Stochastic Calculus for Finance 1: The Binomial Asset Pricing Model

Chapter 1: The Binomial No-Arbitrage Pricing Model

Chapter 2: Probability Theory on Coin Toss Space
Chapter 3: State Prices
(Study Note FET-174-10)
(Pages 1-15, 25-45, 61-71)

These chapters are included for background only. Therefore, you should not allocate too much
of your limited study time to these chapters.

One-Period Binomial Model

S1 ( H ) = uS0
S0
S1 (T ) = dS0
To eliminate arbitrage,
0 < d < 1+r < u

( )
Can solve for the risk-neutral probability of an up ( p% ) and down d% move

1+ r - d u -1 - r
p% = q% =
u-d u-d
p% + q% = 1 p% > 0 q% > 0
Can also solve for the delta of the hedge portfolio
V1 ( H ) - V1 (T )
D0 =
S1 ( H ) - S1 (T )

Multiperiod Binomial Model

S 2 ( HH ) = u 2 S0
S1 ( H ) = uS 0
S0 S 2 ( HT ) = S 2 (TH ) = udS0
S1 (T ) = dS0
S 2 (TT ) = d 2 S 0

FETE Seminar Page 35 of 36 Section 3

Fundamental properties of conditional expectations
1. Linearity of conditional expectations
En ( c1 X + c2Y ) = c1 En ( X ) + c2 En (Y )
2. Taking out what is known
If X depends only on the first n coin tosses, then En [ XY ] = X × En [Y ]
3. Iterated conditioning
If 0 £ n £ m £ N , then
En [ Em ( X ) ] = En ( X )
4. Independence
If X depends only on tosses n+1 through N, then En [ X ] = E ( X )
5. Conditional Jensen’s inequality
En [j ( X ) ] ³ j [ En ( X ) ] where j ( x) is a convex function

Martingale
M n = En [ M n+1 ] , n = 0,1,K , N - 1

Actual versus Risk-Neutral Probabilities

Capital Asset Pricing Model (CAPM)

FETE Seminar Page 36 of 36 Section 3