Call Price with Random Interest Rate

Mauricio Bedoya
javierma36@gmail.com
September 2014
To understand this blog, we must know
1. Forward price of S
(t)
.
2. Radon-Nikodym Derivative Theorem.
3. Change of Measure.
Normally the blogs that we have developed, take 2 or 3 pages maximum. This one will take
more than 3 pages, but I will guide you step by step during the whole procedure.
Forward price of S
(t)
.
Mathematically, the Forward price of S
(t)
is
F[S
(t)
, T] = S
(t)
e
r(Tt)
=
S
(t)
B(t, T)
(1)
with B(t, T) = e
r(Tt)
.
Because the Forward price is dened positive, the elements that characterize its behaviour
must be dened positive too. We can assure that B(t, T) is always positive. At the same time,
we can use the Geometric Brownian Motion under a risk neutral world, to characterize S
(t)
,
and guarantee non negativity. With this in mind, we can estimate dF[S
(t)
, T] from equation 1
(using Ito Quotient Rule)
1
dF[S
(t)
, T]
F[S
(t)
, T]
=
dS
(t)
S
(t)

dB(t, T)
B(t, T)
+ (
dB(t, T)
B(t, T)
)
2

dt
2
= 0

dS
(t)
S
(t)

dB(t, T)
B(t, T)

dt
2
= 0 and dt dw = 0
dF[S
(t)
, T]
F[S
(t)
, T]
=
S
(t)
(r dt +
(s)
dw
(t)
)
S
(t)

r dt B(t, T)
B(t, T)
dF[S
(t)
, T]
F[S
(t)
, T]
=
(s)
dw
(t)

t
0
dF[S
(u)
, T]
F[S
(u)
, T]

Lebesgue Integral
=

t
0

(s)
dw
(u)

Ito Integral
Ln[
F[S
(t)
, T]
F[S
(0)
, T]
=
(s)
w
(t)

1
2

2
t
F[S
(t)
, T] = F[S
(0)
, T] e

(s)
w
(t)

1
2

2
t
t [t,T]
(2)
Equation 2 result is Martingala (easy to prove) and characterize the evolution of F[S
(t)
, T].
Radon-Nikodym Derivative Theorem.
In this section, I will NOT restate the Theorem (search it in google or Wikipedia). In English,
how do we get the Radon-Nikodym Derivative expression
e
w
(t)

1
2

2
t
(3)
Assume that we have w
(t)
N[0, 1]; and dene a new variable Y
(t)
= w
(t)
+ . Operating, its
easy to verify that Y
(t)
N[, 1]. Now, lets estimate the quotient
dY
dW
likelihood
dY
dW
=
1

2
e

(w
(t)
)
2
2
1

2
e

w
2
(t)
2
= e

1
2

2
+w
(t)
(4)
Change of Measure
To characterize the change of measure, we must select a numeraire (N
(t)
). Next, we can say
that
2

E
N
[I
{...}
] =
1
N
(0)
E[D(t) N(T) I
{...}
] (5)
were
E[
D(t) N(T)
N(0)
|f
(t)
] = Radon Nikodym Derivative (6)
with D(t) = e
rt
. If we dene N
(t)
= S
(t)
, and implement equation 6, we will get equation 3.
Now, lets put the all in practices while we estimate the price of the European Call Option with
random interest rates. The discounted option pay-o (Risk Neutral World) is
C
(0)
=

E[D(T) (S
(T)
K) I
{S
(T)
K}
]
=

E[D(T) S
(T)
I
{S
(T)
K}
] K

E[D(T) I
{S
(T)
K}
]
= S
(0)
1
S
(0)

E[D(T)S
(T)
I
{S
(T)
K}
] KB(0, T)
1
B(0, T)

E[D(T)B(T, T)I
{S
(T)
K}
]
= S
(0)


E
S
(0)
[I
{S
(T)
K}
] K B(0, T)

E
B(0,t)
[I
{S
(T)
K}
]
(7)
In equation 7 we have two measures (numeraires): one is B(0,T) and the other one is S
(0)
.
In equation 1, we use B(t,T) as numeraire. However, we havent use S
(0)
as numeraire. From
equation 1, we know that
F[S
(T)
, T] = S
(T)
Using S
(t)
as numeraire in equation 1 we get the relation
1
F[S
(t)
, T]
=
e
r(Tt)
S
(t)
(8)
Applying Ito Quotient Rule to the previous equation we get
d(
1
F[S
(t)
,T]
)
1
F[S
(t)
,T]
=
dB(t, T)
B(t, T)

dS
(t)
S
(t)
+ (
dS
(t)
S
(t)
)
2

dS
(t)
S
(t)

dB(t, T)
B(t, T)
= r dt (r dt +
(s)
dw(t)) +
2
(s)
dt 0
=
(s)
(
(s)
dt dw(t))

dw
s
(t)
=
(s)
dw
s
(t)
(9)
Under W
s
(t),
1
F[S
(t)
,T]
is Martingala. To prove this, just integrate the previous equation in the
interval [0,T] and take expectation. Using equation 9 in 7, we get
3
C
(0)
= S
(0)


E
S
(0)
[I
{F[S
T
,T]K}
] K B(0, T)

E
B(0,t)
[I
{F[S
T
,T]K}
]
= S
(0)


E
S
(0)
[I
{F[S
(0)
,T]e

(s)
w
(T)

1
2

2
T
K}

change measure here
] K B(0, T)

E
B(0,t)
[I
{F[S
(0)
,T]e

(s)
w
(T)

1
2

2
T
K}
]
= S
(0)


E
S
(0)
[I
{F[S
(0)
,T]e
1
2

2
T
(s)
w
s
(T)
K}
] K B(0, T)

E
B(0,t)
[I
{F[S
(0)
,T]e

(s)
w
(T)

1
2

2
T
K}
]
= S
(0)


E
S
(0)
[I
{
1
2

2
T
(s)
w
s
(T)
Ln(
K
F[S
(0)
,T]
)}
] K B(0, T)

E
B(0,t)
[I
{
(s)
w
(T)

1
2

2
TLn(
K
F[S
(0)
,T]
}
]
= S
(0)


E
S
(0)
[I
{w
s
(T)

Ln(
F[S
(0)
,T]
K
)+
1
2

2
T

(s)
}
] K B(0, T)

E
B(0,t)
[I
{w
(T)

Ln(
F[S
(0)
,T]
K
)
1
2

2
T

(s)
}
]
= S
(0)


E
S
(0)
[I
{Z
(T)

Ln(
F[S
(0)
,T]
K
)+
1
2

2
T

(s)

T
}
] K B(0, T)

E
B(0,t)
[I
{Z
(T)

Ln(
F[S
(0)
,T]
K
)
1
2

2
T

(s)

T
}
]
= S
(0)
N(d1) K B(0, T) N(2)
(10)
with N characterizing the CDF of an Standard Normal Distribution.
4