Superreplication Cost of Derivatives Under Discrete Time Models Risk

Superreplication cost of financial derivatives
under model uncertainty in discrete time

Theodor Munteanu
Summary
1 Abstract 2
2 Introduction, notations and necessary results 2

2.1 What is model risk and how it occurs? . . . . . . . . . . . . . 3
2.2 Notations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
2.3 Needed results . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
3 Replication under binomial and trinomial models 8

3.1 Matching discrete and continuous time models . . . . . . . . . 10
3.2 Dividend paying stocks . . . . . . . . . . . . . . . . . . . . . . 15
3.3 Stochastic volatility and interest rates: Strategy and cost . . . 16
3.4 Markov process approach . . . . . . . . . . . . . . . . . . . . . 18
3.5 Incomplete fixed income markets . . . . . . . . . . . . . . . . 20
3.6 Further examples . . . . . . . . . . . . . . . . . . . . . . . . . 22
3.6.1 European options . . . . . . . . . . . . . . . . . . . . . 22
3.6.2 Path dependent options . . . . . . . . . . . . . . . . . 23
4 Replication under trinomial models 26

4.1 Generalities about trinomial models. . . . . . . . . . . . . . . 27
4.2 Popular models . . . . . . . . . . . . . . . . . . . . . . . . . . 33
4.2.1 Boyle model . . . . . . . . . . . . . . . . . . . . . . . . 33
4.2.2 Kamrad-Ritchken and Hull White models . . . . . . . 34
4.3 Convergence of european option price under trinomial vs bi-
nomial model . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
4.4 Super-replication under stochastic volatility or interest rate . . 41
1
4.5 Generalized random walks . . . . . . . . . . . . . . . . . . . . 44
4.6 More examples . . . . . . . . . . . . . . . . . . . . . . . . . . 47
4.6.1 American options replication . . . . . . . . . . . . . . . 47
4.6.2 Convertible bonds . . . . . . . . . . . . . . . . . . . . . 50
5 Stochastic convergence under model uncertainty 52

5.1 Notions and preliminary results . . . . . . . . . . . . . . . . . 52
5.2 Option price convergence under model risk . . . . . . . . . . . 53
6 References 54
7 APPENDIX 54
1 Abstract
The purpose of this paper is to showcase the problematics of model risk of
pricing and hedging different types of financial derivatives, when the models
are discrete.
The reader will see how a problem of model risk becomes an optimization
one.
2 Introduction, notations and necessary re-

sults
Model risk occurs when we don’t have enough information implied from the
market, either because the market is not liquid or enough diversified.
So, there are three approaches to overcome that:
a. To ”find” new instruments that could explain the probability distri-

butions or model parameters.
b. To restrain the generality of the model by reducing the number of

parameters.
2
c. To transform the replication problem into an optimization one.
2.1 What is model risk and how it occurs?

An usual probabilistic model consists of a measurable space (Ω, F) and a
probability measure P that determines the distribution of the underlying
asset(s)(or rather saying, variables at risk).
In mathematical finance, there are two general ways of pricing a financial
derivative:
• Through portfolio replications;
• Using martingale measures.
The portfolio replication approach works well when the market is liq-
uid and diversified. Otherwise we work with estimators, or use martingale
measures that match some of the properties in discrete and continuous time
models.
In standard pricing procedures, a model is chosen from a parametric
family and the parameters are determined through a calibration.
Sometimes, the models used may have too many parameters for an exact
covering strategy to be found so an infinite number of martingale measures
will satisfy the no-arbitrage condition. This gives rise to what is called model
risk, namely the risk occurring when the calibrated probability distribution is
wrong (parametric model risk). (When the model itself is wrong, it is called
structural model risk).
In [1] and [2] (see the References section), the authors try (and to a certain
degree succeed) linking the replication cost of an option to the maximum
possible price under all martingale measures. In this way, the two approaches
above are somehow unified.
Throughout this paper I will note P a collection of possible mod-
els, each model being represented by a probability measure on (Ω, F). The
collection may include binomial/trinomial models with different parameters,
but also a mix of different types of models, with discrete and continuous
marginal distributions.
3
I am interested in finding the super-replication cost and strategy of fi-
nancial derivatives under parametric and structural model risk, given by the
collection P. It is required that this super-replication to be held simultane-
ously under all P ∈ P.
Definition 2.1.1.
Given an adapted process S and a random variable f (representing a

financial derivative payoff), the minimal super-replication price is defined
x∗ (f ) := inf{x ∈ R : ∃H, x + H ◦ ST ≥ f, P − a.s.} where H is a trading
strategy (defined simultaneously under all P ∈ P) and where H ◦ ST is the
terminal wealth resulting from trading in the assets whose value is S at the
times t = 1, ..., T according to this trading strategy H.
I will link this quantity to supQ∈Q EQ [f ] where Q is a set of martingales

that will be defined in the next subsection. My contribution will be to find
the universe of martingale measures Q and find the hedging cost as the max-
imum expectation over this universe of measures Q.
In what follows I will present a few needed results and definitions on

which the present work is based.
2.2 Notations
Given a measurable space (Ω, A) we denote P the set of all probability mea-
sures on the space (Ω, A).
IF Ω is a topological space, B(Ω) denotes its Borel σ - field and we always
endow P with the topology of weak convergence.
(We say that a net Xλ ⊂ X converges in the weak topology to the element
x ∈ X ⇔ φ(xλ ) → φ(x), ∀x ∈ X ∗ .)
Whenever Ω is Polish space (complete metrisable topological space), (P)

is also a Polish space.
AP
T
Definition 2.2.1. We call the universal completion of A the σ-field P ∈P
where AP is the P-completion of A.
4
Definition 2.2.2. If Ω is Polish, A ⊂ Ω is called analytic if it is the image
of a Borel subset of another Polish space under a Borel-measurable mapping.
Definition 2.2.3. A function f : Ω → R = [−∞, ∞] is upper semi-analytic

if {f > c} is an analytic set, ∀c ∈ R.
Remark 2.2.1. Any Borel set is analytic, and any analytic set is universally
measurable.
Any Borel function is upper semi-analytic
We shall often deal with a set P ⊂ P(⊗) of measures. Then a subset

A ⊂ Ω is called (P) - polar if A ⊂ A0 for some A0 where P (A0 ) = 0, ∀P ∈ P.
Also a property is said to be held P-q.s. (quasi-surely) if it holds outside a
P-polar set.
Example
2.2.1. Let Ω = {HH,
T H, T T }, A = P (Ω)
HT, and
HH HT T H T T HH HT T H T T
P1 : P2 : ,
1/4 1/4 1/4 1/4 0 1/3 1/3 1/3
HH HT T H T T
P3 : , P1 = {P2 , P3 }, P2 = {P1 , P2 , P3 }.
0 1/2 1/3 1/6
Then {HH} is P1 - polar set, but ∅ is the only P2 -polar set.
Let T ∈ N be the time horizon, and let Ω1 be a Polish space. For

t ∈ {0, 1, 2, ..., T }, let Ωt := Ωt1 be the t-fold cartesian product.(In binomial
asset pricing, Ω1 = {H, T }, in trinomial model Ω1 = {U, M, D}, etc.)
The convention is that Ω0 is a singleton.
Let Ft be the universal completion of B(Ωt ) and write (Ω, F) = (ΩT , FT ).

This is our basic measurable space and we shall often see (Ωt , Ft ) as a sub-
space of (Ω, F).
For each t ∈ {0, 1, ..., T − 1} and ω ∈ Ωt , we are given a nonempty con-

vex set Pt (ω) ⊆ ⊗1 of probability measures;We think of Pt (ω) as the set of
possible models for the t - th period, given state ω at time t. Intuitively, the
role of Pt (ω) is to determine which events at the node (t, ω) are negligible
(polar), and which ones are relevant (have positive probability under at least
one model).
5
Let d ∈ N and let St = (St1 , ..., Std ) : Ωt → Rd be Borel-measurable for all
t ∈ 0, 1, ..., T . We think of St as the (discounted) prices of d traded stocks
at time t. Moreover, let H be the set of all predictable Rd -valued processes,
the trading strategies.
Definition 2.2.4. Given H ∈ H, the corresponding wealth process (from

vanishing initial capital) is the discrete-time integral H◦S = (H◦St )t∈{0,1,...,T } ,
H ◦ St = Tt=1 Hu ∆Su where ∆Su = Su − Su−1 is the price increment, and
P
Hu ∆Su = di=1 Hui ∆Sui on Rd .

P
Moreover, let e ∈ N ∪ {0}, and let g = (g 1 , ..., g e ) : Ω ⇒ Re be Borel

measurable. Each g i is seen as a traded option which can be bought and sold
at time t = 0 for the price g0i . We will assume that options can be traded
only statically, which accounts for difference in liquidity between options and
stocks.
e
Pe h ∈i R
Given a vector
i
the value of the corresponding option portfolio is
given by hg = i=1 h g and a pair (H, h) is called a semi-static hedging (H
is a dynamic strategy of stocks, while h is a static strategy over options).
Example 2.2.2.
S uppose an authorized trader has in its trading book 4 options on Apple
Inc , (current price is S0 = 309.51$) as follows in the below table :
Option Strike Price Maturity
A 300 $ 6 months
B 305 $ 6 months
C 310 $ 6 months
D 315 $ 6 months
The trader wishes to issue a new option E, with strike price 309, which
turns out to be highly liquid, and for simplicity we assume it has the same
maturity as the other 4 options. (If the option lifetime is longer, we will use
a partial hedging over the 6 months horizon) .
In this case, the trader could use a dynamic hedging using the apple stock
(d = 1) and any (or all) of the 4 options (e = 4). H would be an R1 -valued
predictable process, while g, h : Ω → R4 .
An initial guess for the book values of each option can be determined by
using implied volatility models for the highly traded option E (either using
Black Scholes or some other reverse engineering tree models). s
6
Definition 2.2.5.
We say that Q is absolute continuous w.r.t. P in the strong sense (and

we write thiss Q <<< P) if there exists P ∈ P such that Q << P .
Definition 2.2.6.
s If Q is a martingale measure, then it should be consistent with the given

prices of the traded options g i if EQ [g i ] = g0i for i = 1, 2, ..., e. We thus define
Q = {Q <<< P : Q is a martingale measure and EQ [g i ] = g0i i = 1, 2, ..., e}.
As in any model of mathematical finance, a no-arbitrage condition is
needed for the model be viable. We give the following formulation:
Definition 2.2.7.
Condition N A(P) holds if for all (H, h) ∈ H × Re , H ◦ ST + hg ≥ 0, P-

q.s. implies H ◦ ST + hg = 0, P -q.s. (That is, from 0 capital, if there is a
semi-static strategy (H,h) producing a positive output, the payoff cannot be
strictly positive with probability 1.)
2.3 Needed results

Theorem 2.3.1 (First fundamental theorem). The following statements are
equivalent:
i)NA(P) holds.
ii)For all P ∈ P there exists Q ∈ Q such that P << Q.
iii)P and Q have the same polar sets.
Theorem 2.3.2 (Superhedging theorem).
Let N A(P) hold, and let f : Ω → R be upper semianalytic. Then the

minimal superhedging price π(f ) := inf{x ∈ R|∃(H, h) ∈ H × Re , x + H ◦
ST + hg ≥ f, P-q.s.} satisfies π(f ) = supQ∈Q EQ [f ] ∈ (−∞, ∞], and there
exists (H, h) ∈ H × Re such that π(f ) + H ◦ ST + hg ≥ f , P - q.s.
7
3 Replication under binomial and trinomial
models
In this section I will emphasize the existence of x and the predictable process
H ∈ H defined under the binomial asset pricing model.
I assume a binomial model and I note:

r: the risk-free interest rate corresponding to one period discounting/-
compounding. When matching discrete and continuous time models I will
use continuous compounding, otherwise I will use specific compounding (de-
pending on the problem).
S0 : current underlying asset value.
N : number of periods used in the model.
The main approach in [3] (Shreve) when computing the value of an option
is to setup a replicating portfolio consisting of stocks of the underlying asset
of the option and a money market account (starting from a hypothetical
initial wealth X0 ).
We begin with the following example of an european call option:
Example 3.0.1.
Suppose we define the space Ω = ΩN = {H, T }N , the filtration (Ft )t=1,...,T

where F1 = σ(AH ), AH = {ω ∈ Ω|pr1 (ω) = H} (the first toss is a head),
F2 = σ(AHH , AHT , AT H , AT T ), AHHN= {ωN∈ Ω|pr N 1,2 (ω) = HH} (the first two
tosses are heads) etc. and P = P0 P0 ... P0 and P0 (H) = p̃, P0 (T ) =
q̃, p̃ + q̃ = 1.
At time 0, we buy ∆0 stocks and the remaining amount of money we
invest in the debt markets: The wealth at time 1 will be X1 = ∆0 S1 + (1 +
r) · (X0 − ∆0 · S0 ) = ∆0 · (S1 − S0 · (1 + r)) + (1 + r) · X0
At time 1, with the wealth X1 we allocate ∆1 S2 in stocks, and the
remaining wealth, X1 − ∆1 · S1 in the money market account.
So, at time 2, the wealth will be: X2 = ∆1 · S2 + (1 + r) · (X1 − ∆1 · S1 ) =
∆1 S2 +(1+r)·∆0 ·S1 +(1+r)2 (X0 −∆0 ·S0 )−(1+r)∆1 S1 = V2 (from theorem
1.2.2 in [3]) ⇒ (1+r)2 ·X0 +∆1 ·(S2 −(1+r)S1 )+∆0 ·((1+r)·S1 −S0 ·(1+r)2 ) =
V2 .
S2 S1 S1 V2
Therefore X0 + ∆1 · ( (1+r)2 − 1+r ) + ∆0 · ( 1+r − S0 ) = (1+r)2
8
St
From theorem 2.4.4 in [3], the discounted stock price process St = (1+r) t,t =
0, ..., N is an Ft -martingale.
It is easy to prove by induction that for any n ∈ {1, 2, ..., N }, Xn =
(1 + r)n · X0 + ∆0 ((1 + r)n−1 S1 − (1 + r)n · S0 ) + ... + ∆n−1 · ((1 + r)SP
n−1 − Sn )
Xn Vn n−1
If we divide the equality by (1 + r)n then (1+r) n = (1+r)n
+ i=0 ∆i ·
(Si+1 − Si )
Here the process ∆ = (∆0 , ∆1 , ..., ∆N −1 ) given by ∆0 = SV11 (H)−S (H)−V1 (T )
1 (T )
,
∆1 (H) = SV22 (HH)−V 2 (HT )
(HH)−S2 (HT )
, ∆1 (T ) = SV22 (T
(T H)−V2 (T T )
H)−S2 (T T )
,etc. is a predictable pro-
cess.
We have therefore reconstructed the processes H = ∆,S = S (the dis-
counted asset price) and the value x = X0 (initial capital) from the super-
hedging theorem.
Remark 3.0.1. From theorem 2.4.5 from [3], the wealth process (Xt )t∈0,1,...,N
is a martingale and from 2.4.5 and 1.2.2 or from 2.4.7, Vt is a martingale.
Let u = the up factor, d = down factor, p = risk-neutral up probability.

We assume now continuous compounding for interest rates.
In the log-normal model (geometric brownian motion with constant pa-
rameters), dSt = rSt dt + σSp t dBt , the solution of that equation is given by
2
St = S0 · exp((r + σ2 )t + σ (T ) · Z) where Z ∼ N (0, 1).
By equating the ( first two moments of the asset price St+∆t we obtain the
S · (p · u + (1 − p) · d) = S · er∆t
following system: 2 ⇔
S 2 · (p · u2 + (1 − p) · d2 ) = S 2 · e(2r+σ )·∆t
(
p · u + (1 − p) · d = er∆t (1)
2 There are two equations and three un-
p · u2 + (1 − p) · d2 = e(2r+σ )∆t (2)
knowns u, d, p. An extra condition is needed to determine a unique solution.
Remark 3.0.2.
r∆t
Note that from (1) you obtain p = e u−d−d and for ∆t → 0, p u 1+r∆t−d
u−d
(which is the risk-neutral probability found through replication) (we ignore
the terms of order higher than 2 in ∆t from the Taylor expansion).
We denote for simplicity R = er·dt .
9
3.1 Matching discrete and continuous time models
Some well known discrete time models, binomial and trinomial altogether,
are obtained by matching their first couple of moments (usually the mean,
variance or skew) with those of Levy processes (such as geometric brownian
motion) or stochastic volatility models. Sometimes extra assumptions are
made.
Among the binomial models, I will mention in the following paragraph
Cox-Ross-Rubinstein (CRR), Tian, and Jarrow Rudd.
Cox-Ross-Rubinstein model
In this case, the extra condition is ud( = 1. (3)
1
p
u = 2R (σ̂ 2 + 1 + (σ̂ 2 + 1)2 − 4R2 ),
The solutions to (1),(2) and (3) are : 1
p
d = 2R (σ̂ 2 + 1 − (σ̂ 2 + 1)2 − 4R2 )
2
where σ̂ 2 = e(2r+σ )∆t . √
3
σ ∆t
If
√
the term of higher order O((∆t) 2 ) is ignored in u, d then u = e ,d =
−σ ∆t
e .
Proof :
2
σ̂ 2 = e(2r+σ )∆t = p·(u2 −d2 )+d2 = R−d u−d
(u−d)(u+d)+d2 = Ru−du+Rd =
Ru − 1 + Ru ⇒ Ru2 − (1 + σ̂ 2 )u + R = 0.
√
1+σ̂ 2 + (1+σ 2 )2 −4·R2 2
As u > d, we get the unique solutions: utrue = = 1+σ̂
q √ 2R
q 2R
2 1+σ̂ 2 − (1+σ 2 )2 −4·R2 2 2
+ ( 1+σ̂ 2
)2 − 1, dtrue = u1 = 2R
= 1+σ̂
2R
- ( 1+σ̂2
)2 − 1.
2 2
Moreover, 1+σ̂2R
= 12 · (e(2r+σ )∆t + 1) · e−r∆t = 21 · (2 + (2r + σ 2 )∆t +
O((∆t)2 ))(1 − r∆t + O((∆t)2 )) = 21 · (2 + σ 2 ∆t + O((∆t)2 )) = 1 + 12 σ 2 ∆t +
O((∆t)2 ),
q q
2
p
and therefore ( 1+σ̂
2R
) 2−1= (1 + 12 σ 2 ∆t + O((∆t)2 ))2 − 1 = 1 + σ 2 ∆t + O((∆t)2 ) − 1 =
√ p √ √ 3
σ · ∆t 1 + O(∆t) = σ · ∆t(O(∆t) + 1) = σ ∆t + O((∆t) 2 ) ⇒ utrue =
√ 3
1 + 12 σ 2 ∆t +σ ∆t + O((∆t) 2 ). √
√ The Cox Ross and Rubinstein model uses the factor u = eσ δt = 1 +
3
σ ∆t + 12 σ 2 · ∆t + O((∆t) 2 )
Hence the first three terms in the Taylor series of the CRR value u and
10
3
the true value utrue match. So u = utrue + O((∆t) 2 ).
Estimating the error in (2) by this value of u we obtain: Error √= p ·

2 2
u +√ (1 − p) · d2 − e(2r+σ )·∆t = R(u + d) − 1 − e(2r+σ )∆t = er∆t (eσ· ∆t +
2
2
e−σ· ∆t ) − 1 − e(2r+σ )∆t =(1 + r∆t + O((∆t)2 ))(2 + σ 2 ∆t + O((∆t)2 )) − 1
−(1 + (2r + σ 2 )∆t + O((∆t)2 )) =O((∆t)2 )
Tian Model
Unlike CRR model, the extra condition here is
2
pu3 + (1 − p)d3 = e3r∆t+3σ ∆t . (4)
This is obtained by equalizing the third order moments of St+∆t under

binomial and log-normal models.
The solutions to (1),(2) and (4) are:

p p
u = RQ2
(Q+1+ Q2 + 2Q − 3); d = RQ
2
(Q+1− Q2 + 2Q − 3); p = R−d
u−d
2
where R = er∆t , Q = eσ ∆t
3 1
√
If the terms of order O((∆t) 2 ) are ignored then p = 2
− 34 σ ∆t
Some might wonder if the system formed by (1),(2) and (4) is not over-
determined because we have a system of 3 equations with 3 unknowns u, p, d
where p = p(u, d).
The answer is NO. Let’s see why.

Proof 
pu + (1 − p)d = R

2
By noting R = er∆t , Q = eσ ∆t we have the following system: pu2 + (1 − p)d2 = R2 Q ⇒

 3
pu + (1 − p)d3 = R3 Q
( (
R−d 2
u + u−R d2 = R 2 Q (R − d)u2 + (u − R)d2 = R2 Q(u − d)
p = R−d
u−d
So u−d
R−d 3
u−d
⇒ ⇒
u−d
u + u−R
u−d
d3 = R 3 Q 3 (R − d)u3 + (u − R)d3 = R3 Q3 (u − d)
(
R(u − d)(u + d) − du(u − d) = R2 Q(u − d)
⇒
R(u − d)(u2 + du + d2 ) − du(u2 − d2 ) = R3 Q3 (u − d)
11
(
R(u + d) − du = R2 Q(1)
R(u2 + d2 + du) − du(u + d) = R3 Q3 (2)
Therefore multiplying (1) by (u+d) we obtain R(u + d)2 − du(u + d) =
R Q(u + d). Combined with R(u2 + d2 + ud) − du(u + d) = R3 Q3 we ob-
2
tain Rud = R2 Q(u + d) − R3 Q3 ⇒ ud = RQ(u + d) − R2 Q3 ⇒ (by using

(1))R(u + d) − RQ(u + d) + R2 Q3 = R2 Q ⇒ (R − RQ)(u + d) = R2 (Q − Q3 )
So R(1 − Q)(u + d) = R2 (Q − Q3 ) ⇒ (1 − Q)(u + d) = RQ(1 − Q2 ) ⇒

u + d = RQ(1 + Q). (3) From (1) we obtain that du = R(u + d) − R2 Q =
R2 Q(1 + Q) − R2 Q = R2 Q2 (4)
(
u + d = RQ(R + Q)
So ⇒ u, d are solutions of the equation
du = R2 Q2
√
2 2 2 RQ(1+Q− Q2 +2Q−3)
x − RQ(R + Q)x + R Q = 0 so x1 = d = , x2 =
√ 2
2
RQ(1+Q+ Q +2Q−3)
2
=u .
I assumed here subsequently that u > d and Q > 1 which are reasonable
assumptions if we consider that u = d would imply a non-stochastic quantity
2
as well as Q = eσ ∆t = 1 ⇒ σ = 0
Remark 3.1.1.
Note that ud = R2 Q2 6= 1 so the tree loses its symmetry around S.
Remark 3.1.2.
Some people might wonder if u > 1, 0 < d < R = er∆t p
To answer the first question, we remark that R > 1, Q > 1, 1+Q+√ Q2 + 2Q − 3 ≥
Q+ Q2 +2Q−3
2 since the function f (Q) = Q2 +2Q−3 ≥ 0, ∀Q ∈ / (−3, 1) ⇒ 2
>
σ 2 ∆t
1 and Q = e ≥1
.
Also we need to check that d < 1 which should be true because if both
u, d > 1 then simply investing in the stock would be considered an arbitrage
opportunity. So d < 1 < R.
Jarrow-Rudd model
1
Unlike CRR model, the extra condition here is p = 2
(5)
From (1),(2) and (5) we obtain the following system:
12
( (
up + (1 − p)d = er∆t u + d = 2R
2 ⇒ where R = er∆t , Q =
u2 p + (1 − p)d2 = e(2r+σ )∆t u2 + d2 = 2R2 Q
2
eσ ∆t
So (u + d)2 =(u2 + d2 + 2ud = 2R2 Q + 2ud = 4R2 → ud = 2R2 − R2 Q =

u + d = 2R
R2 (2 − Q) ⇒ ⇒ u, d are solutions of the equation
ud = R2 (2 − Q)
x2 − 2Rx + R2 (2 − Q) = 0
√
2R− 4R2 −4R2 (2−Q) √
Therefore we √have x1 = 2
= R(1 − Q − 1) = d and
then x2 = R(1 + Q − 1) = u. √ √
So we obtain that u = R(1 + eσ2 ∆t − 1) and d = R(1 − eσ2 ∆t − 1).
Remark 3.1.3.
2
Under Jarrow-Rudd
√ model we have the restriction σ ∆t < log(2).
Because x1 =√R(1 − Q − 1) = d we question the fact that d > 0.
d > 0 ⇔ 1 > Q − 1 ⇔ 1 > Q − 1 ⇔ 2 > Q.
2
But Q = eσ ∆t < 2 ⇔ σ 2 ∆t < log(2).
If this is not true we have d < 0.
Remark 3.1.4.
3 σ2
√ σ2
√
If O((∆t) 2 ) is ignored, then u = e(r− 2 )∆t+σ ∆t and d = e(r− 2
)∆t−σ ∆t
.
The relations (1) and (2) are satisfied up to O((∆t)2 ).
The prices under the 3 models converge when the number of periods
increases as we can see as follows:
In the following example I will compare the three models replication prices
when σ ∈ [10%, 30%] and then when the number of periods increases from 1
to 20.
Example 3.1.1.
Suppose we have a european call option when S = 100, K = 100, r =

5%, T = 1years. First we consider the number of periods N = 5.
13
Remark 3.1.5.
One can easily see that the call option price is an increasing function of
σ. Also the prices under Jarrow-Rudd and CRR almost coincide, while the
price under Tian model is slightly lower.
Now we consider σ = 20% and make the number of periods vary.
The prices of the option under the three models converge when the num-
ber of periods grows.
14
3.2 Dividend paying stocks
Suppose that we consider the N-period binomial model (Ω, F, Ft=1,N , P ) and
(
u, ωn+1 = H
Yn+1 (ω1 ...ωn ωn+1 ) = .
d, ωn + 1 = T
Also at the end of each period we consider a dividend is paid An (ω1 ...ωn ) ∈
(0, 1) as part of the new stock price. The stock price at time n + 1 will be
therefore Sn+1 = (1 − An+1 )Yn+1 Sn .
Theorem 3.2.1.
Suppose that an agent starts with the wealth X0 and at each time n takes
a position of ∆n shares of a stock and the remaining capital is invested in
the money market account. We also consider the probabilities of going up
and down p̃ = 1+r−d
u−d
, q̃ = u−(1+r)
u−d
. Then the following statements hold:
Xn
a. The discounted wealth process (1+r) n , 1, n is still a martingale.
b. The risk neutral formula still applies.

Sn
c. The discounted stock price (1+r) n is not a martingale. However, if the
Sn
dividend rate is a constant a ∈ (0, 1), then (1−a)(1+r) n is a martingale.
Proof:
a. The wealth accumulated at time n+1 is Xn+1 = ∆n Sn+1 +(1+r)(Xn −

∆n Sn ) + ∆n An+1 Yn+1 Sn (W)
= ∆n (1−An+1 )Yn+1 Sn +(1+r)(Xn −Sn ∆n )+∆n An+1 Yn+1 Sn = ∆n Yn+1 Sn +
(1 + r)(Xn − ∆n Sn ) .
Xn+1 ∆n Yn+1 Sn (1+r)(Xn −∆n Sn ∆n Sn Xn −∆n Sn ∆n Sn
So En [ (1+r) n+1 = En [ (1+r)n+1 + (1+r)n+1
]= (1+r) n+1 En [Yn+1 ]+ (1+r)n = (1+r) n+1 [up̃+
Xn −∆n Sn ∆n S n Xn −∆n Sn Xn
dq̃] + (1+r)n = (1+r)n+1 + (1+r)n = (1+r)n .
(
∆n uSn + (1 + r)(Xn − ∆n Sn ) = Xn+1 (H)
b. From the relation (W) above, we have: .
∆n dSn + (1 + r)(Xn − ∆n Sn ) = Xn+1 (T )
So ∆n = Xn+1 (H)−X n+1 (T )
Sn (u−d)
and Xn = En [ X1+r
n+1 XN
] = En [ (1+r)N −n ]
But Xn is the unique replicating portfolio consisting of stock and money

market account and XN = VN .
By the definition that the security price is the replicating portfolio value Xn
it results by backwardation that Xn = Vn , ∀0 < n < N
15
Sn 1 Sn
c. En [ (1+r)n+1 ] = (1+r)n+1 En [(1−An+1 )Yn+1 Sn ] = = (1+r)n+1 [p(1−An+1 (H))+
Sn Sn Sn
q(1 − An+1 (T ))] < (1+r) n+1 [pu + qd] = (1+r)n+1 (1 + r) = (1+r)n hence the dis-
counted asset price is a sub-martingale.

Sn+1 Sn (1−a)(pu+qd) Sn
If An+1 = a then En [ (1+r) n+1 ] = (1+r)n+1
= (1+r)n (1 − a)
Sn+1 Sn
⇒ En [ (1+r)n+1 (1−a)n+1
]= (1+r)n (1−a)n
Remark 3.2.1.
In pricing financial derivatives, what matters most is to find a martingale
measure for the discounted wealth process, and not for the discounted asset
price process, because martingales provide unbiased estimators for the option
value.
Remark 3.2.2.
Sn
If we consider the probability Q such that (1+r)n
is a martingale, then the
discounted asset process is a sub-martingale.
Proof :
Xn+1 ∆n Sn −∆n Sn Xn −∆n Sn
En [ (1+r)n+1 ] = E [Y ]+ Xn(1+r)
(1+r)n+1 n n+1 n
∆n Sn
= (1+r) n+1 (up+dq)+ (1+r)n =
= ∆n Sn
(1+r)n
−∆n Sn
(1−a)+ Xn(1+r) n = ∆n Sn (1−a−1)+X
(1+r)n
n −a∆n Sn
= Xn(1+r) n
Xn
= (1+r) ∆n Sn
n −a· (1+r)n
3.3 Stochastic volatility and interest rates: Strategy

and cost
We consider now an N-period binomial pricing model, where at each time
the ”up factor” u = un (ω1 ω2...ωn ), d = dn (ω1 ω2...ωn ), r = rn (ω1 ω2 ...ω (n )
u0 S0 , ω1 = H
The initial up factor u0 is considered to be non-random and S1 (ω1 ) =
d0 S0 , ω1 = T
and
( for n ≥ 1 the stock price at time n + 1 is given by: S n+1 (ω ω
1 2 ...ωn+1 ) =
un (ω1 ...ωn )Sn (ω1 ...ωn )
.
dn (ω1 ω2 ...ωn )Sn (ω1 ...ωn )
We assume that 0 < dn (ω1 ...ωn ) < 1 + rn (ω1 ω2 ...ωn ) < un (ω1 ω2 ...ωn )
16
I will provide a formula for the options replication by stocks. The risk
n −dn
neutral probabilities are given by pñ = 1+r
un −dn
and qñ = 1 − pñ .
We build the risk-neutral measure on {H, T }n , P̃ as follows:

P̃ (ωn+1 |ω1 ω2 ...ωn ) = pñ , P̃ (ωn+1 = T |ω1 ...ωn ) = qñ .
Then Vn = pñ Vn+1 (H)+1+rn
qñ Vn+1 (T )
and ∆n = SVn+1 (H)−Vn+1 (T )

n+1 (H)−Sn+1 (T )
= Vn+1(u(H)−V n+1 (T )
n −dn )Sn
The theorems 2.4.4, 2.4.5 and 2.4.7 still hold under P̃ but with slight
adjustments.
Consider the process Sn = (1+r0 )(1+rS1n)...(1+rn−1 ) the discounted asset pro-
Xn
cess and Xn = (1+r0 )...(1+r n−1 )
the discounted wealth process where Xn+1 =
∆n Sn+1 + (1 + rn )(Xn − ∆n Sn ) where ∆n , n ∈ {0, 1, ..., N } is an adapted
process.
Theorem 3.3.1.
The discounted asset process Sn is a P̃ - martingale.

Proof :
Let us call Dn = (1+r0 )(1+r11)...(1+rn−1 ) the discount factor. Dn is Fn−1

measurable.
En [Sn+1 ] = En [Sn+1 Dn+1 ](ω1 ω2 ...ωn ) = Dn+1 · En [pñ un Sn + (1 − pñ )dn Sn ] =
n −dn 1 (1+rn )(un −dn )
Sn Dn · 1+r1n−1 [ 1+r
un −dn
·un + unu−1−r
n −dn
n
·dn ] = Sn Dn−1 · 1+rn un −dn
= Sn Dn−1
thereby Sn is a P̃ - martingale w.r.t Fn .
Theorem 3.3.2.
The discounted wealth process Xn is a martingale.

Proof :
Eñ [ (1+r0 )(1+r
Xn+1
1 )...(1+rn−1 )
] = Eñ [(∆n Sn+1 + (Xn − ∆n Sn )(1 + rn ))Dn+1 ] =
∆n ·En [Sn+1 Dn+1 ]+En [Xn −∆n Sn ]Dn = ∆n Sn Dn +(Xn −∆n Sn )Dn = Xn Dn
Also theorem 2.4.7 (of risk-neutral valuation) from [3] stands, that is
Vn = Eñ (1+rn+1 )(1+r
VN
n+2 )...(1+rN )
I present here an example of discrete time stochastic driven volatility.
17
Example 3.3.1.
Suppose the initial stock price is S0 = 80.I assume that at every point in
time, the stock price increases by 10 or decreases by 10 with equal chances
p = q = 12 . Consider a European call having the strike price K = 80.
I consider that the term structure of interest rates is at r = 0% level. The
call price at time 0, c(0, S0 ) using N = 5 periods is found as follows:
At each time un = Sn+1Sn

(H)
= 1 + S10n and dn = Sn+1
Sn
(T )
= SnS−10
n
= 1 − S10n
So the risk neutral probabilities evolve as pñ = u1−d n
n −dn
= 21 and qn = 21 as
well.
1 5 +
V0 = (1+r)5 [p̃ (S0 + 50 − 80) + 5p̃4 (1 − p̃)(S0 + 30 − 80)+ + 10p̃3 (1 −
p̃)2 (S0 + 10 − 80)+ + ...] (the remaining payoffs are 0) = 9.375.
3.4 Markov process approach

Most OTC options depend on contingencies or have non-linear payoffs, or
both. Sometimes these products depend on several primary risk factors. As
a consequence, it is hard to find a closed-form formula for the prices of these
instruments.
So an idea that works with all financial instruments is to find the relevant
information to be extracted in computing conditional expectations.
That can be done using Markov processes and then to define a backward
recursive relation on that.
Definition 3.4.1.
Let {(Xn1 , ..., XnK ), n = 0, N } be a K-dimensional adapted process in a dis-

crete time model(binomial, trinomial, etc). If ∀n ∈ 0, N − 1, ∀f (x1 , ..., xK ),
∃g(x1 , ..., xK ) such that En [f (x1 , ..., xK )] = g(x1 , ..., xK ) then (X 1 , ..., X K ) is
a Markov process.
Example 3.4.1 (Fixed strike lookback call).
18
Suppose we consider an N-period binomial model and we wish to find a
pricing algorithm for a fixed strike lookback call option having the payoff
φ(ST , MT ) = max(MT − K, 0) where MT = max(Su )u∈[0,T ] .
If we denote Sn = the stock price at time n and Mn = maximum to date

stock price, then we have that Vn = En1+r
[Vn+1 ]
, and the fact that Mn is not a
Markov process but the couple (Mn , Sn ) is.
Proof :
If (Mn )n≥0 were Markov, then ∃f : Ω → R such that En [Mn+1 ](ω1 ...ωn ) =
f (ω1 ..ωn ), ∀n, ∀ω1 ..ωn
So E2k [M2k+1 ](T HT H...T H) = p̃M2k+1 (T HT H...T HH)+q̃M2k+1 (T HT H...T HT ) =
p̃S0 u + q̃S0 = S0 (pu + q)
E2k [M2k+1 ](T HT H...T HT T ) = S0 while M2k (T H...T H) = M2k (T H...T HT T ) =

S0 so g(S0 ) = S0 (pu + q) on one hand while g(S0 ) = S0 on the other hand,
obviously a contradiction.
To prove the second part, En [f (Sn+1 , Mn+1 )] = En [f (Sn Yn+1 , Mn ∨(Sn Y ))] =
f (Sn u, Mn ∨ (Sn Y )) · p + f (Sn d, Mn )q
So the transition function is g(s, m) = En f (sY, m∨(sY )) = pf (us, mv(us))+

qf (ds, m) where s, m are dummy variables replacing the stock price at time
n and the maximum-to-date stock price.
The pricing algorithm using Markov process approach is the following:

Step 1: Compute vn = VN (s, m) for every possible trajectory in {H, T }N
Step 2: Use the recurrence vn (s, m) = vn+1 (us,m∨(su))p+v
1+r
n+1 (ds,m∨(ds))
.
One could go one step further backwards and we would obtain:

2 2 2 2
vn−1 (s, m) = vn+1 (u s,m∨(su ))p +(vn+1 (s,m∨(su))+v
(1+r)2
n+1 (s,m))pq+vn+1 (s,m)q
Example 3.4.2.
Max-min asset/strike lookback call

Suppose a financial instrument that pays off φ(MN , MN∗ ) = maxu∈0,N Su −
minu∈0,N Su is issued. I am interested in its valuation algorithm.
19
The first arising question: Is the process Zn = (Mn , Mn∗ )n≥1 Markov (a
Markov chain in this case)? The answer is NO:
Considering the events ω 1 = HT HH, ω 2 = HHT T , then E4 [Z5 ](HT HH) =
(pM5 (HT HHH) + qM5 (HT HHT ), pM5 (HT HHH) + qM5∗ (HT HHT )) =
(S0 u2 (pu + q), S0 ),
E4 [(M5 , M5∗ )](HHT T ) = (pS0 u2 + qS0 , pS0 + qS0 d) = S0 (pu2 + q), S0 (p +
qd)).
On the other hand if, assuming by absurd, there would exists a func-
tion g : R2 → R2 such that E4 [Z5 ] = g(Z4 ), then E4 [Z5 ](HT HH) =
g(M4 (HT HH), M4∗ (HT HH)) = g(S0 u2 , S0 ) and E4 [M5 ](HHT T ) = g(S0 u2 , S0 )
resulting g(S0 u2 , S0 ) = (S0 u2 (pu + q), S0 ),obviously a contradiction.
However, the process (Mn , Mn∗ , Sn ) is Markov, and therefore we can com-
pute the price of this instrument:
En [Vn+1 ] = 1+r1
En [(max(Mn , Sn Y )−min(Mn∗ , Sn Y ))] = 1
1+r
((max(Mn , Sn u)−
min(Mn∗ , Sn u)) · p + (max(Mn , Sn d) − min(Mn∗ , Sn d)) · q)
The transition function is therefore:

1
g(s, m, M ) = 1+r ((max(M, su) − min(m, su)) · p + (max(M, sd) − min(m, sd)) · q) =
1
1+r
((max(M, su) − m) · p + (M − min(m, sd)) · q)
3.5 Incomplete fixed income markets

So far the binomial models presented were recombining (u · d = 1). Therefore
there was no model risk. In fixed income financial models, that is no longer
the case.
Let’s consider the following example:
Suppose a financial market contains the following instruments:

A. One 1Y zero-coupon bond, with price 99.4 $ per 100$ notional.
B. One 2Y coupon bond (c=2%,paid yearly), having the price 102.4$
C. One 3Y cap with strike rate K = 1% and price 0.25 We also know
(estimate) that r1 (H) = 1.2%, r1 (T ) = 0.4%, r2 (HH) = 2%, r2 (HT ) =
1%, r2 (T H) = 0.8%, r2 (T T ) = 0.4%
20
The notionals considered for both the cap and the floor are F V = 100$.
Question: What is the price range for a 3Y-floor with strike K = 1%?
Answers:
100
The zero-rate now, r0 is found as r0 = 99.4 − 1 = 0.6%
The price of the 2-year bond is B0,2 = E0 [D1 (CF1 )] + E0 [D2 (CF2 )] =
1 1
1+r0
· 2 + 1+r0
· ( 1+r11 (H) · p1 (H) + 1+r11 (T ) · p1 (T )) · 102 = 102.4
After replacing r0 , r1 (H), r1 (T ), we obtain therefore the following system

of equations:
(
1 1 2
p (H) + 1.004
1.012 1
· p1 (T ) = (102.4 − 1.006 ) · 1.006
102
⇒ p1 (H) = 72.15%, p1 (T ) =
p1 (H) + p1 (T ) = 1
27.85%
For the cap pricing, we consider each underlying caplet separately.

c0,1 = 0
1
c0,2 = (1+r0 )(1+r 1 (H))
· (1.2% − 1%) · 100 · 95 = 0.10913$
c0,3 = (1+r0 (HH))(1+r11(HH))(1+r2 (HH)) · p1 (H) · p2 (HH|H) · (2% − 1%) · 100
But the 3-year has the value Cap3 = 0.25, Cap0,2 = 0.2035 so p2 (HT |H) =
0.7965
As for p2 (T H|T ), p2 (T T |T ) we denote them with p, 1 − p
Therefore the price of a floor with strike 1% will be, E[D1 (1% − r0 )+ ] +
1
E0 [D2 (1% − r1 )+ ] + E0 [D3 (1% − r2 )+ ] = 0 + 1.01·(1+r 1 (T ))
· (1% − 0.4%) ×
1
27.85% × 100 + 1.01·(1+r1 (T ))(1+r2 (T H)) × (1% − 0.8%) × 27.85% × p(T H|T ) +
1
1.01(1+r1 (T )))(1+r2 (T T ))
× (1% − 0.8%) × 27.85% × p(T T |T ) = 0.3286 − 0.1097p
after some computations.
Since p ∈ [0, 1], the floor price lies in the range [0.2289; 0.3286].
21
3.6 Further examples
3.6.1 European options
Example 3.6.1.
For an APPLE Inc. stock whose current underlying price is S0 = 309$

we consider an european call option having the strike price K = 310 and
lifetime 6 months. The annualized volatility has been estimated at σ = 14%.
I consider N = 3 periods for the binomial model and find the option value
and strategy of replication if:
a.CRR model is considered.
b.Tian model is used.
c.Jarrow-Rudd model is used.
The yield curve is flat at 0%.
Solution:
√ √1
The up factor is given by u = eσ· ∆t = e0.14· 6 . In the following table
I provide the up-factor, risk-neutral probability and the price of the option
under each model.
Model u p price
CRR 1.0588 0.4857 12.7598
Tian 1.0623 0.4572 12.7252
Jarrow-Rudd 1.0572 0.5 12.7419
where u = up-factor, p = risk-neutral probability.
3 3 3
N N
IfI consider the risk-neutral
measures P1= P1 P1 P 1 .P2 , P3 where:
H T H T H T
P1 : P2 : P3 :
0.4857 0.5143 0.4572 0.5428 0.5 0.5
and P = {P13 , P23 , P33 } then the super-replication cost under the meta-model
P would be max{12.7598$, 12.7252$, 12.7419$} = 12.7598$.
Remark 3.6.1.
22
All three measures considered are equivalent (agree on the null-sets, which
are none) and all make the discounted asset price St e−r·(T −t) be a martingale
(according to theorem 2.4.4 in [3]), because all probabilities p follow the con-
dition p = 1+r−d
u−d
The hedging strategies characterized by the ∆ positions obtained under

each model are the following:
CRR model, ∆0 = SV11 (H)−V 1 (T )
(H)−S1 (T )
21.9798−4.0519
= 327.1752−291.8343 = 0.5072
V2 (HH)−V2 (HT ) V2 (T H)−V2 (T T )
∆1 (H) = S2 (HH)−S2 (HT )
= 0.7503 ∆1 (T ) = S2 (T H)−S2 (T T )
= 0.25 ∆2 (HH) =
V3 (HHH)−V3 (HHT )
S3 (HHH)−S3 (HHT )
so the investor, in order
to hedge a short call position should
buy initially 0.5 stocks. If the stock goes up, the investor should buy an ad-
ditional 0.25 shares of stock and if the stock goes down, he should sell 0.25
shares of its stock allocation.
We can summarize the results into the

following ∆-process: ∆0 = 0.5,
∆1 (H) = 0.7503 ∆1 (T ) = 0.2499
∆1 :
0.4857 0.5143

1 0.4859 0
∆2 :
0.2359 0.4995 0.2645
Under Tian model, I obtain the following delta process: ∆0 = 0.52142
(longstocks)
∆1 (H) = 0.7796 ∆1 (T ) = 0.2775
∆1 :
0.4572 0.5428
∆2 (HH) = 1 ∆2 (HT ) = 0.5715 ∆2 (T T ) = 0
∆2 :
0.2090 0.4963 0.2946
Under Jarrow-Rudd model, we have:

0.7373 0.2341 1 0.4429 0
∆0 = 0.50, ∆1 : 1 1 , ∆2 : 1 1 1
2 2 4 2 4
3.6.2 Path dependent options

I will present here a description of the price x∗ (f ) and trading strategy H
for a lookback option and an arithmetic asian option.
The fixed-strike lookback option has the payoff (the gross profit
23
function), f (S) = (sup0≤t≤T Su − ST )+ . In discrete time it goes as f (X) =
(max0≤i≤N Si − SN )+ . R T
S du
The fixed strike arithmetic asian option has the payoff f (S) = ( 0 Tu −
S +S +...+S
K)+ and in discrete time it is f (S) = ( t0 tN1 +1 tN −K)+ where t0 , t1 , ..., tN
are a division of the interval [0, T ]
.
The algorithm to find the predictable process H = ∆, according to theo-
rem 1.2.2 from [3] is:
1. To build the price process vn (s, m) where s = Sn , m = Mn .
1
vn (s, m) = 1+r (pu · vn+1 (us, m ∨ us) + pd vn+1 (ds, m))
2. To build the hedging (∆) process from ∆n (s, m) = vn+1 (us,m∨us)−vn+1 (ds,m∨ds
(u−d)s
Example 3.6.2 (Lookback option replication).
Suppose the underlying asset price is S0 = 4, u = 2, d = 12 , r = 14 and

V3 = max0≤n≤3Sn − S3 at time
we consider a lookback option that pays off
0 2 3.5 6 8
three. Then: p̃ = q̃ = 1+R−d
u−d
= 12 and V3 : 3 2 1 1 1 because:
8 8 8 8 8
V3 (HHH) = max{S0 , S1 (H), S2 (HH), S3 (HHH)} − S3 (HHH) = 0;
V3 (HHT ) = max{S0 , S1 (H), S2 (HH), S3 (HHT )} − S3 (HHT ) = 8 and
so on.
The payoff is always positive. We go backwards to find the price tree and
then to find the replication strategy:
1
V2 (HH) = 1+r [pV3 (HHH)+(1−p)V3 (HHT )] = 54 [ 12 ·0+ 12 ·8] = 45 ·4 = 3.20;
V2 (HT ) = 2.40;V2 (T H) = 0.80;V2 (T T ) = 2.20;
V1 (H) = 54 [ 12 · V2 (HH) + 12 V2 (HT )] = 2.24; V1 (T ) = 1.20 and V0 = 1.376$.
If we sell the lookback option for 1.376$ we can hedge the short position
by buying ∆0 = SV11 (H)−S
(H)−V1 (T )
1 (T )
= 2.24−1.20
8−2
= 0.1733 shares of stock.
This costs 0.6933 = 0.1733 · 4$, which leaves the agent with 1.376 $-0.6933 $
= 0.6827 $ to invest in the money market at 25% interest.
At time 1, the agent will have 0.6827(1+0.25) = 0.8533 in the money market.
If the stock price goes up, S1 (U ) = 0.1733 · 8 = 1.3867$ so X1 (H) = 1.3867 +
0.8533 = 2.24 = V1 (H), S1 (T ) = 0.3467 ⇒ X1 (T ) = 0.8533 + ∆0 S1 (T ) =
1.20 = V1 (T ).
24
Example 3.6.3. Asian option replication
Consider
Pn again a 3-period model with the same data as previously. Define
Yn = k=0 Sk be the sum of the stock prices between times 0 and n.
Consider an Asian call option that expires at time three and has strike K = 4
and the payoff is ( 14 Y3 − 4)+ . Let vn (s, y) denote the price of this option at
time n if Sn = s, Yn = y.
The pricing algorithm is the following:

1. v3 (s, y) = ( 14 y − 4)+
2. If yn = y, yn+1 (U ) = yn + Sn+1 (U ) = y + su = y + 2s; yn+1 (D) =
y+Sn+1 (D) = y+sd = y+ 2s . So vn (s, y) = 52 ·(vn+1 (2s, y+2s)+vn+1 ( 2s , y+ 2s ))
At time t = 3, there are 8 possible values for (S3 , Y3 ): (32, 4+8+16+32 4
)=
4+8+16+8
(32, 15), (8, 4
)) = (8, 9), (8, 6), (8, 4.5), (2, 4.5), (2, 3), (2, 2.25), (0.5, 1.875)
The terminal payoffs are: v3 (32, 15) = (15−4)+ = 11, v3 (8, 9) = 5, v3 (8, 6) =
2, v3 (8, 4.5) = 0.5, v3 (2, 4.5) = 0.5, v3 (2, 3) = 0, v3 (2, 2.25) = 0, v3 (0.5, 1.875) =
0, v2 (16, 4+8+16
3
) = v2 (16, 32
3
) = 25 (v3 (32, 15) + v3 (8, 9)) = 52 (11 + 5) = 32 5
. We
obtain v0 = 1.696.
Example 3.6.4 ( Up-and-out call option pricing).
Suppose we have an up and out call option defined on a stock ABC whose
price S0 = 100$, with annualized volatiliy σ = 30%.
The option is considered to expire worthless if it crosses the level of H = 120$.
The time to expiry is T = 1 year. The strike price is K = 100. We consider
the annualized interest rate r = 0%
We will consider the binomial model with 3,4 and 12 periods.

√ √
1. If N=3 then u = eσ∗ ∆t = e0.3· 1/3 = 1.18
so the option expires worthless if maxt∈0,3 (St ) > S0 u or S3 ≤ S0 .
1−d
Also the risk neutral probability is p3 = u−d = 1.1891
In other words
if we consider
the random walk Mn = X1 + X2 + ... + Xn
1 −1
where Xi : and its maximum Mn∗ = max(Mi )i=1,n then we
p3 1 − p3
must find P (Mn∗ < 2, Mn = 1) ⇒ ω ∈ {HT H, T HH} with probability
P ({HT H, T HH}) = 2p2 (1 − p). Therefore the option price is C0U oc =
25
2p2 (1 − p) · (S0 u − K)exp(−rT ) = 4.2871.
p
2. If N=4, u4 = exp(σ 1/4) = 1.16, u24 = 1.32 > 1.2 So, Φ(ST ) 6= 0 ⇔
ST = S0 ·u which is impossible, because if we consider the same random-walk
.
and its maximum, we obtain M4 ..2. Therefore C0 = 0.
3. If N=12, u = 1.09 so the random walk Mn ≤ 2, ∀n ∈ 1, 12 while
M1 2 ∈ {1, 2} for the option to have non-zero payoff.
P (ST = 2, MT ≤ 2) = P (ST = 2) − P (ST = 2, MT ≥ 2).
P (ST = 2) = P(7 up-movements, 5 down-movements/total of 12) =
7 7
C12 p · (1 − p)5
The joint distribution of Mt and max Mt in this case is given by P (Mn =
n−b n+b
m, Mn∗ ≥ b) = (m+ n−b )!(
n!
n+b
−m)!
pm+ 2 (1 − p) 2 −m
2 2
In order for the option to knock-out, one must have that max(Mt )t=1,T ≥
3. P (MT = 1, max(Mt ) ≥ 3) = 0, P (M1 2 = 2, M1 2 ≤ 2) = P (M1 2 =
2) − P (M1 2 = 2, M1 2∗ ≥ 3) = C127
· p7 (1 − p)5 − C12
8
· p8 · (1 − p)4 , p = 0.4738.
The price is in this case, is c0 = 1.4153.
For a more general pricing formula for up-and-out call options you can
refer to the APPENDIX.
4 Replication under trinomial models

The trinomial model is considerably faster in convergence than the binomial
model. We will explain here why.
Suppose I consider the 1-step trinomial model and Ω = {U, M, D} Then

if X=wealth, V =option value and S = underlying asset price and r = in-
terest rate (risk-free) then if we build a portfolio as in [3], Chapter 1, then
the wealth equations will be: (because X1 = ∆0 S1 + (1 + r)(X0 − ∆0 S0 ) =
 + r)X0 + ∆0 (S1 − (1 + r)S0 ))
(1
X1 (U ) = X0 (1 + r) + ∆0 S0 (u − (1 + r)) = V1 (U )

X1 (M ) = X0 (1 + r) + ∆0 S0 (m − (1 + r))) = V1 (M )

X1 (D) = X0 (1 + r) + ∆0 S0 (d − (1 + r)) = V1 (D)

1
By substracting the second equation from the first we have ∆0 · 1+r · (S1 (U ) −
26
S1 (M )) = V1 (U )−V
1+r
1 (M )
⇒ ∆0 = SV11 (U )−V1 (M )
(U )−S1 (M )
V1 (M )−V1 (D) V1 (U )−V1 (M )
Similarly ∆0 = S1 (M )−S1 (D)
which is possible if and only if S1 (U )−S1 (M )
=
V1 (M )−V1 (D)
S1 (M )−S1 (D)
which doesn’t happen in most of the cases.
One can identify two situations when this problem is bypassed.

1. Add a new hedging instrument (another call/put option with a different
strike price or different maturity).
2. Or find the minimal superreplication cost e.g. find min(a · S0 + b) where
a
 = no. of invested stocks, b = amount of cash, under the constraints:
a · S0 u + b ≥ V1 (U )

a · S0 m + b ≥ V1 (M )

a · S0 d + b ≥ V1 (D)

More general, we need to find inf{x ∈ R+ |x + H ◦ ST (ω = ω1 ...ωN ) ≥
V (ω1 ...ωN ), ∀ω ∈ Ω}.
4.1 Generalities about trinomial models.

Under trinomial models, where the volatility is considered constant, finding
the replication cost becomes a maximization of one variable functions. If the
volatility is non-constant, or if the volatility, dividende rate, interest rates or
other variables become stochastic then the optimization is multivariate.
Considering the probability space (Ω, F, P) where Ω = {U, M, D}N , P =
a set of probabilities that is to be defined later on (a set of probability
measures).
The first step will be to determine the risk neutral measures and prove
that these all produce martingale measures for the discounted asset price.
Then we will check the superhedging theorem for 1-period and multi-
period case.
Theorem 4.1.1.
‘(‘ If p1 , p2 , p3 are risk-neutral probabilities of U, M, D, then:
p1 = 1+r−m−(d−m)p
u−m
3
∈ [0, 1]
u−(1+r)−p3 (u−d) (RN)
p2 = u−m
∈ [0.1]
where p3 ∈ [ m−(1+r)
m−d
, u−(1+r)
u−d
] if m ≥ 1 + r and p3 ∈ [0, u−(1+r)
u−d
] if m < 1 + r.
27
Proof:
Because p1 , p2 , p3 are risk-neutral, E P [S1 ] = S0 (1 + r) so: S0 · (p1 u + p2 m +
p3 d) = S0 (1 + r) ⇒ p1 u + p2 m + p3 d = 1 + r
Also, p1 + p2 + p3 = 1.
( From the system of equations:

(
p1 u + p2 m + p 3 d = 1 p1 u + p2 m = 1 − p3 d
⇔ , we obtain the desired
p1 + p2 + p3 = 1 p1 + p2 = 1 − p3
probabilities.
From the conditions 0 < p1 < 1, 0 < p2 < 1 we obtain also the restrictions
regarding p3 . .
In the following subsection I will show that each risk neutral probability
in trinomial model, generates a martingale measure for the discounted asset
price.
Theorem 4.1.2.
Consider the general trinomial model where 0 < d < 1 + r, m < u. Let
the risk neutral probabilities be given by (RN) from Theorem 4.1.1.
Sn
Then, under the risk neutral measure, the discounted asset price (1+r) n is a
martingale.
Proof:
Sn+1 1 1
En [ (1+r)n+1 ](ω1 ω2 ...ωn ) = (1+r)n · 1+r ·[p1 uSn (ω1 ω2 ...ωn )+p2 ·m·Sn +p3 ·d·Sn ] =
Sn
· 1 [p u + p2 m + p3 d]
(1+r)n 1+r 1
1+r−m−(d−m)p3
Now, p1 u + p2 m + p3 d = u−m
· u + u−(1+r)−p
u−m
3 (u−d)
· m + p3 d =
u+ur−mu−(du−mu)p3 +um−m−mr−mp3 u+mp3 d
u−m
+ p3 d
u−m+(u−m)r+p3 d(m−u)
= u−m
+ p3 d = 1 + r
Sn+1 Sn 1+r Sn
So p1 u + p2 m + p3 d = 1 + r therefore En [ (1+r) n+1 ] = (1+r)n · 1+r = (1+r)n
.
Based on theorems 4.1.1 and 4.1.2 we have succeeded in defining a
parametrised set of martingale measures.
In what follows I will give an important property about the wealth pro-
cess generated by the trading strategy involving a stock and a money market
28
account.
Theorem 4.1.3.
If X0 = supQ∈Q E Q [Ṽ ] is the initial capital where Ṽ is the discounted

payoff of the option, and the wealth process defined by investment in the
stock market and money market account is defined by Xn+1 = ∆n · Sn+1 +
(1 + r)(Xn − ∆n · Sn ) then:
Xn
a. (1+r)n
,n = 1, N is a martingale.
b. Xn (ω1 ...ωn ) ≥ VnQ (ω1 ...ωn ), ∀ω1 ...ωn ∈ Fn , Q ∈ Q where Q is the set
of martingale measures of the model.
In other words, the wealth accumulated by this dynamic-strategy domi-

nates the value of the contract at any time, w.r.t. any risk-neutral probability
measure.
Remark 4.1.1.
The delta-hedging strategy can be defined for instance as ∆Q 0 = 2 ·

1
Q Q Q Q Q Q
( VS Q (U )−V (M )
(U )−S Q (M )
+ VS Q (M
(M )−V (D)
)−S Q (D)
) and ∆Q 1 V (ω1 ...ωn U )−V (ω1 ...ωn M )
n (ω1 ...ωn ) = 2 ( S(ω1 ...ωn U )−S(ω1 ...ωn M ) +
V Q (ω1 ...ωn M )−V Q (ω1 ...ωn D)
S(ω1 ...ωn M )−S(ω1 ...ωn D)
).
Lemma 4.1.1.
Let P be a probability measure on a finite space probability space Ω. Let

Z be a random variable on Ω with the property that P (Z ≥ 0) = 1 and
E[Z] = 1 under P. ForPω ∈ Ω we define P̃ (ω) = Z(ω)P (ω) and for events
A ⊂ Ω define P̃ (A) = ω∈A P̃ (ω).
If Z > 0 P-a.s. then P ∼ P̃ .
Proof:
If P (A) = 0 then P̃ (A) = 0. P
This is true because P̃ (A) = Z(ω)P (ω) = 0, P (ω) ≤ P (A) = 0.
29
1
P
Similar for P (A) = P (ω) = Z(ω)
P̃ (ω) = 0 because P̃ (ω) ≤ P̃ (A) = 0
.
Let us check now the super-hedging theorem through a numerical exam-

ple.
Example 4.1.1.
1
Suppose that S0 = 1 the underlying price, R = 0, u = 2, m = 1, l = 2
and K = 1 the strike price of a european call option.
a. Find all the risk neutral probabilities and the range of prices generated
by them for a call option with strike price K = 1.
b. Find the super-replication price for this call option.
Solution:
( (
1 + R = u · p u + m · pm + d · pd 1 = 2pu + pm + 12 pd
a. We have the system ⇔
1 = pu + pm + pd 1 = pu + pm + pd
(
1 − x = 2pu + 21 pd
For pm = x ⇒
1 − x = pu + pd
1
Therefore pu = 3 · (1 − x), pd = 23 · (1 − x)
Therefore the option price is the given by:
C = 23 ·(1−x)·(d−K)+ +x·(m−K)+ + 13 ·(1−x)·(u−K)+ = 13 ·(1−x), 0 < x < 1.
b. We have here two methods to compute the super-replication price:

x
Method 1. Using theorem 2.3.2, x∗ (f ) = supE P [C] = sup0<x<1 13 · (1 −
x) = 13
Method 2. Let’s consider a super-replicating portfolio with a units of

share and b units cash.
Then a · S0 d + b = a · d + b ≥ (d − K)+ = 0
a · S0 m + b = am + b ≥ (m − K)+ = 0
+
 aS0 u + b = au + b ≥ (u − K) = 1 so we have the system of constraints:
a
2 + b ≥ 0

a+b≥0

2a + b ≥ 0

30
What we want is to minimize the initial cost x∗ (f ) = aS0 + b = a + b
under the constraints above.
We use Kuhn-Tucker theorem for that.
Let g1 (a, b) = − a2 −b ≤ 0, g2 (a, b) = −a−b ≤ 0, g3 (a, b) = −2a−b+1 ≤ 0

and L(a, b; v1 , v2 , v3 ) = a + b + v1· (− a2 − b) + v2 · (−a − b) + v3 ·  (−2a − b + 1).


0
La (a, b; v1 , v2 , v3 ) = 0 
 1 − v21 − v2 − 2v3 = 0
 
L0b (a, b; v1 , v2 , v3 ) = 0 1 − v1 − v2 − v3 = 0

 

 
a
We put the KKT conditions: v1 · (− 2 − b) = 0 ⇒ v1 · ( a2 + b) = 0
 
v2 · (−a − b) = 0

 v2 (a + b) = 0



 

v · (−2a − b + 1) = 0 v (2a + b − 1) = 0
3 3

v

 2
1
+ v2 + 2v3 = 1

v1 + v2 + v3 = 1

 (
 v2 + 2v3 = 1
⇒ v1 ( a2 + b) = 0 If v1 = 0 ⇒ so v3 = 0, v2 = 1 ⇒
 v 2 + v3 = 1
v2 (a + b) = 0





v (2a + b − 1) = 0
3
a + b = 0 ⇒ b = −a.
But − a2 − b = − a2 − (−a) = a2 ≤ 0 ⇒ a ≤ 0 and 2a + b ≥ 1 ⇒ a ≥ 1 so
v1 = 0 is not possible.
Therefore v1 6= 0 ⇒ a2 +b = 0 ⇒ b = − a2 So −2a−b+1 = −2a−(−a/2)+
1 = −3a/2 + 1 ≤ 0 so a ≥ 1.
(
v1
+ 2v3 = 1
If v2 = 0 then 2 so v1 = 2/3, v2 = 1/3.
v1 + v3 = 1
(
2a + b = 1
Therefore a so a = 23 , b = − 13 .
2
+ b = 0
This gives the smallest portfolio that dominates the option payoff and
has the value a · S0 + b = a + b = 23 + −1 3
= 13 the same results as obtained in
method 1.
If v2 6= 0 then v2 (a + b) = 0 ⇒ a( + b = 0. But in this case a2 + b = 0 and
v1
+ v2 = 1
a + b = 0 so v3 = 0 and therefore 2 so v1 = 0 contradiction
v1 + v2 = 1
with the fact that we are in the case v1 6= 0.
Therefore our unique solution is a = 32 , b = − 13 so the minimum super-
31
replication cost is 13 .
This was a numerical example where using KKT duality was possible,
but in most of the cases (especially in multiple period cases), this process
can become a tedious one.
What would be the super-replication cost in a 2-period model?
If we wanted the super-replication cost in 2 - period trinomial model for

the same call option using KKT we would have N = 5 restrictions to embed
into the Lagrange function. For 3 - period trinomial model we would have
N = 7 restrictions, etc. which makes it unpractical to solve. (And this is a
case where m = 1 and ud = 1 therefore the tree is recombining.)
In a non-recombining tree, where ud 6= 1, m 6= 1, ud 6= m2 the trinomial

tree would generate 3 = 2·3 2
terminal values for 1-period model, 6 = 3·42
terminal values for the 2-period model,and 10 terminal values for the 3-period
model. (So imagine putting the restrictions in that case).
To answer our question however, the call price under trinomial model
would be:
p2u · (u2 − K)+ + 2pu pm (u − K)+ + (2pu pd + p2m )(1 − K)+ + 2md(d − K)+ +
d2 (d2 − K)+ == p2u · 3 + 2pu pm · 1 =
2
= 91 (1 − x)2 · 3 + 2x(1−x)
3
= 1−x
3
2
The superreplication cost is given by supE Q [(S − K)+ ] = supx∈[0,1] 1−x
3
= 31
(the same result as in 1-step trinomial model).
In 3-step trinomial model the most practical way is to find for which
values of S3 is the payoff 6= 0. (S3 − K)+ 6= 0 ⇔ S3 ∈ {S0 u3 , S0 u2 , S0 u}. We
need therefore to find the probability of each event.
P (S3 = S0 u3 ) = p3u P (S3 = S0 u2 ) = P (S3 = S0 u2 |S2 = S0 u2 ) · P (S2 =
S0 u2 )+ P (S3 = S0 u2 |S2 = S0 u) · P (S2 = S0 u) = pm p2u + pu (2pu pm ) = 3p2u pm
P (S3 = S0 u) = P (S3 = S0 u|S2 = S0 u2 )P (S2 = S0 u2 ) + P (S3 = S0 u|S2 =
S0 u)P (S2 = S0 u)P (S2 = S0 u) + P (S3 = S0 u|S2 = S0 )P (S2 = S0 ) =
3pd p2u + 3pu p2m
7
So the option price is p3u ·7+3p2u ·pm ·3+(3pd p2u +3pu p2m )·1 = ... = 27 ·(1−
x)3 +x(1−x)2 +( 29 (1−x)3 +(1−x)x2 ) = 13 27
(1−x)3
+x(1−x) 2
+(1−x)x 2
= f (x)
But supx∈[0,1] f (x) = f (0) because f is decreasing on [0,1]. So the super-
32
13
replication cost of the option is 27
.
Remark 4.1.2.
In the 1-step, 2 -step and 3-step binomial models, the exact prices are
1 1
,
3 3
and 13
27
4.2 Popular models

4.2.1 Boyle model
As discussed in binomial models section, some people match the properties
of continuous and discrete time distributions (such as moments), to quickly
find corresponding risk neutral probabilities.
As stated in the introduction, closed-form analytical formulas are hard

to obtain under continuous time models. Therefore alternatives are often
used such as: Partial Differential Equations, Monte Carlo methods, or tree
methods.
Among all, the tree methods require the least operational effort, even
though the convergence is slower than of alternative methods.
The reader will see in section 4.3 that trinomial models have a faster
convergence rate than binomial models.
For the Boyle method we match the first and second order moments and
put m = 1 and ud = 1 (recombining tree).
Property 4.2.1.
If σ is the annualized volatiltiy of the underlying asset, r = risk-free in-
−R)u−(R−1) (W −R)u2 −(R−1)u3
terest rate, then pu = (W(u−1)(u2 −1) , pm = 1 − pu − pd , pd = (u−1)(u2 −1)
2 )∆t
where R = er∆t , W = e(2r+σ
Proof:
By matching the first order and second order moments of St+∆t under trino-
mial
 and log-normal models, we obtain the system:
p u + p m + p d = 1

upu + mpm + dpd = er∆t

 2 2
u pu + m2 pm + d2 pd = e(2r+σ )∆t
33
   −1  
pu 1 1 1 1
Therefore pm  =  u m d  ·  er∆t .
2
pd u2 m2 d2 e(2r+σ )∆t
 −1
1 1 1
1
The inverse of the Vandermonde matrix  u m d  = − (u−m)(u−d)(m−d) ·
2 2 2
  u m d
2 2
md(m − d) m − d d − m
−ud(d − u) d2 − u2 d − u 
um(m − u) u2 − m2 m − u
1
Therefore pu = − (u−m)(u−d)(m−d) [md(d − m) + (m2 − d2 ) · R + (d − m)W ] =
1 1 1
(u−m)(u−d)
[md−(m+d)R+W ] = (u−1)(u− 1 [d−(1+d)R+W ] = (u−1)(u2 −1)) [1−
)
u
(u + 1)R + uW ].
By computations that are similar we obtain pd .
Under
√ Boyle Model an extra assumption is made by putting u =
λσ ∆t
e where λ is a free parameter (usually is calibrated).
If λ = 1 the model has the same u parameter with that in CRR. Also for
λ < 1 some probabilities might turn negative.
To find the general price under trinomial model of Boyle we need the
distribution of Sn where n = number of periods. (see section 4.3)
4.2.2 Kamrad-Ritchken and Hull White models

If S follows a log-normal process then we can write lnS(t + ∆t) = lnS(t) + Z
where Z ∼ N ((r − σ 2 /2)∆t, σ 2 ∆t)
KR approximate Z by a discrete random variable Z a as:

suggested to
∆x 0 −∆x √
Za : where ∆x = λσ ∆t
pu pm pd
.
The corresponding u, m, d are therefore u = exp(∆x), m = 1, d = exp(−∆x).
By omitting the higher order term O((∆t)2 ), the risk neutral probabilities
34
are:

1 1 2
√

 p u = 2λ 2 + 2λσ
(r − σ /2) ∆t
1
pm = 1 − λ2
 2 √
pd = 2λ1 2 − 2λσ
1
(r − σ2 ) ∆t

Proof:
2 2
As mentioned we approximate Z ∼ N ((r − σ /2)∆t, σ ∆t)
previously,
√

∆x 0 −∆x
with Z a : where ∆x = λσ ∆t.
pu pm pd
 By matching the first two orders of Z and Za we obtain:

p u + p m + p d = 1

E(Z a ) = (pu − pd )∆x = (r − σ 2 )∆t(2)

V ar(Z a ) = (∆x)2 (pu + pd ) − (∆x)2 (pu − pd )2 = σ 2 ∆t(3)

(r−σ 2 /2)∆t 2
From (2), pu − pd = ∆x ( (pu − pd ) and ignore
so if in (3), we replace
(∆x)2 (pu + pd ) = σ 2 ∆t
the term containing (∆t)2 then we obtain the system
∆x(pu − pd ) = (r − σ 2 )∆t
√
and by replacing ∆x = σλ ∆t we obtain the formulas.
If λ = 1 we obtain the binomial case. √
Hull White is just a particular case of Boyle model where λ = 3. It is most
often used in calibrating interest rate trees.
Kamrad-Ritchken approach gives us a parametric formula for the risk-

neutral probabilities.
Remark 4.2.1.
The two approaches, Boyle’s and KR are two representations
√ of the same
∆x σλ ∆t
model. Replacing KR in the trinomial tree, u = e = e , m = 1, d =
−∆x
e .
Calibration of Boyle model and Kamrad model

As mentioned before, λ is a free parameter. It can be implied from the
market price of a traded option, or several traded options.
35
The problem of calibration is always a tricky one, and a source of model
risk, because there are many methodologies and stochastic volatility models.
If there is a single traded option on the market, one can find the implied
volatility from the Black Scholes model or a parametric model, and use it to
find the rest of parameters.
If there are several options with one single maturity and several strike
prices, one way is to find the volatility in several points, and then interpolate
between these points.
If a volatility term structure is used, then one can use the forward volatil-
ity formula:q
T σ 2 −tσ 2
σt,T = 0,T
T −t
0,t T
to calibrate any period of length ∆t = N , ti = TN·i , 1, N
√ √
and further use ui = exp(σ(ti−1 , ti )λi ∆t), mi = 1, di = exp(−σ(ti−1 , ti )λi ∆t)
where σti−1 ,ti is the implied forward volatility and λi is the free parameter
corresponding to period i.
Example 4.2.1.
Suppose a stock of the ”Alpha” company is worth S0 = 100 euros. A call
option with strike price K = 100 euros and lifetime T = 1 year, is worth
c0 = 9.94 euros. The risk-free rate is considered to be 0.
The implied volatility according to Black & Scholes is σimp = 25%.
2
• If we consider the 1-period trinomial model, W = e(2r+σ )∆t , R = er∆t =
1. The call value is E0 [(S1 − K)+ ] = (S0 u − K) · pu (the remainder of
terms are equal to 0, there is a single 6= 0 payoff )= c0
−R)u−(R−1) −R)u−(R−1)
But pu = (W(u−1)·(u2 −1) ⇒ (S0 u − K) · (W(u−1)(u2 −1) = c0 ⇒ c0 u3 − (c0 +
S0 (W − R))u2 − (c0 − K(W − R) − (R − 1)S0 )u + c0 − K(R − 1) = 0
√
We find (using bisection/Newton algorithm), that u = 1.38, u = exp(λσ ∆t) ⇒
λ = log(u)
σ
= 1.3062
• When the trinomial model has N = 2 periods, p2u · (S0 u2 − S0 ) + 2pu ·
pm (S0 u − S0 ) = c0 .
After some computations, Sc00 · (u − 1)3 (u + 1) − 2(W − 1)u(u − 1)2 +
u2 (W − 1)2 = 0 where W = exp(σ 2 ∆t). The only solution using New-
ton’s algorithm starting from initial guess u0 = 1.0 is u∗ = 0.89 < 1.
36
There is no u that fits the trinomial model with 2 periods, due to the
cross effect between vega and theta risk (risks determined by the im-
plied volatility and the time-to-expiry).
Example 4.2.2.
Suppose this time, there is another traded option, with expiry in 2 years,
and market price c20 = 11.09$.
The annualized implied vol σ(0, 2) = 19.72%
4.3 Convergence of european option price under tri-

nomial vs binomial model
The distribution of a trinomial model can be found easily using generating
functions. What is more interesting, is that the distribution of the maximum
(and minimum) of a generalized random walk depends linearly on the distri-
bution of this random walk.
If the volatility (implied or historical) of the underlying asset is assumed

constant and non-stochastic, then the trinomial pricing model can be reduced
to a log-sum of independent random variables.
If the volatility is local but non-stochastic, the movements u, m, d =
u(t), m(t), d(t), t = 1, n. If the volatility is stochastic then un , mn , dn ∈ F\−∞ .
Property 4.3.1.

−1 0 1
Let X1 , X2 , ..., Xn :
p1 p2 p 3
m
Then Sn = X1 + X2 + ... + Xn has the distribution where
P (Sn = m)
m ∈ {−n, ..., n} and P (Sn = m) = pn2 ( pp12 )m bk=a ( pp1 p2 3 )k · (k−m)!(n+m−2k)!k!
n!
P
2
where a = max(m, 0), b = [ m+n
2
]
Proof :
37
1
We consider the generating polynomial g(x) = (p1 · x
+ p2 + p3 x)n and
P (Sn = m) is the coefficient of xm in g(x).
1 i j
So (p1 · x1 +p2 +p3 x)n = k n!
pi1 pj2 pk3 xk−i ·
P P
i+j+k=n (p1 · x ) ·p2 ·(p3 x) · i!j!k! = i+j+k=n
n!
i!j!k!
But i = k − m ≥ 0 ⇒ k ≥ m.
Also j = n − (k + i) = n − (k + k − m) = n + m − 2k ≥ 0
Therefore k ≥ max(m, 0), k ≤ m+n2
⇒ k ≤ [ m+n
2
]
Pb
So P (Sn = m) = k=a pk−m
1 p2n+m−2k pk3 · n!
(k−m)!(n+m−2k)!k!
Using the above result we can find the distribution of Sn using trinomial
distribution.
Under these circumstances we know the general distribution of the trino-

mial model, when m = 1 and ud = 1. (the most frequent condition used).
SN = S0 ui mj dk = S0 ui · u−k = S0 ui−k ∈ {S0 un , ..., S0 u−n } and

b k−m n+m−2k k n!
P (SN = S0 um ) =
P
k=a p1 p2 p3 · (k−m)!(n+m−2k)!k! as stated in the
previous proposition.
Under the trinomial model, the european call

price canbe written as:
1 0 −1
E[D0,T max(S0 uX1 +...+Xn − K)+ ] where Xi ∼ .
p1 p2 p3
λσ √T (X1 +...+XN )
Particularly under Boyle model the price is E[(S0 e N − K)+ ]
I will illustrate in what follows an example of comparison in efficiency be-

tween the trinomial model and binomial model convergence towards BS price.
Example 4.3.1.
Suppose we have an european call with strike K = 90, current underly-

ing asset price S = 100, lifetime T = 1 year using Boyle model (trinomial),
Cox-Ross-Rubinstein (binomial model) and Black Scholes model (continuous
38
Figure 1: Error dependence on the number of periods
time model).
The number of periods is increasing from N = 1 to N = 20 periods, while

the risk-free interest rate is held constant at 5% and annualized
√ volatility is
σ = 20%. We use the Boyle model with the parameterλ = 3. (Hull White
model)
As you can remark, the trinomial model price is much more stable than
its binomial counterpart in both put and call case.
The error analysis for the above options (ITM) and for a pair of ATM
put and call options is displayed below.
39
The evolution of the trinomial price with the number of periods increased
is smoother.
Property 4.3.2.
The trinomial pricing approach converges to Black Scholes pricing ap-
proach.
Proof:
Based on the remark in the previous section, we shall use the Kamrad-
Ritchken representation of the model.
√ √
SN = S0 uX1 +...+Xn = S0 eλσ T /N (X1 +...+XN ) = S0 ·exp(λσ T · X1σ+...+X
√ N ·
N N
p
σN ) where σN = (pN + rN ) − (pN − rN )2 is the standard deviation of the
trinomial distribution.
√ √
So SN = S0 exp(λσσN T ZN ) · exp(λσ T N (pN − rN )) where ZN =
X1 +...+XN −N (p−r)
√
σN N q
σ2
p 1 1 T 1
σN = (pN + rN ) − (pN − rN )2 = λ2
− λ2 σ 2
(r − 2
) · N
→ λ
√
On the other hand, σλ T N (pN − rN ) = (r − σ 2 /2)T
(D)
Taking into account that ZN → N (0, 1) (convergence in distribution) from
(D)
central limit theorem, we obtain that SN → LogN ((r − σ 2 /2)∆t, σ 2 ∆t)).
We take into account the fact that if f is a continuous mapping and

(D) (D)
Xn → X then f (Xn ) → f (X) and in that case E[f (Xn )] → E[f (X)].
(D)
Because SN → LogN ((r−σ 2 /2)∆t, σ 2 ∆t) and because f : R+ → R+ , f (x) =
(e − K)+ is a continuous function, it results that the model is convergent to-
x
wards the Black Scholes pricing.

I will continue the previous example to see how well is behaving the con-
vergence for different values of λ as well as compute the mean error between
the prices under KR(λ, N ) and Black Scholes, N ∈ {1, 2, ..., 20} periods.
√
The best convergence is insured by the Hull White case. (λ = 3).
40
Figure 2: convergence for different λ parameters
Table 1: Mean error for trinomial pricing

λ Mean error
λ =√1 0.091
λ = 3 6.08 · 10−5
λ=2 -0.03
4.4 Super-replication under stochastic volatility or in-

terest rate
Stochastic volatility and interest rate are frequently used model risk factors.
We illustrate in what follows an example.
Example 4.4.1.
Suppose the underlying asset price is given by S0 = 4, S1 (H) = 8, S1 (T ) =
2 and S2 (HH) = 12, S2 (HT ) = S2 (T H) = 8, S2 (T T ) = 2.
We are interested in the situations when the interest rates are assumed:
a) Constant and flat at level r = 41 ;
b) Given by r0 = 41 and r1 (H) = 41 , r1 (T ) = 12 . The time-0 value of a
T = 2-year lifetime european call option with exercise price K = 7 is found
as follows:
41
S1 (H) S1 (T ) 1+r−d0
a) u0 = S0
= 2, d0 = S0
= 12 ; p0 = u0 −d0
= 21 , q0 = 12 , p1 (H) =
1
1+r0 −u1 (H) 1+ −1 0 −d1 (T )
u1 (H)−d1 (H)
= 3 −1 4
= 12 , q1 (H) = 12 ; p1 (T ) = u1+r
1 (T )−d1 (T )
= 1+1/4−1
4−1
1
= 12 ,
2
q1 (T ) = 11
12
.
P̃ (HH) = p0 p1 (H) = 12 · 12 = 41 ; P̃ (HT ) = p0 q1 (H) = 21 · 12 = 41 ;

1
P̃ (T H) = q0 p1 (T ) = 12 · 12 1
= 24 ; P̃ (T T ) = q0 q1 (T ) = 11
24
.
V2
The time-0 option value is V0 = Ẽ[ (1+r 2 ] = [5 · P̃ (HH) + (P̃ (T H) +
0)
1
P̃ (HT )) · 1 + P̃ (T T ) · 0] · (1+r)2
= [5 · 14 + 7
24
] · ( 45 )2 = 592
600
.
1
The time-1 option values are: V1 (H) = 1+r [p1 (H)V2 (HH)+q1 (H)V2 (HT )] =
4 1
2.4, V1 (T ) = 5 [p1 (T ) · V2 (T H) + q1 (T )V2 (T T )] = 15
b) As in case I), u0 = 2, d0 = 12 , u1 (H) = 1.5, d1 (H) = 1, u1 (T ) =

4, d1 (T ) = 1; So p˜0 = 1+r 0 −d0
u0 −d0
= 12 , p˜1 (H) = 1+r 1 (H)−d1 (H)
u1 (H)−d1 (H)
= 21 , q˜1 (H) =
1
2
, p˜1 (T ) = 16 , q˜1 (T ) = 56 .
Therefore the risk neutral probs are P̃ (HH) = p˜0 p˜1 (H) = 14 , P̃ (HT ) =
1 1 5
4
, P̃ (T H) = 12 , P̃ (T T ) = 12 .
On the other hand V2 (HH) = (S2 (HH) − 7)+ = 5, V2 (HT ) = V2 (T H) =

1 1
1.V2 (T T ) = 0. Hence V0 = (1+r0 )(1+r1 (H))
· V2 (HH) · P̃ (HH) + (1+r0 )(1+r1 (H))
·
1 1
V2 (HT )·P̃ (HT )+ (1+r0 )(1+r 1 (T ))
·V2 (T H)·P̃ (T H)+ (1+r0 )(1+r 1 (T ))
V2 (T T )P̃ (T T ) =
1 1 1 1 1 1 226
(1+1/4)(1+1/4)
· 5 · 4 + (1+1/4)(1+1/4) · 4 + (1+1/4)(1+1/2) · 1 · 12 = 225
V1 (H) = 1+r11 (H) · [p˜1 (H)V2 (HH) + (1 − p˜1 (H))V2 (HT )] = 2.4 ;
V1 (T ) = 1+r11 (T ) [p1 (T )V2 (T H) + q1 (T )V2 (T T )] = 19 .
II. Suppose now that S1 (U ) = 8, S1 (M ) = 4, S1 (D) = 2, S2 (U U ) =

12, S2 (U M ) = S2 (M U ) = 8, S2 (M M ) = S2 (U D) = S2 (DU ) = 4, S2 (M D) =
2, S2 (DD) = 1.
————————————————————–
We are now interested in the super-replication price if:
a) The interest rate is constant and flat at level r = 41
b) The interest rate follows the distribution r0 = 1/4, r1 (U ) = 1/3, r1 (M ) =
42
1
, r (D)
4 1
= 12 .
————————————————————–
( a). At time 0, the risk-neutral probabilities must satisfy:
p0 + q0 + r0 = 1
1 5
⇒ p0 = 14 + r20 , q0 = 34 − 3r20 (1 )
p0 · 2 + q0 + r0 2 = 4
From q0 ≥ 0 ⇒ r0 ≤ 12 ⇒ 0 ≤ r0 ≤ 12 (1’)
At time 1: we need to study the risk-neutral probabilities only around the
payoffs that are 6= 0 at time 2, that is (S2 (HH) − 7)+ = 5,(S2 (HT ) − 7)+ = 1
(
p1 (U ) + q1 (U ) + r1 (U ) = 1
First ⇒ p1 (U ) = 21 +r1 (U ), q1 (U ) =
1.5p1 (U ) + q1 (U ) + 0.5r1 (U ) = 45
1
2
− 2r1 (U ) (2)
Also, as seen in (1’) we obtain q1 (U ) = 21 − 2r1 (U ) ≥ 0 ⇒ r1 (U ) ≤ 41 (2’)

(
p1 (M ) + q1 (M ) + r1 (M ) = 1
Then, 1 5
⇒ p1 (M ) = 14 + r1 (M
2
)
, q1 (M ) =
2p1 (M ) + q1 (M ) + r1 (M ) · 2 = 4
3 3r1 (M )
4
− 2
(3)
We have the constraint 0 ≤ r1 (M ) ≤ 12 (3’)

1
The risk neutral price is given by V0 = (1+r) 2 [p0 p1 (U )·5+(q0 p1 (M )+p0 q1 (M ))·
1] = (after some computations)= 25 16

[1 + 5r1 (U )+5r0 +5r04r1 (U )−6r0 r1 (M ) ].
We therefore need to find (according to super-hedging theorem) sup E Q [f ] =
supr0 ,r1 (U ),r1 (M ) 16
25
[1 + 5r1 (U )+5r0 +5r04r1 (U )−6r0 r1 (M ) ]
For that I need to maximize
f (r0 , r1 (U ), r1 (M )) = 5r1 (U ) + 5r0 + 5r0 r1 (U ) − 6r0 r1 (M ) u.c. (1’),(2’),(3’)
arg max f (r0 , r1 (U ), r1 (M )) = [0.5, 0.25, 0]

16
In that, the super-replication price is supE Q [f ] = 25 [1 + (5 · 0.25 + 52 + 5 ·
1 1 1
· − 6 · 2 · 0)/4] = 1.34
2 4
The super-replication price under trinomial is slightly larger
than the binomial price obtained in Example 3.6.2.
b) As at a), p0 = 14 + r20 , q0 = 34 − 3r20 .
Also p1 (M ) = 14 + r1 (M2
)
, q1 (M ) = 34 − 3r12(M )
. Only for the risk neutral probabilities at time 1 when stock goes up, the
situation changes (because the interest rate r1 (U ) = 31 instead of 41 )as implied
43
by the
( following system:
p̃1 (U ) + q̃1 (U ) = 1 − r̃1 (U )
⇒ p1 (U ) = 32 + r1 (U ), q1 (U ) = 31 −
1.5p̃1 (U ) + q̃1 (U ) = 34 − r1 (U
2
)
2r1 (U ) (To not be confused the two r’s, the interest rate and risk neutral
probability)
The risk neutral probabilities for 2-period case change: P̃ (U U ) = p0 p1 (U ) =

( 41 + r˜20 )( 32 + r˜1 (U )); P̃ (U M ) = p˜0 q˜1 (U ); P̃ (M U ) = q˜0 p˜1 (U )
1 1
So V0 = (1+r0 )(1+r1 (U ))
P̃ (U U )V2 (U U ) + (1+r0 )(1+r1 (U ))
P̃ (U M )V2 (U M ) +
1
(1+r0 )(1+r1 (M ))
P̃ (M U )V2 (M U ) = ... = 3( 4 + 2 )( 3 + r1 (U )) + 35 ( 14 + r20 )( 13 −
1 r0 2
2r1 (M )) + 16 ( 3 − 3r20 )( 23 + r1 (U ))
25 4
The restrictions are 0 ≤ r0 ≤ 1/2, 0 ≤ r1 (U ) ≤ 61 , 0 ≤ r1 (M ) ≤ 12
Using optimization algorithms I obtain: p0 = 21 , p1 (U ) = 16 , p1 (M ) = 0
and the super-replication price 1.225$
Remark 4.4.1.
Comparing I with II we can remark that when the interest rate is not a
risk-factor, the price is lower than the situation when r is stochastic, because
the adjusted risk-neutral probability for going down is getting lower, when
interest rates go up.
4.5 Generalized random walks

Consider a sequence of independent random variables X1 , X2 , ..., Xn taking
values in integers. Let Sn = X1 + X2 + ... + Xn as being the nth position of
a random walk which takes steps Xi and Tb = inf{n|Sn = b}.
I call a random walk right-continuous if P (Xi ≤ 1) = 1 and left-continuous

if P (Xi ≥ −1) = 1.
The next theorem is very useful in finding the distribution of maximum
and minimum of random walks when we use the trinomial model. The re-
flection principle is impossible to use under these circumstances. The proof
of the next theorem uses probability generating functions as power series.
44
Theorem 4.5.1 (Hitting time theorem).
i. Assume that S is a right-continuous random walk and let Tb be the

first hitting time of point b. Then P (Tb = n) = nb P (Sn = b) for b, n ≥ 1.
ii. For left-continuous walks the conclusion becomes P (T−b = n) =
b
n
P (Sn = −b) for n, b ≥ 1.
Proof
P1
We introduce P the function G(z) = E(z −X1 ) = n=−∞ z −n P (X1 = n),
Fb (z) = E(z Tb ) = ∞ n
n=0 z P (Tb = n)
The walk is assumed to be right-continuous so in order to reach b > 0 it

must pass through all the points 1, 2, ..., b − 1.
r (n) = P (S1 6= r, S2 6= r, ..., Sn−1 6= r, Sn = r) so we have that

For fP
fr (n) = n−1k=1 fr−1 (n − k)f1 (k) if r > 1.
Multiplying by sn and summing over n we obtain Fr (s) = Fr−1 (s)F1 (s) =

F1 (s)r
On the other hand, F1 (z) = E(z T1 ) = E(E(z T1 |X1 )) = E(z 1+TJ ) where
J = 1 − X1 since, conditional on X1 , the further time required to reach 1
has the same distribution as T1−X1 . Now 1 − X1 ≥ 0 and therefore F1 (z) =
zE(F1−X1 (z)) = zE(F1 (z)1−X1 ) = zF1 (z)G(F1 (z))
So z = G(F11 (z)) .
To compute the inverse of the function we use Lagrange’s inversion
formula. (LIF)
Let z = w/f (w) where w/f (w) is an analytic function of w in a neigh-
bourhoodP∞of 1then origin. If g is infinitely differentiable, then g(w(z)) =
dn−1 0
g(0) + n=1 n! z [ dun−1 [g (u)f (u)n ]]u=0
We apply (LIF) for w = F1 (z),f (w) = wG(w) and g(w) = wb so that
z = 1/G(w) becomes z = w/f (w). Note that f (w) = E(w1−X1 ), and because
of the right-continuity of the walk, it is a power series in w which converges
w
for w < 1. Also f (0) = P (X1 = 1) > 0 and hence f (w) is analytic on the
neighbourhood of the origin.
The inversion formula becomes now Fb (z) = g(w(z)) = g(0) + n!1 z n Dn
dn−1 b−1 n
(FB) where Dn = du n−1 [bu u G(u)n ]|u=0 .
45
1
We pick out the coefficient of z n in (FB) to obtain P (Tb = n) = D
n! n
for
n ≥ 1.
dn−1
Now G(u)n = ni=−∞ u−i P (Sn = i), so that Dn =
P Pn b+n−1−i

dun−1
b· i=−∞ u P (Sn = i) u=0
=
b · (n − 1)!P (Sn = b), hence the conclusion.
Remark 4.5.1.
In order to obtain information about maximum and minimum altogether,
the random walk should be both right and left continuous. The only random
walk with integer
values
obeying these properties is the symmetric random
−1 0 1
walk Zi :
p1 p2 p3
Example 4.5.1.
Suppose a company named ”Alpha”, whose stock price is S0 = 100$ is
issuing two equity derivatives A and B, expiring in 1 year.
A is paying off 10$ if the stock will have a peak performance of at most
30% compared to its base value while B will pay off the instrument holder
10$ if the stock ever goes below 90$ threshold. The stock price expectations
measured at every 4 months are either to increase their value with 10%, to
remain at their level, or to go down with the same rate. We are interested to
find the highest and lowest estimator for the derivative value. The annualized
risk-free rate is considered flat at level rf = 6%.
————————————————————–
————————————————————–
We consider as best suitable a trinomial model with 3 periods, the up,middle
and down factors being equal to u = 1.1, m = 1, d = 1/u.
φA (ST ) = 10 · 1MT <130 , MT = max .
t∈[0,T ]
10 10
The value at time 0, = V0A·P (T3 ≥ 4) = 1+r
1+r
·(1−P (T3 = 1)−P (T3 =
10 10 3 10
2)−P (T3 = 3)) = 1+r ·(1−P (T3 = 3)) = 1+r ·(1− 3 P (S3 = 3)) = 1+r ·(1−p3u )
h i
But m = 1 < 1 + r/3 = 1.02 ⇒ pd ∈ 0, u−(1+r) u−d
= [0; 0.4] while
1+r−m−(d−m)pu
pu = u−m
= 0.2 + pd ∈ [0.2; 0.6]
10
So V0A = 1.06
· (1 − p3u ) ∈ [7.3962; 9.3584]
46
For V0B we need P (T−2 ≤ 3) = P (T−2 = 2) = P (S2 = −2) = 3p2d (1 − pm ).
d ·d
But pm = u−(1+r)−p
u−d
∈ [0, 22; 0.4]
1.8·p2d +1.35·pd
So V0B = 1
1.06
[3·p2d (1−pm )] = 1.06
∈ [0; 0.32] when pd ∈ [0; 1.02−m−(d−m)p
u−m
3
]=
[0; 0.2].
4.6 More examples

4.6.1 American options replication
We work in a collection of discrete time models P (that includes N-period
models, binomial, trinomial or mixed).
We note Sn the set of all stopping times, that take value in the set {n, n+
1, ...N, ∞}.
Definition 4.6.1.
For each n, let Gn be a random variable depending on the first n coin

tosses. An american derivative security with intrinsic value process Gn is a
contract that can be exercised at any time prior to and including at time N ,
that pays off, if exercised at time n, Gn .
The value process Vn is defined as Vn = maxEn [1τ ≤N (1+r)1 τ −n Gτ ]
τ ∈Sn
Theorem 4.6.1.
The american derivative security price process given by the previous def-
inition has the properties:
1. Vn ≥ Gn = max(Xn , 0) (Xn is called intrinsic value) (for example, in

the call option case, Xn (S) = S − K, Gn (S) = (S − K)+ ).
2. The discounted process (1+r)1 n Vn is a super-martingale.
3. Vn is the smallest process satisfying 1 and 2.
Proof
1. Let n be given and we consider the stopping time T1n = n, ∀ω ∈ Ω.
h i h i
1 1
Then En 1τ ≤N n Xn = Xn . Because Vn = supτ ∈Sn En 1τ ≤N n Xn
(1+r)T1 −n (1+r)T1 −n
we have that Vn ≥ Xn .
47
If we consider the stopping time T2 = ∞∀ω ∈ Ω then En [1T2 ≤N (1+r)1T2 −n ] =
0. Because Vn = supτ ∈Sn (...) it results Vn ≥ 0 therefore, Vn ≥ max(Xn , 0).
2. Suppose T ∗ attains its maximum by the definition of Vn+1 . Therefore
T ∗ ∈ Sn+1 and Vn+1 = Ẽn+1 [1T ∗≤N (1+r)T1∗−n−1 GT ∗ ] therefore T ∗ ∈ Sn so via
the iterating conditioning property, we obtain Vn ≥ En [1T ∗ ≤N (1+r)1T ∗−n GT ∗ ] =
1
... = En [ 1+r Vn+1 ].
1
Dividing both sides by (1+r) n , we obtain the desired super-martingale
property.
The first example will be based on example 4.2.1 provided by [3].

I will study the price and strategy under the binomial and trinomial
models altogether.
Example 4.6.1.
Suppose that the price of the underlying stock of an american put option
with strike price K = 5 is S0 = 4$.
We have the distribution tree: S1 (H) = 8, S1 (T ) = 2, S2 (HH) = 16, S2 (HT ) =
4, S2 (T T ) = 1. We consider the risk free rate r = 41 .
a. What is the replication price and strategy under binomial model?
b. What is the super/replication cost of the corresponding european put
under trinomial model if u = 2, m = 1, d = 1/2 at each step.
c. What is the superreplication cost of the american put under the same
trinomial model?
Solution:
a. For the first question we pose the following algorithm according to [3].
v2 (s) = max(5 − s, 0) vn (s) = max{5 − s, 52 [vn+1 (2s) + vn+1 ( 2s )]}
V2 (HH) = 0, V2 (HT ) = 1, V2 (T T ) = 4 ⇒ V1 (H) = max{0, 52 [0 + 1]} = 25
and V1 (T ) = max{3, 25 [4 + 1]} = 3 ≥ V1eur (T ) = 2
V0 = max{1, 52 ( 25 + 3)} = 1.36
The replication strategy consists of taking an initial long position on
∆0 = SV11 (H)−V1 (T )
(H)−S1 (T )
= v1 (8)−v
8−2
1 (2)
= 2/5−3
6
= −0.43 shares (it is actually a short
position on 0.43 shares of stock) and at time 1, this position is re-balanced
to either ∆1 (H) = v2 (16)−v16−4
2 (4)
= −1
12
(shares) (that means to buy 0.28 shares
of stock), or to ∆1 (T ) = −1 (shorting extra 0.57 shares).
48
b. For the european put under trinomial model, we must find all the
martingale
( measures:
p+q+r =1
and if we parametrize after r we obtain
pu + qm + rd = 1 + R = 54
that p̃ = 2r̃+1
4
, q̃ = 3 (1−2r̃)
4
, r̃
The payoff distribution would be given by V2 (U U ) = 0, V2 (U M ) = 0, V2 (U D) =

1, V2 (DM ) = 3, V2 (DD) = 4
P (S2 = S0 ) = q 2 + 2pr = ( 3(1−2r)4

)2 + 2 · 2r+1
4
·r
3(1−2r)
P (S2 = S0 d) = 2qr = 2 r
P (S2 = S0 d2 ) = r2
So the price V0r = ( 45 )2 · [1 · ( 16
9
(1 − 2r)2 + (2r+1)r
2
)+ 9(1−2r)r
2
+ 4r2 ] =... =
1 2
25
(9 + 44r − 28r )
But from the existence of q = 3(1−2r)4

≥ 0 ⇒ r ≤ 12 so in order to seek
1
the superreplication price of the european put we must find supr∈[0, 1 ] 25 [9 +
2
2
44r − 28r ].
1
But argmaxf (r) = 25 (−28r2 + 44r + 9) is 44
56
so f is increasing on [0,44/56]
and therefore also on [0, 1/2] so supf (r) = f ( 12 ) = 24
25
.
In this case, the superreplication cost of the european put is the same as
the price under binomial assumption.
1
c. In the american put case, V1 (U ) = max(g1 (U ), 1+R [p̃V2 (U U )+q̃V2 (U M )+
4 4
r̃V2 (U D)]) = 5 r̃ = 5 r.
1
V1 (M ) = max{g1 (M ), 1+R [p̃V2 (M U )+q̃V2 (M M )+r̃V2 (M D)]} = max{1, 45 [ 2r+1
4
·
3(1−2r) 3(1+2r)
0 + 4 · 1 + r · 3]} = max{1, 4 }
1
V1 (D) = max(g1 (D), 1+r [p̃V2 (DU ) + q̃V2 (DM ) + r̃V2 (DD)]) = max(3, 54 ·
2r+1+9−18r+16r
4
) = max(3, 45 · 10
4
) = max(3, 2) = 3
At its turn, V0 = max(1, 54 [pV1 (U ) + qV1 (M ) + rV1 (D)]) =

2
= max(1, 54 · [ 2r+1
4
· 45 r + 3(1−2r)
4
· max(1, 3(1+2r)
5
) + 3r]) =... = max(1, 54 ( 2r 5+r +
3(1−2r) 2
20
· max(5, 3(1 + 2r) + 60r 20
))) = max(1, 8r +4r+3(1−2r)max(5,3(1+r))+60r
25
)=
49
2 +46r+9+6(1−2r)max(1,3r)
max(1, 8r 25
)
2
If r > 13 , then V0 = max(1, −28r 25
+64r+9
).
−28r2 +64r+9 2 +64r+9
But 1 < 25
⇔ r ∈ [ 7 , 2] which is true so max(1, −28r 25
2
) =
−28r2 +64r+9
25
(
2 1, r ∈ [0, 0.2716]
If r < 13 , V0 = max(1, 8r +34r+15
25
) = 8r2 +34r+15 .
25
, r ∈ [0.2716; 13 ]
What we have is that, depending on the parameter
 r which is the risk neu-
−28r2 +64r+9

 25
, r ∈ [ 13 , 1]
tral probability of the stock going down, V0 = 1, r ∈ [0; 0.2716]
 8r2 +34r+15

25
, r ∈ [0.2716; 13 ]
2 +64r+9
So the superreplication cost will be given by supr∈[1/3,1] g(r) = −28r 25
which is increasing on (−∞, 64/56] so sup g(r) = g(1) = 73−28
25
= 95 = 1.8.
Remark 4.6.1.
The super-hedging cost in the american put case (1.8) is greater than in
the case of the european put ( 24
25
).
4.6.2 Convertible bonds

Convertible bonds are a good example of financial instruments to test the
model uncertainty on.
They can be structured as options + other primary assets as well. For

instance, suppose a bondholder has the right to convert at maturity N shares
at a price S0 in exchange for a certain face value.
The payoff in that case is max(F V, N · ST ) = N max(ST − FNV , 0) + F V =

N call options + a zero-coupon bond with face value FV.
That is why a zero-coupon bond is cheaper than a convertible bond.
Example 4.6.2.
50
Suppose a company issues a 10,000,000 $ bond, with 2 year expiry, and
the bond can be converted at any time for 20,000 shares at a price K = 500$.
The current share price is S0 = 500$ and we know that the up-factor, middle-
factor and down-factor are u, m, d = 1.2, 1, 1/1.2.
What is the range in which the instrument price should be if on the

market there are only stocks and money market instruments. The risk-free
interest rate is considered r = 120bps.
Answer:
Let’s
 consider the trinomial model with 2 periods.
V2 = max(N · ST , F V )

V1 = max(E1 [V2 ], N · S1 ) .

V0 = E[V1 ]

E1 [V2 ] = N · S1 · E1 [max(Y2 , NF·SV 1 )]

V1 = max(N ·S1 ·E1 [max(Y2 , NF·SV 1 )], N ·S1 ) = N ·S1 ·max(E1 [max(Y2 , NF·SV 1 )], 1)
= N · S1 · max(p · max(u, NF·SV 1 ) + q max(m, NF·SV 1 ) + r max(d, NF·SV 1 ), 1) = N ·
S0 · Y1 · max(p · max(u, Y11 ) + q · max(m, Y11 ) + r · max(d, Y11 ), 1) = N · S0 · [up ·
max(pu + q + rd, 1) + qm max(pu + q + r, 1) + rd max(pu + qu + ru, 1)] =
N · S0 · [up + q(pu + q + r) + rd]
1
r(1−d) 1− u 1
On the other hand p = u−1
= r· u−1
= r· u
= rd, q = 1 − r − p =
1 − r − r(1−d)
u−1
= 1 − r − rd
So V0 = N · S0 · (urd + (1 − r − d)(dru + 1 − r − rd + r) + rd) = N S0 · f (r)
After some computations f (r) = r(1 − d) + r2 (d2 − 1) + 1

−∆
rmax = 2(dd−1 1 6 45
2 −1) = 2(d+1) = 22 and fmax = 4a = 22
45 6
f (0) = 1, f (rmax ) = 22 , f ( 11 ) = 1 therefore the range of prices for the
convertible bond is V0 ∈ [10, 000, 000; 20, 454, 545.454]
51
5 Stochastic convergence under model uncer-
tainty
Under this section I will extend the notions of almost sure convergence, con-
vergence in probability, in Lp and in distribution when a collection of prob-
ability measures P is chosen.
5.1 Notions and preliminary results

Definition 5.1.1.
P−q.s. Ω−N
We say that Xn → X if Xn → X where N is a P-polar set.
Definition 5.1.2.
P n→∞
We say that Xn → X if P (|Xn − X| > ) → 0, ∀ > 0, ∀P ∈ P.
Definition 5.1.3.
(P,D) n→∞
We say Xn → X if P (Xn ≤ x) → P (X ≤ x), ∀x ∈ R continuity point
of distribution function of X and ∀P ∈ P.
Definition 5.1.4.
Lp ,P n→∞
We say that Xn → X if E P [|Xn − X|p ] → 0, ∀P ∈ P, > 0.
Theorem 5.1.1.
If P, P̃ are equivalent probability measures in the measurable space (Ω, F)
D D
(that is, P (A) = 0 ⇔ P̃ (A) = 0 then, Xn → X under P ⇔ Xn → X under P̃ .
Property 5.1.1 (Almost sure and P q.s. convergence).

∞
P
a. If (n )n≥1 is a sequence of positive numbers, n → 0 and P ({ω ∈
n=1
P −a.s.
Ω||Xn (ω) − X(ω)| > n }) < ∞ ⇒ Xn → X.
52
∞
b. If for P = {P λ |λ ∈ I}, sup P λ ({ω ∈ Ω||Xn (ω) − X(ω)| > n }) < ∞
P
λ∈I n=1
P−q.s.
then Xn → X.
Example 5.1.1.
Let us consider the family of distributions P λ defined on (Ω, F) =(((0, 1), B(0, 1))
1, 0 ≤ x ≤ n12
with P λ (x) = λxλ−1 and the sequence of random variables Xn (x) = .
0, n12 < x ≤ 1
P λ ,a.s. P−q.s.
Then Xn → 0 when λ = 1 and Xn → 0 when P = {P λ |λ ∈ [1, ∞]}.
The proof of this statement is left as exercise to the reader.
5.2 Option price convergence under model risk

Example 5.2.1.
I consider the model universe P = {P λ |λ ∈ [1, ∞)]} where P λ is the
Kamrad-Ritchken probability distribution from section 4.2.2 and I work on
the example from section 4.3. I compute the superreplication cost of the
call option for each number of periods. The superreplication cost converges
towards the Black Scholes price when the number of periods grows, under
model P.
Figure 3: Price convergence under model risk
53
6 References
1. Marcel Nutz ”Superreplication under Model Uncertainty”:
https://arxiv.org/pdf/1301.3227v2.pdf
2. Bruno Bouchard, Marcel Nutz: ”Arbitrage and duality in non-dominated
discrete-time models”: https://arxiv.org/pdf/1305.6008.pdf
7 APPENDIX
Joint maximum and minimum – why it is a non-Markov process?
In my attempt to compute the price of a double knock-out option, it was
important to see if the joint maximum and minimum form a Markov process.
So I have considered a sequence of functions fn : {H, T }∞ → R+ 2

, fn (ω) =
(max(S0 , S1 , ..., Sn )(ω), min(S0 , S1 , ..., Sn )(ω)) with ω = ω1 ...ωn ... or fn (ω) =
(Mn (ω), Mn∗ (ω))
I tried to prove by recurrence that fn is an injection.
1 2
( So, assuming f( n + 1)(ω ) = fn+1 (ω ) it would result:
max(Mn (ω 1 ), Sn · Yn+1 (ω 1 )) = max(Mn (ω 2 ), Sn · Yn+1 (ω 2 ))
min(Mn∗ (ω1 ), Sn (ω 1 )Yn+1 (ω 1 )) = min(Mn∗ (ω 2 , Sn · Yn+1 (ω 2 )))
We treat the 4 cases resulting on the possible values of Yn+1 (ω 1 ), Yn+1 (ω 2 ).
1. Yn+1 (ω 1 ) = u, Yn+1 (ω 2 ) = u.
2. Yn+1 (ω 1 ) = d, Yn+1 (ω 2 ) = d.
3. Yn+1 (ω 1 ) = u, Yn+1 (ω 2 ) = d.
4. Yn+1 (ω 1 ) = d, Yn+1 (ω 2 ) = u.
1 2
From the first two cases, it results that
( ω =ω .
max(Mn (ω 1 ), Sn (ω 1 ) · u) = Mn (ω 2 )
However, in the third case, it results
Mn∗ (ω 1 ) = min(Mn∗ (ω 2 ), Sn (ω 2 ) · d)
We assume that Mn (ω 1 ) > Sn (ω 1 ) · u and Mn∗ (ω 2 ) > Sn (ω 2 ) · d otherwise
it results that ω 1 = ω 2
(
Mn (ω 2 ) = Sn (ω 1 ) · u
So
Mn∗ (ω 1 ) = Sn (ω 2 ) · d
54
Now we check a candidate for ω ! and we see ω 1 ⊃ HT H so S3 (HT H) ·
u = S0 u2 = M3 (ω 2 ) and M3+ (HT H) = S0 = S3 (ω 2 ) · d so it results that
S3 (ω 2 ) = S0 u
We obtain therefore S3 (ω 2 ) = S0 u, M3 (ω 2 ) = S0 u2 so ω 2 ⊃ HHT so
there is ω 1 ⊃ HT HH, ω 2 ⊃ HHT T such that M3 (ω 1 ) = S0 u, M3∗ (ω 1 ) =
S0 , M3 (ω 2 ) = S0 u2 , M3∗ (ω 2 ) = S0 and M4 (ω 1 ) = M4 (ω 2 ) = S0 u2 , M4∗ (ω 1 ) =
M4∗ (ω 2 ) = S0 .
On the other hand, E4 [(M5 , M5∗ )](HT HH) = (pS0 u3 + q · S0 u2 , p · S0 u2 +
q · S0 u2 )
Up-and-out-barrier option pricing
If we consider the N-period binomial pricing model and a barrier option

where the underlying asset has value S0 , √ strike price K and barrier level
H > max(S0 , K) then given u = exp(σ · ∆t) the up-factor, p - the risk
neutral probability and k = log(H/S
log(u)
0)
and l = log(K/S
log(u)
0)
then the price at time
0 of the barrier option is: P 0 0
a.If N=2N’,price0 = j=max([l/2]+1,−N/2) (CNN +j ·pN +j (1−p)N −j −CNk+N −j pk+N −j (1−
min([k/2],N/2) 0 0 0
0
p)N +j−k )(S0 uj − K)+
Pmin([ k−1 ,N 0 ]) N 0 +j N 0 +j 0
b. If N=2N’+1, price0 = 2
j=max([ l−1 ]+1,− N −1 (CN
)
p (1 − p)N −j −
2 2
N 0 +j 0
CNk+N −j pk+N −j (1 − p)N +j−k )(S0 uj − K)+
0 0 0 0
CN pN +j (1 − p)N −j −
55

Superreplication Cost of Derivatives Under Discrete Time Models Risk

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Superreplication Cost of Derivatives Under Discrete Time Models Risk

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Superreplication cost of financial derivatives

under model uncertainty in discrete time

2 Introduction, notations and necessary results 2

3 Replication under binomial and trinomial models 8

4 Replication under trinomial models 26

5 Stochastic convergence under model uncertainty 52

2 Introduction, notations and necessary re-

So, there are three approaches to overcome that:

a. To ”find” new instruments that could explain the probability distri-

b. To restrain the generality of the model by reducing the number of

2.1 What is model risk and how it occurs?

• Through portfolio replications;

• Using martingale measures.

Given an adapted process S and a random variable f (representing a

I will link this quantity to supQ∈Q EQ [f ] where Q is a set of martingales

In what follows I will present a few needed results and definitions on

Whenever Ω is Polish space (complete metrisable topological space), (P)

Definition 2.2.3. A function f : Ω → R = [−∞, ∞] is upper semi-analytic

We shall often deal with a set P ⊂ P(⊗) of measures. Then a subset

Let T ∈ N be the time horizon, and let Ω1 be a Polish space. For

The convention is that Ω0 is a singleton.

Let Ft be the universal completion of B(Ωt ) and write (Ω, F) = (ΩT , FT ).

For each t ∈ {0, 1, ..., T − 1} and ω ∈ Ωt , we are given a nonempty con-

Definition 2.2.4. Given H ∈ H, the corresponding wealth process (from

Hu ∆Su = di=1 Hui ∆Sui on Rd .

Moreover, let e ∈ N ∪ {0}, and let g = (g 1 , ..., g e ) : Ω ⇒ Re be Borel

We say that Q is absolute continuous w.r.t. P in the strong sense (and

s If Q is a martingale measure, then it should be consistent with the given

Condition N A(P) holds if for all (H, h) ∈ H × Re , H ◦ ST + hg ≥ 0, P-

2.3 Needed results

Theorem 2.3.2 (Superhedging theorem).

Let N A(P) hold, and let f : Ω → R be upper semianalytic. Then the

I assume a binomial model and I note:

Suppose we define the space Ω = ΩN = {H, T }N , the filtration (Ft )t=1,...,T

Let u = the up factor, d = down factor, p = risk-neutral up probability.

Estimating the error in (2) by this value of u we obtain: Error √= p ·

This is obtained by equalizing the third order moments of St+∆t under

The solutions to (1),(2) and (4) are:

The answer is NO. Let’s see why.

tain Rud = R2 Q(u + d) − R3 Q3 ⇒ ud = RQ(u + d) − R2 Q3 ⇒ (by using

So R(1 − Q)(u + d) = R2 (Q − Q3 ) ⇒ (1 − Q)(u + d) = RQ(1 − Q2 ) ⇒

So (u + d)2 =(u2 + d2 + 2ud = 2R2 Q + 2ud = 4R2 → ud = 2R2 − R2 Q =

Suppose we have a european call option when S = 100, K = 100, r =

b. The risk neutral formula still applies.

a. The wealth accumulated at time n+1 is Xn+1 = ∆n Sn+1 +(1+r)(Xn −

But Xn is the unique replicating portfolio consisting of stock and money

counted asset price is a sub-martingale.

3.3 Stochastic volatility and interest rates: Strategy

We build the risk-neutral measure on {H, T }n , P̃ as follows:

and ∆n = SVn+1 (H)−Vn+1 (T )

The discounted asset process Sn is a P̃ - martingale.

Let us call Dn = (1+r0 )(1+r11)...(1+rn−1 ) the discount factor. Dn is Fn−1

The discounted wealth process Xn is a martingale.

I present here an example of discrete time stochastic driven volatility.

At each time un = Sn+1Sn

3.4 Markov process approach

Let {(Xn1 , ..., XnK ), n = 0, N } be a K-dimensional adapted process in a dis-

Example 3.4.1 (Fixed strike lookback call).

If we denote Sn = the stock price at time n and Mn = maximum to date

E2k [M2k+1 ](T HT H...T HT T ) = S0 while M2k (T H...T H) = M2k (T H...T HT T ) =

So the transition function is g(s, m) = En f (sY, m∨(sY )) = pf (us, mv(us))+

The pricing algorithm using Markov process approach is the following:

One could go one step further backwards and we would obtain:

Max-min asset/strike lookback call

The transition function is therefore:

3.5 Incomplete fixed income markets

We can summarize the results into the