r> d, we have 0r > d. Ou the other hand, it fullows frum (2.5) that p is a sisk-ueutral probability (ie. it satisfies 0
r>d. Here is a simple example of a model that does not admit any risk-neutral probability. and therefore, permits arbitrage: Example 2.1 Consider a Binomial model with ftvo risky asset and a bond. Let Sj and Sp denote the initial prices of the risky assets, and let their possible prices after one period be denoted by wiS\ and djS,. 2 = 1.2. Finally, suppose that the asset prices ate perfectly correlated, so that there are only two possible sets of prices after one period: (r B, tS, 252) and (1B. 4h 51,52). For p to be a risk-neutral probability in this setting, the expected return of both risky assets under p must equal r, ie., we must have puy-+(1—p)di =r as well as puz+(I—p)d2 =r. Therefore, p must satisfy rad p (212) una However, it is chviously possible to choose r, uj and dj so that the fractions in (2.12) are unequal; evidently, no risk-neutral probability can exist in this ease. We will naw show that the model admits an arbitrage opportunity if and only if the two fraction: in (2.12) are unequal. Consider a portfolio which invests $a in the bond, and $b and $c. ‘The current. cost of this portfolio is atte (243) Rangarajan K. Sundaram: Risk-Neutral Pricing while its possible values at maturity are { ar + buy + cuz if (u1,uz) occurs eu ar+$bdy+ed; if (dy,dz) occurs portfolio to generate a free lunch, there must exist a value of (a, b,€) such that (2.13) strictly negative, and both values in (2.14) are zero, Such a solution exists when, and only when, the two fractions in (2.12) are unequal. This can be seen by setting the two quantities (2.14) tu zetu, using them to solve fur « aud b iu tertus of ¢, and then substituting these solutions intu (2.13), Thus, the couditious iu this uudel that lead to the nouexisteuce of sweutzal probability are also identically the cunditions that lead to the existence of an arbitrage oppurtunity. o 2.8 Risk-Neutral Probabilities and Completeness We have also mentioned many times that a market is complete if and only if the model admits a unique risk-neutral probability. Once again. the validity of this statement in the Binomial model is easy to sce: we showed in subsection 2.2 that the Binomial model is complete, while from (2.5), the risk-neutral probability is obviously unique. Here is a simple example of a model which admits more than one risk-neutral probability. and is therefore not complete: Example 2.2 Consider a frinommal model in which there are three possible values for the mS. with probability qu (215) dS, with probability g; where u> m > d, and q > 0 for i = u,m.d. Suppose also that the hond continues to return ith certainty, For the vectur (JisPmn-p2) tu be a riskeneutral prubability in this snodel, it aatisfy p, > 0 for = wyra.d, av well as | uS, with probability q. mus puutpad+ pm = 1 & pytpmtpa=he (2.16) Expressions (2.16) give us two equations in three unknowns, There are infinitely many solutions that satisfy both equations as well as p; > 0 for 2 — usmed. Thus, there are infinitely many riskeneutral probabilities in this model. To sce that the trincmial model is also not complete, cbserve that a contingent claim with payoff (X,.Nin- Xz) can be replicated by a portfolic consisting of the stock and the bond if and only if there is a sclution (a*,*) to the following system of equations: wus +itr = Xy (247) atmS +0 = Xx (us) ads +br = X; (219) Rangarajan K. Sundaram: Risk-Neutral Pricing “12 From (2.17) and (2.18), any such solution must satisfy f= a, (2.20) while from (2.18) and (2.19), we must also have w= = (221) It is an elementary matter to choose values of (Xu, Xm, Xa) such that (2.20) and (2.21) are inconsistent (for example, let Xy = Xin = 1 and X4 = 0). a 3. Continuous-Time Models: Some Comments At least since the paper of Black and Scholes (1973), it has become commonplace in the study of derivative pricing to employ continuous-time models of asset-price evclution, The method of risk-neutral pricing can be used in such cases also, although the added technical complexity of continuous-time models makes the actual operations more difficult. The purpose of this section is to offer a few comments about the procedure that is involved. For a more detailed and mathematically precise description of the material of this section. we refer the reader to Duffie (1996). With a few (notable) exceptions, most continuous-time models of asset-price evolution in Finance are based on Wiener processes. We will use such a framework in our description. To cep the notation from getting too complicated, we will confine attention to a two security model and make some other simplifying assumptions, (Of course, the argument: apply much more generally.) Finally, we will assume through this section and the next that the reader has at least an intuitive familiarity with Ito processes and Ito’s Lemma. The Underlying Securses The fitst security in our two-sccurity world, the bond, is riskless, The rate of interest r (now expressed in continuously compounded terms) is constant, so the bond price evolves from i initial value Br = 1 according to the ordinary differential equation (3.1) its price evolves from its initial value The second security, the stock, is a Sp according to the stochastic differential equation dS = adi+ dW. ( where a is the instantaneous drift of the process, ? instantaneous variance, and W a Wiener process (i.e., a standard Brownian motion). Here, a and are not necessarily sumed to be constants: they could be time-dependent or be functions of the current stock price, Rangarajan K. Sundaram: Risk-Neutral Pricing The Discounted Price Process The discounted price process, dencted Z, is as usual, obtained by discounting the growth in stock prices at the risk-free rate. ise, by dividing the stock price by the bond price: Ss B Using Ito’s Jemma in conjunction with (3.1) and and variance of the Z proces Ne Let ys denote this drift and 0? the variance: aZ, = wdl-+odW. (a4) The Risk=) tral Probability Under the risk-neutral probability, the discounted price process Z must he a martingale This means that the expected change in its value at all points must be zero, which can be qual to zero, ‘Thus, the first condition that the is that Z has zero drift under this structure, However, there is also a second condition that the riskeneutral structure must satisfy: it must also be equivalent to the original structure (i.e., the same set of price paths must have positive probability under beth structures), The key to achieving both ends lies in a result known as Girsanav’s Theorem, Girsanov’s Theorem: A Description Girsanov's Theorem provides conditions under which the drift of a given Ito process may be in an equivalent probability We will state the content of the theorem at a general level, and then explain how it may be applied to convert the discounted price process Z into one with zero drift, Assume that we are given some Ito process Y with drift jx and variance 07: d¥ — pditodW, (35) Once again, . and o are not required to he constants but could depend on time or the current value of Y, Suppose we wish to change the drift of the Y process to 7 (again, not necessarily a constant) in an equivalent probability structure. We use the following two-step procedure, 1. First, we define a new Wiener process WW’ using the old Wiener process 1, and the quantities yr, 0, and y. 2. Next, we redefine the ’ process using the new Wiener process 1 Rangarajan K. Sundaram: Risk-Neutral Pricing The manner in which WW’ is defined in the first step ensures that when the Y process redefined in the second step, the required change in the drift is achieved. Here are the two steps in more detail: Step 1: Define \ by the solution to (3.6) uit, since jt, 0 and 1 are not requited tu be cunstants, Nuw Note that \ need not be a cor define the process W by dW = Ndt $a. (2.7) Under certain technical conditions (see the Append that (a) there is a probability structure equivalent to the ori a Wiener process under the new structure. for details}, Girsanov’s Theorem states ial structure such that (b) 1 Step 2: Now let the process Y’ be defined by d¥ = ndlt+odW. (3.8) drift of 7). A little bit of algebra shows that this process = Y defined in (3.5): ___By definition, the ¥’ process hi ¥ is actually identical to the proces a nat tod dt +o[\dt + dW] hy (3.7) ytoXdt-+odW yt (u—)dttodW by (2.6) pdt tod =a by (3.5) redefined as a process with drift equal to 7. Moreover, sanov's Theorem ensures that the new probability structure is equivalent to the original structure.® Unfortunately, Girsanov’s Theorem does not come “for fre that W as defined by (3.7) will be a Wiener process in an equivalent. probability structure only provided a tech ide-condition holds. The nature of this condition and a formal statement of the theorem are presented in Appendix A of this paper. Using Girsanov’s Theorem to identify the RisheNeutral Probability Recall that the discounted price proc is given by "Note ako the very impertant pcint that that the variance o? has nct changed in gcing frcm the of process te the new prceess. Rangarajan K. Sundaram: Risk-Neutral Pricing ... af = pdt tod, Ty find a riskeueutial prubability, we have to find an equivalent probability structure in can be achieved by setting q = 0 throughuut the preceding 6), Vis given by w= do (3.10) If we now define WW by dl’ = Adé + dVV, then Girsanov’s Theorem ensures that there is an equivalent probability structure under which W is a Wiener process: moreover, as we have just seen, the Z process may be rewritten using IW as a process with zero drift: dZ = odW. (ly Since the new probability structure is equivalent to the original structure, and since Z is a martingale under the new structure, we have identified the risk-neutral probability, 4 An Example: The Black-Scholes Model The Black-Scholes model involves two securities, a stock whose price S; evolves from initial value So according to dS = pSdt+oSd% (1) initial value By = 1 according to and a bond whose price B, evolves from dB = Bat. U. The parameters j1, 0, and r are all assumed to be constants, Black and Scholes (1973) consider the problem of pricing in this framework a (European+ style) call option on the stock with a strike price of K’ and maturity of 7. At time T, the payoff from this option is eiven by max{Sr = K,0}. (4a) Black and Scholes shew that this option is capable of being replicated, and, therefore, that it may be priced by aribtrage. ‘They also show that the arbitrage-free price of the call ‘ven by © = SN(d) = e"TKNG2), (4) where N(-) is the cumulative standard normal distribution, and dy and dy are defined by S/R) 152 ad, = MSIE + rt po) (45) ovT Rangarajan K. Sundaram: Risk-Neutral Pricing ... dy = h-ovT. In the remainder uf this section, we will show how this arbitrage-fice price can also be recovered using the method of riskeueutral pricing, To this end, we first define the discounted price process, verify that the conditions of Girsanoy’s Theoret ate satisfied, and identify the discounted price process under the equivalent inartingale measure, The Discounted Price Process Let Z = S/B denute the discounted stuck price prucess in the Black-Schules unudel, Using Ito's Lemma together with (4.1) and (4.2), we have dZ = (nar)Zdt+oZdw. (4.7) Hdentifying the Risk-Neutral Probability We will appeal to Girsanav's Theorem, a: described in the previous section. ‘The drift of the counted price process (4.7) is (i= r)Z. while its variance is 0#Z#, We wish to change t drift to zero. Therefore, define \ by (oZ)d = (u-r)Z. (48) 30 \=(u— r/o. Let W be defined by dl” = Adt+dW. By Girsanov’s Theorem, there exists an equivalent probability structure such that 1 Wiener process in the new structure, Moreover, the discounted price process may be represented using W as a zero-drift process: dZ — oZdW. (49) Equivalently. appealing to Tto’s lemma, we can express (4.9) as hea Zyresp {tot ott}. (4.10) Valuing the Call Option To value the call option using ing, we must take the expectation under the risk-neutral probability of the discounted payoff= from the call, Now, using the fact that Zr — €-"' Sr, the discounted payoffs from the call are given by e7'T . max{S7 — KO} = max{ Zr — eT KO}. (LD Thus, we need to take the expectation of the probability. To do this, we recall that Jht-hand side of (4.11) under the risk-neutral Rangarajan K. Sundaram: Risk-Neutral Pricing ... 1. (li) isa standard Brownian motion under the risk-neutral probal Wr~ N(G,2). 2. From (4.10), Zr is given by y, 0, in particular, A = he ex { $1 sath} ld Substituting (4.12) into the right-hand side of (4.11), therefore, we are to take the expectation of nnn where Wy ~ N(O.T). The remainder of this section is concerned with showing that this expectation is precisely equal to the Black-Scholes formula (4.4)-(4.6). We proceed in several steps. emt-4ot bolle} - etKo}, (ala Step 1: Let f{+) denote the density of Wr. Since Wr ~ N(O,7), we have (44) Uap Step 2: Now, define the constant a hy a= Ue Then, using the fact that So = Zo, itis easily verified that Zoe {4o°t tou} > TK ifand only itu >a. (un Step 3: Using (4.17), the integial (415) may be written as L Zee {-bot + ou} fwide = [PK fluid. (4s) ider the first term in (4.18). By substituting the form of f(+) from (4.14) into this expression and rearranging terms, the first term can be written as Rangarajan K. Sundaram: Risk-Neutral Pricing 6.....0.c.c0s000+ ls af (=) oof joer tow Ue Since (—40°T + ow —4(w — 07%, expression (4.19) may be further rewritten as 1) exp dt (eet ‘ dw (4.20) Jolley} The term under the intgral is the density of a normal distribution with mean oT and variance T. Therefore, the integral itself is the area under this distribution between a and 20. A standard transformation shows that this area may be represented using a standard normal —dj),” where dj = (a—0T}/ VT, Thus, (4.20) reduces to of VT Substituting for a from (4.16), and using the fact that Z simply the first term in the Black-Scholes formula, namely ZoN(—di), where dj = (21) it can be seen that (4.21) i Nd). Step 5: An analogous, but much simpler argument a= in Step 4 shows that the second term of (4.18) is equal to the second term in the Black-Scholes formula e~r TK N(dz). The details are omitted. This completes the demonstration that the expectation of the call payoff under the risk-neutral measure is simply the Black-Scholes formula (4.4). 5 Conclusions We have described the main properties of risk-neutral proba usefulness through simple examples. We have also explained the role of Girsanov's Theorem in identifying the risk-neutral price processes in continuous-time models. A final note of caution is in order. Although the properties we have identified are valid very generally, there are technical side-conditions that may need to be satisfied in some ca: (notably in continuous-time models). The purpose of this paper being primarily expository. ‘we have ignored these technical issues here, Readers wishing for a more completeand rigorous treatment are referred to the work of Duffie (1996), and the references cited there, 6 Appendix: A Formal Statement of Girsanov’s The- orem Let Y he an Ito process defined by "Recall that (>) is the cumulative standard normal distribution, Rangarajan K. Sundaram: Risk-Neutral Pricing dy = pditodW. (6.1) Suppose we change the drift of the process to 4. Define ) by the sulution tu way = on Now define 1” by aw Adt + av. ‘Theorem states that Tso defined is a Wiener process under an equive ability structure, provided a technical condition is satisfied. This technical condi the process &() must he a martingale under the original probability structure, where sf Wass fra} (64) gO = ef ‘We can now state the full result: ‘Lheorem 6.1 (Girsanov’s ‘Lheorem) Suppose &(A) is q martingale, ‘Then, there exists an equivalent probability structure such that the now W° defined by (6.3) is a Wiener process under the new structure. not always an easy one to check, and this makes it difficult to identify a risk-neutral probability, The issue is, of course, a critical one: if we cannot be sure that a risk-neutral probability exists, then the model may be inconsistently specified, i.e. it may admit arbitrage opportunities. In some cases, the following result comes in handy in ensuring that the process €(A) in (6-4) is, in fact, a martingale: Theorem 6.2 (Novikhov’s Condition) Define \ as im (6.2). Suppose that the followmng condilvon holds: a [ow {3 val]
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