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Albert Cohen

Department of Mathematics

Department of Statistics and Probability

C336 Wells Hall

Michigan State University

East Lansing MI

48823

albert@math.msu.edu

acohen@stt.msu.edu

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 1 / 161

Course Information

Homework assignments will posted there as well

Page can be found at https://www.math.msu.edu/classpages/

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 2 / 161

Course Information

Many examples within these slides are used with kind permission of

Prof. Dmitry Kramkov, Dept. of Mathematics, Carnegie Mellon

University.

Book for course: Financial Mathematics: A Comprehensive Treatment

(Chapman and Hall/CRC Financial Mathematics Series) 1st Edition.

Can be found in MSU bookstores now

Some examples here will be similar to those practice questions

publicly released by the SOA. Please note the SOA owns the

copyright to these questions.

This book will be our reference, and some questions for assignments

will be chosen from it. Copyright for all questions used from this book

belongs to Chapman and Hall/CRC Press .

From time to time, we will also follow the format of Marcel Finan’s A

Discussion of Financial Economics in Actuarial Models: A Preparation

for the Actuarial Exam MFE/3F. Some proofs from there will be

referenced as well. Please find these notes here

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 3 / 161

What are financial securities?

For example:

Stocks

Commodities

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 4 / 161

What are financial securities?

For example:

Stocks

Commodities

Non-Traded Securities - price remains to be computed.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 4 / 161

What are financial securities?

For example:

Stocks

Commodities

Non-Traded Securities - price remains to be computed.

Is this always true?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 4 / 161

What are financial securities?

For example:

Stocks

Commodities

Non-Traded Securities - price remains to be computed.

Is this always true?

We will focus on pricing non-traded securities.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 4 / 161

How does one fairly price non-traded securities?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 5 / 161

How does one fairly price non-traded securities?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 5 / 161

How does one fairly price non-traded securities?

Unfair prices arise from Arbitrage Strategies

Start with zero capital

End with non-zero wealth

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 5 / 161

How does one fairly price non-traded securities?

Unfair prices arise from Arbitrage Strategies

Start with zero capital

End with non-zero wealth

We will search for arbitrage-free strategies to replicate the payoff of a

non-traded security

How does one fairly price non-traded securities?

Unfair prices arise from Arbitrage Strategies

Start with zero capital

End with non-zero wealth

We will search for arbitrage-free strategies to replicate the payoff of a

non-traded security

This replication is at the heart of the engineering of financial products

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 5 / 161

More Questions

If not, what is needed of our financial model to guarantee at least one

arbitrage-free price?

Uniqueness - are there conditions where exactly one arbitrage-free

price exists?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 6 / 161

And What About...

in the market?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 7 / 161

And What About...

in the market?

Mathematically, if P is a probabilty measure attached to a series of

price movements in underlying asset, is P used in computing the

price?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 7 / 161

Notation

Forward Contract:

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 8 / 161

Notation

Forward Contract:

A financial instrument whose initial value is zero, and whose final

value is derived from another asset. Namely, the difference of the

final asset price and forward price:

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 8 / 161

Notation

Forward Contract:

A financial instrument whose initial value is zero, and whose final

value is derived from another asset. Namely, the difference of the

final asset price and forward price:

for no premium up front

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 8 / 161

Notation

Interest Rate:

The rate r at which money grows. Also used to discount the value

today of one unit of currency one unit of time from the present

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 9 / 161

Notation

Interest Rate:

The rate r at which money grows. Also used to discount the value

today of one unit of currency one unit of time from the present

1

V (0) = , V (1) = 1 (2)

1+r

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 9 / 161

An Example of Replication

domestic:

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 10 / 161

An Example of Replication

domestic:

SAB = 4 is the spot exchange rate - one unit of B is worth SAB of A

today (time 0)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 10 / 161

An Example of Replication

domestic:

SAB = 4 is the spot exchange rate - one unit of B is worth SAB of A

today (time 0)

r A = 0.1 is the domestic borrow/lend rate

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 10 / 161

An Example of Replication

domestic:

SAB = 4 is the spot exchange rate - one unit of B is worth SAB of A

today (time 0)

r A = 0.1 is the domestic borrow/lend rate

r B = 0.2 is the foreign borrow/lend rate

An Example of Replication

domestic:

SAB = 4 is the spot exchange rate - one unit of B is worth SAB of A

today (time 0)

r A = 0.1 is the domestic borrow/lend rate

r B = 0.2 is the foreign borrow/lend rate

Compute the forward exchange rate FAB . This is the value of one unit

of B in terms of A at time 1.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 10 / 161

An Example of Replication: Solution

currency A.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 11 / 161

An Example of Replication: Solution

currency A.

This is a forward contract - we pay nothing up front to achieve this.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 11 / 161

An Example of Replication: Solution

currency A.

This is a forward contract - we pay nothing up front to achieve this.

Initially borrow some amount foreign currency B, in foreign market to

grow to one unit of B at time 1. This is achieved by the initial

SB

amount 1+rA B (valued in domestic currency)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 11 / 161

An Example of Replication: Solution

currency A.

This is a forward contract - we pay nothing up front to achieve this.

Initially borrow some amount foreign currency B, in foreign market to

grow to one unit of B at time 1. This is achieved by the initial

SB

amount 1+rA B (valued in domestic currency)

FAB

Invest the amount 1+r A

in domestic market (valued in domestic

currency)

An Example of Replication: Solution

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 12 / 161

An Example of Replication: Solution

FAB SAB

V (0) = − (3)

1 + rA 1 + rB

Since the initial value is 0, this means

1 + rA

FAB = SAB = 3.667 (4)

1 + rB

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 12 / 161

Discrete Probability Space

This includes the events ”The stock doubled in price over two trading

periods” or ”the average stock price over ten years was 10 dollars”.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 13 / 161

Discrete Probability Space

This includes the events ”The stock doubled in price over two trading

periods” or ”the average stock price over ten years was 10 dollars”.

In our initial case, we will consider the simple binary space

Ω = {H, T } for a one-period asset evolution. So, given an initial

value S0 , we have the final value S1 (ω), with

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 13 / 161

Discrete Probability Space

This includes the events ”The stock doubled in price over two trading

periods” or ”the average stock price over ten years was 10 dollars”.

In our initial case, we will consider the simple binary space

Ω = {H, T } for a one-period asset evolution. So, given an initial

value S0 , we have the final value S1 (ω), with

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 13 / 161

Discrete Probability Space

This includes the events ”The stock doubled in price over two trading

periods” or ”the average stock price over ten years was 10 dollars”.

In our initial case, we will consider the simple binary space

Ω = {H, T } for a one-period asset evolution. So, given an initial

value S0 , we have the final value S1 (ω), with

with d < 1 < u. Hence, a stock increases or decreases in price,

according to the flip of a coin.

Discrete Probability Space

This includes the events ”The stock doubled in price over two trading

periods” or ”the average stock price over ten years was 10 dollars”.

In our initial case, we will consider the simple binary space

Ω = {H, T } for a one-period asset evolution. So, given an initial

value S0 , we have the final value S1 (ω), with

with d < 1 < u. Hence, a stock increases or decreases in price,

according to the flip of a coin.

Let P be the probability measure associated with these events:

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 13 / 161

Arbitrage

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 14 / 161

Arbitrage

Where is the risk involved with investing in the asset S ?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 14 / 161

Arbitrage

Where is the risk involved with investing in the asset S ?

Assume that S0 (1 + r ) < dS0

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 14 / 161

Arbitrage

Where is the risk involved with investing in the asset S ?

Assume that S0 (1 + r ) < dS0

Why would anyone hold a bank account (zero-coupon bond)?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 14 / 161

Arbitrage

Where is the risk involved with investing in the asset S ?

Assume that S0 (1 + r ) < dS0

Why would anyone hold a bank account (zero-coupon bond)?

Lemma Arbitrage free ⇒ d < 1 + r < u

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 14 / 161

Derivative Pricing

following instruments:

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 15 / 161

Derivative Pricing

following instruments:

1

Zero-Coupon Bond : V0B = B

1+r , V1 (ω) = 1

Forward Contract : V0F = 0, V1F = S1 (ω) − F

Call Option : V1C (ω) = max(S1 (ω) − K , 0)

Put Option : V1P (ω) = max(K − S1 (ω), 0)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 15 / 161

Derivative Pricing

following instruments:

1

Zero-Coupon Bond : V0B = B

1+r , V1 (ω) = 1

Forward Contract : V0F = 0, V1F = S1 (ω) − F

Call Option : V1C (ω) = max(S1 (ω) − K , 0)

Put Option : V1P (ω) = max(K − S1 (ω), 0)

In both the Call and Put option, K is known as the Strike.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 15 / 161

Derivative Pricing

following instruments:

1

Zero-Coupon Bond : V0B = B

1+r , V1 (ω) = 1

Forward Contract : V0F = 0, V1F = S1 (ω) − F

Call Option : V1C (ω) = max(S1 (ω) − K , 0)

Put Option : V1P (ω) = max(K − S1 (ω), 0)

In both the Call and Put option, K is known as the Strike.

Once again, a Forward Contract is a deal that is locked in at time 0 for

initial price 0, but requires at time 1 the buyer to purchase the asset for

price F .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 15 / 161

Derivative Pricing

following instruments:

1

Zero-Coupon Bond : V0B = B

1+r , V1 (ω) = 1

Forward Contract : V0F = 0, V1F = S1 (ω) − F

Call Option : V1C (ω) = max(S1 (ω) − K , 0)

Put Option : V1P (ω) = max(K − S1 (ω), 0)

In both the Call and Put option, K is known as the Strike.

Once again, a Forward Contract is a deal that is locked in at time 0 for

initial price 0, but requires at time 1 the buyer to purchase the asset for

price F .

What is the value V0 of the above put and call options?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 15 / 161

Put-Call Parity

Can we replicate a forward contract using zero coupon bonds and put and

call options?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 16 / 161

Put-Call Parity

Can we replicate a forward contract using zero coupon bonds and put and

call options?

Yes: The final value of a replicating strategy X has value

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 16 / 161

Put-Call Parity

Can we replicate a forward contract using zero coupon bonds and put and

call options?

Yes: The final value of a replicating strategy X has value

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 16 / 161

Put-Call Parity

Can we replicate a forward contract using zero coupon bonds and put and

call options?

Yes: The final value of a replicating strategy X has value

This is achieved (replicated) by

Purchasing one call option

Selling one put option

Purchasing K − F zero coupon bonds with value 1 at maturity.

all at time 0.

Put-Call Parity

Can we replicate a forward contract using zero coupon bonds and put and

call options?

Yes: The final value of a replicating strategy X has value

This is achieved (replicated) by

Purchasing one call option

Selling one put option

Purchasing K − F zero coupon bonds with value 1 at maturity.

all at time 0.

Since this strategy must have zero initial value, we obtain

F −K

V0C − V0P = (8)

1+r

Put-Call Parity

Can we replicate a forward contract using zero coupon bonds and put and

call options?

Yes: The final value of a replicating strategy X has value

This is achieved (replicated) by

Purchasing one call option

Selling one put option

Purchasing K − F zero coupon bonds with value 1 at maturity.

all at time 0.

Since this strategy must have zero initial value, we obtain

F −K

V0C − V0P = (8)

1+r

Question: How would this change in a multi-period model?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 16 / 161

General Derivative Pricing -One period model

If we begin with some initial capital X0 , then we end with X1 (ω). To price

a derivative, we need to match

to have X0 = V0 , the price of the derivative we seek.

A strategy by the pair (X0 , ∆0 ) wherein

X0 is the initial capital

∆0 is the initial number of shares (units of underlying asset.)

What does the sign of ∆0 indicate?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 17 / 161

Replicating Strategy

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 18 / 161

Replicating Strategy

Value of portfolio at maturity is

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 18 / 161

Replicating Strategy

Value of portfolio at maturity is

Pathwise, we compute

V1 (T ) = (X0 − ∆0 S0 )(1 + r ) + ∆0 dS0

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 18 / 161

Replicating Strategy

Value of portfolio at maturity is

Pathwise, we compute

V1 (T ) = (X0 − ∆0 S0 )(1 + r ) + ∆0 dS0

Algebra yields

V1 (H) − V1 (T )

∆0 = (11)

(u − d)S0

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 18 / 161

Risk Neutral Probability

Let us assume the existence of a pair (p̃, q̃) of positive numbers, and use

these to multiply our pricing equation(s):

q̃V1 (T ) = q̃(X0 − ∆0 S0 )(1 + r ) + q̃∆0 dS0

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 19 / 161

Risk Neutral Probability

Let us assume the existence of a pair (p̃, q̃) of positive numbers, and use

these to multiply our pricing equation(s):

q̃V1 (T ) = q̃(X0 − ∆0 S0 )(1 + r ) + q̃∆0 dS0

Addition yields

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 19 / 161

If we constrain

0 = p̃u + q̃d − (1 + r )

1 = p̃ + q̃

0 ≤ p̃

0 ≤ q̃

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 20 / 161

If we constrain

0 = p̃u + q̃d − (1 + r )

1 = p̃ + q̃

0 ≤ p̃

0 ≤ q̃

V0 = X0 = Ẽ[V1 ] =

1+r 1+r

1+r −d

p̃ = P̃[X1 (ω) = H] =

u−d

u − (1 + r )

q̃ = P̃[X1 (ω) = T ] =

u−d

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 20 / 161

Example: Pricing a forward contract

S0 = 400

u = 1.25

d = 0.75

r = 0.05

Then the forward price is computed via

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 21 / 161

Example: Pricing a forward contract

S0 = 400

u = 1.25

d = 0.75

r = 0.05

Then the forward price is computed via

1

0= Ẽ[S1 − F ] ⇒ F = Ẽ[S1 ] (13)

1+r

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 21 / 161

This leads to the explicit price

F = p̃uS0 + q̃dS0

= (p̃)(1.25)(400) + (1 − p̃)(0.75)(400)

= 500p̃ + 300 − 300p̃ = 300 + 200p̃

1 + 0.05 − 0.75 3

= 300 + 200 · = 300 + 200 ·

1.25 − 0.75 5

= 420

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 22 / 161

This leads to the explicit price

F = p̃uS0 + q̃dS0

= (p̃)(1.25)(400) + (1 − p̃)(0.75)(400)

= 500p̃ + 300 − 300p̃ = 300 + 200p̃

1 + 0.05 − 0.75 3

= 300 + 200 · = 300 + 200 ·

1.25 − 0.75 5

= 420

above,with strike K = 375?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 22 / 161

General one period risk neutral measure

subcollection of outcomes A ∈ F1 := 2Ω an event.

Furthermore, we define a probability measure P̃, not necessarily the

physical measure P to be risk neutral if

P̃[ω] > 0 ∀ ω ∈ Ω

1

X0 = 1+r Ẽ[X1 ]

for all strategies X .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 23 / 161

General one period risk neutral measure

risky asset X

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 24 / 161

General one period risk neutral measure

risky asset X

The same initial capital X0 in both cases produces the same

”‘average”’ return after one period.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 24 / 161

General one period risk neutral measure

risky asset X

The same initial capital X0 in both cases produces the same

”‘average”’ return after one period.

Not the physical measure attached by observation, experts, etc..

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 24 / 161

General one period risk neutral measure

risky asset X

The same initial capital X0 in both cases produces the same

”‘average”’ return after one period.

Not the physical measure attached by observation, experts, etc..

In fact, physical measure has no impact on pricing

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 24 / 161

Example: Risk Neutral measure for trinomial case

S1 (ω1 ) = uS0

S1 (ω2 ) = S0

S1 (ω3 ) = dS0

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 25 / 161

Example: Risk Neutral measure for trinomial case

S1 (ω1 ) = uS0

S1 (ω2 ) = S0

S1 (ω3 ) = dS0

strategy exists?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 25 / 161

Example: Risk Neutral measure for trinomial case

Homework:

Try our first example with

V1digital (ω) = 1{S1 (ω)>450} (ω).

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 26 / 161

Example: Risk Neutral measure for trinomial case

Homework:

Try our first example with

V1digital (ω) = 1{S1 (ω)>450} (ω).

1

V0digital = Ẽ[V1digital ] = 0.25. (14)

1+r

Use this extra information to price a call option with strike K = 420.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 26 / 161

Solution: Risk Neutral measure for trinomial case

(p̃1 , p̃2 , p̃3 ). This can be done by finding the rref of the matrix M:

1 1 1 1

M = 500 400 300 420 (15)

1 0 0 0.25(1.05)

which results in

1 0 0 0.2625

rref (M) = 0 1 0 0.675 . (16)

0 0 1 0.0625

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 27 / 161

Solution: Risk Neutral measure for trinomial case

1

V0C = Ẽ[(S1 − 420)+ | S0 = 400]

1.05 (17)

0.2625

= × (500 − 420) = 20.

1.05

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 28 / 161

Solution: Risk Neutral measure for trinomial case

1

V0C = Ẽ[(S1 − 420)+ | S0 = 400]

1.05 (17)

0.2625

= × (500 − 420) = 20.

1.05

n o

V1d1 (ω), V1d2 (ω), V1d3 (ω) = {1A1 (ω), 1A2 (ω), 1A3 (ω)} (18)

How about (A1 , A2 , A3 ) = ({ω1 } , {ω2 } , {ω3 }) ?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 28 / 161

Exchange one stock for another

and

(110, 105) : ω = ω1

(X1 (ω), Y1 (ω)) = (100, 100) : ω = ω2

(80, 95) : ω = ω3 .

(20)

W1 (ω) = Y1 (ω) − X1 (ω).

Price V0 and W0 .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 29 / 161

Exchange one stock for another

In this case, our matrix M is such that

1 1 1 1

M = 110 100 80 101 (21)

105 100 95 101

which results in

3

1 0 0 10

6

rref (M) = 0 1 0

10 . (22)

1

0 0 1 10

It follows that

Ẽ[Y1 ] − Ẽ[X1 ]

W0 = = Y0 − X0 = 0

1.01 (23)

1 1.5

V0 = · (15p̃3 ) = = 1.49.

1.01 1.01

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 30 / 161

Existence of Risk Neutral measure

equivalent:

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 31 / 161

Existence of Risk Neutral measure

equivalent:

P̃ is a risk neutral measure

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 31 / 161

Existence of Risk Neutral measure

equivalent:

P̃ is a risk neutral measure

1

For all traded securities S i , S0i =

i

1+r Ẽ S1

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 31 / 161

Existence of Risk Neutral measure

equivalent:

P̃ is a risk neutral measure

1

For all traded securities S i , S0i =

i

1+r Ẽ S1

Proof: Homework (Hint: One direction is much easier than others. Also,

strategies are linear in the underlying asset.)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 31 / 161

Complete Markets

be replicated.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 32 / 161

Complete Markets

be replicated.

Fundamental Theorem of Asset Pricing 1: A market is arbitrage free

iff there exists a risk neutral measure

Fundamental Theorem of Asset Pricing 2: A market is complete iff

there exists exactly one risk neutral measure

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 32 / 161

Complete Markets

be replicated.

Fundamental Theorem of Asset Pricing 1: A market is arbitrage free

iff there exists a risk neutral measure

Fundamental Theorem of Asset Pricing 2: A market is complete iff

there exists exactly one risk neutral measure

Proof(s): We will go over these in detail later!

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 32 / 161

Optimal Investment for a Strictly Risk Averse Investor

Characterize an investor by her pair (x, U) of initial capital x ∈ X and

utility function U : X → R+ .

Assume U 0 (x) > 0.

Assume U 00 (x) < 0.

Define the Radon-Nikodym derivative of P̃ to P as the random

variable

P̃(ω)

Z (ω) := . (24)

P(ω)

Note that Z is used to map expectations under P to expectations

under P̃: For any random variable X , it follows that

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 33 / 161

Optimal Investment for a Strictly Risk Averse Investor

of a portfolio at time 1, given initial capital at time 0:

X1 ∈Ax

(26)

Ax := { all portfolio values at time 1 with initial capital x} .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 34 / 161

Optimal Investment for a Strictly Risk Averse Investor

Theorem

Define X̂1 via the relationship

U 0 X̂1 := λZ (27)

Then X̂1 is the optimal strategy.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 35 / 161

Optimal Investment for a Strictly Risk Averse Investor

Proof.

Assume X1 to be an arbitrary strategy with initial capital x. Then for

it follows that

h i

f 0 (0) = E U 0 (X̂1 ) X1 − X̂1

h i

= E λZ X1 − X̂1

h i (30)

= λẼ X1 − X̂1 = 0

2

00 00

f (y ) = E U (yX1 + (1 − y )X̂1 ) X1 − X̂1 <0

E[U(X1 )] < E[U(X̂1 )] for any admissible strategy X1 .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 36 / 161

Optimal Investment: Example

U(x) = ln (x)

(31)

(S0 , u, d, p, q, r ) = (400, 1.25.0.75, 0.5, 0.5, 0.05).

It follows that

3 2

(p̃, q̃) = ,

5 5

(32)

6 4

(Z (H), Z (T )) = , .

5 5

Since U 0 (x) = x1 , we have

1 1

X̂1 (ω) =

λ Z (ω)

(33)

1 1 1p 1q 1 1

x = X0 = Ẽ[X̂1 ] = p̃ · + q̃ · = .

1+r 1+r λ p̃ λ q̃ λ1+r

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 37 / 161

Optimal Investment: Example

x(1 + r )

X̂1 (ω) =

Z (ω)

u(x) = p ln X̂1 (H) + (1 − p) ln X̂1 (T )

(34)

x(1 + r ) x(1 + r )

= p ln + (1 − p) ln

Z (H) Z (T )

(1 + r )

= ln x = ln (1.0717x) > ln (1.05x).

Z (H)p Z (T )1−p

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 38 / 161

Optimal Investment: Example

ˆ 0 S0

∆ S0 X̂1 (H) − X̂1 (T ) 1+r

1 1

π̂0 := = = −

X0 x S1 (H) − S1 (T ) u − d Z (H) Z (T )

(35)

1+r p 1−p 1.05 5 5

= − = − = −0.875.

u − d p̃ 1 − p̃ 0.5 6 4

her initial wealth x and invest the proceeds into a safe bank account.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 39 / 161

Optimal Investment: Example

1+r p 1−p

In fact, since π̂0 = u−d p̃ − 1−p̃ , we see that qualitatively, her optimal

strategy involves

> 0 : p > p̃

π̂0 = = 0 : p = p̃

< 0 : p < p̃.

1 + r̂1 (ω) := = (1 − π̂0 )(1 + r ) + π̂0 (36)

X0 S0

and so for our specific case where (r , u, d, π̂0 ) = (0.05, 1.25, 0.75, −0.875),

we have

(37)

1 + r̂1 (T ) = (1 − π̂0 )(1 + r ) + π̂0 d = 1.3125.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 40 / 161

√

Optimal Investment: U(x) = x

Consider now the same set-up as before, only that the utility function

√

changes to U(x) = x.

It follows that

1 1

U 0 (X̂1 ) =

p

2 X̂1

(38)

1 1

⇒ X̂1 = 2 2

4λ Z

Solving for λ returns

x(1 + r ) = Ẽ[X̂1 ]

= E[Z X̂1 ]

1 1 (39)

=E Z 2 2

4λ Z

1 1

= 2E .

4λ Z

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 41 / 161

√

Optimal Investment: U(x) = x

x(1 + r )

X̂1 =

Z 2 E Z1

q "s #

x(1 + r )

⇒ u(x) = E X̂1 = E (40)

Z 2 E Z1

s

p 1

= x(1 + r ) E .

Z

Question: Is it true for all (p, p̃) ∈ (0, 1) × (0, 1) that

s s

1 p 2 (1 − p)2

E = + ≥ 1? (41)

Z p̃ 1 − p̃

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 42 / 161

Optimal Betting at the Omega Horse Track!

There are three horses: ω1 , ω2 and ω3 .

She can bet on any of the horses to come in 1st .

The payoff is 1 per whole bet made.

She observes the price of each bet with payoff 1 right before the race

to be

(B01 , B02 , B03 ) = (0.5, 0.3, 0.2). (42)

Symbolically,

B1i (ω) = 1{ωi } (ω). (43)

Our investor feels the physical probabilities of each horse winning is

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 43 / 161

Optimal Betting at the Omega Horse Track!

This directly implies that

0.5 0.3 0.2

(Z (ω1 ), Z (ω2 ), Z (ω3 )) = , , . (46)

0.6 0.35 0.05

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 44 / 161

Optimal Betting at the Omega Horse Track!

Her optimal strategy X̂1 reflects her betting strategy, and satisfies

X0

X̂1 (ω) =

Z (ω)

! (47)

X̂1 (ω1 ) X̂1 (ω2 ) X̂3 (ω1 ) 6 7 1

∴ , , = , , .

X0 X0 X0 5 6 4

So, per dollar of wealth, she buys 65 of a bet for Horse 1 to win, 7

6 of

a bet for Horse 2 to win, and 14 of a bet for Horse 3 to win.

The total price (per dollar of wealth) is thus

6 7 1

· 0.5 + · 0.3 + · 0.2 = 0.6 + 0.35 + 0.05 = 1. (48)

5 6 4

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 45 / 161

Dividends

What about dividends? How do they affect the risk neutral pricing of

exchange and non-exchange traded assets? What if they are paid at

discrete times? Continuously paid?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 46 / 161

Dividends

What about dividends? How do they affect the risk neutral pricing of

exchange and non-exchange traded assets? What if they are paid at

discrete times? Continuously paid?

Recall that if dividends are paid continuously at rate δ, then 1 share at

time 0 will accumulate to e δT shares upon reinvestment of dividends into

the stock until time T .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 46 / 161

Dividends

What about dividends? How do they affect the risk neutral pricing of

exchange and non-exchange traded assets? What if they are paid at

discrete times? Continuously paid?

Recall that if dividends are paid continuously at rate δ, then 1 share at

time 0 will accumulate to e δT shares upon reinvestment of dividends into

the stock until time T .

It follows that to deliver one share of stock S with initial price S0 at time

T , only e −δT shares are needed. Correspondingly,

Fprepaid = e −δT S0

(49)

F = e rT e −δT S0 = e (r −δ)T S0 .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 46 / 161

Binomial Option Pricing w/ cts Dividends and Interest

Over a period of length h, interest increases the value of a bond by a

factor e rh and dividends the value of a stock by a factor of e δh .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 47 / 161

Binomial Option Pricing w/ cts Dividends and Interest

Over a period of length h, interest increases the value of a bond by a

factor e rh and dividends the value of a stock by a factor of e δh .

Once again, we compute pathwise,

V1 (T ) = (X0 − ∆0 S0 )e rh + ∆0 e δh dS0

V1 (H) − V1 (T )

∆0 = e −δh

(u − d)S0

e (r −δ)h − d

p̃ =

u−d

u − e (r −δ)h

q̃ =

u−d

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 47 / 161

Binomial Models w/ cts Dividends and Interest

For σ, the annualized standard deviation of continuously compounded

stock return, the following models hold:

Futures - Cox (1979)

√

u = eσ h

√

d = e −σ h

.

√

u = e (r −δ)h+σ h

√

d = e (r −δ)h−σ h

.

√

u = e (r −rf )h+σ h

√

d = e (r −rf )h−σ h

.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 48 / 161

1- and 2-period pricing

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 49 / 161

1- and 2-period pricing

Now price two digital options, using the

1 General Stock Model

2 Futures-Cox Model

with respective payoffs

V2K (ω) := 1{S2 ≥K } (ω).

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 49 / 161

Calibration Exercise

Assume table below of realized gains & losses over a ten-period cycle.

Use the adjusted values (r , δ, h, S0 , K ) = (0.02, 0, 0.10, 10, 10).

Calculate binary options from last slide using these assumptions.

Period Return

S1

1 S0 = 1.05

S2

2 S1 = 1.02

S3

3 S2 = 0.98

S4

4 S3 = 1.01

S5

5 S4 = 1.02

S6

6 S5 = 0.99

S7

7 S6 = 1.03

S8

8 S7 = 1.05

S9

9 S8 = 0.96

S10

10 S9 = 0.97

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 50 / 161

Calibration Exercise: Linear Approximation

Si

We would like to compute σ for the logarithm of returns ln Si−1 .

Assume the returns per period are all independent.

Q: Can we use a linear (simple) return model instead of a compound

return model as an approximation?

If so, then for our observed simple return rate values:

Calculate the sample variance σ∗2 .

σ∗

Estimate that σ ≈ √ h

.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 51 / 161

Calibration Exercise: Linear Approximation

Si

Note that if Si−1 = 1 + γ for γ 1, then

Si Si − Si−1

ln ≈γ= . (50)

Si−1 Si−1

Over small time periods h, define linear return values for i th period:

Si − Si−1

Xi h := . (51)

Si−1

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 52 / 161

Calibration Exercise: Linear Approximation

Our returns table now looks like

Period Return

S1 −S0

1 S0 = 0.05

S2 −S1

2 S1 = 0.02

S3 −S2

3 S2 = −0.02

S4 −S3

4 S3 = 0.01

S5 −S4

5 S4 = 0.02

S6 −S5

6 S5 = −0.01

S7 −S6

7 S6 = 0.03

S8 −S7

8 S7 = 0.05

S9 −S8

9 S8 = −0.04

S10 −S9

10 S9 = −0.03

sample standard deviation σ∗ = 0.0319

estimated return deviation σ ≈ 0.1001

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 53 / 161

Calibration Exercise: Linear Approximation

e 0.002 − e −0.0319 (53)

p̃ = = 0.5234.

e 0.0319 − e −0.0319

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 54 / 161

Calibration Exercise: Linear Approximation

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 55 / 161

Calibration Exercise: Linear Approximation

For the two-period digital option:

(55)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 55 / 161

Calibration Exercise: No Approximation

√

σY h = 0.03172

(u, d) = (e 0.03172 , e −0.03172 ) = (1.0322, 0.9688) (56)

e 0.002 − e −0.03172

p̃ = 0.03172 = 0.5246.

e − e −0.03172

For the one-period digital option:

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 56 / 161

Calibration Exercise: No Approximation

√

σY h = 0.03172

(u, d) = (e 0.03172 , e −0.03172 ) = (1.0322, 0.9688) (56)

e 0.002 − e −0.03172

p̃ = 0.03172 = 0.5246.

e − e −0.03172

For the one-period digital option:

For the two-period digital option:

(58)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 56 / 161

1- and 2-period pricing

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 57 / 161

1- and 2-period pricing

on a case-by-case basis, or

by developing a general theory for multi-period asset pricing.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 57 / 161

1- and 2-period pricing

on a case-by-case basis, or

by developing a general theory for multi-period asset pricing.

In the latter method, we need a general framework to carry out our

computations

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 57 / 161

Risk Neutral Pricing Formula

Assume now that we have the ”regular assumptions” on our coin flip

space, and that at time N we are asked to deliver a path dependent

derivative value VN . Then for times 0 ≤ n ≤ N, the value of this

derivative is computed via

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 58 / 161

Risk Neutral Pricing Formula

Assume now that we have the ”regular assumptions” on our coin flip

space, and that at time N we are asked to deliver a path dependent

derivative value VN . Then for times 0 ≤ n ≤ N, the value of this

derivative is computed via

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 58 / 161

Risk Neutral Pricing Formula

Assume now that we have the ”regular assumptions” on our coin flip

space, and that at time N we are asked to deliver a path dependent

derivative value VN . Then for times 0 ≤ n ≤ N, the value of this

derivative is computed via

and so

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 58 / 161

Risk Neutral Pricing Formula

space, and that at time N we are asked to deliver a path dependent

derivative value VN . Then for times 0 ≤ n ≤ N, the value of this

derivative is computed via

and so

X0 = Ẽ0 [XN ]

Vn (60)

Xn := nh .

e

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 58 / 161

Computational Complexity

1

p̃ = q̃ =

2 (61)

4 3

S0 = 4, u = , d =

3 4

but now with term n = 3.

There are 23 = 8 paths to consider.

However, there are 3 + 1 = 4 unique final values of S3 to consider.

In the general term N, there would be 2N paths to generate SN , but

only N + 1 distinct values.

At any node n units of time into the asset’s evolution, there are n + 1

distinct values.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 59 / 161

Computational Complexity

Using multi-period risk-neutral pricing, we can generate for

vn (s) := Vn (Sn (ω1 , ..., ωn )) on the node (event) Sn (ω1 , ..., ωn ) = s:

h 4 3 i

vn (s) = e −rh p̃vn+1 s + q̃vn+1 s . (62)

3 4

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 60 / 161

An Example:

1 9

p̃ = = q̃, e −rh =

2 10

1 (63)

S0 = 4, u = 2, d =

2

V3 := max {10 − S3 , 0} .

It follows that

v3 (32) = 0

v3 (8) = 2

(64)

v3 (2) = 8

v3 (0.50) = 9.50.

Compute V0 .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 61 / 161

Markov Processes

If we use the above approach for a more exotic option, say a lookback

option that pays the maximum over the term of a stock, then we find

this approach lacking.

There is not enough information in the tree or the distinct values for

S3 as stated. We need more.

Consider our general multi-period binomial model under P̃.

sequence of flips ω := (ω1 , ..., ωn )

0 ≤ n ≤ N − 1 and every function f (x) there exists another function g (x)

such that

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 62 / 161

Markov Processes

algorithm.

Indeed, our stock process evolves from time n to time n + 1, using

only the information in Sn .

We can in fact say that for every f (s) there exists a g (s) such that

h 4 3 i

g (s) = e −rh p̃f s + q̃f s . (67)

3 4

So, for any f (s) := VN (s), we can work our recursive algorithm

backwards to find the gn (s) := Vn (s) for all 0 ≤ n ≤ N − 1

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 63 / 161

Markov Processes

Consider the example of a Lookback Option.

Here, the payoff is dependent on the realized maximum

Mn := max0≤i≤n Si of the asset.

Mn is not Markov by itself, but the two-factor process (Mn , Sn ) is.

Why?

Let’s generate the tree!

Homework Can you think of any other processes that are not Markov?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 64 / 161

Call Options on Zero-Coupon Bonds

One period is one year

The one year short term interest rate from time n to time n + 1 is rn .

The rate evolves via a stochastic process:

r0 = 0.02

rn+1 = Xrn (68)

1

P̃[X = 2k ] = for k ∈ {−1, 0, 1} .

3

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 65 / 161

Call Options on Zero-Coupon Bonds

common face and redemption value F = 100.

Also consider a call option on this bond that expires in 2−years with

strike K = 97.

Denote Bn and Cn as the bond and call option values, respectively.

Note that we iterate backwards from the values

B3 (r ) = 100

(69)

C2 (r ) = max {B2 (r ) − 97, 0} .

Compute (B0 , C0 ).

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 66 / 161

Call Options on Zero-Coupon Bonds

1

Bn (r ) = Ẽ[Bn+1 (rn+1 ) | rn = r ]

1+r

(70)

1

Cn (r ) = Ẽ[Cn+1 (rn+1 ) | rn = r ].

1+r

Iterating backwards, we see that at t = 2,

1

1 1 X

B2 (r ) = B3 (2k r ). (71)

1+r 3

k=−1

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 67 / 161

Call Options on Zero-Coupon Bonds

r2 B2 C2

0.08 92.59 0

0.04 96.15 0

0.02 98.04 1.04

0.01 99.01 2.01

0.005 99.50 2.50

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 68 / 161

Call Options on Zero-Coupon Bonds

Our associated Bond and Call Option values at time 1:

r1 B1 C1

0.04 91.92 0.33

0.02 95.82 1.00

0.01 97.87 1.83

r0 B0 C0

0.02 93.34 1.03

Symbolically, what if

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 69 / 161

Capital Structure Model

whether a company’s stock and/or bonds are over/under-priced.

You receive a quarterly report from this company on it’s return on

assets, and have compiled a table for the last ten quarters below.

Today, just after the last quarter’s report was issued, you see that in

billions of USD, the value of the company’s assets is 10.

There are presently one billions shares of this company that are being

traded.

The company does not pay any dividends.

Six months from now, the company is required to pay off a billion

zero-coupon bonds. Each bond has a face value of 9.5.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 70 / 161

Capital Structure Model

of a company equal the sum of its share and bond price.

Presently, the market values are (B0 , S0 , r ) = (9, 1, 0.02).

The Merton model for corporate bond pricing asserts that at

redemption time T ,

(74)

St = e −r (T −t) Ẽ [max {AT − F , 0}] .

With all of this information, your job now is to issue a Buy or Sell on

the stock and the bond issued by this company.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 71 / 161

Capital Structure Model

Table of return on assets for Company X, with h = 0.25.

A1 −A0

1 A0 = 0.05

A2 −A1

2 A1 = 0.02

A3 −A2

3 A2 = −0.02

A4 −A3

4 A3 = 0.01

A5 −A4

5 A4 = 0.02

A6 −A5

6 A5 = −0.01

A7 −A6

7 A6 = 0.03

A8 −A7

8 A7 = 0.05

A9 −A8

9 A8 = −0.04

A10 −A9

10 A9 = −0.03

sample standard deviation σ∗ = 0.0319

estimated return deviation σ ≈ 0.0638

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 72 / 161

Capital Structure Model

We scale all of our calculation in terms of billions ($, shares, bonds).

Using the Futures- Cox model, we have

e 0.005 − e −0.0319 (75)

p̃ = = 0.5706.

e 0.0319 − e −0.0319

Using this model, the only time the payoff of the bond is less than the

face is on the path ω = TT .

The price of the bond and stock are thus modeled to be

S˜0 = 10 − 9.38 = 0.62 < 1.00.

is underpriced and one should Sell the stock as it is overpriced.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 73 / 161

The Interview Process

After graduating, you go on the job market, and have 4 possible job

interviews with 4 different companies.

So sure of your prospects that you know that each company will make

an offer, with an identically, independently distributed probability

attached to the 4 possible salary offers:

P [Salary Offer=70, 000] = 0.3

(77)

P [Salary Offer=80, 000] = 0.4

P [Salary Offer=100, 000] = 0.2.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 74 / 161

The Interview Process

Questions:

How should you interview?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 75 / 161

The Interview Process

Questions:

How should you interview?

Specifically, when should you accept an offer and cancel the

remaining interviews?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 75 / 161

The Interview Process

Questions:

How should you interview?

Specifically, when should you accept an offer and cancel the

remaining interviews?

How does your strategy change if you can interview as many times as

you like, but the distribution of offers remains the same as above?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 75 / 161

The Interview Process: Strategy

At any time the student will know only one offer, which she can either

accept or reject.

Of course, if the student rejects the first three offers, than she has to

accept the last one.

So, compute the maximal expected salary for the student after the

graduation and the corresponding optimal strategy.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 76 / 161

The Interview Process: Optimal Strategy

n h io

Xk (s) = max s, Ẽ Xk+1 | k th offer = s . (78)

At time 4, the value of this game is X4 (s) = s, with s being the salary

offered.

At time 3, the conditional expected value of this game is

h i

Ẽ X4 | 3rd offer = s = Ẽ[X4 ]

= 0.1 × 50, 000 + 0.3 × 70, 000 (79)

+ 0.4 × 80, 000 + 0.2 × 100, 000

= 78, 000.

Hence, one should accept an offer of 80, 000 or 100, 000, and reject

the other two.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 77 / 161

The Interview Process: Optimal Strategy

X3 (70, 000) = 78, 000

(80)

X3 (80, 000) = 80, 000

X3 (100, 000) = 100, 000.

X2 (70, 000) = 83, 200

(81)

X2 (80, 000) = 83, 200

X2 (100, 000) = 100, 000.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 78 / 161

The Interview Process: Optimal Strategy

At time 1,

X1 (50, 000) = 86, 560

X1 (70, 000) = 86, 560

(82)

X1 (80, 000) = 86, 560

X1 (100, 000) = 100, 000.

Finally, at time 0, the value of this optimal strategy is

Ẽ0 [X1 ] = Ẽ[X1 ] = 0.8 × 86, 560 + 0.2 × 100, 000 = 89, 248. (83)

So, the optimal strategy is, for the first two interviews, accept only an

offer of 100, 000. If after the third interview, and offer of 80, 000 or

100, 000 is made, then accept. Otherwise continue to the last interview

where you should accept whatever is offered.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 79 / 161

Review

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 80 / 161

Review

Forward Contract Initial Value is 0, because both buyer and seller

may have to pay a balance at maturity.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 80 / 161

Review

Forward Contract Initial Value is 0, because both buyer and seller

may have to pay a balance at maturity.

(European) Put/Call Option Initial Value is > 0, because both only

seller must pay balance at maturity.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 80 / 161

Review

Forward Contract Initial Value is 0, because both buyer and seller

may have to pay a balance at maturity.

(European) Put/Call Option Initial Value is > 0, because both only

seller must pay balance at maturity.

(European) ”Exotic” Option Initial Value is > 0, because both only

seller must pay balance at maturity.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 80 / 161

Review

Forward Contract Initial Value is 0, because both buyer and seller

may have to pay a balance at maturity.

(European) Put/Call Option Initial Value is > 0, because both only

seller must pay balance at maturity.

(European) ”Exotic” Option Initial Value is > 0, because both only

seller must pay balance at maturity.

During the term of the contract, can the value of the contract ever fall

below the intrinsic value of the payoff? Symbolically, does it ever occur

that

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 80 / 161

Review

Forward Contract Initial Value is 0, because both buyer and seller

may have to pay a balance at maturity.

(European) Put/Call Option Initial Value is > 0, because both only

seller must pay balance at maturity.

(European) ”Exotic” Option Initial Value is > 0, because both only

seller must pay balance at maturity.

During the term of the contract, can the value of the contract ever fall

below the intrinsic value of the payoff? Symbolically, does it ever occur

that

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 80 / 161

Review

Forward Contract Initial Value is 0, because both buyer and seller

may have to pay a balance at maturity.

(European) Put/Call Option Initial Value is > 0, because both only

seller must pay balance at maturity.

(European) ”Exotic” Option Initial Value is > 0, because both only

seller must pay balance at maturity.

During the term of the contract, can the value of the contract ever fall

below the intrinsic value of the payoff? Symbolically, does it ever occur

that

where g (s) is of the form of g (S) := max {S − K , 0}, in the case of a Call

option, for example.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 80 / 161

Early Exercise

exercise early if

rK > δS. (85)

If σ > 0, then the situation involves deeper analysis.

Whether solving a free boundary problem or analyzing a binomial

tree, it is likely that a computer will be involved in helping the

investor to determine the optimal exercise time.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 81 / 161

For Freedom! (we must charge extra...)

the contract whenever she feels it to be in her advantage? By allowing this

extra freedom, we must

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 82 / 161

For Freedom! (we must charge extra...)

the contract whenever she feels it to be in her advantage? By allowing this

extra freedom, we must

Charge more than we would for a European contract that is exercised

only at the term N.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 82 / 161

For Freedom! (we must charge extra...)

the contract whenever she feels it to be in her advantage? By allowing this

extra freedom, we must

Charge more than we would for a European contract that is exercised

only at the term N.

Hedge our replicating strategy X differently, to allow for the

possibility of early exercise.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 82 / 161

American Options

In the end, the option v is valued after the nth value of the stock

Sn (ω) = s is revealed via the recursive formula along each path ω:

n h io

vn (Sn (ω)) = max g (Sn (ω)), e −rh Ẽ v (Sn+1 (ω)) | Sn (ω)

(86)

τ ∗ (ω) = inf {k ∈ {0, 1, .., N} | vk (Sk (ω)) = g (Sk (ω))} .

In the Binomial case, we reduce to

n o

vn (s) = max g (s), e −rh [p̃vn+1 (us) + q̃vn+1 (ds)]

(87)

τ ∗ = inf {k | vk (s) = g (s)} .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 83 / 161

American Options

Some examples:

”American Bond:” g (s) = 1

”American Digital Option:” g (s) = 1{6≤s≤10}

”American Square Option:” g (s) = s 2 .

Does an investor exercise any of these options early? Consider again the

setting

1 9

p̃ = = q̃, e −rh =

2 10 (88)

1

S0 = 4, u = 2, d = .

2

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 84 / 161

American Square Options

that

h i h i

e −rh Ẽ g (Sn+1 ) | Sn = e −rh Ẽ Sn+12

| Sn

h i2

≥ e −rh Ẽ Sn+1 | Sn

2 (89)

−rh rh

=e e Sn

= e rh Sn2 > Sn2 = g (Sn ).

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 85 / 161

American Square Options

n o

vN−1 (s) = max g (s), e −rh Ẽ[vN (SN ) | SN−1 = s]

n o

= max s 2 , e −rh Ẽ[SN2 | SN−1 = s]

(90)

= e −rh Ẽ[SN2 | SN−1 = s]

= e −rh Ẽ[vN (SN ) | SN−1 = s].

The American and European option values coincide. Keep going.

How about with two periods left before expiration?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 86 / 161

American Options

1 9

p̃ = = q̃, e −rh =

2 10

1 (91)

S0 = 4, u = 2, d =

2

V3 := max {10 − S3 , 0} .

1

It follows that S3 (ω) ∈ 2 , 2, 8, 32 .

Use this to compute v3 (s) and the American Put recursively.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 87 / 161

Matching Interest Rates to Market Conditions

Consider again a series of coin flips (ω1 , ..., ωn ) where at time n, the

interest rate from n to n + 1 is modeled via

and a stochastic volatility σ at time n via

1 rn (ω1 , ..., ωn−1 , ωn = H)

σn = ln . (93)

2 rn (ω1 , ..., ωn−1 , ωn = T )

Keep in mind that we will build a recombining binomial tree for this

model. So, for example,

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 88 / 161

Matching Interest Rates to Market Conditions

Futhermore, we can define the yield rate y (t, T , r (t)) for a zero-coupon

bond B(t, T , r (t)) via

1

B(t, T , r (t)) = (95)

(1 + y (t, T , r (t)))T −t

and the corresponding yield rate volatility

1 y (1, n, r1 (H))

σ̃n = ln . (96)

2 y (1, n, r1 (T ))

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 89 / 161

Matching Interest Rates to Market Conditions

(97)

y (1, 2, r1 (T )) = r1 (T ).

But, for example, it is not clear how to obtain

Furthermore, how can we match to market conditions and update our

estimates for interest rates rn ?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 90 / 161

Matching Interest Rates to Market Conditions

1 0.100 N.A.

2 0.110 0.190

3 0.120 0.180

4 0.125 0.150

5 0.130 0.140

1

Black, Fischer, Emanuel Derman, and William Toy. ”A one-factor model

of interest rates and its application to treasury bond options.” Financial

Analysts Journal 46.1 (1990): 33-39.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 91 / 161

Matching Interest Rates to Market Conditions

time, an interest rate moves up or down with a ”risk-neutral”

probability of 12 .

It follows that we have from time t = 0 to t = 1, with an initial rate

r0 = r ,

1 1

=

1 + y (0, 1, r ) 1+r (99)

⇒ y (0, 1, r ) = r .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 92 / 161

Matching Interest Rates to Market Conditions

From time t = 0 to t = 2, again with our initial rate r0 = r ,

Connecting our observed two-year yield with yearly interest rates

returns

1 1 1 1 1 1

= +

(1 + y (0, 2, r ))2 1 + r 2 1 + r1 (H) 2 1 + r1 (T )

(100)

1 1 1 1 1 1

⇒ = + .

1.112 1.10 2 1 + r1 (H) 2 1 + r1 (T )

Also, connecting our one-year yields with yearly interest rates leads to

1 r1 (H) 1 y (1, 2, r1 (H))

σ1 = ln = ln

2 r1 (T ) 2 y (1, 2, r1 (T )) (101)

= σ̃2 = 0.190.

Solution leads to the pair

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 93 / 161

Matching Interest Rates to Market Conditions

From time t = 0 to t = 3, again with our initial rate r0 = r , we try to

estimate the matching (r2 (H, H), r2 (H, T ), r2 (T , T )).

Connecting our observed two-year yield with yearly interest rates

returns

1 1 1 1 1

=

(1 + y (0, 3, r ))3 1 + r 4 1 + r1 (H) 1 + r2 (H, H)

1 1 1 1

+

1 + r 4 1 + r1 (H) 1 + r2 (H, T )

(103)

1 1 1 1

+

1 + r 4 1 + r1 (T ) 1 + r2 (T , H)

1 1 1 1

+ .

1 + r 4 1 + r1 (T ) 1 + r2 (T , T )

(r , r1 (H), r1 (T ), y (0, 3, r )) = (0.10, 0.1432, 0.0979, 0.120).

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 94 / 161

Matching Interest Rates to Market Conditions

1 r2 (H, H)

σ2 = ln

2 r2 (H, T )

1 r2 (T , H) (104)

σ2 = ln

2 r2 (T , T )

p

⇒ r2 (H, T ) = r2 (T , H) = r2 (H, H)r2 (T , T ).

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 95 / 161

Matching Interest Rates to Market Conditions

1 y (1, 3, r1 (H))

0.180 = σ̃3 = ln (105)

2 y (1, 3, r1 (T ))

where

1 1 1 1 1 1

= +

(1 + y (1, 3, r1 (H))2 1 + r1 (H) 2 1 + r2 (H, H) 2 1 + r2 (H, T )

1 1 1 1 1 1

= + .

(1 + y (1, 3, r1 (T ))2 1 + r1 (T ) 2 1 + r2 (T , H) 2 1 + r2 (T , T )

(106)

Now solve for (r2 (H, H), r2 (H, T ), r2 (T , T ))!!

HW1: Price a bond that matures in two years, with the above

observations for term structure, and with F = 100 and coupon rate 10%.

HW2: What about r3 , r4 , r5 ? Can we compute them?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 96 / 161

Pricing a Two-year Coupon Bond Using Market Conditions

Consider the previous observations for term structure, and a bond with

F = 100 and coupon rate 10%. In this setting, we have

0 r0 0.100

1 r1 (H) 0.1432

1 r1 (T ) 0.0979

2 r2 (H, H) 0.1942

2 r2 (H, T ) 0.1377

2 r2 (T , H) 0.1377

2 r2 (T , T ) 0.0976

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 97 / 161

Pricing a Two-year Coupon Bond Using Market Conditions

zero-coupon bonds.

The first is B (1) , which has face 10, maturity T = 1, and initial price

B (1) (0, T , r ) at t = 0.

The first is B (2) , which has face 110, maturity T = 2, and initial price

B (2) (0, T , r ) at t = 0.

The total coupon bond price is thus

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 98 / 161

Pricing a Two-year Coupon Bond Using Market Conditions

0 r0 = 0.10 B (1) (0, 1, r0 ) = 9.09

1 r1 (H) = 0.1432 B (1) (1, 1, r1 (H)) = 10

1 r1 (T ) = 0.0979 B (1) (1, 1, r1 (T )) = 10

0 r0 = 0.10 B (2) (0, 2, r

0 ) = 89.28

1 r1 (H) = 0.1432 (2)

B (1, 2, r1 (H)) = 96.22

1 r1 (T ) = 0.0979 B (2) (1, 2, r1 (T )) = 100.19

2 r2 (H, H) = 0.1942 B (2) (2, 2, r2 (H, H)) = 110

2 r2 (H, T ) = 0.1377 B (2) (2, 2, r2 (H, T )) = 110

2 r2 (T , H) = 0.1377 B (2) (2, 2, r2 (T , H)) = 110

2 r2 (T , T ) = 0.0976 B (2) (2, 2, r2 (T , T )) = 110

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 99 / 161

Pricing a Two-year Coupon Bond Using Market Conditions

0 r0 = 0.10 B(0, 2, r0 ) = 98.37

1 r1 (H) = 0.1432 B(1, 2, r1 (H)) = 106.22

1 r1 (T ) = 0.0979 B(1, 2, r1 (T )) = 110.19

2 r2 (H, H) = 0.1942 B(2, 2, r2 (H, H)) = 110

2 r2 (H, T ) = 0.1377 B(2, 2, r2 (H, T )) = 110

2 r2 (T , H) = 0.1377 B(2, 2, r2 (T , H)) = 110

2 r2 (T , T ) = 0.0976 B(2, 2, r2 (T , T )) = 110

Note: Note that with our coupons, the yield yc (0, 2, r ) = 0.1095, which is

obtained by solving

10 110

98.37 = + . (108)

1 + yc (0, 2, r ) (1 + yc (0, 2, r ))2

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 100 / 161

Pricing a 1-year Call Option on our 2-year Coupon Bond

Consider the previous term structure, and a European Call Option on the

two year bond with K = 97 and expiry of 1 year.

Compute the initial Call price C0 (r ).

Compute the initial number of bonds to hold to replicate this option.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 101 / 161

Pricing a 1-year Call Option on our 2-year Coupon Bond

In this case, we look at the price of the bond minus the accrued interest:

0 r0 = 0.10 B(0, 2, r0 ) = 98.37

1 r1 (H) = 0.1432 B(1, 2, r1 (H)) = 96.22

1 r1 (T ) = 0.0979 B(1, 2, r1 (T )) = 100.19

2 r2 (H, H) = 0.1942 B(2, 2, r2 (H, H)) = 100

2 r2 (H, T ) = 0.1377 B(2, 2, r2 (H, T )) = 100

2 r2 (T , H) = 0.1377 B(2, 2, r2 (T , H)) = 100

2 r2 (T , T ) = 0.0976 B(2, 2, r2 (T , T )) = 100

1 1 1

C0 (0.10) = · 0 + 3.19 = 1.45

1.10 2 2

(109)

0 − 3.19

∆0 (0.10) = = 0.804.

96.22 − 100.19

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 102 / 161

Asian Options

protect against large price movements over an entire time period, using an

average. For example, if a company is looking at foreign exchange markets

or markets that may be subject to stock pinning due to large actors.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 103 / 161

Asian Options

protect against large price movements over an entire time period, using an

average. For example, if a company is looking at foreign exchange markets

or markets that may be subject to stock pinning due to large actors.

instead of the spot price.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 103 / 161

Asian Options

protect against large price movements over an entire time period, using an

average. For example, if a company is looking at foreign exchange markets

or markets that may be subject to stock pinning due to large actors.

instead of the spot price.

T

There are two possibilities for the input in the discrete case: h = N and

Arithmetic Average: IA (T ) := N1 N

P

k=1 Skh .

1

N

Geometric Average: IG (T ) := ΠN S

k=1 kh .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 103 / 161

Asian Options

protect against large price movements over an entire time period, using an

average. For example, if a company is looking at foreign exchange markets

or markets that may be subject to stock pinning due to large actors.

instead of the spot price.

T

There are two possibilities for the input in the discrete case: h = N and

Arithmetic Average: IA (T ) := N1 N

P

k=1 Skh .

1

N

Geometric Average: IG (T ) := ΠN S

k=1 kh .

HW: Is there an ordering for IA , IG that is independent of T ?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 103 / 161

Asian Options: An Example:

Notice that these are path-dependent options, unlike the put and call

options that we have studied until now. Assume r , δ, and h are such that

1 9

S0 = 4, u = 2, d = , e −rh =

2 10 (110)

g (I ) = max {I − 2.5, 0} .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 104 / 161

Asian Options: An Example:

8 + 16

v2 (HH) = max − 2.5, 0 = 9.5

2

8+4

v2 (HT ) = max − 2.5, 0 = 3.5

2

(111)

2+4

v2 (TH) = max − 2.5, 0 = 0.5

2

2+1

v2 (TT ) = max − 2.5, 0 = 0.

2

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 105 / 161

Asian Options: An Example:

8 + 16

v2 (HH) = max − 2.5, 0 = 9.5

2

8+4

v2 (HT ) = max − 2.5, 0 = 3.5

2

(111)

2+4

v2 (TH) = max − 2.5, 0 = 0.5

2

2+1

v2 (TT ) = max − 2.5, 0 = 0.

2

Compute v0 , assuming a European structure.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 105 / 161

Asian Options: An Example:

8 + 16

v2 (HH) = max − 2.5, 0 = 9.5

2

8+4

v2 (HT ) = max − 2.5, 0 = 3.5

2

(111)

2+4

v2 (TH) = max − 2.5, 0 = 0.5

2

2+1

v2 (TT ) = max − 2.5, 0 = 0.

2

Compute v0 , assuming a European structure. How about an American

structure?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 105 / 161

Lognormality

A probability space Ω, F, P .

Our asset St (ω) has an associated return over any period (t, t + u)

defined as !

St+u (ω)

rt,u (ω) := ln . (112)

St (ω)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 106 / 161

Lognormality

T −t

Partition the interval [t, T ] into n intervals of length h = n , then:

The return over the entire period can be taken as the sum of the

returns over each interval:

n

!

ST (ω) X

rt,T −t (ω) = ln = rtk ,h (ω)

St (ω) (113)

k=1

tk = t + kh.

distribution.

Employing the Central Limit Theorem, it can be shown that as

n → ∞, this distribution approaches normality.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 107 / 161

Binomial Tree and Discrete Dividends

Another issue encountered in elementary credit and investment theory

is the case of different compounding and deposit periods.

This also occurs in the financial setting where a dividend is not paid

continuously, but rather at specific times.

It follows that the dividend can be modeled as delivered in the middle

of a binomial period, at time τ (ω) < T .

This view is due to Schroder and can be summarized as viewing the

inherent value of St (ω) as the sum of a prepaid forward PF and the

present value of the upcoming dividend payment D:

√

u = e rh+σ h

(114)

√

d = e rh−σ h

.

moves is PF instead of S.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 108 / 161

Back to the Continuous Time Case

up or down movement at the end of each day. Over the period of one

year, this amounts to a tree with depth 365. If the tree is not recombining,

then this amounts to 2365 branches. Clearly, this is too large to evaluate

reasonably, and so an alternative is sought.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 109 / 161

Back to the Continuous Time Case

up or down movement at the end of each day. Over the period of one

year, this amounts to a tree with depth 365. If the tree is not recombining,

then this amounts to 2365 branches. Clearly, this is too large to evaluate

reasonably, and so an alternative is sought.

Whatever the alternative, the concept of replication must hold. This is

the reasoning behind the famous Black-Scholes-Merton PDE approach.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 109 / 161

Monte Carlo Techniques

1 2 )t+σ

√

⇒ St = S0 e (α−δ− 2 σ tZ

(115)

Z ∼ N(0, 1).

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 110 / 161

Monte Carlo Techniques

1 2 )t+σ

√

⇒ St = S0 e (α−δ− 2 σ tZ

(115)

Z ∼ N(0, 1).

simulating the random variable Z , or in fact an i.i.d. sequence Z (i) i=1 .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 110 / 161

Monte Carlo Techniques

1 2 )t+σ

√

⇒ St = S0 e (α−δ− 2 σ tZ

(115)

Z ∼ N(0, 1).

simulating the random variable Z , or in fact an i.i.d. sequence Z (i) i=1 .

For a European option with time expiry T , we can simulate the expiry

time payoff mulitple times:

1 2

√ (i)

V S (i) , T = G S (i) = G S0 e (α−δ− 2 σ )T +σ T Z . (116)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 110 / 161

Monte Carlo Techniques

n on

If we sample uniformly from our simulated values V S (i) , T we

i=1

can appeal to a sampling-convergence theorem with the appoximation

n

−rT 1 X (i)

V (S, 0) = e V S ,T . (117)

n

i=1

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 111 / 161

Monte Carlo Techniques

n on

If we sample uniformly from our simulated values V S (i) , T we

i=1

can appeal to a sampling-convergence theorem with the appoximation

n

−rT 1 X (i)

V (S, 0) = e V S ,T . (117)

n

i=1

evolution.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 111 / 161

Monte Carlo Techniques

n on

If we sample uniformly from our simulated values V S (i) , T we

i=1

can appeal to a sampling-convergence theorem with the appoximation

n

−rT 1 X (i)

V (S, 0) = e V S ,T . (117)

n

i=1

evolution.

multiple of them to simulate the path of the evolution until T .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 111 / 161

Monte Carlo Techniques

If we sample uniformly from our simulated values V S (i) , T we

i=1

can appeal to a sampling-convergence theorem with the appoximation

n

−rT 1 X (i)

V (S, 0) = e V S ,T . (117)

n

i=1

evolution.

multiple of them to simulate the path of the evolution until T .

Monte Carlo Techniques

number U taken from a uniform distribution U[0, 1].

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 112 / 161

Monte Carlo Techniques

number U taken from a uniform distribution U[0, 1].

It follows that one can now map U → Z via inversion of the Nornal cdf N:

Z = N −1 (U). (118)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 112 / 161

Monte Carlo Techniques

number U taken from a uniform distribution U[0, 1].

It follows that one can now map U → Z via inversion of the Nornal cdf N:

Z = N −1 (U). (118)

average σsample is related to the standard deviation of an individual draw

via

σdraw

σsample = √ . (119)

n

If σdraw = σ, then we can see that we must increase our sample size by

22k if we wish to cut our σsample by a factor of 2k .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 112 / 161

Black Scholes Pricing using Underlying Asset

In the next course, we will derive the following solutions to the

Black-Scholes PDE:

= Se −δ(T −t) N(d1 ) − Ke −r (T −t) N(d2 )

V P (S, t) = e −r (T −t) Ẽ [(K − ST )+ | St = S]

= Ke −r (T −t) N(−d2 ) − Se −δ(T −t) N(−d1 )

(120)

ln KS + (r − δ + 21 σ 2 )(T − t)

d1 = √

σ T −t

√

d2 = d1 − σ T − t

Z x

1 z2

N(x) = √ e − 2 dz.

2π −∞

Notice that V C (S, t) − V P (S, t) = Se −δ(T −t) − Ke −r (T −t) .

Question: What underlying model of stock evolution leads to this value?

How can we support such a probability measure?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 113 / 161

Lognormal Random Variables

We say that Y ∼ LN(µ, σ) is Lognormal if ln(Y ) ∼ N(µ, σ 2 ).

As sums of normal random variables remain normal, products of lognormal

random variables remain lognormal.

Recall that the moment-generating function of

X ∼ N(µ, σ 2 ) ∼ µ + σN(0, 1) is

1 2t2

MX (t) = E[e tX ] = e µt+ 2 σ (121)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 114 / 161

Lognormal Random Variables

We say that Y ∼ LN(µ, σ) is Lognormal if ln(Y ) ∼ N(µ, σ 2 ).

As sums of normal random variables remain normal, products of lognormal

random variables remain lognormal.

Recall that the moment-generating function of

X ∼ N(µ, σ 2 ) ∼ µ + σN(0, 1) is

1 2t2

MX (t) = E[e tX ] = e µt+ 2 σ (121)

If Y = e µ+σZ , then, it can be seen that

1 2 n2

E[Y n ] = E[e nX ] = e µn+ 2 σ (122)

and

!

1 (ln(y ) − µ)2

fY (y ) = √ exp − (123)

σ 2πy 2σ 2

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 114 / 161

Stock Evolution and Lognormal Random Variables

evolution of asset prices S. If we assume a physical measure P with α the

expected return on the stock under the physical measure, then

St 1

ln = N (α − δ − σ 2 )t, σ 2 t

S0 2 (124)

1 2 )t+σ

√

⇒ St = S0 e (α−δ− 2 σ tZ

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 115 / 161

Stock Evolution and Lognormal Random Variables

E[St ] = S0 e (α−δ)t

!

ln SK0 + (α − δ − 0.5σ 2 )t (125)

P[St > K ] = N √ .

σ t

Note that under the risk-neutral measure P̃, we exchange α with r , the

risk-free rate:

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 116 / 161

Stock Evolution and Lognormal Random Variables

E[St ] = S0 e (α−δ)t

!

ln SK0 + (α − δ − 0.5σ 2 )t (125)

P[St > K ] = N √ .

σ t

Note that under the risk-neutral measure P̃, we exchange α with r , the

risk-free rate:

Ẽ[St ] = S0 e (r −δ)t

(126)

P̃[St > K ] = N(d2 ).

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 116 / 161

Stock Evolution and Lognormal Random Variables

of random variables:

h i

E X 1{X >k}

CTEX (k) := E[X | X > k] = . (127)

P[X > k]

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 117 / 161

Stock Evolution and Lognormal Random Variables

In our case,

" #

1 2

√

E S0 e (α−δ− 2 σ )t+σ tZ 1 (α−δ− 1 σ2 )t+σ√tZ

S0 e 2 >K

E[St | St > K ] = h 1 2

√ i

P S0 e (α−δ− 2 σ )t+σ tZ > K

!

S0

ln +(α−δ+0.5σ 2 )t

N K √

σ t

= S0 e (α−δ)t !

S0

ln +(α−δ−0.5σ 2 )t

N K √

σ t

N(d1 )

⇒ Ẽ[St | St > K ] = S0 e (r −δ)t

N(d2 )

(128)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 118 / 161

Stock Evolution and Lognormal Random Variables

In fact, we can use this CTE framework to solve for the European Call

option price in the Black-Scholes framework, where P̃0 [A] = P̃[A | S0 = S]

and

h i

V C (S, 0) := e −rT Ẽ (ST − K )+ | S0 = S

h i

= e −rT Ẽ0 ST − K | ST > K · P̃0 [ST > K ]

h i

= e −rT Ẽ0 ST | ST > K · P̃0 [ST > K ] − Ke −rT P̃0 [ST > K ]

N(d1 )

= e −rT Se (r −δ)T · N(d2 ) − Ke −rT N(d2 )

N(d2 )

= Se −δT N(d1 ) − Ke −rT N(d2 ).

(129)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 119 / 161

Black Scholes Analysis: Option Greeks

For any option price V (S, t), define its various sensitivities as follows:

∂V

∆=

∂S

∂∆ ∂2V

Γ= =

∂S ∂S 2

∂V

ν=

∂σ (130)

∂V

Θ=

∂t

∂V

ρ=

∂r

∂V

Ψ= .

∂δ

These are known accordingly as the Option Greeks.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 120 / 161

Black Scholes Analysis: Option Greeks

∆P = −e −δ(T −t) N(−d1 )

e −δ(T −t) N 0 (d1 ) (131)

ΓC = ΓP = √

σS T − t

√

ν C = ν P = Se −δ(T −t) T − tN 0 (d1 )

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 121 / 161

Black Scholes Analysis: Option Greeks

as well as..

ρP = −(T − t)Ke −r (T −t) N(−d2 )

(132)

ΨC = −(T − t)Se −δ(T −t) N(d1 )

ΨP = (T − t)Se −δ(T −t) N(−d1 ).

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 122 / 161

Black Scholes Analysis: Option Greeks

as well as..

ρP = −(T − t)Ke −r (T −t) N(−d2 )

(132)

ΨC = −(T − t)Se −δ(T −t) N(d1 )

ΨP = (T − t)Se −δ(T −t) N(−d1 ).

What do the signs of the Greeks tell us?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 122 / 161

Option Elasticity

Define

V (S+,t)−V (s,t)

V (S,t)

Ω(S, t) := lim S+−S

→0

S

S V (S + , t) − V (s, t) (133)

= lim

V (S, t) →0 S +−S

∆·S

= .

V (S, t)

Consequently,

∆C · S Se −δ(T −t)

ΩC (S, t) = = ≥1

V C (S, t) Se −δ(T −t) − Ke −r (T −t) N(d2 )

(134)

∆P · S

ΩP (S, t) = P ≤ 0.

V (S, t)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 123 / 161

Option Elasticity

Theorem

The volatility of an option is the option elasticity times the volatility of the

stock:

The proof comes from Finan: Consider the strategy of hedging a portfolio

of shorting an option and purchasing ∆ = ∂V ∂S shares.

The initial and final values of this portfolio are

Initally: V (S(t), t) − ∆(S(t), t) · S(t)

Finally: V (S(T ), T ) − ∆(S(t), t) · S(T )

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 124 / 161

Option Elasticity

Proof.

If this portfolio is self-financing and arbitrage-free requirement, then

e r (T −t) V (S(t), t) − ∆(S(t), t) · S(t) = V (S(T ), T ) − ∆(S(t), t) · S(T ).

(136)

It follows that for κ := e r (T −t) ,

" #

V (S(T ), T ) − V (S(t), t) S(T ) − S(t)

=κ−1+ +1−κ Ω

V (S(t), t) S(t)

" # " #

V (S(T ), T ) − V (S(t), t) 2 S(T ) − S(t) (137)

⇒ Var = Ω Var

V (S(t), t) S(t)

⇒ σoption = σstock × | Ω | .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 125 / 161

Option Elasticity

If γ is the expected rate of return on an option with value V , α is the

expected rate of return on the underlying stock, and r is of course the risk

free rate, then the following equation holds:

γ · V (S, t) = α · ∆(S, t) · S + r · V (S, t) − ∆(S, t) · S . (138)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 126 / 161

Option Elasticity

If γ is the expected rate of return on an option with value V , α is the

expected rate of return on the underlying stock, and r is of course the risk

free rate, then the following equation holds:

γ · V (S, t) = α · ∆(S, t) · S + r · V (S, t) − ∆(S, t) · S . (138)

Furthermore, we have the Sharpe Ratio for an asset as the ratio of risk

premium to volatility:

(α − r ) (α − r )Ω

Sharpe(Stock) = = = Sharpe(Call). (140)

σ σΩ

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 126 / 161

Option Elasticity

If γ is the expected rate of return on an option with value V , α is the

expected rate of return on the underlying stock, and r is of course the risk

free rate, then the following equation holds:

γ · V (S, t) = α · ∆(S, t) · S + r · V (S, t) − ∆(S, t) · S . (138)

Furthermore, we have the Sharpe Ratio for an asset as the ratio of risk

premium to volatility:

(α − r ) (α − r )Ω

Sharpe(Stock) = = = Sharpe(Call). (140)

σ σΩ

HW Sharpe Ratio for a put? How about elasticity for a portfolio of

options? Now read about Calendar Spreads, Implied Volatility, and

Perpetual American Options.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 126 / 161

Example: Hedging

option a non-dividend paying stock with the following:

S0 = 10 = K

σ = 0.2 (141)

r = 0.02.

Calculate the initial number of shares of the stock for your hedging

program.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 127 / 161

Example: Hedging

Recall

ln KS + (r − δ + 12 σ 2 )(T − t)

d1 = √ (142)

σ T −t

√

d2 = d1 − σ T − t.

It follows that

∆C = N 0.4 = 0.6554. (143)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 128 / 161

Example: Risk Analysis

information:

The expected rate of return on the underlying asset is 0.10.

The expected rate of return on a riskless asset is 0.05.

The volatility on the underlying asset is 0.20.

V (S, t) = e −0.05(10−t) S 2 e S

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 129 / 161

Example: Risk Analysis

By definition,

∆·S S · ∂V∂S

(S,t)

Ω(S, t) = =

V (S, t) V (S, t)

d

S dS (S 2 e S ) S · (2Se S + S 2 e S ) (144)

= =

(S 2 e S ) S 2e S

= 2 + S.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 130 / 161

Example: Risk Analysis

By definition,

∆·S S · ∂V∂S

(S,t)

Ω(S, t) = =

V (S, t) V (S, t)

d

S dS (S 2 e S ) S · (2Se S + S 2 e S ) (144)

= =

(S 2 e S ) S 2e S

= 2 + S.

Furthermore, since Ω = 2 + S ≥ 2, we have

0.10 − 0.05

Sharpe = = 0.25. (145)

0.20

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 130 / 161

Example: Black Scholes Pricing

consists of a put and a call, both with strike K = 5 = S0 . What is the Γ

for this option as well as the option value at time 0 if the time to

expiration is T = 4, r = 0.02, σ = 0.2.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 131 / 161

Example: Black Scholes Pricing

consists of a put and a call, both with strike K = 5 = S0 . What is the Γ

for this option as well as the option value at time 0 if the time to

expiration is T = 4, r = 0.02, σ = 0.2.

In this case,

V = VC + VP

∂2 C (146)

P

Γ= V + V = 2ΓC .

∂S 2

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 131 / 161

Example: Black Scholes Pricing

√

Consequently, d1 = 0.4 and d2 = 0.4 − 0.2 4 = 0, and so

= 5 N(d1 ) + e −4r N(−d2 ) − e −4r N(d2 ) − N(−d1 )

= 5 N(0.4) + e −4r N(0) − e −4r N(0) − N(−0.4) (147)

= 1.5542

2N 0 (0.4) 1 2

Γ(5, 0) = √ = N 0 (0.4) = √ e −0.5·(0.4) = 0.4322.

0.2 · 5 · 4 2π

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 132 / 161

Market Making

rebalancing the portfolio designed to replicate the payoff written into the

option contract.

Define

∆i = Delta required i periods from inception (148)

∴ Pi = ∆i Si − Vi

Rebalancing at time i requires an extra (∆i+1 − ∆i ) shares.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 133 / 161

Market Making

rebalancing the portfolio designed to replicate the payoff written into the

option contract.

Define

∆i = Delta required i periods from inception (149)

∴ Pi = ∆i Si − Vi = Cost of Strategy

Rebalancing at time i requires an extra (∆i+1 − ∆i ) shares.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 134 / 161

Market Making

Define

∂Si = Si+1 − Si

∂Pi = Pi+1 − Pi (150)

∂∆i = ∆i+1 − ∆i

Then

(151)

= ∆i ∂Si − ∂Vi − r ∆i Si − Vi

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 135 / 161

Market Making

∂V

For a continuous rate r , we can see that if ∆ := ∂S , Pt = ∆t St − Vt ,

1

≈ Θdt + ∆ · dSt + Γ · (dSt )2

2

⇒ dPt = ∆t dSt − dVt − rPt dt

1 2

≈ ∆t dSt − Θdt + ∆ · dSt + Γ · (dSt ) − r (∆t St − Vt ) dt

2

!

1

≈ − Θdt + r (∆St − V (St , t))dt + Γ · [dSt ]2 .

2

(152)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 136 / 161

Market Making

the evolution of St , the periodic jump in value from St → St + dSt may be

known exactly and correspond to a non-zero jump in Market Maker profit

dPt .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 137 / 161

Market Making

the evolution of St , the periodic jump in value from St → St + dSt may be

known exactly and correspond to a non-zero jump in Market Maker profit

dPt .

If dSt · dSt = σ 2 St2 dt, then if we sample continuously and enforce a zero

net-flow, we retain the BSM PDE for all relevant (S, t):

∂V ∂V 1 2 2 ∂2V

+r S −V + σ S =0

∂t ∂S 2 ∂S 2 (153)

V (S, T ) = G (S) for final time payoff G (S).

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 137 / 161

Note: Delta-Gamma Neutrality vs Bond Immunization

its portfolio. This refers to the relationship between a non-zero value

for the second derivative with respect to interest rate of the

(deterministic) cashflow present value and the subsequent possibility

of a negative PV.

This is similar to the case of market maker with a non-zero Gamma.

In the market makers cash flow, a move of dS in the stock

corresponds to a move 12 Γ(dS)2 in the portfolio value.

In order to protect against large swings in the stock causing non-linear

effects in the portfolio value, the market maker may choose to offset

positions in her present holdings to maintain Gamma Neutrality or she

wish to maintain Delta Neutrality, although this is only a linear effect.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 138 / 161

Option Greeks and Analysis - Some Final Comments

Actuarial Reserving. In engineering the portfolio to replicate the

payoff written into the contract, the market maker requires capital.

The idea of Black Scholes Merton pricing is that the portfolio should

be self-financing.

One should consider how this compares with the capital required by

insurers to maintain solvency as well as the possibility of obtaining

reinsurance.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 139 / 161

Exam Practice

Consider an economy where :

The current exchange rate is x0 = 0.011 dollar

yen .

A four-year dollar-denominated European put option on yen with a

strike price of 0.008$ sells for 0.0005$.

The continuously compounded risk-free interest rate on dollars is 3%.

The continuously compounded risk-free interest rate on yen is 1.5%.

Compute the price of a 4−year dollar-denominated European call option

on yens with a strike price of 0.008$.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 140 / 161

Exam Practice

Consider an economy where :

The current exchange rate is x0 = 0.011 dollar

yen .

A four-year dollar-denominated European put option on yen with a

strike price of 0.008$ sells for 0.0005$.

The continuously compounded risk-free interest rate on dollars is 3%.

The continuously compounded risk-free interest rate on yen is 1.5%.

Compute the price of a 4−year dollar-denominated European call option

on yens with a strike price of 0.008$.

ANSWER: By put call parity, and the Black Scholes formula, with the

asset S as the exchange rate, and the foreign risk-free rate rf = δ,

= 0.0005 + 0.011e −0.015·4 − 0.008e −0.03·4 (154)

= 0.003764.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 140 / 161

Exam Practice

a non-dividend paying stock by borrowing at the risk-free rate r .

The investor paid V C (S0 , 0) = 10.

Six months later, the investor finds out that the Call option has

increased in value by one: V C (S0.05 , 0.5) = 11.

Assume (σ, r ) = (0.2, 0.02).

Should she close out her position after 6 months?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 141 / 161

Exam Practice

a non-dividend paying stock by borrowing at the risk-free rate r .

The investor paid V C (S0 , 0) = 10.

Six months later, the investor finds out that the Call option has

increased in value by one: V C (S0.05 , 0.5) = 11.

Assume (σ, r ) = (0.2, 0.02).

Should she close out her position after 6 months?

ANSWER: Simply put, her profit if she closes out after 6 months is

1

11 − 10e 0.02 2 = 0.8995. (155)

So, yes, she should liquidate her position.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 141 / 161

Exam Practice

non-dividend paying stock.

You are told that ∆C = 0.65, and the economy bears a 1% rate.

Can you estimate the volatility σ?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 142 / 161

Exam Practice

non-dividend paying stock.

You are told that ∆C = 0.65, and the economy bears a 1% rate.

Can you estimate the volatility σ?

ANSWER: By definition,

r + 1 σ2

∆C = e −δT N(d1 ) = N 2

σ

0.01 + 1 σ 2

2

=N = 0.65

σ

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 142 / 161

Exam Practice

non-dividend paying stock.

You are told that ∆C = 0.65, and the economy bears a 1% rate.

Can you estimate the volatility σ?

ANSWER: By definition,

r + 1 σ2

∆C = e −δT N(d1 ) = N 2

σ

0.01 + 1 σ 2

2

=N = 0.65

σ

0.01 + 12 σ 2

⇒ = 0.385

σ

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 142 / 161

Exam Practice

non-dividend paying stock.

You are told that ∆C = 0.65, and the economy bears a 1% rate.

Can you estimate the volatility σ?

ANSWER: By definition,

r + 1 σ2

∆C = e −δT N(d1 ) = N 2

σ

0.01 + 1 σ 2

2

=N = 0.65

σ (156)

1 2

0.01 + 2σ

⇒ = 0.385

σ

⇒ σ ∈ {0.0269, 0.7431} .

More information is needed to choose from the two roots computed above.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 142 / 161

Exam Pointers

When reviewing the material for the exam, consider the following

milestones and examples:

The definition of the Black-Scholes pricing formulae for European

puts and calls.

What are the Greeks? Given a specific option, could you compute the

Greeks?

What is the Option Elasticity? How is it useful? How about the

Sharpe ratio of an option? Can you compute the Elasticity and

Sharpe ration of a given option?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 143 / 161

Exam Pointers

If the Delta and Gamma values of an option are known, can you

calculate the change in option value given a small change in the

underlying asset value?

How does this correspond the Market Maker’s profit?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 144 / 161

Probability Spaces - Introduction

We define the finite set of outcomes, the Sample Space, as Ω and any

subcollection of outcomes A ⊂ Ω an event.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 145 / 161

Probability Spaces - Introduction

We define the finite set of outcomes, the Sample Space, as Ω and any

subcollection of outcomes A ⊂ Ω an event.

How does this relate to the case of 2 consecutive coin flips

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 145 / 161

Probability Spaces - Introduction

We define the finite set of outcomes, the Sample Space, as Ω and any

subcollection of outcomes A ⊂ Ω an event.

How does this relate to the case of 2 consecutive coin flips

Ω ≡ {HH, HT , TH, TT }

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 145 / 161

Probability Spaces - Introduction

We define the finite set of outcomes, the Sample Space, as Ω and any

subcollection of outcomes A ⊂ Ω an event.

How does this relate to the case of 2 consecutive coin flips

Ω ≡ {HH, HT , TH, TT }

Set of events includes statements like at least one head

Probability Spaces - Introduction

We define the finite set of outcomes, the Sample Space, as Ω and any

subcollection of outcomes A ⊂ Ω an event.

How does this relate to the case of 2 consecutive coin flips

Ω ≡ {HH, HT , TH, TT }

Set of events includes statements like at least one head

= {HH, HT , TH}

Probability Spaces - Introduction

We define, ∀A, B ⊆ Ω

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 146 / 161

Probability Spaces - Introduction

We define, ∀A, B ⊆ Ω

Ac = {ω ∈ Ω : ω ∈

/ A}

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 146 / 161

Probability Spaces - Introduction

We define, ∀A, B ⊆ Ω

Ac = {ω ∈ Ω : ω ∈

/ A}

A ∩ B = {ω ∈ Ω : ω ∈ A and ω ∈ B}

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 146 / 161

Probability Spaces - Introduction

We define, ∀A, B ⊆ Ω

Ac = {ω ∈ Ω : ω ∈

/ A}

A ∩ B = {ω ∈ Ω : ω ∈ A and ω ∈ B}

A ∪ B = {ω ∈ Ω : ω ∈ A or ω ∈ B}

Probability Spaces - Introduction

We define, ∀A, B ⊆ Ω

Ac = {ω ∈ Ω : ω ∈

/ A}

A ∩ B = {ω ∈ Ω : ω ∈ A and ω ∈ B}

A ∪ B = {ω ∈ Ω : ω ∈ A or ω ∈ B}

φ as the Empty Set

Probability Spaces - Introduction

We define, ∀A, B ⊆ Ω

Ac = {ω ∈ Ω : ω ∈

/ A}

A ∩ B = {ω ∈ Ω : ω ∈ A and ω ∈ B}

A ∪ B = {ω ∈ Ω : ω ∈ A or ω ∈ B}

φ as the Empty Set

A, B to be Mutually Exclusive or Disjoint if A ∩ B = φ

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 146 / 161

σ−algebras

subsets of Ω that satisfies

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 147 / 161

σ−algebras

subsets of Ω that satisfies

∅∈F

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 147 / 161

σ−algebras

subsets of Ω that satisfies

∅∈F

A ∈ F ⇒ Ac ∈ F

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 147 / 161

σ−algebras

subsets of Ω that satisfies

∅∈F

A ∈ F ⇒ Ac ∈ F

A1 , A2 , A3 , .... ∈ F ⇒ ∪∞

n=1 An ∈ F

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 147 / 161

σ−algebras

subsets of Ω that satisfies

∅∈F

A ∈ F ⇒ Ac ∈ F

A1 , A2 , A3 , .... ∈ F ⇒ ∪∞

n=1 An ∈ F

Some Examples

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 147 / 161

σ−algebras

subsets of Ω that satisfies

∅∈F

A ∈ F ⇒ Ac ∈ F

A1 , A2 , A3 , .... ∈ F ⇒ ∪∞

n=1 An ∈ F

Some Examples

F0 = {∅, Ω}

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 147 / 161

σ−algebras

subsets of Ω that satisfies

∅∈F

A ∈ F ⇒ Ac ∈ F

A1 , A2 , A3 , .... ∈ F ⇒ ∪∞

n=1 An ∈ F

Some Examples

F0 = {∅, Ω}

F1 = {∅, Ω, {HH, HT }, {TT , TH}}

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 147 / 161

σ−algebras

subsets of Ω that satisfies

∅∈F

A ∈ F ⇒ Ac ∈ F

A1 , A2 , A3 , .... ∈ F ⇒ ∪∞

n=1 An ∈ F

Some Examples

F0 = {∅, Ω}

F1 = {∅, Ω, {HH, HT }, {TT , TH}}

F2 = {∅, Ω, {HH}, {HT }, {TT }, {TH}, ....}

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 147 / 161

σ−algebras

subsets of Ω that satisfies

∅∈F

A ∈ F ⇒ Ac ∈ F

A1 , A2 , A3 , .... ∈ F ⇒ ∪∞

n=1 An ∈ F

Some Examples

F0 = {∅, Ω}

F1 = {∅, Ω, {HH, HT }, {TT , TH}}

F2 = {∅, Ω, {HH}, {HT }, {TT }, {TH}, ....}

F2 is completed by taking all unions of ∅, Ω, {HH}, {HT }, {TT }, {TH}.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 147 / 161

Power Sets

n elements?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 148 / 161

Power Sets

n elements?

Answer: 2n

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 148 / 161

Power Sets

n elements?

Answer: 2n

Proof:

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 148 / 161

Power Sets

n elements?

Answer: 2n

Proof:

Consider strings of length n where the elements are either 0 or 1....

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 148 / 161

Notice that F0 ⊂ F1 ⊂ F2 .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 149 / 161

Notice that F0 ⊂ F1 ⊂ F2 .

Filtration as ..

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 149 / 161

Notice that F0 ⊂ F1 ⊂ F2 .

Filtration as ..

a sequence of σ−algebras F0 , F1 , F2 , ..., Fn , ... such that

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 149 / 161

Notice that F0 ⊂ F1 ⊂ F2 .

Filtration as ..

a sequence of σ−algebras F0 , F1 , F2 , ..., Fn , ... such that

F0 ⊂ F1 ⊂ F2 ⊂ ... ⊂ Fn ⊂ ...

Notice that F0 ⊂ F1 ⊂ F2 .

Filtration as ..

a sequence of σ−algebras F0 , F1 , F2 , ..., Fn , ... such that

F0 ⊂ F1 ⊂ F2 ⊂ ... ⊂ Fn ⊂ ...

and F = σ(Ω) as the σ−algebra of all subsets of Ω.

Notice that F0 ⊂ F1 ⊂ F2 .

Filtration as ..

a sequence of σ−algebras F0 , F1 , F2 , ..., Fn , ... such that

F0 ⊂ F1 ⊂ F2 ⊂ ... ⊂ Fn ⊂ ...

and F = σ(Ω) as the σ−algebra of all subsets of Ω.

Given a pair (Ω, F), we define a Random Variable X (ω) as a mapping

X :Ω→R

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 149 / 161

Given a pair (Ω, F), we define a Probability Space as the triple

(Ω, F, P), where

P : F → [0, 1]

P[∅] = 0

For any countable disjoint sets A1 , A2 , ... ∈ F

P∞

P [∪∞

n=1 An ] = n=1 P[An ]

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 150 / 161

And so

P

P[A] := P[ω]

Pω∈A

E[X ] := ω X (ω)P[ω] = nk=1 xk P[{X (ω) = xk }]

P

h i

with Variance := E (X − E[X ])2

Some useful properties:

P[Ac ] = 1 − P[A]

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 151 / 161

And so

P

P[A] := P[ω]

Pω∈A

E[X ] := ω X (ω)P[ω] = nk=1 xk P[{X (ω) = xk }]

P

h i

with Variance := E (X − E[X ])2

Some useful properties:

P[Ac ] = 1 − P[A]

P[A] ≤ 1

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 151 / 161

And so

P

P[A] := P[ω]

Pω∈A

E[X ] := ω X (ω)P[ω] = nk=1 xk P[{X (ω) = xk }]

P

h i

with Variance := E (X − E[X ])2

Some useful properties:

P[Ac ] = 1 − P[A]

P[A] ≤ 1

P[A ∪ B] = P[A] + P[B] − P[A ∩ B]

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 151 / 161

And so

P

P[A] := P[ω]

Pω∈A

E[X ] := ω X (ω)P[ω] = nk=1 xk P[{X (ω) = xk }]

P

h i

with Variance := E (X − E[X ])2

Some useful properties:

P[Ac ] = 1 − P[A]

P[A] ≤ 1

P[A ∪ B] = P[A] + P[B] − P[A ∩ B]

P[A ∪ B ∪ C ] =

P[A] + P[B] + P[C ] − P[A ∩ B] − P[A ∩ C ] − P[B ∩ C ] + P[A ∩ B ∩ C ]

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 151 / 161

Example

Consider the case where two dice are rolled separately. What is the Sample

Space Ω here? How about the probability that the dots on the faces of the

pair add up to 3 or 4 or 5?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 152 / 161

How Should We Count?

How many pairings of aliens and humans, (aliens, human), can we

have if we can choose from 8 aliens and 9 people?

How many different strings of length 5 can we expect to find of 00s

and 10s ?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 153 / 161

Examples

councils can be formed with 2 of each on the board?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 154 / 161

Examples

councils can be formed with 2 of each on the board?

What if two of the humans refuse to serve together?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 154 / 161

Permutations

Combinations of ways r objects could be grouped when selected from a

pool of n total objects. Notationally, for r ≤ n we define this as nr and

the formula can be shown to be

n n!

=

r (n − r )!r !

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 155 / 161

Permutations

Combinations of ways r objects could be grouped when selected from a

pool of n total objects. Notationally, for r ≤ n we define this as nr and

the formula can be shown to be

n n!

=

r (n − r )!r !

n! = 1 · 2 · ... · n

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 155 / 161

Permutations

Combinations of ways r objects could be grouped when selected from a

pool of n total objects. Notationally, for r ≤ n we define this as nr and

the formula can be shown to be

n n!

=

r (n − r )!r !

n! = 1 · 2 · ... · n (157)

n n−1 n−1

= +

r r −1 r

If order matters when selecting the r objects, then we define the number

of Permutations

n n!

Pk,n = r ! · = (158)

r (n − r )!

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 155 / 161

What if another event has already occured?

Consider the case where two events in our σ−field are under consideration.

In fact, we know that B has already happened. How does that affect the

chances of A happening?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 156 / 161

What if another event has already occured?

Consider the case where two events in our σ−field are under consideration.

In fact, we know that B has already happened. How does that affect the

chances of A happening?

For example, if you know your friend has one boy, and the chance of a boy

or girl is equal at 0.5, then what is the chance all three of his children are

boys?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 156 / 161

What if another event has already occured?

In symbols, we seek

P [A ∩ B]

P [A | B] ≡

P [B]

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 157 / 161

What if another event has already occured?

In symbols, we seek

P [A ∩ B]

P [A | B] ≡

P [B]

P [ all are boys ∩ first child is a boy]

=

P [ first child is a boy]

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 157 / 161

What if another event has already occured?

In symbols, we seek

P [A ∩ B]

P [A | B] ≡

P [B]

P [ all are boys ∩ first child is a boy]

=

P [ first child is a boy]

P [ all are boys]

=

P [ first child is a boy]

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 157 / 161

What if another event has already occured?

In symbols, we seek

P [A ∩ B]

P [A | B] ≡

P [B]

P [ all are boys ∩ first child is a boy]

=

P [ first child is a boy]

P [ all are boys]

=

P [ first child is a boy]

1 1 1

· ·

= 2 21 2

2

What if another event has already occured?

In symbols, we seek

P [A ∩ B]

P [A | B] ≡

P [B]

P [ all are boys ∩ first child is a boy]

=

P [ first child is a boy]

P [ all are boys]

= (159)

P [ first child is a boy]

1 1 1

· ·

= 2 21 2

2

1

=

4

What if another event has already occured?

Now, what if you know your friend has at least one boy. Then what is the

chance all three of his children are boys? This is also known as The

Boy-Girl Paradox.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 158 / 161

What if another event has already occured?

Now, what if you know your friend has at least one boy. Then what is the

chance all three of his children are boys? This is also known as The

Boy-Girl Paradox.

P [A ∩ C ]

P [A | C ] ≡

P [C ]

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 158 / 161

What if another event has already occured?

Now, what if you know your friend has at least one boy. Then what is the

chance all three of his children are boys? This is also known as The

Boy-Girl Paradox.

P [A ∩ C ]

P [A | C ] ≡

P [C ]

P [ all are boys ∩ at least one child is a boy]

=

P [at least one child is a boy]

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 158 / 161

What if another event has already occured?

chance all three of his children are boys? This is also known as The

Boy-Girl Paradox.

P [A ∩ C ]

P [A | C ] ≡

P [C ]

P [ all are boys ∩ at least one child is a boy]

=

P [at least one child is a boy]

P [ all are boys]

=

P [ at least one child is a boy]

What if another event has already occured?

chance all three of his children are boys? This is also known as The

Boy-Girl Paradox.

P [A ∩ C ]

P [A | C ] ≡

P [C ]

P [ all are boys ∩ at least one child is a boy]

=

P [at least one child is a boy]

P [ all are boys]

=

P [ at least one child is a boy]

P [ all are boys]

=

1 − P [all girls]

What if another event has already occured?

chance all three of his children are boys? This is also known as The

Boy-Girl Paradox.

P [A ∩ C ]

P [A | C ] ≡

P [C ]

P [ all are boys ∩ at least one child is a boy]

=

P [at least one child is a boy]

P [ all are boys]

=

P [ at least one child is a boy]

P [ all are boys]

=

1 − P [all girls]

1 1 1

2 · 2 · 2

=

1 − 18

What if another event has already occured?

chance all three of his children are boys? This is also known as The

Boy-Girl Paradox.

P [A ∩ C ]

P [A | C ] ≡

P [C ]

P [ all are boys ∩ at least one child is a boy]

=

P [at least one child is a boy]

P [ all are boys]

= (160)

P [ at least one child is a boy]

P [ all are boys]

=

1 − P [all girls]

1 1 1

2 · 2 · 2 1

= 1

=

1− 8 7

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 158 / 161

Total Probability

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 159 / 161

Total Probability

We can expand on this idea: For our sample space Ω, assume we have a

set {A1 , ..., An } where the members are

mutually exclusive - Ai ∩ Aj = φ for all i 6= j

exhaustive - A1 ∪ A2 ∪ ... ∪ An = Ω .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 159 / 161

Total Probability

We can expand on this idea: For our sample space Ω, assume we have a

set {A1 , ..., An } where the members are

mutually exclusive - Ai ∩ Aj = φ for all i 6= j

exhaustive - A1 ∪ A2 ∪ ... ∪ An = Ω .

Then

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 159 / 161

Total Probability

We can expand on this idea: For our sample space Ω, assume we have a

set {A1 , ..., An } where the members are

mutually exclusive - Ai ∩ Aj = φ for all i 6= j

exhaustive - A1 ∪ A2 ∪ ... ∪ An = Ω .

Then

(162)

= P[B | A1 ]P[A1 ] + P[B | A2 ]P[A2 ] + ... + P[B | An ]P[An ]

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 159 / 161

Bayes Theorem

{A1 , ..., An } with prior probabilities P[Ai ] for i = 1, .., n. Then for any

other event B in our σ−field where P[B] > 0, the posterior probabilty of

Aj given that B has occured is

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 160 / 161

Bayes Theorem

{A1 , ..., An } with prior probabilities P[Ai ] for i = 1, .., n. Then for any

other event B in our σ−field where P[B] > 0, the posterior probabilty of

Aj given that B has occured is

P [Aj ∩ B]

P [Aj | B] = =

P [B]

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 160 / 161

Bayes Theorem

{A1 , ..., An } with prior probabilities P[Ai ] for i = 1, .., n. Then for any

other event B in our σ−field where P[B] > 0, the posterior probabilty of

Aj given that B has occured is

P [Aj ∩ B] P [B ∩ Aj ]

P [Aj | B] = =

P [B] P [B]

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 160 / 161

Bayes Theorem

{A1 , ..., An } with prior probabilities P[Ai ] for i = 1, .., n. Then for any

other event B in our σ−field where P[B] > 0, the posterior probabilty of

Aj given that B has occured is

P [Aj ∩ B] P [B ∩ Aj ]

P [Aj | B] = =

P [B] P [B]

(163)

P[B | Aj ] · P[Aj ]

=

P[B | A1 ]P[A1 ] + ... + P[B | An ]P[An ]

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 160 / 161

Independent Events

For our sample space Ω, assume we have two events A, B. We say that A

and B are independent if P[A | B] = P[A] and dependent if

P[A | B] 6= P[A]

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 161 / 161

Independent Events

For our sample space Ω, assume we have two events A, B. We say that A

and B are independent if P[A | B] = P[A] and dependent if

P[A | B] 6= P[A]

In other words, A and B are independent if and only if

P[A ∩ B] = P[A] · P[B].

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 161 / 161

Independent Events

For our sample space Ω, assume we have two events A, B. We say that A

and B are independent if P[A | B] = P[A] and dependent if

P[A | B] 6= P[A]

In other words, A and B are independent if and only if

P[A ∩ B] = P[A] · P[B].

Generally speaking, for any collection of events {A1 , ..., An } we have for

any subcollection {Ai1 , ..., Ain } ⊆ {A1 , ..., An }

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 161 / 161

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