MATH5320: Discrete Time Finance

Lecture 5

G. Aivaliotis, c University of Leeds

February, 2021

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 In the last lecture

• Introduction to Multi-Period Models

• σ−algebras and information

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• Extend the notions from single period model to multi-period
model: Videos 2 and 3
• Arbitrage in multi-period models: Video 3
• Replicating on a two-period tree: Video 4
• Complete models and conditional probabilities: Video 5
• Conditional Expectation: Video 6

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 Market model

1 Time t = 0, 1, 2, . . . , T .
2 A probability space (Ω, P) with the filtration (Ft )t=0,...,T .
3 A money market account (Bt ), which evolves according to
Bt = (1 + r)t B0 , B0 = 1.
4 A collection of n financial assets whose prices are given by
stochastic processes

(St1 ), ..., (Stn )

t=0,...,T
,

which are assumed to be (Ft )-adapted.

Filtration is usually assumed to be generated by the asset prices.

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 Trading strategy
A trading strategy is a stochastic process (φt )0≤t≤T with values in
Rn+1 :
φt = (φ0t , φ1t , . . . , φnt ).

A trading strategy φ is (Ft )-adapted, if the stochastic process

(φt )0≤t≤T is adapted to the filtration (Ft )0≤t≤T .

A trading strategy φ = (φt )0≤t≤T is called self-financing, if for all

t = 0, ..., T − 1

n
X n
X
φ0t Bt+1 + φit St+1
i
= φ0t+1 Bt+1 + φit+1 St+1
i
.
i=1 i=1

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 Good trading strategies

T = (Ft )-adapted and self-financing

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 Value process

The value process corresponding to the trading strategy

φ = (φt )0≤t≤T −1 is the stochastic process Vt (φ) 0≤t≤T , where

n
X
Vt (φ) = φ0t Bt + φit Sti , t = 0, . . . , T.
i=1

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 Increment process

The increment process (∆Sti )1≤t≤T corresponding to the i-th stock

is defined by

∆Sti := Sti − St−1

i
, t = 1, ..., T.

The increments of the money market account are given by

∆Bt = Bt − Bt−1 = (1 + r)t−1 r = Bt r, t = 1, . . . , T.

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 Gains process

Given a trading strategy φ, the corresponding gains process

(Gt (φ))0≤t≤T is given by G0 (φ) = 0 and

t−1
X n X
X t−1
Gt (φ) = φ0s ∆Bs+1 + φis ∆Ss+1
i
, t = 1, . . . , T.
s=0 i=1 s=0

Lemma. An adapted trading strategy φ = (φt )0≤t≤T is

self-financing, if and only if

Vt (φ) = V0 (φ) + Gt (φ), for all 0 ≤ t ≤ T.

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 Discounted...

Discounted prices:

Sti
Ŝti = .
Bt

Discounted gains (increments):

∆Ŝti = Ŝti − Ŝt−1

i
.

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 Discounted...

Discounted value process corresponding to a trading strategy

φ = (φt )0≤t≤T :

Vt (φ)
V̂t (φ) = .
Bt

Discounted gains process corresponding to a trading strategy

φ = (φt )0≤t≤T : Ĝ0 (φ) = 0,

n X
X t−1
Ĝt (φ) = φis ∆Ŝs+1
i
, t = 1, . . . , T .
i=1 s=0

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 Arbitrage

A trading strategy φ = (φt )0≤t≤T in a general multi period market

model is called an arbitrage if
1 V0 (φ) = 0
2 VT (φ) ≥ 0
3 E(VT (φ)) > 0

As in a single period market model condition 3. can be replaced

by:
3’. there exists ω ∈ Ω such that VT (φ)(ω) > 0.

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 Arbitrage (in discounted terms 1)

A trading strategy φ = (φt )0≤t≤T in a general multi period market

model is called an arbitrage if
1 V̂0 (φ) = 0
2 V̂T (φ) ≥ 0
3 E(V̂T (φ)) > 0

As in a single period market model condition 3. can be replaced

by:
3’. there exists ω ∈ Ω such that V̂T (φ)(ω) > 0.

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 Arbitrage (in discounted terms 2)

A trading strategy φ = (φt )0≤t≤T in a general multi period market

model is called an arbitrage if
1 V0 (φ) = 0
2 ĜT (φ) ≥ 0
3 E(ĜT (φ)) > 0

As in a single period market model condition 3. can be replaced

by:
3’. there exists ω ∈ Ω such that ĜT (φ)(ω) > 0.

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 Arbitrage - a weaker condition

Theorem. If there exists a trading strategy φ = (φt )0≤t≤T and

t∗ ≤ T such that
1 V0 (φ) = 0
2 Vt∗ (φ) ≥ 0
3 E(Vt∗ (φ)) > 0
then there exists an arbitrage in the market model.

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 Contingent claim

A contingent claim is an FT -measurable random variable X on Ω

representing a payoff at the terminal time T .

A hedging strategy for X is a trading strategy φ ∈ T s.t.

VT (φ) = X,

i.e. the terminal value of the trading strategy is equal to the payoff
of the contingent claim.

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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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 Complete market

A contingent claim X is called attainable in T , if there exists a

trading strategy φ ∈ T which replicates X, i.e. satisfies
VT (φ) = X.

A general multi period market model is called complete, if and only

if every contingent claim is attainable.

A model that is not complete is called incomplete.

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 Conditional probability

Let (Ω, P) be a probability space and let A, B ⊂ Ω be two events.

The conditional probability of B given A is defined as the number

P(B ∩ A)
P(B|A) = .
P(A)

Sn
Let A1 , . . . , An ⊂ Ω satisfy i=1 Ai = Ω and Ai ∩ Aj = ∅ if i 6= j.
Then n
X
P(B) = P(B|Ai ) P(Ai ).
i=1

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 Conditional probability on a tree

3
4
7
S2 = 12 ω1

@
S1 = 8
1
4
2
5
'
S2 = 6 ω2

S0 = 5

3
5
2
7
7 S2 = 6 ω3


S1 = 4
5
7

'
S2 = 3 ω4

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 Conditional expectation

Let (Ω, P) be a finite probability space, X a random variable and G

a σ-algebra of sets of Ω. Denoting the unique partition of G with
(Ai )i∈I the conditional expectation E(X|G) of X with respect to
G is defined as the random variable which satisfies

ω ∈ Ai .
P
E(X|G)(ω) = x x P(X = x|Ai ),

Here
P({X = x} ∩ Ai )
P(X = x|Ai ) =
P(Ai )
denotes the conditional probability of the event {ω|X(ω) = x}
given the event Ai .

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Conditional expectation on a tree

3
4
7
S2 = 12 ω1

@
S1 = 8
1
4
2
5
'
S2 = 6 ω2

S0 = 5

3
5
2
7
7 S2 = 6 ω3


S1 = 4
5
7

'
S2 = 3 ω4

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 Properties of conditional expectation

(Ω, P) – a probability space

σ-algebras G, G1 and G2 of subsets of Ω, and G2 ⊂ G1 .

1. If X : Ω → R is a random variable then

E (X|G) is a G-measurable random variable.

2. If X : Ω → R is a random variable then

E(X|G2 ) = E(E(X|G1 )|G2 )

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 Properties of conditional expectation 2

(Ω, P) – a probability space

σ-algebras G, G1 and G2 of subsets of Ω, and G2 ⊂ G1 .

3. If Y : Ω → R is a G-measurable random variable, then

E(Y · X|G) = Y · E(X|G).

4. If G = {∅, Ω} is the trivial σ-algebra, then

E(X|G) = E(X)

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