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Financial Mathematics I
Lecture NotesUniversit¨at Ulm
VERSION: February 6, 2004
THIS IS A PRELIMINARY VERSION THERE WILL BE UPDATES DURING THE COURSE 
Prof.Dr. R¨udiger KieselAbteilung FinanzmathematikUniversit¨at Ulmemail:kiesel@mathematik.uni-ulm.de
 
2
Short Description.
Times and Location:
Lectures will be Monday 10-12; Tuesday 8-10 in He120.
First Lecture Tuesday, 14.10.2003 
Content.
This course covers the fundamental principles and techniques of financial mathematics in discrete-and continuous-time models. The focus will be on probabilistic techniques which will be discussedin some detail. Specific topics are
•
Classical Asset Pricing: Mean-Variance Analysis, CAPM, Arbitrage.
•
Martingale-based stochastic market models: Fundamental Theorems of Asset Pricing.
•
Contingent Claim Analysis: European, American and Exotic Options.
•
Interest Rate Theory: Term Structure Models, Interest Rate Derivatives.
Pre-requisites.
Probability Theory, Calculus, Linear Algebra
Literature.
•
N.H.Bingham & R.Kiesel, Risk Neutral Valuation, Springer 1998.
•
H.F¨ollmer & A.Schied: Stochastic Finance: An Introduction in Discrete Time, De Gruyter2002.
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J.Hull: Options, Futures & Other Derivatives, 4th edition, Prentice Hall, 1999.
•
R.Jarrow & S.Turnbull, Derivative Securities, 2nd edition, 2000.
Office Hours.
Tuesday 10-11. He 230course webpage: www.mathematik.uni-ulm.de/finmathemail: kiesel@mathematik.uni-ulm.de.
 
Contents
1 Arbitrage Theory 5
1.1 Derivative Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51.1.1 Derivative Instruments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51.1.2 Underlying securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71.1.3 Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81.1.4 Types of Traders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81.1.5 Modelling Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91.2 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101.3 Arbitrage Relationships . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121.3.1 Fundamental Determinants of Option Values . . . . . . . . . . . . . . . . . 121.3.2 Arbitrage bounds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 141.4 Single-Period Market Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151.4.1 A fundamental example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151.4.2 A single-period model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 171.4.3 A few financial-economic considerations . . . . . . . . . . . . . . . . . . . . 22
2 Financial Market Theory 24
2.1 Choice under Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242.1.1 Preferences and the Expected Utility Theorem . . . . . . . . . . . . . . . . 242.1.2 Risk Aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252.1.3 Further measures of risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282.2 Optimal Portfolios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312.2.1 The mean-variance approach . . . . . . . . . . . . . . . . . . . . . . . . . . 312.2.2 Capital asset pricing model . . . . . . . . . . . . . . . . . . . . . . . . . . . 342.2.3 Portfolio optimisation and the absence of arbitrage . . . . . . . . . . . . . . 35
3 Discrete-time models 39
3.1 The model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393.2 Existence of Equivalent Martingale Measures . . . . . . . . . . . . . . . . . . . . . 423.2.1 The No-Arbitrage Condition . . . . . . . . . . . . . . . . . . . . . . . . . . 423.2.2 Risk-Neutral Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 453.3 Complete Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473.4 The Cox-Ross-Rubinstein Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 493.4.1 Model Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503.4.2 Risk-Neutral Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513.4.3 Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 533.5 Binomial Approximations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 563.5.1 Model Structure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 563.5.2 The Black-Scholes Option Pricing Formula . . . . . . . . . . . . . . . . . . 573.6 American Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603.6.1 Stopping Times, Optional Stopping and Snell Envelopes . . . . . . . . . . . 603.6.2 The Financial Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 673
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