THE CONCEPTS AND PRACTICE OF

MATHEMATICAL FINANCE
Second Edition

M. s. JOSHI
University of Melbourne

CAMBRIDGE
UNIVERSITY PRESS

Contents

Preface
Acknowledgements
1 Risk
1.1 What is risk?
1.2 Market efficiency
1.3 The most important assets
1.4 Risk diversification and hedging
1.5 The use of options
1.6 Classifying market participants
1.7 Key points
1.8 Further reading
1.9 Exercises
2 Pricing methodologies and arbitrage ,
2.1 Some possible methodologies
2.2 Delta hedging
2.3 What is arbitrage?
2.4 The assumptions of mathematical finance
2.5 An example of arbitrage-free pricing
2.6 The time value of money
2.7 Mathematically defining arbitrage
2.8 Using arbitrage to bound option prices
2.9 Conclusion
2.10 Key points
2.11 Further reading
2.12 Exercises
3 Trees and option pricing
3.1 A two-world universe
3.2 A three-state model
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3.3 Multiple time steps

3.4
Many time steps
3.5
A normal model
3.6
Putting interest rates in
3.7
A log-normal model
3.8
Consequences
3.9
Summary
3.10 Key points
3.11 Further reading
3.12 Exercises
Practicalities
4.1 Introduction
4.2 Trading volatility
4.3
Smiles
4.4 The Greeks
4.5 Alternative models
4.6 Transaction costs
4.7
Key points
4.8 Further reading
4.9
Exercises
The Ito calculus
Introduction
5.1
5.2
Brownian motion
5.3
Quadratic variation
5.4
Stochastic processes
5.5
Ito's lemma
5.6
Applying Ito's lemma
5.7
An informal derivation of the Black-Scholes equation
5.8
Justifying the derivation
5.9
Solving the Black-Scholes equation
5.10 Dividend-paying assets
5.11 Key points
5.12 Further reading
5.13 Exercises
Risk neutrality and martingale measures
Plan
6.1
6.2 Introduction
6.3
The existence of risk-neutral measures
6.4
The concept of information
6.5
Discrete martineale oricine

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6.6
Continuous martingales and nitrations
Identifying continuous martingales
6.7
Continuous martingale pricing
6.8
6.9 Equivalence to the PDE method
6.10 Hedging
6.11 Time-dependent parameters
6.12 Completeness and uniqueness
6.13 Changing numeraire
6.14 Dividend-paying assets
6.15 Working with the forward
6.16 Key points
6.17 Further reading
6.18 Exercises
The practical pricing of a European option
Introduction
7.1
Analytic formulae
7.2
7.3 Trees
7.4 Numerical integration
Monte Carlo
7.5
PDE methods
7.6
7.7 Replication
Key points
7.8
7.9 Further reading
7.10 Exercises
Continuous barrier options
Introduction
8.1
The PDE pricing of continuous barrier options
8.2
8.3 Expectation pricing of continuous barrier options
The reflection principle
8.4
Girsanov's theorem revisited
8.5
8.6 Joint distribution
Pricing continuous barriers by expectation
8.7
American digital options
8.8
Key points
8.9
8.10 Further reading
8.11 Exercises
Multi-look exotic options
Introduction
9.1
9.2 Risk-neutral pricing for path-dependent options
9.3 Weak path dependence

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9.4
Path generation and dimensionality reduction
9.5
Moment matching
9.6
Trees, PDEs and Asian options
9.7
Practical issues in pricing multi-look options
9.8
Greeks of multi-look options
9.9
Key points
Further reading
9.10
9.11
Exercises
10 Static replication
ireplication
10.1 Introduction
Continuous barrier options
i0.2
Discrete
barriers
10.3
10.4 Path-dependent exotic options
10.5 The up-and-in put with barrier at strike
10.6 Put-call symmetry
10.7 Conclusion and further reading
10.8
Key points
10.9 Exercises
11 Multiple sources of risk
risk
11.1 Introduction
11.2 Higher-dimensional Brownian motions
11.3 The higher-dimensional Ito calculus
11.4 The higher-dimensional Girsanov theorem
11.5 Practical pricing
11.6 The Margrabe option,
11.7 Quanto options
11.8 Higher-dimensional trees
11.9 Key points
11.10 Further reading
11.11 Exercises
12 Options with early exercise features
12.1 Introduction
12.2 The tree approach
12.3 The PDE approach to American options
12.4 American options by replication
12.5 American options by Monte Carlo
12.6 Upper bounds by Monte Carlo
12.7 Key points
12.8 Further reading
12.9 Exercises

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13 Interest rate derivatives

13.1 Introduction
13.2 The simplest instruments
13.3 Caplets and swaptions
13.4 Curves and more curves
13.5 Key points
13.6 Further reading
13.7 Exercises
14 The pricing of exotic interest rate derivatives
14.1 Introduction
14.2 Decomposing an instrument into forward rates
14.3 Computing the drift of a forward rate
14.4 The instantaneous volatility curves
14.5 The instantaneous correlations between forward
rates
14.6 Doing the simulation
14.7 Rapid pricing of swaptions in a BGM model
14.8 Automatic calibration to co-terminal swaptions
14.9 Lower bounds for Bermudan swaptions
14.10 Upper bounds for Bermudan swaptions
14.11 Factor reduction and Bermudan swaptions
14.12 Interest-rate smiles
14.13 Key points
14.14 Further reading
14.15 Exercises
15 Incomplete markets and jump-diffusion processes
15.1 Introduction
15.2 Modelling jumps with a tree
15.3 Modelling jumps in a continuous framework
15.4 Market incompleteness
15.5 Super- and sub-replication
15.6 Choosing the measure and hedging exotic options
15.7 Matching the market
15.8 Pricing exotic options using jump-diffusion
models
15.9 Does the model matter?
15.10 Log-type models
15.11 Key points
15.12 Further reading
15.13 Exercises

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16 Stochastic volatility
16.1 Introduction
16.2 Risk-neutral pricing with stochastic-volatility models
16.3 Monte Carlo and stochastic volatility
16.4 Hedging issues
16.5 PDE pricing and transform methods
16.6 Stochastic volatility smiles
16.7 Pricing exotic options
16.8 Key points
16.9 Further reading
16.10 Exercises
17 Variance Gamma models
17.1 The Variance Gamma process
17.2 Pricing options with Variance Gamma models
17.3 Pricing exotic options with Variance Gamma models
17.4 Deriving the properties
17.5 Key points
17.6 Further reading
17.7 Exercises
18 Smile dynamics and the pricing of exotic options
18.1 Introduction
18.2 Smile dynamics in the market
18.3 Dynamics implied by models
18.4 Matching the smile to the model
18.5 Hedging
18.6 Matching the modelto the product
18.7 Key points
18.8 Further reading
Appendix A Financial and mathematical jargon
Appendix B Computer projects
B.I
Introduction
B.2
Two important functions
B.3
Project 1: Vanilla options in a Black-Scholes world
B.4
Project 2: Vanilla Greeks
B.5
Project 3: Hedging
B.6
Project 4: Recombining trees
B.7
Project 5: Exotic options by Monte Carlo
B.8
Project 6: Using low-discrepancy numbers
Project 7: Replication models for continuous barrier options
B.9
B.10 Proiect 8: Multi-asset options

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B.I 1 Project 9: Simple interest-rate derivative pricing
B.12 Project 10: LIBOR-in-arrears
B.13 Project 11: BGM
B.14 Project 12: Jump-diffusion models
B.15 Project 13: Stochastic volatility
B.16 Project 14: Variance Gamma
Appendix C Elements of probability theory
C.I
Definitions
C.2
Expectations and moments
C.3
Joint density and distribution functions
C.4
Covariances and correlations
Appendix D Order notation
D.I
BigO
D.2
Small o
Appendix E Hints and answers to exercises
References
Index

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