Yuji Yamada: Control and Dynamical Systems California Institute of Technology
Yuji Yamada: Control and Dynamical Systems California Institute of Technology
First Term
Fall 2001
Mathematics
(Basic stochastic
calculus)
This course
Engineering Finance
(Numerical (Derivative pricing
technique) And hedging)
What are we going to learn?
Theory Application
Discrete
Continuous
Course outline
Application Theory
Pricing and Hedging on Conditional Expectation
- European option Martingale theory
- American option Markov processes
- Exotic option Ito formula
CT max(ST K , 0)
X T t St t t
t=0 t=1
uS (1+r)
p
Stock S Bond
1-p d<1+r<u
dS (1+r)
Portfolio X1(uS)=uS+r)
X0=S+
X1(dS)=dS+r)
Single period binomial model
C1 (uS ) max(uS K , 0)
C0
C1 (dS ) max(dS K , 0)
• Compare with portfolio process
1 1 r d u (1 r )
C0 C (uS ) C ( dS )
1 r u d
1 1
ud
1 1 r d u (1 r )
C0 C (uS ) C ( dS )
1 r u d
1 1
ud
~
p q~
1 ~
C0 pC1 (uS ) q~C1 (dS )
1 r
~
p q~ 1, ~ p 0, q~ 0
~ ~
It is (notationally) convenient to regard p and q as probabilities
~
p , q~ : Risk neutral probability (real probability is irrelevant)
Multi-period binomial lattice model
Stock price Call price
u4S u 4S K
u 3S
u2S
u 3 dS u 3 dS K
uS u 2 dS
Finite number
udS
S u 2d 2 S u 2d 2S K of one step
ud 2 S models
dS
ud 3 S 0
2
d S
d 3S
d 4S 0
Stock price Call price
uS3 ~ C4 (uS3 ) max(uS3 K , 0)
p
S3 C3 ( S 3 )
C3 ( S3 )
1 ~
pC4 (uS3 ) q~C4 (dS3 ), ~p 1 r d , q~ 1 ~p
1 r ud
Apply one step pricing formula at each step, and solve
backward until initial price is obtained.
1 ~ Ck (uS k 1 ) Ck (dS k 1 )
Ck 1 ( S k 1 ) pCk (uSk 1 ) q~Ck (dSk 1 ) k 1
uS k 1 dS k 1
1 r
Multi-period binomial lattice model
Market is complete
u 3S
u 2S
uS u 2 dS
udS
S
ud 2 S
dS
d 2S
d 3S
• Given a random experiment (three coin tosses), you are
only told if or
• This does not tell us anything except S 0 ( )
• We want S k ( ) to be “measurable”
3.
Ak , Ak
k 1
0 , : trivial -algebra
0 1 2
• 0 contains no information
• 1 contains the information up to time 1 (the first toss)
• 2 contains the information up to time 2 (the first two tosses)
1. () 1
2. If A1 , A2 , is a sequence of disjoint sets in , then
Ak ( Ak )
k 1 k 1
• What else?
d 2S
d 3S
There are four sets for S11 ( B)
S 1 uS AH , S
1 uS AH
S 1 uS dS , S
1 uS , S1 dS
Definition 1.6:
algebra (X) generated by a random variable X is the
smallest -algebra on containing all the sets
X 1 ( B); B (open interval on )