Pricing Options with Mathematical Models

8. Model independent pricing

relations: forwards, futures and swaps

Some of the content of these slides is based on material from the

book Introduction to the Economics and Mathematics of Financial
Markets by Jaksa Cvitanic and Fernando Zapatero.
 Pricing forward contracts
• Consider a forward contract on asset S, starting at 𝑡𝑡,
with payoff at 𝑇𝑇equal to
S(T) – F(t)
• Here, F(t) is the forward price, decided at 𝑡𝑡 and paid at
𝑇𝑇.
• QUESTION: What is the value of F(t) that makes time
𝑡𝑡 value of the contract equal to zero?
• Suppose $1.00 invested/borrowed at risk-free rate at
time t results in payoff $B(t,T) at time 𝑇𝑇.
• CLAIM: There is no arbitrage if and only if

𝐹𝐹 𝑡𝑡 = 𝐵𝐵 𝑡𝑡, 𝑇𝑇 𝑆𝑆 𝑡𝑡 ,
that is, if the forward price is equal to the time 𝑇𝑇 value of one
share worth invested at the risk-free rate at time 𝑡𝑡.
• Suppose first 𝐹𝐹 𝑡𝑡 > 𝐵𝐵 𝑡𝑡, 𝑇𝑇 𝑆𝑆 𝑡𝑡 :
- At t: borrow S(t) to buy one share, and go short in the
forward contract;
- At T: deliver the share, receive 𝐹𝐹 𝑡𝑡 , which is more than
enough to cover the debt of 𝐵𝐵 𝑡𝑡, 𝑇𝑇 𝑆𝑆 𝑡𝑡 . Arbitrage!

• Suppose now 𝐹𝐹 𝑡𝑡 < 𝐵𝐵 𝑡𝑡, 𝑇𝑇 𝑆𝑆 𝑡𝑡 :

- At t: sell short one share, invest S(t) risk-free, long the
forward contract.
- At T: have more than enough in savings to pay for 𝐹𝐹 𝑡𝑡 for
one share and close the short position.
• Suppose S pays deterministic dividends between 𝑡𝑡 and 𝑇𝑇,
with present value 𝐷𝐷 𝑡𝑡 . Then,
𝐹𝐹 t = B t, T (S t − D t ) .
• Suppose dividends will be paid between 𝑡𝑡 and 𝑇𝑇,
continuously at a constant rate 𝑞𝑞. Then,
𝐹𝐹 t = B t, T 𝑒𝑒 −𝑞𝑞 𝑇𝑇−𝑡𝑡 S t .
 EXAMPLE: S(t)=100, a dividend of 5.65 is paid in 6 months. The 1-
year continuous interest rate is 10%, and the 6-month continuous
annualized rate is 7.41%.The price of the 1-year forward contract
should be
𝐹𝐹 t = 𝑒𝑒 0.1 (100 - 𝑒𝑒 −0.0741/2 � 5.65) = 104.5
Suppose that the price is instead 𝐹𝐹 t = 104.
- At 𝑡𝑡: long the forward, sell one share, buy the 6-month bond in
the amount of 𝑒𝑒 −0.0741/2 � 5.65 = 5.4445; invest the remaining
balance, 100-5.4445=94.5555, in the 1-year bond.
- At 6 months from 𝑡𝑡 : receive 5.65 from the 6-month bond and
pay the dividend of 5.65.
- At 1 year from 𝑡𝑡 : receive 𝑒𝑒 0.1 ∙94.5555 = 104.5 from the 1-year
bond; pay 𝐹𝐹 t = 104 for one share, and deliver the share to cover
the short position; keep 104.5-104 = 0.5, as profit. Arbitrage!
 EXAMPLE: Forward contract on foreign currency. Let S(t)
denote the current price in dollars of one unit of the foreign
currency. We denote by 𝑟𝑟𝑓𝑓 (𝑟𝑟) the foreign (domestic) risk-
free rate, with continuous compounding. The foreign interest
is equivalent to continuously paid dividends, so we guess that
𝐹𝐹 t = 𝑒𝑒 (𝑟𝑟− 𝑟𝑟𝑓𝑓 ) 𝑇𝑇−𝑡𝑡 S t .
If, for example, 𝐹𝐹 t < 𝑒𝑒 (𝑟𝑟− 𝑟𝑟𝑓𝑓 ) 𝑇𝑇−𝑡𝑡 S t :
- At time 𝑡𝑡: long the forward, borrow 𝑒𝑒 − 𝑟𝑟𝑓𝑓 𝑇𝑇−𝑡𝑡 units of
foreign currency and invest its value in dollars 𝑒𝑒 − 𝑟𝑟𝑓𝑓 𝑇𝑇−𝑡𝑡 S t
at rate 𝑟𝑟.
- At time T: use part of the amount 𝑒𝑒 (𝑟𝑟− 𝑟𝑟𝑓𝑓 ) 𝑇𝑇−𝑡𝑡 S t > 𝐹𝐹(𝑡𝑡)
from the domestic risk-free investment to pay 𝐹𝐹(𝑡𝑡) for one
unit of foreign currency in the forward contract, and deliver
that unit to cover the foreign debt. There is still extra money
left. Arbitrage! Similarly if 𝑒𝑒 (𝑟𝑟− 𝑟𝑟𝑓𝑓 ) 𝑇𝑇−𝑡𝑡 S t < 𝐹𝐹(𝑡𝑡).
 Futures
• Main difference relative to forwards: marked to market daily.
• The daily profit/loss is deposited to/taken out of the margin
account:
Total profit/loss for a contract starting at t, ignoring the margin
interest rate, using F(T)=S(T),
= [F(t+1)-F(t)] + … + [F(T)-F(T-1)] = S(T)-F(t)
• CLAIM: If the interest rate is deterministic, futures price F(t) is
equal to the corresponding forward price.
• REPLICATION: At t=0, go long 𝑒𝑒 −𝑟𝑟 𝑇𝑇−1 futures; at t=1,
increase to 𝑒𝑒 −𝑟𝑟 𝑇𝑇−2 futures, …, at t=T-1, increase to 1 future
contract.
Profit/loss in period (k,k+1) = [𝐹𝐹 𝑘𝑘 + 1 − 𝐹𝐹 𝑘𝑘 ]𝑒𝑒 −𝑟𝑟 𝑇𝑇−(𝑘𝑘+1) ,
the time T value of which is= [𝐹𝐹 𝑘𝑘 + 1 − 𝐹𝐹 𝑘𝑘 ] . Thus, time T
profit/loss is S(T)-F(0), the same as for a forward contract.
Swaps pricing
Swaps pricing (continued)
Swaps pricing (continued)
Example
Example (continued)
Example (continued)
 Pricing Options with Mathematical Models

9. Model independent pricing

relations: options

Some of the content of these slides is based on material from the

book Introduction to the Economics and Mathematics of Financial
Markets by Jaksa Cvitanic and Fernando Zapatero.
• Notation:
- European call and put prices at time t, 𝑐𝑐 𝑡𝑡 , 𝑝𝑝 𝑡𝑡
- American call and put prices at time t, C 𝑡𝑡 , 𝑃𝑃 𝑡𝑡

• RELATION 1: 𝑐𝑐 𝑡𝑡 ≤ 𝐶𝐶 𝑡𝑡 ≤ 𝑆𝑆 𝑡𝑡
• RELATION 2: p 𝑡𝑡 ≤ 𝑃𝑃 𝑡𝑡 ≤ 𝐾𝐾
• RELATION 3: p 𝑡𝑡 ≤ 𝐾𝐾𝑒𝑒 −𝑟𝑟 𝑇𝑇−𝑡𝑡
• RELATION 4: 𝑐𝑐 𝑡𝑡 ≥ 𝑆𝑆 𝑡𝑡 − 𝐾𝐾𝐾𝐾 −𝑟𝑟 𝑇𝑇−𝑡𝑡 , if 𝑆𝑆 pays no dividends
- Suppose not: 𝑐𝑐 𝑡𝑡 + 𝐾𝐾𝐾𝐾 −𝑟𝑟 𝑇𝑇−𝑡𝑡 < 𝑆𝑆 𝑡𝑡 ; sell short one share and have
more than enough money to buy one call and invest 𝐾𝐾𝐾𝐾 −𝑟𝑟 𝑇𝑇−𝑡𝑡 at rate
𝑟𝑟.
At T: If 𝑆𝑆 𝑇𝑇 > 𝐾𝐾, exercise the option by buying S(T) for K;
If 𝑆𝑆 𝑇𝑇 ≤ 𝐾𝐾, buy stock from your invested cash.
• RELATION 5: 𝑝𝑝 𝑡𝑡 ≥ 𝐾𝐾𝐾𝐾 −𝑟𝑟 𝑇𝑇−𝑡𝑡 − 𝑆𝑆(𝑡𝑡)
• RELATION 6: 𝑐𝑐 𝑡𝑡 = 𝐶𝐶 𝑡𝑡 , if 𝑆𝑆 pays no dividends.

- Suppose not: 𝑐𝑐 𝑡𝑡 < 𝐶𝐶 𝑡𝑡

1. At t : Sell 𝐶𝐶 𝑡𝑡 and have more than enough to buy c 𝑡𝑡 ;
2. If 𝐶𝐶 exercised at τ : have to pay 𝑆𝑆(τ) − 𝐾𝐾, which is possible by
selling 𝑐𝑐, because 𝑐𝑐 𝑡𝑡 ≥ 𝑆𝑆 𝑡𝑡 − 𝐾𝐾𝐾𝐾 −𝑟𝑟 𝑇𝑇−𝑡𝑡 ≥ 𝑆𝑆 𝑡𝑡 − 𝐾𝐾 ;
3. If 𝐶𝐶 never exercised, there is no obligation to cover.
Arbitrage!
• COROLLARY: An American call on an asset that pays no dividends
should not be exercised early.
- Indeed, it is better to sell it than to exercise it: 𝐶𝐶 𝑡𝑡 ≥ 𝑆𝑆 𝑡𝑡 − 𝐾𝐾 .
• What if there are dividends?
• What about the American put option?
• RELATION 7, Put-Call Parity:
𝑐𝑐 𝑡𝑡 + 𝐾𝐾𝐾𝐾 −𝑟𝑟 𝑇𝑇−𝑡𝑡 = 𝑝𝑝 𝑡𝑡 + 𝑆𝑆(𝑡𝑡)
1. Portfolio A: buy c 𝑡𝑡 and invest discounted 𝐾𝐾 at risk-free rate;
2. Portfolio B: buy put and one share.
- If 𝑆𝑆 𝑇𝑇 > 𝐾𝐾, both portfolios worth 𝑆𝑆(𝑇𝑇) at time 𝑇𝑇.
- If 𝑆𝑆 𝑇𝑇 ≤ 𝐾𝐾, both portfolios worth 𝐾𝐾 at time 𝑇𝑇.
• RELATION 8:
S t − K ≤ 𝐶𝐶 𝑡𝑡 − 𝑃𝑃 𝑡𝑡 ≤ 𝑆𝑆(𝑡𝑡) −𝐾𝐾𝐾𝐾 −𝑟𝑟 𝑇𝑇−𝑡𝑡
- The RH side follows from put-call parity and 𝑃𝑃 𝑡𝑡 ≥ 𝑝𝑝 𝑡𝑡 , 𝐶𝐶 𝑡𝑡 = 𝑐𝑐 𝑡𝑡 .
- For the LHS, suppose not: S t + P t > 𝐶𝐶 𝑡𝑡 + 𝐾𝐾.
1. At t : Sell the LHS and have more than enough to buy the RHS;
2. If 𝑃𝑃 exercised at τ : use the invested cash to pay 𝐾𝐾 for 𝑆𝑆(τ);
3. If 𝑃𝑃 never exercised, exercise 𝐶𝐶 at maturity.