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Summaries: book " Stochastic Calculus for Finance I" Steven

Shreve - Summary of chapters 1 / 4 and 6
Introduction to Mathematical Finance (Technische Universiteit Delft)

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H1: The Binomial No-Arbitrage Pricing Model

The binomial asset-pricing model provides a powerful tool to understand arbitrage pricing theory
and probability. The no-arbitrage rule is given by:
0< <1+ <

Payoffs
-

Call: (1 )+
Put: ( 1 )+
Forward: 1

Replication in the multiperiod binomial model

Risk-neutral pricing formula:
(1 2 ) =

+1 (1 2 ) + +1 (1 2 )
1+

Risk-neutral probabilities:
=

1+

These are only numbers that assist in the solution of the replicating portfolio equation. Under the
actual probabilities and , the average rate of growth of the stock is typically strictly greater than
the rate of growth of an investment in the money market; otherwise, no one would want to incur the
risk associated with investing in the stock.
Delta-hedging formula:
(1 2 ) =

+1 (1 2 ) +1 (1 2 )
+1 (1 2 ) +1 (1 2 )

Wealth equation:
+1 = +1 + (1 + )( )
Assumptions for this model:
-

Shares of stock can be subdivided for sale or purchase

The interest rate for investing is the same as the interest rate for borrowing
The purchase price of stock is the same as the selling price (there is zero bid-ask spread)
At any time, the stock can take only two possible values in the next period (not valid for
continuous model)

Complete market: Every derivative security can be replicated by trading in the underlying stock and
the money market.

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H2: Probability Theory on Coin Toss Space

Finite probability spaces consist of a sample space and a probability measure . The sample
space is a nonempty finite set and the probability measure is a function that assigns to each
element of a number in [0,1] so that:
() = () = 1

An event is a subset of , and we define the probability of an event to be:

() = ()
A

The distribution of a random variable is a specification of the probabilities that the random variable
takes various values.
Let be a random variable defined on a finite probability space (, ). The expectation (or expected
value) of is defined to be:
= ()()

, we use the
When we compute the expectation using the risk-neutral probability measure
notation:
= ()
()

The variance of is:

() = [( [])2 ] = [ 2 2[] + ([])2 ] = [ 2 ] 2[][] + ([])2
= [ 2 ] ([])2

Jensens Inequality
average of the function > the function of the average
Let be a random variable on a finite probability space, and let () be a convex function of a
dummy variable . Then:
[()] ()
Consequence:
[ 2 ] ()2

Conditional Expectations
=

[+1 ]

1+

[+1 ] is the conditional expectation of +1 based on the information at time (hence

Where
the subscript). In general:
[](1 ) =

#(+1 ) #(+1 ) (1 +1 )

+1

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Where #(+1 ) is the number of heads in the continuation and #(+1 ) is the
[] the conditional expectation of based on the
number of tails in the continuation. Call
information at time .

Fundamental properties of conditional expectations:

i.

Linearity of conditional expectations. For all constants 1 and 2 , we have:

[1 + 2 ] = 1 [] + 2 []

ii.

Taking out what is known. If actually depend only on the first coin tosses, then:
[] = []

iii.

Iterated conditioning (average of averages). If 0 , then:

[ []] = []

iv.

Independence. If depends only on tosses + 1 through , then:

[] = []

v.

Conditional Jensens inequality. If () is a convex function of the dummy variable , then:

[()] ( [])

Martingales
Consider the binomial asset-pricing model. Let 0 , 1 , , be a sequence of random variables,
with each depending only on the first coin tosses (and 0 constant). Such a sequence of
random variables is called an adapted stochastic process.
i.

The process is a martingale if:

= [+1 ]

ii.

The process is a submartingale (even though it may have a tendency to increase) if:
[+1 ]

iii.

The process is a supermartingale (even though it may have a tendency to decrease) if:
[+1 ]

The best estimate based on the information at time of the value of the discounted stock price at
time + 1 is the discounted stock price at time :

+1
[
=
]

(1 + )
(1 + )+1
The expected value of a martingale cannot change with time and so must always be equal to the
time-zero value of the martingale (multi-step ahead): 0 = [1 ] = = [1 ] = [ ]

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Also the discounted wealth process is a martingale under the risk-neutral measure:

+1
[
=
]

(1 + )
(1 + )+1
The First Fundamental Theorem of Asset Pricing states that if we can find a risk-neutral measure in a
model, then there is no arbitrage in the model. So we cannot begin with zero wealth 0 = 0 and end
up with > 0.
The discounted price of the derivative security is a martingale under the risk-neutral measure as well:

+1
[
=

]
(1 + )
(1 + )+1
Note that the martingales shown here are only martingales because we have choses a risk-neutral
measure.
Consider a series of payments to be made by an agent, or cashflow 0 , 1 , , . The value of the
payments can be calculated by:
(1 2 ) = (1 2 )

+1 (1 2 ) + +1 (1 2 )
1+

The wealth equation becomes:

+1 = +1 + (1 + )( )

Markov Processes
The next state depends only on the current state and not on the sequence of events that preceded it.
Consider the binomial asset-pricing model. If, for every between 0 and 1 and for every
function (), there is another function () (depending on and ()) such that:
[(+1 )] = ( )
Then we say that 0 , 1 , , is a Markov process.

Lemma 2.5.3 (Independence)

[(, )] = ()
Here, is known at time , so is held constant by replacing the random variable by an arbitrary
but fixed dummy variable . Then:
[(, )] = ()
The randomness of the conditional expectation is due only to the dependence of on tosses + 1
through . Therefore (due to (iv) Independence), the conditional expectation is the same as the
unconditional expectation:
[(, )] = ()
Let 0 , 1 , , be a Markov process under the risk-neutral probability measure in the binomial
model. Let () be a function of the dummy variable , and consider a derivative security whose
payoff at time is ( ). Then, for each between 0 and , the price of this derivative
security is some function of :
= ( )

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H3: State prices

Change of Measure
In the -period binomial model with actual probability measure and risk-neutral probability
, let denote the Radon-Nikodm derivative of
with respect to :
measure
(1 2 )

#(1 ) #(1 )
(1 2 ) =
=( )
( )
(1 2 )

With three important properties:

i.
ii.
iii.

( > 0) = 1
= 1
= []
For any random variable :

The state price density (time-zero price per unit of actual probability) random variable is:
() =

()
(1 + )

The state price corresponding to is:

()()
The time-zero price of an arbitrary derivative security paying at time , in terms of state price
density:
0 = [ ] = ()()()

Radon-Nikodm Derivative Process

Let be a random variable in an -period binomial model. Define:
= []
Then is a martingale under (actual probability measure). In particular:
= and 0 = 1

Capital Asset Pricing Model

The capital asset pricing model (CAPM) is based on balancing supply with demand among investors
who have utility functions that convert units of consumption to units of satisfaction.
Utility is taken to be correlative to Desire or Want. Desires cannot be measured directly, but only
indirectly, namely by the outward phenomena to which they give rise. In economics, the measure is
found in the price which a person is willing to pay for the fulfilment or satisfaction of his desire.
Utility based models are the only theoretically defensible way of treating incomplete markets, where
prices cannot be determined from no-arbitrage considerations alone.
Given the non-decreasing concave utility function (usually () = ()), the CAPM is consistent
with intuition. In other words, investors require a higher return for holding a more risky asset.
To solve an optimal investment problem concerning a utility function, the state price density can be
used. Given an initial wealth 0 , find an adapted portfolio process 0 , 1 , , 1 that maximizes:
( )

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The adapted portfolio process can be calculated as follows:

(1 2 ) =

+1 (1 2 ) +1 (1 2 )
+1 (1 2 ) +1 (1 2 )

To maximize the expected utility, a vector (1 , 2 , , ) must be found that maximizes:

( )
=1

Subject to:

= 0
=1

Where is an actual probability. Set up the Lagrangian:

= ( ) ( 0 )
=1

=1

Where is a Lagrangian multiplier. Let the derivative of equal zero:

= ( ) = ( ) = 0

Express in terms of and fill in () into the following equation and solve for :

= 0
=1

Then solve for the vector (1 , 2 , , ) and calculate the adapted portfolio process.

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H4: American Derivative Securities

Non-Path-Dependent American Derivatives
An American derivative security can be exercised at any time prior to its expiration. Therefore it can
never be worth less than the payoff associated with immediate exercise. The value of the derivative
security at each time is at least as much as the so-called intrinsic value ( ):
( )
Also, the replicating portfolio at that time must equal the value of the derivative security. For nonpath-dependent American derivatives, where the stock price is Markov, the value of can be
written as a function of the stock price at that time:
= ( )
The risk-neutral pricing formula implies that for 0 , the function is defined by the
American algorithm:
() = {(), 0}
1
[+1 () + +1 ()]}
() = {(),
1+
The discounted price process of an American option is a supermartingale under the risk-neutral
measure. The holder of the option may fail to exercise at the optimal exercise time (the best time for
the holder to exercise the option) and in this case the option has a tendency to lose value. This
means that, if the writer has a hedging portfolio, the writer has the possibility of consumption .
The wealth equation becomes:
+1 = +1 + (1 + )( )
With:
= ( )

1
[+1 ( ) + +1 ( )]
1+

Stopping Times
The time at which an American derivative security should be exercised. In an -period binomial
model, a stopping time is a random variable that takes values 0,1, , or and satisfies the
condition that if (1 2 +1 ) = , then (1 2 +1
) = for all
+1
.
Another exercise rule is based on foreknowledge and can only be implemented using insider
information. It is denoted by and it calls for the decision of whether or not to exercise at time zero
to be based on the outcome of the first coin toss.
A stopped process (the notation denotes the minimum of and ) is a stochastic process
(like a binomial model) subject to a stopping time . The value of the process is frozen at time . Note
that time does not stop: the process continues after , but subsequent values of the frozen value
remain the same.
Optional sampling: a martingale stopped at a stopping time is a martingale. A supermartingale (or
submartingale) stopped at a stopping time is a supermartingale (or submartingale, respectively). Or
in mathematical terms:

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Martingale:
Supermartingale:
Submartingale:

General American Derivatives

Let be a random variable depending on the first coin tosses. An American derivative security
with intrinsic value process is a contract that can be exercised at any time prior to and including
time and, if exercised at time , pays off .
The price process of such a contract is defined by the American risk-neutral pricing formula:
[{}
= max

1
]
(1 + )

Where is the set of all stopping times and the term {} states that the whole term between
brackets must be replaced by zero on those paths for which = . Intrinsic value for an American
put is determined by:
= { , 0}

The American derivative security price process has the following properties:
i.

{ , }. This condition implies that no matter when the option is exercised,

the agents portfolio value is sufficient to pay off the option.

ii.

The discounted process is a supermartingale. This condition guarantees that an agent

beginning with initial capital 0 can construct a hedging portfolio whose value at each
time is .

iii.

If is another process satisfying { , } for all and for which the

discounted process is a supermartingale, then for all . This condition says
that the price is no higher than necessary in order to be acceptable to the seller. It also
ensures that the price is fair for the buyer.

For path-dependent American options, the price process is given by:

(1 2 ) = { (1 2 ), 0}
1
[+1 (1 ) + +1 (1 )]}
(1 2 ) = { (1 2 ),
1+
With:
+1 = +1 + (1 + )( )
= (1 2 )

1
[+1 (1 ) + +1 (1 )]
1+

The optimal exercise time for the holder of an American option is at stopping time which achieves
the maximum in the American risk-neutral pricing formula when = 0. The stopping time is the
first time that the value of an American option and its intrinsic value equal:
= {; = }
[{ }
0 =

1
]
(1 + )

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H6: Interest-Rate-Dependent Assets

Binomial Model for Interest Rates
An interest rate process is defined to be a sequence of random variables:
0 , 1 , , 1
Where 0 is not random and > 0. Then a discount process can be defined:
=

1
(1 + 0 ) (1 + 1 )

The risk-neutral pricing formula say that the value at time zero of a payment received at time
(maturity) is:
[ ]
0 =
Assume = 1 for a zero-coupon bond that pays 1 at maturity time to be:
[ ]
0, =
The yield (constant rate of interest between times 0 and ) for this bond equals:
= (

1
0,

) 1

Let be a random variable. The conditional expectation of based on the information at time can
be defined by the formula:
[](

1
) =

(
1

+1
)

+1 ,,

1

+1
}
{1 =

1 , , =
}

0 [] =
[] and
[] = .
With
The price at time of a zero-coupon bond maturing at time is defined to be:
[
, =

If the taking out what is known property is applied, this equation becomes:
[ ]
, =
.
So the discounted bond price is a martingale under
Also, the discounted wealth of an agent constitutes a martingale:

+1 = ,+1 + , +1, + (1 + ) ( , , )
=+2

=+1

Where , is the number of -maturity zero-coupon bonds held by the agent between times and
+ 1. Regardless of how the portfolio random variables , are chosen, the discounted wealth
.
process is a martingale under

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Fixed-Income Derivatives
is taken to be a risk-neutral measure, so the discounted asset price is a martingale:

[+1 +1 ]
=
A forward contract is an agreement to pay a specified delivery price at a delivery date , for the
asset whose price at time is . The -forward price at time of the asset is:
, =

The hedge for a short position in a forward contract is called a static hedge, because it calls for no
trading between the time when the hedge is set up and the time when the forward contract
expires.
The forward interest rate at time for investing at time is defined by:
, =

, ,+1
,+1

An -period interest rate swap is a contract that makes payments 1 , , where:

= 1
The fixed rate is constant. The -period swap rate is the value of that makes the time-zero
no-arbitrage price of the interest rate swap equal to zero:
=

=1 0, 0,1

=1 0,

The time-zero no-arbitrage price of the -period interest rate swap is:

= 0, ( 0,1 )
=1

An -period interest rate cap is a contract that makes payments 1 , , where:

= (1 )+
An -period interest rate floor is a contract that makes payments 1 , , where:
= ( 1 )+
A contract that makes payment at only one time is called an interest rate caplet and a contract
that makes payment at only one time is called an interest rate floorlet.
The risk-neutral prices of an -period interest rate cap and floor are:

(1 )+
=
=1

( 1 )+
=
=1

Furthermore: + =

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Forward Measures
Let be the payoff at time of some contract (either a derivative security or some primary
security such as a bond). The risk-neutral pricing formula of this contract is:
=

1
[ ]

In order to compute the conditional expectation appearing in this formula when both and are
random, one would need to know the joint conditional distribution of and under the risk . Therefore, forward measures are used rather than neutral measures. The neutral measure
is defined by the formula:
forward measure
() = ,
()

Where , is a Radon-Nikodm derivative to change to a different measure, given by:

, =

0,

denote the -forward measure. If is a random variable depending on

Let be fixed and let
only the first coin tosses, then:

[ ] =

Futures
Like a forward contract, a futures contract is designed to lock in a price for purchase or sale of an
asset before the time of the purchase or sale. A future is defined by:
[ ]
, =

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