A first course in

Options Pricing Theory

Simone Calogero

Chalmers University of Technology

 Preface

This text presents a self-contained introduction to the binomial model and the Black-Scholes
model in options pricing theory. It is the main literature for the course “Options and
Mathematics” at Chalmers, which provides the students with a first basic knowledge in the
theoretical valuation of financial derivatives (in particular, without using stochastic calculus).
The pre-requisites to follow this text are the standard Bachelor courses in mathematics, such
as calculus and linear algebra. No previous knowledge on probability theory and finance are
required. Each chapter is complemented with a number of exercises and Matlab codes. The
solution of some selected exercises can be found in the appendix at the end of the text. The
exercises marked with the symbol (?) aim to critical thinking and should be solved using
judgment and intuition (possibly reinforced by a short calculation). Finally the proof of the
theorems and the sections marked with the symbol (∗) can be skipped on first reading.

Remark: The Matlab codes presented in this text are not optimized. Moreover the powerful
vectorization tools of Matlab are not employed, in order to make the codes easily adaptable
to other computer softwares and languages. The task to improve the codes presented in this
text is left to the interested reader.

Front cover picture: 10 years historical price of the Lehman Brothers stock
Contents

1 Warm-up 3
1.1 Basic financial concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 Fundamental principles and qualitative properties of option prices . . . . . . 21
1.3 Further exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

2 Binomial markets 31
2.1 The binomial stock price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
2.2 Binomial markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.3 Arbitrage portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
2.4 Computation of the binomial stock price with Matlab . . . . . . . . . . . . . 45
2.5 Further Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47

3 European derivatives 48
3.1 The binomial price of European derivatives . . . . . . . . . . . . . . . . . . . 49
3.2 Replicating portfolio processes of European derivatives . . . . . . . . . . . . 60
3.3 Computation of the binomial price of European derivatives with Matlab . . . 63
3.4 Further exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69

4 American derivatives 70
4.1 The binomial price of American derivatives . . . . . . . . . . . . . . . . . . . 71
4.2 The American put option . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
4.3 Replicating portfolio processes of American derivatives . . . . . . . . . . . . 78
4.4 Computation of the binomial price of American derivatives with Matlab . . . 81
4.5 Further exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84

1
5 Introduction to Probability Theory 85
5.1 Finite Probability Spaces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
5.2 Applications to the binomial model . . . . . . . . . . . . . . . . . . . . . . . 105
5.3 Infinite Probability Spaces . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
5.4 Further exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125

6 Black-Scholes options pricing theory 126

6.1 Black-Scholes markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126
6.2 The risk-neutral pricing formula in Black-Scholes markets . . . . . . . . . . . 128
6.3 Black-Scholes price of European call and put options . . . . . . . . . . . . . 132
6.4 Convergence of the binomial price to the Black-Scholes price (*) . . . . . . . 139
6.5 Black-Scholes price of the Asian option . . . . . . . . . . . . . . . . . . . . . 145
6.6 Standard European derivatives on a dividend-paying stock . . . . . . . . . . 149
6.7 Multi-asset options (*) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
6.8 Bonds valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 156
6.9 Further exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162

A Solutions to selected exercises 164

2
Chapter 1

Warm-up

The purpose of this chapter is threefold: (1) introduce a few basic financial concepts, (2)
formulate and discuss the main assumptions on the market dynamics used in the rest of the
text, (3) derive some fundamental qualitative properties of options prices.

1.1 Basic financial concepts

For a more detailed discussion on the concepts introduced in this section, see [2, 6].

Financial assets
The term asset may be used to identify any resource capable of producing value and which,
under specific legal terms, can be bought and sold (i.e., converted into cash). Assets may be
tangible (e.g., lands, buildings, commodities, etc.) or intangible (e.g., patents, copyrights,
stocks, etc.). Assets are also divided into real assets, i.e, assets whose value is derived by
an intrinsic property (e.g., tangible assets), and financial assets, such as stocks, options,
bonds, etc., whose value is instead derived from a contractual claim on the income generated
by another (possibly real) asset. For example, upon holding shares of the Volvo stock (a
financial asset), we can make a profit from the production and sale of cars even if we do not
own an auto plant (a real asset). As we consider only financial assets in this text, the terms
“asset” and “financial asset” will be henceforth used interchangeably.

Price
The price of a financial asset is the value, measured in some units of currency (e.g. dollars),
at which the buyer and the seller agree to exchange ownership of the asset. The price is
chosen by the two parties as a result of some kind of “negotiation”. More precisely, the ask

3
price is the minimum price at which the seller is willing to sell the asset, while the bid price
is the maximum price that the buyer is willing to pay for the asset. When the difference
between these two values, called bid-ask spread, becomes zero, the exchange of the asset
takes place at the corresponding price.
A generic financial asset will be denoted by U and its price at time t by ΠU (t). Prices are
generally positive, although some financial assets (e.g., forward contracts) have zero price.
The asset price refers to the price per share of the asset, where “share” stands for the
minimum amount of an asset that can be traded. All prices in this text are given in a fixed
currency, which is however left unspecified.

Markets
Financial assets can be traded in exchange markets or over the counter (OTC). In the
former case all trades are subject to a common regulation, while in the latter the trading
conditions are more flexible and, to a certain degree, can be agreed upon by the individual
traders. The same asset can often be traded both in an exchange market and OTC, usually
for a different price. The advantage of trading in regularized exchange markets is the higher
level of transparency and protection offered by standardized contracts.
Any transaction in the market is subject to transaction costs (e.g., broker’s commissions)
and transaction delays (trading in real markets is not instantaneous).
Buyers and sellers of assets in a market will be called investors or agents.

Long and short position

Besides the usual operations of “buying” and “selling” the asset, we need to consider an
additional common type of transaction, which is called short-selling. Short-selling an asset
(typically a stock) is the practice of selling the asset without actually owning it. Concretely,
an investor is short-selling N shares of an asset if the investor borrows the shares from a
third party and then sell them immediately on the market. The reason for short-selling an
asset is the expectation that the price of the asset will decrease in the future. In fact, assume
that N shares of an asset U are short-sold at time t = 0 for the price ΠU (0) and let T > 0.
If ΠU (T ) < ΠU (0), then upon re-purchasing the N shares at time T , and returning them to
the lender, the short-seller will make the profit N (ΠU (0) − ΠU (T )).
An investor is said to have a long position on an asset if the investor owns the asset and
will therefore profit from an increase of the price of the asset. Conversely, the investor is
said to have a short position on the asset if the investor will profit from a decrease of its
value, as it happens for instance when the investor is short-selling the asset.

4
Stocks and dividends
The capital stock of a company is the part of the company equity capital that is made
publicly available for trading. Stocks are most commonly traded in official exchange markets.
For instance, over 300 company stocks are traded in the Stockholm exchange market. The
price per share of a generic stock at time t will be denoted by S(t).
A stock may occasionally pay a dividend to its shareholders, usually in form of a cash
deposit. The amount (per share) of the dividend and its payment date must be declared
in advance (announcement date). The ex-dividend date is the first day before the
payment date (from a few days to a few weeks before it) at which buying the stock does not
entitle to the dividend. At the ex-dividend day, the price of the stock often (but not always!)
drops of roughly the same amount paid by the dividend.

Exercise 1.1 (?). Explain why it is reasonable to expect that at the ex-dividend day the price
of the stock will drop by the same amount paid by the dividend.

Market index and ETFs

A market index is a weighted average of the value of a collection of assets traded in one
or more exchange markets. For example, S&P500 (Standard and Poor 500) measures the
average value of 500 stocks traded at the New York stock exchange (NYSE) and NASDAQ
markets. Market indexes can be regarded themselves as tradable assets. More precisely an
ETF (Exchange Traded Fund) on a market index is a financial asset whose value tracks
exactly the value of the market index (or a given fraction thereof). Hence one share of an
ETF on S&P500 will increase its value of 1% in one day if during that day S&P 500 has
gained 1%. An inverse ETF however will in the same example decrease its value of 1%.
Thus ETFs give investors the possibility to speculate whether the market will gain or loose
value in the future.

Portfolio position and portfolio process

Consider an agent that invests on N assets U1 , . . . , UN during the time interval [0, T ]. Assume
that the agent trades on a1 shares of the asset U1 , a2 shares of the asset U2 ,. . . , aN shares
of the asset UN . Here ai ∈ Z, where ai < 0 means that the investor has a short position on
the asset Ui , while ai > 0 means that the investor has a long position on the asset Ui (the
reason for this interpretation will become soon clear). The vector A = (a1 , a2 , . . . , aN ) ∈ ZN
is called a portfolio position, or simply a portfolio. The value of the portfolio at time t is
given by
N
X
VA (t) = ai ΠUi (t), t ∈ [0, T ], (1.1)
i=1

5
where ΠUi (t) denotes the price of the asset Ui at time t. The value of the portfolio measures
the wealth of the investor: the higher is V (t), the “richer” is the investor at time t. Now we
see that when the price of the asset Ui increases, the value of the portfolio increases if ai > 0
and decreases if ai < 0, which explains why ai > 0 corresponds to a long position on the
asset Ui and ai < 0 to a short position. We also remark that portfolios can be added by using
the linear structure on ZN , namely if A, B ∈ ZN , A = (a1 , . . . , aN ), B = (b1 , . . . , bN ) are two
portfolios and α, β ∈ Z, then C = αA + βB is the portfolio C = (αa1 + βb1 , . . . , αaN + βbN ),
whose value is given by VC (t) = αVA (t) + βVB (t).
In the definition of portfolio position and portfolio value given above, the investor keeps the
same number of shares of each asset during the whole time interval [0, T ]. Suppose now that
the investor changes the position on the assets at some times t1 , . . . , tM −1 , where

0 = t0 < t1 < t2 < · · · < tM −1 < tM = T ;

for simplicity we assume that at each time t1 , . . . , tM −1 the change in the portfolio position
occurs instantaneously. Let A0 denote the initial (at time t = t0 = 0) portfolio position of the
investor and Aj denote the portfolio position of the investor in the interval of time (tj−1 , tj ],
j = 1, . . . , M . As positions hold for one instance of time only are clearly meaningless, we
may assume that A0 = A1 , i.e., A1 is the portfolio position in the closed interval [0, t1 ]. The
vector (A1 , . . . , AM ) is called a portfolio process. If we denote by aij the number of shares
of the asset i in the portfolio Aj , then we see that a portfolio process is in fact equivalent to
the N × M matrix A = (aij ), i = 1, . . . , N , j = 1, . . . , M . The value V (t) of the portfolio
process at time t is given by the value of the corresponding portfolio position at time t as
defined by (1.1), that is
N
X
V (t) = VAj (t) = aij ΠUi (t), for t ∈ (tj−1 , tj ] and j = 1, . . . , M .
i=1

The initial value V (0) = VA0 = VA1 (0) of the portfolio, when it is positive, is called the
initial wealth of the investor.
A portfolio process is said to be self-financing if no cash is ever withdrawn or infused in
the portfolio. Let us look at one example. Suppose that at time t0 = 0 the investor is short
400 shares on the asset U1 , long 200 shares on the asset U2 and long 100 shares on the asset
U3 . This corresponds to the portfolio

A0 = (−400, 200, 100),

whose value is
VA0 = −400 ΠU1 (0) + 200 ΠU2 (0) + 100 ΠU3 (0).
If this value is positive, the investor needs an initial wealth to set up this portfolio position:
the income derived from short selling the asset U1 does not suffice to open the desired long
position on the other two assets.

6
As mentioned before, we may assume that the investor keeps the same position in the interval
(0, t1 ], i.e., A1 = A0 . The value of the portfolio process at time t = t1 is

V (t1 ) = VA1 (t1 ) = −400 ΠU1 (t1 ) + 200 ΠU2 (t1 ) + 100 ΠU3 (t1 ).

Now suppose that at time t = t1 the investor buys 500 shares of U1 , sells x shares of U2 , and
sells all the shares of U3 . Then in the interval (t1 , t2 ] the investor has a new portfolio which
is given by
A2 = (100, 200 − x, 0),
and so the value of the portfolio process for t ∈ (t1 , t2 ] is given by

V (t) = 100 ΠU1 (t) + (200 − x) ΠU2 (t), t ∈ (t1 , t2 ].

If we now take the limit of this quantity as t → t+ 1 , we get the value of the portfolio
“immediately after” the position has been changed at time t1 . Denoting this limit by V (t+
1)
and assuming that the prices are continuous, we have
U1 U2
V (t+
1 ) = 100 Π (t1 ) + (200 − x) Π (t1 ).

The difference between the value of the two portfolios immediately after and immediately
before the transaction is then
U1 U2
V (t+
1 ) − V (t1 ) = 100 Π (t1 ) + (200 − x) Π (t1 )
− (−400 ΠU1 (t1 ) + 200 ΠU2 (t1 ) + 100 ΠU3 (t1 ))
= 500 ΠU1 (t1 ) − x ΠU2 (t1 ) − 100 ΠU3 (t1 ).

If this difference is positive, then the new portfolio cannot be created from the old one
without infusing extra cash. Conversely, if this difference is negative, then the new portfolio
is less valuable than the old one, the difference being equivalent to cash withdrawn from the
portfolio. Hence for self-financing portfolio processes we must have V (t+ 1 ) − V (t1 ) = 0, and
+
similarly V (tj ) − V (tj ) = 0, for all j = 1, . . . M − 1. This implies in particular that the
number x of shares of the asset U2 to be sold at time t1 in a self-financing portfolio must be

500ΠU1 (t1 ) − 100ΠU3 (t1 )

x= .
ΠU2 (t1 )

Of course, x will be an integer only in exceptional cases, which means that perfect self-
financing strategies in real markets are almost impossible.
Suppose that a portfolio process is opened at time t = 0 and closed at time t = T > 0, i.e., all
positions in the portfolio are liquidated at time T . If the portfolio process is self-financing,
then its return in the interval [0, T ] is given by

R(T ) = V (T ) − V (0), (1.2)

7
where V (t) denotes the value of the portfolio at time t. If the return is positive, the investor
makes a profit in the interval [0, T ], if it is negative the investor incurs in a loss. When
V (0) > 0 we may also compute the relative return of the portfolio, which is given by
V (T ) − V (0)
R∗ (T ) = . (1.3)
V (0)
A portfolio process is said to generate a cash flow if some cash is withdrawn or added to
the portfolio at some times in the interval (0, T ). A positive cash flow corresponds to cash
removed from the portfolio, while a negative cash flow corresponds to cash added to the
portfolio. Assume for instance that the investor adds the cash Cin < 0 into the portfolio
process at time t1 ∈ (0, T ) (e.g., to finance the purchase of new shares of an asset) and
withdraws the cash Cout > 0 at time t2 ∈ (0, T ) (e.g., after selling some shares of an asset or
receiving a dividend). The value of the portfolio process changes according to

V (t+
1 ) = V (t1 ) − Cin , V (t+
2 ) = V (t2 ) − Cout .

Hence a negative cash flow increases the value of the portfolio, while a positive cash flow
decreases it. The total cash flow generated by the portfolio process in the interval [0, T ] is
C = Cin + Cout and can be negative, positive or zero. If Cin = Cout = 0, the portfolio process
is self-financing, otherwise it is not (even if the total cash flow C is zero). Note also that
constant portfolio positions are self-financing provided the assets pay no dividends.
The total cash flow C generated by a (non-self-financing) portfolio process must be included
in the computation of the return of the portfolio in the interval [0, T ] according to the formula

R(T ) = V (T ) − V (0) + C. (1.4)

Finally we remark that portfolio returns are commonly “annualized” by dividing the return
R(T ) by the time T expressed in fraction of years (e.g., T = 1 week = 1/52 years), although
this is recommended only for investments that last longer than one year.

Historical volatility
The historical volatility of an asset measures the amplitude of the time fluctuations of the
asset price, thereby giving information on its level of uncertainty. It is computed as the
standard deviation of the log-returns of the asset based on historical data. More precisely,
let [t0 , t] be some interval of time in the past, with t denoting possibly the present time, and
let T = t − t0 > 0 be the length of this interval. Let us divide [t0 , t] into n equally long
periods, say

t0 < t1 < t2 < · · · < tn = t, ti − ti−1 = h, for all i = 1, . . . , n.

The set of points {t0 , t1 , . . . tn } is called a partition of the interval [t0 , t]. Assume for instance
that the asset is a stock. The historical log-return of the stock price in the interval [ti−1 , ti ]

8
is given by1  
bi = log S(ti ) − log S(ti−1 ) = log S(ti )
R , i = 1, . . . n. (1.5)
S(ti−1 )
The average of the log-returns is
n  
b = 1 bi = 1 log S(t)
X
R(t) R . (1.6)
n i=1 n S(t0 )

The T-historical mean of log-return of the stock is obtained by “annualizing” the average
of log-returns, i.e., by dividing R(t)
b by the length h of the interval in which the log returns
are computed:
   
1 S(t) 1 S(t)
α
bT (t) = log = log (T -historical mean of log-return). (1.7)
nh S(t0 ) T S(t0 )

The (corrected) sample variance of the log-returns is

n
1 X b 2
∆(t) = (Ri − R(t))
b .
n − 1 i=1

The T-historical variance of the stock is obtained by “annualizing” ∆(t), i.e.,

n
1 1 X b
bT2 (t)
σ = (Ri − R(t))
b 2
(T -historical variance). (1.8)
h n − 1 i=1

The square root of the T −historical variance is the T-historical volatility of the stock:
v
u n
1 u 1 X b
σbT (t) = √ t (Ri − R(t))
b 2 (T -historical volatility). (1.9)
h n − 1 i=1

Note carefully that the historical volatility of the stock depends on the partition being used
to compute it.
Suppose for example that t − t0 = T = 20 days, which is quite common in the applications,
and let t1 , . . . t20 be the market closing times at these days. Let h = 1 day = 1/365 years.
Then v
n
√ u1 X
u
b20 (t) = 365t
σ bi − R(t))
(R b 2
19 i=1

is called the 20days-historical volatility. We remark that h = 1/252 is also commonly used
as normalization factor, since there are 252 trading days in one year (markets are closed in
1
Throughout this text, log x stands for the natural logarithm of x > 0, which is also frequently denoted
by ln x in the literature.

9
the week-end). As a way of example, Figure 1.1 shows the 20days-volatility of four stocks
in the Stockholm exchange market from January 1st , 2014 until May 2nd , 2014 (88 trading
days). Note that in a few cases the historical volatility remains approximately constant
within periods of about 20 days.
Exercise 1.2 (Matlab). Write a Matlab function TwentyDaysAlphaSigma(data) which
computes the 20days-historical mean of log-return and volatility of a stock. Here data is a
20-dimensional column (or row) vector containing the closing market price of the stock on
20 successive days.

Assets correlation (*)

Consider again a uniform partition {t0 , . . . , tn = t} of the past interval [t0 , t] with length
T = t − t0 . Let S (1) (t), S (2) (t) be the prices of two stocks. Let R b(1) , R
b(2) be the log-returns
i i
of each stock in the interval [ti−1 , ti ] and R(1) , R(2) be the averages of log-returns. The
T-historical correlation of log-returns is computed with the formula
Pn b(1) b(1) b(2) b(2)
(R − R )(Ri − R )
ρbT (t) = qP i=1 i . (1.10)
n
( b(1) − R
R b(1) )2 Pn (Rb(2) − R
b(2) )2
i=1 i i=1 i

b1(j) − R
Denoting a1 , a2 the n-dimensional vectors aj = (R b2(j) − R
b(j) , R bn(j) − R
b(j) , . . . , R b(j) ),
j = 1, 2, we can rewrite ρbT (t) as
a1 · a2
ρbT (t) = = cos θ,
|a1 ||a2 |
where · denotes the inner product of vectors, |aj | is the norm of the vector aj and θ ∈ [0, π]
is the angle between a1 and a2 . Hence ρbT (t) ∈ [−1, 1] and the closer is ρbT (t) to 1 (resp. −1)
the more the stock prices have tendency to move in the same (resp. opposite) direction.
Exercise 1.3 (Matlab). Write a Matlab function the compute the 20days-historical corre-
lation of two stocks.

Financial derivatives. Options

A financial derivative (or derivative security) is an asset whose value depends on the
performance of one (or more) other asset(s), which is called the underlying asset. There
exist several types of financial derivatives, the most common being options, futures, forwards
and swaps. In this section we discuss option derivatives on a single asset, which could be for
instance a stock2 .
2
Options are available on many different types of assets, including currencies, market indexes, bonds,
commodities, etc.

10
 40

80

30

60

20
40
Getinge
10
20

Electrolux
0 0
0 20 40 60 80 0 20 40 60 80

(a) ELUXY-B.ST (b) GETIB.ST

100
20 Seb
80

18

60

40
Scania 16

14
20

0 12
0 20 40 60 80 0 20 40 60 80

(c) SCV-B.ST (d) SEB-C.ST

Figure 1.1: 20-days volatility of 4 stocks in the Stockholm exchange market on May 2nd ,
2014. The caption in each graph shows the ticker of the stock.

A call option is a contract between two parties: the buyer, or owner, of the call and the
seller, or writer, of the call. The contract gives the owner the right, but not the obligation,
to buy the underlying asset for a given price, which is fixed at the time when the contract is
stipulated, and which is called strike price of the call. If the buyer can exercise this right
only at some given time T in the future then the call option is called European, while if
the option can be exercised at any time earlier than or equal to T , then the option is called
American. The time T is called maturity time, or expiration date of the call. The
writer of the call is obliged to sell the asset to the buyer if the latter decides to exercise the
option. If the option to buy in the definition of a call is replaced by the option to sell, then
the option is called a put option.
In exchange for the option, the buyer must pay a premium to the seller (options are not
free). Suppose that the option is a European option with strike price K and maturity time
T . Assume that the underlying asset is a stock with price S(t) at time t ≤ T and let Π0
be the premium paid by the buyer to the seller. In which case is it then convenient for the

11
buyer to exercise the option at maturity? Let us define the pay-off of the European call as

0 if S(T ) ≤ K
Ycall = (S(T ) − K)+ := max(0, S(T ) − K) = .
S(T ) − K if S(T ) > K

Similarly, we define the pay-off of the European put by


0 if S(T ) ≥ K
Yput = (K − S(T ))+ = .
K − S(T ) if S(T ) < K

Clearly, the buyer should exercise the call option at maturity if and only if Ycall > 0, as in
this case it is cheaper to buy the stock at the strike price rather than at the market price.
Similarly the owner of the put should exercise if and only if Yput > 0, as in this case the
income generated by selling the stock at the strike price is higher then the income generated
by selling it at the market price. Hence the call or put option must be exercised at maturity if
and only if the pay-off is positive, in which case the option is said to expire in the money.
The return for the owner of the option is given by N (Ycall − Π0 ) in the case of the call and by
N (Yput − Π0 ) in the case of the put, where N is the number of option contracts in the buyer
portfolio. Note carefully that the buyer makes a profit only if the pay-off is greater than the
premium. One of the main problems in options pricing theory is to define a reasonable fair
value for the price Π0 of options (and other derivatives).
Let us introduce some further terminology. The European call (resp. put) with strike K is
said to be in the money at time t if S(t) > K (resp. S(t) < K). The call (resp. put) is
said to be out of the money at time t if S(t) < K (resp. S(t) > K). If S(t) = K, the (call
or put) option is said to be at the money at time t. The meaning of this terminology is
self-explanatory, see Figure 1.2.
The pay-off of the American call exercised at time t is Y (t) = (S(t) − K)+ , while for the
American put we have Y (t) = (K − S(t))+ . The quantity Y (t) is also called intrinsic value
of the American option. In particular, the intrinsic value of an out-of-the-money American
option is zero.

Exercise 1.4 (?). What is the new major factor of risk in trading on stock options as
compared to trading on stocks?

Option markets
Option markets are relatively new compared to stock markets. The first one has been
established in Chicago in 1974 (the Chicago Board Options Exchange, CBOE). Market
options are available on different assets (stocks, debts, indexes, etc.) and with different
strikes and maturities. Most commonly, market options are of American style.
Clearly, the deeper in the money is the option, the higher will be its price in the market,
while the price of an option deeply out of the money is usually quite low (but never zero!).

12
 SHtL
600

500 call in the money

400

300

K
200
call out of
100
the money
0
T t
Figure 1.2: The call option with strike K = 200 and maturity T is in the money in the upper
region and out of the money in the lower region. The put option with the same parameters
is in the money in the lower region and out of the money in the upper region.

It is also clear that the buyer of the option is the party holding the long position on the
option, since the buyer owns the option and thus hopes for an increase of its value, while
the writer is the holder of the short position.
One reason why investors buy call options is to protect a short position on the underlying
asset. Suppose for instance that an investor short-sells 100 shares of a stock at time t = 0
for the price S(0). A cautious investor will also buy 100 shares of the American call option
on the stock with strike K ≈ S(0) and maturity T > 0. If at some time t0 ∈ (0, T ) the price
of the stock is no lower than S(0) the investor has the option to exercise the call and thus
obtain 100 shares of the stock for the price K ≈ S(0). In this way the investor will be able
to close the short position on the stock with minimal losses. At the same fashion, investors
buy put options to protect a long position on the underlying asset3 .
Of course, speculation is also an important factor in option markets. However the stan-
dard theory of options pricing is firmly based on the interpretation of options as derivative
securities and does not take speculation into account.
3
A trading position that is not covered by a suitable security is said to be naked.

13
European, American and Asian derivatives
By far the majority of financial derivatives, including options other than simple calls and
puts, are traded OTC. In this section we discuss a few examples, but first it is convenient to
introduce a precise mathematical definition of European and American derivatives.
Given a function g : (0, ∞) → R, the standard4 European derivative with pay-off Y =
g(S(T )) and maturity time T > 0 is the contract that pays to its owner the amount Y
at time T > 0. Here S(T ) is the price of the underlying stock at time T , while g is the
pay-off function of the derivative (e.g., g(x) = (x − K)+ for European call options, while
g(x) = (K − x)+ for European put options). Hence, the pay-off of standard European
derivatives depends only on the price of the stock at maturity and not on the earlier history
of the stock price. An important example of standard European derivative (other than call
and put options) is the digital option. Denote by H(x) the Heaviside function,

1, for x > 0
H(x) = , (1.11)
0, for x ≤ 0

and let K, L > 0 be constants expressed in units of some currency (e.g., dollars). The
standard European derivative with pay-off function g(x) = LH(x−K) is called cash-settled
digital call option; this derivative pays the amount L if S(T ) > K, and nothing otherwise.
The physically-settled digital call option has the pay-off function g(x) = xH(x − K),
which means that at maturity the buyer receives either the stock (when S(T ) > K), or
nothing. Digital options are also called binary options. Figure 1.3 shows the graph of the
pay-off function for call, put and digital call options with strike K = 10. Drawing the graph
of the pay-off function of a derivative helps to get a first insight onto its properties.

Exercise 1.5. Given K, ∆ > 0, consider the standard European derivative with maturity T
and pay-off function g(x) = (x − K + ∆)+ − 2(x − K)+ + (x − K − ∆)+ . Draw the graph of
g and derive the range of S(T ) for which the derivative expires in the money.

If the pay-off depends on the history of the stock price during the interval [0, T ], and not
just on S(T ), we shall say that the contract is a non-standard European derivative. An
example of non-standard European
RT derivative is the so-called Asian call option, the pay-off
1
of which is given by Y = ( T 0 S(t) dt − K)+ .
The value at time t of the European derivative with pay-off Y and expiration date T will be
denoted by ΠY (t) (we do not include the expiration date in our notation).
The term “European” refers to the fact that the contract cannot be exercised before time
T . For a standard American derivative the buyer can exercise the contract at any time
t ∈ (0, T ] and so doing the buyer will receive the amount Y (t) = g(S(t)), where g is the pay-
off function of the American derivative. Non-standard American derivatives can be defined
4
The terminology “standard” and “non-standard” derivative is used in this text for easy reference. It is
not employed in the financial world.

14
 10 10

8 8

6 6

4 4

SHT L SHT L
2 2
K K
5 10 15 20 5 10 15 20
premium premium
-2 -2

(a) Call option (b) Put option

10 20
premium
8
15
6
L 10
4 premium

SHT L
2 5

SHT L
K K
5 10 15 20
5 10 15 20
-2

(c) Digital option (cash-settled) (d) Digital option (physically-settled)

Figure 1.3: Pay-off function (continuous line) and return (dashed line) of some standard
European derivatives.

similarly to the European ones, but with the further option of earlier exercise. The price at
time t of the American derivative with intrinsic value Y (t) and maturity T will be denoted
Π
b Y (t).

Exercise 1.6. Look for the definition of the following options: Bermuda option, Com-
pound option, Lookback option, Barrier option, Chooser option. Classify them as Ameri-
can/European, standard/non-standard and write down their pay-off function.

Forward contracts (*)

A forward contract with delivery price K and maturity (or delivery) time T on an asset
U is a European type financial derivative stipulated by two parties in which one promises to
the other to sell (and possibly deliver) the asset U at time T in exchange for the cash K.
As opposed to option contracts, both parties in a forward contract are obliged to fulfill their
part of the agreement. In particular, as they both have the same right/obligation, neither
of the two parties has to pay a premium to the other when the contract is stipulated, that is
to say, forward contracts are free; in fact, the terminology used for forward contracts is “to
enter a forward contract” and not “to buy/sell a forward contract”. The party who must

15
sell the asset at maturity holds the short position, while the party who must buy the asset
is the holder of the long position. Hence the pay-off for a long position in a forward contract
on the asset U is
Ylong = (ΠU (T ) − K),
while for the holder of the short position the pay-off is

Yshort = (K − ΠU (T )).

Forward contracts are traded OTC and most commonly on commodities or market indexes,
such as currency exchange rates, interest rates and volatilities. In the case that the underlying
asset is an index, forward contracts are also called swaps (e.g., currency swaps, interest rate
swaps, volatility swaps, etc.). Let us give two examples.
Example of forward contract on a commodity. Consider a farmer who grows wheat and a
miller who needs wheat to produce flour. Clearly, the farmer interest is to sell the wheat for
the highest possible price, while the miller interest is to pay the least possible for the wheat.
The price of the wheat depends on many economical and non-economical factors (such as
whether conditions, which affect the quality and quantity of harvests) and it is therefore
quite volatile. As a form to reduce risks, the farmer and the miller stipulate a forward
contract on the wheat in the winter (before the plantation, which occurs in the spring) with
expiration date in the end of the summer (when harvest occurs) in order to lock the future
price of the wheat at a value which is convenient for both of them.
Example of a currency swap. Suppose that a car company in Sweden promises to deliver a
stock of 100 cars to another company in the United States in exactly one month. Suppose
that the price of each car is fixed in Swedish crowns, say 100.000 crowns. Clearly the
American company will benefit by an increase of the exchange rate crown/dollars and will
be damaged in the opposite case. To avoid possible high losses, the American company
stipulates a forward contract (currency swap) on 100×100.000=ten millions Swedish crowns
expiring in one month and which gives the company the right and the obligation to buy
ten millions crowns for a price in dollars agreed upon today. The other party of the forward
contract could be a company exposed to the opposite risk, i.e., to an increase of the exchange
rate crown/dollars.
As it is clear from these examples, one purpose of forward contracts is to share risks. Irre-
spective of the movement of the underlying asset in the market, its price at time T for the
holders of the forward contract will be K. The delivery price agreed by the two parties in a
forward contract is also called the forward price of the asset. More precisely, the T -forward
price ForU (t, T ) of an asset U at time t < T is the strike price of a forward contract on U
stipulated at time t and with maturity T , while the current, actual price ΠU (t) of the asset
is called the spot price. Note that the forward price ForU (t, T ) is unlikely to be a good
estimation for the price of the asset at time T , since the consensus on this value is limited to
the participants of the forward contract and different parties may agree to different delivery
prices. The delivery price of futures contracts on the asset, which we define below, gives a
better and more commonly accepted estimation for the future value of an asset.

16
 510

505

500

Future Price
495

490

485

480
Jan15 Jan16
Delivery Time

Figure 1.4: Futures price of corn on May 12, 2014 (dashed line) and on May 13, 2014
(continuous line) for different delivery times

Futures contracts (*)

Futures are standardized forward contracts, i.e., rather than being OTC, they are negotiated
in regularized markets. Specifically, a futures market is a market in which the object of
trading are futures contracts. Unlike forward contracts, all futures contracts in a futures
market are subject to the same regulation, and so in particular all contracts on the same
asset with the same time of maturity T have the same delivery price. The T-future price
FutU (t, T ) of the asset U at time t ≤ T is defined as the delivery price at time t ≤ T in
the futures contract with maturity T on the asset U . Futures markets have been existing
for more than 300 years and nowadays the most important ones are the Chicago Mercantile
Exchange (CME), the New York Mercantile Exchange (NYMEX), the Chicago Board of
Trade (CBOT) and the International Exchange Group (ICE).
In a futures market, anyone (after a proper authorization) can stipulate a futures contract.
More precisely, holding a position in a futures contract in the futures market consists in the
agreement to receive as a cash flow the change in the future price of the underlying asset
during the time in which the position is held. The cash flow may be positive or negative.
In a long position the cash flow is positive when the future price goes up and it is negative
when the future price goes down. Moreover, in order to alleviate the risk of insolvency,
the cash flow is distributed in time through the mechanism of the margin account. For
example, assume that at t = 0 we open a long position in a futures contract expiring at time
T . At the same time, we need to open a margin account which contains a certain amount
of cash (usually, 10 % of the current value of the T -future price for each contract opened).
At t = 1 day, the amount FutU (1, T ) − Fut(0, T ) will be added to the account, if it positive,
or withdrawn, if it is negative. The position can be closed at any time t < T (multiple of

17
 4.5

4.4

Future Price
4.3

4.2

4.1

4.0
Jul14 Jan15 Jul15
Delivery Time

Figure 1.5: Futures price of natural gas on May 13, 2014 for different delivery times

days), in which case the total amount of cash flown in the margin account is

(FutU (t, T ) − FutU (t − 1, T )) + (FutU (t − 1, T ) − FutU (t − 2, T ))+

· · · + (FutU (1, T ) − FutU (0, T )) = (FutU (t, T ) − FutU (0, T )).

If a long position is held up to the time of maturity, then the holder of the long position
should buy the underlying asset. However futures contracts are often cash settled and not
physically settled, which means that the delivery of the underlying asset does not occur,
and the equivalent value in cash is paid instead.
An option on futures with maturity T > 0 and strike K is a contract that gives to the
owner the right to enter at time T in a futures contract (expiring at time S > T ) at the
future price K. In the case of a call (resp. put) option, the owner has the right to take a long
(resp. short) position on the futures contract and thus the pay-off will be (FutU (T, S) − K)+
(resp. (K − FutU (T, S))+ ). If the option on futures expires in the money, the owner can
decide to keep open the position on the futures contract or to close it immediately, thereby
cashing the pay-off of the option. Options on futures are example of second derivatives,
i.e., financial derivatives whose underlying asset is another derivative.

Money market
The money market is a component of the debt market consisting of short term loan con-
tracts, i.e., loan contracts with maturity between one day and one year. In contrast to stock
and option markets, money markets are typically accessible only by financial institutions and
not by private investors.
The most liquid money market asset is the treasury bill. A treasury bill with face value

18
K and maturity T (typically 3 or 6 months) is a contract that promises to pay to its owner
the amount K at time T . Treasure bills are issued periodically by national governments
as a way to borrow money and finance their activities. Once a treasury bill is issued by
the government (primary market), it becomes a tradable asset in the secondary market
until it expires at maturity. Trading in the secondary money market is similar to trading
in the stock market, e.g., investors can take long and short positions on treasury bills. Of
course, only the investors who own shares of the bill at maturity will receive from the original
issuer the face value K (multiplied by the number of shares owned).
Other examples of money market assets are commercial papers, certificates of deposit, saving
accounts and repurchase agreements (repo). The value at time t of a generic asset in the
money market will be denoted by B(t). The difference B(t2 ) − B(t1 ), t1 < t2 , determines
the interest rate of the asset in the interval [t1 , t2 ]. In particular, the money market asset
is said to have simply compounded interest rate R(t) in the time period [t, t + h] if the
value of the asset satisfies
B(t + h) = B(t)(1 + R(t)h). (1.12)
Inverting (1.12) we have
B(t + h) − B(t)
R(t) = ,
hB(t)
i.e., R(t) is the annualized relative return of the asset in the interval [t, t + h]. Letting h → 0
we obtain the continuously compounded interest rate (or short rate) r(t) of the asset,
namely
B 0 (t) d
R(t) → r(t) = = log B(t), as h → 0. (1.13)
B(t) dt
Integrating (1.13) on [t, t + h] we find
R t+h
r(s) ds
B(t + h) = B(t)e t , (1.14)

which is the continuum analog of (1.12). Thus simply compounded and continuously com-
pounded rates differ by how frequently the interest rate is compounded. In the simple case
the interest rate is compounded over finite time intervals, while in the continuous case the
interest
R t+h
rate is compounded instantaneously. Note that, since r(t) and h are small, then
r(s) ds
et ≈ er(t)h ≈ 1 + r(t)h and thus, comparing (1.12) and (1.14), we have r(t) ≈ R(t).
However, despite being small, the difference between r(t) and R(t) can have a substantial
impact over large capitals and therefore any loan contract offering an interest rate instead
of a face value (e.g., repo) must specify how the interest rate is compounded.
In this text we use only the continuously compounded interest rate r(t) and thus write the
value at time t of the money market asset in terms of its initial value as
Z t 
B(t) = B(0) exp r(s) ds . (1.15)
0

19
For a treasury bill with face value K and maturity T we have clearly B(T ) = K and so,
using (1.15), we can write the current (at time t = 0) value of the treasury bill as
 Z T 
B(0) = K exp − r(s) ds .
0

Under normal market conditions the interest rate of loan contracts is usually positive, and
thus B(0) < K, i.e., we pay less than K today to receive K in the future, but exceptions are
possible. For instance, short term loans issued by the Swedish central bank (Riksbanken)
have presently (2017) a negative interest rate.
If the current value B(0) of the treasury bill approaches zero, the government issuing the
bill is in risk of default, i.e., in risk of not being able to pay the face value at maturity. In
the event of default, the treasury bill becomes worthless (B(0) = 0).

Frictionless markets
As all mathematical models, also those in financial mathematics are based on a number of
assumptions. Some of these assumptions are introduced only with the purpose of simplifying
the analysis of the models and often correspond to facts that do not occur in reality. Among
these “simplifying” assumptions we impose that

1. There is no bid/ask spread5

2. There are no transaction costs and trades occur instantaneously

3. An investor can trade any fraction of shares

4. When a stock pays a dividend, the ex-dividend date and the payment date are the
same and the stock price at this date drops by the exact same amount paid by the
dividend

We have seen in the previous sections that real markets do not satisfy exactly these assump-
tions, although in some case they do it with reasonable approximation. For instance, if the
investor is a professional agent managing large portfolios then the above assumptions reflect
reality quite well. However they work very badly for private investors. We summarize the
validity of these assumptions by saying that the market has no friction. The idea is that,
when the above assumptions hold, trading proceeds “smoothly without resistance”.
In a frictionless market we may define the portfolio process of an agent who is investing on
N assets during the time interval [0, T ] as a function

A : [0, T ] → RN , A(t) = (a1 (t), . . . , aN (t)),

5
In particular, any offer to buy/sell an asset is matched by an offer to sell/buy the asset, provided of
course the price is fair.

20
i.e., by assumptions 2 and 3, the number of shares ai (t) of each single asset at time t is
now allowed to be any real number and to change at any arbitrary time in the interval
[0, T ]. Portfolio processes can be added using the linear structure in RN , namely if B =
(b1 (t), . . . , bN (t)), and α, β ∈ R, then αA + βB is the portfolio process

αA + βB = (αa1 (t) + βb1 (t), . . . , αaN (t) + βbN (t)).

The value at time t of the portfolio process A is

N
X
VA (t) = a(t)ΠUi (t),
i=1

and clearly
VαA (t) + VβB (t) = VαA+βB (t).
Moreover, thanks to assumption 3, perfect self-financing portfolio processes in frictionless
markets always exist.

1.2 Fundamental principles and qualitative properties

of option prices
The purpose of this section is to introduce a number of basic fundamental principles in
financial mathematics and to derive from them some qualitative properties of option prices,
without invoking any specific mathematical model for the market dynamics. The following
notation will be used. S(t) denotes the price at time t > 0 of a given stock, C(t, S(t), K, T )
denotes the price at time t ∈ [0, T ] of the European call option on the stock with strike
K > 0 and maturity T > 0. The price of the European put option with the same parameters
will be denoted by P (t, S(t), K, T ); finally C(t,
b S(t), K, T ) and Pb(t, S(t), K, T ) denote the
values of the corresponding American call and put option.

No-dummy investor principle

Probably the most self-evident of all financial principles is the following, which we call the
no-dummy investor principle6 :

Investors prefer more to less and do not undertake

trading strategies which result in a sure loss.

This principle has a number of straightforward consequences. For example, an investor will
never exercise an option which is out of the money, while an option that expires in the
6
More commonly (and respectfully) known as rational investor principle.

21
money is always exercised. Moreover the price of stocks and options (prior to expire) is
always positive7 .

Exercise 1.7 (?). Use the no-dummy investor principle to justify the following properties.

(i) The price of a financial derivative tends to its pay-off as maturity is approached. In
particular, for European call/put options,

C(t, S(t), K, T ) → (S(T ) − K)+ , P (t, S(t), K, T ) → (K − S(T ))+ ,

as t → T − and similarly for American options.

(ii) An American derivative is at least as valuable as its European counterpart. In partic-

ular, for call/put options,

b S(t), K, T ) ≥ C(t, S(t), K, T ),

C(t, Pb(t, S(t), K, T ) ≥ P (t, S(t), K, T ).

(iii) The price of an American derivative is always larger or equal to its intrinsic value. In
particular, for American call/put options,

b S(t), K, T ) ≥ (S(t) − K)+ ,

C(t, Pb(t, S(t), K, T ) ≥ (K − S(t))+ .

(iv) The price of European and American call options at time t is no larger than the price
of the underlying asset at time t, i.e.,

C(t, S(t), K, T ) ≤ S(t) and b S(t), K, T ) ≤ S(t).

C(t,

Any reasonable mathematical model for the price of options must be consistent with the
properties (i)-(iv) in the previous exercise. In the rest of this section they are assumed to
hold without any further comment.

Existence of risk-free investments

A further, and often controversial, principle in financial mathematics is the following:

There exist risk-free assets in the money market,

i.e., assets which bear no risk of default.

While there is no general consensus on this, many investors believe that the only actual
risk-free assets in the money market are the US treasure bills.
7
The limiting case S(t) = 0 (zero stock price) is included in some mathematical models to capture the
risk of default of the stock.

22
In a frictionless market the interest rate all risk-free assets must necessarily be the same,
otherwise one would generate a profit by borrowing risk-free at the lower rate and lending
risk-free at the higher rate (this is an example of arbitrage opportunity, see Definition 1.1
below). The (hypothetical) common short rate of all risk-free assets in the money market
will be referred to as the risk-free rate. Which market parameter represents a realistic
estimate for the value of the risk-free rate is an important and constantly debated issue in
finance. A popular choice is the yield of domestic treasure bills. Another frequent choice is to
identify the risk-free rate with an interbank offered rate, such as LIBOR, or EURIBOR,
etc., i.e., the average interest rate at which banks in a given geographical zone lend money
to one another. An alternative approach is to interpret the risk-free rate as an implied
parameter, i.e., a parameter whose value is determined by calibrating a mathematical model
for the market dynamics. An example of the latter point of view is given in Exercise 1.19
below. In this text we assume that the risk-free rate is a (possibly negative) constant r;
this is reasonable for investments on short term contracts, such as options, which will be the
main focus of discussion in the following chapters.

Arbitrage-free principle
Before we introduce our next principle we need to discuss the fundamental concept of arbi-
trage portfolio process.

Definition 1.1. Let t be the present time and T > t. A portfolio process A is called an
arbitrage in the interval [t, T ] if

(a) VA (t) = 0;

(b) It is known at time t that the return of A is positive in the interval [t, T ].

Hence an arbitrage portfolio is an investment strategy that requires no initial wealth and
which ensures a positive profit without taking any risk. For example, suppose that at time
t = 0 an investor sells one share the American call option with strike K and maturity T1
and buys one share of the American call on the same stock with the same strike but with
maturity T2 > T1 . Suppose that the price of the latter option is lower than the price of
the former, i.e., C
b1 := C(0,
b S(0), K, T1 ) > C(0,
b S(0), K, T2 ) := C b2 . The investor will then
have the cash Cb1 − Cb2 available to buy shares of a risk-free asset in the money market. This
(constant) portfolio is clearly an arbitrage in any interval [0, T ] ⊆ [0, T1 ]. In fact it has zero
initial value and if the owner of the option with maturity T1 decides to exercise at some
time T ≤ T1 , the investor can pay-off the buyer by exercising the option in the portfolio; the
remaining value in the portfolio at time T would equal the (positive) value of the risk-free
asset.

Exercise 1.8 (?). It is very unlikely that an arbitrage opportunity as described in the latter
example can be found in real markets. Why?

23
Despite appearing “too good to be true”, arbitrage opportunities do actually exist in real
markets, but only for a very short time, as they are quickly exploited and “traded away”
by investors8 . In this text we neglect arbitrage opportunities altogether by imposing the
arbitrage-free principle:

Asset prices are such that no arbitrage can

be found in the market.

Qualitative properties of option prices

The arbitrage-free principle can be used to derive a number of qualitative properties of option
prices, which are not as obvious as (i)-(iv) in Exercise 1.7. To this purpose we shall use the
following simple theorem.
Theorem 1.1. Assume that the arbitrage-free principle holds and let A be a portfolio process
in the interval [t, T ]. Suppose that it is known at time t that the portfolio will generate the
total cash flow CA in the interval (t, T ).

(a) If it is known at time t that VA (T ) ≥ −CA , then VA (t) ≥ 0.

(b) If it is known at time t that VA (T ) = −CA , then VA (t) = 0.

Proof. Recall that the return of the portfolio in the interval [t, T ] is RA = VA (T )−VA (t)+CA .
If it is known at time t that VA (T ) ≥ −CA , then it is known at time t that RA ≥ −VA (t).
Assume (by contradiction) that VA (t) < 0. The latter means that after opening the portfolio
process A at time t the investor is left with the cash −VA (t). The investor can then use this
cash to add to the portfolio A at time t the number h of shares of a risk-free asset such that
hB(t) = −VA (t). Let us call A0 this new portfolio process. Then A0 is an arbitrage, because
its value at time t is zero and moreover at time t it is known that its return in the interval
[t, T ] satisfies

RA0 = RA + hB(T ) − hB(t) = RA + hB(T ) + VA (t) = VA (T ) + CA + hB(T ) ≥ hB(T ) > 0.

Hence in a arbitrage-free market VA (t) ≥ 0 must hold, which proves (a). To prove (b) we
apply the result (a) to −A, i.e., V−A (T ) ≥ −C−A implies V−A (t) ≥ 0. As C−A = −CA and
V−A (t) = −VA (t), we obtain that VA (T ) ≤ −CA implies VA (t) ≤ 0. Combining the latter
result with (a) completes the proof of (b).

We now apply Theorem 1.1 to prove some qualitative properties for the price of European
call/put options in arbitrage-free markets. We collect these properties in two theorems.
The properties in the first theorem hold under the assumption that the risk-free rate in the
8
Investors who try to make profits by exploiting arbitrage opportunities in the market are called arbi-
tragers.

24
interval [t, T ] is known at time t and for simplicity we take it to be constant, whereas the
properties in the second theorem do not require this hypothesis. We denote these properties
by (v), (vi), . . . , (x) in order to continue the list (i)-(iv) given in Exercise 1.7.
Theorem 1.2. Assume that the arbitrage-free principle holds. Assume also that the risk-free
rate is a constant r ∈ R and that the underlying stock does not pay dividends in the interval
(t, T ).

(v) The put-call parity holds

C(t, S(t), K, T ) − P (t, S(t), K, T ) = S(t) − Ke−r(T −t) . (1.16)

(vi) If r ≥ 0, then C(t, S(t), K, T ) ≥ (S(t) − K)+ ; the strict inequality C(t, S(t), K, T ) >
(S(t) − K)+ holds when r > 0.
(vii) If r ≥ 0, the map T → C(t, S(t), K, T ) is non-decreasing.
(viii) P (t, S(t), K, T ) ≤ Ke−r(T −t) .

Proof. (v) Consider a constant portfolio A which is long one share of the stock and one
share of the put option, and short one share of the call and K/B(T ) shares of the
risk-free asset. The value of this portfolio at maturity is
K
VA (T ) = S(T ) + (K − S(T ))+ − (S(T ) − K)+ − B(T ) = 0,
B(T )
where we used that (K − x)+ − (x − K)+ = K − x, for all x ∈ R. Since the portfolio
A is constant and the stock does not pay dividends, then A is self-financing. Using
Theorem 1.1(b) with CA = 0 we conclude that VA (t) = 0, for t < T , that is
S(t) + P (t, S(t), K, T ) − C(t, S(t), K, T ) − Ke−r(T −t) = 0,
which is the claim.
(vi) We can assume S(t) ≥ K, otherwise the claim is obvious (the price of a call cannot be
negative). By the put-call parity, using that P (t, S(t), K, T ) ≥ 0,
C(t, S(t), K, T ) = S(t) − Ke−r(T −t) + P (t, S(t), K, T ) ≥ S(t) − Ke−r(T −t) ;
the right hand side equals S(t) − K for r = 0 and is strictly greater than this quantity
for r > 0. As S(t) − K = (S(t) − K)+ for S(t) ≥ K, the claim follows.
(vii) Consider a portfolio A which is long one call with maturity T2 and strike K, and short
one call with maturity T1 and strike K, where T2 > T1 ≥ t. By the property (vi) we
have
C(T1 , S(T1 ), K, T2 ) ≥ (S(T1 ) − K)+ = C(T1 , S(T1 ), K, T1 ),
i.e., VA (T1 ) ≥ 0, for t < T1 . Hence Theorem 1.1(a) (with CA = 0) entails VA (t) ≥ 0,
i.e., C(t, S(t), K, T2 ) ≥ C(t, S(t), K, T1 ), which is the claim.

25
(viii) Follows immediately by (iv) and the put-call parity.

Exercise 1.9 (?). Assume r < 0. Then property (viii) does not exclude the possibility that
the put option could be more expensive than the strike price. Since K is the maximum pay-off
that the owner of the put can hope to receive, this possibility seems infeasible. Explain why
this is not the case.
Exercise 1.10 (Sol. 1). Assume that at time t it is known that the underlying stock will pay
the dividend D < S(t0 ) at time t0 ∈ (t, T ). Prove the following variant of the put-call parity
for t < t0 :
C(t, S(t), K, T ) − P (t, S(t), K, T ) = S(t) − Ke−r(T −t) − De−r(t0 −t) . (1.17)
Theorem 1.3. Assume that the arbitrage-free principle holds and that the underlying stock
does not pay dividends in the interval (t, T ).

(ix) If K0 ≤ K1 , then C(t, S(t), K0 , T ) ≥ C(t, S(t), K1 , T ), i.e., the price of European call
options is non-increasing with the strike price. Similarly the price of put options is
non-decreasing with the strike price.
(x) The maps K → C(t, S(t), K, T ) and K → P (t, S(t), K, T ) are convex9 .

Proof. (ix) Consider the portfolio A which is long one share of the call with strike K0 and
short one share of the call with strike K1 . The value of this portfolio at maturity
is (S(T ) − K0 )+ − (S(T ) − K1 )+ , which, as K1 ≥ K0 , is always non-negative. By
Theorem 1.1(a) (with CA = 0) we then have C(t, S(t), K0 , T ) − C(t, S(t), K1 , T ) ≥ 0.
The proof of the statement for put options is similar.
(x) We prove the claim for call options, the argument for put options being the same. Let
K0 , K1 > 0 and 0 < θ < 1 be given. Consider a portfolio A which is short one share of
a call with strike θK1 + (1 − θ)K0 and maturity T , long θ shares of a call with strike
K1 and maturity T , long (1 − θ) shares of a call with strike K0 and maturity T . The
value of this portfolio at maturity is
VA (T ) = −(S(T ) − (θK1 + (1 − θ)K0 ))+ + θ(S(T ) − K1 )+ + (1 − θ)(S(T ) − K0 )+ .
The convexity of the function f (x) = (S(T ) − x)+ gives VA (T ) ≥ 0 and so VA (t) ≥ 0
by Theorem 1.1(a) (with CA = 0). The latter inequality is
C(t, S(t), θK1 + (1 − θ)K0 , T ) ≤ θC(t, S(t), K1 , T ) + (1 − θ)C(t, S(t), K0 , T ),
which is the claim for call options.

9
Recall that a real-valued function f on an interval I is convex if f (θx + (1 − θ)y) ≤ θf (x) + (1 − θ)f (y),
for all x, y ∈ I and θ ∈ (0, 1). This means that the graph of f between two points in the plane lies below the
straight line connecting these two points.

26
Exercise 1.11. Consider the following table of European options prices at time t = 0:

CALL PUT
Maturity Strike Price Maturity Strike Price

1 month 104 20 1 month 96 14

1 month 110 16 1 month 100 16
1 month 116 10 1 month 104 18
3 months 110 15 3 months 110 18

Assume that the risk-free rate is r = 0 and that the price of the underlying stock at time t = 0
is S(0) = 100. Explain why these option prices violate the arbitrage-free principle. Find a
constant arbitrage portfolio on these assets. HINT: Look for violations of the properties in
Theorems 1.2-1.3.

In the following exercises it is assumed that the arbitrage-free principle holds and that the
stock pays no dividend.

Exercise 1.12 (Sol. 2). Consider the European derivative U with maturity time T and pay-
off Y given by
Y = min[(S(T ) − K1 )+ , (K2 − S(T ))+ ],
where K2 > K1 and (x)+ = max(0, x). Draw the graph of the pay-off function of the
derivative. Find a constant portfolio consisting of European calls and puts expiring at time
T which replicates the value of U (i.e., whose value at any time t ≤ T equals the value of U).

Exercise 1.13. Let K, T > 0 and consider the European style derivative with pay-off Y =
min(K, |S(T ) − K|) at maturity T , where S(t) is the price of the underlying stock at time t.
Write the value of this derivative in terms of the value of call and put options.
ANSWER: ΠY (t) = C(t, S(t), K, T ) + P (t, S(t), K, T ) − C(t, S(t), 2K, T ).

Exercise 1.14. Suppose K, ∆ > 0. A butterfly spread on call options is a portfolio that
consists of 1 share of the call with strike K − ∆, −2 shares of the call with strike K and 1
share of the call with strike K + ∆; the maturity is the same for all call options. Show that
the value of this portfolio is non-negative at any time.

Exercise 1.15 (Sol. 3). Consider the standard European derivative with pay-off Y at ma-
turity T and the derivative with pay-off Z = ΠY (t∗ ) at maturity t∗ < T . Show that
ΠZ (t) = ΠY (t), t ∈ [0, t∗ ]

Exercise 1.16 (Sol. 4). (Chooser option). Let T2 > T1 . A chooser option with maturity
T1 is a contract which gives to the buyer the right to choose at time T1 whether the derivative
transforms (at zero cost) into a call or a put option with strike K and maturity T2 . Write

27
down the pay-off Y of the chooser option. Let r ∈ R be constant. Show that the value of the
chooser option is given by the formula

ΠY (t) = C(t, S(t), K, T2 ) + P (t, S(t), Ke−r(T2 −T1 ) , T1 ), t ≤ T1 .

HINT: You need the result of Exercise 1.15 and the put-call parity.

Exercise 1.17 (?). What is the purpose of a chooser option? Which of the following state-
ments is true and why?

(a) At any given time, the price of the chooser option is lower than the maximum between
the price of the call and the price of the put to either of which it will convert at maturity,
i.e.,
ΠY (t) ≤ max(C(t, S(t), K, T2 ), P (t, S(t), K, T2 )), t ≤ T1 .

(b) At any given time, the price of the chooser option is lower than the sum of the price
of the call and of the put to either of which it will convert at maturity, i.e.,

ΠY (t) ≤ C(t, S(t), K, T2 ) + P (t, S(t), K, T2 ), t ≤ T1 .

Exercise 1.18. Assume that the risk-free rate is constant. Show that the forward price of
an asset in an arbitrage-free market is given by ForU (t, T ) = er(T −t) ΠU (t).

Optimal exercise time of American options

Consider a no-dummy investor owning an American put option. Suppose that the investor
wants to close the position on the American put at time t. This can be done by either selling
the option or by exercising it. In which case should the investor exercise the option? At any
time t < T we have, by (iii),

either Pb(t, S(t), K, T ) > (K − S(t))+ or Pb(t, S(t), K, T ) = (K − S(t))+ .

Exercising the American put at a time t when the strict inequality Pb(t, S(t), K, T ) > (K −
S(t))+ holds is a dummy decision, because the income generated by exercising the option
is lower than the amount that the buyer would receive by selling the option. On the other
hand, if the equality Pb(t, S(t), K, T ) = (K − S(t))+ holds at time t, then the exercise of
the American put is optimal, as in this case the pay-off equals the value of the derivative,
i.e., the investor takes full advantage of the American put. This leads us to introduce the
following definition.

Definition 1.2. A time t < T is called an optimal exercise time for the American put
with value Pb(t, S(t), K, T ) if

Pb(t, S(t), K, T ) = (K − S(t))+ .

28
A similar definition can be justified for American call options, i.e., an optimal exercise
b S(t), K, T ) = (S(t) − K)+ . However,
time for the American call is a time t at which C(t,
if the underlying stock does not pay dividends and the risk-free rate is positive, we have
b S(t), K, T ) ≥ C(t, S(t), K, T ) > (S(t) − K)+ , for t < T , see (ii) and (vi). We conclude
C(t,
that, in an arbitrage-free market with r > 0, and assuming that the stock pays no dividend,
it is never optimal to exercise the American call prior to maturity10 .
As in the absence of dividends the option of earlier exercise of American calls is worthless,
we have the following, last property for the price of options:

(xi) When the underlying stock pays no dividend and the risk-free rate is positive, the value
of the European call and the value of the American call with equal parameters are the
same, i.e.,
C(t,
b S(t), K, T ) = C(t, S(t), K, T ).

Final remarks: The properties (i)-(xi) are quite well represented in real markets, thereby
giving indirect support to the arbitrage-free principle. Note also that these properties depend
only on the validity of the arbitrage-free principle and not on the specific market dynamics.
In the following chapters we shall give an alternative proof of (some of) these properties by
using explicit models for the price of stocks and options in the market.
Exercise 1.19 (Comparison with market data). Call and put options on Nasdaq 100
are of European style and so they can be used to test the properties derived in this section.
The market price of call and put options on Nasdaq 100, for different strikes and maturities,
can be found for instance in the Yahoo Finance webpage (google “Nasdaq 100 options chain
Yahoo”). Compile a table of prices for options “nearly at the money”, for instance using
the first 10 options in and out of the money (if an option appears with zero price it means
that it has not yet been traded; you can just skip it). Use these data to plot (with Matlab
for instance) the price of call and put options in terms of the strike price and the time of
maturity. Are the properties (vii), (ix), (x) verified? Next use the put-call parity identity to
compute the value of the risk-free rate r for each pair of call-put with the same strike and
maturity. What can you conclude? Do the data support the put-call parity?

1.3 Further exercises

For the following exercises assume that the arbitrage-free principle holds, the stock pays no
dividend and the risk-free rate is constant.
Exercise 1.20. Let r > 0. Prove that C(t, S(t), K, T ) → S(t) as T → ∞. HINT: see (viii)
and the put-call parity.
10
As opposed to this, it can be shown that when the underlying stock pays a dividend, then it is optimal
to exercise the American call just before the dividend is paid, provided the price of the stock is sufficiently
high, see [3].

29
Exercise 1.21. Prove that ∂K C(t, S(t), K, T ) ≥ − exp(−rτ ), provided the derivative exists.
HINT: see (ix) and the put-call parity.

Exercise 1.22. Prove that C(t, S(t), K, T ) → 0 as S(t) → 0. HINT: This follows easily by
one of the properties (i)-(xi).

Exercise 1.23. Prove that ∂s C(t, s, K, T ) − ∂s P (t, s, K, T ) = 1. HINT: Use the put-call
parity.

Exercise 1.24 (?). Give an intuitive explanation, using the no-dummy investor principle,
of the properties in Exercises 1.20 and 1.22.

Exercise 1.25. Find a constant portfolio consisting of European calls and puts with expira-
tion date T such that the value of the portfolio at time T equals

V (T ) = min[(S(T ) − K)+ , (L − S(T ))+ , (L − K)/4],

where 0 < K < L. HINT: Draw the graph of the pay-off function and write it as a combina-
tion of call and put pay-offs.

Exercise 1.26 (?). Which of the following statements is true and why?

(1) If it is known at time t that the underlying stock pays a dividend at time t0 > t, then
for t < t0 the European call on the stock with maturity T > t0 is less valuable than in
the absence of dividends;

(2) If it is known at time t that the underlying stock pays a dividend at time t0 > t, then
for t < t0 the European call on the stock with maturity T > t0 is more valuable than in
the absence of dividends;

(3) If it is known at time t that the underlying stock pays a dividend at time t0 > t, then
for t < t0 the European call on the stock with maturity T > t0 is as valuable as in the
absence of dividends.

What is the right statement for put options? How does the dividend payment affect the value
of the call/put for t ∈ (t0 , T ]?

30
Chapter 2

Binomial markets

In this and the following two chapters we present a time-discrete model for the valuation
of options first proposed in [4] and which is known as binomial options pricing model.
The model is very popular among practitioners due to its implementation simplicity. The
present chapter deals with the dynamics of the underlying asset, which we assume to be a
stock. The following two chapters are concerned with European and American derivatives
on the stock. The time-continuum analog of the binomial model is the Black-Scholes model,
which will be studied in Chapter 6.

2.1 The binomial stock price

The binomial asset price is a model for the evolution in time of the price of financial
assets. It is often applied to stocks, hence we denote by S(t) the price of the asset at time
t. We are interested in monitoring the stock price in some finite time interval [0, T ], where
T > 0 could be for instance the expiration date of an option on the stock. The price of the
stock at time t = 0 is denoted by S(0) or S0 and is assumed to be known.
The binomial stock price can only change at some given pre-defined equidistant times:

0 = t0 < t1 < t2 < · · · < tN = T, ti − ti−1 = h > 0, i = 1, . . . , N,

where we recall that time in finance is measured in fraction of years. In the applications one
should choose h << T . Moreover the price of the stock at time ti depends only on the price
at time ti−1 and the result of “tossing a coin”. Precisely, letting

u, d ∈ R, u > d, and p ∈ (0, 1),

we assume 
S(ti−1 )eu , with probability pu = p,
S(ti ) =
S(ti−1 )ed , with probability pd = 1 − p,

31
for all i = 1, . . . , N . Here we may interpret p as the probability to get a head in a coin
toss (p = 1/2 for a fair coin). We restrict to the standard binomial model, which assumes
that the parameters u, d, p are time-independent and that the stock pays no dividend in the
interval [0, T ].
The pair (pu , pd ) is called physical (or real-world) probability vector, to distinguish
it from the risk-neutral probability vector introduced later in this chapter. In the
applications one typically chooses u > 0 and d < 0 (e.g., d = −u is quite common), hence
u stands for “up”, since S(ti ) = S(ti−1 )eu > S(ti−1 ), while d stands for “down”, since
S(ti ) = S(ti−1 )ed < S(ti−1 ). In the first case we say that the stock price goes up at time ti ,
in the second case that it goes down at time ti .

Definition 2.1. The instantaneous mean of log-return α ∈ R and the instantaneous

volatility σ > 0 of the binomial stock price are defined respectively by
1 u − dp
α= [pu + (1 − p)d], σ= √ p(1 − p). (2.1)
h h
The quantity σ 2 is called instantaneous variance.

The parameter α measures the average movement of the binomial stock price, while σ mea-
sures the average uncertainty of the binomial stock price, i.e., the higher is σ the larger is the
range of possible values of the stock price at any given time. The parameters α, σ are both
expressed in yearly percentage; for instance α = 0.05 means that the stock price is expected
to increase in average 5% in one year.

Remark 2.1. The parameters (α, σ) are related to, but conceptually very different from, the
historical mean of log-return and the historical volatility (b
αT , σ
bT ) introduced in Chapter 1,
see (1.7), (1.9). In fact, (b
αT , σ
bT ) are computed using past (historical) data for the stock
prices, while the parameters (α, σ) describe expected properties of the stock price in the
future and are computed using the physical probability p.

We can invert (2.1) and obtain

1 − p√ p √
r r
u = αh + σ h, d = αh − σ h. (2.2)
p 1−p

Hence we may formulate the binomial stock price by either (i) specifying the parameters
u, d, p, h, T or by (ii) specifying the parameters α, σ, p, h, T and computing u, d from (2.2).
The formulation (ii) is the most common in the applications and will be used for the numerical
implementation of the model, see Section 2.4. The formulation (i) is more suitable for hand
calculations and will be used for the theoretical analysis of the model. Moreover for the
latter purpose we assume, without loss of generality, that h = 1, and so

t1 = 1, t2 = 2, ..., tN = T = N,

32
with N >> 1. It is convenient to denote

I = {1, . . . , N }.

Hence, from now on, for the theoretical analysis of the binomial model we assume that the
binomial stock price is determined by the rule S(0) = S0 > 0 and

S(t − 1)eu , with probability p

(
S(t) = , t ∈ I. (2.3)
S(t − 1)ed , with probability 1 − p

Exercise 2.1 (?). Assume that the stock pays the dividend D < S(t0 ) at some time t0 ∈
{2, . . . , N − 1}. How should one modify (2.3) in this case?

Remark 2.2 (Notation). The notation used in the present text is slightly different from the
one used in the other literature on the binomial model, see e.g. [10]. In fact the binomial
stock price is more commonly written as
(
S(t − 1)u, with probability p
S(t) = ,
S(t − 1)d, with probability 1 − p

with 0 < d < u. All the results in the present text can be translated into the standard
notation by the substitutions eu → u, ed → d. In our notation the log-returns of the stock
take a slightly simpler form, which is useful when passing to the time-continuum limit (see
Section 6.4).

Each possible sequence (S(0), S(1), . . . , S(N )) of stock prices determined by the binomial
model is called a path of the stock price. Clearly, there exists 2N possible paths of the stock
price in a N -period model. Letting

{u, d}N = {x = (x1 , x2 , . . . , xN ) ∈ RN : xt = u or xt = d, t ∈ I}

be the space of all possible N -sequences of “ups” and “downs”, we obtain a unique path of
the stock price (S(0), S(1), . . . , S(N )) for each x ∈ {u, d}N . For instance, for N = 3 and
x = (u, d, u) the corresponding stock price path is given by

S0 → S(1) = S0 eu → S(2) = S(1)ed = S0 eu+d → S(3) = S(2)eu = S0 e2u+d .

33
In general the possible paths of the stock price for the 3-period model can be represented as

S(3) = S0 e3u
6
u

S(2)
6
= S0 e2u
u d
(
S(1) = S0 eu S(3) = S0 e2u+d
6 6
u d u
(
S(0) = S0 S(2) = S0 eu+d
6
d u d
( (
S(1) = S0 ed S(3) = S0 eu+2d
6
d u
(
S(2) = S0 e2d
d
(
S(3) = S0 e3d

which is an example of recombining binomial tree. The term “recombining” indicates

the property that going down from one node and going up from the node immediately below
lead to same node. The admissible values for the binomial stock price S(t) at time t are
given by
S(t) ∈ {S0 eku+(t−k)d , k = 0, . . . , t},
for all t ∈ I, where k is the number of times that the price goes up up to the time t included.
In particular, at time t there are t + 1 possible values for the stock price.
Definition 2.2. Given x = (x1 , . . . xN ) ∈ {u, d}N , the binomial stock price at time t ∈ I
along the path x is given by

S(t, x1 , . . . , xt ) = S0 exp(x1 + x2 + . . . xt ).

The vector S x = (S(0), S(1, x1 ), S(2, x1 , x2 ), . . . , S(N, x1 , . . . , xN )) is called the x-path of the
binomial stock price. Moreover we define the probability1 of the path S x as

P(S x ) = pNu (x) (1 − p)Nd (x) ,

where Nu (x) is the number of u’s in the sequence x and Nd (x) = N − Nu (x) is the number
of d’s. The probability that the binomial stock price follows one of the two paths S x , S y is
given by P(S x ) + P(S y ), and similarly for any number of paths.
1
We shall say more about the probabilistic interpretation of the binomial model in Chapter 5.

34
For instance, for x = (u, d, d, d, u) in a 5-period binomial model, the x-path of the stock price
is

S x = (S(0), S(1, u), S(2, u, d), S(3, u, d, d), S(4, u, d, d, d), S(5, u, d, d, d, u))
= (S0 , S0 eu , S0 eu+d , S0 eu+2d , S0 eu+3d , S0 e2u+3d )

and the probability that the stock follows this path is P(S x ) = p2 (1 − p)3 .

Exercise 2.2 (Sol. 5). Show that

X
P(S x ) = 1.
x∈{u,d}N

2.2 Binomial markets

A (1+1 dimensional) binomial market is a market that consists of one stock and one risk-
free asset, such that the price of the stock is given by the binomial model (2.3) and the value
of the risk-free asset at time t ∈ I is given by

B(t) = B0 ert , t ∈ I, (2.4)

where B0 = B(0) > 0 is the present (at time t = 0) value of the risk-free asset. We assume
that the risk-free rate r is constant (not necessarily positive), which is reasonable for short
time investments (T / 1 year). The constants u, d, r, p are called market parameters.

Remark 2.3 (Notation). As a follow-up to Remark 2.2, we mention that our notation
for the value of the risk-free asset in the binomial model is also slightly different from the
standard one. In fact, in most of the literature on the binomial model this value is written
as B(t) = B0 (1 + R)t , where R is the simply compounded risk-free rate. To translate our
results into the standard notation one just needs to replace er with (1 + R).

Remark 2.4 (Discounted price). The discounted price (at time t = 0) of the stock in
a binomial market is defined by S ∗ (t) = e−rt S(t) and has the following meaning: S ∗ (t) is
the amount that should be invested at time t = 0 on the risk-free asset in order that the
value at time t of this investment replicates the value of the stock at time t. Note that
whenever r > 0, i.e., as long as buying the risk-free asset ensures a positive return, we have
S ∗ (t) < S(t). The discounted price of the stock measures the loss in the stock value due to
the “time-devaluation” of money expressed by the ratio B0 /B(t) = e−rt . More precisely, in
finance it is agreed that 1 dollar today (t = 0) is equivalent, in terms of purchasing power,
to ert dollars at time t in the future, because one can invest the dollar in the money market
today and receives (risk-free) ert dollars at time t. Hence S ∗ (t) = S(t)/ert measures the
value of the stock at the future time t relative to the purchasing value of 1 dollar at time t.

35
Definition 2.3. A portfolio process invested in a binomial market is a finite sequence

{(hS (t), hB (t))}t∈I ,

where hS (t) ∈ R is the number of shares invested in the stock and hB (t) ∈ R is the number
of shares invested in the risk-free asset during the time interval (t − 1, t], t ∈ I. The value
of the portfolio process at time t is given by

V (t) = hS (t)S(t) + hB (t)B(t). (2.5)

The initial position of the investor is given by (hS (0), hB (0)). As portfolio positions held for
one instant of time only are clearly meaningless, we may assume that

hS (0) = hS (1), hB (0) = hB (1), (2.6)

i.e, (hS (1), hB (1)) is the investor position on the closed interval [0, 1] (and not just in the
semi-open interval (0, 1]). Recall that hS (t) > 0 means that the investor has a long position
on the stock in the interval (t − 1, t], while hS (t) < 0 corresponds to a short position.
It is clear that the investor will change the position on the stock and the risk-free asset
according to the path followed by the stock price, and so (hS (t), hB (t)) is in general path-
dependent. We are only interested in portfolio processes for which the position on the assets
in the interval (t − 1, t] is chosen based on the information available at time t − 1 and not on
the uncertain future. By “information” at time t here we mean the knowledge of the path
(x1 , . . . , xt ) followed by the stock price up to time t.

Definition 2.4. A portfolio process {(hS (t), hB (t)}t∈I is called predictable if hS (t) and
hB (t) depend only on the path (x1 , . . . , xt−1 ) followed by the stock price up to time t − 1.

When we want to emphasize the dependence of a predictable portfolio position on the path
of the stock price we shall write

hS (t) = hS (t, x1 , . . . , xt−1 ), hB (t) = hB (t, x1 , . . . , xt−1 ).

Likewise we write

V (t, x1 , . . . , xt ) = hS (t, x1 , . . . , xt−1 )S(t, x1 , . . . , xt ) + hB (t, x1 , . . . , xt−1 )B(t),

for the value of predictable portfolio processes.

Exercise 2.3. Show that a portfolio process {hS (t), hB (t)}t∈I in a binomial market is pre-
dictable if and only if there exists functions H1 , . . . , HN such that

(hS (t), hB (t)) = Ht (S(0), S(1), . . . , S(t − 1)).

HINT: Express x1 , . . . , xt in terms of the stock prices.

36
For instance a portfolio process is predictable when the position (hS (t), hB (t)) in the interval
(t − 1, t] is a deterministic function of the stock price at time t − 1, that is

(hS (t), hB (t)) = Ht (S(t − 1)), Ht : (0, ∞) → R2 , t ∈ I. (2.7)

In this case the portfolio process can be represented with a recombining binomial tree, as in
the following example for N = 3:

(hS (3), hB (3)) = H3 (S0 e2u )

3
u

(hS (2),3 hB (2)) = H2 (S0 eu )

u d
+
(hS (1), hB (1)) = H1 (S0 ) (hS (3), hB (3)) = H3 (S0 eu+d )
3
d u
+
(hS (2), hB (2)) = H2 (S0 ed )
d
+
(hS (3), hB (3)) = H3 (S0 e2d )

Note that since (hS (0), hB (0)) = (hS (1), hB (1)), the binomial tree for a portfolio process
satisfying (2.7) in an N -period binomial model has only N − 1 periods. The interpretation
of this binomial tree is the following. In the interval [0, 1] the investor is taking the position
(hS (1), hB (1)) = H1 (S0 ). If the price of the stock goes up at time t = 1, i.e., S(1) = S0 eu ,
then the investor takes the position (hS (2), hB (2)) = (hS (2, u), hB (2, u)) = H2 (S0 eu ) in
the interval (1, 2], while if S(1) = S0 ed the investor takes the position (hS (2), hB (2)) =
(hS (2, d), hB (2, d)) = H2 (S0 ed ) in the same time interval. If S(2) = S0 eu+d , i.e., if the
stock price goes up at time t = 1 and down at time t = 2 (or up at time t = 1 and down
at time t = 2), the investor takes the position (hS (3), hB (3)) = (hS (3, u, d), hB (3, u, d)) =
(hS (3, d, u), hB (3, d, u)) = H3 (S0 eu+d ) on the interval (2, 3], and so on.

Self-financing portfolio processes

A portfolio process in the binomial market is self-financing if purchasing more shares of one
asset is possible only by selling shares of the other asset for an equivalent value (and not
by infusing new cash into the portfolio), and, conversely, if any cash obtained by selling
shares of one asset is immediately re-invested to buy shares of the other asset (and not
withdrawn from the portfolio). To translate this condition into a mathematical formula, let
(hS (t − 1), hB (t − 1)) be the investor position on the stock and the risk-free asset during
the time interval (t − 2, t − 1]. Assume that the investor sells/buys shares of the assets at

37
time t − 1. Let (hS (t), hB (t)) be the new position on the stock and the risk-free asset in the
interval (t − 1, t]. The value of the portfolio process at time t − 1 is

V (t − 1) = hS (t − 1)S(t − 1) + hB (t − 1)B(t − 1),

while the value immediately after changing the position at time t − 1 is

V 0 (t − 1) = hS (t)S(t − 1) + hB (t)B(t − 1).

The difference V 0 (t − 1) − V (t − 1), if not zero, corresponds to cash withdrawn or added

to the portfolio as a result of the change in the position on the assets. In a self-financing
portfolio, however, this difference must be zero. We thus must have V 0 (t − 1) = V (t − 1),
which leads to the following definition.
Definition 2.5. A portfolio process {(hS (t), hB (t))}t∈I invested in a binomial market is said
to be self-financing if

hS (t)S(t − 1) + hB (t)B(t − 1) = hS (t − 1)S(t − 1) + hB (t − 1)B(t − 1) (2.8)

holds for all t ∈ I.

Remark 2.5. Constant (i.e., time-independent) portfolio processes are clearly self-financing
(and of course also predictable). In fact, (2.8) holds if hS (t) = hS (t−1) and hB (t) = hB (t−1),
for all t ∈ I; recall that we assume that the stock pays no dividend.
Remark 2.6. Denoting ∆f = f (t) − f (t − 1), for any function f of t ∈ I, (2.8) implies

∆V (t) = hS (t)∆S(t) + hB (t)∆B(t).

This shows that the change in value of a self-financing portfolio process at any given time
is only due to the change of the price of the assets and not to the change in the portfolio
position.
Exercise 2.4 (Sol. 6). Consider a 3-period binomial model with the following parameters:
5 1 3
u = log , d = log , r = log , S(0) = B(0) = 64
4 2 4
and the portfolio process in this market given by

hS (1) = 1, hB (1) = −1,

hS (2, u) = −1, hB (2, u) = 7/3, hS (2, d) = 7/2, hB (2, d) = −8/3,
hS (3, u, u) = 1, hB (3, u, u) = −29/9, hS (3, d, d) = 49/4, hB (3, d, d) = −59/9,
hS (3, u, d) = hS (3, d, u) = −7/2, hB (3, u, d) = hB (3, d, u) = 46/9.

Show that this portfolio is self-financing. Compute the value of the portfolio process along
any possible path and represent the result with a binomial tree.

38
Our next purpose is to show that the value of a self-financing portfolio at time t = N
determines uniquely the initial value at time t = 0 of the portfolio. This result is crucial
to justify the definition of binomial price of European derivatives in the next chapter. We
begin by fixing some notation. First we define the parameters qu , qd as
er − ed
qu = q, qd = 1 − q, where q = . (2.9)
eu − ed
Note that (qu , qd ) is the unique solution of the linear system
qu + qd = 1, qu eu + qd ed = er . (2.10)
Now, given a self-financing portfolio process, we denote
V u (t) = hS (t)S(t − 1)eu + hB (t)B(t − 1)er ,
which is the value of the portfolio at time t assuming that the stock price goes up at time t,
and
V d (t) = hS (t)S(t − 1)ed + hB (t)B(t − 1)er
which is the value of the portfolio at time t, assuming that the stock price goes down at time
t. Note that
V u (t) = V u (t, x1 , . . . , xt−1 ) = V (t, x1 , . . . , xt−1 , u)
and similarly for V d (t). We can now prove the main result of this section.
Theorem 2.1. Let {(hS (t), hB (t))}t∈I be a self-financing portfolio process with value V (N, x)
at time t = N along the path x. The portfolio value V (t) at earlier times satisfies the following
recurrence formula:
V (t) = e−r [qu V u (t + 1) + qd V d (t + 1)], for t = 0, . . . , N − 1. (2.11)
Moreover
X
V (t) = e−r(N −t) qxt+1 · · · qxN V (N, x), for t = 0, . . . , N − 1. (2.12)
(xt+1 ,...,xN )∈{u,d}N −t

In particular, at time t = 0 we have

X N (x)
V (0) = e−rN quNu (x) qd d V (N, x). (2.13)
x∈{u,d}N

Proof. Using the definition of V u (t), V d (t), the right hand side of (2.11) is
e−r [qu V u (t + 1) + qd V d (t + 1)] = e−r [qu (hS (t + 1)S(t)eu + hB (t + 1)B(t)er )
+ qd (hS (t + 1)S(t)ed + hB (t + 1)B(t)er )]
= e−r [hS (t + 1)S(t)(qu eu + qd ed ) + hB (t + 1)B(t)er (qu + qd )]
= hS (t + 1)S(t) + hB (t + 1)B(t), (2.14)

39
where in the last step we used (2.10). By definition of self-financing portfolio, the last
member of (2.14) equals V (t), and so (2.11) is proved.
It remains to establish (2.12); we argue by backward induction on t = 0, . . . , N − 1.
Step 1. We first prove (2.12) for t = N − 1. In this case the sum on the right hand side
of (2.12) is over two terms, one for which xN = u and one for which xN = d. Hence we have
to prove
V (N − 1) = e−r [qu V (N, x1 , . . . , xN −1 , u) + qd V (N, x1 , . . . , xN −1 , d)]. (2.15)
In the right hand side of (2.15) we recognize
V (N, x1 , . . . , xN −1 , u) = hS (N )S(N − 1)eu + hB (N )B(N − 1)er = V u (N )
and
V (N, x1 , . . . , xN −1 , d) = hS (N )S(N − 1)ed + hB (N )B(N − 1)er = V d (N ),
and so (2.15) is equivalent to (2.11) at time t = N −1. As (2.11) has already been established
for all times, the proof of (2.15) is completed.

Step 2. Now assume that (2.12) is true at time t + 1, i.e.,

X
V (t + 1) = e−r(N −t−1) qxt+2 · · · qxN V (N, x).
(xt+2 ,...xN )∈{u,d}N −t−1

Step 3. We now prove (2.12) at time t. By the induction hypothesis of step 2 we have
V u (t + 1) = V (t + 1, x1 , . . . , xt , u)
X
= e−r(N −t−1) qxt+2 · · · qxN V (N, x1 , . . . , xt , u, xt+2 , . . . , xN ),
(xt+2 ,...,xN )∈{u,d}N −t−1

and similarly
V d (t + 1) = V (t + 1, x1 , . . . , xt , u)
X
= e−r(N −t−1) qxt+2 · · · qxN V (N, x1 , . . . , xt , d, xt+2 , . . . , xN ).
(xt+2 ,...,xN )∈{u,d}N −t−1

Replacing in (2.11) we obtain

h X
V (t) = e−r(N −t) qu qxt+2 · · · qxN V (N, x1 , . . . , xt , u, xt+2 , . . . , xN )
(xt+2 ,...,xN )∈{u,d}N −t−1
X i
+ qd qxt+2 · · · qxN V (N, x1 , . . . , xt , d, xt+2 , . . . , xN )
(xt+2 ,...,xN )∈{u,d}N −t−1
X
= e−r(N −t) qxt+1 · · · qxN V (N, x),
(xt+1 ,...xN )∈{u,d}N −t

which completes the proof.

40
Exercise 2.5. Show that the self-financing portfolio process in Exercise 2.4 satisfies the
recurrence formula (2.11). HINT: Use the binomial tree of the portfolio value.

Portfolio generating a cash flow

Our next purpose is to introduce the concept of portfolio process in the binomial market
that generates a cash flow. This concept is crucial to justify the definition of fair price of
American derivatives in Chapter 4. We argue as we did for self-financing portfolios. As
usual, let (hS (t − 1), hB (t − 1)) be the investor position on the stock and the risk-free asset
during the time interval (t − 2, t − 1]. Suppose that at the time t − 1, the investor sells/buys
shares of the two assets. Let (hS (t), hB (t)) be the new position on the stock and the risk-free
asset in the interval (t − 1, t]. Then the value of the portfolio process immediately after
changing the position at time t − 1 is given by V 0 (t − 1) = hS (t)S(t − 1) + hB (t)B(t − 1).
The cash flow C(t) is defined as V 0 (t − 1) − V (t − 1) = −C(t − 1) and corresponds to cash
withdrawn (if C(t − 1) > 0) or added (if C(t − 1) < 0) to the portfolio as a result of changing
the position on the assets (for a self-financing portfolio we have of course C(t) = 0, for all
t ∈ {0, . . . , N − 1}). This leads to the following definition.
Definition 2.6. A portfolio process {(hS (t), hB (t))}t∈I is said to generate the cash flow
{C(t), t = 0, . . . , N − 1}, if

hS (t)S(t − 1) + hB (t)B(t − 1) = hS (t − 1)S(t − 1) + hB (t − 1)B(t − 1) − C(t − 1), t ∈ I,

or, equivalently, letting ∆f (t) = f (t) − f (t − 1),

∆V (t) = hS (t)∆S(t) + hB (t)∆B(t) − C(t − 1).

In particular, if C(t − 1) > 0, then the cash is withdrawn from the portfolio, causing a
decrease of its value, while if C(t − 1) < 0, then the cash is added to the portfolio, causing
an increasing of its value.
Remark 2.7. As we assume hS (0) = hS (1) and hB (0) = hB (1), then C(0) = 0. Therefore
the first time at which the investor can add/remove cash from the portfolio is after chang-
ing the position (instantaneously) at time t = 1, i.e., when passing from (hS (1), hB (1)) to
(hS (2), hB (2)), generating the cash flow C(1). Note also that the cash flow is not defined at
time t = N , as the portfolio process has no value “immediately after” time N .

Like portfolio positions and portfolio values, the cash flow generated by a portfolio pro-
cess is also in general path dependent. As usual, we assume that the cash flow C(t)
depends only on the information available at, and no later than, time t. Equivalently,
C(t) = C(t, x1 , x2 , . . . , xt ). The total cash flow generated by the portfolio along the path
x ∈ {u, d}N is given by
N
X −1
Ctot (x) = C(t, x1 , . . . , xt ).
t=1

41
We have the following analog of the recurrence formula (2.11) for portfolio processes gener-
ating a cash flow.
Theorem 2.2. Let {(hS (t), hB (t))}t∈I be a portfolio process with value V (N ) at time t = N
and generating the cash flow {C(t), t = 0, . . . , N − 1}. The portfolio value V (t) at earlier
times satisfies the following recurrence formula:

V (t) = e−r [qu V u (t + 1) + qd V d (t + 1)] + C(t), for t = 0, . . . , N − 1. (2.16)

The proof of Theorem 2.2 is identical to the proof of (2.11) for self-financing portfolios. Just
use the definition of portfolio process generating a cash flow in the last line of (2.14). There
is no simple analog of (2.12) for portfolio processes generating a cash flow.
Exercise 2.6. Consider a 3-period binomial model with the following parameters:
5 1 3
u = log , d = log , r = log , S(0) = B(0) = 64
4 2 4
and the portfolio process in this market given by

hS (1) = 1, hB (1) = −1,

hS (2, u) = −2, hB (2, u) = 3, hS (2, d) = 2, hB (2, d) = −1,
hS (3, u, u) = 2, hB (3, u, u) = 2, hS (3, d, d) = −1, hB (3, d, d) = −2,
hS (3, u, d) = hS (3, d, u) = 3, hB (3, u, d) = hB (3, d, u) = 0.

Compute the cash flow generated by this portfolio process and express the result with a bino-
mial tree. Remark: the binomial tree of the cash flow in this exercise is not recombining.
ANSWER: C(0) = 0 (which is always true by definition of cash flow), C(1, u) = 48,
C(1, d) = −32, C(2, u, u) = −364, C(2, u, d) = −92, C(2, d, u) = −76, C(2, d, d) = 84.
Since C(2, u, d) 6= C(2, d, u), the binomial tree of the cash flow generated by this portfolio
process is not recombining.

2.3 Arbitrage portfolio

The ultimate purpose of this section is to prove that the binomial market does not admit
self-financing arbitrage portfolio processes, provided the market parameters satisfy d < r < u
(no condition is required on the probability p). To achieve this we first need to introduce
the precise definition of arbitrage portfolio in the binomial market.
Definition 2.7. A portfolio process {(hS (t), hB (t)}t∈I invested in a binomial market is called
an arbitrage portfolio process if it is predictable and if its value V (t) satisfies

1) V (0) = 0;

42
 2) V (N, x) ≥ 0, for all x ∈ {u, d}N ;

3) There exists y ∈ {u, d}N such that V (N, y) > 0.

Let us comment on the previous definition. Condition 1) means that no initial wealth is
required to set up the portfolio, i.e., the long and short positions on the two assets are
perfectly balanced. Condition 2) means that the investor is sure not to loose money with
this investment: regardless of the path followed by the stock price, the return of the portfolio
is always non-negative. Condition 3) means that there is a strictly positive probability to
make a profit, since along at least one path of the stock price the return of the portfolio is
strictly positive.
Exercise 2.7 (?). What is the difference between the definition of arbitrage given here and
the one in Definition 1.1?
Theorem 2.3. There exists a self-financing arbitrage portfolio in the binomial market if and
only if r ∈
/ (d, u)

Proof. We divide the proof in two steps. In step 1 we prove the claim for the 1-period
model, i.e., N = 1. The generalization to the multiperiod model (N > 1) is carried out
in step 2.
Step 1: the 1-period model. Because of our convention (2.6), we can set

hS (0) = hS (1) = hS , hB (0) = hB (1) = hB ,

i.e., the portfolio position in the 1-period model is constant (and thus predictable and self-
financing) over the interval [0, 1]. The value of the portfolio at time t = 0 is

V (0) = hS S0 + hB B0 ,

while at time t = 1 it is given by one of the following:

V (1) = V (1, u) = hS S0 eu + hB B0 er ,

if the stock price goes up at time t = 1, or

V (1) = V (1, d) = hS S0 ed + hB B0 er ,

if the stock price goes down at time t = 1. Thus the portfolio is an arbitrage if V (0) = 0,
i.e.,
hS S0 + hB B0 = 0, (2.17)
if V (1) ≥ 0, i.e.,

hS S0 eu + hB B0 er ≥ 0, (2.18)
hS S0 ed + hB B0 er ≥ 0, (2.19)

43
and if at least one of the inequalities in (2.18)-(2.19) is strict. Now assume that (hS , hB )
is an arbitrage portfolio. From (2.17) we have hB B0 = −hS S0 and therefore (2.18)-(2.19)
become
hS S0 (eu − er ) ≥ 0, (2.20)
hS S0 (ed − er ) ≥ 0. (2.21)
Since at least one of the inequalities must be strict, then hS 6= 0. If hS > 0, then (2.20) gives
u ≥ r, while (2.21) gives d ≥ r. As u > d, the last two inequalities are equivalent to r ≤ d.
Similarly, for hS < 0 we obtain u ≤ r and d ≤ r which, again due to u > d, are equivalent
to r ≥ u. We conclude that the existence of an arbitrage portfolio implies r ≤ d or r ≥ u,
that is r ∈
/ (d, u), which proves the “only if” part of the theorem. To establish the “if” part
we construct an arbitrage portfolio when r ∈ / (d, u). Assume r ≤ d. Let us pick hS = 1 and
hB = −S0 /B0 . Then V (0) = 0 and (2.19) is trivially satisfied. Moreover, since u > d,
hS S0 eu + hB B0 er = S0 (eu − er ) > S0 (ed − er ) ≥ 0,
hence the inequality (2.18) is strict. This shows that one can construct an arbitrage portfolio
if r ≤ d and a similar argument can be used to find an arbitrage portfolio when r ≥ u. The
proof of the theorem for the 1-period model is complete.

Step 2: the multiperiod model. Let r ∈ / (d, u). As shown in the previous step,
there exists an arbitrage portfolio (hS , hB ) in the single period model. We can now build
a self-financing arbitrage portfolio process {(hS (t), hB (t))}t∈I for the multiperiod model
by investing at time t = 1 the whole value of the portfolio (hS , hB ) in the risk-free as-
set. This portfolio process is clearly predictable and its value satisfies V (0) = 0 and
V (N, x) = V (1, x)er(N −1) ≥ 0 along every path x ∈ {u, d}N . Moreover, since (hS , hB ) is
an arbitrage, then V (1, y) > 0 along some path y ∈ {u, d}N and thus V (N, y) > 0. Hence
the constructed self-financing portfolio process {(hS (t), hB (t))}t∈I is an arbitrage and the
“if” part of the theorem is proved. To prove the “only if” part for the multiperiod model,
assume that the binomial market contains a self-financing arbitrage portfolio process. By
Theorem 2.1 the value at time t = 0 of this portfolio process satisfies (2.12), that is,
X
V (0) = e−rN q Nu (x) (1 − q)Nd (x) V (N, x),
x∈{u,d}N

where q is given by (2.9), Nu (x) is the number of “ups” in x and Nd (x) = N − Nu (x) the
number of “downs”. Now, since the portfolio process is assumed to be an arbitrage, then
V (0) = 0 and V (N, x) ≥ 0. Of course, the above sum can be restricted to the paths along
which V (N, x) > 0, which exist since the portfolio process is an arbitrage. But then V (0) = 0
implies that either q = 0, or q = 1, or that q and 1 − q have opposite sign, which means that
q > 1 or q < 0. In conclusion, V (0) = 0 ⇒ q ∈ / (0, 1). Since u > d, the denominator in the
expressions (2.9) is positive, hence
q = 0, resp. q = 1 ⇒ r = d, resp. u = r,

44
 q > 1, resp. q < 0 ⇒ u < r, resp. r < d.
We conclude that the existence of a self-financing arbitrage portfolio process entails r ∈
/ (d, u),
which completes the proof of the theorem.

The condition d < r < u is equivalent to require that the parameters qu , qd given by (2.9)
satisfy qu ∈ (0, 1) and qd = 1 − qu ∈ (0, 1), i.e., that the pair (qu , qd ) defines a probability
vector, which is called risk-neutral probability or martingale probability vector; the
reason for this terminology will become clear in Chapter 5.

2.4 Computation of the binomial stock price with Mat-

lab
In this section we study how to compute the binomial stock price with Matlab. More
precisely, our goal is to construct a binomial tree for the stock price in some interval [0, T ],
with T > 0 measured in fraction of years. Let us start by dividing the interval [0, T ] into N
subintervals of length h = T /N , i.e.,

0 = t1 < t2 < · · · < tN +1 = T, ti+1 = ti + h, i = 1, . . . , N.

Let S(i) = S(ti ). We define the binomial stock price on the given partition of [0, T ] as

S(i)eu , with probability p

(
S(i + 1) = , i ∈ I.
S(i)ed , with probability 1 − p

The following code defines the Matlab function BinomialStock which generates the binomial
tree for the stock price on the partition Q = {t1 , . . . tN +1 } of the interval [0, T ]:
function [Q,S]=BinomialStock(p,alpha,sigma,s,T,N)
h=T/N;
u=alpha*h+sigma*sqrt(h)*sqrt((1-p)/p);
d=alpha*h-sigma*sqrt(h)*sqrt(p/(1-p));
Q=zeros(N+1,1);
S=zeros(N+1);
Q(1)=0;
S(1,1)=s;
for j=1:N
Q(j+1)=j*h;
S(1,j+1)=S(1,j)*exp(u);
for i=1:j
S(i+1,j+1)=S(i,j)*exp(d);
end

45
end

The arguments of the function are the parameters p, α, σ, the time T > 0 (expressed in
fraction of years), the initial price of the stock s and the number of steps N in the binomial
model; the parameters u and d are computed using (2.2). The function returns a column
vector Q containing the times t1 , . . . , tN +1 of the partition, and an upper-triangular (N +
1) × (N + 1) matrix S. The column j of S contains, in decreasing order along rows, the
possible prices of the stock at time tj = (j − 1)h. A path of the stock price is obtained by
moving from each column to the next one by either staying in the same row (which means
that the price went up at this step) or going down one row (which means that the price went
down at this step). For example, by running the command

[Q,S]=BinomialStock(0.5,0.01,0.2,10,1/12,5);

we get the output

0
0.0167
0.0333
Q=
0.0500
0.0667
0.0833

10.0000 10.2633 10.5335 10.8108 11.0954 11.3875

0 9.7467 10.0033 10.2667 10.5370 10.8144
0 0 9.4999 9.7500 10.0067 10.2701
S= (2.22)
0 0 0 9.2593 9.5030 9.7532
0 0 0 0 9.0248 9.2624
0 0 0 0 0 8.7962
As T = 1/12 years and N = 5, the matrix S shows the stock prices in a period of 1 month
with intervals of 1/(12 ∗ 5) years, i.e., about 6 days2 . The mean of log-return of the stock is
α = 1%, while its volatility is σ = 20%.

Remark 2.8. Throughout these notes, the computations in Matlab are performed in high
precision arithmetic and the results are truncated to the fourth decimal digit. In the appli-
cations, where the results correspond to prices expressed in some unit of currency, a cruder
truncation may be required.

2
We do not adjust our calculations to take into account that markets are closed in the week-ends.

46
2.5 Further Exercises
Exercise 2.8. In the trinomial model the stock price is determined by the rule S(0) =
S0 > 0 and
S(t − 1)eu ,


 with probability pu

S(t) = S(t − 1)em , with probability pm ,


S(t − 1)ed ,

with probability pd
where u > m > d, pu , pm , pd ∈ (0, 1) : pu + pm + pd = 1. Draw the trinomial tree of the 3-
period model. Derive the number of possible stock prices at time t. Under which condition on
the parameters (u, m, d) is the trinomial tree recombining? How many possible stock prices
are there at time t if the recombination condition is satisfied?
ANSWER: The number of possible stock prices at time t is (t+1)(t+2)/2; the recombination
condition is m = (u+d)/2, in which case the number of possible stock prices at time t becomes
2t + 1.

47
Chapter 3

European derivatives

This chapter deals with the valuation of European derivatives on a single stock under the
assumption that the price of the underlying stock is given by S(0) = S0 > 0 at time t = 0
and 
S(t − 1)eu with probability pu = p
S(t) = , t ∈ I = {1, . . . , N }.
S(t − 1)ed with probability pd = 1 − p
Here 0 < p < 1, (pu , pd ) is the physical probability vector and u > d. S(t) is the binomial
stock price at time t ∈ I. We say that the price goes up at time t if S(t) = S(t − 1)eu and
that it goes down at time t if S(t) = S(t − 1)ed (although this terminology is strictly correct
only if d < 0 and u > 0, which is most often the case in the applications). Moreover we
assume the existence of a risk-free asset with value

B(t) = B0 ert , t ∈ I,

where B0 = B(0) > 0 is the initial value of the risk-free asset and r is the constant risk-free
rate of the money market. We impose d < r < u. In particular, the binomial market does
not admit self-financing arbitrage portfolios and the risk-neutral probability vector (qu , qd )
is well defined:
er − ed
qu = q, qd = 1 − q, where q = u ∈ (0, 1).
e − ed
We denote by {(hS (t), hB (t)}t∈I a predictable portfolio process invested in the stock and
the risk-free asset, where (hS (t), hB (t)) is the portfolio position in the interval (t − 1, t] and
hS (0) = hS (1), hB (0) = hB (1). The value at time t of the portfolio is

V (t) = hS (t)S(t) + hB (t)B(t).

The portfolio process is said to be self-financing if

V (t − 1) = hS (t)S(t − 1) + hB (t)B(t − 1),

48
which means that no cash is ever withdrawn or added to the portfolio. The value of self-
financing portfolio processes at time t satisfies the formula
X
V (t) = e−r(N −t) qxt+1 · · · qxN V (N, x). (3.1)
(xt+1 ,...xN )∈{u,d}N −t

which we proved in Theorem 2.1.

3.1 The binomial price of European derivatives

Consider a European derivative on the stock expiring at time T = N . The derivative will
be called standard if its pay-off depends only on the price of the stock at maturity, i.e.,
Y = g(S(N )), for some function g : (0, ∞) → R, which is called the pay-off function
of the derivative. The European call, for instance, is a standard European derivative with
pay-off function g(z) = (z − K)+ , where K > 0 is the strike price of the call. In the case of
a non-standard European derivative, the pay-off is a (deterministic) function of the stock
price at time t = N and at times earlier than maturity, i.e., Y = g(S(1), . . . , S(N )). Of
course, in both cases the pay-off depends on the path x = (x1 , . . . , xN ) ∈ {u, d}N followed
by the stock price, in particular,
Y (x) = g(S(N, x)), for standard European derivatives
and
Y (x) = g(S(1, x1 ), S(2, x1 , x2 ), . . . , S(N, x)), for non-standard European derivatives.
Now, assume that a European derivative is sold at time t < T for the price ΠY (t). The first
concern of the seller is to hedge the derivative, i.e., to invest the premium ΠY (t) in such
a way that the seller portfolio value at the expiration date is enough to pay-off the buyer
of the derivative. We assume that the seller invests the premium in the binomial market
consisting of the underlying stock and the risk-free asset (delta-hedging).
Definition 3.1. An hedging portfolio process for the European derivative with pay-off Y
and maturity T = N is a predictable portfolio process {(hS (t), hB (t))}t∈I invested in the
underlying stock and the risk-free asset such that its value V (t) satisfies V (N ) = Y . If V (t) =
ΠY (t) holds for all t = 0, . . . , N , and not only at maturity, we say that {hS (t), hB (t)}t∈I is
a replicating portfolio process for the given derivative.

Note that the equality V (N ) = Y of hedging portfolio processes (and the equality ΠY (t) =
V (t) for replicating portfolios) must be satisfied along all possible paths of the price of the
underlying stock, i.e., V (N, x) = Y (x), for all x ∈ {u, d}N .
It follows by (3.1) that the value V (t) of any self-financing hedging portfolio at time t is
given by X
V (t) = e−r(N −t) qxt+1 · · · qxN Y (x1 , . . . , xN ). (3.2)
(xt+1 ,...xN )∈{u,d}N −t

49
Definition 3.2. The binomial (fair) price at time t = 0, . . . , N − 1 of the European
derivative with pay-off Y and maturity T = N is given by
X
ΠY (t) := e−r(N −t) qxt+1 · · · qxN Y (x1 , . . . , xN ), (3.3)
(xt+1 ,...xN )∈{u,d}N −t

while ΠY (N ) := Y . In particular at time t = 0,

X
ΠY (0) = e−rN q Nu (x) (1 − q)Nd (x)Y (x), (3.4)
x∈{u,d}N

where Nu (x) in the number of u’s in x and Nd (x) = N − Nu (x) the number of d’s.

Hence the binomial price at time t of the European derivative equals the value required to
open at time t a self-financing hedging portfolio process for the derivative. Note carefully
that we have not proved yet that hedging self-financing portfolios exist. However we know
that, if they exist, their value at time t is given by (3.2). The existence of self-financing
hedging portfolios is proved in Theorem 3.3 below.
The identification of the fair price of the derivative with the value of self-financing hedging
portfolios can be motivated as follows. Firstly the only purpose of the hedging portfolio is
to pay-off the buyer of the derivative; the seller does not try to ensure a profit from the
derivative (as it would be if V (N ) > Y ). The second reason is the absence of cash flow. In
fact, if the writer needs to add cash to the portfolio in order to hedge the derivative, then the
contract is clearly unfair for the writer. Conversely, if the writer could withdraw cash from
the portfolio and still be able to hedge the derivative, then the contract would be unfair for
the buyer1 .
Remark 3.1. By Definition 3.2, self-financing hedging portfolios of European derivatives
are also replicating portfolios. We shall see in Chapter 4 that this is not the case for
American derivatives, namely, replicating portfolios for American derivatives are in general
not self-financing.
Remark 3.2. Since self-financing hedging portfolios replicate the derivative at any time,
then the return on the derivative for a seller who is hedging the derivative self-financially is
zero. This raises the question of why investors should sell derivatives if no profit is expected.
The question gives us the opportunity to explain the difference between two types of investors:
speculators and hedgers. A speculator is an investor who sells derivatives (typically in the
market) seeking to profit from the time fluctuation of prices without worrying about hedging
the derivative. As opposed to this, hedgers (which include banks, insurance companies, etc.)
will undertake an hedging strategy to secure their (short) position on the derivative. In the
case of hedgers the profit for the seller comes in the form of fees added to the fair value of
the derivative. The theory presented in this text is for hedgers and not for speculators.
1
We take the opportunity to make the obvious remark that our theory treats the buyer and the seller on
equal foot.

50
Since the sum in (3.3) is over all future paths (xt+1 , . . . , xN ), then the binomial price ΠY (t)
of the derivative depends on the path of the stock price only up to time t, i.e.,

ΠY (t) = ΠY (t, x1 , . . . , xt )

and not on the uncertain future. Hence the value of ΠY (t) can be computed using the
information available at time t. For example, since by Definition 2.2 we have

S(N, x) = S0 exp(x1 + · · · + xN ), S(t, x1 , . . . , xt ) = S0 exp(x1 + · · · + xt )

then
S(N, x) = S(t, x1 , . . . , xt ) exp(xt+1 + · · · + xN ),
and therefore the binomial fair price for the standard European derivative with pay-off
Y = g(S(N )) can be written as
X
ΠY (t, x1 , . . . , xt ) = e−r(N −t) qxt+1 · · · qxN g(S(t, x1 , . . . , xt )ext+1 +···+xN ).
(xt+1 ,...xN )∈{u,d}N −t

This shows that the binomial price at time t of standard European derivatives is a deter-
ministic function of S(t), namely

ΠY (t) = vt (S(t)), (3.5)

where X
vt (z) = e−r(N −t) qxt+1 · · · qxN g(z exp(xt+1 + · · · + xN )).
(xt+1 ,...xN )∈{u,d}N −t

is called the pricing function of the derivative (at time t). In the particular case of
the European call, respectively put, with strike K and maturity T = N , the binomial
price at time t = 0, . . . , N − 1 can be written in the form C(t, S(t), K, N ), respectively
P (t, S(t), K, N ), where
X
C(t, S(t), K, N ) = e−r(N −t) qxt+1 · · · qxN (S(t)ext+1 +···+xN − K)+ , (3.6)
(xt+1 ,...xN )∈{u,d}N −t
X
P (t, S(t), K, N ) = e−r(N −t) qxt+1 · · · qxN (K − S(t)ext+1 +···+xN )+ . (3.7)
(xt+1 ,...xN )∈{u,d}N −t

We use these formulas to give an alternative proof of some of the properties in Theorems 1.2-
1.3, which does not require the abstract arbitrage-free principle.
Theorem 3.1 (∗). The binomial price of European calls and puts satisfy the following prop-
erties:

1 The put-call parity holds

C(t, S(t), K, N ) − P (t, S(t), K, N ) = S(t) − Ke−r(N −t) .

51
 2 If r ≥ 0, then C(t, S(t), K, N ) ≥ (S(t) − K)+ ; the strict inequality C(t, S(t), K, N ) >
(S(t) − K)+ holds when r > 0.
3 If r ≥ 0, the map N → C(t, S(t), K, N ) is non-decreasing.
4 The maps K → C(t, S(t), K, N ) and K → P (t, S(t), K, N ) are convex.

Proof. Let k be the number of u in (xt+1 , . . . , xN ) and N − t − k be the number of d. Then

ext+1 +···+xN = eku+(N −t−k)d , qxt+1 · · · qxN = quk qdN −t−k .
Now, the number of paths
(xt+1 , . . . , xN ) for which the number of u is k is given by the
binomial coefficient Nk−t . Hence we can rewrite the pricing functions (3.6)-(3.7) as
N −t  
−r(N −t)
X N − t k N −t−k
C(t, S(t), K, N ) = e qu qd (S(t)eku+(N −t−k)d − K)+ ,
k=0
k
N −t  
−r(N −t)
X N − t k N −t−k
P (t, S(t), K, N ) = e qu q d (K − S(t)eku+(N −t−k)d )+ .
k=0
k
We can now prove the properties 1-4.

1 We have
N −t  
−r(N −t)
X N − t k N −t−k
C(t, S(t), K, N ) − P (t, S(t), K, N ) = e qu qd
k=0
k
× [(S(t)eku+(N −t−k)d − K)+ − (K − S(t)eku+(N −t−k)d )+ ].
Using that (z − K)+ − (K − z)+ = z − K, for all z ∈ R, we obtain
N −t  
−r(N −t)
X N − t k N −t−k
C −P =e q u qd (S(t)eku+(N −t−k)d − K)
k=0
k
N −t  
−r(N −t)
X N − t k N −t−k ku+(N −t−k)d
= S(t)e qu qd e
k=0
k
N −t  
X N − t k N −t−k
−K qu q d = S(t)I1 − KI2 .
k=0
k

Hence the put-call parity follows if we show that I2 = e−r(N −t) and I1 = 1. We have
N −t  
−r(N −t)
X N − t k N −t−k ku+(N −t−k)d
I1 = e qu qd e
k=0
k
N −t 
N − t  qu e u  k
X 
−r(N −t) d N −t
=e (qd e ) d
.
k=0
k q de

52
 PN N

k
Using the binomial theorem (1 + a)N = k=0 k
a and the identity qu eu + qd ed = er
we obtain
 qu eu N −t
I1 = e−r(N −t) (qd ed )N −t 1 +
qd ed
= e−r(N −t) (qu eu + qd ed )N −t = 1.
The proof that I2 = e−r(N −t) is similar.
2 The proof follows by the put-call parity as in Theorem 1.2.
3 We want to show that
C(t, S(t), K, N ) ≤ C(t, S(t), K, N + 1).
The following proof is quite technical. In C(N + 1) := C(t, S(t), K, N + 1) we replace
the Pascal identity      
N +1−t N −t N −t
= +
k k−1 k
N


(with the convention −1 = 0) and obtain
( N +1−t 
X N − t
−r(N +1−t)
C(N + 1) =e quk qdN +1−t−k (S(t)eku+(N +1−t−k)d − K)+
k=1
k−1
NX
+1−t   )
N − t k N +1−t−k ku+(N +1−t−k)d
+ qu q d (S(t)e − K)+ .
k=0
k
In the first sum we make the change of index j = k − 1, while for the second sum we
use that it is greater than the sum extended only up to N − t (i.e., we neglect the last
term k = N + 1 − t). So doing we obtain
( N −t 
X N − t
C(N + 1) ≥ e −r(N +1−t)
quj+1 qdN −t−j (S(t)e(j+1)u+(N −t−j)d − K)+
j=0
j
N −t   )
X N − t k N +1−t−k
+ qu q d (S(t)eku+(N +1−t−k)d − K)+
k=0
k
( N −t 
X N − t N −t−j
−r(N +1−t)
=e quj qd qu (S(t)eju+(N −t−j)d eu − K)+
j=0
j
N −t   )
X N − t k N −t−k
+ qu qd qd (S(t)eku+(N −t−k)d ed − K)+
k=0
k
N −t  
−r(N +1−t)
X N − t k N −t−k
=e q u qd
k=0
k
× [(S(t)eku+(N −t−k)d qu eu − Kqu )+ + (S(t)eku+(N −t−k)d qd ed − Kqd )+ ].

53
 Using the simple inequality (y)+ + (z)+ ≥ (y + z)+ , we obtain
N −t  
−r(N +1−t)
X N − t k N −t−k
C(N + 1) ≥ e qu qd
k=0
k
× [(S(t)eku+(N −t−k)d (qu eu + qd ed ) − K(qu + qd ))+ ].

As qu eu + qd ed = er , qu + qd = 1 and r ≥ 0 we find
N −t  
X
−r(N +1−t) N − t k N −t−k
C(N + 1) ≥ e qu q d (S(t)eku+(N −t−k)d er − K)+
k=0
k
N −t
X N − t
=e −r(N −t)
quk qdN −t−k (S(t)eku+(N −t−k)d − Ke−r )+
k=0
k
≥ C(N ).

4 The only dependence on K of the functions C(t, S(t), K, N ), P (t, S(t), K, N ) is through
the terms (z − K)+ , (K − z)+ . As both these functions are convex in K, the result
follows.

Exercise 3.1. Show that the binomial price at time t of non-standard European derivatives
is a deterministic function of S(1), . . . , S(t).

Exercise 3.2. Show that the map x → C(t, x, K, T ) is non-decreasing and that the map
x → P (t, x, K, T ) is non-increasing.

Now let ΠuY (t) denote the binomial fair price of the European derivative at time t assuming
that the stock price goes up at time t (i.e., S(t) = S(t − 1)eu , or equivalently, xt = u); note
that
ΠuY (t) = ΠuY (t, x1 , . . . , xt−1 ) = ΠY (t, x1 , . . . , xt−1 , u).
Similarly define ΠdY (t), with “up” replaced by “down”. By the proven formula (2.11) in
Theorem 2.1 we have

Theorem 3.2. The binomial price of European derivatives satisfies the recurrence formula

ΠY (N ) = Y, and ΠY (t) = e−r [qu ΠuY (t+1)+qd ΠdY (t+1)], for t ∈ {0, . . . , N − 1}. (3.8)

The recurrence formula (3.8) is very useful to compute the binomial price of standard Euro-
pean derivatives, as shown in the next example.

54
Example: A standard European derivative
p
Consider the standard European derivative with pay-off Y = ( S(2) − 1)+ at maturity time
T = 2. Assume that the market parameters are given by

u = log 2, d = 0, r = log(4/3), p = 1/4.

Assume also S0 = 1. In this example we compute the possible paths for the binomial price
ΠY (t) of the derivative and the probability that the derivative expires in the money.
The stock price and the risk-free asset satisfy

S(t − 1)eu
S(t) = , B(t) = B0 ert t ∈ {1, 2},
S(t − 1)ed

where
eu = 2, ed = 1, er = 4/3.
Hence
er − ed 1 2
qu =
u d
= , qd = 1 − qu = .
e −e 3 3
Now, let us write the binomial tree of the stock price, including the possible values of the
derivative at the expiration time T = 2 (where we use that ΠY (2) = Y ):
√
S(2)
2
= 4 ⇒ ΠY (2) = ( 4 − 1)+ = 1
u

S(1)
9
=2
u d
, √ √
S0 = 1 S(2) = 2 ⇒ ΠY (2) = ( 2 − 1)+ = 2 − 1
2
d u
%
S(1) = 1
d
, √
S(2) = 1 ⇒ ΠY (2) = ( 1 − 1)+ = 0

Using the recurrence formula

ΠY (t) = e−r (qu ΠuY (t + 1) + qd ΠdY (t + 1))

55
we have, at time t = 1,
S(1) = S(1, u) = 2 ⇒ ΠY (1) = ΠY (1, u) = e−r (qu ΠuY (2, u) + qd ΠdY (2, u))
= e−r (qu ΠY (2, u, u) + qd ΠY (2, u, d))
3 1 2 √ 1 √
= ( · 1 + ( 2 − 1)) = (2 2 − 1)
4 3 3 4

S(1) = S(1, d) = 1 ⇒ ΠY (1) = ΠY (1, d) = e−r (qu ΠuY (2, d) + qd ΠdY (2, d))
= e−r (qu ΠY (2, d, u) + qd ΠY (2, d, d))
3 1 √ 2 1 √
= ( ( 2 − 1) + · 0) = ( 2 − 1)
4 3 3 4

while at time t = 0 we have

ΠY (0) = e−r (qu ΠuY (1) + qd ΠdY (1))
3 1 1 √ 2 1 √ 1 √ 3
= e−r (qu ΠY (1, u) + qd ΠY (1, d)) = ( · (2 2 − 1) + · ( 2 − 1)) = ( 2 − ).
4 3 4 3 4 4 4
Hence we have found the following diagram for the binomial price of the derivative
ΠY (2) = 1
4
u

√
ΠY (1) = 14 (2 2 − 1)
4
u d

√ * √
1 3
ΠY (0) = ( 2− ) ΠY (2) = 2−1
4 4 4
d u
* √
ΠY (1) = 14 ( 2 − 1)
d
*
ΠY (2) = 0
As to the probability that the derivative expires in the money, i.e., P(Y > 0), we see from
the above diagram that this happens along the paths (u, u), (u, d), (d, u), hence
 2
(u,u) (u,d) (d,u) 1 1 3 3 1 7
P(Y > 0) = P(S ) + P(S ) + P(S )= + · + · = ,
4 4 4 4 4 16
which corresponds to 43, 75%.
Remark 3.3. Throughout this text the probability that a derivative expires in the money, as
well as the probability of positive return and the expected return of a portfolio, are computed
using the physical probability and not the risk-neutral probability.

56
Exercise 3.3 (Sol. 7). A compound option is an option whose underlying is another
option. For instance, given T2 > T1 > 0 and K1 , K2 > 0, a call on a put with maturity T1
and strike K1 is a contract that gives to its owner the right to buy at time T1 for the price
K1 the put option on the stock with maturity T2 and strike K2 . Let S(t) be the price of the
underlying stock of the put option. Assume that S(t) follows a 2-period binomial model with
parameters
7 1 9 1
eu = , ed = , er = , p = , S(0) = 16.
4 2 8 4
Assume further that T2 = 2, T1 = 1, K1 = 23 9
, K2 = 12. Compute the initial price of the call
on the put. Compute also the probability of positive return for the owner of the call on the
put. HINT: Show that the compound option can be seen as a standard European derivative
on the stock expiring at time T1 = 1.

Exercise 3.4. A European derivative with expiration T = N pays the amount Y = log( S(T
S(0)
)
).
Find ΠY (0). HINT: Use the identity
   
N N −1
k=N .
k k−1

ANSWER: ΠY (0) = N e−rN (qu u + qd d).

Example: A non-standard European derivative

Consider a 3-period binomial market with the parameters eu = 43 , ed = 23 , p = 34 , S0 = 2 and
r = 0. In this example we shall compute the binomial price at time t = 0 of the European
derivative with pay-off
 11 
Y = − min(S0 , S(1), S(2), S(3)) , (z)+ = max(0, z),
9 +

and time of maturity T = 3. This is an example of lookback option. We will also compute
the probability that the derivative expires in the money and the probability that the return
of a constant portfolio with a long position on this derivative be positive.

57
We start by writing down the binomial tree of the stock price
128
S(3) =
8 27
u

32
S(2) =
8 9
u d
&
8 64
S(1) = S(3) =
8 3 8 27
u d u
&
16
S0 = 2 S(2) =
8 9
d u d
& &
4 32
S(1) = S(3) =
3 8 27
d u
&
8
S(2) = 9
d
&
16
S(3) = 27

To compute the initial binomial price of non-standard European derivatives it is convenient

to use the formula X
ΠY (0) = e−rN (qu )Nu (x) (qd )Nd (x) Y (x), (3.9)
x∈{u,d}N

see (3.4). Here Y (x) denotes the pay-off as a function of the path of the stock price, Nu (x)
is the number of times that the stock price goes up in the path x and Nd (x) = N − Nu (x)
is the number of times that it goes down. In this example we have N = 3, r = 0 and
1
qu = qd = .
2
So, it remains to compute the pay-off for all possible paths of the binomial stock price, where
 
11
Y = − min(S0 , S(1), S(2), S(3)) , (z)+ = max(0, z).
9 +

For instance
   
11 11 7
Y (u, u, u) = − min(2, 8/3, 32/9, 128/27) = −2 = max(0, − ) = 0.
9 + 9 + 9

58
Similarly we find
 
11
Y (u, u, d) = − min(2, 8/3, 32/9, 64/27) =0
9 +
 
11
Y (u, d, u) = − min(2, 8/3, 16/9, 64/27) =0
9 +
 
11
Y (u, d, d) = − min(2, 8/3, 16/9, 32/27) = 1/27
9 +
 
11
Y (d, u, u) = − min(2, 4/3, 16/9, 64/27) =0
9 +
 
11
Y (d, u, d) = − min(2, 4/3, 16/9, 32/27) = 1/27
9 +
 
11
Y (d, d, u) = − min(2, 4/3, 8/9, 32/27) = 1/3
9 +
 
11
Y (d, d, d) = − min(2, 4/3, 8/9, 16/27) = 17/27
9 +

Replacing in (3.9) we obtain

ΠY (0) = qu (qd )2 Y (u, d, d) + (qd )2 qu Y (d, u, d) + (qd )2 qu Y (d, d, u) + (qd )3 Y (d, d, d),

the other terms being zero. Hence

1 1 1 1 17  7
ΠY (0) = + + + = .
8 27 27 3 27 54
The probability that the derivative expires in the money is the probability that Y > 0.
Hence we just sum the probabilities of the paths which lead to a positive pay-off:

P(Y > 0) = P(S (u,d,d) ) + P(S (d,u,d) ) + P(S (d,d,u) ) + P(S (d,d,d) )
= p(1 − p)2 + (1 − p)2 p + (1 − p)2 p + (1 − p)3
 2  3
2 3 1 3 1 5
= 3(1 − p) p + (1 − p) = 3 + = ≈ 15, 6%
4 4 4 32
Next consider a constant portfolio with a long position on the derivative. This means that
we buy the derivative at time t = 0 and we wait (without changing the portfolio) until the
expiration time t = 3. The return will be positive (i.e., the buyer makes a profit) if and only
if ΠY (3) > ΠY (0). But ΠY (3) = Y , which, according to the computations above, is greater
that ΠY (0) = 7/54 only when the binomial stock price follows one of the paths (d, d, u) or
(d, d, d). Hence
1
P(R > 0) = P(S (d,d,u) ) + P(S (d,d,d) ) = (1 − p)2 p + (1 − p)3 = (1 − p)2 = ≈ 6, 2%
16
59
Exercise 3.5. Compute ΠY (t) at each time t = 0, 1, 2, 3 for the derivative in the previous
example.
ANSWER: ΠY (2, u, u) = 0, ΠY (2, u, d) = ΠY (2, d, u) = 1/54, ΠY (2, d, d) = 13/27, ΠY (1, u) =
1/108, ΠY (1, d) = 1/4.
Exercise 3.6 (Sol. 8). Suppose u > r > 0 ≥ d. A non-standard European derivative with
maturity time N has pay-off Y = S(N ) if S(0) < S(1) < · · · < S(N ) and Y = S(0)
otherwise. Find ΠY (0).
Exercise 3.7 (Sol. 9). A non-standard European derivative pays the amount Y = N
P
t=1 (S(t)−
PN −1 k xN −1
S(t−1))+ at maturity T = N . Find ΠY (0). HINT: Use the formula k=0 x = x−1 , x 6= 1.

3.2 Replicating portfolio processes of European deriva-

tives
Next we treat the important problem of building a self-financing replicating, and thus hedg-
ing, portfolio process for European derivatives.
Theorem 3.3. Consider the European derivative with pay-off Y at the time of maturity
T = N . Then the portfolio process given by

hS (0) = hS (1), hB (0) = hB (1) (3.10a)

and, for t ∈ I,
1 ΠuY (t) − ΠdY (t)
hS (t) = , (3.10b)
S(t − 1) eu − ed
e−r eu ΠdY (t) − ed ΠuY (t)
hB (t) = (3.10c)
B(t − 1) eu − ed
is a self-financing replicating portfolio process.

Proof. We first show that the given portfolio replicates the derivative. We have
S(t) ΠuY (t) − ΠdY (t) e−r B(t) eu ΠdY (t) − ed ΠuY (t)
V (t) = hS (t)S(t) + hB (t)B(t) = + .
S(t − 1) eu − ed B(t − 1) eu − ed

Note that e−r B(t)/B(t − 1) = 1, while S(t)/S(t − 1) is either eu or ed . By straightforward

calculations we obtain

V u (t) = hS (t)S(t − 1)eu + hB (t)B(t)

ΠuY (t) − ΠdY (t) eu ΠdY (t) − ed ΠuY (t)
= eu u d
+ u d
= ΠuY (t),
e −e e −e

60
and similarly V d (t) = ΠdY (t). Thus V (t) = ΠY (t), for all t ∈ I, i.e., the portfolio process is
replicating, and therefore also hedging, the derivative. As to the self-financing property, we
have
ΠuY (t)(1 − ed−r ) + ΠdY (t)(eu−r − 1)
hS (t)S(t − 1) + hB (t)B(t − 1) =
eu − ed
−r
= e (qu ΠY (t) + qd ΠdY (t)) = ΠY (t − 1),
u

where we used the definition of qu , qd , as well as the recurrence formula (3.8). By the already
proven fact that V (t) = ΠY (t), for all t ∈ I, we have

hS (t)S(t − 1) + hB (t)B(t − 1) = V (t − 1),

which proves the self-financing property. Finally we show that the portfolio is predictable.
Assume first that the European derivative is standard, i.e., Y = g(S(N )). Then ΠY (t) =
vt (S(t)), see (3.5), and therefore

ΠuY (t) = vt (S(t − 1)eu ), ΠdY (t) = vt (S(t − 1)ed ),

i.e., ΠuY (t) and ΠdY (t) are deterministic functions of S(t−1). It follows that hS (t), hB (t) given
by (3.10b)-(3.10c) are also deterministic functions of S(t − 1), and so this portfolio process is
predictable. In the case of non-standard derivatives we have similarly, by Exercise 3.1, that
ΠuY (t) and ΠdY (t) are deterministic functions of S(1), . . . , S(t − 1), which again implies that
the portfolio (3.10b)-(3.10c) is predictable.

Example. Let us compute the position on the stock in the hedging portfolio (3.10) for the
example of standard derivative in Section 3.1. When the stock price goes up in the first step
we have S(1) √ = S(1, u) = 2 and ΠuY (2) = ΠuY (2, u) = ΠY (2, u, u) = 1, ΠdY (2) = ΠdY (2, u) =
ΠY (2, u, d) = 2 − 1, hence (3.10b) gives
√
1 ΠuY (2, u) − ΠdY (2, u) 1 − ( 2 − 1) √
hS (2, u) = = = 2 − 2 > 0 (long position).
S(1, u) eu − ed 2−1
√
When S(1) = S(1, d) = 1 we have ΠuY (2) = ΠuY (2, d) = ΠY (2, d, u) = 2 − 1 and ΠdY (2) =
ΠdY (2, d) = ΠY (2, d, d) = 0, hence

1 ΠuY (2, d) − ΠdY (2, d) √

hS (2, d) = = 2 − 1 > 0 (long position).
S(1, d) eu − ed

Recall that hS (2) is the position in the stock in the interval (1, 2]. In the interval [0, 1] we
have
√ √ √
1 ΠuY (1) − ΠdY (1) 1 41 (2 2 − 1) − 41 ( 2 − 1) 2
hS (1) = = = > 0 (long position).
S(0) eu − ed 2 2−1 4

61
The result can be expressed in a binomial tree as follows:
√
hS (2) = 2 − 2
6
u

√
2
hS (1) = 4
d
( √
hS (2) = 2−1

The position on the risk-free asset can be computed likewise using (3.10c).
Exercise 3.8 (?). Is the following statement true or false and why? “In the hedging portfolio
of a call option the seller always keeps, at any time, a long position on the underlying stock”.
Exercise 3.9 (Sol. 10). Consider a 3-period binomial market with the following parameters:
5 1 1
eu = , ed = , er = 1 p = .
4 2 2
64
Assume S0 = 25
. Consider the European derivative expiring at time T = 3 and with pay-off

Y = S(3)H(S(3) − 1),

where H is the Heaviside function (1.11) (this is an example of physically-settled digital

option). Compute the possible paths of the derivative price and for each of them give the
number of shares of the underlying stock in the self-financing hedging portfolio process (3.10).

Within the proof of Theorem 3.3 we have shown that, in the case of standard European
derivatives, the position in the interval (t − 1, t] in the hedging portfolio process (3.10) is a
deterministic function of the stock at time t − 1. It can be shown that (3.10) is the only
self-financing hedging portfolio process satisfying this property. In the next exercise it is
asked to prove this property for N = 2. Note however that (3.10) is in general not unique
in the largest class of predictable portfolios; see Exercise 3.11 below.
Exercise 3.10 (Sol. 11). Let N = 2. Show that the portfolio process (3.10) is the unique self-
financing hedging portfolio such that the position (hS (t), hB (t)) is a deterministic function
of S(t − 1), t = 1, 2.
Exercise 3.11 (Sol. 12). Consider the standard European derivative with pay-off Y =
g(S(2)) at the time of maturity T = 2. Let

∆ = g(S0 e2d ) − ed−u g(S0 eu+d ) − g(S0 eu+d ) + g(S0 e2u )ed−u .

Show that a constant hedging portfolio (hS , hB ) depending only on S0 exists if and only if
∆ = 0 and find such portfolio.

62
3.3 Computation of the binomial price of European
derivatives with Matlab
In this section we discuss the numerical implementation of the binomial options pricing
model with Matlab. This numerical implementation is only practical for standard European
derivatives, since for non-standard derivatives one should compute the pay-off along all
possible 2N paths. Even for a relative small number of periods, say N = 20, this is well
beyond the power of present day computers. In Section 6.5 we shall present another numerical
method, namely the Monte Carlo method, which works also for non-standard derivatives.
As in Section 2.4, we consider a partition 0 = t1 < t2 < · · · < tN +1 = T of the interval [0, T ]
and the binomial stock price
S(i)eu , with probability p
(
S(i + 1) = , i ∈ I = {1, . . . , N },
S(i)ed , with probability 1 − p

where S(i) = S(ti ) and

1 − p√ p √
r r
T
u = αh + σ h, d = αh − σ h, h= . (3.11)
p 1−p N

The value of the risk-free asset at time ti is given by B(ti ) = B0 erti = B0 e(rh)i := B(i). Hence
the pair (S(i), B(i)) defines a binomial market, in the sense of Section 2.2, with parameters
u, d given by (3.11) and risk-free rate rh. Note that

p √ 1 − p√
r r
αh − σ h < rh < αh + σ h (3.12)
1−p p
holds for h small, hence the condition for the non-existence of self-financing arbitrage portfo-
lios in the market is satisfied provided we take our time partition to be sufficiently fine. The
recurrence formula (3.8) for the price of the European option with pay-off Y at maturity T
becomes

ΠY (N + 1) = Y, and ΠY (i) = e−rh [qu ΠuY (i + 1) + qd ΠdY (i + 1)], for t ∈ I,

where ΠY (i) = ΠY (ti ) and

√ p √
rh αh−σ 1−p h
e −e
qu = q √ √ p √ , qd = 1 − qu .
αh+σ 1−p h αh−σ 1−p h
e p
−e
The recurrence formula for pricing standard European options is implemented by the Matlab
function BinomialEuropean defined by the following code:

function Price=BinomialEuropean(Q,S,r,g)
h=Q(2)-Q(1);

63
N=length(Q)-1;
expu=S(1,2)/S(1,1);
expd=S(2,2)/S(1,1);
qu=(exp(r*h)-expd)/(expu-expd);
qd=(expu-exp(r*h))/(expu-expd);
if (qu<0 || qd<0)
display(’Error: the market is not arbitrage free.’);
Price=0;
return
end
Price=zeros(N+1);
Price(:,N+1)=g(S(:,N+1));
for j=N:-1:1
for i=1:j
Price(i,j)=exp(-r*h)*(qu*Price(i,j+1)+qd*Price(i+1,j+1));
end
end

The arguments are the partition Q = {t1 , . . . , tN +1 } and the binomial tree S for the price of
the underlying stock, computed with the function BinomialStock defined in Section 2.4, the
risk-fee rate r and the pay-off function g (e.g., g =@(x)max(x-10,0) for a call with strike
K = 10). The function returns an upper-triangular (N + 1) × (N + 1) matrix which contains
the binomial tree for the fair price of the derivative. The column j contains the possible
prices of the derivative at time tj . A path of the derivative price is obtained by moving from
each column to next one by either stays in the same row (which means that the price of the
underlying stock went up at this step) or going down one row (which means that the price
of the underlying stock went down at this step). Note that the Matlab function also checks
that (qu , qd ) defines a probability, i.e., that (3.12) holds; if not, the function stops.
For example, let S be the binomial tree (2.22) and run the command

Price=BinomialEuropean(Q,S,0.01,@(x)max(x-10,0))

which computes the binomial price of a European call with strike K = 10. The result is

0.2461 0.3817 0.5705 0.8141 1.0971 1.3875

0 0.1140 0.1978 0.3333 0.5387 0.8144
0 0 0.0325 0.0658 0.1333 0.2701
P rice = (3.13)
0 0 0 0 0 0
0 0 0 0 0 0
0 0 0 0 0 0

Observe that if the price of the stock goes down in the first three steps, then the price of
the call becomes zero and remains zero for all subsequent times, regardless of the future

64
path of the stock price. This happens because the binomial model predicts that the call has
no chance to expire in the money when the stock price goes down in the first three steps
and hence the call becomes worthless. This of course is in contradiction with reality, as the
market price of calls is never zero prior to expire. This inconsistency of the binomial model
becomes less and less relevant the higher is the number of steps used for the computation.
On the one hand if N is too low the contribution of the paths along which the call price
vanishes is significant for the computation of the fair price of the call and will determine an
underestimation of this price. On the other hand it will be shown in Chapter 6 that in the
time continuum limit, i.e., as N → ∞ and h → 0 such that N h = T , the binomial price of
the call converges to its Black-Scholes price, and within the Black-Scholes model the fair price
of a call is always positive before maturity. As the binomial model is used almost exclusively
as a numerical algorithm to compute the Black-Scholes price of standard European and,
most importantly, American derivatives (see Section 4.4), we conclude that one can trust the
binomial model only if N is sufficiently large. As a way of example, Figure 3.1 shows the
initial binomial price of a call as a function of N = 2, . . . , 100. It is clear that for a small
number of steps the result is unreliable, while for sufficiently many steps, say N & 20, the
result becomes stable. The red line in the figure indicates the Black-Scholes price of the call,
which in Matlab can be computed using the function blsprice.

0.45

0.4

0.35

0.3

0.25
C(0)

0.2

0.15

0.1

0.05
N
0
0 10 20 30 40 50 60 70 80 90 100

Figure 3.1: Initial price C(0) = P rice(1, 1) of the call computed for increasing values of N
(S0 = 10, K = 10.5, T = 1/2, α = 0.1, σ = 0.2, r = 0.01, p = 1/2). The red line indicates the
Black-Scholes price of the call. The binomial price stabilizes around the Black-Scholes price
for N & 20.

65
Parameters sensitivity analysis
An important application of the binomial model, as of any other options pricing model, is
the study of how the value of an option depends on the market parameters. In this section
we perform this parameters sensitivity analysis for the call option using the Matlab code
given above. In the subsequent discussion the numbers of periods N is fixed to N = 10000.
With such a large number of steps, and for realistic values of the market parameters, the
binomial price and the Black-Scholes price of the call option are practically the same.
We begin by studying the dependence of the call binomial price on the physical probability
p ∈ (0, 1) and on the mean of log-return α. The results are reported in Figure 3.2. The blue
and yellow lines show the initial price of the call computed for different values of p ∈ (0, 1)
and α ∈ [−0.1, 0.1] respectively; the red line indicates the Black-Scholes price, which is
independent of the parameters (α, p). As it is clear from the picture, the binomial price
is very weakly dependent on the parameter α, i.e., the price of the call is not sensitive to
the average movement of the stock price. Thus, according to the binomial model, the seller
should not charge more for a call option if the stock price is expected to increase in the
future. Figure 3.2 also shows that the binomial price of the call is weakly dependent on the
the physical probability p and the closest value to the Black-Scholes price is obtained for
p ≈ 1/2. In fact it can be shown that the fastest convergence of the binomial price to the
Black-Scholes price as N → ∞ is obtained for p = 1/2.
In view of the preceding results, we shall set α = 0 and p = 1/2 in the remaining computa-
tions. We emphasize that this choice is only justified when N is sufficiently large.

Exercise 3.12 (?). Can you give an intuitive explanation for the found dependence on the
parameters p and α of the call option binomial price?

Next we discuss the sensitivity of the call binomial price with respect to the volatility pa-
rameter σ. Figure 3.3 shows that the binomial price of the call increases with the volatility
of the stock, which means that the call option gains value when the stock price is expected
to oscillate in the future. Note that the value of the call tends to the value of the stock as
σ → ∞. As real calls are always cheaper than the underlying stock, one can always find
a value of σ, called implied volatility of the call, such that the market price of the call
coincides with its theoretical fair value computed with the binomial model2 . The implied
volatility is the most important parameter of the call and it is often listed together with its
price. We shall return to this important concept in Chapter 6.

Exercise 3.13 (?). Can you give an intuitive explanation for the found dependence on the
parameters σ of the call option binomial price?

2
Actually, the computation of the implied volatility is typically done using the Black-Scholes model.
However, as already mentioned, the binomial price and the Black-Scholes price are practically the same for
N sufficiently large.

66
 -0.1 0 0.1
0.3803
(p=1/2)
0.3802

0.3801

0.38

0.3799

0.3798

0.3797

0.3796

0.3795
p ( =0)
0.3794
0.25 0.5 0.75

Figure 3.2: Initial price C(0) = P rice(1, 1) of the call computed for different values of
p ∈ (0, 1) (blue line) and α ∈ [−0.1, 0.1] (yellow line). The red line indicates the Black-
Scholes price (S0 = 10, K = 10.5, T = 1, σ = 0.1, r = 0.01).

10 6

9
5
8

7
4
6
C(0)

C(0)

5 3

4
2
3

2
1
1

0 0
0 1 2 3 4 5 6 7 8 9 10 0 0.5 1 1.5 2 2.5

(a) Dependence on σ (b) Dependence on σ (small values)

Figure 3.3: Initial price C(0) = P rice(1, 1) of the call computed for different values of the
volatility σ (S0 = 10, K = 10.5, T = 1, r = 0.01).

Finally, Figure 3.4 depicts the behavior of the binomial price of the call in terms of the
parameters (r, K, T, S0 ). We see that the price of the call is an increasing function of the
parameters r, T, S0 and a decreasing convex function of K, in agreement with the results
obtained in Chapter 1.

67
 0.38 5

4.5
0.375
4
0.37
3.5
0.365
3
C(0)

C(0)
0.36 2.5

2
0.355
1.5
0.35
1
0.345
0.5

0.34 0
-0.01 -0.008 -0.006 -0.004 -0.002 0 0.002 0.004 0.006 0.008 0.01 5 6 7 8 9 10 11 12 13 14 15
r K
(a) Dependence on r (b) Dependence on K
1.2 20

18
1
16

14
0.8
C(0) 12
C(0)

0.6 10

8
0.4
6

4
0.2
2

0 0
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2 0 5 10 15 20 25 30
T S0
(c) Dependence on T (d) Dependence on S0

Figure 3.4: Sensitivity of the call option binomial price with respect to the parameters
(r, K, T, S0 ).

Exercise 3.14 (?). Give an intuitive explanation for the results depicted in Figure 3.4.
Exercise 3.15. Write a Matlab function that computes the hedging portfolio of standard
European derivatives.
Exercise 3.16. Look for the market price of call options on S&P500 which expire in about
one month from now. Select 20 prices, 10 for the first options in the money and 10 for the
first options out of the money. Let S0 be the current value of S&P500 and σ20 its current
20-days volatility (computed using the Matlab code in Exercise 1.2). Compile a table with the
following information: the first column contains the strike price K, the second column the
market price, the third column the binomial price. For the computation of the binomial price
use σ = σ20 and choose, as the risk-free rate, the yield of US treasury bills (which can easily
be found on the internet). Plot the difference between the market price and the theoretical
price as a function of K and discuss the results.

68
3.4 Further exercises
In the following exercises, {S(t), B(t)}t∈I , is a binomial market with parameters d < r < u,
p ∈ (0, 1). The value of the market parameters is specified in each single exercise.
Exercise 3.17. A barrier option is an option that expires worthless as soon as the stock
price crosses a specified level (the barrier of the option3 ). For example, consider a 3-period
binomial market with parameters eu = 43 , ed = 23 , p = 34 , S0 = 2 and r = 0, and the barrier
call option with strike K = 2 and barrier B = 3. This means that the derivative expires
worthless if S(3) ≤ 2 or if S(t) > 3 at some time t ∈ {1, 2, 3}. Compute the binomial price
ΠY (0) of this barrier option at time t = 0 and the probability that it expires in the money.
ANSWER: ΠY (0) = 5/54. P(Y > 0) = 28, 125%.
Exercise 3.18. Assume d = −u, r = u/2 and N = 2 and let g(x) = 1 if x = 0, g(x) = 0 if
x 6= 0. Consider a European derivative with pay-off Y = g(S(2) − S(0)) at time of maturity
T = N = 2. Find ΠY (0) and hS (0).
e−u/2 qd −qu
ANSWER: ΠY (0) = 2e−u qu qd , hS (0) = hS (1) = S(0) eu −e−u
.
Exercise 3.19. Let u > r > 0, d = −u and N = 3. A European style derivative with
expiration date T = N = 3 pays the amount 1 if the underlying stock moves always in the
same direction (up or down) and 0 otherwise. Compute ΠY (0).
ANSWER: ΠY (0) = e−3r (qu3 + qd3 ).
Exercise 3.20. Let N = 2 and er = (eu + ed )/2. Derive the hedging portfolio of a European
derivative paying the amount Y = |S(2)/S(1) − S(1)/S(0)| at time of maturity T = 2.
Exercise 3.21. Let N = 3 and
5 1 64
eu = , ed = , er = 1, S0 = , p ∈ (0, 1).
4 2 25
Consider a European derivative with maturity T = 3 and pay-off
1 X3 
Y = S(i) − 2 ,
4 i=0 +

which is an example of Asian call option. Compute the price of the derivative at time t = 0.
Compute the probability that the derivative expires in the money and the probability that a
long position in one share of the derivative gives a positive return.
ANSWER: ΠY (0) = 52/75, P(Y > 0) = p, P(R > 0) = p2 .
Exercise 3.22. Compute the self-financing hedging portfolio for the compound option in
Exercise 3.3. Assume B(0) = 1.
Exercise 3.23 (?). Can you think of a reason to buy a call on the put, a barrier option, an
Asian option or a look-back option?
3
To be more precise, the definition just given refers to a knock-out barrier option with American barrier.
There exists several variants (google it!)

69
Chapter 4

American derivatives

This chapter is concerned with American derivatives on a stock in the binomial model. We
assume that the stock price is given by S(0) = S0 > 0 and
(
S(t − 1)eu with probability p
S(t) = , t ∈ I = {1, . . . , N },
S(t − 1)ed with probability 1 − p
where 0 < p < 1, u > d. Moreover we assume that the risk-free rate r of the money market
is constant, so that the value of the risk-free asset at time t is
B(t) = B0 ert .
We impose d < r < u. In particular, the risk-neutral probability is well defined:
er − ed
qu = q, qd = 1 − q, where q = ∈ (0, 1).
eu − ed
We denote by {(hS (t), hB (t)}t∈I a predictable portfolio process invested in the stock and
the risk-free asset, where (hS (t), hB (t)) is the portfolio position in the interval (t − 1, t] and
hS (0) = hS (1), hB (0) = hB (1). The value at time t of the portfolio is V (t) = hS (t)S(t) +
hB (t)B(t). Recall that the portfolio process is said to generate the cash flow {C(t), t =
0, . . . , N − 1} if
hS (t)S(t − 1) + hB (t)B(t − 1) = V (t − 1) − C(t − 1), t ∈ I;
since (hS (1), hB (1)) = (hS (0), hB (0)), then C(0) = 0.
We shall need the proven recurrence formula for the binomial fair price ΠY (t) of European
derivatives. Namely, denoting ΠuY (t) the value of the European derivative at time t assuming
that the stock price goes up at time t (i.e., S(t) = S(t − 1)eu , or equivalently, xt = u), and
similarly for ΠdY (t), with “up” replaced by “down”, we have seen in Theorem 3.2, that ΠY (t)
satisfies
ΠY (N ) = Y, and ΠY (t) = e−r [qu ΠuY (t+1)+qd ΠdY (t+1)], for t ∈ {0, . . . , N − 1}. (4.1)

70
4.1 The binomial price of American derivatives
In contrast to European derivatives, American derivatives can be exercised at any time prior
or including the expiration date. Let Y (t) be the pay-off of an American derivative exercised
at time t. We assume that t ∈ I = {1, . . . , N }, while t = 0 is the present time. Let S(t) be
the binomial stock price of the underlying stock at time t. We restrict ourselves to standard
American derivatives, which means that
Y (t) = g(S(t)), t ∈ {0, 1, . . . , N },
where g : (0, ∞) → R is the pay-off function of the derivative1 . For example, g(z) =
(z − K)+ for American call options and g(z) = (K − z)+ for American put options, where
(z)+ = max(0, z) and K is the strike price of the option. Y (t) is also called intrinsic value
of the derivative. If Y (t) ≤ 0 then the derivative is out of the money at time t. The initial
pay-off Y (0) is also denoted by Y0 ; as it depends only on the initial price S0 = S(0) of the
stock, the value of Y0 is known. However for t = 1, . . . , N , Y (t) is path-dependent, namely,
Y (t) = Y (t, x1 , . . . , xt ) = g(S(t, x1 , . . . , xt )).
Out first goal is to introduce a reasonable definition for the binomial fair price of the American
derivative with intrinsic value Y (t) and maturity T = N . We denote this price by Π b Y (t),
while ΠY (t) denotes the binomial price of the corresponding European derivative with pay-
off Y (N ) = g(S(N )) at maturity T = N . As already discussed in Chapter 1, any meaningful
definition of fair price for American derivatives must satisfy the following: (a) Π b Y (N ) =
Y (N ), (b) ΠY (t) ≥ Y (t) and (c) ΠY (t) ≥ ΠY (t). Property (a) fixes the price of the American
b b
derivative at time N . Due to (b) and (c), a reasonable definition for the fair price of the
American derivative at time t = N − 1 is
b Y (N − 1) = max(Y (N − 1), ΠY (N − 1)).
Π (4.2)
Using the recurrence formula (4.1), we have

ΠY (N − 1) = e−r (qu ΠuY (N ) + qd ΠdY (N )) = e−r (qu Π

b u (N ) + qd Π
Y
b d (N )),
Y

where for the second equality we used that Π

b Y (N ) = ΠY (N ). Hence (4.2) becomes

b Y (N − 1) = max[Y (N − 1), e−r (qu Π

Π b uY (N ) + qd Π
b dY (N ))].

This suggests to introduce the following definition:

Definition 4.1. The binomial (fair) price Π b Y (t) of the standard American derivative with
intrinsic value Y (t) = g(S(t)) at time t ∈ {0, 1, . . . , N } is defined by the recurrence formula

Π
b Y (N ) = Y (N ) (4.3)
b Y (t) = max[Y (t), e−r (qu Π
Π b u (t + 1) + qd Π
b d (t + 1))], t ∈ {0, . . . , N − 1}. (4.4)
Y Y
1
For non-standard American derivatives, the pay-off has the form Y (t) = gt (S(1), . . . , S(t)), where
gt : (0, ∞)t → R.

71
Exercise 4.1 (?). Why did we not define the binomial fair price of the American derivative
as Π
b Y (t) = max(Y (t), ΠY (t))?

In Section 4.3 we shall give further support to the statement that Π

b Y (t) does actually define
a fair price for American derivatives. For the moment we limit ourselves to show that
Definition 4.1 captures the properties of American derivatives discussed in Chapter 1.

Theorem 4.1 (∗). Let Π b Y (t), t ∈ I, denote the binomial price of the standard American
derivative with intrinsic value Y (t) = g(S(t)) and maturity T = N . Let ΠY (t) denote the
binomial price of the corresponding European derivative with pay-off Y (N ) = g(S(N )) at
maturity N . The following holds:

(a) Π
b Y (t) is a deterministic function of S(t).

b Y (t) ≥ ΠY (t), for all t ∈ I.

(b) Π

(c) Assuming r ≥ 0, the American call and the European call with the same strike and
maturity have the same binomial price.

Proof. (a) We have to show that Π b Y (t) = vt (S(t)) for some pricing function vt : (0, ∞) → R.
We argue by induction. First this is true at time N , because Π b Y (N ) = Y (N ) = g(S(N )),
hence vN = g. Now assume that the claim is true at time t + 1, i.e., there exists vt+1 :
(0, ∞) → R such that Πb Y (t + 1) = vt+1 (S(t + 1)). Hence

b u (t + 1) = vt+1 (S(t)eu ),
Π b d (t + 1) = vt+1 (S(t)ed ).
Π
Y Y

Thus, using Y (t) = g(S(t)), we have

b Y (t) = max(g(S(t)), e−r (qu vt+1 (S(t)eu ) + qd vt+1 (S(t)ed )) = vt (S(t)),

Π

where vt (z) = max(g(z), e−r (qu vt+1 (zeu ) + qd vt+1 (zed )).
(b) Also in this case we can argue by induction. The claim is true at maturity N , since
at this time the value of both derivatives equals the pay-off by definition. Now assume the
claim is true at time t + 1, i.e.,
b Y (t + 1) ≥ ΠY (t + 1).
Π

Hence
e−r (qu Π b dY (t + 1)) ≥ e−r (qu ΠuY (t + 1) + qd ΠdY (t + 1)),
b uY (t + 1) + qd Π

which implies
b Y (t) = max(Y (t), e−r (qu Π
Π b dY (t + 1)) ≥ e−r (qu Π
b uY (t + 1) + qd Π b uY (t + 1) + qd Π
b dY (t + 1))
≥ e−r (qu ΠuY (t + 1) + qd ΠdY (t + 1)) = ΠY (t),

72
where we used that the price of European calls satisfies the recurrence relation (4.1)
(c) To prove that American and European calls with equal parameters have the same value,
we first observe that it suffices to prove that Π b call (t) ≤ Πcall (t), since we already proved in (b)
that Πb call (t) ≥ Πcall (t) holds (we prove this for all standard American derivatives!). We argue
again by induction. At maturity Π b call (N ) = Πcall (N ). Assume that Π b call (t+1) ≤ Πcall (t+1).
Then
e−r (qu Π b d (t + 1)) ≤ e−r (qu Πu (t + 1) + qd Πd (t + 1)).
b ucall (t + 1) + qd Π
call call call (4.5)
Now let Πput (t) be the price of the European put with the same parameters as the European
call. We have shown in Theorem 3.1 that the put-call parity holds:
Πcall (t) = S(t) − Ke−r(T −t) + Πput (t).
As Πput (t) ≥ 0 and r ≥ 0 we have Πcall (t) ≥ S(t) − K. Since Πcall (t) ≥ 0, we have
Πcall (t) ≥ max(S(t) − K, 0) = (S(t) − K)+ = Y (t),
where Y (t) is the intrinsic value of the American call. As
Πcall (t) = e−r (qu Πucall (t + 1) + qd Πdcall (t + 1)),
we have
Y (t) ≤ e−r (qu Πucall (t + 1) + qd Πdcall (t + 1)).
Hence, using that max(a, b) ≤ max(c, b) holds when a ≤ c,
b call (t) = max(Y (t), e−r (qu Π
Π b ucall (t + 1) + qd Π
b dcall (t + 1))
≤ max(e−r (qu Πucall (t + 1) + qd Πdcall (t + 1)), e−r (qu Π
b u (t + 1) + qd Π
call
b d (t + 1))).
call

By (4.5),

max(e−r (qu Πucall (t + 1) + qd Πdcall (t + 1)), e−r (qu Π

b u (t + 1) + qd Π
call
b d (t + 1)))
call
= e−r (qu Πucall (t + 1) + qd Πdcall (t + 1)) = Πcall (t).
b call (t) ≤ Πcall (t), and the proof is complete.
Hence Π
Exercise 4.2 (?). In Theorem 4.1(c) it is assumed r ≥ 0, while in the analogous property
(xi) in Chapter 1 we assumed the stronger condition r > 0. Explain why.
Exercise 4.3 (?). Which of the following statements is true and why?

1. If Π
b Y (0) = ΠY (0), then Π
b Y (t) = ΠY (t) for all times along any path of the stock price.

b Y (t, x̄1 , . . . , x̄t ) = ΠY (t, x̄1 , . . . , x̄t ) for a given (x̄1 , . . . , x̄t ) ∈ {u, d}t , then
2. If Π

Π
b Y (s, x̄1 , . . . , x̄t , xt+1 , . . . , xs ) = ΠY (s, x̄1 , . . . , x̄t , xt+1 , . . . , xs ),

for all t < s < T and for all (xt+1 , . . . , xs ) ∈ {u, d}s−t .

73
We conclude this section with a formal definition of optimal exercise time of American
derivatives in the binomial model.

Definition 4.2. An optimal exercise time for the American derivative with intrinsic
value Y (t) in a binomial market is a time t ∈ I such that Y (t) > 0 and ΠY (t) = Y (t).

As discussed in Chapter 1, the interpretation of optimal exercise time is that of a time at

which exercising the derivative is as lucrative as selling the derivative (if ΠY (t) > Y (t),
selling the derivative is more profitable than exercising it). The condition Y (t) > 0 in
Definition 4.2 is necessary because in the binomial model an American derivative with non-
negative pay-off (such as the put option) may still have zero price prior to maturity, in which
case ΠY (t) = Y (t) entails Y (t) = 0 and thus the exercise of the derivative is worthless.

4.2 The American put option

The last claim in Theorem 4.1 is consistent with what we have seen in Chapter 1, namely
that it is never optimal to exercise an American call option prior to expiration when the
underlying stock pays no dividends. The example discussed below in this section shows that
this is not true for put options. To this regard we remark that, when the American put is
priced using the binomial model, an optimal exercise time in the sense of Definition 4.2 is a
time t ∈ I such that

(K − S(t))+ = max[(K − S(t))+ , e−r (qu Π

b u (t + 1) + qd Π
put
b d (t + 1))],
put

that is to say, a time t ∈ I at which

(K − S(t))+ ≥ e−r (qu Π

b u (t + 1) + qd Π
put
b d (t + 1)).
put (4.6)

It can be shown that the inequality (4.6) holds at time t ∈ {1, . . . , N − 1} if and only if
S(t) ≤ S∗ (t), where S∗ (t) < K depends only on the market parameters. The exact expression
for S∗ (t) is unknown, but it can be easily determined numerically, see Exercise 4.9. This
fact is very important in the applications, for it tells us that the optimal time to exercise
the American put is as soon as the price of the stock falls below the value S∗ (t), irrespective
of whether the market price of the put option equals its intrinsic value. In the next theorem
the exact value of S∗ (t) is derived in the 2-period model.

Theorem 4.2 (∗). In a 2-period binomial model with parameters u > 0, d < 0, 0 < r < u,
the earlier exercise at time t = 1 of the American put with strike K and maturity T = 2 is
optimal if and only if S(1) ≤ S∗ (1), where

1 − e−r qd
S∗ (1) = K . (4.7)
1 − e−r qd ed

74
Proof. We need to study for which values of S(1) is (4.6) satisfied at time t = 1. Since
b put (2) = (K − S(1)ed )+ , (4.6) becomes
b uput (2) = (K − S(1)eu )+ and Π
Π Y

(K − S(1))+ ≥ e−r (qu (K − S(1)eu )+ + qd (K − S(1)ed )+ ). (4.8)

We study the inequality (4.8) for separate values of S(1) in the intervals

S(1) ∈ [0, Ke−u ] := I1 , S(1) ∈ [Ke−u , K] := I2 ,

S(1) ∈ [K, Ke−d ] := I3 , S(1) ∈ [Ke−d , +∞) := I4 .

For S(1) ∈ I1 we have,

e−r (qu (K − S(1)eu )+ + qd (K − S(1)ed )+ ) = e−r (qu eu (Ke−u − S(1)) + qd ed (Ke−d − S(1))).

Using qu + qd = 1 and qu eu + qd ed = er we obtain

e−r (qu (K − S(1)eu )+ + qd (K − S(1)ed )+ ) = K − S(1) = (K − S(1))+ , for S(1) ∈ I1 .

Similarly, for S(1) ∈ I2 we have


−r u d (K − S(1))+ for S(1) ≤ S∗ (1)
e (qu (K − S(1)e )+ + qd (K − S(1)e )+ ) =
e−r qd ed (Ke−d − S(1)) for S(1) > S∗ (1)

where S∗ (1) is given by (4.7). Treating similarly the cases S(1) ∈ I3 and S(1) ∈ I4 we find
that the price of the American put at time t = 1 is given by

 (K − S(1))+ for 0 < S(1) ≤ S∗ (1)
Πput (1) =
b e qd e (Ke − S(1)) for S∗ < S(1) ≤ Ke−d
−r d −d

0 for S > Ke−d



We conclude that it is optimal to exercise the American put at time t = 1 if and only if
S(1) ≤ S∗ (1).

Example of American put option

Next we consider an example of American put option. We let the strike price K = 3/4, and
so  
3
Y (t) = − S(t) .
4 +

We present an example in N = 2 periods. Consider a market with the following parameters:

7 1 9
eu = , ed = , er = ,
4 2 8

75
so that qu = qd = 1/2. Assuming S0 = 1, the binomial tree for the stock price is
49
S(2) =
8 16
u

7
S(1) =
9 4
u d
&
7
S0 = 1 S(2) =
8 8
d u
%
1
S(1) = 2
d
&
1
S(2) = 4

The binomial tree for the intrinsic value Y (t) of the American put is

Y (2) = 0 = Π
b Y (2)
6
u

Y (1) = 0
9
u d
(
Y0 = 0 Y (2) = 0 = Π
b Y (2)
6
d u
%
1
Y (1) = 4
d
(
1
Y (2) = 2
=Π
b Y (2)

Now we compute the binomial price of the American put option at the times t = 0, 1. If the
stock price goes up at time t = 1 we have, by (4.4),
h i
b Y (1, u) = max Y (1, u), e−r (qu Π
Π b u (2, u) + qd Π
b d (2, u))
Y Y
h i
−r
= max Y (1, u), e (qu ΠY (2, u, u) + qd ΠY (2, u, d))
b b
  
8 1 1
= max 0, ·0+ ·0 = 0.
9 2 2
This of course has to be expected, since when the stock price goes up at time t = 1 the
American put has no chance to expire in the money, hence it is worth nothing. If the stock

76
price goes down at time t = 1 we have
h i
−r u d
ΠY (1, d) = max Y (1, d), e (qu ΠY (2, d) + qd ΠY (2, d))
b b b
h i
= max Y (1, d), e−r (qu Π
b Y (2, d, u) + qd Π
b Y (2, d, d))
    
1 8 1 1 1 1 2 1
= max , ·0+ · = max , = .
4 9 2 2 2 4 9 4

At time t = 0 we find
  
h
−r u d
i 8 1 1 1 1
ΠY (0) = max Y (0), e (qu ΠY (1) + qd ΠY (1)) = max 0,
b b b ·0+ · = .
9 2 2 4 9

Hence the binomial price of the American put along the different paths of the stock price is
as follows:
Π
b Y (2) = 0
7
u

Π
b Y (1) = 0
7
u d
'
1
Π
b Y (0) = Π
b Y (2) = 0
9 9
d u
%
b Y (1) = 1
Π
4
d

%
1
Π
b Y (2) =
2

We observe that if and only if the stock price goes down at time t = 1 the intrinsic value of
the American put is positive and equals its binomial price prior to maturity, hence in this
case (and only in this case) the earlier exercise of the put is optimal. This result agrees with
Theorem 4.2, since the value (4.7) for this option is given by

3 1 − 98 12
 
15 1 7
S∗ (1) = = ∈ , .
4 1 − 89 12 12 28 2 4

Hence when the price of the stock is S(1) = 1/2, the barrier S∗ (1) = 15/28 has been crossed
and thus the exercise of the American put is optimal.

77
4.3 Replicating portfolio processes of American deriva-
tives
In this section we describe how to obtain hedging portfolio processes for American derivatives.
Recall that for the European derivative with pay-off Y at the expiration date T = N ,
hedging portfolio processes have been defined by imposing that their value V (t) satisfies
V (N ) = Y , see Definition 3.1. Because of the earlier exercise option of American derivatives,
this definition cannot be adopted in the American case. In fact, since the goal of an hedging
portfolio is to secure the writer position (i.e., the short position) and the buyer of the
American derivative has the right to exercise the derivative at any time t ∈ I, then we need
to ensure that the value of the writer portfolio is at any time—and not only at maturity—
sufficient to pay-off the buyer, i.e., V (t) ≥ Y (t). This leads us to define hedging portfolio
processes for American derivatives as follows.
Definition 4.3. A predictable portfolio process {hS (t), hB (t)}t∈I is said to be hedging the
American derivative with intrinsic value Y (t) and maturity T = N if

V (N ) = Y (N ), V (t) ≥ Y (t), t = 0, . . . , N − 1,

where V (t) = hS (t)S(t) + hB (t)B(t) is the value of the portfolio process at time t. If V (t) =
Π
b Y (t) for all t = 0, . . . , N , the portfolio process is said to be replicating the American
derivative.
Exercise 4.4 (?). Why the hedging portfolio is not required to have at any time the exact
same value needed to pay-off the buyer? I.e., why V (t) ≥ Y (t) and not V (t) = Y (t)?

Note that replicating portfolio processes are hedging portfolios, because Π b Y (t) ≥ Y (t). In the
European case any self-financing hedging portfolio process is (trivially) replicating, because
ΠY (t) has been defined as the common value of any such portfolio. However, in the American
case, the class of self-financing portfolios is in general too small to contain replicating portfolio
processes. In fact, as shown in the following theorem, replicating portfolios for American
derivatives may generate a cash flow.
Theorem 4.3. Consider the standard American derivative with intrinsic value Y (t) and
maturity T = N . Let Π b Y (t) be its binomial price as given by (4.3)-(4.4). Define the portfolio
process {(b
hS (t), b
hB (t))}t∈I and the cash flow process C(t) as follows:

C(0) = 0, b Y (t) − e−r [qu Π

C(t) = Π b uY (t + 1) + qd Π
b dY (t + 1)], t ∈ {1, . . . , N − 1}, (4.9)

hS (1) = b
b hS (0), hB (0) = b
b hB (1) (4.10a)
and, for t = 1, . . . , N ,
1 b u (t) − Π
Π b d (t)
Y Y
hS (t) =
b
u d
, (4.10b)
S(t − 1) e −e

78
 e−r eu Π
b d (t) − ed Π
Y
b u (t)
Y
hB (t) =
b . (4.10c)
B(t − 1) eu − ed
The portfolio process (4.10) is predictable, replicates the American derivative and generates
the cash-flow (4.9).

Proof. We have shown in Theorem 4.1 that Π

b Y (t) is a deterministic function of S(t), i.e.,
Π
b Y (t) = vt (S(t)). Hence

b u (t) = vt (S(t − 1)eu ),

Π b d (t) = vt (S(t − 1)ed )
Π
Y Y

are deterministic functions of S(t−1), by which it follows immediately that the portfolio pro-
cess (4.10) is predictable. To show that the portfolio replicates the derivative and generates
the cash flow (4.9) we have to show that

V (t) = Π
b Y (t), for all t ∈ {0, . . . N } (4.11)

and
V (t − 1) = b
hS (t)S(t − 1) + b
hB (t)B(t − 1) + C(t − 1), for all t ∈ I. (4.12)
The proof is straightforward: just replace (4.9) and (4.10) into (4.11)-(4.12). For instance,
assuming that the price goes up at time t, we compute

V u (t) = b
hS (t)S(t − 1)eu + b hB (t)B(t − 1)er
! !
Π b d (t)
b u (t) − Π e u bd
Π (t) − ed bu
Π (t)
Y Y Y Y
= eu +
eu − ed eu − ed
b uY (t),
=Π

and at the same fashion one proves that V d (t) = Π b d (t). Hence (4.11) holds. In a similar
Y
fashion, replacing (4.9) and (4.10) into the right hand side of (4.12) we find that the latter
b Y (t − 1), which we already proved to be equal to V (t − 1). Hence (4.12) holds
is equal to Π
as well.

The previous theorem is telling us that the writer can hedge the derivative and still be able
to withdraw cash from the portfolio. While this might seem unfair from the buyer point
of view, we remark that whether the writer is allowed or not to withdraw cash from the
portfolio (i.e., C(t) > 0) depends on the “smartness” of the buyer. In fact, using (4.4)
in (4.9), we have, for t ∈ {1, . . . , N − 1},

C(t) = max(Y (t), e−r (qu Π b dY (t + 1)) − e−r (qu Π

b uY (t + 1)) + qd Π b uY (t + 1)) + qd Π
b dY (t + 1)).

This quantity is positive at time t if and only if only Y (t) > e−r (qu Π
b u (t + 1)) + qd Π
Y
b d (t + 1)),
Y
which implies that t is an optimal exercise time. Hence the writer of the American put can
withdraw cash from the portfolio only if the buyer fails to exercise the derivative optimally.

79
If however the buyer exercises the derivative optimally, then the seller needs the full value
of the portfolio to pay-off the buyer and thus no cash can be withdrawn.

Example. Computing the cash flow at t = 1 for the American put considered in Section 4.2,
we find C(1, u) = 0, while if the price of the stock goes down at time t = 1 we obtain
 
−r
b Y (1, d) − e [qu Π u d
b (2)] = −1 8 1 1 1 1
C(1, d) = Π b (2) + qd Π
Y Y ·0+ · = .
4 9 2 2 2 36

Hence if at time t = 1 the price of the stock goes down, and the buyer does not exercise the
1
American put, the writer can withdraw the cash 36 from the portfolio. The value remaining
1 1 2
in the portfolio is 4 − 36 = 9 . The American put can be hedged with this value by short
selling 54 shares of the stock and buying ( 92 + 45 · 12 ) = 28
45
shares of the risk-free asset. So
doing the writer will receive the amount 28 ·
45 8
9
= 7
10
at time t = 2; if the stock price goes up
at time t = 2 the American put expires out of the money and the writer will use the amount
7
10
to buy 45 shares of the stock at the price S(2) = 78 and close the short position on the
stock without losses. If the price of the stock goes down at time t = 2, the writer will give
the pay-off 12 to the buyer of the American put and use the remaining value 10 7
− 12 = 51 in
the portfolio to buy 45 shares of the stock at the price S(2) = 41 and again close the short
position on the stock without losses.

Exercise 4.5 (Sol. 13). Consider the American derivative with intrinsic value

Y (t) = min(S(t), (24 − S(t))+ )

and expiring at time T = 3. The initial price of the underlying stock is S(0) = 27, while at
future times it follows the binomial model

4S(t)/3 with probability 1/2
S(t + 1) =
2S(t)/3 with probability 1/2

for t = 0, 1, 2. Assume also that the risk-free rate of the money market is zero. Compute
the possible paths of the binomial price of the derivative. In which case it is optimal for the
buyer to exercise the derivative prior to expiration? What is the amount of cash that the
seller can withdraw from the portfolio if the buyer does not exercise the derivative optimally?

Exercise 4.6 (Sol. 14). Consider a 3-period binomial model with the following parameters:
5 1
eu = , ed = , er = 1, p ∈ (0, 1).
4 2
Let S(0) = 64
25
be the initial price of the stock. Consider an American style derivative on the
stock with maturity T = 3 and intrinsic value
 

Y (t) = 3 − S(t) H S(t) − 7/5 ,

80
where H(x) is the Heaviside function (1.11) and |x| is the absolute value of x. Compute
the binomial price of the derivative at each time t ∈ {0, 1, 2, 3} and the initial position on
the stock in the replicating portfolio. Compute the cash that the seller can withdraw from
the portfolio if the buyer does not exercise the derivative at optimal times. Compute the
probability that the derivative is in the money at time t and the probability that the return
for the buyer is positive at time t, where t ∈ {0, 1, 2, 3}.

Exercise 4.7. Consider a 3 period binomial model with parameters u = log(4/3), d =

log(2/3), r = log(7/6), S(0) = 27. Consider the a put option with strike K = 24 and
expiring at time T = 3. Compute the binomial price of the put at time t = 0 under each of
the following terms:

(i) The owner can exercise the derivative only at maturity (European style put option)

(ii) The owner can exercise at any time prior to or including maturity (American style put
option)

(iii) The owner of the derivative is allowed to exercise at time t = 2 or at maturity, but not
at time t = 1 (Bermuda style put option)

In cases (i) and (ii), identify the optimal exercise times prior to expiration and the amount
of cash that the seller can withdraw from the hedging portfolio if the buyer does not exercise
the derivative optimally.
ANSWER: European case: ΠY (0) = 299/343; American case Π b Y (0) = 522/343; Bermuda
case: Πe Y (0) = 351/343. In the American case the early optimal exercise times are t = 1 if
the stock price goes down in the first time step and t = 2 if the stock price goes down in the
first and second time step; if the buyer does not exercise at either of these times the seller
can withdraw from the hedging portfolio the cash C(1, d) = 114/49 and C(2, d, d) = 24/7. In
the Bermuda case it is optimal to exercise at time t = 2 when the stock price goes down in
the first and second time step and if the buyer does not exercise the derivative optimally, the
writer can withdraw the cash C(2, d, d) = 24/7 from the hedging portfolio.

4.4 Computation of the binomial price of American

derivatives with Matlab
We work under the same set-up as in Section 3.3. Namely we consider a partition 0 = t1 <
t2 < · · · < tN +1 = T of the interval [0, T ] and the binomial stock price

S(i)eu , with probability p

(
S(i + 1) = , i ∈ I = {1, . . . , N },
S(i)ed , with probability 1 − p

81
where S(i) = S(ti ) and

1 − p√ p √
r r
u = αh + σ h, d = αh − σ h. (4.13)
p 1−p

The value of the risk-free asset at time ti is given by B(ti ) = B0 erti = B0 e(rh)i := B(i).
Hence the pair (S(i), B(i)) defines a binomial market with parameters u, d given by (4.13)
and interest rate rh. The definition (4.1) of binomial price of American derivative becomes

Π b Y (i) = max(Y (i), e−rh (qu Π

b Y (N + 1) = Y (N + 1) Π b u (i + 1)) + qd Π
b d (i + 1)), t ∈ I,
Y Y

where Π
b Y (i) = Π
b Y (ti ) and
√ p √
rh αh−σ 1−p h
e −e
qu = q √ √ p √ , qd = 1 − qu .
αh+σ 1−p h αh−σ 1−p h
e p
−e
Moreover Y (i) = g(S(i)), i = 1, . . . , N + 1, is the intrinsic value of the American derivative.
The following code defines a function BinomialAmerican which computes the binomial price
and the cash flow of standard American derivatives.

function [Price,C]=BinomialAmerican(Q,S,r,g)
h=Q(2)-Q(1);
N=length(Q)-1;
expu=S(1,2)/S(1,1);
expd=S(2,2)/S(1,1);
qu=(exp(r*h)-expd)/(expu-expd);
qd=(expu-exp(r*h))/(expu-expd);
if (qu<0 || qd<0)
display(’Error: the market is not arbitrage free.’);
P=0;
return
end
Price=zeros(N+1);
Price(:,N+1)=g(S(:,N+1)));
C(:,N+1)=0;
Y=g(S));
for j=N:-1:1
for i=1:j
Price(i,j)=max(Y(i,j),exp(-r*h)*(qu*Price(i,j+1)+qd*Price(i+1,j+1)));
C(i,j)=Price(i,j)-exp(-r*h)*(qu*Price(i,j+1)+qd*Price(i+1,j+1));
end
end

82
The binomial price of the derivative is stored in the upper-triangular (N + 1) × (N + 1)
matrix Price, while the cash flow is stored in the upper-triangular (N + 1) × (N + 1) matrix
C. We use the convention that at time of maturity the cash flow is equal to zero.
For example, using as inputs the binomial stock price (2.22), the interest rate r = 0.01 and
the pay-off function of the put with strike 10, i.e., g(x) = (10 − x)+, we obtain the output

0.2385 0.1120 0.0320 0 0 0

0 0.3619 0.1899 0.0633 0 0
0 0 0.5297 0.3133 0.1250 0
P rice =
0 0 0 0.7407 0.4970 0.2468
0 0 0 0 0.9752 0.7376
0 0 0 0 0 1.2038

0 0 0 0 0 0
0 0 0 0 0 0
C= 0 0 0 0 0 0
0 0 0 0.0017 0.0017 0
0 0 0 0 0.0017 0

Remark 4.1. Using the pay-off of the call, g(x) = (x − 10)+ , we obtain that the price of
the American call is exactly the same as the corresponding European call, see (3.13), while
C ≡ 0. This of course is consistent with the proven fact that, in the absence of dividends, it
is never optimal to exercise an American call prior to expire.

Exercise 4.8. Perform a parameter sensitivity analysis for the American put option.

Exercise 4.9. Plot the pairs (ti , S(ti )) in the plane, for each optimal exercise time ti of
the American put. Experiment for different values of K, T . Use a large number of steps
(N ≈ 1000). What happens when T → +∞?

In the time-continuum limit, N → +∞, h → 0 such that N h = T , the points (ti , S(ti ))
for each optimal exercise time form the so-called optimal exercise curve (or optimal
exercise boundary) of the American put option.

Exercise 4.10. Show numerically that the initial binomial price of the American put with
strike K and maturity T converges, as T → +∞, to the value v(S0 ), where v is the function
(
K −x 0≤x≤L
v(x) =
2r
x − σ2
(K − L) L x>L

and
2r
L= K.
2r + σ 2
How is this result related to your findings in Exercise 4.9?

83
4.5 Further exercises
In the following exercises, {S(t), B(t)}t∈I , is a binomial market with parameters d < r < u,
p ∈ (0, 1). The value of the market parameters is specified in each single exercise.

Exercise 4.11. Compute the replicating portfolio for the American put given in Section 4.2
(assume B0 = 1).
ANSWER: b hS (1) = bhS (0) = −1/5, bhB (1) = b
hB (0) = 14/45; b
hS (2, u) = b
hB (2, u) = 0;
hS (2, d) = −4/5, hB (2, d) = 224/405.
b b

Exercise 4.12. Assume eu = 74 , ed = 12 , S(0) = 1, p = 3/4, er = 9/8.

a) Compute the binomial price at t = 0, 1, 2 of an American put with strike K = 3/4 and
maturity T = 2

b) Compute the binomial price at t = 0, 1, 2 of a European call with strike K = 3/4 and
maturity T = 2

c) A derivative U gives to its owner the right to convert U at time t = 1 into either the
European call or the American put defined above. Compute the binomial price of U at
time t = 0

d) Describe the optimal strategy that the holder of U should follow

ANSWER: c) ΠU (0) = 16/27.

84
Chapter 5

Introduction to Probability Theory

One goal of this chapter is to reformulate the binomial options pricing model in the language
of probability theory. To this purpose we shall first review some basic concepts in probability
theory on finite spaces; a more systematic presentation of this theory can be found e.g. in [5].
In the last section of the chapter we discuss some more advanced tools in probability theory
which will be applied to introduce and study the Black-Scholes options pricing model in
Chapter 6.

5.1 Finite Probability Spaces

Let Ω be a set containing a finite number of elements ω1 , ω2 , . . . , ωM . We denote Ω as
Ω = {ω1 , . . . , ωM }, or Ω = {ωi }i=1,...,M (5.1)
and call it a sample space. The elements ωi ∈ Ω, i = 1, . . . , M , are called sample points.
The sample points identify the possible outcomes of an experiment. For instance, if the
experiment consists in “rolling a die”, then
Ω = {1, 2, 3, 4, 5, 6} (M = 6),
while for the experiment “tossing a coin once”, we have
Ω = Ω1 := {H, T } (M = 2),
where H stands for “Head” and T for “Tail”; the subscript 1 in Ω1 indicates that the coin
is tossed only once. In the experiment “tossing a coin twice” we have
Ω = Ω2 := {(H, H), (H, T ), (T, H), (T, T )} = Ω1 × Ω1 (M = 22 = 4)
and in the experiment “tossing a coin N times” we have
Ω = ΩN := {ω = (γ1 , γ2 , . . . , γN ); γj = H or T, j = 1, . . . , N }
= Ω1 × Ω1 × · · · × Ω1 = {H, T }N (M = 2N ).
| {z }
N times

85
We denote by 2Ω the power set of Ω, i.e., the set of all subsets of Ω. It consists of the
empty set ∅, the subsets containing one element, i.e., {ω1 }, {ω2 }, . . . , {ωM }, which are called
atomic sets, the subsets containing two elements, i.e.,

{ω1 , ω2 }, . . . , {ω1 , ωM }, {ω2 , ω3 }, . . . , {ω2 , ωM }, . . . , {ωM −1 , ωM },

the subsets containing 3 elements and so on, and the set Ω = {ω1 , . . . , ωM } itself. Thus 2Ω
contains 2M elements. For instance

2Ω1 = {∅, {H}, {T }, {H, T } = Ω1 }.

Exercise 5.1. Write down 2Ω2 .

The elements of 2Ω (i.e., the subsets of Ω) are called events. They identify possible events
that occur in the experiment. For example

{2, 4, 6} ≡ [the result of throwing a die is an even number],

{(H, H), (T, T )} ≡ [tossing a coin twice gives the same outcome in both tosses].

Exercise 5.2. Write down the following events A, B, C ∈ 2Ω4 :

A = [number heads=number tails], B = [successive tosses are different],

C = [there exist at least three identical tosses].

If A, B ∈ 2Ω are events, then A ∪ B is the event that A or B happens, while A ∩ B is the

event that both A and B happen. If the sets A, B ⊂ Ω are disjoint, i.e., A ∩ B = ∅, the
events A and B cannot occur simultaneously. For instance, {1, 3, 5} ∩ {2, 4, 6} = ∅ means
that the outcome of a die roll cannot be both even and odd.
The atomic set {ωi } identifies the event that the outcome of the experiment is exactly ωi .
We want to assign a probability P to such special events. To this purpose we introduce M
real numbers p1 , p2 , . . . pM such that
M
X
0 < pi < 1, for all i = 1, . . . , M , and pi = 1. (5.2)
i=1

The m-dimensional vector (p1 , p2 , . . . , pm ) is called a probability vector. We define pi to

be the probability of the event {ωi }, that is

P({ωi }) = pi , i = 1, . . . , M.

Any event A ∈ 2Ω can be written as the disjoint union of atomic events, e.g.,

{ω1 , ω3 , ω6 } = {ω1 } ∪ {ω3 } ∪ {ω6 }.

86
This leads to define the probability of the event A ∈ 2Ω as
X X
P(A) = P({ωi }) = pi . (5.3)
i:ωi ∈A i:ωi ∈A

For instance P({ω1 , ω3 , ω6 }) = p1 + p3 + p6 . We shall also write the definition of P(A) as

X
P(A) = P({ω}).
ω∈A

In particular
X M
X
P(Ω) = P({ω}) = pi = 1.
ω∈Ω i=1
We also set
P(∅) = 0, (5.4)
which means that it is impossible that the experiment gives no outcome. Clearly ∅ is the
only event with zero probability: any other such event is excluded a priori by the sample
space. At this point every event has been assigned a probability.
Definition 5.1. Given p1 , . . . , pM satisfying (5.2) and a set Ω = {ω1 , . . . , ωM }, the function
P : 2Ω → [0, 1] defined by (5.3)-(5.4) is called a probability measure. The pair (Ω, P), is
called a finite probability space.

Examples

• In the experiment “throwing a die”, let p1 = p2 = p3 = p4 = p5 = p6 = 1/6. We say

that the die is fair, as any number between 1 and 6 has the same probability to appear
as a result of the roll. Then P({2, 4, 6}) = 1/6 + 1/6 + 1/6 = 1/2, i.e., we have 50%
chances to get an even number.
• In Ω1 we let P({H}) = pH , P({T }) = pT , where pT = 1 − pH , pH ∈ (0, 1). The coin is
said to be fair if pH = pT = 1/2.
• In Ω2 we assign a probability to the atomic events by setting
P({(H, H)}) = p2H , P({(T, H)}) = P({(H, T )}) = pT pH , P({(T, T )}) = p2T .
Notice that P({(H, H)}) + P({(T, H)}) + P({(H, T )}) + P({(T, T )}) = (pH + pT )2 = 1,
as it should be. This way of assigning probabilities is equivalent to the assumption
that the two tosses are independent, i.e., the result of the first toss does not influence
the result of the second toss (see Definition 5.4 below). As an example of computing
the probability of non-atomic events, consider the event
A = [the outcome of the two tosses is the same].
Then
P(A) = P({(H, H), (T, T )}) = P({(H, H)}) + P({(T, T )}) = p2H + p2T .

87
 • In ΩN = {H, T }N , we assign a probability to each of the 2N atomic events by letting
P({ω}) = (pH )NH (ω) (pT )NT (ω) , for all ω ∈ ΩN ,
where NH (ω) and NT (ω) = N − NH (ω) are respectively the number of heads and tails
in the N -toss corresponding to ω. Again, this definition of probability makes the N -
tosses independent. Since for all k = 0, . . . , N the number of N -tosses ω ∈ ΩN having
NH (ω) = k is given by the binomial coefficient
 
N N!
= ,
k k!(N − k)!
then
X X X  pH NH (ω)
NH (ω) NT (ω) N
P({ω}) = (pH ) (pT ) = (pT )
ω∈ΩN ω∈ΩN ω∈Ω
pT
N
N   k
X N pH
= (pT )N .
k=0
k pT
PN

k N
By the binomial theorem, (1 + a)N = a , hence
k=0 k
 N
X
N pH
P(Ω) = P({ω}) = (pT ) 1+ = (pT + pH )N = 1.
ω∈Ω
p T
N

The probability of any other event A ∈ 2ΩN is the sum of the probabilities of the atomic
events whose (disjoint) union forms the set A.

The last example deserves to be given a separate definition.

Definition 5.2. Given 0 < p < 1, the pair (ΩN , Pp ) given by ΩN = {H, T }N and
X
Pp (A) = pNH (ω) (1 − p)NT (ω) , for all A ∈ 2ΩN , (5.5)
ω∈A

is called the N -coin toss probability space. Here NH (ω) is the number of H in the sample
ω and NT (ω) = N − NH (ω) is the number of T .

Example. Given k ∈ {0, . . . , N }, let Ak = {ω : NH (ω) = k} ⊂ ΩN be the event that the

number of heads in the N -toss is k. Then
X X X
Pp (Ak ) = pNH (ω) (1−p)NT (ω) = pk (1−p)N −k = pk (1−p)N −k 1 = pk (1−p)N −k Mk ,
ω∈Ak ω∈Ak ω∈Ak

N
P

where Mk = ω∈Ak 1 is the number of N -tosses with k heads. As Mk = k
we get
 
N k
Pp (Ak ) = p (1 − p)N −k .
k

88
Exercise 5.3. Compute Pp (A), where A = {ω : NH (ω) = NT (ω)} ⊂ ΩN .
Remark 5.1. We emphasize that Pp is not the only possible probability that can be defined
on the sample space ΩN . In the probability Pp all tosses are independent and each toss has
the same probability p to result in a head. However other choices are possible, e.g., one may
introduce a probability on ΩN such that the result of the toss n depends on the results of
the tosses 1, 2, . . . , n − 1. Whether or not such an experiment can be realized in practice it
is irrelevant for mathematical purposes.

It is possible that the occurrence of an event A affects the probability that a second event
B occurred. For instance, for a fair coin we have Pp ({H, H}) = 1/4, but if we know that
the first toss is a tail, then Pp ({H, H}) = 0. This simple remark leads to the definition of
conditional probability.
Definition 5.3. Given two events A, B such that P(B) > 0, the conditional probability
of A given B is defined as
P(A ∩ B)
P(A|B) = .
P(B)
Similarly, if B1 , B2 , . . . , Bn are events such that P(B1 ∩ · · · ∩ Bn ) > 0, the conditional prob-
ability of A given1 B1 , . . . , Bn is
P(A ∩ B1 ∩ · · · ∩ Bn )
P(A|B1 , . . . , Bn ) = .
P(B1 ∩ · · · ∩ Bn )

If the occurrence of B does not affect the probability of occurrence of A, i.e., if P(A|B) =
P(A), we say that the two events are independent. By the previous definition, the indepen-
dence property is equivalent to the following.
Definition 5.4. Two events A, B are said to be independent if

P(A ∩ B) = P(A)P(B).

Similarly, n events A1 , . . . , An are said to be independent if

P(Ak1 ∩ · · · ∩ Akm ) = P(Ak1 ) · . . . · P(Akm ),

for all 1 ≤ k1 < k2 < · · · < km ≤ n.

Exercise 5.4. Write down all the identities that must be verified in order for three events
A, B, C to be independent.
Exercise 5.5. Compute the probability Pp of the events defined in Exercise 5.2 and verify
whether there are pairs of independent events among them. Compute

Pp (A|B), Pp (B|A), Pp (A|C), Pp (B|C).

1
i.e., given the simultaneous occurrence of the events B1 , . . . , Bn , or, equivalently, given the occurrence
of the event B1 ∩ · · · ∩ Bn .

89
Random Variables
In general the purpose of an experiment is to determine the value of quantities which depend
on the outcome of the experiment (e.g., the velocity of a particle, which is determined by
successive measurements of its position). We call such quantities random variables.
Definition 5.5. Let (Ω, P) be a finite probability space. A random variable is a function
X : Ω → R. If g : Rn → R, then the random variable Y = g(X1 , X2 , . . . , Xn ) is said to be
measurable with respect to X1 , . . . , Xn .

Note that the property of Y being measurable with respect to X means that the value
attained by Y in the experiment can be inferred by the value attained by X, i.e., Y (ω) =
g(X(ω)), for all ω ∈ Ω.
Given A ⊂ Ω, the random variable IA : Ω → {0, 1} given by

1 if ω ∈ A
IA (ω) =
0 if ω ∈ /A
is called the indicator function of the event A.
Since Ω = {ω1 , . . . , ωM }, then a random variable X on a finite probability space is necessarily
a finite random variable, i.e., it can attain only a finite number of values x1 , . . . , xM ,
namely
X(ωi ) = xi , i = 1, . . . , M.
The values x1 , . . . , xM need not be distinct. If X(ωi ) = c, for all i = 1, . . . , M , we say
that X is a deterministic constant (the value of X is independent of the outcome of the
experiment). The image of X is the finite set defined as
Im(X) = {x ∈ R such that X(ω) = x, for some ω ∈ Ω},
that is the set of possible values attainable by X. If Ω = {ω1 , . . . , ωM }, then Im(X) contains
at most M elements. Given a ∈ R, we denote
{X = a} = {ω ∈ Ω : X(ω) = a},
which is the event that X attains the value a. Of course, {X = a} = ∅ if a ∈
/ Im(X). In
general, given I ⊆ R, we denote
{X ∈ I} = {ω ∈ Ω : X(ω) ∈ I},
which is the event that the value attained by X lies in the set I. Moreover we denote
{X = a, Y = b} = {X = a} ∩ {Y = b}, {X ∈ I1 , Y ∈ I2 } = {X ∈ I1 } ∩ {Y ∈ I2 }.
The probability that X takes value a is given by
X
P(X = a) = P({X = a}) = pi .
i:X(ωi )=a

90
If a ∈
/ Im(X), then P(X = a) = P(∅) = 0. More generally, given any open subset I of R, we
write X
P(X ∈ I) = P({X ∈ I}) = pi ,
i:X(ωi )∈I

which is the probability that the value of X belongs to I. For example, in the probability
space of a fair die consider the random variable

X(ω) = (−1)ω , ω ∈ {1, 2, 3, 4, 5, 6}. (5.6)

Then X(ω) = 1 if ω is even and X(ω) = −1 is ω is odd. Moreover

P(X = 1) = P({2, 4, 6}) = 1/2, P(X = −1) = P({1, 3, 5}) = 1/2,

whereas
P(X 6= ±1) = P(∅) = 0.
The set A = {2, 4, 6} is said to be resolved by X, because the occurrence of the event A (i.e.,
the fact that the outcome of the throw is an even number) is equivalent to X taking value 1.
In general, given a random variable X : Ω → R, the events resolved by X are the sets of the
form {X ∈ I}, for some I ⊆ R. These events comprise the so called information carried
by X. The idea is that even if the outcome of an experiment is unknown, measuring the
value attained by a random variable gives some information on the result of the experiment.

Definition 5.6. Let (Ω, P) be a finite probability space and X : Ω → R a random variable.
The function fX : R → [0, 1] defined by

fX (x) = P(X = x)

is called the probability distribution of X, while FX : R → [0, 1] given by

FX (x) = P(X ≤ x), x∈R

is called the cumulative distribution of X.

Note that fX (x) is non-zero if only if x ∈ Im(X), and that FX is a non-decreasing function
satisfying 0 ≤ FX (x) ≤ 1, limx→−∞ FX (x) = 0, limx→∞ FX (x) = 1. For example, for the
random variable (5.6) defined on the probability space of a fair die we have

 0, x < −1,
FX (x) = 1/2, x ∈ [−1, 1),
1, x ≥ 1.


For the applications to the binomial options pricing model, the following probability distri-
bution plays a fundamental role.

91
Definition 5.7. Given N ∈ N, N ≥ 1, and p ∈ (0, 1), a finite random variable X is said to
be binomially distributed if Im(X) = {0, 1, . . . , N } and if the probability distribution of
X is given by the binomial distribution
 
N k
fX (k) = φN,p (k) := p (1 − p)N −k , k = 0, . . . , N.
k

For instance, the random variable X(ω) = NH (ω) in the N -coin toss probability space is
binomially distributed, see the example following Definition 5.2 . We denote the cumulative
distribution of binomial random variables as
X
ΦN,p (x) = φN,p (k). (5.7)
k≤x

The probability that a random variable X takes value in the interval [a, b] can be written in
terms of the distribution of X as
X X
P(a ≤ X ≤ b) = P(X = xi ) = fX (xi ). (5.8)
i:X(ωi )=xi ∈[a,b] i:a≤xi ≤b

In a similar fashion, if g : R → R then

X X
P(a ≤ g(X) ≤ b) = P(X = xi ) = fX (xi ). (5.9)
i:g(X(ωi ))=g(xi )∈[a,b] i:a≤g(xi )≤b

We shall use these formulas later on.

Independent random variables

We have seen before that a random variable X carries information. Now, if Y = g(X) for
some (non-constant) function g : R → R, then Y carries no more information than X: any
event resolved by knowing the value of Y is also resolved by knowing the value of X. The
other extreme case is when two random variables carry independent information.

Definition 5.8. Let (Ω, P) be a finite probability space. Two random variables X1 , X2 : Ω →
R are said to be independent if the events {X1 ∈ I1 }, {X2 ∈ I2 } are independent events,
for all sets I1 ⊆ Im(X1 ), I2 ⊆ Im(X2 ). This means that

P(X ∈ I1 , X2 ∈ I2 ) = P(X1 ∈ I1 )P(X2 ∈ I2 ).

More generally, n random variables X1 , . . . , Xn : Ω → R are independent if the events

{X1 ∈ I1 }, {X2 ∈ I2 }, . . . , {Xn ∈ In } are independent (in the sense of Definition 5.4) for all
sets I1 , I2 , . . . , In such that Ij ⊆ Im(Xj ).

92
Exercise 5.6 (Sol. 15). Show that when X, Y are independent random variables, then the
only events which are resolved by both variables are ∅ and Ω. Assume Y = g(X) and show
that in this case the two random variables are independent if and only if Y is a deterministic
constant.

Note that the independence property is linked to the probability defined on the sample
space. Thus two random variables may be independent with respect to some probability and
not-independent with respect to another. We shall use later the following important result:

Theorem 5.1. Let X1 , X2 , . . . , Xn be independent random variables, k ∈ {1, . . . , n − 1} and

g : Rk → R, f : Rn−k → R. Then the random variables

Y = g(X1 , X2 , . . . , Xk ), Z = f (Xk+1 , · · · , Xn )

are independent.

Exercise 5.7 (Sol. 16). Prove the theorem for n = 2.

Expectation and Variance

Next we define the expectation and variance of random variables. We may think of the
expectation of X as an estimate on the average value of X and the variance of X as a
measure of how far is this estimate from to the precise value of X.

Definition 5.9. Let (Ω, P) be a finite probability space and X : Ω → R a random variable.
The expectation (or expected value) of X is defined by
M
X
E[X] = X(ωi )P(ωi ).
i=1

We shall write the definition of E[X] also as

X
E[X] = X(ω)P({ω}). (5.10)
ω∈Ω

For instance, in the N -coin toss probability space (ΩN , Pp ) we have

X
Ep [X] = X(ω)pNH (ω) (1 − p)NT (ω) , (5.11)
ω∈ΩN

where NH (ω) is the number of heads and NT (ω) = N − NH (ω) is the number of tails in
the N -toss ω ∈ ΩN , see Definition 5.2. Note that we denote by Ep the expectation in the
probability measure Pp on the N -coin toss probability space.

93
Exercise 5.8. X
: ΩN → R, X(ω) = NH (ω) − NT (ω). Compute Ep [X]. HINT: Use the

LetN −1
N
identity k k = k−1 N.
ANSWER: Ep [X] = N (2p − 1).

We can rewrite the definition of expectation as

X
E[X] = x P(X = x),
x∈Im(X)

or equivalently, X
E[X] = xfX (x). (5.12)
x∈Im(X)

The importance of (5.12) is that it allows to compute the expectation of X from its distri-
bution, without any reference to the original probability space. For instance, if we are told
that a random variable X takes the following values:

 1 with probability 1/4
X= 2 with probability 1/4 , (5.13)
−1 with probability 1/2


then we can compute E[X] using (5.12) as

1 1 1 1
E[X] = 1 · +2· −1· = .
4 4 2 4
Some simple properties of the expectation are collected in the following theorem.
Theorem 5.2. Let X, Y be random variables on a finite probability space (Ω, P), g : R → R,
a, b ∈ R. The following holds:

1. E[aX + bY ] = aE[X] + bE[Y ] (linearity).

2. If X ≥ 0 and E[X] = 0, then X = 0.
3. If X, Y are independent, then E[XY ] = E[X]E[Y ].
4. If Y = g(X), i.e., if Y is X-measurable, then
X
E[Y ] = g(x)fX (x). (5.14)
x∈Im(X)

Proof. The (easy) proof of 1,2,4 is left as an exercise. For the proof of 3, let Ai = {X = xi },
Bj = {Y = yj }, i = 1, . . . N , j = 1, . . . M . We can write X, Y as
N
X M
X
X= xi IAi , Y = yj IBj .
i=1 j=1

94
Hence
N X
X M N X
X M
XY = xi yj IAi IBj = xi yj IAi ∩Bj
i=1 j=1 i=1 j=1

Hence, by the linearity of the expectation, and the assumed independence of X, Y ,

N X
X M
E[XY ] = xi yj E[IAi ∩Bj ]
i=1 j=1
N X
X M
= xi yj P(Ai ∩ Bj )
i=1 j=1
N X
X M
= xi yj P(Ai )P(Bj )
i=1 j=1
N
X M
X
= xi P(Ai ) P(Bj ) = E[X]E[Y ].
i=1 j=1

Exercise 5.9. Prove the properties 1,2,4 in Theorem 5.2.

Definition 5.10. Let (Ω, P) be a finite probability space. The variance of a random variable
X : Ω → R is defined by
Var[X] = E[(E[X] − X)2 ].

Using the linearity of the expectation, we obtain easily the formula

Var[X] = E[X 2 ] − E[X]2 . (5.15)

Moreover Var[aX] = a2 Var[X] holds for all constants a ∈ R, and

Var[X + Y ] = E[(X + Y )2 ] − E[X + Y ]2 = Var[X] + Var[Y ] + 2(E[XY ] − E[X]E[Y ]). (5.16)

It follows by Theorem 5.2(3) that the variance of the sum of two independent random vari-
ables is the sum of their variance (this holds under the more general property that the
random variables are uncorrelated, see below). Furthermore the variance of a random vari-
able is always non-negative and it is zero if and only if the random variable is a deterministic
constant. Hence we may also interpret the variance as a measure of the “randomness” of a
random variable.
Using (5.14) with g(x) = x2 , we can rewrite the definition of variance in terms of the
distribution function of X as
 2
X X
Var[X] = x2 fX (x) −  xfX (x) , (5.17)
x∈Im(X) x∈Im(X)

95
which allows to compute Var[X] without any reference to the original probability space. For
instance for the random variable (5.13) we find
 2
1 1 1 1 27
Var[X] = 1 · + 4 · + 1 · − = .
4 4 2 4 16

Exercise 5.10. Let X be a binomially distributed random variable. Use (5.12) and (5.17)
to compute E[X] and Var[X].
ANSWER: E[X] = N p, Var[X] = N p(1 − p).

Exercise 5.11. Let R∗ be the relative return of a portfolio which is long 1 share of the
derivative in Exercise 3.9. Compute E[R∗ ] and Var[R∗ ].
ANSWER: E[R∗ ] ≈ −21%, Var[R∗ ] ≈ 29%.

Remark 5.2. The variance (in the physical probability) of the relative return of a portfolio
is a measure of the portfolio risk.

Example: mean of log return and volatility of the binomial stock price

Let 0 = t0 < t1 < · · · < tN = T be a partition of the interval [0, T ] with ti − ti−1 = h, for all
i = 1, . . . , N . Given u > d and p ∈ (0, 1), consider a random variable X such that X = u
with probability p and X = d with probability 1 − p. We may think of X as being defined
on Ω1 = {H, T }, with X(H) = u and X(T ) = d. Now, the binomial stock price at time ti
can be written as S(ti ) = S(ti−1 ) exp(X). Hence the log-return R of the stock in the interval
[ti−1 , ti ] is
S(ti )
R = log S(ti ) − log S(ti−1 ) = log = X.
S(ti−1 )
It follows that the expectation and the variance of the log-return of the stock in the interval
[ti−1 , ti ] are
E[R] = E[X] = (pu + (1 − p)d),
Var[R] = Var[X] = [pu2 + (1 − p)d2 − (pu + (1 − p)d)2 )] = p(1 − p)(u − d)2 .
Thus the parameters α, σ 2 defined in (2.1) can be rewritten as
1 1
α= E[R], σ2 = Var[R]. (5.18)
h h
We see now that α is the expected value of the log-return R of the binomial stock price in
the interval [ti−1 , ti ] per unit of time (instantaneous log-return), while σ 2 is the variance of
R per unit of time (instantaneous variance). The parameter σ itself is called instantaneous
volatility of the binomial stock. It is part of our assumptions on the binomial model that
the parameters α and σ are the same for every interval [ti−1 , ti ] of the partition.

96
Correlation (*)
Definition 5.11. Let (Ω, P) be a finite probability space. The covariance of two random
variables X, Y : Ω → R is defined by
Cov(X, Y ) = E[(E[X] − X)(E[Y ] − Y )].
If Cov(X, Y ) = 0, the two random variables are said to be uncorrelated.

Using the linearity of the expectation we can rewrite the definition of covariance as
Cov(X, Y ) = E[XY ] − E[X]E[Y ]. (5.19)
The interpretation is the following: If Cov(X, Y ) > 0, then Y tends to increase (resp.
decrease) when X increases (resp. decrease), while if Cov(X, Y ) < 0, the two variables have
tendency to move in the opposition direction. For instance, assuming Var[X] > 0,
Cov(X, 2X) = 2Var[X] > 0, Cov(X, −2X) = −2Var[X] < 0.
It follows by (5.19) and Theorem 5.2(3) that
X, Y independent ⇒ X, Y uncorrelated.
However two uncorrelated random variables are not necessarily independent. To see this, let

 −1 with prob. 1/3
X= 0 with prob. 1/3 Y = X 2.
1 with prob. 1/3


The random variables X, Y are not independent, since Y = g(X) is not a deterministic
constant (see Exercise 5.6). Moreover XY = X 3 = X and thus E[XY ] = E[X 3 ] = E[X] = 0.
Thus Cov(X, Y ) = 0, i.e., the two random variables are uncorrelated.
Exercise 5.12 (Sol. 17). Assume that X, Y are not deterministic constants. Prove the
inequality p p
− Var[X]Var[Y ] ≤ Cov(X, Y ) ≤ Var[X]Var[Y ]. (5.20)
Show that the left (resp. right) inequality becomes an equality if and only if there exists a
negative (resp. positive) constant a0 and a real constant b0 such that Y = a0 X + b0 .

By inequality (5.20) it is convenient to introduce the following definition.

Definition 5.12. Let X, Y : Ω → R be two random variables such that Var[X] and Var[Y ]
are both positive (i.e., X, Y are not deterministic constants). Then
Cov(X, Y )
Cor(X, Y ) = p ∈ [−1, 1]
Var[X]Var[Y ]
is called the correlation of X, Y .

97
Hence, the closer is Cor(X, Y ) to 1 (resp. −1) the more Y has the tendency to move in the
same (resp. opposite) direction of X. For instance Cor(X, 2X) = 1, and Cor(X, −2X) = −1.

Exercise 5.13. Compute the correlation of the random variables X, Y : Ω3 → R given by

X(ω) = NT (ω) − NH (ω), Y (ω) = NH (ω).

Joint distribution (*)

Definition 5.13. If X, Y are two random variables on a finite probability space, then the
function fX,Y : R2 → [0, 1] given by

fX,Y (x, y) = P(X = x, Y = y)

is called the joint distribution of X and Y , while FX,Y (x, y) = P(X ≤ x, Y ≤ y) is called
the cumulative joint distribution.

Exercise 5.14. Let X, Y have the joint distribution fX,Y . Show that the distributions of X
and Y are given by
X X
fX (x) = fX,Y (x, y), fY (y) = fX,Y (x, y).
y∈Im(Y ) x∈Im(X)

Show that X, Y are independent if and only if fX,Y (x, y) = fX (x)fY (y).

If the joint distribution is given, then the covariance of two random variables can easily be
computed without any reference to the original probability space. In fact, since
M
X X X
E[XY ] = X(ωi )Y (ωi )P(ωi ) = x y fX,Y (x, y), (5.21)
i=1 x∈Im(X) y∈Im(Y )

then
X X X X
Cov(X, Y ) = x y fX,Y (x, y) − xfX (x) y fY (y), (5.22)
x∈Im(X) y∈Im(Y ) x∈Im(X) y∈Im(Y )

where the distributions fX , fY are computed from fX,Y as shown in Exercise 5.14. In con-
clusion, if the joint distribution of two random variables X, Y is given, then all relevant
information on X, Y (independence, expectation, variance, correlation, etc.) can be inferred
without any reference to the original probability space.

Example. Consider two random variables X, Y such that Im(X) = {−1, 1, 3, 4}, Im(Y ) =
{−1, 0, 1, 2} and let their joint probability distribution be given as in the following table:

98
 Y ↓, X → -1 1 3 4
-1 1/64 2/64 1/64 4/64
0 5/64 1/64 9/64 6/64
1 6/64 10/64 1/64 12/64
2 2/64 1/64 1/64 2/64

For instance, fX,Y (−1, 1) = 1/64, fX,Y (−1, 0) = 5/64, and so on. Let us compute E[X],
E[Y ] and Cov(X, Y ).
X X X
E[X] = xfX (x) = x fX,Y (x, y)
x∈Im(X) x∈Im(X) y∈Im(Y )
X X X X
=− fX,Y (−1, y) + fX,Y (1, y) + 3 fX,Y (3, y) + 4 fX,Y (4, y)
y∈Im(Y ) y∈Im(Y ) y∈Im(Y ) y∈Im(Y )
1 5 6 2 2 1 10 1
= −( + + + )+( + + + )
64 64 64 64 64 64 64 64
1 9 1 1 4 6 12 2 33
+ 3( + + + ) + 4( + + + )= .
64 64 64 64 64 64 64 64 16
X X X
E[Y ] = yfY (y) = y fX,Y (x, y)
y∈Im(Y ) y∈Im(Y ) x∈Im(X)
X X X X
=− fX,Y (x, −1) + 0 · fX,Y (x, 0) + fX,Y (x, 1) + 2 fX,Y (x, 2)
x∈Im(X) x∈Im(X) x∈Im(X) x∈Im(X)
1 2 1 4 5 1 9 6
= −( + + + )+0·( + + + )
64 64 64 64 64 64 64 64
6 10 1 12 2 1 1 2 33
+( + + + ) + 2( + + + )= .
64 64 64 64 64 64 64 64 64
X X
E[XY ] = x y fX,Y (x, y)
x∈Im(X) y∈Im(Y )
1 2 1
+ 1(−1) + 3(−1)
= (−1)(−1)
64 64 64
55
+ ············ = .
64
Hence Cov(X, Y ) = E[XY ] − E[X]E[Y ] ≈ −0.204.
Exercise 5.15. Compute Cor(X, Y ).

Conditional expectation
If X, Y are independent random variables, knowing the value of Y does not help to estimate
the random variable X. However if X, Y are not independent, then we can use the infor-
mation carried by Y to find an estimate of X which is better than E[X]. This leads to the
important concept of conditional expectation.

99
Definition 5.14. Let (Ω, P) be a finite probability space, X, Y : Ω → R random variables
and y ∈ Im(Y ). The expectation of X conditional to Y = y (or given the event {Y = y}) is
defined as X
E[X|Y = y] = P(X = x|Y = y) x
x∈Im(X)

where P(X = x|Y = y) is the conditional probability of the event {X = x}, given the event
{Y = y} (see Def. 5.3). The random variable

E[X|Y ] : Ω → R, E[X|Y ](ω) = E[X|Y = Y (ω)]

is called the expectation of X conditional to Y .

In a similar fashion one defines the conditional expectation with respect to several random
variables, i.e., E[X|Y1 = y1 , Y2 = y2 , . . . YN = yN ] and E[X|Y1 , . . . , YN ]. For example, in the
probability space of a fair die, consider

X(ω) = (−1)ω , Y (ω) = (ω − 1)(ω − 2)(ω − 3), ω ∈ {1, 2, 3, 4, 5, 6}. (5.23)

Note that Im(Y ) = {0, 6, 24, 60}. Then we compute

E[X|Y = 0] = P(X = 1|Y = 0) − P(X = −1|Y = 0)

P(X = 1, Y = 0) P(X = −1, Y = 0)
= −
P(Y = 0) P(Y = 0)
P({2}) P({1, 3})
= − = −1/3.
P({1, 2, 3}) P({1, 2, 3})

Similarly we find

E[X|Y = 6] = 1, E[X|Y = 24] = −1, E[X|Y = 60] = 1,

hence E[X|Y ] is the random variable


 −1/3 if ω = 1, 2 or 3
E[X|Y ](ω) = 1 if ω = 4 or 6
−1 if ω = 5.


The following theorem collects a few important properties of the conditional expectation
that will be used later on.

Theorem 5.3. Let X, Y, Z : Ω → R be random variables on the finite probability space

(Ω, P). Then

(0) The random variable E[X|Y ] is Y -measurable;

100
 (1) The conditional expectation is a linear operator, i.e.,

E[αX + βY |Z] = αE[X|Z] + βE[Y |Z],

for all α, β ∈ R;
(2) If X is independent of Y , then E[X|Y ] = E[X];
(3) If X is measurable with respect to Y , i.e., X = g(Y ) for some function g, then
E[X|Y ] = X;
(4) E[E[X|Y ]] = E[X];
(5) If X is measurable with respect to Z, then E[XY |Z] = XE[Y |Z];
(6) If Z is measurable with respect to Y then E[E[X|Y ]|Z] = E[X|Z].

These properties remain true if the conditional expectation is taken with respect to several
random variables.

The interpretation of 2-3 in the previous theorem is the following: If X is independent of

Y , then the information carried by Y does not help to improve our estimate on X and thus
our best estimate for X remains E[X]. On the other hand, if X is measurable with respect
of Y , then by knowing Y we also know X and thus our best estimate on X is X itself.
Exercise 5.16 (?). What is the interpretation of 4, 5, 6 in Theorem 5.3?

Stochastic processes
Definition 5.15. Let (Ω, P) be a finite probability space and T > 0. A one parameter family
of random variables, X(t) : Ω → R, t ∈ [0, T ], is called a stochastic process. We denote
the stochastic process by {X(t)}t∈[0,T ] and by X(t, ω) the value of the random variable X(t)
on the sample ω ∈ Ω. For each fixed ω ∈ Ω, the curve t → X(t, ω), is called a path of the
stochastic process.

We shall refer to the parameter t as the time variable, as this is what it represents in most
applications. If X(t, ω) = C(t), for all ω ∈ Ω, i.e., if the paths are the same for all sample
points, we say that the stochastic process is a deterministic function of time. If t runs
over a (possibly finite) discrete set {t0 , t1 , . . . } ⊂ [0, T ], then we say that the stochastic
process is discrete. Note that a discrete stochastic process is equivalent to a sequence of
random variables:
{X0 , X1 , . . . }, where Xi = X(ti ), i = 0, 1, . . . .
If the discrete stochastic process is finite, i.e., if it runs only for a finite number N of time
steps, we shall denote it by {Xn }n=0,...,N and call it a N -period process. If it runs for
infinitely many steps we denote it by {Xn }n∈N .

101
Recall that a random variable Y is said to be measurable with respect to the random variables
X1 , . . . , Xn if and only if Y = g(X1 , . . . , Xn ) for some function g : Rn → R. In the case of
stochastic processes we have a similar definition.
Definition 5.16. Let {Xn }n∈N and {Yn }n∈N be two discrete stochastic processes on a finite
probability space. The process {Yn }n∈N is said to be measurable with respect to {Xn }n∈N
if for all n ∈ N there exists a function gn : Rn+1 → R such that Yn = gn (X0 , X1 , . . . , Xn ).
If Yn = hn (X0 , . . . , Xn−1 ) for some function hn : Rn → R, then {Yn }n∈N is said to be
predictable from the process {Xn }n∈N .

The interpretation of {Yn }n∈N being measurable with respect to {Xn }n∈N is that the stochas-
tic process {Yn }n∈N at the time step n is determined by looking at the process {Xn }n∈N up
to the time step n. Of course predictable ⇒ measurable but the opposite implication is in
general not true.
At each (time) step, a discrete stochastic process on a finite probability space is a random
variable with finitely many possible values. More precisely, for all n ∈ N, the value xn of Xn
satisfies xn ∈ Im(Xn ). We call xn an admissible state of the stochastic process. Note that
xn is an admissible state if and only if P(Xn = xn ) > 0.
Example: The random walk. Consider the following (discrete and finite) stochastic
process {Xn }n=1,...,N defined on the N -coin toss probability space (ΩN , Pp ):

1 if γn = H
ω = (γ1 , . . . , γN ) ∈ ΩN , Xn (ω) =
−1 if γn = T

Clearly, the random variables X1 , . . . , XN are independent and identically distributed (i.i.d),
namely
Pp (Xn = 1) = p, Pp (Xn = −1) = 1 − p, for all n = 1, . . . , N .
Hence
E[Xn ] = 2p − 1, Var[Xn ] = 4p(1 − p), for all n = 1, . . . , N .
Now, for n = 1, . . . , N , let
n
X
M0 = 0, Mn = Xi .
i=1

The stochastic process {Mn }n=0,...,N is measurable (but not predictable) with respect to the
process {Xn }n=1,...,N and is called the (N -period) random walk. It satisfies

E[Mn ] = n(2p − 1), for all n = 0, . . . , N .

Moreover, being the sum of independent random variables, the symmetric random walk has
variance given by
n
X
Var[M0 ] = 0, Var[Mn ] = Var(X1 + X2 + · · · + Xn ) = Var[Xi ] = 4np(1 − p).
i=1

102
When p = 1/2, the random walk is said to be symmetric. In this case {Mn }n=0,...,N
satisfies E[Mn ] = 0, n = 0, . . . , N and Var[Mn ] = n. When p 6= 1/2, {Mn }n=0,...,N is called
asymmetric random walk, or random walk with drift.
If Mn = k then Mn+1 is either k + 1 (with probability p), or k − 1 (with probability 1 − p).
Hence we can represent the paths of the random walk by using a binomial tree, as in the
following example for N = 3:
M
7 3=3
p

M
7 2=2
p 1−p

'
M
7 1=1 M
7 3=1
p 1−p p

'
M0 = 0 M
7 2=0
1−p p 1−p

' '
M1 = −1 M7 3 = −1
1−p p

'
M2 = −2
1−p

'
M3 = −3

Note that the admissible states of the random walk at the step n are given by

Im(Mn ) = {−n, −n + 2, −n + 4, . . . , n − 2, n} = {−n + 2j, j = 0, . . . , n}.

The increments of the random walk are defined as follows. Given 0 = k0 < k1 < · · · <
km = N , we let
ki+1
X
∆i = Mki+1 − Mki = Xj , i = 0, . . . , m − 1,
j=ki +1

i.e., ∆0 = Mk1 , ∆1 = Mk2 − Mk1 , . . . , ∆m−1 = Mkm − Mkm−1 . Note that ∆j is the total
displacement of the random walk from time kj−1 to time kj .
Remark 5.3. It follows by Theorem 5.1 that the increments of the random walk are
independent random variables, that is to say, the distance traveled by the random walk in
the time interval [kj−1 , kj ] is independent of the movements during any earlier or later time
interval. Moreover

E[∆i ] = (1 − 2p)(ki+1 − ki ), Var[∆i ] = ki+1 − ki . (5.24)

In particular, E[∆i ] = 0 for a symmetric random walk.

103
Exercise 5.17 (Sol. 18). Let {Mn }n=0,...,N be the symmetric random walk. Let T > 0 and
n ∈ N be given. Define the stochastic process
1
{Wn (t)}t∈[0,T ] , Wn (t) = √ M[nt] , (5.25)
n
where [z] denotes the greatest integer smaller than or equal to z. It is assumed that N > [nT ],
so that Wn (t) is defined for all t ∈ [0, T ]. Compute E[Wn (t)], Var[Wn (t)], Cov[Wn (t), Wn (s)].
Show that Var(Wn (t)) → t and Cov(Wn (t), Wn (s)) → min(s, t) as n → +∞.
Remark 5.4. For large n ∈ N, the process {Wn (t)}t∈[0,T ] can be used as an approximation
for the Brownian motion, see Definition 5.20 below. An example of path of the stochastic
process {Wn (t)}t∈[0,T ] for n = 1000 is shown in Figure 5.1.
Exercise 5.18 (Matlab). Write a Matlab function that generates a random path of the
stochastic process {Wn (t)}t∈[0,T ] .

25

20

15

10

200 400 600 800 1000

-5

-10

Figure 5.1: A path of the stochastic process (5.25) for n = 1000.

Martingales
A martingale is a stochastic process which has no tendency to rise or fall. The precise
definition is the following.
Definition 5.17. A discrete stochastic process {Xn }n∈N on the finite probability space (Ω, P)
is called a martingale if

E[Xn+1 |X0 , X1 , . . . Xn ] = Xn , for all n ∈ N. (5.26)

104
The interpretation is the following: The variables X0 , X1 , . . . Xn contains the information
obtained by “looking” at the stochastic process up to the step n. For a martingale process,
this information is not enough to estimate whether, in the next step, the process will raise
or fall. Note carefully that the martingale property depends on the probability being used:
if {Xn }n∈N is a martingale in the probability P and P
e is another probability measure on the
sample space Ω, then {Xn }n∈N need not be a martingale with respect to P. e

Remark 5.5. Taking the expectation on both sides of (5.26) and using property 4 in
Theorem 5.3 we obtain
E[Xn+1 ] = E[Xn ], for all n ∈ N.
Thus, iterating, E[Xn ] = E[X0 ], for all n ∈ N, i.e., martingales have constant expectation.

Next we show that the symmetric random walk is a martingale. In fact, using the linearity
of the conditional expectation we have, for all n = 0, . . . , N − 1,

E[Mn+1 |M0 , . . . , Mn ] = E[Mn + Xn+1 |M0 , . . . , Mn ]

= E[Mn |M0 , . . . , Mn ] + E[Xn+1 |M0 , . . . , Mn ].

As Mn is measurable with respect to M0 , . . . , Mn , then E[Mn |M0 , . . . , Mn ] = Mn , see

Theorem 5.3(3). Moreover, as Xn+1 is independent of M0 , . . . , Mn , Theorem 5.3(2) gives
E[Xn+1 |M0 , . . . , Mn ] = E[Xn+1 ] = 0. It follows that E[Mn+1 |M0 , . . . , Mn ] = Mn , i.e., the
symmetric random walk is a martingale. However the asymmetric random walk (p 6= 1/2)
is not a martingale, as it follows by the fact that its expectation E[Mn ] = n(2p − 1) is not
constant.
Exercise 5.19. Let {Mn }n=0,...,N be an asymmetric random walk. Show that the process
{Kn }n=0,...,N defined by Kn = Mn − (2p − 1)n is a martingale. The quantity (2p − 1)n is
called the drift of the asymmetric random walk.
Exercise 5.20. Let {Yn }n∈N be predictable from the martingale {Xn }n∈N . Show that {Yn }n∈N
is also a martingale. Is the conclusion still true if {Yn }n∈N is just measurable with respect to
{Xn }n∈N ?

5.2 Applications to the binomial model

In this section we reformulate the binomial options pricing model using the language of
probability theory. We first show that the binomial stock price can be interpreted as a
stochastic process defined on the N -coin toss probability space (ΩN , Pp ), see Definition 5.2.
Recall that, for a given 0 < p < 1, the binomial stock price at time t = 0 is given by the
deterministic constant S(0) = S0 > 0, while at future times we have

S(t − 1)eu with probability p
S(t) = , t ∈ I = {1, . . . , N }, (5.27)
S(t − 1)ed with probability 1 − p,

105
where u > d. Now, for t ∈ I, consider the random variable

1, if the tth toss in ω is H
Xt : ΩN → R, Xt (ω) = .
−1, if the tth toss in ω is T

From (5.27) we have

u+d u−d u+d u−d

S(t) = S(t − 1) exp( + Xt ) = S(t − 2) exp(2 + (Xt + Xt−1 )
2 2 2 2
u+d u−d
= · · · = S0 exp(t + Mt ) : ΩN → R, (5.28)
2 2
where Mt = X1 + · · · + Xt . Thus S(t) is a random variable and therefore {S(t)}t=0,...,N
is a N -period stochastic process. For each ω ∈ ΩN , the vector (S(0, ω), . . . , S(N, ω)) is a
path for the stock price. Letting M0 = 0 we obtain that {Mt }t=0,...,N is a random walk and
{S(t)}t=0,...,N is measurable, but not predictable, with respect to {Mt }t=0,...,N .
The value at time t of the risk-free asset is the deterministic function of time B(t) =
B0 exp(rt), where r is the (constant) risk-free rate of the money market and B0 = B(0) > 0
is the initial value of the risk-free asset. Recall that S ∗ (t) = e−rt S(t) is called the discounted
price of the stock, see Remark 2.4.

Theorem 5.4. If r ∈ / (d, u), there is no probability measure Pp on the sample space ΩN
such that the discounted stock price process {S ∗ (t)}t=0,...,N is a martingale. For r ∈ (d, u),
{S ∗ (t)}t=0,...,N is a martingale with respect to the probability measure Pp if and only if p = q,
where
er − ed
q= u .
e − ed

Proof. By definition, {S ∗ (t)}t=0,...,N is a martingale if and only if

Ep [e−rt S(t)|S ∗ (0), . . . , S ∗ (t − 1)] = e−r(t−1) S(t − 1), for all t ∈ I.

As r is constant, taking the expectation conditional to S ∗ (0), . . . , S ∗ (t − 1) is the same as

taking the expectation conditional to S(0), . . . , S(t − 1) (in fact, and for the same reason,
we could also remove S(0) from the conditioning variables); hence the above equation is
equivalent to
Ep [S(t)|S(0), . . . , S(t − 1)] = er S(t − 1), for all t ∈ I, (5.29)
where we canceled out a factor e−rt in both sides of the equation. Moreover

S(t)
Ep [S(t)|S(0), . . . , S(t − 1)] = Ep [ S(t − 1)|S(0), . . . , S(t − 1)]
S(t − 1)
S(t)
= S(t − 1)Ep [ |S(0), . . . , S(t − 1)],
S(t − 1)

106
where we used that S(t − 1) is measurable with respect to the conditioning variables and
thus it can be taken out from the conditional expectation (see property 5 in Theorem 5.3).
As  u
e with prob. p
S(t)/S(t − 1) =
ed with prob. 1 − p
is independent of S(0), . . . , S(t − 1), then by Theorem 5.3(2) we have

S(t) S(t)
Ep [ |S(0), . . . , S(t − 1)] = Ep [ ] = eu p + ed (1 − p).
S(t − 1) S(t − 1)

Hence (5.29) holds if and only if eu p + ed (1 − p) = er . Solving in p we find p = q. Moreover

q ∈ (0, 1) holds if and only if r ∈ (d, u).

Remark 5.6. Due to Theorem 5.4, Pq is called martingale probability measure. More-
over we can reformulate Theorem 2.3 as follows: a binomial market is free of self-financing
arbitrages if and only if there exists a martingale probability measure.

Since martingales have constant expectation (see Remark 5.5), we obtain the important
result Eq [S ∗ (t)] = E[S ∗ (0)], or equivalently,

Eq [S(t)] = S0 ert . (5.30)

Thus in the martingale probability measure one expects the same return on the stock as on
the risk-free asset. For this reason, Pq is also called risk-neutral probability. However,
as shown in the following exercise, the situation is very different in the physical (real-world)
probability.

Exercise 5.21 (Sol. 19). Let Ep [·] denote the expectation in the probability measure Pp . Show
that
Ep [S(N )] = S(0)(eu p + ed (1 − p))N .
Compute also Varp [S(N )].

The value of a portfolio position (hS , hB ) invested on hS shares of the stock and hB shares
of the risk-free asset is the stochastic process {V (t)}t=0,...,N given by

V (t) = hB B(t) + hS S(t) : ΩN → R, t = 0, . . . , N.

Note that V (0) = hS S0 + hB B0 is a deterministic constant. If we change the portfo-

lio position depending on the price of the stock (i.e., depending on ω ∈ ΩN ), then we
get a portfolio (stochastic) process {(hS (t), hB (t))}t=0,...,N . We recall that (hS (t), hB (t))
corresponds to the portfolio position held in the interval (t − 1, t] and, by convention,
(hS (0), hB (0)) = (hS (1), hB (1)). The portfolio process is predictable if hS (t), hB (t) is a
deterministic function of S(0), . . . , S(t − 1) (see Exercise 2.3), which means that the stochas-
tic process {hS (t), hB (t)}t=0,...,N is predictable from the stochastic process {S(t)}t=0,...,N in

107
the sense of Definition 5.16. The value {V (t)}t=0,...,N of the portfolio process is the stochastic
process given by
V (t) = hB (t)B(t) + hS (t)S(t) : ΩN → R, t = 0, . . . , N. (5.31)
A portfolio process {(hS (t), hB (t))}t=0,...,N is said to be self-financing if
V (t − 1) = hB (t)B(t − 1) + hS (t)S(t − 1), t ∈ I. (5.32)
In Theorem 2.1 we have shown that the value at time t = 0 of self-financing processes is
determined by the value at time N through the formula (2.13). This result can be written
in terms of the expectation in the martingale probability measure as
V (0) = e−rN Eq [V (N )]. (5.33)
Now, let Y : ΩN → R be a random variable and consider the European derivative with pay-
off Y at time of maturity T = N . The binomial price of this derivative at time t = 0 equals
the value at time t = 0 of any self-financing hedging portfolio. Hence replacing V (N ) = Y
in (5.33) we obtain the following fundamental result.
Theorem 5.5. The binomial price at time t = 0 of the European derivative with pay-off Y
at maturity T = N satisfies
ΠY (0) = e−rN Eq [Y ], (5.34)
or equivalently ΠY (0) = Eq [Y ∗ ], where Y ∗ is the discounted value of the pay-off.

Equation (5.34) is known as risk-neutral pricing formula (at time t = 0) and it is the
cornerstone of options pricing theory. It holds not only for the binomial model but for any
discrete—or even continuum—pricing model for financial derivatives (see Chapter 6 for the
definition of risk-neutral pricing formula in the time-continuum Black-Scholes model). It is
used for standard as well as non-standard European derivatives and offers a very intuitive
interpretation for the fair price of the derivative. In fact, according to (5.34), the current
(at time t = 0) fair value of the derivative is our expectation on the future payment of the
derivative (the pay-off) expressed in terms of the future value of money (discounted pay-
off). The expectation has to be taken with respect to the martingale probability measure, i.e.,
ignoring any (subjective or illegal2 ) estimate on future movements of the stock price (except
for the loss in value due to the time-devaluation of money).
Exercise 5.22 (Put-call parity for Asian options. Sol. 20). Consider a N -period bino-
mial market with r 6= 0 and let S(t) denote the price of the stock at time t ∈ {0, . . . , N }.
The Asian call, resp. put, with maturity T = N and strike K is the non-standard European
style derivative with pay-off
" N
# " N
#
 1 X   1 X 
Ycall = S(t) − K , resp. Yput = K − S(t) .
N + 1 t=0 N + 1 t=0
+ +
2
Trading in the market using privileged information is a crime (insider trading).

108
Denote by AC(0) and AP (0) the binomial price at time t = 0 of the Asian call and put,
respectively. Prove the following put-call parity identity:
h S(0) er(N +1) − 1 i
AC(0) − AP (0) = e−rN − K .
N + 1 er − 1
1−αN +1
PN
HINT: For α 6= 1, k=0 αk = 1−α
.

The risk-neutral pricing formula (5.34) can be generalized to future times t > 0. For this
purpose we need the following result.

Theorem 5.6 (*). Let {(hS (t), hB (t))}t=0,...,N be a self-financing predictable portfolio process
with value {V (t)}t=0,...,N . The discounted portfolio value {V ∗ (t)}t=0,...,N is a martingale in
the risk-neutral probability. Moreover the following identity holds:

V ∗ (t) = Eq [V ∗ (N )|S(0), . . . , S(t)], t = 0, . . . , N. (5.35)

Proof. The martingale claim is

Eq [V ∗ (t)|V ∗ (0), . . . , V ∗ (t − 1)] = V ∗ (t − 1).

We now show that this follows by

Eq [V ∗ (t)|S(0), . . . , S(t − 1)] = V ∗ (t − 1). (5.36)

In fact, by (5.36),

V ∗ (t − 1) = Eq [V ∗ (t − 1)|V ∗ (0), . . . , V ∗ (t − 1)]

= Eq Eq [V ∗ (t)|S(0), . . . , S(t − 1)]|V ∗ (0), . . . , V ∗ (t − 1)
 

= Eq [V ∗ (t)|V ∗ (0), . . . , V ∗ (t − 1)];

here we have used property 3 of Theorem 5.3 in the first step and property 6 in the last step.
The latter is possible because V ∗ (t) is measurable with respect to S(0), . . . , S(t) (being the
portfolio process predictable). Now we claim that (5.36) also implies the formula (5.35). We
argue by backward induction. Letting t = N in (5.36) we see that (5.35) holds at t = N − 1.
Assume now that (5.35) holds at time t + 1, i.e.,

V ∗ (t + 1) = Eq [V ∗ (N )|S(0), . . . , S(t + 1)].

Taking the conditional expectation with respect to S(0), . . . , S(t) in the risk-neutral proba-
bility we have, by (5.36),
h i
V ∗ (t) = Eq [V ∗ (t + 1)|S(0), . . . , S(t)] = Eq Eq [V ∗ (N )|S(0), . . . , S(t + 1)]|S(0), . . . , S(t)
= Eq [V ∗ (N )|S(0), . . . , S(t)].

109
Thus (5.36) ⇒ (5.35), as claimed. Hence the proof of the theorem is completed if we show
that (5.36) holds. As B(t) = B(t − 1)er , (5.32) gives
hB (t)B(t) = er V (t − 1) − hS (t)S(t − 1)er .
Replacing in (5.31) we find
V (t) = er V (t − 1) + hS (t)[S(t) − S(t − 1)er ].
Taking the conditional expectation in the risk-neutral probability with respect to the random
variables S(0), . . . , S(t − 1) we obtain
Eq [V (t)|S(0), . . . S(t − 1)] = er Eq [V (t − 1)|S(0), . . . , S(t − 1)]
+ Eq [hS (t)(S(t) − S(t − 1)er )|S(0), . . . , S(t − 1)]. (5.37)
As V (t − 1) and hS (t) are measurable with respect to the conditioning variables we have
Eq [V (t − 1)|S(0), . . . , S(t − 1)] = V (t − 1), as well as
Eq [hS (t)(S(t) − S(t − 1)er )|S(0), . . . , S(t − 1)]
= hS (t)Eq [S(t) − S(t − 1)er |S(0), . . . , S(t − 1)]
 
= hS (t) Eq [S(t)|S(1), . . . , S(t − 1)] − S(t − 1)er = 0,
where in the last step we used that {S ∗ (t)}t=0,...,N is a martingale in the risk-neutral proba-
bility. Going back to (5.37) we obtain
Eq [V (t)|S(0), . . . S(t − 1)] = er V (t − 1),
which is the same as (5.36). This concludes the proof of the theorem.
Remark 5.7. We can use the martingale property of {V ∗ (t)}t=0,...,N to give a simple proof
that the existence of a risk-neutral probability implies the absence of self-financing arbitrage
portfolios in the market. In fact, assume that {hS (t), hB (t)}t=0,...,N is an arbitrage (see
Definition 2.7). Then V ∗ (0) = 0 and since martingales have constant expectation then
Eq [V ∗ (t)] = 0, for all t = 0, 1 . . . , N . But V ∗ (N ) ≥ 0, hence by Theorem 5.2(2) it must be
V ∗ (N, x) = 0 along any path x ∈ {u, d}N . Thus the portfolio is not an arbitrage.

By definition, the binomial price at time t = 0, . . . , N of the European derivative with pay-off
Y and maturity T = N equals the value V (t) of self-financing, hedging portfolios. Using the
hedging condition V (N ) = Y and (5.35), we obtain the following generalization of (5.34).
Theorem 5.7. The binomial price at time t of the European derivative with pay-off Y at
maturity T = N satisfies
ΠY (t) = e−r(N −t) Eq [Y |S(0), . . . , S(t)], t = 0, . . . , N. (5.38)
Exercise 5.23 (Sol. 21). Use (5.38) to show the discounted binomial price {Π∗Y (t)}t=0,...,N
of European derivatives is a martingale in the risk-neutral probability measure and to give an
alternative proof of the recurrence formula (3.8). Next consider the augmented binomial mar-
ket consisting of the stock, the risk-free asset and a European derivative on the stock priced
by the risk-neutral pricing formula (5.38). Use the martingale property of {S ∗ (t)}t=0,...,N and
{Π∗Y (t)}t=0,...,N to show that this market does not admit self-financing arbitrages.

110
Probability distribution of the binomial stock price (*)
Let us now derive the distribution of the binomial stock price S(t), t ∈ I. First we notice
that the image of S(t) is Im S(t) = {s0 , . . . , st }, where

sj = S(0) exp(ju + (t − j)d), j = 0, . . . , t.

Hence fS(t) (x) = 0 if x 6= sj , for all j = 0, . . . , t and t ∈ I. The value of S(t) is sj if there
are exactly j heads in the first t tosses of the N -toss, which shows that fS(t) is given by
 
t k
fS(t) (sj ) = Pp [S(t) = sj ] = p (1 − p)t−j = φt,p (j), j = 0, . . . , t, t ∈ I, (5.39)
j

see Definition 5.7. In particular, in the case of a fair coin p = 1/2, we have
 
t 1
fS(t) (x) = δ(x − S(0) exp(ju + (t − j)d)) (fair coin),
j 2t

where δ(z) = 1 if z = 0 and δ(z) = 0 for z 6= 0. It is convenient to express this result

in terms of the log-price of the stock log S(t), as this can take both positive and negative
values. For a fair coin we get
 
t 1
flog(S(t)/S(0)) (x) = δ(x − (ju + (t − j)d). (5.40)
j 2t

An example of this distribution is depicted in Figure 5.2. For large values of N ∈ N, the
profile of the distribution of log(S(N )/S(0)) = log S(N ) − log S(0) approaches the profile
of a normal distribution, i.e., a distribution of the form (5.47) below3 . One of the main
critics to the binomial model is that it assigns very low probabilities to large variations of
the (log-)stock price.
The binomial distribution can be used to compute the probability that the price of the stock
lies in an interval [a, b] at time t. By (5.8) we have
X X t
P(a ≤ S(t) ≤ b) = fS(T ) (sj ) = pj (1 − p)t−j j = 0, . . . , t, t ∈ I. (5.41)
j:a≤s ≤b j:a≤s ≤b
j
j j

Moreover if g : R → R then, by (5.9),

 
X X t j
P(a ≤ g(S(t)) ≤ b) = fS(T ) (sj ) = p (1 − p)t−j j = 0, . . . , t, t ∈ I.
j
j:a≤g(sj )≤b j:a≤g(sj )≤b
(5.42)
3
A rigorous proof of the fact that the distribution of log S(N )/S(0) converges to a normal distribution in
the time-continuum limit is given in Theorem 6.9.

111
The formula (5.42) can be used to compute the (physical) probability that a derivative on
the stock is in the money at time t. Consider the standard European or American derivative
with pay-off Y = g(S(N )) at the expiration date T = N . Then the probability that the
derivative is in the money at time t is given by
X t
P(Y (t) > 0) = P(g(S(t)) > 0) = pj (1 − p)t−j .
j
j:g(sj )>0

These formulas can be easily implemented with Matlab.

Exercise 5.24 (Matlab). Write a Matlab function ProbInTheMoney(S,t,g,p) which com-
putes the physical probability that a standard derivative with pay-off function g is in the money
at time t. Here S is the matrix of stock prices, computed with the function BinomialStock
in Section 2.4.

f S HN L HxL

0.08

0.06

0.04

0.02

x
-100 -50 50 100

Figure 5.2: The distribution of log(S(N )). It is assumed S(0) = 1, u = −d = 1, p = 1/2

and N = 100.
Consider now the standard European derivative with pay-off Y = g(S(N )) at maturity
T = N . Using the binomial distribution (5.39) of S(N ) in (5.34) and Theorem 5.2(3) we
can write the risk-neutral price ΠY (0) of the derivative at time t = 0 as
X X
ΠY (0) = e−rN E[g(S(N ))] = e−rN g(x)fS(N ) (x) = e−rN g(sj )φN,q (j), (5.43)
x∈Im(S(N )) j:g(sj )6=0

112
where we recall that Im(S(N )) = {s0 , . . . , sN }, sj = S0 exp(ju + (N − j)d). For some simple
derivatives the formula (5.43) can be written as a neat closed expression in terms of the
binomial cumulative distribution, as shown in the following exercise.
Exercise 5.25 (Sol. 22). Show that for the European put option with strike K and maturity
T , the risk-neutral binomial price at time t = 0 can be written as

ΠY (0) = Ke−rN ΦN,q (γ) − S(0)ΦN,q∗ (γ), (5.44)

S0
log +N d
where ΦN,p (x) is the cumulative binomial distribution (5.7), γ = − u−d K
and q∗ = eu−r q ∈
(0, 1). Remark: the property q∗ ∈ (0, 1) follows at once by the definition of q and the inequality
u > r.
Exercise 5.26. Derive the analog of (5.44) for European call and digital options.

5.3 Infinite Probability Spaces

In this last section we consider briefly probability spaces consisting of an infinite number of
sample points. Assume first that Ω is a countable set. This means that

Ω = {ωn }n∈N .

For countable sample spaces the definitions given in Section 5.1 for finite sets extend straight-
forwardly. Precisely, given a sequence
X
p = (pn )n∈N such that 0 < pn < 1, pn = 1,
n∈N

we define the probability of the atomic events as

P({ωn }) = pn .

If A ∈ 2Ω , then we define X X
P(A) = pi = P({ω}).
i:ωi ∈A ω∈A

If X : Ω → R is a random variable, then

X X
E[X] = X(ωn )pn = X(ω)P({ω}).
n∈N ω∈Ω

The remaining definitions introduced in the finite case (variance, covariance, independent
random variables, etc.) continue to be valid for countable probability spaces.
In the rest of this section we assume that Ω is uncountable (e.g., Ω = R). In this case there
is no general procedure to construct a probability space, but only an abstract definition. In

113
particular a probability measure P on events A ⊆ Ω is defined only axiomatically by requiring
that 0 ≤ P(A) ≤ 1, P(Ω) = 1 and that, for any sequence of disjoint events A1 , A2 , . . . , it
should hold
P(A1 ∪ A2 ∪ . . . ) = P(A1 ) + P(A2 ) + . . .
Moreover it is not necessary—and almost never convenient—to assume that P is defined for
all events A ⊂ Ω. We denote by F the set of events (i.e., subsets of Ω) which have a well
defined probability satisfying the properties above.
Example. Let Ω = R. We say that A ⊆ R is a regular set if it can be written as the union
of countably many intervals. Let F be the collection of all regular sets. Let p : R → R be a
continuous non-negative function such that
Z
p(x) dx = 1.
R

Then P : F → [0, 1] given by Z

P(A) = p(x) dx (5.45)
A
defines a probability. If X : R → R is a random variables, the expectation of X in the
probability measure (5.45) is given by
Z
E[X] = X(x)p(x) dx, (5.46)
R

provided the integral converges.

Fortunately for most applications (and in particular for those in financial mathematics) the
knowledge of the full probability space is usually not necessary, as in the applications one
is typically concerned only with random variables and their distributions, rather than with
generic events. More precisely, we are only interested in assigning a probability to events of
the form {X ∈ I}, where X is a random variable on the (abstract) probability space and
I ⊂ R, that is to say, events which can be resolved by one (or more) random variables.
Remark 5.8. Even though Ω is uncountable, the image of X : Ω → R need not be
uncountable (e.g., X could be piecewise constant). To avoid technical complications we
assume in the following that Im(X) does not contain isolated points. We shall refer to these
random variables as continuum random variables. The only case of non-continuum
random variable that we allow in this section is when X is a deterministic constant, in which
case the image of X consists of one real number only.

The probability P(X ∈ I) can be computed explicitly when X has a density.

Definition 5.18. Let fX : R → [0, ∞) be a continuous function, except possibly on finitely
many points. A random variable X : Ω → R is said to have probability density fX if
Z
P(X ∈ A) = fX (x) dx,
A

for all regular sets A ⊆ R.

114
Note that if X has a probability density in the sense of the previous definition, then it is not
a deterministic constant. Moreover the density fX satisfies
Z
fX (x) dx = 1
R

and the cumulative distribution FX (x) = P(X ≤ x) satisfies

Z x
dFX
FX (x) = fX (y) dy, for all x ∈ R, hence fX = .
−∞ dx

Examples

• A random variable X : Ω → R is said to be a normal random variable with mean

m ∈ R and variance σ 2 > 0 if it admits the density

|x − m|2
 
1
fX (x) = √ exp − . (5.47)
2πσ 2 2σ 2

We denote N (m, σ 2 ) the set of all such random variables. A variable X ∈ N (0, 1)
is called a standard normal random variable. The cumulative distribution of
standard normal random variables is denoted by Φ(x) and is called the standard
normal distribution, i.e.,
Z x
1 1 2
Φ(x) = √ e− 2 y dy.
2π −∞

Moreover we denote by φ(x) the standard normal (probability) density, that is

1 x2
φ(x) = Φ0 (x) = √ e− 2 .
2π

• A random variable X : Ω → R is said to be an exponential random variable with

intensity λ > 0 if  −λx
λe x ≥ 0,
fX (x) =
0 x < 0.
We denote E(λ) the set of all exponential random variables with intensity λ.

The following theorem, which we give without proof, shows that the probability density,
when it exists, provides all the relevant statistical information on a random variable.

Theorem 5.8. The following holds for all sufficiently regular4 functions g : R → R:
4
In particular, for all functions g such that the integrals in the theorem are well-defined.

115
 (i) Let X : Ω → R be a random variable with density fX . Then for all regular sets A ⊆ R,
Z
P(g(X) ∈ A) = fX (x) dx,
x:g(x)∈A

which extends (5.9) to general probability spaces.

(ii) Let X : Ω → R be a random variable with density fX . Then
Z
E[g(X)] = g(y)fX (y) dy,
R

which extends (5.14) to general probability spaces.

Moreover the properties 1,2,3 in Theorem 5.2 still hold for continuum random variables.

As an example of application of (i), suppose X ∈ N (0, 1). Then

Z 1
1 x2
2
P(X ≤ 1) = √ e− 2 dx ≈ 0.683,
2π −1
that is to say, a standard normal random variable has about 68,3% probability to take value
on the interval (−1, 1).
By (ii) in Theorem 5.8, the expectation and the variance of a continuum random variable X
with density fX are given by
Z Z Z 2
2 2 2
E[X] = xfX (x) dx, Var[X] = E[X ] − E[X] = x fX (x) dx − xfX (x) dx .
R R R
(5.48)
These formulas generalize (5.12) and (5.17) to continuum random variables which admit a
density distribution. In particular, for normal variables we obtain

X ∈ N (m, σ 2 ) =⇒ E[X] = m, Var[X] = σ 2 . (5.49)

Exercise 5.27. Prove (5.49). Compute the expectation and the variance of exponential
random variables.

Joint probability density (*)

Definition 5.19. Two random variables X, Y : Ω → R are said to have the joint proba-
bility density fX,Y : R2 → [0, ∞), if
Z Z
P(X ∈ A, Y ∈ B) = fX,Y (x, y) dx dy,
A B

for all regular sets A, B ⊆ R.

116
Note that if fX,Y is a joint probability density, then
Z Z
fX,Y (x, y) dx dy = 1.
R R

Moreover if we define the joint cumulative distribution as FX,Y (x, y) = P(X ≤ x, Y ≤ y)

then
fX,Y (x, y) = ∂x ∂y FX,Y (x, y).
Exercise 5.28. Assume that X, Y have the joint density fX,Y (x, y). Show that X, Y admit
the densities Z Z
fX (x) = fX,Y (x, y) dy, fY (y) = fX,Y (x, y) dx.
R R

Example: Jointly normally distributed random variables. Let m ∈ R2 and C =

(Cij )i,j=1,2 be a symmetric, positive definite 2×2 matrix. Two random variables X1 , X2 :
Ω → R are said to be jointly normally distributed with mean m and covariance matrix C
if they admit the joint density
 
1 1 −1
fX1 ,X2 (x) = p exp − (x − m)C (x − m) , for all x = (x1 , x2 ) ∈ R2 .
2
(2π) det C 2
(5.50)
The following theorem generalizes Theorem 5.8 in the presence of two variables.
Theorem 5.9. Let X, Y : Ω → R be random variables with joint density fX and g : R2 → R.

(i) For all regular sets A ⊆ R there holds

Z
P(g(X, Y ) ∈ A) = fX,Y (x, y) dx dy.
(x,y):g(x,y)∈A

(ii) There holds Z

E[g(X, Y )] = g(x, y)fX,Y (x, y) dx dy.
R2

By (ii) of Theorem 5.9, if X1 , X2 have the joint density fX1 ,X2 , then
Cov(X1 , X2 ) = E[X1 X2 ] − E[X1 ]E[X2 ]
Z
= x1 x2 fX1 ,X2 (x1 , x2 ) dx1 dx2
2
RZ Z
− x1 fX1 ,X2 (x1 , x2 ) dx1 dx2 x2 fX1 ,X2 (x1 , x2 ) dx1 dx2 ,
R2 R2

which generalizes (5.22). In particular, if X1 , X2 are jointly normal distributed with mean
m ∈ R2 and covariance matrix C = (Cij )i,j=1,2 , we find
m = (m1 , m2 ), Cij = Cov(Xi , Xj ). (5.51)

117
Exercise 5.29. Prove (5.51).

The following result on the linear combination of independent normal random variables will
play an important role on our discussion in multi-asset options in Section 6.7.

Theorem 5.10. Let X1 , X2 ∈ N (0, 1) be independent and a, b, c, d ∈ R. Then aX1 + bX2 ∈

N (0, a2 + b2 ). Moreover if

Y1 = aX1 + bX2 , Y2 = cX1 + dX2 ,

and if the matrix  

a b
A=
c d
is invertible, then Y1 , Y2 are jointly normally distributed with zero mean and covariant matrix
C = AAT .

If two random variables admit a joint density, one can use the following result to establish
whether the random variables are independent.

Theorem 5.11. The following holds.

(i) If two random variables X, Y admit densities fX , fY and are independent, then they
admit the joint density
fX,Y (x, y) = fX (x)fY (y).

(ii) If two random variables X, Y admit a joint density fX,Y of the form

fX (x, y) = u(x)v(y),

for some functions u, v : R → [0, ∞), then X, Y are independent and admit densities
fX , fY given by
1
fX (x) = cu(x), fY (y) = v(y),
c
where Z Z −1
c= v(x) dx = u(y) dy .
R R

Proof. As to (i) we have

Z Z
P(X ∈ A, Y ∈ B) = P(X ∈ A)P(Y ∈ B) = fX (x) dx fY (y) dy
ZA B

= fX (x)fY (y) dx dy.

A×B

118
To prove (ii), we first write

{X ∈ A} = {X ∈ A} ∩ Ω = {X ∈ A} ∩ {Y ∈ R} = {X ∈ A, Y ∈ R}.

Hence, by definition of joint density,

Z Z ∞ Z Z Z
P(X ∈ A) = fX,Y (x, y) dx dy = u(x) dx v(y) dy = cu(x) dx
A −∞ A R A
R
where c = R v(x) dx. Thus X admits the density fX (x) = c Ru(x). At the same fashion one
proves that Y admits the density fY (y) = c0 v(y), where c0 = R u(y)dy. Since
Z Z Z Z
1= fX,Y (x, y) dx dy = u(x) dx v(y) dy = c0 c,
R R R R

then c0 = 1/c. It remains to prove that X, Y are independent. This follows by

Z Z Z Z
P(X ∈ A, Y ∈ B) = fX,Y (x, y) dx dy = u(x) dx v(y) dy
ZA B Z A
Z B Z
1
= cu(x) dx v(y) dy = fX (x) dx fY (y) dy
A B c A B
= P(X ∈ A)P(Y ∈ B).

Exercise 5.30. Let X ∈ N (0, 1) and Y ∈ E(1) be independent. Compute P(X ≤ Y ).

√
ANSWER: P(X ≤ Y ) = 1/2 + e(1 − Φ(1)) ≈ 76%.

As an application of Theorem 5.11 we now prove the following result.

Theorem 5.12. Let X1 , X2 : Ω → R be normal random variables which are jointly normally
distributed. Then the following properties are equivalent:

(a) X1 , X2 are independent;

(b) X1 , X2 are uncorrelated.

Proof. (a)=⇒(b) is always true, for all random variables. As to the implication (b)=⇒(a),
by (5.51) we have C12 = C21 = 0. Substituting in (5.50) we obtain the fX1 ,X2 has the form
fX1,X2 (x1 , x2 ) = u(x1 )v(x2 ), and so the claim follows by (ii) of Theorem 5.9.

119
Central limit theorem (*)
The normal distribution is certainly the most important random variable distribution used
in finance (and in many other applications of probability theory). This is due in part to
historical reasons, but also to the following fundamental result.

Theorem 5.13 (Central Limit Theorem). Let {Xn }n∈N be a sequence of independent
and identically distributed random variables with E[Xi ] = 0 and Var[Xi ] = 1. Let Sn be the
sample average of the first n random variables, i.e.,
1
Sn = (X1 + X2 + · · · + Xn ).
n
√
Then, as n → ∞, nSn converges in distribution to a standard normal random variable,
that is Z x
1 1 2
√
lim F nSn (x) = √ e− 2 y dy, for all x ∈ R.
n→∞ 2π −∞

For example, Theorem 5.13 applied to the symmetric

√ random walk {Mn }n∈N implies that
in the limit n → +∞, the random variable Mn / n converges in distribution to a standard
normal random variable. The proof of the Central Limit Theorem can be found in any
textbook in probability theory (e.g., [5]).

Exercise 5.31. Prove the following. Let {Xn }n∈N be a sequence of i.i.d. random variables
Var[Xi ] = σ 2 . Let Sn be the sample average of the first n random
with E[Xi ] = µ and √
variables. Then σ −1 n(Sn − µ) converges in distribution to a standard normal random
variable. HINT: make a change of variables and apply Theorem 5.13.

Stochastic processes. Martingales

Let Ω be an uncountable sample space. A stochastic process is a one parameter family
{X(t)}t≥0 of (continuum) random variables X(t) : Ω → R. We denote X(t, ω) = X(t)(ω).
The parameter t is referred to as the time variable, since this is what it represents in the
applications that we have in mind. For each ω ∈ Ω fixed, the function t → X(t, ω) is called
a path of the stochastic process. If the paths are all the same for all ω ∈ Ω, then we say that
X(t) is a deterministic function of time.
As it is clear from the discussion in Section 5.2, martingale stochastic processes play a
fundamental role in options pricing theory5 . To define this concept for stochastic processes
on uncountable sample spaces, let FX (t) denote the information accumulated by “looking”
at the stochastic process up to time t, i.e., the collection of events resolved by X(s) for
0 ≤ s ≤ t. Intuitively, the stochastic process {X(t)}t≥0 is a martingale if, based on the
information contained in FX (s), our “best estimate” on X(t) for t > s is X(s), i.e., we
5
In fact, this theory is also called martingale pricing theory in some literature.

120
are not able to estimate whether the process will raise or fall in the interval [s, t] with the
information available at time s. This intuitive definition is encoded in the formula

E[X(t)|FX (s)] = X(s), 0 ≤ s ≤ t, (5.52)

which generalizes the definition (5.26) of martingales in finite probability theory. The left
hand side of (5.52) is the conditional expectation of X(t) with respect to the information
FX (s), whose precise definition, which we do not need, can be found for instance in [11] . It
can be shown that (5.52) implies that martingales have constant expectation.

Brownian motion
Next we define the most important of all stochastic processes.
Definition 5.20. A Brownian motion, or Wiener process, is a stochastic process
{W (t)}t≥0 with the following properties:

1. For all 6 ω ∈ Ω, the paths are continuous (i.e., t → W (t, ω) is a continuous function)
and W (0, ω) = 0;

2. For all 0 = t0 < t1 < t2 < . . . , the increments

W (t1 ) = W (t1 ) − W (t0 ), W (t2 ) − W (t1 ), . . . ,

are independent random variables and

E[W (ti+1 ) − W (ti )] = 0, Var[W (ti+1 ) − W (ti )] = ti+1 − ti , for all i = 0, 1, . . . ;

3. The increments are normally distributed, that is to say, for all 0 ≤ s < t,
Z
1 y2
P(W (t) − W (s) ∈ A) = p e− 2(t−s) dy,
2π(t − s) A

for all regular sets A ⊆ R.

It can be shown that Brownian motions exist, yet a formal construction is technically quite
difficult and beyond the purpose of this text. One particular way to construct a Brownian
motion is suggested in Exercise 5.17, namely by running a properly rescaled symmetric
random walk for infinitely many steps. In fact it is useful to think of Brownian motions as
time-continuum generalizations of the symmetric random walk. To this regard we observe
that the increments of a symmetric random walk also satisfy the independence property 2 in
Definition 5.20, see Remark 5.3. The fact that in the time-continuum limit they are normally
distributed follows by the Central Limit Theorem.
6
More precisely, for all ω ∈ Ω up to a set of zero probability.

121
Exercise 5.32 (Sol. 23). Let {W (t)}t≥0 be a Brownian motion. Show that
Cov[W (s), W (t)] = min(s, t), for all s, t ≥ 0.
(Compare this with Exercise 5.17.)
Remark 5.9. Since the definition of Brownian motion depends on the probability measure P,
then a stochastic process {W (t)}t≥0 which is a Brownian motion in the probability measure
P will in general not be a Brownian motion in another probability measure P. e When we
want to emphasize that {W (t)}t≥0 is a Brownian motion in the probability measure P, we
shall say that {W (t)}t≥0 is a P-Brownian motion.
Remark 5.10. Letting s = 0 in property 3 in Definition 5.20 we obtain that W (t) ∈ N (0, t),
for all t > 0. In particular, W (t) has zero expectation for all times. It can also be shown
that Brownian motions are martingales.

The following result is used in some exercises in the next chapter.

RT 3
Theorem 5.14. Let {W (t)}t≥0 be a P-Brownian motion. Then 0 W (t) dt ∈ N (0, T3 ) in
the probability P.
RT RT 3
Exercise 5.33. Show that E[ 0 W (t) dt] = 0 and Var[ 0 W (t) dt] = T3 , as claimed in
RT
Theorem 5.14. (The proof that 0 W (t) dt is normally distributed can be found for instance
in [11].)

Equivalent probability measures. Girsanov theorem

One further technical complication arising for uncountable sample spaces is the existence of
non-trivial events with zero measure, e.g., the event {W (t) = 0} that the Brownian motion
W (t) takes value zero when t > 0. We shall need to consider the concept of equivalent
probability measures:
e on the events A ∈ F are said to be equivalent
Definition 5.21. Two probability measure P, P
if P(A) = 0 ⇔ P(A)
e = 0.

Hence equivalent probability measures agree on which events are impossible. Note that in a
finite probability space all probability measures are equivalent, as in the finite case the empty
set is the only event with zero probability. The following important theorem characterizes
the relation between equivalent probability measures on uncountable sample spaces and is
known as the Radon-Nikodým theorem.
Theorem 5.15 (Radon-Nikodým theorem). Let P, P e : F → [0, 1] be two probability measures
and denote by E[·], E[·]
e the expectation in these measures. Then P and P e are equivalent if
and only if there exists a random variable Z : Ω → R such that Z > 0 (with probability 1),
E[Z] = 1 and P(A)
e = E[ZIA ]. Moreover if P and Pe are equivalent then E[X]
e = E[ZX], for
all random variables X : Ω → R.

122
For example, assume Ω = R and that P and P
e are defined as in (5.45), namely
Z Z
P(A) = p(x) dx, P(A)
e = pe(x) dx,
A A

where p(x), pe(x) are two continuous non-negative functions such that
Z Z
p(x) dx = pe(x) = 1.
R R

Then, according to Theorem 5.15 and (5.46), P and P e are equivalent if and only if there
exists a function Z : R → R such that Z > 0,
Z
Z(x)p(x) dx = 1
R

and Z Z Z
P(A)
e = pe(x) dx = Z(x)IA (x)p(x) dx = Z(x)p(x) dx.
A R A
R R
As the equality A pe(x) dx = A Z(x)p(x) dx has to be satisfied for all regular sets A ⊂ R,
then pe(x) = Z(x)p(x) (for almost all x ∈ R).

Theorem 5.16 (and Definition). Let {W (t)}t≥0 be a P-Brownian motion. Given θ ∈ R

and T > 0 define
1 2
Zθ = e−θW (T )− 2 θ T . (5.53)
Then Pθ (A) = E[Zθ IA ] defines a probability measure equivalent to P, which is called Gir-
sanov’s probability with parameter θ ∈ R. Moreover Pθ is of the form (5.45), explicitly
Z
1 (x+θT )2
Pθ (A) = pθ (x) dx, pθ (x) = √ e− 2T , A ∈ F.
A 2πT

Proof. The proof follows immediately from Theorem 5.15, since the random variable (5.53)
satisfies Zθ > 0 and
x2
e− 2T
Z
−θW (T )− 21 θ2 T −θx− 12 θ2 T
E[Zθ ] = E[e ]= e √ dx = 1,
R 2πT
where we used the density of the normal random variable W (T ) ∈ N (0, T ) to compute the
expectation of Zθ in the probability measure P (see Theorem 5.8(ii)). Moreover
x2
e− 2T
Z Z
−θx− 21 θ2 T
Pθ (A) = E[Zθ IA ] = e √ dx = pθ (x) dx.
A 2πT A

123
Note that the Girsanov probability measure Pθ depend also on T , but this is not reflected in
our notation. In the following we denote by Eθ [·] the expectation computed in the probability
measure Pθ for θ 6= 0. When θ = 0 then Pθ = P, in which case the expectation is denoted
as usual by E[·]. By Theorem 5.15 we have Eθ [X] = E[Zθ X], for all random variables
X : Ω → R.

Exercise 5.34 (Sol. 24). Show that Eθ [W (t)] = −θt.

It follows by Exercise 5.34 that {W (t)}t≥0 is not a Pθ -Brownian motion, since Brownian
motions, by definition, have zero expectation at any time. Now we can state a fundamen-
tal theorem in probability theory with deep applications in financial mathematics, namely
Girsanov’s theorem7 .

Theorem 5.17. Let {W (t)}t≥0 be a P-Brownian motion. Given θ ∈ R and T > 0, let Pθ be
the Girsanov probability measure with parameter θ introduced in Theorem 5.16. Define the
stochastic process {W (θ) (t)}t≥0 by

W (θ) (t) = W (t) + θt. (5.54)

Then {W (θ) (t)}t≥0 is a Pθ -Brownian motion.

Note carefully that {W (θ) (t)}t≥0 is not a P-Brownian motion, as it follows by the fact that
E[W (θ) (t)] = θt. In particular, according to the probability measure P, the stochastic process
{W (θ) (t)}t≥0 has a drift, i.e., a tendency to move up (if θ > 0) or down (if θ < 0). However
in the Girsanov probability this drift is removed, because Eθ [W (θ) (t)] = Eθ [W (t)] + θt = 0,
see Exercise 5.34.

Multi-dimensional Girsanov theorem (*)

We conclude this chapter with a generalization of Girsanov’s theorem in the presence of
two independent Brownian motions. This generalization is important for the discussion of
multi-asset options in Section 6.7. We limit ourselves to state without proof the analogs of
Theorems 5.16 and 5.17 required for this purpose.

Theorem 5.18 (and Definition). Let {W1 (t)}t≥0 , {W2 (t)}t≥0 be P-independent Brownian
motions. Given θ = (θ1 , θ2 ) ∈ R2 and T > 0 define
1 2 2
Zθ = e−θ1 W1 (T )−θ2 W2 (T )− 2 (θ1 +θ2 )T . (5.55)

Then Pθ (A) = E[Zθ IA ] defines a probability measure equivalent to P, which is called Gir-
sanov’s probability with parameters θ1 , θ2 ∈ R.

7
Actually we consider only a special case of this theorem, which suffices for our purposes.

124
Theorem 5.19. Let {W1 (t)}t≥0 , {W2 (t)}t≥0 be P-independent Brownian motions. Given
θ = (θ1 , θ2 ) ∈ R2 and T > 0, let Pθ be the Girsanov probability with parameters θ1 , θ2
(θ) (θ)
introduced in Theorem 5.18. Define the stochastic processes {W1 (t)}t≥0 , {W2 (t)}t≥0 by
(θ) (θ)
W1 (t) = W1 (t) + θ1 t, W2 (t) = W2 (t) + θ2 t (5.56)
(θ) (θ)
Then {W1 (t)}t≥0 , {W2 (t)}t≥0 are Pθ -independent Brownian motions.

Exercise 5.35. Prove Theorem 5.18.

5.4 Further exercises

In the following exercises the focus is on computing the return of portfolio processes con-
taining European or American derivatives.

Exercise 5.36 (Sol. 25). Consider a 2-period binomial model with the parameters u =
log(4/3), d = log(2/3), r = log(7/6), S(0) = 27, p ∈ (0, 1). Compute the price at time t ∈
{0, 1, 2} of the American put on the stock with maturity T = 2 and strike price K2 = 115
and
identify the possible optimal exercise times prior to maturity. Next consider the compound
option which gives to its owner the right to buy the American put at time t = 1 for the price
8
K1 = 25 . Compute the price of the compound option at time t = 0 and the hedging portfolio
for the compound option (assume B(0) = 1). Compute the maximum expected return in the
interval t ∈ [0, 2] for the owner of the compound option as a function of p ∈ (0, 1).

Exercise 5.37. Consider a portfolio that is long 1 share of the American put option in
Section 4.2. Assume p = 1/2 and compute the expected relative return of the portfolio.
ANSWER: E[R] = 17/648.

Exercise 5.38. Repeat the previous exercise for the compound option in Exercise 3.3.
ANSWER: E[R] = 77/16.

125
Chapter 6

Black-Scholes options pricing theory

This chapter is concerned with the most famous of all models in options pricing theory,
namely the Black-Scholes model, which first appeared in the seminal paper [1]. We introduce
the Black-Scholes price of European derivatives in two different ways. The first strategy is
to use the risk-neutral pricing formula (at time t = 0); the second strategy is to derive the
Black-Scholes model from the binomial options pricing model in the time-continuum limit.

6.1 Black-Scholes markets

In the binomial model the stock price at time t is a finite random variable S(t). In this chapter
the stock price will be modeled as a continuum random variable with image Im(S(t)) =
(0, ∞). Moreover the stock price will be allowed to change at any time t ∈ [0, T ]. These
properties are satisfied by the geometric Brownian motion defined as follows.

Definition 6.1. Let {W (t)}t≥0 be a Brownian motion, α ∈ R, σ > 0 and S0 > 0 be

constants. The positive stochastic process {S(t)}t≥0 given by

S(t) = S0 eαt+σW (t) (6.1)

is called a geometric Brownian motion.

We shall use geometric Brownian motions to model the dynamics of stock prices in the time-
continuum case. More precisely, a (1+1 dimensional) Black-Scholes market is a market
that consists of a stock with price given by (6.1), and a risk-free asset with constant interest
rate r; in particular, the value of the risk-free asset at time t is given by B(t) = B0 ert , B0 > 0.
We assume throughout that t ∈ [0, T ], where T > 0 could be for instance the time of maturity
of a financial derivative on the stock. The probability P with respect to which {W (t)}t≥0 is
Brownian motion is the physical (or real-world) probability of the Black-Scholes market.
Moreover α is the instantaneous mean of log-return, σ is the instantaneous volatility

126
and σ 2 is the instantaneous variance of the geometric Brownian motion. To justify this
terminology we now show that α and σ satisfy the analogs of (5.18) in the time-continuum
case, namely, for all t ∈ [0, T ] and h > 0 such that t + h ≤ T we have
1 1
α= E[log S(t + h) − log S(t)], σ2 = Var[log S(t + h) − log S(t)].
h h
In fact, since W (t) ∈ N (0, t), we have
E[log S(t + h) − log S(t)] = E[αh + σW (t + h) − σW (t)]
= αh + σ(E[W (t + h)] − E[W (t)]) = αh.
Similarly
Var[log S(t + h) − log S(t)] = Var[αh + σW (t + h) − σW (t)]
= σ 2 Var[W (t + h) − W (t)] = σ 2 h,
where we used that the increment W (t + h) − W (t) belongs to N (0, h).
For the problem of pricing European style derivatives on the stock, one has to pick a value
for the volatility σ (while, as we shall see, the value of stock options in Black-Scholes theory
does not depend on the parameter α). In the following exercise it is asked to prove that the
historical variance (1.8) of a stock is an unbiased estimator for the instantaneous variance
of the geometric Brownian motion used to model its price.
Exercise 6.1 (Sol. 26). Suppose that at time t = 0 it is assumed that the stock price is
described by a geometric Brownian motion (6.1) in the interval [0, T ]. Given any arbitrary
subinterval [t0 , t] ⊂ [0, T ] with length τ = t − t0 , define the random variable
n
1 X
στ2 (t) = (R b 2,
bi − R) (6.2)
h(n − 1) i=1

where t0 < t1 < t2 < · · · < tn = t is a partition of [t0 , t] with h = ti − ti−1 and R
bi , R
b are
given by (1.5), (1.6). Show that
E[στ (t)2 ] = σ 2 .
In other words, σ 2 is the expected value of the τ -historical variance at any time t ∈ [0, T ].

We interpret the claim of Exercise 6.1 as follows: if we believe that in the interval [0, T ] the
stock price follows a geometric Brownian motion, then it is part of our assumption that we
expect the historical variance should be equal to the constant σ 2 in the interval [0, T ].
Next we derive the density function of the geometric Brownian motion.
Theorem 6.1. The density of the random variable S(t) is given by
(log x − log S(0) − αt)2
 
H(x) 1
fS(t) (x) = √ exp − , (6.3)
2πσ 2 t x 2σ 2 t
where H(x) is the Heaviside function (1.11).

127
Proof. The density of S(t) is given by
d
fS(t) (x) = FS(t) (x),
dx
where FS(t) is the distribution of S(t), i.e.,

FS(t) (x) = P(S(t) ≤ x).

Clearly, fS(t) (x) = FS(t) (x) = 0, for x ≤ 0. For x > 0 we use that
 
1 x
S(t) ≤ x if and only if W (t) ≤ log − αt := A(x).
σ S(0)
Thus, using W (t) ∈ N (0, t),
Z A(x)
1 y2
P(S(t) ≤ x) = P(−∞ < W (t) ≤ A(x)) = √ e− 2t dy,
2πt −∞

where for the second equality we used that W (t) ∈ N (0, t). Hence
Z A(x) !
d 1 y2 1 − A(x)2 dA(x)
fS(t) (x) = √ e− 2t dy = √ e 2t ,
dx 2πt −∞ 2πt dx

for x > 0, that is

(log x − log S(0) − αt)2
 
1 1
fS(t) (x) = √ exp − , x > 0.
2πσ 2 t x 2σ 2 t
The proof is complete.
Exercise 6.2. Express P(a < S(t) < b) in terms of the standard normal distribution Φ(x).
1 x
ANSWER: P(a < S(t) < b) = Φ(Γ(b)) − Φ(Γ(a)), where Γ(x) = √
σ t
(log S(0) − αt).

6.2 The risk-neutral pricing formula in Black-Scholes

markets
The purpose of this section is to introduce the definition of Black-Scholes price of European
derivatives from a probability theory point of view. Recall that the probabilistic formulation
of the binomial options pricing model is encoded in the risk-neutral pricing formula (5.38).
Our goal is to derive a similar risk-neutral pricing formula (at time t = 0) for the time-
continuum Black-Scholes model.
Motivated by the approach for the binomial model presented in Section 5.2, we first look
for a probability measure in which the the discounted stock price in Black-Scholes markets

128
is a martingale (martingale probability measure). It is natural to seek such martingale
probability within the class of Girsanov probabilities Pθ equivalent to the physical probability
P which we defined in Theorem 5.16, namely
Z
1 (x+θT )2
Pθ (A) = pθ (x) dx, pθ (x) = √ e− 2T . (6.4)
A 2πT
To this purpose we shall need the form of the density function of the geometric Brownian
motion in the probability measure Pθ .

Theorem 6.2. Let θ ∈ R, T > 0 and Pθ be Girsanov probability measure (6.4) equivalent to
the physical probability P. The geometric Brownian motion (6.1) has the following density
in the probability measure Pθ :

(log x − log S0 − (α − θσ)t)2

 
(θ) H(x) 1
fS(t) (x) = √ exp − . (6.5)
2πσ 2 t x 2σ 2 t

Proof. Since
(θ) (t)
S(t) = S0 eαt+σW (t) = S0 e(α−θσ)t+σW , W (θ) (t) = W (t) + θt

and since {W (θ) (t)}t≥0 is a Brownian motion in the probability measure Pθ (see Girsanov’s
(θ)
Theorem 5.17), then the density fS(t) is the same as fS(t) with α replaced by α − θσ.

Let Eθ [·] denote the expectation in the measure Pθ . Recall that martingales have constant
expectation. Hence in the martingale (or risk-neutral) probability measure the expectation
of the discounted value of the stock must be constant, i.e., Eθ [S(t)] = S0 ert . This condition
alone suffices to single out a unique possible value of θ.

Theorem 6.3. The identity Eθ [S(t)] = S0 ert holds if and only if θ = q, where
α−r σ
q= + . (6.6)
σ 2

Proof. Using the density (6.5) of S(t) in the measure Pθ and (5.48) we have
Z ∞
(log x − log S0 − (α − θσ)t)2
Z  
(θ) 1
Eθ [S(t)] = xfS(t) (x) dx = √ exp − dx.
R 2πσ 2 t 0 2σ 2 t
√
With the change of variable y = log x−logσS√0 −(α−θσ)t
t
, dx = xσ t dy, we obtain
Z √
Z √
S0 2
− y2 +σ ty
2
(α−θσ+ σ2 )t 1 −
(y+σ t)2
Eθ [S(t)] = √ e(α−θσ)t e dy = S0 e √ e 2 dy.
2π R 2π R

x2
√1 e− 2 dx = 1, the result follows.
R
As 2π R

129
Even though the validity of Eθ [S(t)] = S0 ert is only necessary for the discounted geometric
Brownian motion to be a martingale, one can show that the following result holds.

Theorem 6.4. The discounted value of the geometric Brownian motion stock price is a
martingale in the probability measure Pθ if and only if θ = q, where q is given by (6.6).

The previous discussion leads us to the following definition.

Definition 6.2. Given α ∈ R, σ > 0, r ∈ R and T > 0, the probability measure

α−r σ
Z
1 (x+qT )2
Pq (A) = pq (x) dx, pq (x) = √ e− 2T , q = +
A 2πT σ 2

is called the martingale probability, or risk-neutral probability, in the interval [0, T ]

of the Black-Scholes market with parameters α, σ, r.

Remark 6.1. In the risk-neutral probability the stock price is given by the geometric Brow-
nian motion
σ2 (q)
S(t) = S(0)e(r− 2 )t+σW (t) , (6.7)
where, by Girsanov’s theorem, W (q) (t) = W (t) + qt is a Brownian motion in the risk-neutral
probability. This follows by replacing α = r + qσ − 12 σ 2 into (6.1).

At this point we have all we need to define the Black-Scholes price of European derivatives
at time t = 0 using the risk-neutral pricing formula.

Definition 6.3. The Black-Scholes price at time t = 0 of the European derivative with
pay-off Y at maturity T is given by the risk-neutral pricing formula

ΠY (0) = e−rT Eq [Y ], (6.8)

i.e., it equals the expected value of the discounted pay-off in the risk-neutral probability mea-
sure of the Black-Scholes market.

In the case of standard European derivatives we can use the density of the geometric Brow-
nian motion in the risk-neutral probability measure to write the Black-Scholes price in the
following integral form.

Theorem 6.5. For the standard European derivative with pay-off Y = g(S(T )) at maturity
T > 0, the Black-Scholes price at time t = 0 can be written as ΠY (0) = v0 (S0 ), where S0 is
the price of the underlying stock at time t = 0 and v0 : (0, ∞) → R is the pricing function
of the derivative at time t = 0, which is given by
√
Z
σ2 1 2 dy
−rT
v0 (x) = e g(xe(r− 2 )T +σ T )e− 2 y √ . (6.9)
R 2π

130
Proof. Replacing θ = q in (6.5) we obtain that the geometric Brownian motion has the
following density in the risk-neutral probability measure Pq :
!
σ2 2
(q) H(x) 1 (log x − log S0 − (r − 2
)t)
fS(t) (x) = √ exp − 2t
. (6.10)
2
2πσ t x 2σ

Using the density (6.10) for t = T in the risk-neutral pricing formula (6.8) we obtain
Z
−rT −rT (q)
ΠY (0) = e Eq [Y ] = e Eq [g(S(T ))] = g(x)fS(T ) (x) dx
R
!
−rT Z ∞ σ2 2
e g(x) (log x − log S0 − (r − 2
)t)
=√ exp − 2
dx.
2
2πσ t 0 x 2σ t

log x−log S0 −(α−θσ)t

With the change of variable y = √
σ t
we obtain
√
Z
σ2 1 2 dy
−rT
ΠY (0) = e g(S0 e(r− 2
)T +σ T
)e− 2 y √ = v0 (S0 ),
R 2π
as claimed.

Definition 6.3 is only valid at time t = 0. The risk-neutral pricing formula for t > 0 is

ΠY (t) = e−rT Eq [Y |FS (t)], (6.11)

which generalizes (5.38) to the time continuum case. The right hand side of (6.11) is the ex-
pectation of the discounted pay-off in the risk-neutral probability measure conditional to the
information available at time t, which in a Black-Scholes market is determined by the history
of the stock price up to time t. It can be shown that in the case of the standard European
derivative with pay-off Y = g(S(T )) at maturity T , the risk-neutral pricing formula (6.11)
entails that the Black-Scholes price at time t ∈ [0, T ] can be written in the integral form

e−rτ
Z  √ 
σ2 y2
ΠY (t) = v(t, S(t)), where v(t, x) = √ g xe(r− 2 )τ eσ τ y e− 2 dy, τ = T − t.
2π R
(6.12)
Hence the pricing function v(t, x) of the derivative at time t is the same as the pricing
function (6.9) at time t = 0 but with maturity T replaced by the time τ left to maturity,
which is rather intuitive. In the next section we apply (6.12) to derive a closed formula for
the Black-Scholes price of European call and put options.

Remark 6.2. Of course we are tacitly assuming that the pay-off function g is such that the
integral in the right hand side of (6.12) is finite. Note also that the Black-Scholes price at
time t is a deterministic function of S(t) and thus can be computed with the information
available at time t.

131
Hedging portfolio
A portfolio process {hS (t), hB (t)}t∈[0,T ] invested in a Black-Scholes market is said to be
hedging the European derivative with pay-off Y and maturity T > 0 if V (T ) = Y , where
V (t) = hS (t)S(t) + hB (t)B(t) is the value of the portfolio process at time t ∈ [0, T ]. The
portfolio process is said to be replicating the derivative if V (t) = ΠY (t), for all t ∈ [0, T ],
where ΠY (t) is the Black-Scholes price of the derivative. It can be shown that the Black-
Scholes price ΠY (t) coincides with the value at time t ∈ [0, T ] of any self-financing portfolio
processes hedging the derivative, precisely as in the binomial model. However the definition
of self-financing portfolio in Black-Scholes markets requires the use of stochastic calculus and
it is therefore beyond the purpose of this text. Moreover it can be shown that in the case of
standard European derivatives the portfolio process {(hS (t), hB (t))}t∈[0,T ] given by

1
hS (t) = ∆(t, S(t)), ∆(t, x) = ∂x v(t, x), hB (t) = (ΠY (t) − hS (t)S(t)) (6.13)
B(t)

is self-financing and hedges the derivative. Here v denotes the pricing function (6.12) and
∂x v the partial derivative of v in the second variable (i.e., the derivative in x assuming that
t is constant). Note that the formula for hB (t) is equivalent to the replicating condition
V (t) = ΠY (t) of the portfolio process {hS (t), hB (t)}t∈[0,T ] . For a heuristic derivation of the
fomula for hS (t), see Exercise 6.14 below. In the next section we compute the replicating
portfolio process (6.13) for European call and put options.

6.3 Black-Scholes price of European call and put op-

tions
In this section we focus the discussion on call/put options. We thereby assume that the
pay-off of the derivative is given by

Y = (S(T ) − K)+ , i.e., Y = g(S(T )), g(z) = (z − K)+ , for a call option,

Y = (K − S(T ))+ , i.e., Y = g(S(T )), g(z) = (K − z)+ , for a put option.
As usual, we denote by C(t, S(t), K, T ) the value at time t of the call option with strike K
and maturity T and by P (t, S(t), K, T ) the value of the corresponding put option.

Theorem 6.6. The Black-Scholes price at time t of the European call option with strike
price K > 0 and maturity T > 0 is given by C(t, S(t), K, T ), where

C(t, x, K, T ) = xΦ(d1 ) − Ke−rτ Φ(d2 ), (6.14a)

log Kx + r − 12 σ 2 τ



√
d2 = √ , d1 = d2 + σ τ , τ = T − t (6.14b)
σ τ

132
 Rx 1 2
and where Φ(x) = √12π −∞ e− 2 y dy is the standard normal distribution. The Black-Scholes
price of the corresponding put option is given by P (t, S(t), K, T ), where

P (t, x, K, T ) = Φ(−d2 )Ke−rτ − Φ(−d1 )x. (6.15)

Moreover the put-call parity identity holds:

C(t, S(t), K, T ) − P (t, S(t), K, T ) = S(t) − Ke−rτ . (6.16)

Proof. We derive the Black-Scholes price of call options only, the argument for put options
being similar (see Exercise 6.3 below). We substitute g(z) = (z − K)+ into (6.12) and obtain

e−rτ
Z  √ y2

(r− 12 σ 2 )τ σ τ y
v(t, x) = C(t, x, K, T ) = √ xe e − K e− 2 dy.
2π R +

1 2 )τ √
Now we use that xe(r− 2 σ eσ τy
> K if and only if y > −d2 . Hence
Z ∞ Z ∞
e−rτ

√ 2 2
(r− 12 σ 2 )τ σ τ y − y2 − y2
C(t, x, K, T ) = √ xe e e −K e dy .
2π −d2 −d2
√ √ 2
Using − 21 y 2 + σ τ y = − 21 (y − σ τ )2 + σ2 τ and changing variable in the integrals we obtain
Z ∞ Z ∞
e−rτ
 
√ 2
rτ − 12 (y−σ τ )2 − y2
C( t, x, K, T ) = √ xe e dy − K e dy
2π −d2 −d2
" Z d2 +σ√τ Z d2 #
e−rτ 1 2 y2
=√ xerτ e− 2 y dy − K e− 2 dy
2π −∞ −∞

= xΦ(d1 ) − Ke−rτ Φ(d2 ).

As to the put-call parity, we have

C(t, x, K, T ) − P (t, x, K, T ) = xΦ(d1 ) − Ke−rτ Φ(d2 ) − Φ(−d2 )Ke−rτ + xΦ(−d1 )

= x(Φ(d1 ) + Φ(−d1 )) − Ke−rτ (Φ(d2 ) + Φ(−d2 )).

As Φ(z) + Φ(−z) = 1, the claim follows.

Remark 6.3. Note that the Black-Scholes price of call and put options is strictly positive
for all t ∈ [0, T ), while the binomial price can also attain the (unrealistic) zero value prior
to maturity, see Section 3.3.
Exercise 6.3. Derive the Black-Scholes price P (t, S(t), K, T ) of European put options claimed
in Theorem 6.6.
Exercise 6.4 (Sol. 27). Prove that

lim C(t, x, K, T ) = (x − Ke−rτ )+ , lim C(t, x, K, T ) = x.

σ→0+ σ→∞

133
Compute also the following limits:

lim C(t, x, K, T ), lim C(t, x, K, T ), lim C(t, x, K, T ), lim C(t, x, K, T )

K→0+ K→+∞ τ →+∞ x→0+

and show that C(t, x, K, T ) is asymptotic to x − Ke−rτ as x → ∞. Compute the same limits
for put options.

Next we construct replicating, and thus hedging, portfolio processes for call and put options.
Theorem 6.7. The following are self-financing replicating portfolio processes for European
call/put options on Black-Scholes markets:
Ke−rτ Φ(d2 )
hS (t) = Φ(d1 ), hB (t) = − for call options (6.17a)
B(t)
Ke−rτ Φ(−d2 )
hS (t) = −Φ(−d1 ), hB (t) = for put options. (6.17b)
B(t)

Proof. Recall that hS (t) = ∆(t, S(t)), where ∆(t, x) = ∂x v(t, x) = ∂x C(t, x, K, T ) for call
options and ∆(t, x) = ∂x P (t, x, K, T ) for put options, see (6.13), while the number of shares
of the risk-free asset in the hedging portfolio is given by

hB (t) = (C(t, S(t), K, T ) − hS (t)S(t))/B(t), for call options, (6.18a)

hB (t) = (P (t, S(t), K, T ) − hS (t)S(t))/B(t), for put options. (6.18b)

Let us compute ∂x C:

∂x C(t, x, K, T ) = Φ(d1 ) + xΦ0 (d1 )∂x (d1 ) − Ke−rτ Φ0 (d2 )∂x d2 .

1 2 √
As ∂x (d1 ) = ∂x (d2 ) = σ√1τ x , and Φ0 (x) = e− 2 x / 2π, we obtain
 
1 − 12 d21 K −rτ − 1 d22
∂x C(t, x, K, T ) = Φ(d1 ) + √ e − e e 2 .
σ 2πτ x
√
Replacing d1 = d2 + σ τ we obtain
1 2 
e− 2 d2

√ K −rτ
− 12 σ 2 τ −d2 σ τ
∂x C(t, x, K, T ) = Φ(d1 ) + √ e − e .
σ 2πτ x
Using the definition of d2 , the term within round brackets in the previous expression is easily
found to be zero, hence
∂x C(t, x, K, T ) = Φ(d1 ).
By the put-call parity we find also

∂x P (t, x, K, T ) = Φ(d1 ) − 1 = −Φ(−d1 ).

In both cases, the number of shares in the risk-free asset is computed using (6.18).

134
Remark 6.4. Note that ∂x C > 0, while ∂x P < 0. This agrees with the fact that call options
are bought to protect a short position on the underlying stock, while put options are bought
to protect a long position on the underlying stock.

Exercise 6.5 (Sol. 28). A binary (or digital) call option with strike K and maturity T
pays-off the buyer if and only if S(T ) > K. If the pay-off is a fixed amount of cash L, then
the binary call option is said to be “cash-settled”, while if the pay-off is the stock itself then
the option is said to be “physically settled”. Compute the Black-Scholes price of the cash-
settled binary call option and the number of shares on the stock in the self-financing hedging
portfolio.

Exercise 6.6. Compute the Black-Scholes price and the self-financing hedging portfolio of
the physically-settled binary call.
φ(d1 )
ANSWER: ΠY (t) = S(t)Φ(d1 ), hS (t) = Φ(d1 ) + √ .
σ τ

Exercise 6.7 (Sol. 29). Consider the European derivative with maturity T and pay-off Y
given by
Y = k + S(T ) log S(T ),
where k > 0 is a constant. Find the Black-Scholes price of the derivative at time t < T and
the self-financing hedging portfolio. Find the probability that the derivative expires in the
money.

Exercise 6.8 (Sol. 30). Consider the European derivative with pay-off Y = S(T )(S(T ) − K)
and time of maturity T , where K > 0 is a constant. Compute the Black-Scholes price ΠY (t)
of this derivative and the self-financing hedging portfolio. Finally, assume S(0) = K, r > 0
and compute the expected relative return of a constant portfolio with 1 share of this derivative.

Exercise 6.9 (Sol. 31). Let K > 0. A European style derivative on a stock with maturity
T > 0 gives to its owner the right to choose between selling the stock for the price K at time
T or paying the amount K at time T . Draw the pay-off function of the derivative. Compute
the Black-Scholes price of the derivative. Show that there exists a value K∗ > 0 of K such
that the Black-Scholes price of the derivative is zero.

The greeks
The Black-Scholes price of call and put options derived in Theorem 6.6 depends on the price
of the underlying stock, the time to maturity, the strike price, as well as on the (constant)
market parameters r, σ (it does not depend on α). The partial derivatives of the pricing
function with respect to these variables are called greeks. We collect the most important
ones (for call options) in the following theorem.

135
Theorem 6.8. The pricing function C(t, x, K, T ) of call options satisfies the following:

∆ := ∂x C = Φ(d1 ), (6.19)
φ(d1 )
Γ := ∂x2 C = √ , (6.20)
xσ τ
ρ := ∂r C = Kτ e−rτ Φ(d2 ), (6.21)
xφ(d1 )σ
Θ := ∂t C = − √ − rKe−rτ Φ(d2 ), (6.22)
2 τ
√
ν := ∂σ C = xφ(d1 ) τ (called “vega”), (6.23)
√ z2
where we recall that φ(z) = Φ0 (z) = ( 2π)−1 e− 2 . In particular:

• ∆ > 0, i.e., the price of a call is increasing on the price of the underlying stock;

• Γ > 0, i.e., the price of a call is convex on the price of the underlying stock;

• ρ > 0, i.e., the price of the call is increasing on the interest rate of the risk-free asset;

• Θ < 0, i.e., the price of the call is decreasing in time;

• ν > 0, i.e., the price of the call is increasing on the volatility of the stock.
Exercise 6.10. Use the put-call parity to derive the greeks of put options.

The greeks measure the sensitivity of option prices with respect to the market conditions.
This information can be used to draw some important conclusions. For instance, let us
comment on the fact that vega is positive. It implies that the wish of an investor with a long
position on a call option is that the volatility of the underlying stock increased. As usual,
since this might not happen, the buyer of the call may incur in a loss if the stock volatility
decreases (since the call option will loose value). This exposure to volatility can be secured
by adding volatility swaps into the portfolio1 .

Implied volatility
Let C(t, S(t), K, T ) denote the Black-Scholes price of the European call with strike price K,
maturity time T on a stock with price S(t) at time t. In fact, assuming that the underlying
stock pays no dividend before time T , this is also the Black-Scholes price of the corresponding
American call, which is the one most often traded in the market. Recall that in the derivation
of the Black-Scholes price it is assumed that the price of the stock follows the geometric
Brownian motion
S(t) = S(0)eαt+σW (t) ,
1
Volatility swaps are however available only in a rather limited selection of underlying assets, e.g., foreign
exchange rates.

136
where {W (t)}t∈[0,T ] is a Brownian motion stochastic process, σ > 0 is the instantaneous
volatility and α ∈ R is the instantaneous mean of log-return. The function C(t, x, K, T ) is
given by
C(t, x, K, T ) = xΦ(d1 ) − Ke−rτ Φ(d2 ),
where r > 0 is the (constant) risk-free rate of the money market, τ = T − t is the time left
to the expiration of the call,
σ2
log Kx + (r − 2
)τ √
d2 = √ , d1 = d2 + σ τ
σ τ
and Φ denotes the standard normal distribution,
Z z
y2 dy
Φ(z) = e− 2 √ .
−∞ 2π
Remarkably, C(t, S(t), K, T ) does not depend on the mean of log-return α of the stock price.
However it depends on the parameters (σ, r) and since here we are particularly interested in
the dependence on the volatility, we re-denote the Black-Scholes price of the call as
C(t, S(t), K, T, σ).
Moreover, as shown in Theorem 6.8,
∂C x 1√
d2
= vega = √ e− 2 τ > 0.
∂σ 2π
Hence the Black-Scholes price of the option is an increasing function of the volatility. Fur-
thermore,
lim C(t, S(t), K, T, σ) = (S(t) − Ke−rτ )+ , lim C(t, S(t), K, T, σ) = S(t),
σ→0+ σ→+∞

see Exercise 6.4. Therefore the function C(t, S(t), K, T, ·) is a one-to-one map from (0, ∞)
into the interval I = ((S(t)−Ke−rτ )+ , S(t)), see Figure 6.1. It follows that if the real market
e ∈ I, then there exists a unique value of σ, which we denote
price of the call at time t is C(t)
by σimp , such that
C(t, S(t), K, T, σimp ) = C(t).
e
σimp is called the implied volatility of the option. The implied volatility must be computed
numerically (for instance with the function blsimpv in Matlab), since there is no close
formula for it.
The implied volatility of an option (in this example of a call option) is a very important
parameter and it is often quoted together with the price of the option. If the market followed
exactly the assumptions in the Black-Scholes theory, then the implied volatility would be
constant (independent of time) and it would be the same for all call options on the same
stock with the same strike and maturity. However for real market options this turns out to
be false, i.e., the implied volatility depends on time, K and T . In this respect, σimp may
be viewed as a quantitative measure of how real markets deviate from ideal Black-Scholes
markets.

137
 10

cHt, SHtL, K, T, ΣL
6

0
0 5 10 15 20

Σ
Figure 6.1: We fix S(t) = 10, K = 12, r = 0.01, τ = 1/12 and depict the Black-Scholes price
of the call as a function of the volatility.

Volatility smile
As mentioned before, the implied volatility in real markets depends on the parameters K, T .
Here we are particularly interested in the dependence on the strike price, hence we re-denote
the implied volatility as σimp (K). If the market behaved exactly as in the Black-Scholes
theory, then σimp (K) = σ for all values of K, hence the graph of the function K → σimp (K)
would be a straight horizontal line. Given that real markets do not satisfy exactly the
assumptions in the Black-Scholes theory, what can we say about the graph of the function
K → σimp (K)? Remarkably, it has been found that there exists recurrent convex shapes for
the graph of this function, which are known as volatility smile and volatility skew, see
Figures 6.2-6.3. The minimum of the volatility smile is reached at the strike price K ≈ S(t),
i.e., when the call is at the money. This behavior indicates that the more the call is far
from being at the money, the more it will be overpriced. Volatility smiles and skews have
been found in the market especially after the crash in 1987 (Black Monday), indicating that
this event led investors to be more cautious when trading on options that are in or out
of the money. Devise mathematical models of stochastic volatility and asset prices able to
reproduce volatility curves is an active research topic in mathematical finance.

Exercise 6.11 (?). What can we infer about the investors behavior from the volatility skew?

138
 Σimp
50

40 æ

æ
æ
æ
æ
30
æ æ
æ æ
æ æ
æ æ
æ æ æ
æ æ
20

120 125 130 135 K

Figure 6.2: Volatility Smile of a call option on Apple expiring May 15th , 2015. The data
were taken on May 12th , when the Apple stock quoted 126.34 dollars.

Σimp
10

Reverse Forward
8
Skew Skew
6

S-K
-4 -2 0 2 4

Figure 6.3: Volatility skews (not from real data!)

6.4 Convergence of the binomial price to the Black-

Scholes price (*)
The ultimate purpose of this section is to show that the Black-Scholes price of standard
Europen derivatives is the time-continuum limit of the binomial price. We begin by show-
ing that the discrete binomial stock price converges to the the time-continuous geometric

139
Brownian motion model. Consider an interval of time [0, t] and a partition

0 = t0 < t1 < · · · < tN = t, ti+1 − ti = h > 0, for all i = 0, . . . , N − 1.

We define a binomial stock price on this partition by setting, for u > d,


S(ti−1 )eu with probability p
S(ti ) = d .
S(ti−1 )e with probability 1 − p

Now consider N independent and identically distributed random variables X1 , . . . , XN sat-

isfying 
1 with probability p
Xi = .
−1 with probability 1 − p
We can rewrite the binomial model above as
    
u+d u−d
S(ti ) = S(ti−1 ) exp + Xi .
2 2

Let us assume for simplicity that p = 1/2 (see Exercise 6.12 below for the general case).
Then iterating the previous identity we obtain
     
u+d u−d
S(t) = S(0) exp N + MN , (6.24)
2 2

where MN = X1 + · · · + XN is the symmetric random walk stochastic process. Now, given

α ∈ R and σ > 0, choose u, d depending on h as
√ √
u = uh = αh + σ h, d = dh = αh − σ h.
√
Note that this choice is equivalent to α = (uh + dh )/(2h) and σ = (uh − dh )/(2 h); in par-
ticular the instantaneous mean of log-return and the instantaneous volatility of the binomial
stock price are independent of h. Substituting (u, d) = (uh , dh ) and N = ht into (6.24) we
obtain h √ i
S(t) = S(0) exp αt + σ hMt/h , (6.25)
where As indicated in Exercise 5.17, we have
√
hMt/h ≈ W (t), for h small.

Therefore for small h we can approximate (6.25) by the geometric Brownian motion

S(t) ≈ S(0) exp [αt + σW (t)] .

The following simple application of the Central Limit Theorem turns the above argument
into a rigorous result.

140
Theorem 6.9. Consider the binomial stock price stochastic process {SN (t)}t∈[0,T ] given by
√ M
αt+σ t √N
SN (t) = S(0)e N ,

where MN is the symmetric random walk. Then

SN (t) → S(t), in distribution as N → ∞,

where S(t) = S(0)eαt+σW (t) is the geometric Brownian motion with instantaneous mean of
log-return α and instantaneous volatility σ.

Proof. We have, for all x > 0,

x
MN log S(0) − αt
FSN (t) (x) = P(SN (t) ≤ x) = P( √ ≤ √ ).
N σ t

By the Central Limit Theorem, the random variable M√ N converges in distribution to a

N √
random variable X ∈ N (0, 1) as N → ∞. Letting X = W (t)/ t we then have
x
W (t) log S(0) − αt
FSN (t) (x) → P( √ ≤ √ ) = P(S(t) ≤ x) = FS(t) (x), as N → ∞.
t σ t

Exercise 6.12. Show that the binomial stock price converges in distribution to the geometric
Brownian motion even for p 6= 1/2. Remark: it can be shown that the value of p ∈ (0, 1) only
affects the rate of convergence. In particular the fastest convergence is obtained for p = 1/2,
which is the reason why this choice is usually made in the binomial model.

The binomial fair price at time t = 0 of the standard European derivative with pay-off
Y = g(S(N )) at maturity T = N is given by (3.4), that is
N  
−rN
X
−rN
X N
ΠY (0) = e q Nu (x)
(1 − q)Nd (x)
g(S(N )) = e q k (1 − q)N −k g(sk ),
k
x∈{u,d}N k=0

where Nu (x) is the number of “ups” in the path x ∈ {u, d}N , Nd (x) = N −Nu (x) the number
of “downs”, s0 , . . . , sN are the possible values of S(N ), i.e.,

sk = S(0) exp(ku + (N − k)d), k = 0 . . . , N, (6.26)

and
er − ed
q= , r ∈ (d, u) (⇔ q ∈ (0, 1)). (6.27)
eu − ed

141
Note the important formula
   
1 sk
k= log − Nd , (6.28)
u−d S(0)

which is obtained by inverting (6.26). We can rewrite ΠY (0) as

N  k  N −k  
−rN
X q 1−q N k
ΠY (0) = e p (1 − p)N −k g(sk ).
k=0
p 1−p k

N
pk (1−p)N −k


Recalling that the distribution of S(N ) in the physical probability is given by k
(see Section 5.2), we obtain
N
X
−rN
ΠY (0) = e ZN (sk )fS(N ) (sk )g(sk ), (6.29)
k=0

where
1 sk 1 sk
 k 
q 1−q
N −k   u−d
q [log( S(0) )−N d]  1 − q N − u−d [log( S(0) )−N d]
ZN (sk ) = = , (6.30)
p 1−p p 1−p

the second equality following by (6.28). From now on we assume p = 1/2 for simplicity.
Denoting sk = x, we rewrite (6.29) as
X
ΠY (0) = e−rN ZN (x)fS(N ) (x)g(x), (6.31)
x∈ImS(N )

where ImS(N ) is the image of S(N ), fS(N ) is the probability distribution of S(N ), and
1 x 1 x
ZN (x) = (2q) u−d [log( S(0) )−N d] (2(1 − q))N − u−d [log( S(0) )−N d] . (6.32)

Next consider the partition of the interval [0, T ] given by

0 = t0 < t1 < · · · < tN = T, tj − tj−1 = h > 0, j ∈ I.

Let us define the binomial model S(0) = S0 > 0,

S(tj−1 )eu , with probability p = 1/2

(
S(tj ) = , j ∈ I, (6.33)
S(tj−1 )ed , with probability p = 1/2

where √ √
u = αh + σ h, d = αh − σ h. (6.34)
Note that
u−d u+d
σ= √ , α= ,
2 h 2h

142
hence, by Theorem 6.9, in the limit h → 0 the price of the stock follows the geometric
Brownian motion S(t) = S(0) exp(αt + σW (t)). Moreover B(tj ) = B0 ertj = B0 erhj . Hence
the pair (S(j)
e = S(tj ), B(j)
e = B(tj )) is equivalent to a binomial market with parameters
(u, d, rh) and p = 1/2. In particular the parameter q defined by (6.27) becomes
√
erh − eαh−σ h
q= √ √ (6.35)
eαh+σ h − eαh−σ h
and since √ √
αh − σ h < rh < αh + σ h
holds for h small, then we can assume that q ∈ (0, 1). Therefore the initial price of the
European derivative with pay-off Y = g(S(N
e )) = g(S(T )) is given by (6.31). Using N h = T ,
we rewrite (6.31) as
X X
ΠY (0) = e−rhN ZN (x)fS(N
e ) (x)g(x) = e−rT
Qh (x)fS(T ) (x)g(x), (6.36)
x∈ImS(N
e ) x∈ImS(T )

where Qh (x) = ZT /h (x); by (6.32), (6.35) and the definitions of u, d, we have Qh (x) =
ηh (x)ξh (x), where
√ ! 1√ x
(log S(0) T
−αT )+ 2h
rh αh−σ h 2σ h
e −e
ηh (x) = 2 √ √ ,
eαh+σ h − eαh−σ h

√ !− 1√ x
(log S(0) T
−αT )+ 2h
eαh+σ − erh h 2σ h

ξh (x) = 2 √ √ .
eαh+σ h − eαh−σ h

Exercise 6.13. Prove that

2
(α+ σ2 −r)2 T 2
 
1 x
− − (log S(0) −αT ) α+ σ2 −r
lim Qh (x) = e 2σ 2 e σ2 := Q(x).
h→0

We are now in the position to derive the Black-Scholes price of the derivative. In view of
the analogies between finite and uncountable probability spaces pointed out in Theorem 5.8,
the natural generalization of (6.36) in the time-continuum case is
Z
−rT
ΠY (0) = e Q(x)fS(T ) (x)g(x) dx,
R

where fS(T ) is now the probability density of the random variable S(T ) = S(0)eαT +σW (T ) ,
i.e.,
x
!
H(x) 1 (log S(0) − αT )2
fS(T ) (x) = √ exp − , (6.37)
2πσ 2 T x 2σ 2 T

143
see (6.3). Explicitly, ΠY (0) is given by
2 2
e−rT
Z ∞
−
(α+ σ2 −r)2 T
− 1 x
(log S(0)
2
−αT )(α+ σ2 −r) −
(log S(0)
x −αT
) g(x)
ΠY (0) = √ e 2σ 2 e σ2 e 2σ 2 T dx.
2πσ 2 T 0 x

Now, the exponents in the exponential functions inside the integral form a perfect square:
Z ∞
e−rT
 i2
−αT )+ α+ σ2 −r T g(x)
2
h 
− 12 (log S(0)
x
ΠY (0) = √ e 2σ T dx
2πσ 2 T 0 x
Z ∞
e−rT
 i2
+ σ2 −r T g(x)
h  2
− 12 log S(0)
x
= √ e 2σ T dx.
2πσ 2 T 0 x

Note that the dependence on α is gone! Finally, the change of variable

  2  
1 x σ
y= √ log + −r T
σ T S(0) 2

gives
e−rT √ 
Z 
σ2 y2
ΠY (0) = √ g S(0)e(r− 2 )T eσ T y e− 2 dy,
2π R
which is exactly the same result obtained in Theorem 6.5 using the risk-neutral pricing
formula.

Remark 6.5. The fact that the Black-Scholes price is independent of the mean of log-
return α of the stock is consistent with the numerical observation made in Section 3.3 that
the binomial price of European options is weakly dependent on the parameter α. In the
time-continuum limit, this dependence disappears completely.

Exercise 6.14. The goal of this exercise is to justify the formula (6.13) for a self-financing
and hedging portfolio process of standard European derivatives priced by the Black-Scholes
formula. Recall that in the time discrete case we have

1 ΠuY (t) − ΠdY (t)

hS (t) = , (6.38)
S(t − 1) eu − ed

see Theorem 3.3. Now, as for the derivation of the Black-Scholes price given in this section,
consider a partition {t0 , . . . , tN } of the interval [0, T ] and let
√ √
t − 1 = tj−1 , t = tj = tj−1 + h, u = αh + σ h, d = αh − σ h,

see (6.33) and (6.34). Let ΠY (tj ) = v(tj , S(tj )), where v is the Black-Scholes price function.
Show that (6.38) converges to ∂x v(t, x) as h → 0.

144
6.5 Black-Scholes price of the Asian option
For European call and put options, and for other simple standard European derivatives,
the Black-Scholes pricing formula can be reduced to a simple expression in terms of the
standard normal distribution, see Theorem 6.5. For non-standard derivatives, i.e., when the
pay-off depends on the price of the stock at different times (and not only at maturity), this
reduction is in general not possible. Nevertheless the risk-neutral pricing formula can be
used to compute numerically the Black-Scholes price of non-standard derivatives using the
so called Monte Carlo method. We illustrate the procedure in the important case of the
Asian option.
Recall that the Asian call, resp. put, option in the time-continuum case is defined as the
non-standard European derivative with pay-off
 Z T
1 T
  Z 
1
Ycall = S(t) dt − K , resp. Yput = K − S(t) dt ,
T 0 + T 0 +

where K > 0 is the strike price of the option. The Black-Scholes price at time t = 0 of these
options are given respectively by

ΠAC (0) = e−rT Eq [Ycall ], ΠAP (0) = e−rT Eq [Ycall ].

Exercise 6.15 (Sol. 32). Derive the following put-call parity identity:
 rT 
−rT e −1
ΠAC (0) − ΠAP (0) = e S0 − K . (6.39)
rT
Exercise 6.16. The Asian call with geometric average is the non-standard European deriva-
tive with pay-off  1 RT 
log S(t) dt
Q= e T 0 −K . (6.40)
+

Show that the Black-Scholes price at time t = 0 of this derivative is given by

(G)
ΠAC (0) = e−rT (eqT S0 Φ(d1 ) − KΦ(d2 )) (6.41a)

where
σ2
r
1 σ2 T log SK0 + 12 (r + 6
)T
q = (r − )T, d 2 = d1 − σ , d1 = p .
2 6 3 σ T /3
HINT: You need Theorem 5.14.

The Monte Carlo method

The Monte Carlo method is, in its simplest form, a numerical method to compute the
expectation of a random variable. Its mathematical validation is based on the Law of

145
Large Numbers, which states the following: Suppose {Xi }i≥1 is a sequence of i.i.d. random
variables with expectation E[Xi ] = µ. Then the sample average of the first n components of
the sequence, i.e.,
1
X = (X1 + X2 + · · · + Xn ),
n
converges (in probability) to µ as n → ∞.
The law of large numbers can be used to justify the fact that if we are given a large number
of independent trials X1 , . . . , Xn of the random variable X, then
1
E[X] ≈ (X1 + X2 + · · · + Xn ).
n
Example. Let X : Ω2 → R be the random variable that takes value 1 if the two tosses
are different and value −1 if they are equal. If the coin is fair we have of course E[X] = 0.
Suppose that we perform the experiment “tossing the coin twice” 100 times. Then we shall
obtain 100 trials X1 , . . . X100 for the random variable X. If our 2-tosses were different, say,
55 times and equal 45 times, then our approximation for E[X] = 0 is (55-45)/100=0.1.
To measure how reliable is the approximation of E[X] given by the sample average, consider
the standard deviation of the trials X1 , . . . , Xn :
v
u n
u 1 X
sX = t (X − Xi )2 .
n − 1 i=1

A simple application of the Central Limit Theorem proves that the random variable
µ−X
√
sX / n
converges in distribution to a standard normal random variable. We use this result to show
that the true value µ of E[X] has about 95% probability to be in the interval
s s
[X − 1.96 √ , X + 1.96 √ ].
n n
Indeed, for n large,
  Z 1.96
µ−X 2 dx
P −1.96 ≤ √ ≤ 1.96 ≈ e−x /2 √ ≈ 0.95.
sX / n −1.96 2π

Application to the Asian option

Consider now a European derivative with pay-off Y at maturity T . We approximate the
price at time t = 0 by
Y1 + · · · + Yn
ΠY (0) = e−rT Eq [Y ] ≈ e−rT (6.42)
n
146
where Y1 , . . . , Yn is a large number of independent pay-off trials. As the pay-off depends on
the path of the stock price, the trials Y1 , . . . , Yn can be created by first generating a sample
of paths for the stock price. Letting 0 = t0 < t1 < · · · < tN = T be a partition of the
interval [0, T ] with size ti − ti−1 = h, we may construct a sample of n paths of the geometric
Brownian motion on the given partition with the following simple Matlab function:
function Path=StockPath(s,sigma,r,T,N,n)
h=T/N;
W=randn(n,N);
q=ones(n,N);
Path=s*exp((r-sigma^2/2)*h.*cumsum(q’)+sigma*sqrt(h)*cumsum(W’));
Path=[s*ones(1,n);Path];
Note carefully that the stock price is modeled as a geometric Brownian motion with mean of
log return α = r − σ 2 /2, which means that the geometric Brownian motion is risk-neutral,
see Remark 6.1. This is of course correct, since the expectation in (6.42) that we want to
compute is in the risk-neutral probability measure.
In the case of the Asian call option with strike K and maturity T the pay-off is given by
 Z T  N
!
1 1 X
Y = S(t) dt − K ≈ S(ti ) − K .
T 0 + N i=1
+

The following function computes the approximate price of the Asian option using the Monte
Carlo method:
function [price, err]=MonteCarlo AC(s,sigma,r,K,T,N,n)
tic
stockPath=StockPath(s,sigma,r,T,N,n);
payOff=max(0,mean(stockPath)-K);
price=exp(-r*T)*mean(payOff);
err=1.96*std(payOff)/sqrt(n);
toc
The function also returns the error in the 95% confidence interval, that is
s
Err = 1.96 √ . (6.43)
n

For example, by running the command

[price, err]=MonteCarlo AC(100,0.5,0.05,100,1/2,100,1000000)
we get price=8.5799, err=0.0283, which means that the Black-Scholes price of the Asian
option with the given parameters has 95% probability to be in the interval 8.5799 ± 0.0283.
The calculation took about 4 seconds. Note that the 95% confidence is 0.0565/8.5799∗100 ≈
0.66% of the price.

147
Exercise 6.17. Write a Matlab code which applies the Monte Carlo method to compute
the Black-Scholes price and the confidence interval of the following non-standard European
derivatives:

• Barrier option (with American barrier)

• Lookback option

Use the code to perform a parameter sensitivity analysis of these options.

It follows by (6.43) that in order to reduce the error, i.e., to shrink the confidence interval, of
the Monte Carlo approximation, one needs to either (i) increase the number of trials n or (ii)
reduce the standard derivation s. Increasing n can be very costly in terms of computational
time, hence the approach (ii) is more efficient. There exist several methods to decrease
the standard deviation of a Monte Carlo computation, which go by the name of variance
reduction techniques. An example for the Asian option is studied next.

Control variate method (*)

The performance of the Monte Carlo method described above to price Asian options can
be improved substantially by using variance reduction techniques. The technique explained
below is called control variate and was first applied to the Asian option in [8]. The idea is
to write the risk-neutral price at time t = 0 of the Asian call as
ΠAC (0) = e−rT Eq [Y call ] = e−rT Eq [Y ] + e−rT Eq [Q],
where Q (the control variate) is the pay-off of the Asian option with geometric meaning,
see (6.40), and Y = Y call − Q. Hence the Monte Carlo estimate of ΠAC (0) becomes
Y1 + · · · + Yn (G)
ΠAC (0) ≈ e−rT + ΠAC (0),
n
(G)
where Y1 , . . . , Yn are independent trials of the random variable Y , while ΠAC (0) is the Black-
Scholes price at time t = 0 of the Asian call with geometric meaning, which is given by
the exact formula (6.41). To show that this approximation improves the crude Monte Carlo
estimate (without control variate), we have to show that the sample average estimator of
E[Y ] is better than the sample average estimator of Eq [Y call ]. That this is actually the
case will come up in the numerical computations in the next exercise, but to conclude the
discussion we give here a simple justification for it. Because of (6.43), it suffices to show
that (sY )2 < (sY call )2 . Letting Y1call , . . . , Yncall be independent trials of the pay-off Y call and
Q1 , . . . , Qn be independent trials of the pay-off Q, we compute
n n
2 1 X 1 X
(sY ) = (Y − Yi )2 = ((Y call − Q) − (Yicall − Qi ))2
n − 1 i=1 n − 1 i=1
= (sY call )2 + (sQ )2 − 2C(Y call , Q),

148
where C(Y call , Q) is the sample covariance of the pay-off trials, namely
n
X
call
C(Y , Q) = (Y call − Yicall )(Q − Qi ).
i=1

Hence (sY )2 < (sY call )2 holds provided C(Y call , Q) is sufficiently large and positive. Given
the structure of the pay-off Q, it is clear that there is a large positive correlation between
Q and the pay-off Y call of the Asian call, which explains why the use of Q as control variate
reduces the error in the Monte Carlo method.
Exercise 6.18 (Matlab). Write a Matlab code that applies the control variate Monte Carlo
method to the Asian option discussed above. Compare the new method with the crude Monte
Carlo method and show that the control variate technique improves the performance of the
computation.
Exercise 6.19 (Matlab). Use the Monte Carlo method in Exercise 6.18 to study numerically
how the price of the Asian call depend on the parameters of the option. In particular:

(a) Verify numerically the put-call parity (6.39)

(b) Show that the Asian call is less sensitive to volatility than the standard call. Do you
have an intuitive explanation for this?
(c) Show that for large volatility the Monte Carlo method becomes unstable (the confidence
interval grows very fast)
(d) Show that the Asian call is cheaper than the standard call with the same strike. Do
you have an intuitive explanation for this?

6.6 Standard European derivatives on a dividend-paying

stock
In this section we compute the Black-Scholes price of standard European derivatives on a
dividend-paying stock. In a frictionless market this means that the price of the stock drops
at some time t0 ∈ (0, T ) of a quantity D < S(t0 ), which is deposited in the account of the
shareholders. Letting S(t−0 ) = limt→t−
0
S(t), we then have

S(t0 ) = S(t−
0 ) − D. (6.44)
We assume that on each of the intervals [0, t0 ), [t0 , T ], the stock price follows a geometric
Brownian motion. In the risk-neutral probability Pq this means that
1 2 )(s−t)+σ(W (q) (s)−W (q) (t))
S(s) = S(t)e(r− 2 σ , t ∈ [0, t0 ), s ∈ [t, t0 ) (6.45)
(r− 12 σ 2 )(s−u)+σ(W (q) (s)−W (q) (u))
S(s) = S(u)e , u ∈ [t0 , T ], s ∈ [u, T ], (6.46)

149
see Remark 6.1. To simplify the discussion we consider the case in which the dividend D is
expressed as percentage of the stock price just before the dividend is paid, i.e., D = aS(t−
0 ),
for some a ∈ (0, 1). Note that this means that we do not know at time t = 0 what amount
the dividend will pay at time t0 > 0, but we known for sure that D < S(t− 0 ).

Theorem 6.10. Consider the standard European derivative with pay-off Y = g(S(T )) and
(a,t )
maturity T . Let ΠY 0 (0) be the Black-Scholes price of the derivative at time t = 0 assuming
that the underlying stock pays the dividend aS(t−
0 ) at time t0 ∈ (0, T ), where a ∈ (0, 1). Then
(a,t0 )
ΠY (0) = v0 ((1 − a)S0 ),
where v0 (x) is the pricing function (6.9) in the absence of dividends.

Proof. Recall that the price at time t = 0 of the derivative is given by the risk-neutral pricing
formula ΠY (0) = e−rT Eq [g(S(T ))]. We want to express S(T ) in this formula in terms of S(0)
using (6.45)-(6.46). Taking the limit s → t− 0 in (6.45) and using the continuity of the paths
of the Brownian motion we find
1 2 )(t −t)+σ(W (q) (t )−W (q) (t))
S(t−
0 ) = S(t)e
(r− 2 σ 0 0
, t ∈ [0, t0 ).
Replacing in (6.44) we obtain
1 2 )(t −t)+σ(W (q) (t )−W (q) (t))
S(t0 ) = (1 − a)S(t)e(r− 2 σ 0 0
, t ∈ [0, t0 ).
Hence, letting (s, u) = (T, t0 ) into (6.46) and then expressing S(t0 ) with the equation above,
we find
1 2 (q) (q)
S(T ) = (1 − a)S(t)e(r− 2 σ )(T −t)+σ(W (T )−W (t)) , t ∈ [0, t0 ).
Letting t = 0 and replacing in the risk-neutral pricing formula we obtain
(a,t0 ) 1 2 )T +σW (q) (T )
ΠY (0) = e−rT Eq [g((1 − a)S(0)e(r− 2 σ )],
√
or, setting X = W (q) (t)/ T ,
1 2 )T +σ
√
(a,t0 )
ΠY (0) = e−rT Eq [g((1 − a)S(0)e(r− 2 σ TX
)],
As X ∈ N (0, 1) in the risk-neutral probability, we have
√
Z
σ2 1 2 dy
−rT
ΠY (a, t0 )(0) = e g((1 − a)S(0)e(r− 2 )T +σ T )e− 2 y √ = v0 ((1 − a)S0 ),
R 2π
as claimed.
Exercise 6.20 (?). Use the previous result to show that the call option is less valuable at
time t = 0 if the stock pays a dividend at time t0 > 0. Give an intuitive explanation for this
property.
Exercise 6.21 (Sol. 33). A standard European derivative pays the amount Y = (S(T ) −
S(0))+ at time of maturity T . Find the Black-Scholes price ΠY (0) of this derivative at time
t = 0 assuming r > 0 and that the underlying stock pays the dividend (1 − e−rT )S( T2 −) at
time t = T2 . Compute the probability of positive return for a constant portfolio which is short
1 share of the derivative and short S(0)e−rT shares of the risk-free asset (assume B(0) = 1).

150
6.7 Multi-asset options (*)
In this final section we consider standard European derivatives on two stocks, i.e., European
style derivatives with pay-off of the form Y = g(S1 (T ), S2 (T )), where S1 (t), S2 (t) are the
prices of the underlying stocks at time t ∈ [0, T ] and T > 0 is the time of maturity of the
derivative. Before we describe how to valuate these derivatives in Black-Scholes theory, let
us look at some examples.

Examples of options on two stocks

Given K1 , K2 > 0, a two assets correlation call option with maturity T is the European
derivative with pay-off

(S2 (T ) − K2 )+ if S1 (T ) > K1
Y = .
0 otherwise

A maximum call option on two stocks with maturity T is the European style derivative
with pay-off Y = max((S1 (T )−K1 )+ , (S2 (T )−K2 )+ ), and similarly one defines the minimum
call option on two (or more) stocks and the analogous put options.
The European derivative with maturity T and pay-off

Y = (S1 (T ) − S2 (T ))+

is called a spread option (or exchange asset option). The European derivative with
maturity T and pay-off  
S1 (T )
Y = −K
S2 (T ) +

is called a relative outperformance option.

A quanto option is a call or put option on a stock in which the pay-off is paid in a different
currency than the one in which the stock is traded. Thus, letting Ξ(t) be the exchange rate
of the two currencies at time t, the pay-off of a quanto call option with maturity T is

Y = Ξ(T )(S(T ) − K)+ .

Note that in this example the second asset is not at stock but a market parameter (the
exchange rate Ξ(t)).

Remark 6.6. New types of multi-asset options are created frequently. All multi-asset
options are traded OTC.

151
Black-Scholes price of 2-assets standard European derivatives
In Black-Scholes theory it is assumed that the stocks prices are given by a 2-dimensional
geometric Brownian motion, namely:

S1 (t) = S1 (0)eα1 t+σ11 W1 (t)+σ12 W2 (t) , (6.47a)

S2 (t) = S2 (0)eα2 t+σ21 W1 (t)+σ22 W2 (t) , (6.47b)

where {W1 (t)}t≥0 , {W2 (t)}t≥0 are independent Brownian motions in the physical probability
P and α1 , α2 , σ11 , σ12 , σ21 , σ22 are real constants. We assume that the volatility matrix
σ = (σij ) is invertible. Letting W (t) = (W1 (t), W2 (t)) and

σ1 = (σ11 , σ12 ), σ2 = (σ21 , σ22 ),

we can rewrite the 2-dimensional geometric Brownian motion in the more concise form

Sj (t) = Sj (0)eαj t+σj ·W (t) ,

where · denotes the standard scalar product of vectors. We start by deriving the joint density
of the stocks prices.
Theorem 6.11. The random variables log S1 (t), log S2 (t) are jointly normally distributed
with mean m = (log S1 (0) + α1 t, log S2 (0) + α2 t) and covariant matrix C = tσσ T . In partic-
ular, the random variables S1 (t), S2 (t) have the joint density
 x 

x y  log S(0) − α1 t
1
− 2t log S(0) − α1 t log S(0) − α2 t (σσ T )−1  y

log S(0) − α2 t
e
fS1 (t),S2 (t) (x, y) = p . (6.48)
txy (2π)2 det(σ · σ T )

Proof. We have

log S1 (t) = log S1 (0) + α1 t + σ11 W1 (t) + σ12 W2 (t),

log S2 (t) = log S2 (0) + α2 t + σ21 W1 (t) + σ22 W2 (t),

hence the first statement of the theorem follows by Theorem 5.10. The joint density of
S1 (t), S2 (t) is computed using that

FS1 (t),S2 (t) (x, y) = P(S1 (t) ≤ x, S2 (t) ≤ y)

= P(log S1 (t) ≤ log x, log S2 (t) ≤ log y) = Flog S1 (t),log S2 (t) (log x, log y),

hence

fS1 (t),S2 (t) (x, y) = ∂x ∂y FS1 (t),S2 (t) (x, y) = ∂x ∂y [Flog S1 (t),log S2 (t) (log x, log y)]
= (xy)−1 flog S1 (t),log S2 (t) (log x, log y),

which, using the joint normal density of log S1 (t) and log S2 (t), gives (6.48).

152
The geometric Brownian motion is often given in a different but equivalent (in distribution)
form, as shown in the next exercise.

Exercise 6.22. Show that the process (6.47) is equivalent, in distribution, to the process

S1 (t) = S1 (0)eα1 t+|σ1 |W1 (t) (6.49a)

√
1−ρ2 W2 (t))
S2 (t) = S2 (0)eα2 +|σ2 |(ρW1 (t)+ , (6.49b)
p
2 2
where |σi | = σi1 + σi2 is the Euclidean norm of the vector σi and
σ1 · σ2
ρ= ∈ [−1, 1] (6.50)
|σ1 ||σ2 |

is the cosine of the angle between σ1 , σ2 . Show that the historical variances of the two stocks
are unbiased estimators for |σ1 |2 , |σ2 |2 , while the historical correlation of the log-returns of
the two stocks is an unbiased estimator for ρ.

Now, exactly as in the one-dimensional case discussed in Section 6.2, it is possible to define a
risk-neutral (or martingale) probability measure with respect to which the discounted value
of both stocks are martingales. We seek this probability measure in the class of Girsanov
probabilities Pθ introduced in Theorem 5.18, where θ = (θ1 , θ2 ) ∈ R2 . The problem is solved
in the following two theorems, which are the 2-dimensional generalizations of Theorem 6.3
and Theorem 6.4 respectively.

Theorem 6.12. Let µ = (α1 − r, α2 − r). The discounted values S1∗ (t) = e−rt S1 (t) and
S2∗ (t) = e−rt S2 (t) of the stocks have constant expectation in the Girsanov probability Pθ if
and only if θ = q = (q1 , q2 ), where q is the (unique) solution of the linear system σq = µ.

Theorem 6.13. The stochastic processes {S1∗ (t)}t≥0 and {S2∗ (t)}t≥0 are martingales in the
probability measure Pθ if and only if θ = q = (q1 , q2 ).

Exercise 6.23. Prove Theorem 6.12.

The probability measure Pq is the martingale (or risk-neutral) probability of the 2-dimensional
Black-Scholes market.

Exercise 6.24. Prove that in the probability Pq the stocks prices are given by the following
2-dimensional geometric Brownian motion
|σ1 |2
)t+σ1 ·W (q) (t)
S1 (t) = S1 (0)e(r− 2 , (6.51a)
|σ |2
(r− 22 )t+σ2 ·W (q) (t)
S2 (t) = S2 (0)e , (6.51b)
(q) (q) (q) (q)
where W (q) (t) = (W1 (t), W2 (t)) = (W1 (t)+q1 t, W2 (t)+q2 t) and {W1 (t)}t≥0 , {W1 (t)}t≥0
are Pq -independent Brownian motions.

153
Denoting by Eq the expectation in the probability Pq , the Black-Scholes price at time t = 0
of the 2-assets European derivative with pay-off Y at maturity T is given by the risk-neutral
pricing formula ΠY (0) = e−rT Eq [Y ]. In the case of standard European derivative we have
the following analog of Theorem 6.5.
Theorem 6.14. The Black-Scholes price at time t = 0 of the 2-stocks option with pay-off
Y = g(S1 (T ), S2 (T )) is given by

ΠY (0) = v0 (S1 (0), S2 (0)),

where the pricing function v0 is given by

  
1

T −1 ξ
√ √
 exp − 2 ξ η (σσ )
η

|σ1 |2 |σ2 |2
Z
v0 (x, y) = g xe(r− 2 )T + T ξ , ye(r− 2 )T + T η p dξ dη.
R2 2π det(σσ T )
(6.52)

Exercise 6.25. Prove Theorem 6.14

The Black-Scholes price at time t > 0 of the 2-assets European derivative with pay-off
Y = g(S1 (T ), S2 (T )) is given by a formula similar to the one in Theorem 6.14, namely

ΠY (t) = v(t, S1 (t), S2 (t)),

where the pricing function v is given by

  
1

T −1 ξ
√ √
 exp − 2 ξ η (σσ )
η

|σ1 |2 |σ2 |2
Z
v(t, x, y) = g xe(r− 2 )τ + τ ξ , ye(r− 2 )τ + τ η p dξ dη.
R 2 2π det(σσ T )
(6.53)
Moreover it can be shown that the number of shares on the two stocks in the self-financing
hedging portfolio of the derivative is given by

hS1 (t) = ∂x v(t, S1 (t), S2 (t)), hS2 (t) = ∂y v(t, S1 (t), S2 (t)),

while the number of shares hB (t) on the risk-free asset is determined by the replicating
condition ΠY (t) = hS1 (t)S1 (t) + hS2 (t)S2 (t) + hB (t)B(t), i.e.,

hB (t) = B(t)−1 (ΠY (t) − hS1 (t)S1 (t) − hS2 (t)S2 (t)).

Example: relative outperformance options

For the relative outperformance call option with strike K the pay-off function is given by
 
x
g(x, y) = −K .
y +

154
Let’s compute the Black-Scholes price at time t = 0 using the risk-neutral pricing formula
ΠY (0) = e−rT Eq [g(S1 (T ), S2 (T ))], i.e., using (6.51),
  
−rT S1 (T )
ΠY (0) = e Eq −K
S2 (T ) +
  
−rT S1 (0) ( |σ2 | − |σ1 |2 )T +(σ1 −σ2 )·W (q) (T )
2
= e Eq e 2 2 −K ,
S2 (0) +

(q) (q) (q) (q)

where we recall that W (q) (t) = (W1 (t), W2 (t)) and {W1 (t)}t≥0 , {W1 (t)}t≥0 are inde-
pendent Brownian motion in the risk-neutral probability measure. Now we write
√ √
(σ1 − σ2 ) · W (q) (T ) = T [(σ11 − σ21 )G1 + (σ12 − σ22 )G2 ] = T (X1 + X2 ),
(q)
√
where Gj = Wj (T )/ T ∈ N (0, 1), and so Xj ∈ N (0, (σ1j − σ2j )2 ), j = 1, 2. In addition,
X1 , X2 are independent random variables, hence X1 + X2 is normally distributed with zero
mean and variance (σ11 − σ21 )2 + (σ12 − σ22 )2 = |σ1 − σ2 |2 (again by Theorem 5.10). It follows
that
S1 (0) ( |σ2 |2 − |σ1 |2 )T +√T |σ1 −σ2 |G)
  
−rT
ΠY (0) = e Eq e 2 2 −K ,
S2 (0) +

where G ∈ N (0, 1). Hence, letting

|σ1 − σ2 |2 |σ2 |2 |σ1 |2

 
r̂ = + −
2 2 2

and a = e(r̂−r)τ , we have

S1 (0) (r̂− |σ1 −σ2 |2 )T +√T |σ1 −σ2 |G

  
−r̂T
ΠY (0) = ae Eq e 2 −K .
S2 (0) +

Up to the multiplicative parameter a, this is the Black-Scholes price at time t = 0 of a call

on a stock with price S1 (0)/S2 (0), volatility |σ1 − σ2 | and for a risk-free rate given by r̂.
Hence, Theorem 6.6 gives
 
S1 (0) −r̂T
ΠY (0) = a Φ(d+ ) − Ke Φ(d− ) := v0 (S1 (0), S2 (0)), (6.54)
S2 (0)

where 2
S1 (t)
log KS2 (t)
+ (r̂ ± |σ1 −σ
2
2|
)τ
d± = √ .
|σ1 − σ2 | τ
Exercise 6.26. Compute the Black-Scholes price of exchange stock options.
ANSWER: ΠY (0) = v0 (S1 (0), S2 (0)), where v0 (x, y) = xΦ(d+ (x/y)) − yΦ(d− (x/y)) and
σ 2 +σ 2
d± (z) = √ 21 2 (log z ± 1 2 2 T ).
(σ1 +σ2 )T

155
6.8 Bonds valuation
Bonds are debt instruments issued by national governments and private companies as a
way to borrow money and fund their activities. In this final section we study the so-called
classical approach to the problem of bonds pricing. Other important topics, such as hedging,
calibration and the HJM methodology, are not discussed. For further reading on these topics,
see [7, 11].

Zero-coupon bonds
A zero-coupon bond (ZCB) with face (or nominal) value K and maturity T > 0 is a
contract that promises to pay to its owner the amount K at time T in the future. The
maturity of bonds can reach up to 30 or more years. In the following we assume that all
ZCB’s are issued by one given institution, so that all bonds differ merely by their face values
and maturities. Once a debt is issued in the so-called primary market, it becomes a
tradable asset in the secondary bond market. It is therefore natural to model the value at
time t of the ZCB maturing at time T > t as a random variable, which we denote by B(t, T ).
Hence {B(t, T )}t∈[0,T ] is a stochastic process. We assume throughout the discussion that
the institution issuing the bond bears no risk of default, i.e., B(t, T ) > 0, for all t ∈ [0, T ].
Clearly B(T, T ) = K and, under normal market conditions, B(t, T ) < K, for t < T , i.e.,
ZCB’s are risk-free assets ensuring a positive return. However exceptions are possible; for
instance zero-coupon (and other) national bonds in Sweden with maturity shorter than 5
years yield currently (2017) a negative return. Without loss of generality we assume from
now on that K = 1, as owning a ZCB with face value K is clearly equivalent to own K shares
of a ZCB with face value 1. A zero-coupon bond market (ZCB market) is a market in
which the objects of trading are ZCB’s with different maturities. For modeling purposes we
assume that all ZCB’s in the market expire before time S (e.g., S ≈ 50 years) and that there
exists a ZCB which matures at any time T ∈ (0, S).

Remark 6.7. The term “bond” is more specifically used for long term loans with maturity
T > 1 year. Short term loans have different names (e.g., bills, repo, etc.) and they constitute
the component of the loan market called money market. Bonds with less than one year
left to maturity are also considered money market assets.

The difference in value of ZCB’s with different maturities is expressed through the implied
forward rate of the bond. To define this concept, suppose that at the present time t we open
a portfolio that consists of −1 share of a ZCB with maturity t < T and B(t, T )/B(t, T + δ)
shares of a ZCB expiring at time T + δ. This investment has zero value and entails that we
pay 1 at time T and receive B(t, T )/B(t, T + δ) at time T + δ. Hence our investment at
the present time t is equivalent to an investment in the future time interval [T, T + δ] with

156
(annualized) return given by

1 B(t, T ) − B(t, T + δ)
Fδ (t, T ) = (B(t, T )/B(t, T + δ) − 1) = . (6.55)
δ δB(t, T + δ)

The quantity Fδ (t, T ) is also called discretely compounded forward rate in the interval
[T, T +δ] locked at time t (or forward LIBOR, as it is commonly applied to LIBOR interest
rate contracts). The name is intended to emphasize that the investment return in the future
interval [T, T + δ] is locked at the present time t ≤ T , that is to say, we know today which
interest rate has to be charged to borrow in the future time interval [T, T + δ] (if a different
rate were locked today, then an arbitrage opportunity would arise). When δ → 0+ we obtain
the continuously compounded T -forward rate
1 B(t, T ) − B(t, T + δ)
f (t, T ) = lim+ = −∂T log B(t, T ), (6.56)
δ→0 δ B(t, T + δ)
which is the rate locked at time t to borrow at time T for an “infinitesimal” period of time.
In the following we shall consider only continuously compounded rates.
The curve T → f (t, T ) is called forward rate curve of the ZCB market. The knowledge
of the forward rate curve determines the price B(t, T ) of all ZCB’s in the market through
the formula  Z T 
B(t, T ) = exp − f (t, s) ds , 0 ≤ t ≤ T ≤ S, (6.57)
t

which follows easily by integrating (6.56).

Remark 6.8. By (6.57), a theoretical price of ZCB’s at all maturities can be derived by
modeling the forward rate curve of the ZCB market. This approach to the problem of bonds
pricing is called HJM (Heath, Jarrow, Morton) approach and is described for instance in [7].
In this text we consider only the so-called “classical approach” to bonds pricing, which is
described below in this section.

The quantity
r(t) = f (t, t), t ∈ [0, S] (6.58)
is called the (continuously compounded) spot rate of the ZCB market at time t and
represents the interest rate locked at time t to borrow instantaneously at time t (i.e., on
the spot). Note that r(t) coincides with the risk-free rate which in the previous sections
was assumed to be constant. While this is reasonable for short maturity contracts, such as
options, in the case of long maturity bonds the time fluctuations of the spot rate must be
taken into account.
Example. Suppose that today (November 1st, 2017) an investor wants to sign a contract
to borrow 1000000 Kr on May 1st, 2018 for a period of 6 months. There are essentially two
ways in which this loan can be issued. The first way is to fix the interest rate today as the
forward rate f (t, T ), where t =November 1st, 2017 and T =May 1st, 2018. Note that f (t, T )

157
is known at time t, as it depends on the present day price of ZCB’s (which can be found
on-line or in the financial press). The second way to issue the loan is at the spot rate R(T ).
However the interest rate R(T ) is not known at time t, hence in this case the investor must
wait until the first of May 2018 to know which interest rate will be charged to the loan. Of
course, this second method entails a risk for both the borrower and the lender. This risk can
be hedged by interest rate derivatives, such as interest rate swaps.
The spot rate can be used to define the discount process:
 Z t 
d(t) = exp − r(s) ds (6.59)
0

If t is the present time and X(τ ) is the value of an asset at some given future time τ > t,
then the quantity  Z τ 
d(τ )
X(τ ) = exp − r(s) ds X(τ )
d(t) t

is called the present (at time t) discounted value of the asset and represents the future
(at time τ ) value of the asset relative to the purchasing value of money at that time. When
t = 0, we denote the discounted value as d(τ )X(τ ) = X ∗ (τ ). If r(t) = r is constant, we have
d(t) = e−rt , hence X ∗ (τ ) = e−rτ X(τ ) is precisely the discounted value used for stock prices
in our previous discussions.
The (continuously compounded) yield (to maturity) y(t, T ) at time t of the ZCB with
maturity T is the constant forward rate which entails the value B(t, T ) of the ZCB. Hence
the yield y(t, T ) of a ZCB is obtained by replacing f (t, v) = y(t, T ) in (6.57), i.e.,

log B(t, T )
B(t, T ) = e−y(t,T )(T −t) , i.e., y(t, T ) = − . (6.60)
T −t
To put it in different words: Selling a ZCB for the price B(t, T ) at time t (i.e., borrowing
B(t, T ) at time t) is equivalent to lock the constant forward rate y(t, T ) until maturity. Note
also that the first equation in (6.60) expresses B(t, T ) as the discounted value at time t of
the future payment = 1 at maturity assuming that the spot rate is constant and equal to
y(t, T ) in the interval [t, T ].

Coupon bonds
Let 0 < t1 < t2 < · · · < tM = T be a partition of the interval [0, T ]. A coupon bond with
maturity T , face value 1 and coupons c1 , c2 , . . . , cM ∈ [0, 1) is a contract that promises to pay
the amount ck at time tk and the amount 1+cM at maturity T = tM . Note that some ck may
be zero, which means that no coupon is actually paid at that time. We set c = (c1 , . . . , cM )
and denote by Bc (t, T ) the value at time t of the bond paying the coupons c1 , . . . , cM and
maturing at time T . Now, let t ∈ [0, T ] and k(t) ∈ {1, . . . , M } be the smallest index such
that tk(t) > t, that is to say, tk(t) is the first time after t at which a coupon is paid. Holding

158
the coupon bond at time t is clearly equivalent to holding a portfolio containing ck(t) shares
of the ZCB expiring at time tk(t) , ck(t)+1 shares of the ZCB expiring at time tk(t)+1 , and so
on, hence
MX −1
Bc (t, T ) = cj B(t, tj ) + (1 + cM )B(t, T ), (6.61)
j=k(t)

the sum being zero when k(t) = M .

The yield of a coupon bond is defined implicitly by the equation
M
X −1
Bc (t, T ) = cj e−yc (t,T )(tj −t) + (1 + cM )e−yc (t,T )(T −t) . (6.62)
j=k(t)

Hence the yield of the coupon bond is the constant spot rate used to discount the total future
payments of the coupon bond.
Remark 6.9. Most commonly the coupons are equal. Letting cj = c, for all j = 1, . . . , M ,
the formula (6.62) simplifies to
M
X −1
Bc (t, T ) = c e−yc (t,T )(tj −t) + (1 + c)e−yc (t,T )(T −t) . (6.63)
j=k(t)

Example. Consider a 3 year maturity coupon bond with face value 1 which pays 2% coupon
semiannually. Suppose that the bond is listed with an yield of 1%. What is the value of the
bond at time zero? The coupon dates are

(t1 , t2 , t3 , t4 , t5 , t6 ) = (1/2, 1, 3/2, 2, 5/2, 3),

and c1 = c2 = · · · = c6 = 0.02. Hence

Bc (0, T ) = 0.02e−0.01·1/2 + 0.02e−0.01·1 + 0.02e−0.01·3/2 + 0.02e−0.01·2 + 0.02e−0.01·5/2

+ 1.02e−0.02·3 ≈ 1.087.

In the previous example we computed the value of a coupon bond with given yield. How-
ever in the applications one is more often faced with the opposite problem, i.e., computing
the yield of a coupon bond with given value Bc (t, T ). To solve this problem one has to
invert (6.61). For instance, assume t = 0, T = M years and that the coupons are paid
annually, that is t1 = 1, t2 = 2, . . . , tM = M . Then x = e−yc (0,T ) solves p(x) = 0, where p is
the M -order polynomial given by

p(x) = c1 x + c2 x2 + · · · + (1 + cM )xM − Bc (0, T ). (6.64)

The roots of this polynomial can easily be computed numerically, e.g., with the command
roots[p] in Matlab, as in the following exercise.

159
Exercise 6.27 (Matlab). Write a Matlab function

yield(B, Coupon, FirstCoupDate, CoupFreq, T)

that computes the continuously compounded yield of a coupon bond. Here, B is the cur-
rent (i.e., at time t = 0) price of the bond, Coupon ∈ [0, 1) is the (constant) coupon,
FirstCoupDate is the first future date at which the coupon is paid, CoupFreq is the fre-
quency of coupon payments and T is the time left to maturity of the bond. Remember that
time in finance is measured in fraction of years and 1 year = 252 days (unless otherwise
stated in the contract). For example

yield(1.01, 0.02, 46/252, 1, 19 + 201/252)

computes the yield of a 2% coupon bond which today is priced 1.01, pays the first coupon in
46 days and which matures in 19 years and 201 days.

Bonds are listed in the market in terms of their yield rather than in terms of their price.
The curve T → yc (t, T ) is called the yield curve of the ZCB market. Figure 6.4 shows an
example of yield curve for governmental Swedish bonds.

Exercise 6.28. Yield curves observed in the market are classified based on their shape (e.g.,
steep, flat, inverted, etc.). Find out on the Internet what the different shapes mean from an
economical point of view.

The classical approach to ZCB’s pricing

We conclude by describing the so-called classical approach to ZCB’s pricing. A cornerstone
of this approach is to interpret bonds as financial derivatives on the spot rate. As in the
case of stock options, the dynamics of the underlying asset (in this case the spot rate) is
prescribed a priori in the form of a stochastic process {r(t)}t∈[0,S] .

Definition 6.4. Let {r(t)}t∈[0,S] be a stochastic process modeling the spot interest rate of the
ZCB market, where we assume that that r(0) = r0 is a deterministic constant. Then
RT
B(0, T ) = E[d(T )] = E[e− 0 r(s) ds
], 0 < T < S. (6.65)

Hence the value at time t = 0 of the ZCB is the expected value of the discounted future pay-
ment = 1 of the ZCB. Note that in a purely ZCB market, one cannot define a martingale, or
risk-neutral, probability, hence the expectation in (6.65) is taken in the physical probability.
Equivalently, in the classical approach to ZCB’s pricing, the physical probability is assumed
to be risk-neutral.

160
Figure 6.4: Yield curve for Swedish bonds. Note that the yield is negative for maturities
shorter than 5 years. Bonds with maturity larger than 2 years have coupon and thus their
yield is computed using (6.62) (instead of (6.60)).

Example: The Ho-Lee model

In the Ho-Lee model, the risk-free rate is assumed to satisfy

r(t) = r(0) + θ(t) + σW (t), θ(0) = 0, (6.66)

where {W (t)}t≥0 is a Brownian motion, σ > 0 is constant and θ(t) is a deterministic function
of time. Within this model the initial price (6.65) of the ZCB with face value 1 and maturity
T is given by Z T 3
 
2T
B(0, T ) = exp −r(0)T − θ(s) ds + σ . (6.67)
0 6
RT 3
The formula (6.67) follows immediately by using that 0 W (t) dt ∈ N (0, T3 ), see Theo-
rem (5.14).
The literature abounds of stochastic models for the spot rate and new models are introduced
frequently, see [9]. Often it is not possible to derive a simple closed formula for the price
of the ZCB implied by an interest rate model, in which case the use of numerical methods
become essential. The most popular numerical method applied to price ZCB’s is the Monte
Carlo method, as exemplified in the following exercise.

161
Exercise 6.29 (Matlab). Let {W (t)}t≥0 be a Brownian motion and consider the process
{X(t)}t≥0 given by Z t
X(t) = X0 + σW (t) + σθ W (s)e−θ(t−s) ds,
0
which is an example of Ornstein-Uhlenbeck process. Here X0 , σ, θ are deterministic
constants with σ, θ > 0. Assume that the spot rate of the ZCB market is given by r(t) =
X(t)2 . Apply the (crude) Monte Carlo method to compute the initial price of the ZCB and
the confidence interval of the result. Apply the code in Exercise 6.27 to perform a parameter
sensitivity analysis of the yield curve. Can you reproduce all the typical shapes found in
Exercise 6.28?

6.9 Further exercises

In the following exercises, the stock price S(t) is given by a geometric Brownian motion with
instantaneous volatility σ > 0 and instantaneous mean of log-return α.
Exercise 6.30. Find the Black-Scholes price of a European derivative with pay-off Y =
2
S(T ) + S(T )−1 at maturity T > 0. ANSWER: ΠY (t) = S(t) + e(σ −2r)τ S(t)−1 .
Exercise 6.31. Let 0 < a < b. A European derivative pays 1 if S(T ) lies in the interval
(a, b) and zero otherwise. (a) Compute the Black-Scholes price ΠY (t) of the derivative and
√ σ2
(b) find the value of S(t) for which ΠY (0) is maximal. ANSWER (b): S(0) = abe−(r− 2 )τ .
Exercise 6.32. A European derivative pays 1 if S(T ) > K and −1 otherwise, where K > 0.
σ2
Determine K such that ΠY (0) = 0. ANSWER: K = S(0)e(r− 2
)T
.
Exercise 6.33. Let 0 < L < K. A European style derivative on a stock with maturity T > 0
pays nothing to its owner when S(T ) > K, while for S(T ) < K it lets the owner choose
between 1 share of the stock and the fixed amount L. (a) Draw the pay-off function of the
derivative. (b) Compute the Black-Scholes price of the derivative. (c) Compute the number of
shares of the stock in the hedging self-financing portfolio.
√ ANSWER (c): hS (t) = ∆(t, √ S(t)),
where ∆(t, x) = Φ(d2 (K)) − √ Φ(d2 (L)) − φ(d2 (K))/σ τ , where d2 (a) = d1 (a) − σ τ and
a σ2
d1 (a) = (log x − (r − 2 )τ )/σ τ .
Exercise 6.34. Consider a European derivative with pay-off Y = (S(T ) − S(0))2 /S(T ) at
time of maturity T > 0. Compute the Black-Scholes price ΠY (t) and the number of shares of
2
the stock in the hedging portfolio. ANSWER: ΠY (t) = S(t)−2S(0)e−rτ +S(0)2 e(σ −2r)r S(t)−1 ;
2
hS (t) = 1 − S(0)2 e(σ −2r)τ S(t)−2 .
Exercise 6.35. Compute the Black-Scholes price ΠY (0) at time t = 0 of the European
derivative with pay-off Y = max(S(T ), B(T )), where B(t) is the price of the risk-free asset,
S(t) is the price of the underlying stock and T is the time of maturity of the derivative.
Derive the low volatility limit (σ → 0+ ) and the high volatility limit (σ → +∞) of ΠY (0).

162
 √ √ 
B0

ANSWER: ΠY (0) = S0 − S0 Φ(d − σ T ) + B0 Φ(d), where d = 21 σ T + 1
√
σ T
log S0
.
Moreover limσ→+∞ ΠY (0) = S0 + B0 and limσ→0+ ΠY (0) = max(S0 , B0 ).

Exercise 6.36. Let v(t, x) be the Black-Scholes price function of a European derivative with
pay-off Y = g(S(T )). Show that v is convex in the variable x; show also that v(t, x) ≥ g(x)
if g(0) = 0. Finally prove that v(t, x) satisfies the Black-Scholes PDE:

σ2 2 2
∂t v + rx∂x v + x ∂x v − rv = 0, 0 ≤ t < T, x > 0,
2
with terminal value v(T, x) = g(x).

Exercise 6.37. Let C(t, x, K, T ) be the Black-Scholes pricing function of a call option with
strike K and maturity T . Show that

∂ 2C xd1 d2 √
= φ(d 1 ) τ.
∂σ 2 σ
Conclude from this that the function σ → C is convex in the interval (0, σ0 ] and concave in
the interval [σ0 , ∞), where r
2 xerτ
σ0 = | log |.
τ K

163
Appendix A

Solutions to selected exercises

1. Solution to Exercise 1.10. Since the stock pays no dividend in the interval (t0 , T ), the
standard put-call parity holds at time t0 :

C(t0 , S(t0 ), K, T ) − P (t0 , S(t0 ), K, T ) = S(t0 ) − Ke−r(T −t0 ) . (A.1)

Now consider a constant portfolio that consists of −1 share of the call, 1 share of the put,
1 share of the stock and −(K/B(T ) + D/B(t0 )) shares of the risk-free asset. The value of
this portfolio at time t0 is
K
V (t0 ) = −C(t0 , S(t0 ), K, T ) + P (t0 , S(t0 ), K, T ) + S(t0 ) − B(t0 ) − D = −D,
B(T )

where we used (A.1). As this portfolio has a long position on 1 share of the stock, then it
generates the positive cash flow D in the interval (t, t0 ). Hence, by Theorem 1.1(b) with
CA = D we have V (t) = 0, for t < t0 , which is equivalent to (1.17).

2. Solution to Exercise 1.12. To draw the graph of the pay-off function of the derivative
we first draw the graph of the functions S(T ) → (S(T ) − K1 )+ and S(T ) → (K2 − S(T ))+
and then we take their minimum. Now let B1 be a portfolio that consists of one share
of the derivative U and let VB1 (t) be its value at time t ∈ [0, T ]. The exercise asks to
derive a constant portfolio B2 consisting of European calls and puts which replicates the
value of B1 , i.e., such that VB1 (t) = VB2 (t), for all t ≤ T , or equivalently VA (t) = 0, where
A = B1 − B2 . By Theorem 1.1(b) (with CA = 0) it is enough to find the portfolio B2 such
that VA (T ) = VB1 (T ) − VB2 (T ) = 0. Clearly VB1 (T ) = Y , since the value of a derivative at
the expiration date always equals its pay-off. So we have to find a combination of pay-off
functions of puts and calls such that their sum equals Y . By inspecting the graph of the
pay-off function it is easy to see that
K1 + K2
Y = (S(T ) − K1 )+ − 2(S(T ) − )+ + (S(T ) − K2 )+ .
2

164
Hence, letting

U1 = European call with strike K1

U2 = European call with strike (K1 + K2 )/2
U3 = European call with strike K2

where for all calls the expiration date is T , the sought portfolio is B2 = (1, −2, 1). This
concludes the solution of the exercise.
3. Solution to Exercise 1.15. Consider a portfolio A which is long 1 share of the derivative
with pay-off Y and short 1 share of the derivative with pay-off ΠY (t∗ ). As the value of this
portfolio is zero at time t∗ , then by Theorem 1.1(b) (with CA = 0) its value is zero for all
t < t∗ .
4. Solution to Exercise 1.16. The pay-off at time T1 for the chooser option is

Y = max(C(T1 , S(T1 ), K, T2 ), P (T1 , S(T1 ), K, T2 )).

Using the identity max(a, b) = a + max(0, b − a) we obtain

Y = C(T1 , S(T1 ), K, T2 ) + max(0, P (T1 , S(T1 ), K, T2 ) − C(T1 , S(T1 ), K, T2 )).

By the put-call parity,

Y = C(T1 , S(T1 ), K, T2 ) + max(0, Ke−r(T2 −T1 ) − S(T1 )) = Z + U.

Hence
ΠY (t) = ΠZ (t) + ΠU (t). (A.2)
Since U is the pay-off of a put option with strike Ke−r(T2 −T1 ) expiring at time T1 then

ΠU (t) = P (t, S(t), Ke−r(T2 −T1 ) , T1 ). (A.3)

Applying the result of Exercise 1.15 with Z = C(T1 , S(T1 ), K, T2 ) = Π(S(T2 )−K)+ (T1 ) we
obtain
ΠZ (t) = C(t, S(t), K, T2 ). (A.4)
Replacing (A.3) and (A.4) into (A.2) we finally obtain, for the fair price of the chooser
option,
ΠY (t) = C(t, S(t), K, T2 ) + P (t, S(t), Ke−r(T2 −T1 ) , T1 ).
5. Solution to Exercise 2.2. The sum is
 Nu (x)
X
x
X
Nu (x) Nd (x) N
X p
P(S ) = p (1 − p) = (1 − p) ,
1−p
x∈{u,d}N x∈{u,d}N x∈{u,d}N

where for the last equality we used Nd (x) = N − Nu (x). Now, even though the sum is over
x ∈ {u, d}N , the terms to be summed depend only on Nu (x). Hence, the paths x with the

165
same value of Nu (x) (i.e., the same number of “ups”) give the same contribution to the sum.
It is easy to show that given k ∈ {0, 1, . . . , N }, the number of paths x for which Nu (x) = k
is given by the binomial coefficient:
 
N N!
= .
k k!(N − k)!

Each of the term in the sum for which Nu (x) = k equals (p/(1 − p))k , hence, as there are
N


k
of them, we obtain
N   k
X
x
X N N p
P(S ) = (1 − p) .
N k=0
k 1−p
x∈{u,d}

The binomial theorem asserts that (a + b)N = N N

P
k N −k
k=0 k a b . Letting a = p/(1 − p)
and b = 1 we conclude
 N
X
x N p
P(S ) = (1 − p) 1+ = 1.
N
1−p
x∈{u,d}

6. Solution to Exercise 2.4. The binomial tree of the stock price is

S(3) = 125
7
u

S(2) = 100
7
u d
'
S(1) = 80 S(3) = 50
7 7
u d u
'
S(0) = 64 S(2) = 40
7
d u d
' '
S(1) = 32 S(3)
7
= 20
d u
'
S(2) = 16
d
'
S(3) = 8

166
while the value of the risk-free asset at future times is
3
B(1) = B(0)er = 64 · = 48,
4
 2
2r 3
B(2) = B(0)e = 64 · = 36,
4
 3
3r 3
B(3) = B(0)e = 64 · = 27.
4
We may also represent the given portfolio process with a recombining binomial tree:
(hS (3), hB (3)) = (1, − 29 )
3 9
u

(hS (2), hB (2)) = (−1, 37 )

3
u d
+
(hS (1), hB (1)) = (1, −1) (hS (3), hB (3)) = (− 72 , 46 )
3 9
d u
+
(hS (2), hB (2)) = ( 27 , − 38 )
d
+
(hS (3), hB (3)) = ( 49
4
, − 59
9
)

To show that this portfolio process is self-financing we have to check that (2.8) is satisfied
for t = 2, 3 (for t = 1 it is trivially satisfied, because hS (1) = hS (0) and hB (1) = hB (0)). For
t = 2 equation (2.8) reads
hS (2)S(1) + hB (2)B(1) = hS (1)S(1) + hB (1)B(1). (A.5)
Note that (A.5) consists of two equations, one for S(1) = S(1, u) = 80 (the stock price goes
up at time t = 1) and one for S(1) = S(1, d) = 32 (the stock price goes down at time t = 1).
In the first case hS (2) = hS (2, u) = −1 and hB (2) = hB (2, u) = 7/3; substituting these
values in (A.5) we obtain
−1 · 80 + 7/3 · 48 = 1 · 80 − 1 · 48,
which is a true identity. When S(1) = 32, we have hS (2) = hS (2, d) = 7/2, hB (2) =
hB (2, d) = −8/3 and so (A.5) becomes
7 8
· 32 − · 48 = 1 · 32 − 1 · 48,
2 3
which is also a true identity. Hence our portfolio process satisfies (2.8) for t = 2. At time
t = 3 the self-finance condition (2.8) becomes
hS (3)S(2) + hB (3)B(2) = hS (2)S(2) + hB (2)B(2),

167
which is equivalent to the 4 equations

hS (3, u, u)S(2, u, u) + hB (3, u, u)B(2) = hS (2, u)S(2, u, u) + hB (2, u)B(2)

hS (3, u, d)S(2, u, d) + hB (3, u, d)B(2) = hS (2, u)S(2, u, d) + hB (2, u)B(2)
hS (3, d, u)S(2, d, u) + hB (3, d, u)B(2) = hS (2, d)S(2, d, u) + hB (2, d)B(2)
hS (3, d, d)S(2, d, d) + hB (3, d, d)B(2) = hS (2, d)S(2, d, d) + hB (2, d)B(2).

Replacing the value of the various quantities as given in the exercise it is straightforward to
see that these equations are satisfied. Next we compute the value of the portfolio process
along any possible path. At time t = 0 we have

V (0) = hS (0)S(0) + hB (0)B(0) = hS (1)S(0) + hB (1)B(0) = 64 − 64 = 0,

while at times t = 1, 2 we have

V (1, u) = hS (1)S(1, u) + hB (1)B(1) = 80 − 48 = 32,

V (1, d) = hS (1)S(1, d) + hB (1)B(1) = 32 − 48 = −16,

7
V (2, u, u) = hS (2, u)S(2, u, u) + hB (2, u)B(2) = −100 + · 36 = −6,
3
7
V (2, u, d) = hS (2, u)S(2, u, d) + hB (2, u)B(2) = −40 + · 36 = 44,
3
7 8
V (2, d, u) = hS (2, d)S(2, d, u) + hB (2, d)B(2) = − · 40 − · 36 = 44,
2 3
7 8
V (2, d, d) = hS (2, d)S(2, d, d) + hB (2, d)B(2) = − · 16 − · 36 = −40
2 3
The computation of V (3) along all possible paths is similar and results in the following:

V (3, u, u, u) = 38
V (3, u, u, d) = V (3, u, d, u) = V (3, d, u, u) = −37
V (3, u, d, d) = V (3, d, u, d) = V (3, d, d, u) = 68 V (3, d, d, d) = −79.

The value of the portfolio process at different times can be expressed with the following

168
recombining binomial tree:

V (3) = 38
6
u

V (2) = −16
6
u d
(
V (1) = 32 V (3) = −37
7 6
u d u
(
V (0) = 0 V (2) = 44
6
d u d
( (
V (1) = −16 V6 (3) = 68
d u
(
V (2) = −40
d
(
V (3) = −79

7. Solution to Exercise 3.3. The binomial tree for the price of the stock is

S(2)
7
= 49
u

S(1) = 28
8
u d
'
S0 = 16 S(2) = 14
7
d u
&
S(1) = 8
d
'
S(2) = 4

er −ed
Moreover qu = eu −ed
= 1/2 = qd . Using the recurrence formula ΠY (2) = Y ,

ΠY (t) = e−r (qu ΠuY (t + 1) + qd ΠdY (t + 1)), t = 0, 1,

169
we find that the price Πput (t) of the put option is

Πput (2) = 0
6
u

Πput (1) = 0
6
u d
'
128
Πput (0) = Πput (2) = 0
81 7
d u
(
32
Πput (1) = 9
d
'
Πput (2) = 8

The pay-off for the call on the put at maturity T1 = 1 is (Πput − K1 )+ . Note that since
Πput (1) = g(S(1)), then the call on the put can be treated as a standard European derivative
on the stock expiring at time T1 = 1. Hence the price Πcp (t) of the call on the put is

Πcp (1) = 0
7
u

4
Πcp (0) = 9
d
'
Πcp (1) = 1

This completes the first part of the exercise. Now, the return of a portfolio with +1 share
of the call on the put is path dependent. We have
4 4 4 4
R(u, u) = 0 − =− , R(u, d) = 0 − =−
9 9 9 9
4 23 4 23
R(d, u) = 0 − − = −3, R(d, d) = 8 − − = 5.
9 9 9 9
Hence the probability of positive return for the buyer is is
 2
(u,u) 3
P(R > 0) = P(S )= = 75%.
4
8. Solution to Exercise 3.6. We have the general formula
X
ΠY (0) = e−rN (qu )Nu (x) (qd )Nd (x) Y (x), (A.6)
x∈{u,d}N

170
where (qu , qd ) is the risk-neutral probability vector, Nu (x) is the number of “u” in the path
x and Nd (x) = N − Nu (x) is the number of “d” in the path x. Moreover Y (x) denotes the
pay-off as a function of the path of the stock price. The exercise tells us that
Y (x) = S(N, x), if x = x∗ = (u, u, . . . u), i.e., xi = u for all i = 1, . . . , N ,
while Y (x) = S(0) for x 6= x∗ . Moreover, since S(N, x∗ ) = S(0)eN u , then
Y (x∗ ) = S(0)eN u .
Since in addition Nu (x∗ ) = N , we can rewrite the sum (A.6) as
X
ΠY (0) = e−rN (qu )Nu (x∗ ) (qd )Nd (x∗ ) Y (x∗ ) + e−rN (qu )Nu (x) (qd )Nd (x) Y (x)
x6=x∗
X
= e−rN (qu )N S(0)eN u + e−rN (qu )Nu (x) (qd )Nd (x) Y (x). (A.7)
x6=x∗

Next we compute the sum on x 6= x∗ . First replacing Nd (x) = N − Nu (x) and Y (x) = S(0)
we have
X X  qu Nu (x)
Nu (x) Nd (x) N
(qu ) (qd ) Y (x) = S(0)(qd ) . (A.8)
x6=x x6=x
q d
∗ ∗

Now, Nu (x) takes value in {0, 1, . . . , N −1} in (A.8); it cannot be equal to N because the only
element in {u, d}N for which Nu (x) = N is x∗ , but this element is not taken into account in
the sum that we are computing. Using
that the number of x ∈ {u, d}N for which Nu (x) = k
is given by the binomial coefficient Nk , we obtain

X  qu Nu (x) N −1   k
X N qu
= .
x6=x∗
qd k=0
k qd

N


Adding and subtracting the term k = N (where we use that N
= 1), we find

X  qu Nu (x) N −1   k
X N qu
=
x6=x∗
qd k=0
k qd
N   k  N
X N qu qu
= −
k=0
k qd qd
 N  N
qu qu
= 1+ − ,
qd qd
PN N


where for the last equality we used the binomial theorem: (1 + a)N = k=0 k
ak . Substi-
tuting into (A.8) and using that qu + qd = 1 we obtain
X
(qu )Nu (x) (qd )Nd (x) Y (x) = S(0) 1 − (qu )N .


x6=x∗

171
Finally, replacing in (A.7) we find
ΠY (0) = e−rN S(0) (qu )N (eN u − 1) + 1 .
 

9. Solution to Exercise 3.7. By definition of binomial price we have

X N
X
−rN Nu (x) Nd (x)
ΠY (0) = e (qu ) (qd ) ((S(t) − S(t − 1))+ .
x∈{u,d}N t=1

Moreover
S(t) = S(t, x1 , . . . , xt ) = S0 ex1 +···+xt .
Hence we start by rewriting the price at time t = 0 of the derivative as
N
X X
−rN
ΠY (0) = S0 e (qu )Nu (x) (qd )Nd (x) (ex1 +···+xt − ex1 +···+xt−1 )+ .
t=1 x∈{u,d}N

Now we split the sum over the paths as

X X X
= ,
x∈{u,d}N (x1 ,...,xt−1 )∈{u,d}t−1 (xt ,...,xN )∈{u,d}N −t+1

and we also write Nu (x) = Nu ((x1 , . . . , xt−1 )) + Nu ((xt , . . . , xN )) and similarly for Nd (x).
Thus
X
(qu )Nu (x) (qd )Nd (x) (ex1 +···+xt , −ex1 +···+xt−1 )+
x∈{u,d}N
X
= (qu )Nu ((x1 ,...xt−1 )) (qd )Nd ((x1 ,...,xt−1 ))
(x1 ,...,xt−1 )∈{u,d}t−1
X
× (qu )Nu ((xt ,...,xN )) (qd )Nd ((xt ,...,xN )) (ex1 +···+xt − ex1 +···+xt−1 )+ .
(xt ,...,xN )∈{u,d}N −t+1

Distinguishing the cases xt = u or d, the second sum in the right hand side can be written
as
X
(qu )Nu ((xt ,...,xN )) (qd )Nd ((xt ,...,xN )) (ex1 +···+xt − ex1 +···+xt−1 )+
(xt ,...,xN )∈{u,d}N −t+1
X
= (qu )Nu ((xt+1 ,...,xN )) (qd )Nd ((xt+1 ,...,xN )) [qu (eu − 1)+ + qd (ed − 1)+ ]ex1 +···+xt−1 .
(xt+1 ,...,xN )∈{u,d}N −t

Let A = [qu (eu − 1)+ + qd (ed − 1)+ ]. We have obtained

N
X X
−rN
ΠY (0) = S0 e A (qu )Nu ((x1 ,...,xt−1 )) (qd )Nd ((x1 ,...,xt−1 )) ex1 +···+xt−1
t=1 (x1 ,...,xt−1 )∈{u,d}t−1
X
× (qu )Nu ((xt+1 ,...,xN )) (qd )Nd ((xt+1 ,...,xN )) .
(xt+1 ,...,xN )∈{u,d}N −t

172
Using
x1 + · · · + xt−1 = Nu ((x1 , . . . , xt−1 ))u + Nd ((x1 , . . . , xt−1 ))d
and
Nd ((x1 , . . . , xt−1 )) = t − 1 − Nu ((x1 , . . . , xt−1 )),
we obtain, letting k = Nu ((x1 , . . . , xt−1 )),
t−1  
X
Nu ((x1 ,...,xt−1 )) Nd ((x1 ,...,xt−1 ))
X t−1
(qu ) (qd ) = (qu )k (qd )t−1−k eku e(t−1−k)d
k
(x1 ,...,xt−1 )∈{u,d}t−1 k=0
t−1 
t − 1  qu eu k
X 
d t−1
= (e qd ) .
k=0
k qd ed

PN N

k
By the binomial theorem k=0 k a = (1 + a)k and qu eu + qd ed = er we have
X
(qu )Nu ((x1 ,...,xt−1 )) (qd )Nd ((x1 ,...,xt−1 )) = er(t−1) .
(x1 ,...,xt−1 )∈{u,d}t−1

Similarly one can show that

X
(qu )Nu ((xt+1 ,...,xN )) (qd )Nd ((xt+1 ,...,xN )) = 1.
(xt+1 ,...,xN )∈{u,d}N −t

Hence
N
X 1 − e−rN
ΠY (0) = S0 e−rN A er(t−1) = S0 A ,
t=1
er − 1
where we used the formula in the hint.

10. Solution to Exercise 3.9. We start by writing down the binomial tree of the stock

173
price and the value of the derivative at time of maturity T = 3 (which is equal to the pay-off)

S(3) = 5 ⇒ ΠY (3) = 5
5
u

S(2) = 4
8
u d
)
16
S(1) = S(3) =5 2 ⇒ ΠY (3) = 2
7 5
u d u
&
64 8
S(0) = S(2) =
25 8 5
d u d
' )
32 4
S(1) = S(3) = ⇒ ΠY (3) = 0
25 5 5
d u
&
16
S(2) = 25
d
)
8
S(3) = 25
⇒ ΠY (3) = 0

The parameters of the binomial model are such that

2 1
qu = , qd = , r = 0.
3 3
To compute the price of the derivative at the times t ∈ {0, 1, 2} we use the recurrence formula
2 1
ΠY (t) = e−r (qu ΠuY (t + 1) + qd ΠdY (t + 1)) = ΠuY (t + 1) + ΠdY (t + 1), t ∈ {0, 1, 2}.
3 3
Hence at time t = 2 we have
2 1 2 1
S(2) = S(2, u, u) = 4 ⇒ ΠY (2, u, u) = ΠuY (3, u, u) + ΠdY (3, u, u) = · 5 + · 2 = 4
3 3 3 3
8 2 u 1 d 2 1 4
S(2) = S(2, u, d) = ⇒ ΠY (2, u, d) = ΠY (3, u, d) + ΠY (3, u, d) = · 2 + · 0 =
5 3 3 3 3 3
16 2 u 1 d 2 1
S(2) = S(2, d, d) = ⇒ ΠY (2, d, d) = ΠY (3, d, d) + ΠY (3, d, d) = · 0 + · 0 = 0.
25 3 3 3 3
At time t = 1 we have
16 2 1 2 1 4 28
S(1) = S(1, u) = ⇒ ΠY (1, u) = ΠuY (2, u) + ΠdY (2, u) = · 4 + · =
5 3 3 3 3 3 9
32 2 u 1 d 2 4 1 8
S(1) = S(1, d) = ⇒ ΠY (1, d) = ΠY (2, d) + ΠY (2, d) = · + ·0=
25 3 3 3 3 3 9

174
and at time t = 0 we have
2 1 2 28 1 8 64
ΠY (0) = ΠuY (1) + ΠdY (1) = · + · =
3 3 3 9 3 9 27
Hence we obtain the following diagram for the derivative price
ΠY (3) = 5
7
u

ΠY (2) = 4
7
u d
'
28
ΠY (1) = ΠY7 (3) = 2
7 9
u d u
'
64 4
ΠY (0) = ΠY (2) =
27 7 3
d u d
' '
8
ΠY (1) = 9
ΠY7 (3) = 0
d u
'
ΠY (2) = 0
d
'
ΠY (3) = 0
This concludes the first part of the exercise. To compute the number of shares of the
underlying asset in the hedging portfolio we use the formula
1 ΠuY (t) − ΠdY (t)
hS (t) =
S(t − 1) eu − ed
for t = 1, 2, 3 and hS (0) = hS (1), where we recall that hS (t) is the position in the interval
(t − 1, t]. Letting t = 3 we obtain
4 ΠuY (3) − ΠdY (3)
hS (3) = ,
3 S(2)
whence
4 ΠuY (3, u, u) − ΠdY (3, u, u) 4 5−2
hS (3, u, u) = = · =1
3 S(2, u, u) 3 4
4 ΠuY (3, u, d) − ΠdY (3, u, d) 4 2−0 5
hS (3, u, d) = = · =
3 S(2, u, d) 3 8/5 3
u d
4 ΠY (3, d, d) − ΠY (3, d, d)
hS (3, d, d) = = 0.
3 S(2, d, d)

175
Likewise
4 ΠuY (2) − ΠdY (2)
hS (2) = .
3 S(1)
Hence
4 ΠuY (2, u) − ΠdY (2, u) 4 4 − 4/3 10
hS (2, u) = = · =
3 S(1, u) 3 16/5 9
u d
4 ΠY (2, d) − ΠY (2, d) 4 4/3 − 0 25
hS (2, d) = = · =
3 S(1, d) 3 32/25 18

and finally
4 ΠuY (1) − ΠdY (1) 4 28/9 − 8/9 125
hS (0) = hS (1) = = · = .
3 S(0) 3 64/25 108
Thus {hS (t)}t∈I is given by the binomial tree

hS (3) = 1
6
u

hS (2) = 10/9
5
u d
(
hS (1) = 125/108 hS (3) = 5/3
6
d u
)
hS (2) = 25/18
d
(
hS (3) = 0

This concludes the second part of the exercise.

11. Solution to Exercise 3.10. The hedging condition reads

hS (2)S(2) + hB (2)B0 e2r = g(S(2)).

Since hS (2), hB (2) are required to depend only on S(1), then we have to express S(2) as a
function of S(1) in the previous equation. Therefore to find a portfolio as required we have
to write the hedging condition as

hS (2)S(1)eu + hB (2)B(1)er = g(S(1)eu ),

hS (2)S(1)ed + hB (2)B(1)er = g(S(1)ed ).

Since u > d, the previous system is solvable on hS (2), hB (2) and the unique solution is given

176
by
1 g(S(1)eu ) − g(S(1)ed )
hS (2) = , (A.9a)
S(1) eu − ed
e−r eu g(S(1)ed ) − ed g(S(1)eu )
hB (2) = . (A.9b)
B(1) eu − ed
In particular hS (2) and hB (2) depend only on S(1) (and the given parameters r, u, d). Now,
the self-financing property at time t = 1 is

V (1) = hS (2)S(1) + hB (2)B(1),

i.e., using V (1) = hS (1)S(1) + hB (1)B(1) and (A.9),

hS (1)S(1) + hB (1)B(1) = e−r [qu g(S(1)eu ) + qd g(S(1)ed )].

Again distinguishing the cases S(1) = S0 eu and S(1) = S0 ed , we derive the system

hS (1)S0 eu + hB (1)B0 er = e−r [qu g(S0 e2u ) + qd g(S0 eu+d )] := fu (S0 ),

hS (1)S0 ed + hB (1)B0 er = e−r [qu g(S0 eu+d ) + qd g(S0 e2d )] := fd (S0 ).

As before, since u > d, the previous system is solvable in hS (1), hB (1) and the unique
solution is given by
1 fu (S0 ) − fd (S0 )
hS (1) = , (A.10a)
S0 eu − ed
e−r eu fd (S0 ) − ed fu (S0 )
hB (1) = . (A.10b)
B0 eu − ed
Note that hS (1) and hB (1) are determined by S0 . Finally the self-financing property at time
0 is
V (0) = hS (1)S0 + hB (1)B0 . (A.11)
Since V (0) may also be written as V (0) = hS (0)S0 + hB (0)B0 , and we defined hS (0) = hS (1),
hB (0) = hB (1), then (A.11) holds. Hence we have found that there exists a unique self-
financing, hedging portfolio process which, at time t, depends only on S(t − 1) . Moreover
we claim that the found portfolio process is exactly (3.10). In fact, ΠuY (2) = g(S(1)eu ) and
ΠdY (2) = g(S(1)ed ), hence we can rewrite (A.9) as

1 ΠuY (2) − ΠdY (2)

hS (2) = ,
S(1) eu − ed
e−r eu ΠdY (2) − ed ΠuY (2)
hB (2) = ,
B(1) eu − ed
which is exactly (3.10b)-(3.10c) for t = 2. Similarly, one can show that (A.10) coincide
with (3.10b)-(3.10c) for t = 1.

177
12. Solution to Exercise 3.11. The hedging condition reads

hS S(2) + hB B0 e2r = g(S(2)).

Since the portfolio is constant and is required to depend only S0 = S(0), and not on
S(1), S(2), then we have to express S(2) in terms of S0 in the previous equation. As
S(2) ∈ {S(0)e2u , S0 eu+d , S0 e2d }, we obtain the system

hS S0 e2u + hB B0 e2r = g(S0 e2u )

hS S0 eu+d + hB B0 e2r = g(S0 eu+d )
hS S0 e2d + hB B0 e2r = g(S0 e2d ).

It is straightforward to show that the previous system has a (unique) solution (hS , hB ) if
and only if ∆ = 0 and in this case the solution is given by

eu g(S0 eu+d ) − g(S0 e2u )ed g(S0 e2u )(2ed − eu ) − eu g(S0 eu+d )
hB = , hS = .
B0 e2r (ed − eu ) S0 e2u (ed − eu )

13. Solution to Exercise 4.5. With the given values of the parameters u, d, r, we have

er − ed 1 − 23 1
qu = u d
= 4 2 = = qd .
e −e 3
−3 2

The fair price Π

b Y (t) of the American derivative satisfies

b Y (t) = max(Y (t), e−r (qu Π

Π b u (t + 1) + qd Π
b d (t + 1)))
Y Y
1 bu b d (t + 1))),
= max(Y (t), (ΠY (t + 1) + Π Y
2
b u (t) (resp. Π
where Π b d (t)) is the price of the derivative at time t assuming that the stock
Y Y

178
price goes up (resp. down) at time t. The diagram of the stock price is

S(3)
7
= 64
u

S(2)
7
= 48
u d
'
S(1)
7
= 36 S(3)
7
= 32
u d u
'
S(0) = 27 S(2)
7
= 24
d u d
' '
S(1) = 18 S(3) = 16
7
d u
'
S(2) = 12
d
'
S(3) = 8

to which there corresponds the following diagram for the intrinsic value:

Y (3) = 0 = Π
b Y (3)
6
u

Y (2) = 0
8
u d
(
Y7 (1) = 0 Y (3) 6 = 0 = Π
b Y (3)
u d u
&
Y (0) = 0 Y8 (2) = 0
d u d
' (
Y (1) = 6 Y (3) 6 = 8 = Π
b Y (3)
d u
&
Y (2) = 12
d
(
Y (3) = 8 = Π
b Y (3)

179
Therefore

S(2) = 48 ⇒ Π
b Y (2) = 0, S(2) = 24 ⇒ Π
b Y (2) = 4, S(2) = 12 ⇒ Π
b Y (2) = 12

S(1) = 36 ⇒ Π
b Y (1) = 2, S(1) = 18 ⇒ Π
b Y (1) = 8,

and Π
b Y (0) = 5. We thereby obtained the following diagram for the price of the derivative:

Π
b Y (3) = 0
7
u

Π
b Y (2) = 0
7
u d
'
Π
b Y (1) = 2 Π
b Y (3) = 0
7 7
u d u
'
Π
b Y (0) = 5 Π
b Y (2) = 4
7
d u d
' '
Π
b Y (1) = 8 Π
b Y (3) = 8
8
d u
&
Π
b Y (2) = 12
d
&
Π
b Y (3) = 8

This completes the first part of the exercise. The only case in which the price of the derivative
is positive and equals its intrinsic value prior to expiration is at time t = 2 when the price
of the stock is S(2) = 12 (i.e., the stock price goes down in the first two steps). This is
indicated in the previous diagram by putting the price of the derivative in a box. In this
case, and only in this case, it is optimal to exercise the derivative prior to expiration. If the
buyer does not exercise the derivative at the optimal moment, the writer can withdraw the
amount

b Y (2, d, d) − e−r [qu Π

C(2, d, d) = Π b dY (3, d, d)] = 12 − ( 1 · 8 + 1 · 8) = 4.
b uY (3, d, d) + qd Π
2 2
Note that after withdrawing this cash, the value of the portfolio is 8, which is exactly what
the writer needs to hedge the derivative!

14. Solution to Exercise 4.6. The binomial trees for the stock price S(t) and for the

180
intrinsic value Y (t) are as follows.
S(3) = 5
7
u

S(2) = 4
8
u d
&
16
S(1) = S(3)
8
=2
7 5
u d u
&
64 8
S(0) = S(2) =
25 8 5
d u d
' &
32 4
S(1) = S(3) =
25 8 5
d u
&
16
S(2) = 25
d
&
8
S(3) = 25

Y8 (3) = 2
u

Y8 (2) = 1
u d
&
1
Y (1) = Y (3) = 1
7 5 8
u d u
&
11 7
Y (0) = Y (2) =
25 8 5
d u d
' &
Y (1) = 0 Y (3) = 0
8
d u
&
Y (2) = 0
d
&
Y (3) = 0
The binomial price of the American derivative is defined as
Π
b Y (3) = Y (3), b Y (t) = max[Y (t), e−r (qu Π
Π b u (t + 1) + qd Π
b d (t + 1))], t = 0, 1, 2,
Y Y

181
where qu = 2/3 and qd = 1/3. Applying the above formula one finds the following binomial
tree for Π
b Y (t).

Π
b Y (3) = 2
7
u

5
Π
b Y (2) =
7 3
u d
'
71
Π
b Y (1) = Π
b Y (3) = 1
8 45 9
u d u
&

Π
b Y (0) = 184 b Y (2) = 7
Π
135
5
9
d u d

& %
14
Π
b Y (1) = Π
b Y (3) = 0
15 7
d u
'
Π
b Y (2) = 0
d
'
Π
b Y (3) = 0

This concludes the first part of the exercise. The initial position on the stock in the hedging
portfolio is
1 Π b u (1) − Π
Y
b d (1)
Y 1 71
45
− 14
15 145
hS (0) = hS (1) = u d
= 64 3 = ,
S(0) e −e 25 4
432
which answers the second question. As to the cash flow, observe that the only optimal early
exercise time is t = 2 when S(2) = 8/5, as in this case, and only in this case, Π
b Y (t) and Y (t)
are equal and positive prior to expire. If the buyer does not exercise the derivative at this
instance, the seller can withdraw the amount

b Y (2, u, d) − e−r (qu Π

C(2, u, d) = Π b d (3, u, d)) = 7 − 2 = 11 .
b u (3, u, d) + qd Π
Y Y
5 3 15
This answers the third question. The probability that the derivative is in the money at time
t is P(Y (t) > 0). We have
P(Y (0) > 0) = 1, P(Y (1) > 0) = p,
P(Y (2) > 0) = p2 + 2p(1 − p) = p(2 − p), P(Y (3) > 0) = p2 + 3p2 (1 − p) = p2 (3 − 2p).
This answers the fourth question. Finally, the return for the buyer at time t is positive if and
only if Y (t) > ΠY (0) (the question is relevant because the buyer can exercise at any time).

182
This happens only at time t when S(2) = 8/5 (the optimal exercise time) and at maturity
t = 3 when S(3) = 5. Hence we have

P(R(0) > 0) = 0, P(R(1) > 0) = 0,

P(R(2) > 0) = 2p(1 − p) P(R(3) > 0) = p3 .

This completes the exercise.

15. Solution to Exercise 5.6. Let A be an event that is resolved by both variables X, Y .
This means that there exist I, J ⊆ R such that A = {X ∈ I} = {Y ∈ J}. Hence, using the
independence of X, Y ,

P(A) = P(A ∩ A) = P(X ∈ I, Y ∈ J) = P(X ∈ I)P(Y ∈ J) = P(A)P(A) = P(A)2 .

Therefore P(A) = 0 or P(A) = 1. In a finite probability space this implies A = ∅ or A = Ω,

respectively. Next we show that X and Y = g(X) are independent if and only if Y is a
deterministic constant. For the “if” part, assume that Y = a is a deterministic constant.
Then 
1 if a ∈ I
P(Y ∈ I) = ,
0 otherwise
hence 
P(X ∈ J) if a ∈ I
P(Y ∈ I, X ∈ J) = = P(Y ∈ I)P(X ∈ J).
0 otherwise
For the “only if” part, let z ∈ R and I = {g(X) ≤ z} = {X ∈ g −1 (−∞, z]}. Then, using
the independence of X and Y = g(X),

P(g(X) ≤ z) = P(g(X) ≤ z, g(X) ≤ z) = P(X ∈ g −1 (−∞, z], g(X) ≤ z)

= P(X ∈ g −1 (−∞, z])P(g(X) ≤ z) = P(g(X) ≤ z)P(g(X) ≤ z).

Hence P(Y ≤ z) is either 0 or 1, which implies that Y is a deterministic constant.

16. Solution to Exercise 5.7. The exercise asks to prove the following: Let X1 , X2 be
independent random variables, g : R → R, and f : R → R. Then the random variables

Y = g(X1 ), Z = f (X2 )

are independent. Given I, J ⊆ R we have {Y ∈ I} = {X1 ∈ {g ∈ I}} and {Z ∈ J} = {X2 ∈

{f ∈ J}}. Hence, using the independence of X1 , X2 ,

P(Y ∈ I, Z ∈ J) = P(X1 ∈ {g ∈ I}, X2 ∈ {f ∈ J})

= P(X1 ∈ {g ∈ I})P(X2 ∈ {f ∈ J}) = P(Y ∈ I)P(Z ∈ J).

17. Solution to Exercise 5.12. To prove the inequality we first notice that

Var[αX] = E[α2 X 2 ] − E[αX]2 = α2 E[X 2 ] − α2 E[X]2 = α2 Var[X],

183
 Cov(αX, Y ) = E[αXY ] − E[αX]E[Y ] = αCov(X, Y )
and
Var[X + Y ] = E[(X + Y )2 ] − E[X + Y ]2 = E[X 2 ] + E[Y 2 ] + 2E[XY ]
− E[X]2 − E[Y ]2 − 2E[X]E[Y ] = Var[X] + Var[Y ] + 2Cov(X, Y ).
Hence letting a ∈ R we have
Var[Y − aX] = a2 Var[X] + Var[Y ] − 2aCov(X, Y ).
Since the variance of a random variable is always non-negative, the parabola
y(a) = a2 Var[X] + Var[Y ] − 2aCov(X, Y )
must always lie above the a-axis, or touch it at one single point a = a0 . Hence
Cov(X, Y )2 − Var[X]Var[Y ] ≤ 0,
which proves (5.20). Moreover Cov(X, Y )2 = Var[X]Var[Y ] if and only if there exists a0
such that Var[−a0 X + Y ] = 0, i.e., Y = a0 X + b0 , for some constant b0 . Note that a0 6= 0,
otherwise Y is a deterministic constant. Substituting in the definition of covariance, we see
that Cov(X, a0 X + b0 ) = a0 Var[X]. Hence if the right inequality in (5.20) is an equality we
have p
a0 Var[X] = Var[X]Var[a0 X + b0 ]), i.e., a0 Var[X] = |a0 |Var[X],
and thus a0 > 0. Similarly one shows that if the left inequality becomes an equality then
a0 < 0.
18. Solution to Exercise 5.17. By linearity of the expectation,
1
E[Wn (t)] = √ E[M[nt] ] = 0,
n
where we used that E[Mk ] = 0. Since Var[Mk ] = k, we obtain
[nt]
Var[Wn (t)] = .
n
Since nt ∼ [nt], as n → ∞, then limn→∞ Var[Wn (t)] = t. As to the covariance of Wn (t) and
Wn (s) for s 6= t, we compute
Cov[Wn (t), Wn (s)] = E[Wn (t)Wn (s)] − E[Wn (t)]E[Wn (s)] = E[Wn (t)Wn (s)]
 
1 1 1
= E √ M[nt] √ M[ns] = E[M[nt] M[ns] ]. (A.12)
n n n
Assume t > s (a similar argument applies to the case t < s). If [nt] = [ns] we have
E[M[nt] M[ns] ] = Var[M[ns] ] = [ns]. If [nt] ≥ 1 + [ns] we have
2
E[M[nt] M[ns] ] = E[(M[nt] −M[ns] )M[ns] ]+E[M[ns] ] = E[M[nt] −M[ns] ]E[M[ns] ]+Var[M[ns] ] = [ns],

184
where we used that the increment M[nt] −M[ns] is independent of M[ns] . Replacing into (A.12)
we obtain
[ns]
Cov[Wn (t), Wn (s)] = .
n
It follows that limn→∞ Cov[Wn (t), Wn (s)] = s.

19. Solution to Exercise 5.21. To prove the formula for the expectation we use

Ep [S(N )] = Ep [S(0) exp(X1 + · · · + XN )] = S(0)Ep [Y ],

where Y is the random variable

Y (ω) = exp(X1 (ω) + · · · + XN (ω)) = exp(uNH (ω) + dNT (ω)), ω ∈ ΩN .

Hence, using NT (ω) = N − NH (ω) and (5.11) we obtain

X
Ep [S(N )] = S(0) e(uNH (ω)+dNT (ω)) pNH (ω) (1 − p)NT (ω)
ω∈ΩN
 NH (ω)
Nd N
X
(u−d)NH (ω) p
= S(0)e (1 − p) e .
ω∈ΩN
(1 − p)

N


Now we use that for k = 0, . . . , N there exist exactly k
sample points ω ∈ ΩN such that
NH (ω) = k. Hence we can write
N   k
Nd N
X N eu p
Ep [S(N )] = S(0)e (1 − p) .
k=0
k ed (1 − p)
PN N

k
By the binomial theorem, (1 + a)N = k=0 k
a , hence
N
eu p

Nd N
Ep [S(N )] = S(0)e (1 − p) 1+ = S(0)(ed (1 − p) + eu p)N .
ed (1 − p)

Similarly one finds that Varp [S(N )] = S(0)2 [(e2u p + e2d (1 − p))N − (eu p + ed (1 − p))2N ].

20. Solution to Exercise 5.22. By the risk-neutral pricing formula (5.34) at time t = 0
we have AC(0) = e−rN Eq [Ycall (x)] and similarly for the Asian put. Thus

AC(0) − AP (0) = Eq [Ycall − Yput ]

Using
" N
# " N
# N
 1 X  1 X    1 X 
Ycall −Yput = S(t) − K − K− S(t) = S(t) −K
N + 1 t=0 N + 1 t=0 N + 1 t=0
+ +

185
we find !
N
e−rN X
AC(0) − AP (0) = Eq [S(t)] − Ke−rN Eq [1],
N +1 t=0

where Eq [·] denotes the expectation in the risk-neutral probability measure. As Eq [1] = 1
and Eq [S(t)] = S(0)ert , we obtain
N
!
h S(0) X i
AC(0) − AP (0) = e−rN ert − K .
N + 1 t=0

Using the formula in the HINT concludes the exercise.

21. Solution to Exercise 5.23. The martingale property of Π∗Y (t) = e−rt ΠY (t) in the
risk-neutral probability is
Π∗Y (t − 1) = Eq [Π∗Y (t)|Π∗Y (0), . . . , Π∗Y (t − 1)]. (A.13)
As Π∗Y (0), . . . , Π∗Y (t − 1) are measurable with respect to S(0), . . . , S(t − 1), (A.13) follows by
Π∗Y (t − 1) = Eq [Π∗Y (t)|S(0), . . . , S(t − 1)], (A.14)
which we prove below. Using the risk-neutral pricing formula
ΠY (t) = e−r(N −t) Eq [Y |S(0), . . . , S(t)],
the right hand side of (A.14) is
Eq [Π∗Y (t)|S(0), . . . , S(t − 1)] = e−rN Eq [Eq [Y |S(0), . . . , S(t)]|S(0), . . . , S(t − 1)]
= e−rN Eq [Y |S(0), . . . , S(t − 1)].
Using again the risk-neutral pricing formula, the last member of the previous equation co-
incides with Π∗Y (t − 1), hence (A.14) is proved. The proof of the recurrence formula (3.8) is
straightforward. First we observe that, by the risk-neutral pricing formula,
ΠuY (t + 1) = e−r(N −t−1) Eq [Y |S(0), . . . , S(t), S(t + 1) = S(t)eu ],
and similarly for ΠdY (t + 1). Hence, by definition of conditional expectation,
ΠY (t) = e−r(N −t) Eq [Y |S(0), . . . , S(t)]
= e−r(N −t) (Eq [Y |S(0), . . . , S(t), S(t + 1) = S(t)eu ]qu
+ Eq [Y |S(0), . . . , S(t), S(t + 1) = S(t)ed ]qd )
= e−r (qu ΠuY (t + 1) + qd ΠdY (t + 1)).
As to the last question in the exercise, we observe that, since {Π∗Y (t)}t=0,...,N and {S ∗ (t)}t=0,...,N
are martingales in the risk-neutral probability, then so it is the discounted value {V ∗ (t)}t=0,...,N
of any self-financing portfolio in the augmented market. Hence the argument in Remark 5.7
shows that any such portfolio process is not an arbitrage.

186
22. Solution to Exercise 5.25. By (5.43) we have
X X X
ΠY (0) = e−rN (K − sj )φN,q (j) = Ke−rN φN,q (j) − e−rN sj φN,q (j),
j:sj ≤K j:sj ≤K j:sj ≤K

where sj = S0 eju+(N −j)d . Hence sj ≤ K is equivalent to j ≤ γ. It follows that

X X
Ke−rN φN,q (j) = Ke−rN φN,q (j) = Ke−rN ΦN,q (γ).
j:sj ≤K j≤γ

Moreover
X X N 
−rN
e sj φN,q (j) = S0 ej(u−r)+(N −j)(d−r) q j (1 − q)N −j
j:sj ≤K j≤γ
j
X N 
= S0 (eu−r q)j (ed−r (1 − q))N −j .
j≤γ
j

Using q∗ = eu−r q and q = (er − ed )/(eu − ed ), we find ed−r (1 − q) = 1 − q∗ , hence

X X N 
−rN
e sj φN,q (j) = S0 q∗j (1 − q∗ )N −j = S0 ΦN,q∗ (γ).
j:s ≤K j≤γ
j
j

23. Solution to Exercise 5.32. As E[W (t)] = 0 for all t ≥ 0,

Cov[W (s), W (t)] = E[W (s)W (t)].
Assume t > s (for t < s the argument is identical). Using that the increments W (t) − W (s)
and W (s) = W (s) − W (0) are independent we have
E[W (s)W (t)] = E[W (s)(W (t) − W (s))] + E[W (s)2 ]
= E[W (s)]E[W (t) − W (s)] + Var[W (s)] = Var[W (s)] = s.
24. Solution to Exercise 5.34. By the Radon-Nikodým theorem we have
1 2
Eθ [W (t)] = E[Zθ W (t)] = E[e−θW (T )− 2 θ T W (t)].
Adding and subtracting W (t) in the exponent of the exponential function we have
1 2 1 2
Eθ [W (t)] = E[e−θ(W (T )−W (t))− 2 θ T e−θW (t) W (t)] = E[e−θ(W (T )−W (t))− 2 θ T ]E[e−θW (t) W (t)],
1 2
where in the last step we used that the random variables X = e−θ(W (T )−W (t))− 2 θ T and Y =
e−θW (t) W (t) are independent (why?). Using W (T )−W (t) ∈ N (0, T −t) and W (t) ∈ N (0, t),
we can compute the expectations of X and Y as
Z
− 21 θ2 T 1 x2 θ2
E[X] = e p e−θx− 2(T −t) dx = e− 2 t ,
2π(T − t) R
Z
1 x2 θ2
E[Y ] = √ e−θx− 2t x dx = −e 2 t θt.
2πt R
Hence Eθ [W (t)] = E[X]E[Y ] = −θt, as claimed.

187
25. Solution to Exercise 5.36. The binomial tree for the stock price and for the intrinsic
value Y (t) of the American put are

S(2) = 4
8
u

16
S(1) =
7 5
u d
&
64 8
S(0) = S(2) =
25 8 5
d u
'
32
S(1) = 25
d
&
16
S(2) = 25

Y7 (2) = 0
u

Y (1) = 0
7
u d
'
3
Y (0) = 0 Y (2) =
8 5
d u
'
23
Y (1) = 25
d
&
39
Y (2) = 25

b put (t) be the price at time t ∈ {0, 1, 2} of the American put. We have the recurrence
Let Π
formula Π b put (2) = Y (2) and

b put (t) = max[Y (t), e−r (qu Π

Π b u (t + 1) + qd Π
b d (t + 1))],
put put

where
er − ed 2 1
qu = u d
= , qd = 1 − qu = , er = 1.
e −e 3 3

188
Hence the binomial tree for Π
b put (t) is

Π
b put (2) = 0
6
u

1
Π
b put (1) =
6 5
u d
(
11 3
Π
b put (0) = Π
b put (2) =
25 8 5

d u
'
b put (1) = 23
Π
25
d

&
39
Π
b put (2) =
25

The only optimal exercise time prior to maturity is t = 1 when S(1) = 32

25
. This concludes
the first part of the exercise. The compound option has maturity T = 1 and pay-off

b put (1) − 8
Q = (Π )+ .
25

Since Π
b put (1) is a function of S(1), then we can treat the compound option as a standard
derivative on the stock. The compound option expires in the money if the stock price goes
down at time t = 1 and out of the money otherwise. Hence the price of the compound option
at time t = 0 is
2 1 8 1 23 8 1
Πcp (0) = e−r (qu Πucp (1) + qd Πdcp (1)) = ( − )+ + ( − )+ = .
3 5 25 3 25 25 5
This answers the second question. As to the hedging portfolio, the compound option can be
hedged by investing on the stock and the risk-free asset. The number of shares in the stock
is
1 Πucp (1) − Πdcp (1) 25 0 − 35 5
hS = u d
= 5 1 = −
S(0) e −e 64 4 − 2 16
The number of shares in the risk-free asset is obtained by solving the replicating equation
at time t = 0:
Πcp (0) − hS S(0) 31
hS S(0) + hB B(0) = Πcp (0) ⇒ hB = = .
B(0) 25

This answers the third question. Finally we compute the expected return E[R] for the owner
of the compound option as a function of p ∈ (0, 1). If the stock price goes up at time t = 1,

189
the compound option expires out of the money, hence the buyer losses the premium Πcp (0).
Thus
1
R=− with prob. p,
5
If the stock price goes down at time t = 1, the owner of the compound option will buy the
American put for K1 = 8/25. If the American put is exercised at this optimal exercise time,
then the return will be
23 1 8 2
R= − − = with prob. 1 − p.
25 5 25 5
Hence, if the American put is exercised at t = 1, the expected return is
1 2 2 3
E[R] = − p + (1 − p) = − p.
5 5 5 5
If the American put is exercised at t = 2, the expected return is
1 3 8 1
39 8 1
1
E[R] = − p + − − p(1 − p) + − − (1 − p)2 = (3p − 2)(8p − 13) = f (p).
5 5 25 5 25 25 5 25
Now, it is straightforward to verify that f (p) > 25 − 53 p when 0 < p < 2/3 and f (p) < 25 − 35 p
when 2/3 < p < 1. Hence the strategy which maximizes the expected return for the
compound option is: for 0 < p < 2/3, the American put should not be exercised at time
t = 1, while for 2/3 < p < 1 the American put should be exercised at time t = 1. For
p = 2/3 the two strategies lead to the same expected return. This answers the last question.
26. Solution to Exercise 6.1. In (6.2) we replace

b = 1 log S(t) = 1 (α(t − t0 ) + σ(W (t) − W (t0 )) = αh + σ (W (t) − W (t0 )), and
R
n S(t0 ) n n

bi = log S(ti ) = α(ti − ti−1 ) + σ(W (ti ) − W (ti−1 ) = αh + σ(W (ti ) − W (ti−1 ).
R
S(ti−1 )
So doing we obtain
n  2
σ2 X 1
στ2 (t) = W (ti ) − W (ti−1 ) − (W (t) − W (t0 ))
h(n − 1) i=1 n
" n #
σ2 X 1
= (W (ti ) − W (ti−1 ))2 − (W (t) − W (t0 ))2 .
h(n − 1) i=1 n

Taking the expectation and using that E[(W (t) − W (s))2 ] = Var[W (t) − W (s)] = t − s we
obtain
" n #
2
σ2
 
2 σ X 1 1
E[στ ] = (ti − ti−1 ) − (t − t0 ) = (t − t0 ) 1 − = σ2.
h(n − 1) i=1 n h(n − 1) n

190
27. Solution to Exercise 6.4. Recall that

C(t, x, K, T ) = xΦ(d1 ) − Ke−rτ Φ(d2 ), (A.15)

where
x
+ r − 12 σ 2 τ



log K
√
d2 = √ , d1 = d2 + σ τ , (A.16)
σ τ
Rx 1 2
and where Φ(x) = √1
2π −∞
e− 2 y dy is the standard normal distribution. As σ → 0+ we have
d1 → d2 and
1 x
d2 ∼ √ (log + rτ )σ −1 .
τ K
Hence

d2 → +∞, if x > Ke−rτ ,

d2 → −∞, if x < Ke−rτ ,
d2 → 0, if x = Ke−rτ ,

Thus

lim Φ(d1 ) = lim+ Φ(d2 ) = 1, if x > Ke−rτ ,

σ→0+ σ→0
lim Φ(d1 ) = lim+ Φ(d2 ) = 0, if x < Ke−rτ ,
σ→0+ σ→0
lim Φ(d1 ) = lim+ Φ(d2 ) = Φ(0), if x = Ke−rτ .
σ→0+ σ→0

It follows that

lim C(t, x, K, T ) = x − Ke−rτ if x > Ke−rτ ,

σ→0+
lim C(t, x, K, T ) = 0, if x ≤ Ke−rτ ,
σ→0+

i.e., limσ→0+ C(t, x, K, T ) = (x − Ke−rτ )+ . For σ → +∞ we have d2 → −∞ and d1 → +∞,

hence Φ(d1 ) → 1 and Φ(d2 ) → 0. Thus C(t, x, K, T ) → x as σ → +∞. As K → 0+ , both d1
and d2 diverge to +∞, hence
lim+ C(t, x, K, T ) = x.
K→0

For K → +∞, d1 , d2 diverge to −∞. Hence the first term in C(t, x, K, T ) converges to zero.
As the first term in C(t, x, K, T ) always dominates the second term (since C(t, x, K, T ) > 0),
then the second term also goes to zero and thus

lim C(t, x, K, T ) = 0.
K→+∞

For T → +∞ we obtain
lim C(t, x, K, T ) = x.
T →+∞

191
Finally, for x → 0+ , both d1 , d2 diverge to −∞ and thus

lim C(t, x, K, T ) = 0.
x→0+

As x → ∞, d1 , d2 diverge to ∞, hence C(t, x, K, T ) ∼ x − Ke−rτ as x → ∞. To compute

the limits for put options we use the put-call parity:

C(t, x, K, T ) − P (t, x, K, T ) = x − Ke−rτ ,

by which it follows that

lim+ P (t, x, K, T ) = (Ke−rτ − x)+ , lim P (t, x, K, T ) = Ke−rτ

σ→0 σ→+∞

lim P (t, x, K, T ) = 0, lim P (t, x, K, T ) = +∞,

K→0+ K→+∞

lim P (t, x, K, T ) = 0, lim P (t, x, K, T ) = Ke−rτ .

T →+∞ x→0+

28. Solution to Exercise 6.5. The pay-off is Y = LH(S(T ) − K), where H(z) is the
Heaviside function. Replacing g(z) = LH(z − K) into (6.12) we obtain
e−rτ
Z √
σ2 y2
v(t, x) = √ L H(xe(r− 2 )τ eσ τ y − K)e− 2 dy
2π
−rτ ZR∞
e y2
=√ L e− 2 dy,
2π −d2

1 σ2
where we recall that d2 = √
σ τ
[log(x/K) + (r − 2
)τ ]. With the change of variable y → −y
we obtain
ΠY (t) = e−rτ LΦ(d2 ).
The number of shares of the stock in the self-financing hedging portfolio is given by ∂x v(t, S(t)),
i.e.,
e−rτ L φ(d2 (x))
∂x v(t, x) = ∂x (e−rτ LΦ(d2 (x))) = e−rτ LΦ0 (d2 (x))∂x (d2 (x)) = √ .
σ τ x
29. Solution to Exercise 6.7. The pay-off function is g(z) = k + z log z. Hence the
Black-Scholes price of the derivative is ΠY (t) = v(t, S(t)), where
Z   2 √ 
r− σ2 τ +σ τ y y 2 dy
−rτ
v(t, x) = e g xe e− 2 √
2π
ZR 
σ2 √

2 √ y 2 dy
−rτ (r− σ2 )τ +σ τ y
=e k + xe (log x + (r − )τ + σ τ y) e− 2 √
R 2 2π
Z √
1 2 dy
= ke−rτ + x log x e− 2 (y−σ τ ) √
2π
Z R
2 √
√
Z √ 2 dy
σ − 21 (y−σ τ )2 dy 1
+ x(r − )τ e √ + xσ τ ye− 2 (y−σ τ ) √
2 R 2π R 2π

192
Using that
√
Z √
Z √
− 12 (y−σ τ )2 dy 1
τ )2 dy
e √ = 1, ye− 2 (y−σ √ = σ τ,
R 2π R 2π
we obtain
σ2
v(t, x) = ke−rτ + x log x + x(r + )τ.
2
Hence
σ2
ΠY (t) = ke−rτ + S(t) log S(t) + S(t)(r +
)τ.
2
This completes the first part of the exercise. The number of shares of the stock in the hedging
portfolio is given by
hS (t) = ∆(t, S(t)),
σ2
where ∆(t, x) = ∂x v(t, x) = log x + 1 + (r + 2
)τ . Hence

σ2
hS (t) = 1 + (r + )τ + log S(t).
2
The number of shares of the risk-free asset is obtained by using that

ΠY (t) = hS (t)S(t) + B(t)hB (t),

hence
1
hB (t) = (ΠY (t) − hS (t)S(t))
B(t)
σ2 σ2
= e−rt (ke−rτ + S(t) log S(t) + S(t)(r + )τ − S(t) − S(t)(r + )τ − S(t) log S(t))
2 2
= ke−rT − S(t)e−rt .

This completes the second part of the exercise. To compute the probability that Y > 0,
we first observe that the pay-off function g(z) has a minimum at z = e−1 and we have
g(e−1 ) = k − e−1 . Hence if k ≥ e−1 , the derivative has probability 1 to expire in the money.
If k < e−1 , there exist a < b such that

g(z) > 0 if and only if 0 < z < a or z > b.

Hence for k < e−1 we have

P(Y > 0) = P(S(T ) < a) + P(S(T ) > b).

√
Since S(T ) = S(0)eαT +σ TG
, with G ∈ N (0, 1), then

log S(0)
a
+ αT log S(0)
b
+ αT
S(T ) < a ⇔ G < − √ := −A, S(t) > b ⇔ G > − √ := −B.
σ T σ T

193
Thus
Z −A Z +∞
dy − y2
2 y 2 dy
P(Y > 0) = P(G < −A) + P(G > −B) = e √ + e− 2 √
−∞ 2π −B 2π
= Φ(−A) + 1 − Φ(−B) = 1 − Φ(A) + Φ(B).

This completes the solution of the third part of the exercise.

30. Solution to Exercise 6.8. The pay-off function is g(z) = z(z − K); the Black-Scholes
price is given by ΠY (t) = v(t, S(t)), where
Z √
σ2 y 2 dy
−rτ
v(t, x) = e g(xe(r− 2 )τ −σ τ y )e− 2 √
ZR  2π
σ2 √  σ2 √  y2 dy
= e−rτ xe(r− 2 )τ −σ τ y xe(r− 2 )τ −σ τ y − K e− 2 √
2π
 R 2 
= x xe(r+σ )τ − K .

This solves the first part of the exercise. The number of shares of the underlying stock in
the hedging portfolio is given by hS (t) = ∆(t, S(t)), where
2 )τ
∆(t, x) = ∂x v(t, x) = 2xe(r+σ − K.

The number of shares of the risk-free is obtained using

1 e−rt (r+σ2 )τ
ΠY (t) = hS (t)S(t) + hB (t)B(t) ⇒ hB (t) = (ΠY (t) − hS (t)S(t)) = − e S(t)2 .
B(t) B(0)

This completes the second part of the exercise. The relative return of the portfolio is

ΠY (T )
R∗ = − 1.
ΠY (0)
2 )T
Using ΠY (T ) = S(T )(S(T ) − K) and ΠY (0) = K 2 (e(r+σ − 1) > 0, we obtain

E[S(T )(S(T ) − K)]

E[R∗ ] = − 1.
K 2 (e(r+σ2 )T − 1)

Writing the geometric Brownian motion at time T as

√
S(T ) = S(0)eαT +σW (T ) = KeαT +σ TG
,
√
where G = W (T )/ T ∈ N (0, 1), we get
√
Z
1 2 dy 2
2 2 2αT
E[S(T ) ] = K e e2σ T y− 2 y √ = K 2 e2(α+σ )T ,
R 2π

194
 √
Z
αT T y− 12 y 2 dy σ2
E[S(T )] = Ke eσ √ = Ke(α+ 2 )T .
R 2π
Therefore
σ2
 2

E[S(T )(S(T ) − K)] = E[S(T )2 ] − KE[S(T )] = K 2 e2(α+σ )T − e(α+ 2 )T .

We conclude that the expected relative return is given by

σ2 3 2
e(α+ 2
)T
(e(α+ 2 σ )T − 1)
E[R∗ ] = − 1.
e(r+σ2 )T − 1
This completes the third part of the exercise.

31. Solution to Exercise 6.9. The graph of the pay-off looks like in the following picture
(the numbers on the axes are irrelevant).

10

K 2K
10 20 30 40 50

-5

-10

By this picture one can see that

g(x) = (K − x)+ − (x − K)+ + (x − 2K)+ = g1 (x) + g2 (x) + g3 (x).

As the Black-Scholes price is linear in the pay-off function, the Black-Scholes price of the
derivative is the sum of the Black-Scholes price of the derivatives with pay-off functions
g1 , g2 , g3 , hence

ΠY (t) = P (t, S(t), K, T ) − C(t, S(t), K, T ) + C(t, S(t), 2K, T )

= Ke−rτ − S(t) + C(t, S(t), 2K, T ),

195
where for the second equality we used the put-call parity. Here C(t, S(t), K, T ) denotes the
Black-Scholes price of the European call with strike K and maturity T . Hence

C(t, S(t), 2K, T ) = S(t)Φ(de1 ) − 2Ke−rτ Φ(de2 ),

where
σ2 σ2
log S(t)
2K
+ (r + 2
)τ log S(t)
2K
+ (r − 2
)τ
d1 =
e √ , d2 =
e √ .
σ τ σ τ
This completes the second part of the exercise. For the last part, denote

f (K) = Ke−rτ − S(t) + C(t, S(t), 2K, T )

the price of the derivative as a function of K. We want to prove that there exists K∗ > 0
such that f (K∗ ) = 0. First we observe that f (K) > 0 for K > S(t)erτ . Hence, if we prove
that f (K) can also take negative values, then, since f is continuous, there must exist K∗
such that f (K∗ ) = 0. To this purpose define K0 such that de2 = 0, that is
1 σ2
K0 = S(t)e(r− 2 )τ .
2

For this strike price we have Φ(de2 ) = 1/2 and so the function f evaluated at K0 is

f (K0 ) = (Φ(de1 ) − 1)S(t).

As Φ(de1 ) < 1, we find f (K0 ) < 0. Hence there exists K0 < K∗ < S(t)erτ such that
f (K∗ ) = 0.

32. Solution to Exercise 6.15. We have

ΠAC (0) − ΠAP (0) = e−rT Eq [Ycall ] − e−rT Eq [Yput ]

 Z T 
−rT −rT 1
=e Eq [Ycall − Yput ] = e Eq K− S(t) dt ,
T 0

where we used that (x − K)+ − (K − x)+ = x − K. Hence

Z T
−rT 1
ΠAC (0) − ΠAP (0) = Ke − Eq [S(t)] dt. (A.17)
T 0

Recall that the expectation of e−rt S(t) in the risk-neutral probability measure is constant.
Hence Eq [S(t)] = S0 ert . Replacing in (A.17) and computing the integral in time concludes
the exercise.

33. Solution to Exercise 6.21. Letting a = 1−e−rT , the price at time t = 0 of a European

196
derivative with pay-off function g(x) = (x − S(0))+ is
√
Z
2 y 2 dy
−rT
ΠY (0) = e g((1 − a)S(0)e(r−σ /2)T +σ T y )e− 2 √
R3 2π
√
Z
σ2 y 2 dy
= e−rT S(0) (e− 2 T +σ T y − 1)+ e− 2 √
3 2π
ZR+∞  √
1 2 y 2  dy
= e−rT S(0) √ e− 2 (y−σ T ) − e 2 √
σ T /2 2π
√ √
σ T σ T
= e−rT S(0)[Φ( ) − Φ(− )]
2√ 2
σ T
= S(0)e−rT (2Φ( ) − 1)
2
where Φ is the standard normal cumulative distribution. The value of the given portfolio at
times t = 0, T is
V (T ) = −g(S(T )) − S(0)e−rT erT = −(S(T ) − S(0))+ − S(0)
√
−rT −rT σ T
V (0) = −ΠY (0) − S(0)e = −2S(0)e Φ( )
2
Hence R(T ) = V (T ) − V (0) is given by
√
−S(T ) + 2S(0)e−rT

√ Φ(σ T /2) if S(T ) > S(0)
R(T ) = −rT
S(0)[2e Φ(σ T /2) − 1] if S(T ) < S(0)
In particular, for S(T ) > S(0) we have
√
R(T ) < S(0)[2e−rT Φ(σ T /2) − 1], for S(T ) > S(0).
√
It follows√that for 2e−rT Φ(σ T /2) − 1 ≤ 0, the portfolio return is always negative. For
2e−rT Φ(σ T /2) − 1 > 0 we have
√
P(R(T ) > 0) = P(S(T ) > S(0)) + P(S(0) < S(T ) < 2S(0)e−rT Φ(σ T /2))
√
= P(S(T ) < 2S(0)e−rT Φ(σ T /2))
As √ √
2 /2)T +σ σ2
S(T ) = (1 − a)S(0)e(r−σ TG
= S(0)− 2
T +σ TG
,
where G is a standard normal random variable, then
√
S(T ) < 2S(0)e−rT Φ(σ T /2) ⇔ G ≤ δ
where 2 √
( σ2 − r)T + log(2Φ(σ T /2))
δ= √ .
σ T
Hence √
P(S(T ) < 2S(0)e−rT Φ(σ T /2)) = P(G ≤ δ) = Φ(δ).

197
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