Prof.

Roberto Steri Derivatives I - Problem Set 6 Spring 2019

Problem Set 6
Suggested Deadline: 30/04/2019

Option Pricing: One-Period Financial Market Model

1
Prof. Roberto Steri Derivatives I - Problem Set 6 Spring 2019

1. In the one-period model of …nancial markets discussed in class, the …rst fundamental theorem
of asset pricing states that the following statements are equivalent:
1) no-arbitrage holds;
2) there exist state-price vectors;
3) there exist risk-neutral probabilities;
4) there exist stochastic discount factors.

a) Prove the equivalence of statements 2) and 3) in the …rst fundamental theorem of asset
pricing.
b) Prove the equivalence of statements 2) and 4) in the …rst fundamental theorem of asset
pricing.
c) Consider the following lemma (Stiemke’s Lemma):
"Let A be a matrix with m rows and l columns, let y denote the generic (column)
vector in Rm and x the generic column vector in R. Furthermore, let T denote matrix
transposition. Then, one and only one of the following statements is true:
– there exists y >> 0 (i.e. a vector with all strictly positive coordinates) such that
y T A = 0;
– there exists x such that A x > 0 (i.e. A x is a vector with all non-negative
coordinates, and at least one strictly positive coordinate)."
Use Stiemke’s lemma (i.e. no proof is required for it) to prove the equivalence of state-
ments 1) and 2) in the …rst fundamental theorem of asset pricing.
[Hint: apply Stiemke’s lemma to the payo¤ matrix M and characterize no-arbitrage ap-
propriately using the condition M > 0]

Solution

a) To prove the equivalence of 2) and 3), we …rst prove that 2) ) 3). Suppose there exists
a state-price vector with coordinates

(! 1 ); (! 2 ); ...; (! K ) > 0

and starting from it we construct the quantities Q(! k ), k = 1; :::; K as follows:

Q(! k ) = (! k ) (1 + r) (1)

Since (! k ) > 0, we have Q(! k ) > 0.

2
Prof. Roberto Steri Derivatives I - Problem Set 6 Spring 2019

Furthermore, by the de…nition of state prices, we obtain

X
K
1
(! k ) =
k=1
1+r

and, exploiting (1) we have

X
K
1 X
K
1
(! k ) = Q(! k ) =
k=1
1 + r k=1 1+r
P
which implies that K k=1 Q(! k ) = 1, that is that Q(! k ) are probabilities. Finally, to
complete the proof that 2) ) 3), we shall show that we can price risky securities by
using those probabilities, that is:

1 X
K
1
Si (0) = E Q [Si (1)] = Q(! k ) Si (! k )
1+r 1 + r k=1

Since
X
K
Si (0) = (! k ) Si (! k )
k=1

by the existence of state prices, using (1) we obtain:

X
K
1 X
K
Si (0) = (! k ) Si (! k ) = Q(! k ) Si (! k )
k=1
1 + r k=1

i.e. the existence of state prices implies the existence of risk-neutral probabilities.
We shall now prove that 3) ) 2). If there exists a risk-neutral probability, then we can
construct the quantities (! k ), k = 1; :::; K as follows:
Q(! k )
(! k ) = (2)
1+r
Since Q(! k ) > 0, we have (! k ) > 0.
Furthermore, by the de…nition of risk-neutral probabilities, we obtain
X
K
Q(! k ) = 1
k=1

which implies
X
K
1
(! k ) =
k=1
1+r

3
Prof. Roberto Steri Derivatives I - Problem Set 6 Spring 2019

Finally, to complete the proof that 3) ) 2), we shall show that we can price risky
securities by using the candidate state prices, that is:
X
K
Si (0) = (! k ) Si (! k )
k=1

Since
1 X
K
1
Si (0) = E Q [Si (1)] = Q(! k ) Si (! k )
1+r 1 + r k=1

by the existence of state prices, using (2) we obtain:

1 X X
K K
Si (0) = Q(! k ) Si (! k ) = (! k ) Si (! k )
1 + r k=1 k=1

i.e. the existence of risk-neutral probabilities implies the existence of state prices.
b) To prove the equivalence of 2) and 4), we …rst prove that 2) ) 4). Suppose there exists
a state-price vector with coordinates

(! 1 ); (! 2 ); ...; (! K ) > 0

and starting from it we construct the quantities m(! k ), k = 1; :::; K as follows:

(! k )
m(! k ) = (3)
P (! k )

Since (! k ) > 0, we have m(! k ) > 0.

Furthermore, by the de…nition of state prices, we obtain
X
K
1
(! k ) =
k=1
1+r

and, exploiting (3) we have

X
K X
K
1
(! k ) = m(! k ) P (! k ) = E P [m(1)] =
k=1 k=1
1+r

1
which implies that E P [m(1)] = 1+r , that is that the candidate stochastic discount factor
prices the riskfree asset correctly. Finally, to complete the proof that 2) ) 4), we shall
show that we can price risky securities by using the candidate stochastic discount factor,
that is:
XK
P
Si (0) = E [m(1)Si (1)] = m(! k ) P (! k ) Si (! k )
k=1

4
Prof. Roberto Steri Derivatives I - Problem Set 6 Spring 2019

Since
X
K
Si (0) = (! k ) Si (! k )
k=1

by the existence of state prices, using (3) we obtain:

X
K X
K
Si (0) = (! k ) Si (! k ) = P (! k ) m(! k ) Si (! k )
k=1 k=1

i.e. the existence of state prices implies the existence of stochastic discount factors.
We shall now prove that 4) ) 2). If there exists a stochastic discount factor, then we
can construct the quantities (! k ), k = 1; :::; K as follows:

(! k ) = m(! k ) P (! k ) (4)

Since m(! k ) > 0, we have (! k ) > 0.

Furthermore, by the de…nition of stochastic discount factor, we obtain

X
K
1
m(! k ) P (! k ) =
k=1
1+r

which implies
X
K
1
(! k ) =
k=1
1+r

Finally, to complete the proof that 4) ) 2), we shall show that we can price risky
securities by using the candidate state prices, that is:

X
K
Si (0) = (! k ) Si (! k )
k=1

Since
X
K
Si (0) = P (! k ) m(! k ) Si (! k )
k=1

by the existence of state prices, using (4) we obtain:

X
K X
K
Si (0) = P (! k ) m(! k ) Si (! k ) = (! k ) Si (! k )
k=1 k=1

i.e. the existence of stochastic discount factors implies the existence of state prices.

5
Prof. Roberto Steri Derivatives I - Problem Set 6 Spring 2019

c) We apply Stiemke’s lemma with A = M , m = K + 1, l = N + 1, where M is the

((K + 1) (N + 1)) payo¤ matrix. No arbitrage holds if and only if there exists no
investment strategy such that M > 0;i.e. whether the second statement in the
lemma is the false one. Thus, according to the Lemma, if there is no arbitrage (i.e. there
is no strategy such that M > 0) there must exist a K + 1-dimensional vector y >> 0
(i.e. a vector with all strictly positive coordinates) such that y T M = 0, and viceversa.
Hence, if there is no arbitrage
8
> z2
M
}|
>
>
> 3{
>
> 1 S1 (0) ::: SN (0) 2 3
>
> 0
>
> z yT 6 7
>
> }| { 6 1 + r S1 (! 1 ) ::: SN (! 1 ) 7 6 7
< 6 7 6 0 7
y0 y1 ::: yK 6 1 + r S1 (! 2 ) ::: SN (! 2 ) 7=6 7
6 7 4 ::: 5
>
> 4 ::: ::: ::: ::: 5
>
> 0
>
> 1 + r S1 (! N ) ::: SN (! N )
>
>
>
>
>
>
: y > 0, k = 0; 1; :::; K
k

which boils down to

8 PK
>
> y0 + yk (1 + r) = 0
>
>
k=1
>
< PK
y0 Si (0) + k=1 yk Si (! k ) = 0, i = 1; :::; N
>
>
>
>
>
:
yk > 0, k = 0; 1; :::; K

De…ning
yk
(! k ) = , for k = 1; :::; K
y0
yields 8 PK 1
>
> k=1 (! k ) =
>
>
1+r
>
< PK
Si (0) = k=1 (! k ) Si (! k ), i = 1; :::; N
>
>
>
>
>
:
(! k ) > 0, k = 1; :::; K
which is exactly the de…nition of state prices. We have therefore proved that no-arbitrage
holds if and only if state prices exist.

6
Prof. Roberto Steri Derivatives I - Problem Set 6 Spring 2019

2. Consider a one-period security market with risk-free rate r = 20% and a risky security S1
whose time-1 price is as follows:
S1 (! 1 ) = 8
S1 (! 2 ) = 6
S1 (! 3 ) = 4

a) Is this market complete?

b) If the time 0 price of the risky security is

S1 (0) = 5

does the market admit risk-neutral probabilities? If your answer is positive, determine
the set of all risk-neutral probabilities for the market.
c) Suppose now that an European call option on security S1 is introduced in the market,
with maturity T = 1 and strike price K = 6: Is the new security redundant? If this
is not the case, determine the set of time 0 prices for the new security compatible with
no-arbitrage in the extended market.
d) Assume that the call option introduced in the previous point sells at time 0 for the price
5
SX (0) =
12
Is this price compatible with no-arbitrage in the extended market? If your answer is
positive, determine the risk-neutral probabilities compatible with no-arbitrage in the
extended market.

Solution.

a) The market is not complete because the number of assets (2) is lower than the number
of possible states (3).
b) In order to work out risk neutral probabilities, we solve the following system:
8
> 1
< S1 (0) = 1+r fS1 (! 1 )Q[! 1 ] + S(1)(! 2 )Q[! 2 ] + S(1)(! 3 )Q[! 3 ]g
Q[! 1 ] + Q[! 2 ] + Q[! 3 ] = 1 (5)
>
: Q[! ]; Q[! ]; Q[! ] > 0
1 2 3

Plugging the information about security prices into (5) we obtain

8 1
< 5 = 1:2 f8Q[! 1 ] + 6Q[! 2 ] + 4Q[! 3 ]g
Q[! 1 ] + Q[! 2 ] + Q[! 3 ] = 1
:
Q[! 1 ]; Q[! 2 ]; Q[! 3 ] > 0

7
Prof. Roberto Steri Derivatives I - Problem Set 6 Spring 2019

which is solved by

Q[! 1 ] = ;
Q[! 2 ] = 1 2 ;
1
Q[! 3 ] = 2 0;
2

c) The payo¤ of the call option is given by

SX (! 1 ) = max[S1 (! 1 ) K; 0] = 2
SX (! 2 ) = max[S1 (! 2 ) K; 0] = 0
SX (! 3 ) = max[S1 (! 3 ) K; 0] = 0

The security is not redundant because the rank of the payo¤ matrix is
2 3
1:2 8 2
Rank 41:2 6 05 = 3
1:2 4 0

Hence, the call option cannot be obtained by combining the riskfree and the risky security.
The set of prices compatible with no arbitrage can be obtained using the risk-neutral
probabilities we worked out in point b), that is

1 1
SX (0) 2 inf E Q SX (1) ; supE Q SX (1)
Q 1+r Q 1+r

In particular,
0 1
1 1 B C
EQ SX (1) = @ 2 |{z} + |{z}
0 (1 2 )+ 0 |{z}A
1+r 1:2 |{z} | {z } |{z}
SX (! 1 ) Q[! 1 ] SX (! 2 ) Q[! 2 ] SX (! 3 ) Q[! 3 ]

1
= 1:6667 for any 2 0;
2
Hence
1
inf E Q SX (1) = inf 1:6667 = 0
Q 1+r 2(0; 12 )

and
1
supE Q SX (1) = sup 1:6667 = 0:8333
Q 1+r 2(0; 21 )

As a consequence
SX (0) 2 (0; 0:8333)

8
Prof. Roberto Steri Derivatives I - Problem Set 6 Spring 2019

d) The price of the call option at time 0 is compatible with no-arbitrage because it falls in
the range of no-arbitrage prices, that is
5
0< < 0:8333
12
In order to …nd the risk-neutral probabilities compatible with no-arbitrage in the ex-
tended market.we solve the following system:
8
1
>
> S1 (0) = 1+r fS1 (! 1 )Q[! 1 ] + S1 (! 2 )Q[! 2 ] + S1 (! 3 )Q[! 3 ]g
>
< 1
SX (0) = 1+r fSX (! 1 )Q[! 1 ] + SX (! 2 )Q[! 2 ] + SX (! 3 )Q[! 3 ]g
(6)
>
> Q[! 1 ] + Q[! 2 ] + Q[! 3 ] = 1
>
: Q[! ]; Q[! ]; Q[! ] > 0
1 2 3

Plugging the information about security prices into (6) we obtain

8
> 1
> 5 = 1:2 f8Q[! 1 ] + 6Q[! 2 ] + 4Q[! 3 ]g
>
< 5 1
12
= 1:2 f2Q[! 1 ] + 0Q[! 2 ] + 0Q[! 3 ]g
>
> Q[! 1 ] + Q[! 2 ] + Q[! 3 ] = 1
>
: Q[! ]; Q[! ]; Q[! ] > 0
1 2 3

which is solved by

Q[! 1 ] = 0:25;
Q[! 2 ] = 0:5;
Q[! 3 ] = 0:25:

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Prof. Roberto Steri Derivatives I - Problem Set 6 Spring 2019

3. Consider the following one-period model along the lines of Cox, Ross, and Rubinstein (1979).
At time t = 0 a risky asset has price S(0) > 0 and a riskless asset has price B(0) = 1; and at
t = 1 two possible states ! 1 and ! 2 can occur. The payo¤s of the risky and riskless securities
at time t = 1 are summarized in the following …gure

B(! 1 ) = 1 + r S(! 1 ) = S(0) u

% %
1 1
& &
B(! 2 ) = 1 + r S(! 2 ) = S(0) d
Riskless Security Risky Security

where 1 + r > 0 is the one-period gross riskfree rate, and u > d are the gross returns on the risky
security in states ! 1 and ! 2 respectively.

a) Under which conditions on u; d; and r is the market complete?

b) Under which conditions on u; d; and r is the Law of one Price satis…ed?

c) Under which conditions on u; d and r is the market free of arbitrage?

d) Consider a call option C written on S with strike K. Find a replicating portfolio for C: Under
the assumptions at point c), use this replicating portfolio to determine the no-arbitrage price
of C.

e) Consider a call option P written on S with strike K. Find a replicating portfolio for P: Under
the assumptions at point c), use this replicating portfolio to determine the no-arbitrage price
of P .

f) Under the assumptions at point c), compute risk-neutral probabilities and use risk-neutral
valuation to verify that the prices you obtained for P and C in point c) are correct.

g) Prove the put-call parity for European options, that is:

K
P (0) = C(0) S(0) +
1+r

Solution.

a) The future payo¤ matrix A is

1 + r S(0) u
A=
1 + r S(0) d

10
Prof. Roberto Steri Derivatives I - Problem Set 6 Spring 2019

The market is complete if A has full rank, i.e. if its determinant is not zero. Therefore:

(1 + r) [S(0) d S(0) u] 6= 0

Since u > d, S(0) > 0, and 1 + r > 0 the market is always complete (i.e. no additional
conditions are needed).
T
b) To check that the law of one price is satis…ed, consider two strategies = 0 1 and
0 0 0 T
= 0 1 such that V (! k ) = V 0 (! k ), k = 1; 2, i.e.
8 0 0
< 0 (1 + r) + 1 u S(0) = 0 (1 + r) + 1 u S(0)
: 0 0
0 (1 + r) + 1 d S(0) = 0 (1 + r) + 1 d S(0)

that is 8 0 0
< ( 0 0) (1 + r) ( 1 1) u S(0) = 0
: 0 0
( 0 0) (1 + r) ( 1 1) d S(0) = 0

Since S(0) and d < u it must be that = 0.

Then, it must be the case that V (0) = V 0 (0), since
0 0
V (0) = 0 + 1 S(0) = 0 + 1 S(0) = V 0 (0)

Therefore, the law of one price always holds in the market (i.e. no additional conditions are
needed).

c) Using the …rst fundamental theorem of asset pricing, one can check the absence of arbitrage
by (for example) imposing the existence of (positive) state prices. State prices (! 1 ) and
(! 2 ) solve the following system:
8
>
<
1
(! 1 ) + (! 2 ) = 1+r
>
: S(0) = (! ) u S(0) + (! ) d S(0)
1 2

Solving the system yields 8

>
< (! 1 ) = 1
1+r
1+r d
u d

>
: 1 u (1+r)
(! 2 ) = 1+r u d

11
Prof. Roberto Steri Derivatives I - Problem Set 6 Spring 2019

Thus, in order to guarantee no-arbitrage, we must impose

1+r d>0

and
u (1 + r) > 0

which implies the additional condition

d<1+r <u

T
d) Denote as C = C
0
C
1 a replicating strategy for a call. Since the market is complete,
such a replicating strategy always exists. Then:
8 C C
< 0 (1 + r) + 1 u S(0) = max(u S(0) K; 0)
: C C
0 (1 + r) + 1 d S(0) = max(d S(0) K; 0)

The system above is solved by:

8 C u max(d S(0) K;0) d max(u S(0) K;0)
>
< 0 = (1+r)(u d)

>
: C max(u S(0) K;0) max(d S(0) K;0)
1 = S(0)(u d)

The no-arbitrage call option price C(0) is therefore:

C C
C(0) = V C (0) = 0 + 1 S(0)

that is:
u max(d S(0) K; 0) d max(u S(0) K; 0)
C(0) = +
(1 + r)(u d)
max(u S(0) K; 0) max(d S(0) K; 0)
+ S(0)
S(0)(u d)

that simpli…es to:

1 1+r d u (1 + r)
C(0) = max(u S(0) K; 0) + max(d S(0) K; 0)
1+r u d u d

12
Prof. Roberto Steri Derivatives I - Problem Set 6 Spring 2019

T
e) Denote as P = P
0
P
1 a replicating strategy for a put. Since the market is complete,
such a replicating strategy always exists. Then:
8 P P
< 0 (1 + r) + 1 u S(0) = max(K u S(0); 0)
: P P
0 (1 + r) + 1 d S(0) = max(K d S(0); 0)

The system above is solved by:

8 P u max(K d S(0);0) d max(K u S(0);0)
>
< 0 = (1+r)(u d)

>
: P max(K u S(0);0) max(K d S(0);0)
1 = S(0)(u d)

P P
The no-arbitrage put option price P (0) is therefore:P (0) = V P (0) = 0 + 1 S(0) that is:
u max (K d S(0); 0) d max (K u S(0); 0)
P (0) = +
(1 + r)(u d)
max (K u S(0); 0) max (K d S(0); 0)
+ S(0)
S(0)(u d)

that simpli…es to:

1 1+r d u (1 + r)
P (0) = max(u S(0) K; 0) + max(d S(0) K; 0)
1+r u d u d

f) From the state prices computed in point c) we can obtain risk-neutral probabilities as
8
> 1+r d
< Q(! 1 ) = (1 + r) (! 1 ) = u d
>
: Q(! ) = (1 + r) u (1+r)
2 (! 2 ) = u d

The price of a call is therefore:

1 1+r d u (1 + r)
C(0) = max(u S(0) K; 0) + max(d S(0) K; 0)
1+r u d u d

that is equal to the price obtained with the replicating portfolio of point d).
The price of a put is instead:
1 1+r d u (1 + r)
P (0) = max(K u S(0); 0) + max(K d S(0); 0)
1+r u d u d

that is equal to the price obtained with the replicating portfolio of point e).

13
Prof. Roberto Steri Derivatives I - Problem Set 6 Spring 2019

g) Using the call and put prices derived in the previous points, we compute P (0) C(0); that is:

1 1+r d u (1 + r)
max(K u S(0); 0) + max(K d S(0); 0) +
1+r u d u d
1 1+r d u (1 + r)
max(u S(0) K; 0) + max(d S(0) K; 0)
1+r u d u d

Since max(K u S(0); 0) max(u S(0) K; 0) = K u S(0), and max(K d S(0); 0)

max(d S(0) K; 0) = K d S(0) we obtain:

1 1+r d u (1 + r)
P (0) C(0) = (K u S(0)) + (K d S(0)) =
1+r u d u d
1 1 + r d u (1 + r) 1+r d u (1 + r)
= + K u+ d S(0) =
1+r u d u d u d u d
1 K
= [K (1 + r) S(0)] = S(0)
1+r 1+r

that is:
K
P (0) = C(0) + S(0)
1+r

14