Stochastic Calculus for Finance I: The

Binomial Asset Pricing Model

Solution of Exercise Problems
Yan Zeng
Version 1.1, last revised on 2014-10-26

Abstract
This is a solution manual for Shreve [6]. If you find any typos/errors or have any comments, please
email me at [email protected].

Contents
1 The Binomial No-Arbitrage Pricing Model 2

2 Probability Theory on Coin Toss Space 9

3 State Prices 21

4 American Derivative Securities 30

5 Random Walk 37

6 Interest-Rate-Dependent Assets 46

1
1 The Binomial No-Arbitrage Pricing Model
⋆ Comments:
1) Example 1.1.1 illustrates the essence of arbitrage: buy low, sell high. Since concrete numbers often
obscure the nature of things, we review Example 1.1.1 in abstract symbols.
First, the possibility of replicating the payoff of a call option, (S1 − K)+ , and its reverse, −(S1 − K)+ .
To replicate the payoff (S1 − K)+ of a call option at time 1, we at time 0 construct a portfolio (X0 −
∆0 S0 , ∆0 S0 ). At the operational level, we borrow X0 , buy ∆0 shares of stock, and invest the residual
amount (X0 − ∆0 S0 ) into money market account. The result is a net cash flow of X0 into the portfolio. The
replication requirement at time 1 is

(1 + r)(X0 − ∆0 S0 ) + ∆0 S1 = (S1 − K)+ .

Plug in S1 (H) = uS0 and S1 (T ) = dS0 , we obtain a system of two linear equations for two unknowns (X0
and ∆0 ) and it has a unique solution as long as u ̸= d. This is how we obtain the magic number X0 = 1.20
and ∆0 = 12 in Example 1.1.1.
To replicate the reverse payoff −(S1 −K)+ of a call option at time 1, we at time 0 construct a portfolio
(−X0 + ∆0 S0 , −∆0 S0 ). At the operational level, we short sell ∆0 shares of stock, invest the income ∆0 S0
into money market account, and withdraw a cash amount of X0 from the money market account. The result
is a net cash flow of X0 out of the portfolio.
Second, the realization of arbitrage opportunity through buy low, sell high.
If the market price C0 of the call option is greater than X0 , we just sell the call option for C0 (sell high),
spend X0 on constructing the synthetic call option (buy low), and take the residual amount (C0 − X0 ) as
arbitrage profit. At time 1, the payoff of short position in the call option will cancel out with the payoff of
the synthetic call option.
If the market price C0 of the call option is less than X0 , we buy the call option for C0 (buy low) and set
up the portfolio (−X0 + ∆0 S0 , −∆0 S0 ) at time 0, which allows us to withdraw a cash amount of X0 (sell
high). The net cash flow (X0 − C0 ) at time 0 is taken as arbitrage profit. At time 1, the payoff of long
position in the call option will cancel out with the payoff of the portfolio (−X0 + ∆0 S1 , −∆0 S1 ).
2) The essence of Definition 1.2.3 is that we can find a replicating portfolio (∆0 , · · · , ∆N −1 ) and “define”
the portfolio’s value at time n as the price of the derivative security at time n. The rationale is that if
P (ω1 ω2 · · · ωN ) > 0 and the price of the derivative security at time n does not agree with the portfolio’s
value, we can make an arbitrage on sample path ω1 ω2 · · · ωN , starting from time n. For a formal presentation
of this argument, we refer to Delbaen and Schachermayer [3], Chapter 2.
Also note the definition needs the uniqueness of the replicating portfolio. This is guaranteed in the
binomial model as seen from the uniqueness of solution of equation (1.1.3)-(1.1.4).
Finally, we note the wealth equation (1.2.14) can be written as
[ ]
Xn+1 Xn Sn+1 Sn
= + ∆ n −
(1 + r)n+1 (1 + r)n (1 + r)n+1 (1 + r)n

This leads to a representation by discrete stochastic integral:

eT = X0 + (∆ · S)
X e T,

en =
where X Xn
and Sen = Sn
n = 1, 2, · · · , N .
(1+r)n (1+r)n ,

I Exercise 1.1. Assume the one-period binomail market of Section 1.1 that both H and T have positive
probability of occurring. Show that condition (1.1.2) precludes arbitrage. In other words, show that if
X0 = 0 and
X1 = ∆0 S1 + (1 + r)(X0 − ∆0 S0 ),
then we cannot have X1 strictly positive with positive probability unless X1 is strictly negative with positive
probability as well, and this is the case regardless of the choice of the number ∆0 .

2
Proof. Note the random stock price has only two states at time 1, H and T . So “we cannot have X1 strictly
positive with positive probability unless X1 is strictly negative with positive probability as well” can be
succinctly summarized as

‘‘X1 (H) > 0 ⇒ X1 (T ) < 0 and X1 (T ) > 0 ⇒ X1 (H) < 0”.

We prove a slightly more general version of the problem to expose the nature of no-arbitrage:

‘‘X1 (H) > (1 + r)X0 ⇒ X1 (T ) < (1 + r)X0 and X1 (T ) > (1 + r)X0 ⇒ X1 (H) < (1 + r)X0 ”.

Note this is indeed a generalization since the original problem assumes X0 = 0.

For a formal proof, we write X1 as
( )
S1 − S0
X1 = ∆0 S0 − r + (1 + r)X0 .
S0
Then
X1 (H) − (1 + r)X0 = ∆0 S0 [u − (1 + r)]
and
X1 (T ) − (1 + r)X0 = ∆0 S0 [d − (1 + r)].
Given the condition d < 1 + r < u, the factor S0 [u − (1 + r)] is positive and the factor S0 [d − (1 + r)] is
negative. So
X1 (H) > (1 + r)X0 ⇒ ∆0 > 0 ⇒ X1 (T ) < (1 + r)X0
and
X1 (T ) > (1 + r)X0 ⇒ ∆0 < 0 ⇒ X1 (H) < (1 + r)X0 .
This concludes our proof.
Remark 1.1. The textbook (page 2-3) has shown “negation of d < 1 + r < u ⇒ arbitrage”, or equivalently,
“no arbitrage ⇒ d < 1 + r < u”. This exercise problem asks us to prove “d < 1 + r < u ⇒ no arbitrage”.
Remark 1.2. In the equation X1 = ∆0 S1 + (1 + r)(X0 − ∆0 S0 ), the first term ∆0 S1 is the value of the
stock position at time 1 while the second term (1 + r)(X0 − ∆0 S0 ) is the value of the money market account
at time 1.
Remark 1.3. The condition X0 = 0 in the original problem formulation is not really essential, as far as a
proper definition of arbitrage can be given. Indeed, for the one-period binomial model, we can define arbitrage
as a trading strategy such that P (X1 ≥ X0 (1 + r)) = 1 and P (X1 > X0 (1 + r)) > 0. That is, arbitrage is
a trading strategy whose return beats the risk-free rate. See Shreve [7, page 254] Exercise 5.7 for this more
general definition.

Remark 1.4. Note the condition d < 1 + r < u is just S1 (TS)−S 0

0
< r < S1 (H)−S
S0
0
: the return of the stock
investment is not guaranteed to be greater or less than the risk-free rate. This agrees with the intuition that
“arbitrage is a trading strategy that is guaranteed to beat the risk-free investment”.

I Exercise 1.2. Suppose in the situation of Example 1.1.1 that the option sells for 1.20 at time zero.
Consider an agent who begins with wealth X0 = 0 and at time zero buys ∆0 shares of stock and Γ0 options.
The numbers ∆0 and Γ0 can be either positive or negative or zero. This leaves the agent with a cash position
of −4∆0 − 1.20Γ0 . If this is positive, it is invested in the money market; if it is negative, it represents money
borrowed from the money market. At time one, the value of the agent’s portfolio of stock, option, and money
market assets is
5
X1 = ∆0 S1 + Γ0 (S1 − 5)+ − (4∆0 + 1.20Γ0 ).
4
Assume that both H and T have positive probability of occurring. Show that if there is a positive probability
that X1 is positive, then there is a positive probability that X1 is negative. In other words, one cannot find
an arbitrage when the time-zero price of the option is 1.20.

3
Proof. X1 (u) = ∆0 × 8 + Γ0 × 3 − 54 (4∆0 + 1.20Γ0 ) = 3∆0 + 1.5Γ0 , and X1 (d) = ∆0 × 2 − 54 (4∆0 + 1.20Γ0 ) =
−3∆0 − 1.5Γ0 . That is, X1 (u) = −X1 (d). So if there is a positive probability that X1 is positive, then there
is a positive probability that X1 is negative. This finishes the proof of the original problem.
Since the use of numbers often obscures the nature of a problem, and since the notation of this exercise
problem is rather confusing (given the notation in Example 1.1.1), we shall re-state the problem in different
notation and rewrite the proof in abstract symbols.
First, a re-statement of the problem in different notation: “If the option is priced at the replication cost
C0 (which is denoted by X0 in Example 1.1.1), we cannot find arbitrage by investing in tradable securities
(stock, option, and money market account). Formally, suppose an investor borrows money to buy α shares
of stock and β options at time 0, the portfolio thus constructed is (−αS0 − βC0 , αS0 + βC0 ). Its value at
time 1 becomes
X1 = αS1 + βV1 − (1 + r)(αS0 + βC0 )
where V1 is the option payoff (S1 − K)+ . Prove P (X1 > 0) > 0 ⇒ P (X1 < 0) > 0.”
Second, our proof in abstract symbols. Recall for the replication cost C0 , there exists some δ > 0 such
that
(1 + r)(C0 − δS0 ) + δS1 ≡ V1 .
Plug this into the expression of X1 , we have

X1 = αS1 + βV1 − (1 + r)(αS0 + βC0 )

= αS1 + β[(1 + r)(C0 − δS0 ) + δS1 ] − (1 + r)(αS0 + βC0 )
= αS1 + β(1 + r)C0 − βδS0 (1 + r) + δβS1 − (1 + r)αS0 − (1 + r)βC0
= (α + δβ)S1 − S0 (1 + r)(α + βδ)
[ ]
S1
= (α + βδ)S0 − (1 + r) .
S0

Since S1 /S0 = u or d and d < 1 + r < u, we conclude X1 (H) and X1 (T ) have opposite signs. This concludes
our proof.

Remark 1.5. Example 1.1.1 has shown that “no arbitrage ⇒ the time-zero price of the option is 1.20”
by proving “the time-zero price of the option is not 1.20 ⇒ there exists arbitrage via linear combination of
investments in stock, option, and money market account”.
This exercise problem asks us to prove “the time-zero price of the option is 1.20 ⇒ there exists no arbitrage
via the linear combination of investments in stock, option and money market account”. Although logically,
“linear combination of tradable securities” is only a special way of constructing portfolios, in practice it is
the only way. So it’s all right to use this special form of arbitrage to stand for general arbitrage.

I Exercise 1.3. In the one-period binomial model of Section 1.1, suppose we want to determine the price
at time zero of the derivative security V1 = S1 (i.e., the derivative security pays off the stock price.) (This
can be regarded as a European call with strike price K = 0). What is the time-zero price V0 given by the
risk-neutral pricing formula (1.1.10)?
[ ] ( )
1 1+r−d u−1−r S0 1+r−d u−1−r
Solution. V0 = 1+r u−d S1 (H) + u−d S1 (T ) = 1+r u−d u + u−d d = S0 . This is not surprising,
since this is exactly the cost of replicating S1 , via the buy-and-hold strategy.

I Exercise 1.4. In the proof of Theorem 1.2.2, show under the induction hypothesis that

Xn+1 (ω1 ω2 · · · ωn T ) = Vn+1 (ω1 ω2 · · · ωn T ).

4
Proof.
Xn+1 (T ) = ∆n dSn + (1 + r)(Xn − ∆n Sn )
= ∆n Sn (d − 1 − r) + (1 + r)Vn
Vn+1 (H) − Vn+1 (T ) p̃Vn+1 (H) + q̃Vn+1 (T )
= (d − 1 − r) + (1 + r)
u−d 1+r
= p̃[Vn+1 (T ) − Vn+1 (H)] + p̃Vn+1 (H) + q̃Vn+1 (T )
= p̃Vn+1 (T ) + q̃Vn+1 (T )
= Vn+1 (T ).

I Exercise 1.5. In Example 1.2.4, we considered an agent who sold the look-back option for V0 = 1.376
and bought ∆0 = 0.1733 shares of stock at time zero. At time one, if the stock goes up, she has a portfolio
valued at V1 (H) = 2.24. Assume that she now takes a position of ∆1 (H) = SV22 (HH)−V 2 (HT )
(HH)−S2 (HT ) in the stock.
Show that, at time two, if the stock goes up again, she will have a portfolio valued at V2 (HH) = 3.20,
whereas if the stock goes down, her portfolio will be worth V2 (HT ) = 2.40. Finally, under the assumption
that the stock goes up in the first period and down in the second period, assume the agent takes a position
of ∆2 (HT ) = SV33 (HT H)−V3 (HT T )
(HT H)−S3 (HT T ) in the stock. Show that, at time three, if the stock goes up in the third
period, she will have a portfolio valued at V3 (HT H) = 0, whereas if the stock goes down, her portfolio will
be worth V3 (HT T ) = 6. In other words, she has hedged her short position in the option.
Proof. First, on the path ω1 = H, the investor’s portfolio is worth of
X1 (H) = (1 + r)(X0 − ∆0 S0 ) + ∆0 S1 (H) = (1 + 0.25)(1.376 − 0.1733 · 4) + 0.1733 · 8 = 2.24 = V1 (H).
If on the path ω1 = H, the investor takes a position of
V2 (HH) − V2 (HT ) 3.20 − 2.40
∆1 (H) = = = 0.0667
S2 (HH) − S2 (HT ) 16 − 4
in the stock, then on the path ω1 ω2 = HH, the investor’s portfolio is worth of
X2 (HH) = (1 + r)[X1 (H) − ∆1 (H)S1 (H)] + ∆1 (H)S2 (HH)
= (1 + 0.25)(2.24 − 0.0667 · 8) + 0.0667 · 16
= 3.2
= V2 (HH),
while on the path ω1 ω2 = HT , the investor’s portfolio is worth of
X2 (HT ) = (1 + r)[X1 (H) − ∆1 (H)S1 (H)] + ∆1 (H)S2 (HT )
= (1 + 0.25)(2.24 − 0.0667 · 8) + 0.0667 · 4
= 2.4
= V2 (HT ).
Second, if on the path ω1 ω2 = HT , the agent takes a position
V3 (HT H) − V3 (HT T ) 0−6
∆2 (HT ) = = = −1
S3 (HT H) − S3 (HT T ) 8−2
in the stock, then on the path ω1 ω2 ω3 = HT H, the investor’s portfolio is worth of
X3 (HT H) = (1 + r)[X2 (HT ) − ∆2 (HT )S2 (HT )] + ∆2 (HT )S3 (HT H)
= (1 + 0.25)[2.4 − (−1) · 4] + (−1) · 8
= 0
= V3 (HT H),

5
while on the path ω1 ω2 ω3 = HT T , the investor’s portfolio is worth of

X3 (HT T ) = (1 + r)[X2 (HT ) − ∆2 (HT )S2 (HT )] + ∆2 (HT )S3 (HT T )

= (1 + 0.25)[2.4 − (−1) · 4] + (−1) · 2
= 6
= V3 (HT T ).

I Exercise 1.6. (Hedging a long position-one period). Consider a bank that has a long position in
the European call written on the stock price in Figure 1.1.2. The call expires at time one and has strike
price K = 5. In Section 1.1, we determined the time-zero price of this call to be V0 = 1.20. At time zero,
the bank owns this option, while ties up capital V0 = 1.20. The bank wants to earn the interest rate 25% on
this capital until time one (i.e., without investing any more money, and regardless of how the coin tossing
turns out, the bank wants to have
5
· 1.20 = 1.50
4
at time one, after collecting the payoff from the option (if any) at time one). Specify how the bank’s trader
should invest in the stock and money markets to accomplish this.
Solution. The bank’s trader should set up a replicating portfolio whose payoff is the opposite of the option’s
payoff. More precisely, we solve the equation

(1 + r)(X0 − ∆0 S0 ) + ∆0 S1 = −(S1 − K)+ .

Then X0 = −1.20 and ∆0 = − 21 since this equation is a linear equation of X0 and ∆0 . The solution means
the trader should sell short 0.5 share of stock, put the income 2 into a money market account, and then
transfer 1.20 into a separate money market account. At time one, the portfolio consisting of a short position
in stock and 0.8(1 + r) in money market account will cancel out with the option’s payoff. In the end, we end
up with 1.20(1 + r) in the separate money market account.
Remark 1.6. This problem illustrates why we are interested in hedging a long position. In case the stock
price goes down at time one, the option will expire worthless. The initial amount of money 1.20 paid at
time zero will be wasted. By hedging, we convert the option back into liquid assets (cash and stock) which
guarantees a sure payoff at time one. As to why we hedge a short position (as a writer), see Wilmott [8,
page 11-13], 1.4 What are Options For?

I Exercise 1.7. (Hedging a long position-multiple periods). Consider a bank that has a long position
in the lookback option of Example 1.2.4. The bank intends to hold this option until expiration and receive
the payoff V3 . At time zero, the bank has capital V0 = 1.376 tied up in the option and wants to earn the
interest rate of 25% on this capital until time three (i.e., without investing any more money, and regardless
of how the coin tossing turns out, the bank wants to have
( )3
5
· 1.376 = 2.6875
4

at time three, after collecting the payoff from the lookback option at time three). Specify how the bank’s
trader should invest in the stock and the money market account to accomplish this.
Solution. The idea is the same as Exercise 1.6. The bank’s trader only needs to set up the reverse of the
replicating trading strategy described in Example 1.2.4. More precisely, he should short sell 0.1733 share of
stock, invest the income 0.6933 into money market account, and transfer 1.376 into a separate money market
account. The portfolio consisting a short position in stock and 0.6933-1.376 in money market account will
replicate the opposite of the option’s payoff. After they cancel out, we end up with 1.376(1 + r)3 in the
separate money market account.

6
I Exercise 1.8. (Asian option). Consider the three-period model of Example 1.3.1,1 with ∑n S0 = 4, u = 2,
d = 21 , and take the interest rate r = 14 , so that p̃ = q̃ = 12 . For n = 0, 1, 2, 3, define Yn = k=0 Sk to be the
sum of the stock prices between times zero and n. Consider an Asian call option that expires at time three
( )+
and has strike K = 4 (i.e., whose payoff at time three is 41 Y3 − 4 ). This is like a European call, except
the payoff of the option is based on the average stock price rather than the final stock price. Let vn (s, y)
( )+
denote the price of this option at time n if Sn = s and Yn = y. In particular, v3 (s, y) = 14 y − 4 .
(i) Develop an algorithm for computing vn recursively. In particular, write a formula for vn in terms of vn+1 .
Solution. By risk-neutral pricing formula,
1 2[ (s s )]
vn (s, y) = [p̃vn+1 (us, y + us) + q̃vn+1 (ds, y + ds)] = vn+1 (2s, y + 2s) + vn+1 ,y + .
1+r 5 2 2

(ii) Apply the algorithm developed in (i) to compute v0 (4, 4), the price of the Asian option at time zero.

S3 (HHH) = 32
Y3 (HHH) = 60
S2 (HH) = 16 v3 (32, 60) = 11
Y2 (HH) = 28
v2 (16, 28) = 6.4 S3 (HHT ) = 8
Y3 (HHT ) = 36
S1 (H) = 8 v3 (8, 36) = 5
Y1 (H) = 12
v1 (8, 12) = 2.96 S3 (HT H) = 8
Y3 (HT H) = 24
S2 (HT ) = 4 v3 (8, 24) = 2
Y2 (HT ) = 16
v2 (4, 16) = 1 S3 (HT T ) = 2
Y3 (HT T ) = 18
v3 (2, 18) = 0.5
S0 = 4 Y0 = 4
v0 (4, 4) = 1.216
S3 (T HH) = 8
Y3 (T HH) = 18
S2 (T H) = 4 v3 (8, 18) = 0.5
Y2 (T H) = 10
v2 (4, 10) = 0.2 S3 (T HT ) = 2
Y3 (T HT ) = 12
S1 (T ) = 2 v3 (2, 12) = 0
Y1 (T ) = 6
v1 (2, 6) = 0.08 S3 (T T H) = 2
Y3 (T T H) = 9
S2 (T T ) = 1 v3 (2, 9) = 0
Y2 (T T ) = 7
v2 (1, 7) = 0 S3 (T T T ) = 0.5
Y3 (T T T ) = 7.5
v3 (0.5, 7.5) = 0

Exercise 1.8. Asian option.

Solution.
1 The textbook said “Example 1.2.1” by mistake.

7
(iii) Provide a formula for δn (s, y), the number of shares of stock that should be held by the replicating
portfolio at time n if Sn = s and Yn = y.
Solution.
vn+1 (us, y + us) − vn+1 (ds, y + ds)
δn (s, y) = .
(u − d)s

I Exercise 1.9. (Stochastic volatility, random interest rate). Consider a binomial pricing model,
but at each time n ≥ 1, the “up factor” un (ω1 ω2 · · · ωn ), the “down factor” dn (ω1 ω2 · · · ωn ), and the interest
rate rn (ω1 ω2 · · · ωn ) are allowed to depend on n and on the first n coin tosses ω1 ω2 · · · ωn . The initial up
factor u0 , the initial down factor d0 , and the initial interest rate r0 are not random. More specifically, the
stock price at time one is given by {
u0 S0 if ω1 = H,
S1 (ω1 ) =
d0 S0 if ω1 = T ,
and, for n ≥ 1, the stock price at time n + 1 is given by
{
un (ω1 ω2 · · · ωn )Sn (ω1 ω2 · · · ωn ) if ωn+1 = H,
Sn+1 (ω1 ω2 · · · ωn ωn+1 ) =
dn (ω1 ω2 · · · ωn )Sn (ω1 ω2 · · · ωn ) if ωn+1 = T .

One dollar invested in or borrowed from the money market at time zero grows to an investment or debt of
1 + r0 at time one, and, for n ≥ 1, one dollar invested in or borrowed from the money market at time n
grows to an investment or debt of 1 + rn (ω1 ω2 · · · ωn ) at time n + 1. We assume that for each n and for all
ω1 ω2 · · · ωn , the no-arbitrage condition

0 < dn (ω1 ω2 · · · ωn ) < 1 + rn (ω1 ω2 · · · ωn ) < un (ω1 ω2 · · · ωn )

holds. We also assume that 0 < d0 < 1 + r0 < u0 .

(i) Let N be a positive integer. In the model just described, provide an algorithm for determining the price
at time zero for a derivative security that at time N pays off a random amount VN depending on the result
of the first N coin tosses.
Solution. Similar to Theorem 1.2.2, but replace r, u and d everywhere with rn , un and dn . More precisely,
n −dn
un −dn and q̃n = 1 − p
set p̃n = 1+r en . Then

p̃n Vn+1 (H) + q̃n Vn+1 (T )

Vn = .
1 + rn

(ii) Provide a formula for the number of shares of stock that should be held at each time n (0 ≤ n ≤ N − 1)
by a portfolio that replicates the derivatives security VN .
Vn+1 (H)−Vn+1 (T ) Vn+1 (H)−Vn+1 (T )
Solution. ∆n = Sn+1 (H)−Sn+1 (T ) = (un −dn )Sn .

(iii) Suppose the initial stock price is S0 = 80, with each head the stock price increases by 10, and with each
tail the stock price decreases by 10. In other words, S1 (H) = 90, S1 (T ) = 70, S2 (HH) = 100, etc. Assume
the interest rate is always zero. Consider a European call with strike price 80, expiring at time five. What
is the price of this call at time zero?

Solution. un = Sn+1 Sn
(H)
= SnS+10
n
= 1 + S10n and dn = Sn+1Sn
(T )
= SnS−10
n
= 1 − S10n . So the risk-neutral
probabilities at time n are p̃n = u1−d n
n −dn
= 12 and q̃n = 12 .
To price the European call, we only need to focus on the nodes at time 5 of the binomial tree since p̃n
and q̃n are constants. In order to have non-zero payoffs, a node at time 5 must have at least 3 H’s. For such
a node, we have

8
 number of H’s option payoff risk-neutral probability of paths
3 (80 + 30 − 20) − 80 = 10 25 · 3!2! = 32
1 5! 10

4 (80 + 40 − 10) − 80 = 30 25 · 5 = 32
1 5

5 (80 + 50) − 80 = 50 1
25 = 32
1

So the price of the call at time zero is

1 5 10 300
· 50 + · 30 + · 10 = = 9.375.
32 32 32 32

2 Probability Theory on Coin Toss Space

⋆ Comments:
1) The second proof of Theorem 2.4.4 also works for the random interest rate model of Exercise 1.9, as
Sn+1
far as (1+r) Sn+1 e
n+1 is replaced by (1+r )···(1+r ) . The requirement on the risk-neutral probability P is that
0 n

e n+1 = H|ω1 , · · · , ωn ) := p̃n = 1 + rn − dn

P(w
un − dn
and
e n+1 = T |ω1 , · · · , ωn ) := 1 − p̃n = q̃n .
P(w
Results in measure theory guarantee the existence and uniqueness of such a probability measure P e on the
sample space Ω = {w : (w1 , · · · , wN )} for a given family of conditional probabilities (p̃n , q̃n )n=1 . With this
N 2

setup, we have [ ]
e n Sn+1 = un p̃n + dn q̃n = (1 + rn ).
E
Sn
In other words, the stock price process, when discounted by the random interest rates, is a martingale under
e When rn ’s are deterministic, we are back to the case where ωn ’s are independent of each other. This
P.
unifies the deterministic and random interest rate models.
2) On Theorem 2.4.8 (Cash flow valuation): by Theorem 2.4.7, it is natural to “conjecture” that the
no-arbitrage price process of the derivative security is given by the risk-neutral pricing formula (2.4.13).
However, pricing always needs to be justified by hedging/replication. We need to find a portfolio process
which replicates the cash flows while equals to (Vn )Nn=0 in value. The key insight to the construction of such
a replicating portfolio is the wealth equation (2.4.16)

Xn+1 = ∆n Sn+1 + (1 + r)(Xn − Cn − ∆n Sn ),

which clearly indicates that the wealth process (Xn )N

n=1 produces a cash outflow of Cn at step n.
Note the presentation of Theorem 2.4.8 follows the following flow of logic:

define Vn ’s ⇒ define ∆n ’s ⇒ define Xn ’s ⇒ prove Xn = Vn .

We could have taken a different, yet more natural path of logic, namely

define Xn ’s and ∆n ’s simultaneously

⇒ prove formula (2.4.14) holds with Vn ’s replaced by Xn ’s
⇒ prove formula (2.4.13) holds with Vn ’s replaced by Xn ’s
⇒ define Vn = Xn .
2 See, for example, Shiryaev [5, page 249], Theorem 2 (Ionescu Tulcea’s Theorem on Extending a Measure and the Existence

of a Random Sequence).

9
Indeed, we define XN = CN and solve for XN −1 and ∆N −1 in the following equation

XN = ∆N −1 SN + (1 + r)(XN −1 − CN −1 − ∆N −1 SN −1 ).

By imitating the trick of (1.1.3)-(1.1.8) (page 6), we obtain

CN (ω1 · · · ωN −1 H) − CN (ω1 · · · ωN −1 T )
∆N −1 (ω1 · · · ωN −1 ) =
SN (ω1 · · · ωN −1 H) − SN (ω1 · · · ωN −1 T )

1
XN −1 = CN −1 + [p̃XN (ω1 · · · ωN −1 H) + q̃XN (ω1 · · · ωN −1 T )]
1+r
[ ]
e n XN
= CN −1 + E
1+r
[ N ]
∑ C
en
= E
k
.
k=N −1
(1 + r)k−(N −1)

Working backward by induction, we can provide definitions for each Xn and ∆n , and prove for each n
[ ] [ N ]
X ∑ C
Xn = Cn + Een n+1
=Een k
.
1+r (1 + r)k−n
k=n

Finally, we comment that Theorem 1.2.2 is a special case of Theorem 2.4.8, with C0 = C1 = · · · =
CN −1 = 0.
3) The textbook gives readers the impression that Markov property is preserved under the risk-neutral
probability, at least in the setting of binomial model. A general result in this regard is recently announced
in Schmock [4]:
Theorem 1 (Uwe Schmock and Ismail Cetin Gülüm). Let (Ω, F, {Ft }t=0,··· ,T , P) be a (general) filtered
probability space and let S = {St }t∈{0,··· ,T } be an adapted, Rd -valued discounted asset price process, which
has the k-multiple Markov property w.r.t. P. Then the following properties are equivalent:
(a) The financial market model is free of arbitrage.
(b) There exists a probability measure P∗ on (Ω, F, P) such that
• P∗ ∼ P with ϱ := dP∗ /dP ∈ L∞ (Ω, FT , P).
• Integrability: St ∈ L1 (Ω, Ft , P∗ ) for all t ∈ {0, · · · , T }.
• Martingale property w.r.t. P∗ :
a.s.
EP∗ [St |Ft−1 ] = St−1 for all t ∈ {1, · · · , T }.

• k-multiple Markov property: For all B ∈ E and t ∈ {k, · · · , T }

P∗ (St ∈ B|Ft−1 ) = P∗ (St ∈ B|St−1 , St−2 , · · · , St−k ).

a.s.

For continuous time financial models, it is well-known that for Lipschitz continuous f , g, the stochastic
differential equation of K. Itô
∫ t ∫ t
Xt = X0 + f (s, Xs )dWs + g(s, Xs )ds
0 0

has a unique solution which is a Markov process with continuous paths. Moreover if f and g satisfy f (t, x) =
f (x), g(t, x) = g(x), then X is a time homogenous strong Markov process. These results combined with
Girsanov’s Theorem (Shreve [7] Chapter 5) will preserve Markov property of discounted asset process under
the risk-neutral measure.

I Exercise 2.1. Using Definition 2.1.1, show the following.

(i) If A is an event and Ac denotes its complement, then P(Ac ) = 1 − P(A).

10
 ∑ ∑ ∑
Proof. P(Ac ) + P(A) = ω∈Ac P(ω) + ω∈A P(ω) = ω∈Ω P(ω) = 1.

(ii) If A1 , A2 , · · · , AN is a finite set of events, then

∑
N
P(∪N
n=1 An ) ≤ P(An ). (2.8.1)
n=1

If the events A1 , A2 , · · · , AN are disjoint, then equality holds in (2.8.1).

Proof.
∑ By induction, work on the case N = 2. When A1 and A2 are disjoint, P(A1 ∪ A2 ) =
∑it suffices to ∑
ω∈A1 ∪A2 P(ω) = ω∈A1 P(ω) + ω∈A2 P(ω) = P(A1 ) + P(A2 ). When A1 and A2 are arbitrary, using
the result when they are disjoint, we have P(A1 ∪ A2 ) = P((A1 − A2 ) ∪ A2 ) = P(A1 − A2 ) + P(A2 ) ≤
P (A1 ) + P(A2 ).

I Exercise 2.2. Consider the stock price S3 in Figure 2.3.1.

(i) What is the distribution of S3 under the risk-neutral probabilities p̃ = 12 , q̃ = 12 .

Solution. Under the risk-neutral probability, the distribution of ωn+1 conditioning on ω1 , · · · , ωn is deter-
ministic

e n+1 = H|ω1 ω2 · · · ωn ) := p̃ = 1 + r − d , P(ω

P(ω e n+1 = T |ω1 ω2 · · · ωn ) := q̃ = u − 1 − r .
u−d u−d
e and we have
So ωn ’s are independent of each other under P

e 3 = 32) = p̃3 = 1 , P(S

P(S e 3 = 8) = 3p̃2 q̃ = 3 , P(S
e 3 = 2) = 3p̃q̃ 2 = 3 , P(S
e 3 = 0.5) = q̃ 3 = 1 .
8 8 8 8

e 1 , ES
(ii) Compute ES e 2 , and ES
e 3 . What is the average rate of growth of the stock price under P?
e

Solution. 
 e e e
E[S1 ] = 8P(S1 = 8) + 2P(S1 = 2) = 8p̃ + 2q̃ = 5
e
E[S2 ] = 16p̃ + 4 · 2p̃q̃ + 1 · q̃ 2 = 6.25
2

e
E[S3 ] = 32 · 18 + 8 · 38 + 2 · 38 + 0.5 · 18 = 7.8125.

So the average rates of growth of the stock price under P e are, respectively:

 e 1]

 r̃ = E[S
S0 − 1 = 4 − 1 = 0.25,
5
 0 e 2]
E[S
e 1 ] − 1 = 5 − 1 = 0.25,
6.25
r̃1 = E[S


r̃ = E[S
 e 3]
− 1 = 7.8125 − 1 = 0.25.
2 e 2]
E[S 6.25

Remark 2.1. An alternative solution is to use martingale property:

[ ] e
e
E
Sn e [Sn ] = (1 + r)n S0 , E [Sn ] = (1 + r).
= S0 ⇒ E
(1 + r)n e [Sn−1 ]
E

(iii) Answer (i) and (ii) again under the actual probabilities p = 23 , q = 13 .
Solution. P(S3 = 32) = ( 32 )3 = 27
8
, P(S3 = 8) = 3 · ( 23 )2 · 13 = 94 , P(S3 = 2) = 2 · 19 = 29 , and P(S3 = 0.5) = 27
1
.
Accordingly, E[S1 ] = 6, E[S2 ] = 9 and E[S3 ] = 13.5. So the average rates of growth of the stock price
under P are, respectively: r0 = 64 − 1 = 0.5, r1 = 69 − 1 = 0.5, and r2 = 13.5 9 − 1 = 0.5.

11
Remark 2.2. An alternative solution is to use Markov property: En [Sn+1 ] = Sn En [Sn+1 /Sn ] = Sn (pu+qd).

I Exercise 2.3. Show that a convex function of a martingale is a submartingale. In other words, let M0 ,
M1 , · · · , MN be a martingale and let φ be a convex function. Show that φ(M0 ), φ(M1 ), · · · , φ(MN ) is a
submartingale.
Proof. Apply conditional Jensen’s inequality, Theorem 2.3.2 (v).

I Exercise 2.4. Toss a coin repeatedly. Assume the probability of head on each toss is 12 , as is the
probability of tail. Let Xj = 1 if the jth toss results in a head and Xj = −1 if the jth toss results in a tail.
Consider the stochastic process M0 , M1 , M2 , · · · defined by M0 = 0 and
∑
n
Mn = Xj , n ≥ 1.
j=1

This is called a symmetric random walk; with each head, it steps up one, and with each tail, it steps down
one.
(i) Using the properties of Theorem 2.3.2, show that M0 , M1 , M2 , · · · is a martingale.
Proof. En [Mn+1 ] = Mn + En [Xn+1 ] = Mn + E[Xn+1 ] = Mn .
(ii) Let σ be a positive constant and, for n ≥ 0, define
( )n
2
Sn = eσMn .
eσ + e−σ
Show that S0 , S1 , S2 , · · · is a martingale. Note that even though the symmetric random walk Mn has no
tendency to grow, the “geometric symmetric random walk” eσMn does have a tendency to grow. This is the
result of putting a martingale into the (convex) exponential function (see Exercise 2.3). In order to again
2
have a martingale, we must “discount” the geometric symmetric random walk, using the term eσ +e −σ as the

discount rate. This term is strictly less than one unless σ = 0.

Proof. [ ] [ ]
Sn+1 2 2 [ ]
En = En eσXn+1
σ −σ
= σ −σ
E eσXn+1 = 1.
Sn e +e e +e

I Exercise 2.5. Let M0 , M1 , M2 , · · · be the symmetric random walk of Exercise 2.4, and define I0 = 0
and
∑
n−1
In = Mj (Mj+1 − Mj ), n = 1, 2, · · · .
j=0

(i) Show that

1 2 n
In = M − .
2 n 2
Proof.

∑
n−1 ∑
n−1 ∑
n−1 ∑
n−1
2In = 2 Mj (Mj+1 − Mj ) = 2 Mj Mj+1 + Mn2 − 2
Mj+1 − Mj2
j=0 j=0 j=0 j=0

∑
n−1 ∑
n−1
= Mn2 − (Mj+1 − Mj )2 = Mn2 − 2
Xj+1 = Mn2 − n.
j=0 j=0

12
Remark 2.3. This is the discrete version of the integration-by-parts formula for stochastic integral:
∫ T
MT2 − M02 = 2 Mt dMt + [M, M ]T .
0
∫T
with IT = 0
Mt dMt .
(ii) Let n be an arbitrary nonnegative integer, and let f (i) be an arbitrary function of a variable i. In terms
of n and f , define another function g(i) satisfying

En [f (In+1 )] = g(In ).

Note that although the function g(In ) on the right-hand side of this equation may depend on n, the only
random variable that may appear in its argument is In ; the random variable Mn may not appear. You will
need to use the formula in part (i). The conclusion of part (ii) is that the process I0 , I1 , I2 , · · · is a Markov
process.
Solution.

En [f (In+1 )]
= En [f (In + Mn (Mn+1 − Mn ))]
= En [f (In + Mn Xn+1 )]
1
= [f (In + Mn ) + f (In − Mn )]
2
= g(In ),
√ √ √
where g(x) = 12 [f (x + 2x + n) + f (x − 2x + n)], since 2In + n = |Mn |.

I Exercise 2.6 (Discrete-time stochastic integral). Suppose M0 , M1 , · · · , MN is a martingale, and

let ∆0 , ∆1 , · · · , ∆N −1 be an adapted process. Define the discrete-time stochastic integral (sometimes called
a martingale transform) I0 , I1 , · · · , IN by setting I0 = 0 and

∑
n−1
In = ∆j (Mj+1 − Mj ), n = 1, · · · , N.
j=0

Show that I0 , I1 , · · · , IN is a martingale.

Proof. En [In+1 − In ] = En [∆n (Mn+1 − Mn )] = ∆n En [Mn+1 − Mn ] = 0.

I Exercise 2.7. In a binomial model, give an example of a stochastic process that is a martingale but is
not Markov.
Solution. We denote by Xn the result of the nth coin toss:
{
Xn = 1 if ωn = H
Xn = −1 if ωn = T

We also suppose P(X = 1) = P(X = −1) = 12 . Define S1 = X1 and Sn+1 = Sn + bn (X1 , · · · , Xn )Xn+1 ,
where bn (·) is a bounded function on {−1, 1}n , to be determined later on. Clearly (Sn )n≥1 is an adapted
stochastic process, and we can show it is a martingale. Indeed,

En [Sn+1 − Sn ] = bn (X1 , · · · , Xn )En [Xn+1 ] = 0.

For any arbitrary function f , En [f (Sn+1 )] = 21 [f (Sn + bn (X1 , · · · , Xn )) + f (Sn − bn (X1 , · · · , Xn ))]. Then
intuitively, En [f (Sn+1 ] cannot be solely dependent upon Sn when bn ’s are properly chosen. Therefore in
general, (Sn )n≥1 cannot be a Markov process.

13
Remark 2.4. If Xn is regarded as the gain/loss of n-th bet in a gambling game, then Sn would be the wealth
at time n. bn is therefore the wager for the (n + 1)th bet and is devised according to past gambling results.

I Exercise 2.8. Consider an N -period binomial model.

(i) Let M0 , M1 , · · · , MN and M0′ , M1′ , · · · , MN
′ e Show that
be martingales under the risk-neutral measure P.
′
if MN = MN (for every possible outcome of the sequence of coin tosses), then, for each n between 0 and N ,
we have Mn = Mn′ (for every possible outcome of the sequence of coin tosses).
′
Proof. Note Mn = En [MN ] = En [MN ] = Mn′ , n = 0, 1, · · · , N .

(ii) Let VN be the payoff at time N of some derivative security. This is a random variable that can depend
on all N coin tosses. Define recursively VN −1 , VN −2 , · · · , V0 by the algorithm (1.2.16) of Chapter 1. Show
that
V1 VN −1 VN
V0 , ,··· , ,
1+r (1 + r)N −1 (1 + r)N
e
is a martingale under P.
Proof. In the proof of Theorem 1.2.2, we proved by induction that{Xn = V}n where Xn is defined by (1.2.14)
of Chapter 1: Xn+1 = ∆n Sn+1 + (1 + r)(Xn − ∆n Sn ). Since (1+r) Xn
n is a martingale under Pe
{ } 0≤n≤N
(Theorem 2.4.5), Vn
n
e
is also a martingale under P.
(1+r)
0≤n≤N

(iii) Using the risk-neutral pricing formula (2.4.11) of this chapter, define
[ ]
en VN
Vn′ = E , n = 0, 1, · · · , N − 1.
(1 + r)N −n

Show that
V1′ VN′ −1 VN
V0′ , ,··· , ,
1+r (1 + r)N −1 (1 + r)N
is a martingale.

Proof. This is obvious by iterated conditioning.

(iv) Conclude that Vn = Vn′ for every n (i.e., the algorithm (1.2.16) of Theorem 1.2.2 of Chapter 1 gives the
same derivative security prices as the risk-neutral pricing formula (2.4.11) of Chapter 2).
Proof. Combine (ii) and (iii), then use (i).

I Exercise 2.9 (Stochastic volatility, random interest rate). Consider a two-period stochastic volatil-
ity, random interest rate model of the type described in Exercise 1.9 of Chapter 1. The stock prices and
interest rates are shown in Figure 2.8.1.
(i) Determine risk-neutral probabilities

e
P(HH), e
P(HT e H), P(T
), P(T e T ),

such that the time-zero value of an option that pays off V2 at time two is given by the risk-neutral pricing
formula [ ]
e V2
V0 = E .
(1 + r0 )(1 + r1 )

14
 S2 (HH) = 12

S1 (H) = 8
r1 (H) = 14

S2 (HT ) = 8
S0 = 4
r0 = 14
S2 (T H) = 8

S1 (T ) = 2
r1 (T ) = 12

S2 (T T ) = 2

Fig. 2.8.1. A stochastic volatility, random interest rate model.

Solution.
S1 (H) S1 (H) 1
u0 = = 2, d0 = = ,
S0 S0 2
S2 (HH) S2 (HT )
u1 (H) = = 1.5, d1 (H) = = 1,
S1 (H) S1 (H)
S2 (T H) S2 (T T )
u1 (T ) = = 4, d1 (T ) = = 1.
S1 (T ) S1 (T )
Therefore
1 + r0 − d0 1 1
p̃0 = = , q̃0 = 1 − p̃0 =
u0 − d0 2 2
1 + r1 (H) − d1 (H) 1 1
p̃1 (H) = = , q̃1 (H) = 1 − p̃1 (H) = ,
u1 (H) − d1 (H) 2 2
1 + r1 (T ) − d1 (T ) 1 5
p̃1 (T ) = = , q̃1 (T ) = 1 − p̃1 (T ) = .
u1 (T ) − d1 (T ) 6 6
and
e 1 e 1 e 1 e 5
P(HH) = p̃0 p̃1 (H) = , P(HT ) = p̃0 q̃1 (H) = , P(T H) = q̃0 p̃1 (T ) = , P(T T ) = q̃0 q̃1 (T ) = .
4 4 12 12
The proofs of Theorem 2.4.4, Theorem 2.4.5 and Theorem 2.4.7 still work for the random interest rate
model, with proper modifications (i.e. P e would be constructed according to the family of conditional proba-
e
bilities P(ωn+1 = H|ω1 , · · · , ωn ) := p̃n and P(ω e n+1 = T |ω1 , · · · , ωn ) := q̃n . See Footnote 2 for comments.).
So the time-zero
[ value
] of an option that pays off V2 at time two is given by the risk-neutral pricing formula
V0 = E e V2
(1+r0 )(1+r1 ) .

(ii) Let V2 = (S2 − 7)+ . Compute V0 , V1 (H), and V1 (T ).

Solution. V2 (HH) = 5, V2 (HT ) = 1, V2 (T H) = 1 and V2 (T T ) = 0. So
p̃1 (H)V2 (HH) + q̃1 (H)V2 (HT )
V1 (H) = = 2.4
1 + r1 (H)
p̃1 (T )V2 (T H) + q̃1 (T )V2 (T T ) 1
V1 (T ) = =
1 + r1 (T ) 9
p̃0 V1 (H) + q̃0 V1 (T )
V0 = = 1.00444.
1 + r0

15
(iii) Suppose an agent sells the option in (ii) for V0 at time zero. compute the position ∆0 she should take
in the stock at time zero so that at time one, regardless of whether the first coin toss results in head or tail,
the value of her portfolio is V1 .
V1 (H)−V1 (T ) 2.4− 19
Solution. ∆0 = S1 (H)−S1 (T ) = 8−2 = 0.4 − 1
54 ≈ 0.3815.

(iv) Suppose in (iii) that the first coin toss results in head. What position ∆1 (H) should the agent now take
in the stock be sure that, regardless of whether the second coin toss results in head or tail, the value of her
portfolio at time two will be (S2 − 7)+ ?
V2 (HH)−V2 (HT ) 5−1
Solution. ∆1 (H) = S2 (HH)−S2 (HT ) = 12−8 = 1.

I Exercise 2.10 (Dividend-paying stock).3 We consider a binomial asset pricing model as in Chapter
1, except that, after each movement in the stock price, a dividend is paid and the stock price is reduced
accordingly. To describe this in equations, we define
{
u, if ωn+1 = H,
Yn+1 (ω1 · · · ωn ωn+1 ) =
d, if ωn+1 = T .

Note that Yn+1 depends only on the (n + 1)st coin toss. In the binomial model of Chapter 1, Yn+1 Sn was
the stock price at time n + 1. In the dividend-paying model considered here, we have a random variable
An+1 (ω1 · · · ωn ωn+1 ), taking values in (0, 1), and the dividend paid at time n + 1 is An+1 Yn+1 Sn . After the
dividend is paid, the stock price at time n + 1 is
Sn+1 = (1 − An+1 )Yn+1 Sn .
An agent who begins with initial capital X0 and at each time n takes a position of ∆n shares of stock,
where ∆n depends only on the first n coin tosses, has a portfolio value governed by the wealth equation (see
(2.4.6))4
Xn+1 = ∆n Sn+1 + (1 + r)(Xn − ∆n Sn ) + ∆n An+1 Yn+1 Sn = ∆n Yn+1 Sn + (1 + r)(Xn − ∆n Sn ). (2.8.2)

(i) Show that the discounted wealth process is a martingale under the risk-neutral measure (i.e., Theorem
2.4.5 still holds for the wealth process (2.8.2)). As usual, the risk-neutral measure is still defined by the
equations
1+r−d u−1−r
p̃ = , q̃ = .
u−d u−d
Proof.
[ ] [ ]
en
E
Xn+1 e n ∆n Yn+1 Sn + (1 + r)(Xn − ∆n Sn )
= E
(1 + r)n+1 (1 + r)n+1 (1 + r)n+1
∆ n Sn e Xn − ∆n Sn
= n+1
En [Yn+1 ] +
(1 + r) (1 + r)n
∆ n Sn Xn − ∆n Sn
= (up̃ + dq̃) +
(1 + r)n+1 (1 + r)n
∆n Sn + Xn − ∆n Sn Xn
= = .
(1 + r)n (1 + r)n

3 Compare this problem with §5.5 of Shreve [7].

4 Note the assumption of the equation is that the dividends are reinvested. Also note the equation can be written as
Xn+1 − Xn = ∆n (Sn+1 − Sn ) + r(Xn − ∆n Sn ) + ∆n An+1 Yn+1 Sn ,
which gives three sources of wealth change: change of stock price, interest earned from money market account, and stock
dividends.

16
(ii) Show that the risk-neutral pricing formula still applies (i.e., Theorem 2.4.7 holds for the dividend-paying
model).
Proof. From (2.8.2), we have
{
∆n uSn + (1 + r)(Xn − ∆n Sn ) = Xn+1 (H)
∆n dSn + (1 + r)(Xn − ∆n Sn ) = Xn+1 (T ).

So [ ]
Xn+1 (H) − Xn+1 (T ) e Xn+1
∆n = , Xn = E n .
uSn − dSn 1+r
[ ]
To make the portfolio replicate the payoff at time N , we must have XN = VN . So Xn = E en XN
N −n =
[ ] (1+r)
en
E VN
. Since (Xn )0≤n≤N is the value process of the unique replicating portfolio (uniqueness is
(1+r)N −n
guaranteed by the uniqueness
[ of the
] solution to the above linear equations), the no-arbitrage price of VN at
e
time n is Vn = Xn = En (1+r)N −n .
VN

(iii) Show that the discounted stock price is not a martingale under the risk-neutral measure (i.e., Theorem
2.4.4 no longer holds). However, if An+1 is a constant a ∈ (0, 1), regardless of the value of n and the outcome
of the coin tossing ω1 · · · ωn+1 , then (1−a)Snn(1+r)n is a martingale under the risk-neutral measure.

Proof.
[ ]
en Sn+1
E
(1 + r)n+1
1 e n [(1 − An+1 )Yn+1 Sn ]
= E
(1 + r)n+1
Sn
= {p̃[1 − An+1 (ω1 · · · ωn H)]u + q̃[1 − An+1 (ω1 · · · ωn T )]d}
(1 + r)n+1
Sn
< [p̃u + q̃d]
(1 + r)n+1
Sn
= .
(1 + r)n

If An+1 is a constant a, then

[ ]
en Sn+1 Sn Sn
E = (1 − a)(p̃u + q̃d) = (1 − a).
(1 + r)n+1 (1 + r)n+1 (1 + r)n
[ ]
So Een Sn+1 Sn Sn
(1+r)n+1 (1−a)n+1 = (1+r)n (1−a)n , which implies (1−a)n (1+r)n is a martingale under the risk-neutral
measure.

I Exercise 2.11 (Put-call parity). Consider a stock that pays no dividend in an N -period binomial
model. A European call has payoff CN = (SN − K)+ at time N . The price Cn of this call at earlier times
is given by the risk-neutral pricing formula (2.4.11):
[ ]
en CN
Cn = E , n = 0, 1, · · · , N − 1.
(1 + r)N −n

Consider also a put with payoff PN = (K − SN )+ at time N , whose price at earlier time is
[ ]
en PN
Pn = E , n = 0, 1, · · · , N − 1.
(1 + r)N −n

17
Finally, consider a forward contract to buy one share of stock at time N for K dollars. The price of this
contract at time N is FN = SN − K, and its price at earlier times is
[ ]
e FN
Fn = E n , n = 0, 1, · · · , N − 1.
(1 + r)N −n

(Note that, unlike the call, the forward contract requires that the stock be purchased at time N for K dollars
and has a negative payoff if SN < K.)
(i) If at time zero you buy a forward contract and a put, and hold them until expiration, explain why the
payoff you receive is the same as the payoff of call; i.e., explain why CN = FN + PN .
Solution.
{
SN − K + K − SN if K > SN
FN + PN = SN − K + (K − SN )+ = = (SN − K)+ = CN .
SN − K if K ≤ SN

(ii) Using the risk-neutral pricing formulas given above for Cn , Pn , and Fn and the linearity of conditional
expectations, show that Cn = Fn + Pn for every n.
e n [ CNN −n ] = E
Proof. Cn = E e n [ FNN −n ] + E
e n [ PNN −n ] = Fn + Pn .
(1+r) (1+r) (1+r)

(iii) Using the fact that the discounted stock price is a martingale under the risk-neutral measure, show that
F0 = S0 − (1+r)
K
N .

e FN N ] =
Proof. F0 = E[ 1 e N − K] = S0 −
E[S K
.
(1+r) (1+r)N (1+r)N

(iv) Suppose you begin at time zero with F0 , buy one share of stock, borrowing money as necessary to do
that, and make no further trades. Show that at time N you have a portfolio valued at FN . (This is called
a static replication of the forward contract. If you sell the forward contract for F0 at time zero, you can use
this static replication to hedge your short position in the forward contract.)

Proof. At time zero, the trader has F0 − S0 in money market account and one share of stock. At time N ,
the trader has a wealth of (F0 − S0 )(1 + r)N + SN = −K + SN = FN .

(v) The forward price of the stock at time zero is defined to be that value of K that causes the forward
contract to have price zero at time zero. The forward price in this model is (1 + r)N S0 . Show that, at time
zero, the price of a call struck at the forward price is the same as the price of a put struck at the forward
price. This fact is called put-call parity.
(1+r)N S0
Proof. By (iii), F0 = S0 − (1+r)N
= 0. So by (ii), C0 = F0 + P0 = P0 .

Remark 2.5. The forward price can be easily determined by the static replication: to hedge a short position
in forward contract, we can buy and hold one share of stock until time N . The cost of this strategy is S0 at
time zero and S0 (1 + r)N at time N . At time N , we receive K dollars for compensation. So we must have
K = S0 (1 + r)N to eliminate arbitrage.

(vi) If we choose K = (1 + r)N S0 , we just saw in (v) that C0 = P0 . Do we have Cn = Pn for every n?

e n [ SN −K
Proof. By (ii), Cn = Pn if and only if Fn = 0. Note Fn = E ] = Sn − (1+r)N S0
= Sn − S0 (1 + r)n .
(1+r)N −n (1+r)N −n
So Fn is zero if and only if n = 0 or r = 0.

18
I Exercise 2.12 (Chooser option). Let 1 ≤ m ≤ N − 1 and K > 0 be given. A chooser option is a
contract sold at time zero that confers on its owner the right to receive either a call or a put at time m.
The owner of the chooser may wait until time m before choosing. The call or put chosen expires at time
N with strike K. Show that the time-zero price of a chooser option is the sum of the time-zero price of a
put, expiring at time N and having strike price K, and a call, expiring at time m and having strike price
K
(1+r)N −m
. (Hint: Use put-call parity (Exercise 2.11).)

Proof. First, the no-arbitrage price of the chooser option at time m must be max(Cm , Pm ), where
[ ] [ ]
e (SN − K)+ e (K − SN )+
Cm = Em and Pm = Em .
(1 + r)N −m (1 + r)N −m
That is, Cm is the no-arbitrage price of a call option at time m and Pm is the no-arbitrage price of a put
option at time m. Both of the call and the put have maturity date N and strike price K. Suppose the market
is liquid, then the chooser option is equivalent to receiving a payoff of max(Cm , Pm ) at time m. Therefore,
its no-arbitrage price at time 0 should be E[e max(Cm ,P m)
].
(1+r)m
[ ]+
By the put-call parity, Cm = Sm − (1+r)KN −m + Pm . So max(Cm , Pm ) = Pm + Sm − (1+r)KN −m .
Therefore, the time-zero price of a chooser option is
( )+  ( )+ 
[ ] Sm − (1+r)N −m
K [ ] Sm − (1+r)N −m
K
e Pm e  e (K − SN )+ e 
E m
+E  m =E N
+E  .
(1 + r) (1 + r) (1 + r) (1 + r)m

The first term stands for the time-zero price of a put, expiring at time N and having strike price K, and the
second term stands for the time-zero price of a call, expiring at time m and having strike price (1+r)KN −m .

I Exercise 2.13 (Asian option). Consider an N -period binomial model. An Asian option has a payoff
based on the average stock price, i.e.,
( )
1 ∑
N
VN = f Sn ,
N + 1 n=0

where the function f ∑ is determined by the contractual details of the option.

n
(i) Define Yn = k=0 Sk and use the Independence Lemma 2.5.3 to show that the two-dimensional
process {Sn , Yn }, n = 0, 1, · · · , N is Markov.
Proof. Note the conditional distribution
{
1+r−d
e n+1 = i|ω1 , · · · , ωn ) = if i = H
P(ω u−d
u−1−4
u−d if i = T

e as well as under P. Hence,

is deterministic (i.e., independent of ω1 , · · · , ωn ). So ωn ’s are i.i.d. under P,
without loss of generality, we can work under P. For any function g,
En [g(Sn+1 , Yn+1 )]
[ ( )]
Sn+1 Sn+1
= En g Sn , Y n + Sn
Sn Sn
= pg(uSn , Yn + uSn ) + qg(dSn , Yn + dSn ),
which is a function of (Sn , Yn ). This shows (Sn , Yn )0≤n≤N is Markov under P.
(ii) According to Theorem 2.5.8, the price Vn of the Asian option at time n is some function vn of Sn
and Yn ; i.e.
Vn = vn (Sn , Yn ), n = 0, 1, · · · , N.
Give a formula for vN (s, y), and provide an algorithm for computing vn (s, y) in terms of vn+1 .

19
 ( ∑N )
n=0 Sn
Proof. Set vN (s, y) = f ( Ny+1 ). Then vN (SN , YN ) = f N +1 = VN . Suppose vn+1 is given, then
[ ]
Vn e n Vn+1
= E
1+r
[ ]
e n vn+1 (Sn+1 , Yn+1 )
= E
1+r
1
= [p̃vn+1 (uSn , Yn + uSn ) + q̃vn+1 (dSn , Yn + dSn )].
1+r
So the formula for computing vn (s, y) in terms of vn+1 is
p̃vn+1 (us, y + us) + q̃vn+1 (ds, y + ds)
vn (s, y) = .
1+r

I Exercise 2.14 (Asian option continued). Consider an N -period binomial model, and let M be a fixed
number between 0 and N − 1. Consider an Asian option whose payoff at time N is
( )
1 ∑N
Vn = f Sn ,
N −M
n=M +1

where again the function f is determined by the contractual details of the option.
(i) Define {
0, if 0 ≤ n ≤ M ,
Y n = ∑n
S
k=M +1 k , if M + 1 ≤ n ≤ N .
Show that the two-dimensional process (Sn , Yn ), n = 0, 1, · · · , N is Markov (under the risk-neutral measure
e
P).
e (Sn , Yn )0≤n≤M is Markov
Proof. For n ≤ M , (Sn , Yn ) = (Sn , 0). Since coin tosses ωn ’s are i.i.d. under P,
e e
under P . More precisely, for any function h, En [h(Sn+1 )] = p̃h(uSn ) + q̃h(dSn ), for n = 0, 1, · · · , M − 1.
For any function g of two variables, we have
e M [g(SM +1 , YM +1 )] = E
E e M [g(SM +1 , SM +1 )] = p̃g(uSM , uSM ) + q̃g(dSM , dSM ).

And for n ≥ M + 1,
[ ( )]
e e Sn+1 Sn+1
En [g(Sn+1 , Yn+1 )] = En g Sn , Y n + Sn = p̃g(uSn , Yn + uSn ) + q̃g(dSn , Yn + dSn ).
Sn Sn
e
So (Sn , Yn )0≤n≤N is Markov under P.
(ii) According to Theorem 2.5.8, the price Vn of the Asian option at time n is some function vn of Sn
and Yn , i.e.
Vn = vn (Sn , Yn ), n = 0, 1, · · · , N.
Of course, when n ≤ M , Yn is not random and does not need to be included in this function. Thus, for such
n we should seek a function vn of Sn alone and have
{
vn (Sn ), if 0 ≤ n ≤ M ,
Vn =
vn (Sn , Yn ), if M + 1 ≤ n ≤ N .

Give a formula for vN (s, y), and provide an algorithm for computing vn in terms of vn+1 . Note that the
algorithm is different for n < M and n > M , and there is a separate transition formula for vM (s) in terms
of vM +1 (·, ·).

20
 ( ∑N )
y Sk
Proof. Set vN (s, y) = f ( N −M ). Then vN (SN , YN ) = f K=M +1
N −M = VN .
Suppose vn+1 is already given.
a) If n > M , then
e n [vn+1 (Sn+1 , Yn+1 )] = p̃vn+1 (uSn , Yn + uSn ) + q̃vn+1 (dSn , Yn + dSn ).
E
So vn (s, y) = p̃vn+1 (us, y + us) + q̃vn+1 (ds, y + ds).
b) If n = M , then
e M [vM +1 (SM +1 , YM +1 )] = p̃vM +1 (uSM , uSM ) + ṽn+1 (dSM , dSM ).
E
So vM (s) = p̃vM +1 (us, us) + q̃vM +1 (ds, ds).
c) If n < M , then
e n [vn+1 (Sn+1 )] = p̃vn+1 (uSn ) + q̃vn+1 (dSn ).
E
So vn (s) = p̃vn+1 (us) + q̃vn+1 (ds).

3 State Prices
⋆ Comments:
According to the Fundamental Theorem of Asset Pricing (FTAP), the no-arbitrage property is associated
with the existence of a probability measure called equivalent martingale measure (EMM) and a positive
process called numéraire, such that the price processes of tradable assets discounted by the numéraire are
martingales under the given probability measure (hence the name martingale measure).
Theorem 2.4.4 shows that the risk-neutral probability P defined by
1+r−d u−1−r
p̃ = , q̃ =
u−d u−d
and the value process of the money market account {(1 + r)n }Nn=0 is such an EMM-numéraire pair. Theorem
{ }N
3.2.7 shows that the actual probability P and the inverse of the state price density process ζ1n is such
n=0
an EMM-numéraire pair. Note numéraire does not have to the price process of a tradable asset, as the
inverse of the state price density process is just an abstract stochastic process.
For a survey of the various formulations of the two Fundamental Theorem of Asset Pricing, we refer to
Zeng [9].

I Exercise 3.1. Under the conditions of Theorem 3.1.1, show the following analogues of properties (i)-(iii)
of that ( theorem:
)
e 1 > 0 = 1;
(i’) P Z
e 1 = 1;
(ii’) E Z
(iii’) for any random variable Y , [ ]
e 1
EY = E ·Y .
Z
In other words, 1 e to E in the same way Z facilitates the switch from E to E.
facilitates the switch from E e
Z

e
Proof. Define Z(ω) P(ω) 1 e Z replaced by P,
Apply Theorem 3.1.1 with P, P, e P, Z,
e we get the
:= e
P(ω)
= Z(ω) .
analogues of properties (i)-(iii) of Theorem 3.1.1.

I Exercise 3.2. Let P be a probability measure on a finite probability space Ω. In this problem, we
allow the possibility that P(ω) = 0 for some values of ω ∈ Ω. Let Z be a random variable on Ω with the
e
property that P(Z ≥ 0) = 1 and EZ = 1. For ω ∈ Ω, define P(ω) = Z(ω)P(ω), and for events A ⊂ Ω, define
e ∑ e
P(A) = ω∈A P(ω). Show the following.
e is a probability measure; i.e., P(Ω)
(i) P e = 1.

21
 e ∑ e ∑
Proof. P(Ω) = ω∈Ω P(ω) = ω∈Ω Z(ω)P(ω) = E[Z] = 1.
e = E[ZY ].
(ii) If Y is a random variable, then EY
e ]=∑
Proof. E[Y e ∑
ω∈Ω Y (ω)P(ω) = ω∈Ω Y (ω)Z(ω)P(ω) = E[Y Z].

e
(iii) If A is an event with P(A) = 0, then P(A) = 0.
e ∑ e
Proof. P(A) = ω∈A Z(ω)P(ω). Since P(A) = 0, P(ω) = 0 for any ω ∈ A. So P(A) = 0.
e
(iv) Assume that P(Z > 0) = 1. Show that if A is an event with P(A) = 0, then P(A) = 0.
e ∑
Proof. If∑P(A) = ω∈A Z(ω)P(ω) = 0, by P(Z > 0) = 1, we conclude P(ω) = 0 for any ω ∈ A. So
P(A) = ω∈A P(ω) = 0.

When two probability measures agree which events have probability zero (i.e., P(A) = 0 if and only
e
if P(A) = 0), the measure are said to be equivalent. From (iii) and (iv) above, we see that P and P e are
equivalent under the assumption that P(Z > 0) = 1.
(v) Show that if P and Pe are equivalent, then they agree which events have probability one (i.e., P(A) = 1
e
if and only if P(A) = 1).
e c ) = 0 ⇐⇒ P(A)
Proof. P(A) = 1 ⇐⇒ P(Ac ) = 0 ⇐⇒ P(A e = 1.
e are not equivalent.
(vi) Construct an example in which we have only P(Z ≥ 0) = 1 and P and P

Solution. Pick ω0 such that 1 > P(ω0 ) > 0. Define

{
0 if ω ̸= ω0
Z(ω) = 1
P(ω0 ) if ω = ω0 .

Then P(Z ≥ 0) = 1 and E[Z] = 1

P(ω0 ) · P(ω0 ) = 1.
Clearly ∑
e \ {ω0 }) =
P(Ω Z(ω)P(ω) = 0.
ω̸=ω0

e cannot be equivalent.
But P(Ω \ {ω0 }) = 1 − P(ω0 ) > 0 since P(ω0 ) < 1. Hence P and P

I Exercise 3.3. Using the stock price model of Figure 3.1.1 and the actual probabilities p = 2
3, q = 1
3,
define the estimates of S3 at various times by

Mn = En [S3 ], n = 0, 1, 2, 3.

Fill in the values of Mn in a tree like that of Figure 3.1.1. Verify that Mn , n = 0, 1, 2, 3, is a martingale.

22
 M3 (HHH) = 32

M2 (HH) = 24

M1 (H) = 18 M3 (HHT ) = M3 (HT H) = M3 (T HH) = 8

M0 = 13.5 M2 (HT ) = M2 (T H) = 6

M1 (T ) = 4.5 M3 (HT T ) = M3 (T HT ) = M3 (T T H) = 2

M2 (T T ) = 1.5

M3 (T T T ) = .50

Exercise 3.3.

Solution. M3 = S3 ,
2 1
M2 (HH) = E2 [S3 ](HH) = pS3 (HHH) + qS3 (HHT ) = · 32 + · 8 = 24
3 3
2 1
M2 (HT ) = E2 [S3 ](HT ) = pS3 (HT H) + qS3 (HT T ) = · 8 + · 2 = 6
3 3
2 1
M2 (T H) = E2 [S3 ](T H) = pS3 (T HH) + qS3 (T HT ) = · 8 + · 2 = 6
3 3
2 1
M2 (T T ) = E2 [S3 ](T T ) = pS3 (T T H) + qS3 (T T T ) = · 2 + · 0.5 = 1.5
3 3
M1 (H) = E1 [S3 ](H) = p2 S3 (HHH) + pqS3 (HHT ) + qpS3 (HT H) + q 2 S3 (HT T )
( )2 ( )2
2 2 1 1
= · 32 + · · (8 + 8) + · 2 = 18
3 3 3 3
M1 (T ) = E1 [S3 ](T ) = p2 S3 (T HH) + pqS3 (T HT ) + qpS3 (T T H) + q 2 S3 (T T T )
( )2 ( )2
2 2 1 1
= · 8 + · · (2 + 2) + · 0.5 = 4.5
3 3 3 3
( )3 ( )2 ( )2 ( )3
2 2 1 2 1 1
M0 = E0 [S3 ] = · 32 + · · (8 + 8 + 8) + · · (2 + 2 + 2) + · 0.5 = 13.5
3 3 3 3 3 3

23
 To verify (Mn )3n=0 is a martingale, we note M2 = E2 [S3 ] = E2 [M3 ], since M3 = S3 . Moreover, we have
2 1
E1 [M2 ](H) = pM2 (HH) + qM2 (HT ) = · 24 + · 6 = 18 = M1 (H)
3 3
2 1
E1 [M2 ](T ) = pM2 (T H) + qM2 (T T ) = · 6 + · 1.5 = 4.5 = M1 (T )
3 3
2 1
E0 [M1 ](T ) = pM1 (H) + qM1 (T ) = · 18 + · 4.5 = 13.5 = M0 .
3 3

Therefore, (Mn )3n=0 is a martingale.

I Exercise 3.4. This problem refers to the model of Example 3.1.2, whose Radon-Nikodým process Zn
appears in Figure 3.2.1.
(i) Compute the state price densities

ζ3 (HHH),
ζ3 (HHT ) = ζ3 (HT H) = ζ3 (T HH),
ζ3 (HT T ) = ζ3 (T HT ) = ζ3 (T T H),
ζ3 (T T T )

explicitly.
Solution. By formula (3.1.5), we have
27 1
ζ3 (HHH) = · = 0.216
64 (1 + 0.25)3
27 1
ζ3 (HHT ) = ζ3 (HT H) = ζ3 (T HH) = · = 0.432
32 (1 + 0.25)3
27 1
ζ3 (HT T ) = ζ3 (T HT ) = ζ3 (T T H) = · = 0.864
16 (1 + 0.25)3
27 1
ζ3 (T T T ) = · = 1.728.
8 (1 + 0.25)3

(ii) Use the numbers computed in (i) in formula (3.1.10) to find the time-zero price of the Asian option of
Exercise 1.8 of Chapter 1. You should get v0 (4, 4) computed in part (ii) of that exercise.
Solution. Recall in Example 3.1.2, we have p = 23 and q = 13 . So, by formula (3.1.10), the time-zero price of
the Asian option of Exercise 1.8 is
[ ( )+ ] ∑ ( )+
1 1
V0 = E ζ3 Y3 − 4 = Y3 (ω) − 4 ζ(ω)P(ω)
4 4
ω∈Ω
( )+ ( )3 ( )+ ( )2 ( )
1 2 1 2 1
= · 60 − 4 · 0.216 · + · 36 − 4 · 0.432 · · +
4 3 4 3 3
( )+ ( )2 ( ) ( )+ ( )2 ( )
1 2 1 1 1 2
· 24 − 4 · 0.432 · · + · 18 − 4 · 0.864 · · +
4 3 3 4 3 3
( )+ ( )2 ( )
1 2 1
· 18 − 4 · 0.432 · ·
4 3 3
= 1.216.

24
 S3 (HHH) = 32
Y3 (HHH) = 60
S2 (HH) = 16
Y2 (HH) = 28
S3 (HHT ) = 8
Y3 (HHT ) = 36
S1 (H) = 8
Y1 (H) = 12
S3 (HT H) = 8
Y3 (HT H) = 24
S2 (HT ) = 4
Y2 (HT ) = 16
S3 (HT T ) = 2
Y3 (HT T ) = 18
S0 = 4 Y0 = 4
S3 (T HH) = 8
Y3 (T HH) = 18
S2 (T H) = 4
Y2 (T H) = 10
S3 (T HT ) = 2
Y3 (T HT ) = 12
S1 (T ) = 2
Y1 (T ) = 6
S3 (T T H) = 2
Y3 (T T H) = 9
S2 (T T ) = 1
Y2 (T T ) = 7
S3 (T T T ) = 0.5
Y3 (T T T ) = 7.5

Exercise 1.8. Asian option.

(iii) Compute also the state price densities ζ2 (HT ) = ζ2 (T H).

[ ]
2 = E2 · (1 + r). By formula (3.1.5),
Z2 Z
Solution. We note ζ2 = (1+r) (1+r)3

3 · 32 + 3 · 16
2 27 1 27
1
ζ2 (HT ) = [pZ(HT H) + qZ(HT T )] = = 0.72
(1 + r)2 1.252
1 1
ζ2 (T H) = [pZ(T HH) + qZ(T HT )] = [pZ(HT H) + qZ(HT T )] = 0.72.
(1 + r)2 (1 + r)2

(iv) Use the risk-neutral pricing formula (3.2.6) in the form

1
V2 (HT ) = E2 [ζ3 V3 ](HT ),
ζ2 (HT )
1
V2 (T H) = E2 [ζ3 V3 ](T H)
ζ2 (T H)

to compute V2 (HT ) and V2 (T H). You should get V2 (HT ) = v2 (4, 16) and V2 (T H) = v2 (4, 10), where v2 (s, y)
was computed in part (ii) of Exercise 1.8 of Chapter 1. Note that V2 (HT ) ̸= V2 (T H).

Solution. By Exercise 1.8 of Chapter 1, V2 (HT ) = v2 (4, 16) = 1, V2 (T H) = v2 (4, 10) = 0.2. Meanwhile, we

25
have
1 1
V2 (HT ) = E2 [ζ3 V3 ](HT ) = [pζ3 (HT H)V3 (HT H) + qζ3 (HT T )V3 (HT T )]
ζ2 (HT ) ζ2 (HT )
[ ( )+ ( )+ ]
1 2 1 1 1
= · 0.432 · · 24 − 4 + · 0.864 · · 18 − 4
0.72 3 4 3 4
= 1,
and
1 1
V2 (T H) = E2 [ζ3 V3 ](T H) = [pζ3 (T HH)V3 (T HH) + qζ3 (T HT )V3 (T HT )]
ζ2 (T H) ζ2 (T H)
[ ( )+ ( )+ ]
1 2 1 1 1
= · 0.432 · · 18 − 4 + · 0.864 · · 12 − 4
0.72 3 4 3 4
= 0.2.

I Exercise 3.5 (Stochastic volatility, random interest rate). Consider the model of Exercise 2.9 of
Chapter 2. Assume that the actual probability measure is
4 2 2 1
P(HH) = , P(HT ) = , P(T H) = , P(T T ) = .
9 9 9 9
The risk-neutral measure was computed in Exercise 2.9 of Chapter 2.
e with respect to P.
(i) Compute the Radon-Nikodým derivative Z(HH), Z(HT ), Z(T H), and Z(T T ) of P
Solution. In Exercise 2.9 of Chapter 2, we have
e 1 e 1 e 1 e 5
P(HH) = , P(HT ) = , P(T H) = , P(T T ) = .
4 4 12 12
Therefore
e
P(HH) 9
Z(HH) = =
P(HH) 16
e
P(HT ) 9
Z(HT ) = =
P(HT ) 8
e
P(T H) 3
Z(T H) = =
P(T H) 8
e T)
P(T 15
Z(T T ) = = .
P(T T ) 4

(ii) The Radon-Nikodým derivative process Z0 , Z1 , Z2 satisfies Z2 = Z. Compute Z1 (H), Z1 (T ), and Z0 .

Note that Z0 = EZ = 1.
Solution. From the specification of P(HH), P(HT ), P(T H), and P(T T ), we can conclude ω1 and ω2 are i.i.d.
under P , with p := P(ω1 = H) = P(ω2 = H) = 32 and q := P(ω1 = T ) = P(ω2 = T ) = 13 . Therefore,
9 2 9 1 3
Z1 (H) = E1 [Z2 ](H) = Z2 (HH)p + Z2 (HT )q = · + · = ,
16 3 8 3 4
3 2 15 1 3
Z1 (T ) = E1 [Z2 ](T ) = Z2 (T H)p + Z2 (T T )q = · + · = ,
8 3 4 3 2
2 3 1 3
Z0 = E[Z1 ] = pZ1 (H) + qZ1 (T ) = · + · = 1.
3 4 3 2

26
(iii) The version of the risk-neutral pricing formula (3.2.6) appropriate for this model, which does not use
the risk-neutral measure, is
[ ]
1 + r0 Z2
V1 (H) = E1 V2 (H)
Z1 (H) (1 + r0 )(1 + r1 )
1
= E1 [Z2 V2 ](H),
Z1 (H)(1 + r1 (H))
[ ]
1 + r0 Z2
V1 (T ) = E1 V2 (T )
Z1 (H) (1 + r0 )(1 + r1 )
1
= E1 [Z2 V2 ](T ),
Z1 (H)(1 + r1 (H))
[ ]
Z2
V0 = E V2 .
(1 + r0 )(1 + r1 )
Use this formula to compute V1 (H), V1 (T ), and V0 when V2 = (S2 − 7)+ . Compare the result with your
answers in Exercise 2.9(ii) of Chapter 2.5
Solution.
Z2 (HH)V2 (HH)p + Z2 (HT )V2 (HT )q 9
· (12 − 7)+ · 32 + 15
4 )· (8 − 7) ·
+ 1
V1 (H) = = 16 ( 3
= 2.4,
4 · 1+ 4
Z1 (H)(1 + r1 (H)) 3 1

Z2 (T H)V2 (T H)p + Z2 (T T )V2 (T T )q 3

· (8 − 7)+ · 2 15
3(+ 4 · (2 − 7)+ · 1
1
V1 (T ) = = 8 ) 3
= ,
Z1 (T )(1 + r1 (T )) 3
2 · 1+ 1
2
9
and
Z2 (HH)V2 (HH) Z2 (HT )V2 (HT ) Z2 (T H)V2 (T H)
V0 = P(HH) + P(HT ) + P(T H) + 0
(1 + r0 )(1 + r1 (H)) (1 + r0 )(1 + r1 (H)) (1 + r0 )(1 + r1 (T ))
16 · (12 − 7) · 9 · (8 − 7)+ · 29 8 · (8 − 7) · 9
9 + 4 9 3 + 2
= 1 1 + 8 1 1 +
(1 + 4 )(1 + 4 ) (1 + 4 )(1 + 4 ) (1 + 4 )(1 + 12 )
1

= 1.00444.

I Exercise 3.6. Consider Problem 3.3.1 in an N -period binomial model with the utility function U (x) =
ln x. Show that the optimal wealth process corresponding to the optimal portfolio process is given by
Xn = X ζn , n = 0, 1, · · · , N , where ζn is the state price density process defined in (3.2.7).
0

[ ]
(1+r)N
Proof. U ′ (x) = x1 , so I(x) = x1 . (3.3.26) gives E (1+r) Z
N λZ = X0 . So λ = X10 . By (3.3.25), we have
(1+r)N X0
XN = λZ + r)N . Hence
= Z (1
[ ] [ ] [ ] [ ]
e XN e X0 (1 + r)n ne 1 n 1 1 X0
Xn = En N −n
= En = X0 (1 + r) En = X0 (1 + r) En Z · = ,
(1 + r) Z Z Zn Z ζn
where the second to last “=” comes from Lemma 3.2.6.
I Exercise 3.7. Consider Problem 3.3.1 in an N -period binomial model with the utility function U (x) =
p x , where p < 1, p ̸= 0. Show that the optimal wealth at time N is
1 p

1
X0 (1 + r)N Z p−1
XN = [ p ] ,
E Z p−1

e with respect to P.
where Z is the Radon-Nikodým derivative of P
5 The textbook said “Exercise 2.6” by mistake.

27
 [ ( 1 ]
) p−1
1
Proof. U ′ (x) = xp−1 , so I(x) = x p−1 . By (3.3.26), we have E Z
(1+r)N
λZ
(1+r)N
= X0 . Solve it for λ,
we get
 p−1
 X0  X p−1 (1 + r)N p
λ=
 [ p
]
 = ( 0 [ p ])p−1 .
E Z p−1
Np E Z p−1
(1+r) p−1

So by (3.3.25),
[ ] p−1
1 1 1 Np 1 1
λZ λ p−1 Z p−1 X0 (1 + r) p−1 Z p−1 (1 + r)N X0 Z p−1
XN = = N = [ p ] N = [ p ] .
(1 + r)N (1 + r) p−1 E Z p−1 (1 + r) p−1 E Z p−1

I Exercise 3.8. The Lagrange Multiplier Theorem used in the solution of Problem 3.3.5 has hypotheses
that we did not verify in the solution of that problem. In particular, the theorem states that if the gradient
of the constraint function, which in this case is the vector (p1 ζ1 , · · · , pm ζm ), is not the zero vector, then
the optimal solution must satisfy the Lagrange multiplier equations (3.3.22). This gradient is not the zero
vector, so this hypothesis is satisfied. However, even when this hypothesis is satisfied, the theorem does not
guarantee that there is an optimal solution; the solution to the Lagrange multiplier equations may in fact
minimize the expected utility. The solution could also be neither a maximizer nor a minimizer. Therefore,
in this exercise, we outline a different method for verifying that the random variable XN given by (3.3.25)
maximizes the expected utility.
∗
We begin by changing the notation, calling the random variable given by (3.3.25) XN rather than XN .
In other words, ( )
∗ λ
XN =I Z , (3.6.1)
(1 + r)N
where λ is the solution of equation (3.3.26). This permits us to use the notation XN for an arbitrary (not
necessarily optimal) random variable satisfying (3.3.19). We must show that
∗
EU (XN ) ≤ EU (XN ). (3.6.2)

(i) Fix y > 0, and show that the function of x given by U (x) − yx is maximized by x = I(y).6 Conclude that
U (x) − yx ≤ U (I(y)) − yI(y) for every x. (3.6.3)
2
d
Proof. dx (U (x) − yx) = U ′ (x) − y. So x = I(y) is an extreme point of U (x) − yx. Because dx
d
2 (U (x) − yx) =
′′
U (x) ≤ 0 (U is concave), x = I(y) is a maximum point. Therefore U (x) − yx ≤ U (I(y)) − yI(y) for every
x.
(ii) In (3.6.3), replace the dummy variable x by the random variable XN and replace the dummy variable
λZ
y by the random variable (1+r) N . Take expectations of both sides and use (3.3.19) and (3.3.26) to conclude

that (3.6.2) holds.

Proof. Following the hint of the problem, we have
[ ] [ ( ( ))] [ ( )]
λZ λZ λZ λZ
E[U (XN )] − E XN ≤ E U I − E I ,
(1 + r)N (1 + r)N (1 + r)N (1 + r)N
i.e.
[ ] [ ]
(3.3.19)
e XN λZ
E[U (XN )] − λX0 = E[U (XN )] − λE = E[U (XN )] − E XN
(1 + r)N (1 + r)N
[ ( )]
∗ Z λZ (3.3.26) ∗
≤ E[U (XN )] − λE I = E[U (XN )] − λX0 .
(1 + r)N (1 + r)N
6 The textbook said “y = I(x)” by mistake.

28
 ∗
So E[U (XN )] ≤ E[U (XN )].
I Exercise 3.9 (Maximizing probability of reaching a goal). (Kulldorf [30], Heath [19]) A wealthy
investor provides a small amount of money X0 for you to use to prove the effectiveness of your investment
scheme over the next N periods. You are permitted to invest in the N -period binomial model, subject to
the condition that the value of your portfolio is never allowed to be negative. If at time N the value of your
portfolio XN is at least γ, a positive constant specified by the investor, then you will be given a large amount
of money to manage for her. Therefore, your problem is the following:
Maximize
P(XN ≥ γ),
where XN is generated by a portfolio process beginning with the initial wealth X0 and where the value Xn
of your portfolio satisfies
Xn ≥ 0, n = 1, 2, · · · , N.
In the way that Problem 3.3.1 was reformulated as Problem 3.3.3, this problem may be reformulated as
Maximize
P(XN ≥ γ)
subject to
e XN
E = X0 , Xn ≥ 0, n = 1, 2, · · · , N.
(1 + r)N
(i) Show that if XN ≥ 0, then Xn ≥ 0 for all n.
[ ]
Proof. By the martingale property, Xn = Een XN
N −n . So if XN ≥ 0, then Xn ≥ 0 for all n.
(1+r)

(ii) Consider the function {

0, if 0 ≤ x < γ,
U (x) =
1, if x ≥ γ.
Show that for each fixed y > 0, we have
U (x) − yx ≤ U (I(y)) − yI(y) ∀x ≥ 0,
where {
γ, if 0 < y ≤ γ1 ,
I(y) =
0, if y > γ1 .

Proof. We consider the following four scenarios.

a) If 0 ≤ x < γ and 0 < y ≤ γ1 , then U (x) − yx = −yx ≤ 0 and U (I(y)) − yI(y) = U (γ) − yγ = 1 − yγ ≥ 0.
So U (x) − yx ≤ U (I(y)) − yI(y).
b) If 0 ≤ x < γ and y > γ1 , then U (x) − yx = −yx ≤ 0 and U (I(y)) − yI(y) = U (0) − y · 0 = 0. So
U (x) − yx ≤ U (I(y)) − yI(y).
c) If x ≥ γ and 0 < y ≤ γ1 , then U (x) − yx = 1 − yx and U (I(y)) − yI(y) = U (γ) − yγ = 1 − yγ ≥ 1 − yx.
So U (x) − yx ≤ U (I(y)) − yI(y).
d) If x ≥ γ and y > γ1 , then U (x) − yx = 1 − yx < 0 and U (I(y)) − yI(y) = U (0) − y · 0 = 0. So
U (x) − yx ≤ U (I(y)) − yI(y).

(iii) Assume there is a solution λ to the equation

[ ( )]
Z λZ
E I = X0 . (3.6.4)
(1 + r)N (1 + r)N
Following the argument of Exercise 3.8, show that the optimal XN is given by
( )
∗ λZ
XN = I .
(1 + r)N

29
 [ ]
λZ
Proof. Using (ii) and set x = XN , y = (1+r) e
N , where XN is a random variable satisfying E
XN
= X0 ,
(1+r)N
we have [ ] [ ]
λZ ∗ λZ ∗
E[U (XN )] − E XN ≤ E[U (XN )] − E X .
(1 + r)N (1 + r)N N
∗ ∗
That is, E[U (XN )] − λX0 ≤ E[U (XN )] − λX0 . So E[U (XN )] ≤ E[U (XN )].
(iv) As we did to obtain Problem 3.3.5, let us list the M = 2N possible coin toss sequences, labeling them
ω 1 , · · · , ω M , and then define ζm = ζ(ω m ), pm = P(ω m ). However, here we list these sequences in ascending
order of ζm i.e., we label the coin toss sequences so that

ζ1 ≤ ζ2 ≤ · · · ≤ ζM .

Show that the assumption that there is a solution λ to (3.6.4) is equivalent to assuming that for some positive
integer K we have ζK < ζK+1 and
∑K
X0
ζm pm = . (3.6.5)
m=1
γ

Proof. Plug pm and ξm into (3.6.4), we have

∑ ∑
N N
2 2
X0 = pm ξm I(λξm ) = pm ξm γ1{λξm ≤ γ1 } .
m=1 m=1

X0 ∑2N X0
So γ = m=1 pm ξm 1{λξm ≤ γ1 } . Suppose there is a solution λ to (3.6.4), note γ > 0, we then can conclude
{m : λξm ≤ γ1 } ̸= ∅. Let K = max{m : λξm ≤ γ1 }, then λξK ≤ γ1 < λξK+1 . So ξK < ξK+1 and
∑K
m=1 pm ξm (Note, however, that K could be 2 . In this case, ξK+1 is interpreted as ∞. Also, note
X0 N
γ =
we are looking for positive solution λ > 0). Conversely, suppose there exists some K so that ξK < ξK+1 and
∑K X0 1
m=1 ξm pm = γ . Then we can find λ > 0, such that ξK < λγ < ξK+1 . For such λ, we have

[ ] ∑2N ∑K
Z λZ
E I( ) = pm ξ m 1 {λξ ≤ 1 γ =
} pm ξm γ = X0 .
(1 + r)N (1 + r)N m=1
m γ
m=1

Hence (3.6.4) has a solution.

∗
(v) Show that XN is given by {
γ, if m ≤ K
XN (ω m ) =
0, if m ≥ K + 1.

Proof. {
∗ γ, if m ≤ K,
XN (ω m ) = I(λξm ) = γ1{λξm ≤ γ1 } =
0, if m ≥ K + 1.

4 American Derivative Securities

⋆ Comments:
1) Before proceeding to the exercise problems, we first give a brief summary of pricing American derivative
securities as presented in the textbook. We shall use the notation of the book.
From the buyer’s perspective. At time n, if the derivative security has not been exercised, then the buyer
can choose a policy τ with τ ∈ Sn . The valuation formula for cash flow (Theorem 2.4.8) gives the fair price

30
of the derivative security exercised according to τ (the cash flow sequence Cn , · · · , CN at times n, · · · , N
are defined by Cn = 1{τ =n} Gn , · · · , CN = 1{τ =N } GN ):

∑
N [ ] [ ]
e n 1{τ =k} Gk e n 1{τ ≤N } Gτ
Vn (τ ) = E = E .
(1 + r)k−n (1 + r)τ −n
k=n

The buyer wants to consider all the possible τ ’s, so that he can find the least upper bound of security value,
which will be the maximum price of [ the derivative security
] acceptable to him. This is the price given by
e
Definition 4.4.1: Vn = maxτ ∈Sn En 1{τ ≤N } (1+r)τ −n Gτ .
1

From the seller’s perspective. A price process (Vn )0≤n≤N is acceptable to him if and only if at each time
n, (i) Vn ≥ Gn (selling price is sufficient to cover potential obligation) and (ii) he needs no further investing
into the portfolio as time goes by (no follow-up cost to maintain (i)).
Formally, the seller can find hedging process (∆n )0≤n≤N and cash flow{ process } (Cn )0≤n≤N such that
Cn ≥ 0 and Vn+1 = ∆n Sn+1 + (1 + r)(Vn − Cn − ∆n Sn ) ≥ Gn+1 . Since Sn
(1+r)n is a martingale
0≤n≤N
e we conclude
under the risk-neutral measure P,
[ ]
e Vn+1 Vn Cn
En − =− ≤ 0,
(1 + r)n+1 (1 + r)n (1 + r)n
{ }
Vn
i.e. (1+r) n is a supermartingale under P. e This inspires us to check if the converse is also true.
0≤n≤N
This is exactly the content of Theorem
{ 4.4.4.
} So (Vn )0≤n≤N is the value process of a portfolio that needs
Vn
no further investing if and only if (1+r)n e (note this is independent of
is a supermartingale under P
0≤n≤N
the requirement V{n ≥ Gn}). In summary, a price process (Vn )0≤n≤N is acceptable to the seller if and only if
(i) Vn ≥ Gn ; (ii) (1+r)
Vn
n
e
is a supermartingale under P.
0≤n≤N
Theorem 4.4.2 shows the buyer’s upper bound is the seller’s lower bound. So it gives the price acceptable
to both. Theorem 4.4.3 gives a specific algorithm for calculating the price, Theorem 4.4.4 establishes the
one-to-one correspondence between super-replication and supermartingale property, and finally, Theorem
4.4.5 shows how to decide on the optimal exercise policy.
2) The definition of a stopping time typically seen in textbooks is

{τ = n} ∈ Fn := σ(ω1 , · · · , ωn ), n = 0, 1, 2, · · · , N.

To see Definition 4.3.1 agrees with this version of definition, note a typical element of Fn has the form
{ω : ω1 ∈ A1 , · · · , ωn ∈ An }. So {τ = n} imposes conditions on ω1 , ω2 , · · · , ωn only.
3) Comment on Theorem 4.4.4 (Replication of path-dependent American derivatives): in the proof, the
condition that (Vn ){N } from Definition 4.4.1 is only used for Vn ≥ Gn . The proof applies to any
n=0 comes
e
P-supermartingale Vn
. This justifies the paragraph immediately after Theorem 4.4.2. Conversely, if
(1+r)n
n { }
(Vn )n can be replicated via formula (4.4.16) with Cn ≥ 0, then (1+r)
Vn
n
e
is a P-supermartingale. That is,
n
if we can replicate a stochastic
{ process
} (Vn )n by money market account and stock without injecting more
Vn
cash into the portfolio, then (1+r)n e
is a P-supermartingale.
n

I Exercise 4.1. In the three-period model of Figure 1.2.2 of Chapter 1, let the interest rate be r = 14 so
the risk-neutral probabilities are p̃ = q̃ = 21 .
(i) Determine the price at time zero, denoted V0P , of the American put that expires at time three and has
intrinsic value gP (s) = (4 − s)+ .

31
Solution. At time three, the payoff of the put is

V3P (HHH) = (4 − 32)+ = 0

V3P (HHT ) = V3P (HT H) = V3P (T HH) = (4 − 8)+ = 0
V3P (HT T ) = V3P (T HT ) = V3P (T T H) = (4 − 2)+ = 2
V3P (T T T ) = (4 − 0.5)+ = 3.5.

At time two, the value of the put is calculated by

{ [ P ]} { }
e 2 V3 p̃V P (·H) + q̃V3P (·T )
V2P (·) = max (4 − S2 )+ , E = max (4 − S2 )+ , 3 .
1+r 1+r

Therefore,
{ } { }
+ 2 + 2
V2P (HH) = max [4 − S2 (HH)] , [V3 (HHH) + V3 (HHT )] = max (4 − 16) , (0 + 0) = 0
P P
5 5
{ } { }
2 2
V2 (HT ) = max [4 − S2 (HT )] , [V3 (HT H) + V3 (HT T )] = max (4 − 4) , (0 + 2) = 0.8
P + P P +
5 5
{ } { }
2 + 2
V2 (T H) = max [4 − S2 (T H)] , [V3 (T HH) + V3 (T HT )] = max (4 − 4) , (0 + 2) = 0.8
P + P P
5 5
{ } { }
2 2
V2 (T T ) = max [4 − S2 (T T )] , [V3 (T T H) + V3 (T T T )] = max (4 − 1) , (2 + 3.5) = 3
P + P P +
5 5

A time one, the value of the put is calculated by

{ [ P ]} { }
e 1 V2 p̃V P (·H) + q̃V2P (·T )
V1P (·) = max (4 − S1 )+ , E = max (4 − S1 )+ , 2
1+r 1+r

Therefore
{ } { }
2 2
V1P (H) = max [4 − S1 (H)]+ , [V2P (HH) + V2P (HT )] = max (4 − 8)+ , (0 + 0.8) = 0.32
5 5
{ } { }
2 2
V1P (T ) = max [4 − S1 (T )]+ , [V2P (T H) + V2P (T T )] = max (4 − 2)+ , (0.8 + 3) = 2.
5 5

Finally, the value of the put at time zero is

{ } { }
+ 2 + 2
V0 = max (4 − S0 ) , [V1 (H) + V1 (T )] = max (4 − 4) , (0.32 + 2) = 0.928.
P P P
5 5

(ii) Determine the price at time zero, denoted V0C , of the American call that expires at time three and has
intrinsic value gC (s) = (s − 4)+ .
Solution. By Theorem 4.5.1, at the time zero, the price of the American call is the same as the price of the
European call with the same strike. Therefore, at time three,

V3C (HHH) = (32 − 4)+ = 28,

V3C (HHT ) = V3C (HT H) = V3C (T HH) = (8 − 4)+ = 4,
V3C (HT T ) = V3C (T HT ) = V3C (T T H) = (2 − 4)+ = 0,
V3C (T T T ) = (0.5 − 4)+ = 0.

32
At time two,
2 2 2
V2C (HH) = (28 + 4) = 12.8, V2C (HT ) = V2C (T H) = (4 + 0) = 1.6, V2C (T T ) = (0 + 0) = 0.
5 5 5

At time one,
2 2
V1C (H) = (12.8 + 1.6) = 5.76, V1C (T ) = (1.6 + 0) = 0.64.
5 5
And finally, at time zero,
2
V0C = (5.76 + 0.64) = 2.56.
5

(iii) Determine the price at time zero, denoted V0S , of the American straddle that expires at time three and
has intrinsic value gS (s) = gP (s) + gC (s).
Solution. gS (s) = |4 − s|. At time three,

V3S (HHH) = |4 − 32| = 28,

V3S (HHT ) = V3S (HT H) = V3S (T HH) = |4 − 8| = 4,
V3S (HT T ) = V3S (T HT ) = V3S (T T H) = |4 − 2| = 2,
V3S (T T T ) = |4 − 0.5| = 3.5.

At time two,
{ }
2
V2S (HH) = max |4 − 16|, (28 + 4) = 12.8,
5
{ }
2
V2 (HT ) = V2 (T H) = max |4 − 4|, (4 + 2) = 2.4,
S S
5
{ }
2
V2S (T T ) = max |4 − 1|, (2 + 0.5) = 3.
5

At time one,
{ }
2
V1S (H) = max |4 − 8|, (12.8 + 2.4) = 6.08,
5
{ }
2
V1S (T ) = max |4 − 2|, (2.4 + 3) = 2.16.
5

Finally, at time zero, { }

2
V0S = max |4 − 4|, (6.08 + 2.16) = 3.296.
5

(iv) Explain why V0S < V0P + V0C .

Solution. In our previous calculations,

V0S = 3.296 < V0P + V0C = 0.928 + 2.56.

To explain this, we first note the simple inequality

max(a1 , b1 ) + max(a2 , b2 ) ≥ max(a1 + a2 , b1 + b2 ),

33
where “>” holds if and only if b1 > a1 and b2 < a2 or b1 < a1 and b2 > a2 .
At time N , VNS = gS (SN ) = gP (SN ) + gC (SN ) = VNP + VNC . By induction, we can show
{ S }
p̃V S + q̃Vn+1
VnS = max gS (Sn ), n+1
1+r
{ P P C C }
p̃Vn+1 + q̃Vn+1 p̃Vn+1 + q̃Vn+1
≤ max gP (Sn ) + gC (Sn ), +
1+r 1+r
{ P P } { C C }
p̃Vn+1 + q̃Vn+1 p̃Vn+1 + q̃Vn+1
≤ max gP (Sn ), + max gC (Sn ),
1+r 1+r
= VnP + VnC ,

n = 0, 1, · · · , N − 1.
p̃V C +q̃V C
To see when “<” holds, note for American call options, we always have gC (Sn ) < n+1
1+r
n+1
for
n = 0, 1, · · · , N − 1. In view of our observation of the simple inequality at the beginning of our solution,
“<” holds whenever
p̃V P + q̃Vn+1
P
gP (Sn ) > n+1 .
1+r
This is typically the case at the optimal exercise time of the put.
Beside the mathematical argument, intuitively, a straddle is not an American put plus an American call,
since when exercised, a straddle has a payoff equal to the sum of the payoff of a put and the payoff of a
call. However, the exercise time of a put typically differs from that of a call. So intuitively, we must have
V0S < V0P + V0C .

I Exercise 4.2. In Example 4.2.1, we computed the time-zero value of the American put with strike price
5 to be 1.36. Consider an agent who borrows 1.36 at time zero and buys the put. Explain how this agent
can generate sufficient funds to pay off his loan (which grows by 25% each period) by trading in the stock
and money markets and optimally exercising the put.
Solution. For this problem, we need Figure 4.2.1, Figure 4.4.1 and Figure 4.4.2. Then

V2 (HH) − V2 (HT ) 1 V2 (T H) − V2 (T T )
∆1 (H) = = − , ∆1 (T ) = = −1,
S2 (HH) − S2 (HT ) 12 S2 (T H) − S2 (T T )

and
V1 (H) − V1 (T )
∆0 = ≈ −0.433.
S1 (H) − S1 (T )
The optimal exercise time is τ = inf{n : Vn = Gn }. So

τ (HH) = ∞, τ (HT ) = 2, τ (T H) = τ (T T ) = 1.

Therefore, the agent borrows 1.36 at time zero and buys the put. At the same time, to hedge the long
position, he needs to borrow again and buy 0.433 shares of stock at time zero.
At time one, if the result of coin toss is tail and the stock price goes down to 2, the value of the portfolio
is X1 (T ) = (1 + r)(−1.36 − 0.433S0 ) + 0.433S1 (T ) = (1 + 41 )(−1.36 − 0.433 × 4) + 0.433 × 2 = −3. The agent
should exercise the put at time one and get 3 to pay off his debt.
At time one, if the result of coin toss is head and the stock price goes up to 8, the value of the portfolio
is X1 (H) = (1 + r)(−1.36 − 0.433S0 ) + 0.433S1 (H) = −0.4. The agent should borrow to buy 12 1
shares of
stock. At time two, if the result of coin toss is head and the stock price goes up to 16, the value of the
portfolio is X2 (HH) = (1 + r)(X1 (H) − 12 1 1
S1 (H)) + 12 S2 (HH) = 0, and the agent should let the put expire.
If at time two, the result of coin toss is tail and the stock price goes down to 4, the value of the portfolio is
X2 (HT ) = (1 + r)(X1 (H) − 12 1
S1 (H)) + 121
S2 (HT ) = −1. The agent should exercise the put to get 1. This
will pay off his debt.

34
I Exercise 4.3. In the three-period model of Figure 1.2.2 of Chapter 1, let the interest rate be r = 14 so
the risk-neutral probabilities are p̃ = q̃ = 21 . Find the time-zero price and optimal exercise policy (optimal
stopping time) for the path-dependent American derivative security whose intrinsic value at each time n,
( ∑n )+
n = 0, 1, 2, 3, is 4 − n+1
1
S
j=0 j . This intrinsic value is a put on the average stock price between time
zero and time n.
Solution. We need Figure 1.2.2 for this problem, and calculate the intrinsic value process and price process
of the put as follows.
For the intrinsic value process, G0 = 0, G1 (T ) = 1, G2 (T H) = 32 , G2 (T T ) = 53 , G3 (T HT ) = 1,
G3 (T T H) = 1.75, G3 (T T T ) = 2.125. All the other outcomes of G is negative.
For the price process, V0 = 0.4, V1 (T ) = 1, V1 (T H) = 32 , V1 (T T ) = 53 , V3 (T HT ) = 1, V3 (T T H) = 1.75,
V3 (T T T ) = 2.125. All the other outcomes of V is zero.
Therefore the time-zero price of the derivative security is 0.4 and the optimal exercise time satisfies
{
∞ if ω1 = H,
τ (ω) =
1 if ω1 = T .

I Exercise 4.4. Consider the American put of Example 4.2.1, which has strike price 5. Suppose at time
zero we sell this put to a purchaser who has inside information about the stock movements and uses the
exercise rule ρ of (4.3.2). In particular, if the first toss is going to result in H, the owner of the put exercises
at time zero, when the put has intrinsic value 1. If the first toss results in T and the second toss is going to
result in H, the owner exercises at time one, when the put has intrinsic value 3. If the first two tosses result
in T T , the owner exercises at time two, when the intrinsic value is 4. In summary, the owner of the put has
the payoff random variable

Y (HH) = 1, Y (HT ) = 1, Y (T H) = 3, Y (T T ) = 4. (4.8.1)

The risk-neutral expected value of this payoff, discounted from the time of payment back to zero, is
[( )ρ ] [ ]
e 4 1 4 16
E Y = 1+1+ ·3+ · 4 = 1.74. (4.8.2)
5 4 5 25

The time-zero price of the put computed in Example 4.2.1 is only 1.36. Do we need to charge the insider
more than this amount if we are going to successfully hedge our short position after selling the put to her?
Explain why or why not.

Solution. 1.36 is the cost of super-replicating the American derivative security. It enables us to construct a
portfolio sufficient to pay off the derivative security, no matter when the derivative security is exercised. So
to hedge our short position after selling the put, there is no need to charge the insider more than 1.36.
To understand the paradox that the risk-neutral expected value 1.74 of the insider’s payoff is greater than
the fair price 1.36, we note the rationale for risk-neutral pricing is the existence of a self-financing replicating
portfolio:
Xn+1 = ∆n Sn+1 + (1 + r)(Xn − Cn − ∆n Sn ), n = 0, 1, · · · , N − 1,
where the hedging process (∆n )n is assumed to be adapted, i.e. ∆n ∈ Fn . This is in contradiction of the
use of inside information. Therefore, it is fishy to use risk-neutral pricing formula when insider information
exists.

I Exercise 4.5. In equation (4.4.5), the maximum is computed over all stopping times in S0 . List all
the stopping times in S0 (there are 26), and from among them, list the stopping times that never exercise
when the option is out of the money (there are 11). For each stopping time τ in the latter set, compute
[ ( ) ]
e 1{τ ≤2} 4 τ Gτ . Verify that the largest value for this quantity is given by the stopping time of (4.4.6),
E 5
the one that makes this quantity equal to the 1.36 computed in (4.4.7).

35
Solution. The stopping times in S0 are
(1) τ ≡ 0;
(2) τ ≡ 1;
(3) τ (HT ) = τ (HH) = 1, τ (T H), τ (T T ) ∈ {2, ∞} (4 different ones);
(4) τ (HT ), τ (HH) ∈ {2, ∞}, τ (T H) = τ (T T ) = 1 (4 different ones);
(5) τ (HT ), τ (HH), τ (T H), τ (T T ) ∈ {2, ∞} (16 different ones).
When the option is out of money, the following stopping times do not exercise
(i) τ ≡ 0;
(ii) τ (HT ) ∈ {2, ∞}, τ (HH) = ∞, τ (T H), τ (T T ) ∈ {2, ∞} (8 different ones);
(iii) τ (HT ) ∈ {2, ∞}, τ (HH) = ∞, τ (T H) = τ (T T ) = 1 (2 different ones). [ ]
[ ( ) ] [ ( ) ] ( ) ∗
e 1{τ ≤2} 4 τ Gτ = G0 = 1. For (ii), E
For (i), E e 1{τ ≤2} 4 τ Gτ ≤ E e 1{τ ∗ ≤2} 4 τ Gτ ∗ , where
5 5 5
τ ∗ (HT ) = 2, τ ∗ (HH) = ∞, τ ∗ (T H) = τ ∗ (T T ) = 2. So
[ ( )τ ∗ ] [( ) ( )2 ]
2
e 4 1 4 4
E 1{τ ∗ ≤2} Gτ ∗ = ·1+ (1 + 4) = 0.96.
5 4 5 5
[ ( ) ]
e 1{τ ≤2} 4 τ Gτ has the biggest value when τ satisfies τ (HT ) = 2, τ (HH) = ∞, τ (T H) =
For (iii), E 5
τ (T T ) = 1. This value is 1.36.

I Exercise 4.6 (Estimating American put prices). For each n, where n = 0, 1, · · · , N , let Gn be a
random variable depending on the first n coin tosses. The time-zero value of a derivative security that can
be exercised at nay time n ≤ N for payoff Gn but must be exercised at time N if it has not been exercised
before that time is [ ]
e 1
V0 = max E Gτ . (4.8.3)
τ ∈S0 ,τ ≤N (1 + r)τ
In contrast to equation (4.4.1) in the Definition 4.4.1 for American derivative securities, here we consider
only stopping times that take one of the values 0, 1, · · · , N and not the value ∞.
(i) Consider Gn = K − Sn , the derivative security that permits its owner to sell one share of stock for
payment K at any time up to and including N , but if the owner does not sell by time N , then she must do
so at time N . Show that the optimal exercise policy is to sell the stock at time zero and that the value of
this derivative security is K − S0 .
Proof. The value of the put at time N , if it is not exercised at previous times, is K − SN . Hence
{ [ ]} { }
e VN K
VN −1 = max K − SN −1 , EN −1 = max K − SN −1 , − SN −1 = K − SN −1 .
1+r 1+r

The second equality comes from the fact that discounted stock price process is a martingale under risk-
neutral probability. By induction, we can show Vn = K − Sn (0 ≤ n ≤ N ). So by Theorem 4.4.5, the
optimal exercise policy is to sell the stock at time zero and the value of this derivative security is K − S0 .
Remark 4.1. We cheated a little bit by using American algorithm and Theorem 4.4.5, since they are developed
for the case where τ is allowed to be ∞. But intuitively, results in this chapter should still hold for the case
τ ≤ N , provided we replace “max{Gn , 0}” with “Gn ”.

(ii) Explain why a portfolio that holds the derivative security in (i) and a European call with strike K and
expiration time N is at least as valuable as an American put struck at K with expiration time N . Denote
the time-zero value of the European call by V0EC and the time-zero value of the American put by V0AP .
Conclude that the upper bound
V0AP ≤ K − S0 + V0EC (4.8.4)
on V0AP holds.

36
Proof. This is because at time N , if we have to exercise the put and K − SN < 0, we can exercise the
European call to set off the negative payoff. In effect, throughout the portfolio’s lifetime, the portfolio has
intrinsic values no less than that of an American put stuck at K with expiration time N . So, we must have
V0AP ≤ K − S0 + V0EC .
(iii) Use put-call parity (Exercise 2.11 of Chapter 2) to derive the lower bound on V0AP :
K
− S0 + V0EC ≤ V0AP . (4.8.5)
(1 + r)N
Proof. Let V0EP denote the time-zero value of a European put with strike K and expiration time N . Then
[ ]
V0AP ≥ V0EP = V0EC − E e SN − K = V EC − S0 + K
.
N 0
(1 + r) (1 + r)N

I Exercise 4.7. For the class of derivative securities described in Exercise 4.6 whose time-zero price is
given by (4.8.3), let Gn = Sn − K. This derivative security permits its owner to buy one share of stock in
exchange for a payment of K at any time up to the expiration time N . If the purchase has not been made at
time N , it must be made then. Determine the time-zero value and optimal exercise policy for this derivative
security.7
Solution. VN = SN − K,
{ [ ]} { }
e N −1 VN
VN −1 = max SN −1 − K, E = max SN −1 − K, SN −1 −
K
= SN −1 −
K
.
1+r 1+r 1+r

By induction, we can prove Vn = Sn − (1+r) K

N −n (0 ≤ n ≤ N ) and Vn > Gn for 0 ≤ n ≤ N − 1. So the

time-zero value is S0 − (1+r)N and the optimal exercise time is N .

K

5 Random Walk
I Exercise 5.1. For the symmetric random walk, consider the first passage time τm to the level m. The
random variable τ2 − τ1 is the number of steps required for the random walk to rise from level 1 to level 2,
and this random variable has the same distribution as τ1 , the number of steps required for the random walk
to rise from level 0 to level 1. Furthermore, τ2 − τ1 and τ1 are independent of one another; the latter depends
only on the coin toss 1, 2, · · · , τ1 , and the former depends only on the coin tosses τ1 + 1, τ1 + 2, · · · , τ2 .
(i) Use these facts to explain why
Eατ2 = (Eατ1 )2 for all α ∈ (0, 1).
Proof. E[ατ2 ] = E[α(τ2 −τ1 )+τ1 ] = E[α(τ2 −τ1 ) ]E[ατ1 ] = E[ατ1 ]2 .
Remark 5.1. The i.i.d. property of τ2 − τ1 and τ1 can be proven by strong Markov property of random walk.
(ii) Without using (5.2.13), explain why for any positive integer m we must have
Eατm = (Eατ1 )m for all α ∈ (0, 1). (5.7.1)
(m) (m)
Proof. If we define Mn = Mn+τm − Mτm (m = 1, 2, · · · ), then (M· )m as random functions are i.i.d. with
(m)
distributions the same as that of M . So τm+1 − τm = inf{n : Mn = 1} are i.i.d. with distributions the
same as that of τ1 . Therefore
E[ατm ] = E[α(τm −τm−1 )+(τm−1 −τm−2 )+···+τ1 ] = E[ατ1 ]m .

7 Compare with American call option, Theorem 4.5.1.

37
 (m)
Remark 5.2. For those concerned with the meaning of “(M· )m as random functions...”, note the function
∑∞
space E := {f : N → Z} is a Polish space with metric ||f − g|| = n=1 |fn2−gn| (m)
n . Then each M· :Ω→E
is a random element from one probability space to another measurable space so that we can talk about its
distribution.
(iii) Would equation (5.7.1) still hold if the random walk is not symmetric? Explain why or why not.

Solution. Yes, it would still hold since the strong Markov property of random walk, hence the i.i.d. property
of (τm+1 − τm )∞
m=0 , still holds and the argument of (ii) still works for asymmetric random walk.

I Exercise 5.2 (First passage time for random walk with upward drift). Consider the asymmetric
random walk with probability p for an up step and probability q = 1 − p for a down step, where 12 < p < 1
so that 0 < q < 12 . In the notation of (5.2.1), let τ1 be the first time the random walk starting from level 0
reaches level 1. If the random walk never reaches this level, then τ1 = ∞.
(i) Define f (σ) = peσ + qe−σ . Show that f (σ) > 1 for all σ > 0.
Proof. For all σ > 0, f ′ (σ) = peσ − qe−σ > p − q > 0. So f (σ) > f (0) = 1 for all σ > 0.

(ii) Show that, when σ > 0, the process

( )n
σMn 1
Sn = e
f (σ)

is a martingale.
[ ] [ ]
−σ 1
Proof. En SSn+1
n
= En e σXn+1 1 σ 1
f (σ) = pe f (σ) + qe f (σ) = 1.

(iii) Show that, for σ > 0, [ ( )τ1 ]

−σ 1
e = E 1{τ1 <∞} .
f (σ)
Conclude that P(τ1 < ∞) = 1.

Proof. By optional sampling theorem (Theorem 4.3.2), E[Sn∧τ1 ] = E[S0 ] = 1. Note

( )n∧τ1
1
Sn∧τ1 = e σMn∧τ1
≤ eσ
f (σ)
( )n
for all σ > 0, by bounded convergence theorem and the fact 0 < 1{τ1 =∞} Sn∧τ1 ≤ eσ f (σ)
1
→ 0 as n → ∞,
we have
E[1{τ1 <∞} Sτ1 ] = E[ lim Sn∧τ1 ] = lim E[Sn∧τ1 ] = 1.
n→∞ n→∞
[ ( )τ1 ] [ ( )τ1 ]
That is, E 1{τ1 <∞} eσ f (σ)
1
= 1. So e−σ = E 1{τ1 <∞} f (σ) 1
. Let σ ↓ 0, again by bounded
[ ( )τ1 ]
convergence theorem, 1 = E 1{τ1 <∞} f (0) 1
= P (τ1 < ∞).

(iv) Compute Eατ1 for α ∈ (0, 1).

−σ , then as σ varies from 0 to ∞, α can take all the values in (0, 1). Write
1 1
Solution. Set α = f (σ) = peσ +qe
σ in terms of α, we have (note 4pqα2 < 4( p+q 2 ) · 1 = 1)
2 2

√
σ 1± 1 − 4pqα2
e = .
2pα

38
 ( √ )
1+ 1−4pqα2
We want to choose σ > 0, so we should take σ = ln 2pα . Therefore

√
2pα 1− 1 − 4pqα2
E[α ] =
τ1
√ = .
1 + 1 − 4pqα2 2qα

(v) Compute Eτ1 .

Solution. ∂α E[α ]
∂ τ1
= E[ ∂α
∂
ατ1 ] = E[τ1 ατ1 −1 ], and
( √ )′
1− 1 − 4pqα2
2qα
1 [ √ ]′
= (1 − 1 − 4pqα2 )α−1
2q
[ √ ]
1 1
− (1 − 4pqα2 )− 2 (−4pq2α)α−1 + (1 − 1 − 4pqα2 )(−1)α2 .
1
=
2q 2

Therefore
[ ]
∂ 1 1 √ 1 1
− (1 − 4pq)− 2 (−8pq) − (1 − 1 − 4pq) =
1
E[τ1 ] = lim E[ατ1 ] = = .
α↑1 ∂α 2q 2 2p − 1 p−q

I Exercise 5.3 (First passage time for random walk with downward drift). Modify Exercise 5.2
by assuming 0 < p < 12 so that 12 < q < 1.
(i) Find a positive number σ0 such that the function f (σ) = peσ + qe−σ satisfies f (σ0 ) = 1 and f (σ) > 1 for
all σ > σ0 .
Solution. Solve the equation peσ + qe−σ = 1 and a positive solution is
√
1 + 1 − 4pq 1−p
ln = ln = ln q − ln p.
2p p
Set σ0 = ln q − ln p, then f (σ0 ) = 1 and
[ ln q−ln p
]
f ′ (σ) = peσ − qe−σ = qe−σ e2(σ− 2 ) − 1 > 0

for σ > σ0 . So f (σ) > f (σ0 ) = 1 for all σ > σ0 .

(ii) Determine P{τ1 < ∞}. (This quantity is no longer equal to 1.)
( )n
1
Solution. As in Exercise 5.2, Sn = eσMn f (σ) is a martingale, and
[ ( )τ1 ∧n ]
1
1 = E[S0 ] = E[Sn∧τ1 ] = E e σMn∧τ1
.
f (σ)

Suppose σ > σ0 , then by bounded convergence theorem and f (σ) > 1, we have
[ ( )n∧τ1 ] [ ( )τ1 ]
1 1
1 = E lim e σMn∧τ1
= E 1{τ1 <∞} eσ .
n→∞ f (σ) f (σ)

Let σ ↓ σ0 , we get P(τ1 < ∞) = e−σ0 = p

q < 1.

39
(iii) Compute Eατ1 for α ∈ (0, 1).
[ ( )τ 1 ]
Solution. Choose σ > σ0 , then f (σ) > 1 and we have from (ii) E 1{τ1 <∞} f (σ)
1
= e−σ . Set α = f (σ)
1
,
then [ ]
E ατ1 1{τ1 <∞} = e−σ(α)
√ ( √ )
σ(α) 1± 1−4pqα2 1+ 1−4pqα2
where σ(α) satisfies e = 2pα . To make sure σ(α) > σ0 , we choose σ(α) = ln 2pα . As
a consequence, √
[ τ1 ] 1 − 1 − 4pqα2
E α 1{τ1 <∞} = .
2qα

[ ]
(iv) Compute E 1{τ1 <∞} τ1 . (Since P(τ1 = ∞) > 0, we have Eτ1 = ∞.)

Solution. Using result in (iii) and bounded convergence theorem, we have

[ ]
[ ] ( τ1 −1
) [( )] ∂
E τ1 1{τ1 <∞} = E lim τ1 α = lim E τ1 ατ1 −1 = lim E[ατ1 ]
α↑1 α↑1 α↑1 ∂α
[ ] [ ]
1 4pq √ 1 4pq
= √ − (1 − 1 − 4pq) = − 1 + 2q − 1
2q 1 − 4pq 2q 2q − 1
p 1
= .
qq−p

I Exercise 5.4 (Distribution of τ2 ). Consider the symmetric random walk, and let τ2 be the first time
the random walk, starting from level 0, reaches the level 2. According to Theorem 5.2.3,
( √ )2
1− 1 − α2
Eατ2 = for all α ∈ (0, 1).
α

Using the power series (5.2.21), we may write the right-hand side as
( √ )2 √
1− 1 − α2 2 1 − 1 − α2
= · −1
α α α
∑∞ ( )2j−2
α (2j − 2)!
= −1 +
j=1
2 j!(j − 1)!
∑∞ ( )2j−2
α (2j − 2)!
=
j=2
2 j!(j − 1)!
∞ ( )2k
∑ α (2k)!
= .
2 (k + 1)!k!
k=1

(i) Use the power series above to determine P {τ2 = 2k}, k = 1, 2, · · · .

∑∞ ∑∞ ( )2k (2k)!
Solution. E[ατ2 ] = k=1 P(τ2 = 2k)α2k = k=1 α2 P(τ2 = 2k)4k . So P(τ2 = 2k) = 4k (k+1)!k!
.

(ii) Use the reflection principle to determine P{τ2 = 2k}, k = 1, 2, · · · .

40
Solution. P(τ2 = 2) = 14 . For k ≥ 2, P(τ2 = 2k) = P(τ2 ≤ 2k) − P(τ2 ≤ 2k − 2).

P(τ2 ≤ 2k) = P(M2k = 2) + P(M2k ≥ 4) + P(τ2 ≤ 2k, M2k ≤ 0)

= P(M2k = 2) + 2P(M2k ≥ 4)
= P(M2k = 2) + P(M2k ≥ 4) + P(M2k ≤ −4)
= 1 − P(M2k = −2) − P(M2k = 0).

Similarly, P(τ2 ≤ 2k − 2) = 1 − P(M2k−2 = −2) − P(M2k−2 = 0). So

P(τ2 = 2k) = P(M2k−2 = −2) + P(M2k−2 = 0) − P(M2k = −2) − P(M2k = 0)

( )2k−2 [ ] ( )2k [ ]
1 (2k − 2)! (2k − 2)! 1 (2k)! (2k)!
= + − +
2 k!(k − 2)! (k − 1)!(k − 1)! 2 (k + 1)!(k − 1)! k!k!
[ ]
(2k)! 4 4
= (k + 1)k(k − 1) + (k + 1)k − k − (k + 1)
2
4k (k + 1)!k! 2k(2k − 1) 2k(2k − 1)
[ ]
(2k)! 2(k 2 − 1) 2(k 2 + k) 4k 2 − 1
= + −
4k (k + 1)!k! 2k − 1 2k − 1 2k − 1
(2k)!
= .
4k (k + 1)!k!

I Exercise 5.5 (Joint distribution of random walk and maximum-to-date). Let Mn be a symmetric
random walk, and define its maximum-to-date process

Mn∗ = max Mk . (5.7.2)

1≤k≤n

Let n and m be even positive integers, and let b be an even integer less than or equal to m. Assume m ≤ n
and 2m − b ≤ n.
(i) Use an argument based on reflected paths to show that

P{Mn∗ ≥ m, Mn = b} = P{Mn = 2m − b}
( )n
n! 1
= ( n−b ) ( n+b ) .
2 + m ! 2 − m ! 2

Proof. For every path that crosses level m by time n and resides at b at time n, there corresponds a reflected
path that resides at time 2m − b. So
( )n
1 n!
P(Mn∗ ≥ m, Mn = b) = P(Mn = 2m − b) = ( ) ( n+b ).
2 m+ 2 ! 2 −m !
n−b

(ii) If the random walk is asymmetric with probability p for an up step and probability q = 1 − p for a down
step, where 0 < p < 1, what is P{Mn∗ ≥ m, Mn = b}?
Solution. The argument is similar to (i), but we need to determine the powers of p and q from the following
equations {
xp + xq = n
xp − xq = 2m − b.
Solving it gives us {
xp = m + n−b
2
xq = n+b
2 − m.

41
Therefore
n!
P(Mn∗ ≥ m, Mn = b) = P(Mn = 2m − b) = ( ) pm+ 2 q 2 −m .
n−b n+b
) ( n+b
m+ n−b
2 ! 2 −m !

I Exercise 5.6. The value of the perpetual American put in Section 5.4 is the limit as n → ∞ of the
value of an American put with the same strike price 4 that expires at time n. When the initial stock price
is S0 = 4, the value of the perpetual American put is 1 (see (5.4.6) with j = 2). Show that the value of an
American put in the same model when the initial stock price is S0 = 4 is 0.80 if the put expires at time 1,
0.928 if the put expires at time 3, and 0.96896 if the put expires at time 5.

Proof. Instead of numerical examples, we give a rigorous proof.

On the infinite coin-toss space, we define Mn = {stopping times that takes values 0, 1, · · · , n, ∞} and
M∞ = {stopping times that takes values 0, 1, 2, · · · }. Then the time-zero value V ∗ of the perpetual Ameri-
can put as in Section 5.4 can be defined as
[ ]
∗ e (K − Sτ )+
V = sup E 1{τ <∞} .
τ ∈M∞ (1 + r)τ

For an American put with the same strike price K that expires at time n, its time-zero value V (n) is
[ ]
e 1{τ <∞} (K − Sτ ) .
+
V (n) = max E
τ ∈Mn (1 + r)τ

Clearly (V (n) )n≥0 is nondecreasing and V (n){≤ V ∗ for every n. So limn V (n) exists and limn V (n) ≤ V ∗ .
∞, if τ = ∞
For any given τ ∈ M∞ , we define τ (n) = , then τ (n) is also a stopping time, τ (n) ∈ Mn
τ ∧ n, if τ < ∞
and limn→∞ τ (n) = τ . By bounded convergence theorem,
[ ] [ ]
e (K − Sτ )+ e (K − Sτ (n) )+
E 1{τ <∞} = lim E 1{τ (n) <∞} ≤ lim V (n) .
(1 + r)τ n→∞ (1 + r)τ (n) n→∞

Take sup at the left hand side of the inequality, we get V ∗ ≤ limn→∞ V (n) . Therefore V ∗ = limn V (n) .

I Exercise 5.7 (Hedging a short position in the perpetual American put). Suppose you have sold
the perpetual American put of Section 5.4 and are hedging the short position in this put. Suppose that at
the current time the stock price is s and the value of your hedging portfolio is v(s). Your hedge is to first
consume the amount8 [ ]
4 1 1 (s)
c(s) = v(s) − v(2s) + v (5.7.3)
5 2 2 2
and then take a position (s)
v(2s) − v 2
δ(s) = (5.7.4)
2s − 2s
in the stock. (See Theorem 4.2.2 of Chapter 4. The processes Cn and ∆n in that theorem are obtained by
replacing the dummy variable s by the stock price Sn in (5.7.3) and (5.7.4); i.e. Cn = c(Sn ) and ∆n = δ(Sn ).)
If you hedge this way, then regardless of whether the stock goes up or down on the next step, the value of
your hedging portfolio should agree with the value of the perpetual American put.
(i) Compute c(s) when s = 2j for the three cases j ≤ 0, j = 1, and j ≥ 2.
8 The 1
(s)
text missed a factor of 2
in fron of v 2
.

42
Solution. By (5.4.6),
{
4 − 2j if j ≤ 1
v(2j ) = 4
2j if j ≥ 1.

For j ≤ 0,
[ ]
4 1 1 2 4
c(2 ) = v(2 ) −
j j
v(2 ) + v(2 ) = (4 − 2j ) − (4 − 2j+1 + 4 − 2j−1 ) = .
j+1 j−1
5 2 2 5 5

For j = 1, [ ]
4 1 1 2 2
c(2) = v(2) − v(4) + v(1) = 2 − (1 + 4 − 1) = .
5 2 2 5 5
For j ≥ 2, ( )
2 [ j+1 ] 4 2 4 4
c(2j ) = v(2j ) − v(2 ) + v(2j−1 ) = j − + = 0.
5 2 5 2j+1 2j−1

(ii) Compute δ(s) when s = 2j for the three cases j ≤ 0, j = 1, and j ≥ 2.

Solution. For j ≤ 0,

v(2j+1 ) − v(2j−1 ) (4 − 2j+1 ) − (4 − 2j−1 )

δ(2j ) = = = −1.
2j+1 − 2j−1 2j+1 − 2j−1
For j = 1,
v(4) − v(1) 1 − (4 − 1) 2
δ(2) = = =− .
4−1 4−1 3
For j ≥ 2,
v(2j+1 ) − v(2j−1 ) j+1 − j−1
4 4
1
δ(2j ) = = 2j+1 2j−1 = − j−1 .
2j+1 −2 j−1 2 −2 4

(iii) Verify in each of the three cases s = 2j for j ≤ 0, j = 1, and j ≥ 2 that the hedge works (i.e., regardless
of whether the stock goes up or down, the value of your hedging portfolio at the next time is equal to the
value of the perpetual American put at that time).
Proof. The computation is too tedious; skipped for this version.

I Exercise 5.8 (Perpetual American call). Like the perpetual American put of Section 5.4, the per-
petual American call has no expiration. Consider a binomial model with up factor u, down factor d, and
interest rate r that satisfies the no-arbitrage condition 0 < d < 1 + r < u. The risk-neutral probabilities are
1+r−d u−1−r
p̃ = , q̃ = .
u−d u−d
The intrinsic value of the perpetual American call is g(s) = s − K, where K > 0 is the strike price. The
purpose of this exercise is to show that the value of the call is always the price of the underlying stock, and
there is no optimal exercise time.
(i) Let ) = s. Show that v(Sn ) is always at least as large as the intrinsic value(g(Sn)) of the call
( v(s) n n
1 1
and 1+r v(Sn ) is a supermartingale under the risk-neutral probabilities. In fact, 1+r v(Sn ) is a
9
martingale. These are the analogues of properties (i) and (ii) for the perpetual American put of Section
5.4.
9 The textbook said “supermartingale” by mistake.

43
Proof. v(Sn ) = Sn ≥ Sn −K = g(Sn ). Under risk-neutral probabilities, 1
(1+r)n v(Sn ) = Sn
(1+r)n is a martingale
by Theorem 2.4.4.

(ii) to show that v(s) = s is not too large to be the value of the perpetual American call, we must find a
good policy for the purchaser of the call. Show that if the purchaser of the call exercises at time n, regardless
of the stock price at that time, then the discounted risk-neutral expectation of her payoff is S0 − (1+r) K
n.

Because this is true for every n, and

[ ]
K
lim S0 − = S0 ,
n→∞ (1 + r)n

the value of the call at time zero must be at least S0 . (The same is true at all other times; the value of the
call is at least as great as the current stock price.)

Proof. If the purchaser

[ chooses
] to exercises the call at time
[ n, then the] discounted risk-neutral expectation
e Sn −K
of her payoff is E (1+r)n = S0 − (1+r)n . Since limn→∞ S0 − (1+r)
K K
n = S0 , the value of the call at time
[ ]
zero is at least supn S0 − (1+r)
K
n = S0 .

(iii) In place of (i) and (ii) above, we could verify that v(s) = s is the value of the perpetual American
call by checking that this function satisfies the equation (5.4.16) and boundary conditions (5.4.18). Do this
verification.
{ }
Proof. max g(s), pev(us)+e
1+r
q v(ds)
= max{s − K, peu+e
1+r s} = max{s − K, s} = s = v(s), so equation (5.4.16) is
qv

satisfied. Clearly v(s) = s also satisfies the boundary condition (5.4.18).

(iv) Show that there is no optimal time to exercise the perpetual American call.

Proof. Suppose τ is an optimal exercise time, then according to result in (ii),

[ ] [ ]
e Sτ − K 1{τ <∞} ≥ sup S0 −
E
K
= S0 ,
(1 + r)τ n (1 + r)n
[ ] [ ] [ ]
which implies P(τ < ∞) ̸= 0 and hence E e K
τ 1{τ <∞} > 0. So Ee Sτ −Kτ 1{τ <∞} < E
e Sτ
τ 1{τ <∞} .
( ) (1+r) (1+r) (1+r)
Sn
Since (1+r) n is a martingale under the risk-neutral measure, by Fatou’s lemma,
n≥0
[ ] [ ] [ ]
e Sτ e Sτ ∧n e Sτ ∧n e 0 ] = S0 .
E 1{τ <∞} ≤ lim inf E 1{τ <∞} ≤ lim inf E = lim inf E[S
(1 + r)τ n→∞ (1 + r)τ ∧n n→∞ (1 + r)τ ∧n n→∞

Combined, we have [ ] [ ]
e Sτ − K e Sτ
S0 ≤ E 1 {τ <∞} < E 1{τ <∞} ≤ S0 .
(1 + r)τ (1 + r)τ
Contradiction.
[ So there ]is no optimal time to exercise the perpetual American call. Simultaneously, we have
e Sτ −K
shown E (1+r)τ 1{τ <∞} < S0 for any stopping time τ . Combined with (ii), we conclude S0 is the least
upper bound for all the prices acceptable to the buyer.

I Exercise 5.9. (Provided by Irene Villegas.) Here is a method for solving equation (5.4.13) for the value
of the perpetual American put in Section 5.4.
(i) We first determine v(s) for large values of s. When s is large, it is not optimal to exercise the put, so the
maximum in (5.4.13) will be given by the second term
[ ]
4 1 1 (s) 2 2 (s)
v(2s) + v = v(2s) + v .
5 2 2 2 5 5 2

44
We thus seek solutions to the equation
2 2 (s)
v(s) = v(2s) + v . (5.7.5)
5 5 2
All such solutions are of the form sp for some constant p or linear combination of functions of this form.
Substitute sp into (5.7.5), obtain a quadratic equation for 2p , and solve to obtain 2p = 2 or 2p = 21 . This
leads to the values p = 1 and p = −1, i.e., v1 (s) = s and v2 (s) = 21 are soltuions to (5.7.5).
2 sp 2p+1 21−p
Proof. Suppose v(s) = sp , then we have sp = 25 2p sp + 5 2p . So 1 = 5 + 5 . Solve it for p, we get p = 1
or p = −1.
(ii) The general solution to (5.7.5) is a linear combination of v1 (s) and v2 (s), i.e.,
B
v(s) = As + . (5.7.6)
s
For large values of s, the value of the perpetual American put must be given by (5.7.6). It remains to
evaluate A and B. Using the second boundary condition in (5.4.15), show that A must be zero.
B
Proof. Since lims→∞ v(s) = lims→∞ (As + s) = 0, we must have A = 0.

(iii) We have thus established that for large values of s, v(s) = Bs for some constant B still to be determined.
For small values of s, the value of the put is its intrinsic value 4−s. We must choose B so these two functions
coincide at some point, i.e., we must find a value for B so that, for some s > 0,
B
fB (s) = − (4 − s)
s
equals zero. Show that, when B > 4, this function does not take the value 0 for any s > 0, but, when B ≤ 4,
the equation fB (s) = 0 has a solution.
Proof. fB (s) = 0 if and only if B + s2 − 4s = 0. The discriminant ∆ = (−4)2 − 4B = 4(4 − B). So for B ≤ 4,
the equation has roots and for B > 4, this equation does not have roots.
(iv) Let B be less than or equal to 4, and let sB be a solution of the equation fB (s) = 0. Suppose sB is
a stock price that can be attained in the model (i.e., sB = 2j for some integer j). Suppose further that
the owner of the perpetual American put exercises the first time the stock price is sB or smaller. Then the
discounted risk-neutral expected payoff of the put is vB (S0 ), where vB (s) is given by the formula
{
4 − s, if s ≤ sB ,
vB (s) = B (5.7.7)
s, if s ≥ sB .

Which values of B and sB give the owner the largest option value?
√
Proof. Suppose B ≤ 4, then the equation s2 − 4s + B = 0 has solution 2 ± 4 − B. By drawing graphs of
4 − s and Bs , we can see the largest vB (s) is obtained by making 4 − s and Bs tangent to each other, which
implies {
∆ = 4(4 − B) = 0
4 − sB = sBB .
Solving it gives us B = 4 and sB = 2.
′ ′
(v) For s < sB , the derivative of vB (s) is vB (s) = −1. For s > sB , this derivative is vB (s) = − sB2 . Show
that the best value of B for the option owner makes the derivative of vB (s) continuous at s = SB (i.e., the
′
two formulas for vB (s) give the same answer at s = sB ).
Proof. To have continuous derivative, we must have −1 = − sB2 . Plug B = s2B back into 4 − sB = B
sB , we
B
get sB = 2. This gives B = 4.

45
6 Interest-Rate-Dependent Assets
⋆ Comments:
1) In previous chapters, we started with a real probability measure and derived the risk-neutral measure
based on the no-arbitrage argument. The concrete form of the risk-neutral measure is known in that setting.
In the current chapter, models are built under the risk-neutral measure, whose existence is assumed a priori
and whose concrete form (in terms of the real probability measure) is unknown. The justification for this is
the following result by Dalang et al. [2]:
Theorem 2 (Dalang-Morton-Willinger, Fundamental Theorem of Asset Pricing). Let (Ω, F, {Ft }t=0,··· ,T , P)
be a (general) filtered probability space and let S = {St }t∈{0,··· ,T } be an adapted, Rd -valued stochastic process
describing the discounted prices of d ∈ N financial assets. Then the following properties are equivalent:
(a) The financial market model is free of arbitrage.
(b) There exists a probability measure P∗ on (Ω, F, P) such that
• P∗ is equivalent to P and the Radon-Nikodým density ϱ := dP∗ /dP is bounded, i.e. in L∞ (Ω, FT , P),
• Integrability: St ∈ L1 (Ω, Ft , P∗ ) for all t ∈ {0, · · · , T },
• Martingale property w.r.t. P:
a.s.
EP∗ [St |Ft−1 ] = St−1 for all t ∈ {0, · · · , T }.

According to the Fundamental Theorem of Asset Pricing (FTAP), the no-arbitrage property is associated
with the existence of a probability measure called equivalent martingale measure (EMM) and a positive
process called numéraire, such that the price processes of tradable assets discounted by the numéraire are
martingales under the equivalent martingale measure. In the current chapter, the numéraire is the value
process of the money market account

Mn = (1 + R0 ) · · · (1 + Rn−1 ), n = 1, 2, · · · , N ; M0 = 1.

And the risk-neutral measure is the EMM associated with this numéraire. This justifies Definition 6.2.4
(zero-coupon bond prices) since
[ ]
e n Dm · 1 .
e n [Dm Bm,m ] ⇒ Bn,m = E
Dn Bn,m = E
Dn

2) The wealth equation (6.2.6) essentially assumes all coupons and other payouts of cash are reinvested
in the portfolio.
3) To see the intuition of the forward interest rate at time n for investing at time m (Definition 6.3.4),
1
note at time n, we can invest $1 to buy Bn,m shares of zero-coupon bond maturing at time m; at time m,
1
we reinvest the payoff Bn,m at rate Fn,m to get paid at time (m + 1). To eliminate arbitrage, this investing
strategy should have the same return as investing $1 at time n in the zero-coupon bond maturing at time
(m + 1):
1 1
(1 + Fn,m ) = .
Bn,m Bn,m+1
This gives formula (6.3.3)
Bn,m Bn,m − Bn,m+1
Fn,m = −1= .
Bn,m+1 Bn,m+1

4) Whenever there is a hedge, static or not, the discounted value of the hedging portfolio is a martingale
under the risk-neutral measure, and the risk-neutral pricing formula applies. This is regardless of whether
or not the market is complete.
i) Forward contract. a) Hedging of a short position: at time n, short BSn,mn
zero-coupon bond maturing
at time m and long 1 share of asset at price of Sn , hold the portfolio until maturity time m. b) Risk-neutral
pricing:
e n [Dm (K − Sm )] = KDn Bn,m − Dn Sn = Dn Vn ,
E

46
where Vn is the contract value at time n. By setting Vn = 0, we obtain m-forward price of the asset at time
n (Theorem 6.3.2).
ii) Forward rate agreement (FRA).10 a) Hedging of a short position: the portfolio whose value is Rm at
time (m + 1) can be replicated by a cash inflow of $1 at time m and a cash outflow of $1 at time (m + 1),
since the inflow of $1 at time m can be invested in the money market account to return (1 + Rm ) at time
(m + 1). The cash inflow of $1 at time m can be obtained by longing at time n a zero-coupon bond maturing
at time m, while the cash outflow of $1 at time (m + 1) can be obtained by shorting at time n a zero-coupon
bond maturing at time (m + 1). So the value of the portfolio at time n is

Vn = Bn,m − Bn,m+1 .

b) Risk-neutral pricing (Exercise 6.3):

[ ] [ ]
e Dm+1 Rm e Dm − Dm+1
Vn = En = En = Bn,m − Bn,m+1 .
Dn Dn
This is Theorem 6.3.5.
iii) Interest rate swap. A long swap position (“receive fixed”) is a long position in a coupon bond plus a
short position in a series of FRA’s. Therefore, an interest rate swap can be hedged and risk-neutral pricing
formula applies. This is Theorem 6.3.7. More specifically,
∑
m
Swapm = K +B0,m − 1
n=1

suggests a long position in a bond with coupon K and maturity m and a short position of $1 in the money
market account. A short position of $1 in the money market account at the beginning of each period will
result in −(1 + Rn ) at the end of the period.
iv) Interest rate caps and floors. Suppose the replication uses the money market account and zero-coupon
bonds with various maturities. The wealth equation satisfies

Xn+1 = (1 + Rn )(Xn − ∆n Bn,m ) + ∆n Bn+1,m .

To successfully replicate Vn+1 , it’s necessary and sufficient that Bn+1,m (H) ̸= Bn+1,m (T ). See Exercise 6.4
for illustration.
5) According to the Fundamental Theorem of Asset Pricing (FTAP), the no-arbitrage property is associ-
ated with the existence of a probability measure called equivalent martingale measure (EMM) and a positive
process called numéraire, such that the price processes of tradable assets discounted by the numéraire are
martingales under the given probability measure (hence the name martingale measure).
The m-forward measure is the EMM associated with the zero-coupon bond (Bn,m )m n=0 as the numéraire.
For a European contingent claim with maturity m, we have the risk-neutral pricing formula (note Bm,m ≡ 1)

e m [Vm ] = 1 E
Vn = Bn,m E e n [Dm Vm ].
n
Dn
If we denote the Radon-Nikodým derivative process by (Zn,m )m
n=0 , that is,

em
dP
Zm,m := e n [Zm,m ],
, Zn,m := E
e
dP
Dm
by setting n = 0 in the risk-neutral pricing formula, we have Zm,m = B0,m and hence

e n [Dm ]
E Dn Bn,m
Zn,m = = , n = 0, · · · , m.
B0,m B0,m
10 A FRA is a contract involving three time instants: the current time t, the expiry time T > t, and the maturity time S > T .

The contract gives its holder an interest-rate payment for the period between T and S. See Brigo and Mercurio [1, page 11] for
a general definition.

47
This gives an alternative presentation of the m-forward measure Pem . A notable feature of working under
this measure is that any asset price process discounted by the zero-coupon bond (Bn,m )mn=0 is exactly its
m-forward price process (Theorem 6.3.2).

I Exercise 6.1. Prove Theorem 2.3.2 when conditional expectation is defined by Definition 6.2.2.
Proof. The proof is tedious and is not a lot simpler than the one using the most general definition of
conditional expectation (see, for example, Shiryaev [5]); skipped for this version.

I Exercise 6.2. Verify that the discounted value of the static hedging portfolio constructed in the proof of
e
Theorem 6.3.2 is a martingale under P.
Proof. The static hedging portfolio consists of shorting one forward contract, shorting BSn,m
n
zero-coupon
bonds maturing at time m, and longing one share of the asset. So for any k = n, · · · , m, the value of the
portfolio at time k is
Xk = Sk − E e k [Dm (Sm − K)]D−1 − Sn Bk,m .
k
Bn,m
Then
[ ]
e k−1 [Dk Xk ] e e Sn
E = Ek−1 Dk Sk − Ek [Dm (Sm − K)] − Bk,m Dk
Bn,m
[ ]
e k−1 [Dm (Sm − K)] − Sn E
= Dk−1 Sk−1 − E e k−1 E e k [Dm · 1]
Bn,m
{ }
= Dk−1 Sk−1 − E e k−1 [Dm (Sm − K)]D−1 − Sn Bk−1,m
k−1
Bn,m
= Dk−1 Xk−1 .

This shows the discounted value of the static hedging portfolio constructed in the proof of Theorem 6.3.2 is
e
a martingale under P.

I Exercise 6.3. Let 0 ≤ n ≤ m ≤ N − 1 be given. According to the risk-neutral pricing formula, the
contract that pays Rm at time m + 1 has time-n price D1n E e n [Dm+1 Rm ]. Use the properties of conditional
expectations to show that this gives the same result as Theorem 6.3.5, i.e.,
1 e
En [Dm+1 Rm ] = Bn,m − Bn,m+1 .
Dn
Proof.
1 e 1 e 1 e
En [Dm+1 Rm ] = En [Dm (1 + Rm )−1 Rm ] = En [Dm − Dm+1 ] = Bn,m − Bn,m+1 .
Dn Dn Dn

I Exercise 6.4 (Short position hedge for caplets). Using the data in Example 6.3.9, this exercise
( )+
constructs a hedge for a short position in the caplet paying R2 − 31 at time three. We observe from the
second table in Example 6.3.9 that the payoff at time three of this caplet is
2
V3 (HH) = , V3 (HT ) = V3 (T H) = V3 (T T ) = 0.
3
Since this payoff depends on only the first two coin tosses, the price of the caplet at time two can be
determined by discounting:
1 1
V2 (HH) = V3 (HH) = , V2 (HT ) = V2 (T H) = V2 (T T ) = 0.
1 + R2 (HH) 3

48
Indeed, if one is hedging a short position in the caplet and has a portfolio valued at 13 at time two in the
event ω1 = H, ω2 = H, then one can simply invest this 13 in the money market in order to have the 23
required to pay off the caplet at time three.
2
In Example 6.3.9, the time-zero price of the caplet is determined to be 21 (see (6.3.10)).
(i) Determine V1 (H) and V1 (T ), the price at time one of the caplet in the events ω1 = H and ω1 = T ,
respectively.
e 1 [D2 V2 ] = D2 E
Solution. D1 V1 = E e 1 [V2 ]. So V1 = D2 e 1 e
D1 E1 [V2 ] = 1+R1 E1 [V2 ].
In particular,
( )
V2 (HH)P (ω2 = H|ω1 = H) + V2 (HT )P (ω2 = T |ω1 = H) 6 1 2 1 4
V1 (H) = = · +0· = ,
1 + R1 (H) 7 3 3 3 21
V2 (T H)P (ω2 = H|ω1 = T ) + V2 (T T )P (ω2 = T |ω1 = T )
V1 (T ) = = 0.
1 + R1 (T )

2
(ii) Show how to begin with 21 at time zero and invest in the money market and the maturity two bond in
order to have a portfolio value X1 at time one that agrees with V1 , regardless of the outcome of the first coin
toss. Why do we invest in the maturity two bond rather than the maturity three bond to do this?
2
Proof. Let X0 = 21 . Suppose we buy ∆0 shares of the maturity two bond, then at time one, the value of
our portfolio is X1 = (1 + R0 )(X0 − ∆0 B0,2 ) + ∆0 B1,2 . To replicate the value V1 , we must have
{
V1 (H) = (1 + R0 )(X0 − ∆0 B0,2 ) + ∆0 B1,2 (H)
V1 (T ) = (1 + R0 )(X0 − ∆0 B0,2 ) + ∆0 B1,2 (T ).
So
V1 (H) − V1 (T ) 21 − 0
4
4
∆0 = = = .
B1,2 (H) − B1,2 (T ) 7 − 7
6 5 3
The hedging strategy is therefore to borrow 43 B0,2 − 21 2
= 20 4
21 and buy 3 share of the maturity two bond.
The reason why we do not invest in the maturity three bond is that B1,3 (H) = B1,3 (T )(= 74 ) and the
portfolio will therefore have the same value at time one regardless the outcome of first coin toss. This makes
impossible the replication of V1 , since V1 (H) ̸= V1 (T ).
(iii) Show how to take the portfolio value X1 at time one and invest in the money market and the maturity
three bond in order to have a portfolio value X2 at time two that agrees with V2 , regardless of the outcome
of the first two coin tosses. Why do we invest in the maturity three bond rather than the maturity two bond
to do this?
Proof. Suppose we buy ∆1 share of the maturity three bond at time one, then to replicate V2 at time two,
we must have V2 = (1 + R1 )(X1 − ∆1 B1,3 ) + ∆1 B2,3 . So
V2 (HH) − V2 (HT ) 2 V2 (T H) − V2 (T T )
∆1 (H) = = − , ∆1 (T ) = = 0.
B2,3 (HH) − B2,3 (HT ) 3 B2,3 (T H) − B2,3 (T T )
The hedging strategy is as follows. If the outcome of first coin toss is T , then we keep everything in the
money market account. If the outcome of first coin toss is H, we short 32 shares of the maturity three bond
and invest the income into the money market account. We do not invest in the maturity two bond, because
at time two, the value of the bond is its face value and our portfolio will therefore have the same value
regardless outcomes of coin tosses. This makes impossible the replication of V2 .

I Exercise 6.5. Let m be given with 0 ≤ m ≤ N − 1, and consider the forward interest rate
Bn,m − Bn,m+1
Fn,m = , n = 0, 1, · · · , m.
Bn,m+1

(i) Use (6.4.8) and (6.2.5) to show that Fn,m , n = 0, 1, · · · , m, is a martingale under the (m + 1)-forward
measure Pem+1 .

49
 Bn,m −Bn,m+1
Proof. Before we start the computation, note Fn,m = is a tradable asset discounted by
Bn,m+1
em+1 associated with
(Bn,m+1 )n , so it must be a martingale under the equivalent martingale measure P
the numéraire (Bn,m+1 )n . To verify this, suppose 1 ≤ n ≤ m, then

e m+1 [Fn,m ] =
E e n−1 [B −1 (Bn,m − Bn,m+1 )Zn,m+1 Z −1
E
n−1 n,m+1 n−1,m+1 ]
[( ) ]
e n−1 Bn,m Bn,m+1 Dn
= E −1
Bn,m+1 Bn−1,m+1 Dn−1
Dn e n−1 [Bn,m − Bn,m+1 ]
= E
Bn−1,m+1 Dn−1
Dn e n−1 [D−1 E
e n [Dm ] − D−1 E
e n [Dm+1 ]]
= E n n
Bn−1,m+1 Dn−1
e n−1 [Dm − Dm+1 ]
E
=
Bn−1,m+1 Dn−1
Bn−1,m − Bn−1,m+1
=
Bn−1,m+1
= Fn−1,m .

(ii) Compute F0,2 , F1,2 (H), and F1,2 (T ) in Example 6.4.4 and verify the martingale property

e 3 [F1,2 ] = F0,2 .
E

Solution.
B0,2 0.9071
F0,2 = −1= − 1 = 0.05
B0,3 0.8639
B1,2 (H) 0.9479
F1,2 (H) = −1= − 1 = 0.055
B1,3 (H) 0.8985
B1,2 (T ) 0.9569
F1,2 (T ) = −1= − 1 = 0.045
B1,3 (T ) 0.9158

Therefore
e 3 [F1,2 ] = P
E e3 (H)F1,2 (H) + P
e3 (T )F1,2 (T ) = 0.4952 · 0.055 + 0.5048 · 0.045 = 0.05 = F0,2 .

I Exercise 6.6. Let Sm be the price at time m of an asset in a binomial interest rate model. For
n = 0, 1, · · · , m, the forward price is Forn,m = BSn,m
n e n [Sm ].11
and the futures price is Futn,m = E
(i) Suppose that at each time n an agent takes a long forward position and sells this contract at time n + 1.
S Bn+1,m
Show that this generates cash flow Sn+1 − nBn,m at time n + 1.

Proof. At time n + 1, the forward contract has a value of

1 e Sn Bn+1,m
En+1 [Dm (Sm − Futn,m )] = Sn+1 − Futn,m Bn+1,m = Sn+1 − .
Dn+1 Bn,m

So if the agent takes a long forward position at time n for no cost and sells this contract at time n + 1, he
S Bn+1,m
will receive a cash flow of Sn+1 − nBn,m .
11 The textbook said “Sn ” by mistake.

50
(ii) Show that if the interest rate is a constant r and at each time n an agent takes a long position of
(1 + r)m−n−1 forward contracts, selling these contracts at time n + 1, then the resulting cash flow is the
same as the difference in the futures price Futn+1,m − Futn,m .

Proof. By (i), the cash flow generated at time n + 1 is

( )
Sn Bn+1,m
(1 + r) m−n−1
Sn+1 −
Bn,m
( Sn
)
(1+r)m−n−1
= (1 + r)m−n−1 Sn+1 − 1
(1+r)m−n
Sn+1 Sn
= (1 + r)m − (1 + r)m
(1 + r)n+1 (1 + r)n
[ ] [ ]
e n+1 Sm me Sm
= (1 + r)m E − (1 + r) E n
(1 + r)m (1 + r)m
= Futn+1,m − Futn,m .

I Exercise 6.7. Consider a binomial interest rate model in which the interest rate at time n depends on
only the number of heads in the first n coin tosses. In other words, for each n there is a function rn (k) such
that
Rn (ω1 , · · · , ωn ) = rn (#H(ω1 , · · · , ωn )).
Assume the risk-neutral probabilities are p̃ = q̃ = 12 . The Ho-Lee model (Example 6.4.4) and the Black-
Derman-Toy model (Example 6.5.5) satisfy these conditions.
Consider a derivative security that pays 1 at time n if and only if there are k heads in the first n tosses;
i.e., the payoff is Vn (k) = 1{#H(ω1 ,··· ,ωn )=k} . Define ψ0 (0) = 1 and , for n = 1, 2, · · · , define

e [Dn Vn (k)] , k = 0, 1, · · · , n,
ψn (k) = E

to be the price of this security at time zero. Show that the functions ψn (k) can be computed by the recursion

ψn (0)
ψn+1 (0) =
2(1 + rn (0))
ψn (k − 1) ψn (k)
ψn+1 (k) = + , k = 1, · · · , n,
2(1 + rn (k − 1)) 2(1 + rn (k))
ψn (n)
ψn+1 (n + 1) = .
2(1 + rn (n))

Proof.

ψn+1 (0) = e [Dn+1 Vn+1 (0)]

E
[ ]
e Dn
= E 1{#H(ω1 ···ωn+1 )=0}
1 + rn (0)
[ ]
e Dn
= E 1{#H(ω1 ···ωn )=0} 1{ωn+1 =T }
1 + rn (0)
1 [ ]
= e Dn 1{#H(ω ···ω )=0}
E 1 n
2(1 + rn (0))
ψn (0)
= .
2(1 + rn (0))

51
For k = 1, 2, · · · , n,
[ ]
e Dn
ψn+1 (k) = E 1{#H(ω1 ···ωn+1 )=k}
1 + rn (#H(ω1 · · · ωn ))
[ ] [ ]
e Dn e Dn
= E 1{#H(ω1 ···ωn )=k} 1{ωn+1 =T } + E 1{#H(ω1 ···ωn )=k−1} 1{ωn+1 =H}
1 + rn (k) 1 + rn (k − 1)
e n Vn (k)] 1 E[D
1 E[D e n Vn (k − 1)]
= +
2 1 + rn (k) 2 1 + rn (k − 1)
ψn (k) ψn (k − 1)
= + .
2(1 + rn (k)) 2(1 + rn (k − 1))

Finally,
[ ]
e n+1 Vn+1 (n + 1)] = E
e Dn ψn (n)
ψn+1 (n + 1) = E[D 1{#H(ω1 ···ωn )=n} 1{ωn+1 =H} = .
1 + rn (n) 2(1 + rn (n))

Remark 6.1. In the above proof, we have used the independence of ωn+1 and (ω1 , · · · , ωn ) under P. e This is
e e
guaranteed by the assumption that P(ωn+1 = H|ω1 , · · · , ωn ) = p̃ and P(ωn+1 = T |ω1 , · · · , ωn ) = q̃, which are
deterministic. In case the binomial model has stochastic up- and down-factor un and dn , we have P(ω e n+1 =
e 1+rn −dn un −1−rn
H|ω1 , · · · , ωn ) = p̃n and P(ωn+1 = T |ω1 , · · · , ωn ) = q̃n , where p̃n = un −dn and q̃n = un −dn . Then for
e
any X ∈ Fn = σ(ω1 , · · · , ωn ), we have E[Xf e E[f
(ωn+1 )] = E[X e (ωn+1 )|Fn ]] = E[X(p̃
e n f (H) + q̃n f (T ))].

References
[1] D. Brigo and F. Mercurio. Interest rate models - Theory and practice: With smile, inflaiton and credit,
2nd Edition. Springer, 2007. 47

[2] R. C. Dalang, A. Morton, and W. Willinger. “Equivalent martingale measures and no-arbitrage in
stochastic securities market models”. Stochastics and Stochastics Reports 29, pp. 185-202, (1989). 46

[3] F. Delbaen and W. Schachermayer. The mathematics of arbitrage. Springer, 2006. 2

[4] U. Schmock. “Existence of an equivalent martingale measure in the Dalang-Morton-Willinger Theorem,
which preserves the dependence structure”. 6th AMaMeF and Banach Center Conference, Warsaw, 2013.
http://bcc.impan.pl/6AMaMeF/uploads/presentations/Folien_AMaMeF_2013.pdf. 10

[5] A. N. Shiryaev. Probability, 2nd Edition. Springer, 1995. 9, 48

[6] S. Shreve. Stochastic calculus for finance I: The binomial asset pricing model. Springer-Verlag, New
York, 2004. 1
[7] S. Shreve. Stochastic calculus for finance II: Continuous-time models. Springer-Verlag, New York, 2004.
3, 10, 16
[8] P. Wilmott. The mathematics of financial derivatives: A student introduction. Cambridge University
Press, 1995. 6
[9] Y. Zeng. “Fundamental Theorem of Asset Pricing in a nutshell: With a view toward numéraire change”,
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