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1
THE BINOMIAL MODEL

In this chapter we will study, in some detail, the simplest possible nontrivial
model of a financial market—the binomial model. This is a discrete time
model, but despite the fact that the main purpose of the book concerns
continuous time models, the binomial model is well worth studying. The
model is very easy to understand, almost all important concepts which we
will study later on already appear in the binomial case, the mathematics
required to analyze it is at high school level, and last but not least the
binomial model is often used in practice.

1.1 The One Period Model

We start with the one period version of the model. In the next section we
will (easily) extend the model to an arbitrary number of periods.

1.1.1 Model Description

Running time is denoted by the letter t, and by definition we have two
points in time, t = 0 (“today”) and t = 1 (“tomorrow”). In the model we
have two assets: a bond and a stock. At time t the price of a bond is
denoted by Bt , and the price of one share of the stock is denoted by St .
Thus we have two price processes B and S.

1. The bond price process is deterministic and given by

a. This is a discrete time model, but despite the fact that the
main purpose of the book concerns continuous time models, the
binomial model is well worth studying.
b. The model is very easy to understand, almost all important con-
cepts which we will study later on already appear in the binomial
case, the mathematics required to analyze it is at high school
level, and last but not least the binomial model is often used in
practice.
2. The constant R is the spot rate for the period, and we can also
interpret the existence of the bond as the existence of a bank with
R as its rate of interest.

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2 THE BINOMIAL MODEL

The stock price process is a stochastic process, and its dynamical behavior
is described as follows:

S0 = s, (1.1)

s · u, with probability pu .
S1 = (1.2)
s · d, with probability pd .

It is often convenient to write this as


S0 =s,
S1 =s · Z,

where Z is a stochastic variable defined as1


u, with probability pu .
Z=
d, with probability pd .

• We2 assume that today’s stock price s is known, as are the positive
constants u, d, pu and pd . We assume that d < u, and we have of
course pu + pd = 1. We can illustrate the price dynamics using the
tree structure in Fig. 1.1.
• We will study the behavior of various portfolios on the (B, S)
market, and to this end we define a portfolio as a vector h = (x, y).
For Margin We will study the behavior of various portfolios on the (B, S) market,
Everyone wants and to this end we define a portfolio as a vector h = (x, y). The interpreta-
to make a profit tion is that x is the number of bonds we hold in our portfolio, whereas y is
by trading on the number of units of the stock held by us. Note that it is quite acceptable
the market, and for x and y to be positive as well as negative. If, for example, x = 3, this
in this context means that we have bought three bonds at time t = 0. If on the other
a so called hand y = −2, this means that we have sold two shares of the stock at time
arbitrage t = 0. In financial jargon we have a long position in the bond and a short
portfolio is a position in the stock. It is an important assumption of the model that short
dream come positions are allowed.
true; this is one Consider now a fixed portfolio h = (x, y). This portfolio has a
of the central deterministic market value at t = 0 and a stochastic value at t = 1.
concepts of the Everyone wants to make a profit by trading on the market, and in this
theory. context a so called arbitrage portfolio is a dream come true; this is one of
the central concepts of the theory
1 We assume that today’s stock price s is known, constants u, d, p and p . We assume
u d
that d < u, and we have of course pu + pd = 1.
2 We assume that d < u, and we have of

a+b=c
course pu + pd = 1.

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THE ONE PERIOD MODEL 3

Definition 1.1 An arbitrage portfolio is a portfolio h with the properties

V0h = 0, (1.3)
V1h > 0, with probability 1. (1.4)

An arbitrage portfolio is thus basically a deterministic money making

machine, and we interpret the existence of an arbitrage portfolio as equiv-
alent to a serious case of mispricing on the market. It is now natural to
investigate when a given market model is arbitrage free, i.e. when there are
no arbitrage portfolios.
Proposition 1.2 The model above is free of arbitrage if and only if the
following conditions hold:

d ≤ (1 + R) ≤ u. (1.5)

The condition (1.25) has an easy economic interpretation. It simply says

that the return on the stock is not allowed to dominate the return on the
bond and vice versa.
Now assume that (1.25) is satisfied. To show that this implies absence
of arbitrage let us consider an arbitrary portfolio such that V0h = 0. We
thus have x + ys = 0, i.e. x = −ys. Using this relation we can write the
value of the portfolio at t = 1 as

ys(u − (1 + R)), if Z = u.
V1h =
ys(d − (1 + R)), if Z = d.

Assume now that y > 0. Then h is an arbitrage strategy if and only if we

have the inequalities

u > 1 + R, (1.6)
d > 1 + R, (1.7)

but this is impossible because of the condition (1.25). The case y < 0 is
treated similarly.
At first glance this result is perhaps only moderately exciting, but we
may write it in a more suggestive form. To say that (1.25) holds is equivalent
to saying that 1 + R is a convex combination of u and d, i.e.

1 + R = qu · u + qd · d,

where qu , qd ≥ 0 and qu + qd = 1. In particular we see that the weights qu

and qd can be interpreted as probabilities for a new probability measure Q

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4 THE BINOMIAL MODEL

with the property Q(Z = u) = qu , Q(Z = d) = qd . Denoting expectation

w.r.t. this measure by E Q we now have the following easy calculation

1 1
QS1 = 11 + R(qu su + qd sd) = · s(1 + R) = s.
1+R 1+R

We thus have the relation

1
s= S1 ,
1+R

which to an economist is a well-known relation. It is in fact a risk neu-

tral valuation formula, in the sense that it gives today’s stock price as the
discounted expected value of tomorrow’s stock price. Of course we do not
assume that the agents in our market are risk neutral—what we have shown
is only that if we use the Q-probabilities instead of the objective proba-
bilities then we have in fact a risk neutral valuation of the stock (given
absence of arbitrage). A probability measure with this property is called a
risk neutral measure, or alternatively a risk adjusted measure or a
martingale measure. Martingale measures will play a dominant role in
the sequel so we give a formal definition.
Definition 1.3 A probability measure Q is called a martingale measure
if the following condition holds:

1
S0 = S1 .
1+R

We may now state the condition of no arbitrage in the following way.

For the binomial model it is easy to calculate the martingale probabil-
ities. The proof is left to the reader.

1.1.2 Contingent Claims

Let us now assume that the market in the preceding section is arbitrage
free. We go on to study pricing problems for contingent claims.
Definition 1.4 A contingent claim (financial derivative) is any stochas-
tic variable X of the form X = Φ(Z), where Z is the stochastic variable
driving the stock price process above.
We interpret a given claim X as a contract which pays X SEK to the
holder of the contract at time t = 1. See Fig. ??, where the value of the
claim at each node is given within the corresponding box. The function Φ is
called the contract function. A typical example would be a European call
option on the stock with strike price K. For this option to be interesting
we assume that sd < K < su. If S1 > K then we use the option, pay K to

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THE ONE PERIOD MODEL 5

get the stock and then sell the stock on the market for su, thus making a
net profit of su − K. If S1 < K then the option is obviously worthless. In
this example we thus have

su − K, if Z = u,
X=
0, if Z = d,
and the contract function is given by

Φ(u) = su − K, (1.8)
Φ(d) = 0. (1.9)

Our main problem is now to determine the “fair” price, if such an object
exists at all, for a given contingent claim X. If we denote the price of X at
time t by X, then it can be seen that at time t = 1 the problem is easy to
solve. In order to avoid arbitrage we must (why?) have

X = X,

and the hard part of the problem is to determine X. To attack this problem
we make a slight detour.
Since we have assumed absence of arbitrage we know that we cannot
make money out of nothing, but it is interesting to study what we can
achieve on the market.
Definition 1.5 A given contingent claim X is said to be reachable if
there exists a portfolio h such that

V1h = X,

with probability 1. In that case we say that the portfolio h is a hedging

portfolio or a replicating portfolio. If all claims can be replicated we say
that the market is complete.
If a certain claim X is reachable with replicating portfolio h, then, from
a financial point of view, there is no difference between holding the claim
and holding the portfolio. No matter what happens on the stock market,
the value of the claim at time t = 1 will be exactly equal to the value of
the portfolio at t = 1. Thus the price of the claim should equal the market
value of the portfolio, and we have the following basic pricing principle.
The word “reasonable” above can be given a more precise meaning as
in the following proposition. We leave the proof to the reader.
We see that in a complete market we can in fact price all contingent
claims, so it is of great interest to investigate when a given market is
complete. For the binomial model we have the following result.
Proof. We fix an arbitrary claim X with contract function Φ, and we want
to show that there exists a portfolio h = (x, y).

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6 THE BINOMIAL MODEL

1.1.3 Risk Neutral Valuation

Since the binomial model is shown to be complete we can now price any
contingent claim.
Proposition 1.6 If the binomial model is free of arbitrage, then the
arbitrage free price of a contingent claim X is given by

1
X= X. (1.10)
1+R

Here the martingale measure Q is uniquely determined by the relation

1
S0 = , (1.11)
1+R

and the explicit expression for qu and qd are given in Proposition ??.
Furthermore the claim can be replicated using the portfolio

1 uΦ(d) − dΦ(u)
x= · ,
1+R u−d
1 Φ(u) − Φ(d)
y= · .
s u−d

We see that the formula (1.10) is a “risk neutral” valuation formula,

and that the probabilities which are used are just those for which the stock
itself admits a risk neutral valuation. The main economic moral can now
be summarized.
We end by studying a concrete example.
Example 1.7 We set s = 100, u = 1.2, d = 0.8, pu = 0.6, pd = 0.4 and,
for computational simplicity, R = 0. By convention, the monetary unit is

Table 1.1 Table caption

Possible cuts 1–100 m

Total plasma mass 10 − 10 − 2 gm
Ion concentration 10 − 10 m −3
Temperature 1–40 keV
Pressure 0.1–5 atmospheres
Ion thermal velocity 100–1000 km s
Electron thermal velocity 0.01c–0.1c
Magnetic field 1–10 T
Total plasma current 0.1–7 MA

Table footnote

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THE ONE PERIOD MODEL 7

the US dollar. Thus we have the price dynamics

S0 = 100, (1.12)

120, with probability 0.6.
S1 = (1.13)
80, with probability 0.4.

If we compute the discounted expected value (under the objective probabil-

ity measure P ) of tomorrow’s price we get assume a constant deterministic
short rate of interest R, which is interpreted as the simple period rate. This
means that the bond price dynamics are given by

Bn+1 = (1 + R)Bn , (1.14)

B0 = 1. (1.15)

We now go on to define the concept of a dynamic portfolio strategy.

Definition 1.8 A portfolio strategy is a stochastic process such that

ht is a function of S0 , S1 , . . . , St−1 . For a given portfolio strategy h we set
h0 = h1 by convention. The value process corresponding to the portfolio
h is defined by
Vth = xt (1 + R) + yt St .

The condition above is in fact also sufficient for absence of arbitrage,

but this fact is a little harder to show, and we will prove it later. In any
case we assume that the condition holds.

Lemma 1.9 If the model is free of arbitrage then the following conditions
necessarily must hold.
d ≤ (1 + R) ≤ u. (1.16)

It is possible, and not very hard, to give a formal proof of the

proposition, using mathematical induction.

Proposition 1.10 The multiperiod binomial model is complete, i.e. every

claim can be replicated by a self-financing portfolio.

The formal proof will, however, look rather messy with lots of indices, so
instead we prove the proposition for a concrete example, using a binomial
tree.

Example 1.11 We set T = 3, S0 = 80, u = 1.5, d = 0.5, pu = 0.6,

pd = 0.4 and, for computational simplicity, R = 0.

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8 THE BINOMIAL MODEL

Figure 1.1. Price dynamics to this end we define a portfolio as a vector

h = (x, y)

Unlist
The bond price process is deterministic and given by
The constant R is the spot rate for the period, and we can also interpret
the existence of the bond as the existence of a bank with R as its rate
of interest.
The constant R is the spot rate for the period, and we can also interpret
the existence of the bond as the existence of a bank with R as its rate of
interest.

Description
The constant R is the spot rate for the period, and we can also interpret
the existence of the bond as the existence of a bank with R as its rate
of interest.
The constant R is the spot rate for the period, and we can also interpret
the existence of the bond as the existence of a bank with R as its rate
of interest.
The constant R is the spot rate for the period, and we can also interpret
the existence of the bond as the existence of a bank with R as its rate of
interest.

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THE ONE PERIOD MODEL 9

Verse

The constant R is the spot rate for the period, and we can also
interpret the existence of the bond as the existence of a bank
with R as its rate of interest.
The constant R is the spot rate for the period, and we can also
interpret the existence of the bond as the existence of a bank
with R as its rate of interest.
The constant R is the spot rate for the period, and we can also interpret
the existence of the bond as the existence of a bank with R as its rate of
interest.

Quotation

The constant R is the spot rate for the period, and we can also
interpret the existence of the bond as the existence of a bank with
R as its rate of interest.
The constant R is the spot rate for the period, and we can also
interpret the existence of the bond as the existence of a bank with
R as its rate of interest.
The constant R is the spot rate for the period, and we can also interpret
the existence of the bond as the existence of a bank with R as its rate of
interest.

Quote

The constant R is the spot rate for the period, and we can also interpret the
existence of the bond as the existence of a bank with R as its rate of interest.
The constant R is the spot rate for the period, and we can also interpret the
existence of the bond as the existence of a bank with R as its rate of interest.

The constant R is the spot rate for the period, and we can also interpret
the existence of the bond as the existence of a bank with R as its rate of
interest.
Theorem 1.12 The model above is free of arbitrage if and only if the
following conditions hold:

d ≤ (1 + R) ≤ u. (1.17)

The constant R is the spot rate for the period, and we can also interpret
the existence of the bond as the existence of a bank with R as its rate of
interest.

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10 THE BINOMIAL MODEL

Fundamental Problems 1.1 The model above is free of arbitrage if and

only if the following conditions hold:

d ≤ (1 + R) ≤ u. (1.18)

The constant R is the spot rate for the period, and we can also interpret
the existence of the bond as the existence of a bank with R as its rate of
interest.
Corollary 1.13 The model above is free of arbitrage if and only if the
following conditions hold:

d ≤ (1 + R) ≤ u. (1.19)

The constant R is the spot rate for the period, and we can also interpret
the existence of the bond as the existence of a bank with R as its rate of
interest.
Assumption 1.1.1 The model above is free of arbitrage if and only if the
following conditions hold:

d ≤ (1 + R) ≤ u. (1.20)

The constant R is the spot rate for the period, and we can also interpret
the existence of the bond as the existence of a bank with R as its rate of
interest.
Condition 1.1.1 The model above is free of arbitrage if and only if the
following conditions hold:

d ≤ (1 + R) ≤ u. (1.21)

The constant R is the spot rate for the period, and we can also interpret
the existence of the bond as the existence of a bank with R as its rate of
interest.
Idea 1.1.1 The model above is free of arbitrage if and only if the following
conditions hold:
d ≤ (1 + R) ≤ u. (1.22)
The constant R is the spot rate for the period, and we can also interpret
the existence of the bond as the existence of a bank with R as its rate of
interest.
Remark 1.1.1 The model above is free of arbitrage if and only if the
following conditions hold:

d ≤ (1 + R) ≤ u. (1.23)

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EXERCISES 11

The constant R is the spot rate for the period, and we can also interpret
the existence of the bond as the existence of a bank with R as its rate of
interest.
Result 1.1.1 The model above is free of arbitrage if and only if the
following conditions hold:

d ≤ (1 + R) ≤ u. (1.24)

The constant R is the spot rate for the period, and we can also interpret
the existence of the bond as the existence of a bank with R as its rate of
interest.
Notation convention 1.1.1 The model above is free of arbitrage if and
only if the following conditions hold:

d ≤ (1 + R) ≤ u. (1.25)

1.2 Exercises
The constant R is the spot rate for the period, and we can also interpret
the existence of the bond as the existence of a bank with R as its rate of
interest.

Boxed Text Crossed the Page

INVESTIGATION
Blind Embedding and Linear Correlation Detection
The embedding algorithm in the system we describe here implements a blind
embedder. We denote this algorithm by EBLIND, which refers to this specific
example of blind embedding rather than the generic concept of blind embedding.
In fact, there are many other algorithms for blind embedding.
The detection algorithm uses linear correlation as its detection metric. This is a
very common detection metric, which is discussed further in Section 3.5.
To keep things simple, we code only one bit of information. Thus, m is either
1 or 0. We assume that we are working with only grayscale images. Most of the
algorithms presented in this book share these simplifications. Methods of encoding
more than one bit are discussed in Chapters 4 and 5.

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12 THE BINOMIAL MODEL

Figure 1.9
Distribution of linear correlations between images and a low-pass filtered random
noise pattern.

watermarked image in Figure 3.8 has significantly worse fidelity than that in
Figure 3.7, because the human eye is more sensitive to low-frequency patterns than
to high-frequency patterns.
If a certain claim X is reachable with replicating portfolio h, then, from a financial
point of view, there is no difference between holding the claim and holding the
portfolio. No matter what happens on the stock market, the value of the claim at
time t = 1 will be exactly equal to the value of the portfolio at t = 1. Thus the
price of the claim should equal the market value of the portfolio, and we have the
following basic pricing principle.
If a certain claim X is reachable with replicating portfolio h, then, from a financial
point of view, there is no difference between holding the claim and holding the
portfolio. No matter what happens on the stock market, the value of the claim at
time t = 1 will be exactly equal to the value of the portfolio at t = 1. Thus the
price of the claim should equal the market value of the portfolio, and we have the
following basic pricing principle.
If a certain claim X is reachable with replicating portfolio h, then, from a financial
point of view, there is no difference between holding the claim and holding the
portfolio.

No matter what happens on the stock market, the value of the claim at
time t = 1 will be exactly equal to the value of the portfolio at t = 1. Thus
the price of the claim should equal the market value of the portfolio, and
we have the following basic pricing principle.
The reader may wish to view (or revisit) the animation “Inductive and
Radiative Coupling” on the CD.
Mathematica is very flexible and most calculations can be carried out
in more than one way. Depending on how you think, some sequences of
calculations may make more sense to you than others, even if they are less
efficient than the most efficient way to perform the desired calculations.
Often, the difference in time required for Mathematica to perform equiv-
alent – but different – calculations is quite small. For the beginner, we think
it is wisest to work with familiar calculations first and then efficiency.

Example 1.1.13 Calculate (a) 121 + 542; (b) 3231 − 9876; (c) (−23)(76); (d) (22341)(832748)
467
(387281); and (e) .
31
Solution These calculations are carried out in the following screen shot. In each case, the
input is typed and then evaluated by pressing Enter. In the last case, the Basic
Math template is used to enter the fraction.

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EXERCISES 13

Mathematica is very flexible and most calculations can be carried out

in more than one way. Depending on how you think, some sequences of
calculations may make more sense to you than others, even if they are less
efficient than the most efficient way to perform the desired calculations.
Often, the difference in time required for Mathematica to perform equiva-
lent – but different – calculations is quite small. For the beginner, we think
it is wisest to work with familiar calculations first and then efficiency.

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References

[1] Amin, K. & Jarrow, R. (1991). Pricing Foreign Currency Options under
Stochastic Interest Rates. Journal of International Money and Finance 10,
310–329.
[2] Anderson, N., Breedon, F., Deacon, M., Derry, A. & Murphy, G. (1996).
Estimating and Interpreting the Yield Curve. Wiley, Chichester.
[3] Artzner, P. & Delbaen, F. (1989). Term Structure of Interest Rates: The
Martingale Approach. Advances in Applied Mathematics 10, 95–129.
[4] Amin, K. & Jarrow, R. (1991). Pricing Foreign Currency Options under
Stochastic Interest Rates. Journal of International Money and Finance 10,
310–329.
[5] Anderson, N., Breedon, F., Deacon, M., Derry, A. & Murphy, G. (1996).
Estimating and Interpreting the Yield Curve. Wiley, Chichester.
[6] Artzner, P. & Delbaen, F. (1989). Term Structure of Interest Rates: The
Martingale Approach. Advances in Applied Mathematics 10, 95–129.
[7] Amin, K. & Jarrow, R. (1991). Pricing Foreign Currency Options under
Stochastic Interest Rates. Journal of International Money and Finance 10,
310–329.
[8] Anderson, N., Breedon, F., Deacon, M., Derry, A. & Murphy, G. (1996).
Estimating and Interpreting the Yield Curve. Wiley, Chichester.
[9] Artzner, P. & Delbaen, F. (1989). Term Structure of Interest Rates: The
Martingale Approach. Advances in Applied Mathematics 10, 95–129.
[10] Amin, K. & Jarrow, R. (1991). Pricing Foreign Currency Options under
Stochastic Interest Rates. Journal of International Money and Finance 10,
310–329.
[11] Anderson, N., Breedon, F., Deacon, M., Derry, A. & Murphy, G. (1996).
Estimating and Interpreting the Yield Curve. Wiley, Chichester.
[12] Artzner, P. & Delbaen, F. (1989). Term Structure of Interest Rates: The
Martingale Approach. Advances in Applied Mathematics 10, 95–129.
[13] Amin, K. & Jarrow, R. (1991). Pricing Foreign Currency Options under
Stochastic Interest Rates. Journal of International Money and Finance 10,
310–329.
[14] Anderson, N., Breedon, F., Deacon, M., Derry, A. & Murphy, G. (1996).
Estimating and Interpreting the Yield Curve. Wiley, Chichester.
[15] Artzner, P. & Delbaen, F. (1989). Term Structure of Interest Rates: The
Martingale Approach. Advances in Applied Mathematics 10, 95–129.
[16] Amin, K. & Jarrow, R. (1991). Pricing Foreign Currency Options under
Stochastic Interest Rates. Journal of International Money and Finance 10,
310–329.
[17] Anderson, N., Breedon, F., Deacon, M., Derry, A. & Murphy, G. (1996).
Estimating and Interpreting the Yield Curve. Wiley, Chichester.

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REFERENCES 15

[18] Artzner, P. & Delbaen, F. (1989). Term Structure of Interest Rates: The
Martingale Approach. Advances in Applied Mathematics 10, 95–129.
[19] Amin, K. & Jarrow, R. (1991). Pricing Foreign Currency Options under
Stochastic Interest Rates. Journal of International Money and Finance 10,
310–329.
[20] Anderson, N., Breedon, F., Deacon, M., Derry, A. & Murphy, G. (1996).
Estimating and Interpreting the Yield Curve. Wiley, Chichester.
[21] Artzner, P. & Delbaen, F. (1989). Term Structure of Interest Rates: The
Martingale Approach. Advances in Applied Mathematics 10, 95–129.
[22] Amin, K. & Jarrow, R. (1991). Pricing Foreign Currency Options under
Stochastic Interest Rates. Journal of International Money and Finance 10,
310–329.
[23] Anderson, N., Breedon, F., Deacon, M., Derry, A. & Murphy, G. (1996).
Estimating and Interpreting the Yield Curve. Wiley, Chichester.
[24] Artzner, P. & Delbaen, F. (1989). Term Structure of Interest Rates: The
Martingale Approach. Advances in Applied Mathematics 10, 95–129.

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References

Amin, K. & Jarrow, R. (1991). Pricing Foreign Currency Options under

Stochastic Interest Rates. Journal of International Money and Finance
10, 310–329.
Anderson, N., Breedon, F., Deacon, M., Derry, A. & Murphy, G. (1996).
Estimating and Interpreting the Yield Curve. Wiley, Chichester.
Artzner, P. & Delbaen, F. (1989). Term Structure of Interest Rates: The
Martingale Approach. Advances in Applied Mathematics 10, 95–129.

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Appendix A

We will study the behavior of various portfolios on the (B, S) market, and
to this end we define a portfolio as a vector h = (x, y). The interpretation
is that x is the number of bonds we hold in our portfolio, whereas y is the
number of units of the stock held by us. Note that it is quite acceptable
for x and y to be positive as well as negative. If, for example, x = 3, this
means that we have bought three bonds at time t = 0. If on the other
hand y = −2, this means that we have sold two shares of the stock at time
t = 0. In financial jargon we have a long position in the bond and a short
position in the stock. It is an important assumption of the model that short
positions are allowed.

A.1 Appendix Head1

Consider now a fixed portfolio h = (x, y). This portfolio has a deterministic
market value at t = 0 and a stochastic value at t = 1.
Everyone wants to make a profit by trading on the market, and in this
context a so called arbitrage portfolio is a dream come true; this is one of
the central concepts of the theory.
We will study the behavior of various portfolios on the (B, S) market,
and to this end we define a portfolio as a vector h = (x, y). The interpreta-
tion is that x is the number of bonds we hold in our portfolio, whereas y is
the number of units of the stock held by us. Note that it is quite acceptable
for x and y to be positive as well as negative. If, for example, x = 3, this
means that we have bought three bonds at time t = 0. If on the other
hand y = −2, this means that we have sold two shares of the stock at time
t = 0. In financial jargon we have a long position in the bond and a short
position in the stock. It is an important assumption of the model that short
positions are allowed.

A.2 Appendix Head2

Consider now a fixed portfolio h = (x, y). This portfolio has a deterministic
market value at t = 0 and a stochastic value at t = 1.
Everyone wants to make a profit by trading on the market, and in this
context a so called arbitrage portfolio is a dream come true; this is one of
the central concepts of the theory.
We will study the behavior of various portfolios on the (B, S) market,
and to this end we define a portfolio as a vector h = (x, y). The interpreta-
tion is that x is the number of bonds we hold in our portfolio, whereas y is

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18

the number of units of the stock held by us. Note that it is quite acceptable
for x and y to be positive as well as negative. If, for example, x = 3, this
means that we have bought three bonds at time t = 0. If on the other
hand y = −2, this means that we have sold two shares of the stock at time
t = 0. In financial jargon we have a long position in the bond and a short
position in the stock. It is an important assumption of the model that short
positions are allowed.

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Appendix B

Consider now a fixed portfolio h = (x, y). This portfolio has a deterministic
market value at t = 0 and a stochastic value at t = 1.

B.1 Appendix Head1

Everyone wants to make a profit by trading on the market, and in this
context a so called arbitrage portfolio is a dream come true; this is one of
the central concepts of the theory.
We will study the behavior of various portfolios on the (B, S) market,
and to this end we define a portfolio as a vector h = (x, y). The interpreta-
tion is that x is the number of bonds we hold in our portfolio, whereas y is
the number of units of the stock held by us. Note that it is quite acceptable
for x and y to be positive as well as negative. If, for example, x = 3, this
means that we have bought three bonds at time t = 0. If on the other
hand y = −2, this means that we have sold two shares of the stock at time
t = 0. In financial jargon we have a long position in the bond and a short
position in the stock. It is an important assumption of the model that short
positions are allowed.

B.2 Appendix Head2

Consider now a fixed portfolio h = (x, y). This portfolio has a deterministic
market value at t = 0 and a stochastic value at t = 1.
Everyone wants to make a profit by trading on the market, and in this
context a so called arbitrage portfolio is a dream come true; this is one of
the central concepts of the theory.
We will study the behavior of various portfolios on the (B, S) market,
and to this end we define a portfolio as a vector h = (x, y). The interpreta-
tion is that x is the number of bonds we hold in our portfolio, whereas y is
the number of units of the stock held by us. Note that it is quite acceptable
for x and y to be positive as well as negative. If, for example, x = 3, this
means that we have bought three bonds at time t = 0. If on the other
hand y = −2, this means that we have sold two shares of the stock at time
t = 0. In financial jargon we have a long position in the bond and a short
position in the stock. It is an important assumption of the model that short
positions are allowed.
Consider now a fixed portfolio h = (x, y). This portfolio has a
deterministic market value at t = 0 and a stochastic value at t = 1.

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20

Everyone wants to make a profit by trading on the market, and in this

context a so called arbitrage portfolio is a dream come true; this is one of
the central concepts of the theory.
We will study the behavior of various portfolios on the (B, S) market,
and to this end we define a portfolio as a vector h = (x, y). The interpreta-
tion is that x is the number of bonds we hold in our portfolio, whereas y is
the number of units of the stock held by us. Note that it is quite acceptable
for x and y to be positive as well as negative. If, for example, x = 3, this
means that we have bought three bonds at time t = 0. If on the other
hand y = −2, this means that we have sold two shares of the stock at time
t = 0. In financial jargon we have a long position in the bond and a short
position in the stock. It is an important assumption of the model that short
positions are allowed.
Consider now a fixed portfolio h = (x, y). This portfolio has a
deterministic market value at t = 0 and a stochastic value at t = 1.
Everyone wants to make a profit by trading on the market, and in this
context a so called arbitrage portfolio is a dream come true; this is one of
the central concepts of the theory.

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