MATH5320: Discrete Time Finance

Lecture 1

G. Aivaliotis, c University of Leeds

January, 2021

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 Video Index

• Video 1 Week 1: Slides 3-6

• Video 2 Week 1: Slides 6-11
• Video 3 Week 1: Slides 12-13
• Video 4 Week 1: Slides 14-16

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 Organizational information

Lectures and Videos: There will be 11 Lectures with a

corresponding set of slides. For each set, I will be uploading several
videos explaining the lecture slides.
Live Sessions: 11 x 2 hours (1 hour tutorial + 1 hour questions
approximately)

Private study:
6 hours per lecture: 60 hours
4 hours per tutorial: 40 hours
Preparation for assessment: 20 hours.

Method of assessment: 2 hour written exam (100% of mark)

Contact: G.Aivaliotis@leeds.ac.uk
Office hours: You can email for a Teams appointment anytime.

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 Objectives

After completion of the module you will be able to:

• describe the main instruments available in financial markets,
• use mathematical tools to describe the market,
• understand the concept of no-arbitrage (fairness of the
market),
• calculate prices of options,
• find "optimal" ways to invest money,
• understand what dealers and asset managers are talking to
you about.

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 Timetable

• Weeks 1-4: basic model – sophisticated ideas,

• Week 5-8: advanced model,
• Week 9-11: investment models,
• EXAM

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 References

Pliska : Introduction to Mathematical Finance, Blackwell

Publishing
Shreve : Stochastic Calculus for Finance Volume 1 : The
Binomial Asset Pricing Model, Springer
Luenberger : Investment Science, Oxford University Press
Elliott; Kopp : Mathematics of Financial Markets, Springer
Finance.

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 Models

• what is a model?
• a copy of sth, usually smaller than the original object
• a simple description of a system, used for explaining how sth
works or calculating what might happen, etc.
• what models do you know?
• do you find them useful?
• why do we need models?
• mathematical models

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 Models of financial markets

• single period coin toss models,

• general single period models,
• multiperiod models,
• Binomial models,
• Black-Scholes models
• ...
• IDEAS

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 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

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 Trading strategy

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

• what about the money in the bank (the money market
account)?
• borrowing money, short-sales
• Example: r = 2%, S0 = 10, u = 1.2, d = 0.9
• (20, 1)
• (0, 1)
• (3, −1)

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 Value process

The value process of the trading strategy (x, φ) in our elementary

market model is given by (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 .

Example: r = 2%, S0 = 10, u = 1.2, d = 0.9.

• (20, 1)
• (0, 1)
• (3, −1)

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 Arbitrage

r = 2%, S0 = 10, u = 1.2, d = 1.02

Trading strategies:

(0, 1), (0, 10), (0, n)

The value process...

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.

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 Arbitrage

• what happens if d ≥ 1 + r?
• what happens if u ≤ 1 + r?

The model arbitrage free if and only if d < 1 + r < u.

We have not fully proved it. See exercises.

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 European call option

A European call option is a contract which gives its buyer the right
(but not the obligation) to buy a good at a future time T for a
price K. The good, the maturity time T and the strike price K are
specified in the contract.
• the "good",
• T,
• K

h(x) = (x − K)+ the payoff function

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 European put option

A European put option is a contract which gives its buyer the right
(but not the obligation) to sell a good at a future time T for a
price K. The good, the maturity time T and the strike price K are
specified in the contract.
• the "good",
• T,
• K

h(x) = (K − x)+ the payoff function

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 Example

r = 25%, S0 = 4, u = 2, d = 0.5

European call option written on the stock with K = 5

Strategy: (1.2, 0.5)

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 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 ).

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