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Yufeng Guo

Contents

Introduction ix

9.1 Put-call parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

9.1.1 Option on stocks . . . . . . . . . . . . . . . . . . . . . . . 1

9.1.2 Options on currencies . . . . . . . . . . . . . . . . . . . . 11

9.1.3 Options on bonds . . . . . . . . . . . . . . . . . . . . . . . 12

9.1.4 Generalized parity and exchange options . . . . . . . . . . 13

9.1.5 Comparing options with respect to style, maturity, and

strike . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

10.1 One-period binomial model: simple examples . . . . . . . . . . . 35

10.2 General one-period binomial model . . . . . . . . . . . . . . . . . 36

10.2.1 Two or more binomial trees . . . . . . . . . . . . . . . . . 49

10.2.2 Options on stock index . . . . . . . . . . . . . . . . . . . 64

10.2.3 Options on currency . . . . . . . . . . . . . . . . . . . . . 67

10.2.4 Options on futures contracts . . . . . . . . . . . . . . . . 71

11.1 Understanding early exercise . . . . . . . . . . . . . . . . . . . . 79

11.2 Understanding risk-neutral probability . . . . . . . . . . . . . . . 80

11.2.1 Pricing an option using real probabilities . . . . . . . . . 81

11.2.2 Binomial tree and lognormality . . . . . . . . . . . . . . . 88

11.2.3 Estimate stock volatility . . . . . . . . . . . . . . . . . . . 91

11.3 Stocks paying discrete dividends . . . . . . . . . . . . . . . . . . 95

11.3.1 Problems with discrete dividend tree . . . . . . . . . . . . 96

11.3.2 Binomial tree using prepaid forward . . . . . . . . . . . . 98

12 Black-Scholes 105

12.1 Introduction to the Black-Scholes formula . . . . . . . . . . . . . 105

12.1.1 Call and put option price . . . . . . . . . . . . . . . . . . 105

12.1.2 When is the Black-Scholes formula valid? . . . . . . . . . 107

12.2 Applying the formula to other assets . . . . . . . . . . . . . . . . 107

iii

iv CONTENTS

12.2.2 Options on stocks with discrete dividends . . . . . . . . . 108

12.2.3 Options on currencies . . . . . . . . . . . . . . . . . . . . 108

12.2.4 Options on futures . . . . . . . . . . . . . . . . . . . . . . 110

12.3 Option the Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . 110

12.3.1 Delta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111

12.3.2 Gamma . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111

12.3.3 Vega . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112

12.3.4 Theta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112

12.3.5 Rho . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112

12.3.6 Psi . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112

12.3.7 Greek measures for a portfolio . . . . . . . . . . . . . . . 112

12.3.8 Option elasticity and volatility . . . . . . . . . . . . . . . 113

12.3.9 Option risk premium and Sharp ratio . . . . . . . . . . . 114

12.3.10 Elasticity and risk premium of a portfolio . . . . . . . . . 115

12.4 Profit diagrams before maturity . . . . . . . . . . . . . . . . . . . 115

12.4.1 Holding period profit . . . . . . . . . . . . . . . . . . . . . 115

12.4.2 Calendar spread . . . . . . . . . . . . . . . . . . . . . . . 118

12.5 Implied volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . 119

12.5.1 Calculate the implied volatility . . . . . . . . . . . . . . . 119

12.5.2 Volatility skew . . . . . . . . . . . . . . . . . . . . . . . . 120

12.5.3 Using implied volatility . . . . . . . . . . . . . . . . . . . 121

12.6 Perpetual American options . . . . . . . . . . . . . . . . . . . . . 121

12.6.1 Perpetual calls and puts . . . . . . . . . . . . . . . . . . . 121

12.6.2 Barrier present values . . . . . . . . . . . . . . . . . . . . 125

13.1 Delta hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 129

13.2 Examples of Delta hedging . . . . . . . . . . . . . . . . . . . . . 129

13.3 Textbook Table 13.2 . . . . . . . . . . . . . . . . . . . . . . . . . 138

13.4 Textbook Table 13.3 . . . . . . . . . . . . . . . . . . . . . . . . . 140

13.5 Mathematics of Delta hedging . . . . . . . . . . . . . . . . . . . . 141

13.5.1 Delta-Gamma-Theta approximation . . . . . . . . . . . . 141

13.5.2 Understanding the market maker’s profit . . . . . . . . . 142

14.1 Asian option (i.e. average options) . . . . . . . . . . . . . . . . . 145

14.1.1 Characteristics . . . . . . . . . . . . . . . . . . . . . . . . 145

14.1.2 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . 146

14.1.3 Geometric average . . . . . . . . . . . . . . . . . . . . . . 146

14.1.4 Payoﬀ at maturity T . . . . . . . . . . . . . . . . . . . . . 147

14.2 Barrier option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

14.2.1 Knock-in option . . . . . . . . . . . . . . . . . . . . . . . 147

14.2.2 Knock-out option . . . . . . . . . . . . . . . . . . . . . . . 147

14.2.3 Rebate option . . . . . . . . . . . . . . . . . . . . . . . . . 148

CONTENTS v

14.2.5 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

14.3 Compound option . . . . . . . . . . . . . . . . . . . . . . . . . . 149

14.4 Gap option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

14.4.1 Definition . . . . . . . . . . . . . . . . . . . . . . . . . . . 151

14.4.2 Pricing formula . . . . . . . . . . . . . . . . . . . . . . . . 151

14.4.3 How to memorize the pricing formula . . . . . . . . . . . 151

14.5 Exchange option . . . . . . . . . . . . . . . . . . . . . . . . . . . 152

18.1 Normal distribution . . . . . . . . . . . . . . . . . . . . . . . . . 155

18.2 Lognormal distribution . . . . . . . . . . . . . . . . . . . . . . . . 156

18.3 Lognormal model of stock prices . . . . . . . . . . . . . . . . . . 156

18.4 Lognormal probability calculation . . . . . . . . . . . . . . . . . . 157

18.4.1 Lognormal confidence interval . . . . . . . . . . . . . . . . 158

18.4.2 Conditional expected prices . . . . . . . . . . . . . . . . . 162

18.4.3 Black-Scholes formula . . . . . . . . . . . . . . . . . . . . 162

18.5 Estimating the parameters of a lognormal distribution . . . . . . 163

18.6.1 Histogram . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

18.6.2 Normal probability plots . . . . . . . . . . . . . . . . . . . 166

18.7 Sample problems . . . . . . . . . . . . . . . . . . . . . . . . . . . 167

19.1 Example 1 Estimate E (ez ) . . . . . . . . . . . . . . . . . . . . . 173

19.2 Example 2 Estimate π . . . . . . . . . . . . . . . . . . . . . . . . 177

19.3 Example 3 Estimate the price of European call or put options . . 180

19.4 Example 4 Arithmetic and geometric options . . . . . . . . . . . 184

19.5 Eﬃcient Monte Carlo valuation . . . . . . . . . . . . . . . . . . . 193

19.5.1 Control variance method . . . . . . . . . . . . . . . . . . . 193

19.6 Antithetic variate method . . . . . . . . . . . . . . . . . . . . . . 197

19.7 Stratified sampling . . . . . . . . . . . . . . . . . . . . . . . . . . 199

19.7.1 Importance sampling . . . . . . . . . . . . . . . . . . . . . 199

19.8 Sample problems . . . . . . . . . . . . . . . . . . . . . . . . . . . 199

20.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205

20.1.1 Big picture . . . . . . . . . . . . . . . . . . . . . . . . . . 206

20.2 Brownian motion . . . . . . . . . . . . . . . . . . . . . . . . . . . 207

20.2.1 Stochastic process . . . . . . . . . . . . . . . . . . . . . . 207

20.2.2 Definition of Brownian motion . . . . . . . . . . . . . . . 207

20.2.3 Martingale . . . . . . . . . . . . . . . . . . . . . . . . . . 209

20.2.4 Properties of Brownian motion . . . . . . . . . . . . . . . 210

20.2.5 Arithmetic Brownian motion and Geometric Brownian

motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 214

vi CONTENTS

20.3 Definition of the stochastic calculus . . . . . . . . . . . . . . . . . 216

20.4 Properties of the stochastic calculus . . . . . . . . . . . . . . . . 222

20.5 Ito’s lemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 223

20.5.1 Multiplication rules . . . . . . . . . . . . . . . . . . . . . 223

20.5.2 Ito’s lemma . . . . . . . . . . . . . . . . . . . . . . . . . . 223

20.6 Geometric Brownian motion revisited . . . . . . . . . . . . . . . 225

20.6.1 Relative importance of drift and noise term . . . . . . . . 225

20.6.2 Correlated Ito processes . . . . . . . . . . . . . . . . . . . 226

20.7 Sharpe ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230

20.8 Risk neutral process . . . . . . . . . . . . . . . . . . . . . . . . . 233

20.9 Valuing a claim on S a . . . . . . . . . . . . . . . . . . . . . . . . 233

20.9.1 Process followed by S a . £. . . . ¤. . . . . . . . . . . . . . . 233

20.9.2 Formula for S A (t) and E S A (t) . . . . . . . . . . . . . . 234

20.9.3 Expected return of a claim on S A (t) . . . . . . . . . . . . 235

20.9.4 Specific examples . . . . . . . . . . . . . . . . . . . . . . . 235

21.1 Diﬀerential equations and valuation under certainty . . . . . . . 245

21.1.1 Valuation equation . . . . . . . . . . . . . . . . . . . . . . 245

21.1.2 Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 246

21.1.3 Dividend paying stock . . . . . . . . . . . . . . . . . . . . 246

21.2 Black-Scholes equation . . . . . . . . . . . . . . . . . . . . . . . . 246

21.2.1 How to derive Black-Scholes equation . . . . . . . . . . . 246

21.2.2 Verifying the formula for a derivative . . . . . . . . . . . . 247

21.2.3 Black-Scholes equation and equilibrium returns . . . . . . 250

21.3 Risk-neutral pricing . . . . . . . . . . . . . . . . . . . . . . . . . 252

22.1 All-or-nothing options . . . . . . . . . . . . . . . . . . . . . . . . 253

23 Volatility 255

24.1 Market-making and bond pricing . . . . . . . . . . . . . . . . . . 257

24.1.1 Review of duration and convexity . . . . . . . . . . . . . . 257

24.1.2 Interest rate is not so simple . . . . . . . . . . . . . . . . 264

24.1.3 Impossible bond pricing model . . . . . . . . . . . . . . . 265

24.1.4 Equilibrium equation for bonds . . . . . . . . . . . . . . . 268

24.1.5 Delta-Gamma approximation for bonds . . . . . . . . . . 270

24.2 Equilibrium short-rate bond price models . . . . . . . . . . . . . 271

24.2.1 Arithmetic Brownian motion (i.e. Merton model) . . . . . 271

24.2.2 Rendleman-Bartter model . . . . . . . . . . . . . . . . . . 272

24.2.3 Vasicek model . . . . . . . . . . . . . . . . . . . . . . . . 272

24.2.4 CIR model . . . . . . . . . . . . . . . . . . . . . . . . . . 274

24.3 Bond options, caps, and the Black model . . . . . . . . . . . . . 275

CONTENTS vii

24.3.2 Interest rate caplet . . . . . . . . . . . . . . . . . . . . . . 279

24.4 Binomial interest rate model . . . . . . . . . . . . . . . . . . . . 279

24.5 Black-Derman-Toy model . . . . . . . . . . . . . . . . . . . . . . 283

Introduction

This study guide is for SOA MFE and CAS Exam 3F. Before you start, make

sure you have the following items:

2. Errata of Derivatives Markets. You can download the errata at http://

www.kellogg.northwestern.edu/faculty/mcdonald/htm/typos2e_01.

html.

3. Download the syllabus from the SOA or CAS website.

4. Download the sample MFE problems and solutions from the SOA website.

5. Download the recent SOA MFE and CAS Exam 3 problems.

ix

Chapter 9

relationships

9.1.1 Option on stocks

Notation

T Option expiration date (maturity date)

S0 Current price of the underlying asset

ST The price of the underlying asset at the option expiration date

K Strike price or exercise price

CEur (K, T ) Premium of a European call option with strike price K and T years to expiration

CEur (K, 0) Premium of a European call option on the expiration date

PEur (K, T ) Premium of a European put option with strike price K and T years to expiration

PEur (K, 0) Premium of a European put option on the expiration date

r The continuously compounded annual risk-free interest rate

δ The continuously compounded annual dividend rate

F0,T Delivery price in a forward contract expiring in T

Put-call parity

The textbook gives the following formula

The textbook explains the intuition behind Equation 9.1. If we set the

forward price F0,T as the common strike price for both the call and the put

2 CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

Buying a call and selling a put with K = F0,T synthetically creates a forward

contract and the premium for a forward contract is zero.

However, often I find that Equation 9.1 is not intuitive at all. In fact, it’s

annoyingly complex and hard to memorize. So I like to rewrite 9.1 as follows:

Later I will explain the intuition behind 9.2. First, let’s prove 9.2. The proof

is extremely important.

Suppose at time zero we have two portfolios:

Ke−rT . P V (K) is the present value of the strike price K and r is the

continuously compounded risk free interest rate per year.

• Portfolio #2 consists of a European put option on the stock and one share

of the stock with current price S0 .

• Both the call and put have the same underlying stock, the same strike price

K, and the same expiration date T . Notice that at time zero Portfolio #1

is worthy CEur (K, T ) + P V (K); Portfolio #2 is worth PEur (K, T ) + S0 .

Since it’s diﬃcult to compare the value of Portfolio #1 and the value of

Portfolio #2 at time zero, let’s compare them at the expiration date T . We’ll

soon see that the two portfolios have the same value at T .

If ST < K If ST ≥ K

Call payoﬀ is max (0, ST − K) 0 ST − K

Payoﬀ of P V (K) K K

Total K ST

If ST < K If ST ≥ K

Put payoﬀ max (0, K − ST ) K − ST 0

Payoﬀ of S0 ST ST

Total K ST

If you have one stock worth S0 at t = 0, you’ll have one stock at T worth

ST .

You see that Portfolio #1 and Portfolio #2 have identical payoﬀs of max (K, ST )

at T . If ST < K, both portfolios are worth the strike price K; if ST ≥ K, both

9.1. PUT-CALL PARITY 3

portfolios are worth the stock price ST . Since Portfolio #1 and #2 are worth

the same at T , to avoid arbitrage, they must be worth the same at any time

prior to T . Otherwise, anyone can make free money by buying the lower priced

portfolio and selling the higher priced one. So Portfolio #1 and #2 are worth

the same at time zero. Equation 9.2 holds.

I recommend that from this point now you throw Equation 9.1 away and use

Equation 9.2 instead.

How to memorize Equation 9.2:

Tip 9.1.1. Many candidates have trouble memorizing Equation 9.2. For exam-

ple, it’s very easy to write a wrong formula CEur (K, T ) + S0 = PEur (K, T ) +

P V (K). To memorize Equation 9.2, notice that for a call to work, a call must

go hand in hand with the strike price K. When exercising a call option, you

give the call seller both the call certificate and the strike price K. In return, the

call seller gives you one stock. Similarly, for a put to work, a put must go hand

in hand with one stock. When exercising a put, you must give the put seller both

the put certificate and one stock. In return, the put seller gives you the strike

price K.

Tip 9.1.2. Another technique that helps me memorize Equation 9.2 is the

phrase “Check (CK) Please (PS).” At expiration T , CEur (K, 0)+K = PEur (K, 0)+

ST . Discounting this equation to time zero, we get: CEur (K, T ) + P V (K) =

PEur (K, T ) + S0 .

Example 9.1.1. The price of a 6-month 30-strike European call option is 12.22.

The stock price is 35. The continuously compounded risk-free interest rate is 8%

per year. What”s the price of a 6-month 30-strike European put option on the

same stock?

Solution.

CEur + P V (K) = PEur + S0

→ 12.22 + 30e−0.08(0.5) = PEur + 35, PEur = 6. 043

This is why we need to subtract the term P V (Div). At expiration, CEur (K, T )+

K = PEur (K, T ) + ST . If we discount ST from T to time zero, we’ll get

4 CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

S0 − P V (Div). If you have one stock worth S0 at time zero, then during [0, T ],

you’ll receive dividend payments. Then at T , you not only have one share of

stock, you also have the accumulated value of the dividend. To get exactly one

stock at T , you need to have S0 − P V (Div) at time zero.

Discounting this equation back to time zero, we get Equation 9.3

Please note that Equation 9.3 assumes that both the timing and the amount

of each dividend are 100% known in advance.

Example 9.1.2. The price of a 9-month 95-strike European call option is 19.24.

The stock price is 100. The stock pays dividend of $1 in 3 months and $2 in 6

months. The continuously compounded risk-free interest rate is 10% per year.

What”s the price of a 9-month 95-strike European put option on the same stock?

Solution.

CEur = 19.24

P V (Div) = e−0.1(3/12) + 2e−0.1(6/12) = 2. 877 8

19.24 + 95e−0.1(0.75) = PEur (K, T ) + 100 − 2. 877 8, PEur (K, T ) = 10. 25

Example 9.1.3. The price of a 9-month 83-strike European put option is 13.78.

The stock price is 75. The stock pays dividend of $1 in 3 months, $2 in 6 months,

$3 in 9 months, and $4 in 12 months. The continuously compounded risk-free

interest rate is 6% per year. What”s the price of a 9-month 95-strike European

call option on the same stock?

Solution.

PEur = 13.78

P V (Div) = e−0.06(3/12) + 2e−0.06(6/12) + 3e−0.06(9/12) = 5. 794

CEur (K, T ) + 83e−0.06(0.75) = 13.78 + 75 − 5. 794 CEur (K, T ) = 3. 64

Tip 9.1.3. When calculating P V (Div) in Equation 9.3, discard any dividend

paid after the option expiration date. In this example, the $4 is paid in 12

months, which is after the expiration date of the option. This dividend is ignored

when we use Equation 9.3.

9.1. PUT-CALL PARITY 5

If the stock pays dividends at a continuously compounded rate of δ per year,

the parity formula is:

T to time zero, we’ll get S0 e−δT . If you have e−δT share of a stock, by investing

dividends and buying additional stock, you’ll have exactly one stock at T . This

concept is called tailing. Refer to Derivatives Markets Section 5.2 about tailing.

Example 9.1.4. The price of a 6-month 90-strike European put option is 5.54.

The stock price is 110. The stock pays dividend at a continuously compounded

rate of 2% per year. The continuously compounded risk-free interest rate is 6%

per year. What”s the price of a 6-month 90-strike European call option on the

same stock?

Solution.

PEur = 5.54

CEur (K, T ) + P V (K) = PEur (K, T ) + S0 e−δT

CEur (K, T ) + 90e−0.06(0.5) = 5.54 + 110e−0.02(0.5) CEur (K, T ) = 27. 11

Example 9.1.5. The price of a 3-month 40-strike European call option is 6.57.

The stock price is 44. The stock pays dividend at a continuously compounded

rate of 5% per year. The continuously compounded risk-free interest rate is 8%

per year. What”s the price of a 3-month 40-strike European put option on the

same stock?

Solution.

CEur = 6.57

CEur (K, T ) + P V (K) = PEur (K, T ) + S0 e−δT

6.57 + 40e−0.08(0.25) = PEur (K, T ) + 44e−0.05(0.25) PEur (K, T ) = 2. 32

Synthetic stock

Rearranging Equation 9.3, we get:

To understand the meaning of Equation 9.5, notice

6 CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

Symbol Meaning at t = 0

+CEur (K, T ) buy a K-strike call expiring in T

−PEur (K, T ) sell a K-strike put expiring in T

+P V (K) buy a zero-coupon bond that pays K at T

+P V (Div) buy a zero-coupon bond that pays Div at T

always receive K from the zero-coupon bond seller. However, the call and put

values depend on whether ST ≥ K.

• If ST ≥ K, the sold put expires worthless; you exercise the call, paying K

and receiving one stock.

• If on the other hand, ST ≤ K, the purchased call expires worthless and the

sold put is exercised against you. You pay the put holder K and receive

one stock from him.

• Either way, if at time zero you buy a call, sell a put, and invest P V (K)

in a zero-coupon bond, then at T you are guaranteed to have one stock.

Once you understand CEur (K, T )−PEur (K, T )+P V (K) is worth one stock

at T , the meaning of Equation 9.5 is obvious: if you buy one stock at time zero,

then at time T , you’ll have one stock worth ST . In addition, you’ll receive the

future value of the dividends due to owning a stock.

non dividend-paying stock is 33.4420. The price of a 9-month 52-strike European

put option on the same stock is 15.1538. The continuously compounded risk-free

interest rate is 6% per year. How can you synthetically create one stock at time

zero? What’s the price of this synthetically created stock at time zero?

Solution.

CEur (K, T ) + P V (K) = PEur (K, T ) + S0

Rearranging this equation, we get:

S0 = CEur (K, T ) + P V (K) − PEur (K, T )

To synthetically create the ownership of one stock, you need to do the fol-

lowing at time zero:

• Buy a 9-month 52-strike European call option

• Sell a 9-month 52-strike European put option

• Invest 52e−0.06(0.75) = 49. 711 9 in an account earning risk-free interest

rate (i.e. buying a zero coupon bond that pays 52 in 9 months)

The current price of this synthetically created stock is:

S0 = 33.4420 + 49. 711 9 − 15.1538 = 68

9.1. PUT-CALL PARITY 7

Synthetic T-bill

Rearranging Equation 9.3, we get:

According to Equation 9.6, buying one stock, buying a K-strike put, and

selling a K-strike call synthetically creates a zero coupon bond with a present

value equal to P V (Div) + P V (K).

Creating synthetic T-bill by buying the stock, buying a put, and selling a

call is called a conversion. If we short the stock, buy a call, and sell a put, we

create a short position on T-bill. This is called a reverse conversion.

you for one year. She’s willing to pay you 50% interest rate for using your

money for one year. You really want to take her oﬀer and earn 50% interest.

However, state anti-usury laws prohibits any lender from charging an interest

rate equal to or greater than 50%. Since you happen to know the put-call parity,

you decide to synthetically create a loan and circumvent the state anti-usury

law. Explain how you can synthetically create a loan and earn 50% interest.

You want to lend $1000 at time zero and receive $1000 (1.5) = 1500 at T = 1.

To achieve this, at time zero you can

option on the asset

the asset.

• If ST ≥ 1500, you exercise the put and sell the asset to your mother-in-law

for 1500

• if ST ≤ 1500, your mother-in-law exercises the call and buys the asset

from you for 1500.

The net eﬀect is that you give your mother-in-law $1000 at time zero and

receive $1500 from her at T = 1.

In this example, you have a long position on the synthetically created T-

bill. This is an example of conversion. In contrast, your mother-in-law has a

short position in the synthetically created T-bill. This is an example of reverse

conversion.

8 CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

Rearranging Equation 9.3, we get:

CEur (K, T ) = PEur (K, T ) + S0 − P V (Div) − P V (K)

dividend-paying stock is 8.06. The stock price is 80. The continuously com-

pounded risk-free interest rate is 5% per year. The continuously compounded

dividend rate is 3% per year. Explain how you can create a synthetic 6-month

75-strike European call option on the stock. Calculate the premium for such a

synthetic call option.

Solution.

CEur (K, T ) + P V (K) = PEur (K, T ) + S0 e−δT

CEur (K, T ) = PEur (K, T ) + S0 e−δT − P V (K)

= 8.06 + 80e−0.03(0.5) − 75e−0.05(0.5) = 13. 72

This is how to synthetically create a 6-month 75-strike European call

symbol at t = 0

+PEur (K, T ) buy a 6-month 75-strike European put

+S0 e−δT buy e−0.03(0.5) = 0.985 share of stock

−P V (K) sell a bond that pays 75 in 6 months

will grow into one stock if you reinvest the dividend and buy additional share of

stock. If at T = 0.5 the stock price is greater than 75 (i.e. ST > 75), then two

things happen: your purchased put expires worthless; the bond matures and

you need to pay the bond holder K = 75. So the net eﬀect is that if ST > 75

then at T you pay K = 75 and own one stock. This is the same as if ST > 75

you exercise the call, paying K = 75 and receiving one stock.

If ST ≤ 75, then two things will happen. You exercise the put, selling your

stock for K = 75; the bond matures and you pay the bond holder K = 75. So

the net eﬀect is that if ST ≤ 75 you net cash flow is zero and you don’t own a

stock. This is the same as if ST ≤ 75 you do nothing and let your call expire

worthless.

a dividend-paying stock is 42.81. The stock price is 100. The continuously

compounded risk-free interest rate is 8% per year. The stock will pay $1 dividend

in 3 months and $1 dividend in 6 months. Explain how you can create a synthetic

9-month 110-strike European call option on the stock. Calculate the premium

for such a synthetic call option.

9.1. PUT-CALL PARITY 9

= 42.81 + 100 − e−0.08(0.25) − e−0.08(0.5) − 110e−0.08(0.75) = 37. 27

symbol at t = 0

+PEur (K, T ) buy a 9-month 110-strike European put

+S0 buy one share of stock paying 100

−P V (Div) sell Bond #1 that pays $1 in 3 months and $1 in 6 months

−P V (K) sell Bond #2 that pays $110 in 6 months

If at expiration date ST > 110

end of Month 6. You use the dividends to pay oﬀ Bond #1

The net eﬀect is that you’ll pay K = 110 at T = 0.75 and own one stock.

This is the same as owning a call option and ST > 110.

If at expiration date ST ≤ 110

end of Month 6. You use the dividends to pay oﬀ Bond #1

• You exercise your put, surrendering one stock and receiving K = 110

The net eﬀect is that you have zero cash left and don’t own one stock. This

is the same as owning a call option and ST ≤ 110.

Rearranging Equation 9.3, we get:

PEur (K, T ) = CEur (K, T ) − S0 + P V (Div) + P V (K)

10 CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

dividend-paying stock is 18.62. The stock price is 50. The continuously com-

pounded risk-free interest rate is 6% per year. The stock will pay $1 dividend in

3 months. Explain how you can create a 6-month 45-strike European put option

on the stock. Calculate the premium for such a synthetic put option.

Solution.

PEur (K, T ) = CEur (K, T ) − S0 + P V (Div) + P V (K)

= 18.62 − 50 + e−0.06(0.25) + 45e−0.06(0.5) = 13. 28

symbol at t = 0

+CEur (K, T ) buy a 6-month 45-strike European call

−S0 short sell one share receiving 50 and invest in a savings account

+P V (Div) buy Bond #1 that pays $1 in 3 months

+P V (K) sell Bond #2 that pays $45 in 6 months

If ST ≥ 45

• (2) You exercise the call at T = 0.5, paying K = 45 which you get from

(1) and receiving one stock

• (3) at T = 0.5 you give the stock you get from (2) to the broker from

whom you borrowed the stock for short sale

• (4) Bond #1 pays you $1 dividend at the end of Month 3. After receiving

this dividend, you Immediately pay this dividend to the original owner of

the stock you sold short

The net eﬀect is that if ST ≥ 45 you keep the proceeds from the short sale,

which you can use to buy a stock. This is "keeping your asset (i.e. proceeds from

the short sale)." This is the same as if you own a 6-month 45-strike European

put and ST ≥ 45. If you own a 6-month 45-strike European put and ST ≥ 45,

you let the put option expire worthless and you still own a stock.

If ST < 45

• (2) You let the call expire worthless

• (3) At T = 0.5 you buy a stock from the open market using the proceeds

from the short sale; you give the stock to the broker from whom you

borrowed the stock for short sale

9.1. PUT-CALL PARITY 11

• (4) Bond #1 pays you $1 dividend at the end of Month 3. After receiving

this dividend, you Immediately pay this dividend to the original owner of

the stock you sold short

The net eﬀect is that if ST ≥ 45 you receive K = 45 and you spent the

proceeds from the short sale. This is "giving up an asset (proceeds from the

short sale) and getting the strike price K."

The put-call parity when currencies are underlying is

In Equation 9.7, the underlying asset is 1 euro. The call holder has the

right, at T , to buy the underlying (i.e. 1 euro) by paying a fixed dollar amount

K. The premium of this call option is CEur (K, T ) dollars. Similarly, the put

holder has the right, at T , to sell the underlying (i.e. 1 euro) for a fixed dollar

amount K. The premium of this put option is PEur (K, T ) dollars. x0 is the

price, in dollars, of buying the underlying (i.e. 1 euro) at time zero. r€ is the

continuously compounded euro interest rate per year earned by the underlying

(i.e. 1 euro).

To understand the term x0 e−r€ in 9.7, notice that to have 1€ at T , you need

to have e−r€ € at time zero. Since the cost of buying 1€ at time zero is x0

dollars, the cost of buying e−r€ € at time zero is x0 e−r€ dollars.

Equation 9.4 becomes 9.7. This shouldn’t surprise us. Both S0 and x0 refer to

the price of an underlying asset at time zero. S0 is the dollar price of a stock;

x0 is the dollar price of 1 euro. Both δ and r€ measure the continuous rate of

reward earned by an underlying asset.

Tip 9.1.4. How to memorize Equation 9.7. Just memorize Equation 9.4. Next,

set S0 = x0 and δ = r€ .

Tip 9.1.5. When applying Equation 9.7, remember that K, CEur (K, T ), PEur (K, T ),

and x0 are in U.S. dollars. To remember this, assume that you are living in the

U.S. (i.e. US dollar is your home currency); that your goal is to either buy or

sell the underlying asset (i.e.1€) with a fixed dollar amount. Also remember

that r€ is the euro interest rate on euro money.

Example 9.1.11. The current exchange rate is 1€= 1.33 US dollars. The

dollar-denominated 6-month to expiration $1.2-strike European call option on

one euro has a premium $0.1736. The continuously compounded risk-free in-

terest rate on dollars is 6% per year. The continuously compounded risk-free

12 CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

interest rate on euros is 4% per year. Calculate the premium for the dollar-

denominated 6-month to expiration $1.2-strike European put option on one euro.

Solution.

K = 1.2 T = 0.5 CEur (K, T ) = $0.1736

r = 0.06 δ = 0.04 S0 = 1.33

0.1736 + 1.2e−0.06(0.5) = PEur (K, T ) + 1.33e−0.04(0.5)

9-month to expiration $1-strike European put option on one euro has a premium

$0.0733. The continuously compounded risk-free interest rate on dollars is 7%

per year. The continuously compounded risk-free interest rate on euros is 3% per

year. Calculate the premium for the dollar-denominated 9-month to expiration

$1-strike European call option on one euro.

K=1 T = 0.5 PEur (K, T ) = 0.0733

1

r = 0.07 δ = 0.03 S0 = = 1. 282 05

0.78

1 −0.03(0.75)

CEur (K, T )+e−0.07(0.75) = 0.0733+ e CEur (K, T ) = $0.3780

0.78

This is an option contract where the underlying asset is a bond. Other than

having diﬀerent underlying assets, a stock option and a bond option have no

major diﬀerences. You buy a call option on stock if you think the stock price

will go up; you buy a put option if you think the stock price will drop. Similarly,

you buy a call option on a bond if you think that the market interest rate will

go down (hence the price of a bond will go up); you buy a put option on a bond

if you think that the market interest rate will go up (hence the price of the bond

will go down).

The coupon payments in a bond are like discrete dividends in a stock. Using

Please note that in Equation 9.8, in the term P V (Coupon), "coupon" refers

to the coupon payments during [0, T ]. In other words, only the coupons made

during the life of the options are used in Equation 9.8. Coupons made after T

are ignored.

9.1. PUT-CALL PARITY 13

Example 9.1.13. A 10-year $1,000 par bond pays 8% annual coupons. The

yield of the bond is equal to the continuously compounded risk-free rate of 6%

per year. A 15-month $1,000-strike European call option on the bond has a

premium $180. Calculate the premium for a 15-month $1,000-strike European

put option on the bond.

Solution.

1 − 1.06184−10 ¡ ¢

B0 = 1000 (0.08) a10| +1000v 10 = 1000 (0.08)× +1000 1.06184−10 =

0.06184

1132. 50

We need to be careful about calculating P V (Coupon). The bond matures

in 10 years. There are 10 annual coupons made at t = 1, 2, ..., 10. However,

since the option expires at T = 15/12 = 1. 25, only the coupon paid at t = 1 is

used in Equation 9.8.

CEur (K, T ) + P V (K) = PEur (K, T ) + B0 − P V (Coupon)

180 + 1000e−0.06(1.25) = PEur (K, T ) + 1132. 50 − 75. 34

PEur (K, T ) = 50. 59

General definition of call and put

Most times, the strike price is a constant and we can easily tell whether an

option is a call or a put. For example, an option that gives you the privilege of

buying one Google stock in 1 year for $35 is a call option; an option that gives

you the privilege of selling one Google stock in 1 year for $35 is a put option.

However, occasionally, the strike price is not a constant and it’s hard to

determine whether an option is a call or put. For example, you purchase an

option that gives you the privilege of receiving one Google stock by surrendering

one Microsoft stock in 1 year. If at T = 1, the price of a Google stock is higher

than that of a Micros0ft stock (i.e. STGoogle >.STMicrosof t ), it’s advantageous for

you to exercise the option. To exercise the call, you buy one Microsoft stock

from the open market for STM icrosof t , give it to the option writer. In return,

the option writer gives you one Google stock worth STGoogle . Your payoﬀ is

STGoogle −.STMicrosof t . If, on the other hand, STGoogle ≤.STMicrosof t , you let your

option expires worthless and your payoﬀ is zero. Is this option a call or a put?

It turns out that this option can be labeled as either a call or a put. If

you view the Google stock as the underlying asset and the Microsoft stock as

the strike asset, then it’s a call option. This option gives you the privilege of

buying, at T = 1, one Google stock by paying one Microsoft stock. If you view

14 CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

the Microsoft stock as the underlying asset and the Google stock as the strike

asset, then it’s a put option. This option gives you the privilege of selling, at

T = 1, one Microsoft stock for the price of one Google stock.

surrendering an asset AT and receiving an asset BT (we denote the option as

AT → BT ). This is a call option if we view B as the underlying asset and A as

the strike asset (the option holder has the privilege of buying BT by paying AT ).

This is a put option if we view A as the underlying asset and B as the strike

asset (the option holder has the privilege of selling AT and receiving BT ).

Example 9.1.14. An option gives the option holder the privilege, at T = 0.25

(i.e. 3 months later), of buying €1 with $1.25. Explain why this option can be

viewed (perhaps annoyingly) as either a call or a put.

Solution.

This option is $1.25 →€1. The option holder has the privilege, at T = 0.25,

of surrendering $1.25 and receiving €1 (i.e. give $1.25 and get €1).

This is a call option if we view €1 as the underlying asset. The option holder

has the privilege of buying €1 by paying $1.25.

This is also a put option if we view $1.25 as the underlying asset. The option

1

holder has the privilege of selling $1.25 for €1 (i.e. selling $1 for € =€

1.25

0.8).

Example 9.1.15. An option gives the option holder the privilege, at T = 0.25,

of buying one Microsoft stock for $35. Explain why this option can be viewed

(perhaps annoyingly) as either a call or a put.

This option is $35 → 1 M icrosof t stock (give $35 and get 1 Microsoft stock).

If we view the Microsoft stock as the underlying asset, this is a call option. The

option holder has the privilege of buying one Microsoft stock by paying $35.

This is also a put option if we view $35 as the underlying. The option holder

has the privilege of selling $35 for the price of one Microsoft stock.

Example 9.1.16. An option gives the option holder the privilege, at T = 0.25,

of selling one Microsoft stock for $35. Explain why this option can be viewed as

either a call or a put.

This option is 1 M icrosof t stock → $35 (give 1 Microsoft stock and get $35).

If we view the Microsoft stock as the underlying asset, this is a put option. The

option holder has the privilege of selling one Microsoft stock for $35. This is

also a call option if we view $35 as the underlying. The option holder has the

privilege of buying $35 by paying one Microsoft stock.

9.1. PUT-CALL PARITY 15

(AT → BT )0 + P V (AT ) = (BT → AT )0 + P V (BT ) (9.9)

of giving AT and getting BT at T . Similarly, (BT → AT )0 is the premium paid

at t = 0 for the privilege of giving BT and getting AT at T . P V (AT ) is the

present value of AT . If you have P V (AT ) at time zero and invest it from time

zero to T , you’ll have exactly AT . Similarly, if you have P V (BT ) at time zero

and invest it from time zero to T , you’ll have exactly BT .

This is the proof of Equation 9.9. Suppose we have two portfolios. Portfolio

#1 consists a European option AT → BT and the present value of the asset AT .

Portfolio #2 consists a European option BT → AT and the present value of the

asset BT .

Payoﬀ of Portfolio #1 at T

If AT ≥ BT If AT < BT

Option AT → BT 0 BT − AT

P V (AT ) AT AT

Total AT BT

Payoﬀ of Portfolio #2 at T

If AT ≥ BT If AT < BT

Option BT → AT AT − BT 0

P V (BT ) BT BT

Total AT BT

arbitrage, these two portfolios must cost us the same to set up at any time prior

to T . The cost of setting up Portfolio #1 is (AT → BT )0 + P V (AT ). The cost

of setting up Portfolio #2 is (BT → AT )0 +P V (BT ). Hence Equation 9.9 holds.

Example 9.1.17. Stock A currently sells for $30 per share. It doesn’t pay

any dividend. Stock B currently sells for $50 per share. It pays dividend at a

continuously compounded rate of 5% per year. The continuously compounded

risk-free interest rate is 6% per year. A European option gives the option holder

the right to surrender one share of Stock B and receive one share of Stock A at

the end of Year 1. This option currently sells for $8.54. Calculate the premium

for another European option that gives the option holder the right to surrender

one Stock A and receive one Stock B at the end of Year 1.

(AT → BT )0 + P V (AT ) = (BT → AT )0 + P V (BT )

(AT → BT )0 + 30 = 8.54 + 50e−0.05

(AT → BT )0 = 26. 1

Please note that the risk free interest rate 6% is not needed for solving the

problem. In addition, you don’t need to decide whether to call the option "give

16 CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

Stock B and receive Stock A" or "give Stock A and receive Stock B" as a call or

put. Equation 9.9 holds no matter you call the option AT → BT or BT → AT

a call or put.

Example 9.1.18. Stock A currently sells for $55 per share. It pays dividend of

$1.2 at the end of each quarter. Stock B currently sells for $72 per share. It pays

dividend at a continuously compounded rate of 8% per year. The continuously

compounded risk-free interest rate is 6% per year. A European option gives the

option holder the right to surrender one share of Stock A and receive one share

of Stock B at the end of Year 1. This option currently sells for $27.64. Calculate

the premium for another European option that gives the option holder the right

to surrender one Stock B and receive one Stock A at the end of Year 1.

P V (AT ) = A0 − 1.2a4|i = 55 − 1.2a4|i

i is the eﬀective interest rate per quarter.

i = e0.25r − 1 = e0.25(0.06) − 1 = 1. 511

µ 3% ¶

1 − 1.01 511 3−4

P V (AT ) = 55 − 1.2a4|i = 55 − 1.2 = 50. 38

0.01 511 3

P V (BT ) = B0 e−δB T = 72e−0.08 = 66. 46

27.64 + 50. 38 = (BT → AT )0 + 66. 46

(BT → AT )0 = 11. 56

Currency options

Example 9.1.19. Let’s go through the textbook example. Suppose that a 1-year

dollar-denominated call option on €1 with the strike price $0.92 is $0.00337.

The current exchange rate is €1 = $0.9. What’s the premium for a 1-year

1

euro-denominated put option on $1 with strike price € = €1. 087?

0.92

First, let’s walk through the vocabulary. The phrase "dollar-denominated

option" means that both the strike price and the option premium are expressed

in U.S. dollars. Similarly, the phrase "euro-denominated option" means that

both the strike price and the option premium are expressed in euros.

Next, let’s summarize the information using symbols. "dollar-denominated

call option on €1 with the strike price $0.92" is $0.92 →€1. The premium for

this option is $0.00337. This is represented by ($0.92 → €1)0 =$0.0337.

1

"Euro-denominated put option on $1 with strike price € = €1. 087" can

0.92µ ¶

1 1

be represented by $1 →€ . The premium for this option is $1 → €

0.92 0.92 0

Now the solution

µ ¶ should µ be simple. ¶

1 1 1

$1 → € = $1 × 0.92 → € × 0.92

0.92 0 0.92 0.92 0

1 1

= ($0.92 → €1)0 = ×$0.0337

0.92 0.92

9.1. PUT-CALL PARITY 17

1

Since the exchange rate is €1 = $0.9 or $1 =€ , we have:

µ ¶ 0.9

1 1 1 1

$1 → € = ×$0.0337 = × 0.0337 × € = €0.04 07

0.92 0 0.92 0.92 0.9

18 CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

General formula:

1

The current exchange rate is €1 = $x0 or $1=€

x0

m

( $K → €1)0 = $a or ( $K → €1)$0 = a

1

A euro-denominated € strike put on $1 has a premium of €b

K

m

µ ¶ µ ¶€

1 1

$1 → € =€b or $1 → € =b

K 0 K 0

It then follows:

µ ¶€ µ ¶$

1 1 1

$1 → € × x0 = $1 → € = × ( $K → €1)$0 (9.10)

K 0 K 0 K

µ ¶€

1 1

In Equation 9.10, $1 → € is the euro-cost of "give $1, get € ." Since

K0 K

µ ¶€

1

the exchange rate is €1 = $x0 , $1 → € × x0 is the dollar cost of "give

K 0

1

$1, get ." Similarly, ( $K → €1)$0 is the dollar-cost of "give $K, get €1."

K

1 1

Equation 9.10 essentially says that the dollar cost of "give $1, get " is of

K K

the dollar cost "give $K, get €1." This should make intuitive sense.

µ ¶

1 1

Tip 9.1.6. The textbook gives you the complex formula C$ (x0 , K, T ) = x0 KPf , ,T .

x0 K

Do not memorize this formula or Equation 9.10. Memorizing complex formulas

is often prone to errors. Just translate options into symbols. Then a simple

solution should emerge. See the next example.

9.1. PUT-CALL PARITY 19

Example 9.1.20. The current exchange rate is €0.9 per dollar. A European

euro-denominated call on 1 dollar with a strike price €0.8 and 6 months to

expiration has a premium €0.0892. Calculate the price of a European dollar-

denominated put option on 1 euro with a strike price $1.25.

Just translate the options into symbols. Then you’ll see a solution.

1

The current exchange rate is €0.9 per dollar. $1 =€0.9 or €1 = $

0.9

Euro-denominated call on 1 dollar with strike price €0.8 has a premium €0.0892

(€0.8 → $1)0 =€0.0892

Calculate the price of a dollar-denominated put on 1 euro with strike price $1.25

(€1 → $1.25)0 = $?

µ ¶

1

(€1 → $1.25)0 = 1.25 × € → $1 = 1.25 × (€0.8 → $1)0

1.25 0

1

= 1.25 × €0.0892 = 1.25 × 0.08928 × $ = $0.124

0.9

and strike

European vs American options

American options can be exercised at any time up to (and including) the matu-

rity. In contrast, European options can be exercised only at the maturity. Since

we can always convert an American option into a European option by exercising

the American option only at the maturity date, American options are at least

as valuable as an otherwise identical European option.

Equation 9.11 and Equation 9.12 are not earth-shaking observations. You

shouldn’t have trouble memorizing them.

1. The price of a call option is always non-negative. CAmer (K, T ) ≥

CEur (K, T ) ≥ 0. Any option (American or European, call or put) is a

privilege with non-negative payoﬀ. The price of a privilege can never be

negative. The worst thing you can do is to throw away the privilege.

2. The price of a call option can’t exceed the current stock price.

S0 ≥ CAmer (K, T ) ≥ CEur (K, T ). The best you can do with a call option

is to own a stock. So a call can’t be worth more than the current stock.

20 CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

3. The price of a European call option must obey the put call

parity. For a non-dividend paying stock, the parity is CEur (K, T ) =

PEur (K, T ) + S0 − P V (K) ≥ S0 − P V (K)

For a non-dividend paying stock

£ ¤

S0 ≥ CAmer (K, T ) ≥ CEur (K, T ) ≥ max 0, S0 e−δT − P V (K) (9.15)

Tip 9.1.7. You don’t need to memorize Equation 9.13, 9.14, or 9.15. Just mem-

orize basic ideas behind these formulas and derive the formulas from scratch.

PEur (K, T ) ≥ 0.

value of the strike price. PEur (K, T ) ≤ P V (K). The best you can

do with a European put option is to get the strike price K at T . So a

European put can’t be worth more than the present value of the strike

price.

price. K ≥ CAmer (K, T ). The best you can do with an American put

option is to exercise it immediately after time zero and receive the strike

price K. So an American put can’t be worth more than the strike price.

4. The price of a European put option must obey the put call

parity. For a non-dividend paying stock, the parity is PEur (K, T ) =

CEur (K, T ) + P V (K) − S0 ≥ P V (K) − S0

For a non-dividend paying stock

9.1. PUT-CALL PARITY 21

For a discrete-dividend paying stock

£ ¤

P V (K) ≥ CEur (K, T ) ≥ max 0, P V (K) − S0 e−δT (9.19)

Tip 9.1.8. You don’t need to memorize Equation 9.16, 9.17, 9.18, or 9.19. Just

memorize the basic ideas behind these formulas and derive the formulas from

scratch.

Suppose an American option is written at time zero. The option expires in date

T . Today’s date is t where 0 ≤ t < T . The stock price at the option expiration

date is ST . Today’s stock price is St . The continuously compounded risk-free

interest rate is r per year.

Proposition 9.1.1. It’s never optimal to exercise an American call early on a

non-dividend paying stock.

If at t you exercise an American call option , your payoﬀ is St − K.

If at t you sell the remaining

£ call option, you’ll

¤ get at least CEur (St , K, T ) ≥

max [0, St − P V (K)] = max 0, St − Ke−r(T −t) , the premium for a European

call option written in t and expiring in T . £ ¤

Clearly, CEur (St , K, T ) ≥ max [0, St − P V (K)] = max 0, St − Ke−r(T −t) >

St − K for r > 0

It’s not optimal to exercise an American call option early if you can sell the

remaining call option.

What if you can’t sell the remaining call option? If you can’t sell the call

option written in t and expiring in T ., you can short sell one stock at t, receiving

St and accumulating to St er(T −t) . Then at T , if ST > K, you exercise your call,

paying K and receiving one stock. Next, you return the stock to the broker.

Your total profit is St er(T −t) − K > St − K for a positive r; if at T , ST < K,

you let your call option expire worthless, purchase a stock in the market, and

return it to the broker. Your profit is St er(T −t) − ST > St er(T −t) − K > St − K

for a positive r.

Intuition behind not exercising American call option early. If you exercise the

call option early at t, you pay the strike price K at t and gain physical possession

of the stock at t. You lose the interest you could have earned during [t, T ] had

you put K in a savings account, yet you gain nothing by physically owning a

22 CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

stock during [t, T ] since the stock doesn’t pay any dividend. In addition, by

exercising the call option t, you throw away the remaining call option during

[t, T ].

months on a non-dividend paying stock. 2 months later the stock reaches a high

price of $90. You are 100% sure that the stock will drop to $10 in 4 months.

You are attempted to exercise the call option right now (i.e. at t = 2/12 = 1/6

year) and receive 90 − 30 = 60 profit. The continuously compounded risk-free

interest rate is 6% per year. Explain why it’s not optimal to exercise the call

early.

Solution. The problem illustrates the pitfall in common thinking "If you I know

for sure that the stock price is going to fall, shouldn’t I exercise the call now and

receive profit right away, rather than wait and let my option expire worthless?"

Suppose indeed the stock price will be $10 at the call expiration date T =

6/12 = 0.5. If you exercise the call early at t = 2/12 = 1/6, you’ll gain

St − K = 90 − 30 = 60, which will accumulate to 60e0.06(4/12) = 61. 212 at

T = 0.5.

Instead of exercising the call early, you can short-sell the stock at t = 2/12 =

1/6. Then you’ll receive 90, which will accumulate to 90e0.06(4/12) = 91. 818 at

T = 0.5. Then at T = 0.5, you purchase a stock from the market for 10 and

return it to the brokerage firm where you borrow the stock for short sale. Your

profit is 91. 818 − 10 = 81. 818, which is the greater than 61. 212 by 81. 818 − 61.

212 = 20. 606.

Proposition 9.1.2. It might be optimal to exercise an American call option

early for a dividend paying stock.

Suppose the stock pays dividend at tD .

Time 0 ... ... tD ... ... T

and earn interest during [tD , T ]

• −. You’ll pay the strike price K at tD , losing interest you could have

earned during [tD , T ]

• −. You throw away the remaining call option during [tD , T ]. Had you

waited, you would have the call option during [tD , T ]

However, if the accumulated value of the dividend is big enough, then it can

optimal to exercise the stock at tD .

Proposition 9.1.3. If it’s optimal to exercise an American call early, then the

best time to exercise the call is immediately before the dividend payment.

9.1. PUT-CALL PARITY 23

Time 0 t1 ... ... tD t2 ... ... T

It’s never optimal to exercise an American call at t1 . If you exercise the call

at t1 instead of tD , you’ll

It’s never optimal to exercise an American call at t2 . If you exercise the call

at t2 instead of tD , you’ll

• gain a tiny interest that can be earned during [tD , t2 ] but lose the dividend

that can be earned if the call is exercised at tD

call early, you should exercise the call immediately before the dividend payment,

no sooner or later.

Combining these two proposition, we have:

Proposition 9.1.4. It’s only optimal to exercise an American call option either

at maturity or immediately before a dividend payment date. Any other time is

not optimal.

The pros and cons of exercising an American put at t instead of T

• −. You lose the remaining put option during [t, T ]. If you wait and

delay exercising the option, you’ll have a put option during [t, T ] and can

decide whether to exercise it or discarding it. This is especially painful if

ST > K. If ST > K and you exercise the put at t, you’ll get K at t, which

accumulates to Ker(T −t) at T . If you wait and ST > K, you’ll let the put

option expire worthless and have ST at T . If ST > Ker(T −t) , then you

lose money by exercising the put at t. So one danger of exercising the put

at t is that the stock might be worth more than K after t.

optimal to exercise the put at t instead of T .

24 CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

Appendix 9.5A (and 9.5B) is not on the syllabus. However, I still recommend

that you study it.

Appendix 9.5A has two important ideas

2. How to calculate the non-arbitrage boundary price for American options

Why the put-call parity doesn’t hold for American options The put-

call parity such as Equation 9.2 holds only for European options. It doesn’t hold

for American options. To understand why, let’s start from European options.

For Equation 9.2 to hold, among other things, the call and the put must be

exercised at the same time. Recall our proof of the put-call parity. At time t

we have two portfolios. Portfolio #1 consists a European call option on a stock

and P V (K), the present value of the strike price K. Portfolio #2 consists a

European put option on the stock and one share of the stock with current price

St . Both the call and put have the same underlying stock, have the same strike

price K, and the same expiration date T . We have found that Portfolio #1 and

Portfolio #2 have an identical payoﬀ of max (K, ST ) at the common exercise

date T . To avoid arbitrage, the two portfolios must cost us the same at time

zero. Hence we have Equation 9.2.

Now suppose the call is exercised at T1 and the put is exercised at T2 where

T1 6= T2 . Portfolio #1 consists of a European call option and P V (K) = Ke−rT1 ;

Portfolio #2 consists an American put and one stock worth S0 . Then at

T1 , Portfolio #1 has a payoﬀ of max (K, ST1 ); Portfolio #2 has a payoﬀ of

max (K, ST2 ). Now the two payoﬀs diﬀer in timing and the amount. As a

result, we don’t know whether the two portfolios have the same set-up cost.

Now you should understand why Equation 9.2 doesn’t hold for American

options. American options can be exercised at any time up to (and including)

the maturity. Even when an American call and an American put have the same

maturity T , the American call can be exercised at T1 where 0 ≤ T1 ≤ T ; the

American put can be exercised at T1 where 0 ≤ T2 ≤ T . Hence an American

call and an American put can be exercised at diﬀerent times, they don’t follow

the put-call parity.

pays discrete dividend, the key formula is

an intuitive proof without using complex math.

9.1. PUT-CALL PARITY 25

This is why Equation 9.21 holds. Clearly, CAme (K, T ) ≥ CEur (K, T ). This

is because an American call option can always be converted to a European call

option.

To understand why CEur (K, T ) + P V (Div) ≥ CAme (K, T ), consider an

American call option and an otherwise identical European call option. Both

call options have the same underlying stock, the same strike price K, the same

expiration date T . The European call option is currently selling for CEur (K, T ).

How much more can the American call option sell for?

The only advantage of an American option over an otherwise identical Eu-

ropean call option is that the American call option can be exercised early. The

only good reason for exercising an American call early is to get the dividend.

Consequently, the value of an American call option can exceed the value of an

otherwise identical European call option by no more than the present value of

the dividend. So CEur (K, T ) + P V (Div) ≥ CAme (K, T ). A rational person

will pay no more than CEur (K, T ) + P V (Div) to buy the American call option.

So Equation 9.21 holds.

European put.

In addition, the value of an American put exceeds the value of an otherwise

identical European put by no more than K − P V (K). The only advantage of

an American put over an otherwise identical European put is that the American

put can be exercised early. The only good reason for exercising an American

put early is to receive the strike price K immediately at time zero (as opposed

to receiving K at T in a European put) and earn the interest on K from time

zero to T . The maximum interest that can be earned on K during [0, T ] is

K − P V (K) = K − Ke−rT . Consequently, PEur (K, T ) + K − P V (K) ≥

PAme (K, T ). Equation 9.22 holds.

Next, we are ready to prove Equation 9.20. CAme (K, T ) − PAme (K, T )

reaches its minimum value when CEur (K, T ) reaches it minimum value CEur (K, T )

and PAme (K, T ) reaches its maximum value PEur (K, T ) + K − P V (K):

CAme (K, T ) − PAme (K, T ) ≤ CEur (K, T ) − [PEur (K, T ) + K − P V (K)]

From the put-call parity, we have:

CEur (K, T ) + P V (K) = PEur (K, T ) + S0 − P V (Div)

→ CEur (K, T ) = PEur (K, T ) + S0 − P V (Div) − P V (K)

→ CEur (K, T ) − [PEur (K, T ) + K − P V (K)]

= PEur (K, T ) + S0 − P V (Div) − P V (K)

26 CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

= S0 − P V (Div) − K

Similarly, CAme (K, T )−PAme (K, T ) reaches it maximum value when CAme (K, T )

reaches its maximum value and PAme (K, T ) reaches it minimum value.

CAme (K, T ) − PAme (K, T ) ≤ CEur (K, T ) + P V (Div) − PEur (K, T )

CEur (K, T )+P V (Div)−PEur (K, T ) = [PEur (K, T ) + S0 − P V (Div) − P V (K)]

+P V (Div) − PEur (K, T )

= S0 − P V (Div)

Equation 9.20 holds.

Tip 9.1.9. If you can’t memorize Equation 9.20, just memorize Equation 9.21,

Equation 9.22, and Equation 9.3. Then can derive Equation 9.20 on the spot.

Example 9.1.22. If the interest rate is zero. Is it ever optimal to exercise an

American put on a stock?

Solution. According to Equation 9.22, if the risk-free interest rate is zero, then

K = P V (K) and PEur (K, T ) ≥ PAme (K, T ) ≥ PEur (K, T ). This gives us

PAme (K, T ) = PEur (K, T ). So it’s never optimal to exercise an American put

early if the interest rate is zero.

Example 9.1.23. Is it ever optimal to exercise an American call on a non-

dividend paying stock?

Solution. According to Equation 9.21, if Div = 0, then CEur (K, T ) ≥ CAme (K, T ) ≥

CEur (K, T ) or CAme (K, T ) = CEur (K, T ). It’s never optimal to exercise the

American call option.

Example 9.1.24. An American call on a non-dividend paying stock with

exercise price 20 and maturity in 5 months is worth 1.5. Suppose that the current

stock price is 1.9 and the risk-free continuously compounded interest rate is 10%

per year. Calculate the non-arbitrage boundary price of the American put option

on the stock with strike price 20 and 5 months to maturity.

Solution.

S0 − P V (K) ≥ CAme (K, T ) − PAme (K, T ) ≥ S0 − P V (Div) − K

−0.184 ≥ 1.5 − PAme (K, T ) ≥ −1

1 ≥ PAme (K, T ) − 1.5 ≥ 0.184

9.1. PUT-CALL PARITY 27

2. 5 ≥ PAme (K, T ) ≥ 1. 684

If you can’t memorize Equation 9.20, this is how to solve the problem using

basic reasoning.

The American put is worth at least the otherwise identical European put.

PAme (K, T ) ≥ PEur (K, T )

Using the put-call parity: PEur (K, T ) = CEur (K, T ) + P V (K) − S0

Since the stock doesn’t pay any dividend, CAme (K, T ) = CEur (K, T ) = 1.5

PEur (K, T ) = CEur (K, T ) + P V (K) − S0

= 1.5 + 20e−0.1(5/12) − 19 = 1. 684

The value of an American put can exceed the value of an otherwise identical

European put by no more the early-exercise value. Since the only possible reason

to exercise an American put early is to receive K and earn interest K − P V (K)

during [0, T ], so the maximum early-exercise value is

K − P V (K) = 20 − 20e−0.1(5/12) = 0.816

→ PAme (K, T ) ≤ PEur (K, T ) + K − P V (K) = 1.684 + 0.816 = 2. 5

Time to expiration

American option An American option (call or put) has more time to expi-

ration is at least as valuable as an otherwise identical American option with less

time to expiration. If options are on the same stock and T1 > T2 , we have:

PAmer (K, T1 ) > PEur (K, T2 ) (9.24)

least as valuable as an otherwise identical European call option with a shorter

time to expiration. This is because for a non-dividend paying stock, an European

call option is worth the same as an otherwise identical American call option.

And an American call option with a longer time to expiration is more valuable

than an otherwise identical American option with a shorter time to expiration.

If both options are on the same non-dividend paying stock and T1 > T2 , we

have:

CEur (K, T1 ) > CEur (K, T2 ) (9.25)

If the stock pays dividend, then a longer-lived European option may be less

valuable than an otherwise identical but shorter-lived European option. The

textbook gives two good examples.

In Example #1, a stock is valuable only because of its dividend. The stock

pays a dividend at the end of Week 2. Once the dividend is paid, the stock dies

28 CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

weeks, CEur (K, T ) might be worth something depending on how high the strike

price K is.

asset of the bankrupt company is a constant c. The put is worth P V (c) = ce−rT .

If the risk-free interest rate r > 0, ce−rT will decrease if time to expiration T

increases.

European options when the strike price grows over time Typically,

a call or put has a fixed strike price K. However, there’s nothing to prevent

someone from inventing a European option whose strike price changes over time.

Consider a European option whose strike price grows with the risk-free in-

terest rate. That is, KT = KerT . What can we say about the price of such a

European option?

For a European option with strike price KT = KerT , a longer-lived European

option is at least as valuable as an otherwise identical but shorter-lived European

option.

¡ ¢ ¡ ¢

CEur KerT1 , T1 ≥ CEur KerT2 , T2 if T1 > T2 (9.26)

¡ ¢ ¡ ¢

PEur KerT1 , T1 ≥ PEur KerT2 , T2 if T1 > T2 (9.27)

This is why Equation 9.26 holds. Suppose at time zero we buy two European

calls on the same stock. The first call expires at T1 and has a strike price KerT1 .

The second call expires at T2 and has a strike price KerT2 , where T1 > T2 .

Let’s choose a common time T1 and compare¡ the payoﬀs of ¢these two calls

at T1 . The payoﬀ of the longer-lived call is max 0, ST1 − KerT1 .

The payoﬀ of the shorter-lived call is calculated as follows. First, we calculate

its payoﬀ at T2 . Next, we accumulate this payoﬀ from ¡ T2 to T1 . rT ¢

The payoﬀ of the shorter-lived

¡ call at T 2¢ is max 0, ST2 − Ke 2 . Next, we

rT2

accumulate this payoﬀ max 0, ST2 − Ke from T2 to T1 .

As we’ll soon see, it’s much harder for a short-lived call to have a positive

payoﬀ at T1 .

The longer-lived call will have a positive payoﬀ at ST1 − KerT1 at T1 if

ST1 > KerT1 ; all else, the payoﬀ is zero.

On the other hand, the shorter-lived call will have a positive payoﬀ ST1 −

KerT1 at T1 only if the following two conditions are met

9.1. PUT-CALL PARITY 29

If ST2 ≤ KerT2 , the shorter-lived call will expire worthless, leading to zero

payoﬀ at T2 , which accumulates to zero payoﬀ at T1 .

If ST2 > KerT2 , we’ll receive a positive payoﬀ ST2 − KerT2 at T2 . If we

accumulate ST2 − KerT2 from T2 to T1 , ST2 will accumulate to ST1 and KerT2

to KerT2 er(T1 −T2 ) = KerT1 , leading to a total amount ST1 − KerT1 at T1 . The

total payoﬀ amount ST1 − KerT1 is positive if ST1 > KerT1 .

In summary, both calls can reach the common positive payoﬀ ST1 −KerT1 at

T1 . The longer-lived call will reach this payoﬀ if ST1 > KerT1 . The shorter-lived

call will reach this payoﬀ if both ST2 > KerT2 and ST1 > KerT1 . Consequently,

the long-lived call has a better payoﬀ and should be at least as valuable as the

shorter-lived call. Hence Equation 9.26 holds.

If you still have trouble understanding why the longer-lived call has a richer

payoﬀ, you can draw the following payoﬀ table:

The accumulated payoﬀ of the shorter-lived call at T1

If ST1 ≤ KerT1 If ST1 > KerT1

rT2

If ST2 ≤ Ke P ayof f = 0 P ayof f = 0

If ST2 > KerT2 P ayof f = ST1 − KerT1 ≤ 0 P ayof f = ST1 − KerT1 > 0

If ST1 ≤ KerT1 If ST1 > KerT1

rT2

If ST2 ≤ Ke P ayof f = 0 P ayof f = ST1 − KerT1 > 0

rT2

If ST2 > Ke P ayof f = 0 P ayof f = ST1 − KerT1 > 0

You can see that the longer-lived call has a slightly better payoﬀ than the

shorter-lived payoﬀ. To avoid arbitrage, the longer-lived call can’t sell for less

than the shorter-lived call. Hence Equation 9.26 holds. Similarly, you can prove

Equation 9.27.

is at least as valuable as an otherwise identical call with a higher strike price.

However, the excess premium shouldn’t exceed the excess strike price.

Equation 9.28 should make intuitive sense. The lower-strike call allows the

call holder to buy the underlying asset by the guaranteed lower strike price.

Clearly, the payoﬀ of a lower-strike call can never be less than the payoﬀ of

an otherwise identical but higher-strike call. Consequently, 0 ≤ C (K1 , T ) −

C (K2 , T ). And this is why C (K1 , T ) − C (K2 , T ) ≤ K2 − K1 . The only advan-

tage of a K1 -strike call over the K2 -strike call is that the guaranteed purchase

price of the underlying asset is K2 − K1 lower in the K1 -strike call; to buy the

asset, the K1 -strike call holder can pay K1 yet the K2 -strike call holder will pay

30 CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

to buy the K1 -strike call.

Proposition 9.1.7. A European call with a low strike price is at least as valu-

able as an otherwise identical call with a higher strike price. However, the excess

premium shouldn’t exceed the present value of the excess strike price.

The only advantage of a K1 -strike European call over the K2 -strike European

call is that the guaranteed purchase price of the underlying asset is K2 − K1

lower in the K1 -strike call at T . Consequently, no rational person will pay more

than CEur (K2 , T ) + P V (K2 − K1 ) to buy the K1 -strike call.

Please note that CEur (K1 , T )−CEur (K2 , T ) ≤ P V (K2 − K1 ) doesn’t apply

to American call options because two American options can be exercised at

diﬀerent dates.

is at least as valuable as an otherwise identical put with a lower strike price.

However, the excess premium shouldn’t exceed the excess strike price.

with a lower strike price. Since the only advantage of a K2 -strike put over the

K1 -strike put is that the guaranteed sales price of the underlying asset is K2 −K1

high in the K2 -strike put, no rational person will pay C (K1 , T ) + K2 − K1 to

buy the K2 -strike put.

valuable as an otherwise identical put with a lower strike price. However, the

excess premium shouldn’t exceed the present value of the excess strike price.

Please note that PEur (K2 , T ) − PEur (K1 , T ) ≤ P V (K2 − K1 ) won’t apply

to two American put options because they can be exercised at two diﬀerent

dates.

undiversified option. For K1 < K2 and 0 < λ < 1

9.1. PUT-CALL PARITY 31

Please note that Equation 9.32 and Equation 9.33 apply to both European

options and American options.

A call portfolio consists of λ portion of K1 -strike call and (1 − λ) portion

of K2 -strike call. The premium of this portfolio, λC (K1 ) + (1 − λ) C (K2 ),

can be no less than the premium of a single call with a strike price λK1 +

(1 − λ) K2 . Similarly, a call portfolio consists of λ portion of K1 -strike put and

(1 − λ) portion of K2 -strike put. The premium of this portfolio, λP (K1 ) +

(1 − λ) P (K2 ), can be no less than the premium of a single call with a strike

price λK1 + (1 − λ) K2 .

Before proving Equation 9.32, let’s look at an example.

65, K3 = 0.4 (50) + 0.6 (65) = 59. C (K1 , T ) = 14, C (K2 , T ) = 5. Explain why

C (59) ≤ 0.4C (50) + 0.6C (65).

59-strike call (a) 0 0 ST − 59 ST − 59

65-strike call (c) 0 0 0 ST − 65

0.4b + 0.6c 0 0.4 (ST − 50) 0.4 (ST − 50) ST − 591

If we buy 0.4 unit of 50-strike call, buy 0.6 unit of 65-strike call, and sell

1 unit of 59-strike call, our initial cost is (0.4b + 0.6c) − a and our payoﬀ at

T is always non-negative. To avoid arbitrage, the position of always having a

non-negative payoﬀ at expiration T surely has a non-negative cost at t = 0.

Imagine what happens otherwise. For example, you always have a non-negative

payoﬀ at T and it costs you −$10 (i.e. you receive $10) to set up this position

at t = 0. Then you’ll make at least $10 free money.

Clearly, the call portfolio consisting of 40% 50-strike call and 60% 65-strike

call is at least as good as the 59-strike call. Consequently, the portfolio is at

least as valuable as the 59-strike call. C (59) ≤ 0.4C (50) + 0.6C (65) .

1 0.4 (S − 50) + 0.6 (ST − 65) = ST − 59

T

2 0.4 (S − 50) − (ST − 59) = 0.6 (65 − ST )

T

32 CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

Payoﬀ ST < K1 K1 ≤ ST < K3 K3 ≤ ST < K2 ST ≥ K2

K3 -strike call (a) 0 0 ST − K3 ST − K3

K2 -strike call (c) 0 0 0 ST − K2

λb + (1 − λ) c 0 λ (ST − K1 ) λ (ST − K1 ) ST − K3

Please note

λ (ST − K1 ) + (1 − λ) (ST − K2 ) = ST − [λK1 + (1 − λ) K2 ] = ST − K3

In addition,

λ (ST − K1 ) − (ST − K3 ) = K3 − λK1 − (1 − λ) ST

= λK1 + (1 − λ) K2 − λK1 − (1 − λ) ST = (1 − λ) K2 − (1 − λ) ST

= (1 − λ) (K2 − ST )

If we buy λ unit of K1 -strike call, buy (1 − λ) unit of K2 call, and sell 1 unit

avoid arbitrage, the initial cost must be non-negative. Hence λb+(1 − λ) c−a >

0.

Anyway, the call portfolio consisting of λ portion of K1 -strike call and 1 − λ

portion of K2 -strike call is at least as good as the call with the strike price

K3 = λK1 + (1 − λ) K2 . To avoid arbitrage, C [λK1 + (1 − λ) K2 ] ≤ λC (K1 ) +

(1 − λ) C (K2 ).

70, K3 = 0.75 (50) + 0.25 (70) = 55. P (K1 , T ) = 4, P (K2 , T ) = 16. Explain

why P (55) ≤ 0.75P (50) + 0.25P (70).

55-strike put (a) 55 − ST 55 − ST 0 0

70-strike put (c) 70 − ST 70 − ST 70 − ST 0

0.75b + 0.25c 55 − ST 0.25 (70 − ST ) 0.25 (70 − ST ) 0

Please note

0.75 (50 − ST ) + 0.25 (70 − ST ) = 55 − ST

0.25 (70 − ST ) − (55 − ST ) = 0.75 (ST − 50)

3 0.4 (S − 50) − (ST − 59) = 0.6 (65 − ST )

T

9.1. PUT-CALL PARITY 33

consisting of 75% 50-strike put and 25% 70-strike put is at least as good as

the 55-strike put. Consequently, to avoid arbitrage, the portfolio is at least as

valuable as the 55-strike put. P (55) ≤ 0.75P (50) + 0.25P (70).

Let K3 = λK1 + (1 − λ) K2 . Clearly, K1 < K3 < K2

Payoﬀ ST < K1 K1 ≤ ST < K3 K3 ≤ ST < K2 ST ≥ K2

K3 -strike put (a) K3 − ST K3 − ST 0 0

K2 -strike put (c) K2 − ST K2 − ST K2 − ST 0

λb + (1 − λ) c K3 − ST (1 − λ) (K2 − ST ) λ (K2 − ST ) ST − K3

Please note

λ (K1 − ST ) + (1 − λ) (K2 − ST ) = K3 − ST

In addition,

(1 − λ) (K2 − ST ) − (K3 − ST )

= (1 − λ) (K2 − ST ) − λK1 − (1 − λ) K2 + ST = λ (ST − K1 )

λ (ST − K1 ) − (ST − K3 ) = K3 − λK1 − (1 − λ) ST

= λK1 + (1 − λ) K2 − λK1 − (1 − λ) ST = (1 − λ) K2 − (1 − λ) ST

= (1 − λ) (K2 − ST )

The payoﬀ is always non-negative. Consequently, the call portfolio consisting

good as the put with the strike price K3 = λK1 +(1 − λ) K2 . To avoid arbitrage,

P [λK1 + (1 − λ) K2 ] ≤ λP (K1 ) + (1 − λ) P (K2 ).

Proposition 9.1.11. If it’s optimal to exercise an option, it’s also optimal to

exercise an otherwise identical option that’s more in-the-money.

This is just common sense. The textbook gives an example. Suppose it’s

optimal to exercise a 50-strike American call on a dividend paying stock. The

current stock price is 70. If it’s optimal to exercise the American a 50-strike

American call, then it must also be optimal to exercise an otherwise identical

call but with a strike price 40.

34 CHAPTER 9. PARITY AND OTHER OPTION RELATIONSHIPS

Chapter 10

This chapter is one of the easiest chapters in Derivatives Markets. The textbook

did a good job explaining the mechanics of how to calculate the option price in

a one-period binomial model. Besides learning the mechanics of option pricing,

you should focus on understanding two basic ideas: the non-arbitrage pricing

and the risk-neutral probabilities.

ples

Example 10.1.1. Suppose we want to find the price of a 12-month European

call option on a stock with strike price $15. The stock currently sells for $20. In

12 months, the stock can either go up to $30 or go down to $10. The continuously

compounded risk-free interest rate per year is 10%.

30 15

20 ?

10 0

Time 0 T =1 Time 0 T =1

It’s hard to directly calculate the price of the call option. So let’s build

something that behaves like a call, something that has the same payoﬀ pattern

as the call. Suppose at time zero we create a portfolio by buying X stocks and

putting Y dollars in a savings account. We want this portfolio to have the exact

payoﬀ as the call.

30X Y e0.1 15

20X + Y = ?

10X Y e0.1 0

Time 0 T =1 Time 0 T =1 Time 0 T =1

35

36 CHAPTER 10. BINOMIAL OPTION PRICING: I

In the above diagram, 2X stocks at time zero are worth either 30X or 10X

at T = 1. Putting Y dollars in a savings account at time zero will produce Y e0.1

at T = 1.

We want our portfolio to behave like a call. So the payoﬀ of our portfolio

should

½ the same 0.1as the payoﬀ of the call. We set up the following equation:

30X + Y e = 15

X = 0.75 Y = −10 (0.75) e−0.1 = −6. 786

10X + Y e0.1 = 0

Y = −6. 786 means that we borrow 6. 786 at t = 0 and pays 6. 786e0.1 = 7.

5 at T = 1

If at t = 0 we buy 0.75 share of a stock and borrow $6. 786, then at T = 1,

this portfolio will have the same payoﬀ as the call. To avoid arbitrage, the

portfolio and the call should have the same cost at t = 0.

C = 20X + Y = 20 (0.75) − 6. 786 = 8. 214

Example 10.1.2. Find the price of a 12-month European put option on a stock

with strike price $15. The stock currently sells for $20. In 12 months, the

stock can either go up to $30 or go down to $10. The continuously compounded

risk-free interest rate per year is 10%.

Suppose at time zero we create a replicating portfolio by buying X stocks

and investing Y dollars in a savings account. We want this portfolio to have the

exact payoﬀ as the put.

30X Y e0.1 0

20X + Y = ?

10X Y e0.1 5

Time 0 T =1 Time 0 T =1 Time 0 T =1

½

30X + Y e0.1 = 0

X = −0.25 Y = 6. 786

10X + Y e0.1 = 5

ing 6. 786 in a savings account.

The price of the put at t = 0 is:

P = 20X + Y = 20 (−0.25) + 6. 786 = 1. 786

Let’s check whether the put-call parity holds.

C + P V (K) = 8. 214 + 15e−0.1 = 21. 787

P + S0 = 1. 786 + 20 = 21. 786

Ignoring the rounding diﬀerence, we get: C + P V (K) = P + S0

Suppose we have two points in time, t = 0 (today) and t = h (some point in

the future). The continuously compounded risk-free interest rate per year is r

( a positive constant). We have two assets: a stock that pays zero dividend and

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 37

time h, the stock price is Sh ; the bond price is Bh .

The bond price is deterministic: B0 = 1 Bh = erh

Su

S0 = S Sh =

Sd

So at h the stock price either goes up to Su ("up state") or goes down to Sd

("down state").

Su

S

Sd

Time 0 Time h

is allowed to short sell any security and receive full proceeds. In addition, we

assume that anyone can buy or sell any number of securities without aﬀecting

the market price.

We assume that the market is an invisible cop automatically enforcing Sd <

Serh < Su . For example, if Su > Sd > Serh , then the stock’s return is guar-

anteed to be higher than the risk-free interest rate. If this is the case, then the

risk-free interest rate was set too low and stock’s return is too good. Everyone

will jump on this opportunity, withdraw all his money from his savings account,

and invest it in the stock. This will instantaneously bid up the price of the stock

and the risk-free interest rate, forcing Sd < Serh < Su to hold.

at the yield δ?

Suppose you buy e−δh share of a stock at t = 0 (thus you pay Se−δh ) , buy

reinvesting dividend in the stock, you’ll have exactly one e−δh eδh = 1 stock at

time h, which is worth either Su or Sd .

Su

Se−δh

Sd

Time 0 Time h

Suppose

¡ −δhyou invest Se−δh in a savings account, then your wealth at h is

¢ rh

simply Se e = Se(r−δ)h .

Se(r−δ)h

Se−δh

Se(r−δ)h

Time 0 Time h

38 CHAPTER 10. BINOMIAL OPTION PRICING: I

• At good times (i.e. when the stock goes up), the return you earn from the

stock should exceed the risk free interest rate. So Su > Se(r−δ)h

• At bad times (i.e. when the stock goes down), the return you earn from

the stock should be less than the risk free interest rate. So Sd < Se(r−δ)h

If the condition is not met, we’ll end up in a weird situation where the stock

is always better oﬀ than the savings account or the savings account is always

better oﬀ than the stock. Then everyone will invest his money in the better

performing asset, instantly bidding up the price of the lower-performing asset

and forcing the above condition to be met.

To avoid arbitrage, Su , Sd , and r need to satisfy the following condition:

Let’s continue.

Let C represent the option price at time zero. Let Cu and Cd represent the

payoﬀ at time h of an option in the up state and down state respectively:

Cu

C

Cd

Time 0 Time h

payoﬀ. We build the replicating portfolio by buying 4 shares of the stock and

investing $B in a zero-coupon bond. So we set up the following equation:

4Su Berh Cu

4S + B = C

4Sd Berh Cd

t=0 t=h t=0 t=h t=0 t=h

½

4Su + Berh = Cu

4Sd + Berh = Cd

Cu − Cd

4= (10.3)

Su − Sd

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 39

Su Cd − Sd Cu

B = e−rh (10.4)

Su − Sd

is critical as we’ll soon see.

The value of the portfolio at the up state is

4Su + Berh = 4Su + e−rh (Cu − 4Su ) erh = Cu

4Sd + Berh = 4Sd + e−rh (Cu − 4Sd ) erh = Cd

Using Equation 10.3 and Equation 10.4, we get (verify this for yourself):

µ rh ¶

−rh Se − Sd Su − Serh

C = 4S + B = e Cu + Cd (10.5)

Su − Sd Su − Sd

Define

Serh − Sd

π u = p∗ = (10.6)

Su − Sd

rh

Su − Se

πd = q∗ = (10.7)

Su − Sd

0 < πp < 1 (10.9)

πu + πd = 1 (10.10)

Then Equation 10.5 becomes

C = e−rh (π u Cu + π d Cd ) (10.11)

Doing some algebra, we also get (verify this for yourself):

µ ¶

−rh Serh − Sd Su − Serh

S=e Su + Sd = e−rh (π u Su + π d Sd ) (10.12)

Su − Sd Su − Sd

π u and π d , the call price at t = 0 is simply the expected present value of the

40 CHAPTER 10. BINOMIAL OPTION PRICING: I

call payoﬀs discounted at the risk-free interest rate; the stock price at t = 0 is

simply the expected present value of the future stock prices discounted at the

risk-free interest rate. Since the discounting rate is risk-free interest rate, π u

and πd are called risk neutral probabilities.

Please note that π u and πd are not real probabilities. They are artificially

created probabilities so that Equation 10.11 and 10.12 have simple and intuitive

explanations.

Example 10.2.1. Using the risk-neutral probabilities, find the price of a 12-

month European call option on a stock with strike price $15. The stock currently

sells for $20. In 12 months, the stock can either go up to $30 or go down to

$10. The continuously compounded risk-free interest rate per year is 10%.

Solution.

Time 0 T Time 0 T

Su = 30 Cu = max (0, 30 − 15) = 15

S = 20 C =?

Sd = 10 Cd = max (0, 10 − 15) = 0

Serh − Sd 20e0.1(1) − 10

πu = = = 0.605

Su − Sd 30 − 10

πd = 1 − 0.605 = 0.395

Cu = 30 − 15 = 15 Cd = 0

C = e−rh (π u Cu + π d Cd ) = e−0.1(1) (0.605 × 15 + 0.395 × 0) = 8. 211

Example 10.2.2. Using the risk-neutral probabilities, find the price of a 12-

month European put option on a stock with strike price $15. The stock currently

sells for $20. In 12 months, the stock can either go up to $30 or go down to

$10. The continuously compounded risk-free interest rate per year is 10%.

Stock price tree Option terminal payoﬀ

Time 0 T Time 0 T

Su = 30 Cu = max (0, 15 − 30) = 0

S = 20 C =?

Sd = 10 Cd = max (0, 15 − 10) = 5

Serh − Sd 20e0.1(1) − 10

πu = = = 0.605

Su − Sd 30 − 10

πd = 1 − 0.605 = 0.395

Cu = 0 Cd = 5

C = e−rh (π u Cu + π d Cd ) = e−0.1(1) (0.605 × 0 + 0.395 × 5) = 1. 787

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 41

year. At time zero, our replicating portfolio consists of 4 shares of stocks and

$B in a bond (or a savings account). If we continuously reinvest dividends and

buy additional stocks during [0, h], our 4 shares at time zero will grow into

4eδh shares at time h. Our 4eδh shares will be worth either 4eδh Su in the up

state or 4eδh Sd in the down state. We want our replicating portfolio to have

the same payoﬀ as the option at time h.

½

4eδh Su + Berh = Cu

4eδh Sd + Berh = Cd

Solving the equations, we get:

Cu − Cd

4 = e−δh (10.13)

Su − Sd

Su Cd − Sd Cu

B = e−rh (10.14)

Su − Sd

Notice whether the stock pays dividend or not, at time zero, we always need

Su Cd − Sd Cu Su Cd − Sd Cu

to have e−rh in a savings account, which grows into

Su − Sd Su − Sd

Cu − Cd

dollars at t = h. If the stock doesn’t pay dividend, at t = 0 we hold

Su − Sd

Cu − Cd

shares of stock, which is shares of stock at t = h ; if the stock pays

Su − Sd

Cu − Cd

dividend at a continuously compounded rate δ, at t = 0 we hold e−δh ,

Su − Sd

Cu − Cd

which grows shares of stock at t = h.

Su − Sd

Cu − Cd Su Cd − Sd Cu

So at time h we need to have units of stocks and

Su − Sd Su − Sd

dollars in a savings account (or a bond), regardless of whether the stock pays

dividend or not.

of U shares of stocks and V dollars in a savings account. Then regardless of

whether the stock pays dividend or not, we need to have:

½

U Su + V = Cu

U Sd + V = Cd

Cu − Cd Su Cd − Sd Cu

U= V =

Su − Sd Su − Sd

Su Cd − Sd Cu Cu − Cd

e−rh at t = 0. To have U = shares of stocks at t = h,

Su − Sd Su − Sd

42 CHAPTER 10. BINOMIAL OPTION PRICING: I

Cu − Cd

have U e−δh = e−δh shares of stocks at t = 0. If we use the dividends

Su − Sd

received to buy additional stocks, then we’ll have U shares of stock at t = h.

Now let’s find the cost of the option on a stock that pays dividends at a

continuously compounded rate δ per year. The option cost at time zero is

Cu − Cd Su Cd − Sd Cu

4S + B = e−δh × S + e−rh

S − S

µ u (r−δ)h

d Su − Sd ¶

−rh Se − Sd Su − Se(r−δ)h

=e Cu + Cd

Su − Sd Su − Sd

C = 4S + B = e−rh (πu Cu + πd Cd ) (10.15)

where

Se(r−δ)h − Sd

πu = (10.16)

Su − Sd

Su − Se(r−δ)h

πd = (10.17)

Su − Sd

e(r−δ)h − d

πu = (10.18)

u−d

u − e(r−δ)h

πd = (10.19)

u−d

Tip 10.2.1. If you don’t want to memorize Equation 10.12, 10.15, 10.16, 10.17,

just set up the replication portfolio and calculate 4 and B from scratch.

Example 10.2.3. Find the price of a 12-month European call option on a stock

with strike price $15. The stock pays dividends at a continuously compounded

rate 6% per year. The stock currently sells for $20. In 12 months, the stock can

either go up to $30 or go down to $10. The continuously compounded risk-free

interest rate per year is 10%.

Time 0 T Time 0 T

Su = 30 Cu = max (0, 30 − 15) = 15

S = 20 C =?

Sd = 10 Cd = max (0, 10 − 15) = 0

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 43

Replicating portfolio

Time 0 T

(4u , Bu ) = (0.75, −7. 50)

(4, B) = (0.706 32, −6. 786 28)

(4d , Bd ) = (0.75, −7. 50)

Our replicating portfolio at t = 0 consists of 4 shares of stocks and $B in a

savings account.

Cu − Cd 15 − 0

4 = e−δh = e−0.06(1) = 0.706 32

Su − Sd 30 − 10

Su Cd − Sd Cu 30 (0) − 10 (15)

B = e−rh = e−0.1(1) = −6. 786 28

Su − Sd 30 − 10

C = 4S + B = 0.706 3 (20) − 6. 786 3 = 7. 34

4u = 4d = 4eδh = 0.706 32e0.06(1) = 0.75

Bu = Bd = Berh = −6. 786 28e0.1(1) = −7. 5

Verify that the replicating portfolio and the option have the same value:

The value of the replicating portfolio at the up state:

4u Su + Bu = 0.75 (30) − 7. 50 = 15 = Cu

The value of the replicating portfolio at the down state:

4d Sd + Bd = 0.75 (10) − 7. 50 = 0 = Cd

C = 4S + B = 0.706 32 (20) − 6. 78628 = 7. 34

Alternatively,

Se(r−δ)h − Sd 20e(0.1−0.06)1 − 10

πu = = = 0.540 81

Su − Sd 30 − 10

π d = 1 − πu = 1 − 0.540 81 = 0.459 19

C = e−rh (πu Cu + πd Cd ) = e−0.1(1) (0.540 81 × 15 + 0.459 19 × 0) = 7. 34

Example 10.2.4. Find the price of a 12-month European put option on a stock

with strike price $15. The stock pays dividends at a continuously compounded

rate 6% per year. The stock currently sells for $20. In 12 months, the stock can

either go up to $30 or go down to $10. The continuously compounded risk-free

interest rate per year is 10%.

Solution.

Time 0 T Time 0 T

Su = 30 Cu = max (0, 15 − 30) = 0

S = 20 C =?

Sd = 10 Cd = max (0, 15 − 10) = 5

44 CHAPTER 10. BINOMIAL OPTION PRICING: I

Replicating portfolio

Time 0 T

(4u , Bu ) = (−0.25, 7. 50)

(4, B) = (−0.235 4, 6. 786 3)

(4d , Bd ) = (−0.25, 7. 50)

Our replicating portfolio at t = 0 consists of 4 shares of stocks and $B in a

savings account.

Cu − Cd 0−5

4 = e−δh = e−0.06(1) = −0.25e−0.06(1) = −0.235 4

Su − Sd 30 − 10

Su Cd − Sd Cu 30 (5) − 10 (0)

B = e−rh = e−0.1(1) = 6. 786 3

Su − Sd 30 − 10

C = 4S + B = −0.235 4 (20) + 6. 786 3 = 2. 078

The replicating portfolio at T is:

4u = 4d = 4eδh = −0.235 4e0.06(1) = −0.25

Bu = Bd = Berh = 6. 786 3e0.1(1) = 7. 5

Verify that the replicating portfolio and the option have the same value:

The value of the replicating portfolio at the up state:

4u Su + Bu = −0.25 (30) + 7. 50 = 0 = Cu

The value of the replicating portfolio at the down state:

4d Sd + Bd = −0.25 (10) + 7. 50 = 5 = Cd

C = 4S + B = −0.235 4 (20) + 6. 786 3 = 2. 078

Alternatively,

Se(r−δ)h − Sd 20e(0.1−0.06)1 − 10

πu = = = 0.540 8

Su − Sd 30 − 10

πd = 1 − π u = 1 − 0.540 8 = 0.459 2

C = e−rh (π u Cu + π d Cd ) = e−0.1(1) (0.540 8 × 0 + 0.459 2 × 5) = 2. 078

If an option sells for more or less than the price indicated by Equation 10.15,

we can make money by "buy low, sell high."

Example 10.2.5. A 12-month European call option on a stock has strike price

$15. The stock pays dividends at a continuously compounded rate 6% per year.

The stock currently sells for $20. In 12 months, the stock can either go up to

$30 or go down to $10. The continuously compounded risk-free interest rate per

year is 10%. This call currently sells for $8. Design an arbitrage strategy.

Solution.

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 45

Time 0 T Time 0 T

Su = 30 Cu = max (0, 30 − 15) = 15

S = 20 C =?

Sd = 10 Cd = max (0, 10 − 15) = 0

Replicating portfolio

Time 0 T

(4u , Bu ) = (0.75, −7. 50)

(4, B) = (0.706 32, −6. 786 28)

(4d , Bd ) = (0.75, −7. 50)

There are two calls. One is in the market selling for $8 at t = 0. The other is

a synthetic call, which consists, at t = 0, of holding 0.706 3 stock and borrowing

$6. 786 3 at risk-free interest rate. The synthetic call sells for $7. 34 at t = 0.

These two calls have identical payoﬀs at t = 1.

To make a riskless profit, we buy low and sell high. At t = 0, we sell a

call for $8 (sell high). Then at t = 1, if the stock price is $30, the call holder

exercises the call and our payoﬀ is 15 − 30 = −15; if the stock is $10, the call

expires worthless and our payoﬀ is zero.

−15

8

0

Time 0 Time t = 1

Payoﬀ of a written call

at risk-free interest rate (buy low). This costs us 0.706 3 (20) − 6. 786 3 = 7.

34 at t = 0. At t = 1, our initial 0.706 3 stock becomes 0.706 3e0.06(1) stock

and our initial debt 6. 786 3 grows into 6. 786 3e0.1(1) . Our portfolio is worth

0.706 3e0.06(1) S1 − 6. 786 3e0.1(1) .

If S1 = 30, our portfolio is worth

0.706 3e0.06(1) (30) − 6. 786 3e0.1(1) = 15

If S1 = 10, our portfolio is worth

0.706 3e0.06(1) (10) − 6. 786 3e0.1(1) = 0

15

−7.34

0

Time 0 Time t = 1

So at t = 0, we gain 8 − 7. 34 = 0.66. At t = 1, the portfolio exactly oﬀsets

our payoﬀ in the call. We earn 0.66 sure profit at t = 0.

46 CHAPTER 10. BINOMIAL OPTION PRICING: I

Example 10.2.6. A 12-month European call option on a stock has strike price

$15. The stock pays dividends at a continuously compounded rate 6% per year.

The stock currently sells for $20. In 12 months, the stock can either go up to

$30 or go down to $10. The continuously compounded risk-free interest rate per

year is 10%. This call currently sells for $7. Design an arbitrage strategy.

Stock price tree Option terminal payoﬀ

Time 0 T Time 0 T

Su = 30 Cu = max (0, 30 − 15) = 15

S = 20 C =?

Sd = 10 Cd = max (0, 10 − 15) = 0

Replicating portfolio

Time 0 T

(4u , Bu ) = (0.75, −7. 50)

(4, B) = (0.706 32, −6. 786 28)

(4d , Bd ) = (0.75, −7. 50)

There are two calls. One is in the market selling for $7 at t = 0. The other is

a synthetic call, which consists, at t = 0, of holding 0.706 3 stock and borrowing

6. 786 3 dollars at risk-free interest rate. The synthetic call sells for $7. 34 at

t = 0. These two calls have identical payoﬀs at t = 1.

To make a riskless profit, we buy low and sell high. At t = 0, we buy a

call for $7 (buy low). Then at t = 1, if the stock price is $30, the call holder

exercises the call and our payoﬀ is 30 − 15 = 15; if the stock is $10, the call

expires worthless and our payoﬀ is zero.

15

−7

0

Time 0 Time t = 1

Payoﬀ of a purchased call

0.706 3 stock and lend 6. 786 3 dollars at risk-free interest rate (sell high). We

gain 0.706 3 (20) − 6. 786 3 = 7. 34 at t = 0.

At t = 1, our initially borrowed 0.706 3 stock becomes 0.706 3e0.06(1) stock

and our lent principal 6. 786 3 grows into 6. 786 3e0.1(1) . Our portfolio is worth

6. 786 3e0.1(1) − 0.706 3e0.06(1) S1 .

6. 786 3e0.1(1) − 0.706 3e0.06(1) (30) = −15

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 47

−15

7.34

0

Time 0 Time t = 1

So at t = 0, we gain7.34 − 7 = 0.34. At t = 1, the call payoﬀ exactly oﬀsets

our liabilities in the replicating portfolio We earn 0.34 sure profit at t = 0.

Tip 10.2.2. An option and its replicating portfolio are exactly the same in terms

of payoﬀ and cost. If an option in the market sells for more than the fair price

indicated in Equation 10.15, we can make a sure profit by buying the replicating

portfolio and selling the option. If an option in the market sells for less than

the fair price indicated in Equation 10.15, we can make a sure profit by selling

the replicating portfolio and buying the option.

If we use π u and π d to calculate the undiscounted stock price, we get:

Se(r−δ)h − Sd Su − Se(r−δ)h

π u Su + π d Sd = Su + Sd

Su − Sd Su − Sd

(r−δ)h

= Se = F0,h

F0,h is the delivery price at t = h of a forward contract signed at t = 0.

The textbook uses the symbol Ft,t+h to indicate that the forward contract is

signed at time t and the asset is to be delivered at t + h. If we treat the contract

initiation date t as time zero, then the asset deliver date is time h. So the

notation doesn’t matter. If you want to use the textbook notation, you’ll have

If you want to use my notation, you’ll get Equation 10.20.

Suppose you enter into a forward contract as a seller agreeing to deliver one

stock for a guaranteed price F0,h at t = h. To ensure you indeed can deliver

one stock at time h, you’ll want to buy e−δh stock at time zero. If you reinvest

dividend and buy additional stocks, your initial e−δh stock will grow into exactly

one stock at time h. Your cost of buying e−δh stock at time zero is Se−δh . Since

you’ll tie up your money Se−δh during [0, h], you’ll want the forward price to

include the interest you could otherwise earn on Se−δh . So the forward price is

just the future value of Se−δh :

F0,h = Se−δh erh = Se(r−δ)h

48 CHAPTER 10. BINOMIAL OPTION PRICING: I

According to Equation 10.20, the undiscounted stock price equals the for-

ward price under the risk neutral probability. If a problem gives you a forward

price, you can use Equation 10.20 to calculate the risk-neutral probability.

Suppose we are standing at time t. If we can be 100% certain about the stock

price at time t + h, then investing in stocks doesn’t have any risk. Then stocks

must earn a risk-free interest rate. Since the stock already pays dividends at

rate δ, to earn a risk free interest rate, the stock price just needs to grow at

the rate of r − δ. Hence the stock price at t + h is Se(r−δ)h , which is just the

forward price Ft,t+h because Ft,t+h is also equal to Se(r−δ)h .

However, the stock price is a random variable and we generally can’t be

100% certain about a stock’s future price. To incorporate uncertainty, we use

Formula 11.16 in Derivatives Markets:

St+h √

ln = (r − δ) h ± σ h (Textbook 11.16)

St

St+h

In the above equation, ln is the continuously compounded rate of return

St

during [t, t√+ h]. This return consists of a known element (r − δ) h and a random

element σ h, where σ is the annualized standard deviation of the continuously

compounded stock return. The variance of the stock return in one year is σ 2 .

The variance during the interval [t, t + h] (which is h year long) is σ 2 h and this

is why. [t, t + h] can be broken down into h intervals, with each interval being

one year long. Assume stock return during each year is independent identically

distributed. The total return during [t, t + h] is the sum of the returns over h

intervals. Then the total variance is just the sum of the variance over h intervals,

σ 2 h.

√ √ √

So St+h = St e(r−δ)h±σ h = Se(r−δ)h±σ h = Ft,t+h √

e±σ h . In the

√

binomial

(r−δ)h+σ h σ h

model, the stock price

√

either goes √up to Se = Ft,t+h e or goes

down to Se(r−δ)h−σ h = Ft,t+h e−σ h . So we have

√

uSt = Ft,t+h eσ h

(10.22)

√

dSt = Ft,t+h e−σ h

(10.23)

If we set volatility σ to zero, then Equation 10.22 and 10.23 becomes uSt =

dSt = Ft,t+h . This means that if the stock price is 100% certain, then the stock

price is just the forward price.

Apply Equation 10.21 to Equation 10.22 and 10.23, we get:

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 49

√

u = e(r−δ)h+σ h

(10.24)

√

d = e(r−δ)h−σ h

(10.25)

Example 10.2.7. Let’s reproduce Derivatives Markets Figure 10.4. Here is the

recap of the information on a European call option. The current stock price is 41.

The strike price K = 40. The annualized standard deviation of the continuously

compounded stock return is σ = 30%. The continuously compounded risk-free

rate per year is r = 8%. The continuously compounded dividend rate per year

is δ = 0%.The option expiration date is T = 2 years. Use a 2-period binomial

tree to calculate the option premium.

T

Each period is h = = 1 year long.

2

Step 1 Draw a stock price tree.

√ √

u = e(r−δ)h+σ√ h = e(0.08−0)1+0.3√1 = 1. 462 28

d = e(r−δ)h−σ h = e(0.08−0)1−0.3 1 = 0.802 52

Stock price

Period 0 1 2 Period 0 1 2

Su2 Suu = 87.6693

Su Su = 59.9537

=⇒

S Sud S = 41 Sud = 48.1139

Sd Sd = 32.9033

2

Sd Sdd = 26.4055

47.6693 = max (0, 87.6693 − 40)

8.1139 = max (0, 48.1139 − 40)

Option Payoﬀ

Period 0 1 2

Cuu = 47.6693

Cu

C =? Cud = 8.1139

Cd

Cdd = 0

culate the premium using the formula

C = e−rh (πu Cu + πd Cd )

e(r−δ)h − d e(0.08−0)1 − 0.802 52

πu = = = 0.425 56

u−d 1. 462 28 − 0.802 52

50 CHAPTER 10. BINOMIAL OPTION PRICING: I

πd = 1 − π u = 1 − 0.42556 = 0.574 44

Option premium

Period 0 1 2

Cuu = 47.6693

Cu = 23.0290

C = 10.7369 Cud = 8.1139

Cd = 3.1875

Cdd = 0

= e−0.08(1) (0.425 56 × 47.6693 + 0.574 44 × 8.1139) = 23. 029 0

= e−0.08(1) (0.425 56 × 8.1139 + 0.574 44 × 0) = 3. 187 5

The call premium is

C = e−rh (π u Cu + π d Cd )

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 51

−δh Cu − Cd Su Cd − Sd Cu

4=e B = e−rh

Su − Sd Su − Sd

To avoid errors, put the stock price tree and the premium tree side by side:

Period 0 1 2 Period 0 1 2

Suu = 87.6693 Cuu = 47.6693

Su = 59.9537 Cu = 23.0290

S = 41 Sud = 48.1139 C = 10.7369 Cud = 8.1139

Sd = 32.9033 Cd = 3.1875

Sdd = 26.4055 Cdd = 0

Period 0 1

(4, B) = (0.7335, −19.3367)

(4d , Bd ) = (0.3738, −9.1107)

4u = e−δh = e−0(1) = 1.0

Suu − Sdd 87.6693 − 48.1139

Cud − Cdd 8.1139 − 0

4d = e−δh = e−0(1) = 0.373 8

Sud − Sdd 48.1139 − 26.4055

Cu − Cd 23.0290 − 3.1875

4 = e−δh = e−0(1) = 0.733 5

Su − Sd 59.9537 − 32.9033

Bu = e−rh

Suu − Sud

−0.08(1) 87.6693 (8.1139) − 48.1139 (47.6693)

=e = −36.9247

87.6693 − 48.1139

Bd = e−rh

Sdu − Sdd

−0.08(1) 48.1139 (0) − 26.4055 (8.1139)

=e = −9. 110 7

48.1139 − 26.4055

Su Cd − Sd Cu

B = e−rh

Su − Sd

−0.08(1) 59.9537 (3.1875) − 32.9033 (23.0290)

=e = −19. 3367

59.9537 − 32.9033

52 CHAPTER 10. BINOMIAL OPTION PRICING: I

Step 5 Verify that the portfolio replicates the premium tree. Here is

recap of the information:

Period 0 1 2 0 1 2

Suu = 87.6693 Cuu = 47.6693

Su = 59.9537 Cu = 23.0290

S = 41 Sud = 48.1139 C = 10.7369 Cud = 8.1139

Sd = 32.9033 Cd = 3.1875

Sdd = 26.4055 Cdd = 0

Period 0 1

(4, B) = (0.7335, −19.3367)

(4d , Bd ) = (0.3738, −9.1107)

4S + B = 0.7335 (41) − 19.3367 = 10. 736 8 = C

4u Su + Bu = 1.0 (59.9537) − 36.9247 = 23. 029 = Cu

The value of(4d , Bd ) at Node d (down state):

4d Sd + Bd = 0.3738 (32.9033) − 9.1107 = 3. 188 = Cd

Finally, let’s verify that the portfolio replicates the terminal payoﬀ. First,

we need to find the replicating portfolio at the expiration date.

Period 1 2

(4uu , Buu ) = (1.0, −40)

(4u , Bu ) = (1.0, −36.9247)

(4ud , Bud ) = (1.0, −40) = (0.3738, −9. 869 5)

(4d , Bd ) = (0.3738, −9.1107)

(4dd , Bdd ) = (0.3738, −9. 869 5)

into Bu erh after h¡ years. ¢ ¡ ¢

(4uu , Buu ) = 4u eδh , Bu erh = 1.0e0(1) , −36.9247e0.08(1) = (1.0, −40)

4uu Suu + Buu = 1.0 (87.6693)

¡ − 40 = 47.

¢ 669¡ 3 = Cuu ¢

Similarly, (4dd , Bdd ) = 4d eδh , Bd erh = 0.3738e0(1) , −9.1107e0.08(1) =

(0.373 8, −9. 869 5)

4dd Sdd + Bdd = 0.3738 (26.4055) − 9. 869 5 = 0.00 = Cdd

Finally, (4ud , Bud ) = (1.0, −40) = (0.3738, −9. 869 5)

Portfolios (1.0, −40) and (0.3738, −9. 869 5) have equal values at Node ud.

1.0 (48.1139) − 40 = 8. 113 9 = Cud

0.3738 (48.1139) − 9. 869 5 = 8. 115 = Cud (ignore rounding diﬀerence)

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 53

Tip 10.2.3. For a multi-binomial tree, using the risk neutral probability to find

the premium is faster than using the replicating portfolio. The risk neutral prob-

abilities π u and π d are constant cross nodes. However, the replicating portfolio

(4, B) varies by node.

Tip 10.2.4. For European options, you can calculate the premium using the

terminal payoﬀs. This is how to quickly find the premium for this problem.

Node at T = 2 Payoﬀ at T Risk neutral probability of reaching this node1

uu Cuu = 47.6693 π 2u = 0.425 562 = 0.181 1

ud Cud = 8.1139 2π u πd = 2 (0.425 56) (0.574 44) = 0.488 9 2

dd Cdd = 0 π 2d = 0.574 442 = 0.3300

2

Total (πu + π d ) = 0.181 1 + 0.488 9 + 0.3300 = 1 3

The premium is the expected present value of the terminal payoﬀ using the

risk neutral probability.

¡ ¢

C = e−rT π2u Cuu + 2π u πd Cud + π 2d Cdd

¡ ¢

= e−0.08(2) 0.425 562 × 47.6693 + 0.488 9 × 8.1139 + 0.33 × 0 = 10. 736 9

Tip 10.2.5. If you purchased the textbook Derivatives Markets, you should see

a CD attached to the back cover of the book. Install the CD in your computer.

Run the spreadsheet titled "optall2’" or "optbasic2." These two spreadsheets can

calculate European and American option prices. When you solve a practice prob-

lem, you can use either of these two spreadsheets to double check you answer.

Please note that these two spreadsheets don’t calculate the replicating portfo-

lio (4, B). So you can’t use them to verify your calculation of the replicating

portfolio.

the recap of the information on a European call. The current stock price is 41.

The strike price K = 40. The annualized standard deviation of the continuously

compounded stock return is σ = 30%. The continuously compounded risk-free

rate per year is r = 8%. The continuously compounded dividend rate per year

is δ = 0%.The option expiration date is T = 1 year. Use a 3-period binomial

tree to calculate the option premium.

Solution.

1

Each period is h = year long.

3

√ √

u = e(r−δ)h+σ h

= e(0.08−0)1/3+0.3 1/3 = 1. 221 246

1 The probabilities in this column are the 3 terms of (π u + πd )2 = π 2d + 2π d π u + π 2u

2 There are two ways of reaching Node ud: up and dow or down and up.

3 The total probability is one. Otherwise, you made an error.

54 CHAPTER 10. BINOMIAL OPTION PRICING: I

√ √

d = e(r−δ)h−σ h = e(0.08−0)1/3−0.3 1/3

= 0.863 693

Stock price

Period 0 1 2 3

Su3 = 74.6781

Su2 = 61.1491

Su = 50.0711 Su2 d = 52.8140

S = 41 Sud = 43.2460

Sd = 35.4114 Sd2 u = 37.3513

2

Sd = 30.5846

Sd3 = 26.4157

Calculate the premium by working backward from right to left.

Period 0 1 2 3

Cu3 = max (0, 74.6781 − 40) = 34. 678 1

Cu2 = 22. 201 6

Cu = 12. 889 5 Cu2 d = max (0, 52.8140 − 40) = 12. 814

C = 7. 073 9 Cud = 5. 699 5

Cd = 2. 535 1 Cd2 u = max (0, 37.3513 − 40) = 0

Cd2 = 0

Cd3 = max (0, 26.4157 − 40) = 0

−rh

C=e (π u Cu + π d Cd )

e(r−δ)h − d e(0.08−0)1/3 − 0.863 693

πu = = = 0.456 806

u−d 1. 221 246 − 0.863 693

πd = 1 − π u = 1 − 0.456 806 = 0.543 194

= e−0.08(1/3) (0.456 806 × 34. 678 1 + 0.543 194 × 12. 814) = 22. 201 7

Cud = e−rh (π u Cu2 d + π d Cd2 u )

= e−0.08(1/3) (0.456 806 × 12. 814 + 0.543 194 × 0) = 5. 699 5

Cd2 = e−rh (πCd2 u + πd Cd3 ) = 0

= e−0.08(1/3) (0.456 806 × 22. 201 6 + 0.543 194 × 5. 699 5) = 12. 889 5

Cd = e−rh (π u Cud + π d Cd2 )

= e−0.08(1/3) (0.456 806 × 5. 699 5 + 0.543 194 × 0) = 2. 535 1

C = e−rh (πu Cu + πd Cd )

= e−0.08(1/3) (0.456 806 × 12. 889 5 + 0.543 194 × 2. 535 1) = 7. 073 9

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 55

Now I’m going to tell you a calculator shortcut I used when I was preparing

for the old Course 6. The above calculations are intense and prone to errors.

To quickly and accurately calculate the premium at each node, use TI-30X IIS

calculator because TI-30X IIS allows you to modify formulas easily.

For example, to calculate Cu2 = e−rh (π u Cu3 + π d Cu2 d ), enter

Please note for TI-30 IIS, the above expression is the same as

eˆ(−0.08/3)(0.456 806 × 34. 678 1 + 0.543 194 × 12. 814)

In other words, you can omit the ending parenthesis ")". I tell you this

because occasionally people emailed me saying they discovered a typo. This is

not a typo.

eˆ(−0.08/3)(0.456 806 × 34. 678 1 + 0.543 194 × 12. 814.

Press "=" and you should get: 22.20164368

Next, to calculate Cud = e−rh (πud Cu2 d + πd Cd2 u ), you don’t need to enter

a brand new formula. Just reuse the formula

eˆ(−0.08/3) (0.456 806 × 34. 678 1 + 0.543 194 × 12. 814)

Change 34. 678 1 to 12. 8140 (so 0.456 806 ×34. 678 1 becomes 0.456 806 × 12.

8140).

Change 12. 814 into 00.000 (so 0.543 194×12. 814 becomes 0.543 194×00.000).

Now the modified formula is

eˆ(−0.08/3) (0.456 806 × 12. 8140 + 0.543 194 × 00.000)

Press "=" and you should get: 5.6994813

To calculate Cu = e−rh (πu Cu2 + π d Cud ), once again reuse a previous for-

mula. Change the formula

eˆ(−0.08/3) (0.456 806 × 12. 8140 + 0.543 194 × 00.000)

into

eˆ(−0.08/3) (0.456 806 × 22. 201 6 + 0.543 194 × 05. 699 5)

Press "=" and you should get:12.8894166

Reusing formulas avoids the need to retype e−rh , π u , and π d (these three

terms are constant across all nodes) and increases your speed and accuracy. By

reusing formulas, you should quickly find C = 7. 073 9.

56 CHAPTER 10. BINOMIAL OPTION PRICING: I

Cu − Cd Su Cd − Sd Cu

4 = e−δh B = e−rh

Su − Sd Su − Sd

To avoid errors, put the stock price tree and the premium tree side by side:

Period 0 1 2 3

Su3 = 74.6781

Su2 = 61.1491

Su = 50.0711 Su2 d = 52.8140

S = 41 Sud = 43.2460

Sd = 35.4114 Sd2 u = 37.3513

2

Sd = 30.5846

Sd3 = 26.4157

Period 0 1 2 3

Cu3 = 34. 678 1

Cu2 = 22. 201 6

Cu = 12. 889 5 Cu2 d = 12. 814

C = 7. 073 9 Cud = 5. 699 5

Cd = 2. 535 1 Cd2 u = 0

Cd2 = 0

Cd3 = 0

Period 0 1 2

(4, B)u = (0.921 8, −33. 263 6)

(4, B) = (0.706 3, −21. 885 2) (4, B)ud = (0.828 7, −30. 138 6)

(4, B)d = (0.450 1, −13. 405 2)

(4, B)d2 = (0, 0)

4u2 = e−δh = e−0(1/3) =1

Su3 − Su2 d 74.6781 − 52.8140

Su3 Cu2 d − Su2 dCu2 d 74.6781 (12. 814) − 52.8140 (34. 678 1)

Bu2 = e−rh = e−0.08(1/3) =

Su3 − Su2 d 74.6781 − 52.8140

−38. 947 4

4ud = e−δh2 2

= e−0(1/3) = 0.828 7

Su d − Sd u 52.8140 − 37.3513

2 2

Su dCd2 u − Sd uCu2 d 52.8140 (0) − 37.3513 (12. 814)

Bud = e−rh 2 2

= e−0.08(1/3) =

Su d − Sd u 52.8140 − 37.3513

−30. 138 6

Cd2 u − Cd3

4d2 = e−δh =0

Su2 d − Sd3

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 57

Bd2 = e−rh =0

Su2 d − Sd3

Cu2 − Cud 22. 201 6 − 5. 699 5

4u = e−δh = e−0(1/3) = 0.921 8

Su2 − Sud 61.1491 − 43.2460

Su2 Cud − SudCu2 61.1491 (5. 699 5) − 43.2460 (22. 201 6)

Bu = e−rh 2

= e−0.08(1/3) =

Su − Sud 61.1491 − 43.2460

−33. 263 6

Cud − Cd2 5. 699 5 − 0

4d = e−δh = e−0(1/3) = 0.450 1

Sud − Sd2 43.2460 − 30.5846

SudCd2 − Sd2 Cud 43.2460 (0) − 30.5846 (5. 699 5)

Bd = e−δh 2

= e−0.08(1/3) =

Sud − Sd 43.2460 − 30.5846

−13. 405 2

Cu − Cd 12. 889 5 − 2. 535 1

4 = e−δh = e−0(1/3) = 0.706 3

Su − Sd 50.0711 − 35.4114

Cu − Cd 50.0711 (2. 535 1) − 35.4114 (12. 889 5)

B = e−rh = e−0.08(1/3) =

Su − Sd 50.0711 − 35.4114

−21. 885 2

If our goal is to calculate the premium without worrying about the replicating

portfolio, then we just need to know the risk neutral probability and the terminal

payoﬀ.

u3 Cu3 = 34. 678 1 π 3u¡= 0.456 806¢

3

3π u πd = 3 0.456 806 0.543 194

ud2 Cd2 u = 0 3π u π 2d = 3 (0.456 806) 0.543 1942

d3 Cd3 = 0 π 3d = 0.543 1943

The option premium is just the expected present value of the terminal payoﬀs

using the risk¡neutral probability. ¢

C = e−rT Cu3 π 3u + Cu2 d × 3π 2u πd + Cd2 u × 3πu π 2d + Cd3 π 3d

¡ ¢

= e−0.08(1) 34. 678 1 × 0.456 8063 + 12. 814 × 3 × 0.456 8062 × 0.543 194

= 7. 073 9

the recap of the information on a European put. The current stock price is 41.

The strike price K = 40. The annualized standard deviation of the continuously

compounded stock return is σ = 30%. The continuously compounded risk-free

rate per year is r = 8%. The continuously compounded dividend rate per year

is δ = 0%.The option expiration date is T = 1 year. Use a 3-period binomial

tree to calculate the option premium.

4 The probabilities of this column is just the four terms in (π + π )3 = π 3 + 3π π 2 +

u d u d u

3π 2d π u + π 3d = 1.

58 CHAPTER 10. BINOMIAL OPTION PRICING: I

Solution.

1

Each period is h = year long.

3

√ √

u = e(r−δ)h+σ√ h = e(0.08−0)1/3+0.3√1/3 = 1. 221 246

d = e(r−δ)h−σ h = e(0.08−0)1/3−0.3 1/3 = 0.863 693

Stock price

Period 0 1 2 3

Su3 = 74.6781

Su2 = 61.1491

Su = 50.0711 Su2 d = 52.8140

S = 41 Sud = 43.2460

Sd = 35.4114 Sd2 u = 37.3513

2

Sd = 30.5846

Sd3 = 26.4157

Period 0 1 2 3

Cu3 = max (0, 40 − 74.6781) = 0

Cu2 = 0

Cu = 0.740 9 Cu2 d = max (0, 40 − 52.8140) = 0

C = 2. 998 5 Cud = 1. 400 9

Cd = 5. 046 2 Cd2 u = max (0, 40 − 37.3513) = 2. 648 7

Cd2 = 8. 362 9

Cd3 = max (0, 40 − 26.4157) = 13. 584 3

C = e−rh (π u Cu + π d Cd )

e(r−δ)h − d e(0.08−0)1/3 − 0.863 693

πu = = = 0.456 806

u−d 1. 221 246 − 0.863 693

πd = 1 − π u = 1 − 0.456 806 = 0.543 194

0

Cud = e−rh (π u Cu2 d + π d Cd2 u ) = e−0.08(1/3) (0.456 806 × 0 + 0.543 194 × 2. 648 7) =

1. 400 9

Cd2 = e−rh (πu Cd2 u + πd Cd3 ) = e−0.08(1/3) (0.456 806 × 2. 648 7 + 0.543 194 × 13. 584 3) =

8. 362 9

0.740 9

Cd = e−rh (π u Cud + π d Cd2 ) = e−0.08(1/3) (0.456 806 × 1. 400 9 + 0.543 194 × 8. 362 9) =

5. 046 2

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 59

2. 998 5

Cu − Cd Su Cd − Sd Cu

4 = e−δh B = e−rh

Su − Sd Su − Sd

Period 0 1 2

(4, B)u = (−0.07 82, 4. 658 9)

(4, B) = (−0.293 7, 15. 039 5) (4, B)ud = (−0.171 3, 8. 808 8)

(4, B)d = (−0.549 9, 24. 517 3)

(4, B)d2 = (1, 38. 947 4)

4u2 = e−δh = e−0(1/3) =0

Su3 − Su2 d 74.6781 − 52.8140

Su3 Cu2 d − Su2 dCu2 d 74.6781 (0) − 52.8140 (0)

Bu2 = e−rh = e−0.08(1/3) =0

Su3 − Su2 d 74.6781 − 52.8140

4ud = e−δh 2 2

= e−0(1/3) = −0.171 3

Su d − Sd u 52.8140 − 37.3513

2 2

Su dCd2 u − Sd uCu2 d 52.8140 (2. 648 7) − 37.3513 (0)

Bud = e−rh 2 2

= e−0.08(1/3) =

Su d − Sd u 52.8140 − 37.3513

8. 808 8

4d2 = e−δh = e−0(1/3) = −1.0

Su2 d − Sd3 37.3513 − 26.4157

2 3

Su dCd3 − Sd Cd2 u 37.3513 (13. 584 3) − 26.4157 (2. 648 7)

Bd2 = e−rh = e−0.08(1/3) =

Su2 d − Sd3 37.3513 − 26.4157

38. 947 4

C 2 − Cud 0 − 1. 400 9

4u = e−δh u2 = e−0(1/3) = −0.07 82

Su − Sud 61.1491 − 43.2460

2

Su Cud − SudCu2 61.1491 (1. 400 9) − 43.2460 (0)

Bu = e−rh 2

= e−0.08(1/3) =

Su − Sud 61.1491 − 43.2460

4. 659

4d = e−δh = e−0(1/3) = −0.549 9

Sud − Sd2 43.2460 − 30.5846

SudCd2 − Sd2 Cud 43.2460 (8. 362 9) − 30.5846 (1. 400 9)

Bd = e−δh = e−0.08(1/3) =

Sud − Sd2 43.2460 − 30.5846

24. 517 3

Cu − Cd 0.740 9 − 5. 046 2

4 = e−δh = e−0(1/3) = −0.293 7

Su − Sd 50.0711 − 35.4114

Cu − Cd 50.0711 (5. 046 2) − 35.4114 (0.740 9)

B = e−rh = e−0.08(1/3) = 15.

Su − Sd 50.0711 − 35.4114

039 5

60 CHAPTER 10. BINOMIAL OPTION PRICING: I

If our goal is to calculate the premium without worrying about the replicating

portfolio, then we just need to know the risk neutral probability and the terminal

payoﬀ.

u3 Cu3 = 0 π3u¡= 0.456 806¢

3

u2 d Cu2 d = 0 2 2

3πu π d = 3 0.456 806 0.543 194

ud2 Cd2 u = 2. 648 7 3π u π2d = 3 (0.456 806) 0.543 1942

d3 Cd3 = 13. 584 3 π3d = 0.543 1943

The option premium is just the expected present value of the terminal payoﬀs

using the risk¡neutral probability. ¢

C = e−rT Cd2 u × 3π u π 2d + Cd3 π 3d

¡ ¢

= e−0.08(1) 2. 648 7 × 3 × 0.456 806 × 0.543 1942 + 13. 584 3 × 0.543 1943 =

2. 998 5

the recap of the information on an American put. The current stock price is 41.

The strike price K = 40. The annualized standard deviation of the continuously

compounded stock return is σ = 30%. The continuously compounded risk-free

rate per year is r = 8%. The continuously compounded dividend rate per year

is δ = 0%.The option expiration date is T = 1 year. Use a 3-period binomial

tree to calculate the option premium.

Solution.

1

Each period is h = year long.

3

√ √

u = e(r−δ)h+σ√ h = e(0.08−0)1/3+0.3√1/3 = 1. 221 246

d = e(r−δ)h−σ h = e(0.08−0)1/3−0.3 1/3 = 0.863 693

Step 1 Find the stock price tree

Period 0 1 2 3

3

Su = 74.6781

Su2 = 61.1491

Su = 50.0711 Su2 d = 52.8140

S = 41 Sud = 43.2460

Sd = 35.4114 Sd2 u = 37.3513

2

Sd = 30.5846

Sd3 = 26.4157

5 The probabilities of this column is just the four terms in (π + π )3 = π 3 + 3π π 2 +

u d u d u

3π 2d π u + π3d = 1.

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 61

Period 0 1 2 3

Vu3 = max (0, 40 − 74.6781) = 0

Vu2

Vu Vu2 d = max (0, 40 − 52.8140) = 0

V Vud

Vd Vd2 u = max (0, 40 − 37.3513) = 2. 648 7

Vd2

Vd3 = max (0, 40 − 26.4157) = 13. 584 3

Step 3 Calculate the value of the American put one step left to the

expiration.

An American put can be exercised immediately. The value of an American

option if exercised immediately is called the exercise value (EV ) or intrinsic

value. At Period 2, we compare the value calculated using backwardization and

the exercise value. We take the greater of the two as the value of the American

put.

Cu2 = e−rh (πu Cu3 + π d Cu2 d ) = e−0.08(1/3) (0.456 806 × 0 + 0.543 194 × 0) =

0

Cud = e−rh (πu Cu2 d + πd Cd2 u ) = e−0.08(1/3) (0.456 806 × 0 + 0.543 194 × 2. 648 7) =

1. 400 9

Cd2 = e−rh (π u Cd2 u + πd Cd3 ) = e−0.08(1/3) (0.456 806 × 2. 648 7 + 0.543 194 × 13. 584 3) =

8. 362 9

¡ ¢

EVu2 = max 0, K − Su2 = max (0, 40 − 61.1491) = 0

EVud = max ¡(0, K − Sud)¢ = max (0, 40 − 43.2460) = 0

EVd2 = max 0, K − Sd2 = max (0, 40 − 30.5846) = 9. 415 4

We take the greater of the two as the value of the American put.

Vu2 = max (Cu2 , EVu2 ) = max (0, 0) = 0

Vud = max (Cud , EVud ) = max (1. 400 9, 0) = 1. 400 9

Vd2 = max (Cd2 , EVd2 ) = max (8. 362 9, 9. 415 4) = 9. 415 4

Now we have:

Period 0 1 2 3

Vu3 = 0

Vu2 = 0

Vu Vu2 d = 0

V Vud = 1. 400 9

Vd Vd2 u = 2. 648 7

Vd2 = 9. 415 4

Vd3 = 13. 584 3

62 CHAPTER 10. BINOMIAL OPTION PRICING: I

Step 3 Move one step to the left. Repeat Step 2. Compare the back-

wardized value and the exercise value. Choose the greater.

The backwardized values are:

Cu = e−0.08(1/3) (0.456 806 × 0 + 0.543 194 × 1. 400 9) = 0.740 9

The exercise value at Period 1 is:

EVd = max (0, K − Sd ) = max (0, 40 − 35.4114) = 4. 588 6

Vud = max (Cd , EVd ) = max (5. 602 9, 4. 588 6) = 5. 602 9

Hence we have:

Period 0 1 2 3

Vu3 = 0

Vu2 = 0

Vu = 0.740 9 Vu2 d = 0

V Vud = 1. 400 9

Vd = 5. 602 9 Vd2 u = 2. 648 7

Vd2 = 9. 415 4

Vd3 = 13. 584 3

Step 4 Repeat Step 3. Move one step left. Compare the backwardized

value and the exercise value. Choose the greater value.

The backwardized value at t = 0 is:

C = e−0.08(1/3) (0.456 806 × 0.740 9 + 0.543 194 × 5. 602 9) = 3. 292 9

The exercise value is:

EV = max (0, K − S) = max (0, 40 − 41) = 0

Hence the premium for the American put is:

V = max (C, EV )= max (3. 292 9, 0) = 3. 292 9

Now we have:

Period 0 1 2 3

Vu3 = 0

Vu2 = 0

Vu = 0.740 9 Vu2 d = 0

V = 3. 292 9 Vud = 1. 400 9

Vd = 5. 602 9 Vd2 u = 2. 648 7

Vd2 = 9. 415 4

Vd3 = 13. 584 3

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 63

Cu − Cd Su Cd − Sd Cu

4 = e−δh B = e−rh

Su − Sd Su − Sd

Period 0 1 2

(4, B)u = (−0.07 82, 4. 658 9)

(4, B) = (−0.331 66, 16. 890 9) (4, B)ud = (−0.171 3, 8. 808 8)

(4, B)d = (−0.632 99, 28. 017 8)

(4, B)d2 = (1, 38. 947 4)

4u2 = e−δh 3 2

= e−0(1/3) =0

Su − Su d 74.6781 − 52.8140

Su3 Vu2 d − Su2 dVu2 d 74.6781 (0) − 52.8140 (0)

Bu2 = e−rh 3 2

= e−0.08(1/3) =0

Su − Su d 74.6781 − 52.8140

4ud = e−δh 2 2

= e−0(1/3) = −0.171 3

Su d − Sd u 52.8140 − 37.3513

2 2

Su dVd2 u − Sd Vu2 d 52.8140 (2. 648 7) − 37.3513 (0)

Bud = e−rh 2 2

= e−0.08(1/3) =

Su d − Sd u 52.8140 − 37.3513

8. 808 8

4d2 = e−δh = e−0(1/3) = −1.0

Su2 d − Sd3 37.3513 − 26.4157

Su2 dVd3 − Sd3 Vd2 u 37.3513 (13. 584 3) − 26.4157 (2. 648 7)

Bd2 = e−rh = e−0.08(1/3) =

Su2 d − Sd3 37.3513 − 26.4157

38. 947 4

V 2 − Vud 0 − 1. 400 9

4u = e−δh u2 = e−0(1/3) = −0.07 82

Su − Sud 61.1491 − 43.2460

Su2 Vud − SudVu2 61.1491 (1. 400 9) − 43.2460 (0)

Bu = e−rh = e−0.08(1/3) =

Su2 − Sud 61.1491 − 43.2460

4. 659

4d = e−δh 2

= e−0(1/3) = −0.632 99

Sud − Sd 43.2460 − 30.5846

2

SudVd2 − Sd Vud 43.2460 (9. 415 4) − 30.5846 (1. 400 9)

Bd = e−δh 2

= e−0.08(1/3) =

Sud − Sd 43.2460 − 30.5846

28. 017 8

Vu − Vd 0.740 9 − 5. 602 9

4 = e−δh = e−0(1/3) = −0.331 66

Su − Sd 50.0711 − 35.4114

Vu − Vd 50.0711 (5. 602 9) − 35.4114 (0.740 9)

B = e−rh = e−0.08(1/3) = 16.

Su − Sd 50.0711 − 35.4114

890 9

Please note that for an American option, you can’t use the following ap-

proach to find the option price:

64 CHAPTER 10. BINOMIAL OPTION PRICING: I

u3 Vu3 = 0 π3u¡= 0.456 806¢

3

2 2 2

u d Vu2 d = 0 3πu π d = 3 0.456 806 0.543 194

ud2 Vd2 u = 2. 648 7 3π u π2d = 3 (0.456 806) 0.543 1942

3

d Vd3 = 13. 584 3 π3d = 0.543 1943

¡ ¢

V = e−rT Cd2 u × 3π u π2d + Cd3 π3d

¡ ¢

= e−0.08(1) 2. 648 7 × 3 × 0.456 806 × 0.543 1942 + 13. 584 3 × 0.543 1943 =

2. 998 5

This approach is wrong because it ignores the possibility that the American

option can be exercised early.

The price of an option on stock index can be calculated the same way as the

price of an option on a stock is calculated.

Example 10.2.11. Let’s reproduce Derivatives Markets Figure 10.8. Here is

the recap of the information on an American call. The current stock index

is 110. The strike price K = 100. The annualized standard deviation of the

continuously compounded stock index return is σ = 30%. The continuously

compounded risk-free rate per year is r = 5%. The continuously compounded

dividend rate per year is δ = 3.5%.The option expiration date is T = 1 year.

Use a 3-period binomial tree to calculate the option premium.

Solution.

1

Each period is h = year long.

3

√ √

u = e(r−δ)h+σ√ h = e(0.05−0.035)1/3+0.3√1/3 = 1. 195 07

d = e(r−δ)h−σ h = e(0.05−0.035)1/3−0.3 1/3 = 0.845 18

e(r−δ)h − d e(0.05−0.035)1/3 − 0.845 18

πu = = = 0.456 807

u−d 1. 195 07 − 0.845 18

πd = 1 − π u = 1 − 0.456 807 = 0.543 193

Step 1 Find the stock price tree

Period 0 1 2 3

Su3 = 187.7471

Su2 = 157.1013

Su = 131.4577 Su2 d = 132.7789

S = 110 Sud = 111.1055

Sd = 92.9699 Sd2 u = 93.9042

2

Sd = 78.5763

Sd3 = 66.4112

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 65

Period 0 1 2 3

Vu3 = max (0, 187.7471 − 100) = 87. 747 1

Vu2

Vu Vu2 d = max (0, 132.7789 − 100) = 32. 778 9

V Vud

Vd Vd2 u = max (0, 93.9042 − 100) = 0

Vd2

Vd3 = max (0, 66.4112 − 100) = 0

the greater of the backwardized value and the exercise value at each node.

Cu2 = e−rh (πu Vu3 + π d Vu2 d ) = e−0.05(1/3) (0.456 807 × 87. 747 1 + 0.543 193 × 32. 778 9) =

56. 931 9

Cud = e−rh (πu Vu2 d + πd Vd2 u ) = e−0.05(1/3) (0.456 807 × 32. 778 9 + 0.543 193 × 0) =

14. 726 1

Cd2 = e−rh (π ud Vd2 u + π d Vd3 ) = e−0.05(1/3) (0.456 807 × 0 + 0.543 193 × 0) =

0

¡ ¢

EVu2 = max 0, Su2 − K = max (0, 157.1013 − 100) = 57. 101 3

EVud = max ¡(0, Sud − K)

¢ = max (0, 111.1055 − 100) = 11. 105 5

EVd2 = max 0, Sd2 − K = max (0, 78.5763 − 100) = 0

Vu2 = max (Cu2 , EVu2 ) = max (56. 931 9, 57. 101 3) = 57. 101 3

Vud = max (Cud , EVud ) = max (14. 726 1, 11. 105 5) = 14. 726 1

Vd2 = max (Cd2 , EVd2 ) = max (0, 0) = 0

Now we have:

Period 0 1 2 3

Vu3 = 87. 747 1

Vu2 = 57. 101 3

Vu Vu2 d = 32. 778 9

V Vud = 14. 726 1

Vd Vd2 u = 0

Vd2 = 0

Vd3 = 0

the greater of the backwardized value and the exercise value at each node.

Cu = e−rh (πu Vu2 + πd Vud ) = e−0.05(1/3) (0.456 807 × 57. 101 3 + 0.543 193 × 14. 726 1) =

33. 520 02

66 CHAPTER 10. BINOMIAL OPTION PRICING: I

Cd = e−rh (π u Vud + π d Vd2 ) = e−0.05(1/3) (0.456 807 × 14. 726 1 + 0.543 193 × 0) =

6. 615 8

EVd = max (0, Sd − K) = max (0, 92.9699 − 100) = 0

Vu = max (Cu , EVu ) = max (33. 520 02, 31. 457 7) = 33. 520 02

Vd = max (Cd , EVd ) = max (6. 615 8, 0) = 6. 615 8

Now we have:

Period 0 1 2 3

Vu3 = 87. 747 1

Vu2 = 57. 101 3

Vu = 33. 520 02 Vu2 d = 32. 778 9

V Vud = 14. 726 1

Vd = 6. 615 8 Vd2 u = 0

Vd2 = 0

Vd3 = 0

the greater of the backwardized value and the exercise value at each node.

18. 593 35

EV = max (0, S − K) = max (0, 110 − 100) = 10

V = max (C, EV ) = max (18. 593 35, 10) = 18. 593 35

Our goal is to replicate the following values:

Period 0 1 2 3

Vu3 = 87. 747 1

Vu2 = 57. 101 3

Vu = 33. 520 02 Vu2 d = 32. 778 9

V = 18. 593 35 Vud = 14. 726 1

Vd = 6. 615 8 Vd2 u = 0

Vd2 = 0

Vd3 = 0

Cu − Cd Su Cd − Sd Cu

4 = e−δh B = e−rh

Su − Sd Su − Sd

Period 0 1 2

4u = 0.910 598

4 = 0.690 923 4ud = 0.988 401

4d = 0.447 45

4d2 = 0

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 67

Period 0 1 2

Bu = −86. 185 1

B = −57. 408 1 Bud = −77. 870 8

Bd = −34. 983 9

Bd2 = 0

4u2 = e−δh 3 2

= e−0.035(1/3) = 0.988 401

Su − Su d 187.7471 − 132.7789

3 2

Su Vu2 d − Su dVu3 187.7471 (32. 778 9) − 132.7789 (87. 747 1)

Bu2 = e−rh 3 2

= e−0.05(1/3) =

Su − Su d 187.7471 − 132.7789

−98. 347 1

4ud = e−δh = e−0.035(1/3) = 0.988 401

Su2 d − Sud2 187.7471 − 132.7789

3 2

Su dVu2 d − Su dVu3 187.7471 (0) − 132.7789 (32. 778 9)

Bud = e−rh = e−0.05(1/3) =

Su3 − Su2 d 187.7471 − 132.7789

−77. 870 8

Vd2 u − Vd3

4d2 = e−δh =0

Sd2 u − Sd3

Sd2 uVd3 − Sd3 Vd2 u

Bd2 = e−rh =0

Sd2 u − Sd3

4u = e−δh 2

= e−0.035(1/3) = 0.910 598

Su − Sud 157.1013 − 111.1055

2

Su Vud − SudVu2 157.1013 (14. 726 1) − 111.1055 (57. 101 3)

Bu = e−rh 2

= e−0.05(1/3) =

Su − Sud 157.1013 − 111.1055

−86. 185 1

4d = e−δh = e−0.035(1/3) = 0.447 45

Sud − Sd2 111.1055 − 78.5763

2

Su Vud − SudVu2 111.1055 (0) − 78.5763 (14. 726 1)

Bd = e−rh = e−0.05(1/3) =

Su2 − Sud 111.1055 − 78.5763

−34. 983 9

4 = e−δh = e−0.035(1/3) = 0.690 923

Su − Sd 131.4577 − 92.9699

SuVd − SdVu 131.4577 (6. 615 8) − 92.9699 (33. 520 02)

B = e−rh = e−0.05(1/3) =

Su − Sd 131.4577 − 92.9699

−57. 408 1

Now let’s find the price of a European call option on €1. The underlying asset is

€1. The option expires in h years. The current dollar value of the underlying is

68 CHAPTER 10. BINOMIAL OPTION PRICING: I

can go up to $Su or go down to $Sd . The strike price is $K. The continuously

compounded risk-free interest rate on dollars is r per year (so dollars earn a

return r). The continuously compounded interest rate on the underlying asset

of €1 is δ per year (so euros earn a return δ).

Let’s calculate the call price using one-period binomial tree. The asset price

tree and the option payoﬀ tree are as follows:

Asset price tree (in dollars) Option payoﬀ (in dollars)

time 0 h time 0 h

Su Cu = max (0, Su − K)

S C

Sd Cd = max (0, Sd − K)

To replicate the payoﬀ, at t = 0 we’ll buy ∆ units of the underlying (i.e.

buy ∆ euros) and simultaneously invest B dollars in a savings account. Since

the underlying asset €∆ earns interest at a continuous interest δ, it will grow

into €∆eδh at T , which is worth $∆eδh Su in the up state and $∆eδh Sd in the

down state.

∆eδh Su Berh Cu

4S + B = C

∆eδh Sd Berh Cd

t=0 t=h t=0 t=h t=0 t=h

½

∆eδh Su + Berh = Cu

∆eδh Sd + Berh = Cd

Solving these equations, we get:

Cu − Cd

4 = e−δh (10.26)

Su − Sd

Su Cd − Sd Cu

B = e−rh (10.27)

Su − Sd

Equation 10.26 and 10.27 are exactly the same as Equation 10.13 and 10.14.

This tells us that if we treat the currency as a stock and treat the euro return

δ as the stock’s dividend rate, we can find the currency option’s price and the

replicating portfolios using all the formulas available for a stock option.

Example 10.2.12. Reproduce Derivatives Markets Figure 10.9. Here is the re-

cap of the information on an American put option on €1. The current exchange

rate is S = $1.05/€. The strike price is K = $1.10. The annualized standard

deviation of the continuously compounded return on dollars is σ = 10%. The

continuously compounded risk-free rate on dollars is r = 5% per year. The

continuously compounded return on euros is δ = 3.1% per year. The option

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 69

expiration date is T = 0.5 year. Use a 3-period binomial tree to calculate the

option premium.

Solution.

T 1

The length period is h = =

3 6

√ √

u = e(r−δ)h+σ√ h = e(0.055−0.031)1/6+0.1√1/6 = 1. 045 845

d = e(r−δ)h−σ h = e(0.055−0.031)1/6−0.1 1/6 = 0.963 845

e(r−δ)h − d e(0.055−0.031)1/6 − 0.963 845

πu = = = 0.489 795

u−d 1. 045 845 − 0.963 845

π d = 1 − πu = 1 − 0.489 795 = 0.510 205

Period 0 1 2 3

Su3 = 1.2011

Su2 = 1.1485

Su = 1.0981 Su2 d = 1.1070

S = 1.05 Sud = 1.0584

Sd = 1.0120 Sd2 u = 1.0202

2

Sd = 0.9754

Sd3 = 0.9402

Period 0 1 2 3

Vu3 = max (0, 1.10 − 1.2011) = 0

Vu2

Vu Vu2 d = max (0, 1.10 − 1.1070) = 0

V Vud

Vd Vd2 u = max (0, 1.10 − 1.0202) = 0.079 8

Vd2

Vd3 = max (0, 1.10 − 0.9402 ) = 0.159 8

the greater of the backwardized value and the exercise value at each node.

Cu2 = e−rh (πu Vu3 + π d Vu2 d ) = e−0.055(1/6) (0.489 795 × 0 + 0.510 205 × 0) =

0

Cud = e−rh (πu Vu2 d + πd Vd2 u ) = e−0.055(1/6) (0.489 795 × 0 + 0.510 205 × 0.079 8) =

0.04 034

Cd2 = e−rh (π ud Vd2 u + π d Vd3 ) = e−0.055(1/6) (0.489 795 × 0.079 8 + 0.510 205 × 0.159 8) =

0.119 5

70 CHAPTER 10. BINOMIAL OPTION PRICING: I

¡ ¢

EVu2 = max 0, K − Su2 = max (0, 1.10 − 1.1485) = 0

EVud = max ¡(0, K − Sud)

¢ = max (0, 1.10 − 1.0584) = 0.041 6

EVd2 = max 0, K − Sd2 = max (0, 1.10 − 0.9754) = 0.124 6

Vu2 = max (Cu2 , EVu2 ) = max (0, 0) = 0

Vud = max (Cud , EVud ) = max (0.04 034 , 0.041 6) = 0.041 6

Vd2 = max (Cd2 , EVd2 ) = max (0.119 5, 0.124 6) = 0.124 6

Now we have:

Period 0 1 2 3

Vu3 = 0

Vu2 = 0

Vu Vu2 d = 0

V Vud = 0.041 6

Vd Vd2 u = 0.079 8

Vd2 = 0.124 6

Vd3 = 0.159 8

the greater of the backwardized value and the exercise value at each node.

Cu = e−rh (π u Vu2 + π d Vud ) = e−0.055(1/6) (0.489 795 × 0 + 0.510 205 × 0.041 6) =

0.02 10

Cd = e−rh (π u Vud + π d Vd2 ) = e−0.055(1/6) (0.489 795 × 0.041 6 + 0.510 205 × 0.124 6) =

0.08 31

EVd = max (0, K − Sd ) = max (0, 1.10 − 1.0120 ) = 0.088

Vu = max (Cu , EVu ) = max (0.02 10 , 0.001 9) = 0.021

Vd = max (Cd , EVd ) = max (0.088 , 0.021) = 0.088

Now we have:

Period 0 1 2 3

Vu3 = 0

Vu2 = 0

Vu = 0.021 Vu2 d = 0

V Vud = 0.041 6

Vd = 0.088 Vd2 u = 0.079 8

Vd2 = 0.124 6

Vd3 = 0.159 8

the greater of the backwardized value and the exercise value at each node.

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 71

0.05 47

EV = max (0, K − S ) = max (0, 1.10 − 1.05) = 0.05

V = max (C, EV ) = max (0.05 47, 0.05) = 0.054 7

Now we have:

Period 0 1 2 3

Vu3 = 0

Vu2 = 0

Vu = 0.021 Vu2 d = 0

V = 0.054 7 Vud = 0.041 6

Vd = 0.088 Vd2 u = 0.079 8

Vd2 = 0.124 6

Vd3 = 0.159 8

Period 0 1 2

4u2 = 0.0000

4u = −0.4592

4 = −0.7736 4ud = −0.9151

4d = −0.9948

4d2 = −0.9948

Period 0 1 2

Bu2 = $0.0000

Bu = $0.5253

B = $0.8669 Bud = $1.0089

Bd = $1.0900

Bd2 = $1.0900

Suppose we want to find the price of a European call option on a stock futures

contract. The underlying asset is futures. The option expires in h years. The

current price of the underlying asset is F0,h = F , where F0,h is the price of a

futures contract signed at t = 0 and expiring on date h.In h years the futures

price can go up to Fh,h = Fu = F u or go down to Fh,h = Fd = F d, where Fh,h

is the price of a futures contract signed at t = h and expiring on date h years

(i.e. expiring immediately). Fh,h is equal to the spot price Sh . The fact that

Fh,h can be either Fu or Fd is the same as fact that the stock price at t = h is

72 CHAPTER 10. BINOMIAL OPTION PRICING: I

year. Stocks pay dividend at a continuously compounded rate of δ per year.

The strike price is K.

The find the European call price on the futures, we draw the price tree of

the underlying asset and the payoﬀ tree.

Asset price tree Option payoﬀ

time 0 h time 0 h

Fu = F u Cu = max (0, Fu − K)

F C

Fd = F d Cd = max (0, Fd − K)

We form a replicating portfolio at t = 0 by entering ∆ futures contracts as

a buyer and simultaneously putting $B in the savings account. Assume that

no margin account is needed before one enters a futures contract. Then the

cost of entering a futures contracts is zero. At the contract expiration date h,

the ∆ futures contracts are settled in cash. If the futures price at expiration is

Fu > F , then the seller in the futures pays ∆ (Fu − F ) to us, the buyer.

If on the other hand, the futures price at h is Fd < F , then we pay the seller

∆ (F − Fd ). Paying ∆ (F − Fd ) is the same as receiving ∆ (Fd − F ).

We assume that Fd < F < Fu holds so there’s no arbitrage.

time 0 h

$∆ (Fu − F )

$0

$∆ (Fd − F )

We want the replicating portfolio and the option have the same payoﬀ.

∆ (Fu − F ) Berh Cu

0 + B = C

∆ (Fd − F ) Berh Cd

t=0 t=h t=0 t=h t=0 t=h

½

∆ (Fu − F ) + Berh = Cu

∆ (Fd − F ) + Berh = Cd

Cu − Cd Cu − Cd

4= = (10.28)

Fu − Fd F (u − d)

µ ¶

−rh 1−d u−1

B=e Cu + Cd (10.29)

u−d u−d

µ ¶

1−d u−1

V = 4 × 0 + B = B = e−rh Cu + Cd (10.30)

u−d u−d

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 73

Define

F − Fd 1−d

πu = = (10.31)

Fu − Fd u−d

Fu − 1 u−1

πd = = (10.32)

Fu − Fd u−d

Then

V = e−rh (Cu πu + Cd π d ) (10.33)

Consequently, we can find the price of a futures option by using Equation 10.16

Cu − Cd

if we set δ = r. We just need to remember that 4 = instead of

µ Fu − Fd¶

Cu − Cd 1−d u−1

4 = e−rδ and that B = V = e−rh Cu + Cd instead of

Fu − Fd u−d u−d

Su Cd − Sd Cu

B = e−rh .

Su − Sd

How we can specify u or d?

u= u=

F0,h F0,h

( √

S0 e(r−δ)h+σ√h

We know that Fh,h = Sh = . In addition, F0,h = S0 e(r−δ)h .

S0 e(r−δ)h−σ h

√

up price of Fh,h S0 e(r−δ)h+σ h √

σ h

u= = = e

F0,h S0 e(r−δ)h √

down price of Fh,h S0 e(r−δ)h−σ h √

−σ h

d= = = e

F0,h S0 e(r−δ)h

√

u = eσ h

(10.34)

√

d = e−σ h

(10.35)

Equation 10.34 and 10.35 are the same as Equation 10.24 and 10.25 if we

set δ = r. We can use the stock option’s formula on u and d for futures options.

Tip 10.2.6. To find the price of a futures option, just use the price formula for

a stock option and set δ = r. However, remember that for aµ futures option, 4 = ¶

Cu − Cd Cu − Cd 1−d u−1

instead of 4 = e−rh and B = V = e−rh Cu + Cd

Fu − Fd Fu − Fd u−d u−d

Su Cd − Sd Cu

instead of B = e−rh .

Su − Sd

74 CHAPTER 10. BINOMIAL OPTION PRICING: I

the recap of the information on an American call on a futures contract. The

current futures price is S = 300. The strike price K = 300. The annualized

standard deviation of the continuously compounded stock index return is σ =

10%. The continuously compounded risk-free rate per year is r = 5%.The option

expiration date is T = 1 year. Use a 3-period binomial tree to calculate the

option premium.

Solution.

We’ll reuse the stock option formula and set δ = r.

1

Each period is h = year long.

3

√ √ √

u = e(r−δ)h+σ√ h = eσ √h

= e0.1 1/3

√ = 1. 059 434

d = e(r−δ)h−σ h = e−σ h = e−0.1 1/3 = 0.943 900

e(r−δ)h − d 1−d 1 − 0.943 900

πu = = = = 0.485 57

u−d u−d 1. 059 434 − 0.943 900

πd = 1 − π u = 1 − 0.485 57 = 0.514 43

Period 0 1 2 3

Su3 = 356.7330

Su2 = 336.7203

Su = 317.8303 Su2 d = 317.8303

F = 300 Sud = 300.0000

Sd = 283.1700 Sd2 u = 283.1700

2

Sd = 267.2842

Sd3 = 252.2895

Period 0 1 2 3

Vu3 = max (0, 356.7330 − 300) = 56. 733

Vu2

Vu Vu2 d = max (0, 317.8303 − 300) = 17. 830 3

V Vud

Vd Vd2 u = max (0, 283.1700 − 300) = 0

Vd2

Vd3 = max (0, 252.2895 − 300) = 0

the greater of the backwardized value and the exercise value at each node.

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 75

Cu2 = e−rh (πu Vu3 + π d Vu2 d ) = e−0.05(1/3) (0.485 57 × 56. 733 + 0.514 43 × 17. 830 3) =

36. 113 3

Cud = e−rh (πu Vu2 d + πd Vd2 u ) = e−0.05(1/3) (0.485 57 × 17. 830 3 + 0.514 43 × 0) =

8. 514 7

Cd2 = e−rh (π ud Vd2 u + π d Vd3 ) = e−0.05(1/3) (0.485 57 × 0 + 0.514 43 × 0) =

0

¡ ¢

EVu2 = max 0, Su2 − K = max (0, 336.7203 − 300) = 36. 720 3

EVud = max (0, Sud − K) = max (0, 300.0000 − 300) = 0

¡ ¢

EVd2 = max 0, Sd2 − K = max (0, 267.2842 − 300) = 0

Vu2 = max (Cu2 , EVu2 ) = max (36. 113 3, 36. 720 3) = 36. 720 3

Vud = max (Cud , EVud ) = max (8. 514 7, 0) = 8. 514 7

Vd2 = max (Cd2 , EVd2 ) = max (0, 0) = 0

Now we have:

Period 0 1 2 3

Vu3 = 56. 733

Vu2 = 36. 720 3

Vu Vu2 d = 17. 830 3

V Vud = 8. 514 7

Vd Vd2 u = 0

Vd2 = 0

Vd3 = 0

the greater of the backwardized value and the exercise value at each node.

Cu = e−rh (πu Vu2 + πd Vud ) = e−0.05(1/3) (0.485 57 × 36. 720 3 + 0.514 43 × 8. 514 7) =

21. 843 4

Cd = e−rh (π u Vud + π d Vd2 ) = e−0.05(1/3) (0.485 57 × 8. 514 7 + 0.514 43 × 0) =

4. 066 2

EVd = max (0, Sd − K) = max (0, 283.1700 − 300) = 0

Vu = max (Cu , EVu ) = max (21. 843 4, 17. 830 3) = 21. 843 4

Vd = max (Cd , EVd ) = max (4. 066 2, 0) = 4. 066 2

Now we have:

76 CHAPTER 10. BINOMIAL OPTION PRICING: I

Period 0 1 2 3

Vu3 = 56. 733

Vu2 = 36. 720 3

Vu = 21. 843 4 Vu2 d = 17. 830 3

V Vud = 8. 514 7

Vd = 4. 066 2 Vd2 u = 0

Vd2 = 0

Vd3 = 0

the greater of the backwardized value and the exercise value at each node.

12. 488 4

EV = max (0, S − K) = max (0, 300 − 300) = 0

V = max (C, EV ) = max (12. 488 4, 0) = 12. 488 4

Now we have:

Period 0 1 2 3

Vu3 = 56. 733

Vu2 = 36. 720 3

Vu = 21. 843 4 Vu2 d = 17. 830 3

V = 12. 488 4 Vud = 8. 514 7

Vd = 4. 066 2 Vd2 u = 0

Vd2 = 0

Vd3 = 0

Next, we need to find the replicating portfolio. Our goal is to replicate the

following values:

Period 0 1 2 3

Vu3 = 56. 733

Vu2 = 36. 720 3

Vu = 21. 843 4 Vu2 d = 17. 830 3

V = 12. 488 4 Vud = 8. 514 7

Vd = 4. 066 2 Vd2 u = 0

Vd2 = 0

Vd3 = 0

Period 0 1 2

4u2 = 1

4u = 0.7681

4 = 0.5129 4ud = 0.5144

4d = 0.2603

4d2 = 0

10.2. GENERAL ONE-PERIOD BINOMIAL MODEL 77

Period 0 1 2

Bu = $21. 843 4

B = $12. 488 4 Bud = $8. 514 7

Bd = $4. 066 2

Bd2 = $0

For example,

V 3 − Vu2 d 56. 733 − 17. 830 3

4u2 = u = = 1.0

Su3 − Su2 d 356.7330 − 317.8303

Bu2 = Vu2 = $36. 720 3

Vu − Vd 21. 843 4 − 4. 066 2

4= = = 0.512 9

Su − Sd 317.8303 − 283.1700

B = V = $12. 488 4

I recommend that you reproduce my replicating portfolio in each node.

Options on commodities

The textbook is brief on this topic. So you don’t need to spend lot of time on it.

This is the main idea: we can price commodity options using the same framework

for pricing stock options if we can build a replicating portfolio using commodities

and bonds with zero transaction cost. In reality, it’s hard to build a replicating

portfolio using commodities. Unlike stocks, commodities such as corn may incur

storage cost or other cost. It may be impossible to short sell commodities.

As such, our ability to build a replicating portfolio is limited. However, if

we can build any replicating portfolios using commodities instantaneously and

eﬀortlessly, commodity options and stock options are conceptually the same.

We can use the same framework to calculate the price of a commodity option

and the price of a stock option.

Example 10.2.14. Here is the information on an American call on a com-

modity. The current commodity price is 110. The strike price is K = 100.

The annualized standard deviation of the continuously compounded return on

the commodity is σ = 30%. The continuously compounded risk-free rate per

year is r = 5%. The continuously compounded lease rate of the commodity is

δ = 3.5% per year. The option expiration date is T = 1 year. Use a 3-period

binomial tree to calculate the option premium. Assume that you can eﬀortlessly

and instantaneously build any replicating portfolio using the commodity and the

bond.

We just treat the commodity as a stock. The lease rate δ = 3.5% is the same

as the stock dividend rate. We can use the framework for pricing stock options

to price this commodity option. The solution to this problem is in the textbook

Figure 10.8.

78 CHAPTER 10. BINOMIAL OPTION PRICING: I

Options on bonds

The textbook points out two major diﬀerences between bonds and stocks:

1. A bond’s volatility decreases over time as the bond approaches its matu-

rity. A stock’s volatility doesn’t have this pattern.

2. When pricing a stock option, we assume that the interest rate is constant

over time. The random variable is the stock price under a fixed interest.

However, when pricing a bond, we can’t assume that the interest rate is

constant any more. If the interest rate is constant, then the bond’s price

is known with 100% certainty. If the bond price doesn’t change randomly,

an option on the bond has zero value. Who wants to buy a call or put on

an asset whose price is known with 100% certainty?

from options on stocks. This is all you need to know about bond options right

now. Chapter 24 will cover more on options on bonds.

Chapter 11

Pros and cons of exercising an American call option early

Pro:

Cons

• Pay the strike price early and lost interest that could have earned on the

strike price.

• Lose the insurance implicit in the call. If you hold the option, the stock

price might be below the strike price at expiration, in which case you

would not exercise the option. However, if you exercise the American call

early, you lose the privilege of not exercising it. To understand this point,

suppose you go to a garage sale and find a book you like that sells for

only $1. You think "How cheap the book is. I must buy it." You pay $1

and buy the book. You think you get a good deal. However, if you resist

the temptation to buy the book immediately and wait till the end of the

garage sale, the book’s price may drop to $0.25. Better yet, you may even

get the book for free. That same thing may happen when you exercise

an American call early. At the moment, the stock price is high and you

might be attempted to exercise the call. However, if we wait for a while,

the stock price may drop below the strike price.

Next, the textbook gives us a rule to determine when it’s optimal to exercise

a perpetual 1 American call early. For a perpetual American call with zero

volatility, it’s optimal to exercise a perpetual American call early if the dividend

to be received exceeds the interest savings on the strike price:

1 The textbook errata say the formulas work for an infinitely-lived American call option.

79

80 CHAPTER 11. BINOMIAL OPTION PRICING: II

δST > rK

¡ δ ¢

µ ¶ gain if you exercise the call early is ST e − 1 =

The annual dividend you

1

ST 1 + δ + δ 2 + ... − 1 ≈ δST for a small δ. The annual interest earned on

2 µ ¶

1

K is K (e − 1) = K 1 + r + r2 + ... − 1 ≈ rK for a small r. If you early

r

2

exercise, you’ll pay K and receive ST ; during a year you’ll receive δST dividend

but you will lose rK interest. Hence early exercise is optimal if the annual

dividend exceeds the annual interest, δST > rK.

And it’s optimal to defer exercising a perpetual American call if the interest

savings on the strike price exceeds dividends lost:

δST < rK

price $50. The stock pays dividend at a continuously compounded rate of 8%

per year. The continuously compounded risk-free interest rate is 6% per year.

The volatility of the stock price is zero. When is it optimal to exercise this

American call option early? When is it optimal to defer exercise?

Sδ > rK

rK 0.06 (50)

S> = = 37. 5

δ 0.08

Once the stock price becomes greater than 37. 5, then it’s optimal to exercise

this perpetual American call option early.

If the stock price is less than 37. 5, then it’s optimal to defer exercising this

perpetual American call option early.

Please note that zero volatility doesn’t mean that the stock price is a con-

stant. It means that the stock price is known in advance with 100% certainty.

Next, the textbook says that the decision to exercise a perpetual American

call option early is complex if the volatility of the stock price is greater than

zero. In this case, the insurance in the call option is greater than zero. For

each non-zero volatility, there’s a lowest stock price at which the early exercise

is optimal.

Risk neutral probability is explained in the previous chapter. There’s not much

new information about the risk neutral probability in this chapter. The key

point to remember is that risk neutral probability is a shortcut or a math trick

that enables us to quickly find the price of an option. We can use risk neutral

probability to find the correct price of an option whether consumers are really

risk neutral or not.

The risk neutral probability is similar to the moment generating function in

Exam P. The moment generating function (M GF ) is merely a math trick that

11.2. UNDERSTANDING RISK-NEUTRAL PROBABILITY 81

allows us to quickly find the mean and variance of a random variable (hence

the name "moment generating"). If we don’t use GM F , we can still find the

mean and variance, but we have to work a lot harder. With the help of GM F ,

we can quickly find the mean and variance. Similarly, if we don’t use the risk

neutral probability, we can still find the option price, but we have to work a lot

harder. Once we use risk-neutral probability, we can quickly find an option’s

price. Risk neutral probability is merely a math risk.

By the way, one investment consultant told me that risk neutral probability

is often hard to non-technical clients to understand. If you tell a non-technical

client that an option price is calculated using risk-neutral probability and that

the risk neutral probability not real, the client often immediately ask "So the

price you calculated is wrong then?" It may take the consultant a while to

explain why the risk neutral probability is not real yet the price is still correct.

Next, the textbook answers a frequently asked question: Can we calculate the

option price as the expected payoﬀ using real probabilities of the stock price?

The answer is "Yes if you know the discount rate."

Let p and q = 1−p represent the real probability of stock going up and down

respectively. Let γ represent the real discount rate (instead of the risk-free rate,

which is used to discount payoﬀ in the risk neutral world).

S C =?

dS with real probability q Cd with real probability q

t=0 t=h t=0 t=h

C = e−γh (pCu + qCd )

How can we find the real probability p and the real discount rate γ? Suppose

we know that the expected return on the stock during [0, h] is α. Assume that

the continuously compounded dividend rate is δ per year. If we have one stock

at t = 0, then at t = h we’ll have eδh stocks. The value at t = 0 is the expected

value at t = h discounted at rate α.

S

dSeδh with real probability q

Value t = 0 Value t = h

¡ ¢ e(α−δ)h − d

S = e−αh puSeδh + qdSeδh →p=

u−d

e(α−δ)h − d

p= (11.1)

u−d

82 CHAPTER 11. BINOMIAL OPTION PRICING: II

u − e(α−δ)h

q= (11.2)

u−d

Tip 11.2.1. If we set r = α Equation 10.16 and 10.17 become Equation 11.1

and 11.2. So you just need to memorize Equation 10.16 and 10.17. To get the

formulas for the real probability, just set r = α.

We can use the replicating portfolio to find γ. Suppose the replicating port-

folio at t = 0 consists of ∆ shares of stock and putting $B in a savings account.

We already know that we can calculate ∆ and B using Equation 10.13 and

10.13.

At t = 0, the replicating portfolio is worth ∆S + B. At t = h, the replicating

portfolio consists of ∆eδh shares of stock and $Berh in a savings account, which

is worth ∆eδh dS + Berh in the up state and ∆eδh dS − Berh in the down state.

∆S + B

dS∆eδh + Berh with real probability q

Value t = 0 Value t = h

The value at

£ t¡ = 0 is the expected

¢ value

¡ at t = h discounted

¢¤ at rate γ:

∆S + B = p uS∆eδh + Berh + q dS∆eδh + Berh e−γh

£ ¡ ¢ ¤

= ∆ puSeδh + qdSeδh + Berh (p + q) e−γh

¡ ¢

= ∆Seαh + Berh e−γh

∆S + B

e−γh = (11.3)

∆Seαh + Berh

∆S + B

C = e−γh (pCu + qCd ) = (pCu + qCd )

∆Seαh + Berh

Since C = ∆S + B, we just need to prove that pCu + qCd = ∆Seαh + Berh .

pCu + qCd

e(α−δ)h − d u − e(α−δ)h

= Cu + C

u−d

∙ (r−δ)h u−d ¸ ∙ ¸

(α−δ)h

e −d e − e(r−δ)h u − e(r−δ)h e(r−δ)h − e(α−δ)h

= Cu + Cu + Cd + Cd

u−d u−d u−d u−d

∙ (r−δ)h ¸

e −d u − e(r−δ)h e(α−δ)h − e(r−δ)h

= Cu + Cd + (Cu − Cd )

u−d u−d u−d

e(r−δ)h − d u − e(r−δ)h

Cu + Cd = erh (∆S + B)

u−d u−d

11.2. UNDERSTANDING RISK-NEUTRAL PROBABILITY 83

Cu − Cd

According to Equation 10.13, = ∆eδh S

u−d

pCu + qCd £ ¤

= erh (∆S + B) + ∆eδh¡ S e(α−δ)h¢ − e(r−δ)h

= erh (∆S + B) + ∆S eαh − erh = eαh ∆S + Berh

∆S + B

→C= (pCu + qCd ) = ∆S + B

∆Seαh + Berh

The above derivation tell us that

• Real probabilities lead to the same answer as the risk neutral probability

• Any consistent pair of (α, γ) will produce the correct answer. The above

derivation doesn’t require that α has to be reasonable or precise. Any α

will generate a corresponding γ. Together, α and γ will produce the option

price correctly.

• The simplest calculation is to set α = γ = r. Setting α = γ = r means

using risk neutral probabilities.

Example 11.2.1. Reproduce the textbook Figure 11.3 (which is the same as the

textbook Figure 10.5). A European call option has strike price K = 40. The

current price is S = 41. The annualized standard deviation of the continuously

compounded stock return is σ = 30%. The continuously compounded risk-free

rate per year is r = 8%. The continuously compounded dividend rate per year

is δ = 0%. The continuously compounded expected return on the stock per year

is α = 15%. The option expiration date is T = 1 year. Use a 1-period binomial

tree and real probabilities to calculate the option premium.

Solution.

√ √

u = e(r−δ)h+σ √h = e(0.08−0)1+0.3√1 = 1. 462 3

u = e(r−δ)h−σ h = e(0.08−0)1−0.3 1 = 0.802 5

1. 462 3 (41) = 59. 954 with real probability p

41

0.802 5 (41) = 32. 9023 with real probability q

t=0 t=h=1

Cu = max (0, 59. 954 − 40) = 19. 954 with real probability p

C =?

Cd = max (0, 32. 9023 − 40) = 0 with real probability q

t=0 t=h=1

41e0.15(1) = 59. 954p + 32. 9023 (1 − p)

84 CHAPTER 11. BINOMIAL OPTION PRICING: II

Cu − Cd 19. 954 − 0

4 = e−δh = e−0(1) = 0.737 6

Su − Sd 59. 954 − 32. 9023

Su Cd − Sd Cu 59. 954 (0) − 32. 9023 (19. 954)

B = e−rh = e−0.08(1) = −22.

Su − Sd 59. 954 − 32. 9023

403 6

Calculate the

¡ discounting rate:

¢

∆S + B = ∆Seαh + Berh e−γh

(∆S + B) eγh = ∆Seαh + Berh

(0.737 6 × 41 − 22. 403 6) eγ(1) = 0.737 6 × 41e0.15(1) − 22. 403 6e0.08(1)

eγ(1) = 1. 386 γ = 0.326 4

C = e−γh (pCu + qCd ) = e−0.326 4(1) (0.544 6 × 19. 954 + 0.455 4 × 0) = 7. 84

This option price is the same as the price in the textbook Figure 10.3.

Example 11.2.2. Reproduce the textbook Figure 11.4 (the risk neutral solution

to an otherwise identical European call is in the textbook Figure 10.5). Here is

the recap of the information on an American call. The current stock price is 41.

The strike price K = 40. The annualized standard deviation of the continuously

compounded stock return is σ = 30%. The continuously compounded risk-free

rate per year is r = 8%. The continuously compounded expected return on the

stock per year is α = 15%.The continuously compounded dividend rate per year

is δ = 0%.The option expiration date is T = 1 year. Use a 3-period binomial

tree and real probabilities to calculate the option premium.

Solution.

1

Each period is h = year long.

3

√ √

u = e(r−δ)h+σ√ h = e(0.08−0)1/3+0.3√1/3 = 1. 221 246

d = e(r−δ)h−σ h = e(0.08−0)1/3−0.3 1/3 = 0.863 693

Stock price

Period 0 1 2 3

Su3 = 74.6781

Su2 = 61.1491

Su = 50.0711 Su2 d = 52.8140

S = 41 Sud = 43.2460

Sd = 35.4114 Sd2 u = 37.3513

2

Sd = 30.5846

Sd3 = 26.4157

11.2. UNDERSTANDING RISK-NEUTRAL PROBABILITY 85

The replicating portfolios are copied over from the textbook Figure 10.5.

Period 0 1 2

(4, B)u = (0.921 8, −33. 263 6)

(4, B) = (0.706 3, −21. 885 2) (4, B)ud = (0.828 7, −30. 138 6)

(4, B)d = (0.450 1, −13. 405 2)

(4, B)d2 = (0, 0)

In addition, we need to calculate the discount rate for each node. We put

the stock price table and the replicating portfolio table side by side:

Stock price (4, B)

Period 0 1 2 3 Period 0 1 2

74.6781

61.1491 (1, −38. 947 4)

50.0711 52.8140 (0.921 8, −33. 263 6)

41 43.2460 (0.706 3, −21. 885 2) (0.828 7, −30. 138 6)

35.4114 37.3513 (0.450 1, −13. 405 2)

30.5846 (0, 0)

26.4157

Calculate the common discounting factor Node u →Node 0 and Node d →Node

0:

e−γ(1/3) = = =

∆Seαh + Berh 0.706 3 (41) e0.15(1/3) − 21. 885 2e0.08(1/3)

0.887 87

e−γ(1/3) = 0.887 87 γ = 0.356 8

ud →Node u :

e−γ(1/3) = αh rh

= =

∆Se + Be 0.921 8 (50.0711) e0.15(1/3) − 33. 263 6 2e0.08(1/3)

0.897 84

e−γ(1/3) = 0.897 84 γ = 0.323 3

d2 →Node d :

e−γ(1/3) = = =

∆Seαh + Berh 0.450 1 (35.4114) e0.15(1/3) − 13. 405 2 64e0.08(1/3)

0.847 79

e−γ(1/3) = 0.847 79 γ = 0.495 4

86 CHAPTER 11. BINOMIAL OPTION PRICING: II

u d →Node u2 :

2

e−γ(1/3) = = =

∆Seαh + Berh 1 (61.1491) e0.15(1/3) − 38. 947 4e0.08(1/3)

0.914 24

e−γ(1/3) = 0.914 24 γ = 0.2690

2

ud →Node ud :

∆S + B 0.828 7 (43.2460) − 30. 138 6

e−γ(1/3) = αh rh

= =

∆Se + Be 0.828 7 (43.2460) e0.15(1/3) − 30. 138 6e0.08(1/3)

0.847 83

e−γ(1/3) = 0.847 83 γ = 0.495 2

Calculate the common discounting factor Node ud2 →Node d2 and Node

d →Node d2 :

3

∆S + B 0 (30.5846) − 0

e−γ(1/3) = = = N/A

∆Seαh + Berh 0 (30.5846) e0.15(1/3) − 0 6e0.08(1/3)

e−γ(1/3) = N/A γ = N/A

node, we take the greater of the backwardized value and the exercise value.

Calculate the common real probability of stock going up and down at each

node.

41e0.15(1/3) = 50.0711p + 35.4114 (1 − p)

p = 0.524 6 q = 1 − 0.524 6 = 0.475 4

Period 0 1 2 3

Cu3 = max (0, 74.6781 − 40) = 34. 678 1

γ = 0.2690

γ = 0.323 3 Cu2 d = max (0, 52.8140 − 40) = 12. 814

γ = 0.356 8 γ = 0.495 2

γ = 0.495 4 Cd2 u = max (0, 37.3513 − 40) = 0

γ = N/A

Cd3 = max (0, 26.4157 − 40) = 0

Period 0 1 2 3

Su3 = 74.6781

Su2 = 61.1491

Su = 50.0711 Su2 d = 52.8140

S = 41 Sud = 43.2460

Sd = 35.4114 Sd2 u = 37.3513

2

Sd = 30.5846

Sd3 = 26.4157

11.2. UNDERSTANDING RISK-NEUTRAL PROBABILITY 87

Cu2 = (34. 678 1 × 0.524 6 + 12. 814 × 0.475 4) e−0.2690(1/3) = 22. 201 2

EVu2 = max (0, 61.1491 − 40) = 21. 149 1

EVud = max (0, 43.2460 − 40) = 3. 246

Cd2 = 0

EVd2 = max (0, 30.5846 − 40) = 0

Now we have:

Period 0 1 2 3

Vu3 = 34. 678 1

Vu2 = 22. 201 2

γ = 0.323 3 Vu2 d = 12. 814

γ = 0.356 8 Vud = 5. 699 4

γ = 0.495 4 Vud2 = 0

Vd2 = 0

Vd3 = 0

Similarly,

Cu = (22. 201 2 × 0.524 6 + 5. 699 4 × 0.475 4) e−0.323 3(1/3) = 12. 889 6

EVu = max (0, 50.0711 − 40) = 10. 071 1

EVd = max (0, 35.4114 − 40) = 0

Now we have:

Period 0 1 2 3

Vu3 = 34. 678 1

Vu2 = 22. 201 2

Vu = 12. 889 6 Vu2 d = 12. 814

γ = 0.356 8 Vud = 5. 699 4

Vd = 2. 534 8 Vud2 = 0

Vd2 = 0

Vd3 = 0

Finally,

C = (12. 889 6 × 0.524 6 + 2. 534 8 × 0.475 4) e−0.356 8(1/3) = 7. 0734

EV = max (0, 41 − 40) = 1

88 CHAPTER 11. BINOMIAL OPTION PRICING: II

So we have:

Period 0 1 2 3

Vu3 = 34. 678 1

Vu2 = 22. 201 2

Vu = 12. 889 6 Vu2 d = 12. 814

V = 7. 073 4 Vud = 5. 699 4

Vd = 2. 534 8 Vud2 = 0

Vd2 = 0

Vd3 = 0

Tip 11.2.2. Real probability pricing requires intensive calculation. Not only

do we need to find the real probability of up and down, we also need to find

the replicating portfolio at each node. In contrast, in risk neutral pricing, we

either use risk neutral probabilities or use replicating portfolio but not both. In

comparison, risk neutral pricing is more eﬃcient than real probability pricing.

Random Walk model

Here’s a brief review of the random walk model. There are 3 schools of thoughts:

the chartist approach (or technical analysis), fundamental analysis, and the

random walk model. Those who use the chartist approach draw charts to predict

stock future prices. They believe that history repeats itself and that past stock

prices help predict future stock prices. Fundamental analysis believes that at

any point the stock has an intrinsic value that depends on the earning potential

of the stock. Random Walk model, on the other hand, believes that the price of

a stock is purely random and that past price can’t help predict the stock price

in the future.

Is the random walk model true? Is stock price purely random? Some scholars

challenged the random walk theory. If interested, you can look into the book

A Non-Random Walk Down Wall Street at Amazon.com http://www.amazon.

com/

Now let’s look at the random walk math model. Imagine that an object zero

starts from point zero and travels along a straight line (such as Y axis). At each

step, the object either move up by 1 unit with probability p or move down by 1

unit with probability 1 − p. An equivalent description of the movement is this:

at each move a coin is tossed. If we get a head, the object moves up by 1 unit;

if we get a tail, the object moves down by 1 unit.

Let Y½ i represent the movement in the i-th step. Then

1 with probability p

Yi =

−1 with probability 1 − p

Let Zn represent the position of the article after n steps. Then

Zn = Y1 + Y2 + ... + Yn

Y1 , Y2 , ...Yn are independent identically distributed.

11.2. UNDERSTANDING RISK-NEUTRAL PROBABILITY 89

To apply the random walk model to stock prices, we can use Yi to represent

the price movement during an interval of time. We can use Zn to represent the

ending price of a stock after n equal intervals.

To get a good feel of the random variable Zn , check out the simulation of

the random walk model at

http://math.furman.edu/~dcs/java/rw.htmll

There are 3 problems if we use Zn = Y1 + Y2 + ... + Yn to model the price of a

stock:

2. The incremental change of any stock price Yi is either 1 or −1. Though

$1 change might be OK for modeling the change of a low priced stock, it

may be inappropriate to model the change of a high priced stock.

3. The expected return on stock whose price following a random walk is zero,

that is E (Zn ) = nE (Y ) = n × 0 = 0. However, stock on average should

have a positive return.

Let rt,t+h represent the continuously compounded return earned during the time

interval [t, t + h]. Let St and St+h represent the stock price at time t and t + h

respectively. Then

St+h St+h

St ert,t+h = St+h ert,t+h = rt,t+h = ln

St St

Continuously compounded returns are additive. Consider the time interval

[t, t + nh]. We have:

St+nh St+h St+2h St+3h St+nh

ert,t+nh = = × × × ... ×

St St St+h St+2h St+(n−1)h

= ert,t+h ert+h,t+2h ert+2h,t+3h ...ert+(n−1)h,t+nh

⇒ rt,t+nh = rt,t+h +rt+h,t+2h +rt+2h,t+3h + ... + rt+(n−1)h,t+nh

Continuously compounded returns can be negative. Even if r < 0, we still

have er > 0. Thus if ln S follows a random walk, S can’t be negative.

The annual return is the sum of the returns in each of the 12 months:

rannual = rJan + rF eb + ... + rDec

Assume each monthly return is independent identical distributed with com-

mon variance σ 2Monthly . Let σ 2 represent the variance of the return over 1 year

period.

90 CHAPTER 11. BINOMIAL OPTION PRICING: II

σ

σ 2 = 12σ2M onthly σMonthly = √

12

Suppose we split one year into n intervals with each interval being h long (so

nh = 1). Let σ h represent the standard deviation of the return over an interval

of h long, then

rannual = r0,h + rh,2h + r2h,3h

£ + ... + r(n−1)h,nh ¤

σ = V ar (rannual ) = V ar r0,h + rh,2h + r2h,3h + ... + r(n−1)h,nh = n σ 2h

2

σ

σh = √

n

σ √

However, nh = 1. So we have: σ h = √ = σ h

n

Binomial model

√ √

Previously, we set u = e(r−δ)h+σ h and d = √

e(r−δ)h−σ h . Now let’s

√

see why do-

(r−δ)h+σ h (r−δ)h−σ h

ing so is reasonable. Setting u = e and d = e is equivalent

to setting √

St+h = St e(r−δ)h±σ h , which is equivalent to

√

rt,t+h = (r − δ) h ± σ h (11.4)

Let’s see why Equation 11.4 solves the three problems in the random walk

model:

1. Even when rt,t+h is negative, the stock price St+h is always positive.

2. The change

h in stock priceiis proportional to the stock price. ∆S = St+h −

√

(r−δ)h±σ h

St = St e −1 .

3. The expected return during [t, t + h] is largely driven by the constant term

(r − δ) h. Hence the expected return is no long always zero.

The Cox-Ross-Rubinstein binomial tree

√

u = eσ h

(11.5)

√

d = e−σ h

(11.6)

The lognormal tree (also called the Jarrow-Rudd binomial model)

2

√

u = e(r−δ−0.5σ )h+σ h

(11.7)

2

√

d = e(r−δ−0.5σ )h−σ h

(11.8)

11.2. UNDERSTANDING RISK-NEUTRAL PROBABILITY 91

Formulas

n+1 number of stock prices observed: S0 , S1 ,...,Sn−1 ,and Sn

n number of stock returns observed. Continuously compounded

return per period is estimated as

S1 S2 S3 Sn

r1 = ln r2 = ln r3 = ln ...rn = ln

S0 S1 S2 Sn−1

Since our focus is stock returns not stock price, the number of observations

is n (i.e. the number of stock prices observed minus one). Remember this point.

The expected return is:

∧ r1 + r2 + ... + rn

r=

n

The v

estimated standard deviation is:

u³ ´2 ³ ´

∧ 2

³ ´

∧ 2

u r −∧ r + r − r + ... + r − r

∧ t 1 2 n

σ=

n−1

Example 11.2.3. Reproduce the textbook Figure 11.1 and estimate the standard

deviation of the continuously compounded return per year earned by S&P 50

index.

St ³ ´

∧ 2

Week S&P 500 price rt =ln rt − r

St−1

0 829.85

1 804.19 −0.0314 0.001846

2 874.02 0.0833 0.005143

3 869.95 −0.0047 0.000263

4 880.9 0.0125 0.000001

5 865.99 −0.0171 0.000819

6 879.91 0.0159 0.000019

7 919.02 0.0435 0.001020

8 916.92 −0.0023 0.000191

9 929.62 0.0138 0.000005

10 939.28 0.0103 0.000001

11 923.42 −0.0170 0.000817

12 953.22 0.0318 0.000409

Total 0.1386 0.010534

∧ r1 + r2 + ... + r12 0.1386

r= = = 0.011 55

n 12

estimated as:

92 CHAPTER 11. BINOMIAL OPTION PRICING: II

r

∧ 0.010534

σ= = 0.03 095

12 − 1

1 Year = 52 Weeks

Let Y represent the continuously compounded return per year and Xi rep-

resent the continuously compounded return earned in the i-th week.

Then Y = X1 + X2 + ... + X52

Where X1 , X2 , ..., X52 are assumed to be independent identically distributed.

V ar (Y√) = V ar (X

√ 1 + X2 + ... + X52 ) = 52V ar (X)

σ Y = 52σ Y = 52 (0.03 095) = 0.223 18

Please note my calculation was done using Excel. If you can’t perfectly

reproduce my numbers, that’s fine.

By the way, in Excel, the formula for the mean is AVERAGE; the formula

for the sample variance is VAR

per year earned by S&P 500 index. Suppose the stock prices are entered in

Column C (from C3 to C15) and the weekly returns are calculated in Column

D (from D4 to D15).

St

2 Week S&P 500 price rt =ln

St−1

3 0 829.85

4 1 804.19 −0.0314

5 2 874.02 0.0833

6 3 869.95 −0.0047

7 4 880.9 0.0125

8 5 865.99 −0.0171

9 6 879.91 0.0159

10 7 919.02 0.0435

11 8 916.92 −0.0023

12 9 929.62 0.0138

13 10 939.28 0.0103

14 11 923.42 −0.0170

15 12 953.22 0.0318

The expected continuously compounded return per week is:

∧

r =AVERAGE(D4:D15)= 0.01155006

The sample variance of the continuously compounded return per week is

estimated as:

∧2

σ =VAR(D4:D15)= 0.000957682

∧ √

σ = 0.000957682 = 0.030946434

Make sure you don’t use the population variance formula:

VARP(D4:D15)= 0.000877875

11.2. UNDERSTANDING RISK-NEUTRAL PROBABILITY 93

³ ´

∧ 2

³ ´

∧ 2

³ ´

∧ 2

r1 − r + r2 − r + ... + rn − r

V ARP =

n

While VAR is³calculated

´ as ³ ´ ³ ´

∧ 2 ∧ 2 ∧ 2

r1 − r + r2 − r + ... + rn − r

V AR =

n−1

n

So V AR = V ARP ×

n−1

shortcut for quickly finding the sample mean and the sample standard deviation.

BA II Plus and BA II Plus Professional have a 1-V Statistics Worksheet. This

worksheet can calculate the sample mean, the sample standard deviation, the

population mean (which is the same as the sample mean), and the population

standard deviation.

In 1-V Statistics Worksheet, enter:

1 Column B Column C Column D

St

2 Week S&P 500 price rt =ln

St−1

3 0 829.85

4 1 804.19 −0.0314

5 2 874.02 0.0833

6 3 869.95 −0.0047

7 4 880.9 0.0125

8 5 865.99 −0.0171

9 6 879.91 0.0159

10 7 919.02 0.0435

11 8 916.92 −0.0023

12 9 929.62 0.0138

13 10 939.28 0.0103

14 11 923.42 −0.0170

15 12 953.22 0.0318

804.19

X01 = ln = −0.03 140 940

829.85

Y 01 = 1 (we observed X01 only once)

874.02

X02 = ln = 0.08 326 770

804.19

Y 02 = 1 (we observed X02 only once)

953.22

X12 = ln = 0.03 176 156

923.42

Y 12 = 1 (we observed X12 only once)

94 CHAPTER 11. BINOMIAL OPTION PRICING: II

n = 12

X = 0.01155006

This is the sample mean (or population mean) of the continuously com-

pounded return per week.

SX = 0.03094643

This is the estimated standard deviation (or sample standard deviation) of

the continuously compounded return per week.

σ X = 0.02962895

This is the estimated standard deviation (or population standard deviation)

of the continuously compounded return per week.

You should use SX and discard σ X when estimating the stock volatility.

Example 11.2.4. Reproduce the textbook Figure 11.1 and estimate the standard

deviation of the continuously compounded return per year earned by IBM.

St

Week S&P 500 price rt =ln

St−1

0 77.73

1 75.18 −0.0334

2 82 0.0868

3 81.55 −0.0055

4 81.46 −0.0011

5 78.71 −0.0343

6 82.88 0.0516

7 85.75 0.0340

8 84.9 −0.0100

9 86.68 0.0207

10 88.7 0.0230

11 86.18 −0.0288

12 87.57 0.0160

X01 = −0.0334 Y 01 = 1

X02 = 0.0868 Y 02 = 1

X03 = −0.0055 Y 03 = 1

......

X13 = 0.0160 Y 12 = 1

You should get: SX = 0.0365

So the estimated standard deviation (or sample standard deviation) of the

continuously compounded return per week is:

σ X = 0.0365

The standard deviation of the continuously compounded return per year is:

11.3. STOCKS PAYING DISCRETE DIVIDENDS 95

√

52 (0.0365) = 0.263 2

in reality, dividends are paid discretely (such as quarterly or annually). Now

let’s build a binomial tree to calculate the price of a stock that pays discrete

dividends.

Suppose we have a European option on a stock that pays a discrete dividend.

The option is written at t (today) and expires in t+h. The stock pays a dividend

or several dividends during [t, t + h]. The future value of the dividends at t + h

is D. The continuously compounded risk-free interest rate per year is r ( a

positive constant). The stock price today is St . At t + h, the stock price either

goes up to Stu = uSt or goes down to Std = dSt . The standard deviation of the

continuously compounded return earned by the stock per year is σ. We want

to calculate the option price.

Stu = uSt = Ft,t+h eσ h Std = dSt = Ft,t+h e−σ h

However, Ft,t+h = St erh − D

This gives us:

¡ ¢ √

Stu = St erh − D eσ h (11.9)

¡ ¢ √

Std = St erh − D e−σ h (11.10)

To find the price of the European option, we calculate the cost of the repli-

cating portfolio. We have two assets: the stock and a savings account. The

savings account is the same as a zero-coupon bond. At time t + h, the stock

price is Sh ; the bond price is Bt+h . The bond price is deterministic:

Bt = 1 Bt+h = erh

The stock

( price at¡ t + h is stochastic:

¢ √

Stu = St erh − D eσ √h

St+h = ¡ ¢

Std = St erh − D e−σ h

So at t + h the stock price either goes up to Stu ("up state") or goes down

to Std ("down state").

96 CHAPTER 11. BINOMIAL OPTION PRICING: II

Stu

St

Std

Time t Time t + h

Our task is to determine C by setting a portfolio that replicates the option

payoﬀ of Cu in the up state and Cd in the down state. We build the replicating

portfolio by buying 4 stocks and investing $B in a zero-coupon bond.

If we own one stock at t, then at t + h our total wealth is St+h + D. We

not only can sell the stock in the market for St+h , we’ll also have D, the future

value of the dividend earned during [t, t + h].

So we need to set up the following equation:

4 (Stu + D) Berh Cu

4St ¡ ¢ + B = C

4 Std + D Berh Cd

t t+h t t+h t t+h

½

4 ¡(Stu + D)¢ + Berh = Cu

4 Std + D + Berh = Cd

Solving these equations, we get:

Cu − Cd

4= (11.11)

Stu − Std

µ ¶

Stu Cd − Std Cu

B = e−rh − 4D (11.12)

Stu − Std

One major problem with the stock price tree using Equation 11.9 and 11.10 is

that the tree doesn’t complete recombine after the discrete dividend.

Example 11.3.1. Reproduce the textbook Figure 11.1 but just for the 2 periods.

Show that the stock price tree doesn’t recombine at Period 2. This is the recap

of the information. The current stock price is 41. The stock pays a dividend

during Period 1 and Period 2. The future value of the dividend accumulated

at the risk-free interest rate r from Period 1 to Period 2 is 5. Other data are:

r = 0.08, σ = 0.3, t = 1,and h = 1/3.

11.3. STOCKS PAYING DISCRETE DIVIDENDS 97

Period 0 1 2 3

Stuuu = 67. 417 15

Stuu = 55. 203

Stu = 50. 071 Stuud = Studu = 47. 678 91

Stud = 39. 041

Studd = 33. 719 59

St = 41

Stduu = 45. 553 05

Stdu = 37. 300

Std = 35. 411 Stdud = Stddu = 32. 216 14

Stdd = 26. 380

Stddd = 22. 783 97

¡ ¢ √ ¡ ¢ √

Stu = St erh − D eσ h = 41e0.08×1/3 − 0 e0.3 1/3 = 50. 071 09

¡ ¢ √ ¡ ¢ √

Std = St erh − D e−σ h = 41e0.08×1/3 − 0 e−0.3 1/3 = 35. 411 39

√ at Period 2 is 5.

¡ ¢ √ ¡ ¢

Stuu = Stu erh − D eσ h = 50. 071 09e0.08×1/3 − 5 e0.3 1/3 = 55. 203 57

¡ ¢ √ ¡ ¢ √

Stud = Stu erh − D e−σ h = 50. 071 09e0.08×1/3 − 5 e−0.3 1/3 = 39. 041 20

¡ ¢ √ ¡ ¢ √

Stdu = Std erh − D eσ h = 35. 411 39e0.08×1/3 − 5 e0.3 1/3 = 37. 300 47

¡ ¢ √ ¡ ¢ √

Stdd = Std erh − D e−σ h = 35. 411 39e0.08×1/3 − 5 e−0.3 1/3 = 26. 379 73

Now you see that Stud 6= Stdu , . The tree doesn’t recombine.

No dividend is paid during Period 2 and Period 3. √

¡ ¢ √ ¡ ¢

Stuuu = Stuu erh − D eσ h = 55. 203 57e0.08×1/3 − 0 e0.3 1/3 = 67. 417 15

¡ ¢ √ ¡ ¢ √

Stuud = Stuu erh − D e−σ h = 55. 203 57e0.08×1/3 − 0 e−0.3 1/3 = 47.

678 91 ¡ ¢ √ ¡ ¢ √

Studu = Stud erh − D eσ h = 39. 041 20e0.08×1/3 − 0 e0.3 1/3 = 47. 678 91

¡ ¢ √ ¡ ¢ √

Studd = Stud erh − D e−σ h = 39. 041 20e0.08×1/3 − 0 e−0.3 1/3 = 33.

719 59

¡ ¢ √ ¡ ¢ √

Stduu = Stdu erh − D eσ h = 37. 300 47e0.08×1/3 − 0 e0.3 1/3 = 45. 553 05

¡ ¢ √ ¡ ¢ √

Stdud = Stdu erh − D e−σ h = 37. 300 47e0.08×1/3 − 0 e−0.3 1/3 = 32.

216 14 ¡ ¢ √ ¡ ¢ √

Stddu = Stdd erh − D eσ h = 26. 379 73e0.08×1/3 − 0 e0.3 1/3 = 32. 216 14

¡ ¢ √ ¡ ¢ √

Stddd = Stdd erh − D e−σ h = 26. 379 73e0.08×1/3 − 0 e−0.3 1/3 = 22.

783 97

Please note that in this example Stuud = Studu and Stdud = Stddu . This is not

a coincidence.

98 CHAPTER 11. BINOMIAL OPTION PRICING: II

¡ ¢ √ √

Stu = St erh − 0 eσ h = St³erh eσ h ´ √

¡ ¢ √ √

Stuu = Stu erh − 5 eσ h = St erh eσ h − 5 eσ h

¡ ¢ √ ³³ √ ´ √ ´ √

Stuud = Stuu erh − 0 e−σ h = St erh eσ h − 5 eσ h erh e−σ h

³ √ ´

= St erh eσ h − 5 erh

¡ ¢ √ ³ √ ´ √

Stud = Stu erh − 5 e−σ h = St erh eσ h − 5 e−σ h

¡ ¢ √ ³³ √ ´ √ ´ √

Studu = Stud erh − 0 eσ h = St erh eσ h − 5 e−σ h erh − 0 eσ h

³ √ ´

= St erh eσ h − 5 erh

Clearly, Stuud = Studu . Similarly, you can verify for yourself that Stdud =

Stddu .

In this problem, Period 2 had 4 prices. If the stock pays continuous dividend,

Period 2 will have only 3 prices.

Similarly, in this problem, Period 3 has 5 distinct prices. In contrast, if the

stock pays continuous dividend, Period 3 will have only 4 prices.

In addition to non-combining stock prices, the above method may produce

negative stock prices.

Schroder presents a method that overcomes the two shortcomings of the above

method.

stock price tree (which proves to be non-combining after the discrete dividend is

paid), we’ll build a tree of a series of prepaid forward prices on the same stock.

Hopefully, the prepaid forward

³ price

´ tree is recombining and looks like this:

uu

P

Ft+2h,T

³ ´u

P

Ft+h,T

³ ´ud

P P

Ft,T Ft+2h,T

³ ´d

P

Ft+h,T

³ ´dd

P

Ft+2h,T

P

• Ft,T is the prepaid price of a forward contract signed at t expiring on date

T

11.3. STOCKS PAYING DISCRETE DIVIDENDS 99

P

• Ft+h,T is the prepaid price of a forward contract signed at t + h expiring

on date T

P

• Ft+2h,T is the prepaid price of a forward contract signed at t + 2h expiring

on date T

the stock price, we can change the (recombining) prepaid forward price tree into

a (recombining) stock price tree. Once we have a recombining stock price tree,

we’ll can easily find the price of the option using either risk-neutral probability

or the replicating portfolio.

First, let’s find the relationship between the stock price and the prepaid

forward price on the stock. Suppose today is time t . At t we enter into a

forward contract agreeing to buy a stock on date T . The stock will pay dividend

D on date TD where TD < T .

Suppose we want to prepay the seller at t. The price of this prepaid forward

contract is the current stock price

½ St −r(T

minus the present value of the dividend:

D −t)

P De if TD ≥ t

Ft,T = St − P Vt (D) = St −

0 if TD < t

½

P De−r(TD −t) if TD ≥ t

→ St = Ft,T +

0 if TD < t

Similarly, ½

P De−r(TD −t−h) if TD ≥ t + h

Ft+h,T= St+h − P Vt+h (D) = St+h −

0 if TD < t + h

½ −r(TD −t−h)

P De if TD ≥ t + h

→ St+h = Ft+h,T +

0 if TD < t + h

So there’s a one-to-one mapping between the prepaid forward price and the

stock price.

Next, let’s find out how to build a prepaid forward price tree. We need to

know how the prepaid forward price changes over time. Suppose today is time

t . At t + h we enter into a forward contract agreeing to buy a stock at date T

where T > t + h. The stock will pay dividend D in date TD where t < TD < T .

If the stock volatility is zero (meaning that the future stock price is known today

with 100% certainty), then the price of the prepaid forward contact at t + h is

P P rh

Ft+h,T = Ft,T e (11.13)

P

Ft+h,T

P

= erh (11.14)

Ft,T

P

This is why Equation 11.13 holds. If we pay Ft,T at t, we’ll receive one stock

P

at T . This gives us Ft,T = ST e−r(T −t) . Similarly, if we pay Ft+h,T

P

at t + h, we’ll

100 CHAPTER 11. BINOMIAL OPTION PRICING: II

P

also receive a stock at T . This gives us Ft+h,T = ST e−r(T −t−h) . Then Equation

11.13 holds.

Now suppose that the forward price has a volatility of σ F per year. Then

it’s reasonable

( to assume that

√

P rh σ h P

P F t,T e e = Ft,T u in the up state

Ft+h,T = P rh −σ h

√

P

Ft,T e e = Ft,T d in the down state

√ √

where u = erh+σF h

and d = erh−σF h

½ P

P Ft+h,T u in the up state

Similarly, Ft+2h,T = P

Ft+h,T d in the down state

using the following approximation:

St

σF = σS × P

Ft,T

Now the prepaid forward price³tree is: ´

uu

P P

Ft+2h,T = Ft,T u2

³ ´u

P P

Ft+h,T = Ft,T u

³ ´ud ³ ´du

P P P P

Ft,T Ft+2h,T = Ft+2h,T = Ft,T ud

³ ´d

P P

Ft+h,T = Ft,T d

³ ´dd

P P 2

Ft+2h,T = Ft,T d

Once we have the prepaid forward price tree, we’ll transform it into the stock

price tree:

³ ´uu

uu P

St+2h = Ft+2h,T + P Vt+2h (D)

³ ´u

u P

St+h = Ft+h,T + P Vt+h (D)

³ ´ud

P ud P

St = Ft,T + P Vt (D) St+2h = Ft+2h,T + P Vt+2h (D)

³ ´d

d P

St+h = Ft+h,T + P Vt+h (D)

³ ´dd

dd P

St+2h = Ft+2h,T + P Vt+2h (D)

Example 11.3.2. Let’ s reproduce the textbook Figure 11.11. Here is the recap

of the information on an American call option. The stock pays a dividend of $5

in 8 months. Current stock price is $41. The strike price K = $40. The stock

volatility is σS = 0.3. The continuously compounded risk-free rate is r = 0.08.

The option expires in T = 1 year. Use a 3-period binomial tree to calculate the

option price.

11.3. STOCKS PAYING DISCRETE DIVIDENDS 101

St

σF = σS × P

Ft,T

P

Ft,T = St − P Vt (D) = 41 − 5e−0.08(8/12) = 36. 26

St 41

σ F = σ S × P = 0.3 × = 0.339 2

Ft,T 36. 26

√ √

u = erh+σF √ h = e0.08(1/3)+0.3392 √1/3 = 1. 249 20

d = erh−σF h = e0.08(1/3)−0.3392 1/3 = 0.844 36

³ ´uuu

P

Ft+3h,T

³ ´uu

P

Ft+2h,T

³ ´u ³ ´uud

P P

Ft+h,T Ft+3h,T

³ ´ud

P P

Ft,T Ft+2h,T

³ ´d ³ ´udd

P P

Ft+h,T Ft+3h,T

³ ´dd

P

Ft+2h,T

³ ´ddd

P

Ft+3h,T

³ ´u

P P

Ft+h,T = Ft,T u = 36. 26 × 1. 249 20 = 45. 296

³ ´d

P P

Ft+h,T = Ft,T d = 36. 26 × 0.844 36 = 30. 616

³ ´uu ³ ´u

P P

Ft+2h,T = Ft,T u2 = Ft+h,T

P

u = 45. 296 × 1. 249 20 = 56. 584

³ ´ud ³ ´u

P P

Ft+2h,T = Ft+h,T d = 45. 296 × 0.844 36 = 38. 246

³ ´dd ³ ´d

P P 2 P

Ft+3h,T = Ft,T d = Ft+h,T d = 30. 616 × 0.844 36 = 25. 851

³ ´uuu ³ ´uu

P P

Ft+3h,T = Ft+2h,T u = 56. 584 × 1. 249 20 = 70. 685

³ ´uud ³ ´uu

P P

Ft+3h,T = Ft+2h,T d = 56. 584 × 0.844 36 = 47. 777

³ ´udd ³ ´ud

P P

Ft+3h,T = Ft+2h,T d = 38. 246 × 0.844 36 = 32. 293

³ ´ddd ³ ´dd

P P

Ft+3h,T = Ft+2h,T d = 25. 851 × 0.844 36 = 21. 828

102 CHAPTER 11. BINOMIAL OPTION PRICING: II

70. 685

56. 584

45. 296 47. 777

36. 26 38. 246

30. 616 32. 293

25. 851

21. 828

Next, we change the prepaid forward price tree into a stock price tree. The

one-to-one mapping between

½ the prepaid forward price and the stock price is

−r(TD −t−∆t)

P De if TD ≥ t + ∆t

St+∆t = Ft+∆t,T +

0 if TD < t + ∆t

where 0 ≤ ∆t ≤ T − t ¡ ¢uuu

¡ ¢uu St+3/3

St+2/3

¡ ¢u ¡ ¢uud

St+1/3 St+3/3

¡ ¢ud

St St+2/3

¡ ¢d ¡ ¢udd

St+1/3 St+3/3

¡ ¢dd

St+2/3

¡ ¢ddd

St+3/3

8

In this problem, TD = + t, D = 5,T = t + 1

12

P −r(TD −t)

St = Ft,T + De = 36. 26 + 5e−0.08(8/12) = 41. 000

¡ ¢u ³ P ´u

St+1/3 = Ft+1/3,T + De−r(TD −t−1/3) = 45. 296 + 5e−0.08(8/12−1/3) =

50. 164

¡ ¢d ³ P ´d

St+1/3 = Ft+1/3,T + De−r(TD −t−1/3) = 30. 616 + 5e−0.08(8/12−1/3) =

35. 484

¡ ¢uu ³ P ´uu

St+2/3 = Ft+2/3,T +De−r(TD −t−2/3) = 56. 584+5e−0.08(8/12−2/3) =

61. 584

¡ ¢ud ³ P ´ud

St+2/3 = Ft+2/3,T +De−r(TD −t−2/3) = 38. 246+5e−0.08(8/12−2/3) =

43. 246

¡ ¢dd ³ P ´dd

St+2/3 = Ft+2/3,T + De−r(TD −t−2/3) = 25. 851 + 5e−0.08(8/12−2/3) =

30. 851

¡ ¢uuu ³ P ´uuu

St+3/3 = Ft+3/3,T = 70. 685 (because TD < t + 3/3)

Similarly,

¡ ¢uud ³ P ´uud

St+3/3 = Ft+3/3,T = 47. 777

¡ ¢udd ³ ´udd

P

St+3/3 = Ft+3/3,T = 32. 293

¡ ¢ddd ³ ´ddd

P

St+3/3 = Ft+3/3,T = 21. 828

11.3. STOCKS PAYING DISCRETE DIVIDENDS 103

70. 685

61. 584

50. 164 47. 777

41. 000 43. 246

35. 484 32. 293

30. 851

21. 828

After getting the stock price tree, we calculate the price of the American

call option as usual. We work backward from right to left. At each node, we

compare the backwardized value with the exercise value, taking the maximum

of the two.

erh − d e0.08(1/3) − 0.844 36

πu = = = 0.451 2

u−d 1. 249 20 − 0.844 36

π d = 1 − 0.451 2 = 0.548 8

Payoﬀ tree:

Vuuu = 30. 685

Vuu = 21. 584

Vu = 11. 308 Vuud = 7. 777

V = 5.770 Vud = 3. 417

Vd = 1. 501 Vudd = 0

Vdd = 0

Vddd = 0

Vuud = Cuud = max (0, 47. 777 − 40) = 7. 777

Vudd = Cudd = max (0, 32. 293 − 40 ) = 0

Vddd = Cddd = max (0, 21. 828 − 40) = 0

Cuu = (30. 685 × 0.451 2 + 7. 777 × 0.548 8) e−0.08(1/3) = 17. 636

EVuu = max (0, 61. 584 − 40) = 21. 584

Vuu = max (17. 636 , 21. 584) = 21. 584

EVud = max (0, 43. 246 − 40) = 3. 246

Vud = max (3. 417 , 3. 246) = 3. 417

Cdd = 0

EVdd = max (0, 30. 851 − 40) = 0

Vud = 0

EVu = max (0, 50. 164 − 40) = 10. 164

104 CHAPTER 11. BINOMIAL OPTION PRICING: II

EVd = max (0, 35. 484 − 40) = 0

Vd = max (1. 501 , 0) = 1. 501

EV = max (0, 41. 000 − 40) = 1.0

V = max (5. 770, 1.0) = 5. 77

Chapter 12

Black-Scholes

Except the option Greeks and the barrier option price formula, this chapter is

an easy read.

12.1.1 Call and put option price

The price of a European call option is:

µ ¶

S 1 2

ln + r−δ+ σ T

K 2

d1 = √ (12.3)

σ T

√

d2 = d1 − σ T (12.4)

Notations used in Equation 12.1, 12.3, and 12.4:

• S, the current stock price (i.e. the stock price when the call option is

written)

105

106 CHAPTER 12. BLACK-SCHOLES

stock return (i.e. stock volatility)

(S, K, σ, r, T, δ)

(S, K, σ, r, T, δ)

Tip 12.1.1. To help memorize Equation 12.2, we can rewrite Equation 12.2

similar to Equation 12.1 as P (S, K, σ, r, T, δ) = (−S) e−δT N (−d1 )+(−K) e−rT N (−d2 ).

In other words, change S,K,d1 ,and d2 in Equation 12.1 and you’ll get Equation

12.2.

Example 12.1.1. Reproduce the textbook example 12.1. This is the recap of

the information. S = 41, K = 40,r = 0.08, σ = 0.3, T = 0.25 (i.e. 3 months),

and δ = 0. Calculate the price of the price of a European call option.

µ ¶

S 1 2

ln + r−δ+ σ T

K 2

d1 = √

µ σ T ¶

41 1

ln + 0.08 − 0 + × 0.32 0.25

40 2

= √ = 0.3730

√ 0.3 0.25 √

d2 = d1 − σ T = 0.3730 − 0.3 0.25 = 0.2230

N (d1 ) = 0.645 4 N (d2 ) = 0.588 2

−0(0.25)

C = 41e 0.645 4 − 40e−0.08(0.25) 0.588 2 = 3. 399

Example 12.1.2. Reproduce the textbook example 12.2. This is the recap of

the information. S = 41, K = 40,r = 0.08, σ = 0.3, T = 0.25 (i.e. 3 months),

and δ = 0. Calculate the price of the price of a European put option.

P = −41e−0(0.25) 0.354 6 + 40e−0.08(0.25) 0.411 8 = 1. 607

12.2. APPLYING THE FORMULA TO OTHER ASSETS 107

Assumptions under the Black-Scholes formula:

1. Continuously compounded returns on the stock are normally distributed

(i.e. stock price is lognormally distributed) and independent over time

2. The volatility of the continuously compounded returns is known and con-

stant

3. Future dividends are known, either as a dollar amount (i.e. D and TD are

known in advance) or as a fixed dividend yield (i.e. δ is a known constant)

Assumptions about the economic environment

1. The risk-free rate is known and fixed (i.e. r is a known constant)

2. There are no transaction costs or taxes

3. It’s possible to short-sell costlessly and to borrow at the risk-free rate

12.2.1 Black-Scholes formula in terms of prepaid forward

price

P

The prepaid forward price for the stock is: F0,T (S) = Se−δT

P

The prepaid forward price for the strike asset is: F0,T (K) = P V (K) =

−rT

Ke √

Define V (T ) = σ T

The price of a European call option in terms of repaid forward is:

¡ P P

¢ P P

C F0,T (S) , F0,T (K) , V (T ) = F0,T (S) N (d1 ) − F0,T (K) N (d2 ) (12.5)

¡ P P

¢ P P

P F0,T (S) , F0,T (K) , V (T ) = −F0,T (S) N (−d1 ) + F0,T (K) N (−d2 ) (12.6)

P

F0,T (S) 1

ln P

+ V 2 (T )

F0,T (K) 2

d1 = (12.7)

V (T )

d2 = d1 − V (T ) (12.8)

108 CHAPTER 12. BLACK-SCHOLES

When the stock pays discrete dividends, the prepaid forward price is:

P

F0,T (S) = S − P V0,T (Div)

P

Apply F0,T (S) in Equation 12.5 and 12.6, you should get the price of the

European call and put where the stock pays discrete dividends.

Example 12.2.1. Reproduce the textbook example 12.3. Here is the recap of

the information. S = 41, K = 40, σ = 0.3, r = 0.08, and T = 0.25 (i.e. 3

months). The stock pays dividend of 3 in 1 month, but makes no other payouts

over the life of the option (so δ = 0). Calculate the price of the European call

and put.

P

F0,T (S) = S − P V0,T (Div) = 41 − 3e−(0.08)1/12 = 38. 020

P

F0,T (K) = P V (K) = Ke−rT = 40e−0.08(0.25) = 39. 208

√ √

V (T ) = σ T = 0.3 0.25 = 0.15

P

F0,T (S) 1

ln P + V 2 (T ) 38. 020 1

F0,T (K) 2 ln + 0.152

d1 = = 39. 208 2 = −0.130 1

V (T ) 0.15

d2 = d1 − V (T ) = −0.130 1 − 0.15 = −0.280 1

N (d1 ) = 0.448 2 N (d2 ) = 0.389 7

N (−d1 ) = 1 − 0.448 2 = 0.551 8

N (−d2 ) = 1 − 0.389 7 = 0.610 3

P P

C = F0,T (S) N (d1 ) − F0,T (K) N (d2 )

= 38. 020 (0.448 2) − 39. 208 (0.389 7) = 1. 76

P P

P = −F0,T (S) N (−d1 ) + F0,T (K) N (−d2 )

= −38. 020 (0.551 8) + 39. 208 (0.610 3) = 2. 95

Notation

return on dollars

(x0 , K, σ, r, T, rf )

12.2. APPLYING THE FORMULA TO OTHER ASSETS 109

(x0 , K, σ, r, T, rf )

µ ¶

x 1

ln + r − rf + σ2 T

K 2

d1 = √ (12.11)

σ T

√

d2 = d1 − σ T (12.12)

Tip 12.2.1. For currency options, just set S = x and δ = rf and apply the

Black-Scholes formulas on European call and put. The same thing happened in

Equation 10.26 and 10.27.

Example 12.2.2. Reproduce the textbook example 12.4. Here is the recap of the

information. The current dollar price of €1 is $0.92. The strike dollar price of

€1 is $0.9. The annualized standard deviation of the continuously compounded

return on dollars is σ = 0.1. The continuously compounded risk-free rate earned

by dollars is r = 6%. The the continuously compounded risk-free rate earned

by €1 is rf = 3.2%. The option expires in 1 year. Calculate the price of the

European call and put on €1.

µ ¶

x 1 2

ln + r − rf + σ T

K 2

d1 = √

µ σ T ¶

0.92 1

ln + 0.06 − 0.032 + × 0.12 1

0.9 2

= √ = 0.549 8

√ 0.1 1 √

d2 = d1 − σ T = 0.549 8 − 0.1 1 = 0.449 8

N (d1 ) = 0.708 8

N (−d1 ) = 1 − N (d1 ) = 1 − 0.708 8 = 0.291 2

N (d2 ) = 0.673 6

N (−d2 ) = 1 − N (d2 ) = 1 − 0.673 6 = 0.326 4

C = xe−rf T N (d1 ) − Ke−rT N (d2 )

= 0.92e−0.032(1) 0.708 8 − 0.9e−0.06(1) 0.673 6 = 0.06 06

P = −xe−rf T N (−d1 ) + Ke−rT N (−d2 )

= −0.92e−0.032(1) 0.291 2 + 0.9e−0.06(1) 0.326 4 = 0.017 2

110 CHAPTER 12. BLACK-SCHOLES

For a futures contract, the prepaid price is just the present value of the futures

P

price. Set F0,T (F ) = F e−rT and F0,T

P

(K) = Ke−rT , we get:

P

F0,T (F ) 1

ln P

+ σ2T

F0,T (K) 2

d1 = √ (12.13)

σ T

√

d2 = d1 − σ T (12.14)

Example 12.2.3. Reproduce the textbook example 12.5. Here is the recap of

the information about the European option on a 1-year futures contract. The

current futures price for natural gas is $2.10. The strike price is K = 2.10. The

volatility is σ = 0.25. r = 0.055, T = 1. Calculate the price of the European

call and put.

F 1 2.10 1

ln + σ2T ln + × 0.252 (1)

d1 = K √ 2 = 2.10 2¡√ ¢ = 0.125

σ T 0.25 1

√ ¡√ ¢

d2 = d1 − σ T = 0.125 − 0.25 1 = −0.125

N (d1 ) = 0.549 7 N (d2 ) = 0.450 3

N (−d1 ) = 1 − N (d1 ) = 1 − 0.549 7 = 0.450 3

N (−d2 ) = 1 − N (d2 ) = 1 − 0.450 3 = 0.549 7

C = F e−rT N (d1 ) − Ke−rT N (d2 )

= 2.10e−0.055(1) 0.549 7 − 2.10e−0.055(1) 0.450 3 = 0.197 6

P = −F e−rT N (−d1 ) + Ke−rT N (dd2 )

= −2.10e−0.055(1) 0.450 3 + 2.10e−0.055(1) 0.549 7 = 0.197 6

The learning objectives in the SOA’s syllabus is to Interpret the option Greeks.

The learning objective in CAS Exam 3 Financial Economics is to Interpret

the option Greeks and elasticity measures. How to derive the option Greeks

is explained in the textbook Appendix 12.B, but Appendix 21.B is excluded

from the SOA MFE and CAS FE. So you might want to focus on the learning

objective of the exam.

Of all the Greeks, delta and gamma are the most important.

12.3. OPTION THE GREEKS 111

12.3.1 Delta

Cu − Cd

Delta ∆. You already see ∆ = when we try to find the replicating

Su − Sd

portfolio of a European call or put. It’s the number of stocks you need to

own at time zero to replicate the discrete payoﬀ of a European call or put at

∂C ∂C

expiration date T . If the payoﬀ is continuous, then ∆ = . Here ∆ =

∂S ∂S

is the number of stocks you need to have now to replicate the payoﬀ of the

next instant (i.e. the payoﬀ one moment later). The European call price is

∂C

C = Se−δT N (d1 ) − Ke−rT N (d2 ) and the delta for a call is ∆call = =

∂S

e−δT N (d1 ).

One less visible thing to know is that d1 is also a function of S. So it’ll tame

∂C

some work to derive ∆call = = e−δT N (d1 ). One naive approach is treat

∂S

∂C

N (d1 ) as a constant and get ∆call = = e−δT N (d1 ). Interestingly, this gives

∂S

the correct answer!

Since deriving delta is not on the syllabus, you don’t need to go through the

∂C

messy math and prove ∆call = = e−δT N (d1 ). Just memorize that ∆call =

∂S

e−δT N (d1 ) for a European call and ∆put = −e−δT N (−d1 ) = −e−δT [1 − N (d1 )] =

∆call − e−δT for a European put.

Other results you might want to memorize:

0 ≤ ∆call ≤ 1

−1 ≤ ∆put ≤ 0

Example 12.3.1. Calculate the delta of the following European call and put.

The information is: S = 25,K = 20, σ = 0.15, r = 6%, δ = 2%, and T = 1

year.

µ ¶ µ ¶

S 1 2 25 1 2

ln + r−δ+ σ T ln + 0.06 − 0.02 + × 0.15 1

K 2 20 2

d1 = √ = √ =

σ T 0.15 1

1. 829 3

N (d1 ) = 0.966 3

N (−d1 ) = 1 − 0.966 3 = 0.033 7

∆call = e−δT N (d1 ) = e−0.02(1) 0.966 3 = 0.947 2

∆put = −e−δT N (−d1 ) = −e−0.02(1) 0.033 7 = −0.03 30

12.3.2 Gamma

Gamma is a measure of the change in delta regarding change in the underlying

stock price.

∂∆ ∂2C

Γ= =

∂S ∂S 2

If gamma is too large a small change in stock price will cause a big change

in ∆. The bigger Γ, the more often you need to adjust your holding of the

underlying stocks.

112 CHAPTER 12. BLACK-SCHOLES

∂∆put ∂∆call

Since ∆put = ∆call − e−δT , then = or Γcall = Γput .

∂S ∂S

12.3.3 Vega

Vega is the change of option price for 1% change of stock volatility (you can

think that the letter V stands for volatility).

∂C

V ega =

100∂σ

12.3.4 Theta

Theta is the change of option price regarding change in time when the option

is written (you can think that the letter T represents time). Let t represent the

time when the option is written and T the expiration date. Then

∂C (T − t)

θ=

∂t

12.3.5 Rho

Rho is a measure of the change in option value regarding a 1% change in the

risk free interest rate (you can think the letter R represent r)

∂C

ρ=

100∂r

12.3.6 Psi

Psi is a measure of the change in option value regarding a 1% change in the

dividend yield.

∂C

Ψ=

100∂δ

The portfolio’s Greek is just the sum of the individual Greek.

identical puts. The information about the European call and put is as follows:

S = 60,K = 65, σ = 0.25, r = 6%, δ = 4%, and T = 0.75 year. Calculate the

portfolio delta.

µ ¶ µ ¶

S 1 2 60 1 2

ln + r−δ+ σ T ln + 0.06 − 0.04 + × 0.25 0.75

K 2 65 2

d1 = √ = √ =

σ T 0.25 0.75

−0.192 2

N (d1 ) = N (−0.192 2) = 1 − N (0.192 2)

N (0.192 2) = 0.576 2

N (d1 ) = 1 − 0.576 2 = 0.423 8

N (−d1 ) = N (0.192 2) = 0.576 2

12.3. OPTION THE GREEKS 113

∆put = −e−δT N (−d1 ) = −e−0.04(0.75) 0.576 2 = −0.559 2

∆portf olio = 10 (0.411 3) + 50 (−0.559 2) = −23. 847

Example 12.3.3. You buy 20 European calls and simultaneously write 35 Eu-

ropean puts on the same stock. The call expires in 3 months. The put both

expires in 9 months. The current stock price is 40. The call strike price is 35.

The put strike price is 45. The volatility is 20%. r = 8%, δ = 3%. Calculate

the delta of your portfolio.

−δT

Calculate ∆call

µ=e N (d¶

1) µ ¶

S 1 2 40 1 2

ln + r−δ+ σ T ln + 0.08 − 0.03 + × 0.2 0.25

K 2 35 2

d1 = √ = √ =

σ T 0.2 0.25

1. 510 3

N (d1 ) = 0.934 5

∆call = e−δT N (d1 ) = e−0.03(0.25) 0.934 5 = 0.927 5

−δT

Calculate ∆put µ = −e N (−d

¶ 1) µ ¶

S 1 2 40 1

ln + r−δ+ σ T ln + 0.08 − 0.03 + × 0.22 0.75

K 2 45 2

d1 = √ = √ =

σ T 0.2 0.75

−0.376 9

N (−d1 ) = 0.646 9

∆put = −e−0.03(0.75) 0.646 9 = −0.632 5

∆portf olio = 20 (0.927 5) − 35 (−0.632 5) = 40. 687 5

Since your write 35 puts, the delta of 35 puts is −35 (−0.632 5).

The elasticity is

% change in option price

Ω=

% change in stock price

Suppose the stock price increase by where can be positive or negative.

Then the option price will change by ∆.

% change in stock price=

S

∆

% change in option price=

C

∆

C ∆S

Ω= = (12.17)

C

S

114 CHAPTER 12. BLACK-SCHOLES

Example 12.3.4. Calculate the elasticity and the volatility of a European call

option and an otherwise identical European put option. The information is:

S = 80,K = 70, σ = 0.35, r = 5%, δ = 3%, and T = 0.5.

µ ¶ µ ¶

S 1 80 1

ln + r − δ + σ2 T ln + 0.05 − 0.03 + × 0.352 0.5

K 2 70 2

d1 = √ = √ =

σ T 0.35 0.5

0.703 7

N (d1 ) = 0.759

√ 2 N (−d1 ) = √ 1 − 0.759 2 = 0.240 8

d2 = d1 − σ T = 0.703 7 − 0.35 0.5 = 0.456 2

N (d2 ) = 0.675 9 N (−d2 ) = 1 − 0.675 9 = 0.324 1

C = Se−δT N (d1 )−Ke−rT N (d2 ) = 80e−0.03(0.5) 0.759 2−70e−0.05(0.5) 0.675 9 =

13. 687

P = −Se−δT N (−d1 )+Ke−rT N (−d2 ) = −80e−0.03(0.5) 0.240 8+70e−0.05(0.5)

0.324 1 = 3. 150

∆call = e−δT N (d1 ) = e−0.03(0.5) 0.759 2 = 0.747 9

∆put = −e−δT N (−d1 ) = −e−0.03(0.5) 0.240 8 = −0.237 2

∆call S 0.747 9 × 80

Ωcall = = = 4. 371

C 13. 687

∆put S −0.237 2 × 80

Ωput = = = −6. 024

P 3. 150

σ call = σ stock × |Ωcall | = 0.35 (4. 371) = 1. 530

σ put = σstock × |Ωput | = 0.35 (6. 024) = 2. 108

years. Let α represent the expected annual return on the stock, r the contin-

uously compounded risk-free rate per year, and γ the expected continuously

compounded return earned on the option per year. According to Equation 11.3,

we have

∆S + B

e−γh =

∆Seαh + Berh

However, ∆S + B = C µ ¶

∆Seαh + Berh ∆S αh ∆S

eγh = = e + 1− erh

C C C

eγh = Ωeαh + (1 − Ω) erh (12.19)

Equation 12.19 holds for any h. Using the Taylor’s expansion, we have:

1

1 + γh + (γh)2 + ...

∙ 2 ¸ ∙ ¸

1 1

= Ω 1 + ah + (ah)2 + ... + (1 − Ω) 1 + rh + (rh)2 + ...

2 2

12.4. PROFIT DIAGRAMS BEFORE MATURITY 115

For the above equation to hold for any h, it seems reasonable to assume that

1 = Ω + (1 − Ω)

γh = Ωah + (1 − Ω) rh

∙ ¸ ∙ ¸

1 2 1 2 1 2

(γh) + ... = Ω (ah) + ... + (1 − Ω) (rh) + ...

2 2 2

So we have γh = Ωah + (1 − Ω) rh or

γ − r = Ω (α − r) (12.20)

The Sharp ratio of an asset is the asset’s risk premium divided by the asset’s

volatility:

α−r

Sharp Ratio = (12.21)

σ

The Sharp ratio of an option is

Ω (α − r) α−r

Sharp Ratiooption = = = Sharp Ratiostock (12.22)

Ωσ stock σ stock

So the Sharp ratio of an option equals the Sharp ratio of the underlying

stock.

The elasticity of a portfolio is the weighted average of the elasticities of the

portfolio components. In contrast, the Greek of a portfolio is just the sum of

the Greeks of the portfolio components.

The risk premium of a stock portfolio is just the portfolio’s elasticity times

the stock’s risk premium:

12.4.1 Holding period profit

Example 12.4.1.

You buy a European call option that expires in 1 year and hold it for one

day. Calculate your holding profit. Information is:

116 CHAPTER 12. BLACK-SCHOLES

• K = 40

• r = 0.08

• δ=0

• σ = 30%

Solution.

At time zero, you buy a 1-year European option. Your purchase price is the

call price. µ ¶

S 1 2

ln + r−δ+ σ T

K 2

d1 = √

µ σ T ¶

40 1

ln + 0.08 − 0 + × 0.32 1

40 2

= √ = 0.416 7

√ 0.3 1 √

d2 = d1 − σ T = 0.416 7 − 0.3 1 = 0.116 7

N (d1 ) = 0.661 6 N (d2 ) = 0.546 5

C = 40e−0(1) 0.661 6 − 40e−0.08(1) 0.546 5 = 6. 285

¶

40 1 364

ln + 0.08 − 0 + × 0.32

40 2 365

d1 = r = 0.416 1

364

0.3

365 r

√ 364

d2 = d1 − σ T = 0.416 1 − 0.3 = 0.116 5

365

N (d1 ) = 0.661 33

N (d2 ) = 0.546 37

C = 40e−0(364/365) 0.661 33 − 40e−0.08(364/365) 0.546 37 = 6. 274

Suppose you buy the option at t = 0 by paying 6. 285 and sell the option

one day later for 6. 274 . Your holding period profit is:

6. 274 − 6. 285e0.08(1/365) = −0.01 2

You buy a European call option that expires in 1 year and hold it for 6

months. Calculate your holding profit. Information is:

• The stock price is 40 after 6 months.

• K = 40

• r = 0.08

12.4. PROFIT DIAGRAMS BEFORE MATURITY 117

• δ=0

• σ = 30%

At time zero, you buy a 1-year European option. Your purchase price is the

call price. As calculated before, the call price is 6. 285

40 1

ln + 0.08 − 0 + × 0.32 0.5

40 2

d1 = √ = 0.294 6

√ 0.3 0.5 √

d2 = d1 − σ T = 0.294 6 − 0.3 0.5 = 0.082 5

N (d1 ) = 0.615 9 N (d2 ) = 0.532 9

C = 40e−0(0.5) 0.615 9 − 40e−0.08(0.5) 0.532 9 = 4. 156

Your holding profit is:

4. 156 − 6. 285e0.08(0.5) = −2. 385

You buy a European put option that expires in 1 year and hold it for 6

months. Calculate your holding profit. Information is:

• The stock price is 42 after 6 months.

• K = 40

• r = 0.08

• δ = 0.02

• σ = 30%

At time zero, you buy a 1-year European option. Your purchase price is the

call price. µ ¶

S 1

ln + r − δ + σ2 T

K 2

d1 = √

µ σ T ¶

40 1 2

ln + 0.08 − 0.02 + × 0.3 1

40 2

= √ = 0.35

√ 0.3 1 √

d2 = d1 − σ T = 0.35 − 0.3 1 = 0.05

N (−d1 ) = 0.363 2 N (−d2 ) = 0.480 1

P = −40e−0.02(1) 0.363 2 + 40e−0.08(1) 0.480 1 = 3. 487

µ option is worth: ¶

42 1

ln + 0.08 − 0.02 + × 0.32 0.5

40 2

d1 = = √ = 0.477 5

√ 0.3 0.5√

d2 = d1 − σ T = 0.477 5 − 0.3 0.5 = 0.265 4

118 CHAPTER 12. BLACK-SCHOLES

P = −42e−0.02(0.5) 0.316 5 + 40e−0.08(0.5) 0.395 4 = 2. 035

Suppose you buy the option at t = 0 by paying 3. 487 and sell the option 6

months later for 2. 035. Your holding period profit is:

2. 035 − 3. 487e0.08(0.5) = −1. 59

The textbook has an intimidating diagram (Figure 12.14). Don’t worry about

this diagram. Just focus on understanding what a calendar spread is.

A calendar spread (also called time spread or horizontal spread) is an option

strategy that takes advantage of the deteriorating time value of options. A

calendar spread involves selling one option that has a shorter expiring date and

simultaneously buying another option that has a longer expiration date, with

both options on the same stock and having the same strike price.

Suppose that Microsoft is trading for $40 per share. To have a calendar

spread, you can sell a $40-strike call on a Microsoft stock with option expiring

in 2 month. Simultaneously, you buy a $40-strike call on a Microsoft stock

with option expiring in 3 months. Suppose the price of a $40-strike 2-month to

expiration call is $2; the price of a $40-strike 3-month to expiration call is $5.

So your net cost of having a calendar spread at time zero is $3.

Then as time goes by, suppose the stock price doesn’t move much and is still

around $40, then the value of your sold call and purchased call both deteriorate

but at a diﬀerent deteriorating speed. The value of the $40-strike 2-month to

expiration call deteriorates much faster. With each day passing, this option has

less and less value left. If there are only several days left before expiration, the

value of the sold call will be close to zero.

With each day passing, the value of the $40-strike 3-month to expiration call

also decreases but at a slower speed.

For example, one month later, the sold call has 1 month to expiration and

is worth only $1. The purchased call has 2-month to expiration and is worth

$4.5. Now the calendar spread is worth $3.5. You can close out your position by

buying a $40-strike 1-month to expiration call (price: $1) and sell a $40-strike

2-month to expiration call (price: $4.5). If you close out your position, you’ll

get $3.5.

At time zero, you invest $3 to set up a calendar spread. One month later,

you close out your position and get $3.5. Your profit (assuming no transaction

cost) is $0.5.

Time zero: your cost is $3

$40-strike call $40-strike call

Value $2 $5

Time to expiration 2 months 3 months

12.5. IMPLIED VOLATILITY 119

$40-strike call $40-strike call

Value $1 $4.5

Time to expiration 1 month 2 months

A calendar spread can create value because as time passes the sold option

(which is your liability) can quickly become worthless yet the purchased option

(your asset) is still worth something.

For more examples, please refer to

• http://www.optionsxpress.com/educate/strategies/calendarspread.

aspx

• http://www.highyieldstrategy.com/artclndrsprds.htm.

12.5.1 Calculate the implied volatility

Volatility cannot be observed. One approach to estimating volatility is use past

returns to calculate the historical volatility. However, past volatility may be a

poor estimate of future volatility because the market condition may change.

Another approach to estimating volatility is to calculate the implied volatil-

ity. The call and put values depend on (S, K, T, r, δ, σ). Given (S, K, T, r, δ)

and the option price, we can calculate σ. This is called the implied volatility.

Calculate the implied volatility given the following information about a Eu-

ropean call.

• CEuropean = 7.25

• S = 60

• K = 55

• T = 0.75 (i.e. 9 months)

• r = 0.06

• δ = 0.02

Solution.

This is a diﬃcult problem to solve manually. However, the calculation pro-

cedure is conceptually simple.

Implied volatility is solved by trial and error. You use a trial σ and see

whether the computed option price under the trial σ reproduces the actual

option price. If the computed option price is lower than the observed option

price, use a higher trial σ and try again; if the computed option price is higher

120 CHAPTER 12. BLACK-SCHOLES

than the observed option price, use a lower trial σ and try again. Keep doing

this until you find a σ such the computed option price equals the observed option

price.

First, let’s tryµσ = 10% ¶

60 1 2

ln + 0.06 − 0.02 + 0.1 0.75

55 2

d1 = √ = 1. 3944

√ 0.1 0.75 √

d2 = d1 − σ T = 1. 3944 − 0.1 0.75 = 1. 307 8

N (d1 ) = 0.918 4 N (d2 ) = 0.904 5

−0.02(0.75)

C = 60e 0.918 4 − 55e−0.06(0.75) 0.904 5 = 6. 725

6. 725 < CEuropean = 7.25. So increase σ and try again.

Try σ = 20% µ ¶

60 1 2

ln + 0.06 − 0.02 + 0.2 0.75

55 2

d1 = √ = 0.762 2

√ 0.2 0.75 √

d2 = d1 − σ T = 0.762 2 − 0.2 0.75 = 0.5890

N (d1 ) = 0.777 0 N (d2 ) = 0.722 1

C = 60e−0.02(0.75) 0.777 0 − 55e−0.06(0.75) 0.722 1 = 7. 958

7. 958 > CEuropean = 7.25. So decrease σ and try again

Try σ = 15% µ ¶

60 1

ln + 0.06 − 0.02 + 0.152 0.75

55 2

d1 = √ = 0.965 7

√ 0.15 0.75 √

d2 = d1 − σ T = 0.965 7 − 0.15 0.75 = 0.835 8

N (d1 ) = 0.832 9 N (d2 ) = 0.798 4

C = 60e−0.02(0.75) 0.832 9 − 55e−0.06(0.75) 0.798 4 = 7. 25

7. 25 = CEuropean = 7.25.

So the implied σ is 15%.

Volatility skew refers to

• Options on the same stock with diﬀerent strike price and expiration date

should have the same implied volatility. However, in reality, options on

the same stock with diﬀerent strike price and expiration date don’t have

the same implied volatility.

"smiles," "frowns," and "smirks."

12.6. PERPETUAL AMERICAN OPTIONS 121

Implied volatility is important because it helps us

• We can generate option price that’s consistent with the price of other

similar options

• We can quote the option in terms of volatility rather than a dollar price

• Volatility skew helps us see how well an option pricing formula works.

Volatility skew shows that the Black-Scholes formula and assumptions are

not perfect.

This is all you need to know about how to use the implied volatility.

Perpetual American options are excluded from the exam syllabus. Please ignore

this chapter.

I included this section for completeness, but you don’t need to read it.

Our task here is to derive the price formula for a perpetual American call with

strike price K.

A perpetual American option never expires and the option holder can exer-

cise the option at any time. It’s a typical American option where the expiration

date T = +∞.

The theoretical framework behind the perpetual option formula is the Black-

Scholes partial diﬀerential equation (called the Black-Scholes PDE). The Black-

Scholes PDE is Derivatives Market Equation 21.11 (page 682):

1

Vt + σ 2 S 2 VSS + (r − δ) SVS − rV = 0 (Textbook 20.11)

2

(page 430):

1

θ + σ 2 St2 Γt + rSt ∆t − rV (St ) = 0 (Textbook 13.10)

2

stead of V ) to represent the option price.

The Black-Scholes PDE is commonly written as:

+ σ St + (r − δ) St − rV (t, St ) = 0 (12.24)

∂t 2 ∂St2 ∂St

122 CHAPTER 12. BLACK-SCHOLES

In the above equation, V (t, St ) is the option price at time t where the stock

price is St .

If you are interested in learning how to derive the Black-Scholes PDE, refer

to the textbook. For now let’s accept Equation 12.24.

∂V

For a perpetual option, its value doesn’t depends on time. Hence = 0.

∂t

The Black-Scholes PDE becomes an ordinary diﬀerential equation:

1 2 2 d2 V (t, St ) dV (t, St )

σ St + (r − δ) St − rV (t, St ) = 0 (12.25)

2 dSt2 dSt

To find the solution to Equation 12.25, let’s simplify the equation as

d2 V (t, St ) dV (t, St )

St2 + St − V (t, St ) = 0

dSt2 dSt

We can guess the solution is in the form of V (t, St ) = Sth . Then

dV (t, St ) d2 V (t, St )

= hSth−1 = h (h − 1) Sth−2

dSt dSt2

d2 V (t, St ) dV (t, St )

St2 + St − V (t, St )

dSt2 dSt

= St2 h (h − 1) Sth−2 + St hSth−1¡ − Sth ¢

= Sth [h (h − 1) + h − 1] = Sth h2 − 1

¡ ¢ d2 V (t, St ) dV (t, St )

So as long as h2 − 1 = 0, or h = ±1, Equation St2 2 +St −

dSt dSt

V (t, St ) = 0 has a solution.

Of course, if Sth is a solution, aSth must also be a solution.

Similarly, we can guess that the solution to Equation 12.25 is in the form of

V (t, St ) = Sth . Some brilliant thinker guessed the following solution:

µ ¶h

∗ St H∗ − K h

V (t, St ) = (H − K) = h

St = aSth

H∗ (H ∗ )

Here H ∗ the stock price where exercise is optimal (H ∗ is a constant). H ∗ −K

µ ¶h

St

is the terminal payoﬀ at exercise time. is an indicator telling us how

H∗

∗

close the stock price approaches H .

dV (t, St ) d ¡ h¢ d2 V (t, St )

= aSt = ahSth−1 = ah (h − 1) Sth−2

dSt dS dSt2

Equation 12.25 becomes:

1 2 2

σ St ah (h − 1) Sth−2 + (r − δ) St ahSth−1 − raSth = 0

2

1 2

σ h (h − 1) + (r − δ) h − r = 0

2 µ ¶

1 2 2 1 2

σ h + r−δ− σ h−r =0

2 2

sµ ¶2

1 2 1

σ − (r − δ) ± r − δ − σ 2 + 2σ 2 r

2 2

h= 2

σ

12.6. PERPETUAL AMERICAN OPTIONS 123

sµ ¶2

1 r−δ r−δ 1 2r

= − 2 ± − +

2 σ σ2 2 σ2

sµ ¶2

1 r−δ 1 r−δ 2r

= − 2 ± − 2 +

2 σ 2 σ σ2

But how can we find H ∗ ? Since the perpetual American option can be ex-

ercised at any time, the option holder will choose H ∗ such that V (t, St ) =

µ ¶h

St dV (t, St )

(H ∗ − K) ∗

reaches its maximum value. This requires setting =

H dH ∗

0. " µ ¶h #

dV (t, St ) d ∗ St

= (H − K)

dH ∗ dH ∗ H∗

d h i

∗ 1−h ∗ −h

= Sth (H ) − K (H )

hdH ∗ i

−h −h−1

= St (1 − h) (H ∗ ) − K (−h) (H ∗ )

h

=0

(1 − h) H ∗ − K (−h) = 0

K (−h) h

H∗ = = K

1−h h−1

h 1

H∗ − K = K −K = K

h−1 h−1

µ ¶h µ ¶h

∗ St K h − 1 St

So V (t, St ) = (H − K) =

H∗ h−1 h K

Set t = 0. Let S represent the stock price at time zero (i.e. S = S0 ). Then

the option value at time zero is

µ ¶h µ ¶h

S K h−1 S

V (0, S) = (H ∗ − K) =

H∗ h−1 h K

1

K. To avoid h − 1 becoming negative, we choose the bigger h:

h−1 sµ ¶2

1 r−δ 1 r−δ 2r

hcall = − + − 2 + 2

2 σ2 2 σ σ

the put value is:

µ ¶h

∗ St K − H∗ h

V (t, St ) = (K − H ) = h

St = bSth

H∗ (H ∗ )

124 CHAPTER 12. BLACK-SCHOLES

1 2

σ h (h − 1) + (r − δ) h − r = 0

2 µ ¶

1 2 2 1

σ h + r − δ − σ2 h − r = 0

2 s2µ ¶2

1 r−δ 1 r−δ 2r

h= − 2 ± − + 2

2 σ 2 σ2 σ

dV (t, St )

Set = 0:

dH ∗ " µ ¶h #

dV (t, St ) d S h i

∗ t h d ∗ ∗ −h

= (K − H ) = (St ) (K − H ) (H )

dH ∗ dH ∗ H∗ dH ∗

d h i

= (St )h K (H ∗ )−h − (H ∗ )1−h

hdH ∗ i

h −h−1 −h

= (St ) K (−h) (H ∗ ) − (1 − h) (H ∗ ) =0

−h−1 −h

K (−h) (H ∗ ) − (1 − h) (H ∗ ) =0

h

K (−h) − (1 − h) H ∗ = 0 → H∗ = K

µ ¶ h − 1

h 1

→ K − H∗ = 1 − K= K

h−1 1−h

To avoid 1 − h becoming

sµ negative, ¶

we choose the smaller h:

2

1 r−δ 1 r−δ 2r

hput = − − − + 2

2 σ2 2 σ2 σ

Summary of the formulas for perpetual American calls and perpetual Amer-

ican puts:

µ ¶hcall µ ¶hcall

∗ S K hcall − 1 S

Cperpetual = (HCall − K) ∗ =

HCall hcall − 1 hcall K

(12.26)

∗ hcall

HCall = K (12.27)

hcall − 1

µ ¶ sµ ¶2

1 r−δ 1 r−δ 2r

hcall = − 2

+ − 2 + 2 (12.28)

2 σ 2 σ σ

µ ¶hput µ ¶hput

¡ ∗

¢ S K hput − 1 S

Pperpetual = K − Hput ∗ = (12.29)

Hput 1 − hput hput K

∗ hput

Hput = K (12.30)

hput − 1

12.6. PERPETUAL AMERICAN OPTIONS 125

µ ¶ sµ ¶2

1 r−δ 1 r−δ 2r

hput = − 2 − − 2 + (12.31)

2 σ 2 σ σ2

1 2

hcall and hput satisfies: σ h (h − 1) + (r − δ) h − r = 0 (12.32)

2

Example 12.6.1. Calculate the price of a perpetual American call and the price

of an otherwise identical perpetual American put. The information is as follows.

The current stock price is S = 50. The strike price is K = 45. The continuously

compounded risk-free rate is r = 6%. The continuously compounded dividend

yield is 2%. The stock volatility is σ = 25%.

Solution.

Solve for h.

1 2

σ h (h − 1) + (r − δ) h − r = 0

2

1

× 0.252 h (h − 1) + (0.06 − 0.02) h − 0.06 = 0

2

h1 = 1. 252 7 h2 = −1. 532 7

Use the bigger h for call and the smaller h for put.

Next, calculate the stock price where exercising the option is optimal.

∗ hcall 1. 252 7

HCall = K= × 45 = 223. 08

hcall − 1 1. 252 7 − 1

∗ hput −1. 532 7

Hput = K= × 45 = 27. 23

hput − 1 −1. 532 7 − 1

µ ¶hcall µ ¶1. 252 7

∗ S 50

Cperpetual = (HCall − K) ∗ = (223. 08 − 45) =

HCall 223. 08

27. 35 µ ¶hput µ ¶−1. 532 7

¡ ∗

¢ S 50

Pperpetual = K − Hput ∗ = (45 − 27. 23 ) = 7.

Hput 27. 23

00

Tip 12.6.1. The CD attached to the textbook Derivatives Markets has a spread-

sheet that calculates the price of a perpetual American call and a perpetual Amer-

ican put. The spreadsheet is titled "optbasic2." You can use this spreadsheet to

double check your solution.

Consider the following barrier option. If the stock price first reaches a preset

price H from below, then the payoﬀ of $1 is received. This is a special case of a

∗

perpetual American call option by setting the terminal payoﬀ HCall − K as $1

∗

and by setting HCall = H.

126 CHAPTER 12. BLACK-SCHOLES

The value at time zero of $1 received when the stock price first reaches H

from below (i.e. the stock first rises to H) is

µ ¶h1

S

(12.33)

H

µ ¶ sµ ¶2

1 r−δ 1 r−δ 2r

h1 = − 2 + − 2 + (12.34)

2 σ 2 σ σ2

Similarly, the value at time zero of $1 received when the stock price first

reaches H from above (i.e. the stock first falls to H) is

µ ¶h2

S

(12.35)

H

µ ¶ sµ ¶2

1 r−δ 1 r−δ 2r

h2 = − 2 − − 2 + (12.36)

2 σ 2 σ σ2

1 2

h1 and h2 satisfies: σ h (h − 1) + (r − δ) h − r = 0 (12.37)

2

Example 12.6.2.

Calculate the value of a $1 paid if the stock price first reaches $100 and $60

respectively. The information is:

• S = 80

• r = 6%

• δ = 2%

• σ = 30%

Solution.

• calculate the value of a $1 paid if the stock price first reaches $100

H = 100 > S. So we need to calculate the price of $1 payoﬀ when the stock

price first rises to H from below

1 2

σ h (h − 1) + (r − δ) h − r = 0

2

1 2

0.3 h (h − 1) + (0.06 − 0.02) h − 0.06 = 0

2

h1 = 1. 211 6 h2 = −1. 100 5

Use the bigger h

µ ¶h1 µ ¶1. 211 6

S 80

= = 0.763

H 100

12.6. PERPETUAL AMERICAN OPTIONS 127

• calculate the value of a $1 paid if the stock price first reaches $90

H = 60 < S.So we need to calculate the price of $1 payoﬀ when the stock

price first falls to H from above.

h1 = 1. 211 6 h2 = −1. 100 5

Use the smaller

µ ¶h2 µ ¶−1. 100 5h

S 80

= = 0.729

H 60

Tip 12.6.2. The CD attached to the textbook Derivatives Markets has a spread-

sheet that calculates the price of a barrier option. The spreadsheet is titled "opt-

basic2." You can use this spreadsheet to double check your solution.

128 CHAPTER 12. BLACK-SCHOLES

Chapter 13

Market-making and

delta-hedging

∂V

Here is the main idea behind delta hedging. Delta of an option is ∆ = .

∂S

Hence for a small change in stock price, the change of the option value is ap-

proximately V1 − V0 ≈ ∆ (S1 − S0 ). Suppose you sell one European call option.

If you hold ∆ shares of stock, you are immunized against a small change of the

stock price.

If the stock price goes up from S0 to S1 , then the call will be more valuable

to the buyer and your are exposed to more risk. Suppose the value of the call

goes up from V0 to V1 as the stock price goes up from S0 to S1 , then your

liability will increase by V1 − V0 . At the same time, the value of your ∆ shares

of stock will go up by ∆ (S1 − S0 ). Because V1 − V0 ≈ ∆ (S1 − S0 ), the increase

of your liability will be roughly oﬀset by the increase of your asset.

However, under delta hedging, you are immunized against only a small

change of the stock price (just like immunization by duration matching assets

and liabilities is only good for a small change of interest rate). If a big change

of stock price knocks oﬀ your hedging, you’ll need to rebalance your hedging.

However, in the real world, continuously rebalancing the hedging portfolio

is impossible. Traders can only do discrete rebalancing.

Make sure you can reproduce the textbook calculation of delta-hedging for 2

days. In addition, make sure you can reproduce the textbook table 13.2 and

13.3

Exam problems may ask you to outline hedging transactions or calculate the

hedging profit.

129

130 CHAPTER 13. MARKET-MAKING AND DELTA-HEDGING

The major diﬃculty many candidates face is not knowing how to hedge.

They wonder "Should the market-maker buy stocks? Should he sell stocks?"

To determine how to hedge a risk, use the following ideas:

on option, he must lose money on stock; if he loses money on

option, he must make money on stock.

ask "If the stock price go up (or down), will the trader make

money or lose money on the option?"

• If a trader loses money on the option as the stock price goes up,

then the trader needs to initially own (i.e. buy) stocks. This

way, the value of the trader’s stocks will go up and the trader

will make money on his stocks. He can use this profit to oﬀset

his loss in the option.

up, then the trader needs to initially short sell stocks. This way,

as the stock price goes up, the trader will lose money on the

short sale (because he needs to buy back the stocks at a higher

price). His loss in short sale can oﬀset his profit in option.

Example 13.2.1. The trader sells a call. How can he hedge his risk,?

If the stock price goes up, the call payoﬀ is higher and the trader will lose

money. To hedge this risk, the trader should buy stocks. This way, if the stock

price goes up, the trader makes money in the stocks. This profit can be used to

oﬀset the trader’s loss in the written call.

You can also ask the question "If the stock goes down, will the trader make

money or lose money on the option?" If the stock goes down, the call payoﬀ is

lower and the trader will make money. To eat up his profit in the option, the

trader needs to buy stocks. This way, as the stock price goes down, the value

of the trader’s stocks will go down too and the trader will lose money in his

stocks. This loss will oﬀset the trader’s profit in the written call.

Example 13.2.2. The trader sells a put. How can he hedge his risk?

If the stock price goes down, the put payoﬀ is higher and the trader will

make money. To hedge his risk, the trader should short sell stocks. This way,

if the stock price goes down, the trader can buy back stocks at lower price,

making a profit on stocks. This profit can be used to oﬀset the trader’s loss in

the written put.

You can also ask the question "If the stock goes up, will the trader make

money or lose money on the option?" If the stock goes up, the put payoﬀ is

lower and the trader will make money on the written put. To eat up his profit

in the option, the trader needs to short sell stocks. This way, as the stock price

13.2. EXAMPLES OF DELTA HEDGING 131

goes up, the trader needs to buy back stocks at a higher price. The trader will

lose money in his stocks. This loss will oﬀset the trader’s profit in the written

put.

Example 13.2.3. The trader buys a call. How can he hedge his risk?

If a trader buys a call, the most he can lose is his premium and there’s no

need to hedge. This is diﬀerent from selling a call, where the call seller has

unlimited loss potential.

However, if a trader really wants to hedge his limited risk, he can short sell

stocks.

Example 13.2.4. The trader buys a put. How can he hedge his risk?

If a trader buys a put, the most he can lose is his premium and there’s no

need to hedge. This is diﬀerent from selling a put, where the call seller has a

big loss potential.

However, if a trader really wants to hedge his limited risk, he can buy stocks.

Example 13.2.5.

recap of the information. At time zero the market maker sells 100 European

call options on a stock. The option expires in 91 days.

• K = $40

• r = 0.08

• δ=0

• σ = 0.3

The market-maker delta hedges its position daily. Calculate the market-

maker’s daily mark-to-market profit

Solution.

First, let’s calculate the call premium and delta at Day 0, Day 1, and Day 2.

I used my Excel spreadsheet to do the following calculation. If you can’t fully

match my numbers, it’s OK.

132 CHAPTER 13. MARKET-MAKING AND DELTA-HEDGING

Expiry T (Yrs) 91/365 90/365 89/365

µ ¶ St 40 40.50 39.25

St 1

ln + 0.08 + × 0.32 T

40 2

d1 = √ 0.208048 0.290291 0.077977

0.3 T

N (d

√1 ) 0.582404 0.614203 0.531077

d2 = d1 − 0.3 T 0.058253 0.141322 −0.070162

N (d2 ) 0.523227 0.556192 0.472032

C = St N (d1 ) − 40e−0.08T N (d2 ) 2.7804 3.0621 2.3282

∆ = e−δ(T −t) N (d1 ) 0.58240 0.61420 0.53108

Time t Day 0 t = 0 Day 1 t = 1/365 Day 2 t = 2/365

Expiry T T0 = 91/365 T1 = 90/365 T2 = 89/365

St S0 = 40 S1 = 40.50 S2 = 39.25

Ct C0 = 100 × 2.7804 = 278. 04 C1 = 306.21 C2 = 232.82

∆t ∆0 = 100 × 0.58240 = 58. 24 ∆1 = 61.420 ∆2 = 53.108

Beginning of Day 0

Trader #0 goes to work

Day 0 t = 0

T0 = 91/365

S0 = 40

C0 = 278.04

∆0 = 58.240

Trader #0 goes to work. The brokerage firm (i.e. the employer of Trader

#0) gives Trader #0 C0 = $278. 04. This is what the call is worth today.

Trader #0 needs to hedge the risk of the written call throughout Day 0.

To hedge the risk, Trader #0 buys ∆0 stocks, costing ∆0 S0 = 58. 24×40 = $

2329. 6. Since Trader #0 gets $278. 04 from the brokerage firm, he needs to

borrow:

∆0 S0 − C0 = 2329. 6 − 278. 04 = $2051. 56.

The trader can borrow $2051. 56 from a bank or use this own money. Either

way, this amount is borrowed. The borrowed amount earns a risk free interest

rate.

Now Trader #0’s portfolio is:

Component Value

∆0 = 58.24 stocks 2487. 51

call liability −278. 04

borrowed amount 2051. 56

Net position 0

13.2. EXAMPLES OF DELTA HEDGING 133

Day 1 t = 1/365

T1 = 90/365

S1 = 40.50

C1 = 306.21

Method 1

To cancel out his position, Trader #0 can at t = 0

• buy a call (we call this the 2nd call) from the market paying C1 = $306.

21. At expiration, the payoﬀ of this 2nd call will exactly oﬀset the payoﬀ

of the 1st call. The 1st call is the call sold by the brokerage firm at t = 0

to the customer who bought the call. For example, if at expiration the

stock price is ST = 100, then both calls are exercised. The trader gets

ST − K = 100 − 40 = 60 from the 2nd call. The liability of the first call

is also $60. These two calls cancel each other out.

2052. 01

−306. 21 + 2358. 72 − 2052. 01 = 0.5

Trader #0 hands in $0.5 profit to his employer and goes home.

2329. 6. In the end of Day 0 (or the beginning of Day 1), the trader’s stock

is worth ∆0 S1 = 58. 24 (40.5) = 2358. 72. The value of the trader’s 58. 24

stocks goes up by 58. 24 (40.5 − 40) = 29. 12. This is good for the trader.

• In the beginning of Day 0, the call is worth C0 = $278. 04. In the end of

Day 0 (or the beginning of Day 1), the call is worth C1 = 306.21. The call

value is the trader’s liability. Now the trader’s liability increases by 306.

21 − 278. 04 = 28. 17. So the trader has a loss 28. 17 (or a gain of −28.75).

Recall under Method 1, the trader has to buy a call for 306. 21 to cancel

out the call he sold. So call value increase is bad for the trader.

In the end of Day 0 (or the beginning of Day 1), this borrowed amount

grows to (∆0¡S0 − C0 ¢) erh = 2051. 56e0.08×1/365 = 2052. 01. The increase

(∆0 S0 − C0 ) erh − 1 = 2051. 56e0.08×1/365 − 2051. 56 = 0.45. This is

the interest paid on the amount borrowed. No matter the trader borrows

money from a bank or uses his own money, the borrowed money needs to

earn a risk free interest rate.

134 CHAPTER 13. MARKET-MAKING AND DELTA-HEDGING

¡ ¢

∆0 S1 − ∆0 S0 − (C1 − C0 ) − (∆0 S0 − C0 ) erh − 1 = 29. 12 − 28. 17 − 0.45 =

0.5

You can verify that ¡ ¢

∆0 S1 −∆0 S0 −(C1 − C0 )−(∆0 S0 − C0 ) erh − 1 = −C1 +∆0 S1 −(∆0 S0 − C0 ) erh

Method 3

On Day 0, the trader owns ∆0 = 58.240 stocks to hedge the call liability

C0 = $278. 04. The trader’s net asset is

M V (0) = ∆0 S0 − C0 = 58. 24 × 40 − 278. 04 = $2051. 56

In the end of Day 0 (or the beginning of Day 1) before the trader rebalances

his portfolio, the trader’s asset is:

M V BR (1) = ∆0 S1 − C1 = 58. 24 × 40.5 − 100 × 3.0621 = 2052. 51

BR stands for before rebalancing.

The trader’s profit at the end of Day 0 is:

M V BR (1) − M V (0) e0.08×1/365 = (∆0 S1 − C1 ) − (∆0 S0 − C0 ) erh = 2052.

51 − 2051. 56e0.08×1/365 = 0.50

Please note that Trader #0 doesn’t need to rebalance the portfolio. The

portfolio is rebalanced by the next trader.

Beginning of Day 1

Trader #1 goes to work

Day 1 t = 1/365

T1 = 90/365

S1 = 40.50

C1 = 306.21

∆1 = 61.420

automatically rebalanced since Trader #1 starts from scratch.

Trader #1 needs to hedge the risk of the written call throughout Day 1.

To hedge the risk, Trader #1 buys ∆1 = 61.420 stocks, costing ∆1 S1 =

61.42 × 40.5 = $2487. 51. Since Trader #1 gets $306.21 from the brokerage firm,

he needs to borrow:

∆1 S1 − C1 = 2487. 51 − 306.21 = 2181. 3

The trader can borrow $2181. 3 from a bank or use this own money. Either

way, this amount is borrowed. The borrowed amount earns a risk free interest

rate.

Now Trader #1’s portfolio is:

13.2. EXAMPLES OF DELTA HEDGING 135

component value

∆1 = 61.42 stocks 2487. 51

call liability −306.21

borrowed amount 2181. 3

Net position 0

One question arises, "What if Trader #1 doesn’t start from a clean slate?"

Next, we’ll answer this question.

Instead of starting from scratch, Trader #1 can start oﬀ with Trader #0’s

portfolio. At the end of Day 0, Trader #0 has

• ∆0 = 58.24 stocks

• a borrowed amount (∆0 S0 − C0 ) erh = 2051. 56e0.08×1/365 = 2052. 01

• 0.5 profit

buys additional shares:

∆1 − ∆0 = 61.42 − 58.24 = 3. 18

The cost of these additional shares is (∆1 − ∆0 ) S1 = 3. 18 × 40.5 = 128. 79

Since these additional shares are bought at the current market price, Trader

#1 can sell these shares at the same price he bought them. This doesn’t aﬀect

the mark-to-market profit.

Trader #1 can borrow 128. 79 to pay for the purchase of 3. 18 stocks.

Now Trader #1 has a total of ∆1 = 61.42 shares worth ∆1 S1 = 61.42×40.5 =

2487. 51

His liability is now C1 = 306.21

The borrowed amount is now 2052. 01 + 128. 79 + 0.5 = 2181. 3. The 0.5 (the

profit made by Trader #0) is the amount of money Trader #1 borrows from

Trader #0.

component value

∆1 = 61.42 stocks $2487. 51

call liability −306.21

borrowed amount 2181. 3

Net position 0

The portfolio is the same as the portfolio if Trader #1 starts from scratch.

Calculation is simpler and cleaner if we start from scratch.

Mark to market without rebalancing the portfolio

Day 2 t = 2/365

T2 = 89/365

S2 = 39.25

C2 = 232.82

136 CHAPTER 13. MARKET-MAKING AND DELTA-HEDGING

Method 1

To cancel out his position, the trader can

• buy a call from the market paying C2 = 232.82. The payoﬀ of this call

will exactly oﬀset the payoﬀ of the call sold by the brokerage firm to the

customer. These two call have the common expiration date T1 = 89/365

and the same payoﬀ. They will cancel each other out.

• sell out ∆1 = 61.420 stocks for ∆1 S2 = 61.420 × 39.25 = 2410. 735

• pay oﬀ the loan. The payment is (∆1 S1 − C1 ) erh = 2181. 3e0.08×1/365 =

2181. 778

−C2 + ∆1 S2 − (∆1 S1 − C1 ) erh = 232.82 + 2410. 735 − 2181. 778 = −3. 863

Trader #1 hands in −3. 863 profit to his employer and goes home.

the end of Day 1 (or the beginning of Day 2).

Day 1 (or the beginning of Day 2), the trader’s stock is worth ∆1 S2 . The

value of the trader’s stocks goes up by ∆1 S2 − ∆1 S1

• In the beginning of Day 1, the call is worth C1 ; In the end of Day 1 (or the

beginning of Day 2), the call is worth to C2 . The call value is the trader’s

liability. Now the trader’s liability increases by C2 − C1

• In the beginning of Day 1, the borrowed amount is ∆1 S1 − C1 . In the

end of Day 1 (or the beginning of Day 2), this borrowed

¡ ¢amount grows

to (∆1 S1 − C1 ) erh . The increase is (∆1 S1 − C1 ) erh − 1 . This is the

interest paid on the amount borrowed. No matter the trader borrows

money from a bank or uses his own money, the borrowed money needs to

earn a risk free interest rate.

(∆1 S2 − ∆1 S1 ) − (C2 − C1 ) − (∆1 S1 − C1 ) erh − 1

= −C2 + ∆1 S2 − (∆1 S1 − C1 ) erh = −3. 863

Method 3

M V (1) = ∆1 S1 − C1 = 61.420 × 40.5 − 306.21 = 2181. 3

In the end of Day 1 before the trader rebalances his portfolio, the trader’s

asset is:

M V BR (2) = ∆1 S2 − C2 = 61.420 × 39.25 − 232.82 = 2177. 915

The trader’s profit at the end of Day 1 is:

M V BR (2) − M V (1) erh = 2177. 915 − 2181. 3e0.08×1/365 = −3. 863

13.2. EXAMPLES OF DELTA HEDGING 137

M V BR (2) − M V (1) erh ¡ ¢

= (∆1 S2 − ∆1 S1 ) − (C2 − C1 ) − (∆1 S1 − C1 ) erh − 1

= −C2 + ∆1 S2 − (∆1 S1 − C1 ) erh

Method 3 is often faster. Under this method,

Profit during a day=Asset at the end of Day before rebalancing the portfolio

- Future value of the asset at the beginning of the day

Asset at the end of Day before rebalancing the portfolio = delta at the

beginning of the day × stock price at the end of the day

Profit at the end of Day t = M V BR (t + 1)−M V (t) erh = (∆t St+1 − Ct+1 )−

(∆t St − Ct ) erh

Next, let’s do additional calculations and calculate the profit at the end of

Day 2, 3, and 4 (or the profit at the beginning of Day 3,4,5)

Time t t = 2/365 t = 3/365 t = 4/365 t = 5/365

Expiry T T2 = 89/365 T3 = 88/365 T4 = 87/365 T5 = 86/365

St S2 = 39.25 S3 = 38.75 S4 = 40 S5 = 40

Ct C2 = 232.82 C3 = 205. 46 C4 = 271.04 C5 = 269.27

∆t ∆2 = 53.108 ∆3 = 49. 564 ∆4 = 58.06 ∆5 = 58.01

Profit end of Day 0.40 −4. 0 1. 32

232.82 = 1851. 669

53.108 × 38.75 − 205. 46 = 1852. 475

• Profit at the end of Day 2: M V BR (3) − M V (2) erh = 1852. 475 − 1851.

669e0.08/365 = 0.400 1

205. 46 = 1715. 145

49. 564 × 40 − 271.04 = 1711. 52

145e0.08/365 = −4. 000 96

138 CHAPTER 13. MARKET-MAKING AND DELTA-HEDGING

271.04 = 2051. 36

58.06 × 40 − 269.27 = 2053. 13

36e0.08/365 = 1. 320 3

You can verify that the profit at the end of Day 2, 3, 4 calculated above

matches Derivatives Markets Table 13.2. However, in Table 13.2, the profit at

the end of Day 0 is posted in Day 1 column. Similarly, the profit at the end of

Day 1 is posted in Day 1 column. So on and so forth.

Next, we want to reproduce the textbook Table 13.2.

Profit at the end of Day t (or the beginning of Day t + 1) can be broken

down into two parts:

= M V BR (t + 1) − M V (t) erh = M V BR (t + 1) − M V (t) − M V (t) erh +

M V (t) ¡ ¢

= M V BR (t + 1) − M V (t) − M V (t) erh − 1

¡ ¢

= M V BR (t + 1) − M V (t) + −M V (t) erh − 1

| {z } | {z }

capital gain at end of Day t Interest earned at the end of Day t

CapitalGain (t) is also equal to:

M V BR (t + 1)−M V (t) = (∆t St+1 − Ct+1 )−(∆t St − Ct ) = ∆t (St+1 − St )−

(Ct+1 − Ct )

¡ ¢

Define −M V (t) erh − 1 as the interest earned at the end of Day t. If the

trader invests

¡ money

¢ at the beginning of Day t, then M V (t) is positive and

−M V (t) erh − 1 is negative. The negative interest earned is just the interest

expense incurred by the trader.

is negative, then it means that the trader receives money.

Example 13.3.1.

We already reproduced the daily profit in Table 13.2. We just need to

reproduce the investment, interest, and the capital gain.

13.3. TEXTBOOK TABLE 13.2 139

Day 0 1 2

Time t t=0 t = 1/365 t = 2/365

Expiry T T0 = 91/365 T1 = 90/365 T2 = 89/365

St S0 = 40 S1 = 40.5 S2 = 39.25

Ct C0 = 278.04 C1 = 306.21 C2 = 232.82

∆t ∆0 = 58.2404 ∆1 = 61.42 ∆2 = 53.108

Investment (beginning of the day) 2051. 56 2051. 56 1851. 669

interest earned during the day −0.45 −3. 385 −0.41

Capital gain (end of the day) 0.95 −0.478 0.81

Profit (end of the day) 0.50 −3. 863 0.40

Day 0

We already know:

M V (0) = ∆0 S0 − C0 = 58. 24 × 40 − 278. 04 = $2051. 56

M V BR (1) = ∆0 S1 − C1 = 58. 24 × 40.5 − 100 × 3.0621 = 2052. 51

The trader’s profit at the end of Day 0 is:

M V BR (1) − M V (0) erh = 2052. 51 − 2051. 56e0.08×1/365 = 0.50

To find the capital gain and the interest earned at the end of Day 0, we just

need to break down the profit M V BR (1) − M V (0) erh into two parts:

M V BR (1) − M V (0) erh

= M V BR (1) − M V (0) − M V (0) erh + M V (0)

¡ rh ¢

BR

= MV (1) − M V (0) + −M V (0) e − 1

| {z } | {z }

capital gain interest earned

M V BR (1) − M V (0) = 2052. 51 − 2051. 56 = 0.95

The interest

¡ credited

¢ at the end¡of Day 0: ¢

−M V (0) erh − 1 = −2051. 56 e0.08×1/365 − 1 = −0.449 7 = −0.45

Investment at the beginning of Day 0:

M V (0) = 2051. 56

Please note the textbook shows the interest credited at the end of Day 0,

capital gain earned at the end of Day 0, and daily profit at the end of Day 0 in

Day 1 column.

Day 1

M V (1) = ∆1 S1 − C1 = 61.420 × 40.5 − 306.21 = 2181. 3

M V BR (2) = ∆1 S2 − C2 = 61.420 × 39.25 − 232.82 = 2177. 915

The trader’s profit at the end of Day 1 is:

M V BR (2) − M V (1) erh = 2177. 915 − 2181. 3e0.08×1/365 = −3. 863

140 CHAPTER 13. MARKET-MAKING AND DELTA-HEDGING

To find the capital gain and the interest earned at the end of Day 0, we just

need to break down the profit M V BR (1) − M V (0) erh into two parts:

¡ ¢

M V BR (2) − M V (1) erh = M V BR (2) − M V (1) + −M V (1) erh − 1

| {z } | {z }

capital gain interest earned

Capital gain at the end of Day 1: M V BR (2) − M V (1) = 2177. 915 − 2181.

3 = −3. 385

¡ ¢ ¡ ¢

Interest earned at the end of Day 1: −M V (1) erh − 1 = −2181. 3 e0.08×1/365 − 1 =

−0.478

Investment at the beginning of Day 1:

M V (1) = ∆1 S1 − C1 = 61.420 × 40.5 − 306.21 = 2181. 3

You should be able to reproduce Table 13.2 for the other days.

Day 3 4 5

Time t t = 3/365 t = 4/365 t = 5/365

Expiry T T3 = 88/365 T4 = 87/365 T5 = 86/365

St S3 = 38.75 S4 = 40 S5 = 40

Ct C3 = 205. 46 C4 = 271.04 C5 = 269.27

∆t ∆3 = 49. 564 ∆4 = 58.06 ∆5 = 58.01

Investment (beginning of the day) 1715. 15 2051. 36

interest earned during the day −0.38 −0.45

Capital gain (end of the day) −3. 63 1. 77

Profit (end of the day) −4. 01 1. 32

The stock price of Table 13.3 follows the binomial tree with σ = 0.3.

On Day 0, the stock price is S0 = 40

On Day 1 the√stock moves up 1 σ√

S1 = S0 erh+σ h = 40e0.08/365+0.3 1/365 = 40.642

Day 2 the stock√

moves down 1 σ √

S2 = S1 e rh−σ h

= 40.642e0.08/365−0.3 1/365 = 40. 018

Day 3 the stock√

moves down 1 σ √

S3 = S2 erh−σ h = 40. 018e0.08/365−0.3 1/365 = 39. 403

Day 4 the stock√

moves down 1 σ √

S4 = S3 e rh−σ h

= 39. 403e0.08/365−0.3 1/365 = 38. 797

Day 5 the stock√

moves up 1 σ √

S5 = S4 erh+σ h = 38. 797e0.08/365+0.3 1/365 = 39. 420

If you use the same method for reproducing Table 13.2, you should be able

to reproduce Table 13.3. When reading Table 13.3, remember the interest, the

capital gain, and the daily profit on Day 1 is the interest, the capital gain, and

the daily profit at the end of Day 0 (or the beginning of Day 1). Similarly, the

13.5. MATHEMATICS OF DELTA HEDGING 141

interest, the capital gain, and the daily profit on any other day is the interest,

the capital gain, and the daily profit at the end of the previous day or the

beginning of that day.

The author of the textbook uses Table 13.3 to show us that if the stock price

moves up or down 1 σ daily, then the trader’s profit is zero.

13.5.1 Delta-Gamma-Theta approximation

First, let’s understand the textbook Equation 13.6:

1 2

V (St+h , T − t − h) ≈ V (S0 , T − t) + ∆t + θh + Γt (Textbook 13.6)

2

in T − t years). The value of this option is V (St , T − t), where St is the stock

price at t. Suppose a tiny time interval h (such as 0.00001 second) has passed

and we are now standing at t + h. Now the option has a remaining life T − t − h

years and is worth V (St+h , T − t − h), where St+h is the stock price at t + h.

Suppose St+h = St + .

Time t t+h T

Stock price St St+h = St +

Option value V (St , T − t) V (St+h , T − t − h)

∂f (x0 , y0 ) ∂f (x0 , y0 )

f (x0 + x , y0 + y ) ≈ f (x0 , y0 ) + x+ y

∂x ∂y

2 2

1 ∂ f (x0 , y0 ) 2 1 ∂ f (x0 , y0 ) 2

+ x+ y

2 ∂x2 2 ∂y 2

Similarly,

V (St+h , T − t − h) = V [St+h , − (t + h) + T ]

∂V (St , T − t) ∂V (St , T − t)

≈ V (St , T − t) + + h

∂S ∂t

2 2

∂

1 V (St , T − t) 2 1 ∂ V (St , T − t) 2

+ + h

2 ∂S 2 2 ∂t2

However,

∂V (St , T − t) ∂V (St , T − t) ∂ 2 V (St , T − t)

= ∆t =θ = Γt

∂S ∂t ∂S 2

1 ∂ 2 V (St , T − t) 2

We decide to ignore h since it’s close to zero. However,

2 ∂t2

1 ∂ 2 V (St , T − t) 2 1 ∂ 2 V (St , T − t) 2

is not close to zero. The reason that h

2 ∂S 2 2 ∂t2

142 CHAPTER 13. MARKET-MAKING AND DELTA-HEDGING

1 ∂ 2 V (St , T − t) 2

is close to zero but is not close to zero will be explained

2 ∂S 2

in Derivatives Markets Chapter 20 when we derive Ito’s Lemma. For now just

accept it.

Now we have:

1 2

V (St+h , T − t − h) ≈ V (St , T − t) + ∆t + θh + Γt

2

Suppose a trader sets up a hedging portfolio at time t. The trader’s profit after

a short interval h (i.e. at time t + h) is:

P rof it (t + h)

= M V BR (t + h) − M V (t) erh

= (∆t St+h − Ct+h ) − (∆t St − Ct ) e¡rh ¢

= (∆t St+h − Ct+h ) − (∆t St − Ct ) erh − 1 + (∆ t St − ¢

¡ rh Ct )

= ∆t (St+h − St ) − (Ct+h − Ct ) − (∆t St − Ct ) e − 1

For a small h, using Taylor series, we get erh ≈ 1 + rh

P rof it (t + h) = ∆t (St+h − St ) − (Ct+h − Ct ) − rh (∆t St − Ct )

1

Ct+h − Ct = ∆t + θh + Γt 2

2 µ ¶

1

P rof it (t + h) = ∆t (St+h − St ) − ∆t + θh + Γt 2 − rh (∆t St − Ct )

2

Since St+h = St + , we have:

P rof it (tµ+ h) ¶

1 2

= ∆t − ∆t + θh + Γt − rh (∆t St − Ct )

2

µ ¶

1 2

= − θh + Γt − rh (∆t St − Ct )

2

µ ¶

1 2

P rof it (t + h) ≈ − Γt + θh − rh [∆t St − Ct ] (Textbook 13.7)

2

√

However, St+h = St erh+σ h

√ ³ √ ´ 1³ √ ´2

Using the Taylor series, we have: erh+σ h

= 1+ rh + σ h + rh + σ h +

2

...

1³ √ ´2

As h → 0, rh + σ h and higher order terms all approach zero.

2 √

√ In addition, as h approaches 0, h is much larger than h. For example,

0.0001 = 0.01 is much larger than 0.0001.Hence, we can discard rh but keep

√

σ h.

13.5. MATHEMATICS OF DELTA HEDGING 143

µ ³ ¶

√ √ ´ 1³ √ ´2 ³ √ ´

→ St+h = St erh+σ h

= St 1 + rh + σ h + rh + σ h + ≈ St 1 + σ h

√ 2

→ = St+h − St ≈ St σ h

→ 2 ≈ St2 σ2 h

Plug the above equation in Textbook Equation 13.7, we get:

µ ¶

1 2 2

P rof it (t + h) ≈ − St σ hΓt + θh − rh [∆t St − Ct ] (Textbook 13.9)

2

From the textbook Table 13.3, we know that if the stock price moves up or

down µ

by 1 σ, the trader’s profit is zero. ¶So

1 2 2

− S σ hΓt + θh − rh [∆t St − Ct ] = 0

2 t

This gives us the Black-Scholes PDE:

1 2 2

S σ Γt + θ − r [∆t St − Ct ] = 0 (Textbook 13.10)

2 t

• The advantage to frequent rehedging

• Delta-hedging in practice

• Market making as insurance

These topics are minor ideas. I recommend that you skip them.

144 CHAPTER 13. MARKET-MAKING AND DELTA-HEDGING

Chapter 14

Exotic options: I

Any option that is not a plain vanilla call or put is called an exotic option.

There are usually no markets in these options and they are purely bought OTC

(over-the-counter). They are much less liquid than standard options. They often

have discontinuous payoﬀs and can have huge deltas near expiration which make

them diﬃcult to hedge.

Before studying this chapter, make sure you understand the learning objec-

tive.

SOA’s learning outcome for this chapter:

• Explain the cash flow characteristics of the following exotic options: Asian,

barrier, compound, gap and exchange

If you want to cut corners, you can skip the pricing formula for exotic options

because calculating the exotic option price is out of the scope of the learning

outcome or learning objective.

14.1.1 Characteristics

Asian options (also called average options) have payoﬀs that are based on the

average price of the underlying asset over the life of the option. The average

price can be the average stock price or the average strike price. The average

can be arithmetic or geometric.

asset prices are averaged over some predefined time interval.

• Averaging dampens the volatility and therefore average price options are

less expensive than standard options

145

146 CHAPTER 14. EXOTIC OPTIONS: I

• Average price options are path-dependent, meaning that the value of the

option at expiration depends on the path by which the stock arrives at its

final price. The price path followed by the underlying asset is crucial to

the pricing of the option.

is concerned only about the average price of a commodity which they

regularly purchase.

14.1.2 Examples

1

Examples are based on

• A 9-month European average price contract calls for a payoﬀ equal to the

diﬀerence between the average price of a barrel of crude oil and a fixed

exercise price of USD18. The averaging period is the last two months of

the contract. The impact of this contract relative to a standard option

contract is that the volatility is dampened by the averaging of the crude oil

price, and therefore the option price is lower. The holder gains protection

from potential price manipulation or sudden price spikes.

foreign exchange risk every week. For budgeting purposes the treasurer

must pick some average exchange rate in which to quote Can$ cash flows

(derived from US$ revenue) for the current quarter. Suppose the treasurer

chooses an average FX rate of Can$1.29/US$1.00. If the US$ strength-

ens, the cash flows will be greater than estimated, but if it weakens, the

company’s Can$ cash flows are decreased.

Arithmetic average

We record the stock price every h periods from time 0 to time T . There are

N = T /h periods. The arithmetic average is:

n

1 X

A (T ) = Sih

N i=1

1 Based on

http://www.fintools.com/doc/exotics/exoticsAbout_Average_Options.html

14.2. BARRIER OPTION 147

Let AV G (T ) represent the average stock price. For arithmetic average, AV G (T ) =

n

1 X

A (T ) = Sih . For geometric average, AV G (T ) = (Sh S2h ...SN h )1/N .

N i=1

Option Payoﬀ

average price call max [0, AV G (T ) − K]

average price put max [0, K − AV G (T )]

average strike call max [0, ST − AV G (T )]

average strike put max [0, AV G (T ) − ST ]

Barrier options are similar to standard options except that they are extinguished

or activated when the underlying asset price reaches a predetermined barrier or

boundary price. As with average options, a monitoring frequency is defined as

part of the option which specifies how often the price is checked for breach of

the barrier. The frequency is normally continuous but could be hourly, daily,

etc.

• "In" option starts its life worthless and becomes active only if the barrier

price is reached

• Technically, this type of contract is not an option until the barrier price

is reached. So if the barrier price is never reached it is as if the contract

never existed.

• down-and-in (spot price starts above the barrier level and has to move

down for the option to become activated.)

• up-and-in (spot price starts below the barrier level and has to move up

for the option to become activated.)

• "Out" option starts its life active and becomes null and void if the barrier

price is reached

• The option will expire worthless if the asset price exceeds the barrier price

• down-and-out (spot price starts above the barrier level and has to move

down for the option to become null and void)

• up-and-out (spot price starts below the barrier level and has to move up

for the option to be knocked out)

148 CHAPTER 14. EXOTIC OPTIONS: I

• Barrier options are sometimes accompanied by a rebate, which is a payoﬀ

to the option holder in case of a barrier event.

”Knock − in” option + ”Knock − out” option = Ordinary Option (14.1)

Example 14.2.1.

Explain why

up-and-in option + up-and-out option = Ordinary option.

tH =time when the stock price first reaches the barrier, where the barrier

price is greater than the current stock price

During the time interval [0, tH )

on the same stock, having the same barrier price and the same strike price, then

at any moment in the interval [0, T ], we’ll always have exactly one ordinary

option alive. Hence down-and-in option + down-and-out option = Ordinary

option.

Similarly, down-and-in option + down-and-out option = Ordinary option.

14.2.5 Examples

1. A European call option is written on an underlying with spot price $100,

and a knockout barrier of $120. This option behaves in every way like

a vanilla European call, except if the spot price ever moves above $120,

the option "knocks out" and the contract is null and void. Note that the

option does not reactivate if the spot price falls below $120 again. Once

it is out, it’s out for good.

14.3. COMPOUND OPTION 149

17,000 with a down-and-out barrier price of 16,000. If the price of the

Nikkei falls to 16,000 or below, during the 9-month period, the bank will

no longer have the benefit of Nikkei price appreciation since the call option

will have been knocked out.

the price of fuel. An up-and-in call would allow the airline to buy crude

oil futures at a fixed price if some knock-in boundary price is reached.

The price of the U&I call would be less than a standard call with the

same expiration and exercise price so it might be viewed as a cost eﬀective

hedging instrument.

Definition

• With a compound option one has the right to buy an ordinary option at

a later date

option, as the purchaser has received a price guarantee and eﬀectively

extended the life of the option

For a compound call (i.e. call on call) to be valuable, the following two

conditions need to be met:

• St1 > S ∗

• St1 > K

The key formula is DM 14.12:

This formula looks scary but is actually easy to remember. We know the

put-call parity C + Ke−rT = P + S0 . If we treat the standard BSCall as the

underlying asset, then applying the standard put-call parity, we get:

CallOnCall + xe−rt1 = P utOnCall + BSCall

This is DM 14.12.

Similarly, we have:

CallOnP ut + xe−rt1 = P utOnP ut + BSP ut

150 CHAPTER 14. EXOTIC OPTIONS: I

This section is a minor part of Exam MFE. I recommend that you skip it.

However, if you don’t want to skip, here is the main idea.

At t1 , the value of an American call option CA (St1 , T − t1 ) is (see the text-

book’s explanation for this formula):

we get:

CE (St1 , T − t1 ) = PE (St1 , T − t1 ) + St1 − Ke−r(T −t)

So £ ¤

CA (St1 , T − t1 ) = max PE (St1 , T − t1 ) + St1 − Ke−r(T −t) , St1 + D − K

£ ¤

= St1 +D−K+max PE (St1 , T − t1 ) + St1 − Ke−r(T −t) − (St1 + D − K) , 0

£ ¡ ¡ ¢¢ ¤

= St1 + D − K + max PE (St1 , T − t1 ) − D − K 1 − e−r(T −t) , 0

h ³ ³ ´´ i

CA (St1 , T − t1 ) = St1 +D−K+max PE (St1 , T − t1 ) − D − K 1 − e−r(T −t) , 0

£ ¡ ¡ ¢¢ ¤ (DM 14.14)

max PE (St1 , T − t1 ) − D − K 1 − e−r(T −t) , 0 is payoﬀ of a call on put

¡ ¢

with strike price equal to D − K 1 − e−r(T −t) .

Exercising call on put at t1 is the same as not exercising the American call

at t

¡ 1 . If you

¡ exercise the ¢¢ call on put, then it must be true that PE (St1 , T − t1 )−

D − K 1 − e−r(T −t) ≥ 0 (otherwise you won’t exercise it). Then DM 14.14

becomes ¡ ¡ ¢¢

CA (St1 , T − t1 ) = St1 + D − K + PE (St1 , T − t1 ) − D − K 1 − e−r(T −t)

= St1 + PE (St1 , T − t1 ) − Ke−r(T −t) = CE (St1 , T − t1 )

So exercising the call on put at t1 means that not early exercising the Amer-

ican call option at t1 (so the American call option becomes a European call

option).

¡ the call on

¢¢ put at t1 , then it must

be true that PE (St1 , T − t1 ) − D − K 1 − e−r(T −t) < 0.

This gives us CA (St1 , T − t1 ) = St1 + D − K. This equation means that we

receive dividend D at t1 and immediately exercise the call at t1 (so the American

call option at t1 is equal to St1 + D − K). So not exercising the call on put at

t1 is the same as early exercising the American call option at t1 .

14.4. GAP OPTION 151

DM Example 14.2 shows you how to use DM 14.14 to calculate the price of

an American call option with a single dividend. When reading this example,

please note two things:

(1) DM Example 14.2 has errors. Make sure you download the errata. The

DM textbook errata can be found at the SOA website.

(2) The call on put price is calculated using the Excel spreadsheet (so don’t

worry about how to manually calculate the call on put).

14.4.1 Definition

• An option in which one strike price K1 determines the size of the payoﬀ

and another strike price K2 determines whether or not the payoﬀ is made.

The strike price K1 = 5 determines the size of the payoﬀ but a diﬀerent

strike price K2 = 8 determines whether or not the payoﬀ is made. K2 is

called the payment trigger.

The strike price K1 = 8 determines the size of the payoﬀ but a diﬀerent

strike price K2 = 8 determines whether or not the payoﬀ is made.

• As the footnote in Page 457 of the textbook indicates, a gap call or put

option is really not a option; once the payment trigger is satisfied, the

owner of a gap option MUST exercise the option. Hence the premium of

a gap option can be negative.

To find the price of a gap option, you can modify a standard option’s formula

by changing d1 :

C (K1 , K2 ) = Se−δT N (d1 ) − K1 e−rT N (d2 )

−rT −δT

P (K1 , K2 ) = K

µ1 e N (−d¶

2 ) − Se N (−d1 )

S 1 2

ln + r−δ+ σ T

K2 2

d1 = √

√ σ T

d2 = d1 − σ T

• The call payoﬀ is 0 if ST ≤ K2 and ST − K1 if ST > K2 . The call option

price is just the risk-neutral expected discounted value of the payoﬀ. So

the call price is Se−δT N (d1 ) − K1 e−rT N (d2 ). Similarly, the put price is

K1 e−rT N (−d2 ) − Se−δT N (−d1 ).

152 CHAPTER 14. EXOTIC OPTIONS: I

Calculate

S = 40 K1 = 60 K2 = 50 r = 0.06

δ = 0.02 T = 0.5

µ ¶ µ ¶

S 1 2 40 1 2

ln + r−δ+ σ T ln + 0.06 − 0.02 + × 0.3 0.5

K2 2 50 2

d1 = √ = √ =

σ T 0.3 0.5

−0.851 6 √ √

d2 = d1 − σ T = −0.851 6 − 0.3 0.5 = −1. 063 7

N (d1 ) = 0.197 2 N (d2 ) = 0.143 7

N (−d2 ) = 0.856 3 N (−d1 ) = 0.802 8

C = Se−δT N (d1 ) − K1 e−rT N (d2 ) = 40e−0.02×0.5 0.197 2 − 60e−0.06×0.5

0.143 7 = −0.56

0.802 8 = 18. 07

• Allows the holder of the option to exchange one asset for another

• Pricing

p formula. Use the standard Black-Scholes formula except changing

σ to σ 2S + σ 2K − 2ρσ S σ K . Also, make sure you know which is the stock

asset and which is the strike asset. If you give up Asset 2 and receive

Asset 1, Asset 1 is the stock and Asset 2 is the strike asset.

14.5. EXCHANGE OPTION 153

S = 95.92 K = 3.5020 × 27.39 = 95. 92 = S (i.e. at-the-money call)

δ S = 0.75% δ K = 1.17% σ = 0.1694 T =1

95.92e−0.0075×1 1

ln −0.0117×1

+ × 0.16942 × 1

d1 = 95.92e √2 = 0.109 5

√ 0.1694 1 √

d2 = d1 − σ T = 0.109 5 − 0.1694 1 = −0.059 9

N (d1 ) = 0.543 6 N (d2 ) = 0.476 1

C = Se−δS T N (d1 ) − K1 e−δK T N (d2 )

= 95.92e−0.0075×1 × 0.543 6 − 95.92e−0.0117×1 × 0.476 1 = 6. 616

This is slightly diﬀerent from the textbook call price 6.6133 due to rounding.

You can verify the call price using the Excel worksheet "Exchange."

Inputs:

Underlying Asset

Price 95.92

Volatility 20.300%

Dividend Yield 0.750%

Strike Asset

Price 95.92

Volatility 22.270%

Dividend Yield 1.170%

Other

Correlation 0.6869

Time to Expiration (years) 1

Output:

Exchange Option

Black-Scholes

Call Put

Price 6.6144 6.2154

So the exchange call price is 6.6144; the exchange put price is 6.2154.

154 CHAPTER 14. EXOTIC OPTIONS: I

Chapter 18

Lognormal distribution

This chapter is an easy read. I’m going to highlight the major points.

The normal distribution has the following pdf (probability density function)

(DM 18.1):

" µ ¶2 #

1 1 x−μ

φ (x; μ, σ) = √ exp −

σ 2π 2 σ

In the standard normal

µ distribution,

¶ μ = 0 and σ = 1. Its pdf is:

1 1 2

φ (x; 0, 1) = √ exp − x

2π 2

Ra Ra 1 1

P (z 6 a) = N (a) = −∞ φ (x; 0, 1) dx = −∞ √ exp − x2 dx

2π 2

N (−a) = 1 − N (a)

¢ random variable to the standard normal random

variable. If x ∼ N μ, σ2 , then we can transform x into a standard normal

random variable using DM 18.4:

x−μ

z=

σ

1 1

We can verify that z ∼ N (0, 1). First, notice that z = x − μ is normal

σ σ

(linear combination

µ of¶normal random variables are also normal). Next,

x−μ 1

E (z) = E = [E (x) − μ] = 0

σ σ

155

156 CHAPTER 18. LOGNORMAL DISTRIBUTION

µ ¶

x−μ 1 1 1

V ar (z) = V ar = 2

V ar (x − μ) = 2 V ar (x) = 2 × σ 2 = 1

σ σ σ σ

So z ∼ N (0, 1)

¡Sum of ¢ normal random

¡ variables

¢ is still normal. For example, if x1 ∼

N μ1 , σ 21 and x2 ∼

¡ N μ2 , σ 2

2 , then ¢

ax1 + bx2 ∼ N aμ1 + bμ2 , aσ 21 + bσ 22 + 2abρσ1 σ 2

Next, the textbook briefly explains the central limit theorem, a concept you

most likely already know.

If x is normal, then y = ex is lognormal. If you say y is lognormal, it means

that ln y is normal.

Let R (0, t) represent the not-annualized continuously compounded return

over the interval [0, t], the stock price at time t is (DM 18.12):

St = S0 eR(0,t)

St

This leads to DM 18.11: R (0, t) = ln

S0

Next comes an important formula: ³ 2 ´

¡ ¢ 2 2

If x ∼ N m, v 2 , then E (ex ) = em+0.5v and V ar (ex ) = e2m+v ev − 1 .

You don’t need to know how to derive these formulas. Just memorize them.

Define:

the stock

• δ, the (annualized) continuously compounded dividend yield

• σ, the stock’s volatility

• z, the standard normal random variable

¡ compounded¢ return earned during

[0, t] is normally distributed with mean α − δ − 0.5σ 2 t and standard deviation

√

σ t (DM 18.18):

St ¡¡ ¢ ¢

ln ∼ N α − δ − 0.5σ 2 t, σ 2 t

S0

√ random variable with mean

α − δ − 0.5σ t and standard deviation σ t as:

18.4. LOGNORMAL PROBABILITY CALCULATION 157

¡ ¢ √

x = α − δ − 0.5σ2 t + σ tz

St ¡ ¢ √

ln = x = α − δ − 0.5σ 2 t + σ tz

S0

The stock’s price at time t is (DM 18.20):

£¡ ¢ √ ¤

St = S0 ex = S0 exp α − δ − 0.5σ 2 t + σ tz

Using DM 18.13,

¡ we£¡ get DM 18.22:¢ √ ¤¢ ¡¡ ¢ ¢

E (St ) = S0 E exp α − δ − 0.5σ 2 t + σ tz = S0 exp α − δ − 0.5σ2 t + 0.5σ 2 t =

S0 e(α−δ)t

" ¡ ¢ # µ ¶

ln K − ln S0 − α − δ − 0.5σ 2 t ∧

P (St < K) = N √ = N −d 2

σ t

¡ ¢ S0 ¡ ¢

∧ ln K − ln S0 − α − δ − 0.5σ 2 t ln + α − δ − 0.5σ 2 t

where d2=− √ = K √

σ t σ t

£ ¡ ¢ ¤

Here’s how to derive it. ln St ∼ N ln S0 + α − δ − 0.5σ 2 t, σ 2 t

" is: ¡ ¡ ¢ ¢#

ln K − ln S0 + α − δ − 0.5σ2 t

P (St < K) = P (ln St < ln K) = N √

σ t

In the above formula, if we set α = r, we’ll get the risk neutral probability

of St < K: " ¡ ¡ ¢ ¢#

∗

ln K − ln S0 + r − δ − 0.5σ 2 t

P (St < K) = N √ = N (−d2 )

σ t

Next, let’s calculate the real world probability of P (St > K). Please note

that P (St = K) = 0. This is because St is a continuous random variable; the

probability for a continuous random variable to take on a specific value is zero.

So P (St > K) = 1 − P (St < K) − P (St = K) = 1 − P (St < K). The real

world probability of St > K is:

⎛ ¢ ⎞

µ ¶ ∙ µ ¶¸ µ ¶ S0 ¡ 2

∧ ∧ ∧ ln + α − δ − 0.5σ t

⎜ ⎟

P (St > K) = 1−N −d2 = 1− 1 − N d2 = N d2 = N ⎝ K √ ⎠

σ t

158 CHAPTER 18. LOGNORMAL DISTRIBUTION

If we set α = r, we’ll get the risk neutral probability of P (St > K):

⎛ ¢ ⎞

S0 ¡

ln + r − δ − 0.5σ2 t

⎜ ⎟

P ∗ (St > K) = N (d2 ) = N ⎝ K √ ⎠

σ t

The textbook’s explanation is a bit confusing. Here is how to build a confidence

interval of the stock price.

First, let’s consider building a 95% confidence interval for the standard nor-

mal random variable z. We need to find a value a positive value b such that

P (−b < z < b) = 0.95.

P (−b < z < b) = N (b) − N (−b) = N (b) − [1 − N (b)] = 2N (b) − 1 = 0.95

1 + 0.95

=⇒ N (b) = = 0.975

2

b = N −1 (0.975) = 1.96.

Then the 95% confidence interval is −1.96 < z < 1.96.

P (−b < z < b) = N (b) − N (−b) = [1 − N (−b)] − N (−b) = 1 − 2N (−b) =

0.95

1 − 0.95

Then N (−b) = = 0.025

2

−1

−b = N (0.025) = −1.96

So the 95% confidence interval is −1.96 < z < 1.96.

The

µ p confidence

¶ interval

µ of ¶the standard normal random variable z is

−1 1−p −1 1+p

N <z<N .

2 2

µ ¶ µ ¶

1 − 0.95 1 + 0.95

N −1 < z < N −1 , which is N −1 (0.025) < z <

2 2

N −1 (0.975) , which is −1.96 < z < 1.96.

to build a 95% confidence interval, we just set p = 5%.

The µ(1 − p) confidence

¶ interval of

µ the standard ¶ normal random variable z

1 − (1 − p) 1 + (1 − p) ³ ´

−1 −1 −1 p

is N < z < N , which is N < z <

³ ´ 2 2 2

p

N −1 1 − .

2

For example, if p = 5%, then the 1 − 5% = 95% confidence interval is:

18.4. LOGNORMAL PROBABILITY CALCULATION 159

µ ¶ µ ¶

0.05 0.05

N −1 < z < N −1 1 − , which is N −1 (0.025) < z < N −1 (0.975),

2 2

which is −1.96 < z < 1.96.

¡ ¢ building the 95% confidence interval for normal random

variable x ∼ Nµ μ, σ2 ¶. Since x = μ + zσ,µthe p ¶

confidence interval of x is:

1 − p 1 + p

μ + σN −1 < x < μ + σN −1 .

2 2

¡ ¢

For example, the 95% confidence interval of x ∼ N 1, 22 is: 1+2 (−1.96) <

x < 1 + 2 (1.96), which is −2. 92 < x < 4. 92.

If we specify the confidence interval in terms of 1−p, then the 1−p confidence

interval is: ³p´ ³ p´

μ + σN −1 < x < μ + σN −1 1 −

2 2

µ ¶

1−p

You don’t need to memorize messy formulas such as μ + σN −1 <

µ ¶ 2

1+p ³p´ ³ p´

x < μ + σN −1 or μ + σN −1 < x < μ + σN −1 1 − . The

2 2 ¡ 2¢

following is a simple way to find a confidence interval for x ∼ N μ, σ 2 .

• Step 1. Find the confidence interval −b < z < b for the standard normal

random variable z. Just solve the equation P (−b < z < b) = N (b) −

N (−b) = 2N (b) − 1 =the confidence interval.

• Step 2. After finding b, the confidence interval for x is μ −bσ < x < μ + bσ

¡ ¢

Example. Find the 90% confidence interval for x ∼ N 1, 22 . First, we find

the 90% confidence interval for the standard normal random variable z. We

solve the equation:

P (−b < z < b) = N (b) − N (−b) = N (b) − [1 − N (b)] = 2N (b) − 1 = 0.9

1 + 0.9

So N (b) = = 0.95 and b = 1.645.

2

Then the 90% confidence interval for z is −1.645 < z < 1.645; for x is

1 − 1.645 × 2 < x < 1 + 1.645 × 2, which is −2. 29 < x < 4. 29.

Similarly, the 99% confidence interval is calculated as follows:

1 + 0.99

2N (b) − 1 = 0.99, 2N (b) = = 0.995, b = 2.576

2 ¡ ¢

The 99% confidence interval for z is −2.576 < z < 2.576; for x ∼ N 1, 22

is 1 − 2.576 × 2 < x < 1 + 2.576 × 2, which is −4. 152 < x < 6. 152.

Now let’s walk through DM example 18.6. Here we need to find the 95%

confidence interval for the stock price St . The inputs are:

• S0 = 100

• t=2

160 CHAPTER 18. LOGNORMAL DISTRIBUTION

• α = 0.1

• σ = 0.3

• δ=0

St £¡ ¢ ¤

We know that ln ∼ N a − δ − 0.5σ 2 t, σ 2 t .

¡ ¢ S0¡ ¢

a − δ − 0.5σ 2 t = 0.1 − 0 − 0.5 × 0.32 2 = 0.11

σ 2 t = 0.32 (2) = 0.18

S2

=⇒ ln ∼ N (0.11, 0.18)

100

How to find the 95% confidence interval for S2 .

Step 1 What’s the 95% confidence interval for z ∼ N (0, 1)?

Answer: −1.96 < z < 1.96.

St

Step 2 What’s the 95% confidence interval for ln ∼ N (0.11, 0.18)?

100

√ S2 √

Answer: 0.11 − 1.96 0.18 < ln < 0.11 + 1.96 0.18,

100

S2

or −0.721 56 < ln < 0.941 56.

100

S2

Step 3 Take exponentiation of −0.721 56 < ln < 0.941 56

µ ¶ 100

S2

exp (−0.721 56) < exp ln < exp (0.941 56)

100

µ ¶

S2

exp (−0.721 56) = 0.485 994 exp (0.941 56) = 2. 563 98 exp ln =

100

S2

100

S2

=⇒ 0.485 994 < < 2. 563 98 48.60 < S2 < 256.40

100

So the 95% confidence interval for S2 is (48.60, 256.40) .

Now let’s walk through Row 1 (i.e. 1 day horizon) in DM Table 18.1. The

inputs are:

• S0 = 50

• α = 0.15

• δ=0

• σ = 0.3

18.4. LOGNORMAL PROBABILITY CALCULATION 161

and the confidence interval that corresponds to −2 < z < 2. First, let consider

−1 < z < 1.

St £¡ ¢ ¤

ln ∼ N a − δ − 0.5σ 2 t, σ 2 t

S0 µ ¶ µ ¶

S1/365 0.15 − 0 − 0.5 × 0.32 0.32 −4 0.3

2

ln ∼N , = N 2. 876 71 × 10 ,

50 365 365 365

What’s the confidence interval for the standard normal random variable z?

Answer: −1 < z < 1.

S1/365

What’s the corresponding confidence interval for ln ?

50

Answer: r r

−4 0.32 S1/365 0.32

2. 876 71 × 10 − 1 × < ln < 2. 876 71 × 10−4 + 1 ×

365 50 365

S1/365

−1. 541 505 × 10−2 < ln < 1. 599 04 × 10−2

−2

50 −2

50e−1. 541 505×10 < S1/365 < 50e1. 599 04×10

So the confidence interval for S1/365 is 49. 24 < S1/365 < 50. 81.

P (−1 < z < 1) = N (1) − N (−1) = 2N (1) − 1 = 2 × 0.841 34 − 1 = 0.682 7

will fall in the range (49. 24, 50. 81).

z < 2. r r

−4 0.32 S1/365 −4 0.32

2. 876 71 × 10 − 2 × < ln < 2. 876 71 × 10 + 2 ×

365 50 365

S1/365

−3. 111 776 × 10−2 < ln < 3. 169 311 × 10−2

−2

50 −2

50e−3. 111 776 ×10 < S1/365 < 50e3. 169 311×10

So the confidence interval for S1/365 is 48. 47 < S1/365 < 51. 61.

What confidence interval is that?

P (−2 < z < 2) = 2N (2) − 1 = 2 (0.977 25) − 1 = 0.954 5

So the 95.45% confidence interval for S1/365 is 48. 47 < S1/365 < 51. 61.

162 CHAPTER 18. LOGNORMAL DISTRIBUTION

One key formula is DM 18.27. The partial expectation of St on the condition

St < K is: µ ¶ µ ¶

RK ∧

(α−δ)t

∧

0

St × g (St ; S0 ) dSt = E (St ) N −d1 = S0 e N −d 1

S0 ¡ ¢

∧ ln + α − δ + 0.5σ 2 t

d1 = K √

σ t

g (St ; S0 ) is the probability density function of St . Here St ; S0 indicates that

the initial stock price for St is S0 .

how to prove DM 18.27. Just memorize it. Once you memorize DM 18.27, you

can derive DM 18.28:

µ ¶

∧

RK S0 e(α−δ)t N −d1

St × g (St ; S0 ) dSt

E (St |St < K) = 0 = µ

∧

¶

P (St < K)

N −d2

R∞ R∞ RK

K

St × g (St ; S0 ) dSt = 0

St × g (St ; S0 ) dSt − 0

St × g (St ; S0 ) dSt

R∞

St × g (St ; S0 ) dSt = E (St ) = S0 e(α−δ)t

0 µ ¶ µ ¶

RK ∧ ∧

0

St × g (St ; S0 ) dSt = E (St ) N −d1 = S0 e(α−δ)t N −d1

∙ µ ¶¸

R∞ (α−δ)t

∧

=⇒ K St × g (St ; S0 ) dSt = S0 e 1 − N −d1

µ ∙ µ ¶¸¶ µ ¶

∧ ∧

= S0 e(α−δ)t 1 − 1 − N d1 = S0 e(α−δ)t N d1

∧ ∧

R∞ S0 e(α−δ)t

1 − N −d 1 S0 e(α−δ)t

N d1

K

St × g (St ; S0 ) dSt

E (St |St > K) = = µ ¶ = µ ¶

P (St > K) ∧ ∧

1 − N −d2 N d2

This section derives the Black-Scholes formula with simple math. The Black-

Scholes formula was originally derived using stochastic calculus and partial dif-

ferential equation. Many years after the Black-Scholes formula was published,

someone came up with this simple proof (hindsight is always 20-20).

18.5. ESTIMATING THE PARAMETERS OF A LOGNORMAL DISTRIBUTION163

The European

R ∞ call option price in the risk-neutral world, is:

C = e−rt K (St − K)×g ∗ (St ; S0 ) dSt = e−rt E ∗ (St − K|St > K) P ∗ (St > K)

Here any term with the ∗ sign indicates the term is valuated in the risk-

neutral world (i.e. by setting α = r).

E ∗ (St − K|St > K) P ∗ (St > K) = E ∗ (St |St > K) P ∗ (St > K)−E ∗ (K|St > K) P ∗ (St > K)

S0 e(r−δ)t N (d1 )

E ∗ (St |St > K) = P ∗ (St > K) = N (d2 )

N (d2 )

E ∗ (K|St > K) = K

=⇒ E ∗ (K|St > K) P ∗ (St > K) = KN (d2 )

£ ¤

=⇒ C = e−rt S0 e(r−δ)t N (d1 ) − KN (d2 ) = S0 e−δt N (d1 )−Ke−rt N (d2 )

P = Ke−rt N (−d2 ) − S0 e−δt N (−d1 )

distribution

Consider the stock price over the time interval [t − h, t].

2

√

St = St−h e(α−δ−0.5σ )h+σ hz

E (z) = 0 and V ar (Z) = 1

St ¡ ¢ √

=⇒ ln = α − δ − 0.5σ 2 h + σ hz

St−h

µ ¶ h¡

St ¢ √ i ¡ ¢

=⇒ E ln = E α − δ − 0.5σ2 h + σ hz = α − δ − 0.5σ 2 h+

√ ¡ St−h ¢

2

σ hE (z) = α −µδ − 0.5σ¶ h

St h¡ ¢ √ i

=⇒ V ar ln = V ar α − δ − 0.5σ 2 h + σ hz

¡ St−h

¢

Since α − δ − 0.5σ 2 h is a constant, we have:

h¡ ¢ √ i ³ √ ´2

V ar α − δ − 0.5σ 2 h + σ hz = σ h V ar (z) = σ 2 h

164 CHAPTER 18. LOGNORMAL DISTRIBUTION

µ ¶2

St St

week S ln ln

St−1 St−1

1 100

2 105.04 0.049171 0.0024178

3 105.76 0.006831 0.0000467

4 108.93 0.029533 0.0008722

5 102.5 −0.060843 0.0037018

6 104.8 0.022191 0.0004924

7 104.13 −0.006414 0.0000411

sum 0 0.040470 0.0075721

Weµhave: ¶

St ¡ ¢ 0.040470

E ln = α − δ − 0.5σ 2 h = = 0.006 745

St−h 6

0.006 745

=⇒ α = δ + 0.5σ 2 +

h

In the above equations,

α is the stock’s expected (annual) continuously compounded return

δ is the stock’s (annual) continuously compounded dividend yield (δ = 0 in

this problem)

σ is the stock’s (annual) volatility

h = 1/52 (52 weeks in one year)

⎛ ⎛ ⎞2 ⎞

P St

µ ¶ µ ¶2 ln

St n ⎜ ⎜ 1 × P ln St

⎜ St−1 ⎟ ⎟

V ar ln = σ2h = −⎜ ⎟ ⎟=

St−h n − 1 ⎝n St−1 ⎝ n ⎠ ⎠

µ ¶

6 1

× 0.0075721 − 0.006 7452 = 0.001 459 83

5 6

0.001 459 83

=⇒ σ2 =

h

0.006 745 0.001 459 83 0.006 745

=⇒ α = δ + 0.5σ 2 + = 0 + 0.5 × + =

h 1/52 1/52

0.388 7

found this approach

r confusing. I recommend

r that you use my approach.

0.001 459 83 0.001 459 83

=⇒ σ= = = 0.275 5

h 1/52

So the stock’s expected return per year is α = 38.8 7% and its annual volatil-

ity is σ = 0.275 5.

µ ¶

St 1P St 1P

Please note that E ln = ln = (ln St − ln St−h ) =

St−h n St−h n

1 1 Sn ¡ ¢

(ln Sn − ln S0 ) = ln = α − δ − 0.5σ 2 h

n n S0

18.6. HOW ARE ASSET PRICES DISTRIBUTED 165

In µthis problem,

¶ we could have estimated

St ¡ ¢ 1 Sn 1 104.13

E ln = α − δ − 0.5σ2 h = ln = ln = 0.006745

St−h n S0 6 100

In addition, we have:

1 Sn 1 Sn

α − δ − 0.5σ 2 = ln = ln

nh S0 T S0

where T = nh is the length of the observation.

matter:

• the stock’s starting price S0

• the stock’s ending price Sn

The stock prices between S0 and Sn are irrelevant. And for a given T ,

increasing the number of observations n doesn’t aﬀect our estimate of α − δ −

0.5σ 2 (because as n goes up, h goes down, and T = nh is a constant). Frequent

observations don’t improve our estimate of α − δ − 0.5σ 2 . To improve our

estimate of α − δ − 0.5σ 2 , we need to increase T .

When we estimate σ, the in-between stock prices do matter and more fre-

quent observations do improve our estimate.

The lognormal stock price model assumes that the stock returns are normally

distributed. Are stock returns really normally distributed?

18.6.1 Histogram

One method to assess whether stock returns are normally distributed is to plot

the continuously compounded returns as a histogram. Look at DM Figure 18.4.

The histograms in Figure 18.4 don’t appear normal. The textbook oﬀers

two explanations:

• Stock returns are normally distributed, but the variance of the return

changes over time.

166 CHAPTER 18. LOGNORMAL DISTRIBUTION

draw a normal probability plot.

To see what a normal probability plot is, let’s go through an example. We

know that the 99% confidence interval for a standard normal random variable is

[−2.58, 2.58]. Suppose we take the following samples from the range [−2.58, 2.58]

with the step equal to 0.01:

−2.58, −2.57, −2.56, −2.55, ..., 0, 0.01, 0.02, ..., 2.57, 2.58

we plot the data pairs (xi , yi ), what do we get? Answer: we’ll get roughly a

straight line.

A B

1 xi yi = P (Z < xi )

2 −2.58 0.00494

3 −2.57 0.005085

4 −2.56 0.005234

... ... ...

260 0 0.5

261 0.01 0.503989

262 0.02 0.507978

... ... ...

517 2.57 0.994915

518 2.58 0.99506

Sample formulas.

Cell A2 = −2.58 A3 = A2 + 0.01 ... A518 = A517 + 0.01

B2 = N ORM DIST (A2, 0, 1, 1) B3 = N ORM DIST (A3, 0, 1, 1) ... B518 =

N ORM DIST (A518, 0, 1, 1)

Next, plot the range "A2:B518" as xy diagram in Excel. The plot you got

should look like the 2nd diagram in DM Figure 18.2 (see DM page 589). You

can see that from diagram from z = −2.58 to z = 2.58 is roughly a straight line.

The point of this Excel experiment: if you plot samples from a normal

distribution in a normal probability plot, you’ll get roughly a straight-line. If

you plot samples from an unknown distribution in a normal probability plot and

get roughly a straight line, then the samples are from approximately normal

distribution.

Steps on how to construct a normal probability plot:

1, 2, 3, ..., n. So you samples are x1 , x2 , ..., xn .

18.7. SAMPLE PROBLEMS 167

i − 0.5

2. Assign the cumulative probability to xi as yi = P (x < xi ) = .Here

n

−1

0.5 is the continuity adjustment. Calculate the corresponding zi = N (yi ).

normal.

Here’s a table to summarize the 3 steps for building a normal probability

plot:

i − 0.5

index xi yi = P (x < xi ) = zi = N −1 (yi )

n µ ¶

0.5 0.5

1 x1 y1 = z1 = N −1

n µ n ¶

1.5 1.5

2 x2 y2 = z2 = N −1

n µ n ¶

2.5 2.5

3 x3 y3 = z3 = N −1

n n

... ... ... ... µ ¶

n − 0.5 −1 n − 0.5

n xn yn = zn = N

n n

i − 0.5

i xi

yi = P (x < xi ) = zi = N −1 (yi )

n

0.5

1 3 = 0.1 N −1 (0.1) = −1.2816

5

1.5

2 4 = 0.3 N −1 (0.3) = −0.5244

5

2.5

3 5 = 0.5 N −1 (0.5) = 0

5

3.5

4 7 = 0.7 N −1 (0.7) = 0.5244

5

4.5

5 11 = 0.9 N −1 (0.9) = 1.2816

5

Next, plot the data pairs (xi , yi ) or (xi , zi ). The result is the top two dia-

grams in DM Figure 18.6.

Problem 1

• S0 = 100

168 CHAPTER 18. LOGNORMAL DISTRIBUTION

• α = 0.12

• δ = 0.06

• σ = 0.25

• T =2

Solution

First we find the 95% confidence interval for the standard normal random

variable z. We need to b such that P (−b < z < b) = 0.95.

P (−b < z < b) = N (b) − N (−b) = N (b) − [1 − N (b)] = 2N (b) − 1 = 0.95

1 + 0.95

N (b) = = 0.975 b = N −1 (0.975) = 1. 96

2

ST £¡ ¢ ¤

ln ∼ N a − δ − 0.5σ 2 T, σ 2 T

S0

¡ ¢ ¡ ¢

a − δ − 0.5σ 2 T = 0.12 − 0.06 − 0.5 × 0.252 2 = 0.057 5

σ 2 T = 0.252 × 2

ST

The 95% confidence interval for ln is:

√ S0

0.057 5 − 1.96√0.252 × 2 = −0.635 46

0.057 5 + 1.96 0.252 × 2 = 0.750 46

100e−0.635 46 = 52. 97 100e0.750 46 = 211. 80

You are given the following information for a stock with current price 0.25:

pounded expected annual rate of return α = 0.15.

18.7. SAMPLE PROBLEMS 169

Using the procedure described in the McDonald text, determine the upper

bound of the 90% confidence interval for the price of the stock in 6 months.

Solution

90% confidence interval for a standard normal random variable is (−1.645, 1.645).

ST £¡ ¢ ¤

ln ∼ N a − δ − 0.5σ 2 T, σ 2 T

S0

¡ ¢ ¡ ¢

a − δ − 0.5σ 2 T = 0.15 − 0 − 0.5 × 0.352 0.5 = 0.044 375

σ 2 T = 0.352 × 0.5

ST ¡ √ √ ¢

90% confidence interval for ln is 0.044 375 − 1.645 × 0.352 × 0.5, 0.044 375 + 1.645 × 0.352 × 0.5 .

S0

So the upper bound√for ST is:

2

0.25e0.044 375+1.645× 0.35 ×0.5 = 0.392 7

Problem 3

A European call option and a European put option are written on the same

stock. You are given:

• S0 = 100

• K = 105

• α = 0.08

• δ=0

• σ = 0.3

• T = 0.5

Calculate the probability that the put option will be exercised.

Solution

⎛T > K. We

The call will be exercised is S just need to use

⎞ DM 18.24.

µ ¶ S0 ¡ ¢

∧ ln + α − δ − 0.5σ 2 t

⎜ ⎟

P (ST > K) = N d2 = N ⎝ K √ ⎠

σ t

⎛ ⎞

100 ¡ ¢

ln + 0.08 − 0 − 0.5 × 0.32 0.5

⎜ ⎟

= N ⎝ 105 √ ⎠

0.3 0.5

= N (−0.147 5 ) = 1 − N (0.147 5 ) = 1 − NormalDist (0.147 5 ) = 0.441 4

µ be ¶exercise is S

µT <¶K

∧ ∧

P (ST < K) = N −d2 = 1 − N d2 = 1 − 0.441 4 = 0.558 6

170 CHAPTER 18. LOGNORMAL DISTRIBUTION

Alternatively,

Problem 4

• S0 = 50

• α = 0.1

• δ=0

• σ = 0.4

Calculate the conditional expected value of the stock at T = 3 given ST > 75.

Calculate the conditional expected value of the stock at T = 3 given ST < 75.

Solution

µ ¶ µ ¶

∧ ∧

S0 e(α−δ)t N −d1 S0 e(α−δ)t N d1

E (St |St < K) = µ ¶ E (St |St > K) = µ ¶

∧ ∧

N −d 2 N d2

S0 ¡ ¢ 50 ¡ ¢

∧ ln + α − δ + 0.5σ 2 t ln + 0.1 − 0 + 0.5 × 0.42 3

d1 = K √ = 75 √ = 0.194 2

σ t 0.4 3

S0 ¡ ¢ 50 ¡ ¢

∧ ln + α − δ − 0.5σ 2 t ln + 0.1 − 0 − 0.5 × 0.42 3

d2 = K √ = 75 √ = −0.498 6

σ t 0.4 3

50e(0.1−0)3 N (−0.194 2) 50e(0.1−0)3 0.423 0

E (St |St < K) = = = 41. 32

N (0.498 6) 0.6910

E (St |St > K) = == = 126.

N (−0.498 6) 1 − 0.6910

03

Problem 5

Stock prices follow lognormal distribution. You are given:

• S0 = 100

• α = 0.08

• δ=0

• σ = 0.3

• T =5

18.7. SAMPLE PROBLEMS 171

Solution

75 percentile of a standard normal random variable z is N −1 (0.75) = 0.674 5.

ST £¡ ¢ ¤

ln ∼ N a − δ − 0.5σ 2 T, σ 2 T

S0

¡ ¢ ¡ ¢

a − δ − 0.5σ 2 T = 0.08 − 0 − 0.5 × 0.32 5 = 0.175

σ 2 T = 0.32 × 5

ST

75 percentile of ln is

S0 √

x = 0.175 + 0.674 5 × 0.32 × 5 = 0.627 47

75 percentile of ST is:

100ex = 100e0.627 47 = 187. 29

Median of ST is: 100e0.175 = 119. 12

The price of a stock in seven consecutive months is:

Month Price

1 54

2 56

3 48

4 55

5 60

6 58

7 62

Based on the procedure described in the McDonald text, calculate the an-

nualized expected return of the stock.

(A) Less than 0.28

(B) At least 0.28, but less than 0.29

(C) At least 0.29, but less than 0.30

(D) At least 0.30, but less than 0.31

(E) At least 0.31

Solution

172 CHAPTER 18. LOGNORMAL DISTRIBUTION

St

month price x = ln x2

St−1

1 54

2 56 0.036368 0.001323

3 48 −0.154151 0.023762

4 55 0.136132 0.018532

5 60 0.087011 0.007571

6 58 −0.033902 0.001149

7 62 0.066691 0.004448

sum 0.138150 0.056785

µ ¶

St ¡ ¢ 0.138150

E ln = α − δ − 0.5σ 2 h = = 0.023 025

St−h 6

0.023 025

=⇒ α = δ + 0.5σ 2 +

h

In the above equations,

α is the stock’s expected (annual) continuously compounded return

δ is the stock’s (annual) continuously compounded dividend yield (δ = 0 in

this problem)

σ is the stock’s (annual) volatility

h = 1/12 (12 months in one year)

⎛ ⎛ ⎞2 ⎞

P St

µ ¶ µ ¶2 ln

St n ⎜ ⎜ 1 × P ln St

⎜ St−1 ⎟ ⎟

V ar ln = σ2h = ⎝ −⎜

⎝

⎟ ⎟=

⎠ ⎠

St−h n−1 n St−1 n

µ ¶

6 1

× 0.056785 − 0.023 0252 = 0.010 720 8

5 6

0.010 720 8

σ2 =

h

0.023 025 0.010 720 8 0.023 025

=⇒ α = δ + 0.5σ 2 + = 0 + 0.5 × + =

h 1/12 1/12

0.340 624 8

The answer is E.

Chapter 19

In this chapter, I’m going to walk you through some examples. If you understand

my examples, you’ll know enough for the exam.

Let’s forget about option pricing for now and focus on a random variable X.

Suppose we want to find out E (X), the mean of X, but we don’t have an easy

formula to do so. For example, we have a random variable X = ez where z is a

standard normal random variable with mean 0 and variance 1.

R∞ R∞ 1 ¡ ¢

E (X) = −∞ x (z) f (z) dz = −∞ exp (z) √ exp −0.5z 2 dz

2π

¡ ¢

Suppose we haven’t heard of DM 18.13 E (ex ) = exp m + 0.5v 2 .

R∞ 1 ¡ ¢

We don’t know how to do the integration −∞ exp (z) √ exp −0.5z 2 dz.

2π

How can we calculate E (X)?

One approach is to create n instances of z , µ calculate

¶ the corresponding

z 1 P n

value of X = e , and find the sample mean μ = Xi . Based on the cen-

µn ¶ n i=1

1 P

tral limit theorem, μ = Xi is normally distributed with mean E (μ) =

µn ¶ n i=1 µn ¶

1 P 1 1 P

E Xi = (nE (X)) = E (X) and variance V ar (μ) = 2 V ar Xi =

n i=1 n n i=1

1 V ar (X)

2

× nV ar (X) = . Since E (μ) = E (X), we can calculate the mean of

n n

the sample mean E (μ) and use it to approximate the population mean E (X).

Let’s come back to the example of estimating E (ez ). I’m going to produce 10

sample means and the use the average of these 10 sample means as an estimate

to E (ez ). To produce each sample mean, I’m going to randomly draw 10, 000

z 0 s (so I have 10, 000 values of ez to produce each sample mean). Another way

173

174 CHAPTER 19. MONTE CARLO VALUATION

to describe this process is to say that I’m going to have 10 trials with each trial

having 10, 000 samples.

I’m going to do this in Microsoft Excel. The following table shows how to

calculate the sample mean for one trial.

A B C

1 simulation i zi Xi = ezi

2 1 −0.042457 0.958432

3 2 0.253383 1.288376

4 3 0.017632 1.017788

5 4 −1.167590 0.311116

6 5 0.273333 1.314338

7 6 −0.206665 0.813292

8 7 0.305234 1.356942

...... ... ... ...

10001 10000 −1.506862 0.221604

10002 Total 16, 479.279610

10003 sample mean 1.647928

B2=NORMINV(RAND(),0,1) = −0.042457 C2 = e−0.042457 = 0.958 432

Let’s walk through B2. Rand() is Excel’s formula for a random draw in a

uniform distribution over (0, 1). Norminv(p, μ, σ) is Excel’s formula for the in-

verse normal distribution. For example, for a standard normal random variable

z ∼ N (0, 1), P (z ≤ 1.96) = N (1.96) = 0.975. Then Norminv(0.975, 0, 1) =

N −1

¡ (0.975)

¢ = 1.96. Another example. For a normal random variable Z ∼

N 2, 0.32 , P (Z ≤ 2) = 0.5. Then Norminv(0.5, 2, 0.3) = 2.

NORMINV(RAND(),0,1) works this way. First, Rand() generates a number

from a uniform distribution over (0, 1). Say this random number is 0.4831. Then

Excel finds that P (z ≤ −0.042457) = 0.4831. Hence a =NORMINV(0.4831,0,1) =

−0.042457.

Please note that Excel has a similar formula normsinv for calculating the

inverse normal random variable. The "s" in normsinv stands for standard. So

normsinv produces the inverse standard normal distribution, while norminv pro-

duces the inverse normal distribution with mean μ and standard deviation σ. In

other words, normsinv(p) =norminv(p, μ = 0, σ = 1). So normsinv(0.975) =norminv(0.975, 0, 1) =

1.96.

Similarly, the formula for B3 and C3 are:

B10001=NORMINV(RAND(),0,1) = −1.506862 C10001 = e−1.506862 =

0.221 604

C10002=sum(C2:C10001)=16, 479.279610

¡ ¢

19.1. EXAMPLE 1 ESTIMATE E E Z 175

The sampleµmean ¶

is

1 Pn 16, 479.279610

μ= Xi = = 1.647928

10000 i=1 10000

Next, I’m going to produce 9 more trials. Here is the snapshot of Excel:

i zi Xi = ezi zi Xi = ezi zi Xi = ezi

1 −0.042457 0.958432 −0.985719 0.373171 −0.783098 0.456988

2 0.253383 1.288376 −1.324269 0.265997 0.186120 1.204567

3 0.017632 1.017788 −0.157924 0.853915 0.504305 1.655835

...

10000 −1.506862 0.221604 −1.673002 0.187683 1.177804 3.247236

P

X 16, 479 16, 512 16, 554

μ 1.6479 1.6512 1.6554

Trial μ μ2

1 1.6479 2.715574

2 1.6512 2.726461

3 1.6163 2.612426

4 1.6325 2.665056

5 1.6821 2.82946

6 1.6626 2.764239

7 1.6656 2.774223

8 1.5994 2.55808

9 1.6459 2.708987

10 1.6554 2.740349

total 16.4589 27.09486

1 P 1.6479 + 1.6512 + ... + 1.6554

E (X) = E (μ) ' μi = = 1.64589

10 10

E (X) = e0.5 = 1. 648 721.

We can also construct the confidence interval of E (μ). The estimated vari-

ance of the sample mean μ ¢ is P Ã

P¡ P µ ¶2 !

μi − μ2

μ2i − k ( μi )2 k 1P 2 1P

V ar (μ) ' = = μi − μi =

k−1 k−1 k−1 k k

10 ¡ ¢

2.709486 − 1.645892 = 0.000 591 2

9

p √

V ar (μ) ' 0.000 591 2 = 0.02 431

The 95% confidence interval is [1. 598 24, 1. 693 54]. This is calculated as

follows:

176 CHAPTER 19. MONTE CARLO VALUATION

1 − 0.95

First, we calculate the critical value z ∗ where P (z ≤ z ∗ ) = =

2

0.025 . This gives us z ∗ = −1.96.

Then lower bound of the 95% confidence interval is

1.64589 − 1.96 (0.02 431) = 1. 598 242 4

1.64589 + 1.96 (0.02 431) = 1. 693 537 6

So we are 95% certain that the sample mean E (μ) is in the range [1. 598 24, 1. 693 54].

Since E (X) = E (μ), we are 95% certain that E (X) is in the range [1. 598 24, 1. 693 54].

1 − 0.99

First, we calculate the critical value z ∗ where P (z ≤ z ∗ ) = =

∗

2

0.005 . This gives us z = −2.58.

Then lower bound of the 99% confidence interval is

1.64589 − 2.58 (0.02 431) = 1. 583 170 2

Then upper bound of the 99% confidence interval is

1.64589 + 2.58 (0.02 431) = 1. 708 609 8

So we are 99% certain that E (X) is in the range [1. 583 2, 1. 708 6]

This method to generate a normal random variable is called the inversion

method (DM textbook page 622 and 623). This method works as follows:

(0, 1). Say p = 0.4831.

• Step 2. Ask "For a normal random variable Z with mean μ and standard

deviation σ, what’s the number a such that P (Z ≤ a) = p?" In this ex-

ample, we find P (z ≤ a) = 0.4831. Then a = −0.042457 is the simulated

normal random variable.

We can also generate the normal random variable as the sum of 12 uniformly

distributed random variables minus 6 (DM textbook 622):

∼

Z = u1 + u2 + ... + u12 − 6 where ui is an independent identically distributed

uniform random variable over (0, 1).

R1 R1 ¡ ¢ R1 R1

E (ui ) = 0 uf (t) du = 0 udu = 1/2 E u2i = 0 u2 f (t) du = 0 u2 du =

1/3

µ ¶2

1 1 1

V ar (ui ) = − =

3 2 12

The normal random variable with a constant −6 added is still normal. Hence

∼

Z is normal.

19.2. EXAMPLE 2 ESTIMATE π 177

µ ¶

∼ 1

E Z = E (u1 + u2 + ... + u12 ) − 6 = 12 × − 6 = 0

µ ¶ 2

∼ 1

V ar Z = V ar (u1 + u2 + ... + u12 ) = 12 × =1

12

∼

So Z roughly a standard normal random variable.

The following snapshot shows how to create 5 standard normal random vari-

ables in Excel:

ui trial 1 trial 2 trial 3 trial 4 trial 5

1 0.6316 0.3308 0.0062 0.3634 0.3207

2 0.0247 0.6775 0.0296 0.8678 0.7361

3 0.4223 0.3489 0.8446 0.4283 0.8308

4 0.1326 0.5315 0.3436 0.3937 0.5658

5 0.1944 0.6660 0.2083 0.4484 0.6079

6 0.5996 0.3129 0.5807 0.3446 0.2882

7 0.7959 0.7749 0.9899 0.5553 0.9242

8 0.5468 0.2398 0.7499 0.5410 0.7900

9 0.1719 0.0645 0.0679 0.8638 0.0394

10 0.0964 0.4656 0.1779 0.8405 0.5718

11 0.1059 0.9432 0.3354 0.6266 0.4902

12 0.6106 0.0310 0.6455 0.8713 0.7856

sum 4.3328 5.3868 4.9794 7.1447 6.9508

sum-6 -1.6672 -0.6132 -1.0206 1.1447 0.9508

Each uniform random variable is created using Excel’ formula Rand().

The last row show the 5 standard normal random variable created.

For example, the first standard normal random variable is created as follows:

(0.6316 + 0.0247 + 0.4223 + ... + 0.6106) − 6 = −1.6672

We decide to estimate π using the Monte Carlo simulation (we can treat π as

a random variable that happens to be a constant). We’ll estimate π using a

classic "throwing the dart" method.

Imagine a square whose size is two units. The center of this square is the

origin (0, 0). Inside this square sits a unit circle x2 + y 2 = 1. The center of

this circle is also (0, 0). If we randomly throw a dart at the square, what’s the

probability that the dart falls within the unit circle?

178 CHAPTER 19. MONTE CARLO VALUATION

1.0

y

0.8

0.6

0.4

0.2

-1.0 -0.8 -0.6 -0.4 -0.2 0.2 0.4 0.6 0.8 1.0

-0.2 x

-0.4

-0.6

-0.8

-1.0

Of all the darts falling into the square (we ignore the darts falling out of the

square), the probability that the dart falls within the circle

¡ ¢ is the area of the

π 12 π

circle divided by the area of the square, which is P = = .

22 4

We can also focus on the first quadrant. Of all the darts falling in square in

1 ¡ 2¢

π 1

the first quadrant, the probability that they fall in the circle is P = 4 2 =

1

π ∧

. Then π = 4P .

4

Next, we need to simulate darts falling in the first quadrant. Once again,

we’ll do the simulation in Excel. We plan to produce 20 estimates of π. For

each estimate, we’ll use 10, 000 simulations. Here’s how to produce one trial

(one trial=10, 000 simulations).

• Create the first point (x1 , y1 ), where 0 < x1 < 1 and 0 < y1 < 1. We can

create x1 and y1 by randomly drawing two numbers from U ∼ (0, 1), a

uniform distribution over [0, 1].

• If x21 + y12 ≤ 1, then (x1 , y1 ) falls in the circle in the first quadrant.

• Similarly, create the 2nd point (x2 , y2 ) by randomly drawing two numbers

from U ∼ (0, 1). Determine whether (x2 , y2 ) falls in the circle in the first

quadrant.

• ......

19.2. EXAMPLE 2 ESTIMATE π 179

[0, 1]. Determine whether (xn , yn ) falls in the circle in the first quadrant.

Set n = 65, 000.

• Count m, the total number of points that fall in the circle.

m ∧

• P ≈ . Then π = 4P .

n

A B C D E

1 throw i xi yi x2i + yi2 Fall in the circle? (1=Yes, 0=No)

2 1 0.2854 0.1694 0.1102 1

3 2 0.5147 0.2787 0.3426 1

4 3 0.1915 0.2699 0.1095 1

5 4 0.6501 0.8420 1.1317 0

6 5 0.0007 0.6580 0.4330 1

7 6 0.1520 0.9772 0.9780 1

8 7 0.3179 0.5713 0.4274 1

... ... ... ... ... ...

10, 001 10, 000 0.5560 0.5679 0.6317 1

We find that the number of darts falling in the circle in the first quadrant:

m = 7, 894

m 7, 894

P ≈ = = 0.7894

n 10, 000

∧

π = 4 (0.7894) = 3. 157 6

B2=rand()=0.2854 C2=rand()=0.1694

D2=B2^2+C2^2=0.1102 E2=if(D2>=1,1,0)=1

B3=rand()=0.5147 C3=rand()=0.2787

D3=B3^2+C3^2=0.3426 E3=if(D3>=1,1,0)=1

m=SUM(E2:E10001)=7, 894

We produce 19 more trials. The total number of trials is k = 20. Here is the

snapshot of Excel:

∧

³ ∧ ´2

trial mi pi πi πi

1 7,894 0.7894 3.1576 9.97043776

2 7,818 0.7818 3.1272 9.77937984

3 7,830 0.783 3.1320 9.80942400

4 7,752 0.7752 3.1008 9.61496064

5 7,879 0.7879 3.1516 9.93258256

6 7,879 0.7879 3.1516 9.93258256

7 7,778 0.7778 3.1112 9.67956544

180 CHAPTER 19. MONTE CARLO VALUATION

9 7,891 0.7891 3.1564 9.96286096

10 7,896 0.7896 3.1584 9.97549056

11 7,844 0.7844 3.1376 9.84453376

12 7,880 0.788 3.1520 9.93510400

13 7,920 0.792 3.1680 10.03622400

14 7,821 0.7821 3.1284 9.78688656

15 7,825 0.7825 3.1300 9.79690000

16 7,870 0.787 3.1480 9.90990400

17 7,886 0.7886 3.1544 9.95023936

18 7,822 0.7822 3.1288 9.78938944

19 7,839 0.7839 3.1356 9.83198736

20 7,762 0.7762 3.1048 9.63978304

total 62.7856 197.10829728

³∧´ P π ∧

62.7856

i

π≈E π = = = 3. 139 28

k 20

The estimated variance

Ã of the sample mean is:

³∧´ µ ¶2 ! µ ¶

k 1 P 1 P 20 197.10829728

V ar π ' μ2i − μi = − 3. 139 282 =

k−1 k k 19 20

0.0003536 27

p √

V ar (μ) ' 0.0003536 27 = 0.01880 5

The 95% confidence interval is [3. 102 4, 1. 3. 176 1]. This is calculated as

follows:

3. 139 28 − 1.96 (0.01880 5) = 3. 102 422 2

3. 139 28 + 1.96 (0.01880 5) = 3. 176 137 8

The 99% confidence interval is [3. 090 8, 3. 187 8]. This is calculated as fol-

lows:

3. 139 28 − 2.58 (0.01880 5) = 3. 090 763 1

Then upper bound of the 99% confidence interval is

3. 139 28 + 2.58 (0.01880 5) = 3. 187 796 9

Now you have some ideas about the Monte Carlo simulation. Let’s look at

the textbook.

call or put options

Monte Carlo simulation can be used to price European options, especially when

there’s no simple formula for the option price such as the arithmetic Asian

option.

19.3. EXAMPLE 3 ESTIMATE THE PRICE OF EUROPEAN CALL OR PUT OPTIONS181

First, let’s use the Monte Carlo method to calculate the price of a European

call option and put option. The inputs are (See DM page 377 Example 12.1):

• S0 = 41

• K = 40

• σ = 0.3

• r = 8%

• δ=0

• T = 0.25 (3 months)

Solution

We’ll use DM Equation 19.6 to calculate the option price:

1 −rT P n ¡ ¢ Pn 1 ¡ ¢

V (S0 , 0) = e V STi , T = e−rT V STi , T

n t=1 t=1 n

P

n 1 ¡ i ¢

V ST , T is the average terminal payoﬀ. So the price of the European

t=1 n

option is just the discounted value of the terminal payoﬀ.

We’re are going to produce 5 sample means. For each sample mean, we’ll

use 10 simulations. So we have 5 trials with 20 simulations per trial. For each

trial, we need to generate the stock’s terminal price at T = 0.25.

We generate hthe terminal stock price using DM 19.3:

¡ ¢ √ i

ST = S0 exp α − δ − 0.5σ 2 T + σ T Z

Please note that the above formula produces the real world stock price at

T . If we use the real world terminal stock price to calculate the option price,

you have to use the real world discount rate, which is path-dependent (see DM

Table 19.1). Path dependent discount rates are diﬃcult to calculate. To avoid

the diﬃculty of finding the path-dependent discount rates, we’ll want to live in

the risk neutral world where everything earns the risk-free rate. To move into

the risk neutral hworld, we just set α = r andi change DM 19.3 into:

¡ ¢ √

ST = S0 exp r − δ − 0.5σ2 T + σ T Z

¡¡ ¢ √ ¢

S0.25 = 41 exp 0.08 − 0.5 × 0.32 0.25 + 0.3 0.25Z = 41 exp (0.15Z + 0.008 75)

snapshot of Excel simulation:

1 0.67830 45.7901 5.7901 0.0000

2 0.65327 45.6185 5.6185 0.0000

3 1.21158 49.6034 9.6034 0.0000

182 CHAPTER 19. MONTE CARLO VALUATION

5 0.62495 45.4251 5.4251 0.0000

6 -1.89286 31.1369 0.0000 8.8631

7 0.57282 45.0712 5.0712 0.0000

8 -0.84887 36.4154 0.0000 3.5846

9 -0.34767 39.2586 0.0000 0.7414

10 -0.34540 39.2720 0.0000 0.7280

Total 429.4146 43.3317 13.9171

Sample calculations.

If Z = 0.67830, S0.25 = 41 exp (0.15 × 0.67830 + 0.008 75) = 45. 790 1

The call payoﬀ is 45. 790 1 − 40 = 5. 790 1

The put payoﬀ is zero.

43.3317

The average call payoﬀ at T is: = 4. 333 17

10

−rT

So the call price is 4. 333 17e = 4. 333 17e−0.08×0.25 = 4. 247 4

13.9171

The average put payoﬀ at T is: = 1. 391 71

10

−0.08×0.25

So the put price is 1. 391 71e = 1. 364 2

Now I’m going to repeat this process 4 more times. This is my final result:

trials call price put price

1 4. 247 4 1. 364 2

2 3.9132 1.2391

3 0.5436 2.4875

4 1.6850 1.8342

5 2.4911 1.9250

The mean of the sample mean for the call price is:

4. 247 4 + 3.9132 + 0.5436 + 1.6850 + 2.4911

= 2. 58

5

Compare this with the correct price using the Black-Scholes formula (see

DM page 377): C = 3.40

The mean of the sample mean for the put price is:

1. 364 2 + 1.2391 + 2.4875 + 1.8342 + 1.9250

= 1. 77

5

Compare this with the correct price using the Black-Scholes formula (see

DM page 377): P = 1.61

The prices from the Monte Carlo simulations are oﬀ because the number of

simulations per trial is small.

After running 10 trials (5,000 simulations per trial), I got the following:

trials call call^2 put put^2

1 3.4132 11.6502 1.5976 2.5523

19.3. EXAMPLE 3 ESTIMATE THE PRICE OF EUROPEAN CALL OR PUT OPTIONS183

3 3.4085 11.6182 1.6007 2.5622

4 3.4002 11.5614 1.6249 2.6402

5 3.4019 11.5729 1.5815 2.5012

6 3.4224 11.7129 1.6056 2.5778

7 3.4089 11.6206 1.6158 2.6108

8 3.4140 11.6551 1.6039 2.5725

9 3.3998 11.5587 1.5879 2.5214

10 3.4018 11.5725 1.6216 2.6297

So the mean of the sample mean for call price is:

34.0639

= 3. 40639

10

Theµvariance of the sample ¶ mean for the call price is:

10 116.03585

− 3. 406 392 = 1. 024 1 × 10−4

9 10

√

1. 024 1 × 10−4 = 0.01

So the 95% confidence interval for the call price is [3. 39, 1. 3. 43]. This is

calculated as follows:

3. 40639 − 1.96 (0.01) = 3. 39

3. 40639 + 1.96 (0.01) = 3. 43

16.0398

= 1. 603 98

10

Theµvariance of the sample¶ mean for the put price is:

10 25.7292

− 1. 603 982 = 0.000 186 844

9 10

√

0.000 186 844 = 0.014

So the 95% confidence interval for the call price is [1.58, 1.63]. This is cal-

culated as follows:

1. 603 98 − 1.96 (0.014) = 1. 58

1. 603 98 + 1.96 (0.014) = 1. 63

By the way, there’s no need for us to use Monte Carlo summations to cal-

culate a European call or put option. The Black-Scholes formula can produce

the price of a European call or put option. Here we calculate European option

prices to illustrate how to use the Monte Carlo simulation.

Please note that using the Monte Carlo simulation to calculate the American

option price is covered in DM 1936, which is out of the scope of exam MFE.

184 CHAPTER 19. MONTE CARLO VALUATION

tions

Let’s use the Monte Carlo method to calculate the price of an arithmetic call

option and an arithmetic put option. The inputs are (See DM page 629 Table

19.3):

• S0 = 40

• K = 40

• σ = 0.3

• r = 8%

• δ=0

• T = 0.25 (3 months)

• The average stock price is the average stock prices at the end of Month 1,

Month2, and Month 3

Solution

The stock prices (the real world price)

³¡ at the end of Month 1,´ 2, and 3 are:

¢ √

end of Month 1: Sh = S0 exp α − δ − 0.5σ 2 h + σ hz1

³¡ ¢ √ ´

end of Month 2: S2h = Sh exp α − δ − 0.5σ 2 h + σ hz2

³¡ ¢ √ ´

end of Month 3: S3h = ST = S2h exp α − δ − 0.5σ 2 h + σ hz3

where z1 , z2 , and z3 are three separate random draws of the standard normal

distribution.

Since our goal is to calculate the option price, we don’t need the real world

stock price. We just need the risk-neutral stock price. We change the stock’s

expected return α into the risk free rate r. The risk neutral stock prices at the

end of Month 1,³2, and 3 are:

¡ ¢ √ ´

Sh = S0 exp r − δ − 0.5σ 2 h + σ hz1

³¡ ¢ √ ´

S2h = Sh exp r − δ − 0.5σ 2 h + σ hz2

³¡ ¢ √ ´

S3h = S2h exp r − δ − 0.5σ 2 h + σ hz3

Sh + S2h + S3h

The average stock price is S =

3 ¡ ¢

The arithmetic call price is: C = e−rT max S − K, 0

¡ ¢

The arithmetic call price is: P = e−rT max K − S, 0

19.4. EXAMPLE 4 ARITHMETIC AND GEOMETRIC OPTIONS 185

The following snapshot of Excel shows one trial (5000 simulations per trial)

of the call/put price:

i z1 Sh z2 S2h z3 S3h S C pay P pay

1 0.8424 43.1529 0.258 44.2568 −2.4041 36.0434 41.1510 1.1510 0.0000

2 0.066 40.3468 −1.4415 35.7157 −2.0925 29.8830 35.3152 0.0000 4.6848

3 0.5357 42.0218 0.1255 42.6051 −0.8295 39.7677 41.4649 1.4649 0.0000

4 0.0014 40.1217 1.0027 43.8893 −0.8446 40.9128 41.6413 1.6413 0.0000

5 −1.598 34.9321 −1.5906 30.5258 1.2832 34.2134 33.2238 0.0000 6.7762

6 1.2843 44.8364 −0.6896 42.3605 −0.3961 41.0516 42.7495 2.7495 0.0000

7 −0.0712 39.8702 0.2363 40.8134 0.0147 40.9848 40.5561 0.5561 0.0000

8 −1.0075 36.7649 −0.5005 35.3082 0.6539 37.4745 36.5159 0.0000 3.4841

... ... ... ... ... ... ... ... ... ...

5000 −0.0168 40.0585 −1.2203 36.1464 0.6609 38.3874 38.1974 0.0000 1.8026

normal distribution.

Ã r !

¡ ¢ 0.25 0.25

Sh = 40 exp 0.08 − 0 − 0.5 × 0.32 + 0.3 × 0.8424 = 40 exp (0.075 87) =

3 3

43. 152 9

Ã r !

¡ ¢

2 0.25 0.25

S2h = 43. 152 9 exp 0.08 − 0 − 0.5 × 0.3 + 0.3 × 0.258 =

3 3

¡ −2

¢

43. 152 9 exp 2. 526 01 × Ã 10 = 44. 256 8 !

r

¡ ¢

2 0.25 0.25

S3h = 44. 256 8 exp 0.08 − 0 − 0.5 × 0.3 + 0.3 × (−2.4041) =

3 3

44. 256 8 exp (−0.205 28) = 36. 0434

43. 152 9 + 44. 256 8 + 36. 0434

S= = 41. 151 0

3

1 1.1510 0.0000 1.1282 0.0000 1.2728 0.0000

2 0.0000 4.6848 0.0000 4.5920 0.0000 21.0865

3 1.4649 0.0000 1.4359 0.0000 2.0618 0.0000

4 1.6413 0.0000 1.6088 0.0000 2.5882 0.0000

5 0.0000 6.7762 0.0000 6.6420 0.0000 44.1162

6 2.7495 0.0000 2.6951 0.0000 7.2636 0.0000

7 0.5561 0.0000 0.5451 0.0000 0.2971 0.0000

8 0.0000 3.4841 0.0000 3.4151 0.0000 11.6629

... ... ... ... ... ... ...

5000 0.0000 1.8026 0.0000 1.7669 0.0000 3.1219

sum 10, 111.9410 7, 390.6006 9, 911.7119 7, 244.2548 61, 373.4417 32, 916.8904

186 CHAPTER 19. MONTE CARLO VALUATION

Put payoﬀ: e−rT ×put payoﬀ= e−0.08(0.25) × 0.0000 = 0

C 2 = 1. 128 22 = 1. 272 8 P 2 = 02 = 0

The estimated option prices are calculated as follows.

sum 10, 111.9410 7, 390.6006 9, 911.7119 7, 244.2548 61, 373.4417 32, 916.8904

The average call price of these 5000 simulations:

1 P 10111.9410

e−rT × call payoﬀ= e−0.08(0.25) × = 1. 982 34

5000 5000

1 P 9911.7119

or C= = 1. 982 34

5000 5000

1 P 7390.6006

e−rT × put payoﬀ= e−0.08(0.25) × = 1. 448 9

5000 5000

1 P 7244.2548

or P = = 1. 448 9

5000 5000

Ã µ P ¶2 ! µ ¶

n 1 P 2 C 5000 1

× C − = × 61373.4417 − 1. 982 342 =

n−1 n n 5000 − 1 5000

8. 346 7

Ã µ P ¶2 ! Ã µ ¶2 !

n 1 P 2 P 5000 1 7244.2548

× P − = × 32916.8904 −

n−1 n n 5000 − 1 5000 5000

= 4. 485 1

The following is the snapshot of Excel for 30 trials (5000 simulations per

trial) for the arithmetic European call and put prices:

19.4. EXAMPLE 4 ARITHMETIC AND GEOMETRIC OPTIONS 187

i C P C2 P2

1 1.9823 1.4489 3.929513 2.099311

2 1.9409 1.4486 3.767093 2.098442

3 1.9467 1.4920 3.789641 2.226064

4 2.0098 1.4211 4.039296 2.019525

5 1.9894 1.4447 3.957712 2.087158

6 1.9515 1.4886 3.808352 2.215930

7 1.9825 1.4813 3.930306 2.194250

8 2.0462 1.4408 4.186934 2.075905

9 2.1270 1.3565 4.524129 1.840092

10 1.9583 1.4675 3.834939 2.153556

11 1.9878 1.4691 3.951349 2.158255

12 1.9664 1.4496 3.866729 2.101340

13 2.0147 1.3785 4.059016 1.900262

14 1.9664 1.4327 3.866729 2.052629

15 1.9915 1.4253 3.966072 2.031480

16 1.9504 1.4592 3.804060 2.129265

17 1.9414 1.4800 3.769034 2.190400

18 1.9804 1.4186 3.921984 2.012426

19 1.9666 1.4724 3.867516 2.167962

20 2.0276 1.3779 4.111162 1.898608

21 1.9940 1.4217 3.976036 2.021231

22 1.9307 1.4815 3.727602 2.194842

23 1.9221 1.4903 3.694468 2.220994

24 1.9710 1.4491 3.884841 2.099891

25 1.9185 1.4526 3.680642 2.110047

26 1.9529 1.4638 3.813818 2.142710

27 1.9791 1.4538 3.916837 2.113534

28 1.9776 1.4676 3.910902 2.153850

29 1.9713 1.5092 3.886024 2.277685

30 1.9689 1.4640 3.876567 2.143296

sum 59.3139 43.5069 117.3193 63.1309

For the remaining part of the calculation, all you need to know is the fol-

lowing:

Trial C P C2 P2

sum 59.3139 43.5069 117.3193 63.1309

¡ ¢ 59.3139

E C = = 1. 977 13

30

The estimated variance of the call price (per trial) is:

188 CHAPTER 19. MONTE CARLO VALUATION

⎛ ⎞2 ⎞

⎛ n=30

P

Ci ⎟ µ ¶

¡ ¢ n ⎜ P 2 ⎜

⎜ 1 n=30 ⎟ ⎟

⎟ ⎟ = 30 1

V ar C = ⎜ × Ci − ⎜ i=1

⎝ n ⎠ ⎠ 30 − 1 30 × 117.3193 − 1. 977 12

=

n − 1 ⎝n i=1

0.001 778 √

The standard deviation is: 0.001 778 = 0.04 217

For each trial, the average call price of the 5, 000 simulations is used to

P

1 5,000

estimate the call price. C = Ci .

5, 000 i=1

So the variance of the

µ call price¶per trial is:

¡ ¢ 1 P

5,000 1 1

V ar C = 2

V ar Ci = 2

×5, 000V ar (C) = V ar (C) =

5, 000 i=1 5, 000 5000

8. 346 7

= 0.001 669

5000 √

The standard deviation is: 0.001 669 = 0.0406

Please note that the two methods of estimating the variance of the call price

per trial often produce close, but not identical, results. The results are not

identical because the estimated variance per trial changes depending how many

trial you have and how many simulations per trial.

¡ ¢ 43.5069

E P = = 1. 450 23

30

The estimated variance of the put price (per trial) is:

⎛ ⎛ n=30 ⎞2 ⎞

P

P µ ¶

n ⎜ ⎟ ⎟

i

¡ ¢ ⎜ 1 n=30P 2 ⎜ ⎜ i=1 ⎟ ⎟ 30 1 2

V ar P = ⎜ × Pi − ⎝ ⎟= × 63.1309 − 1. 450 23 =

n − 1 ⎝n i=1 n ⎠ ⎠ 30 − 1 30

0.001 237 5 √

The standard deviation is: 0.001 237 5 = 0.03 518

For each trial, the average call price of the 5, 000 simulations is used to

P

1 5,000

estimate the call price. P = Pi .

5, 000 i=1

µ ¶

¡ ¢ 1 P

5,000 1 1

V ar P = 2

V ar Pi = 2

×5, 000V ar (P ) = V ar (P ) =

5, 000 i=1 5, 000 5000

4. 4668

= 0.000 89

5000 √

The standard deviation is: 0.000 89 = 0.0298

Now let’s use Monte Carlo simulation to estimate the geometric call and put

prices. I’m going to use the same inputs:

19.4. EXAMPLE 4 ARITHMETIC AND GEOMETRIC OPTIONS 189

• S0 = 40

• K = 40

• σ = 0.3

• r = 8%

• δ=0

• T = 0.25 (3 months)

• The average stock price is the average stock prices at the end of Month 1,

Month2, and Month 3

In addition, I’m going to use the same random draws of standard normal

random variables z1 , z2 , and z3 as used for simulating the arithmetic call/put

prices. Though I don’t have to use the z1 , z2 , and z3 used for estimating the

arithmetic call/put prices, reuse saves me time. Here is a snapshot of Excel

doing one trial:

1 0.8424 43.1529 0.258 44.2568 −2.4041 36.0434 40.9831 0.9831 0

2 0.066 40.3468 −1.4415 35.7157 −2.0925 29.8830 35.0508 0 4.9492

3 0.5357 42.0218 0.1255 42.6051 −0.8295 39.7677 41.4466 1.4466 0

4 0.0014 40.1217 1.0027 43.8893 −0.8446 40.9128 41.6101 1.6101 0

5 −1.598 34.9321 −1.5906 30.5258 1.2832 34.2134 33.1662 0 6.8338

6 1.2843 44.8364 −0.6896 42.3605 −0.3961 41.0516 42.7209 2.7209 0

7 −0.0712 39.8702 0.2363 40.8134 0.0147 40.9848 40.5532 0.5532 0

8 −1.0075 36.7649 −0.5005 35.3082 0.6539 37.4745 36.5047 0 3.4953

... ... ... ... ... ... ... ... .... ...

5000 −0.0168 40.0585 −1.2203 36.1464 0.6609 38.3874 38. 163 6 0 1. 836 4

sum 9, 911.3146 7, 528.5134

Sample calculations.

The 1st simulation.

S = (43.1529 × 44.2568 × 36.0434)1/3 = 40. 983 1

Call payoﬀ: 40. 983 1 − 40 = 0.983 1

Put payoﬀ: 0

i z1 Sh z2 S2h z3 S3h S C pay P pay

5000 −0.0168 40.0585 −1.2203 36.1464 0.6609 38.3874 38. 163 6 0 1. 836 4

Call payoﬀ: 0

Put payoﬀ: 40 − 38. 163 6 = 1. 836 4

190 CHAPTER 19. MONTE CARLO VALUATION

i call payoﬀ put payoﬀ C P C2 P2

1 0.9831 0 0.9636 0 0.9285 0

2 0 4.9492 0 4.8512 0 23.5341

3 1.4466 0 1.418 0 2.0107 0

4 1.6101 0 1.5782 0 2.4907 0

5 0 6.8338 0 6.6985 0 44.8699

6 2.7209 0 2.667 0 7.1129 0

7 0.5532 0 0.5422 0 0.2940 0

8 0 3.4953 0 3.4261 0 11.7382

... ... ... ... ...

5000 0 1. 836 4 0 1. 800 0 0 3.24

sum 9, 911.3146 7, 528.5134 9, 715.0581 7, 379.4385 59, 337.3153 33, 852.0593

Sample calculation.

The 1st simulation.

Call price: 0.9831e−0.08×0.25 = 0.963 6

Call price: 0

The average call price of these 5000 simulations:

1 P 10111.9410

e−rT × call payoﬀ= e−0.08(0.25) × = 1. 982 34

5000 5000

1 P 9911.7119

or C= = 1. 982 34

5000 5000

The following calculation uses this part of the table:

i call payoﬀ put payoﬀ C P C2 P2

sum 9, 911.3146 7, 528.5134 9, 715.0581 7, 379.4385 59, 337.3153 33, 852.0593

1 P 9911.3146

e−rT × call payoﬀ= e−0.08(0.25) × = 1. 943 0

5000 5000

1 P 9715.0581

or C= = 1. 943 0

5000 5000

The estimated

Ã variance of the call price per simulation is:

µ P ¶2 ! µ ¶

n 1 P 2 C 5000 1

× C − = × 59337.3153 − 1. 943 02 =

n−1 n n 5000 − 1 5000

8. 093 8

19.4. EXAMPLE 4 ARITHMETIC AND GEOMETRIC OPTIONS 191

1 P 7528.5134

e−rT × put payoﬀ= e−0.08(0.25) × = 1. 475 9

5000 5000

1 P 7379.4385

or P = = 1. 475 9

5000 5000

The estimated

µ variance of the put price per

¶ simulation is:

5000 1

× 33852.0593 − 1. 475 92 = 4. 593 0

5000 − 1 5000

i C P C2 P2

1 1. 943 0 1.4759 3.775249 2.178281

2 1.9001 1.4754 3.610380 2.176805

3 1.9080 1.5200 3.640464 2.310400

4 1.9698 1.4476 3.880112 2.095546

5 1.9506 1.4727 3.804840 2.168845

6 1.9112 1.5171 3.652685 2.301592

7 1.9436 1.5091 3.777581 2.277383

8 2.0058 1.4675 4.023234 2.153556

9 2.0854 1.3830 4.348893 1.912689

10 1.9191 1.4958 3.682945 2.237418

11 1.9487 1.4959 3.797432 2.237717

12 1.9281 1.4775 3.717570 2.183006

13 1.9748 1.4058 3.899835 1.976274

14 1.9272 1.4608 3.714100 2.133937

15 1.9519 1.4523 3.809914 2.109175

16 1.9116 1.4863 3.654215 2.209088

17 1.9039 1.5072 3.624835 2.271652

18 1.9424 1.4453 3.772918 2.088892

19 1.9274 1.5007 3.714871 2.252100

20 1.9867 1.4049 3.946977 1.973744

21 1.9535 1.4483 3.816162 2.097573

22 1.8924 1.5100 3.581178 2.280100

23 1.8845 1.5182 3.551340 2.304931

24 1.9328 1.4771 3.735716 2.181824

25 1.8804 1.4809 3.535904 2.193065

26 1.9133 1.4916 3.660717 2.224871

27 1.9399 1.4814 3.763212 2.194546

28 1.9398 1.4947 3.762824 2.234128

29 1.9318 1.5376 3.731851 2.364214

30 1.9279 1.4921 3.716798 2.226362

sum 58.1356 44.3327 112.7048 65.5497

192 CHAPTER 19. MONTE CARLO VALUATION

trial C P C2 P2

sum 58.1356 44.3327

112.7048 65.5497

58.1356

The estimated call price is: = 1. 937 85

30

44.3327

The estimated put price is: = 1. 477 76

30

The estimated

µ variance of the call price

¶ per trial:

30 1 2

× 112.7048 − 1. 937 85 = 0.001618

30 − 1 30 √

The standard deviation is: 0.001618 = 0.040 22

The estimated variance of the call per trial can also be calculated as follows:

For each trial, the average call price of the 5, 000 simulations is used to

P

1 5,000

estimate the call price. C = Ci .

5, 000 i=1

So the variance of the

µ call price¶per trial is:

¡ ¢ 1 P

5,000 1 8. 093 8

V ar C = 2

V ar Ci = V ar (C) = = 0.001 619

5, 000 i=1 5000 5000

√

The standard deviation is: 0.001 619 = 0.04 02

The estimated

µ variance of the put¶price per trial:

30 1

× 65.5497 − 1. 477 762 = 0.001 257 3

30 − 1 30

√

The standard deviation is: 0.001 257 3 = 0.03545 8

The estimated variance of the call per trial can also be calculated as follows:

For each trial, the average put price of the 5, 000 simulations is used to

P

1 5,000

estimate the put price. P = Pi .

5, 000 i=1

So the variance of the

µ put price¶per trial is:

¡ ¢ 1 P

5,000 1 4. 593 0

V ar P = 2

V ar Pi = V ar (P ) = = 0.000 918 6

5, 000 i=1 5000 5000

√

The standard deviation is: 0.000 918 6 = 0.0303

Here’s a question. We know that the estimated standard √ variance of the put

price per simulation is 4. 593 0 (the standard deviation is 4. 593 0 = 2. 143 1).

If we want the standard deviation of the put price per trial is 0.02, how many

simulations should be performed in one trial? Here is how to find it.

µ ¶

¡ ¢ 1 P

n 1 V ar (C)

V ar C = 2 V ar Ci = × nV ar (C) =

n i=1 n2 n

19.5. EFFICIENT MONTE CARLO VALUATION 193

r r

V ar (C) 4. 593 0 4.5930

Set = 0.02. We have: = 0.02 or n = = 11482.

n n 0.022

5

We need to have about 11,500 simulations per trial.

19.5.1 Control variance method

prices V1 , V2 , ..., Vn . We can use the sample mean of these option prices to

estimate the true option price. So the true option is estimated as:

V1 + V2 + ... + Vn

V =

n

µ ¶

¡ ¢ V1 + V2 + ... + VnnV ar (V ) V ar (V )

V ar V = V ar 2

= =

n n n

σV

The standard deviation of the sample mean is σ V = √ , where n is the num-

n

ber of the simulations and σ V is the standard deviation of the option price per

simulation. To decrease σ V , we need to increase n by doing more simulations.

Doing more simulations costs time.

However, there are techniques out there to reduce σ V without increasing n.

One method is called the control variate method. It goes like this.

Suppose we have two random similar variables X and Y . We need to calcu-

late E (X) and E (Y ). We can calculate E (X) easily because there’s a formula

for E (X). E (Y ), on the other hand, doesn’t have a formula and needs to be

calculated through the Monte Carlo simulation. Since X and Y are similar, we

expect that our errors in estimating E (X) are similar to our errors in estimating

E (Y ):

∧ ∧

E (X) − μX ≈ E (Y ) − μY

In the above formula, E (X) and E (Y ) are the true means of X and Y ;

∧ ∧

μX and μY are the estimated means of X and Y based on the Monte Carlo

simulation.

Since our goal his to find E (Y

i ), we

³ arrange´the above formula into:

∧ ∧ ∧ ∧

E (Y ) ≈ μY + E (X) − μX = μY − μX + E (X)

³∧ ∧

´

So we can use μY − μX + E (X) to estimate E (Y ). We define this new

∧∗

³∧ ∧

´

estimate as μY = μY − μX + E (X).

194 CHAPTER 19. MONTE CARLO VALUATION

∧∗

³∧ ∧

´

Why is the new estimate E (Y ) ≈ μY = μY − μX + E (X) better than

∧

the old estimate E (Y ) ≈ μY ? It turns out the new estimate often has lower

∧ ∧

variance if μX and μY are positively correlated.

The ³

variance

´ of the

h³new estimate

´ is: i ³∧ ´ ³∧ ´

∧∗ ∧ ∧ ∧

V ar μY = V ar μY − μX + E (X) = V ar μY − μX = V ar μX +

³∧ ´ ³∧ ∧ ´

V ar μY − 2Cov μX ,μY

The above formula holds because E (X) is a constant.

European call option price; there’s a formula for the geometric European call

option price. So we’ll use the Monte Carlo simulation to estimate the arithmetic

European call option. We’ll use the geometric European price as the control

variate (i.e. a dummy variable).

price.

∧∗ ∧ ∧

μAC = μAC − μGC + E (GC)

∧ ∧

We’ll find μAC and μGC through Monte Carlo simulation. We’ll calculate

E (GC) using the equation DM 14.18 and DM 14.19 (see Derivatives Markets

Appendix 14.A). Once again, the inputs are:

• S0 = 40

• K = 40

• σ = 0.3

• r = 8%

• δ=0

• T = 0.25 (3 months)

• The average stock price is the average stock prices at the end of Month 1,

Month2, and Month 3 (so N = 3)

First, we’ll calculate the geometric European call option price. By the way,

the appendix 14.5 is not on the syllabus of the exam MFE. You can ignore my

calculation and just accept that the geometric call option price is 1. 938 5.

Using DM 14.18, we get:

µ ¶

1 2 ¡ ¢ 4 0.32 4 × 7

δ∗ = 0.08 × + 0 + 0.5 × 0.32 − 2 × = 0.03 333

2 3 3 3 6

19.5. EFFICIENT MONTE CARLO VALUATION 195

r

0.3 4×7

σ∗ = = 0.216 025

3 6

∗

C (S, K, σ ∗ , r, T, δ ∗ ) = Se−δ T N (d1 ) − Ke−rT N (d2 )

µ ¶ µ ¶

S 1 40 1

ln + r − δ ∗ + (σ ∗ )2 T ln + 0.08 − 0.03 333 + × 0.216 0252 0.25

K 2 40 2

d1 = √ = √ =

σ T 0.216 025 0.25

0.162 026

√ √

d2 = d1 − σ ∗ T = 0.162 026 − 0.216 025 0.25 = 0.054 013 5

Now we have:

∧∗ ∧ ∧

μAC = μAC − μGC + 1. 938 5

196 CHAPTER 19. MONTE CARLO VALUATION

i AC GC AC − GC (AC − GC)2

1 1.9823 1.9430 0.0393 0.001544

2 1.9409 1.9001 0.0408 0.001665

3 1.9467 1.9080 0.0387 0.001498

4 2.0098 1.9698 0.0400 0.001600

5 1.9894 1.9506 0.0388 0.001505

6 1.9515 1.9112 0.0403 0.001624

7 1.9825 1.9436 0.0389 0.001513

8 2.0462 2.0058 0.0404 0.001632

9 2.1270 2.0854 0.0416 0.001731

10 1.9583 1.9191 0.0392 0.001537

11 1.9878 1.9487 0.0391 0.001529

12 1.9664 1.9281 0.0383 0.001467

13 2.0147 1.9748 0.0399 0.001592

14 1.9664 1.9272 0.0392 0.001537

15 1.9915 1.9519 0.0396 0.001568

16 1.9504 1.9116 0.0388 0.001505

17 1.9414 1.9039 0.0375 0.001406

18 1.9804 1.9424 0.0380 0.001444

19 1.9666 1.9274 0.0392 0.001537

20 2.0276 1.9867 0.0409 0.001673

21 1.9940 1.9535 0.0405 0.001640

22 1.9307 1.8924 0.0383 0.001467

23 1.9221 1.8845 0.0376 0.001414

24 1.9710 1.9328 0.0382 0.001459

25 1.9185 1.8804 0.0381 0.001452

26 1.9529 1.9133 0.0396 0.001568

27 1.9791 1.9399 0.0392 0.001537

28 1.9776 1.9398 0.0378 0.001429

29 1.9713 1.9318 0.0395 0.001560

30 1.9689 1.9279 0.0410 0.001681

sum 59.3139 58.1356 1.1783 0.046313

So

i AC GC AC − GC (AC − GC)2

sum 59.3139 58.1356 1.1783 0.046313

∧ 59.3139

μAC = = 1. 977 13

30

∧ 58.1356

μGC = = 1. 937 85

30

Hence the updated estimated price of the geometric European call option is:

∧∗ ∧ ∧

μAC = μAC − μGC + 1. 938 5 = 1. 977 13 − 1. 937 85 + 1. 938 5 = 1. 977 78

Alternatively,

19.6. ANTITHETIC VARIATE METHOD 197

∧ ∧ 1.1783

μAC − μGC = = 0.03927 67

30

∧∗

μAC = 0.03927 67 + 1. 938 5 = 1. 977 78

∧∗

The variance of μAC is: µ ¶

³∧∗ ´ ³∧ ∧

´ ³∧ ∧

´ 30 1

V ar μAC = V ar μAC − μGC + 1. 938 5 = V ar μAC − μGC = × 0.046313 − 0.03927 672 =

30 − 1 30

1. 145 7 × 10−6

without ³using´the control variate method is, as calculated before,

∧

V ar μGC = 0.001618

³ ∧∗ ´ ³∧ ´

We can see that V ar μAC is much smaller than V ar μAC .

∧∗

³∧ ∧

´

Boyle points out that μY = μY − μX + E (X) doesn’t always produce

∧

lower variance than the variance of the original estimate μY . Boyle recommends

the following new³estimate: ´

∧∗ ∧ ∧

μY = μY + β E (X) − μX

¢ notation, the above new estimate is DM 19.10:

A∗ = A + β G − G

£ ¡ ¢¤ ¡ ¢ ¡ ¢ ¡ ¢

V ar (A∗ ) = V ar A + β G − G = V ar A − βG = V ar A +β 2 V ar G −

¡ ¢

2βCov A, G

¡ ¢

∗

Cov A, G

The textbook says that V ar (A ) is minimized if we set β = ¡ ¢ .

V ar G

How do we find β? Typically, we perform a small number of Monte Carlo

simulations, run regression of DM 19.10, and estimate β. Then we apply the

estimated β to DM 19.10, run more simulations, and calculate A∗ .

This is all you need to know about the Boyle’s improved control variate

method.

have generated random numbers from a symmetric distribution such as a stan-

dard normal random variables. We have n random draws z1 , z2 ,...,zn from the

198 CHAPTER 19. MONTE CARLO VALUATION

standard normal distributions. Since z1 , z2 ,...,zn are random draws from the

standard normal distribution, −z1 , -z2 ,...,−zn are also random draws from the

standard normal distribution. Next, we calculate two samples means, X 1 (using

z1 , z2 ,...,zn ) and X 2 (using −z1 , -z2 ,...,−zn ). Then we can estimated E (X) as

the average of X 1 and X 2 :

X1 + X2

E (X) ≈

2

This method is called the antithetic variate method.

Here’s an example. We want to estimate E (ez ) where z is the standard

normal random variable. We have generated the following 10 standard normal

random variables:

i zi

1 −0.0183

2 2.0478

3 −0.4849

4 −0.6583

5 −0.4666

6 −0.3757

7 1.1392

8 2.1566

9 0.1096

10 −1.5389

i zi Xi = exp (zi ) −zi Yi = exp (−zi )

1 −0.0183 0.981866 0.0183 1.018468

2 2.0478 7.750831 −2.0478 0.129018

3 −0.4849 0.615759 0.4849 1.624013

4 −0.6583 0.517731 0.6583 1.931506

5 −0.4666 0.627131 0.4666 1.594563

6 −0.3757 0.686808 0.3757 1.456010

7 1.1392 3.124268 −1.1392 0.320075

8 2.1566 8.641706 −2.1566 0.115718

9 0.1096 1.115832 −0.1096 0.896193

10 −1.5389 0.214617 1.5389 4.659462

sum 24.276548 13.745027

24.276548

X= = 2. 427 654 8

10

13.745027

Y = = 1. 374 502 7

10

E (ez ) ≈ = 1. 901 078 75

2

19.7. STRATIFIED SAMPLING 199

In stratified sampling, we divide the population into several non-overlapping

group. Each group is called a strata. Then we take a sample from each group.

Example. We divide the range [0, 1] into 100 groups: [0, 0.01), [0.01, 0.02),

[0.02, 0.03),...,[0.99, 1). Next, we draw 100 numbers u1 , u2 , ..., u100 from the

uniform distribution [0, 1]. All these 100 numbers are divided by 100. So we

u1 u2 u3 u100 i−1 ui

have , , , ..., .Next, we add to the i-th number . Now

100 100 100 100 100 100

we have:

u1 u2 u3 u100

, + 0.01, + 0.02, ..., + 0.99

100 100 100 100

ui

Since 0 ≤ ui < 1, 0 ≤ < 0.01.

100

u1

So falls in the group [0, 0.01).

100

u2 u2

Similarly, 0.01 ≤ +0.01 < 0.02. So +0.01 falls into group [0.01, 0.02).

100 100

u3 u3

Similarly, 0.02 ≤ +0.02 < 0.03. So +0.01 falls into group [0.02, 0.03).

100 100

So on and so forth.

The end result is that we take one sample from [0, 0.01), one sample from

[0.01, 0.02), ..., and one sample from [0.99, 1).

This is all you need to know about the stratified sample for the purpose of

passing Exam MFE.

bution, not from the original distribution. For example, we want to estimate

the price of an option that is deep out of the money. If we perform simulations

from the original distribution, then most of the simulated payoﬀs will be zero.

This is a waste of our time. To make the simulations more eﬃcient, we’ll draw

random numbers from the conditional distribution where the payoﬀ is not zero.

This is all you need to know about the importance sampling.

The textbook also mentioned Latin hypercube sampling and low discrepancy

sequences. Since the textbook merely mentioned these terms without providing

much explanation, I don’t think SOA expects you to know much about term.

Skip these terms and move on.

Problem 1

200 CHAPTER 19. MONTE CARLO VALUATION

You are simulating the standard normal random variable z by taking random

draws from a uniform distribution over (0, 1). Let a represent the simulated

value of z. Calculate P (z ≤ a). You are given:

i ui

1 0.3763

2 0.1349

3 0.414

4 0.0405

5 0.5225

6 0.0423

7 0.2041

8 0.9282

9 0.6792

10 0.3368

11 0.1535

12 0.157

Solution

P

ui = 0.3763+ 0.1349 + 0.414 + 0.0405+ 0.5225 + 0.0423 + 0.2041+ 0.9282 +

0.6792 + 0.3368 + 0.1535 + 0.157 = 3. 989 3

P

The simulated value is a = ui − 6 = 3.9893 − 6 = −2. 010 7

P (z ≤ a) = N (−2. 010 7) = 1 − N (2. 010 7) = 0.022

Problem 2

You are simulating E (ez ) by taking random 10 draws from a uniform dis-

tribution over (0, 1). Calculate the simulated value of E (ez ). You are given:

i ui

1 0.878

2 0.762

3 0.069

4 0.8

5 0.048

6 0.22

7 0.178

8 0.661

9 0.191

10 0.258

Solution

19.8. SAMPLE PROBLEMS 201

i ui zi = N −1 (ui ) xi = ezi

1 0.878 1.17 3.221993

2 0.762 0.71 2.033991

3 0.069 −1.48 0.227638

4 0.8 0.84 2.316367

5 0.048 −1.66 0.190139

6 0.22 −0.77 0.463013

7 0.178 −0.92 0.398519

8 0.661 0.42 1.521962

9 0.191 −0.87 0.418952

10 0.258 −0.65 0.522046

sum 11.314619

11.314619

The estimated value is E (ez ) = = 1. 131 461 9

10

Sample calculation. u1 = 0.878. Look at the normal table. You see that

roughly P (z < 1.17) = 0.878 so z1 = 1.17.

By the way, I’m using Excel to find zi = N −1 (ui ) for me so I don’t have to

look at the normal table. So if you can’t match my z, that’s OK. For example,

for u1 = 0.878, you might get z1 = 1.16 or z1 = 1.165. However, your final

estimated E (ez ) should be close to mine.

x1 = e1.17 = 3. 221 993

u3 = 0.069. Since 0.069 < 0.5, you know that z3 = N −1 (u3 ) < 0. You

can’t directly look up z3 from the normal table (the normal table lists only the

positive z values). Use the formula N (−z3 ) = 1 − N (z3 ) = 1 − 0.069 = 0.931 .

From the normal table you see that P (z < 1.48) = 0.931. So −z3 = 1.48 or

z3 = −1.48.

Problem 3

• S0 = 100

• α = 0.06

• r = 0.08

• δ = 0.02

• T = 0.5

• σ = 0.3

202 CHAPTER 19. MONTE CARLO VALUATION

i ui ∼ U (0, 1)

1 0.6515

2 0.8839

•

3 0.7621

4 0.3922

5 0.1748

Solution

³¡ price at T is: ¢ √ ´ 2

√

ST = S0 exp α − δ − 0.5σ 2 T + σ T z = 100e(0.06−0.02−0.5×0.3 )0.5+0.3 0.5z =

√

100e−0.002 5+0.3 0.5z

√

i u1 ∼ U (0, 1) zi = N −1 (u1 ) ST = 100e

√

−0.002 5+0.3 0.5z

1 0.6515 0.39 100e = 108. 353 8

2 0.8839 1.19 128. 394 5

3 0.7621 0.71 115.9645

4 0.3922 −0.27 94.1976

5 0.1748 −0.94 81.7173

Total 528.6276

528.6276

The average of the simulated stock prices is: = 105. 73

5

Please note that the risk free rate r is not needed for solving this problem.

Problem 4

You are simulating the price of an arithmetic average stock price European

call option and put option. You are given:

• S0 = 40

• K = 40

• α = 0.06

• r = 0.08

• δ=0

• T =1

• σ = 0.3

19.8. SAMPLE PROBLEMS 203

• The 3 random draws from a uniform distribution (0, 1) are 0.4828, 0.6177,

and 0.9345, which are used to simulate the stock price at the end of Month

4, 8, and 12 respectively.

Calculate the simulated values of this arithmetic Asian call option and put

option.

Solution

∗ ∗

S1/3 + S2/3 + S1∗

−rT

e max − K, 0

3

³¡ stock price at t.

¢ √ ´ 2

√

St∗ = St−h exp r − δ − 0.5σ 2 h + σ hz = St−h e(0.08−0−0.5×0.3 )h+0.3 hz

∗ ∗

u1 z1 S1/3 u2 z2 S2/3 u3 z3 S1∗

0.4828 −0.04 40.1900 0.6177 0.3 42.8303 0.9345 1.51 56.2864

Sample calculation. √

2

∗

S1/3 = 40e(0.08−0−0.5×0.3 )1/3+0.3 1/3(−0.04) = 40. 1900

2

√

∗

S2/3 = 40.1900e(0.08−0−0.5×0.3 )1/3+0.3 1/3(0.3) = 42. 830 3

2

√

S ∗ = 42.8303e(0.08−0−0.5×0.3 )1/3+0.3 1/3(1.51) = 56. 286 4

1

Average stock price: = 46. 435 6

3

The call payoﬀ: max (46. 435 6 − 40, 0) = 6. 435 6

The put payoﬀ: max (40 − 46. 435 6, 0) = 0

The simulated value of the call price is: e−0.08×1 6. 435 6 = 5. 940 8

The price of a non dividend-paying stock is to be estimated using simulation.

It is known that:

204 CHAPTER 19. MONTE CARLO VALUATION

Using the following uniform (0, 1) random numbers and the inversion method,

three prices for two years from the current date are simulated 0.9830, 0.0384, 0.7794.

Calculate the mean of the three simulated prices.

(A) Less than 75 (B) At least 75, but less than 85 (C) At least 85,

but less than 95 (D) At least 95, but less than 115 (E) At least 115

Solution

³¡ ¢ √ ´ 2

√

ST = S0 exp α − δ − 0.5σ 2 T + σ T z = 50e(0.15−0−0.5×0.3 )2+0.3 2z =

√

50e0.21+0.3 2z

√

i u1 ∼ U (0, 1) zi = N −1 (u1 ) ST √= 50e0.21+0.3 2z

1 0.9830 2. 12 50e0.21+0.3

√

2×2.12

= 151. 63

0.21+0.3 2×(−1. 77)

2 0.0384 −1. 77 50e √

= 29. 11

0.21+0.3 2×(0. 77)

3 0.7794 0.77 50e = 85. 52

Total 151. 63 + 29. 11 + 85. 52 = 266. 26

266. 26

The average of the simulated prices is = 88. 75. The answer is C.

3

Chapter 20

Lemma

20.1 Introduction

According to Wikipedia, Brownian motion (named in honor of the botanist

Robert Brown) is either the random movement of particles suspended in a fluid

or the mathematical model used to describe such random movements, often

called a Wiener process.

In 1827, while examining pollen grains suspended in water under a micro-

scope, Brown observed minute particles in the pollen grains executing a contin-

uous jittery motion. He observed the same motion in particles of dust, enabling

him to rule out the hypothesis that the motion was due to pollen being alive.

Although he did not provide a theory to explain the motion, the phenomenon

is now known as Brownian motion in his honor.

Brownian motion is a useful tool for modeling the stock price. The price

of a stock is constantly hit by random events, just as a particle in the water is

constantly hit by water molecules. In fact, the Brownian motion is to stochastic

processes as the standard normal distribution to random variables.

Brownian motion is an abstract concept. The first step toward learning the

Brownian motion is to see it and experiment it. You can easily find Brownian

motion simulations in the internet. Here are some simulations in the internet:

• http://www.phy.ntnu.edu.tw/java/gas2d/gas2d.html

• http://www.aip.org/history/einstein/brownian.htm

• http://www.stat.umn.edu/~charlie/Stoch/brown.html

• http://www.matter.org.uk/Schools/Content/BrownianMotion

There’s a large body of knowledge on the internet about the Brownian mo-

tion. For example, you can check out Wikipedia’s explanation at:

205

206 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

http://en.wikipedia.org/wiki/Brownian_motion

titled "Simulate Brownian Motion." Download this spreadsheet.

My spreadsheet uses the following Excel functions:

• Rand() returns a random number equal to or greater than 0 but less than 1.

In other words, Rand() simulates a random variable uniformly distributed

over [0, 1).

mal cumulative distribution for the specified mean and standard deviation.

When studying the Brownian motion and Ito’s lemma, remember the following

big picture. The Black-Scholes option pricing formula Equation 12.1 relies on

the Black-Scholes PDE (Equation 12.24). Equation 12.24 assumes the following

price model for a risk-free asset and a risky asset (i.e. stock):

The price of a risk free asset (i.e. the savings account or a bond) is

The price of a risky asset (i.e. stock) at time t is:

# $

1 2 √

α− σ t+σ tY (t)

S (t) = S (0) e 2 (20.2)

In the above equation:

¸ of the

1 S (t)

stock. In other words, E [S (t)] = S (0) eαt or α = ln E

t S (0)

• r is the (annualized continuously compounded) risk-free interest rate.

Y (t2 ) are independent for t1 6= t2

dS (t)

= αdt + σdZ (t) (Textbook 20.1)

S (t)

20.2. BROWNIAN MOTION 207

20.2.1 Stochastic process

A stochastic process is a family of random variables indexed by time. For

example, the temperature out side your house X (t) is a stochastic process. Let

t = 0 represent now and t = 1 represent the next time (such as next hour, next

day, next week). Then for a series of time points t = 1, 2, 3, ... there is a family

of random temperatures X (0), X (1), X (2), X (3) ....

This is the major diﬀerence between a stochastic process and a deterministic

process. In a stochastic process you’ll see a series of random variables; for

each time t there’s a corresponding random variable X (t). In contrast, in a

deterministic process, you’ll see only one random variable.

Consider a particle that jumps, at discrete times, up or down along the vertical

line. At t = 0 the particle is at position zero. After each h-long time period,

the particle jumps up or down by a constant distance of k and with equal

probability of 0.5. That is, at t = h, 2h, 3h, ..., nh, the particle either moves

up by k or moves down by k, with up and down movements having an equal

probability of 0.5. Let Z (t) represent the height of the article from the position

zero at time t. Clearly Z (0) = 0. We like to find Z (T ), the height of the article

at time T = nh.

4k

3k

2k 2k

k k

0 0 0

−k −k

−2k −k

−3k

−4k

time 0 h 2h 3h 4h

Let’s walk through the above table. At t = 0 the particle is at the position

zero. At t = h, the particle’s height is either k or −k. At t = 2h, the k node

either goes up to 2k or goes down to 0. Similarly, the −k node either goes up

to 0 or goes down to −2k. So on and so forth.

The jump at t = h is: Z (h) − Z (0) = Y (h) k

Here Y (h) is a direction indicator. If Y (h) = 1, then the particle moves up

by k; if Y (h)

½ = −1, then the particle moves down by k:

1 Probability 0.5

Y (h) =

−1 Probability 0.5

208 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

1 Probability 0.5

Y (2h) =

−1 Probability 0.5

Here Y (nh)

½ is a direction indicator:

1 Probability 0.5

Y (nh) =

−1 Probability 0.5

The direction indicators Y (h), Y (2h), Y (3h), ..., Y (nh) are independent

identically distributed binomial random variables. For i = 1 to n,

E h(ih) =i(1) 0.5 + (−1) 0.5 = 0

E (ih)2 = (1)2 0.5 + (−1)2 0.5 = 1

h i

2

V ar (ih) = E (ih) − E 2 (ih) = 1

The particle’s height at time T is:

Z (T ) = [ Z (h) − Z (0)]+[ Z (2h) − Z (h)]+[ Z (3h) − Z (2h)]+...+[ Z (nh = T ) − Z [(n − 1) h]]

= Y (h) k + Y (2h) k + Y (3h) k + ... + Y (nh) k

= [Y (h) + Y (2h) + Y (3h) + ... + Y (nh)] k

mean and variance as:

V ar [Z (T )] = k 2 V ar [Y (h) + Y (2h) + Y (3h) + ... + Y (nh)]

T k2

= k2 n = k2 = T

h h

2

k

We want V ar [Z (T )] = T to exist (i.e. not to become infinite) as n → ∞.

h

2

k k2

To achieve this, we set to a positive constant: = c. To make our

h h

model simple, we set c = 1. Hence

k2 √

=1 k= h

h

Now we have:

√

Z (ih) − Z [(i − 1) h] = Y (ih) h (20.3)

k2

Now Z (T ) is approximately normal with mean zero and variance T = T:

h

Z (T ) ∼ N (0, T )

Please note that another way to specify the model is treat Y (ih) as a random

draw of a standard normal random variable (instead of a binomial random

variable):

20.2. BROWNIAN MOTION 209

√

Z (ih) − Z [(i − 1) h] = Y (ih) h and Y (ih) ∼ N (0, 1) (20.4)

My spreadsheet for simulating the Brownian motion uses both Equation 20.3

and Equation 20.4.

Wiener process.

Next, let’s formally define the Brownian motion.

Definition 20.2.1.

A stochastic process Z (t) is a Brownian motion or a Wiener process if

1. Z (0) = 0 . Brownian motion starts at zero (this is merely for our conve-

nience).

2. Z (t + h) − Z (t) is normally distributed with mean 0 and variance h. This

means that the increments over a time interval h is normally distributed

with mean 0 and variance h. This stands true no matter how small or big

h is.

3. Z (t + s1 ) − Z (t) is independent of Z (t) − Z (t − s2 ) where s1 , s2 > 0.

4. Z (t) is continuous.

20.2.3 Martingale

The following part is based on Wikipedia.

A martingale is a stochastic process (i.e., a sequence of random variables)

such that the conditional expected value of an observation at some time t, given

all the observations up to some earlier time s, is equal to the observation at that

earlier time s.

Originally, martingale referred to a betting strategy popular in 18th century

France. The rule of the game is that the gambler wins his stake if a coin comes

up heads and loses it if the coin comes up tails. The martingale strategy had

the gambler double his bet after every loss, so that the first win would recover

all previous losses plus win a profit equal to the original stake. Since eventually

a gambler will win at least once, the martingale betting strategy was thought

to be sure way of winning. In reality, however, the exponential growth of the

bets would eventually bankrupt the gambler.

A stochastic process (i.e., a sequence of random variables) X (t) is a martin-

gale if the following holds:

E [X (t) |X (s)] = X (s) for t > s.

210 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

E [Z (t) |Z (s)]

= E [Z (t) − Z (s) + Z (s) |Z (s)]

= E [Z (t) − Z (s) |Z (s)] + E [Z (s) |Z (s)]

Z (t) − Z (s) is independent of Z (s).

→ E [Z (t) − Z (s) |Z (s)] = E [Z (t) − Z (s)] = 0

→ E [Z (t) |Z (s)] = E [Z (t) − Z (s) |Z (s)] + E [Z (s) |Z (s)] = Z (s)

Hence Z (t) is martingale.

E [Z (t) |Z (s)] = Z (s) means that the best estimate of the future value of a

Brownian motion is its current value.

1. The Brownian motion is continuous everywhere yet diﬀerentiable nowhere.

2. The first-order variation is infinite: lim |Z (h)−Z (0) |+|Z (2h)−Z (h) |+

n→∞

... + |Z (nh) − Z [(n − 1) h] | → ∞

2 2

length of the time interval: lim {[Z (h) − Z (0)] + [Z (2h) − Z (h)] +

n→∞

... + (Z (nh) − Z [(n − 1) h])2 } = T

4. Cov [Z (s) , Z (t)] = min (s, t). The covariance of two Brownian motions is

the shorter time interval.

½

0 if n is odd

5. The higher moments of Z (t) is: E [Z n (t)] =

tn/2 (n − 1) (n − 3) ...1 if n is even

If you look at the simulation of Brownian motion over the internet, you’ll

find that the Brownian motion is always continuous yet it’s not diﬀerentiable

anywhere. Can you imagine that a function is continuously anywhere yet diﬀer-

entiable nowhere? If I hadn’t studied the Brownian motion, I would have never

thought that such a function exists.

We can explain the non-diﬀerentiality using the following equation (it’s text-

book Equation 20.4):

√

dZ (t) = Y (t) dt (20.5)

dZ (t) = Z (t + dt) − Z (t) = Y (t) dt

The textbook explains in the footnote that you can treat Y (t) as a binomial

20.2. BROWNIAN MOTION 211

normal random variable.

From Equation 20.5, we have:

dZ (t) Y (t)

= √ → ∞ as dt → 0

dt dt

Let’s look at the 2nd property. The following is an intuitive but not rigorous

proof.

Z (h), ..., Z (nh) − Z [(n − 1) h] are independent identically distributed normal

random variable with mean 0 and variance h. On average, |Z [(i + 1) h]−Z (ih) |

approaches E|X| where X ∼ N (0, h). Let f (x) represent the probability den-

sity functionR of X, then

∞

E|X| = −∞ |x|f (x) dx > 0 (since |x| ≥ 0, it’s mean must be positive)

Then lim (|Z (h) − Z (0) | + |Z (2h) − Z (h) | + ... + |Z (nh) − Z [(n − 1) h] |)

n→∞

times n must also approach infinity.) √

Property 2 should be easy to understand. Since ∆Z (t)√= Y (t) ∆t, for a

√ 0.000001

tiny interval ∆t, ∆t is much large than ∆t. For example, = 1, 000.

0.000001

Hence during any short interval, the Brownian motion can move up or down by

an infinitely large amount.

In contrast, for a continuously diﬀerentiable function y = f (t), we have:

∆y = f 0 (t) ∆t → 0 as ∆t → 0

¡ feel¢ of the 3rd property. On average, {Z [(i + 1) h] −

2 2

Z (ih)}¡ ¢approaches E X .

E X 2 = E 2 (X) + V ar (X) = 02 + h = h

2 2 2

lim [Z (h) − Z (0)] + [Z (2h) − Z (h)] + ... + (Z (nh) − Z [(n − 1) h]) ap-

n→∞

proaches

h + h + ... + h = nh = T

In contrast, the 2nd order variation of a diﬀerentiable function is zero. For

example, we can find the 2nd order variation of the function y = x is zero.

Divide the interval [0, T ] into [0, h],[h, 2h],...,[(n − 1) h, nh = T ]

µ ¶2

2 2 2 2 T

lim {(h − 0) + (2h − h) +... +[nh − (n − 1) h]} = nh = lim n =

n→∞ n→∞ n

0

It can be proven that the quadratic variation of any continuously diﬀeren-

tiable function is zero. The quadratic variation of any continuously diﬀerentiable

function is zero because such a function is roughly linear at any point. For a

continuously diﬀerentiable function y = f (t), we have:

2

∆y = f 0 (t) ∆t → (∆y)2 = [f 0 (t)] (∆t)2

2 2

For a tiny interval ∆t, (∆t) → 0 must faster than ∆t → 0. Hence (∆y) → 0

212 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

√ 2

In contrast, for a Brownian motion we have ∆Z (t) = Y (t) ∆t and [∆Z (t)] =

2 P 2 P

[Y (t)] ∆t → ∆t. Hence [∆Z (t)] → ∆t = T

Brownian motion Property 3 reconfirms the idea that Brownian motion is

not diﬀerentiable anywhere. If it’s diﬀerentiable, then its second order variation

would be zero.

√

Tip 20.2.1. Just memorize Equation 20.5 dZ (t) = Y (t) dt. This equation

tells you that the Brownian motion Z (t) is not diﬀerentiable anywhere, its sec-

ond order variation is t, and its first order variation is infinite.

√

Tip 20.2.2. To get an intuitive feel of the equation dZ (t) = Y (t) dt, imagine

you are looking at the Brownian motion under a magnifying class. If you zoom

in on the Brownian motion by shrinking the time interval dt, no matter how

much you reduce dt, you’ll see a jigsaw. In comparison, if you zoom in on a

continuously diﬀerentiable function such as y = t2 , you’ll see a straight line.

Please note that Derivatives Markets explains Property 2 and 3 using the

following formula: √

Z [(i + 1) h] − Z (ih) = Y [(i + 1) h] h

Since Y [(i + 1) h] is a√binomial random variable having a value of ±1, then

|Z [(i + 1) h] − Z (ih) | = h and {Z [(i + 1) h] − Z (ih)} = h. Hence √

lim (|Z (h) − Z (0) | + |Z (2h) − Z (h) | + ... + |Z (nh) − Z [(n − 1) h] |) = n h →

n→∞

∞

2 2 2

lim {[Z (h) − Z (0)] + [Z (2h) − Z (h)] + ... + (Z (nh) − Z [(n − 1) h]) } =

n→∞

nh = T

The problem with this explanation is that it works if we treat Y [(i + 1) h]

as binomial random variable whose value is ±1. Such explanation won’t work if

we treat Y [(i + 1) h] as a random draw of a standard normal random variable.

The explanation I provided here works no matter if you treat Y [(i + 1) h] as a

binomial random variable or a standard normal random variable.

Let’s look at Property 4. Suppose s ≤ t

Cov [Z (s) , Z (t)] = Cov{Z (s) , Z (s) + [Z (t) − Z (s)]}

Using the formula Cov (a, b + c) = Cov (a, b) + Cov (a, c), we get:

Cov{Z (s) , Z (s)+[Z (t) − Z (s)]} = Cov{Z (s) , Z (s)}+Cov{Z (s) , [Z (t) − Z (s)]}

Cov{Z (s) , Z (s)} = V ar [Z (s)] = s

Since Z (s) and [Z (t) − Z (s)] are independent (Brownian motion definition

Point #3), Cov{Z (s) , [Z (t) − Z (s)]} = 0

→ Cov [Z (s) , Z (t)] = s = min (s, t)

Property 5 is based on the moment formula for a standard normal random

variable φ

½

0 if n is odd

E (φn ) = (20.6)

(n − 1) (n − 3) ...1 if n is even

We can find the n-th moment of a random variable X using the moment

generating function (MGF):

20.2. BROWNIAN MOTION 213

∙ ¸

n dn

E (X ) = MX (t) (20.7)

dtn t=0

The MGF of a normal random variable X with mean μ and the standard

deviation σ is:

1

¡ tX ¢ μt+ σ 2 t2

MX (t) = E e =e 2 (20.8)

1 2

t

→ Mφ (t) = e 2

Using Equation 20.7, you can verify that Equation 20.6 holds.

Since Z (t) is a normal random variable with mean 0 and variance t, then

Z (t)

√ is a standard normal random variable. Hence

t

½

0 if n is odd

E [Z n (t)] = n/2 (20.9)

t (n − 1) (n − 3) ...1 if n is even

Example 20.2.1. Calculate P [Z (3) > 1]

Z (3) is a normal random variable with mean

µ 0 and¶variance 3.

1−0

P [Z (3) > 1] = 1 − P [Z (3) ≤ 1] = 1 − Φ √ = 1 − Φ (0.577 35) =

3

0.281 9

Example 20.2.2. Calculate P [Z (1) ≤ 0 ∩ Z (2) ≤ 0]

Z (1) is a normal random variable with mean 0 and variance 1. Let X = Z (1)

Z (2) − Z (1) is a normal random variable with mean 0 and variance 1.

Z (2) = Z (1) + [Z (2) − Z (1)] ≤ 0 → [Z (2) − Z (1)] ≤ −Z (1)

Let Y = Z (2) − Z (1).

X and Y are independent.

P [Z (1) ≤ 0 ∩ Z (2) ≤ 0] = P (X ≤ 0 ∩ Y ≤ −X)

To have X ≤ 0 ∩ Y ≤ −X, we first fix X at a tiny interval (x, x + dx)

where −∞ < x < 0. Next, we set Y < −x. Then we are guaranteed to have

X ≤ 0∩Y ≤ −X. Let f (x) and Φ (x) represent the probability density function

(pdf) and the cumulative density function (cdf) of a standard normal random

variable. R0 R0

P (X ≤ 0 ∩ Y ≤ −X) = −∞ P (x < X < x + dx) P (Y < −x) = −∞ [f (x) dx] P (Y < −x)

However, f (x) dx = dΦ (x) and P (Y < −x) = Φ (−x) = 1 − Φ (x)

R0 R0 R0

−∞

[f (x) dx] P (−x) = −∞ [dΦ (x)] [1 − Φ (x)] = −∞ [1 − Φ (x)] dΦ (x) =

R0

−∞

[1 − Φ (x)] dΦ (x)

∙ ¸0

1 2

= Φ (x) − Φ (x)

2 −∞

214 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

1£ 2 ¤

= [Φ (0) − Φ (−∞)] − Φ (0) − Φ2 (−∞)

∙ ¸ " µ ¶2 2 #

1 1 1 2

= −0 − −0

2 2 2

µ ¶2

1 1 1 3

= − =

2 2 2 8

Example 20.2.3. Calculate Cov [Z (5) , Z (2)]

£ ¤

Example 20.2.4. Calculate E Z 4 (t) .

£ ¤

E Z 4 (t) = t4/2 (4 − 1) = 3t2

ian motion

A standard Brownian motion is normally distributed with mean 0 and variance

1. Now we want to extend the Brownian motion to allow for non-zero mean and

an arbitrary variance. Define a stochastic

√ process:

X (t + h) − X (t) = αh + σY (t + h) h

Breaking down [0, T ] into small intervals [0, h],[h, 2h],...,[(n − 1) h, nh = T ],

we have: Pn h √ i Pn h √ i

X (T ) − X (0) = i=1 αh + σY (ih) h = αT + σ i=1 Y (ih) h

P h √ i

As n → ∞, ni=1 Y (ih) h → Z (T )

X (T ) − X (0) = αT + σZ (T ) (20.10)

Equation 20.10 and 20.11 are called arithmetic Brownian motion. α is the

instantaneous mean per unit of time; σ is the instantaneous standard deviation

per unit of time.

Equation 20.10 and 20.11 indicate that X (T )−X (0) is normally distributed.

Its mean and variance are:

E [X (T ) − X (0)] = E [αT + σZ (T )] = αT + σE [Z (T )] = αT + σ × 0 = αT

V ar [X (T ) − X (0)] = V ar [αT + σZ (T )] = V ar [σZ (T )] = σ2 V ar [Z (T )] =

σ2T

The textbook lists the major properties and weaknesses of Equation 20.11.

Major properties:

20.2. BROWNIAN MOTION 215

3. We can change the mean by changing the parameter α. Now the mean is

no longer zero if α 6= 0. And we have E [X (T )] − E [X (0)] = αT . This

means that after time T , the stock price drifts away from the price at time

zero.

Major weaknesses:

1. The stock price X (t) can be negative. Since X (t) is normally distributed,−∞ <

X (t) < ∞. Equation 20.11 allows a negative stock price. Of course, the

stock price can’t become negative.

2. The expected change of the stock price does not depend on the stock price.

In reality, the expected change of the stock price should be proportional

to the stock price. The higher the stock price, the higher the expected

change. So we like to have E [dX (t)] = αX (t). We need to modify

Equation 20.11 to allow E [dX (t)] = αX (t).

3. The variance of the stock price does not depend on the stock price. In

reality, the variance should be proportional to the stock price. So we need

to modify Equation 20.11 to allow σ [X (t) , t] = σX (t).

Major Weakness #2 and #3 can also be stated this way. Equation 20.11 can

dX (t) α σ dX (t)

be rewritten as = dt + dZ (t). This indicates that ,

X (t) X (t) X (t) X (t)

the percentage return on the stock depends on the stock price X (t). However,

in reality, we think that the stock return on average shouldn’t depend on the

stock price. In other words, instead of Equation 20.11, we like to see

dX (t)

= αdt + σdZ (t) (20.12)

X (t)

or

Equation 20.12 and 20.13 are called the geometric Brownian motion.

We can modify Equation 20.11 to allow for mean reversion. It’s reasonable for

us to assume that the stock price or the interest rate will revert to the mean.

For example, if the stock price is too high, then it might go down; if the stock

price is too low, it might go up. We modify the drift term in Equation 20.11:

216 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

stochastic process in financial modeling.

We can rewrite Equation 20.12 as:

RT RT RT

0

dX (t) = 0 X (t) αdt + 0 σX (t) dZ (t)

RT RT RT RT

or X (T )−X (0) = 0 X (t) αdt+ 0 σX (t) dZt = α 0 X (t) dt+σ 0 X (t) dZt

RT

But what’s the meaning of 0 X (t) dZ (t)? Or generally, what’s the meaning

Rb

of a g (t) dZ (t)?

To answer this question, let’s

R 1take a step back and find out the meaning of

a simple deterministic calculus 0 x2 dx.

R1 2

0

x dx is the area of the function x2 bounded by x = 0 and x = 1. To find

this area, we divide the interval [0, 1] into n intervals [0, h], [h, 2h], [2h, 3h], ...,

[(n − 1) h, nh = 1]. Then we approximate the area with the sum of n rectangles.

The area of function x2 over the interval [(i − 1) h, ih] is roughly the area of the

rectangular with height [(i − 1) h]2 and width ih − (i − 1) h = h.

R ih

(i−1)h

x2 dx ≈ [(i − 1) h]2 h = (i − 1)2 h3

R1 2 Pn R ih 2

Pn 2 3 2

0

x dx = lim i=1 (i−1)h x dx = lim i=1 (i − 1) h = lim {0 h +

n→∞ n→∞ n→∞

2 2 2

h h + (2h) h + ... + [(n − 1) h] h}

02 h +hh2 h + (2h)2 h + ... + [(n − 1)i h]2 h

= h3 02 + 12 + 22 + ... + (n − 1)2

Using the famous formula:

n (n + 1) (2n + 1)

12 + 22 + 32 + ... + n2 =

h i6 (n − 1) (n) (2n − 1)

2

h 0 + 1 + 2 + ... + (n − 1) = h3

3 2 2 2

6

1

Since h = , we have:

n

R1 1 (n − 1) (n) (2n − 1)

0

x2 dx = lim 3

∙ n→∞

µ n¶ µ 6 ¶¸

1 1 1 1

= lim 1− (1) 2 − =

n→∞ 6 n n 6

R ih

There are other ways to approximate (i−1)h x2 dx. For example, the area of

function x2 over the interval [(i − 1) h, ih] is roughly the area of the rectangular

with height (ih)2 and width ih − (i − 1) h = h.

R ih 2

(i−1)h

x2 dx ≈ (ih) h = i2 h3

20.3. DEFINITION OF THE STOCHASTIC CALCULUS 217

R1 Pn R ih Pn n (n + 1) (2n + 1) 3

0

x2 dx = lim i=1 (i−1)h x2 dx = lim i=1 i2 h3 = lim h

n→∞ n→∞ n→∞ 6

n (n + 1) (2n + 1) 1 1

= lim =

n→∞ 6 n3 R 6

ih

The 3rd way to approximate (i−1)h x2 dx is to take the average height of

the rectangular. So the area of function x2 over the interval [(i − 1) h, ih] is

2 2

(i − 1) h2 + (ih)

roughly the area of the rectangular with height and width

2

ih − (i − 1) h = h.

2 2 2

(i − 1) h2 + (ih) (i − 1) + i2 2

= h

2 " 2 #

2

R ih 2 (i − 1) + i2 2

(i−1)h

x dx ≈ h h

2

" #

2

R1 2 Pn R ih 2

P n (i − 1) + i 2

0

x dx = lim i=1 (i−1)h x dx = n→∞ lim i=1 h2 h

n→∞ 2

1 Pn h 2 2

i 1 Pn £ 2 2 ¤

= lim i=1 (i − 1) h h + lim i h h

2µn→∞ ¶ µ ¶ 2 n→∞ i=1

1 1 1 1 1

= + =

2 6 2 6 6

It seems natural that we extend this logic of deterministic integration to a

define a stochastic integration.

Suppose we partition [a, b] into a = t0 < t1 < t2 < ... < tn = b. We can

make the partition intervals [t0, t1 ], [t1, t2 ], ..., [tn−1, tn ] have the same length

b−a

tk+1 − tk = . We can also have the partition intervals [t0, t1 ], [t1, t2 ], ...,

n

[tn−1, tn ] have diﬀerent lengths.

Rb Pn−1

a

g (t) dZ (t) = lim k=0 g (tk ) [Z (tk+1 ) − Z (tk )]

n→∞

Definition 20.3.1.

Suppose g (t) is a simple process, meaning that g (t) is piecewise-constant

Rb £ ¤

but may have jumps at a = t0 < t1 < t2 < ... < tn = b. If a E g 2 (t) dt < ∞,

Rb

then the stochastic integral a g (t) dZ (t) is defined as

Z b n−1

X

g (t) dZ (t) = g (tk ) [Z (tk+1 ) − Z (tk )] (20.16)

a k=0

Rb £ ¤

In the above definition, a E g 2 (t) dt < ∞ is the suﬃcient condition for

Pn−1

k=0 g (tk ) [Z (tk+1 ) − Z (tk )] to exist.

RT

Example 20.3.1. Calculate 0

dZ (t)

Solution.

218 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

Here g (t) = 1.

R T ¡ 2¢ RT

0

E 1 dt = T < ∞. So 0 dZ (t) exists.

RT Pn−1

0

dZ (t) = k=0 [Z (tk+1 ) − Z (tk )] = Z (T )

Example 20.3.2.

⎧

⎨ 1 if 0 ≤ t ≤ 1

X (t) = 2 if 1 < t ≤ 2

⎩

3 if 2 < t ≤ 3

R3

Calculate 0 X (t) dZ (t)

Solution.

Dividend [0, 3] into (0, 1), (1, 2), and (2, 3). Then X (t) is constant during

the Rinterval and jumps at t = 1 and t = 2. Hence

3

0

X (t) dZ (t)

= X (0) [Z (1) − Z (0)] + X (1) [Z (2) − Z (1)] + X (2) [Z (3) − Z (2)]

= 1 [Z (1) − Z (0)] + 2 [Z (2) − Z (1)] + 3 [Z (3) − Z (2)]

= 1Z (1) + 2 [Z (2) − Z (1)] + 3 [Z (3) − Z (2)]

= 3Z (3) − Z (2) − Z (1)

follows.

If E lim (X − a)2 = 0, we say that X approach a in mean square.

n→∞

Explain why the sample mean approaches the population mean in mean

square.

Suppose we take n random samples X1 , X2 ,...,Xn from the population X.

1 Pn

Let μ represent the population mean. Then the sample mean is Xk . It

n k=1

can be shown that

µ ¶2

1 Pn

E lim k=1 Xk − μ =0

n→∞ n

Toµsee why, notice¶

1 Pn 1 Pn 1

E Xk = E ( k=1 Xk ) = nμ = μ

n k=1 n n

µ ¶2

1 Pn

E Xk − μ

n µk=1 ¶

1 Pn 1 P

= V ar k=1 Xk = 2 V ar ( nk=1 Xk )

n n

1 V ar (X)

= 2 nV ar (X) =

n µ n ¶2

1 Pn

→ E lim k=1 X k − μ =0

n→∞ n

So the sample mean approaches the population mean in mean square.

20.3. DEFINITION OF THE STOCHASTIC CALCULUS 219

Definition 20.3.2.

Let a = t0 < t1 < t2 < ... < tn = b represent a partition of [a, b]. Define

P

random variable In = n−1

k=0 g (tk ) [Z (tk+1 ) − Z (tk )], where g (tk ) is a simple

or a complex process and g (tk ) and Z (tk+1 ) − Z (tk ) are independent. If

Rb £ 2 ¤

a

E g (t) dt < ∞ and the mean squared diﬀerence between In and U is zero

as n → ∞:

2

E lim (In − U ) = 0 (20.17)

n→∞

Then we say

Rb

• a

g (t) dZ (t) = U

Rb

• In converges to a

g (t) dZ (t) in mean square

Please note that in the term g (tk ) [Z (tk+1 ) − Z (tk )], g is evaluated at the

left of the interval [tk , tk+1 ]:

Rb Pn−1

a

g (t) dZ (t) = lim k=0 g (tk ) [Z (tk+1 ) − Z (tk )]

n→∞

Rb Pn−1

a

g (t) dZ (t) 6= lim k=0 g (tk+1 ) [Z (tk+1 ) − Z (tk )]

n→∞

Rb Pn−1 g (tk ) + g (tk+1 )

a

g (t) dZ (t) 6= lim k=0 [Z (tk+1 ) − Z (tk )]

n→∞ 2 R ih

This is diﬀerent from the deterministic calculus (i−1)h x2 dx, which can be

approximated using 3 heights:

(i − 1)2 h2 + (ih)2

• The average height

2

other words, we require that g (tk ) not depend on the future Brownian incre-

ment Z (tk+1 ) − Z (tk ). The requirements that we evaluate g at the left of the

interval [tk , tk+1 ] and that g (tk ) and Z (tk+1 ) − Z (tk ) are independent agree

with our intuition. We calculating g (tk ) [Z (tk+1 ) − Z (tk )], g (tk ) is based on

the information available to us during [0, tk ] and is independent of the future

Brownian increment Z (tk+1 ) − Z (tk ).

RT 2

Example 20.3.3. Calculate 0 [dZ (t)] .

220 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

RT 2 RT 2

0

[dZ (t)] = 0 g (t) [dZ (t)] where g (t) = 1

Partition [0, T ] into [0, h], [h, 2h],...,[(n − 1) h, nh = T ].

P Pn

Let In = n−1 k=0 {Z [(k + 1) h] − [Z (kh)]} =

2

k=1 {Z (kh) − [Z (k − 1) h]}

2

h. Using Equation 20.9, we have

2

E{Z (kh)

Pn − [Z (k − 1) h]} = h

In = k=1 {Z (kh) − [Z (k − 1) h]}2

RT 2

Since E (In ) = nh = T , we guess that 0 [dZ (t)] = T

The diﬃcult part is to verify that the mean square error is zero as n → ∞:

hP i2

2

lim E ( nk=1 {Z (kh) − [Z (k − 1) h]}) − T = 0

n→∞

Let ∆k = Z (kh) − [Z (k − 1) h]

Pn 2

→ ( k=1 {Z (kh) − [Z (k − 1) h]}) = ∆21 + ∆22 + ... + ∆2n

hP i2

n 2

→ ( k=1 {Z (kh) − [Z (k − 1) h]}) − T

£¡ ¢ ¤2 ¡ ¢2 ¡ ¢

= ∆21 + ∆22 + ... + ∆2n − T = ∆21 + ∆22 + ... + ∆2n +T 2 −2T ∆21 + ∆22 + ... + ∆2n

¡ 2 ¢2

∆1 + ∆22 + ... + ∆2n = ∆41 + ∆42 + ...∆4n + 2∆21 ∆22 + 2∆21 ∆23 + ...

¡ ¢2 ¡ ¢ ¡ ¢

→ E ∆21 + ∆22 + ... + ∆2n = E ∆41 + ∆42 + ...∆4n +2E ∆21 ∆22 + ∆21 ∆23 + ...

∆k is¡normal

¢ with mean 0 and variance h

→ E ¡∆4k = 3h2 ¢

→ E ∆41 + ∆42 + ...∆4n = 3nh2

∆i and ∆j where i 6= j are two independent normal random variables (Point

3 of the Brownian

¡ ¢ motion

¡ ¢definition)

¡ ¢

→ E ∆2i ∆2j = E ∆2i E ∆2j = h × h = h2

1

There are n (n − 1) pairs of ∆i and ∆j where i 6= j

2

¡ ¢ 1

→ 2E ∆21 ∆22 + ∆21 ∆23 + ... = 2 × n (n − 1) h2 = n (n − 1) h2

¡ ¢2 2

E ∆21 + ∆22 + ... + ∆2n = 3nh2 + n (n − 1) h2

£ ¡ ¢¤ ¡ ¢

E 2T ∆21 + ∆22 + ... + ∆2n = 2T E ∆21 + ∆22 + ... + ∆2n = 2T (nh) = 2T 2

hP i2

n 2

→ E ( k=1 {Z (kh) − [Z (k − 1) h]}) − T

= 3nh2 + n (n − 1) h2 + T 2 − 2T = [3n + n (n − 1)] h2 − T 2

T

However, h =

n µ ¶2

2 2 T 3n + n (n − 1) 2

→ [3n + n (n − 1)] h −T = [3n + n (n − 1)] −T 2 = T −

n n2

T2

3n + n (n − 1) 3n + n (n − 1) 2

As n → ∞, →1 T − T2 → 0

n2 n2

20.3. DEFINITION OF THE STOCHASTIC CALCULUS 221

hP i2

2

lim E ( nk=1 {Z (kh) − [Z (k − 1) h]}) − T = 0

n→∞

RT

Hence 0 [dZ (t)]2 = T .

RT

Example 20.3.4. Calculate 0 Z (t) dZ (t)

Partition [0, T ] into [0, h], [h, 2h],...,[(n − 1) h, nh = T ].

Pn−1 Pn

Let In = k=0 Z (kh) {Z [(k + 1) h]−Z (kh)} = k=1 Z [(k − 1) h] {Z (kh)−

Z [(k − 1) h]} ¡ ¢

2

(a + b) − a2 + b2

Use the formula: ab =

2

Let a = Z [(k − 1) h] b = Z (kh) − Z [(k − 1) h]

a

P+n b = Z (kh)

k=1 Z [(k − 1) h] {Z (kh) − Z [(k − 1) h]}

2 2

P [Z (kh)] − Z [(k − 1) h] − {Z (kh) − Z [(k − 1) h]}2

= nk=1

2

1 Pn 2 2 1 Pn

= k=1 {[Z (kh)] − Z [(k − 1) h] }− {Z (kh) − Z [(k − 1) h]}2

2 2 k=1

1 2 1 Pn

= [Z (nh)] − {Z (kh) − Z [(k − 1) h]}2

2 2 k=1

1 2 1 Pn

= [Z (T )] − {Z (kh) − Z [(k − 1) h]}2

2 2 k=1

1 2 1 Pn

→ In = [Z (T )] − {Z (kh) − Z [(k − 1) h]}2

2 2 k=1

Pn

lim k=1 Z [(k − 1) h] {Z (kh) − Z [(k − 1) h]} = n→∞ lim In

n→∞

1 2 1 P n

= [Z (T )] − lim {Z (kh) − Z [(k − 1) h]}2

2 2 n→∞ k=1

Pn

From the previous example, we know that k=1 {Z (kh)−Z [(k − 1) h]}2 ap-

RT RT

proaches 0 [dZ (t)]2 = T in the mean square. So we guess that 0 Z (t) dZ (t) =

1 1

[Z (T )]2 − T

2 2 ∙ µ ¶¸2

1 2 1

Next, we need to prove that E lim In − [Z (T )] − T =0

µ ¶ n→∞ 2 2

1 2 1 1 1 Pn

In − [Z (T )] − T = T − {Z (kh) − Z [(k − 1) h]}2

2 2 2 2 k=1

In − E (In ) µ ¶

1 1 Pn 1 1

= [Z (T )]2 − {Z (kh) − Z [(k − 1) h]} 2

− [Z (T )]2

− T

2 2 k=1 2 2

1¡ Pn 2

¢

= T − k=1 {Z (kh) − Z [(k − 1) h]}

2

From the previous example, we found that

¡ Pn ¢2

lim E T − k=1 {Z (kh) − Z [(k − 1) h]}2 = 0

n→∞

∙ µ ¶¸2

1 1

→ E lim In − [Z (T )]2 − T =0

n→∞ 2 2

222 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

So we have

Z T

1 2 1

Z (t) dZ (t) = [Z (T )] − T (20.18)

0 2 2

RT

Equation 20.18 is surprising. In the deterministic calculus, we have 0

xdx =

1 2

T .

2

1

Equation 20.18 has an extra term − T . This is why this extra term is

2

needed. Taking expectation of Equation 20.18:

hR i 1 1

T 2

E 0 Z (t) dZ (t) = E [Z (T )] − T

2 2

hR i

T

As to be explained later, E 0 Z (t) dZ (t) = 0. We already know that

hR i 1 1

2 T 2

E [Z (T )] = T . Hence E 0 Z (t) dZ (t) = E [Z (T )] − T = 0. The extra

2 2

1

term − T is needed so the expectations of both sides of Equation 20.18 are

2

equal.

RT RT RT

1. Lineality. 0

[c1 g (t) + c2 h (t)] dZ (t) = c1 0

g (t) dZ (t)+c2 0

h (t) dZ (t)

RT £ ¤ ³R ´

T

2. Zero mean property. If 0

E X 2 (t) dt < ∞, then E 0 X (t) dZ (t) =

0

The proof is complex. However, for a simple process g (t) and h (t), Property

#1 holds due to the definition of the stochastic integral. For a simple process

g (t), Property #2 can be easily established.

RT P

0

g (t) dZ (t) = n−1

k=0 g (tk ) [Z (tk+1 ) − Z (tk )]

Z (tk ). Then

E{g (tk ) [Z (tk+1 ) − Z (tk )]} = E [g (tk )] E [Z (tk+1 ) − Z (tk )] = E [g (tk )] 0 =

0

RT RT £ ¤ RT

Let’s apply Property 2 to 0 Z (t) dZ (t). Since 0 E Z 2 (t) dt = 0 tdt =

1 2 hRT i

T < ∞, we have E 0 Z (t) dZ (t) = 0

2

20.5. ITO’S LEMMA 223

20.5.1 Multiplication rules

dZ dt

dZ dt 0

dt 0 0

[dZ (t)]2 = dt dZ (t) dt = 0 (dt)2 = 0

dZ (t) is a normal random variable with mean 0 and variance dt (see the

footnote of Derivatives Markets Page 652). Hence E [dZ (t)]2 = dt

2

E [dZ (t) − dt] = V ar [dZ (t)] = dt → 0

2 2

Hence dt approach [dZ (t)] in mean square. So [dZ (t)] = dt

2 2 2 3

E [dZ (t) dt − 0] = E [dZ (t)] (dt) = (dt) → 0

Hence 0 approaches dZ (t) dt in mean square. dZ (t) dt = 0.

2

Example 20.5.3. Explain why (dt) = 0

2

(dt) doesn’t contain any Brownian motion term dZ. So we need to calculate

(dt)2 according to the deterministic calculus. In the deterministic calculus,

2 2

(dt) → 0 as dt → 0. Hence (dt) = 0.

The textbook Derivatives Markets also gives the following formula:

0

dZ × dZ = ρdt (20.19)

The above formula will be explained later.

In essence, Ito’s lemma is a Taylor series applied to Brownian motion.

∧

Suppose that a stock has an expected instant return α [S (t) , t], dividend

∧ ∧

yield δS (t) , t, and instant volatility σ [S (t) , t] follows geometric Brownian mo-

tion:

µ ¶

∧ ∧ ∧

dS (t) = α − δ dt + σdZ (t) (20.20)

∧ ∧ ∧

Here α, δ, and σ are function of the stock price S (t) and time t.

224 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

Let C [S (t) , t] represent the value of a call or put option. We want to find

out the change of the option value given there’s a small change of the stock price

and a small change of time. Using Taylor series, we have:

dC [S (t) , t] = dS + dt+ (dS) + (dt) + dSdt (20.21)

∂S ∂t 2 ∂S 2 2 ∂t2 ∂S∂t

∙µ ¶ ¸2 µ ¶ µ ¶

∧ ∧ ∧ ∧ ∧ 2 ∧ ∧ ∧

2 2

[dS (t)] = α − δ dt + σdZ (t) = α − δ (dt) +2 α − δ σdZ (t) dt+

∧2 2

σ [dZ (t)] µ ¶

∧ ∧ ∧

2

dSdt = α − δ (dt) + σdZ (t) dt

2 2

Using the multiplication rules: (dt) = 0 [dZ (t)] = dt dZ (t) dt = 0

2 ∧2

[dS (t)] = σ dt dSdt = 0

Now we have:

∂C ∂C 1 ∂2C 2 ∂C ∂C 1 ∂ 2 C ∧2

dC [S (t) , t] = dS + dt + (dS) = dS + dt + σ dt

∂S ∂t 2 ∂S 2 ∂S ∂t 2 ∂S 2

(20.22)

Next, apply Equation∙µ 20.20 to¶Equation ??:¸

∂C ∧ ∧ ∧ ∂C 1 ∂ 2 C ∧2

→ dC [S (t) , t] = α − δ dt + σdZ (t) + dt + σ dt

∙µ ¶ ∂S ¸ ∂t 2 ∂S 2

∧ ∧ ∂C 1 ∧2 ∂ 2 C ∂C ∂C ∧

= α−δ + σ + dt + σdZ (t)

∂S 2 ∂S 2 ∂t ∂S

∙µ ¶ ¸

∧ ∧ ∂C 1 ∧2 ∂ 2 C ∂C ∂C ∧

dC [S (t) , t] = α−δ + σ 2

+ dt + σdZ (t) (20.23)

∂S 2 ∂S ∂t ∂S

Equation 20.23 is called the Ito’s lemma.

Tip 20.5.1. Don’t bother memorizing Equation 20.23. Just derive Equation

20.23 on the spot. First, write down the Taylor series Equation 20.22. Next,

apply the multiplication rules. Then you’ll get Equation 20.23.

If S (t) follows a geometric Brownian motion, we have:

∧

• α [S (t) , t] = αS (t)

∧

• δ [S (t) , t] = δS (t)

∧

• σ [S (t) , t] = σS (t)

Equation 20.23 becomes:

∙ ¸

∂C 1 ∂2C ∂C ∂C

dC [S (t) , t] = (α − δ) S + σ2S 2 2 + dt + σSdZ (t) (20.24)

∂S 2 ∂S ∂t ∂S

20.6. GEOMETRIC BROWNIAN MOTION REVISITED 225

Tip 20.5.2. Don’t bother memorizing Equation 20.24. Just derive Equation

20.24 on the spot.

Please note that

∂C ∂2C ∂C

=∆ =Γ =θ (option Greeks)

∂S ∂S 2 ∂t

Then Equation 20.22 becomes:

1 2

dC [S (t) , t] = ∆dS + θdt + Γ (dS) (20.25)

2

dC [S (t) , t] ≈ C [S (t + h) , t + h] − C [S (t) , t]

dS ≈ S (t + h) − S (t)

Equation 20.25 becomes:

1 2

C [S (t + h) , t + h]−C [S (t) , t] ≈ ∆ [S (t + h) − S (t)]+θh+ Γ [S (t + h) − S (t)]

2

(20.26)

Equation 20.26 is just the textbook Equation 13.6 (Derivatives Markets page

426).

If S (t) were deterministic (i.e. if Equation 20.20 didn’t have dZ (t) term),

∂2C

then → 0 and Equation 20.22 would be:

∂S 2

∂C ∂C

dC [S (t) , t] = dS + dt

∂S ∂t

There are two minor concepts under geometric Brownian motion. SOA can

easily write a question on these concepts. So let’s study them.

Consider a discrete geometric Brownian motion:

√

X (t + h) − X (t) = αX (t) h + σX (t) Y (t) h

| {z } | {z }

deterministic component random comp onent

One phrase you need to know is called "the ratio of the standard deviation

to the drift" (the drift is actually the deterministic component). The ratio of

the standard deviation to the drift is defined as:

√

σX (t) h σ

= √ (20.27)

αX (t) h α h

226 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

Let W1 (t) and W2 (t) represent two independent Brownian motions. Suppose

0 p

Z (t) = ρW1 (t) + 1 − ρ2 W2 (t) (20.29)

Please note that Z (t) is normally distributed with mean 0 and variance t

because W1 (t) is normally distributed with mean 0 and variance

p t.

You might wonder why Equation 20.29 has constants ρ and 1 − ρ2 . These

0

two constants are needed to make Z (t) normally distributed with variance t.

Because W1 (t) and W2 (t) areptwo independent normal random variables, the

linearhcombination 2

0

i hρW1 (t) + p1 − ρ W2 (t) iis also normally distributed.

E Z (t) = E ρW1 (t) + 1 − ρ2 W2 (t)

hp i

= E [ρW1 (t)] + E 1 − ρ2 W2 (t)

p

= ρE [W1 (t)] + 1 − ρ2 E [W2 (t)]

p

= ρ0 + 1 − ρ2 0 = 0

h 0 i h p i

V ar Z (t) = V ar ρW1 (t) + 1 − ρ2 W2 (t)

hp i

= V ar [ρW1 (t)] + V ar 1 − ρ2 W2 (t)

¡ ¢

= ρ2 V ar [W1 (t)] + 1 − ρ2 V ar [W2 (t)]

¡ ¢

= ρ2 t + 1 − ρ2 t = t

0

h 0

i

The covariance between Z (t) and Z (t) is: Cov Z (t) , Z (t)

Using the

h standard formula:

i h Cov (X, Yi) = E (XY ) −hE (X)iE (Y )

0 0 0

→ Cov Z (t) , Z (t) = E Z (t) Z (t) − E [Z (t)] E Z (t)

h 0

i h 0

i

= E Z (t) Z (t) − 0 × 0 = E Z (t) Z (t)

0

h p i p

Z (t) Z (t) = W1 (t) ρW1 (t) + 1 − ρ2 W2 (t) = ρ [W1 (t)]2 + 1 − ρ2 W1 (t) W2 (t)

h 0

i ³ ´ hp i

E Z (t) Z (t) = E ρ [W1 (t)]2 + E 1 − ρ2 W1 (t) W2 (t)

2

p

= ρE [W1 (t)] + 1 − ρ2 E [W1 (t) W2 (t)]

E [W1 (t)]2 = t

E [W1 (t) W2 (t)] = E [W1 (t)] E [W2 (t)] = 0 × 0 = 0

h 0

i

E Z (t) Z (t) = ρt (20.30)

20.6. GEOMETRIC BROWNIAN MOTION REVISITED 227

h 0

i h 0

i

The textbook says calls Cov Z (t) , Z (t) = E Z (t) Z (t) = ρt the corre-

0

lation between Z (t) and Z (t). However, the term correlation between X and

Y typically means the following:

Cov (X, Y )

ρX,Y =

σX σY

0

If wehuse the typical

i definition, the correlation between Z (t) and Z (t) is:

0

Cov Z (t) , Z (t) ρt

= √ √ =ρ

σ Z(t) σ Z 0 (t) t t

Since Derivatives Markets is the textbook, we have to adopt its definition

0

that the correlation between Z (t) and Z (t) is ρt.

0

dZ (t) and dZ (t) are both normal random variables with mean 0 and vari-

ance dt. Applying Equation 20.30 and replacing t with dt, we have:

h 0

i

E dZ (t) dZ (t) = ρdt (20.31)

0

Finally,

h let’s explain

i why Equation 20.19 dZ × dZ = ρdt holds.

0

E dZ (t) dZ (t) = ρdt

h 0

i2 h 0

i h 0

i2 h 0

i

E dZ (t) dZ (t) − ρdt = V ar dZ (t) dZ (t) = E dZ (t) dZ (t) −E 2 dZ (t) dZ (t)

0

dZ (t) dZ (t) h i

p

= dW1 (t) × d ρW1 (t) + 1 − ρ2 W2 (t)

h p i

= dW1 (t) × ρdW1 (t) + 1 − ρ2 dW2 (t)

p

= ρ [dW1 (t)]2 + 1 − ρ2 dW1 (t) dW2 (t)

h 0

i2

dZ (t) dZ (t)

4 ¡ ¢ 2 2

p 3

= ρ2 [dW1 (t)] + 1 − ρ2 [dW1 (t)] [dW2 (t)] +2ρ 1 − ρ2 [dW1 (t)] dW2 (t)

h 0

i2

E dZ (t) dZ (t)

¡ ¢ ³ ´ p ³ ´

= ρ2 E [dW1 (t)]4 + 1 − ρ2 E [dW1 (t)]2 [dW2 (t)]2 +2ρ 1 − ρ2 E [dW1 (t)]3 dW2 (t)

¡ ¢ p

= ρ2 E [dW1 (t)]4 + 1 − ρ2 E [dW1 (t)]2 E [dW2 (t)]2 +2ρ 1 − ρ2 E [dW1 (t)]3 E [dW2 (t)]

¡ ¢ p

= ρ2 3 (dt)2 + 1 − ρ2 dt × dt + 2ρ 1 − ρ2 0 × 0

2 ¡ ¢

= ρ2 3 (dt) + 1 − ρ2 dt × dt

£ ¡ ¢¤ ¡ ¢

= 3ρ2 + 1 − ρ2 (dt)2 = 2ρ2 + 1 (dt)2

h 0

i

E dZ (t) dZ (t) = ρdt

h 0

i2 h 0

i

E dZ (t) dZ (t) − E 2 dZ (t) dZ (t)

¡ ¢ 2 2 ¡ ¢ 2

= 2ρ2 + 1 (dt) − ρ2 (dt) = ρ2 + 1 (dt)

228 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

2

(dt) = 0

h 0

i2 h 0

i

→ E dZ (t) dZ (t) − E 2 dZ (t) dZ (t) = 0

h 0

i2 h 0

i

→ E dZ (t) dZ (t) − ρdt = V ar dZ (t) dZ (t) = 0

0

Hence dZ (t) dZ (t) approach ρdt in mean square. Hence

0

dZ × dZ = ρdt (20.32)

Suppose the stock price S (t) follows a geometric Brownian motion:

dS (t)

= αdt + σdZ (t)

S (t)

and derive that

¢ ¤ ln S (t) is a normal random

variable with mean ln S (0) + α − 0.5σ 2 t and variance σ 2 t.

2. Derive that the mean of S (t) is E [S (t)] = S (0) eαt

2

orize Ito’s lemma. Just use the Taylor expansion but keep the (dZ) term.

First, use Taylor expansion:

∂ ln S ∂ ln S 1 ∂ 2 ln S 2

d ln S = dS + dt + (dS)

∂S ∂t 2 ∂S 2

∂ ln S ∂ ln S

In the deterministic calculus, you just write d ln S = dS + dt.

∂S ∂t

2 2

However, in the stochastic calculus, we can’t ignore (dZ) since (dZ) = dt.

In this problem, d ln S is a linear function of dZ, so:

h i

2 2 2 2

(dS) = [Sαdt + σdZ] = S 2 α2 (dt) + 2ασdtdZ + σ 2 (dZ)

h rule (DM 20.17 a, ib, c), we get:

2 2 2 £ ¤

(dS) = S α (dt) + 2αdtσdZ + σ 2 (dZ) = S 2 α2 × 0 + 2ασ × 0 + σ 2 dt =

2 2

S 2 σ 2 dt

1 ∂ 2 ln S 2

So we have to keep the term (dS) .

2 ∂S 2

Anyway, Taylor expansion gives us:

∂ ln S ∂ ln S 1 ∂ 2 ln S 2 2

d ln S = dS + dt + S σ dt

∂S ∂t 2 ∂S 2

2

∂ ln S 1 ∂ ln S 1 ∂ ln S

Next, = =− 2 =0

∂S S ∂S S ∂t

µ ¶

dS 1 2 1 2 1 2

→ d ln S = − σ dt = αdt + σdZ − σ dt = α − σ dt + σdZ

S 2 2 2

During a tiny time interval [t, t + dt], the change of ln S is d ln S.

d ln S is a normal random variable. This is why. √

First, dZ ∼ N (0, dt) .According to DM 20.4, dZ = Y dt. So dZ is a normal

random variable with mean 0 and variance dt.

20.6. GEOMETRIC BROWNIAN MOTION REVISITED 229

During the fixed interval [t, t + dt], dt is a constant. Since a constant plus a

random variable is also a random variable,

µ ¶ µ ¶

1 1

d ln S = α − σ 2 dt+σdZ is a normal random variable with mean α − σ 2 dt

2 2

and variance σ2 dt

Now consider the time interval [0, t].

µ ¶

Rt Rt 1 2 Rt

ln S (t) = ln S (0) + 0 d ln S = ln S (0) + 0 α − σ ds + 0 σdZ

2

µ ¶

1 2 Rt Rt ¡ ¢

= ln S (0) + α − σ 0

ds + σ 0 dZ = ln S (0) + α − 0.5σ 2 t + σZ

2

Z is a standard

¡ ¢ normal random variable with mean 0 and variance 1, that

is, Z ∼ N 0, σ 2 t . Hence σZ is a normal random variable ¡with mean¢ 0 and

variance σ 2 t. And ln S (t) is normal with mean ln S (0) + α − 0.5σ 2 t and

variance σ 2 t:

£ ¡ ¢ ¤

ln S (t) ∼ N ln S (0) + α − 0.5σ 2 t, σ 2 t

¡ ¢

Next, from ln S (t) = ln S (0) + α − 0.5σ 2 t + σZ, we get:

2

eln S(t) = eln S(0)+(α−0.5σ )t+σZ h i

2 2

→ S (t) = S (0) e(α−0.5σ )t+σZ = S (0) e(α−0.5σ )t eσZ

h 2

i ¡ ¢

→ E [S (t)] = S (0) e(α−0.5σ )t E eσZ

¡ ¢

We can use DM Equation 18.13 to calculate E eσZ . DM Equation ¡ 18.13¢

says that if x is normal with mean m and variance v 2 , that is x ∼ N m, v 2 ,

then

2

E (ex ) = em+0.5v (DM 18.13)

¡ ¢ 2

→ E eσZ = e0+0.5σ t

h 2

i

→ E [S (t)] = S (0) e(α−0.5σ )t e0+0.5σ = S (0) eαt

2

£ ¡ ¢ ¤

Alternative method to calculate E [S (t)]. Since ln S (t) ∼ N S (0) + α − 0.5σ 2 t, σ 2 t ,

using DM 18.13, we have:

2 2

E [S (t)] = eS(0)+(α−0.5σ )t+0.5σ t = S (0) eαt

230 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

I want you to memorize the following results (these results are used over and

over in Exam MFE):

Z ∼ N (0, t) (20.34)

¡ ¢ 2

x ∼ N m, v 2 → E (ex ) = em+0.5v (20.35)

dS (t)

S (t) is geometric Brownian motion → = αdt + σdZ (t) (20.36)

S (t)

dS (t) ¡ ¢

= αdt + σdZ (t) → d ln S (t) = α − 0.5σ 2 dt + σdZ (20.37)

S (t)

dS (t) £ ¡ ¢ ¤

= αdt+σdZ (t) → ln S (t) ∼ N ln S (0) + α − 0.5σ 2 t, σ 2 t (20.38)

S (t)

dS (t) 2

= αdt + σdZ (t) → S (t) = S (0) e(α−0.5σ )t+σZ (20.39)

S (t)

dS (t)

= αdt + σdZ (t) → E [S (t)] = S (0) eαt (20.40)

S (t)

An asset’s Sharpe ratio is equal to the asset’s risk premium α − r divided by

the asset’s volatility σ:

α−r

SR = (20.41)

σ

If two non-dividend paying assets are perfectly corrected (i.e. they are driven

by the same Brownian motion Z (t)), then their Sharpe ratios are equal. Let’s

derive this.

The price processes of Asset 1 and Asset 2 are:

dS1 = α1 S1 dt + σ1 S1 dZ (20.42)

dS2 = α2 S2 dt + σ2 S2 dZ (20.43)

We can form a riskless portfolio by removing the random Brownian motion

dZ. Rewrite Equation 20.42 and 20.43 as:

20.7. SHARPE RATIO 231

µ ¶

1 α1

dS1 = dt + dZ (20.44)

σ 1 S1 σ1

µ ¶

1 α2

dS2 = dt + dZ (20.45)

σ 2 S2 σ2

1

Suppose at time zero we buy N1 = units of Asset 1 and short sell

σ 1 S1

1

N2 = units of Asset 2. If we hold one unit of Asset 1 at time zero, then

σ 2 S2

after a tiny interval dt, the value of Asset 1 increases by the amount dS1 . If

1

we hold N1 = units of Asset 1 at time zero, then after dt the value of

σ 1 S1 µ ¶

1 1 α1

N1 = units of Asset 1 will increase by dS1 = dt + dZ. Notice

σ 1 S1 σ 1 S1 σ1

that the increase of the value of Asset 1 has a random component dZ, where dZ

is a normal random variable with mean 0 and variance dt.

1

Similarly, if we short sell N2 = units of Asset 2 at time zero, after dt,

σµ2 S2 ¶

1 α2

the value of Asset 2 will increase by dS2 = dt + dZ. The increase of

σ 2 S2 σ2

the value of Asset 2 has a random component dZ, where dZ is a normal random

variable with mean 0 and variance dt.

Suppose at time zero we simultaneously buy N1 units of Asset 1 and short

sell N2 units of Asset 2. Then at dt, we close our position by selling N1 units

of Asset 1 in the open market and buying N2 units of Asset 2 from the open

market.

The cash flow at time zero:

µ ¶

1 1

• We pay N1 S1 = S1 = dollar to buy N1 units of Asset 1.

σ 1 S1 σ1

1

• We receive N2 S2 = dollars for short selling N2 units of Asset 2

σ2

1 1 1 1

• The net cost is − dollars. If − < 0, then we receive

µ ¶ σ1 σ2 σ1 σ2

1 1

− − net cash. To avoid tying up our capital, we go to a bank

σ1 σ2 µ ¶

1 1 1 1 1 1

and borrow − dollars. If − < 0, then we lend − − .

σ1 σ2 σ1 σ2 σ1 σ2

• Our net cash outgo is zero.

• At time dt, we sell oﬀ N1 units of Asset 1 in the open market for the price

1 α1

of S1 + dS1 , receiving N1 (S1 + dS1 ) = N1 S1 + N1 dS1 = + dt + dZ

σ1 σ1

232 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

1 α2

S2 + dS2 . We pay N2 (S2 + dS2 ) = N2 S2 + N2 dS2 = + dt + dZ

σ2 σ2

• At time dt, we pay back the bank both the principal µ and the¶accrued

1 1

interest. The sum of the principal and the interest is − erdt

σ1 σ2

Our profit at dt is:

µ ¶ µ ¶ µ ¶

1 α1 1 α2 1 1

P rof it = + dt + dZ − + dt + dZ − − erdt (20.46)

σ1 σ1 σ2 σ2 σ1 σ2

µ ¶

1 1 1 1

If − < 0, we’ll lend − − at t = 0. Then at dt, we’ll receive

µ σ 1 σ¶2 σ1 σ2

1 1

− − erdt from the borrower.

σ1 σ2

The Taylor expansion:

r2 2 r3 3

erdt = 1 + rdt + (dt) + (dt) + ... = 1 + rdt

2! 3!

Equation

µ 20.46

¶ can

µ be rewritten ¶ as:

µ ¶

1 α1 1 α2 1 1

+ dt − + dt − − erdt

σµ1 σ 1 ¶ µσ 2 σ2 ¶ µσ 1 σ 2 ¶

1 1 α1 α2 1 1

= − + − dt − − erdt

µ σ1 σ2 ¶ µ σ1 σ2 ¶ µ σ1 σ2 ¶ µ ¶

1 1 α1 α2 1 1 1 1

= − + − dt − − − − rdt

µ σ1 σ2 ¶ σµ1 σ2 ¶ σ1 σ2 σ1 σ2

α1 α2 1 1

= − dt − − rdt

µ σ1 σ2 ¶σ 1 σ 2

α1 − r α2 − r

= − dt

σ1 σ2

= (SR1 − SR2 ) dt

µ ¶

α1 − r α2 − r

P rof it = − dt = (SR1 − SR2 ) dt (20.47)

σ1 σ2

Equation 20.46 and 20.47 don’t have the random term dZ (t), indicating that

the profit is surely made.

Our cash outgo is zero at t = 0, but we’ll have the profit indicated by 20.47

at dt. µ ¶

α1 − r α2 − r

Wealth 0 −→ − dt = (SR1 − SR2 ) dt

σ1 σ2

Time 0 −→ dt

α1 − r α2 − r

→ = SR1 = SR2

σ1 σ2

20.8. RISK NEUTRAL PROCESS 233

This section is diﬃcult because the author tired to put too many complex con-

cepts in this small section. It seems that the author was in a big hurry to finish

this chapter. The author mentioned many concepts (such as martingale, Gir-

sanov’s theorem) but he didn’t really explain them, leaving us hanging in the

air asking why.

The only thing worth studying is how to transform a standard geometric

Brownian motion into a risk neutral process.

The standard geometric Brownian motion is:

dS (t)

= (α − δ) dt + σdZ (t)

S (t)

This is how to transform:

dS (t)

= (α − δ) dt + σdZ (t)

S (t)

= (r − δ) dt + σdZ∙ (t) + (α − δ) dt¸

α−δ

= (r − δ) dt + σ dZ (t) + dt

σ

∼ α−δ

Define dZ (t) = dZ (t) + dt

σ

dS (t) ∼

→ = (α − δ) dt + σdZ (t) = (r − δ) dt + σdZ (t)

S (t)

Just learn this transformation and move on.

What if the payoﬀ is linear? For example, what if the payoﬀ at T is S (T ) raised

to some power a?

Though the textbook uses S a , I’m going to use S A . The reason is explained

later.

Suppose the stock price follows geometric Brownian motion:

dS

= (α − δ) dt + σdZ

S

dS

the α (alpha) in the equation = (α − δ) dt + σdZ. This can easily lead to

S

confusion and mistake. As a matter of fact, when I was deriving the formula for

E (S a ), I couldn’t match the textbook’s formula. It took me a while to figure

out that I accidentally switched a and α.

We need to determine the process followed by payoﬀ at T is S A .

234 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

∂S A 1 ∂2S A 2 1 2

dS A = dS + (dS) = AS A−1 dS + A (A − 1) S A−2 (dS)

∂S 2 ∂S 2 ¡ 2 ¢

2 2

However, (dS) = [(α − δ) dt + σdZ] S 2 = σ 2 dt S 2 = σ 2 S 2 dt

1

→ dS A = AS A−1 dS + A (A − 1) S A−2 σ 2 S 2 dt

2

1

= AS A−1 dS + A (A − 1) S A σ 2 dt

2

dS A dS 1

→ =A + A (A − 1) σ 2 dt

SA S 2

2

=A

£ (α − δ) dt + AσdZ + 0.5A2(A

¤ − 1) σ dt

= A (α − δ) + 0.5A (A − 1) σ dt + AσdZ

0.5A (A − 1) σ 2 and risk component AσdZ.

£ ¤

20.9.2 Formula for S A (t) and E S A (t)

Next, we apply Equation 20.37. Replace α with A (α − δ) + 0.5A (A − 1) σ 2 and

σ with Aσ. £ ¤

d ln S A (t) =£ A (α − δ) + 0.5A (A ¤− 1) σ 2 − 0.5A2 σ2 dt + AσdZ

= A (α − δ) dt − 0.5Aσ2 dt + AσdZ

ln S A (t) ∼ N ln S A (0) + A (α − δ) − 0.5Aσ 2 t, A2 σ 2 t

2

S A (t) = S A (0) e[A(α−δ)−0.5Aσ ]t+AσZ

£ ¤ 2

E S A (t) = S A (0) e[A(α−δ)+0.5A(A−1)σ ]t

£ ¤ 2

We can also derive E S A (t) using S A (t) = S A (0) e[A(α−δ)−0.5Aσ ]t+AσZ

£ ¤ ³ 2

´

E S A (t) = E S A (0) e[A(α−δ)−0.5Aσ ]t+AσZ

³ 2

´

= S A (0) E e[A(α−δ)−0.5Aσ ]t+AσZ

³ 2

´

= S A (0) E e[A(α−δ)−0.5Aσ ]t eAσZ

2 ¡ ¢

= S A (0) e[A(α−δ)−0.5Aσ ]t E eAσZ

AσZ is a normal random variable with mean 0 and variance V ar [AσZ (t)] =

A2 σ 2 V ar [Z (t)] = A2 σ2 t. Using Equation 20.35, we get:

¡ ¢ 2 2

E eAσZ = e0.5A σ t

£ A ¤ 2 2

→ E S (t) = S A (0) e[A(α−δ)−0.5Aσ ]t e0.5A σ t = S A (0) e[A(α−δ)+0.5A(A−1)σ ]t

2 2

20.9. VALUING A CLAIM ON S A 235

£ ¤

Alternative method to calculate E S A (t) . Using Equation 20.39, we get:

dS 2

= (α − δ) dt + σdZ → S (t) = S (0) e(α−δ−0.5σ )t+σZ

S

2

→ S A (t) = S A (0)³eA(α−δ−0.5σ )t+AσZ ´

£ A ¤ 2

→ E S (t) = E S A (0) eA(α−δ−0.5σ )t+AσZ

2 ¡ ¢

= S A (0) eA(α−δ−0.5σ )t E eAσZ

2

= S A (0) e[A(α−δ)−0.5Aσ ]t e0.5A σ t

2 2

2

= S A (0) e[A(α−δ)+0.5A(A−1)σ ]t

Consider two geometric Brownian motions S (t) and S A (t).

dS

= (α − δ) dt + σdZ

S

where α is the expected return on a claim on S (t) and δ is the continuous

dividend yield earned by S (t)

dS A £ ¤

A

= A (α − δ) + 0.5A (A − 1) σ 2 dt + AσdZ

S

= (γ − δ ∗ ) dt + AσdZ

where γ is the expected return on a claim on S A (t) and δ ∗ is the continuous

dividend yield earned by S A (t). The textbook calls δ ∗ the lease rate.

These two processes have the same risk dZ. Consequently, they have the

same Sharpe ratio:

α−r γ−r

= → γ = r + A (α − r)

σ Aσ

where r is the continuously compounded risk-free interest rate.

The textbook keeps mentioning Jensen’s inequality. So let’s first talk about

Jensen’s inequality. Jensen’s inequality is in the appendix C of the textbook.

You can also find information at http://en.wikipedia.org/wiki/Convex_

function

Jensen’s inequality says

f [E (x)]

f [E (x)]

236 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

If at any point you draw a tangent line, the function f (x) stays above the

tangent line, then f (x) is a convex function.

If at any point you draw a tangent line, the function f (x) stays below the

tangent line, then f (x) is a concave function.

only if its second derivative is non-negative there.

and only if its second derivative is negative there.

20.9. VALUING A CLAIM ON S A 237

d2 y

Consider y = x2 . Sine = 2 > 0, y = x2 is a convex function. Suppose

dx2

weµtake two points A (1, 1) and¶ B (4, 16). The mid point of the line AB is

1+4 1 + 16

C = 2.5, = 8.5 . The fact that y = x2 is a convex function means

2 2

that y = x2 curves up. Then it follows that the point C must be above the point

¡ ¢ 12 + 42

D 2.5, 2.52 = 6. 25 . From the graph below, we clearly sees that = 8.5

µ ¶2 2

1+4

(which is the height of the point C) is greater than = 6.25 (which

2

is the height of the point D). This is an example where the mean of a convex

function is greater than the function of the average.

25

y

20

B

15

10

C

5 D

A

0

0 1 2 3 4 5

x

µ ¶2

12 + 42 1+4

> , an example of E [f (x)] ≥ f [E (x)].

2 2

238 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

√

Next, let’s consider a concave function

Ãy = x. Consider two points!A (1, 1)

√ √

1+4 1+ 4

and B (4, 2). The mid point of AB is C = 2.5, = 1.5 . Since

2 2

µ ¶

√ 1+4 √

y = x curves down, then it follows that C must be lower than D = 2.5, 2.5 = 1. 58 .

√ √ 2

1+ 4

From the graph below, we clearly sees that = 1.5 (which is the height

r 2

1+4

of the point C) is less than = 1. 58 (which is the height of the point

2

D). This is an example where the mean of a concave function is less than the

function of the average.

y

2.0 B

D

1.5

C

1.0 A

0.5

0.0

0 1 2 3 4 5

x

√ √ r

1+ 4 1+4

< , an example of E [f (x)] ≤ f [E (x)]

2 2

By now you should have intuitive feel of Jensen’s inequality. Let’s move on.

20.9. VALUING A CLAIM ON S A 239

If A = 1, the time 0 value of the claim S (T ) at T is:

P

V (0) = F0,T [S (T )] = e−rT S (0) e[(r−δ)]T = S (0) e−δT

This is just DM Equation 5.4.

P

→ V (0) = F0,T [1] = e−rT

So the time 0 value of getting $1 at T is e−rT . V (0) is equal $1 discounted

back to time 0 at the risk-free rate.

£ 2 ¤ 2

P

V (0) = F0,T S (T ) = e−rT S 2 (0) e[2(r−δ)+σ ]T

As a general rule, the forward price of any asset at T is just the prepaid

forward price accumulating at the risk-rate from time 0 to T :

P

F0,T = F0,T erT

P

as a buyer can either pay the seller F0,T at time 0 or pay the seller F0,T at time

T . To avoid the arbitrage, the two payments should diﬀer only in timing. So

P

F0,T = F0,T erT .

£ 2 ¤ £ 2 ¤ 2

→ F0,T S (T ) = F0,T P

S (T ) erT = S 2 (0) e[2(r−δ)+σ ]T

P

F0,T [S (T )] = F0,T [S (T )] erT = S (0) e−δT erT = S (0) e(r−δ)T

£ 2 ¤ 2

→ F0,T S (T ) = S 2 (0) e[2(r−δ)+σ ]T = (F0,T [S (T )])2 eσ T

2

2 £ ¤

Since eσ T ≥ 1, we have F0,T S 2 (T ) ≥ (F0,T [S (T )])2 . This agrees with

Jensen’s inequality. Roughly speaking 1 , F0,T = E (ST ).

d2 2

S 2 is twice diﬀerentiable and S = 2 > 0. Hence S 2 is convex.

dS £ ¤ 2

According to Jensen’s inequality, we have E S 2 (T ) ≥ (E [S (T )]) . This

£ 2 ¤ £ 2 ¤ 2 2

leads to F0,T S (T ) = E S (T ) ≥ (F0,T [S (T )]) = (E [S (T )]) .

1

If A = −1, the time 0 value of the claim at T is:

∙ ¸ S (T )

P 1 1 [−(r−δ)+σ2 ]T 1 2

V (0) = F0,T = e−rT e = e−rT (r−δ)T

eσ T

∙ S

¸ (T ) ∙ S (0)

¸ S (0) e

1 P 1 1 2

→ F0,T = F0,T erT = eσ T

S (T ) S (T ) S (0) e(r−δ)T

(r−δ)T

However,

∙ F0,T [S¸ (T )] = S (0) e

1 1 2 1

→ F0,T = eσ T ≥

S (T ) F0,T [S (T )] F0,T [S (T )]

1 Experts don’t agree whether F

0,T = E (ST ). Some say the forward price is the unbiased

estimate of the expected future spot price, that is, F0,T = E (ST ). Others disagree. However,

it’s safe to see that F0,T is very close to E (ST ).

240 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

1

Since is concave, according to Jensen’s inequality, we have:

S (T )

∙ ¸ ∙ ¸ µ ∙ ¸¶2 µ ∙ ¸¶2

1 1 1 1

F0,T =E ≥ F0,T = E .

S (T ) S (T ) S (T ) S (T )

d2 −1 2

S −1 is twice diﬀerentiable and 2

S = 3 > 0. Hence S 2 is convex.

dS S∙ ¸ µ ∙ ¸¶2

1 1

According to Jensen’s inequality, we have E ≥ E . This

S (T ) S (T )

∙ ¸ ∙ ¸ µ ∙ ¸¶2 µ ∙ ¸¶2

1 1 1 1

leads to F0,T =E ≥ F0,T = E .

S (T ) S (T ) pS (T ) S (T )

If A = 0.5, thehptime 0ivalue of p the claim S (T ) at T is:

2

V (0) = F0,TP

S (T ) = e −rT

S (0)e[0.5(r−δ)+0.5×0.5(0.5−1)σ ]T

p 2

= he−rT S i(0)e[0.5(r−δ)−0.125 σ ]T

p p 2 p

→ F0,T S (T ) = S (0)e[0.5(r−δ)−0.125 σ ]T = S (0)e0.5(r−δ)T

p p

σ2 T 2

= S (0) e(r−δ)T e−0.125h =i F0,T [S (T )]e−0.125 σ T

2 p p

Since e−0.125 σ T ≤ 1, we see that F0,T S (T ) ≤ F0,T [S (T )]

This agrees with Jensen’s inequality.

p d2 √ p

S (T ) is twice diﬀerentiable. S = −4S −1.5 < 0. Hence S (T ) is

dS 2

concave. hp i hp i p hp i

→ F0,T S (T ) = E S (T ) ≤ F0,T [S (T )] = E (S (T ))

Example 20.9.1.

dS (t)

= (0.1 − 0.04) dt + 0.3dZ

S (t)

The current price of the stock is 10.

The continuously compounded dividend yield is 0.04 per year.

The continuously compounded risk-free rate is 0.06 per year.

The seller and the buyer enter a forward contract. The contract requires the

seller to pay the buyer S 2 (5) five years from now.

Calculate

• γ

• δ∗

20.9. VALUING A CLAIM ON S A 241

Solution.

dS (t)

= (0.1 − 0.04) dt + 0.3dZ

S (t)

£ A ¤ 2

P

F0,T S (T ) = e−rT S A (0) e[A(r−δ)+0.5A(A−1)σ ]T

£ 2 ¤ 2

P

F0,5 S (5) = e−0.06×5 102 e(2(0.06−0.04)+0.5×2(2−1)×0.3 )5 = 141. 906 8

£ 2 ¤ P

£ ¤

F0,5 S (5) = F0,5 S 2 (5) e0.06×5 = 141. 906 8e0.06×5 = 191. 554 1

γ = r + A£ (α − r) = 0.06 + 2 (0.1 − 0.06)

¤ = 0.14

δ ∗ = γ − A ¡(α − δ) + 0.5A (A − 1) σ 2 ¢

= 0.14 − 2 (0.1 − 0.04) + 0.5 × 2 (2 − 1) × 0.32

= −0.07

£ ¤ ¤

ln S A (t) ∼ N ln S A (0) + A (α − δ) − 0.5Aσ 2 t, A2 σ 2

2

£ 2

£ 2

¤ 2 2

¤

¡ S (5) ∼ N ln 10 + 2 (0.1 2−¢ 0.04) − 0.5 × 2 × 0.3 5, 2 × 0.3 × 5

ln

2 (0.1 −¡0.04) − 0.5 × 2 × 0.3 5 = 0.15¢

ln 102 + 2 (0.1 − 0.04) − 0.5 × 2 × 0.32 5 = ln 100 + 0.15 = 4. 755 17

£ ¤ £ ¤

P S 2 (5) ≤ 160 = P ln S 2 (5) ≤ ln 160 = Φ (z)

ln 160 − 4. 755 17

z= √ = 0.238 5

22 × 0.32 × 5 £ ¤

Φ (z) = 0.594 3 → P S 2 (5) ≤ 160 = 0.594 3

Example 20.9.2.

dS (t)

= (0.12 − 0.05) dt + 0.25dZ

S (t)

The current price of the stock is 20.

The continuously compounded dividend yield is 0.05 per year.

The continuously compounded risk-free rate is 0.07 per year.

The seller and the buyer enter a forward contract. The contract requires the

1

seller to pay the buyer four years from now.

S (4)

Calculate

• γ

242 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

• δ∗

1

• The probability that ≤ 0.03.

S (4)

Solution.

dS (t)

= (0.12 − 0.05) dt + 0.25dZ

S (t)

£ ¤ 2

P

F0,T S A (T ) = e−rT S A (0) e[A(r−δ)+0.5A(A−1)σ ]T

∙ ¸

1 1 2

P

F0,4 = e−0.07×4 e(−1(0.07−0.05)+0.5×(−1)(−1−1)×0.25 )4 = 0.04479

∙ S (4) ¸ ∙ 20 ¸

1 P 1

F0,4 = F0,4 e0.07×4 = 0.04479e0.07×4 = 0.05 926

S (4) S (4)

γ = r + A£ (α − r) = 0.07 − 1 (0.12 − 0.07)

¤ = 0.02

δ ∗ = γ − A ¡(α − δ) + 0.5A (A − 1) σ 2 ¢

= 0.02 − −1 (0.12 − 0.05) + 0.5 × (−1) (−1 − 1) × 0.252 = 0.027 5

£ £ ¤ ¤

ln S A (t) ∼ N ln S A (0) + A (α − δ) − 0.5Aσ 2 t, A2 σ 2

∙ ¸

1 1 £ ¤ 2

ln ∼ N ln + −1 (0.12 − 0.05) − 0.5 × (−1) × 0.252 4, (−1) × 0.252 × 4

¡ S (4) 20 ¢

−1 (0.12 − 0.05) − 0.5 × (−1) × 0.252 4 = −0.155

1 £ ¤ 1

ln + −1 (0.12 − 0.05) − 0.5 × (−1) × 0.252 4 = ln −0.155 = −3. 150 7

20 20

∙ ¸ ∙ ¸

1 1

P ≤ 0.03 = P ln ≤ ln 0.03 = Φ (z)

S (4) S (4)

ln 0.03 − (−3. 150 7)

z=q = −0.711 7

2

(−1) × 0.252 × 4

∙ ¸

1

Φ (z) = 0.238 3 →P ≤ 0.03 = 0.238 3

S (4)

Example 20.9.3.

The price of a stock follows a geometric Brownian motion:

dS (t)

= (0.15 − 0.04) dt + 0.35dZ

S (t)

The current price of the stock is 10.

The continuously compounded dividend yield is 0.04 per year.

The continuously compounded risk-free rate is 0.08 per year.

The seller and the buyer

p enter a forward contract. The contract requires the

seller to pay the buyer S (6) six years from now.

Calculate

20.9. VALUING A CLAIM ON S A 243

• the forward price

• γ

• δ∗

p

• The probability that S (6) ≤ 4.

Solution.

dS (t)

= (0.15 − 0.04) dt + 0.35dZ

S (t)

£ ¤ 2

P

F0,T S A (T ) = e−rT S A (0) e[A(r−δ)+0.5A(A−1)σ ]T

hp i √ 2

P

F0,6 S (6) = e−0.08×6 10e(0.5(0.08−0.04)+0.5×0.5(0.5−1)×0.35 )6 = 2. 012 6

hp i hp i

P

F0,6 S (6) = F0,6 S (6) e0.08×6 = 2. 012 6e0.08×6 = 3. 252 5

γ = r + A£ (α − r) = 0.08 + 0.5 (0.15 −¤0.08) = 0.115

δ ∗ = γ − A (α¡ − δ) + 0.5A (A − 1) σ 2 ¢

= 0.115 − 0.5 (0.15 − 0.04) + 0.5 × 0.5 (0.5 − 1) × 0.352 = 0.075 3

£ £ ¤ ¤

ln S A (t) ∼ N ln S A (0) + A (α − δ) − 0.5Aσ 2 t, A2 σ 2

p £ √ £ ¤ ¤

ln

¡ S (6) ∼ N ln 10 + 0.5 (0.15 −¢0.04) − 0.5 × 0.5 × 0.352 5, 0.52 × 0.352 × 6

0.5 (0.15 − 0.04) − 0.5 × 0.5 × 0.352 6 = 0.146 25

√ £ ¤ √

ln 10 + 0.5 (0.15 − 0.04) − 0.5 × 0.5 × 0.352 5 = ln 10 + 0.146 25 = 1.

297 5

hp i h p i

P S (6) ≤ 4 = P ln S (6) ≤ ln 4 = Φ (z)

ln 4 − 1. 297 5

z=√ = 0.207 1

0.52 × 0.352 × 6 h i

p

Φ (z) = 0.582 0 →P S (6) ≤ 4 = 0.582 0

244 CHAPTER 20. BROWNIAN MOTION AND ITO’S LEMMA

Chapter 21

Black-Scholes equation

certainty

21.1.1 Valuation equation

Let’s consider a risk-free world where all assets just earn the risk free interest

rate. Support at time t we spend S (t) to buy one share of a stock. Then at t+h,

we receive D (t + h) h amount of the dividend, where D (t + h) represents the

dividend accumulated per unit of time during [t, t + h]. At t + h after receiving

D (t + h) h dividend, we sell the stock and receive S (t + h). The total amount

of money we have at t + h is D (t + h) h + S (t + h). Had we put S (t) amount of

money in a savings account, we would have S (t) (1 + rh ) amount of money at

t+h, where rh represent the (not-annualized) risk-free interest rate per h period.

To avoid arbitrage, we need to have S (t) (1 + rh ) = D (t + h) h + S (t + h).

Rearranging this equation, we get:

D (t + h) h + S (t + h)

S (t) = (DM 21.1)

1 + rh

dS (t) S (t + h) − S (t) hr i

h

= lim = lim S (t) − D (t + h) = rS (t) − D (t)

dt h→0 h h→0 h

(DM 21.3)

1

In Equation 21.3, r = × rh represents the annualized continuously com-

h

pounded interest rate per year. rh is the interest rate per h period; the total

1 1

number of h lengths in a year is . Hence r = × rh represents the annualized

h h

continuously compounded interest rate per year.

245

246 CHAPTER 21. BLACK-SCHOLES EQUATION

21.1.2 Bonds

dS (t)

For a zero-coupon bond, D (t) = 0. DM Equation 21.3 becomes = rS (t).

dt

This gives us

Since the boundary condition is S (T ) = 1, we have S (t) = e−r(T −t) . This

equation says that $1 at T is worth e−r(T −t) at time t.

At time t, you spend S (t) and buy one share of a stock. This gives you two

things:

• at time T you can sell the stock and get S (T ), which is worth S (T ) e−r(T −t)

at t

• you accumulate dividend at a continuous rate of D (s), where D (s) is the

instant dividend earned per unit of time at time s. The total value of

the continuous dividend earned during the interval [s, s + ds] is D (s) ds,

which is worth [D (s) ds] e−r(s−t) = D (s) e−r(s−t) ds at time t. The present

value at time t of the total continuous dividend earned during the interval

RT

[t, T ] is t D (s) e−r(s−t) ds The PV of this continuous flow of dividend is

1 − e−r(T −t)

DaT −t|r = D

r

RT

To avoid arbitrage, we have S (t) = S (T ) e−r(T −t) + t D (s) e−r(s−t) ds.

RT

Please note that if D (s) = D is a constant, then t D (s) e−r(s−t) ds =

RT 1 − e−r(T −t)

D t e−r(s−t) ds = DaT −t|r = D .

RT r

Anyway, t D (s) e−r(s−t) ds is a continuous annuity. If you have trouble

RT

understanding t D (s) e−r(s−t) ds, refer to your FM book.

21.2.1 How to derive Black-Scholes equation

This section derives DM Equation 21.11.

At time t

21.2. BLACK-SCHOLES EQUATION 247

We pay N S .

• We deposit W means into a savings account. We pay W .

I = V + NS + W = 0 (DM 21.7)

dI is the interest earned on the option during [t, t + dt]. Since W is invested

in a savings account, we have dW = rW dt. This says that the interest earned

on W during [t, t + dt] is rW dt. Notice that the change of S is dS + δSdt (the

sum of the change of the stock price dS and the dividend received δSdt). Apply

It’o lemma:

dV = Vt dt + VS dS + 0.5σ 2 S 2 VSS dt

→ dI = Vt dt + VS dS + 0.5σ2 S 2 VSS dt + N (dS + δSdt) + dW = Vt dt +

(VS + N ) dS + 0.5σ 2 S 2 VSS dt + N δSdt + dW

Because our initial cost is zero, the interest we earned dI should be zero.

This leads to DM 21.11.

Vt + 0.5σ2 S 2 VSS + (r − δ) SVS − rV = 0

Simple PV calculation

Verification that the price of a zero-coupon bond satisfies the Black-Scholes

equation DM 21.11.

=⇒ VS = VSS = 0 Vt = re−r(T −t) = rV

2 2

=⇒ Vt + 0.5σ S VSS + (r − δ) SVS − rV = 0

Verification that the price of a prepaid forward contract satisfies the Black-

Scholes equation DM 21.11.

V (S, t) = S (t) e−δ(T −t)

=⇒ VS = e−δ(T −t) VSS = 0 Vt = δS (t) e−δ(T −t)

=⇒ Vt +0.5σ 2 S 2 VSS +(r − δ) SVS −rV = δSe−δ(T −t) +(r − δ) Se−δ(T −t) −

rSe−δ(T −t) = 0

248 CHAPTER 21. BLACK-SCHOLES EQUATION

Call option

The textbook explains that the price of a European call option satisfies (1) the

boundary condition and, (2) DM 21.11.

V = S (t) e−δ(T −t) N (d1 ) − Ke−r(T −t) N (d2 )

Verification that the call price formula meets the boundary condition.

The boundary condition is that at the call expiration date T the call is worth

S (T ) − K (T ) if S (T ) > K (T ) and zero otherwise.

µ ¶

S (t) 1

ln + r − δ + σ 2 (T − t)

K 2

d1 = √

√ σ T −t

d2 = d1 − σ T − t µ ¶

S (T ) 1 2

ln + r − δ + σ (T − t)

K 2

If t approaches T , then d1 = √ , d2 = d1 ,

σ T −t

and

µ ¶

S (T ) 1 2 √

ln r−δ+ σ T −t

S (T ) S (T ) 2

• If S (T ) > K, then > 1, ln > 0, d1 = √ K + =

K K σ T −t σ

+∞ , N (d1 ) = N (d2 ) = 1, V = S − T.

S (T )

• If S (T ) < K, then ln < 0, d1 = −∞ , N (d1 ) = N (d2 ) = 0 and

K

V =0

bility of S (T ) = K is zero. The probability that a continuous random variable

takes on a fixed value is zero. When we talk about the probability regarding a

continuous random variable X, we talk about the probability that X falls in a

range [a, b], not the probability that X takes on a single value. If the probability

that X takes a single value is not zero, then the total probability that a < X < b

will be infinite because there are infinite number of single values in the range

[a, b].

We have proved that the call price satisfies the boundary condition.

For the verification that the call price satisfies DM 21.11, see my solution to

DM Problem 21.5, 21.6, and 21.7.

We can also verify that the European put price satisfies DM 21.11. The put

price is

V = Ke−r(T −t) N (−d2 ) − S (t) e−δ(T −t) N (−d1 )

Using the formula N (−x) = 1 − N (x), we can rewrite the put price as

V = Ke−r(T −t) [1 − N (d2 )] − S (t) e−δ(T −t) [1 − N (d1 )] = Ke−r(T −t) −

S (t) e−δ(T −t) + S (t) e−δ(T −t) N (d1 ) − Ke−r(T −t) N (d2 )

21.2. BLACK-SCHOLES EQUATION 249

You can also derive the above equation using the put-call parity. Notice that

S (t) e−δ(T −t) N (d1 ) − Ke−r(T −t) N (d2 ) is the call price.

Each of the three terms, Ke−r(T −t) , S (t) e−δ(T −t) , and S (t) e−δ(T −t) N (d1 )−

−r(T −t)

Ke N (d2 ), satisfies the BS PDE. Hence the put price satisfies the BS

PDE.

I won’t prove that the put price satisfies the boundary condition V (t = T ) =

K − S (T ) if K > S (T ) and zero otherwise. You can easily prove this yourself.

If t → T , then d1 = d2 and

The textbook points out that S (t) e−δ(T −t) N (d1 ) and e−r(T −t) N (d2 ) each sat-

isfy the BS PDE (see my solution to DM Problem 21.5, 21.6). So S (t) e−δ(T −t) N (d1 )

can be a price of a derivative; e−r(T −t) N (d2 ) can be a price of another deriv-

ative. What derivatives are priced as S (t) e−δ(T −t) N (d1 ) and e−r(T −t) N (d2 )

respectively?

S (t) e−δ(T −t) N (d1 ) must be the price of an option that pays S (T ) if S (T ) >

K and zero otherwise. Such an option is an asset-or-nothing option.

Similarly, as t → T

• e−r(T −t) N (d2 ) → 0 if S (T ) < K

e−r(T −t) N (d2 ) must be the price of an option that pays 1 if S (T ) > K and

zero otherwise. Such an option is an cash-or-nothing option.

We can break down a European call option into one asset-or-nothing option

and several cash-or-nothing options. Buying a European call option is equivalent

to buying one asset-or-nothing option and selling K units of cash-or-nothing

option (you can verify that they have the same payoﬀ). Hence the price of the

European call option is S (t) e−δ(T −t) N (d1 ) − Ke−r(T −t) N (d2 ).

Similarly, we can break down a gap option (gap option is explained in Chap-

ter 14). In a gap call, the payoﬀ is S (T ) − K1 if S (T ) > K2 . This is equivalent

250 CHAPTER 21. BLACK-SCHOLES EQUATION

tion. So the price of this gap call is S¢ (t) e−δ(T −t) N (d1 ) − K1 e−r(T −t) N (d2 ),

¡ −δ(T −t)

ln St e /K2 e−r(T −t) + 0.5σ 2 (T − t) √

where d1 = √ and d2 = d1 −σ T − t.

σ T −t

• P ∗ (ST > K) = N (d2 ). This is the risk-neutral probability that the call

will be exercised (i.e. call will finish in the money)

• P ∗ (ST < K) = 1 − N (d2 ) = N (−d2 ). This is the risk-neutral probability

that the call will NOT be exercised.

• Ke−r(T −t) N (d2 ) is the strike price multiplied by the risk-neutral proba-

bility that the strike price will ever be paid. This is the expected value of

the strike price *if* the call will be exercised

• S (t) e−δ(T −t) N (d1 ) is the expected value of the stock price *if* the call

will be exercised (i.e. if ST > K)

• N (d1 ) is the expected fractional share of the stock *if* the call will be

exercised

• If an option pays one stock when ST > K and zero otherwise, then this

option is worth S (t) e−δ(T −t) N (d1 )

• If an option pays $1 when ST > K and zero otherwise, then this option is

worth PV of $1 (which is e−r(T −t) ) multiplied by P ∗ (ST > K)

This section derives the BS PDE using the idea that the actual expected return

on an option should be equal to the equilibrium expected return.

The expected continuously compounded return on an option is αoption =

E (dV )

. Here dV is the increase of the option value (i.e. the interest earned

V dt

on the option) during [t, t + dt]. At time t, if you spend V dollars and buy an

option, then during the tiny interval [t, t + dt], your option value will go up by

dV

dV . The (not annualized) return earned on the option per dt period is .

V

1

Since the number of dt periods in one year is , the annualized (continuously

dt

dV 1 dV

compounded) rate of return per $1 invested in the option is × = .

µ ¶ V dt V dt

dV E (dV )

The expected return on the option is E = . Here V and dt are

V dt V dt

treated as constants. dV is a random variable.

21.2. BLACK-SCHOLES EQUATION 251

£ ¤

dV = 0.5σ 2 S 2 VSS + (α − δ) SVS + Vt dt + SVS σdZ

¡£ ¤ ¢

→ E [dV ] = E 0.5σ 2 S 2 VSS + (α − δ) SVS + Vt dt + E (SVS σdZ)

£ ¤

= 0.5σ 2 S 2 VSS + (α − δ) SVS + Vt dt + SVS σE (dZ)

We know that E (dZ) = 0. Recall dZ (t) is a normal random variable with

mean 0 and variance dt (see the footnote of Derivatives Markets Page 652).

Hence αoption = =

V dt V

SVS σdZ

The (not annualized) unexpected return on the option is . Here we

V

didn’t divide SVS σdZ by dt because the unexpected return is not annualized.

SVS σ

Define = σ option .

V

Hence the (not annualized) unexpected return on the option is σoption dZ.

The Ito’s lemma can be written as:

dV

= αoption dt + σoption dZ

V

− = (DM 21.18)

V V V

The correct formula should be: − =

V V V

Consider two assets, an stock and an option on the stock.

dS

The process of the stock price: = αdt + σdZ (DM 20.1)

S

dV

The process of the option price: = αoption dt + σ option dZ

V

These two processes are driven by the same dZ. According to Chapter 20,

the stock and the option on the stock must have the same Sharpe ratio. Hence

α−r αoption − r

=

σ σ option

α−r αoption − r V

=⇒ = α−r = (αoption − r)

σ SV S σ SVS

Vµ ¶

V 0.5σ 2 S 2 VSS + (α − δ) SVS + Vt

=⇒ α−r = −r

SVS V

=⇒ Vt + 0.5σ 2 S 2 VSS + (r − δ) SVS − rV = 0 (BS PDE)

252 CHAPTER 21. BLACK-SCHOLES EQUATION

SVS

By the way, according to DM 12.8, the option elasticity is Ω = . Hence

V

SVS σ

σ option = = σΩ (DM 21.20). DM 21.20 is slightly diﬀerent from DM

V

12.9:

σ option = σ|Ω| (DM 12.9)

σ option = σΩ (DM 21.20)

Obviously, the author of Derivatives Markets changed his definition of σoption .

In Chapter 12, σ option is non negative; in Chapter 21, σ option can be positive,

zero, or negative.

This section repeats the old idea of risk neutral pricing. Under risk neutral

pricing, we can set the expected return on the stock α to r and get the correct

price of a derivative.

This section contains many formulas. Make sure you understand the meaning

of each formula.

The textbook lists the following equations:

dS ˜

= (r − δ) dt + σdZ (DM 21.28)

S

d ∗

E (dV ) = Vt + 0.5σ2 S 2 VSS + (r − δ) SVS (DM 21.30)

dt

d ∗

E (dV ) = rV (DM 21.31)

dt

These equations are risk-neutral version of similar formulas.

conditional probability of the stock’s terminal price ST given that the price

today is St .

You’ll want to memorize

R∞ the following formulas:

P (ST > K) = K f (ST : St ) dST (this holds whether f (ST : St ) is risk-

neutral probability or the true probability)

The price of a European call is

RK R∞

Vt = e−r(T −t) E ∗ (VT ) = e−r(T −t) 0 0× f ∗ (ST : St ) dST +e−r(T −t) K [S (T ) − K]

R ∞

f ∗ (ST : St ) dST = e−r(T −t) K [S (T ) − K] f ∗ (ST : St ) dST

Please note that the price of the call at expiration is VT = 0 if S (T ) < K

and S (T ) − K if S (T ) > K.

RK

Vt = e−r(T −t) E ∗ (VT ) = e−r(T −t) 0 [K − S (T )] × f ∗ (ST : St ) dST

Chapter 22

Exotic options: II

Cash-or-nothing option.

Asset-or-nothing option.

• The price of a cash call option is e−r(T −t) N (d2 ), where N (d2 ) = P ∗ (ST > K)

(i.e. the risk neutral probability of ST > K)

• The price of a cash put option is e−r(T −t) [1 − N (d2 )] = e−r(T −t) N (−d2 ),

where N (−d2 ) = P ∗ (ST < K) (i.e. the risk neutral probability of ST <

K)

• The price of an asset put option is St e−δ(T −t) [1 − N (d1 )] = St e−δ(T −t) N (−d1 )

253

254 CHAPTER 22. EXOTIC OPTIONS: II

asset-or-nothing call and selling K cash-or-nothing calls. The call price is

St e−r(T −t) N (d1 ) − Ke−r(T −t) N (d2 )

• Buying an ordinary European put option is equivalent to buying K cash-

or-nothing puts and selling one asset-or-nothing put. The put price is

Ke−r(T −t) N (−d2 ) − St e−r(T −t) N (−d1 )

with strike price K2 and selling K1 cash-or-nothing calls with strike price

K2 . The gap call price is St e−r(T −t) N (d1 ) − K1 e−r(T −t) N (d2 ) .

• Buying a gap put option is equivalent to buying K1 asset-or-nothing puts

with strike price K2 and selling one asset-or-nothing put with strike price

K2 . The gap put price is K1 e−r(T −t) N (−d2 ) − St e−r(T −t) N (−d1 ) .

¡ ¢

ln St e−δ(T −t) /K2 e−r(T −t) + 0.5σ 2 (T − t)

• For both a gap call and put, d1 = √

√ σ T −t

and d2 = d1 − σ T − t.

It’s diﬃcult to hedge an all-or-nothing option because the payoﬀ is not con-

tinuous. The textbook explains this well. Refer to the textbook.

Chapter 23

Volatility

volatility of an option is the volatility implied by the market price of the option

based on the Black-Scholes formula. If you plug the implied volatility into the

Black-Scholes formula, the formula should produce the option price that is equal

to the current market price of the option.

The Black-Scholes formula assumes that a given stock has a constant volatil-

ity. Under the BS formula, the stock’s volatility is a inherent characteristic of

the stock; it doesn’t depend on other factors (such as the stick price K and the

option’s expiry T ). In reality, however, the implied volatility of a stock depends

on K and T .

The volatility smile is a long-observed pattern where at-the-money options

tend to have lower implied volatilities than in- or out-of-the-money options.

• The implied volatility gets higher and higher as the option gets more and

more in-the-money

• The implied volatility gets higher and higher as the option gets more and

more out-of-the money.

If we plot the implied volatility in a 2-D plane (setting the implied volatility

σ as Y and the strike price K as X), the diagram looks like a letter U (the letter

U looks like a smile).

To see a diagram of the volatility smile, refer to

• http://www.optiontradingpedia.com/volatility_smile.htm

• http://en.wikipedia.org/wiki/Volatility_smile

of the strike price K and time to maturity T .

255

256 CHAPTER 23. VOLATILITY

To account for the factor that the implied volatility depends on K and T ,

dS (t) dS (t)

we can rewrite DM 20.25 = (α − δ) dt + σdZ (t) as DM 23.1 =

S (t) S (t)

(α − δ) dt+σ (St , Xt, t) dZ (t). In DM 23.1, the instant volatility σ (St , Xt, t) dZ (t)

is a function of the stock price St , another factor Xt, , and the

∙ timent. ¸

ˆ2 1 1 P 2

Historical volatility. Please note that DM 23.2 σ = ε is not

h n − 1 i=1 i

new. This formula is already used in DM Chapter 11 "Estimating Volatility." In

1 P n

DM 23.2, ε2 is the estimated variance per h period. Since the number

n − 1 i=1 i ∙ ¸

1 1 1 P n

of h periods in one year is , the variance per year is ε2i .

h h n − 1 i=1

This is all you need to know about Chapter 23.

Chapter 24

24.1.1 Review of duration and convexity

Duration and convexity are explained in Derivatives Markets Section 7.3. Sec-

tion 7.3 is excluded from the MFE syllabus. However, Derivatives Markets page

hedge. Recall that the duration of a zero-coupon bond is the bond’s time to

maturity...

SOA may test your knowledge about duration hedging. So read DM Section

7.3 and take a quick review of duration and convexity. Next, let’s solve a few

problems.

Example 24.1.1.

The yield to maturity of a 5-year zero-coupon bond is 6%. The face amount

of the bond is 100.

Calculate

• the Macaulay duration

• the modified duration

• the convexity

257

258 CHAPTER 24. INTEREST RATE MODELS

• moves up to 7%

• moves down to 5%.

Solution.

The (Macaulay) duration of a zero-coupon bond is its maturity T . So the

(Macaulay) duration is

DMac = T = 5 years.

The modified duration is

DMac 5

Dmod = = = 4. 716 98 years

1 + yield 1.06

The convexity of a zero-coupon bond is:

T (T + 1) 5×6

C= 2 = 1.062 = 26. 699 893

(1 + y)

P1 = 100 × 1.07−5 = 71. 298 6

We can also use duration and convexity to approximate the bond value under

the new yield.

The new bond value µis ¶

∆P

P1 = P0 + ∆P = P0 1 +

P0

∆P 1 1

= −Dmod ∆y+ C (∆y)2 = −4. 716 98×0.01+ ×26. 699 893×(0.01)2 =

P0 2 2

−0.045 8

This is very close to the correct amount of 71. 298 6.

P1 = 100 × 1.05−5 = 78. 352 6

We can also use duration and convexity to approximate the bond value under

the new yield.

∆P 1 2 1

= −Dmod ∆y + C (∆y) = −4. 716 98 × (−0.01) + × 26. 699 893 ×

P0 2 2

(−0.01)2 = 0.048 5

This is very close to the correct amount of 78. 352 6.

Example 24.1.2.

24.1. MARKET-MAKING AND BOND PRICING 259

The yield to maturity of a 4-year zero-coupon bond is 8%. The face amount

of the bond is 100.

Calculate

• the Macaulay duration

• the modified duration

• the convexity

In addition, calculate the bond value if the yield to maturity

• moves up to 9%

• moves down to 7%.

Solution.

DMac = T = 4 years.

DMac 4

Dmod = = = 3. 703 7 years

1 + yield 1.08

T (T + 1) 4×5

C= 2 = 1.072 = 17. 468 8

(1 + y)

If the yield to maturity is now 9%, the bond value is:

P1 = 100 × 1.09−4 = 70. 842 5

We can also use duration and convexity to approximate the bond value under

the new yield.

The new bond value µis ¶

∆P

P1 = P0 + ∆P = P0 1 +

P0

∆P 1 2 1 2

= −Dmod ∆y + C (∆y) = −3. 703 7 × 0.01 + × 17. 468 8 × (0.01) =

P0 2 2

−0.036 2

→ P1 = 73. 5030 (1 − 0.036 2) = 70. 842 2

This is very close to the correct amount of 70. 842 5.

P1 = 100 × 1.07−4 = 76. 289 5

We can also use duration and convexity to approximate the bond value under

the new yield.

∆P 1 1

= −Dmod ∆y + C (∆y)2 = −3. 703 7 × (−0.01) + × 17. 468 8 ×

P0 2 2

2

(−0.01) = 0.037 9

This is very close to the correct amount of 76. 289 5.

260 CHAPTER 24. INTEREST RATE MODELS

Example 24.1.3.

Portfolio B consists of x units of 1-year zero coupon bond and y units of

8-year zero coupon bond. Portfolio B is used to duration hedge Portfolio A.

Each of the three zero-coupon bonds above has 100 face amount.

The current annual eﬀective interest rate is 5% for all three bonds.

Assume that the yield curve changes by a uniform amount if there’s a change.

Demonstrate why duration-hedging leads to arbitrage under two scenarios:

three bonds are issued.

after the three bonds are issued.

Solution.

100 100 100

x+ y=

1.051 1.058 1.054

100 100

x y

1.051 ×1+ 1.058

×8=4

100 100 100 100

x + y x + y

1.051 1.058 1.051 1.058

bonds. If a portfolio consists of multiple bonds, then the portfolio’s duration is

just the weighted average of the each bond’s duration, with weight equal to the

present value of each bond.

µ ¶ µ ¶

100 100 100

The 2nd equation can be simplified as 1

x 1+ 8

y 8 = 4×

1.05 1.05 1.054

1

x+ 8

y=

µ

1.05 ¶1.05 µ 1.05¶4 → x = 0.493 62 , y = 0.520 93

100 100 100

x 1+ y 8=4×

1.051 1.058 1.054

24.1. MARKET-MAKING AND BOND PRICING 261

and 0.520 93 units of 8-year zero coupon bond.

100

Portfolio A is worth: = 79. 2094

1.064

100 100

Portfolio B is worth: × 0.493 62 + × 0.520 93 = 79. 251 7

1.061 1.068

To arbitrage, at t = 0 (when the interest rate is 5%), we buy low and sell

high:

100 100 100

• buy Portfolio B. We pay x+ y= = 82. 270 2

1.051 1.058 1.054

100

• sell Portfolio A. We receive = 82. 270 2

1.054

Portfolio B (our asset) is worth 79. 251 7; Portfolio A (our liability) is worth 79.

2094.

Our net profit is 79. 251 7 − 79. 2094 = 0.042 3

If the interest rate moves down to 4%:

100

Portfolio A is worth: = 85. 480 4

1.044

100 100

Portfolio B is worth: 1

× 0.493 62 + × 0.520 93 = 85. 527 3

1.04 1.048

To arbitrage, at t = 0 (when the interest rate is 5%), we buy low and sell

high:

100 100 100

• buy Portfolio B. We pay 1

x+ 8

y= = 82. 270 2

1.05 1.05 1.054

100

• sell Portfolio A. We receive = 82. 270 2

1.054

Then instantly later at t = 0+ , the interest rate moves down to 4%. Then

Portfolio B (our asset) is worth 85. 527 3; Portfolio A (our liability) is worth 85.

480 4.

Our net profit is 85. 527 3 − 85. 480 4 = 0.046 9

always make free money by buying Portfolio B and selling Portfolio A.

262 CHAPTER 24. INTEREST RATE MODELS

Why is Portfolio B better than Portfolio A? It turns out B has high convexity.

Convexity of A:

TA (TA + 1) 4×5

CA = 2 = 2

= 18. 1406

(1 + y) 1.05

with weights beingµthe present value¶of the bond.µ ¶

1×2 100 8×9 100

× × 0.493 62 + × × 0.520 93

1.052 1.051 1.052 1.058

CB =

100 100

× 0.493 62 + × 0.520 93

1.051 1.058

µ ¶ µ ¶

1×2 100 8×9 100

× × 0.493 62 + × × 0.520 93

1.052 1.051 1.052 1.058

= = 29. 024 9

100

1.054

CB > CA

µ up by

¶ ∆y, then the present value of a portfolio is:

∆P

P1 = P0 + ∆P = P0 1 +

P0

∆P A 1 A 2 ∆P B 1

A

= −D A

mod ∆y + C (∆y) B

B

= −Dmod ∆y + C B (∆y)2

P0 2 P0 2

A B 4 B A

However, Dmod = Dmod = = 3. 809 5 C >C

1.05

∆P B ∆P A

→ B

>

P0 P0A

Since P0 = P0B

A

→ ∆P B > ∆P A

B A

→ P1 > P1 So Portfolio B always worth more than Portfolio A under

a flat yield curve.

For example, if the interest rate moves up to 6%, then

∆P A 1

= −3. 809 5 × 0.01 + × 18. 1406 × 0.012 = −0.037 2

P0A 2

∆P B 1

B

= −3. 809 5 × 0.01 + × 29. 024 9 × 0.012 = −0.036 6

P0 2

100

P1A = (1 − 0.037 2) = 79. 2098

1.054

100

P1B = (1 − 0.036 6) = 79. 259 2

1.054

P1B − P1A = 79. 259 2 − 79. 2098 = 0.049 4

Key point to remember:

24.1. MARKET-MAKING AND BOND PRICING 263

1. Two portfolios can have the same present value, the same duration, but

diﬀerent convexities.

2. Under the assumption of the parallel shift of a flat yield curve, we can

always make free money by buying the high-convexity portfolio and sell

the low-convexity portfolio.

Maturity (Yrs) Face

2 100

4 100

7 100

The current interest rate is 7% for all three bonds. Assume a parallel shift

of a flat yield curve. Design an arbitrage strategy.

We need to form 2 portfolios. These two portfolios have the same PV, the

same duration, but diﬀerent convexity. We can make free money by buying the

high convexity portfolio and selling the low convexity portfolio.

The low convexity portfolio is the 4-year bond (Portfolio A).

The high convexity portfolio consists of x unit of 2-year bond and y unit

of 7-year bond (Portfolio B). This is called a barbell. A barbell bond portfolio

combines short maturities (low duration) with long maturities (high duration)

for a blended, moderate maturity (moderate duration)

100 4×5

A 4 = 76. 29 4 = 17. 468 8 1

1.074 1.072

100 2×3

B 2 = 87. 34 2 = 5. 240 6 x

1.072 1.072

100 7×8

B 7 = 62. 27 7 = 48. 912 6 y

1.077 1.072

x+ y=

1.072 ¶1.077µ

µ 1.07¶4 x = 0.524 1, y = 0.490 0

100 100 100

2

x 2+ 7

y 7=4×

1.07 1.07 1.074

and 0.490 0 unit of 7-year bond). Simultaneously, we sell Portfolio A.

The convexity of Portfolio A is: C A = 17. 468 8

264 CHAPTER 24. INTEREST RATE MODELS

2

× 2

× 0.524 1 + 2

× 0.490 0 × 7

CB = 1.07 1.07 1.07 1.07 = 22. 708 9

100

1.074

For example, if the new interest rate is 7.25% for all bonds with diﬀerent

maturities, then

100 100

P1B = × 0.524 1 + 0.490 0 × = 75. 584 1

1.07252 1.07257

100

P1A = = 75. 580 9

1.07254

B A

P1 > P1

Our profit is 75. 584 1 − 75. 580 9 = 0.003 2

If the new interest rate is 6.5% for all bonds with diﬀerent maturities, then

100 100

P1B = 2

× 0.524 1 + 0.490 0 × = 77. 739 6

1.065 1.0657

100

P1A = = 77. 732 3

1.0654

P1B > P1A

Our profit is 77. 739 6 − 77. 732 3 = 0.007 3

By now you should see that the parallel shift of a flat yield curve is a bad

model.

We all know what an interest rate is, yet a derivative on interest rate is surpris-

ingly diﬃcult. To get a sense of the diﬃculty, suppose we want to calculate the

price of a European call on a 1-year zero-coupon bond that pays $100 one year

from now. Here are the inputs:

d1 = 0.15 d2 = −0.15 N (d1 ) = 0.5596 N (d2 ) = 0.4404

→ C = 94. 18 × 0.5596 − 94. 18 × 0.4404 = 11. 23

24.1. MARKET-MAKING AND BOND PRICING 265

Everything looks fine. However, after further thinking, you realize that the

call price C should be zero. At T = 1, the bond pays $100. Hence the 100-strike

call value is zero. Why should anyone buy a 100-strike call on an asset worth

$100 at call expiration?

What went wrong? It turns out that we can’t use the Black-Scholes formula

to calculate the price of an interest rate derivative:

• The Black-Scholes option formula assume that the term structure of the

interest rate is flat and deterministic (see DM page 379). However, If the

interest rate is known and constant, there won’t be any need for interest

rate derivatives. This is similar to the idea that if the stock price is known

and constant, there won’t be any need for call or put option.

• The standard deviation of the return σ is a constant. However, the stan-

dard deviation of the return σ is not constant. Unlike a stock, a bond has

a finite maturity. At the maturity date, the bond value is its face amount.

Hence the standard deviation of a bond’s return decreases as the bond

approaches its maturity.

The key point. It’s much harder to calculate the price of an option interest

rate because interest rate is not a tradeable underlying asset. For call and put

on stocks, we can buy or short sell stocks to set up the hedge portfolio. However,

we can’t go out and buy a 5% interest rate to hedge an option on interest rate.

Now let’s go to the textbook.

A bond is a derivative on interest rate. We normally don’t think this way, but

a bond derives its value from interest rate. If the market interest rate goes up,

the bond value goes down; if the market interest rate goes down, the bond value

goes up.

short interest rate. The textbook keeps using the phrase "short interest

rate" or "short rate" without giving a clear definition. Here is the definition:

Definition 24.1.1. A short interest rate or short rate is just the instantaneous

interest rate r (t) over a short (hence the name "short rate") interval [t, t + dt].

First, we assume that the short interest rate r (t) follows the Ito’s process:

Next, the text book explains that we can’t assume r (t) follows a flat yield

curve ("impossible bond pricing model").

A flat yield curve means that the interest rate is independent of time. To

have a flat yield curve, the following two conditions are met:

266 CHAPTER 24. INTEREST RATE MODELS

• The initial interest rate r is a constant regarding time, that is, r (t) = t

• If the interest rate changes, the change is also independent of time (i.e.

parallel shift of the yield curve)

value at time t of $1 to be received at T is:

at time zero is P (0, 2) = e−2r . The PV of this bond at t = 1 is P (1, 2) = e−r .

Next, let’s review the textbook’s proof and find out why Equation 24.1 and

24.2 won’t work together.

Suppose we want to delta hedge a bond. Whereas delta hedging a call means

buying ∆ shares of a stock, delta hedging a bond means buying ∆ units of a

bond with a diﬀerent maturity date.

Suppose at time t we buy a bond maturing at T2 . "A bond maturing at T2 "

just means that we, the bond holder, will receive $1 at T2 . So the price of this

bond at time t is P (t, T2 ) = e−r(T2 −t) .

To delta hedge this bond, at t, we buy ∆ bonds maturing at T1 (please note

the textbook uses N instead of ∆). The cost is ∆P (t, T1 ) = ∆e−r(T1 −t)

The total cost of buying two bonds is ∆P (t, T1 ) + P (t, T2 ) = ∆e−r(T1 −t) +

−r(T2 −t)

e . To avoid tying up our capital, at time t we borrow ∆e−r(T1 −t) +

−r(T2 −t)

e from a bank to finance the purchase of two bonds. So at time t, our

portfolio is:

£ I = ∆P (t, T1 ) + P (t, T ¤ 2 ) + W = 0 where W = − [∆P (t, T1 ) + P (t, T2 )] =

− ∆e−r(T1 −t) + e−r(T2 −t) . As seen before, if we borrow money, we use a neg-

ative number. If we lend money, we use the a positive number. This is why W

is negative.

In the next instant dt, the interest rate moves up to r + dr. Now change of

our portfolio value is:

dI = ∆ × dP (t, T1 ) + dP (t, T2 ) + dW

Using Ito’s lemma, we have:

2

2

dP (t, T1 ) = ∂P (t,T

∂t

1)

dt + ∂P (t,T

∂r

1)

dr + 12 ∂ P∂r(t,T

2

1)

(dr)

∂P (t,T1 ) ∂ −r(T1 −t)

∂t = ∂t e = rP (t, T1 )

∂P (t,T1 ) ∂ −r(T1 −t)

∂r = ∂r e = −P (t, T1 ) (T1 − t)

24.1. MARKET-MAKING AND BOND PRICING 267

∂ 2 P (t,T1 )∂ 2

−r(T1 −t) 2 2

∂r2 = ∂r 2e = er(t−T1 ) (T1 − t) = P (t, T1 ) (T1 − t)

2 2 2

(dr) = (αdt + σdZ) = σ2 (dZ) = σ 2 dt

→ dP (t, T1 ) = rP (t, T1 ) dt − P (t, T1 ) (T1 − t) dr + 12 P (t, T1 ) (T1 − t)2 σ 2 dt

Similarly,

2

dP (t, T2 ) = rP (t, T2 ) dt − P (t, T2 ) (T2 − t) dr + 12 P (t, T2 ) (T2 − t) σ 2 dt

W during the interval [t, t + dt]. During [t, t + dt], the continuous interest rate

r can be treated as a discrete interest rate. The interest earned is just

the initial capital × interest rate × length of the interval = rW dt

Now wehhave DM Equation 24.6: i

2

dI = ∆ rP (t, T1 ) dt − P (t, T1 ) (T1 − t) dr + 12 P (t, T1 ) (T1 − t) σ2 dt

h i

+ rP (t, T2 ) dt − P (t, T2 ) (T2 − t) dr + 12 P (t, T2 ) (T2 − t)2 σ 2 dt

+rW dt

change during the same during [t, t + dt]. To make dI = 0, we first choose ∆

such that the dr term is zero.

→ ∆ = − (T 2 −t)P (t,T2 )

(T1 −t)P (t,T1 )

(T2 −t)P (t,T2 )

This negative delta means that we need to sell (T1 −t)P (t,T1 ) units of bond

maturing at T1 .

(T1 −t)P (t,T1 ) is similar to DM Equation 7.13 (Derivatives

Markets page 227):

D1 B1 (y1 ) / (1 + y1 )

N =− (DM 7.13)

D2 B2 (y2 ) / (1 + y2 )

So buying ∆ bonds is really duration-hedging.

Next,

h we want to set the dt term to zero: i h i

2 2

∆ rP (t, T1 ) + 12 P (t, T1 ) (T1 − t) σ 2 + rP (t, T2 ) + 12 P (t, T2 ) (T2 − t) σ 2 +

rW = 0

2 2

→ r [∆P (t, T1 ) + P (t, T2 ) + W ]+ 12 ∆P (t, T1 ) (T1 − t) σ 2 + 12 P (t, T2 ) (T2 − t) σ 2 =

0

However,∆P (t, T1 ) + P (t, T2 ) + W = 0

2 2

→ 12 ∆P (t, T1 ) (T1 − t) σ 2 + 12 P (t, T2 ) (T2 − t) σ 2 = 0

→ − 12 (T21 −t)P (t,T21 ) P (t, T1 ) (T1 − t) σ2 + 12 P (t, T2 ) (T2 − t)2 σ 2 = 0

(T −t)P (t,T ) 2

2

→ − 12 (T2 − t) P (t, T2 ) (T1 − t) σ 2 + 12 P (t, T2 ) (T2 − t) σ2 = 0

→ − 12 (T2 − t) P (t, T2 ) [(T1 − t) − (T2 − t)] σ 2 = 0

268 CHAPTER 24. INTEREST RATE MODELS

→ T1 = T2 ∆ = −1

∆ = −1 means that sell one bond.

If we buy a bond maturing in T2 years, the only way to hedge the risk is to

sell this bond! So one moment you buy a bond. The next moment you sell it.

Your net position is zero. Of course you are hedged against all risks, but this

hedging is really doing nothing type of hedging.

This tells us that the bond pricing model based on Equation 24.1 and 24.2

are impossible. In our words, Equation 24.1 is OK. But Equation 24.2 is bad.

This confirms that a parallel shift of a flat yield curve is a bad assumption for

pricing a bond.

Since it’s bad to assume that r is a flat yield curve, we switch our gears and

assume that r isn’t a flat yield curve. Now we just assume that Equation 24.1

holds.

∂P ∂P 1 ∂2P

dP (r, t, T ) = dr + dt + (dr)2

∂r ∂t 2 ∂t2

2 2 2

(dr) = [α (r) dt + σ (r) dZ] = σ 2 (r) (dZ) = σ 2 (r) dt

∂P ∂P 1 ∂2P 2 ∂P

→ dP (r, t, T ) = dr + dt + σ (r) dt = [α (r) dt + σ (r) dZ] +

∂r ∂t 2 ∂t2 ∂r

2

∂P 1∂ P 2

dt + σ (r) dt

∂t 2 ∂t2

∙ ¸

∂P 1 ∂2P 2 ∂P ∂P

dP (r, t, T ) = α (r) + σ (r) + dt + σ (r) dZ (24.3)

∂r 2 ∂t2 ∂t ∂r

Define

∙ ¸

1 ∂P 1 ∂2P 2 ∂P

α (r, t, T ) = α (r) + σ (r) + (24.4)

P (r, t, T ) ∂r 2 ∂t2 ∂t

1 ∂P

q (r, t, T ) = σ (r) (24.5)

P (r, t, T ) ∂r

dP (r, t, T )

= α (r, t, T ) dt + q (r, t, T ) dZ (24.6)

P (r, t, T )

24.1. MARKET-MAKING AND BOND PRICING 269

dP (r, t, T )

is the bond’s return. Equation 24.6 says that the bond’s return

P (r, t, T )

is the sum of a drift term α (r, t, T ) dt and a random component q (r, t, T ) dZ.

∂P

Please also note that generally q (r, t, T ) is negative. This is because is

∂r

negative. If r goes up, the bond price goes down; if r goes down, P goes up.

Next, we are going to derive DM Equation 24.16:

α1 (r, t, T1 ) − r α2 (r, t, T2 ) − r

= (24.7)

q1 (r, t, T1 ) q2 (r, t, T2 )

respectively. Each bond follows DM Equation 24.6:

dP (r, t, T1 )

= α1 (r, t, T1 ) dt + q1 (r, t, T1 ) dZ

P (r, t, T1 )

dP (r, t, T2 )

= α2 (r, t, T2 ) dt + q2 (r, t, T2 ) dZ

P (r, t, T2 )

• buying 1 Bond #2

r

dP (r, t, T1 ) dP (r, t, T2 )

dI = ∆P (r, t, T1 ) + P (r, t, T2 )

P (r, t, T1 ) P (r, t, T2 )

− [∆P (r, t, T1 ) + P (r, t, T2 )] rdt

= ∆P (r, t, T1 ) [α1 (r, t, T1 ) dt + q1 (r, t, T1 ) dZ]

+P (r, t, T2 ) [α2 (r, t, T2 ) dt + q2 (r, t, T2 ) dZ]−[∆P (r, t, T1 ) + P (r, t, T2 )] rdt

= ∆P (r, t, T1 ) [α1 (r, t, T1 ) − r] dt + P (r, t, T2 ) [α2 (r, t, T2 ) − r] dt

+ [∆P (r, t, T1 ) q1 (r, t, T1 ) + P (r, t, T2 ) q2 (r, t, T2 )] dZ

Choose ∆ such that ∆P (r, t, T1 ) q1 (r, t, T1 )+P (r, t, T2 ) q2 (r, t, T2 ) = 0. This

removes the stochastic random term dZ. Now dI is deterministic. Since the

portfolio is self-financing and riskless, it earns zero interest rate. Hence

∆P (r, t, T1 ) [α1 (r, t, T1 ) − r] dt + P (r, t, T2 ) [α2 (r, t, T2 ) − r] dt = 0

P (r, t, T2 ) q2 (r, t, T2 )

→− P (r, t, T1 ) [α1 (r, t, T1 ) − r] dt+P (r, t, T2 ) [α2 (r, t, T2 ) − r] dt =

P (r, t, T1 ) q1 (r, t, T1 )

0

q2 (r, t, T2 )

→− [α1 (r, t, T1 ) − r] dt + [α2 (r, t, T2 ) − r] dt = 0

q1 (r, t, T1 )

α1 (r, t, T1 ) − r α2 (r, t, T2 ) − r

→ =

q1 (r, t, T1 ) q2 (r, t, T2 )

270 CHAPTER 24. INTEREST RATE MODELS

α (r, t, T ) − r

= φ (r, t) (24.8)

q (r, t, T )

Apply Equation

∙ 24.4 and 24.6 to 24.8: ¸

1 ∂P 1 ∂2P 2 ∂P

α (r) + σ (r) + −r

P (r, t, T ) ∂r 2 ∂t2 ∂t

= φ (r, t)

1 ∂P

σ (r)

P (r, t, T ) ∂r

∙ ¸

∂P 1 ∂2P 2 ∂P ∂P

→ α (r) + σ (r) + − rP = φ (r, t) σ (r)

∂r 2 ∂t2 ∂t ∂r

1 2 ∂2P ∂P ∂P

σ (r) 2 + [α (r) − σ (r) φ (r, t)] + − rP = 0 (24.9)

2 ∂r ∂r ∂t

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