A Course in

Financial Calculus

Alison Etheridge
University of Oxford
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 Contents

Preface page vii

1 Single period models 1

Summary 1
1.1 Some definitions from finance 1
1.2 Pricing a forward 4
1.3 The one-step binary model 6
1.4 A ternary model 8
1.5 A characterisation of no arbitrage 9
1.6 The risk-neutral probability measure 13
Exercises 18

2 Binomial trees and discrete parameter martingales 21

Summary 21
2.1 The multiperiod binary model 21
2.2 American options 26
2.3 Discrete parameter martingales and Markov processes 28
2.4 Some important martingale theorems 38
2.5 The Binomial Representation Theorem 43
2.6 Overture to continuous models 45
Exercises 47

3 Brownian motion 51
Summary 51
3.1 Definition of the process 51
3.2 Lévy’s construction of Brownian motion 56
3.3 The reflection principle and scaling 59
3.4 Martingales in continuous time 63
Exercises 67

4 Stochastic calculus 71
Summary 71

v
vi contents

4.1 Stock prices are not differentiable 72

4.2 Stochastic integration 74
4.3 Itô’s formula 85
4.4 Integration by parts and a stochastic Fubini Theorem 93
4.5 The Girsanov Theorem 96
4.6 The Brownian Martingale Representation Theorem 100
4.7 Why geometric Brownian motion? 102
4.8 The Feynman–Kac representation 102
Exercises 107

5 The Black–Scholes model 112

Summary 112
5.1 The basic Black–Scholes model 112
5.2 Black–Scholes price and hedge for European options 118
5.3 Foreign exchange 122
5.4 Dividends 126
5.5 Bonds 131
5.6 Market price of risk 132
Exercises 134

6 Different payoffs 139

Summary 139
6.1 European options with discontinuous payoffs 139
6.2 Multistage options 141
6.3 Lookbacks and barriers 144
6.4 Asian options 149
6.5 American options 150
Exercises 154

7 Bigger models 159

Summary 159
7.1 General stock model 160
7.2 Multiple stock models 163
7.3 Asset prices with jumps 175
7.4 Model error 181
Exercises 185

Bibliography 189
Notation 191
Index 193
 1 Single period models

Summary
In this chapter we introduce some basic definitions from finance and investigate the
problem of pricing financial instruments in the context of a very crude model. We
suppose the market to be observed at just two times: zero, when we enter into a
financial contract; and T , the time at which the contract expires. We further suppose
that the market can only be in one of a finite number of states at time T . Although
simplistic, this model reveals the importance of the central paradigm of modern
finance: the idea of a perfect hedge. It is also adequate for a preliminary discussion
of the notion of ‘complete market’ and its importance if we are to find a ‘fair’ price
for our financial contract.
The proofs in §1.5 can safely be omitted, although we shall from time to time
refer back to the statements of the results.

1.1 Some definitions from finance

Financial market instruments can be divided into two types. There are the underlying
stocks – shares, bonds, commodities, foreign currencies; and their derivatives, claims
that promise some payment or delivery in the future contingent on an underlying
stock’s behaviour. Derivatives can reduce risk – by enabling a player to fix a price
for a future transaction now – or they can magnify it. A costless contract agreeing to
pay off the difference between a stock and some agreed future price lets both sides
ride the risk inherent in owning a stock, without needing the capital to buy it outright.
The connection between the two types of instrument is sufficiently complex and
uncertain that both trade fiercely in the same market. The apparently random nature
of the underlying stocks filters through to the derivatives – they appear random
too.

Derivatives Our central purpose is to determine how much one should be willing to pay for
a derivative security. But first we need to learn a little more of the language of
finance.

1
2 single period models

Definition 1.1.1 A forward contract is an agreement to buy (or sell) an asset on a

specified future date, T , for a specified price, K . The buyer is said to hold the long
position, the seller the short position.

Forwards are not generally traded on exchanges. It costs nothing to enter into a
forward contract. The ‘pricing problem’ for a forward is to determine what value
of K should be written into the contract. A futures contract is the same as a forward
except that futures are normally traded on exchanges and the exchange specifies
certain standard features of the contract and a particular form of settlement.
Forwards provide the simplest examples of derivative securities and the math-
ematics of the corresponding pricing problem will also be simple. A much richer
theory surrounds the pricing of options. An option gives the holder the right, but not
the obligation, to do something. Options come in many different guises. Black and
Scholes gained fame for pricing a European call option.

Definition 1.1.2 A European call option gives the holder the right, but not the
obligation, to buy an asset at a specified time, T , for a specified price, K .
A European put option gives the holder the right to sell an asset for a specified
price, K , at time T .

In general call refers to buying and put to selling. The term European is reserved for
options whose value to the holder at the time, T , when the contract expires depends
on the state of the market only at time T . There are other options, for example
American options or Asian options, whose payoff is contingent on the behaviour of
the underlying over the whole time interval [0, T ], but the technology of this chapter
will only allow meaningful discussion of European options.

Definition 1.1.3 The time, T , at which the derivative contract expires is called the
exercise date or the maturity. The price K is called the strike price.

The pricing So what is the pricing problem for a European call option? Suppose that a company
problem has to deal habitually in an intrinsically risky asset such as oil. They may for example
know that in three months time they will need a thousand barrels of crude oil. Oil
prices can fluctuate wildly, but by purchasing European call options, with strike K
say, the company knows the maximum amount of money that it will need (in three
months time) in order to buy a thousand barrels. One can think of the option as
insurance against increasing oil prices. The pricing problem is now to determine,
for given T and K , how much the company should be willing to pay for such
insurance.
For this example there is an extra complication: it costs money to store oil. To
simplify our task we are first going to price derivatives based on assets that can
be held without additional cost, typically company shares. Equally we suppose that
there is no additional benefit to holding the shares, that is no dividends are paid.
3 1.1 some definitions from finance

Payoff

K ST K ST K ST

(a) (b) (c)

Figure 1.1 Payoff at maturity of (a) a forward purchase, (b) a European call and (c) a European put with
strike K as a function of ST .

Assumption Unless otherwise stated, the underlying asset can be held without
additional cost or benefit.

This assumption will be relaxed in Chapter 5.

Suppose then that our company enters into a contract that gives them the right, but
not the obligation, to buy one unit of stock for price K in three months time. How
much should they pay for this contract?

Payoffs As a first step, we need to know what the contract will be worth at the expiry date.
If at the time when the option expires (three months hence) the actual price of the
underlying stock is ST and ST > K then the option will be exercised. The option is
then said to be in the money: an asset worth ST can be purchased for just K . The value
to the company of the option is then (ST − K ). If, on the other hand, ST < K , then it
will be cheaper to buy the underlying stock on the open market and so the option will
not be exercised. (It is this freedom not to exercise that distinguishes options from
futures.) The option is then worthless and is said to be out of the money. (If ST = K
the option is said to be at the money.) The payoff of the option at time T is thus

(ST − K )+
max {(ST − K ), 0} .

Figure 1.1 shows the payoff at maturity of three derivative securities: a forward
purchase, a European call and a European put, each as a function of stock price at
maturity. Before embarking on the valuation at time zero of derivative contracts, we
allow ourselves a short aside.

Packages We have presented the European call option as a means of reducing risk. Of course
it can also be used by a speculator as a bet on an increase in the stock price. In
fact by holding packages, that is combinations of the ‘vanilla’ options that we have
described so far, we can take rather complicated bets. We present just one example;
more can be found in Exercise 1.
4 single period models

Example 1.1.4 (A straddle) Suppose that a speculator is expecting a large move

in a stock price, but does not know in which direction that move will be. Then a
possible combination is a straddle. This involves holding a European call and a
European put with the same strike price and maturity.

Explanation: The payoff of this straddle is (ST − K )+ (from the call) plus (K −
ST )+ (from the put), that is, |ST − K |. Although the payoff of this combination is
always positive, if, at the expiry time, the stock price is too close to the strike price
then the payoff will not be sufficient to offset the cost of purchasing the options and
the investor makes a loss. On the other hand, large movements in price can lead to
substantial profits. 2

1.2 Pricing a forward

In order to solve our pricing problems, we are going to have to make some
assumptions about the way in which markets operate. To formulate these we begin
by discussing forward contracts in more detail.
Recall that a forward contract is an agreement to buy (or sell) an asset on a
specified future date for a specified price. Suppose then that I agree to buy an asset
for price K at time T . The payoff at time T is just ST − K , where ST is the actual
asset price at time T . The payoff could be positive or it could be negative and, since
the cost of entering into a forward contract is zero, this is also my total gain (or loss)
from the contract. Our problem is to determine the fair value of K .

Expectation At the time when the contract is written, we don’t know ST , we can only guess at
pricing it, or, more formally, assign a probability distribution to it. A widely used model
(which underlies the Black–Scholes analysis of Chapter 5) is that stock prices are
lognormally distributed. That is, there are constants ν and σ such that the logarithm
of ST /S0 (the stock price at time T divided by that at time zero, usually called the
return) is normally distributed with mean ν and variance σ 2 . In symbols:


  
ST ST
P ∈ [a, b] = P log ∈ [log a, log b]
S0 S0
 log b  
1 (x − ν)2
= √ exp − d x.
log a 2π σ 2σ 2
Notice that stock prices, and therefore a and b, should be positive, so that the integral
on the right hand side is well defined.
Our first guess might be that E[ST ] should represent a fair price to write into our
contract. However, it would be a rare coincidence for this to be the market price. In
fact we’ll show that the cost of borrowing is the key to our pricing problem.

The risk-free We need a model for the time value of money: a dollar now is worth more than a
rate dollar promised at some later time. We assume a market for these future promises
(the bond market) in which prices are derivable from some interest rate. Specifically:
5 1.2 pricing a forward

Time value of money We assume that for any time T less than some horizon τ
the value now of a dollar promised at T is e−r T for some constant r > 0. The
rate r is then the continuously compounded interest rate for this period.

Such a market, derived from say US Government bonds, carries no risk of default –
the promise of a future dollar will always be honoured. To emphasise this we will
often refer to r as the risk-free interest rate. In this model, by buying or selling cash
bonds, investors can borrow money for the same risk-free rate of interest as they can
lend money.
Interest rate markets are not this simple in practice, but that is an issue that we
shall defer.

Arbitrage We now show that it is the risk-free interest rate, or equivalently the price of a cash
pricing bond, and not our lognormal model that forces the choice of the strike price, K , upon
us in our forward contract.
Interest rates will be different for different currencies and so, for definiteness,
suppose that we are operating in the dollar market, where the (risk-free) interest rate
is r .
• Suppose first that K > S0 er T . The seller, obliged to deliver a unit of stock for $K at
time T , adopts the following strategy: she borrows $S0 at time zero (i.e. sells bonds
to the value $S0 ) and buys one unit of stock. At time T , she must repay $S0 er T , but
she has the stock to sell for $K , leaving her a certain profit of $(K − S0 er T ).
• If K < S0 er T , then the buyer reverses the strategy. She sells a unit of stock at time
zero for $S0 and buys cash bonds. At time T , the bonds deliver $S0 er T of which she
uses $K to buy back a unit of stock leaving her with a certain profit of $(S0 er T − K ).
Unless K = S0 er T , one party is guaranteed to make a profit.

Definition 1.2.1 An opportunity to lock into a risk-free profit is called an arbitrage

opportunity.
The starting point in establishing a model in modern finance theory is to specify
that there is no arbitrage. (In fact there are people who make their living entirely
from exploiting arbitrage opportunities, but such opportunities do not exist for a
significant length of time before market prices move to eliminate them.) We have
proved the following lemma.

Lemma 1.2.2 In the absence of arbitrage, the strike price in a forward contract
with expiry date T on a stock whose value at time zero is S0 is K = S0 er T , where r
is the risk-free rate of interest.
The price S0 er T is sometimes called the arbitrage price. It is also known as the
forward price of the stock.
6 single period models

Remark: In our proof of Lemma 1.2.2, the buyer sold stock that she may not own.
This is known as short selling. This can, and does, happen: investors can ‘borrow’
stock as well as money. 2

Of course forwards are a very special sort of derivative. The argument above won’t
tell us how to value an option, but the strategy of seeking a price that does not provide
either party with a risk-free profit will be fundamental in what follows.
Let us recap what we have done. In order to price the forward, we constructed a
portfolio, comprising one unit of underlying stock and −S0 cash bonds, whose value
at the maturity time T is exactly that of the forward contract itself. Such a portfolio is
said to be a perfect hedge or replicating portfolio. This idea is the central paradigm
of modern mathematical finance and will recur again and again in what follows.
Ironically we shall use expectation repeatedly, but as a tool in the construction of a
perfect hedge.

1.3 The one-step binary model

We are now going to turn to establishing the fair price for European call options,
but in order to do so we first move to a simpler model for the movement of market
prices. Once again we suppose that the market is observed at just two times, that at
which the contract is struck and the expiry date of the contract. Now, however, we
shall suppose that there are just two possible values for the stock price at time T . We
begin with a simple example.

Pricing a Example 1.3.1 Suppose that the current price in Japanese Yen of a certain stock is
European 2500. A European call option, maturing in six months time, has strike price 3000.
call An investor believes that with probability one half the stock price in six months time
will be 4000 and with probability one half it will be 2000. He therefore calculates
the expected value of the option (when it expires) to be 500. The riskless borrowing
rate in Japan is currently zero and so he agrees to pay 500 for the option. Is this a
fair price?

Solution: In the light of the previous section, the reader will probably have guessed
that the answer to this question is no. Once again, we show that one party to this
contract can make a risk-free profit. In this case it is the seller of the contract. Here
is just one of the many possible strategies that she could adopt.

Strategy: At time zero, sell the option, borrow 2000 and buy a unit of stock.

• Suppose first that at expiry the price of the stock is 4000; then the contract will be
exercised and so she must sell her stock for 3000. She then holds (−2000+3000).
That is 1000.
• If, on the other hand, at expiry the price of the stock is 2000, then the option will
not be exercised and so she sells her stock on the open market for just 2000. Her
7 1.3 the one-step binary model

x2

(x1, x 2 )
x1

x1 + 1.8x 2 = 30
x 1 + 0.9x2 = 0
Figure 1.2 The seller of the contract in Example 1.3.1 is guaranteed a risk-free profit if she can buy any
portfolio in the shaded region.

net cash holding is then (−2000 + 2000). That is, she exactly breaks even.
Either way, our seller has a positive chance of making a profit with no risk of making
a loss. The price of the option is too high.
So what is the right price for the option?
Let’s think of things from the point of view of the seller. Writing ST for the price
of the stock when the contract expires, she knows that at time T she needs (ST −
3000)+ in order to meet the claim against her. The idea is to calculate how much
money she needs at time zero, to be held in a combination of stocks and cash, to
guarantee this.
Suppose then that she uses the money that she receives for the option to buy a
portfolio comprising x1 Yen and x2 stocks. If the price of the stock is 4000 at
expiry, then the time T value of the portfolio is x1 er T + 4000x2 . The seller of the
option requires this to be at least 1000. That is, since interest rates are zero,

x1 + 4000x2 ≥ 1000.

If the price is 2000 she just requires the value of the portfolio to be non-negative,

x1 + 2000x2 ≥ 0.

A profit is guaranteed (without risk) for the seller if (x1 , x2 ) lies in the interior of
the shaded region in Figure 1.2. On the boundary of the region, there is a positive
probability of profit and no probability of loss at all points other than the intersection
of the two lines. The portfolio represented by the point (x 1 , x 2 ) will provide exactly
the wealth required to meet the claim against her at time T .
Solving the simultaneous equations gives that the seller can exactly meet the claim
if x 1 = −1000 and x 2 = 1/2. The cost of building this portfolio at time zero is
(−1000 + 2500/2), that is 250. For any price higher than 250, the seller can
make a risk-free profit.
8 single period models

If the option price is less than 250, then the buyer can make a risk-free profit by
‘borrowing’ the portfolio (x 1 , x 2 ) and buying the option. In the absence of arbitrage
then, the fair price for the option is 250. 2

Notice that just as for our forward contract, we did not use the probabilities that we
assigned to the possible market movements to arrive at the fair price. We just needed
the fact that we could replicate the claim by this simple portfolio. The seller can
hedge the contingent claim (ST − 3000)+ using the portfolio consisting of x1
and x2 units of stock.

Pricing One can use exactly the same argument to prove the following result.
formula for
European Lemma 1.3.2 Suppose that the risk-free dollar interest rate (to a time horizon
options τ > T ) is r . Denote the time zero (dollar) value of a certain asset by S0 . Suppose
that the motion of stock prices is such that the value of the asset at time T will be
either S0 u or S0 d. Assume further that

d < er T < u.

At time zero, the market price of a European option with payoff C(ST ) at the maturity
T is    −r T 
1 − de−r T ue −1
C (S0 u) + C (S0 d) .
u−d u−d
Moreover, the seller of the option can construct a portfolio whose value at time T is
exactly (ST − K )+ by using the money received for the option to buy
C (S0 u) − C (S0 d)
φ
(1.1)
S0 u − S0 d
units of stock at time zero and holding the remainder in bonds.
The proof is Exercise 4(a).

1.4 A ternary model

There were several things about the binary model that were very special. In particular
we assumed that we knew that the asset price would be one of just two specified
values at time T . What if we allow three values?
We can try to repeat the analysis of §1.3. Again the seller would like to replicate
the claim at time T by a portfolio consisting of x1 and x2 stocks. This time there
will be three scenarios to consider, corresponding to the three possible values of ST .
If interest rates are zero, this gives rise to the three inequalities

x1 + STi x2 ≥ (STi − 3000)+ , i = 1, 2, 3,

where STi are the possible values of ST . The picture is now something like that in
Figure 1.3.
9 1.5 a characterisation of no arbitrage

x2

i
x1i + ST x2 = (STi – 3000)+

x1

Figure 1.3 If the stock price takes three possible values at time T , then at any point where the seller of
the option has no risk of making a loss, she has a strictly positive chance of making a profit.

In order to be guaranteed to meet the claim at time T , the seller requires (x1 , x2 )
to lie in the shaded region, but at any point in that region, she has a strictly positive
probability of making a profit and zero probability of making a loss. Any portfolio
from outside the shaded region carries a risk of a loss. There is no portfolio that
exactly replicates the claim and there is no unique ‘fair’ price for the option.
Our market is not complete. That is, there are contingent claims that cannot be
perfectly hedged.

Bigger Of course we are tying our hands in our efforts to hedge a claim. First, we are
models only allowing ourselves portfolios consisting of the underlying stock and cash
bonds. Real markets are bigger than this. If we allow ourselves to trade in a third
‘independent’ asset, then our analysis leads to three non-parallel planes in R3 .
These will intersect in a single point representing a portfolio that exactly replicates
the claim. This then raises a question: when is there arbitrage in larger market
models? We shall answer this question for a single period model in the next
section. The second constraint that we have placed upon ourselves is that we are
not allowed to adjust our portfolio between the time of the selling of the contract
and its maturity. In fact, as we see in Chapter 2, if we consider the market to
be observable at intermediate times between zero and T , and allow our seller to
rebalance her portfolio at such times (without changing its value), then we can allow
any number of possible values for the stock price at time T and yet still replicate
each claim at time T by a portfolio consisting of just the underlying and cash
bonds.

1.5 A characterisation of no arbitrage

In our binary setting it was easy to find the right price for an option simply by solving
a pair of simultaneous equations. However, the binary model is very special and,
after our experience with the ternary model, alarm bells may be ringing. The binary
model describes the evolution of just one stock (and one bond). One solution to our
10 single period models

difficulties with the ternary model was to allow trade in another ‘independent’ asset.
In this section we extend this idea to larger market models and characterise those
models for which there are a sufficient number of independent assets that any option
has a fair price. Other than Definition 1.5.1 and the statement of Theorem 1.5.2, this
section can safely be omitted.

A market Our market will now consist of a finite (but possibly large) number of tradable
with N assets. Again we restrict ourselves to single period models, in which the market
assets is observable only at time zero and a fixed future time T . However, the extension
to multiple time periods exactly mirrors that for binary models that we describe in
§2.1.
Suppose then that there are N tradable assets in the market. Their prices at time
zero are given by the column vector
 
S01
 t  2
 S0 
S0 = S01 , S02 , . . . , S0N
 
 ..  .
 . 
S0N

Notation For vectors and matrices we shall use the superscript ‘t’ to denote
transpose.

Uncertainty about the market is represented by a finite number of possible states in

which the market might be at time T that we label 1, 2, . . . , n. The security values
at time T are given by an N × n matrix D = (Di j ), where the coefficient Di j is
the value of the ith security at time T if the market is in state j. Our binary model
corresponds to N = 2 (the stock and a riskless cash bond) and n = 2 (the two states
being determined by the two possible values of ST ).
In this notation, a portfolio can be thought of as a vector θ = (θ1 , θ2 , . . . , θn )t ∈
R N , whose market value at time zero is the scalar product S0 · θ = S01 θ1 + S02 θ2 +
· · · + S0N θ N . The value of the portfolio at time T is a vector in Rn whose ith entry is
the value of the portfolio if the market is in state i. We can write the value at time T
as

 
D11 θ1 + D21 θ2 + · · · + D N 1 θ N
 D12 θ1 + D22 θ2 + · · · + D N 2 θ N 
 
  = D t θ.
 .. 
 . 
D1n θ1 + D2n θ2 + · · · + D N n θ N
11 1.5 a characterisation of no arbitrage

Notation For a vector x ∈ Rn we write x ≥ 0, or x ∈ Rn+ , if x =

(x 1 , . . . , xn ) and xi ≥ 0 for all i = 1, . . . , n. We write x > 0 to mean
x ≥ 0, x = 0. Notice that x > 0 does not require x to be strictly positive in
all its coordinates. We write x  0, or x ∈ Rn++ , for vectors in Rn that are
strictly positive in all coordinates.

In this notation, an arbitrage is a portfolio θ ∈ R N with either

S0 · θ ≤ 0, Dt θ > 0 or S0 · θ < 0, D t θ ≥ 0.

Arbitrage The key to arbitrage pricing in this model is the notion of a state price vector.
pricing
Definition 1.5.1 A state price vector is a vector ψ ∈ Rn++ such that S0 = Dψ.
To see why this terminology is natural, we first expand this to obtain
       
S01 D11 D12 D1n
 S02       
  D21 D22 D2n
  = ψ1 
 ..
 
 + ψ2  ..
 
 + · · · + ψn  ..

.
 ..       
(1.2)
 .  . . .
S0N DN 1 DN 2 DN n

The vector, D (i) , multiplying ψi is the security price vector if the market is in state
i. We can think of ψi as the marginal cost at time zero of obtaining an additional
unit of wealth at the end of the time period if the system is in state i. In other
words, if at the end of the time period, the market is in state i, then the value of
our portfolio increases by one for each additional
 ψi of investment at time zero. To
see this, suppose that we can find vectors θ (i) ∈ R N 1≤i≤n such that

(i) ( j) 1 if i = j,
θ ·D =
0 otherwise.

That is, the value of the portfolio θ (i) at time T is the indicator function that the
(i)
market is in state i. Then, using
(i)
n equation(
 (i)the cost of purchasing θ (i)at time
(1.2),
zero is precisely S0 · θ = j=1 ψ j D
j) · θ = ψi . Such portfolios {θ }1≤i≤n
are called Arrow–Debreu securities.
We shall find a convenient way to think about the state price vector in §1.6, but
first, here is the key result.

Theorem 1.5.2 For the market model described above there is no arbitrage if
and only if there is a state price vector.
12 single period models

n
R

1
M R

Figure 1.4 There is no arbitrage if and only if the regions K and M of Theorem 1.5.2 intersect only at the
origin.

This result, due to Harrison & Kreps (1979), is the simplest form of what is often
known as the Fundamental Theorem of Asset Pricing. The proof is an application of
a Hahn–Banach Separation Theorem, sometimes called the Separating Hyperplane
Theorem. We shall also need the Riesz Representation Theorem. Recall that M ⊆ Rd
is a cone if x ∈ M implies λx ∈ M for all strictly positive scalars λ and that a linear
functional on Rd is a linear mapping F: Rd → R.

Theorem 1.5.3 (Separating Hyperplane Theorem) Suppose M and K are closed

convex cones in Rd that intersect precisely at the origin. If K is not a linear subspace,
then there is a non-zero linear functional F such that F(x) < F(y) for each x ∈ M
and each non-zero y ∈ K .
This version of the Separating Hyperplane Theorem can be found in Duffie (1992).

Theorem 1.5.4 (Riesz Representation Theorem) Any bounded linear functional on

Rd can be written as F(x) = v0 · x. That is F(x) is the scalar product of some fixed
vector v0 ∈ Rd with x.

Proof of Theorem 1.5.2: We take d = 1 + n in Theorem 1.5.3 and set

  
M= −S0 · θ, D t θ : θ ∈ R N ⊆ R × Rn = R1+n ,
K = R+ × Rn+ .
Note that K is a cone and not a linear space, M is a linear space. Evidently, there
is no arbitrage if and only if K and M intersect precisely at the origin as shown in
13 1.6 the risk-neutral probability measure

Figure 1.4. We must prove that K ∩ M = {0} if and only if there is a state price
vector.
(i) Suppose first that K ∩ M = {0}. From Theorem 1.5.3, there is a linear
functional F: Rd → R such that F(z) < F(x) for all z ∈ M and non-zero x ∈ K .
The first step is to show that F must vanish on M. We exploit the fact that M
is a linear space. First observe that F(0) = 0 (by linearity of F) and 0 ∈ M, so
F(x) ≥ 0 for x ∈ K and F(x) > 0 for x ∈ K \{0}. Fix x0 ∈ K with x0 = 0. Now
take an arbitrary z ∈ M. Then F(z) < F(x0 ), but also, since M is a linear space,
λF(z) = F(λz) < F(x0 ) for all λ ∈ R. This can only hold if F(z) = 0. z ∈ M was
arbitrary and so F vanishes on M as required.
We now use this actually to construct explicitly the state price vector from F.
First we use the Riesz Representation Theorem to write F as F(x) = v0 · x for some
v0 ∈ Rd . It is convenient to write v0 = (α, φ) where α ∈ R and φ ∈ Rn . Then

F(v, c) = αv + φ · c for any (v, c) ∈ R × Rn = Rd .

Since F(x) > 0 for all non-zero x ∈ K , we must have α > 0 and φ  0 (consider a
vector along each of the coordinate axes). Finally, since F vanishes on M,

−αS0 · θ + φ · D t θ = 0 for all θ ∈ R N .

Observing that φ · D t θ = (Dφ) · θ, this becomes

−αS0 · θ + (Dφ) · θ = 0 for all θ ∈ R N ,

which implies that −αS0 + Dφ = 0. In other words, S0 = D(φ/α). The vector

ψ = φ/α is a state price vector.
(ii) Suppose now that there is a state price vector, ψ. We must prove that K ∩M =
{0}. By definition, S0 = Dψ and so for any portfolio θ,

S0 · θ = (Dψ) · θ = ψ · (D t θ ). (1.3)

Suppose that for some portfolio θ , (−S0 · θ, D t θ ) ∈ K . Then D t θ ∈ Rn+ and

−S0 · θ ≥ 0. But since ψ  0, if D t θ ∈ Rn+ , then ψ · (D t θ ) ≥ 0 which, by
equation (1.3), tells us that S0 · θ ≥ 0. Thus it must be that S0 · θ = 0 and D t θ = 0.
That is, K ∩ M = {0}, as required. 2

1.6 The risk-neutral probability measure

The state price vector then is the key to arbitrage pricing for our multiasset market
models. Although we have an economic interpretation for it, in order to pave the
way for the full machinery of probability and martingales we must think about it in
a different way.
Recall that all the entries of ψ are strictly positive.
14 single period models
n
State prices Writing ψ0 = i=1 ψi , we can think of
and  
ψ1 ψ2 ψn t
probability ψ
, ,... , (1.4)
ψ0 ψ0 ψ0
as a vector of probabilities for being in different states. It is important to emphasise
that they may have nothing to do with our view of how the markets will move. First
of all,
What is ψ0 ?
Suppose that as in our binary model (where we had a risk-free cash bond) the
market allows positive riskless borrowing. In this general setting we just suppose
that we can replicate such a bond by a portfolio θ for which
 
1
 1 
 
Dt θ =  .  ,
 .. 
1
i.e. the value of the portfolio at time T is one, no matter what state the market is
in. Using the fact that ψ is a state price vector, we calculate that the cost of such a
portfolio at time zero is

n
S0 · θ = (Dψ) · θ = ψ · (D t θ ) = ψi = ψ0 .
i=1
That is ψ0 represents the discount on riskless borrowing. In our notation of §1.2,
ψ0 = e−r T .

Expectation Now under the probability distribution given by the vector (1.4), the expected value
recovered of the ith security at time T is
   n
ψj 1  n
1 i
E STi = Di j = Di j ψ j = S0 ,
j=1
ψ 0 ψ0 j=1 ψ0

where in the last equality we have used S0 = Dψ. That is

 
S0i = ψ0 E STi , i = 1, . . . , n. (1.5)
Any security’s price is its discounted expected payoff under the probability distribu-
tion (1.4). The same must be true of any portfolio. This observation gives us a new
way to think about the pricing of contingent claims.

Definition 1.6.1 We shall say that a claim, C, at time T is attainable if it can be

hedged. That is, if there is a portfolio whose value at time T is exactly C.

Notation When we wish to emphasise the underlying probability measure,

Q, we write EQ for the expectation operator.
15 1.6 the risk-neutral probability measure

Theorem 1.6.2 If there is no arbitrage, the unique time zero price of an attainable
claim C at time T is ψ0 EQ [C] where the expectation is with respect to any
probability measure Q for which S0i = ψ0 EQ [STi ] for all i and ψ0 is the discount on
riskless borrowing.

Remark: Notice that it is crucial that the claim is attainable (see Exercise 11). 2

Proof of Theorem 1.6.2: By Theorem 1.5.2 there is a state price vector and this leads
 
to the probability measure (1.4) satisfying S0i = ψ0 E STi for all i. Since the claim
can be hedged, there is a portfolio θ such that θ · ST = C. In the absence of arbitrage,
the time zero price of the claim is the cost of this portfolio at time zero,


N
θ · S0 = θ · (ψ0 E[ST ]) = ψ0 θi E[STi ] = ψ0 E[θ · ST ].
i=1

The same value is obtained if the expectation

  is calculated for any vector of
probabilities, Q, such that S0i = ψ0 EQ STi since, in the absence of arbitrage, there
is only one riskless borrowing rate and this completes the proof. 2

Risk-neutral In this language, our arbitrage pricing result says that if we can find a probability
pricing vector for which the time zero value of each underlying security is its discounted
expected value at time T then we can find the time zero value of any attainable
contingent claim by calculating its discounted expectation. Notice that we use the
same probability vector, whatever the claim.

Definition 1.6.3 If our market can be in one of n possible states at time T , then
any vector, p = ( p1 , p2 , . . . , pn )  0, of probabilities for which each security’s
price is its discounted expected payoff is called a risk-neutral probability measure or
equivalent martingale measure.
The term equivalent reflects the condition that p  0; cf. Definition 2.3.12. Our
simple form of the Fundamental Theorem of Asset Pricing (Theorem 1.5.2) says
that in a market with positive riskless borrowing there is no arbitrage if and only if
there is an equivalent martingale measure. We shall refer to the process of pricing by
taking expectations with respect to a risk-neutral probability measure as risk-neutral
pricing.

Example 1.3.1 revisited Let us return to our very first example of pricing a European
call option and confirm that the above formula really does give us the arbitrage price.
Here we have just two securities, a cash bond and the underlying stock. The
discount on borrowing is ψ0 = e−r T , but we are assuming that the Yen interest
rate is zero, so ψ0 = 1. The matrix of security values at time T is given by
 
1 1
D= .
4000 2000
16 single period models

Writing p for the risk-neutral probability that the security price vector is (1, 4000)t ,
if the stock price is to be equal to its discounted expected payoff, p must solve

4000 p + 2000(1 − p) = 2500,

which gives p = 0.25. The contingent claim is 1000 if the stock price at expiry
is 4000 and zero otherwise. The expected value of the claim under the risk-neutral
probability, and therefore (since interest rates are zero) the price of the option, is then
0.25 × 1000 = 250, as before.
An advantage of this approach is that, armed with the probability p, it is now
a trivial matter to price all European options on this stock with the same expiry
date (six months time) by taking expectations with respect to the same probability
measure. For example, for a European put option with strike price 3500, the price
is
 
E (K − ST )+ = 0.75 × 1500 = 1125.

Our original argument would lead to a new set of simultaneous equations for each
new claim. 2

Complete We now have a prescription for the arbitrage price of a claim if one exists, that is if
markets the claim is attainable. But we must be a little cautious. Arbitrage prices only exist
for attainable claims – even though the prescription may continue to make sense.

Definition 1.6.4 A market is said to be complete if every contingent claim is

attainable, i.e. if every possible derivative claim can be hedged.

Proposition 1.6.5 A market consisting of N tradable assets, evolving according

to a single period model in which at the end of the time period the market is one of
n possible states, is complete if and only if N ≥ n and the rank of the matrix, D, of
security prices is n.

Proof: Any claim in our market can be expressed as a vector v ∈ Rn . A hedge for
that claim will be a portfolio θ = θ (v) ∈ R N for which D t θ = v. Finding such a θ
amounts to solving n equations in N unknowns. Thus a hedging portfolio exists for
every choice of v if and only if N ≥ n and the rank of D is n, as required. 2

Notice in particular that our single period binary model is complete.

Suppose that our market is complete and arbitrage-free and let Q and Q be any
two equivalent martingale measures. By completeness every claim is attainable, so
for every random variable X , using that there is only one risk-free rate,

EQ [X ] = EQ [X ] .

In other words Q = Q . So in a complete arbitrage-free market the equivalent

martingale measure is unique.
17 1.6 the risk-neutral probability measure

The main Let us summarise the results for our single period markets. They will be reflected
results so far again and again in what follows.

Results for single period models

• The market is arbitrage-free if and only if there exists a martingale measure,
Q.
• The market is complete if and only if Q is unique.
• The arbitrage price of an attainable claim C is e−r T EQ [C] .

Martingale measures are a powerful tool. However, in an incomplete market, if a

claim C is not attainable different martingale measures can give different prices. The
arbitrage-free notion of fair price only makes sense if we can hedge.

Trading in We must sound just one more note of caution. It is important in calculating the
two different risk-neutral probabilities that all the assets being modelled are tradable in the same
markets market. We illustrate with an example.

Example 1.6.6 Suppose that in the US dollar markets the current Sterling
exchange rate is 1.5 (so that £100 costs $150). Consider a European call option that
offers the holder the right to buy £100 for $150 at time T . The riskless borrowing
rate in the UK is u and that in the US is r . Assuming a single period binary model in
which the exchange rate at the expiry time is either 1.65 or 1.45, find the fair price
of this option.

Solution: Now we have a problem. The exchange rate is not tradable. Nor, in dollar
markets, is a Sterling cash bond – it is a tradable instrument, but in Sterling markets.
However, the product of the two is a dollar tradable and we shall denote the value of
this product by St at time t.
Now, since the riskless interest rate in the UK is u, the time zero price of a Sterling
cash bond, promising to pay £1 at time T , is e−uT and, of course, at time T the bond
price is one. Thus we have S0 = e−uT 150 and ST = 165 or ST = 145.
Let p be the risk-neutral probability that ST = 165. Then, since the discounted
price (in the dollar market) of our ‘asset’ at time T must have expectation S0 , we
obtain
150e−uT = e−r T (165 p + 145(1 − p)) ,

which yields
150e(r −u)T − 145
p= .
20
The price of the option is the discounted expected payoff with respect to this
18 single period models

probability which gives

3 
V0 = e−r T 15 p = 150e−uT − 145e−r T .
4
2

Exercises
1 What view about the market is reflected in each of the following strategies?
(a) Bullish vertical spread: Buy one European call and sell a second one with the
same expiry date, but a larger strike price.
(b) Bearish vertical spread: Buy one European call and sell a second one with the
same expiry date but a smaller strike price.
(c) Strip: Buy one European call and two European puts with the same exercise date
and strike price.
(d) Strap: Buy two European calls and one European put with the same exercise date
and strike price.
(e) Strangle: Buy a European call and a European put with the same expiry date but
different strike prices (consider all possible cases).
2 A butterfly spread represents the complementary bet to the straddle. It has the
following payoff at expiry:

Payoff

E1 E2 ST

Find a portfolio consisting of European calls and puts, all with the same expiry date,
that has this payoff.
3 Suppose that the price of a certain asset has the lognormal distribution. That is
log (ST /S0 ) is normally distributed with mean ν and variance σ 2 . Calculate E[ST ].
4 (a) Prove Lemma 1.3.2.
(b) What happens if we drop the assumption that d < er T < u?
5 Suppose that at current exchange rates, £100 is worth e160. A speculator believes
that by the end of the year there is a probability of 1/2 that the pound will have fallen
to e1.40, and a 1/2 chance that it will have gained to be worth e2.00. He therefore
buys a European put option that will give him the right (but not the obligation) to
19 exercises

sell £100 for e1.80 at the end of the year. He pays e20 for this option. Assume that
the risk-free interest rate is zero across the Euro-zone. Using a single period binary
model, either construct a strategy whereby one party is certain to make a profit or
prove that this is the fair price.
6 How should we modify the analysis of Example 1.3.1 if we are pricing an option
based on a commodity such as oil?
7 Show that if there is no arbitrage in the market, then any portfolio constructed at time
zero that exactly replicates a claim C at time T has the same value at time zero.
8 Put–call parity: Denote by Ct and Pt respectively the prices at time t of a European
call and a European put option, each with maturity T and strike K . Assume that the
risk-free rate of interest is constant, r , and that there is no arbitrage in the market.
Show that for each t ≤ T ,

Ct − Pt = St − K e−r (T −t) .

9 Use risk-neutral pricing to value the option in Exercise 5. Check your answer by
constructing a portfolio that exactly replicates the claim at the expiry of the contract.
10 What is the payoff of a forward at expiry? Use risk-neutral pricing to solve the pricing
problem for a forward contract.
11 Consider the ternary model for the underlying of §1.4. How many equivalent
martingale measures are there? If there are two different martingale measures, do
they give the same price for a claim? Are there arbitrage opportunities?
12 Suppose that the value of a certain stock at time T is a random variable with
distribution P. Note we are not assuming a binary model. An option written on
this stock has payoff C at time T . Consider a portfolio consisting of φ units of the
underlying and ψ units of bond, held until time T , and write V0 for its value at time
zero. Assuming that interest rates are zero, show that the extra cash required by the
holder of this portfolio to meet the claim C at time T is


C − V0 − φ (ST − S0 ) .

Find expressions for the values of V0 and φ (in terms of E [ST ], E [C], var [ST ] and
cov (ST , C)) that minimise  
E 2 ,
and check that for these values E [] = 0.
Prove that for a binary model, any claim C depends linearly on ST − S0 . Deduce that
in this case we can find V0 and φ such that  = 0.  
When the model is not complete, the parameters that minimise E  2 correspond
to finding the best linear approximation to C (based on ST − S0 ). The corresponding
value of the expectation is a measure of the intrinsic risk in the option.
20 single period models

13 Exchange rate forward: Suppose that the riskless borrowing rate in the UK is u
and that in the USA is r . A dollar investor wishes to set the exchange rate, C T , in
a forward contract in which the two parties agree to exchange C T dollars for one
pound at time T . If a pound is currently C0 dollars, what is the fair value of C T ?
14 The option writer in Example 1.6.6 sells a digital option to a speculator. This amounts
to a bet that the asset price will go up. The payoff is a fixed amount of cash if the
exchange rate goes to $165 per £100, and nothing if it goes down. If the speculator
pays $10 for this bet, what cash payout should the option writer be willing to write
into the option? You may assume that interest rates are zero.
15 Suppose now that the seller of the option in Example 1.6.6 operates in the Sterling
markets. Reexpress the market in terms of Sterling tradables and find the corre-
sponding risk-neutral probabilities. Are they the same as the risk-neutral probabilities
calculated by the dollar trader? What is the dollar cost at time zero of the option as
valued by the Sterling trader?
This is an example of change of numeraire. The dollar trader uses the dollar bond as
the reference risk-free asset whereas the Sterling trader uses a Sterling bond.