Dynamic Asset Pricing Theory THIRD EDITION Darrell Duffie Princeton University Press Princeton and OxfordCopyright © 2001 Wy Princeton University Press Published by Princeton University Press, 41 William Sue Priacecont. Nev Jersey 08540 {In the United Kingdom: Princeton University Press, 3 Market Place, Woodstock, Oxfordshire OX20 1S AIL Rights Reserved Library of Congress Catalogingin Publication Data Duthie, Darrel Dynamic asset pricing theory / Darrell Dulfie—3 ed poem. Includes bibliographical references and index. ISBN 0-691-09022-X (alk. paper) 1. Capital assets pricing model, 2, Portfolio management 3, Uncertainty L Tine, 11G4637.D84 2001 3826-de21 2001021235 British Library Catalogingin Publication Data is available ‘This book has heen composed in New Baskerville Printed on acie free paper © veww.pup.princeton.edi Printed in the United Suites of America wos Tee 4827 Kor ColinContents Preface xxl PART I DISCRETE-TIME MODELS 1 Introduction to State Pricing... - - eerie Arbitrage and State Prices tee Risk-Neutral Probabilities ©... 2... it Optimality and Asset Pricing 2... Efficiency and Complete Markets Optimality and Representative Agents : StatePrice Beta Models... eee a Exercises oe ee eee eee eee Notes mm ORS ‘The Basie Multiperiod Model Etec e a A Uncertainty beens aes 21 B Security Markers : ; se ete eaa: © Arbitrage, State Prices, ar ingales cree D Individual Agent Optimality eee E Equilibrium and Pareto Optimality. . 26 F Equilibrium Asset Pricing»... « pansteerenigue 2 G Arbitrage and Martingale Measures. ce 8 H Valuation of Redundant Securities . « 30 American Exercise Policies and Valuat 31 J} Is Barly Exercise Optimal? 35 Exercises. eee eo Notes 455 The Dynanie Programming Approach ‘The Bellman Approach First-Order Bellman Conditions... . « Markov Uncertainty . . Markos Asset Pricing Sceurity Pricing by Markov Control Markov ArbitrageFree Valuation G Early Exercise and Sotial Seovving Exercises . Notes moose 4 The InfiniteHorizon Setting... .. . A. Markov Dynamic Programming . B Dynamic Programming and Equilibrium © Agbitrage and State Prices... D Optimality and State Prices =... ee £ Methotof-Momemts Estimation Exercises eee Notes... PART I CONTINUOUS-TIME MODELS 5 The Black-Scholes Model... . . ‘Trading Gains for Brownian Prices Martingale Trading Gains . . . Ito Prices and G Tto’s Formula ; The Bluck Scholes Option Pricing Formala Black Scholes Formula: First Try... ss + ‘The PDE for Arbitrage-Free Prices The Feynman-Kae Sojution . . : The Multidimensional Case Exercises... Notes. -rosmpoeS Stale Pies and Hapivent Martingale Mens A Arbitrage ete Serie B Numeraive Invariance G State Prices and Doubling Seas D Expected Rates of Return - 86 Contents 49 49 50 51 32 52 58 8 6 69 a 2B 8 a 83 8h 88 90 92 98 ot 100 + 10h 305 102 103 106 7 TermStructure Models... .. 8 Derivative Pricing... .. Contents Equivalent Martingale Measures... . F State Prices and Martingale Measures G Gievanov and Marker Prices of Risk H Black-Scholes Again 4 Complete Markets... . J. Redundant Security Pricing K Martingale Measures from No Arbiuage . L_ Arbitrage Pricing with Dividends M Lumpy Dividends and Term Structures XX Martingale Measures, Infinite Horizon . Exercises... eee Notes cee ‘The Ferm Seructure ‘The Gaussian SingleFactor Models The Cox-ingersol-Ross Model The Affine Single Factor Models ‘Term Serucuare Derivatives ‘The Fundamental Solution . Multifactor Models Affine Term Structure Models The HJM Model of Forward Rates Matkovian Yield Gonves and SPDEs Exercises : Notes... A B c D E ¥ Roe A Martingale Measutes in a Black Box B Forward Prices : © Futures and Continuous Reseilement D ArbitrageFree Futures Prices... E Stochastic Volauility .. . F Option Vahuation by Teanaforin Analysis. - G American Security Valuation A HC American Exercise Boundaries 1 Lookback Options... « Exercises a Notes . One-Kactor TermStructure Models pute - 14g - 14g _ 8 108, - ito un us. 16 ng 120 193 + 185 127 128 13 + 138 136 137 139 14d M46, 148, 151 . 154 » 155 161 . 167 167 - bg - 171 V9 174 178 182 186 ~ 189 191 196x Contents Contents xi 9 Portfolio and Consumption Choice +. ee eevee eee es 208, 12 Numerical Methods ©... 6.2 eee eee ee +. 298 A Stochastic Control BECP Res Pe eH Sete Hoete aa A Central Limit Theorems |. 11.1.1... vee 298 B Merton's Problem 206 B Binomial to BlackScholes . 204 © Solution to Merton’s Problem 6... « 209 © Binomial Convergence for Unbounded Derivative Payotis . | 297 D The Infinite-Horizon Case... -.-..- sees 218 D_ Discretization of Asset Price Processes... 2. 297 E. The Martingale Formulation 2l4 E Monte Carlo Simulation 299 F Martingale Solution .......... 2. see. 27 F Efficient SDE Simulation |... .. 22) 300 G A Generalization He vee. 220 G Applying Feynman-Kac : peste a0 H The Usiliy-Gradient Approach : seen BBL H FiniteDifference Methods... =... + + see + 808 Exercises 6. Beate vee B24 I Term-Structure Example 306, Notes cee eecre terre try 232 J Finite-Difference Algorithms with Early Exercise Options». 309 K The Numerical Solution of State Prices ves. 310 7 eee fatto L._ Numerical Solution of the Pricing Semi-Group 313 a ees ge re SHereecatantSR peers M Fising the Til enn Streare othe ArrowDebreu Equilibrium... .. . - 237 Nae BSE eEeeee 7 D Implementing ArrowDebreu Equilibrium . . see 238 eee eet Beet E Real Security Prices... 6. eee es 240 F Optimality with Additive Utility... 2 fecihaesuraasd ie G Equilibrium with Additive Utlity oo BAB A FinkeState Probability 200.60 e eee eens B88 HH The Consumption-Based CAPM... 245 ; I The CIR Term Structure 6... eee eee eee 246 B Separating Hyperplanes and Optimality - . ae eee J The GCAPM in Incomplete Markets o.oo veces. 24) lesbain ECE teeter eeeH eet eae ECE nag Exercises. Reece eee Seer eer ain Notes 255 D Stochastic Integration... oo eee eee eee eee 984 11 Corporate Securities. Heer _ 359 E SDE, PDE, and Feynman Kac. oss e ee eee eee . 40 A The BlackScholewMerton Model bee 359 F to's Formula with Jumps... 000.0 Hi cea B Endogenous Default Timing . . . . - ct 262 © Example: Brownian Dividend Growth oo... 0.0.0... 364 G Ubility Gradients. Hae : vee 351 D Taxes and Bankruptcy Costs 2 268 ; E. Endogenous Caplal seructare coe od Hi Ito's Formula for Complex Functions... 6. = 355 F Technology Choice... « wee ne 1 Counting Processes... 22 +--+ + cee 387 G Other Market Imperfections oo... oss lee. 878 H IntensityBased Modeling of Default 274 : J FiniteDifference Code oe ee eevee cee eee ee 868 1 Risk-Neutral Intensity Process ; 277 sit J) ZeroRecovery Bond Pricing... OB eee eal eaten K Pricing with Recovery at Default... 0... eee ees, 280 Symbol Glossary 6. eevee eee eee eee ee AB L. Default Adjusted Short Rate... ee 2. 381 Exercises . bees BE ee reece . 7” Notes RePEc eae Subject Index... . eee e ABTPreface Tas1s ROOK 18 an introduction to the theory of portfolio choice and asset pricing in multiperiod settings under uncertainty. An alternate title might be Arbitrage, Optimality, and Equiliéum, because the book is built around the three basic constraints on asset prices: absence of arbitrage, single- agent optimality, and market equilibrium. The most important unifying principle is that any of these three conditions implies that there are “state prices,” meaning positive discount factors, one for each state and date, stich that the price of any security is merely the state-price weighted sum of its future payofls. This idea can be traced to the invention by Arrow (1953) of the general equilibrium model of security markets, Identifying the state prices is the major task at hand. Technicalities are given relatively litte emphasis so as to simplify these concepts and to make plain the similarities between discrete-and continuous-time models.ricing model. To someone who came out of graduate schoo! in the mid-eighties, the decade spanning roughly 1969-79 scems like a golden age of dynamic asset pricing theory. Robert Merton started continuous-time financial modeling with his explicit dynamic programming solution for optimal portfolio and. consumption policies, This set the stage for his 1973 general equilibrium model of security prices, another milestone. His next major contribution vwas his arbitrage-based proof of the option pricing formula introduced by Fisher Black and Myron Scholes in 1973, and his continual develop- ment of that approach to derivative pricing. The Black-Scholes model now seems to be, by far, the most important single breakthrough of this ‘golden decade,” and ranks alone with the Modigliani and Miller (1958) ‘Theorem and the Capital Asset Pricing Model (CAPM) of Sharpe (1964) and Lintner (1965) in its overall importance for financial theory and practice, A tremendously influential simplification of the BlackScholes ‘model appeared in the “binomial” option pricing model of Cox, Ross, and Rubinstein (1979), who drew on an insight of Bill Sharpe.