MATH5320: Discrete Time Finance

Lecture 6

G. Aivaliotis, c University of Leeds

March 2021

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 In the last lecture

In the last lecture

• Extend the notions from single period model to multi-period
model
• Replicating on a two-period tree
• Conditional Expectation

In this lecture
• Risk neutral measures: Video 2
• Risk-neutral pricing in multi-period models: Video 3
• The binomial asset pricing model: Videos 4 and 5
• Classification of options: Video 6

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 Risk neutral probability measure

A measure Q on Ω is called a risk neutral probability measure if

1 Q(ω) > 0 for all ω ∈ Ω
2 EQ (∆Ŝti |Ft−1 ) = 0 for i = 1, .., n and for all 1 ≤ t ≤ T .

Another way of formulating the second condition is:

1
 
EQ S i Ft = Sti , 0 ≤ t ≤ T − 1.
1 + r t+1

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 Financial market

3
4
4 S2 = 12 ω1

;
S1 = 8 1
4
2
5 *
S2 = 6 ω2

S0 = 5

3
5
2
7
4 S2 = 6 ω3

#
S1 = 4 5
7

*
S2 = 3 ω4

B0 = 1 / B1 = 1 + 14 / B2 = (1 + 14 )2

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 Proposition

If φ is an adapted and self-financing trading strategy and Q is a

risk-neutral measure, then

V̂s (φ) = EQ (V̂t (φ)|Fs ).

In particular,
 V (φ) 
T
Vt (φ) = Bt EQ Ft , t = 0, 1, . . . , T.
BT

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 Single period models made useful

If there is only one risky asset in the multi period market model
then:
• There are no arbitrages if and only if all the constituent single
period models are arbitrage-free.
• All risk neural measures can be computed by considering
constituent single period market models.
• Single period market models give conditional probabilities for
risk neutral measures.

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 Fundamental Theorem of Asset Pricing

There are no arbitrages in the set T of adapted and

self-financing trading strategies.

if and only if

There exists a risk neutral probability measure.

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 Financial market

3
4
6 S2 = 9 ω1

=
S1 = 8 1
4
2
5
(
S2 = 6 ω2

S0 = 5

3
5
2
7
6 S2 = 6 ω3

!
S1 = 4 5
7
(
S2 = 3 ω4

B0 = 1 / B1 = 1 / B2 = 1

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 Proposition

If φ is an adapted and self-financing trading strategy and Q is a

risk-neutral measure, then

V̂s (φ) = EQ (V̂t (φ)|Fs ).

In particular,
 V (φ) 
T
Vt (φ) = Bt EQ Ft , t = 0, 1, . . . , T.
BT

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 Price process of a Contingent Claim

If X is an attainable contingent claim at time T , its price at time t

equals to
X 
Xt = Bt EQ Ft , t = 0, 1, . . . , T.
BT
Or, Xt = Vt (φ∗ ), i.e. the price of the hedging strategy at time t.

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 Cardinality of M

There are only three possibilities:

• M = ∅ if and only if there is an arbitrage.
• M has one element if and only if the model is arbitrage free
and complete.
• M is infinite if and only if the model is arbitrage free but
incomplete.
The set M cannot consist of more than one element and be finite.

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 Price process of a Contingent Claim

Let X be a contingent claim at time T (possibly unattainable). Its

price at time t equals to
X 
Xt = Bt EQ Ft , t = 0, 1, . . . , T.
BT
Notice that for complete markets we have a unique risk-neutral
measure and we always get a unique price.

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 Two-period binomial model

S5 2 = S0 u2 ω1
p

S1 > = S0 u
1−p
p )
S2 = S0 ud ω2

S0
1−p
S5 2 = S0 du ω3
p

S1 = S0 d
1−p
)
S2 = S0 d2 ω4

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 Parameters and properties

Parameters: u, d, r, S0 , p.

Theorem. The model is arbitrage free if and only if

u > 1 + r > d.

Theorem. If the model is arbitrage free, then it is complete.

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 Pricing of options

S5 2 = S0 u2 ···
p

S1 > = S0 u
1−p
p )
S2 = S0 ud ···

S0
1−p
S5 2 = S0 du ···
p

S1 = S0 d
1−p
)
S2 = S0 d2 ···

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 Recombination of the binomial tree
5
5 S0 u 4

5 S0 u3 6(
)
6 S0 u2 5 S0 u3 d
)
6 S0 u 5 S0 u2 d 6(
( )
S0 6 S0 ud
5 S0 u2 d2
( )
S0 d 5 S0 ud2 6(
( )
S0 d2 5 S0 ud3
) (6
S0 d3
)
S0 d4
)
Recombining tree can only be used to price path independent options!!!!!
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 Is recombining tree better?

Speed = how many single period models have to be

solved

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 Options

• Call option: (ST − K)+

• Put option: (K − ST )+
• Binary call option: 1ST ≥K
• Binary put option: 1ST ≤K

Options as building blocks:

• Bull spread
• Butterfly spread
• straddle

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 Asian options

An Asian call option is in a way a European call option on the

average stock price. There are two kinds which are mainly traded
(put options are analogous):
• arithmetic average option:

T
!+
1X
X= St − K
T t=1

• geometric average option:

 +
T
! T1
 Y
X= St − K

t=1

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 Barrier options

Barrier options are options which are activated or deactivated if

the stock price hits a certain barrier. As an example we consider so
called "knock out" barrier options:
• Down and Out call:

X = (ST − K1 )+ · 1{min0<t≤T St >K2 }

• Down and In call:

X = (ST − K1 )+ · 1{min0<t≤T St ≤K2 }

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 Lookback options

A look back option is an option on a maximum or a minimum of

the stock price on the interval [0, T ].
• Call option on maximum:
 +
X= max St − K
0<t≤T

• Call option on minimum:

 +
X= min St − K
0<t≤T

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 American options

American options can be exercised at any moment in [0, T ] and

their payoff is specified for each of the exercise moments.
• American call option:

payoff at t: (St − K)+

• American put option:

payoff at t: (K − St )+

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 Classification

• European options - we know how to price them.

• path independent - the payoff depends only on ST
• path dependent
• American options - more difficult to price.

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