Pricing Model of

Financial Engineering
Fang-Bo Yeh
System Control Group
Department of Mathematics
Tunghai University
www.math.thu.tw/~fbyeh/
 葉芳柏 教授 英國 Glasgow 大學 數學博士
專長
控制工程理論、科學計算模擬、飛彈導引、泛函分析、財務金融工程
現任
東海大學數學系教授
國立交通大學應用數學研究所 , 財務金融研究所兼任教授
亞洲控制工程學刊編輯 .
歷任
  1. 英國 Glasgow 大學數學系客座教授 2. 英國 Newcastle 大學數學統計系客座教授
   3. 英國 Oxford 大學財務金融中心研究 4. 荷蘭國立 Groningen 大學資訊數學系客座授   
5. 日本國立大阪大學電子機械控制工程系客座教授
6. 成功大學航空太空研究所兼任教授
7. 航空發展中心顧問
8. 東海大學數學系主任、所長、理學院院長、教務長
    9. 國科會中心學門審議委員、諮議委員
10. 教育部大學評鑑委員
11. 國際數學控制學刊編輯委員
學術獎勵
1. 國際電機電子工程師學會獎 IEEE M. Barry Carlton Award
2. 國際航空電子系統傑出論文獎
3. 國科會傑出研究獎
 

2
 Contents

1. Classic and Derivatives Market

2. Derivatives Pricing
3. Methods for Pricing
4. Numerical Solution for Pricing Model
 Classic and Derivatives Market

• Underlying Assets • Contracts

Cash Forward & Swap :
Commodities ( wheat, gold )
FRAs ,
Fixed income ( T-bonds )
Caps, Floors,
Stock
Interest Rate Swaps
Equities ( AOL stock )
Equity indexes ( S&P 500 )
Futures & Options :
Options,
Currency
Convertibles Bond Option,
Currencies ( GBP, JPY )
Swaptions
 Derivative Securities

• Forward Contract :
is an agreement to buy or sell.
• Call Option :
gives its owner the right but not the obligation to
buy a specified asset on or before a specified date
for a specified price.
European, American, Lookback, Asian, Capped,
Exotics…..
5
 Call Option on AOL Stock
on Sep. 8, you buy one on Sep. 8,…
Nov.call option contract • you pay the premium of
written on AOL
$712.50 at maturity on
 contract size: December 26,…
100 shares • if you exercise the option,
 strike price: you take delivery of 100
80 shares of AOL stock and
 maturity: pay the strike price of
December 26 $8,000
 option premium: • otherwise, nothing happens
71/8 per share

6
 Call Option on AOL Stock

denote by ST the price of AOL stock on December 26

date Sep. 8 December 26

scenario (if ST < 80) (if ST  80)
exercise option? no yes

cash flows (on per-share basis)

pay option premium -7.125  
receive stock   ST
pay strike price   -80

7
Fang-bo Yeh

Call Option on AOL Stock

pay-off pay-off net profit

profit

AOL stock price

0
60 70 80 90 100 on December 26
7.125

8
Mathematics Finance 2003 Option Markets

Maximal Losses and Gains on Option Positions

long call short call
maximal gain: maximal gain:
0 unlimited 0 premium
maximal loss: maximal loss:
premium unlimited

long put short put

maximal gain: maximal gain:
strike minus premium
0 0
premium maximal loss:
maximal loss: strike minus
premium premium

9
Fang-Bo Yeh Tunghai Mathematics
Mathematics Finance 2003 Option Markets

Simple Option Strategies: Covered Call

covered call: • covered call pay-offs:
• the potential loss on a short call cash flows at maturity
position is unlimited
• the worst case occurs when the case: ST < K ST  K
stock price at maturity is very Short call - K-ST
high and the option is exercised
long stock ST ST
• the easiest protection against
this case is to buy the stock at
• Cost
total:of strategy:
ST K
the same time as you write the
option you receive the option premium
C while paying the stock price S
this strategy is called
the total cost is hence S-C
“covered call”

10
Fang-Bo Yeh Tunghai Mathematics
Mathematics Finance 2003 Option Markets

Simple Option Strategies: Covered Call

pay-off
K
short
call profit

premium
+ long 0
stock ST
K

= covered
call
K

11
Fang-Bo Yeh Tunghai Mathematics
Mathematics Finance 2003 Option Markets

Simple Option Strategies: Protective Put

protective put: • protective put pay-offs:
• suppose you have a long
position in some asset, and you cash flows at maturity
are worried about potential
capital losses on your position case: ST < K ST  K
• to protect your position, you long stock ST ST
can purchase an at-the-money long put K-ST -
put option which allows you to
• costtotal:
of strategy: K ST
sell the asset at a fixed price
should its value decline the additional cost of protection
is the price of the option, P
this strategy is called
the total cost is hence S+P
“protective put”

12
Fang-Bo Yeh Tunghai Mathematics
Mathematics Finance 2003 Option Markets

Simple Option Strategies: Protective Put

pay-off
long K
stock

+ long 0
put premium ST
K
profit

= protective
put
K

13
Fang-Bo Yeh Tunghai Mathematics
 Financial Engineering

• Bond + Single Option

S&P500 Index Notes
• Bond + Multiple Option
Floored Floating Rate Bonds, Range Notes
• Bond + Forward (Swap) ;Structured Notes
Inverse Floating Rate Note
• Stock + Option
Equity-Linked Securities, ELKS
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 Main Problem:

What is the fair price for the

contract?
Ans:

(1). The expected value of the discounted future

stochastic payoff
(2). It is determined by market forces which is
impossible have a theoretical price
Main result:

• It is possible

• have a theoretical price which is consistent

with the underlying prices given by the market

• But

• is not the same one as in answer (1).

 Methods
Assume efficient market

• Risk neutral • The elimination of

valuation and solving randomness and
conditional solving diffusion
expectation of the equation
random variable
Problem Formulation

Contract F :
dSt
  dt   dZ t
Underlying asset S, return St

Future time T, future pay-off f(ST)

Riskless bond B, return dBt
 r dt
Bt

Find contract value

F(t, St)
 Deterministic Stochastic

Differentiable Not differentiable

Deterministic Function

20
Stochastic Brownian Motion Zt

Zt

21
 From Calculus to Stochastic Calculus

Calculus Stochastic Calculus

Differentiation Ito Differentiation
Integration Ito Integration
Statistics Stochastic Process
Distribution Measure
Probability Equivalent Probability

22
Assume

1). The future pay-off is attainable: (controllable)

exists a portfolio ( t ,  t )
 t   t S t   t Bt
such that
d t   t dSt   t d Bt

2). Efficient market: (observable)

If  T  F (T , ST ) then  t  F (t, St )
By assumptions (1)(2)

dF(t, S)  δ d S  α d B
 [(μ  r) δ S  r F] dt  σ δ S dZ
Ito’s lemma
 F F 1 2 2  2 F  F
dF(t, S)    μ S  2σ S 2
dt  σ S dZ
 t S S  S

The Black-Scholes-Merton Equation:

F F 1 2 2  2 F
rS  2σ S rF
t S S 2

F(T, ST )  f(ST )
European Call Option Price:

Fc (t , St )  St N ( d1 )  e  r ( T t ) KN ( d 2 )

ln SKt  ( r  12  2 )(T  t )
d1 
 T t
d 2  d1   T  t
Martingale Measure
 rt
S  e St ,
*
t
 t*  e  rt t
dSt*  S *t dZ t* , d t*   tS *dZ t* t

-r
dZ 
*
t dt  dZ t  dt  dZ t


Z t* ~ N p (  r t , t ) Z t ~ N p (0, t )

CMG Z t* ~ N p* (0, t )

Drift Brownian Motion Brownian Motion

 Z t  12 2t
E p* (Y )  E p (e Y)
 t*  E p* ( T* )
 e  rt t  E p*[e  rt f ( ST )]
F (t , St )   t  e  r (T t ) E p*[ f ( ST )]
 e  r E p*[ f ( ST )]

Where
dSt
 rdt   dZ t*
St
( r  12  2 ) t  Z t*
St  S 0e
1
 2
F (t , x)  e  r  f ( xe
( r  2  )  2 y
1
) ( y )dy


 ~ N (0, 1)
 Main Result

F (t , St )  e  r (T t ) E p*[ f ( ST )]

The fair price is

the expected value of the
discounted future stochastic payoff under
the new martingale measure.
 From Real world to Martingale world

Discounted Asset Price

& Derivatives Price

Under Real World Measure

is not Martingale
But

Under Risk Neutral Measure

is Martingale

29
 Numerical Solution

Methods

Finite Difference Monte Carlo Simulation

• Idea: Idea:
Approximate differentials Monte Carlo Integration

by simple differences via Generating and sampling

Taylor series Random variable

30
 Introduction to
Financial Mathematics (1)
Topics for 2003:
1. Pricing Model for Financial Engineering.
2. Asset Pricing and Stochastic Process.
3. Conditional Expectation and Martingales.
4. Risk Neutral Probability and Arbitrage Free Principal.
5. Black-Scholes Model : PDE and Martingale
and Ito’s Calculus.
6. Numerical method and Simulations.

31
 References
• M. Baxter, A. Rennie , Financial Calculus,Cambridge
university press, 1998
• R.J. Elliott and P.E. Kopp, Mathematics of Financial
Markets, Springer Finance, 2001
• N.H. Bingham and R. Kiesel , Risk Neutral Evaluation,
Springer Finance, 2000.
• P. Wilmott, Derivatives, John Wiley and Sons, 1999.
• J.C. Hull , Options, Futures and other derivatives, Prentice
Hall. 2002.
• R. Jarrow and S. Turnbull, Derivatives Securities,
Southern College Publishing, 1999.
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