Kotebe University of Education

Financial Mathematics I (Math 3142)

Endalkachew Abebe
PhD Student in Statistics
Department of Mathematics
E-mail:w1endalk@gmail.com

April 22, 2023

Addis Ababa, Ethiopia

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Description Course

Course Title: Financial Mathematics I

Course Code: Math 3142

Credit hours: 3

Contact hours: 3 ECTS: 5 Tutorial hrs: 2

Prerequisites: Stat 2072, Math 2022

Course category: Compulsory

Year: IV Semester: II

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 Description: This course rigorously discusses the basic concepts of Financial
Mathematics like: basic finance, probability spaces, random variables, options
and arbitrage, Discrete-Time Portfolio Processes and expectations.

Objective of the course: At the end of this course students will be able to:

- describe an elementary account of the basic principles of finance

- describes the most common types of financial derivatives

- grasp the idea of the role of arbitrage in finance theory

- get the notion of rigorous mathematical framework for the notion of a

self-financing portfolio

- describe what is meant by expectations and able to apply it in financial

market

Endalkachew Abebe Kotebe University of Education Financial Mathematics I, 2023 3 / 72

Course Outline

1 Basic Finance (3 hrs)

Interest
Inflation
Annuities
Bonds
Internal Rate of Return
2 Revisions on Probability Spaces and Random Variables (6 hrs)
Discrete Probability Spaces and General Probability Spaces
Conditional Probability and Independence
General Properties of Random Variables
Endalkachew Abebe Kotebe University of Education Financial Mathematics I, 2023 4 / 72
 Distributions of Random Variables

Independent Random Variables

Identically Distributed Random Variables

Sums of Independent Random Variables

3 Options and Arbitrage (15 hrs)

The Price Process of an Asset

Arbitrage

Classification of Derivatives

Forwards

Currency Forwards

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 Futures and Equality of Forward and Future Prices

Call and Put Options

Properties of Options

Dividend-Paying Stocks and Exotic Options

Portfolios and Payoff Diagrams

4 Discrete-Time Portfolio Processes (15 hrs)

Discrete Time Stochastic Processes

Portfolio Processes and the Value Process

Self-Financing Trading Strategies

Equivalent Characterizations of Self-Financing

Option Valuation by Portfolios

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5 Expectation (9 hrs)

Expectation of a Discrete Random Variable

Expectation of a Continuous Random Variable
Basic Properties of Expectation
Variance of a Random Variable
Moment Generating Functions
The Strong Law of Large Numbers
The Central Limit Theorem
∆ Teaching Methods: Lectures, projects, assignments, problem solving,
computing
∆ Assessment Methods: Projects, assignments, exams
∆ Assessment Specification: Assignment/Quizzes (20%) + Mid Semester
Examination (30%) + Final Exam (50%) = 100%
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References

Junghenn, H. J. (2019). An introduction to financial mathematics. 2nd ed.,

Taylor & amp; Francis Group, LLC. New York.

Arash Fahim A. (2019). Introduction to Financial Mathematics Concepts &

Computational Methods. Florida State University.

Buchanan J.R. (2006). An undergraduate introduction to financial

mathematics. USA: World scientific publishing Co. Pvt. Ltd.

Taylor & amp; Francis Group. New York.2014 Fahim A. (2019). Introduction
to Financial Mathematics Concepts & Computational Methods. Florida State
University.

Hastings, K. J. (2015). Introduction to financial mathematics. CRC Press.

Endalkachew Abebe Kotebe University of Education Financial Mathematics I, 2023 8 / 72

Basic Finance

In this chapter we consider assets whose future values are completely determined
by a fixed interest rate. Here our goal is to describe how risk-free assets are
valued.

Interest; Inflation; Annuities; Bonds; Internal Rate of Return

Endalkachew Abebe Kotebe University of Education Financial Mathematics I, 2023 9 / 72

 Asset: is anything of value or a resource of value that can be converted into
cash owned by individuals, companies, and governments.

- Please read for more:

https://www.investopedia.com/ask/answers/12/what-is-an-asset.asp

A risky asset is an asset with an uncertain future price, e.g. the stock of a
company in an exchange market.

Unlike a risky asset, a bank account with a fixed interest rate has an
absolutely predictable value, and is called a risk-free asset.

Financial securities is one of risky assets, which constitute the largest body
of risky assets, are traded in the exchange markets and are divided into three
subcategories: equity, debt, and derivatives.

An equity is a claim of ownership of a company.

Endalkachew Abebe Kotebe University of Education Financial Mathematics I, 2023 10 / 72

- If it is issued by a corporation, it is called common stock, stock, or share.

Debt, sometimes referred to as a fixed-income instrument, promises a fixed

cash flow until a time called maturity and is issued by an entity as a means of
borrowing through its sale.

A derivative is an asset whose price depends on a certain event.

- For example, a derivative can promise a payment (payoff) dependent on the

price of a stock, the price of a fixed-income instrument, the default of a
company, or a climate event.

An important class of assets that are not financial securities are described as
commodities.

- is an asset which is not a financial security but is still traded in a market, for
example crops, energy, metals, and the like.

- are important because our daily life depends on them.

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 There are other assets that are not usually included in any of the above
classes, for instance real estate.

If the asset is easily traded in an exchange market, it is called liquid

Financial risk is defined as the risk of loss of investment in financial markets.

- Two of the main categories of financial risk are market risk, causes by the
changes in the price of market equities, and credit risk, caused by the default
of a party in meeting its obligations.

Financial derivatives are designed to cover the loss caused by the market
risk and the credit risk.

There are other important forms of financial risk such as operational risk and
systemic risk.

Endalkachew Abebe Kotebe University of Education Financial Mathematics I, 2023 12 / 72

Interest

is a fee paid by one party for the use of assets of another.

Its amount is generally time dependent: the longer the outstanding balance,
the more interest is accrued.
A familiar example is the interest generated by a money market account.
The bank pays the depositor an amount that is a predetermined fraction of
the balance in the account, that fraction derived from a prorated annual
percentage called the nominal rate, denoted typically by the symbol r.
Simple Interest: Consider first an account that pays simple interest at an
annual rate of r × 100%. If an initial deposit of A0 is made at time zero,
then after one year the account has value A1 = A0 + rA0 = A0 (1 + r), after
two years the account has value A2 = A0 + 2rA0 = A0 (1 + 2r), and so forth.
Endalkachew Abebe Kotebe University of Education Financial Mathematics I, 2023 13 / 72
...Con’t

In general, after t years the account has value:

At = A0 (1 + tr) (1)

which is the so-called simple interest formula.

Notice that interest is paid only on the initial deposit.

Discrete-Time Compound Interest: Suppose now that an account pays

the same annual rate r × 100% but with interest compounded m times per
year, for example, monthly (m = 12) or daily (m = 365). The interest rate
per period is then i := r/m.

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...Con’t

In this setting, if an initial deposit of A0 is made at time zero, then after the
first period the value of the account is A1 = A0 + iA0 = A0 (1 + i), after the
second period the value is A2 = A1 + iA1 = A1 (1 + i) = A0 (1 + i)2 , and so
forth.

In general, the value of the account at time n is A0 (1 + i)n . The formula

reflects the fact that interest is paid not just on the principle A0 but on the
accrued amounts in the account. Since there are m periods per year, the
value of the account after t years is:

At = A0 (1 + r/m)mt (2)

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...Con’t

(2) which is the compound interest formula. In this context, A0 is called the
present value or discounted value of the account and At is the future value at
time t.

Continuous-Time Compound Interest: Now consider what happens when

the number m of compounding periods per year increases without bound.
Write (2) as: At = A0 [(1 + 1/x)x ]rt ; where x = m/r.

As m ∼ ∞, the term in brackets tends to e, the base of the natural

logarithm. This leads to the formula for the value of an account after t years
under continuously compounded interest:

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...Con’t

At = A0 ∗ ert (3)

Effective Rate: In view of the various ways one can compute interest, it is
useful to have a method to compare investment strategies.

- One such device is the effective interest rate re , defined as the simple interest
rate that produces the same yield in one year as compound interest.

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...Con’t

- Thus if interest is compounded m times a year, then the effective rate must
satisfy the equation A0 (1 + r/m)m = A0 (1 + re ) and so re = (1 + r/m)m − 1

Similarly, if interest is compounded continuously, then A0 er = A0 (1 + re ), so

re = er − 1.

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Inflation

is defined as an increase over time of the general level of prices of goods and
services, resulting in a decrease of purchasing power.

For a mathematical model, assume that inflation is running at an annual rate

of rf .

- If the price of an item now is A0 , then the price after one year is A0 (1 + rf ),
the price after two years is A0 (1 + rf )2 , and so on.

- Thus inflation is governed by a compound interest formula.

For example, if inflation is running at 5% per year, then prices will increase by
5% each year, so an item costing $100 now will cost 100(1 : 05)2 = $110:25
in 2 years.

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...Con’t

To see the combined effects of inflation and interest, suppose we make an

investment whose (nominal) rate of return is r, compounded yearly.

- What is the actual annual rate of return ra if inflation is taken into account?

A dollar investment now will have future value (1 + r) in one year.

- In purchasing power this is equivalent to the amount (1 + r)/(1 + rf ) now.

- Thus, in terms of constant purchasing units, the investment transforms $1 of

purchasing units into the amount (1 + r)/(1 + rf ).

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...Con’t

The annual interest rate ra that produces the same return is called the
inflation-adjusted rate of return.

- Thus 1 + ra = (1 + r)/(1 + rf ) and so

1+r r − rf
ra = −1= (4)
1 + rf r + rf

For small rf we have the approximation ra ≈ r − rf ; which is frequently

taken as the definition of ra .

Now suppose you are to receive a payment of Q dollars one month from now,
i.e., at time 1.

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...Con’t

If the investment pays interest at an annual rate of r, then, taking inflation

into account, the time-0 value of this payment is (approximately)
A0 = (1 + i − if )−1 Q, where i = r/12 and if = rf /12.

Similarly a payment of Q two months from now would have time-1 value
(1 + i − if )−1 Q and hence a time-0 value of A0 = (1 + i − if )−2 Q.

In general if you are to receive a payment of Q in n months, then the present

value of this payment, taking monthly inflation into account, is

A0 = (1 + i − if )−n Q : (5)

This is the same as the present value formula for an annual rate of r − rf spread
over 12 months.
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Annuities

is a sequence of periodic payments of a fixed amount P .

The payments may be deposits into an account such as a pension fund or a

layaway plan, or withdrawals from an account, as in a trust fund or
retirement account.

Assume the account pays interest at an annual rate r compounded m times

per year and that a deposit (withdrawal) is made at the end of each
compounding interval. We seek the value An of the account at time n, that
is, the value immediately after the nth deposit (withdrawal).

Deposits: For deposits, the quantity An is the sum of the time-n values of
payments 1 to n. Since payment j accrues interest over n - j compounding
periods,
Endalkachew Abebe Kotebe University of Education Financial Mathematics I, 2023 23 / 72
...Con’t

its time-n value is P (1 + r/m)n−j . The scheme is illustrated in Figure 1.1.

Summing from j = 1 to n we obtain An = P (1 + x + x2 + + xn−1 ), where
x := 1 + r/m.

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...Con’t

The preceding geometric series sums to (xn − 1)/(x − 1), hence the value of
the account at time n is

(1 + i)n − 1 r
An = P ; i := (6)
i m

More generally, if a deposit of A0 is made at time 0, then the time-n value of

the account is

(1 + i)n − 1
An = A0 (1 + i)n + P (7)
i

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...Con’t

Using this equation, one may easily calculate the number n of monthly
deposits required to reach a goal of A.

Indeed, setting A = An , solving for (1 + i)n , and then taking logarithms we

see that the desired value n is the quantity:
(ln(iA + P ) − ln(iA0 + P ))/ln(1 + i) rounded up to the nearest integer.
This is the smallest integer n for which An ≥ A.

Withdrawals: For withdrawal annuities we argue as follows:

- Let A0 be the initial value of the account and let An denote the value of the
account immediately after the nth withdrawal.

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...Con’t

- The value just before withdrawal is An−1 plus the interest over that period.

- Making the withdrawal reduces that value by P and so

An = aAn−1 − P ; a := 1 + i.

- Iterating, we obtain An = a(aAn−2 − P ) − P = a2 An−2 − (1 + a)P and

eventually An = an A0 − (1 + a+, ..., +an−1 )P .

Summing the geometric series yields

1 − (1 + i)n
An = (1 + i)n A0 + P (8)
i

Now assume that the account is drawn down to zero after N withdrawals.
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...Con’t

Setting n = N and AN = 0 in (8) and solving for A0 we obtain, after

simplification,
1 − (1 + i)−N
A0 = P (9)
i

This is the initial deposit required to support exactly N withdrawals of size P

from, say, a retirement account or trust fund.
It may be seen as the sum of the present values of the N withdrawals.
Solving for P in (9) we obtain the formula
i
P = A0 (10)
1 − (1 + i)−N
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...Con’t

which may be used, for example, to calculate the mortgage payment for a
mortgage of size A0 (see below).

- Substituting (10) into (8) we obtain the following formula for the time-n
value of an annuity supporting exactly N withdrawals:

1 − (1 + i)n−N
P = A0 (11)
1 − (1 + i)−N

Reading Assignment Annuities Application on (From text book-1)

- Retirement

- Amortization
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Bonds

A bond is a financial contract issued by governments, corporations, or other

institutions.

It requires that the holder be reimbursed a specific amount at a prescribed

time in the future.

The simplest is the zero coupon bond, of which U.S. Treasury bills and U.S.
savings bonds are common examples.

Here, the purchaser of a bond pays an amount B0 (which is frequently

determined by bids) and receives a prescribed amount F , the face value or
par value of the bond, at a prescribed time T , called the maturity date. The
value Bt of the bond at time t may be expressed in terms of a continuously
compounded interest rate r determined by the equation:
Endalkachew Abebe Kotebe University of Education Financial Mathematics I, 2023 30 / 72
...Con’t

B0 = F e−rT (12)

Here, r is computed by the formula r = [ln(F ) − ln(B0 ]/T . The value Bt is

then the face value of the bond discounted to time t:
Bt = F e−r(T −t) = B0 ert ; 0 ≤ t ≤ T .

Thus, during the time interval [0 , T ], the bond acts like a savings account
with continuously compounded interest.

The time restriction 0 ≤ t ≤ T may be theoretically removed as follows: At

time T , reinvest the proceeds F from the bond by buying F/B0 bonds, each
for the amount B0 and each with par value F and maturity date 2T.
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...Con’t

At time t ϵ [T, 2T ] each bond has value

F e−r(2T −t) = F e−rT e−r(T −t) = B0 e − rT ert , so the bond account has value

- Bt = (F/B0 )B0 e−rT ert = F e−rT ert = B0 ert , T ≤ t ≤ 2T

Continuing this process, we see that the formula Bt = B0 ert holds for all
times t ≥ 0, assuming par values are unchanged.

With a coupon bond one receives not only the amount F at time T but also a
sequence of payments, called coupons, during the life of the bond. Thus, at
prescribed times t1 < t2 < ... < tN , the bond pays an amount Cn , and at
maturity T one receives the face value F , as illustrated in the figure.

Endalkachew Abebe Kotebe University of Education Financial Mathematics I, 2023 32 / 72

...Con’t

The price of the bond is the total present value

n
X
B0 = e−rt nCn + F ∗ e−rT (13)
i=1

which may be seen as the initial value of a portfolio consisting of N + 1

zero-coupon bonds maturing at times t1 , t2 , ... , tN , and T.
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Internal Rate of Return

It is a measure used to evaluate a sequence of financial events.

Typically used to rank projects that involve future cash flows: the higher the
rate of return the more desirable the project.

For a mathematical model, consider a scenario that returns, for an initial

investment of P > 0, an amount An > 0 at the end of periods n = 1, 2, ...,
N, as illustrated in the diagram.

Examples of such investments are annuities and coupon bonds.

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...Con’t

The internal rate of return (IRR) of the investment P is defined as that

periodic interest rate i for which the present value of the sequence of returns
(under that rate) equals the initial payment P

Thus i satisfies the equation

N
X
P = An (1 + i)−n (14)
n=1

Please read text book-1 page 11-12

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Revisions on Probability Spaces and Random Variables (6
hrs)

Discrete Probability Spaces and General Probability Spaces

Conditional Probability and Independence

General Properties of Random Variables

Distributions of Random Variables

Independent Random Variables

Identically Distributed Random Variables

Sums of Independent Random Variables

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Introduction

Probability

Is a set function, defined for sets of outcomes, known as events.

The probability of an event measures its “size,” in the sense of likelihood or

frequency.

- Like other measures of size such as cardinality, length, area and mass.

Is additive: if A and B are disjoint events, then P(A ∪ B) = P(A) + P(B).

Is a number between 0 and 1 that expresses the likelihood of the occurrence

of an event in an experiment.

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...Con’t

Random experiment:- is a process by which we observe something

uncertain.
- After the experiment, the result of the random experiment is known, i.e.
Random experiment associated with Ω, ω and Events.
Experiment: Any activity that generates an outcome.
Outcome: The result of a single trial of a random experiment.
Sample Space: Set of all possible outcomes of a probability experiment
(denoted by Ω).
- Ω may be: finite set, countable set, the real line R, finitely many replications,
infinitely many replications and function spaces.
Event: It is a subset of sample space (are denoted by capital letters).
Endalkachew Abebe Kotebe University of Education Financial Mathematics I, 2023 38 / 72
Basic set operations

The complement of A is: Ac = { ω : ω ∈

/ A }.

The union of A and B are: A ∪ B = { ω : ω ∈ A or ω ∈ B }.

The intersection of A and B are: A ∩ B = { ω : ω ∈ A and ω ∈ B }.

- Sets A and B are disjoint if A ∩ B = ∅.

The set difference between B and A, denoted by B \ A, is the consists of

those points in B but not in A.
def
- B \ A = B ∩ Ac

The symmetric difference between A and B, denoted by A ∆ B, is the set of

points in one but not both of A and B.
def
- A ∆ B = A \ B + B \ A.
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Basic Set Operation by Vein-diagram

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Indicator Function

The indicator function of the set A ⊆ Ω is the function on Ω given by:


1 if ω ∈ A

1A (ω) =
0 if ω ∈

/A

Set Operation for 1A (ω)

- 1A∪B = max(1A , 1B )

- 1A∩B = min(1A , 1B ) = 1A * 1B

- 1Ac = 1- 1A

- 1A∆B = |1A − 1B |

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General Probability Spaces

σ-algebra on Ω

A σ-algebra on Ω is a family of subsets of Ω containing Ω and closed under

countable union, countable intersection and complementation.

- That is, F is a σ-algebra if Ω ∈ F, if whenever A1 , A2 , A3 ,... are sets such

S∞ T∞
that Ai ∈ F for each i, then i=1 Ai ∈ F and i=1 Ai ∈ F, and if
whenever A ∈ F, then Ac ∈ F.

The two extreme σ-algebra on Ω are the:

- trivial σ-algebra, F = {∅ , Ω }

- power set P(Ω), consisting of all subsets of Ω

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...Con’t

Note that: Let Ω be a sample space

A d-system is a family of subsets containing Ω and closed under proper

difference (if A, B ∈ D and A ⊆ B, then B \ A ∈ D) and countable
increasing union.

A π-system is a family of subsets closed under finite intersection.

- A σ-algebra is a d-system and a π-system.

- In addition, a class that is both a π-system and a d-system is a σ-algebra.

The Borel σ-algebra on R is the σ-algebra B(R) generated by the π-system a

of intervals (a, b], where a < b in R.

- We also allow the possibility that a = -∞ or b = ∞

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...Con’t

Its elements are called Borel sets.

For A ∈ B(R), σ-algebra: B(A) = {B ⊆ A: B ∈ B(R } of Borel subsets of A

is termed the Borel σ-algebra on A.

Every “reasonable” subset of R - in particular, each interval, closed set, open

set, finite set and countable set - is a Borel set.

However, B(R) ̸= P(R), although this latter property is deep and difficult to
prove.

Borel sets are also defined in multi-dimensional Euclidean spaces.

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Probability and Its Space

Probability: is a set function, defined for events, and is (countably) additive:

the probability of the countable disjoint union of events is the sum of their
individual probabilities.

Let (Ω , F) be a sample space and a σ-algebra of events.

A probability on (Ω , F) is a function P: F → R such that:

a P(A) ≥ 0 for all A ∈ F.

b P(Ω) = 1
S∞
c Whenever A1 , A2 , A3 , ... are (pairwise) disjoint sets in F , then P( n An )
P∞
= n P (An )

The triple (Ω, F, P) is a probability space.

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Discrete Probability Spaces

Consider an experiment whose outcomes may be represented by a finite or

infinite sequence, say, ω1 , ω2 , ω3 ,...
- Let pn denote the probability of outcome ωn
- In practice, the determination of pn may be based on: relative frequency
considerations, logical deduction, or analytical methods, and approximate or
theoretical.
Whatever method is used to determine the probabilities pn of an experiment,
the resulting assignment is required to satisfy the following conditions:
P
0 ≤ pn ≤ 1 and n pn

- The finite or infinite sequence (p1 , p1 , ...) is called the probability vector or
probability distribution for the experiment.
Endalkachew Abebe Kotebe University of Education Financial Mathematics I, 2023 46 / 72
...Con’t

The probability P(A) of a subset A of the sample space ω ={ ω1 , ω2 , ω3 ,...} is

then defined as
X
P(A) = pn (15)
ωn ϵA

- If A = ∅, the sum is interpreted as having the value zero.

- The function P is called a probability measure for the experiment and

- The pair (Ω , P) is called a discrete probability space.

- The following proposition summarizes the basic properties of P, i.e., for a

discrete probability space:

Endalkachew Abebe Kotebe University of Education Financial Mathematics I, 2023 47 / 72

...Con’t

1 0 ≤ P(A) ≤ 1
2 P(∅) = 0 and P(Ω) =1
3 If A1 , A2 , A3 , ... is a finite or infinite sequence of pairwise disjoint subsets of
S P
Ω, then P( n An ) = n P (An )

- Part (3) of the proposition is called the additivity property of P

Equal Likelihood Probability Spaces

For finite sample space Ω and each outcome is equally likely pn = 1 / |Ω|
hence equation (15) reduced to P(A) = |A| /|Ω| , A ⊆ Ω, where |A| denotes
the number of elements in a finite set A.

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Elementary Properties

Let (Ω , F, P) be a probability space. Then,

a P(∅) = 0

b P is finitely additive: if A1 , A2 , A3 , ... are (pairwise) disjoint, then

n
[ n
X
P( Ai ) = P(Ai ) (16)
i=1 i=1

Consequently, for each A,

P(Ac ) = 1 − P(A) (17)

c If A ⊆ B, then

Endalkachew Abebe Kotebe University of Education Financial Mathematics I, 2023 49 / 72

...Con’t

P(B\A) = P(B) − P(A) (18)

Thus, P is monotone: if A ⊆ B, then P(A) ≤ P(B)

d For all A and B (disjoint or not),

P(A ∪ B) + P(A ∩ B) = P(A) + P(B) (19)

Hence, P is (finitely) sub-additive: for all A and B, disjoint or not,

P(A ∪ B) ≤ P(A) + P(B) (20)

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Conditional Probability

Suppose we assign probabilities to the events A of an experiment and then

learn that an event B has occurred.

One would expect that this new information could have an effect on the
original probabilities P(A).

The (possibly) altered probability of an event A is called the conditional

probability of A given B and is denoted by P(A | B) and defined by:

P(A|B) = P(A ∩ B)/P(B)

2.4.3 Theorem (Multiplication Rule for Conditional Probabilities)

Suppose that A1 , A2 , ..., An are events with P(A1 ∩ A2 ∩ ... ∩ An−1 ) >
0. Then,
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...Con’t

P (A1 ∩ A2 ∩, ..., ∩An ) = P (A1 ) ∗ P (A2 |A1 )∗, ...., ∗P (An |(A1 ∩ A2 ∩, ..., ∩An−1 ))

2.4.6 Theorem (Total Probability Law)

Let B1 , B2 , ..., be a finite or infinite sequence of mutually exclusive events

whose union is Ω. If P(Bn ) > 0 for every n, then for any event A
X
P(A) = P(A|Bn )P(Bn )
n

Bayes Theorem: If A1 , A2 , ..., An are m.e.e that satisfying A1 ∪ A2 ∪, ..., ∪

An = Ω and P(Aj ) > 0 for i = 1, 2, 3, ..., n, the nth conditional probability of
Aj given arbitrary event B on Ω is given by:
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...Con’t

P(B|Aj ) ∗ P(Aj )
P(Aj |B) = Pn (21)
i=1 P(B|Aj ) ∗ P(Aj )

Independence:

Events A and B in a probability space are said to be independent if

P(A ∩ B) = P(A) ∗ P(B)

if A and B are independent what will be P(A|B)

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Random Variable

A random variable is a function X: Ω → R such that X −1 (B) ∈ F for

every B ∈ B (R).

A function X: Ω → R is a random variable if {X ≤ t} ∈ F for every t ∈ R

- Or a real-valued function X on a probability space (Ω, F, P) is a random

variable iff any one of the following conditions holds:

a {X ≤ t} ϵ F for all t ϵ R

b {X < t} ϵ F for all t ∈ R

c {X ≥ t} ϵ F for all t ∈ R

d {X > t} ϵ F for all t ∈ R

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...Con’t

Random variables can be: discrete or continuous

Discrete Random Variables: A random variable X on a probability space

(Ω , F, P) is said to be discrete if the range of X is countable. The
probability mass function (pmf ) of a discrete random X is defined by:

- pX (x) := P(X = x), x ∈ R :

- Since pX (x) > 0 for at most countably many real numbers x, for an arbitrary
P
subset A of R, we may write P(X ∈ A) = x∈A pX (x)

- where the sum is either finite or a convergent infinite series (ignoring zero
P
terms). In particular, x∈R pX (x) = P(X ∈ R) = 1 and
P
FX (x) = y≤x pX (x); where FX (x) is CDF of X

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...Con’t

Example: Find the pmf and CDF of the number X of heads that come up in
three tosses of a fair coin.

Continuous Random Variables: A random variable X is said to be

continuous if there exists a nonnegative (improperly) integrable function fX
such that:
R
- P(X ∈ J) = J
fX (t)dt for all intervals J

- The function fX is called the probability density function (pdf) of X.

Ry
- Note that the probability P(x ≤ X ≤ y) = x fX (t)dt is simply the area
under the graph of fX between x and y.
Rx
- The CDF of X takes the form FX (x) = P(X ≤ x) = −∞
fX (t)dt

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General Properties of Random Variables

3.2.1 Theorem: Let X1 , X2 , ..., Xn be random variables. If f(X1 , X2 , ..., Xn )

is a continuous function, then f(X1 , X2 , ..., Xn ) is a random variable, where
f(X1 , X2 , ..., Xn )(ω) := ω ∈ Ω. (Proof this theorem)
3.2.2 to 3.2.4 Corollary: Let X and Y be random variables. Then,

a aX + bY is a random variable for all a, b ∈ R.

b max { X, Y} and min {X, Y} are random variables.

c XY is a random variable.

d Provided that Y(ω) ̸= 0 for each ω, X/Y is a random variable.

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Distributions of Random Variables

It is a distribution function that the random variable will have; which describes
how the probabilities are distributed over the values of the random variable.

The distribution function of P is the function FP : R → [0, 1] defined by

FP (t) = P((−∞, t])

Properties of Distribution Function

- Uniqueness

- FP is right-continuous: FP (t+) = FP (t) for each t.

- limt→−∞ FP (t) = 0 and limt→∞ FP (t) = 1

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...Con’t

Common discrete distributions

- Bernoulli

- Binomial

- Negative binomial

- Uniform

- Poisson

- Geometric

- Hyper-geometric

- List more and differentiate their properties

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...Con’t

Common Continuous distributions

- Uniform

- Normal

- Exponential

- Gamma

- Beta

- Weibull

- List more and differentiate their properties

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Joint Distributions of Random Variables

In many situations one needs to consider several random variables simultaneously

as, for example, in the case of a portfolio consisting of several stocks. In this
section we consider the joint distribution of two random variables. The general
case of finitely many random variables is entirely similar.
The joint cumulative distribution function FX,Y of a pair of random variables
X and Y is defined by: FX,Y (x, y) = P(X ≤ x, Y ≤ y)
- Discrete Joint Distribution
- Continuous Joint Distribution
Marginal Distribution of Random Variables
Marginal Probability Mass Functions
Marginal Density Functions
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Discrete Joint Distribution

The joint probability mass function of discrete random variables X and Y is

defined by:

- pX,Y (x, y) = P(X = x, Y = y)

The joint CDF takes the form:

P P
- FX,Y (x, y) = u≤x v≤y pX,Y (x, y)

The Marginal Probability Mass Functions of X and Y are given by:

P
pX (x) = P(X = x, Y ∈ R) = y pX,Y (x, y) with range of x.
P
pY (y) = P(Y = y, X ∈ R) = x pX,Y (x, y) with range of y.

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Continuous Joint Distribution

Continuous random variables X and Y are said to be jointly continuous if there

exists a non-negative integrable function FX,Y , called the joint probability density
function of X and Y , such that
Rx Ry
FX,Y (x, y) = −∞ −∞ fX,Y (s, t)dsdt for all real numbers x and y.

The Marginal Density Functions of X and Y are given by:

R∞
fX (x) = −∞ fX,Y (x, y)dy with x intervals
R∞
fY (y) = −∞ fX,Y (x, y)dx with y intervals

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Independent Random Variables

Let X and Y be random variables. Then X and Y are independent iff

FX,Y (x, y) = FX (x) ∗ FY (y) for all x and y.
Proof: If the equation holds, then
P(a < X ≤ b, c < Y ≤ d) =
FX,Y (b, d) − FX,Y (a, d) − FX,Y (b, c) + FX,Y (a, c) =
[FX (b) − FX (a)] ∗ [FY (d) − FY (c)] = P(a < X ≤ b) ∗ P(c < Y ≤ d) =
FX (x) ∗ FY (y)
- Let X and Y be jointly continuous random variables. Then X and Y are
independent iff fX,Y (x, y) = fX (x) ∗ fY (y) for all x and y:
- Discrete random variables X and Y are independent iff
pX,Y (x, y) = pX (x) ∗ pY (y) for all x and y.
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Identically Distributed Random Variables

A collection of random variables with the same cdf is said to be identically

distributed.

If the random variables are also independent, then the collection is said to be
iid.

Sums of Independent Random Variables

If X and Y are independent discrete random variables then

P P
pX+Y (z) = x P(X = x, Y = z − x) = x pX (x) ∗ pY (z − x)

If X and Y are jointly continuous random variables, then

R∞
FX+Y (z) = ∞ fX (x − y) ∗ f Y (y)dy called the convolution of the densities
fX and fY

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Example on the Chapters

Consider the following experiments

1 Tossing a single coin once.
2 Tossing a coin once two times.
3 Rolling two distinct dice once.

Based on the above experiment answer the following questions by letting random
variable X denotes number of heads in experiments 1 and 2; but, sum of upturned
face in the 3 experiment.

a Sample Space, Range of X

b Probability distribution of X

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...Con’t

The following functions are given:

x+2
a f(x) = 25 for x = 1, 2, 3, 4 and 5.

b

c ∗ e−3∗x

if x > 0
f (x) =
0

Otherwise

Considering these two functions

1 Show the function in part a is pmf.
2 Find the value for c and show the function given is pdf for function in part b.

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...Con’t

Consider the joint probability mass and density function given in 1 and 2 below.

1

c(2 ∗ x + y) if 0 ≤ x ≤ 2, 0 ≤ x ≤ 2

f (x) =
0

Otherwise

2

e−(x+y

if x ≥ 0, y ≥ 0
f (x) =
0

Otherwise

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...Con’t

Based on the above functions (1 and 2) answer the following:

1 Find c
2 P(X ≤ 2, Y ≤ 2)
3 Find the marginals pmfs and pdfs.
4 Find the CDFs for the marginals distribution obtained in question 3.
5 Show whether the the given random variables X and Y are independent or
not.

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...Con’t

Given random variable X and Y follows the following distributions:

a Binomial distribution with (n, p) and (m, y) respectively.

b Poisson distribution with λx and λy respectively.

c Normal distribution with (µx , σx2 ) and (µy , σy2 ) respectively.

then, find the distributions of X + Y.

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Options and Arbitrage (15 hrs)

The Price Process of an Asset

Arbitrage
Classification of Derivatives
Forwards
Currency Forwards
Futures and Equality of Forward and Future
Prices
Call and Put Options
Properties of Options
Dividend-Paying Stocks and Exotic Options
Portfolios and Payoff Diagrams
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 Thank You for Your Attention !

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