Lectures on Financial Mathematics

Harald Lang


c Harald Lang, KTH Mathematics 2012
Preface

Preface
My main goal with this text is to present the mathematical modelling
of financial markets in a mathematically rigorous way, yet avoiding math-
ematical technicalities that tends to deter people from trying to access
it.
Trade takes place in discrete time; the continuous case is considered
as the limiting case when the length of the time intervals tend to zero.
However, the dynamics of asset values are modelled in continuous time as
in the usual Black-Scholes model. This avoids some mathematical techni-
calities that seem irrelevant to the reality we are modelling.
The text focuses on the price dynamics of forward (or futures) prices
rather than spot prices, which is more traditional. The rationale for this is
that forward and futures prices for any good—also consumption goods—
exhibit a Martingale property on an arbitrage free market, whereas this is
not true in general for spot prices (other than for pure investment assets.)
It also simplifies computations when derivatives on investment assets that
pay dividends are studied.
Another departure from more traditional texts is that I avoid the no-
tion of “objective” probabilities or probability distributions. I think they
are suspect constructs in this context. We can in a meaningful way assign
probabilities to outcomes of experiments that can be repeated under simi-
lar circumstances, or where there are strong symmetries between possible
outcomes. But it is unclear to me what the “objective” probability distri-
bution for the price of crude oil, say, at some future point in time would
be. In fact, I don’t think this is a well defined concept.
The text presents the mathematical modelling of financial markets. In
order to get familiar with the workings of these markets in practice, the
reader is encouraged to supplement this text with some text on financial
economics. A good such text book is John C. Hull’s: Options, Futures, &
Other Derivatives (Prentice Hall,) which I will refer to in some places.

13/9–2012
Harald Lang
Contents

Contents
I: Introduction to Present-, Forward- and Futures Prices . . . 1
Zero Coupon Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Money Market Account . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Relations between Present-, Forward- and Futures Prices . . . . . 3
Comparison of Forward- and Futures Prices . . . . . . . . . . . . . 4
Spot Prices, Storage Cost and Dividends . . . . . . . . . . . . . . . 6
Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
II: Forwards, FRA:s and Swaps . . . . . . . . . . . . . . . . . . . 8
Forward Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Forward Rate Agreements . . . . . . . . . . . . . . . . . . . . . . . . 10
Plain Vanilla Interest Rate Swap . . . . . . . . . . . . . . . . . . . . 11
Exercises and Examples . . . . . . . . . . . . . . . . . . . . . . . . . 12
Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
III: Optimal Hedge Ratio . . . . . . . . . . . . . . . . . . . . . . 17
Exercises and Examples . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
IV: Conditions for No Arbitrage . . . . . . . . . . . . . . . . . 21
Theorem (The No Arbitrage Theorem) . . . . . . . . . . . . . . . . 22
The No Arbitrage Assumption . . . . . . . . . . . . . . . . . . . . . . 23
V: Pricing European Derivatives . . . . . . . . . . . . . . . . . 25
Black’s Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
The Black-Scholes Pricing Formula . . . . . . . . . . . . . . . . . . . 26
Put and Call Options . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
The Interpretation of σ and the Market Price of Risk . . . . . . . 26
Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Exercises and Examples . . . . . . . . . . . . . . . . . . . . . . . . . 28
Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
VI: Yield and Duration . . . . . . . . . . . . . . . . . . . . . . . 32
Forward Yield and Forward Duration . . . . . . . . . . . . . . . . . 34
Black’s Model for Bond Options . . . . . . . . . . . . . . . . . . . . 36
Portfolio Immunising . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Exercises and Examples . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
VII: Risk Adjusted Probability Distributions . . . . . . . . . 42
An Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
Forward Distributions for Different Maturities . . . . . . . . . . . . 44
Exercises and Examples . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
VIII: Conditional Expectations and Martingales . . . . . . . 48
Martingale Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Contents

IX: Asset Price Dynamics and Binomial Trees . . . . . . . . . 51

Black-Scholes Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . 51
Binomial Approximation . . . . . . . . . . . . . . . . . . . . . . . . . 51
The Binomial Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
Pricing an American Futures Option . . . . . . . . . . . . . . . . . . 53
American Call Option on a Share of a Stock . . . . . . . . . . . . . 54
Options on Assets Paying Dividends . . . . . . . . . . . . . . . . . . 54
Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Exercises and Examples . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
X: Random Interest Rates: The Futures Distribution . . . . 66
XI: A Model of the Short Interest Rate: Ho-Lee . . . . . . . 69
The Price of a Zero Coupon Bond . . . . . . . . . . . . . . . . . . . 70
Forward and Futures on a Zero Coupon Bond . . . . . . . . . . . . 71
The Forward Distribution . . . . . . . . . . . . . . . . . . . . . . . . 71
Pricing a European Option on a Zero Coupon Bond . . . . . . . . 72
XII: Ho-Lee’s Binomial Interest Rate Model . . . . . . . . . . 73
Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
Exercises and Examples . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
I: Present-, Forward and Futures Prices

I: Introduction to Present-, Forward-

and Futures Prices

Assume that we want to buy a quantity of coffee beans with delivery in

nine months. However, we are concerned about what the (spot) price of
coffee beans might be then, so we draw up a contract where we agree on
the price today. There are now at least three ways in which we can arrange
the payment: 1) we pay now, in advance. We call this price the present
price of coffee beans with delivery in nine months time, and denote it by
P . Note that this is completely different from the spot price of coffee
beans, i.e., the price of coffee for immediate delivery. 2) we pay when the
coffee is delivered, i.e., in nine months time. This price is the forward
price, which we denote by G. 3) we might enter a futures contract with
delivery in nine months time. A futures contract works as follows:
Let us denote the days from today to delivery by the numbers 0, 1, . . .
. . . , T , so that day 0 is today, and day T is the day of delivery. Each day
n a futures price Fn of coffee beans with delivery day T is noted, and FT
equals the prevailing spot price of coffee beans day T . The futures price
Fj is not known until day j; it will depend on how the coffee bean crop is
doing, how the weather has been up to that day and the weather prospects
up till day T , the expected demand for coffee, and so on. One can at any
day enter a futures contract, and there is no charge for doing so. The long
holder of the contract will each day j receive the amount Fj − Fj−1 (which
may be negative, in which he has to pay the corresponding amount,) so if
I enter a futures contract at day 0, I will day one receive F1 − F0 , day two
F2 − F1 and so on, and day T , the day of delivery, FT − FT −1 . The total
amount I receive is thus FT − F0 . There is no actual delivery of coffee
beans, but if I at day T buy the beans at the spot price FT , I pay FT , get
my coffee beans and cash the amount FT − F0 from the futures contract.
In total, I receive my beans, and pay F0 , and since F0 is known already
day zero, the futures contract works somewhat like a forward contract.
The difference is that the value FT − F0 is paid out successively during
the time up to delivery rather than at the time of delivery.
Here are timelines showing the cash flows for “pay now”, forwards
and futures contracts:
Pay now
day 0 1 2 3 ··· T−1 T
cash flow −P 0 0 0 ··· 0 X

Forward contract
day 0 1 2 3 ··· T−1 T
cash flow 0 0 0 0 ··· 0 X −G

1
I: Present-, Forward and Futures Prices

Futures contract
day 0 1 2 3 ··· T−1 T
cash flow 0 F1 −F0 F2 −F1 F3 −F2 ··· FT−1 −FT−2 X−FT−1

The simplest of these three contracts is the one when we pay in advance,
at least if the good that is delivered is non-pecuniary, since in that case
the interest does not play a part. For futures contracts, the interest rate
clearly plays a part, since the return of the contract is spread out over
time.
We will derive some book-keeping relations between the present prices,
forward prices and futures prices, but first we need some interest rate
securities.

Zero Coupon Bonds

A zero coupon bond with maturity T and face value V is a contract
where the long holder pays ZT V in some currency day 0 and receives V
in the same currency day T . The ratio ZT of the price today and the
amount received at time T is the discount factor converting currency at
time T to currency today. One can take both long and short positions on
zero coupon bonds.

We need a notation for the currency, and we use a dollar sign $, even
though the currency may be Euro or any other currency.

Money Market Account

A money market account (MMA) is like a series of zero coupon bonds,
maturing after only one day (or whatever periods we have in our futures
contracts—it might be for example a week.) If I deposit the amount $1
day 0, the balance of my account day 1 is $er1 , where r1 is the short
interest rate from day 0 to day 1. The rate r1 is known already day 0.
The next day, day 2, the balance has grown to $er1 +r2 , where r2 is the
short interest rate from day 1 to day 2; it is random as seen from day 0,
and its outcome is determined day 1. The next day, day 3, the balance
has grown to $er1 +r2 +r3 , where r3 is the short interest rate from day 2
to day 3; it is random as seen from day 0 and day 1, and its outcome
occurs day 2, and so on. Day T the balance is thus $er1 +···+rT which is
a random variable. In order to simplify the notation, we introduce the
symbol R(t, T ) = rt+1 + · · · + rT .

2
I: Present-, Forward and Futures Prices

Relations between Present-, Forward- and Futures Prices

(T )
Let P0 [X] be the present price today of a contract that delivers the
random value X (which may take negative values) at time T . Likewise,
(T )
let G0 [X] denote the forward price today of the value X delivered at
(T )
time T and Ft [X] the futures price as of time t of the value X delivered
at time T . We then have the following theorem:

Theorem
The following relations hold:
(T ) (T ) (T )
a) P0 , G0 and F0 are linear functions, i.e., if X and Y are random
payments made at time T , then for any constants a and b
(T ) (T ) (T )
P0 [aX + bY ] = aP0 [X] + bP0 [Y ],
(T ) (T )
and similarly for G0 and F0 .
(T )
b) For any deterministic (i.e., known today) value V, G0 [V ] = V ,
(T ) (T )
F0 [V ] = V and P0 [V ] = ZT V
(T ) (T )
c) P0 [X] = ZT G0 [X]
(T ) (T )
d) P0 [XeR(0,T ) ] = F0 [X]
(T ) (T )
e) P0 [X] = F0 [Xe−R(0,T ) ]

Proof
The proof relies on an assumption of the model: the law of one price.
It means that there can not be two contracts that both yield the same
payoff X at time T , but have different prices today. Indeed, if there were
two such contracts, we would buy the cheaper and sell the more expensive,
and make a profit today, and have no further cash flows in the future. But
so would everyone else, and this is inconsistent with market equilibrium.
In Ch. IV we will extend this model assumption somewhat.
To prove c), note that if we take a long position on a forward contract
on X and at the same time a long position on a zero coupon bond with
(T ) (T )
face value G0 [X], then we have a portfolio which costs ZT G0 [X] today,
and yields the income X at time T . By the law of one price, it hence must
be that c) holds.
To prove d), consider the following strategy: Deposit F0 on the money
market account, and take er1 long positions on the futures contract on X
for delivery at time T .
The next day the total balance is then F0 er1 + er1 (F1 − F0 ) = F1 er1 .
Deposit this on the money market account, and increase the futures posi-
tion to er1 +r2 contracts.

3
I: Present-, Forward and Futures Prices

The next day, day 2, the total balance is then F1 er1 +r2 + er1 +r2 (F2 −
F1 ) = F2 er1 +r2 . Deposit this on the money market account, and increase
the futures position to er1 +r2 +r3 contracts.
And so on, up to day T when the total balance is FT er1 +···+rT =
Xer1 +···+rT . In this way we have a strategy which is equivalent to a
contract where we pay F0 day zero, and receive the value FT er1 +···+rT =
Xer1 +···+rT day T . This proves d).
Since relation d) is true for any random variable X whose outcome
is known day T , we may replace X by Xe−R(0,T ) in that relation. This
proves e).
(T )
It is now easy to prove b). The fact that P0 [V ] = ZT V is simply
(T )
the definition of ZT . The relation G0 [V ] = V now follows from c) with
(T )
X = V . In order to prove that F0 [V ] = V , note that by the definition
of money market account, the price needed to be paid day zero in order
(T )
to receive V eR(0,T ) day T is V ; hence V = P0 [V eR(0,T ) ]. The relation
(T )
F0 [V ] = V now follows from d) with X = V .
(T )
Finally, to prove a), note that if we buy a contracts which cost P0 [X]
day zero and gives the payoff X day T , and b contracts that gives payoff Y ,
(T ) (T )
then we have a portfolio that costs aP0 [X]+bP0 [Y ] day zero and yields
(T ) (T ) (T )
the payoff aX + bY day T ; hence P0 [aX + bY ] = aP0 [X] + bP0 [Y ].
The other two relations now follow immediately employing c) and d). This
completes the proof.

Comparison of Forward- and Futures Prices

Assume first that the short interest rates ri are deterministic, i.e.,
that their values are known already day zero. This means that eR(0,T ) is
a constant (non-random,) so

(T ) (T )
$1 = P0 [$eR(0,T ) ] = P0 [$1]eR(0,T ) = $ZT eR(0,T ) ,
hence
ZT = e−R(0,T ) .
Therefore
(T ) (T ) (T )
ZT G0 [X] = P0 [X] = F0 [Xe−R(0,T ) ]
(T ) (T )
= F0 [X]e−R(0,T ) = F0 [X]ZT ,
and hence
(T ) (T )
G0 [X] = F0 [X].

We write this down as a corollary:

4
I: Present-, Forward and Futures Prices

Corollary
If interest rates are deterministic, the forward price and the futures
(T ) (T )
price coincide: G0 [X] = F0 [X]

The equality of forward- and futures prices does not in general hold if
interest rates are random, though. To see this, we show as an example
(T ) (T )
that if eR(0,T ) is random, then F0 [$eR(0,T ) ] > G0 [$eR(0,T ) ].
Indeed, note that the function y = x1 is convex for x > 0. This implies
1
that its graph lies over its tangent. Let y = m + k(x − m) be the tangent
1 1 1
line through the point (m, m ). Then x ≥ m + k(x − m) with equality
only for x = m (we consider only positive values of x.) Now use this with
x = e−R(0,T ) and m = ZT . We then have

eR(0,T ) ≥ ZT−1 + k(e−R(0,T ) − ZT )

where the equality holds only for one particular value of R(0, T ). In the
absence of arbitrage (we will come back to this in Ch. IV,) the futures
price of the value of the left hand side is greater than the futures price of
the value of the right hand side, i.e.,

(T ) (T )
F0 [$eR(0,T ) ] > $ZT−1 + k(F0 [$e−R(0,T ) ] − $ZT )

(T )
But F0 [$e−R(0,T ) ] = P (T ) [$1] = $ZT , so the parenthesis following k is
equal to zero, hence

(T )
F0 [$eR(0,T ) ] > $ZT−1

On the other hand,

(T ) (T )
ZT G0 [$eR(0,T ) ] = P0 [$eR(0,T ) ] = $1

(T )
so G0 [$eR(0,T ) ] = $ZT−1 , and it follows that

(T ) (T )
F0 [$eR(0,T ) ] > G0 [$eR(0,T ) ].

In general, if X is positively correlated with the interest rate, then the

futures price tends to be higher than the forward price, and vice versa.

5
I: Present-, Forward and Futures Prices

Spot Prices, Storage Cost and Dividends

Consider a forward contract on some asset to be delivered at a future
time T . We have talked about the forward price, i.e., the price paid at
the time of delivery for the contract, and the present price, by which we
mean the price paid for the contract today, but where the underlying asset
is still delivered at T . This should not be confused with the spot price
today of the underlying asset. The present price should equal the spot
price under the condition that the asset is an investment asset , and that
there are no storage costs or dividends or other benefits of holding the
asset. As an example: consider a forward contract on a share of a stock
to be delivered at time T . Let r be the interest rate (so that ZT = e−rT )
and S0 the spot price of the share. Since $1 today is equivalent to $erT
(T )
at time T , the forward price should then be G0 = S0 erT . But only if
there is no dividend of the share between now and T , for if there is, then
one could make an arbitrage by buying the share today, borrow for the
cost and take a short position on a forward contract. There is then no
net payment today, and none at T (deliver the share, collect the delivery
(T ) (T )
price G0 of the forward and pay the S0 erT = G0 for the loan.) But it
would give the trader the dividend of the share for free, for this dividend
goes to the holder of the share, not the holder of the forward. Likewise,
the holder of the share might have the possibility of taking part in the
annual meeting of the company, so there might be a convenience yield.

Comments
You can read about forward and futures contracts John Hull’s book
“Options, Futures, & other Derivatives 1 ”. He describes in detail how fu-
tures contracts work, and why they are specified in the somewhat peculiar
way they are.
The mathematical modelling of a futures contract is a slight simplifi-
cation of the real contract. We disregard the maintenance account, thus
avoiding any problems with interest on the balance. Furthermore, we as-
sume that the delivery date is defined as a certain day, not a whole month.
We also disregard the issues on accounting and tax.
We use “continuous compounding” of interest rates (use of the expo-
nential function.) If you feel uncomfortable with this, you may want to
read relevant chapters in Hull’s book. We will use continuous compound-
ing unless otherwise explicitly stated, since it is the most convenient way
to handle interest. It is of course easy to convert between continuous
compounded interest and any other compounding.

1
Prentice Hall

6
I: Present-, Forward and Futures Prices

It is important not to confuse the present price with the spot price
of the same type of good. The spot price is the price of the good for
immediate delivery.
It is also extremely important to distinguish between constants (val-
ues that are currently known) and random variables. For instance, as-
sume that ZT = e−rT (where r hence is a number.) Then it is true that
(T ) (T ) (T )
P0 [X] = e−rT G0 [X] (Theorem c,) however, the relation P0 [X] =
(T )
e−R(0,T ) G0 [X] is invalid and nonsense! Indeed, R(0, T ) is a random
(T ) (T )
variable; its outcome is not known until time T−1, whereas G0 and P0
are known prices today.

7
II: Forwards, FRA:s and Swaps

II: Forwards, FRA:s and Swaps

Forward Prices
In many cases the theorem of Ch. I can be used to calculate forward
prices. As we will see later, in order to calculate option prices, it is essential
to first calculate the forward price of the underlying asset.

Example 1.
Consider a share of a stock which costs S0 today, and which gives
a known dividend amount d in t years, and whose (random) spot price
at time T > t is ST . Assume that there are no other dividends or other
convenience yield during the time up to T . What is the forward price G
on this stock for delivery at time T ?
Assume that we buy the stock today, and sell it at time T . The cash
flow is
day 0 t T
cash flow −S0 d ST
The present value of the dividend is Zt d and the present value of the
income ST at time T is Zt G. Hence we have the relation

S0 = Zt d + ZT G

from which we can solve for G

Example 2.
Consider a share of a stock which costs S0 now, and which gives a
known dividend yield d St i t years, where St is the spot price immediately
before the dividend is paid out. Let the (random) spot price at time T > t
be ST . Assume that there are no other dividends or other convenience
yield during the time up to T . What is the forward price G on this stock
for delivery at time T ?
Consider the strategy of buying the stock now, and sell it at time t
immediately before the dividend is paid out.
day 0 t
cash flow −S0 St
With the notation of Ch. I, we have the relation
(t)
P0 [St ] = S0 (1)

Consider now the strategy of buying the stock now, cash the dividend at
time t, and eventually sell the stock at time T .

8
II: Forwards, FRA:s and Swaps

day 0 t T
cash flow −S0 dSt ST
The present value of the dividend is d P (t) [St ] and the present value of the
income ST at time T is ZT G. Hence we have the relation
(t)
S0 = d P0 [St ] + ZT G

If we combine with (1) we get

(1 − d)S0 = ZT G

from which we can solve for G

Example 3.
With the same setting as in example 2, assume that there are dividend
yield payments at several points in time t1 < . . . < tn , where tn < T, each
time with the amount d Stj . As in the above example, we can buy the
stock today and sell it just before the first dividend is paid out, so the
relation
(t1 )
P0 [St1 ] = S0 (2)

holds. For any k = 2, 3, . . . , n we can buy the stock at time tk−1 imme-
diately before the payment of the dividend, collect the dividend, and sell
the stock immediately before the dividend is paid out at time tk .
day 0 tk−1 tk
cash flow 0 −Stk−1 + dStk−1 Stk
The price of this strategy today is zero, so we have
(tk−1 ) (tk−1 ) (tk )
0 = −P0 [Stk−1 ] + d P0 [Stk−1 ] + P0 [Stk ], i.e.,
(t ) (t )
P0 k [Stk ] = (1 − d)P0 k−1 [Stk−1 ]
(T ) (tn )
and repeated use of this relation and P0 [ST ] = (1 − d)P0 [Stn ] gives
(T ) (t1 )
P0 [ST ] = (1 − d)n P0 [St1 ] = (1 − d)n S0

where we have used (2) to obtain the last equality. Hence, by the theorem
of Ch. I, we have the relation

ZT G = (1 − d)n S0 (3)

9
II: Forwards, FRA:s and Swaps

Example 4.
We now consider the setting in example 3, but with a continuous
dividend yield ρ, i.e., for any small interval in time (t, t + δt) we get the
dividend ρSt δt. If we divide the time interval (0, T ) into a large number
n of intervals of length δt = T /n, we see from (3) that

ZT G = (1 − ρ δt)n S0

and when n → ∞ we get

ZT G = e−ρT S0
  
Derivation
 of the limit: ln (1 −ρ δt)n = n ln(1 − ρ δt) = n − ρ δt +
O(δt2 ) = n − ρT /n + O(1/n2 ) → −ρT. Taking exponential gives the
limit.

Example 5.
Assume we want to buy a foreign currency in t years time at an
exchange rate, the forward rate, agreed upon today. Assume that the
interest on the foreign currency is ρ and the domestic rate is r per year.
Let X0 be the exchange rate now (one unit of foreign currency costs X0 in
domestic currency,) and let Xt be the (random) exchange rate as of time
t. Let G be the forward exchange rate.
Consider now the strategy: buy one unit of foreign currency today,
buy foreign zero coupon bonds for the amount, so that we have eρt worth
of bonds in foreign currency at time t when we sell the bonds.
day 0 t
ρt
cash flow −X0 e Xt
Since the exchange rate at that time is Xt , we get Xt eρt in domestic
currency. Since the price we have paid today is X0 we have the relation
(t)  
X0 = P 0 Xt eρt = e−rt G eρt = G e(ρ−r)t
i.e.,
G = X0 e(r−ρ)t

Forward Rate Agreements

A forward rate agreement is a forward contract where the parties agree
that a certain interest rate will be applied to a certain principal during a
future time period. Let us say that one party is to borrow an amount L at
time t and later pay back the amount Lef (T −t) at time T > t. The cash
flow for this party is thus L at time t and −Lef (T −t) at time T . Since this
contract costs nothing now, we have the relation

10
II: Forwards, FRA:s and Swaps

0 = Zt L − ZT Lef (T −t) .

From this we can solve for f . The interest rate f is the forward rate from
t to T .

Plain Vanilla Interest Rate Swap

The simplest form of an interest swap is where one party, say A, pays
party B:
the floating interest on a principal L1 from time t0 to t1 at time t1
the floating interest on a principal L2 from time t1 to t2 at time t2
the floating interest on a principal L3 from time t2 to t3 at time t3
···
the floating interest on a principal Ln from time tn−1 to tn at time
tn .

The floating rate between tj and tk is the zero coupon rate that prevails
between these two points in time. The amount that A pays at time tk is
thus Lk · (1/Z(tk−1 , tk ) − 1), where Z(tk−1 , tk ) of course is the price of the
zero coupon bond at time tk−1 that matures at tk . Note that this price
is unknown today but known at time tk−1 . The total amount that B will
receive, and A will pay is thus random.
On the other hand, party B pays A a fixed amount c at each of the
times t1 , . . . , tn . The question is what c ought to be in order to make this
deal “fair”.
The notation with continuous compounding is here bit inconvenient.
Let us introduce the one period floating rate r̂j : the interest from time
tj−1 to time tj , i.e., if I deposit an amount a on a bank account at time
tj−1 the balance at time tj is a + ar̂j . This is the same as to say that a
zero coupon bond issued at time tj−1 with maturity at tj is 1/(1 + r̂j ).
Note that r̂j is random whose value becomes known at time tj−1 . The
cash flow that A pays to B is then

day t0 t1 t2 t3 ··· tn
cash flow 0 r̂1 L1 r̂2 L2 r̂3 L3 ··· r̂n Ln
In order to calculate the present value of this cash flow, we first determine
(t )
the present value P0 k (r̂k Lk ).
Consider the strategy: buy Lk worth of zero coupon bonds at time
tk−1 with maturity at tk and face value (1 + r̂k )Lk . This costs nothing
today, so the cash flow is

day t0 ··· tk−1 tk

cash flow 0 ··· −Lk (1 + r̂k )Lk

11
II: Forwards, FRA:s and Swaps

(t ) (tk ) (tk )
hence 0 = −P0 k−1 [Lk ] + P0 [Lk ] + P0 [r̂k Lk ] = −Ztk−1 Lk + Ztk Lk +
(t )
P0 k [r̂k Lk ], so we get
(tk )
P0 [r̂k Lk ] = (Ztk−1 − Ztk )Lk .

It is now easy to calculate the present value of the cash flow from A to B:
it is
n

PAB = (Ztk−1 − Ztk )Lk
1

The present value of B:s payments to A is, on the other hand,

n

PBA = c Ztk
1

so we can calculate the fair value of c by solving the equation we get by

setting PBA = PAB .

Exercises and Examples

Interest rates always refer to continuous compounding. Answers are
given in parenthesis; solutions to some problems are given in the next
section

1. A share is valued at present at 80 dollars. In nine months it will give

a dividend of 3 dollars. Determine the forward price for delivery in
one year given that the rate of interest is 5% a year. (81.06 dollars)

2. A share is valued at present at 80 dollars. In nine months it will give

a dividend of 4% of its value at that time. Determine the forward
price for delivery in one year given that the rate of interest is 5% a
year. (80.74 dollars)

3. The current forward price of a share to be delivered in one year is

110 dollars. In four months the share will give a dividend of 2 dollars
and in ten months will give a dividend of 2% of its value at that time.
Determine the current spot price of the share given that the rate of
interest is 6% a year. (107.67 dollars)

4. The exchange rate of US dollars is today 8.50 SEK per dollar. The
forward price of a dollar to be delivered in six months is 8.40 SEK.
If the Swedish six month interest rate is 4% a year, determine the
American six month interest rate. (6.367%)

12
II: Forwards, FRA:s and Swaps

5. The forward price of a US dollar the first of August with delivery at

the end of December is 0.94630 EUR. The forward price of a dollar to
be delivered at the end of June next year is 0.95152 EUR. Assuming
a flat term structure for both currencies and that the Euro interest
rate is 4% a year—what is the American rate of interest? (2.90%)

6. Determine the forward price of a bond to be delivered in two years.

The bond pays out 2 EUR every 6-months during 4 12 years (starting
in six months), and 102 EUR after five years. Thus the bond is, as
of today, a 5-year 4%-coupon bond with a coupon dividend every six
months with a 100 EUR face value.
The bond is to be delivered in two years immediately after the
dividend has been paid. The present term structure is given by the
following rates of interest (on a yearly basis)

6 months 5.0% 18, 24 months 5.6%

12 months 5.4% 30–60 months 5.9%

(94.05 EUR)

7. A one-year forward contract of a share which pays no dividend before

the contract matures is written when the share has a price of 40 dollars
and the risk-free interest rate is 10% a year.

a) What is the forward price? (44.207 dollars)

b) If the share is worth 45 dollars six months later, what is the value
of the original forward contract at this time? If another forward
contract is to be written with the same date of maturity, what
should the forward price be? (2.949 dollars, 47.307 dollars)

8. Determine the forward price in SEK of a German stock which costs

25 EUR today. The time of maturity is in one year, and the stock
pays a dividend in nine months of 5% of the current stock price at
that time. The interest rate of the Euro is 4.5% per year, and the
crown’s rate of interest is 3% per year. One Euro costs 9.40 SEK
today. (230.05 SEK)

13
II: Forwards, FRA:s and Swaps

9. Let ri be the random daily rate of interest (per day) from day i − 1
to day i, and R(0, t) = r1 + · · · + rt . The random variable Xt is the
stock exchange index day t (today is day 0.) The random variables
Xt and R(0, t) are not independent.
The forward price of a contract for delivery of the payment
Xt eR(0,t) EUR day t is 115 EUR, a zero coupon bond which pays
1 EUR day t costs 0.96 EUR.
Determine the futures price of a contract for delivery of Xt EUR
day t. The stock exchange index is today X0 = 100.

10. A share of a stock currently costs 80 EUR. One year from now, it will
pay a dividend of 5% of its price at the time of the payment, and the
same happens two years from now. Determine the forward price of
the asset for delivery in 2.5 years. The interest rate for all maturities
is 6% per year. (83.88 EUR)

11. The 6 month zero rate is 5% per year and the one year rate is 5.2%
per year. What is the forward rate from 6 to 12 months? (5.4% per
year)

12. Show that the present value of a cash flow at time T that equals the
floating interest from t to T (t < T ) on a principal $L is the same
as if the floating rate is replaced by the current forward rate. (Note
that this is an easy way to value interest rate swaps: just replace any
floating rate by the corresponding forward rate.)

Solutions
3. (The problem is admittedly somewhat artificial, but serves as an ex-
ercise.)
If we buy the stock today and sell it after one year, the cash flow can
be represented:
month 0 4 10 12
cash flow −S0 2 0.02S10 S12
i.e.,
(10)   (12)  
S0 = 2e−0.06·4/12 + 0.02 P0 S10 + P0 S12 . (1)

On the other hand, if we sell the stock after 10 months, before the
dividend, then the cash flow is
month 0 4 10
cash flow −S0 2 S10
i.e.,

14
II: Forwards, FRA:s and Swaps

(10)  
S0 = 2e−0.06·4/12 + P0 S10

(10)  
If we here solve for P0 S10 and substitute into (1) we get

(12)  
0.98S0 = 1.96e−0.06·4/12 + P0 S12

(12)   (12)  
But P0 S12 = e−0.06 G0 S12 = $e−0.06 110, hence

0.98S0 = 1.96e−0.06·4/12 + e−0.06 110

which yields S0 ≈ $107.67.

5. See example 5. We have (X0 = current exchange rate, r = American

interest rate)

X0 = e(r−0.04)5/12 0.94630 EUR

and
X0 = e(r−0.04)11/12 0.95152 EUR
hence
e(r−0.04)5/12 0.94630 = e(r−0.04)11/12 0.95152

from which we can solve for r (take logarithms,) r ≈ 2.90%.

6. The present value P0 of the cash flow of the underlying bond after 2
years (that is, after the bond has been delivered) is

P0 = 2 e−0.059·2.5 + 2 e−0.059·3 + 2 e−0.059·3.5 + 2 e−0.059·4

+ 2 e−0.059·4.5 + 102 e−0.059·5 ≈ 84.0836 EUR

The forward price G0 = P0 /Z2 , so

G0 = 84.0836 · e0.056·2 ≈ 94.05 EUR

Note that we don’t need the interest rates for shorter duration than
two years!

7a. Since there are no dividends or other convenience yield, the present
(1) (1) (1)
price P0 is the same as the spot price: P0 = $40. Hence G0 =
(1)
Z1−1 P0 = e0.1 · 40 ≈ $44.207.

15
II: Forwards, FRA:s and Swaps

(12)  
b. By the same argument, six months later the present price P6 S12
= $45; S12 is the (random) spot price of the stock at 12 months.
The cash flow of the forward contract is S12 − $44.207 at 12 months,
(12)  
so the present value of this cash flow at 6 months is P6 S12 −
e−0.1·0.5 44.207 ≈ $2.949.
If a forward contract were drawn up at six months, the forward
(12) −1
price would be G6 = Z6,12 S6 = e0.1·0.5 45 ≈ $47.303, given that
the interest rate is still 10% per year.

(t) (t) (t)

9. F0 [X] = P0 [XeR ] = 0.96 · G0 [XeR ] = 0.96 · 115 = 110.40 EUR.
 
12. The cash flow at time T is $ er(T −t) −1 L where r is the zero coupon
interest rate that pertain at time t for the duration up to time T . The
present value today of this cash flow can be written as
(T )    (T )   
P0 = P0 $er(T −t) − $1 L = P0 $er(T −t) − $ZT L

Now consider the strategy: we do nothing today, but at time t we

deposit the amount $1 at the rate r up to time T when we withdraw
the amount $er(T −t) . The present value of this cash flow is zero, so
(T )   (T )  
−$Zt + P0 $er(T −t) = $0 i.e., P0 $er(T −t) = $Zt . Substitute
this into the relation above:

P0 = $(Zt − ZT ) L

The
 deterministic cash flow at T when the forward rate is applied is
$ ef (T −t) − 1 L where f is the forward rate, and its present value is
of course
   
P0 = $ZT ef (T −t) − 1 L = $ ZT ef (T −t) − ZT L

But ZT ef (T −t) = Zt (see “Forward Rate Agreements”,) hence

P0 = $(Zt − ZT ) L = P0

Q.E.D. (“Quad Erat Demonstrandum”.)

16
III: Optimal Hedge Ratio

III: Optimal Hedge Ratio

A company that knows that it is due to buy an asset in the future can
hedge by taking a long futures position on the asset. Similarly, a firm that
is going to sell may take a short hedge. But it may happen that there is
no futures contract on the market for the exact product or delivery date.
For instance, the firm might want to buy petrol or diesel, whereas the
closest futures contract is on crude oil, or the delivery date of the futures
contract is a month later than the date of the hedge. In this case one
might want to use several futures on different assets, or delivery times,
to hedge. Let S be the price of the asset to be hedged at the date t of
delivery, and Ft1 , . . . , Ftn the futures prices at date t of the contracts that
are being used to hedge. All these prices are of course random as seen
from today, but we assume that there are enough price data so that it is
possible to estimate their variances and covariances.
Assume that for each unit of volume of S we use futures contracts
corresponding to βi units of volume for contract F i . The difference be-
tween the spot price S and n the total futures price at the date of the end
of the hedge is e = S − i=1 βi Fti , or
n

S= βi Fti + e
i=1

n
The total price
 paid for the asset including the hedge is S − i=1 βi (Fti −
n
F0i ) = e + i=1 βi F0i , where only e is random, i.e., unknown to us to-
day. The task is to choose βi such that the variance of the residual e is
minimised.

Lemma
If we choose the coefficients βi such that Cov(Fti , e) = 0 for i =
1, . . . , n, then the variance Var(e) is minimised.

Proof
Assume that we have chosen βi such that Cov(Fti , e) = 0 for i =
1, . . . , n, and consider any other choice of coefficients:
n

S= γi Fti + f
i=1

For notational convenience, let δi = βi − γi . We can write the residual f

as

17
III: Optimal Hedge Ratio

n
 n
 n

f =S− γi Fti = βi Fti + e − γi Fti
i=1 i=1 i=1
n

= δi Fti + e
i=1
n
Note that since Cov(Fti , e) = 0 it holds that Cov( i=1 δi Fti , e) = 0, hence

n

Var(f ) = Var δi Fti + Var(e) ≥ Var(e)

i=1
Q.E.D.

Theorem
The set of coefficients βi that minimises the variance Var(e) of the
residual is the solution to the system
n

Cov(Ftj , Fti )βi = Cov(Ftj , S) j = 1, . . . , n.
i=1

Proof
The condition that Cov(Ftj , e) = 0 means that
n

0 = Cov(Ftj , S − βi Fti )
i=1
n
= Cov(Ftj , S) − βi Cov(Ftj , Fti )
i=1

from which the theorem follows. Q.E.D.

If we regard S and Fti as any random variables, then the coefficients βi

are called the regression coefficients of S onto Ft1 , . . . , Ftn ; in the context
here they are the optimal hedge ratios when the futures Ft1 , . . . , Ftn are
used to hedge S: for each unit of volume of S we should use futures Fti
corresponding to βi units of volume in the hedge.
Let us consider the case n = 1. In this case we have that
Cov(S, Ft )
β=
Var(Ft )
Using the lemma, we have the following relation of variances:

Cov2 (S, Ft )
Var(S) = β 2 Var(Ft ) + Var(e) = + Var(e)
Var(Ft )
= ρ2 (S, Ft ) Var(S) + Var(e)

18
III: Optimal Hedge Ratio

where ρ(S, Ft ) = Cov(S, Ft )/ Var(S) Var(Ft ) is the correlation coeffi-
cient between S and Ft .

Solving
 for Var(e) we get the pleasant relation Var(e) = Var(S) 1 −
ρ2 (S, Ft ) which means that the standard deviation of the hedged position

is 1 − ρ2 (S, Ft ) times that of the unhedged position.

Exercises and Examples

Interest rates always refer to continuous compounding. Answers are
given in parenthesis; solutions to the problems are given in the next section

1. Suppose that the standard deviation of the spot price of a commodity

a quarter into the future is estimated to be $0.65, the standard devi-
ation of quarterly changes in a futures price on the commodity with
maturity in four months is $0.81, and the coefficient of correlation
between the two prices is 0.8. What is the optimal hedge ratio for a
three month contract, and what does it mean. (0.642)
In addition: After the hedge, what is the standard deviation per
unit of the commodity of the hedged position? ($0.39)

2. On July 1, an investor holds 50’000 shares of a certain stock. The

market price is $30 per share. The investor is interested in hedging
against movements in the market over the next months, and decides
to use the September Mini S&P 500 futures contract. The index is
currently 1’500 and one contract is for delivery of $50 times the index.
The beta of the stock is 1.3. What strategy should the investor follow?
(short 26 futures)
Comment. The beta of a stock is the regression coefficient of the
return of the stock on the return of the index. The investor thinks
that this particular share will do better than the index, but he wants
to hedge against a general decline of the market. The strategy is
to capitalise on this better performance, even if there is a general
decline.

Solutions
1. The optimal hedge ratio β is the solution to

Cov(F, F ) β = Cov(F, S)

where S = spot price and F = futures price at the time of the hedge.
Since Cov(F, F ) = Var(F ) we get (SD = standard deviation; ρ =
correlation coefficient)

19
III: Optimal Hedge Ratio

Cov(F, S) SD(F) SD(S) ρ(S, F )

β= =
Var(F ) Var(F )
SD(S) 0.65
= ρ(S, F ) = 0.8 ≈ 0.642
SD(F) 0.81
This means that for every unit of the commodity to be hedged we
should take short futures positions on 0.642 units.
 The hedged po-
sition will have a standard deviation of $0.65 1 − ρ2 = $0.39 per
unit.

2. Let X be the value of one share some months from now, X0 = $30
is the current value. Likewise, let I be the value of the index some
months from now, I0 = 1’500 is the current value. The beta value β
is by definition such that

X I
=β +e
X0 I0
where the covariance Cov(I, e) = 0. In other words,

X0
X=β I + X0 e
I0
The idea of the strategy is to hedge the term containing I; this is the
impact on the value of the share due to general market movements.
We want to capitalise on the idiosyncratic term containing e.
Assume now that we own one share and short k futures. Each
future is for delivery of n = $50 times the index. The value of the
hedged position after some months is then
 X0 
X − knI = β − kn I + X0 e
I0
X0
so, obviously, in order to get rid if the I-term we should have β I0 −
kn = 0, i.e.,

1 X0
k= β = 0.00052
n I0
If we own 50’000 shares, we should thus short 50’000 · 0.00052 = 26
futures.

20
IV: Conditions for No Arbitrage

IV: Conditions for No Arbitrage

Let us consider a forward contract drawn up today, at time 0, on some

underlying asset with value X at maturity t. The contract is defined by the
random variable X and the forward price—which is determined today—
(t)
G = G0 [X]; we describe it by the pair (G, X). The total cash flow for
the long holder at time t is thus X − G, which is random, whereas the
cash flow today is 0. There are no other cash flows in relation to entering
the contract.
The problem under study in this chapter is the following: assume
that we draw up a another derivative contract with the same underlying
value X. A (European) derivative on X is a contract where the payoff for
the long holder at maturity date t is some function f (X) of X. A typical
one is a call option on X with a strike price K. This means that the long
holder has the option (but not obligation) at time t to buy the asset for the
pre-determined price K. Hence, in this case f (X) = max(X − K, 0). It is
obvious that the value today for a call option is positive, and normally the
long holder pays for the contract today, but in this chapter we will assume
that all cash flows occur at time t, i.e., the derivative is also a forward
(t)
contract with forward price G = G0 [f (X)]. A (European) derivative is
hence a forward contract which we describe by the pair (G, Y ), where
(t)
G = G0 [f (X)] and Y = f (X), i.e., the contract is a usual forward
contract with underlying value Y = f (X). A special case is of course
Y = f (X) = X, in which case the derivative is the usual forward contract
on X.
Assume that there are already a number of derivative contracts on
the market, and we want to draw up yet another one. The problem is to
choose a forward price for this new contract such that it is “compatible”
in some sensible way with the contracts already existing on the market,
e.g., such that the law of one price is maintained.
The market consists of a set of such derivative contracts, and we as-
sume that we can compose arbitrary portfolios of contracts, i.e., if we have
contracts 1, . . . , m with payoffs Y1 , . . . , Ym with forward prices G1 , . . . , Gm ,
(where lower index now refer to contract ) then we can compose a portfolio
consisting of λi units of contract i, i = 1, . . . , m, where λ1 , . . . , λm are ar-
bitrary real numbers. I.e., we assume that we can take a short position in
any contract, and ignore any divisibility
m problems. The total forward
 m price
of such a portfolio is of course 1 λ i G i and the total payoff is 1 λi Yi .
We call also such portfolios “contracts”, so the set of contracts, defined as
pairs (G, Y ), constitutes a linear space.
We simplify the analysis by first assuming that the underlying value
X can take on only a finite number n of values, x1 , . . . , xn (where of course

21
IV: Conditions for No Arbitrage

n may be huge!). Then the payoff Y of any derivative can also take on
only n values y1 , . . . , yn (some of which may coincide.)
We assume that the market is arbitrage free in the sense that the law
of one price prevails (Ch. I,) but also in the sense that

If yk ≥ 0 for all k, then G[Y ] ≥ 0,

If yk ≥ 0 for all k and yk > 0 for some k, then G[Y ] > 0.

These conditions avoid obvious arbitrage opportunities.

Theorem (The No Arbitrage Theorem)

Under the assumptions above, there is a probability distribution
pX (xk ) > 0 for X such that the forward price G[f (X)] of any deriva-
tive
 n contract is the expected value G[f (X)] = E[f (X)] =
1 f (xk )pX (xk ) with respect to this probability distribution.

Note that the

 n converse is obvious: if forward prices are set such that
G[f (X)] = 1 f (xk )pX (xk ), then the market is arbitrage free in the sense
above.

Proof
We associate with each contract (G, Y ) the vector (−G, y1 , . . . , yn ) in
Rn+1 . The set of such vectors constitutes a linear subspace V of Rn+1 .
We now prove that there is a vector q̄ which is orthogonal to V, all of
whose coordinates are positive.
Let K be the subset of Rn+1 : K = {ū = (u0 , . . . , un ) ∈ Rn+1 |
u0 + · · · + un = 1 and ui ≥ 0 for all i}. Obviously K and V have no
vector in common; indeed, it is easy to see that any such common vector
would represent an arbitrage. Now let q̄ be the vector of shortest Euclidean
length such that q̄ = ū−v̄ for some vectors ū and v̄ in K and V respectively.
The fact that such a vector exists needs to be proved, however, we will
skip that proof. We write q̄ = ū∗ − v̄ ∗ where ū∗ ∈ K and v̄ ∗ ∈ V.
Now note that for any t ∈ [0, 1] and any ū ∈ K, v̄ ∈ V , the vector tū+
(1−t)ū∗ ∈ K and tv̄+(1−t)v̄ ∗ ∈ V, hence |(tū+(1−t)ū∗ )−(tv̄+(1−t)v̄ ∗ )|
as a function of t on [0, 1] has a minimum at t = 0, by definition of ū∗ and
v̄ ∗ , i.e., |t(ū − v̄) + (1 − t)q̄|2 = t2 |ū − v̄|2 + 2t(1 − t)(ū − v̄) · q̄ + (1 − t)2 |q̄|2
has minimum at t = 0 which implies that the derivative w.r.t. t at t = 0
is ≥ 0. This gives (ū − v̄) · q̄ − |q̄|2 ≥ 0 or, equivalently, ū · q̄ − |q̄|2 ≥ v̄ · q̄
for all v̄ ∈ V and ū ∈ K. But since V is a linear space, it follows that we
must have v̄ · q̄ = 0 for all v̄ ∈ V (the inequality must hold if we replace
v̄ by λv̄ for any scalar λ.) It remains to prove that q̄ has strictly positive
entries. But we have ū · q̄ − |q̄|2 ≥ 0 for all ū ∈ K, in particular we can
take ū = (1, 0, . . . , 0) which shows that the first entry of q̄ is > 0 and so
on.

22
IV: Conditions for No Arbitrage

Hence, we have found positive numbers q0 , . . . , qn such that

−q0 G + q1 y1 + · · · + qn yn = 0

for all contracts, and by scaling the qk :s we can arrange that q0 is equal
to one, hence
n
G= qk yk .
1
n
Since G[1] = 1 we have 1 qk = 1, so pX (xk ) = qk defines a probability
distribution for X such that for any payoff function f (X) it holds that

G[f (X)] = E[f (X)].

Q.E.D.

A Generalisation
In the discussion above we have considered only one underlying asset
X. But the arguments apply equally well to the situation when X repre-
sents a vector of underlying values X = (X1 , . . . , Xj ). Hence, if we have
a finite number of underlying assets X1 , . . . , Xj , all of which can take on
only a finite number of values, then, on an arbitrage free market, there
is a joint probability distribution for X = (X1 , . . . , Xj ) such that for any
derivative on X with payoff f (X) it holds that

G[f (X)] = E[f (X)].

Even though the assumption that the value of the underlying assets
can take on only a finite (but possibly huge) number of values is not
entirely unrealistic, it is inconvenient for the theoretical modelling. So we
do away with this assumption and henceforth assume the following No
Arbitrage Condition:

The No Arbitrage Assumption

If X = (X1 , . . . , Xj ) are asset values at the future time t, then there
exists a joint probability distribution for X such that the forward price
(t)
G0 [f (X)] of any derivative contract with payoff f (X) is given by
(t)
the expected value w.r.t. this probability distribution: G0 [f (X)] =
E[f (X)].

It is important to recognise that the expectation above is not with re-

spect to some “objective” probability distribution; in fact, the probability
distribution has been constructed from prices on contracts already ex-
isting on the market (this probability distribution need not be uniquely
determined, though!) Furthermore, these prices are measured in some

23
IV: Conditions for No Arbitrage

“currency” or numeraire and the probability distribution may depend on

which numeraire we employ. More about this later. For now we denote
the expectation E(t) to emphasise that the expectation equals the forward
price (in some currency) with maturity date t:
(t)
G0 [f (X)] = E(t) [f (X)] (1)
(t) (t)
P0 [f (X)] = Zt E [f (X)] (2)

and we call the probability distribution the forward probability distribu-

tion.
The procedure for pricing a new derivative contract is now as fol-
lows: first we find a probability distribution such that prices on existing
contracts are given by (1) and (2). Then we price any new derivative
employing the same formulas.

24
V: Pricing European Derivatives

V: Pricing European Derivatives

Black’s Model
A European derivative on some underlying value X is a contract which
at a certain date, the date of maturity, pays the long holder of the contract
a certain function f (X) of the value X. A typical example is an option to
buy X for the strike price K. The strike price K is a deterministic value
written in the contract, and the payoff is f (X) = max(X − K, 0).
In order to compute the price of a European derivative on some un-
derlying asset value X, we assume that there is already a forward contract
for X on the market, or that we can compute the forward price of X, and
(t)
denote the current forward price for delivery at t by G0 [X]. Black’s
model assumes that the value X has a log-Normal forward probability
distribution (see comments below:)
√
X = Aeσ tz
where z ∈ N (0, 1). (1)

In accordance with (1) of Ch. IV we can express the forward value of

the underlying asset as
√
 ∞ √
(t) 1 1 2
G0 [X] = E(t) [X] = E(t) [Aeσ t z ] = A √ eσ t x e− 2 x dx
2π −∞
1 2
= A e 2 σ t.
(t) 1 2
Hence A = G0 [X] e− 2 σ t
which we substitute into (1):
2
√
(t) 1
X = G0 [X] e− 2 σ t+σ t z
. (2)

The current price of any derivative f (X) of X is thus, by (1) of Ch. IV,
(t)     (t) 1 2
√ 
P0 f (X) = Zt E(t) [f (X)] = Zt E(t) f G0 [X] e− 2 σ t+σ t z
 ∞
Zt  (t) 1 2
√  1 2
=√ f G0 [X]e− 2 σ t+σ t x e− 2 x dx. (3)
2π −∞
This is Black’s pricing formula.

The Black-Scholes Pricing Formula

Let us consider the case when the underlying asset is an investment
asset with no dividends or convenience yield, for example, it might be a
share of a stock which pays no dividend before maturity of the contract. In
(t)
this case there is a simple relationship between the forward price G0 and
(t)
the current spot price S0 of the underlying asset. Indeed, G0 = ert S0
where r is the t-year zero coupon interest rate. (To see this, note that

25
V: Pricing European Derivatives

(t) (t) (t)

S0 = P0 = Zt G0 , i.e., S0 = e−rt G0 , see Ch. II, example 1 with d = 0.)
Hence the present price of the derivative can be written

e−rt ∞  1 2
√  1 2
price = √ f S0 ert− 2 σ t+σ t x e− 2 x dx
2π −∞
This is the Black-Scholes pricing formula.

Put and Call Options

A call option with strike price K is specified by f (X) = max(X −
K, 0), and a put option by f (X) = max(K − X, 0). In these cases the
expectation in Black’s formula can be evaluated, and the result is that the
call option price c and put option price p are
 (t) 
c = Zt G0 Φ(d1 ) − KΦ(d2 )
 (t) 
p = Zt KΦ(−d2 ) − G0 Φ(−d1 )
where
(t)
ln(G0 /K) 1 √
d1 = √ + σ t
σ t 2
√
d 2 = d1 − σ t
and Φ is the distribution function of the standard Normal distribution.

The Interpretation of σ and the Market Price of Risk.

The parameter σ is called the volatility of the asset X. It is the
standard deviation of the logarithm of X divided by the square-root of
the time to maturity. It is defined here as a parameter of the underly-
ing forward probability distribution, but is usually considered to be the
same under the “true” (objective; the one given by “nature”) probability
distribution, if any such probability distribution exists.
The true expected value of X, or the market’s subjective assessment
(t)
of this expected value, E[X], may differ from the forward value G0 =
(t)
E [X]. The difference may depend on the balance of supply and demand;
if many traders want to take long positions on the underlying value X but
few wants to take short positions, then the forward price will be bid up so
as to draw speculators into the short side of the market to clear it. The
(t)
difference between E[X] and G0 [X] then measures the expected gain a
speculator will get as a compensation for the risk he takes. The number
λ, defined by
(t)
E[X] = G0 [X] eλσt

is called the market price of risk. It measures the expected rate of return
on a forward contract on X per unit of σ.

26
V: Pricing European Derivatives

The situation when λ > 0 is called backwardation, and when λ < 0

the situation is known as contango.

Comments
The specification (1) may need some clarification. The idea is this.
Let X be the value at some future time t of some asset, for example a share
of a stock, or a commodity like a barrel of oil. There are several different
(t)
random events which can influence this value. If G0 is the forward price
today, then tomorrow the forward price may change by a factor (1 + w1 ),
(t) (t)
i.e. tomorrow the forward price is G1 = G0 (1 + w1 ). Here w1 is a
random variable with rather small standard deviation.
The day after tomorrow, the forward price has changed by a new
(t) (t)
factor (1 + w2 ) such that the forward price then is G2 = G1 (1 + w2 ) =
(t)
G0 (1 + w1 )(1 + w2 ) and so on. Eventually, at time t when the forward
expires, the “forward” price is the same as the spot price, and we have

(t)
X = G0 (1 + w1 )(1 + w2 ) · · · (1 + wt ), i.e.,
 (t) 
ln X = ln G0 + ln(1 + w1 ) + ln(1 + w2 ) + · · · + ln(1 + wt )

If we assume that the random variables wk are independent and identically

distributed, then the Central Limit Theorem says that the sum in the right
hand side has a tendency to be Normally distributed, and the variance is
proportional to the time interval up to t (the number of terms.) The
logarithm ln X √ is then Normally distributed with a standard deviation
proportional to t. This is the rationale for the specification (1).

Black’s model is applicable on a variety of European options. It contains

the well known “Black-Scholes” pricing formula as a special case, and it
can be used to price options on shares of stocks which pay dividends, stock
indices, currencies, futures and bonds. In all cases the procedure is in two
(t)
steps: first we must find the forward price G0 of the underlying asset.
We have seen some examples of such computations in Ch. I–III. The next
step is to decide on a volatility σ. There is no obvious way to do this.
One way is to estimate it from historical data, another is to use “implied
volatilities”. The last method could be as follows: Assume we want to
price a call option on a particular stock with strike price K. There is
already an option on the market with a different strike price L. Since
this option already has a price given by the market, we can use Black’s
model on that option to solve for σ; then use that same σ, the “implied
volatility”, for the option we want to price.

27
V: Pricing European Derivatives

Note, however, that Black’s model (or Black-Scholes) doesn’t per-

fectly conform with empirical data; you may read about “volatility smiles”
in the book by Hull1 .

There is one problem with Black’s model applied to futures options. The
problem is that it is the forward price that should go into the formula, not
the futures price. However, the forward price equals the futures price if
the value of the asset is essentially independent of the interest rate. This
is proven in Ch. VII.

Exercises and Examples

Interest rates always refer to continuous compounding. Answers are
given in parenthesis; solutions to the problems are given in the next sec-
tion.

1. Determine the price of a European futures call option on a barrel of

crude oil to be delivered in 4 months. This is also the time of maturity
of the option. The futures price today is F0 = $25.00, the strike price
is $23.00 and the volatility of the futures price is estimated to be 25%
for one year. The risk-free interest rate is 9% per year. ($2.527)

2. Determine the price of a European call option on a share which does

not pay dividends before the maturity of the option. The present
spot price of the share is 45 SEK, the option matures in 4 months,
the volatility is 25% in one year, the option’s strike price is 43 SEK
and the risk-free interest rate is 9% a year. (4.463 SEK)

3. The same question as above, but now we assume the share pays a
dividend of 0.50 SEK in 3 months, all other assumptions are the
same. (4.115 SEK)

4. Determine the price of a European put option on 1 GBP with a

strike price of 14 SEK in 6 months. The exchange rate is 13 SEK for
1 GBP, and the pound’s volatility is assumed to be 14% in one year.
The pound’s rate of interest is 11% and the Swedish crown’s rate of
interest is 7% a year. (1.331 SEK)

1
John C. Hull: Options, Futures, & Other Derivatives; Prentice Hall.

28
V: Pricing European Derivatives

5. Determine the price of a European call option on an index of shares

which is expected to give a dividend of 3% a year, continuously. The
current value of the index is 93 SEK, the strike price is 90 SEK and
the option matures in two months. The risk-free interest rate is 8% a
year and the index has a volatility of 20% in one year. (5.183 SEK)

6. Let S(t) be the spot price of a share at time t (year) which does not
pay dividends the following year. Determine the price of a contract
S(1)2
which after one year gives the owner . The risk-free rate of
S(0)
interest is 6% a year, and the share’s volatility is assumed to be 30%
for one year. (S(0) e0.15 )

7. Let S(t) be the spot price of a share at time t (year) which does not
pay dividends the following year. Determine the price of a contract
which after one year gives the owner $100 if S(1) > $50 and nothing if
S(1) ≤ $50. The current spot price is S0 = $45, the share’s volatility
is assumed to be 30% for one year and the risk-free rate of interest is
6% a year. ($35.94)

8. Show the put-call parity: If c and p are the prices of a call and a put
option with the same strike price K, then

c − p = Zt (G0 − K)

29
V: Pricing European Derivatives

Solutions
I suggest that you make a spread-
sheet in Excel (or some such)
where you can calculate call- and
put options with Black’s formula.
You input the parameters K, G0 ,
σ, time to maturity T and dis-
count factor ZT . You find the
relevant formulas in this chapter.
You can then use this spreadsheet
to solve most of the problems be-
low; the major problem is to find
the correct value for G0 to go into
the formula.

1. Since we assume that the price of oil is essentially unaffected by in-

terest rates, we set G0 = F0 = $25 in Black’s formula. Of course
ZT = e−0.09/3 . In my spreadsheet the answer appears as in the figure
above.

2. Since the share doesn’t pay any dividend and there is no convenience
(4)
yield, we get the forward price G0 from the relation (see example 1
(4) (4)
of Ch. II with d = 0) 45 SEK = e−0.09/3 G0 , i.e., G0 ≈ 46.37 SEK.

3. See example 1 in Ch. II. We get G0 ≈ 45.867 SEK.

4. See example 5 in Ch. II. The forward price of 1 GBP is ≈ 12.7426

SEK. Note that ZT = e−0.035 , i.e., the discounting should use the
Swedish interest rate (why?)

5. See example 4 in Ch. II. The index yields a continuous dividend of

3% per year, and S0 = 93 SEK.
We get 93 e(0.08−0.03)/6 SEK ≈ 93.7782 SEK.
(1) (1)  
6. We determine the forward price G0 as in problem 2: G0 S(1) =
S(0) e0.06 . Hence Black’s formula (3) yields
 1 (1) 1 2
√ 
p = e−0.06 E S(0) (G0 e− 2 0.3 +0.3 1 w )2
 (1) 2 −2 1 0.32  2·0.3 w 
= e−0.06 S(0)
1
G0 e 2 E e
 
(1) 2 −2 2 0.3
1 2 2
= e−0.06 S(0)
1
G0 e e2·0.3 = S(0) e0.15 .

30
V: Pricing European Derivatives

7. First we determine the forward price of the underlying asset as before:

(1)
G0 = e0.06 S(0) = $45 · e0.06 . Next, let A be the event S > $50 and
IA (S) the indicator function of this event, i.e.,

1 if S > $50
IA (S) =
0 if S ≤ $50

The payoff of the derivative is then $100 · IA (S(1)), hence the value
of the contract is, with the usual notation
 (1) 1 2
√ 
p = Z1 E 100 · IA (G0 e− 2 σ 1+σ 1 w )
 
= e−0.06 E 100 · IA (45 · e0.06−0.045+0.3w )
 
= e−0.06 100 · Pr 45 · e0.06−0.045+0.3w > 50
 1  50  
= e−0.06 100 · Pr w > ln − 0.05 ≈ $35.94
0.3 45
8. Let x+ denote max(x, 0). Then the price of a call option with maturity
(t)
t and strike price K on the underlying asset value X is P0 [(X −K)+ ],
(t)
and similarly, the price of the corresponding put option is P0 [(K −
+
X) ]. Hence
(t) (t)
c − p = P0 [(X − K)+ ] − P0 [(K − X)+ ]
(t)
= P0 [(X − K)+ − (K − X)+ ]
(t) (t) (t)
= P0 [X − K] = P0 [X] − P0 [K]
 (t) 
= Zt G0 [X] − K

Remark: This relation is called the put-call parity formula.

31
VI: Yield and Duration

VI: Yield and Duration

The value of a bond, or a portfolio of bonds, depends on the current term

structure. The situation is particularly simple for a zero coupon bond;
indeed, the value at time t = 0 of a zero coupon bond which matures at
time t = D with a face value of PD is of course P0 (y) = PD e−yD where y
is the relevant zero coupon interest rate. The duration D measures how
sensitive the value is to changes in the yield y :

P0 (y)
D=−
P0 (y)

For coupon bearing bonds, and portfolios of bonds, the situation is more
complicated, since the value depends on more than one point on the zero
rate curve. The consequence is that the sensitivity of the value to changes
in the zero rate curve can not be exactly measured by a single number, and
furthermore that it is hard to come up with a model for pricing options
on such instruments.
The remedy is approximation. We will show that a coupon bearing
bond, or portfolio of bonds, can be approximated by a zero coupon bond
with a certain maturity, the duration of the bond or portfolio.
Note that for a zero coupon bond with time to maturity D and cor-
responding zero rate y0 , it holds that

1 
D=− P (y0 ) (1)
P0 0
P0 (y) = PD e−yD (2)
−y(D−t)
Pt (y) = PD e (3)

where Ps (y) is the value at time s, if the zero coupon interest rate at that
time equals y, which may differ from y0 .
The idea of the concepts yield (y) and duration (D) is to define a
number D for a coupon paying bond, or a portfolio of bonds, such that
the relations (2) and (3) still hold approximately. Hence, let P0 be the
present value of a bond, or a portfolio of bonds:
n

P0 = Zti ci
i=1

where Zti is the price today of a zero coupon bond maturing at time ti
and ci is the payment received at time ti . Now define the yield y0 by the
relation

32
VI: Yield and Duration

n

P0 = e−y0 ti ci = P0 (y0 ) (4)
i=1

and the duration D by

n
1  1  −y0 ti
D=− P0 (y0 ) = ti e ci (5)
P0 P0 i=1

Now define P̂D (y) = P0 (y)eyD [see (4).] We then have


P̂D (y0 ) = P0 (y0 )ey0 D + DP0 (y0 )ey0 D = 0,

hence we can consider P̂D (y) to be constant regarded as a function of y,

to a first order approximation. Henceforth we will treat P̂D = P̂D (y0 ) =
P0 ey0 D as constant. We now have

P0 (y) = P̂D e−yD (2 )

−y(D−t)
Pt (y) = P̂D e (3 )

Here (2 ) follows from the definition of P̂D and (3 ) holds if the yield is y
at time t, as is seen as follows:
n
 n

Pt (y) = e−y(ti −t) ci = eyt e−yti ci = eyt P0 (y) = P̂D e−y(D−t)
i=1 i=1

Summary
A bond, or a portfolio of bonds, has a yield y0 , defined by (4), and
a duration D, defined by (5). At any time t before any coupon or other
payments have been paid out, the value Pt (y) of the asset is approximately
equal to

Pt (y) = P̂D e−y(D−t) where P̂D = P0 ey0 D

and y is the yield prevailing at that time. In particular, the value of

the asset at time t = D is P̂D = P0 ey0 D , and hence independent of any
changes in the yield to a first order approximation.

Duration is a measure of how long on average the holder of the portfolio

has to wait before receiving cash payments, but more importantly, it is a
measure of the sensitivity of the portfolio’s value to changes in the rate
of interest. It can also be thought of as a time when the value of the
portfolio is nearly unaffected by the rate of interest: If the interest (yield)
falls today, then the value of the portfolio immediately increases (if it is

33
VI: Yield and Duration

a portfolio of bonds,) but it’s growth rate goes down, and at the time
t = duration the two effects nearly net out. Similarly, of course, if the
rate of interest goes up. All this is captured in (3 ). Note, however, that
in the meantime coupon dividends have been paid out, and when these
are re-invested, the duration goes up, so in order to keep a certain date
as a target for the value of the portfolio, it has to be re-balanced.

Example
Consider a portfolio of bonds that gives the payment 1’000 after one
year, 1’000 after two years and 2’000 after three years. Assume that
Z1 = 0.945, Z2 = 0.890 and Z3 = 0.830. The present value of the portfolio
is then

P0 = 0.945 · 1’000 + 0.890 · 1’000 + 0.830 · 2’000 = 3’495

The yield y0 is obtained by solving for y0 in the relation

3’495 = P0 = e−y0 1’000 + e−2y0 1’000 + e−3y0 2’000

which gives y0 = 0.06055. Now

−P0 (y0 ) = e−y0 1’000 + 2 e−2y0 1’000 + 3 e−3y0 2’000 = 7’716.5

so the duration is D = 7’716.5 years = 2.208 years. The value of the port-
3’495
folio at time t, if the yield at that time is y and t is less than one year,
can thus be approximated by

Pt (y) = 3’995 e−y(2.208−t)

(where 3’995 = P0 ey0 D .)

Forward Yield and Forward Duration

Consider a bond, or any interest rate security, that after time t gives
the holder deterministic payments c1 , c2 , . . . , cn at times t1 < t2 < · · · < tn
(where t1 > t.) Today is time 0 < t and we want to compute the forward
price of the security to be delivered at time t. Note that the security may
give the holder payments also before time t, but this is of no concern to
us, since we only are interested in the forward value of the security.
Let Pt be the (random) value of the security at time t and consider
the strategy of buying the security at time t for this price and then cash
the payments c1 , . . . , cn . The pricing methods of Ch. II shows that the
(t) (t)
forward price G0 = G0 [Pt ] of the value Pt is given by

34
VI: Yield and Duration

n

(t)
Zt G0 = Zti ci
i=1

The forward yield yF is defined by

n

(t)
G0 = ci e−yF (ti −t) (6)
i=1

When we arrive at time t it may be that the prevailing yield y at that

time is not the same as yF . Let y be the prevailing yield at time t. Then
the value of the security at that time is
n

Pt = Pt (y) = ci e−y(ti −t)
i=1

In particular, we see that Pt (yF ) = G(t) . We define the forward duration

DF of the portfolio for time t as
n
Pt (yF ) 1 
DF = − = (t) ci (ti − t)e−yF (ti −t) . (7)
Pt (yF ) G0 i=1

Now define PF by PF (y) = Pt (y)eDF y . The same calculation as in the

previous section shows that PF is independent of y, to a first order ap-
(t)
proximation, so we will regard PF = PF (yF ) = G0 eDF yF as a constant.
So we have

Pt = PF e−DF y

Summary
An interest rate security that after time t gives the deterministic
payments c1 , c2 , . . . , cn at times t1 < t2 < · · · < tn has a forward yield yF ,
defined by (6), and a forward duration DF defined by (7). The value of
the asset as of time t, 0 < t < t1 is then, to a first order approximation

(t)
Pt = PF e−DF y where PF = G0 eDF yF

and y is the yield prevailing at that time.

35
VI: Yield and Duration

Example
In the previous example, assume that Z1.5 = 0.914. The forward price
G0 (1.5) of the portfolio for delivery in one and a half years is obtained
from the relation (note that the first payment of 1’000 has already been
paid out, and hence does not contribute to the forward value:)

(1.5) (1.5)
0.914 G0 = 0.890 · 1’000 + 0.830 · 2’000 ⇒ G0 = 2’790

The forward yield yF is obtained from

(1.5)
2’790 = G0 = e−0.5yF 1’000 + e−1.5yF 2’000 ⇒ yF = 0.06258

Now, by (7)

(1.5)
DF G0 = 0.5 e−0.5yF 1’000 + 1.5 e−1.5yF 2’000 = 3’215.8

so the forward duration is DF = 3’215.8 years = 1.153 years.

2’790

Black’s Model for Bond Options

Consider again the bond or security in the section “Forward Yield and
Forward Duration” above. In this section we want to price a European
option on the value Pt , a bond option.
First we specify a random behaviour of y, the yield that will prevail
for the underlying security at time t. We will assume that as seen from
today, y is a Normally distributed random variable:
√
y = α − σ t z, where z ∈ N(0, 1)

The minus sign is there for notational convenience later on; note that z
and −z have the same distribution. Hence, the present value Pt at time t
of the asset is
√ √
Pt = PF e−DF (α−σ t z)
= A eDF σ tz

where A = PF e−DF α .
Note that this is exactly the same specification as (1) in Ch. V with σ
replaced by DF σ.√We can thus use Black’s formula for European options
of Ch. V, where σ t in that formula stands for the product of the standard
deviation of the yield and the forward duration of the underlying asset.

36
VI: Yield and Duration

Portfolio Immunisation
Assume that we have portfolio P of bonds whose duration is DP . The
duration reflects its sensitivity to changes in the yield, so we might well
want to change that without making any further investments. One way
to do this is to add a bond futures to the portfolio (or possibly short such
a futures.)
Consider again the security discussed under “Forward Yield and For-
ward Duration” above. We will look at a futures contract on the value
Pt . Using the notation of Ch. I, the futures price is F0 = F0 [Pt ] =
F0 [PF e−DF y ], where the yield y at time t is random as seen from to-
day. Assume now that the present yield y0 of the portfolio P changes to
y0 + δy. The question arises what impact this has on y. If y = (current
yield) + (random variable independent of current yield), then y should
simply be replaced by y + δy. The new futures price should then be

F0 [PF e−DF (y+δy) ] = e−DF δy F0 [PF e−DF y ] = e−DF δy F0

The“marking-to-market” is hence (e−DF δy − 1)F0 .
Assume now that we add such a futures contract to our initial port-
folio P . We let P = P (y0 ) denote its original value, and P (y0 + δy) its
value after the yield has shifted by δy. The value of the total portfolio
Ptot before the shift is equal to P , since the value of the futures contract
is zero. However, after the yield shift, the marking-to-market is added to
the portfolio, so after the shift the value of the total portfolio is

Ptot (y0 + δy) = P (y0 + δy) + (e−DF δy − 1)F0

If we differentiate this w.r.t. δy we get for δy = 0

−Ptot (y0 ) = −P  (y0 ) + DF F0 = DP P + DF F0
The duration of the total portfolio is thus
1  F0
Dtot = − Ptot (y0 ) = DP + DF
P P
If we take N futures contracts (where negative N corresponds to going
short the futures,) we get

F0
Dtot = DP + N DF
P

Exercises and Examples

Interest rates always refer to continuous compounding. Answers are
given in parenthesis; solutions are given in the next section.

37
VI: Yield and Duration

1. Determine the
a) forward price (1’993.29 SEK)
b) forward yield (9.939%)
c) forward duration (1.861 years)
two years into the future for a bond that pays out 100 SEK in 2.5, 3
and 3.5 years and 2’100 SEK in 4 years. Zero-coupon interest rates
are at present 6%, 6.5%, 7%, 7.5% and 8% for the duration of 2, 2.5,
3, 3.5 and 4 years.

2. Calculate approximately the duration of a portfolio containing a cou-

pon bearing-bond which matures in two years with face value 100’000
SEK and pays a 6%-coupon (this means that the coupon is paid
every six month at 3% of the face value,) plus a short position of
a futures contract with maturity in two years on a three year (at
the time of maturity of the futures) 6% coupon-bearing bond (the
first coupon payment is six months after the maturity of the futures)
with face value 50’000 SEK. Interest rates are today 5.5% a year with
continuous compounding for any length of duration. (Approximate
the futures price with the forward price.) (0.514 years)

3. Determine the price of a European put option with maturity in two

years on a five year 6% coupon bond issued today (the first coupon
payment after the maturity of the option occurs six months after the
maturity of the option) with face value 50’000 SEK, which is also the
option’s strike price. The forward yield of the bond is 6.5% a year
and the standard deviation of the yield is 0.012 in one year. The two
year zero-coupon rate of interest is 5.5% a year. (1’253 SEK)

4. Calculate the value of a one-year put option on a ten year bond issued
today. Assume that the present price of the bond is 1’250 SEK, the
strike price of the option is 1’200 SEK, the one-year interest rate is
10% per year, the yield has a standard deviation of 0.013 in one year,
the forward duration of the bond as of the time of maturity for the
option is 6.00 years and the present value of the coupon payments
which will be paid out during the lifetime of the option is 133 SEK.
(20.90 SEK)

38
VI: Yield and Duration

5. We want to determine the price of a European call bond option. The

maturity of the option is in 1.5 years and the underlying bond yields
coupon payments $100 in 2 years, $100 in 2.5 years and matures with
a face value (including coupon) of $2’000 3 years from today. We
assume that the standard deviation of the change in the one-year
yield is 0.01 in one year. Current zero coupon rates are (% per year)
1 yr 1.5 yr 2 yr 2.5 yr 3 yr
3.5 4.0 4.5 4.8 5.0
Use Black’s model to find the price of the option when the strike price
is $1’950. (≈ $65.35)

Solutions
1. First we calculate the present price P0 of the bond:

P0 = e−2.5·0.065 100 + e−3·0.07 100 + e−3.5·0.075 100

+ e−4·0.08 2’100 ≈ 1’767.886 SEK

The forward price is thus G0 = Z2−1 · P0 = e2·0.06 1’767.886 SEK ≈

1’993.29 SEK.
Next we determine the forward yield yF from the relation
y y
1’993.29 = G0 = 100 e− F ·0.5 + 100 e− F ·1
y y
+ 100 e− F ·1.5 + 2’100 e− F ·2

which we solve numerically (trial and error) to yF = 0.09939.

Finally, the forward duration DF is obtained from
yF ·0.5 yF ·1
1’993.29 · DF = G0 DF = 0.5 · 100 e− + 1 · 100 e−
yF ·1.5 yF ·2
+ 1.5 · 100 e− + 2 · 2’100 e−

and gives DF = 1.861 years.

2. First we determine the present value P0 of the portfolio. Note that

the value of the futures contract is zero.

P0 = 3’000 e−0.055·0.5 + 3’000 e−0.055·1

+ 3’000 e−0.055·1.5 + 103’000 e−0.055·2 ≈ 100’791.43 SEK

We get the duration of the bond DP in the portfolio from the relation

P0 DP = 0.5 · 3’000 e−0.055·0.5 + 1 · 3’000 e−0.055·1

+ 1.5 · 3’000 e−0.055·1.5 + 2 · 103’000 e−0.055·2 ≈ 192’984.25

which yields DP = 1.915 years.

39
VI: Yield and Duration

Next we calculate the present value of the cash flow from the
bond underlying the futures:

p = 1’500 e−0.055·2.5 + 1’500 e−0.055·3 + 1’500 e−0.055·3.5

+ 1’500 e−0.055·4 + 1’500e−0.055·4.5 + 51’500 e−0.055·5
≈ 45’309.35 SEK

so the futures price, which we approximate with the forward price, is

(2)
F0 = Z2−1 p = e0.055·2 · 45’309.35 ≈ 50’577.84 SEK

The forward yield yF is determined by

(2) yF ·0.5 yF ·1 yF ·1.5
F0 = 1’500 e− + 1’500 e− + 1’500 e−
yF ·2 yF ·2.5 yF ·3
+ 1’500 e− + 1’500 e− + 50’500 e−

which yields yF = 0.055, which we should have anticipated: if the

term structure is flat, all yields, also the forward yield, are equal to
the prevailing interest rate. The forward duration DF of the bond
underlying the futures is now determined from
(2) yF ·0.5 yF ·1 yF ·1.5
F0 DF = 0.5 · 1’500 e− + 1 · 1’500 e− + 1.5 · 1’500 e−
yF ·2 yF ·2.5 yF ·3
+ 2 · 1’500 e− + 2.5 · 1’500 e− + 3 · 50’500 e−

which gives DF = 2.791 years. Finally, we can calculate the duration

of the portfolio:

F0 50’577.84
Dtot = DP − DF = 1.915 − 2.791 years ≈ 0.514 years.
P 0 100’791.43

3. We will employ Black’s model for put options—see Ch. V—so we

need the forward price G of the underlying asset, and the relevant
volatility σ.
Since we know the forward yield yF = 0.065 we can easily calcu-
late G:

G = 1’500e−0.5·0.065 + 1’500e−1·0.065 + 1’500e−1.5·0.065

+ 1’500e−2·0.065 + 1’500e−2.5·0.065 + 51’500e−3·0.065
≈ 49’186.44 SEK

The forward duration DF is obtained from

40
VI: Yield and Duration

G DF = 0.5 · 1’500e−0.5·0.065 + 1 · 1’500e−1·0.065 + 1.5 · 1’500e−1.5·0.065

+ 2 · 1’500e−2·0.065 + 2.5 · 1’500e−2.5·0.065 + 3 · 51’500e−3·0.065
≈ 137122.40

and we get DF = 2.788 years. The relevant value of σ in Black’s

model is thus σ = 0.012 · DF = 0.0335. Finally, the price of the put
option is 1’252.76 SEK.

4. Again we need the forward price of the underlying asset and the
appropriate value of σ. The value of G is easy; the present price
of the cash flow from the bond after the maturity of the option is
1’250 − 133 = 1’117 SEK, hence G = 1117e0,1 ≈ 1’234.48 SEK. The
relevant value of σ is σ = 0.013 · 6 = 0.0780. We get the option’s price
20.90 SEK from Black’s formula.

5. The forward price of the underlying bond is

 
G = e1.5·0.04 100 e−0.045·2 + 100 e−0.048·2.5 + 2’000 e−0.050·3
= $2’019.08
y y y
= 100 e− F ·0,5 + 100 e− F ·1 + 2’000 e− F ·1.5
for yF = 0.06

The forward duration DF is calculated from

yF ·0,5 yF ·1 yF ·1.5
G DF = 0.5 · 100 e− + 1 · 100 e− + 1.5 · 2’000 e−
= 2’891.00,

hence DF = 1.429 years. Now G = $2’019.08 and σ = 0.01 · DF =

0.01429. The option’s price is $65.35.

41
VII: Risk Adjusted Probability Distributions

VII: Risk Adjusted Probability Distributions

In Ch. IV we introduced the notion that a forward price can be expressed

as an expectation: G(t) [X] = E(t) [X]. This can be generalised; the means
of payment need not be a currency, but may be any asset with a positive
value. For instance, we can use gold or cigarettes as means of payment.
Let us say that we use one pack of cigarettes as the unit of payment. If X
represents, say, one kilo of coffee, then the value of X expressed in packs
of cigarettes is X
N , where now X stands for the value of one kilo of coffee in
some currency, and N, the numeraire, is the value of one pack of cigarettes
expressed in the same currency. The ratio X N is of course independent of
which currency we employ—we need not even think of any currency at
all: if X
N = 2, it simply means that I can exchange, on the market, two
packs of cigarettes for one kilo of coffee.
The “forward price” of one kilo of coffee, measured in packs of cigar-
rettes, to be delivered at time t can thus be expressed as an expectation:
EN [ X
N ]. Here N is the value of one pack of cigarettes at time t, and X the
value of one kilo of coffe at that time. The upper index N on the expec-
tations operator E indicates that the probability distribution pertains to
the numeraire N : one pack of cigarettes at time t. The number of packs
of cigarettes I have to deliver at time t in order to get one kilo of coffee
at that time, if we draw up a forward contract today, is n = EN [ X N ]. If
I want to do the payment today, I can pay for the n packs of cigarettes
(t)
(to be delivered at time t) today at the cost P0 [N ] n. Hence, the present
(t)
price of one kilo of coffee to be delivered at time t, P0 [X], is

(t) (t)
P0 [X] = P0 [N ] EN [ X
N] (1)

(t)
Here P0 [·] is the present price in any currency. In this way we have
defined a new probability distribution Pr N such that the probability of
any event A, whose outcome is known at time t, is defined by
(t)
P0 [IA · N ]
Pr N (A) = EN [IA ] = (t)
P0 [N ]

where IA is the indicator function of A, i.e., IA is equal to one if A occurs

and zero otherwise (set X = IA · N in (1).) This relation is easy to inter-
pret:

42
VII: Risk Adjusted Probability Distributions

The probability of any event is the ratio of the value of receiving one
unit of N conditional upon the happening of the event, and the value
of receiving one unit of N unconditionally.1
This seems to be a reasonable definition of the market’s assessment of
the probability of an event. It is called the risk adjusted probability with
respect to the numeraire N . However, this probability may depend on the
numeraire N employed. For example, if the event A is “the price of one
kilo of gold exceeds 10’000 EUR”, then the probability of A, defined by
employing the numeraire “one kilo of gold” is reasonably higher than if
the numeraire “one EUR” is employed.
If the numeraire N = one unit of some currency, i.e., the numeraire
is a zero coupon bond, then the probability distribution is the “usual”
forward probability distribution in that currency.

An Example
Assume that we want to price a call option on 1’000 barrels of crude
oil when the “strike price” is 3 kilos of gold and the date of maturity is
t. We model the value of one barrel of crude oil in terms of gold to be
log-Normal with respect to the forward-gold distribution:

X √
= Aeσ t w w ∈ N (0, 1)
N
where X is the value at time t of one barrel of crude oil, and N is the
value at time t of one kilo of gold. The forward-gold distribution of w is
N (0, 1). The parameter σ has to be somehow assessed by the writer of the
contract, e.g. by studying historical data (this parameter is assumed to
be the same for the “true” probability distribution as for the forward-oil
distribution.) The value of A can be computed using (1):
(t)
P0 [X] 1 2
(t) = EN [ X
N ] = Ae
2 σ t , i.e.,
P0 [N ]
(t)
P0 [X] − 1 σ 2 t
A= (t) e 2 .
P0 [N ]

Hence
X (t) √
P0 [X] − 1 σ 2 t+σ t w
= (t) e 2 w ∈ N (0, 1)
N P0 [N ]

The value-flow at time t for the long holder of the call option is (x+ denotes
max(x, 0))

1
Thomas Bayes’ (1702–1761) definition was: “The probability of any event is the
ratio of the value of which an expectation depending on the event ought to be computed,
and the value of the thing expected upon its happening.”

43
VII: Risk Adjusted Probability Distributions

(t) √
+
P [X] 1 2
(1’000X − 3N )+ = 1’000 0(t) e− 2 σ t+σ t w − 3 N
P0 [N ]

The present price of this value-flow is, according to (1)

 (t) √
+ 
(t) P [X] 1 2
c = P0 [N ] EN 1’000 0(t) e− 2 σ t+σ t w − 3
P0 [N ]
(t)
 ∞ (t) √
+ 1 2
P0 [N ] P0 [X] − 1 σ 2 t+σ t x
= √ 1’000 (t) e 2 − 3 e− 2 x dx
2π −∞ P0 [N ]
 ∞
1  (t) 1 2
√
(t) + 1 2
=√ 1’000P0 [X] e− 2 σ t+σ t x − 3 P0 [N ] e− 2 x dx
2π −∞

(t) (t)
It may be preferable to replace P0 [·] by Zt G0 [·] and factor out Zt to get
 ∞
Zt  (t) 1 2
√
(t) + 1 2
c= √ 1’000G0 [X] e− 2 σ t+σ t x − 3 G0 [N ] e− 2 x dx
2π −∞

(t) (t)
The values G0 [X] and G0 [N ] can be observed on the futures market
(we assume that forward-price = futures price for these commodities.)
The expression for the option value is thus the same as Black’s “usual”
(t)
formula, when K is replaced by KG0 [N ], but the volatility σ is now the
volatility of the relative price of X compared to N .

Forward Distributions for Different Maturities

Now we focus on the situation when the numeraire is a zero coupon
bond for some currency. The forward expectation E(t) will in general
depend on the time of maturity t; i.e., in general, if t < T , then E(t) [X] =
E(T ) [X]. However, if interest rates are deterministic, then the two coincide;
more specifically, we have the following theorem: let Z(t, T ) be the price
at time t of a zero coupon bond maturing at T ;

Theorem 1
Assume that t < T and that the zero coupon bond price Z(t, T ) is
known at the present time 0. Then, for any random variable X whose
outcome is known at time t,

E(t) [X] = E(T ) [X]

44
VII: Risk Adjusted Probability Distributions

Proof:
Consider the following strategy: Enter a forward contract on X ma-
turing at t (so G(t) = E(t) [X],) invest the net payment X − G(t) in zero
coupon bonds maturing at T . In this way we have constructed a contract
which pays Z(t, T )−1 (X − G(t) ) at time T and costs 0 today. Hence

0 = ZT E(T ) [Z(t, T )−1 (X − G(t) )], i.e.,

(T ) (t)
0=E [(X − G )], i.e.,
(T ) (t) (t)
E [X] = G = E [X]

which proves the theorem.

There is another important situation when E(t) [X] = E(T ) [X]:

Theorem 2
Assume that t < T and that the random interest rate R(t, T ) is inde-
pendent of the random variable X whose outcome is known at time t.
Then

E(t) [X] = E(T ) [X]

Proof:
(t) (t) (T ) (1)
Zt E(t) [X] = Zt G0 [X] = P0 [X] = P0 [eR(t,T ) X]
(T )
= ZT G0 [eR(t,T ) X] = ZT E(T ) [eR(t,T ) X]
(2)
= ZT E(T ) [eR(t,T ) ] E(T ) [X]
(T )
= $−1 ZT G0 [$eR(t,T ) ] E(T ) [X]
(T ) (t) (3)
= $−1 P0 [$eR(t,T ) ] E(T ) [X] = $−1 P0 [$1] E(T ) [X]
= Zt E(T ) [X]

Here (1) is seen as follows: At time t deposit X on the money market

account (MMA), and withdraw the balance eR(t,T ) X at time T . The
(t) (T )
cost today is zero, hence −P0 [X] + P0 [eR(t,T ) X] = 0. The relation
(3) is obtained by the same token. The relation (2) holds because of the
assumption that X and R(t, T ) are independent random variables (w.r.t.
the T -forward distribution.)
Hence E(t) [X] = E(T ) [X], Q.E.D.

When E(t) [X] is independent of the date of maturity t (as long as the
outcome of X precedes time t,) we denote this expectation by a star:
E∗ [X].

45
VII: Risk Adjusted Probability Distributions

Theorem 3
Assume the random interest rate R(0, t) is independent of the random
variable X whose outcome is known at time t. Then the forward price
(t) (t)
and the futures price coincide: G0 [X] = F0 [X].

We leave the proof as exercise 4.

Exercises and Examples

Interest rates always refer to continuous compounding. Answers are
given in parenthesis; solutions are given in the next section.

1. Show that
(t) (t) X 
G0 [X] = G0 [N ] EN N

2. It is now May 1:st. Let N be the value of 1 kg of gold August 31:st.

We now write a forward contract on X = 100 barrels of crude oil to
be delivered August 31:st where the payment should be paid in gold.
Show rigorously that the forward price should be
(t)
G0 [X]
(t)
kg of gold,
G0 [N ]
where May 1:st = 0 and Aug 31:st = t.

3. Derive an expression for Black’s formula, similar to (3) in Ch. V, for

a European exchange option, meaning that asset X can be exchanged
for asset Y , or vice versa.

4. Prove theorem 3.

Solutions
1. This follows immediately from (1) if we divide both sides of the equal-
ity with Zt (see Ch. I.)

2. Let g[X] be the forward price of X in terms of gold. For the long
holder of the contract, the cash flow at maturity is then X − g[X]N .
The present value of this cash flow is zero (= value of contract.) Hence
(t)   (t) (t)
0 = P0 X − g[X]N = P0 [X] − g[X]P0 [N ].
Hence
(t) (t)
P [X] G0 [X]
g[X] = 0(t) = (t)
P0 [N ] G0 [N ]
(the last equality follows as in exercise 1.)

46
VII: Risk Adjusted Probability Distributions

3. We choose one of the asset values at time t, the date of maturity of

the option, as numeraire. Take Y . We specify the relative prices as

X √
= Aeσ t w (2)
Y
where w ∈ N (0, 1) with respect to√the forward-Y probability distri-
bution. The standard deviation σ t of ln X − ln Y is assumed to
be the same as under the “true” probability distribution (if there is
any such thing) and has to be somehow assessed or estimated. Taking
EY of (2) gives, as in the example above,
(t) (t)
1 2 P0 [X] G0 [X]
A e2σ t
= (t) = (t)
P0 [Y ] G0 [Y ]
so
X (t) √
G0 [X] − 1 σ 2 t+σ t w
= (t) e 2
Y G0 [Y ]

The payoff of the option is |X − Y |, so the value of the option is

(t)  |X−Y |  (t)  
p = P0 [Y ] EY = Zt G0 [Y ]EY | X
Y Y − 1|
 (t) √ 
(t) G [X] 1 2
= Zt G0 [Y ]EY | 0(t) e− 2 σ t+σ t w − 1|
G0 [Y ]
Y
 (t) 1 2
√
(t) 
= Zt E |G0 [X]e− 2 σ t+σ t w − G0 [Y ]|
 ∞ √
Zt (t) 1 2 (t) 1 2
=√ |G0 [X]e− 2 σ t+σ t x − G0 [Y ]| e− 2 x dx
2π −∞
This integral is the expression we were looking for. It can be evaluated
analytically, indeed, it is the value of the sum of one call and one put
(t)
option on X with strike price G0 [Y ] and σ is as described above.

4. The fact that the interest rate R(0, t) is independent of X (under the
t-forward distribution) implies that

E(t) [XeR(0,t) ] = E(t) [X] E(t) [eR(0,t) ].

Hence
(t) (t) (t)
F0 [X] = P0 [XeR(0,t) ] = Zt G0 [XeR(0,t) ]
= Zt E(t) [XeR(0,t) ] = Zt E(t) [X] E(t) [eR(0,t) ]
(t) (t) (t)
= G0 [X] P0 [$eR(0,t) ]$−1 = G0 [X]

47
VIII: Conditional Expectations and Martingales

VIII: Conditional Expectations and Martingales

The outcome of random variables may occur at different points in time.
For instance, if I toss a coin, the outcome X, which is heads or tails, is
random before the coin is actually tossed, but at the time it has been
tossed, the outcome is observed.
Let 0 < t < T be three points in time where 0 = now, let X a random
variable whose outcome is observed at time T , and U a random variable
whose outcome is observed at the earlier time t. Assume that for any
event A whose outcome can be observed at time t, the relation

E[IA X] = E[IA U ] (1)

holds. We then say that U is the conditional expectation at time t of the

variable X. It is easy to see that the variable U is essentially uniquely
determined by X, i.e., if U1 and U2 both satisfy E[IA X] = E[IA Ui ] for all
A, then U1 = U2 with probability = 1.
The conditional expectation is denoted Et [X], i.e., U = Et [X]. The
conditional expectation E0 [X] is the same as the unconditional expec-
tation E[X]. To see this, note that IA for an event whose outcome is
observed now, is either the constant 1 or the constant 0.
The definition of Et [X] may seem a bit strange, but the interpretation
is as follows: if we at time t form the expectation of X, using all relevant
information available at the time, then Et [X] is the sensible choice. Note
that as seen from a point in time earlier than t, this expectation is random,
since we do not have all the information to be revealed at time t when the
expectation is formed.
We can also see that the conditional expectation behaves in accor-
dance with the intuitive notion from the following properties:

Properties
– If X is stochastically independent of any random variable observed
at time t, then the conditional expectation equals the unconditional
expectation: Et [X] = E[X].

– More generally, if X is stochastically independent of any random vari-

able observed at time t, and Y is a random variable observed at time
t, then Et [Y X] = Y E[X].

The first property is the special case of the second when Y ≡ 1. In order
to see the second property, recall that if two random variables are inde-
pendent, then the expected value of their product is the product of their
expected values. Hence, if A is any event whose outcome is observed at
time t, then

48
VIII: Conditional Expectations and Martingales
 
E[IA Y X] = E[IA Y ]E[X] = E IA Y E[X] .
Hence Et [Y X] = Y E[X].

Note in particular the law of iterated expectations

 
E Et [X] = E[X] (2)
which is obtained by letting A be the event “anything” in (1) so that
IA = 1. It is even true that
 
Es Et [X] = Es [X] if s < t. (2 )
The proof of this relation follows immediately from the definition (1): Let
A be any event with outcome at time s, and denote Y = Et [X]. Note that
the outcome of A is known also at time t > s, hence
   
E IA Es [Y ] = E[IA Y ] = E IA Et [X] = E[IA X].
It follows, by definition, that Es [Y ] = Es [X], Q.E.D.

Assume now that the time interval from 0 to T is discretised by the points
0 = t0 < t1 , . . . < tn = T , and that we have a sequence of random variables
Xj , j = 0, . . . , n, where the outcome of Xj is observed at time tj . Such a
sequence is a stochastic process. A stochastic process is a martingale if it
is true that

Xj = Etj [Xj+1 ] for j = 0, . . . , n − 1. (3)

It follows immediately from (2 ) that in order for a stochastic process to
be a martingale, it suffices that Xj = Etj [Xn ] for j < n.

Martingale Prices
Consider a contract that gives the random payoff X at time T . The
(T )
forward price Gt , 0 ≤ t < T , of this contract at time t is a random
variable whose outcome is determined at time t.

Theorem
(T )
For any t, 0 ≤ t ≤ T , the forward price Gt equals the conditional
expectation
(T ) (T )
Gt = Et [X]
Hence, the forward process has the martingale property (3) w.r.t. the
forward distribution, i.e.,
(T ) (T ) (T )
Gtj = Etj [Gtj+1 ]

49
VIII: Conditional Expectations and Martingales

Proof
Consider the following strategy: Let A be any event whose outcome
occurs at time t. Wait until time t and then, if A has occurred, enter a
(T )
forward contract on X maturing at T with forward price Gt , but if A
has not occurred, do nothing. We have thus constructed a contract which
(T )
gives payoff IA (X − Gt ) at time T which costs 0 today. Hence
(T ) (T )
ZT E(T ) [IA (X − Gt )] = 0 i.e., E(T ) [IA X] = E(T ) [IA Gt ]

Since this is true for any event A whose outcome is known at time t, we
have by the definition of conditional expectation
(T ) (T )
Gt = Et [X]

Q.E.D.

Remark 1
From this we deduce (c.f. Ch. I) that the present price pt at time t
of the contract yielding X at time T is
(T )
pt = Z(t, T )Et [X]

where Z(t, T ) is the price at time t of a zero coupon bond maturing at

time T . Especially, if the interest rate is deterministic and equal to r,
then the present prices satisfy

pj = e−r Δt E∗j [pj+1 ] (4)

where pj is the present price as of time tj and Δt = tj+1 − tj ; E∗ de-

notes expectation w.r.t. the forward distribution (which is independent of
maturity date, according to Theorem 1.)

Remark 2
The Martingale property holds for distributions referring to any nu-
meraire. By the same token as above, it follows that
(T )
Pt [X] X
(T ) = EN
t [N ]
Pt [N ]

50
IX: Asset Price Dynamics and Binomial Trees

IX: Asset Price Dynamics and Binomial Trees

In Black’s model, there are only two relevant points in time: the time
when the contract is written, and the time when it matures. In many
cases we have to consider also what happens in between these two points
in time.
First some notation. Time is discrete, t = t0 < . . . < tn = T , and
we let for notational simplicity t0 = 0 and all time spells tk − tk−1 = Δt
be equally long; hence tk = kΔt. Let X be some random value whose
outcome becomes known at time T ; we are interested in evaluating the
prices of derivatives of X.

Black-Scholes Dynamics
The Black-Scholes assumption about the random behaviour of X is
that
n
X = Aeσ Σ1 wj (1)

where A is some constant, σ a parameter called the volatility, and the wj :s

are stochastically independent Normal N(0, Δt) √ random variables (Δt is
the variance; the standard deviation is thus Δt) where the outcome of
wj occurs at time tj .
This is the model for the price dynamics under the forward (T ) prob-
ability distribution. A problem is the assessment of the volatitity σ. Some-
times it is estimated from real data, i.e., as if the specification (1) holds
under a historical natural probability distribution. The constant A, in
contrast, must be calculated from real prices and may differ depending on
which numeraire probability distribution we employ.
(T )
Now we take expectations E(T ) of both sides of (1). Since G0 =
(T ) 1 2
E(T ) [X], it follows that A = G0 e− 2 σ T .

Binomial Approximation
In almost all cases when the whole price path has to be taken into
account, it is necessary to use some numerical procedure to calculate the
price of the derivative. A useful numerical procedure is to approximate
√ In (1), we replace wj by a binary
the specification (1) by a binomial tree.
variable bj which takes the value − Δt with probability
√ (under the for-
ward probability distribution) 0.5 and the value + Δt with probability
0.5. For large values of n, and small Δt, this is a good approximation—in
fact, as n → ∞ and Δt → 0 the price of a derivative calculated from the
binomial tree will converge to the theoretical value it would have from the
specification (1).

51
IX: Asset Price Dynamics and Binomial Trees

The binomial specification is thus

n
X = B eσ Σ1 bj
√
Note that E(T ) [eσbj ] = cosh(σ Δt). In order to ease notation, we write
(T ) (T )
Gk for Gtk . We know from the previous chapter that Gk [X] = Ek [X],
so
k √
Gk = B eσ Σ1 bj coshn−k (σ Δt)

Combining this relation with the same for Gk+1 , we get the relation

eσ bk+1  √
Gk+1 = Gk √ = Gk 1 ± ε) where ε = tanh(σ Δt)
cosh(σ Δt)
and the plus and minus sign occur with probability (under the forward
probability distribution) 0.5 each.

Binomial trees were introduced by J. Cox, S. Ross, and M. Rubenstein

in “Option pricing: A simplified approach”, Journal of Financial Eco-
nomics 7 (1979), 87–106, and has been a very extensively used numerical
procedure. The idea is that the binary variable
√
b= √Δt with probability 0.5
− Δt with probability 0.5
has the same first and second moments (expectation and variance) in com-
mon with a Normal N (0, Δt) variable. Hence, a sum of many independent
such variables will have almost the same distribution as a corresponding
sum of N (0, Δt) variables (Bernulli’s theorem, or the Central Limit The-
orem.)

The Binomial Model

In the previous section we derived the binomial specification of the
forward price dynamics of the asset that will be underlying a derivative.
The forward price refers to a forward contract that matures at the same
time T as the derivative, or later. If we write the dynamics in the usual
tree style, we have for the forward price dynamics

G0 G0 u G 0 u 2 G0 u 3 G0 u 4 ··· G0 un
G0 d G0 du G0 du G0 du3
2
··· G0 dun−1
G 0 d2 G0 d 2 u G 0 d2 u 2 ··· G0 d2 un−2
G0 d 3 G0 d3 u ··· G0 d3 un−3
.. ..
. ··· .
G 0 dn

52
IX: Asset Price Dynamics and Binomial Trees

In this diagram, each column represents an instant of time, and moving

from one instant to the next (one step right) means that the forward price
either moves “up” or “down”. In this diagram “up” means going one step
to the right on the same line, and “down” going one step to the right on
the line below (this configuration is convenient in a spreadsheet.) Under
the forward distribution the probabilities of moving up and down are both
1
2 . The specification of u and d are as follows:

u=1+ε √
where ε = tanh(σ Δt)
d=1−ε

where Δt is the time spell between columns, and σ is the volatility of the
forward price.

Pricing an American Futures Option

As long as we assume that interest rates are deterministic, the forward
prices in the binomial tree equals the corresponding futures prices. Hence
we can use this tree for calculating the price of an American futures option.
In order to do so, we construct a tree of prices of the futures option. In this
tree the prices are calculated from right to left. If the time for maturity
of the option is at T = t4 , then we construct the following tree of prices
for the futures option:

p p1,0 p2,0 p3,0 p4,0

p1,1 p2,1 p3,1 p4,1
p2,2 p3,2 p4,2
p3,3 p4,3
p4,4

Here the prices in the rightmost column are known, since they represent
the value of the option at maturity when the underlying futures price
is that in the corresponding position of the tree of futures prices. Then
option prices are calculated backwards:
 
p̂j,k = e−rΔt 0.5 pj+1,k + 0.5 pj+1,k+1 (1)
pj,k = max(p̂j,k , value if exercised) (2)

Indeed, p̂j,k = e−rΔt E∗ [pj+1,• ], which is just another way of writing (1),
is the value if the option is not exercised (see (4) of Ch. VIII,) and the
highest value of this and the value if exercised is the present value. In
order to calculate the value if exercised, we employ the original tree of
futures prices, of course. The end result p is the price of the option today.

53
IX: Asset Price Dynamics and Binomial Trees

American Call Option on a Share of a Stock

If we want to price an American call option on a share of a stock
which pays no dividend before maturity, we need a binomial tree for the
current stock price, not the futures price of the stock. The assumption is
still that the forward price dynamics is as above, and we derive the stock
prices from there. This is easy; according to Ch. II, example 1 with d = 0,
the relation between the current stock price St and the forward price at
the same date Gt is St = Gt e−r(T −t) . The relevant binomial tree for the
stock price is thus

S0 S0 erΔt u S0 e2rΔt u2 S0 e3rΔt u3 ···

S0 erΔt d S0 e2rΔt du S0 e3rΔt du2 ···
S0 e2rΔt d2 S0 e3rΔt d2 u ···
S0 e3rΔt d3 ···

The price of the option is then calculated in the same way as above.

Options on Assets Paying Dividends

Known Dividend Amount
Assume we want to price an option on a share of a stock when just
before time i the stock pays a known dividend d. We need to set up a
binomial tree for the current price St of the stock. Let n > i be the period
at which time T the option matures.
For any time j ≤ n we have the relation
−r(i−j)Δt
e d + e−r(n−j)Δt Gj if j < i
Sj = −r(n−j)Δt (3)
e Gj if i ≤ j ≤ n

This follows as in Ch. II, example 1.

In particular, we have

G0 = S0 ernΔt − d er(n−i)Δt (4)

It is now easy to build the tree of stock prices: First compute G0 from (4),
then construct the tree for Gj , and from these prices, compute Sj from
(3).

Known Dividend Yield

Now assume instead that at some time between times i − 1 and i
the stock will pay a dividend d Si where Si is the stock price the moment
before the dividend is paid out.
The relation between the stock price Sj and the futures price Gj for
times j later or at time i is as before

54
IX: Asset Price Dynamics and Binomial Trees

Sj = e−r(n−j)Δt Gj j≥i (5)

For times j before i we can compute the stock price in accordance with
example 2 of Ch. II:

Sj (1 − d) = e−r(n−j)Δt Gj

from which it follows that

1
Sj = Gj e−r(n−j)Δt j<i (6)
1−d
In particular,

G0 = (1 − d)S0 ernΔt (7)

It is now easy to build the tree of stock prices: First compute G0 from (7),
then construct the tree for Gj , and from these prices, compute Sj from
(5) and (6).

Options on Consumption Assets

Usually an option on a consumption asset is designed as a futures
option, but there are exceptions. If we are about to price an option (or
other derivative) where the underlying value is the spot price of some con-
sumption asset (as opposed to investment asset,) then there is no obvious
relationship between spot prices and forward prices, so a binomial tree of
the latter is of no use. Instead, we should construct a binomial tree of spot
prices which is consistent with current forward prices with maturity date
equal to the corresponding future spot price. A tree of the spot prices St
is
S0 G10 u G20 u2 G30 u3 G40 u4
G10 d G20 du G0 du G40 du3
3 2

G20 d2 G30 d2 u G40 d2 u2

G30 d3 G40 d3 u
G40 d4
(t)
We leave as an exercise to check that in this tree, G0 = E∗ [St ].

Comments
There is more than one way to specify the binomial model. The one
given here is slightly different from the original model by Cox, Ross and
Rubenstein. I find the specification given here more appealing, and also
easier to generalise to different situations (see for example Ch. XII, where
we discuss an interest rate model.) It is important not to mix up different
specifications!

55
IX: Asset Price Dynamics and Binomial Trees

One can construct binomial trees for various underlying assets: in-
dices, currencies, futures, and shares paying various forms of dividends.
In order to make these appear less ad-hoc, I do this in two steps: First
we construct a tree over the forward prices of the underlying asset. These
trees are constructed the same way independent of underlying asset. Then
we construct a tree over the relevant spot prices (unless the underlying is
a futures contract,) where we use the techniques from Ch. II. Finally, we
construct the tree over the derivative price.
Many texts construct the binomial tree directly for the spot prices un-
derlying the derivative, without first specifying one for the corresponding
forward prices. This is a somewhat risky approach: the tree of spot prices
must be consistent with the fact that the corresponding forward prices
have the Martingale property. In order to ensure that this happens, I pre-
fer to first make a tree over the forward prices such that the Martingale
property is satisfied. Now I know that there are no arbitrage possibilities
lurking in the model; thereafter I derive the relevant spot prices, and I
can feel safe that the model is sound.

One can also use trinomial trees, where the N (0, Δt) variable is approxi-
mated by the “trinary” variable
⎧√
⎪
⎨ 3Δt with probability 16
u= 0 with probability 23
⎩ √
⎪
− 3Δt with probability 16

This variable shares the same five first moments with the N (0, Δt) vari-
able, so the approximation is better in a corresponding trinomial tree
compared to a binomial tree.
Trinomial trees are also used in many interest rate models (Hull and
White.)

Exercises and Examples

Interest rates always refer to continuous compounding. Answers are
given in parenthesis; solutions to some problems are given in the next
section
In these examples we use binomial trees with very few time steps. In
a “real” situation one would of course use many more, maybe 50–100.

56
IX: Asset Price Dynamics and Binomial Trees

1. The futures price of coffee (100 kg) to be delivered in four weeks is

$70. The volatility is 2% in a week. The risk-free rate of interest is
0.1% per week. In the following cases, use a binomial tree with time
interval of one week.
a) Determine the price of a European futures put option on coffee
(100 kg) with strike price $72. The option matures in four weeks
(which is also the maturity of the futures.) ($2.4255)
b) The same question, though for an American option, ceteris pari-
bus (latin: “everything else being the same”.) ($2.4287)

2. A share costs today $13.28. The volatility is 2% in a week, and the

share pays no dividends the coming month. The risk-free rate of
interest is 0.1% a week. In the following cases, use a binomial tree
with time interval one week.
a) Determine the price of an American put option with maturity in
four weeks at a strike price of $13.70. ($0.464143)
b) The same question, but the share pays a dividend of $0.27 in just
under two weeks (that is just before time 2 in the binomial tree.)
Also, the current price of the share is $13.55, ceteris paribus.
($0.462168)

3. Determine the price of an American option to buy 100 GBP at 13 SEK

per pound, which is the value of the pound today. The time to matu-
rity is one year, the pound’s volatility relative to the Swedish crown
is 10% in one year. The rate of interest of the Swedish crown is 3%
a year, and the one year forward exchange rate is 12.60 SEK for one
GBP. Use a binomial tree to solve the problem, with time interval
three months. (37.70 SEK)

4. Determine the price of an American call option on a share whose

present price is 100 SEK with maturity in one year with strike price
98 SEK. The share’s volatility is 20% in one year, the rate of interest
is 6% a year, and the share will pay a dividend in 5.5 months of 4%
of the value of the share at that time. Use a binomial tree with time
interval three months. (9.345 SEK)

5. Calculate the price of an eight month American call option on a maize

futures when the present futures price is $26.4, the strike price of the
option is 26.67, the risk-free rate of interest is 8% and the volatility
of the futures price is 30% over one year. Use a binomial tree with
time interval two months. ($2.3515)

57
IX: Asset Price Dynamics and Binomial Trees

6. A two month American put option on an index of shares has the strike
price 480. The present value of the index is 484, the risk-free rate of
interest is 10% per year, the dividend of the index is 3% per year and
the volatility is 25% over a year. Determine the value of the option
by using a binomial tree with time interval of half a month. (15.2336)

7. The spot price of copper is $0.60 per pound. Assume that, at present,
the futures price of copper is
maturity futures price
3 months 0.59
6 months 0.57
9 months 0.54
12 months 0.50

The volatility of the price of copper is 40% during one year and the
risk-free interest rate is 6% a year. Use a suitable binomial tree with
time interval three months to estimate the price of an American call
option on copper with strike price $0.60 and maturity in one year.
($0.063167.)

Solutions
1.

Here are three binomial trees (the display shows decimal commas,
which is Swedish standard) cut from an Excel spreadsheet. Note

58
IX: Asset Price Dynamics and Binomial Trees

that time goes from bottom to top; I think this is the easiest way to
arrange binomial trees in a spreadsheet.
The first tree displays the futures (=forward) prices of coffee.
Week 0 (today) it is $70, week 1 it is either $71.3998 or $68.6002, each
with probability 0.5 under the forward probability measure. Week
two, the futures price is $72.8276 or $69.9720 if the futures price were
$71.3998 week 1, and $69.9720 or $67.2284 if the futures price were
$68.6002 week 1; and so on. This tree is generated in accordance with
the first tree (forward prices) appearing in Ch. IX.
The second tree displays the value of the European put option.
It is generated from top to bottom: week 4 the option is worth 0 if
the futures price is more than or equal to $72, otherwise it is worth
$72 − futures price (where the futures price equals the spot price of
coffee, since the futures contract matures week 4.) Hence we get
the first row (week 4) easily from the previous tree’s week 4. Next we
compute the week 3 option prices, employing (4) of Ch. VIII: the price
week 3 is the discounted value of the expected value week 4 under the
forward probability measure. Hence, each price week 3 is e−0.001 times
(0.5·p1 +0.5·p2 ) where p1 and p2 are the prices above and right-above
respectively, For example, 3.4238 = e−0.001 (0.5 · 2.0560 + 0.5 · 4.7985).
Going down through the tree, we finally find the price week 0 to
be $2.4255.
The third tree displays the values of the corresponding American
put option. It is obtained as in the tree on the European option,
except that the price is replaced by the exercise value if that is higher.
These numbers are in boldface. For instance, the value $3.4272 is the
value if the option is exercised: 3.4272 = 72 − 68.5728 which is more
than e−0.001 (0.5 · 2.0560 + 0.5 · 4.7985).
Going down through this tree, we end up with the price $2.4287
for the American option.

59
IX: Asset Price Dynamics and Binomial Trees

2a.

First we compute the forward price of the share according to Ch. II:
G0 = S0 e0.004 = $13.3332. Starting out with this value, we construct
the first tree of forward prices. Now we know that the forward prices
of the underlying share indeed have the Martingale property under
the forward probability measure.
Next we construct the tree of spot prices of the share: for exam-
ple, week 2 the spot price S2 = G2 e−2·0.001 , so we get the spot prices
by just discounting the values in the forward price tree. Of course,
week 0 we get the initial spot price of the share.
Now we construct the tree of option prices. We start with the
prices week 4. Next week three: these prices are computed as the
mean of the two prices above and right-above, discounted by the one
period interest rate. However, we must check that it isn’t profitable
to exercise the option. This happens in a few places; these are shown
in boldface. Finally, the option price is found to be $0.464143.

60
IX: Asset Price Dynamics and Binomial Trees

2b.

First we compute the forward price of the underlying share according

to example 1, Ch. II. Starting from this value, we construct the first
tree which contains the forward prices.
Next we compute the tree of spot prices, again using example 1
of Ch. II. For the time periods 2 and 3 this means just discounting
the forward price (example 1 with d=0.)
Finally, we compute the tree of option prices in the same way as
in part a. Early exercise is shown in boldface. The present price of
the option is $0.462168.

61
IX: Asset Price Dynamics and Binomial Trees

3.

First we construct the three of forward exchange rates.

According to example 5, Ch. II, the relation between forward
exchange rate G and the spot exchange rate X is X = G eΔr/12 τ
where τ is the number of months to maturity and Δr is the foreign
interest rate minus the domestic rate. For τ = 12 we have 13 =
12.60 eΔr which gives Δr = 0.03125. We use this value to create the
second tree containing the spot exchange rates.
Finally, we compute the last tree, the tree of option prices in the
usual way. Here we discount with the SEK interest rate, of course
(3% per year.) Early exercise is labeled in boldface. The price of the
option is 37.70 SEK.

62
IX: Asset Price Dynamics and Binomial Trees

4.

The forward price of the underlying share is 100 (1 − 0.04) e0.06 =

101.9363 SEK (example 2, Ch. II.) We construct the first tree: for-
ward prices of the underlying asset.
From the forward prices we compute the spot prices by just dis-
counting (example 1 with d=0, Ch. II) for times later than 5.5 months.
For times previous to 5.5 months we discount and divide by 0.96 (ex-
ample 2, Lecture Note 2.) Thus we obtain the second tree of spot
prices.
Finally, we construct the tree of option prices in the usual way.
Early exercise is never profitable. Note that for non-paying dividend
stocks, early exercise is never profitable for a call option, but in this
case we couldn’t know, since there is a dividend payment. The option
price is 9.3451 SEK.

63
IX: Asset Price Dynamics and Binomial Trees

6.

The forward value of the index is 484 e(0.10−0.03)·2/12 ) ≈ 489.6797

(Ch. II, example 4.) We use this value to generate the tree of forward
values of the index.
Next we construct the tree of spot index values, again using
example 5 of Ch. II.
Finally we construct the tree of option prices; early exercise is as
usual shown in boldface. The present option value is 15.2336

7.

The first tree is a tree on spot prices on copper. We know from

Ch. IV that the forward price is the expected value w.r.t. the for-
ward probability measure of the spot price at the time of maturity:
(t)
G0 = E∗ [St ]. In order to achieve this, we construct the tree like this
(t=quarters:)

64
IX: Asset Price Dynamics and Binomial Trees

G40 u4 G40 u3 d G40 u2 d2 G40 ud3 G40 d4

G30 u3 G30 u2 d1 G30 ud2 G30 d3
G20 u2 G20 ud G20 d2
G10 u G10 d
S0
(t)
You can check that in this tree, G0 = E∗ [St ] (see notation in Ch.
VII.)
The tree of option prices is now calculated as usual. Early exer-
cise in boldface.

65
X: Random Interest Rates: The Futures Distribution

X: Random Interest Rates: The Futures Distribution

In order to study interest rate derivatives, or other situations where in-

terest rates are assumed to be random and the underlying asset depends
on the interest rate, we need a different probability distribution than the
forward distribution. One reason for this is that when interest rates are
random, forward distributions for different maturity dates are not the
same. Rather than having zero coupon bonds as numeraires we use the
money market account, MMA, (see Ch. I) as a numeraire. Hence, let the
numeraire N be N = $eR(0,t) delivered at time t, where we have used the
notation introduced in Ch. I and VII. Let X = $W be a random payment
at time t (W is a dimensionless random variable.) Then (see (1) of Ch.
VII)

(t) (t) (t)  ]

F0 [X] = P0 [$W eR(0,t) ] = P0 [$eR(0,t) ] E[W
 ] = E[X]
= $1 E[W  (1)

 denotes expectation w.r.t. the probability distribution associ-

where E[·]
ated with the numeraire N = $eR(0,t) . It seems natural to call the proba-
bility distribution associated with this numeraire the futures distribution.
In the literature it is often called the Equivalent Martingale Measure (Hull
uses the term “traditional risk neutral measure.”)
It is important to note that the forward distributions (pertaining to
expectation E(T ) ) differ for different maturities T when interest rates are
random. This is not the case for the futures distribution, though. Indeed,
we will now prove two theorems on the futures distribution:

Theorem 1
The futures distribution as defined above is independent of the date of
maturity T in the following sense: if the outcome of X is known at
time tn then E (n) [X] = E
 (m) [X] if m > n, where we denote by E (k)
the futures distribution for contracts maturing at time tk .

Hence there is no need to index the futures distribution by maturity date.

In order to ease notation, we write Fj for Ftj .

Theorem 2
The futures prices {Fj } have the martingale property w.r.t. the futures
distribution: Fj = E t [Fk ] for j < k. In particular, the futures price
j
F0 is the expected value w.r.t. the futures distribution of X, the spot
price at delivery.

66
X: Random Interest Rates: The Futures Distribution

Proof of Theorem 1
Let P0 be the present price of the value XeR(0,n) to be delivered at
time tn . We can convert this contract to one where instead the value
XeR(0,m) is delivered at time tm by simply depositing the payoff XeR(0,n)
in the money market account up to time tm . The present price is of course
the same. Using the theorem in Ch. I, we have the following equalities
from the two contracts:
(tn ) (tn )
P0 = P 0 [XeR(0,n) ] = F0 [X] and
(t ) (t )
P0 = P0 m [XeR(0,m) ] = F0 m [X]

By (1) this implies that

 (n) [X] = E
E  (m) [X]

Q.E.D.

Proof of theorem 2
Consider the following strategy: Let A be any event whose outcome is
known at time tj < tk . At time tk−1 enter a long position of eR(0,k) futures
contracts if A has occurred, otherwise do nothing. At time tk collect
IA (Fk − Fk−1 )eR(0,k) (which may be negative) and close the contract.
This gives the payment IA (Fk − Fk−1 )eR(0,k) at time tk and no other cash
flow. The present price is zero, hence

0 = P0
(tk )  A (Fk − Fk−1 )]
[IA (Fk − Fk−1 )eR(0,k) ] = F0 [IA (Fk − Fk−1 )] = E[I

Hence,

 A Fk ] = E[I
E[I  A Fk−1 ]

Employing this equality repeatedly gives, for j < k:

 A Fj ] = E[I
E[I  A Fk ]

Since A can be any event whose outcome is known at time tj , this means
that (Ch. VIII)

 t [Fk ]
Fj = E for j < k.
j

This proves theorem 2.

67
X: Random Interest Rates: The Futures Distribution

Theorem 3
The following formula for the present price pj as of time tj for the
asset Y to be delivered at time tk > tj holds:

 t [Y e−R(j,k) ].
pj = E j

Proof
With the notation of Ch. I,
(k)  t [Y e−R(j,k) ]
pj = Fj [Y e−R(j,k) ] = E j

Q.E.D.

68
XI: A Model of the Short Interest Rate: Ho-Lee

XI: A Model of the Short Interest Rate: Ho-Lee

We divide time into short time intervals t0 , < . . . < tn = T , tk −tk−1 = Δt.
Ideally, the points in time tk should coincide with the times of settlement
of futures contracts.
At tk−1 there is an interest rate rk Δt prevailing from tk−1 to tk . This
interest rate is random, but its value is known at time tk−1 . The Ho-Lee
model of the interest rate is:
√
rk = θk + σ Δt (z1 + · · · + zk−1 )

where θk are some numbers, the factor σ is the volatility of the short in-
terest rate. The zj :s are independent N(0,1)-variables and the outcome of
each zj occurs at time tj . This is under the futures probability distribu-
tion.
It remains to compute the exact value of θk , but first a notational
simplification: multiplying by Δt yields
3
rk Δt = θk Δt + σΔt 2 (z1 + · · · + zk−1 )

We now normalise Δt = 1. This means that rk is the one period interest

rate—it is proportional to Δt whereas σ is proportional to Δt3/2 . Now
the model reads

rk = θk + σ(z1 + · · · + zk−1 ) (1)

Let $Ztk be the price of a zero coupon bond maturing at tk with face value
$1. Then, according to Theorem 3, Ch. X,

 e−r1 −···−rk ]
Ztk = E[1

In order for the model (1) to correctly represent the current term structure,
we must thus have

 −θ1 −···−θk −σ((k−1)z1 +(k−2)z2 +···+1 zk−1 ) ]

Ztk = E[e
 −σ((k−1)z1 +(k−2)z2 +···+1 zk−1 ) ]
= e−θ1 −···−θk E[e
i.e.,
σ2
((k−1)2 +···+12 )
Ztk = e−θ1 −···−θk e 2

Since this must hold for any k, this is equivalent to

Z
σ2
tk−1
θk = ln + (k − 1)2
Ztk 2
The Ho-Lee model thus reads

69
XI: A Model of the Short Interest Rate: Ho-Lee

Z
σ2
t−1
rt = ln + (t − 1)2 + σ(z1 + · · · + zt−1 ) (2)
Zt 2

under the futures distribution.

The Price of a Zero Coupon Bond

Consider a zero coupon bond with face value $1 which matures at
time T . We will now compute its price $Z(t, T ) at an earlier time t < T .
At this time, the bond’s value is, by Theorem 3, Ch. X (the sub index t
on E indicates conditional expectation as of time t, i.e., the outcomes of
zj for j ≤ t are already known and are regarded as constants):

 t [e−rt+1 −···−rT ]
Z(t, T ) = E
ZT  − σ2 (t2 +···+(T −1)2 )−σ(T −t)(z1 +···+zt )
= Et [e 2
Zt
× e−σ((T −t−1)zt+1 +(T −t−2)zt+2 +···+1 zT −1 ) ]
ZT − σ2 (t2 +···+(T −1)2 ) −σ(T −t)(z1 +···+zt )
= e 2 e
Zt
×E  t [e−σ((T −t−1)zt+1 +(T −t−2)zt+2 +···+1 zT −1 ) ]
ZT −σ(T −t)(z1 +···+zt ) − σ2 (t2 +···+(T −1)2 ) σ2 ((T −t−1)2 +···+12 )
= e e 2 e2
Zt

We compute the sums

σ2 2 σ2
− (t + · · · + (T − 1)2 ) + ((T − t − 1)2 + · · · + 12 )
2 2
T −t−1
σ2 
=− (t + j)2 − j 2
2 j=0

T −t−1
σ2 
=− t (2j + t)
2 j=0

σ2
=− (T − 1)(T − t)t
2
Hence,
ZT − σ2 (T −1)(T −t)t −σ(T −t)(z1 +···+zt )
Z(t, T ) = e 2 e (3)
Zt

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XI: A Model of the Short Interest Rate: Ho-Lee

Forward and Futures on a Zero Coupon Bond

We will now compute the futures and forward prices of a contract
maturing at t on a zero coupon bond maturing at T > t with face value
$1. The forward price is easy, it is

(t) ZT
G0 = $
Zt
regardless of the interest rate model. We leave the proof to the reader.
The futures price F0 is

 ZT e− σ2
2

F0 = E[$Z(t, T )] = E[$ (T −1)(T −t)t −σ(T −t)(z1 +···+zt )
e ]
Zt
2
(t)
= G0 e − σ2 (T −1)(T −t)t  −σ(T −t)(z1 +···+zt ) ]
E[e
σ2 σ2 σ2
(t) (T −t)2 t (t)
= G0 e− 2 (T −1)(T −t)t
e 2 = G0 e− 2 (T −t)(t−1)t

Recall that we have normalised Δt = 1. With no normalisation, we must

3
replace σ by σΔt 2 and t and T by tΔt−1 and T Δt−1 respectively, hence
σ2 σ2
(t) (t) (t) (T −t)t2
F0 = G0 e− 2 (T −t)(t−Δt)t
−→ G0 e− 2 when Δt → 0.

We see that in contrast to the situation when interest rates are determinis-
tic, the forward price G0 and the futures price F0 differ. Since the price of
the underlying asset (the bond) is negatively correlated with the interest
σ2
(T −t)t2
rate, the futures price is lower; in the Ho-Lee model by factor e− 2 .

The Forward Distribution

The computation of prices on bond options, for example, is simpler
if we use the forward distribution rather than the futures distribution.
We will see that in the next section. Let us therefore derive the forward
distribution for a certain maturity t. Let D ⊂ Rt , Pr (t) denote t-forward
probability, z̄t = (z1 , . . . , zt ) and let ID (x̄t ) denote the indicator function
of D, i.e., ID (x̄t ) = 1 if x̄t ∈ D, ID (x̄t ) = 0 if x̄t ∈ D. The constants
Ck are independent of the choice of D, and their actual values are of no
concern. We have:
  (t)   (1) (t)  
$Pr (t) (z̄t ∈ D) = $E(t) ID (z̄t ) = G0 $ID (z̄t ) = Zt−1 P0 $ID (z̄t )
(1) −1 (t)  t 
= Zt F0 $ID (z̄t ) e−Σ1 rk
(t)  t 
= C1 F0 $ID (z̄t ) e−σ Σ1 (t−j)zj
 
t 1 2
= $C2 . . . ID (x̄t )e−σ Σ1 (t−j)xj e− 2 Σxj dx1 . . . dxt

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XI: A Model of the Short Interest Rate: Ho-Lee
 
1 2
= $C3 . . . e− 2 Σ(xj +σ(t−j)) dx1 . . . dxt
D

Here the equalities (1) follow from the theorem in Ch. I. Hence, under
 random variables zj (j ≤ t) are
the t-forward probability distribution, the
independent and zj ∈ N − σ(t − j), 1 . In particular, we have from (3)
that under the E(t) -distribution, with wj independent ∈ N (0, 1) :

ZT − σ2 (T −1)(T −t)t −σ(T −t)(w1 −σ(t−1)+···+wt−1 −σ·1+wt )

Z(t, T ) = e 2 e
Zt
ZT − σ2 (T −t)2 t −σ(T −t)(w1 +···+wt )
= e 2 e (4)
Zt

Pricing a European Option on a Zero Coupon Bond

It is now easy to calculate the price of a European option maturing
at t on a zero coupon bond maturing at time T > t. Let f ($Z(t, T )) be
the value in $ of the option at maturity. Then its price today is, using
√ w1 + · · · + wt is a Normal distributed variable with
(4) and the fact that
standard deviation t,
  
p = Zt E(t) f $Z(t, T )
 ∞
Zt  $ZT − σ2 (T −t)2 t σ(T −t)√t x  − 1 x2
=√ f e 2 e e 2 dx
2π −∞ Zt

But $Z T
Zt = G0 , the forward price of the underlying bond, hence, (also
with no normalisation of time,)
  
p = Zt E(t) f $Z(t, T )
 ∞
Zt  σ2 2
√  1 2
=√ f G0 e− 2 (T −t) t eσ(T −t) t x e− 2 x dx
2π −∞
Note that the same formula may be obtained by Black’s model for bond
options (Ch. VI.)

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XII: Ho-Lee’s Binomial Interest Rate Model

XII: Ho-Lee’s Binomial Interest Rate Model

When we want to price other than European interest rate derivatives, we
need a numerical procedure, and one such is again a binomial tree. This is
constructed by replacing zk in Ch. XI by binomial variables bj (see Ch. IX,
“Binomial Approximation”.) Hence, time is discrete: t0 , t1 , . . . , tn = T ,
tk − tk−1 = Δt. The interest rate rk from tk−1 to tk is assumed to be
k

rk = θk + σ bj k = 1, . . . , n
2

where {bk } are binomial random variables which takes the values ±1, each
with probability 0.5 under the futures distribution; they are thus assumed
to be statistically independent. The outcome of the variable bk occurs at
3
time tk−1 . The volatility parameter σ is proportional to Δt 2 just as in
Ch. XI.
We will choose the terms θj :s such that the model is consistent with
the current term structure—it will be close to, but not exactly, the same
as in the Normal distribution case.
Let us compute the price Z4 at time t0 of a zero coupon bond maturing
at time t4 with face value 1:
 · e−r1 −r2 −r3 −r4 ] = E[e
Z4 = E[1  −θ1 −θ2 −θ3 −θ4 −σ(3b2 +2b3 +b4 ) ]
= e−θ1 −θ2 −θ3 −θ4 E[e  −2σb3 ] E[e
 −3σb2 ] E[e  −σb4 ]
= e−θ1 −θ2 −θ3 −θ4 cosh(3σ) cosh(2σ) cosh(σ)
And, by the same token, in general
 
Zk = e−θ1 −···−θk cosh (k − 1)σ · . . . · cosh(σ)
Since this must hold for all k, we must have
Z
  
k−1
θk = ln + ln cosh (k − 1)σ
Zk
and the dynamics under the futures distribution is thus described by
Z
   k

k−1
rk = ln + ln cosh (k − 1)σ + σ bj k = 1, . . . , n
Zk 2

1
bj = 1 with probability 2
where 1
bj = −1 with probability 2

Once we have the parameters of the model, we can price interest rate
derivatives in the binomial tree. We show the procedure by an example,

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XII: Ho-Lee’s Binomial Interest Rate Model

where we want to price a European call option maturing at t2 with strike

price 86 on a zero coupon bond maturing at t4 with face value 100 when
the following parameters are given: f1 =0.06, f2 = 0.06095, f3 = 0.06180,
f4 = 0.06255, σ = 0.01, where fk = ln Zk−1 /Zk are the forward rates.
We represent the interest rates in a binomial tree:

t0 t1 t2 t3
0.06 0.071 0.082 0.093
0.051 0.062 0.073
0.042 0.053
0.033
The interest rate from one period to the next is obtained by going either
one step to the right on the same line, or step to the right to the line
below; each with a (risk adjusted) probability of 0.5. We can compute the
value at t2 of the bond: since its value at t4 is 100, the value at t3 and
t2 is obtained recursively backwards by use of the formula of theorem 3
in Ch. X, i.e., we take the average of the values in the next period and
discount by the interest rate given in the above tree:

t2 t3
84.794 91.119
88.254 92.960
91.856 94.838
96.754
The value of the option can now also be obtained by backward recursion:

t0 t1 t2
2.309 1.050 0
3.853 2.254
5.856
The value of the option is thus 2.309. It is also easy to price other more
exotic derivatives in this binomial tree model.

Comments
The model presented in this and the previous chapter is Ho-Lee’s
interest rate model. It was originally presented as a binomial model. It is
the simplest interest rate model, and it can be calibrated so as to fit the
current term structure perfectly. There are two features with this model
that many people feel unhappy with: (1) the short rate will eventually
far into the future take negative values with a probability that approaches
one half, and (2) there is no “mean reversion” which means that all shocks
to the short rate are permanent; they don’t wear off with time.

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XII: Ho-Lee’s Binomial Interest Rate Model

A modification of Ho-Lee’s model is Hull-White’s model, which is a

combination of Ho-Lee’s model and Vasicek’s model. In a time-discrete
version it looks like this:
√
rk = θk + σ Δt (β (k−2)Δt z1 + · · · + β Δt zk−2 + zk−1 ),

where 0 < β ≤ 1 is the mean-reverting factor. As you can see, the shock
z1 , for instance, wear off exponentially with time, since β (k−2)Δt → 0 as
k → ∞ if β < 1. The Ho-Lee model is the special case β = 1 (compare
with the first expression in Ch. XI.) In Hull-White’s model, the standard
σ
deviation of the short rate is always bounded by √ , so if β is small,
−2 ln β
the probability of negative interest rates can stay small.
This model can not be represented by a (recombining) binomial tree
(if β = 1,) but it can be implemented as a trinomial tree; see the book
by Hull1 . The difference between Ho-Lee’s and the Hull-White model is
solely on technicalities concerning the construction of the tree of interest
rates; the conceptual ideas are the same.

Exercises and Examples

Interest rates always refer to continuous compounding. Answers are
given in parenthesis; solutions to some problems are given in the next
section.

1. We have the following Ho-Lee binomial tree of the interest rate in %

per time-step:

period 0 1 2 3
3.0 3.3 3.5 3.8
2.9 3.1 3.4
2.7 3.0
2.6
The interest from period 0 to period 1 is hence 3.0%, and so on. An
interest rate security is in period 3 worth 400 r where r is the interest
(if r = 3.8% the value is $1’520, if r = 2.6 the value is $1’040 etc.)
a) Determine today’s futures price of the security to two decimal
places. ($1’280.00)
b) Determine today’s forward price of the security to two decimal
places. ($1’279.52)

1
John C. Hull: Options, Futures, & Other Derivatives; Prentice Hall.

75
XII: Ho-Lee’s Binomial Interest Rate Model

2. The following zero-coupon rates of interest holds: 1-year: 8%, 2-year:

8.25%, 3-year: 8.5%, 4-year: 8.75%. The volatility of the one-year
rate is assumed to be 1.5% during one year. Determine the price of a
European call option with maturity in two years on a (at maturity of
the option) zero coupon bond with face value 10’000 SEK (thus the
bond matures in four years time from the present.) The strike price
of the option is 8’000 SEK.

a) Use a binomial tree based on Ho-Lee’s model with a time interval

of one year. (302.05 SEK.)

b) Calculate the value using Black’s model. (293.24 SEK.)

3. Determine the price of a “callable bond” by use of a Ho-Lee tree.

A callable bond is a bond where the issuer have the option to buy
back the bond at certain points in time at predetermined prices (see
relevant chapter in Hull’s book.) The topical bond is a coupon paying
bond which pays $300 each half year and matures with face value
$10’000 (i.e., $10’300 is paid out including the coupon) after 2.5 years.
The issuer has the option to buy back the bond for $9’950 plus
the coupon dividend after 18 months.
Use the following Ho-Lee tree:

0-6 6-12 12-18 18-24 24-30 months

3.0 3.3 3.5 3.8 4.0
2.9 3.1 3.4 3.6
2.7 3.0 3.2
2.6 2.8
2.4

The numbers are the interest rate in percent per 6 months, i.e., per
time step in the tree. ($9’896.85)

Remark. This problem can also be solved “analytically” with Black’s

model. Note that the callable bond is equivalent to the corresponding
non-callable bond and a short position of a European call option on
the bond with maturity 18 months. See Ch. VI, “Black’s Model for
Bond Options”.

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XII: Ho-Lee’s Binomial Interest Rate Model

4. Calculate the value of a callable zero-coupon bond with maturity in

10 years and strike price price 100 SEK. The bond can be exercised
after 3 years at 70 SEK, after 6 years at 80 SEK and after 8 years at
90 SEK. The volatility of the one-year rate of interest is assumed to
be 1.5% during one year. The present zero coupon rates of interest
are (% per year with continuous compounding):

maturity interest maturity interest

1 year 4.0 6 year 5.0
2 year 4.2 7 year 5.2
3 year 4.4 8 year 5.4
4 year 4.6 9 year 5.6
5 year 4.8 10 year 5.8

Use a binomial tree with a time interval of one year. (53.1950)

5. Calculate the futures price of a ten-year zero-coupon bond with face

value 100 and maturity in six years. The volatility of the one year
rate of interest is assumed to be 1.5% during one year, and the zero-
coupon rate of interest is the same as in the previous question.

a) Use a binomial tree with time interval of one year based on Ho-
Lee’s model. (74.5689)

b) Do the calculation analytically using the continuous time Ho-Lee

model (see the last formula in section “Forward and Futures on a
Zero Coupon Bond” in Ch. XI.) (74.3639)

Solutions
1. Here is first the tree of interest rates:

The futures prices of the security is calculated simply as the average

0.5(number above + number above-right), since the futures prices are
a Martingale under the futures measure; see Ch. VII:

The futures price is thus $1’280.

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XII: Ho-Lee’s Binomial Interest Rate Model

In order to calculate the forward price G0 , we first calculate the

present price P0 . This is done with discounting; the values in a row
is 0.5(number above + number above-right) × discount;

The present price is thus $1167.07. In order to calculate the forward

−1
price G0 = Z30 we need the zero coupon price Z30 . But Z30 = P030 [1]:

We have thus G0 = $1’167.07/0.912114 = $1’279.52. The difference

is small but in accordance with theory; the security is positively cor-
related with the interest rate, so the futures price is higher than the
forward price.

2a. The interest rate tree:

The
 value of the bond is calculated backwards in time:
0.5(number above + number above-right) × discount where we get
the discounting rate from the above tree:

The value of the option is calculated in the same way:

The option price is thus 302.05 SEK.

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XII: Ho-Lee’s Binomial Interest Rate Model

b. This is an ordinary call option where the forward price of the under-
lying asset is 8’311.04 SEK and the volatility is 0.015 · 2 = 0.03. The
factor 2 is the forward duration (time to maturity of the underlying
bond when the option is exercised.)

3. Here is the interest rate tree, now with time going from bottom to
top:

The values of the bond can be arranged in various ways in a tree.

Here I have written the values with the dividend excluded in each
period.

After 30 months, the value is $10’000 plus dividend. In each subse-

quent
 row, the value, net of dividend, is 
0.5(number above + number above-right) + 300 × discount,
except in two places after 18 months (boldface) where the bond is
retracted.

79