I am trying to make my posts a little bit more mathematical to gain more understanding of pricing of

derivatives. Today I will be writing a little bit about Risk Neutral Probabilities, which is the main
concept behind Asset pricing.
Martingales
In the insurance industry pricing is done based on the following equation:C (t) = [

C (T)] .. (i)

C (T) is the claim that they have to provide in the future. The price of that today C (t) is just the
discounted, conditional expected value at time t. This is a conditional expectation based on all the
information we have up to time t. So this expectation is computed under real probabilities for
Insurance Pricing, but we cant exactly use the same logic in financial pricing, but we will use a very
similar logic. If we want to use the same logic to price a Stock the equation will look like:S (t) = [

S (T)] (ii)

This means on average the stock price today is just the discounted Stock price in the future. Now this
does not make any sense because, if this is true then on average the stock is just behaving like that
of a bank account. So there is no point investing in a stock, we can just invest in a risk free bank
account.
For the time being lets just assume that the above equations hold, then these types of processes are
known as Martingale Processes and the above property is called a Martingale Property. You can
think of a Martingale as a fair gamble, where you dont win nor loose. So in reality Stocks are not
typically going to be Martingales under real probabilities, but we can change the probabilities to
make them martingales. These probabilities can be called as Martingale, Risk-Neutral or Pricing
Probabilities. It can be denoted in the following way:S (t) =

S (T)] (iii)

So we hope to have for some risk-neutral probability Q,

Price of Claim today= expected value, under Q, of the claims discounted future payoff
Lets look at a simple 1 period binomial option pricing model.
R=0.005, S (0) =100, u=1.01, d=.99, K=100
I claim that we can replicate this portfolio by just having a position in the underlying stock and bank
account.
a (1+.005) + b(101)=1
a (1+.005) + b(99)=0
These are the only 2 possible cases that can happen in the future, and after solving we see, a=49.254, b=0.5
This means borrow 49.254 and buy half share of the stock, and the cost for setting up this portfolio is
50-49.254=0.746, this is the arbitrage free price of buying the option. This has to be the arbitrage
free price, because if the price is anything different from 0.746 there will be arbitrage opportunities,
try doing the maths yourself and check it out.

Martingale Pricing
Lets suppose that discounted wealth process is a Martingale under Q, and suppose it replicates C
(T), so that X (T) =C (T), then by Martingale property,
( )=

( )=

( )

This gives us
X (t) = , ( )C (T)] (iv) {X (t) is the cost of replicating C (T), and by definition this
has
to be the price. This will work under 2 assumptions, 1- There exists a martingale
probability under which the discounted wealth process is a martingale, 2- We can replicate the
claim. This formula is correct under any model as long as you can replicate the claim and there is a
martingale probability, this will work for European type payoffs}. Lets try to use this in the 1 period
binomial model:The future wealth value will be
X (1) = a (1+r) +bS (1)
When discounted it will be
( )=a+b ( )
So if the discounted stock is a martingale, so is the discounted wealth. For the stock to be a Q
Martingale we need to have
( )

S (0) =

[p*su + (1-p)*sd]

Replacing su= S (0) u, sd= S (0) d, and solving we get

p=

(this is my pricing probability)

Now lets use this in the above example:Su=101, Sd = 99, p = 0.75, the price of the call option is
C (0) =

( )

C (0) =

[p*Cu + (1-p)*Cd]

[0.75*(101-100) + (1-0.75)*0] = 0.746

Now the question is why is the pricing in financial markets different than that in insurance? The
reason is we can replicate/hedge the value of the option by trading in the underlying assets and
bank accounts. In traditional Insurance you cant hedge, you sell a life insurance, you cant actually
hedge that, hence the pricing is done under actual probability.
Lets try to price forward using martingale probabilities.
Lets D (t) =
t=0 :0=

,* ( )

, We want the forward price F(t) such that the value of the forward contract at time
( )+

( )
]
( )

, ( )

( )
]
( )

, ( )

( )
]
( )

We know D (t) at time t, so we can take it out of the expectation and re-write the equation:-

0=

( )

, ( ) ( )] -

, ( )

( )
]
( )

Under Q probabilities we also know that

re-write the equation again
0 = S (t) -

( )
( )

, ( ) ( )] = D (t) S (t), we also know F (t) at time t, lets

, ( )]

The only Expectation which is left is the expectation on the future discounting, and this holds if your
discount rate is random. In this case we are assuming continuously compounded deterministic
discount rates. Hence the above eq. Can be re written as:F (t) = S (t)

. This is the price of a forward contract at time t, maturing at time T.