MScFE 620 Discrete-time Stochastic Processes – Video Transcripts Module 5

Video Transcripts
Module 5
MScFE 620
Discrete-time Stochastic Processes

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Revised: 07/21/2020
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MScFE 620 Discrete-time Stochastic Processes – Video Transcripts Module 5

Table of Contents

Unit 1: Modeling on a Tree ............................................................... 3

Unit 2: Pricing on a Tree ................................................................... 5
Unit 3: Hedging ................................................................................... 7
Unit 4: Exotic Derivatives ................................................................ 8

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MScFE 620 Discrete-time Stochastic Processes – Video Transcript (Lecture 1) Module 5: Unit 1

Unit 1: Modeling on a Tree

Looking at the Binomial Model

Hi, in this video, we study a simple but important example of a complete market model called the
binomial model.

In this model we will assume that the market consists of only one risky asset, 𝑋, and the riskless
asset 1.

The risky asset is assumed to evolve as follows: 𝑋! is fixed, and for every 𝑡 ∈ {0, 1, 2, … , 𝑇 − 1}, 𝑋"#$
is a function of 𝑋" :
𝑢𝑋!
𝑋!"# = $
𝑑𝑋!

where 0 < 𝑑 < 𝑢.

This model has a unique EMM if and only if 𝑑 < 1 < 𝑢 and, in this case, the risk neutral conditional
probability of an upward movement is:

1−𝑑
𝑝∗ =
𝑢−𝑑

Let 𝑌" be the number of up movements up to time 𝑡 (with 𝑌! ∶= 0). Then 𝑌 has a binomial
distribution with parameters 𝑡 and 𝑝∗ . That is,

𝑡
ℙ(𝑌" = 𝑦) = 8𝑦9 𝑝∗& (1 − 𝑝∗ )"'& 𝑦 = 0, 1, … , 𝑡

The random variables 𝑍" ≔ 𝑌" − 𝑌"'$ are i.i.d Bernoulli random variables.

If 𝐻 is a contingent claim, then the price of 𝐻 is given by:

&
∗ (𝐻)
𝜋(𝐻) = 𝔼 = / 𝐻(𝑧) 1 𝑝∗%! (1 − 𝑝∗ )#(%!
%∈* !'#

where 𝑍 = >𝑧 = (𝑧$ , … , 𝑧( ) ∶ 𝑧" ∈ {0, 1}@.

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MScFE 620 Discrete-time Stochastic Processes – Video Transcript (Lecture 1) Module 5: Unit 1

If 𝐻 is a derivative that depends only on the terminal value of 𝑋, 𝐻 = ℎ(𝑋( ), then we can write the
price as:
&
𝑇
𝜋(𝐻) = 𝔼∗ (𝐻) = 𝔼∗ 2ℎ(𝑋+ 𝑢," 𝑑 &(," )4 = / ℎ(𝑋+ 𝑢," 𝑑 &(," ) 5 8 𝑝∗- (1 − 𝑝∗ )&(-
𝑦
-'+

Now that we’ve introduced the binomial model, in the next set of notes and video we are going to
look at an example of pricing an option using the binomial model.

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MScFE 620 Discrete-time Stochastic Processes – Video Transcript (Lecture 2) Module 5: Unit 2

Unit 2: Pricing on a Tree

Hi, in this video we look at an example of pricing an option in the binomial model.

Let us look at a concrete example of a call option. A call option is a derivative 𝐻 with payoff
function 𝐻 = ℎ(𝑋( ) = (𝑋( − 𝐾)# , where 𝐾 is the strike price. The price is therefore given by:

&
𝑇
𝜋. ≔ 𝜋(𝐻) = 𝔼∗ (𝐻) = /(𝑋+ 𝑢 - 𝑑 &(- − 𝐾)" 5 8 𝑝∗- (1 − 𝑝∗ )&(-
𝑦
-'+

With the following values 𝑋! = 100, 𝐾 = 110, 𝑢 = 1/𝑑 = 1.2, 𝑇 = 2, we get:

1 − 𝑑 45 5
𝑝∗ = = =
𝑢 − 𝑑 99 11

and the price is

+ * , + , *
𝜋) = 𝔼∗ (𝐻) (100 × 1.2'* − 110)# 8$$9 + 2(100 − 110)# 8$$9 8$$9 + (100 × 1.2* − 110)# 8$$9

5 * 850
= 34 K M =
11 121

Another popular example is the put option with a payoff function of 𝐻 = (𝐾 − 𝑋( )# , where 𝐾 is
again called the strike price. The price is given by:

&
∗ (𝐻) 𝑇
𝜋/ ∶= 𝜋(𝐻) = 𝔼 = /(𝐾 − 𝑋+ 𝑢 - 𝑑 &(- )" 5 8 𝑝∗- (1 − 𝑝∗ )&(-
𝑦
-'+

Using the same parameters as above (𝑋! = 100, 𝐾 = 110, 𝑢 = 1/𝑑 = 1.2, 𝑇 = 2), we get:

1 0 2 1 2 0
𝜋/ = (110 − 100 × 1.2(0 )" C##D + 2(110 − 100)" C##D C##D + (110 − 100 × 1.20 )" C##D

850
= 10 +
121

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MScFE 620 Discrete-time Stochastic Processes – Video Transcript (Lecture 2) Module 5: Unit 2

Now consider the derivative 𝐻 which is the difference between the call option and the put option.
Then the payoff of 𝐻 is:

𝑋 −𝐾 if 𝑋& > 𝐾
𝐻 = (𝑋& − 𝐾)" − (𝐾 − 𝑋& )" = $ & = 𝑋& − 𝐾
𝑋& − 𝐾 if 𝑋& ≤ 𝐾

Hence,

𝔼∗ ((𝑋& − 𝐾)" − (𝐾 − 𝑋& )" ) = 𝔼∗ (𝑋& − 𝐾)

which implies that

𝜋. − 𝜋/ = 𝑋+ − 𝐾

This relationship between the call price 𝜋) and the put price 𝜋- is called the put-call parity. We can
also verify for the prices calculated above as:

850 850
− 510 + 8 = −10 = 100 − 110
121 121

Now that we’ve looked at an example of pricing an option in the binomial model, in the next set of
notes and video we are going to look at hedging in the binomial model.

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MScFE 620 Discrete-time Stochastic Processes – Video Transcript (Lecture 3) Module 5: Unit 3

Unit 3: Hedging

Hedging an Option in the Binomial Model

Hi, in this video we go through an example of hedging an option in the binomial model.

Consider the example discussed in the previous section, with the following values: 𝑋! = 100, 𝑢 =
1/𝑑 = 1.2, 𝑇 = 2. Consider a call option with strike price 𝐾 = 110. We want to calculate 𝜑. , where
𝐻 = (𝑋( − 110)# .

Since 𝑇 = 2, the sample space is:

𝛺 = {(1, 1), (1, 0), (0, 1), (0, 0)}

For convenience, we will replace 1 with 𝑢 and 0 with 𝑑, and write

𝛺 = {(𝑢, 𝑢), (𝑢, 𝑑), (𝑑, 𝑢), (𝑑, 𝑑)}

The values of 𝑉 can be summarized in the following table:

The hedging strategy 𝜑. is given by:

𝑉!3 − 𝑉!(#
3
𝜑!3 =
𝑋! − 𝑋!(#

The values are summarized below:

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MScFE 620 Discrete-time Stochastic Processes – Video Transcript (Lecture 4) Module 5: Unit 4

Unit 4: Exotic Derivatives

How to Price Some Exotic Options

Hi, in this video, we go through examples of how to price some exotic options.

The first example we consider is an Asian option. The payoff of an arithmetic average Asian call
option with strike price 𝐾 is:

+
𝑇 𝑇
1 1
𝐻 ≔ 𝑚𝑎𝑥 & ' 𝑋𝑡 − 𝐾, 0 ( = & ' 𝑋𝑡 − 𝐾 (
𝑇+1 𝑇+1
𝑡=0 𝑡=0

Its payoff is similar to that of a vanilla (ordinary) call option, but instead of using the terminal value
of the stock price 𝑋( , one uses the average of 𝑋 over the lifetime of the option. There are
variations on the time points used to calculate the average.

In our example, the payoff looks like this:

The price can then be calculated as:

34 850
𝜋(𝐻) = × 𝑝∗0 =
3 363

Next, we look at the lookback option. The payout of a lookback put option is:

𝐻 ≔ max 𝑋! − 𝑋&
+9!9&

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MScFE 620 Discrete-time Stochastic Processes – Video Transcript (Lecture 4) Module 5: Unit 4

For our example, the payoff values are tabulated below:

The price of 𝐻 is calculated as follows:

5 6 275 6 0
𝜋(𝐻) = 20 × × + × 5 8 ≈ 14.0496
11 11 9 11

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