Financial Mathematics For Actuaries I

MATH 361: Financial Mathematics for Actuaries I
Albert Cohen
Actuarial Sciences Program

Department of Mathematics
Department of Statistics and Probability
C336 Wells Hall
Michigan State University
East Lansing MI
48823
albert@math.msu.edu
acohen@stt.msu.edu
Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 1 / 161
Course Information
Syllabus to be posted on class page in first week of classes

Homework assignments will posted there as well
Page can be found at https://www.math.msu.edu/classpages/
Course Information
Many examples within these slides are used with kind permission of
Prof. Dmitry Kramkov, Dept. of Mathematics, Carnegie Mellon
University.
Book for course: Financial Mathematics: A Comprehensive Treatment
(Chapman and Hall/CRC Financial Mathematics Series) 1st Edition.
Can be found in MSU bookstores now
Some examples here will be similar to those practice questions
publicly released by the SOA. Please note the SOA owns the
copyright to these questions.
This book will be our reference, and some questions for assignments
will be chosen from it. Copyright for all questions used from this book
belongs to Chapman and Hall/CRC Press .
From time to time, we will also follow the format of Marcel Finan’s A
Discussion of Financial Economics in Actuarial Models: A Preparation
for the Actuarial Exam MFE/3F. Some proofs from there will be
referenced as well. Please find these notes here
What are financial securities?
Traded Securities - price given by market.

For example:
Stocks
Commodities

For example:
Stocks
Commodities
Non-Traded Securities - price remains to be computed.

For example:
Stocks
Commodities
Is this always true?

For example:
Stocks
Commodities
Is this always true?
We will focus on pricing non-traded securities.
How does one fairly price non-traded securities?
By eliminating all unfair prices

Unfair prices arise from Arbitrage Strategies
Start with zero capital
End with non-zero wealth

We will search for arbitrage-free strategies to replicate the payoff of a
non-traded security

We will search for arbitrage-free strategies to replicate the payoff of a
non-traded security
This replication is at the heart of the engineering of financial products
More Questions
Existence - Does such a fair price always exist?

If not, what is needed of our financial model to guarantee at least one
arbitrage-free price?
Uniqueness - are there conditions where exactly one arbitrage-free
price exists?
And What About...
Does the replicating strategy and price computed reflect uncertainty

in the market?
And What About...
Does the replicating strategy and price computed reflect uncertainty

in the market?
Mathematically, if P is a probabilty measure attached to a series of
price movements in underlying asset, is P used in computing the
price?
Notation
Forward Contract:
Notation
Forward Contract:
A financial instrument whose initial value is zero, and whose final
value is derived from another asset. Namely, the difference of the
final asset price and forward price:
V (0) = 0, V (T ) = S(T ) − F (1)
Notation
Forward Contract:
A financial instrument whose initial value is zero, and whose final
value is derived from another asset. Namely, the difference of the
final asset price and forward price:
V (0) = 0, V (T ) = S(T ) − F (1)
Value at end of term can be negative - buyer accepts this in exchange

for no premium up front
Notation
Interest Rate:
The rate r at which money grows. Also used to discount the value
today of one unit of currency one unit of time from the present
Notation
Interest Rate:
The rate r at which money grows. Also used to discount the value
today of one unit of currency one unit of time from the present
1
V (0) = , V (1) = 1 (2)
1+r
An Example of Replication
Forward Exchange Rate: There are two currencies, foreign and

domestic:

domestic:
SAB = 4 is the spot exchange rate - one unit of B is worth SAB of A
today (time 0)

domestic:
today (time 0)
r A = 0.1 is the domestic borrow/lend rate

domestic:
today (time 0)
r B = 0.2 is the foreign borrow/lend rate

domestic:
today (time 0)
r B = 0.2 is the foreign borrow/lend rate
Compute the forward exchange rate FAB . This is the value of one unit
of B in terms of A at time 1.
An Example of Replication: Solution
At time 1, we deliver 1 unit of B in exchange for FAB units of domestic

currency A.

currency A.
This is a forward contract - we pay nothing up front to achieve this.

currency A.
Initially borrow some amount foreign currency B, in foreign market to
grow to one unit of B at time 1. This is achieved by the initial
SB
amount 1+rA B (valued in domestic currency)

currency A.
Initially borrow some amount foreign currency B, in foreign market to
grow to one unit of B at time 1. This is achieved by the initial
SB
amount 1+rA B (valued in domestic currency)
FAB
Invest the amount 1+r A
in domestic market (valued in domestic
currency)
This results in the initial value

FAB SAB
V (0) = − (3)
1 + rA 1 + rB
Since the initial value is 0, this means
1 + rA
FAB = SAB = 3.667 (4)
1 + rB
Discrete Probability Space
Let us define an event as a point ω in the set of all possible outcomes Ω.

This includes the events ”The stock doubled in price over two trading
periods” or ”the average stock price over ten years was 10 dollars”.

In our initial case, we will consider the simple binary space
Ω = {H, T } for a one-period asset evolution. So, given an initial
value S0 , we have the final value S1 (ω), with

S1 (H) = uS0 , S1 (T ) = dS0 (5)

S1 (H) = uS0 , S1 (T ) = dS0 (5)

with d < 1 < u. Hence, a stock increases or decreases in price,
according to the flip of a coin.

S1 (H) = uS0 , S1 (T ) = dS0 (5)

with d < 1 < u. Hence, a stock increases or decreases in price,
according to the flip of a coin.
Let P be the probability measure associated with these events:
P[H] = p = 1 − P[T ] (6)
Arbitrage
Assume that S0 (1 + r ) > uS0
Arbitrage

Where is the risk involved with investing in the asset S ?
Arbitrage

Assume that S0 (1 + r ) < dS0
Arbitrage

Why would anyone hold a bank account (zero-coupon bond)?
Arbitrage

Why would anyone hold a bank account (zero-coupon bond)?
Lemma Arbitrage free ⇒ d < 1 + r < u
Derivative Pricing
Let S1 (ω) be the price of an underlying asset at time 1. Define the

following instruments:
Derivative Pricing

1
Zero-Coupon Bond : V0B = B
1+r , V1 (ω) = 1
Forward Contract : V0F = 0, V1F = S1 (ω) − F
Call Option : V1C (ω) = max(S1 (ω) − K , 0)
Put Option : V1P (ω) = max(K − S1 (ω), 0)
Derivative Pricing

1
1+r , V1 (ω) = 1
In both the Call and Put option, K is known as the Strike.
Derivative Pricing

1
1+r , V1 (ω) = 1
Once again, a Forward Contract is a deal that is locked in at time 0 for
initial price 0, but requires at time 1 the buyer to purchase the asset for
price F .
Derivative Pricing

1
1+r , V1 (ω) = 1
Once again, a Forward Contract is a deal that is locked in at time 0 for
initial price 0, but requires at time 1 the buyer to purchase the asset for
price F .
What is the value V0 of the above put and call options?
Put-Call Parity
Can we replicate a forward contract using zero coupon bonds and put and
call options?
Put-Call Parity
call options?
Yes: The final value of a replicating strategy X has value
Put-Call Parity
call options?
V1C − V1P + (K − F ) = S1 − F = X1 (ω) (7)
Put-Call Parity
call options?
V1C − V1P + (K − F ) = S1 − F = X1 (ω) (7)

This is achieved (replicated) by
Purchasing one call option
Selling one put option
Purchasing K − F zero coupon bonds with value 1 at maturity.
all at time 0.
Put-Call Parity
call options?
V1C − V1P + (K − F ) = S1 − F = X1 (ω) (7)

all at time 0.
Since this strategy must have zero initial value, we obtain
F −K
V0C − V0P = (8)
1+r
Put-Call Parity
call options?
V1C − V1P + (K − F ) = S1 − F = X1 (ω) (7)

all at time 0.
Since this strategy must have zero initial value, we obtain
F −K
V0C − V0P = (8)
1+r
Question: How would this change in a multi-period model?
General Derivative Pricing -One period model
If we begin with some initial capital X0 , then we end with X1 (ω). To price
a derivative, we need to match
X1 (ω) = V1 (ω) ∀ ω∈Ω (9)

to have X0 = V0 , the price of the derivative we seek.
A strategy by the pair (X0 , ∆0 ) wherein
X0 is the initial capital
∆0 is the initial number of shares (units of underlying asset.)
What does the sign of ∆0 indicate?
Replicating Strategy
Initial holding in bond (bank account) is X0 − ∆0 S0

Value of portfolio at maturity is
X1 (ω) = (X0 − ∆0 S0 )(1 + r ) + ∆0 S1 (ω) (10)

X1 (ω) = (X0 − ∆0 S0 )(1 + r ) + ∆0 S1 (ω) (10)
Pathwise, we compute
V1 (H) = (X0 − ∆0 S0 )(1 + r ) + ∆0 uS0

V1 (T ) = (X0 − ∆0 S0 )(1 + r ) + ∆0 dS0

X1 (ω) = (X0 − ∆0 S0 )(1 + r ) + ∆0 S1 (ω) (10)
Pathwise, we compute
V1 (H) = (X0 − ∆0 S0 )(1 + r ) + ∆0 uS0

V1 (T ) = (X0 − ∆0 S0 )(1 + r ) + ∆0 dS0
Algebra yields
V1 (H) − V1 (T )
∆0 = (11)
(u − d)S0
Risk Neutral Probability
Let us assume the existence of a pair (p̃, q̃) of positive numbers, and use
these to multiply our pricing equation(s):
p̃V1 (H) = p̃(X0 − ∆0 S0 )(1 + r ) + p̃∆0 uS0

q̃V1 (T ) = q̃(X0 − ∆0 S0 )(1 + r ) + q̃∆0 dS0
Risk Neutral Probability
Let us assume the existence of a pair (p̃, q̃) of positive numbers, and use
these to multiply our pricing equation(s):
p̃V1 (H) = p̃(X0 − ∆0 S0 )(1 + r ) + p̃∆0 uS0

q̃V1 (T ) = q̃(X0 − ∆0 S0 )(1 + r ) + q̃∆0 dS0
Addition yields
X0 (1 + r ) + ∆0 S0 (p̃u + q̃d − (1 + r )) = p̃V1 (H) + q̃V1 (T ) (12)
If we constrain
0 = p̃u + q̃d − (1 + r )
1 = p̃ + q̃
0 ≤ p̃
0 ≤ q̃
If we constrain
0 = p̃u + q̃d − (1 + r )
1 = p̃ + q̃
0 ≤ p̃
0 ≤ q̃
then we have a risk neutral probability P̃ where
1 p̃V1 (H) + q̃V1 (T )

V0 = X0 = Ẽ[V1 ] =
1+r 1+r
1+r −d
p̃ = P̃[X1 (ω) = H] =
u−d
u − (1 + r )
q̃ = P̃[X1 (ω) = T ] =
u−d
Example: Pricing a forward contract
Consider the case of a stock with

S0 = 400
u = 1.25
d = 0.75
r = 0.05
Then the forward price is computed via
Example: Pricing a forward contract
Consider the case of a stock with

S0 = 400
u = 1.25
d = 0.75
r = 0.05
Then the forward price is computed via
1
0= Ẽ[S1 − F ] ⇒ F = Ẽ[S1 ] (13)
1+r
This leads to the explicit price
F = p̃uS0 + q̃dS0
= (p̃)(1.25)(400) + (1 − p̃)(0.75)(400)
= 500p̃ + 300 − 300p̃ = 300 + 200p̃
1 + 0.05 − 0.75 3
= 300 + 200 · = 300 + 200 ·
1.25 − 0.75 5
= 420
This leads to the explicit price
F = p̃uS0 + q̃dS0
= (p̃)(1.25)(400) + (1 − p̃)(0.75)(400)
= 500p̃ + 300 − 300p̃ = 300 + 200p̃
1 + 0.05 − 0.75 3
= 300 + 200 · = 300 + 200 ·
1.25 − 0.75 5
= 420
Homework Question: What is the price of a call option in the case

above,with strike K = 375?
General one period risk neutral measure
We define a finite set of outcomes Ω ≡ {ω1 , ω2 , ..., ωn } and any

subcollection of outcomes A ∈ F1 := 2Ω an event.
Furthermore, we define a probability measure P̃, not necessarily the
physical measure P to be risk neutral if
P̃[ω] > 0 ∀ ω ∈ Ω
1
X0 = 1+r Ẽ[X1 ]
for all strategies X .
The measure is indifferent to investing in a zero-coupon bond, or a

risky asset X

risky asset X
The same initial capital X0 in both cases produces the same
”‘average”’ return after one period.

risky asset X
Not the physical measure attached by observation, experts, etc..

risky asset X
Not the physical measure attached by observation, experts, etc..
In fact, physical measure has no impact on pricing
Example: Risk Neutral measure for trinomial case
Assume that Ω = {ω1 , ω2 , ω3 } with
S1 (ω1 ) = uS0
S1 (ω2 ) = S0
S1 (ω3 ) = dS0
Assume that Ω = {ω1 , ω2 , ω3 } with
S1 (ω1 ) = uS0
S1 (ω2 ) = S0
S1 (ω3 ) = dS0
Given a payoff V1 (ω) to replicate, are we assured that a replicating

strategy exists?
Homework:
Try our first example with
(S0 , u, d, r ) = (400, 1.25.0.75, 0.05)

V1digital (ω) = 1{S1 (ω)>450} (ω).
Homework:
Try our first example with
(S0 , u, d, r ) = (400, 1.25.0.75, 0.05)

V1digital (ω) = 1{S1 (ω)>450} (ω).
Now, assume you are observe the price on the market to be

1
V0digital = Ẽ[V1digital ] = 0.25. (14)
1+r
Use this extra information to price a call option with strike K = 420.
Solution: Risk Neutral measure for trinomial case
The above scenario is reduced to finding the risk-neutral measure

(p̃1 , p̃2 , p̃3 ). This can be done by finding the rref of the matrix M:
 
1 1 1 1
M = 500 400 300 420  (15)
1 0 0 0.25(1.05)
which results in
 
1 0 0 0.2625
rref (M) = 0 1 0 0.675  . (16)
0 0 1 0.0625
It follows that (p̃1 , p̃2 , p̃3 ) = (0.2625, 0.675, 0.0625), and so
1
V0C = Ẽ[(S1 − 420)+ | S0 = 400]
1.05 (17)
0.2625
= × (500 − 420) = 20.
1.05
It follows that (p̃1 , p̃2 , p̃3 ) = (0.2625, 0.675, 0.0625), and so
1
V0C = Ẽ[(S1 − 420)+ | S0 = 400]
1.05 (17)
0.2625
= × (500 − 420) = 20.
1.05
Could we perhaps find a set of digital options as a basis set

n o
V1d1 (ω), V1d2 (ω), V1d3 (ω) = {1A1 (ω), 1A2 (ω), 1A3 (ω)} (18)
with A1 , A2 , A3 ∈ F1 to span all possible payoffs at time 1?

How about (A1 , A2 , A3 ) = ({ω1 } , {ω2 } , {ω3 }) ?
Exchange one stock for another
Assume now an economy with two stocks, X and Y . Assume that
(X0 , Y0 , r ) = (100, 100, 0.01) (19)

and

 (110, 105) : ω = ω1
(X1 (ω), Y1 (ω)) = (100, 100) : ω = ω2
(80, 95) : ω = ω3 .

Consider two contracts, V and W , with payoffs
V1 (ω) = max {Y1 (ω) − X1 (ω), 0}

(20)
W1 (ω) = Y1 (ω) − X1 (ω).
Price V0 and W0 .
Exchange one stock for another
In this case, our matrix M is such that
 
1 1 1 1
M = 110 100 80 101 (21)
105 100 95 101
which results in
3
 
1 0 0 10
6 
rref (M) = 0 1 0

10 . (22)
1
0 0 1 10
It follows that
Ẽ[Y1 ] − Ẽ[X1 ]
W0 = = Y0 − X0 = 0
1.01 (23)
1 1.5
V0 = · (15p̃3 ) = = 1.49.
1.01 1.01
Existence of Risk Neutral measure
Let P̃ be a probability measure on a finite space Ω. The following are

equivalent:

equivalent:
P̃ is a risk neutral measure

equivalent:
1
For all traded securities S i , S0i =
i
1+r Ẽ S1

equivalent:
1
For all traded securities S i , S0i =
i
1+r Ẽ S1
Proof: Homework (Hint: One direction is much easier than others. Also,
strategies are linear in the underlying asset.)
Complete Markets
A market is complete if it is arbitrage free and every non-traded asset can

be replicated.
Complete Markets

be replicated.
Fundamental Theorem of Asset Pricing 1: A market is arbitrage free
iff there exists a risk neutral measure
Fundamental Theorem of Asset Pricing 2: A market is complete iff
there exists exactly one risk neutral measure
Complete Markets

be replicated.
Fundamental Theorem of Asset Pricing 1: A market is arbitrage free
iff there exists a risk neutral measure
Fundamental Theorem of Asset Pricing 2: A market is complete iff
there exists exactly one risk neutral measure
Proof(s): We will go over these in detail later!
Optimal Investment for a Strictly Risk Averse Investor
Assume a complete market, with a unique risk-neutral measure P̃.

Characterize an investor by her pair (x, U) of initial capital x ∈ X and
utility function U : X → R+ .
Assume U 0 (x) > 0.
Assume U 00 (x) < 0.
Define the Radon-Nikodym derivative of P̃ to P as the random
variable
P̃(ω)
Z (ω) := . (24)
P(ω)
Note that Z is used to map expectations under P to expectations
under P̃: For any random variable X , it follows that
Ẽ[X ] = E[ZX ]. (25)
A strictly risk-averse investor now wishes to maximize her expected utility

of a portfolio at time 1, given initial capital at time 0:
u(x) := max E[U(X1 )]

X1 ∈Ax
(26)
Ax := { all portfolio values at time 1 with initial capital x} .
Theorem
Define X̂1 via the relationship

U 0 X̂1 := λZ (27)
where λ sets X̂1 as a strategy with an average return of r under P̃:
Ẽ[X̂1 ] = x(1 + r ). (28)

Then X̂1 is the optimal strategy.
Proof.
Assume X1 to be an arbitrary strategy with initial capital x. Then for
f (y ) := E[U(yX1 + (1 − y )X̂1 )] (29)

it follows that
h i
f 0 (0) = E U 0 (X̂1 ) X1 − X̂1
h i
= E λZ X1 − X̂1
h i (30)
= λẼ X1 − X̂1 = 0
2
00 00
f (y ) = E U (yX1 + (1 − y )X̂1 ) X1 − X̂1 <0
and so f attains its maximum at y = 0. We conclude that

E[U(X1 )] < E[U(X̂1 )] for any admissible strategy X1 .
Optimal Investment: Example
Assume an investor and economy defined by
U(x) = ln (x)
(31)
(S0 , u, d, p, q, r ) = (400, 1.25.0.75, 0.5, 0.5, 0.05).
It follows that
3 2
(p̃, q̃) = ,
5 5
(32)
6 4
(Z (H), Z (T )) = , .
5 5
Since U 0 (x) = x1 , we have
1 1
X̂1 (ω) =
λ Z (ω)
(33)
1 1 1p 1q 1 1
x = X0 = Ẽ[X̂1 ] = p̃ · + q̃ · = .
1+r 1+r λ p̃ λ q̃ λ1+r
Combining the previous results, we see that
x(1 + r )
X̂1 (ω) =
Z (ω)
u(x) = p ln X̂1 (H) + (1 − p) ln X̂1 (T )
(34)

x(1 + r ) x(1 + r )
= p ln + (1 − p) ln
Z (H) Z (T )

(1 + r )
= ln x = ln (1.0717x) > ln (1.05x).
Z (H)p Z (T )1−p
In terms of her actual strategy, we see that
ˆ 0 S0
∆ S0 X̂1 (H) − X̂1 (T ) 1+r

1 1

π̂0 := = = −
X0 x S1 (H) − S1 (T ) u − d Z (H) Z (T )
(35)
1+r p 1−p 1.05 5 5
= − = − = −0.875.
u − d p̃ 1 − p̃ 0.5 6 4
Therefore, the optimal strategy is to sell a stock portfolio worth 87.5% of

her initial wealth x and invest the proceeds into a safe bank account.

1+r p 1−p
In fact, since π̂0 = u−d p̃ − 1−p̃ , we see that qualitatively, her optimal
strategy involves

 > 0 : p > p̃
π̂0 = = 0 : p = p̃
< 0 : p < p̃.

This links with her strategy via
X̂1 (ω) S1 (ω)

1 + r̂1 (ω) := = (1 − π̂0 )(1 + r ) + π̂0 (36)
X0 S0
and so for our specific case where (r , u, d, π̂0 ) = (0.05, 1.25, 0.75, −0.875),
we have
1 + r̂1 (H) = (1 − π̂0 )(1 + r ) + π̂0 u = 0.875

(37)
1 + r̂1 (T ) = (1 − π̂0 )(1 + r ) + π̂0 d = 1.3125.
√
Optimal Investment: U(x) = x
Consider now the same set-up as before, only that the utility function
√
changes to U(x) = x.
It follows that
1 1
U 0 (X̂1 ) =
p
2 X̂1
(38)
1 1
⇒ X̂1 = 2 2
4λ Z
Solving for λ returns
x(1 + r ) = Ẽ[X̂1 ]
= E[Z X̂1 ]

1 1 (39)
=E Z 2 2
4λ Z

1 1
= 2E .
4λ Z
√
Optimal Investment: U(x) = x
Combining the results above, we see that
x(1 + r )
X̂1 =
Z 2 E Z1

q "s #
x(1 + r )
⇒ u(x) = E X̂1 = E (40)
Z 2 E Z1

s
p 1
= x(1 + r ) E .
Z
Question: Is it true for all (p, p̃) ∈ (0, 1) × (0, 1) that
s s
1 p 2 (1 − p)2
E = + ≥ 1? (41)
Z p̃ 1 − p̃
Optimal Betting at the Omega Horse Track!
Imagine our investor with U(x) = ln (x) visits a horse track.

There are three horses: ω1 , ω2 and ω3 .
She can bet on any of the horses to come in 1st .
The payoff is 1 per whole bet made.
She observes the price of each bet with payoff 1 right before the race
to be
(B01 , B02 , B03 ) = (0.5, 0.3, 0.2). (42)
Symbolically,
B1i (ω) = 1{ωi } (ω). (43)
Our investor feels the physical probabilities of each horse winning is
(p1 , p2 , p3 ) = (0.6, 0.35, 0.05). (44)
How should she bet if the race is about to start?
In this setting, we can assume r = 0.

This directly implies that
(p̃1 , p̃2 , p̃3 ) = (0.5, 0.3, 0.2). (45)
Our Radon-Nikodym derivative of P̃ to P is now

0.5 0.3 0.2
(Z (ω1 ), Z (ω2 ), Z (ω3 )) = , , . (46)
0.6 0.35 0.05
Her optimal strategy X̂1 reflects her betting strategy, and satisfies
X0
X̂1 (ω) =
Z (ω)
! (47)
X̂1 (ω1 ) X̂1 (ω2 ) X̂3 (ω1 ) 6 7 1
∴ , , = , , .
X0 X0 X0 5 6 4
So, per dollar of wealth, she buys 65 of a bet for Horse 1 to win, 7
6 of
a bet for Horse 2 to win, and 14 of a bet for Horse 3 to win.
The total price (per dollar of wealth) is thus
6 7 1
· 0.5 + · 0.3 + · 0.2 = 0.6 + 0.35 + 0.05 = 1. (48)
5 6 4
Dividends
What about dividends? How do they affect the risk neutral pricing of
exchange and non-exchange traded assets? What if they are paid at
discrete times? Continuously paid?
Dividends
Recall that if dividends are paid continuously at rate δ, then 1 share at
time 0 will accumulate to e δT shares upon reinvestment of dividends into
the stock until time T .
Dividends
Recall that if dividends are paid continuously at rate δ, then 1 share at
time 0 will accumulate to e δT shares upon reinvestment of dividends into
the stock until time T .
It follows that to deliver one share of stock S with initial price S0 at time
T , only e −δT shares are needed. Correspondingly,
Fprepaid = e −δT S0
(49)
F = e rT e −δT S0 = e (r −δ)T S0 .
Binomial Option Pricing w/ cts Dividends and Interest
Over a period of length h, interest increases the value of a bond by a
factor e rh and dividends the value of a stock by a factor of e δh .
Binomial Option Pricing w/ cts Dividends and Interest
Over a period of length h, interest increases the value of a bond by a
factor e rh and dividends the value of a stock by a factor of e δh .
Once again, we compute pathwise,
V1 (H) = (X0 − ∆0 S0 )e rh + ∆0 e δh uS0

V1 (T ) = (X0 − ∆0 S0 )e rh + ∆0 e δh dS0
and this results in the modified quantities
V1 (H) − V1 (T )
∆0 = e −δh
(u − d)S0
e (r −δ)h − d
p̃ =
u−d
u − e (r −δ)h
q̃ =
u−d
Binomial Models w/ cts Dividends and Interest
For σ, the annualized standard deviation of continuously compounded
stock return, the following models hold:
Futures - Cox (1979)
√
u = eσ h
√
d = e −σ h
.
General Stock Model

√
u = e (r −δ)h+σ h
√
d = e (r −δ)h−σ h
.
Currencies with rf the foreign interest rate, which acts as a dividend:

√
u = e (r −rf )h+σ h
√
d = e (r −rf )h−σ h
.
1- and 2-period pricing
Consider the case r = 0.10, δ = 0.05, h = 0.01, σ = 0.1, S0 = 10 = K .
Consider the case r = 0.10, δ = 0.05, h = 0.01, σ = 0.1, S0 = 10 = K .

Now price two digital options, using the
1 General Stock Model
2 Futures-Cox Model
with respective payoffs
V1K (ω) := 1{S1 ≥K } (ω)

V2K (ω) := 1{S2 ≥K } (ω).
Calibration Exercise
Assume table below of realized gains & losses over a ten-period cycle.
Use the adjusted values (r , δ, h, S0 , K ) = (0.02, 0, 0.10, 10, 10).
Calculate binary options from last slide using these assumptions.
Period Return
S1
1 S0 = 1.05
S2
2 S1 = 1.02
S3
3 S2 = 0.98
S4
4 S3 = 1.01
S5
5 S4 = 1.02
S6
6 S5 = 0.99
S7
7 S6 = 1.03
S8
8 S7 = 1.05
S9
9 S8 = 0.96
S10
10 S9 = 0.97
Calibration Exercise: Linear Approximation

Si
We would like to compute σ for the logarithm of returns ln Si−1 .
Assume the returns per period are all independent.
Q: Can we use a linear (simple) return model instead of a compound
return model as an approximation?
If so, then for our observed simple return rate values:
Calculate the sample variance σ∗2 .
σ∗
Estimate that σ ≈ √ h
.
Si
Note that if Si−1 = 1 + γ for γ 1, then

Si Si − Si−1
ln ≈γ= . (50)
Si−1 Si−1
Approximation: Convert our previous table, using simple interest.

Over small time periods h, define linear return values for i th period:
Si − Si−1
Xi h := . (51)
Si−1
In other words, for simple rate of return Xi for period i:
Si = Si−1 · (1 + Xi h). (52)
Our returns table now looks like
Period Return
S1 −S0
1 S0 = 0.05
S2 −S1
2 S1 = 0.02
S3 −S2
3 S2 = −0.02
S4 −S3
4 S3 = 0.01
S5 −S4
5 S4 = 0.02
S6 −S5
6 S5 = −0.01
S7 −S6
7 S6 = 0.03
S8 −S7
8 S7 = 0.05
S9 −S8
9 S8 = −0.04
S10 −S9
10 S9 = −0.03
sample standard deviation σ∗ = 0.0319
estimated return deviation σ ≈ 0.1001
We estimate, therefore, that under the Futures-Cox model
(u, d) = (e 0.0319 , e −0.0319 ) = (1.0324, 0.9686)

e 0.002 − e −0.0319 (53)
p̃ = = 0.5234.
e 0.0319 − e −0.0319
For the one-period digital option:
V0 = e −rh Ẽ0 [1{S1 ≥10} ] = e −0.002 · p̃ = 0.5224. (54)
V0 = e −rh Ẽ0 [1{S1 ≥10} ] = e −0.002 · p̃ = 0.5224. (54)

For the two-period digital option:
V0 = e −2rh Ẽ0 [1{S2 ≥10} ] = e −0.004 · p̃ 2 + 2p̃q̃ = 0.7698.

(55)
Calibration Exercise: No Approximation
Without the linear approximation, we can directly estimate

√
σY h = 0.03172
(u, d) = (e 0.03172 , e −0.03172 ) = (1.0322, 0.9688) (56)
e 0.002 − e −0.03172
p̃ = 0.03172 = 0.5246.
e − e −0.03172
V0 = e −rh Ẽ0 [1{S1 ≥10} ] = e −0.002 · p̃ = 0.5236. (57)
Calibration Exercise: No Approximation
Without the linear approximation, we can directly estimate

√
σY h = 0.03172
(u, d) = (e 0.03172 , e −0.03172 ) = (1.0322, 0.9688) (56)
e 0.002 − e −0.03172
p̃ = 0.03172 = 0.5246.
e − e −0.03172
V0 = e −rh Ẽ0 [1{S1 ≥10} ] = e −0.002 · p̃ = 0.5236. (57)

For the two-period digital option:
V0 = e −2rh Ẽ0 [1{S2 ≥10} ] = e −0.004 · p̃ 2 + 2p̃q̃ = 0.7721.

(58)
We can solve for 2-period problems

on a case-by-case basis, or
by developing a general theory for multi-period asset pricing.

on a case-by-case basis, or
by developing a general theory for multi-period asset pricing.
In the latter method, we need a general framework to carry out our
computations
Risk Neutral Pricing Formula
Assume now that we have the ”regular assumptions” on our coin flip
space, and that at time N we are asked to deliver a path dependent
derivative value VN . Then for times 0 ≤ n ≤ N, the value of this
derivative is computed via
Vn = e −rh Ẽn [Vn+1 ] (59)
Vn = e −rh Ẽn [Vn+1 ] (59)

and so
Vn = e −rh Ẽn [Vn+1 ] (59)

and so
X0 = Ẽ0 [XN ]
Vn (60)
Xn := nh .
e
Computational Complexity
Consider the case

1
p̃ = q̃ =
2 (61)
4 3
S0 = 4, u = , d =
3 4
but now with term n = 3.
There are 23 = 8 paths to consider.
However, there are 3 + 1 = 4 unique final values of S3 to consider.
In the general term N, there would be 2N paths to generate SN , but
only N + 1 distinct values.
At any node n units of time into the asset’s evolution, there are n + 1
distinct values.
Computational Complexity
At each value s for Sn , we know that Sn+1 = 34 s or Sn+1 = 34 s.

Using multi-period risk-neutral pricing, we can generate for
vn (s) := Vn (Sn (ω1 , ..., ωn )) on the node (event) Sn (ω1 , ..., ωn ) = s:
h 4 3 i
vn (s) = e −rh p̃vn+1 s + q̃vn+1 s . (62)
3 4
An Example:
Assume r , δ, and h are such that

1 9
p̃ = = q̃, e −rh =
2 10
1 (63)
S0 = 4, u = 2, d =
2
V3 := max {10 − S3 , 0} .
It follows that
v3 (32) = 0
v3 (8) = 2
(64)
v3 (2) = 8
v3 (0.50) = 9.50.
Compute V0 .
Markov Processes
If we use the above approach for a more exotic option, say a lookback
option that pays the maximum over the term of a stock, then we find
this approach lacking.
There is not enough information in the tree or the distinct values for
S3 as stated. We need more.
Consider our general multi-period binomial model under P̃.
Definition We say that a process X is adapted if it depends only on the

sequence of flips ω := (ω1 , ..., ωn )
Definition We say that an adapted process X is Markov if for every

0 ≤ n ≤ N − 1 and every function f (x) there exists another function g (x)
such that
Ẽn [f (Xn+1 )] = g (Xn ). (65)
Markov Processes
This notion of Markovity is essential to our state-dependent pricing

algorithm.
Indeed, our stock process evolves from time n to time n + 1, using
only the information in Sn .
We can in fact say that for every f (s) there exists a g (s) such that
g (s) = Ẽn [f (Sn+1 ) | Sn = s] . (66)
In fact, that g depends on f :

h 4 3 i
g (s) = e −rh p̃f s + q̃f s . (67)
3 4
So, for any f (s) := VN (s), we can work our recursive algorithm
backwards to find the gn (s) := Vn (s) for all 0 ≤ n ≤ N − 1
Markov Processes
Some more thoughts on Markovity:

Consider the example of a Lookback Option.
Here, the payoff is dependent on the realized maximum
Mn := max0≤i≤n Si of the asset.
Mn is not Markov by itself, but the two-factor process (Mn , Sn ) is.
Why?
Let’s generate the tree!
Homework Can you think of any other processes that are not Markov?
Call Options on Zero-Coupon Bonds
Assume an economy where

One period is one year
The one year short term interest rate from time n to time n + 1 is rn .
The rate evolves via a stochastic process:
r0 = 0.02
rn+1 = Xrn (68)
1
P̃[X = 2k ] = for k ∈ {−1, 0, 1} .
3
Consider now a zero-coupon bond that matures in 3−years with

common face and redemption value F = 100.
Also consider a call option on this bond that expires in 2−years with
strike K = 97.
Denote Bn and Cn as the bond and call option values, respectively.
Note that we iterate backwards from the values
B3 (r ) = 100
(69)
C2 (r ) = max {B2 (r ) − 97, 0} .
Compute (B0 , C0 ).
Our general recursive formula is

1
Bn (r ) = Ẽ[Bn+1 (rn+1 ) | rn = r ]
1+r
(70)
1
Cn (r ) = Ẽ[Cn+1 (rn+1 ) | rn = r ].
1+r
Iterating backwards, we see that at t = 2,
1
1 1 X
B2 (r ) = B3 (2k r ). (71)
1+r 3
k=−1
At time t = 2, we have that
r2 ∈ {0.08, 0.04, 0.02, 0.01, 0.005} . (72)
Our associated Bond and Call Option values at time 2:
r2 B2 C2
0.08 92.59 0
0.04 96.15 0
0.02 98.04 1.04
0.01 99.01 2.01
0.005 99.50 2.50
r1 B1 C1
0.04 91.92 0.33
0.02 95.82 1.00
0.01 97.87 1.83
r0 B0 C0
0.02 93.34 1.03
Question: What if the delivery time of the option is changed to 3?

Symbolically, what if
C3 (r ) = max {B3 (r ) − 97, 0}? (73)

Capital Structure Model
As an analyst for an investments firm, you are tasked with advising

whether a company’s stock and/or bonds are over/under-priced.
You receive a quarterly report from this company on it’s return on
assets, and have compiled a table for the last ten quarters below.
Today, just after the last quarter’s report was issued, you see that in
billions of USD, the value of the company’s assets is 10.
There are presently one billions shares of this company that are being
traded.
The company does not pay any dividends.
Six months from now, the company is required to pay off a billion
zero-coupon bonds. Each bond has a face value of 9.5.
Assume Miller-Modigliani holds with At = Bt + St , where the assets

of a company equal the sum of its share and bond price.
Presently, the market values are (B0 , S0 , r ) = (9, 1, 0.02).
The Merton model for corporate bond pricing asserts that at
redemption time T ,
Bt = e −r (T −t) Ẽ [min {AT , F }]

(74)
St = e −r (T −t) Ẽ [max {AT − F , 0}] .
With all of this information, your job now is to issue a Buy or Sell on
the stock and the bond issued by this company.
Table of return on assets for Company X, with h = 0.25.
Period Return on Assets

A1 −A0
1 A0 = 0.05
A2 −A1
2 A1 = 0.02
A3 −A2
3 A2 = −0.02
A4 −A3
4 A3 = 0.01
A5 −A4
5 A4 = 0.02
A6 −A5
6 A5 = −0.01
A7 −A6
7 A6 = 0.03
A8 −A7
8 A7 = 0.05
A9 −A8
9 A8 = −0.04
A10 −A9
10 A9 = −0.03
sample standard deviation σ∗ = 0.0319
estimated return deviation σ ≈ 0.0638
We scale all of our calculation in terms of billions ($, shares, bonds).
Using the Futures- Cox model, we have
(u, d) = (e 0.0319 , e −0.0319 ) = (1.0324, 0.9686)

e 0.005 − e −0.0319 (75)
p̃ = = 0.5706.
e 0.0319 − e −0.0319
Using this model, the only time the payoff of the bond is less than the
face is on the path ω = TT .
The price of the bond and stock are thus modeled to be
B̃0 = e −0.02·(2·0.25) p̃ 2 · 9.5 + 2p̃q̃ · 9.5 + q̃ 2 · 9.38

= 9.38 > 9.00 (76)

S˜0 = 10 − 9.38 = 0.62 < 1.00.
It follows that,according to our model, one should Buy the bond as it

is underpriced and one should Sell the stock as it is overpriced.
The Interview Process
Consider the following scenario:

After graduating, you go on the job market, and have 4 possible job
interviews with 4 different companies.
So sure of your prospects that you know that each company will make
an offer, with an identically, independently distributed probability
attached to the 4 possible salary offers:
P [Salary Offer=50, 000] = 0.1

(77)
P [Salary Offer=100, 000] = 0.2.
Questions:
How should you interview?
Questions:
Specifically, when should you accept an offer and cancel the
remaining interviews?
Questions:
Specifically, when should you accept an offer and cancel the
remaining interviews?
How does your strategy change if you can interview as many times as
you like, but the distribution of offers remains the same as above?
The Interview Process: Strategy
Some more thoughts...

At any time the student will know only one offer, which she can either
accept or reject.
Of course, if the student rejects the first three offers, than she has to
accept the last one.
So, compute the maximal expected salary for the student after the
graduation and the corresponding optimal strategy.
The Interview Process: Optimal Strategy
The solution process {Xk }4k=1 follows an Optimal Stopping Strategy:

n h io
Xk (s) = max s, Ẽ Xk+1 | k th offer = s . (78)
At time 4, the value of this game is X4 (s) = s, with s being the salary
offered.
At time 3, the conditional expected value of this game is
h i
Ẽ X4 | 3rd offer = s = Ẽ[X4 ]
= 0.1 × 50, 000 + 0.3 × 70, 000 (79)
+ 0.4 × 80, 000 + 0.2 × 100, 000
= 78, 000.
Hence, one should accept an offer of 80, 000 or 100, 000, and reject
the other two.
This strategy leads to a valuation:
X3 (50, 000) = 78, 000

X3 (70, 000) = 78, 000
(80)
X3 (80, 000) = 80, 000
X3 (100, 000) = 100, 000.
At time 2, similar reasoning using Ẽ2 [X3 ] leads to the valuation
X2 (50, 000) = 83, 200

X2 (70, 000) = 83, 200
(81)
X2 (80, 000) = 83, 200
X2 (100, 000) = 100, 000.
At time 1,
X1 (50, 000) = 86, 560
X1 (70, 000) = 86, 560
(82)
X1 (80, 000) = 86, 560
X1 (100, 000) = 100, 000.
Finally, at time 0, the value of this optimal strategy is
Ẽ0 [X1 ] = Ẽ[X1 ] = 0.8 × 86, 560 + 0.2 × 100, 000 = 89, 248. (83)
So, the optimal strategy is, for the first two interviews, accept only an
offer of 100, 000. If after the third interview, and offer of 80, 000 or
100, 000 is made, then accept. Otherwise continue to the last interview
where you should accept whatever is offered.
Review
Let’s review the basic contracts we can write:
Review

Forward Contract Initial Value is 0, because both buyer and seller
may have to pay a balance at maturity.
Review

(European) Put/Call Option Initial Value is > 0, because both only
seller must pay balance at maturity.
Review

(European) ”Exotic” Option Initial Value is > 0, because both only
Review

During the term of the contract, can the value of the contract ever fall
below the intrinsic value of the payoff? Symbolically, does it ever occur
that
Review

that
vn (s) < g (s) (84)
Review

that
vn (s) < g (s) (84)

where g (s) is of the form of g (S) := max {S − K , 0}, in the case of a Call
option, for example.
Early Exercise
If σ = 0, and so uncertainty vanishes, then an investor would seek to

exercise early if
rK > δS. (85)
If σ > 0, then the situation involves deeper analysis.
Whether solving a free boundary problem or analyzing a binomial
tree, it is likely that a computer will be involved in helping the
investor to determine the optimal exercise time.
For Freedom! (we must charge extra...)
What happens if we write a contract that allows the purchaser to exercise

the contract whenever she feels it to be in her advantage? By allowing this
extra freedom, we must

Charge more than we would for a European contract that is exercised
only at the term N.

Charge more than we would for a European contract that is exercised
only at the term N.
Hedge our replicating strategy X differently, to allow for the
possibility of early exercise.
American Options
In the end, the option v is valued after the nth value of the stock
Sn (ω) = s is revealed via the recursive formula along each path ω:
n h io
vn (Sn (ω)) = max g (Sn (ω)), e −rh Ẽ v (Sn+1 (ω)) | Sn (ω)
(86)
τ ∗ (ω) = inf {k ∈ {0, 1, .., N} | vk (Sk (ω)) = g (Sk (ω))} .
Here, τ ∗ is the optimal exercise time.

In the Binomial case, we reduce to
n o
vn (s) = max g (s), e −rh [p̃vn+1 (us) + q̃vn+1 (ds)]
(87)
τ ∗ = inf {k | vk (s) = g (s)} .
American Options
Some examples:
”American Bond:” g (s) = 1
”American Digital Option:” g (s) = 1{6≤s≤10}
”American Square Option:” g (s) = s 2 .
Does an investor exercise any of these options early? Consider again the
setting
1 9
p̃ = = q̃, e −rh =
2 10 (88)
1
S0 = 4, u = 2, d = .
2
American Square Options
Consider the American Square Option. We know via Jensen’s Inequality

that
h i h i
e −rh Ẽ g (Sn+1 ) | Sn = e −rh Ẽ Sn+12
| Sn
h i2
≥ e −rh Ẽ Sn+1 | Sn
2 (89)
−rh rh
=e e Sn
= e rh Sn2 > Sn2 = g (Sn ).
American Square Options
It follows that vN (s) = s 2 and

n o
vN−1 (s) = max g (s), e −rh Ẽ[vN (SN ) | SN−1 = s]
n o
= max s 2 , e −rh Ẽ[SN2 | SN−1 = s]
(90)
= e −rh Ẽ[SN2 | SN−1 = s]
= e −rh Ẽ[vN (SN ) | SN−1 = s].
In words, with one period to go, don’t exercise yet!!

The American and European option values coincide. Keep going.
How about with two periods left before expiration?
American Options
Let’s return to the previous European Put example, where

1 9
p̃ = = q̃, e −rh =
2 10
1 (91)
S0 = 4, u = 2, d =
2
V3 := max {10 − S3 , 0} .
1
It follows that S3 (ω) ∈ 2 , 2, 8, 32 .
Use this to compute v3 (s) and the American Put recursively.
Matching Interest Rates to Market Conditions
Consider again a series of coin flips (ω1 , ..., ωn ) where at time n, the
interest rate from n to n + 1 is modeled via
rn = rn (ω1 , ..., ωn ) (92)

and a stochastic volatility σ at time n via

1 rn (ω1 , ..., ωn−1 , ωn = H)
σn = ln . (93)
2 rn (ω1 , ..., ωn−1 , ωn = T )
Keep in mind that we will build a recombining binomial tree for this
model. So, for example,
r2 (H, T ) = r2 (T , H). (94)
Futhermore, we can define the yield rate y (t, T , r (t)) for a zero-coupon
bond B(t, T , r (t)) via
1
B(t, T , r (t)) = (95)
(1 + y (t, T , r (t)))T −t
and the corresponding yield rate volatility

1 y (1, n, r1 (H))
σ̃n = ln . (96)
2 y (1, n, r1 (T ))
We can in fact see that
y (1, 2, r1 (H)) = r1 (H)

(97)
y (1, 2, r1 (T )) = r1 (T ).
But, for example, it is not clear how to obtain
(y (1, 3, r1 (H)), y (1, 3, r1 (T ))) . (98)

Furthermore, how can we match to market conditions and update our
estimates for interest rates rn ?
One way forward is the Black Derman Toy Model 1
Consider a market with the following observations:
Maturity Yield to Maturity y (0, T , r ) Yield Volatility σ̃T

1 0.100 N.A.
2 0.110 0.190
3 0.120 0.180
4 0.125 0.150
5 0.130 0.140
(For Daily US Treasury Real Yield Curve Rates click here )
1
Black, Fischer, Emanuel Derman, and William Toy. ”A one-factor model
of interest rates and its application to treasury bond options.” Financial
Analysts Journal 46.1 (1990): 33-39.
In this setting, we match market conditions to a model where at each

time, an interest rate moves up or down with a ”risk-neutral”
probability of 12 .
It follows that we have from time t = 0 to t = 1, with an initial rate
r0 = r ,
1 1
=
1 + y (0, 1, r ) 1+r (99)
⇒ y (0, 1, r ) = r .
From time t = 0 to t = 2, again with our initial rate r0 = r ,
Connecting our observed two-year yield with yearly interest rates
returns

1 1 1 1 1 1
= +
(1 + y (0, 2, r ))2 1 + r 2 1 + r1 (H) 2 1 + r1 (T )
(100)
1 1 1 1 1 1
⇒ = + .
1.112 1.10 2 1 + r1 (H) 2 1 + r1 (T )
Also, connecting our one-year yields with yearly interest rates leads to

1 r1 (H) 1 y (1, 2, r1 (H))
σ1 = ln = ln
2 r1 (T ) 2 y (1, 2, r1 (T )) (101)
= σ̃2 = 0.190.
Solution leads to the pair
(r1 (H), r1 (T )) = (0.1432, 0.0979). (102)

From time t = 0 to t = 3, again with our initial rate r0 = r , we try to
estimate the matching (r2 (H, H), r2 (H, T ), r2 (T , T )).
Connecting our observed two-year yield with yearly interest rates
returns

1 1 1 1 1
=
(1 + y (0, 3, r ))3 1 + r 4 1 + r1 (H) 1 + r2 (H, H)

1 1 1 1
+
1 + r 4 1 + r1 (H) 1 + r2 (H, T )
(103)
1 1 1 1
+
1 + r 4 1 + r1 (T ) 1 + r2 (T , H)

1 1 1 1
+ .
1 + r 4 1 + r1 (T ) 1 + r2 (T , T )
We can now substitute our values

(r , r1 (H), r1 (T ), y (0, 3, r )) = (0.10, 0.1432, 0.0979, 0.120).
We also know that σ2 6= σ2 (ω1 , ω2 ) and so

1 r2 (H, H)
σ2 = ln
2 r2 (H, T )

1 r2 (T , H) (104)
σ2 = ln
2 r2 (T , T )
p
⇒ r2 (H, T ) = r2 (T , H) = r2 (H, H)r2 (T , T ).
Finally, we have one more matching condition via

1 y (1, 3, r1 (H))
0.180 = σ̃3 = ln (105)
2 y (1, 3, r1 (T ))
where

1 1 1 1 1 1
= +
(1 + y (1, 3, r1 (H))2 1 + r1 (H) 2 1 + r2 (H, H) 2 1 + r2 (H, T )

1 1 1 1 1 1
= + .
(1 + y (1, 3, r1 (T ))2 1 + r1 (T ) 2 1 + r2 (T , H) 2 1 + r2 (T , T )
(106)
Now solve for (r2 (H, H), r2 (H, T ), r2 (T , T ))!!
HW1: Price a bond that matures in two years, with the above
observations for term structure, and with F = 100 and coupon rate 10%.
HW2: What about r3 , r4 , r5 ? Can we compute them?
Pricing a Two-year Coupon Bond Using Market Conditions
Consider the previous observations for term structure, and a bond with
F = 100 and coupon rate 10%. In this setting, we have
Time Interest Rate Value

0 r0 0.100
1 r1 (H) 0.1432
1 r1 (T ) 0.0979
2 r2 (H, H) 0.1942
2 r2 (H, T ) 0.1377
2 r2 (T , H) 0.1377
2 r2 (T , T ) 0.0976
We can decompose the two-year coupon bond into two component

zero-coupon bonds.
The first is B (1) , which has face 10, maturity T = 1, and initial price
B (1) (0, T , r ) at t = 0.
The first is B (2) , which has face 110, maturity T = 2, and initial price
B (2) (0, T , r ) at t = 0.
The total coupon bond price is thus
B(0, 2, r ) = B (1) (0, 1, r ) + B (2) (0, 2, r ). (107)
Our component bonds thus have prices
Time Interest Rate B 1 (t, T , r )

0 r0 = 0.10 B (1) (0, 1, r0 ) = 9.09
1 r1 (H) = 0.1432 B (1) (1, 1, r1 (H)) = 10
1 r1 (T ) = 0.0979 B (1) (1, 1, r1 (T )) = 10
Time Interest Rate B 2 (t, T , r )

0 r0 = 0.10 B (2) (0, 2, r
0 ) = 89.28
1 r1 (H) = 0.1432 (2)
B (1, 2, r1 (H)) = 96.22
1 r1 (T ) = 0.0979 B (2) (1, 2, r1 (T )) = 100.19
2 r2 (H, H) = 0.1942 B (2) (2, 2, r2 (H, H)) = 110
2 r2 (H, T ) = 0.1377 B (2) (2, 2, r2 (H, T )) = 110
2 r2 (T , H) = 0.1377 B (2) (2, 2, r2 (T , H)) = 110
2 r2 (T , T ) = 0.0976 B (2) (2, 2, r2 (T , T )) = 110
Finally, we have our coupon bond with price
Time Interest Rate B(t, T , r )

0 r0 = 0.10 B(0, 2, r0 ) = 98.37
1 r1 (H) = 0.1432 B(1, 2, r1 (H)) = 106.22
1 r1 (T ) = 0.0979 B(1, 2, r1 (T )) = 110.19
2 r2 (H, H) = 0.1942 B(2, 2, r2 (H, H)) = 110
2 r2 (H, T ) = 0.1377 B(2, 2, r2 (H, T )) = 110
2 r2 (T , H) = 0.1377 B(2, 2, r2 (T , H)) = 110
2 r2 (T , T ) = 0.0976 B(2, 2, r2 (T , T )) = 110
Note: Note that with our coupons, the yield yc (0, 2, r ) = 0.1095, which is
obtained by solving
10 110
98.37 = + . (108)
1 + yc (0, 2, r ) (1 + yc (0, 2, r ))2
Pricing a 1-year Call Option on our 2-year Coupon Bond
Consider the previous term structure, and a European Call Option on the
two year bond with K = 97 and expiry of 1 year.
Compute the initial Call price C0 (r ).
Compute the initial number of bonds to hold to replicate this option.
Pricing a 1-year Call Option on our 2-year Coupon Bond
In this case, we look at the price of the bond minus the accrued interest:
Time Interest Rate B(t, T , r )

0 r0 = 0.10 B(0, 2, r0 ) = 98.37
1 r1 (H) = 0.1432 B(1, 2, r1 (H)) = 96.22
1 r1 (T ) = 0.0979 B(1, 2, r1 (T )) = 100.19
2 r2 (H, H) = 0.1942 B(2, 2, r2 (H, H)) = 100
2 r2 (H, T ) = 0.1377 B(2, 2, r2 (H, T )) = 100
2 r2 (T , H) = 0.1377 B(2, 2, r2 (T , H)) = 100
2 r2 (T , T ) = 0.0976 B(2, 2, r2 (T , T )) = 100
Pricing and hedging is accomplished via

1 1 1
C0 (0.10) = · 0 + 3.19 = 1.45
1.10 2 2
(109)
0 − 3.19
∆0 (0.10) = = 0.804.
96.22 − 100.19
Asian Options
In times of high volatility or frequent trading, a company may want to

protect against large price movements over an entire time period, using an
average. For example, if a company is looking at foreign exchange markets
or markets that may be subject to stock pinning due to large actors.
Asian Options

As an input, the average of an asset is used as an input against a strike,

instead of the spot price.
Asian Options


T
There are two possibilities for the input in the discrete case: h = N and
Arithmetic Average: IA (T ) := N1 N
P
k=1 Skh .
1
N
Geometric Average: IG (T ) := ΠN S
k=1 kh .
Asian Options


T
There are two possibilities for the input in the discrete case: h = N and
Arithmetic Average: IA (T ) := N1 N
P
k=1 Skh .
1
N
Geometric Average: IG (T ) := ΠN S
k=1 kh .
HW: Is there an ordering for IA , IG that is independent of T ?
Asian Options: An Example:
Notice that these are path-dependent options, unlike the put and call
options that we have studied until now. Assume r , δ, and h are such that
1 9
S0 = 4, u = 2, d = , e −rh =
2 10 (110)
g (I ) = max {I − 2.5, 0} .
Consider an arithmetic average with N = 2. Then

8 + 16
v2 (HH) = max − 2.5, 0 = 9.5
2

8+4
v2 (HT ) = max − 2.5, 0 = 3.5
2
(111)
2+4
v2 (TH) = max − 2.5, 0 = 0.5
2

2+1
v2 (TT ) = max − 2.5, 0 = 0.
2

8 + 16
v2 (HH) = max − 2.5, 0 = 9.5
2

8+4
v2 (HT ) = max − 2.5, 0 = 3.5
2
(111)
2+4
v2 (TH) = max − 2.5, 0 = 0.5
2

2+1
v2 (TT ) = max − 2.5, 0 = 0.
2
Compute v0 , assuming a European structure.

8 + 16
v2 (HH) = max − 2.5, 0 = 9.5
2

8+4
v2 (HT ) = max − 2.5, 0 = 3.5
2
(111)
2+4
v2 (TH) = max − 2.5, 0 = 0.5
2

2+1
v2 (TT ) = max − 2.5, 0 = 0.
2
Compute v0 , assuming a European structure. How about an American
structure?
Lognormality
Analyzing returns, we assume:

A probability space Ω, F, P .
Our asset St (ω) has an associated return over any period (t, t + u)
defined as !
St+u (ω)
rt,u (ω) := ln . (112)
St (ω)
Lognormality
T −t
Partition the interval [t, T ] into n intervals of length h = n , then:
The return over the entire period can be taken as the sum of the
returns over each interval:
n
!
ST (ω) X
rt,T −t (ω) = ln = rtk ,h (ω)
St (ω) (113)
k=1
tk = t + kh.
We model the returns as being independent and possessing a binomial

distribution.
Employing the Central Limit Theorem, it can be shown that as
n → ∞, this distribution approaches normality.
Binomial Tree and Discrete Dividends
Another issue encountered in elementary credit and investment theory
is the case of different compounding and deposit periods.
This also occurs in the financial setting where a dividend is not paid
continuously, but rather at specific times.
It follows that the dividend can be modeled as delivered in the middle
of a binomial period, at time τ (ω) < T .
This view is due to Schroder and can be summarized as viewing the
inherent value of St (ω) as the sum of a prepaid forward PF and the
present value of the upcoming dividend payment D:
PFt (ω) = St (ω) − De −r (τ (ω)−t)

√
u = e rh+σ h
(114)
√
d = e rh−σ h
.
Now, the random process that we model as having up and down

moves is PF instead of S.
Back to the Continuous Time Case
Consider the case of a security whose binomial evolution is modeled as an

up or down movement at the end of each day. Over the period of one
year, this amounts to a tree with depth 365. If the tree is not recombining,
then this amounts to 2365 branches. Clearly, this is too large to evaluate
reasonably, and so an alternative is sought.
Back to the Continuous Time Case
Consider the case of a security whose binomial evolution is modeled as an

up or down movement at the end of each day. Over the period of one
year, this amounts to a tree with depth 365. If the tree is not recombining,
then this amounts to 2365 branches. Clearly, this is too large to evaluate
reasonably, and so an alternative is sought.
Whatever the alternative, the concept of replication must hold. This is
the reasoning behind the famous Black-Scholes-Merton PDE approach.
Monte Carlo Techniques
Our model for asset evolution is

1 2 )t+σ
√
⇒ St = S0 e (α−δ− 2 σ tZ
(115)
Z ∼ N(0, 1).

1 2 )t+σ
√
⇒ St = S0 e (α−δ− 2 σ tZ
(115)
Z ∼ N(0, 1).
Consider now the possibility of simulating the stock evolution by n

simulating the random variable Z , or in fact an i.i.d. sequence Z (i) i=1 .


1 2 )t+σ
√
⇒ St = S0 e (α−δ− 2 σ tZ
(115)
Z ∼ N(0, 1).
Consider now the possibility of simulating the stock evolution by n

simulating the random variable Z , or in fact an i.i.d. sequence Z (i) i=1 .

For a European option with time expiry T , we can simulate the expiry
time payoff mulitple times:
1 2
√ (i)

V S (i) , T = G S (i) = G S0 e (α−δ− 2 σ )T +σ T Z . (116)
n on
If we sample uniformly from our simulated values V S (i) , T we
i=1
can appeal to a sampling-convergence theorem with the appoximation
n
−rT 1 X (i)
V (S, 0) = e V S ,T . (117)
n
i=1
n on
i=1
n
−rT 1 X (i)
V (S, 0) = e V S ,T . (117)
n
i=1
The challenge now is to simulate our lognormally distributed asset

evolution.
n on
i=1
n
−rT 1 X (i)
V (S, 0) = e V S ,T . (117)
n
i=1

evolution.
One can simulate the value ST directly by one random variable Z , or a

multiple of them to simulate the path of the evolution until T .
n on
i=1
n
−rT 1 X (i)
V (S, 0) = e V S ,T . (117)
n
i=1

evolution.
One can simulate the value ST directly by one random variable Z , or a

multiple of them to simulate the path of the evolution until T .
The latter method is necessary for Asian options.
There are multiple ways to simulate Z . One way is to find a random

number U taken from a uniform distribution U[0, 1].

It follows that one can now map U → Z via inversion of the Nornal cdf N:
Z = N −1 (U). (118)

It follows that one can now map U → Z via inversion of the Nornal cdf N:
Z = N −1 (U). (118)
It can be shown that in a sample, the standard deviation of the sample

average σsample is related to the standard deviation of an individual draw
via
σdraw
σsample = √ . (119)
n
If σdraw = σ, then we can see that we must increase our sample size by
22k if we wish to cut our σsample by a factor of 2k .
Black Scholes Pricing using Underlying Asset
In the next course, we will derive the following solutions to the
Black-Scholes PDE:
V C (S, t) = e −r (T −t) Ẽ [(ST − K )+ | St = S]

= Se −δ(T −t) N(d1 ) − Ke −r (T −t) N(d2 )
V P (S, t) = e −r (T −t) Ẽ [(K − ST )+ | St = S]
= Ke −r (T −t) N(−d2 ) − Se −δ(T −t) N(−d1 )
(120)

ln KS + (r − δ + 21 σ 2 )(T − t)
d1 = √
σ T −t
√
d2 = d1 − σ T − t
Z x
1 z2
N(x) = √ e − 2 dz.
2π −∞
Notice that V C (S, t) − V P (S, t) = Se −δ(T −t) − Ke −r (T −t) .
Question: What underlying model of stock evolution leads to this value?
How can we support such a probability measure?
Lognormal Random Variables
We say that Y ∼ LN(µ, σ) is Lognormal if ln(Y ) ∼ N(µ, σ 2 ).
As sums of normal random variables remain normal, products of lognormal
random variables remain lognormal.
Recall that the moment-generating function of
X ∼ N(µ, σ 2 ) ∼ µ + σN(0, 1) is
1 2t2
MX (t) = E[e tX ] = e µt+ 2 σ (121)
Lognormal Random Variables
We say that Y ∼ LN(µ, σ) is Lognormal if ln(Y ) ∼ N(µ, σ 2 ).
As sums of normal random variables remain normal, products of lognormal
random variables remain lognormal.
Recall that the moment-generating function of
X ∼ N(µ, σ 2 ) ∼ µ + σN(0, 1) is
1 2t2
MX (t) = E[e tX ] = e µt+ 2 σ (121)
If Y = e µ+σZ , then, it can be seen that
1 2 n2
E[Y n ] = E[e nX ] = e µn+ 2 σ (122)
and
!
1 (ln(y ) − µ)2
fY (y ) = √ exp − (123)
σ 2πy 2σ 2
Stock Evolution and Lognormal Random Variables
One application of lognormal distributions is their use in modeling the

evolution of asset prices S. If we assume a physical measure P with α the
expected return on the stock under the physical measure, then

St 1
ln = N (α − δ − σ 2 )t, σ 2 t
S0 2 (124)
1 2 )t+σ
√
⇒ St = S0 e (α−δ− 2 σ tZ
We can use the previous facts to show
E[St ] = S0 e (α−δ)t
!
ln SK0 + (α − δ − 0.5σ 2 )t (125)
P[St > K ] = N √ .
σ t
Note that under the risk-neutral measure P̃, we exchange α with r , the
risk-free rate:
We can use the previous facts to show
E[St ] = S0 e (α−δ)t
!
ln SK0 + (α − δ − 0.5σ 2 )t (125)
P[St > K ] = N √ .
σ t
Note that under the risk-neutral measure P̃, we exchange α with r , the
risk-free rate:
Ẽ[St ] = S0 e (r −δ)t
(126)
P̃[St > K ] = N(d2 ).
Risk managers are also interested in Conditional Tail Expectations (CTE’s)

of random variables:
h i
E X 1{X >k}
CTEX (k) := E[X | X > k] = . (127)
P[X > k]
In our case,
" #
1 2
√
E S0 e (α−δ− 2 σ )t+σ tZ 1 (α−δ− 1 σ2 )t+σ√tZ
S0 e 2 >K
E[St | St > K ] = h 1 2
√ i
P S0 e (α−δ− 2 σ )t+σ tZ > K
!
S0
ln +(α−δ+0.5σ 2 )t
N K √
σ t
= S0 e (α−δ)t !
S0
ln +(α−δ−0.5σ 2 )t
N K √
σ t
N(d1 )
⇒ Ẽ[St | St > K ] = S0 e (r −δ)t
N(d2 )
(128)
In fact, we can use this CTE framework to solve for the European Call
option price in the Black-Scholes framework, where P̃0 [A] = P̃[A | S0 = S]
and
h i
V C (S, 0) := e −rT Ẽ (ST − K )+ | S0 = S
h i
= e −rT Ẽ0 ST − K | ST > K · P̃0 [ST > K ]
h i
= e −rT Ẽ0 ST | ST > K · P̃0 [ST > K ] − Ke −rT P̃0 [ST > K ]
N(d1 )
= e −rT Se (r −δ)T · N(d2 ) − Ke −rT N(d2 )
N(d2 )
= Se −δT N(d1 ) − Ke −rT N(d2 ).
(129)
Black Scholes Analysis: Option Greeks
For any option price V (S, t), define its various sensitivities as follows:
∂V
∆=
∂S
∂∆ ∂2V
Γ= =
∂S ∂S 2
∂V
ν=
∂σ (130)
∂V
Θ=
∂t
∂V
ρ=
∂r
∂V
Ψ= .
∂δ
These are known accordingly as the Option Greeks.
Straightforward partial differentiation leads to
∆C = e −δ(T −t) N(d1 )

∆P = −e −δ(T −t) N(−d1 )
e −δ(T −t) N 0 (d1 ) (131)
ΓC = ΓP = √
σS T − t
√
ν C = ν P = Se −δ(T −t) T − tN 0 (d1 )
as well as..
ρC = (T − t)Ke −r (T −t) N(d2 )

ρP = −(T − t)Ke −r (T −t) N(−d2 )
(132)
ΨC = −(T − t)Se −δ(T −t) N(d1 )
ΨP = (T − t)Se −δ(T −t) N(−d1 ).
as well as..
ρC = (T − t)Ke −r (T −t) N(d2 )

ρP = −(T − t)Ke −r (T −t) N(−d2 )
(132)
ΨC = −(T − t)Se −δ(T −t) N(d1 )
ΨP = (T − t)Se −δ(T −t) N(−d1 ).
What do the signs of the Greeks tell us?
HW: Compute Θ for puts and calls.
Option Elasticity
Define
V (S+,t)−V (s,t)
V (S,t)
Ω(S, t) := lim S+−S
→0
S
S V (S + , t) − V (s, t) (133)
= lim
V (S, t) →0 S +−S
∆·S
= .
V (S, t)
Consequently,
∆C · S Se −δ(T −t)
ΩC (S, t) = = ≥1
V C (S, t) Se −δ(T −t) − Ke −r (T −t) N(d2 )
(134)
∆P · S
ΩP (S, t) = P ≤ 0.
V (S, t)
Option Elasticity
Theorem
The volatility of an option is the option elasticity times the volatility of the
stock:
σoption = σstock × | Ω | . (135)
The proof comes from Finan: Consider the strategy of hedging a portfolio
of shorting an option and purchasing ∆ = ∂V ∂S shares.
The initial and final values of this portfolio are
Initally: V (S(t), t) − ∆(S(t), t) · S(t)
Finally: V (S(T ), T ) − ∆(S(t), t) · S(T )
Option Elasticity
Proof.
If this portfolio is self-financing and arbitrage-free requirement, then

e r (T −t) V (S(t), t) − ∆(S(t), t) · S(t) = V (S(T ), T ) − ∆(S(t), t) · S(T ).
(136)
It follows that for κ := e r (T −t) ,
" #
V (S(T ), T ) − V (S(t), t) S(T ) − S(t)
=κ−1+ +1−κ Ω
V (S(t), t) S(t)
" # " #
V (S(T ), T ) − V (S(t), t) 2 S(T ) − S(t) (137)
⇒ Var = Ω Var
V (S(t), t) S(t)
⇒ σoption = σstock × | Ω | .
Option Elasticity
If γ is the expected rate of return on an option with value V , α is the
expected rate of return on the underlying stock, and r is of course the risk
free rate, then the following equation holds:

γ · V (S, t) = α · ∆(S, t) · S + r · V (S, t) − ∆(S, t) · S . (138)
In terms of elasticity Ω, this reduces to
Risk Premium(Option) := γ − r = (α − r )Ω. (139)
Option Elasticity


Furthermore, we have the Sharpe Ratio for an asset as the ratio of risk
premium to volatility:
(α − r ) (α − r )Ω
Sharpe(Stock) = = = Sharpe(Call). (140)
σ σΩ
Option Elasticity


Furthermore, we have the Sharpe Ratio for an asset as the ratio of risk
premium to volatility:
(α − r ) (α − r )Ω
Sharpe(Stock) = = = Sharpe(Call). (140)
σ σΩ
HW Sharpe Ratio for a put? How about elasticity for a portfolio of
options? Now read about Calendar Spreads, Implied Volatility, and
Perpetual American Options.
Example: Hedging
Under a standard framework, assume you write a 4 − yr European Call

option a non-dividend paying stock with the following:
S0 = 10 = K
σ = 0.2 (141)
r = 0.02.
Calculate the initial number of shares of the stock for your hedging
program.
Example: Hedging
Recall
∆C = e −δ(T −t) N(d1 )

ln KS + (r − δ + 12 σ 2 )(T − t)
d1 = √ (142)
σ T −t
√
d2 = d1 − σ T − t.
It follows that

∆C = N 0.4 = 0.6554. (143)
Example: Risk Analysis
Assume that an option is written on an asset S with the following

information:
The expected rate of return on the underlying asset is 0.10.
The expected rate of return on a riskless asset is 0.05.
The volatility on the underlying asset is 0.20.

V (S, t) = e −0.05(10−t) S 2 e S
Compute Ω(S, t) and the Sharpe Ratio for this option.
By definition,
∆·S S · ∂V∂S
(S,t)
Ω(S, t) = =
V (S, t) V (S, t)
d
S dS (S 2 e S ) S · (2Se S + S 2 e S ) (144)
= =
(S 2 e S ) S 2e S
= 2 + S.
By definition,
∆·S S · ∂V∂S
(S,t)
Ω(S, t) = =
V (S, t) V (S, t)
d
S dS (S 2 e S ) S · (2Se S + S 2 e S ) (144)
= =
(S 2 e S ) S 2e S
= 2 + S.
Furthermore, since Ω = 2 + S ≥ 2, we have
0.10 − 0.05
Sharpe = = 0.25. (145)
0.20
Example: Black Scholes Pricing
Consider a portfolio of options on a non-dividend paying stock S that

consists of a put and a call, both with strike K = 5 = S0 . What is the Γ
for this option as well as the option value at time 0 if the time to
expiration is T = 4, r = 0.02, σ = 0.2.
Consider a portfolio of options on a non-dividend paying stock S that

consists of a put and a call, both with strike K = 5 = S0 . What is the Γ
for this option as well as the option value at time 0 if the time to
expiration is T = 4, r = 0.02, σ = 0.2.
In this case,
V = VC + VP
∂2 C (146)
P
Γ= V + V = 2ΓC .
∂S 2
√
Consequently, d1 = 0.4 and d2 = 0.4 − 0.2 4 = 0, and so
V (5, 0) = V C (5, 0) + V P (5, 0)

= 5 N(d1 ) + e −4r N(−d2 ) − e −4r N(d2 ) − N(−d1 )

= 5 N(0.4) + e −4r N(0) − e −4r N(0) − N(−0.4) (147)
= 1.5542
2N 0 (0.4) 1 2
Γ(5, 0) = √ = N 0 (0.4) = √ e −0.5·(0.4) = 0.4322.
0.2 · 5 · 4 2π
Market Making
On a periodic basis, a Market Maker, services the option buyer by

rebalancing the portfolio designed to replicate the payoff written into the
option contract.
Define
Vi = Option Value i periods from inception

∆i = Delta required i periods from inception (148)
∴ Pi = ∆i Si − Vi
Rebalancing at time i requires an extra (∆i+1 − ∆i ) shares.
Market Making
On a periodic basis, a Market Maker, services the option buyer by

rebalancing the portfolio designed to replicate the payoff written into the
option contract.
Define
Vi = Option Value i periods from inception

∆i = Delta required i periods from inception (149)
∴ Pi = ∆i Si − Vi = Cost of Strategy
Rebalancing at time i requires an extra (∆i+1 − ∆i ) shares.
Market Making
Define
∂Si = Si+1 − Si
∂Pi = Pi+1 − Pi (150)
∂∆i = ∆i+1 − ∆i
Then
∂Pi = Net Cash Flow = ∆i ∂Si − ∂Vi − rPi

(151)
= ∆i ∂Si − ∂Vi − r ∆i Si − Vi
Under what conditions is the Net Flow = 0?
Market Making
∂V
For a continuous rate r , we can see that if ∆ := ∂S , Pt = ∆t St − Vt ,
dV := V (St + dSt , t + dt) − V (St , t)

1
≈ Θdt + ∆ · dSt + Γ · (dSt )2
2
⇒ dPt = ∆t dSt − dVt − rPt dt

1 2
≈ ∆t dSt − Θdt + ∆ · dSt + Γ · (dSt ) − r (∆t St − Vt ) dt
2
!
1
≈ − Θdt + r (∆St − V (St , t))dt + Γ · [dSt ]2 .
2
(152)
Market Making
If dt is small, but not infinitessimally small, then on a periodic basis given

the evolution of St , the periodic jump in value from St → St + dSt may be
known exactly and correspond to a non-zero jump in Market Maker profit
dPt .
Market Making
If dt is small, but not infinitessimally small, then on a periodic basis given

the evolution of St , the periodic jump in value from St → St + dSt may be
known exactly and correspond to a non-zero jump in Market Maker profit
dPt .
If dSt · dSt = σ 2 St2 dt, then if we sample continuously and enforce a zero
net-flow, we retain the BSM PDE for all relevant (S, t):
∂V ∂V 1 2 2 ∂2V
+r S −V + σ S =0
∂t ∂S 2 ∂S 2 (153)
V (S, T ) = G (S) for final time payoff G (S).
Note: Delta-Gamma Neutrality vs Bond Immunization
In an actuarial analysis of cashflow, a company may wish to immunize

its portfolio. This refers to the relationship between a non-zero value
for the second derivative with respect to interest rate of the
(deterministic) cashflow present value and the subsequent possibility
of a negative PV.
This is similar to the case of market maker with a non-zero Gamma.
In the market makers cash flow, a move of dS in the stock
corresponds to a move 12 Γ(dS)2 in the portfolio value.
In order to protect against large swings in the stock causing non-linear
effects in the portfolio value, the market maker may choose to offset
positions in her present holdings to maintain Gamma Neutrality or she
wish to maintain Delta Neutrality, although this is only a linear effect.
Option Greeks and Analysis - Some Final Comments
It is important to note the similarities between Market Making and

Actuarial Reserving. In engineering the portfolio to replicate the
payoff written into the contract, the market maker requires capital.
The idea of Black Scholes Merton pricing is that the portfolio should
be self-financing.
One should consider how this compares with the capital required by
insurers to maintain solvency as well as the possibility of obtaining
reinsurance.
Exam Practice
Consider an economy where :
The current exchange rate is x0 = 0.011 dollar
yen .
A four-year dollar-denominated European put option on yen with a
strike price of 0.008$ sells for 0.0005$.
The continuously compounded risk-free interest rate on dollars is 3%.
The continuously compounded risk-free interest rate on yen is 1.5%.
Compute the price of a 4−year dollar-denominated European call option
on yens with a strike price of 0.008$.
Exam Practice
Consider an economy where :
The current exchange rate is x0 = 0.011 dollar
yen .
A four-year dollar-denominated European put option on yen with a
strike price of 0.008$ sells for 0.0005$.
The continuously compounded risk-free interest rate on dollars is 3%.
The continuously compounded risk-free interest rate on yen is 1.5%.
Compute the price of a 4−year dollar-denominated European call option
on yens with a strike price of 0.008$.
ANSWER: By put call parity, and the Black Scholes formula, with the
asset S as the exchange rate, and the foreign risk-free rate rf = δ,
V C (x0 , 0) = V P (x0 , 0) + x0 e −rf T − Ke −rT

= 0.0005 + 0.011e −0.015·4 − 0.008e −0.03·4 (154)
= 0.003764.
Exam Practice
An investor purchases a 1−year, 50− strike European Call option on

a non-dividend paying stock by borrowing at the risk-free rate r .
The investor paid V C (S0 , 0) = 10.
Six months later, the investor finds out that the Call option has
increased in value by one: V C (S0.05 , 0.5) = 11.
Assume (σ, r ) = (0.2, 0.02).
Should she close out her position after 6 months?
Exam Practice
An investor purchases a 1−year, 50− strike European Call option on

a non-dividend paying stock by borrowing at the risk-free rate r .
The investor paid V C (S0 , 0) = 10.
Six months later, the investor finds out that the Call option has
increased in value by one: V C (S0.05 , 0.5) = 11.
Assume (σ, r ) = (0.2, 0.02).
Should she close out her position after 6 months?
ANSWER: Simply put, her profit if she closes out after 6 months is
1
11 − 10e 0.02 2 = 0.8995. (155)
So, yes, she should liquidate her position.
Exam Practice
Consider a 1−year at the money European Call option on a

non-dividend paying stock.
You are told that ∆C = 0.65, and the economy bears a 1% rate.
Can you estimate the volatility σ?
Exam Practice

ANSWER: By definition,
r + 1 σ2
∆C = e −δT N(d1 ) = N 2
σ
0.01 + 1 σ 2
2
=N = 0.65
σ
Exam Practice

r + 1 σ2
∆C = e −δT N(d1 ) = N 2
σ
0.01 + 1 σ 2
2
=N = 0.65
σ
0.01 + 12 σ 2
⇒ = 0.385
σ
Exam Practice

r + 1 σ2
∆C = e −δT N(d1 ) = N 2
σ
0.01 + 1 σ 2
2
=N = 0.65
σ (156)
1 2
0.01 + 2σ
⇒ = 0.385
σ
⇒ σ ∈ {0.0269, 0.7431} .
More information is needed to choose from the two roots computed above.
Exam Pointers
When reviewing the material for the exam, consider the following
milestones and examples:
The definition of the Black-Scholes pricing formulae for European
puts and calls.
What are the Greeks? Given a specific option, could you compute the
Greeks?
What is the Option Elasticity? How is it useful? How about the
Sharpe ratio of an option? Can you compute the Elasticity and
Sharpe ration of a given option?
Exam Pointers
What is Delta Hedging?

If the Delta and Gamma values of an option are known, can you
calculate the change in option value given a small change in the
underlying asset value?
How does this correspond the Market Maker’s profit?
Probability Spaces - Introduction
We define the finite set of outcomes, the Sample Space, as Ω and any
subcollection of outcomes A ⊂ Ω an event.
How does this relate to the case of 2 consecutive coin flips
Ω ≡ {HH, HT , TH, TT }
Set of events includes statements like at least one head
Set of events includes statements like at least one head
= {HH, HT , TH}
We define, ∀A, B ⊆ Ω
Ac = {ω ∈ Ω : ω ∈
/ A}
Ac = {ω ∈ Ω : ω ∈
/ A}
A ∩ B = {ω ∈ Ω : ω ∈ A and ω ∈ B}
Ac = {ω ∈ Ω : ω ∈
/ A}
A ∩ B = {ω ∈ Ω : ω ∈ A and ω ∈ B}
A ∪ B = {ω ∈ Ω : ω ∈ A or ω ∈ B}
Ac = {ω ∈ Ω : ω ∈
/ A}
A ∩ B = {ω ∈ Ω : ω ∈ A and ω ∈ B}
A ∪ B = {ω ∈ Ω : ω ∈ A or ω ∈ B}
φ as the Empty Set
Ac = {ω ∈ Ω : ω ∈
/ A}
A ∩ B = {ω ∈ Ω : ω ∈ A and ω ∈ B}
A ∪ B = {ω ∈ Ω : ω ∈ A or ω ∈ B}
φ as the Empty Set
A, B to be Mutually Exclusive or Disjoint if A ∩ B = φ
σ−algebras
Given a non-empty set Ω of outcomes, a σ−algebra F is a collection of

subsets of Ω that satisfies
σ−algebras

∅∈F
σ−algebras

∅∈F
A ∈ F ⇒ Ac ∈ F
σ−algebras

∅∈F
A ∈ F ⇒ Ac ∈ F
A1 , A2 , A3 , .... ∈ F ⇒ ∪∞
n=1 An ∈ F
σ−algebras

∅∈F
A ∈ F ⇒ Ac ∈ F
A1 , A2 , A3 , .... ∈ F ⇒ ∪∞
n=1 An ∈ F
Some Examples
σ−algebras

∅∈F
A ∈ F ⇒ Ac ∈ F
A1 , A2 , A3 , .... ∈ F ⇒ ∪∞
n=1 An ∈ F
Some Examples
F0 = {∅, Ω}
σ−algebras

∅∈F
A ∈ F ⇒ Ac ∈ F
A1 , A2 , A3 , .... ∈ F ⇒ ∪∞
n=1 An ∈ F
Some Examples
F0 = {∅, Ω}
F1 = {∅, Ω, {HH, HT }, {TT , TH}}
σ−algebras

∅∈F
A ∈ F ⇒ Ac ∈ F
A1 , A2 , A3 , .... ∈ F ⇒ ∪∞
n=1 An ∈ F
Some Examples
F0 = {∅, Ω}
F1 = {∅, Ω, {HH, HT }, {TT , TH}}
F2 = {∅, Ω, {HH}, {HT }, {TT }, {TH}, ....}
σ−algebras

∅∈F
A ∈ F ⇒ Ac ∈ F
A1 , A2 , A3 , .... ∈ F ⇒ ∪∞
n=1 An ∈ F
Some Examples
F0 = {∅, Ω}
F1 = {∅, Ω, {HH, HT }, {TT , TH}}
F2 = {∅, Ω, {HH}, {HT }, {TT }, {TH}, ....}
F2 is completed by taking all unions of ∅, Ω, {HH}, {HT }, {TT }, {TH}.
Power Sets
As a useful example, how many subsets are there of a set containing

n elements?
Power Sets

n elements?
Answer: 2n
Power Sets

n elements?
Answer: 2n
Proof:
Power Sets

n elements?
Answer: 2n
Proof:
Consider strings of length n where the elements are either 0 or 1....
Notice that F0 ⊂ F1 ⊂ F2 .
Correspondingly, given an Ω, we define a

Filtration as ..

Filtration as ..
a sequence of σ−algebras F0 , F1 , F2 , ..., Fn , ... such that

Filtration as ..
F0 ⊂ F1 ⊂ F2 ⊂ ... ⊂ Fn ⊂ ...

Filtration as ..
F0 ⊂ F1 ⊂ F2 ⊂ ... ⊂ Fn ⊂ ...
and F = σ(Ω) as the σ−algebra of all subsets of Ω.

Filtration as ..
F0 ⊂ F1 ⊂ F2 ⊂ ... ⊂ Fn ⊂ ...
and F = σ(Ω) as the σ−algebra of all subsets of Ω.
Given a pair (Ω, F), we define a Random Variable X (ω) as a mapping
X :Ω→R
Given a pair (Ω, F), we define a Probability Space as the triple
(Ω, F, P), where
P : F → [0, 1]
P[∅] = 0
For any countable disjoint sets A1 , A2 , ... ∈ F
P∞
P [∪∞
n=1 An ] = n=1 P[An ]
And so
P
P[A] := P[ω]
Pω∈A
E[X ] := ω X (ω)P[ω] = nk=1 xk P[{X (ω) = xk }]
P
h i
with Variance := E (X − E[X ])2
Some useful properties:
P[Ac ] = 1 − P[A]
And so
P
P[A] := P[ω]
Pω∈A
P
h i
P[Ac ] = 1 − P[A]
P[A] ≤ 1
And so
P
P[A] := P[ω]
Pω∈A
P
h i
P[Ac ] = 1 − P[A]
P[A] ≤ 1
P[A ∪ B] = P[A] + P[B] − P[A ∩ B]
And so
P
P[A] := P[ω]
Pω∈A
P
h i
P[Ac ] = 1 − P[A]
P[A] ≤ 1
P[A ∪ B] = P[A] + P[B] − P[A ∩ B]
P[A ∪ B ∪ C ] =
P[A] + P[B] + P[C ] − P[A ∩ B] − P[A ∩ C ] − P[B ∩ C ] + P[A ∩ B ∩ C ]
Example
Consider the case where two dice are rolled separately. What is the Sample
Space Ω here? How about the probability that the dots on the faces of the
pair add up to 3 or 4 or 5?
How Should We Count?
Think about the following problems:

How many pairings of aliens and humans, (aliens, human), can we
have if we can choose from 8 aliens and 9 people?
How many different strings of length 5 can we expect to find of 00s
and 10s ?
Examples
From a group of 3 aliens and 5 humans, how many alien-people

councils can be formed with 2 of each on the board?
Examples
From a group of 3 aliens and 5 humans, how many alien-people

councils can be formed with 2 of each on the board?
What if two of the humans refuse to serve together?
Permutations
In general, we are interested in the number of different ways, or

Combinations of ways r objects could be grouped when selected from a
pool of n total objects. Notationally, for r ≤ n we define this as nr and
the formula can be shown to be

n n!
=
r (n − r )!r !
Permutations


n n!
=
r (n − r )!r !
n! = 1 · 2 · ... · n
Permutations


n n!
=
r (n − r )!r !
n! = 1 · 2 · ... · n (157)

n n−1 n−1
= +
r r −1 r
If order matters when selecting the r objects, then we define the number
of Permutations

n n!
Pk,n = r ! · = (158)
r (n − r )!
What if another event has already occured?
Consider the case where two events in our σ−field are under consideration.
In fact, we know that B has already happened. How does that affect the
chances of A happening?
Consider the case where two events in our σ−field are under consideration.
In fact, we know that B has already happened. How does that affect the
chances of A happening?
For example, if you know your friend has one boy, and the chance of a boy
or girl is equal at 0.5, then what is the chance all three of his children are
boys?
In symbols, we seek
P [A ∩ B]
P [A | B] ≡
P [B]
In symbols, we seek
P [A ∩ B]
P [A | B] ≡
P [B]
P [ all are boys ∩ first child is a boy]
=
P [ first child is a boy]
In symbols, we seek
P [A ∩ B]
P [A | B] ≡
P [B]
=
P [ all are boys]
=
In symbols, we seek
P [A ∩ B]
P [A | B] ≡
P [B]
=
P [ all are boys]
=
1 1 1
· ·
= 2 21 2
2
In symbols, we seek
P [A ∩ B]
P [A | B] ≡
P [B]
=
P [ all are boys]
= (159)
1 1 1
· ·
= 2 21 2
2
1
=
4
Now, what if you know your friend has at least one boy. Then what is the
chance all three of his children are boys? This is also known as The
Boy-Girl Paradox.
Boy-Girl Paradox.
P [A ∩ C ]
P [A | C ] ≡
P [C ]
Boy-Girl Paradox.
P [A ∩ C ]
P [A | C ] ≡
P [C ]
P [ all are boys ∩ at least one child is a boy]
=
P [at least one child is a boy]
Boy-Girl Paradox.
P [A ∩ C ]
P [A | C ] ≡
P [C ]
=
P [ all are boys]
=
P [ at least one child is a boy]
Boy-Girl Paradox.
P [A ∩ C ]
P [A | C ] ≡
P [C ]
=
P [ all are boys]
=
P [ all are boys]
=
1 − P [all girls]
Boy-Girl Paradox.
P [A ∩ C ]
P [A | C ] ≡
P [C ]
=
P [ all are boys]
=
P [ all are boys]
=
1 − P [all girls]
1 1 1
2 · 2 · 2
=
1 − 18
Boy-Girl Paradox.
P [A ∩ C ]
P [A | C ] ≡
P [C ]
=
P [ all are boys]
= (160)
P [ all are boys]
=
1 − P [all girls]
1 1 1
2 · 2 · 2 1
= 1
=
1− 8 7
Total Probability
Notice from our definition of conditional probabiltity that
P[A ∩ B] = P[A | B] · P[B] (161)
Total Probability
P[A ∩ B] = P[A | B] · P[B] (161)

We can expand on this idea: For our sample space Ω, assume we have a
set {A1 , ..., An } where the members are
mutually exclusive - Ai ∩ Aj = φ for all i 6= j
exhaustive - A1 ∪ A2 ∪ ... ∪ An = Ω .
Total Probability
P[A ∩ B] = P[A | B] · P[B] (161)

Then
P[B] = P[B ∩ A1 ] + P[B ∩ A2 ] + ... + P[B ∩ An ]
Total Probability
P[A ∩ B] = P[A | B] · P[B] (161)

Then
P[B] = P[B ∩ A1 ] + P[B ∩ A2 ] + ... + P[B ∩ An ]

(162)
= P[B | A1 ]P[A1 ] + P[B | A2 ]P[A2 ] + ... + P[B | An ]P[An ]
Bayes Theorem
For our sample space Ω, assume we have an exhaustive set of events

{A1 , ..., An } with prior probabilities P[Ai ] for i = 1, .., n. Then for any
other event B in our σ−field where P[B] > 0, the posterior probabilty of
Aj given that B has occured is
Bayes Theorem

P [Aj ∩ B]
P [Aj | B] = =
P [B]
Bayes Theorem

P [Aj ∩ B] P [B ∩ Aj ]
P [Aj | B] = =
P [B] P [B]
Bayes Theorem

P [Aj ∩ B] P [B ∩ Aj ]
P [Aj | B] = =
P [B] P [B]
(163)
P[B | Aj ] · P[Aj ]
=
P[B | A1 ]P[A1 ] + ... + P[B | An ]P[An ]
Independent Events
For our sample space Ω, assume we have two events A, B. We say that A
and B are independent if P[A | B] = P[A] and dependent if
P[A | B] 6= P[A]
Independent Events
P[A | B] 6= P[A]
In other words, A and B are independent if and only if
P[A ∩ B] = P[A] · P[B].
Independent Events
P[A | B] 6= P[A]
In other words, A and B are independent if and only if
P[A ∩ B] = P[A] · P[B].
Generally speaking, for any collection of events {A1 , ..., An } we have for
any subcollection {Ai1 , ..., Ain } ⊆ {A1 , ..., An }
P[Ai1 ∩ ... ∩ Ain ] = P[Ai1 ] · .. · ...P[Ain ] (164)

Financial Mathematics For Actuaries I

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Financial Mathematics For Actuaries I

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MATH 361: Financial Mathematics for Actuaries I

Actuarial Sciences Program

Syllabus to be posted on class page in first week of classes

Traded Securities - price given by market.

Traded Securities - price given by market.

Traded Securities - price given by market.

Traded Securities - price given by market.

By eliminating all unfair prices

By eliminating all unfair prices

By eliminating all unfair prices

By eliminating all unfair prices

Existence - Does such a fair price always exist?

Does the replicating strategy and price computed reflect uncertainty

Does the replicating strategy and price computed reflect uncertainty

V (0) = 0, V (T ) = S(T ) − F (1)

V (0) = 0, V (T ) = S(T ) − F (1)

Value at end of term can be negative - buyer accepts this in exchange

Forward Exchange Rate: There are two currencies, foreign and

Forward Exchange Rate: There are two currencies, foreign and

Forward Exchange Rate: There are two currencies, foreign and

Forward Exchange Rate: There are two currencies, foreign and

Forward Exchange Rate: There are two currencies, foreign and

At time 1, we deliver 1 unit of B in exchange for FAB units of domestic

At time 1, we deliver 1 unit of B in exchange for FAB units of domestic

At time 1, we deliver 1 unit of B in exchange for FAB units of domestic

At time 1, we deliver 1 unit of B in exchange for FAB units of domestic

This results in the initial value

Let us define an event as a point ω in the set of all possible outcomes Ω.

Let us define an event as a point ω in the set of all possible outcomes Ω.

Let us define an event as a point ω in the set of all possible outcomes Ω.

S1 (H) = uS0 , S1 (T ) = dS0 (5)

Let us define an event as a point ω in the set of all possible outcomes Ω.

S1 (H) = uS0 , S1 (T ) = dS0 (5)

Let us define an event as a point ω in the set of all possible outcomes Ω.

S1 (H) = uS0 , S1 (T ) = dS0 (5)

P[H] = p = 1 − P[T ] (6)

Assume that S0 (1 + r ) > uS0

Assume that S0 (1 + r ) > uS0

Assume that S0 (1 + r ) > uS0

Assume that S0 (1 + r ) > uS0

Assume that S0 (1 + r ) > uS0

Let S1 (ω) be the price of an underlying asset at time 1. Define the

Let S1 (ω) be the price of an underlying asset at time 1. Define the

Let S1 (ω) be the price of an underlying asset at time 1. Define the

Let S1 (ω) be the price of an underlying asset at time 1. Define the

Let S1 (ω) be the price of an underlying asset at time 1. Define the

V1C − V1P + (K − F ) = S1 − F = X1 (ω) (7)

V1C − V1P + (K − F ) = S1 − F = X1 (ω) (7)

V1C − V1P + (K − F ) = S1 − F = X1 (ω) (7)

V1C − V1P + (K − F ) = S1 − F = X1 (ω) (7)

X1 (ω) = V1 (ω) ∀ ω∈Ω (9)

Initial holding in bond (bank account) is X0 − ∆0 S0

X1 (ω) = (X0 − ∆0 S0 )(1 + r ) + ∆0 S1 (ω) (10)

Initial holding in bond (bank account) is X0 − ∆0 S0

X1 (ω) = (X0 − ∆0 S0 )(1 + r ) + ∆0 S1 (ω) (10)

V1 (H) = (X0 − ∆0 S0 )(1 + r ) + ∆0 uS0

Initial holding in bond (bank account) is X0 − ∆0 S0

X1 (ω) = (X0 − ∆0 S0 )(1 + r ) + ∆0 S1 (ω) (10)

V1 (H) = (X0 − ∆0 S0 )(1 + r ) + ∆0 uS0

p̃V1 (H) = p̃(X0 − ∆0 S0 )(1 + r ) + p̃∆0 uS0

p̃V1 (H) = p̃(X0 − ∆0 S0 )(1 + r ) + p̃∆0 uS0

X0 (1 + r ) + ∆0 S0 (p̃u + q̃d − (1 + r )) = p̃V1 (H) + q̃V1 (T ) (12)

then we have a risk neutral probability P̃ where