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ST439 - Chapter 1
Financial derivatives, Binomial models
Beatrice Acciaio
Department of Statistics
the London School of Economics and Political Science
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Financial Derivatives Binomial models Risk neutral valuation
More on derivatives
I A European put option written on an underlying S, with strike
K and exercise date T , gives the holder the right to sell the
underlying asset in T at price K . The payoff is (K − ST )+ .
The term European means that the option can only be
exercised exactly at the date of maturity. We instead use
American to indicate that the option can be exercised any
time before maturity.
The term option refers to the fact that the owner has the
right but not the obligation to buy/sell.
Since payoffs of derivatives depend on some underlying value, they
are usually called contingent claims. The underlying objects can
be: stock, FX, bond, swap, mortgage, commodity, weather,...
Some simple standard options are traded in exchanges, more
complicated ones are traded over the counter (OTC).
Derivatives can be used to reduce risk in underlying assets or
to speculate on future price movements.
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Assumptions
No portfolio constraint: h ∈ R2 (short positions, as well as
fractional holdings, are allowed).
No bid-ask spread.
No transaction costs of trading.
The market is perfectly liquid: possible to buy or sell
unlimited quantities on the market. (Possible to borrow
unlimited amounts from the bank.)
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Financial Derivatives Binomial models Risk neutral valuation
Arbitrage
The value process of the portfolio h is
That is
V0 = x + ys,
ysu , with prob. pu
V1 = x(1 + r ) +
ysd , with prob. pd
Definition
An Arbitrage is a portfolio h such that
V0h = 0,
P(V1h ≥ 0) = 1 and P(V1h > 0) > 0.
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Financial Derivatives Binomial models Risk neutral valuation
Arbitrage free
Proposition
The model above is arbitrage free if and only if
d ≤ 1 + r ≤ u. (NA)
proof.
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Financial Derivatives Binomial models Risk neutral valuation
Martingale measure
1 + r = qu u + qd d.
As a result,
1
EQ [S1 ] = S0 ,
1+r
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Financial Derivatives Binomial models Risk neutral valuation
Martingale measure
Definition
A probability measure Q is called a martingale measure (or
risk-neutral measure) if the process (1+r )−t St is a Q-martingale.
Proposition
The market model is arbitrage free if and only if there exists a
martingale measure Q.
Proposition
For the binomial model above, the martingale probabilities are
given by
(1 + r ) − d u − (1 + r )
qu = and qd = .
u−d u−d
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Financial Derivatives Binomial models Risk neutral valuation
Definition
A given contingent claim X is said to be attainable (eqv. perfectly
replicable) if there exists a portfolio h such that V1h = X a.s.. Such
an h is called a hedging portfolio (eqv. replicating portfolio) for X .
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Financial Derivatives Binomial models Risk neutral valuation
Pricing principle
Π(t; X ) = Vth , t = 0, 1.
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Financial Derivatives Binomial models Risk neutral valuation
Complete market
Definition
The market is complete if every contingent claim is attainable.
Therefore the pricing issue is settled for all contingent claims in
complete markets (and each claim has a unique price).
Proposition
Assume that the binomial model is free of arbitrage, then it is also
complete.
proof.
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Financial Derivatives Binomial models Risk neutral valuation
Proposition
If the binomial model is arbitrage free, then the arbitrage free price
of a contingent claim X is given by
1
Π(0; X ) = EQ [X ].
1+r
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Financial Derivatives Binomial models Risk neutral valuation
Remarks
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Financial Derivatives Binomial models Risk neutral valuation
Imagine someone offers you the following deal: a (fair) coin will be
flipped and if Head comes up, then you will receive 10000 GBP, if
Tail comes up you will have to pay 10000 GBP. (Think of r = 0.)
Will you enter the game at 0 price? Think about it... This
would be the ”evaluation” under the objective probability (1/2
probability of Head and 1/2 of Tail). But...we are risk averse!
So, for example, you may be willing to enter the bet for 3000
GBP (i.e., you are paid 3000 GBP to play the game). This
basically corresponds to ”giving higher probability” to the
event that we fear (losing 10000 GBP).
Think: what is the ”martingale measure” here?
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Financial Derivatives Binomial models Risk neutral valuation
Example
We set S0 = 100, u = 1.2, d = 0.8, pu = 0.6, pd = 0.4 and r = 0.
Calculate the arbitrage free prices of a European call option and a
European put option with strike K = 110. Then calculate the
replicating portfolios.
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Financial Derivatives Binomial models Risk neutral valuation
Self-financing portfolio
Consider any market, in discrete time t = 0, 1, . . . , T , consisting of
a bank account B and a risky asset S.
Definition
A portfolio (xt , yt ) (where xt =n. of units in B held at time t, and
yt =n. of shares of S held at time t) is a self-financing portfolio if
xt Bt+1 + yt St+1 = xt+1 Bt+1 + yt+1 St+1 , for t = 0, · · · , T − 1.
(no fund is added or withdrawn at any moment)
The previous identity is equivalent to the following one, where Vt
is the value of the portfolio at time t:
Vt+1 − Vt = xt (Bt+1 − Bt ) + yt (St+1 − St ), t = 0, · · · , T − 1,
Vt = V0 + t−1
P Pt−1
that is u=0 xu ∆Bu + u=0 yu ∆Su .
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Financial Derivatives Binomial models Risk neutral valuation
St = su j d t−j , j = 0, · · · t, t = 0, · · · , T
t
Bt = (1 + r ) , t = 0, · · · , T .
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Pricing algorithm
Proposition
Assume NA. Then any T -claim X = Φ(ST ) can be replicated
using a self-financing portfolio. If Vt (j) denotes the value of the
portfolio at the node (t, j), then Vt (j) can be computed recursively
1
Vt (j) = (qu Vt+1 (j + 1) + qd Vt+1 (j)) ,
1+r
VT (j) = Φ(su j d T −j ).
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Key messages
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More exercises
1. Consider the market model with a bank account with interest rate
r = 0.05, and a stock with S0 = 80 and S1 = 120; 90; 60 with respective
probabilities pu = 0.2, pm = 0.3, pd = 0.5.
Compute the set of arbitrage free prices for the European put option
(100 − S1 )+ .
Is it possible to replicate that put?
Find the set of all attainable contingent claims.
2. Consider the market model with a bank account B0 = 1 and B1 = 1.5,
and a stock with S0 = 1.5 and S1 = 3; 1.5; 0.5 with respective
probabilities pu = 1/2, pm = 1/3, pd = 1/6.
Is it possible to replicate the payoff Y1 = 1; 0; 2 with B and S?
Draw conclusions on the completeness of the market (B, S).
Is the market free of arbitrages? If so, determine all the martingale
measures.
Determine the interval of fair prices for the claim Y1 .
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Financial Derivatives Binomial models Risk neutral valuation
Final notes
Recommended readings:
Steven E. Shreve: “Stochastic Calculus for Finance I”,
Chapters: 1, 2
Refresh what you have seen in ST409, we’ll fish a lot from
there next time!
About exercises.
Every time I will leave you few exercises as homework. These are
meant for you to learn and improve your skills (you shall not turn
them in). Some of them will be solved in class on the subsequent
lecture (by myself, unless there is some volunteer...). Anyway, the
solution to all exercises will be posted on Moodle by the end of the
term.
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