MATH5320: Discrete Time Finance

Lecture 2

G. Aivaliotis, c University of Leeds

February 2021

1 / 21
 In the last lecture

• 2-state single period model setting.

• Arbitrage.
• Options.
• Replication Principle.

2 / 21
 In this lecture

• Recap (Video 1)
• How to calculate a replicating strategy (Video 2)
• Risk neutral measure in 2-state single period model setting.
(Video 3)
• Example of risk neutral pricing (Video 4)
• General single period market model. (Video 5)
• Example and Arbitrage definitions (Video 6)

3 / 21
 Recap-The most elementary market model

Ω = {H, T }, P(H) = p, P(T ) = 1 − p

B0 / B1 B0 / B0 (1 + r)

S (H) 7 S0 u
7 1
p p

S0 S0
1−p 1−p

' '
S1 (T ) S0 d

4 / 21
 Recap-Trading strategy

• (x, φ), x =initial investment, φ =number of shares

• in the bank: x − φS0
• The value process of the trading strategy (x, φ):
(V0 (x, φ), V1 (x, φ)), where V0 (x, φ) = x and V1 is the random
variable

V1 (x, φ) = (x − φS0 )(1 + r) + φS1 .

• An arbitrage is a trading strategy that begins with no money,

has zero probability of losing money, and has a positive
probability of making money.

5 / 21
 Replication principle

If it is possible to find a trading strategy which perfectly

replicates the option, meaning that the trading strategy
guarantees exactly the same payoff as the option at
maturity time, then the price of this trading strategy
must coincide with the price of the option.

A replicating strategy or hedge for the option h(S1 ) is a trading

strategy (x, φ) which satisfies V1 (x, φ) = h(S1 ).

6 / 21
 Pricing

Let h(S1 ) be the payoff of an option and let (x, φ) be a

replicating strategy for h(S1 ), then x is the only price for
the option at time t = 0 which does not introduce
arbitrage.

7 / 21
 How to find a replicating strategy?

(x, φ) is a replicating strategy if

(x − φS0 )(1 + r) + φS1 (H) = h(S1 (H)),

(x − φS0 )(1 + r) + φS1 (T ) = h(S1 (T )).

8 / 21
 Risk neutral measure

1+r−d u−1−r
p̃ := , 1 − p̃ = .
u−d u−d
1
(p̃S1 (H) + (1 − p̃)S1 (T )) = S0 .
1+r
S1
E P̃ = S0 .
1+r



1


x= 1+r p̃ h S1 (H) + (1 − p̃)h S1 (T ) .

9 / 21
 Example

1 1
r= , S0 = 1, u = 2, d=
3 2

European call option: K = 1

European put option: K = 1

Put-Call Parity:
1
price of Call − price of Put = S0 − K.
1+r

10 / 21
 Arbitrage

no arbitrage
m
d<1+r <u
m
 S 
1
∃P̃ S0 = E P̃
1+r

P̃ - a risk neutral measure

11 / 21
 Pricing revisited

Let h(S1 ) be the payoff of an option and let (x, φ) be a

replicating strategy for h(S1 ), then x is the only price for
the option at time t = 0 which does not introduce
arbitrage.

 h(S ) 
1
x = E P̃
1+r

12 / 21
 General single period market model

Ω := {ω1 , ..., ωk }, P

Assumption: P(ω) > 0 for all ω ∈ Ω.

Asset prices:

S1i : Ω → R, i = 1, . . . , n.

Money market account:

B1 = B0 (1 + r).

13 / 21
 Trading strategy

A trading strategy is a pair (x, φ), where x is the initial total

investment at time t = 0 and φ = (φ1 , ..., φn ) ∈ Rn is an
n-dimensional vector specifying the number of shares φi of the i-th
stock that we own at t = 0.

We always assume that the rest of the money:

n
X
x− φi S0i
i=1

is invested in the money market account.

14 / 21
 Value process

The value process of the trading strategy (x, φ) is given by

(V0 (x, φ), V1 (x, φ)), where V0 (x, φ) = x and V1 (x, φ) is the
random variable

Pn iSi

Pn iSi .
V1 (x, φ) = x − i=1 φ 0 (1 + r) + i=1 φ 1

15 / 21
 Gains process

∆S i := S1i − S0i .

The gains process G(x, φ):

Pn iSi

Pn i ∆S i .
G(x, φ) := x − i=1 φ 0 r+ i=1 φ

We have:
V1 (x, φ) = V0 (x, φ) + G(x, φ).

16 / 21
 Discounted...

The discounted stock prices Ŝti :

i i
Ŝ0 := S0 ,
1 i = 1, . . . , n.
i i
Ŝ1 := S1 ,
1+r

The discounted value process corresponding to the trading strategy (x, φ):

V̂0 (x, φ) := x
n n
X X
i i i i
V̂1 (x, φ) := (x − φ S0 ) + φ Ŝ1

i=1 i=1

17 / 21
 Discounted...

∆Ŝ i = Ŝ1
i i
− Ŝ0 .

The discounted gains process Ĝ(x, φ):

Pn
Ĝ(x, φ) := φi ∆Ŝ i
i=1

Properties:

V̂1 (x, φ) = V̂0 (x, φ) + Ĝ(x, φ).

18 / 21
 Example

We consider the following model featuring two stocks S 1 and S 2

as well as the states Ω = {ω1 , ω2 , ω3 }. The prices of the stocks at
time t = 0 are given by S01 = 5 and S02 = 10 respectively. At time
t = 1 the prices depend on the state ω and are given by the
following table:
ω1 ω2 ω3
60 60 40
S11 9 9 9
40 80 80
S12 3 9 9

We assume that the interest rate r is equal to 19 .

19 / 21
 Arbitrage

A trading strategy (x, φ) in our general single period market model

is called an arbitrage, if
1 x = V0 (x, φ) = 0
2 V1 (x, φ) ≥ 0
Pk
3 E(V1 (x, φ)) = i=1 P(ωi )V1 (x, φ)(ωi ) >0

Condition 3. is equivalent to:

3’. There exists ω ∈ Ω such that V1 (x, φ)(ω) > 0.

20 / 21
 Arbitrage-Equivalent definitions

A trading strategy (x, φ) in our general single period market model

is called an arbitrage, if
1 x = V̂0 (x, φ) = 0
2 V̂1 (x, φ) ≥ 0
3 E(V̂1 (x, φ)) > 0 or equivalently: there exists ω ∈ Ω such that
V̂1 (x, φ)(ω) > 0.
Or equivalently if
1 x = V̂0 (x, φ) = 0
2 Ĝ(x, φ) ≥ 0
3 E(Ĝ(x, φ)) > 0 or equivalently: there exists ω ∈ Ω such that
Ĝ(x, φ)(ω) > 0.

21 / 21