03 Lecture

Fin 501: Asset Pricing
Lecture 3: One One-period Model Pricing

Prof. Markus K. Brunnermeier
Slide 03 03-1
O Overview: i Pricing Pi i
1. 2. 3 3. 4. 5. 6. 7. LOOP, No arbitrage [L2,3] Forwards [McD5] Options: Parity relationship [McD6] No arbitrage and existence of state prices [L2,3,5] Market completeness p and uniqueness q of state p prices Pricing kernel q* Four pricing formulas: state prices, prices SDF SDF, EMM EMM, beta pricing [L2,3,5,6] L2 3 5 6] 8. Recovering state prices from options [DD10.6]
Slide 03 03-2
V t Notation Vector N t ti
Notation: y,x y x Rn
y x yi xi for each i=1,,n. y > x y x and y x. x y >> x yi > xi for each i=1,,n.
Inner product
y x = i yx
Matrix multiplication
Slide 03 03-3
specify Preferences & Technology

evolution of states risk preferences aggregation
observe/specify existing Asset Prices

NAC/LOOP NAC/LOOP
absolute asset pricing
State Prices q
(or stochastic discount factor/Martingale measure)
relative asset pricing
LOOP
derive A t Prices Asset Pi
derive P i for Price f (new) ( ) asset t

Only works as long as market Slide 03 03-4 completeness doesnt change
Th Three F Forms of f NoNo N -ARBITRAGE

1. Law of one Price (LOOP) If hX = kX then p h = p k. 2. No strong arbitrage There exists no portfolio h which is a strong arbitrage, that is hX 0 and p h < 0. 3 No arbitrage 3. There exists no strong arbitrage nor portfolio k with k k X > 0 and 0 p k
Slide 03 03-5
Th Three F Forms of f NoNo N -ARBITR AGE

Law of one price is equivalent to every y portfolio p with zero p payoff y has zero price. No arbitrage => > no strong arbitrage No strong arbitrage => law of one price
Slide 03 03-6
1. 2. 3 3. 4. 5. 6. 7. LOOP, No arbitrage Forwards Options: Parity relationship No arbitrage and existence of state prices Market completeness p and uniqueness q of state p prices Pricing kernel q* Four pricing formulas: state prices, prices SDF, SDF EMM, EMM beta pricing 8. Recovering state prices from options
Slide 03 03-7
Alt Alternative ti ways to t buy b a stock t k

Four different payment and receipt timing combinations:
Outright purchase: ordinary transaction Fully leveraged purchase: investor borrows the full amount Prepaid forward contract: pay today, receive the share later Forward contract: agree on price now, pay/receive later
Payments, receipts, and their timing:
Slide 03 03-8
P i i prepaid Pricing id f forwards d

If we can price the prepaid forward (FP), then we can calculate the price for a forward contract: F = Future F t value l of f FP Pricing by analogy
In the absence of dividends, the timing of delivery is irrelevant Price of the prepaid forward contract same as current stock price FP0, T = S0 (where the asset is bought at t = 0, delivered at t = T)
Slide 03 03-9
P i i prepaid Pricing id f forwards d (cont.)

Pricing g by y arbitrage g
If at time t=0, the prepaid forward price somehow exceeded the stock price, i.e., FP0, T > S0 , an arbitrageur could do the following: g
Slide 03 03-10

What if there are deterministic* dividends? Is FP0, T = S0 still valid?
No, because the holder of the forward will not receive dividends that will be paid to the holder of the stock FP0, T < S0 FP0, T = S0 PV(all dividends paid from t=0 to t=T) For discrete dividends Dti at times ti, i = 1,., n
The prepaid forward price: FP0, T = S0 (reinvest the dividend at risk-free rate)
n i=1
PV0, ti (Dti)
For continuous dividends with an annualized yield

The prepaid forward price: FP0, T = S0 eT (reinvest the dividend in this index. One has to invest only S0 eT initially)
* NB 1: if dividends are stochastic, we cannot apply the one period model

Slide 03 03-11

Example 5.1
XYZ stock costs $100 today and will pay a quarterly dividend of $1 25 If the risk-free rate is 10% compounded continuously $1.25. continuously, how much does a 1-year prepaid forward cost? FP0, 1 = $100
4 $1.25e0.025i = i=1
$95.30
Example 5.2
The index is $125 and the dividend yield is 3% continuously compounded. p How much does a 1-year y p prepaid p forward cost? FP0,1 = $125e0.03 = $121.31
Slide 03 03-12
Pricing Pi i f forwards d on stock t k

Forward price is the future value of the prepaid forward
No dividends: F0, T = FV(FP0, T ) = FV(S0) = S0 erT
rT r(T-ti)D Discrete dividends: F0, ti 0 T = S0 e i=1 e Continuous dividends: F0, T = S0 e(r-)T n
Forward premium
The difference between current forward price and stock price Can be used to infer the current stock price from forward price Definition:
Forward premium = F0, T / S0 Annualized forward premium =: a = (1/T) ln (F0, T / S0)
(from e T=F0,T / S0 )
Slide 03 03-13
C ti a synthetic Creating th ti forward f d

One can offset the risk of a forward by creating a synthetic f forward d to offset ff a position ii i in the h actual lf forward d contract How can one do this? (assume continuous dividends at rate )
Recall the long forward payoff at expiration: = ST - F0, T Borrow B and d purchase h shares h as f follows: ll
Note that the total payoff at expiration is same as forward payoff

Slide 03 03-14
Creating a synthetic forward

(cont.) The idea of creating synthetic forward leads to following:
Forward = Stock zero-coupon bond Stock = Forward + zero-coupon bond Zero-coupon bond = Stock forward
Cash-and-carry Cash and carry arbitrage: Buy the index, short the forward
T bl 5.6 Table 56
Slide 03 03-15
Oth issues Other i i in f forward d pricing i i

Does the forward price predict the future price?
According the formula F0, T = S0 e(r-)T the forward price conveys no additional information beyond what S0 , r, r and provides Moreover, the forward price underestimates the future stock price
Forward pricing formula and cost of carry

Forward price =
Spot price + Interest to carry the asset asset lease rate
Cost of carry, (r-)S
Slide 03 03-16
Slide 03 03-17
P Put Putt-Call C ll P Parity it

For European options with the same strike price and time to expiration the parity relationship is:
Call put = PV (forward price strike price) or C(K, T) P(K, T) = PV0,T (F0,T K) = e-rT(F0,T K)
Intuition:
Buying a call and selling a put with the strike equal to the forward price (F0,T T = K) creates a synthetic forward contract and hence must have a zero price.
Slide 03 03-18
P it f Parity for Options O ti on Stocks St k

If underlying asset is a stock and Div is the deterministic* dividend stream, then e-rT F0,T = S0 PV0,T (Div), therefore
C(K, T) = P(K, T) + [S0 PV0,T (Div)] e-rT(K)
Rewriting above,
T(K) S0 = C(K, T) P(K, T) + PV0,T (Div Di ) + e-rT
For index options, S0 PV0,T (Div) = S0e-T, therefore

C(K, T) = P(K, T) + S0e-T PV0,T (K)
* ll *allows to t stick ti k with ith one period i d setting tti

Slide 03 03-19
O ti price Option i b boundaries d i

American vs. European
Since an American option can be exercised at anytime, whereas a European option can only be exercised at expiration, an American option must always be at least as valuable as an otherwise p option: p identical European CAmer(S, K, T) > CEur(S, K, T)
Option price boundaries
PAmer(S, K, T) > PEur(S, K, T)
Call price cannot: be negative, exceed stock price, be less than price implied by put-call parity using zero for put price: S > CAmer(S, K, T) > CEur(S, K, T) > > max [0, PV0,T(F0,T) PV0,T(K)]
Slide 03 03-20
O ti price Option i b bounderies d i (cont.)

Option price boundaries
Call price cannot:
be negative g exceed stock price be less than price implied by put-call parity using zero for put price: S > CAmer(S, K, T) > CEur(S, K, T) > max [0, PV0,T(F0,T) PV0,T(K)]
Put price cannot:

be more than the strike price be less than price implied by put-call parity using zero for call price: K > PAmer(S, K, T) > PEur(S, K, T) > max [0, PV0,T (K) PV0,T(F0,T)]
Slide 03 03-21
Early E l exercise i of fA American i call ll

Early exercise of American options
A non-dividend paying American call option should not be exercised early early, because:
CAmer > CEur > St K + PEur+K(1-e-r(T-t)) > St K
That means, one would lose money be exercising early instead of selling the option If there are dividends, it may be optimal to exercise early It may be optimal to exercise a non-dividend paying put option early if the underlying stock price is sufficiently low
Slide 03 03-22
O ti Options: Time Ti to t expiration i ti

Time to expiration An American option (both put and call) with more time to expiration is at least as valuable as an American option with less time to expiration. This is because the longer option can easily be converted into the shorter option by exercising it early. European call options on dividend-paying stock and European puts may be less valuable than an otherwise identical option with less time to expiration. A European call option on a non-dividend paying stock will be more valuable than an otherwise identical option with less time to expiration expiration. Strike price does not grow at the interest rate. When the strike price grows at the rate of interest, European call and put prices on a non-dividend paying stock increases with time. Suppose to the contrary P(T) < P(t) for T>t, then arbitrage. Buy P(T) and sell P(t) initially. At t if St>Kt, P(t)=0. if St<Kt, negative payoff St Kt. Keep stock and finance Kt. Time T-value ST-Kter(T-t)=ST-KT.
Slide 03 03-23
O ti Options: Strike St ik price i

Different strike Diff ik prices i (K1 < K2 < K3), ) for f both b hE European and d American options A call with a low strike price is at least as valuable as an g strike p price: otherwise identical call with higher C(K1) > C(K2) A put with a high strike price is at least as valuable as an otherwise identical call with low strike price: P(K2) > P(K1) The premium difference between otherwise identical calls with different strike prices cannot be greater than the p difference in strike prices: C(K1) C(K2) < K2 K1 K2 K1
Price of a collar < maximum payoff of a collar Note for K3-K2 more pronounced, hence (next slide) !
Slide 03 03-24
O ti Options: Strike St ik price i (cont.)

Diff Different strike ik prices i (K1 < K2 < K3), ) f for both b h European and American options
The premium difference between otherwise identical puts t with ith different diff t strike t ik prices i cannot tb be greater t th than the difference in strike prices: P(K1) P(K2) < K2 K1 Premiums Premi ms decline at a decreasing rate for calls with ith progressively higher strike prices. (Convexity of option price with respect to strike price): C(K1) C(K2) K1 K2 C(K2) C(K3) K2 K3
Slide 03 03-25
O ti Options: Strike St ik price i
Slide 03 03-26
P Properties ti of f option ti prices i (cont.)
Slide 03 03-27
Summary Su ayo of pa parity y relationships
Slide 03 03-28
Overview: O e e Pricing c g-o one e pe period od model

Slide 03 03-29
back b kt to the th big bi picture i t

State space (evolution of states) (Risk) preferences Aggregation over different agents Security structure prices of traded securities Problem: Difficult to observe risk preferences What can we say about existence of state prices without assuming specific utility functions/constraints for all agents in the economy
Slide 03 03-30


NAC/LOOP NAC/LOOP
State Prices q
LOOP

Th Three F Forms of f NoNo N -ARBITRAGE

1. Law of one Price (LOOP) If hX = kX then p h = p k. 2. No strong arbitrage There exists no portfolio h which is a strong arbitrage, that is hX 0 and p h < 0. 3 No arbitrage 3. There exists no strong arbitrage nor portfolio k with k k X > 0 and 0 p k
Slide 03 03-32
Pi i Pricing
Define for each z <X>,
If LOOP holds h ld q(z) ( ) is i a single-valued i l l d and d linear functional. (i.e. if h and h lead to same z, then price has to
be the same)
Conversely, if q is a linear functional defined in <X> then the law of one price holds holds.
Slide 03 03-33
Pi i Pricing
LOOP q(h hX X) = p .h A linear functional Q in RS is a valuation function if
S, where qs = Q(e ), and e Q(z) = q .z for some q R s s is the vector with ess = 1 and esi = 0 if i s
Q(z) = q(z) for each z <X>.
es is an Arrow-Debreu security y
q is a vector of state prices
Slide 03 03-34
State prices q
q is a vector of state prices if p = X q, that is pj = xj q for each j = 1,,J , , If Q(z) = q z is a valuation functional then q is a vector of state prices Suppose q is a vector of state prices and LOOP holds holds. Then if z = hX LOOP implies that
Q(z) = q z is a valuation functional iff q is a vector of state prices and LOOP holds
Slide 03 03-35
State prices q
p(1,1) = q1 + q2 p(2,1) = 2q1 + q2 Value of portfolio (1,2) (1 2) 3p(1,1) p(2,1) = 3q1 +3q2-2q1-q2 = q1 + 2q2
c2
q2 q1
c1
Slide 03 03-36
The e Fundamental u da e ta Theorem eo e o of Finance

Proposition 1. Security prices exclude arbitrage if and only if there exists a valuation functional with q >> 0. Proposition 1. Let X be an J S matrix, and p RJ. There is no h in RJ satisfying h p 0, h h X 0 and at least one strict inequality if, and only if, there exists a vector q RS with q >> 0 and d p = X q.
No arbitrage positive state prices
Slide 03 03-37
Slide 03 03-38
Multiple State Prices q & Incomplete Markets

bond (1,1) only
c2
q2
What state prices are consistent with p(1,1)? p(1 1) = q1 + q2 p(1,1) Payoff space <X> One equation two unknowns q1, q2 There are (infinitely) many. e.g. if p(1,1)=.9 p(1,1) q1 =.45, , q2 =.45 or q1 =.35, q2 =.55
c1
q1
Slide 03 03-39
Q(x)
x2
complete markets <X> q

x1
Slide 03 03-40
Q(x)
p=Xq
x2
<X> incomplete markets
q
x1
Slide 03 03-41
Q(x)
p=Xqo
x2
<X> incomplete markets
qo
x1
Slide 03 03-42
Multiple u p e q in incomplete co p e e markets c

2
<X>
q* qo v q
p=Xq
c1
Many possible state price vectors s.t. s t p=X p=Xq q. One is special: q* - it can be replicated as a portfolio.
Slide 03 03-43
Uniqueness U que ess a and d Completeness

Proposition 2. If markets are complete, under no arbitrage there exists a unique valuation functional. If markets are not complete, then there exists v i\ RS with 0 = Xv. Suppose there is no arbitrage and let q >> 0 be a vector of state prices. Then q + v >> 0 provided is small enough, and p = X X (q + v). ) Hence Hence, there are an infinite number of strictly positive state prices.
Slide 03 03-44

Slide 03 03-45
F Four Asset A t Pricing P i i Formulas F l

1. State p prices pj = s qs x s j 2. Stochastic discount factor factorpj = E[mxj]
m1 m2 m3 xj1 xj2 xj3
3. Martingale measure 4. State State-price beta model

(in returns Rj := xj /pj)
(reflect risk aversion by over(under)weighing the bad(good) states!)
^ j] pj = 1/(1+rf) E [x
E[Rj] - Rf = j E[R*- Rf]

Slide 03 03-46
1. 1 St State t Price P i Model M d l

so far price in terms of Arrow-Debreu (state) ( ) prices p
p =
j q x s s s
Slide 03 03-47
2 St 2. Stochastic h ti Di Discount tF Factor t
That is, stochastic discount factor ms = qs/s for all s s.
Slide 03 03-48
2 Stochastic Discount Factor 2.

shrink axes by factor
<X>
m* m
c1
Slide 03 03-49
Ri Risk Riskk-adjustment dj t t in i payoffs ff

p = E[mx E[ j] = E[m]E[x] E[ ]E[ ] + Cov[m,x] C [ ] Since pbond=E[m1]. E[m1]. Hence, the risk free rate Rf =1/E[m]. 1/E[m]. p = E[x]/Rf + Cov[m,x] Remarks: (i) If risk risk-free free rate does not exist exist, Rf is the shadow risk free rate (ii) Typically Cov[m,x] < 0, which lowers price and increases return
Slide 03 03-50
3 Equivalent Martingale Measure 3.

Price of any asset Price of a bond
Slide 03 03-51
in i R Returns: t Rj=xj/p / j
E[mRj]=1 Rf E[m]=1 => E[m(Rj-Rf)]=0 E[m]{E[Rj]-Rf} + Cov[m,Rj]=0 E[Rj] Rf = - Cov[m,Rj]/E[m] also holds for portfolios h (2)
Note: risk correction depends only on Cov of payoff/return with discount factor factor. Only compensated for taking on systematic risk not idiosyncratic risk.
Slide 03 03-52
4 State4. State-price BETA Model

shrink axes by factor c2 <X> let underlying asset be x=(1.2,1) R* m* m c1 R*= m*
p=1
(priced with m*)
Slide 03 03-53
4 St 4. State Statet -price i BETA Model M d l

E[Rj] Rf = - Cov[m,Rj]/E[m] (2) also holds for all portfolios h and we can replace m with m* Suppose (i) Var[m*] > 0 and (ii) R* = m* with > 0 E[Rh] Rf = - Cov[R*,Rh]/E[R*] (2)
Define h := Cov[R*,Rh]/ Var[R*] for any portfolio h
Slide 03 03-54
4 St 4. State Statet -price i BETA Model M d l

(2) f for Rh: E[Rh]-R ] Rf=-Cov[R C [R*,R Rh]/E[R*] = - h Var[R*]/E[R*] (2) f for R*: E[R*]-R ] Rf=-Cov[R C [R*,R R*]/E[R*] =-Var[R*]/E[R*] Hence, Hence E[R E[ Rh] - Rf = h E[R*- Rf] where h : := Cov[R*,Rh]/Var[R*] very general but what is R* in reality?
Regression Rhs = h + h (R*)s + s with Cov[R*,]=E[]=0
Slide 03 03-55
F Four Asset A t Pricing P i i Formulas F l

1. State p prices 1 = s qs Rsj 2. Stochastic discount factor factor1 = E[mRj]
m1 m2 m3 xj1 xj2 xj3
3. Martingale measure 4. State State-price beta model

(in returns Rj := xj /pj)
(reflect risk aversion by over(under)weighing the bad(good) states!)
j] 1 = 1/(1+rf) E^ [R
E[Rj] - Rf = j E[R*- Rf]

Slide 03 03-56
Wh t do What d we know k about b t q, m, , R*?

^
Main results so far

Existence iff no arbitrage
Hence, single factor only but doesnt famos Fama-French factor model has 3 factors? multiple factor is due to time-variation (wait for multi-period model)
Uniqueness if markets are complete

Slide 03 03-57
Diff Different t Asset A t Pricing P i i Models M d l

pt = E[mt+1 xt+1]
where
mt+1=f( (, ,, , )
=> E[Rh] - Rf = h E[R*- Rf] where h := Cov[R*,Rh]/Var[R*]
f() = asset pricing model General Equilibrium f() = MRS / Factor Pricing Model a+b1 f1,t+1 + b2 f2,t+1 CAPM CAPM f M R*=Rf ( (a+b1RM) )/(a+b ( 1R ) a+b1 f1,t+1 = a+b R 1t 1 1 M
where R = return of market portfolio Is b1 < 0?

Slide 03 03-58
Diff Different t Asset A t Pricing P i i Models M d l

Theory
All economics and modeling is determined by mt+1= a + b f Entire content of model lies in restriction of SDF
Empirics
m* (which is a portfolio payoff) prices as well as m (which is e.g. a function of income, investment etc.) measurement error of m* is smaller than for any m Run regression on returns (portfolio payoffs)! (e.g. Fama-French three factor model)
Slide 03 03-59

Slide 03 03-60


NAC/LOOP NAC/LOOP
State Prices q
LOOP

Recovering eco e g S State a e Prices ces from o Option Prices

Suppose that ST, the price of the underlying portfolio (we may think of it as a proxy for price of market portfolio), portfolio ), assumes a "continuum" continuum of possible values. Suppose there are a continuum of call options with different strike/exercise prices markets are complete Let us s construct constr ct the following follo ing portfolio portfolio: for some small positive number >0,
Buy one call with Sell one call with Sell one call with Buy one call with
E=S T 2 E=S T 2 + E=S
T 2
+ + E . =S T 2
Slide 03 03-62
Recovering R i State St t Prices Pi (ctd.) ( td )
Slide 03 03-63

Let us thus consider buying 1/ units of the portfolio. The S S + , is 1 1, for total payment, when S T T T 2 2 any choice of . We want to let a 0 , so as to eliminate ,S ) the payments in the ranges ST [ S and T T 2 2 1 ST ( ST + , ST + + ]. The value of / units of this p portfolio 2 2 is :
1 T /2 ) C (S, T /2) {C (S, S K=S S K=S T + /2) C (S, K = S T + /2 + )]} [C (S, K = S

Slide 03 03-64
Taking the limit 0

1 T /2)[C (S, K = S T + /2)C (S, K = S T + /2+)]} T /2)C (S, K = S lim {C (S, K = S 0
T /2 ) C (S, K = S T /2) T + /2 + ) C (S, K = S T + /2) C (S, K = S C (S, K = S lim { }+lim { } 0 0 {z } {z } | |
0 0
Payoff
Divide by and let 0 to obtain state price density as 2C/ K2.
$T S
$T S
$T + S 2
ST
Slide 03 03-65

Evaluating following cash flow
The value today of this cash flow is :
Slide 03 03-66
R Recovering i State St t Prices Pi (di (discrete setting) i )
Slide 03 03-67
Table 8.1 Pricing an Arrow-Debreu State Claim

E 7 C(S,E) 3.354 -0.895 8 9 10 11 12 13 2 459 2.459 -0.789 1.670 1.045 0.604 0.325 -0.161 0 161 0.164 0.184 0 0 0 1 0 0 0 +1.670 -2.090 2.090 +0.604 0 0 0 0 0 0 0 0 0 1 0 0 2 -2 2 0 3 -4 4 1 4 -0.625 -6 6 -0.441 2 -0.279 0.118 0.162 0.184 0.164 0 106 0.106 Cost of position 7 8 Payoff if ST = 9 10 11 12 13 C C) qs (C)=
Slide 03 03-68


NAC/LOOP NAC/LOOP
State Prices q
LOOP


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Fin 501: Asset Pricing

Lecture 3: One One-period Model Pricing

Fin 501: Asset Pricing

Fin 501: Asset Pricing

Fin 501: Asset Pricing

specify Preferences & Technology

observe/specify existing Asset Prices

absolute asset pricing

relative asset pricing

derive A t Prices Asset Pi

derive P i for Price f (new) ( ) asset t

Fin 501: Asset Pricing

Th Three F Forms of f NoNo N -ARBITRAGE

Fin 501: Asset Pricing

Th Three F Forms of f NoNo N -ARBITR AGE

Fin 501: Asset Pricing

Fin 501: Asset Pricing

Alt Alternative ti ways to t buy b a stock t k

Payments, receipts, and their timing:

Fin 501: Asset Pricing

P i i prepaid Pricing id f forwards d

Fin 501: Asset Pricing

P i i prepaid Pricing id f forwards d (cont.)

Fin 501: Asset Pricing

P i i prepaid Pricing id f forwards d (cont.)

For continuous dividends with an annualized yield

* NB 1: if dividends are stochastic, we cannot apply the one period model

Fin 501: Asset Pricing

P i i prepaid Pricing id f forwards d (cont.)

Fin 501: Asset Pricing

Pricing Pi i f forwards d on stock t k

Fin 501: Asset Pricing

C ti a synthetic Creating th ti forward f d

Note that the total payoff at expiration is same as forward payoff

Fin 501: Asset Pricing

Creating a synthetic forward

Fin 501: Asset Pricing

Oth issues Other i i in f forward d pricing i i

Forward pricing formula and cost of carry

Fin 501: Asset Pricing

Fin 501: Asset Pricing

P Put Putt-Call C ll P Parity it

Fin 501: Asset Pricing

P it f Parity for Options O ti on Stocks St k

For index options, S0 PV0,T (Div) = S0e-T, therefore

* ll *allows to t stick ti k with ith one period i d setting tti

Fin 501: Asset Pricing

O ti price Option i b boundaries d i

Option price boundaries

PAmer(S, K, T) > PEur(S, K, T)

Fin 501: Asset Pricing

O ti price Option i b bounderies d i (cont.)

Put price cannot:

Fin 501: Asset Pricing

Early E l exercise i of fA American i call ll

Fin 501: Asset Pricing

O ti Options: Time Ti to t expiration i ti

Fin 501: Asset Pricing

O ti Options: Strike St ik price i

Fin 501: Asset Pricing

O ti Options: Strike St ik price i (cont.)

Fin 501: Asset Pricing

O ti Options: Strike St ik price i

Fin 501: Asset Pricing

Define h := Cov[R,Rh]/ Var[R] for any portfolio h