Valuation Problem: Fair Price via Arbitrage Argument

Introduction to Mathematical Finance: Part I: Discrete-Time Models

AIMS and Stellenbosch University April-May 2012

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State-Prices aka Arrow-Debreu prices or prices of pure securities

Denition (Arrow-Debreu Securities)
Arrow-Debreu Securities: Consider two ctitious assets which pay exactly 1 in one of the two states of the world and zero in the other.

State-Prices aka Arrow-Debreu prices or prices of pure securities

In actual nancial markets, Arrow-Debreu securities do not trade directly, even if they can be constructed indirectly using a portfolio of securities.
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Question: What is a fair price for theses assets?

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State-Prices aka Arrow-Debreu prices or prices of pure securities

Question: What is a fair price for theses assets?

Big Breakthrough: Valuation by replication

The big breakthrough came when two economists (Fischer Black and Myron Scholes in 1973) recognized that arbitrage was the secret to unlocking the pricing formula. Their big insight was that the payo structure of an option can be replicated by a portfolio of market traded assets. Since the cash payos to the portfolio and the option are identical, it must be the case that the price of the option equals the value of the portfolio; otherwise, an arbitrage opportunity would exist. = Law of One Price = Price via Replication

No Arbitrage

Idea: Make a portfolio of Arrow-Debreu AD securities which generate the payos of the existing claims: We call it Replication.
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More on the Law of One Price

State-Prices aka Arrow-Debreu prices or prices of pure securities

Financial economists refer to their essential principle as the law of one price, which states that: Any two securities with identical future payouts, no matter how the future turns out, should have identical current prices. Emanuel Derman: The law of one price is not a law of nature. Its a reection on the practices of human beings, who, when they have enough time and information, will grab a bargain when they see one. Reading Material: The boys guide to pricing and hedging by Emanuel Derman (online document).

Solving the linear system gives the fair prices of the AD securities (also seen as the forward price a1 for state up (resp. a2 for state down)): 1 (1 + r )S0 Sd 1+r Su Sd 1 Su (1 + r )S0 1+r Su Sd

a1 a2

= =

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Arrow-Debreu Securities
These securities are fundamental.

Arrow-Debreu Securities
Homework: Do the same computation for aII What is the fair price of the Arrow-Debreu (AD) security aI ? Set the fair price of the AD security aI equal to the cost of the replicating portfolio: 1 Sd S0 Su Sd 1+r Su Sd 1 (1 + r )S0 Sd a little algebra 1+r Su Sd 1 A1 (up ) q = q 1+r B1 (up ) (1 + r )S0 Sd Su Sd

a1 = 1 S0 + 1

1 1 1 1 * S1 (up ) + (1 + r ) = Su + (1 + r ) = 1 H HH j 1 S1 (down) + 1 (1 + r ) = 1 Sd + 1 (1 + r ) = 0

aI

= =

Lemma
The replicating portfolio for the Arrow-Debreu security aI is given by (1 , 1 ) = 1 Sd 1 , Su Sd 1+r Su Sd with

q :=

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Conclusion

Conclusion Continued

The same (HWK: check this) aII = It follows clearly: (q =

(1+r )S0 Sd Su Sd

1 A2 (down) (1 q ) = (1 q ) 1+r B1 (down)

0<q<1

Sd < (1 + r )S0 < Su arbitrage

, 1 q ) is a probability on = {up , down}, where

P(S1 = Su ) = p real world probability does not matter. Only the list of possible scenarios matters.
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Conclusion

General Case of a Contingent Claim

Remark
The design of an Arrow-Debreu Security is such that once its price is available, it provides the answer to key valuation question: what is a unit of the future state contingent numeraire worth today. As a result, it constitutes the essential piece of information necessary to price arbitrary cash ow. If Arrow-Debreu Securities are traded, their prices constitute the essential building blocks for valuing any arbitrary risky cash-ow: Indeed, any contingent claim/ derivative, with any payo prole in the two possible states of the world, can be obtained as a linear combination of the two Arrow-Debreu securities that have just been described.

C = C0

= Cu aI + Cd aII 1 = q Cu + (1 q ) Cd 1+r 1 = EQ [C1 ] 1+r

This is true for any contingent claim C1 = F (S1 ) / any derivatives! C0 = 1 C1 C1 EQ [C1 ] = EQ [ ] = EQ [ ] 1+r 1+r B1
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Key Result: Probabilistic formulation

C0 = 1 EQ [C1 ] 1+r

Back to the Optimality: Seller/Buyer Point of View

where EQ [] denotes expected value with respect to the new probabilities qu = q and qd = 1 q . Notice that the only unknown argument is q . Key result: (Fair) Prices are discounted expectation under risk neutral probability measure More precisely Key result: (Fair) Prices are the discounted expected values of future payos (under risk neutral probability measure)

Remark
We observe that C0 = 1 EQ [C1 ] = hup = hlow 1+r

in other words, Replication coincides with the Optimality Criterion. Moreover, it is much easier to compute expectation than to solve an optimization problem, provided we know the risk-neutral measure Q .

Remark
We can use a mathematical device, change of probability measure (risk-neutral probabilities), to compute the replication cost more directly. That is useful when we only need to know the price, not the other details of the replicating portfolio.
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Why Risk Neutral?

Why Risk Neutral?

Denition (Arithmetic Return)
The (arithmetic) return RS of an asset S (stock, bond, portfolio...) during the period t = 0 and t = 1 is dened by EQ [C1 ] = (1 + r ) C0 RS = S1 S0 S0

Remark

Any derivatives growth as the risk-less asset under Q. Useful to compute q just by remembering the above expression: EQ [S1 ] = (1 + r ) S0 q Su + (1 q ) Sd = (1 + r ) S0 (1 + r )S0 Sd q= Su Sd

For any probability measure P, the expected return of the riskfree asset B during the period t = 0 and t = 1 is EP [RB ] =

B1 ( ) B0 ( ) P( ) B0 ( ) (1 + r ) 1 P( ) 1 r P( ) = r

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Why Risk Neutral?

For any probability measure P, the expected return of the risky asset S during the period t = 0 and t = 1 is EP [RS ] =

Comparison with True Probabilities

S1 ( ) S0 ( ) P( ) S0 ( ) The risk-neutral probabilities Q generally do not equal the true probabilities P. Usually EP [RS ] = E in order to compensate for risk. S1 S0 >r S0

= =

S1 (up ) S0 S1 (down) S0 P(up ) + P(down) S0 S0 Su S0 Sd S0 P(up ) + P(down) S0 S0

In particular, under the real world probability P: EP [RS ] = Sd S0 Sd Su p S0 S0 = r in general! EQ [RS ] = r

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Only if P = Q, then

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Risk Neutral Valuation: Summary

The risk-neutral probability Q thus dened, is a mathematical construct, a Change of Measure , which is useful to price derivatives. Note that in this risk-neutral world i.e. under Q all securities have the same expected return (equal to the risk-free rate): EQ [RS ] E [RC ]
Q

Equivalent Martingale Measure

We have seen that S0 = 1 S1 S1 S0 = EQ [S1 ] = EQ [ ] = EQ [ ] B0 1+r 1+r B1

= r = r

r )S0 Sd The probability Q = (q = qu = (1+ , 1 q ) has a nice Su Sd interpretation as the unique probability making the discounted stock = { S0 , S1 } move in a fair way: the expectation (under Q ) is price S B0 B1 constant.

under Q, any portfolio/trading strategy (a, b ) has the same expected return (equal to the risk-free rate): EQ [V1 ] = EQ [aS1 + b (1 + r )] = a(1 + r )S0 + b (1 + r ) = (1 + r )V0

The probability measure Q = (q , 1 q ) = (qu , qd = 1 qu ) is called an equivalent martingale measure or equivalent risk neutral measure.

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Market Completeness

First Fundamental Theorem of Asset Pricing

Theorem (First Fundamental Theorem of Asset Pricing)

In this case, the One-Period Binomial Model is also complete (i.e. any contingent claim is replicable): Any risk-neutral measure P must satisfy S0 (1 + r ) = E [S1 ] = p Su + (1 p )Sd , and this condition uniquely determines the parameter p = P (up ) as P (up ) = (1 + r )S0 Sd ]0, 1[ Su Sd

There do not exist arbitrage opportunities if and only if there exists a probability Q , called an equivalent martingale measure , such that Q P and i.e. they are equivalent

S1 S1 1 S0 = EQ = E Q S1 = EQ B0 B1 1+r 1+r
S B S0 S1 = {B , } is a martingale under the measure Q . 0 B1

= In other words, S

Denition
is equivalent to P, written as P P, means that On = {up , down}, P P(up ) = p (0, 1) and P(down) = 1 p .

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Second Fundamental Theorem of Asset Pricing

Comments:

Denition (Complete Market)

A nancial market is complete if and only if every contingent claim is replicable (or attainable).

Theorem (Second Fundamental Theorem of Asset Pricing)

Assuming absence of arbitrage, there exists a unique Equivalent Martingale Measure (EMM) if and only if the market is complete.

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Comments:

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