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Lecture 3: One
One--period Model
Pricing
Prof. Markus K. Brunnermeier
Slide 03
03--1
Fin 501: Asset Pricing
O
Overview:
i Pricing
Pi i
1. LOOP, No arbitrage [L2,3]
2. Forwards [McD5]
3
3. Options: Parity relationship [McD6]
4. No arbitrage and existence of state prices [L2,3,5]
5. Market completeness
p and uniqueness
q of state p
prices
6. Pricing kernel q*
7. Four pricing formulas:
state prices,
prices SDF
SDF, EMM
EMM, beta pricing [L2,3,5,6]
L2 3 5 6]
8. Recovering state prices from options [DD10.6]
Slide 03
03--2
Fin 501: Asset Pricing
V t Notation
Vector N t ti
Notation: y,x
y x Rn
y x yi xi for each i=1,,n.
y > x y x and y x.x
y >> x yi > xi for each i=1,,n.
Inner product
y x = i yx
Matrix multiplication
Slide 03
03--3
Fin 501: Asset Pricing
specify observe/specify
Preferences & existing
Technology Asset Prices
State Prices q
absolute (or stochastic discount relative
factor/Martingale measure)
asset pricing asset pricing
LOOP
derive derive
A t Prices
Asset Pi P i for
Price f (new)
( ) assett
Only works as long as market
Slide 03
03--4
completeness doesnt change
Fin 501: Asset Pricing
Th
Three F
Forms off No-
No
N -ARBITRAGE
1. Law of one Price (LOOP)
If hX = kX then p h = p k.
2. No strong arbitrage
There exists no portfolio h which is a strong
arbitrage, that is hX 0 and p h < 0.
3 No arbitrage
3.
There exists no strong arbitrage
nor portfolio k with k
k X > 0 and 0 p k
Slide 03
03--5
Fin 501: Asset Pricing
Th
Three F
Forms off No-
No
N -ARBITR AGE
Law of one price is equivalent to
everyy portfolio
p with zero p
payoff
y has zero
price.
No arbitrage => > no strong arbitrage
No strong arbitrage => law of one price
Slide 03
03--6
Fin 501: Asset Pricing
O
Overview:
i Pricing
Pi i
1. LOOP, No arbitrage
2. Forwards
3
3. Options: Parity relationship
4. No arbitrage and existence of state prices
5. Market completeness
p and uniqueness
q of state p
prices
6. Pricing kernel q*
7. Four pricing formulas:
state prices,
prices SDF,
SDF EMM,
EMM beta pricing
8. Recovering state prices from options
Slide 03
03--7
Fin 501: Asset Pricing
Alt
Alternative
ti ways to
t buy
b a stock
t k
Four different payment and receipt timing combinations:
Outright purchase: ordinary transaction
Fully leveraged purchase: investor borrows the full amount
Prepaid forward contract: pay today, receive the share later
Forward contract: agree on price now, pay/receive later
Payments, receipts, and their timing:
Slide 03
03--8
Fin 501: Asset Pricing
P i i prepaid
Pricing id fforwards
d
If we can price the prepaid forward (FP), then we can
calculate the price for a forward contract:
F = Future
F t value
l off FP
Pricing by analogy
In the absence of dividends, the timing of delivery is irrelevant
Price of the prepaid forward contract same as current stock price
FP0, T = S0 (where the asset is bought at t = 0, delivered at t = T)
Slide 03
03--9
Fin 501: Asset Pricing
P i i prepaid
Pricing id fforwards
d (cont.)
Pricing
g by
y arbitrage
g
If at time t=0, the prepaid forward price somehow exceeded
the stock price, i.e., FP0, T > S0 , an arbitrageur could do the
following:
g
Slide 03
03--10
Fin 501: Asset Pricing
P i i prepaid
Pricing id fforwards
d (cont.)
What if there are deterministic* dividends? Is FP0, T = S0 still valid?
No, because the holder of the forward will not receive dividends that will be
paid to the holder of the stock FP0, T < S0
Slide 03
03--11
Fin 501: Asset Pricing
P i i prepaid
Pricing id fforwards
d (cont.)
Example 5.1
XYZ stock costs $100 today and will pay a quarterly dividend of
$1 25 If the risk-free rate is 10% compounded continuously
$1.25. continuously, how
much does a 1-year prepaid forward cost?
4
FP0, 1 = $100 i=1
$1.25e0.025i = $95.30
Example 5.2
The index is $125 and the dividend yield is 3% continuously
compounded.
p How much does a 1-year
y p
prepaid
p forward cost?
FP0,1 = $125e0.03 = $121.31
Slide 03
03--12
Fin 501: Asset Pricing
Pricing
P i i fforwards
d on stock
t k
Forward price is the future value of the prepaid forward
No dividends: F0, T = FV(FP0, T ) = FV(S0) = S0 erT
n
0 T = S0 e i=1 e
Discrete dividends: F0, rT ( i)D
r(T-t
ti
Continuous dividends: F0, T = S0 e(r-)T
Forward premium
The difference between current forward price and stock price
Can be used to infer the current stock price from forward price
Definition:
Forward premium = F0, T / S0
Annualized forward premium =: a = (1/T) ln (F0, T / S0) (from e T=F0,T / S0 )
Slide 03
03--13
Fin 501: Asset Pricing
C ti a synthetic
Creating th ti forward
f d
One can offset the risk of a forward by creating a synthetic
f
forward
d to offset
ff a position
i i iin the
h actuall fforward d contract
How can one do this? (assume continuous dividends at rate )
Recall the long forward payoff at expiration: = ST - F0, T
Borrow
B and
d purchase
h shares
h as ffollows:
ll
Slide 03
03--14
Fin 501: Asset Pricing
T bl 5.6
Table 56
Slide 03
03--15
Fin 501: Asset Pricing
Oth issues
Other i iin fforward
d pricing
i i
Does the forward price predict the future price?
According the formula F0, T = S0 e(r-)T the forward price conveys no
additional information beyond what S0 , r, r and provides
Moreover, the forward price underestimates the future stock price
Slide 03
03--16
Fin 501: Asset Pricing
O
Overview:
i Pricing
Pi i
1. LOOP, No arbitrage
2. Forwards
3
3. Options: Parity relationship
4. No arbitrage and existence of state prices
5. Market completeness
p and uniqueness
q of state p
prices
6. Pricing kernel q*
7. Four pricing formulas:
state prices,
prices SDF,
SDF EMM,
EMM beta pricing
8. Recovering state prices from options
Slide 03
03--17
Fin 501: Asset Pricing
P
Put
Put-
t-Call
C ll P
Parity
it
For European options with the same strike price and time to
expiration the parity relationship is:
Call put = PV (forward price strike price)
or
Intuition:
Buying a call and selling a put with the strike equal to the forward
price (F0,T
0 T = K) creates a synthetic forward contract and hence must
have a zero price.
Slide 03
03--18
Fin 501: Asset Pricing
P it ffor Options
Parity O ti on Stocks
St k
If underlying asset is a stock and Div is the
deterministic* dividend stream, then e-rT F0,T = S0 PV0,T
(Div), therefore
C(K, T) = P(K, T) + [S0 PV0,T (Div)] e-rT(K)
Rewriting above,
S0 = C(K,
C(K T) P(K,
P(K T) + PV0,T (Div)
(Di ) + e-rTT(K)
* ll
*allows to
t stick
ti k with
ith one period
i d setting
tti
Slide 03
03--19
Fin 501: Asset Pricing
O ti price
Option i b boundaries
d i
American vs. European
Since an American option can be exercised at anytime, whereas a
European option can only be exercised at expiration, an American
option must always be at least as valuable as an otherwise
p
identical European option:
p
CAmer(S, K, T) > CEur(S, K, T)
Slide 03
03--20
Fin 501: Asset Pricing
O ti price
Option i b bounderies
d i (cont.)
Option price boundaries
Call price cannot:
be negative
g
exceed stock price
be less than price implied by put-call parity using zero for put price:
S > CAmer(S, K, T) > CEur(S, K, T) > max [0, PV0,T(F0,T) PV0,T(K)]
Slide 03
03--21
Fin 501: Asset Pricing
Early
E l exercise
i off A
American
i callll
Early exercise of American options
A non-dividend paying American call option should not be
exercised early
early, because:
CAmer > CEur > St K + PEur+K(1-e-r(T-t)) > St K
That means, one would lose money be exercising early
instead of selling the option
If there are dividends, it may be optimal to exercise early
It may be optimal to exercise a non-dividend paying put option
early if the underlying stock price is sufficiently low
Slide 03
03--22
Fin 501: Asset Pricing
O ti
Options: Time
Ti to
t expiration
i ti
Time to expiration
An American option (both put and call) with more time to expiration is at
least as valuable as an American option with less time to expiration. This is
because the longer option can easily be converted into the shorter option by
exercising it early.
European call options on dividend-paying stock and European puts may be
less valuable than an otherwise identical option with less time to expiration.
A European call option on a non-dividend paying stock will be more
valuable than an otherwise identical option with less time to expiration
expiration.
Strike price does not grow at the interest rate.
When the strike price grows at the rate of interest, European call and put
prices on a non-dividend paying stock increases with time.
Suppose to the contrary P(T) < P(t) for T>t, then arbitrage. Buy P(T)
and sell P(t) initially. At t
if St>Kt, P(t)=0.
if St<Kt, negative payoff St Kt. Keep stock and finance Kt.
Time T-value ST-Kter(T-t)=ST-KT.
Slide 03
03--23
Fin 501: Asset Pricing
O ti
Options: Strike
St ik price
i
Different strike
Diff ik prices
i (K1 < K2 < K3),
) for
f both
b hE European and
d
American options
A call with a low strike price is at least as valuable as an
g
otherwise identical call with higher strike p
price:
C(K1) > C(K2)
A put with a high strike price is at least as valuable as an
otherwise identical call with low strike price:
P(K2) > P(K1)
The premium difference between otherwise identical calls
with different strike prices cannot be greater than the
difference in strike prices:
p
C(K1) C(K2) < K2 K1 K2 K1
S
Price of a collar < maximum payoff of a collar
O ti
Options: Strike
St ik price
i (cont.)
Diff
Different strike
ik prices
i (K1 < K2 < K3),
) ffor both
b h
European and American options
The premium difference between otherwise identical
puts
t with
ith different
diff t strike
t ik prices
i cannott b
be greater
t ththan
the difference in strike prices:
P(K1) P(K2) < K2 K1
Premiums
Premi ms decline at a decreasing rate for calls with ith
progressively higher strike prices. (Convexity of option
price with respect to strike price):
K1 K2 K2 K3
Slide 03
03--25
Fin 501: Asset Pricing
O ti
Options: Strike
St ik price
i
Slide 03
03--26
Fin 501: Asset Pricing
P
Properties
ti off option
ti prices
i (cont.)
Slide 03
03--27
Fin 501: Asset Pricing
Summary
Su ayo of pa
parity
y
relationships
Slide 03
03--28
Fin 501: Asset Pricing
Overview:
O e e Pricing
c g-oone
e pe
period
od
model
1. LOOP, No arbitrage
2. Forwards
3
3. Options: Parity relationship
4. No arbitrage and existence of state prices
5. Market completeness
p and uniqueness
q of state p
prices
6. Pricing kernel q*
7. Four pricing formulas:
state prices,
prices SDF,
SDF EMM,
EMM beta pricing
8. Recovering state prices from options
Slide 03
03--29
Fin 501: Asset Pricing
back
b k tto the
th big
bi picture
i t
State space (evolution of states)
(Risk) preferences
Aggregation over different agents
Security structure prices of traded securities
Problem:
Difficult to observe risk preferences
What can we say about existence of state prices
without assuming specific utility
functions/constraints for all agents in the economy
Slide 03
03--30
Fin 501: Asset Pricing
specify observe/specify
Preferences & existing
Technology Asset Prices
State Prices q
absolute (or stochastic discount relative
factor/Martingale measure)
asset pricing asset pricing
LOOP
derive derive
A t Prices
Asset Pi P i for
Price f (new)
( ) assett
Only works as longSlide
as market
03
03--31
completeness doesnt change
Fin 501: Asset Pricing
Th
Three F
Forms off No-
No
N -ARBITRAGE
1. Law of one Price (LOOP)
If hX = kX then p h = p k.
2. No strong arbitrage
There exists no portfolio h which is a strong
arbitrage, that is hX 0 and p h < 0.
3 No arbitrage
3.
There exists no strong arbitrage
nor portfolio k with k
k X > 0 and 0 p k
Slide 03
03--32
Fin 501: Asset Pricing
Pi i
Pricing
Define for each z <X>,
If LOOP holds
h ld q(z)
( ) is i a single-valued
i l l d and d
linear functional. (i.e. if h and h lead to same z, then price has to
be the same)
Pi i
Pricing
q(h X) = p .h
LOOP q(hX)
A linear functional Q in RS is a valuation function if
Q(z) = q(z) for each z <X>.
Slide 03
03--34
Fin 501: Asset Pricing
State prices q
q is a vector of state prices if p = X q,
that is pj = xj q for each j = 1,,J
, ,
If Q(z) = q z is a valuation functional then q is a vector of
state prices
Suppose q is a vector of state prices and LOOP holdsholds.
Then if z = hX LOOP implies that
Slide 03
03--35
Fin 501: Asset Pricing
State prices q
p(1,1) = q1 + q2
p(2,1) = 2q1 + q2
Value of portfolio (1,2)
(1 2)
c2
3p(1,1) p(2,1) = 3q1 +3q2-2q1-q2
= q1 + 2q2
q2
c1
q1
Slide 03
03--36
Fin 501: Asset Pricing
The
e Fundamental
u da e ta Theorem
eo e oof
Finance
Proposition 1. Security prices exclude arbitrage
if and only if there exists a valuation functional
with q >> 00.
Proposition 1. Let X be an J S matrix, and
p RJ. There is no h in RJ satisfying h p 0, hh
X 0 and at least one strict inequality if, and only
if, there exists a vector q RS with
q >> 0 and d p = X q.
No arbitrage positive state prices
Slide 03
03--37
Fin 501: Asset Pricing
O
Overview:
i Pricing
Pi i
1. LOOP, No arbitrage
2. Forwards
3
3. Options: Parity relationship
4. No arbitrage and existence of state prices
5. Market completeness
p and uniqueness
q of state p
prices
6. Pricing kernel q*
7. Four pricing formulas:
state prices,
prices SDF,
SDF EMM,
EMM beta pricing
8. Recovering state prices from options
Slide 03
03--38
Fin 501: Asset Pricing
Slide 03
03--39
Fin 501: Asset Pricing
Q(x)
x2
complete markets
<X>
q
x1
Slide 03
03--40
Fin 501: Asset Pricing
p=Xq
Q(x)
x2
<X> incomplete markets
x1
Slide 03
03--41
Fin 501: Asset Pricing
p=Xqo
Q(x)
x2
<X> incomplete markets
qo
x1
Slide 03
03--42
Fin 501: Asset Pricing
Multiple
u p e q in incomplete
co p e e
c
markets
2
<X>
p=Xq
q*
qo
v q
c1
Uniqueness
U que ess a
and
d
Completeness
Proposition 2. If markets are complete, under no arbitrage
there exists a unique valuation functional.
Slide 03
03--44
Fin 501: Asset Pricing
Overview:
O e e Pricing
c g-oone
e pe
period
od
model
1. LOOP, No arbitrage
2. Forwards
3
3. Options: Parity relationship
4. No arbitrage and existence of state prices
5. Market completeness
p and uniqueness
q of state p
prices
6. Pricing kernel q*
7. Four pricing formulas:
state prices,
prices SDF,
SDF EMM,
EMM beta pricing
8. Recovering state prices from options
Slide 03
03--45
Fin 501: Asset Pricing
F
Four Asset
A t Pricing
P i i Formulas
F l
1. State p
prices pj = s qs x s j
2. Stochastic discount factor
factorpj = E[mxj]
m1 xj1
m2 xj2
m3
xj3
1.
1 St
State
t Price
P i Model
M d l
so far price in terms of Arrow-Debreu
((state)) prices
p
j j
p = s q s x s
Slide 03
03--47
Fin 501: Asset Pricing
2 St
2. Stochastic
h ti DiDiscountt F
Factor
t
Slide 03
03--48
Fin 501: Asset Pricing
<X>
m*
m c1
Slide 03
03--49
Fin 501: Asset Pricing
Ri
Risk
Risk-
k-adjustment
dj t t in
i payoffs
ff
p = E[mx
E[ j] = E[m]E[x]
E[ ]E[ ] + Cov[m,x]
C [ ]
Since pbond=E[m1].
E[m1]. Hence, the risk free rate Rf =1/E[m].
1/E[m].
p = E[x]/Rf + Cov[m,x]
Remarks:
(i) If risk
risk-free
free rate does not exist
exist, Rf is the shadow risk free
rate
(ii) Typically Cov[m,x] < 0, which lowers price and increases
return
Slide 03
03--50
Fin 501: Asset Pricing
Slide 03
03--51
Fin 501: Asset Pricing
in
i RReturns:
t Rj=xj/p
/ j
E[mRj]=1 Rf E[m]=1
=> E[m(Rj-Rf)]=0
E[m]{E[Rj]-Rf} + Cov[m,Rj]=0
Slide 03
03--52
Fin 501: Asset Pricing
4 State-
4. State-price BETA Model
shrink axes by factor
c2
<X>
m c1
p=1
(priced with m*)
Slide 03
03--53
Fin 501: Asset Pricing
4 St
4. State
State-
t -price
i BETA Model
M d l
E[Rj] Rf = - Cov[m,Rj]/E[m] (2)
also holds for all portfolios h and
we can replace m with m*
Suppose (i) Var[m*] > 0 and (ii) R* = m* with > 0
Slide 03
03--54
Fin 501: Asset Pricing
4 St
4. State
State-
t -price
i BETA Model
M d l
(2) ffor Rh: E[Rh]-R
] Rf=-Cov[R
C [R*,R Rh]/E[R*]
= - h Var[R*]/E[R*]
(2) ffor R*: E[R*]-R
] Rf=-Cov[R
C [R*,R R*]/E[R*]
=-Var[R*]/E[R*]
Hence,
Hence
E[R
E[ Rh] - Rf = h E[R*- Rf]
where h ::= Cov[R*,Rh]/Var[R*]
very general but what is R* in reality?
Slide 03
03--55
Fin 501: Asset Pricing
F
Four Asset
A t Pricing
P i i Formulas
F l
1. State p
prices 1 = s qs Rsj
2. Stochastic discount factor
factor1 = E[mRj]
m1 xj1
m2 xj2
m3
xj3
Wh t do
What d we know
k about
b t q, m, , R*? ^
Diff
Different
t Asset
A t Pricing
P i i Models
M d l
pt = E[mt+1 xt+1] => E[Rh] - Rf = h E[R*- Rf]
where h := Cov[R*,Rh]/Var[R*]
where mt+1=f((,,,, )
f() = asset pricing model
General Equilibrium
f() = MRS /
Factor Pricing Model
a+b1 f1,t+1 + b2 f2,t+1
CAPM CAPM
a+b1 f1,t+1 = a+b R M R*=Rf ((a+b1RM))/(a+b
( 1R )
f
1t 1 1
where R = return of market portfolio
M
Is b1 < 0?
Slide 03
03--58
Fin 501: Asset Pricing
Diff
Different
t Asset
A t Pricing
P i i Models
M d l
Theory
All economics and modeling is determined by
mt+1= a + b f
Entire content of model lies in restriction of SDF
Empirics
m* (which is a portfolio payoff) prices as well as m (which
is e.g. a function of income, investment etc.)
measurement error of m* is smaller than for any m
Run regression on returns (portfolio payoffs)!
(e.g. Fama-French three factor model)
Slide 03
03--59
Fin 501: Asset Pricing
Overview:
O e e Pricing
c g-oone
e pe
period
od
model
1. LOOP, No arbitrage
2. Forwards
3
3. Options: Parity relationship
4. No arbitrage and existence of state prices
5. Market completeness
p and uniqueness
q of state p
prices
6. Pricing kernel q*
7. Four pricing formulas:
state prices,
prices SDF,
SDF EMM,
EMM beta pricing
8. Recovering state prices from options
Slide 03
03--60
Fin 501: Asset Pricing
specify observe/specify
Preferences & existing
Technology Asset Prices
State Prices q
absolute (or stochastic discount relative
factor/Martingale measure)
asset pricing asset pricing
LOOP
derive derive
A t Prices
Asset Pi P i for
Price f (new)
( ) assett
Only works as longSlide
as market
03
03--61
completeness doesnt change
Fin 501: Asset Pricing
Recovering
eco e g S State
a e Prices
ces from
o
Option Prices
Suppose that ST, the price of the underlying portfolio
(we may think of it as a proxy for price of market
portfolio),
portfolio ), assumes a "continuum"
continuum of possible values.
Suppose there are a continuum of call options with
different strike/exercise prices markets are complete
Let uss construct
constr ct the following
follo ing portfolio
portfolio:
for some small positive number >0,
Buy one call with E = ST 2
Sell one call with E = S T
2
Sell one call with E = ST + 2
Buy one call with . = ST + 2 +
E
Slide 03
03--62
Fin 501: Asset Pricing
Recovering
R i State
St t Prices
Pi (ctd.)
( td )
Slide 03
03--63
Fin 501: Asset Pricing
Recovering
R i State
St t Prices
Pi (ctd.)
( td )
Let us thus consider buying 1/ units of the portfolio. The
1
total payment, when ST 2 ST ST + 2 , is 1, for
any choice of . We want to let a 0 , so as to eliminate
the payments in the ranges ST [ ST , ST ) and
2 2
ST ( ST + , ST + + ]. The value of / units of this p
1 portfolio
2 2
is :
1
{C(S K = S
{C(S, ST /2 ) C(S, ST /2)
C(S K = S
Slide 03
03--64
Fin 501: Asset Pricing
Taking the limit 0
1
lim {C(S, K = ST /2)C(S, K = ST /2)[C(S, K = ST +/2)C(S, K = ST +/2+)]}
0
Payoff
$T
S
2
S$ T S$ T + 2 ST
Slide 03
03--65
Fin 501: Asset Pricing
Recovering
R i State
St t Prices
Pi (ctd.)
( td )
Evaluating following cash flow
Slide 03
03--66
Fin 501: Asset Pricing
R
Recovering
i State
St t Prices
Pi (di
(discrete setting)
i )
Slide 03
03--67
Fin 501: Asset Pricing
Slide 03
03--68
Fin 501: Asset Pricing
specify observe/specify
Preferences & existing
Technology Asset Prices
State Prices q
absolute (or stochastic discount relative
factor/Martingale measure)
asset pricing asset pricing
LOOP
derive derive
A t Prices
Asset Pi P i for
Price f (new)
( ) assett
Only works as longSlide
as market
03
03--69
completeness doesnt change