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MATH 361: Financial Mathematics for Actuaries I

Albert Cohen

Actuarial Sciences Program


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

Syllabus to be posted on class page in first week of classes


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?

Traded Securities - price given by market.


For example:
Stocks
Commodities

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 4 / 161
What are financial securities?

Traded Securities - price given by market.


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?

Traded Securities - price given by market.


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?

Traded Securities - price given by market.


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?

By eliminating all unfair prices

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 5 / 161
How does one fairly price non-traded securities?

By eliminating all unfair prices


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?

By eliminating all unfair prices


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

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 5 / 161
How does one fairly price non-traded securities?

By eliminating all unfair prices


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

Existence - Does such a fair price always exist?


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...

Does the replicating strategy and price computed reflect uncertainty


in the market?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 7 / 161
And What About...

Does the replicating strategy and price computed reflect uncertainty


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:

V (0) = 0, V (T ) = S(T ) − F (1)

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:

V (0) = 0, V (T ) = S(T ) − F (1)

Value at end of term can be negative - buyer accepts this in exchange


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

Forward Exchange Rate: There are two currencies, foreign and


domestic:

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 10 / 161
An Example of Replication

Forward Exchange Rate: There are two currencies, foreign and


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

Forward Exchange Rate: There are two currencies, foreign and


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

Forward Exchange Rate: There are two currencies, foreign and


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

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 10 / 161
An Example of Replication

Forward Exchange Rate: There are two currencies, foreign and


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

At time 1, we deliver 1 unit of B in exchange for FAB units of domestic


currency A.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 11 / 161
An Example of Replication: Solution

At time 1, we deliver 1 unit of B in exchange for FAB units of domestic


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

At time 1, we deliver 1 unit of B in exchange for FAB units of domestic


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

At time 1, we deliver 1 unit of B in exchange for FAB units of domestic


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)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 11 / 161
An Example of Replication: Solution

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 12 / 161
An Example of Replication: Solution

This results in the initial value


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

Let us define an event as a point ω in the set of all possible outcomes Ω.


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

Let us define an event as a point ω in the set of all possible outcomes Ω.


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

Let us define an event as a point ω in the set of all possible outcomes Ω.


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

S1 (H) = uS0 , S1 (T ) = dS0 (5)

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

Let us define an event as a point ω in the set of all possible outcomes Ω.


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

S1 (H) = uS0 , S1 (T ) = dS0 (5)


with d < 1 < u. Hence, a stock increases or decreases in price,
according to the flip of a coin.

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

Let us define an event as a point ω in the set of all possible outcomes Ω.


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

S1 (H) = uS0 , S1 (T ) = dS0 (5)


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:

P[H] = p = 1 − P[T ] (6)

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

Assume that S0 (1 + r ) > uS0

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

Assume that S0 (1 + r ) > uS0


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

Assume that S0 (1 + r ) > uS0


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

Assume that S0 (1 + r ) > uS0


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

Assume that S0 (1 + r ) > uS0


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

Let S1 (ω) be the price of an underlying asset at time 1. Define the


following instruments:

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

Let S1 (ω) be the price of an underlying asset at time 1. Define the


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

Let S1 (ω) be the price of an underlying asset at time 1. Define the


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

Let S1 (ω) be the price of an underlying asset at time 1. Define the


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

Let S1 (ω) be the price of an underlying asset at time 1. Define the


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

V1C − V1P + (K − F ) = S1 − F = X1 (ω) (7)

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

V1C − V1P + (K − F ) = S1 − F = X1 (ω) (7)


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.

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

V1C − V1P + (K − F ) = S1 − F = X1 (ω) (7)


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

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

V1C − V1P + (K − F ) = S1 − F = X1 (ω) (7)


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

X1 (ω) = V1 (ω) ∀ ω∈Ω (9)


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

Initial holding in bond (bank account) is X0 − ∆0 S0


Value of portfolio at maturity is

X1 (ω) = (X0 − ∆0 S0 )(1 + r ) + ∆0 S1 (ω) (10)

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

Initial holding in bond (bank account) is X0 − ∆0 S0


Value of portfolio at maturity is

X1 (ω) = (X0 − ∆0 S0 )(1 + r ) + ∆0 S1 (ω) (10)

Pathwise, we compute

V1 (H) = (X0 − ∆0 S0 )(1 + r ) + ∆0 uS0


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

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

Initial holding in bond (bank account) is X0 − ∆0 S0


Value of portfolio at maturity is

X1 (ω) = (X0 − ∆0 S0 )(1 + r ) + ∆0 S1 (ω) (10)

Pathwise, we compute

V1 (H) = (X0 − ∆0 S0 )(1 + r ) + ∆0 uS0


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):

p̃V1 (H) = p̃(X0 − ∆0 S0 )(1 + r ) + p̃∆0 uS0


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):

p̃V1 (H) = p̃(X0 − ∆0 S0 )(1 + r ) + p̃∆0 uS0


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

Addition yields

X0 (1 + r ) + ∆0 S0 (p̃u + q̃d − (1 + r )) = p̃V1 (H) + q̃V1 (T ) (12)

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

then we have a risk neutral probability P̃ where

1 p̃V1 (H) + q̃V1 (T )


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

Consider the case of a stock with


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

Consider the case of a stock with


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

Homework Question: What is the price of a call option in the case


above,with strike K = 375?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 22 / 161
General one period risk neutral measure

We define a finite set of outcomes Ω ≡ {ω1 , ω2 , ..., ωn } and any


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

The measure is indifferent to investing in a zero-coupon bond, or a


risky asset X

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 24 / 161
General one period risk neutral measure

The measure is indifferent to investing in a zero-coupon bond, or a


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

The measure is indifferent to investing in a zero-coupon bond, or a


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

The measure is indifferent to investing in a zero-coupon bond, or a


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

Assume that Ω = {ω1 , ω2 , ω3 } with

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

Assume that Ω = {ω1 , ω2 , ω3 } with

S1 (ω1 ) = uS0
S1 (ω2 ) = S0
S1 (ω3 ) = dS0

Given a payoff V1 (ω) to replicate, are we assured that a replicating


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

(S0 , u, d, r ) = (400, 1.25.0.75, 0.05)


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

(S0 , u, d, r ) = (400, 1.25.0.75, 0.05)


V1digital (ω) = 1{S1 (ω)>450} (ω).

Now, assume you are observe the price on the market to be


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

The above scenario is reduced to finding the risk-neutral measure


(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

It follows that (p̃1 , p̃2 , p̃3 ) = (0.2625, 0.675, 0.0625), and so

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

It follows that (p̃1 , p̃2 , p̃3 ) = (0.2625, 0.675, 0.0625), and so

1
V0C = Ẽ[(S1 − 420)+ | S0 = 400]
1.05 (17)
0.2625
= × (500 − 420) = 20.
1.05

Could we perhaps find a set of digital options as a basis set


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

with A1 , A2 , A3 ∈ F1 to span all possible payoffs at time 1?


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

Assume now an economy with two stocks, X and Y . Assume that

(X0 , Y0 , r ) = (100, 100, 0.01) (19)


and

 (110, 105) : ω = ω1
(X1 (ω), Y1 (ω)) = (100, 100) : ω = ω2
(80, 95) : ω = ω3 .

Consider two contracts, V and W , with payoffs

V1 (ω) = max {Y1 (ω) − X1 (ω), 0}


(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

Let P̃ be a probability measure on a finite space Ω. The following are


equivalent:

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 31 / 161
Existence of Risk Neutral measure

Let P̃ be a probability measure on a finite space Ω. The following are


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

Let P̃ be a probability measure on a finite space Ω. The following are


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

Let P̃ be a probability measure on a finite space Ω. The following are


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

A market is complete if it is arbitrage free and every non-traded asset can


be replicated.

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

A market is complete if it is arbitrage free and every non-traded asset can


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

A market is complete if it is arbitrage free and every non-traded asset can


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

Assume a complete market, with a unique risk-neutral measure P̃.


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

Ẽ[X ] = E[ZX ]. (25)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 33 / 161
Optimal Investment for a Strictly Risk Averse Investor

A strictly risk-averse investor now wishes to maximize her expected utility


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

u(x) := max E[U(X1 )]


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)

where λ sets X̂1 as a strategy with an average return of r under P̃:

Ẽ[X̂1 ] = x(1 + r ). (28)


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

f (y ) := E[U(yX1 + (1 − y )X̂1 )] (29)


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

and so f attains its maximum at y = 0. We conclude that


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

Assume an investor and economy defined by

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

Combining the previous results, we see that

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

In terms of her actual strategy, we see that

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

Therefore, the optimal strategy is to sell a stock portfolio worth 87.5% of


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.

This links with her strategy via

X̂1 (ω) S1 (ω)


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

1 + r̂1 (H) = (1 − π̂0 )(1 + r ) + π̂0 u = 0.875


(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

Combining the results above, we see that

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!

Imagine our investor with U(x) = ln (x) visits a 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

(p1 , p2 , p3 ) = (0.6, 0.35, 0.05). (44)

How should she bet if the race is about to start?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 43 / 161
Optimal Betting at the Omega Horse Track!

In this setting, we can assume r = 0.


This directly implies that

(p̃1 , p̃2 , p̃3 ) = (0.5, 0.3, 0.2). (45)

Our Radon-Nikodym derivative of P̃ to P is now


 
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 (H) = (X0 − ∆0 S0 )e rh + ∆0 e δh uS0


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

and this results in the modified quantities

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
.

General Stock Model



u = e (r −δ)h+σ h

d = e (r −δ)h−σ h
.

Currencies with rf the foreign interest rate, which acts as a dividend:



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

Consider the case r = 0.10, δ = 0.05, h = 0.01, σ = 0.1, S0 = 10 = K .

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 49 / 161
1- and 2-period pricing

Consider the case r = 0.10, δ = 0.05, h = 0.01, σ = 0.1, S0 = 10 = K .


Now price two digital options, using the
1 General Stock Model
2 Futures-Cox Model
with respective payoffs

V1K (ω) := 1{S1 ≥K } (ω)


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

Approximation: Convert our previous table, using simple interest.


Over small time periods h, define linear return values for i th period:
Si − Si−1
Xi h := . (51)
Si−1

In other words, for simple rate of return Xi for period i:

Si = Si−1 · (1 + Xi h). (52)

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

We estimate, therefore, that under the Futures-Cox model

(u, d) = (e 0.0319 , e −0.0319 ) = (1.0324, 0.9686)


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

For the one-period digital option:

V0 = e −rh Ẽ0 [1{S1 ≥10} ] = e −0.002 · p̃ = 0.5224. (54)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 55 / 161
Calibration Exercise: Linear Approximation

For the one-period digital option:

V0 = e −rh Ẽ0 [1{S1 ≥10} ] = e −0.002 · p̃ = 0.5224. (54)


For the two-period digital option:

V0 = e −2rh Ẽ0 [1{S2 ≥10} ] = e −0.004 · p̃ 2 + 2p̃q̃ = 0.7698.


 
(55)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 55 / 161
Calibration Exercise: No Approximation

Without the linear approximation, we can directly estimate



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:

V0 = e −rh Ẽ0 [1{S1 ≥10} ] = e −0.002 · p̃ = 0.5236. (57)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 56 / 161
Calibration Exercise: No Approximation

Without the linear approximation, we can directly estimate



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:

V0 = e −rh Ẽ0 [1{S1 ≥10} ] = e −0.002 · p̃ = 0.5236. (57)


For the two-period digital option:

V0 = e −2rh Ẽ0 [1{S2 ≥10} ] = e −0.004 · p̃ 2 + 2p̃q̃ = 0.7721.


 
(58)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 56 / 161
1- and 2-period pricing

We can solve for 2-period problems

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 57 / 161
1- and 2-period pricing

We can solve for 2-period problems


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

We can solve for 2-period problems


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

Vn = e −rh Ẽn [Vn+1 ] (59)

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

Vn = e −rh Ẽn [Vn+1 ] (59)


and so

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

Vn = e −rh Ẽn [Vn+1 ] (59)


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

Consider the case


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

At each value s for Sn , we know that Sn+1 = 34 s or Sn+1 = 34 s.


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:

Assume r , δ, and h are such that


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.

Definition We say that a process X is adapted if it depends only on the


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

Definition We say that an adapted process X is Markov if for every


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

Ẽn [f (Xn+1 )] = g (Xn ). (65)

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

This notion of Markovity is essential to our state-dependent pricing


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

g (s) = Ẽn [f (Sn+1 ) | Sn = s] . (66)

In fact, that g depends on f :


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

Some more thoughts on Markovity:


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

Assume an economy where


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

Consider now a zero-coupon bond that matures in 3−years with


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

Our general recursive formula is


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

At time t = 2, we have that

r2 ∈ {0.08, 0.04, 0.02, 0.01, 0.005} . (72)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 67 / 161
Call Options on Zero-Coupon Bonds

Our associated Bond and Call Option values at time 2:

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

Our associated Bond and Call Option values at time 0:

r0 B0 C0
0.02 93.34 1.03

Question: What if the delivery time of the option is changed to 3?


Symbolically, what if

C3 (r ) = max {B3 (r ) − 97, 0}? (73)


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

As an analyst for an investments firm, you are tasked with advising


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

Assume Miller-Modigliani holds with At = Bt + St , where the assets


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 ,

Bt = e −r (T −t) Ẽ [min {AT , F }]


(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.

Period Return on Assets


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

(u, d) = (e 0.0319 , e −0.0319 ) = (1.0324, 0.9686)


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

B̃0 = e −0.02·(2·0.25) p̃ 2 · 9.5 + 2p̃q̃ · 9.5 + q̃ 2 · 9.38


 

= 9.38 > 9.00 (76)


S˜0 = 10 − 9.38 = 0.62 < 1.00.

It follows that,according to our model, one should Buy the bond as it


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

Consider the following scenario:


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=50, 000] = 0.1


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

Some more thoughts...


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

The solution process {Xk }4k=1 follows an Optimal Stopping 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

This strategy leads to a valuation:

X3 (50, 000) = 78, 000


X3 (70, 000) = 78, 000
(80)
X3 (80, 000) = 80, 000
X3 (100, 000) = 100, 000.

At time 2, similar reasoning using Ẽ2 [X3 ] leads to the valuation

X2 (50, 000) = 83, 200


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

Let’s review the basic contracts we can write:

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

Let’s review the basic contracts we can write:


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

Let’s review the basic contracts we can write:


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

Let’s review the basic contracts we can write:


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

Let’s review the basic contracts we can write:


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

Let’s review the basic contracts we can write:


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

vn (s) < g (s) (84)

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

Let’s review the basic contracts we can write:


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

vn (s) < g (s) (84)


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

If σ = 0, and so uncertainty vanishes, then an investor would seek to


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...)

What happens if we write a contract that allows the purchaser to exercise


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...)

What happens if we write a contract that allows the purchaser to exercise


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...)

What happens if we write a contract that allows the purchaser to exercise


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))} .

Here, τ ∗ is the optimal exercise time.


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

Consider the American Square Option. We know via Jensen’s Inequality


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

It follows that vN (s) = s 2 and


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].

In words, with one period to go, don’t exercise yet!!


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

Let’s return to the previous European Put example, where


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

rn = rn (ω1 , ..., ωn ) (92)


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,

r2 (H, T ) = r2 (T , H). (94)

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

We can in fact see that

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


(97)
y (1, 2, r1 (T )) = r1 (T ).
But, for example, it is not clear how to obtain

(y (1, 3, r1 (H)), y (1, 3, r1 (T ))) . (98)


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

One way forward is the Black Derman Toy Model 1

Consider a market with the following observations:

Maturity Yield to Maturity y (0, T , r ) Yield Volatility σ̃T


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

(For Daily US Treasury Real Yield Curve Rates click here )

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

In this setting, we match market conditions to a model where at each


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

(r1 (H), r1 (T )) = (0.1432, 0.0979). (102)


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 )

We can now substitute our values


(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

We also know that σ2 6= σ2 (ω1 , ω2 ) and so


 
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

Finally, we have one more matching condition via


 
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

Time Interest Rate Value


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

We can decompose the two-year coupon bond into two component


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

B(0, 2, r ) = B (1) (0, 1, r ) + B (2) (0, 2, r ). (107)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 98 / 161
Pricing a Two-year Coupon Bond Using Market Conditions

Our component bonds thus have prices

Time Interest Rate B 1 (t, T , r )


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

Time Interest Rate B 2 (t, T , r )


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

Finally, we have our coupon bond with price

Time Interest Rate B(t, T , r )


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:

Time Interest Rate B(t, T , r )


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

Pricing and hedging is accomplished via


 
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

In times of high volatility or frequent trading, a company may want to


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

In times of high volatility or frequent trading, a company may want to


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.

As an input, the average of an asset is used as an input against a strike,


instead of the spot price.

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

In times of high volatility or frequent trading, a company may want to


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.

As an input, the average of an asset is used as an input against a strike,


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

In times of high volatility or frequent trading, a company may want to


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.

As an input, the average of an asset is used as an input against a strike,


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:

Consider an arithmetic average with N = 2. Then


 
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:

Consider an arithmetic average with N = 2. Then


 
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:

Consider an arithmetic average with N = 2. Then


 
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

Analyzing returns, we assume:


 
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.

We model the returns as being independent and possessing a binomial


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:

PFt (ω) = St (ω) − De −r (τ (ω)−t)



u = e rh+σ h
(114)

d = e rh−σ h
.

Now, the random process that we model as having up and down


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

Consider the case of a security whose binomial evolution is modeled as an


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

Consider the case of a security whose binomial evolution is modeled as an


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

Our model for asset evolution is


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

Our model for asset evolution is


1 2 )t+σ

⇒ St = S0 e (α−δ− 2 σ tZ
(115)
Z ∼ N(0, 1).

Consider now the possibility of simulating the stock evolution by n


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

Our model for asset evolution is


1 2 )t+σ

⇒ St = S0 e (α−δ− 2 σ tZ
(115)
Z ∼ N(0, 1).

Consider now the possibility of simulating the stock evolution by n


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

The challenge now is to simulate our lognormally distributed asset


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

The challenge now is to simulate our lognormally distributed asset


evolution.

One can simulate the value ST directly by one random variable Z , or a


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

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

The challenge now is to simulate our lognormally distributed asset


evolution.

One can simulate the value ST directly by one random variable Z , or a


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

The latter method is necessary for Asian options.

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

There are multiple ways to simulate Z . One way is to find a random


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

There are multiple ways to simulate Z . One way is to find a random


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

There are multiple ways to simulate Z . One way is to find a random


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)

It can be shown that in a sample, the standard deviation of the sample


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:

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


= 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

One application of lognormal distributions is their use in modeling the


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

We can use the previous facts to show

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

We can use the previous facts to show

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

Risk managers are also interested in Conditional Tail Expectations (CTE’s)


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

Straightforward partial differentiation leads to

∆C = e −δ(T −t) N(d1 )


∆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..

ρC = (T − t)Ke −r (T −t) N(d2 )


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..

ρC = (T − t)Ke −r (T −t) N(d2 )


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?

HW: Compute Θ for puts and calls.

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:

σoption = σstock × | Ω | . (135)

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)

In terms of elasticity Ω, this reduces to

Risk Premium(Option) := γ − r = (α − r )Ω. (139)

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)

In terms of elasticity Ω, this reduces to

Risk Premium(Option) := γ − r = (α − r )Ω. (139)


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)

In terms of elasticity Ω, this reduces to

Risk Premium(Option) := γ − r = (α − r )Ω. (139)


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

Under a standard framework, assume you write a 4 − yr European Call


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

∆C = e −δ(T −t) N(d1 )


 
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

Assume that an option is written on an asset S with the following


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

Compute Ω(S, t) and the Sharpe Ratio for this option.

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

Consider a portfolio of options on a non-dividend paying stock S that


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

Consider a portfolio of options on a non-dividend paying stock S that


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

V (5, 0) = V C (5, 0) + V P (5, 0)


 
= 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

On a periodic basis, a Market Maker, services the option buyer by


rebalancing the portfolio designed to replicate the payoff written into the
option contract.
Define

Vi = Option Value i periods from inception


∆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

On a periodic basis, a Market Maker, services the option buyer by


rebalancing the portfolio designed to replicate the payoff written into the
option contract.
Define

Vi = Option Value i periods from inception


∆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

∂Pi = Net Cash Flow = ∆i ∂Si − ∂Vi − rPi


  (151)
= ∆i ∂Si − ∂Vi − r ∆i Si − Vi

Under what conditions is the Net Flow = 0?

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 ,

dV := V (St + dSt , t + dt) − V (St , t)


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

If dt is small, but not infinitessimally small, then on a periodic basis given


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

If dt is small, but not infinitessimally small, then on a periodic basis given


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

In an actuarial analysis of cashflow, a company may wish to immunize


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

It is important to note the similarities between Market Making and


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,

V C (x0 , 0) = V P (x0 , 0) + x0 e −rf T − Ke −rT


= 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

An investor purchases a 1−year, 50− strike European Call option on


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

An investor purchases a 1−year, 50− strike European Call option on


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

Consider a 1−year at the money European Call option on a


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

Consider a 1−year at the money European Call option on a


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

Consider a 1−year at the money European Call option on a


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

Consider a 1−year at the money European Call option on a


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

What is Delta Hedging?


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

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
= {HH, HT , TH}

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

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}
φ as the Empty Set

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}
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

Given a non-empty set Ω of outcomes, a σ−algebra F is a collection of


subsets of Ω that satisfies

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 147 / 161
σ−algebras

Given a non-empty set Ω of outcomes, a σ−algebra F is a collection of


subsets of Ω that satisfies
∅∈F

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 147 / 161
σ−algebras

Given a non-empty set Ω of outcomes, a σ−algebra F is a collection of


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

Given a non-empty set Ω of outcomes, a σ−algebra F is a collection of


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

Given a non-empty set Ω of outcomes, a σ−algebra F is a collection of


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

Given a non-empty set Ω of outcomes, a σ−algebra F is a collection of


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

Given a non-empty set Ω of outcomes, a σ−algebra F is a collection of


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

Given a non-empty set Ω of outcomes, a σ−algebra F is a collection of


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

Given a non-empty set Ω of outcomes, a σ−algebra F is a collection of


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

As a useful example, how many subsets are there of a set containing


n elements?

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 148 / 161
Power Sets

As a useful example, how many subsets are there of a set containing


n elements?
Answer: 2n

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 148 / 161
Power Sets

As a useful example, how many subsets are there of a set containing


n elements?
Answer: 2n
Proof:

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 148 / 161
Power Sets

As a useful example, how many subsets are there of a set containing


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 .

Correspondingly, given an Ω, we define a

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 149 / 161
Notice that F0 ⊂ F1 ⊂ F2 .

Correspondingly, given an Ω, we define a


Filtration as ..

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 149 / 161
Notice that F0 ⊂ F1 ⊂ F2 .

Correspondingly, given an Ω, we define a


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 .

Correspondingly, given an Ω, we define a


Filtration as ..
a sequence of σ−algebras F0 , F1 , F2 , ..., Fn , ... such that
F0 ⊂ F1 ⊂ F2 ⊂ ... ⊂ Fn ⊂ ...

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 149 / 161
Notice that F0 ⊂ F1 ⊂ F2 .

Correspondingly, given an Ω, we define a


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.

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 149 / 161
Notice that F0 ⊂ F1 ⊂ F2 .

Correspondingly, given an Ω, we define a


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?

Think about the following problems:


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

From a group of 3 aliens and 5 humans, how many alien-people


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

From a group of 3 aliens and 5 humans, how many alien-people


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

In general, we are interested in the number of different ways, or


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

In general, we are interested in the number of different ways, or


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

In general, we are interested in the number of different ways, or


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

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]
= (159)
P [ first child is a boy]
1 1 1
· ·
= 2 21 2
2
1
=
4

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 157 / 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.

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?

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]
P [ all are boys]
=
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?

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]
P [ all are boys]
=
P [ at least one child is a boy]
P [ all are boys]
=
1 − P [all girls]

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]
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

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]
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

Notice from our definition of conditional probabiltity that

P[A ∩ B] = P[A | B] · P[B] (161)

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 159 / 161
Total Probability

Notice from our definition of conditional probabiltity that

P[A ∩ B] = P[A | B] · P[B] (161)


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

Notice from our definition of conditional probabiltity that

P[A ∩ B] = P[A | B] · P[B] (161)


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

P[B] = P[B ∩ A1 ] + P[B ∩ A2 ] + ... + P[B ∩ An ]

Albert Cohen (MSU) Financial Mathematics for Actuaries I MSU Spring 2016 159 / 161
Total Probability

Notice from our definition of conditional probabiltity that

P[A ∩ B] = P[A | B] · P[B] (161)


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

P[B] = P[B ∩ A1 ] + P[B ∩ A2 ] + ... + P[B ∩ An ]


(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

For our sample space Ω, assume we have an exhaustive set of events


{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

For our sample space Ω, assume we have an exhaustive set of events


{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

For our sample space Ω, assume we have an exhaustive set of events


{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

For our sample space Ω, assume we have an exhaustive set of events


{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 }

P[Ai1 ∩ ... ∩ Ain ] = P[Ai1 ] · .. · ...P[Ain ] (164)

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