Lecture 1

Discrete models
Stochastic Finance in Continuous Time

Lecture 1
Paweª Kliber
Poznan University of Economics and Business
Paweª Kliber Stochastic Finance

Discrete models
An option
Price of the stock is 100e.
In three month two possible outcomes (110e or 90e).
The increase in price is more likely (probability 90%).
Consider a call option with execution price 100e, executed in three

month.
What should be today's price of the option?

Discrete models
Bull market

Discrete models
Bear market

Discrete models
Arbitrage argument
Consider possible payments of a nancial instrument
Consider payments of other instruments
Can you replace one payments with a combination of others?
Todays' prices should be consistent
Arbitrage an opportunity of making sure prots without any risk

Discrete models
The Law of One Price
Rule (Law of One Price)
A single good must sell for the same price in all locations.
In the context of nancial modelling
Rule (Law of One Price)
Financial instruments (assets or portfolios) with the same payos must

have the same price.

Discrete models
Forward contract
Consider forward contract on a stock S with delivery price K.

You can make a portfolio of investments in the underlying stock and in a
risk-free bond maturing at the time of delivery (the current price of the
bond is P(0, T )).
How the payos of this instruments are connected?
What should be the price of the forward contract?

Discrete models
One period binomial model
Two assets: a risk-free bond (bank account) and a stock
Risk free bond: B0 = 1, B1 = 1 + r

Stock there can be two dierent outcomes (higher u or lower d)

Discrete models
Bank account
There are two possible ways in dening the value of the bank account
Simple compounding: B0 = 1, B1 = 1 + r
Continuous compounding: B0 = 1, B1 = e r˜
Connection between them:
r = e r˜ − 1
r˜ = ln(1 + r )

Discrete models
Model

Discrete models
Further assumptions
Frictionless market
No transaction costs
Buying and selling prices are the same
No limits on the position size
No restrictions on short selling
The investor is price-taker. His transactions do not aect prices
Perfect liquidity
Perfect divisibility of assets
Interest rate for borrowing and lending is the same

Discrete models
Probabilistic model
S1 = S0 Z ,
where Z is a discrete random variable with the following distribution
P(Z = u) = p = 1 − P(Z = d).
More formally
Z = uU + d(1 − U),
where U is a random variable from Bernoulli distributions, i.e.
P(U = 1) = p,
P(U = 0) = 1 − p.

Discrete models
Another specication
S1 = S0 e Z ,
where Z is a discrete random variable with the following distribution
˜
P(Z = ũ) = p = 1 − P(Z = d).
˜
u = e ũ , d = e d
ũ = ln(u) d˜ = ln(d)

Discrete models
Some processes
Portfolio (or investment strategy) is a vector H = (h0 , h1 ) ∈ R2 .

h0 investment in bonds (or in money account)
h1 investment in stock (number of shares)
Value process: Vt = h0 Bt + h1 St , (t = 0, 1)
Gain process: G = h0 ∆B + h1 ∆S
Discounted processes S̃t = BStt
Ṽt = h0 B̃t + h1 S̃t , (t = 0, 1)
G̃ = h0 ∆B̃ + h1 ∆S̃ = h1 ∆S̃

Discrete models
Arbitrage opportunity
Arbitrage portfolio a portfolio that makes prot out of nothing.
V0 = 0
V1 ≥ 0
P(V1 > 0) > 0
It can be shown that it is equivalent to
G̃ ≥ 0
P(G̃ > 0) > 0

Discrete models
Arbitrage
Lack of arbitrage
The condition for the lack of arbitrage portfolio is as follows:
d <1+r <u
This means that 1 +r is between d and u.

One can express 1 +r as a weighted average of d and u:
1 + r = qu + (1 − q)d,
where 0 <q<1 can be interpreted as probability. In fact
1 +r −d u − (1 + r )
q= , 1 −q = .
u−d u−d

Discrete models
Expectations
Multiply by s and divide by 1 + r:

1
s= [qsu + (1 − q)du]
1 +r
But on the RHS there are possible stock's prices at the moment 1!
Martingale expectations
If there is no arbitrage, then
1
S0 = EQ [S1 ] .
1 +r
Today's price of stock is the discounted expected value of tomorrow's
prices (with respect to probabilities q, 1 − q ).

Discrete models
Contingent claims
Financial instrument or (contingent claim) any random variable of

the form X = Φ(Z ), where Z is random variable driving the stock price.
In this model nancial instrument can be describe by two numbers: xu

and xd payos in upper and lower state.

Discrete models
Replication of contingent claims
Is contingent claim equivalent to any portfolio?
xu = h0 (1 + r ) + h1 us
xd = h0 (1 + r ) + h1 ud
or, in matrix notation:

xu 1+r us h0
=
xd 1+r ud h1
If d <u the matrix is nondegenerate and there exists a solution.

Discrete models
Replication
The solution is
xd u − xu d
h0 =
(1 + r )(u − d)
xu − xd
h1 =
s(u − d)
The current value of the replicating portfolio equals
xd u − xu d xu − xd
V0 = + ·s =
(1 + r )(u − d) s(u − d)

1 1+r −d u − (1 + r )
= xu + xd =
1+r u−d u−d

1 1 Q Q X
= (qxu + (1 − q)xd ) = E [X ] = E
1 +r 1 +r 1+r

Discrete models
Change of the numeraire
1 xu usq xd ds(1 − q)
V0 = (qxu + (1 − q)xd ) = s +s
1 +r us s(1 + r ) ds s(1 + r )
Let us dene
usq ds(1 − q)
qS = , (1 − q S ) =
s(1 + r ) s(1 + r )
We can check that q S + (1 − q S ) = 1. Thus
u d

V0 Sx S x QS X
=q + (1 − q ) =E
S0 su sd S1

Discrete models
Multiperiod binomial model
T +1 moments of time. Time horizon T = {0, 1, 2, . . . , T }.

Two assets: a risk-free bond and a stock
Risk free bond: Bt = (1 + r )t

Stock at each moment there can be two dierent gross rates of
return (higher u or lower d)

Discrete models
Model mathematically
St = S0 u Nt d t−Nt ,
where
Nt = Z1 + Z2 + Z3 + . . . + Zt ,
Zt iid (identically distributed and independent) random variables from
Bernoulli distribution. The distribution of Nt is binomial Zt ∼ B(t, p).

Discrete models
Binomial tree

Discrete models
Strategy
Strategy is a stochastic process Ht = (h0 (t), h1 (t)), t = 1, 2, . . . , T . It is

a portfolio created at the moment t − 1 and held till the moment t .
From this denition Ht ∈ Ft−1 it is a predictable process.

Discrete models
Some processes
Value process
V0 = h0 (1)B0 + h1 (1)S0
Vt = h0 (t)Bt + h1 (t)St , (t = 1, 2, . . . , T )
Gain process
∆Gt = h0 (t)∆Bt + h1 (t)∆St = rh0 (t)Bt−1 + h1 (t)∆St
Discounted processes
Ṽt = h0 (t) + h1 (t)S̃t , (t = 1, 2, . . . , T )
∆G̃t = h1 (t)∆S̃t

Discrete models
Self-nancing portfolios
Portfolio is self-nancing if it meets the following condition

Vt−1 = h0 (t − 1)Bt−1 + h1 (t − 1)St−1 = h0 (t)Bt−1 + h1 (t)St−1
The value of the old portfolio, created at t −1 and held till t, equals
the value of the new portfolio, created at the moment t.
It can be shown that it is equivalent with
Vt = V0 + Gt
and
Ṽt = Ṽ0 + G̃t
The value of portfolio at any moment t is equal to the initial value plus
gains on the strategy.

Discrete models
Arbitrage
An arbitrage possibility is a self-nancing portfolio with the following

properties
V0 = 0
P(VT ≥ 0) = 1 (almost surely a.s.)
P(VT > 0) > 0
It is equivalent with the following conditions
P(G̃T ≥ 0) = 1
P(G̃T > 0) > 0
One can make prot out of nothing without any risk.

Discrete models
The martingale probabilities
Denition
1
St = EQ [St+1 | Ft ]
1 +r
Values
+r −d
1
qu =
u−d
u − (1 + r )
qd =
u−d

Discrete models
Financial instruments and pricing
Financial instrument of (contingent claim) is a random variable

X ∈ FT .
Usually it is dened as
X = Φ(ST )
The payos of the instrument depend on the stock's price in the nal
moment T.
Martingale pricing formula
1
Π(t; X ) = EQ [X | Ft ]
(1 + r )T −t
Thus the initial price is given by
1
Π(0; X ) = EQ [X ]
(1 + r )T

Discrete models
Replicating
Replication is a strategy H such that VT = X a.s.
Algorithm
1 Calculate martingale probabilities qu and qd

2 Calculate value at each node
VT (k) = X (k) = Φ(su k d T −k )

1
Vt (k) = [qu Vt+1 (k + 1) + qd Vt+1 (k)] , t = 0, 1, . . . , T − 1
1 +r
3 Calculate replication strategy
1uVt (k) − dVt (k + 1)

h0 (t, k) =
1+r u−d
1 Vt (k + 1) − Vt ()
h1 (t, k) =
St−1 u−d

Discrete models
Example
European put option, S0 = 100, K = 104, r = 0%, u = 1.2, d = 0.8

1
qu = qd = 2

Discrete models
Example
European put option, S0 = 100, K = 104, r = 10%, u = 1.2, d = 0.8

3 1
qu = 4, qd = 4

Discrete models
American instruments
In the instrument of American type the payos could be at any

moment the owner of the instrument decide
Payos are describe by stochastic process X

If exercise is at moment t the payo is Xt = Φ(St )
Execution strategy given by stopping time τ
Option at any moment has two values
the value of execution now (Xt )
the value of waiting pt
The price at any moment is the higher of these values

Discrete models
Algorithm I
1 Calculate martingale probabilities qu and qd

2 Calculate value at nal nodes
VT (k) = XT (k) = Φ(su k d T −k )
3 Assume that you have values calculated for moments t + 1, t + 2,

..., T
4 Calculate the value of waiting
1
pt (k) = [qu Vt+1 (k + 1) + qd Vt+1 (k)] , t = 0, 1, . . . , T − 1
1 +r
5 Calculate value of option
Vt (k) = max{pt (k), Xt k}

Discrete models
Algorithm II
6 If Xt (k) > pt (k) this is a node in which instrument should be

executed
7 Calculate replication strategy
uVt (k) − dVt (k + 1)

1
h0 (t, k) =
1+r u−d
1 Vt (k + 1) − Vt ()
h1 (t, k) =
St−1 u−d

Discrete models
Example
American put option, S0 = 100, K = 104, r = 0%, u = 1.2, d = 0.8

1
qu = qd = 2

Discrete models
Example
American put option, S0 = 100, K = 104, r = 10%, u = 1.2, d = 0.8

3 1
qu = 4, qd = 4

Discrete models
Trinomial model
There are three possible states of the world

Prices go up (change toS0 u )
Prices go down (change to S0 d )
The gross rate of return is somewhere in between (change to S0 b )
Three possible gross rates of return d <b<u
Probabilities pu , pb and pd with pu + pb + pd = 1

Discrete models

Discrete models
Example
1
Assume u = 1.2, b = 1.1, d = 0.8 and pu = pb = pd = 3 . Interest rate
r = 0%
Is there an arbitrage opportunity? What if r = 10% (r = 25%)?

Discrete models
Martingale measure
qu S0 u + qb S0 b + qd S0 d = (1 + r )S0
qu + qb + qd = 1
In our example
120qu + 110qb + 80qd = 100

qu + qb + qd = 1
There are many (innitely many) solutions!

Discrete models
Pricing
Consider a call option with the strike price 100.

Discrete models
Pricing
The replicating strategy (h0 , h1 ).
h0 + 120h1 = 20
h0 + 110h1 = 10
h0 + 80h1 = 0

Discrete models
General one-period model
There are N dierent stock and bank account (or risk-free bond). For
simplicity we treat bond as a stock with number 0.
S00 = 1, S10 = 1 + r
Let S0n be initial price of stock n. The price S1n is a random variable.
Using vector and matrix notation:
S0 = (S00 , S01 , S02 , . . . , S0N ) ∈ RN+1 is a vector of initial prices
S1 = (S10 , S11 , S12 , . . . , S1N )T is a vector random variable with values

N+1
in R initial prices

Discrete models
Model
There are K possible states of the world in the future. The sample space
is thus
Ω = {ω1 , ω2 , . . . , ωK }
All of them have positive probabilities P(ω) > 0.
Let S1n (ω) be the price of stock n in the state of the world ω.
We can also write
S1n = (S1n (ω1 ), S1n (ω2 ), . . . , S1n (ωK ))T
Dene the matrix S ((N + 1) × K ):

S10 (ω1 ) S10 (ω2 ) · · · S10 (ωK )
 
 S11 (ω1 ) S11 (ω2 ) · · · S11 (ωK ) 
S=
 .
.
.
. .. .
.


 . . . . 
S1N (ω1 ) S1N (ω2 ) · · · N
S1 (ωK )

Discrete models
Some processes
Portfolio a vector H = (h0 , h1 , . . . , hN ) ∈ RN+1

Value process
N
X
Vt = Hn Stn
n=0
fort = 0 is deterministic, for t = 1 random variable,

V1 = (V1 (ω1 ), V1 (ω2 ), . . . , V1 (ωK ))T .
In matrix notation
T
V1 = H T S = ST H
Gain process
N
X
G = V1 − V0 = Hn ∆S n
n=0

Discrete models
Example
S01 = 100, S02 = 50, r = 0.

Discrete models
Example
Gross rates of return

For rst stock: u1 = 120/100 = 1.2, b1 = 0.86, d1 = 9.6
For second stock: u2 = 45/50 = 0.9, b2 = 1.16, d2 = 1.26
We have both
b1 < d1 < 1 + r < u1
and
u2 < 1 + r < d2
Check for arbitrage opportunity.

Discrete models
Divide all processes by the value of bank account
Stn
S̃tn =
St0
of course
S̃0n = S0n
and
S̃t0 = St0
Discounted value
N
Vt X
Ṽt = = Hn S̃tn
St0 n=0
Discounted gain (it is dened dierently!)
N
X N
X
G̃ = Ṽ1 − Ṽ0 = Hn ∆S̃tn = Hn ∆S̃tn ,
n=0 n=1
as ∆S̃ = 0.
Discrete models
Matrix notation
S̃0 = (S̃00 , S̃01 , S̃02 , . . . , S̃0N ) = S0
S̃10 (ω1 ) S̃10 (ω2 ) S̃10 (ωK )

 
···
 S̃ 1 (ω1 ) S̃11 (ω2 ) ··· S̃11 (ωK ) 
1
~
S= . . .. . =

. . .

 . . . . 
S̃1N (ω1 ) S̃1N (ω2 ) · · · S̃1N (ωK )
···
 
1 1 1
 S̃11 (ω1 ) S̃11 (ω2 ) ··· S̃11 (ωK ) 
=
 
. . .. .
. . .

 . . . . 
S̃1N (ω1 ) S̃1N (ω2 ) · · · S̃1N (ωK )
Ṽ0 = S0T H
T
Ṽ1 = H T ~
S =~

ST H

Discrete models
Arbitrage I
Strong arbitrage opportunity is a strategy H such that
V0 = 0, V1 > 0 a.s.
It can be stated in equivalent forms
Ṽ0 = 0, Ṽ1 > 0 a.s.
G̃ > 0 a.s.

Discrete models
Arbitrage II
There is another form

Discrete models
Arbitrage III
Theorem
Strong arbitrage opportunity exists if and only if there is a strategy such

that
Ṽ0 < 0, Ṽ1 ≥ 0 a.s.
Proof.
(⇐) G̃ = Ṽ1 − Ṽ0 > 0

(⇒) Let δ = minω Ṽ1 (ω) > 0. Dene strategy H ∗ as follows: Hn∗ = Hn
for n = 1, 2, . . . , N and H0∗ = H0 − δ2 . Then
δ
Ṽ0∗ = Ṽ0 − <0
2
δ δ δ
Ṽ1∗ = Ṽ1 − ≥δ− = >0
2 2 2

Discrete models
Farkas lemma
Theorem (Farkas lemma)
Let A be a matrix m×n and b ∈ Rm . Then one and only one of the
following alternatives is true:
there exists a vector x ∈ Rn such that
Ax = b
x ≥0
there exists a vector y ∈ Rm
yT A ≥ 0
yT b < 0

Discrete models
Let us take A=~

S and b = S0 . Consider second alternative and treat
y ∈ RN+1 as an investment strategy. Then
yT A = yT~
S = Ṽ1T ≥ 0
and
y T b = y T S0 = V0 < 0
And this means that strong arbitrage opportunity exists.
Consider the rst alternative.
Ax = ~
S = S0
PK
From the rst row:
PK k=1 xk = 1. From the next rows:
n n
k=1 xk S1 (ωk ) = S0 . The elements of x can be treated as probabilities:
Q(ωk ) = xk .
Thus we have an alternative. Either
there is a strong arbitrage opportunity, or
there exists a probability measure (martingale measure) Q such than

h i
EQ S̃1n = S0n
Discrete models
Arbitrage and the First Fundamental Theorem
Arbitrage opportunity is an investment strategy that fullls the following

conditions:
V0 = 0, V1 ≥ 0 a.s. P(V1 > 0) > 0
Equivalently
G̃ ≥ 0 a.s. and P(G̃ > 0) > 0
Theorem (First Fundamental Theorem)
There is no arbitrage opportunity if and only if there exists an equivalent

martingale measure, i.e. the probabilistic measure Q, such that Q(ω) > 0
for all ω∈Ω (measures P and Q are equivalent, Q ∼ P) and
h i
EQ S̃1n = S0n

Discrete models
Completness
A nancial instrument is X replicable if there exists a strategy H such

that
V1 = X
In matrix notation
ST H = X
Complete market = all possible contingent claims are replicable

Discrete models
Second theorem
Theorem (Second Fundamental Theorem)
A market is complete if and only if the martingale measure is unique.

The fair price of a nancial instrument X is given by the formula
1
Π(0, X ) = EQ [X ]
1 +r

Discrete models
General version of discrete model

Time horizon T = {0, 1, . . . , T }
0
Bank account St = (1 + r )
t
1 2 N
Stocks St = (St , St , . . . , St ) stochastic processes
0 1 N
Investment strategy: Ht = (ht , ht , . . . , ht ), t = 1, . . . , T
predictable stochastic process
Value process
N
X
V0 = h1n S0n
n=0
N
X
Vt = htn Stn for t>0
n=0
Pt PN
Gain process Gt = s=1 n=0 htn ∆Stn
Strategy is self-nancing if Vt = V0 + Gt
Discrete models
Information
Information available to the investor at moment t is givel by σ -algebra Ft .

Alternatively one can describe the ow of information by set of nested
partitions of Ω.
Pt ∈ 2Ω is partition if
P
A∈Pt =Ω
∀A, B ∈ Pt : A 6= B ⇒ A ∩ B = ∅
Partitions are nested, i.e.
J
[
∀A ∈ Pt ∃A1 , A2 , . . . , AJ ∈ Pt+1 : A = Aj
j=1
Additionaly
P0 = Ω, and PT = {{ω1 }, {ω2 }, . . . , {ωK }}

Discrete models
Partition P0

Discrete models
Partition P1

Discrete models
Partition P2

Discrete models
Partition P3

Discrete models
Stn
S̃tn = St0
S̃t0 = 1
Vt PN
Ṽt = St0
= n=0 htn S̃tn s
Pt PN Pt PN
G̃t = s=1 n=0 htn ∆S̃tn = s=1 n=1 htn ∆S̃tn
For self-nancing strategy Ṽt = V0 + G̃t

Discrete models
Submodels
In this setting one can consider one-to-one period submodels.
Submodel starts in some set A ∈ Pt

Ending nodes are in the sets from Pt+1 which builds A
In the model there is a arbitrage opportunity if and only if there is
such opportunity in one of submodels.
The model is complete if and only if all submodels are complete.

Discrete models
Fundamental theorems
Theorem (First Fundamental Theorem)
There is no arbitrage opportunity if and only if there exists an equivalent

martingale measure, i.e. the probabilistic measure Q, such that all
discounted price processes are martingales
h i
n
EQ S̃t+s | Ft = S̃tn
Theorem (Second Fundamental Theorem)
The arbitrage-free model is complete if and only if the martingale

measure is unique.

Discrete models
Conditional expected value
XT FT -measurable
E [X | Ft ]
Ft -measurable random variable
Formal denition: for all A ∈ Ft :

Z Z
XdP = E [X | Ft ] XdP
A A
Interpretation.

Discrete models
Partition P0

Discrete models
Partition P1

Discrete models
Partition P2

Discrete models
Partition P3

Discrete models
Properties
E [aX + bY | Ft ] = aE [X | Ft ] + bE [Y | Ft ]
If X1 ≤ X2 , then E [X1 | Ft ] ≤ E [X2 | Ft ]
E [X | F0 ] = E [X ]
If X is independent on Ft , then E [X | Ft ] = E [X ]
If X ∈ Ft , then E [X | Ft ] = X
If Y ∈ Ft , then E [XY | Ft ] = Y E [X | Ft ]
(Tower property I) Let s < t . E [E [X | Fs ] | Ft ] = E [X | Fs ]
(Tower property II) Let s < t . E [E [X | Ft ] | Fs ] = E [X | Fs ]

Discrete models
Martingale
Stochastic process Xt is a martingale if
E [Xt+s | Ft ] = Xt
It is equivalent with
Xt = E [XT | Ft ]
where T nal moment
Supermartingale:
E [Xt+s | Ft ] ≤ Xt
Submartingale:
E [Xt+s | Ft ] ≥ Xt

Discrete models
Example
Lets draw a dice many times. Yn = the result of n-th draw.

Let
Xt = Y1 + · · · + Yt−1 + Y (t) − at
We have
E [Xt+s | Ft ] = E [Y1 + · · · Yt + Yt+1 + · · · + Yt+s − at − as | Ft ] =

= E [Y1 + · · · Yt | Ft ] + E [Yt+1 + · · · + Yt+s | Ft ] − at − a(s) =
= E [Y1 + · · · Yt − at | Ft ] + E [Yt+1 | Ft ] + · · · + E [Yt+1 | Ft ] − as =
1 1
+ · · · + − as =
= E [Xt | Ft ] +
6
6
1 1
= Xt + s − as = Xt + −a s
6 6

Discrete models
Forward contracts
An agreement to buy (or sell) a specic commodity or asset at

specied moment of time T for predetermined price O (delivery
price).
It as a right as well as a commitement.
At initial moment no money nor security are exchanged. The initial

value of the contract is zero.
Suppose t initial moment, T date of the delivery, S the price

of the underlying asset
What should be O the delivery price (forward price)?
Payo function: F (ST ) = ST − O

Discrete models
Forward price
Arbitrage pricing
The contract is equivalent with the portfolio in which at T there is 1
stock (S ) and −O euros. Thus its value at t is
St − OP(t, T )
If the value is zero then

St
Ot =
P(t, T )
If r = const
Ot = St (1 + r )T −t

Discrete models
Forward price
Martingale pricing
Value of the contract

Q ST − O Q ST Q 1
E | Ft = E | Ft − OE | Ft
BT BT BT
The value is zero, thus
h i
ST
EQ BT | Ft S
Ot = h i= h t i
1 1
EQ BT | Ft Bt EQ BT | Ft
Ot is forward price a fair delivery price at moment t.

Discrete models
Futures
Similar to forward contracts.
Can be closed in any moments.
Collateral (margin) and clearing house.
Taking position (long or short) is free.
Each day futures price Ut is quoted. The amount of funds in the

margin account changes with the changes of futures price.

Discrete models
Model
Bank account B
Undelying asset S
Futures price U
Strategy H(t) = (H0 (t), H1 (t), H2 (t)), where H2 (t) number of futures
contracts (from moment t − 1 to t ).

Discrete models
Value and gain

Before transaction:
Vt = H0 (t)Bt + H1 (t)St + H2 (t)∆Ut
After transaction:
Vt = H0 (t + 1)Bt + H1 (t + 1)St
If strategy is self-nancing the both values are equal.

We have
Vt = H0 (t)Bt + H1 (t)St + H2 (t)∆Ut

= H0 (t) [Bt−1 + ∆Bt ] + H1 (t) [St−1 + ∆St ] + H2 (t)∆Ut =
= H0 (t)Bt−1 + H1 (t)St−1 + H0 (t)∆Bt + H1 (t)∆St + H2 (t)∆Ut =
= Vt−1 + ∆Gt
Gain process:
∆Gt = H0 (t)∆Bt + H1 (t)∆St + H2 (t)∆Ut

Discrete models
Discounted value and gain

Before transaction:
Ṽt = H0 (t) + H1 (t)S̃t + H2 (t)∆Ut /Bt
After transaction:
Vt = H0 (t + 1) + H1 (t + 1)S̃t
If strategy is self-nancing the both values are equal.

We have
Ṽt = H0 (t) + H1 (t)S̃t + H2 (t)∆Ut /Bt =

h i
= H0 (t) + H1 (t) S̃t−1 + ∆S̃t + H2 (t)∆Ut /Bt =
= H0 (t) + H1 (t)S̃t−1 + H1 (t)∆S̃t + H2 (t)∆Ut /Bt =
= Ṽt−1 + ∆G̃t
Gain process:
∆G̃t = H1 (t)∆S̃t + H2 (t)∆Ut /Bt
Discrete models
Risk-neutral measure
If there is no arbitrage, then there is risk-neutral measure Q, such that
h i
EQ ∆G̃t | Ft−1 = 0
for any trading strategy.

Thus
Q ∆Ut Q Ut − Ut−1
E | Ft−1 = E | Ft−1 = 0
Bt Bt
and h i
Ut
EQ Bt | Ft−1
Ut−1 = h i
1
EQ Bt | Ft−1

Discrete models
If B is predictable (standard assumption) then Ut−1 = EQ [Ut | Ft−1 ].

Thus under martingale measure Q
Discounted prices of assets are martingales

St h i St+s
S̃t = = EQ S̃t+s | Ft = EQ | Ft
Bt Bt+s
Futures prices (not discounted!) are martingales
Ut = EQ [Ut+s | Ft ]

Discrete models
Futures vs. forward
Ut = EQ [UT | Ft ] = EQ [ST | Ft ]
If interest rate is deterministic

ST St BT
Ut = EQ BT | Ft = BT = St = Ot
BT Bt Bt
If interest rate is deterministic, then futures prices and forward prices are
the same.
In other case the dierences between Ot and Ut contains information
about possible changes in interest rates.

Discrete models
Derivatives on futures
Model for pricing derivatives on futures: model futures prices

indirecdirectly or directly.

Discrete models
Binomial model
Le us consider a node k at moment t. Interest rate is constant, r.
1 +r −d u−1−r
q= 1 −q =
u−d u−d

Discrete models
Binomial model
Rates of return of futures prices
u d
ū = d¯ =
1+r 1+r

Discrete models
Binomial model
Martingale probabilities
1 − d¯ ū − 1
q= 1 −q =
ū − d¯ ū − d¯
Discrete models
Option on futures
Let 0 < S < T. Consider a call option on futures prices with delivery at
T. The execution moment is S and the execution price is K.
Payo:
X = (US − K )+
To price we use direct binomial tree with parameters ū and d¯.

Discrete models
Pricing
Let B be the cumulative distribution function for binomial distribution:
n
X n
B(k; n, p) = p i (1 − p)n−i
i
i=k
for k = 0, 1, /ldots, n and B(k; n, p) = 1 for k > n. Let B0 be its

complement:
B 0 (k; n, p) = 1 − B(k; n, p)

Discrete models
Let A be the rst index k such that U0 ū A d¯S−A ≥ K . Then the price of
the option at t= is
S
X
S
S0 ū i d¯S−i − K q i (1 − q)S−i =

X0 (1 + r ) =
i=A
S
X S
X
= S0 ū i d¯S−i q i (1 − q)S−i − K q i (1 − q)S−i =
i=A i=A
S
X S
X
= S0 ¯ 1 − q))S−i − K
(ūq)i (d( q i (1 − q)S−i =
i=A i=A
= S0 B 0 (A; S, ūq) − KB 0 (A; S, q)

Discrete models
Thus
X0 = (1 + r )−S S0 B 0 (A; S, ūq) − (1 + r )−S KB 0 (A; S, q)
where
− S ln d¯
& K
'
ln
U0
A= ū
ln ¯
d

Discrete models
The model change of a numeraire
Three instruments: bank account B and two stocks S1 and S2

Assume that S2 > 0
S1 (t) ˜ S2 (t)
Discounted prices B̃t = 1, S˜1 (t) = Bt , S2 (t) = Bt
S2 as numeraire: B̄t = Bt
S2 (t) , S¯1 (t) = SS12 (t) ¯
(t) , S2 (t) = 1

Discrete models
Value and gain
Value at t before transaction:
V̄t = H0 (t)B̄t + H1 (t)S̄1 (t) + H2 (t)
Increase in gain from t −1 to t:
∆Ḡt = H0 (t)∆B̄t + H1 (t)∆S̄1 (t)

Discrete models
Self-nancing
At t −1 before transaction:
V̄t−1 = H0 (t − 1)B̄t−1 + H1 (t − 1)S̄1 (t − 1) + H2 (t − 1)
After transaction
+
V̄t− 1 = H0 (t)B̄t−1 + H1 (t)S̄1 (t − 1) + H2 (t)
+
For self-nancing strategy V̄t−1 = V̄t− 1.

Discrete models
Self-nancing
V̄t = H0 (t − 1)B̄t + H1 (t)S̄1 (t) + H2 (t) =

= H0 (t − 1) B̄t−1 + ∆B̄t + H1 (t) S̄1 (t − 1) + ∆S̄1 (t) + H2 (t) =
= H0 (t − 1)B̄t−1 + H1 (t)S̄ 1( t − 1) + H2 (t)+
+ H0 (t − 1)∆B̄t + H1 (t)∆S̄1 (t) =
= V̄ (t − 1) + ∆Ḡ (t)
Thus the condition for self-nancing is:
V̄t = V̄0 + Ḡt

Discrete models
Arbitrage
Arbitrage opportunity
V0 = 0
VT ≥ 0
P(VT > 0) > 0
Dividing by S2 :
V̄0 = 0
V̄T ≥ 0
P(V̄T > 0) > 0
Thus
ḠT ≥ 0
P(ḠT > 0) > 0

Discrete models
Martingale measure
Let Q be a martingale measures, i.e.
h i
Sn (0) = EQ S̃n (T )
Let
S2 (T , ω) B0
Q̄(ω) = Q(ω)
S2 (0) BT (ω)
Thus
Q̄(ω) S2 (T , ω) B0
=
Q(ω) S2 (0) BT (ω)

Discrete models
X Sn (T , ω) X Sn (T , ω) S2 (T , ω) B0
EQ̄ S̄n (T ) = Q̄(ω) = Q(ω) =
S2 (T , ω) S2 (T , ω) S2 (0) BT (ω)
ω∈Ω ω∈Ω
1 X Sn (T , ω) 1
h i
= Q(ω) = EQ S̃n (T ) =
S2 (0) BT (ω) S2 (0)
ω∈Ω
Sn (0)
= = S̄n (0)
S2 (0)
Thus Q̄ is a martingale measure for S2 as a numeraire.

Discrete models
Forward measure
Suppose that S2 is a zero-coupon bond maturing at T , P(·, T ). Then

S2 (t) = P(t, T ).
Then S2 (T ) = P(T , T ) = 1
We have a forward measure:
Q̄(ω) 1
=
Q(ω) P(0, T )BT
Prices expressed in units of S2 , S̄n , are martingales:

Sn (0) Sn (0) Sn (T )
S̄n (0) = = = EQ̄ S̄n (T ) = EQ̄ =
S2 (0) P(0, T ) P(T , T )
= EQ̄ [Sn (T )]

Discrete models
Pricing with forward measure
Let X be a random variable that represents payos at moment T.

Martingale pricing formula with S2 as a numeraire:

X0 = P(0, T )EQ̄ X̄ = P(0, T )EQ̄ [X ]
For any moment t:

Xt = P(0, T )EQ̄ X̄ | Ft = P(0, T )EQ̄ [X | Ft ]

Discrete models
Example
Binomial model
u = 1.2, d = 0.9
Interest rate can be r = 10% or r = 0%

Discrete models
Model

Discrete models

Discrete models
All prices

Discrete models
Martingale measures
Martingale measure
22 4 21 2
Q(ω1 ) = = Q(ω2 ) = =
33 9 33 9
11 1 12 2
Q(ω3 ) = = Q(ω4 ) = =
33 9 33 9
Forward measure
4 1 2 1
Q̄(ω1 ) = = 0.4301 Q̄(ω2 ) = = 0.2151
9 0.8540 · 1.21 9 0.8540 · 1.21
1 1 2 1
Q̄(ω3 ) = = 0.1183 Q̄(ω4 ) = = 0.2366
9 0.8540 · 1.1 9 0.8540 · 1.1
Conditional probabilities
2 1
Q̄(ω1 | {ω1 , ω2 }) = Q̄(ω2 | {ω1 , ω2 }) =
3 3
1 2
Q̄(ω3 | {ω3 , ω4 }) = Q̄(ω4 | {ω3 , ω4 }) =
3 3

Discrete models
Pricing
A call option with the strike price K = 100.

Discrete models
Pricing

X0 = Q̄(ω1 )X (ω1 ) + Q̄(ω2 )X (ω2 ) + Q̄(ω3 )X (ω3 ) + Q̄(ω4 )X (ω4 ) =
=0.8540 [0.4301 · 44 + 0.2151 · 8 + 0.1183 · 8 + 0.2366 · 0] =
=18.4390

2 1
X1 (ω1 , ω2 ) = 0.9091 · 44 + · 8 = 29.0909
3 3

1 2 8
X1 (ω3 , ω4 ) = 1 ·8+ ·0 =
3 3 3

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Discrete models

Stochastic Finance in Continuous Time

Poznan University of Economics and Business

Paweª Kliber Stochastic Finance

Price of the stock is 100e.

In three month  two possible outcomes (110e or 90e).

The increase in price is more likely (probability 90%).

Consider a call option with execution price 100e, executed in three

What should be today's price of the option?

Paweª Kliber Stochastic Finance

Paweª Kliber Stochastic Finance

Paweª Kliber Stochastic Finance

Consider possible payments of a nancial instrument

Consider payments of other instruments

Can you replace one payments with a combination of others?

Todays' prices should be consistent

Arbitrage  an opportunity of making sure prots without any risk

Paweª Kliber Stochastic Finance

The Law of One Price

Rule (Law of One Price)

In the context of nancial modelling

Rule (Law of One Price)

Financial instruments (assets or portfolios) with the same payos must

Paweª Kliber Stochastic Finance

Consider forward contract on a stock S with delivery price K.

Paweª Kliber Stochastic Finance

One period binomial model

Two assets: a risk-free bond (bank account) and a stock

Risk free bond: B0 = 1, B1 = 1 + r

Paweª Kliber Stochastic Finance

Paweª Kliber Stochastic Finance

Paweª Kliber Stochastic Finance

Buying and selling prices are the same

No limits on the position size

No restrictions on short selling

The investor is price-taker. His transactions do not aect prices

Perfect divisibility of assets

Interest rate for borrowing and lending is the same

Paweª Kliber Stochastic Finance

P(Z = u) = p = 1 − P(Z = d).

Paweª Kliber Stochastic Finance

Paweª Kliber Stochastic Finance

Portfolio (or investment strategy) is a vector H = (h0 , h1 ) ∈ R2 .

h1  investment in stock (number of shares)

Paweª Kliber Stochastic Finance

Arbitrage portfolio  a portfolio that makes prot out of nothing.

It can be shown that it is equivalent to

P(G̃ > 0) > 0

Paweª Kliber Stochastic Finance

The condition for the lack of arbitrage portfolio is as follows:

This means that 1 +r is between d and u.

where 0 <q<1 can be interpreted as probability. In fact

Paweª Kliber Stochastic Finance

Multiply by s and divide by 1 + r:

If there is no arbitrage, then

Paweª Kliber Stochastic Finance

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Paweª Kliber Stochastic Finance

Replication of contingent claims

Is contingent claim equivalent to any portfolio?

or, in matrix notation:

If d <u the matrix is nondegenerate and there exists a solution.

In three month two possible outcomes (110e or 90e).

Consider possible payments of a nancial instrument

Arbitrage an opportunity of making sure prots without any risk

In the context of nancial modelling

Financial instruments (assets or portfolios) with the same payos must

The investor is price-taker. His transactions do not aect prices

h1 investment in stock (number of shares)

Arbitrage portfolio a portfolio that makes prot out of nothing.

Financial instrument or (contingent claim) any random variable of

In this model nancial instrument can be describe by two numbers: xu

From this denition Ht ∈ Ft−1 it is a predictable process.

Portfolio is self-nancing if it meets the following condition

An arbitrage possibility is a self-nancing portfolio with the following

One can make prot out of nothing without any risk.

In the instrument of American type the payos could be at any

Payos are describe by stochastic process X

6 If Xt (k) > pt (k) this is a node in which instrument should be

There are many (innitely many) solutions!