CHAPTER 3

One-Period Models

Assumptions:

(1) ddd t = 0, 1.

dddddddd t = 0.

(2) sample space Ω = {ω1 , ω2 , ..., ωK } with P({ωi }) > 0 for all i = 1, 2, ..., K.

at time 0, F0 = {∅, Ω}.

at time 1, F1 = the collection of all possible subsets of Ω.

Ft dddddddddddddd t d information dd.

(3) Suppose that there are 1 bond and N stocks⎛in ⎞ the financial market.

⎜Bt ⎟
security price S̄t = (Bt , St1 , St2 , · · · , StN )T = ⎝ ⎠ for t = 0, 1,
St
where T means the transpose of a matrix, St = (St1 , St2 , · · · , StN )T

dddddddddd B0 and S0i are constant, i.e., S̄0 is a deterministic vector.

dddddddddddddd B1 d S1 . dd B1 is a constant, the price of

the ith stock S1i : Ω −→ R+ is a random variable for i = 1, ..., N .

ddddddddd (See Figure 3.1).

Note: dddddddd probability space (Ω, F, P) d finite probability space ddd

d. ddddddddddddddd probability space d, ddddddddddd

∗
dddd dd.
59
60 3. ONE-PERIOD MODELS

_
S1(w1)

_
S1(w2)

_
S0

_
S1(wK)

at time 0 at time 1

Figure 3.1. price in the one-period model

3.1. Portfolio

Definition 3.1.∗ A portfolio is a vector h̄ = (h0 , · · · , hN )T ∈ RN +1 , where hi denotes

the number of shares of the ith asset.

Remark 3.2.∗ The value of the portfolio h̄ at time 0 is given by

V0 (h̄) = h̄ · S̄0 = h0 B0 + h1 S01 + · · · + hN S0N .

The value of the portfolio h̄ at time 1 is given by

V1 (h̄) = h̄ · S̄1 = h0 B1 + h1 S11 + ... + hN S1N .

The profit of the portfolio h̄ is given by

G(h̄) := V1 (h̄) − V0 (h̄) = h̄(S̄1 − S̄0 ) = h̄ · ΔS̄ .

ddddd
Example 3.3. Suppose that
⎛ ⎞ ⎛ ⎞ ⎛⎞
⎜1⎟ ⎜1.02⎟ ⎜1.02⎟
S̄0 = ⎝ ⎠ , S̄1 (ω1 ) = ⎝ ⎠, S̄1 (ω2 ) = ⎝ ⎠.
10 12 9
 3.2. DERIVATIVE SECURITIES 61
⎛ ⎞
⎜−10⎟1
If the portfolio h̄ = ⎝ ⎠ , then its value at time 0 is given by
1
⎛ ⎞⎛ ⎞
⎜ 1 ⎟ ⎜−10⎟
V0 (h̄) = h̄ · S̄0 = ⎝ ⎠ ⎝ ⎠ = 0.
10 1

Moreover, at time 1,

V1 (h̄)(ω1 ) = h̄ · S̄1 (ω1 ) = −10 × 1.02 + 12 = 1.8,

V1 (h̄)(ω2 ) = h̄ · S̄1 (ω2 ) = −10 × 1.02 + 9 = −1.2.

Thus, the value of the portfolio h̄ at time 1 is given by

⎛ ⎞ ⎛ ⎞
⎜ V1 (h̄)(ω1 ) ⎟ ⎜ 1.8 ⎟
V1 (h̄) = ⎝ ⎠=⎝ ⎠.
V1 (h̄)(ω2 ) −1.2

The profit of h̄ is given by

⎛ ⎞
⎜ 1.8 ⎟
G(h̄) = V1 (h̄) − V0 (h̄) = ⎝ ⎠.
−1.2

3.2. Derivative securities

ddddddd, ddd, dddd securities dd, dd option (ddd), derivative

securities (ddddd), or contingent claim (dddddd).

Example 3.4.∗ Forward contract (dddd)

ddddddddddddddddddddddddddddd. One agent agrees

1dddddd, dd, dddddd, dd/dd

62 3. ONE-PERIOD MODELS

to sell to another agent an asset at time 1 for a price K which is specified at time 0.

payoff = S1i − K.

Forward contract ddd (future contract) ddddd. dddddddddddd, d

dddddd, dddddd. d forward contract dddddddd, ddddddd

dddddd.

Example 3.5.∗ Call option (dd)

The owner has the right, but not the obligation to buy the asset at time 1 for a fixed

price K called the strike price.

⎧
⎪
⎪
⎨S1i − K, if S1i > K,
payoff = (S1i +
− K) =
⎪
⎪
⎩0, if S1i ≤ K.

Example 3.6.∗ Put option (dd)

The owner has the right, but not the obligation to sell the asset at time 1 for a fixed price

K.

⎧
⎪
⎪
⎨K − S i ,
1 if S1i < K,
payoff = (K − S1i )+ =
⎪
⎪
⎩0, if S1i ≥ K.

Definition 3.7.∗

(1) A contingent claim (d d d d d d) is a random variable C on a probability

space (Ω, F, P) such that

0≤C<∞ P-a.s.
 3.3. ABSENCE OF ARBITRAGE 63

(2) A contingent claim C is called a derivative of B, S 1 , ..., S N if it is measurable

with respect to σ(B, S 1 , ..., S N ), i.e.,

C = f (B, S 1 , ..., S N )

for a measurable function f on RN +1 .

Question: What is the price of a contingent claim?

3.3. Absence of arbitrage

Definition 3.8.∗ A portfolio h̄ ∈ RN +1 is called an arbitrage opportunity if

(i) V0 (h̄) = h̄ · S̄0 ≤ 0

(ii) V1 (h̄) = h̄ · S̄1 ≥ 0 P-a.s. and P(V1 (h̄) > 0) > 0.

(i) dddddddddddd 0 dddddddddd 0, d (ii) ddddddd

1 ddddddddddddd 0, dddd 0 dddddddddd 0. dddd, d

dddddddddddddd, dddddddd.

Remark 3.9. If Ω = {ω1 , ..., ωK } and there is an arbitrage opportunity, then there

exists a portfolio h̄ ∈ RN +1 such that

(1) V0 (h̄) ≤ 0

(2) V1 (h̄)(ωi ) ≥ 0 for all i and V1 (h̄)(ωj ) > 0 for some j.

Example 3.10. (1) Suppose that Ω = {ω1 , ω2 } with P({ωi }) > 0 for i = 1, 2.

Let
⎛ ⎞ ⎛ ⎞ ⎛ ⎞
⎜1⎟ ⎜1.1⎟ ⎜1.1⎟
S̄0 = ⎝ ⎠ , S̄1 (ω1 ) = ⎝ ⎠ , S̄1 (ω2 ) = ⎝ ⎠ .
10 11 12
64 3. ONE-PERIOD MODELS
⎛ ⎞
⎜−10⎟
Then h̄ = ⎝ ⎠ is an arbitrage opportunity, since
1
⎛ ⎞ ⎛ ⎞
⎜ 1 ⎟ ⎜−10⎟
V0 (h̄) = h̄ · S̄0 = ⎝ ⎠ · ⎝ ⎠=0
10 1
⎛ ⎞ ⎛ ⎞
⎜1.1⎟ ⎜−10⎟
V1 (h̄)(ω1 ) = h̄ · S̄1 (ω1 ) = ⎝ ⎠ · ⎝ ⎠=0
11 1
⎛ ⎞ ⎛ ⎞
⎜1.1⎟ ⎜−10⎟
V1 (h̄)(ω2 ) = h̄ · S̄1 (ω2 ) = ⎝ ⎠ · ⎝ ⎠ = 1 > 0.
12 1

(2) Suppose that Ω = {ω1 , ω2 } with P({ωi }) > 0 for i = 1, 2. Let

⎛ ⎞ ⎛ ⎞ ⎛ ⎞
⎜1⎟ ⎜1.2⎟ ⎜1.2⎟
S̄0 = ⎝ ⎠ , S̄1 (ω1 ) = ⎝ ⎠ , S̄1 (ω2 ) = ⎝ ⎠ .
10 11 13

Then there is no arbitrage opportunity in this model.

(3) Consider Ω = [0, 1], F = B1 , P = Lebesgue measure m. Let

⎛ ⎞ ⎛ ⎞
⎜1⎟ ⎜ 1 ⎟
S̄0 = ⎝ ⎠ , S̄1 = ⎝ ⎠,
10 10Z
⎛ ⎞
⎜ 10 ⎟
where Z is uniformly distributed on [0, 1]. Then h̄ = ⎝ ⎠ is an arbitrage
−1
opportunity, since
⎛ ⎞ ⎛ ⎞
⎜ 10 ⎟ ⎜ 1 ⎟
V0 (h̄) = h̄ · S̄0 = ⎝ ⎠ · ⎝ ⎠ = 0
−1 10
⎛ ⎞ ⎛ ⎞
⎜ 10 ⎟ ⎜ 1 ⎟
V1 (h̄) = h̄ · S̄1 = ⎝ ⎠ · ⎝ ⎠ = 10 − 10Z ≥ 0,
−1 10Z
 3.3. ABSENCE OF ARBITRAGE 65

and

P(V1 (h̄) > 0) = P(10 − 10Z > 0) = P(Z < 1) = 1.

Assumption: Suppose the interest rate of the bond = r > −1, i.e.,

B0 = B, B1 = B(1 + r).

Lemma 3.11.∗ The following statements are equivalent

(1) The market model admits arbitrage opportunity

(2) There exists a vector h ∈ RN such that

hS1 ≥ (1 + r)h · S0 P − a.s.

and

P[h · S1 > (1 + r)h · S0 ] > 0.

dd lemma ddd Definition 3.8 dddddddd bond ddddddd, ddd

dddddddd interest rate r dd constant dddddddd.

Proof. (1) =⇒ (2): Let h̄ = (h0 , h)T be an arbitrage opportunity. Then

0 ≥ h̄ · S̄0 = h0 B + h · S0

. Thus,

h · S1 − (1 + r)h · S0 ≥ h · S1 + (1 + r)h0 B

= h0 B1 + h · S1 = h̄ · S̄1 .

Since h̄ is an arbitrage opportunity,

h · S1 − (1 + r)h · S0 ≥ 0 P − a.s.
66 3. ONE-PERIOD MODELS

and

P[h · S1 > (1 + r)h · S0 ] > 0.

⎛ ⎞
0
⎜h ⎟ h · S0
(2) =⇒ (1): Suppose h satisfies the statement (2). Let h̄ = ⎝ ⎠ with h0 = − .
B
h
Then

V0 (h̄) = h̄ · S̄0 = h0 B + h · S0 = −h · S0 + h · S0 = 0,

V1 (h̄) = h̄ · S̄1 = h0 (1 + r)B + h · S1 ≥ −(1 + r)h · S0 + h · S1 .

By assumption this implies that

V1 (h̄) ≥ 0 P − a.s. and P(V1 (h̄) > 0) > 0.

Thus, h̄ is an arbitrage opportunity. 

Definition 3.12.∗ If there exists no arbitrage opportunity in a financial market we say

that there is no arbitrage (arbitrage-free, no free lunch) in this financial market.

No arbitrage dd financial mathematics dddddddd. ddddd financial

model dddddd.

3.4. No arbitrage and price system

ddd, dddddddd no arbitrage ddddd, dddd finite state space d

dddd. dddddddddddddddd case dddddd, dddddddd

dddddddddddd.
 3.4. NO ARBITRAGE AND PRICE SYSTEM 67

Definition 3.13. (1) The (N + 1) × K matrix D, defined by

⎛ ⎞
⎜ B1 (ω1 ) B1 (ω2 ) · · · B1 (ωK ) ⎟
⎜ ⎟
⎜ 1 ⎟
⎜ S1 (ω1 ) S11 (ω2 ) 1
· · · S1 (ωK ) ⎟
D=⎜ ⎜ .
⎟ = (S̄1 (ω1 ), ..., S̄1 (ωK ))
⎟
⎜ .. .. .. .. ⎟
⎜ . . . ⎟
⎝ ⎠
S1N (ω1 ) S1N (ω2 ) · · · S1N (ωK )

is called the payoff matrix.

(2) The vector b := S̄0 = (B0 , S01 , · · · , S0N )T is called the price vector.

(3) (S̄0 , S̄1 ) ∼

= (b, D) ∈ RN +1 × M(N +1)×K (R)2 is called the market model.

Example 3.14. As in Example 3.3,

⎛ ⎞ ⎛ ⎞
⎜1⎟ ⎜1.02 1.02⎟
b = ⎝ ⎠, D=⎝ ⎠
10 12 9

⎛ ⎞
⎜ c1 ⎟
⎜.⎟
Notation 3.15. Let C = ⎜ .⎟
⎜ . ⎟, for c1 , ..., cn ∈ R.
⎝ ⎠
cn

(1) C ≥ 0 if ci ≥ 0 for all i = 1, 2, ..., n.

(2) C > 0 if ci ≥ 0 for all i = 1, 2, ..., n and ck > 0 for at least one k.

(3) C 0 if ci > 0 for all i = 1, 2, ..., n.

Remark 3.16. Remark 3.9 can be written as

h̄ · b ≤ 0 and DT h̄ > 0.

ddddddddddd, arbitrage opportunity ddddddd.

2M means the collection of all (N + 1) × K matrices with real-valued entries.

(N +1)×K (R)
68 3. ONE-PERIOD MODELS

Remark 3.17. An alternative definition of arbitrage opportunity is

h̄ · b ≤ 0 and DT h̄ > 0

or

h̄ · b < 0 and DT h̄ ≥ 0. (3.1)

ddddd Remark 3.16 ddddddd (3.1) dddd. (3.1) ddddddddd

dd strong arbitrage opportunity. dd, ddddddddddd. ddddd no

arbitrage ddd. In fact, ddddddd (3.1) dd, ddddd arbitrage opportunity

(in the sense of Remark 3.16) dd, ddddddddddddddd no arbitrage d

ddd.

Claim: If there exists a portfolio h̄ satisfying (3.1), there exists an arbitrage opportunity

h̄∗ in the sense of Remark 3.16.

Let h̄ = (h0 , h)T . Set

 T
∗ 0 h̄ · b
h̄ = h − ,h ,
B0

then

⎛ ⎞ ⎛ ⎞
h̄ · b
0
⎜ h − B0 ⎟ ⎜ B0 ⎟
h̄∗ · b = ⎝ ⎠·⎝ ⎠
h S0

= h0 B − h̄ · b + h · S0 = h̄ · b − h̄ · b = 0,
 3.4. NO ARBITRAGE AND PRICE SYSTEM 69

and
⎛ ⎞
⎜ B1 (ω1 ) S11 (ω1 ) ··· S1N (ω1 ) ⎟⎛
⎜ ⎟ ⎞
⎜ ⎟ h0 − h̄ · b
⎜ B1 (ω2 ) S11 (ω2 ) · · · S1N (ω2 ) ⎟⎜
DT h̄∗ = ⎜ ⎟⎝ B0 ⎟ ⎠
⎜ .. .. .. .. ⎟
⎜ . . . . ⎟
⎜ ⎟ h
⎝ ⎠
B1 (ωK ) S11 (ωK ) · · · S1N (ωK )
⎛ ⎞
⎜ B1 (ω1 ) ⎟
h̄ · b ⎜ .. ⎟
= DT h̄ − ⎜ ⎟ 0
B0 ⎜ ⎟
.
⎝ ⎠
B1 (ωK )

due to (3.1). Hence, h̄∗ is an arbitrage opportunity in the sense of Remark 3.16.

Theorem 3.18 (Fundamental Theorem of Asset Pricing). In the market model (b, D),

the following statements are equivalent:

(1) (b, D) is arbitrage-free.

(2) There exists ϕ ∈ RK+1 such that ϕ 0 and

ϕ · L(h̄) = 0 for all h̄ ∈ RN +1 ,

where L : RN +1 −→ RK+1 is a linear transformation given by

⎛ ⎞ ⎛ ⎞
T
⎜−h̄ · b⎟ ⎜ −b ⎟
L(h̄) = ⎝ ⎠=⎝ ⎠ h̄.
DT h̄ DT

(3) There exists a vector ψ ∈ RK , ψ 0 such that

b = Dψ. (3.2)
70 3. ONE-PERIOD MODELS

Proof. (1) =⇒ (2): Suppose that the market model (b, D) is arbitrage-free. Then

there is no h̄ ∈ RN +1 such that

⎛ ⎞
⎜−h̄ · b⎟
L(h̄) = ⎝ ⎠ > 0.
T
D h̄
⎧⎛ ⎞ ⎫
⎪
⎨ −h̄ · b ⎪
⎬
⎜ ⎟ N +1
Hence, the set ⎝ ⎠ : h̄ ∈ R is a proper subset of RK+1 .
⎪
⎩ D h̄
T ⎪
⎭

By ”Separating Theorem”3, there exists a vector φ ∈ RK+1 with φ 0 such that

φ · L(h̄) = 0 for all h̄ ∈ RN +1 .

Figure 3.2
⎛ ⎞
⎜φ0 ⎟
(2) =⇒ (3): Let φ = ⎝ ⎠ ∈ RK+1 , φ0 ∈ R, φ1 ∈ RK with
φ1

φ 0 and φ · L(h̄) = 0 for all h̄ ∈ RN +1 .

3separating theorem ddddddddd, ddddddd disjoint convex sets dddddddd

ddd. ddddddddddddddddddddddd: dddddddddddddddd (d

ddddddddddddd, dddddddddddddddddd) ddd, ddddddddd

ddddddddddddddd (d Figure 3.2).

 3.4. NO ARBITRAGE AND PRICE SYSTEM 71

Since φ 0, we have φ0 > 0 and φ1 0. Thus,

⎛ ⎞ ⎛ ⎞
⎜φ0 ⎟ ⎜−h̄ · b⎟ T
0 = φ · L(h̄) = ⎝ ⎠ · ⎝ ⎠ = −φ0 h̄ · b + φ1 · D h̄.
φ1 DT h̄

φ1
Let ψ = , this implies that
φ0
φ1
h̄ · b = · DT h̄ = ψ · DT h̄ = h̄ · Dψ for all h̄ ∈ RN +1 .
φ0

Hence, b = Dψ for some ψ ∈ RK with ψ 0.

(3) =⇒ (1): Since

h̄ · b = ψ · DT h̄ for all h̄ ∈ RN +1 .

If DT h̄ > 0, due to ψ 0, we have ψ · DT h̄ > 0. Hence, h̄ · b > 0. By Remark 3.16, we

see that the market model (b, D) is arbitrage-free. 

ddddddddd. ddddd (b, D) d, ddddd market model ddd no

arbitrage dddddd (ddd assertion (3)). ddddddddddddd: dd

dd finite probability space. dddddd, dddddddd, dddddddd

section ddd.

Example 3.19. (One-period, two states model) Suppose that the sample space Ω =

{ω1 , ω2 }. Consider a market model with

⎛ ⎞ ⎛ ⎞
⎜B ⎟ ⎜B(1 + r) B(1 + r)⎟
b = ⎝ ⎠, D = ⎝ ⎠,
S0 S1 (ω1 ) S1 (ω2 )

with S1 (ω1 )⎛> S⎞

1 (ω2 ). Suppose that the market model (bD) is arbitrage-free. Then there

⎜ψ1 ⎟
exists ψ = ⎝ ⎠ 0 such that
ψ2
b = Dψ,
72 3. ONE-PERIOD MODELS

i.e., ⎛ ⎞ ⎛ ⎞⎛ ⎞
⎜ B ⎟ ⎜B(1 + r) B(1 + r)⎟ ⎜ψ1 ⎟
⎝ ⎠=⎝ ⎠⎝ ⎠.
S0 S1 (ω1 ) S1 (ω2 ) ψ2
In other words, ψ satisfies
⎧
⎪
⎪
⎨B = B(1 + r)ψ1 + B(1 + r)ψ2 ,
⎪
⎪
⎩S0 = S1 (ω1 )ψ1 + S1 (ω2 )ψ2 ,

and the corresponding solution is given by

⎧
⎪
⎪ 1 (1 + r)S0 − S1 (ω2 )
⎪
⎨ψ1 = · ,
1+r S1 (ω1 ) − S1 (ω2 )
⎪
⎪ 1 S1 (ω1 ) − (1 + r)S0
⎪
⎩ψ2 = · .
1+r S1 (ω1 ) − S1 (ω2 )
Thus, ψ 0 if and only if
⎧
⎪
⎪
⎨(1 + r)S0 > S1 (ω2 ),
⎪
⎪
⎩S1 (ω1 ) > (1 + r)S0 ,

i.e., the market model is arbitrage-free if and only if the stock price at time 0 and 1

satisfies
S1 (ω2 ) S1 (ω1 )
< S0 < .
1+r 1+r

Exercise

(1) Consider the market model

⎛⎛ ⎞ ⎛ ⎞⎞
⎜⎜ 56 ⎟ ⎜ 60 59 57 ⎟⎟
⎜⎜ ⎟ ⎜ ⎟⎟
(b, D) = ⎜ ⎜ ⎟ ⎜ ⎟⎟
⎜⎜ 8 ⎟ , ⎜ 11 7 10 ⎟⎟ .
⎝⎝ ⎠ ⎝ ⎠⎠
33 32 36 41

(a) Show that (b, D) is arbitrage-free and complete, and find the vector ψ such

that b = Dψ.
 3.5. MARTINGALE MEASURE 73

(b) Find the interest rate of the riskless asset in this market model.

3.5. Martingale measure

Remark 3.20. By Theorem 3.18, we have

b = Dψ.

Thus, ⎛ ⎞ ⎛ ⎞⎛ ⎞
⎜ B0 ⎟ ⎜ B1 (ω1 ) B1 (ω2 ) ··· B1 (ωK ) ⎟ ⎜ ψ1 ⎟
⎜ ⎟ ⎜ ⎟⎜ ⎟
⎜ 1⎟ ⎜ 1 ⎟⎜ ⎟
⎜ S0 ⎟ ⎜ S1 (ω1 ) S11 (ω2 ) · · · S11 (ωK ) ⎟ ⎜ ψ2 ⎟
⎜ ⎟=⎜ ⎟⎜ ⎟.
⎜ . ⎟ ⎜ . .. ... .. ⎟⎜ . ⎟
⎜ .. ⎟ ⎜ .. . . ⎟ ⎜ .. ⎟
⎜ ⎟ ⎜ ⎟⎜ ⎟
⎝ ⎠ ⎝ ⎠⎝ ⎠
S0N S1N (ω1 ) S1N (ω2 ) · · · S1N (ωK ) ψK
In the form of the system of equations
⎧
⎪
⎪
⎪
⎪ B0 = B1 (ω1 )ψ1 + · · · + B1 (ωK )ψK
⎪
⎪
⎪
⎪
⎪
⎪
⎪
⎨S 1 = S 1 (ω )ψ + · · · + S 1 (ω )ψ
0 1 1 1 1 K K
(3.3)
⎪
⎪ ..
⎪
⎪ .
⎪
⎪
⎪
⎪
⎪
⎪
⎪
⎩S0N = S1N (ω1 )ψ1 + · · · + S1N (ωK )ψK

If the interest rate = constant r, e.g. B0 = B, B1 = B(1 + r), then

1
ψ1 + · · · + ψK = .
1+r

Thus, (3.3) can be written as

(1 + r)S0i = S1i (ω1 )(1 + r)ψ1 + · · · + S1i (ωK )(1 + r)ψK

ψ1 ψK
= S1i (ω1 ) + · · · + S1i (ωK )
ψ1 + · · · + ψK ψ1 + · · · + ψK

for all 1 ≤ i ≤ N .
74 3. ONE-PERIOD MODELS

Remark 3.21. Define

ψj
Q({ωj }) = for all 1 ≤ j ≤ K. (3.4)
ψ1 + · · · + ψK

Then Q is a probability measure.

Definition 3.22. The probability measure Q defined by (3.4) is called a risk-neutral

probability measure.

Remark 3.23. In general, Q in (3.4) is not unique.

dd Theorem 3.18 dddddddd.

Theorem 3.24. In an arbitrage-free market model (S̄0 , S̄1 ) ∼

= (b, D), there is a risk-

neutral measure Q such that

 
S1i
S0i = EQ for all 1 ≤ i ≤ N, (3.5)
1+r

where EQ means the expectation with respect to the probability measure Q.

ddddddddddd, dddddddddddd, dddddddddddd

ddddddd.

Note that (3.5) is equivalent to the equation b = Dψ.

Example 3.25. As in Example 3.19

⎛ ⎞ ⎛ ⎞
⎜B ⎟ ⎜B(1 + r) B(1 + r)⎟
b = ⎝ ⎠, D=⎝ ⎠,
S0 S1 (ω1 ) S1 (ω2 )

with S1 (ω1 ) > S1 (ω2 ), then

1 (1 + r)S0 − S1 (ω2 )
ψ1 = ·
1+r S1 (ω1 ) − S1 (ω2 )
1 S1 (ω1 ) − (1 + r)S0
ψ2 = · .
1+r S1 (ω1 ) − S1 (ω2 )
 3.5. MARTINGALE MEASURE 75

Thus, the risk-neutral probability measure Q is given by

ψ1 S0 (1 + r) − S1 (ω2 )
Q({ω1 }) = =
ψ1 + ψ2 S1 (ω1 ) − S1 (ω2 )
ψ2 S1 (ω1 ) − S0 (1 + r)
Q({ω2 }) = =
ψ1 + ψ2 S1 (ω1 ) − S1 (ω2 )

and

EQ [S1 ] = S1 (ω1 )Q({ω1 }) + S1 (ω2 )Q({ω2 }) = (1 + r)S0 .

Thus,
 
1 S1
S0 = EQ [S1 ] = EQ .
1+r 1+r

Remark 3.26.∗ Let

X0i = S0i ,
S1i
X1i = discounted stock price.
1+r

Then, (3.5) implies that

X0i = EQ [X1i ] = EQ [X1i | F0 ],

i.e., (Xki , Fk )k=0,1 is a martingale for all i. ddddddd one-period model dddd

dd. ddddddddd multi-period model. d multi-period model ddddddd

d. Hence, the risk-neutral measure Q is called a martingale measure.

Remark 3.27.∗

(1) (Xki )k=0,1 is a martingale with respect to Q for all 1 ≤ i ≤ N . This implies

that (hi Xki )k=0,1 is a martingale with respect to Q for all 1 ≤ i ≤ N . Thus,
 
h̄ · X̄k k=0,1 is a martingale with respect to Q, where X̄k = (Bk , Xk1 , ..., XkN )T .
76 3. ONE-PERIOD MODELS

(2) The random variable

S1i
Yi = − S0i = X1i − X0i
1+r

is called the discounted net gain. Thus,

EQ [Y i ] = 0, for all 1 ≤ i ≤ N.

Definition 3.28.∗

(1) Two probability measures P and Q are called equivalent, denoted by P ∼ Q, if

P(A) = 0 ⇐⇒ Q(A) = 0,

for all A ∈ F.

(2) An equivalent risk-neutral measure is also called an pricing measure or an equivalent

martingale measure (EMM).

Example 3.29. (1) Let Ω = {1, 2, 3, 4} and F the collection of all subsets of Ω.

Set

P1 ({1}) = 1/2, P1 ({2}) = 1/4, P1 ({3}) = 1/6, P1 ({4}) = 1/12,

P2 ({1}) = 1/5, P2 ({2}) = 1/5, P2 ({3}) = 1/5, P2 ({4}) = 2/5,

P3 ({1}) = 1/4, P3 ({2}) = 1/4, P3 ({3}) = 0, P3 ({4}) = 1/2.

Then P1 ∼ P2 , but P1 ∼ P3 and P2 ∼ P3 .

(2) Consider a probability space (Ω, F, P) and let X be a random variable satisfying

X ≥ 1/2, P-a.s. and E[X] = 1. Define


Q(A) = X dP,
A

for all A ∈ F, then

(a) Q is a probability measure;

 3.5. MARTINGALE MEASURE 77

(b) P ∼ Q.

Theorem 3.30 (Fundamental Theorem of Asset Pricing).∗ A market model is arbitrage-

free if and only if the set

P = {Q : Q is a risk-neutral measure with P ∼ Q} = ∅.

Proof. “⇐=” Suppose that there exists a risk-neutral measure Q ∈ P. Let h̄ ∈ RN +1

with

h̄ · S̄1 ≥ 0 P-a.s. and E[h̄ · S̄1 ] > 04.

Since Q is a martingale measure,

 
S̄1 1
h̄ · S̄0 = h̄ · EQ = EQ [h̄ · S̄1 ] > 0.
1+r 1+r

This implies that the market model is arbitrage-free.

“=⇒” dddddddddddd, dddddd Föllmer and Schied [12] P.7. 

dddddd risk-neutral measure ddddd.

Example 3.31. Consider a financial market with one bond and one stock. Consider

the sample space Ω = {ω1 , ω2 , ..., ωK } (K ≥ 2).

⎛ ⎞ ⎛ ⎞
⎜1⎟ ⎜ 1 + r 1 + r ··· 1+r ⎟
b = ⎝ ⎠, D=⎝ ⎠
S0 S1 (ω1 ) S1 (ω2 ) · · · S1 (ωK )

4d h̄ · S̄1 ≥ 0 dddd, ddd P(h̄ · S̄1 > 0) > 0 dddd.

78 3. ONE-PERIOD MODELS

(S1 is not a constant). If this financial market is arbitrage-free, there exists ψ ∈ RK ,

ψ 0 such that
⎛ ⎞
⎛ ⎞ ⎛ ⎞
⎜ ψ1 ⎟
⎜1⎟ ⎜ 1 + r 1 + r ··· 1 + r ⎟⎜ . ⎟
⎝ ⎠ = b = Dψ = ⎝ ⎠⎜ . ⎟
⎜ . ⎟
S0 S1 (ω1 ) S1 (ω2 ) · · · S1 (ωK ) ⎝ ⎠
ψK

Thus,
⎧
⎪
⎪ 1
⎨ψ1 + · · · + ψK = ,
1+r
⎪
⎪
⎩ψ1 S1 (ω1 ) + · · · + ψK S1 (ωK ) = S0 .

How many strictly positive solutions does this system of equations?

(1) K = 2: We know that S1 (ω1 ) = S1 (ω2 ). Without loss of generality, we assume

that S1 (ω1 ) > S1 (ω2 ). By Example 3.25, the equivalent martingale measure is

unique and is given by

ψ1 S0 (1 + r) − S1 (ω2 )
Q({ω1 }) = = ,
ψ1 + ψ2 S1 (ω1 ) − S1 (ω2 )
ψ2 S1 (ω1 ) − S0 (1 + r)
Q({ω2 }) = = .
ψ1 + ψ2 S1 (ω1 ) − S1 (ω2 )

(2) K > 2: the equivalent martingale measure is no more unique. In fact, there are

infinite many equivalent martingale measures in this case.

Theorem 3.30 ddddd, ddddddddd. dd, probability measure Q dd

d, d infinite many assets ddddd.

Example 3.32. Theorem 3.30 is not true in a market model with infinite many assets,

e.g., let

Ω = {1, 2, 3, ...} = N with P({ω}) > 0 for all ω ∈ Ω.

 3.5. MARTINGALE MEASURE 79

Consider

B0 = B1 = 1 ( i.e., interest rate r = 0).

For i = 1, 2, 3, ..., let the stock price S0i = 1, and

⎧
⎪
⎪
⎪
⎪0 ω = i,
⎪
⎪
⎨
S1i (ω) = 2 ω = i + 1,
⎪
⎪
⎪
⎪
⎪
⎪
⎩1 otherwise.

(1) Claim: This market model is arbitrage-free.

Suppose that h̄ = (h0 , h1 , ..., hN , ...)T is a portfolio such that

h̄ · S̄1 ≥ 0 for all ω ∈ Ω and h̄ · S̄0 ≤ 0.

For ω = 1,


∞
0 ≤ h̄ · S̄1 (1) = h0 + hk = h̄ · S̄0 − h1 ≤ −h1 .
k=2

For ω = i > 1,


∞
0 ≤ h̄ · S̄1 (i) = hk + 2hi−1 = h̄ · S̄0 + hi−1 − hi ≤ hi−1 − hi .
k=0,k=i,i+1

This implies that

0 ≥ h1 ≥ h2 ≥ ... ≥ hi−1 ≥ hi ≥ · · ·

Since

h̄ · S̄0 ≤ 0 and h̄ · S̄1 ≥ 0,

we have hi = 0 for all i = 0, 1, 2, ... Thus, there is no arbitrage opportunity in

this market model.

80 3. ONE-PERIOD MODELS

(2) Claim: There is no equivalent martingale measure.

Suppose there is an equivalent martingale measure Q, we have

S̄0 = EQ [S̄1 ]

This implies that


∞
1 = S0i = EQ [S1i ] = 2Q({i + 1}) + Q({k})
k=1,k=i,i+1

= 1 + Q({i + 1}) − Q({i}).

This leads to Q({i}) = Q({i + 1}) for all i = 1, 2, 3, ... This is obviously a

contradiction, since Q(Ω) cannot be 1.

Theorem 3.33 (Law of one price).∗ Suppose that the market model is arbitrage-free

and suppose that

h̄ · S̄1 = k̄ · S̄1

for two different portfolios h̄ and k̄. Then h̄ · S̄0 = k̄ · S̄0 .

dddddddddddddddd. d arbitrage-free dddd, ddddddd

dddddddddd, dddd ddddddddd.

Proof. Since h̄ · S̄1 = k̄ · S̄1 P-a.s., we have

(h̄ − k) · S̄1 = 0 P − a.s.

By the equivalence of P and Q, we have

(h̄ − k̄) · S̄1 = 0 Q − a.s.

Hence,

0 = EQ [(h̄ − k̄) · S1 ] = (h̄ − k̄) · EQ [S̄1 ] = (1 + r)(h̄ − k̄) · S̄0 ,

 3.6. PRICING 81

i.e.,

h̄ · S̄0 = k̄ · S̄0 .

Remark 3.34.∗ If V ∈ {h̄ · S̄1 : h̄ ∈ RN +1 }, then we can define the price of V as

π(V ) = h̄ · S̄0 if V ∈ h̄ · S̄1

whenever the market model is arbitrage-free (By Theorem 3.33, this definition is well-

defined). Moreover, by Theorem 3.24,

 
V
π(V ) = EQ .
1+r

3.6. Pricing

ddddddddd financial mathematics dddddddddd: dddddd

dddd.

Consider a derivative C, the price of C at time 0 π(C) =? ddddddddddd

ddddddd idea: dddddddddddddddd asset, ddddd (S̄0 , S̄1 )

dddddddd. Consider
⎧
⎪
⎪
⎨S1N +1 = C
(3.6)
⎪
⎪
⎩S N +1 = π(C) = π C
0

ddd: ddddddddddd: No arbitrage!

Definition 3.35.∗ A real number π C ≥ 0 is called an arbitrage-free price of a contingent

claim C if the market model extended according to (3.6) is arbitrage-free. The set of all

arbitrage-free prices for C is denoted by Π(C).

82 3. ONE-PERIOD MODELS

Theorem 3.36. Suppose P = ∅. Then Π(C) = ∅, and

   
C
Π(C) = EQ : Q ∈ P with EQ [C] < ∞ .
1+r

Proof. By Theorem 3.24 and Theorem 3.30, π C is arbitrage-free price for C if and

only if there exists Q ∈ P for the market model extended via (3.6), i.e.,
 
S1i
S0i = EQ for i = 1, 2, ..., N + 1.
1+r

Thus,
   
C
Π(V ) ⊆ EQ : Q ∈ P with EQ [C] < ∞ .
1+r

Conversely, if
 
C C
π = EQ for some Q ∈ P,
1+r

then Q is also an equivalent risk-neutral measure for the extended market model. This

implies that
   
C
Π(C) ⊇ EQ : Q ∈ P with EQ [C] < ∞ .
1+r

Example 3.37. Consider a market model with

⎛ ⎞ ⎛ ⎞
⎜1⎟ ⎜1 1 1 ⎟
b = ⎝ ⎠, D=⎝ ⎠.
10 9 11 12

Then there exists ψ ∈ R3 , ψ 0 such that

⎛ ⎞
⎛ ⎞ ⎛ ⎞ ψ ⎛ ⎞
⎜ 1⎟
⎜1⎟ ⎜1 1 1 ⎟ ⎜ ⎟ ⎜ ψ1 + ψ2 + ψ3 ⎟
⎝ ⎠ = b = Dψ = ⎝ ⎠⎜ ⎟
⎜ 2⎟ = ⎝
ψ ⎠.
10 9 11 12 ⎝ ⎠ 9ψ1 + 11ψ2 + 12ψ3
ψ3
 3.6. PRICING 83

Thus, ⎧
⎪
⎪
⎨ψ1 + ψ2 + ψ3 = 1,
⎪
⎪
⎩9ψ1 + 11ψ2 + 12ψ3 = 10.

Suppose ψ1 = a ∈ (0, 1), then

⎧
⎪
⎪
⎨ψ2 + ψ3 = 1 − a,
⎪
⎪
⎩11ψ2 + 12ψ3 = 10 − 9a.

Thus, ⎧
⎪
⎪
⎨ψ2 = 2 − 3a
with 1/2 < a < 2/3.
⎪
⎪
⎩ψ3 = 2a − 1

Obviously, the risk-neutral measure is not unique. Hence,

P = {Q : Q(ω1 ) = a, Q(ω2 ) = 2 − 3a, Q(ω3 ) = 2a − 1, with 1/2 < a < 2/3}.

(i) Consider a contingent claim C with

C(ω1 ) = 6, C(ω2 ) = 8, C(ω3 ) = 9.

Then

π C = EQ [C] = C(ω1 )Q({ω1 }) + C(ω2 )Q({ω2 }) + C(ω3 )Q({ω3 }) = 7.

(ii) Consider a contingent claim C with

C(ω1 ) = 10, C(ω2 ) = 8, C(ω3 ) = 12.

Then

EQ [C] = 10a + 8(2 − 3a) + 12(2a − 1) = 4 + 10a.

Therefore,

Π(C) = {4 + 10a : 1/2 < a < 2/3} = (9, 32/3).

84 3. ONE-PERIOD MODELS

dddddd, dddddddddddddd π C , ddddddddddd. d

dd?

Definition 3.38.∗ A contingent claim C is called attainable (or replicable) if

C = h̄ · S̄1 P − a.s.

for some h̄ ∈ RN +1 . Such a portfolio strategy h̄ is then called a replicating portfolio for

C.

Corollary 3.39. Suppose the market model is arbitrage-free and C is a contingent

claim.

(1) C is attainable if and only if it admits a unique arbitrage-free price.

(2) If C is not attainable , there exists a < b such that Π(C) = (a, b).

Proof. (1) By Theorem 3.33.

(2) Since P is convex, Π(C) is convex. Hence, Π(C) is an interval.

It remains to show that Π(C) is open. ddddddddddddddd.

Remark 3.40. In fact, if C is not attainable,

Π(C) = (πinf (C), πsup (C)) ,

where

   
C C
πinf (C) = inf EQ , and πsup (C) = sup EQ .
Q∈P 1+r Q∈P 1+r
 3.7. COMPLETE MARKET MODEL 85

Example 3.41. A financial market with one bond B0 = B1 = 1 and one stock S0 =

π = 1, S1 = S. Suppose S is a Poisson distributed random variable with parameter 1

under P, i.e.,
e−1
P(S = k) = for k − 0, 1, 2, ...
k!

Then P is a risk-neural measure with E[S1 ] = 1 = π and the market model is arbitrage-

free.

Consider the contingent claim C = (S1 − K)+ . For any Q ∈ P, Due to Jensen’s

inequality,

EQ [C] = EQ [(S − K)+ ] ≥ (EQ [S] − K)+

= (π − K)+ = (1 − K)+ . (3.7)

Conversely, since C ≤ S,

EQ [C] ≤ EQ [S] = π = 1. (3.8)

This implies,

(1 − K)+ ≤ πinf (C) ≤ π C ≤ πsup (C) ≤ 1.

(3.7) (3.8)

In fact, we can prove that

πinf (C) = (1 − K)+ , and πsup (C) ≤ 1.

3.7. Complete market model

Definition 3.42.∗ A (arbitrage-free) market model is called complete if every contin-

gent claim is attainable. Otherwise, this market model is called incomplete.

86 3. ONE-PERIOD MODELS

d Corollary 3.39 ddddddd complete market model ddd contingent claims

ddddddd.

Example 3.43. (1) Consider

⎛ ⎞ ⎛ ⎞
⎜1⎟ ⎜1 1 ⎟
b = ⎝ ⎠, D=⎝ ⎠.
10 9 11

Then (b, D) is a complete market model, since

⎧
⎪
⎪
⎨h0 · 1 + h1 · 9 = C(ω1 )
⎪
⎪
⎩h0 · 1 + h1 · 11 = C(ω2 )

has a unique solution (h0 , h1 )

(2) Consider
⎛ ⎞ ⎛ ⎞
⎜1⎟ ⎜1 1 1 ⎟
b = ⎝ ⎠, D=⎝ ⎠.
10 9 11 12
Then (b, D) is an incomplete market model, since a contingent claim C with

C(ω1 ) = 10, C(ω2 ) = 8, C(ω3 ) = 12 is not attainable.

Theorem 3.44.∗ An arbitrage-free market model is complete if and only if there exists

exactly one risk-neutral probability measure.

Proof. “=⇒” For A ∈ F. IA is a contingent claim. Then the arbitrage-free price is

unique and
 
IA IA 1
π = EQ = Q(A).
1+r 1+r
Thus,

Q(A) = (1 + r) π IA for all A ∈ F .

This mens that Q is unique, i.e., the risk-neutral measure is unique.

 3.7. COMPLETE MARKET MODEL 87

“⇐=” Suppose P = {Q}. Then any contingent claim has a unique arbitrage-free price .

This implies that C is attainable due to Corollary 3.39. 

Example 3.45. Assume that Ω = {ω1 , ω2 } and N = 1, this implies that there are one

bond (with interest rate r) and one stock in the market model.

Moreover, suppose that the bond price is given by

B0 = 1, B1 = 1 + r,

the stock price is at time 1 is given by 0 ≤ a = S1 (ω2 ) < b = S1 (ω1 ) and p = P({ω1 }) =

P(S1 = b) ∈ (0, 1).

(1) This market model does not admit arbitrage opportunity if nd only if
   
S1
S0 ∈ EQ :Q∼P
1+r
   
pb + (1 − p)a a b
= : p ∈ (0, 1) = , .
1+r 1+r 1+r
 
a b
(2) For any given S0 ∈ , , the risk-neutral measure P∗ must satisfy
1+r 1+r

S0 (1 + r) = E∗ [S1 ] = p∗ b + (1 + p∗ )a.

Hence, P∗ is unique and is given by

⎧
⎪
⎪ S (1 + r) − a
⎨P∗ ({ω1 }) = 0
b−a
⎪
⎪ b − S0 (1 + r)
⎩P∗ ({ω2 }) = .
b−a

This means that the market model is complete.

(3) An alternative method to show that the market model is complete: for any

contingent claim C, find h̄ = (h0 , h1 )T such that C = h̄ · S̄1 , i.e., find h0 , h1 such
88 3. ONE-PERIOD MODELS

that
⎧
⎪
⎪
⎨h0 (1 + r) + h1 S1 (ω1 ) = C(ω1 ),
⎪
⎪
⎩h0 (1 + r) + h1 S1 (ω2 ) = C(ω2 ).

Its solution is given by

⎧
⎪
⎪ C(ω2 )b − C(ω1 )a
⎪
⎨h0 = ,
(1 + r)(b − a)
⎪
⎪ C(ω1 ) − C(ω2 )
⎪
⎩h1 = .
b−a

This implies that C is attainable.

(4) The arbitrage-free price π C is given by

 
C ∗ h̄ · S̄1
π = E = h̄ · S̄0
1+r
C(ω2 )b − C(ω1 )a C(ω1 ) − C(ω2 )
= ·1+ · S0
(1 + r)(b − a) b−a
 
C(ω1 ) S0 (1 + r) − a C(ω2 ) b − S0 (1 + r) ∗ C
= + =E .
1+r b−a 1+r b−a 1+r

In particular, if C = (S1 − K)+ with strike price K ∈ (a, b), then

+ b−K 1 (b − K)a
π (S1 −K) = S0 − .
b−a 1+r b−a

Exercise

(1) Consider the market model

⎛⎛ ⎞ ⎛ ⎞⎞
⎜⎜ 1 ⎟ ⎜ 1.1 1.1 ⎟⎟
(b, D) = ⎝⎝ ⎠ , ⎝ ⎠⎠ .
5 8 4

(a) Investigate if the market model is complete and arbitrage-free.

(b) Find the price of the call option with strike price K = 6.
 3.7. COMPLETE MARKET MODEL 89

(2) Consider the market model

⎛⎛ ⎞ ⎛ ⎞⎞
⎜⎜ 1 ⎟ ⎜ 1.1 1.1 1.1 ⎟⎟
(b, D) = ⎝⎝ ⎠ , ⎝ ⎠⎠ .
5 8 4 6

(a) Investigate if the market model is complete and arbitrage-free.

(b) Find the price of the call option with strike price K = 6.

(3) Consider the market model

⎛⎛ ⎞ ⎛ ⎞⎞
⎜⎜ 1 ⎟ ⎜ 1.1 1.1 1.1 ⎟⎟
⎜⎜ ⎟ ⎜ ⎟⎟
(b, D) = ⎜ ⎜ ⎟ ⎜
⎜⎜ 5 ⎟ , ⎜ 7 4 6 ⎟ ⎟
⎟⎟ .
⎝⎝ ⎠ ⎝ ⎠⎠
10 12 9 9

(a) Show that (b, D) is complete, but not arbitrage-free.

(b) Find an arbitrage opportunity.

(4) Consider the market model

⎛⎛ ⎞ ⎛ ⎞⎞
⎜⎜ 1 ⎟ ⎜ 1.1 1.1 1.1 1.1 ⎟⎟
⎜⎜ ⎟ ⎜ ⎟⎟
(b, D) = ⎜ ⎜
⎜⎜ 5
⎟,⎜ 7
⎟ ⎜ 4 6 3 ⎟⎟ .
⎟⎟
⎝⎝ ⎠ ⎝ ⎠⎠
10 12 9 9 13

(a) Show that (b, D) is arbitrage-free, but not complete.

(b) Find the collection of all possible equivalent martingale measures.

(c) Find an contingent claim, which is not replicated.

(d) Find the set of all replicated contingent claims.

(5) Consider the market model

⎛⎛ ⎞ ⎛ ⎞⎞
⎜⎜ 1 ⎟ ⎜ 1.1 1.1 1.1 ⎟⎟
⎜⎜ ⎟ ⎜ ⎟⎟
(b, D) = ⎜
⎜⎜
⎜ 5 ⎟,⎜ 3
⎟ ⎜ 4 7 ⎟⎟ .
⎟⎟
⎝⎝ ⎠ ⎝ ⎠⎠
10 12 9 11

(a) Show that (b, D) is arbitrage-free and complete.

90 3. ONE-PERIOD MODELS

(b) Find the price of a call option and a put option with strike price K = 10.