Derivative Pricing: A Problem-Based

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Derivative Pricing
A Problem-Based Primer
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Derivative Pricing
A Problem-Based Primer

Ambrose Lo
CRC Press
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Contents

List of Figures ix

List of Tables xi

Preface xiii

Symbols xvii

I Conceptual Foundation on Derivatives 1

1 An Introduction to Forwards and Options 3
1.1 Forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.2.1 Call Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.2.2 Put Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.3 Classification of Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
1.4 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

2 Forwards and Futures 27

2.1 Alternative Ways to Buy a Stock . . . . . . . . . . . . . . . . . . . . . . . . 27
2.2 Prepaid Forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
2.2.1 Nondividend-paying Stocks . . . . . . . . . . . . . . . . . . . . . . . 29
2.2.2 Dividend-paying Stocks . . . . . . . . . . . . . . . . . . . . . . . . . 31
2.3 Forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.3.1 Forward Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.3.2 Cash-and-Carry Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . 39
2.3.3 Digression: Market Frictions . . . . . . . . . . . . . . . . . . . . . . . 44
2.4 Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
2.4.1 Differences between Futures and Forwards . . . . . . . . . . . . . . . 46
2.4.2 Marking to Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
2.5 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

3 Option Strategies 57
3.1 Basic Insurance Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
3.1.1 Insuring a Long Position: Floors . . . . . . . . . . . . . . . . . . . . 57
3.1.2 Insuring a Short Position: Caps . . . . . . . . . . . . . . . . . . . . . 61
3.1.3 Selling Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
3.1.4 A Simple but Useful Observation: Parallel Payoffs, Identical Profit . 65
3.2 Put-call Parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
3.2.1 Synthetic Forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
3.2.2 The Put-call Parity Equation . . . . . . . . . . . . . . . . . . . . . . 68
3.3 Spreads and Collars . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
3.3.1 Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

v
vi Contents

3.3.2 Collars . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
3.4 Volatility Speculation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
3.4.1 Straddles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
3.4.2 Strangles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
3.4.3 Butterfly Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
3.5 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

II Pricing and Hedging of Derivatives 113

4 Binomial Option Pricing Models 115
4.1 One-period Binomial Trees . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
4.1.1 Pricing by Replication . . . . . . . . . . . . . . . . . . . . . . . . . . 115
4.1.2 Risk-neutral Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
4.1.3 Constructing a Binomial Tree . . . . . . . . . . . . . . . . . . . . . . 125
4.2 Multi-period Binomial Trees . . . . . . . . . . . . . . . . . . . . . . . . . . 131
4.3 American Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
4.4 Options on Other Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
4.4.1 Case Study 1: Currency Options . . . . . . . . . . . . . . . . . . . . 149
4.4.2 Case Study 2: Options on Futures . . . . . . . . . . . . . . . . . . . 150
4.5 Epilogue: Pricing by Real Probabilities of Stock Price Movements . . . . . 152
4.6 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

5 Mathematical Foundations of the Black-Scholes Framework 171

5.1 A Lognormal Model of Stock Prices . . . . . . . . . . . . . . . . . . . . . . 171
5.2 Lognormal-Based Probabilistic Quantities . . . . . . . . . . . . . . . . . . . 174
5.3 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182

6 The Black-Scholes Formula 185

6.1 Black-Scholes Formula for Stocks Paying Continuous Proportional Dividends 185
6.2 Applying the Black-Scholes Formula to Other Underlying Assets . . . . . . 191
6.2.1 Case study 1: Stocks paying non-random, discrete dividends. . . . . 192
6.2.2 Case Study 2: Currency options. . . . . . . . . . . . . . . . . . . . . 196
6.2.3 Case Study 3: Futures options. . . . . . . . . . . . . . . . . . . . . . 200
6.3 Option Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
6.3.1 Option Delta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
6.3.2 Option Gamma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
6.3.3 Option Greeks of a Portfolio . . . . . . . . . . . . . . . . . . . . . . 211
6.3.4 Option Elasticity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
6.4 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220

7 Option Greeks and Risk Management 231

7.1 Delta-hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
7.2 Hedging Multiple Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
7.3 Delta-Gamma-Theta Approximation . . . . . . . . . . . . . . . . . . . . . . 244
7.4 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253

8 Exotic Options 261

8.1 Gap Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
8.1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
8.1.2 All-or-Nothing Options . . . . . . . . . . . . . . . . . . . . . . . . . 264
8.1.3 Pricing and Hedging Gap Options . . . . . . . . . . . . . . . . . . . 268
8.2 Exchange Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
Contents vii

8.2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273

8.2.2 Pricing Exchange Options . . . . . . . . . . . . . . . . . . . . . . . . 274
8.2.3 Pricing Maximum and Minimum Contingent Claims . . . . . . . . . 280
8.3 Compound Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
8.4 Asian Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
8.4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
8.4.2 Pricing Asian Options . . . . . . . . . . . . . . . . . . . . . . . . . . 290
8.5 Lookback Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
8.6 Shout Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
8.7 Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
8.8 Other Exotic Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
8.8.1 Chooser Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
8.8.2 Forward Start Options . . . . . . . . . . . . . . . . . . . . . . . . . . 311
8.9 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315

III Epilogue 335

9 General Properties of Option Prices 337
9.1 Put-Call Parity and Duality . . . . . . . . . . . . . . . . . . . . . . . . . . 337
9.1.1 Generalized Parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
9.1.2 Currency Put-call Duality . . . . . . . . . . . . . . . . . . . . . . . . 340
9.2 Upper and Lower Bounds on Option Prices . . . . . . . . . . . . . . . . . . 343
9.3 Comparing Options with Respect to Contract Characteristics . . . . . . . . 347
9.3.1 Strike Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347
9.3.2 Maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355
9.4 Early Exercise Decisions for American Options . . . . . . . . . . . . . . . . 357
9.4.1 Proof 1: A Proof Based on No-arbitrage Bounds . . . . . . . . . . . 357
9.4.2 Proof 2: A Cost-benefit Dissection Proof . . . . . . . . . . . . . . . . 358
9.4.3 Early Exercise Criterion for American Puts . . . . . . . . . . . . . . 360
9.5 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362

Appendix A Standard Normal Distribution Table 367

Appendix B Solutions to Odd-Numbered End-of-Chapter Problems 369

B.1 Chapter 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
B.2 Chapter 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370
B.3 Chapter 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373
B.4 Chapter 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378
B.5 Chapter 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389
B.6 Chapter 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391
B.7 Chapter 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398
B.8 Chapter 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404
B.9 Chapter 9 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422

Bibliography 427

Index 429
List of Figures

1.1.1 Payoff diagrams of a long forward (left) and a short forward (right). . . . 6
1.2.1 Payoff and profit diagrams of a long call (left) and a short call (right). . . 10
1.2.2 The profit functions of the three calls in Example 1.2.2. . . . . . . . . . . 13
1.2.3 Payoff and profit diagrams of a long put (left) and a short put (right). . . 16

3.1.1 The payoff diagrams of a long asset (unhedged, dashed) and a long asset
coupled with a long K-strike put (hedged, bold). . . . . . . . . . . . . . . 58
3.1.2 The payoff diagrams of a short asset (unhedged, dashed) and a short asset
coupled with a long K-strike call (hedged, bold). . . . . . . . . . . . . . . 62
3.2.1 The payoff diagram of a long synthetic forward constructed by K-strike
long call and short put options. . . . . . . . . . . . . . . . . . . . . . . . . 67
3.3.1 Payoff diagram of a call K1 -K2 bull spread. . . . . . . . . . . . . . . . . . 76
3.3.2 Payoff diagram of K1 -K2 bear spreads constructed by calls (left) and by
puts (right). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
3.3.3 Payoff diagram of a long K1 -K2 collar. . . . . . . . . . . . . . . . . . . . . 84
3.3.4 Illustration of the construction of two different zero-cost collars: a K1 -K2
zero-cost collar and a K10 -K20 zero-cost collar. . . . . . . . . . . . . . . . . 90
3.4.1 The payoff and profit diagrams of a long K-strike straddle. . . . . . . . . 91
3.4.2 Payoff diagram of a long K1 -K2 strangle. . . . . . . . . . . . . . . . . . . 93
3.4.3 The payoff diagrams of the student’s “strange” and a genuine strangle in
Example 3.4.4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
3.4.4 Payoff diagram of a long K1 -K2 -K3 butterfly spread constructed by a short
K2 -strike straddle coupled with a long K1 -K3 strangle. . . . . . . . . . . 97
3.4.5 Payoff diagram of a long K1 -K2 -K3 call (or put) butterfly spread. . . . . 98

4.1.1 A generic one-period binomial stock price model. The derivative payoffs
are shown in parentheses. . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
4.2.1 A generic two-period binomial stock price tree. . . . . . . . . . . . . . . . 132
4.3.1 The two-period binomial tree for Example 4.3.1. . . . . . . . . . . . . . . 142
4.3.2 The two-period binomial forward tree for Example 4.3.2. . . . . . . . . . 144
4.3.3 The two-period binomial tree for Example 4.3.3. . . . . . . . . . . . . . . 145
4.3.4 The two-period binomial tree for Example 4.3.4. . . . . . . . . . . . . . . 147
4.4.1 The exchange rate evolution in Example 4.4.1. . . . . . . . . . . . . . . . 151
4.4.2 The binomial futures price tree in Example 4.4.2. . . . . . . . . . . . . . . 153

5.1.1 A stock price path in the Black-Scholes stock price model with S(0) = 100,
α = 0.08, and σ = 0.3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174

6.2.1 The cash flows between different parties in Example 6.2.4. . . . . . . . . . 200
6.3.1 The variation of call and put deltas with the current stock price for different
times to expiration. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207

ix
x List of Figures

6.3.2 The variation of gamma with the current stock price for different times to
expiration. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

7.1.1 Comparison of the overnight profit of an unhedged written call and the
overnight profit of a delta-hedged written call. . . . . . . . . . . . . . . . 241
7.2.1 Comparison of the overnight profit of a delta-hedged written call and the
overnight profit of a delta-gamma-hedged written call. . . . . . . . . . . . 245
7.3.1 Geometric meaning of the delta- and delta-gamma approximations of the
option price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249

8.1.1 The payoff diagram of a K1 -strike K2 -trigger European gap call option (in
bold) when (i) K1 < K2 (left), and (ii) K1 ≥ K2 (right). . . . . . . . . . . 262
8.3.1 A timeline diagram showing how a compound option works. . . . . . . . . 284
8.4.1 The three-dimensional descriptions of Asian options. . . . . . . . . . . . . 289
8.4.2 The two-period binomial stock price tree for Example 8.4.2. . . . . . . . . 291
8.5.1 The two-period binomial stock price tree used in Example 8.5.2. . . . . . 296
8.6.1 The two-period binomial stock price tree for Example 8.6.1. . . . . . . . . 298
8.7.1 The three-dimensional descriptions of barrier options. . . . . . . . . . . . 300
8.7.2 The three-period binomial stock price tree for Example 8.7.6. . . . . . . . 307
8.8.1 A timeline diagram showing how a chooser option works. . . . . . . . . . 308
8.8.2 A timeline diagram showing how a forward start option works. . . . . . . 311

B.1.1 Profit diagrams of the three puts in Problem 1.4.5. . . . . . . . . . . . . . 370

B.3.1 The profit diagrams of the 50-60 bear spread and the 50-60 collar in Prob-
lem 3.5.23. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376
B.9.1 The sets of allowable values for the European put price (left) and American
put price (right). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 424
List of Tables

1.1 Cash flows associated with a long forward (physical settlement). . . . . . 5

1.2 Cash settlement of a long forward. . . . . . . . . . . . . . . . . . . . . . . 7
1.3 Cash flows associated with a long European call position. . . . . . . . . . 10
1.5 Different criteria to compare derivatives. . . . . . . . . . . . . . . . . . . . 21

2.1 Four different ways to own one share of stock at time T . . . . . . . . . . . 28

P
2.2 Trading strategies to effect arbitrage when F0,T > S(0). . . . . . . . . . . 31
2.3 Demonstration of (2.3.3) in the case of continuous proportional dividends. 39
2.4 Transactions and cash flows for a cash-and-carry arbitrage. . . . . . . . . 40
2.5 Transactions and cash flows for a reverse cash-and-carry arbitrage. . . . . 42
2.7 Differences between forwards and futures. . . . . . . . . . . . . . . . . . . 47
2.8 Mark-to-market proceeds and margin account balance over 4 days from a
long position in S&P 500 futures contract. . . . . . . . . . . . . . . . . . . 49

6.1 Comparing stock options and currency options in the Black-Scholes frame-
work. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
6.2 The definitions and symbols of the six most common option Greeks. . . . 202

xi
Preface

Derivatives, which are financial instruments whose value depends on or is “derived” from
(hence the name “derivatives”) other more basic underlying variables, have become com-
monplace in financial markets all over the world. The proliferation of these relatively new
financial innovations, options in particular, has underscored the ever-increasing importance
of derivative literacy among a wide range of users that span students, practitioners, reg-
ulators, and researchers, all of whom are in need of a fundamental understanding of the
mechanics, typical uses, and pricing theory of derivatives, though to different extents. De-
spite the diversity of such users, existing books on the subject have predominantly catered
to only a very specific group of users and gone to two extremes. They either adopt a mostly
descriptive approach to the intrinsically technical subject of derivatives, with occasional
number crunching and slavish applications of pricing formulas taken without proof, or are
preoccupied with sophisticated mathematical techniques from such areas as random pro-
cesses and stochastic calculus, which can be inaccessible to students or practitioners lacking
the necessary background and undesirably obscure the underlying conceptual ideas. Neither
the “black box” approach nor the “purely mathematical” approach is of much pedagogical
value.
Being an outgrowth of my lecture notes for a course entitled ACTS:4380 Mathematics
of Finance II offered at the University of Iowa for advanced undergraduate and beginning
graduate students in actuarial science, this book is a solid attempt to strike a balance
between the two aforementioned methods to teach and learn derivatives, and to meet the
needs of different types of readers. Adopting a mathematically rigorous yet widely accessible
approach that will appeal to a wide variety of audience, the book is conceptually driven and
strives to demystify the mechanics of typical derivatives and the fundamental mechanism
of derivative pricing methodologies that should be part of the toolkit of every professional
these days. This is accomplished by a combination of lucid explanations of the theory and
assumptions behind common derivative pricing models, repeated emphasis on a small set
of core ideas (e.g., no-arbitrage principle, replication, risk-neutral pricing), and a careful
selection of fully worked-out illustrative examples and end-of-chapter problems. Readers of
this book will leave with a firm understanding of “what” derivatives are, “how” and, more
importantly, “why” derivatives are used and derivative pricing works.
Here is the skeleton of this book, divided into three parts.
• Part I (Chapters 1 to 3) lays the conceptual groundwork of the whole book by setting up
the terminology of derivatives commonly encountered in the literature and introducing
the definition, mechanics, typical use, and payoff structures of the two primary groups of
derivatives, namely, forwards and options, which bestow upon their holders an obligation
and a right to trade an underlying asset at a fixed price on a fixed date, respectively.
Particular emphasis is placed on how and why a derivative works in a given scenario of
interest. In due course, we also present the all-important no-arbitrage assumption and
the method of pricing by replication. In loose terms, the former says that the prices of
derivatives should be such that the market does not admit “free lunches,” and the latter
implements the former using the common-sense idea that if two derivatives possess the
same payoff structure at expiration, they must enjoy the same initial price. Underlying

xiii
xiv Preface

the pricing and hedging of derivatives throughout this book, these two vehicles are
applied in this part to determine the fair price of a forward, where “fair” is meant in
the sense that the resulting price permits no free lunch opportunities.
• Whereas the pricing of forwards is model-independent in that it works for any asset
price distribution, the pricing of options depends critically on the probabilistic behavior
of the future asset price. In Part II (Chapters 4 to 8), which is the centerpiece of this
book, we build upon the background material in Part I and tackle option pricing in two
stages—first in the discrete-time binomial tree model (Chapter 4), which is simple, intu-
itive, and easy to implement, then in the technically more challenging continuous-time
Black-Scholes model (Chapters 5 to 8). In this part, the no-arbitrage assumption and
the method of replication continue to play a vital role in valuing options and lead to
the celebrated risk-neutral pricing formula, which asserts that the price of a (European)
derivative can be computed as its expected payoff at expiration in a risk-neutral sense,
discounted at the risk-free interest rate. The implementation and far-reaching implica-
tions of the method of risk-neutral valuation for the pricing and hedging of derivatives
are explored in Chapters 6 to 8.
• Finally, we end in Part III (Chapter 9) with a description of some general properties
satisfied by option prices when no asset price model is prescribed. Even in this model-
free framework setting, there is a rich theory describing the no-arbitrage properties
universally satisfied by option prices. Although this part can be read prior to studying
Part II, you will find that what you learn from Part II, especially the notion of an
exchange option in Chapter 8, will provide you with surprisingly useful insights into the
connections between different options.
It deserves mention that this book, as a primer, is indisputably not encyclopedic in
scope. The choice of topics is geared towards the derivatives portion (Topics 6 to 10) of the
Society of Actuaries’ Investment and Financial Markets (IFM) Exam,i which is typically
taken by advanced undergraduate students in actuarial science and allied disciplines. The
theory of random processes and stochastic calculus, while conducive to understanding the
pricing theory of derivatives in full but often an insurmountable barrier to first-time learners,
is not covered in the book, neither are credit and interest rate derivatives (which, without
doubt, are important in practice). By concentrating on the most essential conceptual ideas,
we realize the huge “payoff” of being able to disseminate these core ideas to readers with
minimal mathematical background; it is understandable that individuals interested in using
and pricing derivatives nowadays come from a wide variety of background. To be precise,
readers are only assumed to have taken a calculus-based probability and statistics course
at the level of Hogg, Tanis and Zimmerman (2014) or Hogg, McKean and Craig (2013),
where the basic notions of random variables, expectations, variances, are taught, and be
able to perform simple discounted cash flow calculations as covered in a theory of interest or
corporate finance course. With these modest prerequisites, this book is self-contained, with
the necessary mathematical ideas presented progressively as the book unfolds. For readers
interested in more advanced aspects of the use and pricing of derivatives, this book will
provide them with a springboard for performing further studies in this burgeoning field.
It is widely acknowledged that the best way to learn a subject deeply is to test your un-
derstanding with a number of meaningful exercises. With this in mind, this primer lives up
to its name and features an abundance of illustrative in-text examples and end-of-chapter
problems (to be precise, 177 examples and 209 problems) on different aspects of deriva-
tives. These problems are of a diverse nature and varying levels of difficulty (harder ones
i Section 4.5, Section 7.3 (the portion on the Black-Scholes equation), Subsection 8.1.2, and Section 9.1

are beyond the scope of the Exam IFM syllabus.

Preface xv

are labeled as [HARDER!]); while many emphasize calculating quantities such as payoffs,
prices, profits, a primitive skill that most students in a derivatives course need to acquire,
at least for exam purposes (in this respect, this book is an ideal exam preparation aid for
students who will write Exam IFM), some concern more theoretical aspects of using and
pricing derivatives, and consist of true-or-false items or derivations of formulas. All of these
problems can be worked out in a pen-and-paper environment with the aid of a scientific cal-
culator and a standard normal distribution function calculator (an example is https://www.
prometric.com/en-us/clients/soa/pages/mfe3f_calculator.aspx, which is designed
for students who will take Exam IFM.). If you do not have Internet access, you may use
the less precise standard normal distribution table provided in Appendix A of this book.
Readers who attempt these examples and problems seriously will benefit from a much more
solid understanding of the relevant topics. To help you check your answers, full solutions to
all odd-numbered end-of-chapter problems are provided in Appendix B. A solutions manual
with solutions to all problems is available to qualified instructors.
It would be remiss of me not to thank my past ACTS:4380 students for personally class
testing earlier versions of the book manuscript and many of the end-of-chapter problems,
as well as my esteemed colleague, Professor Elias S.W. Shiu, at the University of Iowa, for
sharing with me his old ACTS:4380 notes and questions, from which some of the examples
and problems in this book were motivated. I am also grateful to the Society of Actuaries
and Casualty Actuarial Society for kindly allowing me to reproduce their past and sample
exam questions, of which they own the sole copyright, and which have proved instrumental
in illustrating ideas in derivative pricing. Doctoral student Zhaofeng Tang at the University
of Iowa merits a special mention for his professional assistance with some of the figures in
this book and for meticulously proofreading part of the book manuscript. All errors that
remain, typographical or otherwise, are solely mine. To help improve the content of the book,
I would deeply appreciate it if you could bring any potential errors you have identified to my
attention; my email address is ambrose-lo@uiowa.edu. For readers’ benefits, an erratum
and updates to the book will be maintained on my web page at https://sites.google.
com/site/ambroseloyp/publications/derivative-pricing.
It is my sincere hope that this book will not only introduce you to the fascinating world
of derivatives, but also to instill in you a little of the enthusiasm I have for this subject
since my undergraduate studies. Welcome and may the fun begin!

Ambrose Lo, PhD, FSA, CERA

Iowa City, IA
May 2018
Symbols

Symbol Description
S or S(0) time-0 price of an underlying Ft,T time-t price of a forward ma-
asset turing at time T
S(t) time-t price of an underlying obs
Ft,T time-t observed price of a for-
asset ward maturing at time T
S a (0) time-0 ask price of an underly- fair
Ft,T time-t fair price of a forward
ing asset maturing at time T
S b (0) time-0 bid price of an underly- V time-0 price of a generic
ing asset derivative
X(t) time-t exchange rate V max time-0 price of a maximum
K strike price of an option contingent claim
K1 strike price of a gap option V min time-0 price of a minimum
K2 payment trigger of a gap op- contingent claim
tion C time-0 price of a generic call
r continuously compounded CE time-0 price of a generic Euro-
risk-free interest rate (per an- pean call
num) CA time-0 price of a generic Amer-
rb continuously compounded ican call
borrowing rate (per annum) C(K, T ) time-0 price of a K-strike T -
rl continuously compounded year call
lending rate (per annum) C gap (K1 , K2 ) time-0 price of a K1 - strike K2 -
i effective annual interest rate trigger generic gap call
(per annum) C(S(t), K, t, T ) time-t price of a K-strike call
PVt,T time-t (present) value of cash maturing at time T when the
flows between time t and time-t stock price is S(t)
timeT P time-0 price of a generic put
FVt,T time-T (future) value of cash PE time-0 price of a generic Euro-
flows between time t and pean put
timeT PA time-0 price of a generic Amer-
T maturity time of a generic ican put
derivative P gap (K1 , K2 ) time-0 price of a K1 -strike K2 -
Tf maturity time of a futures con- trigger generic gap put
tract P (S(t), K, t, T ) time-t price of a K-strike put
T1 maturity time of a compound maturing at time T when the
option time-t stock price is S(t)
T2 maturity time of the underly- BS Black-Scholes pricing function
ing option of a compound op- σ volatility of an underlying as-
tion set
P
Ft,T time-t price of a prepaid for- σoption volatility of an option
ward maturing at time T ∆ delta of a generic derivative

xvii
xviii Symbols

∆C delta of a generic call ρ(X, Y ) correlation coefficient between

∆P delta of a generic put random variables X and Y
Γ gamma of a generic derivative N (·) distribution function of the
ΓC gamma of a generic call standard normal distribution
ΓP gamma of a generic put
N 0 (·) density function of the stan-
Ω elasticity of a generic deriva-
dard normal distribution
tive
ΩC elasticity of a generic call := defined as
ΩP elasticity of a generic put LHS left-hand side
E[X] expectation of random vari- RHS right-hand side
able X
x+ positive part of real number x
Var(X) variance of random variable X
Cov(X, Y ) covariance between random 1A indicator function of event A
variables X and Y ZCB zero-coupon bond
 Part I

Conceptual Foundation on
Derivatives
1
An Introduction to Forwards and Options

Chapter overview: This book centers on derivatives—not those you have studied in your
calculus class, but those instruments whose values (or, in financial parlance, payoffs) depend
on or are “derived” from other more basic underlying variables, such as the price of a stock
or a commodity, an interest rate, a currency exchange rate, or even non-financial variables
like the temperature of a city on a particular day or your semester GPA in college, so long as
they can be quantified. These underlying driving variables are called the underlying asset,
or in short, the underlying. To begin our systematic study of derivatives, this preparatory
chapter provides a conceptual introduction to the two predominant types of derivatives,
namely, forwards and options, and sets up the basic derivatives terminology that will be
intensively used throughout this book. These primitive derivatives are basic building blocks
of more sophisticated financial instruments that will be examined in later chapters. For each
of forwards and options, we analyze its mechanics, typical use, and, most importantly, the
structure and derivation of its payoff.

1.1 Forwards
Instead of spoon-feeding you directly with the terms and conditions of different kinds of
derivatives, a much better way to get you to better understand their use and mechanics is
through a daily-life example most familiar to actuarial students.

Motivating example.
It is now July 1, 3017 (assume that Doomsday has not yet come). You are planning to take
Exam X, a notoriously difficult actuarial exam, in November 3017 and will be in severe need
of a study manual in August for your exam preparation (assume that 3 months are enough
for your study!). According to the Internet (assume that the Internet still exists in the next
millennium), the current price of the study manual for Exam X is $250 (per unit). You are
worried, however, that the price of the study manual would rise dramatically over the next
month, which would seriously jeopardize your financial well-being as a frugal student. Is
there a way to protect yourself against adverse increases in the price of the study manual?
Now consider the following “contract” available in the market:
You will be provided with one copy of the study manual on August 1, 3017 in
exchange for $275. The contract needs to be signed today and will bind you legallyi
to pay $275 for the study manual on August 1.
Such a “contract” is the quintessence of a forward contract, the subject of the current
section.
i We ignore counterparty risk, i.e., the risk that one or more parties fail to deliver on the obligations

imposed by the derivative.

3
4 1 An Introduction to Forwards and Options

What is a forward?
In general, a forward contract, or simply a forward , is an agreement between two parties
(also called counterparties) to buy or sell an asset at a certain time in the future at a certain
price. The contract is agreed upon and signed today, with one party (the buyer) undertaking
to pay the stipulated price in exchange for the asset and the other party (the seller) liable to
deliver the asset and receive the same stipulated price at the particular future time specified
in the contract. This way, a forward effectively removes the uncertainty that one needs to
face with respect to the future price of the underlying asset. Here is a good mnemonic that
helps you remember and make sense of a forward:
A forward allows you to look forward in time and lock in the transaction price of an
asset you wish to buy or sell in the future.
With respect to terminology, the essential elements in a forward are:
Study Manual
Term Description
Example
Underlying asset The asset that the forward is Study manual
based on
Expiration date The time when the forward has August 1, 3017
(or maturity date) to be settled
Forward price The price that will be paid $275
when the forward is settled
You are long the
Long or short If you buy (resp. sell) the
forward
forward, you are said to be in a
long (resp. short) forward
position. The words long and
short can serve as adjectives or
verbs, so we may also say that
you long (resp. short) the
forward.
The most important ingredient in a forward is the forward price. In this introductory chap-
ter, we take the forward price as given. In Chapter 2, we will study in detail how the forward
price can be determined in a way that is fair in a sense to be formalized. Notation-wise,
we denote generically by S(t) the time-t price of the underlying asset (the use of “S” is
motivated by the fact that the most common underlying asset is a stock; in fact the terms
“underlying asset” and “underlying stock” will be used interchangeably in the sequel when
no confusion arises), and by F0,T the forward price that is determined at time 0 and will be
paid at time T . Unless otherwise stated, in this book we will always measure time in years.

The payoff of a forward contract.

A very useful way to describe a derivative, a forward in particular, is to look at its pay-
off. This concept permeates virtually the entire book and is one of the most important
dimensions of a derivative. Loosely speaking, the payoff of a derivative position at a par-
ticular time point at or before the expiration date is defined as the value of the position.
An equivalent, but more informative and concrete definition that lends itself to practical
computations is that the payoff of a derivative at a given point of time equals the amount
of money that its holder would have had if he/she completely liquidated his/her position,
i.e., to sell whatever he/she is holding, and buy back whatever he/she has owed.
Let us apply this line of reasoning to determine the payoff of a T -year long forward (i.e.,
1.1 Forwards 5

Time Transaction Cash Flow

0 You buy a forward. 0
T You settle the forward by paying the −F0,T
seller the forward price, F0,T .
The seller delivers the asset to you. 0
You sell the asset at the spot price (i.e., +S(T )
market price) of the asset, S(T ).
Total: S(T ) − F0,T

TABLE 1.1
Cash flows associated with a long forward (physical settlement).

the forward expires in T years). Under a long forward, at expiration you pay F0,T for the
underlying asset and can cash out by selling the asset at its market price for S(T ) (see Table
1.1). On a net basis, you receive S(T ) − F0,T . This is the payoff of a T -year long forward:

Payoff of long forward = Spot price − forward price = S(T ) − F0,T . (1.1.1)
| {z } | {z }
receive (income) pay (cost)

The cash flows associated with a short forward are the exact opposite of those of a long
forward. Upon receiving the forward price from the buyer, purchasing the underlying asset
at the market price for S(T ), and delivering the asset thus purchased to the buyer, you as
the short forward party receive a payoff of

Payoff of short forward = Forward price − spot price = F0,T − S(T ), (1.1.2)

which is a mirror image of (1.1.1). You may notice that the sum of (1.1.1) and (1.1.2) is
exactly zero. In other words, a forward is a zero-sum game, with what the buyer gains
exactly offset by what the seller loses.

Example 1.1.1. (SOA Exam IFM Introductory Derivatives Sample Question

68: Payoff of long/short forward) For a nondividend-paying stock index, the current
price is 1100 and the 6-month forward price is 1150. Assume the price of the stock index
in 6 months will be 1210.
Which of the following is true regarding forward positions in the stock index?
(A) Long position gains 50
(B) Long position gains 60

(C) Long position gains 110

(D) Short position gains 60
(E) Short position gains 110

Solution. By (1.1.1) and (1.1.2), the long forward will gain 1210 − 1150 = 60 while
the short forward will gain 1150 − 1210 = −60, i.e., a loss of 60. (Answer: (B))

It deserves mention that a forward imposes upon its counterparties an obligation to

6 1 An Introduction to Forwards and Options

Payoff Payoff

Slope = 1

S(T ) S(T )
0 F0,T 0 F0,T

Slope = −1

FIGURE 1.1.1
Payoff diagrams of a long forward (left) and a short forward (right).

execute the contract at expiration. Under a long forward position, you are obligated to pay
the forward price at the expiration date, regardless of how high or low the then market
price is. Even if the ending asset price is less than the forward price, in which case you
suffer a loss, you still need to settle the forward. This is a characteristic of a forward that
distinguishes it from other derivatives.

Payoff diagrams.
In Part I of this book, we will make intensive use of a visual device called a payoff diagram,
which displays graphically the payoff of a derivative as a function of the underlying asset
price at the point of interest. As we shall see soon, the payoff diagrams of many derivatives
possess salient features that say a lot about the properties of the derivatives. In fact, one
of the best ways to remember a derivative is arguably to associate it with the geometry of
its payoff diagram.
Given (1.1.1) and (1.1.2), the payoff diagrams of a long forward and a short forward are
sketched in Figure 1.1.1. They are straight lines cutting the horizontal axis at the forward
price F0,T with a slope of 1 and −1, respectively. The linearity arises from a commitment to
trade the underlying asset in the future. In contrast, we will see in Section 1.2 that options,
the other primary category of derivatives, are characterized by nonlinear payoff functions
because of their intrinsic optionality.

Physical vs cash settlement.

In the above discussions, we assumed that at the expiration of the forward, the seller indeed
delivers the asset to the buyer for F0,T , and the buyer indeed cashes out by selling the asset
for S(T ), realizing a payoff of S(T )−F0,T . This mode of settling a forward involving genuine
delivery of the underlying asset is known as physical settlement of a forward. On second
thought, however, it would make no difference if the seller directly gives the buyer an amount
of S(T ) − F0,T in cash (this amount can be positive or negative); see Table 1.2. The holder
of the long forward will be in the same financial position as when there is genuine physical
delivery of the underlying. Settling a forward this way by means of a direct exchange of cash
without the corresponding delivery of the underlying asset is known as cash (or financial)
settlement. Both physical settlement and cash settlement apply not only to forwards but
also to other derivatives.
The two modes of settlement have their relative merits and demerits. Physical settlement
aids our understanding of the mechanics of a derivative and the reason for using that
1.2 Forwards 7

Time Transaction Cash Flow

0 You buy a forward. 0
T The seller pays you S(T ) − F0,T . S(T ) − F0,T

TABLE 1.2
Cash settlement of a long forward.

derivative in the first place. It is also critical to the fundamental derivation of its payoff
formula (the long forward payoff formula S(T ) − F0,T , while taken by many for granted,
can be derived from basics and need not be taken as a definition). However, a physical
transaction in practice will incur possibly significant transaction costs and is applicable
only to assets for which physical delivery is possible. This excludes more abstract assets
such as temperature, your GPA, interest rates, market volatility, all of which cannot be
physically traded. Cash settlement is widely applicable and simple to understand, but it
does not lend itself to deriving the payoff of a derivative from first principles. Both modes
of settlement will be used in the later part of this book, although cash settlement will play
the dominant role.

Main motivation for using derivatives: Hedging and speculation.

With the payoff formula determined above, we are in a much better position to understand
the typical use of a forward. Back to the study manual example, we again denote by S(T )
the unit price of the study manual on August 1. Suppose that the study manual is a necessity
to you, so that you must buy the study manual however cheap or expensive it is. Under this
assumption, your cash flow on August 1 will be −S(T ), which is inherently random. If you
couple your position with a long forward on the study manual, then your payoff on August 1
will be constant at −S(T ) + (S(T ) − F0,T ) = −F0,T . In effect, what you have to pay to own
the study manual is transformed from a random amount of S(T ) to the constant forward
price F0,T . The long forward therefore allows you to hedge against the risk associated with
the price of the study manual on August 1 by locking in the transaction price.
More generally, hedging aims to use the cash flows generated by a derivative to mitigate
the (often random) cash flows from a given position. In the case of a forward, the payoff from
the long forward counteracts the random cash outflow as a result of buying the underlying
at its random future price. With a forward, you are shielded from the price risk of the un-
derlying; the cash flow uncertainty arising from the future transaction has been completely
eliminated. Long forwards are commonly employed by business companies to hedge against
the future price risk associated with their necessary production inputs and outputs. They
are also popular among importers or exporters concerned with the fluctuations of foreign
exchange rates in the future.
In contrast to hedging, speculation refers to the attempt to profit from anticipated price
movements of the underlying asset without an existing exposure in the asset. In the study
manual example, if your mom, whom I assume does not need the study manual for her own
use (unless she happens to be an actuarial science professor!), is convinced that the price
of the study manual will skyrocket (resp. plummet) in August, she may take advantage of
her belief by buying (resp. selling ) a forward. Should the price of the study manual go up
(resp. go down) as expected, she can reap a huge payoff from her long (resp. short) forward
position. Of course, she may also suffer a huge loss from the forward if the price of the study
manual does not move in the direction she predicts.
8 1 An Introduction to Forwards and Options

1.2 Options
1.2.1 Call Options
Motivation.
Recall from Section 1.1 that if you enter into a forward, you are required under any circum-
stances to settle the forward at the expiration date, even if doing so results in a negative
payoff. In the study manual example, if the price of the study manual on August 1, 3017 is
only $260, it seems stupid (of course, with the benefit of hindsight!) to buy the manual at
the forward price of $275—you will pay $15 more! You may wonder:
Is there a derivative that entitles you the option to buy an asset if and only if doing
so is to your interest, i.e., you have the right to walk away from the deal if you wish
to?
Derivatives that give you an option to buy or sell an asset are naturally called options (pun
intended!). There are two main types of options, namely, call options and put options. They
are intended to provide one-sided protection against unfavorable movements in the price of
the underlying asset.

Definition and terminology of a call option.

A call option (or a call in short) gives its holder the right, but not the obligation, to buy
the underlying asset at a prespecified price. Here is a cheap mnemonic:
By means of a call, you have the option to “call” the asset from someone and own
it.
In addition to “underlying asset” and “long or short,” which enjoy the same definition as a
forward, the following terms are very useful in specifying an option in general and a call in
particular.
1. Exercise: Exercising an option refers to the act of making use of the option to trade the
underlying asset. If you exercise a call, you pay a certain price (see the next point) in
return for the underlying asset.
2. Strike price: The strike price, also known as exercise price or simply the strike, is the
price specified in the contract at which the option holder can exercise the option. In
the case of a call option, the strike price is what the holder can choose to pay for the
underlying asset. We shall denote the strike price of an option generically by K.
3. Expiration: The expiration date is the time when the option holder must decide whether
to exercise the option. As in Section 1.1, the generic symbol for the time to expiration
is T .
4. Exercise style: Exercise style is a characteristic unique to options but not forwards. It
governs when an option can be exercised.
• If the option can only be exercised at the expiration date, it is called a European-
style or simply European option.
• If the option can be exercised anytime prior to or on the expiration date, it is called
an American-style or, in short, American option.
1.2 Options 9

• A Bermudan-style option allows its holder to exercise it during only specified pe-
riods, but not throughout the entire life of the option.
Here is a mnemonic:

E uropean = E xpiration
A merican = A nytime
B ermudan = B between

Unless otherwise stated, options that are studied in the remainder of this book are
European, whose analysis is mathematically more tractable. It is easy to conceive that
American options are more valuable than otherwise identical European and Bermudan
options because of the higher degree of freedom in relation to the time of exercise. We
will see in Chapter 9 that in some cases, it turns out that the opportunity to early
exercise an option is not exploited, so that European and otherwise identical American
and Bermudan options do share the same price.

Payoff of a call option.

To determine the payoff of a long European call at the expiration time T , consider two
cases:
Case 1. If S(T ) > K, you will exercise the call to use the strike price K to buy the
asset and sell it in the market immediately for the market price S(T ), earning
S(T ) − K. Here, we are assuming that the call is settled physically.
Case 2. If S(T ) ≤ K, it is irrational to exercise the call to buy the asset for K because
you are better off buying the asset directly in the market at the cheaper price
of S(T ). In this case, you will opt out of the call, which becomes worthless, and
your payoff is zero.
To sum up, the payoff of holding a Europeanii call is
(
S(T ) − K, if S(T ) > K
Long call payoff =
0, if S(T ) ≤ K
= (S(T ) − K)+ ,

where (·)+ is the positive part function defined by x+ := max(x, 0) for any x ∈ R. For
example, 6+ = 6, 11.3+ = 11.3, (−4)+ = 0, and (−9.21)+ = 0. The positive part function
signifies the optionality inherent in options and is characteristic of option payoffs.
The payoff diagram of a long call is graphed in Figure 1.2.1. Unlike the payoff of a long
forward, that of a long call is zero if the spot price is less than the strike price, and becomes
a straight line emanating from the strike price and pointing to the right with a slope of 1
otherwise. The turning point at the strike price is an indication of the optionality of the
call—the right is exercised when and only when S(T ) ≥ K. In essence, the payoff of a long
call position is obtained from that of a long forward position by zeroing the negative portion
of the latter and keeping the positive part intact.
ii The time-t payoff of a T -year K-strike American call is (S(t) − K)+ .
10 1 An Introduction to Forwards and Options

Payoff
Profit FV0,T (C)

S(T ) S(T )
0 K
0 K
−FV0,T (C) Profit
Payoff

FIGURE 1.2.1
Payoff and profit diagrams of a long call (left) and a short call (right).

Time Transaction Cash Flow

0 You buy a call and pay the call premium C. −C
T You can decide whether to exercise the call, (S(T ) − K)+
depending on the spot price.

TABLE 1.3
Cash flows associated with a long European call position.

Option premium.
By entering into a call option, you have the option to benefit from a rise in the price of asset
without the need for bearing any downside risk. In other words, your payoff at expiration
must be non-negative regardless of the spot price. For the call to be fair to the seller, you
must pay him/her an amount called the option premium, which we designate as C, at the
inception of the option as a form of compensation—the upside protection offered by the call
is not free! The premium is also called the price of the call option. Table 1.3 shows what
and when you pay or receive if you buy a European call.
Parenthetically, the determination of the fair price of an option is a highly nontrivial
task, much more technically complicated than that of the fair price of a forward, and is the
subject of Part II of this book.

Profit of a call option.

The payoff of a derivative captures its value at a particular instant and ignores the cash
flows at other times, particularly the initial cost to set up the derivative. A more global
perspective on a derivative is through its profit, defined as the payoff of the derivative less
the future value of cash flows at previous time points.
In the case of a long call, the profit is obtained by subtracting the future value of the
option premium from the option payoff, i.e.,

Long call profit = (S(T ) − K)+ − FV0,T (C), (1.2.1)

where FV0,T (·) denotes the future value from time 0 to time T . If r represents the con-
tinuously compounded risk-free interest rate,iii then FV0,T (C) = CerT ; if i is the effective
annual interest rate, then FV0,T (C) = C(1 + i)T .
We note in passing that because a forward entails no initial investment by definition, its
profit coincides with its payoff given in (1.1.1) and (1.1.2).
iii Throughout this book, interest rates are measured per annum.
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 The objects, which a man may cherish are limitless. He may
rejoice in his strength, his personal adornment, his lands and money,
his books and works of art. He may find an eager interest in his own
image as pictured in the minds of his relatives, friends, or fellow
citizens. He may take pride in family or in personal glory and honor.
Men pose before the world; they act often with reference to the
appreciation they will receive. It is told that the poet Keats could not
live without applause. Carlyle says men write history, not with
supreme regard for facts, but for the writing. Nero conceived that he
was a musician, poet, and actor, surpassing in merit the geniuses of
his age.
Man’s attitude toward wisdom and religion, the quality of his
thoughts and feelings, his aspirations, constitute his spiritual interest.
The sentiments of his soul are his; for them he is responsible, and in
them he finds satisfaction or humiliation.
As one forgets self and self-interest, more and more he makes the
whole world his possession. Nature, the welfare of others, man in
history and literature, the Maker of all, may become objects of
regard. A French nobleman who in the vicissitudes of revolution lost
his estates and titles, but received a small pension from the
government, became a philosopher and had the world at his
command. For slight pay, willing service for his daily needs was his;
private gardens, public parks, the broad landscape, the sky were his
to enjoy, and he was free from care and fear. Some interests are
universal, not the heritage and possession of one, but, like sun and
air, free. They fall “as the gentle rain from heaven upon the place
beneath,” and bless him that receives. Rich in experience is he who
can see in the drifted gleaming snows on our mountain peaks more
than the summer’s irrigation, in the green plains of May more than
the growing crops of wheat and alfalfa, in the orchard bloom more
than the promise of fruit, in public education and charity more than
political and social prudence, in religious devotion more than
conventionality. For him blessings come on the morning breeze,
gleam from the midnight sky, appear in the quality of mercy, and
spring from communion with the Soul of Nature.
 Prometheus is said to have given to men a portion of all the
qualities possessed by the other animals—the lion, the monkey, the
wolf—hence the many traits that are manifest in his complex nature.
There is a slight suggestion of evolution in this—that man is but the
highest stage of animal development, and that his refined emotions
are but the instincts of the lower orders modified by complex
groupings. We grant the process, but not necessarily the inference.
An apple is none the less an apple because it is the product of an
unbroken development from a germ and simple shoot. The spirit of
self-sacrifice need be none the less valid because it is a late phase
of some simple instinct. We believe the world was fashioned
according to an intelligent plan, a plan gradually realized, and that its
meaning is found, not in the lower, but in the higher stages of
development. We explain the purpose of creation, not by the first
struggle of a protozoan for food, but by the last aspiration of man for
heaven.

“From harmony, from heavenly harmony,

This universal frame began:
From harmony to harmony
Through all the compass of the notes it ran,
The diapason closing full in Man.”

The latest science hesitates to question the validity of our higher

emotional life. It is becoming antiquated to say that, because we are
descended from animals, our sense of duty, our feelings of faith and
reverence have no more significance than the animal instincts from
which they may have developed. There they are in all their
refinement, need, and suggestiveness, and, as such, are a proper
ground of belief. A late philosophical evolutionist says it is useless to
theorize about our impulse to pray, its use or futility—we pray
because we cannot help praying. Evolution is undergoing the test of
the last stage of a scientific process—in this instance that of fitness
to explain the facts of man’s nature. It may not escape the test by
denying the facts.
 Pardon the seeming digression, but the reasonableness of our
faith is the ground of interest. Interest vanishes with the genuineness
of our supposed treasure. We do not like to handle counterfeit coin;
we do not value antiquities and sacred relics of modern manufacture,
or mementos that no longer represent cherished memories. Much
that stimulates the higher life would perish did we doubt the truth of
our nature; the glory of the world would depart were the soul lost out
of it.

Some interests have sacred claims above others; there is a

hierarchy amongst our impulses. Analyze the fact as we may, duty
still remains. Moral laws and their practical application are
progressively revealed by the relations of men in society. We may
believe the laws are there in the nature of things, but that our
discovery of them is gradual, as is the discovery of the unchanging
laws of physics. The moral problem is the old one of the struggle
between light and darkness, between good and evil, between duty
and pleasure—the problem of responsibility, character, and destiny.
In its modern form it is the problem of utility, that is, of life and
happiness. But utilitarianism includes, and ever must include, the
happiness that comes from the exercise of the higher spiritual
functions, from the sense of duty performed, and from belief in divine
approbation.
Interests chosen and pursued reveal the character. Men do not
gather grapes of thorns nor figs of thistles. “A good tree can not bring
forth evil fruit; neither can a corrupt tree bring forth good fruit.” The
outward act is but the visible expression of the inner life.
There is something more than a pleasing myth in the Greek
conception of choosing the lot of life. Every responsible act of free
will is gradually fixing our destiny. The conduct of life is not a series
of skirmishes with fate; it is fate itself, and a thing largely of our own
creation. We are constructing the future out of the present. For the
goal that we may finally reach we are even now running the race, the
direction is already chosen, and, if we find ourselves on the wrong
road, time is already lost.
Times change, science brings in new conceptions, superstitions
vanish, beliefs are modified, new conditions and duties arise. But as
the scenes shift and new actors come on the stage, the themes are
still human history, comedy, and tragedy. The argument of the play is
still the triumph of heroism and the reward of virtue. The spectators
still smile at innocent pleasures, weep with misfortune, and applaud
sentiment and worth, and the orchestra still plays the triumph or the
dirge as the curtain falls on the final scene. The ideals of the saints,
the courage of heroes, the sufferings of martyrs still teach their
lesson. Reverence for God, justice, benevolence, the ethical worth of
the individual are still dominant ideas.
If our ideals are less severe, they are more practical; if our
heroism is less phenomenal, it takes on new forms or is reserved for
imperative need; if we shrink from martyrdom, it may be because
martyrdom is sometimes folly; if we worship with less zeal, we are
more conscious of the rational grounds of worship. Our justice and
benevolence have become more useful and practical, and reach all
men. The problems of physical comfort and material progress, of
practical charity, of political justice, of social purity, of the rights of all
classes of men, of education, of peace and good will, of the true
grounds of religious faith are at the front, and claim our interest and
devotion. Romance is not dead. The modern hero has his
opportunity, an opportunity open as never before to all kinds and
conditions of men. Every educated young man has an unlimited field,
a free lance, and a cause worthy of his valor. Let him go forth, as an
ideal knight of old, pure in heart and life, with consecrated sword, to
aid misfortune, to defend the people, and fight bravely for truth and
right.

I have seen young men going about, dallying with this or that
pleasure, physically lazy, mentally indolent, morally indifferent,
burdened with ennui, aimless, making no struggle. Will power must
be awakened, life given to the mechanism, or it will go to rust and
decay. While there is hope there is life. When interest is gone, the
mind and spirit are dead, and the body is dying. What a hopeless
lump of clay is he who, standing in this infinitely glorious world of
ours and having eyes sees not, having ears hears not, and having a
heart understands not.
What shall men do who have not come to a consciousness of their
better impulses, to whom the number and worth of human
possibilities are unknown, who have hidden, silent chords, awaiting
the touch that will set them vibrating? Plainly by studying the highest
types of men, the completeness of whose inner life is revealed in
their deeds and thoughts. By contact with a better than himself one
comes to know his better self. Under the influence of great
companionship, whether in life or literature, new conceptions may
appear in the vacant soul.
A popular work of fiction lately published shows incidentally how
great conceptions may grow in a foreign and incongenial soil. It
treats of the times of Nero and the early struggles of the Christians in
Rome. Amidst that folly, profligacy, debauchery, strife, and cruelty,
the Christian purity, humility, brotherly love, and faith in God are
made to stand forth in world-wide contrast. Through a series of
dramatic events, possessing for him a powerful interest, a Roman
patrician comes to receive the Christian ideas, and, under the
nurture of interest, they gradually wax strong and become the
dominant impulses of his being. A fellow patrician, maintaining a
persistent attitude of indifference to the new truths, lives and dies, to
the last a degenerate Roman and a Stoic.
A remote interest whose attainment is doubtful may come to
wholly possess the mind. A young man, misunderstood and
underestimated by friends, suffering years of unrequited effort,
persevering in silent determination, standing for the right, making
friends with all classes, seizing strongly the given opportunity,
defying popularity, and thereby winning it, may gradually rise to
prominence through long years of focusing of effort.
 Man’s free will makes him responsible for his interests. Aristotle’s
dictum comes down to us in an unbroken line of royal descent: Learn
to find interest in right things. Repugnance to the sternest demands
of duty may be converted into liking, and, in the process, character is
made. If you have a need for mathematics, science, history, poetry,
or philanthropy, cultivate it, and interest will come as a benediction
upon the effort. I sometimes think the gods love those who in youth
are compelled to walk in hard paths. Rudyard Kipling has a trace of
imperialism which is not the least valuable feature of his unique
writings. In a late story he describes the transformation of a son of
wealth who is already far on the road to folly—one of those nervous,
high-strung lads who in the face of hardship hides behind his mother,
and is a particular nuisance to all sensitive people. Crossing the
ocean in a palatial steamer, he chances to roll off into the Atlantic
and is conveniently hauled aboard a fishing schooner, out for a three
months’ trip. He has literally tumbled into a new life, where he is duly
whipped into a proper frame of mind and made to earn his passage
and a small wage, by sharing the hardships of the fishermen. In time
he is returned to his parents, together with a bonus of newly
acquired common sense and love for useful work. Hardship did for
him what all his father’s wealth could not buy.
It is in the time of need that men seek ultimate reality. A scientific
writer, after speaking of our interest in the friendship and
appreciation of men, refers to our need of friendship and
appreciation in our time of stern trial, when we stand alone in the
performance of duty. Then we have an intuitive consciousness of a
Being supremely just and appreciative, who recognizes worth at its
exact value, and will duly reward. We feel that in Him we live and
move and have our being. The finite conditions of life drive us to the
thought of an infinite One, who possesses in their fullness the ideals
imperfectly realized in us. When the world swings from under our
feet we need a hold on heaven. In these modern days we need the
spirit of the hero who places honor above life, the spirit that places
character above material advantage. Without it we are like Falstaff,
going about asking “What is honor?” and complaining because it
“hath no skill in surgery.” Balzac, describing one of his human types,
paints a striking picture. A miser is on his death bed. As the supreme
moment approaches, and a golden crucifix is held before his face, he
fixes his glazing eyes upon it with a look of miserly greed, and, with a
final effort of his palsied hand, attempts to grasp it. He takes with him
to the other world in his soul the gold, not the Christ crucified.

There are people who demand a series of ever varied, thrilling,

fully satisfying emotional experiences. For them “the higher life
consists in a sort of enthusiastic fickleness. The genius must wander
like a humming-bird in the garden of divine emotions.” When they do
not save themselves by devotion to scholarly work or by refuge in
the church, they frequently end in pessimism, madness, or suicide.
They exalt the Ego, do not lose self in the pursuit of proper objects of
utility. Nordau has done the world one service in branding them as
degenerates, living in abnormal excitement, instead of employing the
calm, strong, balanced use of their powers. Their fate is fittingly
suggested by a choice sentence from a well-known writer, describing
Byron’s “Don Juan”: “It is a mountain stream, plunging down dreadful
chasms, singing through grand forests, and losing itself in a lifeless
gray alkali desert.” Goethe’s Faust sets forth—be it noted, under the
guidance of the devil—to find complete enjoyment, and tries the
whole round of experience. Everything palls upon him, until he at last
finds permanent satisfaction in earnest practical labor for the welfare
of his fellow-men. In the words of Faust:

“He only earns his freedom and existence

Who daily conquers them anew.”

Labor! It is the secret of happiness. We are born bundles of self-

activity, in infancy ever developing our powers by ceaseless
movement, with eager curiosity ever reaching out toward knowledge
of external things, ever laboring and constructing in imitation of the
great, working world. Unless our energies are wasted by folly and
our hearts are chilled by custom, it is the natural condition, even as
children, older and wiser, but still as children, ever to extend with
enthusiasm the boundary of knowledge, and in reality to join in the
labor which was the play-work of our childhood. And when our effort
overcomes, creates, develops power, aids humanity, we are
conscious of the joy of true living. In our work self must be put in the
background. “He that loseth his life shall find it.” The great Goethe,
once weighed down with a mighty sorrow, forgot his grief in the study
of a new and difficult science.
It is a mistake to suppose that interest and happiness may not
attach to duty. Duty is not a dead, barren plant that no more will put
forth green leaves and blossom. Philanthropists do not need our
sympathy. A man of learning, culture, and ability, capable of enjoying
keenly the amenities of civilization, and of winning worldly success,
goes on a mission to the interior of Darkest Africa. Amid hardships
and dangers, he offers his life to help an alien race in its suffering,
ignorance, and savagery. He makes this devotion his supreme
interest, and who shall say that his satisfaction will not be as great as
that of the most favored son of wealth amid the luxuries of
civilization? “He that goeth forth and weepeth, bearing precious
seed, shall doubtless come again with rejoicing, bringing his sheaves
with him.”
One great purpose of education is to increase and strengthen our
interests. It shows the many fields of labor and gives us power to
work therein; it reveals the laws and beauties of the natural world; it
introduces us to many lands and peoples, and acquaints us with the
problems and means of progress; it opens to us the treasury of
man’s best thoughts; it gives us philosophical and poetic insight.

Sydney Smith, indulging one of his quaint conceits, says: “If you
choose to represent the various parts in life by holes upon a table, of
different shapes—some circular, some triangular, some square,
some oblong—and the persons acting these parts by bits of wood of
similar shapes, we shall generally find that the triangular person has
got into the square hole, the oblong into the triangular, and a square
person has squeezed himself into the round hole.” This fancy has
some truth, but more of nonsense. “Men at some time are masters of
their fates.” Create your place in life and fill it, or adapt yourself to the
best place you can find. The choice of occupation is important, but
filling well the profession chosen is more important. Turn your
knowledge and power to the performance of to-day’s duty.
Lowell in his “Vision of Sir Launfal” imparts one of the sweetest
lessons man may learn. Sir Launfal is to set forth on the morrow in
search of the Holy Grail, the cup used by our Saviour at the last
supper, and in his sleep there comes to him a true vision. As in his
dream he rides forth with pride of heart, at his castle gate a leper
begs alms, and in scorn he tosses him a piece of gold. Years of
fruitless search pass, and as he returns old, broken, poor, and
homeless, he again meets the leper at the castle gate, and in
Christ’s name he offers a cup of water. And lo! the leper stands forth
as the Son of God, and proclaims the Holy Grail is found in the
wooden cup shared with communion of heart. The morn came and
Sir Launfal hung up his idle armor. He had found the object of his
quest in the humble duty at hand.
A poet of our day quaintly but not irreverently writes of the future
life, “When the Master of all Good Workmen shall set us to work
anew.” There we shall work for the joy of it; there we shall know
things in their reality; there we shall enjoy the perfect appreciation of
the Master, and know the blessedness of labor performed in His
service. Thus the lesson is good for this world as well as the next.

“And only the Master shall praise us, and only the Master shall blame;
And no one shall work for money, and no one shall work for fame;
But each for the joy of the working, and each, in his separate star,
Shall draw the Thing as he sees It for the God of Things as They Are.”
 THE ETHICAL AND ÆSTHETIC ELEMENTS IN
EDUCATION.
A historic sentiment is associated with the laurel tree, sacred to
Apollo; with the laurel wreath which crowned the victor in the Pythian
games, was the emblem of the poet, rested upon the heads of
victorious generals, later indicated academic honors, and has
become a figure of speech and a gem in poetic literature. The
Baccalaureate Day—the day when victors in the endeavor to reach
the graduate’s goal figuratively are crowned with the fruited laurel—
we would preserve. We would preserve it for its history, its
significance, its associations, its sentiments, its memories, its
promise, and its religious suggestion. We would preserve it, not only
to celebrate scholastic honors already won, but as a fitting occasion
to consider some of those deeper lessons whose meaning will
appear through experience in the School of Life.

Higher education ever enlarges the borders of science and leads

forth into new fields. It transmutes superstition into knowledge. It is
the spirit of civilization and the leader of progress. It stands at the
summit of human development, represents the aggregate of human
knowledge, is the goal for intellectual endeavor, and it points the way
for the discovery and progress of the future.
There was a time when many scholars turned the pages of
literature, in which were preserved the deeds, investigations, and
thoughts of men, solely that they might develop and enjoy their own
powers; when they devoted themselves to Truth for its own sake;
when they stood isolated, as in a world of their own, considering
naught but their own welfare and, perhaps, their relation to their
Maker. Men dwelt in caves, in remote deserts, or within gloomy walls
to dwarf the bodily and worldly impulses and to rise to a serene
contemplation of God and His truths, disregarding the appeal of
ignorant or suffering humanity and the duty of adding works to faith.
Our relations to our fellow-men give rise to nearly the entire Ethical
Code. Society cares for us, educates us, develops us, and it has
claims upon us, not on purely selfish or utilitarian grounds, but under
a higher ethical idea, whose sanction is the perfection and will of
God. The law of God requires effort for humanity, government
enjoins it, charity demands it. The Associationist, the Utilitarian, and
the Evolutionist teach it.
An honorable character and a useful life are full of influence. And
there are hundreds of ways, in some of which, without burdensome
effort, one may be a blessing to others. Ignorance may be awakened
to its condition, vice may be shamed, sorrow may be assuaged, fear
may be changed into hope, sloth may be aroused to action, doubt
may be converted into faith.
Go forth and join in the labor you are fitted for. If you have a truth,
utter it; if you have had superior privileges, impart to others; if you
have an insight into principles of conduct, stand for them; if you have
a trained eye and a deft hand, use your skill. Externalize the powers
of your being; find outward expression for your inward thought.
Thank God for a courageous man, a true Anglo-Saxon man, a
man whose convictions are deeply rooted, and who guards them as
his very life. Heroes, philanthropists, and martyrs are his exemplars.
He has a work to do, and he enters upon it as his fathers battled for
the right. The sensualist, the dreamer, and the fatalist lie supine, are
lulled by the summer breeze, and gaze upon the drifting panorama
of clouds with playful imagination. The man of duty marches forth
and takes the fixed stars for his guide.
The educated young man of to-day has every reason to thank the
stars under which he was born. Behind him is the teaching of the
civilized world—the poetry and art of Greece, the laws and
institutions of Rome, the growth of Christianity, the Mediæval
commingling of forces and evolution of rare products, the
Renaissance, the religious and political emancipation, invention,
science, art, poetry, and philosophy. Behind him is the history of the
Anglo-Saxon race, its courage and deeds of valor, its profound
earnestness, its stern ideals. Behind him is Puritan New England
and liberty. Around him lies the new land of promise with its natural
blessings of air, sun, mountains, and plains, with its mineral wealth
and industrial possibility, with its people of pride, energy, intelligence,
and high enthusiasm. Before him lie the development of a great and
unique civilization, a wonder of material progress, a rare growth of
poetic power and free spirit under new and fostering conditions.
Before the youth of this State is the possibility of success in any
pursuit, of rise to influence, of contributing to the formative period of
a new commonwealth. There is every inducement to be a
courageous, energetic, and ideal man. Those who have made our
history, most of them, are still living, but their work is nearly
accomplished, and you will take up the responsibility. May our great
system of public instruction contribute to fill the State in coming
decades with noble men and women who are not afraid of ideals.

Man may deceive others, but is shamed at the tribunal of his own
better judgment. A celebrated lecturer describes what he calls the
“Laughter of the Soul at Itself,” “a laughter that it rarely hears more
than once without hearing it forever.” He says: “You would call me a
partisan if I were to describe an internal burst of laughter of
conscience at the soul. Therefore let Shakespeare, let Richter, let
Victor Hugo, let cool secular history put before us the facts of human
nature.” We may refer to one illustration: Jean Valjean, one of Hugo’s
characters, an escaped and reformed convict, was about to see an
innocent man condemned for his own act, through mistaken identity.
He tried to make himself believe self-preservation was justifiable,
and as the mental struggle between Self and Duty went on he
seemed to hear a voice: “Make yourself a mask if you please; but,
although man sees your mask, God will see your face; although your
neighbors see your life, God will see your conscience.” And again
came the internal burst of laughter. The author proceeds: “Valjean
finally confessed his identity; and the court and audience, when he
uttered the words, ‘I am Jean Valjean,’ ‘felt dazzled in their hearts,
and that a great light was shining before them.’”

Science does away with superstition and many an error, it makes

known the laws of nature, it applies them to practical ends, it is the
handmaid of civilization, it emphasizes the welfare of humanity, it
shows the working of the mechanism within the field of
demonstrative knowledge, the finite, knowable land of the real.
Science exceeds its purpose only whenever it proclaims that there is
no field of spiritual knowledge, glimpses of which may be seen by
souls that dwell upon the heights. Some would measure the earth
with a carpenter’s rule, forgetting Him “Who hath measured the
waters in the hollow of His hand, and meted out Heaven with the
span, and comprehended the dust of the earth in a measure, and
weighed the mountains in scales, and the hills in a balance.”
Carlyle says: “Religion in most countries is no longer what it was,
and should be—a thousand-voiced psalm from the heart of man to
the invisible Father, the fountain of all goodness, beauty, truth, and
revealed in every revelation of these; but for the most part a wise,
prudential feeling, grounded on mere calculation, a matter, as all
others now are, of expediency and utility; whereby some smaller
quantum of earthly enjoyment may be exchanged for a larger
quantum of celestial enjoyment.” But again and more truly he says:
“Religion cannot pass away. The burning of a little straw may hide
the stars of the sky, but the stars are there and will reappear.”
Once a pupil asked to be excused from exercises in which choice
extracts from the Bible were sometimes read, simply because they
were from the Bible; but he listened with pleasure to good thoughts
from other books, though these books contained many a palpable
error. Aside from the view which makes the Bible the Sacred Book of
the Christian believer, he had not thought of its value to a large
portion of the human race. He had not regarded it in the light of
history and philosophy. The ideals for which the Hebrew race has
stood, the wonderful prophecies of great and far-seeing men, the
grand poems of faith and promise, the words of condensed wisdom,
the maxims for right living, the Beatitudes, the teaching of the
Parables, the spirit of adoration, the moral code, the allegorical
wisdom never had been contemplated apart from the religious view,
against which he had imbibed a prejudice.
Permit me to speak from the standpoint of history and philosophy.
The Christian religion is a chief source of our peculiar civilization, of
the character of our institutions, of the growth of altruism, of the
equality of man, of the supreme worth of the inner motive, of charity,
of liberty. It has given the world the highest examples of pure and
devoted lives.
I have a friend who is struck with the tale of how Buddha, wearing
a Brahman’s form, when “drought withered all the land,” encountered
a starving tigress with her cubs, and, in the unbounded pity of his
heart, offered himself a sacrifice to their hunger. He says: “Here is a
beautiful religion for me.” And yet he is not touched by the story of a
Saviour who carried the burden of the pains and sorrows of many
and died that they might live.
Disregard no good, wherever found. The human race must have
its ideals. Thousands have felt what a famous man has expressed,
that, were there no religion, men would of necessity invent it and
worship a false idea. The religion of Mohammed is better than the
idolatry of the Arab; the idolatry of the Arab was better than nothing.
The races—each at its own stage—have been improved by their
religions. The Scandinavian conception of Walhalla; the Ancient
Oracle at Dodona, where the priests in gloomy groves caught the
responses of Zeus from the whisperings of the sacred oaks; the
ancestor worship of the Chinese, the system of symbolism in Egypt
—all represented the struggle toward ideal life and the notion of
retributive justice. With bowed head and reverential heart I would
stand in the presence of any sincere devotion, the uplifting of the
soul in prayer to the God of its faith; how much more in the presence
of that worship which the best intelligence of the best races has
accepted. And how often one misinterprets the real meaning of an
alien religion. The “Light of Asia” gives a meaning to Nirvana never
heard from the pulpit:

“Foregoing self, the Universe grows ‘I’;

If any teach Nirvana is to cease,
Say unto such they lie.”

Let young men learn as a common-sense proposition that, though

creeds may change, though there may be frequent readjustments of
theological beliefs, the religious sentiment is an essential fact of our
nature, and has a meaning the depth of which they have not
sounded.

The love of Art is necessary to the complete man. Whatever may

be said of the cold, intellectual spirit, one attains a high standard of
humanity only when he possesses a heart warmed and ennobled by
a vivid conception of the Beautiful found in the rainbow, the color of
the leaf, and the sparkle of the rill, works framed in nature and hung
in God’s great art gallery—the universe. Man sees the real spirit
shining through material forms, and architecture, sculpture, painting,
music, and poetry follow. Noble thought and action, right and truth,
all perfect things partake of the essence of Beauty. Art adds to
nature; it casts a halo:

“The light that never was on sea or land,

The consecration and the Poet’s dream.”

I have often dwelt upon the lines of Wordsworth:

“To me the meanest flower that blows can give

Thoughts that do often lie too deep for tears.”

I have often wished to hear a sermon arguing from this thought the
existence of God and the immortality of the soul. The peculiar nature
of the soul, that transmutes sensation into divine emotion—a
sweetness, longing, and reverence that are not of earth—is it not
suggestive of all that is claimed by religious faith? Wordsworth rightly
ascribed a dwarfed nature to him who sees only meaningless form
and dull color in the flower:

“A primrose by a river’s brim

A yellow primrose was to him,
And it was nothing more.”

That education is inadequate which ignores the value of man’s

æsthetic nature and neglects its growth.
 PROGRESS AS REALIZATION.

“For now we see through a glass, darkly.”

“Yet I doubt not through the ages one increasing purpose runs,
And the thoughts of men are widened with the process of the suns.”

In the process of development nature goes from potentiality to

higher and higher actuality; what is in its being as tendency becomes
real. We may not suppose the movement that of spontaneous
energy toward accidental results, but rather the progressive
realization of what is in the entire rational scheme of the universe.
From the nebular mass sprang worlds and suns greater and less,
substance and form in infinite variety, plant life in progressive orders,
animal life in ascending types. Conscious existence gradually
became responsive to the multitude of nature’s impressions. The
broken rays of light displayed their rainbow hues to the growing
power and delicacy of the eye; sound revealed its keys, qualities,
and harmonies to the increasing susceptibility of the ear. Mind, as it
developed, realized in its consciousness new laws and ever greater
wonders of the outer world. On the objective side the laws were, the
tinted sky and the murmuring stream were, before mind became
cognizant of them in their perfection and beauty. Any serious
contemplation of the great law of development, in its full meaning,
should inspire hope and purpose in life. It suggests, not only sublime
fulfilment for the world, but large possibility for the individual man.
The natural world, plants, animals, the human race, institutions,
science, art, religion, all animate individual beings, man as an
individual, have their history of development, which suggests its
lesson.
Nature is aspiration. From chaos to the world of this geologic age,
from protoplasm to man, from savagery to civilization, from
ignorance to culture, from symbolism to developed art, from egoism
to altruism, from germ to fruit, from infancy to maturity, from
realization to higher realization, has been the process. And this plan
seems the only one adapted to satisfy the nature and thought of
rational being. A world perfected, all possibilities realized, no chance
for higher attainment—these are conditions of monotony and death.
The old Heraclitus was right when he proclaimed the principle of the
world to be a becoming.

The child’s history, in a way, is an epitome of the history of the

race. At first he is deaf and blind to the world of objects. Note how
the possibilities of his being become realities, how knowledge grows
in variety and definiteness, until the external world stands revealed,
each object in its place, each event in its order, until notions of time,
space, cause, and right rise into consciousness. The child is father of
the man in the sense that the man can become only what he was
implicitly in childhood.
There is a tale of Greek mythology that Minerva sprang full-grown
from the head of Jove—a perfect being. We would rather
contemplate a being with possibilities not completely revealed. A
philosopher said that if Truth were a bird which he had caught and
held in his hand he would let it escape for the pleasure of renewed
pursuit. There are the wonders of nature and of physical evolution;
but transcendently great are the wonders of mind, and the view of its
possibilities of endless development—a thing that we believe will live
on, when the sun, moon, and stars shall be darkened.

The educated young man of to-day is the heir of the ages. All that
science, art, literature, philosophy, civilization have achieved is his.
All that thought has realized through ages of slow progress, all that
has been learned through the mistakes made in the dim light of the
dawn of human history, all that has been wrought out through
devotion, struggle, and suffering, he may realize by the process of
individual education. The law of progress still holds for the race and
for him. He is a free factor, with a duty to help realize still more of the
promise of human existence.
“Know thyself” was a wonderful maxim of the ancient philosopher,
and it leads to knowledge. “Know thy powers” is a better maxim for
practice, and it is a fault that men regard their limitations and not
their capabilities. We look with contempt upon a lower stage of our
own growth. Not for the world would we lose a little from our highest
attainment. The view is relative, and we have but to advance our
position and life is subject to new interpretation.
This is a period of the fading out of old ideals as they merge into
higher ones not yet clearly defined. The reverence for nature, for its
symbolism, the sanctions of religion, the transcendental belief, the
poetic insight have somewhat fallen away, and the world is partly
barren because not yet rehabilitated. Ideals are regarded as fit for
schoolgirl essays, for weakly sentimentality, for dreamers, for those
who do not understand the meaning of the new science and the new
civilization. Ideals! The transcendent importance of ideals is just
appearing. Not an invention could be made, not a temple could be
built, not a scheme for the improvement of government and society
could be constructed, not a poem or a painting could be executed,
not an instance of progress could occur without ideals. The world
may be conceived as an ideal, the development of all things is
toward ideals. We are at a stage of that development; the
progression is infinite, ever toward perfection, toward God, the
Supreme Good. Lamartine said wisely: “The ideal is only truth at a
distance.”
Do circumstances forbid the possibility of higher development?
Then let the individual, in a chosen vocation, however humble, lose
himself in obedience and devotion to it, and thus, as a hero, live to
his own well-being and the welfare of others. Thereby he will find
blessedness. Carlyle’s “Everlasting Yea” shows this passage: “The
Situation that has not its Duty, its Ideal, was never yet occupied by
man. Yes, here, in this poor, miserable, hampered, despicable
actual, wherein thou even now standest, here or nowhere is thy
Ideal; work it out therefrom; and working, believe, live, be free. Fool!
the Ideal is in thyself, the impediment, too, is in thyself; thy Condition
is but the stuff thou art to shape that same Ideal out of; what matters
whether such stuff be of this sort or that, so the Form thou give it be
heroic, be poetic? O thou that pinest in the imprisonment of the
Actual and criest bitterly to the gods for a kingdom wherein to rule
and create, know this of a truth: the thing thou seekest is already
with thee, here or nowhere, couldst thou only see!”
Here is a striking story, related as true: A young man had met with
misfortune, accident, and disease, and was suffering from a third
paralytic stroke. He had lost the use of his voice, of his limbs, and of
one arm. A friend visited him one day and asked how he was. He
reached for his tablet and wrote: “All right, and bigger than anything
that can happen to me.” By energy of will, by slowly increasing
physical and mental exercise, he reconquered the use of his body
and mind—gradually compelled the dormant nerve centres to awake
and resume their functions. Later he wrote: “The great lesson it
taught me is that man is meant to be, and ought to be, stronger and
more than anything that can happen to him. Circumstances, fate,
luck are all outside, and, if we cannot always change them, we can
always beat them. If I couldn’t have what I wanted, I decided to want
what I had, and that simple philosophy saved me.”
A healthy philosophy, speculative or common sense, a healthy
ethics, theoretical or practical, are indispensable to youth. Away with
unfree will, and pessimism, and pleasure philosophy, and the notion
of a perfected world and a goal attained. Substitute therefor vigorous
freedom, cheerful faith and hope, right and duty, and belief in
development. Most of the great poets and artists, most of the
successful business men have struggled with difficulties, and have
wrought out of their conditions their success. Burns did not permit
poverty, obscurity, lack of funds, lack of patronage, lack of time to
destroy or weaken the impulse of his genius. Shakespeare (if this
poet-king be not indeed dethroned by logic) with but imperfect
implements of his craft wrought heroically, and realized the highest