Financial Mathematics IV

MFM 3133

1
Course Overview

2
 Course Aim
This course is designed to

 review the basic knowledge of stochastic calculus

 review of the basic stochastic processes for stock price dynamics
 understand the assumptions behind the Black-Scholes model
 perform delta-hedging and calculate a hedge profit and its variance
 understand the effect of the strike prices and time to expiration on option values
 understand various bounds for option prices

3
 Learning Outcomes
By the end of this course, the students should be able to

 study the basic type of stochastic processes that can be used in stock price
dynamics
 derive the Black-Scholes formula for financial derivatives
 calculate prices of financial derivatives using the Black-Scholes model
 study Greek Letters
 hedge using multiple Greeks
 study the basic concepts of self-financing and rebalancing the hedge portfolio
 study the factors related to the early exercise of American options

4
 Course Content
1. Review: 2. Modelling Stock Price Dynamics:
• The random walk model,
• Standard Brownian Motion, • A review of the lognormal
• Arithmetic Brownian Motion, distribution,
• Geometric Brownian Motion, • Modelling stock prices with GBM,
• Stochastic Differential equations, • Stock Prices Dynamics under the
• Ito’s Lemma, Black-Scholes Framework,
• An Integral Representation, • Log-normality of Stock Prices
• Differentiation Rule for Stochastic Integrals,
• Solutions of Three SDES,
• Variations of Brownian Motions

5
3. Introduction to the Black-Scholes Formula: 5. General Properties of Options:
• Binary Options, • Different Strike prices,
• The Black-Scholes formulas for options, • Bounds for Option
• Applying the pricing formula for other assets, Prices,
• Options on stock with discrete dividends • Different times to
Expiration,
• Early Exercise for
American Options
4. Risk Management Technique:
• Delta-hedging a Portfolio,
• Understanding the Profit from a hedged Portfolio,
• Self-financing Delta-hedged Portfolio,
• Rebalancing the hedge Portfolio,
• The Boyle-Emanuel formula,
• Gamma Neutrality,
• Risk-neutral valuation

6
 Recommended Textbooks
1. John.C.Hull., (2007). Options, future and other derivatives, Prentice Hall, India.

2. Paul Wilmott (2006) On Quantitative Finance, John Wiley & Sons Ltd

3. Steven Roman,(2012), Introduction to the Mathematics of Finance, Springer

7
Review – Lesson I

8
 Stochastic Processes/ Random walk
o Any variable whose value changes over time in an uncertain way is said to follow a stochastic
process.

o Stochastic processes can be classified as discrete time or continuous time.

o A discrete-time stochastic process is one where the value of the variable can change only at
certain fixed points in time, whereas a continuous-time stochastic process is one where changes
can take place at any time.

o Therefore, stochastic processes can also be classified as continuous variable and discrete
variable.

o In a continuous-variable process, the underlying variable can take any value within a certain
range, whereas in a discrete variable process, only certain discrete values are possible.

9
 Cont’d…
o Learning about this process is the first step to understanding the pricing of options and other
more complicated derivatives.

o It should be noted that, in practice, we do not observe stock prices following continuous-
variable, continuous time processes.

o Stock prices are restricted to discrete values (e.g., multiples of a cent) and changes can be
observed only when the exchange is open for trading.

o Nevertheless, the continuous-variable, continuous-time process proves to be a useful model for

many purposes.

10
Figure 1.1: A sample path of the random walk

11
Markov Process

o A Markov process is a particular type of stochastic process where only the current value of a
variable is relevant for predicting the future.

o The past history of the variable and the way that the present has emerged from the past are
irrelevant.

Definition: A Markov process is a stochastic process with the following properties:

(a.) The number of possible outcomes or states is finite.
(b.) The outcome at any stage depends only on the outcome of the previous stage.
(c.) The probabilities are constant over time.

o Stock prices are usually assumed to follow a Markov process.

12
Cont’d…
Example 1:

Suppose that the bus ridership in a city is studied. After examining several years of data, it was
found that 30% of the people who regularly ride on buses in a given year do not regularly ride the
bus in the next year. Also it was found that 20% of the people who do not regularly ride the bus in
that year, begin to ride the bus regularly the next year.

If 5000 people ride the bus and 10,000 do not ride the bus in a given year, what is the distribution
of riders/non-riders in the next year? In 2 years? In n years?

The number of people who ride bus next year = 5000(0.7) + 10, 000(0.2)
𝑏1 = 5500

The number of people who don’t ride the bus next year = 5000(0.3) + 10, 000(0.8)
𝑏2 = 9500

13
Cont’d…

𝑏 = 𝑀𝑥1

Result after 2 years 𝑥2 =𝑀2 𝑥1

Result after n years 𝑥𝑛 =𝑀𝑛 𝑥1 M-transition matrix

14
Example 2:
A certain protein molecule can have three configurations which we denote as and Every
second the protein molecule can make a transition from one configuration to another
configuration with the following probabilities.

, P = 0.3
, P = 0.5
, P = 0.4

Find the transition matrix M and steady-state vector for this Markov process.

Recall that where is the probability of configuration making the transition to

Therefore

15
Cont’d…
At steady state

Row echelon form

Taking the fact that the total probability is one, the steady state solution
16
Exercise:

Consider a system that alternates between the two states 0 (OFF) and 1 (ON) and that is checked at
discrete time points. If the system is OFF at one time point, the probability that it has switched to
ON at the next time point is p, and if it is ON, the probability that it switches to OFF is q.

(a) Describe the system as a Markov chain.

(b) Find the transition matrix.

Note that:

There are many investors watching the stock market closely. Trying to make a profit from it leads
to a situation where a stock price, at any given time, reflects the information in past prices.
Suppose that it was discovered that a particular pattern in stock prices always gave a 65% chance
of subsequent steep price rises.

Investors would attempt to buy a stock as soon as the pattern was observed, and demand for the
stock would immediately rise. This would lead to an immediate rise in its price and the observed
effect would be eliminated, as would any profitable trading opportunities.
17
Continuous-time Stochastic Processes

Consider a variable that follows a Markov stochastic process. Suppose that its current value is 10 and
that the change in its value during 1 year is N(0, 1), where N (𝑚,𝑣) denotes a probability distribution
that is normally distributed mean m and variance 𝑣 2 . What is the probability distribution of the change
in the value of the variable during 2 years?

18
Cont’d…
The change in 2 years is the sum of two normal distributions, each of which has a mean of zero
and variance of 1.0. Because the variable is Markov, the two probability distributions are
independent.

When we add two independent normal distributions, the result is a normal distribution where the
mean is the sum of the means and the variance is the sum of the variances. Type equation here.

The mean of the change during 2 years in the variable we are considering is, therefore, zero and
the variance of this change is 2.0. Hence, the change in the variable over 2 years has the
distribution N(0, 2). The standard deviation of the distribution is 2.

19
Cont’d…
Consider next the change in the variable during 6 months. The variance of the change in the value
of the variable during 1 year equals the variance of the change during the first 6 months plus the
variance of the change during the second 6 months. We assume these are the same.

It follows that the variance of the change during a 6-month period must be 0.5.

𝑋1 ~ 𝑁 0,0.5 𝑎𝑛𝑑 𝑋2 ~ 𝑁 0,0.5

𝑋1 +𝑋2 ~ 𝑁(0,0.5 + 0.5)

Equivalently, the standard deviation of the change is 0.5.

Hence, the probability distribution for the change in the value of the variable during 6 months is
N(0,0.5).

More generally, the change during any time period of length T is N(0,T). In particular, the change
during a very short time period of length Δt is N(0, Δt).
20
Cont’d…
Note that :

o When Markov processes are considered, the variances of the changes in successive time
periods are additive.

o The standard deviations of the changes in successive time periods are not additive.

o The variance of the change in the variable in our example is 1.0 per year, so that the variance of
the change in 2 years is 2.0 and the variance of the change in 3 years is 3.0.

o The standard deviations of the changes in 2 and 3 years are 2 and 3, respectively. (Strictly
speaking, we should not refer to the standard deviation of the variable as 1.0 per year.)

o The results explain why uncertainty is sometimes referred to as being proportional to the square
root of time.

21
Wiener Process
The process followed by the variable we have been considering is known as a Wiener process.

A variable z follows a Wiener process if it has the following two properties:

1. The change Δ𝑧 during a small period of time Δ𝑡 is Δ𝑧 = 𝜖 Δ𝑡 a standardized normal distribution.

N(0, 1).

2. The values of Δ𝑧 for any two different short intervals of time, Δ𝑡 , are independent.

Brownian Motion
o It is a particular type of Markov stochastic process with a mean change of zero and a variance rate
of 1.0 per year.

o It has been used in physics to describe the motion of a particle that is subject to a large number of
small molecular shocks and is sometimes referred to as Brownian motion.

22
Cont’d…
o It follows from the first property that z itself has a normal distribution with

o The second property implies that z follows a Markov process.

o Consider the change in the value of z during a relatively long period of time, T. This can be
denoted by z(T) – z(0). It can be regarded as the sum of the changes in z in N small time
intervals of length Δt, where

(01)
23
Cont’d…
where the are distributed N(0,1). We know from the second property of Wiener
processes that the are independent of each other.

It follows Wiener Processes and Ito’s Lemma.

from equation (01) that z(T) – z(0) is normally distributed, with

 If 𝜎 2 = 1 is called a standard Wiener process or standard Brownian motion.

Note: The wiener process has no jumps. But fluctuations heavily the paths are continuous but highly
erratic. Those paths are not differentiable with probability 1.

24
Sample path of Brownian motion is shown in the figure as follows.

Figure 1.2: A sample path of a Brownian motion

25
Example:
Suppose that the value, z, of a variable that follows a Wiener process is initially 25 and that time is
measured in years. At the end of 1 year, the value of the variable is normally distributed with a mean of
25 and a standard deviation of 1.0. At the end of 5 years, it is normally distributed with a mean of 25
and a standard deviation of 5, or 2.236. Our uncertainty about the value of the variable at a certain
time in the future, as measured by its standard deviation, increases as the square root of how far we are
looking ahead.

• In ordinary calculus, it is usual to proceed from small changes to the limit as the small changes
become closer to zero.

• Thus, dx = a dt is the notation used to indicate that Δx = a Δt in the limit as Δt 0.

• They have used similar notational conventions in stochastic calculus.

• So, when we refer to dz as a Wiener process, we mean that it has the properties for Δz given above
in the limit as Δt 0.

• Figure 1.3 illustrates what happens to the path followed by z as the limit Δt 0 is
approached.
26
Figure 1.3:How a Wiener process is obtained when Δt 0 in equation

27
Exercise:

1. Let 𝑊(𝑡) be a standard Brownian motion. For all 𝑠, 𝑡 ∈ [0, ∞), find
𝐶𝑜𝑣 𝑊 𝑠 , 𝑊 𝑡 . Assume 𝑠 ≤ 𝑡.

2. Let 𝑊(𝑡) be a standard Brownian motion.

a. Find 𝑃(1 < 𝑊(1) < 2).
b. Find 𝑃(𝑊(2) < 3|𝑊(1) = 1).

28
Generalized Wiener Process
o The mean change per unit time for a stochastic process is known as the drift rate and the variance
per unit time is known as the variance rate.

o The basic Wiener process, dz, that has been developed so far has a drift rate of zero and a
variance rate of 1.0.

o The drift rate of zero means that the expected value of z at any future time is equal to its current
value.

o The variance rate of 1.0 means that the variance of the change in z in a time interval of length T
equals T.

o A generalized Wiener process for a variable x can be defined in terms of dz as

(02)

where a and b are constants.

29
Cont’d…
o To understand above equation, it is useful to consider the two components on the right-hand side
separately.

o The a dt term implies that x has an expected drift rate of a per unit of time.

o Without the b dz term, the equation is dx = a dt, which implies that dx/dt = a.

o Integrating with respect to time, we get

where is the value of x at time 0.

o In a period of time of length T, the variable x increases by an amount aT.

o The b dz term on the right-hand side of equation (02) can be regarded as adding noise or
variability to the path followed by x.

30
Cont’d…
o The amount of this noise or variability is b times a Wiener process.

o A Wiener process has a variance rate per unit time of 1.0.

o It follows that b times a Wiener process has a variance rate per unit time of 𝑏 2 .

o In a small time interval Δt, the change Δx in the value of x is given by

o where, as before, has a standard normal distribution N(0,1). Thus Δx has a normal distribution
with

31
Cont’d…
o Similar arguments to those given for a Wiener process show that the change in the value of x in
any time interval T is normally distributed with

Figure 1.4 32
Example:
Consider the situation where the cash position of a company, measured in thousands of dollars,
follows a generalized Wiener process with a drift of 20 per year and a variance rate of 900 per year.
Initially, the cash position is 50. At the end of 1 year the cash position will have a normal
distribution with a mean of 70 and a standard deviation of 900 ,or 30. At the end of 6 months it
will have a normal distribution with a mean of 60 and a standard deviation of 30 0.5 = 21.21. Our
uncertainty about the cash position at some time in the future, as measured by its standard deviation,
increases as the square root of how far ahead we are looking. (Note that the cash position can
become negative. We can interpret this as a situation where the company is borrowing funds.)

Exercise:
Consider a variable S that follows the process

For the first three years, µ = 2 and ხ = 3; for the next three years, µ = 3 and ხ = 4. If the initial value
of the variable is 5, what is the probability distribution of the value of the variable at the end of year
6?
33
Exercise:

It has been suggested that the short-term interest rate r follows the stochastic process

where a, b, c are positive constants and dz is a Wiener process. Describe the nature of this process.

34
o A further type of stochastic process, known as an Itoˆ process, can be defined.

o This is a generalized Wiener process in which the parameters a and b are functions of the value
of the underlying variable x and time t.

o An Ito process can therefore be written as

o Both the expected drift rate and variance rate of an Ito process are liable to change over time.

o In a small time interval between t and t + Δt , the variable changes from x to x + Δx, where

o This equation involves a small approximation.

o It assumes that the drift and variance rate of x remain constant, equal to their values at time t,
during the time interval between t and t + Δt .
35
The process for a stock price

o In this section we discuss the stochastic process usually assumed for the price of a non dividend-
paying stock.

o Clearly, the assumption of constant expected drift rate is inappropriate and needs to be replaced
by the assumption that the expected return (i.e. expected drift divided by the stock price) is
constant.

o If S is the stock price at time t, then the expected drift rate in S should be assumed to be S for
some constant parameter µ.

o This means that in a short interval of time, Δt, the expected increase in S is µSΔt.

o The parameter µ is the expected rate of return on the stock.

o If the coefficient of dz is zero, so that there is no uncertainty, then this model implies that

36
Cont’d…
o In the limit, as or

o Integrating between time 0 and time T, we get

o In practice, of course, there is uncertainty. A reasonable assumption is that the variability of the
return in a short period of time, Δt, is the same regardless of the stock price.

o In other words, an investor is just as uncertain of the return when the stock price is $50 as when
it is $10.

o This suggests that the standard deviation of the change in a short period of time Δt should be
proportional to the stock price and leads to the model
or (03)

o Equation (03) is the most widely used model of stock price behavior. The variable µ is the
stock’s expected rate of return. The variable ხ is the volatility of the stock price.
37
Cont’d…
o The variable ხ2 is referred to as its variance rate.

o The model in equation (03) represents the stock price process in the real world.

o In a risk-neutral world, µ equals the risk-free rate r.

Discrete Time Model

o The model of stock price behavior we have developed is known as geometric Brownian motion.

o The discrete-time version of the model is

or

38
Cont’d…
o The variable ΔS is the change in the stock price S in a small time interval Δt, and as before has a
standard normal distribution (i.e., a normal distribution with a mean of zero and standard
deviation of 1.0).

o The parameter µ is the expected rate of return per unit of time from the stock.

o The parameter ხ is the volatility of the stock price. In this chapter we will assume these
parameters are constant.

Example:

Consider a stock that pays no dividends, has a volatility of 30% per annum, and provides an expected
return of 15% per annum with continuous compounding. In this case, µ = 15 and ხ = 30. The process
for the stock price is

39
Cont’d…
If S is the stock price at a particular time and ΔS is the increase in the stock price in the next small
interval of time, the discrete approximation to the process is

where has a standard normal distribution. Consider a time interval of 1 week, or 0.0192 year, so
that Δt = 0.0192. Then the approximation gives

or

 Furthermore, A stochastic process of the form 𝑒 𝐻𝑡 |𝑡 ≥ 0 is a Brownian motion process called

a geometric Brownian Motion process.
If we assume that 𝐻𝑡 follows a Brownian motion process with drift then we can write
𝑆 𝑡
𝐻𝑡 = 𝑙𝑛 = 𝜇𝑡 + 𝜎𝐵(𝑡)
𝑆 0
40
Cont’d…
Where {𝐵(𝑡), 𝑡 ≥ 0} is standard Brownian motion. Therefore 𝐻𝑡 has a normal distribution with
𝐸 𝐻𝑡 = 𝜇𝑡
𝑉𝑎𝑟 𝐻𝑡 = 𝜎 2 𝑡

It is clear that the continuous time model is a limiting case of the Cox-Ross-Rubistine model. The
continuously compounded rate of return 𝐻𝑡 , over the time period 0 , 𝑡 , which satisfied the equation

𝑆 𝑡 = 𝑆 0 𝑒 𝐻𝑡

𝑆 𝑡
ln = 𝐻𝑡 = 𝜇𝑡 + 𝜎𝐵(𝑡)
𝑆 0

41
Cont’d…
Differentiate with respect to t

1 𝑑 𝑆 𝑡 𝑑
=𝜇+𝜎 𝐵(𝑡)
𝑆 𝑡 𝑑𝑡 𝑆 0 𝑑𝑡
𝑆 0

1 𝑑𝑆 𝑡 𝑑
= 𝜇 + 𝜎 𝐵(𝑡)
𝑆 𝑡 𝑑𝑡 𝑑𝑡

The most common approach to the continuous time model of stock price assumes that the
instantaneous percentage return is a Brownian motion process more specifically

𝑑𝑆 𝑡 𝑑𝐵(𝑡)
= 𝜇𝑑𝑡 + 𝜎
𝑆 𝑡 𝑑𝑡
𝑑𝑆(𝑡) = 𝑆(𝑡) 𝜇𝑑𝑡 + 𝜎𝑑𝐵(𝑡)
42
Cont’d…
Where {𝐵(𝑡), 𝑡 ≥ 0} is standard Brownian motion and 𝜇 and 𝜎 are constants.
Further
We can say that the stochastic process

𝑑𝑆(𝑡)
|𝑡 ≥ 0 is assume to follow Brownian motion process with drift 𝜇 and volatility 𝜎.
𝑆(𝑡)

The formula can be written

𝑑𝑆 𝑡 = 𝜇𝑆 𝑡 𝑑𝑡 + 𝜎𝑆 𝑡 𝑑𝐵 𝑡

This is an instance of what is known as a stochastic differential equation.

43
Cont’d…
Thus, Geometric BM in differential form is,
𝑑𝑆 𝑡 = 𝜇 𝑆 𝑡 𝑑𝑡 + 𝜎𝑆 𝑡 𝑑𝐵(𝑡)

And

Geometric BM in integral form is,

𝑡 𝑡
𝑆 𝑡 =𝑆 0 + 0
𝜇 𝑆 𝑢 𝑑𝑢 + 0
𝜎𝑆 𝑢 𝑑𝐵(𝑢)

44
Figure 1.5: Two sample paths of Geometric Brownian motion, with different
parameters. The blue line has larger drift, the green line has larger variance.
45
Example
Suppose that stock price {𝑆(𝑡), 𝑡 ≥ 0} follows geometric Brownian motion with drift µ = 8% per
year and variance 𝜎 2 = 8.5% per annum. Assume that, the current price of the stock is 𝑆(0) = 60.
find 𝐸[𝑆(3)].
According to the geometric Brownian motion we have
𝑆 𝑡
𝑙𝑛 = 𝜇𝑡 + 𝜎𝐵(𝑡)
𝑆 0

ln 𝑆 𝑡 − ln 𝑆(0) = 𝜇𝑡 + 𝜎𝐵(𝑡)
ln 𝑆 𝑡 = 𝜇𝑡 + ln 𝑆(0) + 𝜎𝐵(𝑡)
Since 𝐵(𝑡)~𝑁 0 , 𝑡
ln 𝑆 𝑡 ~𝑁 𝜇𝑡 + ln 𝑆(0) , 𝜎 2 𝑡
Therefore
𝑆 𝑡 ~𝑙𝑜𝑔𝑛𝑜𝑟𝑚𝑎𝑙 𝜇𝑡 + ln 𝑆(0) , 𝜎 2 𝑡

46
Result: Suppose that X has the lognormal distribution with parameters 𝜇 𝑎𝑛𝑑 𝜎, then

1 2 2
𝐸 𝑋𝑛 = 𝑒𝑥𝑝 𝑛 𝜇 + 𝑛 𝜎 𝑛∈𝑁
2

Now
𝑆 𝑡 ~𝑙𝑜𝑔𝑛𝑜𝑟𝑚𝑎𝑙 𝜇𝑡 + ln 𝑆(0) , 𝜎 2 𝑡

Therefore

1 2
𝐸 𝑆 𝑡 = 𝑒𝑥𝑝 𝜇𝑡 + ln 𝑆(0) + 𝜎 𝑡
2
1
𝐸 𝑆 3 = 𝑒𝑥𝑝 0.08 × 3 + ln 60 + × 0.085 × 3
2
= 84.65

47
Exercise:
Stock A and stock B both follow geometric Brownian motion. Changes in any short interval of time
are uncorrelated with each other. Does the value of a portfolio consisting of one of stock A and one
of stock B follow geometric Brownian motion? Explain your answer.

48
Stochastic Differential Equations
o In previous sections, we studied in detail the solutions to the equation.

o Now, we consider some more general equations of the type

(04)

o These equations are called stochastic differential equations and a solution of equation (03) is
called a diffusion.

o These equations are useful to model most financial assets.

o There are some properties of the solutions to these equations. Ito’s Lemma is one property for
this.
49
o The price of a stock option is a function of the underlying stock’s price and time.

o More generally, we can say that the price of any derivative is a function of the stochastic
variables underlying the derivative and time.

o A serious student of derivatives must, therefore, acquire some understanding of the behavior of
functions of stochastic variables.

o An important result in this area was discovered by the mathematician K. Ito in 1951 and is
known as Itoˆ’s lemma.

o Suppose that the value of a variable x follows the Ito process

o where dz is a Wiener process and a and b are functions of x and t. The variable x has a drift rate
of a and a variance rate of 𝑏 2 .
50
Ito’s lemma shows that a function G of x and t follows the process

where the dz is the same Wiener process as in equation above.

Thus, G also follows an Ito process, with a drift rate of

and a variance rate of

We can show that the lemma can be viewed as an extension of well known results in differential
calculus. Earlier, we argued that
(03)
51
Cont’d…
From Ito’s lemma, it follows that the process followed by a function G of S and t is

(05)

Note that both S and G are affected by the same underlying source of uncertainty, dz.

Application to Forward Contracts

o To illustrate Ito’s lemma, consider a forward contract on a non-dividend-paying stock.

o Assume that the risk-free rate of interest is constant and equal to r for all maturities.

where is the forward price at time zero, is the spot price at time zero, and T is the time to maturity
of the forward contract. 52
Cont’d…
o Now we learn what happens to the forward price as time passes.

o We define F as the forward price at a general time t, and S as the stock price at time t, with t < T.

o The relationship between F and S is given by

o Assuming that the process for S is given by equation (03).

o We can use Ito’s lemma to determine the process for F. From the above equation

o From the equation (05), the process for F is given by

53
Cont’d…
o Substituting F for gives

o Like S, the forward price F follows geometric Brownian motion.

o It has an expected growth rate of µ - r rather than µ. The growth rate in F is the excess return of S
over the risk-free rate.

The Lognormal Property

We now use Ito’s lemma to derive the process followed by lnS when S follows the process in equation
(03). We define

Since

54
Cont’d…
o It follows from equation (05) that the process followed by G is

o Since µ and ხ are constant, this equation indicates that G = ln S follows a generalized Wiener
process.

o It has constant drift rate and constant variance rate

o The change in ln S between time 0 and some future time T is therefore normally distributed, with
mean and variance This means that

or

o where is the stock price at time T, is the stock price at time 0, and as before denotes
a normal distribution with mean m and variance v. 55
Exercise:

1. Suppose that G is a function of a stock price S and time. Suppose that and are the
volatilities of S and G. Show that, when the expected return of S increases by the growth
rate of G increases by where λ is a constant.

2. Suppose that a stock price has an expected return of 16% per annum and a volatility of 30% per
annum. When the stock price at the end of a certain day is $50, calculate the following:

(a) The expected stock price at the end of the next day
(b) The standard deviation of the stock price at the end of the next day
(c) The 95% confidence limits for the stock price at the end of the next day.

56
57