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# Discrete Financial Mathematics

Wim Schoutens

Leuven, 2004-2005

## (G0Q20a) Discrete Financial Mathematics

Abstract

The aim of the course is to give a rigorous yet accessible introduction to the

## notions of finance is useful.

We start with providing some background on the financial markets and the

## instruments traded. We will look at different kinds of derivative securities, the

main group of underlying assets, the markets where derivative securities are

traded and the financial agents involved in these activities. The fundamen-

## hedging. The pricing is based on the no-arbitrage assumptions. We start by dis-

cussing option pricing in the simplest idealised case: the Single-Period Market.

Next, we turn to Binomial tree models. Under these models we price European

and American options and discuss pricing methods for the more involved exotic

## mathematical counterpart of the economic principle of no-arbitrage: the exis-

tence of equivalent martingale measures. We look when the models are complete,

## asset pricing in a discrete setting.

To conclude the course, we make a bridge to continuous-time models. We

look at them as limiting cases of discrete models. The discrete models will guide

## us in the analysis of continuous-time models in the Continuous Mathematical

Finance Course.

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Contents

1 Derivative Background 1

## 1.1.3 Derivative Instruments . . . . . . . . . . . . . . . . . . . . 9

1.1.4 Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

## 1.1.7 Modelling Assumptions . . . . . . . . . . . . . . . . . . . 17

1.2 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

## 1.3.2 The Forward Contract . . . . . . . . . . . . . . . . . . . . 26

1.3.3 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

1.3.4 Currencies . . . . . . . . . . . . . . . . . . . . . . . . . . . 30

1
1.3.5 Commodities . . . . . . . . . . . . . . . . . . . . . . . . . 32

## 1.3.6 The Cost of Carry . . . . . . . . . . . . . . . . . . . . . . 32

2 Binomial Trees 34

## 3.5 The Fundamental Theorem of Asset Pricing . . . . . . . . . . . . 75

3.5.1 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . 77

4 Exotic Options 82

## 4.3 Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88

2
4.4 Asian Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94

## 5.9 Drawbacks of the Black-Scholes Model . . . . . . . . . . . . . . . 129

6 Miscellaneous 132

## 6.2 Variance Swap . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134

3
Chapter 1

Derivative Background

## 1.1 Financial Markets and Instruments

A market typically consist out of a riskfree Bank account and some other risky

assets. On these basic instruments other financial contracts are written; these

financial contracts are so-called derivative securities. This text is on the (risk-

## This section provides the institutional background on the main group of

underlying assets, the related derivative securities, the markets where derivatives

securities are traded and the financial agents involved in these activities.

## Next, we highlight some of the most common underlying securities.

1
Stocks – Equity

The basis of modern economic life are companies owned by their shareholders;

the shares provide partial ownership of the company, pro rata with investment.

Shares have value, reflecting both the value of the company’s real assets and

the earning power of the company’s dividends. With publicly quoted companies,

shares are quoted and traded on the Stock Exchange. Stock is the generic term

for assets held in the form of shares. Stock markets date back to at least 1531,

when one was started in Antwerp, Belgium. Today there are over 150 stock

exchanges.

## Interest Rates – Fixed-Income

The value of some financial assets depends solely on the level of interest rates,

e.g. Treasury notes, municipal and corporate bonds. These are fixed-income

securities by which national, state and local governments and large companies

## payment of interest in the form of a fixed amount of money at predetermined

points in time, as well as the repayment of the principal at maturity of the secu-

rity. Interest rates themselves are notional assets, which cannot be delivered. A

## be riskfree. We go into more detail on possible bank account models in Section

1.1.2.

2
Currencies – Foreign Exchange

## of foreign currencies and in doing so use derivative instruments.

A foreign currency has the property that the holder of the currency can earn

interest at the risk-free interest rate prevailing in the foreign country. We thus

have to kind of interest rates, the domestic and the foreign interest rate.

Commodities

Commodities are a kind of physical products like gold, oil, cattle, fruit juice.

Trade in these assets can be for different purposes: for using them in the pro-

## duction process or for speculation. Derivative instruments on these asset can

be used for hedging and speculation. Special care has to be taken with com-

modities because of storage costs (see Section 1.3.5) In Figure 1.1, one sees the

some prices (of the market on the 16th of October 2004) of (futures on) energy,

## metal, livestock and other commodities.

3
Figure 1.1: Commodities future prices on 16-10-2004

Miscellaneous

Indexes

## and so on. Derivative instruments on indices may be used for hedging if no

4
derivative instruments on a particular asset in question are available and if the

correlation in movement between the index and the asset is significant. Further-

more, institutional funds (such as pension funds), which manage large diversi-

fied stock portfolios, try to mimic particular stock indices and use derivative on

## him/herself to a particular asset.

In Figure 1.2, one sees the Belgian Bel-20 Index over a period of more than

4 years.

## Figure 1.2: BEL-20

A new kind of index was generated with the Index of Catastrophe Losses

(CAT-index) by the Chicago Board of Trade (CBOT) lately. The growing num-

ber of huge natural disasters (such as hurricanes and earthquakes) has led the

insurance industry to try to find new ways of increasing its capacity to carry

risks. Currently investors are offered options on the CAT-index, thereby taking

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in effect the position of traditional reinsurance.

## Credit Risk Market

Credit risk captures the risk on a financial loss that an institution incurs

when it lends money to another institution or person. This financial loss real-

izes whenever the borrower does not meet all of its obligations under its borrow-

ing contract. Because credit risk is so important for financial institutions the

banking world has developed instruments that allows them to evacuate credit

risk rather easily. The most commonly known and used example is the credit

## default swap. These instruments can best be considered as tradable insurance

contracts. This means that today I can buy protection on a bond and tomorrow

I can sell that same protection as easily as I bought it. Credit default swaps

work just as an insurance contract. The protection buyer (the insurance taker)

pays a fee and in exchange he gets reimbursed his losses if the company on which

## he bought protection defaults.

In Figure 1.3, one sees credit default swap bid and offer rates for major

## 1.1.2 The Bank Account

In the next Chapter we will start building models for the stock or asset price

## process. Here we focus on one instrument which we typically assume to be

available in all the later on encountered market models: the bank account. There

are two (quite related) regimes under which we will work: discrete or continuous

compounding. This has all to do with when and how frequently the interest

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Figure 1.3: Credit Default Swap rates

gained on the invested money is paid out. Typically the discrete compounding

will be only used in discrete time models; the continuous compound can be used

## Consider an amount A is invested for n years at an interest rate of R per

annum. If the rate is compounded once per annum, the terminal value of the

investment is

A(1 + R)n .

## If it is compounded m times per annum, the terminal value of the investment is

 mn
R
A 1+ .
m

We note that there is a difference. Indeed, take A = 100 euro and n = 1, when

7
the interest rate is 10 percent a year. The first regime leads to 110 euros after

one year. However, with quarterly payments (m = 4), i.e. with payments every

three month, we have after one year 100 × (1.0025)4 = 110.38 euros. In Figure

1.4 one sees the effect of increasing the compounding frequency from a yearly

## discrete compound interest rates (A=100, n=1, r=0.10)

110.6

110.5

110.4
end value

110.3

110.2

110.1

110
0 50 100 150 200 250 300 350
compounding frequency (m)

## The limit as m tends to infinity is known as continuous compounding. We

have
 mn
R
lim A 1 + = A exp(nR).
m→∞ m

## With such a continuous compounding the invested amount A grows to A exp(nR)

after n years. Note that it is because of the above discussion, important to state

## example, an interest rate of 10 percent continuous compounding is the same as

8
(1 − exp(0.10))/100 = 10.517 percent annual compounding.

Throughout the text we will make use of a bank account on which we can

put money and borrow money on a fixed continuously compounded interest rate

r. This means that 1 euro on the bank account at time 0 will give rise to ert

euro on time t > 0. Similarly, if we borrow 1 euro now, we have to pay back ert

euro at time t > 0. Or equivalently, if we borrow now e−rt euro we have to pay

## back 1 euro at time t.

One euro on the bank account will grow over time; at some time t we denote

its value by B(t). Note thus that we set B(0) = 1. We call B = {B(t), t ≥ 0}

## the bank account price process or bond price process.

Related to all this is the time value of money. An investor will prefer 100 euro

in his pocket today to 100 euro in his pocket one year from now. The interest

paid on the riskless bank account expresses this. Using continuous compounding

with a rate r = 0.10, 100 euro is equivalent with 110.517 euros in one year. If

## we receive a cash-flow X at some future time T , the equivalent now is equal to

exp(−rT )X. 100 euro in one year is equivalent with 90.484 euros now. This

## In practitioner’s terms a ’derivative security’ is a security whose value depends

on the value of other more basic underlying securities. We adopt the more

precise definition:

## A derivative security, or contingent claim, is a financial contract whose value

9
at expiration date T (more briefly, expiry) is determined exactly by the price

## Derivative securities can be grouped under three general headings: Options,

Forwards and Futures, and Swaps. During this text we will mainly deal with

## futures and swaps as well.

Options

An option is a financial instrument giving one the right but not the oblig-

## ation to make a specified transaction at (or by) a specified date at a specified

price.

A lot of different type of options exists. We give here the basic types. Call

options give one the right to buy. Put options give one the right to sell. European

options give one the right to buy/sell on the specified date, the expiry date,

on when the option expires or matures. American options give one the right

## average price over a period. Lookback options depend on the maximum or

minimum price over a period and barrier options, depend on some price level

## being attained or not.

The price at which the transaction to buy/sell the underlying assets (or

simply the underlying), on/by the expiry date (if exercised), is made is called

the exercise price or strike price. We usually use K for strike price, time t = 0,

for the initial time (when the contract between the buyer and the seller of the

10
option is struck), time t = T for the expiry or final time.

Consider, say, an European call option, with strike price K; write St for the

value (or price) of the underlying at time t. If St > K, the option is in the

## money, if St = K, the option is said to be at the money and if St < K, the

option is out the money. This terminology is of course motivated by the payoff,

## ST − K if ST > K and 0 otherwise

(more briefly written as (ST − K)+ ). This payoff function for K = 100 is

## Payoff of European Call (K=100)

20

18

16

14

12
Payoff

10

0
80 85 90 95 100 105 110 115 120
stock price at maturity

## Figure 1.5: Payoff of Call Option (K=100)

There are two sides to every option contract. On one side there is the person

who has bought the option (the long position); on the other side you have the

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person who has sold or written the option (the short poistion). The writer

## receives cash up front but has potential liabilities later.

In Figure 1.6, one can see that by investing in an option one can make huge

gains, but also if markets goes the opposite direction as anticipate, it is possible

## to loose all money one has invested.

Figure 1.6: Stock Prices and European Call Option at time t = 0 and t = T .

## In 1973, the Chicago Board Options Exchange (CBOE) began trading in

options on some stocks. Since then, the growth of options has been explosive.

Risk Magazine (12/1997) estimated \$35 trillion as the gross figure for worldwide

## derivatives markets in 1996.

In Figure 1.7, one sees some of the prices of call options written on the SP500-

index. The main aim of this text is to give a basic introduction to models for

## determining these kind of option prices.

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Forwards, Futures

## A forward contract is an agreement to buy or sell an asset at a certain future

date T for a certain price K. It is usually between two large and sophisticated

## financial agents (banks, institutional investors, large corporations, and broker-

age firms) and not traded on an exchange. The agents who agrees to buy the

underlying asset is said to have a long position, the other agent assumes a short

position. The payoff from a long position in a forward contract on one unit of

## an asset with price ST at the maturity time T of the contract is

ST − K.

Compared with a call option with the same maturity and strike price K we see

that the investor now faces a downside risk, too. He has the obligation to buy

## A futures contract, like a forward contract, is an agreement to buy or sell an

asset at a certain future date for a certain price. The difference is that futures

are traded. As such, the default risk is removed from the parties to the contract

Swaps

## A swap is an agreement whereby two parties undertake to exchange, at known

dates in the future, various financial assets (or cash flows) according to a pre-

arranged formula that depends on the value of one or more underlying assets.

Examples are currency swaps (exchange currencies) and interest-rate swaps (ex-

13
change of fixed for floating set of interest payments) and the nowadays popular

1.1.4 Markets

## rules, require a certain degree of standardization of the traded instruments

(strike price, maturity dates, size of contract, etc.). Examples are the Chicago

## Board Options Exchange (CBOE), the London International Financial Futures

Exchange (LIFFE).

## intermediary in the transactions. It garantuess the performanjce of the parties

to each transaction. Its main task is to keep track of all the transactions that

take place during a day so it can calculate the net poistions of each of its

members.

OTC trading takes between various commercial and investments banks such

## 1.1.5 Contract Specifications

It is very important that the financial contract specifies in detail the exact nature

of the agreement between the two parties. It must specify the contract size (how

much of the asset will be delivered under one contract), where delivery will be

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an exchange, it should be made clear how prices will be quoted, when trade is

allowed, etc.

## Financial assets in derivatives are generally well defined and unambiguous,

e.g. it is clear what a Japanese Yen is. When the asset is a commodity, there

may be quite a variation in the quality and it is important that the exchange

## stipulates the grade or grades of the commodity that are acceptable.

Most contracts are refered to by its delivery month and year. The contract

must specify in detail the period of that month when delivery can be made. For

some future the delivery period is the entire month. For other contract delivery

## derivatives on indices (like the SP-500). The settlement price is calculated by

the exchange by a very detailed algorithm. It can be e.g. averages of the index

taken every five minutes during one hour, but also just the closing price of the

asset.

Other specification by the exchange deal with movement limits. Trade will be

halted if these limits are exceeded. The purpose of price limits is to prevent large

15
Hedgers

## Successful companies concentrate on economic activities in which they to best.

They use the market to insure themselves against adverse movements of prices,

## currencies, interest rates etc. Hedging is an attempt to reduce exposure to risk.

Hedgers prefer to forgo the chance to make exceptional profits when future un-

## certainty works to their advantage by protecting themselves against exceptional

loss.

Speculators

Speculators want to take a position in the market – they take the opposite

## position to hedgers. Indeed, speculation is needed to make hedging possible, in

that a hedger, wishing to lay off risk, cannot do so unless someone is willing to

take it on.

## In speculation, available funds are invested opportunistically in the hope of

making a profit: the underlying itself is irrelevant to the speculator, who is only

interested in the potential for possible profit that trade involving it may present.

Arbitrageurs

## actions in two or more markets. An arbitrage opportunity exists, for example, if

a security can be bought in New York at one price and sold at a slightly higher

price in London. The underlying concept of the here presented theory is the

## absence of arbitrage opportunities.

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1.1.7 Modelling Assumptions

We will discuss contingent claim pricing in an idealized case. We will not allow

market frictions; there is no default risk, agents are rational and there is no

## arbitrage. More concrete this means

• no transaction costs

• no taxes

• no margin requirements

## • no restrictions on short sales

• no transaction delays

## The risk of failure of a company – bankruptcy – is inescapably present in

its economic activity: death is part of life. Moreover those risks also appear

at the national level: quite apart from war, recent decades have seen default

17
of interest payments of international debt, or the threat of it (see for example

the 1998 Russian crisis). We ignore default risk for simplicity while developing

## understanding of the principal aspects.

We assume financial agents to be price takers, not price makers. This implies

that even large amounts of trading in a security by one agent does not influence

the security’s price. Hence agents can buy or sell as much of any security as

## they wish without changing the security’s price.

To assume that market participants prefer more to less is a very weak as-

## We want to mention the special character of the no-arbitrage assumption.

It is the basis for the arbitrage pricing technique that we shall develop, and we

1.2 Arbitrage

## in unlimited quantity, using the market as a money-pump to extract arbitrarily

large quantities of riskless profit. This would, for instance, make it impossible

## suffice to determine prices - the arbitrage pricing technique.

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To explain the fundamental arguments of the arbitrage pricing technique we

## Example: Consider an investor who acts in a market in which only three

financial assets are traded: (riskless) bonds B (bank account), stocks S and

European Call options C with strike K = 100 on the stock S. The investor may

invest today, time t = 0, in all three assets, leave his investment until time

t = T and gets his returns back then. We assume the option C expires at time

t = T . We assume the current prices (in euro, say) of the financial assets are

given by

## B(0) = 1, S(0) = 100, C(0) = 20

and that at t = T there can be only two states of the world: an up-state with

euro prices

## B(T, d) = 1.25, S(T, d) = 75, and therefore C(T, d) = 0.

Now our investor has a starting capital of 25000 euro from which he buy the

following portfolio,

Portfolio I:
Stock 100 10000

## Call option 250 5000

19
Depending of the state of the world at time t = T the value of his portfolio

will differ: In the up state the total value of his portfolio is 48750 euro:

TOTAL 48750

## Call option 250 × 0 0

TOTAL 20000

Can the investor do better ? Let us consider the restructured portfolio with

Portfolio II:
Stock 70 7000

## Call option 290 5800

We compute its return in the different possible states. In the up-state the total

20
value of his portfolio is again 48750 euro:

## Call option 290 × 75 21750

TOTAL 48750

and in the down-state his portfolio has again a value of 20000 euro:

## Bond 11800 × 1.25 14750

Stock 70 × 75 5250

## Call option 290 × 0 0

TOTAL 20000

We see that this portfolio generates the same time t = T return while costing

only 24600 euro now, a saving of 400 euro against the first portfolio. So the

investor should use the second portfolio and have a free lunch today!

In the above example the investor was able to restructure his portfolio, re-

ducing the current (t = 0) expenses without changing the return at the future

## date t = T in both possible states of the world. So there is an arbitrage pos-

sibility in the above market situation, and the prices quoted are not arbitrage

prices. If we regard (as we shall do) the prices of the bond and the stock

(our underlying) as given, the option must be mispriced. Let us have a closer

look between the differences between Portfolio II, consisting of 11800 bonds, 70

stocks and 29 call options, in short (11800, 70, 290) and Portfolio I, of the form

21
(10000, 100, 250) The difference is the portfolio, Portfolio III say, of the form

## Call option 40 800

So if you sell short 30 stocks, you will receive 3000 euro from which you

buy 40 options, put 1800 euro in your bank account and have a gastronomic

lunch of 400 euro. But what is the effect of doing that ? Let us consider the

consequences in the possible states of the world. We see in both cases that

the effects of the different positions of Portfolio III offset themselves: In the

up-state:

TOTAL 0

## Stock -30 × 75 -2250

Call option 40 × 75 0

TOTAL 0

22
But clearly the portfolio generates an income at t = 0 of which you had a free

## lunch, and a good one. Therefore it is itself an arbitrage opportunity.

If we only look at the position in bonds and stocks, we can say that this

position covers us against possible price movements of the option, i.e. having

1800 euro in your bank account and being 30 stocks short has the opposite time

## a hedge against the position in options.

Let us emphasize that the above arguments were independent of the prefer-

## We will in this section use arbitrage-based arguments to develop general bounds

on the value of options. In our analysis here we use non-dividend paying stocks

## 1.3.1 The Put-Call Parity

Next, we will deduce a fundamental relation between put and call options, the

so-called put-call parity. Suppose there is a stock (with value St at time t), with

European call and put options on it, with value Ct and Pt respectively at time

## t, with expiry time T and strike-price K. Consider a portfolio consisting of one

stock, one put and a short position in one call (the holder of the portfolio has

23
written the call); write Πt for the time t value of this portfolio. So

Πt = S t + P t − C t .

## For the above portfolio we hence get at time T the payoff

if ST ≥ K : ΠT = ST + 0 − (St − K) = K,

if ST ≤ K : ΠT = ST + (K − St ) − 0 = K.

## at time t? The riskless way to guarantee a payoff K at time T is to deposit

Ke−r(T −t) in the bank at time t and do nothing (we assume continuously com-

pounded interest here). Under the assumption that the market is arbitrage-free

the value of the portfolio at time t must thus be Ke−r(T −t) , for it acts as a

synthetic bank account and any other price will offer arbitrage opportunities.

## Let us explore these arbitrage opportunities.

If the portfolio is offered for sale at time t too cheaply–at price Πt <

Ke−r(T −t) – we can buy it, borrow Ke−r(T −t) from the bank, and pocket a

positive profit Ke−r(T −t) − Πt > 0. At time T our portfolio yields K, while our

bank debt has grown to K. We clear our cash account – use the one to pay off

## the other – thus locking in our earlier profit, which is riskless.

If on the other hand the portfolio is priced at time t at a too high price –

at price Πt > Ke−r(T −t) – we can do the exact opposite. We sell the portfolio

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short – that is,we buy its negative: buy one call, write one put, sell short one

stock, for Πt and invest Ke−r(T −t) in the bank account, pocketing a positive

profit Πt − Ke−r(T −t) > 0. At time T , our bank deposit has grown to K, and

again we clear our cash account – use this to meet our obligation K on the

## We illustrate the above with so-called arbitrage tables. In such a table we

simply enter the current value of a given portfolio and then compute its value

in all possible states of the world when the portfolio is cashed in. In the case

ST < K ST ≥ K

## borrow Ke−r(T −t) −K −K

Ke−r(T −t) − St
TOTAL 0 0
−Pt + Ct > 0

Thus the rational price for the portfolio at time t is exactly Ke−r(T −t). Any

other price presents arbitrageurs with an arbitrage opportunity (to make and

## lock in a riskless profit) – which they will take ! Therefore

Proposition 1 We have the following put-call parity between the prices of the

underlying asset and its European call and put options with the same strike price

25
and maturity on stocks that pay no dividends:

St + Pt − Ct = Ke−r(T −t) .

The value of the portfolio above is the discounted value of the riskless equiv-

alent. This is a first glimpse at the central principle, or insight, of the entire

## 1.3.2 The Forward Contract

Next, we will deduce a fair price (based on the no-arbitrage assumption) for the

following forward contract: The contract states that party A (the buyer) must

buy from party B (the seller) the (non-dividend paying) stock at time T at the

## derivative which party A will pay to party B at time t = 0. Indeed, suppose

you are party B, so you sold the forward contract and has received at time

## • borrow exp(−rT )K.

To buy the stock you need S0 . You already have from the forward F = S0 −

exp(−rT )K and receives from your loan exp(−rT )K. So you spent all the

## available money and at time t = 0 you have the following portfolio:

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• long 1 stock.

• short 1 forward;

## • short exp(−rT )K bonds.

Look what happens at time T . You must deliver the stock to party A. You

contract ends and you pay back your bank. You have to pay back the amount

exp(rT ) exp(−rT )K = K. This you can do exactly with the money you received

from party A. In the end everything is settled, you have no gain, no lost. Note

## that your initial investment is also zero.

Note that any other price for the forward would have led to an arbitrage

situation. Indeed, suppose you received F̂ > F . Then by following the above

strategy you pocket at time t = 0 the difference F̂ − F > 0 which you can freely

spent. At time T you just close all the position as described above. Without

any initial investment and risk, you have then spent at time 0, F̂ − F > 0. This

is clearly an arbitrage opportunity (for party B). In case F̂ < F , party A con

set up a portfolio will always leads to an arbitrage opportunity (check this !).

## K, such that F = S0 − exp(−rT )K = 0, i.e.

K = exp(rT )S0 .

By doing this entering (in both ways: long or short) a forward contract is at

zero cost. For this reason, exp(rT )S0 is called the time T forward price of the

stock.

27
Finally, note that the put-call parity can be simply rewritten in terms of

the call price, the put price and the forward contract price as: C − P = F (all

derivatives have the same strike and time to maturity). From this one can see

that at the forward price of the stock, i.e. in case K = exp(rT )S0 and hence

## F = 0, call and puts have the same value: C = P .

1.3.3 Dividends

Up to now, we have assumed that the risky asset pays no dividends, however

in reality stocks can pay some dividend to the stock holders at some moments.

We assume that the amount and timing of the dividends during the live of an

option can be predicted with certainty. Moreover, we will assume that the stock

pays a continuous compound dividend yield at rate q per annum. Other ways

## following a process of the form:

St = exp(−qt)S̄t ,

where S̄ is describing the stock prices behavior not taking into account divi-

dends. A stock which pays continuously dividends and an identical stock that

not pays dividends should provide the same overall return, i.e. dividends plus

capital gains. The payment of dividends causes the growth of the stock price to

## continuous dividend yield of q, the stock price grows from S0 to ST at time T ,

28
then in absence of dividends it would grow from S0 to exp(qt)ST . Alternatively,

## in absence of dividends it would grow from exp(−qt)S0 to ST . This argumen-

tation brings us to the fact that we get the same probability distribution for

the stock price at time T in the following cases: (1) The stock starts at S0

and pays a continuous dividend yield at rate q and (2) the stock starts at price

## exp(−qt)S0 and pays no dividend yield.

The put-call parity for a stock with dividend yield q can be obtained from the

## put-call parity for non-dividend-paying stocks. With no dividends we obtained

St + Pt − Ct = K exp(−r(T − t)).

If we now take into account dividends, the change comes down to replacing St

## This relation can be proven by considering the portfolio consisting of exp(−q(T −

t)) number of stocks, one put option and minus one call option. We reinvest

## future time point t ≤ s ≤ T , we have exp(−q(T − s)) number of stock; at the

expiry date of the option we own one stock, one put and minus one call. The

value of the portfolio at that time thus always equals K. By the no-arbitrage

argument the time T value of the portfolio must equal K exp(−r(T − t)), the

## time t-value of a future payment (at time T ) of K.

If our asset is an index, the dividend yield is the (weighted) average of the

29
dividends yields on the stocks composing the index.In practice, the dividend

yield can be determined from the forward price of the asset. It is the agreement

to buy or sell an asset at a certain future time for a certain price, the delivery

price. At the time the contract is entered into, the delivery price is chosen so

that the value of the forward is zero. This means that it costs nothing to buy or

sell the contract. For an asset paying a continuous yield at rate q, the delivery

## F = S0 exp((r − q)T ). (1.1)

Assuming the short rate r and the delivery price of the forward as given, q can

easily be obtained.

1.3.4 Currencies

If the underlying is not a stock but a currency, we must take into account the

## We are in Europe so our domestic currency is the euro. Consider a forward

contract on the USD: you must buy N USD at some point in the future T for

## the price of K EUR/USD. Assume the currence exchange rate is S0 EUR/USD.

What is the value of this future contract and for what value of K such that

the contract has a zero value (the forward price of the USD). It will turn out

now

K = exp((rd − rf )T )S0 .

30
Indeed, suppose K > exp((rd − rf )T )S0 . An investor can then do the following

## • Borrow N × S0 exp(−rf T ) EUR at rate rd .

• Use this cash to buy N × exp(−rf T ) USD and put this on an USD-

bankaccount at rate rf

## • Short the forward contract.

Then the holding of the foreign currency grows to N because of the interest (rf )

earned. Under the terms of the contract this holding is exchanged for N × K

## borrowing. Hence a net profit of N × (K − S0 exp((rd − rf )T )) > 0 is, therefor,

made at time T . In case K < exp((rd − rf )T )S0 you can the following

## • Borrow N × exp(−rf T ) USD at rate rf .

• Use this cash to buy N × S0 exp(−rf T ) EURD and put this on an EUR-

bankaccount at rate rd

## then the domestic currency grows to N × S0 exp((rd − rf )T )), you pay N × K

to receive N USD and uses these dollars to pay the loan. In total you earned

## N × (S0 exp((rd − rf )T )) − K) which in this case was assumed to be positive.

31
1.3.5 Commodities

We now consider the cas of commodities. Important here is the impact of storage

costs. If the storage costs incurred at any time are proportional to the price of

## this case from equation (1.1),

F = S0 exp((r + u)T ),

where u is the storage costs per annum as a proportion of the spot price.

## 1.3.6 The Cost of Carry

The relationship between all above future/forward prices and spot prices can be

summerized in terms of what is known as the cost of carry. This measures the

storage cost plus the interest that is paid to finance the asset less the income

earned on the asset. For a non-dividend paying stock, the cost of carry is r since

there are no storage costs and no income is earned; for a stock index, it is r − q

## commodity with storage costs that are a proportion u of the price, it is r + u;

and so on.

Define the cost of carry as c. For an investment asset, the future price is

F = S0 exp(cT ).

32
Figure 1.7: Call options on S&P 500 Index

33
Chapter 2

Binomial Trees

## 2.1 Single Period Market Models

Our aim here is to show in the simplest possible non-trivial model how the

## theory based on the principle of no-arbitrage works.

Example

Let our financial market consist of two financial assets, a riskless bank account

(or bond) B and a risky stock S, with today’s price S0 = 20 euro. We look at

a single-period model and assume that starting from today (t = 0) the world

can only be in one of two states at time t = T : the stock price will either be

## ST = 22 euro or ST = 18 euro. We are interested in valuing a European call

option to buy the stock for 21 euro at time t = T . At time t = T , this option

can have only two possible values. It will have value 1 euro, if the stock price

34
Figure 2.1: One-period binomial tree example

is 22 euro; if the stock price turns out to be 18 euro at time t = T , the value of

## the option will be zero. The situtation is illustrated in Figure 2.1.

It turns out that we can price the option by the assumption that no arbitrage

opportunities exist. We set up a portfolio of the stock and the option in such a

way that there is no uncertainty about the value of the portfolio at the time of

expiry, t = T . We then argue that, because the portfolio has no risk, the return

earned on it must equal the risk-free interest rate of the bank account. This

enables us to work out the cost of setting up the portfolio and, therefore, the

option’s price.

## Consider a portfolio consisting of a long postion in ∆ shares of the stock and

a short position in one call option. We calculate the value of ∆ that makes the

portfolio riskless. If the stock price moves up from 20 to 22 euro, the value of

the shares is 22∆ and the value of the option is 1 euro, so that the total value

of the portfolio is 22∆ − 1 euro. If the stock price moves down from 20 to 18

euro, the value of the shares is 18∆ euro and the value of the option is zero, so

that the total value of the portfolio is 18∆ euro. The portfolio is riskless if the

35
value of ∆ is chosen so that the final value of the portfolio is the same for both

22∆ − 1 = 18∆

or

∆ = 0.25

## • Long 0.25 shares.

• Short 1 option.

## If the stock price moves up to 22 euro, the value of the portfolio is

22 × 0.25 − 1 = 4.5.

If the stock price moves down to 18 euro, the value of the portfolio is

18 × 0.25 = 4.5.

Regardless of whether the stock price moves up or down, the value of the port-

folio is always 4.5 euro at the end of the life of the option.

## Riskless portfolios must, in the absence of arbitrage opportunities, earn the

risk free rate of interest. Suppose that in this case the risk-free rate is 12 percent

per annum and that T = 0.5, i.e. six months. It follows that the value of the

## portfolio today must be the present value of 4.5 euro, or

4.5e−0.12×0.5 = 4.238

36
The value of the stock today is known to be 20 euro. Suppose the option price

## is denoted by f . The value of the portfolio today is

20 × 0.25 − f = 5 − f

It follows that

5 − f = 4.238

or

f = 0.762.

This shows that, in the absence of arbitrage opportunities, the current value of

the option must be 0.762. If the value of the option were more than 0.762 euro,

the portfolio would cost less than 4.238 euro to set up and would earn more than

the risk-free rate. If the value of the option were less than 0.762 euro, shorting

the portfolio would provide a way of borrowing money at less than the risk-free

rate.

In other words, if the value of the option were more than 0.762 euro, for

example 1 euro, you can borrow for example 42380 euro and buy 10000 times

## the above portfolio at a cost of

10000(0.25 × 20 − 1) = 40000euro.

You pocket 2380 euro and after 6 months, you sell 10000 portfolio and cashes in

45000, because the value of one portfolio is always 4.5 euro. With this money

you pay back the bank for the money you borrowed plus the interests on it, i.e.

you pay the bank an amount of 42380 × e0.12×0.5 = 45000 euro. At the end

37
Figure 2.2: General one-period binomial tree

of all this you earned 2380 euro without taking any risk and without an initial

capital. If the value of the option were less than 0.762 euro, you do the opposite.

Generalization

## price is initially S0 and an option on the stock whose current price is f . We

suppose that the option lasts for time T and that during the life of the option

the stock can move up from S0 to a new level, S0 u or down from S0 to a new

level, S0 d (u > 1; 0 < d < 1). If the stock price moves up to S0 u, we suppose

that the payoff from the option is fu ; if the stock price moves down to S0 d, we

suppose the payoff from the option is fd . The situation is illustrated in Figure

2.2.

## As before, we imagine a portfolio constisting of a long position in ∆ shares

and a short position in one option. We calculate the value of ∆ that makes the

portfolio riskless. If there is an up movement in the stock price, the value of the

38
portfolio at the end of the life op the option is

S0 u∆ − fu .

S0 d∆ − fd .

## The two are equal when

S0 u∆ − fu = S0 d∆ − fd ,

or

fu − f d
∆= . (2.1)
S0 u − S 0 d

In this case, the portfolio is riskless and must earn the riskless interest

rate. If we denote the risk-free interest rate by r, the present value of the

portfolio is

## The cost of setting up the portfolio is

S0 ∆ − f.

It follows that

(S0 u∆ − fu )e−rT = S0 ∆ − f,

or

f = S0 ∆ − (S0 u∆ − fu )e−rT .

39
Substituting from equation (2.1) for ∆ and simplifying, this equation reduces

to

## f = e−rT [pfu + (1 − p)fd ] (2.2)

where

erT − d
p= (2.3)
u−d

Remark 2 If we assume that u > erT , together with u > 1 and 0 < d < 1,

one can easily show that the value of p given in (2.3) satisfies 0 < p < 1. Note

that it is natural to assume that u > erT , because it means that after a time T ,

you can gain more (a factor u) by investing in the risky stocks, than you can

earn with a riskless investment in bond (a factor erT ). If this was not the case

no one would invest in stocks. Ofcourse, you can also lose money (d factior by

investing in stocks.

Remark 3 Equation (2.1) shows that ∆ is the ratio of the change in the option

## price to the change in the stock price.

Remark 4 The option pricing formula in (2.2) does not involve the probabili-

ties of the stock moving up or down. This is suprising and seems counterintu-

itive. The key reason is that the probabilities of future up or down movements

## are already incorporated into the price of the stock.

Risk-Neutral Valuation

## an up and down movement in order to derive Equation (2.2), it is natural to

40
interpret the variable p in Equation (2.2) as the probability of an up movement

in the stock price. The variable 1−p is then the probability of a down movement,

## and the expression

pfu + (1 − p)fd

is the expected payoff from the option. With this interpretation of p, Equation

(2.2) then states that the value of the option today is its expected future value

## discounted at the risk-free rate.

We now investigate the expected return from the stock when the probability

## of an up movement is assumed to be p. The expected stock price at time T ,

Ep [ST ], is given by

## Ep [ST ] = pS0 u + (1 − p)S0 d

= pS0 (u − d) + S0 d.

## Ep [ST ] = S0 erT (2.4)

showing that the stock price grows, on average, at the risk-free rate. Setting the

## probability of an up movement equal to p is therefore, equivalent to assuming

that the return on the stock equals the rsik-free rate. In a risk-neutral world

the expected return on all securities is the risk-free interest rate. Equation (2.4)

shows that we are assuming a risk-neutral world when we set the proability of

an up movement to p. Equation (2.2) shows that the value of the option is its

## expected payoff in a risk-neutral world discounted at the risk-free rate.

41
This result is an example of an important genereal principle in option pricing

## known as risk-neutral valuation. The principle states that it is valid to assume

the world is risk neutral when pricing options. The resulting option prices

are correct not just in a risk-neutral world, but in the real world as

well.

## The Single-Period Example Revisited

We now turn back to the numerical example in Figure 2.1 to illustrate that risk-

## neutral valuation gives the same answers as no-arbitrage arguments. In Figure

2.1, the stock price is currently 20 euro and will move either up to 22 euro or

down to 18 euro at the end of six months. The option considered is a European

call option with strike price of 21 euro and an expiration date in six months.

## We define p as the probability of an upward movement in the stock price in

a risk-neutral world. (We know from the analysis given earlier in this section

that p is given by Equation (2.3). However, for the purpose of this illustration

## we suppose that we do not know this.) In a risk-neutral world the expected

return on the stock must be the risk-free rate of 12 percent. This means that p

must satisfy

## 22p + 18(1 − p) = 20e0.12×0.5

or
20e0.12×0.5 − 18
p= = 0.8092
4

At the end of the six months, the call option has a 0.8092 probability of being

42
worth 1 euro and a 0.1908 probability of being worth zero. Its expected value

is, therefore,

## value of the option today is, therefore,

0.8092e−0.12×0.5 = 0.7620

This is the same value as the value obtained earlier, illustrating that no-arbitrage

## 2.2 Two-Step Binomial Trees

We can extend the analysis to a two-step binomial tree. The objective of the

analysis is to calculate the option price at the initial node of the tree. This can

## 2.2.1 European Call

We can first apply the analysis to a two-step binomial tree. Here the stock price

starts at 20 euro and in each of the two time steps may go up by 10 percent or

down by 10 percent. We suppose that each time step is six months long and

## We consider a European call option with a strike price of 21 euro. Figure

2.3 shows the tree with both the stock price and the option price at each node.

(The stock price is the upper number and the option price is the lower number.)

43
Figure 2.3: Two-period binomial tree example

The option prices at the final nodes of the tree are easily calculated. They are

the payoffs from the option. At node D, the stock price is 24.2 euro and the

option price is 24.2 − 21 = 3.2 euro; at nodes E and F, the option is out of the

## money and its value is zero.

At node C, the option price is zero, because node C leads to either node E

or node F and at both nodes the option price is zero. Next, we calculate the

## Using the notation introduced earlier in the chapter, u = 1.1, d = 0.9,

r = 0.12, and T = 0.5 so that p = 0.8092. Equation (2.2) gives the value of the

option at node B as

## It remains for us to calculate the option at the initial node, A. We do so by

focusing on the first step of the tree. We know that the value of the option at

node B is 2.4386 and that at node C it is zero. Equation (2.2), therefore, gives

44
Figure 2.4: General two-period binomial tree

## The value of the option is 1.8583 euro.

We can generalize the case of two time steps by considering the situation in

Figure 2.4.

## The stock price is initially S0 . During each step, it either moves up to u

times its value or moves down to d times its value. The notation for the value

of the option is shown on the tree. For example, after two up movements, the

value of the option is fuu . We suppose that the risk-free interest rate is r and

## f = e−r∆t [pfu + (1 − p)fd ] (2.7)

45
Substituting the first two equations in the last one, we get

## This is constistent with the principle of risk-neutral valuation mentioned earlier.

The variable p2 , 2p(1 − p), and (1 − p)2 are the probabilities that the upper,

middle, and lower final nodes will be reached. The option price is equal to

interest rate.

## As we add more steps to a binomial tree, the risk-neutral valuation principle

continues to hold. The option price is always equal to the present value (dis-

world.

## In practice, when constructing a binomial tree to represent the movements in

a stock price, we choose the parameters u and d to match the volatility of the

stock price. To see how this is done, suppose that the expected return on a stock

in the real world is µ: The expected stock price at the end of the first time

## step is S0 (1 + µ∆t). The volatility of a stock price, σ, is defined so that σ 2 ∆t is

the variance of the return in a short period of time of length ∆t. Suppose from

## world is equal to q. In order to match the expected return on the stock, we

46
must therefore, have

or

(1 + µ∆t) − d
q= (2.9)
u−d

## qu2 + (1 − q)d2 − [qu + (1 − q)d]2 .

In order to match the real world stock price volatility we must therefore have

or equivalently

## supposed to be small), one solution to this equation is

u = (1 + σ ∆t) (2.11)

d = (1 − σ ∆t) (2.12)

47
Indeed,

## = −(1 + µ∆t)2 + (1 + µ∆t)(u + d) − ud

√ √
= −1 − 2µ∆t − (µ∆t)2 + 2(1 + µ∆t) − (1 + σ ∆t)(1 − σ ∆t)

= −(µ∆t)2 + σ 2 ∆t

Another setting is

u = eσ ∆t
(2.13)

d = e−σ ∆t
, (2.14)

## which is, because ∆t is supposed to be small, approximatelly the same as (2.11).

These are the values proposed by Cox, Ross and Rubinstein. Note that in both

cases the values of u and d are independent of µ, which implies that if we move

from the real world to the risk-neutral world the volatility on the stock remains

the same (at least in the limit as ∆t tends to zero). This is an illustration

## of an important general result known as Girsanov’s theroem. When we move

from a world with one set of risk preferences to a world with another set of risk

preferences, the expected growth rates change, but their volatilities remain the

same. Moving from one set of risk preferences to another is sometimes referred

## to as changing the measure.

48
2.3 Binomial Trees

The above one- and two-steps binomial trees are very imprecise models of reality

and are used only for illustrative purposes. Clearly an analyst can expect to

## obtain only a very rough approximation to an option price by assuming that

the stock movements during the life of the option consist of one or two binomial

steps. When binomial trees are used in pratice, the life of the option is typically

divided into 30 or more time steps of length ∆t. In each time step there is

a binomial stock movement. With 30 time steps this means that 31 terminal

stock prices and 230 possible stock price paths are considered.

## Consider the evaluation of an option on a non-dividend-paying stock. We start

by dividing the life of the option into a large number of small intervals of length

∆t. We assume that in each time interval the stock price moves from its initial

value S to one of two new values Su and Sd. In general, u > 1 and 0 < d < 1.

The movement from S to Su is, therefore, an ”up” movement and the movement

## from S to Sd is a ”down” movement. In the above sections we introduced what

is known as the risk-neutral valuation principle. This states that any security

which is dependent on a stock can be valued on the assumption that the world

is risk neutral. It means that for the purposes of valuing an option, we can

assume:

• The expected return from all traded securities is the risk-free interest rate.

49
• Future cash flows can be valued by discounting their expected values at

## the risk-free interest rate.

We make use of this when using a binomial tree. The tree is designed to represent

er∆t − d
p= .
u−d

## As mentioned above, a popular way of chosing the parameters u and d is

u = eσ ∆t

d = e−σ ∆t

Figure 2.5 illustrates the tree of stock prices over 5 time periods that is

## considered when the binomial model is used.

At time zero, the stock price S0 is known. At time ∆t there are two possible

stock prices, S0 u and S0 d; at time 2∆t, there are three possible stock prices,

S0 u2 , S0 ud, and S0 d2 ; and so on. In general, at time i∆t, i + 1 stock prices are

## considered. These are

S0 uj di−j , j = 0, . . . , i.

European call and put options are evaluated by starting at the end of the tree

(time T ) and working backward. The value of the option is known at time T .

## For example, a European put option is worth max{K − ST , 0} and a European

call option is worth max{ST − X, 0}, where ST is the stock price at time T and

50
Figure 2.5: General binomial tree for stock price

K is the strike price. Because a risk-neutral world is being assumed, the value

## at each node at time T − ∆t can be calculated as the expected value at time T

discounted at rate r for a time period ∆t. Similarly, the value at each node at

## time T − 2∆t can be calculated as the expected value at time T − ∆t discounted

for a time period ∆t at rate r, and so on. Eventually, by working back through

all the nodes, the value of the option at time zero is obtained. This procedure

## is illustrated in Figure 2.6.

Another way of calculating the option prices is by directly taking the dis-

counted value of the expected payoff of the option in the risk-neutral world. For

example the European put, with strike price K and maturity T has a value:
 
N
X  N 
e−rT 

 max{K − S0 uj dN −j , 0}pj (1 − p)N −j

j=0 j

For more complex options, but where the payoff only depends on the final stock

price, i.e. the payoff is a function of ST , g(ST ) say, a similar expression can be

51
Figure 2.6: General binomial tree for stock price

## derived; the current value of the option is then given by:

 
N
X  N 
e−rT Ep [g(ST )] = e−rT 

 g(S0 uj dN −j )pj (1 − p)N −j ,

j=0 j

where Ep denotes the expectation in the risk-neutral world, i.e. with a probabil-

## of (1 − p), or equivalently, with a probability

 
 N  j
  p (1 − p)N −j (2.15)
 
j

## called the Binomial distribution.

52
2.3.2 American Options

## If the option is American, the procedure only changes slightly. It is necessary

to check at each node to see whether early exercise is preferable to holding the

option for a further time period ∆t. Eventually, again by working back through

all the nodes the value of the option at time zero is obtained.

## Consider a five-month American put option on a non-dividend-paying stock

when the current stock price is 50 euro, the strike price is also 50 euro, the risk-

free interest rate is 10 percent per annum, and the volatility is 40 percent per

annum. With our usual notation, this means that S0 = 50, K = 50, r = 0.10,

σ = 0.40, and T = 152/365 = 0.416. Suppose that we divide the life of the

option into five intervals of length one month (= 0.0833 year) for the purposes

∆t = 0.0833

u = eσ ∆t
= 1.1224

d = e−σ ∆t
= 0.8909

## Figure 2.7 shows the related binomial tree.

At each node there are two numbers. The top one shows the stock price

at the node; the lower one shows the value of the option at the node. The

53
Figure 2.7: Binomial tree for American put option

## time i∆t (i = 0, 1, 2, 3, 4, 5) is calculated as S0 uj di−j .

The option prices at the final nodes are calculated as max{K − ST , 0}. The

option prices at the penultimate nodes are calculated from the option prices at

the final nodes. First, we assume no exercise of the option at the nodes. This

means that the option price is calculated as the present value of the expected

option price one step later. For example at node C, the option price is calculated

as

## (0.5073 × 0 + 0.4927 × 5.45)e−0.10×0.0833 = 2.66

54
whereas at node A it is calculated as

## We then check to see if early exercise is preferable to waiting. At node C,

early exercise would give a value for the option of zero because both the stock

price and the strick price are 50 euro. Clearly it is best to wait. The correct

value for the option at node C is, therefore, 2.66 euro. At node A, it is a different

## story. If the option is exercised, it is worth 50 − 39.69 = 10.31 euro. This is

more than 9.90. If node A is reached, the option should therefore, be exercised

and the correct value for the option at node A is 10.31 euro.

Option prices at earlier nodes are calculated in a similar way. Note that it

is not always best to exercise an option early when it is in the money. Consider

## node B. If the option is exercised, it is worth 50 − 39.69 = 10.31 euro. However,

if it is held, it is worth

## (0.5073 × 6.38 + 0.4927 × 14.64)e−0.10×0.0833 = 10.36

The option should, therefore, not be exercised at this node, and the correct

## option value at the node is 10.36 euro.

Working back through the tree, we find the value of the option at the initial

node to be 4.49 euro. This is our numerical estimate for the option’s current

value. In practice, a smaller value of ∆t, and many more nodes, would be used.

It can be shown that with 30, 50, and 100 time steps we get values for the option

## In general suppose that the life of an American put option on a non-dividend-

55
paying stock is divided into N subintervals of length ∆t. We will refer to the

jth node at time i∆t as the (i, j) node. Define fi,j as the value of the option

at the (i, j) node. The stock price at the (i, j) node is S0 uj di−j . Because the

that

## fN,j = max{K − S0 uj dN −j , 0}, j = 0, 1, . . . , N

There is a probability, p, of moving from the (i, j) node at time i∆t to the

## for 0 ≤ i ≤ N − 1 and 0 ≤ j ≤ i. When early exercise is taken into account, this

value for fi,j must be compared with the option’s intrinsic value, and we obtain

## fi,j = max K − S0 uj di−j , e−r∆t (pfi+1,j+1 + (1 − p)fi+1,j )



Note that, because the calculations start at time T and work backward, the

value at time i∆t captures not only the effect of early exercise possibilities at

time i∆t, but also the effect of early exercise at subsequent times. In the limit as

∆t tends to zero, an exact value for the American put is obtained. In practice,

## N = 30 usually gives reasonable results.

56
It is never optimal to exercise an American call option

We are now going to proof that for a non-dividend paying stock the price of a

European call and an American call are the same. This means that an early

first proof

## Proposition 5 The current price C of a European (and American) call option,

with strike price K and time to expiry T , on a non-dividend paying stock with

## C ≥ max{S − e−rT K, 0}.

Proof: That C ≥ 0 is obvious, otherwise ’buying’ the call would give a riskless

## profit now and no obligations later.

To prove the remaining lower bound, we setup an arbitrage table (Table 2.1)

## So in all possible states of the world at expiry we have a non-negative return

for a portfolio, which has a positive current cash flow. This is clearly an arbitrage

## opportunity and hence our assumption was wrong. •

Suppose now that the American call is exercised at some time t strictly less

than expiry T , i.e. t < T . The financial agent thereby realises a cash-flow

57
Portfolio Current cash flow Value at expiry

ST ≤ K ST > K

## Short 1 stock S −ST −ST

Buy 1 call −C 0 ST − K

## Bank account −e−rT K K K

Balance S − C − e−rT K ≥ 0 K − ST ≥ 0 0

## Table 2.1: Arbitrage table for bounds on calls

St − K. From the above proposition we know that the value of the call must be

## greater or equal to St − e−r(T −t) K, which is greater than St − K. Hence selling

the call would have realised a higher cash-flow and the early exercise of the call

## was suboptimal. In conclusion:

CA = C E

There are two reasons why an American call should not be exercised early.

• Insurance: An investor which holds the call option does not care if the

share price falls far below the strike price - he just discards the option -

but if he held the stock, he would. Thus the option insures the investor

against such a fall in stock price, and if he exercises early, he loses this

insurance.

• Interest on the strike price: When the holder exercises the option, he buys

the stock and pays the strike price, K. Early exercise at time t < T

58
deprives the holder of the interest on K between times t and T : the later

## he pays out K, the better.

Notice how this changes when we consider American puts in place of calls:

The insurance aspect above still holds, but the interest aspect above is reversed

(the holder receives cash K at the exercise time, rather than paying it out).

## 2.4 Moving towards The Black-Scholes Model

By creating a tree with more and more time steps, that is by taking smaller and

smaller time-steps, we can get finer and finer graduations at the final stage and

## about how we do this in order to get the prices to converge to a meaningful

value. Which limiting price we obtain will depend on how we make the tree

finer - this essentially comes down to assumptions we make about the random

## process the asset follows.

Let us try to price an option with payoff function f (ST ) and we will refine

u = eσ ∆t
(2.16)

d = e−σ ∆t
. (2.17)

## Taking N time steps we have that risk-neutral probaility of moving upwards

equals:
p
exp(rT ) − exp(−σ T /N )
pN = p p
exp(σ T /N − exp(−σ T /N))

59
Let us now investigate the risk-neutral limiting distribution of ST :
 
N
Y √ √ XN
ST = S 0 eZj σ T /N = S0 exp σ ∆t Zj  ,
j=1 j=1

where Zj are independent random variables taking the values −1 and 1, with

## probabilities pN and 1 − pN respectively, for j = 1, . . . , N .

In other words:

p N
X
log ST = log S0 + σ T /N Zj .
j=1

## Theorem 6 (CLT) Assume X1 , X2 , . . . is a series of independent random varoables,

all with the same distribution as X of which the second moment is finite. Then
PN
j=1 −N E[X]
p →D N ,
N Var[X]

with N a standard Normal distributed variable (with mean zero and variance

equal to one).

We note that

E[Zj ] = 2pN − 1;

Var[Zj ] = 4pN (1 − pN ).

## Hence, a simple calculation, using

p
N E[Zj ] T /Nσ → (r − (1/2)σ 2 )T ;
q p √
Var[Zj ]N T /Nσ → σ T.

60

 
1 2
log ST →D log S0 + σ T N + r − σ T
2

when N → +∞. The distribution of the logarithm of the stock price thus follows



## The price of the derivative in the limit will be given by

    
1 2
lim exp(−rT )EpN [g(ST )] = exp(−rT )E g S0 exp(σ T N + r − σ T .
N →∞ 2

In case of the European call option with strike K and time to maturity T , one

can with a little effort show that its initial price is given by:

## C(K, T ) = S0 N(d1 ) − K exp(−rT )N(d2 ),

where

σ2
ln(S0 /K) + (r + 2 )T
d1 = √ (2.18)
σ T
σ2 √
ln(S0 /K) + (r − 2 )T
d2 = √ = d1 − σ T (2.19)
σ T

and N (x) is the cumulative probability distribution function for a variable that

## course ”Continuous Financial Mathematics”.

61
Chapter 3

Mathematical Finance in

Discrete Time

Any variable whose value changes over time in an uncertain way is said to

## time or continuous-time. A discrete-time stochastic process is one where the

value of the variable can change only at certain fixed points in time, whereas

## take any value within a certain range, whereas in a discrete-variable process,

only certain discrete values are possible. Binomial tree models belong to the

## discrete-time, discrete-variable stochastic processes.

62
In this chapter we study so-called finite markets, i.e. discrete-time models

of financial markets in which all relevant quantities take a finite number of val-

ues. We specify a time horizon T , which is the terminal date for all economic

activities considered. For a simple option pricing model the time horizon typi-

cally corresponds to the expiry date of the option. We thus work with a finite

probability space (Ω, P ), with a finite number |Ω| of possible outcomes ω, each

## the most important determinant of success in financial life. We shall confine

ourselves to the situation where agents take decisions on the basis of information

in the public domain, available to all. We shall further assume that information

## once known remains known and can be accessed in real time.

Our financial market contains two financial assets. A risk-free asset (the

bond) with a deterministic price process Bi , and a risky assets with a stochastic

## price process Si . We assume B0 = 1 (we reckon in units of the initial value of

the bond) and Bi > 0; we say it is a numeraire. 1/Bi is called the discounting

factor at time i.

## exists a mathematical object to model this information flow, unfolding with

63
time: filtrations. The concept filtration is not that easy to understand. The full

theory will lead us too far. In order to clear this out a bit, we explain the idea

## of filtration in a very idealized situation. We will consider a stochastic process

X which starts at some value, zero say. It will remain there until time t = 1,

## at which it can jump with positive probability to the value a or to a different

value b. The process will stay at that value until time t = 2 at which it will

jump again with positive probability to two different values: c and d say if is

was at time t = 1 at a and f and g say if the process was at time t = 1 at state

b. From then on the process will stay in the same value. The universum of the

probability space consists of all possible paths the process can follow, i.e. all

## ω2 , ω3 and ω4 respectively. So we have Ω = {ω1 , ω2 , ω3 , ω4 }.

In this situation we will take the following flow of information, i.e. filtrations:

Ft = {∅, Ω} 0 ≤ t < 1;

## Ft = {∅, Ω, {ω1, ω2 }, {ω3 , ω4 }} 1 ≤ t < 2;

Ft = D(Ω) = F 2 ≤ t.

## We set here F = D(Ω), the set of all subsets of Ω.

To each of the filtrations given above, we associate resp. the following par-

64
titions (i.e. the finest possible one) of Ω:

P0 = {Ω} 0 ≤ t < 1;

## t = 2 we will know which event ω ∗ ∈ Ω has happened. So at times 0 ≤ t < 1 we

only know that some event ω ∗ ∈ Ω. At time point after t = 1 and strictly before

t = 2, i.e. 1 ≤ t < 2, we know to which state the process has jumped at time

## jumped to b. Finally, at time t = 2, we will know to which set of P2 , ω ∗ will

belong, in other words we will know then the complete path of the process.

During the flow of time we thus learn about the partitions. Having the

## information Ft revealed is equivalent to knowing in which set of the partition

of that time, the event ω ∗ is. The partitions become finer in each step and thus

## We thus keep in mind that a filtration F = (Fi , i = 0, 1, . . . , T ) exists of a

sequence of mathematical objects (σ-algebras), F0 ⊂ F1 ⊂ · · · ⊂ FT , describing

## the information available. At time i we have access to information in Fi . It is

clear that the price of the stock Si at time i (and i − 1, i − 2, ..., 0) is contained

in the information Fi .

## If a random variable X is known with respect to the information G we say

65
it is G-measurable. So we have that Si is Fi -measurable. A stochastic process

## (or just G−adapted) if at every time point i = 0, 1, . . . , T the random variable

Xi is Gi -measurable. So we have that S = {Si , i = 0, 1, . . . , T } is F-adapted.
A trading strategy ϕ = {ϕi = (βi , ζi ), i = 1, . . . , T } is a real vector stochastic

process such that each ϕi is Fi−1 -adapted. Here βi , ζi denotes the numbers of

bonds ands stocks resp. held at time i and to be determined on the basis of

information available strictly before time i: Fi−1 ; i.e. the investor selects his

time i portfolio after observing the prices Si−1 . The components βi , ζi may

assume negative values as well as positive values, reflecting the fact that we

allow short sales and assume that the assets are perfectly divisible.

The value of the portfolio ϕ at time i, Viϕ = Vi , is called the wealth or value

## process of the trading strategy:

Viϕ = Vi = βi Bi + ζi Si , i = 1, 2, . . . , T

## We will denote by V0 the initial investment or endowment of the investor.

Now βi Bi−1 + ζi Si−1 reflects the market value of the portfolio just after it

## has been established at time i − 1, whereas βi Bi + ζi Si is the value just after

time i prices are observed, but before changes are made in the portfolio. Hence

## βi (Bi − Bi−1 ) + ζi (Si − Si−1 )

is the change in the market value due to changes in security prices which occur

## between time i − 1 and i. We call Gϕ = G = {Gi , i = 1, . . . , T }, where

i

X
i = Gi = (βj (Bj − Bj−1 ) + ζj (Sj − Sj−1 ))
j=1

66
the gains process.

After the new prices (Bi , Si ) are quoted at time i, the investor adjusts his

portfolio from ϕi = (βi , ζi ) to ϕi+1 = (βi+1 , ζi+1 ). We do not allow him bringing

## in or consuming any wealth, so we must have

V0 = β 1 B 0 + ζ 1 S 0 , Vi = βi+1 Bi + ζi+1 Si , i = 1, . . . , T

## We say our trading strategy is self-financing and denote this by ϕ ∈ Φ.

To avoid negative wealth and unbounded short sales we also introduce the

## 3.2 No-Arbitrage Condition

The central principle in the Binomial tree models was the absence of arbitrage

opportunities, i.e. the absence of risk-free plans for making profits without any

investment. As mentioned there this principle is central for any market model,

our setting.

## So an arbitrage opportunity is a self-financing strategy with zero initial value,

67
which produces a non-negative final value with probability one and has a postive

## • EQ [Xi |Fi−1 ] = Xi−1 , i = 1, . . . , T

Note that in a more general context a third condition is required: EQ [|Xi |] < ∞.

## Because we work in a finite probability space this condition is in our setting

automatically satisfied.

## One can show that the secound condition is equivalent to

EQ [Xi |Fj ] = Xj , 0 ≤ j ≤ i ≤ T.

## We denote by P(X) the class of equivalent martingale measures for X and

will use the notation X̃ for the discounted version of the process X : X̃i =

Bi−1 Xi . For eaxmple, we will denote by S̃ the discounted stock price process :

S̃i = Bi−1 Si .

68
As a kind of example of the above concepts, we show the following proposit-

tion which we will later on need to prove one direction of the No-Arbitrage

Theorem.

## EP ∗ [Ṽi |Fi−1 ] = EP ∗ [Bi−1 (βi Bi + ζi Si )|Fi−1 ];

= βi + ζi EP ∗ [Bi−1 Si )|Fi−1 ];

−1
= βi + ζi Bi−1 Si−1 ;

−1
= Bi−1 (βi Bi−1 + ζi Si−1 );

−1
= Bi−1 (βi−1 Bi−1 + ζi−1 Si−1 );

= Ṽi−1 ,

where the third line is because S̃ is a P ∗ -martingale and the fifth line is because

## Theorem 8 (No-Arbitrage Theorem) The market is arbitrage-free if and

only if there exists an equivalent martingale measure for the discounted price

## process of the stock S̃i = Bi−1 Si , i.e. P(S̃) 6= ∅.

69
Proof : We only prove that P(S̃) 6= ∅ implies that the market is arbitrage-

free; the other direction can be proven using the Hahn-Banach theorem from

Functional Analysis.

## we have from the above proposition that Ṽ ϕ is a P ∗ -martingale. So

EP ∗ [VTϕ ] = V0ϕ .

## Together with P ∗ ({ω}) > 0, this leads to a contradiction. ♦

One can show that a security market which has no arbitrage opportunities

## 3.3 Risk-Neutral Pricing

We now turn to the main underlying question of this text, namely the pricing

fashion.

## negative FT -measurable random variable. We denote the class of all contingent

claims by X .

70
We say that the claim is attainable if there exists an (admissible) self-

VTϕ = X.

## the same time T cash-flow as X does.

We now return to the main question of the section: given a contingent claim

X, i.e. a cash-flow at time T , how can we determine its value (price) at time

i < T ? For attainable contingent claims this value should be given by the

value of any replicating strategy (perfect hedge) at time i, i.e. there should be

a unique value process (say ViX ) representing the time i value of the claim X.

The following proposition ensures that the value process of replicating strategies

VTϕ = VTψ = X

Viϕ = Viψ

## Definition 11 Suppose the market is arbitrage free. Let X be any attainable

contingent claim with time T to maturity. Then the arbitrage price process π iX ,

71
0 ≤ i ≤ T or simply the arbitrage price of X is given by the value process of

## plications. Hedging is central to the theory of option pricing. The classical

arbitrage valuation models, such as the Binomial tree models and the Black-

Scholes Model (see the next Chapters), depend on the idea that an option can

be perfectly hedged using the underlying risky asset and a risk-free asset.

## Analysing the arbitrage-pricing approach we observe that the derivation of

the price of a contingent claim doesn’t require any specific preferences of the

agents other than that they prefer more to less, which rules out arbitrage. So,

the pricing formula for any attainable contingent claim must be independent

## of all preferences that do not admit arbitrage. In particular, an economy of

risk-neutral investors must price a contigent claim in the same manner. This

## fundamental insight simplifies the pricing formula enormously. In its general

form the price of an attainable contingent claim is just the expected value of

## X is given by the risk-neutral valuation formula

Bi
πiX = EP ∗ [X|Fi ], i = 0, 1, . . . , T
BT

## where EP ∗ is the expectation operator with respect to an equivalent martingale

measure P ∗ .

72
Proof: Since we assume that the market is arbitrage-free there exists (at

## least) an equivalent martingale measure P ∗ for the discounted price process

S̃i . Furthermore because the claim is attainable there exists (at least) one

## process Ṽiϕ = Bi−1 Viϕ is a P ∗ -martingale: Indeed, by the self-financing property

of ϕ = (βi , ζi )

## EP ∗ [Ṽiϕ |Fi−1 ] − Ṽi−1

ϕ

= EP ∗ [Ṽiϕ − Ṽi−1
ϕ
|Fi−1 ]

−1 ϕ
Vi−1 |Fi−1 ]

## = EP ∗ [Bi−1 (βi Bi + ζi Si ) − Bi−1

−1
(βi−1 Bi−1 + ζi−1 Si−1 )|Fi−1 ]

## = EP ∗ [Bi−1 (βi Bi + ζi Si ) − Bi−1

−1
(βi Bi−1 + ζi Si−1 )|Fi−1 ]

−1
Si−1 )|Fi−1 ]

## = ζi EP ∗ [S̃i − S̃i−1 |Fi−1 ]

= 0.

73
The last equality follows because S̃i = Bi−1 Si is P ∗ -martingale. So we have for

each i = 0, 1, . . . , T

πiX = Viϕ

= Bi Ṽiϕ

= Bi EP ∗ [ṼTϕ |Fi ]

## 3.4 Complete Markets

The last section made clear that attainable contingent claims can be priced using

## an equivalent martingale measure. In this section we will discuss the question

of the circumstances under which all contingent claims are attainable. This

would be a very desirable property of the market, because we would then have

solved the pricing question (at least for contingent claims) completely under

the assumption that the market is arbitrage free. Since contingent claims are

## for every non-negative FT -measurable random variables X ∈ X there exists a

74
replicating strategy ϕ ∈ Φ such that VTϕ = X.

## plete if and only if there exists a unique probability measure P ∗ equivalent to P

under which the discounted price process of the stock S̃i = Bi−1 Si is a martin-

## • Completeness Theorem: An arbitrage-free market is complete (all contin-

gent claims can be replicated) if and only if there exists a unique equivalent

martingale measure.

So

75
Theorem 15 (Fundamental Theorem of Asset Pricing) In an arbitrage-

## modelling condition, viz. the existence and uniqueness of equivalent martingale

measures.

Assume now that the market is arbitrage-free and complete and let X ∈ X

then:

VTϕ = X

## Furthemore, we have seen that

Bi
πiX = Viϕ = EP ∗ [X|Fi ], i = 0, 1, . . . , T
BT

and call πiX = Viϕ the the arbitrage price of the contingent claim X at time i.

For, if an investor sells the claim X at time i for πiX , he can follow strategy

ϕ to replicate X at time T and clear the claim; an investor selling this value

is perfectly hedged. To sell the claim for any other amount would provide an

know only:

## • Ω the set of all possible states,

• the filtration F,

• P ∗.

76
We do not need to know the underlying probability measure P (only its null

sets, to know what ’equivalent to P ’ means and actually in our finite model

## there are no non-empty null-sets, so we do not need to know even this).

Now pricing of contingent claims is our central task, and for pricing purposes

P ∗ is vital and P itself irrelevant. We thus may – and shall – focus attention

## on P ∗ , which is called the risk-neutral probability measure.

To summarize, we have:

## Theorem 16 (Risk-Neutral Pricing Formula) In an arbitrage-free complete

market, arbitrage prices of contingent claims are their discounted expected values

3.5.1 Examples

## The One-step Binomial Model

We return to model given in Figure 2.2. There exists only two possible outcomes.

There is an upperstate u if price after one time step equals S1 = uS0 and a

## down-state d if the stock price changes to S1 = dS0 , Ω = {u, d}. In both

cases the riskfree asset goes from 1 to a price b say (b is typically equal to

## er or 1 + r0 ). A probability measure on Ω is completely determined by the

number 0 < P ({u}) < 1; we then have P ({d}) = 1 − P ({u}). In order that

## only one equation:

EP ∗ [b−1 S1 |F0 ] = S0

77
or equivalently

## Rewriting (3.1) gives

b−d
p∗ = (3.2)
u−d

In order that this gives rise to a probability measure, we should have 0 < p∗ < 1,

## In conclusion a martingale measure P ∗ ∈ P for the discounted stock price exists

if and only if (3.3) is satisfied. If (3.3) holds true, then there is a unique such

## one-step binomial model is arbitrage free and complete.

Note that (3.3) means that by investing in a stock one can have a bigger

return than the risk-free return (u > b), but also can have a greater loss (b > d).

Note also that one can easily show that the multi-period model of Section

## f = b−1 p∗ fu + b−1 (1 − p∗ )fd

78
Figure 3.1: The One-step Trinomial Model

In order to hedge or replicated this claim one has to solve the equations

ξuS0 + ηb = fu

ξdS0 + ηb = fd

Note that this system of equations has a unique solution if and only if
 
 uS0 b 
det   6= 0,
 
dS0 b

## The One-step Trinomial Model

Suppose now the following one-step trinomial model: In one time step there

## exists three possible outcomes as shown in picture 3.1. There is an upperstate u

if the stock price changes to S1 = uS0 , a middle state m if the stock price after

one step is S1 = mS0 , and a down-state d if the stock price changes to S1 = dS0 ,

0 ≤ d < m < u: Ω = {u, m, d}. Again, in all cases the riskfree asset changes in

## a deterministic way from 1 to a price b say. A probability measure on Ω is now

79
completely determined by two numbers 0 < P ({u}) < 1 and 0 < P ({m}) < 1;

## price process is a martingale with respect to a probability measure P ∗ , with say

0 < P ∗ ({u}) = p∗ < 1 and 0 < P ∗ ({m}) = q ∗ < 1, on Ω, it has to satisfy again

## only one equation:

EP ∗ [b−1 S1 |F0 ] = S0

or equivalently

## b−1 uS0 p∗ + b−1 mS0 q ∗ + b−1 dS0 (1 − p∗ − q ∗ ) = S0 .

Unfortunately this equation has more than one solution as can be easily been

## seen after a simple rewriting:

(b − d) − (m − d)q ∗
p∗ =
u−d

For every 0 < q ∗ < 1 there is a corresponding p∗ . If we then take also into

account that the values of p∗ and q ∗ must give rise to a probability distribution,

i.e. 0 < p∗ , q ∗ < 1 and p∗ + q ∗ < 1, there still are infinitely many solutions.

In conclusion there exist more then one martingale measure for the discounted

stock price. So the one-step trinomial model is arbitrage free, but is not com-

plete.

## If we have a contingent claim with payoff fu in the upstate, fm in the middle

state and fd in the down state it can only be replicated if there exists a solution

80
to the equations

ξuS0 + ηb = fu

ξmS0 + ηb = fm

ξdS0 + ηb = fd

 
 uS0 b fu 
 
 
det 
 mS0  = 0.
b fm 
 
 
dS0 b fd

## Because we assume that S0 6= 0 and b 6= 0, this is equivalent with

 
 u 1 fu 
 
 
det 
 m 1 fm
 = 0.

 
 
d 1 fd

So only contingent claims which payoff function satisfies the above condition

## are attainable and can be replicated and priced in an arbitrage-free way.

81
Chapter 4

Exotic Options

Derivatives with more complicated payoffs than the standard European or Amer-

ican calls and puts are referred to as exotics options. Most exotics options are

traded in the OTC market and have been designed to meet particular needs of

investors.

In this chapter we describe different types of exotic options and discuss their

## type option can not be handled.

82
4.1 Monte Carlo Pricing

When the payoff depends on the path followed by the underlying variable S

in theory one has to consider every possible path. When using 30 time steps

in the Binomial tree model, there are about a billion different paths and one

has to relay on (Monte Carlo) simulations, which are computationally very time

## 2. Calculate the payoff from the derivative.

3. Repeat steps one and two to get many sample values of the payoff from

## the derivative in a risk neutral world.

4. Calculate the mean of the sample payoff to get an estimate of the expected

## In everything we have encountered so far, uncertainty has unfolded with time,

and our task has been to make optimal use of the information available to date.

For options, at expiry T the investor is in posssesion of the history of the price

evolution over time interval [0, T ] of the option’s life, and it may well be that

83
one could have been doing better. It is only natural to look back with regret.

If only one could buy at the low, and sell at the high ...

In order to provide some investor the right to do that lookback options were

created.

We write S for the stock price process and consider a time interval [0, T ].

## Let us denote the maximum and minimum process, resp., of a process X =

{Xt , 0 ≤ t ≤ T } as

## MtX = sup{Xu ; 0 ≤ u ≤ t} and mX

t = inf{Xu ; 0 ≤ u ≤ t}, 0 ≤ t ≤ T.

The two basic types of continuously montiored lookback options are the

## lookback call, with payoff

LC cont (T ) = ST − mST ,

giving one the right to buy at the low over [0, T ], and the lookback put with

payoff

LP cont (T ) = MTS − ST ,

## One can approximate their value by their discretely monitored counterparts.

Consider an a partition of [0, T ] into n equal time intervals with size ∆t = T /n.

Write Si for the stock price value at time i∆t and MiS , mSi for its maximum

and minimum over [0, i∆t]. The discretely monitored versions payout

LC discr (T ) = Sn − mSn ,

and

LP discr (T ) = MnS − Sn ,

84
respectively.

## We illustrate first how such a discrtely monitored European-type lookback

put can be priced using binomial trees. Later, we will comment on the American

version. When exercised, this provides a payoff equal to the excess of the current

## maximum stock price over the current stock price.

Set
MiS
Yi =
Si

and produce a binomial tree for the stock price (using the Cox-Ross-Rubenstein

setting). See the left tree in Figure 4.1. From this tree produce a corresponding

## tree for Y . Initially Y0 = 1, because M0S = S0 . If there is an up-move in S during

the first step, both the maximum and the stock price increase by a proportional

## amount u and remains Y = 1. If there is a down movement in S during the

first step, the maximum stays at S0 , so that Y = 1/d = 1/ exp(−σ ∆t) = u.

Continuing with these types of arguments, we produce the tree shown in Figure

4.1 (σ = 0.40, r = 0.10). The rules defining the geometry of the tree are

## The probability of an up movement in Y is, therefore, always 1 − p, with p

the probability of a up-movement in the stock. Note thus that p is also the

probability of a down-movement of Y .

We will use the Y -tree to value the lookback option in units of the stock

85
price (rather then in euros). In euros, the payoff from the option is

S n Yn − S n .

## In stock price units, the payoff from the option is

Yn − 1.

We roll back through the tree in the usual way, valuing a derivative that provides

this payoff except that we adjust for the differences in the stock prices (i.e. the

units of measurement) at the nodes. If fi,j is the value of the lookback at the

jth node at time iδt, and Yi,j is the value of Y at this node: Yi,j = uj , the

## rollback procedure gives

eur
fi,j = exp(−r∆t)((1 − p)fi+1,j+1 d + pfi+1,j−1 u),

## when j ≥ 1. Note that fi+1,j+1 is multiplied by d and fi+1,j−1 is multiplied by u

in this equation. This takes into account that the stock price at node (i, j) is the

unit of measurement. The stock price at node (i + 1, j + 1), which was the unit

of measurement for fi+1,j+1 is d times the stock price at node (i, j). Similarly,

the stock price at node (i + 1, j − 1), which was the unit of measurement for

fi+1,j−1 is u times the stock price at node (i, j). When j = 0, the roll back

procedure gives

eur
fi,0 = exp(−r∆t)((1 − p)fi+1,1 d + pfi+1,0 u),

The tree is initialized at the final nodes with the boundary conditions

eur
fn,j = Yn,j − 1

eur
fn,0 = 0.

86
Figure 4.1: Lookback tree example

The tree (with 5 time steps) in the Figure 4.1 estimates the value of the

option at time zero (in stock price units) as 0.230 for the European version.

This means that the value of the option is 0.230 × S0 = 11.50 euros.

## In case of an American type option, these two equations can be adjusted by

comparing the european price with the early exercise price (Yi,j − 1) and taking

## the maximum of both:

amer
fi,j = max {Yi,j − 1, exp(−r∆t)((1 − p)fi+1,j+1 d + pfi+1,j−1 u)} , j≥1

amer
fi,0 = exp(−r∆t)((1 − p)fi+1,1 d + pfi+1,0 u),

87
the boundary conditions remain the same:

amer
fn,j = Yn,j − 1

amer
fn,0 = 0.

## Increasing the number of time-steps n, will give a more precise estimate of a

continuously montinored lookback options. It is quite well known that the tree-

values converge slowly to this value. This is due because, one is actually missing

all the situations where a maximum/minimum has been attained in between two

discrete montoring points and where the stock price has fallen/risen back before

## 4.3 Barrier Options

The payoff of a barrier option depends on whether the price of the underlying

asset crosses a given threshold (the barrier) before maturity. The simplest bar-

rier options are “knock in” options which come into existence when the price of

the underlying asset touches the barrier and “knock-out” options which come

out of existence in that case. For example, an up-and-out call has the same

payoff as a regular plain vanilla call if the price of the underlying asset remains

below the barrier over the life of the option but becomes worthless as soon as

## the price of the underlying asset crosses the barrier.

Let us denote with 1(A) the indicator function, which has a value 1 if A is

## true and zero otherwise.

For single barrier options, we will focus on the following types of call options:

88
• The down-and-out barrier call is worthless unless its minimum remains

## • The down-and-in barrier call is a standard European call with strike K,

if its minimum went below some low barrier H. If this barrier was never

reached during the life-time of the option, the option is worthless. Its

## DIBC = exp(−rT )EQ [(ST − K)+ 1(mST ≤ H)].

• The up-and-in barrier call is worthless unless its maximum crossed some

## U IBC = exp(−rT )EQ [(ST − K)+ 1(MTS ≥ H)].

• The up-and-out barrier call is worthless unless its maximum remains below

## along the same lines.

89
We note that the value, DIBC, of the down-and-in barrier call option with

barrier H and strike K plus the value, DOBC, of the down-and-out barrier

option with same barrier H and same strike K, is equal to the value C of the

vanilla call with strike K. The same is true for the up-and-out together with

the up-and-in:

## DIBC + DOBC = C = U IBC + U OBC. (4.1)

The above options are so-called continuously monitored. Their value can

## be approximated by the discretely monitored counterparts, like in the lookback

case.

These discretely monitored barrier options (of european and american type)

can again be priced using the binomial tree setup. For example an American

## down-and-out put can be valued as in the same way as an regular American

option except that, when we encounter a node below the barrier, we set the


fi,j

## fi,j = 0 if S0 uj di−j < H

and for i = n

fn,j = K − S0 uj dn−j if Sn ≥ H

fn,j = 0 if Sn < H

Similar schemes can be easily deduced for the other combinations. Unfortu-

nately, convergence of the price of the discretely monitored option to the price

90
of the continuouss is also here very slow when this approach is used. A large

## number of time steps is required to obtain a reasonably accurate result. The

reason for this is that the barrier being assumed by the tree is different fom the

true barrier. Define the inner barrier as the barrier formed by nodes on the side

of the true barrier (i.e., closer to the center of the tree) and the outer barrier

as the barrier formed by nodes just outside the true barrier (i.e., farther away

from the center of the tree). Figure 4.2 shows the inner and outer barrier for a

trinomial tree on the assumption the true barrier is horizontal. Figure 4.3 does

the same for a binomial tree. The usual tree calculations implicitly assume that

the outer barrier is the true barrier because the barrier conditions are first used

## For coping with this barrier-problem, one alternative is to calculate when

rolling back through the tree, two values of the derivative (for the nodes on

the inner barrier). The first one is obtained by assuming the inner barrier is

correct; the second one is obtained by assuming the outer barrier is correct. A

final estimate for the value of the derivative for the true barrier is then obtained

## by interpolating between these two values.

For example, suppose that at time i∆t, the true value barrier is 0.2 above the

inner barrier and 0.6 below the outer barrier and suppose further that the value

of the derivative on the inner barrier is zero if the inner barrier is assumed to be

correct and 1.6 if the outer barrier is assumed to be correct. The interpolated

value (for the inner barrier node) is then 0.4. Once we have adjusted the value

at the inner barrier node, we can roll back through the tree to obtain the initial

91
Figure 4.2: Trinomial tree: inner and outer barrier

92
Figure 4.3: Trinomial tree: inner and outer barrier

93
value of the derivative in the usual way.

## In this section we consider the pricing of a European-style arithmetic average

call option with strike price K, maturity T and n averaging days 0 ≤ t1 < . . . <

tn ≤ T .

## Its payoff is given by

 Pn +
k=1 S tk
AAC = −K .
n

The american versions allows early exercise and in that case pays out the surplus

over the strike price K of the running average. For the put version just switch

## the sum and the strike price :

Pn +
K−

k=1 S tk
AAP = .
n

Average price options are typically less expensive than regular options and are

arguably more appropriate than regular options for meeting some of investors

needs. Asian options are widely used in pratice - for instance, for oil and foreign

currencies. The averaging complicates the mathematics, but e.g., protects the

holder against speculative attemps to manipulate the asset price near expiry.

Assume for simplicity that t = 0 and that the averaging has not yet started.
Pn
First note, that for any K1 , . . . , Kn ≥ 0 with K = k=1 Kk , we have

n
!+ n
 + X
+
X
Stk − nK = (St1 − nK1 ) + · · · + (Stn − nKn ) ≤ (Stk − nKk ) .
k=1 k=1

94
Hence the intial price AAC0 (K, T )
 !+ 
n
exp(−rT ) X
AAC0 (K, T ) = EP ∗  Stk − nK

F0
n
k=1
n
exp(−rT ) X h i
+
≤ EP ∗ (Stk − nKk ) F0
n
k=1
n
exp(−rT ) X
= exp(rtk )EC0 (κk , tk ), (4.2)
n
k=1

where EC0 (κk , tk ) denotes the price of a European call option at time 0 with

## strike κk = nKk and maturity tk .

In terms of hedging, this means that we have the following static super-

hedging strategy: for each averaging day tk , buy exp(−r(T − tk ))/n European

call options at time t = 0 with strike κk and maturity tk and hold these until

## their expiry. Then put their payoff on the bank account.

Since the upper bound (4.2) holds for all combinations of κk ≥ 0 that satisfy
Pn
k=1 κk = nK, one still has the freedom to choose strike values.

## However, one naturally look for that combination of κk ’s which minimizes

the right-hand side of (4.2). This can be done using comonotonic theory, but

## will lead us to far in this course.

Next, we discuss the pricing of the European and American AAC using

binomial tree models. However, the procedure is not as simple as in the barrier

95
case and this because at each node we do not know the running average when

we reached that node. Typically, all different paths to reach the node lead to

different average prices, and the number of paths grow exponentially. Luckily,

the tree-approach can be extended to cope with this under certain circumstance.

## European Asian arthimetic option. The payoff of this options depends on a

single function of the path followed, namely the average stock price. We call

## this average function is the determining path function.

The trick is tp carry out, at each node, the calculations for a small number

of representative values of the path function. When the value of the derivative

is required for other values of the path function, we calculate it from the known

## values using interpolation.

Suppose the initial stock price is 50, the strike price is 50, r = 0.10 and

the volatility is 0.40, and the time to maturity is one year. We use a tree with

20 time steps. The parameters describing the binomial tree parameters are

## ∆t = 0.05, u = 1.0936, d = 0.9144, p = 0.5056.

Figure 4.4 shows the calculations that are carried out in one small part of

the tree. Node X is the central node at time 0.2 year (at the end of the fourth

time step). Nodes Y and Z are the two nodes at time 0.25 years that are

reachable from node X. The stock price is X is 50. Forward induction shows

that the maximum average stock price achievable in reaching node X is 53.83.

The minimum is 46.65. (We include both the initial and final stock prices when

## calculating the average, i.e. t1 = 0 and tn = T .) From node X, we branch to

96
Figure 4.4: Part of tree for Asian option

one of the two nodes Y and Z. At node Y , the stock price is 54.68 and the

bounds for the average are 47.99 and 57.39. At node Z, the stock price is 45.72

and the bounds for the average stock price are 43.88 and 52.48.

## Suppose that we have chosen the representative values of the average to

be four equally spaced values at each node. This means that at node X, we

consider the averages 46.65, 49.04, 51.44, and 57.83. At node Y , we consider the

averages 47.99, 51.12, 54.26, and 57.39. At node Z, we consider the averages

43.88, 46.75, 49.61, and 52.48. We assume backward induction has already been

used to calculate the value of the option for each of the alternative valuesof the

average at node Y and Z. The values are shown in Figure 4.4. For exemple, at

97
node Y when the average is 51.12, the value of the option is 8.101.

Consider the calculation at node X for the case where the average is 51.44. If

the stock price moves up to node Y , the new average will be 5×51.44+54.68)/6 =

51.98. The value of the derivative at node Y for this average can be found by

interpolating between the values when the average is 51.12 and when it is 54.26.

It is
(51.98 − 51.12) × 8.635 + (54.26 − 51.98) × 8.101
= 8.247.
54.26 − 51.12

Similarly, if the stock price moves down to node Z, the new average will be

## 5 × 51.44 + 45.72)/6 = 50.49 and by interpolation the value of the derivative

is 4.182. The value of the derivative at node X when the average is 51.44 is,

therefore,

## exp(−0.1 × 0.05)(0.5056 × 8.247 + (1 − 0.5056) × 4.182) = 6.206.

The other values at node X are calculated similarly. Once the values at all

nodes at time 0.2 year have been calculated, we can move on to the nodes at

## time 0.15 year.

The value given by the full tree for the option at time zero is 7.17. As the

number of time steps and the number of averages considered at each node is

increased, the value of the option converges to the correct answer. With 60 time

steps and 100 averages at each node, the value of the option is 5.58. The true

## value of the option is around 5.62.

A key advantage of the method here is that it can handle American options.

The calculations are as we have described them except that we test for early

98
exercise at each node for each of the alternative values of the path function at

the node.

The approach just described can be used in a wide range of different situa-

## tions if the following conditions are satisfied:

• the payoff from the derivative must depend on a single function, the path

## function, of the path followed by the underlying asset;

• it must be possible to calculate the value of the path function at time t+∆t

from the value of this function at time t and the value of underlying asset

at time t + ∆t.

99
Chapter 5

## The Black-Scholes Option

Price Model

In the early 1970s, Fischer Black, Myron Scholes, and Robert Merton made

## a major breakthrough in the pricing of stock options by developing what has

become known as the Black-Scholes model. The model has had huge influence

on the way that traders price and hedge options. In 1997, the importance of the

model was recognized when Myron Scholes and Robert Merton were awarded

the Nobel prize for economics. Sadly, Fischer Black died in 1995, otherwise he

also would undoubtedly have been one of the recipients of this prize.

This chapter shows how the Black-Scholes model for valuing European call

## and put options on a non-dividend-paying stock is derived.

100
5.1 Continuous-Time Stochastic Processes

## This section develops a continuous-time, continuous-variable stochastic process

for stock prices. An understanding of this process is the first step to understand-

ing the pricing of options and other more complicated derivatives. It should

## variable, continuous-time processes. Stock prices are restricted to discrete values

(often multiples of 0.01 euro) and changes can be observed only when the ex-

## 5.1.1 Information and Filtration

The underlying set-up is as in the discrete time case. We assume a fixed finite

## FT : Fs ⊂ Ft ⊂ FT for 0 < s < t ≤ T ; here Ft represents the information

available at time t, and the filtration F = (Ft ) represents the information flow
evolving with time.

We assume that the filtered probability space (Ω, FT , P, F) satisfies the ’usual

## conditions’: a) F0 contains all P -null sets of F. This means intuitively that we

know which events are possible and which not, and b) (Ft ) is right-continuous,

## on (Ω, FT , P, F). We say X is F-adapted if Xt ∈ Ft (i.e. Xt is Ft -measurable)

101
for each t: thus Xt is known at time t.

5.1.2 Martingales

## • E[Xt |Fs ] = Xs , P -a.s., (0 ≤ s ≤ t),

A martingale is ’constant on average’, and models a fair game. This can be seen

from the third condition: the best forecast of the unobserved future value Xt

## The Scottish botanist Robert Brown observed pollen particles in suspension

under a microscope in 1828 and 1829, and observed that they were in constant

## number. In 1923 Norbert Wiener defined and constructed Brownian motion

rigorously for the first time. The resulting stochastic process is often called the

## Wiener process in his honour.

102
Definition 17 A stochastic process X = {Xt , t ≥ 0} is a standard Brownian

1. X0 = 0 a.s.

## 3. X has stationary increments.

4. Xt+s −Xt is normally distributed with mean 0 and variance s: Xt+s −Xt ∼

N(0, s).

## We shall henceforth denote standard Brownian motion by W = {Wt , t ≥ 0}

(W for Wiener).

Construction

No construction of Brownian motion is easy: one needs both some work and

## for granted. To gain some intuition on its behaviour, it is good to compare

Brownian motion with a simple symmetric random walk on the integers. More

## the simple symmetric random walk Z = {Zn , n = 0, 1, 2, . . . } as Z0 = 0 and

Pn
Zn = i=1 Xi , n = 1, 2, . . . . Rescale this random walk as

Yk (t) = Zbktc / k,

103
where bxc is the integer part of x. Then from the Central Limit Theorem,

Yk (t) → Wt as k → ∞,

## In Figure 5.1, one sees a realization of the standard Brownian motion. In

Standard Brownian Motion
1

0.8

0.6

0.4

0.2

−0.2

−0.4

−0.6

−0.8
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

## Figure 5.1: A sample path of a standard Brownian motion

Figure 5.2, one sees the random-walk approximation of the standard Brownian

motion. The process Yk = {Yk (t), t ≥ 0} is shown for k = 1 (i.e. the symmetric

## The universal nature of Brownian motion as a stochastic process is simply

the dynamic counterpart – where we work with evolution in time – of the uni-

## versal nature of its static counterpart, the normal distribution – in probability,

statistics, science, economy etc. Both arise from the same source, the central

limit theorem. This says that when we average large numbers of independent

## and comparable objects, we obtain the normal distribution in a static context,

104
k=1 k=3
10 10

5 5

0 0

−5 −5

−10 −10
0 10 20 30 40 50 0 10 20 30 40 50

k=10 k=50
10 10

5 5

0 0

−5 −5

−10 −10
0 10 20 30 40 50 0 10 20 30 40 50

## Figure 5.2: Random walk approxiamtion for standard Brownian motion

or Brownian motion in a dynamic context. What the central limit theory really

says is that, when what we observe is the result of a very large number of indi-

vidually very small influences, the normal distribution or Brownian motion will

## Next, we look at some of the classical properties of Brownian motion.

Martingale Property

## Brownian motion is one of the most simple examples of a martingale. We have

for all 0 ≤ s ≤ t,

## E[Wt |Fs ] = E[Wt |Ws ] = Ws .

105
We also mention that one has:

## E[Wt Ws ] = min{t, s}.

Path Properties

One can proof that Brownian motion has continuous paths, i.e. Wt is a continu-

ous function of t. However the paths of Brownian motion are very erratic. They

are for example nowhere differentiable. Moreover, one can prove also that the

paths of Brownian motion are of infinite variation, i.e. their variation is infinite

on every interval.

that

## Pr(sup Wt = +∞ and inf Wt = −∞) = 1.

t≥0 t≥0

This result tells us that the Brownian path will keep oscillating between positive

Scaling Property

## There are a well-known set of transformations of Brownian motion which pro-

duce another Brownian motion. One of this is the scaling property which says

## W̃ = {W̃t = cWt/c2 , t ≥ 0} (5.1)

is a Brownian motion.

106
5.3 Itô’s Calculus

## 5.3.1 Stochastic Integrals

Stochastic integration was introduced by K. Itô in 1941, hence its name Itô

Z t
Xu dYu
0

## for suitable stochastic processes X = {Xu , u ≥ 0} and Y = {Yu , u ≥ 0}, the

integrand and the integrator. We shall confine our attention here to the basic

## Because Brownian motion is of infinite (unbounded) variation on every inter-

val, the first thing to note is that stochastic integrals with respect to Brownian

motion, if they exist, must be quite different from the classical deterministic in-

tegrals. We take for granted Itô’s fundamental insight that stochastic integrals

## can be defined for a suitable class of integrands.

We only show how these integrals can be defined for some simple integrands

X.

Indicators

If Xt = 1[a,b] (t), i.e. it equals 1 between a and b and is zero elsewhere, we define
R
XdW : 

 0 if t ≤ a
Z t 

It (X) = Xs dWs = Wt − W a if a ≤ t ≤ b
0 

 Wb − W a
 if t ≥ b

107
Simple deterministic functions

## We can extend the above definition by linearity: if X is a linear combination of

Pn R
indicators, Xt = i=1 ci 1[ai ,bi ] (t), we define XdW :
Z t n
X Z t
It (X) = Xs dWs = ci 1[ai ,bi ] (s)dWs
0 i=1 0

## · · · < tn = T < ∞ and uniformly bounded Ftk -measurable random variables ξk

(|ξk | ≤ C for all k = 0, . . . , n for some C) and if Xt can be written in the form
n−1
X
Xt = ξ0 10 (t) + ξi 1(ti ,ti+1 ] (t), 0 ≤ t ≤ T.
i=0

Then if tk ≤ t ≤ tk+1 , k = 0, . . . , n − 1,
Z t k−1
X
It (X) = Xs dWs = ξi (Wti+1 − Wti ) + ξk (Wt − Wtk )
0 i=0

defined so far:

## • It (aX + bY ) = aIt (X) + bIt (Y ).

• It (X) is a martingale.

Rt
• Itô isometry: E[(It (X))2 ] = 0 E[(Xu )2 ]du.

Rt
The Itô isometry above suggests that 0
XdW should be defined only for processes
Rt
with 0 E[(Xu )2 ]du < ∞ for all t and this is indeed the case. Each such X may

## tic integral may be defined as the limit of this approximation. Furthermore

108
the three above properties remain true. We will not include the technical and

detailed proofs of this procedure in this book. Note that one also can construct

a closely analogous theory for stochastic integrals with the Brownian integrator

## 5.3.2 Itô’s Lemma

The price of a stock option is a function of the underlying stock’s price and

time. More generally, we can say that the price of any derivative is a function of

the stochastic variables underlying the derivative and time. Therefore, we must

as Itô’s lemma.

## Suppose that F : R2 → R is a function, which is continuously differentiable

once in its first argument (which will denote time), and twice in its second

## argument: F ∈ C 1,2 . Denote the partial derivatives

∂F
Ft (t, x) = (t, x)
∂t
∂F
Fx (t, x) = (t, x)
∂x
∂2F
Fxx (t, x) = (t, x)
∂x2

## motion and let F (t, x) ∈ C 1,2 , then

t t t
1
Z Z Z
F (t, Wt )−F (s, Ws ) = Fx (u, Wu )dWu + Ft (u, Wu )du+ Fxx (u, Wu )du.
s s 2 s

109
or
1
dF = Fx dWt + Ft dt + Fxx dt.
2

for short.

Rt
As an application of Itô’s lemma we compute 0 Wu dWu by using F (t, x) =

x2 . Then

t t t
1
Z Z Z
Wt2 = W02 + 2Wu dWu + 2du = 2 Wu dWu + t.
0 2 0 0

So that
t
Wt2 t
Z
Wu dWu = −
0 2 2

Note the contrast with ordinary calculus ! Itô calculus requires the second term

## 5.4 Stochastic Differential Equations

Like with any ordinary and partial differential equations in a deterministic set-

ting (ODEs and PDEs), the two most basic questions are those of existence and

## dXt = b(t, Xt )dt + σ(t, Xt )dWt , Xs = x, (5.2)

110
where the coefficients b and σ satisfy the following Lipschitz and growth condi-

tions

## for all t ≥ 0, x, y ∈ R, for some constant K > 0.

To see that the SDE (5.2) has a solution, we first define recursively

Z t Z t
(0) (n+1)
Xt = x, Xt =x+ b(u, Xu(n) )du + σ(u, Xu(n) )dWu .
s s

(n)
One can then prove that Xt converges (in some sense), to Xt say; Xt is the

## unique (strong) solution to (5.2), i.e.

Z t Z t
X0 = x, Xt = x + b(u, Xu )du + σ(u, Xu )dWu .
s s

The next result, which is an example for the rich interplay between probabil-

ity theory and analysis, links SDEs with PDEs. Suppose we consider a stochastic

## dXu = µ(u, Xu )du + σ(u, Xu )dWu , Xs = x, s≤u≤T

Consider a function F (t, x) ∈ C 1,2 of it. Then we have the following extension

of Itô’s lemma:

## Theorem 19 (Itô’s lemma for SDE’s) Let F (t, x) ∈ C 1,2 , then

Z t
F (t, Xt ) − F (s, Xs ) = σ(u, Xu )Fx (u, Xu )dWu + (5.3)
s
Z t
σ(u, Xu )2

Ft (u, Xu ) + µ(u, Xu )Fx (u, Xu ) + Fxx (u, Xu ) du.
s 2

111
Now suppose that F satisfies the PDE

(σ(t, x))2
Ft (t, x) + µ(t, x)Fx (t, x) + Fxx (t, x) = 0,
2

F (T, x) = h(x).

## Then the above expression for (5.3) gives

Z t
F (s, Xs ) = F (t, Xt ) − σ(u, Xu )Fx (u, Xu )dWu
s

## 5.5 Geometric Brownian Motion

Now that we have both Brownian motion W and Itô’s Lemma to hand, we can

introduce the most important stochastic process for us, a relative of Brownian

## motion – geometric Brownian motion.

112
Suppose we wish to model the time evolution of a stock price St . Consider

how S will change in some small time interval from the present time t to a time

t + ∆t in the near future. Writing ∆St for the change St+∆t − St , the return on

## S in this interval is ∆St /St . It is economically reasonable to expect this return

to decompose into two components, a systematic part and a random part. The

## systematic part could plausibly be modeled by µ∆t, where µ is some parameter

representing the mean rate of the return of the stock. The random part could

plausibly be modeled by σ∆Wt , where ∆Wt represent the noise term driving the

stock price dynamics, and σ is a second parameter describing how much effect

the noise has – how much the stock price fluctuates. Thus σ governs how volatile

the price is, and is called the volatility of the stock. The role of the driving noise

## The differential equation above has the unique solution

σ2
  
St = S0 exp µ− t + σWt .
2

For, writing
σ2
  
f (t, x) = exp µ− t + σx
2

113
Itô’s lemma gives

δf δf 1 δ2 f
df (t, Wt ) = dt + dWt + dt
δt δx 2 δx2
σ2
 
1
= µ− f dt + σf dWt + σ 2 f dt
2 2

= f (µdt + σdWt )

## so f (t, Wt ) is a solution of the stochastic differential equation. This means that

σ2
 
log St = log S0 + µ − t + σWt
2

## geometric Brownian motion model, and the log-normal distribution which it

entails, are the basis for the Black-Scholes model for stock-price dynamics in

continuous time.

In Figure 5.3 one sees the realization of the geometric Brownian motion

based on the sample path of the standard Brownian motion of Figure ??.

## 5.6 The Market Model

We consider a frictionless security market in which two assets are traded con-

## planning horizon T , where all economic activity stops.

The first asset is one without risk (the bank account). Its price process is

## to as stock. The price process of this stock, St , 0 ≤ t ≤ T , is modelled by the

114
Figure 5.3: Sample path of a geometric Brownian motion (S0 = 100, µ =

0.05, σ = 0.40)

## Furthermore, in the previous chapter we derived that St follows a geometric

Brownian motion:

σ2
  
St = S0 exp µ− t + σWt .
2

µ is reflecting the drift and σ models the volatility and are assumed to be

## adapted process. We call this market model the Black-Scholes model.

115
Our principle task will be the pricing and hedging of contingent claims, which

## we model as non-negative FT -measurable random variables. This implies that

the contingent claims specify a stochastic cash-flow at time T and that they

may depend on the whole path of the underlying in [0, T ] – because FT contains

all information.

## ϕ = {ϕt = (βt , ξt ), t ∈ [0, T ]}

a trading strategy or dynamic portfolio process. The conditions ensure that the
Rt
stochastic integral 0
ξt dWt exists. Here βt denotes the money invested in the

riskless asset and ξt denotes the number of stocks held in the portfolio at time

t.

## has to be determined on the basis of information available strictly before time

t, Ft− : the investor selects his time t portfolio just before the observation of the

## predictablity and adaptedness are the same. •

116
The components of ϕt may assume negative as well as positive values, reflect-

ing the fact that we allow short sales and assume that the assets are perfectly

divisible.

## Definition 20 (i) The value of the portfolio ϕ at time t is given by

Vt = Vtϕ = βt Bt + ξt St = βt ert + ξt St

The process Vtϕ is called the value process, or wealth process, of the trading

strategy ϕ.

## (ii) The gains process Gϕ

t is defined by

Z t Z t
Gt = G ϕ
t = βu dBu + ξu dSu
0 0

## (iii) A trading strategy ϕ is called self-financing if the wealth process V tϕ satis-

fies

Vtϕ = V0ϕ + Gϕ
t for all t ∈ [0, T ].

The financial implications of the above equations are that all changes in the

## 5.7 Equivalent Martingale Measures and Risk-

Neutral Pricing

Next, we develop a pricing theory for contingent claims. Again the underlying

concept is the link between the no-arbitrage condition and certain probability

117
measures. We begin with

## Similarly as in the discrete case (admissible strategies), tame strategies prevent

the broker from unbounded short sales. Using tame strategies the investor’s

wealth may never go negative at a time, even if he is able to cover his debt at

the final date. If we would later on allow non-tame strategies, one can show

## that it is possible to construct doubling strategies that can attain arbitrarily

large values of wealth starting with zero initial capital. Such strategies are

## We say that our market is arbitrage-free if there are no tame self-financing

arbitrage opportunities.

## equivalent martingale measure if:

118
(i) P ∗ is equivalent to P

## We denote the set of equivalent martingale measures by P.

As in the discrete case, one can prove that one can preclude arbitrage oppor-

## completeness theorem in the discrete setting: If P = {P ∗ }, then the market

is complete, in the restricted sense that for every contingent claim X satisfy-

## strategy such that VTϕ = X.

Remark: Having seen the above results, a natural question is to ask whether

converse statements are also true. One has to put some further requirements

## on portfolios to establish such converse results. These requirements should of

course be economically meaningful. A lot of effort has been put into solving this

question, and several alternatives have been proposed, but the details will lead

us to far. •

## unique martingale measure ( incomplete market models). Roughly speaking in-

completeness means that a general contingent claim can not be perfectly hedged.

119
Most models are not complete, and most practitioners believe the actual market

## is not complete. we have to choose an equivalent martingale measure in some

way and this is not always clear. Actually, the market is choosing the martingale

## measure for us.

In the Black-Scholes world however, one can prove (Girsanov Theorem) that

## there is a unique equivalent martingale measure and we do not have to deal

with coosing an appropriate one. It is not hard to see that under P ∗ , the stock

## price is following a Geometric Brownian motion again. This risk-neutral stock

price process has the same volatility parameter σ, but the drift parameter µ is

## changed to the continuously compounded risk-free rate r:

σ2
  
St = S0 exp r− t + σWt .
2

Equivalent, we can say that under P ∗ our stock price process S = {St , 0 ≤ t ≤

## dSt = St (rdt + σdWt ), S0 > 0.

This SDE tells us that in a risk-neutral world the total return from the stock

must be r.

Next, we will calculate European call option prices under this model.

## 5.7.1 The Pricing of Options under the Black-Scholes Model

If the payoff function is only depending on the time T value of the stock, i.e.

## G({Su , 0 ≤ u ≤ T }) = G(ST ), then the above formula can be rewritten as (we

120
set for simplicity t = 0):

## = exp(−T r)EP ∗ [G(S0 exp((r − q − σ 2 /2)T + σWT ))]

Z +∞
= exp(−T r) G(S0 exp((r − q − σ 2 /2)T + σx))fN ormal (x; 0, T )dx.
−∞

## the risk-neutral pricing formula (5.4).

Take for example an European call on the stock (with price process S) with

strike K and maturity T (so G(ST ) = (ST − K)+ ). The Black-Scholes formulas

for the price C(K, T ) at time zero of this European call option on the stock

## C(K, T ) = C = S0 N(d1 ) − K exp(−rT )N(d2 ),

where

σ2
log(S0 /K) + (r + 2 )T
d1 = √ , (5.5)
σ T
σ2 √
log(S0 /K) + (r − 2 )T
d2 = √ = d1 − σ T , (5.6)
σ T

and N(x) is the cumulative probability distribution function for a variable that

## is standard normally distributed (Normal(0, 1)).

From this, one can also easily (via the put-call parity) obtain the price

P (K, T ) of the European put option on the same stock with same strike K and

121
same maturity T :

## P (K, T ) = −S0 N(−d1 ) + K exp(−rT )N(−d2 ).

For the call, the probability (under P ∗ ) of finishing in the money corresponds

with N(d2 ). Similarly, the delta (i.e. the change in the value of the option

compared with the change in the value of the underlying asset) of the option

## corresponds with N(d1 ).

Black-Scholes PDE

## Black-Scholes partial differential equation

∂ ∂ 1 ∂2
F (t, s) + (r − q)s F (t, s) + σ 2 s2 2 F (t, s) − rF (t, s) = 0, (5.7)
∂t ∂s 2 ∂s

F (T, s) = G(s)

This will basically follow from the Feynman-Kac representation for Brownian

motion.

## Indeed, let H(t, s) be a solution of

1
Ht (t, s) + rsHs (t, s) + σ 2 s2 Hss (t, s) = 0,
2

## H(T, s) = e−rT G(s).

Then we know from the Feynman-Kac representation that H has the represen-

tation

## H(t, St ) = e−rT EP ∗ [G(ST )|Ft ];

122
Note that by the risk-neutral valuation principle

5.7.2 Hedging

## from the Black-Scholes formulas that

σ2
!
ln(S0 /K) + (r + 2 )T
ξt = ∆call = N (d1 ) = N √
σ T

## from the Black-Scholes formulas that delta is given by

!
σ2
ln(S0 /K) + (r + 2 )T
ξt = ∆put = N (d1 ) − 1 = N √ − 1 = ∆call − 1
σ T

∆ is the rate of change of the option price with respect to the price of the

underlying asset. Suppose that the delta of a call option on as stock is 0.6. This

means that when the stock price changes by a small amount, the option price

changes by about 60 percent of that amount. Suppose further that the stock

price is 100 euro and the option price is 10 euro. Imagine an investor who has

sold 2000 option contracts – that is, options to buy 2000 shares. The investor’s

position could be hedged by buying 0.6 × 2000 = 1200 shares. The gain (loss)

on the option position would then tend to be offset by the loss (gain) on the

stock position. For example, if the stock goes up by 1 euro (producing a gain

of 1200 euro on the shares purchased), the option price will tend to go up by

123
0.6 × 1 = 0.60 euro (producing a loss of 2000 × 0.6 = 1200 euro on the options

written); if the stock price goes down by 1 euro (producing a loss of 1200 euro

on the stock position), the option price will tend to go down by 0.60 (producing

## a gain of 1200 euro on the option position).

It is important to realize that, because delta changes (with time and stock

price movements), the investor’s position remains delta-hedged (or delta neu-

tral) for only a relatively short period of time. In order to have a perfect hedge,

the positions have to be adjusted continuously. In practice however one can only

## adjust periodically. This is known as rebalancing. For example, suppose that

an increase in the stock leads to an increase in delta, say from 0.60 to 0.65. An

extra of 0.05 × 2000 = 100 shares would then have to be purchased to maintain

the hedge.

Tables 5.1 and 5.2 provide two simulations of the operation of periodical

## σ = 0.2 (per year) and T = 20 weeks = 0.3846 years

From this we can easily compute the initial value of the call: C = 2.40047;

and the delta which equals ∆ = 0.52160. This means that as soon as the option

## is written we have to buy 0.52160 × 100000 = 52160 shares at a price of 49 euro,

for the total amount of 49 × 52160 = 2555840 euro. So we must borrow this

124
amount of 2555840 euro to buy 52160 shares. Because the interest rate is 0.05,

## in the first week.

In Table 5.1, the stock price falls to 48.125 euro by the end of the first week.

## and is equal to ∆ = 0.45835. A total of 52160 − (0.45835 × 100000) = 6325

shares must be sold to maintain the hedge. This realizes 6325×48.125 = 304391

cash and the cumulative borrowings at the end of week one are reduced to

2555840 − 304391 + 2459 = 2253908 euro. During the second week the stock

price reduces to 47.375 euro and the delta declines again; and so on. Towards the

end of the life of the option it becomes apparent that the option will be exercised

and the delta approaches 1. By week 20, therefore, the hedger has a fully covered

position. The hedger receives 5000000 euro for the stock held, so that the total

cost of writing the option and hedging it is 5000000 − 5263157 = 263157 euro.

Table 5.2 illustrates an alternative sequence of events such that the option closes

out of the money. As it becomes clearer that the option will not be exercised,

delta approaches zero. By week 20, the hedger has a naked position and has

## incurred costs totaling 256558 euro.

In Table 5.1 and 5.2, the costs of hedging the option, when discounted to

the beginning of the period, i.e. 258145 and 251672 are close to but not exactly

125
Table 5.1: Hedging simulation; call option closes in the money

Table 5.2: Hedging simulation; call option closes out of the money

126
the same as the Black-Scholes price of 240047. If the hedging scheme worked

perfectly, the cost of hedging would, after discounting, be exactly equal to the

theoretical price of the option on every simulation. The reason that there is a

variation in the cost of delta hedging is that the hedge is rebalanced only once a

week. As rebalancing takes place more frequently, the uncertainty in the cost of

hedging is reduced. Of course the simulations above are idealized in that they

assume that the volatility and interest rate are constant and that there are no

transaction costs.

In Figure 5.4, one can see the underlying Standard Brownian Motion, the

related Geometric Brownian Motion, the option prices of a European call option

and the associated hedge over the one year life-time of the option (S0 = 100,

## 5.8 The Greeks

The Black-Scholes option values depend on the (current) stock price S, the

volatility σ, the time to maturity T , the interest rate r, and the strike price K.

The sensitivities of the option price with respect to the first four parameters are

called the Greeks and are widely used for hedging purposes.

## Recall the Black-Scholes formula for a European call:

σ2
!
ln(S0 /K) + (r + 2 )T
C = C(S, T, K, r, σ) = SN √
σ T
σ2
!
−rT ln(S0 /K) + (r − 2 )T
−Ke N √ .
σ T

127
Figure 5.4: Wt , St , Ct and ∆t , t ∈ [0, 1] (S0 = 100, K = 105, r = 0.03, µ = 0.09,

σ = 0.4)

128
We therefore get
!
σ2
δC ln(S0 /K) + (r + 2 )T
∆= = N √ >0
δS σ T
σ2
!
√ ln(S0 /K) + (r +
δC 2 )T
V= = S Tn √ >0
δσ σ T
!
σ2
δC Sσ ln(S0 /K) + (r + 2 )T
Θ= = √ n √ +
δT 2 T σ T
σ2
!
ln(S0 /K) + (r − 2 )T
Kre−rT N √ >0
σ T
!
σ2
δC −rT ln(S0 /K) + (r − 2 )T
ρ= = T Ke N √ >0
δr σ T
 2

ln(S0 /K)+(r+ σ2 )T
n √
δ2 C σ T
Γ= = √ > 0,
δS 2 Sσ T

## where as usual N is the cumulative normal distribution function and n is its

density. As discussed before ∆ measures the change in the value of the option

compared with the change in the value of the underlying asset. Furthermore, ∆

gives the number of shares in the replication portfolio for a call option.

Vega, V, measures the change of the option price compared with the change

in the volatility of the underlying, and similar statements hold for theta Θ, rho

## 5.9 Drawbacks of the Black-Scholes Model

Over the last decades the Black-Scholes model turned out to be very popular.

One should bear in mind however, that this elegant theory hinges on several

129
Figure 5.5: Simulated Normally and Nasdaq Composite log-returns

crucial assumptions. We assumed that there were no market frictions, like taxes

## Moreover, most empirical evidence suggests that the classical Black-Scholes

model does not describe the statistical properties of financial time series very

well. Real markets exhibit from time to time very large discontinuous price

## movements. Moreover, according to the Black-Scholes model, the log-returns,

i.e. differences of the form log St+h −log St , are independent and identically nor-

mally distributed. Figure 5.5 shows daily log-returns of the American Nasdaq-

Composite Index over the period 1-1-1990 until 31-12-2000 and simulated i.i.d.

normal variates with variance equal to the sample variance of the Nasdaq-

Composite log-returns.

130
This picture makes two stylized facts immediately apparent, which are typ-

## ical for most financial time series.

• We see that large asset prize movements occur more frequently than in a

## model with normal distributed increments. This feature is often refered

to as excess kurtosis or fat tails; it is the main reason for considering asset

## • There is evidence for volatility clusters, i.e. there seems to be a succession

of periods with high return variance and with low return variance. This

## Typically we enter the realm of incomplete markets whenever we want to

use models for asset price dynamics which are more ’realistic’ than the Black-

Scholes model. For example markets are incomplete if we consider asset price

131
Chapter 6

Miscellaneous

## 6.1 Decomposing Options into Vanilla Position

Consider an option with a payoff function that only depends on the terminal

stock price value, i.e. assume that the payoff function is of the form f (ST ).

Assume furthermore (for technical reasons) that the function f is twice differ-

entiable.

## The fundamental theorem of calculus implies that for any fixed κ:

Z x Z κ
f (x) = f (κ) + 1(x > κ) f 0 (L)dL − 1(x < κ) f 0 (L)dL
κ x
" #
Z x Z L
= f (κ) + 1(x > κ) f 0 (κ) + f 00 (K)dK dL
κ κ
Z κ  Z κ 
0 00
−1(x < κ) f (κ) − f (K)dK dL.
x L

Noting that f 0 (κ) does not depend on L and interchanging the order of integra-

132
tion (Fubini’s theorem) yields:

Z x Z x
f (x) = f (κ) + f 0 (κ)(x − κ) + 1(x > κ) f 00 (K)dLdK
κ K
Z κ Z K
+1(x < κ) f 00 (K)dLdK.
x x

## Performing the integral over L yields:

Z x
f (x) = f (κ) + f 0 (κ)(x − κ) + 1(x > κ) f 00 (K)(x − K)dK
κ
Z κ
00
+1(x < κ) f (K)(K − x)dK
x
Z ∞ Z κ−
= f (κ) + f 0 (κ)(x − κ) + f 00 (K)(x − K)+ dK + f 00 (K)(K − x)+ dK.
κ 0

Thus, the payoff decomposes into bonds, forward contracts with delivery price

κ, calls struck above κ, and puts struck below κ. Letting V0f denote the initial

value of the contract with payoff f (ST ) at T , then the absence of arbitrage

implies:

## V0f = BT−1 EQ [f (ST )]

Z ∞
= f (κ)BT−1 0
+ f (κ)(S0 − κBT−1 ) + f 00 (K)EC0 (K, T )dK
κ
Z κ
+ f 00 (K)EP0 (K, T )dK,
0

where EC0 (K, T ) and EP0 (K, T ) denotes the initial value of resp. an European

call and put option with strike K and time to maturity T . Note that if we

choose κ = BT S0 , i.e. the forward price of the stock, the second term cancels

out.

133
6.2 Variance Swap

## these points, i.e. Sti , by Si for simplicity. Typically, {t0 = 0, t1 , . . . , tn = T }

corresponds to daily closing times and Si is the closing price at day i. Note that

then

log(Si ) − log(Si−1 ), i = 1, . . . , n,

## correspond to the daily log-returns.

The so-called realized variance (or better, 2nd moment) is then calculated

## using the estimator given by

n
!
1 X 2
(log(Si ) − log(Si−1 )) .
n i=1

## A contract with as payoff

n
" ! #
1 X 2
VS =N × (log(Si ) − log(Si−1 )) −K ,
n i=1

where N denotes the notational amount, is called a variance swap. The value of

K is typically chosen such that the contract has a zero value when it is initiated

(just like in the case of futures and forwards). Basically this contract swaps

## changes in second moment (variance) or the related volatility.

Next, we will show how in a general setting this contract can be hedged

## using more basic contracts.

134
We start with the following (Taylor-like) expansion of the 2nd power of the

logarithmic function

2
(log(x)) = 2 x − 1 − log(x) + O((x − 1)3 ) .


## Substituting x by Si /Si−1 leads to

 
2 ∆Si
(log(Si /Si−1 )) = 2 − log(Si /Si−1 ) + O((∆Si /Si−1 )3 ) ,
Si−1

## Summing over i gives the following decomposition:

n
2
X
(log(Si /Si−1 )) (6.1)
i=1
n  
X ∆Si
= 2 − log(Si /Si−1 ) + O((∆Si /Si−1 )3 )
i=1
Si−1
n n
X ∆Si X
= −2(log(ST ) − log(S0 )) + 2 + O( (∆Si /Si−1 )3 ) (6.2)
i=1
S i−1 i=1

due to telescoping. Thus up to 3rd-order terms the sum of the squared log-

returns decomposes into the payout from a log-contract (−2(log(ST ) − log(S0 )))
Pn ∆Si
and a dynamic strategy (2 i=1 Si−1 ).

## The log-contract can be hedge by a dynamic trading strategy in combination

with a static position in bonds, European vanilla call and put options maturing

## at time T. More precisely, first note that for any L > 0

1
log(ST ) − log(S0 ) = (ST − S0 ) − u(ST ) + u(S0 ), (6.3)
L

for
 
x−L
u(x) = − log(x) + log(L) .
L

135
Moreover with the technique explained in Section 6.1, one can show that

L +∞
1 1
Z Z
u(ST ) = (K − ST )+ dK + (ST − K)+ dK. (6.4)
0 K2 L K2
Pn
Since ST − S0 = i=1 ∆Si , substituting (6.4) in (6.3) and (6.2) implies

n n  
X 2
X 1 2
(log(Si /Si−1 )) ≈ − ∆Si − 2u(S0 )
i=1 i=1
Si−1 L
Z L Z +∞
2 + 2
+ 2
(K − S T ) dK + 2
(ST − K)+ dK
0 K L K

136