Dr P. V. Johnson
School of Mathematics
2018
Dr P. V. Johnson MATH20912
Lecture 1
1 Introduction
Elementary economics background
What is financial mathematics?
The role of SDE’s and PDE’s
Dr P. V. Johnson MATH20912
About Me
Dr Paul Johnson
website:
http://www.maths.manchester.ac.uk/~pjohnson/pages/math20912.html
Dr P. V. Johnson MATH20912
General Information
Textbooks:
Assessment:
Dr P. V. Johnson MATH20912
General Information
Lectures 2hr pw (total 21hrs):
Dr P. V. Johnson MATH20912
Elementary Economics Background
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Elementary Economics Background
Dr P. V. Johnson MATH20912
Elementary Economics Background
Dr P. V. Johnson MATH20912
Elementary Economics Background
as have bonds
Dr P. V. Johnson MATH20912
Elementary Economics Background
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What is value?
Oscar Wilde
“A man who knows the price of everything and the value of
nothing...”
Dr P. V. Johnson MATH20912
What is Money?
Dr P. V. Johnson MATH20912
Time value of money
V (T ) = (1 + rT )P (1)
Dr P. V. Johnson MATH20912
Time value of money
V (T ) = erT P. (3)
In the limit m → ∞,
we obtain the results above since
1 z
e = limz→∞ 1 + z .
Throughout this course we assume that the interest rate r will
be continuously compounded.
Dr P. V. Johnson MATH20912
Time value of money
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Investing in Stocks and Shares
Definition: Return
change in value over a period of time
return = (4)
initial investment
Dr P. V. Johnson MATH20912
Historical Returns
50 0.05
return
return
0 0
-50 -0.05
-100 -0.1
0 3650 7300 10950 14600 0 3650 7300 10950 14600
day day
Dr P. V. Johnson MATH20912
Simple Model for Stock Price S(t)
• Return:
∆S
(5)
S
where ∆S = S(t + δt) − S(t)
In the limit δt → 0 :
dS
(6)
S
Dr P. V. Johnson MATH20912
Modelling Return
Return:
dS
= µdt + σdW (7)
S
• µdt is a measure of the deterministic expected rate of growth
of the share price. In general, µ = µ(S, t). In simple models µ is
taken to be constant (µ = 0.1 yr−1 = 10 %yr−1 ).
Dr P. V. Johnson MATH20912
Stochastic differential equation for share
price
dS = µSdt + σSdW
9000
8000
FTSE 100 Index St
7000
6000
5000
4000
3000
2009 2010 2011 2012 2013 2014
Time [yrs]
Dr P. V. Johnson MATH20912
Lecture 2
1 Random Walks
Dr P. V. Johnson MATH20912
General Random Walk
or
k
X
Wk = ∆W.
Dr P. V. Johnson MATH20912
Random Walk
∆W ∼ N (0, ∆t).
Dr P. V. Johnson MATH20912
Random Walk
Consider our discrete random walk as
X
Wk = ∆W
k
it is trivial to show that
Wk ∼ N (0, k∆t)
from standard properties of normal distributions.
Obviously if we write t = k∆t we have
W (t) ∼ N (0, t).
It can be shown in the limit ∆t → 0 we can write it as the
integral Z t
W (t) = dW
0
where
dW ∼ N (0, dt).
Dr P. V. Johnson MATH20912
Wiener process
Definition
The standard Wiener process W (t) is a Gaussian random walk
process such that:
W (0) = 0
W (t) has independent increments: if u ≤ v ≤ s ≤ t, then
W (t) − W (s) and W (v) − W (u) are independent
W (s + t) − W (s) ∼ N (0, t)
W (t) has continuous paths
Dr P. V. Johnson MATH20912
Wiener process
Example 2.2
Show that the following results hold:
E[W ] = 0;
E[W 2 ] = t;
E[∆W ] = 0;
E[(∆W )2 ] = ∆t;
1
∆W = X (∆t) 2 , where X ∼ N (0, 1) .
Dr P. V. Johnson MATH20912
Wiener process
The probability density function for W (t) is
2
1 y
p(y, t) = √ exp −
2πt 2t
Rb
and P (a ≤ W (t) ≤ b) = a p(y, t)dt
1
Wt
-1
-2
-3
0 0.25 0.5 0.75 1
t
Dr P. V. Johnson MATH20912
Wiener process
Dr P. V. Johnson MATH20912
Approximation of SDE for small ∆t
dS = µSdt + σSdW,
then 1
∆S ≈ µS∆t + σSX (∆t) 2
It means ∆S ∼ N µS∆t, σ 2 S 2 ∆t
Dr P. V. Johnson MATH20912
Examples
Example 2.4
Consider a stock that has volatility 30% and provides expected
return of 15% p.a. Find the increase in stock price for one week
if the initial stock price is 100.
Example 2.5
Given the result from Example 2.4, what is the distribution of
the stock price in that case after one week?
Dr P. V. Johnson MATH20912
Examples
Example 2.6
Show that the return ∆S
S is normally distributed with mean
2
µ∆t and variance σ ∆t
Dr P. V. Johnson MATH20912
Lecture 3
1 Itô’s Lemma
4 Examples
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Itô’s Lemma
• Volatility σ = 0
∂f ∂f ∂f ∂f
df = ∂t dt + ∂S dS = ∂t + µS ∂S dt
• Volatility σ 6= 0
Itô’s Lemma:
1 2 2 ∂2f
df = ∂f ∂t + µS ∂f
∂S + 2 σ S ∂S 2
∂f
dt + σS ∂S dW
Dr P. V. Johnson MATH20912
Examples
Dr P. V. Johnson MATH20912
Examples
Dr P. V. Johnson MATH20912
Normal distribution for ln S(t)
This means
ln 2S(t)
has a normal distribution with mean
σ
ln S0 + µ − 2 t and variance σ 2 t.
Dr P. V. Johnson MATH20912
Normal distribution for ln S(t)
Dr P. V. Johnson MATH20912
Probability density function for ln S(t)
Recall that if the random variable X has a normal distribution
with mean µ and variance σ 2 , then the probability density
function is
1 (x − µ)2
p(x) = √ exp −
2πσ 2 2σ 2
N (µ, σ)
µ − 2σ µ µ + 2σ x
Dr P. V. Johnson MATH20912
Exact expression for stock price S(t)
Definition
The model of a stock dS = µSdt + σSdW is known as
geometric Brownian motion.
2
µ− σ2 t+σW (t)
Stock price at time t: S(t) = S0 e
Dr P. V. Johnson MATH20912
Exact expression for stock price S(t)
Dr P. V. Johnson MATH20912
Exact expression for stock price S(t)
Below we plot the lognormal distribution function for µ = 0,
σ = 0.4 and t = 1.
σ2
ln N µ− 2
t, σ 2 t
Dr P. V. Johnson MATH20912
Lecture 4
1 Financial Derivatives
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Derivatives
So what is an Option?
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Trading Contracts
Discussion Point
How would you think the parties agree on the price of oranges
in this contract?
Dr P. V. Johnson MATH20912
Trading Contracts
Dr P. V. Johnson MATH20912
Options on Stocks
Definition
European call option gives the holder the right (not obligation)
to buy the underlying asset at a prescribed time T (expiry
date/maturity) for a specified (exercise/strike) price E.
European put option gives its holder the right (not obligation)
to sell underlying asset at the expiry time T for the exercise
price E.
Dr P. V. Johnson MATH20912
Example: European Call Options
Dr P. V. Johnson MATH20912
Option Payoff Diagrams
Definition
Payoff Diagram is a graph of the value of the option position at
expiration t = T as a function of the underlying share price S.
Call price at t = T :
C(S, T ) = max (S − E, 0)
0, S ≤ E,
=
S − E, S > E.
Dr P. V. Johnson MATH20912
Option Payoff Diagrams
Put price at t = T :
P (S, T ) = max (E − S, 0)
E − S, S ≤ E,
=
0, S > E.
Dr P. V. Johnson MATH20912
Profiting from Options
max (S − E, 0) − C0 erT ,
Dr P. V. Johnson MATH20912
Lecture 5
3 No Arbitrage Principle
Dr P. V. Johnson MATH20912
Portfolios and Short Selling
Definition
Short selling is the practice of selling assets that have been
borrowed from a broker with the intention of buying the same
assets back at a later date to return to the broker.
This technique is used by investors who try to profit from the
falling price of a stock.
Example 5.1:
Starting from zero, create a portfolio that is long or short one
share by borrowing or investing money.
Dr P. V. Johnson MATH20912
Portfolios and Short Selling
Definition
Portfolio is a combination of assets, options and bonds.
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Option positions
E E
0 0
E 2E ST E 2E ST
0 0
ST ST
E E
E 2E E 2E
Dr P. V. Johnson MATH20912
Trading Strategies Involving Options
Straddle is the purchase of a call and a put on the same
underlying security with the same maturity time T and strike
price E.
Example 5.3:
Draw the payoff diagram for going long on a straddle and short
on a straddle.
Dr P. V. Johnson MATH20912
Straddle
Example 5.4:
S0 = 40, E = 40, C0 = 2, P0 = 2.
Can you find the expected return if the stock price at T is given
by the following tree?
p= 3
4
60
S0 = 40
H HH
p= 1
4
20
Ans: 400%
Dr P. V. Johnson MATH20912
Bull Spread
Bull spread is a strategy that is designed to profit from a
moderate rise in the price of the underlying security.
0, S ≤ E1 ,
ΠT = S − E1 , E1 ≤ S < E2 ,
E2 − E1 , S ≥ E2
Example 5.5:
Sketch the payoff diagram for a bull spread.
Dr P. V. Johnson MATH20912
Risk-Free Interest Rate and Bonds
Definition
A Bond is a contract that yields a known amount F , called the
face value, on a known time T , called the maturity date. The
authorised issuer (for example, government) owes the holder a
debt and is obliged to repay the face value at maturity and may
also pay interest (the coupon).
Dr P. V. Johnson MATH20912
Zero-Coupon Bonds
Example 5.7:
Write down the return on a risk free bond if the interest rates
are constant, and calculate the value of the bond if
B(t = T ) = F and r is constant.
Dr P. V. Johnson MATH20912
No Arbitrage Principle
Dr P. V. Johnson MATH20912
Lecture 6
1 No-Arbitrage Principle
2 Put-Call Parity
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Risk
Example 6.1:
Two products are being sold on the market and they offer a
payoff according to some future events at time T . Everyone on
the market knows (and agrees on) the probabilities associated
the events. Product A is described by
Pays £500 with 50% probability at time T
Pays £1500 with 50% probability at time T
Product B is described by
Pays £0 with 99% probability at time T
Pays £100000 with 1% probability at time T
Imagine both products are available to buy at £750, which
offers the better investment?
Dr P. V. Johnson MATH20912
Risk
Example 6.2:
Imagine there are two similar products being sold on the
market, where
Product A is described by
Pays £1000 with 100% probability at time T
Product B is described by
Pays £250 with 100% probability at time T
Imagine the products are available to buy at £800 and £200,
which offers the better investment?
Dr P. V. Johnson MATH20912
Risk
Example 6.3:
Imagine there are two products being sold on the market, where
Product A is described by
Pays £1000 with 100% probability at time T
Product B is described by
Pays £1000 with 99% probability at time T
Pays £2000 with 1% probability at time T
What can we say about the price of these two products?
Dr P. V. Johnson MATH20912
No Arbitrage Principle
Dr P. V. Johnson MATH20912
No Arbitrage Principle
Example 6.4:
Assume that there are two identical risk free products on the
market offering to pay the holder £10 on the same date T in
the future. Imagine that one of those products, Product A is
selling for £5 and the other Product B for £7. What happens?
Well, if everyone can make a free choice to buy either product
then everyone with choose to buy A, as it offers best value.
Dr P. V. Johnson MATH20912
No Arbitrage Principle
Comparing Contracts
Now consider the situation when V and V̂ are two financial
contracts (or a portfolio as in notes) with a payoff that satisfies
the following condition under all circumstances (i.e. share
prices)
VT ≥ V̂T .
at maturity t = T . If no-arbitrage holds, then Vt ≥ V̂t for all t.
Dr P. V. Johnson MATH20912
Put-Call Parity
Example 6.5:
Consider a portfolio of the form
Π = S + P − C.
St + Pt − Ct = Ee−r(T −t) .
Dr P. V. Johnson MATH20912
Put-Call Parity
C0 = P0 + S0 − Ee−rT .
Example 6.6:
Use this formula for a call option along with the No-Arbitrage
Theorem to derive a lower bound for the call option:
C0 ≥ S0 − Ee−rT
Dr P. V. Johnson MATH20912
Examples
Example 6.7(a):
Find a lower bound for a six month European call option with
the strike price £35 when the initial stock price is £40 and the
risk-free interest rate is 5% p.a.
Example 6.7(b):
Consider the situation where the European call option is £4.
Show that there exists an arbitrage opportunity.
Dr P. V. Johnson MATH20912
Lecture 7
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Proving via “No Arbitrage”
No-Arbitrage Principle
“Arbitrage cannot exist in a market”
Ct < 0.
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Upper and Lower Bounds on Call and Put
Options
S0 − Ee−rT ≤ C0 ≤ S0
Ee−rT − S0 ≤ P0 ≤ Ee−rT
Example 7.1:
Sketch the upper and lower bounds for a call
St − Ee−r(T −t) ≤ Ct ≤ St
Dr P. V. Johnson MATH20912
Proof of Put-Call Parity by contradiction
P0 = C0 − S0 + Ee−rT .
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Proof of Put-Call Parity
Example 7.2:
Show that the correct portfolio for arbitrage will be
Example 7.3:
Find arbitrage and show that since our initial assumption on
the put price was false the following must hold true
Dr P. V. Johnson MATH20912
Proof of Put-Call Parity
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Proof of Put-Call Parity
Example 7.4:
Show that the correct portfolio for arbitrage will be
Π=P −C +S−B
Example 7.5:
Find arbitrage and show that since our initial assumption on
the put price was false the following must hold true
Pt ≥ Ct − St + Ee−r(T −t)
Dr P. V. Johnson MATH20912
Example on Arbitrage Opportunity
Pt = Ct − St + Ee−r(T −t)
Example 7.6:
Three month European call and put options with the exercise
price £12 are trading at £3 and £6 respectively. The stock
price is £8 and interest rate is 5%. Show that there exists
arbitrage opportunity.
Dr P. V. Johnson MATH20912
Lecture 8
2 Risk-Neutral Valuation
3 Examples
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One-Step Binomial Model
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One-Step Binomial Model
and
E[CT ] = qCu + (1 − q)Cd .
Example 8.2:
Can we use this expectation to price our option?
Dr P. V. Johnson MATH20912
Risk-free Portfolio
Π = ∆S − C
Example 8.3
Using this portfolio show that this value for ∆
Cu − Cd
∆=
S0 (u − d)
Dr P. V. Johnson MATH20912
No-Arbitrage Argument
Can we price this now? With no risk in the payoff the answer is
YES! If ΠT = K we have
Π0 = Ke−rT
Dr P. V. Johnson MATH20912
Risk-Neutral Valuation
By no-arbitrage arguments we derive the current call
option price is
C0 = ∆S0 − (∆S0 u − Cu ) e−rT ,
where
Cu − Cd
∆=
S0 (u − d)
.
Dr P. V. Johnson MATH20912
Risk-Neutral Valuation
Dr P. V. Johnson MATH20912
Example
Example 8.5:
A stock price is currently $40. At the end of three months it
will be either $44 or $36. The risk-free interest rate is 12%.
What is the value of three-month European call option with a
strike price of $42? Use no-arbitrage arguments and risk-neutral
valuation.
Dr P. V. Johnson MATH20912
Lecture 9
1 Risk-Neutral Valuation
2 Risk-Neutral World
Dr P. V. Johnson MATH20912
Risk-Neutral Valuation
Example 9.1:
Show that in order for No-Arbitrage to hold in a one step
binomial tree model we require
and hence
0 ≤ p ≤ 1.
Dr P. V. Johnson MATH20912
Risk Neutral Valuation
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Risk Neutral Valuation
Dr P. V. Johnson MATH20912
Two-Step Binomial Tree
Example 9.2:
What is a Risk-Neutral World?
Risk-Neutral Valuation:
C0 = e−rT Ep [CT ]
Dr P. V. Johnson MATH20912
Two-Step Binomial Tree
Example 9.3:
Draw the two step tree for stock prices.
Dr P. V. Johnson MATH20912
Option Price
Example 9.4:
Write down formula for Cuu , Cud and Cdd in terms of S0 , E, u
and d.
Dr P. V. Johnson MATH20912
Option Price
Example 9.5:
Draw and annotate the two step tree for option prices.
Dr P. V. Johnson MATH20912
Option Price
Example 9.6:
Substitution gives
Dr P. V. Johnson MATH20912
Option Price
The current put option price can be found in the same way:
or
P0 = e−rT Ep [PT ] .
Dr P. V. Johnson MATH20912
Two-Step Binomial Tree Example
Example 9.7:
Consider six months European put with a strike price of £32 on
a stock with current price £40. There are two time steps and in
each time step the stock price either moves up by 20% or moves
down by 20%. Risk-free interest rate is 10%. Find the current
option price.
Dr P. V. Johnson MATH20912
Lecture 10
Dr P. V. Johnson MATH20912
Binomial model for the stock price
The binomial model for the stock price is a discrete time model:
Dr P. V. Johnson MATH20912
Stock Price Movement in the Binomial Model
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Stock Price Movement in the Binomial Model
Example 10.3: Let us sketch the binomial tree for N = 4.
Dr P. V. Johnson MATH20912
Stock Price Movement in the Binomial Model
S00 is the stock price at the time t = 0. Note that u and d are
the same at every node in the tree.
For example, at the third time-step 3∆t, there are four possible
stock prices: S03 = d3 S00 , S13 = ud2 S00 , S23 = u2 dS00 and
S33 = u3 S00 .
Dr P. V. Johnson MATH20912
Call Option Pricing on Binomial Tree
Example 10.4: Let us sketch the option tree for N = 4.
We denote by Cnm the n-th possible value of call option at
time-step m∆t.
er∆t −d
Here 0 ≤ n ≤ m and p = u−d .
Example: N = 4.
Dr P. V. Johnson MATH20912
Matching volatility σ with u and d
We assume that the stock price starts at the value S0 and the
time step is ∆t. Let us find the expected stock price, E [S] , and
the variance of the return, var ∆S
S , for continuous and
discrete models.
Dr P. V. Johnson MATH20912
Matching volatility σ with u and d
Variance
of the return: Continuous model:
var ∆SS = σ 2 ∆t (Lecture 2)
Dr P. V. Johnson MATH20912
Matching volatility σ with u and d
eµ∆t −d
From the first equation we find q = u−d .
obtain
eµ∆t (u + d) − ud − e2µ∆t = σ 2 ∆t.
Using u = d−1 , we get
1
eµ∆t (u + ) − 1 − e2µ∆t = σ 2 ∆t.
u
This equation can be reduced to the quadratic equation.
(Examples Sheet 4 , part 5).
Dr P. V. Johnson MATH20912
Matching volatility σ with u and d
From
1
eµ∆t (u + ) − 1 − e2µ∆t = σ 2 ∆t.
u
√ √ √
one can obtain u ≈ eσ ∆t ≈ 1 + σ ∆t and d ≈ e−σ ∆t .
Dr P. V. Johnson MATH20912
Lecture 11
2 Replicating Portfolio
Dr P. V. Johnson MATH20912
American Option
An American Option is one that may be exercised at any
time prior to expire (t = T ).
We assume that over each of the next two years the stock
price either moves up by 20% or moves down by 20%. The
risk-free interest rate is 5%.
Find the value of a 2-year American put with a strike price
of $52 on a stock whose current price is $50.
Dr P. V. Johnson MATH20912
Replicating Portfolio
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Replicating Portfolio
Task
How to find (∆, N ) such that ΠT = CT and Π0 = C0 ?
Dr P. V. Johnson MATH20912
Example: One-Step Binomial Model.
Dr P. V. Johnson MATH20912
Lecture 12
1 Black-Scholes Model
2 Black-Scholes Equation
Over the years since the first derivation they have all been
relaxed to try and make the model more realistic.
Dr P. V. Johnson MATH20912
Black - Scholes Assumptions
Assumptions
One can borrow and lend cash at a constant risk-free
interest rate.
The stock price follows a Geometric Brownian motion with
constant expected return and volatility.
No transaction costs.
The stock does not pay dividends.
Securities are perfectly divisible (i.e. one can buy any
fraction of a share of stock).
No restrictions on short selling.
Dr P. V. Johnson MATH20912
Basic Notation
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Itô’s Lemma and Elimination of Risk
1 2 2 ∂2V
∂V ∂V ∂V
dV = + σ S 2
+ µS dt + σS dW
∂t 2 ∂S ∂S ∂S
we get
1 2 2 ∂2V
∂V ∂V ∂V
dΠ = + σ S + µS − ∆µS dt+ σS − ∆σS dW
∂t 2 ∂S 2 ∂S ∂S
Dr P. V. Johnson MATH20912
Black-Scholes Equation
∂V
This choice results in a risk-free portfolio Π = V − ∂S S whose
increment is
1 2 2 ∂2V
∂V
dΠ = + σ S dt
∂t 2 ∂S 2
No-Arbitrage Principle
The return on a risk-free portfolio must be rdt.
so we get
dΠ
= rdt
Π
and 2
∂V
∂t + 12 σ 2 S 2 ∂∂SV2
∂V
=r
V − ∂S S
Dr P. V. Johnson MATH20912
Black-Scholes Equation
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS − rV = 0
∂t 2 ∂S ∂S
Scholes received the 1997 Nobel Prize in Economics. It was not
awarded to Black in 1997, because he died in 1995.
Black received a Ph.D. in applied mathematics from Harvard
University.
Dr P. V. Johnson MATH20912
European Call Option Value
If a PDE is of backward type, we must impose a final condition
at t = T . For a call option, we have
C(S, t = T ) = max(S − E, 0).
C(S, t = 0)
C(S, t = T )
0
E 2E ST
Dr P. V. Johnson MATH20912
Lecture 13
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Boundary Conditions
We use C(S, t) and P (S, t) for call and put options. Boundary
conditions are applied for zero stock price S = 0 and S → ∞.
Examples 13.1 and 13.2: Boundary conditions for a call
option:
Dr P. V. Johnson MATH20912
Exact Solution
The Black-Scholes equation
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS − rV = 0
∂t 2 ∂S ∂S
with appropriate final and boundary conditions has the explicit
solution:
C(S, t) = SN (d1 ) − Ee−r(T −t) N (d2 ),
where
Z x
1 y2
N (x) = √ e− 2 dy (cumulative normal distribution)
2π −∞
and
ln(S/E) + (r + σ 2 /2)(T − t) √
d1 = √ , d2 = d1 − σ T − t.
σ T −t
Dr P. V. Johnson MATH20912
Call Price Premium
E Maximum Value
Actual Value Speculative Value
Intrinsic Value
0
0 E ST
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Example
Example 13.5: Calculate the price of a three-month European
call option on a stock with a strike price of £25 when the
current stock price is £21.6. The volatility is 35% and the
risk-free interest rate is 1% p.a.
Dr P. V. Johnson MATH20912
Example
In this case S0 = 21.6, E = 25, T = 0.25, σ = 0.35 and r = 0.01.
The value of a call option is C0 = S0 N (d1 ) − Ee−rT N (d2 ).
First we compute the values of d1 and d2 :
We know that
and
ln(S/E) + (r + σ 2 /2)(T − t)
d1 = √
σ T −t
can be written as
√ √
ln(S/E) r T −t σ T −t
d1 = √ + +
σ T −t σ 2
Dr P. V. Johnson MATH20912
The Limit of Higher Volatility
√
Now since d2 = d1 − σ T − t, in the limit σ → ∞, d2 → −∞.
Therefore
lim C(S, t) = S.
σ→∞
and this is the upper bound (or maximum value) for the call
option!!!
Dr P. V. Johnson MATH20912
Lecture 14
1 ∆-Hedging
2 The Greeks
Dr P. V. Johnson MATH20912
Delta for European Call Option
∂C
Example 14.2: Let us show that ∆ = ∂S = N (d1 ).
∂C ∂d1 ∂d2
∆= = N (d1 ) + SN 0 (d1 ) − Ee−r(T −t) N 0 (d2 )
∂S ∂S ∂S
∂d
1
= N (d1 ) + SN 0 (d1 ) − Ee−r(T −t) N 0 (d2 )
∂S
We need to prove
SN 0 (d1 ) − Ee−r(T −t) N 0 (d2 ) = 0.
Dr P. V. Johnson MATH20912
Delta-Hedging Example
Example 14.3: Find the value of ∆ for a 6-month European call
option on a stock with a strike price equal to the current stock
price (t = 0). The interest rate is 6% p.a. and the volatility
σ = 0.16.
Dr P. V. Johnson MATH20912
Delta-Hedging Example
We find
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Delta for European Put Option
Example 14.4: Let us find the Delta for a European put option
by using the put-call parity:
S + P − C = Ee−r(T −t) .
Dr P. V. Johnson MATH20912
Greeks
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Greeks
Vega:
∂V
∂σ measures the sensitivity to volatility σ.
√ 0
One can show that ∂V
∂σ = S T − tN (d1 )
Rho:
∂V
ρ= ∂r measures the sensitivity to interest rate r.
One can show that ρ = E(T − t)e−r(T −t) N (d2 ).
Dr P. V. Johnson MATH20912
Lecture 15
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Replicating Portfolio
The aim is to show that the option price V (S, t) satisfies the
Black-Scholes equation
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS − rV = 0
∂t 2 ∂S ∂S
Consider replicating portfolio of ∆ shares held long and N
bonds held short. The value of the portfolio is: Π = ∆S − N B.
Recall that a pair (∆, N ) is called a trading strategy.
Dr P. V. Johnson MATH20912
Replicating Portfolio
By using Itô’s lemma, we find the change in option value
∂2V
∂V ∂V 1 ∂V
dV = + µS + σ 2 S 2 2 + σS dW
∂t ∂S 2 ∂S ∂S
∂V 1 ∂2V ∂V
+ σ 2 S 2 2 + rS − rV = 0.
∂t 2 ∂S ∂S
Dr P. V. Johnson MATH20912
Static Risk-free Portfolio
Let us remember the Put-Call Parity. We set up the portfolio
consisting of a long position in one stock, long position in one
put and a short position in one call both with the same
maturity and strike price. Then the value of the portfolio is
Π = S + P − C.
The payoff for this portfolio is
ΠT = S + max(E − S, 0) − max(S − E, 0) = E
Dr P. V. Johnson MATH20912
Lecture 16
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Options on Dividend-Paying Stock
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Itô’s Lemma and Elimination of Risk
1 2 2 ∂2C
∂C ∂C
dC = + σ S 2
dt + dS
∂t 2 ∂S ∂S
we find
1 2 2 ∂2C
∂C ∂C
dΠ = + σ S − ∆D0 S dt + dS − ∆dS
∂t 2 ∂S 2 ∂S
Dr P. V. Johnson MATH20912
Modified Black-Scholes Equation
Task
Prove that C1 satisfies the Black-Scholes equation with r
replaced by r − D0 .
Dr P. V. Johnson MATH20912
Solution to the Modified Black-Scholes
Equation
where
ln(S/E) + (r − D0 + σ 2 /2)(T − t)
d10 = √
σ T −t
and √
d20 = d10 − σ T − t
Dr P. V. Johnson MATH20912
American Put Option
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American Put Option
∂P
P (Sf (t), t) = max(E − Sf (t), 0), (Sf (t), t) = −1.
∂S
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Lecture 17
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Bond Pricing Equation
Definition
A bond is a contract that yields a known amount (nominal,
principal or face value) on the maturity date, t = T . The bond
may pay a coupon (interest payment) at fixed times.
Dr P. V. Johnson MATH20912
Example
Example 17.4: A zero-coupon bond, V , issued at time t = 0, is
worth V (t = 1) = 1 at maturity T = 1. Find the bond price
V (t) at time t < 1 and V (0), when the continuous interest rate
is
r(t) = t2 .
Dr P. V. Johnson MATH20912
Example
Therefore
Z 1 3
t −1
V (t) = exp − r(s)ds = exp ,
t 3
and
1
V (0) = exp − = 0.7165
3
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Bond Pricing for Continuous Coupon Bonds
where Z T
V1 (t) = C(t) exp − r(s)ds
t
It can be shown that this gives the explicit solution
Z T Z T Z T
V (t) = exp − r(s)ds F + K(y) exp r(s)ds dy ,
t t y
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Lecture 18
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Measure of Future Value of Interest Rate
Now let us introduce the notation V (t, T ) for bond prices. Bond
prices are usually quoted at time t for different value of T .
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Yield
We define
ln(V (t, T )) − ln(V (T, T ))
Y (t, T ) = − ,
T −t
as a measure of the future values of interest rate, where V (t, T )
is taken from financial data.
Dr P. V. Johnson MATH20912
Measure of Future Value of Interest Rate
therefore
1 ∂V (t, T )
r(T ) = − ,
V (t, T ) ∂T
This is the interest rate at the future date T
(forward rate).
Dr P. V. Johnson MATH20912
Term Structure of Interest Rates (Yield
Curve)
We can say that Y (t, T ) is the average value of the interest rate
r(t) in the time interval [t, T ]. Therefore the bond price can be
written as
V (t, T ) = F e−Y (t,T )(T −t)
We define the term structure of interest rates (yield curve):
T
ln(V (0, T )) − ln(V (T, T ))
Z
1
Y (0, T ) = − = r(s)ds
T T 0
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Example
Bond Price:
RT RT
V (t, T ) = F e− t r(s)ds
= F e− t (r0 +as)ds
.
a 2 −t2 )
V (t, T ) = F e−r0 (T −t)− 2 (T .
Term structure of interest rate:
1 T
Z
aT
Y (0, T ) = r(s)ds = r0 + .
T 0 2
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Risk of Default
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Risk of Default
In this case the bond has a yield of the form
Y (0, 1) = r + s
s = − ln(1 − p) = p + O(p2 ) ≈ p
1 T
Z
s(T ) = λ(s)ds
T 0
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Lecture 19
1 Asian Options
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Asian Options
Definition
An Asian Option is a contract giving the holder the right to
buy/sell an underlying asset for its average price over some
prescribed period.
The floating strike Asian put option has the final condition:
1 T
Z
V (S, T ) = max S − S(t)dt, 0 .
T 0
We introduce a new variable:
Z t
dI
I(t) = S(t)dt or = S(t).
0 dt
The final condition can now be written as
I
V (S, I, T ) = max S − , 0 .
T
Dr P. V. Johnson MATH20912
Itô’s Lemma and Elimination of Risk
1 2 2 ∂2V
∂V ∂V ∂V
dV = + σ S 2
dt + dS + dI
∂t 2 ∂S ∂S ∂I
1 2 2 ∂2V
∂V ∂V ∂V
dΠ = + σ S 2
dt + dS − ∆dS + dI
∂t 2 ∂S ∂S ∂I
Dr P. V. Johnson MATH20912
Modified Black-Scholes Equation
dI = Sdt
∂V 1 ∂2V ∂V ∂V
+ σ 2 S 2 2 + rS − rV + S =0
∂t 2 ∂S ∂S ∂I
The value of an Asian option must be calculated numerically
(no analytic solution!).
Dr P. V. Johnson MATH20912