Asset or Nothing Solution

Mauricio Bedoya
javierma36@gmail.com
July 2014
The option pay-o in this case (European) is:
V
0
= e
rT
E[S
T
I
(S
T
K)
] (1)
The indicator function I
(S
T
>K)
is a function that has value 1 if S
t
K, and 0 if S
T
< K.
Something important to mention is that the expectation is under a risk neutral world (price are
Martingala). The behaviour of S
T
in a risk neutral workd, is dene by the following equation
S
T
= S
0
e
(r0,5
2
)T+w(T)
(2)
where r and are constant, and w(T )is a wiener process characterized by N(0,

T). To solve
this equations always search for the Radom Nikodym derivative expression in the expectation.
This is well explained in Glasserman book (Monte Carlo Methods in Financial Engineering)
Apendix B. In this case, we have
V
0
= e
rT
S
0
e
rT
E[e
0,5
2
T+w(T)
I
(S
T
K)
]
setting L = e
0,5
2
T+w(T)
, we have
V
0
= S
0
E[L I
(S
T
K)
] (3)
L is the Radom Nykodim derivative, then we can change the measure dw for other measure,
such that L can be eliminate from the previous equation. Dene

dw = dw sigma dt (4)
The previous measure allow to eliminate L in equation 3. The nal result is
V
0
= S
0

E[I
(S
T
K)
] (5)
Look that the expectation is under a new measure

E and not E. This is very important.
To get the famous nal expression, remember that the expectation of the indicator function, is
the probability of the event.
1
V
0
= S
0

P[(S
T
K]
replacing S
T
V
0
= S
0

P[S
0
e
(r0,5
2
)T+w(T)
K]
HEYYY one moment. This probability is under the measure

P, then we need to change dw by

dw + T. Operating, we get
V
0
= S
0

P[S
0
e
(r+0,5
2
)T+

w(T)
K] (6)
Now, take logarithms
V
0
= S
0

P[

w(T)
ln(
K
S
0
)(r+0,5
2
)T

]
Are you still with me ???; we are almost there.
Because

w(T) is N[0,

T] we can make the following operation:

z(T)

T =

w(T)
with Z(T) been characterized by N[0,1]. This is easy to prove, in case of any doubt just make
a comment. The last two steps are:
V
0
= S
0

P[z(T)
ln(
K
S
0
)(r+0,5
2
)T

T
]
cause Z(T) is N[0,1] (symmetric distribution), this is the same as
V
0
= S
0

P[z(T)
ln(
S
0
K
) + (r + 0,5
2
)T

T
] (7)
What will happen if the underlying pays dividends ?
Remember, always try to leave the Radom Nikodym derivative inside the expectation operator.
If you proceed that way, you will get
V
0
= S
0
e
qT

P[z(T)
ln(
S
0
K
) + (r + 0,5
2
)T

T
] (8)
2