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You are on page 1of 142

Wim Schoutens

Leuven, 2004-2005

Abstract

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,

To conclude the course, we make a bridge to continuous-time models. We

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 .

mn

R

A 1+ .

m

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

110.6

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

20

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,

Portfolio I:

Stock 100 10000

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

Portfolio II:

Stock 70 7000

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,

√ √

= −1 − 2µ∆t − (µ∆t)2 + 2(1 + µ∆t) − (1 + σ ∆t)(1 − σ ∆t)

= −(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

N

X N

e−rT Ep [g(ST )] = e−rT

g(S0 uj dN −j )pj (1 − p)N −j ,

j=0 j

where Ep denotes the expectation in the risk-neutral world, i.e. with a probabil-

N j

p (1 − p)N −j (2.15)

j

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

sequence of mathematical objects (σ-algebras), F0 ⊂ F1 ⊂ · · · ⊂ FT , describing

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

Xi is Gi -measurable. So we have that S = {Si , i = 0, 1, . . . , T } is F-adapted.

A trading strategy ϕ = {ϕi = (βi , ζi ), i = 1, . . . , T } is a real vector stochastic

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

i

Gϕ

X

i = Gi = (βj (Bj − Bj−1 ) + ζj (Sj − Sj−1 ))

j=1

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 )

ϕ

= EP ∗ [Ṽiϕ − Ṽi−1

ϕ

|Fi−1 ]

−1 ϕ

Vi−1 |Fi−1 ]

−1

(βi−1 Bi−1 + ζi−1 Si−1 )|Fi−1 ]

−1

(βi Bi−1 + ζi Si−1 )|Fi−1 ]

−1

Si−1 )|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

uS0 b fu

det

mS0 = 0.

b fm

dS0 b fd

u 1 fu

det

m 1 fm

= 0.

d 1 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

t = inf{Xu ; 0 ≤ u ≤ t}, 0 ≤ t ≤ T.

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

√

first step, the maximum stays at S0 , so that Y = 1/d = 1/ exp(−σ ∆t) = u.

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

fi,j

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 .

Pn +

k=1 S tk

AAC = −K .

n

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

Pn +

K−

k=1 S tk

AAP = .

n

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

Pn

Zn = i=1 Xi , n = 1, 2, . . . . Rescale this random walk as

√

Yk (t) = Zbktc / k,

103

where bxc is the integer part of x. Then from the Central Limit Theorem,

Yk (t) → Wt as k → ∞,

Standard Brownian Motion

1

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

t≥0 t≥0

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

Z t

Xu dYu

0

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

Pn R

indicators, Xt = i=1 ci 1[ai ,bi ] (t), we define XdW :

Z t n

X Z t

It (X) = Xs dWs = ci 1[ai ,bi ] (s)dWs

0 i=1 0

(|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.

t is defined by

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):

Z +∞

= exp(−T r) G(S0 exp((r − q − σ 2 /2)T + σx))fN ormal (x; 0, T )dx.

−∞

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

!

σ2

ln(S0 /K) + (r + 2 )T

ξt = ∆put = N (d1 ) − 1 = N √ − 1 = ∆call − 1

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.

σ2

!

ln(S0 /K) + (r + 2 )T

C = C(S, T, K, r, σ) = SN √

σ T

σ2

!

−rT ln(S0 /K) + (r − 2 )T

−Ke N √ .

σ T

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:

Z ∞

= f (κ)BT−1 0

+ f (κ)(S0 − κBT−1 ) + f 00 (K)EC0 (K, T )dK

κ

Z κ

+ f 00 (K)EP0 (K, T )dK,

0

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 ) .

2 ∆Si

(log(Si /Si−1 )) = 2 − log(Si /Si−1 ) + O((∆Si /Si−1 )3 ) ,

Si−1

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

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