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Original Title: Pricing Derivatives 3

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1. Introduction

There are some aspects of pricing derivative instrument that set them apart

from the general theory of asset valuation. Under simplifying assumptions, one can

express the arbitrage-free price of derivative as a function of some basic securities,

and then obtain a set of formulas that can be used to price the asset without having to

consider any linkages to other financial markets or to the real side of the economy.

There exist specific ways to obtain such formulas. One method was discussed

in Chapter 2. The notion of arbitrage can be used to determine a probability measure

under which financial assets behave as martingales, one discounted properly. The

tools of martingale arithmetic become available, and one can easily calculate

arbitrage-free prices, by evaluating the implied expectations. This approach to pricing

derivatives is called the method of equivalent martingale measure.

The second pricing method that utilizes arbitrage takes a somewhat more

direct approach. One first constructs a risk-free portfolio, and then obtain a partial

differential equation (PDE) that implied by the lack of arbitrage opportunities. This

PDE is either solved analytically or evaluated numerically.

In either case, the problem of pricing derivatives is to find a function F(St ,t) that

relates the price of the derivative product to S t, the price of the underlying asset, and

possibly to some other market risk factors. When a I formula is impossible to

determine, one finds numerical ways to describe the dynamics of F(St ,t)1

This chapter provides examples of how to determine such pricing functions

F(St,t) for linear and nonlinear derivatives. These concept are clarified and an

example of partial differential equation methods is given. This discussion provides

some motivation for the fundamental tools of stochastic calculus that we introduce

later.

2. Pricing functions

The unknown of a derivative pricing problem is a function F(St ,t), where St is

the price of the underlying asset and t is time. Ideally, the financial analyst will try to

obtain a closed-form formula F(St ,t). The Black-Scholes formula that gives the price

of a call option in term of underlying asset and some other relevant parameters in

perhaps the best-known case. There are, however, many examples, some considerably

simpler.

In cases in which a closed-form formula does not exist, the analyst tries to

obtain an equation that governs the dynamics of F(St ,t)

In this section, we show examples of how to determine such as F(St ,t). The

discussion is intended to introduce new mathematical tools and concepts that have

common use in pricing derivative product.

2.1

Forwards

Consider the class of cash-and-carry goods2. Here we show how a pricing

function F(St ,t), where St is the underlying asset, can be obtained for forward

contracts. In particular, we consider a forward contract with the following provisions:

t < T,

(1)

time T.

Hence, we have a contract that imposes an obligation on both counterpartiesthe one that delivers the gold, and the one that accepts the delivery. How can one

determine a function F(St ,t) that gives the fair market value of such a contract at time

t in term of the underlying parameters? We use an arbitrage argument.

1

nonexistence of a pricing function. It may simply mean that we are not able to express the

pricing function in terms of a simple formula. For example, al continuous and smooth

function can be expanded as an infinite Taylor series expansion. At the same time, truncating

Taylor series in Order to obtain a closed-form formula would in general lead to an

approximation error.

2

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