Chapter 1: A simple market model

1. The market model

2. Non Arbitrage

3. Risk and Return

4. Derivative Securities: 1. Forward contracts

5. Derivative Securities: 2. Options

1. The market model The source of risk comes from the randomness in nancial markets. This arises from the fact that a market model can have many possible scenarios tomorrow and this will aect the investment, the consumptions,..., etcetera. In this chapter, our market model is mainely characterized by a two underlying assets. Transactions time: We suppose that for this chapter there is only two times t = 0, and t = 1, where transactions take place. This is called some times a one-step model (or static). Underlying assets: We suppose that there are two assets to be traded. Non risky asset: Bank account, Bonds,.... The price of this asset varies with time, thus we have A(t) = the price of the non-risky asset at time t, t = 0, 1. The quantity A(t) is a positive known constant (does not depend on the random). Risky asset: Stock, a commodity, index, currency,.... The price of this asset at time t is denoted by S(t) for t = 0, 1. The quantity S(0) is known, while S(1) is a positive random variable which is non-trivial. Portfolio: Consists of two numbers x, and y, that represents the number of shares of the Stock and units of Bonds respectively

that the investor decide to invest at time t = 0. The portfolio is denoted by (x, y) x and y can have any sign (positive or negative). x and y can take any value in I R. The value of a portfolio (x, y) is a process and is denoted by (Vt)t=0,1 and is given by Vt = xS(t) + yA(t), t = 0, 1.

A portfolio (x, y) is said to be admissible if it value process satises V (t) 0, t = 0, 1.

2 . Non arbitrage Arbitrage opportunity: is an admissible portfolio (x, y) such that its value process satises V (0) = 0, and P (V (1) > 0) > 0.

Example: The one-step Binomial model. S(1) =

S+ S

with with

p 1p

where S+ > S > 0 and p (0, 1). Theorem 0.1 Suppose that S(0) = A(0) > 0. Then the market model admits no arbitrage opportunities if and only if S < A(1) < S+. Proof.

3. Risk and Return For any process dened in the previous paragraphes, we can dene its return. Return for the non-risky asset KA := This is a known quantity. Return for the risky asset S(1) S(0) . S(0) This a random variable, as S(1) is random. KS := Return for the value of a portfolio V (1) V (0) . V (0) This also a random variable and some times we refer to it as simply return. KV := The expected return is the expected value of the random variable KV . The risk is measured by the variance of the return, that is V = V ar(KV ). A(1) A(0) . A(0)

Derivative Securities:1. Forward contracts Denition: A forward contract is an agreement to buy or sell a risky asset at a specied future date, the delivery date, for a price xed now at F and is called the forward price. If the investor goes long (respectively short) in the forward contract, then she has a payo S(1) F (respectively F S(1)) at time one, while the contract costs nothing. A forward contract is a security, that is an example of derivative securities and the portfolio of an investor may contain this security. Then a portfolio for this case is the triple (x, y, z) and its value is given by V (0) = xS(0) + yA(0) V (1) = xS(1) + yA(1) + z(S(1) F ). Theorem 0.2 Suppose that the market model is arbitrage free. Then A(1) . F = S(0) A(0) Proof.

Derivative Securities: 2. Two examples of options Denition: An option is a contract that gives to its holder the right (Not the obligation) to buy or sell a share of the stock in a future date, the maturity date, at a xed price K called the exercise price or the strike price. The option is called a call option if the right is about buying the stock, while it is called put option in the case of selling the stock. The option price is stochastic process O(t), t = 0, 1 that has the following features If the option is a call, then O(1) = (S(1) K)+ If the option is a put, then O(1) = (S(1) K) = (K S(1))+ the price at the present O(0) can be calculated using the arbitrage principle and it will be determined later, and this process of calculating this price is called pricing. Portfolio for the new set of assets: is a triple (x, y, z) and its value process is given by V (0) = xS(0) + yA(0) + zO(0) V (1) = xS(1) + yA(1) + zO(1) The terminal price of the option O(1) can be seen as a payo and one think to replicate it by investing in stock and bonds.

Theorem: Suppose that the market is arbitrage free , and there exist numbers x and y such that O(1) = xS(1) + yA(1). Then the price of the option is O(0) = xS(0) + yA(0). Proof. Examples.