Module 4 Slides

Asset-Liability and Derivative Models
Jonathan Ziveyi1
1 UNSW
Australia
Risk and Actuarial Studies, UNSW Business School
j.ziveyi@unsw.edu.au
Module 4 Topic Notes
1/77 Version 2017. Copyright UNSW School of Risk and Actuarial Studies
Plan
Topic: Continuous Time Derivative Valuation
Measure Theory
Radon-Nikodym Derivative
Equivalent Measures
Expectations and the Radon-Nikodym Derivative
Radon-Nikodym as a Process
Radon-Nikodym Summary
Stochastic Processes
Stochastic Calculus
Itos Lemma for processes
Martingales
The Continuous Radon-Nikodym Derivative
Change of Measure Cameron-Martin-Girsanov Theorem
Change of Measure and Processes
Martingale Representation Theorem: Brownian Motion Based Model
Replicating Portfolios - Construction Strategies
Pricing Steps: Continuous Time Model
Black-Scholes Model
Arbitrage Pricing
Price Dependence
2/77 Hedging
Continuous Time Derivative Valuation
Learning Outcome
Apply contingent-claim pricing techniques to value and manage
the risks of embedded options and guarantees.
How to create a continuous time model based on

Brownian motion
3/77
What to Expect in this Module
In Module 3, we explored financial modelling in a discrete

time framework.
We saw that some key mathematical ideas were
Martingales
Filtration, conditional expectations
Q measure (vs P measure)
We now focus on how to create a continuous time model
(based on Brownian motion), and explore the concepts
above in a continuous time model.
A continuous time model can often allow much more
modelling flexibility, and in some cases can be numerically
much simpler to apply.
Note that in the following we will focus on the main ideas,
and some results will be shown only heuristically.
4/77
Plan
Measure Theory
Equivalent Measures
Stochastic Calculus
Martingales
Black-Scholes Model
Arbitrage Pricing
Price Dependence
5/77 Hedging
Change of Measure - Binomial model
We firstly stay in a (two step) binomial tree setting, and
explore the relationship between P and Q in a bit more
detail.
With each possible path we can attach a P probability :
Path (states) P-Probability

1-3-7 p 1 p3 7
1-3-6 p1 (1 p3 ) 6
1-2-5 (1 p1 ) p2 5
1-2-4 (1 p1 ) (1 p2 ) 4
If we were to define another measure Q on this process,
we can set
Path (states) Q-Probability
1-3-7 q 1 q3 7
1-3-6 q1 (1 q3 ) 6
1-2-5 (1 q1 ) q2 5
1-2-4 (1 q1 ) (1 q2 ) 4
5/77
Radon-Nikodym: Mathematical Derivative
We can encode the differences between the two measures by

the ratios
j
j
We call (define) this
dQ
Y =
dP
the "Radon Nikodym derivative" of Q with respect to P, up to
time 2.
dQ
Using dP , we can immediately derive Q from P.

The only concern is if with p or q is zero or one.
6/77
Plan
Measure Theory
Equivalent Measures
Stochastic Calculus
Martingales
Black-Scholes Model
Arbitrage Pricing
Price Dependence
7/77 Hedging
Equivalent Probability Measures
The probability measure Q is sometimes called an

equivalent martingale measure for the real-world
probability measure P.
Definition: Two measures P and Q are equivalent if:
P (A) > 0 Q (A) > 0 for any outcome A.
Heuristically, this means that the two probability measures

agree on the possible outcomes, but disagree on some (or
all) the individual probabilities.
7/77
Plan
Measure Theory
Equivalent Measures
Stochastic Calculus
Martingales
Black-Scholes Model
Arbitrage Pricing
Price Dependence
8/77 Hedging
dQ
Expectations and dP
The Radon Nikodym derivative acts in a very natural way

when we consider expectations. We know that
X
EP [X ] = i xi .
i
So,
X
EQ [X ] = i xi
i
X
i
= i xi
i
i

dQ
= EP X
dP
8/77
Disussion Question
h i
dQ
What is EP dP =?
9/77
Plan
Measure Theory
Equivalent Measures
Stochastic Calculus
Martingales
Black-Scholes Model
Arbitrage Pricing
Price Dependence
10/77 Hedging
At the moment we have only defined the Radon Nikodym

derivative as a random variable (on maturity T).
How about a process? Turns out we can do this by defining
(t) to be the Radon-Nikodym (mathematical) derivative
(as a random variable) up to time t.
In fact, there is another representation: (proof not required)

dQ
(t) = EP |F(t)
dP
10/77
Plan
Measure Theory
Equivalent Measures
Stochastic Calculus
Martingales
Black-Scholes Model
Arbitrage Pricing
Price Dependence
11/77 Hedging
Given P and Q equivalent measures and a time horizon T,

we can define a random variable dQ dP defined on the P
possible paths, taking positive values, such that

dQ
EQ [X ] = EP X
dP
for a random variable X known at time T.
We also have
for 0 t T ,
EQ [X |Ft ] = 1 (t) EP [ (T ) X |Ft ]
where
dQ
(t) = EP |Ft .
dP
11/77
Foundations for Continuous Time Models - Brownian
Motion
In the discrete time model we split time into n discrete

periods. What happens when we let n become very large?
Example: Arithmetic Random Walk Wn (t):
Consider a binomial process Wn (t) with
1. Wn (0) = 0
2. Layer spacing n1
3. Up and Down jumps equal of size 1n
4. Consider measure P, with probability of up and down jumps
to be 12 .
12/77
Brownian Motion cont...
Let Xi be a series of IID random variables that takes value
1
We have, for i = 1, 2, .., nt:

i i 1 X
Wn = Wn + i
n n n
and in particular
Xnt
X
Wn (t) = 0 + i
i=1
n
nt
!
X X
= t i
i=1
nt
and so when n , the term inside the bracket

approaches a N (0, 1) by the CLT.1
1
13/77 Note we assumed for simplicity that nt is an integer
Hence
Wn (t) N (0, t)
n
and in fact this type of relationship is true for ALL

Marginal Distributions
Conditional Distribution (conditional on say Ft )
Formally this process converges to Brownian Motion
14/77
Definition
Definition: A stochastic process {W (t) , t 0} is said to be a
P-Brownian motion process if and only if:
1. W (t) is continuous and W (0) = 0;
2. The value of W (t) is distributed, under P, as N (0, t)
3. The increment W (s + t) W (s) is distributed, under P, as
N (0, t), and is independent of Fs
15/77
In fact, Brownian motion is an extremely odd process. For

example:
1. W is continuous, but is differentiable nowhere (with
probability 1)
2. It will hit any and every real value no matter how large or
negative.
3. Once W hits a particular value, it immediately hits it again
infinitely often, and then again from time to time in the
future
4. Scaling doesnt matter - it is a fractal.
16/77
Application for Stock Prices
Brownian motion on its own is not a good choice for modelling stock
prices.
It is missing (amongst others) two important properties that stock
prices tend to have:
Stock Prices tend to increase in the real world (P)
Stock Prices do not become negative
Hence perhaps an example such as
S (t) = eW (t)+t
may be a good choice. In general we will want processes that are

functions of Brownian motion.
17/77
Methods of Specifying a Stochastic Process
How can we specify a stochastic process X (t) as a

function of Brownian motion?
Two main methods:
1. Explicit function linking X (t) with W (t) and t.
2. Specify how it changes over time (i.e. its dynamics)
18/77
Definition:
In the Brownian motion framework a stochastic process
X (t) is a continuous process (on t) such that
Z t Z t
X (t) = X (0) + (s) dW (s) + (s) ds
0 0
where (s) and (s) are (possible random) Fs processes

satisfying certain technical conditions.2 The differential
form can be written as (with X (0) a constant)
dX (t) = (t) dW (t) + (t) dt
2
19/77 e.g., are known at time t, and are bounded
Stochastic Processes cont...
In the special case when (s) and (s) are simple

deterministic functions of X (s) the equation
dX (t) = (X (t) , t) dW (t) + (X (t) , t) dt
is called a stochastic differential equation for X .

Generally it is easier to specify the SDE for X as opposed
to finding an explicit functional form (ie the solution) of X.
20/77
Discussion
Let X (0) = x
1. What is the solution to
dX (t) = dW (t) + dt
2. Guess the solution to the slightly more complicated
dX (t) = X (t) dW (t) + X (t) dt
21/77
Stochastic Calculus
Suppose we have got a deterministic function x (t). Then

we know that if we wanted to know about H (x (t)) then
roughly we know from
dH (x) = H (x) dx
But what about something like
F (W (t)) = eW (t)
or something even more complicated like
G (W (t) , t) = eW (t)+t ?
22/77
Key observation
Denote Zi as IID N(0, 1) random variables. Observe that
Z t X n 2
2 ti t(i 1)
(dW (u)) W W
0 n n
i=1
n r !2
X t
2
= (Zi )
n
i=1
n
!
X Z2
i
= t
n
i=1
t
as n .
Hence we have
Z t Z t
(dW (u))2 t = du
0 0
or in other words, a key result we often use in stochastic calculus
is
(d(W (t)))2 dt
23/77
Discussion: Itos lemma - Differentiation Rule with
Given
(dW (t))2 = dt,
discuss why
1
dF (W (t)) = F (W (t)) dW (t) + F (W (t)) dt
2
(Hint: Use Taylor series expansion)
This is known as Itos lemma.
24/77
Plan
Measure Theory
Equivalent Measures
Stochastic Calculus
Martingales
Black-Scholes Model
Arbitrage Pricing
Price Dependence
25/77 Hedging
Itos Lemma with more General Processes
Consider a stochastic process X (t) with
dX (t) = (X (t)) dW (t) + (X (t)) dt
and f is a deterministic twice continuously differentiable

function with
Y (t) = f (X (t))
then Y (t) is also a stochastic process, then similar
reasoning (ito) gives
d(f (X (t))) = dY (t)

f 1 2f
= dX (t) + (dX (t))2
x 2 x 2
25/77
Itos Lemma cont...
On substitution, we have
dY (t) = (X (t)) f (X (t)) dW (t)

1
+ (X (t)) f (X (t)) + 2 (X (t)) f (X (t)) dt
2
26/77
Example: Finding the SDE Satisfied by a Process
(with closed form solution)
Suppose, for S(0) = 1, we have
S (t) = eW (t)+t
We can use Ito to help us find dS(t). Let
X (t) = W (t) + t
then we have
S (t) = eX (t) = f (X (t)) .
Hence
f (X (t)) = f (X (t))
= f (x (t))
= eX (t)
= S (t)
27/77
Example cont...
Simplifying yields
f 1 2f
dS (t) = dX (t) + (dX (t))2
x 2 x 2
1 2
= S(t) dW (t) + + dt
2
28/77
Finding a Closed Form Solution of a Process from its
SDE
In normal calculus, differentiation is often easier then

integration.
The same applies for Ito integration.
In general it is very hard to solve for an explicit form, and
we often dont.
In other cases we rely on educated guesses
Luckily, (provided certain technical conditions are
satisfied), knowing the dynamics of a process is often
sufficient for applications.
29/77
Example: Geometric Brownian Motion (GBM)
What is the solution to
dS (t) = S (t) {dt + dW (t)}
with S(0) = s?
30/77
Summary of Pricing Steps - Binomial Tree Model
S(t)
1. Identify a measure Q such that Z (), with Z (t) = B(t) , is a
Q martingale.
2. Observe that both Z () and Y (), with

X
Y (t) = EQ |F(t)
B(T )
are Q martingales.
By the martingale representation theorem, we know that
there is a previsible process () such that
t
X
Y (t) = Y (0) + (k ) (Z (k ) Z (k 1))
k =1
31/77
Summary of Pricing Steps cont...
3. From this (t) process we can consider a trading strategy

of holding
(t + 1) of the stock S(t)
(t + 1) = Y (t) (t + 1)B(t)1 S(t) units of the bond B(t)
4. This strategy had that interesting result that, no matter
what the real world probability measure P is,

It cost (1)S(0) + (1)B(0) = EQ B(T )1 X at the start.
It is self financing
At maturity T, (T )S(T ) + (T )B(T ) = X
5. Hence if there ishno arbitrage
i the price of the derivative
X
must just be EQ B(T ) at time 0.
32/77
Reflection
Following on from the previous slides, the mathematical

tools we still need to investigate in continuous time are
Martingales
Change of Measure
Martingale representation theorem
Remark - As in the previous sections a lot of the
theorems/results are subject to various technical
conditions. We will not focus on these technical conditions
here - we will instead focus on the main insights. However
when applying these in practice it is always recommended
that the precise mathematical details be checked e.g. by
reference to the text.
33/77
Plan
Measure Theory
Equivalent Measures
Stochastic Calculus
Martingales
Black-Scholes Model
Arbitrage Pricing
Price Dependence
34/77 Hedging
Martingales in continuous time
A stochastic Process M () is a martingale with respect to a

measure Q and filtration F if 3
EQ [M (t) |Fs ] = M (s) , s t.
3
34/77 subject to technical conditions e.g. the expectations are well defined
Examples of Martingales
1. A constant process c is a martingale with respect to any

measure
2. A P Brownian motion W () is a P martingale
3. A Q Brownian motion WQ ()is a Q martingale
4. A P conditional expectation is always a P martingale
5. A Q conditional expectation is always a Q martingale
6. Let W () be a P-Brownian motion. Consider a process X ()
with
X (t) = W (t) + t
for some constant . When is this a P martingale?
35/77
Examples cont...
7 The process M() with
Z t
M(t) = (s)dW (s)
0
is a P martingale subject to technical conditions - For

example if () is bounded, pre-visible.
8 Show that the process X (), with
1 2t
X (t) = X (0)eW (t) 2
(where is a constant) is a P martingale.
36/77
Plan
Measure Theory
Equivalent Measures
Stochastic Calculus
Martingales
Black-Scholes Model
Arbitrage Pricing
Price Dependence
37/77 Hedging
Change of Measure - the Continuous Radon-Nikodym
Derivative
Consider a time horizon of T . In the binomial tree setting

we observed that to change from P to Q we can apply the
Radon-Nikodym derivative
dQ
dP
This can be interpreted as the ratio of the probabilities
between Q and P on each possible path of outcomes.
For any event A, we have the following relationship

dQ
Q(A) = EP 1A
dP
where 1A represents the indicator function for the event A.
37/77
Change of Measure - cont...
In continuous time, heuristically we can also consider the
(continuous) Radon-Nikodym derivative as the ratios of the
probabilities.
Heuristically, for a path , consider discrete time points
{t1 , t2 , .., tn 1, tn }, with tn = T , and a P Brownian motion
with corresponding path {x1 , .., xn }, the density (on these
time points) are represented by
fPn (x1 , .., xn )
We can consider
dQ f n (x1 , .., xn )
() = limn Qn
dP fP (x1 , .., xn )
Key idea (even for more complicated models) - focus on

what happens to the W () process on the change from P to
Q.
38/77
Change of Measure - Simple Case
Suppose that W (t) is a P Brownian motion. Define a

process Y () with
1 2t
Y (t) = eW (t) 2
where is a constant.
We can define an arbitrary measure Q (note: this is a
generic result at this stage, and not necessary the Q we
want for financial modelling) by
Q [A] = EP [Y (T ) 1A ]
where A is some event.

(Exercise - show that indeed the EP [Y (T )] = 1)
39/77
Discussion - cont...
Recall that the moment generating function of a normally
distributed (under say measure P) random variable X with
mean and variance 2 can be represented by
h i 1 2 2
EP eX = e+ 2
Task: Using Y () from the previous slide, find the

distribution of W (T ) under both P and Q.
A more general but similar result applies for the process
W ().
40/77
Plan
Measure Theory
Equivalent Measures
Stochastic Calculus
Martingales
Black-Scholes Model
Arbitrage Pricing
Price Dependence
41/77 Hedging
Change of Measure: Cameron-Martin-Girsanov
Theorem
More generally, if W () is a P Brownian motion, and a

pre-visible process (), then there exist4 a measure Q
such that
1. Q is equivalent to P
2.
dQ RT 1
RT 2
= e 0 (t)dW (t) 2 0 (t)dt
dP
3. Z t
WQ (t) = W (t) + (s) ds
0
is a Q Brownian motion.
4
subject to technical conditions - e.g. if () was bounded, or even
41/77 constant
Plan
Measure Theory
Equivalent Measures
Stochastic Calculus
Martingales
Black-Scholes Model
Arbitrage Pricing
Price Dependence
42/77 Hedging
Discussion Example
Consider the process X () with
X (t) = W (t) + t
what happens (e.g. distribution and process dynamics of

X () when we change measure to Q, using
dQ Rt Rt 2
= e 0
dW (s) 21 0 ( ) ds
?
dP
42/77
Discussion Example
Find the Radon-Nikodym derivative such that we have
dX (t) = X (t) (dW (t) + dt)
and
dX (t) = X (t) (dWQ (t) + dt) .
43/77
Fundamental Theorem of Asset Pricing
In the Binomial model we found that there was a Q

measure that we can use to price derivatives.
A feature of Q was that discounted stock prices are Q
martingales.
This will end up to be a defining feature of Q, and is called
the Fundamental Theorem of Asset Pricing.
Subject to technical conditions, this important Theorem
says that there is no arbitrage if and only if there is an
equivalent measure Q such that discounted asset prices
(discounted by the risk free rate) are Q martingales.
44/77
Plan
Measure Theory
Equivalent Measures
Stochastic Calculus
Martingales
Black-Scholes Model
Arbitrage Pricing
Price Dependence
45/77 Hedging
Martingale Representation Theorem: Brownian Motion
Based Model
Suppose that M () is a Q martingale process with volatility

() non zero. Then if N () is any other Q martingale, then
there exists an pre-visible process5 () such that we have
the representation
Z t
N (t) = N (0) + (s) dM (s)
0
(Proof not required - just use the result)
5
45/77 technically - pre-visible, square integrable, (essentially) unique
Plan
Measure Theory
Equivalent Measures
Stochastic Calculus
Martingales
Black-Scholes Model
Arbitrage Pricing
Price Dependence
46/77 Hedging
Replicating Portfolios - Trading Strategies (1)
We now have the mathematical tools we need. In

anticipation of the martingale approach to financial
modelling, we are interested in a trading strategy
((), ()).
The strategy has associated portfolio value
V (t) = (t) S (t) + (t) B (t)
.
What properties do we want them to have?
46/77
Replicating Portfolios - cont...
(1) Previsible
( () , ()) should be previsible - to remove insider
trading.
Note that previsibility in continuous time means that (t) is
known at time t - this is different in notation to the discrete
time case.
47/77
(2) Self Financing

This ensures that no additional cash in/out flows are
required.
In discrete time, we found that our self financing portfolio
satisfies
Vi Vi1 = i (Si Si1 ) + i (Bi Bi1 )
The requirement for continuous time is
dV (t) = (t) dS (t) + (t) dB (t)
Note that this is not automatic - since () , () are in

general random processes!
48/77
(3) Replicating Strategy

We want to make use a strategy and associated portfolio to
replicate a contingent claim.
A replicating strategy for X is a self financing portfolio such
that6
V (T ) = (T ) S (T ) + (T ) B (T ) = X
6
49/77 subject to technical conditions
Example
Consider the simple model of S (t) = W (t) , B (t) = 1. Are

the following self financing?
(1) (t) = (t) = 1
(2) (t) = 2W (t) , (t) = t W 2 (t)
50/77
Plan
Measure Theory
Equivalent Measures
Stochastic Calculus
Martingales
Black-Scholes Model
Arbitrage Pricing
Price Dependence
51/77 Hedging
S(t)
1. Identify a measure Q such that Z (), with Z (t) = B(t) , is a
Q martingale.
2. Observe that both Z () and Y (), with
h i
Y (t) = EQ B(T )1 X |Ft
are Q martingales.
By the martingale representation theorem, we know that
there is a pre-visible process () such that
Z t
Y (t) = Y (0) + (s)dZ (s)
0
51/77
Pricing Steps cont...
3. From this () process we can consider a trading strategy

of holding
(t) of the stock S(t)
(t) = Y (t) (t)B(t)1 S(t) units of the bond B(t)
4. This strategy had that interesting result that, no matter
what the real world probability measure P is,

It cost (0)S(0) + (0)B(0) = EQ B(T )1 X at the start.
It is self financing
At maturity T, (T )S(T ) + (T )B(T ) = X
5. Hence if there isno arbitrage
the price of the derivative
must just be EQ B(T )1 X at time 0.
52/77
Plan
Measure Theory
Equivalent Measures
Stochastic Calculus
Martingales
Black-Scholes Model
Arbitrage Pricing
Price Dependence
53/77 Hedging
Black-Scholes Model
The Black Scholes model assumes that
dB (t) = rB (t) dt
dS (t) = S (t) dt + S (t) dW (t)
where the parameters and starting values B(0) = 1, S(0) = s

are constants.
(Assume for the moment that there are no dividends payable)
The stock price SDE has solution
1 2
S(t) = S(0)e( 2 )t+W (t)
which is also known as a Geometric Brownian Motion (GBM).
53/77
Step 1 - Finding the Q Measure and Dynamics
Given the pricing steps, we see that we will wish to identify

the dynamics of the stock prices process under the Q
measure
By the Fundamental Theorem of Asset Pricing this Q
measure has the property that discounted stock prices are
Q martingales7 .
7
54/77 as usual, subject to technical conditions
Revision Example
Show that Z () satisfies
dZ (t) = ( r ) Z (t) dt + Z (t) dW (t)

r
= Z (t) dW (t) + dt

55/77
Example cont...
By the CMG theorem, heuristically, we known that under
an equivalent measure Q we have a Q Brownian motion
WQ (), where
dWQ (t) = dW (t) + (t)dt
hence

r
dZ (t) = Z (t) dWQ (t) + (t) dt .

But to be a Q martingale, we need
dZ (t) = Z (t)dWQ (t)

and hence we need for all t
r
(t) =

56/77
Discussion Example
What are the dynamics of the stock price process under

Q?
57/77
Step 2 - Martingale Representation
Form
1
Y (t) = EQ X |Ft
B (T )
We have 2 Q martingales Z () and Y (), so we know there
exists (t) such that
dY (t) = (t) dZ (t)
58/77
Plan
Measure Theory
Equivalent Measures
Stochastic Calculus
Martingales
Black-Scholes Model
Arbitrage Pricing
Price Dependence
59/77 Hedging
Steps 3,4 - Self Financing, Replicating strategies
Construction strategy is to hold

(t) of the stock S (t)
(t) = Y (t) (t) Z (t) of the bond
To check that this is a replicating portfolio. Notice that
V (t) = (t) S (t) + (t) B (t)

S (t)
= (t) S (t) + Y (t) (t) B(t)
B (t)
= Y (t) B (t) .
59/77
Steps 3,4 cont...
Ito then gives
dV (t) = d (Y (t) B (t))

= B (t) dY (t) + Y (t) dB (t)
but by the martingale representation theorem
dY (t) = (t) dZ (t)
and rearrangements for the equation for V (t) gives
Y (t) = (t) Z (t) + (t)
60/77
Steps 3,4 cont...
Hence
dV (t) = B (t) dY (t) + Y (t) dB (t)

= B (t) (t) dZ (t) + ( (t) Z (t) + (t)) dB (t)
= (t) (B (t) dZ (t) + Z (t) dB (t)) + (t) dB (t)
= (t) d(Z (t) B (t)) + (t) dB (t)
= (t) dS (t) + (t) dB (t)
which shows that this strategy is self financing.
61/77
Steps 3,4 cont...
On maturity T we have
V (T ) = Y (T ) B (T )

1
= EQ X |FT B (T )
B (T )
= X
so this is a replicating strategy.
62/77
Step 5
So for there to be no arbitrage in the model, the price of

our contingent claim at time t MUST be
V (t) = Y (t)B(t)

1
= EQ X |Ft B (t)
B (T )
h i
= EQ er (T t) X |Ft
the Q discounted expectation!
63/77
Derivative Valuation in the Black Scholes model
Consider the Black-Scholes model. The price of a

derivative is

V (0) = erT EQ (S (T ) K )+
Take for example a call option. How do we calculate this?
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Distribution of S(T)
From earlier slides we know that the dynamics of S under

Q is:
dS(t) = rS(t)dt + S(t)dWQ (t)
and hence
1 2 )t+W
S(t) = S(0)e(r 2 Q (t)
What is the distribution of S(T ) under Q?

This implies that S (T ) is lognormal with parameters

1
ln S (0) + r 2 T , 2 T
2
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Discussion Example: Black Scholes Formula (1)
We can represent the price of a call as

erT EQ (S (T ) K )+

= erT EQ S (T ) 1S(T )>K KerT EQ 1S(T )>K
Find:
KerT EQ 1S(T )>K =?
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Black-Scholes Formula (2)

To calculate erT EQ S (T ) 1S(T )>K we can complete the
square. Denoting

1 2 2
H = ln (S (T ) /S (0)) N rT T , T
2
we have:
h i Z
EQ S (T ) 1S(T )>K = (S (0) exp {z})
z=ln K
S(0)
2
z rT 21 2 T

1 1

exp dz

2 T 2 2
T

1
Z
rT
= S (0) e
z=ln K 2 T 2
S(0)
2
z rT + 12 2 T

1

exp dz

2 T

ln (S (0) /K ) + r + 12 2 (T )

rT
= S (0) e
T
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Black-Scholes Formula
We have just derived the Black Scholes call option formula.

At time t, the value of the option V (S (t) , t) is
V (S (t) , t) = S (t) (d1 ) Ker (T t) (d2 )

ln (S (t) /K ) + r + 21 2 (T t)
d1 =
T t

d2 = d1 T t
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Plan
Measure Theory
Equivalent Measures
Stochastic Calculus
Martingales
Black-Scholes Model
Arbitrage Pricing
Price Dependence
69/77 Hedging
Price Dependence
Looking at the Black Scholes formula immediately tells us

something about how option prices depend on parameters:
1. : Do not need this at all!
2. S (t): As S (t) increases to much greater than K the
optionality disappears. As S (t) falls to zero the option is
also worth very little.
3. (T t): As this decreases, the variability of the stock
prices from t to T becomes smaller and smaller, and the
option gets closer and closer to the intrinsic value.
4. : The more volatile the stock, the more the option is
worth. At the extreme, if is very small, the option will
behave like a riskless bond. At the other extreme, it will
behave like the stock.
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Discussion: Valuation of other options
There are many other options that
investors/speculators/hedgers (etc) are interested in. Some
examples include
Barrier Options (Knock in)
Barrier Options (Knock out)
Lookback Options
Asian Options
Chooser Options
How would one value the above options under the
Black-Scholes model?
70/77
Plan
Measure Theory
Equivalent Measures
Stochastic Calculus
Martingales
Black-Scholes Model
Arbitrage Pricing
Price Dependence
71/77 Hedging
Risk Management and Hedging of Options
We have seen the important fact that pricing is just

discounted Q expectation.
But we may also be interested in risk management of the
option position. (e.g. how to hedge the option position)
In particular we know that the replicating portfolio consists
of (t) stocks and (t) bonds.
But what is (t)?
In the binomial model we have a formula for (t).
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Representation of (t)
Theorem: Terminal Value Pricing

If the contingent claim has payoff X = f (S (T )) then the
value is
V (s, t) = er (T t) EQ [f (S (T )) |S (t) = s]
and the Trading Strategy is
V (s, t)
(t) =
s
ie just the mathematical derivative of the price with respect
to the stock price.
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Extension: Models with Dividends
So far we have assumed that no dividends are payable on
the stocks.
How does dividends affect the option prices?
Remember: Option price = Price of Replicating Portfolio
So need to account for the fact that if you hold 1 unit of the
stock from time 0 to time t, you will also be getting the
dividend that are paid during that time.
For options on say indices, a continuous dividend is often a

good approximation ie the dividend payment at each small
instance of time can be modelled as
S (t) dt
where is the dividend rate.

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Extension: Models with Dividends cont...
How do we do arbitrage pricing? Consider the stock prices
e (t). In other
with dividends reinvested in the stocks, S
words:
At any small time dt, S (t) dt is paid out.
With this cash we buy dt units of the stock.
Modelling S as GMB, we have
e (t) = S (0) e( 21 2 +)t+W (t)

S
The Fundamental Theorem of Asset Pricing in this setting

e (t) is a
says that we can use a Q measure such that ert S
martingale and price all our derivatives by
h i
EQ erT X
and so all we need to do now is to find the dynamics of

S (t) under Q.
74/77
Derivative Valuation under Alternate Models
There have been a number of alternatives/extensions to

the Black Scholes model.
For example
Constant Elasticity of Variance model
Black-Scholes model with multiple stocks
The framework we have looked at is still applicable.
Key requirement is that we are able to form self-financing
replicating strategies
Question: What would you expect to find the price of an option
under these alternative models?
75/77
Numerical Techniques: Simulation
In general it may be hard to derive a closed form formula to

calculate
erT EQ [X ]
but being expressed as an expectation means that an
obvious numerical technique is simulation.
76/77
Numerical Techniques for American Options
Remember that an American option can be thought of as
its European counterpart, but with the right to exercise it
immediately.
Q When would we want to exercise it immediately?

A: Intuitively, it only makes sense if the cash we get by
exercising it today is more than the value of holding the
option.
To calculate American options we will often use the

Binomial Tree (viewed as an approximation to the
continuous time model).
Example : Consider the 2 step binomial tree with

= 0.2, er = 1.1. What is the price of an American Put
with Strike $10.5? The current share price is $10 and no
dividends are payable.
77/77

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Asset-Liability and Derivative Models

Module 4 Topic Notes

How to create a continuous time model based on

In Module 3, we explored financial modelling in a discrete

Path (states) P-Probability

We can encode the differences between the two measures by

The only concern is if with p or q is zero or one.

The probability measure Q is sometimes called an

P (A) > 0 Q (A) > 0 for any outcome A.

Heuristically, this means that the two probability measures

The Radon Nikodym derivative acts in a very natural way

At the moment we have only defined the Radon Nikodym

Given P and Q equivalent measures and a time horizon T,

In the discrete time model we split time into n discrete

and so when n , the term inside the bracket

and in fact this type of relationship is true for ALL

In fact, Brownian motion is an extremely odd process. For

Hence perhaps an example such as

may be a good choice. In general we will want processes that are

How can we specify a stochastic process X (t) as a

where (s) and (s) are (possible random) Fs processes

dX (t) = (t) dW (t) + (t) dt

In the special case when (s) and (s) are simple

dX (t) = (X (t) , t) dW (t) + (X (t) , t) dt

is called a stochastic differential equation for X .

2. Guess the solution to the slightly more complicated

dX (t) = X (t) dW (t) + X (t) dt

Suppose we have got a deterministic function x (t). Then

But what about something like

or something even more complicated like

Consider a stochastic process X (t) with

dX (t) = (X (t)) dW (t) + (X (t)) dt

and f is a deterministic twice continuously differentiable

d(f (X (t))) = dY (t)

dY (t) = (X (t)) f (X (t)) dW (t)

In normal calculus, differentiation is often easier then

What is the solution to

dS (t) = S (t) {dt + dW (t)}

3. From this (t) process we can consider a trading strategy

Following on from the previous slides, the mathematical

A stochastic Process M () is a martingale with respect to a

EQ [M (t) |Fs ] = M (s) , s t.

1. A constant process c is a martingale with respect to any

is a P martingale subject to technical conditions - For

(where is a constant) is a P martingale.

Consider a time horizon of T . In the binomial tree setting

where 1A represents the indicator function for the event A.

fPn (x1 , .., xn )

Key idea (even for more complicated models) - focus on

Suppose that W (t) is a P Brownian motion. Define a

where A is some event.

Task: Using Y () from the previous slide, find the

More generally, if W () is a P Brownian motion, and a

Consider the process X () with

what happens (e.g. distribution and process dynamics of

Find the Radon-Nikodym derivative such that we have

dX (t) = X (t) (dW (t) + dt)

In the Binomial model we found that there was a Q

Suppose that M () is a Q martingale process with volatility

(Proof not required - just use the result)

We now have the mathematical tools we need. In

V (t) = (t) S (t) + (t) B (t)

(2) Self Financing

Vi Vi1 = i (Si Si1 ) + i (Bi Bi1 )