Lecture Single Period Models

SinglePeriod Securities Markets
Peter Ouwehand
Department of Mathematical Sciences
University of Stellenbosch
November 2010
P. Ouwehand (Stellenbosch Univ.)
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Motivation
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Motivation
SP SMM are the simplest theoretical models of financial markets.
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Motivation
I
Trading and consumption are possible only at the initial and terminal
dates of a finite time interval.
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Motivation
I
At the terminal date, there are just finitely many states describing the
possible (uncertain) outcomes of decisions made at the initial date.
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Motivation
I
Such models are clearly unrealistic. Nevertheless, studying these

models offers some advantages:
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Motivation
I

I
Mathematically they are simple.
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Motivation
I

I
I

They illustrate many important economic principles, allowing us to
concentrate on these rather than getting bogged down in the
mathematics.
November 2010
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Motivation
I

I
I

They illustrate many important economic principles, allowing us to
concentrate on these rather than getting bogged down in the
mathematics.
Viewed correctly, they point the way to more realistic generalizations
and better models.
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Model Description
A theoretical model of financial markets should include the following:
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Model Description

Time the time period over which the model is valid, as well as the
times at which trading and consumption are possible.
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Model Description

Uncertainty Described by listing the basic events (states) that
could occur during the life of the model, and assigning probabilities to
these events.
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Model Description

these events.
Goods for consumption.
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Model Description

these events.
Securities contracts for future delivery of goods or money,
contingent on the prevailing state.
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Model Description

these events.
Traders i.e. consumers, investors, and their agents.
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Model Description

these events.
Information available to different traders at different times.
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Model Description

these events.
Consumption Possibilities of traders during the life of the model.
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Model Description

these events.
Consumption Possibilities of traders during the life of the model.
Preferences in consumption possibilities and risk open to traders.
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Model Description
II
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Model Description
II
Consumption Possibilities of traders during the life of the model

we ignore this.
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Model Description
II
Consumption Possibilities of traders during the life of the model

we ignore this.
Preferences in consumption possibilities and risk open to traders
we assume only that, other things being equal, investors prefer more
to less, so that they will take advantage of arbitrage opportunities.
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Model Description
III
The basic building blocks of a SP SMM are:
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Model Description
III

An initial date t = 0 and a terminal date t = T , with trading and
consumption possible only at those dates.
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Model Description
III

A finite sample space with K < elements
= {1 , 2 , . . . , K }
Each should be thought of as a possible state of the world.
This state is unknown at t = 0 but becomes apparent at t = T .
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Model Description
III

= {1 , 2 , . . . , K }
A probability measure P on , with P({}) > 0 for each .
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Model Description
III

= {1 , 2 , . . . , K }
N risky financial securities with time t prices denoted by
St1 , St2 . . . StN .
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Model Description
III

= {1 , 2 , . . . , K }
St1 , St2 . . . StN .
I
The initial prices S01 , . . . , S0N are known constants.
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Model Description
III

= {1 , 2 , . . . , K }
St1 , St2 . . . StN .
I
I

The terminal prices ST1 , . . . , STN are random variables on with
values dependent on the state , which is known only at t = T .
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Model Description
III

= {1 , 2 , . . . , K }
St1 , St2 . . . StN .
I
I

E.g ST5 (3 ) is the price of the 5th security at time T in state 3 .
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Model Description
III

= {1 , 2 , . . . , K }
St1 , St2 . . . StN .
I
I
I
I

E.g ST5 (3 ) is the price of the 5th security at time T in state 3 .
We have a price process S := (St1 , . . . StN )t{0,T }
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Model Description
IV
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Model Description
IV
We also have a riskless bank account, with value at time t denoted

by St0 , or sometimes Bt . We shall always take
S00 = B0 = 1
Note that the interest rate over the single period [0, T ] is r = ST0 1
(because ST0 = S00 (1 + r )).
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Model Description
IV

S00 = B0 = 1
(because ST0 = S00 (1 + r )).
We define discounted price processes
Sn
Stn = present value of Stn := t0
St
S0n = S0n
Sn
STn = T
1+r
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Model Description
IV

S00 = B0 = 1
(because ST0 = S00 (1 + r )).
We define discounted price processes
Sn
Stn = present value of Stn := t0
St
S0n = S0n
Sn
STn = T
1+r
A trading strategy or portfolio is represented by a vector

= (0 , 1 , . . . , N )
which describes the number of securities of each type held. Thus: A
deposit 0 in a bank account, 1 shares of risky security S 1 , etc. The
n may be negative: short sales!
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Model Description
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Model Description
With each portfolio we can associate a value process

(Vt () : t = 0, T ), and a gains process G ():
Vt () := St =
N
X
n Stn
G () := (ST S0 ) = S
n=0
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Model Description
With each portfolio we can associate a value process

(Vt () : t = 0, T ), and a gains process G ():
Vt () := St =
N
X
n Stn
G () := (ST S0 ) = S
n=0
We also obtain discounted value and gains processes:

N
X
() := Vt (() =
V
n Sn T
St0
n=0
Then
() =
G
N
X
n S n
() := (S
T S
0)
G
where
S n := STn S0n
n=1
If two portfolios differ only in their bank accounts, i.e. if they take
identical positions in the risky securities, then they have the same
discounted gains.
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Arbitrage
An arbitrage strategy or arbitrage opportunity is a trading strategy
such that
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Arbitrage
such that
V0 () = 0
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Arbitrage
such that
V0 () = 0
VT () 0
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Arbitrage
such that
V0 () = 0
VT () 0
EVT () > 0
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Arbitrage
such that
V0 () = 0
VT () 0
EVT () > 0
An arbitrage strategy is a trading strategy with zero initial cost, no
chance of making a loss, and some (nonzero) chance of making a
profit a free lottery ticket.
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Arbitrage
such that
V0 () = 0
VT () 0
EVT () > 0
Fundamental Assumption: There are no arbitrage strategies.
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Arbitrage
such that
V0 () = 0
VT () 0
EVT () > 0
Proposition: There is arbitrage iff there is a portfolio such that
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Arbitrage
such that
V0 () = 0
VT () 0
EVT () > 0
I
() 0
G
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Arbitrage
such that
V0 () = 0
VT () 0
EVT () > 0
I
I
() 0
G
()] > 0.
E[G
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Separating Hyperplane Theorem

Theorem: Suppose that K , C are two disjoint closed convex subsets
of Rn , and that K is compact. Then there exists a vector Rn
and a real number R such that
x>
for all x K
y <
for all y C
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Separating Hyperplane Theorem

Theorem: Suppose that K , C are two disjoint closed convex subsets
of Rn , and that K is compact. Then there exists a vector Rn
and a real number R such that
x>
for all x K
y <
for all y C
Corollary: If L is a linear subspace of Rn , and K Rn is compact

convex with K L = , then there exists a vector Rn such that
x>0
for all x K
y =0
for all y L
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NoArbitrage Theorem
Define
S00
1
S0
0 =
S
.
..

S0N
ST0 (1 )
S 1 (1 )
T
D = ..
.
STN (1 )
ST0 (2 )
ST1 (2 )
..
.
N
ST (2 )
. . . ST0 (K )
. . . ST1 (K )
..
...
.
N
. . . S (K )
T
0 = S0 is the vector of initial prices, and D

is the matrix of
Thus S
nk is the
discounted terminal prices in all possible states of the world, i.e. D
n
discounte t = T price of S in state k .
Theorem: (NoArbitrage Theorem)
The SP SMM is arbitragefree if and only if there exists a vector q =
(q1 , . . . , qK ) RK such that q has strictly positive components,
and such that
0 = Dq
S
P
Moreover, K
k=1 qk = 1.
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Geometry of Arbitrage
0 = Dq
as
We can write the equation S
0
0
0
ST (K )
ST (2 )
ST (1 )
S0
S 1 (K )
S 1 (2 )
S 1 (1 )
S 1
T
T
0
.. = q1 .. + q2 .. + + qK
..
.
.
.
.
N
N
N
N
S (K )
S (2 )
S (1 )
S
0
0 of initial prices is a linear

Thus there is no arbitrage iff the vector S
T (k ) of terminal prices, using positive
combination of the vectors S
scalars only, i.e.
There is no arbitrage the vector of (discounted) initial
prices is contained in the positive cone generated by the vectors
of (discounted) final prices.
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0 = Dq
as
0
0
0
ST (K )
ST (2 )
ST (1 )
S0
S 1 (K )
S 1 (2 )
S 1 (1 )
S 1
T
T
0
.. = q1 .. + q2 .. + + qK
..
.
.
.
.
N
N
N
N
S (K )
S (2 )
S (1 )
S
0

scalars only, i.e.
A vector is an arbitrage strategy if and only if
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0 = Dq
as
0
0
0
ST (K )
ST (2 )
ST (1 )
S0
S 1 (K )
S 1 (2 )
S 1 (1 )
S 1
T
T
0
.. = q1 .. + q2 .. + + qK
..
.
.
.
.
N
N
N
N
S (K )
S (2 )
S (1 )
S
0

scalars only, i.e.
I
0
is perpendicular to S
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0 = Dq
as
0
0
0
ST (K )
ST (2 )
ST (1 )
S0
S 1 (K )
S 1 (2 )
S 1 (1 )
S 1
T
T
0
.. = q1 .. + q2 .. + + qK
..
.
.
.
.
N
N
N
N
S (K )
S (2 )
S (1 )
S
0

scalars only, i.e.
I
I
0
tr
The dot products ST (k ) 0
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0 = Dq
as
0
0
0
ST (K )
ST (2 )
ST (1 )
S0
S 1 (K )
S 1 (2 )
S 1 (1 )
S 1
T
T
0
.. = q1 .. + q2 .. + + qK
..
.
.
.
.
N
N
N
N
S (K )
S (2 )
S (1 )
S
0

scalars only, i.e.
I
I
I
0
tr
The dot products ST (k ) 0
At least one of the dot products tr ST (k ) is > 0.
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Equivalent Martingale Measures
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Two probability measures P, Q on (, F) are said to be equivalent
(and we write P Q) iff they have the same sets of measure 0, i.e
the same events are almost impossible under P, Q.
F F [P(F ) = 0
Q(F ) = 0]
In that case
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F F [P(F ) = 0
Q(F ) = 0]
In that case
I
The same events are possible: P(F ) > 0 Q(F ) > 0.
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F F [P(F ) = 0
Q(F ) = 0]
In that case
I
I

The same event are almost certain: P(F ) = 1 Q(F ) = 1.
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F F [P(F ) = 0
Q(F ) = 0]
In that case
I
I

Suppose that P, Q are equivalent measures for a SMM. Then a

trading strategy is a Parbitrage iff it is a Qarbitrage.
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F F [P(F ) = 0
Q(F ) = 0]
In that case
I
I


Let (, F, P, (St0 , . . . , StN )t{0,T } ) be a SP SMMM. An equivalent
martingale measure (EMM) or, riskneutral measure is a
measure Q on (, F) such that:
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F F [P(F ) = 0
Q(F ) = 0]
In that case
I
I


I
QP
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F F [P(F ) = 0
Q(F ) = 0]
In that case
I
I


I
I
QP
h n i
ST
EQ [STn ] = S0n , i.e. EQ 1+r
= S0n , for all n = 0, 1, . . . , N.
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First Fundamental Theorem of Asset Pricing
Theorem: A SP SMM is arbitrage-free if and only if there exists a

EMM.
Proposition: If Q is an EMM and a trading strategy, the
T ()] = V
0 ()
EQ [V
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Pricing Contingent Claims by Replication
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Definition: A contingent claim is a random variable X representing

a payoff at time T .
If the state of the world turns out to be (visible at time T ), then
long will receive a (possibly negative) amount X () from short.
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Examples of contingent claims: Call options, put options, forward
contracts, forward rate agreements, interest rate swaps, credit default
swaps, etc.
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swaps, etc.
The basis of arbitrage pricing is:
Law of One Price:
Two securities that are guaranteed to have the
same value at time t = T must have the same
value at time t = 0.
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swaps, etc.
The basis of arbitrage pricing is:
Law of One Price:
Two securities that are guaranteed to have the
same value at time t = T must have the same
value at time t = 0.
For suppose that X , Y are securities, and that XT = YT in all states
of the world. If X0 < Y0 , you can buy X and sell Y at time t = 0
for an immediate profit of Y0 X0 at zero cost and with no risk.
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II
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II
A contingent claim X is said to be attainable if there exists a

replicating portfolio such that
X () = VT ()
for all
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II

X () = VT ()
for all
Example: Consider a twostate SP SMM with one risky asset S in

addition to the bank account B (with simple interest rate r = 1/9).
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II

X () = VT ()
for all

I
Suppose the model dynamics of the stock price are

S0 = 5
ST (1 ) =
60
9
ST (2 ) =
40
9
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II

for all
X () = VT ()

I

S0 = 5
ST (1 ) =
60
9
ST (2 ) =
40
9
Consider a call option X on S with stike K = 5. It has payoff

X = (ST K )+ , i.e.
X (1 ) =
15
9
X (2 ) = 0
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II

for all
X () = VT ()

I

S0 = 5
ST (1 ) =
ST (2 ) =
40
9
Consider a call option X on S with stike K = 5. It has payoff

X = (ST K )+ , i.e.
X (1 ) =
60
9
15
9
X (2 ) = 0
A replicating portfolio = (0 , 1 ) must satisfy

(
(
10
60
15
VT ()(1 ) = X (1 )
9 0 + 9 1 = 9
i.e.
10
40
VT ()(2 ) = X (2 )
9 0 + 9 1 = 0
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III
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III
By the Law of One Price, if is a replicating portfolio for X , then

X0 = V0 () or else there will be arbitrage.
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III

Example (continued): Thus if our SP SMM is arbitragefree, then
the model price of the call option X is
X0 = V0 () = 3 1 +
3
4
5=
3
4
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III

X0 = V0 () = 3 1 +
3
4
5=
3
4
But how do we know that our model is arbitragefree?
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III

X0 = V0 () = 3 1 +
I
I
3
4
5=
3
4

The SP SMM is arbitrage free iff there is an EMM Q.
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III

X0 = V0 () = 3 1 +
I
I
I
3
4
5=
3
4

To see if Q exists we must find qk := Q({k }) for k = 1, 2 such that
S0 = EQ [ST ]
i.e.
40/9
5 = q1 60/9
10/9 + q2 10/9
where q1 , q2 > 0 and q1 + q2 = 1.
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III

X0 = V0 () = 3 1 +
I
I
I
5=
3
4

To see if Q exists we must find qk := Q({k }) for k = 1, 2 such that
S0 = EQ [ST ]
3
4
i.e.
40/9
5 = q1 60/9
10/9 + q2 10/9
where q1 , q2 > 0 and q1 + q2 = 1.

Solving, we get q1 = 21 = q2 , so the model is arbitragefree.
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Pricing Contingent Claims by Expectation
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Principle of Martingale Pricing (RiskNeutral Valuation):
If X is attainable, and Q is an EMM, then
T ]
X0 = EQ [X
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T ]
X0 = EQ [X
I
0 = V
0 () = EQ [V
T ()] = EQ [X
T ]
Indeed, X0 = X
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T ]
X0 = EQ [X
I
0 = V
0 () = EQ [V
T ()] = EQ [X
T ]
Indeed, X0 = X
Example (continued): If we price our call option X by riskneutral

valuation, we obtain
T ] = q1 X (1 ) + q2 X (2 ) =
X0 = EQ [X
1+r
1+r
1
2
15/9
10/9
1
2
0
10/9
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3
4
17 / 20

T ]
X0 = EQ [X
I
0 = V
0 () = EQ [V
T ()] = EQ [X
T ]
Indeed, X0 = X
Example (continued): If we price our call option X by riskneutral

valuation, we obtain
T ] = q1 X (1 ) + q2 X (2 ) =
X0 = EQ [X
1+r
1+r
1
2
15/9
10/9
1
2
0
10/9
3
4
Problem: Before we can use martingale pricing to price a contingent

claim X , we have to know that X is attainable.
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Complete Markets
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Complete Markets
Definition: A SP SMM is said to be complete if every continent

claim is attainable.
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Complete Markets

When is a SP SMM complete?
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Complete Markets

I
Think of a claim X as a vector X = (X (1 ), . . . , X (K ))tr
November 2010
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Complete Markets

I
I

To replicate X , we must find a portfolio = (0 , 1 , . . . , N )tr such that
X (k ) = 0 ST0 (k ) + 1 ST1 (k ) + + N STN (k )
for each state of the world k .
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Complete Markets

I
I

To replicate X , we must find a portfolio = (0 , 1 , . . . , N )tr such that
X (k ) = 0 ST0 (k ) + 1 ST1 (k ) + + N STN (k )
for each state of the world k .

We thus have K equations (one for each state) in N + 1 unknowns
(the n ), and can summarize this by writing
where
X (1 )
X (2 )
X = .
..
X (K )
X tr = tr D
0
ST (1 )
ST1 (1 )
D= .
..
ST0 (2 )
ST1 (2 )
..
.
...
...
...
STN (1 ) STN (2 ) . . .
ST0 (K )
ST1 (K )
..
STN (K )
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Complete Markets
II
November 2010
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Complete Markets
II
November 2010
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Complete Markets
I
II
Such a solution will exist when the vector X RK lies in the column
space of the matrix D tr :
ST (1 )
X (1 )
ST (1 )
X (2 )
S 0 (2 )
S N (2 )
X = D tr
iff
.. = 0 .. + +N
..
.
.
.
X (K )
ST0 (K )
STN (K )
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Complete Markets
I
II
ST (1 )
X (1 )
ST (1 )
X (2 )
S 0 (2 )
S N (2 )
X = D tr
iff
.. = 0 .. + +N
..
.
.
.
X (K )
ST0 (K )
STN (K )
Hence such a solution will exist for every conceivable X RK when the
column space of D tr is RK
November 2010
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Complete Markets
I
II
ST (1 )
X (1 )
ST (1 )
X (2 )
S 0 (2 )
S N (2 )
X = D tr
iff
.. = 0 .. + +N
..
.
.
.
X (K )
ST0 (K )
STN (K )
Hence such a solution will exist for every conceivable X RK when the
column space of D tr is RK
Theorem: A SP SMM is complete when the cashflow matrix D is full

rank,
i.e. has rank = K no. of states of the world.
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Second Fundamental Theorem of Asset Pricing
Theorem: A SP SMM is complete and arbitragefree if and only if

there exists a unique EMM.
November 2010
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Lecture Single Period Models

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Lecture Single Period Models

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SinglePeriod Securities Markets

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

Such models are clearly unrealistic. Nevertheless, studying these

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

Such models are clearly unrealistic. Nevertheless, studying these

Mathematically they are simple.

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

Such models are clearly unrealistic. Nevertheless, studying these

Mathematically they are simple.

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

Such models are clearly unrealistic. Nevertheless, studying these

Mathematically they are simple.

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

A theoretical model of financial markets should include the following:

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

A theoretical model of financial markets should include the following:

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

A theoretical model of financial markets should include the following:

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

A theoretical model of financial markets should include the following:

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

A theoretical model of financial markets should include the following:

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

A theoretical model of financial markets should include the following:

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

A theoretical model of financial markets should include the following:

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

A theoretical model of financial markets should include the following:

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

A theoretical model of financial markets should include the following:

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

Consumption Possibilities of traders during the life of the model

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

Consumption Possibilities of traders during the life of the model

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets

The basic building blocks of a SP SMM are:

P. Ouwehand (Stellenbosch Univ.)

SinglePeriod Securities Markets