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Derivative Pricing
A Problem-Based Primer
CHAPMAN & HALL/CRC
Financial Mathematics Series
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world examples is highly encouraged.

Series Editors
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Centre for Financial Research
Department of Pure Mathematics and Statistics
University of Cambridge

Dilip B. Madan
Robert H. Smith School of Business
University of Maryland

Rama Cont
Department of Mathematics
Imperial College

C++ for Financial Mathematics

John Armstrong

Model-free Hedging
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Pierre Henry-Labordere

Stochastic Finance
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Jan Vecer

Equity-Linked Life Insurance

Partial Hedging Methods
Alexander Melnikov, Amir Nosrati

High-Performance Computing in Finance

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M. A. H. Dempster, Juho Kanniainen, John Keane, Erik Vynckier

Derivative Pricing
A Problem-Based Primer
Ambrose Lo

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Chapman-and-HallCRC-Financial-Mathematics-Series/book-series/CHFINANCMTH
Derivative Pricing
A Problem-Based Primer

Ambrose Lo
CRC Press
Taylor & Francis Group
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Contents

List of Figures ix

List of Tables xi

Preface xiii

Symbols xvii

I Conceptual Foundation on Derivatives 1

1 An Introduction to Forwards and Options 3
1.1 Forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.2.1 Call Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
1.2.2 Put Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.3 Classification of Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
1.4 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

2 Forwards and Futures 27

2.1 Alternative Ways to Buy a Stock . . . . . . . . . . . . . . . . . . . . . . . . 27
2.2 Prepaid Forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
2.2.1 Nondividend-paying Stocks . . . . . . . . . . . . . . . . . . . . . . . 29
2.2.2 Dividend-paying Stocks . . . . . . . . . . . . . . . . . . . . . . . . . 31
2.3 Forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.3.1 Forward Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.3.2 Cash-and-Carry Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . 39
2.3.3 Digression: Market Frictions . . . . . . . . . . . . . . . . . . . . . . . 44
2.4 Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
2.4.1 Differences between Futures and Forwards . . . . . . . . . . . . . . . 46
2.4.2 Marking to Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
2.5 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

3 Option Strategies 57
3.1 Basic Insurance Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
3.1.1 Insuring a Long Position: Floors . . . . . . . . . . . . . . . . . . . . 57
3.1.2 Insuring a Short Position: Caps . . . . . . . . . . . . . . . . . . . . . 61
3.1.3 Selling Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
3.1.4 A Simple but Useful Observation: Parallel Payoffs, Identical Profit . 65
3.2 Put-call Parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
3.2.1 Synthetic Forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
3.2.2 The Put-call Parity Equation . . . . . . . . . . . . . . . . . . . . . . 68
3.3 Spreads and Collars . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
3.3.1 Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

v
vi Contents

3.3.2 Collars . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
3.4 Volatility Speculation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
3.4.1 Straddles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 91
3.4.2 Strangles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 92
3.4.3 Butterfly Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
3.5 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102

II Pricing and Hedging of Derivatives 113

4 Binomial Option Pricing Models 115
4.1 One-period Binomial Trees . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
4.1.1 Pricing by Replication . . . . . . . . . . . . . . . . . . . . . . . . . . 115
4.1.2 Risk-neutral Pricing . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
4.1.3 Constructing a Binomial Tree . . . . . . . . . . . . . . . . . . . . . . 125
4.2 Multi-period Binomial Trees . . . . . . . . . . . . . . . . . . . . . . . . . . 131
4.3 American Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140
4.4 Options on Other Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
4.4.1 Case Study 1: Currency Options . . . . . . . . . . . . . . . . . . . . 149
4.4.2 Case Study 2: Options on Futures . . . . . . . . . . . . . . . . . . . 150
4.5 Epilogue: Pricing by Real Probabilities of Stock Price Movements . . . . . 152
4.6 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

5 Mathematical Foundations of the Black-Scholes Framework 171

5.1 A Lognormal Model of Stock Prices . . . . . . . . . . . . . . . . . . . . . . 171
5.2 Lognormal-Based Probabilistic Quantities . . . . . . . . . . . . . . . . . . . 174
5.3 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182

6 The Black-Scholes Formula 185

6.1 Black-Scholes Formula for Stocks Paying Continuous Proportional Dividends 185
6.2 Applying the Black-Scholes Formula to Other Underlying Assets . . . . . . 191
6.2.1 Case study 1: Stocks paying non-random, discrete dividends. . . . . 192
6.2.2 Case Study 2: Currency options. . . . . . . . . . . . . . . . . . . . . 196
6.2.3 Case Study 3: Futures options. . . . . . . . . . . . . . . . . . . . . . 200
6.3 Option Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 202
6.3.1 Option Delta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203
6.3.2 Option Gamma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
6.3.3 Option Greeks of a Portfolio . . . . . . . . . . . . . . . . . . . . . . 211
6.3.4 Option Elasticity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 212
6.4 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220

7 Option Greeks and Risk Management 231

7.1 Delta-hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
7.2 Hedging Multiple Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
7.3 Delta-Gamma-Theta Approximation . . . . . . . . . . . . . . . . . . . . . . 244
7.4 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253

8 Exotic Options 261

8.1 Gap Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
8.1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261
8.1.2 All-or-Nothing Options . . . . . . . . . . . . . . . . . . . . . . . . . 264
8.1.3 Pricing and Hedging Gap Options . . . . . . . . . . . . . . . . . . . 268
8.2 Exchange Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
Contents vii

8.2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273

8.2.2 Pricing Exchange Options . . . . . . . . . . . . . . . . . . . . . . . . 274
8.2.3 Pricing Maximum and Minimum Contingent Claims . . . . . . . . . 280
8.3 Compound Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 284
8.4 Asian Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
8.4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288
8.4.2 Pricing Asian Options . . . . . . . . . . . . . . . . . . . . . . . . . . 290
8.5 Lookback Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293
8.6 Shout Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
8.7 Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
8.8 Other Exotic Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
8.8.1 Chooser Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
8.8.2 Forward Start Options . . . . . . . . . . . . . . . . . . . . . . . . . . 311
8.9 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315

III Epilogue 335

9 General Properties of Option Prices 337
9.1 Put-Call Parity and Duality . . . . . . . . . . . . . . . . . . . . . . . . . . 337
9.1.1 Generalized Parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337
9.1.2 Currency Put-call Duality . . . . . . . . . . . . . . . . . . . . . . . . 340
9.2 Upper and Lower Bounds on Option Prices . . . . . . . . . . . . . . . . . . 343
9.3 Comparing Options with Respect to Contract Characteristics . . . . . . . . 347
9.3.1 Strike Price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 347
9.3.2 Maturity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 355
9.4 Early Exercise Decisions for American Options . . . . . . . . . . . . . . . . 357
9.4.1 Proof 1: A Proof Based on No-arbitrage Bounds . . . . . . . . . . . 357
9.4.2 Proof 2: A Cost-benefit Dissection Proof . . . . . . . . . . . . . . . . 358
9.4.3 Early Exercise Criterion for American Puts . . . . . . . . . . . . . . 360
9.5 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 362

Appendix A Standard Normal Distribution Table 367

Appendix B Solutions to Odd-Numbered End-of-Chapter Problems 369

B.1 Chapter 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 369
B.2 Chapter 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 370
B.3 Chapter 3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 373
B.4 Chapter 4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378
B.5 Chapter 5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 389
B.6 Chapter 6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391
B.7 Chapter 7 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398
B.8 Chapter 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 404
B.9 Chapter 9 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422

Bibliography 427

Index 429
List of Figures

1.1.1 Payoff diagrams of a long forward (left) and a short forward (right). . . . 6
1.2.1 Payoff and profit diagrams of a long call (left) and a short call (right). . . 10
1.2.2 The profit functions of the three calls in Example 1.2.2. . . . . . . . . . . 13
1.2.3 Payoff and profit diagrams of a long put (left) and a short put (right). . . 16

3.1.1 The payoff diagrams of a long asset (unhedged, dashed) and a long asset
coupled with a long K-strike put (hedged, bold). . . . . . . . . . . . . . . 58
3.1.2 The payoff diagrams of a short asset (unhedged, dashed) and a short asset
coupled with a long K-strike call (hedged, bold). . . . . . . . . . . . . . . 62
3.2.1 The payoff diagram of a long synthetic forward constructed by K-strike
long call and short put options. . . . . . . . . . . . . . . . . . . . . . . . . 67
3.3.1 Payoff diagram of a call K1 -K2 bull spread. . . . . . . . . . . . . . . . . . 76
3.3.2 Payoff diagram of K1 -K2 bear spreads constructed by calls (left) and by
puts (right). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78
3.3.3 Payoff diagram of a long K1 -K2 collar. . . . . . . . . . . . . . . . . . . . . 84
3.3.4 Illustration of the construction of two different zero-cost collars: a K1 -K2
zero-cost collar and a K10 -K20 zero-cost collar. . . . . . . . . . . . . . . . . 90
3.4.1 The payoff and profit diagrams of a long K-strike straddle. . . . . . . . . 91
3.4.2 Payoff diagram of a long K1 -K2 strangle. . . . . . . . . . . . . . . . . . . 93
3.4.3 The payoff diagrams of the student’s “strange” and a genuine strangle in
Example 3.4.4. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
3.4.4 Payoff diagram of a long K1 -K2 -K3 butterfly spread constructed by a short
K2 -strike straddle coupled with a long K1 -K3 strangle. . . . . . . . . . . 97
3.4.5 Payoff diagram of a long K1 -K2 -K3 call (or put) butterfly spread. . . . . 98

4.1.1 A generic one-period binomial stock price model. The derivative payoffs
are shown in parentheses. . . . . . . . . . . . . . . . . . . . . . . . . . . . 117
4.2.1 A generic two-period binomial stock price tree. . . . . . . . . . . . . . . . 132
4.3.1 The two-period binomial tree for Example 4.3.1. . . . . . . . . . . . . . . 142
4.3.2 The two-period binomial forward tree for Example 4.3.2. . . . . . . . . . 144
4.3.3 The two-period binomial tree for Example 4.3.3. . . . . . . . . . . . . . . 145
4.3.4 The two-period binomial tree for Example 4.3.4. . . . . . . . . . . . . . . 147
4.4.1 The exchange rate evolution in Example 4.4.1. . . . . . . . . . . . . . . . 151
4.4.2 The binomial futures price tree in Example 4.4.2. . . . . . . . . . . . . . . 153

5.1.1 A stock price path in the Black-Scholes stock price model with S(0) = 100,
α = 0.08, and σ = 0.3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 174

6.2.1 The cash flows between different parties in Example 6.2.4. . . . . . . . . . 200
6.3.1 The variation of call and put deltas with the current stock price for different
times to expiration. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 207

ix
x List of Figures

6.3.2 The variation of gamma with the current stock price for different times to
expiration. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 210

7.1.1 Comparison of the overnight profit of an unhedged written call and the
overnight profit of a delta-hedged written call. . . . . . . . . . . . . . . . 241
7.2.1 Comparison of the overnight profit of a delta-hedged written call and the
overnight profit of a delta-gamma-hedged written call. . . . . . . . . . . . 245
7.3.1 Geometric meaning of the delta- and delta-gamma approximations of the
option price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 249

8.1.1 The payoff diagram of a K1 -strike K2 -trigger European gap call option (in
bold) when (i) K1 < K2 (left), and (ii) K1 ≥ K2 (right). . . . . . . . . . . 262
8.3.1 A timeline diagram showing how a compound option works. . . . . . . . . 284
8.4.1 The three-dimensional descriptions of Asian options. . . . . . . . . . . . . 289
8.4.2 The two-period binomial stock price tree for Example 8.4.2. . . . . . . . . 291
8.5.1 The two-period binomial stock price tree used in Example 8.5.2. . . . . . 296
8.6.1 The two-period binomial stock price tree for Example 8.6.1. . . . . . . . . 298
8.7.1 The three-dimensional descriptions of barrier options. . . . . . . . . . . . 300
8.7.2 The three-period binomial stock price tree for Example 8.7.6. . . . . . . . 307
8.8.1 A timeline diagram showing how a chooser option works. . . . . . . . . . 308
8.8.2 A timeline diagram showing how a forward start option works. . . . . . . 311

B.1.1 Profit diagrams of the three puts in Problem 1.4.5. . . . . . . . . . . . . . 370

B.3.1 The profit diagrams of the 50-60 bear spread and the 50-60 collar in Prob-
lem 3.5.23. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 376
B.9.1 The sets of allowable values for the European put price (left) and American
put price (right). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 424
List of Tables

1.1 Cash flows associated with a long forward (physical settlement). . . . . . 5

1.2 Cash settlement of a long forward. . . . . . . . . . . . . . . . . . . . . . . 7
1.3 Cash flows associated with a long European call position. . . . . . . . . . 10
1.5 Different criteria to compare derivatives. . . . . . . . . . . . . . . . . . . . 21

2.1 Four different ways to own one share of stock at time T . . . . . . . . . . . 28

P
2.2 Trading strategies to effect arbitrage when F0,T > S(0). . . . . . . . . . . 31
2.3 Demonstration of (2.3.3) in the case of continuous proportional dividends. 39
2.4 Transactions and cash flows for a cash-and-carry arbitrage. . . . . . . . . 40
2.5 Transactions and cash flows for a reverse cash-and-carry arbitrage. . . . . 42
2.7 Differences between forwards and futures. . . . . . . . . . . . . . . . . . . 47
2.8 Mark-to-market proceeds and margin account balance over 4 days from a
long position in S&P 500 futures contract. . . . . . . . . . . . . . . . . . . 49

6.1 Comparing stock options and currency options in the Black-Scholes frame-
work. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
6.2 The definitions and symbols of the six most common option Greeks. . . . 202

xi
Preface

Derivatives, which are financial instruments whose value depends on or is “derived” from
(hence the name “derivatives”) other more basic underlying variables, have become com-
monplace in financial markets all over the world. The proliferation of these relatively new
financial innovations, options in particular, has underscored the ever-increasing importance
of derivative literacy among a wide range of users that span students, practitioners, reg-
ulators, and researchers, all of whom are in need of a fundamental understanding of the
mechanics, typical uses, and pricing theory of derivatives, though to different extents. De-
spite the diversity of such users, existing books on the subject have predominantly catered
to only a very specific group of users and gone to two extremes. They either adopt a mostly
descriptive approach to the intrinsically technical subject of derivatives, with occasional
number crunching and slavish applications of pricing formulas taken without proof, or are
preoccupied with sophisticated mathematical techniques from such areas as random pro-
cesses and stochastic calculus, which can be inaccessible to students or practitioners lacking
the necessary background and undesirably obscure the underlying conceptual ideas. Neither
the “black box” approach nor the “purely mathematical” approach is of much pedagogical
value.
Being an outgrowth of my lecture notes for a course entitled ACTS:4380 Mathematics
of Finance II offered at the University of Iowa for advanced undergraduate and beginning
graduate students in actuarial science, this book is a solid attempt to strike a balance
between the two aforementioned methods to teach and learn derivatives, and to meet the
needs of different types of readers. Adopting a mathematically rigorous yet widely accessible
approach that will appeal to a wide variety of audience, the book is conceptually driven and
strives to demystify the mechanics of typical derivatives and the fundamental mechanism
of derivative pricing methodologies that should be part of the toolkit of every professional
these days. This is accomplished by a combination of lucid explanations of the theory and
assumptions behind common derivative pricing models, repeated emphasis on a small set
of core ideas (e.g., no-arbitrage principle, replication, risk-neutral pricing), and a careful
selection of fully worked-out illustrative examples and end-of-chapter problems. Readers of
this book will leave with a firm understanding of “what” derivatives are, “how” and, more
importantly, “why” derivatives are used and derivative pricing works.
Here is the skeleton of this book, divided into three parts.
• Part I (Chapters 1 to 3) lays the conceptual groundwork of the whole book by setting up
the terminology of derivatives commonly encountered in the literature and introducing
the definition, mechanics, typical use, and payoff structures of the two primary groups of
derivatives, namely, forwards and options, which bestow upon their holders an obligation
and a right to trade an underlying asset at a fixed price on a fixed date, respectively.
Particular emphasis is placed on how and why a derivative works in a given scenario of
interest. In due course, we also present the all-important no-arbitrage assumption and
the method of pricing by replication. In loose terms, the former says that the prices of
derivatives should be such that the market does not admit “free lunches,” and the latter
implements the former using the common-sense idea that if two derivatives possess the
same payoff structure at expiration, they must enjoy the same initial price. Underlying

xiii
xiv Preface

the pricing and hedging of derivatives throughout this book, these two vehicles are
applied in this part to determine the fair price of a forward, where “fair” is meant in
the sense that the resulting price permits no free lunch opportunities.
• Whereas the pricing of forwards is model-independent in that it works for any asset
price distribution, the pricing of options depends critically on the probabilistic behavior
of the future asset price. In Part II (Chapters 4 to 8), which is the centerpiece of this
book, we build upon the background material in Part I and tackle option pricing in two
stages—first in the discrete-time binomial tree model (Chapter 4), which is simple, intu-
itive, and easy to implement, then in the technically more challenging continuous-time
Black-Scholes model (Chapters 5 to 8). In this part, the no-arbitrage assumption and
the method of replication continue to play a vital role in valuing options and lead to
the celebrated risk-neutral pricing formula, which asserts that the price of a (European)
derivative can be computed as its expected payoff at expiration in a risk-neutral sense,
discounted at the risk-free interest rate. The implementation and far-reaching implica-
tions of the method of risk-neutral valuation for the pricing and hedging of derivatives
are explored in Chapters 6 to 8.
• Finally, we end in Part III (Chapter 9) with a description of some general properties
satisfied by option prices when no asset price model is prescribed. Even in this model-
free framework setting, there is a rich theory describing the no-arbitrage properties
universally satisfied by option prices. Although this part can be read prior to studying
Part II, you will find that what you learn from Part II, especially the notion of an
exchange option in Chapter 8, will provide you with surprisingly useful insights into the
connections between different options.
It deserves mention that this book, as a primer, is indisputably not encyclopedic in
scope. The choice of topics is geared towards the derivatives portion (Topics 6 to 10) of the
Society of Actuaries’ Investment and Financial Markets (IFM) Exam,i which is typically
taken by advanced undergraduate students in actuarial science and allied disciplines. The
theory of random processes and stochastic calculus, while conducive to understanding the
pricing theory of derivatives in full but often an insurmountable barrier to first-time learners,
is not covered in the book, neither are credit and interest rate derivatives (which, without
doubt, are important in practice). By concentrating on the most essential conceptual ideas,
we realize the huge “payoff” of being able to disseminate these core ideas to readers with
minimal mathematical background; it is understandable that individuals interested in using
and pricing derivatives nowadays come from a wide variety of background. To be precise,
readers are only assumed to have taken a calculus-based probability and statistics course
at the level of Hogg, Tanis and Zimmerman (2014) or Hogg, McKean and Craig (2013),
where the basic notions of random variables, expectations, variances, are taught, and be
able to perform simple discounted cash flow calculations as covered in a theory of interest or
corporate finance course. With these modest prerequisites, this book is self-contained, with
the necessary mathematical ideas presented progressively as the book unfolds. For readers
interested in more advanced aspects of the use and pricing of derivatives, this book will
provide them with a springboard for performing further studies in this burgeoning field.
It is widely acknowledged that the best way to learn a subject deeply is to test your un-
derstanding with a number of meaningful exercises. With this in mind, this primer lives up
to its name and features an abundance of illustrative in-text examples and end-of-chapter
problems (to be precise, 177 examples and 209 problems) on different aspects of deriva-
tives. These problems are of a diverse nature and varying levels of difficulty (harder ones
i Section 4.5, Section 7.3 (the portion on the Black-Scholes equation), Subsection 8.1.2, and Section 9.1

are beyond the scope of the Exam IFM syllabus.

Preface xv

are labeled as [HARDER!]); while many emphasize calculating quantities such as payoffs,
prices, profits, a primitive skill that most students in a derivatives course need to acquire,
at least for exam purposes (in this respect, this book is an ideal exam preparation aid for
students who will write Exam IFM), some concern more theoretical aspects of using and
pricing derivatives, and consist of true-or-false items or derivations of formulas. All of these
problems can be worked out in a pen-and-paper environment with the aid of a scientific cal-
culator and a standard normal distribution function calculator (an example is https://www.
prometric.com/en-us/clients/soa/pages/mfe3f_calculator.aspx, which is designed
for students who will take Exam IFM.). If you do not have Internet access, you may use
the less precise standard normal distribution table provided in Appendix A of this book.
Readers who attempt these examples and problems seriously will benefit from a much more
solid understanding of the relevant topics. To help you check your answers, full solutions to
all odd-numbered end-of-chapter problems are provided in Appendix B. A solutions manual
with solutions to all problems is available to qualified instructors.
It would be remiss of me not to thank my past ACTS:4380 students for personally class
testing earlier versions of the book manuscript and many of the end-of-chapter problems,
as well as my esteemed colleague, Professor Elias S.W. Shiu, at the University of Iowa, for
sharing with me his old ACTS:4380 notes and questions, from which some of the examples
and problems in this book were motivated. I am also grateful to the Society of Actuaries
and Casualty Actuarial Society for kindly allowing me to reproduce their past and sample
exam questions, of which they own the sole copyright, and which have proved instrumental
in illustrating ideas in derivative pricing. Doctoral student Zhaofeng Tang at the University
of Iowa merits a special mention for his professional assistance with some of the figures in
this book and for meticulously proofreading part of the book manuscript. All errors that
remain, typographical or otherwise, are solely mine. To help improve the content of the book,
I would deeply appreciate it if you could bring any potential errors you have identified to my
attention; my email address is [email protected]. For readers’ benefits, an erratum
and updates to the book will be maintained on my web page at https://sites.google.
com/site/ambroseloyp/publications/derivative-pricing.
It is my sincere hope that this book will not only introduce you to the fascinating world
of derivatives, but also to instill in you a little of the enthusiasm I have for this subject
since my undergraduate studies. Welcome and may the fun begin!

Ambrose Lo, PhD, FSA, CERA

Iowa City, IA
May 2018
Symbols

Symbol Description
S or S(0) time-0 price of an underlying Ft,T time-t price of a forward ma-
asset turing at time T
S(t) time-t price of an underlying obs
Ft,T time-t observed price of a for-
asset ward maturing at time T
S a (0) time-0 ask price of an underly- fair
Ft,T time-t fair price of a forward
ing asset maturing at time T
S b (0) time-0 bid price of an underly- V time-0 price of a generic
ing asset derivative
X(t) time-t exchange rate V max time-0 price of a maximum
K strike price of an option contingent claim
K1 strike price of a gap option V min time-0 price of a minimum
K2 payment trigger of a gap op- contingent claim
tion C time-0 price of a generic call
r continuously compounded CE time-0 price of a generic Euro-
risk-free interest rate (per an- pean call
num) CA time-0 price of a generic Amer-
rb continuously compounded ican call
borrowing rate (per annum) C(K, T ) time-0 price of a K-strike T -
rl continuously compounded year call
lending rate (per annum) C gap (K1 , K2 ) time-0 price of a K1 - strike K2 -
i effective annual interest rate trigger generic gap call
(per annum) C(S(t), K, t, T ) time-t price of a K-strike call
PVt,T time-t (present) value of cash maturing at time T when the
flows between time t and time-t stock price is S(t)
timeT P time-0 price of a generic put
FVt,T time-T (future) value of cash PE time-0 price of a generic Euro-
flows between time t and pean put
timeT PA time-0 price of a generic Amer-
T maturity time of a generic ican put
derivative P gap (K1 , K2 ) time-0 price of a K1 -strike K2 -
Tf maturity time of a futures con- trigger generic gap put
tract P (S(t), K, t, T ) time-t price of a K-strike put
T1 maturity time of a compound maturing at time T when the
option time-t stock price is S(t)
T2 maturity time of the underly- BS Black-Scholes pricing function
ing option of a compound op- σ volatility of an underlying as-
tion set
P
Ft,T time-t price of a prepaid for- σoption volatility of an option
ward maturing at time T ∆ delta of a generic derivative

xvii
xviii Symbols

∆C delta of a generic call ρ(X, Y ) correlation coefficient between

∆P delta of a generic put random variables X and Y
Γ gamma of a generic derivative N (·) distribution function of the
ΓC gamma of a generic call standard normal distribution
ΓP gamma of a generic put
N 0 (·) density function of the stan-
Ω elasticity of a generic deriva-
dard normal distribution
tive
ΩC elasticity of a generic call := defined as
ΩP elasticity of a generic put LHS left-hand side
E[X] expectation of random vari- RHS right-hand side
able X
x+ positive part of real number x
Var(X) variance of random variable X
Cov(X, Y ) covariance between random 1A indicator function of event A
variables X and Y ZCB zero-coupon bond
 Part I

Conceptual Foundation on
Derivatives
1
An Introduction to Forwards and Options

Chapter overview: This book centers on derivatives—not those you have studied in your
calculus class, but those instruments whose values (or, in financial parlance, payoffs) depend
on or are “derived” from other more basic underlying variables, such as the price of a stock
or a commodity, an interest rate, a currency exchange rate, or even non-financial variables
like the temperature of a city on a particular day or your semester GPA in college, so long as
they can be quantified. These underlying driving variables are called the underlying asset,
or in short, the underlying. To begin our systematic study of derivatives, this preparatory
chapter provides a conceptual introduction to the two predominant types of derivatives,
namely, forwards and options, and sets up the basic derivatives terminology that will be
intensively used throughout this book. These primitive derivatives are basic building blocks
of more sophisticated financial instruments that will be examined in later chapters. For each
of forwards and options, we analyze its mechanics, typical use, and, most importantly, the
structure and derivation of its payoff.

1.1 Forwards
Instead of spoon-feeding you directly with the terms and conditions of different kinds of
derivatives, a much better way to get you to better understand their use and mechanics is
through a daily-life example most familiar to actuarial students.

Motivating example.
It is now July 1, 3017 (assume that Doomsday has not yet come). You are planning to take
Exam X, a notoriously difficult actuarial exam, in November 3017 and will be in severe need
of a study manual in August for your exam preparation (assume that 3 months are enough
for your study!). According to the Internet (assume that the Internet still exists in the next
millennium), the current price of the study manual for Exam X is $250 (per unit). You are
worried, however, that the price of the study manual would rise dramatically over the next
month, which would seriously jeopardize your financial well-being as a frugal student. Is
there a way to protect yourself against adverse increases in the price of the study manual?
Now consider the following “contract” available in the market:
You will be provided with one copy of the study manual on August 1, 3017 in
exchange for $275. The contract needs to be signed today and will bind you legallyi
to pay $275 for the study manual on August 1.
Such a “contract” is the quintessence of a forward contract, the subject of the current
section.
i We ignore counterparty risk, i.e., the risk that one or more parties fail to deliver on the obligations

imposed by the derivative.

3
4 1 An Introduction to Forwards and Options

What is a forward?
In general, a forward contract, or simply a forward , is an agreement between two parties
(also called counterparties) to buy or sell an asset at a certain time in the future at a certain
price. The contract is agreed upon and signed today, with one party (the buyer) undertaking
to pay the stipulated price in exchange for the asset and the other party (the seller) liable to
deliver the asset and receive the same stipulated price at the particular future time specified
in the contract. This way, a forward effectively removes the uncertainty that one needs to
face with respect to the future price of the underlying asset. Here is a good mnemonic that
helps you remember and make sense of a forward:
A forward allows you to look forward in time and lock in the transaction price of an
asset you wish to buy or sell in the future.
With respect to terminology, the essential elements in a forward are:
Study Manual
Term Description
Example
Underlying asset The asset that the forward is Study manual
based on
Expiration date The time when the forward has August 1, 3017
(or maturity date) to be settled
Forward price The price that will be paid $275
when the forward is settled
You are long the
Long or short If you buy (resp. sell) the
forward
forward, you are said to be in a
long (resp. short) forward
position. The words long and
short can serve as adjectives or
verbs, so we may also say that
you long (resp. short) the
forward.
The most important ingredient in a forward is the forward price. In this introductory chap-
ter, we take the forward price as given. In Chapter 2, we will study in detail how the forward
price can be determined in a way that is fair in a sense to be formalized. Notation-wise,
we denote generically by S(t) the time-t price of the underlying asset (the use of “S” is
motivated by the fact that the most common underlying asset is a stock; in fact the terms
“underlying asset” and “underlying stock” will be used interchangeably in the sequel when
no confusion arises), and by F0,T the forward price that is determined at time 0 and will be
paid at time T . Unless otherwise stated, in this book we will always measure time in years.

The payoff of a forward contract.

A very useful way to describe a derivative, a forward in particular, is to look at its pay-
off. This concept permeates virtually the entire book and is one of the most important
dimensions of a derivative. Loosely speaking, the payoff of a derivative position at a par-
ticular time point at or before the expiration date is defined as the value of the position.
An equivalent, but more informative and concrete definition that lends itself to practical
computations is that the payoff of a derivative at a given point of time equals the amount
of money that its holder would have had if he/she completely liquidated his/her position,
i.e., to sell whatever he/she is holding, and buy back whatever he/she has owed.
Let us apply this line of reasoning to determine the payoff of a T -year long forward (i.e.,
1.1 Forwards 5

Time Transaction Cash Flow

0 You buy a forward. 0
T You settle the forward by paying the −F0,T
seller the forward price, F0,T .
The seller delivers the asset to you. 0
You sell the asset at the spot price (i.e., +S(T )
market price) of the asset, S(T ).
Total: S(T ) − F0,T

TABLE 1.1
Cash flows associated with a long forward (physical settlement).

the forward expires in T years). Under a long forward, at expiration you pay F0,T for the
underlying asset and can cash out by selling the asset at its market price for S(T ) (see Table
1.1). On a net basis, you receive S(T ) − F0,T . This is the payoff of a T -year long forward:

Payoff of long forward = Spot price − forward price = S(T ) − F0,T . (1.1.1)
| {z } | {z }
receive (income) pay (cost)

The cash flows associated with a short forward are the exact opposite of those of a long
forward. Upon receiving the forward price from the buyer, purchasing the underlying asset
at the market price for S(T ), and delivering the asset thus purchased to the buyer, you as
the short forward party receive a payoff of

Payoff of short forward = Forward price − spot price = F0,T − S(T ), (1.1.2)

which is a mirror image of (1.1.1). You may notice that the sum of (1.1.1) and (1.1.2) is
exactly zero. In other words, a forward is a zero-sum game, with what the buyer gains
exactly offset by what the seller loses.

Example 1.1.1. (SOA Exam IFM Introductory Derivatives Sample Question

68: Payoff of long/short forward) For a nondividend-paying stock index, the current
price is 1100 and the 6-month forward price is 1150. Assume the price of the stock index
in 6 months will be 1210.
Which of the following is true regarding forward positions in the stock index?
(A) Long position gains 50
(B) Long position gains 60

(C) Long position gains 110

(D) Short position gains 60
(E) Short position gains 110

Solution. By (1.1.1) and (1.1.2), the long forward will gain 1210 − 1150 = 60 while
the short forward will gain 1150 − 1210 = −60, i.e., a loss of 60. (Answer: (B))

It deserves mention that a forward imposes upon its counterparties an obligation to

6 1 An Introduction to Forwards and Options

Payoff Payoff

Slope = 1

S(T ) S(T )
0 F0,T 0 F0,T

Slope = −1

FIGURE 1.1.1
Payoff diagrams of a long forward (left) and a short forward (right).

execute the contract at expiration. Under a long forward position, you are obligated to pay
the forward price at the expiration date, regardless of how high or low the then market
price is. Even if the ending asset price is less than the forward price, in which case you
suffer a loss, you still need to settle the forward. This is a characteristic of a forward that
distinguishes it from other derivatives.

Payoff diagrams.
In Part I of this book, we will make intensive use of a visual device called a payoff diagram,
which displays graphically the payoff of a derivative as a function of the underlying asset
price at the point of interest. As we shall see soon, the payoff diagrams of many derivatives
possess salient features that say a lot about the properties of the derivatives. In fact, one
of the best ways to remember a derivative is arguably to associate it with the geometry of
its payoff diagram.
Given (1.1.1) and (1.1.2), the payoff diagrams of a long forward and a short forward are
sketched in Figure 1.1.1. They are straight lines cutting the horizontal axis at the forward
price F0,T with a slope of 1 and −1, respectively. The linearity arises from a commitment to
trade the underlying asset in the future. In contrast, we will see in Section 1.2 that options,
the other primary category of derivatives, are characterized by nonlinear payoff functions
because of their intrinsic optionality.

Physical vs cash settlement.

In the above discussions, we assumed that at the expiration of the forward, the seller indeed
delivers the asset to the buyer for F0,T , and the buyer indeed cashes out by selling the asset
for S(T ), realizing a payoff of S(T )−F0,T . This mode of settling a forward involving genuine
delivery of the underlying asset is known as physical settlement of a forward. On second
thought, however, it would make no difference if the seller directly gives the buyer an amount
of S(T ) − F0,T in cash (this amount can be positive or negative); see Table 1.2. The holder
of the long forward will be in the same financial position as when there is genuine physical
delivery of the underlying. Settling a forward this way by means of a direct exchange of cash
without the corresponding delivery of the underlying asset is known as cash (or financial)
settlement. Both physical settlement and cash settlement apply not only to forwards but
also to other derivatives.
The two modes of settlement have their relative merits and demerits. Physical settlement
aids our understanding of the mechanics of a derivative and the reason for using that
1.2 Forwards 7

Time Transaction Cash Flow

0 You buy a forward. 0
T The seller pays you S(T ) − F0,T . S(T ) − F0,T

TABLE 1.2
Cash settlement of a long forward.

derivative in the first place. It is also critical to the fundamental derivation of its payoff
formula (the long forward payoff formula S(T ) − F0,T , while taken by many for granted,
can be derived from basics and need not be taken as a definition). However, a physical
transaction in practice will incur possibly significant transaction costs and is applicable
only to assets for which physical delivery is possible. This excludes more abstract assets
such as temperature, your GPA, interest rates, market volatility, all of which cannot be
physically traded. Cash settlement is widely applicable and simple to understand, but it
does not lend itself to deriving the payoff of a derivative from first principles. Both modes
of settlement will be used in the later part of this book, although cash settlement will play
the dominant role.

Main motivation for using derivatives: Hedging and speculation.

With the payoff formula determined above, we are in a much better position to understand
the typical use of a forward. Back to the study manual example, we again denote by S(T )
the unit price of the study manual on August 1. Suppose that the study manual is a necessity
to you, so that you must buy the study manual however cheap or expensive it is. Under this
assumption, your cash flow on August 1 will be −S(T ), which is inherently random. If you
couple your position with a long forward on the study manual, then your payoff on August 1
will be constant at −S(T ) + (S(T ) − F0,T ) = −F0,T . In effect, what you have to pay to own
the study manual is transformed from a random amount of S(T ) to the constant forward
price F0,T . The long forward therefore allows you to hedge against the risk associated with
the price of the study manual on August 1 by locking in the transaction price.
More generally, hedging aims to use the cash flows generated by a derivative to mitigate
the (often random) cash flows from a given position. In the case of a forward, the payoff from
the long forward counteracts the random cash outflow as a result of buying the underlying
at its random future price. With a forward, you are shielded from the price risk of the un-
derlying; the cash flow uncertainty arising from the future transaction has been completely
eliminated. Long forwards are commonly employed by business companies to hedge against
the future price risk associated with their necessary production inputs and outputs. They
are also popular among importers or exporters concerned with the fluctuations of foreign
exchange rates in the future.
In contrast to hedging, speculation refers to the attempt to profit from anticipated price
movements of the underlying asset without an existing exposure in the asset. In the study
manual example, if your mom, whom I assume does not need the study manual for her own
use (unless she happens to be an actuarial science professor!), is convinced that the price
of the study manual will skyrocket (resp. plummet) in August, she may take advantage of
her belief by buying (resp. selling ) a forward. Should the price of the study manual go up
(resp. go down) as expected, she can reap a huge payoff from her long (resp. short) forward
position. Of course, she may also suffer a huge loss from the forward if the price of the study
manual does not move in the direction she predicts.
8 1 An Introduction to Forwards and Options

1.2 Options
1.2.1 Call Options
Motivation.
Recall from Section 1.1 that if you enter into a forward, you are required under any circum-
stances to settle the forward at the expiration date, even if doing so results in a negative
payoff. In the study manual example, if the price of the study manual on August 1, 3017 is
only $260, it seems stupid (of course, with the benefit of hindsight!) to buy the manual at
the forward price of $275—you will pay $15 more! You may wonder:
Is there a derivative that entitles you the option to buy an asset if and only if doing
so is to your interest, i.e., you have the right to walk away from the deal if you wish
to?
Derivatives that give you an option to buy or sell an asset are naturally called options (pun
intended!). There are two main types of options, namely, call options and put options. They
are intended to provide one-sided protection against unfavorable movements in the price of
the underlying asset.

Definition and terminology of a call option.

A call option (or a call in short) gives its holder the right, but not the obligation, to buy
the underlying asset at a prespecified price. Here is a cheap mnemonic:
By means of a call, you have the option to “call” the asset from someone and own
it.
In addition to “underlying asset” and “long or short,” which enjoy the same definition as a
forward, the following terms are very useful in specifying an option in general and a call in
particular.
1. Exercise: Exercising an option refers to the act of making use of the option to trade the
underlying asset. If you exercise a call, you pay a certain price (see the next point) in
return for the underlying asset.
2. Strike price: The strike price, also known as exercise price or simply the strike, is the
price specified in the contract at which the option holder can exercise the option. In
the case of a call option, the strike price is what the holder can choose to pay for the
underlying asset. We shall denote the strike price of an option generically by K.
3. Expiration: The expiration date is the time when the option holder must decide whether
to exercise the option. As in Section 1.1, the generic symbol for the time to expiration
is T .
4. Exercise style: Exercise style is a characteristic unique to options but not forwards. It
governs when an option can be exercised.
• If the option can only be exercised at the expiration date, it is called a European-
style or simply European option.
• If the option can be exercised anytime prior to or on the expiration date, it is called
an American-style or, in short, American option.
1.2 Options 9

• A Bermudan-style option allows its holder to exercise it during only specified pe-
riods, but not throughout the entire life of the option.
Here is a mnemonic:

E uropean = E xpiration
A merican = A nytime
B ermudan = B between

Unless otherwise stated, options that are studied in the remainder of this book are
European, whose analysis is mathematically more tractable. It is easy to conceive that
American options are more valuable than otherwise identical European and Bermudan
options because of the higher degree of freedom in relation to the time of exercise. We
will see in Chapter 9 that in some cases, it turns out that the opportunity to early
exercise an option is not exploited, so that European and otherwise identical American
and Bermudan options do share the same price.

Payoff of a call option.

To determine the payoff of a long European call at the expiration time T , consider two
cases:
Case 1. If S(T ) > K, you will exercise the call to use the strike price K to buy the
asset and sell it in the market immediately for the market price S(T ), earning
S(T ) − K. Here, we are assuming that the call is settled physically.
Case 2. If S(T ) ≤ K, it is irrational to exercise the call to buy the asset for K because
you are better off buying the asset directly in the market at the cheaper price
of S(T ). In this case, you will opt out of the call, which becomes worthless, and
your payoff is zero.
To sum up, the payoff of holding a Europeanii call is
(
S(T ) − K, if S(T ) > K
Long call payoff =
0, if S(T ) ≤ K
= (S(T ) − K)+ ,

where (·)+ is the positive part function defined by x+ := max(x, 0) for any x ∈ R. For
example, 6+ = 6, 11.3+ = 11.3, (−4)+ = 0, and (−9.21)+ = 0. The positive part function
signifies the optionality inherent in options and is characteristic of option payoffs.
The payoff diagram of a long call is graphed in Figure 1.2.1. Unlike the payoff of a long
forward, that of a long call is zero if the spot price is less than the strike price, and becomes
a straight line emanating from the strike price and pointing to the right with a slope of 1
otherwise. The turning point at the strike price is an indication of the optionality of the
call—the right is exercised when and only when S(T ) ≥ K. In essence, the payoff of a long
call position is obtained from that of a long forward position by zeroing the negative portion
of the latter and keeping the positive part intact.
ii The time-t payoff of a T -year K-strike American call is (S(t) − K)+ .
10 1 An Introduction to Forwards and Options

Payoff
Profit FV0,T (C)

S(T ) S(T )
0 K
0 K
−FV0,T (C) Profit
Payoff

FIGURE 1.2.1
Payoff and profit diagrams of a long call (left) and a short call (right).

Time Transaction Cash Flow

0 You buy a call and pay the call premium C. −C
T You can decide whether to exercise the call, (S(T ) − K)+
depending on the spot price.

TABLE 1.3
Cash flows associated with a long European call position.

Option premium.
By entering into a call option, you have the option to benefit from a rise in the price of asset
without the need for bearing any downside risk. In other words, your payoff at expiration
must be non-negative regardless of the spot price. For the call to be fair to the seller, you
must pay him/her an amount called the option premium, which we designate as C, at the
inception of the option as a form of compensation—the upside protection offered by the call
is not free! The premium is also called the price of the call option. Table 1.3 shows what
and when you pay or receive if you buy a European call.
Parenthetically, the determination of the fair price of an option is a highly nontrivial
task, much more technically complicated than that of the fair price of a forward, and is the
subject of Part II of this book.

Profit of a call option.

The payoff of a derivative captures its value at a particular instant and ignores the cash
flows at other times, particularly the initial cost to set up the derivative. A more global
perspective on a derivative is through its profit, defined as the payoff of the derivative less
the future value of cash flows at previous time points.
In the case of a long call, the profit is obtained by subtracting the future value of the
option premium from the option payoff, i.e.,

Long call profit = (S(T ) − K)+ − FV0,T (C), (1.2.1)

where FV0,T (·) denotes the future value from time 0 to time T . If r represents the con-
tinuously compounded risk-free interest rate,iii then FV0,T (C) = CerT ; if i is the effective
annual interest rate, then FV0,T (C) = C(1 + i)T .
We note in passing that because a forward entails no initial investment by definition, its
profit coincides with its payoff given in (1.1.1) and (1.1.2).
iii Throughout this book, interest rates are measured per annum.
Exploring the Variety of Random
Documents with Different Content
 “There,” said my companion, “comes the storm-breeder. He
always leaves a Scotch mist behind him. By many a wet jacket do I
remember him. I suppose the poor fellow suffers much himself,—
much more than is known to the world.”
Presently a man with a child beside him, with a large black
horse, and a weather-beaten chair, once built for a chaise-body,
passed in great haste, apparently at the rate of twelve miles an hour.
He seemed to grasp the reins of his horse with firmness, and
appeared to anticipate his speed. He seemed dejected, and looked
anxiously at the passengers, particularly at the stage-driver and
myself. In a moment after he passed us, the horses’ ears were up,
and bent themselves forward so that they nearly met.
“Who is that man?” said I; “he seems in great trouble.”
“Nobody knows who he is, but his person and the child are
familiar to me. I have met him more than a hundred times, and have
been so often asked the way to Boston by that man, even when he
was travelling directly from that town, that of late I have refused any
communication with him; and that is the reason he gave me such a
fixed look.”
“But does he never stop anywhere?”
“I have never known him to stop anywhere longer than to inquire
the way to Boston; and let him be where he may, he will tell you he
cannot stay a moment, for he must reach Boston that night.”
We were now ascending a high hill in Walpole; and as we had a
fair view of the heavens, I was rather disposed to jeer the driver for
thinking of his surtout, as not a cloud as big as a marble could be
discerned.
“Do you look,” said he, “in the direction whence the man came;
that is the place to look. The storm never meets him; it follows him.”
We presently approached another hill; and when at the height,
the driver pointed out in an eastern direction a little black speck
about as big as a hat. “There,” said he, “is the seed-storm. We may
possibly reach Polley’s before it reaches us, but the wanderer and
his child will go to Providence through rain, thunder, and lightning.”
 And now the horses, as though taught by instinct, hastened with
increased speed. The little black cloud came on rolling over the
turnpike, and doubled and trebled itself in all directions. The
appearance of this cloud attracted the notice of all the passengers,
for after it had spread itself to a great bulk it suddenly became more
limited in circumference, grew more compact, dark, and
consolidated. And now the successive flashes of chain lightning
caused the whole cloud to appear like a sort of irregular net-work,
and displayed a thousand fantastic images. The driver bespoke my
attention to a remarkable configuration in the cloud. He said every
flash of lightning near its centre discovered to him, distinctly, the form
of a man sitting in an open carriage drawn by a black horse. But in
truth I saw no such thing; the man’s fancy was doubtless at fault. It is
a very common thing for the imagination to paint for the senses, both
in the visible and invisible world.
In the mean time the distant thunder gave notice of a shower at
hand; and just as we reached Polley’s tavern the rain poured down
in torrents. It was soon over, the cloud passing in the direction of the
turnpike toward Providence. In a few moments after, a respectable-
looking man in a chaise stopped at the door. The man and child in
the chair having excited some little sympathy among the
passengers, the gentleman was asked if he had observed them. He
said he had met them; that the man seemed bewildered, and
inquired the way to Boston; that he was driving at great speed, as
though he expected to outstrip the tempest; that the moment he had
passed him, a thunder-clap broke directly over the man’s head, and
seemed to envelop both man and child, horse and carriage. “I
stopped,” said the gentleman, “supposing the lightning had struck
him, but the horse only seemed to loom up and increase his speed;
and as well as I could judge, he travelled just as fast as the thunder-
cloud.”
While this man was speaking, a pedler with a cart of tin
merchandise came up, all dripping; and on being questioned, he said
he had met that man and carriage, within a fortnight, in four different
States; that at each time he had inquired the way to Boston; and that
a thunder-shower like the present had each time deluged his wagon
and his wares, setting his tin pots, etc. afloat, so that he had
determined to get a marine insurance for the future. But that which
excited his surprise most was the strange conduct of his horse, for
long before he could distinguish the man in the chair, his own horse
stood still in the road, and flung back his ears. “In short,” said the
pedler, “I wish never to see that man and horse again; they do not
look to me as though they belonged to this world.”
This was all I could learn at that time; and the occurrence soon
after would have become with me, “like one of those things which
had never happened,” had I not, as I stood recently on the door-step
of Bennett’s hotel in Hartford, heard a man say, “There goes Peter
Rugg and his child! he looks wet and weary, and farther from Boston
than ever.” I was satisfied it was the same man I had seen more than
three years before; for whoever has once seen Peter Rugg can
never after be deceived as to his identity.
“Peter Rugg!” said I; “and who is Peter Rugg?”
“That,” said the stranger, “is more than any one can tell exactly.
He is a famous traveller, held in light esteem by all innholders, for he
never stops to eat, drink, or sleep. I wonder why the government
does not employ him to carry the mail.”
“Ay,” said a by-stander, “that is a thought bright only on one side;
how long would it take in that case to send a letter to Boston, for
Peter has already, to my knowledge, been more than twenty years
travelling to that place.”
“But,” said I, “does the man never stop anywhere; does he never
converse with any one? I saw the same man more than three years
since, near Providence, and I heard a strange story about him. Pray,
sir, give me some account of this man.”
“Sir,” said the stranger, “those who know the most respecting
that man, say the least. I have heard it asserted that Heaven
sometimes sets a mark on a man, either for judgment or a trial.
Under which Peter Rugg now labors, I cannot say; therefore I am
rather inclined to pity than to judge.”
 “You speak like a humane man,” said I; “and if you have known
him so long, I pray you will give me some account of him. Has his
appearance much altered in that time?”
“Why, yes. He looks as though he never ate, drank, or slept; and
his child looks older than himself, and he looks like time broken off
from eternity, and anxious to gain a resting-place.”
“And how does his horse look?” said I.
“As for his horse, he looks fatter and gayer, and shows more
animation and courage than he did twenty years ago. The last time
Rugg spoke to me he inquired how far it was to Boston. I told him
just one hundred miles.”
“‘Why,’ said he, ‘how can you deceive me so? It is cruel to
mislead a traveller. I have lost my way; pray direct me the nearest
way to Boston.’
“I repeated, it was one hundred miles.
“‘How can you say so?’ said he; ‘I was told last evening it was
but fifty, and I have travelled all night.’
“‘But,’ said I, ‘you are now travelling from Boston. You must turn
back.’
“‘Alas,’ said he, ‘it is all turn back! Boston shifts with the wind,
and plays all around the compass. One man tells me it is to the east,
another to the west; and the guide-posts too, they all point the wrong
way.’
“‘But will you not stop and rest?’ said I; ‘you seem wet and
weary.’
“‘Yes,’ said he, ‘it has been foul weather since I left home.’
“‘Stop, then, and refresh yourself.’
“‘I must not stop; I must reach home to-night, if possible: though I
think you must be mistaken in the distance to Boston.’
“He then gave the reins to his horse, which he restrained with
difficulty, and disappeared in a moment. A few days afterward I met
 38
the man a little this side of Claremont, winding around the hills in
Unity, at the rate, I believe, of twelve miles an hour.”
“Is Peter Rugg his real name, or has he accidentally gained that
name?”
“I know not, but presume he will not deny his name; you can ask
him,—for see, he has turned his horse, and is passing this way.”
In a moment a dark-colored, high-spirited horse approached,
and would have passed without stopping, but I had resolved to
speak to Peter Rugg, or whoever the man might be. Accordingly I
stepped into the street; and as the horse approached, I made a feint
of stopping him. The man immediately reined in his horse. “Sir,” said
I, “may I be so bold as to inquire if you are not Mr. Rugg? for I think I
have seen you before.”
“My name is Peter Rugg,” said he. “I have unfortunately lost my
way; I am wet and weary, and will take it kindly of you to direct me to
Boston.”
“You live in Boston, do you; and in what street?”
“In Middle Street.”
“When did you leave Boston?”
“I cannot tell precisely; it seems a considerable time.”
“But how did you and your child become so wet? It has not
rained here to-day.”
“It has just rained a heavy shower up the river. But I shall not
reach Boston to-night if I tarry. Would you advise me to take the old
road or the turnpike?”
“Why, the old road is one hundred and seventeen miles, and the
turnpike is ninety-seven.”
“How can you say so? You impose on me; it is wrong to trifle with
a traveller; you know it is but forty miles from Newburyport to
Boston.”
“But this is not Newburyport; this is Hartford.”
 “Do not deceive me, sir. Is not this town Newburyport, and the
river that I have been following the Merrimack?”
“No, sir; this is Hartford, and the river the Connecticut.”
He wrung his hands and looked incredulous. “Have the rivers,
too, changed their courses, as the cities have changed places? But
see! the clouds are gathering in the south, and we shall have a rainy
night. Ah, that fatal oath!”
He would tarry no longer; his impatient horse leaped off, his hind
flanks rising like wings; he seemed to devour all before him, and to
scorn all behind.
I had now, as I thought, discovered a clew to the history of Peter
Rugg; and I determined, the next time my business called me to
Boston, to make a further inquiry. Soon after, I was enabled to collect
the following particulars from Mrs. Croft, an aged lady in Middle
Street, who has resided in Boston during the last twenty years. Her
narration is this:
Just at twilight last summer a person stopped at the door of the
late Mrs. Rugg. Mrs. Croft on coming to the door perceived a
stranger, with a child by his side, in an old weather-beaten carriage,
with a black horse. The stranger asked for Mrs. Rugg, and was
informed that Mrs. Rugg had died at a good old age, more than
twenty years before that time.
The stranger replied, “How can you deceive me so? Do ask Mrs.
Rugg to step to the door.”
“Sir, I assure you Mrs. Rugg has not lived here these twenty
years; no one lives here but myself, and my name is Betsy Croft.”
The stranger paused, looked up and down the street, and said,
“Though the paint is rather faded, this looks like my house.”
“Yes,” said the child, “that is the stone before the door that I used
to sit on to eat my bread and milk.”
“But,” said the stranger, “it seems to be on the wrong side of the
street. Indeed, everything here seems to be misplaced. The streets
are all changed, the people are all changed, the town seems
changed, and what is strangest of all, Catherine Rugg has deserted
her husband and child. Pray,” continued the stranger, “has John Foy
come home from sea? He went a long voyage; he is my kinsman. If I
could see him, he could give me some account of Mrs. Rugg.”
“Sir,” said Mrs. Croft, “I never heard of John Foy. Where did he
live?”
“Just above here, in Orange-tree Lane.”
“There is no such place in this neighborhood.”
“What do you tell me! Are the streets gone? Orange-tree Lane is
at the head of Hanover Street, near Pemberton’s Hill.”
“There is no such lane now.”
“Madam, you cannot be serious! But you doubtless know my
brother, William Rugg. He lives in Royal Exchange Lane, near King
Street.”
“I know of no such lane; and I am sure there is no such street as
King Street in this town.”
“No such street as King Street! Why, woman, you mock me! You
may as well tell me there is no King George. However, madam, you
see I am wet and weary, I must find a resting-place. I will go to Hart’s
tavern, near the market.”
“Which market, sir? for you seem perplexed; we have several
markets.”
“You know there is but one market near the town dock.”
“Oh, the old market; but no such person has kept there these
twenty years.”
Here the stranger seemed disconcerted, and uttered to himself
quite audibly: “Strange mistake; how much this looks like the town of
Boston! It certainly has a great resemblance to it; but I perceive my
mistake now. Some other Mrs. Rugg, some other Middle Street.—
Then,” said he, “madam, can you direct me to Boston?”
 “Why, this is Boston, the city of Boston; I know of no other
Boston.”
“City of Boston it may be; but it is not the Boston where I live. I
recollect now, I came over a bridge instead of a ferry. Pray, what
bridge is that I just came over?”
“It is Charles River bridge.”
“I perceive my mistake: there is a ferry between Boston and
Charlestown; there is no bridge. Ah, I perceive my mistake. If I were
in Boston my horse would carry me directly to my own door. But my
horse shows by his impatience that he is in a strange place. Absurd,
that I should have mistaken this place for the old town of Boston! It is
a much finer city than the town of Boston. It has been built long since
Boston. I fancy Boston must lie at a distance from this city, as the
good woman seems ignorant of it.”
At these words his horse began to chafe, and strike the
pavement with his forefeet. The stranger seemed a little bewildered,
and said, “No home to-night;” and giving the reins to his horse,
passed up the street, and I saw no more of him.
It was evident that the generation to which Peter Rugg belonged
had passed away.
This was all the account of Peter Rugg I could obtain from Mrs.
Croft; but she directed me to an elderly man, Mr. James Felt, who
lived near her, and who had kept a record of the principal
occurrences for the last fifty years. At my request she sent for him;
and after I had related to him the object of my inquiry, Mr. Felt told
me he had known Rugg in his youth, and that his disappearance had
caused some surprise; but as it sometimes happens that men run
away,—sometimes to be rid of others, and sometimes to be rid of
themselves,—and Rugg took his child with him, and his own horse
and chair, and as it did not appear that any creditors made a stir, the
occurrence soon mingled itself in the stream of oblivion; and Rugg
and his child, horse, and chair were soon forgotten.
“It is true,” said Mr. Felt, “sundry stories grew out of Rugg’s affair,
whether true or false I cannot tell; but stranger things have happened
in my day, without even a newspaper notice.”
“Sir,” said I, “Peter Rugg is now living. I have lately seen Peter
Rugg and his child, horse, and chair; therefore I pray you to relate to
me all you know or ever heard of him.”
“Why, my friend,” said James Felt, “that Peter Rugg is now a
living man, I will not deny; but that you have seen Peter Rugg and
his child, is impossible, if you mean a small child; for Jenny Rugg, if
living, must be at least—let me see—Boston massacre, 1770—
Jenny Rugg was about ten years old. Why, sir, Jenny Rugg, if living,
must be more than sixty years of age. That Peter Rugg is living, is
highly probable, as he was only ten years older than myself, and I
was only eighty last March; and I am as likely to live twenty years
longer as any man.”
Here I perceived that Mr. Felt was in his dotage, and I despaired
of gaining any intelligence from him on which I could depend.
I took my leave of Mrs. Croft, and proceeded to my lodgings at
the Marlborough Hotel.
“If Peter Rugg,” thought I, “has been travelling since the Boston
massacre, there is no reason why he should not travel to the end of
time. If the present generation know little of him, the next will know
less, and Peter and his child will have no hold on this world.”
In the course of the evening, I related my adventure in Middle
Street.
“Ha!” said one of the company, smiling, “do you really think you
have seen Peter Rugg? I have heard my grandfather speak of him,
as though he seriously believed his own story.”
“Sir,” said I, “pray let us compare your grandfather’s story of Mr.
Rugg with my own.”
“Peter Rugg, sir,—if my grandfather was worthy of credit,—once
lived in Middle Street, in this city. He was a man in comfortable
circumstances, had a wife and one daughter, and was generally
esteemed for his sober life and manners. But unhappily, his temper,
at times, was altogether ungovernable, and then his language was
terrible. In these fits of passion, if a door stood in his way, he would
never do less than kick a panel through. He would sometimes throw
his heels over his head, and come down on his feet, uttering oaths in
a circle; and thus in a rage, he was the first who performed a
somerset, and did what others have since learned to do for
merriment and money. Once Rugg was seen to bite a tenpenny nail
in halves. In those days everybody, both men and boys, wore wigs;
and Peter, at these moments of violent passion, would become so
profane that his wig would rise up from his head. Some said it was
on account of his terrible language; others accounted for it in a more
philosophical way, and said it was caused by the expansion of his
scalp, as violent passion, we know, will swell the veins and expand
the head. While these fits were on him, Rugg had no respect for
heaven or earth. Except this infirmity, all agreed that Rugg was a
good sort of a man; for when his fits were over, nobody was so ready
to commend a placid temper as Peter.
“One morning, late in autumn, Rugg, in his own chair, with a fine
large bay horse, took his daughter and proceeded to Concord. On
his return a violent storm overtook him. At dark he stopped in
Menotomy, now West Cambridge, at the door of a Mr. Cutter, a friend
of his, who urged him to tarry the night. On Rugg’s declining to stop,
Mr. Cutter urged him vehemently. ‘Why, Mr. Rugg,’ said Cutter, ‘the
storm is overwhelming you. The night is exceedingly dark. Your little
daughter will perish. You are in an open chair, and the tempest is
increasing.’ ‘Let the storm increase,’ said Rugg, with a fearful oath, ‘I
will see home to-night, in spite of the last tempest, or may I never
see home!’ At these words he gave his whip to his high-spirited
horse and disappeared in a moment. But Peter Rugg did not reach
home that night, nor the next; nor, when he became a missing man,
could he ever be traced beyond Mr. Cutter’s, in Menotomy.
“For a long time after, on every dark and stormy night the wife of
Peter Rugg would fancy she heard the crack of a whip, and the fleet
tread of a horse, and the rattling of a carriage passing her door. The
neighbors, too, heard the same noises, and some said they knew it
was Rugg’s horse; the tread on the pavement was perfectly familiar
to them. This occurred so repeatedly that at length the neighbors
watched with lanterns, and saw the real Peter Rugg, with his own
horse and chair and the child sitting beside him, pass directly before
his own door, his head turned toward his house, and himself making
every effort to stop his horse, but in vain.
“The next day the friends of Mrs. Rugg exerted themselves to
find her husband and child. They inquired at every public house and
stable in town; but it did not appear that Rugg made any stay in
Boston. No one, after Rugg had passed his own door, could give any
account of him, though it was asserted by some that the clatter of
Rugg’s horse and carriage over the pavements shook the houses on
both sides of the streets. And this is credible, if indeed Rugg’s horse
and carriage did pass on that night; for at this day, in many of the
streets, a loaded truck or team in passing will shake the houses like
an earthquake. However, Rugg’s neighbors never afterward
watched. Some of them treated it all as a delusion, and thought no
more of it. Others of a different opinion shook their heads and said
nothing.
“Thus Rugg and his child, horse, and chair were soon forgotten;
and probably many in the neighborhood never heard a word on the
subject.
“There was indeed a rumor that Rugg was seen afterward in
Connecticut, between Suffield and Hartford, passing through the
country at headlong speed. This gave occasion to Rugg’s friends to
make further inquiry; but the more they inquired, the more they were
baffled. If they heard of Rugg one day in Connecticut, the next they
heard of him winding round the hills in New Hampshire; and soon
after a man in a chair, with a small child, exactly answering the
description of Peter Rugg, would be seen in Rhode Island inquiring
the way to Boston.
“But that which chiefly gave a color of mystery to the story of
Peter Rugg was the affair at Charleston bridge. The toll-gatherer
asserted that sometimes, on the darkest and most stormy nights,
when no object could be discerned, about the time Rugg was
missing, a horse and wheel-carriage, with a noise equal to a troop,
would at midnight, in utter contempt of the rates of toll, pass over the
bridge. This occurred so frequently that the toll-gatherer resolved to
attempt a discovery. Soon after, at the usual time, apparently the
same horse and carriage approached the bridge from Charlestown
square. The toll-gatherer, prepared, took his stand as near the
middle of the bridge as he dared, with a large three-legged stool in
his hand; as the appearance passed, he threw the stool at the horse,
but heard nothing except the noise of the stool skipping across the
bridge. The toll-gatherer on the next day asserted that the stool went
directly through the body of the horse, and he persisted in that belief
ever after. Whether Rugg, or whoever the person was, ever passed
the bridge again, the toll-gatherer would never tell; and when
questioned, seemed anxious to waive the subject. And thus Peter
Rugg and his child, horse, and carriage, remain a mystery to this
day.”
This, sir, is all that I could learn of Peter Rugg in Boston.
FURTHER ACCOUNT OF PETER RUGG
By JONATHAN DUNWELL
In the autumn of 1825 I attended the races at Richmond in
Virginia. As two new horses of great promise were run, the race-
ground was never better attended, nor was expectation ever more
deeply excited. The partisans of Dart and Lightning, the two race-
horses, were equally anxious and equally dubious of the result. To
an indifferent spectator, it was impossible to perceive any difference.
They were equally beautiful to behold, alike in color and height, and
as they stood side by side they measured from heel to forefeet within
half an inch of each other. The eyes of each were full, prominent,
and resolute; and when at times they regarded each other, they
assumed a lofty demeanor, seemed to shorten their necks, project
their eyes, and rest their bodies equally on their four hoofs. They
certainly showed signs of intelligence, and displayed a courtesy to
each other unusual even with statesmen.
It was now nearly twelve o’clock, the hour of expectation, doubt,
and anxiety. The riders mounted their horses; and so trim, light, and
airy they sat on the animals as to seem a part of them. The
spectators, many deep in a solid column, had taken their places, and
as many thousand breathing statues were there as spectators. All
eyes were turned to Dart and Lightning and their two fairy riders.
There was nothing to disturb this calm except a busy woodpecker on
a neighboring tree. The signal was given, and Dart and Lightning
answered it with ready intelligence. At first they proceed at a slow
trot, then they quicken to a canter, and then a gallop; presently they
sweep the plain. Both horses lay themselves flat on the ground, their
riders bending forward and resting their chins between their horses’
ears. Had not the ground been perfectly level, had there been any
undulation, the least rise and fall, the spectator would now and then
have lost sight of both horses and riders.
While these horses, side by side, thus appeared, flying without
wings, flat as a hare, and neither gaining on the other, all eyes were
diverted to a new spectacle. Directly in the rear of Dart and
Lightning, a majestic black horse of unusual size, drawing an old
weather-beaten chair, strode over the plain; and although he
appeared to make no effort, for he maintained a steady trot, before
Dart and Lightning approached the goal the black horse and chair
had overtaken the racers, who, on perceiving this new competitor
pass them, threw back their ears, and suddenly stopped in their
course. Thus neither Dart nor Lightning carried away the purse.
The spectators now were exceedingly curious to learn whence
came the black horse and chair. With many it was the opinion that
nobody was in the vehicle. Indeed, this began to be the prevalent
opinion; for those at a short distance, so fleet was the black horse,
could not easily discern who, if anybody, was in the carriage. But
both the riders, very near to whom the black horse passed, agreed in
this particular,—that a sad-looking man and a little girl were in the
chair. When they stated this I was satisfied that the man was Peter
Rugg. But what caused no little surprise, John Spring, one of the
riders (he who rode Lightning) asserted that no earthly horse without
breaking his trot could, in a carriage, outstrip his race-horse; and he
persisted, with some passion, that it was not a horse,—or, he was
sure it was not a horse, but a large black ox. “What a great black ox
can do,” said John, “I cannot pretend to say; but no race-horse, not
even flying Childers, could out-trot Lightning in a fair race.”
 This opinion of John Spring excited no little merriment, for it was
obvious to every one that it was a powerful black horse that
interrupted the race; but John Spring, jealous of Lightning’s
reputation as a horse, would rather have it thought that any other
beast, even an ox, had been the victor. However, the “horse-laugh”
at John Spring’s expense was soon suppressed; for as soon as Dart
and Lightning began to breathe more freely, it was observed that
both of them walked deliberately to the track of the race-ground, and
putting their heads to the earth, suddenly raised them again and
began to snort. They repeated this till John Spring said,—“These
horses have discovered something strange; they suspect foul play.
Let me go and talk with Lightning.”
He went up to Lightning and took hold of his mane; and
Lightning put his nose toward the ground and smelt of the earth
without touching it, then reared his head very high, and snorted so
loudly that the sound echoed from the next hill. Dart did the same.
John Spring stooped down to examine the spot where Lightning had
smelled. In a moment he raised himself up, and the countenance of
the man was changed. His strength failed him, and he sidled against
Lightning.
At length John Spring recovered from his stupor and exclaimed,
“It was an ox! I told you it was an ox. No real horse ever yet beat
Lightning.”
And now, on a close inspection of the black horse’s tracks in the
path, it was evident to every one that the forefeet of the black horse
were cloven. Notwithstanding these appearances, to me it was
evident that the strange horse was in reality a horse. Yet when the
people left the race-ground, I presume one half of all those present
would have testified that a large black ox had distanced two of the
fleetest coursers that ever trod the Virginia turf. So uncertain are all
things called historical facts.
While I was proceeding to my lodgings, pondering on the events
of the day, a stranger rode up to me, and accosted me thus,—“I think
your name is Dunwell, sir.”
“Yes, sir,” I replied.
 “Did I not see you a year or two since in Boston, at the
Marlborough Hotel?”
“Very likely, sir, for I was there.”
“And you heard a story about one Peter Rugg?”
“I recollect it all,” said I.
“The account you heard in Boston must be true, for here he was
to-day. The man has found his way to Virginia, and for aught that
appears, has been to Cape Horn. I have seen him before to-day, but
never saw him travel with such fearful velocity. Pray, sir, where does
Peter Rugg spend his winters, for I have seen him only in summer,
and always in foul weather, except this time?”
I replied, “No one knows where Peter Rugg spends his winters;
where or when he eats, drinks, sleeps, or lodges. He seems to have
an indistinct idea of day and night, time and space, storm and
sunshine. His only object is Boston. It appears to me that Rugg’s
horse has some control of the chair; and that Rugg himself is, in
some sort, under the control of his horse.”
I then inquired of the stranger where he first saw the man and
horse.
“Why, sir,” said he, “in the summer of 1824, I travelled to the
North for my health; and soon after I saw you at the Marlborough
Hotel I returned homeward to Virginia, and, if my memory is correct, I
saw this man and horse in every State between here and
Massachusetts. Sometimes he would meet me, but oftener overtake
me. He never spoke but once, and that once was in Delaware. On
his approach he checked his horse with some difficulty. A more
beautiful horse I never saw; his hide was as fair and rotund and
glossy as the skin of a Congo beauty. When Rugg’s horse
approached mine he reined in his neck, bent his ears forward until
they met, and looked my horse full in the face. My horse immediately
withered into half a horse, his hide curling up like a piece of burnt
leather; spell-bound, he was fixed to the earth as though a nail had
been driven through each hoof.
 “‘Sir,’ said Rugg, ‘perhaps you are travelling to Boston; and if so,
I should be happy to accompany you, for I have lost my way, and I
must reach home to-night. See how sleepy this little girl looks; poor
thing, she is a picture of patience.’
“‘Sir,’ said I, ‘it is impossible for you to reach home to-night, for
you are in Concord, in the county of Sussex, in the State of
Delaware.’
“‘What do you mean,’ said he, ‘by State of Delaware? If I were in
Concord, that is only twenty miles from Boston, and my horse
Lightfoot could carry me to Charlestown ferry in less than two hours.
You mistake, sir; you are a stranger here; this town is nothing like
Concord. I am well acquainted with Concord. I went to Concord
when I left Boston.’
“‘But,’ said I, ‘you are in Concord, in the State of Delaware.’
“‘What do you mean by State?’ said Rugg.
“‘Why, one of the United States.’
“‘States!’ said he, in a low voice; ‘the man is a wag, and would
persuade me I am in Holland.’ Then, raising his voice, he said, ‘You
seem, sir, to be a gentleman, and I entreat you to mislead me not:
tell me, quickly, for pity’s sake, the right road to Boston, for you see
my horse will swallow his bits; he has eaten nothing since I left
Concord.’
“‘Sir,’ said I, ‘this town is Concord,—Concord in Delaware, not
Concord in Massachusetts; and you are now five hundred miles from
Boston.’
“Rugg looked at me for a moment, more in sorrow than
resentment, and then repeated, ‘Five hundred miles! Unhappy man,
who would have thought him deranged; but nothing in this world is
so deceitful as appearances. Five hundred miles! This beats
Connecticut River.’
“What he meant by Connecticut River, I know not; his horse
broke away, and Rugg disappeared in a moment.”
 I explained to the stranger the meaning of Rugg’s expression,
“Connecticut River,” and the incident respecting him that occurred at
Hartford, as I stood on the door-stone of Mr. Bennett’s excellent
hotel. We both agreed that the man we had seen that day was the
true Peter Rugg.
Soon after, I saw Rugg again, at the toll-gate on the turnpike
between Alexandria and Middleburgh. While I was paying the toll, I
observed to the toll-gatherer that the drought was more severe in his
vicinity than farther south.
“Yes,” said he, “the drought is excessive; but if I had not heard
yesterday, by a traveller, that the man with the black horse was seen
in Kentucky a day or two since, I should be sure of a shower in a few
minutes.”
I looked all around the horizon, and could not discern a cloud
that could hold a pint of water.
“Look, sir,” said the toll-gatherer, “you perceive to the eastward,
just above that hill, a small black cloud not bigger than a blackberry,
and while I am speaking it is doubling and trebling itself, and rolling
up the turnpike steadily, as if its sole design was to deluge some
object.”
“True,” said I, “I do perceive it; but what connection is there
between a thunder-cloud and a man and horse?”
“More than you imagine, or I can tell you; but stop a moment, sir,
I may need your assistance. I know that cloud; I have seen it several
times before, and can testify to its identity. You will soon see a man
and black horse under it.”
While he was speaking, true enough, we began to hear the
distant thunder, and soon the chain-lightning performed all the
figures of a country-dance. About a mile distant we saw the man and
black horse under the cloud; but before he arrived at the toll-gate,
the thunder-cloud had spent itself, and not even a sprinkle fell near
us.
As the man, whom I instantly knew to be Rugg, attempted to
pass, the toll-gatherer swung the gate across the road, seized
Rugg’s horse by the reins, and demanded two dollars.
Feeling some little regard for Rugg, I interfered, and began to
question the toll-gatherer, and requested him not to be wroth with the
man. The toll-gatherer replied that he had just cause, for the man
had run his toll ten times, and moreover that the horse had
discharged a cannon-ball at him, to the great danger of his life; that
the man had always before approached so rapidly that he was too
quick for the rusty hinges of the toll-gate; “but now I will have full
satisfaction.”
Rugg looked wistfully at me, and said, “I entreat you, sir, to delay
me not; I have found at length the direct road to Boston, and shall
not reach home before night if you detain me. You see I am dripping
wet, and ought to change my clothes.”
The toll-gatherer then demanded why he had run his toll so
many times.
“Toll! Why,” said Rugg, “do you demand toll? There is no toll to
pay on the king’s highway.”
“King’s highway! Do you not perceive this is a turnpike?”
“Turnpike! there are no turnpikes in Massachusetts.”
“That may be, but we have several in Virginia.”
“Virginia! Do you pretend I am in Virginia?”
Rugg then, appealing to me, asked how far it was to Boston.
Said I, “Mr. Rugg, I perceive you are bewildered, and am sorry to
see you so far from home; you are, indeed, in Virginia.”
“You know me, then, sir, it seems; and you say I am in Virginia.
Give me leave to tell you, sir, you are the most impudent man alive;
for I was never forty miles from Boston, and I never saw a Virginian
in my life. This beats Delaware!”
“Your toll, sir, your toll!”
“I will not pay you a penny,” said Rugg; “you are both of you
highway robbers. There are no turnpikes in this country. Take toll on
the king’s highway! Robbers take toll on the king’s highway!” Then in
a low tone, he said, “Here is evidently a conspiracy against me; alas,
I shall never see Boston! The highways refuse me a passage, the
rivers change their courses, and there is no faith in the compass.”
But Rugg’s horse had no idea of stopping more than one minute;
for in the midst of this altercation, the horse, whose nose was resting
on the upper bar of the turnpike-gate, seized it between his teeth,
lifted it gently off its staples, and trotted off with it. The toll-gatherer,
confounded, strained his eyes after his gate.
“Let him go,” said I, “the horse will soon drop your gate, and you
will get it again.”
I then questioned the toll-gatherer respecting his knowledge of
this man; and he related the following particulars:—
“The first time,” said he, “that man ever passed this toll-gate was
in the year 1806, at the moment of the great eclipse. I thought the
horse was frightened at the sudden darkness, and concluded he had
run away with the man. But within a few days after, the same man
and horse repassed with equal speed, without the least respect to
the toll-gate or to me, except by a vacant stare. Some few years
afterward, during the late war, I saw the same man approaching
again, and I resolved to check his career. Accordingly I stepped into
the middle of the road, and stretched wide both my arms, and cried,
‘Stop, sir, on your peril!’ At this the man said, ‘Now, Lightfoot,
confound the robber!’ at the same time he gave the whip liberally to
the flank of his horse, which bounded off with such force that it
appeared to me two such horses, give them a place to stand, would
overcome any check man could devise. An ammunition wagon which
had just passed on to Baltimore had dropped an eighteen pounder in
the road; this unlucky ball lay in the way of the horse’s heels, and the
beast, with the sagacity of a demon, clinched it with one of his heels
and hurled it behind him. I feel dizzy in relating the fact, but so nearly
did the ball pass my head, that the wind thereof blew off my hat; and
the ball embedded itself in that gate-post, as you may see if you will
cast your eye on the post. I have permitted it to remain there in
memory of the occurrence,—as the people of Boston, I am told,
preserve the eighteen-pounder which is now to be seen half
imbedded in Brattle Street church.”
I then took leave of the toll-gatherer, and promised him if I saw or
heard of his gate I would send him notice.
A strong inclination had possessed me to arrest Rugg and
search his pockets, thinking great discoveries might be made in the
examination; but what I saw and heard that day convinced me that
no human force could detain Peter Rugg against his consent. I
therefore determined if I ever saw Rugg again to treat him in the
gentlest manner.
In pursuing my way to New York, I entered on the turnpike in
Trenton; and when I arrived at New Brunswick, I perceived the road
was newly macadamized. The small stones had just been laid
thereon. As I passed this piece of road, I observed that, at regular
distances of about eight feet, the stones were entirely displaced from
spots as large as the circumference of a half-bushel measure. This
singular appearance induced me to inquire the cause of it at the
turnpike-gate.
“Sir,” said the toll-gatherer, “I wonder not at the question, but I
am unable to give you a satisfactory answer. Indeed, sir, I believe I
am bewitched, and that the turnpike is under a spell of enchantment;
for what appeared to me last night cannot be a real transaction,
otherwise a turnpike-gate is a useless thing.”
“I do not believe in witchcraft or enchantment,” said I; “and if you
will relate circumstantially what happened last night, I will endeavor
to account for it by natural means.”
“You may recollect the night was uncommonly dark. Well, sir, just
after I had closed the gate for the night, down the turnpike, as far as
my eye could reach, I beheld what at first appeared to be two armies
engaged. The report of the musketry, and the flashes of their
firelocks, were incessant and continuous. As this strange spectacle
approached me with the fury of a tornado, the noise increased; and
the appearance rolled on in one compact body over the surface of
the ground. The most splendid fireworks rose out of the earth and
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