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Preface
This text is an introduction to pricing and hedging in discrete and continuous time financial models without friction (i.e. without transaction costs),
with an emphasis on the complementarity between analytical and probabilistic methods. Its contents are mostly mathematical, and also aim at making
the reader aware of both the power and limitations of mathematical models
in finance, by taking into account their conditions of applicability. The book
covers a wide range of classical topics including Black-Scholes pricing, exotic
and american options, term structure modeling and change of numeraire, as
well as models with jumps. It is targeted at the advanced undergraduate and
graduate level in applied mathematics, financial engineering, and economics.
The point of view adopted is that of mainstream mathematical finance in
which the computation of fair prices is based on the absence of arbitrage hypothesis, therefore excluding riskless profit based on arbitrage opportunities
and basic (buying low/selling high) trading. Similarly, this document is not
concerned with any prediction of stock price behaviors that belong other
domains such as technical analysis, which should not be confused with the
statistical modeling of asset prices. The text also includes 104 figures and
simulations, along with about 20 examples based on actual market data.
The descriptions of the asset model, self-financing portfolios, arbitrage and
market completeness, are first given in Chapter 1 in a simple two time-step
setting. These notions are then reformulated in discrete time in Chapter 2.
Here, the impossibility to access future information is formulated using the
notion of adapted processes, which will play a central role in the construction
of stochastic calculus in continuous time.
In order to trade efficiently it would be useful to have a formula to estimate the fair price of a given risky asset, helping for example to determine
whether the asset is undervalued or overvalued at a given time. Although
such a formula is not available, we can instead derive formulas for the pricing of options that can act as insurance contracts to protect their holders
against adverse changes in the prices of risky assets. The pricing and hedging
of options in discrete time, particularly in the fundamental example of the
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Cox-Ross-Rubinstein model, are considered in Chapter 3, with a description
of the passage from discrete to continuous time that prepares the transition
to the subsequent chapters.
A simplified presentation of Brownian motion, stochastic integrals and
the associated Ito formula, is given in Chapter 4. The Black-Scholes model is
presented from the angle of partial differential equation (PDE) methods in
Chapter 5, with the derivation of the Black-Scholes formula by transforming
the Black-Scholes PDE into the standard heat equation wich is then solved
by a heat kernel argument. The martingale approach to pricing and hedging
is then presented in Chapter 6, and complements the PDE approach of Chapter 5 by recovering the Black-Scholes formula via a probabilistic argument.
An introduction to volatility estimation is given in Chapter 7, including historical, local, and implied volatilities. This chapter also contains a comparison
of the prices obtained by the Black-Scholes formula with option price market
data.
Exotic options such as barrier, lookback, and Asian options in continuous
asset models are treated in Chapter 8. Optimal stopping and exercise, with
application to the pricing of American options, are considered in Chapter 9.
The construction of forward measures by change of numeraire is given in
Chapter 10 and is applied to the pricing of interest rate derivatives in Chapter 12, after an introduction to the modeling of forward rates in Chapter 11,
based on material from [60]. The pricing of defaultable bonds is considered
in Chapter 13.
Stochastic calculus with jumps is dealt with in Chapter 14 and is restricted
to compound Poisson processes which only have a finite number of jumps on
any bounded interval. Those processes are used for option pricing and hedging
in jump models in Chapter 15, in which we mostly focus on risk minimizing strategies as markets with jumps are generally incomplete. Chapter 16
contains an elementary introduction to finite difference methods for the numerical solution of PDEs and stochastic differential equations, dealing with
the explicit and implicit finite difference schemes for the heat equations and
the Black-Scholes PDE, as well as the Euler and Milshtein schemes for SDEs.
The text is completed with an appendix containing the needed probabilistic
background.
The material in this book has been used for teaching in the Masters of
Science in Financial Engineering at City University of Hong Kong and at the
Nanyang Technological University in Singapore. The author thanks Ju-Yi
Yen (University of Cincinnati) for several corrections and improvements.
The cover graph represents the time evolution of the HSBC stock price
from January to September 2009, plotted on the price surface of a European
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Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9
9
10
11
14
15
16
17
23
Discrete-Time Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.1 Stochastic Processes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.2 Portfolio Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.3 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.4 Contingent Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.5 Martingales and Conditional Expectation . . . . . . . . . . . . . . . . . .
2.6 Risk-Neutral Probability Measures . . . . . . . . . . . . . . . . . . . . . . . .
2.7 Market Completeness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2.8 The Cox-Ross-Rubinstein (CRR) Market Model . . . . . . . . . . . .
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
25
25
26
29
29
31
36
37
38
40
41
41
45
47
49
52
59
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4
67
67
71
75
80
80
84
87
89
93
93
93
97
98
99
108
109
112
117
117
119
122
123
127
132
Estimation of Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7.1 Historical Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7.2 Implied Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7.3 The Black-Scholes Formula vs Market Data . . . . . . . . . . . . . . . .
7.4 Local Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
141
141
142
143
148
Exotic Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8.1 Generalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8.2 The Reflexion Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8.3 Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8.4 Lookback Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8.5 Asian Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
151
151
155
163
182
205
222
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227
227
228
230
239
252
259
10 Change of Num
eraire and Forward Measures . . . . . . . . . . . . .
10.1 Notion of Numeraire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10.2 Change of Numeraire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10.3 Foreign Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10.4 Pricing of Exchange Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10.5 Self-Financing Hedging by Change of Numeraire . . . . . . . . . . . .
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
269
269
271
278
284
286
289
295
295
297
305
311
315
320
327
329
337
337
339
341
344
345
349
359
359
361
363
364
366
369
369
375
378
380
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14.5 Stochastic Differential Equations with Jumps . . . . . . . . . . . . . . 385
14.6 Girsanov Theorem for Jump Processes . . . . . . . . . . . . . . . . . . . . 389
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 395
15 Pricing and Hedging in Jump Models . . . . . . . . . . . . . . . . . . . . .
15.1 Risk-Neutral Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
15.2 Pricing in Jump Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
15.3 Black-Scholes PDE with Jumps . . . . . . . . . . . . . . . . . . . . . . . . . .
15.4 Exponential Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
15.5 Self-Financing Hedging with Jumps . . . . . . . . . . . . . . . . . . . . . . .
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
397
397
398
400
402
404
408
411
411
413
417
418
421
421
425
426
427
429
434
441
443
445
Exercise Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Chapter 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Chapter 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Chapter 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Chapter 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Chapter 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Chapter 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Chapter 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Chapter 9 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Chapter 10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Chapter 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Chapter 12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Chapter 13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Chapter 14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Chapter 15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Background on Probability Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . .
449
449
450
451
455
459
462
468
482
499
505
511
525
528
532
535
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List of Figures
0.1
0.2
0.3
5
6
7
1.1
12
2.1
27
4.1
4.2
4.3
4.4
70
71
71
72
5.1
5.2
5.3
5.4
5.5
5.6
5.7
5.8
5.9
94
103
103
104
106
106
107
107
113
6.1
6.2
6.3
6.4
6.5
6.6
6.7
120
136
137
137
139
139
140
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7.1
7.2
7.3
7.4
7.5
7.6
7.7
7.8
7.9
Implied volatility of Asian options on light sweet crude oil futures.1 . 143
Graph of the (market) stock price of Cheung Kong Holdings. . . . . . . 144
Graph of the (market) call option price on Cheung Kong Holdings. . 144
Graph of the Black-Scholes call option price on Cheung Kong Holdings. 145
Graph of the (market) stock price of HSBC Holdings. . . . . . . . . . . . . 145
Graph of the (market) call option price on HSBC Holdings. . . . . . . . 146
Graph of the Black-Scholes call option price on HSBC Holdings. . . . 146
Graph of the (market) put option price on HSBC Holdings. . . . . . . . 147
Graph of the Black-Scholes put option price on HSBC Holdings. . . . 147
8.1
8.2
8.3
8.4
8.5
8.6
8.7
8.8
8.9
8.10
8.11
8.12
8.13
8.14
8.15
8.16
8.17
8.18
8.19
8.20
8.21
8.22
8.23
8.24
8.25
8.26
153
154
157
158
160
162
167
173
173
175
175
176
180
183
192
193
194
195
200
200
201
201
202
203
210
211
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
229
229
232
243
244
244
245
250
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250
253
254
254
256
257
257
296
303
303
304
307
312
316
317
318
318
319
319
320
321
321
322
322
323
326
326
328
370
376
383
383
384
384
384
386
387
388
389
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16.2 Stability of the implicit finite difference method. . . . . . . . . . . . . . . . . 417
16.3 Average return by selling at the maximum vs selling at maturity T . . 469
16.4 Graph of the down-and-in long forward contract price with
K < B = 80. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 472
16.5 Delta of the down-and-in long forward contract with K < B = 80. . . . 473
16.6 Graph of the up-and-out long forward contract price with K < B = 80. 474
16.7 Graph of the up-and-out long forward contract price with K < B = 80. 475
16.8 Graph of the down-and-in long forward contract price with
K < B = 80. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 476
16.9 Delta of the down-and-in long forward contract with K < B = 80. . . . 476
16.10Graph of the down-and-out long forward contract price with
K < B = 80. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477
16.11Delta of the down-and-out long forward contract with K < B = 80. . 478
16.12Lookback call option as a function of maturity time T . . . . . . . . . . . . . 479
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Introduction
Historical Sketch
We start with a description of some of the main steps, ideas and individuals
that played an important role in the development of the field over the last
century.
Robert Brown, botanist, 1827
Brown observed the movement of pollen particles as described in his paper
A brief account of microscopical observations made in the months of June,
July and August, 1827, on the particles contained in the pollen of plants; and
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on the general existence of active molecules in organic and inorganic bodies.
Phil. Mag. 4, 161-173, 1828.
Philosophical Magazine, first published in 1798, is a journal that publishes
articles in the field of condensed matter describing original results, theories
and concepts relating to the structure and properties of crystalline materials,
ceramics, polymers, glasses, amorphous films, composites and soft matter.
Louis Bachelier, mathematician, PhD 1900
Bachelier used Brownian motion for the modelling of stock prices in his
PhD thesis Theorie de la speculation, Annales Scientifiques de lEcole Normale Superieure 3 (17): 21-86, 1900.
Albert Einstein, physicist
Einstein received his 1921 Nobel Prize in part for investigations on the
theory of Brownian motion: ... in 1905 Einstein founded a kinetic theory to
account for this movement, presentation speech by S. Arrhenius, Chairman
of the Nobel Committee, Dec. 10, 1922.
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Oldrich Vasicek, economist, 1977
Interest rates behave differently from stock prices, notably due to the phenomenon of mean reversion, and for this reason they are difficult to model
using geometric Brownian motion. Vasicek was the first to suggest a meanreverting model for stochastic interest rates, based on the Ornstein-Uhlenbeck
process, in An equilibrium characterisation of the term structure, Journal
of Financial Economics 5: 177-188.
David Heath, Robert Jarrow, A. Morton
These authors proposed in 1987 a general framework to model the evolution of (forward) interest rates, known as the HJM model, see their joint paper
Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation, Econometrica, (January 1992), Vol.
60, No. 1, pp 77-105.
Alan Brace, Dariusz Gatarek, Marek Musiela (BGM)
The BGM model is actually based on geometric Brownian motion, and it
is specially useful for the pricing of interest rate derivatives such as caps and
swaptions on the LIBOR market, see The Market Model of Interest Rate
Dynamics. Mathematical Finance Vol. 7, page 127. Blackwell 1997, by Alan
Brace, Dariusz Gatarek, Marek Musiela.
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Fig. 0.1: Graph of the Hang Seng index - holding a put option might be useful here.
Definition 0.1. A (European) put option is a contract that gives its holder
the right (but not the obligation) to sell a quantity of assets at a predefined
price K called the strike and at a predefined date T called the maturity.
In case the price ST falls down below the level K, exercising the contract
will give the holder of the option a gain equal to K ST in comparison to
those who did not subscribe the option and sell the asset at the market price
ST . In turn, the issuer of the option will register a loss also equal to K ST
(in the absence of transaction costs and other fees).
If ST is above K then the holder of the option will not exercise the option
as he may choose to sell at the price ST . In this case the profit derived from
the option is 0.
In general, the payoff of a (so called European) put option will be of the
form
K ST , ST K,
+
(ST ) = (K ST ) =
0,
ST K.
Two possible scenarios (ST finishing above K or below K) are illustrated
in Figure 0.2.
On the other hand, if the trader aims at buying some stock or commodity,
his interest will be in prices not going up and he might want to purchase a
call option, which is a contract allowing him to buy the considered asset at
time T at a price not higher than a level K fixed at time t.
Here, in the event that ST goes above K, the buyer of the option will
register a potential gain equal to ST K in comparison to an agent who did
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10
ST-K>0
9
8
7
Strike
St
K=6
5
4
ST-K<0
3
2
S0=1
0
0
0.2
0.4
|
0.6
t=0.62
0.8
T=1
ST K, ST K,
+
(ST ) = (ST K) =
0,
ST K.
In market practice, options are often divided into a certain number n of warrants, the (possibly fractional) quantity n being called the entitlement ratio.
In order for an option contract to be fair, the buyer of the option should
pay a fee (similar to an insurance fee) at the signature of the contract. The
computation of this fee is an important issue, which is known as option
pricing.
The second important issue is that of hedging, i.e. how to manage a given
portfolio in such a way that it contains the required random payoff (K ST )+
(for a put option) or (ST K)+ (for a call option) at the maturity date T .
The next figure illustrates a sharp increase and sharp drop in asset price,
making it valuable to hold a call option during the first half of the graph,
whereas holding a put option would be recommended during the second half.
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Chapter 1
We consider a simplified financial model with only two time instants t = 0 and
t = 1. In this simple setting we introduce the notions of portfolio, arbitrage,
completeness, pricing and hedging using the notation of [25]. A binary asset
price model is considered as an example in Section 1.7.
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S (0) = (1 + r) (0) .
d
X
(i) (i)
i=0
at time t = 0.
At time t = 1 the value of the portfolio has evolved into
S =
d
X
(i) S (i) .
i=0
If (0) > 0, the investor puts the amount (0) (0) > 0 on a savings account
with interest rate r, while if (0) < 0 he borrows the amount (0) (0) > 0
with the same interest rate.
For i = 1, . . . , d, if (i) > 0 then the investor buys a (possibly fractional)
quantity (i) > 0 of the asset no i, while if (i) < 0 he borrows a quantity
(i) > 0 of asset i and sells it to obtain the amount (i) (i) > 0. In the
latter case one says that the investor short sells a quantity (i) > 0 of the
asset no i.
Usually, profits are made by first buying at a lower price and then selling
at a higher price. Short-sellers apply the same rule but in the reverse time
order: first sell high, and then buy low if possible, by applying the following
procedure.
1. Borrow the asset no i.
2. At time t = 0, sell the asset no i on the market at the price (i) and
invest the amount (i) at the interest rate r > 0.
3. Buy back the asset no i at time t = 1 at the price S (i) , with hopefully
S (i) < (1 + r) (i) .
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1.3 Arbitrage
As stated in the next definition, an arbitrage opportunity is the possibility
to make a strictly positive amount of money starting from 0 or even from a
negative amount. In a sense, an arbitrage opportunity can be seen as a way
to beat the market.
The short-selling procedure described in Section 1.2 represents a way to
realize an arbitrage opportunity. One can proceed similarly by simply buying
an asset instead short-selling it.
1. Borrow the amount (0) (0) > 0 on the riskless asset no 0.
2. Use the amount (0) (0) > 0 to buy the risky asset no i at time t = 0
and price (i) , for a quantity (i) = (0) (0) / (i) , i = 1, . . . , d.
3. At time t = 1, sell the risky asset no i at the price S (i) , with hopefully
S (i) > (i) .
4. Refund the amount (1 + r) (0) (0) > 0 with interest rate r > 0.
At the end of the operation the profit made is
S (i) (1 + r) (i) > 0,
which is positive provided S (i) > (i) and r is sufficiently small.
Next we state a mathematical formulation of the concept of arbitrage.
Definition 1.1. A portfolio Rd+1 constitutes an arbitrage opportunity if
the three following conditions are satisfied:
i)
0,
1
The cost p of shortselling will not be taken into account in later calculations.
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ii) S 0,
"
(1.1)
Interestingly, the market price of the right was $13.20 at the close of the
session on March 24. The difference of $0.50 can be explained by the presence
of various market factors such as transaction costs, the time value of money,
or simply by the fact that asset prices are constantly fluctuating over time.
It may also represent a small arbitrage opportunity, which cannot be at all
excluded. Nevertheless, the absence of arbitrage argument (1.1) prices the
right at $13.70, which is quite close to its market value. Thus the absence of
arbitrage hypothesis appears as an accurate tool for pricing.
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d
X
i=0
(i) (i) =
d
1 X (i) (i)
1
> 0,
IE [S ] =
IE [ S]
1 + r i=0
1+r
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0
if S (i) < K,
where K is called the strike price. The claim C is called contingent because its value may depend on various market conditions, such as S (i) > K.
A contingent claim is also called a derivative for the same reason.
Similarly, referring to Definition 0.1, a European put option with maturity
t = 1 on the asset no i is a contingent claim with payoff
K S (i) if S (i) K,
(i) +
C = (K S ) =
0
if S (i) > K,
Definition 1.4. A contingent claim with payoff C is said to be attainable if
there exists a portfolio strategy such that
C = S.
When a contingent claim C is attainable, a trader will be able to:
1. at time t = 0, build a portfolio allocation = ( (0) , (1) , . . . , (d) ) Rd+1 ,
2. invest the amount
=
d
X
(i) (i)
i=0
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S of the portfolio.
3. at time t = 1, pay the claim amount C using the value
The above shows that in order to attain the claim, an initial investment
(1.3)
(1.4)
"
1.7 Example
In this section we work out a simple example that allows us to apply Theorem 1.1 and Theorem 1.2.
We take d = 1, i.e. there is only a riskless asset no 0 and a risky asset
S (1) . In addition we choose
= { , + },
which is the simplest possible non-trivial choice of a probability space, made
of only two possible outcomes with
P({ }) > 0
in order for the setting to be non-trivial. In other words the behavior of the
market is subject to only two possible outcomes, for example, one is expecting
an important binary decision of yes/no type, which can lead to two distinct
scenarios called and + .
In this context, the asset price S (1) is given by a random variable
S (1) : R
whose value depends whether the scenario , resp. + , occurs.
Precisely, we set
S (1) ( ) = a,
and
S (1) ( + ) = b,
i.e. the value of S (1) becomes equal a under the scenario , and equal to b
under the scenario + , where 0 < a b.
The first natural question we ask is:
- are there arbitrage opportunities in such a market ?
We will answer this question using Theorem 1.1, which amounts to searching
for a risk-neutral measure P . In this simple framework, any measure P on
= { , + } is characterized by the data of two numbers P ({ }) [0, 1]
and P ({ + }) [0, 1], such that
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P () = P ({ }) + P ({ + }) = 1.
(1.5)
and P ({ + }) > 0.
aP ({ }) + bP ({ + }) = (1 + r) (1)
(1.7)
P ({ }) + P ({ + }) = 1,
with solution
P ({ }) =
b (1 + r) (1)
ba
and
P ({ + }) =
(1 + r) (1) a
.
ba
(1.8)
then there exists a risk-neutral measure P which is unique, hence by Theorems 1.1 and 1.2 the market is without arbitrage and complete.
If a = b = (1 + r) (1) then (1.2) admits an infinity of solutions, hence the
market is without arbitrage but it is not complete. More precisely, in this
case both the riskless and risky assets yield a deterministic return rate r and
the value of the portfolio becomes
S = (1 + r)
,
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or
(1.9)
This means that the investor borrows the amount (0) (0) > 0 on the
riskless asset and uses it to buy one unit (1) = 1 of the risky asset. At
time t = 1 she sells the risky asset S (1) at a price at least equal to a and
refunds the amount (1 + r) (0) (0) > 0 she borrowed, with interests. Her
profit is
S = (1 + r) (0) (0) + (1) S (1)
(1 + r) (0) (0) + (1) a
2. If a < b < (1 + r) (1) , let (0) > 0 and choose (1) such that (0) (0) +
(1) (1) = 0, i.e.
(1) = (0) (0) / (1) < 0.
This means that the investor borrows a (possibly fractional) quantity
(1) > 0 of the risky asset, sells it for the amount (1) (1) , and invests this money on the riskless account for the amount (0) (0) > 0. As
mentioned in Section 1.2, in this case one says that the investor shortsells
the risky asset. At time t = 1 she obtains (1 + r) (0) (0) > 0 from the
riskless asset and she spends at most b to buy the risky asset and return
it to its original owner. Her profit is
S = (1 + r) (0) (0) + (1) S (1)
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(1 + r) (0) (0) + (1) b
> 0,
bC( ) aC( + )
(0) (1 + r)(b a)
and (1) =
C( + ) C( )
.
ba
(1.11)
In this case we say that the portfolio ( (0) , (1) ) hedges the contingent claim
C. In other words, any contingent claim C is attainable and the market is
indeed complete. Here, the quantity
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bC( ) aC( + )
(1 + r)(b a)
(1) =
(1.12)
where ( (0) , (1) ) are given by (1.11). Note that (C) cannot be 0 since this
would entail the existence of an arbitrage opportunity according to Definition 1.1.
The next proposition shows that the arbitrage price (C) of the claim can
be computed as the expected value of its payoff C under the risk-neutral
measure, after discounting at the rate 1 + r for the time value of money.
Proposition 1.1. The arbitrage price (C) =
of the contingent claim
C is given by
1
(C) =
IE [C].
(1.13)
1+r
Proof. We have
(C) =
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1
C( )P (S (1) = a) + C( + )P (S (1) = b)
1+r
1
=
IE [C].
1+r
In the case of a European call option with strike K [a, b] we have C =
(S (1) K)+ and
((S (1) K)+ ) = (1)
(b K)a
bK
.
ba
(1 + r)(b a)
Here, ( (1) K)+ is called the intrinsic value at time 0 of the call option.
The simple setting described in this chapter raises several questions and
remarks.
Remarks
1. The fact that (C) can be obtained by two different methods, i.e. an
algebraic method via (1.11) and (1.12) and a probabilistic method from
(1.13) is not a simple coincidence. It is actually a simple example of the
deep connection that exists between probability and analysis.
In a continuous time setting, (1.11) will be replaced with a partial differential equation (PDE) and (1.13) will be computed via the Monte Carlo
method. In practice, the quantitative analysis departments of major financial institutions can be split into the PDE team and the Monte Carlo
team, often trying to determine the same option prices by two different
methods.
2. What if we have three possible scenarios, i.e. = { , o , + } and the
random asset S (1) is allowed to take more than two values, e.g. S (1)
{a, b, c} according to each scenario ? In this case the system (1.7) would
be rewritten as
aP ({ }) + bP ({ o }) + cP ({ + }) = (1 + r) (1)
P ({ }) + P ({ o }) + P ({ + }) = 1,
and this system of two equations for three unknowns does not have a
unique solution, hence the market can be without arbitrage but it cannot
be complete. Completeness can be reached by adding a second risky asset,
i.e. taking d = 2, in which case we will get three equations and three
unknowns. More generally, when has n 2 elements, completeness
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Exercises
Exercise 1.1 Consider a financial model with two instants t = 0 and t = 1
and two assets:
- a riskless asset with price 0 at time t = 0 and value 1 = 0 (1 + r) at
time t = 1,
- a risky asset S with price S0 at time t = 0 and random value S1 at time
t = 1.
We assume that S1 can take only the values S0 (1 + a) and S0 (1 + b), where
1 < a < r < b. The return of the risky asset is defined as
R=
S1 S0
.
S0
br
,
ba
P (R = b) =
ra
,
ba
if R = a,
C=
if R = b.
Show that the portfolio (, ) defined2 by
=
(1 + b) (1 + a)
0 (1 + r)(b a)
and =
,
S0 (b a)
Here, is the (possibly fractional) quantity of asset and is the quantity held of
asset S.
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1 + S1 = C.
Hint: distinguish two cases R = a and R = b.
6. Compute the arbitrage price (C) of the contingent claim C using , 0 ,
, and S0 .
7. Compute IE [C] in terms of a, b, r, , .
8. Show that the arbitrage price (C) of the contingent claim C satisfies
(C) =
1
IE [C].
1+r
(1.14)
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Chapter 2
Discrete-Time Model
A basic limitation of the two time step model considered in Chapter 1 is that it
does not allow for trading until the end of the time period is reached. In order
to be able to re-allocate the portfolio over time we need to consider a discretetime financial model with N + 1 time instants t = 0, 1, . . . , N . The practical
importance of this model lies also in its direct computer implementability.
N. Privault
St
= (1 + r)t (0) ,
t = 0, 1, . . . , N.
(d)
(1)
t = (t , t , . . . , t )
remains constant over the period (t 1, t] while the stock price changes from
St1 to St over this period.
In other terms,
(i)
(i)
t St1
represents the amount invested in asset i at the beginning of the time period
(t 1, t], and
(i) (i)
t St
represents the value of this investment at the end of (t 1, t], t = 1, . . . , N .
The value of the porfolio at the beginning of the time period (t 1, t] is
t St1 =
d
X
(i)
(i)
t St1 ,
i=0
"
t St =
d
X
(i)
(i)
t St
(2.1)
i=0
Note that the stock price St is assumed to remain constant overnight, i.e.
from the end of (t 1, t] to the beginning of (t, t + 1].
Obviously the question arises whether (2.1) should be identical to (2.2). In
the sequel we will need such a consistency hypothesis, called self-financing,
on the portfolio strategy t .
Definition 2.1. We say that the portfolio strategy (t )t=1,...,N is self-financing
if
t St = t+1 St ,
t = 1, . . . , N 1.
(2.3)
The meaning of the self-financing condition (2.3) is simply that one cannot
take any money in or out of the portfolio during the overnight transition
period at time t. In other words, at the beginning of the new trading period
(t, t+1] one should re-invest the totality of the portfolio value obtained at the
end of period (t 1, t]. The next figure is an illustration of the self-financing
condition.
t St1
Portfolio value
- t St=t+1 St
- t+1 St+1
Asset value
St1
St St
St+1
Time scale
t1
t t
t t+1
t+1
Portfolio allocation
t+1
@
I
@
I
@
@
@
Morning
Evening
Morning
@
@
Evening
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N. Privault
stock price. Also, 0 is not defined and its value is actually not needed in this
framework.
Of course the chosen unit of time may not be the day, and it can be replaced
by weeks, hours, minutes, or even fractions of seconds in high-frequency trading.
We will denote by
Vt := t St
t = 0, . . . , N 1,
Xt
1
(i)
S ,
(1 + r)t t
or
t :=
X
i = 0, 1, . . . , d,
1
St ,
(1 + r)t
t = 0, 1, . . . , N,
t = 0, 1, . . . , N.
1
Vt ,
(1 + r)t
t = 0, 1, . . . , N.
We have
Vet =
=
1
t St
(1 + r)t
d
X
1
(i) (i)
S
(1 + r)t i=0 t t
d
X
(i)
(i)
t Xt
i=0
t,
= t X
and
t = 1, . . . , N,
Ve0 = 1 X0 = 1 S0 .
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2.3 Arbitrage
The definition of arbitrage in discrete time follows the lines of its analog in
the two-step model.
Definition 2.2. A portfolio strategy (t )t=1,...,N constitutes an arbitrage opportunity if all three following conditions are satisfied:
(i) V0 0,
(ii) VN 0,
European options
The payoff of a European call on the underlying asset no i with maturity N
and strike K is
(i)
C = (SN K)+ .
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The payoff of a European put on the underlying asset no i with exercise date
N and strike K is
(i)
C = (K SN )+ .
Let us mention also the existence of binary, or digital options, also called
cash-or-nothing options, whose payoffs are
(i)
$1 if SN K,
(i)
C = 1[K,) (SN ) =
0 if S (i) < K,
N
for call options, and
C=
(i)
1(,K] (SN )
(i)
$1 if SN K,
0 if S (i) > K,
N
Asian options
The payoff of an Asian call option (also called average value option) on the
underlying asset no i with exercise date N and strike K is
N
C=
1 X (i)
S K
N + 1 t=0 t
!+
.
The payoff of an Asian put option on the underlying asset no i with exercise
date N and strike K is
!+
N
1 X (i)
C= K
St
.
N + 1 t=0
We refer to Section 8.5 for the pricing of Asian options in continuous time.
Barrier options
The payoff of a down-an-out barrier call option on the underlying asset no i
with exercise date N , strike K and barrier B is
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(i)
C = SN K
+
1(
min
t=0,1,...,N
(i)
St > B
(i)
(i)
S K if min St > B,
N
t=0,1,...,N
if
min
t=0,1,...,N
(i)
St B.
This option is also called a Callable Bull Contract with no residual value, in
which B denotes the call price B K. It is also called a turbo warrant with
no rebate.
The payoff of an up-and-out barrier put option on the underlying asset no
i with exercise date N , strike K and barrier B is
(i)
(i)
max St < B,
K SN if t=0,1,...,N
+
(i)
) =
C = K SN
1(
(i)
(i)
max St < B
0
if max St B.
t=0,1,...,N
t=0,1,...,N
This option is also called a Callable Bear Contract with no residual value, in
which the call price B usually satisfies B K. See [23], [77] for recent results
on the pricing of CBBCs, also called turbo warrants. We refer the reader to
Chapter 8 for the pricing and hedging of similar exotic options in continuous
time. Barrier options in continuous time are priced in Section 8.3.
Lookback options
The payoff of a floating strike lookback call option on the underlying asset
no i with exercise date N is
(i)
C = SN
min
t=0,1,...,N
(i)
St .
The payoff of a floating strike lookback put option on the underlying asset
no i with exercise date N is
(i)
(i)
C=
max St
SN .
t=0,1,...,N
We refer to Section 8.4 for the pricing of lookback options in continuous time.
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Conditional expectations
Clearly, the expected value of any risky asset or random variable is dependent
on the amount of available information. For example, the expected return on
a real estate investment typically depends on the location of this investment.
In the probabilistic framework the available information is formalized as
a collection G of events, which may be smaller than the collection F of all
available events, i.e. G F.1
The notation IE[F |G] represents the expected value of a random variable F
given (or conditionally to) the information contained in G, and it is read the
conditional expectation of F given G. In a certain sense, IE[F |G] represents
the best possible estimate of F in mean square sense, given the information
contained in G.
The conditional expectation satisfies the following five properties, cf. Section 16.4 for details and proofs.
(i) IE[F G | G] = G IE[F | G] if G depends only on the information contained in G.
(ii) IE[G | G] = G when G depends only on the information contained in G.
(iii) IE[IE[F | H] | G] = IE[F | G] if G H, called the tower property, cf.
also Relation (16.24).
(iv) IE[F | G] = IE[F ] when F does not depend on the information
contained in G or, more precisely stated, when the random variable F is
independent of the -algebra G.
(v) If G depends only on G and F is independent of G, then
IE[h(F, G) | G] = IE[h(x, F )]x=G .
When H = {, } is the trivial -algebra we have IE[F | H] = IE[F ], F
L1 (). See (16.24) and (16.28) for illustrations of the tower property by
conditioning with respect to discrete and continuous random variables.
1
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t = 0, 1, . . . , N 1,
which means that the amount of information available on the market increases over time.
(i)
(i)
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(iv) IE[F | Ft ] = IE[F ] when F does not depend on the information contained in Ft .
(v) If F depends only on Ft and G is independent of Ft , then
IE[h(F, G) | Ft ] = IE[h(x, G)]x=F .
Note that by the tower property (iii) the process t 7 IE[F | Ft ] is a martingale, cf. e.g. Relation (6.1) for details.
Martingales
A martingale is a stochastic process whose value at time t+1 can be estimated
using conditional expectation given its value at time t. Recall that a process
(Mt )t=0,1,...,N is said to be Ft -adapted if the value of Mt depends only on
the information available at time t in Ft , t = 0, 1, . . . , N .
Definition 2.3. A stochastic process (Mt )t=0,1,...,N is called a discrete time
martingale with respect to the filtration (Ft )t=0,1,...,N if (Mt )t=0,1,...,N is Ft adapted and satisfies the property
IE[Mt+1 |Ft ] = Mt ,
t = 0, 1, . . . , N 1.
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Mt =
t
X
k=1
k (Xk Xk1 ),
t N,
(2.4)
is a martingale.
Proof. Given n 0 we have
#
" n
X
IE [Mn | Ft ] = IE
k (Xk Xk1 )Ft
k=1
"
= IE
n
X
k=1
t
X
k=1
t
X
k=1
#
IE [k (Xk Xk1 ) | Ft ]
IE [k (Xk Xk1 ) | Ft ] +
k (Xk Xk1 ) +
= Mt +
n
X
k=t+1
n
X
k=t+1
n
X
k=t+1
IE [k (Xk Xk1 ) | Ft ]
IE [k (Xk Xk1 ) | Ft ]
IE [k (Xk Xk1 ) | Ft ] .
t + 1 k n.
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N. Privault
= 0,
k = 1, . . . , n,
(i)
IE [St+1 | Ft ] = (1 + r)St ,
t = 0, 1, . . . , N 1,
(2.5)
Since St
as
In other words, taking risks under P by buying the risky asset no i has a
neutral effect, as the expected return is that of the riskless asset. The measure
P would be represent a risk premium if we had
(i)
(i)
IE [St+1 | Ft ] = (1 + r)St ,
t = 0, 1, . . . , N 1,
with r > r.
The definition of risk-neutral probability measure can be reformulated
using the notion of martingale.
Proposition 2.2. A probability measure P on is a risk-neutral measure
(i)
if and only if the discounted price process Xt is a martingale under P , i.e.
(i)
(i)
IE [Xt+1 | Ft ] = Xt ,
t = 0, 1, . . . , N 1,
(2.6)
i = 0, 1, . . . , d.
Proof. It suffices to check that Conditions (2.5) and (2.6) are equivalent since
(i)
(i)
and
t = 0, 1, . . . , N 1, i = 1, . . . , d.
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(i)
(i)
St = (1 + r)t Xt ,
"
(2.7)
"
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N. Privault
St
= (0) (1 + r)t ,
t = 0, 1, . . . , N.
St St1
,
St1
(1)
be defined as
t = 1, . . . , N.
In the CRR model the return Rt is random and allowed to take only two
values a and b at each time step, i.e.
Rt {a, b},
t = 1, . . . , N,
with 1 < a < b. That means, the evolution of St1 to St is random and
given by
(1 + b)St1 if Rt = b
St =
= (1 + Rt )St1 ,
t = 1, . . . , N,
(1 + a)St1 if Rt = a
and
St = S0
t
Y
(1 + Rj ),
t = 0, 1, . . . , N.
j=1
Note that the price process (St )t=0,1,...,N evolves on a binary recombining (or
binomial) tree. The discounted asset price is
Xt =
St
,
(1 + r)t
t = 0, 1, . . . , N,
with
Xt =
1+b
Xt1
1+r
if Rt = b
1+a
Xt1
1+r
if Rt = a
and
Xt =
1 + Rt
Xt1 ,
1+r
t = 1, . . . , N,
t
t
Y
Y
1 + Rj
S0
(1 + Rj ) = X0
.
t
(1 + r) j=1
1+r
j=1
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"
t = 1, . . . , N.
The information Ft known in the market up to time t is given by the knowledge of S1 , . . . , St , which is equivalent to the knowledge of X1 , . . . , Xt or
R1 , . . . , Rt , i.e. we write
Ft = (S1 , . . . , St ) = (X1 , . . . , Xt ) = (R1 , . . . , Rt ),
t = 0, 1, . . . , N,
(i)
IE [St+1 | Ft ] = (1 + r)St ,
t = 0, 1, . . . , N 1.
Rewriting IE [St+1 | Ft ] as
IE [St+1 | Ft ] = (1 + a)St P (Rt+1 = a | Ft ) + (1 + b)St P (Rt+1 = b | Ft ),
it follows that any risk-neutral measure P should satisfy the equations
P (Rt+1 = b | Ft ) + P (Rt+1 = a | Ft ) = 1,
i.e.
bP (Rt+1 = b | Ft ) + aP (Rt+1 = a | Ft ) = r
P (Rt+1 = b | Ft ) + P (Rt+1 = a | Ft ) = 1,
with solution
P (Rt+1 = b | Ft ) =
ra
ba
and
P (Rt+1 = a | Ft ) =
br
.
ba
(2.8)
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N. Privault
distributed (i.i.d.) random variables.
In other words, Rt+1 is independent of R1 , . . . , Rt for all t = 1, . . . , N 1,
the random variables R1 , . . . , RN are independent under P , and by (2.8) we
have
ra
br
P (Rt+1 = b) =
and
P (Rt+1 = a) =
.
ba
ba
As a consequence, letting p := (r a)/(b a), when (k1 , . . . , kn ) {a, b}N +1
we have
P (R1 = k1 , . . . , RN = kn ) = (p )l (1 p )N l ,
Exercises
(1 + b)St1
St =
(1 + a)St1
with 1 < a < r < b. The return of the risky asset S is defined as
Rt :=
St St1
,
St1
t = 1, . . . , N,
and Ft is generated by R1 , . . . , Rt , t = 1, . . . , N .
1. What are the possible values of Rt ?
2. Show that under the probability measure P defined by
P (Rt+1 = a | Ft ) =
br
,
ba
P (Rt+1 = b | Ft ) =
ra
,
ba
t = 0, . . . , N k,
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k = 0, . . . , N.
"
Chapter 3
(3.1)
at time t = 0, resp.
V0 = 1 S0
(3.2)
Vt = t St
(3.3)
N. Privault
Lemma 3.1. The following statements are equivalent:
(i) The portfolio strategy (t )t=1,...,N is self-financing.
t = t+1 X
t for all t = 1, . . . , N 1.
(ii) t X
(iii) We have
Vet = Ve0 +
t
X
j=1
j X
j1 ),
j (X
t = 0, 1, . . . , N.
(3.4)
t = 1, . . . , N,
t
X
j=1
= Ve0 +
t
X
j=1
= Ve0 +
t
X
j=1
= Ve0 +
t
X
j=1
(Vej Vej1 )
j j1 X
j1
j X
j j X
j1
j X
j X
j1 ),
j (X
t = 1, . . . , N.
t t1 X
t1 = t (X
t X
t1 ),
t X
t1 = t X
t1 ,
t1 X
t = 1, . . . , N.
t X
t1 ) represents the profit and loss
In Relation (3.4), the term t (X
t X
t1 ),
Vet Vet1 = t (X
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"
N
X
t=1
t X
t1 ).
t (X
(3.5)
t that
Note that in the above formula it is the use of discounted asset price X
t X
t1 ) since they are
allows us to add up the profits and losses t (X
expressed in units of currency at time 0. In general, $1 at time t = 0 and
$1 at time t = 1 cannot be added without proper discounting.
Theorem 3.1. The arbitrage price t (C) of a contingent claim C is given
by
1
t (C) =
IE [C | Ft ],
t = 0, 1, . . . , N,
(3.6)
(1 + r)N t
where P denotes any risk-neutral probability measure.
e = C/(1 + r)N denote the discounted payoff of the claim C. We
Proof. Let C
will show that under any risk-neutral measure P the discounted value of any
self-financing portfolio hedging C is given by
h
i
e | Ft ,
Vet = IE C
t = 0, 1, . . . , N,
(3.7)
which shows that
Vt =
"
1
IE [C | Ft ]
(1 + r)N t
43
N. Privault
after multiplication of both sides by (1 + r)t . To conclude we will note that
the arbitrage price t (C) of the claim at any time t is by definition equal to
the value Vt of the corresponding self-financing portfolio.
We now need to prove (3.7), and for this we will use the martingale transform argument of Proposition 2.1. Since the portfolio strategy (t )t=1,2,...,N
is self-financing, from Lemma 3.1 we have
h
i
h
i
e | Ft = IE VeN | Ft
IE C
N
X
j X
j1 )Ft
= IE Ve0 +
j (X
j=1
N
i X
j X
j1 ) | Ft
= IE Ve0 | Ft +
IE j (X
j=1
= Ve0 +
t
X
j=1
= Ve0 +
t
X
j=1
= Vet +
N
X
j X
j1 ) | Ft +
j X
j1 ) | Ft
IE j (X
IE j (X
j=t+1
j X
j1 ) +
j (X
N
X
j=t+1
N
X
j=t+1
j X
j1 ) | Ft
IE j (X
j X
j1 ) | Ft ,
IE j (X
where we used Relation (3.4) of Lemma 3.1. In order to obtain (3.7) we need
to show that
N
X
j X
j1 ) | Ft = 0.
IE j (X
j=t+1
j X
j1 ) | Ft = 0,
IE j (X
"
j = 1, . . . , N,
t = 0, . . . , N 1,
"
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N. Privault
In the setting of this chapter, hedging an attainable contingent claim C
means computing a self-financing portfolio strategy (t )t=1,...,N such that
N SN = C, i.e.
N = C,
e
N X
(3.8)
by first solving Equation (3.8) for N . The idea is then to work by backward
induction and to compute successively N 1 , N 2 , . . ., 4 , down to 3 , 2 ,
and finally 1 .
In order to implement this algorithm we may use the self-financing condition which yields N 1 equations
t = t+1 X
t,
t X
t = 1, . . . , N 1,
(3.9)
for N 1 , then
N 2 SN 2 = N 1 SN 2
Then the discounted value Vet at time t of the portfolio claim can be obtained from
0
Ve0 = 1 X
and
t,
Vet = t X
t = 1, . . . , N.
(3.10)
In the proof of Theorem 3.1 we actually showed that the price t (C) of the
claim at time t coincides with the value Vt of any self-financing portfolio
hedging the claim C, i.e.
t (C) = Vt ,
t = 0, 1, . . . , N,
1
IE [C | Ft ],
(1 + r)N t
t = 0, 1, . . . , N,
(3.11)
hence the price of the claim can be computed either algebraically by solving (3.8) and (3.9) and then using (3.10), or by a probabilistic method by
evaluating the expectation (3.11).
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"
and
Vet =
1
t,
Vt = t X
(1 + r)t
t = 1, 2, . . . , N.
Here we will be concerned with the pricing of vanilla options with payoffs of
the form
C = f (SN ),
e.g. f (x) = (x K)+ in the case of a European call. Equivalently, the discounted claim
C
e=
C
(1 + r)N
e = fe(SN ) with fe(x) = f (x)/(1+r)N , i.e. fe(x) =
satisfies C
1
+
(x K)
(1 + r)N
1
IE [f (SN ) | Ft ],
(1 + r)N t
t = 0, 1, . . . , N.
(3.12)
"
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N. Privault
N
Y
1
v(t, x) =
IE f x
(1 + Rj )
(1 + r)N t
j=t+1
=
(3.13)
N
t
X
N t
1
j
N tj
(p )j (1 p )N tj f x (1 + b) (1 + a)
.
(1 + r)N t j=0
j
N
Y
(1 + Rj ),
j=t+1
and (3.12) we have, using Property (v) of the conditional expectation and
the independence of the returns {R1 , . . . , Rt } and {Rt+1 , . . . , RN },
1
IE [f (SN ) | Ft ]
(1 + r)N t
N
Y
1
IE f St
(1 + Rj ) Ft
=
(1 + r)N t
j=t+1
N
Y
1
=
(1 + Rj )
.
IE f x
(1 + r)N t
j=t+1
t (C) =
x=St
ra
ba
and
1 p =
br
,
ba
(3.14)
t (C) =
In the above proof we have also shown that t (C) is given by the conditional expectation
t (C) =
1
IE [f (SN ) | St ]
(1 + r)N t
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"
(1)
and
(1)
(0)
t
"
t = 1, . . . , N,
t = 1, . . . , N,
49
N. Privault
where the function ve(t, x) = (1 + r)t v(t, x) is given by (3.13).
Proof. Recall that by Lemma 3.1 the following statements are equivalent:
(i) The portfolio strategy (t )t=1,...,N is self-financing.
(ii) We have
Vet = Ve0 +
t
X
j=1
j X
j1 ),
j (X
t = 1, . . . , N.
Xt
= (1 + r)t St
= (0) ,
we have
t X
t1 ) = t(0) (Xt(0) X (0) ) + t(1) (Xt(1) X (1) )
t (X
t1
t1
(0)
(1)
(1)
(1)
(1)
(1)
t (Xt Xt1 )
(1)
t (Xt Xt1 ),
(1)
Xt1 )
t = 1, . . . , N.
Hence we have
(1)
t = 1, . . . , N,
1+a
(1)
v
e
(t,
(1
+
a)S
)
v
e
(t
1,
S
)
=
X
,
t1
t1
t1
t1
t
1+r
1+b
(1)
Xt1 Xt1 ,
ve (t, (1 + b)St1 ) ve(t 1, St1 ) = t
1+r
t = 1, . . . , N , i.e.
(1) a r
br
t = 1, . . . , N,
hence
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"
t = 1, . . . , N,
(1)
t = 1, . . . , N.
t
and
(1)
b r (1) a r (1)
,
ba t
ba t
we get
(1)
t = 1, . . . , N,
which only depends on St1 as expected. This is consistent with the fact
(1)
that t represents the (possibly fractional) quantity of the risky asset to be
present in the portfolio over the time period [t 1, t] in order to hedge the
claim C at time N , and is decided at time t 1.
(0)
t = 1, . . . , N,
hence
(0)
(1) (1)
Vet t Xt
(0)
Xt
(1) (1)
Vet t Xt
(0)
ve(t, St ) t Xt
,
(0)
(1)
(1)
t = 1, . . . , N.
(0)
(1)
ve(t 1, St1 ) + (e
v (t, St ) ve(t 1, St1 )) t Xt
(0)
(1)
(1) (1)
ve(t 1, St1 ) + t (Xt Xt1 ) t Xt
=
(0)
(1)
ve(t 1, St1 ) t Xt1
=
,
t = 1, . . . , N.
(0)
=
"
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N. Privault
(0)
(3.15)
(0)
t St
(0)
= (1 + r)t t (0)
(0)
(1)
and
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"
= (1 , . . . , k1 , 1, k+1 , . . . , N ).
t
Rt (
) = a,
and
t = 1, . . . , N,
br
= q,
t = +1,
Rt r b a
=
t = 1, . . . , N.
Yt :=
ba
ar
= p, t = 1,
ba
Note that under the risk-neutral measure P we have
Rt r
IE [Yt ] = IE
ba
br
ar
P (Rt = a) +
P (Rt = b)
=
ba
ba
ar br
br ra
=
+
baba baba
= 0,
and
Var [Yt ] = pq 2 + qp2 = pq,
t = 1, . . . , N.
1 + Rt
Xt1
1+r
1
Xt1 (Rt r)
1+r
ba
=
Yt Xt1 ,
t = 1, . . . , N.
1+r
We also have
Dt Yt =
br
ra
+
= 1,
ba ba
t = 1, . . . , N,
and
"
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N. Privault
Dk SN = S0 (1 + b)
N
Y
t=1
t6=k
= S0 (b a)
= S0
=
N
Y
(1 + Rt ) S0 (1 + a)
N
Y
(1 + Rt )
t=1
t6=k
(1 + Rt )
t=1
t6=k
N
ba Y
(1 + Rt )
1 + Rk t=1
ba
SN ,
1 + Rk
k = 1, . . . , N.
X
IE [Dk F |Fk1 ]Yk .
(3.17)
F = IE [F ] +
k=1
N
X
Yk Dk Mk ,
k=1
N 0.
Proof. We have
MN = IE [MN ] +
= IE [MN ] +
= IE [MN ] +
X
k=1
X
k=1
k=1
= IE [MN ] +
N
X
Yk Dk Mk .
k=1
In addition to the Clark-Ocone formula we also state a discrete-time analog of Itos change of variable formula, which can be useful for option hedging.
The next result extends Proposition 1.13.1 of [59] by removing the unnecessary martingale requirement on (Mt )nN .
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"
t
X
Dk f (Zk , k)Yk
k=1
t
X
k=1
(3.18)
t
X
k=1
= IE [f (Zt , t)|Ft1 ]
t
X
= IE [f (Zt , t)|Ft1 ]
= f (Zt1 , t 1)
t1
X
k=1
t
X
k=1
t 1.
Note that if (Zt )tN is a martingale in L2 () with respect to (Ft )tN and
written as
t
X
Zt = Z0 +
uk Yk ,
t N,
k=1
(3.19)
"
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N. Privault
is analog to the finite variation part in the continuous time It
o formula, and
can be written as
pf (Zt1 + qut , t) + qf (Zt1 put , t) f (Zt1 , t 1) .
Naturally, if (f (Zt , t))tN is a martingale we recover the decomposition
f (Zt , t) = f (Z0 , 0)
t
X
+
(f (Zk1 + quk , k) f (Zk1 puk , k)) Yk
k=1
= f (Z0 , 0) +
t
X
Yk Dk f (Zk , k).
(3.20)
k=1
This identity follows from Corollary 3.1 as well as from Proposition 3.3. In
this case the Clark-Ocone formula (3.17) and the change of variable formula
(3.20) both coincide and we have in particular
Dk f (Zk , k) = IE[Dk f (ZN , N )|Fk1 ],
k = 1, . . . , N . For example this recovers the martingale representation
Xt = S0 +
t
X
Yk Dk Xk
k=1
= S0 +
t
ba X
Xk1 Yk
1+r
k=1
= S0 +
= S0 +
t
X
Xk1
k=1
t
X
Rk r
1+r
(Xk Xk1 ),
k=1
"
1
IE [Dt C|Ft1 ],
St1 (b a)
(3.22)
t = 1 . . . , N , and
t =
1
(1 + r)(N t) IE [C|Ft ] t St ,
At
(3.23)
t = 1 . . . , N,
IE [C]
S0
and t+1 = t
(t+1 t )St
,
At
t = 1, . . . , N 1.
Let now
V0 = IE [C](1 + r)N ,
and Vt = t At + t St ,
t = 1, . . . , N,
and
Vet = Vt (1 + r)t
t = 0, . . . , N.
t
X
Yk k Sk1 (1 + r)k ,
(3.24)
k=1
N
X
#
IE [Di C|Fi1 ](1 + r)N Ft Yi
i=0
= IE [C](1 + r)
t
X
i=0
"
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N. Privault
= IE [C](1 + r)N + (b a)
t
X
i Si1 (1 + r)i Yi
i=0
= Vet
from (3.24). Hence
Vet = (1 + r)N IE [C|Ft ],
and
t = 0, 1, . . . , N,
Vt = (1 + r)(N t) IE [C|Ft ],
t = 0, 1, . . . , N.
(3.25)
N
Y
1
1
IE [C|Ft ] =
IE f x
(1 + Rj )
v(t, St ) =
(1 + r)N t
(1 + r)N t
j=t+1
x=St
Note that in this case we have C = v(N, SN ), IE[C] = v(0, M0 ), and the
e = (1 + r)N C = ve(N, SN ) satisfies
discounted claim payoff C
n
h i X
e = IE C
e +
C
Yt IE [Dt ve(N, SN )|Ft1 ]
t=1
n
h i X
e +
= IE C
Yt Dt ve(t, St )
t=1
n
h i X
e +
= IE C
(1 + r)t Yt Dt v(t, St )
t=1
n
h i X
e +
= IE C
Yt Dt IE [e
v (N, SN )|Ft ]
t=1
n
h i
X
e + (1 + r)N
= IE C
Yt Dt IE[C|Ft ],
t=1
hence we have
IE[Dt v(N, SN )|Ft1 ] = (1 + r)N t Dt v(t, St ),
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t = 1, . . . , N,
"
t =
thus we need to renormalize r so that the interest rate on each time interval
becomes rN , with limN rN = 0.
It turns out that the correct renormalization is
rN = r
T
,
N
so that
"
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N. Privault
N
T
1+r
= erT ,
N
N
lim (1 + rN )N = lim
T R+ .
(3.26)
dAt
= rdt,
At
which means that the return of the riskless asset is rdt on the small time
interval [t, t + dt]. Equivalently, one says that r is the instantaneous interest
rate per unit of time.
The same equation rewrites in integral form as
AT A0 =
wT
0
dAt = r
wT
0
At dt.
and
T
1 + bN
= e N ,
1 + rN
and
bN = (1 + rN )e
i.e.
aN = (1 + rN )e
1.
(N )
Consider the random return Rk {aN , bN } and the price process defined
as
t
Y
(N )
(t)
St = S0
(1 + Rk ),
t = 1, . . . , N.
k=1
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"
t = 1, . . . , N,
T
rN aN
1 e N
q
P (Rt = bN ) =
=
,
2
bN aN
2 sinh NT
t = 1, . . . , N,
P (Rt = aN ) =
and
Continuous-time limit
We have the following convergence result.
Proposition 3.6. Let f be a continuous and bounded function
on R. The
(N )
price at time t = 0 of a contingent claim with payoff C = f SN
converges
as follows:
i
h
h
i
2
1
(N )
IE f (SN ) = erT IE f (S0 e T X+rT T /2 )
(1 + rT /N )N
(3.27)
where X ' N (0, 1) is a standard Gaussian random variable.
lim
2
2
ex /2
erT IE f (S0 e T X+rT T /2 ) = erT
f (S0 e T x+rT T /2 )
dx,
hence we have
h
i
w
x2 /2
1
(N )
rT
T x+rT 2 T /2 e
I
E
f
(S
)
=
e
f
(S
e
)
dx.
0
N
N (1 + rT /N )N
2
lim
It is a remarkable fact that in case f (x) = (xK)+ , i.e. when C = (ST K)+
is the payoff of a European call option with strike K, the above integral can
be computed according to the Black-Scholes formula:
i
h
2
erT IE (S0 e T X+rT T /2 K)+ = S0 (d+ ) KerT (d ),
where
d =
"
(r 21 2 )T + log
S0
K
d+ = d + T ,
61
N. Privault
and
1 w x y2 /2
(x) =
e
dy,
2
x R,
A0 = 1,
t R+ ,
i.e.
At = A0 ert ,
t R+ ,
we now need to construct a mathematical model for the price of the risly
asset in continuous time.
The return of the risky asset St over the time period [t, d + dt] will be
defined as
dSt
= dt + dBt ,
St
where dBt is a small Gaussian random component, also called Brownian
increment, parametrized by the volatility parameter > 0. In the next Chapter 4 we will turn to the formal definition of the stochastic process (Bt )tR+
which will be used for the modeling of risky assets in continuous time.
Exercises
"
1
IE [C | Ft ],
(1 + r)N t
t = 0, 1, . . . , N.
St St1
,
St1
t = 1, . . . , N,
is random and allowed to take only two values a and b, with 1 < a < r < b.
The discounted asset price is Xt = St /(1 + r)t , t = 0, 1, . . . , N .
1. Show that this model admits a unique risk-neutral measure P and explicitly compute P (Rt = a) and P (Rt = b) for all t = 1, . . . , N .
2. Does there exist arbitrage opportunities in this model ? Explain why.
3. Is this market model complete ? Explain why.
4. Consider a contingent claim with payoff1
C = (SN )2 .
Compute the discounted arbitrage price Vt , t = 0, . . . , N , of a selffinancing portfolio hedging the claim C, i.e. such that
1
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(SN )2
VN = C =
.
(1 + r)N
5. Compute the portfolio strategy
(t )t=1,...,N = (t0 , t1 )t=1,...,N
associated to Vt , i.e. such that
t = 0X 0 + 1X 1,
Vt = t X
t t
t t
t = 1, . . . , N.
t = 1, . . . , N 1.
(1 + b)St1
St =
(1 + a)St1
with 1 < a < r < b. The return of the risky asset is defined as
Rt :=
St St1
,
St1
t = 1, . . . , N.
Let t , resp. t , denote the (possibly fractional) quantities of the risky, resp.
riskless, asset held over the time period [t 1, t] in the portfolio with value
Vt = t St + t t ,
t = 0, . . . , N.
(3.29)
1. Show that
Vt = (1 + Rt )t St1 + (1 + r)t t1 ,
t = 1, . . . , N.
(3.30)
br
,
ba
P (Rt = b | Ft1 ) =
ra
,
ba
"
t = 1, . . . , N,
(3.31)
1
E [Vt | Ft1 ],
1+r
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N. Privault
We refer to Theorem 10.28 of [24] and to Chapter 1 of [65] for the proof of
the existence of Brownian motion as a stochastic process (Bt )tR+ satisfying
the above properties (i)-(iv).
In particular, Condition (iv) above implies
IE[Bt Bs ] = 0
and
Var[Bt Bs ] = t s,
0 s t.
In the sequel the filtration (Ft )tR+ will be generated by the Brownian paths
up to time t, in other words we write
Ft = (Bs : 0 s t),
t 0.
(4.1)
"
Bt = t
(4.2)
1
1
t
t = 0,
2
2
and
1
1
t + t = t.
2
2
According to this representation, the paths of Brownian motion are not differentiable, although they are continuous by Property (ii), as we have
dBt
dt
1
'
= ' .
(4.3)
dt
dt
dt
Var[Bt ] = IE[(Bt )2 ] =
Xk = T = N t = N Bt
with probabilities (1/2, 1/2) we have V ar(Xk ) = T and
Xk
Bt = = t
N
is the increment of Bt over ((k 1)t, kt], and we get
BT '
X
0<t<T
Bt '
X1 + + XN
.
N
Hence by the central limit theorem we recover the fact that BT has a centered
Gaussian distribution with variance T , cf. point (iv) of the above definition
of Brownian motion. Indeed, the central limit theorem states that given any
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sequence (Xk )k1 of independent identically distributed centered random
variables with variance 2 = V ar(Xk ) = T , the normalized sum
X1 + + Xn
n
converges (in distribution) to a centered Gaussian random variable N (0, 2 )
with variance 2 as n goes to infinity. As a consequence, Bt could in fact
be replaced by any centered random variable with variance t in the above
description.
Note that there is no point in computing the value of Bt as it is a
random variable for all t > 0, however we can generate samples of Bt , which
are distributed according to the centered Gaussian distribution with variance
t. Below we draw three sample paths of a standard Brownian motion obtained
by computer simulation using (4.2).
2
1.5
Bt
0.5
-0.5
-1
-1.5
-2
0
0.2
0.4
0.6
0.8
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1.5
0.5
-0.5
-1
-1.5
-2
-2
-1.5
-1
-0.5
0.5
1.5
2.5
2
1.5
1
0.5
0
-0.5
-2
-1.5
-1
-1
-0.5
-1.5
-2 -2
-1.5
-1
0
0.5
-0.5
0.5
1.5
1
1.5
2
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wT
0
wT
f (t)dSt =
f (t)dBt
f (t)dBt =
w
0
f (t)
dBt
dt,
dt
and evaluating the above integral with respect to dt. However this definition
fails because the paths of Brownian motion are not differentiable, cf. (4.3).
Next we present Itos construction of the stochastic integral with respect to
Brownian motion. Stochastic integrals will be first constructed as integrals
of simple step functions of the form
f (t) =
n
X
t R+ ,
i=1
(4.4)
t1
t2
t3
t4
kf kL2 (R+ ) :=
|f (t)|2 dt.
Recall also that the classical integral of f given in (4.4) is interpreted as the
area under the curve f and computed as
w
0
f (t)dt =
n
X
i=1
ai (ti ti1 ).
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f (t)dBt :=
n
X
i=1
ai (Bti Bti1 ).
(4.5)
r
Proposition 4.1. The definition of the stochastic integral 0 f (t)dBt can
be extended to any measurable function f L2 (R+ ), i.e. to f such that
w
|f (t)|2 dt < .
(4.6)
0
In this case,
w
0
with variance
w
0
w
f (t)dBt ' N 0,
|f (t)|2 dt
0
w
f (t)dBt
2
w
0
|f (t)|2 dt.
(4.7)
n
X
i=1
the sum
w
0
"
f (t)dBt =
n
X
k=1
t R+ ,
ak (Btk Btk1 )
73
N. Privault
has a centered Gaussian distribution with variance
n
X
k=1
since
Var [ak (Btk Btk1 )] = a2k Var [Btk Btk1 ] = a2k (tk tk1 ),
hence the stochastic integral
w
0
f (t)dBt =
n
X
k=1
n
X
ak (Btk Btk1 )
k=1
hw
0
n
i X
f (t)dBt =
|ak |2 (tk tk1 )
k=1
n
X
k=1
=
=
|ak |2
n
wX
0
w
0
k=1
w tk
tk1
dt
|f (t)|2 dt.
hw
0
w
i
2 hw
i2
f (t)dBt = IE
f (t)dBt
IE
f (t)dBt
0
0
w
2
f (t)dBt
.
= IE
0
w
0
1/2
|f (t) fn (t)|2 dt
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=
IE
L2 ()
w
fk (t)dBt
w
0
fn (t)dBt
2 1/2
r
which tends to 0 as k, n tend to infinity, hence 0 fn (t)dBt nN is it con2
2
verges for the L -norm as L () is a complete space, cf. e.g. Chapter 4 of
[18]. In this case we let
w
w
f (t)dBt := lim
fn (t)dBt
n
provided limt t|f (t)|2 = 0 and f L2 (R+ ), cf. e.g. Remark 2.5.9 in [59].
4.3 It
o Stochastic Integral
In this section we extend the Wiener stochastic integral to square-integrable
adapted processes. Recall that a process (Xt )tR+ is said to be Ft -adapted if
Xt is Ft -measurable for all t R+ , where the information flow (Ft )tR+ has
been defined in (4.1).
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In other words, a process (Xt )tR+ is Ft -adapted if the value of Xt at time
t depends only on information known up to time t. Note that the value of Xt
may still depend on known future data, for example a fixed future date in
the calendar, such as a maturity time T > t, as long as its value is known at
time t.
The extension of the stochastic integral to adapted random processes is
actually necessary in order to compute a portfolio value when the portfolio
process is no longer deterministic. This happens in particular when one needs
to update the portfolio allocation based on random events occurring on the
market.
Stochastic integrals of adapted processes will be first constructed as integrals
of simple predictable processes (ut )tR+ of the form
ut =
n
X
i=1
t R+ ,
(4.8)
i=1
The next proposition gives the extension of the stochastic integral from
simple predictable processes to square-integrable Ft -adapted processes (Xt )tR+
for which the value of Xt at time t only depends on information contained
in the Brownian path up to time t. This also means that knowing the future
is not permitted in the definition of the Ito integral, for example a portfolio
strategy that would allow the trader to buy at the lowest and sell at the
highest is not possible as it would require knowledge of future market data.
Note that the difference between Relation (4.10) below and Relation (4.7)
is the expectation on the right hand side.
Proposition 4.2. The stochastic integral with respect to Brownian motion
(Bt )tR+ extends to all adapted processes (ut )tR+ such that
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"
hw
0
i
|ut |2 dt < ,
with the It
o isometry
IE
w
ut dBt
2
= IE
hw
0
i
|ut |2 dt .
(4.10)
In addition, the It
o integral of an adapted process (ut )tR+ is always a centered random variable:
hw
i
IE
us dBs = 0.
(4.11)
0
Proof. We start by showing that the Ito isometry (4.10) holds for the simple
predictable process u of the form (4.8). We have
!2
w
n
2
X
IE
ut dBt
Fi (Bti Bti1 )
= IE
0
i=1
= IE
n
X
i,j=1
"
= IE
n
X
i=1
+2 IE
1i<jn
n
X
i=1
+2
1i<jn
n
X
+2
1i<jn
n
X
+2
1i<jn
n
X
i=1
"
i=1
i=1
N. Privault
"
= IE
n
X
i=1
= IE
hw
0
#
|Fi |2 (ti ti1 )
i
|ut |2 dt ,
Note also that the Ito isometry (4.10) can also be written as
i
hw
i
hw
w
IE
ut dBt
vt dBt = IE
ut vt dt ,
0
ut dBt :=
w
0
In particular we have
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"
and
1[a,b] (t)dBt = Bb Ba ,
wb
a
dBt = Bb Ba ,
0 a b,
0 a b.
0 a b c,
In the sequel we will define the return at time t R+ of the risky asset
(St )tR+ as
dSt
= dt + dBt ,
St
with R and > 0. This equation can be formally rewritten in integral
form as
wT
wT
ST = S0 +
St dt +
St dBt ,
0
hence the need to define an integral with respect to dBt , in addition to the
usual integral with respect to dt.
In Proposition 4.2 we have defined the stochastic integral of squareintegrable processes with respect to Brownian motion, thus we have made
sense of the equation
ST = S0 +
wT
0
St dt +
wT
0
St dBt ,
dSt
= dt + dBt .
St
(4.12)
This model will be used to represent the random price St of a risky asset at
time t. Here the return dSt /St of the asset is made of two components: a constant return dt and a random return dBt parametrized by the coefficient
, called the volatility.
Our goal is now to solve Equation (4.12) and for this we will need to
introduce Itos calculus in Section 4.5 after reviewing classical deterministic
calculus in Section 4.4.
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(4.13)
(dBt )2 = ( dt)2 = dt
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dBt
1
dt
'
' '
dt
dt
dt
does not exist.
Integrating (4.14) on both sides and using the relation
f (Bt ) f (B0 ) =
wt
0
df (Bs )
we get the integral form of Itos formula for Brownian motion, i.e.
f (Bt ) = f (B0 ) +
wt
0
f 0 (Bs )dBs +
1 w t 00
f (Bs )ds.
2 0
or in differential notation
dXt = vt dt + ut dBt ,
where (ut )tR+ and (vt )tR+ are square-integrable adapted processes.
f
x
denote partial differentiation with respect to the second variable in f (t, x),
f
while
denote partial differentiation with respect to the first (time) variable
s
in f (t, x).
Given f (t, x) a smooth function of two variables, from now on we let
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N. Privault
w t f
w t f
f (t, Xt ) = f (0, X0 ) +
vs (s, Xs )ds +
us (s, Xs )dBs
0
0
x
x
w
w t f
2
1 t
2 f
(s, Xs )ds.
(4.16)
(s, Xs )ds +
|us |
+
0 s
2 0
x2
Proof. cf. [64], Theorem II-32.
we get
wt
0
df (s, Xs ) =
w t f
f
us (s, Xs )dBs
vs (s, Xs )ds +
0
x
x
w t f
w
1 t
2f
+
(s, Xs )ds +
|us |2 2 (s, Xs )ds,
0 s
2 0
x
wt
0
f
f
f
1
2f
(t, Xt )dt+ut (t, Xt )dBt +vt (t, Xt )dt+ |ut |2 2 (t, Xt )dt,
t
x
x
2
x
(4.17)
or
f
f
(t, Xt )dt +
(t, Xt )dXt +
t
x
Next, given two processes (Xt )tR+ and (Yt )tR+
df (t, Xt ) =
Xt = X0 +
wt
vs ds +
Yt = Y0 +
wt
bs ds +
and
wt
0
wt
0
1
2f
|ut |2 2 (t, Xt )dt.
2
x
written as
us dBs ,
t R+ ,
as dBs ,
t R+ ,
dtdBt = 0,
(dBt )2 = dt,
(4.18)
i.e.
dXt dYt = (vt dt + ut dBt )(bt dt + at dBt )
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"
= (ut )2 dt,
dt
dBt
dt
0
0
dBt
0
dt
(4.19)
f
f
1 2f
(t, Xt )dt +
(t, Xt )dXt +
(t, Xt )(dXt )2 .
t
x
2 x2
w t f
w t f
1 w t 2f
(s, Bs )ds +
(s, Bs )dBs +
(s, Bs )ds,
0 s
0 x
2 0 x2
f
1 2f
f
(t, Bt )dt +
(t, Bt )dBt +
(t, Bt )dt.
t
x
2 x2
(4.20)
and f (t, x) = x2 ,
we get
dBt2 = df (Bt )
f
f
1 2f
=
(t, Bt )dt +
(t, Bt )dBt +
(t, Bt )dt
t
x
2 x2
= 2Bt dBt + dt,
since
f
(t, x) = 0,
t
f
(t, x) = 2x,
x
and
1 2f
(t, x) = 1,
2 x2
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wT
wT
BT2 = B0 + 2
Bs dBs +
dt
0
0
wT
=2
Bs dBs + T,
0
and
wT
BT2
T
.
2
2
We close this section with some comments on the practice of It
os calculus.
In some finance textbooks, Itos formula for e.g. geometric Brownian motion
can be found written in the notation
wT
wT
f
f
(t, St )dBt +
(t, St )dt
St
f (T, ST ) = f (0, X0 ) +
St
0
0
St
St
w T f
w
2
T
1
f
+
(t, St )dt + 2
St2 2 (t, St )dt,
0 t
0
2
St
0
or
df (St ) = St
Bs dBs =
f
f
1
2f
(St )dBt + St
(St )dt + 2 St2 2 (St )dt.
St
St
2
St
f
(St ) can in fact be easily misused in combination with the
St
fundamental theorem of classical calculus, and lead to the wrong identity
The notation
df (St ) =
f
(St )dSt .
St
Similarly, writing
df (Bt ) =
df
1 d2 f
(Bt )dBt +
(Bt )dt
dx
2 dx2
1 d2 f (Bt )
df (Bt )
dBt +
dt
dBt
2 dBt2
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(4.21)
"
It can be solved by applying Itos formula to f (St ) = log St with f (x) = log x,
which shows that
1
d log St = St f 0 (St )dt + St f 0 (St )dBt + 2 St2 f 00 (St )dt
2
1
= dt + dBt 2 dt,
2
hence
log St log S0 =
wt
d log Sr
0
wt
wt
1
=
2 dr +
dBr
0
0
2
1
t R+ ,
= 2 t + Bt ,
2
and
St = S0 exp
1
2 t + Bt ,
2
t R+ .
t/2
t R+ .
f
1 2f
f
(t, Bt )dt +
(t, Bt )dBt +
(t, Bt )dt.
t
x
2 x2
Comparing this expression to (4.21) and identifying the terms in dBt we get
f
(t, Bt ) = St ,
x
and
"
f
1 2f
(t, Bt ) +
(t, Bt ) = St .
t
2 x2
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N. Privault
Using the relation St = f (t, Bt ) these two equations rewrite as
f
(t, Bt ) = f (t, Bt ),
x
and
f
1 2f
(t, Bt ) = f (t, Bt ).
(t, Bt ) +
t
2 x2
Since Bt is a Gaussian random variable taking all possible values in R, the
equations should hold for all x R, as follows:
f
(t, x) = f (t, x),
x
(4.23)
and
f
1 2f
(t, x) +
(t, x) = f (t, x).
t
2 x2
Letting g(t, x) = log f (t, x), the first equation (4.23) shows that
(4.24)
g
log f
1 f
(t, x) =
(t, x) =
(t, x) = ,
x
x
f (t, x) x
i.e.
g
(t, x) = ,
x
which is solved as
g(t, x) = g(t, 0) + x,
hence
f (t, x) = eg(t,0) ex = f (t, 0)ex .
Plugging back this expression into the second equation (4.24) yields
ex
1
f
(t, 0) + 2 ex f (t, 0) = f (t, 0)ex ,
t
2
g
(t, 0) = 2 /2,
t
i.e.
g(t, 0) = g(0, 0) + 2 /2 t,
and
f (t, x) = eg(t,x)
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"
hence
/2)t
/2)t
t R+ .
t/2+t
we may
dSt = df (t, Bt )
f
f
1 2f
=
(t, Bt )dt +
(t, Bt )dBt +
(t, Bt )dt
t
x
2 x2
2
Bt +( 2 /2)t
2
= /2 S0 e
dt + S0 eBt +( /2)t dBt
2
1
+ 2 S0 eBt +( /2)t dt
2
2
2
= S eBt +( /2)t dt + S eBt +( /2)t dB
0
= St dt + St dBt .
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N. Privault
Xt = X0 +
wt
0
(s, Xs )dBs +
wt
0
t R+ ,
b(s, Xs )ds,
where (Bt )tR+ is a d-dimensional Brownian motion, see e.g. [64], Theorem V7.
Next we consider a few examples of stochastic differential equations that
can be solved explicitly using Ito calculus.
Examples
1. Consider the stochastic differential equation
dXt = Xt dt + dBt ,
X0 = x0 ,
wt
0
e(ts) dBs ,
t > 0,
rt
after applying Theorem 4.1 to the Ito process x0 + 0 b(s)dBs of the form
(4.15) with ut = b(t) and v(t) = 0, and to the function f (t, x) = a(t)x.
Remark: the solution of this equation cannot be written as a function
f (t, Bt ) of t and Bt as in the proof of Proposition 4.3.
2. Consider the stochastic differential equation
dXt = tXt dt + et
/2
dBt ,
X0 = x0 .
rt
Looking for a solution of the form Xt = a(t) X0 + 0 b(s)dBs , where
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Yt dBt ,
"
2
p
wt
et Y0 + e(ts) dBs .
0
Exercises
Exercise 4.1 Let (Bt )tR+ denote a standard Brownian motion.
1. Let c > 0. Among the following processes, tell which is a standard Brownian motion and which is not. Justify your answer.
a. (Bc+t Bc )tR+ .
b. (cBt/c2 )tR+ .
c. (Bct2 )tR+ .
2. Compute the stochastic integrals
wT
0
2dBt
wT
and
sin(t) dBt .
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N. Privault
for all < 1/T . Hint: expand (BT )2 using Itos formula.
Exercise 4.4 Solve the ordinary differential equation df (t) = cf (t)dt and the
stochastic differential equation dSt = rSt dt + St dBt , t R+ , where r, R
are constants and (Bt )tR+ is a standard Brownian motion.
Exercise 4.5 Given T > 0, let (XtT )t[0,T ] denote the solution of the stochastic
differential equation
dXtT = dBt
XtT
dt,
T t
t [0, T ],
(4.25)
wt
0
1
dBs ,
T s
t [0, T ].
(4.26)
(4.27)
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/2
"
(4.28)
(4.29)
w t f
f
1 w t 2 2f
(Xs )dBs + vs (Xs )ds+
u
(Xs )ds,
0
0
x
x
2 0 s x2
(4.30)
wt
wt
where Xt = X0 +
us dBs +
vs ds.
f (Xt ) = f (X0 )+
us
?
Bt +t
,
P (ST > K | St = x) =
where = T t. Hint: use the decomposition ST = St e(BT Bt )+ .
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4. Given 0 t T and > 0, let
X = (BT Bt )
and
2 = Var[X],
> 0.
What is equal to ?
Exercise 4.9 Let (Bt )tR+ be a standard Brownian motion generating the
information flow (Ft )tR+ .
1. Let 0 t T . What is the probability law of BT Bt ?
2. From the answer to Exercise 16.5, show that
r
Bt2
Bt
e 2 + Bt
,
IE[(BT )+ | Ft ] =
2
w t f
f
1 w t 2 2f
(Xs )dBs + vs (Xs )ds+
u
(Xs )ds
0
x
x
2 0 s x2
wt
wt
stated here for a process Xt = X0 +
us dBs +
vs ds, t R+ , and
0
0
applied to f (x) = ex .
4. Let St = eXt , t R+ , and r > 0. For which value of does (St )tR+
satisfy the stochastic differential equation
f (Xt ) = f (X0 )+
us
IE[( BT )+ | Ft ] =
e
+ ( Bt )
,
2
0 t T,
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Chapter 5
In this section we review the notions of assets, self-financing portfolios, riskneutral measures, and arbitrage in continuous time. We also derive the BlackScholes PDE for self-financing portfolios, and we solve this equation using the
heat kernel method.
t R+ ,
i.e. At = A0 ert ,
t R+ .
t R+ .
t R+ .
"
St = (At , St ),
t R+ ,
N. Privault
denote the associated portfolio and asset price processes. The value of the
portfolio Vt at time t is given by
Vt = t St = t At + t St ,
t R+ .
(5.1)
The portfolio strategy (t , t )tR+ is self-financing if the portfolio value remains constant after updating the portfolio from (t , t ) to (t+dt , t+dt ), i.e.
t St+dt = At+dt t + St+dt t = At+dt t+dt + St+dt t+dt = t+dt St+dt , (5.2)
which is the continuous-time equivalent of the self-financing condition already
encountered in the discrete setting of Chapter 2, see Definition 2.1. A major
difference with the discrete-time case of Definition 2.1, however, is that the
continuous-time differentials dSt and dt do not make pathwise sense as the
stochastic integral is defined by an L2 limit, cf. Proposition 4.2, or by convergence in probability.
Portfolio value
Asset value
t St
Time scale
Portfolio allocation
St
St+dt St+dt
t
t
t + dt t + dt
t t+dt
- t+dt St+2dt
St+2dt
t + 2dt
t+2dt
(5.3)
or
At+dt (t+dt t ) = St+dt (t+dt t ),
i.e. when one sells a quantity dt > 0 of the risky asset St+dt between the
time periods [t, t + dt] and [t + dt, t + 2dt] for a total amount St+dt dt , one
should entirely use this income to buy a quantity dt > 0 of the riskless asset
for an amount At+dt dt > 0.
Similarly, if one sells a (possibly fractional) quantity dt > 0 of the
riskless asset At+dt between the time periods [t, t + dt] and [t + dt, t + 2dt]
for a total amount At+dt dt , one should entirely use this income to buy a
quantity dt > 0 of the risky asset for an amount St+dt dt > 0, i.e.
St+dt dt = At+dt dt ,
or
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(5.4)
Vt = ert Vt
and
Xt = ert St
respectively denote the discounted portfolio value and discounted risky asset
prices at time t 0. We have
dXt = d(ert St )
= rert St dt + ert dSt
= Xt (( r)dt + dBt ).
In the next lemma we show that when a portfolio is self-financing, its discounted value is a gain process given by the sum of discounted profits and
losses (number of risky assets t times discounted price variation dXt ) over
time.
Lemma 5.1. Let (t , t )tR+ be a portfolio strategy with value
Vt = t At + t St ,
t R+ .
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i) the portfolio strategy (t , t )tR+ is self-financing,
ii) we have
Vt = V0 +
wt
u dXu ,
t R+ .
(5.5)
Proof. Assuming that (i) holds, the self-financing condition shows that
dVt = t dAt + t dSt
= rt At dt + t St dt + t St dBt
= rVt dt + ( r)t St dt + t St dBt
t R+ ,
hence
dVt = d ert Vt
rt
= re
Vt dt + ert dVt
= ( r)t Xt dt + t Xt dBt
= t dXt ,
t R+ ,
wt
0
dVu =
wt
0
u dXu ,
t R+ .
wT
0
u dXu .
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Roughly speaking, (ii) means that the investor wants no loss, (iii) means
that he wishes to sometimes make a strictly positive gain, and (i) means that
he starts with zero capital or even with a debt.
Next we turn to the definition of risk-neutral measures in continuous time.
Recall that the filtration (Ft )tR+ is generated by Brownian motion (Bt )tR+ ,
i.e.
Ft = (Bu : 0 u t),
t R+ .
0 u t,
(5.7)
0 u t,
we interpret (5.7) by saying that the expected return of the risky asset St
under P equals the return of the riskless asset At . The discounted price Xt
of the risky asset is defined by
Xt = ert St =
St
,
At /A0
t R+ ,
i.e. At /A0 plays the role of a numeraire in the sense of Chapter 10.
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Definition 5.4. A continuous time process (Zt )tR+ of integrable random
variables is a martingale with respect to the filtration (Ft )tR+ if
IE[Zt |Fs ] = Zs ,
0 s t.
0 u t.
0 u t.
"
In this case the price of the claim at time t will be equal to the value Vt of
any self-financing portfolio hedging C.
Definition 5.6. A market model is said to be complete if every contingent
claim C is attainable.
The next result is a continuous-time restatement of the second fundamental
theorem of mathematical finance.
Theorem 5.2. A market model without arbitrage is complete if and only if
it admits only one risk-neutral measure.
Proof. cf. Chapter VII-4a of [70].
In the Black-Scholes model one can show the existence of a unique risk-neutral
measure, hence the model is without arbitrage and complete.
1,2
t R+ ,
rg(t, x) =
g
g
1
2g
(t, x) + rx (t, x) + x2 2 2 (t, x),
t
x
2
x
t, x > 0,
and t is given by
t =
g
(t, St ),
x
t R+ .
(5.8)
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dVt = t dAt + t dSt
= rt At dt + t St dt + t St dBt
(5.9)
wt
0
vs ds +
wt
0
us dBs ,
t R+ ,
as in (4.15), by taking
ut = St ,
and vt = St ,
t R+ .
dg(t, St ) = g(0, S0 ) + vt
g
g
1 2 2 2g
1 2 2 2g
g
t = g (t, St ),
x
i.e.
g
1 2 2 2g
g
t = g (t, St ).
x
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(5.11)
"
g
(t, St ),
x
and t is given by
t =
Vt t St
At
g(t, St ) St
g(t, St ) St
g
(t, St )
x
At
g
(t, St )
x
.
A0 ert
g
g
1
2g
rg(t, x) =
(t, x) + rx (t, x) + x2 2 2 (t, x),
t
x
2
x
g(T, x) = f (x).
t, x > 0,
g
(t, St ) = 1,
x
0 t T,
cf. Exercise 5.3. The forward contract can be realized by the option issuer as
follows:
a) At time t, receive the option premium St er(T t) K from the option
buyer.
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b) Borrow er(T t) K from the bank, to be refunded at maturity.
c) Buy the risky asset using the amount St er(T t) K + er(T t) K = St .
d) Hold the risky asset until maturity (do nothing, constant portfolio strategy).
e) At maturity T , hand in the asset to the option holder, who gives the price
K in exchange.
f) Use the amount K = er(T t) er(T t) K to refund the bank of the sum
er(T t) K borrowed at time t.
Recall that in the case of a European call option with strike K the payoff
function is given by f (x) = (x K)+ and the Black-Scholes PDE reads
g
1
2g
g
+
gc (T, x) = (x K) .
In the next sections we will prove that the solution of this PDE is given by
the Black-Scholes formula
gc (t, x) = BS(K, x, , r, T t) = x(d+ ) Ker(T t) (d ),
(5.12)
x R,
log(x/K) + (r + 2 /2)(T t)
,
T t
d =
log(x/K) + (r 2 /2)(T t)
,
T t
d+ = d + T t.
+, x > K,
, x < K,
x>K
x(+) K(+) = x K,
gc (T, x) =
= (x K)+
x() K() = 0,
x<K
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80
70
60
50
40
30
20
10
0
150 140
130 120
110 100
underlying HK$
90
80
70
60
10
0
1
2
3
4
Time to maturity T-t
Fig. 5.2: Graph of the Black-Scholes call price function with strike K = 100.
In Figure 5.3 we consider the stock price of HSBC Holdings (0005.HK) over
one year:
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Consider a call option issued by Societe Generale on 31 December 2008 with
strike K=$63.704, maturity T = October 05, 2009, and an entitlement ratio of
100, meaning that one option contract is divided into 100 warrants, cf. page
6. The next graph gives the time evolution of the Black-Scholes portfolio
price
t 7 gc (t, St )
driven by the market price t 7 St of the underlying risky asset as given in
Figure 5.3, in which the number of days is counted from the origin and not
from maturity.
40
35
30
25
20
15
10
5
0
100
90
80
70
underlying HK$
60
50
40
200
150
50
100
Time in days
Fig. 5.4: Path of the Black-Scholes price for a call option on HSBC.
The next proposition is proved by direct differentiation of the Black-Scholes
function, and will be recovered later using a probabilistic argument in Proposition 6.7 below.
Proposition 5.4. The Black-Scholes Delta of a European call option is given
by
t = (d+ ).
Proof. We have
g
(x, t) =
(5.13)
x
2
2
log(x/K) + (r + /2)(T t)
log(x/K) + (r /2)(T t)
x
K
x
T t
T t
log(x/K) + (r + 2 /2)(T t)
=x
x
T t
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"
log(x/K) + (r 2 /2)(T t)
K
x
T t
log(x/K) + (r 2 /2)(T t)
+
T t
2 !
1
1 log(x/K) + (r + 2 /2)(T t)
=
exp
2
T t
2 T t
2 !
K
1 log(x/K) + (r 2 /2)(T t)
exp
2
T t
2x T t
log(x/K) + (r 2 /2)(T t)
+
T t
log(x/K) + (r 2 /2)(T t)
=
.
T t
As a consequence of Proposition 5.4, in the Black-Scholes model the amount
invested on the risky asset is
log(St /K) + (r + 2 /2)(T t)
0,
St t = St (d+ ) = St
T t
which is always positive, i.e. there is no short-selling, and the amount invested
on the riskless asset is
log(St /K) + (r 2 /2)(T t)
t At = KA0 er(T t)
0,
T t
Similarly, in the case of a European put option with strike K the payoff
which is always negative, i.e. we are+constantly borrowing money.
function is given by f (x) = (K x) and the Black-Scholes PDE reads
g
1
2 gp
g
gp (T, x) = (K x)+ ,
with explicit solution
gp (t, x) = Ker(T t) (d ) x(d+ ),
Note that the call-put parity relation
as illustrated in the next graph.
g(t, St ) = gc (t, St ) gp (t, St ),
0 t T,
is satisfied here.
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Black-Scholes price
Risky investment
Riskless investment
Underlying
100
80
K
60
HK$
40
20
-20
-40
-60
0
50
100
150
200
Fig. 5.5: Time evolution of the hedging portfolio for a call option on HSBC.
14
12
10
8
6
4
2
0
90
95
100
105
underlying HK$
110
115
120
10
8 9
6 7
Time to maturity T-t
Fig. 5.6: Graph of the Black-Scholes put price function with strike K = 100.
For one more example we consider a put option issued by BNP Paribas on
04 November 2008 with strike K=$77.667, maturity T = October 05, 2009,
and entitlement ratio 92.593, cf. page 6. In the next Figure 5.7 the number
of days is counted from the origin and not from maturity.
In the case of a Black-Scholes put option the Delta is given by
t = (d+ ),
and the amount invested on the risky asset is
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45
40
35
30
25
20
15
10
5
0
50
100
Time in days
150
200
100
90
80
40
50
60
70 underlying
HK$
Fig. 5.7: Path of the Black-Scholes price for a put option on HSBC.
log(St /K) + (r + 2 /2)(T t)
St (d+ ) = St
0,
T t
i.e. there is always short-selling, and the amount invested on the riskless asset
is
log(St /K) + (r 2 /2)(T t)
Ker(T t)
0,
T t
which is always positive, i.e. we are constantly investing on the riskless asset.
Black-Scholes price
Risky investment
Riskless investment
Underlying
100
80
60
HK$
40
20
-20
-40
-60
0
50
100
150
200
Fig. 5.8: Time evolution of the hedging portfolio for a put option on HSBC.
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N. Privault
g
1 2g
(t, y) =
(t, y)
t
2 y 2
g(0, y) = (y)
(5.14)
(z)e
(yz)2
2t
dz
.
2t
(5.15)
Proof. We have
(yz)2
dz
g
w
(t, y) =
(z)e 2t
t
t
2t
!
(yz)2
w
2t
e
=
(z)
dz
t
2t
1w
(y z)2
1 (yz)2 dz
2t
=
(z)
e
2
t2
t
2t
w
1
2 (yz)2 dz
2t
=
(z) 2 e
2
z
2t
w
2
2
1
(yz) dz
2t
=
(z) 2 e
2
y
2t
w
(yz)2
1 2
dz
2t
(z)e
=
2 y 2
2t
2
1 g
=
(t, y).
2 y 2
t0
(z)e
(yz)2
2t
w
z2
dz
dz
= lim
(y + z)e 2t
= (y),
2t t0
2t
y R.
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"
dz
2t
w
x2
dx
=
(y + x)e 2t
2t
= IE[(y + Bt )],
g(t, y) =
(z)e
(yz)2
2t
g
(t, y) =
IE[(y + Bt )]
t
t
1 2
=
IE [(y + Bt )]
2 y 2
2
1 g
=
(t, y).
2 y 2
Concerning the initial condition we check that
g(0, y) = IE[(y + B0 )] = IE[(y)] = (y).
f
1
2f
f
rf (t, x) =
(t, x) + rx (t, x) + x2 2 2 (t, x),
t
x
2
x
+
f (T, x) = (x K) ,
"
(5.16)
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with terminal condition h(x) = (x K)+ . Then the function g(t, y) defined
by
2
(5.17)
g(t, y) = ert f T t, ey+( /2r)t
solves the heat equation (5.14), i.e.
g
1 2g
(t, y) =
(t, y)
t
2 y 2
g(0, y) = h(ey ),
with initial condition
g(0, y) = h(ey ).
Proof. Letting s = T t and x = ey+(
/2r)t
(5.18)
we have
2
2
g
f
(t, y) = rert f (T t, ey+( /2r)t ) ert (T t, ey+( /2r)t )
t
s
2
2
2
f
+
r ert ey+( /2r)t (T t, ey+( /2r)t )
2
x
2
f
f
= rert f (T t, x) ert (T t, x) +
r ert x (T t, x)
s
2
x
1 rt 2 2 2 f
2 rt f
= e x
(T t, x) +
e x (T t, x),
(5.19)
2
x2
2
x
and
2
1 g 2
2 rt y+(2 /r)t/2 f
(t, y) =
e e
(T t, ey+( /2r)t )
2 y 2
2
x
2
2
2
2f
+ ert e2y+2( /2r)t 2 (T t, ey+( /2r)t )
2
x
2 rt 2 2 f
2 rt f
e x (T t, x) +
e x
(T t, x),
=
2
x
2
x2
which, in view of (5.19), means that g(t, x) satisfies the heat equation (5.14)
with initial condition
g(0, y) = f (T, ey ) = h(ey ).
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"
1 w x y2 /2
e
dy,
(x) =
2
x R,
and
d+ =
log(x/K) + (r + 2 /2)(T t)
,
T t
d =
log(x/K) + (r 2 /2)(T t)
.
T t
f (s, x) = er(T s) g T s,
/2r)t
( 2 r)(T s) + log x
we get
!
.
!
2
w
z2
( 2 r)(T t) + log x
dz
r(T t)
=e
+ z e 2(T t) p
2(T t)
w
z2
2
dz
= er(T t)
h xez( /2r)(T t) e 2(T t) p
2(T t)
+
w
z2
2
dz
= er(T t)
xez( /2r)(T t) K e 2(T t) p
2(T t)
w
z2
2
dz
= er(T t) (r+2 /2)(T t)+log(K/x) xez( /2r)(T t) K e 2(T t) p
2(T t)
w
z2
2
dz
= xer(T t)
ez( /2r)(T t) e 2(T t) p
d T t
2(T t)
w
z2
dz
Ker(T t)
e 2(T t) p
d T t
2(T t)
w
2
z2
dz
=x
ez (T t)/2 2(T t) p
d T t
2(T t)
w
z2
dz
Ker(T t)
e 2(T t) p
d T t
2(T t)
"
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=x
dz
2(T t)
w
2
dz
2(Tz t)
r(T t)
p
Ke
e
d T t
2(T t)
w
z2
dz
=x
e 2(T t) p
d T t(T t)
2(T t)
w
z2
dz
e 2(T t) p
Ker(T t)
d T t
2(T t)
w
w
2
2
dz
dz
=x
ez /2 Ker(T t)
ez /2
d T t
d
2
2
= x (1 (d+ )) Ker(T t) (1 (d ))
d
T t
= x (d+ ) Ker(T t) (d ) ,
where we used the relation
1 (a) = (a),
a R.
Exercises
Exercise 5.1
1. Solve the stochastic differential equation
dSt = St dt + dBt
in terms of , > 0, and the initial condition S0 .
2. For which values M of is the discounted price process St = ert St ,
t [0, T ], a martingale under P ?
3. Compute the arbitrage price C(t, St ) = er(T t) IE[exp(ST ) | Ft ] at time
t [0, T ] of the contingent claim of exp(ST ), with = M .
4. Explicitly compute the strategy (t , t )t[0,T ] that hedges the contingent
claim exp(ST ).
Exercise 5.2 In the Black-Scholes model, the price at time t of a European
claim on the underlying asset St , with strike price K, maturity T , interest
rate r and volatility is given by the Black-Scholes formula as
f (t, St ) = St (d+ ) Ker(T t) (d ),
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T t
Recall that
and d+ = d + T t.
f
(t, St ) = (d+ ),
x
0.5
HK$
0.4
0.3
0.2
0.1
0
0.5
0.6
0.7
0.8
0.9
1
sigma
1.1
1.2
1.3
1.4
1.5
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Exercise 5.3 Forward contracts. Recall that the price t (C) of a claim C =
h(ST ) of maturity T can be written as t (C) = g(t, St ), where the function
g(t, x) satisfies the Black-Scholes PDE
g
1
g
2g
rg(t, x) =
(t, x) + rx (t, x) + x2 2 2 (t, x),
t
x
2
x
g(T, x) = h(x),
(1)
with terminal condition g(T, x) = h(x).
1. Assume that C is a forward contract with payoff
C = ST K,
at time T . Find the function h(x) in (1).
2. Find the solution g(t, x) of the above PDE and compute the price t (C)
at time t [0, T ].
Hint: search for a solution of the form g(t, x) = x (t) where (t) is a
function of t to be determined.
3. Compute the quantity
g
t =
(t, St )
x
of risky assets in a self-financing portfolio hedging C.
Exercise 5.4 Forward contracts revisited. Consider a risky asset whose price
2
St is given by St = S0 eBt +rt t/2 , t R+ , where (Bt )tR+ is a standard
Brownian motion. Consider a forward contract with maturity T and payoff
ST .
1. Compute the price Ct of this claim at any time t [0, T ].
2. Compute a hedging strategy for the option with payoff ST .
Exercise 5.5 Computation of Greeks. Consider an option with payoff function
and price
h
i
C(x, T ) = erT IE (ST )S0 = x ,
where (x) is a twice continuously differentiable (C 2 ) function, on the underlying (St )tR+ given by the stochastic differential equation
dSt = rSt dt + (St )dWt , ,
with S0 = x and Lipschitz coefficient (x).
Using the Ito formula, show that the sensitivity
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erT IE [(ST )]
T
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Chapter 6
0 s t.
The following result shows that the indefinite Ito integral is a martingale with
respect to the Brownian filtration (Ft )tR+ . It is the continuous-time analog
of the discrete-time Proposition 2.1.
r
t
Proposition 6.1. The indefinite stochastic integral
u dBs
of a
0 s
tR+
In particular,
"
rt
0
us dBs is Ft -measurable, t R+ .
N. Privault
Proof. The statement is first proved in case u is a simple predictable process,
and then extended to the general case, cf. e.g. Proposition 2.5.7 in [59].
In particular, since F0 = {, }, this recover the fact that the It
o integral is
a centered random variable:
i w0
hw
i
hw
us dBs = 0.
IE
us dBs = IE
us dBs F0 =
0
Examples
1. Given any square-integrable random variable F L2 (), the process
(Xt )tR+ defined by Xt := IE[F | Ft ], t R+ , is a martingale under P,
as follows from the tower property
IE[Xt | Fs ] = IE[IE[F | Ft ] | Fs ] = IE[F | Fs ] = Xs ,
0 s t, (6.1)
0 s t.
= Xs ,
(6.2)
t/2
t/2
t/2
IE[e
t/2
= X0 e
t/2+Bs
= X0 e
t/2+Bs
= X0 e
|Fs ]
Bt
|Fs ]
IE[e(Bt Bs ) ]
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t/2+Bs 2 (ts)/2
= X0 eBs
s/2
0 s t.
= Xs ,
This fact can also be recovered from Proposition 6.1 since Xt satisfies the
equation
dXt = Xt dBt ,
i.e. it can be written as the Brownian stochastic integral
wt
Xt = X0 + Xu dBu ,
t R+ .
0
t R+ ,
t R+ ,
since
dXt = Xt (( r)dt + dBt ).
Since the Black-Scholes theory is in fact valid for any value of the parameter
we will look forward to including the case 6= r in the sequel.
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t ,
dXt = Xt dB
where
t := r t + Bt ,
B
t R+ .
Therefore the search for a risk-neutral measure can be replaced by the search
t )tR is a standard Brownian
for a probability measure P under which (B
+
motion.
Let us come back to the informal interpretation of Brownian motion via
its infinitesimal increments:
Bt = dt,
with
1
P(Bt = + dt) = P(Bt = dt) = .
2
2
Drifted Brownian motion
Drift
1.6
1.2
0.8
0.4
0.2
0.4
0.6
0.8
1
1
(dt + dt) + (dt dt) = dt 6= 0.
2
2
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p + q = 1.
1
(1 dt)
2
and q =
1
(1 + dt).
2
= exp
X
0<t<T
log 1 dt
1 X
' exp
dt
( dt)2
2
0<t<T
0<t<T
!
X
1 2 X
= exp
dt
dt
2
0<t<T
0<t<T
1 2
= exp BT T .
2
X
"
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N. Privault
w
1
=
f (T + BT ) exp BT 2 T dP
2
w
x2
1 2
dx
f (T + x) exp x T e 2T
=
2
2T
w
y2
dy
2T
=
f (y)e
2T
w
=
f (BT )dP
"
wt
0
s ds,
t [0, T ],
r
,
t [0, T ],
(6.4)
2
Hence the discounted price process given by
dXt
t ,
= ( r)dt + dBt = dB
Xt
t R+ ,
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N. Privault
Recall that from the first fundamental theorem of mathematical finance,
a continuous market is without arbitrage opportunities if there exists (at
least) a risk-neutral probability measure P under which the discounted price
process
Xt := ert St ,
t R+ ,
t R+ ,
S0 > 0
we have
St = S0 eBt
t/2+t
and Xt = S0 e(r)t+Bt
t/2
t R+ ,
hence from Section 6.2 the discounted price process is a martingale under the
probability measure P defined by (6.5), and P is a martingale measure.
We have
t ,
dXt = ( r)Xt dt + Xt dBt = Xt dB
t R+ ,
(6.6)
t [0, T ],
"
0 t T,
(6.7)
wt
0
u ,
u Xu dB
t R+ ,
= erT IE [C | Ft ],
which implies
0 t T,
and by Proposition 5.2 the function C(t, x) solves the Black-Scholes PDE:
C
1
2C
C
rC(t, x) =
(t, x) + x2 2 2 (t, x) + rx
(t, x)
t
2
x
x
C(T, x) = (x).
In the case of European options with payoff function (x) = (x K)+ we recover the Black-Scholes formula (5.12), cf. Proposition 5.7, by a probabilistic
argument.
Proposition 6.4. The price at time t of a European call option with strike
K and maturity T is given by
C(t, St ) = St (d+ ) Ker(T t) (d ),
t [0, T ].
ST = St er(T t)+(BT Bt )
(T t)/2
t [0, T ].
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N. Privault
Vt = er(T t) IE [C|Ft ]
= er(T t) IE [(ST K)+ |Ft ]
=e
=e
r(T t)
IE [(xe
IE [(e
(T t)/2
T B
t ) 2 (T t)/2
r(T t)+(B
m(x)+X
K) ]x=St ,
K)+ |Ft ]
K)+ ]x=St
0 t T,
where
m(x) = r(T t) 2 (T t)/2 + log x
T B
t ) is a centered Gaussian random variable with variance
and X = (B
T B
t )] = 2 Var [B
T B
t ] = 2 (T t)
Var [X] = Var [(B
under P . Hence by Lemma 6.1 below we have
Vt = er(T t) IE [(em(x)+X K)+ ]x=St
= er(T t) em(St )+
Ke
r(T t)
(T t)/2
0 t T.
v2
2
Proof. We have
IE[(em+X K)+ ] =
=
=
1
2v 2
em
2v 2
1
2v 2
x2
m+log K
m+log K
ex 2v2 dx
x2
K
2v 2
m+log K
x2
e 2v2 dx
v2
(v 2 x)2
2
em+ 2 w
K w
=
e 2v2 dx
ex /2 dx
2
2 (m+log K)/v
2v m+log K
v2
x2
em+ 2 w
=
e 2v2 dx K((m log K)/v)
2v 2 v2 m+log K
= em+
v2
2
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the price of the put option with strike K and maturity T , we check from
Proposition 6.3 that
C(t, St ) P (t, St )
wT
0
t ,
t dB
(6.8)
t R+ ,
S0 > 0,
"
t R+ ,
X0 = S0 > 0,
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N. Privault
t )tR is a standard Brownian motion under the risk-neutral probwhere (B
+
ability measure P .
The following proposition applies to arbitrary square-integrable payoff
functions, i.e. it covers exotic and path-dependent options.
Proposition 6.5. Consider a random payoff C L2 () such that (6.8)
holds, and let
er(T t)
t ,
St
er(T t) IE [C|Ft ] t St
t =
,
At
t =
(6.9)
t [0, T ].
(6.10)
Vt = t At + t St ,
(6.11)
we have
Vt = er(T t) IE [C|Ft ],
t [0, T ].
(6.12)
In particular we have
VT = C,
(6.13)
r(T t)
u
u dB
=e
IE [C] +
rt
= e V0 + e
r(T t)
= ert V0 +
wt
0
wt
0
u
u dB
u
u Su er(tu) dB
wt
u
u Xu ert dB
wt
= ert V0 + ert
u dXu ,
t [0, T ],
= ert V0 +
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The above proposition shows that there always exists a hedging strategy
starting from
V0 = IE [C]erT .
In addition, since there exists a hedging strategy leading to
VeT = erT C,
then (Vet )t[0,T ] is necessarily a martingale with
h i
Vet = IE VeT Ft = erT IE [C|Ft ],
and initial value
t [0, T ],
h i
Ve0 = IE VeT = erT IE [C].
0 u t,
0 s t u.
(6.14)
0 u t T , and we have
Pu,t f (x) = IE [f (St ) | Su = x] = IE [f (xSt /Su )],
0 u t.
(6.15)
The next lemma allows us to compute the process (t )t[0,T ] in case the payoff
C is of the form C = (ST ) for some function . In case C L2 () is the
payoff of an exotic option, the process (t )t[0,T ] can be computed using the
Malliavin gradient on the Wiener space, cf. [54], [59].
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N. Privault
Lemma 6.2. Let Cb2 (Rn ). The predictable representation
(ST ) = IE [(ST )] +
wT
0
t
t dB
(6.16)
t [0, T ].
(6.17)
is given by
t = St
(Pt,T )(St ),
x
Proof. Since Pt,T is in C (R), we can apply the Ito formula to the process
t 7 Pt,T (St ) = IE [(ST ) | Ft ],
which is a martingale from the tower property (6.1) of conditional expectations as in (6.14), cf. also Relation (6.1). From the fact that the finite variation
term in the Ito formula vanishes when (Pt,T (St ))t[0,T ] is a martingale, (see
e.g. Corollary II-1 of [64]), we obtain:
Pt,T (St ) = P0,T (S0 ) +
wt
0
Su
u ,
(Pu,T )(Su )dB
x
t [0, T ],
(6.18)
t = St
hence
1 r(T t)
e
t
St
= er(T t)
IE [(xST /St )]x=St ,
x
t =
(6.19)
t [0, T ],
which recovers the formula (5.8) for the Delta of a vanilla option. As a consequence we have t 0 and there is no short selling when the payoff function
is non-decreasing.
In the case of European options, the process can be computed via the next
proposition.
Proposition 6.6. Assume that C = (ST K)+ . Then for 0 t T we
have
ST
ST
1[K,) x
.
t = St IE
St
St
x=St
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"
0
(6.20)
t = (d+ ) =
T t
of the risky asset, and to borrow a quantity
log(St /K) + (r t2 /2)(T t)
t = KerT
0
T t
(6.21)
of the riskless (savings) account, cf. also Corollary 10.2 in Chapter 10. In the
next proposition we prove another proof of the result of Proposition 5.4.
Proposition 6.7. The Delta of a European call option with payoff function
f (x) = (x K)+ is given by
log(St /K) + (r + 2 /2)(T t)
,
0 t T.
t = (d+ ) =
T t
Proof. By Propositions 6.5 and 6.6 we have
1 r(T t)
e
t
St
ST
ST
1[K,) x
= er(T t) IE
St
St
x=St
t =
t)
= er(T
h
i
2
2
2(T t) d / T t
1 w 1 (y(T t))2
=
e 2
dy
2 d
w
1 2
1
=
e 2 y dy
2 d+
1 w d+ 1 y2
=
e 2 dy
2
= (d+ ).
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N. Privault
The result of Proposition 6.7 can also be recovered by (5.8) or (6.19) and
direct differentiation of the Black-Scholes function, cf. (5.13).
Exercises
Exercise 6.1 In this problem, (t , t )t[0,T ] denotes a portfolio strategy with
value
Vt = t At + t St ,
0 t T,
where St , resp. At , denotes the price at time t of a risky, resp. riskless, asset.
Consider the price process (St )t[0,T ] given by
dSt
= rdt + dBt
St
and a riskless asset of value At = A0 ert , t [0, T ], with r > 0.
1. Compute the arbitrage price
C(t, St ) = er(T t) IEQ [|ST |2 | Ft ],
at time t [0, T ], of the contingent claim of payoff |ST |2 .
2. Compute the portfolio strategy (t , t )t[0,T ] hedging the claim |ST |2 .
3. Check that this strategy is self-financing.
Exercise 6.2 Again, (t , t )t[0,T ] denotes a portfolio strategy with value
Vt = t At + t St ,
0 t T,
where St , resp. At , denotes the price at time t of a risky, resp. riskless, asset.
1. Recall (without proof) the solution of the stochastic differential equation
dSt = rSt dt + dBt .
2. Show that the discounted price process St = ert St , t [0, T ], is a
martingale under P.
3. Compute the arbitrage price
C(t, St ) = er(T t) IE[exp(ST ) | Ft ]
at time t [0, T ] of the contingent claim of exp(ST ).
4. Explicitly compute the portfolio strategy (t , t )t[0,T ] that hedges the
contingent claim exp(ST ).
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(T t)/2
0 t T.
E[ST | Ft ] = er(T t) St ,
/2
0 t T,
rt
"
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N. Privault
dSt
= rdt + dBt ,
St
S0 = 1,
$1 if ST K,
$1 if ST K,
Cd :=
resp.
Pd :=
0 if ST < K,
0 if ST > K.
Recall that the prices t (Cd ) and t (Pd ) at time t of the digital call and put
options are given by the discounted expected payoffs
t (Cd ) = er(T t) IE[Cd | Ft ]
and
and
Pd = 1[0,K] (ST ).
2. Using Relation (6.22) and Question 1, prove the call-put parity relation
t (Cd ) + t (Pd ) = er(T t) ,
0 t T.
(6.23)
,
Cd (t, x) = er(T t)
where = T t.
5. Show that the price t (Cd ) of the digital call option is given by
t (Cd ) = er(T t) (d ),
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6. Using the results of Questions 2 and 5, show that the price t (Pd ) of the
digital put is given by
t (Pd ) = er(T t) (d ).
7. Using the result of Question 5, compute the Delta
t :=
Cd
(t, St )
x
of the digital call option. Does the Black-Scholes hedging strategy of such
a call option involve short-selling ? Why ?
8. Using the result of Question 6, compute the Delta
t :=
Pd
(t, St )
x
of the digital put option. Does the Black-Scholes hedging strategy of such
a put option involve short-selling ? Why ?
Exercise 6.5
1. Consider a market model made of a risky asset with price (St )tR+ as in
Exercise 4.9-(4) and a riskless asset with price At = $1 ert and riskless
interest rate r = 2 /2. From the answer to Exercise 4.9-(2), show that
the arbitrage price
Vt = er(T t) IE[(log ST )+ | Ft ]
at time t [0, T ] of a log call option with payoff (log ST )+ is equal to
r
Bt2
Bt
Vt = er
e 2 + er Bt
,
2
f (, y) =
e 2 + y
.
2
"
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N. Privault
3. Figure 6.2 represents the graph of (, x) 7 g(, x), with r = 0.05 = 5%
per year and = 0.1. Assume that the current underlying price is $1 and
there remains 700 days to maturity. What is the price of the option ?
Price
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
700
600
500
400
T-t
300
200
100
0 0
0.5
1.5
St
Fig. 6.2: Option price as a function of the underlying and of time to maturity
g
(, St ) of St at
x
time t in a portfolio hedging the payoff (log ST )+ is equal to
1
log St
t = er
,
0 t T.
St
g
(, x). Assuming that the
5. Figure 6.3 represents the graph of (, x) 7 x
current underlying price is $1 and that there remains 700 days to maturity, how much of the risky asset should you hold in your portfolio in
order to hedge one log option ?
1
1 f
f (, log x) =
(, y)|y=log x .
x
x y
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0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
02
1.8
1.6
1.4
1.2
St
0.8
0.6
0.4
0.2
700
600
500
400
300
200
100
T-t
t = er 2
e 22
,
0 t T.
St 2
8. Figure 6.4 represents the graph of Gamma. Assume that there remains
60 days to maturity and that St , currently at $1, is expected to increase.
Should you buy or (short) sell the underlying asset in order to hedge the
option ?
Gamma
1
0.8
0.6
0.4
0.2
0
-0.20.2
0.4
0.6
0.8
St
1.2
1.4
1.6
1.8
180200
140160
T-t
100120
80
60
"
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N. Privault
9. Let now = 1. Show that the function f (, y) of Question 2 solves the
heat equation
f (, y) = 1 f (, y)
2 y 2
f (0, y) = (y)+ .
Exercise 6.6
1. Consider a market model made of a risky asset with price (St )tR+ as
in Exercise 4.8 and a riskless asset with price At = $1 ert and riskless
interest rate r = 2 /2. From the answer to Exercise 16.4-(2), show that
the arbitrage price
Vt = er(T t) IE[(K log ST )+ | Ft ]
at time t [0, T ] of a log call option with strike K and payoff (K
log ST )+ is equal to
r
K/ Bt
(Bt K/)2
2
Vt = er
e
+ er (K Bt )
,
2
e 22 + (K y)
.
f (, y) =
2
3. Figure 6.5 represents the graph of (, x) 7 g(, x), with r = 0.125 per
year and = 0.5. Assume that the current underlying price is $3 and
there remains 700 days to maturity. What is the price of the option ?
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"
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
2.2
2.4
2.6 2.8
St
3.2
3.4
3.6
3.8
100
200
300
400
600
500
700
T-t
Fig. 6.5: Option price as a function of the underlying and of time to maturity
g
(, St ) of St at time t in a portfolio
x
hedging the payoff (K log ST )+ is equal to
1
K log St
t = er
,
0 t T.
St
g
(, x). Assuming that the
5. Figure 6.6 represents the graph of (, x) 7 x
current underlying price is $3 and that there remains 700 days to maturity, how much of the risky asset should you hold in your portfolio in
order to hedge one log option ?
Delta
0
-0.05
-0.1
-0.15
-0.2
-0.25
-0.3
-0.35
-0.4
-0.45
-0.5
4
3.8
3.6
3.4
3.2
St
2.8
2.6
2.4
2.2
700
600
500
400
300
200
100
T-t
"
1 f
f (, log x) =
(, y)|y=log x .
x
x y
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N. Privault
6. Based on the framework and answers of Questions 3 and 5, should you
borrow or lend the riskless asset At = $1 ert , and for what amount ?
2g
(, St ), equals
7. Show that the Gamma of the portfolio, defined as t =
x2
(Klog St )2
1
K log St
1
t = er 2
e 22
+
,
0 t T.
St 2
8. Figure 6.7 represents the graph of Gamma. Assume that there remains
10 days to maturity and that St , currently at $3, is expected to increase.
Should you buy or (short) sell the underlying asset in order to hedge the
option ?
Gamma
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
010
20
30
T-t
40
50
60
70
80
90
100
3.8
3.6
3.4
3.2
2.8 2.6
St
2.4
2.2
1 2f
f
(, y) = 2 2 (, y)
2 y
f (0, y) = (K y)+ .
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Chapter 7
Estimation of Volatility
The values of the parameters r, t, St , T , and K used to price a call option via the Black-Scholes formula can be easily obtained from market data.
Estimating the volatility coefficient can be a more difficult task, and several estimation methods are considered in this section with some examples
of how the Black-Scholes formula can be fitted to market data. We cover the
historical, implied, and local volatility models, and refer to [26] for stochastic
volatility models.
N :=
N 1
Stk+1 Stk
1 X
1
,
N
tk+1 tk
Stk
k=0
N
:=
2
N 1
1 X
1
Stk +1 Stk
N (tk+1 tk ) .
N 1
tk+1 tk
Stk
k=0
"
N. Privault
Parameter estimation based on historical data requires a lot of samples and
it can only be valid on a given time interval, or as a moving average.
1 w x y2 /2
(x) =
e
dy,
2
x R,
and
d+ =
log(x/K) + (r + 2 /2)(T t)
,
T t
d =
log(x/K) + (r 2 /2)(T t)
.
T t
Equating
f (t, St , K, , r, T ) = M
to the observed value M of a given market price, when t, St , r, T are known,
allows one to infer a value for . This value is called the implied volatility
and denoted here by imp (K, T ). The implied volatility value can be used
as an alternative way to quote the option price, based on the knowledge of
the remaining parameters (such as underlying asset price, time to maturity,
interest rate, and strike price).
Given two European call options with strikes K1 , resp. K2 and maturities
T1 , resp. T2 , on the same stock S, this procedure should yield two estimates
imp
(K1 , T1 ) and imp (K2 , T2 ) of implied volatilites.
Clearly, there is no reason a priori for the implied volatilites imp (K1 , T1 )
and imp (K2 , T2 ) to coincide. However, in the standard Black-Scholes model
the value of the parameter should be unique for a given stock S. This contradiction between a model and market data is a reason for the development
of more sophisticated stochastic volatility models.
Plotting the different values of the implied volatility as a function of K
and T will yield a planar curve called the volatility surface.
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0.6
0.55
0.5
0.45
Vol.
0.4
0.35
0.3
0.25
8000
8500
9000
9500
10000
Strike
10500
11000
11500
35
30
25
20
15
10
Time to maturity
Fig. 7.1: Implied volatility of Asian options on light sweet crude oil futures.1
As observed in Figure 7.1, the volatility surface can exhibit a smile phenomenon, in which implied volatility is higher at a given end (or at both
ends) of the range of strike values.
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Fig. 7.2: Graph of the (market) stock price of Cheung Kong Holdings.
The market price of the option (17838.HK) on September 28 was $12.30, as
obtained from http://www.hkex.com.hk/dwrc/search/listsearch.asp
The next graph shows the evolution of the market price of the option over
time. One sees that the option price is much more volatile than the underlying
stock price.
Fig. 7.3: Graph of the (market) call option price on Cheung Kong Holdings.
In Figure 7.4 we have fitted the path
t 7 gc (t, St )
of the Black-Scholes price to the data of Figure 7.3 using the stock price data
of Figure 7.2, by varying the values of the volatility .
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Black-Scholes price
0.18
HK$
0.16
0.14
0.12
0.1
Jul17
Aug06
Aug26
Sep15
Fig. 7.4: Graph of the Black-Scholes call option price on Cheung Kong Holdings.
Another example
Let us consider the stock price of HSBC Holdings (0005.HK) over one year:
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Fig. 7.6: Graph of the (market) call option price on HSBC Holdings.
As above, in Figure 7.7 we have fitted the path t 7 gc (t, St ) of the BlackScholes price to the data of Figure 7.6 using the stock price data of Figure 7.5.
0.3
Black-Scholes price
HK$
0.2
0.1
0
Nov 08
Jan 09
Mar 09
May 09
Jul 09
Sep 09
Fig. 7.7: Graph of the Black-Scholes call option price on HSBC Holdings.
In this case we are in the money at maturity, and we also check that the
option is worth 100 0.2650 = $26.650 at that time which, by absence of
arbitrage, is very close to the value $90 - $63.703 = $26.296 of its payoff.
For one more example, consider the graph of the price of a put option issued by BNP Paribas on 04 November 2008 with strike K=$77.667, maturity
T = October 05, 2009, and entitlement ratio 92.593.
One checks easily that at maturity, the price of the put option is worth $0.01
(a market price cannot be lower), which almost equals the option payoff $0,
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Fig. 7.8: Graph of the (market) put option price on HSBC Holdings.
Black-Scholes price
0.4
HK$
0.3
0.2
0.1
0
Nov 08
Jan 09
Mar 09
May 09
Jul 09
Sep 09
Fig. 7.9: Graph of the Black-Scholes put option price on HSBC Holdings.
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(7.1)
where (t, x) is a deterministic function of time and the stock price. Such
models are called local volatility models. The corresponding Black-Scholes
PDE can be written as
g
g
1
2g
rg(t, x, K) =
(t, x, K) + rx (t, x, K) + x2 2 (t, x) 2 (t, x, K),
t
x
2
x
g(T, x, K) = (x K)+ ,
(7.2)
with terminal condition g(T, x, K) = (x K)+ , i.e. we consider European
call options.
Note that the Black-Scholes PDE would allow one to recover the value of
(t, x) as a function of the option price g(t, x, K), as
v
u
u 2rg(t, x, K) 2 g (t, x, K) 2rx g (t, x, K)
u
t
x
(t, x) = u
,
x, t > 0,
t
2
2 g
x
(t, x, K)
2
x
however this formula requires the knowledge of the option price for different
values of the underlying x, in addition to the knowledge of the strike price K.
The Dupire formula brings a solution to the local volatility calibration
problem by providing an estimator of (t, x) as a function (t, K) based on
the values of the strike price K.
Proposition 7.1. Assume that a family (C(T, K))T,K>0 of market call option prices with maturities T and strikes K is given at time t with St = x,
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T, K > 0.
(7.4)
(7.6)
On the other hand, for any sufficiently smooth function f , using the It
o
formula we have
w
T (y)f (y)dy = IE[f (ST )]
wT
1 w T 00
f 0 (St )dSt +
f (St ) 2 (t, St )dt
= IE f (S0 ) +
0
2 0
wT
wT
1 w T 00
0
f 0 (St )St dBt +
= IE f (S0 ) + r
f (St )St dt +
f (St ) 2 (t, St )dt
0
0
2 0
w
wT
T
1
= f (S0 ) + IE r
f 0 (St )St dt +
f 00 (St )St2 2 (t, St )dt
0
2 0
w wT
1 w w T 2 00
0
= f (S0 ) + r
yf (y)t (y)dtdy +
y f (y) 2 (t, y)t (y)dtdy,
0
2 0
hence after differentiating both sides of the equality with respect to T ,
w
w
1 w 2 00
T
(y)f (y)dy = r
yf 0 (y)T (y)dy+
y f (y) 2 (T, y)T (y)dy.
T
2
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Integrating by parts in the above relation yields
w
T
(y)f (y)dy
T
w
1w
2
y
2
y
for all smooth functions f (y) with compact support, hence
T
1 2 2 2
(y) = r (yT (y)) +
(y (T, y)T (y)),
T
y
2 y 2
y R.
2C
2C
(T, y)
(T, y)
2
y
T y 2
2
C
1 2
2C
2 2
=r
y 2 (T, y)
y
(T,
y)
(T,
y)
,
y
y
2 y 2
y 2
y R.
y
(T, y) r
(T, y)
y 2 2 (T, y) 2 (T, y) ,
=r
y
y
y
2 y
y
or
(T, y) = r
y T
y
C
1
2C
y
(T, y)
y 2 2 (T, y) 2 (T, y) .
y
2 y
y
C
1
2C
C
(T, y) = ry
(T, y) y 2 2 (T, y) 2 (T, y),
T
y
2
y
y R,
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Chapter 8
Exotic Options
t R+ ,
where (Bt )tR+ is a standard Brownian motion under the risk-neutral probability measure P . In particular the value Vt of a self-financing portfolio
satisfies
wT
VT erT = V0 +
t St ert dBt , t [0, T ].
0
8.1 Generalities
An exotic option is an option whose payoff may depend on the whole path
{St : t [0, T ]} of the price process via a complex operation such as
averaging or computing a maximum. They are opposed to vanilla options
whose payoff
C = (ST ),
where is called a payoff function, depends only on the terminal value ST of
the price process.
An option with payoff C = (ST ) can be priced as
w
erT IE[(ST )] = erT
(y)fST (y)dy
where fST (y) is the (one parameter) probability density function of ST , which
satisfies
wy
fST (v)dv,
P(ST y) =
y R.
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Recall that typically we have
+
(x) = (x K) =
x K
if x K,
if x < K,
$1 if x K,
(x) = 1[K,) (x) =
0 if x < K,
for a binary call option with strike K.
Exotic Options
Exotic options, also called path-dependent options, are options whose payoff
C may depend on the whole path
{St : 0 t T }
of the underlying price process instead of its terminal value ST . Next we
review some examples of exotic options.
Options on Extrema
We take
C := (MT ),
where
MT = max St
t[0,T ]
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Xt
Bt
2.5
2
Bt , X t
1.5
1
0.5
0
-0.5
-1
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
2.0
Barrier Options
The payoff of an up-and-out barrier put option on the underlying asset St
with exercise date T , strike K and barrier B is
C = (K ST ) 1(
max St < B
0tT
(K ST )+
if max St < B,
if max St B.
0tT
0tT
This option is also called a Callable Bear Contract with no residual value, in
which the call price B usually satisfies B K.
The payoff of a down-and-out barrier call option on the underlying asset
St with exercise date T , strike K and barrier B is
C = (ST K)
1(
min St > B
0tT
(S K)+
if min St > B,
if min St B.
0tT
0tT
This option is also called a Callable Bull Contract with no residual value, in
which B denotes the call price B K. It is also called a turbo warrant with
no rebate.
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Lookback Options
The payoff of a floating strike lookback call option on the underlying asset
St with exercise date T is
C = ST min St .
0tT
The payoff of a floating strike lookback put option on the underlying asset
St with exercise date T is
C = max St ST .
0tT
Options on Average
In this case we can take
C=
1 wT
St dt
T 0
where
1 wT
St dt
T 0
represents the average of (St )tR+ over the time interval [0, T ] and : R R
is a payoff function.
Xt
Bt
2.5
2
Bt , X t
1.5
1
0.5
0
-0.5
-1
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
2.0
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Asian Options
Asian options are particular cases of options on average, and they were first
traded in Tokyo in 1987. The payoff of the Asian call option on the underlying
asset St with exercise date T and strike K is given by
C=
+
1 wT
St dt K
.
T 0
Similarly, the payoff of the Asian put option on the underlying asset St with
exercise date T and strike K is
+
1 wT
St dt
.
C= K
T 0
Due to the fact that their dependence on averaged asset prices, Asian options are less volatile than plain vanilla options whose payoffs depend only
on the terminal value of the underlying asset. Asian options have become
particularly popular in commodities trading.
of geometric Brownian motion (St )tR+ over a given time interval [0, T ].
In such situations the option price at time t = 0 can be expressed as
w w
(x, y)f(MT ,ST ) (x, y)dxdy
erT IE[(MT , ST )] = erT
where f(MT ,ST ) is the joint probability density function of (MT , ST ), which
satisfies
wx wy
f(MT ,ST ) (u, v)dudv,
x, y R.
P(MT x, ST y) =
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Maximum of Standard Brownian Motion
Let (Bt )tR+ denote a standard Brownian motion started at B0 = 0. While
it is well-known that BT ' N (0, T ), computing the law of the maximum
XT = max Bt
t[0,T ]
might seem a difficult problem. However this is not the case, due to the
reflection principle. Note that since B0 = 0 we have
XT 0,
almost surely.
Given a > B0 = 0, let
a = inf{t R+ : Bt = a}
denote the first time (Bt )tR+ hits the level a > 0.
Due to the space symmetry of Brownian motion we have the identity
P(BT > a | a < T ) =
1
= P(BT < a | a < T ).
2
(8.1)
"
Bt
1.5
1
0.5
0
-0.5
-1
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
2.0
a R+ ,
fXT (a) =
"
dP(XT a)
=
da
2 a2 /(2T )
e
1[0,) (a),
T
a R.
(8.2)
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1
Density function
0.8
density
0.6
0.4
0.2
0
-4
-3
-2
-1
0
x
Fig. 8.4: Probability density of the maximum of Brownian motion over [0, 1].
Using the density of XT we can price an option with payoff (XT ), as
w
erT IE [(XT )] = erT
(x)dP(XT = x)
r
2
2 w
(x)e|x| /(2T ) dx.
= erT
T 0
Next we consider
MT = max St
t[0,T ]
= S0 max eBt
t[0,T ]
= S0 e maxt[0,T ] Bt
= S0 eXT ,
since > 0. When the payoff takes the form
C = (MT ),
where
ST = S0 eBT ,
we have
C = (MT ) = (S0 eXT ),
hence
erT IE [C] = erT IE (S0 eXT )
w
= erT
(S0 ex )dP(XT = x)
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2
2 rT w
e
(S0 ex )ex /(2T ) dx.
0
T
This however is not sufficient since this imposes the condition r = 2 /2. In
order to do away with this condition we need to consider the maximum of
drifted Brownian motion, and for this we have to compute the joint density
of XT and BT .
Joint Density
The reflection principle also allows us to compute the joint density of Brownian motion BT and its maximum XT . Indeed, for b [0, a] we also have
P(BT > a + (a b) | a < T ) = P(BT < b | a < T ),
i.e.
P(BT > 2a b & a < T ) = P(BT < b & a < T ),
or, by (8.1),
1 w x2 /(2T )
e
dx,
2T 2ab
dP(XT a & BT b)
dP(XT a & BT b)
=
,
dadb
dadb
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a, b R, by (16.15), i.e., letting a b := max(a, b),
r
fXT ,BT (a, b) =
e
,
T
T
=
0,
(8.4)
a > b 0,
a < b 0.
Density function
0.5
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0-1
-0.5
b
0.5
1.5
2.5
2.5
1.5
0.5
a
-0.5 -1
Fig. 8.5: Joint probability density of B1 and its maximum over [0,1].
t[0,T ]
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2
dP
= eBT T /2 ,
dP
(8.5)
is given by (8.4).
T under P
hence the density of X
Now, using the density (8.5) we get
h
i
T a & B
T b) = IE 1
P(X
T b}
{XT a & B
h
i
eBT +2 T /2 1
= IE
T b}
{XT a & B
h
i
eBT 2 T /2 1
= IE
T b}
{XT a & B
r
2
2 wawb
(2x y) (2xy)2 /(2T )
=
1(,x] (y)ey T /2
e
dxdy,
T 0
T
0 b a, which yields the joint probability density
fX T ,BT (a, b) =
T a & B
T b)
dP(X
,
dadb
i.e.
1
T
2
2
2
(2a b)eb(2ab) /(2T ) T /2
T
2
2
2
1
0,
(8.6)
a > b 0,
a < b 0.
We also find
r
2
2 waw
(2x y) (2xy)2 /(2T )
T a) =
P(X
1(,x] (y)ey T /2
e
dydx
T 0
T
r
w
w
a
a
2 2 T /2
(2x y) (2xy)2 /(2T )
=
e
ey
e
dxdy
y0
T
T
r
2
2
1 2 T /2 w a
=
e
ey(2(y0)y) /(2T ) ey(2ay) /(2T ) dy
2T
r
2
2
2
1 w a yy2 /(2T )2 T /2
=
e
ey2a /T +2ay/T y /(2T ) T /2 dy
2T
"
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2
1 w a (yT )2 /(2T )
e
e(y(T +2a)) /(2T )+2a dy
2T
r
r
1 w a (yT )2 /(2T )
1 w a (y(T +2a))2 /(2T )
=
e
dy e2a
e
dy
2T
2T
r
r
1 w aT y2 /(2T )
1 w aT y2 /(2T )
=
e
dy e2a
e
dy
2T
2T
a T
a T
e2a
,
(8.7)
=
T
T
r
cf. Corollary 7.2.2 and pages 297-299 of [71] for another derivation. This
yields the density
r
T a)
dP(X
a T
2 (aT )2 /(2T )
=
e
2e2a
,
da
T
T
of the supremum of drifted Brownian motion, and recovers (8.2) for = 0.
=0
=-0.5
=0.5
1.4
1.2
density
0.8
0.6
0.4
0.2
0
-1
of the minimum
t[0,T ]
T = min B
t = min (Bt + t)
R
t[0,T ]
t[0,T ]
"
1
T
2
2
2
(b 2a)eb(2ab) /(2T ) T /2
T
2
2
2
1
0,
(8.8)
a < b 0,
a > b 0.
y0
T /2+rT
= S0 eBT ,
T = BT + T , and
with = /2 + r/ and B
MT = max St
t[0,T ]
= S0 max eBt
t/2+rt
t[0,T ]
= S0 max eBt
t[0,T ]
= S0 e maxt[0,T ] Bt
T
X
= S0 e
"
,
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N. Privault
we have
C = (ST , MT )
= (S0 eBT
= (S0 e
T
B
T /2+rT
, MT )
, S0 eXT ),
hence
h
i
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"
behavior
down-and-out
payoff
+
(ST K) 1(
min St > B
0tT
down-and-in
(ST K) 1(
min St < B
0tT
(ST K) 1(
max St < B
0tT
up-and-in
(ST K) 1(
max St > B
0tT
down-and-out
(K ST ) 1(
min St > B
0tT
down-and-in
(K ST ) 1(
min St < B
0tT
(K ST ) 1(
max St < B
0tT
up-and-in
(K ST ) 1(
max St > B
0tT
We have the following obvious relations between the prices of barrier and
vanilla call and put options:
Cupin (t) + Cupout (t) = C(t) = er(T t) IE [(ST K)+ ],
Cdownin (t) + Cdownout (t) = C(t) = er(T t) IE [(ST K)+ ],
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Pupin (t) + Pupout (t) = P (t) = er(T t) IE [(K ST )+ ],
Pdownin (t) + Pdownout (t) = P (t) = er(T t) IE [(K ST )+ ],
where C(t), resp. P (t) denotes the price of a European call, resp. put option
with strike K as obtained from the Black-Scholes formula. Consequently, in
the sequel we will only compute the prices of the up-and-out call and put,
and down-and-out barrier call and put options.
C = (ST K) 1(
max St B
0tT
S K
if max St B,
if max St > B,
0tT
0tT
+
ST t
r(T t)
e
1{Mt B } IE x
K
1(
S0
x
max
0rT t
Sr /S0 B
x=St
of the up-and-out call option with maturity T , strike K and barrier B is given
by
er(T t) IE [C | Ft ]
(8.9)
S
S
t
t
T t
T t
= St 1{Mt B } +
+
K
B
1+2r/2
2
!
B
B
B
T t
T t
+
+
St
KSt
St
St
St
T t
T t
er(T t) K1{Mt B }
K
B
12r/2
2
!
St
B
B
T t
T t
,
B
KSt
St
where
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"
(s) =
1
log s + r 2 ,
2
1
s > 0.
(8.10)
Note that taking B = + in the above identity (8.9) recovers the BlackScholes formula for the price of a European call option, and that the price of
the up-and-out barrier call option is 0 when B < K.
The following graph represents the up-and-out call option price given the
value St of the underlying and the time t [0, T ] with T = 220 days.
up and out call price
Option price path
16
14
12
10
8
6
4
2
0
50
55
60
65
70
underlying
75
80
85
220
200
180
160
Time in days
140
120
100
90
x K if y B,
+
(x, y) = (x K) 1{yB} =
0
if y > B,
hence
#
"
+
er(T t) IE [C | Ft ] = er(T t) IE (ST K) 1{MT B} Ft
#
"
+
= er(T t) IE (ST K) 1{MT B } Ft
+
)
= er(T t) IE (ST K) 1{Mt B } 1(
Ft
max Sr B
trT
"
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+ (
)
=e
1{Mt B } IE (ST K) 1
Ft
max Sr B
trT
+
ST
r(T t)
)
=e
1{Mt B } IE x
1(
K
St
x max Sr /St B
r(T t)
trT
+
ST t
= er(T t) 1{Mt B } IE x
K
1(
S0
x
x=St
max
0rT t
Sr /S0 B
x=St
It suffices to compute
i
h
+
er IE [C] = er IE (S K) 1{M B}
+
= er IE S0 eB K 1{S0 eX B}
w w
+
= x, B
= y)
= er
(S0 ey K) 1{S0 ex B} dP(X
y0
r
1
1
2 r w log(B/S0 )
=
e
w
2
2
+
(S0 ey K) 1{S0 ex B} (2x y)e /2+y(2xy) /(2 ) dxdy
y0
r
1
2 w 1 log(B/S0 )
= er
0
w
2
2
+
(S0 ey K) 1{S0 ex B} (2x y)e /2+y(2xy) /(2 ) dxdy
y
r
1
2 w0
+ er
w
2
2
+
(S0 ey K) 1{S0 ex B} (2x y)e /2+y(2xy) /(2 ) dxdy
0
r
2 w 1 log(B/S0 )
1
= er
0
w
2
2
+
(S0 ey K) 1{x1 log(B/S0 )} (2x y)e /2+y(2xy) /(2 ) dxdy
y
r
1
2 w0
+ er
w
2
2
+
(S0 ey K) 1{x1 log(B/S0 )} (2x y)e /2+y(2xy) /(2 ) dxdy
0
r
1
2 w 1 log(B/S0 )
= er
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"
/2+y(2xy)2 /(2 )
dxdy
/2+y(2xy)2 /(2 )
dxdy
2 w0
1
+ er
w 1 log(B/S0 )
0
2 w 1 log(B/S0 )
1 log(K/S0 )
1 r
e
w 1 log(B/S0 )
1 log(K/S0 )
w 1 log(B/S0 )
(2x y)e2x(yx)/ dxdy,
y0
y0
(2x y)e2x(yx)/ dx =
=
=
=
=
wb
(2x y)e2x(yx)/ dx
ix=b
h
e2x(yx)/
2
x=a
2a(ya)/
(e
e2b(yb)/ )
2
2(y0)(yy0)/
(e
e2b(yb)/ )
2
(1 e2b(yb)/ ),
2
a
er IE [C] = e (r+
"
/2)
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N. Privault
1 w b yy2 /(2 )
e
dy
2 c
w
b
2
2
2
1
+Ke (r+ /2)2b /
ey(+2b/ )y /(2 ) dy.
2 c
2
Ke (r+
/2)
2
c +
b +
1 w b yy2 /(2 )
e
dy = e /2
2 c
we find
h
i
+
er IE [C] = erT IE (ST K) 1{MT B}
2
2
c + ( + )
b + ( + )
= S0 e (r+ /2)+(+) /2
c
+
b
+
Ker
S0
S0
= S0 +
+
K
B
2
B
B
(r+2 /2)2b2 / +(++2b/ )2 /2
S0 e
+
+
KS0
S0
S0
S0
Ker
K
B
2
B
B
(r+2 /2)2b2 / +(+2b/ )2 /2
+Ke
,
KS0
S0
0 x B, where
(s) is defined in (8.10). Given the relations
(8.11)
"
= S0 +
+
K
B
S0
S0
r
e
K
K
B
2r/2 2
B
B
B
+
+
B
S0
KS0
S0
12r/2 2
S0
B
B
+er K
B
KS0
S0
S0
S0
= S0 +
+
K
B
1+2r/2 2
B
B
B
S0
+
+
S0
KS0
S0
S0
S0
er K
K
B
12r/2 2
S
B
B
0
er K
,
B
KS0
S0
and this yields the result of Proposition 8.1, cf. 7.3.3 pages 304-307 of [71]
for a different calculation. This concludes the proof of Proposition 8.1.
r(T t)
+
ST t
1(
1{Mt B } IE K x
S0
x
max
0rT t
Sr /S0 B
x=St
+
1
St
KSt
St
T t
er(T t) K1{Mt B }
1
K
"
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12r/2
!
2
B
T t
1
KSt
1+2r/2
2 !
St
B
B
T t
T t
= St 1{Mt B } +
+
+
K
St
KSt
St
B
Ker(T t)
1{Mt B }
12r/2
2 !
St
St
B
T t
T t
,
+
K
B
KSt
if B > K, and
St
T t
er(T t) IE [P | Ft ] = St 1{Mt B } +
1
B
1+2r/2
!
B
B
T t
+
1
St
St
St
T t
1
er(T t) K1{Mt B }
B
!
2
12r/
St
B
T t
1
B
St
1+2r/2
!
B
St
B
T t
T t
+
+
= St 1{Mt B } +
B
St
St
Ker(T t)
1{Mt B }
!
12r/2
St
B
St
T t
T t
+
,
B
B
St
(8.12)
if B < K.
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"
12
10
8
6
4
2
0 50
55
60
-2
65
70
underlying
75
80
85
220
200
180
160
Time in days
140
120
90 100
Fig. 8.8: Graph of the up-and-out put option price with B > K.
50
45
40
35
30
25
20
15
10
5
0 50
55
60
65
70
underlying
75
80
85
220
200
180
160
Time in days
140
120
90 100
Fig. 8.9: Graph of the up-and-out put option price with K > B.
C = (ST K)
1(
min St > B
0tT
S K
if min St > B,
if min St B,
0tT
0tT
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N. Privault
We have
er(T t) IE [C | Ft ]
St
St
T t
T t
= g(t, St ) = St +
er(T t) K
(8.13)
K
K
2r/2
2
B
B
T t
B
+
St
Kx
12r/2
2
St
B
T t
+er(T t) K
(8.14)
B
KSt
= BSc (St , r, T t, K)
2r/2
2
B
B
T t
B
+
St
KSt
2
12r/2
B
St
T t
+er(T t) K
B
KSt
12r/2
1 St
BSc (B/St , r, T t, K/B),
= BSc (St , r, T t, K)
B B
St > B, 0 t T , and
+
IE (ST K) 1(
min St > B
0tT
Ft = 1{mint[0,T ] St >B} g(t, St ),
(8.15)
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"
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0 50
55
60
65
70
underlying
75
80
85
140
135
130
125
120
Time in days
115
110
105
90 100
Fig. 8.10: Graph of the down-and-out call option price with B < K.
60
50
40
30
20
10
0 50
55
60
65
70
underlying
75
80
85
220
200
180
160
Time in days
140
120
90 100
Fig. 8.11: Graph of the down-and-out call option price with K > B.
r(T t)
+
ST t
1{mt B } IE K x
1(
S0
x
min
0rT t
Sr /S0 B
x=St
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N. Privault
er(T t) IE [P | Ft ]
(8.16)
St
St
T t
T t
= St 1{mt B } +
+
K
B
1+2r/2
!
2
B
B
B
T t
T t
+
+
St
KSt
St
St
St
T t
T t
er(T t) K1{mt B }
K
B
12r/2
2
!
St
B
B
T t
T t
+
,
B
KSt
St
while the corresponding price vanishes when B < K.
down and out put price
14
12
10
8
6
4
2
0 50
-2
55
60
65
70
underlying
75
80
85
220
200
180
160
Time in days
140
120
90 100
Fig. 8.12: Graph of the down-and-out put option price with K > B.
Note that although Figures 8.8 and 8.10, resp. 8.9 and 8.11, appear to share
some symmetry property, the functions themselves are not exactly symmetric.
Concerning 8.7 and 8.12 the pricing function is actually the same, but the
conditions B < K and B > K play opposite roles.
PDE Method
Having computed the up-and-out call option price by probabilistic arguments,
we are now interested in deriving a PDE for this price.
The option price can be written as
#
"
+
r(T t)
e
IE (ST K) 1{MT B} Ft
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"
er(T t) 1(
) IE (S K)+ 1(
T
max Sr B
0rt
max Sr B
trT
Ft
= g(t, St , Mt ),
where the function g(t, x) of t and St is given by
+
g(t, x, y) = 1{yB} er(T t) IE (ST K) 1(
max Sr B
trT
St = x .
(8.17)
Next, by the same argument as in the proof of Proposition 5.2 we derive the
Black-Scholes partial differential equation (PDE) satisfied by g(t, x), for the
price of a self-financing portfolio.
Proposition 8.2. Let (t , t )tR+ be a portfolio strategy such that
(i) (t , t )tR+ is self-financing,
(ii) the value Vt := t At + t St , t R+ , takes the form
Vt = g(t, St , Mt ),
t R+ .
g
g
1
2g
(t, x, y) + ry (t, x, y) + x2 2 2 (t, x, y),
t
x
2
x
(8.18)
g
(t, St , Mt ),
x
t [0, T ],
(8.19)
provided Mt < B.
Proof. By (8.17) the price at time t of the down-and-out call barrier option
discounted to time 0 is given by
+ (
rt
rT
)
e g(t, St , Mt ) = 1{Mt B} e
IE (ST K) 1
St = x
max Sr B
trT
rT
)
=e
IE (ST K) 1{Mt B} 1(
St = x
max Sr B
trT
"
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N. Privault
=e
rT
+
IE (ST K) 1(
max Sr B
0rT
St = x ,
C = (ST K) 1(
max St B
0tT
S K
if max St B,
if max St > B,
0tT
0tT
with B > K.
Proposition 8.3. The price of any self-financing portfolio of the form Vt =
g(t, St ) hedging the up-and-out barrier call option satisfies the Black-Scholes
PDE
g
g
1
2g
rg(t, x) =
(t, x) + rx (t, x) + x2 2 2 (t, x),
t
x
2
x
g(t, x) = 0,
x B, t [0, T ],
(8.20)
Condition (8.20) holds since the price of the claim at time t is 0 whenever
St = B, cf. e.g. [23].
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"
x
x
T t
T t
+
(8.21)
g(t, x) = x +
K
B
2
x 12r/2
B
B
T t
T t
x
+
+
B
Kx
x
x
x
T t
T t
Ker(T t)
K
B
2
x 12r/2
B
B
T t
T t
+Ker(T t)
,
B
Kx
x
0 < x B, 0 t T .
We note that the expression (8.21) can be rewritten using the standard
Black-Scholes formula
S
S
BSc (S, K, r, , ) = S +
Ker
K
K
for the price of a European call option, as
x
x
T t
T t
g(t, x) = BSc (x, K, r, , T t) x +
+ er(T t) K
B
B
2r/2
2
B
B
B
T t
T t
B
+
+
x
Kx
x
2
2
x 12r/
B
B
T t
T t
r(T t)
,
+e
K
B
Kx
x
0 < x B, 0 t T .
Figure 8.13 represents the value of Delta obtained from (8.19) for the
up-and-out call option, cf. Exercise 8.3-(1).
"
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1
0.8
0.6
0.4
0.2
0
90
85
80
75
70
underlying
65
60
55
100
120
140
160
Time in days
180
200
220
50
x > B.
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"
+ if s > 1,
if s = 1,
= 0
if s < 1,
K ( () ())
2r/2
B
( (+) (+))
B
x
2r/2
B
+K
( (+) (+))
K
= 0,
K ( (+) ())
2r/2
B
B
( (+) (+))
x
2
2r/
B
+K
( (+) (+))
K
= x K,
K ( (+) (+))
2r/2
B
( () ())
B
x
2r/2
B
( () ())
+K
K
= 0.
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N. Privault
g
1
2g
g
t
x
2
x
g(t, B) = 0, t [0, T ],
and
Mst = sup Su ,
u[s,t]
The payoff of such of an option is of the form (ST , MT0 ) with (x, y) =
x y in the case of lookback call options, and (x, y) = y x in the case of
lookback put options. We let
er(T t) IE [(ST , MT0 )|Ft ]
denote the price at time t [0, T ] of such an option.
The Lookback Put Option
The standard lookback put option gives its holder the right to sell the underlying asset at its historically highest price. In this case the strike is M0T
and the payoff is
C = M0T ST .
Our goal is to prove the following pricing formula for lookback put options.
Proposition 8.4. The price at time t [0, T ] of the lookback put option with
payoff M0T ST is given by
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"
er(T t) IE [M0T ST | Ft ]
St
2
St
T t
T t
+ St 1 +
+
= M0t er(T t)
t
t
M0
2r
M0
t 2r/2
t
2
M0
M0
T t
St er(T t)
St .
2r St
St
Figure 8.14 represents the lookback put price as a function of St and M0t , for
different values of the time to maturity T t.
T = 7.0000
100
80
60
40
20
Mt
0
80
60
40
20
0 0
20
40
St
60
80
and
IE [M0T | Ft ] = IE [M0t MtT | Ft ]
Next, we have
"
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N. Privault
!
M0t
M T
> t Ft
St
St
!
MtT
=P x>
Ft
St
x=M0t /St
!
M0T t
=P
<x
.
S0
t
x=M0 /St
=
e2 log x
2
=
(1/x) x1+2r/
(x) .
Hence
P(M0t
>
MtT )
!
M0T t
<x
S0
=P
x=M0t /St
T
=
St
M0t
M0t
St
1+2r/2
t
M0
T
.
St
Next, we have
"
MtT
t
1 T
St {Mt /St >M0 /St }
#
"
Sr
= St IE max
1{maxr[t,T ] Sr /St >x} Ft
r[t,T ] St
x=M0t /St
S
r
1{maxr[0,T t] Sr /S0 >x}
,
= St IE
max
r[0,T t] S0
x=M t /St
#
Ft
and
Sr
IE max
1{maxr[0, ] Sr /S0 >x}
r[0, ] S0
"
log x
r
!
w
2 (z )2 /(2 )
z
= 1
ez
dz
e
2e2z
log x
r
w
2
2 w
z
=
ez(z ) /(2 ) dz 2 1
ez(+2)
dz.
1 log x
log
x
log x
2
w
2
1
er
=
ez /(2 ) dz
(+) + 1 log x
2
1
,
= er +
x
dz
ez(+2)
1
log x
with a =
log x. We let
z
u(z) =
which satisfy
u0 (z) =
2
1
e(z+ ) /(2 )
2
and v(z) =
1
ez(+2) ,
+ 2
and
w
a
"
ez(+2)
dz =
w
a
v 0 (z)u(z)dz
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N. Privault
w
= u(+)v(+) u(a)v(a)
v(z)u0 (z)dz
a
1
a
=
ea(+2)
+ 2
1
z(+2) (z+ )2 /(2 )
e
+
e
dz
( + 2) 2 a
1
a
ea(+2)
=
+ 2
w
2
1
( (+)2 2 )/2
+
e
e(z (+)) /(2 ) dz
a
( + ) 2
a
1
ea(+2)
=
+ 2
w
1
z 2 /2
( (+)2 2 )/2
+
dz
e
e
(a (+))/
( + 2) 2
1
a
=
ea(+2)
+ 2
2
2
1
a + ( + )
+
e( (+) )/2
+ 2
2r
(r/ /2) 1 log x
2r/ 2
= (x)
+ (r/ + /2) 1 log x
2r (+2)/2
+ e
r
1
2r/2
e +
x
(x) ,
=
2r
x
2r
cf. pages 317-319 of [71] for a different derivation using double integrals.
Hence we have
"
IE
#
Sr
1{maxr[0,T t] Sr /S0 >x}
max
Ft = St IE
r[0,T t] S0
x=M0t /St
S
S
t
t
T t
T t
St er(T t) +
= 2St er(T t) +
M0t
r
M0t
2r/2
t
M0t
M0
T t
+St
,
r
St
St
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"
S
= M0t
t
t
M0
St
St
St
T t
r(T t)
+2St e
+
M0t
2
St
T t
St 1
er(T t) +
2r
M0t
t 2r/2
t
2
M0
M0
T t
+St 1
2r
St
St
2
St
St
T t
T t
t
r(T t)
= M0
+
S
e
1
+
t
+
M0t
2r
M0t
t 2r/2
t
2
M0
M0
T t
St
,
2r St
St
hence
er(T t) IE [M0T ST | Ft ] = er(T t) IE [M0T | Ft ] er(T t) IE [ST | Ft ]
r(T t) M0
M0
T t
T t
+St +
e
.
t
2r
M0t
2r
St
St
This concludes the proof of Proposition 8.4.
PDE Method
If the couple (St , Mt ) is Markov, the price can be written as a function
f (t, St , Mt ) = erT IE [(ST , MT ) | Ft ],
and in this case the function f (t, x, y) can solve a PDE.
Next we derive the Black-Scholes partial differential equation (PDE) for
the price of a self-financing portfolio.
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N. Privault
(ii) the portfolio value Vt := t At + t St , t R+ , takes the form
Vt = f (t, St , M0t ),
2
t R+ ,
f
f
1
2f
(t, x, y) + rx (t, x, y) + x2 2 2 (t, x, y),
t
x
2
x
t, x, y > 0,
(8.22)
r(T t)
y,
0 t T, y R+ ,
f (t, 0, y) = e
f
(t, x, y)x=y = 0,
0 t T, y > 0,
f (T, x, y) = y x,
0 x y.
(8.23a)
(8.23b)
(8.23c)
f
(t, St , M0t ),
x
t [0, T ],
(8.24)
0 t T.
(8.25)
Proof. The existence of f (t, x, y) follows from the Markov property, more
precisely the function f (t, x, y) satisfies
f (t, x, y) = er(T t) IE [(ST , M0T ) | St = x, M0t = y]
ST y MTt
= er(T t) IE x ,
St x
St
"
!#
S
y
MT0 t
T
t
= er(T t) IE x
,
,
S0 x
x
t [0, T ],
from the time homogeneity of the asset price process (St )tR+ . Applying the
change of variable formula to the discounted portfolio value
f(t, x, y) = ert f (t, x, y) = erT IE [(ST , M0T ) | St = x, M0t = y]
which is a martingale for t [0, T ], we have
df(t, St , M0t ) = rert f (t, St , M0t )dt + ert df (t, St , M0t )
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"
f
f
(t, St , M0t )dt + rert St (t, St , M0t )dt
t
x
1
2f
+ ert 2 St2 2 (t, St , M0t )dt
2
x
f
f
+ert (t, St , M0t )dM0t + ert St (t, St , M0t )dBt .
y
x
Since IE [(ST , M0T ) | Ft ] t[0,T ] is a P-martingale and (M0t )t[0,T ] has finite
variation (it is in fact a non-decreasing process), we have:
df (t, St , M0t ) = St
f
(t, St , M0t )dBt ,
x
t [0, T ],
(8.26)
wT
0
St
f
(t, x, M0t )|x=St dBt ,
x
In other words, the price of the lookback put option takes the form
#
"
r(T t)
T
f (t, St , Mt ) = e
IE M0 ST Ft ,
where the function f (t, x, y) is given by
"
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N. Privault
2
T t
T t
f (t, x, y) = yer(T t)
(x/y) + x 1 +
+
(x/y)
2r
2
2r/ 2
T t
x er(T t) (y/x)
(y/x) x.
2r
= xer(T t) ,
+
e
(1) 1,
C( ) = er
(1) + 1 +
(1)
2r
2r
> 0, hence
f
(t, x, x) = C(T t),
x
t [0, T ],
0 x y.
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"
r(T t)
t
T
=e
IE M0 Mt ST St = x, Mt = y
#
"
t
T
M 0 Mt
= er(T t) x IE
1 St = x, Mt = y
St
St
"
#
T
y Mt
= er(T t) x IE
1 St = x, Mt = y
x
St
#
"
y
= er(T t) x IE M0t MtT 1 St = 1, Mt =
x
= xf (t, 1, y/x)
= xg(T t, x/y),
where we let
g(, z) :=
2
1 r
e
(z) + 1 +
+
(z)
z
2r
2r/2
2
1
er
(
(1/z)) 1,
2r
z
(, 1) = 0,
g(0, z) = 1 1,
z
> 0,
z (0, 1].
(8.27a)
(8.27b)
The next Figure 8.15 shows a graph of the function g(, z).
"
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N. Privault
0.6
0.7
z
0.8
0.9
0.2
0.4
0.6
0.8
2
2
+
(z) er z 2r/
(1/z) ,
2r
(8.28)
depends only on time and z = St /M0t . In other words, due to the relation
x
x
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"
(8.29)
z
2
z 2
(8.30)
hp (0, z) = 0,
The next Figures 8.16 and 8.17 show the decompositions (8.29) of the normalized lookback put option price g(, z) in Figure 8.15 into the Black-Scholes
put function BSp (1, 1/z, r, , ) and hp (, z).
0.6
0.7
z
0.8
0.9
0.2
0.4
0.6
0.8
"
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N. Privault
h(,x)
1.2
1
0.8
0.6
0.4
0.2
0
0.6
0.7
z
0.8
0.9
0.2
0.4
0.6
0.8
m
e
mt0
mt0
t 2r/2
t
2
St
m0
2
m0
T t
T t
+er(T t) St
St +
.
2r St
St
2r
mt0
Figure 8.18 represents the price of the lookback call option as a function of
mt0 and St for different values of the time to maturity T t.
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"
90
80
70
60
50
40
30
20
10
0
80
60
80
60
mt
40
40
20
20
0
St
t 1+2r/2
t
St
m0
m0
T t
T t
=
mt0
St
St
and
"
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N. Privault
IE [mTt 1{mt0 >mTt } | Ft ] = St IE
Sr
1{mt0 /St >mTt /St }
r[t,T ] St
min
x=mt0 ,y=St
Sr
= St IE min
1{minr[t,T ] Sr /St <x}
r[t,T ] St
x=mt0 /St
S
r
1{minr[0,T t] Sr /S0 <x}
= St IE
min
r[0,T t] S0
x=mt0 /St
S
St
t
T t
T t
= 2St er(T t) +
St er(T t) +
t
t
m0
r
m0
2r/2
t
mt0
m
0
T t
+St
.
r
St
St
Given the relation /r = 1 2 /(2r), this yields
er(T t) IE [ST mT0 | Ft ] = St mt0 er(T t) P
!
mT0 t
>x
S0
x=mt0 /St
Sr
1{minr[0,T t] Sr /S0 <x}
S0
x=mt0 /St
t 1+2r/2
t
m0
m0
St
T t
T t
+ mt0 er(T t)
= St mt0 er(T t)
t
m0
St
St
St
St
T t
T t
2St +
+ St +
mt0
r
mt0
t 2r/2
t
m0
m0
T t
St er(T t)
r
St
St
2
St
St
T t
T t
t r(T t)
= St m0 e
St 1 +
+
t
t
m0
2r
m0
t 2r/2
t
2
m0
m0
T t
+St er(T t)
2r St
St
S
St
t
T t
T t
er(T t) mt0
= St +
t
t
m0
m0
t 2r/2
t
!
2
S
m
m
St
0
0
T t
T t
r(T t) t
r(T t)
+e
e
+
.
2r
St
St
mt0
St er(T t) IE
min
r[0,T t]
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"
BSc (S, K, r, , ) = S +
Ker
K
K
denote the standard Black-Scholes formula for the price of a European call
option, we observe that the lookback call option price satisfies
er(T t) IE [ST mT0 | Ft ] = BSc (St , mt0 , r, , T t)
t 2r/2
t !
St
2
m0
m0
T t
T t
r(T t)
+
,
St
2r
mt0
St
St
i.e.
St
er(T t) IE [ST mT0 | Ft ] = BSc (St , mt0 , r, , T t) + St hc T t, t
m0
where the function
hc (, z) =
2
2
+
(z) er z 2r/
(1/z) ,
2r
(8.31)
2
2
1 er z 2r/ ,
2r
R+ ,
z R+ ,
f
f
1
2f
(t, x, y) + rx (t, x, y) + x2 2 2 (t, x, y),
t
x
2
x
t, x > 0,
lim f (t, x, y) = x,
y&0
f
(t, x, y)x=y = 0,
f (T, x, y) = x y,
"
0 t T,
0 t T,
0 y x,
x > 0,
(8.32a)
y > 0,
(8.32b)
(8.32c)
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N. Privault
and the corresponding self-financing hedging strategy is given by
t =
f
(t, St , mt0 ),
x
t [0, T ],
(8.33)
which represents the quantity of the risky asset St to be held at time t in the
hedging portfolio.
In other words, the price of the lookback call option takes the form
f (t, St , mt ) = er(T t) IE [ST mT0 | Ft ],
where the function f (t, x, y) is given by
x
x
T t
T t
f (t, x, y) = x +
er(T t) y
(8.34)
y
y
2
x
2 y 2r/ T t y
T t
er(T t) +
+er(T t) x
2r
x
x
y
2
x
x
T t
T t
= x yer(T t)
x 1+
+
y
2r
y
2 2r/ 2
y
T t y
r(T t)
+xe
.
2r x
x
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"
C( ) = 1 er
(1) 1 +
+
(1) + er
(1) ,
2r
2r
> 0, hence
f
(t, x, x) = C(T t),
x
t [0, T ],
0 x y.
1 St = x, mt = y
St
St
"
#
T
y mt
= er(T t) x IE
1 St = x, mt = y
x
St
"
#
r(T t)
t
T
=e
x IE m0 mt 1 St = 1, mt = y/x
= xf (t, 1, y/x),
hence letting
1
2
g(, z) = 1 er
(z) 1 +
+
(z)
z
2r
2
2
+ er z 2r/ (
(1/z)),
2r
we have g(, 1) = C(T t), and
f (t, x, y) = xg(T t, x/y)
and the boundary condition
"
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N. Privault
(, 1) = 0,
> 0,
g(0, z) = 1 1 ,
z
(8.35a)
z 1.
(8.35b)
The next Figure 8.19 shows a graph of the function g(, z).
2.5
z
1.5
200
150
100
50
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"
60
50
40
30
20
10
0
50
100
150
200
St
mt
90
80
70
60
50
40
30
20
50
100
150
200
BSc (x, y, r, , ) = x +
yer
y
y
= xBSc (1, y/x, r, , )
for the standard Black-Scholes call formula, we observe that f (t, x, y) satisfies
"
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N. Privault
f (t, x, y) = xBSc (1, y/x, r, , T t) + xhc (T t, x/y),
i.e.
f (t, x, y) = xg(T t, x/y),
with
g(, z) = BSc (1, 1/z, r, , ) + hc (, z),
(8.36)
z 1.
The next Figures 8.23 and 8.24 show the decomposition of g(t, z) in (8.36) and
Figures 8.19-8.20 into the sum of the Black-Scholes call function BSc (1, 1/z, r, , )
and h(t, z).
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
03
2.5
z
1.5
200
150
100
50
Fig. 8.23: Black-Scholes call price in the decomposition (8.36) of the normalized
lookback call option price g(, z).
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"
h(T-t,x)
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
03
2.5
z
1.5
200
150
100
50
T t
T t
+xer(T t)
1
(1)
(1) .
2r
Hedging of Lookback Options
In this section we compute hedging strategies for lookback options by application of the Delta hedging formula (8.33). See [3], 2.6.1, page 29, for
another approach to the following result using the Clark-Ocone formula.
Here we use (8.33) instead, cf. Proposition 4.6 of [45].
Proposition 8.7. The hedging strategy of the lookback call option is given
by
2
St
St
T t
T t
(8.37)
t = +
+
mt0
2r
mt0
"
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N. Privault
+er(T t)
mt0
St
2r/2
t
2
m0
T t
1
,
2r
St
t [0, T ].
2
2
+
(z) er z 2r/
(1/z)
2r
BSc (x, y, r, , ) = +
x
y
is known, cf. Propositions 5.4 and 6.7. Next, we have
x
x
x hc
x
xhc ,
= hc ,
+
,
,
x
y
y
y z
y
and
hc
2
(, z) =
z
2r
2
+
(z) er z 2r/
(
(1/z))
x
z
2 2r r 12r/2
e
z
(
(1/z))
2r 2
2
=
exp +
(z)
2
2rz 2
1
2
r 2r/ 2
e
z
exp (
(1/z))
2
2rz 2
2
2r
+ 2 er z 12r/ (
(1/z)) .
4r
1
(z)
+
(z)
= exp +
2
2
2
2
1 4r2
4r
1 2
(z))
12 (+
=e
exp
log
z
+
(r
+
)
2 2
2
2
2
2
2
1
2r
2r
2r
+ 2 log z + 2 + r
= e 2 (+ (z)) exp
2
e( (1/z))
/2
/2
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(8.38)
"
,
= er z 12r/ (
(1/z)),
z
y
and
y 2r/2 y
x
x
,
xhc ,
= hc ,
er
y
y
x
x
Similar calculations using (8.24) can be carried out for other types of lookback options, such as options on extrema and partial lookback options, cf.
[44].
As a consequence of (8.37) we have
IE [ST mT0 | Ft ]
St
St
T t
T t
t r(T t)
= St +
m
e
mt0
mt0
2r/2
t
2
St
m0
St
2
T t
T t
S
+er(T t) St
t
+
2r mt0
St
2r
mt0
12r/2
t !
St
St
m0
T t
T t
= t St mt0 er(T t)
+
,
mt0
mt0
St
r(T t)
and the quantity of the riskless asset ert in the portfolio is given by
t = mt0 erT
12r/2
t !
St
St
m0
T t
T t
+
mt0
mt0
St
0,
so that the portfolio value Vt at time t satisfies
Vt = t St + t ert ,
t R+ ,
and one has to constantly borrow from the riskless account in order to hedge
the lookback option.
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N. Privault
General Results
An option on average is an option whose payoff has the form
C = (YT , ST ),
where
YT = S0
wT
0
eBu +ru
u/2
du =
wT
0
T R+ .
Su du,
For example when (y, x) = (y/T K) this yields the Asian call option
with payoff
w
+
+
1 T
YT
Su du K
=
K
,
(8.39)
T 0
T
which is a path-dependent option whose price at time t [0, T ] is given
by
"
+ #
1 wT
r(T t)
e
IE
Su du K
(8.40)
Ft .
T 0
As another example, when (y, x) = ey this yields the price
h rT
i
P (0, T ) = IE e 0 Su du = IE eYT
at time 0 of a bond with underlying short term rate process St .
The option with payoff C = (YT , ST ) can be priced as
"
wT
er(T t) IE [(YT , ST ) | Ft ] = er(T t) IE Yt +
Su du, ST
t
"
#
wT S
ST
u
r(T t)
du, x
=e
IE y + x
Ft
t St
St
y=Yt ,x=St
w T t S
ST t
u
r(T t)
du, x
.
=e
IE y + x
0
S0
S0
y=Yt ,x=St
#
Ft
(8.41)
"
t > 0,
has been computed in the case = 2, cf. also [52]. In the next proposition
we restate this result for an arbitrary variance parameter after rescaling.
Let (v, ) denote the function defined as
2
ve /(2 ) w 2 /(2 ) v cosh
(v, ) =
e
e
sinh() sin (/ ) d,
2 3 0
v, > 0.
(8.42)
u/2 2
pu/2p2 2 t/8
1 + eu
t dz
4e
e
exp 2
,
du,
2
2
z
2 z
4
z
u R, z > 0.
The expression of this probability density can then been used for the pricing
of options on average such as (8.41), as
w T t S
ST t
v
dv, x
f (t, x, y) = er(T t) IE y + x
0
S0
S0
= er(T t)
w T t S
w
2
v
y + xz, xeu+r(T t) (T t)/2 P
dv dz, BT t du
0
0
S0
ww
2 2
2
0
2
!
!
2
2
1 + eup (T t)/2
p
4eu/2p (T t)/4 2 (T t)
dz
exp 2
u
,
du
2 z
2
2 z
4
z
ww
r(T t)p2 2 (T t)/8
2 r(T t) 2 (T t)/2
=e
y + x/z, xv e
0
0
2
1+v
4vz 2 (T t)
dz
v 1p exp 2z
,
dv ,
2
2
4
z
"
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N. Privault
which actually stands as a triple integral due to the definition (8.42) of (v, ).
Note that here the order of integration between du and dz cannot be exchanged without particular precautions, at the risk of wrong computations.
r(T t)
y+x
du K
=e
IE
Ft
t St
T
x=St ,
"
#
+
w T t S
1
u
= er(T t) IE
y+x
du K
0
T
S0
er(T t) IE
"
y=Yt
x=St , y=Yt
r(T t)
"
IE
+
1 wT
Su du K
T 0
#
Ft ,
Probabilistic Approach
First we note that the numerical computation of Asian option prices can be
done using the probability density of
YT =
wT
0
St dt.
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"
wt
0
eBs p
s/2
ds,
as follows:
w
t
2
P
eBs p s/2 ds du
0
!
!
2
2
p2 2 t/8 w
p
1 + evp t/2
4ev/2p t/4 2 t
e
v
,
exp 2
dvdu
2u
2 u
2
2 u
4
w
2 2
4v 2 t
du
1 + v2
= ep t/8
v 1p exp 2 2
,
dv ,
0
u
2 u 4
u
=
St dt du
(8.43)
0
w
2
2
2 2
1+v
4v t
du
= ep t/8
v 1p exp 2 2
,
dv ,
0
u
2 u 4
u
y + xz
= er(T t) ep (T t)/8
K
0
0
2
T
1 + v2
4v 2 (T t)
dz
1p
,
dv
v
exp 2 2
z
2 z
4
z
w
1 r(T t)p2 2 (T t)/8 w
= e
(xz + y KT )
0(KT y)/x 0
T
2
2
1+v
4v (T t)
dz
exp 2 2
,
dv
z
2 z
4
z
+
4x r(T t)p2 2 (T t)/8 w w 1 2 (KT y)
= 2 e
0
0
T
z
4x
1 + v2
2 (T t)
dz
1p
v
exp z
vz,
dv ,
2
4
z
cf. the Theorem in 5 of [9], which is actually a triple integral due to the
definition (8.42) of (v, t). Note that since the integrals are not absolutely
convergent, here the order of integration between dv and dz cannot be ex"
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N. Privault
changed without particular precautions, at the risk of wrong computations.
The time Laplace transform of Asian option prices has been computed in
[29], and this expression can be used for pricing by numerical inversion of the
Laplace transform. The following Figure 8.25 represents Asian option prices
computed by the Geman-Yor [29] method.
Asian option price
30
25
20
15
10
5
100
95
underlying
90
85
80 0
100
50
150
200
250
300
350
Time in days
Fig. 8.25: Graph of the Asian option price with = 0.3, r = 0.1 and K = 90.
We refer to e.g. [2], [9], [20], and references therein for more on Asian option pricing using the probability density of the averaged geometric Brownian
motion.
Figure 7.1 presents a graph of implied volatility surface for Asian options on
light sweet crude oil futures.
Lognormal approximation
Other numerical approaches to the pricing of Asian options include [49], [73]
which relies on approximations of the average price probability based on
the Lognormal distribution. The lognormal distribution with mean and
variance 2 has the probability density function
2
2 dx
1
g(x) = e(log x) /(2 ) ,
x
2
/2
(8.45)
wT
0
St dt
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"
/2)t
t [0, T ],
log(E[T ]/(KT ))
T
T +
2 T log(KT )
=
2
log(E[T ]/(KT ))
T
d2 = d1
T =
,
2
and
,
are estimated as
2 =
1
log
T
E[2T ]
(E[T ])2
and
1 2
1
log E[T ]
,
T
2
based on the first two moments of the lognormal distribution, cf. (8.45) below.
The next Figure 8.26 compares the lognormal approximation to a Monte
Carlo estimate of Asian option prices with = 0.5, r = 0.05 and K/St = 1.1
0.24
lognormal approximation
Monte Carlo estimate
0.22
0.2
0.18
0.16
0.14
0.12
0.1
0.08
0.06
0.04
0
5
time t
10
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For reference, in the next proposition we compute the unconditional mean
and variance of T , which have been used in (8.46), cf. also (7) and (8) page
480 of [49].
Proposition 8.9. We have
E[T ] = S0
and
E[(T )2 ] = 2S02
re(2r+
erT 1
,
r
)T
(2r + 2 )erT + (r + 2 )
.
r(r + 2 )(2r + 2 )
re(2r+
)T
(2r + 2 )erT + (r + 2 )
,
r(r + 2 )(2r + 2 )
since r 2 /2 = p 2 /2.
"
t R+ ,
where (Wt )tR+ is a standard Brownian motion under the historical probability measure P.
Proposition 8.10. Let (t , t )tR+ be a portfolio strategy such that
(i) (t , t )tR+ is self-financing,
(ii) the value Vt := t At + t St , t R+ , takes the form
Vt = f (t, Yt , St ),
t R+ ,
rf (t, x, y) =
f
f
f
1
2f
(t, x, y) + x (t, x, y) + rx (t, x, y) + x2 2 2 (t, x, y),
t
y
x
2
x
y
+
f (t, 0, y) = er(T t)
K ,
0 t T,
lim f (t, x, y) = 0,
0 t T, x R+ ,
y
y
+
f (T, x, y) =
K ,
x, y R+ ,
T
y R+ ,
(8.48a)
(8.48b)
(8.48c)
and t is given by
f
(t, St , Yt ),
t R+ .
x
Proof. We note that the self-financing condition implies
t =
(8.49)
(8.50)
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f
f
(t, St , Yt )dt + St (t, St , Yt )dt
t
y
f
f
1 2 2 2f
+St (t, St , Yt )dt + St
(t, St , Yt )dt + St (t, St , Yt )dWt .
x
2
x2
x
(8.51)
df (t, St , Yt ) =
f
f
f
rt At dt + t St dt =
(t, St , Yt )dt + St (t, St , Yt )dt + St (t, St , Yt )dt
t
y
x
1 2 2 2f
+ St
(t, St , Yt )dt,
2
x2
S dW = S f (t, S , Y )dW ,
t t
t
t
t
t
t
x
hence
t
y
2
x2
t = f (t, St , Yt ),
x
i.e.
f
f
f
t
y
x
1
2f
+ St2 2 2 (t, St , Yt ),
2
x
= f (t, S , Y ).
t
t
t
x
Next we examine two methods which allow one to reduce the Asian option
pricing PDE from two variables to one variable.
t [0, T ].
"
r(T t)
r(T t)
e
IE
IE ST (ZT )+
Su du K
Ft = e
T 0
#
Ft .
Lemma 8.1. The price (8.40) at time t of the Asian option with payoff
(8.39) can be written as
t [0, T ],
St g(t, Zt ),
where
+ #
1 w T t Su
du
T 0
S0
"
+ #
YT t
= er(T t) IE
z+
.
S0 T
g(t, z) = er(T t) IE
"
z+
(8.52)
St Zt
1 w t Su
= Zs +
du,
Ss
T s Ss
t s.
Since for any t [0, T ], St is positive and Ft -measurable, and Su /St is independent of Ft , u t, we have:
#
"
"
+ #
ST
r(T t)
+
r(T t)
ZT
e
IE ST (ZT ) Ft = e
St IE
Ft
St
"
#
+
w
1 T Su
du
= er(T t) St IE
Zt +
Ft
T t St
#
"
+
w
T
Su
1
= er(T t) St IE
z+
du
Ft
T t St
z=Zt
"
#
+
1 w T t Su
r(T t)
=e
St IE
z+
du
T 0
S0
z=Zt
"
+ #
YT t
r(T t)
=e
St IE
z+
S0 T
z=Zt
= St g(t, Zt ),
which proves (8.52).
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Note that as in (8.44), g(t, z) can be computed from the density (8.43) of
YT t , as
"
+ #
YT t
g(t, z) = IE
z+
S0 T
w
u +
P(Yt /S0 du)
z+
=
0
T
p2 2 t/8
=e
w
u + w 1p
1 + v2
4v 2 (T t)
du
z+
v
exp 2
,
dv
2
2
0
0
T
u
4
u
2
= ep t/8
w
u w 1p
1 + v2
4v 2 (T t)
du
v
exp 2
,
dv
(zT )0
0
T
2
2 u
4
u
w
w
2
2
2 2
1
+
v
(T
t)
du
4v
= zep t/8
v 1p exp 2
,
dv
(zT )0 0
2
2 u
4
u
w
1 + v2
1 p2 2 t/8 w
4v 2 (T t)
1p
+ e
v
exp 2
,
dvdu.
(zT )0 0
T
2
2 u
4
z+
The next proposition gives a replicating hedging strategy for Asian options.
Proposition 8.11. Let (t , t )tR+ be a portfolio strategy such that
(i) (t , t )tR+ is self-financing,
(ii) the value Vt := t At + t St , t R+ , takes the form
Vt = St g(t, Zt ),
t R+ ,
1
rz
T
g
1
2g
(t, z) + 2 z 2 2 (t, z) = 0,
z
2
z
(8.53)
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1
St
=
1
St
+ 2 dt dWt ,
hence
1 Yt
K
St T
Yt
K
=d
T St
St
Yt
1
1
= d
Kd
T
St
St
1 dYt
1
Yt
=
K d
+
T St
T
St
1
dt
+ St Zt d
=
T
St
dt
+ Zt + 2 dt Zt dWt .
=
T
dZt = d
By self-financing we have
dVt = t dAt + t dSt
= rt At dt + t St dt + t St dWt ,
(8.54)
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N. Privault
By respective identification of the terms in dWt and dt in (8.54) and (8.51)
we get
g
g
t
z
1 g
1
g
S = S g(t, Z ) S Z g (t, Z ),
t t
t
t
t t
t
z
hence
g
1 g
1
2g
t
T z
2
z
t = g(t, Zt ) Zt g (t, Zt ),
z
i.e.
g
1
g
1
2g
(t, z) +
rz
(t, z) + 2 z 2 2 (t, z) = 0,
t
T
z
2
z
= g(t, Z ) Z g (t, Z ),
t
t
t
t
z
under the terminal condition
g(T, z) = z + .
We check that
f
f
t = er(T t) St f (t, St , Zt ) Zt f (t, St , Zt )
x
z
g
r(T t)
=e
Zt (t, Zt ) + g(t, Zt )
z
!
g
1 1 wt
r(T t)
=e
St
t,
Su du K
+ g(t, Zt )
x
x T 0
|x=St
w
1 1 t
=
xer(T t) g t,
Su du K
, t [0, T ].
x
x T 0
|x=St
We also find that the amount invested on the riskless asset is given by
t At = Zt St
g
(t, Zt ).
z
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"
Ut :=
i.e.
Zt = er(T t) Ut +
er(T t) 1
,
rT
t [0, T ].
We have
1
dUt = er(T t) dt + rer(T t) Zt dt + er(T t) dZt
T
= er(T t) 2 Zt dt er(T t) Zt dWt ( r)er(T t) Zt dt
t,
= er(T t) Zt dW
t R+ ,
where
t = dWt dt +
dW
r
t dt
dt = dW
t/2
dP = erT
ST
dP .
S0
#
Ft ,
0 t T.
Proof. We have
UT =
1
ST
1 wT
Su du K = ZT ,
T 0
and
"
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N. Privault
|F
dP
2
erT ST
t
= e(WT Wt ) (T t)/2 = rt ,
dP|Ft
e St
hence the price of the Asian option is
er(T t) IE [ST (ZT )+ | Ft ] = er(T t) IE [ST (UT )+ | Ft ]
#
"
erT ST
+
(U
)
= St IE
Ft
T
ert St
#
"
|F
dP
t
= St IE
(UT )+ Ft
dP|Ft
+
= St IE[(U
T ) | Ft ].
The next proposition gives a replicating hedging strategy for Asian options.
See 7.5.3 of [71] and references therein for a different derivation of the
PDE (8.55).
Proposition 8.12. Let (t , t )tR+ be a portfolio strategy such that
(i) (t , t )tR+ is self-financing,
(ii) the value Vt := t At + t St , t R+ , takes the form
t R+ ,
Vt = St h(t, Ut )
2
1 er(T t)
y
rT
2
2h
(t, y) = 0,
y 2
(8.55)
h
(t, Ut ),
y
t [0, T ].
(8.56)
"
h
h
y
t
1
2h
+ St 2 Zt2 2 (t, Ut ),
2
y
t = h(t, Ut ) Zt (t, Ut ),
y
hence
2
1
h
2 h
2
t = h(t, Ut ) Zt h (t, Ut ),
y
and
"
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N. Privault
2 2
h
1 2 1 er(T t)
h
(t, y) = 0,
(t,
y)
+
t
2
rT
y 2
1 er(T t)
h
t = h(t, Ut ) +
Ut
(t, Ut ),
rT
y
under the terminal condition
h(T, z) = z + .
We also find
h
1 er(T t) h
(t, Ut ) = St Zt (t, Ut ).
t At = er(T t) St Ut
rT
y
y
Exercises
(8.57)
interval [0, T ] ?
4. Compute the expected value E[ST ] of the maximum
!
ST := sup St = S0 sup eBt = S0 exp sup Bt
t[0,T ]
t[0,T ]
t[0,T ]
2 x2 /(2t)
e
1[0,) (x),
t
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x R.
"
/(2t)
/t.
dP(YT a & BT b)
,
dadb
a, b R,
T b)
dP(YT a & B
,
dadb
a, b R,
t[0,T ]
C = (ST K)
1(
min St > B
0tT
S K
if min St > B,
if min St B,
0tT
0tT
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N. Privault
date T , strike K, barrier B, and the following payoffs. In addition, compute
the corresponding hedging strategies.
1. Up-and-in barrier long forward contract. Take
C = (ST K) 1(
max St > B
S K if max St > B,
T
0tT
0tT
if max St B.
0tT
C = (ST K) 1(
max St < B
S K if max St < B,
T
0tT
0tT
if max St B.
0tT
C = (ST K) 1(
min St < B
S K if min St < B,
T
0tT
0tT
if min St B.
0tT
C = (ST K) 1(
min St > B
S K if min St > B,
T
0tT
0tT
if min St B.
0tT
C = (K ST ) 1(
max St > B
K ST if max St > B,
0tT
0tT
if max St B.
0tT
C = (K ST ) 1(
max St < B
0tT
K ST if max St < B,
0tT
if max St B.
0tT
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"
C = (K ST ) 1(
min St < B
K ST if min St < B,
0tT
0tT
if min St B.
0tT
C = (K ST ) 1(
min St > B
K ST if min St > B,
0tT
0tT
if min St B.
0tT
?
2. Compute the price value
e
T /2
E ST min St
t[0,T ]
rT
0
rs ds.
Exercise 8.8 Asian call options with negative strike. Consider the asset price
process
"
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St = S0 ert+Bt
t/2
t R+ ,
where (Bt )tR+ is a standard Brownian motion. Assuming that 0, compute the price
"
+ #
1 wT
er(T t) IE
Su du
Ft
T 0
of the Asian option at time t [0, T ].
Exercise 8.9 Pricing of Asian options by PDEs. Show that the functions
g(t, z) and h(t, y) are linked by the relation
1 er(T t)
g(t, z) = h t,
+ er(T t) z ,
rT
t [0, T ],
z > 0,
and that the PDE (1.35) for h(t, y) can be derived from the PDE (1.33) for
g(t, z) and the above relation.
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"
Chapter 9
American Options
In contrast with European option which have fixed maturities, the holder of
an American option is allowed to exercise at any given (random) time. This
transforms the valuation problem into an optimization problem in which one
has to find the optimal time to exercise in order to maximize the payoff of
the option. As will be seen in the first section below, not all random times
can be considered in this process, and we restrict ourselves to stopping times
whose value at time t be can decided based on the historical data available.
"
N. Privault
0 s t,
Zs IE[Zt | Fs ],
0 s t,
Zs IE[Zt | Fs ],
0 s t.
resp.
resp.
Clearly, a process (Zt )tR+ is a martingale if and only if it is both a supermartingale and a submartingale.
A particular property of martingales is that their expectation is constant.
Proposition 9.1. Let (Zt )tR+ be a martingale. We have
IE[Zt ] = IE[Zs ],
0 s t.
The above proposition follows from the tower property (16.24) of conditional expectations, which shows that
IE[Zt ] = IE[IE[Zt | Fs ]] = IE[Zs ],
0 s t.
(9.1)
0 s t.
0 s t.
Independent increments processes whose increments have negative expectation give examples of supermartingales. For example, if (Xt )tR+ is such a
process then we have
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"
0 s t.
= Xs ,
Similarly, a process with independent increments which have positive expectation will be a submartingale. Brownian motion Bt + t with positive drift
> 0 is such an example, as in Figure 9.1 below.
5
drifted Brownian motion
drift
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0
-0.5
0
10
12
14
16
18
20
Fig. 9.2: Evolution of the fortune of a poker player vs number of games played.
A natural way to construct submartingales is to take convex functions of
martingales. Indeed, if (Mt )tR+ is a martingale and is a convex function,
Jensens inequality states that
"
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N. Privault
(IE[Mt | Fs ]) IE[(Mt ) | Fs ],
0 s t,
(9.2)
0 s t,
i.e. ((Mt ))tR+ is a submartingale. More generally, the above shows that
(Mt )tR+ remains a submartingale when is convex non-decreasing and
(Mt )R+ is a submartingale. Similarly, ((Mt ))tR+ will be supermartingale
when (Mt )R+ is a martingale and the function is concave.
Other examples of (super, sub)-martingales include geometric Brownian
motion
2
St = S0 ert+Bt t/2 ,
t R+ ,
which is a martingale for r = 0, a supermartingale for r 0, and a
submartingale for r 0.
t R+ .
"
t N.
In gambling, a hitting time can be used as an exit strategy from the game.
For example, letting
x,y := inf{t R+ : Xt = x or Xt = y}
(9.4)
defines a hitting time (hence a stopping time) which allows a gambler to exit
the game as soon as losses become equal to x = 10, or gains become equal
to y = +100, whichever comes first.
However, not every R+ -valued random variable is a stopping time. For
example the random time
(
)
= inf
t [0, T ] : Xt = sup Xs
s[0,T ]
which represents the first time the process (Xt )t[0,T ] reaches its maximum
over [0, T ], is not a stopping time with respect to the filtration generated by
(Xt )t[0,T ] . Indeed, the information known at time t (0, T ) is not sufficient
to determine whether { > t}.
Given (Zt )tR+ a stochastic process and : R+ {+} a stopping
time, the stopped process (Zt )tR+ is defined as
Z if t ,
Zt =
Zt if t < ,
Using indicator functions we may also write
Zt = Z 1{ t} + Zt 1{ >t} ,
t R+ .
"
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N. Privault
0.065
0.06
0.055
0.05
0.045
0.04
0.035
0.03
0.025
0
10
t
15
20
n
X
l=1
(Ml Ml1 ) = M0 +
X
l=1
we have
M n = M0 +
X
n
l=1
(Ml Ml1 ) = M0 +
X
l=1
and for k n,
IE[M n | Fk ] = M0 +
= M0 +
X
l=1
k
X
l=1
X
l=k+1
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"
= M0 +
k
X
(Ml Ml1 ) IE[1{l n} | Fk ]
l=1
X
l=k+1
= M0 +
k
X
(Ml Ml1 )1{l n}
l=1
X
l=k+1
= M0 +
nk
X
l=1
= M0 +
k
X
(Ml Ml1 )1{l n}
l=1
= M k ,
k = 0, 1, . . . , n.
(9.5)
In case is finite with probability one but not bounded we may also write
h
i
IE[M ] = IE lim M t = lim IE[M t ] = IE[M0 ],
(9.6)
t
provided
|M t | C,
a.s.,
t R+ .
(9.7)
More generally, (9.6) will hold provided the limit and expectation signs can
be exchanged, and this can be done using e.g. the Dominated Convergence
Theorem.
In case P( = +) > 0, (9.6) will hold under the above conditions,
provided
M := lim Mt
(9.8)
t
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exists with probability one.
In addition, if and are two bounded stopping times such that ,
a.s., we have
IE[M ] IE[M ]
(9.9)
if (Mt )tR+ is a supermartingale, and
IE[M ] IE[M ]
(9.10)
if (Mt )tR+ is a submartingale, cf. Exercise 9.2 below for a proof in discrete
time. As a consequence of (9.9) and (9.10) (or directly from (9.5)), if and
are two bounded stopping times such that , a.s., we have
IE[M ] = IE[M ]
(9.11)
(9.12)
10
11
1
,
11
IE[limn Fn ] limn IE[Fn ] for any sequence (Fn )nN of nonnegative random
variables, provided the limits exist.
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"
t [0, T ] : Mt = sup Ms
)
,
s[0,T ]
Mt
"
martingale
submartingale
IE[M ] = IE[M ]
IE[M ] IE[M ]
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N. Privault
Examples of application
In this section we note that, as an application of the stopping time theorem,
a number of expectations can be computed in a simple and elegant way.
0 s t.
t R+ .
Hence we have
x = IE[Ba,b | B0 = x] = aP(Ba,b = a | B0 = x)+bP(Ba,b = b | B0 = x),
under the additional condition
P Xa,b = a | X0 = x + P(Xa,b = b | X0 = x) = 1.
which yields
P(Ba,b = b | B0 = x) =
xa
,
ba
a x b,
bx
,
ba
a x b.
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Xt = x + Bt + t,
In this case the process (Xt )tR+ is no longer a martingale and in order to
use Theorem 9.1 we need to construct a martingale of a different type. Here
we note that the process
Mt := eBt
t/2
t R+ ,
t R+ .
t/2
= ex Mt ,
hence
1 = IE[Ma,b ]
= ex IE[eXa,b ]
= e(ax) P Xa,b = a | X0 = x + e(bx) P(Xa,b = b | X0 = x),
under the additional condition
P Xa,b = a | X0 = x + P(Xa,b = b | X0 = x) = 1.
Finally this gives
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P(Xa,b = a | X0 = x) =
e2x e2b
ex eb
= 2a
,
ea eb
e
e2b
(9.13)
a x b, and
P(Xa,b = b | X0 = x) =
e2a e2x
,
e2a e2b
a x b.
Letting b tend to infinity in the above equalities shows that the probability
of escape to infinity of Brownian motion started from x [a, ) is equal to
1 P(Xa, = a | X0 = x) = 1 e2(xa) ,
x > a,
= Bs2 s,
0 s t.
= IE[B2a,b a,b | B0 = x]
= IE[B2a,b | B0 = x] IE[a,b | B0 = x]
Here we note that it can be showed that IE[a,b ] < in order to apply (9.6).
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a x b.
= IE[Xa,b | X0 = x] IE[a,b | X0 = x]
hence
IE[a,b | X0 = x] =
a x b.
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under the risk-neutral probability measure P , where the supremum is taken
over stopping times between t and a fixed maturity T . Similarly, the price of
a finite expiration American call option with strike K is expressed as
i
h
f (t, St ) =
sup
IE er( t) (S K)+ St .
t T
stopping time
and
f (t, St ) =
sup
t
stopping time
i
h
IE er( t) (S K)+ St .
(9.14)
"
(9.15)
We note that the starting date t does not matter when pricing perpetual
options, hence fL (t, x) is actually independent of t R+ , and the pricing of
the perpetual put option can be performed by taking t = 0 and in the sequel
we will work under
fL (t, x) = fL (x),
x > 0.
Recall that the underlying asset price is written as
St = S0 eBt
t/2+rt
t R+ ,
(9.16)
K x,
0 < x L,
=
2
(K L) x 2r/ , x L.
L
Proof. The result is obvious for St = x L since in this case we have L = t
and SL = St = x, so that we only focus on the case x L. In addition we
take t = 0 without loss of generality. By the relation
h
i
h
i
IE er(L t) (K SL )+ St = x = IE er(L t) (K L)St = x ,
(9.17)
h
i
we check that it suffices to compute IE er(L t) St = x . For this we note
that from (9.16), for all R the process (Zt )tR+ defined as
Zt :=
St
S0
ert+
t/22 2 t/2
= eBt
2 t/2
t R+ ,
Here the exchange of limit and expectation can be justified by monotone convergence, cf. p. 347 of [71].
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2
2 2
SL
e(r /2+ /2)L
S0
2
2 2
L
=
e(r /2+ /2)L ,
S0
Z L =
which yields
IE
i.e.
"
L
S0
#
e(r
/2+2 2 /2)L
= 1,
h
i S
2
2 2
0
IE e(r /2+ /2)L =
,
L
or
IE erL =
S0
L
,
(9.18)
2
( + 2r/ 2 )( 1).
2
(9.19)
This equation admits two solutions and we choose the negative solution =
2r/ 2 since S0 = x > L and the expectation IE [erL ] < 1 in (9.18) is
strictly smaller than 1 as r 0. Consequently we have
h
i x 2r/2
IE er(L t) St = x =
L
x L,
(9.20)
We note that taking L = K would yield a payoff always equal to 0 for the
option holder, hence the value of L should be strictly lower than K. On the
other hand, if L = 0 the value of L will be infinite almost surely, hence
the option price will be 0 when r 0 from (9.15). Therefore there should
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"
35
L=75
L=L*=85.71
L=98
(K-x)+
30
Option price
25
20
15
10
5
0
70
80
90
100
110
120
Underlying
Fig. 9.4: Graphs of the option price by exercise at L for several values of L.
In order to compute L we observe that, geometrically, the slope of fL (x) at
x = L is equal to 1, i.e.
2
fL0 (L ) =
i.e.
(L )2r/ 1
2r
(K L )
= 1,
2
(L )2r/2
2r
(K L ) = L ,
2
or
L =
2r
K < K,
2r + 2
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35
30
Option price
25
20
15
10
5
0
70
80
90
100
110
120
Underlying
Fig. 9.5: Animated graph of the option price depending on the values of L.
The next figure gives another view of the put option prices according to
different values of L, with the optimal value L = 85.71.
(K-x)+
fL(x)
fL*(x)
K-L
30
25
20
15
10
5
0
70
75
80
75
85 90
70
65
Underlying x 95 100 105
110 60
80
85
90
100
95
L
Fig. 9.6: Graph of the option price as a function of L and of the underlying asset
price.
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"
Time in days
200
100
90
80
70
50
60
underlying HK$
40
30
Fig. 9.7: Path of the American put option price on the HSBC stock.
PDE approach
We can check by hand that
2r
K x,
0 < x L =
K,
2r + 2
fL (x) =
2r/2
2r + 2 x
2r
K 2
, x L =
K,
2r + 2
2r K
2r + 2
satisfies the PDE
rf
(x) +
rxfL0 (x)
rK < 0,
1 2 2 00
+ x fL (x) =
2
0,
0 < x L < K,
x > L .
(9.21)
fL (x) = K x,
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N. Privault
This can be summarized in the following differential inequalities, or variational differential equation:
(9.22a)
fL (x) (K x)+ ,
(9.22b)
rxfL0 (x) + 2 x2 fL00 (x) rfL (x),
2
1 2 2 00
x
f
(fL (x) (K x)+ ) = 0, (9.22c)
rf
(x)
L
L
L
i .e.
St > L ,
and the expected rate of return of the option price fL (St ) then equals the
rate r of the risk-free asset as
d(fL (St )) = d(ert fL (St )) = rfL (St )dt + ert dfL (St ),
and the investor prefers to wait.
On the other hand if fL (St ) = (K St )+ , i.e. 0 < St < L , it is not
worth waiting as (9.22b) and (9.22c) show that the return of the option is
lower than that of the risk-free asset, i.e.:
1
rfL (St ) + rSt fL0 (St ) + 2 St2 fL00 (St ) < 0,
2
and exercise becomes immediate since the process fL (St ) becomes a (strict)
supermartingale. In this case, (9.22c) implies fL (x) = (K x)+ .
In view of the above derivation it should make sense to assert that fL (St )
is the price at time t of the perpetual American put option. The next propo246
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"
i
h
IE er( t) (K S )+ St
i
h
= IE er(L t) (K SL )+ St
K St , 0 < St L ,
2r/2
=
K 2
2r + 2 St
,
St L .
2r + 2
2r K
Proof. By Itos formula (9.23) and the inequality (9.22b) one checks that the
discounted portfolio price
u 7 eru fL (Su ),
u t,
sup
t
stopping time
i
h
IE er (K S )+ St .
(9.24)
sup
IE er( t) (K S )+ St ,
t
stopping time
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N. Privault
u 7 eruL fL (SuL ),
u t,
sup
IE erL (K SL )+ St ,
t
stopping time
sup
t
stopping time
i
h
IE er (K S )+ St ,
t 0.
"
fL (x) =
x K,
x L > K,
(L K) x ,
L
0 < x L.
(9.25)
Proof. We only need to consider the case x < L. Note that for all R,
Zt :=
St
S0
ert+
t/22 2 t/2
= eBt
2 t/2
t R+ ,
Hence the
is a martingale under the risk-neutral probability measure P.
stopped process (ZtL )tR+ is a martingale and it has constant expectation. Hence we have
IE [ZtL ] = IE [Z0 ] = 1,
and by letting t go to infinity we get
"
#
2
2 2
SL
e(r /2+ /2)L = 1,
IE
S0
which yields
h
i S
2
2 2
0
,
IE e(r /2+ /2)L =
L
i.e.
IE erL =
S0
L
,
(9.26)
2
( + 2r/ 2 )( 1).
2
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N. Privault
Here we choose the positive solution = 1 since S0 = x < L and the
expectation (9.26) is lower than 1.
One sees from Figure 9.8 that the situation completely differs from the perpetual put option case, as there does not exist an optimal value L that would
maximize the option price for all values of the underlying.
450
L=150
L=250
L=400
(x-K)+
x
400
350
Option price
300
250
200
150
100
50
0
0
50
100
150
200
250
Underlying
300
350
400
450
Fig. 9.8: Graphs of the option price by exercising at L for several values of L.
The intuition behind this picture is that there is no upper limit above which
one should exercise the option, and in order to price the American perpetual
call option we have to let L go to infinity, i.e. the optimal exercise strategy
is to wait indefinitely.
(x-K)+
fL(x)
K-L
180
160
140
120
100
80
60
40
20
0
300
150
250
200
150
100
250
200
Underlying x
100
x
= x,
L
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x > 0.
(9.27)
"
sup
t
stopping time
i
h
IE er( t) (S K)+ St = St ,
t R+ . (9.28)
sup
IE er( t) (S K)+ St ,
t 0,
t
stopping time
(9.29)
t
stopping time
from (9.27). On the other hand, for all stopping times t we have, by
(9.12),
i
i
h
h
IE er( t) (S K)+ St IE er( t) S St St ,
t 0,
since u 7 er(ut) Su is a martingale, hence
i
h
sup
IE er( t) (S K)+ St St ,
t
stopping time
t 0,
rt
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N. Privault
and
f (t, St ) =
sup
t T
stopping time
i
h
IE er( t) (S K)+ St .
IE [er( t) (S K)+ | Ft ],
i.e.
(x K)+ IE [er( t) (S K)+ |St = x],
x, t > 0.
x, t > 0.
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"
140
120
underlying 100
HK$
80
60
10 9
2 1 0
5 4to 3maturity T-t
6 Time
"
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1 2
3 4
5
Time to maturity T-t 6
9 10
90
100
110 underlying HK$
120
115
110
100
105
underlying HK$
95
90
"
f
f
1
2f
(t, St ) + rSt (t, St ) + 2 St2 2 (t, St ),
t
x
2
x
f
f
1
2f
(t, St ) + rSt (t, St ) + 2 St2 2 (t, St ).
t
x
2
x
f (t, x) (K x) ,
f
f
1 2 2 2f
x
2
x2
t
(9.30a)
(9.30b)
(9.30c)
x
2
x
t
(f (t, x) (K x)+ ) = 0,
subject to the terminal condition f (T, x) = (K x)+ . In other words, equality holds either in (9.30a) or in (9.30b) due to the presence of the term
(f (t, x) (K x)+ ) in (9.30c).
The optimal exercise strategy consists in exercising the put option as soon
as the equality f (u, Su ) = (K Su )+ holds, i.e. at the time
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= inf{u t : f (u, Su ) = (K Su )+ },
after which the process fL (St ) ceases to be a martingale and becomes a
(strict) supermartingale.
A simple procedure to compute numerically the price of an American put
option is to use a finite difference scheme while simply enforcing the condition
f (t, x) (K x)+ at every iteration by adding the condition
f (ti , xj ) := max(f (ti , xj ), (K xj )+ )
right after the computation of f (ti , xj ).
The next figure shows a numerical resolution of the variational PDE
(9.30a)-(9.30c) using the above simplified (implicit) finite difference scheme.
In comparison with Figure 9.7, one can check that the PDE solution becomes
time-dependent in the finite expiration case.
Finite expiration American put price
Immediate
payoff (K-x)+
L*=2r/(2r+sigma2)
16
14
12
10
8
6
4
2
0
2
4
Time to maturity T-t
90
6
110
100
underlying
10 120
Fig. 9.13: Numerical values of the finite expiration American put price.
In general, one will choose to exercise the put option when
f (t, St ) = (K St )+ ,
i.e. within the blue area in Figure (9.13). We check that the optimal threshold
L = 90.64 of the corresponding perpetual put option is within the exercise
region, which is consistent since the perpetual optimal strategy should allow
one to wait longer than in the finite expiration case.
The numerical computation of the put price
i
h
IE er( t) (K S )+ St
f (t, St ) =
sup
t T
stopping time
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"
16
14
12
10
8
6
4
2
0
2
4
Time to maturity T-t
90
6
110
100
underlying
10 120
Fig. 9.14: Longstaff-Schwartz algorithm for the finite expiration American put price.
In Figure 9.14 above and Figure 9.15 below the optimal threshold of the
corresponding perpetual put option is again L = 90.64 and falls within the
exercise region. Also, the optimal threshold is closer to L for large time to
maturities, which shows that the perpetual option approximates the finite
expiration option in that situation. In the next Figure 9.15 we compare the
numerical computation of the American put price by the finite difference and
Longstaff-Schwartz methods.
10
Longstaff-Schwartz algorithm
Implicit finite differences
Immediate payoff (K-x)+
0
90
100
110
120
underlying
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N. Privault
It turns out that, although both results are very close, the Longstaff-Schwartz
method performs better in the critical area close to exercise at it yields the
expected continuously differentiable solution, and the simple numerical PDE
solution tends to underestimate the optimal threshold. Also, a small error
in the values of the solution translates into a large error on the value of the
optimal exercise threshold.
i.e. the optimal strategy is to wait until the maturity time T to exercise the
option, and = T .
Proof. Since the function is convex and (0) = 0 we have
(px) = ((1 p) 0 + px) (1 p) (0) + p(x) p(x),
for all p [0, 1] and x 0. Hence the process s 7 ers (St+s ) is a
submartingale since taking p = er( t) we have
ers IE [ (St+s ) | Ft ] ers (IE [St+s | Ft ])
ers IE [St+s | Ft ]
= (St ),
where we used Jensens inequality (9.2) applied to the convex function and
the fact that
(px) = ((1 p) 0 + px) (1 p)(0) + p(x) = p(x),
x > 0,
by the convexity of and the fact that (0) = 0. Hence by the optional
stopping theorem for submartingales, cf (9.10), for all (bounded) stopping
times comprised between t and T we have,
IE [er( t) (S ) | Ft ] er(T t) IE [(ST ) | Ft ],
i.e. it is always better to wait until time T than to exercise at time [t, T ],
and this yields
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"
i
i
h
h
IE er( t) (S )St er(T t) IE (ST )St .
sup
t T
stopping time
i
h
IE er( t) (S )St ,
i
h
= er(T t) IE (ST K)+ St ,
i.e. the optimal strategy is to wait until the maturity time T to exercise the
option.
In the following table we summarize the optimal exercise strategies for the
pricing of American options.
option
type
perpetual
0 < St L ,
put
2
option
St 2r/
(K L )
, St L .
L
= L
finite expiration
K St ,
call
option
St
= +
= T
Exercises
Exercise 9.1 Stopping times. Let (Bt )tR+ be a standard Brownian motion
started at 0.
1. Consider the random time defined by
:= inf{t R+ : Bt = B1 },
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N. Privault
which represents the first time Brownian motion Bt hits the level B1 . Is
a stopping time ?
2. Consider the random time defined by
:= inf{t R+ : eBt = et/2 },
which represents the first time the exponential of Brownian motion Bt
crosses the path of t 7 et/2 , where > 1.
Is a stopping time ? If is a stopping time, compute E[e ] by the
stopping time theorem.
3. Consider the random time defined by
:= inf{t R+ : Bt2 = 1 + t},
which represents the first time Brownian motion Bt crosses the straight
line t 7 1 + t, with (, 1).
Is a stopping time ? If is a stopping time, compute E[ ] by the Doob
stopping time theorem.
Exercise 9.2 (Doob-Meyer decomposition in discrete time). Let (Mn )nN
be a discrete-time submartingale with respect to a filtration (Fn )nN , with
F1 = {, }.
1. Show that there exists two processes (Nn )nN and (An )nN such that
(i) (Nn )nN is a martingale with respect to (Fn )nN ,
(ii) (An )nN is non-decreasing, i.e. An An+1 a.s., n N,
(iii) (An )nN is predictable in the sense that An is Fn1 -measurable,
n N, and
(iv) Mn = Nn + An , n N.
Hint: Let A0 = 0,
An+1 = An + IE[Mn+1 Mn | Fn ],
n 0,
and define (Nn )nN in such a way that it satisfies the four required properties.
2. Show that for all bounded stopping times and such that a.s.,
we have
IE[M ] IE[M ].
Hint: Use the stopping time Theorem 9.1 for martingales and (9.11).
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"
Am
1
2
C (t, x) + rx CdAm (t, x) + 2 x2 2 CdAm (t, x).
t d
x
2
x
Based on your answers to Question 1, how would you set the boundary
conditions CdAm (t, K), 0 t < T , and CdAm (T, x), 0 x < K ?
4. The price PdAm (t, St ) of an American digital put option is known to satisfy
the same Black-Scholes PDE
Am
1
2
P (t, x) + rx PdAm (t, x) + 2 x2 2 PdAm (t, x).
t d
x
2
x
(9.31)
Based on your answers to Question 2, how would you set the boundary
conditions PdAm (t, K), 0 t < T , and PdAm (T, x), x > K ?
5. Show that the optimal exercise strategy for the American digital call
option with strike K is to exercise as soon as the underlying reaches the
level K, at the time
rPdAm (t, x) =
K = inf{u t : Su = K},
starting from any level St K, and that the price CdAm (t, St ) of the
American digital call option is given by
CdAm (t, x) = IE[er(K t) 1{K <T } | St = x].
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N. Privault
6. Show that the price CdAm (t, St ) of the American digital call option is equal
to
x
(r + 2 /2) + log(x/K)
CdAm (t, x) =
K
x 2r/2 (r + 2 /2) + log(x/K)
+
,
0 x K,
K
where = T t. Show that this formula is consistent with your answer
to Question 3.
7. Show that the optimal exercise strategy for the American digital put
option with strike K is to exercise as soon as the underlying reaches the
level K, at the time
K = inf{u t : Su = K},
starting from any level St K, and that the price PdAm (t, St ) of the
American digital put option is
PdAm (t, x) = IE[er(K t) 1{K <T } | St = x],
x K.
8. Show that the price PdAm (t, St ) of the American digital put option is equal
to
(r + 2 /2) log(x/K)
x
PdAm (t, x) =
K
x 2r/2 (r + 2 /2) log(x/K)
,
x K,
K
and that this formula is consistent with your answer to Question 4.
9. Does the call-put parity hold for American digital options ?
Exercise 9.4 American forward contracts. Consider (St )tR+ an asset price
process given by
dSt
= rdt + dBt ,
St
where (Bt )tR+ is a standard Brownian motion.
1. Compute the price
f (t, St ) =
sup
t T
stopping time
i
h
IE er( t) (K S )St ,
"
sup
t T
stopping time
i
h
IE er( t) (S K)St ,
St = S0 ert+Bt
t/2
t R+ ,
Yt := ert St
and Zt := ert St ,
t R+ ,
rL
x/L,
IE e
| S0 = x =
2
(x/L)2r/ ,
0 < x L,
x L.
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+ p
(( S ) ) =
( S )p if S ,
if S > ,
t/2
t R+ ,
where (Bt )tR+ is a standard Brownian motion under the risk-neutral probability measure P , r 0 is the risk-free interest rate, and > 0 is the
volatility coefficient.
Given L (0, ) a fixed price, consider the following choices for the exercise
of a put option with strike :
(a) If St L, then exercise at time t.
(b) Otherwise, wait until the first hitting time L := inf{u t : Su = L},
and exercise the option at time L .
1. Under the above strategy, what is the option payoff equal to if St L ?
2. Show that in case St > L, the price of the option is equal to
i
h
fL (St ) = ( L)p IE er(L t) St .
3. Compute the price fL (St ) of the option at time t.
2r/ 2
Exercise 9.7 Same questions as in Exercise 9.6 for the option with payoff
(S )p when exercised at time , with p > 0.
Exercise 9.8 (cf. Exercise 8.5 page 372 of [71]). Consider an underlying asset
price process written as
St = S0 e(ra)t+Bt
t/2
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t R+ ,
"
St
S0
e(ra)t+
t/22 2 t/2
t R+ ,
is a martingale under P .
2. Let L denote the hitting time
L = inf{u R+ : Su L}.
By application of the stopping time theorem to the martingale (Zt )tR+ ,
show that
S0
,
(9.32)
IE erL =
L
with
=
(r a 2 /2)
(r a 2 /2)2 + 4r 2 /2
.
2
(9.33)
K x,
0 < x L,
=
2 /2)2 +4r 2 /2
(ra2 /2) (ra
2
(K L) x
, x L.
L
4. Show that the value L of L that maximizes
h
i
fL (x) := IE erL (K SL )+ S0 = x
for all x is given by
L =
5. Show that
fL (x) =
"
K x,
K.
1
0 < x L =
K,
1
1
1
x
, x L =
K,
1
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N. Privault
6. Show by hand computation that fL (x) satisfies the variational
tial equation
fL (x) (K x)+ ,
1 2 2 00
(f (x) (K x)+ ) = 0.
differen-
(9.34a)
(9.34b)
(9.34c)
sup
stopping time
i
h
IE er (K S )+ S0 .
s R+ ,
sup
stopping time
IE er (K S )+ .
K,
K St ,
0 < St
=
1
St
,
St
K,
1
where is given by (9.33), and
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"
and
t R+ ,
(9.36)
is a martingale.
2. For some fixed L 1, consider the hitting time
L = inf{t R+ : S1 (t) LS2 (t)},
and show that
IE[erL (S1 (L ) S2 (L ))+ ] = (L 1) IE[erL S2 (L )].
3. By an application of the stopping time theorem to the martingale (9.36),
show that we have
IE[erL (S1 (L ) S2 (L ))+ ] =
L1
S1 (0) S2 (0)1 .
L
L 1
S1 (0) S2 (0)1 ,
(L )
where
.
1
5. As an application of Question 4, compute the perpetual American put
option price
sup
IE[er ( S2 ( ))+ ]
L =
stopping time
when r = 22 /2.
"
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Chapter 10
Change of Num
eraire and Forward
Measures
In this chapter we introduce the notion of numeraire. This allows us to consider pricing under random discount rates using forward measures, with the
pricing of exchange options (Margrabe formula) and foreign exchange options (Garman-Kohlagen formula) as main applications. A short introduction to the computation of self-financing hedging strategies under change of
numeraire is also given in Section 10.5. The change of numeraire technique
and associated forward measures will also be applied to the pricing of bonds
and interest rate derivatives such as bond options in Chapter 12.
t R+ .
N. Privault
- the money market account
Nt = exp
w
t
0
rs ds ,
rt
St
St =
= e 0 rs ds St ,
Nt
t R+ ,
St
,
St =
Rt
t R+ ,
represents the price of the asset in units of the foreign currency. For example, if Rt = 1.7 is the exchange rate from Euro to Singapore dollar and
St = S$1, then St = St /Rt =e 0.59.
- forward numeraire: the price
i
h rT
P (t, T ) = IE e t rs ds Ft ,
0 t T,
n
X
k=1
where P (t, T1 ), . . . , P (t, Tn ) are bond prices with maturities T1 < < Tn
arranged according to a tenor structure.
- rcombinations of the above, for example a foreign money market account
t f
e 0 rs ds Rt , expressed in local (or domestic) currency, where (rtf )tR+ rep-
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"
t R+ ,
is a martingale.
In the next section we will see that this property can be extended to any
kind of numeraire.
dP
NT
= e 0 rs ds
.
(10.1)
dP
N0
Recall that from Section 6.3 the above relation rewrites as
= e
dP
"
rT
0
rs ds NT
N0
dP ,
271
N. Privault
which is equivalent to stating that
w
()dP()
=
rT
0
rs ds NT
N0
dP ,
rt
0
rs ds
Nt
(10.2)
IE[F
| Ft ] = IE F e t rs ds
0 t T.
Ft ,
Nt
Note that (10.2) should not be confused with (10.3).
Lemma 10.1. We have
|F
rT
dP
NT
t
,
= e t rs ds
dP|Ft
Nt
0 t T.
(10.3)
Proof. The proof of (10.3) relies on the abstract version of the Bayes formula.
we start by noting that for all integrable Ft -measurable random variable G
we have
t ]] = IE[
t ]]
IE[
|F
IE[G
|F
IE[G
]
= IE[G
r
0T rs ds NT
= IE Ge
N0
Nt r t rs ds r T rs ds NT
= IE G e 0
IE e t
Ft
N0
Nt
rT
N
T
r
ds
t s
G IE e
= IE
Ft ,
Nt
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"
rt
0
rs ds
(10.4)
FT ).
provided /NT L1 (P,
Ft = Nt IE dP|Ft Ft
Nt IE
NT
NT dP|Ft
i
h rT
= IE e t rs ds Ft ,
0 t T.
Next we consider further examples of numeraires and associated examples of
option prices.
Examples:
"
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N. Privault
rt
0 t T,
rT
dP
P (T, T )
e 0 rs ds
= e 0 rs ds
=
dP
P (0, T )
P (0, T )
(10.6)
by (10.1).
c) Annuity numeraire of the form
Nt =
n
X
k=1
where P (t, T1 ), . . . , P (t, Tn ) are bond prices with maturities T1 < <
Tn . Here, (10.4) shows that
i
h rT
IE e t rs ds (P (T, Tn ) P (T, T1 ) NT )+ Ft
"
+ #
P (T, Tn ) P (T, T1 )
= Nt IE
Ft ,
NT
0 t T , where (P (T, Tn ) P (T, T1 ))/NT is a swap rate.
In the sequel, given (Xt )tR+ an asset price process, we define the process of
forward prices
t := Xt ,
X
0 t T,
(10.7)
Nt
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"
under P.
Proof. We need to show that
Xt Fs = Xs ,
IE
Nt
Ns
0 s t,
(10.8)
and we achieve this using a standard characterization of conditional expectation. Namely, for all bounded Fs -measurable random variables G we note
that under Assumption (A) we have
"
#
Xt
Xt dP
IE G
= IE G
Nt
Nt dP
"
##
"
Xt dP
IE
F
= IE G
t
Nt
dP
rt
Xt
= IE Ge 0 ru du
N0
rs
Xs
= IE Ge 0 ru du
N0
X
s
G
= IE
,
0 s t,
Ns
because
t 7 e
rt
0
rs ds
Xt
0 s t,
Next we will rephrase Proposition 10.2 in Proposition 10.3 using the Girsanov
theorem, which briefly recalled below.
"
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N. Privault
Girsanov theorem
Recall that letting
"
t = IE
#
dP
F
,
t
dP
t [0, T ],
t )tR defined by
the Girsanov theorem,1 shows that the process (W
+
t = dWt
dW
1
dt dWt ,
t
t R+ ,
(10.9)
Ft
0 t T,
t
dNt ,
Nt
1
dNt dWt ,
Nt
t R+ .
(10.10)
and
dNt = rt Nt dt + tN Nt dWt ,
(10.11)
where (tX )tR+ and (tN )tR+ are Ft -adapted volatility processes. Then we
have
t = (tX tN )X
t dW
t.
dX
(10.12)
1
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"
1
dNt dWt = dWt tN dt,
Nt
t R+ ,
dt + Xt
dt
Nt2 t t
Nt3
Xt N
Xt X N
| N |2
Xt X
dWt
dWt
dt + Xt t dt
=
Nt t
Nt t
Nt t t
Nt
Xt X
N
X N
N 2
=
dWt t dWt t t dt + |t | dt
Nt t
0
Nt
dP
0 t T,
(10.13)
w
t
N0
exp
rs ds ,
0
Nt
0 t T,
is an Ft -martingale under P.
Proof. For all bounded and Ft -measurable random variables F we have,
"
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N. Privault
F dP = IE [F ]
IE
dP
Nt
= IE F
Nt
w
T
NT
= IE F
exp
rs ds
t
Nt
w
t
N0
= IE F
exp
rs ds .
0
Nt
By Itos calculus and (10.11) we also have
1
1
1
= 2 dNt + 3 (dNt )2
d
Nt
Nt
Nt
1
| N |2
(rt Nt dt + tN Nt dWt ) + t dt
Nt2
Nt
N 2
1
N
N
t + t dt)) + |t | dt
= 2 (rt Nt dt + t Nt (dW
Nt
Nt
1
t ),
= (rt dt + tN dW
Nt
=
and
d
w
w
t
t
1
1
t,
exp
rs ds
=
exp
rs ds tN dW
0
0
Nt
Nt
which recovers the second part of Proposition 10.4, i.e. the martingale property of
w
t
1
exp
rs ds
t 7
0
Nt
under P.
"
In other words, the foreign money market account etr is valued etr Rt on
the local (or domestic) market, and its discounted value on the local market
is
f
etr+tr Rt ,
t R+ .
f
Nt := etr Rt ,
t R+ ,
(10.14)
Next we find a characterization of this arbitrage condition under the parameters of the model.
Proposition 10.5. Assume that the foreign exchange rate Rt satisfies a
stochastic differential equation of the form
dRt = Rt dt + Rt dWt ,
(10.15)
where (Wt )tR+ is a standard Brownian motion under P . Under the absence
of arbitrage Assumption (A) for the numeraire (10.14), we have
= r rf ,
(10.16)
(10.17)
under P .
Proof. The equation (10.15) has solution
Rt = R0 et+Wt
"
t/2
t R+ ,
279
N. Privault
f
hence the discounted value of the foreign money market account etr on the
local market is
f
etr+tr Rt = R0 et(r
r+)+Wt 2 t/2
t R+ .
et(rr
Rt
Xt
Nt
1 t(rrf )tWt +2 t/2
=
e
R0
1 t(rrf )tW
t 2 t/2
=
e
,
R0
=
(10.18)
where
1
dNt dWt
Nt
1
= dWt
dRt dWt
Rt
= dWt dt,
t R+ ,
t = dWt
dW
"
1
Rt
1
1
(Rt dt + Rt dWt ) + 3 2 Rt2 dt
Rt2
Rt
1
= ( 2 ) dt
dWt
Rt
Rt
d Wt
= dt
Rt
Rt
1
= (rf r) dt
dWt ,
Rt
Rt
=
(t, x) =
T t
T t
dNt = d(etr Rt )
f
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N. Privault
= rNt dt + Nt dWt .
Hence a standard application of the Black-Scholes formula yields
f
= eT r
Nt
log(Nt eT r /) + (r + 2 /2)(T t)
T t
!!
f
log(Nt eT r /) + (r 2 /2)(T t)
T t
log(Rt /) + (T t)(r rf + 2 /2)
T r f
=e
Nt
T t
log(Rt /) + (T t)(r rf 2 /2)
T r f (T t)r
T t
eT r
(T t)r
Similarly, from (10.19) rewritten as
rt
e
ert
ert
d
= rf
dt dW
t,
Rt
Rt
Rt
as a
a foreign exchange option with payoff (1/RT )+ can be priced under P
put option in a Black-Scholes model by taking ert /Rt as underlying price, rf
as risk-free interest rate, and as volatility parameter. In this framework
the Black-Scholes formula (5.12) yields
"
+ #
1
(T t)r f
(10.20)
e
IE
Rt
RT
"
#
+
f
erT
+ (t, x) =
and
(t, x) =
T t
T t
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.
"
Let Nt = etr Rt , where Rt is an exchange rate with respect to a foreign currency and rf is the foreign market interest rate.
From Proposition 10.1 and (10.4) we have
"
"
+ #
+ #
1
1
1
(T t)r
RT
RT
e
IE
Rt = Nt IE T rf
Rt ,
e RT
and this yields the call/put duality
"
"
+ #
+ #
1
1
(T t)r f
(T t)r f
IE
IE
RT
e
Rt = e
Rt
RT
RT
"
#
+
f
= etr IE
RT
Rt
f
T
r
e RT
"
+ #
1
trf (T t)r
RT
=
e
IE
Rt
Nt
"
+ #
(T t)r
1
=
RT
e
IE
(10.22)
Rt ,
Rt
between a call option with strike and a (possibly fractional) quantity /Rt
of put option(s) with strike 1/.
In the Black-Scholes case the duality (10.22) can be directly checked by
verifying that (10.20) coincides with
"
+ #
1
(T t)r
e
IE
RT
Rt
Rt
!+
f
(T t)r T rf eT r
T rf
=
e
e
IE
e RT
Rt
Rt
!+
f
(T t)r T rf eT r
=
e
e
IE
NT
Rt
Rt
f
e(T t)r p
=
(t, Rt ) e(T t)r Rt p+ (t, Rt )
Rt
"
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N. Privault
f
e(T t)r p
(t, Rt ) e(T t)r p+ (t, Rt )
Rt
f
er(T t)
1
1
=
+ t,
e(T t)r t,
,
Rt
Rt
Rt
where
and
log(x) + (T t)(r rf t2 /2)
p (t, x) =
,
T t
log(x) + (T t)(r rf + 2 /2)
.
p+ (t, x) =
T t
t R+ ,
(10.23)
and (
t )tR is a standard Brownian motion under P
where (W
t )tR+ is
+
an Ft -adapted process. The following lemma is a consequence of the Markov
t )tR and leads to the Margrabe formula of Propoproperty of the process (X
+
sition 10.8 below.
t )tR has the dynamics
Lemma 10.2. Assume that (X
+
t =
t )dW
t,
dX
t (X
(10.24)
where x 7
t (x) is a Lipschitz function, uniformly in t R+ . Then the
T ) is priced at time t as
option with payoff = NT g(X
i
i
h
h r
X
t ) = Nt IE
g(X
T ) Ft = IE e tT rs ds NT g(X
T ) Ft , (10.25)
Nt C(t,
x) on R+ R+ .
for some (measurable) function C(t,
The next proposition states the Margrabe [51] formula for the pricing of
exchange options by the zero interest rate Black-Scholes formula. It will be
applied in particular in Proposition 12.2 below for the pricing of bond options.
t) =
t , i.e.
Proposition 10.8. (Margrabe formula). Assume that
t (X
(t)X
with de t )t[0,T ] is a geometric Brownian motion under P
the martingale (X
terministic volatility (
(t))t[0,T ] . Then we have
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"
i
h rT
+
t ) Nt 0 (t, X
t ),
IE e t rs ds (XT NT ) Ft = Xt 0+ (t, X
(10.26)
t [0, T ], where
log(x/) v(t, T )
0+ (t, x) =
+
,
v(t, T )
2
and
v 2 (t, T ) =
0 (t, x) =
wT
t
log(x/) v(t, T )
v(t, T )
2
2 (s)ds.
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N. Privault
e
rT
t
i
h
+
IE (XT ) Ft
rT
rT
rT
= Xt 0+ t, e t r(s)ds Xt e t r(s)ds 0 t, e t r(s)ds Xt ,
r(s)ds
0 t T.
+
t,
= IE
t dX
(10.27)
0
NT
NT
t )t[0,T ] is given by (10.23) and (t )t[0,T ] is a square-integrable
where (X
from which it follows that the forward claim price
adapted process under P,
Ft ,
Vt := IE
0 t T,
NT
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"
0 t T.
(10.28)
The next proposition extends the argument of [39] to the general framework of pricing using change of numeraire. Note that this result differs
from
rt
the standard formula that uses the money market account Bt = e 0 rs ds for
hedging instead of Nt , cf. e.g. [28] pages 453-454. The notion of self-financing
portfolio is similar to that of Definition 5.1.
t t , 0 t T , the portfolio
Proposition 10.9. Letting t = Vt X
(t , t )t[0,T ] with value
Vt = t Xt + t Nt ,
0 t T,
0 t T.
(10.29)
Proof. In order to check that the portfolio (t , t )t[0,T ] hedges the claim
it suffices to check that (10.29) holds since by (10.4) the price Vt at time
t [0, T ] of the hedging portfolio satisfies
i
h rT
Vt = Nt Vt = IE e t rs ds Ft ,
0 t T.
Next, we show that the portfolio (t , t )t[0,T ] is self-financing. By numeraire
invariance, cf. e.g. page 184 of [63], we have
dVt = d(Nt Vt )
= Vt dNt + Nt dVt + dNt dVt
t + t dNt dX
t
= Vt dNt + Nt t dX
t dNt + Nt t dX
t + t dNt dX
t + (Vt t X
t )dNt
= t X
t ) + (Vt t X
t )dNt
= t d(Nt X
= t dXt + t dNt .
We now consider an application to the forward Delta hedging of European
T ) where g : R R and (X
t )tR has the
type options with payoff = g(X
+
Markov property as in (10.24), where
: R+ R. Assuming that the function
C(t, x) defined by
"
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N. Privault
i
h
X
t)
g(X
T ) Ft = C(t,
Vt := IE
is C 2 on R+ , we have the following corollary of Proposition 10.9.
X
t) X
t C (t, X
t ), 0 t T , the
Corollary 10.1. Letting t = C(t,
x
!
C
t ), t
portfolio
(t, X
with value
x
t[0,T ]
Vt = t Nt + Xt
C
t ),
(t, X
x
t R+ ,
T ).
is self-financing and hedges the claim = NT g(X
Proof. This result follows directly from Proposition 10.9 by noting that
the stochastic
by Itos formula, and the martingale property of Vt under P
integral representation (10.28) is given by
C
t ),
t =
(t, X
x
0 t T.
+
t (X
(t)X
where (
(t))t[0,T ] is a deterministic function, we have the following corollary
on the hedging of exchange options based on the Margrabe formula (10.26).
Corollary 10.2. The decomposition
i
h rT
+
t ) Nt 0 (t, X
t)
IE e t rs ds (XT NT ) Ft = Xt 0+ (t, X
t ), 0 (t, X
t ))t[0,T ] in (Xt , Nt )
yields a self-financing portfolio (0+ (t, X
+
that hedges the claim = (XT NT ) .
Proof. We apply Corollary 10.1 and the classical relation
C
(t, x) = 0+ (t, x),
x
x R,
Note that the Delta hedging method requires the computation of the func x) and that of the associated finite differences, and may not apply
tion C(t,
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"
rt
in (Xt , e
r(s)ds
Exercises
t/2
t R+ ,
t/2
t R+ .
denote the forward measure relative to the numeraire (Nt )tR , under
Let P
+
t := Xt /Nt of forward prices is known to be a martingale.
which the process X
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N. Privault
1. Using the Ito formula, compute
t = d(Xt /Nt ) = (X0 /N0 )d e()Bt (2 2 )t/2 .
dX
2. Explain why the exchange option price IE[(XT NT )+ ] at time 0 has
the Black-Scholes form
IE[(XT NT )+ ]
!
0 /)
log(X
T
= X0
+
N0
2
(10.30)
!
0 /)
log(X
T
.
2
Hints:
(i) Use the change of numeraire identity
X
T )+ ].
IE[(XT NT )+ ] = N0 IE[(
dP (t, S)
= rt dt + tS dWt ,
P (t, S)
0 t T.
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"
wT
t
4. Compute the self-financing hedging strategy that hedges the bond option
using a portfolio based on the assets P (t, T ) and P (t, S).
Exercise 10.3 Consider two risky assets S1 and S2 modeled by the geometric
Brownian motions
S1 (t) = e1 Wt +t
S2 (t) = e2 Wt +t ,
and
t R+ ,
(10.32)
t R+ .
rt
dP
NT
= erT
.
dP
N0
Recall that
t := Wt 2 t
W
1 (T ) S2 (T ))+ /NT ],
erT IE[(S1 (T ) S2 (T ))+ ] = N0 IE[(S
compute the price
erT IE[(S1 (T ) S2 (T ))+ ].
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N. Privault
of the exchange option on the assets S1 and S2 .
Exercise 10.4 Extension of Proposition 10.3 to correlated Brownian motions.
Assume that (St )tR+ and (Nt )tR+ satisfy the stochastic differential equations
dSt = rt St dt + tS St dWtS ,
1 2 Wt ,
t R+ ,
p
1 2 W t ,
t R+ ,
"
er(T t) IE
Ft
RT
at time t of a quanto option.
"
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Chapter 11
This chapter is concerned with interest rate modeling, in which the mean
reversion property plays an important role. We consider the main short rate
models (Vasicek, CIR, CEV, affine models) and the computation of bond
prices in such models. Next we consider the modeling of forward rates in the
HJM and BGM models, as well as in two-factor models.
(11.1)
t R+ .
(11.2)
The law of rt is Gaussian at all times t, with mean r0 ebt + ab (1 ebt ) and
variance
2
wt
0
(eb(ts) )2 ds = 2
wt
0
e2bs ds =
2
(1 e2bt ),
2b
t R+ .
N. Privault
tribution when b > 0, however its drawback is to allow for negative values of
rt .
Figure 11.1 presents a random simulation of t 7 rt in the Vasicek model
with r0 = a/b = 5%, i.e. the reverting property of the process is with respect
to its initial value r0 = 5%. Note that the interest rate in Figure 11.1 becomes
negative for a short period of time, which is unusual for interest rates but
may nevertheless happen.
0.07
0.065
0.06
0.055
0.05
0.045
0.04
0.035
0.03
0.025
10
15
20
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"
drt = (rt
/2
+ rt )dt + rt
dBt
Affine Models
The class of short rate interest rate models admits a number of generalizations
that can be found in the references quoted in the introduction of this chapter,
among which is the class of affine models of the form
p
(11.3)
drt = ((t) + (t)rt )dt + (t) + (t)rt dBt .
Such models are called affine because the associated zero-coupon bonds can
be priced using an affine PDE of the type (11.10) below, as will be seen after
Proposition 11.2.
They also include the Ho-Lee model
drt = (t)dt + dBt ,
where (t) is a deterministic function of time, and the Hull-White model
drt = ((t) (t)rt )dt + (t)dBt
which is a time-dependent extension of the Vasicek model.
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(rt )tR+ is a basic and important issue in interest rate modeling.
In case the short term interest rate process (rt )tR+ is a deterministic
function of time, a standard arbitrage argument shows that the price P (t, T )
of the bond is given by
P (t, T ) = e
rT
t
rs ds
0 t T.
(11.4)
0 t T,
In the sequel we will only consider zero-coupon bonds, and let P (t, T ) =
P0 (t, T ), 0 t T .
The following proposition shows that Assumption (A) of Chapter 10 is
satisfied, i.e. the bond price process t 7 P (t, T ) can be taken as a numeraire.
Proposition 11.1. The discounted bond price process
t 7 e
rt
rs ds
rt
rs ds
P (t, T )
is a martingale under P .
Proof. We have
e
rt
0
rs ds
i
h rT
IE e t rs ds Ft
i
h rt
rT
= IE e 0 rs ds e t rs ds Ft
i
h rT
= IE e 0 rs ds Ft
P (t, T ) = e
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(11.6)
xF (t, x) =
F
F
1
2F
(t, x) + (t, x)
(t, x) + 2 (t, x) 2 (t, x), (11.7)
t
x
2
x
F (T, x) = 1,
(11.8)
"
rt
0
rt
rs ds
rs ds
F (t, rt )dt + e
rt
rs ds
rt
rs ds F
dF (t, rt )
F (t, rt )dt + e 0
(t, rt )((t, rt )dt + (t, rt )dBt )
x
2
1 2
F
F
r ds
0 s
(t, rt ) 2 (t, rt )dt +
(t, rt )dt
2
x
t
0
rt
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N. Privault
rt
F
(t, rt )
(t, rt )dBt
x
rt
F
+e 0 rs ds rt F (t, rt ) + (t, rt )
(t, rt )
x
1
F
2F
+ 2 (t, rt ) 2 (t, rt ) +
(t, rt ) dt.
2
x
t
= e
rs ds
(11.9)
rt
F
1
2F
F
(t, rt ) + 2 (t, rt ) 2 (t, rt ) +
(t, rt ) = 0.
x
2
x
t
F
F
1
2F
(t, x) + ((t) + (t)x)
(t, x) + ((t) + (t)x) 2 (t, x),
t
x
2
x
(11.10)
t R+ , x R.
The above proposition also shows that t 7 e
stochastic differential equations
rt
0
rs ds
rt
rt
F
(t, rt )dBt .
d e 0 rs ds P (t, T ) = e 0 rs ds (t, rt )
x
Consequently we have
rt
rt
1
dP (t, T )
=
d e 0 rs ds e 0 rs ds P (t, T )
P (t, T )
P (t, T )
rt
rt
1
=
rt P (t, T )dt + e 0 rs ds d e 0 rs ds P (t, T )
P (t, T )
rt
rt
1
e 0 rs ds d e 0 rs ds P (t, T )
= rt dt +
P (t, T )
(t, rt ) F
= rt dt +
(t, rt )dBt
F (t, rt ) x
log F
= rt dt + (t, rt )
(t, rt )dBt .
(11.11)
x
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"
the bond price takes the form P (t, T ) = eA(T t)+C(T t)rt , cf. (11.14) below,
and by (11.11) we find
dP (t, T )
= rt dt (1 eb(T t) )dWt .
P (t, T )
b
(11.12)
Note that more generally, all affine short rate models as defined in Relation (11.3), including the Vasicek model, will yield a bond pricing formula of
the form
P (t, T ) = eA(T t)+C(T t)rt ,
cf. e.g. 3.2.4. of [8].
Probabilistic PDE Solution
Next we solve the PDE (11.7) by a direct computation of the conditional
expectation
i
h rT
(11.13)
P (t, T ) = IE e t rs ds Ft ,
in the Vasicek [74] model
drt = (a brt )dt + dBt ,
i.e. when the short rate (rt )tR+ has the expression
rt = g(t) +
wt
0
wt
a
h(t, s)dBs = r0 ebt + (1 ebt ) + eb(ts) dBs ,
0
b
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= e
g(s)ds
rtrT
0
h(s,u)dsdBu
i
h rT rT
IE e t u h(s,u)dsdBu
r
r
2
h(s,u)dsdBu 12 tT ( uT h(s,u)ds) du
e
r
r
t T b(su)
bs
e
dsdB
t (r0 ebs + a
(1e
))ds
u
b
0 t
e
e
r T r T b(su)
2
2
ds) du
e 2 t ( u e
rT
r
bs
bs
b(T t)
a
) 0t eb(tu) dBu
e t (r0 e + b (1e ))ds e b (1e
r T 2bu ebu ebT 2
2
e
du
2
b
t
= e
=
rT
rT
t
g(s)ds
rT
rt
bt
)+ 1b (1eb(T t) )(r0 ebt + a
))
b (1e
2
r
bu
T 2bu e
ebT
bs
2
(r0 ebs + a
(1e
))ds+
e
du
b
2
b
t
= e b (1e
rT
rtrT
b(T t)
(11.14)
1
C(T t) = (1 eb(T t) ),
b
and
A(T t) =
4ab 3 2 2 2ab
2 ab b(T t)
2
+
(T t) +
e
3 e2b(T t) .
4b3
2b2
b3
4b
2 2
A0 (s) = aC(s)
C (s)
2
C 0 (s) = bC(s) + 1,
which can be solved to recover the above value of P (t, T ).
"
10
15
20
106.00
104.00
102.00
100.00
10
15
20
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N. Privault
Fig. 11.4: Bond price graph with maturity 01/18/08 and coupon rate 6.25%.
(11.16)
where the volatility > 0 and the drift R are constant parameters and
(Bt )tR+ is a standard Brownian motion. In this model the short term interest rate rt remains always positive, while the proportional volatility term rt
accounts for the sensitivity of the volatility of interest rate changes to the
level of the rate rt .
On the other hand, the Dothan model is the only lognormal short rate
model that allows for an analytical formula for the zero coupon bond price
i
h rT
P (t, T ) = IE e t rs ds Ft ,
0 t T.
For convenience of notation we let p = 1 2/ 2 and rewrite (11.16) as
1
drt = (1 p) 2 rt dt + rt dBt ,
2
with solution
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"
t R+ ,
where p/2 identifies to the market price of risk. By the Markov property of
(rt )tR+ , the bond price P (t, T ) is a function F (, rt ) of rt and of the time
to maturity = T t:
i
h rT
0 t T.
(11.17)
P (t, T ) = F (, rt ) = IE e t rs ds rt ,
By computation of the conditional expectation (11.17) using (8.43) we easily
obtain the following result, cf. [56], where the function (v, t) is defined in
(8.42).
Proposition 11.3. The zero-coupon bond price P (t, T ) = F (T t, rt ) is
given for all p R by
!
ww
1 + z2
2 2
4z 2 du dz
F (, x) = e p /8
eux exp 2
,
,
2
2
0
0
u
u 4
u z p+1
(11.18)
x > 0.
Proof. By Proposition 8.8 and (8.43) we have
F (T t, rt ) = P (t, T )
w
T
= IE exp
rs ds Ft
t
wT
2
= IE exp rt
e(Bs Bt ) p(st)/2 ds Ft
(11.19)
t
w
ww
T t
2
=
ert u P
eBs p s/2 ds du, BT t dy
0
0
w
w
T t
2
=
ert u P
eBs p s/2 ds du
0
0
w
w
1 + z2
4z 2 (T t)
dz du
p2 2 (T t)/8
ert u
exp 2 2
=e
,
0
0
u
2 u
4
z p+1 u
where the exchange of integrals is justified by the Fubini theorem and the
non-negativity of integrands.
See [56] and [55] for more results on bond pricing in the Dothan model, and
[62] for numerical computations.
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N. Privault
noted by f (t, T, S), t T S, and called a forward rate.
Let us determine the arbitrage or fair value of this rate using the instruments available in a bond market, which are bonds priced at P (t, T ) for
various maturity dates T > t.
The loan can be realized using the bonds available on the market by proceeding in two steps:
1) at time t, borrow the amount P (t, S) by shortselling one unit of bond
with maturity S, which will mean refunding $1 at time S.
2) since one only needs the money at time T , it makes sense to invest
the amount P (t, S) over the period [t, T ] by buying a (possibly fractional)
quantity P (t, S)/P (t, T ) of a bond with maturity T priced P (t, T ) at time
t. This will yield the amount
$1
P (t, S)
P (t, T )
at time T .
As a consequence the investor will receive P (t, S)/P (t, T ) at time T , and will
refund $1 at time S.
The corresponding forward rate f (t, T, S) is then given by the relation
P (t, S)
exp ((S T )f (t, T, S)) = $1,
P (t, T )
0 t T S,
(11.20)
where we used exponential compounding, which leads to the following definition (11.21).
Definition 11.1. The forward rate f (t, T, S) at time t for a loan on [T, S]
is given by
f (t, T, S) =
(11.21)
log P (t, T )
,
T t
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0 t T,
(11.22)
"
TimeSerieNb
AsOfDate
2D
1W
1M
2M
3M
1Y
2Y
3Y
4Y
5Y
6Y
7Y
8Y
9Y
10Y
11Y
12Y
13Y
14Y
15Y
20Y
25Y
30Y
4.5
3.5
2.5
2
0
10
15
years
20
25
505
7mai03
2,55
2,53
2,56
2,52
2,48
2,34
2,49
2,79
3,07
3,31
3,52
3,71
3,88
4,02
4,14
4,23
4,33
4,4
4,47
4,54
4,74
4,83
4,86
30
log P (t, T )
=
T
1
P (t, T )
=
.
P (t, T ) T
= lim
S&T
(11.23)
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N. Privault
w
T
P (t, T ) = exp
f (t, s)ds ,
0 t T.
(11.24)
w T log P (t, s)
wT
ds =
f (t, s)ds.
t
t
s
1 wS
f (t, s)ds,
ST T
0 t T < S.
(11.25)
k=1
n1
X
k=1
(Tk+1 Tk )e
r Tk+1
t
rs ds
(f (t, Tk , Tk+1 ) ),
n1
X
k=1
n1
X
k=1
rT
k+1
rs ds
(Tk+1 Tk )(f (t, Tk , Tk+1 ) ) IE e t
Ft
(Tk+1 Tk )P (t, Tk+1 )(f (t, Tk , Tk+1 ) ).
The swap rate S(t, T1 , Tn ) is by definition the fair value of that cancels this
cash flow and achieves equilibrium, i.e. S(t, T1 , Tn ) satisfies
n1
X
k=1
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(11.26)
"
n1
X
1
(Tk+1 Tk )P (t, Tk+1 )f (t, Tk , Tk+1 ), (11.27)
P (t, T1 , Tn )
k=1
where
P (t, T1 , Tn ) =
n1
X
k=1
0 t T1 ,
LIBOR Rates
Recall that the forward rate f (t, T, S), 0 t T S, is defined using
exponential compounding, from the relation
f (t, T, S) =
(11.28)
In order to compute swaption prices one prefers to use forward rates as defined on the London InterBank Offered Rates (LIBOR) market instead of the
standard forward rates given by (11.28).
The forward LIBOR L(t, T, S) for a loan on [T, S] is defined using linear
compounding, i.e. by replacing (11.28) with the relation
1 + (S T )L(t, T, S) =
P (t, T )
,
P (t, S)
= lim
S&T
"
P (t, S) P (t, T )
(S T )P (t, S)
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N. Privault
1
P (t, T )
P (t, T ) T
log P (t, T )
=
T
=
as (11.23).
In addition, Relation (11.29) shows that the LIBOR rate can be viewed
t = Xt /Nt with numeraire Nt = (S T )P (t, S) and
as a forward price X
Xt = P (t, T ) P (t, S), according to Relation (10.7) of Chapter 10. As a
consequence, from Proposition 10.2, the LIBOR rate (L(t, T, S))t[T,S] is a
defined by
martingale under the forward measure P
rS
dP
1
=
e 0 rt dt .
dP
P (0, S)
P (t, T1 ) P (t, Tn )
,
P (t, T1 , Tn )
0 t T1 .
(11.30)
S(t, T1 , Tn ) =
k=1
n1
X
1
=
(P (t, Tk ) P (t, Tk+1 ))
P (t, T1 , Tn )
k=1
P (t, T1 ) P (t, Tn )
=
P (t, T1 , Tn )
by a telescoping summation.
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(11.31)
"
dP
P (T1 , T1 , Tn ) r0T1 rt dt
=
e
.
dP
P (0, T1 , Tn )
"
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N. Privault
Forward rate
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
20
15
10
0
10
x
5
15
20
(11.33)
where t 7 (t, T ) and t 7 (t, T ), 0 t T , are allowed to be random (adapted) processes. In the above equation, the date T is fixed and the
differential dt is with respect to t.
Under basic Markovianity assumptions, a HJM model with deterministic
coefficients (t, T ) and (t, T ) will yield a short rate process (rt )tR+ of the
form
drt = (a(t) b(t)rt )dt + (t)dBt ,
cf. 6.6 of [60], which is the [34] Hull-White model, cf. Section 11.1, with
explicit solution
w t rt
wt
rt
rt
rt = rs e s b( )d +
e u b( )d a(u)du +
(u)e u b( )d dBu ,
s
0 s t.
The HJM Condition
How to encode absence of arbitrage in the defining equation (11.33) is an
important question. Recall that under absence of arbitrage, the bond price
P (t, T ) has been defined as
w
T
P (t, T ) = IE exp
rs ds Ft ,
(11.34)
t
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"
(t, T ) = (t, T )
wT
t
t [0, T ],
(t, s)ds,
(11.36)
which is known as the HJM absence of arbitrage condition, the process (11.35)
becomes a martingale.
Proof. Consider the spot forward rate
f (t, t, T ) =
and let
wT
Xt =
1 wT
f (t, s)ds,
T t t
0 t T,
1 wT
Xt
f (t, s)ds =
,
T t t
T t
0 t T,
(11.37)
wT
t
wT
t
g(t)h(s)dsdt,
wT
t
wT
t
dt f (t, s)dsdt,
which can be seen as a form of the Leibniz integral rule. Therefore we have
dt Xt = f (t, t)dt +
"
wT
t
dt f (t, s)ds
313
N. Privault
wT
wT
= f (t, t)dt +
(t, s)dsdt +
(t, s)dsdBt
t
w
tw
T
T
= rt dt +
(t, s)ds dt +
(t, s)ds dBt ,
t
hence
|dt Xt |2 =
w
T
t
2
(t, s)ds dt.
1
+ eXt
2
w
2
(t, s)ds dt,
w
w
2
t
T
1
(t, s)ds dt
+ exp rs ds Xt
0
t
2
w
t
= rt exp rs ds Xt dt
0
w
wT
wT
t
exp rs ds Xt
rt dt +
(t, s)dsdt +
(t, s)dsdBt
0
w
w
2
t
T
1
+ exp rs ds Xt
(t, s)ds dt
0
t
2
w
w
t
T
(t, s)dsdBt
= exp rs ds Xt
0
w
w
2 !
T
t
1 wT
(t, s)dsdt
exp rs ds Xt
(t, s)ds
dt.
t
0
t
2
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"
(t, s)ds
1
2
w
T
t
2
(t, s)ds = 0,
0 t T.
(11.38)
wT
t
(t, s)ds,
+
(eb(St) eb(T t) ) 3 (e2b(St) e2b(T t) ) .
3
ST
b
b
4b
f (t, T, S) =
"
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N. Privault
0.01
f(t,T,S)
0.0095
0.009
0.0085
0.008
0.0075
0.007
0.0065
0.006
0.0055
0.005
10
f (t, T ) : =
and the relation limT &t f (t, T ) = rt is easily recovered from this formula.
The instantaneous forward rate t 7 f (t, T ) can be represented as in
Figure 11.8, with here t = 0 and b/a > r0 :
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"
f(t,T)
0.12
0.1
0.08
0.06
0.04
0.02
0
10
12
14
16
18
20
wT
t
i.e.
(t, T ) = 2 eb(T t)
wT
t
eb(ts) ds,
and
(t, T ) = eb(T t) ,
(11.40)
"
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rate %
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7
6
5
4
3
2
1
0
40
30
0
20
10
15
x
10
20
25
30
Fig. 11.9: Forward instantaneous curve (t, x) 7 f (t, t + x) in the Vasicek model.
8
7
6
rate %
5
4
3
2
1
0
0
10
15
20
25
30
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"
0.07
0.065
0.06
0.055
0.05
0.045
0.04
0.035
0.03
0
10
15
20
Fig. 11.11: Short term interest rate curve t 7 rt in the Vasicek model.
Another example of market data is given in the next Figure 11.12, in which
the red and blue curves refer respectively to July 21 and 22 of year 2011.
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x 0.
z1+(z2+xz3)exp(-xz4)
-2
-4
-6
-8
-10
0
0.2
0.4
0.6
0.8
x 0.
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"
5
x->z1+(z2+z3*x)*exp(-x*z4)+z5*x*exp(-z6*x)
4.5
3.5
2.5
2
0
10
15
lambda
20
25
30
4.5
3.5
2.5
Market data
Svensson curve
2
0
10
15
20
25
30
years
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For example it can be easily shown that the forward curves of the Vasicek
model are included neither in the Nelson-Siegel space, nor in the Svensson
space, cf. [60] and 3.5 of [5]. In addition, such curves do not appear to correctly model the market forward curves considered above, cf. e.g. Figure 11.5.
In the Vasicek model we have
2
2 b(T t) b(T t)
f
(t, T ) = brt + a
+
e
e
,
T
b
b
and one can check that the sign of the derivatives of f can only change once
at most. As a consequence, the possible forward curves in the Vasicek model
are limited to one change of regime per curve, as illustrated in Figure 11.16
for various values of rt , and in Figure 11.17.
0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0
0
10
15
20
0.09
0.08
0.07
0.06
0.05
0.04
0.03
0.02
0
2
20
4
x
15
10
5
10
Fig. 11.17: Forward instantaneous curve (t, x) 7 f (t, t + x) in the Vasicek model.
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0.9
0.8
0.7
0.6
0.5
0.4
P(t,T1)
P(t,T2)
P(t,T3)
0.3
0
10
15
20
25
30
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(1)
(11.42)
(2)
where (Bt )tR+ , (Bt )tR+ have correlated Brownian motion with
(2)
(1)
(2)
dBt dBt
s, t R+ ,
= dt,
(11.43)
(11.44)
(1)
(2)
for some [1, 1]. In practice, (B )tR+ and (B )tR+ can be constructed from two independent Brownian motions (W (1) )tR+ and (W (2) )tR+ ,
by letting
(1)
(1)
Bt = Wt ,
t R+ ,
and Relations (11.43) and (11.44) are easily satisfied from this construction.
In two-factor models one chooses to build the short term interest rate rt via
t R+ .
rt = Xt + Yt ,
= F (t, Xt , Yt ),
(11.45)
since the couple (Xt , Yt )tR+ is Markovian. Using the Ito formula with two
variables and the fact that
t 7 e
rt
0
rs ds
P (t, T ) = e
rt
0
rs ds
w
T
IE exp
rs ds Ft
t
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2F
F
(t, x, y) +
(t, Xt , Yt ) = 0,
xy
t
(11.46)
(1)
dY = bY dt + dB (2) ,
t
t
t
this yields
P (t, T ) = F1 (t, Xt )F2 (t, Yt ) exp (U (t, T )) ,
(11.47)
where F1 (t, Xt ) and F2 (t, Yt ) are the bond prices associated to Xt and Yt in
the Vasicek model, and
ea(T t) 1 eb(T t) 1 e(a+b)(T t) 1
T t+
+
U (t, T ) =
ab
a
b
a+b
(1)
(2)
is a correlation term which vanishes when (Bt )tR+ and (Bt )tR+ are independent, i.e. when = 0, cf [8], Chapter 4, Appendix A, and [60]. [8].
Partial differentiation of log P (t, T ) with respect to T leads to the instantaneous forward rate
f (t, T ) = f1 (t, T ) + f2 (t, T )
(11.48)
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0.24
0.23
0.22
0.21
0.2
0.19
0.18
0
10
15
20
T
25
30
35
40
0.24
0.235
0.23
0.225
0.22
0.215
1.4
1.2
1
0.8
t
0.6
0.4
0.2
0 0
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(11.49)
w
T1
1 (s)dBs(2)
1 w T1
|1 |2 (s)ds .
2 t
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Bond price
P (t, T ) = e(T t)f(t,t,T )
2
Bond price
rT
P (t, T ) = E[e t rs ds | Ft ]
Short rate1 rt
LIBOR rate3
(t,T )P (t,S)
L(t, T, S) = P(ST
)P (t,S)
Forward rate3
)log P (t,S)
f(t, T, S) = log P (t,TST
Bond price
rT
P (t, T ) = e t f(t,s)ds
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Exercises
t R+ ,
Exercise 11.2 Let (Bt )tR+ denote a standard Brownian motion started at
0 under the risk-neutral measure P . We consider a short term interest rate
process (rt )tR+ in a Ho-Lee model with constant deterministic volatility,
defined by
drt = adt + dBt ,
where a > 0 and > 0. Let P (t, T ) will denote the arbitrage price of a
zero-coupon bond in this model:
w
T
P (t, T ) = IE exp
rs ds Ft ,
0 t T.
(11.50)
t
1. State the bond pricing PDE satisfied by the function F (t, x) defined via
w
T
F (t, x) := IE exp
rs ds rt = x ,
0 t T.
t
2. Compute the arbitrage price F (t, rt ) = P (t, T ) from its expression (11.50)
as a conditional expectation.
Hint. One may use the integration by parts relation
wT
t
Bs ds = T BT tBt
wT
t
sdBs
wT
= (T t)Bt + T (BT Bt )
sdBs
t
wT
= (T t)Bt +
(T s)dBs ,
t
2 2
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6. Derive the stochastic equation satisfied by the instantaneous forward rate
f (t, T ).
7. Check that the HJM absence of arbitrage condition is satisfied in this
equation.
Exercise 11.3 Given (Bt )tR+ a standard Brownian motion, consider a HJM
model given by
dt f (t, T ) =
2
T (T 2 t2 )dt + T dBt .
2
(11.51)
0 t T,
(11.52)
wt
0
sT ds,
0 t T,
rt
0
rs ds
P (t, T ),
0 t T,
"
0 t T.
4. Show that
i
h rT
P (t, T ) = IE e t rs ds Ft ,
0 t T.
t [0, T ],
where > 0.
1. Show that the terminal condition P (T, T ) = 1 is satisfied.
2. Compute the forward rate
f (t, T, S) =
1
(log P (t, S) log P (t, T )).
ST
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f (t, T ) = lim
S&T
1
(log P (t, S) log P (t, T )).
ST
4. Show that the limit lim f (t, T ) does not exist in L2 ().
T &t
t [0, T ].
that
i
Ft ,
0 t T,
0 t T,
where
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2(ex 1)
,
2 + ( + )(ex 1)
p
2 + 2 2 .
Exercise 11.7 Let (rt )tR+ denote a short term interest rate process. For any
T > 0, let P (t, T ) denote the price at time t [0, T ] of a zero coupon bond
defined by the stochastic differential equation
dP (t, T )
= rt dt + tT dBt ,
P (t, T )
0 t T,
wt
0
sT ds,
0 t T,
rt
0
rs ds
P (t, T ),
0 t T,
0 t T.
4. Show that
i
h rT
P (t, T ) = IE e t rs ds Ft ,
0 t T.
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N. Privault
of a bond option with strike .
Recall that if X is a centered Gaussian random variable with mean mt
and variance vt2 given Ft , we have
2
vt
1
IE[(eX K)+ | Ft ] = emt +vt /2
+ (mt + vt2 /2 log K)
2
vt
vt
1
K + (mt + vt2 /2 log K)
2
vt
where (x), x R, denotes the Gaussian distribution function.
Exercise 11.8 (Exercise 11.5 continued).
1. Compute the forward rate
f (t, T, S) =
1
(log P (t, S) log P (t, T )).
ST
S&T
1
(log P (t, S) log P (t, T )).
ST
3. Show that the limit lim f (t, T ) does not exist in L2 ().
T &t
t [0, T ].
0 t T,
"
"
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Chapter 12
In this chapter we consider the pricing of caplets, caps, and swaptions, using
change of numeraire and forward swap measures.
1W
2.53
9Y
4.02
1M
2.56
10Y
4.14
2M
2.52
11Y
4.23
3M
2.48
12Y
4.33
1Y
2.34
13Y
4.40
2Y
2.49
14Y
4.47
3Y
2.79
15Y
4.54
4Y
3.07
20Y
4.74
5Y
3.31
25Y
4.83
6Y 7Y
3.52 3.71
30Y
4.86
rt
0
rs ds
P (t, Ti ),
0 t Ti ,
i = 1, . . . , n,
"
N. Privault
r Ti
i
dP
1
=
e 0 rs ds
dP
P (0, Ti )
(12.1)
P (t, Tj )
,
P (t, Ti )
0 t min(Ti , Tj ),
(12.3)
wt
0
i (s)ds,
0 t Ti ,
(12.4)
ti = dWt i (t)dt, ,
dW
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"
tj = dW
ti (j (t) i (t))dt.
dW
i is given by
Hence the dynamics of t 7 P (t, Ti ) under P
dP (t, Ti )
ti ,
= rt dt + |i (t)|2 dt + t dW
P (t, Ti )
(12.5)
i.
ti )tR is a standard Brownian motion under P
where (W
+
j , since we have
ti )tR has drift (j (t) i (t))tR under P
Note that (W
+
+
i = dWt i (t)dt = dW
tj + (j (t) i (t))dt.
dW
t
In case the short rate process (rt )tR+ is Markovian and solution of
drt = (t, rt )dt + (t, rt )dWt ,
i by
its dynamics will be given under P
i.
drt = (t, rt )dt + (t, rt )i (t)dt + (t, rt )dW
t
(12.6)
i (t) = (1 eb(Ti t) ),
b
by (11.12), hence from (12.6) we have
drt = (a brt )dt
0 t Ti ,
2
ti
(1 eb(Ti t) )dt + dW
b
(12.7)
and we obtain
dP (t, Ti )
2
ti ,
= rt dt + 2 (1 eb(Ti t) )2 dt (1 eb(Ti t) )dW
P (t, Ti )
b
b
from (11.12).
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t = Xt /Nt = P (t, Tj )/P (t, Ti ). In the Vasicek model, this formula has
and X
been first obtained in [38].
Proposition 12.2. Assume that the dynamics of the bond prices P (t, Ti ),
P (t, Tj ) are given by
dP (t, Ti )
= rt dt + i (t)dWt ,
P (t, Ti )
dP (t, Tj )
= rt dt + j (t)dWt ,
P (t, Tj )
i
h r Ti
IE e t rs ds (P (Ti , Tj ) )+ Ft
v
1
P (t, Tj )
v
1
P (t, Tj )
= P (t, Tj )
+ log
P (t, Ti ) + log
,
2 v
P (t, Ti )
2 v
P (t, Ti )
with
v2 =
wT
t
"
i
priced at time t [0, T ] from Proposition 10.4 using the forward measure P
as
i
h r Ti
i (f (T, T, Ti ) )+ | Ft ,
IE e t rs ds (f (T, T, Ti ) )+ Ft = P (t, Ti )IE
(12.8)
1
Ti+1 Ti
P (t, Ti )
1 ,
P (t, Ti+1 )
0 t Ti < Ti+1 ,
i
h r Ti+1
rs ds
IE e t
(L(Ti , Ti , Ti+1 ) )+ Ft
(12.9)
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d+ =
,
i (t) Ti t
d =
,
i (t) Ti t
and
and
|i (t)|2 =
1 w Ti
|i |2 (s)ds.
Ti t t
t [0, Ti ], where
BS(, x, , r, ) = x(d+ ) er (d )
is the Black-Scholes function with
|i (t)|2 =
1 w Ti
|i |2 (s)ds,
Ti t t
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"
Cap Pricing
More generally one can consider caps that are relative to a given tenor structure {T1 , . . . , Tn }, with discounted payoff
n1
X
k=1
(Tk+1 Tk )e
r Tk+1
t
rs ds
(f (Tk , Tk , Tk+1 ) )+ .
Pricing formulas for caps are easily deduced from analog formulas for caplets,
since the payoff of a cap can be decomposed into a sum of caplet payoffs. Thus
the price of a cap at time t [0, T1 ] is given by
"n1
#
rT
X
t k+1 rs ds
+
IE
(Tk+1 Tk )e
(f (Tk , Tk , Tk+1 ) ) Ft
k=1
n1
X
k=1
rT
k+1
rs ds
(Tk+1 Tk ) IE e t
(f (Tk , Tk , Tk+1 ) )+ Ft
n1
X
k=1
i
h
k+1 (f (Tk , Tk , Tk+1 ) )+ Ft .
(Tk+1 Tk )P (t, Tk+1 )IE
"
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j1
X
(Tk+1 Tk )P (t, Tk+1 ),
0 t Ti ,
k=i
(12.10)
with in particular
P (t, Ti , Ti+1 ) = (Ti+1 Ti )P (t, Ti+1 ),
0 t Ti .
rt
0
rs ds
P (t, Ti , Tj ) = e
rt
0
rs ds
j1
X
k=i
0 t Ti ,
is a martingale under P.
i,j is defined by
The forward swap measure P
r Ti
i,j
dP
P (Ti , Ti , Tj )
= e 0 rs ds
,
dP
P (0, Ti , Tj )
(12.11)
1 i < j n. We have
"
#
i
h r Ti
i,j
dP
1
IE
IE e 0 rs ds P (Ti , Ti , Tj ) Ft
Ft =
dP
P (0, Ti , Tj )
=
P (t, Ti , Tj ) r t rs ds
e 0
,
P (0, Ti , Tj )
0 t Ti+1 ,
(12.12)
P (t, Tk )
P (t, Ti , Tj )
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"
P (t, Ti ) P (t, Tj )
= vii,j (t) vji,j (t),
P (t, Ti , Tj )
0 t Ti ,
i,j .
defined in Proposition 11.5 is also a martingale under P
Using the forward swap measure we obtain the following pricing formula
for a given integrable claim with payoff of the form P (Ti , Ti , Tj )F :
#
"
i
h r Ti
i,j|F
dP
t
t rs ds
IE e
P (Ti , Ti , Tj )F Ft = P (t, Ti , Tj ) IE F
Ft
dP|Ft
h i
i,j F Ft ,
= P (t, Ti , Tj )IE
(12.13)
after applying (12.11) and (12.12) on the last line, or Proposition 10.1.
at time Ti .
as
IE e
r Ti
t
rs ds
!+
j1
rT
X
T k+1 rs ds
i
(Tk+1 Tk )e
(f (Ti , Tk , Tk+1 ) )
Ft .
k=i
(12.14)
In the sequel and in practice the price (12.14) of the swaption will be evaluated as
!+
j1
r Ti
X
IE e t rs ds
(Tk+1 Tk )P (Ti , Tk+1 )(f (Ti , Tk , Tk+1 ) )
F
t ,
k=i
(12.15)
"
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where we approximate the discount factor e
pectation P (Ti , Tk+1 ) given FTi .
r Tk+1
Ti
rs ds
Note that when j = i + 1, the swaption price (12.15) coincides with the price
at time t of a caplet on [Ti , Ti+1 ] up to a factor Ti+1 Ti since
i
h r Ti
+
IE e t rs ds ((Ti+1 Ti )P (Ti , Ti+1 )(f (Ti , Ti , Ti+1 ) )) Ft
i
h r Ti
+
= (Ti+1 Ti ) IE e t rs ds P (Ti , Ti+1 ) ((f (Ti , Ti , Ti+1 ) )) Ft
r
rT
Ti
i+1 rs ds
+
= (Ti+1 Ti ) IE e t rs ds IE e Ti
FTi ((f (Ti , Ti , Ti+1 ) )) Ft
r
rT
Ti
i+1 rs ds
+
((f (Ti , Ti , Ti+1 ) )) FTi Ft
= (Ti+1 Ti ) IE IE e t rs ds e Ti
i
h r Ti+1
+
rs ds
= (Ti+1 Ti ) IE e t
(f (Ti , Ti , Ti+1 ) ) Ft ,
0 t Ti .
In case we replace the forward rate f (t, T, S) with the LIBOR rate
L(t, T, S) defined in Proposition 11.5, the payoff of the swaption can be
rewritten as in the following lemma which is a direct consequence of the
definition of the swap rate S(Ti , Ti , Tj ).
Lemma 12.1. The payoff of the swaption in (12.15) can be rewritten as
j1
X
k=i
!+
(Tk+1 Tk )P (Ti , Tk+1 )(L(Ti , Tk , Tk+1 ) )
= (P (Ti , Ti ) P (Ti , Tj ) P (Ti , Ti , Tj ))
= P (Ti , Ti , Tj ) (S(Ti , Ti , Tj ) ) .
(12.16)
= S(t, Ti , Tj )
j1
X
k=i
= P (t, Ti , Tj )S(t, Ti , Tj )
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"
= P (t, Ti , Tj ) (S(t, Ti , Tj ) ) ,
and for t = Ti we get
!+
j1
X
(Tk+1 Tk )P (Ti , Tk+1 )(L(Ti , Tk , Tk+1 ) )
k=i
= P (Ti , Ti , Tj ) (S(Ti , Ti , Tj ) ) .
The next proposition simply states that a swaption on the LIBOR rate can
be priced as a European call option on the swap rate S(Ti , Ti , Tj ) under the
i,j .
forward swap measure P
Proposition 12.5. The price (12.15) of the swaption with payoff
j1
X
k=i
!+
(Tk+1 Tk )P (Ti , Tk+1 )(L(Ti , Tk , Tk+1 ) )
(12.17)
i,j as
on the LIBOR market can be written under the forward swap measure P
i
h
i,j (S(Ti , Ti , Tj ) )+ Ft ,
P (t, Ti , Tj )IE
0 t Ti .
Proof. As a consequence of (12.13) and Lemma 12.1 we find
!+
j1
rT
X
t i rs ds
IE e
(Tk+1 Tk )P (Ti , Tk+1 )(L(Ti , Tk , Tk+1 ) )
Ft
h
k=i
r Ti
rs ds
t
= IE e
(P (Ti , Ti ) P (Ti , Tj ) P (Ti , Ti , Tj ))
i
h r Ti
+
t rs ds
= IE e
P (Ti , Ti , Tj ) (S(Ti , Ti , Tj ) ) Ft
"
#
i,j|F
dP
1
+
t
IE
(S(Ti , Ti , Tj ) ) Ft
=
P (t, Ti , Tj )
dP|Ft
i
h
+
i
Ft
(12.18)
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N. Privault
In the next proposition we price a swaption with payoff (12.17) or equivalently
(12.16).
Proposition 12.6. Assume that the LIBOR swap rate (11.30) is modeled as
a geometric Brownian motion under Pi,j , i.e.
ti,j ,
dS(t, Ti , Tj ) = S(t, Ti , Tj )
(t)dW
where (
(t))tR+ is a deterministic function. Then the swaption with payoff
+
j2
X
k=i
d+ =
2
log(S(t, Ti , Tj )/) + i,j
(t)(Ti t)/2
,
i,j (t) Ti t
d =
2
log(S(t, Ti , Tj )/) i,j
(t)(Ti t)/2
,
i,j (t) Ti t
and
and
|i,j (t)|2 =
1 w Ti 2
|
| (s)ds.
Ti t t
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"
(t, S(t, Ti , Tj ))
j2
X
k=i
Exercises
Exercise 12.1 Given two bonds with maturities T , S and prices P (t, T ),
P (t, S), consider the LIBOR rate
L(t, T, S) =
P (t, T ) P (t, S)
(S T )P (t, S)
at time t, modeled as
dL(t, T, S) = t L(t, T, S)dt + L(t, T, S)dWt ,
0 t T,
(12.19)
where (Wt )t[0,T ] is a standard Brownian motion under the risk-neutral measure P , > 0 is a constant, and (t )t[0,T ] is an adapted process. Let
i
h rS
Ft = IE e t rs ds ( L(T, T, S))+ Ft
denote the price at time t of a floorlet option with strike , maturity T , and
payment date S.
S with maturity S.
1. Rewrite the value of Ft using the forward measure P
S ?
2. What is the dynamics of L(t, T, S) under the forward measure P
3. Write down the value of Ft using the Black-Scholes formula.
Hint. Given X a centered Gaussian random variable with variance v 2 we
have
"
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N. Privault
IE[( em+X )+ ] = ((m log )/v) em+
v2
2
(v (m log )/v),
i = 1, 2,
and the dynamics of the P (t, T1 )/P (t, T2 ) under P2 , where P (t, T1 ) and
P (t, T2 ) are bond prices with maturities T1 and T2 .
2. State the expression of the forward rate f (t, T1 , T2 ).
3. Compute the dynamics of f (t, T1 , T2 ) under the forward measure P2 with
r T2
dP2
1
=
e 0 rs ds .
dP
P (0, T2 )
P (t, T1 ) P (t, T2 )
,
(T2 T1 )P (t, T2 )
t [0, T1 ],
under P2 .
6. Compute the swaption price
i
h r T1
(T2 T1 ) IE e t rs ds P (T1 , T2 )(S(T1 , T1 , T2 ) )+ Ft
on the swap rate S(T1 , T1 , T2 ) using the expectation under the forward
swap measure P1,2 .
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"
0 t T1 ,
(12.20)
t2 is a
and L(t, T2 , T3 ) = b, 0 t T2 , for some constants a, b > 0, where W
standard Brownian motion under the forward rate measure P2 defined by
r T2
dP2
e 0 rs ds
=
.
dP
P (0, T2 )
1. Compute L(t, T1 , T2 ), 0 t T2 by solving Equation (12.20).
2. Show that the price at time t of the caplet with strike can be written
as
i
h r T2
2 (L(T1 , T1 , T2 ) )+ | Ft ,
E e t rs ds (L(T1 , T1 , T2 ) )+ Ft = P (t, T2 )E
2 denotes the expectation under the forward measure P2 .
where E
3. Using the hint below, compute the price at time t of the caplet with strike
on L(T1 , T1 , T2 ).
4. Compute
P (t, T1 )
,
P (t, T1 , T3 )
0 t T1 ,
and
P (t, T3 )
,
P (t, T1 , T3 )
0 t T2 ,
0 t T2 .
P (t, T1 ) P (t, T3 )
,
P (t, T1 , T3 )
0 t T1 ,
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6. Using the Black-Scholes formula, compute an approximation of the swaption price
i
h r T1
E e t rs ds P (T1 , T1 , T3 )(S(T1 , T1 , T3 ) )+ Ft
2 (S(T1 , T1 , T3 ) )+ | Ft ,
= P (t, T1 , T3 )E
at time t [0, T1 ]. You will need to approximate 1,3 (s), s t, by freezing all random terms at time t.
Hint. Given X a centered Gaussian random variable with variance v 2 we
have
E[(em+X )+ ] = em+
v2
2
0 t T,
0 t T,
(12.21)
0 t T.
1. Show that
i
h rT
+
IE e t rs ds (P (T, S) K) Ft
h
i wt
wt
+
sS dP (s, S).
= P (0, T ) IET (P (T, S) K) +
sT dP (s, T ) +
0
rt
0
rs ds
P (t, S) denote
"
dVt =
5. Show that
dVt = P (t, S)
C
(Xt , T t, v(t, T ))(tS tT )dBt + Vt dP (t, T ).
x
6. Show that
C
(Xt , T t, v(t, T ))(tS tT )dBt + Vt dP (t, T ).
dVt = P (t, S)
x
7. Compute the hedging strategy (tT , tS )t[0,T ] of the bond option.
8. Show that
C
log(x/K) + v 2 /2
(x, , v) =
.
x
v
Exercise 12.5 Given n bonds with
maturities T1 , . . . , Tn , consider the anPj1
nuitry numeraire P (t, Ti , Tj ) =
k=i (Tk+1 Tk )P (t, Tk+1 ) and the swap
rate
P (t, Ti ) P (t, Tj )
S(t, Ti , Tj ) =
P (t, Ti , Tj )
at time t [0, Ti ], modeled as dS(t, Ti , Tj ) = t S(t, Ti , Tj )dt+S(t, Ti , Tj )dWt ,
0 t Ti , where (Wt )t[0,Ti ] is a standard Brownian motion under the riskneutral measure P , (t )t[0,T ] is an adapted process and > 0 is a constant.
Let
i
h r Ti
IE e t rs ds P (Ti , Ti , Tj )( S(Ti , Ti , Tj ))+ Ft
denote the price at time t [0, Ti ] of a put swaption with strike .
i,j
1. Rewrite the above swaption price using the forward swap measure P
defined from the annuity numeraire P (t, Ti , Tj ).
i,j
2. What is the dynamics of S(t, Ti , Tj ) under the forward swap measure P
?
3. Write down the value of the above swaption price using the Black-Scholes
formula.
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Hint. Given X a centered Gaussian random variable with variance v 2 we have
IE[( em+X )+ ] = ((m log )/v) em+
v2
2
(v (m log )/v),
k = i, . . . , j,
where (rt )tR+ is a short term interest rate process and (Bt )tR+ denotes a standard Brownian motion generating a filtration (Ft )tR+ , and
i (t), . . . , j (t) are volatility processes.
The swap rate S(t, Ti , Tj ) is defined by
S(t, Ti , Tj ) =
where
P (t, Ti , Tj ) =
P (t, Ti ) P (t, Tj )
,
P (t, Ti , Tj )
j1
X
(Tk+1 Tk )P (t, Tk+1 )
k=i
is the annuity numeraire. Recall that a swaption on the LIBOR market can
be priced at time t [0, Ti ] as
!+
j1
r Ti
X
r
ds
s
IE e t
(Tk+1 Tk )P (Ti , Tk+1 )(L(Ti , Tk , Tk+1 ) )
Ft
k=i
i
h
+
= P (t, Ti , Tj ) IEi,j (S(Ti , Ti , Tj ) ) Ft ,
(12.22)
1 i < j n,
under which
ti,j := Bt
B
j1
X
k=i
(Tk+1 Tk )
P (t, Tk+1 )
k+1 (t)dt
P (t, Ti , Tj )
(12.23)
"
0 t Ti ,
(12.24)
where the swap rate volatility is a deterministic function i,j (t). In the sequel
we denote St = S(t, Ti , Tj ) for simplicity of notation.
1. Solve the equation (12.24) on the interval [t, Ti ], and compute S(Ti , Ti , Tj )
from the initial condition S(t, Ti , Tj ).
2. Show that the price (12.18) of the swaption can be written as
P (t, Ti , Tj )C(St , v(t, Ti )),
where
v 2 (t, Ti ) =
w Ti
t
j
X
k=i
tk dP (t, Tk ),
0 t Ti ,
(12.25)
!+
j1
r Ti
X
Vt = IE e t rs ds
(Tk+1 Tk )P (Ti , Tk+1 )(L(Ti , Tk , Tk+1 ) )
F
t
k=i
i
h
+
= P (t, Ti , Tj ) IEi,j (S(Ti , Ti , Tj ) ) Ft ,
0 t Ti . Show that
!+
j1
rT
X
t i rs ds
IE e
(Tk+1 Tk )P (Ti , Tk+1 )(L(Ti , Tk , Tk+1 ) )
Ft
k=i
j w
h
i X
t
+
= P (0, Ti , Tj ) IEi,j (S(Ti , Ti , Tj ) ) +
sk dP (s, Ti ),
k=i
"
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N. Privault
0 t Ti .
4. Show that under the
self-financing condition (12.25), the discounted portrt
folio price Vt = e 0 rs ds Vt satisfies
dVt =
j
X
tk dP (t, Tk ),
k=i
rt
dVt =
7. Show that
C
(St , v(t, Ti ))ti,j dBt + Vt dP (t, Ti , Tj ).
x
8. Show that
j1
dVt = St i (t)
X
C
(St , v(t, Ti ))
(Tk+1 Tk )P (t, Tk+1 )dBt
x
k=i
j1
X
C
(St , v(t, Ti )))
(Tk+1 Tk )P (t, Tk+1 )k+1 (t)dBt
+(Vt St
x
k=i
C
+
(St , v(t, Ti ))P (t, Tj )(i (t) j (t))dBt .
x
9. Show that
dVt =
C
(St , v(t, Ti ))d(P (t, Ti ) P (t, Tj ))
x
C
+(Vt St
(St , v(t, Ti )))dP (t, Ti , Tj ).
x
log(x/K) v(t, Ti )
+
v(t, Ti )
2
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.
"
dP (t, Ti , Tj ).
v(t, Ti )
2
12. Show that the hedging strategy is given by
log(St /K) v(t, Ti )
ti =
+
,
v(t, Ti )
2
log(St /K) v(t, Ti )
log(St /K) v(t, Ti )
+
(Tj+1 Tj )
,
tj =
v(t, Ti )
2
v(t, Ti )
2
and
tk = (Tk+1 Tk )
"
v(t, Ti )
2
,
i + 1 k j 1.
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Chapter 13
0 t T,
with
P( < T | > t) = 1 P( > T | > t)
P( > t) P( > T )
=
P( > t)
P( < T ) P( < t)
=
P( > t)
P(t < < T )
=
,
0 t T,
P( > t)
and the conditional survival probability law
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N. Privault
P( dx | > t) = P(x < < x + dx | > t)
P( < t + dt | > t)
dt
1
P(t < < t + dt)
P( > t)
dt
1
P( > t) P( > t + dt)
P( > t)
dt
d
log P( > t)
dt
1
d
P( > t),
t > 0,
P( > t) dt
t R+ ,
(13.1)
under the initial condition P( > 0) = 1. This allows us to rewrite the survival
probability as
w
T
P( > T )
P( > T | > t) =
(u)du ,
0 t T,
= exp
t
P( > t)
with
P( > t + h | > t) = e(t)h ' 1 (t)h,
(13.2)
(13.3)
and
as h tends to 0. When the failure rate (t) = > 0 is a constant function of
time, Relation (13.1) shows that
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"
T 0,
i.e. has the exponential distribution with parameter . Note that given
(n )n1 a sequence of i.i.d. exponentially distributed random variables, letting
Tn = 1 + + n ,
n 1,
defines the sequence of jump times of a standard Poisson process with intensity > 0, cf. Section 14.1 below for details.
t R+ ,
t R+ .
In the sequel we will not assume that is an Ft -stopping time, and by analogy
with (13.1) we will write P( > t | Ft ) as
w
t
P( > t | Ft ) = exp u du ,
t > 0.
(13.4)
0
This is the case in particular in [48] when u has the form u = h(Xu ), and
is given by
wt
= inf t R+ :
h(Xu )du L ,
0
where h is a non-negative function, (Xt )tR+ is a process generating a filtration (Ft )tR+ , and L is an independent exponentially distributed random
variable.
We let (Gt )tR+ be the filtration defined by
Gt = Ft ({ u} : 0 u t),
"
t R+ ,
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N. Privault
i.e. Gt contains the additional information on whether default at time has
occurred or not before time t. The process t can also be chosen among
the classical mean-reverting diffusion processes, including jump-diffusion processes.
Taking F = 1 in the next Lemma 13.1 shows that the survival probability
up to time T , given information known up to t, is given by
P( > T | Gt ) = IE 1{ >T } | Gt
(13.5)
w
T
= 1{ >t} IE exp
u du Ft ,
0 t T.
t
"
r
T
Taking F = exp t ru du in Lemma 13.1, we get
w
w
T
T
IE 1{ >T } exp
ru du Gt = 1{ >t} IE exp
(ru + u )du Ft ,
t
hence
w
T
(ru + u )du Ft
P (t, T ) = 1{ >t} IE exp
t
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w
T
+ IE 1{ T } exp
ru du Gt ,
t
0 t T.
From the above expression (13.6) we note that the effect of the presence of
a default time is to decrease the bond price, which can be viewed as an
increase of the short rate by the amount u .
This treatment of default risk has some similarity with that of coupon
bonds which can be priced as
w
T
P (t, T ) = ec(T t) IE exp
rs ds Gt ,
t
where
w
T
s ds Ft
Q(t, T ) = IEP exp
t
"
k=i
j1
X
k=i
= St
w
Tk+1
St k IE 1{ >Tk+1 } exp
rs ds Gt
j1
X
k P (t, Tk+1 )
k=i
= St P (t, Ti , Tj ),
where k = Tk+1 Tk , P (t, Ti , Tj ) is the annuity numeraire (12.10), and
w
Tk
P (t, Tk ) = 1{ >t} IE exp
(rs + s )ds Ft ,
0 t Tk ,
t
is the defaultable bond price with maturity Tk , k = i, . . . , j1. For simplicity we have ignored a possible accrual interest term over the time period
[Tk , ] when [Tk , Tk+1 ] in the above value of the premium leg.
- a protection leg: the seller or issuer of the contract makes a payment
1 k+1 to the buyer in case default occurs at time Tk+1 , k = i, . . . , j 1.
The value at time t of the protection leg is
"j1
w
#
X
Tk+1
IE
1(Tk ,Tk+1 ] ( )(1 k+1 ) exp
rs ds Gt ,
k=i
where k+1 is the recovery rate associated with the maturity Tk+1 , k =
i, . . . , j 1.
In the case of a non-random recovery rate k the value of the protection
leg becomes
j1
X
k=i
w
Tk+1
k (1 k+1 ) IE 1(Tk ,Tk+1 ] ( ) exp
rs ds Gt .
t
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N. Privault
= IE
"j1
X
k=i
w
#
Tk+1
k 1(Tk ,Tk+1 ] ( )(1 k+1 ) exp
rs ds Gt ,
t
which yields
St =
w
j1
X
Tk+1
1
k IE 1(Tk ,Tk+1 ] ( )(1 k+1 ) exp
rs ds Gt .
t
P (t, Ti , Tj )
k=i
w
j1
X
Tk+1
1
k IE 1(Tk ,Tk+1 ] ( ) exp
rs ds Gt ,
t
P (t, Ti , Tj )
k=i
h
w
i
1
IE 1[t,T ] ( ) exp
rs ds Gt .
t
P (t, Ti , Tj )
13.5 Exercises
where t is a (random) default rate process which is adapted to the filtration (Ft )tR+ . Recall that the probability of survival up to time T , given
information known up to time t, is given by
w
T
P( > T | Gt ) = 1{ >t} E exp
u du Ft ,
t
where Gt = Ft ({ < u} : 0 u t), t R+ , is the filtration defined by adding the default time information to the history (Ft )tR+ . In this
framework, the price P (t, T ) of defaultable bond with maturity T , short term
interest rate rt and (random) default time is given by
w
T
P (t, T ) = E 1{ >T } exp
ru du Gt
(13.7)
t
w
T
= 1{ >t} E exp
(ru + u )du Ft .
t
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"
(1)
d = b dt + dB (2) ,
t
t
t
(1)
(2)
where (Bt )tR+ and (Bt )tR+ are two standard Ft -Brownian motions with
(1)
(2)
correlation [1, 1], and dBt dBt = dt.
1. Give a justification for the fact that
w
T
E exp
(ru + u )du Ft
t
is an Ft -martingale under P.
3. Use the It
o formula with two variables to derive a PDE on R2 for the
function F (t, x, y).
4. Show that we have
wT
wT
rs ds = C(a, t, T )rt +
C(a, s, T )dBs(1) ,
t
and
wT
t
s ds = C(b, t, T )t +
wT
t
C(b, s, T )dBs(2) ,
where
1
C(a, t, T ) = (ea(T t) 1).
a
5. Show that the random variable
wT
wT
rs ds +
s ds
t
and variance
Var
"
w
T
t
rs ds +
wT
t
s dsFt ,
367
N. Privault
conditionally to Ft .
6. Compute P (t, T ) from its expression (13.7) as a conditional expectation.
7. Show that the solution F (t, x, y) to the 2-dimensional PDE of Question 3
is
F (t, x, y) = exp (C(a, t, T )x C(b, t, T )y)
2w
T
2 w T 2
C 2 (a, s, T )ds +
C (b, s, T )ds
exp
2 t
2 t
wT
exp
C(a, s, T )C(b, s, T )ds .
t
8. Show that the defaultable bond price P (t, T ) can also be written as
w
T
P (t, T ) = eU (t,T ) P( > T | Gt ) IE exp
rs ds Ft ,
t
where
U (t, T ) =
where
f2 (t, u) = t eb(ut)
2 2
C (b, t, u).
2
(1)
11. Show how the result of Question 8 can be simplified when (Bt )tR+ and
(2)
(Bt )tR+ are independent.
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"
Chapter 14
X
k=1
1[Tk ,) (t),
t R+ ,
(14.1)
where
1
The notation Nt is not to be confused with the same notation used for num
eraire
processes in Chapter 10.
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N. Privault
1[Tk ,) (t) =
1 if t Tk ,
0 if 0 t < Tk ,
k 1, and (Tk )k1 is the increasing family of jump times of (Nt )tR+ such
that
lim Tk = +.
k
Nt
0
0
10
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"
((t s))k
,
k!
k N,
(14.2)
The proof of the above Theorem 14.1 is technical and not included here,
cf. e.g. [6] for details, and we could in fact take this distribution property
(14.2) as one of the hypotheses that define the Poisson process.
Precisely, we could restate the definition of the standard Poisson process
(Nt )tR+ with intensity > 0 as being a process defined by (14.1), which is
assumed to have independent increments distributed according to the Poisson
distribution, in the sense that for all 0 t0 t1 < < tn ,
(Nt1 Nt0 , . . . , Ntn Ntn1 )
is a vector of independent Poisson random variables with respective parameters
((t1 t0 ), . . . , (tn tn1 )).
In particular, Nt has the Poisson distribution with parameter t, i.e.
"
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N. Privault
P(Nt = k) =
(t)k t
e ,
k!
t > 0.
(14.4)
h 0,
P(Nh = 0) = eh ' 1 h,
h 0.
and
By stationarity of the Poisson process we find more generally that
P(Nt+h Nt = 1) = heh ' h,
h 0,
P(Nt+h Nt = 0) = eh ' 1 h,
h 0,
and
for all t > 0.
This means that within a short interval [t, t + h] of length h, the increment Nt+h Nt behaves like a Bernoulli random variable with parameter
h. This fact can be used for the random simulation of Poisson process paths.
We also find that
P(Nt+h Nt = 2) ' h2
2
,
2
h 0,
t > 0,
k
,
k!
h 0,
t > 0.
The intensity of the Poisson process can in fact be made time-dependent (e.g.
by a time change), in which case we have
2
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"
k 0.
In particular,
(t)dt
' 1 (t)dt,
o(dt),
k = 0,
k = 1,
k 2,
w
t
es
sn1
ds.
(n 1)!
t R+ ,
"
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N. Privault
P(Tn1 > t) =
w
t
es
(s)n2
ds,
(n 2)!
n 2,
we obtain
P(Tn > t) = P(Tn > t Tn1 ) + P(Tn1 > t)
(t)n
,
n!
t0 , . . . , tn R+ .
1
,
we can check that the higher the intensity (i.e. the higher the probability
of having a jump within a small interval), the smaller is the time spent in
each state k N on average.
In addition, given that {NT = n}, the n jump times on [0, T ] of the Poisson
process (Nt )tR+ are independent uniformly distributed random variables on
[0, T ]n .
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"
(14.5)
i.e. the compensated Poisson process (Nt t)tR+ has centered increments.
Since in addition (Nt t)tR+ also has independent increments we get
the following proposition.
Proposition 14.2. The compensated Poisson process
(Nt t)tR+
is a martingale with respect to its own filtration (Ft )tR+ .
Extensions of the Poisson process include Poisson processes with timedependent intensity, and with random time-dependent intensity (Cox processes). Renewal processes are counting processes
X
Nt =
1[Tn ,) (t),
t R+ ,
n1
wb
a
(dy),
< a b < .
Nt
X
k=1
"
Zk ,
t R+ ,
(14.6)
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N. Privault
is called a compound Poisson process.
The next figure represents a sample path of a compound Poisson process,
with here Z1 = 0.9, Z2 = 0.7, Z3 = 1.4, Z4 = 0.6, Z5 = 2.5, Z6 = 1.5,
Z7 = 1.2.
2.5
Yt
1.5
0.5
-0.5
0
10
R.
Proof. Since Nt has a Poisson distribution with parameter t > 0 and is
independent of (Zk )k1 , for all R we have by conditioning:
"
IE [exp (i(YT Yt ))] = IE exp i
"
= IE exp i
!#
NT
X
Zk
k=Nt +1
NT
Nt
X
!#
Zk
k=1
X
n=0
"
IE exp i
n
X
!#
Zk
k=1
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P(NT Nt = n)
"
= e(T t)
"
!#
n
X
X
n
(T t)n IE exp i
Zk
n!
n=0
k=1
X
n
n
(T t)n (IE [exp (iZ1 )])
= e(T t)
n!
n=0
(dy) = 1.
From the characteristic function we can compute the expectation and variance of Yt for fixed t, as
IE[Yt ] = t IE[Z1 ]
and
w
d
IE[eiYt ]|=0 = t
y(dy) = t IE[Z1 ].
" n
#
X
X
n tn
=e
IE
Zk Nt = n
n!
n=0
k=1
" n
#
X n tn
X
t
=e
IE
Zk
n!
n=0
t
k=1
= te
X
(t)n1
IE[Z1 ]
(n
1)!
n=1
= t IE[Z1 ].
More generally one can show that for all 0 t0 t1 tn and
1 , . . . , n R we have
!
" n
#
n
w
Y i (Y Y
X
(tk tk1 )
(eik y 1)(dy)
IE
e k tk tk1 ) = exp
k=1
k=1
n
Y
k=1
"
(eik y 1)(dy)
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n
Y
i
h
IE ei(Ytk Ytk1 ) .
k=1
This shows in particular that the compound Poisson process (Yt )tR+ has
independent increments, as the standard Poisson process (Nt )tR+ .
Since the compensated Poisson process also has centered increments by
(14.5), we have the following proposition.
Proposition 14.4. The compensated compound Poisson process
Mt := Yt t IE[Z1 ],
t R+ ,
is a martingale.
By construction, compound Poisson processes only have a finite number
of jumps on any interval. They belong to the family of Levy processes which
may have an infinite number of jumps on any finite time interval, cf. [12].
wT
0
t dYt :=
NT
X
Tk Zk .
k=1
wT
Note that this expression
t dYt has a natural financial interpretation as
0
the value at time T of a portfolio containing a (possibly fractional) quantity
t of a risky asset at time t, whose price evolves according to random returns
Zk at random times Tk .
In particular the compound Poisson process (Yt )tR+ in (14.1) admits the
stochastic integral representation
wt
Yt = Y0 +
ZNs dNs .
0
Next, given (Wt )tR+ a standard Brownian motion independent of (Yt )tR+
and (Xt )tR+ a jump-diffusion process of the form
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"
wt
0
us dWs +
wt
0
t R+ ,
vs ds + Yt ,
where (t )tR+ is a process which is adapted to the filtration (Ft )tR+ generated by (Wt )tR+ and (Yt )tR+ , and such that
hw
i
hw
i
IE
2s |us |2 ds < and IE
|s vs |ds < ,
0
we let the stochastic integral of (s )sR+ with respect to (Xs )sR+ be defined
by
wT
0
s dXs :=
wT
0
s us dWs +
wT
0
s vs ds +
NT
X
Tk Z k ,
T > 0.
k=1
IE
"
w
2 #
w
T
= IE[|Z1 |2 ] IE
||2s ds ,
s (dYs IE[Z1 ]dt)
0
(14.7)
provided the process (s )sR+ is adapted to the filtration generated by
(Yt )tR+ , which makes the left limit process (s )sR+ predictable. The proof
of (14.7) is similar to that of Proposition 4.2 in the case of simple predictable
processes.
For the mixed continuous-jump martingale
wt
Xt =
us dWs + Yt t IE[Z1 ],
0
t R+ ,
IE
"
wT
0
2 #
s dXs
= IE
w
T
0
w
T
|s |2 |us |2 ds + IE[|Z1 |2 ] IE
|s |2 ds .
0
(14.8)
provided (s )sR+ is adapted to the filtration (Ft )tR+ generated by (Wt )tR+
and (Yt )tR+ .
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This isometry formula will be used in Section 15.5 for the computation of
hedging strategies in jump models.
When (Xt )tR+ takes the form
Xt = X0 +
wt
0
us dWs +
wt
0
vs ds +
wt
0
t R+ ,
s dYs ,
s dXs :=
wT
wT
s us dWs +
wT
s vs ds +
s us dWs +
wT
s vs ds +
wT
0
NT
X
s s dYs
Tk Tk Zk ,
T > 0.
k=1
14.4 It
o Formula with Jumps
Let us first consider the case of a standard Poisson process (Nt )tR+ with
intensity . We have the telescoping sum
f (Nt ) = f (0) +
Nt
X
(f (k) f (k 1))
k=1
= f (0) +
= f (0) +
wt
0
(f (1 + Ns ) f (Ns ))dNs
wt
Here, Ns denotes the left limit of the Poisson process at time s, i.e.
Ns = lim Nsh .
h&0
In particular we have
k = NTk = 1 + NT ,
k
k 1.
By the same argument we find, in the case of the compound Poisson process
(Yt )tR+ ,
f (Yt ) = f (0) +
Nt
X
(f (YT + Zk ) f (YT ))
k
k=1
= f (0) +
wt
0
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"
wt
0
t R+ ,
we find, by combining the Ito formula for Brownian motion with the above
argument we get
f (Xt ) = f (X0 ) +
+
wt
0
wt
0
us f 0 (Xs )dWs +
vs f (Xs )ds +
wt
NT
X
1 w t 00
f (Xs )|us |2 ds
2 0
(f (XT + Tk Zk ) f (XT ))
k
k=1
1wt
f 00 (Xs )|us |2 ds +
= f (X0 ) +
us f 0 (Xs )dWs +
0
2 0
wt
t R+ .
+ (f (Xs + s ZNs ) f (Xs ))dNs
wt
0
vs f 0 (Xs )ds
i.e.
wt
wt
1 w t 00
f (Xt ) = f (X0 ) +
us f 0 (Xs )dWs +
f (Xs )|us |2 ds +
vs f 0 (Xs )ds
0
0
2 0
wt
+ (f (Xs ) f (Xs ))dNs ,
t R+ .
(14.9)
0
t R+ ,
we get
wt
1wt
f (Xt ) = f (0) +
us f 0 (Xs )dWs +
|us |2 f 00 (Xs )dWs
0
2 0
wt
wt
+ vs f 0 (Xs )ds + (f (Xs + s ) f (Xs ))dNs
0
"
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N. Privault
wt
1wt
= f (0) +
us f 0 (Xs )dWs +
|us |2 f 00 (Xs )dWs
0
2 0
wt
wt
+ vs f 0 (Xs )ds + (f (Xs ) f (Xs ))dNs .
0
(14.10)
wt
us dWs +
wt
vs ds +
wt
s dNs ,
t R+ ,
Yt =
wt
as dWs +
wt
bs ds +
wt
cs dNs ,
t R+ ,
and
dt
dBt
dNt
dt
0
0
0
dBt
0
dt
0
dNt
0
0
dNt
= at ut dt + ct t dNt ,
and in particular
wt
0
us dWs +
wt
0
s dYt ,
t R+ ,
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"
wt
0
t R+ ,
s f 0 (Xs )dYs =
wt
0
Xs f 0 (Xs )dNs ,
t 0.
for f a Cb2 (R) function. Such processes, also called infinite activity Levy
processes [12] are also useful in financial modeling and include the gamma
process, stable processes, variance gamma processes, inverse Gaussian processes, etc, as in the following illustrations.
1. Gamma process, d = 1.
0
t
2. Stable process, d = 1.
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N. Privault
0
t
"
(14.11)
of a stochastic differential equation with respect to the standard Poisson process, with constant coefficient R.
When
Nt = Nt Nt = 1,
i.e. when the Poisson process has a jump at time t, the equation (14.11) reads
dSt = St St = St ,
t > 0.
t > 0.
By induction, applying this procedure for each jump time gives us the solution
St = S0 (1 + )Nt ,
t R+ .
(14.12)
i.e.
STk = (1 + Tk )ST ,
k
and repeating this argument for all k = 1, . . . , Nt yields the product solution
St = S0
Nt
Y
k=1
(1 + Tk ) = S0
(1 + s ),
Ns =1
0st
t R+ .
The equation
dSt = t St dt + t St (dNt dt),
(14.13)
is then solved as
"
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N. Privault
St = S0 exp
w
s ds
wt
0
Y
Nt
(1 + Tk ),
s ds
k=1
t R+ .
St
1.5
0.5
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
2.0
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"
w
s ds IE[Z1 ]
wt
0
Y
Nt
s ds
(1 + Tk Zk )
k=1
t R+ ,
solution of
dSt = t St dt + t St (dYt IE[Z1 ]dt),
is given in Figure 14.10.
"
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N. Privault
2
St
1.5
0.5
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
2.0
Nt
Y
w
s ds IE[Z1 ]
wt
0
s ds +
wt
0
s dWs
1wt
|s |2 ds
2 0
(1 + Tk Zk ),
k=1
t R+ . A random simulation of the geometric Brownian motion with compound Poisson jumps is given in Figure 14.11.
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"
2.5
St
1.5
1
0.5
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
2.0
Nt
Y
(eTk (1 + Tk Zk )),
k=1
t R+ , one can extend this jump model to processes with an infinite number
of jumps on any finite time interval, cf. [12].
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N. Privault
2
T /2
]
(14.14)
(14.15)
hence
under the probability measure
2
= eWT
dP
T /2
dP,
More generally, the Girsanov theorem states that (Wt + t)t[0,T ] is a stan
dard Brownian motion under P.
When Brownian motion is replaced with a standard Poisson process
(Nt )tR+ , the above space shift
Wt 7 Wt + t
may not be used because Nt + t cannot be a Poisson process, whatever the
change of probability applied, since by construction, the paths of the standard Poisson process has jumps of unit size and remain constant between
jump times.
The correct way to proceed in order to extend (14.15) to the Poisson case
is to replace the space shift with a time contraction (or dilation) by a certain
factor 1 + c with c > 1, i.e.
Nt 7 Nt/(1+c) .
By analogy with (14.14) we write
IE[f (NT (1+c) )] =
f (k)P(NT (1+c) = k)
(14.16)
k=0
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"
= e(1+c)T
=e
f (k)
k=0
X
T cT
(T (1 + c))k
k!
f (k)(1 + c)k
k=0
=e
cT
(T )k
k!
k=0
=
f (NT )dP
(NT )],
= IE[f
is defined
for f any bounded function on N, where the probability measure P
by
= ecT (1 + c)NT dP.
dP
Consequently,
under the probability measure
= ecT (1 + c)NT dP,
dP
the law of the random variable NT is that of NT (1+c) under P, i.e. it is a
Poisson random variable with intensity (1 + c)T .
Equivalently we have
(NT /(1+c) )],
IE[f (NT )] = IE[f
the law of NT /(1+c) is that of a standard Poisson random variable
i.e. under P
with parameter T .
In addition we have
Nt/(1+c) =
n1
X
n1
1[(1+c)Tn ,) (t),
t R+ ,
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N. Privault
((1 + c)Tn )n1 ,
and we know that they are distributed as the jump times of a Poisson process
with intensity .
> 0 and
Next taking
c := 1 +
!NT
dP,
Consequently, since both (Nt t)tR+ and (Nt (1+c)t)tR+ are processes
with independent increments, the compensated Poisson process
Nt (1 + c)t = Nt t
by (6.2), although when c 6= 0 it is not a martingale
is a martingale under P
under P.
In the case of compound Poisson processes the Girsanov theorem can be
extended to variations in jump sizes in addition to time variations, and we
have the following more general result.
Theorem 14.2. Let (Yt )t0 be a compound Poisson process with intensity > 0 and jump distribution (dx). Consider another jump distribution
(dx), and let
d
(x) =
(x) 1,
x R.
d
Then,
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"
:= e()T
dP
,
, ,
(1 + (Zk ))dP
k=1
the process
Yt =
Nt
X
t R+ ,
Zk ,
k=1
()T
IE,
[f
(Y
)]
=
e
IE
f
(Y
)
(1
+
(Z
))
T
,
T
i
i=1
=e
()T
"
k
X
IE, f
X
(T )k
k=0
= eT
= eT
=e
Zi
i=1
k=0
= eT
k!
"
IE, f
k
X
i=1
k
Y
#
(1 + (Zi ))NT = k P(NT = k)
i=1
!
Zi
k
Y
#
(1 + (Zi ))
i=1
k
w
Y
(T ) w
k!
i=1
k=0
!
k
w
X (T
Y
)k w
d
f (z1 + + zk )
(zi ) (dz1 ) (dzk )
k!
d
i=1
k=0
X
k=0
w
)k w
(T
f (z1 + + zk )
(dz1 ) (dzk ).
k!
"
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N. Privault
Nt/
Xt :=
h(Zk ),
k=1
= e()T
dP
,
NT
Y
, .
(1 + (Zk ))dP
k=1
(x) 1,
d
x R,
and let (ut )tR+ be a bounded adapted process. Then the process
wt
IE [Z1 ]t
Wt +
us ds + Yt
0
tR+
0
2 0
k=1
(14.17)
As a consequence of Theorem 14.3, if
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"
wt
0
vs ds + Yt
s R,
(14.18)
tR+
tR+
tingales under P
u,,
Exercises
Exercise 14.1 Let (Nt )tR+ be a standard Poisson process with intensity
> 0, started at N0 = 0.
1. Solve the stochastic differential equation
dSt = St dNt St dt = St (dNt dt).
2. Using the first Poisson jump time T1 , solve the stochastic differential
equation
dSt = St dt + dNt
for t (0, T2 ).
Exercise 14.2 Consider the compound Poisson process Yt :=
Nt
X
Zk , where
k=1
(Nt )tR+ is a standard Poisson process with intensity > 0, (Zk )k1 is an
"
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N. Privault
i.i.d. sequence of N (0, 1) Gaussian random variables. Solve the stochastic
differential equation
dSt = rSt dt + St dYt ,
where , r R.
Exercise 14.3 Show, by direct computation or using the characteristic function, that the variance of the compound Poisson process Yt with intensity
> 0 satisfies
w
Var [Yt ] = t IE[|Z1 |2 ] = t
x2 (dx).
t R+ ,
(14.19)
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"
Chapter 15
(15.1)
where (Yt )tR+ is the compound Poisson process defined in Section 14.2, with
jump size distribution (dx) under P . The equation (15.1) has for solution
Y
Nt
1
St = S0 exp t + Wt 2 t
(1 + Zk ),
2
(15.2)
k=1
N. Privault
which yields a martingale under P provided
r + IE [Z1 ] = 0,
however that condition may not be satisfied under P by the market parameters.
In that case a change of measure might be needed. In order for the discounted process (ert St )tR+ to be a martingale, we may choose a drift pa > 0, and a jump distribution satisfying
rameter u R, and intensity
IE [Z1 ].
r = u
(15.3)
"
(15.4)
under Pu,,
.
Clearly the price (15.4) of C is no longer unique in the presence of jumps
due to the infinity of choices satisfying the martingale condition (15.3), and
= = 0, or ( = 0 and
such a market is not complete, except if either
= = 1 ).
(15.5)
!
#
N
T
Y
1 2
= IEu,,
(1 + Zk ) Ft
S0 exp T + WT T
2
k=1
N
T
Y
1 2
(1 + Zk ) Ft
= IEu,,
St exp (T t) + (WT Wt ) (T t)
2
k=Nt
N
T
Y
1 2
(T
t)
(1
+
Z
)
= IEu,,
x
exp
(T
t)
+
(W
W
)
t
T
k
2
k=N
t
X
n=0
Pu,,
(NT Nt = n)
1
(T t)+(WT Wt )
2
IEu,,
xe
NT
(T t)
Y
k=Nt
t))n
X
((T
= e(T t)
n!
n=0
"
1
(T t)+(WT Wt )
2
IEu,,
xe
=e
x=St
(T
t)
(T t)
(1 + Zk ) NT Nt = n
n
Y
x=St
!#
(1 + Zk )
k=1
x=St
w
t))n w
X
((T
n!
n=0
"
1
(T t)+(WT Wt )
2
IEu,,
xe
(T t)
n
Y
k=1
!#
(1 + zk )
x=St
(dz1 ) (dzn ),
hence
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er(T t) IE0,,
[(ST ) | Ft ]
w
X
t))n w
1
((T
= p
e(r+)(T t)
n!
2(T t)
n=0
!
n
2
Y
x
2
St e(T t)+x (T t)/2
(1 + zk ) e 2(T t) (dz1 ) (dzn )dx.
k=1
(15.7)
t
x
f
t
= St (t, St )dW
x
IE [(f (t, x(1 + Z1 )) f (t, x))]x=S dt
+(f (t, St (1 + ZNt )) f (t, St ))dNt
t
f
1 2 2 2f
f
+ (t, St )dt + rSt (t, St )dt + St 2 (t, St )dt
t
x
2
x
df (t, St ) =
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"
rf (t, St ) +
or
f
f
1
2f
(t, x) + rx (t, x) + 2 x2 2 (t, x)
t
x
2
x
IE [(f (t, x(1 + Z1 )) f (t, x))]
IE [Z1 ]x f (t, x) = 0,
+
x
rf (t, x) +
rf (t, x) =
f
1
2f
f
(t, x) + rx (t, x) + 2 x2 2 (t, x)
t
x
2
x
w
f
+
f (t, x(1 + y)) f (t, x) yx (t, x) (dy),
x
(15.8)
df (t, St ) = St
In the case of Poisson jumps with fixed size a, i.e. Yt = aNt , (dx) = a (dx),
the PIDE (15.8) reads
rf (t, x) =
"
f
f
1
2f
(t, x) + rx (t, x) + 2 x2 2 (t, x)
t
x
2
x
f (t, x(1 + a)) f (t, x) ax f (t, x) ,
+
x
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and we have
f
t + rf (t, St )dt
(t, St )dW
x
(t, St (1 + a)) f (t, St ))dt.
+(f (t, St (1 + a)) f (t, St ))dNt (f
df (t, St ) = St
rt
and choose a risk-neutral measure Pu,,
St )tR+ is a mar under which (e
tingale. Then the expectation
er(T t) IEu,,
[(ST ) | Ft ]
also becomes a (non-unique) arbitrage price at time t [0, T ] for the contingent claim with payoff (ST ).
Such an arbitrage price can be expressed as
r(T t)
T +WT +YT
er(T t) IEu,,
IEu,,
) | Ft ]
[(ST ) | Ft ] = e
[(S0 e
(T t)+(WT Wt )+YT Yt
= er(T t) IEu,,
) | Ft ]
[(St e
(T t)+(WT Wt )+YT Yt
= er(T t) IEu,,
)]x=St
[(xe
"
=e
r(T t)
IEu,,
x exp (T t) + (WT Wt ) +
NT
X
!!#
Zk
k=Nt +1
x=St
= er(T t)(T t)
"
!!#
n
X
X
t))n
((T
(T t)+(WT Wt )
IEu,,
exp
Zk
xe
n!
n=0
k=1
.
x=St
/2)t+Wt 2 t/2+Yt
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"
dSt =
1
1
IE [eZ1 1].
+ 2 r = u
2
The Merton Model
We assume that (Zk )k1 is a family of independent identically distributed
Gaussian N (, 2 ) random variables under Pu,,
with
1
IE [eZ1 1] = u (e
+2 /2 1),
+ 2 r = u
2
from (15.3), hence is a standard Brownian motion under Pu,,
. For simplicity
we choose u = 0, i.e.
1
+2 /2 1),
= r 2 (e
2
Hence we have
er(T t) IE,
[(ST ) | Ft ]
= er(T t)(T t)
X
t))n
((T
n!
n=0
"
(T t)+(WT Wt )
IE,
exp
xe
n
X
!!#
Zk
k=1
x=St
i
X
t))n h
((T
= er(T t)(T t)
IE (xe(T t)+n+X )
,
n!
x=St
n=0
where
X = (WT Wt ) +
n
X
k=1
n
X
k=1
Var Zk = 2 (T t) + n 2 .
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BS(x, , v 2 /, r, ) = er IE[(xeXv
/2+r
K)+ ]
we get
+
er(T t)(T t) IE,
[(ST ) | Ft ]
= er(T t)(T t)
= er(T t)(T t)
i
X
t))n h
((T
IE (xe(T t)+n+X )+
n!
x=St
n=0
X
t))n
((T
n!
n=0
h
i
1 2 + 2 /2
1))(T t)+n+X
IE (xe(r 2 (e
)+
x=St
t)
r(T t)(T
=e
X
t))n
((T
n!
n=0
h
i
2
+2 /2 1)(T t)+Xv 2 /2+r(T t)
IE (xen+n /2(e
)+
t)
(T
=e
x=St
X
t))n
((T
n!
n=0
1
BS(St en+ 2 n
+
(e
2 /2
1)(T t)
+
er(T t)(T t) IE,
[(ST ) | Ft ]
= e(T t)
X
t))n
2 + 2 /2
1
((T
1)(T t)
en+ 2 n (e
n!
n=0
2 + 2 /2
1
1)(T t)
, 2 + n 2 /(T t), r, T t
BS St , en 2 n +(e
+ 2 /2
= ee
(T t)
X
+ 12 n2 (T t))n
(e
n!
n=0
+ 2 /2 +2 /2
BS St , , 2 + n 2 /(T t), r + n
(e
1), T t .
T t
"
wT
dVt
df (t, St )
0
0
wT
f
t
(t, St ) dW
= V0 f (0, S0 ) +
St t
0
x
wT
IE [Z1 ]dt)
t St (ZNt dNt
+
= V0 f (0, S0 ) +
wT
"
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N. Privault
wT
+
IE [(f (t, x(1 + Z1 )) f (t, x))]x=St dt.
hence the mean square hedging error is given from the Ito isometry (14.8) by
IEu, [(VT f (T, ST ))2 ]
= (V0 f (0, S0 ))2 + 2 IEu,
+ IEu,
"
wT
0
"
wT
0
2 #
f
t
St t
(t, St ) dW
x
2 #
2 #
f
(t, St ) dt
= (V0 f (0, S0 )) + IEu,
t
0
x
w
T
2
IE
+
((f (t, St (1 + a)) f (t, St ) at St )) dt .
u,
"
St2
Clearly, the initial portfolio value V0 that minimizes the above quantity is
V0 = f (0, S0 ) = erT IEu,,
[(ST )].
When hedging only the risk generated by the Brownian part we let
t =
f
(t, St )
x
as in the Black-Scholes model, and in this case the hedging error due to the
presence of jumps becomes
w
T
2
IE
IEu, [(VT f (T, ST ))2 ] =
((f
(t,
S
(1
+
a))
f
(t,
S
)
a
S
))
dt
.
t
t
t
t
u,
0
Next, let us find the optimal strategy (t )tR+ that minimizes the remaining
hedging error
"
! #
2
wT
f
((f (t, St (1 + a)) f (t, St ) at St ))2 dt .
2 St2 t
(t, St ) +
IEu,
0
x
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"
2
t =
a
f
(t, St ) +
(f (t, St (1 + a)) f (t, St ))
x
St
,
2 + a2
t [0, T ].
(15.14)
f
(t, St ),
x
t [0, T ],
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Exercises
Exercise 15.1 Consider a standard Poisson process (Nt )tR+ with intensity
> 0 under a probability measure P. Let (St )tR+ be defined by the stochastic differential equation
dSt = rSt dt + St (dNt dt),
where > 0.
1. Find the value of R such that the discounted process (ert St )tR+ is
a martingale under P.
2. Compute the price at time t of a power option with payoff |ST |2 at maturity T .
Exercise 15.2 Consider a long forward contract with payoff ST K on a
jump diffusion risky asset (St )tR+ given by
dSt = St dt + St dWt + St dYt .
1. Show that the forward claim admits a unique arbitrage price to be computed in a market with risk-free rate r > 0.
2. Show that the forward claim admits an exact replicating portfolio strategy based on the two assets St and ert .
3. Show that the portfolio strategy of Question 2 coincides with the optimal
portfolio strategy (15.14).
Exercise 15.3 Consider (Wt )tR+ a standard Brownian motion and (Nt )tR+
a standard Poisson process with intensity > 0, independent of (Wt )tR+ ,
under a probability measure P . Let (St )tR+ be defined by the stochastic
differential equation
dSt = St dt + St dNt + St dWt .
(15.15)
"
(15.16)
2. Show that the claim C can be exactly replicated by the hedging strategy
t =
"
1
(f (t, St (1 + )) f (t, St )).
St
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Chapter 16
2
(t, x) =
(t, x)
t
x2
(16.1)
i = 0, . . . , N,
j = 0, . . . , M,
Explicit method
Using the forward time difference approximation of (16.1) we get
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N. Privault
(ti+1 , xj ) (ti , xj )
(ti , xj+1 ) + (ti , xj1 ) 2(ti , xj )
=
t
(x)2
and letting = (t)/(x)2 this yields
(ti+1 , xj ) = (ti , xj+1 ) + (1 2)(ti , xj ) + (ti , xj1 ),
1 j M 1, i.e
i+1 = Ai +
with
i =
and
A=
(ti , x0 )
0
..
.
0
(ti , xM )
The vector
0
0
0
i = 0, 1, . . . , N 1,
(ti , x1 )
..
,
.
(ti , xM 1 )
1 2
0
1 2
0
1 2
..
..
..
.
.
.
0
0
0
(ti , x0 )
0
..
.
0
(ti , xM )
0
0
0
i = 0, 1, . . . , N,
..
.
0
0
0
..
.
0
0
0
..
.
0
0
0
..
.
1 2
0
1 2
0
1 2
i = 0, . . . , N,
can be given by the lateral boundary conditions (t, 0) and (t, X).
Implicit method
Using the backward time difference approximation
(ti , xj ) (ti1 , xj )
(ti , xj+1 ) + (ti , xj1 ) 2(ti , xj )
=
t
(x)2
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"
i1
with
= Bi +
(ti , x0 )
0
..
.
0
(ti , xM )
i = 1, 2, . . . , N,
1 + 2
0
0
0
0
1 + 2
0
0
0
0
1 + 2
0
0
0
..
..
..
..
.. .
..
B = ...
.
.
.
.
.
.
0
0
0 1 + 2
0
0
0
0 1 + 2
0
0
0
0
1 + 2
(ti , x0 )
..
i = B 1 i1 B 1
i = 1, . . . , N.
,
.
0
(ti , xM )
1
2
(16.2)
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Explicit method
Using the backward time difference approximation of (16.2) we get
r(ti , xj ) =
(ti , xj ) (ti1 , xj )
(ti , xj+1 ) (ti , xj1 )
+ rxj
t
2x
1 2 2 (ti , xj+1 ) + (ti , xj1 ) 2(ti , xj )
,
+ xj
2
(x)2
1 j M 1, i.e.
(ti1 , xj ) =
1
t( 2 j 2 rj)(ti , xj1 ) + (1 t( 2 j 2 + r))(ti , xj )
2
1
+ t( 2 j 2 + rj)(ti , xj+1 ),
2
(ti , xM ) = xM Ker(T ti ) ,
0 i N,
(ti , xM ) = 0
0 i N,
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Explicit method
100
50
-50
-1000
0.1
0.2
0.3
0.4
0.5
0.6
time to maturity
0.7
0.8
0.9
20
40
60
80
100
120
140
160
180
200
strike
Implicit method
Using the forward time difference approximation of (16.2) we get
r(ti , xj ) =
(ti+1 , xj ) (ti , xj )
(ti , xj+1 ) (ti , xj1 )
+ rxj
t
2x
1 2 2 (ti , xj+1 ) + (ti , xj1 ) 2(ti , xj )
,
+ xj
2
(x)2
1 j M 1, i.e.
1
(ti+1 , xj ) = t( 2 j 2 rj)(ti , xj1 ) + (1 + t( 2 j 2 + r))(ti , xj )
2
1
t( 2 j 2 + rj)(ti , xj+1 ),
2
1 j M 1, i.e.
1
2 t
i+1
= Bi +
r 2 (ti , x0 )
0
..
.
0
21 t r(M 1) + 2 (M 1)2 (ti , xM )
i = 0, 1, . . . , N 1, with
Bj,j1 =
"
1
t rj 2 j 2 ,
2
Bj,j = 1 + 2 j 2 t + rt,
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N. Privault
and
1
Bj,j+1 = t rj + 2 j 2 ,
2
for j = 1, . . . , M 1, and B(i, j) = 0 otherwise.
By inversion of the matrix B, i is given in terms of i+1 as
1
2
(ti , x0 )
2 t r
.
1
1
i = B i+1 B
,
..
0
1
2
2
2 t r(M 1) + (M 1) (ti , xM )
i = 0, . . . , N,
= cer(T s) ,
as expected, where [x] denotes the integer part of x R. The implicit finite
difference method is known to be more stable than the explicit method, as
illustrated in Figure 16.2, in which the discretization parameters have been
taken to be the same as in Figure 16.1.
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Implicit method
140
120
100
80
60
40
20
0
time to maturity
10
20
40
60
80
100
120
140
160
180
200
strike
tN
X
k
w tk+1
tk
b(Xs )ds +
tN )(tk+1
b(X
k
w tk+1
tk
a(Xs )dWs
tN )(Wt
tk ) + a(X
Wtk ).
k+1
k
"
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N. Privault
we get
tN = X
tN + rX
tN (tk+1 tk ) + X
tN (Wt
X
Wtk ),
k+1
k+1
k
k
k
k
Y
i=1
1 + r(ti ti1 ) + (Wti Wti1 ) .
tk
hence
w tk+1
tk
1
((Wtk+1 Wtk )2 (tk+1 tk )),
2
and
N ' X
N +
X
tk+1
tk
w tk+1
tk
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"
tk
k+1
1
+ a0 (Xtk )a(Xtk )((Wtk+1 Wtk )2 (tk+1 tk ))
2
N + b(Xt )(tk+1 tk ) + a(Xt )(Wt
=X
W tk )
tk
k
k
k+1
1 0
2
+ a (Xtk )a(Xtk )((Wtk+1 Wtk ) (tk+1 tk )).
2
As a consequence the Milshtein scheme is written as
tN ' X
tN + b(X
tN )(tk+1 tk ) + a(X
tN )(Wt
X
W tk )
k+1
k+1
k
k
k
1 0 N
N
2
k
Y
i=1
"
1
1 + (r 2 /2)(ti ti1 ) + (Wti Wti1 ) + 2 (Wti Wti1 )2 .
2
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N. Privault
v) A non-negative, real-valued outcome: = R+ .
In this case the outcome R+ may represent the (non-negative) value
of a continuous random time.
vi) A random continuous parameter (such as time, weather, price or wealth,
temperature, ...): = R.
vii) Random choice of a continuous path in the space = C(R+ ) of all continuous functions on R+ .
In this case, is a function : R+ R and a typical example is
the graph t 7 (t) of a stock price over time.
Product spaces:
Probability spaces can be built as product spaces and used for the modeling
of repeated random experiments.
i) Rolling two dice: = {1, 2, 3, 4, 5, 6} {1, 2, 3, 4, 5, 6}.
In this case a typical element of is written as = (k, l) with
k, l {1, 2, 3, 4, 5, 6}.
ii) A finite number n of real-valued samples: = Rn .
In this case the outcome is a vector = (x1 , . . . , xn ) Rn with n
components.
Note that to some extent, the more complex is, the better it fits a practical
and useful situation, e.g. = {H, T } corresponds to a simple coin tossing
experiment while = C(R+ ) the space of continuous functions on R+ can be
applied to the modeling of stock markets. On the other hand, in many cases
and especially in the most complex situations, we will not attempt to specify
explicitly.
Events
An event is a collection of outcomes, which is represented by a subset of .
The collections G of events that we will consider are called -algebras, and
assumed to satisfy the following conditions.
(i) G,
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"
[
n1
An G,
(iii) A G = ( \ A) G,
where \ A := { :
/ A}.
The collection of all events in will often be denoted by F. The empty set
and the full space are considered as events but they are of less importance
because corresponds to any outcome may occur while corresponds to
an absence of outcome, or no experiment.
In the context of stochastic processes, two -algebras G and F such that
G F will refer to two different amounts of information, the amount of information associated to G being here lower than the one associated to F.
The formalism of -algebras helps in describing events in a short and precise
way.
Examples:
i) = {1, 2, 3, 4, 5, 6}.
The event A = {2, 4, 6} corresponds to
the result of the experiment is an even number.
ii) Taking again = {1, 2, 3, 4, 5, 6},
F := {, , {2, 4, 6}, {1, 3, 5}}
defines a -algebra on which corresponds to the knowledge of parity
of an integer picked at random from 1 to 6.
Note that in the set-theoretic notation, an event A is a subset of , i.e.
A , while it is an element of F, i.e. A F. For example, we have
{2, 4, 6} F, while {{2, 4, 6}, {1, 3, 5}} F.
Taking
G := {, , {2, 4, 6}, {2, 4}, {6}, {1, 2, 3, 4, 5}, {1, 3, 5, 6}, {1, 3, 5}} F,
defines a -algebra on which is bigger than F and corresponds to the
knowledge whether the outcome is equal to 6 or not, in addition to the
parity information contained in F.
iii) Take
= {H, T } {H, T } = {(H, H), (H.T ), (T, H), (T, T )}.
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N. Privault
In this case, the collection F of all possible events is given by
F = {, {(H, H)}, {(T, T )}, {(H, T )}, {(T, H)},
(16.3)
{(T, H), (T, T )}, {(H, T ), (H, H)}, {(T, H), (H, H)},
{(H, H), (T, T ), (T, H)}, {(H, H), (T, T ), (H, T )},
{(H, T ), (T, H), (H, H)}, {(H, T ), (T, H), (T, T )}, } .
Note that the set F of all events considered in (16.3) above has altogether
n
1=
event of cardinal 0,
0
n
4=
events of cardinal 1,
1
n
6=
events of cardinal 2,
2
n
events of cardinal 3,
4=
3
n
1=
event of cardinal 4,
4
with n = 4, for a total of
16 = 2n =
4
X
4
k=0
=1+4+6+4+1
events.
The collection of events
G := {, {(T, T ), (H, H)}, {(H, T ), (T, H)}, }
defines a sub -algebra of F, associated to the information the results of
two coin tossings are different.
Exercise: Write down the set of all events on = {H, T }.
Note also that (H, T ) is different from (T, H), whereas {(H, T ), (T, H)} is
equal to {(T, H), (H, T )}.
In addition we will usually make a distinction between the outcome
and its associated event {} F, which satisfies {} .
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Probability Measures
A probability measure is a mapping P : F [0, 1] that assigns a probability
P(A) [0, 1] to any event A, with the properties
a) P() = 1, and
!
[
X
b) P
An =
P(An ), whenever Ak Al = , k 6= l.
n=1
n=1
(16.4)
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N. Privault
P(A B)
P(B)
[
X
X
X
P B
An =
P(BAn ) =
P(B | An )P(An ) =
P(An | B)P(B),
n=1
n=1
n=1
n=1
X
[
b) P
An B =
P(An | B), whenever Ak Al = , k 6= l.
n=1
n=1
In particular if
n=1
X
n=1
P(B An ) =
X
n=1
P(An | B)P(B) =
X
n=1
[
X
P A
Bn 6=
P(A | Bn ),
n=1
n=1
"
Random Variables
A real-valued random variable is a mapping
X : R
7 X()
(k, l) 7 k + l.
Then X is a random variable giving the sum of the two numbers appearing on each die.
ii) the time needed everyday to travel from home to work or school is a
random variable, as the precise value of this time may change from day
to day under unexpected circumstances.
iii) the price of a risky asset is a random variable.
1
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In the sequel we will often use the notion of indicator function 1A of an event
A. The indicator function 1A is the random variable
1A : {0, 1}
7 1A ()
defined by
1A () =
1 if A,
0 if
/ A,
(16.8)
since
A B { A and B}
{1A () = 1 and 1B () = 1}
1A ()1B () = 1.
We also have
1AB = 1A + 1B 1AB = 1A + 1B 1A 1B ,
and
1AB = 1A + 1B ,
(16.9)
1{X<n} =
1 if X < n,
0 if X n.
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Probability Distributions
The probability distribution of a random variable X : R is the collection
{P(X A) : A measurable subset of R}.
In fact the distributions of X can be reduced to the knowledge of either
{P(a < X b) = P(X b) P(X a) : a < b R},
or
{P(X a) : a R},
or
{P(X a) : a R}.
Two random variables X and Y are said to be independent under the
probability P if their probability distributions satisfy
P(X A , Y B) = P(X A)P(Y B)
for all (measurable) subsets A and B of R.
wb
a
f (x)dx
and
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N. Privault
x 7 P(X x) =
as
fX (x) =
w
x
x R,
fX (s)ds,
wx
w
fX (s)ds =
fX (s)ds,
x
x x
x R.
Examples:
i) The uniform distribution on an interval.
The density of the uniform distribution on the interval [a, b], a < b, is
given by
1
f (x) =
1[a,b] (x),
x R.
ba
x R.
2 2
e(x)
/(2 2 )
x R.
x
,
e
0,
x0
(16.10)
x < 0.
We also have
P(X > t) = et ,
t R+ .
(16.11)
In addition, if X1 , . . . , Xn are independent exponentially distributed random variables with parameters 1 , . . . , n we have
P(min(X1 , . . . , Xn ) > t) = P(X1 > t, . . . , Xn > t)
= P(X1 > t) P(Xn > t)
= et(1 ++n ) ,
t R+ , (16.12)
"
wwy
0
e1 x2 y dxdy =
{(x,y)R2+ : x=y}
1
,
1 + 2
(16.13)
e1 x2 y dxdy = 0.
x1 eax ,
()
1 ax
1[0,) (x)x
e
=
f (x) =
()
0,
where a > 0 and > 0 are parameters and
w
() =
x1 ex dx,
x0
x < 0,
> 0,
1
,
(1 + x2 )
x R.
x 2
(log x)2
2 2
x 2
0,
(log x)2
2 2
, x0
x < 0.
Exercise: For each of the above probability density functions, check that the
condition
w
f (x)dx = 1
is satisfied.
Remark 16.1. Note that if the distribution of X admits a density then for
all a R, we have
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N. Privault
P(X = a) =
wa
a
f (x)dx = 0,
(16.14)
7 (X(), Y ()).
w w
A
and
(x, y) 7 P(X x, Y y) =
ww
x
as
2 w x w y
f(X,Y ) (s, t)dsdt
xy
2 ww
=
f(X,Y ) (s, t)dsdt,
xy x y
f(X,Y ) (x, y) =
(16.15)
x, y R.
The probability densities fX : R R+ and fY : R R+ of X :
R and Y : R are called the marginal densities of (X, Y ) and are given
by
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x R,
fY (y) =
y R.
and
(16.16)
f(X,Y ) (x, y)
,
fY (y)
x, y R,
(16.17)
Discrete Distributions
We only consider integer-valued random variables, i.e. the distribution of X
is given by the values of P(X = k), k N.
Examples:
i) The Bernoulli distribution.
We have
P(X = 1) = p
and
P(X = 0) = 1 p,
(16.18)
n k
p (1 p)nk ,
k
k = 0, 1, . . . , n,
k N,
(16.19)
"
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N. Privault
X := inf{k N : Xk = 0}
has the geometric distribution (16.19).
iv) The negative binomial distribution (or Pascal distribution).
We have
P(X = k) =
k+r1
(1 p)r pk ,
r1
k N,
where p (0, 1) and r 1 are parameters. Note that the negative binomial distribution recovers the geometric distribution when r = 1.
v) The Poisson distribution.
We have
P(X = k) =
k
e ,
k!
k N,
P(X = k) = 0,
k=0
which is a contradiction.
Given two discrete random variables X and Y , the conditional distribution
of X given Y = k is given by
P(X = n | Y = k) =
P(X = n and Y = k)
,
P(Y = k)
n N,
"
Discrete Distributions
Next, let X : N be a discrete random variable. The expectation IE[X]
of X is defined as the sum
IE[X] =
kP(X = k),
k=0
(k)P(X = k),
k=0
and
P(X = k) = 1/2k ,
k 1.
(16.20)
"
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IE[aX + bY ] = a IE[X] + b IE[Y ],
a, b R,
(16.21)
provided
IE[|X|] + IE[|Y |] < .
The notion of expectation takes its full meaning under conditioning. For example, the expected return of a random asset usually depends on information
such as economic data, location, etc. In this case, replacing the expectation by
a conditional expectation will provide a better estimate of the expected value.
For instance, life expectancy is a natural example of a conditional expectation since it typically depends on location, gender, and other parameters.
by
X
k=0
kP(X = k | A).
1
IE [X1A ] .
P(A)
(16.22)
1 X
1 X
kP({X = k} A) =
k IE 1{X=k}A
P(A)
P(A)
k=0
k=0
"
#
X
1 X
1
=
k IE 1{X=k} 1A =
IE 1A
k1{X=k}
P(A)
P(A)
IE[X | A] =
k=0
k=0
1
IE [1A X] ,
=
P(A)
(16.23)
k1{X=k}
k=0
"
One can also define the conditional expectation of X given that {Y = k}, as
IE[X | Y = k] =
X
n=0
nP(X = n | Y = k),
k=0
IE[X | Y = k]P(Y = k)
nP(X = n | Y = k)P(Y = k)
k=0 n=0
X
X
n=0
P(X = n and Y = k)
k=0
nP(X = n) = IE[X],
n=0
k=0
n N,
that follows from the law of total probability (16.7) by taking Ak = {Y = k}.
Hence we have the relation
IE[X] = IE[IE[X | Y ]],
(16.24)
k1Ak ,
k=0
X
k=0
IE[X | Ak ]P(Ak ),
(16.25)
"
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Random sums
Based on the tower property or ordinary conditioning, the expectation of a
Y
X
random sum
Xk , where (Xk )kN is a sequence of random variables, can
k=1
k=1
=
=
X
n=0
"
IE
Y
X
k=1
n
X
"
IE
n=0
#
Xk Y = n P(Y = n)
#
Xk Y = n P(Y = n),
k=1
X
X
X
IE
Xk P(Y = n).
Xk =
IE
k=1
n=0
k=1
Y
X
Y
IE
Xk P(Y = n).
IE
Xk =
k=1
n=0
(16.26)
k=1
Example:
The life expectancy in Singapore is IE[T ] = 80 years overall, where T
denotes the lifetime of a given individual chosen at random. Let G
{m, w} denote the gender of that individual. The statistics show that
IE[T | G = w] = 78
and
IE[T | G = m] = 81.9,
and we have
80 = IE[T ]
= IE[IE[T |G]]
= P(G = w) IE[T | G = w] + P(G = m) IE[T | G = m]
= 81.9 P(G = w) + 78 P(G = m)
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"
81.9 80
1.9
=
= 0.487.
81.9 78
3.9
(x)fX (x)dx,
2
In case X has a Gaussian distribution with mean R and variance 2 > 0
we get
w
2
2
1
IE[(X)] =
(x)e(x) /(2 ) dx.
2
2
In case (X, Y ) : R2 is a R2 -valued couple of random variables whose
distribution admits a density fX,Y : R R+ we have
w w
(x, y)fX,Y (x, y)dxdy,
IE[(X, Y )] =
"
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N. Privault
"
Var
n
X
#
Xk
n
X
= IE
k=1
"
= IE
"
= IE
n
X
Xk
=
=
n
X
n
X
Xk
k=1
l=1
n X
n
X
"
Xl IE
#
Xk Xl
X
IE[Xk2 ] +
k=1
n
X
1k6=ln
"
k=1
k=1 l=1
!2
IE
Xk IE
" n
X
k=1
n X
n
X
#!2
Xk
k=1
n
X
n
X
#
Xl
l=1
IE[Xk ] IE[Xl ]
k=1 l=1
IE[Xk Xl ]
n
X
(IE[Xk ])2
k=1
IE[Xk ] IE[Xl ]
1k6=ln
k=1
n
X
Var [Xk ].
(16.27)
k=1
2 = IE[X 2 ] (IE[X])2 .
and
where the conditional density fX|Y =y (x) is defined in (16.17), with the relation
IE[X] = IE[IE[X | Y ]]
(16.28)
as in the discrete case, since
w
w w
IE[IE[X | Y ]] =
IE[X | Y = y]fY (y)dy =
xfX|Y =y (x)fY (y)dxdy
w
w w
xfX (x)dx = IE[X],
x
f(X,Y ) (x, y)dydx =
=
where we used Relation (16.16) between the density of (X, Y ) and its marginal
X.
For example, an exponentially distributed random variable X with probability density function (16.10) has the expected value
IE[X] =
w
0
xex dx =
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1
.
"
= ( + ) 2
ey dy
ey ey dy
ey yey )dy
0
0
0
1
1
= ( + ) 2
+ ( + )
( + )
( + )2
= ( + ) 2
( + )2
( + )2
( + )2
( + )2 ( + )
= ( + ) 2
( + )2
1
=
= IE[min(X, Y )].
(16.29)
+
Conditional Expectation
The construction of conditional expectation given above for discrete and absolutely continuous random variables can be generalized to -algebras.
For any p 1 we let
Lp () = {F : R : IE[|F |p ] < }
(16.30)
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N. Privault
IE[GF ] = IE[G IE[F | G]],
(16.31)
(16.32)
(16.33)
(16.34)
"
t R,
"
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N. Privault
IE[X n ] =
n
X (0),
t
n 1,
Note that in probability we are using the bilateral Laplace transform for which
the integral is from to +.
The characteristic function X of a random variable X with density f :
R R+ satisfies
w
X (t) =
eitx f (x)dx,
t R.
t R.
n=0
X (t) = Y (t),
s, t R.
s, t R.
IE[eiX ] = ei
2 /2
R.
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(16.35)
"
IE[eX ] = e+
2 /2
R.
(16.36)
2
2
X
/2 itt2 Y
/2
= eit(+)t
2
2
(X
+Y
)/2
t R,
Exercises
Exercise 1 Compute the expected value IE[X] of a Poisson random variable
X with parameter > 0.
Exercise 2 Let X denote a centered Gaussian random variable with variance
2 , > 0. Show that the probability P (eX > c) is given by
P (eX > c) = ((log c)/),
where log = ln denotes the natural logarithm and
1 w x y2 /2
(x) =
e
dy,
2
x R,
1
2 2
(x)2
2 2
x R.
445
N. Privault
1. Write down IE[X] as an integral and show that
= IE[X].
2
x K if x K,
(x K)+ =
0
if x K,
where K R be a fixed real number. Write down IE[(X K)+ ] as an
integral and compute this integral.
Hints: (x K)+ is zero when x < K, and when = 0 and = 1 the
result is
K2
1
IE[(X K)+ ] = e 2 K(K),
2
where
(x) :=
wx
y2
2
dy
,
2
x R.
where
(x) =
wx
y2
2
dy
,
2
x R.
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"
wx
y2
2
dy
,
2
x R.
y2
v 2 2 y v 2
=
.
2
v
4
v
2
2. Compute
IE[(em+X K)+ ] =
1
2v 2
x2
"
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Exercise Solutions
Chapter 1
Exercise 1.1
1. The possible values of R are a and b.
2. We have
IE [R] = aP (R = a) + bP (R = b)
ra
br
+b
=a
ba
ba
= r.
3. By Theorem 1.1, there do not exist arbitrage opportunities in this market
since there exists a risk-neutral measure P from Question 2.
4. The risk-neutral measure is unique hence the market model is complete
by Theorem 1.2.
5. Taking
(1 + b) (1 + a)
=
and =
,
1 (b a)
S0 (b a)
we check that
1 + S0 (1 + a) =
1 + S0 (1 + b) = ,
N. Privault
(1 + b) (1 + a) (1 + r)( )
(1 + r)(b a)
b a r( )
=
.
(1 + r)(b a)
(16.37)
7. We have
IE [C] = P (R = a) + P (R = b)
ra
br
+
.
=
ba
ba
(16.38)
1
IE [C]
1+r
9. The initial value (C) of the portfolio is interpreted as the arbitrage price
of the option contract and it equals the expected value of the discounted
payoff.
10. We have
11 S1 if K > S1 ,
+
+
C = (K S1 ) = (11 S1 ) =
0 if K S1 .
11. We have
=
(11 (1 + a))
2
= ,
ba
3
(1 + b)(11 (1 + a))
8
=
.
(1 + r)(b a)
1.05
Chapter 2
Exercise 2.1
1. The possible values of Rt are a and b.
2. We have
IE [Rt+1 | Ft ] = aP (Rt+1 = a | Ft ) + bP (Rt+1 = b | Ft )
br
ra
=a
+b
= r.
ba
ba
3. We have
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"
IE [St+k | Ft ] =
i
ki
k
X
ra
br
k
(1 + b)i (1 + a)ki St
b
a
b
a
i
i=0
i
ki
k
X
k
ra
br
= St
(1 + b)
(1 + a)
i
ba
ba
i=0
k
ra
br
= St
(1 + b) +
(1 + a)
ba
ba
= (1 + r)k St .
Assuming that the formula holds for k = 1, its extension to k 2 can also
be proved recursively from the tower property (16.24) of conditional
expectations, as follows:
IE [St+k | Ft ] = IE [IE [St+k | Ft+k1 ] | Ft ]
= (1 + r) IE [St+k1 | Ft ]
= (1 + r)2 IE [St+k2 | Ft ]
= (1 + r)k2 IE [St+2 | Ft ]
= (1 + r)k1 IE [St+1 | Ft ]
= (1 + r)k St .
Chapter 3
Exercise 3.1
1. The condition VN = C reads
N N + N (1 + a)SN 1 = (1 + a)SN 1 K
N N + N (1 + b)SN 1 = (1 + b)SN 1 K
N 1 N 1 + N 1 (1 + a)SN 1 = N N 1 + N (1 + a)SN 1
"
N 1 N 1 + N 1 (1 + b)SN 1 = N N 1 + N (1 + b)SN 1 ,
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N. Privault
which yields N 1 = N = 1 and N 1 = N = K(1 + r)N /0 .
Similarly, solving the self-financing condition
= St K(1 + r)(N t)
= Vt = t (C).
Exercise 3.2
0.07 0.05
br
=
,
ba
0.07 (0.02)
P(Rt = b) =
ra
0.05 (0.02)
=
,
ba
0.07 (0.02)
and
t = 1, . . . , N .
2. There are no arbitrage opportunities in this model, due to the existence
of a risk-neutral measure.
3. This market model is complete because the risk-neutral measure is
unique.
4. We have
C = (SN )2 ,
hence
H = (SN )2 /(1 + r)N = h(XN ),
with
h(x) = x2 (1 + r)N .
Now we have
Vt = vt (Xt ),
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"
(N t)!
k!(N t k)!
k=0
k
N tk
k
N tk !
ra
br
1+b
1+a
h x
ba
ba
1+r
1+r
vt (x) =
N
t
X
(N t)!
k!(N t k)!
k=0
k
N tk
2k
2(N tk)
ra
br
1+b
1+a
ba
ba
1+r
1+r
= x2 (1 + r)N
N
t
X
(N t)!
k!(N t k)!
k
N tk
(r a)(1 + b)2
(b r)(1 + a)2
(b a)(1 + r)2
(b a)(1 + r)2
N t
(b r)(1 + a)2
(r
a)(1
+
b)2
+
= x2 (1 + r)N
2
2
(b a)(1 + r)
(b a)(1 + r)
N t
x2 (r a)(1 + b)2 + (b r)(1 + a)2
=
(1 + r)N 2t (b a)N t
N t
2
x (r a)(1 + 2b + b2 ) + (b r)(1 + 2a + a2 )
=
(1 + r)N 2t (b a)N t
= x2 (1 + r)N
k=0
N t
x2 r(1 + 2b + b2 ) a(1 + 2b + b2 ) + b(1 + 2a + a2 ) r(1 + 2a + a2 )
(1 + r)N 2t (b a)N t
N t
(1
+
r(2
+
a
+
b)
ab)
= x2
.
(1 + r)N 2t
5. We have
t1 =
vt
1+b
1+r Xt1
vt
1+a
1+r Xt1
Xt1 (b a)/(1 + r)
2
2
1+b
1+a
1+r
1+r
(1 + r(2 + a + b) ab)N t
= Xt1
(b a)/(1 + r)
(1 + r)N 2t
(1 + r(2 + a + b) ab)N t
= St1 (2 + b + a)
,
t = 1, . . . , N,
(1 + r)N t
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N. Privault
Vt t1 Xt
Xt0
Vt t1 Xt
=
0
t0 =
Xt Xt1 (2 + b + a)/(1 + r)
0 (1 + r)N 2t
S
S
t
t1 (2 + b + a)
= St (1 + r(2 + a + b) ab)N t
0 (1 + r)N
(1 + a)(1 + b)
= (St1 )2 (1 + r(2 + a + b) ab)N t
,
0 (1 + r)N
= Xt (1 + r(2 + a + b) ab)N t
t = 1, . . . , N .
6. Let us check that the portfolio is self-financing. We have
0
1
t+1 St = t+1
St0 + t+1
St1
(1 + a)(1 + b) 0
S
0 (1 + r)N t
(1 + r(2 + a + b) ab)N t1
+(St )2 (2 + b + a)
(1 + r)N t1
(1 + r(2 + a + b) ab)N t1
= (St )2
(1 + r)N t
((2 + b + a)(1 + r) (1 + a)(1 + b))
1
= (Xt )2 (1 + r(2 + a + b) ab)N t
(1 + r)N 3t
= (1 + r)t Vt
= t St ,
t = 1, . . . , N.
= (St )2 (1 + r(2 + a + b) ab)N t1
Exercise 3.3
1. We have
Vt = t St + t t
= t (1 + Rt )St1 + t (1 + r)t1 .
2. We have
IE [Rt |Ft1 ] = aP (Rt = a | Ft1 ) + bP (Rt = b | Ft1 )
ra
br
+b
=a
ba
ba
r
r
=b
a
ba
ba
= r.
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"
Vt1 =
Chapter 4
Exercise 4.1
1. We need to check whether the four properties of the definition of Brownian motion are satisfied. Checking Conditions (i) to (iii) does not pose
any particular problem since the time changes t 7 c + t, t 7 t/c2 and
t 7 ct2 are deterministic, continuous, and increasing. As for Condition (iv), Bc+t Bc+s clearly has a centered Gaussian distribution with
variance t, and the same property holds for cBt/c2 since
Var (c(Bt/c2 Bs/c2 )) = c2 Var (Bt/c2 Bs/c2 ) = c2 (t s)/c2 = t s.
As a consequence, (a) and (b) are standard Brownian motions.
Concerning (c), we note that Bct2 is a centered Gaussian random variable
with variance ct2 - not t, hence (Bct2 )tR+ is not a standard Brownian
motion. w
T
2dBt = 2(BT B0 ) = 2BT , which has a Gaussian law with
2. We have
0
mean 0 and variance 4T . On the other hand,
"
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N. Privault
wT
0
which has a Gaussian law with mean 0 and variance 4(T /2)+T /2 = 5T /2.
w 2
3. The stochastic integral
sin(t) dBt has a Gaussian distribution with
0
mean 0 and variance
w 2
w 2 1 cos(2t)
dt = .
sin2 (t)dt =
0
0
2
4. If 0 s t we have
IE[Bt Bs ] = IE[(Bt Bs )Bs ]+IE[Bs2 ] = IE[(Bt Bs )] IE[Bs ]+IE[Bs2 ] = 0+s = s,
and similarly we obtain IE[Bt Bs ] = t when 0 t s, hence in general
we have IE[Bt Bs ] = min(s, t), s, t 0.
5. We have
d(f (t)Bt ) = f (t)dBt + Bt df (t) + df (t) dBt
= f (t)dBt + Bt f 0 (t)dt,
and by integration on both sides we get
0 = f (T )BT f (0)B0
wT
=
d(f (t)Bt )
0
wT
wT
=
f (t)dBt +
Bt f 0 (t)dt,
0
0 t T.
"
XtT
dXtT
dBt
dt =
+
,
T t (T t)2
T t
w
t
0
1
dBs = 0.
T s
t [0, T ].
w
t
0
1
dBs
T s
1
ds
(T s)2
1
1
= 2 (T t)2
T t T
= 2 (T t)2
= 2 (1 t/T ).
2
IE[rt ] = exp eat log r0 + (1 eat ) +
(1 e2at ) .
a
4a
"
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N. Privault
6. We have lim IE[rt ] = exp
t
2
+
.
a 4a
(16.39)
wt
0
wt
1 w t 2 Xs
u e ds
us eXs dBs +
vs eXs ds +
0
0
2 0 s
wt
wt
2 wt
eXs ds +
= eX0 + eXs dBs +
eXs ds
0
0
2 0
wt
wt
2 wt
= S0 + Ss dBs +
Ss ds +
Ss ds.
0
0
2 0
= eX0 +
wt
2. Let r > 0. The process (St )tR+ satisfies the stochastic differential equation
dSt = rSt dt + St dBt
when r = + 2 /2.
3. Let the process (St )tR+ be defined by St = S0 eBt +t , t R+ . Using
the decomposition ST = St e(BT Bt )+ , we have
P(ST > K | St = x) = P(St e(BT Bt )+(T t) > K | St = x)
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"
=
log(x/K) +
=
,
where = T t.
4. We have
2 = Var[X] = Var[(BT Bt )] = 2 Var[BT Bt ] = 2 (T t),
hence = T t.
Chapter 5
Exercise 5.1
1. We have
St = S0 et +
wt
0
e(ts) dBs .
2. We have M = r.
3. After computing the conditional expectation
2 2r(T t)
C(t, x) = er(T t) exp xer(T t) +
(e
1) .
4r
4. Here we need to note that the usual Black-Scholes argument applies and
yields t = C(t, St )/x, that is
2 2r(T t)
(e
1) .
t = exp St er(T t) +
4r
Exercise 5.2
1. We have, counting approximately 46 days to maturity,
(r 12 2 )(T t) + log SKt
T t
(0.04377 12 (0.9)2 )(46/365) + log
p
=
0.9 46/365
= 2.46,
d =
17.2
36.08
and
"
459
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a turity
D-M -Y)
N. Privault
p
d+ = d + 0.9 46/365 = 2.14.
From the attached table we get
(d+ ) = (2.14) = 0.0162
and
(d ) = (2.46) = 0.0069,
hence
f (t, St ) = St (d+ ) Ker(T t) (d )
= HK$ 0.031.
2. We have
t =
f
(t, St ) = (d+ ) = (2.14) = 0.0162,
x
(16.40)
hence one should only hold a fractional quantity 16.2 of the risky asset
in order to hedge 1000 such call options when = 0.90.
3. From the curve it turns out that when f (t, St ) = 10 0.023 = HK$ 0.23,
the volatility is approximately equal to = 122%.
Print
This approximate value of implied volatility can be found under the column Implied Volatility (IV.) on this set of market data from the Hong
Kong
DeStock
rivaExchange:
tive W a rra nt Se a rch
U pda te d: 6 Nov e mbe r 2008
http://www.hkex.com.hk/dwrc/sear
Ba sic Da ta
Strike
Entitle me nt
Ra tio^
DW
Code
Issue r
UL
Ca ll
/Put
DW
Ty pe
Listing
(D-M -Y)
M a turity
(D-M -Y)
Strik e
Entitle me nt
Ra tio^
Tota l
Issue
Size
01897
FB
00066
Call
Link to Re
le v a nt Ex cha
nge Tra de
d Options
Standard
18-12-2007
23-12-2008
36.
08
10 138, 000, 000 16. 43
04348
BP
00066
Call
38. 88
0. 25
04984
AA
00066
Call
Standard 02-06-2005
22-12-2008
Ma
rke t Da ta
12. 88
0. 36
Tota l
05931
Issue
Size
09133
De lta
Da y
Da y
Closing
SB O/S
00066
Call IV.
Standard
27-03-2008
29-12-2008
27.T/O
868
(%)
(%)
(%)
High Low
Price #
('000)
($)
($)
($)
CT
00066 Call
Standard
31-01-2008
08-12-2008
36. 88
UL
Ba se
Listing
10 200,
000,
000
Price
Docume nt
($)
10 200, 000, 000
O/S
(%)
D
(
Supple
0.
04
2
Announ
0. 15
0
12-2008
36. 08
32
0 17. 200
10 200, 000, 000
0. 10
02-2009
38. 88
30
0 17. 200
10 150, 000, 000
0. 00
12-2008
12. 88
7. 17
0. 31
0. 50
0 17. 200
10 100, 000, 000
0. 81
0. 00
0. 987 127. 080 0. 000 0. 000
0. 026
0 17. 200
00066 Call
Standard 09-07-2008 16-02-2009
23. 88
10 500, 000, 000
0. 88
0. 03
6 17. 200
10 300, 000, 000
0. 00
0. 15
0 17. 200
10 300, 000, 000
0. 86
0. 00
12-2008
36. 88
04-2009
32
12-2008
30
02-2009
26. 6
02-2009
28
01-2009
27. 38
12-2008
28. 8
02-2009
23. 88
02-2009
26. 38
03-2009
27
06-2009
28. 08
0 17. 200
26. 6
10 200, 000, 000
Remark: a typical value for the volatility in standard market
conditions
10 200, 000, 000
0. 04
2. 239 126. 132 0. 000 0. 000
0. 086
0 17. 200
13764
SG
00066 Call
28
10 300, 000, 000
would
be around
20%. The Standard
observed13-06-2008
volatility26-02-2009
value = 1.22
per year
is
10 200, 000, 000
0. 15
0. 416 133. 443 0. 000 0. 000
0. 010
0 17. 200
13785
ML
00066 Call
Standard 17-06-2008 19-01-2009
27. 38
10 100, 000, 000
actually
quite
high.
10 200, 000, 000
0. 10
1. 059
61. 785 0. 000 0. 000
0. 031
13821
JP
00066 Call
Standard 18-06-2008 18-12-2008
10 150,
000, 000
Exercise
5.3
14111
UB
10 200, 000, 000
7. 17
0. 706
BI
1. We 14264
find h(x)
= x00066
K.Call
460 10
200, 000,
000 24,
0. 03
1. 250
58. 172 0. 000 0. 000
0. 030
This10version:
2013
14548April
CT
00066
Call
Standard 12-08-2008 25-05-2009
10 300, 000, 000
0. 00
0. 000
0. 000 0. 000 0. 000 99, 999, 999. 000
http://www.ntu.edu.sg/home/nprivault/indext.html
14571
CT
00066
Put
Standard 15-08-2008 22-06-2009
10 175, 000, 000
0. 15
1. 681
28. 8
0. 053
27
26
"
26. 88
0 17. 200
10 400, 000, 000
0. 03
26
0 17. 200
10 240, 000, 000
0. 06 (6.
0 17. 200
g(t, St ) St
St Ker(T t) St
Vt t St
=
=
= KerT .
At
At
At
g
2 2 2 g
g
(x, t) + rx (x, t) +
x
(x, t)
t
x
2
x2
t [0, T ].
Note again that this hedging strategy is constant over time, and the
relation t = g(St , t)/x for the Delta, cf. (16.40), is satisfied.
"
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N. Privault
Exercise 5.5 Using It
os formula and the fact that the expectation of the
stochastic integral with respect to (Wt )tR+ is zero, cf. Relation (4.11), we
have
C(x, T ) = erT IE [(ST )]
w
T
= (x) IE
rers (St )dt
0
w
w
T
T
rt 0
+ IE r
e (St )St dt + IE
ert 0 (St )bs (St )dWt
0
0
w
T
1
ert 00 (St ) 2 (St )dt
+ IE
0
2
wT
wT
= (x)
rert IE [(St )] dt + r
ert IE [0 (St )St ] dt
0
0
w
1 T rt 00
+
e
IE (St ) 2 (St ) dt.
2 0
Chapter 6
Exercise 6.1
1. For all t [0, T ] we have
C(t, St ) = er(T t) St2 IE
ST2
St2
h
i
2
= er(T t) St2 IE e2(BT Bt ) (T t)+2r(T t)
= St2 e(r+
)(T t)
2
C
(t, x)|x=St = 2St e(r+ )(T t) ,
x
and
t =
2
ert 2 (r+2 )(T t)
C(t, St ) t St
=
(S e
2St2 e(r+ )(T t) )
At
A0 t
S2 2
= t e (T t)+r(T 2t) .
A0
3. We have
dC(t, St ) = d(St2 e(r+
2
)(T t)
= (r + )e
(r+ 2 )(T t)
St2 dt + e(r+
462
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)(T t)
d(St2 )
"
= re
)(T t)
St2 dt
St2 dt + e(r+
+ 2St e
)(T t)
(r+ 2 )(T t)
dSt ,
and
St2 2 (T t)+r(T 2t)
At dt
e
A0
)(T t)
dSt r
= 2St e(r+
)(T t)
dSt rSt2 e
(T t)+r(T t)
dt,
wt
er(ts) dBs .
St = S0 +
wt
ers dBs ,
2. We have
= Ss .
3. We have
C(t, St ) = er(T t) E[exp(ST )|Ft ]
wT
= er(T t) E exp erT S0 +
er(T u) dBu Ft
0
wt
wT
er(T u) dBu Ft
= er(T t) E exp erT S0 + er(T u) dBu +
0
"
463
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N. Privault
w
T
= exp r(T t) + er(T t) St E exp
er(T u) dBu Ft
t
w
T
= exp r(T t) + er(T t) St E exp
er(T u) dBu
t
2w
T
C
2 2r(T t)
(t, St ) = exp St er(T t) +
(e
1)
x
4r
and
C(t, St ) t St
At
er(T t)
2 2r(T t)
(e
1)
=
exp St er(T t) +
At
4r
2
St
(e2r(T t) 1) .
exp St er(T t) +
At
4r
t =
5. We have
2 2r(T t)
dC(t, St ) = rer(T t) exp St er(T t) +
(e
1) dt
4r
2
(e2r(T t) 1) dt
rSt exp St er(T t) +
4r
2 r(T t)
2 2r(T t)
r(T t)
e
exp St e
+
(e
1) dt
2
4r
2
+ exp St er(T t) +
(e2r(T t) 1) dSt
4r
1 r(T t)
2 2r(T t)
r(T t)
+ e
exp St e
+
(e
1) 2 dt
2
4r
2
"
f
(t, x) = f (t, x),
x
2f
(t, x) = 2 f (t, x),
x2
hence
dSt = df (t, Bt )
f
f
1 2f
=
(t, Bt )dt +
(t, Bt )dBt +
(t, Bt )dt
2 x2
t
x
1
1
= r 2 f (t, Bt )dt + f (t, Bt )dBt + 2 f (t, Bt )dt
2
2
= rf (t, Bt )dt + f (t, Bt )dBt
= rSt dt + St dBt .
2. We have
E[eBT |Ft ] = E[e(BT Bt +Bt ) |Ft ]
(T t)/2
3. We have
E[ST |Ft ] = E[eBT +rT
=e
rT T /2
= erT
E[e
"
T /2
BT
|Ft ]
|Ft ]
T /2 Bt + 2 (T t)/2
= erT +Bt
=e
t/2
465
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N. Privault
= er(T t) St .
4. We have
Vt = er(T t) E[C|Ft ]
= er(T t) E[ST K|Ft ]
= St er(T t) K.
1 if x K,
1 if x K,
1[K,) (x) =
resp.
1[0,K] (x) =
0 if x < K,
0 if x > K,
which shows the claimed result by the definition of Cd and Pd .
2. We have
t (Cd ) + t (Pd ) = er(T t) IE[Cd | Ft ] + er(T t) IE[Pd | Ft ]
= er(T t) IE[Cd + Pd | Ft ]
0 t T,
since P(ST = K) = 0.
3. We have
t (Cd ) = er(T t) IE[Cd | Ft ]
4. We have
Cd (t, x) = er(T t) P (ST > K | St = x)
r 2 /2 + log(x/K)
,
= er(T t)
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"
r 2 /2 + log(St /K)
= er(T t) (d ) ,
where
d =
6. We have
t (Pd ) = er(T t) t (Cd )
= er(T t) er(T t)
r 2 /2 + log(x/K)
= er(T t) (1 (d ))
= er(T t) (d ).
7. We have
Cd
(t, St )
x
r 2 /2 + log(x/K)
= er(T t)
x
x=St
1
r(T t)
(d )2 /2
=e
e
2 St
> 0.
t =
The Black-Scholes hedging strategy of such a call option does not involve
short-selling because t > 0 for all t.
8. Here we have
Pd
(t, St )
x
r 2 /2 + log(x/K)
= er(T t)
x
x=St
1
r(T t)
(d )2 /2
= e
e
2 St
< 0.
t =
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N. Privault
Chapter 8
Exercise 8.1
1. We have St = S0 eBt , t R+ .
2. We have
2
IE[ST ] = S0 IE[eBT ] = S0 e T /2 .
3. We have
!
P
sup Bt a
=2
t[0,T ]
w
a
ex
/(2T )
dx
,
2T
a > 0,
r
(a) =
2 a2 /(2T )
e
1[0,) (a),
T
a R.
4. We have
"
!#
= S0
w
0
ex (x)dx
2S0 2
2S0 2 T /2 x2 /(2T )
x2 /2
=
e
e
dx = e T /2
dx
e
T
T
2
2T
w T
2
2
2
= 2S0 e T /2
ex /2 dx = 2S0 e T /2 ( T ) = 2 IE[ST ]( T ).
468
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"
1/2
2 (T
ratio
1.5
0.5
0
0
0.5
1.5
2
time T
2.5
3.5
w
a
r
Xt (x)dx =
2 w x2 /(2t)
e
dx,
t y
y > 0.
2. We have
d
P (a t)
dt
d w
=
Xt (x)dx
a
dt r
r
1 2 3/2 w x2 x2 /(2t)
1 2 3/2 w x2 /(2t)
t
e
dx +
t
e
dx
=
a
a
2
2
t
r
w
2
2
1 2 3/2 w x2 /(2t)
=
t
e
dx + aea /(2t) +
ex /(2t) dx
a
a
2
2
a
=
ea /(2t) ,
t > 0.
2t3
a (t) =
3. We have
"
a w 5/2 a2 /(2t)
E[(a )2 ] =
t
e
dt
2 0
w
2 2
2a
=
x2 ea x /2 dx
2 0
1
= 2,
a
469
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N. Privault
by the change of variable x = t1/2 , x2 = 1/t, t = x2 , dt = 2x3 dx.
Remark: We have
a w 1/2 a2 /(2t)
t
e
dt = +.
E[a ] =
2 0
Exercise 8.3 Barrier options.
1. By (8.33) and (8.21) we find
g
St
St
T t
T t
t =
(t, St ) = +
+
y
K
B
2r/2
2
2r
K
St
B
B
T t
T t
+ er(T t) 1 2
B
B
KSt
St
12r/2
2
B
2r St
B
T t
T t
+
+ 2
+
B
KSt
St
2 !
2
K
1
St
T t
p
1
exp
+
,
B
2
B
2(T t)
0 < St B, 0 t T , cf. also Exercise 7.1-(ix) of [71] and Figure 8.13
above.
2. We find
P(YT a & BT b) = P(BT 2a b),
a < b < 0,
hence
fYT ,BT (a, b) =
dP(YT a & BT b)
dP(YT a & BT b)
=
,
dadb
dadb
a, b R.,
satisfies
r
fYT ,BT (a, b) =
e
,
T
T
=
0,
a < b 0,
a > b 0.
3. We find
fYT ,BT (a, b) = 1(,b0] (a)
1
T
2
2
2
(b 2a)e T /2+b(2ab) /(2T )
T
470
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"
2
2
2
1
0,
a < b 0,
a > b 0.
max Su > B
0uT
= 1(
max Su > B
) (S
t
Ker(T t) ) + 1(
0ut
max Su B
Ft
) (t, S ),
t
0ut
(16.41)
where the function
T t
T t
(t, x) := x +
(x/B) Ker(T t)
(x/B)
2
2
T t
T t
+B(B/x)2r/ +
(B/x) Ker(T t) (B/x)1+2r/
(B/x)
solves the Black-Scholes PDE with the terminal condition
2
"
471
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N. Privault
18
16
14
12
10
8
6
4
2
0
80
75
70
65
60
underlying
55
50
45
40
220
200
140
160
180
100
120
Time in days
Fig. 16.4: Graph of the down-and-in long forward contract price with K < B = 80.
As for the hedging strategy we find
T t
2
1
T t
(x/B) + e(+ (x/B)) /2
(t, St ) = +
x
2
T t
2
2
2r
1
T t
Ker(T t)( (x/B)) /2 2 (B/x)1+2r/ +
(B/x)
x 2
T t
2
2
1
+ (B/x)1+2r/ e(+ (B/x)) /2
2
2
K(1 2r/ 2 ) r(T t)
T t
e
(B/x)2r/
(B/x)
B
T t
2
2
K
(B/x)2r/ er(T t)( (B/x)) /2
B 2
2r
2
T t
T t
= +
(x/B) 2 (B/x)1+2r/ +
(B/x)
T t
T t
2
2
1
B
+ (1 K/B) e(+ (x/B)) /2 + er(T t)( (x/B)) /2
x
2
K
T t
2 r(T t)
2r/ 2
(1 2r/ )e
(B/x)
(B/x) ,
B
t =
e(
and
T t
e(
T t
T t
(B/x))2 /2
(x/B))2 /2
472
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(x/B))2 /2
(B/x))2 /2
"
0.3
0.25
0.2
0.15
0.1
0.05
0
80
75
70
65
underlying
60
55
50
45
40
220
200
180
160
140
100
120
Time in days
Fig. 16.5: Delta of the down-and-in long forward contract with K < B = 80.
2. Up-and-out barrier long forward contract. We have
r(T t)
IE[C | Ft ] = e
r(T t)
IE (ST K) 1(
max Su < B
0uT
= 1(
max Su B
) (t, S ),
t
Ft
(16.42)
0ut
"
473
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N. Privault
220
200
180
160
Time in days
140
120
100 60
65
70
underlying
75
80
Fig. 16.6: Graph of the up-and-out long forward contract price with K < B = 80.
As for the hedging strategy we find
T t
2
1
T t
(x/B) e(+ (x/B)) /2
(t, St ) = +
x
2
T t
2
2
2r
1
T t
+ Ker(T t)( (x/B)) /2 + 2 (B/x)1+2r/ +
(B/x)
x 2
T t
2
2
1
(B/x)1+2r/ e(+ (B/x)) /2
2
2
K(1 2r/ 2 ) r(T t)
T t
+
e
(B/x)2r/
(B/x)
B
T t
2
2
K
+ (B/x)2r/ er(T t)( (B/x)) /2
B 2
2r
2
T t
T t
= +
(x/B) + 2 (B/x)1+2r/ +
(B/x)
T t
T t
2
1 B r(T t)(
1
(x/B))2 /2
e
e(+ (x/B)) /2
2
2 x
T t
T t
2
K
1 K r(T t)(
(x/B))2 /2
+ e(+ (x/B)) /2 +
e
B 2
2 x
2
K
T t
+ (1 2r/ 2 )er(T t) (B/x)2r/
(B/x)
B
2r
2
T t
T t
= +
(x/B) + 2 (B/x)1+2r/ +
(B/x)
T t
T t
2
2
1
B
(1 K/B) e(+ (x/B)) /2 + er(T t)( (x/B)) /2
x
2
K
T t
2 r(T t)
2r/ 2
+ (1 2r/ )e
(B/x)
(B/x) ,
B
t =
by (8.38).
474
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"
1
0.95
0.9
0.85
0.8
0.75
0.7
60
65
70
underlying
75
140
120
80 100
160
220
200
180
Time in days
Fig. 16.7: Graph of the up-and-out long forward contract price with K < B = 80.
3. Down-and-in barrier long forward contract. We have
r(T t)
IE[C | Ft ] = e
r(T t)
IE (ST K) 1(
min Su < B
0uT
= 1(
min Su < B
) (S
t
Ker(T t) ) + 1(
0ut
min Su B
Ft
) (t, S )
t
0ut
(16.43)
where the function
T t
T t
(x/B)
(t, x) := x +
(x/B) Ker(T t)
2
2
T t
T t
+B(B/x)2r/ +
(B/x) Ker(T t) (B/x)1+2r/
(B/x)
solves the Black-Scholes PDE with the terminal condition
2
"
475
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N. Privault
18
16
14
12
10
8
6
4
2
0
100
80
85
120
140
160
Time in days
180
90
200
220
95
underlying
100
Fig. 16.8: Graph of the down-and-in long forward contract price with K < B = 80.
As for the hedging strategy we find
t =
(t, St )
x
2r
2
T t
= +
(x/B) + 2 (B/x)1+2r/
T t
2
1
(1 K/B) e(+ (x/B)) /2 +
2
2
K
+ (1 2r/ 2 )er(T t) (B/x)2r/
B
T t
+
(B/x)
T t
B r(T t)(
(x/B))2 /2
e
x
T t
(B/x) .
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
100
80
85
120
140
160
Time in days
180
90
200
220
95
underlying
100
Fig. 16.9: Delta of the down-and-in long forward contract with K < B = 80.
4. Down-and-out barrier long forward contract. We have
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r(T t)
IE[C | Ft ] = e
r(T t)
IE (ST K) 1(
min Su > B
0uT
= 1(
min Su B
) (t, S )
t
Ft
(16.44)
0ut
2
2
T t
T t
B(B/x)2r/ +
(B/x) + Ker(T t) (B/x)1+2r/
(B/x)
solves the Black-Scholes PDE with the terminal condition
2
40
35
30
25
20
15
10
5
0
220
200
180
Time in days
160
140
120
100 80
85
90
95
underlying
100
Fig. 16.10: Graph of the down-and-out long forward contract price with K < B = 80.
As for the hedging strategy we find
t =
(t, St )
x
2r
2
T t
T t
(x/B) 2 (B/x)1+2r/ +
(B/x)
= +
T t
T t
2
2
1
B
+ (1 K/B) e(+ (x/B)) /2 + er(T t)( (x/B)) /2
x
2
2
K
T t
(1 2r/ 2 )er(T t) (B/x)2r/
(B/x) .
B
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1.1
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
220
100
200
180
Time in days
95
160
140
90
120
85
underlying
100 80
Fig. 16.11: Delta of the down-and-out long forward contract with K < B = 80.
5. Up-and-in barrier short forward contract. The price of the up-and-in barrier short forward contract is identical to (16.41) with a negative sign.
6. Up-and-out barrier short forward contract. The price of the up-and-out
barrier short forward contract is identical to (16.42) with a negative sign.
Note that (t, x) coincides with the price of (8.12) of the standard upand-out barrier put option in the case B < K.
7. Down-and-in barrier short forward contract. The price of the down-andin barrier short forward contract is identical to (16.43) with a negative
sign.
8. Down-and-out barrier short forward contract. The price of the down-andout barrier short forward contract is identical to (16.44) with a negative
sign.
Exercise 8.5
1. We have
P
wa
2
dx
,
min Bt a = 2
ex /(2T )
t[0,T ]
2T
a < 0,
r
(a) =
2 a2 /(2T )
e
1(,0] (a),
T
a R.
2. We have
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min St = S0 IE exp min Bt
t[0,T ]
t[0,T ]
w
w
T
2
2S0 2 T /2 T x2 /(2T )
2S0 2
=
e
e
dx = e T /2
ex /2 dx
2
2T
2
= 2S0 e T /2 T = 2 IE[ST ] 1 T ,
hence
IE ST min St = IE[ST ] IE min St = IE[ST ] 2 IE[ST ] 1 T
t[0,T ]
t[0,T ]
2
= IE[ST ] 2 T 1 = 2S0 e T /2 T 1/2 ,
and
e
T /2
IE ST min St = S0 2 T 1 = S0 1 2 T .
t[0,T ]
2 ((T1/2)-1)
0.8
price
0.6
0.4
0.2
0
0
time T
M0t
t =
"
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+er(T t)
M0t
St
2r/2
1
2
2r
t
M0
T t
,
St
t [0, T ], and
t At = f (t, St , M0t ) t St
t 1+2r/2
t
M0
St
M0
T t
T t
= M0t er(T t)
er(T t)
.
t
M0
St
St
Exercise 8.7
rT
1. The integral
= 2
= 2
wT wT
0
IE[Bs Bt ]dsdt
wT wT
min(s, t)dsdt
0
0
wT wt
= 2 2
sdsdt
0
0
wT
= 2
t2 dt
0
= 2 T 3 /3.
2. Since the integral
rT
0
we have
e
rT
IE
"
w
erT
+ #
w
ru du
= erT
(x )+ (x)dx
(x )e3x /(2 T ) dx
2 2 T 3 /3
p
2
erT w
=
(x 2 T 3 /3 )ex /2 dx
2 / 2 T 3 /3
p
2
2
erT 2 T 3 /3 w
erT w
2 3 xex /2 dx
=
ex /2 dx
/ T /3
2
2 / 2 T 3 /3
p
p
erT 2 T 3 /3 h x2 /2 i
erT
e
=
2 3 (1 (/ 2 T 3 /3))
/
T
/3
2
2
= p
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e
(1 (/ 2 T 3 /3))
2
2
!
r
r
2 T 3 32 /(22 T 3 )
erT
3
rT
=e
e
.
6
2 T 3
2
erT
f
f
1
2f
f
(t, x, y) + x (t, x, y) + rx (t, x, y) + x2 2 2 (t, x, y),
t
y
x
2
x
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which shows that
g(t, Zt ) = h(t, Ut ),
and it remains to use the relation
Ut =
1 er(T t)
+ er(T t) Zt ,
rT
t [0, T ].
Chapter 9
Exercise 9.1 Stopping times.
1. When 0 t < 1 the question is > t ? cannot be answered at time t
without waiting to know the value of B1 at time 1. Therefore is not a
stopping time.
2. For any t R+ , the question is > t ? can be answered based on the
observation of the paths of (Bs )0st and of the (deterministic) curve
(es/2 )0st up to the time t. Therefore is a stopping time.
Since is a stopping time and (Bt )tR+ is a martingale, the stopping time
theorem shows that (eBt (t )/2 )tR+ is also a martingale and in particular its expectation IE[eBt (t )/2 ] = IE[eB0 (0 )/2 ] = IE[eB0 0/2 ] =
1 is constantly equal to 1 for all t. This shows that
h
i
IE[eB /2 ] = IE lim eBt (t )/2 = lim IE[eBt (t )/2 ] = 1.
t
/2
= e
] = IE[e
, hence
B /2
] = 1,
i.e.
IE[e ] = 1/ 1.
Remark: note that this argument fails when < 1 because in that case
is not a.s. finite.
3. For any t R+ , the question is > t ? can be answered based on the
observation of the paths of (Bs )0st and of the (deterministic) curve
(1 + s)0st up to the time t. Therefore is a stopping time.
Since is a stopping time and (Bt )tR+ is a martingale, the stopping
2
time theorem shows that (Bt
(t ))tR+ is also a martingale and
2
2
in particular its expectation IE[Bt
(t )] = IE[B0
(0 )] =
IE[B02 0] = 0 is constantly equal to 0 for all t. This shows that
h
i
2
2
IE[B2 ] = IE lim (Bt
(t )) = lim IE[(Bt
(t ))] = 0.
t
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n 0,
and
Nn = Mn An ,
n N,
(16.45)
we have,
(i) for all n N,
IE[Nn+1 | Fn ] = IE[Mn+1 An+1 | Fn ]
= IE[Mn+1 An IE[Mn+1 Mn | Fn ] | Fn ]
= IE[Mn+1 An | Fn ] IE[IE[Mn+1 Mn | Fn ] | Fn ]
= IE[Mn+1 An | Fn ] IE[Mn+1 Mn | Fn ]
= IE[An | Fn ] + IE[Mn | Fn ]
= M n An
= Nn ,
= IE[Mn+1 | Fn ] IE[Mn | Fn ]
= IE[Mn+1 | Fn ] Mn 0,
n N,
n 1,
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2. For all bounded stopping times and such that a.s., we have
IE[M ] = IE[N ] + IE[A ]
IE[N ] + IE[A ]
= IE[N ] + IE[A ]
= IE[M ],
0 t < T,
CdAm (T, x) = 0,
0 x < K.
and
4. Based on the answers to Question 2, we set
PdAm (t, K) = 1,
0 t < T,
and
PdAm (T, x) = 0,
x > K.
e2a
,
P(a u) =
u
u
and by differentiation with respect to u this yields the probability density
function
fa (u) =
(au)2
a
P(a u) =
e 2u 1[0,) (u)
u
2u3
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"
(ut)/2+(ut)
u t,
we find that the probability density function of the first hitting time of
level K after time t by (Su )u[t,) is given by
u 7 p
a
2(u
t)3
(a(ut))2
2(ut)
u t,
1
K
log ,
exp rs 2
=
r
s + log
ds
0 2s3
2 s
2
x
( r2 12 )( r2 + 21 )
K
=
x
2 !
w log(K/x)
1
2
K
exp 2
r+
s + log
ds
0 2s3
2 s
2
x
2r/2 w
2
1 x w y2 /2
1
K
=
e
dy +
ey /2 dy
y+
2 K y
2 x
x
(r + 2 /2) + log(x/K)
=
K
x 2r/2 (r + 2 /2) + log(x/K)
,
0 < x < K,
K
where
y =
2
K
r+
+ log
,
2
x
1
"
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N. Privault
log
K
1
=
x
2
r+
2
2
s + log
K
x
+
1
2
2
K
r+
s + log
.
2
x
We check that
CdAm (t, K) = () + () = 1,
and
2
CdAm (T, x) =
x 2r/
x
() +
() = 0,
K
K
x < K,
exp rs 2
r
s + log
ds
=
0 2s3
2 s
2
K
( r2 21 )( r2 + 12 )
K
=
x
2 !
w log(x/K)
1
2
x
exp 2
r+
s + log
ds
0 2s3
2 s
2
K
2
1 x w y2 /2
1 x 2r/ w y2 /2
=
e
dy +
e
dy
y+
2 K y
2 K
2
(r + /2) log(x/K)
x
=
K
x 2r/2 (r + 2 /2) log(x/K)
,
x > K,
K
with
y =
2
x
r+
+ log
,
2
K
1
We check that
PdAm (t, K) = () + () = 1,
and
2
PdAm (T, x) =
x 2r/
x
() +
() = 0,
K
K
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0 < x < K,
"
,
K
while for x > K we find
x
(r + 2 /2) log(x/K)
+
.
K
Exercise 9.4
1. For all stopping times such that t T we have
i
i
i
h
h
h
IE er( t) (K S )St = K IE er( t) St IE er( t) S St
= er( t) K St ,
since [t, T ] is bounded and (ert St )tR+ is a martingale, and the
above quantity is clearly maximized by taking = t. Hence we have
i
h
f (t, St ) =
sup
IE er( t) (K S )St = K St ,
t T
stopping time
and the optimal strategy is to wait until the maturity time T in order to
exercise.
"
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N. Privault
3. Concerning the perpetual American long forward contract, since u 7
er(ut) Su is a martingale, for all stopping times we have2
i
i
i
h
h
h
IE er( t) (S K)St = IE er( t) S St K IE er( t) St
i
h
= St K IE er( t) St
St ,
t 0.
t 0,
hence
sup
t
stopping time
i
h
IE er( t) (S K)St (St er(T t) K),
T t,
t
stopping time
= St ,
hence we have
f (t, St ) =
sup
t T
stopping time
i
h
IE er( t) (S K)St = St ,
sup
t T
stopping time
i
h
IE er( t) (K S )+ St
= fL (St ).
On the other hand, for = L we have
(K SL ) = (K L ) = (K L )
2
by Fatous Lemma.
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"
sup
IE er( t) (K S )St
t T
stopping time
= f (t, St ),
which shows that
f (t, St ) = fL (St ),
i.e. the perpetual American short forward contract has same price and
exercise strategy as the perpetual American put option.
Exercise 9.5
1. We have
t/2 2r/ 2
t /+rt
2r/ rt2r t/ 2 +2r B
S0
e
t /(2r/)2 t/2
2r/ 2 2r B
S0
e
=
=
and
Zt = ert St = S0 eBt
t/2
which are both martingales under P because they are standard geometric
Brownian motions with respective volatilities and 2r/.
2. Since Yt and Zt are both martingales and L is a stopping time we have
2r/ 2
S0
= IE [Y0 ]
= IE [YL ]
2
= IE [erL S2r/
]
L
2
= IE [erL L2r/ ]
2
= L2r/ IE [erL ],
hence
IE [erL ] = (x/L)2r/
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N. Privault
hence
IE [erL ] = x/L
K L
0 < x L,
x L ,
=
(16.46)
x 2r/2
(K L)
, x L.
L
4. By differentiating
IE erL (K SL ) | S0 = x
L
(x/L)2r/2 2r K 1 1 ,
L
=
Kx ,
L2
0 < L < x,
L > x,
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"
( x)p ,
0 < x L,
=
x 2r/2
( L)p
, x L.
L
4. By differentiating
d
dx (
(16.47)
fL0 (L ) =
i.e.
2r
(L )2r/ 1
= p( L )p1 ,
( L )p
2
(L )2r/2
2r
( L ) = pL ,
2
or
L =
2r
< .
2r + p 2
( St )p ,
0 < St L ,
p
2r/2
f (t, St ) = fL (St ) =
p 2
2r + p 2 St
,
St L ,
2r + p 2
2r
u t,
is a nonnegative supermartingale.
Exercise 9.7
1. The payoff will be (St )p .
2. We have
i
h
fL (St ) = E er(L t) ( (SL )p )St
i
h
= E er(L t) ( Lp )St
h
i
= ( Lp )E er(L t) St .
3. We have
h
i
fL (x) = E er(L t) ( (SL )p )St = x
"
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xp ,
0 < x L,
2
( Lp ) x 2r/ , x L.
L
4. We have
2
fL0 (L ) =
i.e.
2r
(L )2r/ 1
= p(L )p1 ,
( (L )p )
2
(L )2r/2
2r
( (L )p ) = p(L )p ,
2
or
L =
2r
2r + p 2
1/p
< ()1/p .
(16.48)
L
p
=
( L )
L
L
x
2r/2
2r/2
L
L
2r
+ 2 L1 ( Lp )
,
= pLp1
x
x
and equating fL (x)/L to 0 at L = L yields
p(L )p1 +
2r 1
(L ) ( (L )p ) = 0,
2
(St )p ,
0 < St L ,
2
fL (St ) =
(S )2r/
( (L )p ) t 2r/2 ,
St L
(L )
(St )p ,
0 < St L ,
=
2
(St )p ,
0 < St L ,
2r/(p2 )
=
p 2
2r + p 2 Stp
< ,
St L ,
2r + p 2
2r
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"
u t,
does not remain nonnegative when p > 1, so that (9.12) cannot be applied as in the proof of Proposition 9.4.
Exercise 9.8
1. We have that
2
2 2
2 2
St
t R+ ,
is a geometric Brownian motion without drift under the risk-neutral probability measure P , hence it is a martingale.
2. By the stopping time theorem we have
IE [ZL ] = IE [Z0 ] = 1,
which rewrites as
"
IE
SL
S0
#
e((ra)
/2+2 2 /2)L
= 1,
L
S0
h
i
2
2 2
IE e((ra) /2+ /2)L = 1,
i.e.
IE erL =
S0
L
,
(16.49)
i.e.
0 = 2 2 /2 + (r a 2 /2) r.
This equation admits two solutions
p
(r a 2 /2) (r a 2 /2)2 + 4r 2 /2
=
,
2
and we choose the negative solution
"
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(r a 2 /2)
(r a 2 /2)2 + 4r 2 /2
2
since S0 /L = x/L > 1 and the expectation IE [erL ] < 1 is lower than
1 as r 0.
3. Noting that L = 0 if S0 L, for all L (0, K) we have
i
h
IE erL (K SL )+ S0 = x
0 < x L,
K x,
=
h
i
E erL (K L)+ S0 = x , x L.
0 < x L,
K x,
=
h
i
(K L)E erL S0 = x , x L.
0 < x L,
K x,
=
2 /2)2 +4r 2 /2
(ra2 /2) (ra
2
(K L) x
, x L.
L
4. In order to compute L we observe that, geometrically, the slope of fL (x)
at x = L is equal to 1, i.e.
fL0 (L ) = (K L )
(L )1
= 1,
(L )
or
(K L ) = L ,
or
L =
5. For x L we have
K < K.
1
x
L
!
x
K
= K
1
1 K
K
x( 1)
=
1
K
K
x
1
=
1
fL (x) = (K L )
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"
K
x 1 K
=
=
(16.50)
(16.51)
x 1
K
=K
K
+xK
1
!
x 1 1
x
+
1 .
K
1 K
x1
1
we have
x
1
0.
fL (x) (1 x) =
+x1
1
1
1
= x1
+1
0,
(16.52)
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for x L =
K. In case
1
0 x L =
K < K,
1
we have
fL (x) = K x = (K x)+ ,
hence the relation
1
rfL (x) (r a)xfL0 (x) 2 x2 fL00 (x) (fL (x) (K x)+ ) = 0
2
always holds. On the other hand, in that case we also have
1
(r a)xfL0 (x) + 2 x2 fL00 (x) = (r a)x,
2
and to conclude we need to show that
1
(r a)xfL0 (x) + 2 x2 fL00 (x) rfL (x) = r(K x),
2
(16.53)
which is true if
ax rK.
Indeed by (16.49) we have
(r a) = r + ( 1) 2 /2
r,
hence
a
since < 0, which yields
r,
1
ax aL a
K rK.
1
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"
sup
stopping time
i
h
IE er (K S )+ S0 .
(16.54)
sup
IE er (K S )+ S0 .
stopping time
10. By combining the above results and conditioning at time t instead of time
0 we deduce that
i
h
fL (St ) = IE er(L t) (K SL )+ St
"
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K St ,
0 < St
K,
1
1
1
St
St
K,
1
22
> 1,
2 1
since 0 1 < 2 .
2. We have
IE[erL (S1 (L ) S2 (L ))+ ] = IE[erL (LS2 (L ) S2 (L ))+ ]
= (L 1)+ IE[erL S2 (L )].
(16.55)
"
S1 (t)
S2 (t)
S1 (0)
S2 (0)
(16.57)
,
1
IE[er ( S2 ( ))+ ] =
1 2
,
S2 (0) 2
Chapter 10
Exercise 10.1
1. We have
t = d
dX
"
Xt
Nt
=
X0 ()Bt (2 2 )t/2
d e
N0
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2
2
2
2
X0
X0
( )e()Bt ( )t/2 dBt +
( )2 e()Bt ( )t/2 dt
N0
2N0
2
2
X0 2
( 2 )e()Bt ( )t/2 dt
2N0
Xt 2
Xt
Xt
=
( 2 )dt +
( )dBt +
( )2 dt
2Nt
Nt
2Nt
Xt
Xt
( )dBt
= ( )dt +
Nt
Nt
Xt
( )(dBt dt)
=
Nt
Xt
= ( ) dB
t = ( )Xt dBt ,
Nt
IE[(XT ) ] = X0
+
2
2
T
is given by the Black-Scholes formula with zero interest rate and volatility
parameter
= , which shows (10.30) by multiplication by N0 and
0 , i.e.
the relation X0 = N0 X
N0 (XT NT )+
ert IE[(XT NT )+ ] = IE
NT
h
i
T )+
= N0 IE (X
0 (d+ ) N0 (d )
= N0 X
= X0 (d+ ) N0 (d ).
3. We have
= .
Exercise 10.2 Bond options.
1. Itos formula yields
P (t, S)
P (t, S) S
d
=
( (t) T (t))(dWt T (t)dt)
P (t, T )
P (t, T )
P (t, S) S
t,
=
( (t) T (t))dW
(16.58)
P (t, T )
by the Girsanov
t )tR is a standard Brownian motion under P
where (W
+
theorem.
2. From (16.58) we have
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exp X
| (s) (s)| ds K
= P (t, T )IE
Ft
P (t, T )
2 t
+
eX+m(t,T,S) K Ft ,
= P (t, T )IE
where X is a centered Gaussian random variable with variance
wT
v 2 (t, T, S) =
| S (s) T (s)|2 ds
t
given Ft , and
1
P (t, S)
m(t, T, S) = v 2 (t, T, S) + log
.
2
P (t, T )
Recall that when X is a centered Gaussian random variable with variance
v 2 , the expectation of (em+X K)+ is given, as in the standard BlackScholes formula, by
IE[(em+X K)+ ] = em+
v2
2
where
(z) =
wz
ey
/2
dy
,
2
z R,
denotes the Gaussian cumulative distribution function and for simplicity of notation we dropped the indices t, T, S in m(t, T, S) and v 2 (t, T, S).
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Consequently we have
i
h rT
IE e t rs ds (P (T, S) K)+ Ft
v
1
P (t, S)
v
1
P (t, S)
= P (t, S)
+ log
KP (t, T ) + log
.
2 v
KP (t, T )
2 v
KP (t, T )
4. The self-financing hedging strategy that hedges the bond option is obtained by holding a (possibly fractional) quantity
1
P (t, S)
v
+ log
2 v
KP (t, T )
of the bond with maturity S, and by shorting a quantity
v
1
P (t, S)
K + log
2 v
KP (t, T )
of the bond with maturity T .
Exercise 10.3
1. The process
ert S2 (t) = S2 (0)e2 Wt +(r)t
is a martingale if
r=
1 2
.
2 2
2. We note that
2
(22 12 )t/2
S1 (t)
= S1 (0)et1 t/2 e1 Wt +t
2
= S1 (0)e1 Wt 1 t/2
is a martingale, where
2
X(t)
=
Nt
2
= e(2 1 )t/2
S1 (t)
S2 (t)
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where
t := Wt 2 t
W
defined by
is a standard Brownian motion under the forward measure P
rT
dP
NT
= e 0 rs ds
dP
N0
rT S2 (T )
=e
S2 (0)
= erT e2 WT +T
= e2 WT +(r)T
2
= e2 WT 2 t/2 .
2
2
(22 12 )T /2
(22 12 )T /2
IE[(XT e
S2 (T ))+ ]
2
2
(
)T
/2
X
T e 2 1
= S2 (0)e
)+ ]
IE[(
2
2
X
0 e(1 2 )WT (1 2 )2 T /2 e(22 12 )T /2 )+ ]
= S2 (0)e(2 1 )T /2 IE[(
2
2
0 0+ (T, X
0 ) e(22 12 )T /2 0 (T, X
0)
= S2 (0)e(2 1 )T /2 X
(22 12 )T /2
0 0+ (T, X
0)
= S2 (0)e(2 1 )T /2 X
S2 (0)e
=e
=
(22 12 )T /2
(22 12 )T /2
0)
e(2 1 )T /2 0 (T, X
0 ) S2 (0)0 (T, X
0)
X0 0+ (T, X
0
0 ),
S2 (0) (T, X
0)
S1 (0)0+ (T, X
where
0+ (T, x) =
"
( 2 )2 (22 12 )
log(x/)
+ 1
T
2|1 2 |
|1 2 | T
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log(x/)
+ 1 T ,
|1 2 | T
1 > 2 ,
log(x/)
1 T ,
|1 2 | T
1 < 2 ,
and
log(x/)
( 2 )2 + (22 12 )
1
T
2|1 2 |
|1 2 | T
log(x/)
+ 2 T , 1 > 2 ,
|1 2 | T
=
log(x/)
2 T , 1 < 2 ,
|1 2 | T
0 (T, x) =
if 1 6= 2 . In case 1 = 2 we find
erT IE[(S1 (T ) S2 (T ))+ ] = erT IE[S1 (T )(1 S2 (0)/S1 (0))+ ]
= (1 S2 (0)/S1 (0))+ erT IE[S1 (T )]
= (S1 (0) S2 (0))1{S1 (0)>S2 (0)} .
Exercise 10.4
1. It suffices to check that the definition of (WtN )tR+ implies the correlation
identity dWtS dWtN = dt by Itos calculus.
2. We let
q
p
tS tN
N
dWtS 1 2 t dWt ,
t R+ ,
Ft = eaT IE XT eaT Ft
RT
+
T e(ar)T Ft
= e(ar)T IE X
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T t
T t
1
St
(r a
2 /2)(T t)
(ar)T
+
log
e
Rt
T t
T t
(r a +
2 /2)(T t)
St (ra)(T t)
1
St
=
+
log
Rt
Rt
T t
T t
(r a
2 /2)(T t)
1
St
+
log
,
Rt
T t
T t
= e(ar)T
Ft
RT
1
St
(r a +
2 /2)(T t)
St a(T t)
+
log
e
=
Rt
Rt
T t
T t
1
St
(r a
2 /2)(T t)
r(T t)
+
log
.
e
Rt
T t
T t
Chapter 11
Exercise 11.1 Letting Yt = ebt Xt we have
dYt = d(ebt Xt ) = bebt Xt dt+ebt dXt = bebt Xt dt+ebt (bXt dt+ebt dBt ) = dBt ,
hence
Yt = Y0 +
wt
0
dYs = Y0 +
wt
0
dBs = Y0 + Bt ,
and
Xt = ebt Yt = ebt Y0 + ebt Bt = ebt X0 + ebt Bt .
Exercise 11.2
1. We have rt = r0 + at + Bt , and
F (t, rt ) = F (t, r0 + at + Bt ),
hence by Proposition 11.2 the PDE satisfied by F (t, x) is
xF (t, x) +
F
1 2F
F
(t, x) + a
(t, x) + 2 2 (t, x) = 0,
t
x
2 x
(16.59)
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w
T
F (t, rt ) = IE exp
rs ds Ft
t
wT
wT
= IE exp r0 (T t) a
sds
Bs ds Ft
t
t
wT
2
2
= IE er0 (T t)a(T t )/2 exp (T t)Bt
(T s)dBs Ft
t
wT
2
2
= er0 (T t)a(T t )/2(T t)Bt IE exp
(T s)dBs Ft
t
wT
= er0 (T t)a(T t)(T +t)/2(T t)Bt IE exp
(T s)dBs
t
2 w T
= exp (T t)rt a(T t)2 /2 +
(T s)2 ds
2 t
= exp (T t)rt a(T t)2 /2 + 2 (T t)3 /6 ,
hence F (t, x) = exp (T t)x a(T t)2 /2 + 2 (T t)3 /6 .
Note that the PDE (16.59) can also be solved by looking for a solution
of the form F (t, x) = eA(T t)+xC(T t) , in which case one would find
A(s) = as2 /2 + s3 /6 and C(s) = s.
3. We check that the function F (t, x) of Question 2 satisfies the PDE (16.59)
of Question 1, since F (T, x) = 1 and
2
xF (t, x) + x + a(T t)
(T t)2 F (t, x) a(T t)F (t, x)
2
1 2
+ (T t)2 F (t, x) = 0.
2
4. We have
1
f (t, T, S) =
(log P (t, T ) log P (t, S))
ST
1
2
2
=
(T t)rt +
(T t)3 (S t)rt +
(S t)3
ST
6
6
1 2
= rt +
((T t)3 (S t)3 ).
ST 6
5. We have
f (t, T ) =
2
log P (t, T ) = rt
(T t)2 .
T
2
6. We have
dt f (t, T ) = 2 (T t)dt + adt + dBt .
7. The HJM condition (11.36) is satisfied since the drift of dt f (t, T ) equals
rT
t ds.
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wT
t
sds = (t, T )
wT
t
(t, s)ds.
2. We have
f (t, T ) = f (0, T ) +
wt
ds f (s, T )
wt
wt 2
= f (0, T ) +
T (T s2 )ds + T
dBs
0
0
2
w
w
wt
2
2
t
3 t
= f (0, T ) +
T
ds
T
s2 ds + T
dBs
0
0
0
2
2
2 3
2
3
= f (0, T ) + T t/2 T t /6 + T Bt
0
2
3. We have
rt = f (t, t) = f (0, t) + 2 t2 (t2 /2 t2 /6) + tBt = f (0, t) + 2 t4 /3 + tBt .
4. We have
4 2 3
t dt + Bt dt + tdBt
3
1
= 4 2 t3 /3dt + (rt f (0, t) 2 t4 /3)dt + tdBt
t
1
= (rt f (0, t) + 2 t4 )dt + tdBt
t
1
= 2 t3 dt + (rt f (0, t))dt + tdBt ,
t
drt =
Exercise 11.4
1. We have
w
t
s
ru du +
wt
s
uT dBu
1wt T 2
|u | du ,
2 s
0 s t T.
2. We have
rt
rt
d e 0 rs ds P (t, T ) = e 0 rs ds tT P (t, T )dBt ,
which gives a martingale after integration, from the properties of the It
o
integral.
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3. By the martingale property of the previous question we have
i
i
h rT
h
rT
IE e 0 rs ds Ft = IE P (T, T )e 0 rs ds Ft
= P (t, T )e
rt
0
rs ds
0 t T.
P (t, T ) = e
rt
since e
5. We have
rs ds
rt
0
rs ds
w
t
P (s, S)
1wt S 2
P (t, S)
=
exp
(uS uT )dBu
(|u | |uT |2 )du
s
P (t, T )
P (s, T )
2 s
w
t
P (s, S)
1wt S
S
T
T
=
exp
(u u )dBu
(u uT )2 du ,
s
P (s, T )
2 s
0 t T , hence letting s = t and t = T in the above expression we have
w
T
P (t, S)
1wT S
P (T, S) =
exp
(sS sT )dBsT
(s sT )2 ds .
t
P (t, T )
2 t
6. We have
h
i
+
P (t, T ) IET (P (T, S) )
"
+ #
P (t, S) r T (sS sT )dBsT 1 r T (sS sT )2 ds
2
t
t
= P (t, T ) IET
e
P (t, T )
= P (t, T ) IE[(eX )+ | Ft ]
2
vt
1
= P (t, T )emt +vt /2
+ (mt + vt2 /2 log )
2
vt
vt
1
P (t, T ) + (mt + vt2 /2 log ) ,
2
vt
with
mt = log(P (t, S)/P (t, T ))
and
vt2 =
wT
t
1wT S
(s sT )2 ds
2 t
(sS sT )2 ds,
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(S t)
dBs (T t)
dBs
0 Ss
0 T s
ST
T t
1 wt St
dBs
ST 0 Ss T s
w
t (T s)(S t) (T t)(S s)
1
dBs
ST 0
(S s)(T s)
w
t
(s t)(S T )
dBs .
+
S T 0 (S s)(T s)
f (t, T, S) =
=
=
=
=
3. We have
f (t, T ) =
wt
0
ts
dBs .
(T s)2
4. We note that
lim f (t, T ) =
T &t
wt
0
1
dBs
ts
dP (t, T )
1
XtT
= dBt + 2 dt + dt
dt
P (t, T )
2
T t
1
log P (t, T )
= dBt + 2 dt
dt,
2
T t
t [0, T ].
6. Let
1
XtS
rtS = + 2
2
St
wt 1
1
= + 2
dBs ,
0 Ss
2
and apply the result of Exercise 11.11.7-(4).
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7. We have
IE
2
dPT
Ft = eBt t/2 .
dP
t
s + 2 (S T ) log
log P (t, S) + (S T )
dB
,
=
t Ss
St
ST
0 < T < S.
10. We have
i
h
P (t, T ) IET (P (T, S) K)+ Ft
= P (t, T ) IE[(eX )+ | Ft ]
2
1
vt
= P (t, T )emt +vt /2
+ (mt + vt2 /2 log )
2
vt
vt
1
P (t, T ) + (mt + vt2 /2 log )
2
vt
1
1
mt +vt2 /2
= P (t, T )e
vt + (mt log ) P (t, T )
(mt log ) ,
vt
vt
with
mt =
and
ST
St
log P (t, S) + 2 (S T ) log
St
ST
wT
1
ds
(S s)2
1
1
= 2 (S T )2
ST
St
(T t)
2
= (S T )
,
(S t)
vt2 = 2 (S T )2
hence
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ST
2 (ST ) !!
(ST )(St)
1
(P (t, S))
St
P (t, T )
log
.
vt
ST
Exercise 11.6 From Proposition 11.2 the bond pricing PDE is
F
F
1
2F
(t, x) = xF (t, x) ( x)
(t, x) 2 x2 2 (t, x)
t
x
2
x
F (T, x) = 1.
Let us search for a solution of the form
F (t, x) = eA(T t)xB(T t) ,
with A(0) = B(0) = 0, which implies
0
A (s) = 0
2(es 1)
,
2 + ( + )(es 1)
p
2 + 2 2 .
Chapter 12
Exercise 12.1
S is defined from the numeraire Nt := P (t, S) and
1. The forward measure P
this gives
Ft = P (t, S)IE[(
L(T, T, S))+ | Ft ].
2. The LIBOR rate L(t, T, S) is a driftless geometric Brownian motion with
S . Indeed, the LIBOR rate
volatility under the forward measure P
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t = Xt /Nt
L(t, T, S) can be written as the forward price L(t, T, S) = X
where Xt = (P (t, T ) Pr (t, S))/(S T ) and N
=
P
(t,
S).
Since
both dist
rt
t
counted bond prices e 0 rs ds P (t, T ) and e 0 rs ds P (t, S) are martingales
under P , the same is true of Xt . Hence L(t, T, S) = Xt /Nt becomes a
S by Proposition 2.1, and commartingale under the forward measure P
S amounts to removing any dt term in
puting its dynamics under P
(12.19), i.e.
t,
dL(t, T, S) = L(t, T, S)dW
t/2
0 t T,
t )tR is a standard
, where (W
+
Ft = P (t, S)IE[(
L(T, T, S))+ | Ft ]
2
= P (t, S)IE[(
L(t, T, S)e (T t)/2+(WT Wt ) )+ | Ft ]
t (d+ ))
= P (t, S)((d ) X
= P (t, S)(d ) P (t, S)L(t, T, S)(d+ )
(T t)/2
, v 2 = (T t) 2 , and
log(L(t, T, S)/) T t
d+ =
+
,
2
T t
and
d =
log(L(t, T, S)/) T t
,
2
T t
dP (t, Ti )
= rt dt + ti dBt ,
P (t, Ti )
i = 1, 2,
and
P (T, Ti ) = P (t, Ti ) exp
w
0 t T Ti , i = 1, 2, hence
log P (T, Ti ) = log P (t, Ti ) +
rs ds +
wT
t
wT
t
rs ds +
si dBs
wT
t
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1wT i 2
(s ) ds ,
2 t
si dBs
1wT i 2
( ) ds,
2 t s
"
i = 1, 2.
0 t Ti ,
i = 1, 2.
Letting
dBti = dBt ti dt,
defines a standard Brownian motion under Pi , i = 1, 2, and we have
w
T
P (t, T1 )
1wT 1 2
P (T, T1 )
=
exp
(s1 s2 )dBs
((s ) (s2 )2 )ds
t
t
P (T, T2 )
P (t, T2 )
2
w
T
P (t, T1 )
1wT 1
1
2
2
=
exp
(s s )dBs
(s s2 )2 ds ,
t
P (t, T2 )
2 t
which is an Ft -martingale under P2 and under P1,2 , and
w
T
P (T, T2 )
P (t, T2 )
1wT 1
=
exp
(s1 s2 )dBs1
(s s2 )2 ds ,
t
P (T, T1 )
P (t, T1 )
2 t
which is an Ft -martingale under P1 .
2. We have
1
(log P (t, T2 ) log P (t, T1 ))
T2 T1
2
1
((T1 t)3 (T2 t)3 ).
= rt +
T2 T1 6
f (t, T1 , T2 ) =
3. We have
1
d log (P (t, T2 )/P (t, T1 ))
T2 T1
1
1
=
(t2 t1 )dBt ((t2 )2 (t1 )2 )dt
T2 T1
2
1
1
2
1
2
=
(t t )(dBt + t2 dt) ((t2 )2 (t1 )2 )dt
T2 T1
2
1
1 2
2
1
2
1 2
=
(t t )dBt (t t ) dt .
T2 T1
2
df (t, T1 , T2 ) =
4. We have
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1
log (P (T, T2 )/P (T, T1 ))
T2 T1
w
T
1
1
= f (t, T1 , T2 )
(s2 s1 )dBs ((s2 )2 (s1 )2 )ds
t
T2 T1
2
w
T
1
1wT 2
2
1
2
= f (t, T1 , T2 )
(s s )dBs
(s s1 )2 ds
t
T2 T1
2 t
w
wT
T
1
1
(s2 s1 )dBs1 +
(s2 s1 )2 ds .
= f (t, T1 , T2 )
t
T2 T1
2 t
f (T, T1 , T2 ) =
1wT 2
( s1 )2 ds
2 t s
wT
1
( 2 s1 )2 ds.
(T2 T1 )2 t s
Hence
i
h r T2
(T2 T1 ) IE e t rs ds (f (T1 , T1 , T2 ) )+ Ft
i
h
= (T2 T1 )P (t, T2 ) IE2 (f (T1 , T1 , T2 ) )+ Ft
i
h
= (T2 T1 )P (t, T2 ) IE2 (m + X )+ Ft
(m)2
v
= (T2 T1 )P (t, T2 ) e 2v2 + (m )((m )/v) .
2
5. We have
L(T, T1 , T2 ) = S(T, T1 , T2 )
1
P (T, T1 )
=
1
T2 T1 P (T, T2 )
w
T
1
1wT 1 2
P (t, T1 )
=
(s1 s2 )dBs
((s ) (s2 )2 )ds 1
exp
t
T2 T1 P (t, T2 )
2 t
w
T
1
P (t, T1 )
1wT 1
=
exp
(s1 s2 )dBs2
(s s2 )2 ds 1
t
T2 T1 P (t, T2 )
2 t
w
T
1
P (t, T1 )
1wT 1
1
2
1
=
exp
(s s )dBs +
(s s2 )2 ds 1 ,
t
T2 T1 P (t, T2 )
2 t
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"
dS(t, T1 , T2 ) =
=
=
=
=
hence
1
T2 T1
1
+ S(T, T1 , T2 )
T2 T1
w
T
1
1wT 1
(s s2 )2 ds ,
=
+ S(t, T1 , T2 ) exp
(s1 s2 )dBs2
t
T2 T1
2 t
0 t T T1 .
6. We have
i
h r T2
(T2 T1 ) IE e t rs ds (L(T1 , T1 , T2 ) )+ Ft
i
h r T1
= (T2 T1 ) IE e t rs ds P (T1 , T2 )(L(T1 , T1 , T2 ) )+ Ft
i
h
= P (t, T1 , T2 ) IE1,2 (S(T1 , T1 , T2 ) )+ Ft .
The forward measure P2 is defined by
dP2
P (t, T2 ) r t rs ds
e 0
,
IE
Ft =
dP
P (0, T2 )
and the forward swap measure is defined by
dP1,2
P (t, T2 ) r t rs ds
IE
e 0
,
Ft =
dP
P (0, T2 )
0 t T2 ,
0 t T1 ,
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=
1
+
T2 T1
r
r
T
1
1
2 2
2
2
1 T
1
+ S(t, T1 , T2 ) e t (s s )dBs 2 t (s s ) ds ,
T2 T1
P (t, T1 ) X 1 Var [X]
e 2
1 ,
P (t, T2 )
given Ft . Hence
i
h r T2
(T2 T1 ) IE e t rs ds (L(T1 , T1 , T2 ) )+ Ft
= P (t, T1 , T2 )
BS
1
+ S(t, T1 , T2 ),
T2 T1
r T1
t
!
(s1 s2 )2 ds
1
, +
, T1 t .
T1 t
T2 T1
Exercise 12.3
1. We have
rt
L(t, T1 , T2 ) = L(0, T1 , T2 )e
1 (s)dWs2 21
rt
0
|1 (s)|2 ds
0 t T1 ,
1 w T1
|1 (s)|2 ds.
T1 t t
P (t, T1 )
P (t, T1 )
=
P (t, T1 , T3 )
P (t, T2 ) + P (t, T3 )
P (t, T1 )
1
=
P (t, T2 ) 1 + P (t, T3 )/P (t, T2 )
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1 + b
(1 + L(t, T1 , T2 )),
(b + 2)
0 t T1 ,
and
P (t, T3 )
P (t, T3 )
=
P (t, T1 , T3 )
P (t, T2 ) + P (t, T3 )
1
=
1 + P (t, T2 )/P (t, T3 )
1 1
=
,
0 t T2 .
2 + b
(16.60)
5. We have
P (t, T1 )
P (t, T3 )
P (t, T1 , T3 ) P (t, T1 , T3 )
1
1 + b
(1 + L(t, T1 , T2 ))
=
(2 + b)
(2 + b)
1
(b + (1 + b)L(t, T1 , T2 )),
0 t T2 .
=
2 + b
S(t, T1 , T3 ) =
We have
1 + b
L(t, T1 , T2 )1 (t)dWt2
2 + b
b
= S(t, T1 , T3 )
1 (t)dWt2
2 + b
dS(t, T1 , T3 ) =
0 t T2 ,
with
b
1 (t)
S(t, T1 , T3 )(2 + b)
b
= 1
1 (t)
b + (1 + b)L(t, T1 , T2 )
(1 + b)L(t, T1 , T2 )
=
1 (t)
b + (1 + b)L(t, T1 , T2 )
(1 + b)L(t, T1 , T2 )
=
1 (t).
(2 + b)S(t, T1 , T3 )
1,3 (t) =
"
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where |
1,3 (t)|2 is the approximation of the volatility
1 w T1
1 w T1
|1,3 (s)|2 ds =
T1 t t
T1 t t
(1 + b)L(s, T1 , T2 )
(2 + b)S(s, T1 , T3 )
2
1 (s)ds
1,3
(t) =
1
T1 t
(1 + b)L(t, T1 , T2 )
(2 + b)S(t, T1 , T3 )
2 w
T1
|1 (s)|2 ds.
Exercise 12.4
1. We have
i
h rT
wT
+
IE e t rs ds (P (T, S) ) Ft = VT = V0 +
dVt
0
h
i wt
wt
+
= P (0, T ) IET (P (T, S) ) +
sT dP (s, T ) +
sS dP (s, S).
0
2. We have
rt
dVt = d e 0 rs ds Vt
= rt e
=
rt
rs ds
Vt dt + e
rt
r ds
0 s
dVt
T
rt e 0
(t P (t, T )
rt
+tS P (t, S))dt + e 0 rs ds tT dP (t, T )
tT dP (t, T ) + tS dP (t, S).
rt
rs ds
+ e
rt
0
rs ds S
t dP (t, S)
is a martingale under P.
4. We have
dVt = d(Vt /P (t, T ))
h
i
+
= d IET (P (T, S) ) |Ft
=
C
(Xt , T t, v(t, T ))dXt
x
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=
5. We have
C
(Xt , T t, v(t, T ))(tS tT )dBtT + Vt dP (t, T )
x
C
+P (t, S)
(Xt , T t, v(t, T ))(tS tT )tT dt
x
C
= P (t, S)
(Xt , T t, v(t, T ))(tS tT )dBt + Vt dP (t, T ).
x
= P (t, S)
6. We have
dVt = d(e
rt
0
rs ds
rt
Vt )
rs ds
Vt dt + e
rt
r ds
0 s
dVt
C
= P (t, S)
(Xt , T t, v(t, T ))(tS tT )dBt + Vt dP (t, T ).
x
= rt e
7. We have
dVt = P (t, S)
C
(Xt , T t, v(t, T ))(tS tT )dBt + Vt dP (t, T )
x
C
(Xt , T t, v(t, T ))dP (t, S)
x
P (t, S) C
(Xt , T t, v(t, T ))dP (t, T ) + Vt dP (t, T )
P (t, T ) x
P (t, S) C
= Vt
(Xt , T t, v(t, T )) dP (t, T )
P (t, T ) x
C
+
(Xt , T t, v(t, T ))dP (t, S),
x
hence the hedging strategy (tT , tS )t[0,T ] of the bond option is given by
P (t, S) C
(Xt , T t, v(t, T ))
P (t, T ) x
P (t, S) C
(Xt , T t, v(t, T )),
= C(Xt , T t, v(t, T ))
P (t, T ) x
tT = Vt
and
tS =
C
(Xt , T t, v(t, T )),
x
t [0, T ].
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8. We have
C
(x, , v)
x
v
1
x
v
1
x
=
x
+ log
+ log
x
2
v
v
v
1
x
v
1
x
+ log
+ log
=x
x
2
x
2
v
v
v
x
1
+
+ log
2
v
2
2
1
x
1
x
12 v 2 + v
log
log
1 v 2 + v
1
1
e
e 2
=x
v x
v x
2
2
v
1
x
+
+ log
2
v
log(x/) + v 2 /2
=
.
v
As a consequence we get
P (t, S) C
tT = C(Xt , T t, v(t, T ))
(Xt , T t, v(t, T ))
P (t, T ) x
2
P (t, S)
(T t)v (t, T )/2 + log Xt
P (t, T )
T tv(t, T )
1
P (t, S)
v(t, T )
+
log
2
v(t, T )
P (t, T )
P (t, S)
log(Xt /) + (T t)v 2 (t, T )/2
P (t, T )
T tv(t, T )
log(Xt /) (T t)v 2 (t, T )/2
=
,
v(t, T ) T t
and
tS =
C
(Xt , T t, v(t, T )) =
x
v(t, T ) T t
,
= V0
dP (s, T )
0
v(t, T ) T t
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wt
0
v(t, T ) T t
dP (s, S).
,
v(t, T ) T t
and by buying a bond with maturity S for the amount
log(Xt /) + (T t)v 2 (t, T )/2
.
v(t, T ) T t
Exercise 12.5
1. Choosing the annuity numeraire Nt = P (Ti , Ti , Tj ) we have
i
h r Ti
IE e t rs ds P (Ti , Ti , Tj )( S(Ti , Ti , Tj ))+ Ft
i,j P (Ti , Ti , Tj ) ( S(Ti , Ti , Tj ))+ Ft
= Nt IE
NT i
i,j [( S(Ti , Ti , Tj ))+ | Ft ].
= P (t, Ti , Tj )IE
2. Since S(t, Ti , Tj ) is a forward price for the numeraire P (t, Ti , Tj ), it is a
i,j and we have
martingale under the forward swap measure P
ti,j ,
S(t, Ti , Tj ) = S(t, Ti , Tj )dW
0 t Ti ,
T W
t) +
i,j [( S(t, Ti , Tj )e2 (Ti t)/2+(W
i
= P (t, Ti , Tj )IE
) | Ft ]
t (d+ ))
= P (t, Ti , Tj )((d ) X
where em = S(t, Ti , Tj )e
(T t)/2
, v 2 = (T t) 2 , and
log(S(t, Ti , Tj )/) Ti t
+
,
d+ =
2
Ti t
and
"
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N. Privault
d =
log(S(t, Ti , Tj )/) Ti t
,
2
Ti t
w
Ti
i,j (s)dBsi,j
1 w Ti
|i,j |2 (s)ds .
2 t
2. We have
i
h
+
P (t, Ti , Tj ) IEi,j (S(Ti , Ti , Tj ) ) Ft
+
r Ti
r
2
i,j
1 Ti
= P (t, Ti , Tj ) IEi,j S(t, Ti , Tj )e t i,j (s)dBs 2 t |i,j | (s)ds Ft
p
= P (t, Ti , Tj )BS(, v(t, Ti )/ Ti t, 0, Ti t)
= P (t, Ti , Tj )
log(x/K) v(t, Ti )
log(x/K) v(t, Ti )
+
,
S(t, Ti , Tj )
v(t, Ti )
2
v(t, Ti )
2
where
v 2 (t, Ti ) =
w Ti
t
|i,j |2 (s)ds.
rt
rt
dt + e 0 rs ds dVt
j
j
rt
rt
X
X
= rt e 0 rs ds
tk P (t, Tk ), dt + e 0 rs ds
tk dP (t, Tk )
0
rs dsVt
k=i
j
X
k=i
since
tk dP (t, Tk ),
k=i
0 t Ti .
dP (t, Tk )
= k (t)dt,
P (t, Tk )
k = i, . . . , j.
"
(Tk+1 Tk )P (t, Tk+1 )(i (t) k+1 (t)) + P (t, Tj )(i (t) j (t)) dBt
dVt = St
k=i
+Vt dP (t, Ti , Tj )
C
= St
(St , v(t, Ti ))
x
!
j1
X
(Tk+1 Tk )P (t, Tk+1 )(i (t) k+1 (t)) + P (t, Tj )(i (t) j (t)) dBt
k=i
+Vt
j1
X
k=i
= St
X
C
(St , v(t, Ti ))
(Tk+1 Tk )P (t, Tk+1 )(i (t) k+1 (t))dBt
x
k=i
C
(St , v(t, Ti ))P (t, Tj )(i (t) j (t))dBt
x
j1
X
+Vt
(Tk+1 Tk )k+1 (t)P (t, Tk+1 )dBt
+
k=i
j1
= St i (t)
X
C
(St , v(t, Ti ))
(Tk+1 Tk )P (t, Tk+1 )dBt
x
k=i
j1
X
C
St
(St , v(t, Ti ))
(Tk+1 Tk )P (t, Tk+1 )k+1 (t)dBt
x
k=i
C
+
(St , v(t, Ti ))P (t, Tj )(i (t) j (t))dBt
x
j1
X
+Vt
(Tk+1 Tk )k+1 (t)P (t, Tk+1 )dBt
k=i
"
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N. Privault
j1
X
C
(St , v(t, Ti ))
(Tk+1 Tk )P (t, Tk+1 )dBt
x
k=i
X
j1
C
+ Vt St
(St , v(t, Ti ))
(Tk+1 Tk )P (t, Tk+1 )k+1 (t)dBt
x
= St i (t)
k=i
C
(St , v(t, Ti ))P (t, Tj )(i (t) j (t))dBt .
x
9. We have
j1
X
C
(St , v(t, Ti ))
(Tk+1 Tk )P (t, Tk+1 )dBt
x
k=i
X
j1
C
(Tk+1 Tk )P (t, Tk+1 )k+1 (t)dBt
+ Vt St
(St , v(t, Ti ))
x
dVt = St i (t)
k=i
C
+
(St , v(t, Ti ))P (t, Tj )(i (t) j (t))dBt
x
C
= (P (t, Ti ) P (t, Tj ))i (t)
(St , v(t, Ti ))dBt
x
C
(St , v(t, Ti )) dP (t, Ti , Tj )
+ Vt St
x
C
+
(St , v(t, Ti ))P (t, Tj )(i (t) j (t))dBt
x
C
(St , v(t, Ti ))dBt
= (i (t)P (t, Ti ) j (t)P (t, Tj ))
x
C
+ Vt St
(St , v(t, Ti )) dP (t, Ti , Tj )
x
C
(St , v(t, Ti ))d(P (t, Ti ) P (t, Tj ))
=
x
C
+ Vt St
(St , v(t, Ti )) dP (t, Ti , Tj ).
x
10. We have
C
v
1
x
v
1
x
(x, , v) =
x
+ log
+ log
x
x
2 v
2 v
v
1
x
v
1
x
v
1
x
=x
+ log
+ log
+
+ log
x
2 v
x
2 v
2 v
1 v
1
x 2
1
v
1
x 2
e 2 ( 2 + v log )
1
e 2 ( 2 + v log )
1
=x
vx
vx
2
2
v
1
x
+
+ log
2 v
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"
log(x/) v
+
v
2
.
11. We have
C
(St , v(t, Ti ))d(P (t, Ti ) P (t, Tj ))
x
C
+ Vt St
(St , v(t, Ti )) dP (t, Ti , Tj )
x
log(St /K) v(t, Ti )
+
d(P (t, Ti ) P (t, Tj ))
=
v(t, Ti )
2
log(St /K) v(t, Ti )
dP (t, Ti , Tj ).
v(t, Ti )
2
dVt =
Chapter 13
Exercise 13.1 Defaultable bonds.
1. Use the fact that (rt , t )t[0,T ] is a Markov process.
2. Use the tower property (16.24) for the conditional expectation given
Ft .
3. We have
rt
d e 0 (rs +s )ds P (t, T )
= (rt + t )e
rt
(rs +s )ds
P (t, T )dt + e
rt
(rs +s )ds
rt
dP (t, T )
(rs +s )ds
0
(rs +s )ds
dF (t, rt , t )
rt
(rs +s )ds F
= (rt + t )e
rt
= (rt + t )e
rt
(rs +s )ds
P (t, T )dt + e
P (t, T )dt + e
(t, rt , t )drt
x
2
rt
F
1
F
+e 0 (rs +s )ds
(t, rt , t )dt + e 0 (rs +s )ds 2 (t, rt , t )12 (t, rt )dt
y
2
x
1 r t (rs +s )ds 2 F
2
+ e 0
(t, rt , t )2 (t, t )dt
2
y 2
rt
rt
2F
F
+e 0 (rs +s )ds
(t, rt , t )1 (t, rt )2 (t, t )dt + e 0 (rs +s )ds
(t, rt , t )dt
xy
t
rt
rt
F
F
(1)
(2)
= e 0 (rs +s )ds
(t, rt , t )1 (t, rt )dBt + e 0 (rs +s )ds
(t, rt , t )2 (t, t )dBt
x
y
rt
F
+e 0 (rs +s )ds (rt + t )P (t, T ) +
(t, rt , t )1 (t, rt )
x
0
rt
"
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F
1 2F
1 2F
(t, rt , t )12 (t, rt ) +
(t, rt , t )22 (t, t )
(t, rt , t )2 (t, t ) +
y
2 x2
2 y 2
2F
F
+
(t, rt , t )1 (t, rt )2 (t, t ) +
(t, rt , t ) dt,
xy
t
+
4. We have
wt
0
1 (1)
B rt
a t
wt
(1)
Bt
ea(ts) dBs(1)
=
0
a
wt
a(ts)
(1 e
)dBs(1) ,
=
a 0
rs ds =
hence
wT
wT
wt
rs ds =
rs ds
rs ds
0
0
w
T
wt
=
(1 ea(T s) )dBs(1)
(1 ea(ts) )dBs(1)
a 0
a 0
wT
w t a(T s)
=
(e
ea(ts) )dBs(1) +
(ea(T s) 1)dBs(1)
0
t
a
wt
w T a(T s)
a(T t)
a(ts)
(1)
dBs
(e
1)dBs(1)
1) e
= (e
0
a
a t
1
w T a(T s)
= (ea(T t) 1)rt
(e
1)dBs(1) .
a
a t
t
and
Var
w
T
t
rs ds +
wT
t
s dsFt =
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"
= Var
w
T
2 w T a(T s)
= 2
(e
1)2 ds
a t
w
T
+2
(ea(T s) 1)(eb(T s) 1)ds
ab t
2 w T b(T s)
+ 2
(e
1)2 ds
b t
wT
wT
= 2
C 2 (a, s, T )ds + 2
C(a, s, T )C(b, s, T )ds
t
t
wT
+ 2
C 2 (b, sT )ds,
t
2 w T 2
exp
C 2 (a, s, T )ds +
C (b, s, T )eb(T s) ds
2 t
2 t
wT
exp
C(a, s, T )C(b, s, T )ds .
t
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N. Privault
wT
U (t, T ) = exp
C(a, s, T )C(b, s, T )ds
t
= exp
(T t C(a, t, T ) C(b, t, T ) + C(a + b, t, T )) .
ab
9. We have
log P (t, T )
f (t, T ) = 1{ >t}
T
2 2
2
a(T t)
C (a, t, T ) + t eb(T t) C 2 (b, t, T )
= 1{ >t} rt e
2
2
1{ >t} C(a, t, T )C(b, t, T ).
10. We use the relation
w
T
P( > T | Gt ) = 1{ >t} IE exp
s ds Ft
t
2 w T 2
= 1{ >t} exp C(b, t, T )t +
C (b, s, T )ds
2 t
= 1{ >t} e
rT
t
f2 (t,u)du
2 2
C (b, t, u).
2
since U (t, T ) = 0.
Chapter 14
Exercise 14.1
1. When t [0, T1 ) the equation reads
dSt = St dt = St dt,
which is solved as St = S0 et , 0 t < T1 . Next, at the first jump time
t = T1 we have
dSt = St St = St dNt = St ,
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"
Nt
Y
t [T1 , T2 ).
(1 + Zk ), t R+ .
k=1
!2
NT
X
Var [YT ] = IE
Zk IE[YT ]
k=1
IE
n=0
NT
X
k=1
!2
Zk t IE[Z1 ]
NT = k P(NT = k)
!2
n
X
n tn X
=e
IE
Zk t IE[Z1 ]
n!
n=0
k=1
!2
n
n
X
X
n tn X
t
2 2
2
=e
IE
Zk
2t IE[Z1 ]
Zk + t (IE[Z1 ])
n!
n=0
t
k=1
X
n tn
= et
n!
n=0
X
IE 2
1k<ln
= et
Zk Zl +
k=1
n
X
k=1
|Zk | 2t IE[Z1 ]
n
X
2 2
Zk + t (IE[Z1 ])
k=1
X
n tn
n!
n=0
529
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N. Privault
= et (IE[Z1 ])2
X
X
n tn
n tn
+ et IE[|Z1 |2 ]
(n
2)!
(n
1)!
n=2
n=1
X
n tn
+ 2 t2 (IE[Z1 ])2 )
(n 1)!
n=1
Exercise 14.4
1. We have
1
dSt = + 2 St dt + St dWt + (St St )dNt
2
1 2
= + St dt + St dWt + (S0 et+Wt +Yt S0 et+Wt +Yt )dNt
2
1 2
= + St dt + St dWt + (S0 et+Wt +Yt +ZNt et+Wt +Yt )dNt
2
1 2
= + St dt + St dWt + St (eZNt 1)dNt ,
2
hence the jumps of St are given by the sequence (eZk 1)k1 .
2. The discounted process ert St satisfies
1
d(ert St ) = ert r + 2 St dt+ert St dWt +ert St (eZNt 1)dNt .
2
such that
Hence by the Girsanov theorem, choosing u, ,
1
IE [eZ1 1],
r + 2 = u
2
shows that
IE [eZ1 1]dt)
d(ert St ) = ert St (dWt +udt)+ert St ((eZNt 1)dNt
is a martingale under (Pu,,
).
Exercise 14.5
530
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"
Nt
Y
Nt
X
(1 + Yk ) = S0 exp t +
k=1
!
t R+ .
Xk
t R+ ,
k=1
2. We have
ert St = S0 exp ( r)t +
Nt
X
!
Xk
k=1
which is a martingale if
0 = r + IE[Yk ] = r + IE[eXk 1] = r + (e
/2
1).
3. We have
er(T t) IE[(ST )+ | St ]
= er(T t) IE S0 exp T +
Xk
k=1
= er(T t)
IE
Pn
St e(T t)+
Xk
k=1
n=0
=e
(r+)(T t)
=e
(T t)
=e
(T t)
n=0
X
IE
Pn
St e(T t)+
/2
n=0
/2
St
+
St P(NT Nt = n)
k=1
n=0
St e(r)(T t)+n
!+
Nt
X
Xk
+ ((T t))n
St
n!
, r, n 2 /(T t), , T t)
(d+ ) er(T t) (d )
((T t))n
n!
((T t))n
,
n!
with
log(St e(r)(T t)+n
/) + r(T t) + n 2 /2
n
log(St /) + (T t) + n 2
=
,
n
d+ =
d =
=
"
/2
/2
/) + r(T t) n 2 /2
n
log(St /) + (T t)
,
n
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N. Privault
and = r + (1 e
/2
).
Chapter 15
Exercise 15.1
1. We have IE[Nt t] = IE[Nt ]t = tt, hence Nt t is a martingale
if and only if = . Given that
d(ert St ) = ert St (dNt dt),
we conclude that the discounted price process ert St is a martingale if
and only if = .
2. Since we are pricing under the risk neutral measure we take = . Next
we note that
ST = S0 e(r)T (1 + )NT = St e(r)(T t) (1 + )NT Nt ,
0 t T,
X
= |St |2 e(r2)(T t)
(1 + )2n P(NT Nt = n)
n=0
X
2 (r2)(T t)
= |St | e
(1 + )2n
n=0
2
= |St | e
((T t))n
n!
(T t)
0 t T.
Exercise 15.2
1. Independently of the choice of a risk-neutral measure Pu,,
we have
rt
rT
er(T t) IEu,,
ST | Ft ] Ker(T t)
[ST K | Ft ] = e IEu,,
[e
= St Ker(T t)
= f (t, St ),
for
532
"
t, x > 0.
2. Clearly, holding one unit of the risky asset and shorting a (possibly fractional) quantity KerT of the riskless asset will hedge the payoff ST K,
and this hedging strategy is self-financing because it is constant in time.
f
(t, x) = 1 we have
3. Since
x
f
a
(t, St ) +
(f (t, St (1 + a)) f (t, St ))
x
St
t =
2 + a2
(S (1 + a) St )
2 +
St t
=
2 + a2
= 1,
t [0, T ],
2
1
St = S0 exp t + Bt 2 t (1 + )Nt .
2
2. We have
1
St = S0 exp ( r)t + Bt 2 t (1 + )Nt ,
2
and
X
n=0
E
"
P(NT Nt = n)
1
St e(T t)+(BT Bt ) 2
(T t)
+
(1 + )n St
533
N. Privault
= e(r+)(T t)
E
St e(r)(T t)+(BT Bt ) 2
= e(T t)
=e
X
((T t))n
n!
n=0
(T t)
(T t)
+
(1 + )n St
BS(St e(T t) (1 + )n , r, 2 , T t, )
n=0
X
n=0
((T t))n
n!
((T t))n
,
St e(T t) (1 + )n (d+ ) er(T t) (d )
n!
with
log(St e(T t) (1 + )n /) + (r + 2 /2)(T t)
T t
log(St (1 + )n /) + (r + 2 /2)(T t)
,
=
T t
d+ =
and
log(St e(T t) (1 + )n /) + (r 2 /2)(T t)
T t
log(St (1 + )n /) + (r 2 /2)(T t)
.
=
T t
d =
Exercise 15.4
1. The discounted process St = ert St satisfies the equation
dSt = YNt St dNt , ,
and it is a martingale since the compound Poisson process YNt dNt is
centered with independent increments as IE[Y1 ] = 0.
2. We have
NT
Y
ST = S0 erT
(1 + Yk ),
k=1
hence
rT
IE[(ST )] = e
rT
=e
X
n=0
rT
IE S0 erT
IE S0 erT
NT
Y
!+
(1 + Yk )
k=1
NT
Y
!+
(1 + Yk )
NT = n P(NT = n)
k=1
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"
rT T
=e
k=0
= erT T
n
Y
IE S0 erT
(T )
n!
(1 + Yk )
k=1
X
(T )n w 1
k=0
!+
2n n!
w1
S0 erT
n
Y
!+
(1 + yk )
k=1
dy1 dyn .
Exercise 15.5
1. We find = where is the intensity of the Poisson process (Nt )tR+ .
2. We have
er(T t) IE[ST | Ft ] = ert IE[erT ST | Ft ] er(T t) IE[ | Ft ]
= ert IE[ert St | Ft ] er(T t)
= St er(T t) ,
2. We apply the Ito formula with jumps and the martingale property of
t 7 ert f (t, St ) to get
df (t, St ) = rf (t, St )dt
+(f (t, St (1 + )) f (t, St ))dNt (f (t, St (1 + )) f (t, St ))dt,
and we identify the terms in the above formula with those appearing in
(15.16).
X
k=0
"
kP(X = k) = e
X
k
k
k!
k=0
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= e
k=1
X k
k
= e
= .
(k 1)!
k!
k=0
Exercise 2 We have
P(eX > c) = P(X > log c) =
=
(log c)/
ey
/2
log c
ey
dy
/(2 2 )
2 2
dy
Exercise 3
1. If = 0 we have
w
IE[X] =
xf (x)dx =
1
2 2
y2
1 w
1
ye 2 dy =
=
2
2
|y|e
2
y2
dy =
lim
wA
x2
2
y2
|y|e
y2
2
xe 22 dx
lim
A+
wA
ye
y2
2
dy = 0,
dy = 2 lim
wA
ye
y2
2
dy
A
y2
A2
= 2 lim e 2
= 2 lim (1 e 2 ) = 2 < ,
A+
A+
A+
A+
2
y2
xf (x)dx =
2 2
w
1
2 2
2 2
w
1
2 2
xe
(x)2
2 2
dx
y2
(y + )e 22 dy
y2
ye 22 dy +
y2
e 22 dy =
2 2
y2
e 22 dy
f (y)dy = P(X R) = .
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ollmer and A. Schied. Stochastic finance, volume 27 of de Gruyter Studies
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540
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Index
-algebra, 422
absence of arbitrage, 12, 298
abstract Bayes formula, 272
adapted process, 75, 361
admissible portfolio strategy, 97
affine model, 297
American forward contract, 262
American option
finite expiration, 252
perpetual, 239
annuity num
eraire, 344
annuity numeraire, 365
arbitrag
opportunity, 11
arbitrage, 11
absence of, 12
continuous time, 97
discrete time, 29
arbitrage price, 41, 124
Asian option, 155, 205
attainable, 15, 20, 41, 99
backward induction, 46, 49
Barrier forward contract, 223
down-and-in, 224, 475
down-and-out, 224, 476
up-and-in, 224, 471
up-and-out, 224, 473
Barrier options, 163
down-and-in, 166
down-and-out, 166, 173, 175, 181
up-and-in, 166
up-and-out, 166, 171, 173, 176
barrier options, 153
Bernoulli distribution, 433
BGM model, 327
N. Privault
conditional expectation, 31
conditional survival probability, 359
conditioning, 426
contingent claim, 15, 29, 37, 41
attainable, 15, 20, 99
continuous-time limit, 61
continuous-time model, 93
correlation problem, 323
coupon
bond, 298
rate, 303
coupon bond, 364
Courtadon model, 296
credit default swap, 364
CRR model, 38
default rate, 361
Delta, 101, 104, 113, 131
hedging, 129, 287, 288
density
function, 429
marginal, 432
discounted asset prices, 28
discrete distribution, 433
distribution
Bernoulli, 433
binomial, 433
Cauchy, 431
discrete, 433
exponential, 430
gamma, 431
Gaussian, 430
geometric, 433
lognormal, 210, 431
marginal, 437
negative binomial, 434
Pascal, 434
Poisson, 434
uniform, 430
Doob-Meyer decomposition, 260
Dothan model, 297, 304
Dupire PDE, 150
enlargement of filtration, 363
entitlement ratio, 6, 104, 106, 145, 146
equivalent probability measure, 14, 18,
122
Euler discretization, 417
event, 422
exchange options, 284
exotic option, 29, 47
exotic options, 151
continuous time, 151
discrete time, 52
expectation, 434
conditional, 436, 441
exponential distribution, 360, 430
exponential model, 402
exponential Vasicek model, 296
failure rate, 360
Fatous lemma, 234
filtration, 68, 227
enlargement, 363
finite differences
explicit method, 411, 414
implicit method, 412, 415
floorlet, 343
foreign exchange, 278
foreign exchange option, 281
forward
contract, 62, 101, 114, 460
measure, 338
rate, 306
swap rate, 308
forward contract, 62, 101, 114, 460
American, 262, 487
forward rate, 305
spot, 307, 319, 341
swap, 308
gamma distribution, 431
gamma process, 383
Garman-Kohlagen formula, 281
Gaussian
cumulative distribution function, 62
distribution, 102, 430
random variable, 444
generating function, 90, 443
geometric
distribution, 433
geometric Brownian motion, 84
Girsanov theorem, 122, 123, 276
jump processes, 389, 397
heat equation, 108, 411
hedging, 16, 45, 49, 52, 127
hedging by change of num
eraire, 286
hedging strategy, 128
hedging with jumps, 404
hitting probability, 236
hitting time, 231
HJM
condition, 313
model, 311, 363
Ho-Lee model, 297
Hull-White model, 297, 312
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process
gamma, 383
inverse Gaussian, 383
predictable, 34, 44, 379
stable, 383
stopped, 231
variance gamma, 383
put option, 4
random
variable, 427
rate
default, 361
forward, 305
forward swap, 308
instantaneous forward, 307
LIBOR, 309
LIBOR swap, 310, 346, 348
recovery rate, 363
reflexion principle, 155
replication, 16
risk-neutral measure, 14, 397
continuous time, 119
risk-neutral measures
continuous time, 97
discrete time, 36
riskless asset, 62, 93
self-financing portfolio, 286, 288
continuous time, 93, 95, 405
discrete time, 27
short-selling, 10, 19, 105
spot forward rate, 307, 319, 341
stable process, 383
stochastic
calculus, 80
default, 361
differential equations, 87
integral, 43, 71, 75
with jumps, 378
process, 25
stopped process, 231
stopping time, 230, 361
theorem, 232
strike price, 15
submartingale, 228
super-hedging, 16
supermartingale, 228
survival probability, 359
Svensson parametrization, 320
swap, 308
measure, 271, 344, 354
swaption, 345
tenor structure, 337, 364
tower property, 34, 35, 44, 45, 49, 78,
118, 130, 299, 437, 442, 451, 525
two-factor model, 324
uniform distribution, 430
vanilla option, 29, 47
variance, 439
variance gamma process, 383, 384
variational PDE, 255
Vasicek model, 295
volatility
historical, 141
implied, 142
local, 148
smile, 143
surface, 142
warrant, 6, 104
yield, 307, 341
curve, 319
zero-coupon bond, 297
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Author index
Achdou, Y. 150
Barrieu, P. 210
Bermin, H. 203
Bjork, T. 23, 321
Bosq, D. 371
Bosq, S. 371
Brace, A. 327
Brigo, D. 301, 325
Heath, D. 313
Huang, J.Z. 364
Hull, J. 312
Ikeda, N. 78
Ingersoll, J.E. 296
Margrabe, W. 284
Matsumoto, H. 207
Menn, C. 362, 363
Mercurio, F. 301, 325
Merton, R. 285
Meyer, P.A. 260
Morton, A. 313
Musiela, M. 327
Nguyen, H.T. 371
ksendal, B. 129
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Papanicolaou, G. 141
Pintoux, C. 305
Pironneau, O. 150
Pitman, J. 421
Privault, N. 52, 54, 75, 78, 118, 129,
203, 286, 305, 312, 322, 323, 325,
340, 342, 349, 407
Proske, F. 129
Protter, P. 82, 88, 123, 129, 130,
276, 299, 300, 421
Revuz, D. 68
Rochet, J.-C. 271, 287
Rogers, C. 216
Ross, S.A. 38, 296
Rouault, A. 210
Rubinstein, M. 38
Schied, A. 9, 14, 16, 37, 52, 61
Schoenmakers, J. 349
Schroder, M. 209, 210
Schwartz, E.S. 257, 259
Shi, Z. 216
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http://www.ntu.edu.sg/home/nprivault/indext.html
N. Privault
This book is an introduction to the stochastic calculus and PDE approaches to the pricing and hedging of financial derivatives, including vanilla
options and exotic options. The presentation is done both in discrete and
continuous-time financial models, with an emphasis on the complementarity between algebraic and probabilistic methods. It also covers the pricing
of some interest rate derivatives, American options, exotic options such as
barrier, lookback and Asian options, and stochastic models with compound
Poisson jumps. The text is accompanied with a number of figures and simulations, and includes 20 examples based on actual market data.
548
This version: April 24, 2013
http://www.ntu.edu.sg/home/nprivault/indext.html
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