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Introduction to Probability Theory

1.1 The Binomial Asset Pricing Model

1.2 Finite Probability Spaces

1.3 Lebesgue Measure and the Lebesgue Integral

1.4 General Probability Spaces

1.5 Independence

1.5.1 Independence of sets

1.5.2 Independence of -algebras

1.5.3 Independence of random variables

1.5.4 Correlation and independence

1.5.5 Independence and conditionalexpectation

1.5.6 Law of Large Numbers

1.5.7 Central Limit Theorem

Conditional Expectation

2.1 A Binomial Model for Stock Price Dynamics

2.2 Information

2.3 Conditional Expectation

2.3.1 An example

2.3.2 Deﬁnition of Conditional Expectation

2.3.3 Further discussion of Partial Averaging

2.3.4 Properties of Conditional Expectation

2.3.5 Examples from the Binomial Model

2.4 Martingales

Arbitrage Pricing

3.1 Binomial Pricing

3.2 General one-step APT

3.3 Risk-Neutral Probability Measure

3.3.1 Portfolio Process

3.3.2 Self-ﬁnancingValue of a Portfolio Process

3.4 Simple European Derivative Securities

3.5 The Binomial Model is Complete

The Markov Property

4.1 Binomial Model Pricing and Hedging

4.2 Computational Issues

4.3 Markov Processes

4.3.1 Different ways to write the Markov property

4.4 Showing that a process is Markov

4.5 Application to Exotic Options

Stopping Times and American Options

5.1 American Pricing

5.2 Value of Portfolio Hedging an American Option

5.3 Information up to a Stopping Time

Properties of American Derivative
Securities

6.1 The properties

6.2 Proofs of the Properties

6.3 Compound European Derivative Securities

7.3 Stopped Martingales

Random Walks

8.1 First Passage Time

8.2 is almost surely ﬁnite

8.3 The moment generating function for

8.4 Expectation of

8.5 The Strong Markov Property

8.6 General First Passage Times

8.7 Example: Perpetual American Put

8.8 Difference Equation

8.9 Distribution of First Passage Times

8.10 The Reﬂection Principle

Pricing in terms of Market Probabilities:
The Radon-Nikodym Theorem

9.1 Radon-Nikodym Theorem

9.2 Radon-Nikodym Martingales

9.3 The State PriceDensity Process

9.4 Stochastic Volatility Binomial Model

9.5 Another Applicaton of the Radon-Nikodym Theorem

Capital Asset Pricing

10.1 An Optimization Problem

General Random Variables

11.1 Law of a Random Variable

11.2 Density of a Random Variable

11.3 Expectation

11.4 Two random variables

11.5 Marginal Density

11.6 Conditional Expectation

11.7 Conditional Density

11.8 Multivariate Normal Distribution

11.9 Bivariate normal distribution

11.10 MGF of jointly normal random variables

Semi-Continuous Models

12.1 Discrete-timeBrownian Motion

12.2 The Stock PriceProcess

12.3 Remainder of the Market

12.4 Risk-Neutral Measure

12.5 Risk-Neutral Pricing

12.6 Arbitrage

12.7 Stalking the Risk-Neutral Measure

12.8 Pricing a European Call

Brownian Motion

13.1 Symmetric Random Walk

13.2 The Law of Large Numbers

13.3 Central Limit Theorem

13.4 Brownian Motion as a Limit of Random Walks

13.5 Brownian Motion

13.6 Covariance of Brownian Motion

13.7 Finite-Dimensional Distributions of Brownian Motion

13.8 Filtration generated by a Brownian Motion

13.9 Martingale Property

13.10 The Limit of a Binomial Model

13.11 Starting at Points Other Than 0

13.12 Markov Property for Brownian Motion

13.14 First Passage Time

The Itˆo Integral

14.1 Brownian Motion

14.2 First Variation

14.3 Quadratic Variation

14.4 Quadratic Variation as Absolute Volatility

14.5 Construction of the Itˆo Integral

14.6 Itˆo integral of an elementary integrand

14.7 Properties of the Itˆo integral of an elementary process

14.8 Itˆo integral of a general integrand

14.9 Properties of the (general) Itˆo integral

14.10 Quadratic variation of an Itˆo integral

Itˆo’s Formula

15.1 Itˆo’s formula for one Brownian motion

15.2 Derivation of Itˆo’s formula

15.3 GeometricBrownian motion

15.4 Quadratic variation of geometricBrownian motion

15.5 Volatility of GeometricBrownian motion

15.6 First derivation of the Black-Scholes formula

15.7 Mean and variance of the Cox-Ingersoll-Ross process

15.8 Multidimensional Brownian Motion

15.9 Cross-variations of Brownian motions

15.10 Multi-dimensional Itˆo formula

Markov processes and the Kolmogorov
equations

16.1 Stochastic Differential Equations

16.2 Markov Property

16.3 Transition density

16.4 The Kolmogorov Backward Equation

16.5 Connection between stochastic calculus and KBE

16.6 Black-Scholes

16.7 Black-Scholes with price-dependent volatility

17.2 Risk-neutral measure

Martingale Representation Theorem

18.1 Martingale Representation Theorem

18.2 A hedging application

-dimensional Martingale Representation Theorem

18.5 Multi-dimensional market model

A two-dimensional market model

19.2 Hedging when

Pricing Exotic Options

20.1 Reﬂection principle for Brownian motion

20.2 Up and out European call

20.3 A practical issue

21.1 Feynman-Kac Theorem

21.2 Constructing the hedge

21.3 Partial average payoff Asian option

Summary of Arbitrage Pricing Theory

22.1 Binomial model, Hedging Portfolio

22.2 Setting up the continuous model

22.3 Risk-neutral pricing and hedging

22.4 Implementation of risk-neutral pricing and hedging

Recognizing a Brownian Motion

23.1 Identifying volatility and correlation

23.2 Reversing the process

An outside barrier option

24.1 Computing the option value

24.2 The PDE for the outside barrier option

24.3 The hedge

American Options

25.1 Preview of perpetual American put

25.2 First passage times for Brownian motion: ﬁrst method

25.3 Drift adjustment

25.4 Drift-adjusted Laplace transform

25.5 First passage times: Second method

25.6 Perpetual American put

25.7 Value of the perpetual American put

25.8 Hedging the put

25.9 Perpetual American contingent claim

25.10 Perpetual American call

25.11 Put with expiration

25.12 American contingent claim with expiration

Options on dividend-paying stocks

26.1 American option with convex payoff function

26.2 Dividend paying stock

26.3 Hedging at timet

Bonds, forward contracts and futures

27.1 Forward contracts

27.2 Hedging a forward contract

27.3 Future contracts

27.4 Cash ﬂow from a future contract

27.5 Forward-future spread

27.6 Backwardation and contango

Term-structure models

28.1 Computing arbitrage-freebond prices: ﬁrst method

28.2 Some interest-ratedependent assets

28.3 Terminology

28.4 Forward rate agreement

28.6 Computing arbitrage-free bond prices: Heath-Jarrow-Morton
method

28.7 Checking for absence of arbitrage

28.8 Implementation of the Heath-Jarrow-Morton model

Gaussian processes

29.1 An example: Brownian Motion

Hull and White model

30.1 Fiddling with the formulas

30.4 Option on a bond

Cox-Ingersoll-Ross model

31.2 Kolmogorov forward equation

31.3 Cox-Ingersoll-Ross equilibrium density

31.4 Bond prices in the CIR model

31.5 Option on a bond

31.6 Deterministic time change of CIR model

31.7 Calibration

A two-factor model (Dufﬁe & Kan)

32.1 Non-negativity ofY

32.2 Zero-coupon bond prices

32.3 Calibration

Change of num´eraire

33.1 Bond price as num´eraire

33.2 Stock price as num´eraire

33.3 Merton option pricing formula

Brace-Gatarek-Musiela model

34.1 Review of HJM under risk-neutralI P

34.2 Brace-Gatarek-Musiela model

34.3 LIBOR

34.4 Forward LIBOR

34.6 Implementation of BGM

34.7 Bond prices

34.8 Forward LIBOR under more forward measure

34.9 Pricing an interest rate caplet

34.10 Pricing an interest rate cap

34.11 Calibration of BGM

34.12 Long rates

34.13 Pricing a swap

35.1 Probability theory and martingales

35.2 Binomial asset pricing model

35.3 Brownian motion

35.4 Stochastic integrals

35.5 Stochastic calculus and ﬁnancial markets

35.6 Markov processes

35.8 Exotic options

35.9 American options

35.10 Forward and futures contracts

35.11 Term structure models

35.12 Change of num´eraire

35.13 Foreign exchange models

35.14 REFERENCES

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