Detailed Topic List

Introduction

1. Absolute vs. relative pricing

2. Mathematical techniques
• Partial differential equations (Black-Scholes approach)
• Stochastic calculus (Ito Calculus approach)
• Binary trees (Ross-Cox-Rubinstein approach)
3. Economic variables
• time - instant, interval
• value - nominal quantity, nominal dollar, relative valuation
• uncertainty - classical probability
• information - current and future economic environment
4. Economic principles
• Law of one price
• Application areas - stock option valuation, foreign exchange valuation, fixed in-
come asset and derivative valuation
5. Financial instrument example
• ’Fair’ coin flip gamble (Forward)
– Properties
– Applications - domestic equity option valuation, foreign exchange rate depen-
dent assets, interest rate dependent assets
• ’Unfair’ coin flip gamble (Option)
– Properties compared to ’Fair’ gamble
• Introduction wrap-up

Single Period Binary Model

1. Binary tree model

• Primary assets (Equity market)
– Stock (risky)
– Money market (risk-free)

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 Su = uS0 B = RB0
H H u
S0 B0
TS = dS TB = RB
d d d 0

(a) Stock price (b) Bond price

Figure 1: Stock and Bond Trees

– Stock growth rates (u,d)

– Money market period accumulation factor R
Outcome Stock Money Market
– Sample space H Su = 120 Bu = 110
T Sd = 80 Bd = 110
• Asset purchase and sale
– Stock purchase
– Money market deposit
– Stock short sale
– Money market loan
– Comparison of asset uncertainty
• Derived assets
– European call option, option expiration, strike price
– Option payoff formula max(ST − K, 0) and option tree
H Cu
C0 =?
T Cd

– Payoff diagram

Call option
Option value C

S-K

0
0 K S
Stock price S

• Portfolios
– Bank loan and stock short sale

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 – Portfolio (s = 2, b = 1.1) trees and portfolio set-up cost

H 120 H 110
2.0 * 100 + 1.1 * 100
T 80 T 110
(a) stock (b) bond

Figure 2: Portfolio

2. Arbitrage
• Arbitrage portfolio
– Type 1 and type 2 arbitrage portfolios
– Portfolio examples
• No-arbitrage conditions
– No-arbitrage condition on stock and money market growth rates: d < R < u.
– Construction of arbitrage portfolio when condition is not satisfied
• Uniqueness of risk-free asset return used as pricing methodology
3. Replicating portfolio
• Law of one price
– Law of one price in a single period binary model

A A
S L ⇒ S=L
B , B
(a) Asset 1 (b) Asset 2 (c)

Figure 3: Law of one price

– Arbitrage portfolio when law of one price is broken

• Replicating portfolio: Synthetic option built from portfolio of primary assets
– Replicating an option payoff with a portfolio of primary assets:
     
Su Bu Cu
s +b =
Sd Bd Cd

– Solving a 2 x 2 system of linear equations with determinants

– Replicating portfolio components: stock quantity s and money market b
– Replicating portfolio set-up cost as no-arbitrage option price: C0 = sS0 + bB0

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 • Replicating portfolio algebra
– Linear combination of risk profiles
– Stock quantity (purchase or short sale) (s) and money market ’quantity’ (de-
posit or loan) (b)
s = CSuu −C
−Sd
d uCd −dCu
, b = RB 0 (u−d)

Cu −Cd uCd −dCu

– Portfolio set-up cost C0 = Su −Sd
+ R(u−d)

– European call option stock component always positive: s > 0

– Option price independent of probability of coin flip being heads
C0 −sS0
– Alternative computation of money market component: b = B0

4. Arrow-Debreu state prices (λu , λd )

• State hpricing formulas
i h from rearranged
i replicating portfolio set-up cost
R−d u−R
C0 = R(u−d) Cu + R(u−d) Cd

• Unit asset (Arrow-Debreu state risk profile) pricing

H 1 H 0
λu λd
T 0 T 1
(a) Up state (b) Dn state

Figure 4: State Prices

     
Cu 1 0
• Arbitrary risk profiles and state prices: = Cu + Cd
Cd 0 1
• State prices from arbitrary primary assets
• Equivalent no-arbitrage conditions
– Strictly positive state prices for no-arbitrage market model: λu > 0, λd > 0
– Consequence of a zero state price
– Discounting and risk adjustment components of state prices
R−d 1 u−R 1
λu = ∗ , λd = ∗
|u {z
− d} R
|{z} |u {z
− d} R
|{z}
risk discounting risk discounting
component component component component

– Equivalence of positive state prices and no-arbitrage condition on primary

asset growth rates
– Zero coupon bond price as sum of state prices:

• Financial engineering examples

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 H 1 H 0 H 1
λu + λd = zcb
T 0 T 1 T 1
(a) up state (b) down state (c) bond

Figure 5: zcb = λu + λd

– Naked call
– Stock purchase
– Covered call
5. Numeraires
• Numeraire examples: Domestic currency; Inflation-adjusted dollars; Present value
accounting
• Money market numeraire (present value) and stock numeraire computation
• Numeraire probability measure (pN N
u , pd ):
N N Su N Sd N S0
pu + pd = 1, Nu pu + Nd pd = N0
• Numeraire probability from state prices:
pRu = RRu λ0 u , pRd = RRd λ0 d
• Martingale condition and numeraire pricing formula
– Binary probability model
∗ sample space Ω
∗ probability p
∗ random variable X
∗ expected value Ep (X)
∗ variance Ep (X − Ep (X))2
Y0 Y


– No-arbitrage pricing and the martingale condition: R0
= Ep R

– Martingale condition applied to normalized primary assets to compute nu-

meraire probabilities
– Martingale pricing formula
6. Risk-neutral pricing
R−d u−R
• Risk-neutral probability measure: pu = u−d
, pd = u−d

• Risk-neutral pricing
• Risk-free growth rates of all normalized assets under risk-neutral probability:
R = upu + dpd
• Risk-neutral probability and state prices

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 • Importance of stock price volatility for no-arbitrage option price
7. (Optional) State price density pricing
• Radon-Nikodym derivative and state price density function
• State prices and state price density
• Pricing kernel
8. Alternative pricing approach relationships
• Replicating portfolios
• State prices
• Numeraire pricing
• Risk-neutral pricing
• (Optional) State density pricing

Applications of single period option pricing

1. Forward contract on stock

Su − F
H
0
T
Sd − F

2. Exchange rates and foreign currency options

Xu Rd Rf Rf Xu
H H H H
X0 1 1 X0
T Xd T Rd T Rf T RX
f d

(a) X Rate (b) Dom MM (c) For MM (d) For MM $

Figure 6: Foreign Exchange

• Direct quote exchange rates

• Domestic and foreign money markets
• Replicating portfolio and set-up cost
Rd
Rf −d
• Risk-neutral probabilities: pu = u−d
, pd = 1 − pu
pu pd
• State prices: λu = Rd
, λd = Rd

• European call option on foreign currency

K Rd
• Forward exchange rate and interest rate parity: X0
= Rf

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 3. Interest rates and zero coupon bonds
• Interest rate characteristics: when set, when start, when end, how reported, how
computed
• Examples: spot rate, short rate, forward rate, LIBOR
• Zero coupon bond (ZCB)
• Single period zero coupon bond price (P(t, T )) and money market single period
accumulation factor (R)
• Short rate process, accumulation process, discount process
• Coupon bond as portfolio of ZCB
• Risk-neutral pricing of ZCB using short rate tree
• Risk-neutral pricing of bond options
• Single period and arbitrary period forward rate
• Relationships between ZCB price, spot rate and forward rate
4. American option
• Intrinsic value and hold value
• Backward induction tree folding for American put option
• Non-optimality of early exercise for American call option on non-dividend paying
stock

Put-call parity relations

K
1. Put-call parity on stock option: C0 + R
= P0 + S0
K X0
2. Put-call parity on exchange rate option: C0 + Rd
= P0 + Rf

3. Put-call parity on zero coupon bond option: Ct + KP(t, T ) = Pt + P(t, S)

Multi-period Binomial Model

1. Multi-period binomial tree

• Recombinant and non-recombinant trees
• Folding back (backward recursion) using single-period risk-neutral pricing
• Computing replicating portfolio money market component from option price and
stock delta
• Self-financing strategies
2. Multi-period option pricing examples
• European call option

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 • American put option
3. Cox-Ross-Rubinstein (CRR) multi-period binary model
• One, two and three period state prices
• Combinatorics and Pascal’s triangle
• n-period state prices and option pricing formula
• n-period risk-neutral pricing formula
• Relationship between n-period state prices and n-period risk-neutral probabilities
• Location of first in-the-money node
4. Black-Scholes formula for binary model
• European call option as portfolio of share and dollar digital options
• Discrete probability distributions, binomial distribution and complementary bi-
nomial distribution
• Stock numeraire and share digital valuation
• Bond numeraire and dollar digital valuation
• Black-Scholes binary model European call option formula

Multi-period Arrow-Debreu state prices

1. Jamshidian forward recursion state prices

2. State price tree in CRR model - five period example

Options

1. Path dependent options and non-recombinant trees

2. Option payoff diagrams (intrinsic value diagrams)
• European call and put options
• Forward and break forward
• Collar, digital, chooser path independent options
• Barrier, lookback, Asian, one-click call, shout path dependent options
3. Option pricing

Interest Rate Models

1. Rates and bond price process

2. Short rates and state prices forward induction tree construction

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 3. Black-Derman-Toy (BDT) short rate model
• Calibration to market prices
• Interest-sensitive asset valuation
4. Bootstrap Zero Coupon Bond prices

Additional topics (if time permits)

1. Model parameter estimation

• Historical volatility estimation
• Implied volatility estimation
• Root-finding techniques
2. Implied trees
• Implied volatility trees
• Implied binomial trees
3. Additional fixed income models
• Ho-Lee model
• LIBOR market model
• Pricing interest rate caps, floors and swaps
4. Incomplete markets and no-arbitrage pricing intervals