FD Lecture IV Part1 v0511

Financial Derivatives
F. Boniver, lecturer — (chair: J. Hambuckers)
HEC Liège - University of Liège
Academic year 2022 - 2023, v0511

Lecture IV
Pricing of options
part 1
Financial Derivatives J. Hambuckers — F. Boniver 1

Reminder
▶ T : time to maturity
▶ σ: volatility of the underlying’s price.
▶ r : risk-free rate for maturity T .
▶ K : strike price.
▶ S0 : price of the underlying (usually a stock) today.
▶ ST : price of the underlying (usually a stock) at maturity.
▶ c (resp. C ): European (resp. American) call option price.
▶ p (resp. P): European (resp. American) put option price.
▶ D: present value of dividends occurring during the life of the
option.

Reminder: payoffs
Payoff Long Short
Call max{ST − K , 0} − max{ST − K , 0}

Put max{K − ST , 0} − max{K − ST , 0}
Net payoff Long Short
Call max{ST − K , 0} − c c − max{ST − K , 0}

Put max{K − ST , 0} − p p − max{K − ST , 0}

Reminder
The likelihood of a positive payoff depends on the distribution of

ST . Factors influencing this distribution are:
Variable Call Put
Current stock price + −

Strike price − +
Volatility + +
Risk-free rate + −
Time to expiration ? ?
Table: Effect of an increase in the concerned variables on c and p

Summary
1. Introduction
2. No arbitrage pricing
3. Binomial pricing and replication
4. Arrow-Debreu replication
5. Risk neutral valuation (part 1)

Introduction

Introduction
Consider a riskless bond with the following cash flow:
What is the fair price ?

Introduction
Consider a stock with the two following patterns of prices over a
given period:
What is the cash flow at time T ? What is the fair price ?

Introduction
Consider a stock with the following patterns of prices over a given
period:

Introduction
Consider a stock with the following patterns of prices over a given
period:

Introduction
▶ Link (of course) between terminal value ST and fair price S0

▶ Need for discounting
▶ Stochastic processes (stock price and, why not, interest rates)
▶ We cannot predict the future! So we revert to the efficient market
hypothesis and consider S0 is the fair price (theoretically)
▶ Yet, if we assume a reasonable model for the uncertainty of
future underlying stock prices, surprisingly enough, it is
possible to compute rational option prices
▶ Numerous stochastic finance results thus regard the pricing of
derivatives
▶ Milestone: Spring 1973, Black-Scholes, and Merton (2 different
approaches). Rational price for European call options. Relies on Absence
of Arbitrage argument.
No arbitrage pricing
Reference: Hull, 9th Ed., Chapters 13 to 15

An arbitrage opportunity is one which:

▶ Requires no invested capital.
▶ Provides a positive profit with certainty.
usually known as a free lunch
or (more generally)
▶ Requires no invested capital.
▶ Provides a positive profit with a positive probability and has a
zero probability of a loss.

Corollary I: Anyone who prefers more to less would engage in

arbitrage because it represents ”something for nothing”.
Corollary II: In any competitive market, there should be no

arbitrage.
Corollary III: The absence of arbitrage is in some cases

sufficient to allow us to price one security in terms of
another.
Absence of Arbitrage hypothesis (AOA) is usually informally

quoted as “There is no free lunch”.

General idea: assets or portfolios with the same cash flows in

each state must have the same price.
E.g.: a stock anywhere in the world granting you the same cash
flow should have the same price, otherwise there is an arbitrage
opportunity.
Pricing via no-arbitrage is relative pricing: we calculate the price
on one security in terms of the prices of others for which we
know the price with certainty.
E.g.: an option priced as a function of today’s stock price and
today’s risk-free rate.
This is achieved via replication. We built several replication
portfolios in a simple (fixed-outcome) framework during the
previous lectures.

Binomial pricing and replication

Binomial pricing
Consider first a simplistic 1-step binomial model.
▶ 1-step time horizon:
▶ t = 0 (now)
▶ t = T = 1 (future)
▶ Only 3 assets exist:
▶ one riskless bonda
▶ one stock,
▶ one call option on the stock.
▶ 2-possible-outcome future “world”
(or market): up or down (with
up-state stock price > down-state
stock price).
a
or bank account
Note the roles of the assets: the risk-free, the underlying, and the option.
(Additional assumptions will be discussed later on.)

Binomial pricing — an example
Problem: Find the price at t = 0 of a call option on the
underlying risky asset, with strike price K = 100.
Given data: Values in t = 0 and t = 1 of the
▶ riskless bond (certain, through risk-free rate r = 33.3%, and
maturity payoff = 1)
▶ stock (known in t = 0, 2 possibilities in t = 1, reflecting the
asset’s risky nature)
Time States Bond Stock Option

1
t=0 known .75 ≈ 1+.333 75 Unknown
t=1 “UP” 1 120 20

(60% increase)
t=1 “DOWN” 1 90 0
(20% increase)

If we build a portfolio that replicates perfectly the cash flows of
the option in both states, its price must be equal to the one of
the option.
▶ How many units γ of the bond ?
▶ How many units ∆ of the stock ?
UP: γ + ∆120 = 20
DOWN: γ + ∆90 = 0
⇔ γ = −60 and ∆ = 2/3
Assembling a short position of 60 units in the risk-free (rf) asset
and a long position of 2/3 stock share gives birth to a replication
portfolio: it has the same cash flows as the option in all future
states of the world (i.e. market).

the option.
UP: γ + ∆120 = 20
DOWN: γ + ∆90 = 0
⇔ γ = −60 and ∆ = 2/3
What is the price ?

the option.
UP: γ + ∆120 = 20
DOWN: γ + ∆90 = 0
⇔ γ = −60 and ∆ = 2/3
What is the price ? Hint: look at known inception prices for rf
asset and stock. . .

the option.
UP: γ + ∆120 = 20
DOWN: γ + ∆90 = 0
⇔ γ = −60 and ∆ = 2/3
2
P(call) = γ × .75 + ∆ × 75 = −60 × .75 + × 75 = 5.
3

Binomial pricing
The model should be generalised in two directions to be usable:
▶ remove the limit of the number of future states and let
S = {s : future state of the world in T } be larger (possibly
infinite)
▶ extend the number of time steps by indexing time with
rational numbers or real numbers (real numbers meaning
continuous time).
A first question: “How could one formalise arbitrage arguments?”
A first intuition: need for a sufficient number of “independent”
assets to replicate all possible prices in T . (Hint: think of bases in
vector spaces, which allow to write vector in coordinates. . . in a
unique way.)
What we should look for is named a full set of Arrow-Debreu
(AD) securities. And if we find it, the market is named a
complete market.
Arrow-Debreu replication and complete
market

Arrow-Debreu securities
Definition
”An Arrow-Debreu security is one that pays 1 in one particular

state s, and zero in all other states”
State Stock AD1 AD2 AD3 AD4
1 100 1 0 0 0
2 90 0 1 0 0
3 75 0 0 1 0
4 40 0 0 0 1
Example of cashflows from AD securities in a four-state set-up
(Hint: basis vectors having unit coordinates. . . useful for

decomposing other vectors)

Arrow-Debreu securities and complete market
A market in which there is one A-D security for each state is

called complete.
▶ In a complete market it is always possible to replicate any
pattern of cash flows across states with a portfolio of A-D
securities.
▶ Is the replication strategy simple?


called complete.
securities.
▶ Name “state-s” AD security the one with unit payoff in state s
▶ Then, for a cash flow of xs in state s we simply purchase xs
units (a quantity) of this state-s AD security. (with no payoff
in other states.)


called complete.
securities.
▶ Name “state-s” AD security the one with unit payoff in state s
▶ Then, for a cash flow of xs in state s we simply purchase xs
units (a quantity) of this state-s AD security. (with no payoff
in other states.)
E.g. If in state 1 my payoff is 10, I need 10 state-1 AD securities in
my replication portfolio.

Example (continued)
State Required CF AD1 AD2 AD3 AD4 Port. CF
1 100 = x1 100 0 0 0 100

2 90 = x2 0 90 0 0 90
3 75 = x3 0 0 75 0 75
4 40 = x4 0 0 0 40 40
If the price of state-s security at inception is qs , then the price of this

replication portfolio is

Example (continued)
1 100 = x1 100 0 0 0 100

2 90 = x2 0 90 0 0 90
3 75 = x3 0 0 75 0 75
4 40 = x4 0 0 0 40 40
P4
Price x1 q1 x2 q2 x3 q3 x4 q4 s=1 xs qs

4
X
P = x1 q1 + x2 q2 + x3 q3 + x4 q4 = xs qs
s=1

Example (continued)
1 100 = x1 100 0 0 0 100

2 90 = x2 0 90 0 0 90
3 75 = x3 0 0 75 0 75
4 40 = x4 0 0 0 40 40
P4
Price x1 q1 x2 q2 x3 q3 x4 q4 s=1 xs qs

4
X
P = x1 q1 + x2 q2 + x3 q3 + x4 q4 = xs qs
s=1
Otherwise: This combination of available (AD) securities would make possible

to build an arbitrage.
Remark.
▶ AD securities can be implicit, i.e. be constructed from

combinations of conventional securities (see later).
▶ The market is also complete since we can consider those
securities as materialising AD securities.

Generalization of the no-arbitrage principle:
In a market without any arbitrage opportunity
▶ with S possible states
▶ where AD assets exist, (i.e. complete market), and have prices
q = (q1 , . . . , qS )T ,
a portfolio having payoffs x = (x1 , . . . , xS ) with prices must have
price
P = x1 q1 + x2 q2 + . . . + xS qS ,
XS
= xs qs
s=1
= xq (matrix product).
For now, we consider payoffs at time 1 and prices at t = 0, but this can be
generalised.

(Source:https://blog.mahindrafirstchoice.com)

Hence, the replication principle can be used to value option.

▶ We assume a complete market.
▶ It implies that we can always replicate cash flows via a
portfolio of AD securities.
▶ This is not in the sense that an AD security exists for each
detailed state of economy...
▶ ...but rather, that there is an AD security for each possible
value of the price of the underlying security...
▶ ...and so we can replicate all derivatives with cash flows that
are defined by the price of the underlying security.
Completeness implies replication via the underlying or AD
securities, or via risk neutral probabilities (see later).

Replication with Arrow-Debreu securities
We need first to determine the prices of the different AD securities.

Again, they can be obtained from a replication argument.
Then we can price the option.

1) Compute AD prices
Example: Call option with K = 100, rf rate r ≈ 33.3%.
Cash Flow Bond Stock AD(u) AD(d)
Price (t = 0) .75 75 qu qd
payoff UP-state (t = 1) 1 120 1 0

payoff DOWN-state (t = 1) 1 90 0 1

Price (t = 0) .75 75 qu qd

1.1) Replicate and price AD securities

▶ AD(u) with γu units of bond and ∆u units of stock
▶ AD(d) with γd units of bond and ∆d units of stock.

Price (t = 0) .75 75 qu qd


( (
γu + 120∆u = 1 γd + 120∆d = 0
Thus and
γu + 90∆u = 0 γd + 90∆d = 1

Price (t = 0) .75 75 qu qd


( (
γu + 120∆u = 1 γd + 120∆d = 0
Thus and . . . solve. . .
γu + 90∆u = 0 γd + 90∆d = 1

Price (t = 0) .75 75 qu qd


( (
γu + 120∆u = 1 γd + 120∆d = 0
γu + 90∆u = 0 γd + 90∆d = 1
⇝ γu = −3, γd = 4, ∆u = 1/30, and ∆d = −1/30

Price (t = 0) .75 75 qu qd


( (
γu + 120∆u = 1 γd + 120∆d = 0
γu + 90∆u = 0 γd + 90∆d = 1
⇝ γu = −3, γd = 4, ∆u = 1/30, and ∆d = −1/30, and finally

qu = .75γu + 75∆u = .25 and qd = 4γd + 75∆d = .5
2) Replicate the option
Cash Flow AD(u) AD(d) (stock) Call (K = 100)
Price (t = 0) qu = .25 qd = .5 75 c
payoff UP-state (t = 1) 1 0 120 xu = 20

payoff DOWN-state (t = 1) 0 1 90 xd = 0
c = xu qu + xd qd ,
= 20 · .25 + 0 · .5,
= 5.

2) Replicate the option
Cash Flow AD(u) AD(d) (stock) Call (K = 100)
Price (t = 0) qu = .25 qd = .5 75 c
payoff UP-state (t = 1) 1 0 120 xu = 20

payoff DOWN-state (t = 1) 0 1 90 xd = 0
c = xu qu + xd qd ,
= 20 · .25 + 0 · .5,
= 5.
⇝ We have obtained the call price by taking its payoffs as
(linear) proportions of the AD-security prices we had first
determined.
Question
Why would you want to use AD securities rather than the
underlying stock to replicate and price the option ?

Question
Why would you want to use AD securities rather than the
underlying stock to replicate and price the option ?
▶ AD prices do not depend on the payoff of the option.

▶ At the contrary, the replication portfolio is based on those
payoffs.
▶ Thus, one would need to repeat this operation for every
option.
▶ With AD securities, compute AD prices for a given underlying.
▶ Then multiply by the payoffs for a given option.
▶ (Option payoffs are components of the payoff vector in the
AD-asset basis)
▶ and the option is easily linearly-priced using the AD prices.

Risk neutral valuation can be thought in a similar way.

Actually, risk neutral valuation is simply a re-expression of AD
replication technique as a function of the risk-free rate.
Remember that we are still in the binomial case.

Risk neutral valuation
(part 1)

A remarkable corollary.
Notice that the valuation of a portfolio by the scalar product of
payoffs x ∈ RS with AD-security prices q ∈ RS :
P = xq,
gives the price B of the risk-free bond as

S
1 X
B= = (1, . . . , 1)q = qs
1+r
s=1
since the bond gives a payoff of 1 in any state.

Remark. Here we use annual compounding instead of continuous
compounding, because we use a discrete time model (over 1 year).

It is then tempting to normalise AD prices and define
qs qs
πs = = PS ∀s ∈ {1, . . . , S}.
B j=1 qj
In addition, because of this normalisation, for all s,


0 ≤ πs ≤ 1


XS


 πj = 1
j=1
Thus, those πs define a probability over the state-space S. It is

known as risk-neutral probability associated to this discrete-state
1-time-step model.
If we assume that the world states could all really happen (i.e.
with non-zero real probability), then all qs > 0 and thus all πs too,
and finally 0 < πs < 1, ∀πs .
What does the pricing formula look like? We get successively
S
X S
X
P= xs qs = Bπs xs , (def. of π)
s=1 s=1
S
1 X
= πs xs , knowing bond price
1+r
s=1
1
= EQ (x)
1+r
if simply denote by EQ the expectation w.r.t. the risk-neutral
probability (in this case, a weighted average).
In this simple case, we derived a most important fact:
securities can (with suitable hypotheses, esp. a complete
market) be priced as the expected value of their discounted
future cash flows (at the risk-free rate).

Interpretation:
▶ πs can be seen as the probability that cash flow xs takes
place, under risk-neutral preferences, i.e. when risk does
not matter for investors
▶ and since it does not, future cash flows are discounted at the
risk-free rate r .
▶ In addition, risk-neutral probabilities are also forward prices of
qs
the respective AD securities, since πs = = qs × (1 + r ).
B
Remark. We do not actually assume investors to be risk-neutral,
we just underline the crucial role of the risk-free rate in the pricing
formula.

Back to our example: (r ≈ 33.3%)
qs πs Call (K = 100)
UP .25 .25/.75 = .333 20

DOWN .5 .5/.75 = .667 0
Total .75 1 -
1
c = EQ (call payoffs),
1+r
1
≈ (20 × .333 + 0 × .667),
1 + .333
≈ 5.

Similarly to the AD replication, risk-neutral valuation is ”easier” to

compute for a large set of options.
We simply need to
1. Work out the risk-neutral probabilities associated to the
underlying,
2. Determine the cash flow of the option for every s,
3. Calculate the risk-neutral expected value,
4. Discount it with the risk-free rate.
Thus, only step 2 to 4 need to be repeated when the option’s
characteristics change.

Changelog
This version (v0511) replaces the previous one (v0316b), hopefully

improving the presentation of the example on slide 18.

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Financial Derivatives

F. Boniver, lecturer — (chair: J. Hambuckers)

HEC Liège - University of Liège

Academic year 2022 - 2023, v0511

Financial Derivatives J. Hambuckers — F. Boniver 1

Financial Derivatives J. Hambuckers — F. Boniver 2

Payoff Long Short

Call max{ST − K , 0} − max{ST − K , 0}

Net payoff Long Short

Call max{ST − K , 0} − c c − max{ST − K , 0}

Financial Derivatives J. Hambuckers — F. Boniver 3

The likelihood of a positive payoff depends on the distribution of

Variable Call Put

Current stock price + −

Table: Effect of an increase in the concerned variables on c and p

Financial Derivatives J. Hambuckers — F. Boniver 4

Financial Derivatives J. Hambuckers — F. Boniver 5

Financial Derivatives J. Hambuckers — F. Boniver 6

What is the fair price ?

Financial Derivatives J. Hambuckers — F. Boniver 7

What is the cash flow at time T ? What is the fair price ?

Financial Derivatives J. Hambuckers — F. Boniver 8

What is the cash flow at time T ? What is the fair price ?

Financial Derivatives J. Hambuckers — F. Boniver 9

What is the cash flow at time T ? What is the fair price ?

Financial Derivatives J. Hambuckers — F. Boniver 10

▶ Link (of course) between terminal value ST and fair price S0

Reference: Hull, 9th Ed., Chapters 13 to 15

Financial Derivatives J. Hambuckers — F. Boniver 12

An arbitrage opportunity is one which:

Financial Derivatives J. Hambuckers — F. Boniver 13

Corollary I: Anyone who prefers more to less would engage in

Corollary II: In any competitive market, there should be no

Corollary III: The absence of arbitrage is in some cases

Absence of Arbitrage hypothesis (AOA) is usually informally

Financial Derivatives J. Hambuckers — F. Boniver 14

General idea: assets or portfolios with the same cash flows in

Financial Derivatives J. Hambuckers — F. Boniver 15

Financial Derivatives J. Hambuckers — F. Boniver 16

Financial Derivatives J. Hambuckers — F. Boniver 17

Time States Bond Stock Option

t=1 “UP” 1 120 20

Financial Derivatives J. Hambuckers — F. Boniver 18

Financial Derivatives J. Hambuckers — F. Boniver 19

Financial Derivatives J. Hambuckers — F. Boniver 19

If we build a portfolio that replicates perfectly the cash flows of

Financial Derivatives J. Hambuckers — F. Boniver 20

Financial Derivatives J. Hambuckers — F. Boniver 22

”An Arrow-Debreu security is one that pays 1 in one particular

State Stock AD1 AD2 AD3 AD4

Example of cashflows from AD securities in a four-state set-up

(Hint: basis vectors having unit coordinates. . . useful for

Financial Derivatives J. Hambuckers — F. Boniver 23

A market in which there is one A-D security for each state is

Financial Derivatives J. Hambuckers — F. Boniver 24

A market in which there is one A-D security for each state is

Financial Derivatives J. Hambuckers — F. Boniver 24

A market in which there is one A-D security for each state is

Financial Derivatives J. Hambuckers — F. Boniver 24

State Required CF AD1 AD2 AD3 AD4 Port. CF

1 100 = x1 100 0 0 0 100

If the price of state-s security at inception is qs , then the price of this

Financial Derivatives J. Hambuckers — F. Boniver 25