Intro to Mathematical Finance

Part I: Lecture 1
1.1: The one-period binomial model

Dr. Nestor Parolya

Delft University of Technology

Department of Applied Mathematics
Group of Statistics
[email protected]

07.09.2021
Organization of this course

Do it yourself: read the book and solve the exercises. No extra credits - no mandatory

homework - no bonuses. We are all adults here.

Pace: ca. 1 section per class

Exams: Midterm test and Final test (both on campus if covid-19 allows)
Use the net: Shreve’s text is standard. Solutions, blogs, discussions can be
found all over the internet
Some solutions: https://www.quantsummaries.com/shreve_stochcal4fin_1.pdf

https://www.quantsummaries.com/shreve_stochcal4fin_2.pdf

And I am sure that you can find many more. As always with the internet: read carefully
and beware of errors!

ZOOM link for lectures: https://tudelft.zoom.us/j/96446411891

Meeting-ID: 964 4641 1891
Password: 281377
Teaching assistants:
Lisa de Vries [email protected]
Tom Entes [email protected].
The picture that says it all

If you understand this picture fully, then you understand the course
Terminology and Parameters

S stands for stock value or asset price

S0 stands for time zero: NOW
S1 stands for time one: FUTURE
The future is not fixed. It is random. That is why S1 is a random variable.
H stands for Heads and T stands for Tails. To go from time ZERO to time
ONE we toss a coin. If it is H we go to S1 (H) and if it is T we go to S1 (T ).
Binomial

If we look deeper into the future, we will see S2 , S3 , S4 , .... Each time step
corresponds to a toss of the coin. For S5 there are 5 tosses, such as HHTHT
or HTTTH etc. All in all there are 32 different possible coin tosses.
Question: How many of these 32 tosses have 3 heads?
Binomial

If we look deeper into the future, we will see S2 , S3 , S4 , .... Each time step
corresponds to a toss of the coin. For S5 there are 5 tosses, such as HHTHT
or HTTTH etc. All in all there are 32 different possible coin tosses.
Question: How many of these 32 tosses have 3 heads?
5


The answer involves a binomial coefficient – namely 3
– and that is why
this model is called the binomial asset price model.
Binomial is derived from Latin and means: contains two names. There are no names,
there are only numbers. It would have been more accurate to say: binumeral.
Multiplication

On the stock exchange percentage matters!

An investor buys assets and sells them. The return on the investment
depends on the percentage of the change in asset price. That’s why on TV
you get to see percentages like: DJI went down by 0.4 percent or DAX went
up by 0.6 percent.
If an asset goes up by 0.6 percent, its value is multiplied by 1.006. If it goes
down by 0.4 percent, its value is multiplied by 0.996. Etc.
In our mathematical model, if we toss H then S0 is multiplied by a factor u for
up. If we toss T then it is multiplied by a factor d for down.
More multiplication

For your bank account, again percentage matters!

Question Suppose your bank account pays 5 percent interest per year. You deposit 1
euro and wait for a thousand years. How much money will you have then?

An 5 percent interest multiplies your bank account by 1.05. In our

mathematical model, bank accounts are multiplied by 1 + r for each time step.
Arbitrage

In our model:
0 < d < 1 + r < u.
.

Arbitrage: if 1 + r ≤ d there is an opportunity to make money from nothing.

Borrow an amount S0 and buy an asset. At the next time step, sell the asset
for S1 and use that to pay back your debt of (1 + r )S0 . If the toss came up H
then you have made money. If the toss came up T you have not lost any
money.
Model versus the real world

Our market is liquid . We can buy and sell assets instantly.

We do not have to pay fees for trading assets.

The interest rates for borrowing and lending are the same.

There is no difference between the ask price and the bid price of assets.
You will learn all about the real world in your course on principles of asset trading
European Call Options

Option: a choice between possibilities.

Call: to request attendance – buy.
European: does not really exist.
A European call option gives the holder the choice to buy an asset at a certain time for
a certain price. Such options do not exist in the real world. In the real world, options
are American. We will deal with them in Chapter 4.

It is difficult to compute the price of an option. It involves some sophisticated math.

That is why you are all here. You can understand the math, so you can compute the
price of financial products. That is why financial institutes want to hire you.
The picture that says it all revisited

Compute the price of a European Call Option, which expires at time 1 and
has a strike of 5. Interest rate is r = 0.25. Please show me the way to the bank with this interest rate.
Oh don’t ask why.

Let’s say that the price of the option is V .

The picture that says it all revisited

We have to compute V0 . Here is the key idea: V depends on S. At time 1 we

have
1
V1 = S1 − 1
2
So what do we have at time 0?
Computing back from the future

At time 1 we have
1
V1 = S1 − 1
2
That is why at time 0 we have
1 1
V0 = S0 −
2 1+r
Our interest rate is 0.25 and S0 = 4, which is why
4
V0 = 2 − = 1.20
5
If you go up and down in time for random numbers, change the index. If you go up and
down in time for ordinary numbers, discount the interest rate. I could stop right now. If
you understand this fully, you have mastered financial calculus.
Replicating Portfolio

Now we know that V0 = 1.20 how do we operate if we sell the option for that
price?
We buy half an asset for 2 euros. This means that we have to borrow 80
cents from the bank. So we hold half an asset minus eighty cents:

0.5S0 − 0.8

This is called a portfolio. Any combination of assets and money-in-the-bank

is called a portfolio.
We toss the coin and time moves on to the next step. Now our portfolio is

0.5S1 − 1

If the toss came up H then this is equal to V1 and if it came up T then it is

equal to V1 also.
General derivatives

Example 1.1 can be generalized for any V1 . For instance, if V1 (H) = 0 and
V1 (T ) = 3 then we have
1
V1 = − S1 + 4
2
and that is why at time 0 we have

V0 = −2 + 16/5 = 1.20

A product with such a V1 is a European put with strike 5 and expiry 1.

In general we have
V1 = −∆0 S1 + B0
for two constants ∆0 and B0 . We can solve that, build the portfolio, compute
its value at time zero.
Wealth

The value of a portfolio is called the wealth and is denoted by X .

The number of assets in a portfolio is called Delta.
Shreve has no symbol to denote the money-in-the-bank, so I called that B.
Since the portfolio replicates the derivative, the wealth X is equal to the value V . Not
only at time 1 but for all times: if you know that X1 is equal to V1 , then you can conclude
that X0 is equal to V0 . If not, there would be arbitrage. For instance, if X0 < V0 then
you buy X0 and you sell V0 . At time one you sell X1 and buy V1 . That is an arbitrage!

In this example you sell V0 without owning it: you short it. That is OK, because at
time one you buy it back for V1 .
Two equations two unknowns

The replicating portfolio gives 2 equations and 2 unknowns:

∆0 S1 (H) + (1 + r )B0 = V1 (H)

∆0 S1 (T ) + (1 + r )B0 = V1 (T )
Subtract the equations so B0 drops out and ∆0 remains. That is how we get
Equation 1.9:

If you know ∆0 then you know B0 , and then you know the wealth X0 , which is
equal to the option price V0 .
Risk neutral valuation

S1 depends on the toss of a coin. But what kind of coin? Is it a fair coin, is it
biased? We have not used probabilities at all.
There is a neat formula for V0 :

where
1+r −d u−1−r
p̃ = , q̃ =
u−d u−d
Observe that p̃ + q̃ = 1. We can think of these numbers as probabilities! We
say that they are risk-neutral probabilities. Equation 1.10 is called the
risk-neutral pricing formula of the option.
What do you learn in 1.1?

1. The binomial model for assets

2. This model is arbitrage free
3. Options are derivatives: derived from assets
4. Derivatives can be replicated by portfolios
5. Derivatives can be priced by the risk-neutral formula
In fact, this is more or less all that you will learn in this course. The rest is just
an elaboration to go from 1 step to many steps.
Homework

Solve exercises 1.1, 1.2, 1.3