The sensitivities of the option price with respect to the first four parameters are
called the Greeks and are widely used for hedging purposes.
127
Figure 5.4: Wt , St , Ct and ∆t , t ∈ [0, 1] (S0 = 100, K = 105, r = 0.03, µ = 0.09,
σ = 0.4)
128
We therefore get
!
σ2
δC ln(S0 /K) + (r + 2 )T
∆= = N √ >0
δS σ T
σ2
!
√ ln(S0 /K) + (r +
δC 2 )T
V= = S Tn √ >0
δσ σ T
!
σ2
δC Sσ ln(S0 /K) + (r + 2 )T
Θ= = √ n √ +
δT 2 T σ T
σ2
!
ln(S0 /K) + (r − 2 )T
Kre−rT N √ >0
σ T
!
σ2
δC −rT ln(S0 /K) + (r − 2 )T
ρ= = T Ke N √ >0
δr σ T
2
ln(S0 /K)+(r+ σ2 )T
n √
δ2 C σ T
Γ= = √ > 0,
δS 2 Sσ T
density. As discussed before ∆ measures the change in the value of the option
compared with the change in the value of the underlying asset. Furthermore, ∆
gives the number of shares in the replication portfolio for a call option.
Vega, V, measures the change of the option price compared with the change
in the volatility of the underlying, and similar statements hold for theta Θ, rho
Over the last decades the Black-Scholes model turned out to be very popular.
One should bear in mind however, that this elegant theory hinges on several
129
Figure 5.5: Simulated Normally and Nasdaq Composite log-returns
crucial assumptions. We assumed that there were no market frictions, like taxes
model does not describe the statistical properties of financial time series very
well. Real markets exhibit from time to time very large discontinuous price
i.e. differences of the form log St+h −log St , are independent and identically nor-
mally distributed. Figure 5.5 shows daily log-returns of the American Nasdaq-
Composite Index over the period 1-1-1990 until 31-12-2000 and simulated i.i.d.
normal variates with variance equal to the sample variance of the Nasdaq-
Composite log-returns.
130
This picture makes two stylized facts immediately apparent, which are typ-
• We see that large asset prize movements occur more frequently than in a
to as excess kurtosis or fat tails; it is the main reason for considering asset
of periods with high return variance and with low return variance. This
use models for asset price dynamics which are more ’realistic’ than the Black-
Scholes model. For example markets are incomplete if we consider asset price
131
Chapter 6
Miscellaneous
Consider an option with a payoff function that only depends on the terminal
stock price value, i.e. assume that the payoff function is of the form f (ST ).
Assume furthermore (for technical reasons) that the function f is twice differ-
entiable.
Z x Z κ
f (x) = f (κ) + 1(x > κ) f 0 (L)dL − 1(x < κ) f 0 (L)dL
κ x
" #
Z x Z L
= f (κ) + 1(x > κ) f 0 (κ) + f 00 (K)dK dL
κ κ
Z κ Z κ
0 00
−1(x < κ) f (κ) − f (K)dK dL.
x L
Noting that f 0 (κ) does not depend on L and interchanging the order of integra-
132
tion (Fubini’s theorem) yields:
Z x Z x
f (x) = f (κ) + f 0 (κ)(x − κ) + 1(x > κ) f 00 (K)dLdK
κ K
Z κ Z K
+1(x < κ) f 00 (K)dLdK.
x x
Z x
f (x) = f (κ) + f 0 (κ)(x − κ) + 1(x > κ) f 00 (K)(x − K)dK
κ
Z κ
00
+1(x < κ) f (K)(K − x)dK
x
Z ∞ Z κ−
= f (κ) + f 0 (κ)(x − κ) + f 00 (K)(x − K)+ dK + f 00 (K)(K − x)+ dK.
κ 0
Thus, the payoff decomposes into bonds, forward contracts with delivery price
κ, calls struck above κ, and puts struck below κ. Letting V0f denote the initial
value of the contract with payoff f (ST ) at T , then the absence of arbitrage
implies:
where EC0 (K, T ) and EP0 (K, T ) denotes the initial value of resp. an European
call and put option with strike K and time to maturity T . Note that if we
choose κ = BT S0 , i.e. the forward price of the stock, the second term cancels
out.
133
6.2 Variance Swap
corresponds to daily closing times and Si is the closing price at day i. Note that
then
log(Si ) − log(Si−1 ), i = 1, . . . , n,
The so-called realized variance (or better, 2nd moment) is then calculated
n
!
1 X 2
(log(Si ) − log(Si−1 )) .
n i=1
n
" ! #
1 X 2
VS =N × (log(Si ) − log(Si−1 )) −K ,
n i=1
where N denotes the notational amount, is called a variance swap. The value of
K is typically chosen such that the contract has a zero value when it is initiated
(just like in the case of futures and forwards). Basically this contract swaps
Next, we will show how in a general setting this contract can be hedged
134
We start with the following (Taylor-like) expansion of the 2nd power of the
logarithmic function
2
(log(x)) = 2 x − 1 − log(x) + O((x − 1)3 ) .
n
2
X
(log(Si /Si−1 )) (6.1)
i=1
n
X ∆Si
= 2 − log(Si /Si−1 ) + O((∆Si /Si−1 )3 )
i=1
Si−1
n n
X ∆Si X
= −2(log(ST ) − log(S0 )) + 2 + O( (∆Si /Si−1 )3 ) (6.2)
i=1
S i−1 i=1
due to telescoping. Thus up to 3rd-order terms the sum of the squared log-
returns decomposes into the payout from a log-contract (−2(log(ST ) − log(S0 )))
Pn ∆Si
and a dynamic strategy (2 i=1 Si−1 ).
with a static position in bonds, European vanilla call and put options maturing
1
log(ST ) − log(S0 ) = (ST − S0 ) − u(ST ) + u(S0 ), (6.3)
L
for
x−L
u(x) = − log(x) + log(L) .
L
135
Moreover with the technique explained in Section 6.1, one can show that
L +∞
1 1
Z Z
u(ST ) = (K − ST )+ dK + (ST − K)+ dK. (6.4)
0 K2 L K2
Pn
Since ST − S0 = i=1 ∆Si , substituting (6.4) in (6.3) and (6.2) implies
n n
X 2
X 1 2
(log(Si /Si−1 )) ≈ − ∆Si − 2u(S0 )
i=1 i=1
Si−1 L
Z L Z +∞
2 + 2
+ 2
(K − S T ) dK + 2
(ST − K)+ dK
0 K L K
136