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Lecture 1
Lecture 1
Paweª Kliber
An option
Bull market
Bear market
Arbitrage argument
A single good must sell for the same price in all locations.
Forward contract
Bank account
There are two possible ways in dening the value of the bank account
Simple compounding: B0 = 1, B1 = 1 + r
Continuous compounding: B0 = 1, B1 = e r˜
Connection between them:
r = e r˜ − 1
r˜ = ln(1 + r )
Model
Further assumptions
Frictionless market
No transaction costs
Perfect liquidity
Probabilistic model
S1 = S0 Z ,
where Z is a discrete random variable with the following distribution
More formally
Z = uU + d(1 − U),
where U is a random variable from Bernoulli distributions, i.e.
P(U = 1) = p,
P(U = 0) = 1 − p.
Another specication
S1 = S0 e Z ,
where Z is a discrete random variable with the following distribution
˜
P(Z = ũ) = p = 1 − P(Z = d).
˜
u = e ũ , d = e d
ũ = ln(u) d˜ = ln(d)
Some processes
Value process: Vt = h0 Bt + h1 St , (t = 0, 1)
Gain process: G = h0 ∆B + h1 ∆S
Discounted processes S̃t = BStt
Ṽt = h0 B̃t + h1 S̃t , (t = 0, 1)
G̃ = h0 ∆B̃ + h1 ∆S̃ = h1 ∆S̃
Arbitrage opportunity
V0 = 0
V1 ≥ 0
P(V1 > 0) > 0
G̃ ≥ 0
Arbitrage
Lack of arbitrage
d <1+r <u
1 + r = qu + (1 − q)d,
1 +r −d u − (1 + r )
q= , 1 −q = .
u−d u−d
Expectations
Martingale expectations
1
S0 = EQ [S1 ] .
1 +r
Today's price of stock is the discounted expected value of tomorrow's
prices (with respect to probabilities q, 1 − q ).
Contingent claims
xu = h0 (1 + r ) + h1 us
xd = h0 (1 + r ) + h1 ud
Replication
The solution is
xd u − xu d
h0 =
(1 + r )(u − d)
xu − xd
h1 =
s(u − d)
xd u − xu d xu − xd
V0 = + ·s =
(1 + r )(u − d) s(u − d)
1 1+r −d u − (1 + r )
= xu + xd =
1+r u−d u−d
1 1 Q Q X
= (qxu + (1 − q)xd ) = E [X ] = E
1 +r 1 +r 1+r
1 xu usq xd ds(1 − q)
V0 = (qxu + (1 − q)xd ) = s +s
1 +r us s(1 + r ) ds s(1 + r )
Let us dene
usq ds(1 − q)
qS = , (1 − q S ) =
s(1 + r ) s(1 + r )
u d
V0 Sx S x QS X
=q + (1 − q ) =E
S0 su sd S1
Model mathematically
St = S0 u Nt d t−Nt ,
where
Nt = Z1 + Z2 + Z3 + . . . + Zt ,
Zt iid (identically distributed and independent) random variables from
Bernoulli distribution. The distribution of Nt is binomial Zt ∼ B(t, p).
Binomial tree
Strategy
Some processes
Value process
V0 = h0 (1)B0 + h1 (1)S0
Vt = h0 (t)Bt + h1 (t)St , (t = 1, 2, . . . , T )
Gain process
∆Gt = h0 (t)∆Bt + h1 (t)∆St = rh0 (t)Bt−1 + h1 (t)∆St
Discounted processes
Ṽt = h0 (t) + h1 (t)S̃t , (t = 1, 2, . . . , T )
∆G̃t = h1 (t)∆S̃t
Self-nancing portfolios
The value of the old portfolio, created at t −1 and held till t, equals
the value of the new portfolio, created at the moment t.
It can be shown that it is equivalent with
Vt = V0 + Gt
and
Ṽt = Ṽ0 + G̃t
The value of portfolio at any moment t is equal to the initial value plus
gains on the strategy.
Arbitrage
V0 = 0
P(VT ≥ 0) = 1 (almost surely a.s.)
P(G̃T ≥ 0) = 1
P(G̃T > 0) > 0
Denition
1
St = EQ [St+1 | Ft ]
1 +r
Values
+r −d
1
qu =
u−d
u − (1 + r )
qd =
u−d
1
Π(t; X ) = EQ [X | Ft ]
(1 + r )T −t
Thus the initial price is given by
1
Π(0; X ) = EQ [X ]
(1 + r )T
Replicating
Algorithm
Example
Example
American instruments
Algorithm I
1
pt (k) = [qu Vt+1 (k + 1) + qd Vt+1 (k)] , t = 0, 1, . . . , T − 1
1 +r
5 Calculate value of option
Algorithm II
Example
Example
Trinomial model
Example
1
Assume u = 1.2, b = 1.1, d = 0.8 and pu = pb = pd = 3 . Interest rate
r = 0%
Martingale measure
qu S0 u + qb S0 b + qd S0 d = (1 + r )S0
qu + qb + qd = 1
In our example
Pricing
Pricing
h0 + 120h1 = 20
h0 + 110h1 = 10
h0 + 80h1 = 0
There are N dierent stock and bank account (or risk-free bond). For
simplicity we treat bond as a stock with number 0.
S00 = 1, S10 = 1 + r
Let S0n be initial price of stock n. The price S1n is a random variable.
Using vector and matrix notation:
Model
There are K possible states of the world in the future. The sample space
is thus
Ω = {ω1 , ω2 , . . . , ωK }
All of them have positive probabilities P(ω) > 0.
Let S1n (ω) be the price of stock n in the state of the world ω.
We can also write
Some processes
Example
Example
Discounted processes
Divide all processes by the value of bank account
Stn
S̃tn =
St0
of course
S̃0n = S0n
and
S̃t0 = St0
Discounted value
N
Vt X
Ṽt = = Hn S̃tn
St0 n=0
N
X N
X
G̃ = Ṽ1 − Ṽ0 = Hn ∆S̃tn = Hn ∆S̃tn ,
n=0 n=1
as ∆S̃ = 0.
Paweª Kliber Stochastic Finance
Discrete models
Matrix notation
Ṽ0 = S0T H
T
Ṽ1 = H T ~
S =~
ST H
Arbitrage I
V0 = 0, V1 > 0 a.s.
G̃ > 0 a.s.
Arbitrage II
Arbitrage III
Theorem
Proof.
δ
Ṽ0∗ = Ṽ0 − <0
2
δ δ δ
Ṽ1∗ = Ṽ1 − ≥δ− = >0
2 2 2
Farkas lemma
Let A be a matrix m×n and b ∈ Rm . Then one and only one of the
following alternatives is true:
Ax = b
x ≥0
yT A ≥ 0
yT b < 0
yT A = yT~
S = Ṽ1T ≥ 0
and
y T b = y T S0 = V0 < 0
And this means that strong arbitrage opportunity exists.
Ax = ~
S = S0
PK
From the rst row:
PK k=1 xk = 1. From the next rows:
n n
k=1 xk S1 (ωk ) = S0 . The elements of x can be treated as probabilities:
Q(ωk ) = xk .
Thus we have an alternative. Either
Completness
Second theorem
1
Π(0, X ) = EQ [X ]
1 +r
1 2 N
Stocks St = (St , St , . . . , St ) stochastic processes
0 1 N
Investment strategy: Ht = (ht , ht , . . . , ht ), t = 1, . . . , T
predictable stochastic process
Value process
N
X
V0 = h1n S0n
n=0
N
X
Vt = htn Stn for t>0
n=0
Pt PN
Gain process Gt = s=1 n=0 htn ∆Stn
Strategy is self-nancing if Vt = V0 + Gt
Paweª Kliber Stochastic Finance
Discrete models
Information
J
[
∀A ∈ Pt ∃A1 , A2 , . . . , AJ ∈ Pt+1 : A = Aj
j=1
Additionaly
Partition P0
Partition P1
Partition P2
Partition P3
Discounted processes
Stn
S̃tn = St0
S̃t0 = 1
Vt PN
Ṽt = St0
= n=0 htn S̃tn s
Pt PN Pt PN
G̃t = s=1 n=0 htn ∆S̃tn = s=1 n=1 htn ∆S̃tn
For self-nancing strategy Ṽt = V0 + G̃t
Submodels
Fundamental theorems
h i
n
EQ S̃t+s | Ft = S̃tn
XT FT -measurable
E [X | Ft ]
Ft -measurable random variable
Interpretation.
Partition P0
Partition P1
Partition P2
Partition P3
Properties
E [aX + bY | Ft ] = aE [X | Ft ] + bE [Y | Ft ]
If X1 ≤ X2 , then E [X1 | Ft ] ≤ E [X2 | Ft ]
E [X | F0 ] = E [X ]
If X is independent on Ft , then E [X | Ft ] = E [X ]
If X ∈ Ft , then E [X | Ft ] = X
If Y ∈ Ft , then E [XY | Ft ] = Y E [X | Ft ]
(Tower property I) Let s < t . E [E [X | Fs ] | Ft ] = E [X | Fs ]
(Tower property II) Let s < t . E [E [X | Ft ] | Fs ] = E [X | Fs ]
Martingale
E [Xt+s | Ft ] = Xt
It is equivalent with
Xt = E [XT | Ft ]
where T nal moment
Supermartingale:
E [Xt+s | Ft ] ≤ Xt
Submartingale:
E [Xt+s | Ft ] ≥ Xt
Example
Forward contracts
Forward price
Arbitrage pricing
The contract is equivalent with the portfolio in which at T there is 1
stock (S ) and −O euros. Thus its value at t is
St − OP(t, T )
Forward price
Martingale pricing
Value of the contract
Q ST − O Q ST Q 1
E | Ft = E | Ft − OE | Ft
BT BT BT
h i
ST
EQ BT | Ft S
Ot = h i= h t i
1 1
EQ BT | Ft Bt EQ BT | Ft
Futures
Model
Bank account B
Undelying asset S
Futures price U
Strategy H(t) = (H0 (t), H1 (t), H2 (t)), where H2 (t) number of futures
contracts (from moment t − 1 to t ).
After transaction:
Vt = H0 (t + 1)Bt + H1 (t + 1)St
Gain process:
After transaction:
Vt = H0 (t + 1) + H1 (t + 1)S̃t
Gain process:
∆G̃t = H1 (t)∆S̃t + H2 (t)∆Ut /Bt
Paweª Kliber Stochastic Finance
Discrete models
Risk-neutral measure
h i
EQ ∆G̃t | Ft−1 = 0
Risk-neutral measure
St h i St+s
S̃t = = EQ S̃t+s | Ft = EQ | Ft
Bt Bt+s
Ut = EQ [Ut+s | Ft ]
Ut = EQ [UT | Ft ] = EQ [ST | Ft ]
If interest rate is deterministic
ST St BT
Ut = EQ BT | Ft = BT = St = Ot
BT Bt Bt
If interest rate is deterministic, then futures prices and forward prices are
the same.
In other case the dierences between Ot and Ut contains information
about possible changes in interest rates.
Derivatives on futures
Binomial model
Le us consider a node k at moment t. Interest rate is constant, r.
1 +r −d u−1−r
q= 1 −q =
u−d u−d
Binomial model
u d
ū = d¯ =
1+r 1+r
Binomial model
Martingale probabilities
1 − d¯ ū − 1
q= 1 −q =
ū − d¯ ū − d¯
Paweª Kliber Stochastic Finance
Discrete models
Option on futures
Let 0 < S < T. Consider a call option on futures prices with delivery at
T. The execution moment is S and the execution price is K.
Payo:
X = (US − K )+
To price we use direct binomial tree with parameters ū and d¯.
Pricing
n
X n
B(k; n, p) = p i (1 − p)n−i
i
i=k
Let A be the rst index k such that U0 ū A d¯S−A ≥ K . Then the price of
the option at t= is
S
X
S
S0 ū i d¯S−i − K q i (1 − q)S−i =
X0 (1 + r ) =
i=A
S
X S
X
= S0 ū i d¯S−i q i (1 − q)S−i − K q i (1 − q)S−i =
i=A i=A
S
X S
X
= S0 ¯ 1 − q))S−i − K
(ūq)i (d( q i (1 − q)S−i =
i=A i=A
= S0 B 0 (A; S, ūq) − KB 0 (A; S, q)
Thus
where
− S ln d¯
& K
'
ln
U0
A= ū
ln ¯
d
S2 as numeraire: B̄t = Bt
S2 (t) , S¯1 (t) = SS12 (t) ¯
(t) , S2 (t) = 1
Self-nancing
At t −1 before transaction:
After transaction
+
V̄t− 1 = H0 (t)B̄t−1 + H1 (t)S̄1 (t − 1) + H2 (t)
+
For self-nancing strategy V̄t−1 = V̄t− 1.
Self-nancing
Arbitrage
Arbitrage opportunity
V0 = 0
VT ≥ 0
P(VT > 0) > 0
Dividing by S2 :
V̄0 = 0
V̄T ≥ 0
P(V̄T > 0) > 0
Thus
ḠT ≥ 0
P(ḠT > 0) > 0
Martingale measure
h i
Sn (0) = EQ S̃n (T )
Let
S2 (T , ω) B0
Q̄(ω) = Q(ω)
S2 (0) BT (ω)
Thus
Q̄(ω) S2 (T , ω) B0
=
Q(ω) S2 (0) BT (ω)
X Sn (T , ω) X Sn (T , ω) S2 (T , ω) B0
EQ̄ S̄n (T ) = Q̄(ω) = Q(ω) =
S2 (T , ω) S2 (T , ω) S2 (0) BT (ω)
ω∈Ω ω∈Ω
1 X Sn (T , ω) 1
h i
= Q(ω) = EQ S̃n (T ) =
S2 (0) BT (ω) S2 (0)
ω∈Ω
Sn (0)
= = S̄n (0)
S2 (0)
Forward measure
Q̄(ω) 1
=
Q(ω) P(0, T )BT
Sn (0) Sn (0) Sn (T )
S̄n (0) = = = EQ̄ S̄n (T ) = EQ̄ =
S2 (0) P(0, T ) P(T , T )
= EQ̄ [Sn (T )]
X0 = P(0, T )EQ̄ X̄ = P(0, T )EQ̄ [X ]
For any moment t:
Xt = P(0, T )EQ̄ X̄ | Ft = P(0, T )EQ̄ [X | Ft ]
Example
Binomial model
u = 1.2, d = 0.9
Interest rate can be r = 10% or r = 0%
Model
Risk-neutral measure
All prices
Martingale measures
Martingale measure
22 4 21 2
Q(ω1 ) = = Q(ω2 ) = =
33 9 33 9
11 1 12 2
Q(ω3 ) = = Q(ω4 ) = =
33 9 33 9
Forward measure
4 1 2 1
Q̄(ω1 ) = = 0.4301 Q̄(ω2 ) = = 0.2151
9 0.8540 · 1.21 9 0.8540 · 1.21
1 1 2 1
Q̄(ω3 ) = = 0.1183 Q̄(ω4 ) = = 0.2366
9 0.8540 · 1.1 9 0.8540 · 1.1
Conditional probabilities
2 1
Q̄(ω1 | {ω1 , ω2 }) = Q̄(ω2 | {ω1 , ω2 }) =
3 3
1 2
Q̄(ω3 | {ω3 , ω4 }) = Q̄(ω4 | {ω3 , ω4 }) =
3 3
Pricing
A call option with the strike price K = 100.
Pricing
X0 = Q̄(ω1 )X (ω1 ) + Q̄(ω2 )X (ω2 ) + Q̄(ω3 )X (ω3 ) + Q̄(ω4 )X (ω4 ) =
=0.8540 [0.4301 · 44 + 0.2151 · 8 + 0.1183 · 8 + 0.2366 · 0] =
=18.4390
2 1
X1 (ω1 , ω2 ) = 0.9091 · 44 + · 8 = 29.0909
3 3
1 2 8
X1 (ω3 , ω4 ) = 1 ·8+ ·0 =
3 3 3