Financial Mathematics

Financial Mathematics
Wim Schoutens
September 14, 2018

2
Contents
1 Financial Mathematics Principles 9

1.1 Financial Markets and Instruments . . . . . . . . . . . . . . . . . . 9
1.1.1 Basic Instruments . . . . . . . . . . . . . . . . . . . . . . . 9
1.1.2 Indices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
1.1.3 Credit Risk Market and CDSs . . . . . . . . . . . . . . . . 12
1.2 Financial Derivatives and Derivatives Markets . . . . . . . . . . . . 12
1.3 The Risk-Free Bank Account and Discount factors . . . . . . . . . 14
1.4 Vanilla Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
1.5 Modelling Assumptions . . . . . . . . . . . . . . . . . . . . . . . . 21
1.5.1 Frictionless Markets . . . . . . . . . . . . . . . . . . . . . . 21
1.5.2 The No-Arbitrage Assumption . . . . . . . . . . . . . . . . 22
1.6 The Put-Call Parity . . . . . . . . . . . . . . . . . . . . . . . . . . 26
1.7 The Forward Contract . . . . . . . . . . . . . . . . . . . . . . . . . 28
1.8 Spread Inequalities . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
1.8.1 The Call Spread and Put Spread Inequality . . . . . . . . . 29
1.8.2 The Butterfly Spread Inequality . . . . . . . . . . . . . . . 30
1.8.3 The Calender Spread Inequality . . . . . . . . . . . . . . . 30
1.9 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
1.10 Extra . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
1.10.1 Bid - Ask Pricing Inequalities . . . . . . . . . . . . . . . . . 32
1.10.2 Derivatives on Foreign Exchange Rates . . . . . . . . . . . 34
1.10.3 Derivatives on Commodities and the Cost of Carry . . . . . 35
2 Tree Models 45
2.1 The Binomial Tree . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
2.1.1 One Step Binomial Tree . . . . . . . . . . . . . . . . . . . . 45
2.1.2 Risk Neutral Valuation . . . . . . . . . . . . . . . . . . . . 48
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4 CONTENTS
2.1.3 One Step Binomial Tree Revised . . . . . . . . . . . . . . . 49

2.1.4 Two-Step Binomial Trees . . . . . . . . . . . . . . . . . . . 50
2.1.5 Multi-Step Binomial Trees . . . . . . . . . . . . . . . . . . . 51
2.2 Matching Trees with a Given Volatility . . . . . . . . . . . . . . . . 53
2.3 The Trinomial Tree . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
2.3.1 One Step Trinomial Tree . . . . . . . . . . . . . . . . . . . 56
2.3.2 Two-Step Trinomial Trees . . . . . . . . . . . . . . . . . . . 56
2.4 American Option Pricing . . . . . . . . . . . . . . . . . . . . . . . 57
2.5 Limits of Tree Models . . . . . . . . . . . . . . . . . . . . . . . . . 60
3 Mathematical Finance in Discrete Time 73

3.1 Information and Trading Strategies . . . . . . . . . . . . . . . . . . 73
3.2 No-Arbitrage Condition . . . . . . . . . . . . . . . . . . . . . . . . 76
3.3 Risk-Neutral Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . 78
3.4 Complete Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
3.5 The Fundamental Theorem of Asset Pricing . . . . . . . . . . . . . 81
3.5.1 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
3.5.2 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . 83
3.6 The Physical and the Risk-Neutral World . . . . . . . . . . . . . . 85
4 Exotic Options and Structured Products 89

4.1 Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
4.2 Lookbacks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
4.3 Asian Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
4.4 Variance Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
4.5 Structured Products . . . . . . . . . . . . . . . . . . . . . . . . . . 96
5 The Black-Scholes Model 99

5.1 Information, Filtrations and Martingales in Continuous Time . . . 99
5.1.1 Information and Filtration . . . . . . . . . . . . . . . . . . . 99
5.1.2 Martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
5.2 The Normal Distribution and the Brownian Motion . . . . . . . . . 100
5.2.1 The Normal Distribution . . . . . . . . . . . . . . . . . . . 100
5.2.2 Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . 101
5.3 Itô’s Calculus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
5.3.1 Stochastic Integrals . . . . . . . . . . . . . . . . . . . . . . 103
5.3.2 Itô’s Lemma . . . . . . . . . . . . . . . . . . . . . . . . . . 105
5.3.3 Stochastic Differential Equations . . . . . . . . . . . . . . . 106
CONTENTS 5
5.4 Geometric Brownian Motion and The Black-Scholes Model . . . . 108

5.5 The Black-Scholes Option Pricing Model . . . . . . . . . . . . . . . 110
5.5.1 The Black-Scholes Market Model . . . . . . . . . . . . . . . 111
5.6 Continuous Time Finance . . . . . . . . . . . . . . . . . . . . . . . 111
5.6.1 The Risk-Neutral Setting . . . . . . . . . . . . . . . . . . . 112
5.6.2 The Pricing of Options under the Black-Scholes Model . . . 113
5.6.3 Black-Scholes PDE . . . . . . . . . . . . . . . . . . . . . . . 113
5.6.4 Explicit Formula for European Call and Put Options . . . . 114
5.7 Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
5.8 Shortfalls of the Black-Scholes Model . . . . . . . . . . . . . . . . . 118
5.9 Implied Black-Scholes Volatility . . . . . . . . . . . . . . . . . . . . 119
5.10 Extra . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
5.10.1 Drawbacks of the Black-Scholes Model . . . . . . . . . . . . 121
5.10.2 Jumps and Extreme Events . . . . . . . . . . . . . . . . . . 125
5.10.3 No Jumps . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
5.10.4 Non Constant Volatility . . . . . . . . . . . . . . . . . . . . 127
6 Monte Carlo Simulation 141

6.1 Pricing Derivatives by Monte Carlo Simulation . . . . . . . . . . . 141
6.2 Simulation of a Brownian Motion . . . . . . . . . . . . . . . . . . . 142
6 CONTENTS
Preface
The aim of the course is to give a rigorous yet accessible introduction to the
modern theory of financial mathematics.
The student should already be comfortable with calculus and probability the-
ory. Prior knowledge of basic notions of finance is useful as well.
We start with providing some background on the financial markets and the
instruments traded. We will look at different kinds of derivative securities, the
main group of underlying assets and the markets where derivative securities are
traded.
The fundamental problem in the mathematics of financial derivatives is that
of pricing, risk-management and hedging. We focus in this course mainly on
the theory of no-arbitrage pricing. We start by discussing option pricing in the
simplest idealised case: the one-step Binomial tree frictionless market. Next, we
turn to more general Binomial tree models. Under these models we price European
and American derivatives and discuss pricing methods for more involved exotic
derivatives.
In addition, we also elaborate on the Monte-Carlo pricing technique, which
tries to approximate the price of a derivative by the discounted average value of
the payoff under a huge number of simulated paths.
Further, we set up general discrete-time models and look in detail at the
mathematical counterpart of the economic principle of no-arbitrage: the existence
of equivalent martingale measures. We look when the models are complete, i.e.
claims can be hedged perfectly and discuss the fundamental theorem of asset
pricing in a discrete setting.
Finally, we elaborate on the celebrated continuous time Black-Scholes model.
The model is driven by Brownian motions, which are intuitively introduced. We
further provide the basics of Ito Calculus, that learns us how to deal with stochas-
tic integrals and Stochastic Differential Equations (SDEs).
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8 CONTENTS
Throughout the text, we often provide also some extra material, which brings
the student in contact with the more advanced establish quantitative finance the-
ory. We for example, discuss bid-ask pricing, variance swaps, jump and stochastic
volatility models.
Chapter 1
Financial Mathematics
Principles
1.1 Financial Markets and Instruments

In financial markets, many types of assets (also termed securities) are traded and
some are more risky than others. Theoretically, one assumes often the existences
of a risk-free asset, termed the risk-free bank account or risk-free bond. However in
really, no asset is completely risk-free: cash can be stolen, if a bank goes bankrupt
deposits are typically only guaranteed up to a certain amount, bonds issued by
even the major countries like the US, Germany or the UK, can be potentially not
paid back.
On all kinds of such risky assets, other financial contracts are written; these
financial contracts are so-called derivative securities. This text is on the pricing,
hedging and risk-management of such derivative securities.
1.1.1 Basic Instruments

Next, we highlight some of the most common underlying risky assets.
Stocks - Equity
The basis of modern economic life are companies owned by their shareholders;
the shares provide partial ownership of the company, pro rata with investment.
Shares have value, reflecting both the value of the company’s real assets and
the earning power of the company, potentially monetized via dividends (see also
9
10 CHAPTER 1. FINANCIAL MATHEMATICS PRINCIPLES
Section 1.9). With publicly quoted companies, shares are quoted and traded
on the Stock Exchange. Stock is the generic term for assets held in the form
of shares. Stock markets date back to at least 1531, when one was started in
Antwerp, Belgium.
Interest Rates - Fixed-Income
The value of some financial assets depends on the level of interest rates, e.g.
Treasury notes, municipal and corporate bonds. These are fixed-income securities
by which national, state and local governments and companies partially finance
their economic activity. Fixed-income securities require the payment of interest in
the form of a fixed amount of money at predetermined points in time (coupons),
as well as the repayment of the principal at maturity of the security.
Bonds are examples of such fix-income securities. A bond is an instrument of
indebtedness of the bond issuer to the bond holders. The issuer owes the holders
money (debt) and, depending on the terms of the bond, is obliged to pay them
interest (coupons) and to repay the principal at a later date, termed the maturity
date. Interest is usually payable at fixed intervals (quarterly, semi-annual, annual,
sometimes monthly). Bonds are sensitive to default/bankruptcy. When the bond
issuer no longer is solvent, he cannot pay back in full his debt to the bond holders,
which in that situation lose part or all of their initial investment. To compensate
against default risk, and depending on the probability the bond holder will default,
the bond issuers will charge a higher or lower interest rate.
Interest rates themselves are notional assets, which cannot be delivered. A
special fixed-income product is the (artificial) risk-free bank account mentioned
in the introduction. The interest rate on such a risk-free bank account is termed
the risk-free interest rate. We go into more details on interest rate assumptions
in Section 1.3.
Currencies - Foreign Exchange (FX)
A currency is the denomination of the national units of payment (money) and

as such is a financial asset. Example is the EUR/USD rate, which reflects the
amount of euros on gets for one dollar or the other way around.
Example 1. A EUR/USD rate of 1.0975 means that for 1 Euro, one gets 1.0975
US dollars. Note that then the USD/EUR rate equals about 0.9112.
1.1. FINANCIAL MARKETS AND INSTRUMENTS 11
Companies may wish to hedge/risk manage adverse movements of foreign cur-

rencies and in doing so use derivative instruments. Indeed, companies doing
trades with foreign clients in foreign currency, do often not want the exposure to
the movements of that foreign currency. Companies in for example the Euro-zone,
want eventually euros, since they payout their employees in Euro, their bookkeep-
ing is in Euro and the profits they report and potentially payout via dividends
are in Euro. On the other hand, sometimes companies need to also have foreign
currency to buy goods. Oil or gold or many other commodities are for example
quoted in USD.
Note, that a foreign currency has the property that the holder of the currency
can earn interest at the risk-free interest rate prevailing in the foreign country.
We thus have two kind of interest rates, the domestic and the foreign interest
rate.
Commodities
Commodities are a kind of physical products like gold, oil, cattle, fruit juice. Trade
in these assets can be for different purposes: for using them in the production
process or for speculation. Derivative instruments on these asset can be used for
hedging and speculation. Special care has to be taken with commodities because
of storage costs.
1.1.2 Indices
An index tracks the value of a basket of stocks (FTSE100, S&P500, Dow Jones
Industrial, NASDAQ Composite, BEL20, EUROSTOXX50, ...), bonds, and so
on. Derivative instruments on indices may be used for hedging if no derivative
instruments on a particular asset in question are available and if the correlation
in movement between the index and the asset is significant.
Furthermore, institutional funds (such as pension funds), which manage large
diversified stock portfolios, try to mimic particular stock indices and use derivative
on stock indices as a portfolio management tool. On the other hand, a speculator
may wish to bet on a certain overall development in a market without exposing
him/herself to a particular asset.
1.1.3 Credit Risk Market and CDSs

Credit risk captures the risk of a financial loss that an institution incurs when it
lends money to another institution or person. This financial loss realizes whenever
the borrower does not meet all of its obligations under its borrowing contract.
Because credit risk is so important for financial institutions the banking world
has developed instruments that allows them to evacuate some types of credit risk
rather easily. The most commonly known and used example is the credit default
swap. These instruments can best be considered as tradable insurance contracts.
This means that today I can buy protection on a bond and tomorrow I can sell
that same protection as easily as I bought it. Credit default swaps (CDSs) work
just as an insurance contract. The protection buyer (the insurance taker) pays a
fee and in exchange he gets reimbursed his losses if the bond on which he bought
protection defaults.
1.2 Financial Derivatives and Derivatives Markets

A financial derivative is a special type of financial contract whose value and pay-
outs depend on the performance of a more fundamental underlying asset. One
finds derivatives on the basis of all kinds of underlying entities like equity deriva-
tives whose performance is linked to the behaviour of underlying stock prices or
stock indices; fixed income derivatives whose payout depends on the level of inter-
est rates; currency derivatives that are connected with one or more FX exchange
rates; derivatives on commodities which for example can depend on the (joint)
evolution of oil, gas, gold, orange juice or any other commodity prices. Actually,
they can come in all forms and on the basis of all kinds of underliers, sometimes
even a combination of several underliers from different asset classes (hybrids).
Derivatives come into existence in modern economies encouraging price dis-
covery in free markets with its consequent price volatility. Often a good business
planning requires however some limited price stability. This can be (partially)
provided by derivatives. One then shifts price risk to professionals better posi-
tioned to manage the oscillations. Derivatives can be used for many purposes. As
mentioned, they can be used to mitigate price risk, but also to speculate on it.
Many contracts and structured products are implemented using derivatives. A so-
phisticated risk-management of a portfolio uses derivatives to hedge away as best
as possible all undesired exposure. Some capital instruments even have derivative
features and can be seen essentially as cash flows being made contingent on the
1.2. FINANCIAL DERIVATIVES AND DERIVATIVES MARKETS 13
resolution of future uncertainties.

Derivatives are traded on exchanges (like the CBOE) or over-the-counter
(OTC). Derivatives traded on exchanges are typically standardized; OTC deriva-
tives are tailor-made. You can compare it with a clothes collection that comes
in one design and is available in standardized sizes (XS, S, M, L, XL, ...) and
colours. These you find in retail shops (cfr. exchanges). If however you wish
a different design, which fits your frame and specific body form and is printed
in your preferred (non-standard) colour, you have to go to a tailor and have it
custom made (cfr. OTC).
Both forms have their advantages and disadvantages. You buy the standard-
ized contract via the exchange and you don’t know and care about who the actual
counterparty who is selling the derivative to you (cfr. you know the shop but
not the person/tailor who actually made your clothes). It is the exchange that
takes care that the obligations in the contract are met and the exchange is taking
the risk of counter-party default while simultaneously putting in place measures
against such default. As long as the exchange itself doesn’t default, the contract
is honoured, as far as you are concerned. This is different with OTC derivatives,
here there is no inter-mediator and you are directly dealing with your counter-
party (cfr. you interact with the tailor who is actually making your clothes). A
default of this counter-party can lead to huge losses since no matter what was
agreed, a default of your counterpart can mean non delivery of what has been
promised. Of course, OTC derivatives can be designed to your very specific needs
and may better suit you than a standardized exchange traded product. On the
other side, exchange traded products are typically more liquid and can be bought
and sold back easily; there are continuously bid and ask prices quoted at which
you can immediately transact. The bid price is the price at which you can sell
- the price that somebody is bidding for the asset. The ask price is the price at
which you can buy - the price that somebody is asking for it. The more common
the product is, the lower the spread, i.e. the difference between the ask and the
bid price. It is much harder to unwind or sell back an OTC derivative. It can
actually involve a new negotiation round with unclear terms of settlement. Maybe
your counter-party is not even willing to take it back and even in case it is, the
spread is usually much higher than the spread of exchange traded products, be-
cause the product is very specific and exotic. It involves much more uncertainties
(model risk, calibration risk, ...), its hedging is more complex (and hence it is also
more involved for your counter-party to unwind it) and more (safety) margin is
charged. It is just a deal between a very limited number of parties and therefore
the ask and demand forces are not in place like they are on exchanges open to
everybody on the globe.
Derivatives are omnipresent in today’s financial markets. There are various
types. One has futures and forwards which are basically contracts to buy or
sell the underlying at a predetermined price in the future on a predetermined
date. Hence the limited price stability offered. One also has swaps, that agree on
exchanging certain uncertain cash-flows over a predetermined period and finally
one has options, that are agreements in which the holder has a right to buy or
sell the underlying at specific conditions. To buy an option one has to pay the
price or the premium for the option; swaps are often initiated at zero cost and
have therefore an initial market price equal to zero. However they can be written
on a huge underlying notional and although of zero value when the deal is struck
can bare significant risks. The actual size of derivative’s markets is not easy to
estimate but at the end of 2013, the Bank for International Settlements (BIS)
estimated the total notional outstanding for OTC derivatives at USD 710 trillion
and at a USD 18.6 trillion gross market value.
The theory we develop in this book on how to determine prices and how to
deal with the risks of such derivatives, is applicable to all derivative types over all
asset classes mentioned. However, we mainly focus on equity derivative options.
The basic examples are European call and put options, often referred to as vanilla
options, because they can be regarded as the most simple type of options. Before,
we will define them and illustrate their use in Section 1.4, we first recall the
concept of the risk-free bank-account.
1.3 The Risk-Free Bank Account and Discount factors

A risk-free interest rate can be viewed as the interest rate that rewards the de-
positor of some amount of money on lending it to a counter-party that can not
default. Traditionally, ”risk-free” interest rates were derived from the rates asso-
ciated with Treasury bonds issued by governments. However, nothing is actually
without any risk of default and history has shown that some governments can and
have defaulted on their obligations (Argentine, Greece, Cyprus, ...). For practical
applications, we still do infer a risk-free rate from for example US Treasury bonds
or from extremely solvent issuers, like Germany etc. We ignore then the existing
but extremely low probability of default of these issuers and act as if the interest
charged is risk-free.
If you deposit USD 1000 today in a risk-free account earning an interest rate
1.3. THE RISK-FREE BANK ACCOUNT AND DISCOUNT FACTORS 15
of r = 2% (per annum), then the value in one year’s time would be USD 1020
(= 1000(1 + 0.02)). In this calculation we have assumed that the interest is
compounded annually. This means payout after one year.
Now assume, you want to have exactly USD 2000 (N ) in the account in 3
years (T ) time from now and assume we have a (flat) interest rate of r = 2% (per
annum). How much do you have to put into the risk-free account now ? The
answer is given by the formula:
N 2000
T
= = 1884.64
(1 + r) (1 + 0.02)3
Indeed, after putting 1884.64 in the account, it grows under a 2% interest rate
after one year to 1922.33 (= 1884.64(1 + 0.02)) and after another year to 1960.78
(= 1922.33(1 + 0.02)) and finally after the last year to 2000(= 1960.78(1 + 0.02)).
The interest is compounded again annually and we call USD 1884.64 the present
value of USD 2000 received in 3 years. The ratio of both is called the discount
factor or the price of future money and equals to
1
.
(1 + r)T
In our example it equals 0.9423. It basically is today’s value of receiving USD 1

in T years from now.
In the above examples, we had annual compounding, i.e. interest is paid after
each year. One could also have other ways of interest payment schemes, like semi-
annually, quarterly, monthly, weekly, daily, ... In general then N units of currency
will grow to
r mT
N 1+ .
m
if we compound m times per year and keep the money in our account until time
T . The discount factor then equals
r −mT
1+ .
m
For example, if we have quarterly compounding, m = 4, and r = 2% and we
again put 1000 on the account for one year, the account grows after a first interest
payment to 1005 (= 1000(1 + 0.005)) after 3 months. After three other interest
payment, one at 6 month, one at 9 months and one after one year, it would
accumulate at the end of year one to 1020.15 (= 1000(1 + 0.02/4)4 ), which is
just slightly more than with annual compounding. The obvious reason is that
after an interest payment is made, the investor starts to earn interest on this
payment. Note that different compounding conventions lead to different rate
quotes consistent with the same price for future money at a fixed future date.
When pricing derivatives, we usually assume continuous compounding of inter-
est rates, meaning that compounding (i.e. receiving interest) occurs continuously,
i.e. over an infinitesimally small period of time, or in other words if m → ∞. Our
discount factor then becomes
r −mT
lim 1 + = exp(−rT ).
m→∞ m
In Figure 1.1, one clearly sees the convergence if m → ∞; one can also see the
differences between yearly (m = 1), semi-annually (m = 2), quarterly (m = 4),
monthly (m = 12) and weekly (m = 52) compounding on an investment of USD
1000 at r = 2% during a period of exactly one year (T = 1).
In reality each maturity T and quoting convention has its own interest rate,
r(T ) say, reflecting the market expectation of changing interest rates over the
given period. We then speak about a yield curve and the interest rate term
structure.
The risk-free yield curve is a curve showing several yields or risk-free interest
rates across different contract lengths (maturities), known as the ”term”, for a
risk-free debt contract. One has different curves for different currencies. For
example, one has the U.S. dollar yield curve based on interest rates paid on U.S.
Treasury securities for various maturities, which are assumed to be (almost or as
close as possible to) risk-free. In Figure 1.2 the EUR yield curve is shown as of
the 30th of December 2014; this curve is calculated by the ECB and based on
”AAA-rated” Euro area central government bonds.
Interest rate curves are typically upward-sloping, with shorter-term interest
rates lower than longer-term interest rates, but also can be downward sloping
(inverted) or humped. An inverted curve for example would indicate the market
expects lower interest rates in the future. As seen in the EUR-curve of Figure
1.2, yields can be negative; meaning investors are basically paying money to park
their investments in the underlying securities.
Related to a yield curve is a discount curve. The discount curve basically
represents the discount factors for the different terms. For a given term, the
discount factor is the present value of a currency unit promised at the given term.
If r(t) is the yield (continuously compound) associated with the maturity (or
term) t, then the discount factor for that term equals D(t) = exp(−r(t)t). In
1.4. VANILLA OPTIONS 17
Figure 1.3, one finds the discount factors based on the yields of Figure 1.2. From
this one can read of that, on the 30th of December 2014 receiving EUR 100 in
30 years from then is equivalent with receiving EUR 64.16 on that day, since the
30 years interest rate was on the 30th of December 2014 at r(30) = 0.0147947.
Similar, since the one year interest rate was then r(1) = −0.0008869, investors
need to pay about EUR 100.09 on 30th of December 2014 to receiving EUR 100
back on the 30th of December 2015.
Discount factors are used to discount cash flows (at the risk free rate). Assume
for example a cash-flow consisting of N payments of EUR Ci paid out at times
ti , i = 1, . . . , N . Then the present value (P V ) of this cash-flow equals:
N
X N
X
PV = Ci exp(−r(ti )ti ) = Ci D(ti ),
i=1 i=1
with D(t) denoting here the EUR-related discount factor with term t.
1.4 Vanilla Options

A European call option gives the right to the holder (the buyer) of the option to
buy from the writer of the option (the seller) at a predetermined future time point
t = T , called the maturity, the underlying, a stock S say, for a predetermined
price K, called the strike. A European put option is similar but it gives the right
to the holder of the option to sell the underlying to the writer of the option at a
predetermined future time point t = T (maturity) for a predetermined price K
(strike). For such a right the buyer pays a premium to the option seller, when the
deal is initiated, say at t = 0. We refer to the instrument as well as its premium
by the notation EC(K, T ) and EP (K, T ) respectively. It should be clear from
the context whether we are referring to the instrument or the premium.
Besides these so-called European options, also American call and puts options
exist. These are different from their European counterparts in the sense that the
holder can exercise his rights not only at the maturity of the option but during
the entire life-time of the option.
If an option is traded on an exchange, typically bid and ask prices are contin-
uously given. We use the notation bidEC(K, T ) and askEC(K, T ) for the Euro-
pean call’s bid and ask price and correspondingly bidEP (K, T ) and askEP (K, T )
for the European put. It should be clear from the context whether we are referring
to the initial time t = 0 price or to a general time t price, with 0 ≤ t ≤ T.
The holder of an European call option will exercise his right to buy the under-
lying via the option contract only if this is beneficial to him. This happens when
the underlying at maturity (t = T ) has a market price S(T ) that is greater than
the strike price: S(T ) > K. The payoff of the option is then strictly positive and
equals the difference S(T ) − K. In the other situation, it would not be rational to
pay via the option the strike price K which is more than the price S(T ) one pays
in the market and the option contract expires worthless. The payoff is then zero.
Summarizing, the payoff of the call option can in general be given by
payoff of EC(K, T ) : max(S(T ) − K, 0) = (S(T ) − K)+ .
A similar reasoning can be made for the put option where the holder will actually
only sell the underlying via the option contract when at maturity (t = T ) its
actual market price S(T ) is lower than the strike price K: S(T ) < K. The payoff
of the put equals in general
payoff of EP (K, T ) : max(K − S(T ), 0) = (K − S(T ))+ .
In Figures 1.4 and 1.5 the payoff functions of a European Call and a European
put are visualized respectively.
We say a European call option is out-of-the-money (OTM), if the current stock
price is below the strike. If it is above the strike we say it is in-the-money (ITM).
When the underlying stock prices equals (or is very close to) the strike we say it is
at-the-money (ATM). For a European put, out-of-the-money (OTM) corresponds
to the situation where the current stock price is above the strike. If it is below
the strike we say it is in-the-money (ITM). When its stock prices equals (or is
very close to) the strike we again say it is at-the-money (ATM). OTM basically
means that if one would now exercise the option (which is for European options
actually not allowed in reality, but one assumes one does), the payoff would be
zero. ITM means we would have then a non-zero payoff. This amount one would
get if the option would be now exercised is called the intrinsic value of the option.
OTM options have a zero intrinsic value. The difference between the current price
of the option and its intrinsic value is often referred to as time value: the extra
value the option carries because there is still time left until expiry/maturity and
the underlying asset can still move in a beneficial direction for the option holder.
OTM options have only time value.
Put and call options can be used for different purposes. We illustrate this
in the next examples. In the first example, we show how a call option can be
used for speculation. The next example shows how a put can be used as a kind
1.4. VANILLA OPTIONS 19
of insurance against downwards market movements. The third example shows

how a call can be used as building block in a very common structured product, a
Principal Protected Note (PPN).
Example 2. An investor has USD 10000 at his disposal and is clearly convinced
the stock S will rally in the next year. The stock trades now at USD 50. Vanilla
options on the stock are trading as well. The one year at-the-money (ATM), i.e.
with strike equal to the current stock price, European call option is having a bid
price of USD 3.85 and an ask price of USD 4.00. With his USD 10000, he hence
can buy 200 stocks, or he can buy 2500 European ATM call options, (or he could
buy some of both). He decides to buy 2500 ATM calls. Note that he is buying and
hence has to pay the ask price of USD 4.00. After 6 months the stock has indeed
rallied to USD 65. The call options he bought are now deep in the money, i.e.
the current stock pice is higher than the strike. They are also closer to maturity
(6 months) and one call trades at a bid equal to USD 18.00 and has an ask price
of USD 18.25. He decides to close his position and sells his 2500 calls at the bid
price of USD 18.00. He cashes USD 45000 and actually makes a 350% profit.
Compared with a direct investment in the stock this is much better, since that only
would have given him a 30% return.
Derivatives can be used for speculation and can lead to hugely leveraged posi-
tions and hence huge gains. Of course, there is another side to the story. If the
stock would not move higher and for example closes after one year at the same
level of USD 50. The investment in call options would have led to a 100% loss,
since all the call options would have matured worthless. The direct investment
into the stock would have in that case ended flat and would have shown no loss.
Example 3. At the beginning of a new year an investor steps into the equity
market and buys 1000 stocks at a price of USD 65 each. He furthermore has
still a cash account of USD 2000. His initial total wealth is USD 67000. After
9 months, the stock trades now at USD 80. He doesn’t want to exit his position
because he still believes there is still upwards potential in the stock. However he
is also worried about the downside. The first 9 months of the year the stock has
been rallying nicely (at the beginning of the year he entered at USD 65 !) and it
is now vulnerable to potential negative market sentiment in the next months until
year end. He wants to close his year positively and seeks protection against such
averse downside market movement without exiting his position and potentially
missing a continuation of a rally in the stock. Derivatives are trading on the
underlying stock. An out-ot-the-money (OTM), i.e. with strike below the current
spot, European put with maturity 3 months with strike USD 70 is trading with a bid
of USD 1.80 and an ask of USD 2.00. He decides to spent his USD 2000 cash to
buy protection and buys (at the ask price) 1000 3-month European puts with strike
USD 70. By year end the market indeed went down and the stock is now trading
at USD 60. Without any protection (and assuming no interest payments on his
cash account), he would have been down for the year by 7.46% (USD 5000/USD
67000). However due to his put options, he receives an additional payoff. At
expiration the put options gave him a payoff of USD 10 each. He received hence
USD 10000. Compared with the value of his position in the beginning of the year
(USD 65000+USD 2000), he now has stock worth USD 60000 and USD 10000 in
cash, or USD 70000 in total. He hence is up 4.48% (USD 3000/USD 67000) for
the year.
Example 4. Sales people have learnt that their retail customers are very interested
in investing their money in the medium term in the stock market, especially into
some new social media companies. However they are also worried about loosing
their investment. The structuring team therefore designs the following structured
product: a Principal Protected Note (PPN). For each USD 1000 you invest, you
receive after 4 year your initial investment (USD 1000) plus 60% of the positive
performance of a social media stock S. If the stock S would end after 4 year below
its value at initiation, the investor still gets his initial investment back. Denoting
with S(0) the initial stock price of S and with S(4) the stock price after 4 years,
the investor hence receives:

S(4) − S(0)
P P N = 1000 + 1000 × 60% × max ,0 (1.1)
S(0)
The final wealth with an initial investment of USD 1000 in either the PPN or in
the stock is compared in Figure 1.6
Assume that investing now USD 0.82 into a risk-free account would give in 4
years from now USD 1; this corresponds approximately with an interest rate of
5%. Assume S(0) = 20. Note that in this setting Equation (1.1) becomes
P P N = 1000 + 30 × max (S(4) − 20, 0) = 1000 + 30 × (S(4) − 20)+
Further assume that an at-the-money (ATM), i.e. with strike K = 20, 4-year
European call option is available and trades at bid USD 5.25 and ask USD 5.50.
The bank implements this product therefore as follows. For each USD 1000 it
receives, it puts USD 820 on the risk-free bank account. It also buys 30 ATM call
1.5. MODELLING ASSUMPTIONS 21
options at the ask price of USD 5.50 at a total cost of USD 165. From the original
USD 1000, the bank has hence put USD 820 in a risk-free account and has bought
for USD 165 call options; it still has USD 15 (or 1.5% of the investment amount)
left which it considers as its margin. After 4 years the amount on the bank account
has grown to USD 1000; furthermore the 30 call options expire and have each as
payoff (S(4) − 20)+ . The total hence equals 1000 + 30 × max (S(4) − 20, 0), exactly
the amount it owes the structured product investor.
1.5 Modelling Assumptions

1.5.1 Frictionless Markets
As a first start, one often develops a pricing theory in an idealized setting not
allowing so-called market frictions, there is no default risk, agents are rational and
there is no arbitrage (see next subsection). One also assumes market participants
are rational and prefer more to less. More concrete in a frictionless market there
are no transaction costs, no bid/ask spread, no taxes, no margin requirements, no
restrictions on short sales, no transaction delays, same interest for borrowing and
lending and market participants act as price takers.
Unless mentioned otherwise (see for example the exposures on bid/ask pric-
ing), we develop the theory assuming ideal - frictionless - markets so as to focus
irreducible essentials of the theory and as a first-order approximation to reality.
Understanding frictionless markets is also a necessary step to understand markets
with frictions.
However, reality is different. For example, the risk of failure of a company
- bankruptcy - is inescapably present in its economic activity: death is part of
life. Moreover those risks also appear at the national level: quite apart from war,
recent decades have seen default of interest payments of international debt, or the
threat of it (see for example the 1998 Russian crisis, the Greek crisis, the default
of Iceland and Cyprus). Recall also our comments that there is no such a thing
as a perfectly risk-free asset.
Another example that real markets are functioning differently from frictionless
markets, is the fact that one cannot trade unlimited volumes. Frictionless markets,
assume financial agents to be price takers, not price makers. This implies that
even large amounts of trading in a security by one agent does not influence the
security’s price. Hence agents can buy or sell as much of any security as they
wish without changing the security’s price. This is not true in reality, large orders
make the prices move and one cannot transact always the full order at the same
price.
1.5.2 The No-Arbitrage Assumption

The main assumption in the financial engineering theory for pricing financial
derivatives is the absence of arbitrage. Arbitrage is the possibility of making
money without any risk and without any starting capital. We assume that arbi-
trage is not possible. This means that if you can enter into a position which pays
you in the future, say at time T , a payout X ≥ 0 and in some situations (with
non-zero probability) a strictly positive payout X > 0 then the price to enter (at
any time before) for it needs to be strictly positive as well. Indeed, imagine you
can enter at a zero price or at a strictly negative price, meaning you are paid to
enter into the position, then you run no risk, since you can’t loose (X ≥ 0) and
in some cases you can receive a positive payoff (X > 0). In addition, you even
received (in case the price was strictly negative) some premium at initiation. This
is an arbitrage and is ruled out. Hence the price to enter the position needs to be
strictly positive.
Note that if we work in such a framework with bid and ask prices, no arbitrage
means that the price for buying X needs to be then strictly positive. This implies
that the ask price for it needs to be strictly greater than zero.
Hence, the essence of arbitrage is that it should not be possible to guarantee a
profit (strictly more than on a risk-free account) without exposure to risk. Were
it possible to do so, arbitrageurs would do so, in unlimited quantity, using the
market as a money-pump to extract arbitrarily large quantities of risk-less profit.
This would, for instance, make it impossible for the market to be in equilibrium.
We shall see that arbitrage arguments suffice to determine prices in an idealized
frictionless market. To illustrate intuitively the fundamental arguments of the
no-arbitrage pricing technique we use the following example.
Example 5. Consider an investor who acts in a market in which only three finan-
cial assets are traded: a (risk-less) bank account B, a stocks S and an European
Call options C with strike K = 100 and maturity T on the stock S. The investor
may invest today, time t = 0, in all three assets, leave his investment until time
t = T and gets his returns back then. We assume the current prices (in Euro,
say) of the financial assets are given by
B(0) = 1, S(0) = 100, C(0) = 20

Asset Number Total amount in euro

bank account 10000 10000
Stock 100 10000
Call option 250 5000
Table 1.1: Portfolio I
Asset Number × Price Total amount in euro

bank account 10000 × 1.25 12500
Stock 100 × 175 17500
Call option 250 × 75 18750
TOTAL 48750
Table 1.2: Portfolio I: up state values
and that at t = T there can be only two states of the world: an up-state with euro
prices
B(T, u) = 1.25, S(T, u) = 175, and therefore C(T, u) = 75,
and a down-state with euro prices
B(T, d) = 1.25, S(T, d) = 75, and therefore C(T, d) = 0.
Now our investor has a starting capital of EUR 25000 from which he buys the
the portfolio (Portfolio I) given in Table 1.1. Depending of the state of the world
at time t = T the value of his portfolio will differ: In the up state the total value
of his portfolio is EUR 48750 as can be seen from Table 1.2. In the down-state
his portfolio has a value of EUR 20000 as shown in Table 1.3.

bank account 10000 × 1.25 12500
Stock 100 × 75 7500
Call option 250 × 0 0
TOTAL 20000
Table 1.3: Portfolio I: down state values

Asset Number Total amount in euro

Stock 70 7000
Call option 290 5800
Table 1.4: Portfolio II

bank account 11800 × 1.25 14750
Stock 70 × 175 12250
Call option 290 × 75 21750
TOTAL 48750
Table 1.5: Portfolio II: up state values
Can the investor do better ? This may sound to be a strange question - better
how ? Let us consider the restructured portfolio with initial investment of EUR
24600 (Portfolio II) as in Table 1.4. Again we compute its return in the different
possible states. In the up-state the total value of his portfolio is again EUR 48750
as can be seen in Table 1.5. In the down-state this portfolio has a value of again
EUR 20000 as shown in Table 1.6:
We see that this portfolio generates the same time t = T return while costing
only EUR 24600, a saving of EUR 400 against the first portfolio. So the investor
should use the second portfolio.
Now look what happens if he actual considers the following portfolio (Portfolio
III), which is the difference between Portfolio II and Portfolio I and is given in
Table 1.7. Here he short-sells 30 stocks for a total of EUR 3000, he puts EUR

bank account 11800 × 1.25 14750
Stock 70 × 75 5250
TOTAL 20000
Table 1.6: Portfolio II: down state values

Asset Number Total amount in Euro

Stock -30 -3000
Call option 40 800
Table 1.7: Portfolio III

bank account 1800 × 1.25 2250
Stock -30 × 175 -5250
TOTAL 0
Table 1.8: Portfolio III: up state values
1800 on his bank account and buys 40 calls for EUR 800. Hence he still has EUR
400 in his hands. He decides to invite his friends and have an exuberant lunch
with them for EUR 400.
Now, let us have a look what the value is of Portfolio III at time t = T in both
the up state (Table 1.8) and the down state (Table 1.9). In both cases the value
is exact zero ! Hence there is no risk any more and his lunch was actually a free
lunch !
So there is an arbitrage possibility in the above market situation, and the prices
quoted are not arbitrage-free prices. If we regard (as we shall do) the prices of the
bond and the stock (our underlying) as given, the option must be mispriced.
You can repeat the above example for a variety of different call option prices.
However there will be only one price, namely an initial call option price of EUR

bank account 1800 × 1.25 2250
Stock -30 × 75 -2250
TOTAL 0
Table 1.9: Portfolio III: down state values

30, where there is no free-lunch possible any more. Indeed, if the call option would
be EUR 10 more expensive, he needs to pay in total EUR 400 more for it, which
was exactly the price of his exuberant lunch. In absence of arbitrage, the price
of the call hence must be equal to EUR 30 and we have actually now determined
its no-arbitrage price! Let us also here emphasize that the above arguments were
independent of the preferences and plans of the investor.
In addition, if we only look at the position in bonds and stocks, we can say
that this position covers us against possible price movements of the option, i.e.
having EUR 1800 in your bank account and being 30 stocks short has the opposite
time t = T value as owning 40 call options. We say that the bond/stock position
is a hedge against the position in options.
1.6 The Put-Call Parity

In this section, we elaborate on a special relation, called the put-call parity, be-
tween the price of a European call and the price of a European put option on the
same underlying (non-dividend paying) stock, with current price S(0) say, with
the same time to maturity T and the same strike price K. We first start with
proving the put-call parity in the absences of a bid and ask spread, i.e. the prices
at which one can buy the options equal the prices at which one can sell. In this
one-price-world and in absence of arbitrage the following relation holds:
S(0) − exp(−rT )K + EP (K, T ) − EC(K, T ) = 0. (1.2)
This relation can be proven as follows. Assume that S(0) − exp(−rT )K+
EP (K, T )− EC(K, T ) > 0 then you could do the following: (short) sell the stock,
put exp(−rT )K on the risk-free account, write (i.e. sell) the put option and buy
the call option. You receive S(0) for the stock, have to put exp(−rT )K on the
bank account, you receive the put premium EP (K, T ) and you have to pay the
call premium EC(K, T ). You still then have in your hands: S(0) − exp(−rT )K+
EP (K, T )− EC(K, T ), which we assumed to be strictly positive.
The total payoff at maturity of this position equals −S(T ) + (S(T ) − K)+ −
(K − S(T ))+ + K = 0. Indeed, you have to close your short position in the stock
and buy it back (−S(T )), you receive the call payoff ((S(T )−K)+ ) but you have to
pay the put payoff (−(K − S(T ))+ ) and your initial position on the bank account
has now grown over the period of length T to the exact amount K. Hence, you
started with nothing and at the end of the trade there is no risk any more, but
after initiating the trade you had some (free) money left. This is an arbitrage
1.6. THE PUT-CALL PARITY 27
opportunity and hence not possible. Our initial assumption S(0) − exp(−rT )K+
EP (K, T )− EC(K, T ) > 0 hence can not be true.
Now assume S(0) − exp(−rT )K+ EP (K, T )− EC(K, T ) < 0 then you could
do the opposite: buy the stock, borrow exp(−rT )K from the bank, write the
call option and buy the put option. Then at time zero, you have to pay S(0)
for the stock, cash exp(−rT )K from the bank account, pay the put premium
EP (K, T ) and receive the call premium EC(K, T ). You still have in your hands:
−S(0) + exp(−rT )K − EP (K, T ) + EC(K, T ), which we assumed to be strictly
positive.
The total payoff at maturity of this position equals S(T ) − (S(T ) − K)+ +
(K − S(T ))+ − K = 0. Indeed at maturity, your stock is worth S(T ), you receive
the put payoff but you have to pay the call payoff. Finally you have to pay back
the borrowed amount plus interest rates namely the exact amount K. Hence you
started with no money and at the end of this trade there is again no risk any more,
but after initiating the trade you had some (free) money to spent. This is again
an arbitrage opportunity and hence not possible. Our initial assumption S(0) −
exp(−rT )K+ EP (K, T )− EC(K, T ) < 0 hence can not be true. In conclusion,
we must have S(0) − exp(−rT )K+ EP (K, T )− EC(K, T ) = 0.
The situation complicates in the two-price-world where the price of derivatives
depend on whether you are buying or selling. The first trade above namely, short
selling the stock, putting exp(−rT )K on the risk-free account, writing the put
option and buying the call option, gives you S(0) for the stock, you have, since
you are buying, to pay the ask price for the call, askEC(K, T ), you sell the put
and hence receive the bid price of it bidEP (K, T ) and you have to put exp(−rT )K
on the bank account. Net this leads to : S(0) − askEC(K, T ) + bidEP (K, T ) −
exp(−rT )K, which if strictly positive would lead to an arbitrage. Hence
S(0) − askEC(K, T ) + bidEP (K, T ) − exp(−rT )K ≤ 0
and so
S(0) − exp(−rT )K ≤ askEC(K, T ) − bidEP (K, T ).
Similarly, for the second trade, namely buying the stock, borrowing exp(−rT )K
from the bank, buying the put option and selling the call option, you have to pay
S(0) for the stock, receive the call’s bid price bidEC(K, T ), pay the put’s ask price
askEP (K, T ) and cash exp(−rT )K from the bank account. The total amount
you have left in your hands after the trade equals : −S(0) + bidEC(K, T ) −
askEP (K, T ) + exp(−rT )K. This amount can not be strictly positive because
otherwise you could have a free-lunch. Therefore:
S(0) − bidEC(K, T ) + askEP (K, T ) − exp(−rT )K ≥ 0
or
S(0) − exp(−rT )K ≥ bidEC(K, T ) − askEP (K, T ).
In conclusion we have:
bidEC(K, T )−askEP (K, T ) ≤ S(0)−exp(−rT )K ≤ askEC(K, T )−bidEP (K, T ).
1.7 The Forward Contract

A forward contract is an agreement between two parties, the forward buyer, who
is said to be long the forward, and the forward seller, who is so-called short the
forward. The forward buyer agrees to buy from the forward seller the underlying
asset, a non-dividend paying stock say, at a certain future time point T , the
maturity, for a give price K (the strike). The difference with an option is that
the forward buyer must buy the underlying and not just has the right to buy it.
Depending on the agreed strike an up-front premium is paid at initiation from the
forward buyer to the seller or the other way around. The payoff of such a forward
contract for the buyer equals S(T ) − K. If no up-front premium is paid and the
deal is considered fare as it is; the special strike K ∗ for which this is the case is
called the stock’s forward price.
A forward can be synthetically created out of two vanilla options on the same
underlier. Indeed, being long a forward contract is equivalent with buying a
European call option and selling a European put option on the same underlier,
both maturing at time T and both with K as strike, because the payoff equals:
(S(T ) − K)+ − (K − S(T ))+ = S(T ) − K.
In the one-price-world, the up-front premium is therefore equal to EC(K, T )−
EP (K, T ), which equals by the put call parity to
F orward(K, T ) = EC(K, T ) − EP (K, T ) = S(0) − exp(−rT )K.
The forward price is the strike K ∗ for which EC(K ∗ , T ) = EP (K ∗ , T ). One can
easily see from the put-call parity that this is the case when K ∗ = exp(rT )S(0).
1.8. SPREAD INEQUALITIES 29
1.8 Spread Inequalities

In the world-of-one-price three inequalities concerning vanilla options play a spe-
cial role. These are the call and put spread, butterfly spread and calendar spread
inequalities.
In this section we discuss these equalities in the one-price-framework and ex-
tend these into the two-price-framework in a final section.
1.8.1 The Call Spread and Put Spread Inequality

Consider first the call spread inequality. This inequality deals with the prices of
two European call options on the same underlier for two strikes K1 < K2 and a
common maturity T . A call spread is a position long the call with the lower strike
and short the call with the higher strike. It hence has as payoff:
(S(T ) − K1 )+ − (S(T ) − K2 )+ .
As can be seen from Figure 1.7, since K1 < K2 , this payoff is always non-negative
and has a region where it pays out some strictly positive amount.
Hence the price for this position at time zero needs to be strictly positive. In
other words:
EC(K1 , T ) > EC(K2 , T ), if K1 < K2 .
Furthermore, we also have always that (S(T ) − K1 )+ − (S(T ) − K2 )+ ≤ K2 − K1 .
Therefore,
EC(K1 , T ) − EC(K2 , T ) ≤ exp(−rT )(K2 − K1 ),
or
0 ≤ exp(−rT )(K2 − K1 ) + EC(K2 , T ) − EC(K1 , T ).
Similar arguments, lead to the following inequalities for European puts on the
same stock and with he same maturity T and with strikes K1 < K2 .
EP (K2 , T ) > EP (K1 , T ), if K1 < K2 .
And,
EP (K2 , T ) − EP (K1 , T ) ≤ exp(−rT )(K2 − K1 ),
or
0 ≤ exp(−rT )(K2 − K1 ) + EP (K1 , T ) − EP (K2 , T ).
1.8.2 The Butterfly Spread Inequality

Consider three strikes K1 < K2 < K3 and the purchase of a call struck at K1
coupled with the sale of (K3 − K1 )/(K3 − K2 ) calls with strike at K2 and the
purchase of (K2 − K1 )/(K3 − K2 ) calls with strike K3 . All calls are on the same
underlier and have the same time to maturity T . This is the so-called butterfly
spread. The payoff
K3 − K1 K2 − K1
(S(T ) − K1 )+ − (S(T ) − K2 )+ + (S(T ) − K3 )+ ≥ 0
K3 − K2 K3 − K2
is non-negative as can be seen from Figure 1.8.
Hence in a one-price world we have:
K3 − K1 K2 − K1
EC(K1 , T ) − EC(K2 , T ) + EC(K3 , T ) ≥ 0
K3 − K2 K3 − K2
which one may rewrite into:
EC(K1 , T ) − EC(K2 , T ) EC(K2 , T ) − EC(K3 , T )

≥
K2 − K1 K3 − K2
For puts, we can obtain a similar relation:
EP (K3 , T ) − EP (K2 , T ) EP (K2 , T ) − EP (K1 , T )

≥ .
K3 − K2 K2 − K1
1.8.3 The Calender Spread Inequality

The calender spread inequality in the one-price world compares the prices of
two European call options on the same underlier but with different maturities
0 < T1 < T2 :
EC(K exp(−r(T2 − T1 )), T1 ) ≤ EC(K, T2 ),
where we assumed no dividends. To prove this inequality, suppose that this
inequality would not hold and
EC(K exp(−r(T2 − T1 )), T1 ) − EC(K, T2 ) > 0,
then one could buy the long dated call and sell the short dated call and still have
due to the assumed inequality some positive money left at time zero. One then
waits until T1 and if the shorted dated call would end out of the money, the short
1.9. DIVIDENDS 31
dated call is expiring worthless and we still hold the long dated which can only
give us a non-negative payoff. If the short dated call ends in the money, we have
a negative payoff equal to −(S(T1 ) − K exp(−r(T2 − T1 ))), since we sold the call
and it is now ending in the money. At that point, we short one stock for the price
of S(T1 ). All the cash is put on the bank account and totals K exp(−r(T2 − T1 )).
Indeed, we got S(T1 ) from shorting the stock and −(S(T1 ) − K exp(−r(T2 − T1 )),
the (negative) payoff from the short dated call. So now, we are short a stock and
have on our bank account K exp(−r(T2 −T1 )). We then wait until T2 , at which our
bank account has grown to the value K. If the long dated call ends in the money
(S(T2 ) > K), we exercise it and receive the stock for which we pay the price K
and hence our short position in stock (initiated at time T1 ) is closed and the bank
account is back to zero. If the long dated call ends OTM (S(T2 ) ≤ K), we buy a
stock in the market for a value less than K and hence close our short position in
stock and still have money on the bank account left since S(T2 ) ≤ K. In all the
above cases we started with nothing, had some free money after we bought and
sold the two calls. In none of the cases we had a loss at the end, in some we even
had some extra profit. This is a clear arbitrage and hence our starting assumption
is false. We must have that EC(K exp(−r(T2 − T1 )), T1 ) − EC(K, T2 ) ≤ 0.
A similar argument can be made to derive the calender spread inequality for
a put. The prices of two European put options on the same underlier but with
different maturities 0 < T1 < T2 satisfy
EP (K exp(−r(T2 − T1 )), T1 ) ≤ EP (K, T2 ),
where again we assumed no dividends.
1.9 Dividends
Holding a stock entitles the owner of it to receive dividend payments. Usually, the
stock price decreases by approximately the dividend amount after it is paid out
(the ex-dividend date). Since dividend payments hence influence the stock price,
the pricing of an equity derivative instrument should take into account dividends
as well and for this one needs to make an estimation of future dividend payments.
This is however not straightforward, since dividends are decided at firm level and
will depend on the future performance and strategy of the company. Dividends are
usually expressed in a currency amount per stock. As is the case for interest rates,
a continuously compounded dividend rate or yield q can be estimated. Using such
a continuously compound dividend rate often simplifies the calculations and we

will mainly use this setting.
Further, many of the formulae we have encountered so-far can be easily adapted
for such a continuously compound dividend regime. The classical put-call parity
(Equation (1.2)) for example becomes
exp(−qT )S(0) − exp(−rT )K + EP (K, T ) − EC(K, T ) = 0.
The underlying argument of buying one stock and holding it until time T is
replaced with initial buying only exp(−qT ) amount of stock and continuously
investing the proceeds of dividends in additional stock, which again leads to also
one unit of stock at time T .
Note that the put-call parity (including dividends), is actually a way to esti-
mate the dividend yield of an underlying stock if one is given option prices (for a
certain K and T ) on that stock. Indeed, given EP (K, T ), EC(K, T ), S(0) and the
going interest rate r, the only unknown is q and one can look for that particular
q such that the put-call parity is satisfied.
1.10 Extra
1.10.1 Bid - Ask Pricing Inequalities
Above we have derived several price relations most of the time in a one price
world. The situation in a two-price-framework is typically a bit more involved.
The Forward Contract

In a one price world, as discussed in Section 1.7, a forward can be synthetically
created out of two vanilla options on the same underlier. Indeed, being long a
forward contract is equivalent with buying a European call option and selling a
European put option on the same underlier, both maturing at time T and both
with K as strike,
In a world with bid and ask prices, you can buy the call only at askEC(K, T ),
and write a put for the price bidEP (K, T ). Hence, if in addition you go short
the forward and would receive for it bidF orward(K, T ), the total money one has
left, namely bidF orward(K, T ) − askEC(K, T ) + bidEP (K, T ) cannot, due to
the no-arbitrage assumption, be strictly positive, since the risks are completely
covered. Hence
bidF orward(K, T ) ≤ askEC(K, T ) − bidEP (K, T ).
1.10. EXTRA 33
Similarly, if you sell the call and buy the put option - the former is done at bid
price bidEC(K, T ) and the later at the ask price askEP (K, T ) - and in addition
go long, i.e. buy, the forward at askF orward(K, T ), the total cash received, i.e.
bidEC(K, T )− askEP (K, T ) − askF orward(K, T ), can for the same no-arbitrage
reason not be strictly positive. Therefore
askF orward(K, T ) ≥ bidEC(K, T ) − askEP (K, T ).
The Call Spread and Put Spread Inequality

In a two-price-framework, entering a call spread can be done by buying the call
with strike K1 at its ask price and selling the call with strike K2 at its bid price.
Hence, all this can be achieved for the total price askEC(K1 , T ) − bidEC(K2 , T ).
Since the position always gives a non-negative payoff and has possibility to payout
some strictly positive amount, this total amount needs to be strictly positive.
Hence
askEC(K1 , T ) > bidEC(K2 , T ), if K1 < K2 .
Putting exp(−rT )(K2 − K1 ) on the risk-free bank account and selling the
call with strike K1 and buying the call with strike K2 also always gives a non-
negative payoff K2 − K1 + (S(T ) − K2 )+ − (S(T ) − K1 )+ ≥ 0. Therefore the
price to enter also needs to be non-negative. The cash needed to do this equals
exp(−rT )(K2 − K1 ) (to be put on bank account) plus askEC(K2 , T ) (to buy the
call with strike K2 ) minus bidEC(K1 , T ) (the premium one receives from writing
the call with strike K1 ). In conclusion
0 ≤ exp(−rT )(K2 − K1 ) + askEC(K2 , T ) − bidEC(K1 , T ).
Similar arguments establish the following inequalities for bid and ask prices
for put options, or the put spread:
askEP (K2 , T ) > bidEP (K1 , T ), if K1 < K2
and
0 ≤ exp(−rT )(K2 − K1 ) + askEP (K1 , T ) − bidEP (K2 , T ).
The Butterfly Spread Inequality

In a two-price world, dealing with a butterfly spread, we must take into account
that we are buying the lowest and highest strike calls and selling the call with
strike K2 . Hence, we have that:

K3 − K1 K2 − K1
askEC(K1 , T ) − bidEC(K2 , T ) + askEC(K3 , T ) ≥ 0.
K3 − K2 K3 − K2
Equivalently,
askEC(K1 , T ) − bidEC(K2 , T ) bidEC(K2 , T ) − askEC(K3 , T )

≥ .
K2 − K1 K3 − K2
For puts, we can obtain a similar relation:
askEP (K3 , T ) − bidEP (K2 , T ) bidEP (K2 , T ) − askEP (K1 , T )

≥ .
K3 − K2 K2 − K1
The Calender Spread Inequality

In a two-price-world the calender spread inequality becomes:
bidEC(K exp(−r(T2 − T1 )), T1 ) ≤ askEC(K, T2 ). (1.3)
Indeed suppose again the contrary, namely bidEC(K exp(−r(T2 − T1 )), T1 ) −

askEC(K, T2 ) > 0, then again we could buy the long dated call (at the ask)
and sell the short dated call (at the bid) and still have after these transactions
some positive amount of money left. We further could exactly follow the above
procedure, with no possibility of loosing and always ending strictly positive. Hence
again an arbitrage and therefore the Inequality (1.3) must hold.
A similar argument can be made to derive the calender spread inequality for
a put. The prices of two European put options on the same underlier but with
different maturities 0 < T1 < T2 satisfy
bidEP (K exp(−r(T2 − T1 )), T1 ) ≤ askEP (K, T2 ).
1.10.2 Derivatives on Foreign Exchange Rates

If the underlying is not a stock but a currency, we must take into account the
domestic as well as the foreign interest rate. Let us use continuous compounding
and denote these interest rates by rd and rf , respectively. We are in Europe so our
domestic currency is the Euro. Consider a forward contract on the USD: you must
buy N USD at some point in the future T for the price of K USD/EUR, hence
paying N × K Euro. Assume the currency exchange rate is S0 USD/EUR. What
1.10. EXTRA 35
is the value of this forward contract and for what value of K has the contract a
zero value (the forward price of the USD) ? It will turn out that price is now
K = exp((rd − rf )T )S0 .
Indeed, suppose K > exp((rd − rf )T )S0 . An investor can then do the fol-
lowing (at time 0): Borrow exp(−rf T )N S0 euros at rate rd ; use this cash to buy
exp(−rf T )N USD and put this on an USD bank account at rate rf and sell/short
the forward contract. Then the holding of the foreign currency grows to N USD
because of the interest (rf ) earned. Under the terms of the contract this holding is
exchanged for N × K Euro at time T . An amount exp(rd T ) exp(−rf T )N S0 is re-
quired to repay the borrowing. Hence a net profit of N (K−S0 exp((rd −rf )T )) > 0
is, therefore, made at time T .
In case K < exp((rd − rf )T )S0 you can do the following: borrow exp(−rf T )N
USD at rate rf ; use this cash to buy exp(−rf T )N S0 euros and put this on an euro
denominated bank account at rate rd ; take a long (buy) position in the forward
contract. Then the domestic currency grows to N S0 exp((rd − rf )T )), you pay
N × K Euro to receive N USD and uses these dollars to pay the loan. In total
you earned N (S0 exp((rd − rf )T )) − K) euro which in this case was assumed to
be positive.
1.10.3 Derivatives on Commodities and the Cost of Carry

We now consider the case of commodities. Important here is the impact of storage
costs. If the storage costs incurred at any time are proportional to the price of the
commodity, they can be regarded as providing a negative dividend yield. In this
case the forward price is given by F = S0 exp((r + u)T ), where u is the storage
costs per annum as a proportion of the spot price.
The relationship between all above future/forward prices and spot prices can
be summarized in terms of what is known as the cost of carry. This measures
the storage cost plus the interest that is paid to finance the asset less the income
earned on the asset. For a non-dividend paying stock, the cost of carry is r since
there are no storage costs and no income is earned; for a dividend paying stock, it
is r − q since dividend income is earned at rate q on the asset; for a currency it is
rd − rf ; for a commodity with storage costs that are a proportion u of the price,
it is r + u; and so on. Define the cost of carry as c. For an investment asset, the
forward price is
F = S0 exp(cT ).
compounding interest rates

1.020,25
1020,20134
1020.20
1020.18
1.020,15 1020.15
1.020,1 1020.10
1.020,05
1.020
5 10 15 20 25 30 35 40 45 50 55
m
Figure 1.1: Compounding interest rates (T = 1, N = 1000, r = 2%, m =

1, 2, 4, 12, 52)
1.10. EXTRA 37
EUR yield curve (30 december 2014)

1.6
1.4
1.2
1
interest rate (%)
0.8
0.6
0.4
0.2
−0.2
0 5 10 15 20 25 30
maturity
Figure 1.2: EUR Yield curve (30 December 2014)

Discount Factors based on risk−free EUR yield curve (30 december 2014)
1.05
0.95
0.9
discount factor
0.85
0.8
0.75
0.7
0.65
0.6416
0 5 10 15 20 25 30
t
Figure 1.3: Discount factors (EUR - 30 December 2014)

1.10. EXTRA 39
European Call Payoff function (K=100)

50
45
40
35
30
payoff
25
20
15
10
0
0 50 100 150
Stock price at maturity
Figure 1.4: European Call (EC) payoff function (K = 100)

European Put payoff (K=100)

100
90
80
70
60
payoff
50
40
30
20
10
0
0 50 100 150
Figure 1.5: European Put (EP) payoff function (K = 100)

1.10. EXTRA 41
PPN versus direct stock investment

2000
PPN investment
1800
stock investment
1600
1400
1200
wealth
1000
800
600
400
200
0
0 20 40 60 80 100 120 140 160 180 200
final stock price in percentage of spot
Figure 1.6: Comparing the Principal Protected Note (PPN) with a direct stock
investment. Initial investment is USD 1000; participation rate equals 60 %.
Call Spread Payoff (K1=80 and K2=110)

35
30
25
20
payoff
15
10
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
Figure 1.7: Call Spread payoff function (K1 = 80 and K2 = 110)

1.10. EXTRA 43
Butterfly
12
10
8
Payoff
0
0 50 100 150
Figure 1.8: Butterfly payoff function (K1 = 90, K2 = 100 and K3 = 105)
Chapter 2
Tree Models
2.1 The Binomial Tree

Our aim here is to show in the simplest possible non-trivial model how the theory
based on the principle of no-arbitrage works.
2.1.1 One Step Binomial Tree

We start with setting up the most simple tree setting: a one-step binomial tree
and immediately start with an example.
Example 6. Let our financial market consist of two financial assets, a risk-less
bank account (or bond) B and a risky stock S, with today’s price S0 = 20 Euro.
We look at a single-period model and assume that starting from today (t = 0) the
world can only be in one of two states at time t = T : the stock price will either
be ST = 22 Euro or ST = 18 Euro. We are interested in valuing a European call
option to buy the stock for 21 Euro at time t = T . At time t = T , this option can
have only two possible values. It will have value 1 Euro, if the stock price is 22
Euro; if the stock price turns out to be 18 Euro at time t = T , the value of the
option will be zero. The situation is illustrated in Figure 2.1.
It turns out that we can price the option by the assumption that no arbitrage
opportunities exist. We set up a portfolio of the stock and the option in such a way
that there is no uncertainty about the value of the portfolio at the time of expiry,
t = T . We then argue that, because the portfolio has no risk, the return earned
on it must equal the risk-free interest rate of the bank account. This enables us
to work out the cost of setting up the portfolio and, therefore, the option’s price.
45
46 CHAPTER 2. TREE MODELS
Consider a portfolio consisting of a long position in ∆ stocks and a short position

in one call option. We calculate the value of ∆ that makes the portfolio risk-less.
If the stock price moves up from 20 to 22 Euro, the value of the shares is 22∆
and the value of the option is 1 Euro, so that the total value of the portfolio is
22∆ − 1 Euro. If the stock price moves down from 20 to 18 Euro, the value of the
shares is 18∆ Euro and the value of the option is zero, so that the total value of
the portfolio is 18∆ Euro. The portfolio is risk-less if the value of ∆ is chosen so
that the final value of the portfolio is the same for both alternatives. This means
22∆ − 1 = 18∆
or
∆ = 0.25.
A risk-less portfolio is, therefore long 0.25 shares and short 1 option. If the
stock price moves up to 22 Euro, the value of the portfolio is 22×0.25−1 = 4.5. If
the stock price moves down to 18 Euro, the value of the portfolio is 18×0.25 = 4.5.
Regardless of whether the stock price moves up or down, the value of the portfolio
is always 4.5 Euro at the end of the life of the option.
Risk-less portfolios must, in the absence of arbitrage opportunities, earn the
risk free rate of interest. Suppose that in this case the risk-free rate is 12 percent
per annum and that T = 0.5, i.e. six months. It follows that the value of the
portfolio today must be the present value of 4.5 Euro, or 4.5 exp(−0.12 × 0.5) =
4.238 The value of the stock today is known to be 20 Euro. Suppose the option
price is denoted by f . The value of the portfolio today is 20 × 0.25 − f = 5 − f .
It follows that
5 − f = 4.238
or
f = 0.762.
This shows that, in the absence of arbitrage opportunities, the current value of the
option must be 0.762. If the value of the option were more than 0.762 Euro, the
portfolio would cost less than 4.238 Euro to set up and would earn more than the
risk-free rate. If the value of the option were less than 0.762 Euro, shorting the
portfolio would provide a way of borrowing money at less than the risk-free rate.
In other words, if the value of the option were more than 0.762 Euro, for example
1 Euro, you can borrow for example 42380 Euro and buy 10000 times the above
portfolio at a cost of 10000(0.25 × 20 − 1) = 40000 Euro.
2.1. THE BINOMIAL TREE 47
You pocket 2380 Euro and after 6 months, you sell 10000 portfolio and cashes
in 45000, because the value of one portfolio is always 4.5 Euro. With this money
you pay back the bank for the money you borrowed plus the interests on it, i.e. you
pay the bank an amount of 42380 × exp(−0.12 × 0.5) = 45000 Euro. At the end
of all this you earned 2380 Euro without taking any risk and without an initial
capital. If the value of the option were less than 0.762 Euro, you do the opposite.
We can generalize the argument just presented by considering a stock whose

price is initially S0 and an option on the stock whose current price is f . We
suppose that the maturity of the option is T and that the stock can move up from
S0 to a new level, S0 u or down from S0 to a new level, S0 d (u > 1; 0 < d < 1).
If the stock price moves up to S0 u, we suppose that the payoff from the option is
fu ; if the stock price moves down to S0 d, we suppose the payoff from the option
is fd . The situation is illustrated in Figure 2.2. As before, we imagine a portfolio
consisting of a long position in ∆ shares and a short position in one option. We
calculate the value of ∆ that makes the portfolio risk-less. If there is an up
movement in the stock price, the value of the portfolio at the end of the life op
the option is S0 u∆ − fu . If there is a down movement in the stock price, the value
becomes S0 d∆ − fd .
The two are equal when
S0 u∆ − fu = S0 d∆ − fd ,
or
fu − fd
∆= . (2.1)
S0 u − S0 d
In this case, the portfolio is risk-less and must earn the risk-less interest rate. If
we denote the risk-free interest rate by r, the present value of the portfolio is
(S0 u∆ − fu ) exp(−rT ) = (S0 d∆ − fd ) exp(−rT ).
The cost of setting up the portfolio is
S0 ∆ − f.
It follows that
(S0 u∆ − fu ) exp(−rT ) = S0 ∆ − f,
or
f = S0 ∆ − (S0 u∆ − fu ) exp(−rT ).
Substituting from Equation 2.1 for ∆ and simplifying, this equation reduces to
f = exp(−rT )[pfu + (1 − p)fd ] (2.2)
where
exp(rT ) − d
p= . (2.3)
u−d
Note, that if we assume that u > exp(rT ) > d ≥ 0, one can easily show
that the value of p given in Equation 2.3 satisfies 0 < p < 1 and hence can
be interpreted as a probability. Note that it is actual natural to assume that
u > exp(rT ), because it means that after a time T , you can gain more (a factor
u) by investing in the risky stocks, than you can earn with a risk-less investment
in bond (a factor exp(rT )). If this was not the case no one would invest in stocks.
Of course, you can also lose money (d factor) by investing in stocks.
Also note that Equation 2.1 shows that ∆ is the ratio of the change in the
option price to the change in the stock price.
Finally, remark that the option pricing formula in (2.2) does not involve the
actual probabilities of the stock moving up or down; p can be interpreted as an
artificial probability (see later). This is surprising and seems counter-intuitive.
The key reason is that the probabilities of future up or down movements are
already incorporated into the price of the stock.
2.1.2 Risk Neutral Valuation

Although we do not need to make any assumptions about the probabilities of an
up and down movement in order to derive Equation 2.2, it is natural to interpret
the variable p in Equation 2.3 as the probability of an up movement in the stock
price. The variable 1 − p is then the probability of a down movement, and the
expression
pfu + (1 − p)fd
is the expected payoff from the option. With this interpretation of p, Equation
2.2 then states that the value of the option today is its expected future value
discounted at the risk-free rate.
We now investigate the expected return from the stock when the probability of
an up movement is assumed to be p. The expected stock price at time T , Ep [ST ]
(with the subscript p indicating we take the expectation p as up probability), is
given by
Ep [ST ] = pS0 u + (1 − p)S0 d = pS0 (u − d) + S0 d.
Substituting from Equation 2.3 for p, this reduces to
Ep [ST ] = S0 exp(rT ) (2.4)
showing that the stock price grows, on average, at the risk-free rate r. Setting
the probability of an up movement equal to p is therefore, equivalent to assuming
that the return on the stock on average equals the risk-free rate. In a risk-neutral
world the expected return on all securities is the risk-free interest rate. Equation
2.4 shows that we are assuming a risk-neutral world when we set the probability
of an up movement to p. Equation 2.2 shows that the value of the option is
its expected payoff in a risk-neutral world discounted at the risk-free rate. This
result is an example of an important general principle in option pricing known as
risk-neutral valuation. The principle states that it is valid to assume the world
is risk neutral when pricing options. The resulting option prices are correct not
just in a risk-neutral world, but in the real world as well.
2.1.3 One Step Binomial Tree Revised

We now turn back to the numerical example in Figure 2.1 to illustrate that risk-
neutral valuation gives the same answers as no-arbitrage arguments. The stock
price is currently 20 Euro and will move either up to 22 Euro or down to 18
Euro at the end of six months. The option considered is a European call option
with strike price of 21 Euro and an expiration date in six months. The risk-
free interest rate is 12 percent per annum. We define p as the probability of an
upward movement in the stock price in a risk-neutral world. (We know from the
analysis given earlier in this section that p is given by Equation 2.3. However,
for the purpose of this illustration we suppose that we do not know this.) In a
risk-neutral world the expected return on the stock must be the risk-free rate of
12 percent. This means that p must satisfy
22p + 18(1 − p) = 20 exp(0.12 × 0.5)
or
20 exp(0.12 × 0.5) − 18
p= = 0.8092.
4
At the end of the six months, the call option has a 0.8092 (risk-neutral) probability
of being worth 1 Euro and a 0.1908 (risk-neutral) probability of being worth zero.
Its expected value is, therefore,
0.8092 × 1 + 0.1908 × 0 = 0.8092

To arrive to the option price, this should be discounted at the risk-free rate. The
value of the option today is, therefore,
0.8092 exp(−0.12 × 0.5) = 0.7620.
This is the same value as the value obtained earlier, illustrating that no-arbitrage
arguments and risk-neutral valuation give the same answer.
2.1.4 Two-Step Binomial Trees

One-step trees can be again combined into multi-step trees. We first extend the
analysis to a two-step binomial tree and start again with an example.
Example 7. Assume the stock price starts at 20 Euro and in each of the two time
steps may go up by 10 percent or down by 10 percent. We suppose that each time
step is six months long and the risk-free interest rate is 12 percent per annum.
We consider an European call option with a strike price of 21 Euro.
Figure 2.3 shows the tree with both the stock price and the option price at
each node. The stock price is the upper number and the option price is the lower
number. The option prices at the final nodes of the tree are easily calculated. They
are the payoffs from the option. At node D, the stock price is 24.2 Euro and the
option price is 24.2 − 21 = 3.2 Euro; at nodes E and F, the option is out of the
money and its value is zero.
At node C, the option price is zero, because node C leads to either node E or
node F and at both nodes the option price is zero. Next, we calculate the option
price at node B. Using the notation introduced earlier in the chapter, u = 1.1,
d = 0.9, r = 0.12, and T = 0.5 so that p = 0.8092. Equation 2.2 gives the value
of the option at node B as
exp(−0.12 × 0.5)[0.8092 × 3.2 + 0.1908 × 0] = 2.4386.
It remains for us to calculate the option at the initial node, A. We do so by

focusing on the first step of the tree. We know that the value of the option at node
B is 2.4386 and that at node C it is zero. Equation 2.2, therefore, gives the value
at node A as
exp(−0.12 × 0.5)[0.8092 × 2.4386 + 0.1908 × 0] = 1.8583.
The value of the option is 1.8583 Euro.

We can generalize the case of two time steps by considering the situation in
Figure 2.4.
The stock price is initially S0 . During each step, it either moves up to u times
its value or moves down to d times its value. The notation for the value of the
option is shown on the tree. For example, after two up movements, the value of
the option is fuu . We suppose that the risk-free interest rate is r and the length
of the time step is ∆t years.
Repeated application of Equation 2.2 gives
fu = exp(−r∆t)[pfuu + (1 − p)fud ] (2.5)

fd = exp(−r∆t)[pfud + (1 − p)fdd ] (2.6)
f = exp(−r∆t)[pf u + (1 − p)f d] (2.7)
(2.8)
and
exp(r∆t) − d
p=
u−d
Substituting the first two equations in the last one, we get
f = exp(−r2∆t)[p2 fuu + 2p(1 − p)fud + (1 − p)2 fdd ].
This is consistent with the principle of risk-neutral valuation mentioned earlier.

The variable p2 , 2p(1 − p), and (1 − p)2 are the probabilities that the upper,
middle, and lower final nodes will be reached. The option price is equal to its
expected payoff in a risk-neutral world discounted at the risk-free interest rate.
As we add more steps to a binomial tree, the risk-neutral valuation principle
continues to hold. The option price is always equal to the present value (discount-
ing at the risk-free interest rate) of its expected payoff in a risk-neutral world.
2.1.5 Multi-Step Binomial Trees

The above one- and two-steps binomial trees are very imprecise models of reality
and are used only for illustrative purposes. Clearly an analyst can expect to
obtain only a very rough approximation to an option price by assuming that the
stock movements during the life of the option consist of one or two binomial steps.
When binomial trees are used in practice, the life of the option is typically divided
into 50 or more time steps of length ∆t. In each time step there is a binomial
stock movement. With 50 time steps this means that 51 terminal stock prices and
250 possible stock price paths are considered.
Consider the evaluation of an option on a non-dividend-paying stock. We

start by dividing the life of the option into a large number of small intervals of
length ∆t. We assume that in each time interval the stock price moves from
its initial value S to one of two new values Su and Sd. In general, we assume
0 ≤ d < exp(r∆t) < u. The movement from S to Su is, therefore referred to as
an ”up” movement and the movement from S to Sd is a ”down” movement.
In the above sections we introduced what is known as the risk-neutral valuation
principle. This states that any security which is dependent on a stock can be
valued on the assumption that the world is risk neutral. It means that for the
purposes of valuing an option, we can assume:
• The expected return from all traded securities is the risk-free interest rate.
• Future cash flows can be valued by discounting their expected values at the
risk-free interest rate.
We make use of this when using a binomial tree. The tree is designed to
represent the behaviour of a stock price in a risk-neutral world. In this risk-
neutral world the probability of an up movement will be denoted by p. The
probability of a down movement is 1 − p; as seen above in Equation 2.3:
exp(r∆t) − d
p= . (2.9)
u−d
Figure 2.5 illustrates the tree of stock prices over 5 time periods that is consid-
ered when the binomial model is used. At time zero, the stock price S0 is known.
At time ∆t there are two possible stock prices, S0 u and S0 d; at time 2∆t , there
are three possible stock prices, S0 u2 , S0 ud, and S0 d2 ; and so on. In general, at
time i∆t , i + 1 stock prices are considered. These are
S0 uj di−j , j = 0, ..., i.
European options are evaluated by starting at the end of the tree (time T )
and working backward. The value of the option is known at time T . For example,
an European put option is worth (K − ST )+ and an European call option is worth
(ST − K)+ , where ST is the stock price at time T and K is the strike price.
Because a risk-neutral world is being assumed, the value at each node at time
T − ∆t can be calculated as the expected value at time T discounted at rate r
for a time period ∆t. Similarly, the value at each node at time T − 2∆t can be
calculated as the expected value at time T − ∆t discounted for a time period ∆t
2.2. MATCHING TREES WITH A GIVEN VOLATILITY 53
at rate r, and so on. Eventually, by working back through all the nodes, the value
of the option at time zero is obtained. This procedure is illustrated in Figure 2.6.
Another way of calculating the option prices is by directly taking the dis-
counted value of the expected payoff of the option in the risk-neutral world. For
example the European put, with strike price K and maturity T has a value:
N
X + N j
exp(−rT ) K − S0 uj dN −j p (1 − p)N −j . (2.10)
j
j=0
For more complex options, but where the payoff only depends on the final stock
price, i.e. the payoff is a function of ST , g(ST ) say, a similar expression can be
derived; the current value of the option is then given by:
N
X
j N −j N j
exp(−rT )Ep [g(ST )] = exp(−rT ) g(S0 u d ) p (1 − p)N −j . (2.11)
j
j=0
where Ep denotes the expectation in the risk-neutral world, i.e. with a probability
p of an one-step up-move of size u given by Equation 2.9. Then, probability of an
one-step down-move of size d equal 1 − p. Therefore, we have a probability

N j
p (1 − p)N −j , j = 0, 1, . . . , N. (2.12)
j
of ending with a time T in a final stock price of S0 uj dN −j , i.e. j one-step up-

moves and N − j one-step down-moves. The distribution given in (2.12) is called
the Binomial distribution.
2.2 Matching Trees with a Given Volatility

In practice, when constructing a binomial tree to represent the movements in a
stock price, we choose the parameters u and d to match the standard deviation
(in finance this is called the volatility) of the stock price.
This volatility is typically expressed as a yearly or annualized volatility, i.e. it
is the standard deviation of the return of the stock over a period of one year.
Example 8. A stock with an (annual) volatility of σ = 16% means that the
variance of the one year return R1 = (S1 − S0 )/S0 equals
V ar[R1 ] = σ 2 = 0.162 = 0.0256,

where S0 is the current level of the stock and S1 denotes the level of the stock after
one year.
Note, that if we would assume (as is approximately the case in the Black-
Scholes model and in a binomial tree model with many step (due to the CLT))
that (S1 − S0 )/S0 follows a Normal distribution with mean µ and variance σ 2 , we
have
P (µ − σ < R1 < µ + σ) = 0.6827

P (µ − 2σ < R1 < µ + 2σ) = 0.9545
P (µ − 3σ < R1 < µ + 3σ) = 0.9973
In other words, if we have a σ = 16%, roughly speaking, on average once every 6

years (6.31 = 1/((1−0.6832)/2)), the stock ends the year with down more than σ =
16%; once every 44 years (43.95 = 1/((1 − 0.9545)/2)) the stock will end the year
with down more than 2σ = 32% and almost never (every 740 ≈ 1/((1 − 0.9973)/2)
years) the stock will end the year with down more than 3σ = 48%. Note that in
reality however, this is not the case. Our calculations depend heavily on the normal
assumption which we will criticize later on.
To see how one can match the choice of u and d with a given volatility, suppose
that the expected return on a stock in the real world is µ: The expected stock
price at the end of the first time step is S0 (1 + µ∆t). The volatility of a stock
price, σ, is defined so that σ 2 ∆t is the variance of the return in a short period of
time of length ∆t.
Note that ∆t is here typically assumed small and expressed in year terms.
For example we can have ∆t = 1/52, and then it is representing one week. If we
assume independence over each period (in the example a week), we have that due
to linearity of the variance for independent variables, that the variance over one
year is the sum of the variances over each period. If each week is the same, then
52 weeks with each a variance of σ 2 ∆t add up to a yearly variance of σ 2 .
Let us denote the probability of an up movement in the real world by q. In
order to match the expected return on the stock, we must therefore, have
qS0 u + (1 − q)S0 d = S0 (1 + µ∆t),
or
(1 + µ∆t) − d
q= . (2.13)
u−d
2.2. MATCHING TREES WITH A GIVEN VOLATILITY 55
The variance of the stock price return is
qu2 + (1 − q)d2 − [qu + (1 − q)d]2 .
In order to match the real world stock price volatility we must therefore have
qu2 + (1 − q)d2 − [qu + (1 − q)d]2 = σ 2 ∆t
or equivalently
q(1 − q)(u − d)2 = σ 2 ∆t. (2.14)
Substituting from Equation (2.13)into Equation (2.14) we get
((1 + µ∆t) − d)(u − (1 + µ∆t)) = σ 2 ∆t.
When terms in (∆t)2 and higher powers of ∆t are ignored (remember ∆t is

supposed to be small), one solution to this equation is
√
u = (1 + σ ∆t) (2.15)
√
d = (1 − σ ∆t) (2.16)
Indeed, we have then that
((1 + µ∆t) − d)(u − (1 + µ∆t)) = σ 2 ∆t − µ2 (∆t)2 ≈ σ 2 ∆t.
Another setting is
√
u = exp(σ ∆t) (2.17)
√
d = exp(−σ ∆t) (2.18)
which is, because ∆t is supposed to be small, approximately the same as (2.15)

and (2.16). These are the values proposed by Cox, Ross and Rubinstein. Note
that in both cases the values of u and d are independent of µ, which implies that
if we move from the real world to the risk-neutral world the volatility on the
stock remains the same (at least in the limit as ∆t tends to zero). This is an
illustration of an important general result known as Girsanov’s theorem. When
we move from a world with one set of risk preferences to a world with another
set of risk preferences, the expected growth rates change, but their volatilities
remain the same. Moving from one set of risk preferences to another is sometimes
referred to as changing the measure.
2.3 The Trinomial Tree

2.3.1 One Step Trinomial Tree
In a Trinomial tree, there is an additional middle-state and the stock can now
jump after a time-step of ∆t > 0 to three possible values, namely uS0 , mS0 and
dS0 , representing respectively the up-state, middle-state and down-state.
A common choice for the factors u, m and d in terms of a given (yearly)
volatility estimate σ is
√
u = exp((r − σ 2 /2)∆t + σ 3∆t)
m = exp((r − σ 2 /2)∆t) (2.19)
2
√
d = exp((r − σ /2)∆t − σ 3∆t)
Consider now a derivative paying out fu in the up-state, fm in the middle-state

and fd in the down-state as in Figure 2.7.
A popular choice of corresponding probabilities are:
pu = 1/6, pm = 2/3 and pd = 1/6, (2.20)
where pu , pm and pd are respectively the probabilities to move to the up-, middle-
or down-state. One can show that these probabilities are providing us an almost
(but not exact) risk-neutral setting, i.e.
E[S∆t ] = pu uS0 + pm mS0 + pd dS0 ≈ exp(r∆t)S0 .
Therefore, one often refers to these probabilities as the risk-neutral ones and the
current price f of this derivative can be obtained, or better approximated, as the
discounted expected payoff under the ”risk-neutral” measure.
f ≈ exp(−r∆t) (pu fu + pm fm + pd fd ) .
2.3.2 Two-Step Trinomial Trees

One-step trees can be again combined into multi-step trees with the objective to
calculate the option price at the initial node of the tree.
As an example, let us set-up a two-step Trinomial tree. Now, at each time-step
∆t one can move from each state to three possible states. For the sake of easiness,
we assume these moves are always by the factors u, m or d as in Equation (2.19).
2.4. AMERICAN OPTION PRICING 57
This leads to a (self-combining) two-steps Trinomial tree as in Figure 2.8. We

further assume that in each step pu , pm and pd are as in (2.20) and respectively
are the probabilities to move to the corresponding up-, middle- or down-state.
Now, one can calculate (or approximate) the price, as illustrated in Figure 2.9.
We first calculate the prices in the intermediate states. The prices in the three
possible intermediate states are given by
fu ≈ exp(−r∆t) (pu fuu + pm fum + pd fmm )

fm ≈ exp(−r∆t) (pu fum + pm fmm + pd fmd )
fd ≈ exp(−r∆t) (pu fmm + pm fmd + pd fdd ) .
After these are calculated we can move one-step backward to the initial state and
calculate the initial price as
f ≈ exp(−r∆t) (pu fu + pm fm + pd fm ) .
2.4 American Option Pricing

If the option is American, the procedure only changes slightly. It is necessary
to check at each node to see whether early exercise is preferable to holding the
option for a further time period ∆t. Eventually, again by working back through
all the nodes the value of the option at time zero is obtained.
Example 9. Consider a five-month American put option on a non-dividend-

paying stock when the current stock price is 50 euro, the strike price is also 50
euro, the riskfree interest rate is 10 percent per annum, and the volatility is 40
percent per annum. With our usual notation, this means that
S0 = 50, K = 50, r = 0.10, σ = 0.40, T = 152/365 = 0.416.
Suppose that we divide the life of the option into five intervals of length one month
(= 0.0833 year) for the purposes of constructing a binomial tree.
Then
∆t = 0.0833
√
u = exp(σ ∆t) = 1.1224
√
d = exp(−σ ∆t) = 0.8909
p = (exp(r∆t) − d)/(u − d) = 0.5073
Figure 2.10 shows the related binomial tree. At each node there are two num-
bers. The top one shows the stock price at the node; the lower one shows the value
of the option at the node. The probability of an up movement is always 0.5073;
the probability of a down movement is always 0.4927. The stock price at the jth
node (j = 0, 1, ..., i) at time i∆t, i = 0, 1, 2, 3, 4, 5 is calculated as S0 uj di−j . The
option prices at the final nodes are calculated as (K − ST )+ = max{K − ST , 0}.
The option prices at the penultimate nodes are calculated from the option prices
at the final nodes. First, we assume no exercise of the option at the nodes. This
means that the option price is calculated as the present value of the expected option
price one step later. For example at node C, the option price is calculated as
(0.5073 × 0 + 0.4927 × 5.45) exp(−0.10 × 0.0833) = 2.66
whereas at node A it is calculated as
(0.5073 × 5.45 + 0.4927 × 14.64) exp(−0.10 × 0.0833) = 9.90.
We then check to see if early exercise is preferable to waiting. At node C, early

exercise would give a value for the option of zero because both the stock price and
the strike price are 50 Euro. Clearly it is best to wait. The correct value for the
option at node C is, therefore, 2.66 Euro. At node A, it is a different story. If
the option is exercised, it is worth 50 − 39.69 = 10.31 Euro. This is more than
9.90. If node A is reached, the option should therefore, be exercised and the correct
value for the option at node A is 10.31 Euro. Option prices at earlier nodes are
calculated in a similar way. Note that it is not always best to exercise an option
early when it is in the money. Consider node B. If the option is exercised, it is
worth 50 − 39.69 = 10.31 Euro. However, if it is held, it is worth
(0.5073 × 6.38 + 0.4927 × 14.64) exp(−0.10 × 0.0833) = 10.36.
The option should, therefore, not be exercised at this node, and the correct option
value at the node is 10.36 Euro. Working back through the tree, we find the value
of the option at the initial node to be 4.49 Euro. This is our numerical estimate
for the option’s current value. In practice, a smaller value of ∆t, and many more
nodes, would be used. It can be shown that with 30, 50, and 100 time steps we get
values for the option of 4.263, 4.272, and 4.278.
In general suppose that the life of an American put option on a non-dividend

paying stock is divided into N subintervals of length ∆t. We will refer to the jth
2.4. AMERICAN OPTION PRICING 59
node at time i∆t as the (i, j) node. Define fi,j as the value of the option at the
(i, j)node. The stock price at the (i, j) node is S0 uj di−j . Because the value of an
American put at its expiration date is (K − ST )+ = max{K − ST , 0}, we know
that
fN,j = max{K − S0 uj dN −j , 0}, j = 0, 1, ..., N.
There is a probability, p, of moving from the (i, j) node at time i∆t to the (i +
1, j + 1) node at time (i + 1)∆t, and a probability 1 − p of moving from the (i, j)
node at time i∆t to the (i + 1, j) node at time (i + 1)∆t. Assuming no early
exercise, risk-neutral valuation gives
f˜i,j = exp(−r∆t)(pfi+1,j+1 + (1 − p)fi+1,j )
for 0 ≤ i ≤ N − 1 and 0 ≤ j ≤ i. When early exercise is taken into account, this

value for f˜i,j must be compared with the option’s intrinsic value, and we obtain
fi,j = max{K − S0 uj di−j , exp(−r∆t)(pfi+1,j+1 + (1 − p)fi+1,j )}

= max{K − S0 uj di−j , f˜i,j }.
Note that, because the calculations start at time T and we work backward, the
value at time i∆t captures not only the effect of early exercise possibilities at time
i∆t, but also the effects of early exercise at subsequent times.
In the limit as ∆t tends to zero, an exact value for the American put is
obtained. In practice, N = 50 usually gives reasonable results.
Under non-negative interest rates, it is never optimal to exercise an

American call option
We are now going to proof that for a non-dividend paying stock the price of a
European call and an American call are the same if r ≥ 0. This means that in
such a case an early exercise of an American call is never optimal. To prove this
striking result we first proof the next proposition.
Proposition 10. If r ≥ 0, the current price C of a European (and American)

call option, with strike price K and time to expiry T , on a non-dividend paying
stock with current price S satisfies :
C ≥ max{S − exp(−rT )K, 0}.

Portfolio Current cash flow Value at expiry

ST ≤ K ST > K
Short 1 stock S −ST −ST
Buy 1 call −C 0 ST − K
Bank account − exp(−rT )K K K
Balance S − C − exp(−rT )K ≥ 0 K − ST ≥ 0 0
Table 2.1: Arbitrage table for bounds on calls
Proof. That C ≥ 0 is obvious, otherwise buying the call would give a riskless
profit now and no obligations later. To prove the remaining lower bound, we set
up an arbitrage table (see Table 2.1) to examine the cash flows of the following
portfolio:
sell 1 stock short, buy 1 call, invest in bank account exp(−rT )K.
Assuming the condition C ≥ S −exp(−rT )K is violated, i.e. C < S −exp(−rT )K

we get the arbitrage as in Table 2.1 : in all possible states of the world at expiry
we have a non-negative return for a portfolio, which has a positive current cash
flow. This is clearly an arbitrage opportunity and hence our assumption was
wrong.
Suppose now that the American call is exercised at some time t strictly less
than expiry T , i.e. t < T . The financial agent thereby realises a cash-flow St − K.
From the above proposition we know that the value of the call must be greater
or equal to St − exp(−r(T − t))K, which is greater than St − K, if r ≥ 0. Hence
selling the call would have realised a higher cash-flow and the early exercise of the
call was suboptimal. In conclusion the price of an Amercian call equals the price
of an European call:
AC = EC.
Proof yourself that if r ≤ 0, it is never optimal to exercise an American put
option on a non-dividend paying stock : EP = AP .
2.5 Limits of Tree Models

By creating a tree with more and more time steps, that is by taking smaller and
smaller time-steps, we can get finer and finer graduations at the final stage and
2.5. LIMITS OF TREE MODELS 61
thus hopefully a more accurate price. However, we have to be a little careful

about how we do this in order to get the prices to converge to a meaningful value.
Which limiting price we obtain will depend on how we make the tree finer - this
essentially comes down to assumptions we make about the random process the
asset follows. Let us try to price an option with payoff function f (ST ) and we
will refine the Cox-Ross-Rubenstein model with choices
√ √
u = exp(σ ∆t) and d = exp(−σ ∆t).
For a fixed maturity. T and taking N time steps, i.e. ∆t = T /N , we have that
the risk-neutral probability of moving upwards equals:
p
exp(rT /N ) − exp(−σ T /N )
pN = p p .
exp(σ T /N ) − exp(−σ T /N )
Let us now investigate the risk-neutral limiting distribution of ST :
 
YN p p XN
ST = S0 exp(Zj σ T /N ) = S0 exp σ T /N Zj 
j=1 j=1
where Zj are independent random variables taking the values −1 and 1, with
probabilities 1 − pN and pN respectively, for j = 1, . . . , N . In other words:
p N
X
log ST = log S0 + σ T /N Zj
j=1
Now we can apply the Central Limiting Theorem (CLT).

Theorem 11 (CLT). Assume X1 , X2 , . . . is a series of independent random vari-
ables, all with the same distribution as X of which the second moment is finite.
Then PN
j=1 Xj − N E[X]
p →D N ,
N V ar[X]
with N a standard Normal distributed variable (with mean zero and variance equal
to one).
We note that
E[Zj ] = 2pN − 1;
V ar[Zj ] = 4pN (1 − pN ).
Hence, a simple calculation, using

p
N E[Zj ] T /N σ → (r − σ 2 /2)T ;
q p √
V ar[Zj ]N T /N σ → σ T .
leads to √
log ST →D log S0 + σ T N + (r − σ 2 /2)T
when N → +∞. The distribution of the logarithm of the stock price thus follows
a Normal distribution with mean (r −(1/2)σ 2 )T and variance σ 2 T ; the stock price
itself is thus lognormally distributed.
The price of the derivative in the limit will be given by
√
lim exp(−rT )EpN [g(ST )] = exp(−rT )E[g(S0 exp((r − (1/2)σ 2 )T + σ T N ))].
N →+∞
In case of the European call option with strike K and time to maturity T , one
can with a little effort show that its initial price is given by:
EC(K, T ) = S0 N (d1 ) − K exp(−rT )N (d2 ),
where
log(S0 /K) + (r + σ 2 /2)T
d1 = √
σ T
log(S0 /K) + (r − σ 2 /2)T √
d2 = √ = d1 − σ T
σ T
and N (x) is the cumulative probability distribution function for a variable that
is standard Normal distributed. This is the famous Black-Scholes formula. This
lognormal model (the Black-Scholes model), will be studied in Chapter 5.
stock derivative
1
22
f=?
20
0
18
t=0 t=T t=0 t=T
Figure 2.1: Binomial tree example

u S0 fu
S0 f
d S0 fd
Figure 2.2: Binomial tree

Figure 2.3: Two sep Binomial tree example

Figure 2.4: Two step Binomial tree

Figure 2.5: General Binomial tree

Figure 2.6: General Binomial tree example

u S0 fu
f fm
S0 m S0
d S0 fd
Figure 2.7: Trinomial tree

u2 S0
u S0 u m S0
S0 m S0 m2 S0
d S0 d m S0
d2 S0
Figure 2.8: Two-step Trinomial tree (stock values)

fuu
fu fum
f fm fmm
fd fmd
fdd
Figure 2.9: Two-step trinomial tree (derivative values)

Figure 2.10: Binomial Tree for pricing American put

Chapter 3
Mathematical Finance in
Discrete Time
Any variable whose value changes over time in an uncertain way is said to follow
a stochastic process. Stochastic processes can be classified as discrete-time or
continuous-time. A discrete-time stochastic process is one where the value of the
variable can change only at certain fixed points in time, whereas a continuous-time
stochastic process is one where changes can take place at any time. Stochastic
processes can also be classified as continuous-variables or discrete-variables. In a
continuous-variable process, the underlying variable can take any value within a
certain range, whereas in a discrete-variable process, only certain discrete values
are possible. Binomial tree models belong to the discrete-time, discrete-variable
stochastic processes.
In this chapter we study so-called finite markets, i.e. discrete-time models of
financial markets in which all relevant quantities take a finite number of values.
We specify a time horizon T , which is the terminal date for all economic activities
considered. For a simple option pricing model the time horizon typically corre-
sponds to the expiry date of the option. We thus work with a finite probability
space (Ω, P ), with a finite number |Ω| of possible outcomes ω, each with a positive
probability: P ({ω}) > 0.
3.1 Information and Trading Strategies

Access to full, accurate, up-to-date information is clearly essential to anyone ac-
tively engaged in financial activity or trading. Indeed, information is arguably
73
74 CHAPTER 3. MATHEMATICAL FINANCE IN DISCRETE TIME
the most important determinant of success in financial life. We shall confine our-
selves to the situation where agents take decisions on the basis of information in
the public domain, available to all. We shall further assume that information once
known remains known and can be accessed in real time.
Our financial market contains two financial assets. A risk-free asset (the bond)
with a deterministic price process Bi , and a risky assets with a stochastic price
process Si . We assume B0 = 1 (we reckon in units of the initial value of the bond)
and Bi > 0; we say it is a numeraire. 1/Bi is called the discounting factor for
time i.
As time passes, new information becomes available to all agents. There exists
a mathematical object to model this information flow, unfolding with time: fil-
trations. The concept filtration is not that easy to understand. The full theory
will lead us too far.
In order to clear this out a bit, we explain the idea of filtration in a very
idealized situation. We will consider a stochastic process X which starts at some
value, zero say. It will remain there until time t = 1, at which it can jump with
positive probability to the value a or to a different value b. The process will stay
at that value until time t = 2 at which it will jump again with positive probability
to two different values: c and d say if it was at time t = 1 at a and f and g say if
the process was at time t = 1 at state b. From then on the process will stay in the
same value. The set of outcomes of the probability space consists of all possible
paths the process can follow, i.e. all possible outcomes of the experiment. We
will denote the path 0 → a → c by ω1 , similarly the paths 0 → a → d, 0 → b → f
and 0 → b → g are denoted by ω2 , ω3 and ω4 respectively. So we have
Ω = {ω1 , ω2 , ω3 , ω4 }.
In this situation we will take the following flow of information, i.e. filtrations:
Ft = {∅, Ω}, 0 ≤ t < 1;
Ft = {∅, {ω1 , ω2 }, {ω3 , ω4 }, Ω}, 1 ≤ t < 2;
Ft = D(Ω) = F, 2 ≤ t.
We set here D(Ω), the set of all subsets of Ω. To each of the filtrations given
above, we associate resp. the following partitions (i.e. the finest possible one):
P0 = {Ω}, 0 ≤ t < 1;
P1 = {{ω1 , ω2 }, {ω3 , ω4 }} 1 ≤ t < 2;
P2 = {{ω1 }, {ω2 }, {ω3 }, {ω4 }} 2 ≤ t.
3.1. INFORMATION AND TRADING STRATEGIES 75
At time t = 0 we only know that some event ω ∈ Ω will happen, at time t = 2 we

will know which event ω ∗ ∈ Ω has happened. So at times 0 ≤ t <1 we only know
that ω ∗ ∈ Ω. At time point after t = 1 and strictly before t = 2, i.e. 1 ≤ t < 2,
we know to which state the process has jumped at time t = 1: a or b. So at that
time we will know to which set of P1 , ω ∗ will belong: it will belong to {ω1 , ω2 }
if we jumped at time t = 1 to a and to {ω3 , ω4 } if we jumped to b. Finally, at
time t = 2, we will know to which set of P2 , ω ∗ will belong, in other words we
will know then the complete path of the process. During the flow of time we thus
learn about the partitions. Having the information Ft revealed is equivalent to
knowing in which set of the partition of that time, the event ω ∗ is. The partitions
become finer in each step and thus information on ω ∗ becomes more detailed.
We thus keep in mind that a filtration F = (Fi , i = 0, 1, . . . , T ) exists of a
sequence of mathematical objects (σ-algebras), F0 ⊂ F1 ⊂ · · · ⊂ FT , describing
the information available. At time i we have access to information in Fi . It is
clear that the price of the stock Si at time i (and i − 1, i − 2, ..., 0) is contained
in the information Fi . If a random variable X is known with respect to the
information G we say it is G-measurable. So we have that Si is Fi -measurable.
A stochastic process X = {Xi , i = 0, 1, . . . , T } is called adapted to the filtration
G = (Gi , i = 0, 1, . . . , T ) (or just G-adapted) if at every time point i = 0, 1, . . . ,T
the random variable Xi is Gi -measurable. So we have that S = {Si , i = 0, 1, . . . , T }
is F-adapted.
A trading strategy φ = {φi = (βi , ζi ), i = 1, . . . , T } is a real vector stochastic
process such that each φi is Fi−1 -adapted. Here βi , ζi denotes the numbers of
bonds and stocks resp. held at time i and to be determined on the basis of
information available strictly before time i: Fi−1 ; i.e. the investor selects his time
i portfolio after observing the prices Si−1 . The components βi , ζi may assume
negative values as well as positive values, reflecting the fact that we allow short
sales and assume that the assets are perfectly divisible.
The value of the portfolio φi at time i, Viφ = Vi , is called the wealth or value
process of the trading strategy:
Viφ = Vi = βi Bi + ζi Si , i = 1, 2, . . . , T.
We will denote by V0 the initial investment or endowment of the investor.
Now βi Bi−1 + ζi Si−1 reflects the market value of the portfolio just after it has
been established at time i − 1, whereas βi Bi + ζi Si is the value just after time i
prices are observed, but before changes are made in the portfolio. Hence
βi (Bi − Bi−1 ) + ζi (Si − Si−1 )
is the change in the market value due to changes in security prices which occur
between time i − 1 and i. We call Gφ = G = {Gφi , i = 1, . . . , T }, where
i
Gφi =
X
βj (Bj − Bj−1 ) + ζj (Sj − Sj−1 )
j=1
the gains process.

After the new prices (Bi , Si ) are quoted at time i, the investor adjusts his
portfolio from φi = (βi , ζi ) to φi+1 = (βi+1 , ζi+1 ). We do not allow him bringing
in or consuming any wealth, so we must have
V0 = β1 B0 + ζ1 S0 , Vi = βi+1 Bi + ζi+1 Si , i = 1, . . . , T.
We say our trading strategy is self-financing and denote this by φ ∈ Φ.

To avoid (unbounded) negative wealth and unbounded short sales we also
introduce the concept of admissible strategies. A self-financing trading strategy
φ ∈ Φ is called admissible if Viφ ≥ C for each i = 0, 1, . . . , T and C is a fixed
(negative) constant. We write Φa for the class of admissible trading strategies.
Clearly Φa ⊂ Φ.
3.2 No-Arbitrage Condition

The central principle in the Binomial tree models was the absence of arbitrage
opportunities, i.e. the absence of risk-free plans for making profits without any
investment. As mentioned there this principle is central for any market model,
and we now define the mathematical counterpart of this economic principle in
our setting. We call a self-financing trading strategy an arbitrage opportunity if
P (V0φ = 0) = 1 and the terminal wealth of φ satisfies
P (VTφ ≥ 0) = 1 and P (VTφ > 0) > 0.
So an arbitrage opportunity is a self-financing strategy with zero initial value

which produces a non-negative final value with probability one and has a positive
probability of a positive value. We say that our market is arbitrage-free if there
are no self-financing trading strategies which are arbitrage opportunities.
Next, we will link the economic principle of an arbitrage free market to a
mathematical one: the existence of an equivalent martingale.
3.2. NO-ARBITRAGE CONDITION 77
We say a probability measure P ∗ on Ω is equivalent to P , if it has the same

null sets. Here it means that for each ω ∈ Ω, we have P ∗ ({ω}) > 0 - what is
possible under P (we assumed P ({ω}) > 0 for all ω) is possible under P ∗ .
We say a probability measure Q on Ω is a martingale measur e for a process
X = {Xi , i = 0, 1, . . . , T }, if Xi is a Q-martingale with respect to the filtration F,
i.e.
• X is F-adapted
• EQ [Xi |Fi−1 ] = Xi−1 , i = 1, . . . , T
Note that in a more general context a third condition is required:
EQ [|Xi |] < ∞ i = 1, . . . , T.
Because we work in a finite probability space this condition is in our setting

automatically satisfied.
One can show that the second condition is equivalent to
EQ [Xi |Fj ] = Xj , 0 ≤ j ≤ i ≤ T.
We denote by P(X) the class of equivalent martingale measures for X. Further,

we will use the notation X̃ for the discounted version of the process X :
X̃i = Xi /Bi .
For example, we will denote by S̃ the discounted stock price process :
S̃i = Si /Bi .
As a kind of example of the above concepts, we show the following proposition

which we will later on need to prove one direction of the No-Arbitrage Theorem.
Proposition 12. Let P ∗ ∈ P(S̃) and φ ∈ Φ, then Ṽ φ is a P ∗ -martingale.
Proof. First note that
Ṽi = Ṽiφ = Bi−1 (βi Bi + ζi Si )
and since Bi , Si , βi , ζi ∈ Fi , we also have that Ṽiφ ∈ Fi . Hence Ṽ φ is F-adapted.

Next, we will prove EP ∗ [Ṽi |Fi−1 ] = Ṽi−1 , i = 1, . . . ., T . We have
EP ∗ [Ṽi |Fi−1 ] = EP ∗ [Bi−1 (βi Bi + ζi Si )|Fi−1 ]

= βi + ζi EP ∗ [Bi−1 Si |Fi−1 ]
−1
= βi + ζi Bi−1 Si−1
−1
= Bi−1 (βi Bi−1 + ζi Si−1 )
−1
= Bi−1 (βi−1 Bi−1 + ζi−1 Si−1 )
= Ṽi−1
where the third line is because S̃ is a P ∗ -martingale and the fifth line is because
of the self-financing property of φ.
The next result is a key-result in discrete mathematical finance.

Theorem 13 (No-Arbitrage Theorem). The market is arbitrage-free if and only
if there exists an equivalent martingale measure for the discounted price process
of the stock, i.e. P(S̃) 6= ∅.
Proof. We only prove that P(S̃) 6= ∅ implies that the market is arbitrage free; the
other direction can be proven using the Hahn-Banach theorem.
Assume P(S̃) 6= ∅ and let P ∗ ∈ P(S̃). For any self-financing strategy φ ∈ Φ,
we have from the above proposition that Ṽ φ is a P ∗ -martingale. So
EP ∗ [ṼTφ ] = V0φ .
Suppose φ is an arbitrage opportunity. Then P (V0φ = 0) = 1, so P ∗ (V0φ = 0) = 1

and thus EP ∗ [ṼTφ ] = BT−1 EP ∗ [VTφ ] = BT−1 V0φ = 0.
We must have
P ∗ (VTφ ≥ 0) = 1 and P ∗ (VTφ > 0) > 0.
Together with the fact that for each ω ∈ Ω, we have P ∗ ({ω}) > 0, this leads to
a contradiction. Indeed, we can not have a non-negative random variable with a
zero mean and positive mass on the positive real numbers.
3.3 Risk-Neutral Pricing

We now turn to the main underlying question of this text, namely the pricing
of contingent claims (i.e. financial derivatives). First we have to model these
3.3. RISK-NEUTRAL PRICING 79
financial instruments in our current framework. This is done in the following

fashion.
Definition 14. A contingent claim X with maturity date T is an arbitrary non-
negative FT -measurable random variable. We denote the class of all contingent
claims by X .
We say that the claim is attainable if there exists an (admissible) self-financing
strategy φ ∈ Φ such that
VTφ = X.
The self-financing strategy φ ∈ Φ is said to be a replicating strategy. It generates
the same time T cash-flow as X does.
We now return to the main question of the section: given a contingent claim
X, i.e. a cash-flow at time T , how can we determine its value (price) at time i < T
? For attainable contingent claims this value should be given by the value of any
replicating strategy (perfect hedge) at time i, i.e. there should be a unique value
process (say ViX ) representing the time i value of the claim X. The following
proposition ensures that the value process of replicating strategies coincide, thus
proving uniqueness of the value process.
Proposition 15. Suppose the market is arbitrage-free. Then any attainable con-
tingent claim X is uniquely replicated: for all φ, ψ ∈ Φ such that
VTφ = VTψ = X.
we have that for all 0 ≤ i ≤ T

Viφ = Viψ
This uniqueness property can be proven by showing that an arbitrage oppor-
tunity exists when both value processes are not always equal. The self-financing
trading strategy leading to an arbitrage is essential the strategy that goes long
the strategy (φ or ψ) with the higher value and shorts the other strategy with the
lower value whenever the value processes differ.
This uniqueness property allows us now to define the important concept of an
arbitrage price process.
Definition 16. Suppose the market is arbitrage free. Let X be any attainable
contingent claim with time T to maturity. Then the arbitrage price process πiX ,
0 ≤ i ≤ T or simply the arbitrage price of X is given by the value process of any
replicating strategy φ for X.
The construction of hedging strategies that replicate the outcome of a contin-

gent claim is an important problem in both practical and theoretical applications.
Hedging is central to the theory of option pricing. The classical no-arbitrage valu-
ation models, such as the Binomial tree models and the Black- Scholes Model (see
the next Chapters), depend on the idea that an option can be perfectly hedged
using the underlying risky asset and a risk-free asset.
Analysing the no-arbitrage-pricing approach we observe that the derivation
of the price of a contingent claim doesn’t require any specific preferences of the
agents other than that they prefer more to less, which rules out arbitrage. So, the
pricing formula for any attainable contingent claim must be independent of all
preferences that do not admit arbitrage. In particular, an economy of risk-neutral
investors must price a contingent claim in the same manner. This fundamental
insight simplifies the pricing formula enormously. In its general form the price of
an attainable contingent claim is just the expected value of the discounted payoff
with respect to an equivalent martingale measure.
Proposition 17. The arbitrage price process of any attainable contingent claim
X is given by the risk-neutral valuation formula
Bi
πiX = EP ∗ [X|Fi ], 0≤i≤T
BT
where EP ∗ is the expectation operator with respect to an equivalent martingale
measure P ∗ .
Proof. Since we assume that the market is arbitrage-free there exists (at least)
an equivalent martingale measure P ∗ for the discounted price process S̃i . Fur-
thermore because the claim is attainable there exists (at least) one self-financing
replicating strategy φ. First note that by Proposition 12, we have that the dis-
counted value process Ṽ φ = {Ṽiφ = Bi−1 Viφ , i = 0, 1, . . . , T } is a P ∗ -martingale.
So we have for each i = 0, 1, . . . , T :
πiX = Viφ
= Bi Ṽiφ
= Bi EP ∗ [ṼTφ |Fi ]
= Bi EP ∗ [BT−1 VTφ |Fi ]
= (Bi /BT )EP ∗ [ṼTφ |Fi ]
= (Bi /BT )EP ∗ [X̃|Fi ]
3.4. COMPLETE MARKETS 81
3.4 Complete Markets

The last section made clear that attainable contingent claims can be priced using
an equivalent martingale measure. In this section we will discuss the question of
the circumstances under which all contingent claims are attainable. This would
be a very desirable property of the market, because we would then have solved the
pricing question (at least for contingent claims) completely under the assumption
that the market is arbitrage free. Since contingent claims are merely non-negative
FT -measurable random variables in our setting, it should be no surprise that we
can give a criterion in terms of probability measures. We start with:
Definition 18. A market is complete if every contingent claim is attainable,

i.e. for every non-negative FT -measurable random variable X ∈ X there exists a
replicating strategy φ ∈ Φ such that VTφ = X.
In the case of an arbitrage-free discrete market, one can insist on replicating

contingent claims by an admissible strategy φ ∈ Φa .
Based on the no-arbitrage assumption one can prove:
Theorem 19 (Completeness Theorem). An arbitrage free market is complete if

and only if there exists a unique probability measure P ∗ equivalent to P under
which the discounted price process of the stock is a martingale, i.e. P(S̃) = {P ∗ }.
3.5 The Fundamental Theorem of Asset Pricing

3.5.1 Summary
We summarise what we have achieved so far. We call a measure P ∗ under which
the discounted price S̃ is a P ∗ -martingale a martingale measure. Such a P ∗
equivalent to the actual probability measure P is called an equivalent martingale
measure (EMM). Then:
• No-Arbitrage Theorem: A market is arbitrage free if and only if at least one

equivalent martingale measure exists.
• Completeness Theorem: An arbitrage-free market is complete (all contin-

gent claims can be replicated) if and only if there exists a unique equivalent
martingale measure.
So
Theorem 20 (Fundamental Theorem of Asset Pricing). In an arbitrage- free

complete market, there exists a unique equivalent martingale measure P ∗ .
The above theorem establishes the equivalence of an economic modelling con-

dition such as no-arbitrage and completeness to the existence of the mathematical
modelling condition, viz. the existence and uniqueness of equivalent martingale
measures.
Assume now that the market is arbitrage-free and complete and let X ∈ X
be any contingent claim, φ a replicating strategy (which exists by completeness),
then:
VTφ = X
Furthermore, we have seen that
Bi
πiX = Viφ = EP ∗ [X|Fi ], 0≤i≤T
BT
and call πiX the no-arbitrage price of the contingent claim X at time i. For, if an
investor sells the claim X at time i for πiX , he can follow strategy φ to replicate X
at time T and clear the claim; an investor selling this value is perfectly hedged.
To sell the claim for any other amount would provide an arbitrage opportunity.
We note that, to calculate prices as above, we need to know only:
• Ω the set of all possible states,
• the filtration F,
• P ∗.
We do not need to know the underlying probability measure P (only its null
sets, to know what ’equivalent to P ’ means and actually in our finite model there
are no non-empty null-sets, so we do not need to know even this). Now pricing of
contingent claims is our central task, and for pricing purposes P ∗ is vital and P
itself irrelevant. We thus may - and shall - focus attention on P ∗ , which is called
the risk-neutral probability measure.
To summarize, we have:
Theorem 21 (Risk-Neutral Pricing Formula). In an arbitrage-free complete mar-

ket, arbitrage prices of contingent claims are their discounted expected values un-
der the risk neutral (unique equivalent martingale measure) P ∗ .
3.5. THE FUNDAMENTAL THEOREM OF ASSET PRICING 83
3.5.2 Examples
The One-step Binomial Model
We return to model given in Section 2.1.1. There exists only two possible out-
comes. There is an up-state u in which the stock price after one time step equals
S1 = uS0 and a down-state d if the stock price changes to S1 = dS0 :
Ω = {u, d}.
In both cases the risk-free asset goes from B0 = 1 to a price B1 = b say.

A probability measure on Ω is completely determined by the probability to
end in the up-state: 0 < P ({u}) < 1; we then have P ({d}) = 1 − P ({u}). In order
that the discounted price process is a martingale with respect to a (P -equivalent)
probability measure P ∗ , with say 0 < P ∗ ({u}) = p∗ < 1, on Ω, it has to satisfy
only one equation:
(1/b)EP ∗ [S1 |F0 ] = S0 .
or equivalently
(1/b)(uS0 p∗ + dS0 (1 − p∗ )) = S0 . (3.1)
Rewriting Equation 3.1 gives
b−d
p∗ = .
u−d
In order that this gives rise to a probability measure, we should have 0 < p∗ < 1,
which is equivalently with
u > b > d ≥ 0. (3.2)
In conclusion a martingale measure P ∗ ∈ P for the discounted stock price
exists if and only if (3.2) is satisfied. If (3.2) holds true, then there is a unique
such measure in P characterised by (3.1). So in conclusion, if (3.2) is satisfied the
one-step binomial model is arbitrage free and complete.
Note that (3.2) means that by investing in a stock one can have a higher
return than the risk-free return (u >b), but also can have a greater loss (b > d).
Note also that one can easily show that the multi-period model of Section 2.1.5
is complete if and only if the underlying single-period model is complete.
If we now have a contingent claim with payoff fu in the up-state and fd in the
down state, the initial price of this claim is equal to
f = (1/b)(p∗ fu + (1 − p∗ )fd ).
In order to hedge or replicated this claim one has to solve the equations
βb + ζuS0 = fu
βb + ζdS0 = fd
Note that this system of equations has a unique solution if and only if S0 6= 0,
b 6= 0, and u 6= d (all which are ruled out).
The One-step Trinomial Model

Suppose now the setting of a one-step trinomial model as in Section 2.3. In one
time step there exists three possible outcomes. There is an up-state u if the
stock price changes to S1 = uS0 , a middle state m if the stock price after one
step is S1 = mS0 , and a down-state d if the stock price changes to S1 = dS0 ,
0 ≤ d < m < u:
Ω = {u, m, d}.
Again, in all cases the risk-free asset changes in a deterministic way from B0 = 1
to a price B1 = b say. A probability measure on Ω is now completely determined
by two numbers 0 < P ({u}) < 1 and 0 < P ({m}) < 1; we then have P ({d}) =
1 − P ({u}) − P ({m}). In order that the discounted price process is a martingale
with respect to a probability measure P ∗ , with say 0 < p∗ ({u}) = p∗ < 1 and
0 < p∗ ({m}) = q ∗ <1, on Ω, it has to satisfy again only one equation:
(1/b)EP ∗ [S1 |F0 ] = S0
or equivalently
(1/b)(uS0 p∗ + mS0 q ∗ + dS0 (1 − p∗ − q ∗ )) = S0 .
Unfortunately this equation has more than one solution as can be easily been
seen after a simple rewriting:
(b − d) − (m − d)q ∗
p∗ =
u−d
For every 0 < q ∗ < 1 there is a corresponding p∗ . If we then take also into
account that the values of p∗ and q ∗ must give rise to a probability distribution,
i.e. 0 < p∗ , q ∗ < 1 and p∗ + q ∗ < 1, there still are infinitely many solutions. In
conclusion there exist more then one martingale measure for the discounted stock
3.6. THE PHYSICAL AND THE RISK-NEUTRAL WORLD 85
price. So the one-step trinomial model is arbitrage free, but is not complete. If
we have a contingent claim with payoff fu in the up-state, fm in the middle state
and fd in the down state it can only be replicated if there exists a solution to the
equations
βb + ζuS0 = fu
βb + ζmS0 = fm
βb + ζdS0 = fd
This is only the case if  

uS0 b fu
det  mS0 b fm  = 0
dS0 b fd
Because we assume that S0 6= 0 and b 6= 0, this is equivalent with
 
u 1 fu
det  m 1 fm  = 0
d 1 fd
So only contingent claims which payoff function satisfies the above condition are
attainable and can be replicated and priced in an arbitrage-free way.
3.6 The Physical and the Risk-Neutral World

In financial engineering there are essentially two different worlds. The so-called,
real-world (sometimes also referred to as the historical or physical world or P -
world) and the pricing world (sometimes also referred to as the the risk-neutral
world or Q-world or P ∗ -world). We recognize up front that in markets every event
has in principle both a probability or the likelihood of its occurrence and a price,
i.e. the price of a security paying one Euro if the event occurs. If that price
is paid at event resolution, the event price we speak of is then a forward price.
These forward prices are non-negative, being claims to non-negative cash flows.
The prices for disjoint or mutually exclusive events are additive by no-arbitrage.
They sum to unity over a set of mutually exclusive and exhaustive events as the
forward price of a Euro for certain is a Euro. Hence prices of events behave
like probabilities (pricing world) and the mathematics of probability applies to
them, but they are not probabilities, they are forward prices. They can differ
substantially from the probabilities based on demand and supply (real-world). A
typical example is found in insurance where the forward premium paid for life,
fire or car insurance by a particular individual far exceeds the probability of the
insured event. Given the personal damage caused by the event induces people in
markets to pay more than probability for coverage. Competitive pressures do not
reduce prices to probability assessments as sufficiently large pools of identical risks
may not be available, leaving sellers exposed to risk that must be compensated in
the premium. In these two worlds, one looks differently to the stochastic behaviour
of the assets under investigation; the prices of events seen as probabilities (pricing
world) differ from the probabilities of the events happening in the real-world.
Most of the times, the probability measuring how things happen in the real-
world is denoted with a P ; therefore also this real-world is often named the P -
world. This probability measure is measuring how things actually happen in
reality and one refers often to it as the physical measure. Therefore, one is typ-
ically estimating distributions in this world on the basis of historically observed
real data of the underlying asset, like daily log-returns of a stock. In contrast,
the risk-neutral world is the pricing world, created by financial markets trading
event risk and modelled by financial engineers. Most of the times, the probability
measure of how things happen in the pricing world is denoted with a Q and one
refers to it as the pricing measure. One can prove that in absence of arbitrage,
under this measure, traded assets all behave in a ”risk-neutral” way, meaning that
there expected return is equal to the return of the risk-free account. For example,
for a stock with dividend yield q, we have that
EQ [St ] = exp(r − q)S0 , (3.3)
since the price of the forward stock net of intermediate dividends must equal the
cost of buying it in the spot market on borrowed money and repaying the loan.
One then has a rate of return q from the dividends and since r is the rate of
return on the risk-free account, the rate of return on a stock needs to be r − q,
otherwise there would be the spot forward arbitrage opportunity. The pricing
world or Q-world is hence also often referred to as the risk-neutral world.
The reason for the existence of the particular risk-neutral world is the trading
of risks in markets thus leading to the existence of forward prices. As indicted
in this Chapter, fundamental theory actually shows, that under the no-arbitrage
assumption (and some additional technical assumptions), the price of a derivative
is given by the discounted expected payoff of the derivative, with expectations
taken under the risk neutral (Q) measure. One hence has for a European option
3.6. THE PHYSICAL AND THE RISK-NEUTRAL WORLD 87
maturing at time T , that its current fair price is given by
price = exp(−rT )EQ [payoff].
Furthermore the price of any traded event A resolved at T is
price(A) = exp(−rT )Q(A),
with Q(A) the probability under Q of A occurring. This is particularly useful,

since calculating expected values is typically a doable operation in probability
theory and moreover, it is particularly suitable for a Monte-Carlo setting (see
later).
It is not always easy to determine what the appropriate Q is and whether
there are one or more measures under which traded assets behave on average like
the risk-free account. The existence of a Q measure is (modulo some technical
conditions) equivalent with both the model and the market being free of arbi-
trage. The uniqueness of such a Q is then (modulo some technical conditions)
equivalent with the market being complete meaning that under frictionless cir-
cumstances each derivative can be perfectly hedged dynamically with positions
in the underlying asset and the risk-free account. Nonetheless, the point of price
discovery in markets is that when traded it is markets that determine these prices.
It is their raison d’être. With well functioning markets the Q is given uniquely by
the market and determining whether there are other measures under which assets
are behaving also risk-neutrally is a purely theoretical exercise. In addition, one
could argue that actually P is more a personal view and therefore the uniqueness
of P is also an issue of discussion.
The Black-Scholes model introduced in the next Chapter and the Binomial-
tree model of the previous Chapter is an example an arbitrage-free and complete
model. However, all other more advanced models are not complete and there
can be more (often infinitely many) measures under which the underlying asset
behaves risk-neutrally. Important is however, that there is one such special Q
under which all the derivatives are priced, i.e. the price of any derivative on the
underlying asset is given by the discounted expected payoff of the derivative under
Q. It is therefore why one refers to such a measure as the pricing measure. This
pricing measure is as mentioned given/determined by the market.
In many applications the actual P is irrelevant, one tries to estimate directly
the special pricing measure Q, via a so-called calibration procedure. The infor-
mation to estimate Q comes from observable market prices of derivatives. Since,
these market quotes are discounted expectations under one particular Q of the re-
lated payoffs of the derivatives, one can try to estimate this underlying probability
measure Q from these market quotes.
Chapter 4
Exotic Options and Structured

Products
Derivatives with more complicated payoffs than the standard European or Amer-
ican calls and puts are referred to as exotics options. Most exotics options are
traded in the OTC market and have been designed to meet particular needs of
investors.
In this chapter we describe different types of exotic options and discuss their
valuation. Options of an European nature can typically be priced by Monte-Carlo
simulation (see Chapter 6).
4.1 Barrier Options

The payoff of a barrier option depends on whether the price of the underlying
asset crosses a given threshold (the barrier) before maturity. The simplest barrier
options are ’knock in’ options which come into existence when the price of the
underlying asset touches the barrier and ’knock-out’ options which come out of
existence in that case. For example, an up-and-out call has the same payoff as
a regular plain vanilla call if the price of the underlying asset remains below the
barrier over the life of the option but becomes worthless as soon as the price of
the underlying asset crosses the barrier.
Let us denote with 1(A) the indicator function, which has a value 1 if A is
true and zero otherwise.
For single barrier options, we will focus on the following types of call options;
we assume in all cases a maturity T :
89
90 CHAPTER 4. EXOTIC OPTIONS AND STRUCTURED PRODUCTS
• The down-and-out barrier call (DOBC) is worthless unless the asset price
remains during its lifetime, i.e. until T , above some low barrier H, in which
case it retains the structure of a European call with strike K. Staying above
a certain barrier means that the miniumum asset prices never goes below
the barrier. Its initial price is given by:
DOBC = exp(−rT )EQ [(ST − K)+ 1( min St > H)]
0≤t≤T
• The down-and-in barrier call (DIBC) is a standard European call with strike
K, if the asset went below some low barrier H before T . If this barrier was
never reached during the life-time of the option, the option is worthless. Its
initial price is given by:
DIBC = exp(−rT )EQ [(ST − K)+ 1( min St ≤ H)].
0≤t≤T
• The up-and-in barrier call (UIBC) is worthless unless the asset price went
above some high barrier H, in which case it retains the structure of a Eu-
ropean call with strike K. Its price is given by:
U IBC = exp(−rT )EQ [(ST − K)+ 1( max St ≥ H)].
0≤t≤T
• The up-and-out barrier call (UOBC) is worthless unless the asset price re-
mains below some high barrier H, in which case it retains the structure of
a European call with strike K. Its price is given by:
U OBC = exp(−rT )EQ [(ST − K)+ 1( max St < H)].
0≤t≤T
The put-counterparts, replacing (ST − K)+ with (K − ST )+ , can be defined

along the same lines.
We note that the value, DIBC, of the down-and-in barrier call option with
barrier H and strike K plus the value, DOBC, of the down-and-out barrier option
with same barrier H and same strike K, is equal to the value EC of the European
(vanilla) call with strike K. The same is true for the up-and-out together with
the up-and-in call:
DIBC + DOBC = EC = U IBC + U OBC. (4.1)
Similarly, for puts we have with the obvious notation:
DIBP + DOBP = EP = U IBP + U OBP. (4.2)
4.1. BARRIER OPTIONS 91
Example 22. An investor buys a DIBC on the S&P 500 beginning of February.
The option expires the 3rd week of February. So the call is struck at the money
and knocks in when the index falls 10% from its initial level. Assume that this is
offered for 0.94%. With the index at 950, this puts the strike at 950, the barrier
at 855 and the premium is 8.93 index points.
In Figure 4.1, one sees two path where the barrier is crossed. If for example
the stock price would crosses the barrier at 855, end of June, and at expiration,
the index is at 876.05, the option expires worthless, since the strike is at 950; if
however at expiration, the index would be at 1030.78 (and the barrier is crossed
in August), the option pays out 80.78 = 1030.78 - 950.00 index points.
In case the stock price would never crosses the barrier at 855 during its lifetime,
the option expires always worthless.
Figure 4.1: DIBC scenarios

Example 23. An investor buys a UIBP on the S&P 500 on the S&P 500 beginning
of February.The option expires the 3rd week of February, is struck at the money
and knocks in when the index rises 5% from its initial level.
The DIBP is offered for 2.60%. With the index at 950, this puts the strike at
950, the barrier at 997.50 and the premium is 24.70 index points.
In figure 4.2, the first path never reaches a level greater than 952.53, which is
much less than the knock in barrier at 997.50. Hence, the option expires worthless
even though the index at expiration is below the strike. The second path does knock
in, crossing above the 977.50 level in mid June. At expiration, the level of the
index is 911.40, so the option pays out 38.60 = 950.00 - 911.40 index points.
Figure 4.2: UIBP scenarios

4.2. LOOKBACKS 93
4.2 Lookbacks
Lookback options, are a type of exotic options where the payoff depends on the
optimal (maximum or minimum) underlying asset’s price occurring over the life
of the option. The option allows the holder to ”look back” over time to determine
the payoff.
There exist two kinds of lookback options: with floating strike and with fixed
strike.
The floating strike lookback call has a payoff
LC = ST − min St ,
0≤t≤T
giving one essentially the right to buy at the low over [0, T ], and the lookback put
with payoff
LP = max St − ST
0≤t≤T
giving one the right to sell at the high over [0, T ].

The term floating refers to the comparison with the vanilla call and put, now
the option’s strike price is floating and determined at maturity at either the high
or the low over the life time. For the floating strike lookback call, the strike price
is fixed at the asset’s lowest price during the option’s life, and, for the floating
strike lookback put, it is fixed at the asset’s highest price.
For lookback options with fixed strike, as for the standard European options,
the option’s strike price is fixed. The difference is that the option is not exercised
at the asset price at maturity: the payoff is the maximum difference between the
optimal underlying asset price and the strike. For the fixed strike lookback call
option, the holder chooses to exercise at the point when the underlying asset price
is at its highest level. For the fixed strike lookback put option, the holder chooses
to exercise at the underlying asset’s lowest price. The payoff functions for the
fixed strike lookback call and put, respectively, are given by:
+
LCf ix = max St − K
0≤t≤T
and +
LP f ix = K − min St .
0≤t≤T
Example 24. An example of a structured product using a lookback is shown in

Figure 4.3. The investor purchases a six-year lookback on say the FTSE 100,
with monthly observations. At maturity, the investor gets 90% of the highest
performance of the FTSE over the investment period, with full capital protection.
Figure 4.3: Lookback based structured product
4.3 Asian Options

In this section we consider Asian options. We start with the European-style
arithmetic average call option, with strike price K, maturity T and n averaging
4.4. VARIANCE SWAPS 95
days 0 ≤ t1 < · · · < tn ≤ T . Its payoff is given by

Pn +
k=1 Stk
AsianC = −K .
n
For the put version just switch the sum and the strike price :
Pn +
k=1 Stk
AsianP = K− .
n
Average price options are typically less expensive than regular options and
are arguably more appropriate than regular options for meeting some of investors
needs. Asian options are widely used in practice - for instance, for oil and foreign
currencies. The averaging complicates the mathematics, but e.g., protects the
holder against speculative attempts to manipulate the asset price near expiry.
4.4 Variance Swaps

A variance swap is an OTC financial derivative that allows one to speculate on
or hedge risks associated with the volatility, of some underlying product.
The payoff is a certain notional amount N multiplied with the difference be-
2
tween the realized variance σrealized of the price changes of the underlying product
2
and a fixed amount, which is the strike σstrike , quoted at the deal’s inception:
2 2
N (σrealized − σstrike ),
where the realized variance (of the log-returns) is given by
n
2 AX 2
σrealized = log(Sti /Sti−1 )
n
i=1
where A is an annualisation factor normally chosen to be approximately the num-

ber of sampling points in a year (commonly 252) and ti , i = 0, . . . , n are denoting
a series of observation dates, typically consecutive daily closings. Note that the
annualised realised variance does not coincide with the classic statistical definition
of variance as one is not subtracting the mean.
4.5 Structured Products

As already indicated in Example 24, exotics options are often used in the im-
plementation of structured products. Structured products (SPs) are synthetic
investment instruments specially created to meet specific needs that cannot be
met from the standardized financial instruments available in the markets.
SPs can be used for example as an alternative to a direct investment, or as
part of the asset allocation process to reduce risk exposure of a portfolio, or to
utilize the current market trend.
SPs are by nature not homogeneous - as a large number of derivatives and
underlying can be used. One has at least the following categories : Interest rate-
linked notes, Equity-linked notes, Credit-linked notes, FX-linked notes, Commodities-
linked notes, Hybrid-linked notes, etc.
A SP is generally a pre-packaged investment strategy which is based on deriva-
tives (the needs of the investor are translated into these derivatives). Theoretically
investors can just do this themselves, but the costs, handling and transaction vol-
ume requirements of derivatives are beyond many individual investors.
Products can be denominated in any currency, structured within almost any
legal and regulatory environment. Underlying assets can come from all over the
world (e.g. making investing in Emerging Markets available to a more general
public). Level of complexity from ”plain vanilla” to ”exotic” and any degree of
financial leverage can be achieved by using derivatives.
Some SPs have a kind of principal protection either fully or partially. For
such Principal-Protected Notes (PPN), part of the principal is not at risk from
an market perspective. However, the products are still exposed to default risk as
the issuing institution can go bankrupt in which case the investor is also loosing
his investment. A PPN may be suitable for those seeking full protection of their
original investment and for investors who have long-term financial obligations.
PPNs generally offer a return at maturity linked to an underlying asset. In-
vestors typically give up a portion of the potential gains in exchange for principal
protection. In its most basic form, a principal protected note typically consists of
a zero-coupon bond and a derivative. At maturity, the zero-coupon bond is re-
deemed at par, while the derivative offers participation in an underlying reference
asset. We have already encountered two examples: Example 4 and 24, and many
other exist. A Bonus Certificate (BC) for example pays out a bonus at maturity
if certain conditions are satisfied, e.g. the underlying stock has never hit a low
barrier during the life time of the certificate. It gives typically a reduction of the
4.5. STRUCTURED PRODUCTS 97
downside risk, a potential higher bonus in case markets move sideways and an
unlimited upside potential.
Example 25 (Bonus Certificate). Consider a BC on the FTSE-100 with maturity

3 years. See also Figure 4.4 At expiry a holder receives on his investment a return
equal to
1. the FTSE-100 return (over the lifetime of the product) if it is the FTSE-100
ends above 140% of the initial level (at the start of the SP), or
2. a return of 40%, if the final level of the FTSE-100 is between 75% and 140%
of the initial level, unless the index level has fallen below 75% of the initial
level during the lifetime of the certificate in which case ...
3. one receives just the final level
The BC is a combination of a zero-strike European call, i.e. an European call with

strike equal to zero, and a Barrier option,more precisely a down-and-out barrier
put (DOBP). Note that, the payoff is not always better than a direct investment,
because a BC doesn’t pay dividends. These dividends are actually used to finance
the DOBP. This makes high yield stocks/indices appealing to be used in BCs.
Other products can have a early redemption before the maturity date. An
example of such a note that can have early redemption, is the auto-callable. If a
certain trigger is activated, e.g. if stock is below some barrier, then there is early
redemption.
Example 26. Consider an Auto-callable with a maturity of 3 years, but each

year the investor has the chance of an early redemption : If the observation level
is below the barrier after years 1 or 2, the note redeems early, and the investor
receives 100% plus a bonus multiplied with the year (either 1 or 2) in which the
note is terminated. If the note isn’t redeemed early in one of the first 2 years,
but the observation level of is below the barrier at maturity (year 3) the investor
receives 100% plus 3 times the bonus. However, if the observation level is above
the barrier at maturity, the note redeems at 100%.
The ”Bonus in %” and Barrier are fixed according to the market conditions
and could be for example 12% and 105% of spot, respectively.
Figure 4.4: a BC on the FTSE-100

Chapter 5
The Black-Scholes Model
This chapter overviews the most basic and well-known continuous-time, continuous-
variable stochastic model for stock prices: The Black-Scholes(-Merton) model. An
understanding of this is the first step to the understanding of the pricing of options
in a more advanced setting.
In the early 1970s, Fischer Black, Myron Scholes, and Robert Merton made
a major breakthrough in the pricing of stock options by developing what has
become known as the Black-Scholes model. The model has had huge influence
on the way that traders price and hedge options. In 1997, the importance of the
model was recognized when Myron Scholes and Robert Merton were awarded the
Nobel prize for economics. Sadly, Fischer Black died in 1995, otherwise he also
would undoubtedly have been one of the recipients of this prize.
5.1 Information, Filtrations and Martingales in Con-

tinuous Time
5.1.1 Information and Filtration
The underlying set-up is as in the discrete time case. We assume a fixed finite
planning horizon T . We need a complete probability space (Ω, FT , P ), equipped
with a filtration, i.e. a non-decreasing family F = (Ft , 0 ≤ t ≤ T ) of sub-σ-fields of
FT : Fs ⊂ Ft ⊂ FT for 0 ≤ s ≤ t ≤ T ; here Ft represents the information available
at time t, and the filtration F = (Ft , 0 ≤ t ≤ T ) represents the information flow
evolving with time.
We assume that the filtered probability space (Ω, FT , P, F), satisfies the ’usual
99
100 CHAPTER 5. THE BLACK-SCHOLES MODEL
conditions’: a) F0 contains all P -null sets of FT . This means intuitively that

we know which events are possible and which not, and b) (Ft , 0 ≤ t ≤ T ) is
right-continuous, i.e. Ft = ∩s>t Fs ; a technical condition.
Consider a stochastic process X = (Xt , 0 ≤ t ≤ T ) defined on (Ω, FT , P, F).
We say X is F-adapted if Xt ∈ Ft , i.e. Xt is Ft -measurable for each t: thus Xt is
known at time t.
5.1.2 Martingales
A stochastic process X = (Xt , 0 ≤ t ≤ T ) is a martingale relative to (P, F) if
• X is F-adapted;
• E[|Xt |] < ∞ for all t ≥0;
• E[Xt |Fs ] = Xs , P -a.s., (0 ≤ s ≤ t).
A martingale is ’constant on average’, and models a fair game. This can be seen
from the third condition: the best forecast of the unobserved future value Xt
based on information at time s, Fs , is the at time s known value Xs .
5.2 The Normal Distribution and the Brownian Mo-

tion
5.2.1 The Normal Distribution
The Normal distribution, Normal(µ, σ 2 ), is one of the most important distribu-
tions in many areas. It lives on the real line, has mean µ ∈ R and variance σ 2 > 0
and its density function is given as
(x − µ)2

2 1
fN ormal (x; µ, σ ) = √ exp − . (5.1)
2πσ 2 2σ 2
In Figure 5.1, one sees the typical bell-shaped curve of the density of a standard
normal (Normal(0, 1)) density.
We will denote by
Z x
N(x) = fN ormal (u; 0, 1)du (5.2)
−∞
5.2. THE NORMAL DISTRIBUTION AND THE BROWNIAN MOTION 101
the cumulative distribution function (cdf) for a variable that is standard normally
distributed (Normal(0, 1)). This special function is available in most mathematical
software packages. The function is shown in Figure 5.2.
The Normal(µ, σ 2 ) distribution is symmetric around its mean, and has always
a kurtosis equal to 3:
Normal(µ, σ 2 )
mean µ
variance σ2
skewness 0
kurtosis 3
The Normal distribution arises from the Central Limit Theorem (CLT) (see
Theorem 11). Intuitively, it tells us that the suitable normalized sum of many
independent random variables is approximately normally distributed.
5.2.2 Brownian Motion

The big brother of the Normal distribution is the Brownian motion. Brownian
motion is the dynamic counterpart – where we work with evolution in time – of
the static counterpart, the Normal distribution. The history of Brownian motion
dates back to 1828, when the Scottish botanist Robert Brown observed pollen par-
ticles in suspension under a microscope and observed that they were in constant
irregular motion. By doing the same with particles of dust, he was able to rule
out that the motion was due to pollen being ”alive”. In 1900, Louis Bachelier con-
sidered Brownian motion as a possible model for stock market prices. Bachelier’s
model was his thesis. At that time the topic was not thought worthy of study.
In 1923, Norbert Wiener defined and constructed Brownian motion rigorously for
the first time. The resulting stochastic process is often called the Wiener process
in his honour. It was with the work of Samuelson in 1965 that Brownian motion
reappeared as a modelling tool in finance.
Definition
A stochastic process X = {Xt , t ≥ 0} is a standard Brownian motion on some
probability space (Ω, F, P ), if
1. X0 = 0 a.s.
2. X has independent increments.

3. X has stationary increments.
4. Xt+s − Xt is normally distributed with mean 0 and variance s > 0: Xt+s −

Xt ∼ Normal(0, s).
We shall henceforth denote standard Brownian motion by W = {Wt , t ≥

0} (W for Wiener). Note that the second item in the definition implies that
Brownian motion is a Markov process. In Figure 6.1, we depict 10 paths of
standard Brownian motions over the time interval [0, 1]. We refer to Section 6.2
for how to simulate such paths.
In the above, we have defined Brownian motion without reference to a fil-
tration. Without other notice, we will always work with the natural filtration
F = FW = {Ft , 0 ≤ t ≤ T } of W . We have that Brownian motion is adapted with
respect to this filtration and that increments Wt+s − Wt are independent of Ft .
Random-Walk Approximation of Brownian Motion

No construction of Brownian motion is easy. We take the existence of Brownian
motion for granted. To gain some intuition on its behaviour, it is good to compare
Brownian motion with a simple symmetric random walk on the integers. More
precisely, let X = {Xi , i = 1, 2, . . . } be a series of independent and identically
distributed random variables with P (Xi = 1) = P (Xi = −1) = 1/2. Define the
simple
Pn symmetric random walk Z = {Zn , n = 0, 1, 2, . . . } as Z0 = √ 0 and Zn =
i=1 Xi , n = 1, 2, . . . . Rescale this random walk as Yk (t) = Zbktc / k, where bxc
is the integer part of x. Then from the Central Limit Theorem, Yk (t) → Wt as
k → ∞, with convergence in distribution (or weak convergence).
In Figure 5.4, one sees a realization of the standard Brownian motion.
In Figure 5.5, one sees the random-walk approximation of the standard Brown-
ian motion. The process Yk = {Yk (t), t ≥ 0} is shown for k = 1 (i.e. the symmetric
random walk), k = 3, k = 10 and k = 50. Clearly, one sees the Yk (t) → Wt .
Properties
Next, we look at some of the classical properties of Brownian motion.
Martingale Property Brownian motion is one of the most simple examples of

a martingale. We have for all 0 ≤ s ≤ t,
E[Wt |Fs ] = E[Wt |Ws ] = Ws .

5.3. ITÔ’S CALCULUS 103
We also mention that one has:
E[Wt Ws ] = min{t, s}.
Path Properties One can proof that Brownian motion has continuous paths,
i.e. Wt is a continuous function of t. However the paths of Brownian motion
are very erratic. They are for example nowhere differentiable. Moreover, one can
prove also that the paths of Brownian motion are of infinite variation, i.e. their
variation is infinite on every interval.
Another property is that for a Brownian motion W = {Wt , t ≥ 0}, we have
that
P (sup Wt = +∞ and inf Wt = −∞) = 1.
t≥0 t≥0
This result tells us that the Brownian path will keep oscillating between positive
and negative values.
Scaling Property There is a well-known set of transformations of Brownian

motion which produce another Brownian motion. One of this is the scaling prop-
erty which says that if W = {Wt , t ≥ 0} is a Brownian motion, then also for every
c 6= 0,
W̃ = {W̃t = cWt/c2 , t ≥ 0} (5.3)
is a Brownian motion.
5.3 Itô’s Calculus

5.3.1 Stochastic Integrals
Stochastic integration was introduced by K.Itô in 1941, hence its name Itô calcu-
lus. It gives meaning to Z t
Xu dYu
0
for suitable stochastic processes X = (Xu , u ≥ 0) and Y = (Yu , u ≥ 0), the
integrand and the integrator. We shall confine our attention here to the basic case
with integrator Brownian motion: Y = W . Because Brownian motion is of infinite
(unbounded) variation on every interval, the first thing to note is that stochastic
integrals with respect to Brownian motion, if they exist, must be quite different
from the classical deterministic integrals. We take for granted Itô’s fundamental
insight that stochastic integrals can be defined for a suitable class of integrands.
We only show how these integrals can be defined for some simple integrands X.
Indicators
If Xt = 1[a,b] (t), i.e. it equals 1 between a and b and is zero elsewhere, we define

Z t  0 if t ≤ a
It (X) = Xs dWs = Wt − Wa if a ≤ t ≤ b
0 
Wb − Wa if t ≥ b
Simple deterministic functions
We can extend the above definition by linearity: if X is a linear combination of

indicators,
Xn
Xt = ci 1[ai ,bi ] (t),
i=1
we define
Z t n
X Z t
It (X) = Xs dWs = ci 1[ai ,bi ] (s)dWs .
0 i=1 0
Simple stochastic processes
X is called a simple stochastic process if there is a partition 0 = t0 < t1 < · · · <

tn = T < ∞ and uniformly bounded Ftk -measurable random variables ζk , (with
|ζk | ≤ C for all k = 0, . . . , n for some C) and if Xt can be written in the form
n−1
X
Xt = ζ0 10 (t) + ζi 1(ti ,ti+1 ](t), 0 ≤ t ≤ T.
i=0
Then if tk ≤ t ≤ tk+1 , k = 0, . . . , n − 1,
Z t k−1
X
It (X) = Xs dWs = ζi (Wti+1 − Wti ) + ζk (Wt − Wtk ).
0 i=0
Properties
It is not so hard to prove some simple properties of the stochastic integrals defined
so far:
• Linearity: It (aX + bY ) = aIt (X) + bIt (Y );
• It (X) is a martingale;
Rt
• Itô’s isometry: E[(It (X))2 ] = 0 E[Xu2 ]du.
Rt
The Itô isometry above suggests that the stochastic integral 0 Xu dWu should
be defined only for processes with
Z t
E[Xu2 ]du < ∞, for all t ≥ 0
0
and this is indeed the case. Each such X may be approximated by a sequence
of simple stochastic processes and the stochastic integral may be defined as the
limit of this approximation. Furthermore the three above properties remain true.
We will not include the technical and detailed proofs of this procedure in this
book. Note that one also can construct a closely analogous theory for stochastic
integrals with the Brownian integrator W above replaced by a more general (semi-
)martingale integrator M .
5.3.2 Itô’s Lemma

The price of a stock option is a function of the underlying stock’s price and
time. More generally, we can say that the price of any derivative is a function of
the stochastic variables underlying the derivative and time. Therefore, we must
acquire some understanding of the behaviour of functions of stochastic variables.
An important result in this area was discovered by K. Itô, in 1951. It is known
as Itô’s lemma.
Suppose that F : R2 → R is a function, which is continuously differentiable
once in its first argument (which will denote time), and twice in its second argu-
ment (space): F ∈ C 1,2 . Denote the partial derivatives
∂F
Ft (t, x) = (t, x)
∂t
∂F
Fx (t, x) = (t, x)
∂x
∂2F
Fxx (t, x) = (t, x)
∂x2
Lemma 27 (Itô’s Lemma). Let W = {Wt , t ≥ 0} be a standard Brownian motion

and let F (t, x) ∈ C 1,2 then
Z t Z t
1 t
Z
F (t, Wt ) − F (s, Ws ) = Fx (u, Wu )dWu + Ft (u, Wu )du + Fxx (u, Wu )du
s s 2 s
or
1
dF = Fx dWt + Ft dt + Fxx dt
2
for short.
Example 28. As an application of Itô’s Lemma we compute
Z t
Wu dWu
0
by using
F (t, x) = x2 .
We have
Ft (t, x) = 0
Fx (t, x) = 2x
Fxx (t, x) = 2
Hence Z t Z t Z t
Wt2 − 0 = 2 Wu dWu + du = 2 Wu dWu + t
0 0 0
So that
t
Wt2
Z
t
Wu dWu = − .
0 2 2
Note the contrast with ordinary calculus ! Itô calculus requires the second term
on the right - the Itô correction term.
5.3.3 Stochastic Differential Equations

Like with any ordinary and partial differential equations in a deterministic set-
ting (ODEs and PDEs), the two most basic questions are those of existence and
uniqueness of solutions. To obtain existence and uniqueness results, one has to
impose reasonable regularity conditions on the coefficients occurring in the differ-
ential equation. Naturally, stochastic differential equations (SDEs) contain all the
complications of their non-stochastic counterparts, and more besides. Consider

the stochastic differential equation
dXt = b(t, Xt )dt + σ(t, Xt )dWt , Xs = x (5.4)
where the coefficient functions b(t, x) and σ(t, x) satisfy the so-called following
Lipschitz and growth conditions:
|b(t, x) − b(t, y)| + |σ(t, x) − σ(t, y)| ≤ K|x − y|

|b(t, x)|2 + |σ(t, x)|2 ≤ K 2 (1 + |x|2 )
for all t ≥ 0, x, y ∈ R, for some constant K > 0. These are some technical
conditions such that existence and uniqueness of the solutions is guaranteed ; all
SDEs that we will encounter satisfy these conditions.
To see that the SDE (5.5) has a solution, we first define recursively
Z t Z t
(0) (n+1)
Xt = x, Xt =x+ b(u, Xu(n) )du + σ(u, Xu(n) )dWu .
s s
(n)
One can then prove that Xt converges (in some sense), to Xt say; Xt will then
be the unique (strong) solution to SDE (5.5), i.e.
Z t Z t
Xs = x, Xt = x + b(u, Xu )du + σ(u, Xu )dWu .
s s
or
dXt = b(t, Xt )dt + σ(t, Xt )dWt , Xs = x
for short.
Itô’s Lemma for SDEs

The next result, which is an example for the rich interplay between probability
theory and analysis, links SDEs with PDEs. Suppose we consider a stochastic
differential equation (satisfying the above Lipschitz and growth conditions),
dXt = µ(t, Xt )dt + σ(t, Xt )dWt , Xs = x, s≤t≤T (5.5)
Consider a function F (t, x) ∈ C 1,2 . Then we have the following extension of Itô’s
Lemma:
Lemma 29 (Itô’s Lemma for SDEs). Let W = {Wt , t ≥ 0} be a standard Brow-

nian motion and let F (t, x) ∈ C 1,2 then
Z t
F (t, Xt ) − F (s, Xs ) = σ(u, Xu )Fx (u, Xu )dWu + (5.6)
s
Z t
σ(u, Xu )2

Ft (u, Xu ) + µ(u, Xu )Fx (u, Xu ) + Fxx (u, Xu ) du.
s 2
The Feynman-Kac Formula

Now suppose that F satisfies the (ordinary/deterministic) PDE
σ(t, x)2
Ft (t, x) + µ(t, x)Fx (t, x) + Fxx (t, x) = 0,
2
with boundary condition
F (T, x) = h(x).
Then the above expression for (5.6) gives
Z t
F (s, Xs ) = F (t, Xt ) − σ(u, Xu )Fx (u, Xu )dWu
s
The stochastic integral on the right is a martingale, so has constant expectation,

which must be 0 as it starts at 0. So
F (s, x) = E[F (t, Xt )|Fs ]
which leads for t = T to the Feynman-Kac Formula
F (s, x) = E[h(XT )|Fs ].
The Feynman-Kac formula gives a stochastic representation to solutions of PDEs.

We shall return to the Feynman-Kac formula below in connection with the Black-
Scholes partial differential equation.
5.4 Geometric Brownian Motion and The Black-Scholes

Model
Now that we have Brownian motion W , we can introduce an important stochastic
process for us, a relative of Brownian motion – geometric Brownian motion.
5.4. GEOMETRIC BROWNIAN MOTION AND THE BLACK-SCHOLES MODEL109
In the Black-Scholes model, one models the time evolution of a stock price
S = {St , t ≥ 0} as follows. Consider how S will change in some small time
interval from the present time t to a time t + ∆t in the near future. Writing
∆St for the change St+∆t − St , the relative return over this time step is then
∆St /St . It is economically reasonable to expect this return to decompose into
two components, a systematic part and a random part.
Let us first look at the systematic part. One assumes that the stock’s expected
return over a period is proportional to the length of the period considered. This
means that in a short interval of time [t, t + ∆t] of length ∆t, the expected relative
return in S is proportional to the length of the time step, namely ∆t, and is
therefore given by µ∆t, where µ is some parameter representing the mean rate of
the return of the stock.
A stock price fluctuates stochastically, and a reasonable assumption is that
the variance of the return over the interval of time [t, t + ∆t] is proportional to
the length of the interval. Furthermore, taking into account the Central Limit
Theorem and viewing the stock return as the sum on many random effects, it
makes sense to model the random part of the return by a Normally distributed
random variable with variance σ 2 ∆t, with σ > 0 a parameter which describes
how much effect this random part has - or how volatile the return is; σ is called
the volatility of the stock. Putting this together and recognizing that σ∆Wt =
σ(Wt+∆t − Wt ) has a normal distribution with the required variance σ 2 ∆t, we
could write
∆St = St (µ∆t + σ∆Wt ), S0 > 0.
In the limit, as ∆t → 0, we have the Stochastic Differential Equation (SDE)
dSt = St (µdt + σdWt ), S0 > 0. (5.7)
Using Itô’s Lemma (see next example), one can prove that this stochastic
differential equation has the unique solution
σ2

St = S0 exp µ− t + σWt .
2
This (exponential) functional of Brownian motion is called geometric Brownian

motion. Note that
σ2

log St − log S0 = µ − t + σWt
2
has a Normal(t(µ − σ 2 /2), σ 2 t) distribution. Thus St itself has a lognormal distri-

bution. This geometric Brownian motion model, and the log-normal distribution
which it entails, are the basis for the Black-Scholes model for stock-price dynamics
in continuous time.
Example 30. As another application of Itô’s Lemma we consider
F (t, x) = S0 exp((µ − σ 2 /2)t + σx)
We have
Ft (t, x) = (µ − σ 2 /2)S0 exp((µ − σ 2 /2)t + σx) = (µ − σ 2 /2)F (t, x)

Fx (t, x) = σS0 exp((µ − σ 2 /2)t + σx) = σF (t, x)
Fxx (t, x) = σ 2 F (t, x)
Therefore applying Itô’s lemma gives
F (t, Wt ) − F (s, Ws ) =
Z t Z t
1 t 2
Z
2
(µ − σ /2)F (u, Wu )du + σF (u, Wu )dWu + σ F (u, Wu )du
s s 2 s
or
σ2
dF = σF dWt + (µ − σ 2 /2)F dt + F dt = µF dt + σF dWt
2
for short. Hence
St = F (t, Wt ) = S0 exp((µ − σ 2 /2)t + σWt )
satisfies the SDE:
dSt = µSt dt + σSt dWt = St (µdt + σdWt ).
In Figure 6.2, one sees the realization of the geometric Brownian motion based
on the sample path of the standard Brownian motion of Figure 6.1.
5.5 The Black-Scholes Option Pricing Model

In the early 1970s, Fischer Black, Myron Scholes, and Robert C. Merton made
a major breakthrough in the pricing of stock options by developing what has
become known as the Black-Scholes model. The model has had huge influence
5.6. CONTINUOUS TIME FINANCE 111
on the way that traders price and hedge options. In 1997, the importance of the
model was recognized when Myron Scholes and Robert C. Merton were awarded
the Nobel prize for economics. Sadly, Fischer Black died in 1995, otherwise he
also would undoubtedly have been one of the recipients of this prize as well.
Next, we detail the Black-Scholes model and employ it for valuing European
call and put options on a stock.
5.5.1 The Black-Scholes Market Model

Investors are allowed to trade continuously up to some fixed finite planning horizon
T and the market has two basic assets.
The first asset is one without risk (the risk-free account). Its price process
is given by B = {Bt = exp(rt), 0 ≤ t ≤ T }. The second asset is a risky asset,
usually referred to as stock, and which pays a continuous dividend yield q ≥ 0.
The price process of this stock, S = {St , 0 ≤ t ≤ T }, is modelled by geometric
Brownian motion:
σ2

St = S0 exp µ− t + σWt ,
2
where W = {Wt , t ≥ 0} is standard Brownian motion.
Note that Wt has a Normal(0, t) and that S = {St , t ≥ 0} satisfies the SDE
(5.7). The parameter µ is reflecting the drift and σ models the volatility; µ and
σ are assumed to be constant over time.
We call this market model the Black-Scholes model.
5.6 Continuous Time Finance

As in the discrete case, one can prove that one can preclude arbitrage oppor-
tunities if an equivalent martingale measure exists. Furthermore, in the more
general continuous-time setting, we have the following partial analogue of the
completeness theorem in the discrete setting: If P = {P ∗ }, then the market is
complete, in the restricted sense that for every contingent claim X satisfying
EP ∗ [X 2 ] < ∞ there exists at least an admissible self-financing trading strategy
such that VTφ = X.
Having seen the above results, a natural question is to ask whether converse
statements are also true. One has to put some further requirements on portfolios
to establish such converse results. These requirements should of course be eco-
nomically meaningful. A lot of effort has been put into solving this question, and
several alternatives have been proposed, but the details will lead us to far.
By the risk-neutral valuation principle one can prove that the price Vt at time
t, of a contingent claim with payoff function G({Su , 0 ≤ u ≤ T }) is given by
Vt = exp(−(T − t)r)EP ∗ [G({Su , 0 ≤ u ≤ T })|Ft ], 0≤t≤T (5.8)
where P ∗ is an equivalent martingale measure. In a general setting their is not
a unique martingale measure (incomplete market models). Roughly speaking
incompleteness means that a general contingent claim can not be perfectly hedged.
Most models are not complete, and most practitioners believe the actual market
is not complete. we have to choose an equivalent martingale measure in some
way and this is not always clear. Actually, the market is choosing the martingale
measure for us.
In the Black-Scholes world however, one can prove (Girsanov Theorem) that
there is a unique equivalent martingale measure and we do not have to deal with
choosing an appropriate one. It is not hard to see that under P ∗ , the stock price
is following a Geometric Brownian motion again. This risk-neutral stock price
process has the same volatility parameter σ, but the drift parameter µ is changed
to the continuously compounded risk-free rate r.
The Black-Scholes models is hence a complete model, that is, every contingent
claim can be replicated by a dynamic self-financing trading strategy.
5.6.1 The Risk-Neutral Setting

Since the Black-Scholes market model is complete there exists only one risk-
neutral measure or pricing measure. One can show that under this risk-neutral
measure Q the stock price is following again a Geometric Brownian motion and
has the same volatility parameter σ. The drift parameter µ however has to be
equal to the continuously compounded risk-free rate r minus the dividend yield q
to enforce 3.3:
σ2

St = S0 exp r−q− t + σWt .
2
Equivalent, we can say that the risk-neutral stock price process S = {St , 0 ≤ t ≤
T } is satisfying the SDE:
dSt = St ((r − q)dt + σdWt ), S0 > 0.
In a risk-neutral world the total return from the stock must be r; the dividends
provide a return of q, the expected growth rate in the stock price is r − q.
5.6. CONTINUOUS TIME FINANCE 113
Next, we will calculate European call option prices under this model.
5.6.2 The Pricing of Options under the Black-Scholes Model

By the risk-neutral valuation principle the price V of a contingent claim with
payoff function G({Su , 0 ≤ u ≤ T }) is given by
V = exp(−rT )EQ [G({Su , 0 ≤ u ≤ T })], (5.9)
Furthermore, if the payoff function is only depending on the time T value of
the stock, i.e. G({Su , 0 ≤ u ≤ T }) = G(ST ), then the above formula can be
rewritten as :
V = exp(−rT )EQ [G(ST )]
= exp(−rT )EQ [G(S0 exp((r − q − σ 2 /2)T + σWT ))]
Z +∞
= exp(−rT ) G(S0 exp((r − q − σ 2 /2)T + σx))fN ormal (x; 0, T )dx,
−∞
where expectations are taken under the pricing measure Q.
5.6.3 Black-Scholes PDE

If moreover G(ST ) is a sufficiently integrable function, then the price is also given
by Vt = F (t, St ), where F solves the Black-Scholes partial differential equation
∂ ∂ 1 ∂2
F (t, s) + (r − q)s F (t, s) + σ 2 s2 2 F (t, s) − rF (t, s) = 0, (5.10)
∂t ∂s 2 ∂s
F (T, s) = G(s)
This follows from the Feynman-Kac representation for Brownian motion.
Indeed, let H(t, s) be a solution of
1
Ht (t, s) + (r − q)sHs (t, s) + σ 2 s2 Hss (t, s) = 0, H(T, s) = exp(−rT )G(s).
2
Then we know from the Feynman-Kac representation that H has the representa-
tion
H(t, St ) = exp(−rT )EP ∗ [G(ST )|Ft ].
Note that by the risk-neutral valuation principle
Vt = F (t, St ) = exp(−r(T − t))EP ∗ [G(ST )|Ft ] = exp(rt)H(t, St ).
By computing the partial derivatives of F we obtain the PDE (5.10).
5.6.4 Explicit Formula for European Call and Put Options

In some cases it is possible to evaluate explicitly the expected value in the pricing
formula (5.9).
Take for example an European call on the stock with price process S, strike K
and maturity T (so G(ST ) = (ST −K)+ ). The Black-Scholes formula for the price
EC(K, T ) at time zero of this European call option on the stock (with dividend
yield q) is given by
EC(K, T ) = exp(−qT )S0 N(d1 ) − K exp(−rT )N(d2 ),
where
σ2
log(S0 /K) + (r − q + 2 )T
d1 = √ , (5.11)
σ T
σ2 √
log(S0 /K) + (r − q − 2 )T
d2 = √ = d1 − σ T , (5.12)
σ T
and N(x) is the cumulative probability distribution function for a variable that is
standard normally distributed (Normal(0, 1)).
From this, one can also easily (via the put-call parity) obtain the price EP (K, T )
of the European put option on the same stock with same strike K and same ma-
turity T :
EP (K, T ) = − exp(−qT )S0 N(−d1 ) + K exp(−rT )N(−d2 ).
For the call, the risk-neutral probability (Q) of finishing in the money corre-
sponds with N(d2 ). Similarly, the delta (i.e. the change in the value of the option
compared with the change in the value of the underlying asset of the option cor-
responds with N(d1 ) ; see also Section 5.7) .
5.7 Hedging
If we have an investment in a portfolio of a stock, a risk-free account and a
derivative, all 3 asset’s value can change from day to day. The option price changes
because the underlying stock price moved (Delta effect) or the volatility of the
underlying has changed (Vega effect). Moreover because time has passed, we are
closer to maturity and this has an effect on the value (Theta effect). Furthermore
other inputs like the interest rate (Rho effect) or dividends can change and lead to
5.7. HEDGING 115
a change in value of the option price. Finally, second order effects can moreover
come into play (like for example the Gamma effect).
Consider an option with option price O. In the Black-Scholes world, O depends
on the current stock price S, the risk-free rate, r, the dividend yield q and the
stock’s volatility σ and of course of the option characteristics, like the strike K
and time to maturity τ in for example the case of an European Call or Put. We
write O = O(S, r, q, σ, τ ).
We call delta
∂O(S, r, q, σ, τ )
∆= ,
∂S
the rate of change of the option price with respect to the price of the underlying
asset. Suppose that the delta of a call option on as stock is ∆ = 0.6. This means
that when the stock price changes by a small amount h, the option price changes
by about 60 percent of that amount.
Indeed for h small, we have
∂O(S, r, q, σ, τ ) O(S + h, r, q, σ, τ ) − O(S, r, q, σ, τ )
∆= ≈
∂S h
and hence
O(S + h, r, q, σ, τ ) − O(S, r, q, σ, τ ) ≈ h∆. (5.13)
Suppose for example that the stock price is 100 Euro and the option price is
10 Euro. Imagine an investor who has sold 2000 option contracts - that is, he sold
options to buy 2000 shares. The investor’s position could be hedged by buying
0.6 × 2000 = 1200 shares. The gain (loss) on the option position would then tend
to be offset by the loss (gain) on the stock position. For example, if the stock
goes up by 1 Euro (producing a gain of 1200 Euro on the shares purchased), the
option price will tend to go up by 0.6 × 1 = 0.60 Euro (producing a loss of 2000
× 0.6 = 1200 Euro on the options written); if the stock price goes down by 1 Euro
(producing a loss of 1200 Euro on the stock position), the option price will tend
to go down by 0.60 (producing a gain of 1200 Euro on the option position).
It is important to realize that, because delta changes (with time and stock
price movements), the investor’s position remains delta-hedged (or delta neutral)
for only a relatively short period of time. In order to have a perfect hedge, the
positions have to be adjusted continuously. In practice however one can only
adjust periodically. This is known as rebalancing. For example, suppose that an
increase in the stock leads to an increase in delta, say from 0.60 to 0.65. An extra
of 0.05 × 2000 = 100 shares would then have to be purchased to maintain the
hedge.
Similarly, one defines vega as
∂O(S, r, q, σ, τ )
v= ,
∂σ
as the rate of change of the option price with respect to the volatility of the
underlying asset; one defines theta as
∂O(S, r, q, σ, τ )
Θ= ,
∂τ
as the rate of change of the option price with respect to the time to maturity; one
defines rho as
∂O(S, r, q, σ, τ )
ρ= ,
∂r
as the rate of change of the option price with respect to the risk-free rate.
An example of a second order effect is Gamma, the rate of change of delta
with stock price:
∂ 2 O(S, r, q, σ, τ )
Γ= .
∂S 2
An extension of the Taylor Expansion (5.13) incorporating the other effects
can be easily derived:
1
O(S+δS, r+δr, q, σ+δσ, τ +δτ )−O(S, r, q, σ, τ ) ≈ ∆δS+ρδr+Θδτ +vδσ+ Γ(δS)2 .
2
(5.14)
Now, suppose we are long an option, i.e. we have bought derivative for price
O and we delta hedge the derivative, i.e. we sell ∆ stocks for price S. The money
we put on bank account is (and if ∆ is negative this amount can also be negative)
: ∆S − O. After a small time step δt, we receive (or have to pay) interest. The
interest rate received is approximately: r(∆S − O) × δt.
Assume now that the stock moves (no other changes happen). Then Equation
5.14 becomes
O(S + δS, r + δr, q, σ + δσ, τ + δτ ) − O(S, r, q, σ, τ )

1
≈ ∆δS + ρδr + Θδτ + vδσ + Γ(δS)2
2
1 2
≈ ∆δS + Γ(δS) .
2
5.7. HEDGING 117
Our delta hedge is not perfect and the error is:

1
O(S + δS, r + δr, q, σ + δσ, τ + δτ ) − O(S, r, q, σ, τ ) − ∆δS ≈ Γ(δS)2 .
2
Hence due to stock moves our portfolio increases in value by (approximately)
1
Γ(δS)2
2
Now, under the Black-Scholes setting:
√ √
(δS) ≈ µSδt + σS δt ≈ σS δt,
with epsilon a standard normal random variable. So the portfolio increase in value
by
1 √ 1
Γ(σS δt)2 = Γσ 2 S 2 δt2 .
2 2
Since E[2 ] = 1, we have that expected increase due to stock moving is
1 2 2
Γσ S δt.
2
In addition, we have also a time effect and over our step δt, the price of the option
moved by Θδt.
In total, we have due to the interest payment, the time effect (Θδt) and due
to the stock movement, an expected change in value of our portfolio of:
1
Θδt + Γσ 2 S 2 δt + r(∆S − O)δt,
2
which can be rewritten as

1 2 2
Θ + Γσ S + r∆S − rO δt.
2
Going back to the Black-Scholes PDE (which itself was derived from Itô’s lemma),
we know that
1
Θ + Γσ 2 S 2 + r∆S − rO = 0
2
In conclusion, the total change in the value of a delta-hedged portfolio is equal to
zero ... on average.
Therefore actual error caused by discrete hedging is the difference
1 2 2 2 1 2 2 1
Γσ S δt − Γσ S δt = Γσ 2 S 2 δt(2 − 1)
2 2 2
Note that the square of a standard normal random variable, 2 , follows a chi-
squared distribution. Further note that, the error is proportional to the gamma
(often resulting in the fact that the hedging error gets worse close to the money,
close to expiry). In addition, the hedging error is proportional to δt and the
shorter the periods in between rebalancing the better. Finally, remark that the
hedging errors are independent of each other from each day to the next and that
the total hedging error (up to expiration) is path dependent.
5.8 Shortfalls of the Black-Scholes Model

Over the last decades the Black-Scholes model
St = S0 exp((µ − σ 2 /2)t + σWt ), t ≥ 0,
where {Wt , t ≥ 0} is standard Brownian Motion and σ > 0 is the usual volatility,
turned out to be very popular. One should bear in mind however, that this
elegant theory hinges on several crucial assumptions. One assumes that there
are no market frictions, like taxes and transaction costs or constraints on the
stock holding, etc. Moreover, empirical evidence suggests that the classical Black-
Scholes model does not describe the statistical properties of financial time series
very well.
Summarizing we could say that the Black-Scholes framework has several short-
comings which can have a serious impact on the modelling of financial assets and
the corresponding pricing and hedging of financial derivatives. The most common
critiques are:
• log-returns under the Black-Scholes model are Normally distributed. How-

ever it is observed from empirical data that log-returns typically do not
behave according to a Normal distribution. They show most of the time
negative skewness and excess kurtosis.
• related to the above observation on the log-returns, the Black-Scholes model

can not model realistically extreme events.
5.9. IMPLIED BLACK-SCHOLES VOLATILITY 119
• paths of the stock process under the Black-Scholes model are continuous
and show no jumps. However in reality asset prices do jump and the more
pronounced jumps typically have the most impact on the derivative pricing.
• the volatility parameter (the only model parameter of relevance for the
pricing of derivatives) is assumed to be constant. However, it has been
observed that the volatilities or the parameters of uncertainty estimated (or
more generally the environment) change stochastically over time.
• Stock prices may be seen as functions of a more meaningful concept of

time related to the passage of economic activity as opposed to calendar
time. Such economic measures of time, when they are increasing random
processes, are purely discontinuous making the continuity of stock prices a
vacuous and fallacious proposition.
5.9 Implied Black-Scholes Volatility

A way to see that the classical Black-Scholes model cannot capture option prices
in the market consistently, is by looking at the implied volatilities coming from
the market option prices. For every European call option with strike K and
time to maturity T , we calculate the only (free) parameter involved, the volatility
σ = σ(K, T ), such that the theoretical option price (under the Black-Scholes
model) matches the empirical one. This σ = σ(K, T ) is called the implied volatility
of the option. Implied volatility is a timely measure - it reflects the market’s
perception at the time it is measured (and is not backward looking based on
historical data).
There is no closed formula to extract the implied volatility out of the call option
price. We have to rely on numerical methods. One method to find numerically
implied volatilities is the classical Newton-Raphson iteration procedure. Denote
by ECBS (σ) the price of the relevant call option as a function of volatility under
the Black-Scholes model. If ECM arket is the market price of this option we need
to solve the equation
ECM arket = ECBS (σ) (5.15)
for σ. We start with some initial value we propose for σ; we denote this starting
value with σ0 . It turns out that a σ0 around 0.20 performs very well for most
common stocks and indices. In general, if we denote by σn the value obtained
after n iteration steps, the next value σn+1 is given by
ECBS (σn ) − ECM arket

σn+1 = σn − 0 (σ ) ,
ECBS n
where the function in the denominator, ECBS 0 , refers to the differential with
respect to σ of the call price function. This quantity is also referred to as the
vega. For the European call option (under Black-Scholes) we have:
σn2 !
√ √ log(S0 /K) + (r − q +
0
√ 2 )T
ECBS (σn ) = S0 T N(d1 ) = S0 T N ,
σn T
where S0 is the current stock price, d1 as in Equation (5.11) and N(x) is the cumu-
lative probability distribution of a Normal(0, 1) random variable as in Equation
(5.2).
In Figure 5.7 and Figure 5.8 one sees the so-called volatility surface of the S&P
500 on the 12th of December 2014 and the 17th of July 2015 respectively based
on closing mid-prices. Under the Black-Scholes model, all σ’s should be the same;
clearly we observe that there is a huge variation in this volatility parameter both
in strike as in time to maturity. One says often there is a volatility smile or skew
effect. Again this points to the fact that the Black-Scholes model is not appropri-
ate and the traders already count in this deficiency into their prices. Note further,
that both surfaces also differ quite significantly. Volatility or in other words the
parameters of uncertainty estimated (or more generally the environment) change
stochastically over time.
Great care has to be taken by using implied volatilities to price options. Fun-
damentally, using implied volatilities is wrong. Taking different volatilities for
different options on the same underlying asset, give rise to different stochastic
models for one asset. Moreover, the situation worsens in case of exotic options.
One can show that if one tries to find the implied volatilities coming out of exotic
options like barrier options (see Section 4.1), there are cases where there are two
or even three solutions to the implied volatility equation. Implied volatilities are
thus not unique in these situations. More extremely, if we consider an up-and-out
put barrier option, where the strike coincides with the barrier and the risk-free
rate equals the dividend yield, the Black-Scholes price (for which there is a for-
mula in closed form available) is independent of the volatility. So if the market
price happens to coincide with the computed value, you can have any implied
volatility you want. Otherwise there is no implied volatility.
5.10. EXTRA 121
From this, it should be clear that great caution has to be taken by using
European call option implied volatilities for exotic options with apparently similar
characteristics (like the same strike price for example). There is no guarantee that
the obtained prices are reflecting true prices.
5.10 Extra
5.10.1 Drawbacks of the Black-Scholes Model
Normal Returns
In Table 5.1 we summarize i.a. the empirical mean, standard deviation, skewness
and kurtosis for a set of popular indices. The first data set (SP500 (1970-2001))
contains all daily log-returns of the SP500 index over the period 1970-2001. The
second data set (*SP500 (1970-2001)) contains the same data except the excep-
tional log-return (-0.2290) of the crash on the 19th of October 1987. All other
data sets are over the period 1997-1999.
Skewness, Kurtosis and Fait-Tails

We note that the skewness measures the degree to which a distribution is asym-
metric and is defined to be the third moment about the mean, divided by the
third power of the standard deviation:
E[(X − µX )3 ]
Var[X]3/2
For a symmetric distribution (like the Normal(µ, σ 2 )), the skewness is zero. If a
distribution has a longer tail to the left than to the right, it is said to have negative
skewness. If the reverse is true, then the distribution has a positive skewness. If
we look at the daily log-returns of the different indices, we observe typically some
significant (negative) skewness.
Tail behavior and peakedness are measured by kurtosis, which is defined by
E[(X − µX )4 ]
.
Var[X]2
For the Normal distribution (mesokurtic), the kurtosis is 3. If the distribution
has a flatter top (platykurtic), the kurtosis is less than 3. If the distribution has
a high peak (leptokurtic), the kurtosis is greater than 3.
We clearly see that our data always gives rise to a kurtosis clearly bigger than
3, indicating that the tails of the Normal distribution go much faster to zero than
the empirical data suggests and that the distribution is much more peaked. So
large asset price movements occur more frequently than in a model with Normal
distributed increments. This feature is often referred to as excess kurtosis or fat
tails; it is one of the main reasons for considering asset price processes with jumps.
Index Mean St.Dev. Skewness Kurtosis

SP500 (1970-2001) 0.0003 0.0099 -1.6663 43.36
*SP500 (1970-2001) 0.0003 0.0095 -0.1099 7.17
SP500 (1997-1999) 0.0009 0.0119 -0.4409 6.94
Nasdaq-Composite 0.0015 0.0154 -0.5439 5.78
DAX 0.0012 0.0157 -0.4314 4.65
SMI 0.0009 0.0141 -0.3584 5.35
CAC-40 0.0013 0.0143 -0.2116 4.63
Table 5.1: Mean, standard deviation, skewness and kurtosis of major indices
Kernel Density Estimation

Next, we look at the empirical density of daily log-returns.
In order to estimate the empirical density, we make use of kernel density
estimators. The goal of density estimation is to approximate the probability
density function f (x) of a random variable X. Assume we have n independent
observations x1 , . . . , xn from the random variable X. The kernel density estimator
fˆh (x) for the estimation of the density f (x) at point x is defined as
n
ˆ 1 X xi − x
fh (x) = K ,
nh h
i=1
where K(x) is a so-called kernel function, and h is the bandwidth.

√ We typically
2
work with the so-called Gaussian kernel: K(x) = exp(−x /2)/ 2π. Other pos-
sible kernel functions are the so-called Uniform, Triangle, Quadratic and cosine
kernel function. In the above formula one also has to select the bandwidth h. We
use with our Gaussian kernel, Silverman’s rule of thumb value h = 1.06σn−1/5 .
In Figure 5.9, one sees the Gaussian kernel density estimator based on the
daily log-returns of the SP500 Index over the period 1970 until end 2001. We
see a sharp peaked distribution. This tell us that most of the time stock prices
5.10. EXTRA 123
do not move that much; there is a considerable amount of mass around zero.
Also in Figure 5.9 we plotted the Normal density with mean µ = 0.0003112 and
σ = 0.0099 corresponding to the empirical mean and standard deviation of the
daily log-returns.
Semi-Heavy Tails
Density plots focus on the center of the distribution, however also the tail behavior
is important. Therefore, we show in Figure 5.9 the log densities, i.e. log fˆh (x)
and the corresponding log of the Normal density. The log-density of a Normal
distribution has a quadratic decay, whereas the empirical log-density seems to
have a much more linear decay. This feature is typical for financial data and is
often referred to as the semi-heaviness of the tails. We say that a distribution or
its density function f (x) has semi-heavy tails, if the tails of the density function
behave as
f (x) ∼ C− |x|ρ− exp(−η− |x|) as x → −∞

ρ+
f (x) ∼ C+ |x| exp(−η+ |x|) as x → +∞,
for some ρ− , ρ+ ∈ R and C− , C+ , η− , η+ ≥ 0. Equivalently,
log f (x) ∼ A− log |x| − η− |x| as x → −∞

log f (x) ∼ B+ log |x| − η+ |x| as x → +∞,
for some A− , B+ ∈ R and η− , η+ ≥ 0. The log-densities for semi-heavy distri-

butions and apparently also financial returns show a linear behavior of the tails
towards infinity.
The Normal distribution with mean µ and variance σ 2 exhibits a quadratic
decay near infinity of the logarithm of its probability density function:
(x − µ)2 √ 1
log fNormal (x; µ, σ 2 ) = − − log σ 2π ∼ − 2 x2 (5.16)
2σ 2 2σ
as x → ±∞. In conclusion, we clearly see that the Normal distribution leads to
a very bad fit.
Statistical Testing
All the above is confirmed by statistical tests on the Normal hypotheses. A
standard and straightforward way of testing goodness of fit of a distribution can
be done with the so-called χ2 -test. The χ2 -test counts the number of sample
points falling into certain intervals and compares them with the expected number
under the null hypothesis.
More precisely, suppose we have n independent observations x1 , . . . , xn from
the random variable X and we want to test whether these observations follow
a law with distribution D, depending on h parameters which we all estimate by
some method. First, make a partition P = {A1 , . . . Am } of the support (in our
case R) of D. The classes Ak can be chosen arbitrarily; we consider classes of
equal width.
Let Nk , k = 1, . . . , m be the number of observations xi falling into the set
Ak ; Nk /n is called the empirical frequency distribution. We will compare these
numbers with the theoretical frequency distribution πk , defined by
πk = P (X ∈ Ak ), k = 1, . . . , m,
through the Pearson statistic

m
X (Nk − nπk )2
χ̂2 = .
nπk
k=1
If necessary we collapse outer cells, such that the expected value nπk of observa-
tions becomes always greater than five.
We say a random variable χ2j follows a χ2 -distribution with j degrees of free-
dom if it has a Gamma(j/2, 1/2) law (see Chapter 5):
E[exp(iuχ2j )] = (1 − 2iu)−j/2 .
General theory says that the Pearson statistic χ̂2 follows (asymptotically) a χ2 -
distribution with m − 1 − h degrees of freedom.
The P -value of the χ̂2 statistic is defined as
P = P (χ2m−1−h > χ̂2 ).
In words, P is the probability that values are even more extreme (more in the
tail) than our test-statistic. It is clear that very small P -values lead to a rejection
of the null hypotheses, because they are themselves extreme. P -values not close
to zero indicate that the test statistic is not extreme and lead not to a rejection
of the hypothesis. To be precise we reject if the P -value is less than our level of
significance, which we take equal to 0.05.
5.10. EXTRA 125
Index PN ormal -value Class boundaries

SP500 (1970-2001) 0.0000 −0.0300 + 0.0015 i, i = 0, . . . , 40
SP500 (1997-1999) 0.0421 −0.0240 + 0.0020 i, i = 0, . . . , 24
DAX 0.0366 −0.0225 + 0.0015 i, i = 0, . . . , 30
Nasdaq-Comp. 0.0049 −0.0300 + 0.0020 i, i = 0, . . . , 30
CAC-40 0.0285 −0.0180 + 0.0012 i, i = 0, . . . , 30
SMI 0.0479 −0.0180 + 0.0012 i, i = 0, . . . , 30
Table 5.2: Normal χ2 -test: P -values and class boundaries
Next, we calculate the P -value for the same set of indices. Table 5.2 shows
the P -values of the test-statistics.
We see that the Normal hypothesis is always rejected. Basically we can con-
clude that the Normal distribution, is not sufficiently flexible to capture all fea-
tures of the data. We need at least four parameters: a location parameter, a
scale (volatility) parameter, an asymmetry (skewness) parameter and a (kurtosis)
parameter describing the decay of the tails.
We have just seen that the well-mannered bell curve of the Gaussian distri-
bution isn’t so normal at all. Next, we focus a bit more on the impact of this on
the extreme events and the corresponding implications of more fatter tails.
5.10.2 Jumps and Extreme Events

From the above it should be already clear that the stock market doesn’t behave
according to Normal laws. Finance likes it hotter, spicier, more extreme. Indeed,
extreme price swings are more likely than the Black-Scholes incorporates them.
This insight is not new. Mandelbrot for example already elaborated on it in the
sixties, long before the Black-Scholes model was ruling Wall Street.
The fact that the problem with the Normal (Gaussian) distribution lies cer-
tainly also in the tails is illustrated by looking at the most severe crashes in a fifth
years time period. More precisely, we look at the Dow Jones Industrial Average
and Table 5.3 lists the ten largest relative down moves of the Dow over the last
fifty years (1954–2004).
Under the Black-Scholes regime, what is the probability that the Dow will
suffer a big loss tomorrow? Everything depends of course on the volatility that
you plug in. Figure 5.10 shows the annualized historical volatility estimated on
the basis of, say, a three-year window. Clearly, volatility is not constant and
Date Closing logreturn Average frequency under Normal law

19-Oct-87 1738.74 -0.2563 once in 1053 years
US: 100 sexdecillion, UK : 100000 octillion
26-Oct-87 1793.93 -0.0838 once in 72503 years
15-Oct-08 8577.91 -0.0820 once in 41318 years
01-Dec-08 8149.09 -0.0801 once in 21725 years
09-Oct-08 8579.19 -0.0762 once in 6068 years
27-Oct-97 7161.15 -0.0745 once in 3402 years
17-Sep-01 8920.7 -0.0740 once in 2914 years
29-Sep-08 10365.45 -0.0723 once in 1798 years
13-Oct-89 2569.26 -0.0716 once in 1405 years
08-Jan-88 1911.31 -0.0710 once in 1173 years
Table 5.3: Ten largest down moves of the Dow since 1954)
behaves stochastically – another point we will come back to shortly. In the figure,
volatility is typically below 25%. Let us calculate for a 25% vol the frequency of a
negative log-return of -0.0582 or even worse. Under the assumption of Normality,
it happens just once every 35 years. In reality, we have witnessed ten in the last
50 years! If the mathematician Thales (c.624–c.546 BC) – one of the ancient
derivatives traders – would have been granted eternal live, he would according
to the Normal distribution have seen only one down move of -0.0716 or worse up
to now. In the last fifty years we had five! A Homo Sapiens would likely have
witnessed only one down move of -0.0838 or worse up to now. In a particularly
bad month, October 1987, there were two! What is the probability of a down
move of -0.25 or worse: It is of the order once in the 1053 years (in US language:
100 sexdecillion years, UK language: 100000 octillion years). In contrast, the Big
Bang only happened around 15 × 109 years ago. The present generation must be
really exceptional that God allowed the Dow to crash in October 1987.
Expected Shortfall
Let us focus a bit more on the modeling of extreme values and the tale a tail
has to tell. One of the main developer of the theory was the German mathemati-
cian, pacifist, and anti-Nazist Emil Julius Gumbel who described the Gumbel
distribution in the 1950s . Extreme value theory is by now a well-developed area
of statistics and finds applications in many areas of research: besides finance,
5.10. EXTRA 127
it is/can be used in hydrology, cosmology, insurance, pollution and climatology,

geology, etc.
A risk measure currently gaining in popularity is the expected shortfall, defined
as the expected excess over a given (high) level, conditionally on this level being
exceeded. The sample version of the expected shortfall over a certain level is
simply the average of the excesses over that level. The expected shortfall over the
1000 largest negative daily log-returns of the Dow are plotted in Figure 5.11(a).
Note that the expected shortfall is increasing with the level: the higher the level
being exceeded, the higher the excess by which it will be exceeded! Once more,
this is in sharp contrast with panel (b) of the same figure: for a Normal sample
with the same mean and variance, the expected shortfall decreases rapidly (note
the different axes). In a light-tailed world, given that you exceed a high level, you
hardly exceed it at all. But in a heavy-tailed world, once you know you’ll get hit,
you may get hit much harder than expected!
5.10.3 No Jumps
Brownian motion has continuous sample paths, whereas in reality prices are driven
by jumps. The Brownian motion needs a substantial amount of time to reach
a low barrier, whereas in reality jumps can cause an almost immediate move
over the barrier. This has serious impact for example on the pricing of barrier
products. Because the probability that on the short-term Brownian motion will
hit a barrier far away from its current position is almost zero, prices of down-
and-in and up-and-in type of barrier options with short maturities are completely
underestimated. Indeed since under Black-Scholes there is almost no possibility
that n the short-term the Barrier is hit and thus the options becomes ”in”, the
price of the product will be extremely low. In reality however, we have seen above
that even in one day extreme movements are possible and that actually the hitting
of the barrier is much more likelier. Processes with jumps incorporate this effect
and actually make it possible that even in the next instance the Barrier is trigger.
5.10.4 Non Constant Volatility
Another important feature which the Black-Scholes model is missing is the fact
that volatility or more generally the environment is changing stochastically over
time.
Historic Volatility
It has been observed that the volatilities estimated (or more general the parame-
ters of uncertainty) change stochastically over time. This can be seen for example
by looking at historic volatilities. Historical volatility is a retrospective measure of
volatility. It reflects how volatile the asset has been in the recent past. Historical
volatility can be calculated for any variable for which historical data is tracked.
For the SP500 index, we estimated for every day from 1971 to 2001 the stan-
dard deviation of the daily log-returns over a one year period preceding the day.
In Figure 5.12, we plot, for every day in the mentioned period, the annualized
standard deviation, i.e. we multiply the stimulated standard deviation with the
square root of the number of trading days in one calendar year. Typically, there
are around 250 trading days in one year. This annualized standard deviation
is called the historic volatility. In Figure 5.10 the historical volatility estimated
(using a three-years window) was already given for the Dow Jones Industrial Av-
erage. Clearly, we see fluctuations of this historic volatility. Moreover, we see a
kind of mean-reversion effect. The peak in the middle of the figures comes from
the stock market crash on the 19th of October 1987; windows including this day
(with an extremal down-move), give rise to very high volatilities.
Volatility Clusters
Moreover, there is evidence for volatility clusters, i.e. there seems to be a suc-
cession of periods with high return variance and with low return variance. This
can be seen for example in Figure 5.13, where the absolute log-returns of the
SP500-index over a period of more than 30 years is plotted. One clearly sees that
there are periods with high absolute log-returns and periods with lower absolute
log-returns. This is in contrast with the picture in Figure 5.14, where similarly the
absolute value of simulated normal random variables (with the empirical standard
deviation of the SP500) are graphed. Here one sees a more homogeneous picture,
often referred to as white noise. Large price variations are more likely to be fol-
lowed by large price variations. These observations motivate the introduction of
models for asset price processes where volatility is itself stochastic.
5.10. EXTRA 129
Standard Normal Density Function

0.5
0.45
0.4
0.35
0.3
f(x)
0.25
0.2
0.15
0.1
0.05
0
−5 −4 −3 −2 −1 0 1 2 3 4 5
x
Figure 5.1: Density of a standard Normal distribution (Normal(0, 1))

cdf of a standard Normal Distribution
1
N(x)
0.5
0
−5 −4 −3 −2 −1 0 1 2 3 4 5
x
Figure 5.2: Cumulative distribution function of a standard Normal Distribution

(Normal(0, 1))
5.10. EXTRA 131
Brownian Motions
2.5
1.5
0.5
Wt
−0.5
−1
−1.5
−2
−2.5
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
t
Figure 5.3: 10 paths of a standard Brownian Motion

Standard Brownian Motion

1
0.8
0.6
0.4
0.2
−0.2
−0.4
−0.6
−0.8
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Figure 5.4: A sample path of a standard Brownian motion

5.10. EXTRA 133
k=1 k=3
10 10
5 5
0 0
−5 −5
−10 −10
0 10 20 30 40 50 0 10 20 30 40 50
k=10 k=50
10 10
5 5
0 0
−5 −5
−10 −10
0 10 20 30 40 50 0 10 20 30 40 50
Figure 5.5: Random walk approximation for standard Brownian motion

Geometrical Brownian Motions

240
220
200
180
160
St
140
120
100
80
60
40
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
t
Figure 5.6: 10 paths of a Geometrical Brownian Motion (µ = 0.05, σ = 0.40)

5.10. EXTRA 135
Implied Volatility Surface (12 December 2014)

0.45
T=0.0959
T=0.1918
T=0.2685
0.4 T=0.5178
T=0.7671
T=1.0164
T=1.0932
Black Scholes implied volatility
0.35
0.3
0.25
0.2
0.15
1400 1600 1800 2000 2200 2400 2600

Strike
Figure 5.7: Implied Volatility Surface on the 12th of December 2014

Implied Volatility Surface (17 July 2015)
T=0.0959
T=0.1726
0.3 T=0.2493
T=0.4219
T=0.4986
T=0.6712
Black Scholes implied volatility
0.25 T=0.9205
0.2
0.15
0.1
1500 1600 1700 1800 1900 2000 2100 2200 2300 2400 2500
Strike
Figure 5.8: Implied Volatility Surface on the 17th of July 2015

5.10. EXTRA 137
SP500 (1970−2001) Normal and Gaussian Kernel Density Estimators

60
Kernel
50 Normal
40
30
20
10
0
−0.04 −0.03 −0.02 −0.01 0 0.01 0.02 0.03 0.04
SP500 (1970−2001) Normal and Gaussian Kernel log−Densities

4
Kernel
3 Normal
−1
−2
−0.04 −0.03 −0.02 −0.01 0 0.01 0.02 0.03 0.04
Figure 5.9: Normal density and Gaussian Kernel estimator of the density of the
daily log-returns of the SP500 index
Dow Jones Industrial Average − Historic Volatility (1954−2004)

0.26
0.24
0.22
0.2
0.18
historic vol
0.16
0.14
0.12
0.1
0.08
0.06
1954 time 2004
Figure 5.10: Dow Jones Industrial Average – Historic Volatility (1954–2004)
Dow Jones −3 Normal sample

x 10
0.2 5
4.5
0.15 4
expected shortfall
expected shortfall
3.5
0.1 3
2.5
0.05 2
1.5
0 1
0 0.02 0.04 0.06 0.08 0.1 0.005 0.01 0.015 0.02 0.025 0.03 0.035
negative logreturn negative logreturn
(a) (b)
Figure 5.11: (a) Expected shortfall over 1000 largest negative daily log-return of
the Dow (1954–2004). (b) Similarly for a Normal random sample with the same
mean and variance.
5.10. EXTRA 139
Historic Volatility (1year window) SP−500 (1970−2001)

0.4
0.35
0.3
0.25
volatility
0.2
0.15
0.1
0.05
1970 time 2001
Figure 5.12: Historic Volatilities on SP-500
absolute log returns of SP−500 (1970−2001)
0.2
0.15
absolute log return
0.1
0.05
0
1970 time 2001
Figure 5.13: Volatility clusters: absolute log-returns SP500-index between 1970

and 2001
White Noise
0.2
0.15
0.1
0.05
Figure 5.14: White Noise

Chapter 6
Monte Carlo Simulation
6.1 Pricing Derivatives by Monte Carlo Simulation

Recall that the price of a derivative is given by
price = exp(−rT )EQ [payoff],
where the expectation is taken under the pricing (risk-neutral) measure Q.

When the payoff depends on the path followed by the underlying stock price
over its lifetime in theory one has to consider every possible path. When using
30 time steps in the Binomial tree model, there are about a billion different paths
and one has to relay on (Monte Carlo) simulations.
Monte-Carlo simulation can readily be applied to price European type options:
One simulates lots of stock price paths under the risk-neutral dynamics (hence
employing the risk-neutral parameters) and evaluates for each path the payoff
function. Assume we simulated N paths and that the payoff for path i (i =
1, 2, . . . , N ) is denoted by payoffi , then the price of the derivative approximated
by
PN
payoffi
price ≈ exp(−rT ) i=1 .
N
Hence, under such a basic Monte-Carlo simulation, the price is approximated by
the discounted (equally weighted) average of the simulated payoffs.
Hence in summary, when we price derivatives by Monte Carlo simulation, the
expected payoff in a risk-neutral world is calculated using a sampling procedure.
It is then discounted at the risk-free interest rate:
141
142 CHAPTER 6. MONTE CARLO SIMULATION
1. Sample a random path for S in a risk-neutral world under the give parameter
setting.
2. Calculate the payoff from the derivative.
3. Repeat steps one and two to get many sample values of the payoff from the
derivative in a risk neutral world.
4. Calculate the mean of the sample payoff to get an estimate of the expected
payoff in a risk-neutral world.
5. Discount the estimated expected payoff at the risk-free rate to get an esti-
mate of the value of the derivative.
Up to now, we only have seen either tree models, where simulation is very
easy. For example, in the binomial tree, we have to determine in each time step,
whether we go up or down and know the (risk-neutral) probability of such possible
moves.
Next, we briefly show how, one can simulate a standard Brownian motion
W = {Wt , t ≥ 0}. Since this process is driving the Black-Scholes model, once we
have a path of such a Brownian motion, we can easily obtain a path of the stock
price process, which is essential a geometrical Brownian motion:
St = S0 exp((r − q − σ 2 /2)t + σWt ), t ≥ 0.
6.2 Simulation of a Brownian Motion

In order to simulated the paths, we discretize time by taking time steps of size
∆t, which we assume to be very small. It is not necessary to take equal time steps
in a simulation, but for our purposes it is sufficient and convenient.
Recall that standard Brownian motion W = {Wt , t ≥ 0} has Normal dis-
tributed independent increments. One can simulate (by the Euler scheme) the
value of the Brownian motion at the time points {n∆t, n = 0, 1, . . . }:
√
W0 = 0, Wn∆t = W(n−1)∆t + ∆tvn .
In Figure 6.1, we depict 10 paths of standard Brownian motions over the time
interval [0, 1]. Paths of Brownian motion are then easily transformed into paths
6.2. SIMULATION OF A BROWNIAN MOTION 143
of geometrical Brownian motion via:
St = S0 exp((r − q − σ 2 )t + σWt ), t ≥ 0,
for the relevant risk-free rate r, dividend yield q and volatility σ > 0.
In Figure 6.2, one sees the realization of the geometrical Brownian motion
based on the sample path of the standard Brownian motion of Figure 6.1.
Brownian Motions
2.5
1.5
0.5
Wt
−0.5
−1
−1.5
−2
−2.5
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
t
Figure 6.1: 10 paths of a standard Brownian Motion

6.2. SIMULATION OF A BROWNIAN MOTION 145
Geometrical Brownian Motions

240
220
200
180
160
St
140
120
100
80
60
40
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
t
Figure 6.2: 10 paths of a Geometrical Brownian Motion (µ = 0.05, σ = 0.40)


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Financial Mathematics

September 14, 2018

1 Financial Mathematics Principles 9

2.1.3 One Step Binomial Tree Revised . . . . . . . . . . . . . . . 49

3 Mathematical Finance in Discrete Time 73

4 Exotic Options and Structured Products 89

5 The Black-Scholes Model 99

5.4 Geometric Brownian Motion and The Black-Scholes Model . . . . 108

6 Monte Carlo Simulation 141

1.1 Financial Markets and Instruments

1.1.1 Basic Instruments

Interest Rates - Fixed-Income

Currencies - Foreign Exchange (FX)

A currency is the denomination of the national units of payment (money) and

Companies may wish to hedge/risk manage adverse movements of foreign cur-

1.1.3 Credit Risk Market and CDSs

1.2 Financial Derivatives and Derivatives Markets

resolution of future uncertainties.

1.3 The Risk-Free Bank Account and Discount factors

In our example it equals 0.9423. It basically is today’s value of receiving USD 1

1.4 Vanilla Options

payoff of EC(K, T ) : max(S(T ) − K, 0) = (S(T ) − K)+ .

payoff of EP (K, T ) : max(K − S(T ), 0) = (K − S(T ))+ .

of insurance against downwards market movements. The third example shows

P P N = 1000 + 30 × max (S(4) − 20, 0) = 1000 + 30 × (S(4) − 20)+

1.5 Modelling Assumptions

1.5.2 The No-Arbitrage Assumption

B(0) = 1, S(0) = 100, C(0) = 20

Asset Number Total amount in euro

Table 1.1: Portfolio I

Asset Number × Price Total amount in euro

Table 1.2: Portfolio I: up state values

B(T, d) = 1.25, S(T, d) = 75, and therefore C(T, d) = 0.

Asset Number × Price Total amount in euro

Table 1.3: Portfolio I: down state values

Asset Number Total amount in euro

Table 1.4: Portfolio II

Asset Number × Price Total amount in euro

Table 1.5: Portfolio II: up state values

Asset Number × Price Total amount in euro

Table 1.6: Portfolio II: down state values

Asset Number Total amount in Euro

Table 1.7: Portfolio III

Asset Number × Price Total amount in euro

Table 1.8: Portfolio III: up state values

Asset Number × Price Total amount in euro

Table 1.9: Portfolio III: down state values

1.6 The Put-Call Parity

S(0) − exp(−rT )K + EP (K, T ) − EC(K, T ) = 0. (1.2)

S(0) − askEC(K, T ) + bidEP (K, T ) − exp(−rT )K ≤ 0

otherwise you could have a free-lunch. Therefore:

S(0) − bidEC(K, T ) + askEP (K, T ) − exp(−rT )K ≥ 0

bidEC(K, T )−askEP (K, T ) ≤ S(0)−exp(−rT )K ≤ askEC(K, T )−bidEP (K, T ).

1.7 The Forward Contract

F orward(K, T ) = EC(K, T ) − EP (K, T ) = S(0) − exp(−rT )K.

1.8 Spread Inequalities

1.8.1 The Call Spread and Put Spread Inequality

EP (K2 , T ) > EP (K1 , T ), if K1 < K2 .

1.8.2 The Butterfly Spread Inequality

EC(K1 , T ) − EC(K2 , T ) EC(K2 , T ) − EC(K3 , T )

EP (K3 , T ) − EP (K2 , T ) EP (K2 , T ) − EP (K1 , T )

1.8.3 The Calender Spread Inequality