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Background:
Derivative Security: A derivative (or derivative security) is a financial instrument whose value depends on the values of other, more basic underlying variables. ([Hull, 1999]). Example: European Call Option. The right, but not the obligation, to purchase a share of stock at a specified price K (the strike price), at a specified date T (the maturity date). Arbitrage: A riskless profit that involves no investment. (A free lunch)
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St S 0 e
( 1 2 ) t zt 2
2 1 0
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Consider a derivative security whose price depends on St and t. We will call it: By Itos lemma:
dc (ct ScS 1 2 S 2 cSS )dt ScS dz 2
c( St , t )
Our portfolio will consist of D shares of the stock and b of the derivative.
Pt D t S t b t ct
To create a bond, we can dynamically choose D and b so that the portfolio is riskless (i.e. dP has no dz term). Since this portfolio will be riskless, it must earn the same rate of return as the bond. Hence, we must have dP=rPdt. (Otherwise, we can arbitrage by shorting the one with the smaller return, and using that money to buy the one with the larger return). Lets perform these calculations...
Primbs, MS&E 345
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Our portfolio will consist of D shares of the stock and b of the derivative.
Pt D t S t b t ct
The first thing we need to do is compute dP and choose D and b to eliminate the dz term. To compute dP, we could use Itos lemma:
Pt dt D t St dt b t ct dt
If you want, you can rebalance your portfolio now. But if you dont add or take out any money, then
dt period
Pt dt Dt St dt b t ct dt Dt dt St dt b t dt ct dt
So: dPt Pt dt Pt D t St dt b t ct dt (D t St b t ct )
D t ( St dt St ) b t (ct dt ct )
D t dSt b t dct
Primbs, MS&E 345
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Our portfolio will consist of D shares of the stock and b of the derivative. So, we have:
P DS bc
dP DdS bdc
The equation for dP is known as the self-financing constraint. As long as no money is added or taken from the portfolio, it will have the above dynamics.
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DS b ScS 0
So, we have:
P DS bc
dP DdS bdc
D bcS
Substitute in
Lets do some portfolio algebra to compute dP. To make the portfolio riskless, eliminate the dz term
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rPdt
D bcS
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Which derivative was this? If it was a European call option with strike K and maturity T:
c( S , T ) ( S K ) c(0, t ) 0
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ct rScS 1 2 S 2 cSS rc 2
c( S , T ) ( S K )
c(0, t ) 0
Solution:
c( S , t ) SN (d1 ) Ke r (T t ) N (d 2 )
ln( S / K ) ( r 1 2 )(T t ) 2 d1 T t
d 2 d1 T t
where:
dS rSdt Sdz
Next, we will take a bit more abstract look at some of the basic arguments hidden in this derivation and see how far this approach can be generalized...
This will lead to a nice methodology for computing partial differential/difference equations for a surprisingly large number of derivative securities.
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References
Black, F. and M. Scholes, The pricing of options and corporate liabilities, Journal of Political Economy, 81, 637-659, 1973. Hull, J. Options, Futures, and Other Derivatives, 4th Ed. Prentice Hall, 2000.
Luenberger, D. G. Investment Science, Oxford Press, 1998.
Merton, R. C., Theory of rational option pricing, Bell Journal of Economics and Management Science, 4, 141-183, 1973.
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