Wim Schoutens
Leuven, 20022003
Lecture Notes to the Courses
(GM31) Capita Selecta in Statistics
(D312) General Insurance I
(G379) Capita Selecta uit de Wiskunde II
Abstract
The aim of the course is to give a rigorous yet accessible introduction to the
modern theory of nancial mathematics. The student should already be com
fortable with calculus and probability theory. Prior knowledge of important
notions in mathematical nance concerning discrete and continuous stochastic
processes will be useful but is not required.
We start with providing some background on the nancial markets and the
instruments traded. We will look at dierent kinds of derivative securities, the
main group of underlying assets, the markets where derivative securities are
traded and the nancial agents involved in these activities.
The fundamental problem in the mathematics of nancial derivatives is that
of pricing and hedging. The pricing is based on the noarbitrage assumptions.
We start by discussing option pricing in the simplest idealised case: the Single
Period Market. Next, we will turn to the discretetime models and look in detail
at the mathematical counterpart of the economic principle of noarbitrage: the
existence of equivalent martingale measures.
The discrete models will guide us in the analysis of continuoustime models.
We will mainly focus on models based on Brownian motion for which we will
develop a stochastic calculus. With this machinery we will be able to derive
the famous BlackScholes model and its formula for option pricing. It turns
out that the BlackScholes model is complete, i.e. a perfect hedging strategy
exists. Although, the model is worldwide used, it has several imperfections.
We discuss the main drawbacks of the BlackScholes model and some possible
directions of improvement. The more realistic models are unfortunately also
less tractable and mathematically very complex; the main focus will thus here
be on the intuition and not on the mathematical analysis.
2
Contents
1 Derivative Background 1
1.1 Financial Markets and Instruments . . . . . . . . . . . . . . . . . 1
1.1.1 Derivative Instruments . . . . . . . . . . . . . . . . . . . . 2
1.1.2 Underlying Securities . . . . . . . . . . . . . . . . . . . . 5
1.1.3 Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.1.4 Types of Traders . . . . . . . . . . . . . . . . . . . . . . . 8
1.1.5 Modelling Assumptions . . . . . . . . . . . . . . . . . . . 9
1.2 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
1.3 Arbitrage Relationships . . . . . . . . . . . . . . . . . . . . . . . 16
1.3.1 The PutCall Parity . . . . . . . . . . . . . . . . . . . . . 16
2 Binomial Trees 20
2.1 Single Period Market Models . . . . . . . . . . . . . . . . . . . . 20
2.2 TwoStep Binomial Trees . . . . . . . . . . . . . . . . . . . . . . 29
2.2.1 European Call . . . . . . . . . . . . . . . . . . . . . . . . 29
2.2.2 Matching Volatility with u and d . . . . . . . . . . . . . . 32
1
2.3 Binomial Trees . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.3.1 European Call and Put Options . . . . . . . . . . . . . . 35
2.3.2 American Options . . . . . . . . . . . . . . . . . . . . . . 39
2.4 Path Dependent Exotic Options . . . . . . . . . . . . . . . . . . . 45
3 Mathematical Finance in Discrete Time 46
3.1 Information and Trading Strategies . . . . . . . . . . . . . . . . . 47
3.2 NoArbitrage Condition . . . . . . . . . . . . . . . . . . . . . . . 51
3.3 RiskNeutral Pricing . . . . . . . . . . . . . . . . . . . . . . . . . 53
3.4 Complete Markets . . . . . . . . . . . . . . . . . . . . . . . . . . 57
3.5 The Fundamental Theorem of Asset Pricing . . . . . . . . . . . . 58
3.5.1 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
4 ContinuousTime Stochastic Processes 64
4.1 Classes of Processes . . . . . . . . . . . . . . . . . . . . . . . . . 65
4.1.1 Markov Processes . . . . . . . . . . . . . . . . . . . . . . . 65
4.1.2 Martingales . . . . . . . . . . . . . . . . . . . . . . . . . . 66
4.2 Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
4.3 It os Calculus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
4.3.1 Stochastic Integrals . . . . . . . . . . . . . . . . . . . . . 71
4.3.2 It os Lemma . . . . . . . . . . . . . . . . . . . . . . . . . 73
4.4 Stochastic Dierential Equations . . . . . . . . . . . . . . . . . . 74
4.5 Geometric Brownian Motion . . . . . . . . . . . . . . . . . . . . . 77
4.6 Martingale Representations . . . . . . . . . . . . . . . . . . . . . 79
2
5 The BlackScholes Option Price Model 81
5.1 The Market Model . . . . . . . . . . . . . . . . . . . . . . . . . . 82
5.2 Equivalent Martingale Measures and RiskNeutral Pricing . . . . 84
5.3 Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
5.4 In Practice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
5.4.1 Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
5.4.2 Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
5.5 The Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
6 Imperfections of the BlackScholes Model 102
6.1 The NonGaussian Character . . . . . . . . . . . . . . . . . . . . 103
6.1.1 Where is the Normal Distribution Failing ? . . . . . . . . 103
6.1.2 Statistical Testing . . . . . . . . . . . . . . . . . . . . . . 106
6.2 Stochastic Volatility . . . . . . . . . . . . . . . . . . . . . . . . . 109
6.3 Inconsistency with Market Option Prices . . . . . . . . . . . . . . 111
7 Exotic Options 116
7.1 Asian Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116
7.2 Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
7.3 Lookback Options . . . . . . . . . . . . . . . . . . . . . . . . . . 120
7.4 Binary option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
3
Chapter 1
Derivative Background
1.1 Financial Markets and Instruments
This text is on the (riskneutral) pricing of derivative securities. In practitioners
terms a derivative security is a security whose value depends on the value of
other more basic underlying securities. We adopt the more precise denition:
A derivative security, or contingent claim, is a nancial contract whose value
at expiration date T (more briey, expiry) is determined exactly by the price
process of the underlying nancial assets (or instruments) up to time T.
This section provides the institutional background on derivative securities,
the main group of underlying assets, the markets where derivatives securities
are traded and the nancial agents involved in these activities.
1
1.1.1 Derivative Instruments
Derivative securities can be grouped under three general headings: Options,
Forwards and Futures, and Swaps. During this text we will mainly deal with
options although our pricing techniques may be readily applied to forwards,
futures and swaps as well.
Options
An option is a nancial instrument giving one the right but not the oblig
ation to make a specied transaction at (or by) a specied date at a specied
price.
A lot of dierent type of options exists. We give here the basic types. Call
options give one the right to buy. Put options give one the right to sell. European
options give one the right to buy/sell on the specied date, the expiry date,
on when the option expires or matures. American options give one the right
to buy/sell at any time prior to or at expiry. Asian options depend on the
average price over a period. Lookback options depend on the maximum or
minimum price over a period and barrier options, depend on some price level
being attained or not.
The price at which the transaction to buy/sell the underlying assets (or
simply the underlying), on/by the expiry date (if exercised), is made is called
the exercise price or strike price. We usually use K for strike price, time t = 0,
for the initial time (when the contract between the buyer and the seller of the
option is struck), time t = T for the expiry or nal time.
2
Consider, say, an European call option, with strike price K; write S
t
for the
value (or price) of the underlying at time t. If S
t
> K, the option is in the
money, if S
t
= K, the option is said to be at the money and if S
t
< K, the
option is out the money. This terminology is of course motivated by the payo
from the option which is
S
T
K if S
T
> K and 0 otherwise
(more briey written as (S
T
K)
+
).
In Figure 1.1, one can see that by investing in an option one can make huge
gains, but also if markets go the opposite direction as anticipate, it is possible
to loose all money one invested.
Figure 1.1: Stock Prices and European Call Option at time t = 0 and t = T.
In 1973, the Chicago Board Options Exchange (CBOE) began trading in
options on some stocks. Since then, the growth of options has been explosive.
3
Risk Magazine (12/1997) estimated $35 trillion as the gross gure for worldwide
derivatives markets in 1996.
Forwards, Futures and Swaps
A forward contract is an agreement to buy or sell an asset at a certain future
date T for a certain price K. It is usually between two large and sophisticated
nancial agents (banks, institutional investors, large corporations, and broker
age rms) and not traded on an exchange. The agents who agrees to buy the
underlying asset is said to have a long position, the other agent assumes a short
position. The payo from a long position in a forward contract on one unit of
an asset with price S
T
at the maturity time T of the contract is
S
T
K.
Compared with a call option with the same maturity and strike price K we see
that the investor now faces a downside risk, too. He has the obligation to buy
the asset for price K.
A futures contract, like a forward contract, is an agreement to buy or sell an
asset at a certain future date for a certain price. The dierence is that futures
are traded. As such, the default risk is removed from the parties to the contract
and borne by the clearing house.
A swap is an agreement whereby two parties undertake to exchange, at
known dates in the future, various nancial assets (or cash ows) according to
a prearranged formula that depends on the value of one or more underlying
assets. Examples are currency swaps (exchange currencies) and interestrate
4
swaps (exchange of xed for oating set of interest payments). A swap can
always be decomposed into a basket of forwards/futures and/or options. After
pricing the forwards/futures and options separately the corresponding value of
the swap can be determined from these building blocks.
1.1.2 Underlying Securities
Next, we highlight some of the most common underlying securities.
Stocks
The basis of modern economic life are companies owned by their shareholders;
the shares provide partial ownership of the company, pro rata with investment.
Shares have value, reecting both the value of the companys real assets and
the earning power of the companys dividends. With publicly quoted companies,
shares are quoted and traded on the Stock Exchange. Stock is the generic term
for assets held in the form of shares. Stock markets date back to at least 1531,
when one was started in Antwerp, Belgium. Today there are over 150 stock
exchanges.
Interest Rates
The value of some nancial assets depends solely on the level of interest rates,
e.g. Treasury notes, municipal and corporate bonds. These are xedincome
securities by which national, state and local governments and large companies
partially nance their economic activity. Fixedincome securities require the
5
payment of interest in the form of a xed amount of money at predetermined
points in time, as well as the repayment of the principal at maturity of the se
curity. Interest rates themselves are notional assets, which cannot be delivered.
Currencies
A currency is the denomination of the national units of payment (money) and
as such is a nancial asset. Companies may wish to hedge adverse movements
of foreign currencies and in doing so use derivative instruments.
Indexes
An index tracks the value of a basket of stocks (FTSE100, S&P500, Dow Jones
Industrial, NASDAQ Composite, BEL20, EUROSTOXX50, ...), bonds, and so
on. Derivative instruments on indices may be used for hedging if no derivative
instruments on a particular asset in question are available and if the correlation
in movement between the index and the asset is signicant. Furthermore, in
stitutional funds (such as pension funds), which manage large diversied stock
portfolios, try to mimic particular stock indices and use derivative on stock in
dices as a portfolio management tool. On the other hand, a speculator may
wish to bet on a certain overall development in a market without exposing
him/herself to a particular asset.
In Figure 1.2, one sees the belgian Bel20 Index over a period of more than
4 years.
A new kind of index was generated with the Index of Catastrophe Losses
6
Figure 1.2: BEL20
(CATindex) by the Chicago Board of Trade (CBOT) lately. The growing num
ber of huge natural disasters (such as hurricanes and earthquakes) has led the
insurance industry to try to nd new ways of increasing its capacity to carry
risks. Currently investors are oered options on the CATindex, thereby taking
in eect the position of traditional reinsurance.
Derivatives
Derivatives are themselves assets and so can be used as underlying assets for
new contingent claims: options on futures and swaps, options on options, ...
1.1.3 Markets
Financial derivatives are basically traded in two ways: on organized exchanges
and overthecounter (OTC). Organized exchanges are subject to regulatory
rules, require a certain degree of standardization of the traded instruments
7
(strike price, maturity dates, size of contract, etc.). Examples are the Chicago
Board Options Exchange (CBOE), the London International Financial Futures
Exchange (LIFFE).
OTC trading takes between various commercial and investments banks such
as Goldman Sachs, Citibank, Deutsche Bank.
1.1.4 Types of Traders
We can classify the traders of derivatives securities in three dierent classes.
Hedgers
Successful companies concentrate on economic activities in which they to best.
They use the market to insure themselves against adverse movements of prices,
currencies, interest rates etc. Hedging is an attempt to reduce exposure to risk.
Hedgers prefer to forgo the chance to make exceptional prots when future un
certainty works to their advantage by protecting themselves against exceptional
loss.
Speculators
Speculators want to take a position in the market they take the opposite
position to hedgers. Indeed, speculation is needed to make hedging possible, in
that a hedger, wishing to lay o risk, cannot do so unless someone is willing to
take it on.
In speculation, available funds are invested opportunistically in the hope of
8
making a prot: the underlying itself is irrelevant to the speculator, who is only
interested in the potential for possible prot that trade involving it may present.
Arbitrageurs
Arbitrageurs try to lock in riskless prot by simultaneously entering into trans
actions in two or more markets. An arbitrage opportunity exists, for example, if
a security can be bought in New York at one price and sold at a slightly higher
price in London. The underlying concept of the here presented theory is the
absence of arbitrage opportunities.
1.1.5 Modelling Assumptions
We will discuss contingent claim pricing in an idealized case. We will not allow
market frictions; there is no default risk, agents are rational and there is no
arbitrage. More concrete this means
no transaction costs
no bid/ask spread
no taxes
no margin requirements
no restrictions on short sales
no transaction delays
same interest for borrowing and lending
9
market participants act as price takers
market participants prefer more to less
We develop the theory of an ideal frictionless market so as to focus
irreducible essentials of the theory and as a rstorder approximation to real
ity. Understanding frictionless markets is also a necessary step to understand
markets with frictions.
The risk of failure of a company bankruptcy is inescapably present in
its economic activity: death is part of life. Moreover those risks also appear
at the national level: quite apart from war, recent decades have seen default
of interest payments of international debt, or the threat of it (see for example
the 1998 Russian crisis). We ignore default risk for simplicity while developing
understanding of the principal aspects.
We assume nancial agents to be price takers, not price makers. This implies
that even large amounts of trading in a security by one agent does not inuence
the securitys price. Hence agents can buy or sell as much of any security as
they wish without changing the securitys price.
To assume that market participants prefer more to less is a very weak as
sumption on the preferences of market participants. Apart from this we will
develop a preferencefree theory.
The relaxation of all these assumptions is subject to ongoing research.
We want to mention the special character of the noarbitrage assumption.
It is the basis for the arbitrage pricing technique that we shall develop, and we
discuss it in more detail below.
10
1.2 Arbitrage
The essence of arbitrage is that it should not be possible to guarantee a prot
without exposure to risk. Were it possible to do so, arbitrageurs would do so,
in unlimited quantity, using the market as a moneypump to extract arbitrarily
large quantities of riskless prot. This would, for instance, make it impossible
for the market to be in equilibrium. We shall see that arbitrage arguments
suce to determine prices  the arbitrage pricing technique.
To explain the fundamental arguments of the arbitrage pricing technique we
use the following:
Example: Consider an investor who acts in a market in which only three
nancial assets are traded: (riskless) bonds B (bank account), stocks S and
European Call options C with strike K = 100 on the stock S. The investor may
invest today, time t = 0, in all three assets, leave his investment until time
t = T and gets his returns back then. We assume the option C expires at time
t = T. We assume the current prices (in euro, say) of the nancial assets are
given by
B(0) = 1, S(0) = 100, C(0) = 20
and that at t = T there can be only two states of the world: an upstate with
euro prices
B(T, u) = 1.25, S(T, u) = 175, and therefore C(T, u) = 75,
11
and a downstate with euro prices
B(T, d) = 1.25, S(T, d) = 75, and therefore C(T, d) = 0.
Now our investor has a starting capital of 25000 euro from which he buy the
following portfolio,
Portfolio I:
Asset Number Total amount in euro
Bond 10000 10000
Stock 100 10000
Call option 250 5000
Depending of the state of the world at time t = T the value of his portfolio
will dier: In the up state the total value of his portfolio is 48750 euro:
Asset Number Price Total amount in euro
Bond 10000 1.25 12500
Stock 100 175 17500
Call option 250 75 18750
TOTAL 48750
whether in the downstate his portfolio has a value of 20000 euro:
Asset Number Price Total amount in euro
Bond 10000 1.25 12500
Stock 100 75 7500
Call option 250 0 0
TOTAL 20000
12
Can the investor do better ? Let us consider the restructured portfolio with
initial investment of 24600 euro:
Portfolio II:
Asset Number Total amount in euro
Bond 11800 11800
Stock 70 7000
Call option 290 5800
We compute its return in the dierent possible states. In the upstate the total
value of his portfolio is again 48750 euro:
Asset Number Price Total amount in euro
Bond 11800 1.25 14750
Stock 70 175 12250
Call option 290 75 21750
TOTAL 48750
and in the downstate his portfolio has again a value of 20000 euro:
Asset Number Price Total amount in euro
Bond 11800 1.25 14750
Stock 70 75 5250
Call option 290 0 0
TOTAL 20000
We see that this portfolio generates the same time t = T return while costing
only 24600 euro now, a saving of 400 euro against the rst portfolio. So the
investor should use the second portfolio and have a free lunch today!
In the above example the investor was able to restructure his portfolio, re
13
ducing the current (t = 0) expenses without changing the return at the future
date t = T in both possible states of the world. So there is an arbitrage pos
sibility in the above market situation, and the prices quoted are not arbitrage
prices. If we regard (as we shall do) the prices of the bond and the stock
(our underlying) as given, the option must be mispriced. Let us have a closer
look between the dierences between Portfolio II, consisting of 11800 bonds, 70
stocks and 29 call options, in short (11800, 70, 290) and Portfolio I, of the form
(10000, 100, 250) The dierence is the portfolio, Portfolio III say, of the form
(11800, 70, 290) (10000, 100, 250) = (1800, 30, 40).
Asset Number Total amount in euro
Bond 1800 1800
Stock 30 3000
Call option 40 800
So if you sell short 30 stocks, you will receive 3000 euro from which you
buy 40 options, put 1800 euro in your bank account and have a gastronomic
lunch of 400 euro. But what is the eect of doing that ? Let us consider the
consequences in the possible states of the world. We see in both cases that
the eects of the dierent positions of Portfolio III oset themselves: In the
14
upstate:
Asset Number Price Total amount in euro
Bond 1800 1.25 2250
Stock 30 175 5250
Call option 40 75 3000
TOTAL 0
In the down state:
Asset Number Price Total amount in euro
Bond 1800 1.25 2250
Stock 30 75 2250
Call option 40 75 0
TOTAL 0
But clearly the portfolio generates an income at t = 0 of which you had a free
lunch, and a good one. Therefore it is itself an arbitrage opportunity.
If we only look at the position in bonds and stocks, we can say that this
position covers us against possible price movements of the option, i.e. having
1800 euro in your bank account and being 30 stocks short has the opposite time
t = T value as owning 40 call options. We say that the bond/stock position is
a hedge against the position in options.
Let us emphasize that the above arguments were independent of the prefer
ences and plans of the investor.
15
1.3 Arbitrage Relationships
We will in this section use arbitragebased arguments to develop general bounds
on the value of options. In our analysis here we use nondividend paying stocks
as the underlying.
Throughout the text we will make use of a bank account on which we can
put money and borrow money on the same compounded interest rate r. This
means that 1 euro on the bank account at time 0 will give rise to e
rt
euro on
time t > 0. Similarly, if we borrow 1 euro now, we have to pay back e
rt
euro at
time t > 0. Or equivalently, if we borrow now e
rt
euro we have to pay back 1
euro at time t.
1.3.1 The PutCall Parity
Next, we will deduce a fundamental relation between put and call options, the
socalled putcall parity. Suppose there is a stock with value S
t
at time t, with
European call and put options on it, with value C
t
and P
t
respectively, with
expiry time T and strikeprice K. Consider a portfolio consisting of one stock,
one put and a short position in one call (the holder of the portfolio has written
the call); write
t
for the time t value of this portfolio. So
t
= S
t
+P
t
C
t
.
Recall that the payos at expiry are
for the call : C
T
= maxS
T
K, 0 = (S
T
K)
+
,
for the put : P
T
= maxK S
T
, 0 = (K S
T
)
+
.
16
For the above portfolio we hence get at time T the payo
if S
T
K :
T
= S
T
+ 0 (S
t
K) = K,
if S
T
K :
T
= S
T
+ (K S
t
) 0 = K.
This portfolio thus guarantees a payo K at time T. How much is it worth
at time t? The riskless way to guarantee a payo K at time T is to deposit
Ke
r(Tt)
in the bank at time t and do nothing (we assume continuously com
pounded interest here). Under the assumption that the market is arbitragefree
the value of the portfolio at time t must thus be Ke
r(Tt)
, for it acts as a
synthetic bank account and any other price will oer arbitrage opportunities.
Let us explore these arbitrage opportunities.
If the portfolio is oered for sale at time t too cheaplyat price
t
<
Ke
r(Tt)
we can buy it, borrow Ke
r(Tt)
from the bank, and pocket a
positive prot Ke
r(Tt)
t
> 0. At time T our portfolio yields K, while our
bank debt has grown to K. We clear our cash account use the one to pay o
the other thus locking in our earlier prot, which is riskless.
If on the other hand the portfolio is priced at time t at a too high price
at price
t
> Ke
r(Tt)
we can do the exact opposite. We sell the portfolio
short that is,we buy its negative: buy one call, write one put, sell short one
stock, for
t
and invest Ke
r(Tt)
in the bank account, pocketing a positive
prot
t
Ke
r(Tt)
> 0. At time T, our bank deposit has grown to K, and
again we clear our cash account use this to meet our obligation K on the
portfolio we sold short, again locking in our earlier riskless prot.
17
We illustrate the above with socalled arbitrage tables. In such a table we
simply enter the current value of a given portfolio and then compute its value
in all possible states of the world when the portfolio is cashed in. In the case
t
< Ke
r(Tt)
:
Transactions Current cash ow Value at expiry
S
T
< K S
T
K
buy 1 stock S
t
S
T
S
T
buy 1 put P
t
K S
T
0
write 1 call C
t
0 S
T
+K
borrow Ke
r(Tt)
K K
TOTAL
Ke
r(Tt)
S
t
P
t
+C
t
> 0
0 0
Thus the rational price for the portfolio at time t is exactly Ke
r(Tt)
. Any
other price presents arbitrageurs with an arbitrage opportunity (to make and
lock in a riskless prot) which they will take ! Therefore
Proposition 1 We have the following putcall parity between the prices of the
underlying asset and its European call and put options with the same strike price
and maturity on stocks that pay no dividends:
S
t
+P
t
C
t
= Ke
r(Tt)
.
The value of the portfolio above is the discounted value of the riskless equiv
alent. This is a rst glimpse at the central principle, or insight, of the entire
18
subject of option pricing. Arbitrage arguments allow one to calculate precisely
the rational price or arbitrage price of a portfolio. The putcall parity
argument above is the simplest example of the arbitrage pricing technique.
19
Chapter 2
Binomial Trees
2.1 Single Period Market Models
Our aim here is to show in the simplest possible nontrivial model how the
theory based on the principle of noarbitrage works.
Example
Let our nancial market consist of two nancial assets, a riskless bank account
(or bond) B and a risky stock S, with todays price S
0
= 20 euro. We look at
a singleperiod model and assume that starting from today (t = 0) the world
can only be in one of two states at time t = T: the stock price will either be
S
T
= 22 euro or S
T
= 18 euro. We are interested in valuing a European call
option to buy the stock for 21 euro at time t = T. At time t = T, this option
can have only two possible values. It will have value 1 euro, if the stock price
20
Figure 2.1: Oneperiod binomial tree example
is 22 euro; if the stock price turns out to be 18 euro at time t = T, the value of
the option will be zero. The situtation is illustrated in Figure 2.1.
It turns out that we can price the option by the assumption that no arbitrage
opportunities exist. We set up a portfolio of the stock and the option in such a
way that there is no uncertainty about the value of the portfolio at the time of
expiry, t = T. We then argue that, because the portfolio has no risk, the return
earned on it must equal the riskfree interest rate of the bank account. This
enables us to work out the cost of setting up the portfolio and, therefore, the
options price.
Consider a portfolio consisting of a long postion in shares of the stock and
a short position in one call option. We calculate the value of that makes the
portfolio riskless. If the stock price moves up from 20 to 22 euro, the value of
the shares is 22 and the value of the option is 1 euro, so that the total value
of the portfolio is 22 1 euro. If the stock price moves down from 20 to 18
euro, the value of the shares is 18 euro and the value of the option is zero, so
that the total value of the portfolio is 18 euro. The portfolio is riskless if the
21
value of is chosen so that the nal value of the portfolio is the same for both
alternatives. This means
221 = 18
or
= 0.25
A riskless portfolio is, therefore,
Long 0.25 shares.
Short 1 option.
If the stock price moves up to 22 euro, the value of the portfolio is
22 0.25 1 = 4.5.
If the stock price moves down to 18 euro, the value of the portfolio is
18 0.25 = 4.5.
Regardless of whether the stock price moves up or down, the value of the port
folio is always 4.5 euro at the end of the life of the option.
Riskless portfolios must, in the absence of arbitrage opportunities, earn the
risk free rate of interest. Suppose that in this case the riskfree rate is 12 percent
per annum and that T = 0.5, i.e. six months. It follows that the value of the
portfolio today must be the present value of 4.5 euro, or
4.5e
0.120.5
= 4.238
22
The value of the stock today is known to be 20 euro. Suppose the option price
is denoted by f. The value of the portfolio today is
20 0.25 f = 5 f
It follows that
5 f = 4.238
or
f = 0.762.
This shows that, in the absence of arbitrage opportunities, the current value of
the option must be 0.762. If the value of the option were more than 0.762 euro,
the portfolio would cost less than 4.238 euro to set up and would earn more than
the riskfree rate. If the value of the option were less than 0.762 euro, shorting
the portfolio would provide a way of borrowing money at less than the riskfree
rate.
In other words, if the value of the option were more than 0.762 euro, for
example 1 euro, you can borrow for example 42380 euro and buy 10000 times
the above portfolio at a cost of
10000(0.25 20 1) = 40000euro.
You pocket 2380 euro and after 6 months, you sell 10000 portfolio and cashes in
45000, because the value of one portfolio is always 4.5 euro. With this money
you pay back the bank for the money you borrowed plus the interests on it, i.e.
you pay the bank an amount of 42380 e
0.120.5
= 45000 euro. At the end
23
Figure 2.2: General oneperiod binomial tree
of all this you earned 2380 euro without taking any risk and without an initial
capital. If the value of the option were less than 0.762 euro, you do the opposite.
Generalization
We can generalize the argument just presented by considering a stock whose
price is initially S
0
and an option on the stock whose current price is f. We
suppose that the option lasts for time T and that during the life of the option
the stock can move up from S
0
to a new level, S
0
u or down from S
0
to a new
level, S
0
d (u > 1; 0 < d < 1). If the stock price moves up to S
0
u, we suppose
that the payo from the option is f
u
; if the stock price moves down to S
0
d, we
suppose the payo from the option is f
d
. The situation is illustrated in Figure
2.2.
As before, we imagine a portfolio constisting of a long position in shares
and a short position in one option. We calculate the value of that makes the
portfolio riskless. If there is an up movement in the stock price, the value of the
24
portfolio at the end of the life op the option is
S
0
uf
u
.
If there is a down movement in the stock price, the value becomes
S
0
df
d
.
The two are equal when
S
0
uf
u
= S
0
df
d
,
or
=
f
u
f
d
S
0
u S
0
d
. (2.1)
In this case, the portfolio is riskless and must earn the riskless interest
rate. If we denote the riskfree interest rate by r, the present value of the
portfolio is
(S
0
uf
u
)e
rT
= (S
0
df
d
)e
rT
.
The cost of setting up the portfolio is
S
0
f.
It follows that
(S
0
u f
u
)e
rT
= S
0
f,
or
f = S
0
(S
0
uf
u
)e
rT
.
25
Substituting from equation (2.1) for and simplifying, this equation reduces
to
f = e
rT
[pf
u
+ (1 p)f
d
] (2.2)
where
p =
e
rT
d
u d
(2.3)
Remark 2 If we assume that u > e
rT
, together with u > 1 and 0 < d < 1,
one can easily show that the value of p given in (2.3) satises 0 < p < 1. Note
that it is natural to assume that u > e
rT
, because it means that after a time T,
you can gain more (a factor u) by investing in the risky stocks, than you can
earn with a riskless investment in bond (a factor e
rT
). If this was not the case
no one would invest in stocks. Ofcourse, you can also lose money (d factior by
investing in stocks.
Remark 3 Equation (2.1) shows that is the ratio of the change in the option
price to the change in the stock price.
Remark 4 The option pricing formula in (2.2) does not involve the probabili
ties of the stock moving up or down. This is suprising and seems counterintu
itive. The key reason is that the probabilities of future up or down movements
are already incorporated into the price of the stock.
RiskNeutral Valuation
Although we do not need to make any assumptions about the probabilities of
an up and down movement in order to derive Equation (2.2), it is natural to
26
interpret the variable p in Equation (2.2) as the probability of an up movement
in the stock price. The variable 1p is then the probability of a down movement,
and the expression
pf
u
+ (1 p)f
d
is the expected payo from the option. With this interpretation of p, Equation
(2.2) then states that the value of the option today is its expected future value
discounted at the riskfree rate.
We now investigate the expected return from the stock when the probability
of an up movement is assumed to be p. The expected stock price at time T,
E
p
[S
T
], is given by
E
p
[S
T
] = pS
0
u + (1 p)S
0
d
= pS
0
(u d) +S
0
d.
Substituting from (2.3) for p, this reduces to
E
p
[S
T
] = S
0
e
rT
(2.4)
showing that the stock price grows, on average, at the riskfree rate. Setting the
probability of an up movement equal to p is therefore, equivalent to assuming
that the return on the stock equals the rsikfree rate. In a riskneutral world
the expected return on all securities is the riskfree interest rate. Equation (2.4)
shows that we are assuming a riskneutral world when we set the proability of
an up movement to p. Equation (2.2) shows that the value of the option is its
expected payo in a riskneutral world discounted at the riskfree rate.
27
This result is an example of an important genereal principle in option pricing
known as riskneutral valuation. The principle states that it is valid to assume
the world is risk neutral when pricing options. The resulting option prices
are correct not just in a riskneutral world, but in the real world as
well.
The SinglePeriod Example Revisited
We now turn back to the numerical example in Figure 2.1 to illustrate that risk
neutral valuation gives the same answers as noarbitrage arguments. In Figure
2.1, the stock price is currently 20 euro and will move either up to 22 euro or
down to 18 euro at the end of six months. The option considered is a European
call option with strike price of 21 euro and an expiration date in six months.
The riskfree interest rate is 12 percent per annum.
We dene p as the probability of an upward movement in the stock price in
a riskneutral world. (We know from the analysis given earlier in this section
that p is given by Equation (2.3). However, for the purpose of this illustration
we suppose that we do not know this.) In a riskneutral world the expected
return on the stock must be the riskfree rate of 12 percent. This means that p
must satisfy
22p + 18(1 p) = 20e
0.120.5
or
p =
20e
0.120.5
18
4
= 0.8092
At the end of the six months, the call option has a 0.8092 probability of being
28
worth 1 euro and a 0.1908 probability of being worth zero. Its expected value
is, therefore,
0.8092 1 + 0.1908 0 = 0.8092
In a riskneutral world, this should be discounted at the riskfree rate. The
value of the option today is, therefore,
0.8092e
0.120.5
= 0.7620
This is the same value as the value obtained earlier, illustrating that noarbitrage
arguments and riskneutral valuation give the same answer.
2.2 TwoStep Binomial Trees
We can extend the analysis to a twostep binomial tree. The objective of the
analysis is to calculate the option price at the initial node of the tree. This can
be done by repeatedly applying the principles established earlier in the chapter.
2.2.1 European Call
We can rst apply the analysis to a twostep binomial tree. Here the stock price
starts at 20 euro and in each of the two time steps may go up by 10 percent or
down by 10 percent. We suppose that each time step is six months long and
the riskfree interest rate is 12 percent per annum.
We consider a European call option with a strike price of 21 euro. Figure
2.3 shows the tree with both the stock price and the option price at each node.
(The stock price is the upper number and the option price is the lower number.)
29
Figure 2.3: Twoperiod binomial tree example
The option prices at the nal nodes of the tree are easily calculated. They are
the payos from the option. At node D, the stock price is 24.2 euro and the
option price is 24.2 21 = 3.2 euro; at nodes E and F, the option is out of the
money and its value is zero.
At node C, the option price is zero, because node C leads to either node E
or node F and at both nodes the option price is zero. Next, we calculate the
option price at node B.
Using the notation introduced earlier in the chapter, u = 1.1, d = 0.9,
r = 0.12, and T = 0.5 so that p = 0.8092. Equation (2.2) gives the value of the
option at node B as
e
0.120.5
[0.8092 3.2 + 0.1908 0] = 2.4386
It remains for us to calculate the option at the initial node, A. We do so by
focusing on the rst step of the tree. We know that the value of the option at
node B is 2.4386 and that at node C it is zero. Equation (2.2), therefore, gives
30
Figure 2.4: General twoperiod binomial tree
the value at node A as
e
0.120.5
[0.8092 2.4386 + 0.1908 0] = 1.8583
The value of the option is 1.8583 euro.
We can generalize the case of two time steps by considering the situation in
Figure 2.4.
The stock price is initially S
0
. During each step, it either moves up to u
times its value or moves down to d times its value. The notation for the value
of the option is shown on the tree. For example, after two up movements, the
value of the option is f
uu
. We suppose that the riskfree interest rate is r and
the length of the time step is t years.
Repeated application of Equation (2.2) gives
f
u
= e
rt
[pf
uu
+ (1 p)f
ud
] (2.5)
f
d
= e
rt
[pf
ud
+ (1 p)f
dd
] (2.6)
f = e
rt
[pf
u
+ (1 p)f
d
] (2.7)
31
Substituting the rst two equations in the last one, we get
f = e
2rt
[p
2
f
uu
+ 2p(1 p)f
ud
+ (1 p)
2
f
dd
]. (2.8)
This is constistent with the principle of riskneutral valuation mentioned earlier.
The variable p
2
, 2p(1 p), and (1 p)
2
are the probabilities that the upper,
middle, and lower nal nodes will be reached. The option price is equal to
its expected payo in a riskneutral world discounted at the riskfree
interest rate.
As we add more steps to a binomial tree, the riskneutral valuation principle
continues to hold. The option price is always equal to the present value (dis
counting at the riskfree interest rate) of its expected payo in a riskneutral
world.
2.2.2 Matching Volatility with u and d
In practice, when constructing a binomial tree to represent the movements in
a stock price, we choose the parameters u and d to match the volatility of the
stock price. To see how this is done, suppose that the expected return on a stock
in the real world is : The expected stock price at the end of the rst time
step is S
0
(1 +t). The volatility of a stock price, , is dened so that
2
t is
the variance of the return in a short period of time of length t. Suppose from
empirical data we estimated that the probability of an up movement in the real
world is equal to q. In order to match the expected return on the stock, we
32
must therefore, have
qS
0
u + (1 q)S
0
d = S
0
(1 +t),
or
q =
(1 +t) d
u d
(2.9)
The variance of the stock price return is
qu
2
+ (1 q)d
2
[qu + (1 q)d]
2
.
In order to match the real world stock price volatility we must therefore have
qu
2
+ (1 q)d
2
[qu + (1 q)d]
2
=
2
t.
or equivalently
q(1 q)(u d)
2
=
2
t. (2.10)
Substituting from Equation (2.9)into Equation (2.10) we get
((1 +t) d) (u (1 +t)) =
2
t
When terms in (t)
2
and higher powers of t are ignored (remember t is
supposed to be small), one solution to this equation is
u = (1 +
t) (2.11)
d = (1
t) (2.12)
33
Indeed,
((1 +t) d) (u (1 +t))
= (1 +t)
2
+ (1 +t)(u +d) ud
= 1 2t (t)
2
+ 2(1 +t) (1 +
t)(1
t)
= (t)
2
+
2
t
Another setting is
u = e
t
(2.13)
d = e
t
, (2.14)
which is, because t is supposed to be small, approximatelly the same as (2.11).
These are the values proposed by Cox, Ross and Rubinstein. Note that in both
cases the values of u and d are independent of , which implies that if we move
from the real world to the riskneutral world the volatility on the stock remains
the same (at least in the limit as t tends to zero). This is an illustration
of an important general result known as Girsanovs theroem. When we move
from a world with one set of risk preferences to a world with another set of risk
preferences, the expected growth rates change, but their volatilities remain the
same. Moving from one set of risk preferences to another is sometimes referred
to as changing the measure.
34
2.3 Binomial Trees
The above one and twosteps binomial trees are very imprecise models of reality
and are used only for illustrative purposes. Clearly an analyst can expect to
obtain only a very rough approximation to an option price by assuming that
the stock movements during the life of the option consist of one or two binomial
steps. When binomial trees are used in pratice, the life of the option is typically
divided into 30 or more time steps of length t. In each time step there is
a binomial stock movement. With 30 time steps this means that 31 terminal
stock prices and 2
30
possible stock price paths are considered.
2.3.1 European Call and Put Options
Consider the evaluation of an option on a nondividendpaying stock. We start
by dividing the life of the option into a large number of small intervals of length
t. We assume that in each time interval the stock price moves from its initial
value S to one of two new values Su and Sd. In general, u > 1 and 0 < d < 1.
The movement from S to Su is, therefore, an up movement and the movement
from S to Sd is a down movement. In the above sections we introduced what
is known as the riskneutral valuation principle. This states that any security
which is dependent on a stock can be valued on the assumption that the world
is risk neutral. It means that for the purposes of valuing an option, we can
assume:
The expected return from all traded securities is the riskfree interest rate.
35
Future cash ows can be valued by discounting their expected values at
the riskfree interest rate.
We make use of this when using a binomial tree. The tree is designed to represent
the behavior of a stock price in a riskneutral world. In this riskneutral world
the probability of an up movement will be denoted by p. The probability of a
down movement is 1 p; as seen above in (2.3):
p =
e
rt
d
u d
.
As mentioned above, a popular way of chosing the parameters u and d is
u = e
t
d = e
t
Figure 2.5 illustrates the tree of stock prices over 5 time periods that is
considered when the binomial model is used.
At time zero, the stock price S
0
is known. At time t there are two possible
stock prices, S
0
u and S
0
d; at time 2t, there are three possible stock prices,
S
0
u
2
, S
0
ud, and S
0
d
2
; and so on. In general, at time it, i +1 stock prices are
considered. These are
S
0
u
j
d
ij
, j = 0, . . . , i.
European call and put options are evaluated by starting at the end of the tree
(time T) and working backward. The value of the option is known at time T.
For example, a European put option is worth maxK S
T
, 0 and a European
call option is worth maxS
T
X, 0, where S
T
is the stock price at time T and
36
Figure 2.5: General binomial tree for stock price
K is the strike price. Because a riskneutral world is being assumed, the value
at each node at time T t can be calculated as the expected value at time T
discounted at rate r for a time period t. Similarly, the value at each node at
time T 2t can be calculated as the expected value at time T t discounted
for a time period t at rate r, and so on. Eventually, by working back through
all the nodes, the value of the option at time zero is obtained. This procedure
is illustrated in Figure 2.6.
Another way of calculating the option prices is by directly taking the dis
counted value of the expected payo of the option in the riskneutral world. For
example the European put, with strike price K and maturity T has a value:
e
rT
N
j=0
_
_
_
_
N
j
_
_
_
_
maxK S
0
u
j
d
Nj
, 0p
j
(1 p)
Nj
For more complex options, but where the payo only depends on the nal stock
price, i.e. the payo is a function of S
T
, g(S
T
) say, a similar expression can be
37
Figure 2.6: General binomial tree for stock price
derived; the current value of the option is then given by:
e
rT
E
p
[g(S
T
)] = e
rT
N
j=0
_
_
_
_
N
j
_
_
_
_
g(S
0
u
j
d
Nj
)p
j
(1 p)
Nj
,
where E
p
denotes the expectation in the riskneutral world, i.e. with a probabil
ity p given by (2.3) of an upmove of size u , and a probability of a downmove
of (1 p), or equivalently, with a probability
_
_
_
_
N
j
_
_
_
_
p
j
(1 p)
Nj
of ending with a time T stock price of S
0
u
j
d
Nj
.
38
2.3.2 American Options
If the option is American, the procedure only changes slightly. It is necessary
to check at each node to see whether early exercise is preferable to holding the
option for a further time period t. Eventually, again by working back through
all the nodes the value of the option at time zero is obtained.
American put option
Consider a vemonth American put option on a nondividendpaying stock
when the current stock price is 50 euro, the strike price is also 50 euro, the risk
free interest rate is 10 percent per annum, and the volatility is 40 percent per
annum. With our usual notation, this means that S
0
= 50, K = 50, r = 0.10,
= 0.40, and T = 152/365 = 0.416. Suppose that we divide the life of the
option into ve intervals of length one month (= 0.0833 year) for the purposes
of constructing a binomial tree. Then
t = 0.0833
u = e
t
= 1.1224
d = e
t
= 0.8909
p = (e
rt
d)/(u d) = 0.5073
Figure 2.7 shows the related binomial tree.
At each node there are two numbers. The top one shows the stock price
at the node; the lower one shows the value of the option at the node. The
39
Figure 2.7: Binomial tree for American put option
probability of an up movement is always 0.5073; the probability of a down
movement is always 0.4927. The stock price at the jth node (j = 0, 1, . . . , i) at
time it (i = 0, 1, 2, 3, 4, 5) is calculated as S
0
u
j
d
ij
.
The option prices at the nal nodes are calculated as maxKS
T
, 0. The
option prices at the penultimate nodes are calculated from the option prices at
the nal nodes. First, we assume no exercise of the option at the nodes. This
means that the option price is calculated as the present value of the expected
option price one step later. For example at node C, the option price is calculated
as
(0.5073 0 + 0.4927 5.45)e
0.100.0833
= 2.66
40
whereas at node A it is calculated as
(0.5073 5.45 + 0.4927 14.64)e
0.100.0833
= 9.90
We then check to see if early exercise is preferable to waiting. At node C,
early exercise would give a value for the option of zero because both the stock
price and the strick price are 50 euro. Clearly it is best to wait. The correct
value for the option at node C is, therefore, 2.66 euro. At node A, it is a dierent
story. If the option is exercised, it is worth 50 39.69 = 10.31 euro. This is
more than 9.90. If node A is reached, the option should therefore, be exercised
and the correct value for the option at node A is 10.31 euro.
Option prices at earlier nodes are calculated in a similar way. Note that it
is not always best to exercise an option early when it is in the money. Consider
node B. If the option is exercised, it is worth 50 39.69 = 10.31 euro. However,
if it is held, it is worth
(0.5073 6.38 + 0.4927 14.64)e
0.100.0833
= 10.36
The option should, therefore, not be exercised at this node, and the correct
option value at the node is 10.36 euro.
Working back through the tree, we nd the value of the option at the initial
node to be 4.49 euro. This is our numerical estimate for the options current
value. In practice, a smaller value of t, and many more nodes, would be used.
It can be shown that with 30, 50, and 100 time steps we get values for the option
of 4.263, 4.272, and 4.278.
In general suppose that the life of an American put option on a nondividend
41
paying stock is divided into N subintervals of length t. We will refer to the
jth node at time it as the (i, j) node. Dene f
i,j
as the value of the option
at the (i, j) node. The stock price at the (i, j) node is S
0
u
j
d
ij
. Because the
value of an American put at its expiration date is maxK S
T
, 0, we know
that
f
N,j
= maxK S
0
u
j
d
Nj
, 0, j = 0, 1, . . . , N
There is a probability, p, of moving from the (i, j) node at time it to the
(i +1, j +1) node at time (i +1)t, and a probability 1 p of moving from the
(i, j) node at time it to the (i + 1, j) node at time (i + 1)t. Assuming no
early exercise, riskneutral valuation gives
f
i,j
= e
rt
(pf
i+1,j+1
+ (1 p)f
i+1,j
)
for 0 i N 1 and 0 j i. When early exercise is taken into account, this
value for f
i,j
must be compared with the options intrinsic value, and we obtain
f
i,j
= max
_
K S
0
u
j
d
ij
, e
rt
(pf
i+1,j+1
+ (1 p)f
i+1,j
)
_
Note that, because the calculations start at time T and work backward, the
value at time it captures not only the eect of early exercise possibilities at
time it, but also the eect of early exercise at subsequent times. In the limit as
t tends to zero, an exact value for the American put is obtained. In practice,
N = 30 usually gives reasonable results.
42
It is never optimal to exercise an American call option
We are now going to proof that for a nondividend paying stock the price of a
European call and an American call are the same. This means that an early
exercise of an American call is never optimal. To prove this striking result we
rst proof
Proposition 5 The current price C of a European (and American) call option,
with strike price K and time to expiry T, on a nondividend paying stock with
current price S satises :
C maxS e
rT
K, 0.
Proof: That C 0 is obvious, otherwise buying the call would give a riskless
prot now and no obligations later.
To prove the remaining lower bound, we setup an arbitrage table (Table 2.1)
to examine the cash ows of the following portfolio:
sell 1 stock short, buy 1 call, invest in bank account e
rT
K.
Assuming the condition C S e
rT
K is violated, i.e. C < S e
rT
K we
get the arbitrage Table 2.1.
So in all possible states of the world at expiry we have a nonnegative return
for a portfolio, which has a positive current cash ow. This is clearly an arbitrage
opportunity and hence our assumption was wrong.
Suppose now that the American call is exercised at some time t strictly less
than expiry T, i.e. t < T. The nancial agent thereby realises a cashow
43
Portfolio Current cash ow Value at expiry
S
T
K S
T
> K
Short 1 stock S S
T
S
T
Buy 1 call C 0 S
T
K
Bank account e
rT
K K K
Balance S C e
rT
K 0 K S
T
0 0
Table 2.1: Arbitrage table for bounds on calls
S
t
K. From the above proposition we know that the value of the call must be
greater or equal to S
t
e
r(Tt)
K, which is greater than S
t
K. Hence selling
the call would have realised a higher cashow and the early exercise of the call
was suboptimal. In conclusion:
C
A
= C
E
There are two reasons why an American call should not be exercised early.
Insurance: An investor which holds the call option does not care if the
share price falls far below the strike price  he just discards the option 
but if he held the stock, he would. Thus the option insures the investor
against such a fall in stock price, and if he exercises early, he loses this
insurance.
Interest on the strike price: When the holder exercises the option, he buys
the stock and pays the strike price, K. Early exercise at time t < T
44
deprives the holder of the interest on K between times t and T: the later
he pays out K, the better.
Notice how this changes when we consider American puts in place of calls:
The insurance aspect above still holds, but the interest aspect above is reversed
(the holder receives cash K at the exercise time, rather than paying it out).
2.4 Path Dependent Exotic Options
When the payo depends on the path followed by the underlying variable S
in theory one has to consider every possible path. When using 30 time steps,
there are about a billion dierent paths and one has to relay on (Monte Carlo)
simulations, which are computationally very time consuming. The expected
payo in a riskneutral world is calculated using a sampling procedure. It is
then discounted at the riskfree interest rate:
1. Sample a random path for S in a riskneutral world.
2. Calculate the payo from the derivative.
3. Repeat steps one and two to get many sample values of the payo from
the derivative in a risk neutral world.
4. Calculate the mean of the sample payo to get an estimate of the expected
payo in a riskneutral world.
5. Discount the estimated expected payo at the riskfree rate to get an
estimate of the value of the derivative.
45
Chapter 3
Mathematical Finance in
Discrete Time
Any variable whose value changes over time in an uncertain way is said to
follow a stochastic p.rocess. Stochastic processes can be classied as discrete
time or continuoustime. A discretetime stochastic process is one where the
value of the variable can change only at certain xed points in time, whereas
a continuoustime stochastic process is one where changes can take place at
any time. Stochastic processes can also be classied as continuousvariables or
discretevariables. In a continuousvariable process, the underlying variable can
take any value within a certain range, whereas in a discretevariable process,
only certain discrete values are possible. Binomial tree models belong to the
discretetime, discretevariable stochastic processes.
46
In this chapter we study socalled nite markets, i.e. discretetime models
of nancial markets in which all relevant quantities take a nite number of val
ues. We specify a time horizon T, which is the terminal date for all economic
activities considered. For a simple option pricing model the time horizon typi
cally corresponds to the expiry date of the option. We thus work with a nite
probability space (, P), with a nite number [[ of possible outcomes , each
with a positive probability: P() > 0.
3.1 Information and Trading Strategies
Access to full, accurate, uptodate information is clearly essential to anyone
actively engaged in nancial activity or trading. Indeed, information is arguably
the most important determinant of success in nancial life. We shall conne
ourselves to the situation where agents take decisions on the basis of information
in the public domain, available to all. We shall further assume that information
once known remains known and can be accessed in real time.
Our nancial market contains two nancial assets. A riskfree asset (the
bond) with a deterministic price process B
i
, and a risky assets with a stochastic
price process S
i
. We assume B
0
= 1 (we reckon in units of the initial value of
the bond) and B
i
> 0; we say it is a numeraire. 1/B
i
is called the discounting
factor at time i.
As time passes, new information becomes available to all agents. There
exists a mathematical object to model this information ow, unfolding with
47
time: ltrations. The concept ltration is not that easy to understand. The full
theory will lead us too far. In order to clear this out a bit, we explain the idea
of ltration in a very idealized situation. We will consider a stochastic process
X which starts at some value, zero say. It will remain there until time t = 1,
at which it can jump with positive probability to the value a or to a dierent
value b. The process will stay at that value until time t = 2 at which it will
jump again with positive probability to two dierent values: c and d say if is
was at time t = 1 at a and f and g say if the process was at time t = 1 at state
b. From then on the process will stay in the same value. The universum of the
probability space consists of all possible paths the process can follow, i.e. all
possible outcomes of the experiment. We will denote the path 0 a c by
1
, similarly the paths 0 a d, 0 b f and 0 b g are denoted by
2
,
3
and
4
respectively. So we have =
1
,
2
,
3
,
4
.
In this situation we will take the following ow of information, i.e. ltrations:
T
t
= , 0 t < 1;
T
t
= , ,
1
,
2
,
3
,
4
1 t < 2;
T
t
= T() = T 2 t.
We set here T = T(), the set of all subsets of .
To each of the ltrations given above, we associate resp. the following par
48
titions (i.e. the nest possible one) of :
T
0
= 0 t < 1;
T
1
=
1
,
2
,
3
,
4
1 t < 2;
T
2
=
1
,
2
,
3
,
4
2 t.
At time t = 0 we only know that some event will happen, at time
t = 2 we will know which event
will belong:
it will belong to
1
,
2
if we jumped at time t = 1 to a and to
3
,
4
if we
jumped to b. Finally, at time t = 2, we will know to which set of T
2
,
will
belong, in other words we will know then the complete path of the process.
During the ow of time we thus learn about the partitions. Having the
information T
t
revealed is equivalent to knowing in which set of the partition
of that time, the event
i
= V
i
=
i
B
i
+
i
S
i
, i = 1, 2, . . . , T
We will denote by V
0
the initial investment or endowment of the investor.
Now
i
B
i1
+
i
S
i1
reects the market value of the portfolio just after it
has been established at time i 1, whereas
i
B
i
+
i
S
i
is the value just after
time i prices are observed, but before changes are made in the portfolio. Hence
i
(B
i
B
i1
) +
i
(S
i
S
i1
)
is the change in the market value due to changes in security prices which occur
between time i 1 and i. We call G
= G = G
i
, i = 1, . . . , T, where
G
i
= G
i
=
i
j=1
(
j
(B
j
B
j1
) +
j
(S
j
S
j1
))
50
the gains process.
After the new prices (B
i
, S
i
) are quoted at time i, the investor adjusts his
portfolio from
i
= (
i
,
i
) to
i+1
= (
i+1
,
i+1
). We do not allow him bringing
in or consuming any wealth, so we must have
V
0
=
1
B
0
+
1
S
0
, V
i
=
i+1
B
i
+
i+1
S
i
, i = 1, . . . , T
We say our trading strategy is selfnancing and denote this by .
To avoid negative wealth and unbounded short sales we also introduce the
concept of admissible strategies. A selfnancing trading strategie is
called admissible if V
i
0 for each i = 0, 1, . . . , T. We write
a
for the class
of admissible trading strategies. Clearly
a
.
3.2 NoArbitrage Condition
The central principle in the Binomial tree models was the absence of arbitrage
opportunities, i.e. the absence of riskfree plans for making prots without any
investment. As mentioned there this principle is central for any market model,
and we now dene the mathematical counterpart of this economic principle in
our setting.
We call a selfnancing trading strategy an arbitrage opportunity if P(V
0
=
0) = 1 and the terminal wealth of satises
P(V
T
0) = 1 and P(V
T
> 0) > 0
So an arbitrage opportunity is a selfnancing strategy with zero initial value,
51
which produces a nonnegative nal value with probability one and has a postive
probability of a positive value.
We say that our market is arbitragefree if there are no selfnancing trading
strategies which are arbitrage opportunities.
We will link the economic principle of an arbitrage free market to a mathe
matical one: the existence of an equivalent martingale.
We say a probability measure P
S) ,= .
52
One can show that a security market which has no arbitrage opportunities in
a
, is also arbitragefree with respect to .
3.3 RiskNeutral Pricing
We now turn to the main underlying question of this text, namely the pricing
of contingent claims (i.e. nancial derivatives). First we have to model these
nancial instruments in our current framework. This is done in the following
fashion.
Denition 7 A contingent claim X with maturity date T is an arbitrary non
negative T
T
measurable random variable. We denote the class of all contingent
claims by A.
We say that the claim is attainable if there exists an (admissible) self
nancing strategy such that
V
T
= X.
The selfnancing strategy is said to be a replicating strategy. It generates
the same time T cashow as X does.
We now return to the main question of the section: given a contingent claim
X, i.e. a cashow at time T, how can we determine its value (price) at time
i < T ? For attainable contingent claims this value should be given by the
value of any replicating strategy (perfect hedge) at time i, i.e. there should be
a unique value process (say V
X
i
) representing the time i value of the claim X.
53
The following proposition ensures that the value process of replicating strategies
coincide, thus proving uniqueness of the value process.
Proposition 8 Suppose the market is arbitragefree. Then any attainable con
tingent claim X is uniquely replicated: for all , such that
V
T
= V
T
= X
we have that for all 0 i T
V
i
= V
i
This uniqueness property allows us now to dene the important concept of
an arbitrage price process.
Denition 9 Suppose the market is arbitrage free. Let X be any attainable
contingent claim with time T to maturity. Then the arbitrage price process
X
i
,
0 i T or simply the arbitrage price of X is given by the value process of
any replicating strategy for X.
The construction of hedging strategies that replicate the outcome of a con
tingent claim is an important problem in both practical and theoretical ap
plications. Hedging is central to the theory of option pricing. The classical
arbitrage valuation models, such as the Binomial tree models and the Black
Scholes Model (see the next Chapters), depend on the idea that an option can
be perfectly hedged using the underlying risky asset and a riskfree asset.
Analysing the arbitragepricing approach we observe that the derivation of
the price of a contingent claim doesnt require any specic preferences of the
54
agents other than that they prefer more to less, which rules out arbitrage. So,
the pricing formula for any attainable contingent claim must be independent
of all preferences that do not admit arbitrage. In particular, an economy of
riskneutral investors must price a contigent claim in the same manner. This
fundamental insight simplies the pricing formula enormously. In its general
form the price of an attainable contingent claim is just the expected value of
the discounted payo with respect to an equivalent martingale measure.
Proposition 10 The arbitrage price process of any attainable contingent claim
X is given by the riskneutral valuation formula
X
i
=
B
i
B
T
E
P
[X[T
i
], i = 0, 1, . . . , T
where E
P
is the expectation operator with respect to an equivalent martingale
measure P
.
Proof: Since we assume that the market is arbitragefree there exists (at
least) an equivalent martingale measure P
S
i
. Furthermore because the claim is attainable there exists (at least) one
selfnancing replicating strategy . First we prove that the discounted value
process
V
i
= B
1
i
V
i
is a P
i
[T
i1
]
V
i1
= E
P
[
i
V
i1
[T
i1
]
= E
P
[B
1
i
V
i
B
1
i1
V
i1
[T
i1
]
= E
P
[B
1
i
(
i
B
i
+
i
S
i
) B
1
i1
(
i1
B
i1
+
i1
S
i1
)[T
i1
]
= E
P
[B
1
i
(
i
B
i
+
i
S
i
) B
1
i1
(
i
B
i1
+
i
S
i1
)[T
i1
]
= E
P
[
i
(B
1
i
S
i
B
1
i1
S
i1
)[T
i1
]
=
i
E
P
[
S
i
S
i1
[T
i1
]
= 0.
The last equality follows because
S
i
= B
1
i
S
i
is P
X
i
= V
i
= B
i
i
= B
i
E
P
[
T
[T
i
]
= B
i
E
P
[B
1
T
V
T
[T
i
]
= (B
i
/B
T
)E
P
[V
T
[T
i
]
= (B
i
/B
T
)E
P
[X[T
i
]
56
3.4 Complete Markets
The last section made clear that attainable contingent claims can be priced using
an equivalent martingale measure. In this section we will discuss the question
of the circumstances under which all contingent claims are attainable. This
would be a very desirable property of the market, because we would then have
solved the pricing question (at least for contingent claims) completely under
the assumption that the market is arbitrage free. Since contingent claims are
merely nonnegative T
T
measurable random variables in our setting, it should
be no suprise that we can give a criterion in terms of probability measures. We
start with:
Denition 11 A market is complete if every contingent claim is attainable, i.e.
for every nonnegative T
T
measurable random variables X A there exists a
replicating strategy such that V
T
= X.
In the case of an arbitragefree discrete market, one can insist on replicating
contingent claims by an admissible strategy
a
.
Based on the noarbitrage assumption one can prove:
Theorem 12 (Completeness Theorem) An arbitrage free market is com
plete if and only if there exists a unique probability measure P
equivalent to P
under which the discounted price process of the stock
S
i
= B
1
i
S
i
is a martin
gale, i.e. T(
S) = P
.
57
3.5 The Fundamental Theorem of Asset Pricing
We summarise what we have achieved so far. We call a measure P
under
which the discounted price
S is a P
.
The above theorem establishes the equivalence of an economic modelling condi
tion such as noarbitrage and completeness to the existence of the mathematical
modelling condition, viz. the existence and uniqueness of equivalent martingale
measures.
Assume now that the market is arbitragefree and complete and let X A
be any contingent claim, a replicting strategy (which exists by completeness),
then:
V
T
= X
58
Furthemore, we have seen that
X
i
= V
i
=
B
i
B
T
E
P
[X[T
i
], i = 0, 1, . . . , T
and call
X
i
= V
i
the the arbitrage price of the contingent claim X at time i.
For, if an investor sells the claim X at time i for
X
i
, he can follow strategy
to replicate X at time T and clear the claim; an investor selling this value
is perfectly hedged. To sell the claim for any other amount would provide an
arbitrage opportunity. We note that, to calculate prices as above, we need to
know only:
the set of all possible states,
the ltration F,
P
.
We do not need to know the underlying probability measure P (only its null
sets, to know what equivalent to P means and actually in our nite model
there are no nonempty nullsets, so we do not need to know even this).
Now pricing of contingent claims is our central task, and for pricing purposes
P
is vital and P itself irrelevant. We thus may and shall focus attention
on P
.
59
3.5.1 Examples
The Onestep Binomial Model
We return to model given in Figure 2.2. There exists only two possible outcomes.
There is an upperstate u if price after one time step equals S
1
= uS
0
and a
downstate d if the stock price changes to S
1
= dS
0
, = u, d. In both
cases the riskfree asset goes from 1 to a price b say (b is typically equal to
e
r
or 1 + r
(u) = p
+b
1
dS
0
(1 p
) = S
0
. (3.1)
Rewriting (3.1) gives
p
=
b d
u d
(3.2)
In order that this gives rise to a probability measure, we should have 0 < p
< 1,
which is equivalently with
u > b > d 0. (3.3)
In conclusion a martingale measure P
f
u
+b
1
(1 p
)f
d
In order to hedge or replicated this claim one has to solve the equations
uS
0
+b = f
u
dS
0
+b = f
d
Note that this system of equations has a unique solution if and only if
det
_
_
uS
0
b
dS
0
b
_
_
,= 0,
which is equivalent with S
0
,= 0, b ,= 0, and u ,= d (all which are ruled out).
The Onestep Trinomial Model
Suppose now the following onestep trinomial model: In one time step there
exists three possible outcomes as shown in picture 3.1. There is an upperstate u
if the stock price changes to S
1
= uS
0
, a middle state m if the stock price after
61
Figure 3.1: The Onestep Trinomial Model
one step is S
1
= mS
0
, and a downstate d if the stock price changes to S
1
= dS
0
,
0 d < m < u: = u, m, d. Again, in all cases the riskfree asset changes in
a deterministic way from 1 to a price b say. A probability measure on is now
completely determined by two numbers 0 < P(u) < 1 and 0 < P(m) < 1;
we then have P(d) = 1 P(u) P(m). In order that the discounted
price process is a martingale with respect to a probability measure P
, with say
0 < P
(u) = p
(m) = q
+b
1
mS
0
q
+b
1
dS
0
(1 p
) = S
0
.
Unfortunately this equation has more than one solution as can be easily been
seen after a simple rewriting:
p
=
(b d) (md)q
u d
For every 0 < q
and q
, q
< 1 and p
+ q
_
uS
0
b f
u
mS
0
b f
m
dS
0
b f
d
_
_
= 0.
Because we assume that S
0
,= 0 and b ,= 0, this is equivalent with
det
_
_
u 1 f
u
m 1 f
m
d 1 f
d
_
_
= 0.
So only contingent claims which payo function satises the above condition
are attainable and can be replicated and priced in an arbitragefree way.
63
Chapter 4
ContinuousTime Stochastic
Processes
This chapter develops a continuoustime, continuousvariable stochastic process
for stock prices. An understanding of this process is the rst step to understand
ing the pricing of options and other more complicated derivatives. It should
be noted that, in practice, we do not observe stock prices following continuous
variable, continuoustime processes. Stock prices are restricted to discrete values
(often multiples of 0.01 euro) and changes can be observed only when the ex
change is open. Nevertheless, the continuousvariable, continuoustime process
proves to be a useful model for many purposes.
The underlying setup is as in the discrete time case. We assume a xed nite
planning horizon T. We need a complete probability space (, T
T
, P), equipped
64
with a ltration, i.e. a nondecreasing family F = (T
t
)
0tT
of subelds of
T
T
: T
s
T
t
T
T
for 0 < s < t T; here T
t
represents the information
available at time t, and the ltration F = (T
t
) represents the information ow
evolving with time.
We assume that the ltered probability space (, T
T
, P, F) satises the usual
conditions: a) T
0
contains all Pnull sets of T. This means intuitively that we
know which events are possible and which not, and b) (T
t
) is rightcontinuous,
i.e. T
t
=
s>t
T
s
; a technical condition.
A stochastic process X = (X
t
)
0tT
is a family of random variables dened
on (, T
T
, P, F). We say X is Fadapted if X
t
T
t
(i.e. X
t
is T
t
measurable)
for each t: thus X
t
is known at time t.
4.1 Classes of Processes
4.1.1 Markov Processes
A Markov process is a particular type of stochastic process where only the
present value of a variable is relevant for predicting the future. The past history
of the variable and the way that the present has emerged from the past are
irrelevant.
Stock prices are usually assumed to follow a Markov process to some degree .
If the stock price follows a Markov process, our predictions for the future should
be unaected by the price one week ago, one month ago, or one year ago. The
only relevant piece of information is the price now. Predictions for the future
65
are uncertain and must be expressed in terms of probability distributions. The
Markov property implies that the probability distribution of the price at any
particular future time is not dependent on the particular path followed by the
price in the past. Observe that in the binomial tree model of Chapter 2 the
stock price evolution indeed followed a Markov process.
4.1.2 Martingales
A stochastic process X = (X
t
)
t0
is a martingale relative to (P, F) if
X is Fadapted
E[[X
t
[] < for all t 0
E[X
t
[T
s
] = X
s
, Pa.s., (0 s t),
A martingale is constant on average, and models a fair game. This can be seen
from the third condition: the best forecast of the unobserved future value X
t
based on information at time s, T
s
, is the at time s known value X
s
.
4.2 Brownian Motion
The Scottish botanist Robert Brown observed pollen particles in suspension
under a microscope in 1828 and 1829, and observed that they were in constant
irregular motion. In 1900 L. Bachelier considered Brownian motion as a possible
model for stockmarket prices. In 1905 Albert Einstein considered Brownian
motion as a model of particles in suspension and used it to estimate Avogadros
66
number. In 1923 Norbert Wiener dened and constructed Brownian motion
rigorously for the rst time. The resulting stochastic process is often called the
Wiener process in his honour.
Denition 15 A stochastic process X = X
t
, t 0 is a standard Brownian
motion on some probability space (, T, P), if
1. X
0
= 0 a.s.
2. X has independent increments.
3. X has stationary increments.
4. X
t+s
X
t
is normally distributed with mean 0 and variance s: X
t+s
X
t
N(0, s).
5. X has continuous sample paths.
We shall henceforth denote standard Brownian motion by W = W
t
, t
0 (W for Wiener). Note that the second item in the denition implies that
Brownian motion is a Markov process. No construction of Brownian motion is
easy: one needs both some work and some knowledge of measure theory. We
take the existence of Brownian motion for granted. To gain some intuition on
its behaviour, it is good to compare Brownian motion with a simple symmetric
random walk on the integers. More precisely, let X = X
i
, i = 1, 2, . . . be a
series of independent and identically distributed random variables with Pr(X
i
=
1) = Pr(X
i
= 1) = 1/2. Dene the simple symmetric random walk Z =
Z
n
, n = 0, 1, 2, . . . as Z
0
= 0 and Z
n
=
n
i=1
X
i
, n = 1, 2, . . . . Rescale this
67
random walk as Y
k
(t) = Z
kt
/
W =
W
t
= cW
t/c
2 , t 0 (4.1)
is a Brownian motion.
70
4.3 It os Calculus
4.3.1 Stochastic Integrals
Stochastic integration was introduced by K. It o in 1941, hence its name It o
calculus. It gives meaning to
_
t
0
X
u
dY
u
for suitable stochastic processes X = X
u
, u 0 and Y = Y
u
, u 0, the
integrand and the integrator. We shall conne our attention here to the basic
case with integrator Brownian motion: Y = W.
Because Brownian motion is of innite (unbounded) variation on every inter
val, the rst thing to note is that stochastic integrals with respect to Brownian
motion, if they exist, must be quite dierent from the classical deterministic in
tegrals. We take for granted It os fundamental insight that stochastic integrals
can be dened for a suitable class of integrands.
We only show how these integrals can be dened for some simple integrands
X.
Indicators
If X
t
= 1
[a,b]
(t), i.e. it equals 1 between a and b and is zero elsewhere, we dene
_
XdW:
I
t
(X) =
_
t
0
X
s
dW
s
=
_
_
0 if t a
W
t
W
a
if a t b
W
b
W
a
if t b
71
Simple deterministic functions
We can extend the above denition by linearity: if X is a linear combination of
indicators, X
t
=
n
i=1
c
i
1
[ai,bi]
(t), we dene
_
XdW:
I
t
(X) =
_
t
0
X
s
dW
s
=
n
i=1
c
i
_
t
0
1
[ai,bi]
(s)dW
s
Simple stochastic processes
X is called a simple stochastic process if there is a partition 0 = t
0
< t
1
<
< t
n
= T < and uniformly bounded T
t
k
measurable random variables
k
([
k
[ C for all k = 0, . . . , n for some C) and if X
t
can be written in the form
X
t
=
0
1
0
(t) +
n1
i=0
i
1
(ti,ti+1]
(t), 0 t T.
Then if t
k
t t
k+1
, k = 0, . . . , n 1,
I
t
(X) =
_
t
0
X
s
dW
s
=
k1
i=0
i
(W
ti+1
W
ti
) +
k
(W
t
W
t
k
)
It is not so hard to prove some simple properties of the stochastic integrals
dened so far:
I
t
(aX +bY ) = aI
t
(X) +bI
t
(Y ).
I
t
(X) is a martingale.
It o isometry: E[(I
t
(X))
2
] =
_
t
0
E[(X
u
)
2
]du.
The It o isometry above suggests that
_
t
0
XdW should be dened only for processes
with
_
t
0
E[(X
u
)
2
]du < for all t and this is indeed the case. Each such X may
be approximated by a sequence of simple stochastic processes and the stochas
tic integral may be dened as the limit of this approximation. Furthermore
72
the three above properties remain true. We will not include the technical and
detailed proofs of this procedure in this book. Note that one also can construct
a closely analogous theory for stochastic integrals with the Brownian integrator
W above replaced by a (semi)martingale integrator M.
4.3.2 It os Lemma
The price of a stock option is a function of the underlying stocks price and
time. More generally, we can say that the price of any derivative is a function of
the stochastic variables underlying the derivative and time. Therefore, we must
acquire some understanding of the behavior of functions of stochastic variables.
An important result in this area was discovered by K. It o, in 1951. It is known
as It os lemma.
Suppose that F : R
2
R is a function, which is continuously dierentiable
once in its rst argument (which will denote time), and twice in its second
argument: F C
1,2
. Denote the partial derivatives
F
t
(t, x) =
F
t
(t, x)
F
x
(t, x) =
F
x
(t, x)
F
xx
(t, x) =
2
F
x
2
(t, x)
Theorem 16 (It os lemma) Let W = W
t
, t 0 be Standard Brownian
motion and let F(t, x) C
1,2
, then
F(t, W
t
)F(s, W
s
) =
_
t
s
F
x
(u, W
u
)dW
u
+
_
t
s
F
t
(u, W
u
)du+
1
2
_
t
s
F
xx
(u, W
u
)du.
73
or
dF = F
x
dW
t
+F
t
dt +
1
2
F
xx
dt.
for short.
As an application of It os lemma we compute
_
t
0
W
u
dW
u
by using F(t, x) =
x
2
. Then
W
2
t
= W
2
0
+
_
t
0
2W
u
dW
u
+
1
2
_
t
0
2du = 2
_
t
0
W
u
dW
u
+t.
So that
_
t
0
W
u
dW
u
=
W
2
t
2
t
2
Note the contrast with ordinary calculus ! It o calculus requires the second term
on the right the It o correction term.
4.4 Stochastic Dierential Equations
Like with any ordinary and partial dierential equations in a deterministic set
ting (ODEs and PDEs), the two most basic questions are those of existence and
uniqueness of solutions. To obtain existence and uniqueness results, one has to
impose reasonable regularity conditions on the coecients occuring in the dif
ferential equation. Naturally, stochastic dierential equations (SDEs) contain
all the complications of their nonstochastic counterparts, and more besides.
Consider the stochastic dierential equation
dX
t
= b(t, X
t
)dt +(t, X
t
)dW
t
, X
s
= x, (4.2)
74
where the coecients b and satisfy the following Lipschitz and growth condi
tions
[b(t, x) b(t, y)[ +[(t, x) (t, y)[ K[x y[
[b(t, x)[
2
+[(t, x)[
2
K
2
(1 +[x[
2
)
for all t 0, x, y R, for some constant K > 0.
To see that the SDE (4.2) has a solution, we rst dene recursively
X
(0)
t
= x, X
(n+1)
t
= x +
_
t
s
b(u, X
(n)
u
)du +
_
t
s
(u, X
(n)
u
)dW
u
.
One can then prove that X
(n)
t
converges (in some sense), to X
t
say; X
t
is the
unique (strong) solution to (4.2), i.e.
X
0
= x, X
t
= x +
_
t
s
b(u, X
u
)du +
_
t
s
(u, X
u
)dW
u
.
In the above case the solution X
t
is adapted to T
(W)
t
= T
t
which in our
setting is (W
u
, s u t) augmented with all Pnull sets, therefore it is called
a strong solution. It may at rst appear surprising that situations arise where
the solution is not adapted to (T
(W)
t
), but they do exist. However one can in
many cases solve them, by setting up a ltered probability space for oneself,
setting up an SDE of the required form on it, and solving the SDE there.
The resulting solution concept is that of a weak solution. Weak solutions are
distributional, rather than pathwise, in nature. In what follows we will assume
that the coecients of the SDEs we consider satisfy the above Lipschitz and
growth conditions.
The next result, which is an example for the rich interplay between probabil
ity theory and analysis, links SDEs with PDEs. Suppose we consider a stochastic
75
dierential equation (satisfying the above Lipschitz and growth conditions),
dX
u
= (u, X
u
)du +(u, X
u
)dW
u
, X
s
= x, s u T
Consider a function F(t, x) C
1,2
of it. Then we have the following extension
of It os lemma:
Theorem 17 (It os lemma for SDEs) Let F(t, x) C
1,2
, then
F(t, X
t
) F(s, X
s
) =
_
t
s
(u, X
u
)F
x
(u, X
u
)dW
u
+ (4.3)
_
t
s
_
F
t
(u, X
u
) +(u, X
u
)F
x
(u, X
u
) +
(u, X
u
)
2
2
F
xx
(u, W
u
)
_
du.
Now suppose that F satises the PDE
F
t
(t, x) +(t, x)F
x
(t, x) +
((t, x))
2
2
F
xx
(x, t) = 0,
with boundary condition
F(T, x) = h(x).
Then the above expression for (4.3) gives
F(s, X
s
) = F(t, X
t
)
_
t
s
(u, X
u
)F
x
(u, X
u
)dW
u
The stochastic integral on the right is a martingale, so has constant expectation,
which must be 0 as it starts at 0. So
F(s, x) = E[F(t, X
t
)[X
s
= x]
which leads for t = T to the FeynmanKac Formula
F(s, x) = E[h(X
T
)[X
s
= x].
76
The FeynmanKac formula gives a stochastic representation to solutions of
PDEs. We shall return to the FeynmanKac formula below in connection with
the BlackScholes partial dierential equation.
4.5 Geometric Brownian Motion
Now that we have both Brownian motion W and It os Lemma to hand, we can
introduce the most important stochastic process for us, a relative of Brownian
motion geometric Brownian motion.
Suppose we wish to model the time evolution of a stock price S
t
. Consider
how S will change in some small time interval from the present time t to a time
t +t in the near future. Writing S
t
for the change S
t+t
S
t
, the return on
S in this interval is S
t
/S
t
. It is economically reasonable to expect this return
to decompose into two components, a systematic part and a random part. The
systematic part could plausibly be modeled by t, where is some parameter
representing the mean rate of the return of the stock. The random part could
plausibly be modeled by W
t
, where W
t
represent the noise term driving the
stock price dynamics, and is a second parameter describing how much eect
the noise has how much the stock price uctuates. Thus governs how volatile
the price is, and is called the volatility of the stock. The role of the driving noise
term is to represent the random bueting eect of the multiplicity of factors at
work in the economic environment in which the stock price is determined by
supply and demand.
77
Putting this together, we have the following SDEs
S
t
= S
t
(t +W
t
), S
0
> 0.
In the limit as t 0, we have the stochastic dierential equation
dS
t
= S
t
(dt +dW
t
), S
0
> 0.
The dierential equation above has the unique solution
S
t
= S
0
exp
__
2
2
_
t +W
t
_
.
For, writing
f(t, x) = exp
__
2
2
_
t +x
_
It os lemma gives
df(t, W
t
) =
f
t
dt +
f
x
dW
t
+
1
2
2
f
x
2
dt
=
_
2
2
_
fdt +fdW
t
+
1
2
2
fdt
= f(dt +dW
t
)
so f(t, W
t
) is a solution of the stochastic dierential equation. This means that
log S
t
= log S
0
+
_
2
2
_
t +W
t
has a normal distribution. Thus S
t
itself has a lognormal distribution. This
geometric Brownian motion model, and the lognormal distribution which it
entails, are the basis for the BlackScholes model for stockprice dynamics in
continuous time.
In Figure 4.3 one sees the realization of the geometric Brownian motion
based on the sample path of the standard Brownian motion of Figure ??.
78
Figure 4.3: Sample path of a geometric Brownian motion (S
0
= 100, =
0.05, = 0.40)
4.6 Martingale Representations
To discuss questions of market completeness we will need the following theorem,
which has important economic consequences:
Theorem 18 (Representation Theorem) Let C be an T
T
measurable ran
dom variable 0 < T < with E[C
2
] < ; then there exists a adapted (pre
dictable) process H = H
s
, 0 s T such that
C = E[C] +
_
T
0
H
s
dW
s
.
The economic relevance of the representation theorem is that it shows that
the BlackScholes model is complete, that is, that every (square integrable)
contingent claim can be replicated by a dynamic trading strategy. The desirable
mathematical properties of Brownian motion are thus seen to have hidden within
them desirable economic and nancial consequences of real practical value.
79
Remark: We only consider Cs, with E[C
2
] < . In a general setting with
our setting E[[C[] < , a process H exists which is a progressively measurable
processes (a slight enlargement of the predictable, (which equal in our case the
adaptable) processes). There are essentially no naturally occuring examples of
progressively measurable processes that are not adapted.
80
Chapter 5
The BlackScholes Option
Price Model
In the early 1970s, Fischer Black, Myron Scholes, and Robert Merton made
a major breakthrough in the pricing of stock options by developing what has
become known as the BlackScholes model. The model has had huge inuence
on the way that traders price and hedge options. In 1997, the importance of the
model was recognized when Myron Scholes and Robert Merton were awarded
the Nobel prize for economics. Sadly, Fischer Black died in 1995, otherwise he
also would undoubtedly have been one of the recipients of this prize.
This chapter shows how the BlackScholes model for valuing European call
and put options on a nondividendpaying stock is derived.
81
5.1 The Market Model
We consider a frictionless security market in which two assets are traded con
tinously. Investors are allowed to trade continuously up to some xed nite
planning horizon T, where all economic activity stops.
The rst asset is one without risk (the bank account). Its price process is
given by B
t
= e
rt
, 0 t T. The second asset is a risky asset, usually refered
to as stock. The price process of this stock, S
t
, 0 t T, is modelled by the
linear stochastic dierential equation
dS
t
= S
t
(dt +dW
t
), S
0
= x > 0,
where W
t
is standard Brownian motion, dened on a ltered probability space
(, T, P, F). This means that under P, W
t
has a Normal(0, t) distribution.
Furthermore, in the previous chapter we derived that S
t
follows a geometric
Brownian motion:
S
t
= S
0
exp
__
2
2
_
t +W
t
_
.
is reecting the drift and models the volatility and are assumed to be
constant. We assume as underlying ltration, the Brownian ltration F =
(T
t
), basically T
t
= (W
s
, 0 s t), slightly enlarged to satisfy the usual
conditions. Consequently, the stock price process S
t
follows a strictly positive
adapted process. We call this market model the BlackScholes model.
Our principle task will be the pricing and hedging of contingent claims, which
we model as nonnegative T
T
measurable random variables. This implies that
the contingent claims specify a stochastic cashow at time T and that they
82
may depend on the whole path of the underlying in [0, T] because T
T
contains
all information.
We will often have to impose further (integrability) conditions on the con
tingent claims under consideration. As before, the fundamental concept in (ar
bitrage) pricing and hedging contingent claims is the interplay of selfnancing
replicating portfolios and riskneutral probabilities. Although the current (time
continuous) setting is on a much higher level of sophistication, the key ideas
remain the same.
We call a twodimensional adapted (predictable), locally bounded process
=
t
= (
t
,
t
), t [0, T]
a trading strategy or dynamic portfolio process. The conditions ensure that the
stochastic integral
_
t
0
t
dW
t
exists. Here
t
denotes the money invested in the
riskless asset and
t
denotes the number of stocks held in the portfolio at time
t.
Remark: In a more general setting the trading strategy has to be pre
dictable in stead of adapted. Predictability of these processes imply that (
t
,
t
)
has to be determined on the basis of information available strictly before time
t, T
t
: the investor selects his time t portfolio just before the observation of the
price S
t
. Because our Brownian ltration is continuous we have T
t
= T
t
and
predictablity and adaptedness are the same.
The components of
t
may assume negative as well as positive values, reect
ing the fact that we allow short sales and assume that the assets are perfectly
divisible.
83
Denition 19 (i) The value of the portfolio at time t is given by
V
t
= V
t
=
t
B
t
+
t
S
t
=
t
e
rt
+
t
S
t
The process V
t
is called the value process, or wealth process, of the trading
strategy .
(ii) The gains process G
t
is dened by
G
t
= G
t
=
_
t
0
u
dB
u
+
_
t
0
u
dS
u
(iii) A trading strategy is called selfnancing if the wealth process V
t
satis
es
V
t
= V
0
+G
t
for all t [0, T].
The nancial implications of the above equations are that all changes in the
wealth of the portfolio are due to market changes, as opposed to withdrawals of
cash or injections of new funds.
5.2 Equivalent Martingale Measures and Risk
Neutral Pricing
Next, we develop a pricing theory for contingent claims. Again the underlying
concept is the link between the noarbitrage condition and certain probability
measures. We begin with
Denition 20 A trading strategy is called tame, if the associated wealth
84
process is always positive:
V
t
0, for all t [0, T].
Similarly as in the discrete case (admissible strategies), tame strategies prevent
the broker from unbounded short sales. Using tame strategies the investors
wealth may never go negative at a time, even if he is able to cover his debt at
the nal date. If we would later on allow nontame strategies, one can show
that it is possible to construct doubling strategies that can attain arbitrarily
large values of wealth starting with zero initial capital. Such strategies are
examples of arbitrage opportunities, which we dene in general as:
Denition 21 A selfnancing trading strategy is called an arbitrage oppor
tunity if the wealth process V
satises the following set of conditions:
V
0
= 0, P(V
T
0) = 1 and P(V
T
> 0) > 0.
Arbitrage opportunities represent the limitless creation of wealth through risk
free prot and thus should not be present in a wellfunctioning market.
We say that our market is arbitragefree if there are no tame selfnancing
arbitrage opportunities.
The main tool in investigating arbitrage opportunities is the concept of
equivalent martingale measures:
Denition 22 We say that a probability measure P
dened on (, T
T
) is an
equivalent martingale measure if:
(i) P
is equivalent to P
85
(ii) the discounted price process
S
t
= e
rt
S
t
is a P
martingale.
We denote the set of equivalent martingale measures by T.
As in the discrete case, one can prove that one can preclude arbitrage op
portunities if an equivalent martingale measure exists.
Let P
S
t
[T
s
] = E
P
[
S
t
[W
s
]
= E
P
_
S
0
exp
__
( r)
2
2
_
t +W
t
_
[W
s
_
= S
0
exp
__
( r)
2
2
_
t
_
E
P
[exp (W
t
) [W
s
]
= S
0
exp
__
( r)
2
2
_
t
_
exp (W
s
) E
P
[exp((W
t
W
s
)) [W
s
]
= S
0
exp
__
( r)
2
2
_
t
_
exp (W
s
) E
P
[exp((W
t
W
s
))]
= S
0
exp
__
( r)
2
2
_
t
_
exp (W
s
) E
P
[exp(W
ts
)]
= S
0
exp
__
( r)
2
2
_
t
_
exp (W
s
) exp
_
m(t s) +
2
2
(t s)
_
= S
0
exp
_
( r)t +m(t s)
2
2
s +W
s
_
If we now set m = (r )/, then
E
P
[
S
t
[T
s
] = S
0
exp
__
r
2
2
_
s +W
s
_
=
S
s
,
and we see that the discounted price process
S
t
is a martingale under P
.
86
Furthermore under the P
dynamics,
dS
t
= S
t
(dt +d(
W
t
+mt))
= S
t
(dt +mdt +d
W
t
)
= S
t
(rdt +d
W
t
).
We see that the drift is replaced by the riskfree interest rate r.
So we have at least one equivalent martingale measure P
)admissible if
t
=
_
t
0
u
d
S
u
is a P
)admissible
trading strategies.
It is related with the question whether the stochastic integral with respect to a
martingale (
S
u
) remains a martingale. As seen in Section 4.3, this is the case
if integration is with respect to Brownian motion (or by Itos lemma functions
of Brownian motion), but such a result does not hold in all generality for other
possible integrators. The result one gets is:
Theorem 25 The market model contains noarbitrage opportunities in (P
).
87
5.3 Hedging
We now turn to the problem of replicating. We say a contingent claim X
satisfying E
P
[X
2
] < is attainable, if there exists at least one tame self
nancing trading strategy such that V
T
= X. If every contingent claim X
satisfying E
P
[X
2
] < is attainable, we say the model is complete.
Given a contingent claim X such that E
P
[X
2
] < . Consider the martin
gale
M
t
= E
P
[e
rT
X[T
t
].
By the representation theorem, one can write:
M
t
= E
P
[M
t
] +
_
t
0
h
s
d
W
s
Because M
t
is a P
martingale E
P
[M
t
] = M
0
. Recall that S follows the P

dynamics dS = S(rdt + d
W) and that B follows the dynamics dB
t
= rB
t
dt.
Then, the strategy
= (
t
,
t
) =
_
M
t
h
t
,
h
t
B
t
S
t
_
will be the tame selfnancing strategy replicating the claim X. To see this, we
88
calculate rst the gain process of the strategy:
G
u
=
_
u
0
t
dB
t
+
_
u
0
t
dS
t
=
_
u
0
_
M
t
h
t
_
dB
t
+
_
u
0
h
t
B
t
S
t
dS
t
=
_
u
0
M
t
dB
t
_
u
0
h
t
dB
t
+
_
u
0
h
t
B
t
S
t
S
t
rdt +
_
u
0
h
t
B
t
S
t
S
t
d
W
t
=
_
u
0
M
t
dB
t
_
u
0
h
t
dB
t
+
_
u
0
h
t
dB
t
+
_
u
0
h
t
B
t
d
W
t
=
_
u
0
M
t
dB
t
+
_
u
0
h
t
B
t
d
W
t
=
_
u
0
_
M
0
+
_
t
0
h
s
d
W
s
_
dB
t
+
_
u
0
h
t
B
t
d
W
t
= M
0
_
u
0
dB
t
+
_
u
0
_
t
0
h
s
d
W
s
dB
t
+
_
u
0
h
t
B
t
d
W
t
= M
0
(B
u
B
0
) +
_
u
0
_
u
s
h
s
dB
t
d
W
s
+
_
u
0
h
t
B
t
d
W
t
= M
0
(B
u
B
0
) +
_
u
0
h
s
_
u
s
dB
t
d
W
s
+
_
u
0
h
t
B
t
d
W
t
= M
0
(B
u
B
0
) +
_
u
0
h
s
(B
u
B
s
)d
W
s
+
_
u
0
h
t
B
t
d
W
t
= M
0
(B
u
B
0
) +
_
u
0
h
s
B
u
d
W
s
_
u
0
h
s
B
s
d
W
s
+
_
u
0
h
t
B
t
d
W
t
= M
0
(B
u
B
0
) +B
u
_
u
0
h
s
d
W
s
= M
0
(B
u
B
0
) +B
u
(M
u
M
0
)
= M
u
B
u
M
0
B
0
Furthermore one can clearly see that the wealth process equals:
V
u
=
_
M
u
h
u
_
B
u
+
_
h
u
B
u
S
u
_
S
u
= M
u
B
u
0
Clearly is a tame strategy. Furthermore, we have
V
0
= M
0
V
T
= M
T
B
T
= X
89
Putting all things together we see that the strategy is also selfnancing
V
0
+G
u
= M
0
+ (M
u
B
u
M
0
B
0
) = M
u
B
u
= V
u
and that it is replicating X.
We have thus shown that X is attainable, and since X was arbitrary our
BlackScholes model is complete. So we state the second keyresult:
Theorem 26 The BlackScholes market model is complete.
Remark: In the more general continuoustime setting, we have the fol
lowing partial analogue of the completeness theorem in the discrete setting: If
T = P
, then the market is complete, in the restricted sense that for every
contingent claim X satisfying E
P
[X
2
] < there exists at least an admissible
selfnancing trading strategy such that V
T
= X.
Remark: Having seen the above results, a natural question is to ask whether
converse statements are also true. One has to put some further requirements
on portfolios to establish such converse results. These requirements should of
course be economically meaningful. A lot of eort has been put into solving this
question, and several alternatives have been proposed, but the details will lead
us to far.
If a contingent claim X is attainable, it can be replicated by a portfolio ,
called a replicating strategy. This means that the portfolio and holding the
contingent claim are equivalent from a nancial point of view. In the absence of
arbitrage the (arbitrage) price process
X
t
of the contingent claim must therefore
90
satisfy
X
t
= V
t
.
Of course the question arises of what will happen if X can be replicated by more
than one portfolio and what the relation is of the price process to the equivalent
martingale measure(s). The following central theorem (which is also true in a
more general continuoustime setting) is the key to answering these questions.
Theorem 27 The arbitrage price process of any attainable contingent claim X
is given by the riskneutral valuation formula
X
t
= e
(Tt)r
E
P
[X[T
t
], t [0, T].
The uniqueness question is immediate from the above theorem:
Corollary 28 For any two replicating portfolios and we have
V
t
= V
t
, for all t [0, T]
In general, the risk neutral valuation follows the following procedure:
1. Assume that the expected return from the underlying asset is the riskfree
interest rate r (i.e., assume = r)
2. Calculate the expected payo from the option at its maturity.
3. Discount the expected payo at the riskfree interest rate.
91
5.4 In Practice
For practitioners it is of equal importance to explicitly calculate the price and
replicating portfolio (which exists by completeness). The martingale represen
tation theorem guarantees the existence, but the explicit construction is rather
involved.
5.4.1 Pricing
By the riskneutral valuation principle the price of a contingent claim X is given
by
X
t
= e
(Tt)r
E
P
[X[T
t
], t [0, T]
Furthermore, if X is of the form X = G(S
T
) with a suciently integrable
function G, then the price process is also given by
X
t
= F(t, S
t
), where F
solves the BlackScholes partial dierential equation
F
t
(t, s) +rsF
s
(t, s) +
1
2
2
s
2
F
ss
(t, s) rF(t, s) = 0, (5.1)
F(T, s) = G(s) (5.2)
To obtain this PDE, we used the FeynmanKac representation of the P
martingale
M
t
= e
rT
E
P
[X[T
t
];
indeed with H(t, S
t
) = M
t
we know from the FeynmanKac representation that
H satises the PDE (recall that S satises the P
SDE: dS = S(rdt +d
W))
H
t
(t, s) +rsH
s
(t, s) +
1
2
2
s
2
H
ss
(t, s) = 0,
H(T, s) = e
rT
G(s).
92
By the riskneutral valuation principle
X
t
= e
rt
M
t
, and so F(t, s) = e
rt
H(t, s),
and computing the partial derivatives of F we obtain the PDE (5.1).
In some cases it is easier to evaluate the above expected value in the risk
neutral pricing formula, than solving the BlackScholes partial dierential equa
tion. Take for example a European call with strike K and maturity T on the
stock S ( so G(S
T
) = (S
T
K)
+
).
Lemma 29 If V is lognormally distributed, i.e. V = exp(U), where U has a
normal distribution, N(m,
2
) say, then
E[max(V a), 0] = E[V ]N(d
1
) aN(d
2
),
where
d
1
=
ln(E[V ]/a) +
2
2
5.4 (5.3)
d
2
=
ln(E[V ]/a)
2
2
The BlackScholes formulas for the prices at time zero of a European call
option on a nondividendpaying stock and a European put option on a non
dividendpaying stock are
C
K
= S
0
N(d
1
) Ke
rT
N(d
2
)
and
P
K
= S
0
N(d
1
) +Ke
rT
N(d
2
)
where
d
1
=
ln(S
0
/K) + (r +
2
2
)T
T
(5.4)
d
2
=
ln(S
0
/K) + (r
2
2
)T
T
= d
1
T (5.5)
93
and N(x) is the cumulative probability distribution function for a variable that
is standard normal distributed. As usual, S
0
is the stock price at time zero, K
is the strike price, r the continuously compounded riskfree rate, is the stock
volatility, and T is the time to maturity of the option.
5.4.2 Hedging
To obtain a replicating strategy we use Itos lemma to nd the dynamics of the
P
martingale H(t, S
t
) = M
t
:
dM
t
= S
t
H
s
(t, S
t
)d
W
t
which gives for the stock component of the replicating portfolio
t
=
S
t
H
s
(t, S
t
)B
t
S
t
= F
s
(t, S
t
)
and the bank account component
t
= M
t
S
t
H
s
(t, S
t
)
=
F(t, s) S
t
F
s
(t, S
t
)
B
t
The stock component
t
is also called the delta, , of the option.
For a European call option on a nondividendpaying stock, it can be shown
from the BlackScholes formulas that
call
= N(d
1
) = N
_
ln(S
0
/K) + (r +
2
2
)T
T
_
For a European put option on a nondividendpaying stock, it can be shown
from the BlackScholes formulas that delta is given by
put
= N(d
1
) 1 = N
_
ln(S
0
/K) + (r +
2
2
)T
T
_
1 =
call
1
94
is the rate of change of the option price with respect to the price of the
underlying asset. Suppose that the delta of a call option on as stock is 0.6. This
means that when the stock price changes by a small amount, the option price
changes by about 60 percent of that amount. Suppose further that the stock
price is 100 euro and the option price is 10 euro. Imagine an investor who has
sold 2000 option contracts that is, options to buy 2000 shares. The investors
position could be hedged by buying 0.6 2000 = 1200 shares. The gain (loss)
on the option position would then tend to be oset by the loss (gain) on the
stock position. For example, if the stock goes up by 1 euro (producing a gain
of 1200 euro on the shares purchased), the option price will tend to go up by
0.6 1 = 0.60 euro (producing a loss of 2000 0.6 = 1200 euro on the options
written); if the stock price goes down by 1 euro (producing a loss of 1200 euro
on the stock position), the option price will tend to go down by 0.60 (producing
a gain of 1200 euro on the option position).
It is important to realize that, because delta changes (with time and stock
price movements), the investors position remains deltahedged (or delta neu
tral) for only a relatively short period of time. In order to have a perfect hedge,
the positions have to be adjusted continuously. In practice however one can only
adjust periodically. This is known as rebalancing. For example, suppose that
an increase in the stock leads to an increase in delta, say from 0.60 to 0.65. An
extra of 0.05 2000 = 100 shares would then have to be purchased to maintain
the hedge.
Tables 5.1 and 5.2 provide two simulations of the operation of periodical
95
deltahedging. The hedge is assumed to be rebalanced weekly. Assume we have
to hedge a position of 100000 written call options on a nondividend paying
stock with strike price K, with
S
0
= 49, K = 50, r = 0.05 (compound interest rate per year),
= 0.2 (per year) and T = 20 weeks = 0.3846 years
From this we can easily compute the initial value of the call: C = 2.40047;
and the delta which equals = 0.52160. This means that as soon as the option
is written we have to buy 0.52160100000 = 52160 shares at a price of 49 euro,
for the total amount of 49 52160 = 2555840 euro. So we must borrow this
amount of 2555840 euro to buy 52160 shares. Because the interest rate is 0.05,
the interest cost totaling 2555840(exp(0.05/52) 1) = 2459 euro are incurred
in the rst week.
In Table 5.1, the stock price falls to 48.125 euro by the end of the rst week.
is recomputed at the end of the rst week using
S
0
= 48.125, K = 50, r = 0.05 (compound interest rate per year),
= 0.2 (per year) and T = 19 weeks = 0.3654 years
and is equal to = 0.45835. A total of 52160 (0.45835 100000) = 6325
shares must be sold to maintain the hedge. This realizes 632548.125 = 304391
cash and the cumulative borrowings at the end of week one are reduced to
2555840 304391 + 2459 = 2253908 euro. During the second week the stock
price reduces to 47.375 euro and the delta declines again; and so on. Towards the
96
Table 5.1: Hedging simulation; call option closes in the money
end of the life of the option it becomes apparent that the option will be exercised
and the delta approaches 1. By week 20, therefore, the hedger has a fully covered
position. The hedger receives 5000000 euro for the stock held, so that the total
cost of writing the option and hedging it is 5000000 5263157 = 263157 euro.
Table 5.2 illustrates an alternative sequence of events such that the option closes
out of the money. As it becomes clearer that the option will not be exercised,
delta approaches zero. By week 20, the hedger has a naked position and has
incurred costs totaling 256558 euro.
In Table 5.1 and 5.2, the costs of hedging the option, when discounted to
the beginning of the period, i.e. 258145 and 251672 are close to but not exactly
the same as the BlackScholes price of 240047. If the hedging scheme worked
97
Table 5.2: Hedging simulation; call option closes out of the money
perfectly, the cost of hedging would, after discounting, be exactly equal to the
theoretical price of the option on every simulation. The reason that there is a
variation in the cost of delta hedging is that the hedge is rebalanced only once a
week. As rebalancing takes place more frequently, the uncertainty in the cost of
hedging is reduced. Of course the simulations above are idealized in that they
assume that the volatility and interest rate are constant and that there are no
transaction costs.
In Figure 5.1, one can see the underlying Standard Brownian Motion, the
related Geometric Brownian Motion, the option prices of a European call option
and the associated hedge over the one year lifetime of the option (S
0
= 100,
K = 105, r = 0.03, = 0.09, = 0.4). Note how fast is near maturuity
98
Figure 5.1: W
t
, S
t
, C
t
and
t
, t [0, 1] (S
0
= 100, K = 105, r = 0.03, = 0.09,
= 0.4)
99
going to 1 (the option ends in the money).
5.5 The Greeks
The BlackScholes option values depend on the (current) stock price S, the
volatility , the time to maturity T, the interest rate r, and the strike price K.
The sensitivities of the option price with respect to the rst four parameters are
called the Greeks and are widely used for hedging purposes.
Recall the BlackScholes formula for a European call:
C = C(S, T, K, r, ) = SN
_
ln(S
0
/K) + (r +
2
2
)T
T
_
Ke
rT
N
_
ln(S
0
/K) + (r
2
2
)T
T
_
.
We therefore get
=
C
S
= N
_
ln(S
0
/K) + (r +
2
2
)T
T
_
> 0
1 =
C
= S
Tn
_
ln(S
0
/K) + (r +
2
2
)T
T
_
> 0
=
C
T
=
S
2
T
n
_
ln(S
0
/K) + (r +
2
2
)T
T
_
+
Kre
rT
N
_
ln(S
0
/K) + (r
2
2
)T
T
_
> 0
=
C
r
= TKe
rT
N
_
ln(S
0
/K) + (r
2
2
)T
T
_
< 0
=
2
C
S
2
=
n
_
ln(S0/K)+(r+
2
2
)T
T
_
S
T
> 0,
where as usual N is the cumulative normal distribution function and n is its
density. As discussed before measures the change in the value of the option
100
compared with the change in the value of the underlying asset. Furthermore,
gives the number of shares in the replication portfolio for a call option.
Vega, 1, measures the change of the option price compared with the change
in the volatility of the underlying, and similar statements hold for theta , rho
. Gamma measures the sensitivity of our replicating portfolio to the change
in the stock price.
101
Chapter 6
Imperfections of the
BlackScholes Model
Over the last decades the BlackScholes model turned out to be very popular.
One should bear in mind however, that this elegant theory hinges on several
crucial assumptions. We assumed that there were no market frictions, like taxes
and transaction costs or constraints on the stock holding, etc.
Moreover, empirical evidence suggests that the classical BlackScholes model
does not describe the statistical properties of nancial time series very well. We
will focus on two main problems.
We see that the logreturns do not behave according to a Normal distrib
ution.
It has been observed that the volatilities estimated (or more general the
102
parameters or uncertainty) change stochastically over time and are clus
tered.
Next, we focus on these two problems in more detail.
6.1 The NonGaussian Character
6.1.1 Where is the Normal Distribution Failing ?
For a random variable X, we denote by
X
= = E[X]
its mean and by
Var[X] = E[(X
X
)
2
] > 0
its variance.
_
Var[X] is called the standard deviation (or in the context of
nance the volatility).
If we look at the daily logreturns over the period 111997 until 31121999
of dierent indices, we observe the following facts.
Skewness
The skewness measures the degree to which a distribution is asymmetric. The
skewness is dened to be the third moment about the mean, divided by the
third power of the standard deviation:
E[(X
X
)
3
]
Var[X]
3/2
103
For a symmetric distribution, the skewness is zero. If a distribution has a
longer tail to the left than to the right, it is said to have negative skewness. If
the reverse is true, then the distribution has a positive skewness.
In Table 6.1, we show for a set of popular indices the (empirical) skewness
of the daily logreturns over the period 111997 until 31121999. Recall that
since the Normal distribution is symmetric it has a zero skewness.
Index Skewness
SP500 0.4423
Nasdaqcomposite 0.5474
Nikkei225 0.1187
AEX 0.3132
DAX 0.4329
SSMI 0.3595
BEL20 0.4141
CAC40 0.2123
Table 6.1: Skewness of major indices
Looking at the empirical data, we see that there is signicant skewness.
Fat Tails and Excess Kurtosis
We also see that large asset price movements occur more frequently than in a
model with Normal distributed increments. This feature is often referred to
as excess kurtosis or fat tails; it is the main reason for considering asset price
processes with jumps.
104
A way to measure this fat tail behavior is by the looking at the kurtosis
which is dened by
E[(X
X
)
4
]
Var[X]
2
.
For the Normal distribution (mesokurtic), the kurtosis is 3. If the distribution
has a atter top (platykurtic), the kurtosis is less than 3. If the distribution has
a high peak (leptokurtic), the kurtosis is greater than 3.
In the Table 6.2, we calculated for the same set of indices the kurtosis of the
daily logreturns over the same period 111997 until 31121999.
Index Kurtosis
SP500 6.96
Nasdaqcomposite 5.81
Nikkei225 4.76
AEX 5.10
DAX 4.67
SSMI 5.40
BEL20 5.40
CAC40 4.64
Table 6.2: Kurtosis of major indices
We clearly see that our data always gives rise to a kurtosis clearly bigger
than 3, indicating that the tails of the Normal distribution go much faster to
zero than the empirical data suggests and that the distribution is much more
peaked.
105
6.1.2 Statistical Testing
Next, we will use some statistical tests to show that the Normal distribution
does not deliver a very good t.
QQPlots
The fat tails property can also be seen by a graphical method: the quantile
quantile plot (QQplot) of the logreturns. It is a qualitative yet very powerful
method for testing the goodness of t. A QQplot of a sample of n points
plots for every j = 1, . . . , n the empirical (j (1/2))/n)quantile of the data
against the (j (1/2))/n)quantile of the tted distribution. If the empirical
distribution follows the theoretic distribution, their quantiles will be almost the
same: The plotted points should not as such deviate too much from a straight
line.
For the BlackScholes model, where the logreturns follow a Normal distrib
ution, the deviation from the straight line and thus the Normal density is clearly
seen from the QQplot in Figure 6.1 of the Nikkei225 Index logreturns over
the period 111997 until 31121999.
We see always from the QQplots that there is a severe problem in the tails
if we try to t the data with the Normal distribution.
2
Tests
Another way of testing goodness of t is with the so called
2
test. The
2
test
counts the number of sample points falling into certain intervals and compares
106
0.05
0
0.05
0.05 0 0.05
x
Normal
Figure 6.1: Normal QQplot
them with the expected number under the null hypothesis. We consider classes
of equal width as well of equal probability. We take N = 32 classes of equal
width. If necessary we collapse outer cells, such that the expected value of
observations becomes greater than ve. In our Nikkei225 Indexexample, we
choose 0.0225+(j 1) (0.0015), j = 1, . . . , N 1, as the boundary points of
the classes.
We consider also the case with N = 28 classes of equal probability, the class
boundaries are now given by the i/Nquantiles i = 1, . . . , N 1 of the tting
distribution.
Because we have to estimate for the Normal distribution two parameters we
take in this case N 3 degrees of freedom.
107
Table 6.3 shows the values of the
2
test statistic with equal width for the
Normal null hypotheses and dierent quantiles of the
2
29
distributions.
Table 6.4 shows the values of the
2
test statistic with equal probability for
the Normal null hypotheses and dierent quantiles of the
2
25
distributions.
In Tables 6.3 and 6.4, we also give the socalled Pvalues of the teststatistics.
The Pvalue is the probability that values are even more extreme (more in the
tail) than our teststatistic. It is clear that very small Pvalues lead to a rejection
of the null hypotheses, because they are themselves extreme. Pvalues not close
to zero indicate that the test statistic is not extreme and lead to acceptance of
the hypothesis. To be precise we reject if the Pvalue is less than our level of
signicance, which we take 0.05, and accept otherwise.
2
Normal
2
29,0.95
2
29,0.99
P
Normal
value
47.45527092 42.55696780 49.58788447 0.01672773
Table 6.3:
2
1
teststatistics and Pvalues (equal width)
2
Normal
2
25,0.95
2
25,0.99
P
Normal
value
47.87381276 37.65248413 44.31410490 0.00386153
Table 6.4:
2
2
teststatistics and Pvalues (equal probability)
We see that the Normal hypothesis is in both cases clearly rejected. Basi
cally we can conclude that a two parameter model, like the Normal one, is not
sucient to capture all features of the data. We need at least four parameters:
a location parameter, a scale (volatility) parameter, an asymmetry (skewness)
parameter and a (kurtosis) parameter describing the decay of the tails. We will
108
see that the Levy models introduced in the next chapter will have this required
exibility.
6.2 Stochastic Volatility
Another important feature which the BlackScholes model is missing is the fact
that volatility or more generally the environment is changing stochastically over
time.
Historic Volatility
It has been observed that the volatilities estimated (or more general the para
meters of uncertainty) change stochastically over time. This can be seen for
example by looking at historic volatilities. Historical volatility is a retrospective
measure of volatility. It reects how volatile the asset has been in the recent
past. Historical volatility can be calculated for any variable for which historical
data is tracked.
For the SP500 index, we estimated for every day from 1971 to 2001 the
variance of the daily logreturns over a one year period preceeding the day. In
Figure 6.2, we plot, for every day in the mentioned period, the annualized square
root of the estimated variance, i.e. the volatility. Clearly, we see uctuations
of this historic volatility. Moreover, we see a kind of meanreversion eect.
The peak in the middle of the gure comes from the stock market crash on
the 19th of October 1987; 1yearwindows including this day (with an extremal
downmove), give rise to very high volatilities.
109
0.05
0.1
0.15
0.2
0.25
0.3
0.35
0.4
Historic Volatility (1year window) SP500 (19702001)
time
v
o
la
t
ilit
y
2001 1970
Figure 6.2: Historic Volatilities on SP500
Volatility Clusters
Moreover, there is evidence for volatility clusters, i.e. there seems to be a suc
cession of periods with high return variance and with low return variance. This
can be seen for example in Figure 6.3, where the absolute logreturns of the
SP500index over a period of more than 30 years is plotted. One clearly sees
that there are periods with high absolute logreturns and periods with lower
absolute logreturns. Large price variations are more likely to be followed by
large price variations.
These observations motivate the introduction of models for asset price processes
where volatility is itself stochastic.
110
0
0.05
0.1
0.15
0.2
absolute log returns of SP500 (19702001)
time
a
b
s
o
l
u
t
e
l
o
g
r
e
t
u
r
n
1970
2001
Figure 6.3: Volatility clusters: absolute logreturns SP500index between 1970
and 2001
6.3 Inconsistency with Market Option Prices
Calibration on Market Prices
If we estimate the model parameters by minimizing the root mean square error
between market prices and the BSmodel prices, we can observe an enormous
dierence. This can be seen in Figure 6.4 for the SP500index options. The
volatility parameter which gives the best t in the leastsquared sense for the
BSmodel is = 0.1812 (in terms of years).
Implied Volatility
Another way to see that the classical BlackScholes model does not correspond
with option prices in the market, is by looking at the implied volatilities coming
111
1000 1100 1200 1300 1400 1500
0
20
40
60
80
100
120
140
160
180
SP500 / 18042002 / BlackScholes Model / ape = 8.87 %
strike
o
p
t
i
o
n
p
r
i
c
e
Figure 6.4: Black Scholes ( = 0.1812) calibration on SP500 options (os are
market prices, +s are model prices)
from the option prices. For every European call option with strike K and time to
maturity T we calculate the only parameter involved, the volatility = (K, T),
such that the theoretical option price (under the BlackScholes model) matches
the empirical one. This = (K, T) is called the implied volatility of the option.
Implied volatility is a timely measure  it reects the markets perceptions today.
There is no closed formula to extract the implied volatility out of the call
112
option price. We have to rely on numerical methods. One method to nd numer
ically implied volatilities is the classical NewtonRaphson iteration procedure.
Denote by C() the price of the relevant call option as a function of volatility. If
C is the market price of this option we need to solve the transcendental equation
C = C() (6.1)
for . We start with some initial value we propose for ; we denote this starting
value with
0
. In terms of years, it turns out that a
0
around 0.20 performs
very well for most common stocks and indices. In general, if we denote by
n
the value obtained after n iteration steps, the next value
n+1
is given by
n+1
=
n
C(
n
) C
C
(
n
)
,
where in the denominator C
(
n
) = S
0
TN(d
1
) = S
0
TN
_
log(S
0
/K) + (r q +
2
n
2
)T
T
_
,
where S
0
is the current stock price, d
1
as in (5.4) and N(x) is the cumulative
probability distribution of a Normal(0, 1) random variable as in (7.1).
Next, we bring together for every maturity and strike this volatility in
Figure 6.5, where one sees the socalled volatility surface. Under the BSmodel,
all s should be the same; clearly we observe that there is a huge variation in
this volatility parameter both in strike as in time to maturity. One says often
there is a volatility smile or skew eect. Again this points to the fact that the
113
BSmodel is not appropriate and the traders already count in this deciency
into their prices.
900 1000 1100 1200 1300 1400 1500
0.14
0.15
0.16
0.17
0.18
0.19
0.2
0.21
0.22
0.23
Strike
i
m
p
l
i
e
d
v
o
l
a
t
i
l
i
t
y
T=1.7080
T=1.1920
T=0.9360
T=0.6920
T=0.4360
T=0.1840
T=0.880
Figure 6.5: Implied Volatilities
Great care has to be taken by using implied volatilities to price options.
Fundamentally, using implied volatilities is wrong. Taking dierent volatilities
for dierent options on the same underlying asset, give rise to dierent stochastic
models for one asset. Moreover, the situation worsens in case of exotic options.
if one tries to nd the implied volatilities coming out of exotic options like
Barrier options, there are cases where there are two or even three solutions to
114
the implied volatility equation (for the European call option, see Equation (6.1)).
Implied volatilities are thus not unique in these situations. More extremely, if
we consider an UpandOut Put barrier option, where the strike coincides with
the barrier and the riskfree rate equals the dividend yield, the BlackScholes
price (for which there is a closed form formula available) is independent of the
volatility. So if the market price happens to coincide with the computed value,
you can have any implied volatility you want. Otherwise there is no implied
volatility.
From this, it should be clear that great caution has to be taken by using Eu
ropean call option implied volatilities for exotic options with apparently similar
characteristics (like the same strike price for example). There is no guarantee
that the obtained prices are reecting true prices.
115
Chapter 7
Exotic Options
7.1 Asian Options
Here the payo is a function of the average price of the underlying between
contract time and expiry time. Asian options are widely used in pratice  for
instance, for oil and foreign currencies. The averaging complicates the mathe
matics, but e.g., protects the holder against speculative attemps to manipulate
the asset price near expiry.
For a xed strike (K) Asian call option, the payo is
(A
T
K)
+
, A
t
=
1
t
_
t
0
S
u
du,
and riskneutral valuation gives the time t price as
C
asian
(t) = e
r(Tt)
E
P
[(A
T
K)
+
[T
t
].
Suppose at time t we have, K
t
T
A
t
, reecting high stock prices over the
116
already expired time, then German and Yor proved that:
C
asian
(t) = S
t
_
1 e
r(Tt)
rT
_
e
r(Tt)
(K
t
T
A
t
).
This explicit pricing formula the GermanYor formula somewhat resembles
the classic BlackScholes Formula in structure. From the GemanYor formula,
one may make comparisons between Asian prices and their European counter
parts. Geman and Yor showed that (in our setting where r 0) the Asian option
price is less than that of its European counterpart, for any strike K. However,
in more general models (e.g. options on foreign stocks) with a riskneutral drift
which is negative, the reverse can be true.
7.2 Barrier Options
The question of whether or not a particular stock will attain a particular level
within a specied period is quite an important one for risk managers. One
barrier options specify a stocklevel, H say, such that the option pays (knock
in) or not (knock out) according to whether or not level H is attained, from
below (up) or above (down). There are thus four possibilities: up and in,
up and out, down and in, and down and out.
Note that holding both a knock in option and the corresponding knock out
is equivalent to the corresponding vanilla option with the barrier removed. The
sum of the prices of the knock in and the knock out is thus the price of the
vanilla.
Consider, to be specic, an upandin call option with strike K and barrier
117
H (H > S
0
). This option gives the holder the right (not the obligation) to buy
the stock for price K at time T provided the price of the stock S
t
at some time
0 t T rises above H. The payo function is given by
UIC
K,H
(T) = (S
T
K)
+
1( max
0tT
S
t
H) = (S
T
K)1( max
0tT
S
t
H, S
T
K).
An upandout call option with strike K and barrier H (H > S
0
) is a regular
call option that ceases to exists if the asset price reaches the barrier level H;
the payo function is now given by:
UOC
K,H
(T) = (S
T
K)
+
1( max
0tT
S
t
< H) = (S
T
K)1( max
0tT
S
t
< H, S
T
K).
So by the riskneutral pricing the (initial) value of the option is
UOC
K,H
(t = 0) = UOC
K,H
= E[exp(rT)(S
T
K)1( max
0tT
S
t
< H, S
T
K)]
where S is geometric Brownian motion, S
t
= S
0
exp((r
1
2
2
)t +W
t
).
Write c = r
1
2
2
and X
t
= ct +W
t
; then S
t
= S
0
exp(X
t
) and
max
0tT
S
t
H i max
0tT
X
t
ln(H/S
0
).
Writing M for the maximum process of X, i.e.
M
t
= max
0st
X
s
,
the payo function involves the bivariate process (X, M), and the option price
involves the joint law of this process:
UOC
K,H
(T) = (S
T
K)1(M
T
< ln(H/S
0
), X
T
ln(K/S
0
)).
118
By the reexion principle of Brownian motion, one can derive the joint den
sity of (X, M). We will take the resulting formula for granted.
Pr(X
t
dx, M
t
dy) =
2(2y x)
2t
3
exp
_
(2y x)
2
2t
+cx
1
2
c
2
t
_
, 0 x y
Given such an explicit formula for the joint density of (X
t
, M
t
) we can calculate
the option price by integration. The factor S
T
K gives rise to two terms, in
S and K. The details of the integration, which are tedious, are omitted; the
result is
UIC
K,H
= S
0
N(x
1
) Ke
rT
N(x
1
T)
S
0
_
H
S
0
_
(2r+
2
)/
2
[N(y) N(y
1
)]
+Ke
rT
_
H
S
0
_
(2r
2
)/
2
[N(y +
T) N(y
1
+
T)],
where
x
1
=
ln(S
0
/H)
T
+
_
r + (
2
/2)
2
_
T
y =
ln(H
2
/(KS
0
))
T
+
_
r + (
2
/2)
2
_
T
y
1
=
ln(H/S
0
)
T
+
_
r + (
2
/2)
2
_
T
In order to nd the price of UOC
K,H
, one can use the decomposition of the
(BlackScholes) price of the corresponding vanilla call, C
K
say, into UOC
K,H
and UIC
K,H
C
K
= UIC
K,H
+UOC
K,H
The other possibilities can be handled similarly.
119
7.3 Lookback Options
In everything we have encountered so far, uncertainty has unfolded with time,
and our task has been to make optimal use of the information available to date.
For options, at expiry T the investor is in posssesion of the history of the price
evolution over time interval [0, T] of the options life, and it may well be that
one could have been doing better. It is only natural to look back with regret.
If only one could buy at the low, and sell at the high ...
In order to provide some investor the right to do that lookback options were
created.
We write S
t
for the stock price process, M
S
t
, m
S
t
for its maximum and
minimum over [0, t]. The two basic types of lookback options are the lookback
call, with payo
LC(T) = S
T
m
S
T
,
giving one the right to buy at the low over [0, T], and the lookback put with
payo
LP(T) = M
S
T
S
T
,
giving one the right to sell at the high over [0, T].
7.4 Binary option
A binary (or digital) option is a contract whose payo depends in a discontinuous
way on the terminal price of the underlying asset. The most popular variants
are:
120
Cashornothing options. Here the payos at expiry of the European call
resp. put are given by
BCC(T) = C1
{ST >K}
resp. BCP(T) = C1
{ST <K}
Assetornothing options. Here the payos at expiry of the European call
resp. put are given by
BAC(T) = S
T
1
{ST >K}
resp. BAP(T) = S
T
1
{ST <K}
Gap options. Here the payos at expiry of the European call resp. put
are given by
GC(T) = (S
T
C)1
{ST >K}
resp. GP(T) = (C S
T
)1
{ST <K}
One can nd pricing formula for the above binary options in the Black
Scholes world. For example for the Cashornothing option we have an initial
price
BCC = exp(rT)CN(d
2
).
121
Appendix A: The normal
distribution
The Normal Distribution
Denition
The Normal distribution, Normal(,
2
), is one of the most important distrib
utions in many areas. It lives on the real line, has mean R and variance
2
> 0. Its characteristic function is given by
E[exp(iuX)] =
Normal
(u; ,
2
) = exp(iu) exp
_
2
u
2
2
_
and the density function is given as
f
Normal
(x; ,
2
) =
1
2
2
exp
_
(x )
2
2
2
_
.
122
Properties
The Normal(,
2
) distribution is symmetric around its mean, and has always
a kurtosis equal to 3:
Normal(,
2
)
mean
variance
2
skewness 0
kurtosis 3
The Cumulative Probability Distribution Function: N(x)
We will denote by
N(x) =
_
x
f
Normal
(u; 0, 1)du (7.1)
the cumulative probability distribution function for a variable that is standard
normally distributed (Normal(0, 1)). This special function is buildin in most
mathematical software packages. The next approximation produces values of
N(x) to within six decimal places of the true value.
N(x) = 1
exp(x
2
/2)
2
(a
1
k +a
2
k
2
+a
3
k
3
+a
4
k
4
+a
5
k
5
) for x 0;
= 1 N(x) for x < 0,
123
where
k = (1 + 0.2316419x)
1
;
a
1
= 0.319381530;
a
2
= 0.356563782;
a
3
= 1.781477937;
a
4
= 1.821255978;
a
5
= 1.330274429.
124
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