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11 Aufrufe94 SeitenACTL 3182 JZIVEYI

Jul 25, 2017

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ACTL 3182 JZIVEYI

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11 Aufrufe

ACTL 3182 JZIVEYI

© All Rights Reserved

Als PDF, TXT **herunterladen** oder online auf Scribd lesen

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Jonathan Ziveyi1

1 UNSW

Australia

Risk and Actuarial Studies, UNSW Business School

j.ziveyi@unsw.edu.au

1/77 Version 2017. Copyright UNSW School of Risk and Actuarial Studies

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

2/77 Hedging

Continuous Time Derivative Valuation

Learning Outcome

Apply contingent-claim pricing techniques to value and manage

the risks of embedded options and guarantees.

Brownian motion

3/77

What to Expect in this Module

time framework.

We saw that some key mathematical ideas were

Martingales

Filtration, conditional expectations

Q measure (vs P measure)

We now focus on how to create a continuous time model

(based on Brownian motion), and explore the concepts

above in a continuous time model.

A continuous time model can often allow much more

modelling flexibility, and in some cases can be numerically

much simpler to apply.

Note that in the following we will focus on the main ideas,

and some results will be shown only heuristically.

4/77

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

5/77 Hedging

Change of Measure - Binomial model

We firstly stay in a (two step) binomial tree setting, and

explore the relationship between P and Q in a bit more

detail.

With each possible path we can attach a P probability :

1-3-7 p 1 p3 7

1-3-6 p1 (1 p3 ) 6

1-2-5 (1 p1 ) p2 5

1-2-4 (1 p1 ) (1 p2 ) 4

If we were to define another measure Q on this process,

we can set

Path (states) Q-Probability

1-3-7 q 1 q3 7

1-3-6 q1 (1 q3 ) 6

1-2-5 (1 q1 ) q2 5

1-2-4 (1 q1 ) (1 q2 ) 4

5/77

Radon-Nikodym: Mathematical Derivative

the ratios

j

j

We call (define) this

dQ

Y =

dP

the "Radon Nikodym derivative" of Q with respect to P, up to

time 2.

dQ

Using dP , we can immediately derive Q from P.

6/77

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

7/77 Hedging

Equivalent Probability Measures

equivalent martingale measure for the real-world

probability measure P.

Definition: Two measures P and Q are equivalent if:

agree on the possible outcomes, but disagree on some (or

all) the individual probabilities.

7/77

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

8/77 Hedging

dQ

Expectations and dP

when we consider expectations. We know that

X

EP [X ] = i xi .

i

So,

X

EQ [X ] = i xi

i

X

i

= i xi

i

i

dQ

= EP X

dP

8/77

Disussion Question

h i

dQ

What is EP dP =?

9/77

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

10/77 Hedging

Radon-Nikodym as a Process

derivative as a random variable (on maturity T).

How about a process? Turns out we can do this by defining

(t) to be the Radon-Nikodym (mathematical) derivative

(as a random variable) up to time t.

In fact, there is another representation: (proof not required)

dQ

(t) = EP |F(t)

dP

10/77

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

11/77 Hedging

Radon-Nikodym Summary

we can define a random variable dQ dP defined on the P

possible paths, taking positive values, such that

dQ

EQ [X ] = EP X

dP

for a random variable X known at time T.

We also have

for 0 t T ,

EQ [X |Ft ] = 1 (t) EP [ (T ) X |Ft ]

where

dQ

(t) = EP |Ft .

dP

11/77

Foundations for Continuous Time Models - Brownian

Motion

periods. What happens when we let n become very large?

Example: Arithmetic Random Walk Wn (t):

Consider a binomial process Wn (t) with

1. Wn (0) = 0

2. Layer spacing n1

3. Up and Down jumps equal of size 1n

4. Consider measure P, with probability of up and down jumps

to be 12 .

12/77

Brownian Motion cont...

Let Xi be a series of IID random variables that takes value

1

We have, for i = 1, 2, .., nt:

i i 1 X

Wn = Wn + i

n n n

and in particular

Xnt

X

Wn (t) = 0 + i

i=1

n

nt

!

X X

= t i

i=1

nt

approaches a N (0, 1) by the CLT.1

1

13/77 Note we assumed for simplicity that nt is an integer

Brownian Motion cont...

Hence

Wn (t) N (0, t)

n

Marginal Distributions

Conditional Distribution (conditional on say Ft )

Formally this process converges to Brownian Motion

14/77

Brownian Motion cont...

Definition

Definition: A stochastic process {W (t) , t 0} is said to be a

P-Brownian motion process if and only if:

1. W (t) is continuous and W (0) = 0;

2. The value of W (t) is distributed, under P, as N (0, t)

3. The increment W (s + t) W (s) is distributed, under P, as

N (0, t), and is independent of Fs

15/77

Brownian Motion cont...

example:

1. W is continuous, but is differentiable nowhere (with

probability 1)

2. It will hit any and every real value no matter how large or

negative.

3. Once W hits a particular value, it immediately hits it again

infinitely often, and then again from time to time in the

future

4. Scaling doesnt matter - it is a fractal.

16/77

Application for Stock Prices

Brownian motion on its own is not a good choice for modelling stock

prices.

It is missing (amongst others) two important properties that stock

prices tend to have:

Stock Prices tend to increase in the real world (P)

Stock Prices do not become negative

S (t) = eW (t)+t

functions of Brownian motion.

17/77

Methods of Specifying a Stochastic Process

function of Brownian motion?

Two main methods:

1. Explicit function linking X (t) with W (t) and t.

2. Specify how it changes over time (i.e. its dynamics)

18/77

Stochastic Processes

Definition:

In the Brownian motion framework a stochastic process

X (t) is a continuous process (on t) such that

Z t Z t

X (t) = X (0) + (s) dW (s) + (s) ds

0 0

satisfying certain technical conditions.2 The differential

form can be written as (with X (0) a constant)

2

19/77 e.g., are known at time t, and are bounded

Stochastic Processes cont...

deterministic functions of X (s) the equation

Generally it is easier to specify the SDE for X as opposed

to finding an explicit functional form (ie the solution) of X.

20/77

Discussion

Let X (0) = x

1. What is the solution to

dX (t) = dW (t) + dt

21/77

Stochastic Calculus

we know that if we wanted to know about H (x (t)) then

roughly we know from

dH (x) = H (x) dx

F (W (t)) = eW (t)

G (W (t) , t) = eW (t)+t ?

22/77

Key observation

Denote Zi as IID N(0, 1) random variables. Observe that

Z t X n 2

2 ti t(i 1)

(dW (u)) W W

0 n n

i=1

n r !2

X t

2

= (Zi )

n

i=1

n

!

X Z2

i

= t

n

i=1

t

as n .

Hence we have

Z t Z t

(dW (u))2 t = du

0 0

or in other words, a key result we often use in stochastic calculus

is

(d(W (t)))2 dt

23/77

Discussion: Itos lemma - Differentiation Rule with

Stochastic Processes

Given

(dW (t))2 = dt,

discuss why

1

dF (W (t)) = F (W (t)) dW (t) + F (W (t)) dt

2

(Hint: Use Taylor series expansion)

This is known as Itos lemma.

24/77

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

25/77 Hedging

Itos Lemma with more General Processes

function with

Y (t) = f (X (t))

then Y (t) is also a stochastic process, then similar

reasoning (ito) gives

f 1 2f

= dX (t) + (dX (t))2

x 2 x 2

25/77

Itos Lemma cont...

On substitution, we have

1

+ (X (t)) f (X (t)) + 2 (X (t)) f (X (t)) dt

2

26/77

Example: Finding the SDE Satisfied by a Process

(with closed form solution)

Suppose, for S(0) = 1, we have

S (t) = eW (t)+t

We can use Ito to help us find dS(t). Let

X (t) = W (t) + t

then we have

S (t) = eX (t) = f (X (t)) .

Hence

f (X (t)) = f (X (t))

= f (x (t))

= eX (t)

= S (t)

27/77

Example cont...

Simplifying yields

f 1 2f

dS (t) = dX (t) + (dX (t))2

x 2 x 2

1 2

= S(t) dW (t) + + dt

2

28/77

Finding a Closed Form Solution of a Process from its

SDE

integration.

The same applies for Ito integration.

In general it is very hard to solve for an explicit form, and

we often dont.

In other cases we rely on educated guesses

Luckily, (provided certain technical conditions are

satisfied), knowing the dynamics of a process is often

sufficient for applications.

29/77

Example: Geometric Brownian Motion (GBM)

with S(0) = s?

30/77

Summary of Pricing Steps - Binomial Tree Model

S(t)

1. Identify a measure Q such that Z (), with Z (t) = B(t) , is a

Q martingale.

2. Observe that both Z () and Y (), with

X

Y (t) = EQ |F(t)

B(T )

are Q martingales.

By the martingale representation theorem, we know that

there is a previsible process () such that

t

X

Y (t) = Y (0) + (k ) (Z (k ) Z (k 1))

k =1

31/77

Summary of Pricing Steps cont...

of holding

(t + 1) of the stock S(t)

(t + 1) = Y (t) (t + 1)B(t)1 S(t) units of the bond B(t)

4. This strategy had that interesting result that, no matter

what the real world probability measure P is,

It cost (1)S(0) + (1)B(0) = EQ B(T )1 X at the start.

It is self financing

At maturity T, (T )S(T ) + (T )B(T ) = X

5. Hence if there ishno arbitrage

i the price of the derivative

X

must just be EQ B(T ) at time 0.

32/77

Reflection

tools we still need to investigate in continuous time are

Martingales

Change of Measure

Martingale representation theorem

Remark - As in the previous sections a lot of the

theorems/results are subject to various technical

conditions. We will not focus on these technical conditions

here - we will instead focus on the main insights. However

when applying these in practice it is always recommended

that the precise mathematical details be checked e.g. by

reference to the text.

33/77

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

34/77 Hedging

Martingales in continuous time

measure Q and filtration F if 3

3

34/77 subject to technical conditions e.g. the expectations are well defined

Examples of Martingales

measure

2. A P Brownian motion W () is a P martingale

3. A Q Brownian motion WQ ()is a Q martingale

4. A P conditional expectation is always a P martingale

5. A Q conditional expectation is always a Q martingale

6. Let W () be a P-Brownian motion. Consider a process X ()

with

X (t) = W (t) + t

for some constant . When is this a P martingale?

35/77

Examples cont...

7 The process M() with

Z t

M(t) = (s)dW (s)

0

example if () is bounded, pre-visible.

8 Show that the process X (), with

1 2t

X (t) = X (0)eW (t) 2

36/77

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

37/77 Hedging

Change of Measure - the Continuous Radon-Nikodym

Derivative

we observed that to change from P to Q we can apply the

Radon-Nikodym derivative

dQ

dP

This can be interpreted as the ratio of the probabilities

between Q and P on each possible path of outcomes.

For any event A, we have the following relationship

dQ

Q(A) = EP 1A

dP

37/77

Change of Measure - cont...

In continuous time, heuristically we can also consider the

(continuous) Radon-Nikodym derivative as the ratios of the

probabilities.

Heuristically, for a path , consider discrete time points

{t1 , t2 , .., tn 1, tn }, with tn = T , and a P Brownian motion

with corresponding path {x1 , .., xn }, the density (on these

time points) are represented by

We can consider

dQ f n (x1 , .., xn )

() = limn Qn

dP fP (x1 , .., xn )

what happens to the W () process on the change from P to

Q.

38/77

Change of Measure - Simple Case

process Y () with

1 2t

Y (t) = eW (t) 2

where is a constant.

We can define an arbitrary measure Q (note: this is a

generic result at this stage, and not necessary the Q we

want for financial modelling) by

Q [A] = EP [Y (T ) 1A ]

(Exercise - show that indeed the EP [Y (T )] = 1)

39/77

Discussion - cont...

Recall that the moment generating function of a normally

distributed (under say measure P) random variable X with

mean and variance 2 can be represented by

h i 1 2 2

EP eX = e+ 2

distribution of W (T ) under both P and Q.

A more general but similar result applies for the process

W ().

40/77

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

41/77 Hedging

Change of Measure: Cameron-Martin-Girsanov

Theorem

pre-visible process (), then there exist4 a measure Q

such that

1. Q is equivalent to P

2.

dQ RT 1

RT 2

= e 0 (t)dW (t) 2 0 (t)dt

dP

3. Z t

WQ (t) = W (t) + (s) ds

0

is a Q Brownian motion.

4

subject to technical conditions - e.g. if () was bounded, or even

41/77 constant

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

42/77 Hedging

Discussion Example

X (t) = W (t) + t

X () when we change measure to Q, using

dQ Rt Rt 2

= e 0

dW (s) 21 0 ( ) ds

?

dP

42/77

Discussion Example

and

dX (t) = X (t) (dWQ (t) + dt) .

43/77

Fundamental Theorem of Asset Pricing

measure that we can use to price derivatives.

A feature of Q was that discounted stock prices are Q

martingales.

This will end up to be a defining feature of Q, and is called

the Fundamental Theorem of Asset Pricing.

Subject to technical conditions, this important Theorem

says that there is no arbitrage if and only if there is an

equivalent measure Q such that discounted asset prices

(discounted by the risk free rate) are Q martingales.

44/77

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

45/77 Hedging

Martingale Representation Theorem: Brownian Motion

Based Model

() non zero. Then if N () is any other Q martingale, then

there exists an pre-visible process5 () such that we have

the representation

Z t

N (t) = N (0) + (s) dM (s)

0

5

45/77 technically - pre-visible, square integrable, (essentially) unique

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

46/77 Hedging

Replicating Portfolios - Trading Strategies (1)

anticipation of the martingale approach to financial

modelling, we are interested in a trading strategy

((), ()).

The strategy has associated portfolio value

.

What properties do we want them to have?

46/77

Replicating Portfolios - cont...

(1) Previsible

( () , ()) should be previsible - to remove insider

trading.

Note that previsibility in continuous time means that (t) is

known at time t - this is different in notation to the discrete

time case.

47/77

Replicating Portfolios - cont...

This ensures that no additional cash in/out flows are

required.

In discrete time, we found that our self financing portfolio

satisfies

general random processes!

48/77

Replicating Portfolios - cont...

We want to make use a strategy and associated portfolio to

replicate a contingent claim.

A replicating strategy for X is a self financing portfolio such

that6

V (T ) = (T ) S (T ) + (T ) B (T ) = X

6

49/77 subject to technical conditions

Example

the following self financing?

(1) (t) = (t) = 1

(2) (t) = 2W (t) , (t) = t W 2 (t)

50/77

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

51/77 Hedging

Pricing Steps: Continuous Time Model

S(t)

1. Identify a measure Q such that Z (), with Z (t) = B(t) , is a

Q martingale.

2. Observe that both Z () and Y (), with

h i

Y (t) = EQ B(T )1 X |Ft

are Q martingales.

By the martingale representation theorem, we know that

there is a pre-visible process () such that

Z t

Y (t) = Y (0) + (s)dZ (s)

0

51/77

Pricing Steps cont...

of holding

(t) of the stock S(t)

(t) = Y (t) (t)B(t)1 S(t) units of the bond B(t)

4. This strategy had that interesting result that, no matter

what the real world probability measure P is,

It cost (0)S(0) + (0)B(0) = EQ B(T )1 X at the start.

It is self financing

At maturity T, (T )S(T ) + (T )B(T ) = X

5. Hence if there isno arbitrage

the price of the derivative

must just be EQ B(T )1 X at time 0.

52/77

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

53/77 Hedging

Black-Scholes Model

dB (t) = rB (t) dt

dS (t) = S (t) dt + S (t) dW (t)

are constants.

(Assume for the moment that there are no dividends payable)

The stock price SDE has solution

1 2

S(t) = S(0)e( 2 )t+W (t)

53/77

Step 1 - Finding the Q Measure and Dynamics

the dynamics of the stock prices process under the Q

measure

By the Fundamental Theorem of Asset Pricing this Q

measure has the property that discounted stock prices are

Q martingales7 .

7

54/77 as usual, subject to technical conditions

Revision Example

r

= Z (t) dW (t) + dt

55/77

Example cont...

By the CMG theorem, heuristically, we known that under

an equivalent measure Q we have a Q Brownian motion

WQ (), where

hence

r

dZ (t) = Z (t) dWQ (t) + (t) dt .

But to be a Q martingale, we need

and hence we need for all t

r

(t) =

56/77

Discussion Example

Q?

57/77

Step 2 - Martingale Representation

Form

1

Y (t) = EQ X |Ft

B (T )

We have 2 Q martingales Z () and Y (), so we know there

exists (t) such that

58/77

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

59/77 Hedging

Steps 3,4 - Self Financing, Replicating strategies

(t) of the stock S (t)

(t) = Y (t) (t) Z (t) of the bond

To check that this is a replicating portfolio. Notice that

S (t)

= (t) S (t) + Y (t) (t) B(t)

B (t)

= Y (t) B (t) .

59/77

Steps 3,4 cont...

= B (t) dY (t) + Y (t) dB (t)

60/77

Steps 3,4 cont...

Hence

= B (t) (t) dZ (t) + ( (t) Z (t) + (t)) dB (t)

= (t) (B (t) dZ (t) + Z (t) dB (t)) + (t) dB (t)

= (t) d(Z (t) B (t)) + (t) dB (t)

= (t) dS (t) + (t) dB (t)

61/77

Steps 3,4 cont...

On maturity T we have

V (T ) = Y (T ) B (T )

1

= EQ X |FT B (T )

B (T )

= X

62/77

Step 5

our contingent claim at time t MUST be

V (t) = Y (t)B(t)

1

= EQ X |Ft B (t)

B (T )

h i

= EQ er (T t) X |Ft

63/77

Derivative Valuation in the Black Scholes model

derivative is

V (0) = erT EQ (S (T ) K )+

64/77

Distribution of S(T)

Q is:

dS(t) = rS(t)dt + S(t)dWQ (t)

and hence

1 2 )t+W

S(t) = S(0)e(r 2 Q (t)

This implies that S (T ) is lognormal with parameters

1

ln S (0) + r 2 T , 2 T

2

65/77

Discussion Example: Black Scholes Formula (1)

erT EQ (S (T ) K )+

= erT EQ S (T ) 1S(T )>K KerT EQ 1S(T )>K

Find:

KerT EQ 1S(T )>K =?

66/77

Black-Scholes Formula (2)

To calculate erT EQ S (T ) 1S(T )>K we can complete the

square. Denoting

1 2 2

H = ln (S (T ) /S (0)) N rT T , T

2

we have:

h i Z

EQ S (T ) 1S(T )>K = (S (0) exp {z})

z=ln K

S(0)

2

z rT 21 2 T

1 1

exp dz

2 T 2 2

T

1

Z

rT

= S (0) e

z=ln K 2 T 2

S(0)

2

z rT + 12 2 T

1

exp dz

2 T

ln (S (0) /K ) + r + 12 2 (T )

rT

= S (0) e

T

67/77

Black-Scholes Formula

At time t, the value of the option V (S (t) , t) is

ln (S (t) /K ) + r + 21 2 (T t)

d1 =

T t

d2 = d1 T t

68/77

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

69/77 Hedging

Price Dependence

something about how option prices depend on parameters:

1. : Do not need this at all!

2. S (t): As S (t) increases to much greater than K the

optionality disappears. As S (t) falls to zero the option is

also worth very little.

3. (T t): As this decreases, the variability of the stock

prices from t to T becomes smaller and smaller, and the

option gets closer and closer to the intrinsic value.

4. : The more volatile the stock, the more the option is

worth. At the extreme, if is very small, the option will

behave like a riskless bond. At the other extreme, it will

behave like the stock.

69/77

Discussion: Valuation of other options

There are many other options that

investors/speculators/hedgers (etc) are interested in. Some

examples include

Barrier Options (Knock in)

Barrier Options (Knock out)

Lookback Options

Asian Options

Chooser Options

How would one value the above options under the

Black-Scholes model?

70/77

Plan

Topic: Continuous Time Derivative Valuation

Measure Theory

Radon-Nikodym Derivative

Equivalent Measures

Expectations and the Radon-Nikodym Derivative

Radon-Nikodym as a Process

Radon-Nikodym Summary

Stochastic Processes

Stochastic Calculus

Itos Lemma for processes

Martingales

The Continuous Radon-Nikodym Derivative

Change of Measure Cameron-Martin-Girsanov Theorem

Change of Measure and Processes

Martingale Representation Theorem: Brownian Motion Based Model

Replicating Portfolios - Construction Strategies

Pricing Steps: Continuous Time Model

Black-Scholes Model

Arbitrage Pricing

Price Dependence

71/77 Hedging

Risk Management and Hedging of Options

discounted Q expectation.

But we may also be interested in risk management of the

option position. (e.g. how to hedge the option position)

In particular we know that the replicating portfolio consists

of (t) stocks and (t) bonds.

But what is (t)?

In the binomial model we have a formula for (t).

71/77

Representation of (t)

If the contingent claim has payoff X = f (S (T )) then the

value is

V (s, t) = er (T t) EQ [f (S (T )) |S (t) = s]

V (s, t)

(t) =

s

ie just the mathematical derivative of the price with respect

to the stock price.

72/77

Extension: Models with Dividends

So far we have assumed that no dividends are payable on

the stocks.

How does dividends affect the option prices?

So need to account for the fact that if you hold 1 unit of the

stock from time 0 to time t, you will also be getting the

dividend that are paid during that time.

good approximation ie the dividend payment at each small

instance of time can be modelled as

S (t) dt

73/77

Extension: Models with Dividends cont...

How do we do arbitrage pricing? Consider the stock prices

e (t). In other

with dividends reinvested in the stocks, S

words:

At any small time dt, S (t) dt is paid out.

With this cash we buy dt units of the stock.

Modelling S as GMB, we have

S

e (t) is a

says that we can use a Q measure such that ert S

martingale and price all our derivatives by

h i

EQ erT X

S (t) under Q.

74/77

Derivative Valuation under Alternate Models

the Black Scholes model.

For example

Constant Elasticity of Variance model

Black-Scholes model with multiple stocks

The framework we have looked at is still applicable.

Key requirement is that we are able to form self-financing

replicating strategies

Question: What would you expect to find the price of an option

under these alternative models?

75/77

Numerical Techniques: Simulation

calculate

erT EQ [X ]

but being expressed as an expectation means that an

obvious numerical technique is simulation.

76/77

Numerical Techniques for American Options

Remember that an American option can be thought of as

its European counterpart, but with the right to exercise it

immediately.

A: Intuitively, it only makes sense if the cash we get by

exercising it today is more than the value of holding the

option.

Binomial Tree (viewed as an approximation to the

continuous time model).

= 0.2, er = 1.1. What is the price of an American Put

with Strike $10.5? The current share price is $10 and no

dividends are payable.

77/77

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