KeyPoints:Derivatives

LeonidKogan
MIT,Sloan
15.450,Fall2010
c LeonidKogan (MIT,Sloan) KeyPoints:Derivatives 15.450,Fall2010 1/1

DiscreteModels
DenitionsofSPD()andrisk-neutralprobability(Q).
AbsenceofarbitrageisequivalenttoexistenceoftheSPDora
risk-neutralprobability:
T T
P
t
=E
P
t

u
t
D
u
=E
Q
t

B
B
u
t
D
u
u=t +1 u=t +1
Priceofrisk:underGaussianPandQdistributions,

Q
=
P
+
t
t t
Log-normalmodel(discreteversionofBlack-Scholes):

t
r
t
=
t

t
c LeonidKogan (MIT,Sloan) KeyPoints:Derivatives 15.450,Fall2010 3/1
StochasticCalculus
Brownianmotion,basicproperties(IIDGaussianincrements,
continuoustrajectories,nowheredifferentiable).
Quadraticvariation.[Z]
T
=T.Heuristically,
(dZ
t
)
2
=dt .
Stochasticintegral.
Itoslemma:
df(t ,X
t
) =
f(t ,X
t
)
dt+
f(t ,X
t
)
dX
t
+
1
2
f(t ,X
t
)
(dX
t
)
2
t X
t
2 X
t
2
MultivariateItoslemma.
f f f
df(t ,X
t
,Y
t
) = dt+ dX
t
+ dY
t
+
t X
t
Y
t
1
2
f 1
2
f
2
f
(dX
t
)
2
+ (dY
t
)
2
+ dX
t
dY
t
2X
t
2
2Y
t
2
X
t
Y
t
c LeonidKogan (MIT,Sloan) KeyPoints:Derivatives 15.450,Fall2010 4/1
Black-ScholesModel
Arbitrage-freepricingofoptionsbyreplication.
EuropeanoptionwithpayoffH(S
T
).
Replicatingportfoliodeltais
f(t ,S
t
)

t
=
S
t
f(t ,S) f(t ,S) 1

2
S
2

2
f(t ,S)
r f(t ,S) + +rS + =0
t S 2 S
2
withtheboundaryconditionf(T,S) =H(S).
c LeonidKogan (MIT,Sloan) KeyPoints:Derivatives 15.450,Fall2010 5/1
PricingbyReplication:Limitations
Inmanymodelscannotderiveauniquepriceforaderivative.
Termstructuremodels,stochasticvolatility.
Priceassetsrelativetoeachother.Replicationargumentcombined
withassumptionsonpricesofrisk.
Alternatively,specifydynamicsdirectlyunderQ.
c LeonidKogan (MIT,Sloan) KeyPoints:Derivatives 15.450,Fall2010 6/1

Risk-NeutralPricing
Generalpricingformula

T

=E
Q
exp r
s
ds P
t
t
H
T
t
NeedtospecifydynamicsoftheunderlyingunderQ.
Ifunderlyingisastock,onlyonewaytodothis:setexpectedreturnto
r.
QdynamicsisrelatedtoPthroughpriceofrisk
dZ
t
P
=
t
dt+dZ
t
Q
Riskpremium
E
P
t
dS
t
r
t
dt =E
P
t
dS
t
E
Q
t
dS
t
S
t
S
t
S
t
c LeonidKogan (MIT,Sloan) KeyPoints:Derivatives 15.450,Fall2010 7/1

Risk-NeutralPricingandPDEs
DeriveaPDEonderivativepricesusingItoslemma.
One-factortermstructuremodel
E
t
[df(t ,r
t
)]=r
t
f(t ,r
t
)dt
Vasicekmodel:
dr
t
= (r
t
r)dt+dZ
t
Q
f(t ,r
t
)mustsatisfythePDE
f(t ,r)
(r r)
f(t ,r)
+
1

2
f(t ,r )
=rf(t ,r)
t r 2 r
2
withtheboundarycondition
f(T,r) =1
Expectedbondreturnssatisfy
dP(t ,T)
E
t
P(t ,T)
= (r
t
+
P
t

t
)dt
c LeonidKogan (MIT,Sloan) KeyPoints:Derivatives 15.450,Fall2010 8/1
MonteCarloSimulation
Randomnumbergeneration:inversetransform,acceptance-rejection
method.
Variancereduction:antitheticvariates,controlvariates.
Intuitionbehindcontrolvariates:carveoutthepartoftheestimated
momentthatisknowninclosedform,noneedtoestimatethatby
MonteCarlo.
Goodcontrolvariates:highlycorrelatedwiththevariableofinterest,
expectationknowninclosedform.
Examplesofcontrolvariates:stockprice,payoffofsimilaroption,etc.
c LeonidKogan (MIT,Sloan) KeyPoints:Derivatives 15.450,Fall2010 9/1
MIT OpenCourseWare
http://ocw.mit.edu
15.450 Analytics of Finance
Fall 2010
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