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Contents
An Introduction To Financial Markets
Single Period Financial Markets
The Optimal Portfolio and Optimal Consumption-Investment Problems in
Single Period Financial Markets
Multiperiod Financial Markets
The Optimal Portfolio and Optimal Consumption-Investment Problems in
Multiperiod Financial Markets
Suggested Text
1.
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5.
6.
7.
Chapter 1
An introduction to Financial Markets
Governments, multinational and national corporations, international organizations,
firms and businesses, banks, financial institutions and individuals, from time to
time, need to raise money more than they have available at specific times to fund
their activities. Conversely, these same economic agents, from time to time, have
funds available to them which they do not need to make immediate use of and
would not want to keep inactive.
Financial Markets offer opportunities for these actors to facilitate the lending and
borrowing of funds. In transactions involving the transfer of funds it is usual to
expect the borrower to be given access to funds provided that she pays them back
eventually plus some agreed percentage as interest over time. This extra (return)
covers the risk and compensation for the deprivation which the lender has to take
on.
Financial markets have existed for centuries. In the last 40 years they have suffered
tremendous changes which have brought along a degree of sophistication quite
unparalleled in any other phase of the history of finance. It may be stated without
exaggeration that the world of finance and insurance has become the most
aggressive employer of Ph.D. graduates with a deep knowledge of mathematics of
the last 20 years in most countries with developed economies.
For over 30 years there has been a veritable revolution, silent and in constant
evolution, within the world of global finance with the impetus coming from two
major sources. During the 70s there was a switch from fixed exchange rates to
floating rates for currencies in developed countries. This forced a lot of important
currencies to revalue themselves radically in response to the real strength of the
economies which supported them.
The second most important contributor to radical changes in the operations of the
financial world has been the result of the successful convergence of
telecommunications and computer technology. This has meant in everyday practice
global dissemination of price-sensitive information and rapid response to it. Not
only is it very easy and inexpensive to get financial information, it is also very easy
to make deals. The dizzying speed with which the world of finance plunged into an
unknown future when it changed to electronic gear is held responsible for the great
crash of 1987.
Another important, more localized, source of change in nature is the tendency of
major exchanges to merge, regroup and make collaborative agreements amongst
themselves. The introduction of the Euro in 1999 was intended along this line.
Such attempts at synergies have resulted into a trend towards expanding services.
Servicing a global economy 24 hours a day needs collaborative effort to reduce
operating and trading costs.
The result of many of these changes has been an enormously increasing bulk of
business and an incredible increase in the velocity with which transactions are
effected. This in turn has meant a large increase in volatility of market rates.
Uncertainty in markets increased as opportunities and risks multiplied. There were
large pickings promised to those engaged in popular and flourishing academic
studies centred on the mathematical modelling of various mechanisms of financial
4
markets there is little evidence that financial mathematics have become less
important. Instead, the need for more sophisticated mathematics models and
understanding of financial markets has increased.
Before we plunge into mathematical models, theorems and formulas we first study a
bit the structure of capital markets and the way they operate.
1.1
Capital Markets
entities looking for funds while paying for their use, and investors willing to invest
money expecting to obtain returns on their investments. These markets, in contrast
with money markets (refer to section 1.2), cater for long term investments.
1.1.1
Bond Markets
o Eurobonds (international bonds which are not issued in the currency of the
country of issue)
o Medium-term-notes (MTN) (a debt security with maturity date ranging from
5 to 10 years).
A major difference between bonds and stocks is that holders of stocks are also
partial owners of the issuing company, whereas bond-holders are simply lenders.
1.1.2
Equities Markets
On liquidation
(dissolution of the company or part of the company, and so its assets are
distributed) shareholders will be the last to receive any benefit from sale of assets.
Equities thus carry a lot of risk but they can provide better returns, and over the
long term they outperform debt securities. Determining the right price for such
assets is a major problem in the mathematics of finance. One approach, the
Capital Asset Pricing Model (CAPM) seeks to relate the risk and return
available from different investments. The New York Stock Exhange (NYSE)
and the National Association of Securities Dealers Automated Quotations
(NASDAQ) are the largest equity markets with the London and Tokyo Stock
Exchange following.
Non-negotiable debt, as its name implies, cannot be traded in open markets but is
contracted only in primary markets. It includes:
o Interbank deposits
o Federal funds(US)
o Repos and reverses
o Local authority and finance house deposits (UK)
Costs of borrowing can be computed, and compared across different sources,
through interest rates. These are quoted either:
o On a discount yield basis (i.e. as a percentage of face value converted to
annual basis)
o On a money market yield basis (as a percentage of the current price)
Furthermore quotations do not all use the same base: some 360-day years, others
365-day year.
The daily volume of transaction worldwide has exceeded $4,000 billion in April
2007.
Up to 20% of all business is estimated to be trading volume arising out of
commercial transactions.
commercial transactions. About half the foreign exchange is for spot delivery
usually about 2 working days after dealing date. The rest are forward deals which
may be outright forwards (deals involving currencies exchange occurring one way
at a future date between 2 parties only once) or swaps (deals involving exchange of
currency between parties at a future date and a re-exchange later).
Other features which characterize the foreign exchange are its extreme liquidity,
the large number and variety its participants, its long trading hours and its low
margins of profit.
volatile, it would be useful if some guarantees can be bought which would serve to
10
stop rates from inflating future real prices, whose nominal value is being agreed on
at the present time. This process is called hedging.
Derivatives were designed, amongst other things, to cater for the above. Originally
commodity producers used forward and future contracts (refer to sections 1.4.1 and
1.4.2) to hedge prices and reduce risk. Today the derivatives market are linked not
only to the commodities markets, but also to underlying instruments in the cash
markets, with similar exposure to currency fluctuations, interest rates and market
swings.
Formally, a derivative contract is an agreement involving usually 2
counterparties in which they agree to transfer an asset or amount of money on
or before a specified date at a specified price. A derivatives value changes
with changes in one or more underlying market variables, such as interest
rate or foreign exchange rates.
Besides commodities, derivative trading involves all financial instruments. Basic
derivative instruments include:
o Forward contracts
o Future contracts
o Options contracts
o Swaptions
Derivative instruments are also sometimes called contingent claims as their
payout to the holder at maturity is contingent on the price or rate of the underlying
asset. Their major objectives may be summarized as:
o Lower international funding costs
o Get better exchange rates in international markets
o Hedge risk prices
11
1.4.1
Forward Contracts
1.4.1.1
With floating exchanges rate and the increasing range of borrowing facilities
offered by banks during the 60s and 70s, various financial institutions had to
12
finance themselves by borrowing short and lending long (i.e. borrowing for short
term, maybe 3 months, and lending out that same money long term, maybe 20
years. Profit generates from paying less interest on the short end than what you are
charging on the long end) in increasing quantities. The problem was that they were
forced to pay at the going rate which may over time no longer be favourable.
Interest rates became more volatile during the 70s and 80s and corporate
treasures sought bank protection from high borrowing costs. So a problem with
great theoretical implication arises: what is the fair rate to be quoted?
Many studies concentrated on the question of how well, or badly, do existing
predictors of future spot rates perform. Many theoretical models were developed
to obtain formulas which give estimates for future values of interest and exchange
rates.
More
sophisticated models were proposed and studied to give better predictive tools. In
effect, one of the more successful methods used when banks quote forward
exchange and forward interest rates uses the principle of risk-free arbitrage. In
using this technique a dealer considers how to hedge the resulting position using
other transactions whose price is known. Having obtained an estimate of the best
rate to quote for future reference, derivative instruments are issued using this
information.
1.4.1.2
13
Usually the buying company enters some future borrowing agreement and needs a
guarantee against future varying rates.
So it comes into agreement with another company that if rates exceed a fixed
number the buying company is paid the extra money it needs to pay in interest, if
the rates go down it gives the money it saves to the other company. Forward
contracts are typically quoted as a two-way price with bid-offer rates. Prices are
often quoted in standard terms, whole months and rounded numbers for notional
size.
1.4.1.3
SAFE
1.4.2
Futures Contracts
14
A Futures Contract is a firm contractual agreement between buyer and seller for a
specified asset on a fixed date in the future. The contract price will vary according
to the market price but is fixed when the trade is made. The contract has standard
specifications so both parties know exactly what is being traded. Futures are
distinguished from generic forward contracts in that they contain standardized
terms, trade on a formal exchange, are regulated by overseeing agencies and are
guaranteed by clearinghouses.
The risk to the holder has to be taken fully, and because the payoff pattern is
symmetrical, the risk to the seller is unlimited as well. Money lost and gained by
each party on a futures contract are equal and opposite. Thus futures trading is a
zero-sum game. One partys losses are the other partys gain.
Futures contracts originate from all over the world and converge on a pit which
concentrates trading in a single crowded location. Members of futures exchange
have a desk on the exchange with whom clients can transmit their orders. These
orders are transferred to floor brokers who trade contracts as their clients instruct.
The features characterizing trading at the pit are designed to emphasize the
transparency of the whole process. An alternative to the pit is trading by screen.
Services like Reuters Monitor provide prices and deals are executed by telephone.
Institutional problems of establishing a physical futures market with sufficient
liquidity have resulted in a trend in favour of smaller markets with screen-based
infrastructure.
After a trade is executed, the details are passed to the clearing house, which
ensures the correctness of the deal and removes counterparty risk by coming
15
between seller and buyer. The clearing house serves as counterparty to both sides
of the trade.
The contract is not directly between the buyer and seller: the clearing house takes
on the credit risk should a counterparty default.
The great bulk of futures contracts consist of interest rate futures, with bond and
stock index futures forming a smaller market.
Interest rate futures are forward transactions with standard contract sizes
and maturity dates which are traded on a formal exchange.
1.4.2.1
Short-term interest rates futures are futures contract on a short term interest
rate. They are by far the most heavily traded. The three-month U.S. Treasury bill
contract, introduced by the International Money Market in 1976, was the first
futures contract based on short-term interest rates. Three-month Eurodollar time
deposit futures, now one of the most actively traded of all futures contracts started
trading in 1981. Transactions are notional fixed-term deposits where the price is
the fixed rate of interest applying during the term of the deposit covering a certain
period in the future. Cash settlement rather than asset delivery is usually the rule.
Delivery occurs on pre-defined delivery dates, usually 4 times a year. Interest
rates are traded on an indexed price. This is not a real price but a quotation system
which reverses the behaviour of future prices. If rates increase, prices decrease and
16
vice versa. Short-term interest rates are almost exclusively based on Eurocurrency
deposits and are cash settled on Exchange Delivery Price or last price traded.
1.4.3
Options Contracts
The financial tools we have discussed so far contribute a lot towards managing risk
efficiently. However, once they are traded there is no way to go back except
possibly through trading any remaining debt instrument in ones possession. It
would be much more convenient if commitment to buy or sell would not be so
complete, but conditional on the persons wish when she so decides.
17
Options, in a sense, offer this opportunity the possibility not to buy or sell should
market conditions make these actions not desirable at the moment, or the reverse.
Options contracts were introduced on an exchange in 1973 and since then their use
exploded.
An Options contract confers the right, but not the obligation, to buy (call
option) or sell (put option) a specific underlying instrument or asset at a
specific price the strike or exercise price up until or on a specific future
date the expiry date. The price to have this right is paid by the buyer of the
option contract to the seller as a premium.
Options contracts come in various styles, however the most common contracts are
the European and American options. European style options cannot be exercised
before maturity, while American style options do not impose any conditions on
when the right to exercise is activate. The intrinsic value of an option is the net
positive amount that an option would realize if it were exercises immediately. In
virtually all cases, the option seller will demand a premium over and above the
intrinsic value. This intrinsic value may be different tomorrow and the asymmetry
of options means that the seller stands more to lose than gain. This excess is called
time value.
Interest rate options were first introduced in the 1980s to hedge interest rate
exposure. Interest rate options can be written on bonds and bond futures. Options
written on bonds give the buyer the right, but not the obligation, to buy or sell a
specified amount of bonds or notes for a pre-determined price. They are traded
both over-the-counter and on an exchange. They are usually cash settled.
18
1.4.4
Swaps
Swaps are another outstanding success story from the 1980s. Swap transaction is
the simultaneous buying and selling of a similar underlying asset or obligation
of equivalent capital amount where the exchange of financial instruments
provides both parties to the transaction with more favourable conditions than
they would expect otherwise.
19
physical exchange is necessary. The two rates of interest are calculated in the
same currency and the payments are netted so that only differences are settled.
The interest payment structure can vary. The most common is the plain vanilla
which secures a fixed rate for one party and a floating rate for the other. Banks
and corporations are the main market players in interest rate swaps. Different
institutions have different credit ratings and the one with lower rating will get
better terms for floating rates, while high credit ratings make fixed rates more
favourable.
20
Chapter 2
Single Period Financial Markets
2.1 Introduction
In this chapter we initiate the task of developing a mathematical model for
capturing the workings of the securities markets and the fortunes of an investor
who is buying and selling assets over time. Such a model would display its use, if
first and foremost manages to describe, with an acceptable accuracy, real markets.
This is very hard task which, in spite of remarkable progress especially in the last
25 years, is currently very far from completion. Some very powerful, and difficult
mathematics, has been harnessed into studying the problems involved. Notably
stochastic analysis has made significant contributions.
We shall only touch on some of the problems involved and in this chapter we
simplify the setting by considering changes involving only one period.
Consider a set of N+1 securities. The first security is assumed to be a riskless asset
(such as a savings account), which guarantees on giving fixed interest payments.
The other N asset could be bank deposits, treasury or trade bills, government or
corporate bonds, equities involving stocks and shares. Some yield regular interest
payments others are exposed to market risks. We need to model the set of prices as
it varies over time.
21
Let t denote time, which will be measured in discrete units (which are commonly
referred to as ticks). We shall as a first step simplify matters by taking one step,
that is t = 0 to t = 1 .
Markets are unpredictable. However their behaviour is not entirely erratic but
hopefully governed by probabilistic laws which the mathematical finance seeks to
model. Thus we suppose that open to the market for the future time there are a
number of possibilities.
We shall denote by the set of these possibilities which we can look at as possible
paths of evolution over time of the assets under consideration. As we consider
more complex and realistic models will become a larger and more structured set,
but mathematically more difficult to deal with. We will need to endow this set with
the structure of a probability space which will describe mathematically the
probabilistic laws which the market obeys.
We shall next concentrate on the values of various securities. The simultaneous
value of these securities, called a price vector, may be represented by a vector St of
asset prices which at time t, will vary according to which point in we have. In
fact St is a random vector:
T
We are interested in following the prices of these N+1 assets. The price, at time t,
of the riskless asst, will be denoted by Bt. This gives fixed interest payments at an
interest rate r, which is virtually assured till maturity. We shall take B0 = 1 and
Bt +1 = (1 + r ) Bt .
22
Stn ( ) will denote the price at time t of the nth risky asset when possibility
Example 2.1
Suppose the financial market is composed of 4 assets (i.e. N = 4), and we move one
step forward. The first asset we assume is a bank deposit growing by 0.05 from the
value of 1. The second asset is undergoing a very calm period and will stay at 2.5.
The third asset starts at 1.8 can either grow by 0.1 with probability 0.3 or diminish
by 0.1 with probability 0.2. The fourth asset increases by 0.2 with probability 0.4
and decreases by 0.2 with probability 0.2. This gives us 9 possible future price
vectors (1 , 2 ,...9 ) as shown in the table:
1.05
1.05
1.05
1.05
1.05
1.05
1.05
1.05
1.05
2.5
2.5
2.5
2.5
2.5
2.5
2.5
2.5
2.5
2.5
1.8
1.9
1.9
1.9
1.8
1.8
1.8
1.7
1.7
1.7
3.6
3.4
3.8
3.6
3.4
3.8
3.6
3.4
3.8
3.6
The first two assets can only change to 1 value, the third and fourth can each have
3 possibilities : grow, stay as they are or go down. Assuming that these movements
for the two assets are independent of one another, we calculate the probabilities:
23
We can work out expected values for all assets into the next period. Assets 1 and 2
we already know will value at 1.05 and 2.5. For asset 3 the expected value is 1.81
and for the 4th asset we have 3.64.
When we compare these values with the ones at t=0 we see that on average prices
for the last 2 assets will go up. Holders of such assets will not part with them
unless they are offered more than the returns they expect from them. Furthermore
they can consider the option of finding which assets give the highest expected
return and stack all their cards on this asset. But is this a good strategy seeing that
we have nothing guaranteed 100%? Also how are we supposed to accept the
probability figures quoted?
If things were so easy to quantify, why arent all persons participating in these
markets getting continuously rich by putting their money where there are gains to
be made? Some of them are very rich. Others are also stupid and so quickly weave
their own ruin. But most are neither one thing nor the other. We need to understand
better what goes on.
We first need to define mathematically the process of buying and/or selling such
securities in varying amounts over time. This is the subject of the next section.
24
H t0
refers to the number of units held in the riskless asset during the period t-1 t,
while for n = 1,2,N, H tn gives the number of units held in the nth risky asset
during period t-1 t. In general, the process H := { H t }tT , where T = {1, 2,...} is
is said to be a trading strategy, however since we are in a single period market, we
shall only consider the number of units carried forward from time 0 to time 1.
Hence, to simplify notation, we shall remove the dependency on t and write
H n to represent the number of units held in the nth risky asset during period
0 1.
H together with St gives us the information about the investors wealth Vt H at time
t:
N
Vt = H Bt + H n Stn .
H
n =1
t{0,1}
Example 2.2
The following table gives an investors portfolio:
Hn
St in
H 0n Stn
Riskless Asset
3000
3000
Bonds
1200
1.5
1800
Stocks in Comp A
200
2.3
460
25
Stocks in Comp B
300
4.5
1350
6610
Total Value Vt H
At the beginning of each period an investor will decide how much money to keep
invested in each of the assets till the end of the coming period.
Till the end of the next step various possibilities are possible, each having its effect
on the securities prices. The price vector will now become St+1. We need
something which measures the performance of the portfolio for each possibility
and we use the value function Vt H defined earlier.
Given a trading strategy H, the value of the portfolio at time t+1, as viewed at t,
will now be a random variable dependent on future prices and is given by:
H
t +1
( ) = H
Bt +1 + H n Stn+1 ( )
n =1
H
t +1
( ) = H ( Bt +1 Bt ) + H n ( Stn+1 ( ) Stn )
0
t =0
n =1
This random variable gives the total profit or loss generated by the respective
portfolio.
26
S = ( B , S , S ,...S
*
t
*
t
1*
t
2*
t
N* T
t
S1
SN
= 1, t ,... t
, t = 0,1
Bt
Bt
Vt
H*
= H + H n Stn*
0
n =1
N
GtH* = H n Stn*
n =1
Vt H
= Vt H1* + GtH *
Bt
Example 2.3
T
Consider a 3-asset portfolio with corresponding price vector ( B0 , S01 , S02 ) having
four possibilities in the future t =1. B0 corresponds to a riskless asset and moves up
by 0.1 in all cases, but S01 and S02 can move only 0.1 up or 0.1 down with
probabilities as shown in the table below:
27
t=1
Asset
t=0
Bt
1.1
1.1
1.1
1.1
St1
2.3
2.4
2.4
2.2
2.2
St2
3.4
3.5
3.3
3.5
3.3
0.3
0.1
0.2
0.4
Probability
So on average for the next step we expect the value of the portfolio to be 4280. The
table below gives us the discounted price vectors.
t=1
Asset
t=0
Bt*
1.0000
1.0000
1.0000
1.0000
St1*
2.3
2.1818
2.1818
2.0000
2.0000
St2*
3.4
3.1818
3.0000
3.1818
3.0000
28
We see here that there is nothing here to be gained by investing in the risky assets.
And the situation looks silly!
2.6 Arbitrage
There are conditions which the price vector St needs to satisfy if it is not to lead to
untenable situations in a competitive market. We give a simple example:
Example 2.4
Consider the evolution of the price vector over a single step as given by the table
below:
t=1
Asset
t=0
Bt
1.1
1.1
S t1
2.3
2.5
2.4
S t2
1.3
1.5
1.4
0.5
0.5
Probability
(H
, H 1 , H 2 ) = ( 23,10,0 ) , which
T
corresponds to getting rid of 23 units from the first asset and keeping 10 units from
29
the second asset. Its value is 0 at t=0. When carried over to period t=1 this
portfolio gives a sure decrease: either 0.3 or 1.3.
T
such situations were possible, who would be willing to trade with the person
holding the second portfolio? No competitive sort of market would allow for long
one participant to make sure gains. We must now go beyond the simplicity of the
situation above and formulate the condition in a suitably general way.
Assumption 2.5
We shall assume that our probability space has a finite number of
possibilities {1 ,...K } .
Definition 2.6
A trading strategy H is said to be dominant over the period t = 0 to t =1 if there
exists trading strategy H with
V0H = V0H but V1H ( ) > V1H ( ) for all
The above condition is equivalent to the existence of a strategy creating wealth out
of nothing with certainty:
Theorem 2.7
The following statements are equivalent:
1. a dominant trading strategy exists
2. there exists a trading strategy H with V0H = 0 and V1H ( ) > 0, for all
3. there exists a trading strategy H with V0H < 0 and V1H ( ) 0, for all .
30
Proof:
(1)(2): Suppose that there exists a dominant strategy H and let H be a
dominated strategy. Then clearly H := H H satisfies the condition of the
theorem.
(2)(1): Let strategy H satisfy V0H = 0 and V1H ( ) > 0 , . Then if we take
the strategy given by the vector 0, we see that H dominates it.
H + H n S0n = 0
....( i )
n =1
B1 H 0 + H n S0n = 0
n =1
...( iii )
H ( S ( ) B S ) > 0
n
n
1
n
1 0
n =1
Letting
N
H n ( S1n ( ) B1S0n )
n =1
B1
= min
31
be equal to
N
H = H n S0n
0
n =1
Then,
N
n =1
n =1
Also,
V1H ( )
N
N n n
= H S0 B1 + H n S1n ( )
n =1
n=1
= H n ( S1n ( ) B1S0n ) B1
n =1
N
= H
n =1
( S ( ) B S ) min H ( S ( ) B S ) 0
n
1
n
1 0
n
1
n
1 0
n =1
(3)(2): If the strategy H satisfies (3), reversing the argument above, setting
N
H = H n S0n and leaving H n for all n = 1, 2,...N , the same, we get strategy H
0
n =1
satisfying (2).
We shall give yet another equivalent definition to the one above. This definition
will prove to be extremely useful later on, when dealing with pricing of options
contracts. It says that given future prices, there exists a probability measure
32
H
0
= V1
i =1
V1H (i )
(i )
(i ) (i ) =
B
i =1
1
K
H*
B1
i =1
1*
1
S0 S 0
2
2* 2 K S1 (i ) (i )
S0 S 0
=
=
B
i =1
1
S N* S N
0 0 K SN
1 ( i) ( i)
B1
i=1
Proof:
(1)(2)
If theres a linear pricing measure then, by definition, for any strategy H
33
H
0
= V1
V1H (i )
(i )
(i ) (i ) =
B1
i =1
K
H*
i =1
Let us take in particular the strategy with H 0 =1 and H n =0 for all n = 1,2,...N so
thatV0H = 1. But
K
H
0
= V1
i =1
V1H (i )
(i )
(i ) (i ) =
B1
i =1
K
H*
so
K
K
B1
V = (i ) = (i )
i =1 B1
i =1
for this portfolio. Since, by definition, has non-negative components, it can be
H
0
( H ,...H ) = ( 0,..,0,1,0,...0 )
1
where the unit 1 occurs in the jth position. Assume also that H 0 = 0 . Then
N
(i )
i =1
B1
(i )
i =1
Bi
n n
H B1 + H S1 (i )
n =1
S1j (i )
(2)(1)
Suppose that the is form a probability measure which for 1 n N satisfies the
condition :
K
(i )
i =1
Bi
S =
n
0
S1n (i )
H 0 + H n S0n
n =1
N
= H + H
0
(i ) S1n (i )
i =1
B1
n =1
0 N n S1n (i )
= (i ) H + H
B1
i =1
n =1
But
N
H + H n S0n = V0H
0
n =1
And
S1n (i ) V1H (i )
H + H
=
B1
B1
n =1
N
35
Variables
Constraints
Minimization
Problem
0
0
Unrestricted
Maximization
Problem
0
0
Unrestricted
Constraints
Variables
From the above table we know that the following problems are 2 dual LP
problems:
PROBLEM 1 :
max ( 0,0,...0 ) 2
K
st
1
1
S 1*
1*
1 ( 1 ) S1 (2 )
S N * ( ) S N * ( )
1
1
2
1
0
PROBLEM 2 :
1
1
S (K ) S 1
2 0
=
N
N*
S1 (K ) K S0
1*
1
H10
1
1
N H1
min (1, S0 ,...S0 )
HN
1
st
1 S11* ( 1 )
1*
1 S1 (2 )
1*
1 S1 (K )
0
S1N * (1 ) H 0
S1N * (2 ) H 1 0
S1N * ( K ) H N 0
36
Problem 1 captures the condition that decreasing future be consistent with all linear
pricing measures.
Problem 2 tries to find the smallest portfolio which gives positive values under
all possibilities.
(1)(2)
Suppose condition (1) holds and consider Problem 1. By Theorem 2.9, is a
probability measure which satisfies (2) in theorem 2.9. So problem 1 admits a
solution and its optimal objective value is clearly zero.
Recall the Strong Duality Property, again from Linear Programming:
If one problem possesses an optimal solution, then both problems possess optimal
solutions and the two optimal objective function values are equal.
By the above result the optimal value objective value in problem 2 is zero. But the
objective function in problem 2 is precisely V0H (so V0H = 0 ). On the other hand the
constraints represent V1*H (so V1*H ( ) 0 for all ).
This means that there cannot exist a strategy with V0H < 0 (since the minimal
V0H is zero) and V1*H ( ) 0 for all , which, by Theorem 2.7, is equivalent to
1*
1 S1 (2 )
1*
1 S1 (K )
0
S1N * (1 ) H 0
S1N * (2 ) H 1 0
S1N * (K ) H N 0
37
(or equivalently V1H ( ) 0 for all ), V0H cannot be less than zero.
So
E V1H > 0
38
Suppose there exists a dominant strategy H. Then by theorem 2.7 there exists a
trading strategy H with V0H = 0 and V1H ( ) > 0 for all . Clearly for this
strategy E V1H > 0 , as required.
We next give a counterexample to prove the second part of the theorem. We shall
give an example where an arbitrage opportunity exists and yet no dominating
strategy can exist.
Consider the following 2-asset prospectus:
t=1
Asset
t=0
Bt
S t1
2.3
2.4
2.3
1-p
Probability
39
above. They will not necessarily be equal. We denote the expectation of X with
respect to P1 by E P1 [ X ] and similarly with respect to P2 . We present this sections
important concept:
Definition 2.12
Given a set of future possibilities on which we define a probability measure Q .
Then Q is said to be a risk neutral probability if:
Q {} > 0 for all
E Q S n* := E Q S1n* S0n = 0 for each n = 1,2,...N
Example 2.13
Consider a financial market composed of two risky assets and a riskless asset. In
general there will be much more future possibilities than assets and so satisfying
the corresponding set of risk neutral equations may be difficult for we have too
many equations to satisfy. For simplicity we assume that there are only three future
possibilities 1,
2 T
0
( S , S ) = (10, 25)
1
0
12 10 8 p 2 = 10
15 20 30 p 25
40
The first row corresponds to the property of a probability measure (i.e. sum to
T
one). There is a unique solution to this : ( p1 , p2 , p3 ) = (1, 1,1) which clearly does
not give us a probability distribution.
Case 2 :
1 1 1 p1 1
12 10 8 p2 = 10
24 20 16 p 25
3
This set of equations is really just 2 equations which can be reduced to
p3 = 1 p1 p2 and p2 = 1 2 p1 so that there are 2 solutions which exclude risk
T
neutral
probability
( p1 , p2 , p3 )
1 1
= ,0,
2 2
and
( p1, p2 , p3 )
= ( 0,1,0 )
remembering that the risk neutral measure must be strictly positivewhile the
general solution is (, 1-2, ) for 0 < < 1. Situations like this can be found
which exclude completely probabilistic interpretations for the ps.
Case 3:
1 1 1 p1 1
12
10
8
p2 = 10
23 20 30 p 25
3
The above matrix shows the existence of a risk neutral measure which is given by
the unique solution:
T
( p1, p2 , p3 )
= ( 0.38462,0.230769,0.384615 ) .
41
Theorem 2.14
The following 2 conditions are equivalent:
1. There exist no arbitrage opportunities
2. There exists a risk neutral measure
Proof:
(1)(2)
Form a set W of all random vectors corresponding to the gains vector in future of
some portfolio H:
W = { X = ( X 1 , X 2 ,... X K ) : G1H* (1 ) = X 1 ,...G1H* (K ) = X K for some H }
Then W is a vector subspace of RK (it is not difficult to show that for all X , Y
W and for all real numbers , we have X + Y W Exercise).
Let O+ be the positive orthant of RK without the origin, that is
O + = {( x1 , x2 ,...xK ) : xi 0, x1 + x2 + ...xK > 0}
Saying that there does not exist any arbitrage opportunities means there exists no H
such that
V0H = 0
V1H ( ) 0 , that is G1H* ( ) 0,
42
{X = ( X , X
1
Let S1 = W and S2 = A+ . The above result is equivalent to saying that there exists
a K-dimensional vector Y which lies in the orthogonal complement of S1 such that
for all XS2 X.Y > 0.
However it is clear that for any selected index j, we can always choose vector X
from A+ which has 0 components except for the jth which must be strictly
positive. This forces all Y components to be strictly positive. The required risk
neutral probability is then given by:
43
Q { j } =
Yj
Y1 + ...YK
(2)(1)
Suppose risk neutral probability measure Q , that is
Q { j } > 0 for all
E Q S n* := E Q S1n* S0n = 0 for each n = 1,2,...N
Take any trading strategy H, we have
N
N
E Q G1H* := E Q H n S1n* = H n EQ S1n* = 0
n=1
n=1
So there cannot exist G1H* , such that G1H* ( ) 0 for all and E Q G1H* > 0 .
But this is equivalent to not having arbitrage opportunities Exercise.
Example 2.15
Consider a 2 asset situation with price vector profile:
t=1
Asset
t=0
St1
St2
10
12
44
S n*
St1
-1
St2
-2
-2
{( H
1
1
+ 2H 2 , H 1 2 H 2 , H 1 2 H 2 ) , H 1, H 2
This vector space is really two dimensional and can be described as:
W = {( X 1 , X 2 , X 3 ) : X 1 + X 3 = 0}
This shows that there is an arbitrage opportunity. Let us see which portfolio will
give us gain zero for 1, gains X2 for 2, and gain 0 for 3. It will be the portfolio
satisfying:
H 1 + 2 H 2 = 0 and H 1 2 H 2 = X 2
This solves to H 1 =
1
1
X 2 and H 2 = X 2 . If we take X 2 to be any positive
2
4
T
Indeed,
45
at t = 0 the value of the portfolio is zero, for 1 we get zero gain, for 2 we get
strictly positive gains and for 3 we get 0 gain.
1
). Then the risk neutral
B1
46
Then the average discounted future value of any amount of this stock with respect
to this probability measure is always equal to its original value at t = 0. The price
X
should be the average profit, that is E Q = 5 0.8 q = 1.6
B1
(H
option (i.e. the value at time one of the portfolio coincides with the contingent
claim) and we work in t = 1 prices:
H0
H0
1
If stock goes to 20: 5 =
+ 20 H . If the stock goes to 7.5: 0 =
+ 7.5 H 1
0.8
0.8
The net result of all this is that with this replicating portfolio nothing is risked.
We see that selling the option and maintaining the portfolio above exactly balances
because the initial price of the option is set at 1.6. Note that the probabilities with
47
which the stock changes its values were not used at all. If we priced out options
higher we would have made a riskless profit. If it was less than 1.6 we would have
made a riskless profit by exchanging our roles and buying options rather than
selling.
When a trading strategy, called replicating portfolio, exists with this initial value
V0H , we say that the contingent claim is attainable or marketable. It could be
argued that this initial V0H , the value of our riskless portfolio should be the price of
our option. It promises no gains and no profits. However, one can point out
immediately that to argue for its unicity, we must show that no other portfolio
replicates the contingent claim with initial value different fromV0H . More
precisely:
The Law Of One Price holds for a securities market if there exist no trading
1
strategies H 1 and H 2 with V1H ( ) = V1H ( ) for all and V0H > V0H
This is a weaker condition than that prohibiting dominating strategies. This result
is easy to prove. We next show how the law of one price affects valuation:
If the law of one price holds, then the value V0 of an attainable contingent claim at
N
n =1
48
Theorem 2.16
If there are no arbitrage opportunities then the t=0 value of an attainable contingent
claim, which can be considered as a random variable X in the future, is given by
X
EQ where Q is any risk neutral probability.
B1
Proof:
With no arbitrage opportunities we have the existence of a risk neutral probability
satisfying;
E Q S n* := E Q S1n* S0n = 0 for each n = 1,2,...N .
For an attainable contingent claim X, its value at t=0 is given by the value of a
replicating trading strategy H:
N
H
0
= H B0 + H n S0n
0
n =1
N
= H 0 + H n EQ S1n*
n =1
S1n
X
= H + H EQ = E Q
n =1
B1
B1
N
Example 2.17
Consider the following price vectors:
t=1
Assets
t=0
Bt
S t1
9/8
9/8
10
12
49
The existence of a risk neutral probability is provided by the solution of the system
of linear equations:
8 12 q1 8 9 q2
+
= 10
9
9
q1 + q2 = 1
Then
X 3 3 8
+0=2
EQ =
B
4
9
1
12 8 H 1 3 8
: H +
=
9
9
0
98 H1 08
For 2 : H +
=
9
9
0
50
Example 2.18
Consider the following price vectors:
t=1
Assets
t=0
Bt
S t1
12/11
12/11
22
30
20
We want to find the price which should be charged for someone who wants to own
an option to buy the risky security at t=1 for the price of 25 (call option).
The existence of a risk neutral probability is provided by the solution of the system
of linear equations:
30 11 q1 20 11 q2
+
= 22
12
12
q1 + q2 = 1
which gives q1= 2/5 and q2 = 3/5 . This guarantees the existence of no arbitrage
opportunity.
Our contingent claim X can be written as follows:
X (1 ) = 5
X ( 2 ) = 0
because if the price goes down to 20, it does not make sense to exercise the option.
If the price goes up to 30, clearly buying at 25 give a net profit of 5. We next prove
51
that is the
12 H 0
:
+ 30 H 1 = 5
11
12 H 0
+ 20 H 1 = 0
For 2 :
11
This gives H 0 =
55
1
and H 1 = .
6
2
Then the price of the option is the value of this portfolio at t=0, that is
55
1 11
+22 =
6
2 6
From the other point of view we see that the expected value of X according to our
X
2 11
3 11
risk neutral probability is exactly: E Q = 5 + 0 = .
5 12
5 6
B1
Let us now consider a put option at strike price again 25. We let our contingent
claim, giving the right of the option holder to sell the security at price 25 at t=1, be
denoted by Y. So
X (1 ) = 0
X ( 2 ) = 5
because if the price goes up to 30, it make no sense to exercise the option, but if
the price goes down to 20, clearly selling at 25 gives a net profit of 5. Now for the
replicating portfolio:
For 1
12 H 0
:
+ 30 H 1 = 0
11
52
12 H 0
For 2 :
+ 20 H 1 = 5
11
This gives H 0 =
1
55
and H 1 = . Then the price of the option is the value of this
2
4
From the other point of view we see that the expected value of Y according to our
Y
2
3 11 11
risk neutral probability is exactly: E Q = 0 + 5 = .
5
5 12 4
B1
Definition 2.19
A securities market model is said to be complete if every contingent claim X can
be replicated by some trading strategy.
53
Theorem 2.20
Suppose that there exist no arbitrage opportunities within a securities market
model. Then the model is complete if and only if the number of point in the
probability space is equal to the number of independent vectors in the future
price matrix:
B1 (1 ) S11 (1 )
1
B1 (2 ) S1 (2 )
1
B1 (K ) S1 (K )
S1N (1 )
S1N (2 )
S1N (K )
Proof:
The result is easy to see since a contingent claim is nothing else but a random
variable X which gives us the random vector:
X (1 )
X ( 2 )
X ( )
K
1
B1 (2 ) S1 (2 )
1
B1 ( K ) S1 (K )
0
S1N (1 ) H X (1 )
S1N (2 ) H 1 X (2 )
=
S1N (K ) H N X (K )
54
Example 2.21
We would like to find out whether given a securities market with 4 future states
11
10
11
10
11
10
11
10
13
24 6 15
30 7 18
35 11 20
22
2.386364
1.931818
-4.09091
0.681818
0.416667
-0.58333
0.166667
-0.125
0.375
-0.5
0.25
-0.79167
0.708333
0.5
-0.41667
Seeing that the rank is 4 and it is equal to the number of states, we can immediately
conclude that the claim is attainable. In fact to get the replicating portfolio we need
only multiply the above matrix by the claim vector to obtain:
53.04909
2.5
11.25
3.75
55
To obtain the valuation then we need to work out the value of this portfolio at t=0.
Or else, as previously, we get the risk neutral probability and average with respect
to it future gains for this portfolio.
It would be useful to express attainability in terms of valuation with reference to
risk neutral probabilities. It turns out that attainability ensures that valuation under
all such probabilities is the same, a condition we considered earlier:
Theorem 2.22
X
A contingent claim X is attainable if and only if EQ is constant for every risk
B1
neutral probability Q .
Proof:
To prove this result we first need to assume that the set of risk neutral probabilities
is non-empty.
()
X
Suppose contingent claim X is attainable. By the proof of theorem 2.16 EQ is
B1
constant with respect to any risk neutral probability measure as this is equal to the
V0H , the initial value of the replicating portfolio.
(
)
We prove this by contrapositive. So we show that if X is not attainable then we
X
X
can find Q1 , Q2 such that E Q1 E Q2 .
B1
B1
56
B1 (1 ) S11 (1 )
1
B1 (2 ) S1 (2 )
1
B1 ( K ) S1 (K )
0
S1N (1 ) H X (1 )
S1N (2 ) H 1 X (2 )
=
S1N (K ) H N X (K )
X (1 )
S1N (1 )
S1N (2 )
X ( 2 )
, X =
and consider an
X ( )
S1N (K )
K
B1 (1 ) S11 (1 )
B1 (2 ) S11 (2 )
H
Let S =
1
B1 (K ) S1 (K )
System 1:
System 2:
AT= c
for some x in
that is
B
1 1
B
1 2
B1 K
( )
( )
( )
( )
S ( )
S11 1
1
1
1
1
( )
S K
S1N
( )
( )
S1N 1
N
1
( )
K
H 0 X ( 1 )
1
H = X ( 2 )
N
H X ( K )
Since X is not attainable this system has no solution, thus system 1 has a solution.
57
that is
B
( ) B1 ( 2 )
1 1
S 1 ( ) S 1 ( )
1
2
1 1
N
N
S1 ( 1 ) S1 ( 2 )
B1 ( K ) x 0
1
1
S1 ( K ) x2 0
=
S1N ( K ) x K 0
and
( X ( )
1
X ( 2 ) X ( K )
x1
x
2 >0
x
K
Now take any risk neutral probability measure Q1 , then for each k, and > 0 the
expression Q1 (k ) + xk B1 (k ) can be made strictly positive provided is small
enough, call it k. Then take to be the smallest of all ks , so that for this ,
Q1 (k ) + xk B1 (k ) > 0 for all k =1, ... , K.
58
S1n K S1n ( k )
E Q2 =
Q 2 ( k )
B1 k =1 B1
K
K
S1n ( k )
=
Q1 (k ) + S1n ( k ) xk
B1
k =1
k =1
S1n
= E Q1
B1
since the last term in the summation is 0 by the matrix equation we obtained
earlier. So Q2 is a risk neutral measure.
Given the claim X, we see that:
X K X ( k )
E Q2 =
Q 2 ( k )
B1 k =1 B1
K
K
X ( k )
=
Q1 (k ) + X ( k ) xk
B1
k =1
k =1
X
= E Q1 + xX
B1
Since, from Farkas Lemma, xX > 0, it follows that the expectations are not the
same.
Theorem 2.23
A securities market model is complete if it has one and only one risk neutral
probability.
Proof:
(
)
59
Suppose there exists only one risk neutral probability Q for a model. For any
X
contingent claim X , E Q with one value makes X attainable and the model
B1
complete
(
)
We prove this by contradiction.
Suppose that we have two distinct risk neutral probabilities Q1 and Q2 . Then on
some possibility , Q1 ( ' ) Q2 ( ') . Consider the following contingent claim X:
X ( ) = 0
if '
X ( ) = B1 ( ) if = '
Then we have
X
X
X
E Q1 = Q1 ( ' ) and E Q2 = Q2 ( ') E Q1
B1
B1
B1
X
This shows E Q is not constant as Q varies over risk neutral probabilities,
B1
contradicting completeness.
In a sense we have closed a circle of ideas which centre about the existence of the risk
neutral probability. This artificial probability allows us to value propositions one
would like to put on the market under the proviso that such propositions be replicable.
This condition is equivalent to uniqueness of the risk neutral probability.
60
2.10 RETURN
Before concluding the current chapter we introduce another useful terminology in
finance; the return process. We shall define this term relative to the prices of the
assets and the value and gains processes.
We shall start by giving a necessary definition.
Definition 2.24
Given a securities market model built on a probability space ( , F , P ) , and risk
neutral probability measure Q , the state price vector is the random variable L
defined by
Q {}
L ( )
=
P {}
B1 B0
=r.
B0
61
S1n ( ) S0n ( )
S ( ) S =
B1
B0
n*
1
n*
0
S1n ( ) B1S0n ( )
=
B1
B1
(1 + R ( ) ) S (1 + R ) S
=
n
n
0
n
0
1 + R0
n
0
n R ( ) R
= S0
1 + R0
Recall that for probability measure Q to be risk neutral it has to satisfy the
equation:
E Q S1n* ( ) S0n* = 0
And since we are assuming that the interest rate is fixed at r, we get the further
simplification that
Rn r
EQ
=0
1+ r
E Q R n = r
(1)
62
Given a security n and a risk neutral probability Q, the corresponding state price
vector L plays a useful reference role as we shall see.
Directly from the definitions we have:
Q K Q (i )
E[ L] = E =
P (i ) = 1
P i =1 P (i )
and
n
n Q K R (i ) Q (i )
E R L = E R
=
P (i ) = E Q R n
P (i )
P i =1
n
Furthermore:
Cov R n , L = E R n L E R n E [ L ]
= E Q R n E R n = r E R n
is called the risk premium for the security n. r is the risk neutral rate and thus
what we get in excess of it can be viewed as compensation for the risk assumed
when possessing the asset. Obviously this has to be positive if it is to attract
investors to undertake risk.
H
63
VH
V1H ( ) V0H
( ) =
V0H
VH
V1H ( ) V0H
( ) =
V0H
N
H 0 B1 + H n ( ) S1n ( ) H 0 H n ( ) S0n
n =1
n =1
H
0
V
N
H 0 r + H n ( ) S0n ( R n ( ) + 1) H n ( ) S0n
n =1
n =1
H
0
N
H0
H n S0n n
= H r + H R ( )
n =1 V0
V0
which we can interpret as the decomposition of each individual possible return into
fractions of investment in riskless asset and n securities multiplied by the
respective returns (in particular the return on the portfolio is a convex combination
of the return on the individual securities).
We can use this equation and repeat the analysis which we did further up
individually on each asset to deduce that :
E RV E Q RV = E RV r = Cov RV , L
...(*)
Along this line of thinking it makes sense to look at the behaviour of contingent
claims compared to an arbitrary portfolio with reference to state price vector L:
64
Theorem 2.26
Given state price vector L relative to a market prices probability space and take any
real numbers a, b such that the contingent claim a + bL is attainable by a
H
we have:
Cov RV , R V
E RV H r
r =
H
V ar RV
E RV
Proof:
Fix a and b with b 0 such that a + bL corresponds to an attainable claim and
hence has a replicating portfolio H for which we have starting value V0H and final
value V1H = a + bL .
= V1H then L =
V1 a
=
b
V0H 1 + RV
)a
. Given any
) = V
V H 1 + RV H a
0
Cov [ R, L ] = Cov R,
V H 1 + RV H
0
= Cov R,
H
0
Cov R, RV
b
H
H
V0H
Then (*) allows us to write : E [ R ] r =
Cov R, RV .
V
V
E RV r = 0 Cov RV , RV = 0 Var R V
b
b
H
V0H
allowing us to substitute for
giving :
b
Cov R, R V
E RV H r
E[ R] r =
H
Var R V
Cov RV , RV
66
Chapter 3
The Optimal Portfolio and Optimal
Consumption-Investment Problem in Single
Period Financial Markets
3.1 OPTIMAL PORTFOLIOS
The problem at the heart of our studies in this branch of financial mathematics
surely has to be that of finding the portfolio which under the constraints of
operating securities market maximizes some measure of performance of the
corresponding portfolio. Such measures are usually modeled by utility functions.
In simple terms, a utility function reflects the preferences of an individual for
wealth and the risk he or she is willing to take to achieve a higher wealth.
Definition 3.1
A map u : is said to be a utility function if for each fixed ,
u(x,) is a concave and strictly increasing function in x. Then given a portfolio H
its expected terminal wealth utility is given by
E u (V1H , ) = u (V1H ( ) , )P ( )
If we let H denote the set of all trading strategies, we can express the problem as
finding H H whose expected utility at t =1 is equal to:
67
H H
H H
Theorem 3.2
If a securities market model admits of a solution to the optimal portfolio problem
then the same model allows no arbitrage opportunities.
Proof
We shall prove this theorem by proving the contrapositive.
So suppose there is an arbitrage opportunity. Then we have a portfolio H such that
V0H = 0
V1H ( ) 0 , that is G1H* ( ) 0,
E V1H > 0
For any portfolio H' = ( H '1, H '2 ,...H 'N ) with value V0H' = 0 , we have
N
n =1
n =1
n =1
Now this allows us to define a new portfolio H + H' whose initial value has not
changed, but whose expectation under the utility function u has to increase (since u
is an increasing function). But then if any H' were to be optimal, this new portfolio
would contradict it.
68
Definition 3.3
A securities market model is said to be viable if there exists utility function u for
which there exists a portfolio G such that G arg max E u (V1H ) .
H H
And now we establish the link between optimality and arbitrage opportunities
which we already linked very intimately with risk neutral probabilities:
Theorem 3.4
A securities market model is viable if and only if it admits of a risk neutral
probability measure.
Proof:
(
)
Suppose the model is viable. The existence of a solution to the optimal portfolio
problem guarantees the exclusion of arbitrage opportunities which in turn gives us
the existence of a risk neutral probability. We can actually go one step further and
compute such a probability.
The function we are optimizing may be written as:
u ( B (V
H
0
+ H 1S 1* ( ) + H 2 S 2* ( ) + ...H N S N * ( ) ) P {}
H n
u ( B (V
1
H
0
+ H 1S 1*() + .. + H N S N *()))P[{}] = 0
69
Let H with corresponding value V1H be the optimal portfolio whose existence is
our hypothesis. Then we define the probability measure Q as follows:
u (V1H ())
P {}
x
H
(u (V1 ))
E
Q {} =
u (V1H ( ) )
= S
n*
( )
P {}
x
u (V1H )
E
x
u (V1H )
n*
E S
=
= 0 for n = 1,2,...N
u (V1H )
E
x
()
Now suppose that a risk neutral probability Q exists. We set V0H = v and then
define a utility function u as follows:
70
u ( x, ) =
x {}
P {} B1
Note that we are using the more general definition of a utility function here
(i.e. of a mapping on ). Clearly this satisfies all the properties required of
utility functions. Take arbitrary portfolio ( H 1 , H 2 ,...H N ) . Then
E u B1 ( v + H 1S 1* + H 2 S 2* + ...H N S N * ) ,
B1 ( v + H 1S 1* ( ) + H 2 S 2* ( ) + ...H N S N * ( ) ) Q {}
P {} B1
P {}
= ( v + H 1S 1* ( ) + H 2 S 2* ( ) + ...H N S N * ( ) ) Q {}
= v + E Q H n S n* = v
n =1
This applies to all trading strategies H. Thus they are all trivially optimal.
This theorem has to be interpreted correctly. It does not say that existence of
a risk neutral probability is equivalent to the existence of optimal portfolio
solution given any utility function one pleases. It says that existence of risk
neutral probability is equivalent to having some utility function for which the
optimal portfolio solution exists. In fact the utility function which we used in
our theorem is pretty useless for it makes all portfolios equally profitable!
In practice one would be more interested in finding the optimal portfolio for a
given utility function applied to a future scenario of market prices for different
assets. The direct solution to this problem is clearly a classical one in optimization.
71
Example 3.5
Suppose we use the utility function u ( x ) = 1
1
and we take the discounted
1+ x
t=1
2
8/7
8/7
8/7
8/7
14
16
14
21
12
21
24
22
24
30
Assets
t=0
B1S0n
Riskless
Asset 1
Asset 2
The risk neutral probability for the above problem is given by:
1
1
1
Q {
Q
Q
=
,
=
,
=
}
{
}
{
}
1
2 3 3 6
2
This probability guarantees the viability of the model, but the optimum might be
achieved with some utility function different from the one we have. For our utility
functions if we are to have an optimum the following condition is necessary:
n* u (V1H )
E S
= 0 for n = 1, 2
x
Now
u
1
1
u (V1H ( ) ) =
=
2
x
(1 + V1H ( ) ) 1 + B1 (V0H + H 1S 1* ( ) + H 2S 2* ( ) )
72
Then
3
S 1* (i ) P {i }
1* u
H
E S
u (V1 ) =
x
i =1 1 + B1 (V0H + H 1S 1* (i ) + H 2 S 2* (i ) )
1.75P {1}
(1 + B (V
H
0
1.75 H 1 1.75 H 2 )
4.375P {2 }
) (1 + B (V
H
0
+ 4.375 H 1 + 0 H 2 )
3.5P {3}
=0
and
3
S 2* (i ) P {i }
2* u
H
E S
u (V1 ) =
x
i =1 1 + B1 (V0H + H 1S 1* (i ) + H 2 S 2* (i ) )
1.75P {1}
(1 + B (V
H
0
1.75 H 1 1.75H 2 )
0P
{2 }
) (1 + B (V
1
H
0
+ 4.375 H 1 + 0 H 2 )
5.25P {3}
(1 + B (V
1
H
0
3.5H 1 + 5.25H 2 )
=0
There are two unknowns H 1 and H 2 . Solving the two equations above in two
variables would require the use of a computer.
73
The method used in the example above involves optimization over general
nonlinear derivatives of utility functions. An efficient method has been devised to
take care of this. Firstly we note that the optimum we are interested in can be
viewed as the composition of two functions: the first function maps strategies into
the random variable of their final values and the second function gives the
expectation of each such random variable. What we can do is first find the optimal
value W * = arg max E u (W ) . Here we are optimizing over all contingent claims
W
74
Indeed
max E u (W ) becomes:
W W
maxK E u (W ) E Q V0H
(W , )
B1
Q ( )
.
P ( )
ignored, so the objective function becomes:
L ( )W ( )
LW
E u (W )
=
u
W
,
(
)
(
)
P {}
B1
B1
L ( )W ( ) u (W ( ) ) L ( )
=0
u (W ( ) )
=
x
B1
x
B
1
These are
u (W ( ) )
x
any .
L ( )
B1
u
and L
x
always
positive,
L ( ) Q ( )
=
B1
B1P ( )
which gives:
u (W ( ) )
Q ( ) =
B1P ( )
75
P {}
x
H
(u (V1 ))
E
(u (W ))
For each . This forces = B1E
.
This gives us a method for computing the optimal W. Denoting by I the inverse to
u
with reference to its first variable, we have:
x
L ()
u (W ())
I
= W () so W () = I
x
B1
To obtain an explicit formula for we see that for the contingent claim W,
E Q [W / B1 ] = V0H , which in our case translates to the equation:
L ()
I
B
1
= V0H (*)
E Q
B1
This equation has a unique solution because of the nature of the function I. The
expected value of W will give the optimal wealth.
Being in a complete market we can work out the corresponding portfolio H.
Piecing all together, having the discount factor and future prices scenario we
proceed as follows:
compute Q, L and I
76
then solve equation (*) to obtain and hence the optimal wealth W
find the portfolio component H = ( H 1 , H 2 ,...H N ) which generates the optimal
wealth W.
Example 3.6
Consider the following pricing scenario for 2 assets and an underlying riskless
asset:
t=1
2
10/9
10/9
10/9
St1
5.4
St2
13
0.5
0.25
0.25
Assets
t=0
Bt
Probability
Q {1} + Q {2 } + Q {3} = 1
6Q {1} + 8Q {2 } + 4Q {3} = 6
13Q {1} + 9Q {2 } + 8Q {3} = 10
1
which is Q {1} = Q {2 } = Q {3} = . We next take the utility function:
3
u ( x ) = exp ( x )
77
Then
u (W ( ) )
x
equation:
u (W ( ) )
L ( )
W ( ) = I
= I
x
B1
we get:
L ( )
L ( )
W ( ) = log
= log ( ) log
B1
B1
(**)
L ( )
I
B1
Furthermore E Q
= V0H becomes:
B1
V0H
L ( )
L
L ( )
I
log
log
B
B
log
(
)
=E
=
B1
= EQ
E
Q
Q
B1
B1
B1
B1
L
B1
H
= exp BV
1 0 E Q log
which when we plug it in (**), gives the value for the optimal portfolio W whose
utility is given by:
log ( L ( ) )
L ( )
u (W ( ) ) = exp
=
B1
B1
E u (W ) =
E [L]
B1
B1
(***)
We can now put numbers: The state price vector L is given by:
L(1 ) =
Q(1 ) 1/ 3 2
Q(2 ) 1/ 3 4
=
= , L(2 ) =
=
= = L(3 ) .
P (1 ) 1/ 2 3
P (2 ) 1/ 4 3
So
L 1
2
2.9
4.9
E Q log = log
+
2
log
3.10 = 0.04873
3
3.10
B1 3
Then the optimal attainable wealth is given by:
L( ))
L( )
W ( ) = log
= log( ) log
=
B
B
1
1
L
L( )
B1V0H + EQ log log
B1
B1
Thus
W (1 ) =
L
2 10 H
10 H
V0 + EQ log log
= V0 + 0.46209
9
B
3
B
1
1 9
W (2 ) =
L
2 10 H
10 H
V0 + EQ log log
= V0 0.23105 = W (3 )
9
B
3
B
1 9
1
and
10 H
V0 + 0.04873
9
= exp
79
Having computed the random variable W which gives the optimal expected wealth,
we can work backwards to obtain the corresponding trading strategy.
So we need to solve the following:
10
9
10
9
10
9
10 H
6 13
V
+
0.46209
0
9
0
H
1 10 H
8 9 H =
V0 0.23105
H 2
10
H
V0 0.23105
4 8
80
Definition 3.7
The pair (C0, C1) of a real number C0 and random variable C1 are said to consitute
a consumption process. Providing a trading strategy H to form (C0, C1, H) gives a
consumption-investment plan.
Definition 3.8
Given an initial sum of money v 0, consumption-investment plan (C0, C1, H) for
which V0H is the value of H at t = 0 and V1H at t = 1, is said to be admissable if
v = C0 + V0H and C1 = V1H
with
N
H
0
= H + H S and V1 = H B1 + H n S1n
0
n =1
n
0
n =1
81
As is customary the first question which we need to ask is whether we can find a
convenient way of checking whether a given consumption-investment plan is
admissable.
And the answer to this question is yes with the check being given by the usual riskneutral probability:
Theorem 3.9
Given initial amount v 0 and consumption process (C0,C1), trading strategy H
such that the consumption-investment plan (C0, C1, H) is admissable exists if and
C
only if for every risk-neutral probability Q we have: C0 + EQ 1 = v .
B1
Proof
()
Suppose there exists a trading strategy H such that the consumption-investment
plan (C0, C1, H) is admissable. Then v = C0 + V0H and C1 = V1H assures us that C1 is
an attainable contingent claim and we know from theorem 2.16 that
C
C
E Q 1 = V0H for any risk neutral measure thus C0 + EQ 1 = v .
B1
B1
( )
C
On the other hand if equation C0 + EQ 1 = v holds for all risk neutral
B1
82
This theorem again signals to us the possibility for solving the consumptioninvestment problem. We can use a risk-neutral computational approach. Let us state
the problem with precision:
subject to
N
C0 + H 0 + H n S0n = v
n =1
N
C1 H B1 H n S1n = 0
0
n =1
C1 , C0 0
Example 3.10
Given the following price process involving three assets in t=1 prices:
S0n
B1S0n
Riskless Asset
64/61
64/61
64/61
64/61
64/61
Asset 1
732
768
790
750
770
790
Asset 2
1525
1600
1580
1720
1534
1590
Asset 3
2196
2304
2180
2180
2428
2180
1/8
1/8
Probability
x . Then
83
max
u ( C0 ) + E u ( C1 )
H
becomes
1
1
1
1
max C0 + E C1 = max C0 +
C1 (1 ) +
C1 (2 ) +
C1 (3 ) +
C1 (4 )
H
H
2
4
8
8
with
C0 = v H 0 732 H 1 1525 H 2 2196 H 3
and the other consumption components given by:
64 0
H1 + 790 H 1 + 1580 H 2 + 2180 H 3
61
64
C1 (2 ) = H10 + 750 H 1 + 1720 H 2 + 2180 H 3
61
64
C1 (3 ) = H10 + 770 H 1 + 1534 H 2 + 2428 H 3
61
64
C1 (4 ) = H10 + 790 H 1 + 1590 H 2 + 2180 H 3
61
C1 (1 ) =
84
0 to obtain 4 equations:
1
2 v H 0 732H1 1525H 2 2196H 3
64 / 61
64 0
H + 790H 1 +1580H 2 + 2180H 3
61
64 / 61
64 / 61
+
64 0
64 0
8
H + 750H 1 +1720H 2 + 2180H 3 16
H + 770H 1 +1534H 2 + 2428H 3
61
61
64 / 61
+
=0
64 0
16
H + 790H1 +1590H 2 + 2180H 3
61
732
2 v H 0 732 H 1 1525H 2 2196H 3
790
64 0
H + 790 H 1 + 1580 H 2 + 2180 H 3
61
750
770
+
64 0
64 0
8
H + 750 H 1 + 1720 H 2 + 2180 H 3 16
H + 770 H 1 + 1534 H 2 + 2428H 3
61
61
790
+
=0
64 0
16
H + 790 H 1 + 1590 H 2 + 2180 H 3
61
4
85
1525
2 v H 0 732 H 1 1525H 2 2196H 3
1585
64 0
H + 790 H 1 + 1580 H 2 + 2180 H 3
61
1720
1534
+
64 0
64 0
8
H + 750 H 1 + 1720 H 2 + 2180 H 3 8
H + 770 H 1 + 1534 H 2 + 2428H 3
61
61
1590
+
=0
64 0
1
2
3
16
H + 790 H + 1590 H + 2180 H
61
2196
2180
+
2 v H 0 732 H 1 1525H 2 2196H 3 4 64 H 0 + 790 H 1 + 1580 H 2 + 2180 H 3
61
2180
2428
+
64 0
64 0
H + 750 H 1 + 1720 H 2 + 2180 H 3 8
H + 770 H 1 + 1534 H12 + 2428H 3
8
61
61
2180
+
=0
64 0
1
2
3
H + 790 H + 1590 H + 2180 H
16
61
4
C
C
u
u
u
u
(C0 , ) 00 + E[ (C1 ) 10 ] = (C0 , ) + B1E[ (C1 )] = 0 ...(A)
x
x
x
x
H
H
C
C
u
u
u
u
(C0 , ) 0n + E[ (C1 ) 1n ] = S0n
(C0 , ) + E[ (C1 ) S1n ] = 0 ...(B)
x
H
x
H
x
x
for n =1,2,, N.
If we write the equations above as F(H) = 0, then we can iterate the NewtonRaphson way:
86
u
u
(C0 ) = B1E[ (C1 )]
x
x
u
x (C1 ) B1
1= E
u (C0 )
x
Letting
u
(C1 ) B1
L := x
u
(C0 )
x
suggests to us to put :
u
(C1 ( ))
x
Q { } = B1
P { }
u
(C 0 )
x
We can see that this implies the equation:
87
u
( C1 ( ))
n
n
x
E Q S1 = S1 ( ) B1
P { }
u
(C 0 )
x
B1
u
=
E
(C1 ) S1n = B1 S 0n
u
x
(C 0 )
x
where the last equality follows from (B) above. Thus Q is indeed a risk neutral
probability measure.
3.3.2
The reasoning above gives us the basis for the risk neutral oriented solution to the
consumption-investment problem. The idea is to treat C1 as a contingent claim
which should be the solution to:
subject to
C
C0 + E Q 1 = v
B1
C0 , C1 0
Using the Lagrange multiplier technique, this problem then translates to :
88
Q { }
L ( ) =
where
P { } .
We shall assume that the choice of utility function will automatically rule out
negative consumption values. Then we can set up the set of equations which give us
the optimum:
L ( )
u
u
(C0 ) = and
(C1 ( )) =
x
x
B1
Then if we define the function:
1
u
I ( x) = ( x )
x
we have
C0 = I ( )
and
C1 ( ) = I ( L( ) / B1 ) .
Then to solve for we use
C0 + E Q [C1 / B1 ] = v = I ( ) + E Q [ I ( L / B1 ) / B1 ] .
89
I ( x) = ( u ' ) ( x ) =
1
4 x2
gives us:
B12
v = I ( ) + E Q [ I ( L / B1 ) / B1 ] = 2 + E Q 2 2
4
4 L B1
1
{i }
i =1
L(i ) 2
64C0
=
61
Q {i }
i =1
L(i ) 2
64C0
=
61
P {i }
Q { }
i =1
and
2
4 Q { }
4 P { }
B12
64
64
i
i
v=
+ E Q 2 2 = C0 +
C0
= C0 1 +
2
2
4
61 i =1 L(i )
61 i =1 Q {i }
4 L B1
Also
P {1 } = 0.5, P {2 } = 0.25, P {3 } = 0.125, P {4 } = 0.125
so that we compute
L (1 ) = 0.2, L (2 ) = 1.2, L (3 ) = 4, L (4 ) = 0.8
90
v = 4.0383C0
which gives
C0 = v / 4.0383 = 0.2476v
so that
1
2 C0
1.0096
v
0.2726v
1 B1 1
64 v
C1 () = I (L() / B1 ) =
=
4 L() 4 61 1.0096L()
L()2
C1 (1 ) = 6.8145v
C1 (2 ) = 0.1893v
C1 (3 ) = 0.0170v
C1 (4 ) = 0.4259v
and we have obtained C1 as a contingent claim now.
We could work out the replicating portfolio by solving for H in :
91
This gives us the full consumption-investment plan (C0,C1,H) and thus our problem
has been conveniently split up into two parts.
Let us first take care of the context. Given portfolio H = ( H 0 , H 1 , H 2 ,...H N ) with
H
V1H V0H
=
V0H
Earlier we saw that we could split up the return of a portfolio into the sum of returns
from each asset:
H
RV =
N
H0
H n S0n n
r
+
R
H
V0H
V
n =1
0
92
RV = (1 F1 ...FN ) r + Fn R n (*)
H
n =1
where Fn is interpreted as the fraction from the total wealth possessed at t = 0 which
is assumed by the nth risky asset (i.e. Fn =
H n S0 n
) . Thus we can write the average
V0 H
E RV = (1 F1 ...FN ) r + FnE R n
n =1
H
Clearly any rational investor (an investor who behaves rationally in the sense that he
or she always prefers more to less) chooses a portfolio H with the aim of obtaining a
return that is as large as possible. If the average return is the only criterion for this
judgment then clearly one will invest the whole money into that asset which gives the
highest mean return. However, this asset may be very risky and thus the returns can
have huge fluctuations. The idea of Markowitz was to find a tradeoff between the
risk incurred from the portfolio and the returns of the same portfolio. He assumed
that the risk of the portfolio is measured by the variance of the returns and thus
considered two optimization problems:
1. Obtaining a portfolio which minimizes the risk given a fixed (lower bound)
mean return
2. Obtaining a portfolio which maximizes the mean return for a given level of
risk (upper bound).
In this study unit we shall focus only on the first problem. A compact formulation of
this problem is the following:
93
Problem 3.12
Given
a deterministic interest rate r
a fixed with r
that there exists one portfolio with return not equal to r
determine portfolio H* with return RV
H*
= R such that
H
H
(A)
subject to
E RV =
(B)
subject to
N
(1 F1 ...FN ) r + Fn E R n =
n =1
C ij = Cov[ Ri , R j ]
T
94
subject to
E V1 = v (1 + )
V0H = v
H
(C)
This will provide us with a half-way measure towards getting a formulation which
will enable us to somehow compute solutions numerically with a certain ease.
Theorem 3.13
First we show that the constraints give the same solution sets.
H
E[V1H ] = V0H (1 + E[ RV ])
so that both conditions are telling us that
H
V1 H V0H
R=
V0H
95
Var R =
Var V1 H
(V )
H
0
Var V1H
(V )
H
0
= Var RV
v 2 Var RV
V1H v
2
= v Var
v
H
= Var V1H
subject to
(D)
V0H = v
Theorem 3.14
V0H ( (1 + )E Q [L] B1 )
E Q [L] 1
96
Proof:
H
Suppose (B) gives us as solution V1 .
2
Then Var V1 H = Var V0H R V = (V0 H ) ( F' CF ) is a minimum and also for any
other feasible V1
we have E R
VH
V1H V0H
= = E
, which shows that
H
V
0
E V1H
V1H = E V1H Var[V1H ] E V1H
2
2
2
2
1
1
V0H (1 + ) V0H (1 + ) Var[V1H ]
2
2
1
1
V0H (1 + ) V0H (1 + ) Var[V1 H ] =
2
( )
1
1
V1 H
E V1H E V1 H Var[V1 H ] = E V1H
2
2
( )
2
u ( x) = x
1 2
x
2
97
u
then x ( x) = x and I ( x) = x then by previous formulas in section 3.2 the
solution for the optimal wealth which we denote by V1
two equations:
L( ))
L( ))
V1 H ( ) = I
=
B1
B1
B1 ( B1V0H )
L
H
E Q
B1 = V0 =
B
EQ [L]
1
giving
( B1V0H ) L( ) ( E Q [ L ] L( ) ) B1V0H L( )
V1 ( ) =
=
+
EQ [ L]
EQ [ L]
EQ [ L]
H
E V1 =
H
( E Q [ L ] 1)
EQ [ L]
B1V0H
+
EQ [ L]
B1V0H
E V1 = V (1 + ) =
( EQ [ L] 1) + E [ L]
EQ [ L]
Q
H
H
0
( E Q [ L ] 1) = V0H (1 + )E Q [ L ] B1V0H
and thus
V0H ( (1 + )E Q [L] B1 )
E Q [L] 1
98
The formulations above allow us to give a number of results which have important
bearing on some classical problems of mathematical finance.
Theorem 3.15
The return R of the portfolio corresponding to the optimal solution to the meanvariance portfolio problem is an affine function of state price density L :
R ( ) =
E Q [L] r
L ( )
E Q [L] 1 E Q [L] 1
Proof:
( B1V0H )
L( ) = a + bL( )
V1 ( ) =
EQ [ L]
H
V1 H ( ) V0H
1
R ( ) =
= H
H
V0
V0
V0H
( B1V0H )
L
(
)
1 =
E
L
[
]
Q
( B1V0H )
1 H
L( ) =
V E [ L ]
0
Q
(1 + )E Q [L] B1
E Q [L] 1
(1 + )E Q [L] B1
B1
1
L( ) =
(E [L] 1)E [L] E [ L ]
Q
Q
Q
99
L( ) =
(E Q [L] 1) E Q [ L]
E Q [L] ( B1 1) ( B1 1)
E [L] 1
Q
E Q [L] r r
L( )
E Q [ L] 1 E Q [L] 1
E Q [L] 1
L( ) =
If R is the return of any given portfolio and R the return of the optimal solution to
the mean-variance portfolio problem then if r we have:
E[ R ] r =
Cov[ R, R ]
E[ R ] r
V
ar[ R ]
Proof :
To prove this result we can immediately apply Theorem 2.26, in the previous
chapter, to R .
Example 3.17
100
The table below gives the price scenarios for 4 risky assets and the rate for the
riskless asset. We would like to work out the solution to the corresponding meanvariance problem.
S1n
S0 n
Assets
Riskless
576/540
576/540
576/540
576/540
576/540
990
1032
1066
1066
1050
1038
1980
2132
2109
2132
2096
2096
3960
4242
4219
4222
4244
4208
5940
6349
6326
6336
6366
6324
0.25
0.25
0.1
0.2
0.2
Probability
1
Riskless
0.04242
0.07677
0.07677
0.06061
0.04848
0.07677
0.06515
0.07677
0.05859
0.05859
0.07121
0.06540
0.06616
0.07172
0.06263
0.06886
0.06498
0.06667
0.07172
0.06465
101
Probability
0.25
0.25
0.1
0.2
0.2
E [ R1 ] =0.0593
E [ R2 ] =0.0666
E [ R3 ] =0.0676
E [ R4 ] =0.0674
and the corresponding returns covariance matrix C is:
RA
RB
RC
RD
RA
0.0002023
-0.000015
-0.0000136 -0.0000106
RB
-0.000015
0.0000652
0.0000133
0.0000032
RC
-0.0000136 0.0000133
0.0000171
0.0000115
RD
-0.0000106 0.0000032
0.0000115
0.000008
(0.0593-0.05)F1 + (0.0666-0.05)F2 +
(0.0676-0.05)F3 + (0.0674-0.05)F4 = 0.05
holds and the quadratic form:
( F1
F2
F3
0.2023
-0.015
F4 )
-0.0136
-0.0106
-0.0136 -0.0106 F1
0.0652 0.0133 0.0032 F2
0.0133 0.0171 0.0115 F3
F4
0.0032 0.0115 0.008
-0.015
102
is minimized.
We have mulitplied all entries in the matrix by 1000 to make the matrix more
presentable. And we can use the standard methods of quadratic programming.
Let us next solve the same problem using the methods given Theorem 3.14.
L( )=
Q( )
P ( ) gives
0.4
0.75
0.75
and
E Q [ L ] = 1.305
Then
V0H ( (1 + )E Q [L] B1 )
E Q [L] 1
4.27869V0H (1 + ) 3.49727
and then
103
V1 ( ) =
( E Q [ L ] L( ) )
EQ [ L]
B1V0H L( )
+
=
EQ [ L]
576V0H L( )
+
=
1.305 540
= 4.27869V0H (1 + ) 3.49727
(4.27869V0H (1 + ) 3.49727 576V0H / 540)L( )
=
1.305
4.27869V0H (1 + ) 3.49727
( 3.278689V
H
0
(1 + )-2.679899-0.81737V0H ) L( )
104
Chapter 4
Multi-period Discrete Financial Markets
The material presented in the previous chapters shall now be generalized to a
multi-period discrete setting. Apart from few concepts that were not relevant in a
single period environment the various results presented earlier can be extended in a
straight forward manner to multi-period financial markets.
105
} ,
( K1min , K 2min ,... KTmin ) , ( K1min , K 2min 1,... KTmin ) ,... ( K1min , K 2max ,...KTmax )
min
min
min
min
min
min
( K1 1) , K 2 ,... KT , ( K1 1) , K 2 1,... KT ,
,
F1
= ... ( K min 1) , K max ,...K max
T
1
2
...
K max , K 2min ,... KTmin ) , ( K1max , K 2min 1,... KTmin ) ,... ( K1max , K 2max ,...KTmax )
( 1
)(
1
2
3
T
F2
= ... ( K 1min , K 2m in 1, K 3m ax , ... K Tmax )
,
...
min
max
106
K tmax
+1
Ktmax
+1
t
max
ptKt +1
K tmax
+1 1
.
.
j
.
min
pt K. t +1
K tmin
+1
t+1
A Riskless Asset with unit price process { Bt }t =0 , where B0 = 1 and for each
t = 1, 2,...T , Bt = (1 + r ) Bt 1
T
t =0
t =0
where n = 1,2,N.
T
107
Example 4.1
below :
St1 ( )
t=0
t=1
t=2
(1, 2 )
(1,1)
2.3
(1,0 )
2.1
(1, 1)
2.5
(1, 2 )
1.9
( 0, 2 )
2.5
2.1
( 0,1)
2.5
2.2
( 0,0 )
2.5
2.2
( 0, 1)
2.5
( 0, 2 )
2.5
3.4
( 1, 2 )
4.1
( 1,1)
4.1
( 1,0 )
4.1
6.3
108
( 1, 1)
4.1
3.8
( 1, 2 )
4.1
3.6
Definition 4.2
T
t =0
is defined by :
Stn
=
Bt
n*
t
Definition 4.3
T
R0 ( ) = 0
Stn ( ) Stn1 ( )
for t = 1, 2,...T
Stn1 ( )
St = S 0 + Su 1Ru
u =1
t
St = S0 (1 + Ru )
u =1
109
whose sequences start with 0, the other whose sequences start with 1.
Ft is the -algebra generated by the partition of with the 2t subsets each subset
containing sequences start with some particular pattern of t 0's and 1's.
The probability measure on this measurable base can now be set up by knowing
the probability p of an upward move and then a downward move happens with
probability 1-p. In the simplest set-up we would have independent moves with the
same probability and we find the probability of each path of finite length by
multiplying the probabilities of all the individual moves.
Let us define the process Nt, which tells us at time t how many moves upwards we
have. So
110
and
for k = 0,1,..., t
{ : St +1 ( ) = uSt } = p
P
{ : St +1 ( ) = dSt } = 1 p
P
So given the initial price S0
for k = 0,1,..., t
Thus
t
E[ St ] = t Ck p k (1 p )t k S 0u k d t k
k =0
1
2
= S0 t Ck (up ) k (d (1 p ))t k
k =0
= S0 (up + d (1 p ))t
The returns process is given by :
St St 1 S0u Nt ( ) d t Nt ( ) S0u Nt 1 ( ) d t 1 Nt 1 ( )
Rt =
=
St 1
S0u Nt 1 ( ) d t 1 Nt 1 ( )
= u Nt ( ) Nt 1 ( ) d 1 ( Nt ( ) Nt 1 ( )) 1
so that
111
u 1 with probability p
Rt =
d 1 with probability 1-p
whose sequences start with 1, another whose sequences start with 0 and the other
whose sequences start with 1.
Ft is the -algebra generated by the partition of with the 3t subsets each subset
containing sequences start with some particular pattern of t 1s, 0's and 1's.
The probability measure on this measurable base can now be set up by knowing
the probability p1 of an upward move, p2 probability of staying level and then a
downward move happens with probability 1-p1-p2.
The prices of the risky asset thus evolve as follows:
112
P[{ : St () = S0u k d l mt k l }] =
t!
t -k -l
p1k p2l (1 p1 p2 )
k !l !( t k l )!
for k , l = 0,1,..., t , k + l t
where m is the level factor (used to help us visualize the lattice better). Thus the
expectation of St is given by
t
t k
E[ St ] = S0
k =0 l =0
k
( t k )! p d l (1 p p )m t k l
( 2 )(
)
1
2
!
!
!
!
k
t
k
l
t
k
l
( ) l =0 (
)
k =0
k
t
t !( p1u )
t k
=
( p2 d + (1 p1 p2 )m )
k = 0 k !( t k ) !
t
= ( p1u + p2 d + (1 p1 p2 ) m )
t
= S0
t !( p1u )
t!
p1k p2l (1 p1 p2 )t k l u k d l mt k l
k !l !( t k l )!
t k
( x + y + z ) = ( x + ( y + z ) ) = n Ck x k ( y + z )
n
nk
k =0
n nk
n nk
k =0 l =0
k =0 l =0
= n Ck n k Cl x k y l z n k l =
n!
x k y l z n k l
k !l !( n k l ) !
113
so that
u 1 with probability p1
Rt = d 1 with probability p2
m 1 with probability 1 p p
1
2
forward from time t-1 to time t. The collection H := { H t } of portfolios will again
t =1
Definition 4.4
{( H
0
t
,...H tN )
t =1
N + 1 stochastic processes
from time t 1 to time t. Each asset has its own stochastic process which tells us
how many units of the particular asset are contained within the portfolio time step
by time step for each different possible future scenario.
114
the vector
H tn ( ) : t = 1,..., T gives the investment time profile in units of the n'th asset
n
for one possible scenario. The vector H t (i ) : i = 1,.., K gives the portfolio
spread in units of the n'th asset as we scan over all possibilities. The vector
H tn (i ) : n = 1,.., N gives the portfolio spread in units over all the assets for a
particular point in time and a particular possible scenario.
Since Ht represents the number of units to carry forward from time t -1 to time t,
then the decision on how much to invest in each asset must depend on the price of
. This
the asset at time t 1. Hence Ht must be measurable with respect to Ft 1
leads to the notion of predictability of a stochastic process.
Definition 4.5
T
A stochastic process { X t }t =0
is said to be predictable with respect to the filtration
T
X t is Ft 1
measurable.
Definition 4.6
(H
0
t
{Ft }t =0 are
Trading Strategies
(H
0
t
, H t1 , H t2 )
t=1
(H
0
t
, H t1 , H t2 )
t=2
115
4.7
(1, 2 )
( 50,20,15 )
( 40,1, 2 )
(1,1)
( 50,20,15 )
( 40,1, 2 )
(1,0 )
( 50,20,15 )
( 40,1, 2 )
(1, 1)
( 50,20,15 )
( 40,1, 2 )
(1, 2 )
( 50,20,15 )
( 40,1, 2 )
( 0, 2 )
( 50,20,15 )
( 4,3,19 )
( 0,1)
( 50,20,15 )
( 4,3,19 )
( 0,0 )
( 50,20,15 )
( 4,3,19 )
( 0, 1)
( 50,20,15 )
( 4,3,19 )
( 0, 2 )
( 50,20,15 )
( 4,3,19 )
( 1, 2 )
( 50,20,15 )
( 35,31,2 )
( 1,1)
( 50,20,15 )
( 35,31,2 )
( 1,0 )
( 50,20,15 )
( 35,31,2 )
( 1, 1)
( 50,20,15 )
( 35,31,2 )
( 1, 2 )
( 50,20,15 )
( 35,31,2 )
Definition 4.7
T
116
Vt
( ) = H ( ) Bt + H tn ( ) Stn ( )
0
t
for t = 1, 2,...T
n =1
Definition 4.8
T
H
(
t
s =1
n =1 s =1
Definition 4.9
{G }
H* T
{V }
t
t =0
= H + H 1n S 0n *
0
1
n =1
Vt
H*
( )
= H () + H tn ( )Stn * ( )
0
t
for t 1
n =1
) = H sn ( )Ssn * ( )
H*
(
t
for t 1
n =1 s =1
To simplify matters, the value of the portfolio before and after transactions with
assets is retained, that is no cash is assumed to be injected into the process from
outside. This leads to the notion of self-financing trading strategy:
Definition 4.10
for t = 1,.., T 1
n =1
117
4.8
The results which we obtained for a single period all generalize to multiperiod.
Exclusion of arbitrage is also equivalent to the existence of a risk neutral
probability. However risk neutral probability was then defined in terms of one set
of random variables, one set for each asset. Here each time instant has its set of
random variables! This notion of probability has to be suitably modified to fit in
with the multiperiod context:
Definition 4.11
H is self-financing
ii.
V0 = 0
iii.
VT() 0
iv.
E[VT()] > 0
Note that the last condition is equivalent to the fact that P VT ( ) > 0 > 0 , that is
the final wealth is positive with a strict positive probability.
Definition 4.12
n*
The discounted price process St is a martingale under Q , that is for all
ts
E Q [ Stn * | Fs ] = S sn *
118
( )
= S sn
n
generated by the asset price at time s, the conditional expectation E Q [ St * | Fs ] is
}
}
Example 4.13
Consider the following financial market with one risky asset and a bank account.
The price profile of the risky asset is given by:
t=0
t=1
t=2
14
12
10
11
10
8
5
i.e. N = 1 and T = 2 . Our probability space has 4 points 1= (1,1), 2 = (1,0), 3=
(0,1), 4=(0,0) (i.e. K1max = K 2 max = 1, K1min = K1min = 0 ). Suppose the bank account
rate is given by r.
n
n
We need a probability measure Q such that E Q [ S t * | F s ] = S s * for s t. Taking
119
12 ( Q (1 ) + Q (2 ) ) + 8 ( Q (3 ) + Q (4 ) )
1+ r
14Q (1 ) + 10Q (2 )
Q (1 ) + Q (2 )
(1 + r )
= 10 for s = 0, t = 1
12
1+ r
and
11Q (3 ) + 5Q (4 )
Q (3 ) + Q (4 )
(1 + r )
8
for s = 1, t = 2
1+ r
14
Q (1 ) + 10Q (2 ) + 11Q (3 ) + 5Q (4 )
(1 + r )
= 10 for s = 0, t = 2
Q (1 ) + Q (2 ) + Q (3 ) + Q (4 ) = 1
we find that
1 + 5r 1 + 6r
Q ( 1 ) =
2 2
1 + 5r 1 6r
Q( 2 ) =
2 2
1 5r 8r + 3
Q(3 ) =
2 6
1 5r 8 r 3
Q(4 ) =
2 12
120
We shall next state the results, without proof, that generalize from single period to
multiperiod discrete models. This shows how the theory of complete markets can
be generalized in the multiperiod setting by using the martingale measure instead
of the risk-neutral probability.
Theorem 4.14
Theorem 4.15
H*
is a Q -martingale.
Theorem 4.16
In practice these theorems are used, just as we saw for the single period case, to
price various contingent claims. These ideas have also been utilized in more
complex situations related to optimal portfolio problems, consumption-investment
problems and others.
121
We shall finish off by going back to the binomial model which in its simplicity
reveals so many concepts with a clarity that allows deep understanding and wide
generalizability.
If we have a constant interest rate r, the martingale measure will operate
multiplicatively with common upward and downward probabilities. Thus we
proceed to calculate using :
Rtn+1 Rt0+1
E
Ft = 0
0
1
+
R
t +1
q ( u 1 r ) + (1 q )( d 1 r )
=0
1+ r
so that q =
1+ r d
ud
Existence of martingale measure is then guaranteed by 0 < q < 1 so that u > d and u
>1+r
[{ } ] = q N t ( ) (1 q ) t N t ( )
Then Q
If we go back to example 4.13 we see that there we had different jumps for each
period. So we had q and then
Q(1 ) =
(1 + 5r )(1 + 6r )
= q2
4
122
Q(1 ) =
Q ( 2 ) =
(1 + 5r )(1 + 6r )
= q2
4
(1 + 5 r )(1 6 r )
= q (1 q )
4
Q(3 ) =
(1 5r)(1+ 4r)
= (1 q) q
4
Q(4 ) =
(1 5r )(1 4r )
2
= (1 q )
4
Suppose that the initial value of the portfolio is v and H is the set of all selffinancing trading strategies with
N
v = H B0 + H1n S0n
0
1
n =1
max
We want to find that strategy H H whose expected utility at t = T is given
by:
E u VTH
max
) = max E u (V )
H H
H
T
(1)
Existence or otherwise of a portfolio whose expected utility is given as above is
called the optimal portfolio problem.
123
H
H*
Recalling that VT = BT (v + GT ) (since trading strategies are assumed to be self-
financing)
program by considering for the time being the number of units to invest in the
risky assets only:
E u VTH
max
) = max E u (V ) = max E u ( B (v + G ))
H
T
H H
H H
H*
T
1
2
N
where H = H := ( H , H ,...H ) : H is a matrix valued predictable process
H is the vector corresponding to the number of units to invest in the risky assets.
0
Having obtained H max , H can then be found by using the fact that
( H 0 , H max )
= v.
4.5.1.
PORTFOLIO
Using differential calculus
Example 4.17
Let K1min = 1, K1max = 0 , K 2min = 1, K 2max = 0 , T = 2, N = 1 and suppose that the interest
rate which describes the evolution of the riskless asset is r. The prices of the risky
asset are given in the table below:
St1 ( )
t=0
t=1
t=2
P {}
124
1 = ( 1,0 )
10
12
14
1/4
2 = ( 1, 1)
10
12
10
1/4
3 = ( 0,0 )
10
11
1/4
4 = ( 0, 1)
10
1/4
Let
10
12
The changes in the discounted asset prices from time zero to time one and time one
to time two are given below :
125
S11 * (1 ) =
S 21 * (1 ) =
2 10r
2 10r
2 10r
2 10r
, S11 * (2 ) =
, S11 * (3 ) =
, S11 * (4 ) =
1+ r
1+ r
1+ r
1+ r
2 12r
(1 + r )
, S 21 * (2 ) =
2 12r
(1 + r )
, S 21 * (3 ) =
3 8r
(1 + r )
, S 21 * (4 ) =
3 8r
(1 + r )
So
(1+r )2 (v+HS1* )
E u B2 (v + G2H* ) = E e
( )
( )
1
2
1
2
2
2
1+ r
1+r
1
1
(1+ r )
(1+ r )
= e
+
+ 4 e
4
1+r 2 v+ 10 h 210 r + 8 h 38 r
1+r 2 v+ 10 h 210 r + 8 h 38 r
( )
( )
1
2
1
2
2
2
1+r
1+ r
1
1
(1+r )
(1+ r )
+ e
e
4
1 1+r 2 v10 h1(1+r )(210 r )12 h2 (212 r ) 1 (1+r )2 v10 h1(1+r )(210 r )12 h2 (212 r )
= e ( )
e
4
2
2
1 1+r v10 h1(1+r )(210 r ) 8 h2 (38 r ) 1 (1+r ) v10 h1(1+r )(210 r ) 8 h2 (38 r )
e ( )
e
4
2
2
1 1+r vx 1+r 210 r )x3 (38 r ) 1 (1+r ) vx1(1+r )(210 r )x3 (38 r )
e ( ) 1( )(
e
Then
126
0=
( 10 h 1 , 12 h 2 , 8 h 2 )
x1
(1 + r )(2 10 r )
2
(1 + r )(2 10 r ) (1+ r )2 v 10 h 1 (1+ r )(210 r ) 12 h 2 ( 212 r )
(1+ r ) v 10 h 1 (1+ r )(2 10 r ) 12 h 2 (2 12 r )
e
+
e
+
4
4
2
2
(1 + r )( 2 10 r ) (1+ r ) v 10 h 1 (1+ r )( 210 r ) 8 h 2 (38 r ) (1 + r )( 2 10 r ) (1+ r ) v 10 h 1 (1+ r )( 210 r ) 8 h 2 ( 38 r )
e
+
e
4
4
(2)
0=
=
( 10h 1 , 12h 2 , 8h 2 )
x2
2 12r (1+r )2 v10 h 1(1+r )(210 r )12 h 2 (212 r ) (2 12r ) (1+r )2 v10 h 1(1+r )(210 r )12 h 2 (212 r )
e
+
e
4
4
(3)
0=
=
( 10h 1 , 12h 2 , 8h 2 )
x3
3 8r (1+r )2 v10 h 1(1+r )(210 r ) 8 h 2 (38 r ) (3 8r ) (1+r )2 v10 h 1(1+r )(210 r ) 8 h 2 (38r )
e
+
e
4
4
(4)
From (3) and (4) we have
2
(2 +12r ) e
12
h 2 (2+12 r )
=e
(2 12r ) e
12
h 2 (212 r )
and
2
(3 + 8r ) e h (3+8r ) = e(1+r ) v
2
10
h 1 (1+ r )(210 r )
(3 8r ) e h (38r )
2
respectively. Taking logs on both sides of the above and rearranging terms gives
12
1 2 12r
h 2 = ln
4 2 +12r
and
8
1 3 8r
h 2 = ln
6 3 + 8r
127
Substitute these values in (2) to obtain 10h 1 . Having obtained the number of units
to carry forward from time t to t+1 in the risky asset it remains to find the number
of units to carry forward in the riskless asset.
Let
10
h10 be the number of units carried forward from time zero to time one in the
10
h10 use
12 0
Now let h2 be the number of units carried forward from time one to time two in
8 0
the riskless asset, if the price of the risky asset at time one is 12 and h2 be the
number of units carried forward from time one to time two in the riskless asset, if
the price of the risky asset at time one is 8.
12 0
8 0
To find h2 and h2
work out (for each ) the value of the portfolio at time one :
V1H (1 ) = 10h10 (1 + r ) + 12 10h1 = V1H (2 )
V1H (3 ) = 10h10 (1 + r ) + 8 10h1 = V1H (4 )
128
If the number of strategies and time period increases the previous approach for
finding the optimal trading strategies becomes intractable.
Another approach
this
end,
for
each
let
us
introduce
the
value
function
V : {0,1,...T } :
H max *
Vs ,v () = E u BT + Gs ,T Fs () s = 0,1, 2,...T 1
Bs
VT ,v () = u (v, )
129
H*
where Gs ,T represent the discounted gains at time T if time starts from s. (Note that
H*
G0,T
= GTH* ). This function is the optimal cost-to-go over the period {s,s+1,.T}
given that the current time is s and the wealth at this time instant is v.
We claim that this function satisfies the following recursive equation:
Vs ,v () = maxN E V h Fs ()
h
s +1,V s+1
VT ,v () = u (v, )
Where
h
V s +1 = Bs +1 + hiS s*+1
Bs
strategy H implemented in the time period {0,1,2,s}, and V s +1 is the time s+1
wealth if the wealth at time s is v. From the above discussion if we know how to
optimally invest from time s+1 to time T, given any wealth v at time s, then at time
s we only need to find the optimal amount to invest from time s to s+1.
Proposition 4.18
Let V : {0,1,...T }
algorithm:
VT , v () = u (v, )
Vs ,v () = maxN E V h Fs () for s = 0,1,...T 1
h
s +1,V s+1
( (
))
130
This
(5)
We can continue in this manner until we obtain V0,v which is the value we are
interested in. For simplicity of notation we shall sometimes write V ( s, v) as the
value of Vs ,v () for a given .
Example 4.19
Let K1min = 1, K1max = 0 , K 2min = 1, K 2max = 0 , T = 2, N = 1 and suppose that the interest
rate which describes the evolution of the riskless asset is r. The prices of the risky
asset are given in the table below :
St1 ( )
t=0
t=1
t=2
P {}
1 = ( 1,0 )
10
12
14
1/4
2 = ( 1, 1)
10
12
10
1/4
3 = ( 0,0 )
10
11
1/4
4 = ( 0, 1)
10
1/4
131
2 10r
2 10r
2 10r
2 10r
, S11 * (2 ) =
, S11 * (3 ) =
, S11 * (4 ) =
1+ r
1+ r
1+ r
1+ r
S 21 * ( 1 ) =
2 12r
(1 + r )
, S 21 * (2 ) =
2 12r
(1 + r )
, S 21 * ( 3 ) =
3 8r
(1 + r )
, S 21 * (4 ) =
3 8r
(1 + r )
S 1 S 1
2
1
212 r
2 v
(1+r ) 1+r +h(1+r )2
1
1
e
P { : S2 () = 14} { : S1 () = 12}
= max
(1+r )2 v +h212 r
1+r
2
(1+r )
e
P { : S21 () = 10} { : S11 () = 12}
1 1+r v h 212 r )
h 2+12 r )
= max e ( ) e (
+e (
Letting
1 :
1 1+r w x 212 r )
x 2+12 r )
+e (
1 ( x ) = e ( ) e (
we have that
1
1
(h) = e(1+r)w (2 12r ) eh(212 r ) + (2 +12r ) eh(2+12 r) = 0
x
2
1 2 12r
12
h = ln
(compare
with
h2 in the previous example)
4 2 + 12r
132
S 1 S 1
2
1
V (1, v ) = max E u B2 + h { : S1 () = 8}
h
B2 B1
B1
38 r
2 v
(1+r ) 1+r +h(1+r )2
1
1
e
P { : S2 () = 11} { : S1 () = 8}
= max
(1+r )2 v +h38 r
1+r
2
(1+r )
e
P { : S 21 () = 5} { : S11 () = 8}
1 1+r v h 38 r
h 3+8 r
= max e ( ) e ( ) + e ( )
Let
2 :
1 1+r v x 38 r
x 3+8 r
2 ( x ) = e ( ) e ( ) + e ( )
6 3 + 8r
So
212 r 212 r
2+12 r 212 r
ln
1 (1+r )v 4 ln 2+12 r
2+12 r
4
V1,v () = e
e
+
e
where =1 , 2
2
38 r 38 r
3+8 r 38 r
ln
1 (1+r )v 6 ln 3+8r
3+8 r
6
V1,v = e
e
+
e
where = 3 , 4
2
( )
Now let t = 0 so that S01 ( ) = 10 for all . By the dynamic programming equation
we obtain:
133
v
S 1 S 1
v
S1 S1
1
0
r
2+12 r 212 r
ln
= max
1
h
3+8 r 38 r
1 (1+r )B1 Bv +h SB1 BS0 38 r ln 38 r
ln
1
0
0
3+8 r
3+8 r
6
6
e
e
+
e
4
v
v
S1 S1
S1 S1
1
0
0
1
1 (1+r )B1 B0 +h B1 B0
1 (1+r )B1 B0 +h B1 B0
= max e
f ( ) e
f
h
4
4
( )
( )
where
2+12 r 212 r
212 r ln 212 r
e 4 2+12 r + e 4 ln 2+12 r if =
f () =
38 r 38r
3+8 r 38 r
ln
ln
3+8 r
+
r
6
3
8
6
e
+
e
if =
Letting
3 :
2
2
1
1
3 ( x) = e(1+r ) v(1+r )(210 r ) x f () e(1+r ) v(1+r )(210 r ) x f ()
4
4
We have that
2
3
1
(h) = (1 + r )(2 10r ) f () e(1+r) w(1+r)(210 r)h +
4
x
2
^
1
(1 + r )(2 10r ) f e(1+r) w(1+r)(210 r)h = 0
4
f ()
1 2 10r
h=
ln
+ ln ^
20r 2 + 10r
f
134
Another method which generalizes easily from the single period to the multiperiod
case is the martingale approach. The only difference between the single period and
the multiperiod case is the discounting term. Instead of B1 we have to use BT.
Otherwise the equations involved remain the same.
So Wv is now defined as follows:
VTH ( ) = W ( ) , and by the risk neutral valuation principle, for any trading
strategy H with initial value v, E Q [W / BT ] = v
Again using Lagrangian multipliers, maximizing
constraint W Wv becomes :
Max E[u (W )] E Q [W / BT ] v
Q ( )
L
(
)
=
Let
P ( ) and ignoring v (being a constant) we have
135
E[u (W )] E[ LW / BT ] = E[u (W ) LW / BT ] =
u
The necessary differentiability conditions give x (W ( )) L( ) / BT = 0 . But
u
again with x and L always positive,
u
(W ( )) = L( ) / BT for each .
x
u
(W ( )) = L( ) / BT = Q( ) /( BT P( ))
x
which give
Q( ) =
u
(W ( )) BT P( ) /
x
But under optimality, (as shown in chapter two with BT replacing B1)
u ( BT VT ( ), )
P( )
x
Q( ) =
u ( BT VT )
E
forcing = E BT u (W )
x .
u (W ( ), ))
I
= W ( )
136
so
L( ))
u(W ( ), ))
W ( ) = I
= I
x
BT
To obtain an explicit formula for we see that for the contingent claim W,
E Q [W / BT ] = v
EQ I
BT = v
BT
This equation has a unique solution because of the nature of the function I. The
expected value of W will give the optimal wealth. Being in a complete market we
can work out the corresponding portfolio H.
Example 4.20
Let K1min = 1, K1max = 0 , K 2min = 1, K 2max = 0 , T = 2, N = 1 and suppose that the interest
rate which describes the evolution of the riskless asset is r. The prices of the risky
asset are given in the table below :
St1 ( )
t=0
t=1
t=2
P {}
1 = ( 1,0 )
10
12
14
1/4
2 = ( 1, 1)
10
12
10
1/4
3 = ( 0,0 )
10
11
1/4
137
4 = ( 0, 1)
10
1/4
Compute Q , and I
o Q was already obtained in the previous chapter by using the
*
*
martingale property E Q [ St | Fs ] = S s , s < t :
1 + 5r 1 + 6 r
Q(1 ) =
2 2
1 + 5r 1 6 r
Q(2 ) =
2 2
1 5r 1 + 4 r
Q(3 ) =
2 2
1 5r 1 4 r
Q(4 ) =
2 2
Q( )
(
)
L
=
o
P ( )
( )
o I ( y ) = ln y
138
E
I
B
Obtain by using Q B 1 = v
1
=e
ln B2 EQ [ln L ] B2 v
W (2 ) = B2v +
ln (1 + 5r )(1 6r )
4
ln 1 5r 1 4r
W (4 ) = B2v +
(
)(
)
4
h , h , h, h
equations
2 12 0
2
h + 14 12h2
W (1 ) = (1 + r )
2 12 0
2
W (2 ) = (1 + r )
h + 10 12h2
W (3 ) = (1 + r ) 8h20 + 118h2
2
W (4 ) = (1 + r ) 8h20 + 15 8h2
10 0
1
h and 10h1 can then be found by solving the following system of linear
139