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Fin 501: Asset Pricing

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

evolution of states NAC/LOOP NAC/LOOP


risk preferences
aggregation

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

FP0, T = S0 PV(all dividends paid from t=0 to t=T)


For discrete dividends Dti at times ti, i = 1,., n
n
The prepaid forward price: FP0, T = S0 i=1
PV0, ti (Dti)
(reinvest the dividend at risk-free rate)
For continuous dividends with an annualized yield
The prepaid forward price: FP0, T = S0 eT
(reinvest the dividend in this index. One has to invest only S0 eT initially)

* NB 1: if dividends are stochastic, we cannot apply the one period model

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

Note that the total payoff at expiration is same as forward payoff

Slide 03
03--14
Fin 501: Asset Pricing

Creating a synthetic forward


(cont.)
The idea of creating synthetic forward leads to
following:
Forward = Stock zero-coupon bond
Stock = Forward + zero-coupon bond
Zero-coupon bond = Stock forward
Cash-and-carry
Cash and carry arbitrage: Buy the index, short the
forward

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

Forward pricing formula and cost of carry


Forward price =
Spot price + Interest to carry the asset asset lease rate

Cost of carry, (r-)S

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

C(K, T) P(K, T) = PV0,T (F0,T K) = e-rT(F0,T K)

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)

For index options, S0 PV0,T (Div) = S0e-T, therefore


C(K T) = P(K,
C(K, P(K T) + S0e-T PV0,T (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)

PAmer(S, K, T) > PEur(S, K, T)


Option price boundaries
Call price cannot: be negative, exceed stock price, be less than
price implied by put-call parity using zero for put price:
S > CAmer(S,
(S K,
K T) > CEur(S,
(S K,
K T) >
> max [0, PV0,T(F0,T) PV0,T(K)]

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)]

Put price cannot:


be more than the strike price
be less than price implied by put-call parity using zero for call price:
K > PAmer(S, K, T) > PEur(S, K, T) > max [0, PV0,T (K) PV0,T(F0,T)]

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

Note for K3-K2 more pronounced, hence (next slide) !


Slide 03
03--24
Fin 501: Asset Pricing

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):

C(K1) C(K2) C(K2) C(K3)

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

evolution of states NAC/LOOP NAC/LOOP


risk preferences
aggregation

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)

Conversely, if q is a linear functional defined


in <X> then the law of one price holds
holds.
Slide 03
03--33
Fin 501: Asset Pricing

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>.

Q(z) = q .z for some q RS, where qs = Q(es), ) and es


is the vector with ess = 1 and esi = 0 if i s
es is an Arrow-Debreu securityy
q is a vector of state prices

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

Q(z) = q z is a valuation functional


iff q is a vector of state prices and LOOP holds

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

Multiple State Prices q


& Incomplete Markets
bond (1,1) only What state prices are consistent
with p(1,1)?
c2
p(1 1) = q1 + q2
p(1,1)
Payoff space <X>
One equation two unknowns q1, q2
There are (infinitely) many.
e.g. if p(1,1)=.9
p(1,1) q1 =.45,, q2 =.45
q2
or q1 =.35, q2 =.55
c1
q1

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

Many possible state price vectors s.t.


s t p=X
p=Xqq.
One is special: q* - it can be replicated as a portfolio.
Slide 03
03--43
Fin 501: Asset Pricing

Uniqueness
U que ess a
and
d
Completeness
Proposition 2. If markets are complete, under no arbitrage
there exists a unique valuation functional.

If markets are not complete, then there exists


v i\ RS with 0 = Xv.
Suppose there is no arbitrage and let q >> 0 be a vector of
state prices. Then q + v >> 0 provided is small enough,
and p = X X (q + v).
v) Hence
Hence, there are an infinite number of
strictly positive state prices.

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

3. Martingale measure pj = 1/(1+rf) E [x


^ j]

(reflect risk aversion by


over(under)weighing the bad(good) states!)
4. State
State--price beta model E[Rj] - Rf = j E[R*- Rf]
(in returns Rj := xj /pj)
Slide 03
03--46
Fin 501: Asset Pricing

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

That is, stochastic discount factor ms = qs/s for


all ss.

Slide 03
03--48
Fin 501: Asset Pricing

2 Stochastic Discount Factor


2.
shrink axes by factor

<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

3 Equivalent Martingale Measure


3.
Price of any asset
Price of a bond

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

E[Rj] Rf = - Cov[m,Rj]/E[m] (2)


also holds for portfolios h
Note:
risk correction depends only on Cov of payoff/return with
discount factor
factor.
Only compensated for taking on systematic risk not
idiosyncratic risk.

Slide 03
03--52
Fin 501: Asset Pricing

4 State-
4. State-price BETA Model
shrink axes by factor
c2

<X>

let underlying asset


be x=(1.2,1)
R* R*= m*
m*

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

E[Rh] Rf = - Cov[R*,Rh]/E[R*] (2)

Define h := Cov[R*,Rh]/ Var[R*] for any portfolio h

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?

Regression Rhs = h + h (R*)s + s with Cov[R*,]=E[]=0

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

3. Martingale measure 1 = 1/(1+rf) E^ [Rj]


(reflect risk aversion by
over(under)weighing the bad(good) states!)
4. State
State--price beta model E[Rj] - Rf = j E[R*- Rf]
(in returns Rj := xj /pj)
Slide 03
03--56
Fin 501: Asset Pricing

Wh t do
What d we know
k about
b t q, m, , R*? ^

Main results so far


Existence iff no arbitrage
Hence, single factor only

but doesnt famos Fama-French factor model has 3


factors?

multiple factor is due to time-variation


(wait for multi-period model)
Uniqueness if markets are complete
Slide 03
03--57
Fin 501: Asset Pricing

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

evolution of states NAC/LOOP NAC/LOOP


risk preferences
aggregation

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

[C(S, K = ST + /2) C(S, K = ST + /2 + )]}

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

C(S, K = ST /2 ) C(S, K = ST /2) C(S, K = ST + /2 + ) C(S, K = ST + /2)


lim{{ }}+lim{{ }
0 0
| {z } | {z }
0 0

Payoff

Divide by and let 0 to obtain state price density as 2C/ K2.


1

$T
S
2
S$ 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

The value today of this cash flow is :

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

Table 8.1 Pricing an Arrow-Debreu State Claim

E C(S,E) Cost of Payoff if ST =


position 7 8 9 10 11 12 13 C (C) qs
(C)=
7 3.354
-0.895
8 2 459
2.459 0 106
0.106
-0.789
9 1.670 +1.670 0 0 0 1 2 3 4 0.164
-0.625
10 1.045 -2.090
2.090 0 0 0 0 -2
2 -4
4 -6
6 0.184
-0.441
11 0.604 +0.604 0 0 0 0 0 1 2 0.162
-0.279
12 0.325 0.118
-0.161
0 161
13 0.164
0.184 0 0 0 1 0 0 0

Slide 03
03--68
Fin 501: Asset Pricing

specify observe/specify
Preferences & existing
Technology Asset Prices

evolution of states NAC/LOOP NAC/LOOP


risk preferences
aggregation

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

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