An Elementary Introduction to Mathematical Finance Options and Other Topics Second Edition SHELDON M, ROSS ea ef Car eB CaMprrpoE Contents Irodncion and Prefice Probability L Probails and Evens 12 Condon Probability 13 Random Vales and Expected Vales 1S) Exeries Norma Random Variables 21 Continuous Random Vrsbles 22 ‘Normal Random Vales 23. Propenies of Nomal Random Vales 24 ‘The Cental Lit Theorem 25 xeches Geometric Brownian Metion 31” Geometric Browsian Motion 32 Goometie Brownian Mons Limit of Simpler Modes 33. Brownian Motion 34 erases Interest Rates and Present Value Analyse 42. Present Vale Arle $3. Rate of Reta 44 Continaosiy Varying Interest Rates 45 Exercises Pricing Contracts vin Arbitrage 51. AnExample in Options Pricing 52. Other Example of Pricing via Aitagevi Comoe 6 ‘The Arbitrage Theorem 661) TheAritage Theorem 462 The Maltpetod Binomial Mode! 63. Proofef te abieage Theorem: 6a Eeries 7 The Black-Scholes Formula TA Teoucsion 12 The Black Scboles Foemala 173. Properties of he Black -Scbles Option Cost 74 The Dats Hedging Abirage Steey 73. Some Desvatons TS. The Black-Scholes Formula 752 The Pata Desiaves 16 Bresies| 1 Adaional Results on Options 81 Insodacsn 82 Call Options on Disdend Paying euros 821 The Dividend for Fach Share ofthe Security Is Pad Continous Time at Rae Egual waxed Faction f ofthe Price ofthe Security 822 Ter Each Ste Owned, a Single Payment of #5it) 1 Made a Tine fy 823 For Bach Share Owned, 4 Fiaed Amount Ds toBe Psi st Tine 1p 83. Pricing American Pat Options [84 Adling Jumps wo Geomex: Brownian Motion {1 When he Jump Disibaton is Logormal 42 When te Junp Distibaon fk General 55. Fstmating he Volality Parameter 851 Estimating + Poplaton Mean and Vaane 852 The Standard Estimator of Wailily 853 Using Opening and ising Dats 85.4 Using Opening Closing, and High-Low Duta 46 Some Comments R61 Whet he Option Cos ites rom be Black-Sales Formal 162 When the ere Rate Changer R63 Fil Conn rt 85 #7 2 9s 95 95 3° 102 108 108, 0 us, 18 18 ue ng 0 m2 13 19 I 13 2s 16 a 19 10 a Ma M3 a " omen 87 Appendix verses ‘sing by ected ty Timitons of Aiage Pricing 52 Nantes by xp iy 53. The Panolin Selection Problem 9331. Tstinatng Covaranees 94 Vil at Risk ané Conditional Valu Risk 955 ‘The Capita Asets Pricing Model 915 Mean Variance Analysis of Risk Newrl-Piced (Cal Options 97 Rates of Rta: Sngl-Peod and Geomevic Brownian Motion 98 Exes Optimization Models kt Iacodncson 102 A Deterministic Opimizaton Model T02.1_ A Gone SolstonTecaign Based on Dymimic Programming 102.2. Solution Technigue for Coneane Retua Functions 1023 The Roapeack Problem 103 Probebilisie Optimization Problems 103.1 A Gambling Mode! with Unowe Win Probables 103.2 An Investment Allocation Model 104 Eseszes otic Options Ha Inosuction 113. Baser Options 1 Ason and Lookback Options ‘Manis Cal Simaton Pring Exotic Options by Simulation ‘More Ecc StsistionEtinstor: Tit Control snd Ane ribs inthe Sint of Asian and Lookback, ti ations us M6 130 152 1 160, 18 10 m 1 16 m a8 18 18 10 18h 188 10 199 11 9 196, 196 156 im 198 1 201 201x Comens 11.62, Combining Conditions Expectation aad [importnee Sampling in che Simulation of ‘Barer Option Vauations| 1.7. Options with Nonlinear Pals 11.8. Pring Approxinations vie Mutiperied Binomial Models 1g. Exercises 12 Beyond Geometrie Brownlan Motion Models 121 Ieraduton 122 Cre Oi Daa 123 Modes forthe Crude OU Dasa 124 inal Comments 13 Autogressive Models and Mean Reversion 1B The Auoepesive Mode! 15 ting Options hy The Eapected Retr 133 Mean Reersion 14 Enecses Iner 20s 20 213 23 21s m0 m Po ar 29 ast Introduction and Preface [An option gies ome the sgh, but rot the obligation, wo buy or sell a security under specified terns. cal prion is one tat give he right to bay, and a pu option is one that gives he sigh to sel the secu, Hoth types of options wil have an exerts price and an exercise dime. Inadktion there are two standard condition under which options opet- ‘Me: European options canbe wiized only ate exercise ime, wheres ‘American options canbe uilized at any te wp to exeres ime. Ts, Torinstance «European cal option with exercise pice K and exercise ‘ime # gives older the right to purchase atime one share ofthe underlying scoriy for the peice K, whereas an Amerian cal option ives its olde he ight to make the purchase at any me Before o at ‘A prerequisite fora strong market in optionsisa computationally efi cient way of evaluating, atleast spprosimatly, tei worth this was sccompihedforcll options (of ether American or European type) by the famous Black-Scholes formals, The fouls assumes that pices ‘fhe underlying sect follow a geometric Brownian motion. This ‘eans that i SQ) the pie of the secu atime y then, Fr any ‘ic history up totimey, the ratio ofthe price ata specif fre ie 15 tothe price atime y has lognormal distribution wid mean and ‘ovine parumetes and 10? espeively. Thats, sean) soy “vl be normal random variable with mean and variance fo, Black “tu Scholes showed under the assumpsion tht the ries follow 2 geo- tric Brownian motion that theresa singe pric for acl pon hat ‘hes allow an lia teader~ one who can instantaneously make twas without any transection costo follow stategy that wil r= salt ina se pet inal ese, Tha i, thee will be po certain profit tre smarhiage ia only i the pie of the opin sa given by the tak. Sses Fornaio, his pice depends nly onthe