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Lecture - 2 - Basic Conc

The document discusses key concepts in financial derivatives including asset valuation, arbitrage, no-arbitrage pricing, risk-neutral pricing, equivalent measures, and state price techniques. An example is provided to illustrate state price pricing and no-arbitrage option pricing.

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Kessellie T Mulbah
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13 views

Lecture - 2 - Basic Conc

The document discusses key concepts in financial derivatives including asset valuation, arbitrage, no-arbitrage pricing, risk-neutral pricing, equivalent measures, and state price techniques. An example is provided to illustrate state price pricing and no-arbitrage option pricing.

Uploaded by

Kessellie T Mulbah
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Financial Derivatives

Jie Zhu

Shanghai University

September 2022

Jie Zhu (SHU) Financial Derivatives 09/2022 1 / 12


Asset Valuation

How to correctly evaluate a certain asset is a key issue in …nance.


Absolute valuation:
1. The purpose for holding …nancial assets is to receive payo¤s in the
future.
2. If we can estimate all future cash ‡ows, and then discount these
cash ‡ows to present with an appropriate discount rate, the present
value should be the correct price.
T
E0 [CFi ]
P0 = ∑ (1 + R )t .
t =1

Relative valuation
1. First …nd the price for the underlying, or fundamental asset.
2. Then the price for the derivative with payo¤ depending on the
underlying asset should be determined accordingly, if the market is no
arbitrage.
Jie Zhu (SHU) Financial Derivatives 09/2022 2 / 12
Arbitrage
The formal de…nition for arbitrage
V0 = 0, (1)
P (V1 > 0) = 1, and P (V1 > 0) > 0
or
V0 < 0, (2)
P (V1 > 0) = 1.
where V0 is the portfolio’s value today, and V1 is the portfolio’s value
in the future.
Arbitrage basically says that you can get something for nothing. It
means that either
1. You don’t need to pay anything today, and will de…nitely have
some chance to get a positive payo¤ in the future (eq 1), or
2. You receive some positive payo¤ immediately, but will not pay
anything in the future (eq 2).
In an e¢ cient market, arbitrage will not last for long.
Jie Zhu (SHU) Financial Derivatives 09/2022 3 / 12
No-Arbitrage Pricing

No-arbitrage pricing is a fundamental pricing method for …nancial


derivatives
The basic idea is as follows:
1. Using the underlying asset and risk-free asset to construct a
portfolio.
2. The portfolio can replicate the payo¤ of the …nancial derivative to
be priced.
3. Since the portfolio and the …nancial derivative have the same
payo¤, they must have the same price.

Jie Zhu (SHU) Financial Derivatives 09/2022 4 / 12


Risk-Neutral Pricing

Recall the absolute pricing


T
E0 [CFt ]
P0 = ∑ (1 + R )t .
t =1

Here the future cash ‡ows and corresponding discount rate are
estimated in the real world (the P-measure)
We may estimate all cash ‡ows by assuming that they are generated
in a risk-neutral world (the Q-measure), and discount them with the
risk-free rate
T
E Q [CFt ]
P0 = ∑ 0 t
.
t =1 (1 + Rf )

Jie Zhu (SHU) Financial Derivatives 09/2022 5 / 12


Equivalent Measure

Consider the case of throwing a dice.


In this example, if we believe the dice is "fair", then we may de…ne
the following probability measure

P (1) = P (2) = ... = P (6) = 1/6.

Alternatively, if the dice is "unfair", then a possible probability


measure could be:

Q (1) = 1/12, Q (2) = ... = Q (5) = 1/6, and Q (6) = 1/4.

Two probability measure, P and Q are said to be equivalent if the


two measures assign probability zero to exactly the same events:
P (A) = 0 () Q (A) = 0.
In the above example, the two measures, P and Q, are equivalent
since P (∅) = 0 () Q (∅) = 0.
Jie Zhu (SHU) Financial Derivatives 09/2022 6 / 12
State Price

Let’s consider a special asset. This asset will give a payo¤ of 1 if a


certain state is realized, otherwise it will give a payo¤ of 0 in other
states.
The current price for this asset is called the state price.
Suppose that there are N states, and the state prices for N states are
given. Then if we know the payo¤ of a certain asset in each state, it
is possible to …nd its price today.
This is called state-price pricing technique.

Jie Zhu (SHU) Financial Derivatives 09/2022 7 / 12


Example

Assume the current price of a risky security A is P. We assume in one


year, the price will either increase to uP or decrease to dP, where
u > 1 and d < 1.
The probability for price increase (state 1) is q, and the probability for
price decrease (state 2) is 1 q.
Now let’s construct two basic asset. Asset 1 has a payo¤ of 1 if state
1 is realized, and a return of 0 if state 2 is realized. Asset 2 has a
payo¤ of 0 if state 1 is realized, and a return of 1 if state 2 is realized.
The current price for asset 1 is π u , and the current price for asset 2 is
πd .

Jie Zhu (SHU) Financial Derivatives 09/2022 8 / 12


Example
In order to replicate the payo¤ for security A, we just need to
purchase uP units of asset 1 and dP units of asset 2. If state 1 is
realized, such a portfolio will give a payo¤ of uP, and if state 2 is
realized, such a portfolio will give a payo¤ of dP. Due to the law of
one price, security A’s price must be equal to
P = uPπ u + dPπ d ,
or
uπ u + d π d = 1.
On the other hand, if we construct a portfolio of one unit of asset 1
and one unit of asset 2, then whatever state realizes, such a portfolio
will always give a payo¤ of 1.
Thus it is the riskfree asset, and must earn the riskfree rate.
1
πu + πd = .
1+r
Jie Zhu (SHU) Financial Derivatives 09/2022 9 / 12
Example

It is possible to …nd the solution for π u and π d .


As long as we can …nd such two assets, asset 1 and asset 2, then we
can use them to price any other securities.
State price is widely used in option pricing.

Jie Zhu (SHU) Financial Derivatives 09/2022 10 / 12


Exercise

Consider a one-period model with only two possible end-of-period


states. Three assets are traded in an arbitrage-free market. Asset 1 is
a risk-free asset with a price of 1 and an end-of-period payo¤ of R f ,
the risk-free gross rate of return, in either state. Asset 2 has a price
of S and o¤ers a payo¤ of uS in state 1 (good state) and dS in state
2 (bad state), where u > d.
1. Show that if the inequality d < R f < u does not hold, there will
be an arbitrage.
Asset 3 is a call option with payo¤ depending on asset 2. More
speci…cally, the payo¤ of asset 3 is Cu = max(uS K , 0) in state 1
and Cd = max(dS K , 0) in state 2, where max(a, b ) is a function
such that
a, if a > b
max(a, b ) = .
b, if a < b

Jie Zhu (SHU) Financial Derivatives 09/2022 11 / 12


Exercise

2. Show that a portfolio consisting of θ 1 units of asset 1 and θ 2 units of


asset 2, where

1 uCd dCu Cu Cd
θ 1 = (R f ) and θ 2 =
u d (u d )S
will generate the same payo¤ as asset 3.
3. Show that the no-arbitrage price of asset 3 is given by

C = (R f ) 1
[qCu + (1 q )Cd ].

Find the expression for q.

Jie Zhu (SHU) Financial Derivatives 09/2022 12 / 12

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