Financial Mathematics

Contents

1 Martingales 4
1.1 Step-by-Step Understanding of Martingales . . . . . . . . . . . . . . . . . 4
1.2 Properties of Conditional Expectation (CE) . . . . . . . . . . . . . . . . 6
1.2.1 1. Properties of Conditional Expectation (CE): . . . . . . . . . . 6
1.2.2 2. Recursive Relation for Martingales: . . . . . . . . . . . . . . . 6
1.2.3 3. Continuous-Time Martingales: . . . . . . . . . . . . . . . . . . 6
1.2.4 4. Example 11.2: Random Walks . . . . . . . . . . . . . . . . . . 6
1.2.5 Example 11.3: A Geometric Random Walk . . . . . . . . . . . . . 7
1.3 Stopping Time . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.3.1 Definition of Stopping Time . . . . . . . . . . . . . . . . . . . . . 8
1.3.2 Interpretation of Stopping Time . . . . . . . . . . . . . . . . . . . 8
1.3.3 Example: First Hitting Time . . . . . . . . . . . . . . . . . . . . 9
1.3.4 Example: Coin Tossing and Stopping Time . . . . . . . . . . . . . 9
1.3.5 Theorem 11.1: Martingale Property under Stopping Time . . . . 10
1.3.6 Theorem 11.2: Optional Stopping Theorem (OST) . . . . . . . . . 11
1.3.7 Call Options and American Derivative Security (ADS) . . . . . . 12

2 Markov Decision Processes (MDP) 13

2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.1.1 Key Features of MDPs . . . . . . . . . . . . . . . . . . . . . . . . 13
2.1.2 Decision Tree Representation . . . . . . . . . . . . . . . . . . . . 13
2.2 Finite-Stage Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.2.1 Components of MDP . . . . . . . . . . . . . . . . . . . . . . . . . 14
2.2.2 Dynamic Programming Approach . . . . . . . . . . . . . . . . . . 15
2.2.3 Optimal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.3 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.3.1 Example 4.1: Selling a House . . . . . . . . . . . . . . . . . . . . 16
2.3.2 Example 4.1: Selling a House (Corrected) . . . . . . . . . . . . . 17
2.3.3 Example 4.2: An American Call Option Model . . . . . . . . . . . 18
2.4 Discounted Dynamic Programming . . . . . . . . . . . . . . . . . . . . . 19
2.4.1 Lifetime Portfolio Selection: Full Calculation . . . . . . . . . . . . 20
2.4.2 Stochastically Risky Alternative Asset . . . . . . . . . . . . . . . 22

3 Brownian Decision Process 24

3.1 Explanation and Theory of Brownian Motion Process (BM Process) . . . 24
3.1.1 Definition and Process . . . . . . . . . . . . . . . . . . . . . . . . 24
3.1.2 Brownian Motion Properties . . . . . . . . . . . . . . . . . . . . . 25
3.1.3 Martingale Property of Wt . . . . . . . . . . . . . . . . . . . . . . 25

1
CONTENTS

3.1.4 Step 1: Density Function of Brownian Motion . . . . . . . . . . . 26

3.1.5 Step 2: Joint Density Function of W (t1 ), W (t2 ), . . . , W (tn ) . . . . 26
3.1.6 Step 5: Conditional Distribution . . . . . . . . . . . . . . . . . . . 26
3.1.7 Example: Bicycle Race Modeled by Brownian Motion . . . . . . . 27
3.2 Geometric Brownian Motion (GBM): Steps to Derivation . . . . . . . . . 28

4 Stochastic Calculus 31
4.1 Stochastic Calculus and Itô’s Integrals . . . . . . . . . . . . . . . . . . . 31
4.1.1 White Noise and Wiener Process . . . . . . . . . . . . . . . . . . 31
4.1.2 Itô’s Integral . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
4.1.3 Derivation of the Itô Integral Formula . . . . . . . . . . . . . . . 31
4.1.4 Properties of Itô Integrals . . . . . . . . . . . . . . . . . . . . . . 32
4.1.5 Stochastic Integral with Non-Random Integrand . . . . . . . . . . 32
4.1.6 Examples of Itô Integrals . . . . . . . . . . . . . . . . . . . . . . . 32
4.1.7 Summary of Itô’s Integral Formula . . . . . . . . . . . . . . . . . 33
4.1.8 Itô’s Formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
4.1.9 Multiplication Table and Derivations . . . . . . . . . . . . . . . . 33
4.1.10 Examples of Itô’s Lemma . . . . . . . . . . . . . . . . . . . . . . 34
4.2 Statement 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
4.2.1 Example: Geometric Brownian Motion (GBM) . . . . . . . . . . . 35
4.3 Product Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
4.4 Quotient Rule . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
4.4.1 Example: Product of Processes . . . . . . . . . . . . . . . . . . . 36
4.5 Stochastic Differential Equation (SDE) . . . . . . . . . . . . . . . . . . . 36
4.5.1 Itô Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
4.5.2 Existence and Uniqueness . . . . . . . . . . . . . . . . . . . . . . 36
4.5.3 Ornstein-Uhlenbeck Process (OU Process) . . . . . . . . . . . . . 37
4.5.4 Step 4: Stationary Distribution . . . . . . . . . . . . . . . . . . . 38

5 Applications in Finance 40
5.1 Applications in Finance: Pricing Stock Options . . . . . . . . . . . . . . 40
5.1.1 Introduction to Stock Options . . . . . . . . . . . . . . . . . . . . 40
5.1.2 Pricing Problem Setup . . . . . . . . . . . . . . . . . . . . . . . . 40
5.1.3 Calculation of Holdings . . . . . . . . . . . . . . . . . . . . . . . . 40
5.1.4 Case Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
5.1.5 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
5.2 Option Pricing in Discrete Time . . . . . . . . . . . . . . . . . . . . . . . 42
5.2.1 Stock Pricing and Interest Rates . . . . . . . . . . . . . . . . . . 42
5.2.2 Definitions of Call and Put Options . . . . . . . . . . . . . . . . . 42
5.2.3 Classical Valuation of Options . . . . . . . . . . . . . . . . . . . . 42
5.2.4 Example: Option Valuation . . . . . . . . . . . . . . . . . . . . . 42
5.2.5 Replicating Portfolio (Hedging Strategy) . . . . . . . . . . . . . . 43
5.2.6 Fair Price of the Call Option . . . . . . . . . . . . . . . . . . . . . 43
5.2.7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
5.3 Application in Finance: Option Pricing in Discrete Time . . . . . . . . . 43
5.3.1 Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
5.3.2 Classical Expected Payoff Method . . . . . . . . . . . . . . . . . . 44
5.3.3 Replicating Portfolio Method . . . . . . . . . . . . . . . . . . . . 44

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CONTENTS

5.3.4 Calculate the Portfolio Value Today . . . . . . . . . . . . . . . . . 45

5.3.5 Real-World Interpretation . . . . . . . . . . . . . . . . . . . . . . 45
5.4 Binomial Market Model: Framework . . . . . . . . . . . . . . . . . . . . 45
5.4.1 Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
5.4.2 Key Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
5.5 Single-Period Binomial Market . . . . . . . . . . . . . . . . . . . . . . . . 46
5.5.1 Trading Strategy/Portfolio . . . . . . . . . . . . . . . . . . . . . . 46
5.5.2 Hedge Conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
5.5.3 Optimal Hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
5.5.4 Fair Price of Claim . . . . . . . . . . . . . . . . . . . . . . . . . . 47
5.5.5 Example: Pricing a European Call . . . . . . . . . . . . . . . . . 47
5.5.6 Replicating Portfolio Verification . . . . . . . . . . . . . . . . . . 48
5.6 No-Arbitrage (NA) Condition . . . . . . . . . . . . . . . . . . . . . . . . 48
5.6.1 Zero Net Investment . . . . . . . . . . . . . . . . . . . . . . . . . 49
5.7 Multi-Period Binomial Market . . . . . . . . . . . . . . . . . . . . . . . . 49
5.7.1 Two-Period Binomial Market . . . . . . . . . . . . . . . . . . . . 49

3
Chapter 1

Martingales

1.1 Step-by-Step Understanding of Martingales

1. What is a Martingale?
A martingale is a stochastic process where the expected value of the next observation,
given all past observations, equals the current value. Mathematically, this is expressed
as:
E[Xt+1 |Ft ] = Xt
Here:

• Ft : Represents the history (or filtration) up to time t.

• Xt : The value of the process at time t.

Example: Consider a fair coin toss where:

(
Xt + 1 (heads)
Xt+1 =
Xt − 1 (tails)

The expected value remains constant:

E[Xt+1 |Ft ] = Xt

2. Filtration (Ft ): The ”History”

Filtration represents all the information available up to time t. Mathematically:

Ft = {all events observable up to time t}

As time progresses, the filtration becomes richer:

F0 ⊆ F1 ⊆ F2 ⊆ . . .

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Chapter 1. Martingales

3. Binomial Market Model (Financial Context)

Setup:

• The price of an asset St can move:

(
uSt−1 (up movement)
St =
dSt−1 (down movement)

• u: Up factor, d: Down factor.

Sample Space (Ω):

Ω = {all possible sequences of up (u) and down (d) moves over time T }

For example, if T = 2:
Ω = {uu, ud, du, dd}
Filtration in Finance:

• At t = 1: We know whether the price moved u or d.

• At t = 2: We know the entire sequence (e.g., ud).

4. Martingale in Financial Models

A process {Xt } is a martingale if:

E[Xt+1 |Ft ] = Xt

Example: In the Binomial Market Model, if the asset price St is adjusted to remove any
drift (e.g., under a risk-neutral measure):

E[St+1 |Ft ] = St

Key Formula Summary

1. Martingale Definition:
E[Xt+1 |Ft ] = Xt

2. Price Process in Binomial Model:

(
uSt−1 (up movement)
St =
dSt−1 (down movement)

3. Filtration:
Ft = {all events up to time t}

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Chapter 1. Martingales

1.2 Properties of Conditional Expectation (CE)

1.2.1 1. Properties of Conditional Expectation (CE):
These properties are essential for understanding martingales:

• CE1 (Linearity): If a, b are constants:

E[aX + bY |G] = aE[X|G] + bE[Y |G]

• CE2 (Measurability): If Z is G-measurable:

E[ZX|G] = ZE[X|G]

• CE3 (Independence): If X is independent of G:

E[X|G] = E[X]

• CE4 (Tower Property): For nested sigma-fields G0 ⊆ G1 ⊆ G2 :

E[E[X|G1 ]|G0 ] = E[X|G0 ]

1.2.2 2. Recursive Relation for Martingales:

Using CE4 (Tower Property), the martingale property can be recursively expressed:

E[Xt+s |Ft ] = Xt ∀s ≥ 1

Expanding step-by-step:

E[Xt+s |Ft ] = E[E[Xt+s |Ft+s−1 ]|Ft ]

Continuing this recursion, we find:

E[Xt+s |Ft ] = Xt

1.2.3 3. Continuous-Time Martingales:

For continuous time, the martingale property becomes:

E[Xt+s |Ft ] = Xt ∀s ≥ 0

Here, Ft represents the history of information up to time t.

1.2.4 4. Example 11.2: Random Walks

Let Xn = Y1 + Y2 + · · · + Yn , where Yi are independent, identically distributed random
variables (i.i.d.) and E[Yi ] < ∞.

Step 1: Check Integrability

Using the triangle inequality:

E[|Xn |] ≤ E[|Y1 |] + E[|Y2 |] + · · · + E[|Yn |] = nE[|Y1 |] < ∞

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Chapter 1. Martingales

Step 2: Verify the Martingale Property

Using CE1–CE3:
E[Xn+1 |Fn ] = E[Xn + Yn+1 |Fn ] = E[Xn |Fn ] + E[Yn+1 |Fn ]
Since Yn+1 is independent of Fn , we have:
E[Yn+1 |Fn ] = E[Yn+1 ]
Thus:
E[Xn+1 |Fn ] = Xn + E[Yn+1 ]
If E[Yi ] = 0, then:
E[Xn+1 |Fn ] = Xn

Special Case
If P (Yi = 1) = p and P (Yi = −1) = 1 − p, then Xn is a martingale if p = 12 .

1.2.5 Example 11.3: A Geometric Random Walk

We assume that:
Xn := X0 eY1 +···+Yn , n ≥ 1,
where X0 is a constant > 0, and the Yi are i.i.d. random variables (RVs). The question
is: When is {Xn }n≥0 a martingale with respect to the filtration:
Ft := σ(Y1 , . . . , Yt ),
(where F0 is trivial)?

Step 1: Verify Integrability

By independence and property (2.57):
E[|Xn |] = E[Xn ] = X0 E[eY1 +···+Yn ] = X0 (E[eY1 ])n < ∞
if and only if:
φY (1) := E[eY1 ] < ∞.

Step 2: Verify the Martingale Property

For any n ≥ 0:
E[Xn+1 |Fn ] = E[X0 eY1 +···+Yn eYn+1 |Fn ].
Using Xn = X0 eY1 +···+Yn , this simplifies to:
E[Xn+1 |Fn ] = Xn E[eYn+1 |Fn ].
By CE2 (Measurability) and CE3 (Independence):
E[Xn+1 |Fn ] = Xn φY (1),
where:
φY (1) := E[eY1 ].
Thus, {Xn } is a martingale if and only if φY (1) = 1.

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Chapter 1. Martingales

Step 3: Generalization
It is clear that, setting S0 := 0, Sn := Y1 + · · · + Yn , for any v ∈ R such that:

φY (v) := E[evY1 ] < ∞,

the process:
Xn′ := e−vSn −n ln φY (v) , n = 0, 1, 2, . . . ,
is a martingale. Specifically:
evSn
Xn′ = .
φY (v)n

Remarks
For both {Xn } and {Xn′ }, we could, instead of the filtration:

Ft := σ(Y1 , . . . , Yt ),

consider their natural filtrations (they are the same).

1.3 Stopping Time

In both theoretical and applied problems, one often needs to deal with the values of a
martingale {Xt } (or another process) at random times. In this context, the concept of
stopping time (or Markov time) becomes very useful.

1.3.1 Definition of Stopping Time

Consider a filtered probability space (Ω, F, {Ft }, P ), assuming discrete time. A random
variable (RV) τ defined on this space is called a stopping time if:

{τ ≤ t} ∈ Ft for each t = 0, 1, 2, . . .

Reformulation of Stopping Time

Using the observation that {τ > t} = {τ ≤ t}c , we also find that:

{τ = t} = {τ ≤ t} ∩ {τ > t − 1} ∈ Ft ,

which implies:
t
[
{τ ≤ t} = {τ = s}, for t = 0, 1, 2, . . .
s=0

1.3.2 Interpretation of Stopping Time

The name ”stopping time” reflects the idea that τ represents the random time when we
decide to stop doing something based on information available up to time t. For example:
- Stopping gambling after a profit/loss threshold. - Selling shares at a stock exchange
when a certain price is reached.
At time t, the event {τ = t} occurs if you decide to stop at that time based on Ft ,
which represents all the information available at time t.

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Chapter 1. Martingales

1.3.3 Example: First Hitting Time

Stopping times of this kind are common in problems like:
• Optimal control problems.
• Risk models.
• Sequential statistical analysis.
Suppose we are given an adapted process {Xt } and a (boundary) function ut , t =
0, 1, 2, . . .. For simplicity, let the boundary ut be constant, ut = u. Define the first hitting
time:
τ := inf{t ≥ 0 : Xt ≥ ut }.

Why is τ a Stopping Time?

By definition, a stopping time τ satisfies:
{τ ≤ t} ∈ Ft , ∀t ≥ 0.
For the first hitting time:
t
[
{τ ≤ t} = {Xs ≥ us }.
s=0
Since {Xs ≥ us } is measurable in Fs , the event {τ ≤ t} is measurable in Ft . Thus, τ is
a stopping time.

Applications
• Finance: Selling a stock when its price exceeds a target value.
• Gambling: Quitting a game when winnings or losses hit a specific threshold.
• Statistics: Stopping a sequential hypothesis test when a test statistic exceeds a
critical value.

1.3.4 Example: Coin Tossing and Stopping Time

Setup
• A player gains 1f oreachhead(H) and loses 1f oreachtail(T ).
• The outcomes of N coin tosses form the sample space Ω = {H, T }N .
For example, if N = 3:
Ω = {HHH, HHT, HT H, HT T, T HH, T HT, T T H, T T T }.

Filtration and Winnings Process

Define Xk as the player’s net winnings after k-tosses:
Xk = (# Heads up to toss k) − (# Tails up to toss k).
The information after k-tosses is represented by the filtration Fk , which includes all
possible outcomes up to time k.

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Chapter 1. Martingales

Stopping Time
Define the stopping time τ as the first time Xk ≥ 3, i.e., the first time the player’s net
winnings reach or exceed 3 : τ := inf{k ≥ 0 : Xk ≥ 3}.

Why τ is a Stopping Time?

The event {τ ≤ k} means Xs ≥ 3 for some s ∈ {1, 2, . . . , k}, which is measurable in Fk .
Hence, τ is a stopping time.

Martingale Property of {Xk }

The process {Xk } is a martingale if the coin toss is fair (P (H) = p = 0.5):

E[Xk+1 |Fk ] = Xk .

For each step:

E[Xk+1 ] = p(Xk + 1) + (1 − p)(Xk − 1).
If p = 0.5, this simplifies to:
E[Xk+1 |Fk ] = Xk ,
which satisfies the martingale property.

Summary
The coin-tossing example demonstrates how stopping times arise naturally in games of
chance. The first hitting time τ in this example is the first time winnings reach a target
value.

1.3.5 Theorem 11.1: Martingale Property under Stopping Time

Let {Xt }t≥0 be a martingale (MG), and let τ be a stopping time (ST) on a common
filtered probability space. Define:

Zt := Xτ ∧t , t = 0, 1, 2, . . .

Then {Zt }t≥0 is also a martingale on that space.

Proof
1. **Verify Integrability**: For t = 0, we have Z0 = X0 , which is integrable as {Xt } is a
martingale. For t > 0, the representation:
t
X
Zt+1 = Xk 1{τ =k} + Xt+1 1{τ >t}
k=0

implies:
t+1
X
E[|Zt+1 |] ≤ E[|Xk |] < ∞,
k=0

ensuring integrability.

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Chapter 1. Martingales

2. **Verify the Martingale Property**: Using the representation of Zt+1 and applying
conditional expectation:
" t #
X
E[Zt+1 |Ft ] = E Xk 1{τ =k} + Xt+1 1{τ >t} Ft .
k=0

Since Xk 1{τ =k} is Fk -measurable and 1{τ >t} depends only on Ft , we can simplify:
t
X
E[Zt+1 |Ft ] = Xk 1{τ =k} + 1{τ >t} E[Xt+1 |Ft ].
k=0

Using the martingale property of {Xt }, we get:

t
X
E[Zt+1 |Ft ] = Xk 1{τ =k} + 1{τ >t} Xt = Zt .
k=0

Hence, {Zt } is a martingale.

—

1.3.6 Theorem 11.2: Optional Stopping Theorem (OST)

Let {Xt } be a martingale and τ a bounded stopping time (i.e., for a constant C < ∞,
one has τ ≤ C almost surely). Then:

E[Xτ ] = E[X0 ].

Proof
1. By Theorem 11.1, the process Zt := Xτ ∧t is a martingale. From the definition of a
martingale:
E[Zt ] = E[Z0 ], ∀t ≥ 0.
2. As t → ∞, the boundedness of τ ensures Zt → Xτ . Thus, by the Dominated
Convergence Theorem:

E[Xτ ] = lim E[Zt ] = E[Z0 ] = E[X0 ].

t→∞

Remarks
1. In a fair game, the Optional Stopping Theorem states that there is no strategy based
on stopping that can ”beat the system.” The expected value of the martingale remains
constant. 2. In the general case, τ can be unbounded, and additional conditions are
required for the theorem to hold. For example, if Xt is uniformly integrable, the OST
holds even for unbounded τ .
—

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Chapter 1. Martingales

Generalized Forms of OST

1. If τ is unbounded and Xt is integrable, the following condition must hold for OST:

lim E[Xt ; τ > t] = 0.

t→∞

2. In such cases, the OST takes the form:

E[Xτ ; τ < ∞] = E[X0 ].

1.3.7 Call Options and American Derivative Security (ADS)

Call Options
A call option is a financial contract that entitles the holder to buy a block of shares at
a specified price (strike price) within a specified time interval. The holder has the right,
but not the obligation, to execute this option.

Types of Call Options There are two main types of call options:
• European Call Option (Vanilla Option):

– Can only be exercised at the expiration date (terminal point of the time in-
terval).
– Example Scenarios:
∗ Price Drops: The investor ignores the option and buys the shares at the
lower market price.
∗ Price Rises: The investor exercises the option to buy shares at the lower
strike price.

• American Call Option:

– Can be exercised at any time during the life of the option.

– Example Scenarios:
∗ Price Drops: The investor does not exercise the option.
∗ Price Rises: The investor exercises the option and resells the stock for a
profit.

American Derivative Security (ADS)

An American Derivative Security (ADS) is defined as any adapted stochastic process
{Xt }, t = 0, 1, . . . , T , on a filtered probability space (Ω, F, {Ft }, P ).

Applications of ADS: Examples of American Derivative Securities include:

• American call and put options.

• Convertible bonds with early redemption features.

• Real options in corporate finance.

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Chapter 2

Markov Decision Processes (MDP)

2.1 Introduction
Markov Decision Processes (MDPs) provide a framework to model decision-making in en-
vironments where outcomes are influenced by both randomness and the decision-maker’s
actions. These processes are widely used in fields such as operations research, artificial
intelligence, and economics.

2.1.1 Key Features of MDPs

• System Evolution: The system evolves in discrete time steps (t = 1, 2, 3, . . .),
and at each step, the system occupies a specific state.

• Actions: At each step, the decision-maker chooses an action from a set of available
actions.

• Uncertainty: The next state is determined probabilistically, based on the current

state and action.

• Objective: The goal is to identify a sequence of actions (policy) that maximizes

the expected total reward (or minimizes cost) over a given time horizon.

2.1.2 Decision Tree Representation

The decision-making process can be represented as a decision tree, shown in Figure 2.1.2.

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Chapter 1. Markov Decision Processes (MDP)

decision_tree.png

figureA decision
tree illustrating the stages and uncertainty in MDPs.

• Action Nodes (circles): At these nodes, the decision-maker selects an action.

• Chance Nodes (arrows): After an action, the system transitions probabilistically

to the next state.

2.2 Finite-Stage Models

Finite-stage models involve decision-making over a fixed time horizon T . The objective
is to maximize the expected cumulative reward:
" T #
X
E R(Xt , at ) ,
t=1

where Xt is the state at time t, at is the action taken, and R(Xt , at ) is the reward.

2.2.1 Components of MDP

• States (Xt ): The current condition or situation of the system.

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Chapter 1. Markov Decision Processes (MDP)

• Actions (A): The set of possible actions the decision-maker can take at any given
state.

• Transition Probabilities (pij (a)): The probability of transitioning from state i

to state j given action a.

• Reward Function (R(i, a)): The reward earned by taking action a in state i.

• Policy (at ): A rule for choosing actions to optimize the objective.

2.2.2 Dynamic Programming Approach

The solution to finite-stage MDPs involves dynamic programming, which breaks the
problem into smaller subproblems and solves them recursively.

Optimality Equation
The main tool for solving finite-stage models is the optimality equation:
" #
X
Vn (i) = max R(i, a) + pij (a)Vn−1 (j) ,
a
j

where:

• Vn (i): Maximum expected reward at state i with n steps remaining.

• R(i, a): Immediate reward for taking action a in state i.

•
P
j pij (a)Vn−1 (j): Expected future reward for transitioning to state j and following
the optimal policy thereafter.

Backward Calculation
1. Start with the terminal reward VT (i) = maxa R(i, a) at the final stage T .

2. Use the optimality equation recursively to compute VT −1 (i), VT −2 (i), . . . , V1 (i).

2.2.3 Optimal Policy

The optimal policy prescribes the action at that maximizes the total expected reward at
each step. It is determined by solving the optimality equation recursively.
—

2.3 Conclusion
MDPs provide a systematic framework for sequential decision-making under uncertainty.
The finite-stage model optimizes decisions over a fixed horizon by balancing immediate
and future rewards. The dynamic programming approach ensures the solution is both
efficient and optimal.

15
Chapter 1. Markov Decision Processes (MDP)

2.3.1 Example 4.1: Selling a House

A person moving overseas has to sell her house urgently. Three buyers are going to offer
her one after another. Their prices, Zj for j = 1, 2, 3, are independent and identically
distributed random variables with probabilities:

P (Zj = 100) = 0.3, P (Zj = 110) = 0.5, P (Zj = 120) = 0.2,

where Zj is the price (in thousands of dollars). If the seller rejects an offer, it is lost.
The seller aims to maximize the expected selling price. The problem is to derive the
optimal policy for selling the house and find the maximum expected value of the selling
price.

Formulation
We define the process {Xt } to include all necessary information for making decisions:
(
Zt , if the house is not sold yet,
Xt =
0, otherwise,

where t = 1, 2, 3(= T ).
At each step, there are two possible actions:

• a = 1: Sell the house.

• a = 0: Do nothing.

The transition probabilities are:

p20 (1) = 1, p00 (a) = 1 for any a, pxy (0) = P (Zj = y) for any x ̸= 0.

The reward function is defined as:

R(x, 1) = x, R(x, 0) = 0.

Solution
The total additive reward is simply the selling price, as the property is sold only once.
Starting with:
V0 (x) = 0,
we calculate the optimal value functions step by step using the optimality equation:

Vt (x) = max [R(x, a) + Ea (Vt+1 (Xt+1 )|Xt = x)] .

a

Step 1 (t = 3) : At the final stage, the seller accepts the last buyer’s offer, regardless
of its value:
V1 (x) = max R(x, a) = x.
a

16
Chapter 1. Markov Decision Processes (MDP)

Step 2 (t = 2) : The seller’s decision depends on whether the house has been sold or
not:
V2 (x) = max{x, 109},
where 109 is the expected value of the next offer:

E[Z3 ] = 100 · 0.3 + 110 · 0.5 + 120 · 0.2 = 109.

Step 3 (t = 1) : Similarly, we calculate:

V3 (x) = max{x, 111.7},

where:
E[V2 (Z2 )] = 109 · 0.3 + 111.7 · 0.5 + 120 · 0.2 = 111.7.
The maximum expected selling price is:

E[V3 (X1 )] = 113.36.

2.3.2 Example 4.1: Selling a House (Corrected)

A person moving overseas has to sell her house urgently. Three buyers are going to offer
her one after another. Their prices, Zj for j = 1, 2, 3, are independent and identically
distributed random variables with probabilities:

P (Zj = 100) = 0.3, P (Zj = 110) = 0.5, P (Zj = 120) = 0.2,

where Zj is the price (in thousands of dollars). If the seller rejects an offer, it is lost.
The seller aims to maximize the expected selling price. The problem is to derive the
optimal policy for selling the house and find the maximum expected value of the selling
price.

Formulation
We define the process {Xt } to include all necessary information for making decisions:
(
Zt , if the house is not sold yet,
Xt =
0, otherwise,

where t = 1, 2, 3(= T ).
At each step, there are two possible actions:
• a = 1: Sell the house.

• a = 0: Do nothing.
The transition probabilities are:

p20 (1) = 1, p00 (a) = 1 for any a, pxy (0) = P (Zj = y) for any x ̸= 0.

The reward function is defined as:

R(x, 1) = x, R(x, 0) = 0.

17
Chapter 1. Markov Decision Processes (MDP)

Solution
The total additive reward is simply the selling price, as the property is sold only once.
Starting with:
V0 (x) = 0,
we calculate the optimal value functions step by step using the optimality equation:

Vt (x) = max [R(x, a) + Ea (Vt+1 (Xt+1 )|Xt = x)] .

a

Stage t = 3: At the final stage, the seller accepts the last buyer’s offer:

V1 (x) = x.

E[V1 (Z3 )] = E[Z3 ] = 100 · 0.3 + 110 · 0.5 + 120 · 0.2 = 109.

Stage t = 2: The seller’s decision depends on whether the house has been sold or not:

V2 (x) = max{x, 109}.

For the expected value at this stage:

E[V2 (Z2 )] = 109 · 0.3 + 110 · 0.5 + 120 · 0.2 = 112.

Stage t = 1: Similarly:
V3 (x) = max{x, 112}.
For the expected value:

E[V3 (Z1 )] = 112 · 0.8 + 120 · 0.2 = 113.6.

The maximum expected selling price is:

E[V3 (X1 )] = 113.6.

2.3.3 Example 4.2: An American Call Option Model

Let Xt denote the price of a given stock on the t-th day. Assume the dynamics of the
price follow the random walk model:
t+1
X
Xt+1 = Xt + Yt+1 = X0 + Yj ,
j=1

where Yj are i.i.d. random variables with a common distribution F , having finite mean
µ = E[Y1 ].
An American call option entitles the holder to buy a block of shares (exercise the
option) of a given company at a stated price at any time during a specified time interval.

18
Chapter 1. Markov Decision Processes (MDP)

Illustration
An American call option is used for:
• Hedging Risks: Protect against future price rises.

• Speculation: Profit from expected price increases.

For example:
1. An investor hopes that the stock price may drop but is unsure. The investor:

• Buys and ignores the option if the price drops.

• Exercises the option if the price rises.

2. A speculator expects a sharp price rise but is unsure. The speculator:

• Does not exercise the option if the price drops.

• Exercises and resells the stock if the price rises.

Objective
Given an American call option to buy shares at a fixed price c with T -days to expiry, the
task is to maximize the expected profit. The optimal policy prescribes when to exercise
the option based on observed stock prices Xt .

2.4 Discounted Dynamic Programming

Dynamic programming with discounting involves maximizing the sum of discounted re-
wards: " T #
X
max Eπ αt R(Xt , at ) | X0 = i ,
π
t=0

where:
• R(Xt , at ): Reward at time t.

• α: Discount factor (0 < α < 1).

Bellman Equation
• Finite Horizon:
" #
X
Vn (i) = max R(i, a) + α pij (a)Vn−1 (j) .
a
j

• Infinite Horizon:
" #
X
V (i) = max R(i, a) + α pij (a)V (j) .
a
j

19
Chapter 1. Markov Decision Processes (MDP)

2.4.1 Lifetime Portfolio Selection: Full Calculation

Step 1: Reformulate the Problem
Given the constraint Ct = Xt − r−1 Xt+1 , the problem is to maximize:
T −1
X
αt u Xt − r−1 Xt+1 ,


max
t=0

where u(Ct ) = log(Ct ).

—

Step 2: Stationary Points and First-Order Conditions

To find the optimal sequence {Xt }, consider the total sum:
T −1
X
αt u Xt − r−1 Xt+1 .


ϕ=
t=0

The stationary condition for ϕ is:

∂ϕ
= 0,
∂Xt
leading to:
u′ (Xt − r−1 Xt+1 ) = αru′ (Xt+1 − r−1 Xt+2 ).
For u(Ct ) = log(Ct ), we have u′ (Ct ) = 1
Ct
, so:

1 1
−1
= αr .
Xt − r Xt+1 Xt+1 − r−1 Xt+2
Simplify:
Xt − r−1 Xt+1 = αr Xt+1 − r−1 Xt+2 .

Multiply through by r to eliminate the fraction:

rXt − Xt+1 = αrXt+1 − αXt+2 .

Rearrange to form a second-order linear difference equation:

Xt+2 − r(1 + α)Xt+1 + αr2 Xt = 0. (4.11)

Step 3: Solve the Difference Equation

Assume a solution of the form Xt = λt . Substituting into (4.11), we get the **character-
istic equation**:
λ2 − r(1 + α)λ + αr2 = 0.
Solve for the roots λ1 and λ2 using the quadratic formula:
p
r(1 + α) ± [r(1 + α)]2 − 4αr2
λ= .
2
20
Chapter 1. Markov Decision Processes (MDP)

The roots are:

λ1 = r, λ2 = αr.
Thus, the general solution is:

Xt = b1 rt + b2 (αr)t .

Step 4: Boundary Conditions

To determine b1 and b2 , use the boundary conditions: 1. Initial wealth: X0 = b1 + b2 . 2.
Terminal wealth: XT = b1 rT + b2 (αr)T .
Solve this system of equations:

b1 + b2 = X 0 ,

b1 rT + b2 (αr)T = XT .
From the first equation:
b2 = X 0 − b1 .
Substitute into the second equation:

b1 rT + (X0 − b1 )(αr)T = XT .

Simplify:
b1 rT − b1 (αr)T = XT − X0 (αr)T .
Factor out b1 :
b1 rT − (αr)T = XT − X0 (αr)T .
 

Solve for b1 :
XT − X0 (αr)T
b1 = .
rT − (αr)T
Substitute back to find b2 :
b2 = X 0 − b1 .
—

Step 5: Optimal Consumption

The consumption policy is:
Ct = Xt − r−1 Xt+1 .
Substitute Xt = b1 rt + b2 (αr)t and Xt+1 = b1 rt+1 + b2 (αr)t+1 :

Ct = b1 rt + b2 (αr)t − r−1 b1 rt+1 + b2 (αr)t+1 .

 

Factor out b1 and b2 :

Ct = b1 rt − rt + b2 (αr)t − (αr)t+1 .
   

Simplify:
Ct = b2 (1 − α)(αr)t .

21
Chapter 1. Markov Decision Processes (MDP)

X0 −r−T XT
Using b2 = 1−αT
, the final consumption policy is:

X0 − r−T XT
Ct = (1 − α)(αr)t .
1 − αT
For T = ∞, b2 = X0 , and:
Ct = (1 − α)Xt .
—

Final Results
1. **Consumption Policy for Finite Horizon**:
X0 − r−T XT
Ct = (1 − α)(αr)t .
1 − αT
2. **Consumption Policy for Infinite Horizon**:

Ct = (1 − α)Xt .

2.4.2 Stochastically Risky Alternative Asset

Setup
• Safe Asset: Investing $1 at time t yields r at t + 1.
• Risky Asset: Investing $1 at time t yields a random return Zt , where Zt are i.i.d.
random variables.

The individual’s wealth evolves as:

Xt+1 = (Xt − Ct ) [(1 − wt )r + wt Zt ] ,

where:
• Ct : Consumption at time t.
• wt : Fraction invested in the risky asset.
• 1 − wt : Fraction invested in the safe asset.
The objective is to maximize:
"T −1 #
X
max E αt log(Ct ) .
Ct ,wt
t=0

Step 1: Optimality Equation

The Bellman equation is:

Vn (x) = max [log(C) + αE (Vn−1 (Xt+1 )|Xt = x)] ,

C,w

where:
Xt+1 = (x − C) [(1 − w)r + wZ] .

22
Chapter 1. Markov Decision Processes (MDP)

Step 2: Special Case for n = 2

For n = 2:

V2 (x) = max [log(C) + αE [log ((x − C) [(1 − w)r + wZ])]] .

C,w

Maximization over C: Solve:

∂
[log(C) + αE [log(x − C)]] = 0.
∂C
This gives:
x
C= .
1+α

Maximization over w: Solve:

∂
E [log((1 − w)r + wZ)] = 0.
∂w
The solution is:
w∗ = argmaxw E [log((1 − w)r + wZ)] .

Step 3: General Case for n > 2

For n > 2:
Vn (x) = max [log(C) + αVn−1 (x − C)] .
C

The optimal consumption is:

x
Ct = .
1 + α + · · · + αT −t
For T = ∞:
Ct = (1 − α)Xt .
The portfolio decision is:
wt = w ∗ , ∀t.

23
Chapter 3

Brownian Decision Process

3.1 Explanation and Theory of Brownian Motion Pro-

cess (BM Process)
3.1.1 Definition and Process
Brownian motion is a continuous-time stochastic process that describes the random move-
ment of particles suspended in a fluid. It is a fundamental concept in probability theory
and has applications in physics, finance, and mathematics.

Step 1: Position of a Particle Over Time

The position X(t) of a particle at time t can be represented as:
t/∆t
X
X(t) = ∆x Xi
i=1

where:

• ∆x: Step length.

• ∆t: Time increment.

• Xi : Random variables representing the direction of each step:

(
+1, with probability 12 ,
Xi =
−1, with probability 12 .

Step 2: Properties of Xi
Since Xi are independent and identically distributed (i.i.d.) random variables, we have:
1 1
E[Xi ] = (+1) · + (−1) · = 0,
2 2
Var(Xi ) = E[Xi ] − (E[Xi ]) = (1) − (0)2 = 1.
2 2

24
Chapter 1. Brownian Decision Process

Step 3: Expected Value of X(t)

The expected value of X(t) is:
 
t/∆t t/∆t
X X t
E[X(t)] = E ∆x Xi  = ∆x E[Xi ] = ∆x · · 0 = 0.
i=1 i=1
∆t

Step 4: Variance of X(t)

The variance of X(t) is:
 
t/∆t t/∆t
X X t
Var(X(t)) = Var ∆x Xi  = (∆x)2 Var(Xi ) = (∆x)2 · .
i=1 i=1
∆t

Step 5: Limit ∆x → 0, ∆t → 0
√
Let ∆x = σ ∆t, where σ > 0. As ∆t → 0:

E[X(t)] = 0,
√ t
Var(X(t)) = (σ ∆t)2 · = σ 2 t.
∆t
Therefore, X(t) converges in distribution to a normal distribution:

X(t) ∼ N (0, σ 2 t).

3.1.2 Brownian Motion Properties

A process W (t) is called a Brownian motion (or Wiener process) if it satisfies the
following properties:
[label=()]W (0) = 0. W (t) has independent increments: For t2 > t1 , the increment
W (t2 ) − W (t1 ) is independent of the past, i.e., independent of {W (s) : s ≤ t1 }.
W (t) has stationary increments: The distribution of W (t + h) − W (t) depends only
on h, not on t. For s > t, W (s) − W (t) ∼ N (0, s − t). W (t) has continuous paths
with probability 1.

3.1.3 Martingale Property of Wt

Brownian motion Wt is a martingale with respect to its natural filtration Ft :

E[Wt+s | Ft ] = Wt , ∀s ≥ 0.

Example: Yt = Wt2 − t
Consider the process Yt = Wt2 − t. We will show that Yt is a martingale.

25
Chapter 1. Brownian Decision Process

Proof: Compute the conditional expectation:

2
E[Yt+s | Ft ] = E[Wt+s − (t + s) | Ft ]
= E[(Wt + (Wt+s − Wt ))2 − t − s | Ft ]
= E Wt2 + 2Wt (Wt+s − Wt ) + (Wt+s − Wt )2 − t − s | Ft
 

= Wt2 + 2Wt E[Wt+s − Wt | Ft ] + E[(Wt+s − Wt )2 ] − t − s

= Wt2 + 0 + s − t − s
= Wt2 − t
= Yt .

Thus, Yt is a martingale.

3.1.4 Step 1: Density Function of Brownian Motion

For a fixed t > 0, the random variable W (t) is normally distributed with mean 0 and
variance t:
W (t) ∼ N (0, t).
The probability density function (PDF) of W (t) is:
 2
1 x
fW (t) (x) = √ exp − , −∞ < x < ∞.
2πt 2t

3.1.5 Step 2: Joint Density Function of W (t1 ), W (t2 ), . . . , W (tn )

Since W (t) is a Gaussian process with independent increments, the joint distribution
of W (t1 ), W (t2 ), . . . , W (tn ) is multivariate normal with mean vector 0 and covariance
matrix Σ where:
Σij = min(ti , tj ).
The joint probability density function is:
 
1 1 ⊤ −1
f (x1 , x2 , . . . , xn ) = p exp − x Σ x .
(2π)n det(Σ) 2

Alternatively, since the increments are independent:

n
(xk − xk−1 )2
 
Y 1
f (x1 , x2 , . . . , xn ) = p exp − ,
2π(tk − tk−1 ) 2(tk − tk−1 )
k=1

with x0 = 0 and t0 = 0.

3.1.6 Step 5: Conditional Distribution

Given W (t) = B, the distribution of W (s) for 0 ≤ s ≤ t is:
 
s t−s
W (s) | W (t) = B ∼ N B, s .
t t

26
Chapter 1. Brownian Decision Process

Derivation: Since W (s) and W (t) are jointly normal with:

E[W (s)] = 0,
E[W (t)] = 0,
Var(W (s)) = s,
Var(W (t)) = t,
Cov(W (s), W (t)) = E[W (s)W (t)] = s.
The conditional distribution W (s) | W (t) = B is normal with mean and variance:
Cov(W (s), W (t))
E[W (s) | W (t) = B] = E[W (s)] + (B − E[W (t)])
Var(W (t))
s
= 0 + B,
t
[Cov(W (s), W (t))]2
Var(W (s) | W (t) = B) = Var(W (s)) −
Var(W (t))
2
s (t − s)s
=s− = .
t t
Thus, the conditional density function is:

2 !
1 x − st B
fW (s)|W (t) (x | B) = q exp − .
2π (t−s)s 2 (t−s)s
t
t

3.1.7 Example: Bicycle Race Modeled by Brownian Motion

In a bicycle race between two competitors, let Y (t) denote the amount of time (in seconds)
by which the racer that started in the middle position is ahead when 100% of the race has
been completed. The process Y (t), t ∈ [0, 1], is modeled as a Brownian motion process
with variance parameter σ 2 .

Subquestion (i): Probability of Winning the Race

If the middle racer leads by σ seconds at the midpoint (t = 21 ), what is the
probability that this racer wins the race?
We compute:
1
P (Y (1) > 0|Y ( ) = σ).
2

Step-by-Step Solution:
2.
4.
1.
3.
5. By the properties of Brownian motion:
 
1 2 1
Y (1) − Y ( ) ∼ N 0, σ · ,
2 2
and it is independent of Y ( 21 ).
2. Rewrite the probability:
1 1 1
P (Y (1) > 0|Y ( ) = σ) = P (Y (1) − Y ( ) > −σ|Y ( ) = σ).
2 2 2
27
Chapter 1. Brownian Decision Process

3. Simplify using Z ∼ N (0, 1):

 
1 −σ √
P (Y (1) > 0|Y ( ) = σ) = P Z > q  = P (Z > − 2).
2 σ 12

4. Using symmetry of the standard normal distribution:

√ √
P (Z > − 2) = Φ( 2) ≈ 0.9213.

Final Answer: The probability is approximately 0.9213.

Subquestion (ii): Probability of Leading at Midpoint

If the middle racer wins by a margin of σ seconds, what is the probability
that she was ahead at the midpoint?
We compute:
1
P (Y ( ) > 0|Y (1) = σ).
2

Step-by-Step Solution:
1. Use the conditional distribution of Brownian motion:
σ σ2
   
1
Y |Y (1) = σ ∼ N , .
2 2 4
2. The probability of being ahead at the midpoint is:
− σ2
 
1
P (Y ( ) > 0|Y (1) = σ) = P Z > σ ,
2 2

where Z ∼ N (0, 1).

3. Simplify:
1
P (Y ( ) > 0|Y (1) = σ) = P (Z > −1).
2
4. Using the normal distribution:
P (Z > −1) = Φ(1) ≈ 0.8413.

Final Answer: The probability is approximately 0.8413.

3.2 Geometric Brownian Motion (GBM): Steps to

Derivation
Step 1: Definition of GBM
A Geometric Brownian Motion (GBM) models processes where the growth rate is pro-
portional to the current value. It is widely used in finance for modeling stock prices.
The process is governed by the stochastic differential equation:
dX(t) = µX(t)dt + σX(t)dW (t),
where:

28
Chapter 1. Brownian Decision Process

• µ is the drift rate (expected rate of return),

• σ is the volatility (rate of variation of the process),

• W (t) is a standard Brownian motion.

Step 2: Define X(t) as a GBM

Let X(t) represent the solution to the stochastic differential equation. Using Itô’s Lemma,
we can rewrite:
X(t) = X(0) · eY (t) ,
σ2
where Y (t) = (µ − 2
)t + σW (t).

Step 3: Properties of Y (t)

The term Y (t) in the exponential can be expressed as:

σ2
Y (t) = (µ − )t + σW (t),
2
where:
σ2
• E[Y (t)] = (µ − 2
)t,

• Var[Y (t)] = σ 2 t,
 2

• Y (t) ∼ N (µ − σ2 )t, σ 2 t .

Step 4: Conditional Expectation of X(t)

The conditional expectation of X(t) given X(s), where s < t, is given by:
σ2
E[X(t)|X(s)] = X(s) · e(µ+ 2
)(t−s)
.

This shows that X(t) evolves exponentially, conditioned on X(s).

Step 5: Explicit Solution for X(t)

By solving the stochastic differential equation, we get the explicit form of X(t):
2
 
µ− σ2 t+σW (t)
X(t) = X(0) · e ,

where:
 
σ2
• µ− 2
is the effective drift term,

• σW (t) captures the random fluctuations due to Brownian motion.

29
Chapter 1. Brownian Decision Process

Final Form of GBM

The final expression for the Geometric Brownian Motion (GBM) is:
2
 
µ− σ2 t+σW (t)
X(t) = X(0) · e .

Key properties:

• E[X(t)] = X(0) · eµt ,

 
• Var[X(t)] = X(0) · e
2 2µt
· e σ2 t
−1 .

30
Chapter 4

Stochastic Calculus

4.1 Stochastic Calculus and Itô’s Integrals

4.1.1 White Noise and Wiener Process
White noise is a mathematical model for a sequence of random variables that are uncor-
related and have constant variance. It is fundamental in defining a Wiener process.
The Wiener process W (t), t ≥ 0, also called Standard Brownian Motion (SBM), sat-
isfies the following properties:

• W (0) = 0,

• W (t) has independent increments,

• W (t) − W (s) ∼ N (0, t − s), for t > s,

• W (t) has continuous paths almost surely.

4.1.2 Itô’s Integral

The stochastic integral of a function f (t) with respect to a Wiener process W (t) is defined
as: Z b n
X
f (t) dW (t) = lim f (ti−1 ) [W (ti ) − W (ti−1 )] ,
a n→∞
i=1

where a = t0 < t1 < · · · < tn = b forms a partition of [a, b], and max(ti − ti−1 ) → 0.

4.1.3 Derivation of the Itô Integral Formula

Starting with the discrete approximation:
n
X
f (ti−1 ) [W (ti ) − W (ti−1 )] ,
i=1

we expand and simplify:

n
X n
X
f (ti−1 ) [W (ti ) − W (ti−1 )] = f (tn )W (b) − f (t0 )W (a) − W (ti ) [f (ti ) − f (ti−1 )] .
i=1 i=1

31
Chapter 1. Stochastic Calculus

Taking the limit, the Itô integral becomes:

Z b Z b
f (t) dW (t) = f (b)W (b) − f (a)W (a) − W (t) df (t).
a a

4.1.4 Properties of Itô Integrals

• Expectation: Z b 
E f (t) dW (t) = 0.
a

• Variance: Z b  Z b
V f (t) dW (t) = f 2 (t) dt,
a a

derived using Itô’s isometry:

Z b  Xn Z b
2
V f (t) dW (t) = f (ti−1 ) V (W (ti ) − W (ti−1 )) = f 2 (t) dt.
a i=1 a

4.1.5 Stochastic Integral with Non-Random Integrand

When the integrand ft ≡ f (t) is non-random, the stochastic integral:
Z b
f (t) dW (t)
a

follows a normal distribution:

Z b  Z b 
2
f (t) dW (t) ∼ N 0, f (t) dt .
a a

4.1.6 Examples of Itô Integrals

1. Distribution of the Integral: If the integrand f (t) = 1, the integral becomes:
Z t
dW (s) ∼ N (0, t).
0

2. Quadratic Variation: The quadratic variation of the Wiener process is:

Z t
W2 t
W (s) dW (s) = t − .
0 2 2
Rt
3. Higher Powers: For higher powers, like 0
W 2 (s) dW (s), the result can be derived
iteratively: Z t
Wt3 = 3W 2 (s) dW (s) + t.
0

32
Chapter 1. Stochastic Calculus

4.1.7 Summary of Itô’s Integral Formula

Itô’s integral is a foundational tool in stochastic calculus, essential for modeling random
processes and solving stochastic differential equations (SDEs). It establishes a robust
framework for integrating with respect to Wiener processes and lays the groundwork for
advanced topics such as Itô’s Lemma and SDEs.

4.1.8 Itô’s Formula

Consider a process {Xt }t∈[0,T ] in an Itô process (on a filtered probability space (µ, F, F, P ))
with a Brownian Motion {Wt }t∈[0,T ] on F. The Itô process is defined as:
Z t Z t
X t = X0 + as ds + bs dWs , t ∈ [0, T ],
0 0
where X0 is F0 -measurable, and:
RT
1. {at }t∈[0,T ] is an F-adapted process with measurable trajectories such that 0
a2s ds <
∞,
RT
2. {bt }t∈[0,T ] is an F-adapted process such that 0 E[b2s ] ds < ∞.
Then, on [0, T ], the process Xt satisfies the stochastic differential equation (SDE):
dXt = at dt + bt dWt .

4.1.9 Multiplication Table and Derivations

Multiplication Table:
dt · dt = (dt)2 = 0, dt · dWt = dWt · dt = 0, dWt · dWt = dt.
For sums of differentials:
X X X
(∆tk )2 → 0, (∆tk )(∆Wk ) → 0, (∆Wk )2 → t.
Derivation Using Itô’s Formula:
Let {Xt }t∈[0,T ] be an Itô process with the SDE:
dXt = at dt + bt dWt ,
and let Yt = f (Xt ) for t ∈ [0, T ], where f is twice continuously differentiable. Using
Taylor’s formula, we have:
1
dYt ≡ df (Xt ) = f ′ (Xt ) dXt + f ′′ (Xt ) (dXt )2 .
2
From the SDE:
dXt = at dt + bt dWt ,
we calculate (dXt )2 :
(dXt )2 = (at dt + bt dWt )2 = a2t (dt)2 + 2at bt dt dWt + b2t (dWt )2 .
Using the multiplication table, we find:
(dXt )2 = b2t dt.
Substituting into the formula for dYt , we get:
 
1 ′′
dYt = at f (Xt ) + f (Xt )bt dt + bt f ′ (Xt ) dWt .
′ 2
2

33
Chapter 1. Stochastic Calculus

4.1.10 Examples of Itô’s Lemma

Example 1: Yt = 21 Wt2
Using Itô’s formula:
1
dYt = f ′ (Wt )dWt + f ′′ (Wt )(dWt )2
2
Here:
1
f (x) = x2 , f ′ (x) = x, f ′′ (x) = 1
2
Substitute into the formula:
 
1 2 1
d Wt = Wt dWt + dt
2 2
Thus:  
1 2 1
d W = Wt dWt + dt
2 t 2

Example 2: Yt = eWt
Using Itô’s formula:
1
dYt = f ′ (Wt )dWt + f ′′ (Wt )(dWt )2
2
Here:
f (x) = ex , f ′ (x) = ex , f ′′ (x) = ex
Substitute into the formula:
1
d(eWt ) = eWt dWt + eWt dt
2

Summary
- Itô’s Formula (General Form):
1
dYt = f ′ (Xt )dXt + f ′′ (Xt )(dXt )2
2
where (dXt )2 = dt.
- For a Brownian motion Wt , we use:

dWt2 = dt

4.2 Statement 1
Let f (t, x) have continuous partial derivatives ∂t f , ∂x f , and be twice continuously differ-
entiable in x, ∂x2 f . If {Xt } is an Itô process

dXt = at dt + bt dWt ,

then Yt := f (t, Xt ) is also an Itô process with

1
dYt = ∂t f (t, Xt )dt + ∂x f (t, Xt )dXt + ∂x2 f (t, Xt ) b2t dt.


2
34
Chapter 1. Stochastic Calculus

Taylor Series Expansion

The Taylor series expansion of f (x, y) near (a, b) is:
1 1
f (x, y) = f (a, b)+fx (a, b)(x−a)+fy (a, b)(y−b)+ fxx (a, b)(x−a)2 + fyy (a, b)(y−b)2 +fxy (a, b)(x−a)(y−b
2 2

4.2.1 Example: Geometric Brownian Motion (GBM)

Definition
Let Zt = eµt+σWt where µ, σ ∈ R. Define f (t, x) = ex . Then:

∂t f = µf (t, x), ∂x f = σf (t, x), ∂x2 f = σ 2 f (t, x).

Derivation


d(Zt ) = d f (t, Wt ) ,
1
= ∂t f (t, Wt )dt + ∂x f (t, Wt )dWt + ∂x2 f (t, Wt )(dWt )2 .
2
Substituting the derivatives:
1
d(Zt ) = µf (t, Wt )dt + σf (t, Wt )dWt + σ 2 f (t, Wt )dt,
2
1
d(Zt ) = µZt dt + σZt dWt + σ 2 Zt dt,
2
2
 σ
d(Zt ) = µ + Zt dt + σZt dWt .
2

4.3 Product Rule

Let Xt and Yt be Itô processes on a common filtered probability space. Define:

Zt := Xt Yt

The differential of Zt is given by:

dZt = Xt dYt + Yt dXt + dXt dYt

4.4 Quotient Rule

Xt
For the quotient Zt := Yt
, the differential is:

dXt Xt Xt 1
dZt = − 2 dYt + 3 (dYt )2 − 2 dXt dYt
Yt Yt Yt Yt

35
Chapter 1. Stochastic Calculus

4.4.1 Example: Product of Processes

Let:
Xt = Wt , Yt = eWt , Zt := Xt Yt = Wt eWt
Then:
dZt = Wt d eWt + eWt dWt + dWt d eWt

From the chain rule:

1
d eWt = eWt dWt + eWt (dWt )2


2
Substituting back:
   
Wt 1 Wt Wt Wt 1 Wt
dZt = Wt e dWt + e dt + e dWt + e dWt + e dt
2 2
Simplifying:  
1 Wt Wt
dt + Wt eWt + eWt dWt


dZt = Wt e + e
2
or equivalently:
1
dZt = (1 + Wt )eWt dt + (1 + Wt )eWt dWt
2
—

4.5 Stochastic Differential Equation (SDE)

The general form of a stochastic differential equation (SDE) is:
dXt = a(t, Xt )dt + b(t, Xt )dWt , t ∈ [0, T ], X0 = x,
where a(t, x) and b(t, x) are non-random, and Wt is a Brownian motion (BM) on (Ω, F, P).

4.5.1 Itô Process

An Itô process {Xt }t∈[0,T ] on (Ω, F, P) is said to be the solution of the SDE above.

Solution of SDE
The solution of the SDE is given by:
Z t Z t
Xt = X 0 + a(s, Xs )ds + b(s, Xs )dWs , t ∈ [0, T ].
0 0

4.5.2 Existence and Uniqueness

Equation (4) will have a unique solution, provided a and b satisfy regularity conditions.
For instance, if they are measurable and there exists a constant C > 0 such that:
|a(t, x)| + |b(t, x)| ≤ C(1 + |x|),
and
|a(t, x) − a(t, y)| + |b(t, x) − b(t, y)| ≤ C|x − y|,
for t ∈ [0, T ] and x, y ∈ R, then a unique solution exists.

36
Chapter 1. Stochastic Calculus

4.5.3 Ornstein-Uhlenbeck Process (OU Process)

The Ornstein-Uhlenbeck process is a stochastic process defined by the following SDE:

dXt = −rXt dt + σ dWt , X0 = x0 , r > 0, σ > 0.

Step 1: Transform the SDE

Multiply through by ert to simplify the equation:

ert dXt = −rXt ert dt + σert dWt .

Using the product rule:

d ert Xt = ert dXt + rert Xt dt.

Substitute dXt from the original SDE:

d ert Xt = ert − rXt dt + σdWt + rert Xt dt.

Simplify:
d ert Xt = σert dWt .

Step 2: Solve the Transformed Equation

Integrate both sides from 0 to t:
Z t Z t
rs
σers dWs .


d e Xs =
0 0

The left-hand side simplifies to:

ert Xt − X0 .

The right-hand side remains as an Itô integral:

Z t
σers dWs .
0

Thus, the solution becomes:

Z t
rt
e Xt = X0 + σ ers dWs .
0

Divide through by ert :

Z t
−rt −rt
Xt = e X0 + σe ers dWs .
0

Rearrange the integral:

Z t
−rt
Xt = e X0 + σ e−r(t−s) dWs .
0

37
Chapter 1. Stochastic Calculus

Step 3: Mean and Variance of Xt

*(a) Mean of Xt Take the expectation of Xt :
Z t 
−rt −r(t−s)
E[Xt ] = E[e X0 ] + σE e dWs .
0

The first term:

E[e−rt X0 ] = e−rt X0 .
The second term involves the Itô integral, which has zero mean:
Z t 
−r(t−s)
E e dWs = 0.
0

Thus:
E[Xt ] = e−rt X0 .
*(b) Variance of Xt The variance is given by:
Z t 
2 −r(t−s)
Var(Xt ) = σ Var e dWs .
0

Using Itô isometry:

Z t  Z t
2
−r(t−s)
Var e dWs = e−r(t−s) ds.
0 0

Simplify: Z t Z t Z t
−2r(t−s) −2rt 2rs −2rt
e ds = e e ds = e e2rs ds.
0 0 0
Evaluate the integral: Z t
1 2rt
e2rs ds =


e −1 .
0 2r
Substitute back:
1 2rt
Var(Xt ) = σ 2 e−2rt ·


e −1 .
2r
Simplify:
σ2
1 − e−2rt .


Var(Xt ) =
2r

4.5.4 Step 4: Stationary Distribution

As t → ∞:
σ2
Var(Xt ) → , E[Xt ] → 0.
2r
Thus, the stationary distribution is:

σ2
 
Xt ∼ N 0, .
2r

38
Chapter 1. Stochastic Calculus

Summary
The solution to the Ornstein-Uhlenbeck process is:
Z t
−rt
Xt = e X0 + σ e−r(t−s) dWs .
0

- Mean:
E[Xt ] = e−rt X0 .
- Variance:
σ2
1 − e−2rt .


Var(Xt ) =
2r
- Stationary distribution:
σ2
 
Xt ∼ N 0, .
2r

39
Chapter 5

Applications in Finance

5.1 Applications in Finance: Pricing Stock Options

5.1.1 Introduction to Stock Options
A certain amount V at time t in the future is not worth as much as given V immediately.
The value V at time t is:
V · e−αt ,
where α is the discount factor.
Continuous compounding is represented as:
e−αt (discount factor).
We can earn interest at a continuously compounded rate of 100 × α% per unit time.

5.1.2 Pricing Problem Setup

Consider the following stock price movement:
(
200, if price goes up,
Initial Stock Price: 100 Time 1 Price:
50, if price goes down.
At time 0 (option time), at a cost C, you can purchase the option to buy y units of
stock at a fixed strike price k at time 1 (expiry time). We consider two strategies:
• Buy x units of stock and sell y units of options.
• Buy y units of options instead of stock.
We aim to determine the appropriate value of C, the unit cost of an option. Specifi-
cally, we will show that C = 50
3
.

5.1.3 Calculation of Holdings

Value of Holdings at Time 1
The value of holdings at time 1 is:
(
200x + 50y, if price is 200,
Value =
50x, if price is 50.

40
Chapter 1. Applications in Finance

Let us choose y such that:

200x + 50y = 50x =⇒ y = −3x.

Original Cost of Holdings

The original cost of purchasing x units of stock and y = −3x units of options is:
Original Cost = 100x − 3xC.
Gain at time 1 is:
Gain = 50x − (100x − 3xC) = x(3C − 50).
Cases:
• Gain = 0, if 3C = 50,
• Gain > 0, if 3C > 50,
• Gain < 0, if 3C < 50.

5.1.4 Case Analysis

• If C = 20 (unit cost per option):
x = 1, y = −3.
Purchase 1 unit of stock and simultaneously sell 3 units of options. Initial cost:
100 − 3 × 20 = 40.
Value of holdings at time 1 is:
50 (whether stock price is 200 or down to 50).
Guaranteed profit:
50 − 40 = 10.

• If C = 15:
x = 1, y = −3.
Initial cost:
100 − 45 = 55.
Value of holdings at time 1 is:
50.
Guaranteed profit:
55 − 50 = 5.

5.1.5 Conclusion
A sure-win betting scheme is called an arbitrage (risk-free profit). Thus, the only option
cost C that does not result in arbitrage is:
50
C= .
3
41
Chapter 1. Applications in Finance

5.2 Option Pricing in Discrete Time

5.2.1 Stock Pricing and Interest Rates
Let (St )t≥0 denote the price of a security (stock) traded in the market. Additionally, let
(Bt )t≥0 represent the value of a risk-free bond with a fixed interest rate r ≥ 0. The bond
value at time t is given by:
Bt = (1 + r)t B0
where B0 is the initial value of the bond.

5.2.2 Definitions of Call and Put Options

• European Call Option:
(
ST − K, if ST > K
Y = (ST − K)+ =
0, if ST ≤ K

where ST is the stock price at maturity T and K is the strike price.

• American Call Option:

Y = (Sτ − K)+ for τ ∈ [0, T ].

• European Put Option:

(
K − ST , if K > ST
Ys = (K − ST )+ =
0, if K ≤ ST

5.2.3 Classical Valuation of Options

The classical method calculates the expected payoff at maturity:

E(Y ) = E[(ST − K)+ ].

The value of the call option at time t = 0 is:

E(Y )
C0 = .
(1 + r)

5.2.4 Example: Option Valuation

Given:
• Initial stock price: S0 = 100.
• Risk-free rate: r = 0.05.
• Strike price: K = 110.
• Stock price evolution:
(
130, with probability p = 0.4,
ST =
80, with probability 1 − p = 0.6.

42
Chapter 1. Applications in Finance

Expected Payoff at Maturity

E(Y ) = 20 · 0.4 + 0 · 0.6 = 8.

Value of Call Option at t = 0

E(Y ) 8
C0 = = ≈ 7.62.
1+r 1.05

5.2.5 Replicating Portfolio (Hedging Strategy)

The replicating portfolio consists of:
• ∆: Units of stock.

• B: Bonds at t = 0.
The value of the portfolio at t = 0:

V0 (Π) = ∆S0 + B.

At t = 1, the portfolio value is:

V1 (Π) = ∆S1 + B(1 + r).

To replicate the option payoff:

If S1 = 130 : V1 (Π) = 0.4 · 130 + (−30.48 · 1.05) = 20,

If S1 = 80 : V1 (Π) = 0.4 · 80 + (−30.48 · 1.05) = 0.

5.2.6 Fair Price of the Call Option

The fair price of the call option at t = 0 is equal to the price of the replicating portfolio:

C0BS = ∆S0 + B = 0.4 · 100 + (−30.48) = 9.52.

5.2.7 Summary
The Black-Scholes approach shows that the fair price of a call option can be determined
by constructing a replicating portfolio consisting of stock and risk-free bonds. In this
example, ∆ = 0.4 and B = −30.48 provide the appropriate hedge.

5.3 Application in Finance: Option Pricing in Dis-

crete Time
5.3.1 Setup
Consider a stock with:
• Initial stock price S0 = 100.

• Possible future prices:

43
Chapter 1. Applications in Finance

– ST = 130 with probability p = 0.4 (stock performs well).

– ST = 80 with probability 1 − p = 0.6 (stock performs poorly).
• Strike price K = 110 (price at which the stock can be purchased).
• Risk-free interest rate r = 5% (continuously compounded).
The goal is to calculate the fair price of a European call option on the stock, using:
1. The classical expected payoff method.
2. The replicating portfolio method.

5.3.2 Classical Expected Payoff Method

The payoff of a call option at maturity is given by:
Y = max(ST − K, 0) = (ST − K)+ .
• If ST = 130: Payoff Y = 130 − 110 = 20.
• If ST = 80: Payoff Y = 0 (since 80 − 110 < 0).
The expected payoff is:
E(Y ) = 20 · 0.4 + 0 · 0.6 = 8.
To find the fair price of the option at t = 0, we discount the expected payoff using
the risk-free rate:
E(Y ) 8
C0 = = ≈ 7.62.
1+r 1.05
Thus, the fair price of the call option today is $7.62.

5.3.3 Replicating Portfolio Method

In this method, we construct a portfolio that replicates the option’s payoff using:
• ∆: The number of stock units to hold.
• B: The amount of money invested in a risk-free bond.
At maturity (t = 1), the portfolio value must equal the option payoff:
V1 = ∆ST + B(1 + r).
• When ST = 130: V1 = 20.
• When ST = 80: V1 = 0.
We solve for ∆ and B using the two equations:
20 = ∆ · 130 + B(1.05),
0 = ∆ · 80 + B(1.05).
Solving these equations:
∆ = 0.4, B = −30.48.

44
Chapter 1. Applications in Finance

5.3.4 Calculate the Portfolio Value Today

The value of the portfolio at t = 0 is:
V0 = ∆S0 + B = 0.4 · 100 − 30.48 = 9.52.
Thus, the fair price of the call option is $9.52.

5.3.5 Real-World Interpretation

• As an investor, you would pay $9.52 for the call option today, which allows you to
potentially profit if the stock price rises above $110.
• A financial institution can hedge its risk by holding 0.4 units of the stock and
borrowing $30.48 at a 5% interest rate.
This ensures that the market remains arbitrage-free. If the option price deviates
from $9.52, arbitrageurs would exploit the difference, bringing the price back to its fair
value.

5.4 Binomial Market Model: Framework

5.4.1 Framework
1. Time Structure:
• Time is divided into discrete intervals: t = 0, 1, . . . , T , where T is the maturity.
• At each step, the price of a risky asset (e.g., stock) can either move up or
down.
2. Assets in the Market:
• Risk-free Asset: A bond (or bank account) yielding a risk-free rate r per time
period:
Bt = (1 + r)t B0 , t = 0, 1, . . . , T.
• Risky Asset: The stock price St at time t:
(
uSt−1 , if price moves up,
St =
dSt−1 , if price moves down.
Here, u > 1 (up factor) and d < 1 (down factor) are constants such that
d < 1 + r < u.
3. Sample Space:
• The sample space consists of all possible sequences of up and down movements:
Ω = {ω = (ν1 , ν2 , . . . , νT ) : νt ∈ {u, d}, t = 1, 2, . . . , T }.
4. Stock Price Process:
• The stock price at time t for a given path ω is:
t
Y
St (ω) = S0 νi , νi ∈ {u, d}.
i=1

45
Chapter 1. Applications in Finance

5.4.2 Key Properties

1. Non-Arbitrage Condition:

• To prevent arbitrage, the parameters u, d, and r must satisfy:

d < 1 + r < u.

2. Filtration:

• The stock price process is adapted to the filtration {Ft }.

5.5 Single-Period Binomial Market

5.5.1 Trading Strategy/Portfolio
At time t = 0, a trading strategy is represented by:

• ∆: Number of shares

• b: Number of bonds

At time t, the portfolio value Vt is given by:

(
∆S0 + bB0 = ∆S0 + b, at t = 0,
Vt = Vt (ω) =
∆S1 + bB1 = ∆S1 + b(1 + r), at t = 1.

The portfolio will be a hedge if:

V1 (ω) ≥ X(ω), ∀ω ∈ Ω = {u, d}, at T = 1,

where X(ω) ∈ {Xu , Xd }.

5.5.2 Hedge Conditions

∆uS0 + b(1 + r) ≥ Xu , (5.1)

∆dS0 + b(1 + r) ≥ Xd . (5.2)

Rewriting the conditions:

uS0 Xu
b≥− ∆+ , (1)
1+r 1+r
dS0 Xd
b≥− ∆+ . (2)
1+r 1+r

46
Chapter 1. Applications in Finance

5.5.3 Optimal Hedge

The optimal hedge is achieved by minimizing ∆S0 + b across all hedges (∆, b):

∆uS0 + b(1 + r) = Xu , ∆dS0 + b(1 + r) = Xd .

Solving for ∆:
Xu − X d
∆= , (3)
(u − d)S0
and for b:
uXd − dXu
b= . (4)
(1 + r)(u − d)
Equations (3) and (4) provide a perfect hedge for X, and its time t = 0 value is:

Xu − Xd uXd − dXu
V0 = ∆S0 + b = + .
u−d (1 + r)(u − d)

5.5.4 Fair Price of Claim

Using the risk-neutral probability p∗ :

1+r−d u − (1 + r)
p∗ = , 1 − p∗ = .
u−d u−d
The fair price of the claim X at t = 0 is:
1
C= [p∗ Xu + (1 − p∗ )Xd ] .
1+r

5.5.5 Example: Pricing a European Call

Given:

S0 = 1, k = 1, r = 0.25, u = 1.75, d = 0.5.

Calculate:
1+r−d 1.25 − 0.5
p∗ = = = 0.6, 1 − p∗ = 0.4.
u−d 1.75 − 0.5
The fair price of the European call is:
1
C= [p∗ Xu + (1 − p∗ )Xd ] ,
1+r
where:

Xu = (uS0 − k)+ = (1.75 − 1)+ = 0.75, Xd = (dS0 − k)+ = (0.5 − 1)+ = 0.

Thus:
1 1
C= [0.6(0.75) + 0.4(0)] = (0.45) = 0.36.
1.25 1.25

47
Chapter 1. Applications in Finance

5.5.6 Replicating Portfolio Verification

The replicating portfolio is given by:
Xu − Xd 0.75 − 0
∆= = = 0.6,
(u − d)S0 (1.75 − 0.5) × 1

uXd − dXu 1.75 × 0 − 0.5 × 0.75

b= = = −0.24.
(u − d)(1 + r) (1.75 − 0.5) × 1.25

Portfolio Value at t = 0
V0 = ∆S0 + b = 0.6 × 1 − 0.24 = 0.36.

Portfolio Value at t = 1
Case 1: If S1 = uS0 = 1.75:

V1 (u) = ∆S1 + b(1 + r) = 0.6 × 1.75 − 0.24 × 1.25 = 0.75.

Case 2: If S1 = dS0 = 0.5:

V1 (d) = ∆S1 + b(1 + r) = 0.6 × 0.5 − 0.24 × 1.25 = 0.

Replication Verification
In both cases:
V1 (u) = (S1 − k)+ = 0.75, V1 (d) = (S1 − k)+ = 0.
Thus, the replicating portfolio exactly matches the option’s payoff at t = 1.

Summary
• At t = 0, V0 = 0.36 (matches the call price C).

• At t = 1, V1 = (S1 − k)+ , a perfect replication.

1 0.36
Stock Price Tree: ↗ ↘ Call Price Tree: ↗ ↘ .
1.75 0.5 0.75 0

5.6 No-Arbitrage (NA) Condition

Definition: Arbitrage refers to the possibility of making a profit without any initial
investment or risk. For a financial model to be valid and realistic, it must satisfy the
No-Arbitrage (NA) Condition.

48
Chapter 1. Applications in Finance

5.6.1 Zero Net Investment

The NA condition assumes that the portfolio is self-financing with no initial investment:

V0 = ∆S0 + b = 0 =⇒ b = −∆S0

Here:
• ∆: Number of stocks in the portfolio,

• b: Number of bonds in the portfolio.

Portfolio Value at t = 1
At time t = 1, the portfolio value is:

V1 = ∆S1 + b(1 + r)

Substituting b = −∆S0 , we get:

 
S1
V1 = ∆S1 − ∆S0 (1 + r) = ∆(1 + r) − S0
1+r

Inequalities for NA Condition

For the model to satisfy the NA condition:
• S1 > (1 + r)S0 , when S1 = uS0 (upward movement),

• S1 < (1 + r)S0 , when S1 = dS0 (downward movement).

This implies:
d<1+r <u
Here:
• u: Up-factor (e.g., 1.75),

• d: Down-factor (e.g., 0.5).

Conclusion
The condition d < 1 + r < u ensures no arbitrage exists in the binomial market. This
framework guarantees that the financial model is fair and reflects realistic market behav-
ior, avoiding arbitrage opportunities.

5.7 Multi-Period Binomial Market

5.7.1 Two-Period Binomial Market
Scenario
Consider a stock with the initial price S0 = 120, which can move up or down in two time
periods:

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• Up factor (u): u = 1.5

• Down factor (d): d = 0.5

• Risk-free rate (r): r = 0

• Strike price (k): k = 80

Assumptions
1. The market satisfies the No-Arbitrage (NA) condition: d < 1 + r < u.

2. A call option is written on this stock with a strike price of k = 80.

Key Steps in Two-Period Binomial Pricing

1. Stock Price Evolution

• At t = 0: S0 = 120.

• At t = 1:

– Move up: S1 = uS0 = 1.5 × 120 = 180.

– Move down: S1 = dS0 = 0.5 × 120 = 60.

• At t = 2: 
270 if price moves up twice,

S2 = 90 if price moves up and down,

30 if price moves down twice.


2. Risk-Neutral Probability (p∗ )

1+r−d 1 − 0.5
p∗ = = = 0.5, 1 − p∗ = 0.5.
u−d 1.5 − 0.5

3. Claim Value at t = 2 The option’s payoff at each node of t = 2 is:

max(S2 − k, 0) :

• S2 = 270: max(270 − 80, 0) = 190.

• S2 = 90: max(90 − 80, 0) = 10.

• S2 = 30: max(30 − 80, 0) = 0.

4. Replication at t = 2 The hedge portfolio (∆2 , b2 ) is calculated for each branch:

10 − 0 1
∆2 (60) = = .
90 − 30 6

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Chapter 1. Applications in Finance

5. Backward Induction Compute portfolio values at t = 1 to match option payoffs

at t = 2:

V1 (180) = ∆2 (180) × S1 + b2 (180) × (1 + r) = 100,

V1 (60) = ∆2 (60) × S1 + b2 (60) × (1 + r) = 5.

6. Option Value at t = 0 The value of the call option at t = 0 is:

V0 = ∆1 × S0 + b1 = 52.5.

Conclusion
The two-period binomial model allows us to replicate the option by creating a hedging
portfolio (∆ and b) at each step, ensuring the portfolio value matches the option payoff.
This framework is fundamental for understanding multi-period extensions and is widely
used in option pricing, particularly in discrete time.

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