Nicolas Privault

Notes on
Stochastic Finance

This version: May 3, 2024

https://personal.ntu.edu.sg/nprivault/indext.html
 Notes on Stochastic Finance

Preface

This book is an introduction to a wide range of topics in financial math-

ematics, including Black-Scholes pricing, exotic and american options, term
structure modeling and change of numéraire, stochastic volatility, as well as
models with jumps. It presents the mathematics of pricing and hedging in
discrete and continuous-time financial models, with an emphasis on the com-
plementarity between analytical and probabilistic methods. The contents are
mostly mathematical, and also aim at making the reader aware of both the
power and limitations of mathematical models in finance, by taking into ac-
count their conditions of applicability. The text is targeted at the advanced
undergraduate and graduate levels in applied mathematics, financial engi-
neering, and economics.
The point of view adopted is that of mainstream mathematical finance,
in which the computation of fair prices is based on the absence of arbitrage
hypothesis, therefore excluding riskless profit based on arbitrage opportuni-
ties and basic (buying low/selling high) trading. Similarly, this document is
not concerned with any “prediction” of stock price behaviors that belong to
other domains such as technical analysis, which should not be confused with
the statistical modeling of asset prices.
The descriptions of the asset model, self-financing portfolios, arbitrage, and
market completeness, are first given in Chapter 1 in a simple two time-step
setting. These notions are then reformulated in discrete time in Chapter 2.
Here, the impossibility to access future information is formulated using the
notion of adapted processes, which will play a central role in the construction
of stochastic calculus in continuous time.
In order to trade efficiently, it would be useful to have a formula to esti-
mate the “fair price” of a given risky asset, helping for example to determine
whether the asset is undervalued or overvalued at a given time. Although
such a formula is not available, we can instead derive formulas for the pric-
ing of options that can act as insurance contracts to protect their holders
against adverse changes in the prices of risky assets. The pricing and hedging
of options in discrete time, particularly in the fundamental example of the
Cox-Ross-Rubinstein model, are considered in Chapter 3, with a description

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 N. Privault

of the passage from discrete to continuous time that prepares the transition
to the subsequent chapters.
A simplified presentation of Brownian motion, stochastic integrals, and the
associated Itô formula, is given in Chapter 4, with application to stochastic
asset price modeling in Chapter 5. The Black-Scholes model is presented from
the angle of partial differential equation (PDE) methods in Chapter 6, with
the derivation of the Black-Scholes formula by transforming the Black-Scholes
PDE into the standard heat equation, which is then solved by a heat kernel
argument. The martingale approach to pricing and hedging is then presented
in Chapter 7, and complements the PDE approach of Chapter 6 by recover-
ing the Black-Scholes formula via a probabilistic argument. An introduction
to stochastic volatility is given in Chapter 8, followed by a presentation of
volatility estimation tools including historical, local, and implied volatilities,
in Chapter 9. This chapter also contains a comparison of the prices obtained
by the Black-Scholes formula with actual option price market data.
Exotic options such as barrier, lookback, and Asian options are treated
in Chapters 11, 12, and 13, respectively, following an introduction to the
properties of the maximum of Brownian motion given in Chapter 10. Optimal
stopping and exercise, with application to the pricing of American options, are
considered in Chapter 15, following the presentation of background material
on filtrations and stopping times in Chapter 14. The construction of forward
measures by change of numéraire is given in Chapter 16 and is applied to
the pricing of interest rate derivatives such as caplets, caps, and swaptions
in Chapter 19, after an introduction to bond pricing and to the modeling of
forward rates in Chapters 17, and 18.
Stochastic calculus with jumps is dealt with in Chapter 20 and is re-
stricted to compound Poisson processes, which only have a finite number of
jumps on any bounded interval. Those processes are used for option pricing
and hedging in jump models in Chapter 21, in which we mostly focus on
risk-minimizing strategies as markets with jumps are generally incomplete.
Chapter 22 contains an elementary introduction to finite difference meth-
ods for the numerical solution of PDEs and stochastic differential equations,
dealing with the explicit and implicit finite difference schemes for the heat
equations and the Black-Scholes PDE, as well as the Euler and Milshtein
schemes for SDEs. The text is completed with an appendix containing the
needed probabilistic background.
The material in this book has been used for teaching in the Masters of
Science in Financial Engineering at City University of Hong Kong and at the
Nanyang Technological University in Singapore. The author thanks Nicky van
Foreest, Jinlong Guo, Kazuhiro Kojima, Sijian Lin, Panwar Samay, Sandu
Ursu, and Ju-Yi Yen for corrections and improvements.
This text contains 277 exercises and 18 problems with complete solutions.
Clicking on an exercise number inside the solution section will send to the

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 Notes on Stochastic Finance

original problem text inside the file. Conversely, clicking on a problem number
sends the reader to the corresponding solution, however this feature should
not be misused. The cover graph represents the time evolution of the HSBC
stock price from January to September 2009, plotted on the price surface of
a European put option on that asset, expiring on October 05, 2009, see § 6.1.
This pdf file contains internal and external links, 29 tables and 381 fig-
ures, including 57 animated Figures 3.8, 3.10, 4.6, 4.7, 4.10, 4.11, 4.16, 5.5,
6.5, 10.1, 10.2, 10.3, 10.6, 11.11, 13.1, 12.1, 12.6, 12.14, 15.2, 17.16, 18.7,
18.10, 18.11, 18.18, 20.14, 20.16, 20.17, and S.18, 2 embedded videos in Fig-
ures 2 and 9.3, and 3 interacting 3D graphs in Figures 6.4, 6.11 and 11.1,
that may require using Acrobat Reader for viewing on the complete pdf file.
It also includes 30 Python codes e.g. on pages 75, 96, 100, 103, 145, 157, 236,
266, 363, 553 and 908, and 85 codes on pages 155, 157, 159, 163, 217, 213,
237, 239, 253, 245, 263, 266, 279, 363, 364, 379, 342, 421, 430, 652, 707, 731,
735, 749, 751, 825 and 828.

Nicolas Privault
May 2024

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Contents

Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

1 Assets, Portfolios, and Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . 21

1.1 Portfolio Allocation and Short Selling . . . . . . . . . . . . . . . . . . . . . 21
1.2 Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
1.3 Risk-Neutral Probability Measures . . . . . . . . . . . . . . . . . . . . . . . . 28
1.4 Hedging of Contingent Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
1.5 Market Completeness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
1.6 Example: Binary Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

2 Discrete-Time Market Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

2.1 Discrete-Time Compounding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
2.2 Arbitrage and Self-Financing Portfolios . . . . . . . . . . . . . . . . . . . . 56
2.3 Contingent Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
2.4 Martingales and Conditional Expectations . . . . . . . . . . . . . . . . . 66
2.5 Market Completeness and Risk-Neutral Measures . . . . . . . . . . . 72
2.6 The Cox-Ross-Rubinstein (CRR) Market Model . . . . . . . . . . . . 74
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

3 Pricing and Hedging in Discrete Time . . . . . . . . . . . . . . . . . . . . 89

3.1 Pricing Contingent Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
3.2 Pricing Vanilla Options in the CRR Model . . . . . . . . . . . . . . . . 95
3.3 Hedging Contingent Claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
3.4 Hedging Vanilla Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
3.5 Hedging Exotic Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
3.6 Convergence of the CRR Model . . . . . . . . . . . . . . . . . . . . . . . . . . 119
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126

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4 Brownian Motion and Stochastic Calculus . . . . . . . . . . . . . . . . 149

4.1 Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
4.2 Three Constructions of Brownian Motion . . . . . . . . . . . . . . . . . . 153
4.3 Wiener Stochastic Integral . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 158
4.4 Itô Stochastic Integral . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
4.5 Stochastic Calculus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 176
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 190

5 Continuous-Time Market Model . . . . . . . . . . . . . . . . . . . . . . . . . . 203

5.1 Asset Price Modeling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
5.2 Arbitrage and Risk-Neutral Measures . . . . . . . . . . . . . . . . . . . . . 205
5.3 Self-Financing Portfolio Strategies . . . . . . . . . . . . . . . . . . . . . . . . 207
5.4 Two-Asset Portfolio Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210
5.5 Geometric Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 216
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220

6 Black-Scholes Pricing and Hedging . . . . . . . . . . . . . . . . . . . . . . . 229

6.1 The Black-Scholes PDE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
6.2 European Call Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235
6.3 European Put Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 243
6.4 Market Terms and Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248
6.5 The Heat Equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
6.6 Solution of the Black-Scholes PDE . . . . . . . . . . . . . . . . . . . . . . . . 258
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261

7 Martingale Approach to Pricing and Hedging . . . . . . . . . . . . . 271

7.1 Martingale Property of the Itô Integral . . . . . . . . . . . . . . . . . . . . 271
7.2 Risk-Neutral Probability Measures . . . . . . . . . . . . . . . . . . . . . . . . 276
7.3 Change of Measure and the Girsanov Theorem . . . . . . . . . . . . . 280
7.4 Pricing by the Martingale Method . . . . . . . . . . . . . . . . . . . . . . . . 283
7.5 Hedging by the Martingale Method . . . . . . . . . . . . . . . . . . . . . . . 290
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297

8 Stochastic Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325

8.1 Stochastic Volatility Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325
8.2 Realized Variance Swaps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 329
8.3 Realized Variance Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334
8.4 European Options - PDE Method . . . . . . . . . . . . . . . . . . . . . . . . 343
8.5 Perturbation Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 349
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 354

9 Volatility Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359

9.1 Historical Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 359
9.2 Implied Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362
9.3 Local Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
9.4 The VIX® Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376

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 Notes on Stochastic Finance

Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 381

10 Maximum of Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . 387

10.1 Running Maximum of Brownian Motion . . . . . . . . . . . . . . . . . . . 387
10.2 The Reflection Principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 390
10.3 Maximum of Drifted Brownian Motion . . . . . . . . . . . . . . . . . . . . 394
10.4 Average of Geometric Brownian Extrema . . . . . . . . . . . . . . . . . . 405
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 413

11 Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417

11.1 Options on Extrema . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417
11.2 Knock-Out Barrier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422
11.3 Knock-In Barrier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 434
11.4 PDE Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437
11.5 Hedging Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 441
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 442

12 Lookback Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449

12.1 The Lookback Put Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449
12.2 PDE Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 452
12.3 The Lookback Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 458
12.4 Delta Hedging for Lookback Options . . . . . . . . . . . . . . . . . . . . . . 465
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 471

13 Asian Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 473

13.1 Bounds on Asian Option Prices . . . . . . . . . . . . . . . . . . . . . . . . . . 473
13.2 Hartman-Watson Distribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . 480
13.3 Laplace Transform Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 483
13.4 Moment Matching . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484
13.5 PDE Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 501

14 Optimal Stopping Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507

14.1 Filtrations and Information Flow . . . . . . . . . . . . . . . . . . . . . . . . . 507
14.2 Submartingales and Supermartingales . . . . . . . . . . . . . . . . . . . . . 508
14.3 Optimal Stopping Theorem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 512
14.4 Drifted Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525

15 American Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 529

15.1 Perpetual American Put Options . . . . . . . . . . . . . . . . . . . . . . . . . 529
15.2 PDE Method for Perpetual Put Options . . . . . . . . . . . . . . . . . . . 535
15.3 Perpetual American Call Options . . . . . . . . . . . . . . . . . . . . . . . . . 539
15.4 Finite Expiration American Options . . . . . . . . . . . . . . . . . . . . . . 544
15.5 PDE Method with Finite Expiration . . . . . . . . . . . . . . . . . . . . . . 548
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 552

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16 Change of Numéraire and Forward Measures . . . . . . . . . . . . . 565

16.1 Notion of Numéraire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 565
16.2 Change of Numéraire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 568
16.3 Foreign Exchange . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 578
16.4 Pricing Exchange Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 587
16.5 Hedging by Change of Numéraire . . . . . . . . . . . . . . . . . . . . . . . . . 589
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 593

17 Short Rates and Bond Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 601

17.1 Short-Term Mean-Reverting Models . . . . . . . . . . . . . . . . . . . . . . 601
17.2 Calibration of the Vasicek Model . . . . . . . . . . . . . . . . . . . . . . . . . 608
17.3 Zero-Coupon and Coupon Bonds . . . . . . . . . . . . . . . . . . . . . . . . . 613
17.4 Bond Pricing PDE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 618
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 633

18 Forward Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 645

18.1 Construction of Forward Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . 645
18.2 LIBOR and SOFR Swap Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . 657
18.3 The HJM Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 662
18.4 Yield Curve Modeling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 667
18.5 Two-Factor Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 672
18.6 The BGM Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 676
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 677

19 Pricing of Interest Rate Derivatives . . . . . . . . . . . . . . . . . . . . . . 685

19.1 Forward Measures and Tenor Structure . . . . . . . . . . . . . . . . . . . . 685
19.2 Bond Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 689
19.3 Caplet Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 691
19.4 Forward Swap Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 698
19.5 Swaption Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 699
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 709

20 Stochastic Calculus for Jump Processes . . . . . . . . . . . . . . . . . . . 725

20.1 The Poisson Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 725
20.2 Compound Poisson Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 734
20.3 Stochastic Integrals and Itô Formula with Jumps . . . . . . . . . . . 739
20.4 Stochastic Differential Equations with Jumps . . . . . . . . . . . . . . 752
20.5 Girsanov Theorem for Jump Processes . . . . . . . . . . . . . . . . . . . . 757
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 765

21 Pricing and Hedging in Jump Models . . . . . . . . . . . . . . . . . . . . . 771

21.1 Fitting the Distribution of Market Returns . . . . . . . . . . . . . . . . 771
21.2 Risk-Neutral Probability Measures . . . . . . . . . . . . . . . . . . . . . . . . 780
21.3 Pricing in Jump Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 781
21.4 Exponential Lévy Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 783
21.5 Black-Scholes PDE with Jumps . . . . . . . . . . . . . . . . . . . . . . . . . . 787

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21.6 Mean-Variance Hedging with Jumps . . . . . . . . . . . . . . . . . . . . . . 789

Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 793

22 Basic Numerical Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 797

22.1 Euler Discretization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 797
22.2 Milshtein Discretization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 798
22.3 Discretized Heat Equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 799
22.4 Discretized Black-Scholes PDE . . . . . . . . . . . . . . . . . . . . . . . . . . . 802
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 806

Appendix: Background on Probability Theory . . . . . . . . . . . . . . . . 807

A.1 Probability Sample Space and Events . . . . . . . . . . . . . . . . . . . . . 807
A.2 Probability Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 811
A.3 Conditional Probabilities and Independence . . . . . . . . . . . . . . . . 812
A.4 Random Variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 815
A.5 Probability Distributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 816
A.6 Expectation of Random Variables . . . . . . . . . . . . . . . . . . . . . . . . 824
A.7 Conditional Expectation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 836
Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 841

Exercise Solutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 845

Chapter 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 845
Chapter 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 855
Chapter 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 868
Chapter 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 909
Chapter 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 940
Chapter 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 957
Chapter 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 973
Chapter 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1027
Chapter 9 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1033
Chapter 10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1047
Chapter 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1064
Chapter 12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1087
Chapter 13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1097
Chapter 14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1110
Chapter 15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1119
Chapter 16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1147
Chapter 17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1159
Chapter 18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1180
Chapter 19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1193
Chapter 20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1217
Chapter 21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1230
Chapter 22 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1236
Background on Probability Theory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1237

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1241

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Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1257

Author index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1269

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List of Figures

1 Two sample paths of one-dimensional Brownian motion . . . . . . . . . . . . 2

2 “As if a whole new world was laid out before me.”∗ . . . . . . . . . . . . . . . . 3
3 Comparison of WTI vs. Keppel price graphs . . . . . . . . . . . . . . . . . . . . . 5
4 Hang Seng index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
5 Two put option scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
6 Payoff function of a put option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
7 Two call option scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
8 Payoff function of a call option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
9 “Infogrames” stock price curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
10 Brent and WTI price graphs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
11 Price map of a four-way collar option . . . . . . . . . . . . . . . . . . . . . . . . . . 12
12 Payoff function of a four-way call collar option . . . . . . . . . . . . . . . . . . . 12
13 Four-way call collar payoff as a combination of call and put options∗ . . 13
14 Implied probabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
15 Implied probabilities according to bookmakers . . . . . . . . . . . . . . . . . . . 18
16 Implied probabilities according to polling . . . . . . . . . . . . . . . . . . . . . . . 18
17 Fifty sample price paths used for the Monte Carlo method . . . . . . . . . . 19
18 Course plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

1.1 Triangular arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

1.2 Arbitrage: Xbox Retail prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
1.3 Separation of convex sets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

2.1 Illustration of the self-financing condition (2.7) . . . . . . . . . . . . . . . . . . . 59

2.2 Why apply discounting? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
2.3 Oil price graph . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
2.4 Take the quiz . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
2.5 Discrete-time asset price tree in the CRR model . . . . . . . . . . . . . . . . . . 76
2.6 Discrete-time asset price graphs in the CRR model . . . . . . . . . . . . . . . . 77
2.7 Function x 7→ ((1 + x)21 − (1 + x)10 )/x . . . . . . . . . . . . . . . . . . . . . . . . 80
2.8 Graph of the function r 7→ (1 − (1 + r )−12 )/r . . . . . . . . . . . . . . . . . . . . 82

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2.9 Transition probabilities in the recovery theorem . . . . . . . . . . . . . . . . . . 85

3.1 Graph of 120 = (10 7 ) paths with n = 5 and k = 2

∗
................ 97
3.2 Discrete-time call option pricing tree . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
3.3 Discrete-time call option hedging strategy (risky component) . . . . . . . . 105
3.4 Discrete-time call option hedging strategy (riskless component) . . . . . . . 105
3.5 Tree of asset prices in the CRR model . . . . . . . . . . . . . . . . . . . . . . . . . . 110
3.6 Tree of option prices in the CRR model . . . . . . . . . . . . . . . . . . . . . . . . 111
3.7 Tree of hedging portfolio allocations in the CRR model . . . . . . . . . . . . . 111
3.8 Galton board simulation∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
3.9 A real-life Galton board . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
3.10 Multiplicative Galton board simulation∗ . . . . . . . . . . . . . . . . . . . . . . . . 122
3.11 Put spread collar price map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
3.12 Call spread collar price map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
3.13 Tree of market prices with N = 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
3.14 Trees of bid and ask prices with N = 2 . . . . . . . . . . . . . . . . . . . . . . . . . 136
3.15 BTC/USD order book example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 138
3.16 Dividend detachment on Z74.SI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139

4.1 Sample paths of a one-dimensional Brownian motion . . . . . . . . . . . . . . . 150

4.2 Evolution of the fortune of a poker player vs. number of games played . 151
4.3 Web traffic ranking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
4.4 Two sample paths of a two-dimensional Brownian motion . . . . . . . . . . . 152
4.5 Sample path of a three-dimensional Brownian motion . . . . . . . . . . . . . . 153
4.6 Scaling property of Brownian motion∗ . . . . . . . . . . . . . . . . . . . . . . . . . . 153
4.7 Brownian motion as a random walk∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . 154
4.8 Statistics of one-dimensional Brownian paths vs. Gaussian distribution . 156
4.9 Statistics of S&P 500 yearly return graphs from 1950 to 2022 . . . . . . . . 157
4.10 Lévy’s construction of Brownian motion∗ . . . . . . . . . . . . . . . . . . . . . . . 157
4.11 Construction of Brownian motion by series expansions∗ . . . . . . . . . . . . 158
4.12 Step function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
4.13 Area under the step function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
4.14 Infinite vs. finite area under a curve . . . . . . . . . . . . . . . . . . . . . . . . . . . 161
4.15 Squared step function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 162
4.16 Step function approximation∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163
4.17 Adapted pair trading portfolio strategy . . . . . . . . . . . . . . . . . . . . . . . . . 169
4.18 Step function approximation of Brownian motion∗ . . . . . . . . . . . . . . . . 171
4.19 Squared simple predictable process . . . . . . . . . . . . . . . . . . . . . . . . . . . . 173
4.20 NGram Viewer output for the term "stochastic calculus" . . . . . . . . . . . . 176
4.21 Wrong application of Itô’s formula (sample) . . . . . . . . . . . . . . . . . . . . . 185
4.22 Simulated path of (4.33) with α = 10, σ = 0.2 and X0 = 0.5 . . . . . . . . . 187
4.23 Simulated path of (4.37) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
4.24 Simulated path of (4.38) with α = −5 and σ = 1 . . . . . . . . . . . . . . . . . 190

5.1 Why apply discounting? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204

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5.2 Illustration of the self-financing condition (5.4) . . . . . . . . . . . . . . . . . . . 208

5.3 Illustration of the self-financing condition (5.10) . . . . . . . . . . . . . . . . . . 211
5.4 Ten sample paths of geometric Brownian motion . . . . . . . . . . . . . . . . . . 214
5.5 Geometric Brownian motion started at S0 = 1∗ . . . . . . . . . . . . . . . . . . 217
5.6 Statistics of geometric Brownian paths vs. lognormal distribution . . . . . 221

6.1 Underlying market prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230

6.2 Simulated geometric Brownian motion . . . . . . . . . . . . . . . . . . . . . . . . . . 231
6.3 Graph of the Gaussian Cumulative Distribution Function (CDF) . . . . . 236
6.4 Black-Scholes call price map∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237
6.5 Time-dependent solution of the Black-Scholes PDE (call option)∗ . . . . . 238
6.6 Delta of a European call option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240
6.7 Gamma of European call and put options . . . . . . . . . . . . . . . . . . . . . . . 241
6.8 HSBC Holdings stock price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241
6.9 Path of the Black-Scholes price for a call option on HSBC . . . . . . . . . . 242
6.10 Time evolution of a hedging portfolio for a call option on HSBC . . . . . . 243
6.11 Black-Scholes put price function∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
6.12 Time-dependent solution of the Black-Scholes PDE (put option)∗ . . . . . 245
6.13 Delta of a European put option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
6.14 Path of the Black-Scholes price for a put option on HSBC . . . . . . . . . . 247
6.15 Time evolution of the hedging portfolio for a put option on HSBC . . . . 248
6.16 Time-dependent solutions of the Black-Scholes PDE with r > 0∗ . . . . . 249
6.17 Time-dependent solutions of the Black-Scholes PDE with r < 0∗ . . . . . 250
6.18 Time-dependent solutions of the Black-Scholes PDE with r = 0∗ . . . . . 250
6.19 Warrant terms and data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
6.20 Time-dependent solution of the heat equation∗ . . . . . . . . . . . . . . . . . . . 255
6.21 Time-dependent solution of the heat equation∗ . . . . . . . . . . . . . . . . . . . 257
6.22 Short rate t 7→ rt in the CIR model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
6.23 Option price as a function of the volatility σ . . . . . . . . . . . . . . . . . . . . . 265

7.1 Discretized drifted Brownian path . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 277

7.2 Drifted Brownian paths under a shifted Girsanov measure . . . . . . . . . . 279
7.3 Payoff functions of bull spread and bear spread options . . . . . . . . . . . . . 298
7.4 Graphs of call/put payoff functions . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
7.5 Long call butterfly payoff function . . . . . . . . . . . . . . . . . . . . . . . . . . . . 301
7.6 Option price as a function of underlying asset price and time to maturity 319
7.7 Delta as a function of underlying asset price and time to maturity . . . . 320
7.8 Gamma as a function of underlying asset price and time to maturity . . 320
7.9 Option price as a function of underlying asset price and time to maturity 321
7.10 Delta as a function of underlying asset price and time to maturity . . . . 322
7.11 Gamma as a function of underlying asset price and time to maturity . . 322

8.1 Euro / SGD exchange rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326

8.2 Fitting of a lognormal probability density function . . . . . . . . . . . . . . . . 335
8.3 Fitting of a gamma probability density function . . . . . . . . . . . . . . . . . . 340

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8.4 Variance call option prices with b = 0.15 . . . . . . . . . . . . . . . . . . . . . . . . 342

8.5 Variance call option prices with b = −0.05 . . . . . . . . . . . . . . . . . . . . . . . 342
8.6 Option price approximations plotted against v with ρ = −0.5 . . . . . . . . 354

9.1 Underlying asset price vs. log-returns . . . . . . . . . . . . . . . . . . . . . . . . . . 361

9.2 Historical volatility graph . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
9.3 The fugazi: it’s a wazy, it’s a woozie. It’s fairy dust∗ . . . . . . . . . . . . . . . 362
9.4 Option price as a function of the volatility σ . . . . . . . . . . . . . . . . . . . . . 363
9.5 Implied volatility of Asian options on light sweet crude oil futures . . . . 365
9.6 S&P500 option prices plotted against strike prices . . . . . . . . . . . . . . . . . 366
9.7 Market stock price of Cheung Kong Holdings . . . . . . . . . . . . . . . . . . . . 367
9.8 Comparison of market call option prices vs. calibrated Black-Scholes
prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 367
9.9 Market stock price of HSBC Holdings . . . . . . . . . . . . . . . . . . . . . . . . . . 368
9.10 Comparison of market call option prices vs. calibrated Black-Scholes
prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 368
9.11 Comparison of market put option prices vs. calibrated Black-Scholes
prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
9.12 Call option price vs. underlying asset price . . . . . . . . . . . . . . . . . . . . . . 369
9.13 Simulated path of (9.7) with r = 0.5 and σ = 1.2 . . . . . . . . . . . . . . . . . 370
9.14 Local volatility estimated from Boeing Co. option price data . . . . . . . . . 375
9.15 VIX® Index vs. S&P 500 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 380
9.16 VIX® Index vs. historical volatility for the year 2011 . . . . . . . . . . . . . . . 380
9.17 Correlation estimates between GSPC and the VIX® . . . . . . . . . . . . . . . 381
9.18 VIX® Index vs. 30 day historical volatility for the S&P 500 . . . . . . . . . . 381

10.1 Brownian motion (Wt )t∈R+ and its running maximum (X0t )t∈R+ ∗ . . . . 388
10.2 Running maximum of Brownian motion∗ . . . . . . . . . . . . . . . . . . . . . . . . 388
10.3 Zeroes of Brownian motion∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389
10.4 Graph of the Cantor function∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389
10.5 A function with no last point of increase before t = 1 . . . . . . . . . . . . . . 390
10.6 Reflected Brownian motion with a = 1.07∗ . . . . . . . . . . . . . . . . . . . . . . 391
10.7 Probability density of the maximum of Brownian motion . . . . . . . . . . . 392
10.8 Probability density of the maximum of geometric Brownian motion . . . 394
10.9 Probability computed as a volume integral . . . . . . . . . . . . . . . . . . . . . . 395
10.10 Reflected Brownian motion with a = 1.07∗ . . . . . . . . . . . . . . . . . . . . . . 396
10.11 Joint probability density of Brownian motion and its maximum . . . . . . 397
10.12 Heat map of the joint density of W1 and its maximum . . . . . . . . . . . . . 398
10.13 Probability density of the maximum of drifted Brownian motion . . . . . 401

11.1 Up-and-out barrier call option price with B > K ∗ . . . . . . . . . . . . . . . . . 424

11.2 Up-and-out barrier put option price . . . . . . . . . . . . . . . . . . . . . . . . . . . 429
11.3 Pricing data for an up-and-out barrier put option with K = B = $28 . . 430
11.4 Down-and-out barrier call option price . . . . . . . . . . . . . . . . . . . . . . . . . 431
11.5 Down-and-out barrier call option price as a function of volatility . . . . . . 432

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11.6 Down-and-out barrier put option price with K > B . . . . . . . . . . . . . . . 433

11.7 Down-and-in barrier call option price with K > B . . . . . . . . . . . . . . . . . 434
11.8 Up-and-in barrier call option price with K > B . . . . . . . . . . . . . . . . . . . 435
11.9 Down-and-in barrier put option price with K > B . . . . . . . . . . . . . . . . . 436
11.10 Up-and-in barrier put option price . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437
11.11 Delta of the up-and-out barrier call option∗ . . . . . . . . . . . . . . . . . . . . . 442

12.1 Lookback put option price (3D)∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450

12.2 Graph of lookback put option prices . . . . . . . . . . . . . . . . . . . . . . . . . . . 451
12.3 Graph of lookback put option prices (2D) . . . . . . . . . . . . . . . . . . . . . . . 451
12.4 Normalized lookback put option price . . . . . . . . . . . . . . . . . . . . . . . . . . 456
12.5 Normalized Black-Scholes put price and correction term . . . . . . . . . . . . 458
12.6 Lookback call option price∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 459
12.7 Graph of lookback call option prices . . . . . . . . . . . . . . . . . . . . . . . . . . . 459
12.8 Graphs of lookback call option prices (2D) . . . . . . . . . . . . . . . . . . . . . . 460
12.9 Normalized lookback call option price . . . . . . . . . . . . . . . . . . . . . . . . . 462
12.10 Underlying asset prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 462
12.11 Running minimum of the underlying asset price . . . . . . . . . . . . . . . . . . 463
12.12 Lookback call option price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463
12.13 Normalized Black-Scholes call price and correction term . . . . . . . . . . . . 465
12.14 Delta of the lookback call option∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . 467
12.15 Rescaled portfolio strategy for the lookback call option . . . . . . . . . . . . 468
12.16 Delta of the lookback put option∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . 470

13.1 Brownian motion and its moving average∗ . . . . . . . . . . . . . . . . . . . . . . . 474

13.2 Asian option price vs. European option price∗ . . . . . . . . . . . . . . . . . . . 478
13.3 Asian call option prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484
13.4 Lognormal approximation of probability density . . . . . . . . . . . . . . . . . . 486
13.5 Lognormal approximation to the Asian call option price . . . . . . . . . . . . 487
13.6 Dividend detachment graph on Z74.SI . . . . . . . . . . . . . . . . . . . . . . . . . . 506

14.1 Drifted Brownian path . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 509

14.2 Evolution of the fortune of a poker player vs. number of games played . 510
14.3 Convex function example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 510
14.4 Stopped process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 514
14.5 Sample paths of a gambling process (Mn )n∈N . . . . . . . . . . . . . . . . . . . 518
14.6 Brownian motion hitting a barrier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
14.7 Drifted Brownian motion hitting a barrier . . . . . . . . . . . . . . . . . . . . . . . 520
14.8 Hitting probabilities of drifted Brownian motion∗ . . . . . . . . . . . . . . . . 522

15.1 American put prices by exercising at τL for different values of L . . . . . . 533

15.2 Animated graph of American put prices x 7→ fL (x)∗ . . . . . . . . . . . . . . 534
15.3 Option price as a function of L and of the underlying asset price . . . . . 534
15.4 Path of the American put option price on the HSBC stock . . . . . . . . . . 535
15.5 American call prices by exercising at τL for different values of L . . . . . . 542
15.6 Animated graph of American call prices x 7→ fL (x)∗ . . . . . . . . . . . . . . 542

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15.7 American call prices for different values of L . . . . . . . . . . . . . . . . . . . . . 543

15.8 Black-Scholes call option price vs. (x, t) 7→ (x − K )+ . . . . . . . . . . . . . . . 545
15.9 Black-Scholes put option price vs. (x, t) 7→ (K − x)+ . . . . . . . . . . . . . . . 546
15.10 Optimal frontier for the exercise of a put option . . . . . . . . . . . . . . . . . . 547
15.11 PDE estimates of finite expiration American put option prices . . . . . . . 549
15.12 Longstaff-Schwartz estimates of finite expiration American put prices . 550
15.13 Comparison between Longstaff-Schwartz and finite differences . . . . . . . 550
15.14 Butterfly payoff function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 554

16.1 Why change of numéraire? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 567

16.2 Overseas investment opportunity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 578
16.3 Evolution of exchange rate vs. interest rate . . . . . . . . . . . . . . . . . . . . . . 581

17.1 Short rate t 7→ rt in the Vasicek model . . . . . . . . . . . . . . . . . . . . . . . . . 603

17.2 CBOE 10 Year Treasury Note (TNX) yield . . . . . . . . . . . . . . . . . . . . . . 605
17.3 Short rate t 7→ rt in the CIR model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 606
17.4 Calibrated Vasicek simulation vs. market data . . . . . . . . . . . . . . . . . . . . 613
17.5 Five-dollar 1875 Louisiana bond with 7.5% biannual coupons . . . . . . . . 613
17.6 Discrete-time coupon bond pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . . 616
17.7 Continuous-time coupon bond pricing . . . . . . . . . . . . . . . . . . . . . . . . . . 617
17.8 Comparison of Monte Carlo and PDE solutions . . . . . . . . . . . . . . . . . . . 624
17.9 Bond price t 7→ P (t, T ) vs. t 7→ e −r0 (T −t) . . . . . . . . . . . . . . . . . . . . . . 625
17.10 Bond price t 7→ Pc (t, T ) with a 5% coupon rate . . . . . . . . . . . . . . . . . . 625
17.11 Bond price with coupon rate 6.25% . . . . . . . . . . . . . . . . . . . . . . . . . . . 626
17.12 Orange Cnty Calif bond prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 627
17.13 Orange Cnty Calif bond yields . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 627
17.14Fitting of a gamma probability density function . . . . . . . . . . . . . . . . . . 631
17.15 Approximation of Dothan bond prices . . . . . . . . . . . . . . . . . . . . . . . . . 631
17.16 Brownian bridge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 633

18.1 Graph of the spot forward rate S 7→ f (t, t, S ) . . . . . . . . . . . . . . . . . . . . 646

18.2 Indonesian government securities yield curve . . . . . . . . . . . . . . . . . . . . 646
18.3 Example of yield curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 647
18.4 Forward rate process t 7→ f (t, t, T ) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 651
18.5 Instantaneous forward rate process t 7→ f (t, T ) . . . . . . . . . . . . . . . . . . . 652
18.6 Federal Reserve yield curves from 1982 to 2012 . . . . . . . . . . . . . . . . . . 653
18.7 European Central Bank yield curves∗ . . . . . . . . . . . . . . . . . . . . . . . . . 653
18.8 August 2019 Federal Reserve yield curve inversion∗ . . . . . . . . . . . . . . . 654
18.9 Stochastic process of forward curves . . . . . . . . . . . . . . . . . . . . . . . . . . . 662
18.10 Forward instantaneous curve in the Vasicek model∗ . . . . . . . . . . . . . . 666
18.11 Forward instantaneous curve x 7→ f (0, x) in the Vasicek model∗ . . . . . 666
18.12 Short-term interest rate curve t 7→ rt in the Vasicek model . . . . . . . . . 667
18.13 Nelson-Siegel graph . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 668
18.14 Svensson graph . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 668
18.15 Fitting of a Svensson curve to market data . . . . . . . . . . . . . . . . . . . . . 669

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18.16 Graphs of forward rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 670

18.17 Forward instantaneous curve in the Vasicek model . . . . . . . . . . . . . . . . 670
18.18 ECB data vs. fitted yield curve∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 672
18.19 Bond prices t 7→ P (t, T2 ), P (t, T2 ), P (t, T3 ) . . . . . . . . . . . . . . . . . . . . . 672
18.20 Forward rates in a two-factor model . . . . . . . . . . . . . . . . . . . . . . . . . . . 675
18.21 Evolution of instantaneous forward rates in a two-factor model . . . . . . 675
18.22 Roadmap of stochastic interest rate modeling . . . . . . . . . . . . . . . . . . . . 677

19.1 Implied swaption volatilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 705

20.1 Sample path of a counting process (Nt )t∈R+ . . . . . . . . . . . . . . . . . . . . . 726

20.2 Sample path of the Poisson process (Nt )t∈R+ . . . . . . . . . . . . . . . . . . . . 729
20.3 Sample path of the Poisson process (Nt )t∈R+ . . . . . . . . . . . . . . . . . . . . 732
20.4 Sample path of the compensated Poisson process (Nt − λt)t∈R+ . . . . . . 733
20.5 Probability density function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 734
20.6 Sample path of a compound Poisson process (Yt )t∈R+ . . . . . . . . . . . . . 735
20.7 Sample path of a compensated compound Poisson process . . . . . . . . . . . 739
20.8 Sample trajectories of a gamma process . . . . . . . . . . . . . . . . . . . . . . . . . 749
20.9 Sample trajectories of a variance gamma process . . . . . . . . . . . . . . . . . . 750
20.10 Sample trajectories of an inverse Gaussian process . . . . . . . . . . . . . . . . 750
20.11 Sample trajectories of a negative inverse Gaussian process . . . . . . . . . . 750
20.12 Sample trajectories of a stable process . . . . . . . . . . . . . . . . . . . . . . . . . 751
20.13 USD/CNY Exchange rate data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 751
20.14 Geometric Poisson process∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 754
20.15 Ranking data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 755
20.16 Geometric compound Poisson process∗ . . . . . . . . . . . . . . . . . . . . . . . . . 755
20.17 Geometric Brownian motion with compound Poisson jumps∗ . . . . . . . . 756
20.18 Share price with jumps . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 757

21.1 Market returns vs. normalized Gaussian returns . . . . . . . . . . . . . . . . . . 772

21.2 Empirical vs. Gaussian CDF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 773
21.3 Quantile-Quantile plot . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 773
21.4 Empirical density vs. normalized Gaussian density . . . . . . . . . . . . . . . . 774
21.5 Empirical density vs. normalized lognormal density . . . . . . . . . . . . . . . . 775
21.6 Empirical density vs. power density . . . . . . . . . . . . . . . . . . . . . . . . . . . . 775
21.7 Gram-Charlier expansions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 780

22.1 Divergence of the explicit finite difference method . . . . . . . . . . . . . . . . . 804

22.2 Stability of the implicit finite difference method . . . . . . . . . . . . . . . . . . 805

A.1 Probability density function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 817

A.2 Exponential CDF and PDF . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 819
A.3 Probability computed as a volume integral . . . . . . . . . . . . . . . . . . . . . . 820

S.1 Strike price as a function of risk-free rate . . . . . . . . . . . . . . . . . . . . . . . 855

S.2 Investment graph (1) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 856

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S.3 Investment graph (2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 857

S.4 Histogram of replies to Question c). . . . . . . . . . . . . . . . . . . . . . . . . . . . 860
S.5 Phone screenshots . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 861
S.6 Range forward contract payoff as a combination of call and put option
payoffs∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 876
S.7 Put spread collar price map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 882
S.8 Put spread collar payoff function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 882
S.9 Put spread collar payoff as a combination of call and put payoffs∗ . . . . . 883
S.10 Call spread collar price map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 883
S.11 Call spread collar payoff function . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 884
S.12 Call spread collar payoff as a combination of call and put payoffs∗ . . . . 884
S.13 Tree of market prices with N = 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 894
S.14 Put option prices in the trinomial model . . . . . . . . . . . . . . . . . . . . . . . . 908
S.15 Function x 7→ fε (x) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 927
S.16 Derivative x 7→ fε′ (x) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 928
S.17 Samples of linear interpolations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 931
S.18 Brownian crossings of level 1∗ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950
S.19 Brownian path . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 952
S.20 Risk-neutral pricing of a foreign exchange option . . . . . . . . . . . . . . . . . . 952
S.21 Delta hedging of a foreign exchange option . . . . . . . . . . . . . . . . . . . . . . 953
S.22 Bitcoin XBT/USD order book . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 953
S.23 Time spent by Brownian motion within a given range . . . . . . . . . . . . . . 954
S.24 Market data for the warrant #01897 on the MTR Corporation . . . . . . . 964
S.25 Lower bound vs. Black-Scholes call price . . . . . . . . . . . . . . . . . . . . . . . . 977
S.26 Lower bound vs. Black-Scholes put option price . . . . . . . . . . . . . . . . . . 977
S.27 Bull spread option as a combination of call and put options∗ . . . . . . . . 978
S.28 Bear spread option as a combination of call and put options∗ . . . . . . . . 979
S.29 Butterfly option as a combination of call options∗ . . . . . . . . . . . . . . . . . 982
S.30 Delta of a butterfly option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 983
S.31 Gaussian approximation of spread probability density function . . . . . . . 994
S.32 Gaussian approximation of spread option prices . . . . . . . . . . . . . . . . . . 995
S.33 Price of a binary call option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 998
S.34 Risky hedging portfolio value for a binary call option . . . . . . . . . . . . . . 999
S.35 Risk-free hedging portfolio value for a binary call option . . . . . . . . . . . . 999
S.36 Black-Scholes price of the maximum chooser option . . . . . . . . . . . . . . . 1002
S.37 Delta of the maximum chooser option . . . . . . . . . . . . . . . . . . . . . . . . . . 1002
S.38 Black-Scholes price of the minimum chooser option . . . . . . . . . . . . . . . . 1003
S.39 Delta of the minimum chooser option . . . . . . . . . . . . . . . . . . . . . . . . . . 1004
√
S.40 Sample path of dSt = St dBt / 1 − t . . . . . . . . . . . . . . . . . . . . . . . . . . . 1016
S.41 Sample path of dSt = St dBt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2
1017
S.42 Sample path of dSt = St2 dBt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1017
S.43 “Infogrames” stock price curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1020
S.44 Butterfly option payoff as a combination of call and put options∗ . . . . . 1036
S.45 Implied vs. local volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1041
S.46 Average return by selling at the maximum vs. selling at maturity . . . . . 1053

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S.47 Ratios of average returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1055

S.48 Cumulative distribution function of the time of maximum of Brownian
motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1056
S.49 Black-Scholes call price upper bound. . . . . . . . . . . . . . . . . . . . . . . . . . . 1058
S.50 Black-Scholes put price upper bound. . . . . . . . . . . . . . . . . . . . . . . . . . . 1060
S.51 “Optimal exercise” put price upper bound. . . . . . . . . . . . . . . . . . . . . . . 1062
S.52 Down-and-out barrier call option price with rebate as a function of
volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1068
S.53 Price of the up-and-in long forward contract . . . . . . . . . . . . . . . . . . . . . 1069
S.54 Delta of the up-and-in long forward contract . . . . . . . . . . . . . . . . . . . . . 1070
S.55 Price of the up-and-out long forward contract . . . . . . . . . . . . . . . . . . . . 1071
S.56 Delta of up-and-out long forward contract price . . . . . . . . . . . . . . . . . . 1072
S.57 Price of the down-and-in long forward contract . . . . . . . . . . . . . . . . . . . 1073
S.58 Delta of down-and-in long forward contract . . . . . . . . . . . . . . . . . . . . . . 1073
S.59 Price of the down-and-out long forward contract . . . . . . . . . . . . . . . . . . 1074
S.60 Delta of down-and-out long forward contract . . . . . . . . . . . . . . . . . . . . . 1075
S.61 Payoff function of the European knock-out call option . . . . . . . . . . . . . . 1081
S.62 Price map of the European knock-out call option . . . . . . . . . . . . . . . . . 1082
S.63 Payoff function of the European knock-in put option . . . . . . . . . . . . . . . 1083
S.64 Price map of the European knock-in put option . . . . . . . . . . . . . . . . . . 1083
S.65 Payoff function of the European knock-in call option . . . . . . . . . . . . . . . 1084
S.66 Price map of the European knock-in call option . . . . . . . . . . . . . . . . . . 1085
S.67 Payoff function of the European knock-out put option . . . . . . . . . . . . . . 1085
S.68 Price map of the European knock-out put option . . . . . . . . . . . . . . . . . 1086
S.69 Expected minimum of geometric Brownian motion . . . . . . . . . . . . . . . . 1088
S.70 Black-Scholes put price upper bound. . . . . . . . . . . . . . . . . . . . . . . . . . . 1089
S.71 Time derivative of the expected minimum . . . . . . . . . . . . . . . . . . . . . . . 1089
S.72 Expected maximum of geometric Brownian motion . . . . . . . . . . . . . . . . 1091
S.73 Black-Scholes call price upper bound. . . . . . . . . . . . . . . . . . . . . . . . . . . 1092
S.74 Time derivative of the expected maximum . . . . . . . . . . . . . . . . . . . . . . 1092
S.75 Lookback call option price as a function of maturity time T . . . . . . . . . 1095
S.76 Lookback put option price (2D) as a function of M0t . . . . . . . . . . . . . . . 1096
S.77 Hitting times of a straight line started at α < 0 . . . . . . . . . . . . . . . . . . . 1116
S.78 Hitting times of a straight line started at α < 0 . . . . . . . . . . . . . . . . . . . 1117
S.80 Sample path of the random walk (Sn )n∈N . . . . . . . . . . . . . . . . . . . . . . 1118
S.81 American butterfly payoff and price functions . . . . . . . . . . . . . . . . . . . . 1121
S.82 Perpetual vs. finite expiration American put option price . . . . . . . . . . . 1122
S.83 American put price approximation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1123
S.84 Perpetual American binary put price map . . . . . . . . . . . . . . . . . . . . . . . 1136
S.85 Perpetual American binary call price map . . . . . . . . . . . . . . . . . . . . . . . 1136
S.86 Finite expiration American binary call price map . . . . . . . . . . . . . . . . . 1139
S.87 Finite expiration American binary put price map . . . . . . . . . . . . . . . . . 1140
S.88 Log bond prices correlation graph in the two-factor model . . . . . . . . . . 1191

∗
Animated figures (work with Acrobat Reader).

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List of Tables

1.1 Mark Six “Investment Table” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26

2.1 Self-financing portfolio value process . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

2.2 NTRC Input investment plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79
2.3 Avenda Insurance investment plan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

4.1 Itô multiplication table . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182

6.1 Black-Scholes Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 248

6.2 Variations of Black-Scholes prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249

7.1 Call and put options on the Hang Seng Index (HSI) . . . . . . . . . . . . . . . 300
7.2 Contract summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

11.1 Barrier option types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 421

11.2 Boundary conditions for barrier option prices . . . . . . . . . . . . . . . . . . . . 441

12.1 Extended Itô multiplication table . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 453

14.1 Martingales and stopping times . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 518

14.2 List of martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 524

15.1 Optimal exercise strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 552

16.1 Local vs. foreign exchange options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 586

18.1 Stochastic interest rate models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 676

19.1 Forward rates arranged according to a tenor structure . . . . . . . . . . . . . . 685

19.2 A list of numéraire processes and their applications . . . . . . . . . . . . . . . . 708

20.1 Itô multiplication table with jumps . . . . . . . . . . . . . . . . . . . . . . . . . . . . 747

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 N. Privault

21.1 Market models and their properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . 793

S.1 Fixed deposit returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 861

S.2 CRR pricing and hedging table . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 870
S.3 CRR pricing tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 872
S.4 CRR pricing and hedging tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 873
S.5 CRR pricing tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 878
S.6 CRR pricing and hedging tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 878
S.7 CRR pricing tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 880
S.8 CRR pricing and hedging tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 880
S.9 Call and put options on the Hang Seng Index (HSI) . . . . . . . . . . . . . . . 980
S.10 Original call/put options on the Hang Seng Index (HSI) . . . . . . . . . . . . 981

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Introduction

Modern quantitative finance requires a strong background in fields such as

stochastic calculus, optimization, partial differential equations (PDEs) and
numerical methods, or even infinite dimensional analysis. In addition, the
emergence of new complex financial instruments on the markets makes it
necessary to rely on increasingly sophisticated mathematical tools. Not all
readers of this book will eventually work in quantitative financial analy-
sis, nevertheless they may have to interact with quantitative analysts, and
becoming familiar with the tools they employ could be an advantage. In
addition, despite the availability of ready made financial calculators it still
makes sense to be able oneself to understand, design and implement such
financial algorithms. This can be particularly useful under different types of
conditions, including an eventual lack of trust in financial indicators, possible
unreliability of expert advice such as buy/sell recommendations, or other fac-
tors such as market manipulation. Instead of relying on predictions of stock
price movements based on various tools (e.g. technical analysis, charting,
“cup & handle” figures), we acknowledge that predicting the future is a diffi-
cult task and we rely on the Efficient Market Hypothesis. In this framework,
the time evolution of the prices of risky assets will be modeled by random
walks and stochastic processes.

Historical sketch

We start with a description of some of the main steps, ideas and individuals
that played an important role in the development of the field over the last
century.

Robert Brown, botanist, 1828

Brown (1828) observed the movement of pollen particles as described in “A
brief account of microscopical observations made in the months of June, July
and August, 1827, on the particles contained in the pollen of plants; and on

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 N. Privault

the general existence of active molecules in organic and inorganic bodies.”

Phil. Mag. 4, 161-173, 1828.

0.8

0.6

0.4

0.2

-0.2

-0.4
0 0.2 0.4 0.6 0.8 1

Fig. 1: Two sample paths of one-dimensional Brownian motion.

Philosophical Magazine, first published in 1798, is a journal that “publishes

articles in the field of condensed matter describing original results, theories
and concepts relating to the structure and properties of crystalline materials,
ceramics, polymers, glasses, amorphous films, composites and soft matter.”
Albert Einstein, physicist
Einstein received his 1921 Nobel Prize in part for investigations on the theory
of Brownian motion: “... in 1905 Einstein founded a kinetic theory to account
for this movement”, presentation speech by S. Arrhenius, Chairman of the
Nobel Committee, Dec. 10, 1922.
Einstein (1905) “Über die von der molekularkinetischen Theorie der Wärme
geforderte Bewegung von in ruhenden Flüssigkeiten suspendierten Teilchen”,
Annalen der Physik 17.
Louis Bachelier, mathematician, PhD 1900
Bachelier (1900) used Brownian motion for the modeling of stock prices in
his PhD thesis “Théorie de la spéculation”, Annales Scientifiques de l’Ecole
Normale Supérieure 3 (17): 21-86, 1900.
Norbert Wiener, mathematician, founder of cybernetics
Wiener is credited, among other fundamental contributions, for the mathe-
matical foundation of Brownian motion, published in 1923. In particular he
constructed the Wiener space and Wiener measure on C0 ([0, 1]) (the space
of continuous functions from [0, 1] to R vanishing at 0).
Wiener (1923) “Differential space”, Journal of Mathematics and Physics of
the Massachusetts Institute of Technology, 2, 131-174, 1923.
伊藤清 ), mathematician, C.F. Gauss Prize 2006
Kiyoshi Itô (伊
Itô (1944) constructed the Itô integral with respect to Brownian motion,
and the stochastic calculus with respect to Brownian motion, which laid the

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 Notes on Stochastic Finance

foundation for the development of calculus for random processes, see Itô
(1951) “On stochastic differential equations”, in Memoirs of the American
Mathematical Society.
“Renowned math wiz Itô, 93, dies.” (The Japan Times, Saturday, Nov. 15,
2008)
Kiyoshi Itô, an internationally renowned mathematician and professor
emeritus at Kyoto University died Monday of respiratory failure at a Ky-
oto hospital, the university said Friday. He was 93. Itô was once dubbed
“the most famous Japanese in Wall Street” thanks to his contribution
to the founding of financial derivatives theory. He is known for his work
on stochastic differential equations and the “Itô Formula”, which laid the
foundation for the Black and Scholes (1973) model, a key tool for finan-
cial engineering. His theory is also widely used in fields like physics and
biology.

Paul Samuelson, economist, Nobel Prize 1970

Samuelson (1965) rediscovered Bachelier’s ideas and proposed geometric
Brownian motion as a model for stock prices. In an interview he stated “In
the early 1950s I was able to locate by chance this unknown Bachelier (1900)
book, rotting in the library of the University of Paris, and when I opened it
up it was as if a whole new world was laid out before me.” We refer to “Ra-
tional theory of warrant pricing” by Paul Samuelson, Industrial Management
Review, p. 13-32, 1965.

Fig. 2: Clark (2000) “As if a whole new world was laid out before me.”∗

∗
Click on the figure to play the video (works in Acrobat Reader on the entire pdf file).

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 N. Privault

In recognition of Bachelier’s contribution, the Bachelier Finance Society was

started in 1996 and now holds the World Bachelier Finance Congress every
two years.
Robert Merton, Myron Scholes, economists
Robert Merton and Myron Scholes shared the 1997 Nobel Prize in eco-
nomics: “In collaboration with Fisher Black, developed a pioneering formula
for the valuation of stock options ... paved the way for economic valuations
in many areas ... generated new types of financial instruments and facilitated
more efficient risk management in society.”∗
Black and Scholes (1973) “The Pricing of Options and Corporate Liabilities”.
Journal of Political Economy 81 (3): 637-654.
The development of options pricing tools contributed greatly to the expansion
of option markets and led to development several ventures such as the “Long
Term Capital Management” (LTCM), founded in 1994. The fund yielded
annualized returns of over 40% in its first years, but registered a loss of
US$4.6 billion in less than four months in 1998, which resulted into its closure
in early 2000.
Oldřich Vašíček, economist, 1977
Interest rates behave differently from stock prices, notably due to the phe-
nomenon of mean reversion, and for this reason they are difficult to model
using geometric Brownian motion. Vašíček (1977) was the first to suggest a
mean-reverting model for stochastic interest rates, based on the Ornstein-
Uhlenbeck process, in “An equilibrium characterization of the term struc-
ture”, Journal of Financial Economics 5: 177-188.
David Heath, Robert Jarrow, Andrew Morton
These authors proposed in 1987 a general framework to model the evolu-
tion of (forward) interest rates, known as the Heath-Jarrow-Morton (HJM)
model, see Heath et al. (1992) “Bond pricing and the term structure of inter-
est rates: a new methodology for contingent claims valuation”, Econometrica,
(January 1992), Vol. 60, No. 1, pp 77-105.
Alan Brace, Dariusz Gatarek, Marek Musiela (BGM)
The Brace et al. (1997) model is actually based on geometric Brownian
motion, and it is especially useful for the pricing of interest rate derivatives
such as interest rate caps and swaptions on the LIBOR market, see “The
Market Model of Interest Rate Dynamics”. Mathematical Finance Vol. 7,
page 127. Blackwell 1997, by Alan Brace, Dariusz Gatarek, Marek Musiela.
Although LIBOR rates are being phased out, we will still use this terminology
when referring to simple or linear compounded forward rates.
∗
This has to be put in relation with the modern development of risk societies; “societies
increasingly preoccupied with the future (and also with safety), which generates the
notion of risk” (Wikipedia).

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 Notes on Stochastic Finance

Financial derivatives

The following graphs exhibit a correlation between commodity (oil) prices

and an oil-related asset price.

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(a) WTI price graph. (b) Graph of Keppel Corp. stock price

Fig. 3: Comparison of WTI vs. Keppel price graphs.

The study of financial derivatives aims at finding functional relationships

between the price of an underlying asset (a company stock price, a commodity
price, etc.) and the price of a related financial contract (an option, a financial
derivative, etc.).

Option contracts

Early accounts of option contracts can also be found in The Politics Aristotle
(BCE) by Aristotle (384-322 BCE). Referring to the philosopher Thales of
Miletus (c. 624 - c. 546 BCE), Aristotle writes:
“He (Thales) knew by his skill in the stars while it was yet winter that
there would be a great harvest of olives in the coming year; so, having a
little money, he gave deposits for the use of all the olive-presses in Chios
and Miletus, which he hired at a low price because no one bid against him.
When the harvest-time came, and many were wanted all at once and of a
sudden, he let them out at any rate which he pleased, and made a quantity
of money”.
In the above example, olive oil can be regarded as the underlying asset,
while the oil press stands for the financial derivative. Option credit contracts
appear to have been used as early as the 10th century by traders in the
Mediterranean.
Next, we move to a description of (European) call and put options, which
are at the basis of risk management.

European put option contracts

As previously mentioned, an important concern for the buyer of a stock at

time t is whether its price ST can decline at some future date T . The buyer of

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 N. Privault

the stock may seek protection from a market crash by purchasing a contract
that allows him to sell his asset at time T at a guaranteed price K fixed at
time t. This contract is called a put option with strike price K and exercise
date T .

Fig. 4: Graph of the Hang Seng index - holding a put option might be useful here.

Definition 1. A (European) put option is a contract that gives its holder

the right (but not the obligation) to sell a quantity of assets at a predefined
price K called the strike price (or exercise price) and at a predefined date T
called the maturity.
In case the price ST falls down below the level K, exercising the contract will
give the holder of the option a gain equal to K − ST in comparison to those
who did not subscribe the option contract and have to sell the asset at the
market price ST . In turn, the issuer of the option contract will register a loss
also equal to K − ST (in the absence of transaction costs and other fees).
If ST is above K, then the holder of the option contract will not exercise the
option as he may choose to sell at the price ST . In this case the profit derived
from the option contract is 0. Two possible scenarios (ST finishing above K
or below K) are illustrated in Figure 5.

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 Notes on Stochastic Finance

10
(K-ST)+=0
9
8 ST

7
Strike price
K=6 K

St 5
K-ST>0
4
3 ST

2
S0.1
1
0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 T=1

Fig. 5: Two put option scenarios.

Cash settlement vs. physical delivery

Physical delivery. In the case of physical delivery, the put option contract
issuer will pay the strike price $K to the option contract holder in exchange
for one unit of the risky asset priced ST .
Cash settlement. In the case of a cash settlement, the put option issuer will
satisfy the contract by transferring the amount C = (K − ST )+ to the option
contract holder.
In general, the payoff of a (so-called European) put option contract can be
written as
K − ST if ST ⩽ K,
(
ϕ(ST ) = (K − ST )+ :=
0, if ST ⩾ K.

20
Put option payoff (K-x)+

15

(K-x)+

10

0
80 85 90 95 100 105 110 115 120
K

Fig. 6: Payoff function of a put option with strike price K = 100.

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 N. Privault

See e.g. https://optioncreator.com/stwwxvz.

Put option examples
a) The buy back guarantee∗ in currency exchange;
b) the price drop protection in online ticket booking
are common examples of European put options.

The derivatives market

As of year 2015, the size of the financial derivatives market is estimated at over
$1.2 quadrillion† USD, which is more than 10 times the Gross World Prod-
uct (GWP). See here or here for up-to-date data on outstanding notional
amounts and gross market value from the Bank for International Settlements
(BIS).

European call option contracts

On the other hand, if the trader aims at buying some stock or commodity,
his interest will be in prices not going up and he might want to purchase a
call option, which is a contract allowing him to buy the considered asset at
time T at a price not higher than a level K fixed at time t.
Definition 2. A (European) call option is a contract that gives its holder the
right (but not the obligation) to purchase a quantity of assets at a predefined
price K called the strike price, and at a predefined date T called the maturity.
Here, in the event that ST goes above K, the buyer of the option contract
will register a potential gain equal to ST − K in comparison to an agent who
did not subscribe to the call option.
Two possible scenarios (ST finishing above K or below K) are illustrated in
Figure 7.
∗
Right-click to open or save the attachment.
†
One thousand trillion, or one million billion, or 1015 .

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 Notes on Stochastic Finance

10
ST-K>0
9
8 ST

7
Strike price
K=6 K

St 5
(ST -K)+=0
4
3 ST

2
S0.1
1
0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 T=1

Fig. 7: Two call option scenarios.

Cash settlement vs. physical delivery

Physical delivery. In the case of physical delivery, the call option contract
issuer will transfer one unit of the risky asset priced ST to the option contract
holder in exchange for the strike price $K. Physical delivery may include
physical goods, commodities or assets such as coffee, airline fuel or live cattle,
see Schroeder and Coffey (2018).
Cash settlement. In the case of a cash settlement, the call option issuer will
fulfill the contract by transferring the amount C = (ST − K )+ to the option
contract holder.
In general, the payoff of a (so-called European) call option contract can be
written as
ST − K if ST ⩾ K,
(
ϕ(ST ) = (ST − K )+ :=
0, if ST ⩽ K.

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 N. Privault

20
Call option payoff (x-K)+

15

(x-K)+

10

0
80 85 90 95 100 105 110 115 120
K

Fig. 8: Payoff function of a call option with strike price K = 100.

See e.g. https://optioncreator.com/stqhbgn.

Call option example: The price lock guarantee∗ in online ticket booking
is a common example of a European call option.
According to market practice, options are often divided into a certain number
n of warrants, the (possibly fractional) quantity n being called the entitlement
ratio.

Option pricing

In order for an option contract to be fair, the buyer of the option contract
should pay a fee (similar to an insurance fee) at the signature of the contract.
The computation of this fee is an important issue, and is known as option
pricing.

Option hedging

The second important issue is that of hedging, i.e. how to manage a given
portfolio in such a way that it contains the required random payoff (K − ST )+
(for a put option) or (ST − K )+ (for a call option) at the maturity date T .
The next Figure 9 illustrates a sharp increase and sharp drop in asset price,
making it valuable to hold a call option contract during the first half of the
graph, whereas holding a put option contract would be recommended during
the second half.
∗
Right-click to open or save the attachment.

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 Notes on Stochastic Finance

Fig. 9: “Infogrames” stock price curve.

Example: Fuel hedging and the four-way zero-collar option

install.packages("Quandl")
library(Quandl);library(quantmod)
getSymbols("DCOILBRENTEU", src="FRED")
chartSeries(DCOILBRENTEU,up.col="blue",theme="white",name = "BRENT Oil
Prices",lwd=5)
BRENT = Quandl("FRED/DCOILBRENTEU",start_date="2010-01-01",
end_date="2015-11-30",type="xts")
chartSeries(BRENT,up.col="blue",theme="white",name = "BRENT Oil Prices",lwd=5)
getSymbols("WTI", from="2010-01-01", to="2015-11-30")
WTI <- Ad(`WTI`)
chartSeries(WTI,up.col="blue",theme="white",name = "WTI Oil Prices",lwd=5)

WTI Oil Prices [2010−01−04/2015−11−27] BRENT Oil Prices [2010−01−04/2015−11−30]

25
Last 3.52 Last 43.73

120

20

100

15

80

10

60

40

Jan 04 Jan 03 Jan 03 Jan 02 Jan 02 Jan 02 Jan 04 Jan 03 Jan 03 Jan 02 Jan 02 Jan 02
2010 2011 2012 2013 2014 2015 2010 2011 2012 2013 2014 2015

(a) WTI price graph. (b) Brent price graph

Fig. 10: Brent and WTI price graphs.

(April 2011)
Fuel hedge promises Kenya Airways smooth ride in volatile oil market.∗
(November 2015)
A close look at the role of fuel hedging in Kenya Airways $259 million loss.∗

∗
Right-click to open or save the attachment.

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 N. Privault

The four-way call collar call option requires its holder to purchase the un-
derlying asset (here, airline fuel) at a price specified by the blue curve in
Figure 11, when the underlying asset price is represented by the red line.

160
Four-way collar
150 y=x

140

130

120

110

100

90

80

70
70 80 90 100 110 120 130 140 150
x

Fig. 11: Price map of a four-way collar option.

The four-way call collar option contract will result into a positive or negative
payoff depending on current fuel prices, as illustrated in Figure 12.

20
four-way collar payoff
15

10

-5

-10

-15

-20
70 80 90 100 110 120 130 140 150
K1 K2 ST K3 K4

Fig. 12: Payoff function of a four-way call collar option.

The four-way call collar payoff can be written as a linear combination

ϕ(ST ) = (K1 − ST )+ − (K2 − ST )+ + (ST − K3 )+ − (ST − K4 )+

of call and put option payoffs with respective strike prices

K1 = 90, K2 = 100, K3 = 120, K4 = 130,

see e.g. https://optioncreator.com/st5rf51.

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 Notes on Stochastic Finance

20
(K1-x)+-(K2-x)++(x-K3)+
15 -(x-K4)+

10

-5

-10

-15

-20
70 80 90 100 110 120 130 140 150
K1 K2 ST K3 K4

Fig. 13: Four-way call collar payoff as a combination of call and put options.∗

Therefore, the four-way call collar option contract can be synthesized by:
1. purchasing a put option with strike price K1 = $90, and
2. selling (or issuing) a put option with strike price K2 = $100, and
3. purchasing a call option with strike price K3 = $120, and
4. selling (or issuing) a call option with strike price K4 = $130.
Moreover, the call collar option contract can be made costless by adjusting
the boundaries K1 , K2 , K3 , K4 , in which case it becomes a zero-collar option.

Example - The one-step 4-5-2 model

We close this introduction with a simplified example of the pricing and hedg-
ing technique in a binary model. Consider:
i) A risky underlying stock valued S0 = $4 at time t = 0, and taking only
two possible values (
$5
S1 =
$2
at time t = 1.
ii) An option contract that promises a claim payoff C whose values are
defined contingent to the market data of S1 as:

$3 if S1 = $5
(
C :=
$0 if S1 = $2.
∗
The animation works in Acrobat Reader on the entire pdf file.

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 N. Privault

Exercise: Does C represent the payoff of a put option contract? Of a call

option contract? If yes, with which strike price K?
Quiz: Using this form, submit your own intuitive estimate for the price of
the claim C.
At time t = 0 the option contract issuer (or writer) chooses to invest ξ units
in the risky asset S, while keeping $η on our bank account, meaning that we
invest a total amount

ξS0 + $η at time t = 0.

Here, the amount $η may be positive or negative, depending on whether it

is corresponds to savings or to debt, and is interpreted as a liability.
The following issues can be addressed:
a) Hedging: How to choose the portfolio allocation (ξ, $η ) so that the value

ξS1 + $η

of the portfolio matches the future payoff C at time t = 1?

b) Pricing: How to determine the initial cost ξS0 + $η of the portfolio built
by the option contract issuer at time t = 0?

S1 = 5 and C = 3
S1 = 5 and C = 3
S0 = 4 S0 = 4
S1 = 2 and C = 0
S1 = 2 and C = 0

Hedging or replicating the contract means that at time t = 1 the portfolio

value matches the future payoff C, i.e.

ξS1 + $η = C.

Hedge, then price. This condition can be rewritten as

$3 = ξ × $5 + $η if S1 = $5,
(
C=
$0 = ξ × $2 + $η if S1 = $2,

i.e.
5ξ + η = 3, ξ = 1 stock,
( (
which yields
2ξ + η = 0, $η = −$2.

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 Notes on Stochastic Finance

In other words, the option contract issuer purchases 1 (one) unit of the stock
S at the price S0 = $4, and borrows $2 from the bank. The price of the
option contract is then given by the portfolio value

ξS0 + $η = 1 × $4 − $2 = $2.

at time t = 0.
The above computation is implemented in the attached IPython notebook∗
that can be run here or here. This algorithm is scalable and can be extended
to recombining binary trees over multiple time steps.
Definition 3. The arbitrage-free price of the option contract is defined as
the initial cost ξS0 + $η of the portfolio hedging the claim payoff C.
$3 if S1 = $5
(
Conclusion: in order to deliver the random payoff C =
$0 if S1 = $2.
to the option contract holder at time t = 1, the option contract issuer (or
writer) will:
1. charge ξS0 + $η = $2 (the option contract price) at time t = 0,
2. borrow −$η = $2 from the bank,
3. invest those $2 + $2 = $4 into the purchase of ξ = 1 unit of stock valued
at S0 = $4 at time t = 0,
4. wait until time t = 1 to find that the portfolio value has evolved into

ξ × $5 + $η = 1 × $5 − $2 = $3 if S1 = $5,
(
C=
ξ × $2 + $η = 1 × $2 − $2 = 0 if S1 = $2,

so that the option contract and the equality C = ξS1 + $η can be fulfilled,
allowing the option issuer to break even whatever the evolution of the
risky asset price S.
In a cash settlement, the stock is sold at the price S1 = $5 or S1 = $2,
the payoff C = (S1 − K )+ = $3 or $0 is issued to the option contract
holder, and the loan is refunded with the remaining $2.
In the case of physical delivery, ξ = 1 share of stock is handed in to the
option holder in exchange for the strike price K = $2 which is used to
refund the initial $2 loan subscribed by the issuer.
Here, the option contract price ξS0 + $η = $2 is interpreted as the cost of
hedging the option. In Chapters 2 and 3 we will see that this model is scalable
and extends to discrete time.


∗
Right-click to save as attachment (may not work on .

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 N. Privault

We note that the initial option contract price of $2 can be turned to C = $3

(%50 profit) ... or into C = $0 (total ruin).
Thinking further
1) The expected claim payoff at time t = 1 is

E[C ] = $3 × P(C = $3) + $0 × P(C = $0)

= $3 × P(S1 = $5).

In absence of arbitrage opportunities (“fair market”), this expected payoff

E[C ] should equal the initial amount $2 invested in the option. In that case
we should have
E[C ] = $3 × P(S1 = $5) = $2
(

P(S1 = $5) + P(S1 = $2) = 1.

from which we can infer the probabilities
 2
 P(S1 = $5) =
3

(1)
 P(S = $2) = 1 ,

1
3
which are called risk-neutral probabilities. We see that under the risk-neutral
probabilities, the stock S has twice more chances to go up than to go down
in a “fair” market.
2) Based on the probabilities (1) we can also compute the expected value
E[S1 ] of the stock at time t = 1. We find

E[S1 ] = $5 × P(S1 = $5) + $2 × P(S1 = $2)

2 1
= $5 × + $2 ×
3 3
= $4
= S0 .

Here, this means that, on average, no extra profit or loss can be made from
an investment on the risky stock, and the probabilities (2/3, 1/3) are termed
risk-neutral probabilities. In a more realistic model we can assume that the
riskless bank account yields an interest rate equal to r, in which case the
above analysis is modified by letting $η become $(1 + r )η at time t = 1,
nevertheless the main conclusions remain unchanged.
Market-implied probabilities
By matching the theoretical price E[C ] to an actual market price data $M
as

$M = E[C ] = $3 × P(C = $3) + $0 × P(C = $0) = $3 × P(S1 = $5)

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 Notes on Stochastic Finance

we can infer the probabilities


$M
 P(S1 = $5) =

3

(2)
 P(S1 = $2) = 3 − $M ,


3
which are implied probabilities estimated from market data, as illustrated in
Figure 14. We note that the conditions

0 < P(S1 = $5) < 1, 0 < P(S1 = $2) < 1

are equivalent to 0 < $M < 3, which is consistent with financial intuition in a

non-deterministic market. Figure 14 shows the time evolution of probabilities
p(t), q (t) of two opposite outcomes.

Fig. 14: Implied probabilities.

Note that implied probabilities should also be used with caution, as shown
in Figures 15-16.

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Fig. 15: Implied probabilities according to bookmakers.

Fig. 16: Implied probabilities according to polling.

Implied probabilities can be estimated using e.g. binary options, see for ex-
ample Exercise 3.11.
The Practitioner expects a good model to be:
• Robust with respect to missing, spurious or noisy data,
• Fast - prices have to be delivered daily in the morning,
• Easy to calibrate - parameter estimation,
• Stable with respect to re-calibration and the use of new data sets.
Typically, a medium size bank manages 5,000 options and 10,000 deals daily
over 1,000 possible scenarios and dozens of time steps. This can mean a
hundred million computations of E[C ] daily, or close to a billion such com-
putations for a large bank.
The mathematician tends to focus on more theoretical features, such as:
• Elegance,

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 Notes on Stochastic Finance

• Sophistication,
• Existence of analytical (closed-form) solutions / error bounds,
• Significance to mathematical finance.
This includes:
• Creating new payoff functions and structured products,
• Defining new models for underlying asset prices,
• Finding new ways to compute expectations E[C ] and hedging strategies.
The methods involved include:
• Monte Carlo methods (60%),
10

0.0 0.2 0.4 0.6 0.8 1.0

Time

Fig. 17: Fifty sample price paths used for the Monte Carlo method.

• PDEs and finite differences methods (30%),

• Other analytic methods and approximation methods (10%),
+ AI and Machine Learning techniques.

Course plan

The course plan from Chapter 1 to Chapter 7 is structured in layers that

repeat the main concepts (arbitrage, pricing, hedging, risk-neutral measures)
in different time scale settings (one-step, discrete-time, continuous-time).

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 N. Privault

utral measur
-ne es
isk model
R
me Multis
ti te p

s-
p model

C o n t i n uo u

Arb
m
te

od e
One-s

itrage
4-5-2

l
ing

Example
Pric

H
ed
ing g

Fig. 18: Course plan.

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