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S1t
X1t
D1t
Dt = ... ,
DM t
where
Djt = ts=0 Xjs ,
be the accumulated dividend process.
Define the share process:
t+1
1,t+1
..
=
,
.
M,t+1
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Jessica Wachter
where
j,t+1 = shares in security j chosen at time t
and
t+1 = shares in riskfree security.
Recall:
Definition. A consumption plan c is financed by (, ) if
>
St = t Bt + t> (St + Xt ) ct
t+1 Bt + t+1
t = 0, ..., T .
s t
Jessica Wachter
Sjt
=
Bt
ct
Xjt
Djt
= ts=0 Xjs
= ts=0
Xjs
Bs
The following theorem is the multiperiod version of the Fundamental Theorem of Asset
Pricing (FTAP).
Theorem. No arbitrage a probability measure such that
Sjt
+ Djt
= Et [Sj,t+1
+ Dj,t+1
]
3. Subtracting Djt
from both sides implies
Sjt
= Et [Sj,t+1
+ Xj,t+1
].
Sjt
= Et [Ts=t+1 Xjs
].
Jessica Wachter
4. is also called the risk-neutral measure because these relations would hold under
E[] for the risk-neutral agent.
Case of a risk-neutral agent:
Consider the Euler equation for an investor with period utility u:
0
u (ct+1 )
(1 + rj,t+1 ) = 1 j.
Et 0
u (ct )
Consider a risk-neutral agent i.e. u00 = 0 u0 constant. The Euler equation for
the riskfree asset therefore implies
Et [(1 + rf,t+1 )] = 1.
Because the rf,t+1 is known at time t,
1
= .
1 + rf,t+1
Substituting in for in the Euler equation implies
1 + rj,t+1
Et
= 1.
1 + rf,t+1
If we have a risk-neutral agent, expected returns on all assets are equal!
Applying the definition of a return and dividing by Sjt
Sj,t+1 + Xj,t+1
= Sjt .
Et
1 + rf,t+1
Note:
Bt+1 = (1 + rf,t+1 )Bt .
Dividing by Bt gives us
Et
Sj,t+1 + Xj,t+1
Sjt
=
Bt (1 + rf,t+1 )
Bt
Et Sj,t+1
+ Xj,t+1
= Sjt
.
Adding Djt
implies
.
Et Sj,t+1
+ Dj,t+1
= Sjt
+ Djt
Therefore Sjt
+ Djt
is a martingale, as required.
Jessica Wachter
= P
Note that
Therefore
Sj =
Sj
B1 X Xj X Xj X
Xj = E Xj .
=
=
=
B0
B0
B1
B1
This shows that in the 2-period case, there is a straightforward mapping between
and the equivalent martingale measure.
Proof of the multiperiod FTAP
We will assume something slightly stronger than no-arbitrage, namely that one
individual i with u0i > 0 such that
max
Ei
i i
c ,
T
X
it ui (cit )
t=0
has a solution given by the first order conditions (where Ei denotes expectations under
this individuals probability beliefs), and such that the individual assigns strictly
positive probabilities to each state. We will construct under this assumption. For a
proof of both the if and only if that uses only no-arbitrage, see Duffie chapter 2.
Jessica Wachter
at
u0 (ct+1 )
(Sj,t+1 + Xj,t+1 ) .
Sjt = Et 0
u (ct )
(1)
u0 (ct+1 )
Bt+1 .
Bt = Et 0
u (ct )
(2)
Note that successive substitution and the law of iterated expectations implies that
0
T t u (cT )
Bt = Et
BT .
u0 (ct )
(3)
= 1.
u0 (cT ()) BT ()
.
u0 (c0 )
B0
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Jessica Wachter
> 0, > 0.
u0 (cT ())
BT ().
u0 (c0 )
Dividing by B0 implies
X
u0 (cT ()) BT ()
= 1.
u0 (c0 )
B0
= 1.
2. Now we need to show that this implies the martingale property. It suffices to
show that
Sjt
= Et Sj,t+1
+ Xj,t+1
(4)
We first need to calculate the conditional probability at+1 (at ). By definition of at ,
at =
at
u0 (cT ()) BT ()
=
u0 (c0 )
B0
at
X
1
T u0 (cT ())BT ()
= 0
u (c0 )B0 a
t
t 0
at u (ct (at ))Bt (at ) X T t u0 (cT ())BT ()
=
u0 (c0 )B0
at
u0 (ct (at ))Bt (at )
a
X
= at t
if at+1 at
u0 (ct (at ))
Bt (at )
at
at
at+1 (at ) =
0 otherwise
Jessica Wachter
Sjt
(at ) =
t+1
at+1 (at )
t+1
u0 (ct+1 (at+1 ))
(Sj,t+1 (at+1 ) + Xj,t+1 (at+1 ))
u0 (ct (at ))
X at+1 Bt (at )
1
(Sj,t+1 (at+1 ) + Xj,t+1 (at+1 ))
=
Bt (at ) a a at Bt+1 (at+1 )
t+1
X at+1
=
S
(a
)
+
X
(a
)
t+1
t+1
j,t+1
j,t+1
at
at+1 at
X
=
at+1 (at ) Sj,t+1
(at+1 ) + Xj,t+1
(at+1 )
at+1 Ft+1
B0
,
BT ()
at = at
and
B0
,
Bt (at )
as Bt (at )
as
as (at ) =
=
at
at Bs (as )
Bt (at )
Bs (as )
Jessica Wachter
Sjt
Et
T
X
Xjs
s=t+1
T
X
Xjs
s=t+1
X X
X X
Bt
Bs
as (at )
as Fs
Bt (at )
Xjs
Bs (as )
as (at )Xjs .
as Fs
Therefore the price is given by the payoff in each state, multiplied by the value of a
dollar in that state. There is a one-to-one mapping between the equivalent martingale
measure and a system of state prices. Note that we do not need to take a stand on the
true probabilities to define either state prices or the equivalent martingale measure.
Now we ask, when is the equivalent martingale measure unique? Clearly this will be the
case if and only if this process is unique, and it shouldnt be a surprise, given our
2-period work, that this occurs when markets are complete.
Theorem. Assume no arbitrage. Then the equivalent martingale measure is unique if
and only if markets are dynamically complete.
The proof is very similar to the 2-period case.
Individual optimization
T
X
t u(ct )
(P1)
t=0
such that
>
t+1 Bt + t+1
St = t Bt + t> (St + Xt ) ct
(1a)
T BT + T> (ST + XT ) = cT
(1b)
0 B0 + 0> (S0 + X0 ) = W0 .
(1c)
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Jessica Wachter
Recall that if c, , and satisfy the first 2 of these conditions, then we say that (, )
finances c. Note that P1 is the standard dynamic portfolio choice and investment
problem.
Consider problem P2:
max E
c
T
X
t u(ct )
(P2)
t=0
T
X
ct = W0 ,
(2)
t=0
T
X
ct = 0 + 0> (S0 + X0 )
t=0
Think of wealth as an asset that pays consumption as its dividend. Then this statement
has to hold because the LHS is the total dividend, and the RHS is the value of wealth
at time 0.
Proof:
Recall homework problem:
>
t+1 Bt + t+1
St = t Bt + t> (St + Xt ) ct
T BT + T> (ST + XT ) = cT
T
X
t=0
ct = 0 B0 +
0> (S0
+ X0 ) +
T
X
t> (St
+ Xt St1 ) +
t=1
T
X
t (Bt Bt1 )
t=1
T + T> (ST + XT ) = cT
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Jessica Wachter
ct
= 0 +
0> (S0
X0 )
T
X
)
t> (St + Xt St1
t=1
t=0
T
X
t> (St
Xt
)
St1
=E
T
X
)=0
[St + Xt ] St1
t> (Et1
t=1
t=1
which implies
E
T
X
ct = 0 + 0> (S0 + X0 ).
t=0
2
We now prove the theorem.
Proof:
Because the objective functions are the same, it suffices to show that constraints are the
same.
Suppose (, , c) satisfy (1). By (1a,b) and the Lemma, c satisfies
E
T
X
ct = 0 + 0> (S0 + X0 ),
t=0
0> [S0
X0 ]
=E
T
X
ct = W0
t=0
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Jessica Wachter
2
Economic Importance
P2 decomposes the consumption and portfolio problem into 2 parts.
1. Find an optimal consumption plan ct by standard Lagrange method.
2. Implement the optimal consumption plan by dynamically trading in the
underlying securities.
How to do (1)? We need to write b.c. in terms of the physical measure.
First recall the relationship between state prices and the EMM:
B0
at = at
Bt (at )
Define the state-price density as state prices normalized by probabilities:
a
at = t
at
Replace state prices by the state-price density to obtain:
B0
at at = at
Bt (at )
It follows that
E
T
X
ct = E
t=0
X ct
Bt
t
Now the expectation in the objective function and in the budget constraint are taken
under the same measure. We can therefore use standard the standard Lagrange
multiplier method to write the first-order condition for the agent as
t u0 (ct ) = t ,
where is a Lagrange multiplier determined by b.c. (2).
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Jessica Wachter
Assume 2 long-lived securities: Stock (assume dividends are zero) following a binomial
process
1 + rt+1 = SSt+1
can take one of two values u and d. Note that u(up)> d(down) and
t
p is the probability of an up move.
Bond Normalize B0 = 1. Let R = 1 + rf Bt = Rt
Note: markets are dynamically complete. No-arbitrage will give us the price of an
option (Cox, Ross & Rubinstein, 1979).
Let denote probability of u under the equivalent martingale measure.
What is in terms of the model parameters?
We know Et [St+1
] = St . Therefore,
St = St+1
(u) + (1 )St+1
(d).
Substituting in for S :
St
St+1 (u)
St+1 (d)
=
+ (1 )
.
Bt
Bt+1
Bt+1
Therefore
1
1
+ (1 )St+1 (d)
R
R
u
d
= St + (1 )St ,
R
R
St = St+1 (u)
and
1 =
u
d
+ (1 ) .
R
R
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Jessica Wachter
It follows that
=
Rd
.
ud
Note that
uR
.
ud
Given u > d, for > 0, we must have d < R. Also, for 1 > 0, we must have
u > R. This makes sense! If u, d are on the same side of R, we would have an arbitrage.
T
Prob(exactly n up moves at T ) =
( )n (1 )T n
n
T!
=
( )n (1 )T n
n!(T n)!
1 =
ST (exactly n up moves) = S0 un dT n
Consider the price of a European call option (or of an American or European call
option, assuming that rf 0) with exercise price K and time to expiration T . As
shown earlier in the course, the price (and payoff) of this option at time T is given by
CT = max[ST K, 0]. By no-arbitrage:
Ct = Et [CT ]
= Et R(T t) max[ST K, 0] .
Therefore,
Ct = Et R(T t) max[ST K, 0]
T t
X
T t
(T t)
= R
( )n (1 )T tn max[St un dT tn K, 0]
n
n=0
T t
X
T t
(T t)
= R
( )n (1 )T tn St un dT tn
n
n=j
KR
(T t)
T t
X
T t
( )n (1 )T tn
n
n=j
T t
X
T t
(j, T t, ) =
( )n (1 )T tn
n
n=j
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Jessica Wachter
It is convenient to define
0
u
Rd u
=
R
ud R
Then,
0
1 =
0
(u d)R (R d)u
dR + du
uR d
d
=
=
= (1 )
(u d)R
(u d)R
ud R
R
0
Note that > 0, 1 > 0. We can write the call price as follows:
0
(j, T t, ) N (d1 ),
where
d1 =
log(S/K) + (r + 2 /2)(T t)
T t
and
N (d1 ) = P (x d1 ) x N (0, 1).
Moreover,
(j, T t, ) N (d2 ),
where
d2 = d1 T t.
Therefore,
Ct = St N (d1 ) Ker(T t) N (d2 ).
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