MATHEMATICAL FINANCE
Second Edition
M. s. JOSHI
University of Melbourne
CAMBRIDGE
UNIVERSITY PRESS
Contents
Preface
Acknowledgements
1 Risk
1.1 What is risk?
1.2 Market efficiency
1.3 The most important assets
1.4 Risk diversification and hedging
1.5 The use of options
1.6 Classifying market participants
1.7 Key points
1.8 Further reading
1.9 Exercises
2 Pricing methodologies and arbitrage ,
2.1 Some possible methodologies
2.2 Delta hedging
2.3 What is arbitrage?
2.4 The assumptions of mathematical finance
2.5 An example of arbitrage-free pricing
2.6 The time value of money
2.7 Mathematically defining arbitrage
2.8 Using arbitrage to bound option prices
2.9 Conclusion
2.10 Key points
2.11 Further reading
2.12 Exercises
3 Trees and option pricing
3.1 A two-world universe
3.2 A three-state model
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Contents
6.6
Continuous martingales and nitrations
Identifying continuous martingales
6.7
Continuous martingale pricing
6.8
6.9 Equivalence to the PDE method
6.10 Hedging
6.11 Time-dependent parameters
6.12 Completeness and uniqueness
6.13 Changing numeraire
6.14 Dividend-paying assets
6.15 Working with the forward
6.16 Key points
6.17 Further reading
6.18 Exercises
The practical pricing of a European option
Introduction
7.1
Analytic formulae
7.2
7.3 Trees
7.4 Numerical integration
Monte Carlo
7.5
PDE methods
7.6
7.7 Replication
Key points
7.8
7.9 Further reading
7.10 Exercises
Continuous barrier options
Introduction
8.1
The PDE pricing of continuous barrier options
8.2
8.3 Expectation pricing of continuous barrier options
The reflection principle
8.4
Girsanov's theorem revisited
8.5
8.6 Joint distribution
Pricing continuous barriers by expectation
8.7
American digital options
8.8
Key points
8.9
8.10 Further reading
8.11 Exercises
Multi-look exotic options
Introduction
9.1
9.2 Risk-neutral pricing for path-dependent options
9.3 Weak path dependence
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9.4
Path generation and dimensionality reduction
9.5
Moment matching
9.6
Trees, PDEs and Asian options
9.7
Practical issues in pricing multi-look options
9.8
Greeks of multi-look options
9.9
Key points
Further reading
9.10
9.11
Exercises
10 Static replication
ireplication
10.1 Introduction
Continuous barrier options
i0.2
Discrete
barriers
10.3
10.4 Path-dependent exotic options
10.5 The up-and-in put with barrier at strike
10.6 Put-call symmetry
10.7 Conclusion and further reading
10.8
Key points
10.9 Exercises
11 Multiple sources of risk
risk
11.1 Introduction
11.2 Higher-dimensional Brownian motions
11.3 The higher-dimensional Ito calculus
11.4 The higher-dimensional Girsanov theorem
11.5 Practical pricing
11.6 The Margrabe option,
11.7 Quanto options
11.8 Higher-dimensional trees
11.9 Key points
11.10 Further reading
11.11 Exercises
12 Options with early exercise features
12.1 Introduction
12.2 The tree approach
12.3 The PDE approach to American options
12.4 American options by replication
12.5 American options by Monte Carlo
12.6 Upper bounds by Monte Carlo
12.7 Key points
12.8 Further reading
12.9 Exercises
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16 Stochastic volatility
16.1 Introduction
16.2 Risk-neutral pricing with stochastic-volatility models
16.3 Monte Carlo and stochastic volatility
16.4 Hedging issues
16.5 PDE pricing and transform methods
16.6 Stochastic volatility smiles
16.7 Pricing exotic options
16.8 Key points
16.9 Further reading
16.10 Exercises
17 Variance Gamma models
17.1 The Variance Gamma process
17.2 Pricing options with Variance Gamma models
17.3 Pricing exotic options with Variance Gamma models
17.4 Deriving the properties
17.5 Key points
17.6 Further reading
17.7 Exercises
18 Smile dynamics and the pricing of exotic options
18.1 Introduction
18.2 Smile dynamics in the market
18.3 Dynamics implied by models
18.4 Matching the smile to the model
18.5 Hedging
18.6 Matching the modelto the product
18.7 Key points
18.8 Further reading
Appendix A Financial and mathematical jargon
Appendix B Computer projects
B.I
Introduction
B.2
Two important functions
B.3
Project 1: Vanilla options in a Black-Scholes world
B.4
Project 2: Vanilla Greeks
B.5
Project 3: Hedging
B.6
Project 4: Recombining trees
B.7
Project 5: Exotic options by Monte Carlo
B.8
Project 6: Using low-discrepancy numbers
Project 7: Replication models for continuous barrier options
B.9
B.10 Proiect 8: Multi-asset options
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B.I 1 Project 9: Simple interest-rate derivative pricing
B.12 Project 10: LIBOR-in-arrears
B.13 Project 11: BGM
B.14 Project 12: Jump-diffusion models
B.15 Project 13: Stochastic volatility
B.16 Project 14: Variance Gamma
Appendix C Elements of probability theory
C.I
Definitions
C.2
Expectations and moments
C.3
Joint density and distribution functions
C.4
Covariances and correlations
Appendix D Order notation
D.I
BigO
D.2
Small o
Appendix E Hints and answers to exercises
References
Index
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