Financial Derivatives Binomial models Risk neutral valuation

ST439 - Chapter 1
Financial derivatives, Binomial models

Beatrice Acciaio

Department of Statistics
the London School of Economics and Political Science

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Financial Derivatives Binomial models Risk neutral valuation

What are derivatives?

Definition
Derivatives are financial assets which are defined in terms of some
underlying financial asset(s).
I A European call option written on a share of Facebook, with
strike price K GBP and exercise date T is a contract written at
t = 0 with the following properties:
The holder of the contract has, exactly at the time T , the
right to buy a share of Facebook at the price K GBP;
The holder of the option has no obligation to buy the share.
If the price ST of a share of Facebook at T is higher than K GBP,
then the holder exercises this option and obtain ST − K .
If the price is lower than K , then the holder will not exercise and
the payoff is then 0.
Then the payoff of a European call is (ST − K )+ := max{ST − K , 0}.
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More on derivatives
I A European put option written on an underlying S, with strike
K and exercise date T , gives the holder the right to sell the
underlying asset in T at price K . The payoff is (K − ST )+ .
The term European means that the option can only be
exercised exactly at the date of maturity. We instead use
American to indicate that the option can be exercised any
time before maturity.
The term option refers to the fact that the owner has the
right but not the obligation to buy/sell.
Since payoffs of derivatives depend on some underlying value, they
are usually called contingent claims. The underlying objects can
be: stock, FX, bond, swap, mortgage, commodity, weather,...
Some simple standard options are traded in exchanges, more
complicated ones are traded over the counter (OTC).
Derivatives can be used to reduce risk in underlying assets or
to speculate on future price movements.
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Main problems: Pricing and Hedging

Take a fixed derivative as given.

What is a “fair” price for the contract?
Suppose that we have sold a derivative. Then we have
exposed ourselves to a certain amount of financial risk at the
maturity. How do we protect (”hedge”) ourselves against this
risk?

We will see that answers to above questions are closely related!

Fair price = Initial capital needed to hedge the risk.

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(1-period) Model description

Time: t = 0 ”today” and t = 1 ”tomorrow”.
Two assets: Bond Bt and Stock St .
The bond price process is deterministic and given by:
B0 = 1
B1 = 1 + r , where r is the interest rate.

The stock price process is a stochastic process given by:

S0 = s

su , with probability pu
S1 =
sd , with probability pd
with 0 < d < u and clearly pu + pd = 1.
S1 can be written as S1 = sZ , where Z is a random variable that
takes the values u and d with probabilities pu and pd , respectively.
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Portfolio and Arbitrage

A portfolio is a vector h = (x, y ).
x is the units of money on bonds and y is the shares of stock.
x > 0: long position; x < 0: short position, in the bond.
Analogous terminology for the position in the stock.

Assumptions
No portfolio constraint: h ∈ R2 (short positions, as well as
fractional holdings, are allowed).
No bid-ask spread.
No transaction costs of trading.
The market is perfectly liquid: possible to buy or sell
unlimited quantities on the market. (Possible to borrow
unlimited amounts from the bank.)

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Arbitrage
The value process of the portfolio h is

Vth = Vt = xBt + ySt , t = 0, 1.

That is
V0 = x + ys,

ysu , with prob. pu
V1 = x(1 + r ) +
ysd , with prob. pd

Definition
An Arbitrage is a portfolio h such that
V0h = 0,
P(V1h ≥ 0) = 1 and P(V1h > 0) > 0.

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Arbitrage free
Proposition
The model above is arbitrage free if and only if

d ≤ 1 + r ≤ u. (NA)

proof.

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Martingale measure

(NA) means there exist qu , qd ∈ (0, 1) with qu + qd = 1 such that

1 + r = qu u + qd d.

This means there exists a probability measure Q such that

Q(Z = u) = qu and Q(Z = d) = qd .

As a result,
1
EQ [S1 ] = S0 ,
1+r

which means that (1 + r )−t St (the discounted asset price

process) is a Q-martingale.

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Martingale measure

Definition
A probability measure Q is called a martingale measure (or
risk-neutral measure) if the process (1+r )−t St is a Q-martingale.

Proposition
The market model is arbitrage free if and only if there exists a
martingale measure Q.

Proposition
For the binomial model above, the martingale probabilities are
given by
(1 + r ) − d u − (1 + r )
qu = and qd = .
u−d u−d

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Pricing of contingent claims

Assume the market above is arbitrage free.
Definition
A contingent claim is a random variable X of the form X = g (S)
= Φ(Z ), where Z is the r.v. driving the stock price process.
Denote the price of X at time t by Π(t; X ).
At time t = 1, to avoid arbitrage Π(1; X ) = X .
Q: What is Π(0, X )?

Definition
A given contingent claim X is said to be attainable (eqv. perfectly
replicable) if there exists a portfolio h such that V1h = X a.s.. Such
an h is called a hedging portfolio (eqv. replicating portfolio) for X .

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Pricing principle

For an attainable claim, there is no difference between holding the

claim or holding the hedging portfolio.
Therefore, to avoid arbitrage, the price of the claim = the market
value of the hedging portfolio.

Theorem (Pricing principle)

If a claim X is attainable with hedging portfolio h, then the only
reasonable price process for X is given by

Π(t; X ) = Vth , t = 0, 1.

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Complete market
Definition
The market is complete if every contingent claim is attainable.
Therefore the pricing issue is settled for all contingent claims in
complete markets (and each claim has a unique price).
Proposition
Assume that the binomial model is free of arbitrage, then it is also
complete.
proof.

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Financial Derivatives Binomial models Risk neutral valuation

Risk neutral valuation

Use the pricing principle and the proposition in the last slide. The
arbitrage free price of a claim X = g (S) = Φ(Z ) is
 
1  (1 + r ) − d Φ(u) + u − (1 + r ) Φ(d) .

Π(0; X ) =
1+r  u−d u−d 
| {z } | {z }
qu qd

Proposition
If the binomial model is arbitrage free, then the arbitrage free price
of a contingent claim X is given by
1
Π(0; X ) = EQ [X ].
1+r

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Remarks

When we compute the arbitrage free price, we carry out the

computations in the risk-neutral world (i.e., under Q).
Q is called risk-neutral because under that measure we price
as we were neutral to risk (see next slide).
The physical probability only determines which events are
possible and which are impossible.
The valuation formula holds for all investors regardless of their
attitude towards risk as long as they prefer more money to
less.

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About the change of probability for the evaluation

Imagine someone offers you the following deal: a (fair) coin will be
flipped and if Head comes up, then you will receive 10000 GBP, if
Tail comes up you will have to pay 10000 GBP. (Think of r = 0.)
Will you enter the game at 0 price? Think about it... This
would be the ”evaluation” under the objective probability (1/2
probability of Head and 1/2 of Tail). But...we are risk averse!
So, for example, you may be willing to enter the bet for 3000
GBP (i.e., you are paid 3000 GBP to play the game). This
basically corresponds to ”giving higher probability” to the
event that we fear (losing 10000 GBP).
Think: what is the ”martingale measure” here?

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Example
We set S0 = 100, u = 1.2, d = 0.8, pu = 0.6, pd = 0.4 and r = 0.
Calculate the arbitrage free prices of a European call option and a
European put option with strike K = 110. Then calculate the
replicating portfolios.

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Self-financing portfolio
Consider any market, in discrete time t = 0, 1, . . . , T , consisting of
a bank account B and a risky asset S.
Definition
A portfolio (xt , yt ) (where xt =n. of units in B held at time t, and
yt =n. of shares of S held at time t) is a self-financing portfolio if
xt Bt+1 + yt St+1 = xt+1 Bt+1 + yt+1 St+1 , for t = 0, · · · , T − 1.
(no fund is added or withdrawn at any moment)
The previous identity is equivalent to the following one, where Vt
is the value of the portfolio at time t:
Vt+1 − Vt = xt (Bt+1 − Bt ) + yt (St+1 − St ), t = 0, · · · , T − 1,

that is ∆Vt = xt ∆Bt + yt ∆St ,

Vt = V0 + t−1
P Pt−1
that is u=0 xu ∆Bu + u=0 yu ∆Su .
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Multi-period binomial model

For T ∈ N, we assume that the dynamics of the bond and of the
stock price follow

St = su j d t−j , j = 0, · · · t, t = 0, · · · , T
t
Bt = (1 + r ) , t = 0, · · · , T .

As in the 1-period case, here as well we have:

No-Arbitrage ⇐⇒ d ≤ 1 + r ≤ u ⇐⇒ ∃ mart. meas.
In such case the martingale probabilities of going up and down
are as before:
(1 + r ) − d u − (1 + r )
qu = qd = .
u−d u−d
If No-Arbitrage holds, then the market is complete

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Pricing algorithm

Proposition
Assume NA. Then any T -claim X = Φ(ST ) can be replicated
using a self-financing portfolio. If Vt (j) denotes the value of the
portfolio at the node (t, j), then Vt (j) can be computed recursively

1
Vt (j) = (qu Vt+1 (j + 1) + qd Vt+1 (j)) ,
1+r
VT (j) = Φ(su j d T −j ).

And the hedging portfolio is given by

1 uVt (j) − dVt (j + 1) 1 Vt (j + 1) − Vt (j)
xt−1 (j) = , yt−1 (j) = .
1+r u−d St−1 u−d

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Risk neutral valuation

Analogously to the 1-period model, we have the following

Proposition
If the binomial model is arbitrage free, then the arbitrage free price
of a T -contingent claim X is given by
1
Π(0; X ) = EQ [X ]
(1 + r )T
T  
1 X T j T −j
= T
qu qd Φ(su j d T −j ).
(1 + r ) j
j=0

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Key messages

(remember that we are in the case of a complete market, where

every contingent claim is perfectly replicable via an hedging
portfolio)

Holding a contingent claim is equivalent to holding its

hedging portfolio.

Arbitrage free price = market value of the hedging portfolio

= expectation of the discounted payoff
under the martingale measure

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Exercise 1: Asian option

Consider a two periods binomial model with S0 =P4, u = 2, d = 12 , and
n
interest rate r = 14 . For n = 0, 1, 2, define Yn = k=0 Sk to be the sum
of the stock prices between times zero and n. Consider an Asian call
option which pays the average of the asset price from t = 0 until
maturity minus the strike, or pays zero if that is negative. Let the option
expire at time two and have strike K = 4. This is like a European call,
except the payoff of the option is based on average stock price rather
than the final stock price. Let vn (s, y ) denote the price of this option at
time n if Sn = s and Yn = y . In particular, v2 (s, y ) denotes the payoff.
1. Write explicitly the payoff.
2. Determine the martingale measure (find qu and qd ).
3. Develop an algorithm for computing vn recursively. In particular,
write a formula for vn in terms of vn+1 .
4. Apply the algorithm developed in (ii) to compute v0 (4, 4), the price
of the Asian option at time zero.
5. Provide a formula for ∆n (s, y ), the number of shares of stock to
hold in the replicating portfolio at time n if Sn = s, Yn = y .
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Exercise 2: Knock-in and knock-out options

Consider a two-period binomial model, for an asset with initial price
S0 = 120. Suppose the interest rate per period is r = 0.05, that
u = 1.2, d = 0.8 (using the standard notation in lectures for the size of
the up move and down move respectively).
1. Compute the risk-neutral probability of an up move.
2. Calculate the value of the call option at each node of the binomial
tree, and thus determine the initial price of a European Call option,
with strike K = 120.
3. Determine the initial price of a European Put with strike K = 120.
4. Find the price of an American put option with strike K = 120.
5. Consider a European knock-out put option, with barrier L = 130,
strike K = 120. This option is such that, the holder of the option
receives the payoff at maturity of a European put option UNLESS
at any time before or at maturity, price is greater than or equal to L.
6. Determine the price of a European knock-in put option, also with
barrier L = 130 and strike K = 120. This is an option which gives
the holder the payoff from a European Put option IF at some time
the asset is greater than or equal to L.
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Something for you to think about...

Instead of a binomial model, consider a model consisting of a
risk-less Bank account and a Stock whose price process evolves in
(discrete) time along a trinomial tree (for simplicity, you can
consider the interest rate r = 0 and you can think of 1-period
model).
What can we say about arbitrage opportunities?
What can we say about martingale measures when NA is
satisfied? (hint: two equations, three unknowns)
What can we say about replicability of claims? (hint: three
equations, two unknowns)
What can we say about pricing when NA is satisfied and the
market is incomplete? (consider that there are infinitely many
martingale measures)

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More exercises
1. Consider the market model with a bank account with interest rate
r = 0.05, and a stock with S0 = 80 and S1 = 120; 90; 60 with respective
probabilities pu = 0.2, pm = 0.3, pd = 0.5.
Compute the set of arbitrage free prices for the European put option
(100 − S1 )+ .
Is it possible to replicate that put?
Find the set of all attainable contingent claims.
2. Consider the market model with a bank account B0 = 1 and B1 = 1.5,
and a stock with S0 = 1.5 and S1 = 3; 1.5; 0.5 with respective
probabilities pu = 1/2, pm = 1/3, pd = 1/6.
Is it possible to replicate the payoff Y1 = 1; 0; 2 with B and S?
Draw conclusions on the completeness of the market (B, S).
Is the market free of arbitrages? If so, determine all the martingale
measures.
Determine the interval of fair prices for the claim Y1 .
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Final notes

Recommended readings:
Steven E. Shreve: “Stochastic Calculus for Finance I”,
Chapters: 1, 2

Refresh what you have seen in ST409, we’ll fish a lot from
there next time!

About exercises.
Every time I will leave you few exercises as homework. These are
meant for you to learn and improve your skills (you shall not turn
them in). Some of them will be solved in class on the subsequent
lecture (by myself, unless there is some volunteer...). Anyway, the
solution to all exercises will be posted on Moodle by the end of the
term.

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