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Stochastic Methods in Finance: Lecture 1

Pawel Polak

Spring 2017

Acknowledgement: I would like to thank Yuchong Zhan (Columbia University) for


sharing her lecture notes.

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Plan

I Basics on portfolios and derivatives


I Replication and arbitrage
I Simple no-arbitrage pricing

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Basic financial securities

I Today is time 0.
I Fix time horizon T > 0 (tomorrow, next year, end of world. . . )
I Some securities that have well-defined value at time T :
I Zero coupon bond. Value BT = 1 (by definition).
I One unit of money market account. Value = 1 + interest.
I One share of a (liquid) stock. Value ST (from market).
I One CNY (in USD). Value from market.
I Note: value at time T not necessarily known today!
I Long means buying a security with the expectation that the
asset will rise in value. In math, we use a positive number to
represent a long position.
I Short means borrowing a security and selling it, with the
expectation that the asset will drop in value. In math, we use
a negative number to represent a short position.

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Derivative securities

I A derivative security has a value that derives from an


underlying asset.
I Usually will assume underlying asset is a stock, but can also
be a commodity, foreign exchange rate, etc.
I Examples:
I Forward contracts.
I Call options.
I Put options.
I European derivative securities with other payoffs.
I Will look at these in some detail.

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Forward contract

I Holder (owner) must buy one share of stock at the price K .


I Value at time T of forward contract is FT = ST − K .
I Illustrate using payoff diagram (by hand).
I Who might want to buy a forward contract?

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European call option

I Owner may exercise option at time T .


I Exercising means buying one share of the stock at price K .
I K = strike price. T = expiration date.
I Value at time T of call option is
(
ST − K if ST > K
CT = (ST −K )+ = max{ST −K , 0} = .
0 if ST ≤ K

I Payoff diagram looks like hockey stick (by hand).


I “European” means exercise only possible at time T .
“American” options can be exercised earlier.
I Who might want to buy a call option?

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European put option

I Owner may exercise option at time T .


I Exercising means selling one share of the stock at price K .
I K = strike price. T = expiration date.
I Value at time T of put option is
(
K − ST if ST < K
PT = (K −ST )+ = max{K −ST , 0} = .
0 if ST ≥ K

I Payoff diagram looks like hockey stick (by hand).


I Who might want to buy a put option?

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European derivative securities with other payoffs

I By changing payoff structure, get other types of European


derivative securities:
I Bear spreads, bull spreads (pictures by hand).
I Butterflies (picture by hand).
I Who might want to buy these?
I Can consider bond, stock as derivative security, too. (Pictures
by hand.)

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Portfolios

I Can have several securities in portfolio.


I Assumptions/conventions:
I Can buy fractions of a security.
I The interest rate for investing is the same as the interest rate
for borrowing.
I Short selling is allowed.
I No transaction costs.
I Example: payoff diagram of portfolio containing 1 share of
stock, one call option (by hand).
I For now, only look at static portfolio (no rebalancing).

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Replicating portfolios

I One portfolio replicates another if they have the same payoff.


I Example: forward contract (by hand).
I Example: put-call parity (by hand).
I Example: bull spread (by hand).

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Arbitrage portfolio

I The minimum assumption for pricing derivatives is the


absence of arbitrage.
I An arbitrage is a trading opportunity that will not lose for
sure, and that has a positive chance of winning.
I An example of arbitrage: we all know gold is more expensive
than silver. If tomorrow’s silver price happens to be higher
than that of gold, then there is an arbitrage opportunity: We
simply long the undervalued gold, and short the overvalued
silver. Given that the fundamentals of gold and silver do not
change, the gold/silver price will return to normal. We then
close our position and lock the profit.
I Define arbitrage portfolio as portfolio that
I costs nothing to set up: X0 = 0.
I has nonnegative value at time T : XT ≥ 0.
I some chance that XT > 0.

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Replication and arbitrage

I Suppose one portfolio X replicates another Y .


I This means that XT = YT .
I We then must have X0 = Y0 or else there is an arbitrage:
I if X0 < Y0 :
I at time 0, buy X , sell Y , buy (Y0 − X0 )/B0 zero coupon bonds.
I costs nothing to set up this portfolio.
I portfolio worth (Y0 − X0 )/B0 > 0 at time T .
I Arbitrage!
I if X0 > Y0 : get arbitrage portfolio in a similar way (ex.)
I If XT ≥ YT , then Xt ≥ Yt a.s. for all t ∈ [0, T ]. (The security
that pays more will be more expensive.)

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Simple no-arbitrage pricing I

I Example: price of forward contract.


I Usually define K as forward price so that the no-arbitrage
price of the forward contract is zero.
I Find formula for forward price (by hand).

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Simple no-arbitrage pricing II

I Put-call parity (by hand).


I Arbitrage bounds for call option (by hand).

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Reading homework

Review basic probability and martingale theory. (Vol I, Ch. 2.1-2.3


and Vol II, Ch. 1-2)

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