Beruflich Dokumente
Kultur Dokumente
Ana Lacerda
Department of Statistics
Columbia University
1255 Amsterdam Avenue
New York, NY 100027, USA
Abstract
We derive statistical arbitrage bounds for the buying and selling price of
European derivatives under incomplete markets. In this paper, incompleteness is generated due to the fact that the market is dry, i.e., the underlying
asset cannot be transacted at certain points in time. In particular, we refine the notion of statistical arbitrage in order to extend the procedure for
the case where dryness is random, i.e., at each point in time the asset can
be transacted with a given probability. We analytically characterize several
properties of the statistical arbitrage-free interval, show that it is narrower
than the super-replication interval and dominates somehow alternative intervals provided in the literarture. Moreover, we show that, for suciently
incomplete markets, the statistical arbitrage interval contains the reservation price of the derivative.
Introduction
very high Sharpe ratios, whereas Bernardo and Ledoit exclude pricing kernels implying very high gain-loss ratios, for a benchmark utility. Notice
that, for a dierent utility, Bernardo and Ledoit would exclude a dierent
subset of pricing kernels, for the same levels of acceptable gain-loss ratios.
In order to avoid ad-hoc thresholds in either Sharpe or gain-loss ratios,
or to make some parametric assumptions about a benchmark pricing kernel,
as in Bernardo and Ledoit (2000), the work of Bondarenko (2003) introduces
the notion of statistical arbitrage opportunity, by imposing a weak assumption on a functional form of admissible pricing kernels, yielding narrower
pricing implications as compared to the superreplication bounds. A statistical arbitrage opportunity is characterized as a zero-cost trading strategy for
which (i) the expected payo is positive, and (ii) the conditional expected
payo in each final state of the economy is nonnegative. Unlike a pure arbitrage opportunity, a statistical arbitrage opportunity may allow for negative
payos, provided that the average payo in each final state is nonnegative.
In particular, ruling out statistical arbitrage opportunities imposes a novel
martingale-type restriction on the dynamics of securities prices. The important properties of the restriction are that it is model-free, in the sense that it
requires no parametric assumptions about the true equilibrium model, and
continues to hold when investors beliefs are mistaken.
In this paper we extend the notion of statistical arbitrage opportunity
to the case where the underlying asset cannot be transacted at a random
number of points in time and compare the statistical arbitrage-free bounds
with the superreplication bounds. We show that the statistical arbitragefree interval is narrower than the pure arbitrage bounds, and show also that,
for suciently incomplete markets, the statistical arbitrage interval contains
the reservation price of the derivative. We also provide examples that allow
comparison with the results of Cochrane and Sa-Requejo (2000) and discuss
the comparison with Bernardo and Ledoit (2000).
This paper is organized as follows. In section 2, the model is presented
and the pure arbitrage results are derived. In section 3 the notion of statistical arbitrage in the spirit of Bondarenko (2003) is defined. In section
The Model
denote the set of all the nodes at time t that are predecessors of a given
node it . A path on the event tree is a set of nodes w = t{0,1,...,T } it such
it
. Let denote the set of
that each element in the union satisfies it1 It1
posed of t units of the risky asset and an amount Bt invested in the riskless
asset, such that the portfolios cost is t St + Bt for t = 0, 1, . . . T 1.
In order to find the upper (lower) bound of the arbitrage-free range of
variation for the value of the call option we consider a financial institution
that wishes to be fully hedged when selling (buying) that option. The objective of the institution is to minimize (maximize) the cost of replicating the
exercise value of the option at maturity. The value determined under such
optimization procedure avoids what is known as arbitrage opportunities,
reflecting the possibility of certain profits at zero cost.
This section is organized as follows. We first characterize the upper
bound, and then the lower bound for the interval of no-arbitrage admissible prices. For each bound, we first deal with the complete market case,
and then with the fully incomplete market case, finally introducing random
incompleteness.
2.1
1 iT
1
TT1
ST + RBTT1
0,
t1 it
t1
t1
St + RBt1
itt Stit + Btit ,
it
, all it It and all t {0, ..., T 1} .
for any it1 It1
The upper bound for the value of the European option is the maximum
value for which the derivative can be transacted, without allowing for arbitrage opportunities. This is the value of the cheapest portfolio that the
5
seller of the derivative can buy in order to completely hedge his position
against the exercise at maturity, without the need of additional financing at
any rebalancing dates. Hence, for p = 1, the upper bound is Cu1 , given by
Cu1 =
min
{t ,Bt }t=0,....,T 1
0 S0 + B0
subject to
+
i 1 iT
i 1
ST + RBTT1
STiT K ,
TT1
t1 it
t1
t1
St + RBt1
itt Stit + Btit ,
it
, all it It and all t {0, ..., T 1} , where the constraints
for all it1 It1
T
+
R D j U R T j j T j
1 X T
= T
S0 K .
U D
j
R
U D
U D
j=0
Consider now the case where p = 0. In this case, the notion of a trading
strategy satisfying the self-financing constraint is innocuous, since the portfolio t cannot be rebalanced during the life of the option. Under the absence
of arbitrage opportunities, the upper bound for the value is Cu0 satisfying
Cu0 = min 0 S0 + B0
{0 ,B0 }
subject to
+
0 STiT + RT 0 STiT K ,
T
+
+
R DT T
1
U RT T
0
U S0 K +
D S0 K
.
Cu = T
R
U T DT
U T DT
1
2.2
The lower bound for the value of an American derivative is the minimum
value for which the derivative can be transacted without allowing for arbitrage opportunities. This is the value of the most expensive portfolio that
the buyer of the option can sell in order to be fully hedged, and without the
need of additional financing at rebalancing dates.
For p = 1, the lower bound for the value of the derivative under the
absence of arbitrage opportunities is thus Cl1 , given by
Cl1 =
max
{t ,Bt }t=0,....,T 1
0 S0 + B0
subject to
+
i 1 iT
i 1
ST + RBTT1
STiT K
TT1
t1 it
t1
t1
St + RBt1
itt Stit + Btit ,
it
, all it It and all t {0, ..., T 1} , where the constraints
for all it1 It1
T
+
R D j U R T j j T j
1 X T
U D
= T
S0 K ,
j
R
U D
U D
(1)
j=0
subject to
0 ST + RT B0 (ST K)+ .
!
T U T (i+1) D i+1
+
T i i
R
1
Cl0 =
D S0 K
(2)
U
T
T
i
i
T
(i+1)
i+1
R
U
D U
D
+
T i1 i+1
U T i Di RT
1
+ T
D
S
K
.
U
0
R
U T i Di U T (i+1) Di+1
where i is defined as the unique integer satisfying U n(i+1) Di+1 < Rn <
U ni Di , and 0 i n 1.
2.3
tj it
tj
St + Rj Btj
itt Stit + Btit ,
tj
it
for all itj Itj
, all it It and all t {0, ..., T 1} .
min
{t ,Bt }t=0,...,T 1
0 S0 + B0
+R
T t
Btit
+
iT
ST K ,
tj it
tj
tj
St + Rj Btj
itt Stit + Btit
it
for all itj Itj
, all it It and all t {0, ..., T 1} .
On the other hand, the lower bound Clp solves the following problem:
Clp =
max
{t ,Bt }t=0,...,T 1
0 S0 + B0
+
itt STiT + RT t Btit STiT K ,
tj it
tj
tj
St + Rj Btj
itt Stit + Btit
it
for all itj Itj
, all it It and all t {0, ..., T 1} .
Notice that the constraints in the above optimization problems are implied by the absence of arbitrage opportunities and do not depend on the
probability p.3 Therefore, neither Cup nor Clp will depend on p. We are now
in conditions to relate these values to Cu0 and Cl0 as follows.
Theorem 4 For p (0, 1) the upper and lower bound for the prices above do
not depend on p. The optimization problems above lead to the same solutions
as when p = 0.
Proof. Consider first the case of the upper bound. The constraints
characterizing Cup include all the constraints characterizing Cu0 . Thus, Cup
Cu0 . Now, let 00 and B00 denote the optimal values invested, at time t = 0,
This happens since, in order to have an arbitrage opportunity, we must ensure that,
whether market exists or not at each time t {1, ..., T 1} , the agent will never lose
wealth. Therefore, the optimization problem cannot depend on p.
The intuition for this result is straightforward. The upper (lower) bound
of the call option remains the same as when p = 0, because with probability 1 p it would not be possible to transact the stock at each point in
time. In order to be fully hedged, as required by the absence of arbitrage
opportunities, the worse scenario will be restrictive in spite of its possibly
low probability. The fact that no intermediate transactions may occur dominates all other possibilities.
The above result is strongly driven by the definition of arbitrage opportunities. Nevertheless, if this notion is relaxed in an economic sensible way,
a narrower arbitrage-free range of variation for the value of the call option
may be obtained, possibly depending now on p. This is the subject of the
rest of the paper.
Consider the economy described in the previous section. Let Tp = {1, ..., T 1}
denote the set of points in time. At each of these points there is market with
probability p, and there is no market with probability 1 p. The existence
(or not) of the market at time t corresponds to the realization of a random
variable yt that assumes the value 0 (when there is no market) and 1 (when
there is market). This random variable is defined for all t Tp and it is
assumed to be independent of the ordinary source of uncertainty that generates the price process. We can therefore talk about a market existence
process. In order to construct one such process, let us start with the state
space. Let #(Tp ) denote the number of points in Tp . At each of these points,
market may either exist or not exist, leading to 2#(Tp ) possible states of
nature. We then have the collection of possible states of nature denoted by
= {vi }
10
3.1
t t, . . . , t0 1
xt,t0 :
0
pxt,t0 xt,t0 = t = (1 p)t t1 .
0
pxt ,t0 xt,t0 = s = p (1 p)t s1 .
Xt0 1
0
0
pxt ,t0 xt,t0 = s = (1 p)t t1 +
p (1 p)t s1 = 1,
s=t
as it should.
and (is )s{t,... ,T } w. Suppose that the agent is at a given node it , where
rebalancing is possible. As there is uncertainty about the existence of market at the future points in time, there is also uncertainty about the portfolio
that the agent will be holding at a future node it0 . In fact, the portfolio at
i 0 1
0 1
it+1
it+1
, . . . , or tt0 1
, where
it0 may be any of itt , Btit , t+1
, Bt+1
, Bt0t1
(is )s{t,... ,t0 1} w.
Clearly, the expected value of a given trading strategy at node it0 , given
Eit
h
i X
0
ixx Sti0 + Rt x Bxix =
s=t,... ,t0 1
i
h
0
pxt,t0 xt,t0 = s iss Sti0 + Rt s Bsis ,
3.2
t+j iT
t+j
ST + RT tj Bt+j
0
t+j
t+j
t+j
t+j
t+j
itt St+j
+ Rjt Btit t+j
St+j
+ Bt+j
,
Eit
h
i
ixx STiT + RT x Bxix 0,
point in time we then have, for sure, the portfolio itt , Btit at time t + 1.
it+1
it+1 it+1
it+1
0
+ RBtit t+1
St+1 + Bt+1
itt St+1
it+1
it+1
ther have the portfolio itt , Btit or the portfolio t+1
. Under the
, Bt+1
s=t,t+1
it+2
it+2 t+2
it+2
pxt,t+2 (xt,t+2 = s) iss St+2
+ Rt+2s Bsis t+2
St+2 + Bt+2
12
More generally, for any t at which transaction occurs and t < t0 < T, the
statistical self-financing condition becomes
pxt,t0
Eit
Definition 5
h
i
0
i0
i0 i0
i0
ixx St0t + Rt x Bxix tt0 St0t + Bt0t
Eit
h
i
ixxt,T STi + RT x Bxixt,T 0
Eit
h
i
0
i0 i0
i0
ixxt,t0 Sti0 + Rt x Bxixt,t0 tt0 St0t + Bt0t 0
13
Hence, as these expressions are the terms under expectation in the definition
of Statistical Arbitrage opportunity, presented in definition 5, there is also
a statistical arbitrage opportunity.
The set of portfolios that represent a pure arbitrage opportunity is a
subset of the portfolios that represent a statistical arbitrage opportunity, i.e.,
there are portfolios that, in spite of not being a pure arbitrage opportunity,
represent a statistical arbitrage opportunity.
In order to have a statistical arbitrage opportunity it is not necessary
(although it is sucient) that the value of the portfolio at the final date is
positive. It is only necessary that, for all t, the expected value of the portfolio
at the final date is positive.
Consider now the self-financing conditions under statistical arbitrage.
When rebalancing the portfolio it is not necessary (although it is sucient)
that the value of the new portfolio is smaller than the value of the old one.
This happens because future rebalancing is uncertain, leading to uncertainty
about the portfolio that the agent will be holding in any future moment. In
order to avoid a statistical arbitrage opportunity it is only necessary that
the expected value of the portfolio at a given point in time is larger than the
value of the rebalancing portfolio.
Finally, notice that the concept of statistical arbitrage opportunity reduces to the usual concept of arbitrage opportunity in the limiting case
p = 0.
3.3
Augmented measures
14
n
o
(i ,T ),m
q(itT,t)
such that it It , m +
it ,iT , t = 0, . . . , T and
1 X X
X TX
t=0
iT
(i ,T ),m
q(itT,t)
= 1,
it
S0 =
where
q
iT
T
1
X
t=0
(ii)
with
and
(i ,T ),m
(iTt ,t)
it :it It T
1
=
STT1
1
Rn
on
m+
i ,i
t T
iT :iT 1 ITT1
(i ,T ),m iT
ST ;
q(itT,t)
(i ,T ),m iT
ST
(iTt ,t)
(i ,T ),m
i
iT :iT 1 ITT1
(iTt ,t)
T 1
1 X
px (xt,T = T 1)
t=0 t,T
n
X
i
=1
it :it It T 1
on
m+
i ,i
t T
(i ,T ),m
o
:iT 1 m
q(itT,t)
where
=
T
1
X
t=0
pxt,T (xt,T = T 1)
i
iT :iT 1 ITT1
on
i
it :it It T 1
on
m+
i ,i
t T
o
:iT 1 m
(i ,T ),m
q(itT,t)
o
n
(i ,t0 ),m
,for all it0 It0 , it It , m +
(itt0,t)
it ,iT and
iT :ik IkT
15
where
i
iT :ik IkT
(i ,T ),m
(iTt ,t)
(i 0 ,t0 ),m
(itt ,t)
=1
t0 >k
and
k
(i ,T ),m
(iTt ,t)
X
1 X
n
o
pxt,T (xt,T = k)
i
it :it It k n
t=0
(i
,t0 ),m
(itt0,t)
q(itT,t)
(itt0,t)
q(itT,t)
m+
i ,i
1 X
n
o
pxt,t0 xt,t0 = k
i
it :it It k n
t<k
X
t T
(i ,T ),m
o
:ik m
o
m+
i ,i :ik m
(i ,t0 ),m
t t
with
=
i
iT :ik IkT
XX
t0 >k t<k
k
X
pxt,T (xt,T = k)
t=0
pxt,t0
xt,t0 = k
i
it :it It k
i
it :it It k
m+
i ,i
t T
(i ,T ),m
o
:ik m
(i ,t0 ),m
(itt0,t)
m+
it ,it:ik m
Main Results
4.1
4.1.1
min
{t ,Bt }t=0,...,T 1
0 S0 + B0
where
t , Bt Rt+1 , t = 0, ..., T 1
16
Eit
ix i
+
x ST + RT x Bxix STi K ,
Eit
h
i
0
i
i
i
ixx Sti0 + Rt x Bxix tt0 0 St0t0 + Bt0t0 0
t=0
t=1
t=2
t=3
min
{t ,Bt }t=0,...,2
0 S0 + B0
where
{0 , B0 } = {(0 , B0 )}
1 1 2 2
{1 , B1 } =
1 , B1 , 1 , B1
1 1 2 2 3 3
2 , B2 , 2 , B2 , 2 , B2
{2 , B2 } =
17
for any i2 I2 and i1 I1 such that i1 I1i2 , i.e., i1 ,and i2 belong to the
same path (these are 4 constraints) and, finally,
i11 S2i2 + RB1i1 i22 S2i2 + B2i2
for any i2 I2 and i1 I1 such that i1 I1i2 , i.e., i1 ,and i2 belong to the
same path (these are 4 constraints).
4.1.2
Solution
q iT QS
h
i+
1 X
iT
iT
S
q
K
.
T
{iT IT }
RT
18
(3)
t
t,B
Proof. Consider the trading strategy
that solves
t=0,... ,T 1
it is self-financing, i.e.,
i
t1 it
t1
St + RBt1
itt Stit + Btit ,
t1
+
i 1 iT
i 1
TT1
ST + RBTT1
STiT K .
Hence, the solution of the problem for p = 1 cannot be higher than
the value of this portfolio at t = 0 (which is Cu ).
3. limp0 Cu = Cu0 and limp1 Cu = Cu1 .
Proof. See Appendix A.4
An example for T=2 is also show in appendix A.4.
19
4. Cu is a decreasing function of p.
Proof. See Appendix A.4
5. For T = 2, we can prove that
Cu pCu1 + (1 p)Cu0
meaning that the probabilistic upper bound is a convex linear combination of the perfectly liquid upper bound and the perfectly illiquid
upper bound.
Proof. See appendix A.4.
4.2
The organization of this section is analogous to the section for the upper
bound.
4.2.1
The Problem
max
{t ,Bt }t=0,...,T 1
0 S0 + B0
where
t , Bt Rt+1 , t = 0, ..., T 1
subject to the conditions of a positive expected payo
pxt,T
Eit
+
ix i
x ST + RT x Bxix STi K ,
px 0 h
0
i
i
i
Eit t,t ixx Sti0 + Rt x Bxix tt0 0 St0t0 + Bt0t0 0
for any it It , t0 > t, t {0, 1, . . . , T 2} and t0 {1, . . . , T 1} 8 .
As in the upper bound case, for each it there are 2(T t) paths,
as a result,
P and
1 (T t)
(t + 1) restrictions at time t. The total number of restrictions is Tt=0
2
(t + 1).
2
PT 1
8
t0 t
As in the upper bound case, for each it there are
2
.
Hence,
for
each t
0
t =t+1
PT 1
PT 2
PT 1
t0 t
t0 t
there are (t + 1) t0 =t+1 2
. Hence, there are t=0 (t + 1) t0 =t+1 2
restrictions.
7
(T t)
20
4.2.2
Solution
q iT QS
h
i+
1 X
iT
iT
S
q
K
.
T
{iT IT }
RT
In this section we show that the price for which any agent is indierent between transacting or not transacting the derivative, to be called the reservation price of the derivative, is contained within the statistical arbitrage
bounds derived above.
Let ut (.) denote a utility function representing the preferences of an
agent at time t. The argument of the utility function is assumed to be the
consumption at time t. Let y be the initial endowment of the agent, and Zt
21
denote the vector of consumption at time t, i.e., Zt = Ztit
it It
. Let be
E0G,P
sup
{t ,Bt }t=0,...,T 1
XT
t=0
t ut (Zt )
subject to
Z0 + 0 S0 + B0 C + y
it
it
tj it
tj
Ztit + itt Stit + Btit tj
St + Rj Btj
iT
iT
j iT
j
ZTiT TTj
ST + Rj BTTj
GiTT
sup
{t ,Bt }t=0,...,T 1
E0G,P
XT
t=0
t ut (Zt )
subject to
Z0 + 0 S0 + B0 y
it
it
tj it
tj
Ztit + itt Stit + Btit tj
St + Rj Btj
i
ZTiT
i Tj iT
TTj
ST
iT
i j
+ Rj BTTj
Lemma 14 In the case of random dryness, there is p > 0 such that, for
all p < p , the utility attained selling the derivative by Cu , is larger than the
utility attained if the derivative is not included in the portfolio.
usell (Cu , p) u (p) .
Proof. Let, for a given p, {t , Bt }t=0,...,T 1 denote the solution of the
utility maximization problem with no derivative and {ut , Btu }t=0,...,T 1 de-
note the solution of the minimization problem that must be solved to find
22
sell
section 4.1). Moreover, let sell
denote an admissible sot , Bt
t=0,...,T 1
lution of the utility maximization problem when the agent sells one unit of
the derivative. Now, consider the limit case, when p approaches zero. In
that case, the portfolio
o
n
sell
sell
,
B
t
t
t=0,...,T 1
{t + ut , Bt + Btu }t=0,...,T 1
set of the problem that must be solved to find the upper bound is continuous
in p. Hence, when p 0, the solution of the problem is {ut , Btu }t=1,... ,T 1 =
u t u
0 , R B0 where {u0 , B0u } is the solution of following problem
iT
iT
T
min S0 + B s.a. ST + R B GT , iT .
,B
missible solution of the utility maximization problem when one unit of the
sell
Hence, the portfolio sell
is also admissible solution for the
t , Bt
t=0,...,T 1
optimization problem, when one unit of the derivative is being sold, which
guarantees a higher payo than the portfolio {t , Bt }t=0,...,T 1 . Hence,
usell (Cu , 0) u (0) .
Continuity on p of both usell and u ensure the result.
Remark 15 Notice that the existence of p follows from the continuity of
the utilities in p. Furthermore, it is possible to have p = 1. Examples with
dierent values of p are given in the end of this paper. The range of values
p < p characterizes what was vaguely described as suciently incomplete
markets in the introduction.
The reservation price for an agent that is selling the option is defined
as the value of C that makes usell (C, p) = u (p). Let Ru denote such
reservation price.
9
23
sup
{t ,Bt }t=0,...,T 1
C + y (0 S0 + B0 ) + E0G,P
XT
t=1
t ut (Zt ) ;
E0G,P
sup
{t ,Bt }t=0,...,T 1
XT
t=0
t ut (Zt )
subject to
Z0 + 0 S0 + B0 C + y
it
it
tj it
tj
St + Rj Btj
Ztit + itt Stit + Btit tj
iT
iT
j iT
j
ZTiT TTj
ST + Rj BTTj
+ GiTT
Lemma 17 In the case of random dryness, there is p > 0 such that, for
all p < p , the utility attained buying the derivative by Cl , is larger than the
utility attained if the derivative is not included in the portfolio.
ubuy (Cl , p) u (p) .
Proof. The proof is analogous to the one in proposition 14
Let Rl denote the reservation selling price, i.e., the price such that
u (p)
In this example, the reservation price for an agent who is buying the derivative coincides with that of an agent who is selling it.
25
that both intervals include the complete market value and the reservation
price.
We now use the same example to compare our methodology with the
one presented by Cochrane and Sa-Requejo (2000). We show that either
our interval is contained in theirs, or else, their interval do not contain the
above mentioned reservation price.
With the Sharpe ratio methodology the lower bound is given by
subject to
{m}
S0 = E [mS2 ] ; m 0; (m)
h
,
R2
where S0 is the initial price of the risky asset, and S2 is the price of the risky
asset at time t = 211 . The upper bound is
subject to
p = E [mS2 ] ; m 0; (m)
h
.
R2
26
E (
z+)
L.
E (
z)
The fair price is the one that makes the net result of the investment to
be null. In other words, for a benchmark investor, it would correspond to
the pricing kernel that would make
E (
z+)
= 1.
E z+ z = 0
E (
z)
This last equality characterizes the benchmark pricing kernel for a given
utility.
12
In order to get a lower bound higher than 33.88 it is necessary to impose aditionally
that m > 0. If that were not the case, then the lower bound would only be defined for h
0.2980 and would be equal to 33.88.
27
Notice that the fair price constructed in this way coincides with our
larger than
definition of the reservation price. Therefore, by choosing L
one, the interval built by Bernardo and Ledoit contains by construction the
reservation price of the benchmark agent.
can be chosen such that
On the other hand, the arbitrary threshold L
their interval is contained in the statistical arbitrage-free interval.
The disadvantages, however, are clear. First, the threshold is ad-hoc,
just as in the case of Cochrane and Sa-Requejo; second, the constructed
interval depends on the benchmark investor; and finally, the only reservation
price that is contained for sure in that interval, is the reservation price of
the benchmark investor. In other words, we cannot guarantee that the
reservation price of an arbitrary agent, dierent from the benchmark, is
contained in that interval.
Numerical Examples
7.1
40
39
38
37
36
35
34
33
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
Figure 2: The Upper and Lower Bounds for a European Call Option with
dierent value of p in a two period model, with U = 1.2, R = 1.1, D = 0.8,
S0 = 100 and K = 80.
we seem to have the former case, the three period example in Figure 3 seems
to suggest the latter, since the lower bound behaves as a concave function
of p for most of its domain.
Finally, we may use Figure 4 to illustrate several features.
First, let us regard the situations in this Figure that are related to pure
arbitrage. This includes the value of the derivative under perfectly liquid
(p = 1) and perfectly illiquid (p = 0) markets. In the former case, the
unique value of the derivative clearly decreases with the exercise price K, as
it should. In the latter, both the upper bound Cu0 and the lower bound Cl0
also decrease with K. More curiously, however, the spread Cu0 Cl0 has a
non-monotonic behaviour. Obviously this dierence is null for K less than
the infimum value of the stock at maturity and must go to zero as the strike
approaches the supremum of the stocks possible values at maturity. In the
middle of this range it attains a maximum. In our numerical example we
observe that the maximum value of the spread is attained for K close to
120.
29
30
25
20
15
10
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
Figure 3: The Upper and Lower Bounds for a European Call Option with
dierent value of p in a three period model, with U = 1.2, R = 0.9, D = 0.8,
S0 = 100 and K = 80.
50
45
K=80
40
35
K=100
30
25
20
K=120
15
K=140
10
K=160
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
Figure 4: The Upper and Lower bounds of an European Call Option for
dierent values of p and K (K = 80, K = 100, K = 120, K = 140 e
K = 160) in a three period model, with U = 1.2; R = 1.1; D = 0.8 and
S = 100.
30
16
14
p=0
12
10
0
p=1
-2
40
60
80
100
120
140
160
180
7.2
75
Without Derivative
Selling Derivative
Buying Derivative
70
65
60
55
50
45
40
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
33
50
Reservation Selling Price
Reservation Buying Price
Upper Bound
Lower Bound
45
40
35
30
25
20
15
10
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
Figure 7: Statistical Arbitrage free bounds and reservation prices for the
following parameters: U = 1.3, D = 0.6, R = 1, S0 = 100, K = 100,
= 1/r, q = 0.5 and y = 40.
Conclusion
35
References
[1] Amaro de Matos, J. and P. Anto, 2001, Super-Replicating Bounds
on European Option Prices when the Underlying Asset is Illiquid,
Economics Bulletin, 7, 1-7.
[2] Bernardo, A. and Ledoit, O., 2000, Gain, Loss, and Asset Pricing,
Journal of Political Economy, 108, 1, 144-172.
[3] Bondarenko, O., 2003, Statistical Arbitrage and Securities Prices, Review of Financial Studies, 16, 875-919.
[4] Cochrane, J. and Sa-Requejo, J., 2000, Beyond Arbitrage: Good-Deal
Asset Price Bounds in Incomplete Markets, Journal of Political Economy, 108, 1, 79-119.
[5] Edirisinghe, C., V. Naik and R. Uppal, 1993, Optimal Replication of
Options with Transaction Costs and Trading Restrictions, Journal of
Financial and Quantitative Analysis, 28, 117-138.
[6] El Karoui, N. and M.C. Quenez, 1991, Programation Dynamique et
valuation des actifs contingents en march incomplet, Comptes Rendues de l Academy des Sciences de Paris, Srie I, 313, 851-854
[7] El Karoui, N. and M.C. Quenez, 1995, Dynamic programming and
pricing of contingent claims in an incomplete market, SIAM Journal
of Control and Optimization, 33, 29-66.
[8] Hansen. L.P. and R. Jagannathan. Implications of Security Market Data
for Models of Dynamic Economies. Journal of Political Economy, 99,
225-262, 1991.
[9] Karatzas, I. and S. G. Kou, 1996, On the Pricing of Contingent Claims
with Constrained Portfolios, Annals of Applied Probability, 6, 321-369.
[10] Longsta, F., 1995, How Much Can Marketability Aect Security Values?, The Journal of Finance, 50, 17671774.
36
[11] Longsta, F., 2001, Optimal Portfolio Choice and the Valuation of Illiquid Securities, Review of Financial Studies, 14, 407-431.
[12] Longsta, F., 2004, The Flight-to-Liquidity Premium in U.S. Treasury
Bond Prices, Journal of Business, 77, 3.
[13] Mas-Colell, A., Whiston, M. and Green, J., 1995, Microeconomic Theory, Oxford University Press.
37
A.1
Proof of theorem 10
(i ,T ),m
T
Proof. For any given path m +
it ,iT let (it ,t)
h is i
px
iT
t0 s is
0 = s
x
S
p
S
B
K
Eit t,T
0 +R
x
t,t
0
s
s
t
T
t,t
0
s=t,... ,t 1
t0
For any given path m +
it ,i 0 let (it ,t)
t
px 0 h
0
i
i
i
Eit t,t ixxt,t0 Sti0 + Rt x Bxixt,t0 tt0 0 St0t0 + Bt0t0 0.
i
Considering ntt0 be the number of nodes that are predecessors of node it0 at
time t we have
i
ntt0 = min t0 (it0 1) , it0 1, t0 t + 1
The problem that must be solved in order to find the upper bound of
T
+1
X
j=1
h
i+
iT STiT K
where iT is the sum of the dual variables associated with the positive exi+
h
pected payo constraints that have the right member equal to STiT K =
+
T +1i i 1
TD T
S0 K , i.e.,
U
iT
T
1
X
n
o
t=0 {it :it It }
m+
i ,i
t T
38
(i ,T ),m iT
ST
(iTt ,t)
(iTt ,t)
(i ,t0 ),m
, (itt0,t)
straints, one constraint associated with each variable of the primal problem.
As there are
2
XT 1
t=0
(t + 1) = 2
1 + (T 1 + 1)
T = T (T + 1)
2
P
P
px0,T (x0,T = 0)
iT IT
m+
(i ,T ),m iT
ST
(iT0 ,0)
i0 ,iT
PT 1 Qt1
t=2
j=1 py
(yj = 0)
Pn
it :i0 I0t
i0 ,iT
PT 1 Qt1
t=2
j=1 py
(yj =
0) Rt
Pn
(1,1)
(2,1)
m+
i ,i
0 t
(i ,t),m
(it0 ,0) Stit
= S0
(1,1)
(2,1)
iiT0 ,m + R (i0 ,0) + (i0 ,0)
i
it :i0 I0t
m+
i ,i
0 t
(i ,t),m
(it0 ,0)
=1
px1,T
P
Pn
o (iT ,T ),m S iT +
px0,T (x0,T = k) m+
i
T
(i0 ,0)
iT :i0 I0T
i0k ,iT
Pn
P
P
o
o
n
n
o (iT ,T ),m S iT
(x1,T = k)
i
i
T
(i1 ,1)
:i m
i :i I k
m+
i :i I T
1 1
i1 ,iT
....
P
P
P
(i ,T ),m
pxt,T (xt,T = k) n i :i I ik o nm+ :i mo ni :i I iT o (iTt ,t) STiT =
t t
T k
k
t
i
,i
k
t
T
Pn
Pn
Pn
Pk
(iT ,T ),m iT
o
o
o
(it ,t) ST
i
i
t=0 pxt,T (xt,T = k)
m+ :i m
i :i I k
i :i I T
it ,iT
t t
Pn
P
P
Pn
(it0 ,t0 ),m it0
o
o
(it ,t) St0
i
t<k
t0 >k pxt,t0 xt,t0 = k
it :it It k
m+
it ,it:ik m
P
P
(i ,k),m
t<k ni :i I ik o (ikt ,t) Skik = 0.
t t
39
Pn
Pk
Pn
Pn
(iT ,T ),m iT
o
o
o
(it ,t) ST +
i
i
t=0 pxt,T (xt,T = k)
iT :ik IkT
it :it It k
m+
it ,iT :ik m
Pn
P
P
Pn
(it0 ,t0 ),m it0
o
o
(it ,t) St0 +
i
t<k
t0 >k pxt,t0 xt,t0 = k
it :it It k
m+
it ,it:ik m
P
P
(i ,k),m
t<k ni :i I ik o (ikt ,t) Skik = 0
t t
Pn
Pk
Pn
Pn
(iT ,T ),m T k
o
o
o
+
(it ,t) R
i
i
t=0 pxt,T (xt,T = k)
it :it It k
m+
iT :ik IkT
it ,iT :ik m
Pn
0
P
P
Pn
o
o (it0 ,t ),m Rt0 t
ik
+
t<k
t0 >k pxt,t0 xt,t0 = k
(it ,t)
it :it It
mi ,i :ik m
t t
P
Pn
(ik ,k),m
o
(it ,t) = 0
t<k
i
i :i I k
t t
PT 1
Pn
Pn
Pn
(iT ,T ),m iT
o
o
o
(it ,t) ST +
i
i
t=0 pxt,T (xt,T = T 1)
iT :iT 1 ITT1
m+
it :it It T 1
it ,iT :iT 1 m
P
Pn
o (iT 1 ,T 1),m S iT 1 = 0
t<T 1
iT 1
T 1
(it ,t)
it :it It
PT 1
Pn
Pn
Pn
(iT ,T ),m
o
o
o
(it ,t) R +
i
i
t=0 pxt,T (xt,T = T 1)
iT :iT 1 ITT1
m+
it :it It T 1
it ,iT :iT 1 m
P
P
o (iT 1 ,T 1),m = 0
t<T 1 n
iT 1
(it ,t)
it :it It
The left member of each constraint is a linear combination of the variables of the dual problem. The right member is equal to S0 and 1 for the
dual constraints associated with the variables 0 and B0 ,respectively. For
the remaining constraints the right member is equal to zero. First, let us
consider only the constraints associated with primal variables s. For a
given iT the terms involving in the dual constraints regarding ik is
pxt,T (xt,T = k)
it :it It k
on
o
m+
i ,i :ik m
40
t T
(i ,T ),m iT
ST
(iTt ,t)
pxt,T (xt,T = k)
{it :it It } m+
i ,i
t T
(i ,T ),m iT
ST
(iTt ,t)
As,
T
1
X
pxt,T (xt,T = k) = 1,
k=t
summing for all k t, the term associated with STiT that is multiplying by
pxt,T (xt,T = .) is
X
{it :it It } m+
i ,i
t T
(i ,T ),m iT
ST
(iTt ,t)
t T
(i ,T ),m iT
ST
(iTt ,t)
T
1
X
t T
(i ,T ),m iT
ST
(iTt ,t)
= S0
X
s<t
(i ,t),m
is :is Ist
{z
}
from the constraint it
t1 X
t1
X
X
px (xk,t = s)
k,t
n
k=0 s=k
ik :ik Ikt
on
(i ,t),m
(itk ,k) Stit
m+
i ,i :is m
k t
{z
summing up all the constraints ik , with ik Ikit
41
As,
t1
X
pxk,t (xk,t = s) = 1
s=k
the above equations sum up to zero. Summing up over all Stit a zero will
also be obtained. Hence, if all dual constraints that concern Stit are summed
up, the following relation is obtained:
S0 =
T
1
X
t T
(i ,T ),m iT
ST
(iTt ,t)
(4)
Now, proceeding in a similar way but considering the dual constraints associated with Bs. Because the right member of the constraints is equal to 0,
excepting the one associated B0 , we multiply each constraint by a constant.
The constraint associated with the variable Bik is multiplied by Rk . Then,
all the constraints associated with Bs are summed up, and
X
T
1
X
(i ,T ),m
n
o
{iT :iT IT } t=0 {it :it It } m+
i ,i
q(itT,t)
=1
t T
where
(i ,T ),m
q(itT,t)
(i ,T ),m
= RT t (iTt ,t)
Denoting,
q iT =
T
1
X
n
o
t=0 {it :it It } m+
i ,i
(i ,T ),m iT
ST
q(itT,t)
t T
1
RT
q iT STiT
{iT :iT IT }
with
X
q iT = 1
{iT :iT IT }
42
A.2
Proof. As the problem sketched in the example of section to obtain the upper bound is a linear programming problem, considering Stit = U t(it 1) Dit 1 ,
its dual is written as follows:
min
)
(
(i 0 ,t0 ),m
(i ,T ),m
(i T,t)
, (i t,t)
t
+
(1,3)
(1,3)
(1,3)
(0,0) + (1,1) + (1,2) S31 K
+
(2,3),1
(2,3),3
(2,3),3
(2,3),1
(2,3),2
(2,3)
(2,3)
(2,3)
+ (0,0) + (0,0) + (0,0) + (1,1) + (1,1) + (2,1) + (1,2) + (2,2) S32 K
+
(3,3),1
(3,3),2
(3,3),3
(3,3)
(3,3),1
(3,3),2
(3,3)
(3,3)
+ (0,0) + (0,0) + (0,0) + (1,1) + (2,1) + (2,1) + (2,2) + (3,2) S33 K
+
(4,3)
(4,3)
(4,3)
+ (0,0) + (2,1) + (3,2) S34 K
(iTt ,t)
0,
(itt0,t)
i
0,
for all it It t , it0 It0 and t0 = 0, 1 and 2, and subject to twelve equality
constraints, each one associated with a variable of the primal problem. The
constraint associated with 0 is given by
"
P
(1,3)
(2,3),m
(0,0) S32 +
(1 p)2 (0,0) S31 +
m=1,2,3
(1,1)
m=1,2,3
(3,3),m
(4,3)
#
(5)
(2,1)
i
(1,2)
(2,2),1
(2,2),2
(3,2)
+ (1 p) (0,0) S21 + (0,0) + (0,0) S32 + (0,0) S23 = S0
m=1,2,3
(3,3),m
(0,0)
(4,3)
+ (0,0)
h
i
(1,1)
(2,1)
(1,2)
(2,2),1
(1,2),2
(3,2)
+R (0,0) + (0,0) + (1 p) R2 (0,0) + (0,0) + (0,0) + (0,0) = 1
(6)
43
"
(1,3)
+p (1 p) (0,0) S31 +
(2,3),m
m=1,2
(3,3),1
(7)
i
h
(1,1)
(1,2)
(2,2),1
(1,2)
(2,2)
(0,0) S11 + p (0,0) S21 + (0,0) S22 + (1,1) S21 + (1,1) S22 = 0
"
(1,3)
+p (1 p) R2 (0,0) +
(2,3),m
m=1,2
(0,0)
(3,3),1
+ (0,0)
(8)
i
h
i
h
(1,1)
(1,2)
(2,2),1
(1,2)
(2,2)
(0,0) + pR (0,0) + (0,0) + R (1,1) + (1,1) = 0
"
(2,3),3
+p (1 p) (0,0) S32 +
(3,3),m
m=2,3
(4,3)
(9)
i
h
(2,1)
(2,2),2
(3,2)
(2,2)
(3,2)
(0,0) S12 + p (0,0) S22 + (0,0) S23 + (2,1) S22 + (2,1) S23 = 0
"
(2,3),3
+p (1 p) R2 (0,0) +
m=2,3
(3,3),m
(0,0)
(4,3)
+ (0,0) +
h
i
h
i
(2,1)
(2,2),2
(3,2)
(2,2)
(3,2)
(0,0) + pR (0,0) + (0,0) + R (2,1) + (2,1) = 0
44
(10)
(1,3)
(2,3)
(1,3)
(2,3),1
(1,2) U 3 S0 + (1,2) U 2 DS0 + p (1,1) U 3 S0 + (1,1) U 2 DS0
(11)
(12)
(1,3)
(2,3),1
(1,2)
(1,2),1
+p (0,0) U 3 S0 + (0,0) U 2 DS0 (0,0) U 2 S0 (1,1) U 2 S0 = 0
h
i
(1,3)
(2,3),1
(1,2),1
(1,2)
+pR (0,0) + (0,0) (0,0) (1,1) = 0
i
h
(2,3)
(3,3)
(2,3),2
(2,3)
(3,3)
(3,3),1
(2,2) S32 + (2,2) S33 + p (1,1) + (2,1) S32 + (1,1) + (2,1) S33
+p
h
(2,3),2
(2,3),3
(3,3),1
(3,3),2
(0,0) + (0,0) S32 + (0,0) + (0,0) S33
h
h
i
i
(2,2),1
(2,2),2
(2,2)
(2,2)
(0,0) + (0,0) S22 (1,1) + (2,1) S22 = 0
(13)
(14)
i h
i
h
(2,2),1
(2,2),2
(2,2)
(2,2)
(0,0) + (0,0) (1,1) + (2,1) = 0
(15)
(16)
i
h
(3,3),3
(4,3)
(3,2)
(3,2)
+p (0,0) U D2 S0 + (0,0) D3 S0 (0,0) D2 S0 (1,1) D2 S0 = 0
i
h
(3,3),3
(4,3)
(3,2)
(3,2)
+pR (0,0) + (0,0) (0,0) (1,1) = 0
45
(1,3)
(1,3)
(1,3)
S0 = (0,0) + (1,1) + (1,2) S31 +
+
(0,0)
(0,0)
m=1,2,3
m=1,2,3
(2,3),m
(2,3),m
m=1,2
(3,3),m
(1,1)
(2,3)
(2,3)
(3,3)
(3,3)
+ (1,1) +
(2,3)
m=1,2
(3,3),m
(2,1)
(3,3)
(17)
(4,3)
(4,3)
(4,3)
+ (0,0) + (2,1) + (3,2) S34
Multiplying equations (8) and (10) by R and equations (12), (14) and
(15) by R2 and then summing up with equation (6) we obtain
P
P
(1,3)
(2,3),m
(3,3),m
(4,3)
(0,0) +
(0,0) + (0,0) +
(0,0) +
m=1,2,3
m=1,2,3
P (2,3),m
P (3,3),m
(1,3)
(3,3)
(2,3)
(4,3)
(1,1) + (1,1) + (2,1) +
(2,1) + (2,1) +
(1,1) +
m=1,2
(1,3)
(2,3)
+(1,2) + (1,2)
(2,3)
+ (2,2)
(3,3)
+ (2,2)
m=1,2
(3,3)
(4,3)
+ (3,2) + (3,2)
1
R3
Hence, denoting
(i 0 ,t0 )
(i 0 ,t0 )
(1,3)
(1,3)
q4
(4,3)
q(0,0)
m=1,2
(4,3)
(4,3)
+ q(2,1) + q(3,2)
1
R3
1 1
i
1 h (1,3) 1
(2,3)
(1,2) S3 + (1,2) S32
R
46
where
(1,3)
(1,3)
(1,3)
(1,3)
(1,3)
(2,3)
(2,3),1
(2,3),1
(2,3)
(2,3),1
(2,3),1
(1,2) +p(1,1) +p(0,0)
(1,3)
(1,3)
(1,3)
(2,3)
(2,3),1
(2,3),1
(1,2) +p(1,1) +p(0,0) +(1,2) +p(1,1) +p(0,0)
(2,3)
(1,2) =
(1,3)
(1,3)
(1,3)
(1,2) =
(2,3)
(2,3)
(2,2)
(3,3)
(2,2) =
(2,3)
(2,3),2
(2,3)
(2,3),2
(2,3),3
(2,2) +p (1,1) +(2,1) +(0,0) +(0,0)
(2,3)
(2,3),2
(2,3)
(2,3),2
(2,3),3
(3,3)
(3,3)
(3,3),1
(3,3),1
(3,3),2
(2,2) +p (1,1) +(2,1) +(0,0) +(0,0) +(2,2) +p (1,1) +(2,1) +(0,0) +(0,0)
(3,3)
(3,3)
(3,3),1
(3,3),1
(3,3),2
(2,2) +p (1,1) +(2,1) +(0,0) +(0,0)
(2,3)
(2,3),2
(2,3)
(2,3),2
(2,3),3
(3,3)
(3,3)
(3,3),1
(3,3),1
(3,3),2
(2,2) +p (1,1) +(2,1) +(0,0) +(0,0) +(2,2) +p (1,1) +(2,1) +(0,0) +(0,0)
(2,3)
(3,3)
(4,3)
(3,2) =
(3,3)
(4,3)
i
1 h (3,3) 3
(4,3)
(3,2) S3 + (3,2) S34
R
(3,3)
(3,3),2
(3,3),3
(3,2) +p (2,1) +(0,0)
(3,3)
(3,3),2
(3,3),3
(4,3)
(4,3)
(4,3)
(3,2) +p (2,1) +(0,0) +(3,2) +p (2,1) +(0,0)
(4,3)
(4,3)
(4,3)
(3,2) +p (2,1) +(0,0)
(3,3)
(3,3),2
(3,3),3
(4,3)
(4,3)
(4,3)
(3,2) +p (2,1) +(0,0) +(3,2) +p (2,1) +(0,0)
where
(1,3)
(1,1)
"
R2
(2,3)
h
i
(1,3)
(1,3)
R2 (1p)(1,1) +p(1p)(0,0)
(1p)
m=1,2
(1,1) =
(3,3)
(1,1) =
(1,2)
(1,1)
R2
(2,3),m
(1,1) +p(1p)
(2,3),m
m=1,2
(0,0)
i
(3,3)
(3,3),1
(1p)(1,1) +p(1p)(0,0)
i
h
(1,2)
(1,2)
R p(0,0) +(1,1)
(2,2)
(1,1)
47
i
h
(2,2),1
(2,2)
R p(0,0) +(1,1)
h
i
(1,3)
(1,3)
= R2 (1 p) (1,1) + p (1 p) (0,0)
X (2,3),m
X (2,3),m
+R2 (1 p)
(1,1) + p (1 p)
(0,0)
m=1,2
m=1,2
h
i
h
i
(3,3)
(3,3),1
(1,2)
(1,2)
(2,2),1
(2,2)
+R2 (1 p)(1,1) + p(1 p)(0,0) + R p(0,0) + (1,1) + p(0,0) + (1,1)
and
S12 =
i 1 h
i
1 h (1,3) 2
(2,3) 3
(3,3) 4
(1,2) 2
(2,2) 3
S
+
S
+
S
S
+
+
, with
3
3
3
2
2
(2,1)
(2,1)
(2,1)
R2 (2,1)
R (2,1)
(2,3)
h
i
(2,3),3
(2,3),3
R2 (1p)(1,1) +p(1p)(0,0)
(1,3)
(2,1) =
"
#
P
P
(3,3),m
(3,3),m
2
R (1p)
(1,1) +p(1p)
(0,0)
m=1,2
(2,1) =
(3,3)
(2,1) =
(1,2)
(2,1)
R2
m=2,3
i
(4,3)
(4,3)
(1p)(1,1) +p(0,0) (1p)
i
h
(2,2),2
(2,2)
R p(0,0) +(2,1)
(2,2)
(2,1)
i
h
(3,2)
(3,2)
R p(0,0) +(2,1)
h
i
(2,3),3
(2,3),3
= R2 (1 p) (1,1) + p (1 p) (0,0)
X (3,3),m
X (3,3),m
+R2 (1 p)
(1,1) + p (1 p)
(0,0) +
m=1,2
m=2,3
i
h
h
i
(4,3)
(4,3)
(2,2),2
(2,2)
(3,2)
(3,2)
+R2 (1 p) (1,1) + p(0,0) (1 p) + R p(0,0) + (2,1) + p(0,0) + (2,1) .
A.3
For T = 2 the problem that must be solved to find the upper bound of the
arbitrage free range of variation is the following
Cu =
0 S0 + B0
min
{0 ,B0 ,11 ,B11 ,21 ,B12 }
48
p 11 U 2 S0 + RB11 + (1 p) 0 U 2 S0 + R2 B0
p 21 U DS0 + RB12 + (1 p) 0 D2 S0 + R2 B0
p 21 D2 S0 + RB12 + (1 p) 0 D2 S0 + R2 B0
1 U S0 + RB11
1
1 U DS0 + RB11
2
1 U DS0 + RB12
2 2
1 D S0 + RB12
and self-financing,
+
U 2 S0 K (18)
(U DS0 K)+
(U DS0 K)+
+
D2 S0 K (19)
+
2
U S0 K
(U DS0 K)+
(20)
(U DS0 K)+
+
D2 S0 K
(21)
11 U S0 + B11 0 U S0 + RB0
(22)
(23)
i
(1,2)
+(0,0) U 2 S0 K p 11 U 2 S0 + RB11 (1 p) 0 U 2 S0 + R2 B0 +
(2,2),1
+(0,0) (U DS0 K)+ p 11 U DS0 + RB11 (1 p) 0 U DS0 + R2 B0
(2,2),2
+(0,0) (U DS0 K)+ p 21 U DS0 + RB12 (1 p) 0 D2 S0 + R2 B0
h
i
+
(3,2)
+(0,0) D2 S0 K p 21 D2 S0 + RB12 (1 p) 0 D2 S0 + R2 B0
(2,1)
+(0,0) 11 U S0 + B11 0 U S0 RB0
(1,1)
+(0,0) 21 DS0 + B12 (0 DS0 + RB0 )
h
i
+ 1 2
(1,2) 2
1
+(1,1) U S0 K 1 U S0 + RB1
(2,2)
+(1,1) (U DS0 K)+ 11 U DS0 + RB11
(2,2)
+(2,1) (U DS0 K)+ 21 U DS0 + RB12
h
+
i
(3,2)
+(2,1) D2 S0 K 21 D2 S0 + RB12
49
(2,2),2
(1,2)
(3,2)
(3,2)
(2,1)
(1,1)
(2,2)
(2,2)
0 =
i
+ h
2
(U R) (R D) + p (R D)2
U S0 K
S0
i
2
+ h
2
D S0 K
(U R) (R D) + p (R U )
(24)
S0
2DR + 2RU + D2 U 2
S0
p (U DS0 K)
B0 =
+
+
i
+ h 2
2
D (U R) (R D) + pU D (R D)2
U S0 K
R2
i
+ h 2
2
U (U R) (R D) + pU D (R U )2
D S0 K
R2
pR (U DS0 K)
where
= U 2 (U R) (R D) p R2 + 4RD DU
D2 (U R) (R D) p R2 UD + 4RU
2
+
+ i
1 h 2
+
U
D
q
S
K
+
q
(U
DS
K)
+
q
S
K
1
0
2
0
3
0
R2
50
with
q1
q2
q3
(U R) (R D) R2 D2 + p (R D)2 R2 U D
=
2 2
2
(R D) U R + (R U )2 R2 D2
= p
(U R) (R D) U 2 R2 + p (R U )2 U D R2
=
A.4
A.4.1
Property 3
1. Proof. Let the set of admissible solutions that characterize the upper
bound for the case p (0, 1) be denoted by A (p) ,where A (p) is a
correspondence such that
A (p) : [0, 1] Rt(t+1) .
The portfolio (, B) = (it , Bit )it It , t=0,... ,T 1 Rt(t+1) is said to
p1
13
51
p0
2
+
+
U S0 K D2 S0 K
S0 [U 2 D2 ]
+
+
U 2 D2 S0 K D2 U 2 S0 K
R2 (U 2 D2 )
lim Cup = 0 S0 + B0
2
2
+
+
R D2 2
1
U R2 2
U S0 K +
D S0 K
,
=
R2
U 2 D2
U 2 D2
p0
i.e., limp0 Cup = Cu0 . On the other hand, when p 1, which means that
+
2
U S0 K (R D) D2 S0 K (U R) + (U DS0 K)+ (U 2R + D)
0 =
S0 R (U D)2
+
+
D (R D) 2
U (U R) 2
U S0 K +
D S0 K
2
2
R2 (U D)
R2 (U D)
[D (U R) + U (R D)]
+
(U DS0 K)+
R2 (U D)2
B0 =
then,
lim Cup = 0 S0 + B0
p0
2
+
1 X 2
R D j U R 2j j T j
S0 K ,
U D
2
R
U D
U D
j
j=0
i.e.,
limp0 Cup
= Cu1 .
52
A.4.2
Property 4
t,B
t
Proof. Consider the trading strategy
that solves the
t=0,... ,T 1
Fix a given path w, such that (it )t=0,... ,T w. For each path we have T
superreplicating constraints, one for each t {0, . . . , T 1} . For T 1,
+
iT
i
i S iT + RB
K
,
T
T 1 T
T 1
for t = T 2
iT
i
i
i S iT + RB
i S iT + R2 B
+
p
K
,
(1 p)
T
T 2 T
T 2
T 1 T
T 1
which can be rewritten as
+
iT
iT
iT
iT
(1 p) iT 2 ST + R BiT 2 ST K
+ p iT 1 ST + RBiT 1 ST K
0;
for t = T 3
iT
iT
2
3
(1 p) iT 3 ST + R BiT 3 + p (1 p) iT 2 ST + R BiT 2 +
+
iT
iT
S
+
R
B
K
,
S
+ p (1 p) + p2
iT 1 T
iT 1
T
which can be rewritten as
+
iT
iT
iT
iT
2
3
+ p iT 1 ST + RBiT 1 ST K
(1 p) iT 3 ST + R BiT 3 ST K
+
iT
iT
+p (1 p) iT 2 ST + R BiT 2 ST K
0,
More generally, for t
Property 5
The upper bound of the ask price in a complete market can be written as
Cu1 =
+
+ i
1 h liq 2
liq
liq 2
+
K
+
(U
DS
K)
+
K
U
D
0
0
0
2
3
R2 1
with
liq
=
1
liq
=
1
liq
=
1
(R D)2
(U D)2
(R D) (U R)
(U D)2
(U R)2
(U D)2
and the upper bound of the ask price in an illiquid market can be written
as
Cu0 =
with
+
+ i
1 h illiq 2
illiq 2
U
D
K
+
K
0
0
3
R2 1
=
illiq
1
illiq
=
3
R2 D 2
U 2 D2
U 2 R2
U 2 D2
Hence, the upper bound for the ask price in a random dry market can
be written
Cup = Cu1 + (1 ) Cu0
54
(25)
with
R(UD)2
(U R)(U+D)(RD)
= p
1+p
1 =
1+p
R(U D)2
(U R)(U +D)(RD)
1p
R(U D)2
(UR)(U +D)(RD)
i
1
i
1
R (U D)2 (R + D) (U R) (U + D) R2 D2
=n
h
io2 0
p
2
2
2
2
(U R) (U + D) (R D ) + p (R D) U (R + D) + (U R) D (R + D)
Hence, taking the derivative of Cu0 with respect to p we conclude that
Cu0 is a decreasing function of p,
Cup
p
1 0
C
C
p u p u
1
Cu Cu0 0.
p
=
=
Taking the second derivative we can also conclude that Cup is a convex function with respect to p,
2 Cup
p2
2 1 2 0
C
C
p2 u p2 u
2 1
Cu Cu0
2
p
=
=
as
2
0
p2
we have
2 Cup
0.
p2
Alternative proof: After some algebra we obtain that following relation
between , in equation (25) and p:
>p
55
So, as
C0ask liq C0ask illiq 0
we obtain,
0
(p ) C0ask liq C0ask illiq
i
h
pC0ask liq + (1 p) C0ask illiq C ask liq + (1 ) C ask illiq 0
and follows that
C0ask pC0ask liq + (1 p)C0ask illiq .
B
B.1
Proof. The problem that must be solved in order to find the upper bound of
the range of variation of the arbitrage-free value of an European derivative
is a linear programming problem. Its dual problem is
max
iT
T
+1
X
j=1
h
i+
iT STiT K
where iT is the sum of the dual variables associated with the positive exi+
h
pected payo constraints that have the right member equal to STiT K =
+
T +1i i 1
TD T
S0 K , i.e.,
U
iT =
T
1
X
t T
(i ,T ),m iT
ST
(iTt ,t)
(iTt ,t)
(i ,t0 ),m
, (itt0,t)
straints, one constraint associated with each variable of the primal problem.
The other set are equality constraints which are equal to the ones obtained
for the upper bound. Using the same argument as in the proof of theorem
1 the proof is straightforward.
56
B.2
For T = 2 the problem that must be solved to find the lower bound of the
arbitrage free range of variation is the following
Cl =
0 S0 + B0
max
{0 ,B0 ,11 ,B11 ,21 ,B12 }
p 11 U 2 S0 + RB11 + (1 p) 0 U 2 S0 + R2 B0
p 21 U DS0 + RB12 + (1 p) 0 D2 S0 + R2 B0
p 21 D2 S0 + RB12 + (1 p) 0 D2 S0 + R2 B0
1 U S0 + RB11
1
1 U DS0 + RB11
2
1 U DS0 + RB12
2 2
1 D S0 + RB12
and self-financing,
U 2 S0 K
(U DS0 K)+
(U DS0 K)+
+
D2 S0 K
+
2
U S0 K
(U DS0 K)+
(U DS0 K)+
+
D2 S0 K
11 U S0 + B11 0 U S0 + RB0
21 DS0 + B12 0 DS0 + RB0 .
57
i
(1,2)
+(0,0) U 2 S0 K p 11 U 2 S0 + RB11 (1 p) 0 U 2 S0 + R2 B0 +
(2,2),1
+(0,0) (U DS0 K)+ p 11 U DS0 + RB11 (1 p) 0 U DS0 + R2 B0
(2,2),2
+(0,0) (U DS0 K)+ p 21 U DS0 + RB12 (1 p) 0 D2 S0 + R2 B0
h
+
i
(3,2)
+(0,0) D2 S0 K p 21 D2 S0 + RB12 (1 p) 0 D2 S0 + R2 B0
(2,1)
+(0,0) 11 U S0 + B11 0 U S0 RB0
(1,1)
+(0,0) 21 DS0 + B12 (0 DS0 + RB0 )
h
i
+
(1,2)
+(1,1) U 2 S0 K 11 U 2 S0 + RB11
(2,2)
+(1,1) (U DS0 K)+ 11 U DS0 + RB11
(2,2)
+(2,1) (U DS0 K)+ 21 U DS0 + RB12
h
+
i
(3,2)
+(2,1) D2 S0 K 21 D2 S0 + RB12
The constraints that are binding depend on the value of the parameters.
First, if R2 U D < 0 and p >
R2 UD
R2 UD+R(U D)
U DR2
U DR2 +R(U D) or
(3,2)
(2,2)
(2,2)
(2,2),2
(2,1)
(1,1)
(1,2)
(3,2)
(2,2),1
U DR2
U DR2 +R(U D)
(1,2)
(2,2)
(1,1)
(3,2)
(2,1)
(2,2)
(3,2)
(3,2)
R2 U D
R2 U D+R(UD)
(2,2)
(3,2)
(2,1)
and
(1,2)
(2,2),1
(1,1)
(1,2)
(2,2)
with
q
+
+
Cl = q1 U 2 S0 K + q 2 [U DS0 K]+ + q 3 U 2 S0 K
(R D)2 U D R2 + p (U R) (R D) D2 R2
i
h
R2 (U R)2 (D2 U D) + (R D)2 (U D D2 ) + p (U R) (R D) (D2 U 2 )
(U R)2 D2 R2 + (R D)2 R2 U 2
h
i
R2 (U R)2 (D2 U D) + (R D)2 (U D D2 ) + p (U R) (R D) (D2 U 2 )
(U R)2 R2 U D + p (U R) (R D) R2 U 2
h
i
R2 (U R)2 (D2 U D) + (R D)2 (U D D2 ) + p (U R) (R D) (D2 U 2 )
q2 =
q3 =
Cl =
U DR2
or
U DR2 +R(U D)
+
R D2
1
U D R2 2
+
[U
DS
K]
+
S
K
D
0
0
R2 D (U D)
D (U D)
UDR2
UDR2 +R(U D)
(27)
and
+
R UD 2
1
U 2 R2
+
U S0 K +
[U DS0 K]
Cl = 2
R U (U D)
U (U D)
B.3
(26)
(28)
R2 UD
R2 UD+R(U D) .
The proofs are analogous to the ones presented in appendix A.4 for the
upper bound.
B.3.1
Property 3
in (2) for T=2. On the other hand, when p 1, which means that there is
no illiquidity, the values of q1 , q2 and q3 presented in (26) tend to
(R D)2 U D R2 + (U R) (R D) D2 R2
lim q1 =
p1
R2 (U R)2 (D2 U D) + R2 (R D)2 (U D U 2 ) + R2 (U R) (R D) (D2 U 2 )
=
(R D)2
R2 (U D)2
lim q2 =
(U R)2 D2 R2 + (R D)2 R2 U 2
lim q3 =
(U R)2 R2 U D + (U R) (R D) R2 U 2
p1
p1
then,
lim Cl =
p0
+
(R D)2 2
(R D) (U R)
[U DS0 K]+
U S0 K + 2
2
2
2
2
R (U D)
R (U D)
2
(U R)
+
2
+
2 U S0 K
2
R (U D)
60