Financial Engineering & Risk Management

MFIM 7111

Tamirat Temesgen (PhD)

Addis Ababa University

School of Comerce

October 25, 2023

 Table of Contents

1 The Fundamental Theorem of Asset Pricing

Risk
No Arbitrage Principle
Binomial Trees
A one-step binomial model and a no-arbitrage argument
Risk-Neutral Valuation
Two-Step Binomial Trees
Matching Volatility with u and d
Options on Other Assets
The Fundamental Theorem of Asset Pricing
Risk

Risk

Risk is the possibility of exposure to uncertain losses in the future. Types

of risks:
1 Credit risk : the risk of not receiving back loan form the borrower.
2 Market risk : caused by unexpected asset price movement
3 Operational risk : risks form malfuncitoning of a computer system,
or fraudulent activity of employees, etc.
The Fundamental Theorem of Asset Pricing
Risk

Investors prefers less risky investment if all other conditions are the
same.
The basic principle of investment is that the payoff should be large if
the risk level is high.
Risk management refers to management activities to protect asset
values form the risks in investment.
Hedging is completely eliminating the risk in an investment.
The Fundamental Theorem of Asset Pricing
No Arbitrage Principle

No Arbitrage Principle

Arbitrage : An opportunity to make a profit without risking any

future loss. It exists as a result of market inefficiencies.
An arbitrage trade means a transaction generating risk-free profit by
buying and selling related assets with no net investment of cash.
If the market functions perfectly, there would be no arbitrage
opportunities.
All the participants in the financial market look for any possibility of
arbitrage and make riskless profit if there exists one.
Arbitrage chances only last for a very short period of time
The Fundamental Theorem of Asset Pricing
No Arbitrage Principle

Let us denote Vt the value of a portfolio at time t. We consider two time

points t = 0 and t = T > 0.

Definition 1 (Arbitrage)
We say that there exist an arbitrage if there is a portfolio V satisfying
one of the following conditions:
(i) V0 = 0, and VT ≥ 0 with probability one and VT > 0 with positive
probability, or
(ii) V0 < 0, and VT ≥ 0 with probability one.
The no arbitrage principle means that one cannot create positive value
out of nothing, i.e., there is no free lunch.
The Fundamental Theorem of Asset Pricing
Binomial Trees

Binomial Trees

the binomial tree model helps to explain the nature of the

no-arbitrage arguments that are used for valuing options
helps to explain the principle known as risk-neutral valuation
The Fundamental Theorem of Asset Pricing
Binomial Trees

A Simple Binomial Model

A stock price is currently $20

In 3 months it will be either $22 or $18

Stock price =$22

Stock price = $20

Stock price =$18

Figure: Simple Binomial Model: Example

The Fundamental Theorem of Asset Pricing
Binomial Trees

A Call Option

1
A 3-month call option on the stock has a strike price of 21
Stock price =$22
Option Payoff = $1
Stock price = $20
Option Price = ?
Stock price =$18
Option Payoff =$0

1AEuropean call option on security St is the right to buy the security at a present
strike price K. The payoff is given by max(ST − K, 0) = (ST − K)+
The Fundamental Theorem of Asset Pricing
Binomial Trees

Setting Up a Riskless Portfolio

For a portfolio that is long ∆ shares and a short 1 call option values are

22∆ − 1

18∆

The portfolio is riskless if the value of ∆ is chosen so that the final

vale the portfolio is the same for both alternatives.
Portfolio is riskless when 22∆ − 1 = 18∆ or ∆ = 0.25
The Fundamental Theorem of Asset Pricing
Binomial Trees

Valuing the Portfolio

(Risk-Free rate is 4%)

The riskless portfolio is:
long 0.25 shares
short 1 call option
The value of the portfolio in 3 months is

22 × 0.25 − 1 = 4.50

The value of the portfolio today is

4.5e−0.04×0.25 = 4.455

(no arbitrage opportunities =⇒ risk-less portfolios are expected to

yield the risk-free interest rate.)
The Fundamental Theorem of Asset Pricing
Binomial Trees

Valuing the option

The portfolio that is

long 0.25 shares
short 1 option
is worth 4.455
The value of the shares is

5.00(= 0.25 × 20)

The value of the option is therefore

5.00 − 4.455 = 0.545

The Fundamental Theorem of Asset Pricing
Binomial Trees

Generalization

A derivative lasts for time T and is dependent on a stock

S0 u
fu
S0
f
S0 d
fd

Figure: Stock and option prices in a general one-step tree

The Fundamental Theorem of Asset Pricing
Binomial Trees

Value of a portfolio that is long ∆ shares and short 1 derivative:

If there is an up movement in the stock price, the value of the
portfolio at the end of the life of the option is

S0 u∆ − fu

If there is a down movement in the stock price, the value becomes

S0 d∆ − fd

The two are equal when

S0 u∆ − fu = S0 d∆ − fd

or
fu − fd
∆=
S0 u − S0 d
In this case, the portfolio is riskless and, for there to be no arbitrage
opportunities, it must earn the risk-free interest rate
The Fundamental Theorem of Asset Pricing
Binomial Trees

Value of the portfolio at time T is S0 u∆ − fu

Value of the portfolio today is (S0 u∆ − fu )e−rT
Another expression for the portfolio value today is S0 ∆ − f
Hence
f = S0 ∆ − (S0 u∆ − fu )e−rT .
Substituting for ∆ we obtain

f = [pfu + (1 − p)fd ]e−rT (1)

where
erT − d
p=
u−d
The Fundamental Theorem of Asset Pricing
Binomial Trees

p as a Probability

It is natural to interpret p and 1 − p as probability of up and down

movements
The value of a derivative is then its expected payoff in a risk-neutral
world discounted at the risk-free rate

S0 u
p fu
S0
f
(1 − S0 d
p)
fd
The Fundamental Theorem of Asset Pricing
Binomial Trees

Original Example Revisited

S0 u = 22
p fu = 1
S0 = 20
f
(1 −
p) S0 d = 18
fd = 0

Figure:

p is the probability that gives a return on the stock equal to the risk-free
rate:
20e0.04×0.25 = 22p + 18(1 − p)
so that p = 0.5503
The Fundamental Theorem of Asset Pricing
Binomial Trees

Alternatively:

erT − d e0.04×0.25 − 0.9

p= = = 0.5503
u−d 1.1 − 0.9
The Fundamental Theorem of Asset Pricing
Binomial Trees

Irrelevance of Stock’s Expected Return

When we are valuing an option in terms of the price of the

underlying asset, the probability of up and down movements in the
real world are irrelevant
This is an example of a more general result stating that the expected
return on the underlying asset in the real world is irrelevant
The Fundamental Theorem of Asset Pricing
Risk-Neutral Valuation

Risk-Neutral Valuation

When valuing a derivative, we can make the assumption that

investors are risk-neutral.
A world where investors are risk-neutral is referred to as a
risk-neutral world.
A risk-neutral world has two features that simplify the pricing of
derivatives:
1 The expected return on a stock (or any other investment) is the
risk-free rate.
2 The discount rate used for the expected payoff on an option (or any
other instrument) is the risk-free rate.
The Fundamental Theorem of Asset Pricing
Risk-Neutral Valuation

Risk-Neutral Valuation ... Cont’d

In equation (1),
f = [pfu + (1 − p)fd ]e−rT ,

p is the probability of an up movement in a risk-neutral world, so

that 1 − p is the probability of a down movement in this world.
The expression
pfu + (1 − p)fd
is the expected future payoff form the option in a risk-neutral world
equation (1), states that the value of the option today is its
expected future payoff in a risk-neutral world discounted at the
risk-free rate. This is application of risk-neutral valuation.
The Fundamental Theorem of Asset Pricing
Risk-Neutral Valuation

Risk-Neutral Valuation ... Cont’d

To prove the validity of our interpretation of p, we note that, when p is

the probability of an up movement, the expected stock price E(ST ) at
time T is given by

E(ST ) = pS0 u + (1 − p)S0 d

or
E(ST ) = pS0 (u − d) + S0 d
Substituting for p gives,
E(ST ) = S0 erT (2)
The Fundamental Theorem of Asset Pricing
Risk-Neutral Valuation

Risk-Neutral Valuation ... Cont’d

Remark 1
Risk-neutral valuation is a very important general result in the
pricing of derivatives
It also works when the stock price follows a continuous-time
stochastic process
It is a result that is true regardless of the assumptions made about
the evolution of the stock price.
The Fundamental Theorem of Asset Pricing
Risk-Neutral Valuation

Risk-Neutral Valuation ... Cont’d

Remark 2
To apply risk-neutral valuation to the pricing of a derivative,
1 calculate what the probabilities of different outcomes would be if the
world were risk-neutral.
2 calculate the expected payoff from the derivative and
3 discount that expected payoff at the risk-free rate of interest
The Fundamental Theorem of Asset Pricing
Two-Step Binomial Trees

Two-Step Binomial Tree

24.2
D
22
B
19.8
20 A E
18
C
16.2
F

Figure: Stock prices in a two step tree

K = 21, r = 4%
Each time step is 3 months
The Fundamental Theorem of Asset Pricing
Two-Step Binomial Trees

Valuing a Call Option

24.2
D
3.2
22
B
1.7433
19.8
20 A E
0.9497 0.0
18
C
0.0
16.2
F
0.0

Figure:

Value at node B = e−0.04×0.25 (0.5503 × 3.2 + 0.4497 × 0) = 1.7433

Value at node A = e−0.04×0.25 (0.5503 × 1.7433 + 0.4497 × 0) = 0.9497
The Fundamental Theorem of Asset Pricing
Two-Step Binomial Trees

A Put Option Example

72
D
0.0
60
B
1.4147
48
50 A E
4.1923 4
40
C
9.4636
32
F
20

Figure:

K = 52, time step =1yr

r = 5%, u = 1.2, d = 0.8, p = 0.6282
The Fundamental Theorem of Asset Pricing
Two-Step Binomial Trees

What Happens When the Put Option is American2

72
D
0.0
60
B
1.4147
48
50 A E
5.0894 4
40
C
12.0
32
F
20

Figure: Using a two-step tree to value an American put option. At each node,
the upper number is the stock price and he lower number is the option price

2 may
be exercised at any time up to and including the expiration date. The payoff
is (K − St )+ 0 ≤ t ≤ T
The Fundamental Theorem of Asset Pricing
Two-Step Binomial Trees

The American feature increase the value at node C form 9.4636 to

12.0000
This increase the value of the option form 4.1932 to 5.0894
The Fundamental Theorem of Asset Pricing
Two-Step Binomial Trees

Delta

Delta (∆) is the ratio of the change in the price of a stock option to
the change in the price of the underlying stock
It is the number of units of the stock we should hold for each option
shorted in order to create a riskless portfolio.
It is the same as the ∆ introduced earlier.
The value of ∆ varies form node to node.
The construction of a risk-less portfolio is sometimes referred to as
delta hedging.
The Fundamental Theorem of Asset Pricing
Matching Volatility with u and d

Choosing u and d

One way of matching the volatility is to set

√
u = eσ ∆t ,
1 √
d = = e−σ ∆t ,
u
where σ is the volatility and ∆t is the length of the time step. This is
the approach used by Cox, Ross, and Rubinstein (1979).
The Fundamental Theorem of Asset Pricing
Matching Volatility with u and d

The parameters u and d should be chosen to match volatility

The volatility of a stock (or any other asset), σ, is defined so that
the
√ standard deviation of its return in a short period of time ∆t is
σ ∆t.
√
standard deviation of return = Volatility × ∆t

Equivalently the variance of the return in time ∆t is σ 2 ∆t.

Var(return) = Volatility2 × ∆t

Recall that, the variance ot a variable X is defined as

E(X 2 ) − [E(X)]2 , where E denotes expected value.
The Fundamental Theorem of Asset Pricing
Matching Volatility with u and d

During a time step of length ∆t, there is a probability p that the

sock will provide a return of u − 1 and a probability 1 − p that will
provide a return of d − 1.
It follows that volatility is matched if

p(u − 1)2 + (1 − p)(d − 1)2 + [p(u − 1) + (1 − p)(d − 1)]2 = σ 2 ∆t (3)

Substituting for p this simplifies to

er∆t (u + d) − ud − e2r∆t = σ 2 ∆t

When terms in ∆t2 and higher powers of ∆t are ignored, a solution

to the equation is
√ √
u = eσ ∆t
and d = e−σ ∆t
The Fundamental Theorem of Asset Pricing
Matching Volatility with u and d

Grisanov’s Theorem

Volatility is the same in the real world and the risk-neutral world
We can therefore measure volatility in real world and use it to build
a tree for the an asset in the risk-neutral world
The Fundamental Theorem of Asset Pricing
Matching Volatility with u and d

Assets Other than Non-Dividend Paying Stocks

For options on stock indices, currencies and futures the basic procedure
for constructing the tree is the same except for the calculation of p
The Fundamental Theorem of Asset Pricing
Matching Volatility with u and d

The Probability of an Up Move

a−d
p=
u−d
a = er∆t fo a non dividend paying stock
a = e(r−q)∆t for a stock index where q is the dividend yield on the index
a = e(r−rf )∆t for a currency where rf is the foreign risk-free rate
a = 1 for futures contract
The Fundamental Theorem of Asset Pricing
Matching Volatility with u and d

For further reading: (Hull, 2021, Chapter 13) and (Choe et al., 2016,
Chapter 1)
Choe, G. H. et al. (2016). Stochastic analysis for finance with
simulations. Springer.
Hull, J. C. (2021). Options futures and other derivatives. Pearson
Education India.