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1 Introduction

Pricing of nancial derivatives mainly involves nding the expected present value of future

cash ows under a risk neutral probability measure. The expected present value concept is

not new to us; we require three ingredients: a series of cash ows, the corresponding discount

factors and probabilities. Given a series of known/estimated cash ows, the question that now

arises is how do we determine the appropriate discount factors and probabilities?

We could use the actual real world probabilities, which are probabilities estimated using

historical data and/or expert knowledge. However, if we do so, then we need to use

discount factors that reect appropriately the risk inherent in the securitys cash ows.

This poses a problem as every security would require a different discount factor, for they

differ in risk.

Consider for example a stock that is currently priced at $30. In one year, if the economy

is doing well, the stocks price is expected to be $40; this occurs with a (real-world) prob-

ability of 60%. However, if the economy goes into a recession, the price is only $25. We

can illustrate this information as follows:

$30

$25

$40

60%

40%

Our aim now is to use this information to price, say, a call option on the stock with a

strike price of $30 and a time to maturity of 1 year. Recall that, if S

1

denotes the stocks

price at time 1, then the payoff of the call at time 1 is given by max(S

1

30, 0). Using the

information on the stock, we once again illustrate the calls payoffs as follows:

$0

$10

60%

40%

The expected cash owat time 1 is 0.610+0.40 = $6. The value of the call option is thus

the present value of $6, that is, 6(1 +r

C

)

1

, where r

C

is the required annual effective rate

of return on the stock, a rate that is commensurate with the risk of the call option. If we

were dealing with a stock, we can possibly use the CAPM or APT model to calculate the

required return on the stock (essentially, adjust the risk-free rate of return by adding a

risk premium) and then use this to discount the stocks cash ows. However, we do not

have such models for nding the required return on options.

Another problem with this approach is the idea of the real-world probabilities. There

may be no consensus as to what these probabilities should be. One can try to estimate

them based on historical data but at the same time, how long a window should be used?

1

We now look at another means of pricing this option.

In our rst method, we rst found the expected cash ow using the real-world probabil-

ities and then adjusted for risk, by discounting using an appropriate adjusted rate of

return (base risk-free rate + risk premium) . What if we could instead rst adjust the

probabilities for risk, and use a single undajusted discount rate, namely, the risk-free

rate (which can possibly be estimated using Treasury securities). This is what is com-

monly referred to as risk-neutral pricing. The adjusted probabilities are referred to as

risk-neutral probabilities, because they are adjusted in such a manner that the expected

rate of return on all securities equals the risk-free rate.

It is very important to note that the risk-neutral probabilities are not real-world proba-

bilities. Think of an alternate world/dimension where all investors are risk-neutral and

as a result, all assets yield the risk-free rate; yet, the prices of the assets are the same as

what we observe in this world.

The risk-neutral pricing process seems to be more elegant but the question that now

arises is how do we go about nding these so-called risk-neutral probabilities? Well, lets

try to motivate it in an intuitive manner. For now, forget about probabilities and discount

rates. The pricing process assumes the absence of arbitrage opportunities in the market.

This implies that any two securities with the same payoffs must have the same price. We

also assume that the market is perfect.

Lets denote the annual effective risk-free rate of return by r and lets suppose that we

can borrow/lend at the risk-free rate. Recall that the evolution of the stock price over 1

year was as follows:

S0 = $30

Sd = $25

Su = $40

Furthermore, the calls payoffs at time 1 were as follows:

Cd = $0

Cu = $10

Under the assumption that arbitrage opportunities do not exist, lets try to construct a

portfolio using the stock and a risk-free bank account that mimics the possible payoffs

of the call option at time 1 (such a portfolio is usually referred to as a replicating portfo-

lio). If we can do so, then the price of this portfolio must equal the price of the call option.

Suppose that at time 0, we hold shares of stock and invest an amount of money

(measured dollars) in the bank account earning the risk-free rate. The possible payoffs of

the portfolio at time 1 is as follows:

2

Sd + (1 +r)

Su + (1 +r)

If we want to mimic the payoffs at time 1, then we must have

S

u

+ (1 +r) = C

u

S

d

+ (1 +r) = C

d

Solving, we have

=

C

u

C

d

S

u

S

d

=

2

3

and

=

1

1 +r

_

C

u

C

u

C

d

S

u

S

d

S

u

_

=

1

1 +r

C

d

S

u

C

u

S

d

S

u

S

d

=

1

1 +r

50

3

.

Then the price of the replicating portfolio is given by (its time-0 value)

S

0

+ =

C

u

C

d

S

u

S

d

S

0

+

1

1 +r

_

C

u

C

u

C

d

S

u

S

d

S

u

_

which, when simplied, can be written as

1

1 +r

_

(1 +r) S

0

S

d

S

u

S

d

C

u

+

S

u

(1 +r)S

0

S

u

S

d

C

d

_

This is the no-arbitrage price of the call option. Let q =

(1+r)S

0

S

d

S

u

S

d

. Note that 0 < q < 1 iff

S

d

< S

0

(1 +r) < S

u

(Well get back to this condition later.)

Then the price of the option can be written as

1

1 +r

[q C

u

+ (1 q) C

d

]

Assuming that 0 < q < 1, the above expression for the price looks like the expected present

value of the time-1 payoff of the call option. The discount rate is r, the risk-free rate and we

can viewq and 1 q as probabilities. These are actually the risk-neutral probabilities and they

arise through our no-arbitrage pricing argument. Note that we have not used the real-world

probabilities at any point in this method.

In this course, we will rst do an overview of options and other derivative securities. Af-

ter, well move on to some discrete-time models and then to continuous-time models. As for

the latter, some sub-topics include Brownian motion, stochastic integrals, Its lemma and the

Black-Scholes model.

3

2 Derivatives Overview

A derivative security a simply a security whose value/price depends on (or is derived from)

some underlying asset (e.g. stock, bond, currency, commodity, etc).

Before we proceed to discuss some examples of derivatives, lets recall the idea of taking a long

or short position.

Consider a stock. If party A has a long position in the stock, then A has purchased shares of

the stock and will prot if the stock increases in value. On the other hand, if party B has a

short position in the stock, this implies that B has sold shares of stock that B does not actually

own, and will prot if the stock decreases in value. It is usually more difcult to understand

what it means to have a short position in a stock so well elaborate some more.

Suppose you believe that the stock price will decrease in the future (speculation) and think

you can prot from this. You go to your broker and ask to borrow a share of stock, with the

promise to return it in, say, 1 year. This share of stock may come fromthe brokers inventory or

from one of its customers. You sell the stock at the current market price. If your belief (that the

stock price will fall) is correct, then you will make a prot on this investment when you buy

the stock in 1 year (at the lower price) and return it to the broker. On the other hand, if stock

prices increase, then you will end up making a loss when you purchase the stock in 1 year (at

the then-higher price). It is important to note that since you do not own the stock that you

are selling, the stocks lender (the original owner) is entitled to any benets (e.g. dividends)

he/she would have received had he still owned the stock. For example, if a dividend was paid

during the 1-year period, you will need to pay the amount of the dividend to the lender.

Now, with respect to options, a person with a short position is the seller/writer of the option

whereas a person with a long position is the buyer of the option.

2.1 Forwards and Futures Contracts

A forward contract is an obligation to buy/sell an underlying asset at some specied

time (the expiration date) in the future, at a price set today (called the forward price).

The buyer will pay the seller at the time of delivery of the asset.

Forward contracts are private agreements and bear credit (default) risk in the sense that

the parties may not carry through with their obligations.

A futures contract can be thought of as an exchange-traded forward contract. Some

differences from forward contracts include:

Since futures contracts are traded on an exchange, they are standardized agreements

and are as such, are not as customizable as forward contracts. However, they are

more liquid than forward contracts.

Futures contracts bear lower credit risk since they are marked-to-market daily to

reect changes in the settlement price. For example, suppose party A entered into

a futures contract and agrees to sell party B 20 oz of gold in 6 months at $500 per

4

oz (the futures or settlement price). Both A and B would provide margins, which is

collateral in the form of cash. Suppose that one day after entering the contract, the

price of gold increased to $510 per oz. Having a short position in the contract, A

will lose $10 per oz (because A is obliged to sell at $500 but the market selling price

is $510) for a total of $10 20 = $200. This amount is withdrawn from As margin

account and deposited into Bs margin account. This occurs daily and is what is

referred to as marking-to-market. At the end of the 6 month period, lets suppose

that the price remained at $510 per oz. Futures contracts usually are settled in cash

and each party purchases the commodity themself. In this case, the higher selling

price of $510 per oz offsets the loss of $200 (as above) that party A suffers, resulting

in a net selling price of $500 per oz. On the other hand, the gain of $200 that party B

receives offsets the higher price of $510 per oz, so that the net purchase price is $500

per oz.

Delivery and receipt of the underlying asset at the expiration date for the pre-

specied price occurs frequently in forward markets but this is not the case in fu-

tures markets. In fact, delivery hardly occurs in the futures markets. Typically, the

long (respectively short) position in the futures contract is closed off before maturity

by taking a short (respectively long) position in a similar futures contract.

The payoff for a forward contract is its value at expiration:

Long forward = Spot price at expiration Forward price

Short forward = Forward price Spot price at expiration

where the spot price is the market price of the underlying asset at expiration and the

forward price is the price set today.

The payoff diagram for forwards:

5

For a forward contract, since there is zero initial cash ow, the prot for the contract

equals the payoff.

2.2 Call and Put Options

A call (respectively put) option gives the owner the right (but not the obligation) to buy

(respectively sell) an underlying asset at or before a pre-specied time (maturity or expi-

ration date) for a price set today (called the strike or exercise price).

Types:

European - only able to exercise at the expiration date.

American - able to exercise at any time before expiration.

Bermudan - able to exercise during specied periods.

With the forward contract, the initial price was zero and we were exposed to both the

upside and the downside. Call and put options allow us to keep the upside potential

while eliminating the downside. However, this comes at a premium.

The payoff of a purchased call option (long position) is given by

Payoff = max(Spot price at expiration Strike price, 0)

and the prot, measured as the value at expiration of all cash-ows, is given by

Prot = Payoff Future Value at Expiration of Call Premium

The payoff and prot diagrams are as follows:

6

The payoff of a written call option (short position) is given by

Payoff = max(Spot price at expiration Strike price, 0)

and the prot is given by

Prot = Payoff + Future Value at Expiration of Call Premium

The payoff and prot diagrams are as follows:

The payoff of a purchased put option (long position) is given by

Payoff = max(Strike price Spot price at expiration, 0)

and the prot is given by

Prot = Payoff Future Value at Expiration of Put Premium

The payoff and prot diagrams are as follows:

7

The payoff of a written put option (short position) is given by

Payoff = max(Strike price Spot price at expiration, 0)

and the prot is given by

Prot = Payoff + Future Value at Expiration of Put Premium

The payoff and prot diagrams are as follows:

8

3 Financial Forwards and Futures Contracts

The prices of futures may differ from those of similar forwards because of the way the

loss is funded. With forward contracts, the loss is funded at the expiration date. How-

ever, with futures contracts, the loss is funded on a daily basis through the marking-

to-market process. For short-term contracts, the difference in price difference is usually

small but this may not be the case for long-term contracts. In this chapter, we will ignore

the difference between the forwards and futures contracts and only consider forward

contracts.

Recall that a forward contract allows us to guarantee today a price for a future pur-

chase/sale.

For now, lets consider the sale/purchase of a single share of stock.

There are 4 different ways of purchasing this stock:

Outright purchase - Pay for and receive the stock at time 0. This results in a pay-

ment of S

0

at time 0.

Fully leveraged purchase - Borrow an amount of S

0

at time 0 at the (continuously

compounded) risk-free rate r and purchase the stock, with the promise to pay off

the loan at time T. This results in a payment of S

0

e

rT

at time T.

Prepaid forward contract - You pay for the stock at time 0 and receive it at some

specied date in the future.

Forward contract - Both the payment for the stock and the change of ownership take

place at some specied date in the future, at a price set today.

We will look at pricing the above prepaid forward and forward contracts for stocks with

no dividends,

discrete dividends,

continuous dividends.

If we can nd the price of the prepaid forward contract, then the price of the forward

contract is simply the future value of the prepaid forwards price.

Consider a horizon of T years and assume that the risk-adjusted discount rate is . De-

note the prepaid forward price by F

P

0,T

, the forward price by F

0,T

and the stock price at

time t by S

t

.

9

3.1 Prepaid Forward Contract (No Dividends)

Pricing by analogy

Recall that we are paying for the stock today and receiving it at time T.

Ownership changes hands at time T.

If no dividends will be paid over (0, T), it does not make a difference whether the

stock is delivered (ownership changes hands) at time 0, at time T or at any time in

(0, T).

Therefore, the price of the prepaid forward contract should be F

P

0,T

= S

0

, the time-0

value of the stock.

Pricing by discounted present value

The price of the prepaid forward contract should be the expected present value of

the time-T stock price.

At time 0, the expected value of the time-T stock price is E

0

(S

T

). Therefore, the

price should be equal to

F

P

0,T

= e

T

E

0

(S

T

)

where we discount by the appropriate risk-adjusted rate.

The question that now arises is: What is E

0

(S

T

), the time-0 expected value of the

time-T stock price? Well, if S

0

is the current (time-0) price and is the expected

rate of return (continuously compounded yield) on the stock, then we should have

E

0

(S

T

) = S

0

e

T

.

Therefore, F

P

0,T

= S

0

.

Pricing by arbitrage

Consider a strategy where we outright purchase a share of stock for S

0

and sell a

prepaid forward contract at F

P

0,T

.

10

Cash Flows

Transaction Time 0 Time-T

Buy Stock S

0

S

T

Sell Prepaid Forward F

P

0,T

S

T

Net Cash Flow F

P

0,T

S

0

0

If we had F

P

0,T

> S

0

, then one would be able to prot on this investment without

taking any risk (arbitrage opportunity). The initial cash-inow is positive with no

obligations in the future. On the other hand, F

P

0,T

< S

0

, we can reverse the trans-

actions in the above strategy to obtain a risk-free prot. Therefore, we must have

F

P

0,T

= S

0

.

3.2 Prepaid Forward Contract (Dividends)

What if the stock now pays dividends? What should be the appropriate prepaid forward

price in this case? Should we have F

P

0,T

= S

0

, F

P

0,T

> S

0

or F

P

0,T

< S

0

?

Think about it for a second:

You pay for the stock at time 0 but will receive it at time T.

Throughout that time, the stock paid dividends to the original owner of the stock

and not to the holder of the prepaid contract.

You will now be receiving a stock at time T whose price has decreased more or less

by the amount of the dividends (ignoring the time value of money).

Now, which of the above inequalities should hold? We should indeed have F

P

0,T

<

S

0

!

For a stock that pays dividends, we should have

F

P

0,T

= S

0

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

To see this, consider (once again) a strategy where we outright purchase a share of stock

for S

0

and sell a prepaid forward contract at F

P

0,T

. This case differs from the previous one

11

in that we now receive dividends.

Cash Flows

Transaction Time 0 Time-T

Buy Stock S

0

S

T

Sell Prepaid Forward F

P

0,T

S

T

Receive Dividends PV (all dividends paid from t = 0 to t = T) 0

Net Cash Flow F

P

0,T

S

0

+PV (all dividends paid from t = 0 to t = T) 0

where for simplicity, we assume that, at time 0, a single equivalent dividend cash-ow

of PV (all dividends paid from t = 0 to t = T) is made.

For discrete dividends D

t

j

at times t

j

, j = 1, 2, . . . , n, we have

F

P

0,T

= S

0

j=1

PV

0,t

j

(D

t

j

)

where PV

0,t

j

denotes the time-0 value of a cash-ow at t

j

.

For continuous dividends with an annualized continuous yield of , we have

F

P

0,T

= S

0

e

t

(1)

Lets reason this one out:

Suppose we own 1 share of stock at time 0.

At the of 1 day, the stock pays a dividend equal to

365

(Current Stock Price).

We take this dividend and purchase

365

shares of stock so that we nowhave

_

1 +

365

_

shares of stock.

12

Continue in this manner for the rest of the year. At the end, we will have

_

1 +

365

_

365

shares of stock.

At the end of T years, we would then have approximately e

T

shares of stock.

Consider (once again) the same strategy, where we outright purchase a share of stock for

S

0

and sell a prepaid forward contract at F

P

0,T

. We have

Cash Flows

Transaction Time 0 Time-T

Buy Stock (and reinvest dividends) S

0

e

T

S

T

Sell Prepaid Forward F

P

0,T

S

T

Net Cash Flow F

P

0,T

S

0

S

T

_

e

T

1

_

We can continue in this manner to arrive at our answer but theres an easier way. Lets

try to offset the effect of the continuous dividends by instead outright purchasing e

T

shares of stock. This is called tailing our position. At time T, we would have 1 share of

stock. Overall, our strategy here is to outright purchase e

T

shares of stock and sell a

prepaid forward contract at F

P

0,T

. We have

Cash Flows

Transaction Time 0 Time-T

Buy Stock (and reinvest dividends) e

T

S

0

S

T

Sell Prepaid Forward F

P

0,T

S

T

Net Cash Flow F

P

0,T

S

0

e

T

0

13

Using an arbitrage argument, we have F

P

0,T

= S

0

e

T

.

Example 1. A stock costs $100 today and is expected to pay a quarterly dividend of $1. If the

(continuously compounded) risk-free rate is 10%, what is the price of a 1-year prepaid forward?

(Assume that dividends can be reinvested at the risk-free rate.)

Example 2. A stock index is currently $100 with a continuously compounded dividend yield is

5%. What is the price of a 1-year prepaid forward?

3.3 Pricing Forwards on Stocks

Recall that the forward price, F

0,T

is simply the future value of the prepaid forwards

price, F

P

0,T

. We assume that we can lend/borrow at the risk-free rate r. Then we have

F

0,T

= F

P

0,T

e

rT

and the following cases:

For a stock paying no dividends,

F

0,T

= S

0

e

rT

For a stock paying discrete dividends,

F

0,T

= S

0

e

rT

j=1

e

r(Tt

j

)

D

t

j

For a stock paying continuous dividends,

F

0,T

= S

0

e

(r)T

Example 3. Let F

1

and F

2

be the forward prices of the same underlying stock with time to ma-

turity T

1

and T

2

respectively, where T

1

< T

2

, and let r be the annual continuously compounded

risk-free interest rate. If F

2

> F

1

e

r(T

2

T

1

)

, then an arbitrage opportunity exists. Provide one.

14

Sometimes, you may be given the forward premium, which is dened as the ratio of the

current forward price to the current stock price, i.e.

F

0,T

S

0

. If you are given the forward

premium and the forward price, you can gure out the current stock price. Sometimes,

you may be given the annualized forward premium which is calculated as

1

T

ln

_

F

0,T

S

0

_

Sometimes, one can offset the risk of a forward contract by creating a synthetic forward.

Lets take for example a short forward (assume no dividends).

Its payoff at the expiration date is F

0,T

S

T

.

We want to completely offset this position. That is, we want an asset that will mimic

a long forward, one that will pay S

T

F

0,T

at time T, where F

0,T

= S

0

e

rT

.

Well, this payoff can be obtained by borrowing S

0

at time 0 at the risk-free rate

(continuously compounded) and using the money to purchase 1 share of stock at

time 0. We have

15

Cash Flows

Transaction Time 0 Time-T

Borrow S

0

S

0

S

0

e

rT

Buy 1 share of stock S

0

S

T

Net Cash Flow 0 S

T

S

0

e

rT

which is exactly the payoff of a long forward.

The key here is to realize that:

Forward = Stock Zero-coupon Bond

Example 4. How would you create a long synthetic forward for a stock paying continuous divi-

dends? Show that the payoff of the synthetic forward is the same as that of a long forward.

We will now look at currency forward contracts.

16

3.4 Currency Contracts

Currency Prepaid Forward

Suppose $x

0

USD is worth $1 CAD, and r

c

is the CAD-denominated risk-free inter-

est rate.

Suppose we want to purchase $1 CAD (foreign) T years from today using USD (do-

mestic).

Then the price of the T-year prepaid forward is

F

P

0,T

= x

0

e

r

c

T

To see this, suppose we purchased $e

r

c

T

CAD today using USD and reinvested

it at the risk-free rate r

c

. We would pay x

0

e

r

c

T

USD. Suppose we sell the above

prepaid forward contract (on CAD). We have

Cash Flows

Transaction Time 0 Time-T

Buy $e

r

c

T

CAD and reinvest x

0

e

r

c

T

USD 1 CAD

Sell Prepaid Forward F

P

0,T

1 CAD

Net Cash Flow F

P

0,T

x

0

e

r

c

T

0

So the factor e

r

c

T

adjusts the price for interest lost on the CAD since the $1 CAD is

only received at time T.

Currency Forward

Let r

u

be the USD-denominated risk-free interest rate.

Then the price of the T-year forward is

F

0,T

= x

0

e

(r

u

r

c

)T

Similar to that for the forward on stocks, we can create a synthetic currency forward by

borrowing in one currency and lending in another.

17

4 Options: Parity and Other Relationships

4.1 Put-Call Parity

Assume that the continuously compounded risk-free rate is r.

Recall the put-call parity for European options with the same strike/exercise price, K

and time to expiration, T:

Call Price Put Price = PV

0,T

(Forward Price Strike Price)

C(K, T) P(K, T) = PV

0,T

(F

0,T

K)

Remark: Think of the forward price as the fair price (determined at time 0) for selling

the underlying asset at time T. Suppose we buy a call and sell a put, each with a strike

price K. This is equivalent to selling the underlying asset at time T, at a price K set to-

day. If K equals F

0,T

, the forward (fair) price, then the net premium is zero as we have

created a synthetic forward. Any choice for K other than the forward price will result in

a non-zero premium.

Recall that, for stocks,

F

P

0,T

= PV

0,T

(F

0,T

) = S

0

PV

0,T

(Dividends)

Therefore, the put-call parity equation for options on stocks becomes

C(K, T) P(K, T) = S

0

PV

0,T

(Dividends +K)

Using the above equation, we can create the following synthetic securities:

1. Synthetic Stock

Buy a call, sell a put, and lend the present value of the strike price plus divi-

dends

2. Synthetic Call Option

Buy a share of stock, buy a put, and borrow the present value of the strike

price plus dividends

3. Synthetic Put Option

Sell a share of stock, buy a call, and lend the present value of the strike price

plus dividends

4. Synthetic T-bill (also called a Conversion)

Buy a share of stock, sell a call, and buy a put

18

Remark: If an arbitrage opportunity exists, then one could create the synthetic T-bill

above and earn a return higher than the risk-free rate. In reality, if transaction costs

are low and the put-call parity equation is not satised, then one may be able to

make an arbitrage prot. However, if the equation is satised, then one is better off

purchasing a T-bill in order to reduce transaction costs.

4.2 Generalized Put-Call Parity

Instead of having a strike price, use a strike asset, which may be cash, a bond, a dif-

ferent stock, etc. At the expiration date, the strike asset is exchanged in return for the

underlying asset.

Let S

T

and Q

T

denote the respective prices of the underlying asset A and strike asset B

as at the expiration date.

Then at some time t (0 t T), we have the following parity equation:

C(S

t

, Q

t

, T t) P(S

t

, Q

t

, T t) = F

P

t,T

(S) F

P

t,T

(Q)

where

C(S

t

, Q

t

, T t) is the price of a European call with underlying asset A, strike asset

B, and time to expiration T t,

P(S

t

, Q

t

, T t) is the price of a European put with underlying asset A, strike asset

B, and time to expiration T t,

F

P

t,T

(S) is time-t price of a prepaid forward contract on A, paying S

T

at time T, and

F

P

t,T

(Q) is time-t price of a prepaid forward contract on B, paying Q

T

at time T.

19

Cash Flows

Transaction Time 0 Time-T

S

T

Q

T

S

T

> Q

T

Buy Call C(S

t

, Q

t

, T t) 0 S

T

Q

T

Sell Put P(S

t

, Q

t

, T t) S

T

Q

T

0

Sell Prepaid Forward on A F

P

t,T

(S) S

T

S

T

Buy Prepaid Forward on B F

P

t,T

(Q) Q

T

Q

T

Net Cash Flow C(S

t

, Q

t

, T t) +P(S

t

, Q

t

, T t) 0 0

+F

P

t,T

(S) F

P

t,T

(Q)

4.3 Properties of Option Prices

Recall that an European option can be exercised only at the expiration date whereas an

American option can be exercised at any time before expiration. Therefore, an American

option must be at least as valuable as an otherwise identical European option:

C

Amer

(S, K, T) C

Euro

(S, K, T)

P

Amer

(S, K, T) P

Euro

(S, K, T)

Recall the parity equation:

C(S, K, T) P(S, K, T) = PV

0,T

(F

0,T

) PV

0,T

(K)

Bounds on call option prices:

The price cannot be negative.

20

As per the parity equation,

C(S, K, T) PV

0,T

(F

0,T

) PV

0,T

(K)

The call price should not exceed the stock price (since the payoff is max(S

T

K, 0)

S

T

)

Therefore, we must have

S

0

C

Amer

(S, K, T) C

Euro

(S, K, T) max (0, PV

0,T

(F

0,T

) PV

0,T

(K))

Bounds on put option prices:

The price cannot be negative.

As per the parity equation,

P(S, K, T) PV

0,T

(K) PV

0,T

(F

0,T

)

The put price should not exceed the strike price (since the payoff is max(KS

T

, 0)

K)

Therefore, we must have

K P

Amer

(S, K, T) P

Euro

(S, K, T) max (0, PV

0,T

(K) PV

0,T

(F

0,T

))

Remark: A better upper bound would be the present value of the strike price, i.e. Ke

rT

(instead of K).

Early exercise:

With American call options, at any time, we can either hold onto it, sell it for

C

Amer

(S, K, T), or exercise it for S

t

K.

For stocks with no dividends, we have

C

Amer

(S, K, T) S

t

K

implying that an American call option with no dividends should never be exercised

early.

21

If the stock pays dividends, it may be optimal to exercise early.

For American put options, regardless of whether the stock pays dividends or not, it

may be optimal to exercise early.

Time to expiration:

An American option is at least as valuable as an otherwise identical option with less

time to expiration.

A European call option on a non-dividend paying stock is at least as valuable as an

otherwise identical option with less time to expiration.

European call options on dividend-paying stock and European puts may be less

valuable than an otherwise identical option with less time to expiration.

The effect of strike prices (for both European and American options):

Suppose K

1

< K

2

< K

3

.

The call price is a decreasing function of the strike price whereas the put price is an

increasing function:

C(K

1

) C(K

2

)

P(K

2

) P(K

1

)

(Slope) The premium difference between otherwise identical calls/puts with differ-

ent strike prices cannot be greater than the difference in strike prices:

C(K

1

) C(K

2

) K

2

K

1

P(K

2

) P(K

1

) K

2

K

1

22

Convexity of Prices:

C(K

1

) C(K

2

)

K

2

K

1

C(K

2

) C(K

3

)

K

3

K

2

P(K

2

) P(K

1

)

K

2

K

1

P(K

3

) P(K

2

)

K

3

K

2

Example 5. (Exercise 9.9 of the Derivatives Market Textbook) Suppose call and put prices are

given by

Strike 50 55

Call Premium 16 10

Put Premium 7 14

Which no-arbitrage property is violated? What spread position would you use to effect arbitrage?

Demonstrate that the spread position is an arbitrage.

23

Example 6. (Exercise 9.11 of the Derivatives Market Textbook) Suppose call and put prices are

given by

Strike 80 100 105

Call Premium 22 9 5

Put Premium 4 21 24.80

Which no-arbitrage property is violated? What spread position would you use to effect arbitrage?

Demonstrate that the spread position is an arbitrage.

24

4.4 Closing Note

Recall the parity equation:

C(K, T) P(K, T) = PV

0,T

(F

0,T

K) = F

P

0,T

Ke

rT

We can show that this equation holds via a no-arbitrage argument. First, lets write the

equation as

C(K, T) P(K, T) F

P

0,T

+Ke

rT

= 0

and consider a positive sign in each of the terms above as taking a short position in the

respective security

1

, and a negative sign as taking a long position. So given the above

equation, we would need to sell a call, buy a put, buy a prepaid forward contract and

borrow Ke

rT

at the risk free rate. We have

Cash Flows

Transaction Time 0 Time-T

S

T

K S

T

> K

Sell Call C(K, T) 0 (S

T

K)

Buy Put P(K, T) K S

T

0

Buy Prepaid Forward F

P

0,T

S

T

S

T

Borrow Ke

rT

K K K

Net Cash Flow C(K, T) P(K, T) F

P

0,T

+Ke

rT

0 0

and the result follows.

1

You could instead take a negative sign as having a short position and the equation will still hold. This happens

because we have equality.

25

5 Forward Rate Agreements (FRAs) and Swaps - A Short Note

5.1 Term Structure of Interest Rates (Not Covered on Exam - Review Only)

5.1.1 Yield Curves

We have learnt howto nd the price of a bond given the coupon rate, redemption amount

and desired yield rate. We want to look briey now at how yields are determined.

In short, at the time of issue, the terms of the bond (maturity date, coupon and redemp-

tion amount) are set in advance and the price paid is determined by investors (the mar-

ket). Then, given these quantities, the yield can be determined.

Now, lets expand on the above point. The federal government (in Canada and the U.S.)

issues bonds through a central banking system (U.S. Treasury, Bank of Canada). Corpo-

rations and municipal governments typically issue bonds through an investment banker.

To understand how the yields are determined, we will consider U.S. government bonds

where bonds are issued via an auction. The types of securities at this auction may include

Treasury bills (maturity of less than a year), Treasury notes (maturity between 1 and 10

years) and Treasury bonds (maturity between 10 and 30 years).

The government will indicate how much money it would like to borrow.

Then investors will submit their bid: how much of the total debt they would like to

purchase and the price they are willing to pay per $100 of par value.

The price paid for the bond per $100 of par value is given by the maximumbid price

such that the government raises all the money if asked for.

Now, given the terms of the bond and the price paid, the investor can now calcu-

late the bonds yield. For more information, please visit http://edfriendly.

blogspot.ca/2011/03/how-do-treasury-auctions-work.html.

The term structure of interest rates refers to the relationship between yield rates and the

term of the investment (time to maturity). The graph that displays this relationship is

often called a yield curve.

While the most common yield curve is one that involves Treasury securities, a yield curve

can be created for any type of xed income security. It is important to note that each yield

curve should only consider bonds of similar risk.

As we saw above, the bonds price and consequently the yield is inuenced by supply

and demand. We can possibly have normal (upward sloping), inverted, or at yield

curves.

26

5.1.2 Spot Rates and Forward Rates

We tend to assume that the interest/yield rate does not depend on the length of the in-

vestment, which is not the case in reality (as can be seen from the yield curve). We will

now look at a more realistic way of pricing securities.

Let P(0, t) denote the price of a t-year zero coupon bond with a face value of $1.

The t-year spot rate, r(0, t) is dened as the effective annual rate of interest/return on

the t-year zero coupon bond. Therefore, we have

P(0, t) = [1 +r(0, t)]

t

Equivalently, it can be interpreted as the interest rate for borrowing/lending over the

next t years.

Example 7. You are given the following information on four zero coupon bonds:

Bond Time to Maturity (in years) Price

1 1 $96.618

2 2 $92.456

3 3 $87.63

4 4 $82.27

Assume that each bond has face value F = 100. Compute the annual effective spot rates s

1

, s

2

,

s

3

and s

4

.

Solution: We have

s

1

= 0.035

s

2

= 0.04

s

3

= 0.045

s

4

= 0.05

We can also use these spot rates to compute the price of a xed income security

2

. For

example, the price of a security with cash ows of A

t

at time t, t = 1, 2, . . . , n is given by

n

t=1

A

t

[1 +r(0, t)]

t

To see this, decompose the security into a series of zero coupon bonds (zcbs):

Zcb 1: Maturity of 1 year and face value A

1

Zcb 2: Maturity of 2 years and face value A

2

2

We will assume that the xed income security has similar risk to the zero coupon bonds from which the spot

rates were derived.

27

Zcb 3: Maturity of 3 years and face value A

3

.

.

.

Zcb n: Maturity of n years and face value A

n

Then the sum of the prices of the n zcbs will give the above expression.

Example 8. Determine the price of a 4 year $1000 bond with 5% annual coupons using the spot

rates from the previous example.

Solution: The price is

4

k=1

50 [1 +r(0, k)]

k

+ 1000[1 +r(0, 4)]

4

= 1002.187

Remark: The t-year spot rate is the expected/actual rate of return on an investment

where the investor invests money at time 0 and only receives a cash-ow at time t (there

are no cash ows during the investment period). The yield rate, on the other hand, is the

expected rate of return on an investment which may or may not have cash ows during

the investment period.

Example 9. You are given the following data about bonds with a face value of $1,000 and annual

coupons (if applicable):

Maturity (in years) Coupon Rate Yield to maturity

1 0 0.03

2 0.05 0.04

3 0.04 0.05

Compute the implied annual effective spot rates s

1

, s

2

and s

3

.

We have r(0, 1) = 3%. Now, the price of the 2-year bond is

P(0, 2) =

50

1.04

+

1050

1.04

2

= 1018.8609

Then r(0, 2) is such that

P(0, 2) =

50

1 +r(0, 1)

+

1050

[1 +r(0, 2)]

2

Solving, we have r(0, 2) = 0.0403.

Finally, the price of the 3-year bond is

P(0, 2) =

40

1.05

+

40

1.05

2

+

1040

1.05

3

= 972.7675

28

Then s

3

is such that

P(0, 3) =

40

1 +r(0, 1)

+

40

[1 +r(0, 2)]

2

+

1040

[1 +r(0, 3)]

3

Solving, we have r(0, 3) = 0.0506.

The forward rate, r(t, t + k) is dened as the effective annual rate of interest over the

period [t, t +k] (where k > 0):

[1 +r(t, t +k)]

k

=

[1 +r(0, t +k)])

t+k

[1 +r(0, t)]

t

Rearranging, we have

[1 +r(0, t +k)]

t+k

= [1 +r(0, t)]

t

[1 +r(t, t +k)]

k

We sometimes refer to r(t, t +k) as the t-year deferred k-year forward rate.

5.2 Forward Rate Agreements (FRAs)

Suppose a borrower would like to hedge against increases in the interest rate. One way

to do so is via a forward rate agreement (FRA). FRAs are essentially cash-settled forward

contracts on the interest rate. They guarantee a borrowing/lending rate, r

FRA

on a given

notional amount.

Suppose you would like to borrow $1M (notional amount of principal) for 3 months,

beginning in 1 year. Then we can take a long position (purchase) in a FRA and lock in

the implied forward rate over (1, 1.25). If the FRA is settled in arrears (at time 1.25, the

time of repaying the loan), then the payment to the borrower at time 1.25 would be

(r

quarterly

r

FRA

) notional amount

. .

=$1M in this example

where r

quarterly

is the actual quarterly interest rate over (1, 1.25) (known only at time 1).

If instead the FRA is settled at the time of borrowing (at time 1), then the payment to the

borrower at time 1 would be

(r

quarterly

r

FRA

)

1 +r

quarterly

notional amount

5.3 Swaps

A swap is a contract calling for an exchange of payments, on one or more dates. It pro-

vides a means of hedging a stream of risky payments.

29

Asingle-payment swap is the same thing as a cash-settled forward contract. On the other

hand, a multi-payment swap turns out to be the same thing as multiple forward contracts

coupled with borrowing and lending money.

The market value of the swap is initially zero. Usually, for multi-payment swaps, the

swap price will be level each year. Lets look at an example.

Example 10. (Commodity Swap) The forward prices on a barrel of crude oil are $40 and $45 in

years one and two respectively. The annual interest rates on zero-coupon government bonds are

4% and 5% for one-year and two-year bonds respectively. What is the two-year swap price on a

barrel of crude oil?

In this example, we obtained a swap price of 42.4271. Therefore, compared to the for-

ward prices, we are overpaying by 2.4271 in the rst year, and underpaying by 2.5729 in

the second.

You can think of us as lending $2.4271 at time 1 and receiving $2.5729 at time 2. The

implied interest rate is

2.5729

2.4271

1 = 0.0601

which (you can check this!) is equal to the implied forward rate from 1 to 2. It suggests

that you can create a synthetic swap by taking a long position in 1- and 2-year forward

contracts and by lending $2.4271 at the 1-year deferred 1-year forward rate (maybe using

an FRA).

Interest rate swaps also exist where you can swap a oating interest rate (e.g. LIBOR)

with a xed rate. Assuming that the xed swap rate is R, then the fair value of R is

such that

n

i=1

P(0, t

i

)[R r(t

i1

, t

i

)]

where we have payments at times t

i

, i = 1, 2, . . . , n.

Additionally, we also have securities called swaptions which are options to enter into a

swap contract (with pre-specied terms). Note that, because we now have this option, a

swaption will have a premium.

30

6 Binomial Option Pricing

Our objective is to price an option given the evolution of the underlying assets price over time.

For now, the model for the assets price will be discrete. One such model is the binomial model,

also sometimes called the Cox-Ross-Rubinstein model, which assumes that in each period, the

underlying assets price can only increase or decrease by some specifed amount.

At the beginning of each period, think of us as ipping a coin, and

if the result is a head (H), the assets price will increase, or

if the result is a tail (T), the assets price will decrease.

6.1 The One-Period Binomial Tree

Lets consider an example (similar to the introductory example) where we have a stock

with an initial value of S

0

= $30. After 1 year, the stock price will either

increase to S

u

= uS

0

= 1.1S

0

= $33, or

decrease to S

d

= dS

0

= 0.9S

0

= $27, or

Assume that the stock pays no dividends.

We have the following diagram showing the following possible prices after 1 year:

S0 = $30

Sd = dS0 = $27

Su = uS0 = $33

Our aim now is to use this information to price, say, a call option on the stock with a

strike price of $30 and a time to maturity of 1 year. Recall that, if S

1

denotes the stocks

price at time 1, then the payoff of the call at time 1 is given by max(S

1

30, 0). Using the

information on the stock, we once again illustrate the calls payoffs as follows:

Cd = $0

Cu = $3

Assume that we are able to borrow/lend at the continuously compounded risk-free rate,

r = 5%.

Assuming no arbitrage opportunities, we construct a replicating portfolio using the

stock and a risk-free bank account. The portfolio will re-create the possible payoffs

of the call option at time 1. If we can do so, then the price of this portfolio must equal the

price of the call option.

31

Suppose that at time 0, we hold shares of stock and invest an amount of money B

(measured in dollars) in the bank account earning the risk-free rate (or money market).

The possible payoffs of the portfolio at time 1 is as follows:

dS0 +Be

r

uS0 +Be

r

If we want to re-create the calls payoffs at time 1, then we must have

uS

0

+Be

r

= C

u

dS

0

+Be

r

= C

d

Solving, we have

=

C

u

C

d

S

0

(u d)

= 0.5

and

B = e

r

[C

u

uS

0

] = e

r

_

C

u

C

u

C

d

S

0

(u d)

uS

0

_

= 12.8416

Therefore, our replicating portfolio for the call option can be constructed by

buying = 0.5 shares of stock, and

borrowing $12.8416 at the risk-free rate r for 1 year.

Note that is called the delta of the option; it is the number of shares required to repli-

cate the options payoff.

Then the price of the replicating portfolio is given by (its time-0 value)

S

0

+B =

C

u

C

d

S

0

(u d)

S

0

+e

r

_

C

u

C

u

C

d

S

0

(u d)

uS

0

_

which, when simplied, can be written as

e

r

_

e

r

d

u d

C

u

+

u e

r

u d

C

d

_

This is the no-arbitrage price of the call option. Let q =

e

r

d

ud

and write the price of the

option as

e

r

[q C

u

+ (1 q) C

d

]

32

The above expression for the price now looks like the expected present value of the time-

1 payoff of the call option. If it is really an expected present value, then we must have

0 < q < 1 (that is, q must be a probability). In order for this to happen, we need

d < e

r

< u

This is called the no-arbitrage condition and when it is satised, the probabilities q and

1q are called risk-neutral probabilities. The price of the option is the expected present

value of the options payoffs under the risk-neutral probability measure.

Remark: If e

r

> u, then the return on the risk-free account would always exceed that on

the stock. Investors would short sell the stock and invest in the money market to make

an arbitrage prot. On the other hand, if e

r

< d, then the stock will always offer a return

higher than the risk-free rate. In this case, investors would borrow money at the risk-free

rate and purchase (long) shares of stock to make an arbitrage prot.

Example 11. Suppose we have the following one-period binomial model for the stock price over a

period of length h:

S0

dS0

uS0

Assume that the stock pays dividends at a continuous annualized dividend yield of . Consider a

call option which matures at time h. The payoff at time h is C

u

if S

h

= uS

0

and C

d

otherwise.

1. Assuming a continuously compounded risk-free rate r, show that the no-arbitrage price of

this call option is

C

0

= S

0

+B

where

= e

h

C

u

C

d

S

0

(u d)

and B = e

rh

uC

d

dC

u

u d

.

2. Determine the risk-neutral probabilities and the no-arbitrage condition.

33

Remarks:

We can replicate the payoffs of either a call or put option under the binomial model

by purchasing shares of stock and investing an amount of money B at the risk-

free rate.

If the option is a call option, then we would have > 0 and B < 0. That is, we

would purchase (long) shares of stock and borrow an amount of money |B| at

the risk-free rate.

If the option is a put option, then we would have < 0 and B > 0. That is,

we would sell (short) shares of stock and lend an amount of money B at the

risk-free rate.

Does this make sense?

34

For the call option and non-dividend paying stock, the delta of the option was equal

to

=

C

u

C

d

S

0

(u d)

=

C

u

C

d

uS

0

..

S

u

dS

0

..

S

d

=

C

u

C

d

S

u

S

d

.

This can be thought of as measuring the sensitivity (slope) of the call price with re-

spect to the stock price.

The replicating portfolio provides us with a synthetic option. Therefore, if an op-

tion is overpriced, we can sell the option and buy a synthetic option (purchase

shares of stock and invest B in the money market) to make an arbitrage prot. On

the other hand, if the option is underpriced, we can purchase the option and sell a

synthetic option (sell shares of stock and borrow B at the risk-free rate) to make

an arbitrage prot.

6.2 Constructing the Binomial Tree

In the last section, you were provided with the binomial model. We just want to talk

briey how we can go about constructing it.

Suppose we are interested in modelling the price of the stock over (t, t +h). It turns out

that the forward price

F

t,t+h

= S

t

e

(r)h

is the expected value of the stock at time t +h under the risk-neutral probabilities.

To model deviations from the expected value, we will use the standard deviation of the

annualized continuously compounded rate of return on the stock, which we denote by

. The evolution of the stock price is as follows:

uS

t

= F

t,t+h

e

+

h

dS

t

= F

t,t+h

e

h

Note that the geometric mean of the possible prices at time t +h is F

t,t+h

. For now, please

take the

The tree constructed using the above equations is sometimes referred to as a forward

tree.

35

6.3 Two or More Periods

Suppose we are interested in pricing a two-year call option. We set time steps of length 1

year in our binomial model. The tree will look as follows:

S0

Sd

Sdd

Sdu

Su

Sud

Suu

The above is called a non-recombining tree.

To simplify our work, we will assume a recombining tree: whether the stock price moves

up and then down, or moves down and then up, we end up with the same price. That is,

S

ud

= S

du

. The tree becomes:

S

0

S

u

S

d

S

uu

S

ud

= S

du

S

dd

Example 12. Assume a non-dividend paying stock with S

0

= 30. Using time steps of length 1

year with u = 1.1 and d = 0.9, construct the binomial tree for the stock price over the next 2 years.

36

To price a European option, we will use a backward recursive method.

Lets insert the call payoffs in the binomial tree:

S

0

S

u

S

d

S

uu

C

uu

S

ud

C

ud

S

dd

C

dd

Consider the upper right binomial tree and nd the time-1 price of the call option,

C

u

using the risk-neutral approach:

u

B

u

C

u

=

u

S

u

+B

u

C

uu

C

ud

Consider the lower right binomial tree and nd the time-1 price of the call option,

C

d

using the risk-neutral approach:

d

B

d

C

d

=

d

S

d

+B

d

C

ud

C

dd

Construct a tree with time-1 cash ows of C

u

and C

d

, and once again, use the risk-

neutral pricing approach to nd the price (time-0 value) of the call option.

37

B

C

0

= S

0

+B

C

u

C

d

Example 13. Continuing from the previous example, nd the price of a European call option

with 2 years to maturity and a strike price of $30. The continuously compounded risk-free rate is

r = 5%.

38

Remarks:

The options delta and B will be different at each node.

Notice that for the call option example above, the calls delta tends to 1 as we move

more into the money.

If we were to price a put option, then the procedure would be the same except that

at the maturity time, we would calculate max(KS

T

, 0) instead of max(S

T

K, 0).

If you repeat the above example for pricing a similar put option, you would notice

that the puts delta tends to -1 as we move more into the money.

39

6.4 American Options

With American options, at each node, the holder of the option can either

exercise the option, or

hold on to the option and possibly exercise it in the future.

The value of the option at time h is thus given by

max(Exercise value at time h, Holding value at time h)

where the holding value at time h is the value at time-h of the portfolio used to replicate

the possible values of the option in the next period.

For European options, at each node prior to expiration, the options value at that node

was equal to the holding value. In the case of American options, we will use the same

backward recursive method as for European options but will replace the holding value

with

max(Exercise value at time h, Holding value at time h)

For example, suppose we have to price a 2-year American call option with a strike price

of K using a binomial model with time steps of 1 year. Assume that the option cannot be

exercised at time 0. Then the recursive method would be as follows:

Consider the upper right binomial tree and nd the time-1 price of the call option,

C

u

using the risk-neutral approach:

u

B

u

C

u

= max(

u

S

u

+B

u

, max(S

u

K, 0))

C

uu

= max(S

uu

K, 0)

C

ud

= max(S

ud

K, 0)

Consider the lower right binomial tree and nd the time-1 price of the call option,

C

d

using the risk-neutral approach:

40

d

B

d

C

d

= max(

d

S

d

+B

d

, max(S

d

K, 0))

C

ud

= max(S

ud

K, 0)

C

dd

= max(S

dd

K, 0)

Construct a tree with time-1 cash ows of C

u

and C

d

, and once again, use the risk-

neutral pricing approach to nd the price (time-0 value) of the call option.

B

C

0

= S

0

+B

C

u

C

d

Example 14. Using the binomial model for the stock from the previous example, nd the price

of an American call option with 2 years to maturity and a strike price of $30. The continuously

compounded risk-free rate is r = 5%.

u

= 0.9545

B

u

= 26.9674

C

u

= max(

u

S

u

+B

u

, 3) = 4.5326

Not Exercised

d

= 0

B

d

= 0

C

d

= max(

d

S

d

+B

d

, 0) = 0

Not Exercised

= 0.7554

B = 19.4021

C

0

= S

0

+B = 3.2611

36.3 6.3

29.7 0

24.3 0

41

Remark: As mentioned on page 21, it is never optimal to exercise an American call option

on a non-dividend paying stock. Therefore, we should have expected the above result -

that the price of the American call option would be the same as that of a European call

option.

Example 15. Using the binomial model for the stock from the previous example, nd the price

of an American put option with 2 years to maturity and a strike price of $30. The continuously

compounded risk-free rate is r = 5%.

6.5 Model Extensions

Lets now extend the pricing process to dividend paying stocks. The pricing process is

a bit more cumbersome for discrete dividends than for continuous dividends. As such,

lets consider stocks paying continuous dividends rst. The model for the evolution of

the stock price over (t, t +h) in the presence of volatility is

S

t+h

= S

t

e

(r)h

h

Let S

u

and S

d

denote the larger and smaller of the two possible stock prices.

At time h, for an option with payoffs C

u

and C

d

at the end of the next period, we compute

h

= e

h

C

u

C

d

S

u

S

d

and B

h

= e

rh

_

C

u

h

e

h

S

u

_

and then, assuming the option is European, compute the options value at time h as

h

S

h

+B

h

Example 16. Assume a continuous dividend paying stock with S

0

= 30. Using the CRR model

with time steps of length 1 year, and u = 1.1 and d = 0.9, construct the binomial tree for the

42

stock price over the next 2 years. Find the price of a European call option on the stock, with 2

years to maturity and a strike price of $30. The continuously compounded risk-free rate is r = 5%.

In the case of discrete dividends, the tree may not be recombining. Suppose that a div-

idend is paid at some time in (t, t + h) and the future value of the dividend at time h is

D.

At time t, the forward price on the stock with expiration at time t +h is

F

t,t+h

= S

t

e

rh

D

Therefore, based on the CRR model, we have

S

t+h

= F

t,t+h

e

h

Let S

u

and S

d

denote the larger and smaller of the two possible stock prices.

At time h, for an option with payoffs C

u

and C

d

at the end of the next period, we

compute

h

=

C

u

C

d

S

u

S

d

and B

h

= e

rh

[C

u

h

(S

u

+D)]

= e

rh

_

S

u

C

d

S

d

C

u

S

u

S

d

_

h

De

rh

43

and then, assuming the option is European, compute the options value at time h as

h

S

h

+B

h

Example 17. Assume a discrete dividend paying stock with S

0

= 30. Using the CRR

model with time steps of length 1 year and = 0.055 (annual volatility), construct the

binomial tree for the stock price over the next 2 years. If a dividend of $1 is paid only at

time 2 (with certainty), nd the price of a European call option on the stock, with 3 years

to maturity and a strike price of $30. The continuously compounded risk-free rate is r = 5%.

44

7 Discrete-time securities market

Note: The material in this chapter is based on chapters 5 and 6 from the textbook Financial

Economics, Panjer et al. (See the course outline). The denitions, theorems and corollaries

have been obtained from this book.

We nowextend the one period binomial model for a single asset (fromthe previous chap-

ter) to a discrete-time model for a market of securities.

For now, well consider a single period model and then eventually extend it to a multi-

period model.

Consider a market with N securities.

The price of the j-th asset at time t is S

j

(t), t = 0, 1. The price vector is thus

S(t) =

_

S

1

(t) S

2

(t) . . . S

N

(t)

1N

Suppose now at time 1, there are M possible states of the economy: w

1

, w

2

, . . . , w

M

.

We use to denote this state space:

= {w

1

, w

2

, . . . , w

M

}

To make it more explicit that the time-1 price depends on one of the above states,

we may write S

j

(1, w) instead of S

j

(1). We summarize the possible asset prices at

time 1 in a matrix:

S(1, ) =

_

_

S

1

(1, w

1

) S

2

(1, w

1

) . . . S

N

(1, w

1

)

S

1

(1, w

2

) S

2

(1, w

2

) . . . S

N

(1, w

2

)

.

.

.

.

.

.

.

.

.

.

.

.

S

1

(1, w

M

) S

2

(1, w

M

) . . . S

N

(1, w

M

)

_

_

MN

Note that the j-th column describes the possible prices of the j-th asset at time 1.

Typically, the rst asset is a bank account (risk-free bond) which earns interest at an

annual effective rate of i. In this case, we have

S

1

(0) = 1 and S

1

(1, w) = 1 +i for all w

Our aim is to provide a framework for risk-neutral pricing. As we saw before, this was

based on the assumption of no arbitrage opportunities.

We need to hold a combination of securities at time 0 to construct a replicating porttfolio.

Suppose the investor holds

j

units of the j-th asset from 0 to 1. Our trading strategy is

thus

=

_

2

.

.

.

N

_

_

N1

45

and so the value of the portfolio at time t is

S(t)

..

1N

..

N1

=

1

S

1

(t) +

2

S

2

(t) + +

N

S

N

(t)

(Arbitrage) If an arbitrage opportunity exists in the market, then there exists a trading

strategy such that

S(0) 0 and S(1, ) > 0

..

M1

If no arbitrage opportunities exist, then we say that the securities market model is arbitrage-

free.

We will now proceed to dene what we call a state price vector. Its name is derived

from the fact that the m-th element in this vector gives us the price (time-0 value) of $1

received at time 1 if the state w

m

occurs, m = 1, 2, . . . , M.

(State Price Vector) A state price vector is a strictly positive vector

=

_

(w

1

) (w

2

) . . . (w

M

)

1M

such that

S(0)

..

1N

=

..

1M

S(1, )

. .

MN

In scalar form, we have

S

j

(0) =

w

(w)S

j

(1, w) , j = 1, 2, . . . , N

We mentioned that the m-th element in this vector gives us the price (time-0 value) of $1

received at time 1 if the state w

m

occurs.

To see this, we consider a security that pays $1 at time 1 if the state w

m

occurs, and 0

otherwise, m = 1, 2, . . . , M. Such a security is called the Arrow-Debreu security for

state w

m

. The payoff vector is

e

m

=

_

_

0

.

.

.

0

1

0

.

.

.

0

_

_

M1

the m-th state

The price (time-0 value) of such a security is thus

e

m

=

m

46

Further analysis of state price vectors:

Example 18. Assume S(0) = [0.7 , 3.0] and S(1, ) =

_

1 2

1 10

_

. Determine all state-price

vectors for the one-period securities market model.

The question now is: When (or under what conditions) is the market arbitrage-free?.

This leads us to the following theorem.

(The Fundamental Theorem of Asset Pricing) The single-period securities market model is

arbitrage free if and only if there exists a state price vector.

Therefore, if you can nd at least one state price factor, that is, at least one solution for

to the equation

S(0) = S(1, ),

then the market is arbitrage-free.

47

The next example is a bit ahead of its time but is meant to see if you can apply yourself,

using what youve learnt so far in this chapter and the material in the previous chapter(s).

Example 19. Consider a market model given by

S(0) =

_

2 2.5

, S(1, ) =

_

2 4

2 1

_

.

1. Verify that the state price vector is given by

_

0.5 0.5

.

2. Suppose that a new security has been introduced in the market. Its initial price is 2 and, at

time t = 1, its payoff is

_

3

0

_

.

Is the market model with the new security free of arbitrage opportunities? If yes, explain

why. If not, dene a strategy that will lead to an arbitrage opportunity, and determine what

should be the price of the new security so that no arbitrage opportunity is introduced.

48

7.1 Creating a risk-neutral probability measure (One-period model)

Lets assume that S

1

is a bank account earning interest at an annual effective interest rate

of i (or a risk-free bond). Then we must have

1

+

2

+ +

M

=

1

1 +i

(which represents the time-0 value of $1 paid at time 1 regardless of the state), or equiv-

alently

1

(1 +i) +

2

(1 +i) + +

M

(1 +i) = 1

which in a more succinct form is

w

(w)(1 +i) = 1 (2)

Let us dene

Q(w) = (w)(1 +i)

Based on (2), we have

w

Q(w) = 1

More generally, for any one of the N assets, we have

S

j

(0) =

w

(w)S

j

(1, w)

which implies that

S

j

(0) =

w

Q(w)

1 +i

S

j

(1, w)

Now, the time-0 value (price) could be understood as the expected present value of the

future payoffs with respect to a probability measure Q.

Since the discount factor is based on the risk-free rate, Qis a risk-neutral probability mea-

sure.

(Risk-Neutral Probability Measure) A risk-neutral probability measure is dened as a

probability measure Q on such that

Q(w) > 0 for all w , and

49

the expected present value of the future payoffs with respect to a probability mea-

sure Q and an annual effective risk-free rate of i gives the time-0 value (price):

S

j

(0) =

w

Q(w)S

j

(1, w)

1 +i

, j = 1, 2, . . . , N

We now have the following theorem:

(Theorem) Suppose the rst security/asset is a bank account

3

. The following are equiv-

alent:

The single-period model is arbitrage free.

There exists a state price vector.

There exists a risk-neutral probability measure Q.

7.2 Pricing (One-period model)

Suppose we have an asset with a single cash ow X at time 1 and would like to nd the

assets time-0 value. How can we do so?

Note: X =

_

_

X(w

1

)

X(w

2

)

.

.

.

X(w

M

)

_

_

Well, as seen in the previous chapter on the binomial model, we can either

1. compute the time-0 value by computing the time-0 value of a portfolio that repli-

cates X, or

2. expected present value of X with respect to a probability measure Q and an annual

effective risk-free rate of i.

BOTH METHODS ABOVE HINGE ON THE ASSUMPTION THAT THE MODEL IS

ARBITRAGE-FREE.

Method 1:

Find the trading strategy that replicates the cash-ow X. That is, nd such that

S(1, ) = X

In scalar form, we want

N

j=1

S

j

(1, w)

j

= X(w) , for all w

3

To determine if such an asset exists in the market, check for a constant column in S(1, ).

50

If we are able to nd a which replicates X, we say that X is attainable.

Then, if the model is arbitrage-free, we compute the time-0 value of X as the time-0

value of the portfolio that replicates X.

Therefore,

S(0)

gives the time-0 value of X.

The above requires us to rst nd the trading strategy which replicates X and then nd

the price. Is there an easier way?

Well, there is!

Recall that is such that

S(1, ) = X

Multiply both sides by (on the left of each side):

S(1, )

. .

=S(0)

= X

Therefore, instead of nding and computing S(0) , we can nd the state price

vector and compute X.

This leads us to our second method.

Method 2 (Risk-neutral pricing):

Suppose X is attainable and the rst security is a bank account earning interest at

an annual effective risk-free rate of i.

Then the time-0 value of X is

X =

w

Q(w)X(w)

1 +i

51

7.3 Completeness (One-period model)

(Completeness) An arbitrage-free securities market model is said to be complete if every

cash ow X is attainable.

In other words, for every cash ow vector X, there exists a trading strategy such that

S(1, ) = X

(Theorem) An arbitrage-free securities market model is complete if and only if there is a

unique state price vector.

(Corollary) If the rst security is a bank account, then the model is arbitrage-free and

complete if and only if the risk-neutral probability measure is unique.

Example 20. Consider the single period market with state space = {

1

,

2

,

3

}, consisting

of one stock and a money market account with effective interest rate r =

1

4

for the period, initial

stock price S

0

= 5 and stock price evolution according to the table

1

2

3

S

1

5

2

5 10

1. Compute the set of risk neutral measures for this model.

2. Is this model complete?

3. Compute arbitrage free prices (prices that comply with the no-arbitrage principle) for a Eu-

ropean put with strike K = 4.

52

7.4 An Example

Before we move on to multiperiod models, lets look back at the one-period binomial

model. It is a single period model with 2 assets (S

1

and S

2

) and 2 states (w

1

and w

2

).

We assume that prices are strictly positive and the returns on the assets are linearly in-

dependent. The latter implies that the market is complete (that is, we can replicate any

payoff).

Furthermore, if S

1

is the bank account, then

S

1

(0)

S

1

(1)

gives the one-period discount factor.

For a general security with payoff V (1, w) at time 1, the trading strategy that replicates

its payoff at time 1 is such that

V (1, w

1

) =

1

S

1

(1, w

1

) +

2

S

2

(1, w

1

)

V (1, w

2

) =

1

S

1

(1, w

2

) +

2

S

2

(1, w

2

)

and if the market is arbitrage-free, the time-0 value of the security is

V (0) =

1

S

1

(0) +

2

S

2

(0)

In terms of risk-neutral probabilities q and 1 q (corresponding to states w

1

and w

2

respectively), the time-0 value can be written as

V (0) =

S

1

(0)

S

1

(1)

[q V (1, w

1

) + (1 q) V (1, w

1

)]

or, equivalently, in terms of an expectation,

V (0) = E

Q

_

S

1

(0)

S

1

(1)

V (1)

_

V (0)

S

1

(0)

= E

Q

_

V (1)

S

1

(1)

_

where Q is the risk-neutral probability measure.

53

7.5 Multi-period model

Lets now extend the results under the one-period model to a multiperiod model. Con-

sider now a market with N securities over the period (0, T).

We will work with a discrete model so we assume that the asset prices change only at

times k = 1, 2, . . . , T.

Once again, the price vector is

S(k) =

_

S

1

(k) S

2

(k) . . . S

N

(k)

1N

for k = 0, 1, 2, . . . , T.

In what follows, whenever you encounter new terminology, we will bridge it back to the

two-period model.

Example 21. For the two period binomial model, what is the state space at time 0?

(Random Variable vs Random Process)

In the single-period model, for each asset, we have a single random variable coss-

esponding to the time-1 value of the asset price.

In the multiperiod model, for each asset, we have a sequence of random variables

over time, {S

j

(0), S

j

(1), S

j

(2), . . . , S

j

(T)}, j = 1, 2, . . . , N. In this case, we speak of

an asset price (discrete-time) process.

(Sample Path) Sometimes, instead of thinking of the asset price process as a sequence of

random variables over time, we can think of the process as the random function

k S

j

(k, w) (j = 1, 2, . . . , N)

For each w , this function gives a single path of the asset price over time. Such a

path is called a sample path.

Example 22. For the two period binomial model, what are the possible sample paths?

54

We will assume that S

1

is a bank account with the following properties:

S

1

(0, ) = 1

k S

1

(k, w), or simply k S

1

(k) (since we have a single sample path), is a non-

decreasing function. In other words, the accumulation function is non-decreasing

with respect to time. This implies that the forward rate over (k, k + 1),

i

k

=

S

1

(k + 1)

S

1

(k)

1 0, , k = 0, 1, 2, . . . , T 1

When i

k

= i (constant interest rate), we have S

1

(k) = (1 +i)

k

, k = 0, 1, 2, . . . , T.

Before we proceed, we take note the following (implicit) assumptions about investors:

Investors have full knowledge of the possible states of the world in the future, the

real-world probabilities, and the possible stock prices at those states.

At any time k < T, investors cannot know any future states with certainty. They

only know the past and present information.

With this in mind, we now look at the information available to the investor at different

points in time. For k T, P

k

will denote the information that is known to investors at

time k.

Example 23. Consider the following tree:

= {w1, w2, w3, w4, w5}

{w4, w5}

{w5}

{w4}

{w1, w2, w3}

{w3}

{w2}

{w1}

Write down P

0

, P

1

and P

2

.

Solution:

We have

P

0

= {}

P

1

= {{w

1

, w

2

, w

3

}, {w

4

, w

5

}}

P

2

= {{w

1

}, {w

2

}, {w

3

}, {w

4

}, {w

5

}}

55

Let us now understand what this tells us:

At time 0, the only information we have is that one of the states w

1

, w

2

, w

3

, w

4

or w

5

can occur. We know nothing more. Thus, the information is given by P

0

= {}.

At time 1, we have some more information. We can either be in the up state, or in

the down state.

If we are at the up state, then neither w

4

nor w

5

can occur; one of w

1

, w

2

or w

3

must occur.

Similarly, if we are at the down state, one of w

4

or w

4

must occur.

Therefore, the only information we have at time 1 is whether the asset price in-

creased ({w

1

, w

2

, w

3

}) or decreased ({w

4

, w

5

}), and as such, the information at time

1 is given by P

1

= {{w

1

, w

2

, w

3

}, {w

4

, w

5

}}.

Note here that P

1

contains information about the asset price from time 0 up to and

including time 1.

At time 2, we know with certainty which of the states w

1

, w

2

, w

3

, w

4

or w

5

has oc-

curred. Therefore, this information is summarized by P

2

= {{w

1

}, {w

2

}, {w

3

}, {w

4

}, {w

5

}}.

Note here that P

2

contains information about the asset price from time 0 up to and

including time 2.

Remarks:

We can think of P

k

as partitions of .

Furthermore, as k increases and we have more information, the partitions of P

k

be-

come ner (that is, tell us more information).

We sometimes refer to {P

0

, P

1

, . . . , P

T

} as the information submodel.

4

In terms of our market model, P

k

gives us information about the asset prices from

time 0 up to and including time k.

Example 24. For the two period binomial model, write down P

0

, P

1

and P

2

.

4

Typically, one will use a ltration to contain the information, but this is not really required at this time. We will

see it though when we look at continuous time models.

56

(Measurability and Adaptibility)

We say that a random variable X is measurable with respect to P if X(w) is con-

stant on each partition of P.

Lets look back at example 23. Lets consider some random variable X (for now,

well have no context).

If X(w

1

) = X(w

2

) = X(w

3

) = 2 and X(w

4

) = X(w

5

) = 5, then X is measurable

with respect to P

1

. X is constant with over each of the two partitions.

On the other hand, if, say, X(w

1

) = X(w

4

) = 2 and X(w

2

) = X(w

3

) = X(w

5

) =

5, then X is not measurable with respect to P

1

. The random variable is not con-

stant over each of the two partitions (possible states of the world).

Intuitively, we can think of measurability as saying: If you are given the infor-

mation P

k

- the history from time 0 to time k - then can you tell me what value X

would take?

Example 25. Suppose we have the information P

k

at some time k. Is S

j

(k) measurable

with respect to P

k

? What about S

j

(k + 1)?

Now, consider a stochastic process (sequence of random variables over time) X =

{X(k), k = 0, 1, 2, . . . , T}. We say that X is adapted to the information submodel

{P

0

, P

1

, . . . , P

T

} if for each k = 0, 1, . . . , T, X(k) is measurable with respect to P

k

.

Example 26. With respect to our (general) multiperiod model, let X(k) denote the maxi-

mum price of the j-th asset over the period [0, k], k = 0, 1, 2, . . . , T. Is this process adapted?

Now that we have our information submodel, lets move on to conditional expectations.

Example 27. For the two-period binomial model, let w

1

= uu, w

2

= ud, w

3

= du, w

4

= dd.

Assuming q and 1 q are the risk-neutral probabilities of the up and down moves respec-

tively, write down E

Q

(S(2)|{w

1

, w

2

}) and E

Q

(S(2)|{w

3

, w

4

}).

57

We can use those two quantities above to, say, nd the expected value of S(2):

E[S(2)] = q E

Q

[S(2)|{w

1

, w

2

}] + (1 q) E

Q

[S(2)|{w

3

, w

4

}]

If can dene a random variable

E

Q

[S(2)|P

1

] =

_

E

Q

[S(2)|{w

1

, w

2

}] , with probability q

E

Q

[S(2)|{w

3

, w

4

}] , with probability 1 q

,

then we can write

E[S(2)] = E {E

Q

[S(2)|P

1

]}

Remarks on E[S(2)|P

1

]:

It is dened on the partitions of P

1

.

It is adapted to P

1

.

Lets now generalize this.

(Conditional Expectation) Consider some partition B in P

k

. E(X|B) is the conditional

expectation of X given the information in B. If P

k

= {B

1

, B

2

, . . . , B

n

}, then E(X|P

k

) is

a random variable with possible values of E(X|B

1

), E(X|B

2

), . . . , E(X|B

n

).

We have the following properties:

E(X|P

k

) is adapted to P

k

.

If X is adapted to P

k

, then E(X|P

k

) = X.

If X is independent of P

k

, then E(X|P

k

) = E(X).

For k < j,

E[E(X|P

k

)|P

j

] = E[E(X|P

j

)|P

k

] = E(X|P

k

)

58

A stochastic process X = {X(k), k = 0, 1, 2, . . . , T} is said to be a martingale if it is

adapted and

E[X(k + 1)|P

k

] = X(k) , k = 0, 1, 2, . . . , T 1

Remark: If X is a martingale, then we have E(X(k)) = X(0) for all k.

Example 28. Consider the T-period binomial model. Under what conditions is S(k) a martin-

gale under the risk-neutral probability measure?

Example 29. Consider the T-period binomial model. Is

S(k)

(1+i)

k

a martingale under the risk-

neutral probability measure?

Remark: Based on the remark above and the result of the previous example, we can

conclude that

E

Q

_

S(k)

(1 +i)

k

_

= S(0),

the price of the stock.

59

7.6 Trading Strategy

Remember that our eventual aim is to do risk-neutral pricing/valuation. As we did in

the single period case, lets rst dene a trading strategy.

(Trading Strategy) Suppose the investor holds

j

(k) units of the j-th asset from k to

k + 1. Notice that

j

(k) is a random variable and depends on the state. In state w, we

write

j

(k, w).

If we let

(k) =

_

1

(k)

2

(k)

.

.

.

N

(k)

_

_

N1

,

then we call the stochastic process = {(k), k = 0, 1, 2, . . . , T 1} a trading strategy.

We will assume that (k) is measurable with respect to P

k

for all k, and so, is adapted

to the information submodel {P

0

, P

1

, . . . , P

T1

}. In other words, we want (k) to be de-

termined based on the information available up to time k.

Suppose we are in state w at time k and have just rebalanced our portfolio according to

(k, w). The time-k value of the portfolio is thus

V

We are interested in nding conditions for an arbitrage. Suppose we have constructed a

portfolio at time 0 which required no money (the value of the portfolio at time 0 is less

than or equal to 0) and at time T, we were guaranteed a non-negative cash ow. Does

this imply that an arbitrage opportunity exists?

Well, the answer is not necessarily. If we had to inject money into the system to rebalance

the portfolio at times k = 1, 2, . . . , T 1, then we may not have a prot at time T. This

leads us to the denition of a self-nancing trading strategy.

First, dene the value of the portfolio at time k just before rebalancing the portfolio. In

this case, the portfolio will be valued using (k 1, w), the strategy from the previous

time period. This portfolio value is given by

V

(k

, w) = S(k, w) (k 1, w) , k = 1, 2, . . . , T

The cash outow from the portfolio at time k is

c

(k, w) =

_

_

V

(k, w) , k = 0

V

(k

, w) V

(k, w) , k = 1, 2, . . . , T 1

V

(k

, w) , k = T

60

(Self-Financing) A trading strategy is said to be self-nancing if there are no cash in-

ow or outows from rebalancing at times 1, 2, . . . , T 1. In this case,

c

(1) = c

(2) = = c

(T 1) = 0.

In other words, we must have

S(k, w) (k 1, w) = S(k, w) (k, w) , k = 1, 2, . . . , T 1

Example 30. (Example 13 Revisited) Assume a non-dividend paying stock with S

0

= 30. Using

time steps of length 1 year with u = 1.1 and d = 0.9, construct the binomial tree for the stock

price over the next 2 years. Then nd the price of a European call option with 2 years to maturity

and a strike price of $30. The annual effective risk-free rate is r = 5%.

Stock:

30

33

27

36.3

29.7

24.3

Call Option:

36.3 6.3

29.7 0

24.3 0

u

= 0.9545

B

u

= 27

C

u

=

u

S

u

+B

u

= 4.5

d

= 0

B

d

= 0

C

d

=

d

S

d

+B

d

= 0

= 0.75

B = 12.1832

C

0

= S

0

+B = 3.2143

Is the trading strategy self-nancing?

61

(Arbitrage) An arbitrage opportunity exists if there is a self-nancing strategy such that

V

7.7 Risk-neutral probability measure

(Risk-Neutral Probability Measure) A risk-neutral probability measure is a probability

measure Q on such that

1. Q(w) > 0 for all w , and

2.

S

j

S

1

is a martingale under Q for j = 2, 3, . . . , N.

Aside: Recall the case for the one-period binomial model on page 53. The risk-neutral

measure Q was such that

V (0)

S

1

(0)

= E

Q

_

V (1)

S

1

(1)

_

If V = S

2

, then

S

2

(0)

S

1

(0)

= E

Q

_

S

2

(1)

S

1

(1)

_

Therefore, condition 2 is an extension of this result in the case of N assets and multiple

periods. A consequence of this condition is that the time-0 value of the stock can be ob-

tained by taking the expected present value of the future values (payoffs if the stock was

sold) under the risk-neutral measure.

62

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