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Pricing Derivatives

Models and Notation

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
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
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.
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:

At some future date T, where

t < T,


F dollars will be paid for one unit of gold.

The contract is signed at time t, but no payment changes hands until

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.

The nonexistence of a closed-form formula does not necessarily imply the

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.

See Chapter 1 for definition