Mathematical Finance: Hiroshi Toyoizumi September 26, 2012

Mathematical Finance
Hiroshi Toyoizumi 1
September 26, 2012
1 E-mail: toyoizumi@waseda.jp
Contents
1 Introduction 6
2 Normal Random Variables 7

2.1 What is Normal Random Variable? . . . . . . . . . . . . . . . . . 7
2.2 Lognormal Random Variables . . . . . . . . . . . . . . . . . . . 9
2.3 Lognormal Random Variables as the Stock Price Distribution . . . 10
2.4 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
2.5 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
3 Large Sum of Random Variables 14

3.1 The Law of Large Numbers . . . . . . . . . . . . . . . . . . . . . 14
3.2 Poisson Random Variables and the Law of Small Numbers . . . . 16
3.3 The Central Limit Theorem . . . . . . . . . . . . . . . . . . . . . 17
3.4 Examples of Sum of Random Variables . . . . . . . . . . . . . . 17
3.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
3.6 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
4 Useful Probability Theorems 21

4.1 Useful Estimations . . . . . . . . . . . . . . . . . . . . . . . . . 21
4.2 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
5 Easy Money 23
5.1 Virtual Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
5.1.1 Risk Neutralization . . . . . . . . . . . . . . . . . . . . . 24
5.1.2 No Easy Money? . . . . . . . . . . . . . . . . . . . . . . 25
5.2 Ideal Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
5.3 Duplication and Law of One Price . . . . . . . . . . . . . . . . . 28
5.4 Arbitrage Theorem . . . . . . . . . . . . . . . . . . . . . . . . . 30
2
CONTENTS 3
5.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
5.6 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
6 Tools for Modeling Dynamics of Stock Prices 34

6.1 Geometric Brownian Motions . . . . . . . . . . . . . . . . . . . 34
6.2 Discrete Time Tree Binomial Process . . . . . . . . . . . . . . . 36
6.3 Brownian Motions . . . . . . . . . . . . . . . . . . . . . . . . . 41
6.4 Poisson Processes . . . . . . . . . . . . . . . . . . . . . . . . . . 42
6.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
6.6 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
7 On a Way to Black-Scholes Formula 45

7.1 The Only Possible Process to Avoid Arbitrage . . . . . . . . . . . 45
7.2 Option Price on the Discrete Time . . . . . . . . . . . . . . . . . 47
7.3 Black-Scholes Model . . . . . . . . . . . . . . . . . . . . . . . . 47
7.4 Examples of Option Price via Black-Scholes Formula . . . . . . . 52
7.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
7.6 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
8 Delta Hedging Strategy 55

8.1 Bernouilli Hedging Model . . . . . . . . . . . . . . . . . . . . . 55
8.2 Binomial Hedging Model . . . . . . . . . . . . . . . . . . . . . . 57
8.3 Hedging in Black-Scholes Model . . . . . . . . . . . . . . . . . . 60
8.4 Partial Derivative ∆ . . . . . . . . . . . . . . . . . . . . . . . . . 62
8.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
8.6 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
9 Stochastic Integral 65
9.1 Diffusion Process . . . . . . . . . . . . . . . . . . . . . . . . . . 65
9.2 Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
9.3 Definition of Stochastic Integral . . . . . . . . . . . . . . . . . . 68
9.4 Martingale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
9.5 Calculus of Stochastic Integral . . . . . . . . . . . . . . . . . . . 70
10 Examples of Stochastic Integral 74

10.1 Evaluation of E[W (t)4 ] . . . . . . . . . . . . . . . . . . . . . . . 74
10.2 Evaluation of E[eαW (t) ] . . . . . . . . . . . . . . . . . . . . . . . 76
4 CONTENTS
11 Differential Equations 77
11.1 Ordinary Differential Equation . . . . . . . . . . . . . . . . . . . 77
11.2 Geometric Brownian Motion . . . . . . . . . . . . . . . . . . . . 78
11.3 Stochastic Process and Partial Differential Equation . . . . . . . . 79
12 Portfolio Dynamics 81
12.1 Portfolio Model . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
12.2 Rate of Return of Stock and Risk-free Asset . . . . . . . . . . . . 83
12.3 Arbitrage and Portfolio . . . . . . . . . . . . . . . . . . . . . . . 83
13 Pricing via Arbitrage 85

13.1 Way to Black-Scholes Model . . . . . . . . . . . . . . . . . . . . 85
Bibliography
T. Bjork. Arbitrage Theory in Continuous Time. Oxford Finance. Oxford Univ Pr,
2nd edition, 2004.
R. Durrett. Probability: Theory and Examples. Thomson Learning, 1991.
K. Ito. Probability Theory. Iwanami, 1991.
B. Oksendal. Stochastic Differential Equations: An Introduction With Applica-

tions. Springer-Verlag, 2003.
S. M. Ross. An Elementary Introduction to Mathematical Finance: Options and

Other Topics. Cambridge Univ Pr, 2002.
H. Toyoizumi. Statistics and probability for business.

http://www.f.waseda.jp/toyoizumi/classes/accounting/stat/2007/business.pdf,
2007a.
H. Toyoizumi. Mathematics for management.

http://www.f.waseda.jp/toyoizumi/classes/accounting/math/2007/matht.pdf,
2007b.
5
Chapter 1
Introduction
Using the knowledge of probabilities and statistics studied in
• Mathematics for Management (Toyoizumi [2007b]) and
• Statistics and Probability for Business (Toyoizumi [2007a]),
we will learn the advanced probability models and its evaluation related to Math-
ematical Finance.
Especially, we pick up the risk management, portfolio, and evaluation of deriva-
tives. Also, we will even learn the basics of the advanced mathematics such as
geometric Brownian motion, Black-Scholes formula and Ito-calculus.
6
Chapter 2
Normal Random Variables
Normal random variable is important tool to analyze a series of independent ran-

dom variables.
2.1 What is Normal Random Variable?

Let’s begin with the definition of normal random variables.
Definition 2.1 (Normal random variable). Let X be a random variable with its
probability density function
1 2 2
dP{X ≤ x} = f (x)dx = 1/2
e−(x−µ) /2σ dx, (2.1)
(2π) σ
for some µ and σ . This is called the normal random variable with the parameters
µ and σ , or written by N[µ, σ 2 ].
Problem 2.1. Draw the graph of the probability density function f (x) of normal
random variable N[µ, σ ].
Theorem 2.1 (Mean and variance of normal random variables). Let X be a normal
random variable with the parameters µ and σ . Then, we have the mean
E[X] = µ, (2.2)
and the variance
Var[X] = σ 2 . (2.3)
7
8 CHAPTER 2. NORMAL RANDOM VARIABLES
Proof. omit.
Definition 2.2 (Standard normal random variable). Let X be a normal random

variable with µ = 0 and σ = 1. The random variable is called the standard normal
random variable, which is often denoted by N[0, 1].
Lemma 2.1. Let X be a normal random variable with its mean µ and standard
deviation σ . Set Z = (X − µ)/σ . Then, Z is the standard normal random variable.
Proof. See Exercise 2.5.
Theorem 2.2. Let (Xi )i=1,2,...,n are independent normal random variables with
its mean µi and standard deviation σi . Then the sum of these random variables
X = ∑ni=1 Xi is again a normal random variable with
n
µ = ∑ µi , (2.4)
i=1
n
σ 2 = ∑ σi2 . (2.5)
i=1
Proof. We just prove X satisfies (2.4) and (2.5). We have

" #
n n n
µ = E[X] = E ∑ Xi = ∑ E [Xi ] = ∑ µi .
i=1 i=1 i=1
Also, we have
" #
n n n
σ 2 = E[X] = Var ∑ Xi = ∑ Var [Xi] = ∑ σi2.
i=1 i=1 i=1
We can prove that X is a normal random variable by using so-called charac-

teristic function method (or Fourier transform).
So, it is very comfortable to be in the world of normal random variables. Very

closed!
2.2. LOGNORMAL RANDOM VARIABLES 9
2.2 Lognormal Random Variables

Now it is the turn of Lognormal random variable. Lognormal random variables
are used to model the stock price distribution in Mathematical Finance.
Definition 2.3 (lognormal random variable). The random variable Y is said to be
lognormal if log(Y ) is a normal random variable.
Thus, a lognormal random variable can be expressed as
Y = eX , (2.6)
where X is a normal random variable. Lognormal random variables plays a mea-

sure role in finance theory!
Theorem 2.3 (lognormal). If X is a normal random variable having the mean µ
and the standard deviation σ 2 , the lognormal random variable Y = eX has the
mean and the variance as
2 /2
E[Y ] = eµ+σ , (2.7)
2µ+2σ 2 2µ+σ 2
Var[Y ] = e −e . (2.8)
Remark 2.1. It is important to see that although the mean of the lognormal random
variable is subjected to not only the mean of the original normal random variable
but also the standard deviation.
Problem 2.2. Explain why the mean E[Y ] is larger than the “expected” mean
eE[X] .
Proof. Let us assume X is the standard normal random variable, for a while. Let
m(t) be the moment generation function of X, i.e.,
m(t) = E[etX ]. (2.9)
Then, by differentiate the left hand side and setting t = 0, we have

d
m0 (0) = m(t)|t=0 = E[XetX ]|t=0 = E[X]. (2.10)
dt
Further, we have
m00 (0) = E[X 2 ].

Problem 2.3. Derive m00 (0) = E[X 2 ].

On the other hand, since X is the standard normal random variable, we have
1
Z ∞
2 /2
m(t) = E[etX ] = √ etx e−x dx.
2π −∞
Since tx − x2 /2 = {t 2 − (x − t)2 }/2, we have

1
Z ∞
2 2 /2
m(t) = √ et /2 e−(x−t) dx,
2π −∞
where the integrand of the right hand side is nothing but the density of the normal
random variable N(t, 1). Thus,
2 /2
m(t) = et .
More generally, when X is a normal random variable with N(µ, σ ), we can obtain
2 t 2 /2
m(t) = E[etX ] = eµt+σ . (2.11)
(See exercise 2.6.) Since Y = eX , we have

2 /2
E[Y ] = m(1) = eµ+σ , (2.12)
and
2
E[Y 2 ] = m(2) = e2µ+2σ . (2.13)
Thus,
2 2
Var[Y ] = E[Y 2 ] − E[Y ]2 = e2µ+2σ − e2µ+σ . (2.14)
2.3 Lognormal Random Variables as the Stock Price

Distribution
Let S(n) be the price of a stock at time n. Let Y (n) be the growth rate of the stock,
i.e.,
S(n)
Y (n) = (2.15)
S(n − 1)
2.3. LOGNORMAL RANDOM VARIABLES AS THE STOCK PRICE DISTRIBUTION11
In mathematical finance, it is commonly assumed that Y (n) is independent and

identically distributed as the lognormal random variable. Taking log on both side
of (2.15), then we have
log S(n) = log S(n − 1) + X(n), (2.16)
where if X(n) = logY (n) is regarded as the error term and normally distributed,
the above assumption is validated.
Example 2.1 (Stock price rises in two weeks in a row). Suppose Y (n) is the
growth rate of a stock at the n-th week, which is independent and lognormally
distributed with the parameters µ and σ . We will find the probability that the
stock price rises in two weeks in a row.
First, we will estimate P{the stock rises}. Since it is equivalent that y > 1 and
log y > 0, we have
P{the stock rises} = P{S(1) > S(0)}

S(1)
=P >1
S(0)

S(1)
= P log >0
S(0)
= P {X > 0}
where X = logY (1) is N(µ, σ 2 ), and we can define
X −µ
Z= , (2.17)
σ
as the standard normal distribution. Hence, we have

X −µ 0−µ
P{S(1) > S(0)} = P >
σ σ
= P{Z > −µ/σ }
= P{Z < µ/σ },
where we used the symmetry of the normal distribution (see exercise 2.1).
Now we consider the probability of two consecutive stock price rise. Since
Y (n) is assumed to be independent, we have
P{the stock rises two week in a row} = P{Y (1) > 1,Y (2) > 1}
= P{Y (1) > 0}P{Y (2) > 0}
= P{Z < µ/σ }2
Problem 2.4. 1. Derive the probability that stock price down two days in a
row.
2. Derive the probability that stock price up at the first and down at the second
day.
2.4 References
2.5 Exercises
Exercise 2.1. Prove the symmetry of the normal distribution. That is, let X be the
normal distribution with the mean µ and the standard deviation σ , then for any x,
we have
P{X > −x} = P{X < x}. (2.18)
Exercise 2.2 (moment generating function). Let X be a random variable. The

function m(t) = E[etX ] is said to be the moment generating function of X.
1. Prove E[X] = m0 (0).

dn
2. Prove E[X n ] = dt n m(t)|t=0 .
3. Rewrite the variance of X using m(t).
Exercise 2.3. Let X be a normal random variable with the parameters µ = 0 and
σ = 1.
1. Find the moment generating function of X.
2. By differentiation, find the mean and variance of X.

2.5. EXERCISES 13
Exercise 2.4. Use Microsoft Excel to draw the graph of probability distribution
f (x) = dP{X ≤ x}/dx of normal random variable X with
1. µ = 5 and σ = 1,
2. µ = 5 and σ = 2,
3. µ = 4 and σ = 3.
What can you say about these graphs, especially large x? Click help in your Excel
to find the appropriate function. Of course, it won’t help you to find the answer
though...
Exercise 2.5. Let X be a normal random variable with its mean µ and standard
deviation σ . Set Z = (X − µ)/σ . Prove Z is the standard normal random variable.
Exercise 2.6. Verify (2.11) by using Lemma 2.1
Exercise 2.7. Let Y = eX be a lognormal random variable where X is N(µ, σ ).

Find E[Y ] and Var[Y ].
Chapter 3
Large Sum of Random Variables
Problem 3.1. Do you think these figures are similar?
3.1 The Law of Large Numbers

In many cases, we need to evaluate the average of large number of independent
and identically-distributed random variables. Perhaps, you can intuitively assume
the expectation of a random variable X will be approximated by the sample aver-
age of the data, as
1 n
E[X] ≈ ∑ Xi. (3.1)
n i=1
This intuition can be validated by the following theorems.
Theorem 3.1 (Weak law of large numbers). Let X1 , X2 , .... be an i.i.d. sequence
of random variables with
µ = E[Xn ]. (3.2)
Let Sn = ∑ni=1 Xi . Then, for all ε > 0,
P{|Sn /n − µ| > ε} → 0 as n → ∞. (3.3)
Or, if we take sufficiently large number of samples, the average will be close to µ
with high probability.
14
3.1. THE LAW OF LARGE NUMBERS 15
130
120
110
100
90
80
20 40 60 80 100
Figure 3.1: An example of Tree binomial process with d = 0.970446, u =

1.03045, p = 0.516667 and starting from S0 = 100.
Figure 3.2: Exchange rate of yen at 2005/10/19. Adopted from

http://markets.nikkei.co.jp/kawase/index.cfm
16 CHAPTER 3. LARGE SUM OF RANDOM VARIABLES
You can say, “OK. I understand, we can expect the average will be close to the
mean most of the times. So, it might be possible to have some exceptions...”
Problem 3.2. Take the case of coin flipping. Give an example of this kind of
exception.
Actually, the exceptions should follow the rule, they will vanish...
Theorem 3.2 (Strong law of large numbers). Let X1 , X2 , .... be an i.i.d. sequence
of random variables with
µ = E[Xn ]. (3.4)
With probability 1, we have
Sn
→ µ as n → ∞. (3.5)
n
So, now we cay say that almost all trials, the average will be converges to µ.
Problem 3.3. What is the difference between “most of the time” and “almost all”?
3.2 Poisson Random Variables and the Law of Small

Numbers
Compare to the the theorems of large numbers, the law of small numbers are less
famous. But sometimes, it gives us great tool to analyze stochastic events. First
of all, we define Poisson random variable.
Definition 3.1 (Poisson random variable). A random variable N is said to be a
Poisson random variable, when
λ n −λ
P{N = n} = e , (3.6)
n!
where λ is a constant equal to its mean E[N].
Theorem 3.3. Let N be a Poisson random variable.
Var[N] = λ . (3.7)
Theorem 3.4 (The law of Poisson small number). The number of many indepen-
dent rare events can be approximated by a Poisson random variable.
Example 3.1. Let N be the number of customers arriving to a shop. If each
customer visits this shop independently and its frequency to visit there is relatively
rare, then N can be approximated by a Poisson random variable.
3.3. THE CENTRAL LIMIT THEOREM 17
3.3 The Central Limit Theorem

According to Section 3.1,
1 n
E[X] ≈ ∑ Xi. (3.8)
n i=1
for a large n. However, there is an “error” even though n is large. Even this error
should follow some rule!
Let X1 , X2 , .... be an i.i.d. sequence of random variables with
µ = E[Xn ], (3.9)
2
σ = Var[Xn ]. (3.10)
Now we would like to estimate the error of the sum of this random variables to
nµ, i.e.
n
Sn − nµ = ∑ Xi − nµ. (3.11)
i=1
Theorem 3.5 (Central limit theorem). For a large n, we have

Sn − nµ
P √ ≤ x ≈ Φ(x), (3.12)
σ n
where Φ(x) is the distribution function of the standard normal distribution N(0, 1).
Or
Sn ∼ N(nµ, nσ 2 ). (3.13)
The central limit theorem indicates that no matter what the random variable Xi
is like, the sum Sn can be regarded as a normal random variable.
Instead of stating lengthy and technically advanced proof of laws of large num-
bers and central limit theorem, we give some examples of how Sn converges to a
Normal random variable.
3.4 Examples of Sum of Random Variables

Example 3.2 (Average of Bernouilli Random Variables). Let Xi be i.i.d Bernoulli
random variables with p = 1/2. Or more simply, Xi is the result of ith coin flip-
ping. Suppose we are going to evaluate the sample average A of Xi ’s;
1 n
A= ∑ Xi. (3.14)
n i=1
Of course, we expect that A is close to the mean E[Xi ] = 1/2 but how close for a
given n?
Figure 3.3 shows the histogram of 1000 different runs of A with n = 10. Since
n = 10 is relatively small samples, we have large deviation from the expected
mean 1/2. On the other hand, when we have more samples, the sample average A
tends to be 1/2 as we see in Figure 3.4 and 3.5, which can be a demonstration of
Weak Law of Large Numbers (Theorem 3.1).
As we see in in Figure 3.3 to 3.5, we may still have occasional high and low
averages. How about individual A for large sample n. Figure 3.6 shows the sam-
ple path level convergence of the sample average A to E[X] = 1/2, as it can be
expected from Strong Law of Large Numbers (Theorem 3.2).
Now we know that A converges to 1/2. Further, due to Central Limit Theorem
(Theorem 3.5), magnifying the histogram, the distribution can be approximate
by Normal distribution. Figure 3.7 show the detail of the histogram of A. The
histogram is quite similar to the corresponding Normal distribution.
Remark 3.1. In this example, Sn /n → 1/2 but not saying your wealth will be even-
tually balancing if you bet on coin-tossings. Sn will diverge instead of converge,
as n getting large, which means that you have great chance to be bankrupting.
3.5 References
The proofs omitted in this chapter can be found in those books such as [Ito, 1991]
and [Durrett, 1991].
3.6 Exercises
Exercise 3.1. Something here!
3.6. EXERCISES 19
0.2 0.4 0.6 0.8 1
Figure 3.3: Histogram of the sample average A = n1 ∑ni=1 Xi when n = 10, where
Xi is a Bernouilli random variable with E[Xi ] = 1/2.
0.2 0.4 0.6 0.8 1
Figure 3.4: The sample average A when n = 100.

17.5
15
12.5
10
7.5
5
2.5
0.2 0.4 0.6 0.8 1
Figure 3.5: The sample average A when n = 1000.

0.8
0.6
0.4
0.2
100 200 300 400 500
Figure 3.6: The sample path of the sample average A = n1 ∑ni=1 Xi up to n = 100,
where Xi is a Bernouilli random variable with E[Xi ] = 1/2.
30
25
20
15
10
5
0.46 0.48 0.5 0.52 0.54
Figure 3.7: The detailed histgram of the sample average A = 1n ∑ni=1 Xi when n =
10, where Xi is a Bernouilli random variable with E[Xi ] = 1/2. The solid line is
the corresponding Normal distribution.
Chapter 4
Useful Probability Theorems
4.1 Useful Estimations

We have the following two estimation of the distribution, which is sometimes very
useful.
Theorem 4.1 (Markov’s Inequality). Let X be a nonnegative random variable,
then we have
P{X ≥ a} ≤ E[X]/a, (4.1)
for all a > 0.

Proof. Let IA be the indicator function of the set A. It is easy to see
aI{X≥a} ≤ X. (4.2)
Taking expectation on the both side, we have
aP{X ≥ a} ≤ E[X]. (4.3)
Theorem 4.2 (Chernov Bounds). Let X be the random variable with moment gen-
erating function M(t) = E[etX ]. Then, we have
P{X ≥ a} ≤ e−ta M(t) for all t > 0, (4.4)

P{X ≤ a} ≥ e−ta M(t) for all t < 0. (4.5)
21
22 CHAPTER 4. USEFUL PROBABILITY THEOREMS
Proof. For t > 0 we have
P{X ≥ a} = P{etX ≥ eta }. (4.6)
Using Theorem 4.1,
P{etX ≥ eta } ≤ e−ta E[etX ]. (4.7)
Thus, we have the result.
4.2 Exercises
Chapter 5
Easy Money
Problem 5.1. Are there any easy money? If so, what will happen?
5.1 Virtual Market

Consider a simple virtual market of options based on stocks. Let r be the interest
rate. We consider to give the price of an option to purchase a stock at a future time
at a fixed price. Let Xn be the price of stock at time n. Suppose, given X0 = 100,
the price of the stock can be either $200 or $50 at time 1 in this virtual market.
We can consider an option to buy the stock at $150 at time 1. Note that this
option is worthless if X1 = 50, since, in that case, you can buy the stock from the
market at $50 instead.
Problem 5.2. If you were a dealer, how are you going to buy and sell options?
At time 0, how can we determine the price of this option? Or, how much can
we pay for this option? Intuitively, the probability that the stock rises is large, the
value of the option will decrease.
Problem 5.3. Explain the reason intuitively.
Here’s the solution. Surprisingly, regardless of the probability of the stock’s
up and down, the price of the option c should be like this.
100 − 50(1 + r)−1

c= . (5.1)
3
We have a couple of ways to formulate the option price. However, we will
follow the simplest way.
23
24 CHAPTER 5. EASY MONEY
5.1.1 Risk Neutralization

We will see how we can avoid risk of the up and down of stock price.
Let us suppose at time 0 we buy x unit of stocks and y unit of options. We allow
both x and y to be negative. For example, when x < 0, the position of this stock
is short, or we are in the position to selling the stocks without actually having the
stocks. Likewise, when y < 0, we are actually selling the option.
At time 0, the cost of this investment is 100x + cy, where c is the price of the
option. Of course, the value of this investment will be varied according to the
fluctuation of the stock price. However, we can avoid this risk.
At time 1, the option is worthless if X1 = 50, since in that case, you can buy the
stock at $50 which is far less expensive than exercising the option obtaining the
stock at $150. On the other hand, if X1 = 200, you can use the option to buy the
stocks at $150. Moreover, you can sell the stocks at the market price and obtain
the difference $50 immediately. Thus, the value of the investment V1 at time 1
depends on the value of X1 and is
(
200x + 50y, if X1 = 200,
V1 = (5.2)
50x if X1 = 50.
So, if the equation
200x + 50y = 50x, (5.3)
holds regardless of the stock price X1 , the value of the investment V1 can be fixed.
By solving (5.3), we have
y = −3x, (5.4)
which means that either

• by buying x stocks and selling y option at time 0, or
• by selling x stock and buying y option at time 0,

we can avoid the risk of stock value fluctuation, and obtain V1 = 50x at time 1.
You can neutralize the uncertainty of stock and option by using the above
procedure.
Problem 5.4. Can you consider other methods to neutralize the uncertainty of the
stock price?
5.1. VIRTUAL MARKET 25
5.1.2 No Easy Money?

Now we evaluate the overall investment performance. Suppose we borrow the
money needed for this investment. At time 0, we need to invest the money
100x + cy. (5.5)
So, we will borrow the money form a bank. At time 1 we need to pay its interest,
but at the same time we earn the money V1 from our investment. Thus, overall
gain G1 is
G1 = V1 − (100x + cy)(1 + r). (5.6)
Now from the argument in Section 5.1.1, if we adopt the investment strategy such
as in (5.4), we know that we can avoid the risk and V1 = 50x. Thus,
G1 = 50x − (100x + 3xc)(1 + r)

= (1 + r)x{3c − 100 + 50(1 + r)−1 }. (5.7)
Now you are ready to learn how to get easy money. Consider the following
situations:
1. Suppose 3c > 100 − 50(1 + r)−1 . Set some positive x, then G1 > 0. That
means our investment guaranteed to be profitable. Actually, in this case, the
option price c satisfies
100 − 50(1 + r)−1

c> . (5.8)
3
Compared to (5.1), the option price is expensive. So, we can exploit the
situation by selling the options in short.
2. Suppose 3c < 100 − 50(1 + r)−1 . In this case by setting negative x, we can
also get positive gain G1 at time 1. In this case
100 − 50(1 + r)−1

c< , (5.9)
3
which means the options is being selling at a bargain. Thus, buying options,
you can earn money, while hedging the risk of stock price drop by stock on
spot.
3. Suppose 3c = 100 − 50(1 + r)−1 . The option price satisfies (5.1). We’re
sorry but you cannot obtain easy money.
Of course, in some temporary cases, we may experience case 1 and 2. We call
these sure-win situation arbitrage. However, for example, if the option price is
expensive compared to (5.1), as soon as many investors and the dealer of options
realized that they can exploit it by selling the option, everybody starts to sell the
options. Thus, in the end the price of the options will drop. If the option price
is lower than (5.1), everybody wants to buy them, and eventually the option price
will soar. Hence the price of option will converge to (5.1).
Example 5.1. Consider the following thought experiment. Option price is larger
than c = {100 − 50(1 + r)−1 }/3.
Problem 5.5. What are you going to do, when you find the option price is larger
than c = {100 − 50(1 + r)−1 }/3?
Of course, you sell options in short and obtain easy money. However, if other
players read this text, they also start selling options. (They may realize the situa-
tion independent of this text...) Eventually, the price of option falls. But how far
you can continue selling? It should be just before the option price hit c = {100 −
50(1 + r)−1 }/3. Thus, the option price should be c = {100 − 50(1 + r)−1 }/3.
5.2 Ideal Dynamics

This is another way to establish the price of call option. Unlike Section 5.1, here
we will not use the portfolio but buy (or sell) whichever stock or option.
Suppose the initial price of the stock is s. After a week, the stock can be either
a > s or b < s. Let C be the price of call option buying the stock at strike price K.
We can either buy or sell the stock option with C.
We need to find out appropriate value of C, which gives no sure-win. We have
the following two choices:
• buy (or sell) stock,
• buy (or sell) option.
Let p = P{X1 = a} and 1 − p = P{X1 = b}. Suppose we buy one stock at spot.
Let r be the interest rate. Then, the present value of this investment R1 is
R1 = X1 (1 + r)−1 − s (5.10)
5.2. IDEAL DYNAMICS 27
taking into account of the initial payment s. Thus, the expected return of this
investment is
E[R1 ] = p{a(1 + r)−1 − s} + (1 − p){b(1 + r)−1 − s}

a−b b
=p + − s. (5.11)
1+r 1+r
To vanish the opportunity of easy money from a financial product, there should
be a particular situation where its expected profit should be equal to zero (See
Section 5.4). Thus, by setting E[R1 ] = 0, we have
s(1 + r) − b
p= . (5.12)
a−b
Thus, given that the expected return of this investment R1 equals to zero, p should
should have the value like in (5.12).
Next, suppose we buy one option. The present value of the return of this
investment Q1 is
(
(a − K)(1 + r)−1 −C if X1 = a,
Q1 = (5.13)
−C if X1 = b.
Thus, we have
E[Q1 ] = p(a − K)(1 + r)−1 −C (5.14)
Assuming (5.12), we have
(a − K){s − b(1 + r)−1 }

E[Q1 ] = −C (5.15)
a−b
To guarantee to have no sure-win, E[Q1 ] also has to be zero. Thus,
(a − K){s − b(1 + r)−1 }

C= (5.16)
a−b
Hence, by Theorem 5.3, we don’t have sure-win if the option price is (5.16).
Remark 5.1. The option price (5.16) coincides with (5.1).
Example 5.2 (Risk-neutral probabilities). Go back to our virtual market. Assume

the same setting in Section 5.1. Given no arbitrage, the stock price must have
p = P{X1 = 200}
100(1 + r) − 50
=
150
2r + 1
= ,
3
from (5.12). Thus,
E[X1 ] = 200p + 50(1 − p)

= 50 + 150p
2r + 1
= 50 + 150
3
= 100(1 + r).
This means that the only “rational” probability structure for the future stock price
should has the same expected present value. Of course, given that this probability
structure, we have the option price,
100 − 50(1 + r)−1

c= .
3
5.3 Duplication and Law of One Price

The other way to set the option price is following law of one price.
Theorem 5.1 (law of one price). Consider two investments and their costs c1 and
c2 respectively. If the present values of their payoff are same, then either
1. c1 = c2 , or
2. there is an arbitrage opportunity.
Proof. Suppose c1 < c2 , then we can buy c1 and selling c2 , and obtain money.
Corollary 5.1. If there is no arbitrage, the price of the investments with the same
return should be identical.
5.3. DUPLICATION AND LAW OF ONE PRICE 29
Now using Theorem 5.1, we will derive the option cost as in the same situation
as in Section 5.1 by considering two different investments:
1. Buy a call option. The payoff P1 at time 1 is

(
50 if the price of stock is $200,
P1 = (5.17)
0 if the price of stock is $50.
2. Borrow x from bank, and buy y shares. The initial investment is 100y − x.
At time 1 you need to pay back (1 + r)x, while selling the y share. Thus, the
payoff Q1 is
(
200y − x(1 + r) if the price of stock is $200,
Q1 = (5.18)
50y − x(1 + r) if the price of stock is $50.
By choosing appropriate x and y, we have the same pay off P1 = Q1 for these two
investment, i.e.,
200y − x(1 + r) = 50, (5.19)

50y − x(1 + r) = 0, (5.20)
or
1
y= , (5.21)
3
50
x= . (5.22)
3(1 + r)
In this case, two investments have the identical payoff. In other word, we could
duplicate the option by buying stocks at spot and borrowing money from bank.
Thus, using Theorem 5.1, the initial costs of two investments are identical. Thus
the option price c is
100 − 50(1 + r)−1

c = 100y − x = , (5.23)
3
which is identical to (5.1).
5.4 Arbitrage Theorem

Definition 5.1 (risk neutral probability). The probability measure is said to be risk
neutral when the expectation of outcome on all bets is fair.
Consider two investment options whose gain is determined by the future price
of a stock X. Assume that the stock price X can be either a or b. Let R1 and
R2 be the corresponding gain to the investments. Since the gain of investment is
determined by the stock price, we have
(
ri (a) X = a,
Ri = (5.24)
ri (b) X = b.
We can split our money x = x1 + x2 into the two investment, thus the total gain
R is obtained by
R = x1 R1 + x2 R2 . (5.25)
Theorem 5.2 (arbitrage theorem for two investments). Either one of the follow-
ings holds.
1. There exist the risk-neutral probability. More precisely, there exists 0 ≤ p ≤

1 such that
pr1 (a) + (1 − p)r1 (b) = 0, (5.26)

pr2 (a) + (1 − p)r2 (b) = 0 (5.27)
2. There is a sure-win strategy. That is there exist a betting strategy (x1 , x2 )

for which
R = x1 R1 + x2 R2 > 0. (5.28)
Proof. First, suppose we have a risk-neutral probability as in (5.26) and we will

show that there is no sure win. Rewriting (5.26), we have
p−1
r1 (a) = r1 (b), (5.29)
p
p−1
r2 (a) = r2 (b) (5.30)
p
5.4. ARBITRAGE THEOREM 31
Suppose, we somehow find the investment strategy to get some positive gain when
the stock price is b, i.e.
x1 r1 (b) + x2 r2 (b) > 0. (5.31)
Now assume unfortunately our stock price turn out to be a. We have the gain as
R = x1 r1 (a) + x2 r2 (a)
p−1
= {x1 r1 (b) + x2 r2 (b)}
p
However, because of (5.31) and the fact (p − 1)/p ≤ 0, the gain when X = a is
always negative (non-positive). The same argument can be applied to the case
when there is a strategy to have positive gain at X = b. Thus there is no sure-win
when there is risk-neutral probability.
Next we show that whenever there is no sure-win, there exists a risk-neutral
probability. Define two vectors by
r(a) = (r1 (a), r2 (a)), (5.32)

r(b) = (r1 (b), r2 (b)). (5.33)
Then, the gain is nothing but the inner product of these vectors and the vector
x = (x1 , x2 ), i.e.,
(
x1 r1 (a) + x2 r2 (a),
R = (x, r) = . (5.34)
x1 r1 (b) + x2 r2 (b).
If there is no sure-win, the vectors r(a) and r(b) should be in line with the opposite
direction, i.e.,
r(a) = −αr(b) (5.35)
for some constant α ≥ 0. Indeed, if not, we can always find some vector x having
positive inner product with both r(a) and r(b). It is easy to see that
|r1 (b)| |r2 (b)| 1
= = . (5.36)
|r1 (a)| + |r1 (b)| |r2 (a)| + |r2 (b)| α + 1
Set
1
p= . (5.37)
α +1
By (5.35),
1
pr1 (a) + (1 − p)r1 (b) = {|r1 (b)|r1 (a) + |r1 (a)|r1 (b)}
|r1 (a)| + |r1 (b)|
1
= {−|r1 (b)|αr1 (b) + |αr1 (b)|r1 (b)}
|r1 (a)| + |r1 (b)|
= 0.
Similarly, we have
pr2 (a) + (1 − p)r2 (b) = 0. (5.38)
Thus, p is the risk-neutral probability.
Let J be an experiment (of a gamble?). The outcome of J can be {1, ..., m}.
Let ri ( j) be the return fuction, that is, when we bet a unit money on wager i, if the
experiment result is J = j, we can get ri ( j). Note that the amount of bet can be
negative.
We can bet xi on wager i. We call the vector x = (x1 , ..., xn ) the betting strategy.
If we bet on the strategy x, we can get the amount of money
n
∑ xiri(J). (5.39)
i=1
Theorem 5.3 (arbitrage theorem). Either there exists risk neutral probability, or
there is the sure-win strategy (arbitrage). More precisely, either one of the follow-
ings true.
1. There exists a probability vector p = (p1 , ..., pm ) for which
m
E[ri (J)] = ∑ p j ri( j) = 0 for all wager i, (5.40)
j=1
where we regard p j = P{J = j}.
2. There is a betting strategy x = (x1 , ..., xn ) for which

n
∑ xiri( j) > 0 for all outcome j. (5.41)
i=1
5.5. REFERENCES 33
5.5 References
reference here!
5.6 Exercises
Chapter 6
Tools for Modeling Dynamics of

Stock Prices
Brownian Motions and Poisson Processes are the most useful and practical tools
to understand stochastic processes appeared in the real world.
6.1 Geometric Brownian Motions

Definition 6.1 (Geometric Brownian motion). We say S(t) is a geometric Brow-
nian motion with the drift parameter µ and the volatility parameter σ if for any
y ≥ 0,
1. the growth rate S(t + y)/S(t) is independent of all history of S up to t, and
2. log(S(t + y)/S(t)) is a normal random varialble with its mean µy and its
variance σ 2 y.
Let S(t) be the price of a stock at time t. In mathematical finance theory, often,
we assume S(t) to be a geometric Brownian motion. If the price of stock S(t) is a
geometric Brownian motion, we can say that
• the future price growth rate is independent of the past price, and
• the distribution of the growth rate is distributed as the lognormal with the
parameter µt and σ 2t..
The future price is probabilistically decided by the present price. Sometimes,
this kind of stochastic processes are refereed to a Markov process.
34
6.1. GEOMETRIC BROWNIAN MOTIONS 35
Lemma 6.1. If S(t) is a geometric Brownian motion, we have

2 /2)
E[S(t)|S(0) = s0 ] = s0 et(µ+σ . (6.1)
Proof. Set
S(t) S(t)
Y= = .
S(0) s0
Then, Y is lognormal with (tµ,tσ 2 ). Thus by using Theorem 2.3 we have

2 /2)
E[Y ] = et(µ+σ .
On the other hand, we have
E[S(t)]
E[Y ] = .
s0
Hence, we have (6.1).
Remark 6.1. Here the mean of S(t) increase exponentially with the rate µ + σ 2 /2,
not the rate of µ. The parameter σ represents the fluctuation, but since the log-
normal distribution has some bias, σ affects the average exponential growth rate.
Theorem 6.1. Let S(t) be a geometric Brownian motion with its drift µ and
volatility σ , then for a fixed t ≥ 0, S(t) can be represented as
S(t) = S(0)eW , (6.2)
where W is the normal random variable N(µt, σ 2t).
Proof. We need to check that (6.2) satisfies the second part of Definition 6.1,
which is easy by taking log on both sides in (6.2) and by seeing

S(t)
log = W. (6.3)
S(0)
36 CHAPTER 6. TOOLS FOR MODELING DYNAMICS OF STOCK PRICES
Sometimes instead of Definition 6.1, we use the following stochastic differen-

tial equation to define geometric Brownian motions,
dS(t) = µS(t)dt + σ S(t)dB(t), (6.4)
where B(t) is the standard Brownian motion and dB(t) is define by so-called Ito
calculus.
Note that the standard Brownian motion is continuous function but nowhere
differentiable, so the terms like dB(t)/dt should be treated appropriately. Thus,
the following parts is not mathematically rigorous. The solution to this equation
is
2 /2)t+σ B(t)
S(t) = S(0)e(µ−σ . (6.5)
To see this is the solution, we need “unordinary” calculus. We will see the detail
in Theorem 11.2.
Problem 6.1. Use “ordinary” calculus to obtain the derivative,
dS(t)
, (6.6)
dt
formally. Check if it satisfies (6.4), or not.
6.2 Discrete Time Tree Binomial Process

In this section, we imitate a stock price dynamic on the discrete time, which is
subject to geometric Brownian motion.
Definition 6.2 (Tree binomial process). The process Sn is said to be a Tree Bino-
mial process, if the dynamics is express as
(
uSn−1 with probability p,
Sn = (6.7)
dSn−1 with probability 1 − p,
for some constant factors u ≥ d ≥ 0 and some probability p.
Problem 6.2. Figure 6.1 depicts a sample path of Tree Binomial Process. Do you
think it is reasonably similar to Figure 6.2, which is a exchange rate of yen?
6.2. DISCRETE TIME TREE BINOMIAL PROCESS 37
130
120
110
100
90
80
20 40 60 80 100
Figure 6.1: An example of Tree binomial process with d = 0.970446, u =

1.03045, p = 0.516667 and starting from S0 = 100.
Figure 6.2: Exchange rate of yen at 2005/10/19. Adopted from

http://markets.nikkei.co.jp/kawase/index.cfm
Theorem 6.2 (Approximation of geometric brownian motion). A geometric Brow-

nian motion S(t) with the drift µ and the volatillity σ can be approximated by the
limit of a tree binomial process with the parameters:
√
d = e−σ ∆
, (6.8)
√
σ ∆
u=e , (6.9)
1 µ√
p= 1+ ∆ . (6.10)
2 σ
Proof. Let ∆ be a small interval and n = t/∆. Define a tree binomial process on
the discrete time {i∆} such as
(
uS((i − 1)∆) with probability p,
S(i∆) = (6.11)
dS((i − 1)∆) with probability 1 − p,
for all n. The multiplication factors d and u as well as the probability p have
some specific value, as described in the following, to imitate the dynamics of the
Brownian motion. Let Yi be the indicator of “up”s (Bernouilli random variable),
i.e.,
(
1 up at time i∆,
Yi = (6.12)
0 down at time i∆.
Thus, the number of “up”s up to time n∆ is ∑ni=1 Yi , and the number of “down”s is
n − ∑ni=1 Yi . Hence, the stock price at time n∆ given that the initial price S(0) is
S(n∆) = S(0)u∑ Yi d n−∑ Yi

u ∑ Yi
= S(0)d n .
d
Now set
t/∆
S(t) = S(0)d t/∆ (u/d)∑i=1 Yi , (6.13)
and show that the limit S(t) is geometric Brownian motion with the drift µ and
the volatility σ as ∆ → 0. Taking log on the both side, we have

S(t)

t u t/∆
log = log d + log ∑ Yi. (6.14)
S(0) ∆ d i=1
6.2. DISCRETE TIME TREE BINOMIAL PROCESS 39
To imitate the dynamics of geometric Brownian motion, here we artificially set

√
d = e−σ ∆
,
√
σ ∆
u=e ,
1 µ√
p= 1+ ∆ .
2 σ
Note that log d and log u are symmetric, while d and u are asymmetric, and p →
1/2 as ∆ → 0. Now using these, we have
√ t/∆

S(t) −tσ
log = √ + 2σ ∆ ∑ Yi . (6.15)
S(0) ∆ i=1
Consider taking the limit ∆ → 0, then the number of terms in the sum increases.
Using Central Limit Theorem (Theorem 3.5), we have the approximation:
t/∆
∑ Yi ∼ Normal distribution. (6.16)
i=1
Thus, log(S(t)/S(0)) has also the normal distribution with its mean and variance:
−tσ √ t/∆
E[log(S(t)/S(0)] = √ + 2σ ∆ ∑ E[Yi ]
∆ i=1
−tσ √ t
= √ + 2σ ∆ p,
∆ ∆
−tσ √ t µ√
= √ +σ ∆ 1+ ∆
∆ ∆ σ
= µt,
and
t/∆
Var[log(S(t)/S(0)] = 4σ 2 ∆ ∑ Var[Yi ]
i=1
2
= 4σ t p(1 − p)
→ σ 2t, as ∆ → 0,
since p → 1/2. Thus,
log(S(t)/S(0)) ∼ N[µt, σ 2t], (6.17)
and moreover S(t + y)/S(t) is independent with the past because of the construc-
tion of S(t). Hence the limiting distribution of S(t) with ∆ → 0 is a geometric
Brownian motion, which means all the geometric Brownian motion S(t) with the
drift µ and the volatility σ can be approximated by an appropriate tree Binomial
process.
Remark 6.2. In the following, to show the properties of geometric Brownian mo-
tions, we sometimes check the properties holds for the corresponding tree Bino-
mial Process and then taking appropriate limit to show the validity of the proper-
ties of geometric Brownian motions.
Example 6.1 (Trajectories of geometric brownian motions). This is an example

of different trajectories of Geometric Brownian Motions. Here we set the drift
µ = 0.1, the volatility σ = 0.3 and the interval ∆ = 0.01 in the geometric brow-
nian motion. As pointed out in Remark 6.2, we use tree binomial process as an
approximation of geometric brownian motion. Thus, the corresponding parame-
ters are d = 0.970446, u = 1.03045 and p = 0.516667.
130
120
110
100
90
80
20 40 60 80 100
Figure 6.3: Another example of geometric brownian motion with the drift µ = 0.1,
the volatility σ = 0.3 and the interval ∆ = 0.01 and starting from S0 = 100.
It is important to see that the path from geometric brownian motion will differ
time by time, even we have the same parameters. It can rise and down. Figure 6.4
6.3. BROWNIAN MOTIONS 41
gathers those 10 different trajectories. Since we set the drift µ = 0.1 > 0, we can
see up-ward trend while each trajectories are radically different.
On the other hand, Figure 6.5 shows the geometric brownian motion with the
negative drift µ = −0.1, and the probability of the upward change p = 0.483333.
Can you see the difference between Figure 6.5 and Figure 6.4?
200
180
160
140
120
100
80
20 40 60 80 100
Figure 6.4: Many trajectories of geometric brownian motion with the upward
drift µ = 0.1, the volatility σ = 0.3 and the interval ∆ = 0.01 and starting from
S0 = 100.
6.3 Brownian Motions

Definition 6.3 (Brownian motion). A stochastic process S(t) is said to be a Brow-
nian motion, if S(t + y) − S(y) is a normal random variable N[µt, σ 2t], which is
independent with the past history up to the time y.
Note that for a Brownian motion, we have
E[S(t)] = µt, (6.18)

Var[S(t)] = σ 2t. (6.19)
Thus, both quantities are increasing as t increases.

140
120
100
20 40 60 80 100
Figure 6.5: Many trajectories of geometric brownian motion with the downward
drift µ = −0.1.
Brownian motions is more widely used than geometric Brownian motions.

However, to apply them in finance theory, Brownian motion has two major draw
backs. First, Brownian motions allows to have negative value. Second, in Brow-
nian motion, the price differences on the same time intervals with same length is
stochastically same, no matter the initial value, which is not realistic in the real
finance world.
An example of trajectroy of two-dimensional brownian motion can be found
in Figure 6.6.
6.4 Poisson Processes

Definition 6.4 (Counting process). Let N(t) be the number of event during [0,t).
The process N(t) is called a counting process.
Definition 6.5 (Independent increments). A stochastic process N(t) is said to have

independent increment if
N(t1 ) − N(t0 ), N(t2 ) − N(t1 ), ..., N(tn ) − N(tn−1 ), (6.20)
are independent for all choice of the time instants t0 < t1 , < .... < tn .
6.4. POISSON PROCESSES 43
-20 20 40 60
-20
-40
-60
-80
Figure 6.6: An example of trajectory of two-dimensional brownian motion.
Thus, intuitively the future direction of the process which has independent
increment are independent with its past history.
Definition 6.6 (Poisson Processes). Poisson process N(t) is a counting process of

events, which has the following features:
1. N(0) = 0,
2. N(t) has independent increments,

n
3. P{N(t + s) − N(s) = n} = e−λt (λt)
n! , where λ > 0 is the rate of the events.
Theorem 6.3. Let N(t) be a Poisson process with its rate λ , then we have
E[N(t)] = λt, (6.21)

Var[N(t)] = λt. (6.22)
Or rewriting this, we have
E[N(t)]
λ= , (6.23)
t
which validates that we call λ the rate of the process.

Proof. By Definition 6.6, we have

∞
E[N(t)] = ∑ nP{N(t) = n}
n=0
∞ n
−λt (λt)
= ∑ ne
n=0 n!
−λt
∞
(λt)n−1
= λte ∑
n=0 (n − 1)!
= λte−λt eλt
= λt.
The other is left for readers to prove (see Exercise 6.2).
6.5 References
6.6 Exercises
Exercise 6.1. Find E[Sn ] and Var[Sn ] for tree binomial process.
Exercise 6.2. Let N(t) be a Poisson process with its rate λ , and prove
Var[N(t)] = λt. (6.24)

Chapter 7
On a Way to Black-Scholes Formula
7.1 The Only Possible Process to Avoid Arbitrage

We show the particular tree binomial process will emerge form arbitrage theorem.
This is the process we will assume in the analysis of the stock dynamics.
Theorem 7.1 (Risk-neutral tree binomial process). Consider the stock price on
the discrete time. Let r be the interest rate, and let Sn be the stock price at time n
and satisfies the following special dynamics:
(
uSn−1 ,
Sn = (7.1)
dSn−1 ,
where we assume d < (1 + r) < u. If there is no arbitrage opportunity, then the

process Sn should be a tree binomial process with the probability of up is p =
(1 + r − d)/(u − d).
Proof. Let Xn be the indicator of “up”s of stock price at time n, i.e.,

(
1 up at n,
Xn = (7.2)
0 down at n,
Note that (X1 , X2 , . . . , Xn ) determines the stock price Sn . By Arbitrage Theorem

(Theorem 5.2), in order to avoid arbitrage, the expected return of all bet is equal
to zero.
45
46 CHAPTER 7. ON A WAY TO BLACK-SCHOLES FORMULA
First, let us consider an investment scheme. The stock price data up to time
n − 1 are used only for the observation. According to some rule, we decide to buy
stock or not. More precisely, if
(X1 , X2 , . . . , Xn−1 ) = (x1 , x2 , . . . , xn−1 ), (7.3)
we buy the stock at time n − 1 by borrowing money from a bank, and sell it at time
n.
Problem 7.1. Describe why this is fairly common rule.
Let
α = P{(X1 , X2 , . . . , Xn−1 ) = (x1 , x2 , . . . , xn−1 )}, (7.4)
p = P{Xn = 1|(X1 , X2 , . . . , Xn−1 ) = (x1 , x2 , . . . , xn−1 )}. (7.5)
According to the stock price change, the gain of this investment differs. By condi-
tioning the event (X1 , X2 , . . . , Xn−1 ), we can get the expected gain at time n of this
investment E[Gn ]:
E[Gn ] = αE[profit from buying the stock] + (1 − α)0, (7.6)
since we avoid buying stock with probability 1 − α. The probability of stock rise
is p, so
E[profit from buying the stock] = puSn−1 + (1 − p)dSn−1 − (1 + r)Sn−1 , (7.7)
since we need to pay the interest for the money borrowed from the bank. Thus,
E[Gn ] = α{puSn−1 + (1 − p)dSn−1 − (1 + r)Sn−1 }. (7.8)
Thus, setting the expected gain to be zero, we have
0 = E[Gn ] = α{puSn−1 + (1 − p)dSn−1 − (1 + r)Sn−1 }, (7.9)
or,
1+r−d
p = P{Xn = 1|(X1 , X2 , . . . , Xn−1 ) = (x1 , x2 , . . . , xn−1 )} = , (7.10)
u−d
which is independent of our specific rule (x1 , x2 , . . . , xn−1 ). This means that Xn
is independent of (X1 , X2 , . . . , Xn−1 ). Accordingly, using inductive arguments, we
conclude that (X1 , X2 , . . . , Xn ) are independent. Thus, the process Sn is a tree bi-
nomial process.
7.2. OPTION PRICE ON THE DISCRETE TIME 47
7.2 Option Price on the Discrete Time

Definition 7.1 (Option and its Strike price and expiration time). Let Sn be the
price of a stock at time n. Consider an option that we can buy a stock at the price
K at time n. The value K is called the strike price and n is called the expiration
time of the option.
Theorem 7.2 (Option price on binomial process). If there is no arbitrage oppor-
tunity, the option price C should be
C = (1 + r)−n E[(Sn − K)+ ], (7.11)
where Sn is defined and proved to be the risk-neutral binomial tree process in

Theorem 7.1.
Proof. We need to find out appropriate value of C, which gives no sure-win. By
Theorem 7.1, we know that Sn should be the risk-neutral binomial process when
there is no arbitrage opportunities.
Suppose we buy one option at cost C. The option is worthless if the stock price
Sn is less than K. On the other hand, if Sn is larger than the strike price K, then the
value of this option is Sn − K, since we can sell the stock obtained by exercising
the option at the market price Sn . Thus, the payoff of the option at time n is
(Sn − K)+ , (7.12)
where x+ = max(x, 0). Thus, the present value of the expected return of this in-
vestment R is
E[R] = (1 + r)−n E[(Sn − K)+ ] −C. (7.13)
By Arbitrage Theorem (Theorem 5.3), this should be zero, or we have an arbi-

trage. Thus,
C = (1 + r)−n E[(Sn − K)+ ]. (7.14)
7.3 Black-Scholes Model

Now we proceed to the continuous time model. Let S(t) be a stock price at time
t. We assume the stock price S(t) is a geometric Brownian motion with the drift
µ and the volatility σ as defined in Section 6.1. As noted in Theorem 6.2, if we

divide t into n interval, all geometric Brownian motion can be approximated by
discrete-time binomial tree process with
(
uSn−1 with probability p,
Sn = (7.15)
dSn−1 with probability 1 − p,
where
√
d = e−σ ∆
, (7.16)
√
σ ∆
u=e , (7.17)
1 µ√
p= 1+ ∆ . (7.18)
2 σ
and ∆ = t/n is the time interval. However, by Theorem 7.1. if we assume there is
no arbitrage, the binomial process should be risk-neutral with
1 + rt/n − d
p = P{up} = , (7.19)
u−d
since the nominal interest rate is rt/n. Using the Taylor expansion of the expo-
nential function, we have
√ σ 2t
d = e−σ t/n = 1 − σ t/n +
p
+ O((t/n)3/2 ), (7.20)
2n
√ p σ 2t
u = eσ t/n = 1 + σ t/n + + O((t/n)3/2 ). (7.21)
2n
Using these in (7.19), we have
r − σ 2 /2 p

1
p≈ 1+ t/n , (7.22)
2 σ
for a large n.
Problem 7.2. Derive (7.20) by using Taylor expansion and find that p should
satisfy (7.22) for large n.
Comparing this to (7.18), we can conclude that the original geometric Brown-
ian motion has to have the drift
µ = r − σ 2 /2, (7.23)
if we assume there is no arbitrage.
Thus, we have the following theorem.
7.3. BLACK-SCHOLES MODEL 49
Theorem 7.3 (Risk neutral geometric Brownian motion). Let r be the nominal
interest rate. If there is no arbitrage, the geometric Brownian motion representing
stock price dynamics should have the drift µ = r − σ 2 /2 and the volatility σ . This
process is called the risk neutral geometric Brownian motion.
Problem 7.3. Give intuitive explanation why the volatility σ affect the drift µ =
r − σ 2 /2.
Further, we can prove the famous Black-Scholes formula in the simple form.
Theorem 7.4 (Black-Scholes formula). Consider a call option of the stock with
strike price K and the expiration time t. Let C be the price of this option. If we
assume there is no arbitrage opportunity, then we have
C = e−rt E[(S(t) − K)+ ], (7.24)
where S(t) is the geometric Brownian motion with the drift µ = r − σ 2 /2 and the
volatility σ .
Proof. Since we assume no arbitrage, the expected gain of all bets, including
purchase of the option, should be zero. Thus, supposing to buy a option with cost
C, we have
E[gain at time t] = E[(S(t) − K)+ −Cert ] = 0, (7.25)
which results (7.24).
Remark 7.1. Since the term e−rt represents mapping back to present value, (7.24)
is nothing but the present value of expectation of option payoff.
Although, (7.24) is simple for our eyes, it is hard to evaluate.
Problem 7.4. Use Black-Scholes formula (7.24) to analyze the effect of changing
parameters. What will happen to the option price if
1. the strike price K increases.
2. the interest rate r drops.

Corollary 7.1 (Original Black-Scholes formula). Given S(0) = s, the option price
C is obtained by
C = e−rt E[(seW − K)+ ] (7.26)

√
= sΦ(ω) − Ke−rt Φ(ω − σ t), (7.27)
where W is a normal random variable with N((r − σ 2 /2)t, σ 2t), Φ(x) is the dis-
tribution function of the standard normal random variable and
rt + σ 2t/2 − log(K/s)
ω= √ . (7.28)
σ t
To prove this Corollary, we need the following Lemmas. Note that S(t) can be
expressed in
S(t) = seW (7.29)

√
(r−σ 2 /2)t+σ tZ
= se , (7.30)
where Z is the standard normal random variable.

Lemma 7.1. By using the representation in (7.29), the following two set of events
are considered to be equivalent:
√
{S(t) > K} ⇐⇒ Z > σ t − ω . (7.31)
Proof. By (7.29), we have

√

(r−σ 2 /2)t+σ tZ K
{S(t) > K} ⇐⇒ e > . (7.32)
s
Since log is increasing function, we have
√ log(K/s) − (r − σ 2 /2)t

(r−σ 2 /2)t+σ tZ K
e > ⇐⇒ Z > √
s σ t
√
⇐⇒ Z > σ t − ω ,
where we used the fact:

√ log(K/s − (r − σ 2 /2)t
σ t −ω = √ . (7.33)
σ t
7.3. BLACK-SCHOLES MODEL 51
Lemma 7.2. Let I be the indicator such as

(
1 if S(t) > K,
I= (7.34)
0 if S(t) ≤ K.
Then,
√
E[I] = P{S(t) > K} = Φ(σ t − ω). (7.35)
Proof. Using Lemma 7.1, we have
E[I] = P{I = 1} = P{S(t) > K}

√
= P{Z > σ t − ω}
√
= P{Z < ω − σ t}.
Lemma 7.3.
e−rt E[IS(t)] = sΦ(ω). (7.36)

√
Proof. Set α = σ t − ω. Since I and S(t) can be regarded as a function of the
random variable Z, we have
h 2
√ i
E[IS(t)] = E 1{Z>α} se(r−σ /2)t+σ tZ
Z ∞
2 /2)t+σ x
√
= se(r−σ t
dP{Z ≤ x}
Zα∞ √
2 /2)t+σ x 1 2
= se(r−σ t
√ e−x /2 dx
α 2π
1 2 ∞ Z
2
√
= √ se(r−σ /2)t e−(x −2σ x t)/2 dx
2π α
√ √
Since x2 − 2σ x t = (x − σ t)2 − σ 2t, we have
1 ∞ Z √ 2
= √ sert e−(x−σ t) /2 dx
2π α
1
Z ∞
2
= √ sert e−y /2 dy,
2π −ω
√
where we put y = x − σ t. Since the integrant is indeed the density of standard
normal distribution, we have
= sert P{Z > −ω}
= sert Φ(ω),
by the symmetry of Φ.
Proof of Corollary 7.1. Since (S(t) − K)+ = I(S(t) − K), by Theorem 7.4 and ,
we have
C = e−rt E[(S(t) − K)+ ]
= e−rt E[I(S(t) − K)]
= e−rt E[I(S(t)] − Ke−rt E[I]
√
= sΦ(ω) − Ke−rt Φ(σ t − ω),
where we used Lemma 7.2 and 7.3.
7.4 Examples of Option Price via Black-Scholes For-

mula
Example 7.1 (Option price via Black-Scholes). Suppose the current price of a
stock s = S(0) = 30. The yearly interest rate r = 0.08 and the volatility σ = 0.20.
Let C be the price of call option with the strike price K = 36 and its expiration
date is 3 month from now. We will estimate C.
Then, t = 1/4 and ω in (7.28) is
rt + σ 2t/2 − log(K/s)
ω= √
σ t
0.08 · 1/4 + 0.22 · 1/4 · 1/2 − log(36/30)
= p
0.2 1/4
≈ −1.57322.
Thus, by (7.27) in Corollary 7.1, we have
√
C = sΦ(ω) − Ke−rt Φ(ω − σ t),
p
= 30 · Φ(−1.57322) − 36e0.08·1/4 Φ(−1.57322 − 0.2 1/4)
= 0.0715115
7.5. REFERENCES 53
Thus, the price of this option is 0.07. Table 7.1 shows the return of stock and
option purchase. You can get more profit when the stock price rises.
Table 7.1: Return when the stock price rises

value at 0 value at 1 return
Stock 30 40 4/3
Option 0.07 4 4/0.07
However, by Lemma 7.2,

√
P{S(t) > K} = Φ(σ t − ω) = 0.0471424. (7.37)
With high probability you will lose your money with this option. Thus, you can
understand that option is high risk and high return.
In Figure 7.1, we show the simulation of the stock price dynamics. Your
opinion?
40
35
30
25
20 40 60 80 100
Figure 7.1: Example of risk-neutral geometric brownian motion with the volatility
σ = 0.2 starting from S0 = 30, when the interest rate r = 0.08. Here we used the
tree-binomial approximation with the interval ∆ = 0.01.
7.5 References
reference here!
7.6 Exercises
Exercise 7.1. Estimate the value of following call options, given the current price
of a stock s = S(0) = 30, and compare the result with Example 7.1. What can you
say about it.
1. The yearly interest rate r = 0.08 and the volatility σ = 0.40.
2. The yearly interest rate r = 0.04 and the volatility σ = 0.20.
Note that e0.1 = 1.10517 and e0.05 = 1.05127.
Exercise 7.2. Give two examples where buying options is more appropriate than
buying its stocks.
Chapter 8
Delta Hedging Strategy
We have already known that we can duplicate option for one term in Section 5.3.
This idea can be extended to multiple terms.
8.1 Bernouilli Hedging Model

As usual, we use the discrete-time model of stock price. Let S0 = s be the initial
price and
(
us,
S1 = (8.1)
ds.
Here’s our new assignment. Find the amount of money x at time 0 required to
meet a payment P1 below varying according to stock price.
(
a up,
P1 = (8.2)
b down.
Actually, P1 is representing derivatives more general than option. Now assume we

buy y shares at time 0, then we can deposit x − ys at a bank. Note that if x − ys
is negative, we should borrow some money from the bank. The return of this
investment R1 is
(
ys · u + (x − ys)(1 + r) up,
R1 = (8.3)
ys · d + (x − ys)(1 + r) down,
55
56 CHAPTER 8. DELTA HEDGING STRATEGY
where r is the interest rate. Thus, if we can set (x, y) satisfying

ys · u + (x − ys)(1 + r) = a, (8.4)
ys · d + (x − ys)(1 + r) = b, (8.5)
then our assignment is solved. Subtracting both sides, we have
y(us − ds) = a − b.
a−b
y= .
s(u − d)
Substituting this y into (8.4), we have
a−b a−b
· u + (x − )(1 + r) = a,
u−d u−d
a−b
· {u − (1 + r)} + x(1 + r) = a,
u−d
Solving this with respect to x, we have

1 1+r−d u−1−r
x= a +b . (8.6)
1+r u−d u−d
Here we use the risk-neutral probability p defined in Theorem 7.1 as
1+r−d
p= , (8.7)
u−d
u−1−r
1− p = . (8.8)
u−d
Then,
a b
x= p + (1 − p)
1+r 1+r
1
= {pa + (1 − p)b}, (8.9)
1+r
which means that if we prepare x at time 0, which is just the present value of the
expected payoff in the risk-neutral probability, we can cover the pay off at time 1.
Note that in this case, we should buy the stock as much as
a−b
y= , (8.10)
s(u − d)
which is the ratio of the difference of payoff to the stock price change.
8.2. BINOMIAL HEDGING MODEL 57
8.2 Binomial Hedging Model

Now we proceed to the time 2. In this case, the possibilities of payoff are not only
two like a and b in previous discussion, but three cases.
Problem 8.1. Explain why we have three cases, not four.
Let xi,2 be the money required to cover the payoff at time 2, given that
S2 = ui d 2−i s, (8.11)
where i = 0, 1, 2 is the indicator of the number of up’s up to time 2.

First, suppose S1 = us. If S2 = u2 s, we have payoff x2,2 . On the other hand, if
S2 = uds, we have payoff x1,2 . Thus, using previous argument at time 1 and time
2, we know that the money required at the time 1, say x1,1 , should be
1
x1,1 = {px2,2 + (1 − p)x1,2 }. (8.12)
1+r
Note that p = (1 + r − d)/(u − d) depends on the stock price dynamics d, u but
doesn’t depend on the payoff. In order to achieve the payoff, we need to buy stock
as much as
x2,2 − x1,2
y1,1 = , (8.13)
us(u − d)
where s, which is the initial stock price in the previous discussion, is replaced with
us, and the rest will be put in the bank.
Second, assume S1 = ds. With similar argument, we need the money x0,1 at
time 1 as
1
x0,1 = {px1,2 + (1 − p)x0,2 }, (8.14)
1+r
with
x1,2 − x0,2
y0,1 = . (8.15)
ds(u − d)
Summarize the results (8.12) and (8.14), we have
xi,1 = E[ the time-1 present value of payoff at time 2|S(1) = ui s], (8.16)
where i = 0, 1.
Now we can re-evaluate our investment strategy at time 0. As shown above,
we need the payoff x0,1 and x0,1 with respect to the value of S1 . Thus, to cover this
payoff, we need the money as
1
x0,0 = {px1,1 + (1 − p)x0,1 }. (8.17)
1+r
Using (8.12) and (8.14), we have
1
x0,0 = [p{px2,2 + (1 − p)x1,2 } + (1 − p){px1,2 + (1 − p)x0,2 }]
(1 + r)2
1 2 2

= p x2,2 + 2p(1 − p)x1,2 + (1 − p) x0,2 . (8.18)
(1 + r)2
The payoff at time 2 will be achieved by buying the stock

x1,1 − x0,1
y0,0 = . (8.19)
s(u − d)
As it can be predicted, x0,0 , the money required to cover the payoff at time 2, is
the present value of the expected payoff at time 2, i.e.,
x0,0 = E[the present value of payoff at time n|S(0) = s]. (8.20)
Here’s an example how to meet the requirement by adjusting our stock posi-
tion.
1. Prepare the money equal to x0,0 , and buy the stock as much as y0,0 at time
0. The rest is kept at the bank.
2. At time 1, we happen to have S1 = us (up). The value of our investment

at time 1 is x1,1 , which is consisted by y0,0 stocks and (1 + r)(x0,0 − y0,0 )
bank deposit. Then, adjust our position of stock holding to y1,1 by selling
or buying, and put the rest at the bank.
3. At the time 2, we have S2 = uds (up and down), then the value of our in-
vestment have x1,2 . which is our requirement.
Now it’s time to generalize the argument. Let xi,n be the payoff at time n
given that Sn = ui d n−i s. Also let xi,k be the money required at time k given that
8.2. BINOMIAL HEDGING MODEL 59
Sk = ui d k−i s. Then
xi,k = E[time-k present value of payoff at time n|Sk = ui d k−i s]
1
= {pxi+1,k+1 + (1 − p)xi,k+1 } (8.21)
1+r
n−k
−(n−k) n−k j
= (1 + r) ∑ j p (1 − p)n−k− j xi+ j,n, (8.22)
j=0
for i = 0, 1, 2 . . . , k and k = 0, 1, 2, . . . , n. Also we need to adjust the position of

stock as
xi+1,k+1 − xi,k+1
yi,k = , (8.23)
Sk (u − d)
which is the ratio of the difference of next payoff to the stock price change.
Suppose at the time n, we set the payoff having the form like
xi,n = (ui d n−i s − K)+ . (8.24)
for i = 1, 2, . . . , n. Clearly, this is nothing but the payoff of the call option with
strike price K and expiration time n. Thus, if we follow our investment strategy,
we successfully replicate the option payoff.
By the law of one price (Theorem 5.1), the initial cost of our investment strat-
egy x0,0 should be equal to the option price C which was derived from Theorem
7.2).
Thus, we obtained the following theorem.
Theorem 8.1 (Delta hedge in discrete time binomial process). Let Sn be the risk-
neutral binomial tree process. Set the initial investment money as
C = (1 + r)−n E[(Sn − K)+ ], (8.25)
which is equal to the call option price of strike price K and expiration time n. Let
xi,n = (ui d n−i s − K)+ , and recursively set xi,k
1
xi,k = {pxi+1,k+1 + (1 − p)xi,k+1 } (8.26)
1+r
n−k
−(n−k) n−k j
= (1 + r) ∑ j p (1 − p)n−k− j xi+ j,n. (8.27)
j=0
We can hedge the option payoff by continuously adjusting the position of stock by
yi,k = (xi+1,k+1 − xi,k+1 )/(Sk (u − d)), (8.28)
when Sk = ui d k−i s for i = 0, 1, 2 . . . , k and k = 0, 1, 2, . . . , n.
8.3 Hedging in Black-Scholes Model

Problem 8.2. What will happen when we let the time interval ∆ → 0 in the equa-
tion below?
yi,k = (xi+1,k+1 − xi,k+1 )/(Sk (u − d)), (8.29)
Here’s a powerful tool to investigate limits.
Lemma 8.1 (l’Hospital’s Rule). Suppose f and g are differentiable on the interval
(a, b). Assume f , g, f 0 and g0 are continuous on (a, b), and g0 (c) for some fixed
point c ∈ (a, b).
If f (x) → 0 and g(x) → 0 as x → c, and there exists limx→c f 0 (x)/g0 (x), then
f (x) f 0 (x)
lim = 0 . (8.30)
x→c g(x) g (x)
Proof. See Exercise 8.1.
Let us consider a call option for a stock. Assume the stock price dynamics is
governed by a geometric brownian motion. Let K be the strike price of the option,
t be the expiration time and σ be the volatility of the geometric brownian motion.
As usual, we consider the discrete-time approximation of the geometric brow-
nian motion. Let h be the time interval and S(t) be the stock price at time t. Then,
( √
seσ √h,
S(h) = (8.31)
se−σ h .
Let C(s,t) be the cost of call option with the current price s and the expiration
time t. After time h, if the stock price rises, we must prepare the money
√
h
C(seσ ,t − h), (8.32)
√
which is the Black-Schole’s option price when the stock price is seσ h and the
expiration time t − h. Similarly, if stock price goes down, we must prepare
√
C(se−σ h
,t − h). (8.33)
Thus, by the argument in Section 8.2 and (8.10), we know that buying the stock
as much as D,
√ √
C(seσ h ,t − h) −C(se−σ h ,t − h)
D(h) = √ √ , (8.34)
seσ h − se−σ h
8.3. HEDGING IN BLACK-SCHOLES MODEL 61
we can cover the money required to buy the option at time h, given that we have
C(s,t) at the time 0. Now take h → 0 in (8.34), then
√ √
C(seσ h ,t − h) −C(se−σ h ,t − h)
D(0) = lim √ √
h→0 seσ h − se−σ h
C(seσ a ,t − a2 ) −C(se−σ a ,t − a2 )
= lim . (8.35)
a→0 seσ a − se−σ a
√
where a = h. Since both the denominator and numerator are converges to 0 as
h → 0, we need to apply l’Hospital’s Rule (Lemma 8.1). Then,
d
C(seσ a ,t − a2 ) −C(se−σ a ,t − a2 )

da
D(0) = lim d
(8.36)
σa −σ a ]
da [se − se
a→0
Now
∂C(y,t − a2 ) ∂C(seσ a , u)

d σa 2
C(se ,t − a ) = +
da ∂a
y=seσ a ∂a
u=t−a2
= lim Ct (seσ a ,t − a2 )(−2a) +Cs (seσ a ,t − a2 )sσ eσ a

a→0
= sσCs (s.t),
where Ct (s,t) = ∂C(s,t)/∂t and Cs (s,t) = ∂C(s,t)/∂ s. Similarly,
d
C(se−σ a ,t − a2 ) = lim −Ct (se−σ a ,t − a2 )(−2a) −Cs (se−σ a ,t − a2 )(−sσ e−σ a )

−
da a→0
= sσCs (s.t).
Thus, (8.36) can be rewritten as
2sσCy (s.t)
D(0) = lim D(h) =
h→0 2sσ
∂C(s,t)
= . (8.37)
∂s
The quantity D(0) = ∂C(s,t)/∂ s is the sensitivity of the option price with the
initial stock price and is called ∆.
Thus, we have the following theorem:
Theorem 8.2 (Delta hedge in geometric brownian process). Let S(t) be the risk-
neutral geometric brownian process. Set the initial investment money as
C(s,t) = e−rt E[(S(t) − K)+ ], (8.38)
which is equal to the call option price of strike price K and expiration time n. We
can hedge the option payoff by continuously adjusting the position of stock by ∆
∂C(s,t)
∆= , (8.39)
∂s
and the rest can be put (or borrowed) at a bank with the interest rate r.
8.4 Partial Derivative ∆

As in Section 8.3, the partial derivative called ∆ is important for hedging.
Theorem 8.3 (Partial Derivative ∆). The partial derivative ∆ is obtained by
∂C(s,t)
∆= = Φ(ω), (8.40)
∂s
where Φ(ω) is defined as in Lemma 7.3.
Proof. First, recall that
C(s,t) = E[e−rt (S(t) − K)+ ]. (8.41)
Set the indicator function I = 1{S(t)>K} as in Lemma 7.2, then
e−rt (S(t) − K)+ = e−rt (S(t) − K)I. (8.42)
Thus,
∂C(s,t)
∆=
∂s
∂
= E[e−rt (S(t) − K)I]
∂ s
∂ −rt
=E {e (S(t) − K)I} .
∂s
8.5. REFERENCES 63
Now, we have
∂ −rt ∂ {e−rt (S(t) − K)} ∂I
{e (S(t) − K)I} = I + {e−rt (S(t) − K)}
∂s ∂s ∂s
−rt
∂ {e (S(t) − K)}
=I , (8.43)
∂s
on {S(t) 6= K}. Since P{S(t) = K} = 0, we have

∂ −rt
∆=E {e (S(t) − K)I} S(t) 6= K P{S(t) 6= K}
∂s

∂ −rt
+E {e (S(t) − K)I} S(t) = K P{S(t) = K}

∂s
∂ {e−rt (S(t) − K)}

=E I (8.44)
∂s
Since S(t) is the geometric brownian motion, S can be represented as
2 )t+σ
√
S(t) = se(r−σ tZ
, (8.45)
for some standard normal random variable Z (see (7.29)). Thus,

∂ −rt ∂ S(t)
e (S(t) − K) = e−rt
∂s ∂s
S(t)e−rt
= . (8.46)
s
Using (8.46) in (8.44), we have
e−rt
∆= E[IS(t)] (8.47)
s
In Lemma 7.3, we have already shown that
e−rt E[IS(t)] = sΦ(ω). (8.48)
8.5 References
reference here!
8.6 Exercises
Exercise 8.1. Use
f (x) − f (c)
f 0 (x) = lim (8.49)
x−c x−c
to prove l’Hospital’s Rule (Lemma 8.1).
Chapter 9
Stochastic Integral
Consider the asset price on continuous time. Naturally, we need to extend the
notion of integral to stochastic integral, which is quite different with normal (Rie-
mann) integral.
9.1 Diffusion Process

Diffusion process is a building block of stochastic integral.
Definition 9.1 (Diffusion process). A stochastic process X(t) is said to be a dif-

fusion process if
X(t + ∆t) − X(t) = µ(t, X(t))∆t + σ (t, X(t))Z(t). (9.1)
Here, Z(t) is independent normally distributed disturbance term, µ is drift term,

and σ is so-called diffusion term.
Definition 9.2 (Wiener process). A stochastic process W (t) is said to be a Wiener

process if
1. W (0) = 0.
2. Independent increment, i.e., for r < s ≤ t < u
W (u) −W (t),W (s) −W (r) (9.2)
are independent.
65
66 CHAPTER 9. STOCHASTIC INTEGRAL
3. For s < t, W (t) −W (s) is normally distributed as N[0,t − s].
4. W(t) has a continuous trajectory.
Remark 9.1. Sometimes, Wiener process is called by Brownian motion.

Using the Wiener process W (t) in (9.1), we can rewrite it as
X(t + ∆t) − X(t) = µ(t, X(t))∆t + σ (t, X(t))∆W (t), (9.3)
where ∆W (t) = W (t + ∆t) −W (t). Dividing both sides with ∆t and letting ∆t → 0,
we have
dX(t)
= µ + σ v(t). (9.4)
dt
Here,
dW (t)
v(t) = . (9.5)
dt
Remark 9.2. The process v(t) cannot be exist, while the Wiener process W (t)
exists mathematically. Indeed W (t) cannot be differentiable almost everywhere.
Instead of dividing both sides with ∆t, just take ∆t → 0 in (9.1), then we have
(
dX(t) = µdt + σ dW (t),
(9.6)
X(0) = a.
Integrating (9.28) over [0,t], we have

Z t Z t
X(t) = a + µds + σ dW (s). (9.7)
0 0
The termR 0t µds is normal integral, so it is OK. However, we have a problem for
R
the term 0t σ dW (s), which cannot be defined by ordinary integral.

Thus, in the following section, we need to study the integral like
Z t
g(s)dW (s). (9.8)
0
9.2. INFORMATION 67
9.2 Information
Definition 9.3 (Information of X(t)). Define FtX by the information generated by
X(s) on s ∈ [0,t]. Roughly speaking, FtX is “what has happened to X(s) up to
time t.”
When we can decide an event A happened or not by the the trajectory of X(t),
we say that A is FtX -measurable, and
A ∈ FtX . (9.9)
When a random variable Z can be completely determined by the trajectory of X(t),

we write
Z ∈ FtX . (9.10)
Definition 9.4. A stochastic Y is said to be adopted to the filtration {FtX } when
Y (t) ∈ FtX , (9.11)
for all t.
Example 9.1. These are examples of information.
1.
A = {X(s) ≤ 3.14 for all s ≤ 9}. (9.12)
Then, A ∈ F9X .
2.
A = {X(10) > 8}. (9.13)
Then, A ∈ F10
X , but A 6∈ F X .
9
3.
Z 5
Z= X(s)ds. (9.14)
0
Then, Z ∈ F5X .
4. Let W be the Wiener process, and
X(t) = sup W (s). (9.15)

s≤t
Then, X is adopted to FtX . However, when
Y (t) = sup W (s), (9.16)

s≤t+1
Y is not adopted to FtX .
9.3 Definition of Stochastic Integral

Definition 9.5.
g ∈ L 2 [a, b], (9.17)
when
Rb
1. a E[g(s)2 ]ds < ∞,
2. g is adopted FtW .
Rb
Our objective is to define the stochastic integral a g(s)dW (s) on g ∈ L 2 [a, b].
Assume g is simple, i.e.,
g(s) = g(tk ) for s ∈ [tk ,tk+1 ). (9.18)
Then, the stochastic integral can be defined by

Z b n−1
a
g(s)dW (s) = ∑ g(tk )[W (tk+1 −W (tk )]. (9.19)
k=0
Remark 9.3. Note that this stochastic integral is forward incremental.
Problem 9.1. Prove g ∈ L 2 [a, b].
When g is not simple, we will proceed as follows:
1. Approximate g with simple functions gn .

9.3. DEFINITION OF STOCHASTIC INTEGRAL 69
2. Take n → ∞ in
Z b Z b
gn (s)dW (s) → g(s)dW (s). (9.20)
a a
Theorem 9.1. Here are some important properties for our stochastic integral.
When g ∈ L 2 , we have
1.
b
Z
E g(s)dW (s) = 0, (9.21)
a
2.
"Z 2 # Z b
b
E g(s)dW (s) = E[g2 (s)]ds, (9.22)
a a
3.
Z b
g(s)dW (s):FbX -measurable. (9.23)
a
Proof. We prove the case only when g(t) is simple. Set g(t) = A1[a,b] with A ∈
FaX . Since A is independent with the future W (b) −W (a), we have
Z b
E g(s)dW (s) = E[A(W (b) −W (a))]
a
= E[A]E[W (b) −W (a)] = 0.
Similarly, we have
"Z 2 #
b
E g(s)dW (s) = E[A2 (W (b) −W (a))2 ]
a
= E[A2 ]E[(W (b) −W (a))2 ]

= E[A2 ]t
Z b
= E[g2 (s)]ds.
a
We can prove the general case using the approximation with simple functions.
9.4 Martingale
Definition 9.6. Given a filtration Ft (the history observed up time t), a stochastic
process Xt is said to be martingale, when
1. Xt is adopted to Ft ,
2. E[|X(t)|] for all t,
3. for all s ≤ t,
E[X(t)|Ft ] = X(s). (9.24)
Theorem 9.2. Every stochastic integral is martingale. More precisely,

Z t
X(t) = g(s)dW (s), (9.25)
0
is an FtW -martingale.
Theorem 9.3. A stochastic process X(t) is martingale if and only if
dX(t) = g(t)dW (t), (9.26)
which means X(t) has no dt-term.
9.5 Calculus of Stochastic Integral

We consider a stochastic process X(t) satisfying following stochastic integral:
Z t Z t
X(t) = a + µ(s)ds + σ (s)dW (s). (9.27)
0 0
Equivalently, we write
(
dX(t) = µ(t)dt + σ (t)dW (t),
(9.28)
X(0) = a.
(9.28) is called stochastic differential equation.

Remark 9.4. We can see the infinitesimal dynamics more easily in the stochastic
differential equations.
9.5. CALCULUS OF STOCHASTIC INTEGRAL 71
Remark 9.5. Wiener process W (t) is continuous but perfectly rugged. Thus, we
need unusual Ito-calculus.
Since W (t) −W (s) is N[0,t − s],
E[∆W ] = 0, (9.29)
2
E[(∆W ) ] = ∆t, (9.30)
Var[∆W ] = ∆t, (9.31)
Var[(∆W )2 ] = 2(∆t)2 . (9.32)
For small ∆t, Var[(∆W )2 ] rapidly vanish, so deterministically we have
(∆W )2 ∼ ∆t. (9.33)
Thus, we can set
(dW )2 = dt, (9.34)
or
Z t
(dW )2 = t. (9.35)
0
Remark 9.6. Intuitive proof can be found in text Bjork [2004] p26.
Theorem 9.4 (Ito’s formula). Given a stochastic process X(t) with
dX(t) = µdt + σ dW (t), (9.36)
set
Z(t) = f (t, X(t)). (9.37)
Then, we have the following change of variables rule:
dZ(t) = d f (t, X(t)) (9.38)

∂ f 1 2∂2 f

∂f ∂f
= +µ + σ dt + σ dW (t), (9.39)
∂t ∂ x 2 ∂ x2 ∂x
or more conveniently,
∂f ∂f 1 ∂2 f
df = dt + dX + (dX)2 . (9.40)
∂t ∂x 2 ∂ x2
Roughly speaking, Ito’s formula reveals that the dynamics of a function of

stochastic process depends not only on the first order but also the second order of
the underlying stochastic process.
Proof. Take Taylor expansion of f ,
∂f ∂f 1 ∂2 f 2 1 ∂2 f 2 ∂2 f
df = dt + dX + (dX) + (dt) + dtdX. (9.41)
∂t ∂x 2 ∂ x2 2 ∂t 2 ∂ x∂t
Note that the the term (dX)2 should be ignored in normal differential, but in
stochastic differential this terms survive as we see in the following.
By (9.36), formally,
(dX)2 = µ 2 (dt)2 + 2µσ dtdW + σ 2 (dW )2 . (9.42)
Now we can igonre those terms with (dt)2 and dtdW which converges much faster
than dt. Also, by (9.34), (dW )2 = dt. Substituting these, we have the result.
Lemma 9.1. You can use the following conventions:
(dt)2 = 0, (9.43)
dtdW = 0, (9.44)
(dW )2 = 0. (9.45)
Theorem 9.5 (n-dimensional Ito’s formula). Given an n-dimensional stochastic

process
X(t) = (X1 (t), X2 (t), . . . , Xn (t)), (9.46)
with n-dimensional diffusion equation,
dX(t) = µdt + σ dW (t), (9.47)
set
Z(t) = f (t, X(t)). (9.48)
Then, we have the following change of variables rule:
∂f ∂f 1 ∂2 f
df = dt + ∑ dXi (t) + ∑ dXi (t)dX j (t). (9.49)
∂t i ∂ xi 2 i, j ∂ xi x j
9.5. CALCULUS OF STOCHASTIC INTEGRAL 73
Corollary 9.1. Let X(t) and Y (t) be diffusion processes, then
d(X(t)Y (t)) = X(t)dY (t) +Y (t)dX(t) + dX(t)dY (t). (9.50)
Proof. Use Ito’s formula (Theorem 9.5) and
dWi (t)dW j (t) = δi j dt, (9.51)

dWi dt = 0. (9.52)
Chapter 10
Examples of Stochastic Integral
For pricing via arbitrage theory, we need to evaluate the expectation of Wiener
process. We can use Ito’s formula for the evaluation.
10.1 Evaluation of E[W (t)4]

We already know that the mean and variance of W (t) by definition, i.e.,
E[W (t)] = 0, (10.1)
Var[W (t)] = t. (10.2)
But how about the higher moments?
Theorem 10.1. Let W (t) be a Wiener process, then
E[W (t)4 ] = 3t 2 . (10.3)
Proof. Let f (t, x) = x4 and

Z(t) = f (t,W (t)) = W (t)4 . (10.4)
In Ito’s formula (Theorem 9.4), we can set µ = 0 and σ = 1 and,
dX(t) = 0dt + 1dW (t) = dW (t). (10.5)
Then,
∂f ∂f 1 ∂2 f
dZ(t) = dt + dX + (dX)2 . (10.6)
∂t ∂x 2 ∂ x2
74
10.1. EVALUATION OF E[W (T )4 ] 75
Check
∂f
= 0, (10.7)
∂t
∂f
= 4x3 , (10.8)
∂x
∂2 f
= 12x2 , (10.9)
∂ x2
∂2 f
= 0, (10.10)
∂t 2
and we have
dZ(t) = 6W (t)2 dW (t)2 + 4W (t)3 dW (t). (10.11)
Since dW (t)2 = dt by Lemma 9.1, we can rewrite the dynamics for Z(t) = W (t)4
as
(
d(W (t)4 ) = 6W (t)2 dt + 4W (t)3 dW (t),
(10.12)
Z(0) = 0.
Integrating the both side of (10.12), we have
Z t Z t
4 2
W (t) = 6 W (s) ds + 4 W (s)3 dW (s). (10.13)
0 0
Taking the expectation, we have
Z t Z t
4 2 3
E[W (t) ] = 6E W (s) ds + 4E W (s) dW (s) (10.14)
0 0
Z t Z t
2 3

= 6 E W (s) ds + 4E W (s) dW (s) . (10.15)
0 0
√
Since W (s) is N[0, s], we have
E W (s)2 = s.

(10.16)
Also, by Theorem 9.1,
t
Z
3
E W (s) dW (s) = 0. (10.17)
0
Note that we used the fact W (s)3 ∈ L 2 . Now we can evaluate (10.14).
Z t
4
E[W (t) ] = 6 sds = 3t 2 . (10.18)
0
76 CHAPTER 10. EXAMPLES OF STOCHASTIC INTEGRAL
10.2 Evaluation of E[eαW (t)]

Theorem 10.2. Let W (t) be a Wiener process, then
α2
E[eαW (t) ] = e 2 t . (10.19)
Proof. Set Z(t) = eαW (t) . Then, by Ito’s forumula,
1
dZ(t) = α 2 eαW (t) dt + αeαW (t) dW (t). (10.20)
2
Problem 10.1. Show the above equation by using Ito’s formula.
Rewriting this, we have the stochastic differential equation,
1
dZ(t) = α 2 Z(t)dt + αZ(t)dW (t), (10.21)
2
Z(0) = 1. (10.22)
In integral form, we have

Z t Z t
1
Z(t) = 1 + α 2 Z(s)ds + α Z(s)dW (s). (10.23)
2 0 0
Since E[ 0t Z(s)dW (s)] = 0, taking the expectation, we have

R
Z t
1
m(t) = E[Z(t)] = 1 + α 2 m(s)ds. (10.24)
2 0
Or equivalently,
1
m0 (t) = α 2 m(t), (10.25)
2
m(0) = 1. (10.26)
By solving this, we have

2 t/2
E[eαW (t) ] = m(t) = eα . (10.27)
Chapter 11
Differential Equations
11.1 Ordinary Differential Equation

Theorem 11.1. Consider the following ordinary differential equation,
dB(t)
= rB(t), (11.1)
dt
B(0) = B0 . (11.2)
The solution of this equation is given by
B(t) = B0 ert . (11.3)
Proof. By reordering (11.1), we have
dB(t)
= rdt. (11.4)
B(t)
Integrating the both sides, we have
Z t Z t
dB(s)
= rds. (11.5)
0 B(s) 0
Thus,
log B(t) = rt +C, (11.6)
or
B(t) = Cert . (11.7)
77
78 CHAPTER 11. DIFFERENTIAL EQUATIONS
Using the initial condition (11.2), we finally have
B(t) = B0 ert . (11.8)
11.2 Geometric Brownian Motion

Definition 11.1 (Geometric Brownian Motion). A stochastic process X(t) satis-
fying the following dynamics is called geometric brownian motion.
dX(t) = αX(t)dt + σ X(t)dW (t), (11.9)

X(0) = x0 , (11.10)
where α is called the drift and σ is called the volatility.
Theorem 11.2 (SDE of Geometric Brownian Motion). The solution of the equa-
tion
dX(t) = αX(t)dt + σ X(t)dW (t), (11.11)

X(0) = x0 , (11.12)
is given by
2 /2)t+σW (t)
X(t) = x0 e(α−σ . (11.13)
Proof. Here the tricks we used in Theorem 11.1 may not work here because dW (t)
terms should be considered as the stochastic difference.
To simplify the proof, we assume X(t) > 0. Set
Z(t) = f (t, X(t)) = log X(t). (11.14)
Then by Ito’s formula (Theorem 9.4), we have
∂f ∂f 1 ∂2 f
dZ(t) = dt + dX(t) + 2
(dX(t))2
∂t ∂x 2 ∂x
dX(t) 1 (dX(t))2
= − . (11.15)
X(t) 2 X(t)2
11.3. STOCHASTIC PROCESS AND PARTIAL DIFFERENTIAL EQUATION79
By (11.11),
(dX(t))2 = α 2 X(t)2 (dt)2 + 2σ X(t)dW (t)αX(t)dt + σ 2 X(t)2 (dW (t))2

= σ 2 X(t)2 dt. (11.16)
Using this in (11.15) as well as (11.11), we have
1
dZ(t) = αdt + σ dW (t) − σ 2 dt. (11.17)
2
Luckily, the right hand side can be integrated directly here!
Z t t
1
Z
Z(t) − Z(0) = (α − σ 2 )ds + σ dW (s) (11.18)
0 2 0
1
= (α − σ 2 )t + σ dW (t). (11.19)
2
Using the initial condition (11.12), we have Z(0) = log x0 . Thus,
1
Z(t) = (α − σ 2 )t + σ dW (t) + log x0 , (11.20)
2
or
2 /2)t+σW (t)
X(t) = eZ(t) = x0 e(α−σ . (11.21)
Remark 11.1. This proof has not prove the existence of the solution yet. More
rigorous treatment of the proof, see the textbook like Oksendal [2003].
11.3 Stochastic Process and Partial Differential Equa-

tion
Theorem 11.3 (Feynman-Kac Represenation). Consider the following equation
of a function F = F(t, x):
∂F ∂ F 1 2 ∂ 2F
+µ + σ − rF = 0, (11.22)
∂t ∂ x 2 ∂ x2
80 CHAPTER 11. DIFFERENTIAL EQUATIONS
with its boundary condition,
F(T, x) = Φ(x). (11.23)
In addition, consider the following stochastic differential equation,
dX(t) = σ dt + σ dW (t). (11.24)
Then, the solution of (11.22) has the following Feynman-Kac representation:
F(t, x) = e−r(T −t) E[Φ(XT )|X(t) = x]. (11.25)

Chapter 12
Portfolio Dynamics
12.1 Portfolio Model

Theorem 12.1. Assume there is a market including N different stocks. Consider
we have a portfolio consisted with these N stocks. Let Si (t) be the price of stock i.
Let hi (t) be the number of stocks in our portfolio at time t. Then, the value of our
portfolio V (t) = S(t)h(t) has the following dynamics:
dV (t) = h(t)dS(t) − c(t)dt, (12.1)
which can be superficially understood as the change of value of our portfolio are
due to the change of the stock price and the consumption we made. Particularly,
when c(t) = 0,
dV (t) = h(t)dS(t). (12.2)
Proof. Analyze the dynamics of the value of our portfolio V (t). The value of our
portfolio at just before t, V (t − ∆t), can be estimated by
N
V (t − ∆t) = h(t − ∆t)S(t) = ∑ hi (t − ∆t)Si (t), (12.3)
i=1
for a small ∆t.

At time t, within our budget V (t − ∆t), we will make change of our portfolio
from h(t − ∆t) to h(t) based on the observation of the stock price S(t). When we
allow to consume a part of our portfolio, we have
V (t − ∆t) = h(t)S(t) + c(t)∆t, (12.4)
81
82 CHAPTER 12. PORTFOLIO DYNAMICS
where c(t) is the consumption rate at time t. Thus, we have the budget equation
as,
S(t)(h(t) − h(t − ∆t)) + c(t)∆t = 0. (12.5)
Remark 12.1. It is wrong to conclude
S(t)dh(t) + c(t)dt = 0, (12.6)
by letting ∆t → 0 in (12.5). Our stochastic calculus needs to have the forward

difference as,
S(t)(h(t + ∆t) − h(t)) → S(t)dh(t). (12.7)
We will rewrite (12.5) by subtracting the term S(t − ∆t)(h(t) − h(t − ∆t)), as
(S(t) − S(t − ∆t))(h(t) − h(t − ∆t)) + S(t − ∆t)(h(t) − h(t − ∆t)) + c(t)∆t = 0.
This has the appropriate forms of (present value) × (future difference). Thus, we
can take the limit to have the proper budget equation as,
dS(t)dh(t) + S(t)dh(t) + c(t)dt = 0. (12.8)
On the other hand, we can evaluate the current value of our portfolio as
V (t) = S(t)h(t). (12.9)
Using Ito’s formula (see Corollary 9.1) on this, we have
dV (t) = h(t)dS(t) + Sdh(t) + dS(t)dh(t). (12.10)
By (12.8),
dV (t) = h(t)dS(t) − c(t)dt, (12.11)
which can be superficially understood as the change of value of our portfolio are
due to the change of the stock price and the consumption we made. Particularly,
when c(t) = 0,
dV (t) = h(t)dS(t). (12.12)

12.2. RATE OF RETURN OF STOCK AND RISK-FREE ASSET 83
12.2 Rate of Return of Stock and Risk-free Asset

If the dynamics of the value process of some asset does not have any dW (t)-terms,
the value process inceases exponentially without any risk.
Definition 12.1 (Risk-free asset). The stochastic process B(t) is said to be risk-
free with its rate of return r(t) if
dB(t)
= r(t)B(t). (12.13)
dt
Assumption 12.1. Let S(t) be the price of a stock at time t, and the dynamics of
S(t) is governed by the stochastic differential equation as,
dS(t) = S(t)αdt + S(t)σ dW (t). (12.14)
Remark 12.2. Let us compare the rate of return of the risk-free asset B(t) and the
stock S(t). By Definition 12.1, formally, we have the rate of return of B(t) as
dB(t)
= r(t), (12.15)
B(t)dt
which is observable at time t. On the other hand, the rate of return of S(t) is
obtained by
dS(t) dW (t)
= α +σ . (12.16)
S(t)dt dt
Here we have the term of dW (t) that is essentially future information.
Definition 12.1. Let B(t) be the value of a risk-free asset and S(t) be the stock
price at time t. The Black-Scholes model is composed by the (B(t), S(t)), which
has the dynamics as
dB(t) = rB(t)dt, (12.17)
dS(t) = αS(t)dt + σ S(t)dW (t). (12.18)
12.3 Arbitrage and Portfolio

According to the result in Section 12.1, we have the budget dynamics of the port-
folio by
dV (t) = h(t)dS(t) − c(t)dt, (12.19)
84 CHAPTER 12. PORTFOLIO DYNAMICS
Generally, we have dW (t) terms in the dynamics of underlying stock price dy-
namics dS(t). So, overall, portfolio dynamics dV (t) contain the dW (t) terms. But
in some special case, we can make our portfolio so cleverly that we can avoid the
dW (t) terms, which means we have risk-free portfolio. In that case, the following
happens.
Theorem 12.2. Suppose there is a risk free asset as
dB(t) = r(t)B(t)dt. (12.20)
Consider a portfolio h(t) having the dynamics as,
dV (t) = k(t)V (t)dt, (12.21)
for some function k(t). Apparently, the value of our portfolio V (t) does not have
any risk. Assume we have no arbitrage, then the rate of return of our risk-free
portfolio is r(t), i.e.,
k(t) = r(t). (12.22)
Proof. Assume r(t) and k(t) to be constant r and k for simplicity. First, let us
suppose k > r. Then, we can sell the risk-free asset B(t) and use the money in our
portfolio V (t). The rate of return r for selling the risk-free asset can be covered
by our portfolio, which has the rate of return k. This contradicts the no-arbitrage
assumption.
In the case of k < r, we can reverse the argument.
Remark 12.3. Thus, there is a unique rate of return for risk-free asset, which turns
out to be the short-term interest rate of bank account.
Chapter 13
Pricing via Arbitrage
13.1 Way to Black-Scholes Model

We would like to evaluate the price of an option at time t,
Π(t) = Π(t, S(t)), (13.1)
given that the option is expired at time T and have the value
Π(T ) = Φ(S(T )). (13.2)
Typically,
Φ(S(T )) = (S(T ) − K)+ = max(S(T ) − K, 0) (13.3)
Here’s the procedure to derive Black-Scholes equation:
1. Consider the Black-Scholes model,
dB(t) = rB(t)dt, (13.4)

dS(t) = αS(t)dt + σ S(t)dW (t). (13.5)
2. Show we can build a risk-free portfolio h(t) using the Black-Scholes model,
which has no dW (t)-terms.
3. The rate of return of our portfolio should be the short-term interest rate r
because of Theorem 12.2.
85
86 CHAPTER 13. PRICING VIA ARBITRAGE
4. Based on the assumption above, evaluate the dynamics of the option price
Π(t), (13.6)
using Ito’s formula.
5. Solving the dynamics and use so-called Feyman-Kac representation (Theo-

rem 11.3) to have
Π(t, S(t)) = e−r(T −t) E[(S(T ) − K)+ |S(t)]. (13.7)

Bibliography
T. Bjork. Arbitrage Theory in Continuous Time. Oxford Finance. Oxford Univ Pr,
2nd edition, 2004.
R. Durrett. Probability: Theory and Examples. Thomson Learning, 1991.
K. Ito. Probability Theory. Iwanami, 1991.
B. Oksendal. Stochastic Differential Equations: An Introduction With Applica-

tions. Springer-Verlag, 2003.
S. M. Ross. An Elementary Introduction to Mathematical Finance: Options and

Other Topics. Cambridge Univ Pr, 2002.
H. Toyoizumi. Statistics and probability for business.

http://www.f.waseda.jp/toyoizumi/classes/accounting/stat/2007/business.pdf,
2007a.
H. Toyoizumi. Mathematics for management.

http://www.f.waseda.jp/toyoizumi/classes/accounting/math/2007/matht.pdf,
2007b.
87

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Mathematical Finance

September 26, 2012

2 Normal Random Variables 7

3 Large Sum of Random Variables 14

4 Useful Probability Theorems 21

6 Tools for Modeling Dynamics of Stock Prices 34

7 On a Way to Black-Scholes Formula 45

8 Delta Hedging Strategy 55

10 Examples of Stochastic Integral 74

13 Pricing via Arbitrage 85

R. Durrett. Probability: Theory and Examples. Thomson Learning, 1991.

K. Ito. Probability Theory. Iwanami, 1991.

B. Oksendal. Stochastic Differential Equations: An Introduction With Applica-

S. M. Ross. An Elementary Introduction to Mathematical Finance: Options and

H. Toyoizumi. Statistics and probability for business.

H. Toyoizumi. Mathematics for management.

Using the knowledge of probabilities and statistics studied in

• Mathematics for Management (Toyoizumi [2007b]) and

• Statistics and Probability for Business (Toyoizumi [2007a]),

Normal Random Variables

Normal random variable is important tool to analyze a series of independent ran-

2.1 What is Normal Random Variable?

and the variance

Definition 2.2 (Standard normal random variable). Let X be a normal random

Proof. See Exercise 2.5.

Proof. We just prove X satisfies (2.4) and (2.5). We have

We can prove that X is a normal random variable by using so-called charac-

So, it is very comfortable to be in the world of normal random variables. Very

2.2 Lognormal Random Variables

where X is a normal random variable. Lognormal random variables plays a mea-

m(t) = E[etX ]. (2.9)

Then, by differentiate the left hand side and setting t = 0, we have

m00 (0) = E[X 2 ].

Problem 2.3. Derive m00 (0) = E[X 2 ].

Since tx − x2 /2 = {t 2 − (x − t)2 }/2, we have

(See exercise 2.6.) Since Y = eX , we have

2.3 Lognormal Random Variables as the Stock Price

In mathematical finance, it is commonly assumed that Y (n) is independent and

log S(n) = log S(n − 1) + X(n), (2.16)

P{the stock rises} = P{S(1) > S(0)}

where X = logY (1) is N(µ, σ 2 ), and we can define

P{X > −x} = P{X < x}. (2.18)

Exercise 2.2 (moment generating function). Let X be a random variable. The

1. Prove E[X] = m0 (0).

3. Rewrite the variance of X using m(t).

1. Find the moment generating function of X.

2. By differentiation, find the mean and variance of X.

Exercise 2.6. Verify (2.11) by using Lemma 2.1

Exercise 2.7. Let Y = eX be a lognormal random variable where X is N(µ, σ ).

Large Sum of Random Variables

Problem 3.1. Do you think these figures are similar?

3.1 The Law of Large Numbers

This intuition can be validated by the following theorems.

Let Sn = ∑ni=1 Xi . Then, for all ε > 0,

P{|Sn /n − µ| > ε} → 0 as n → ∞. (3.3)

Figure 3.1: An example of Tree binomial process with d = 0.970446, u =

Figure 3.2: Exchange rate of yen at 2005/10/19. Adopted from

3.2 Poisson Random Variables and the Law of Small

3.3 The Central Limit Theorem

Theorem 3.5 (Central limit theorem). For a large n, we have

3.4 Examples of Sum of Random Variables

ping. Suppose we are going to evaluate the sample average A of Xi ’s;