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Derivative Pricing
A Problem-Based Primer
CHAPMAN & HALL/CRC
Financial Mathematics Series
Aims and scope:
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Dilip B. Madan
Robert H. Smith School of Business
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Rama Cont
Department of Mathematics
Imperial College

C++ for Financial Mathematics

John Armstrong

Model-free Hedging
A Martingale Optimal Transport Viewpoint
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
 Soon afterwards Simon and Patricia left. They walked the short
distance to the Manor without speaking, for the Saint was enjoying
the novel experience of finding his flow of small talk entirely dried
up. He had thought of nothing to say until the girl was opening the
door, and then he could only make a postponement.
“May I see you to-morrow morning?” he asked.
“Of course.”
“I’ll come right after breakfast.”
Suddenly she remembered Agatha Girton.
“I think—would you mind if I came over to you instead?”
“I’d love you to. And if I haven’t bored you to tears by then, you
can stay for lunch. Tell me what time you’ll be leaving, and I’ll send
Orace over to fetch you.”
She was surprised.
“Is that necessary?”
“Very necessary,” replied the Saint gravely. “Tigers have nasty
suspicious minds, just like me, and by this time one Tiger is
wondering just how dangerous you are, Pat. Yes, I know it’s
screamingly funny, but let me send Orace—for my own peace of
mind.”
“Well—— About half-past ten, if you like.”
“I do. And Orace will adore it. One other thing. Will you do me a
great favour?”
She had found the switch in the hall, and she turned on the light
to see his face better, but he was not joking.
“Lock your door, and put the key under the pillow. Don’t open to
anybody—not even your aunt. I don’t really think anything’ll happen
so soon, but Tigers can hustle. Will you?”
She nodded.
“You’re very alarming,” she said.
“I’m full of ideas to-night,” he said. “I’ve had a taste of the Tiger’s
speed, and nobody ever stung the Saint in the same way twice.
Don’t believe any messages except they’re brought by Orace. Don’t
trust anybody but me, Orace, or old Carn at a pinch. I know it’s a tall
order, but there are one or two rough days—not to mention rough
nights—in store for the old brigade. You’ve been perfectly marvellous
so far. Can you keep it up?”
“I’ll try,” she said.
He took her hand.
“God bless you, Pat, old pal.”
“Saint——”
He was going when she stopped him. It was odd to hear that
nickname fall from her lips—the name wherewith the Saint had been
christened in strange and ugly places, by hard and godless men. He
had grown so used to it that he had come to accept it without
question, but now the sound of it brought a flood of memories. Once
again he stood in the Bosun’s smoky bar at the back of Mexico City,
looking from the huddled corpse of Senhor Miguel Grasiento to the
girl called Cherry, and heard the rurales pounding on the door. He
had got her away, on an English tramp bound for Liverpool. “ ‘Saint,’ ”
she had said—“that was a true word spoken in jest.” And he had
never heard the name uttered in the same tone since until that
moment. . . .
“Saint, did you really go to Bloem’s?”
“I did not,” he answered. “That was a frame-up. But Mynheer
Bloem is certainly one of the Tiger Cubs. Watch him! I’ll tell you the
whole yarn to-morrow. Bye-bye, kid.”
The Saint found Orace in the lane, curled up under the hedge,
philosophically smoking his pipe.
“We’ll work inland round the village,” said Simon, “I’m hoping the
Tiger’s had enough for one night, but you never know. Nobody’s got
any proof that Bloem was lying about that hold-up merchant, except
me, and a fairy tale like that cuts both ways. If our bodies were
found in a field in the morning, the whole thing’d fit in beautifully.”
Nevertheless, they were not molested on the way back—a fact
which might well have been due to the Saint’s foresight. It took an
hour of the Saint’s killing pace to do the journey which would have
lasted only fifteen minutes by the obvious route, and even then
Simon was not satisfied.
When the outline of the Pill Box loomed dimly up against the dark
sky, he stopped.
 “Booby traps have caught mugs before now,” he murmured. “Just
park yourself in the nettles here, Orace, while I snoop round.”
The Saint could have given most shikars points when it came to
moving across country without being noticed. Orace simply saw a
tall shape melt soundlessly away into the gloom, and thereafter
could trace nothing until the tall shape materialised again beside
him.
“All clear,” said Simon. “That means our Tiger’s burning the
midnight oil thinking out something really slick and deadly.”
The Saint was right. Although he and Orace never relaxed their
vigilance, taking it in turns to sleep and keep watch, they were left
in peace. The Tiger had taken one blind shot, and it had not come
off. Moreover, if his organisation had been only a shade less
thorough, it might have landed him in the tureen. As it was, he had
come out of the encounter none too well. And for the future he
intended to have his moves mapped out well in advance, with every
possible set-back and development legislated for.
None of these reflections disturbed the Saint’s sleep. He had taken
the first watch, and so the sun was shining gaily through the
embrasures when he awoke for the second time, to find Orace
setting a cup of tea down by his bedside.
“Nice morning,” remarked Orace, according to ritual, and vanished
again.
Since the episode of the bullet out of the blue, Simon had
reluctantly decided to forgo his morning dip until the air had become
clearer. However, he skipped and shadow-boxed in the sun with
especial vigour, and finished up with Orace splashing a couple of
buckets of water over him, what time the Saint lay on the grass
drawing deep grateful breaths and blessing his perfect condition. For
the Saint saw a fierce and wearing scrap ahead, and he reckoned
that he would need all his strength and stamina if he was going to
be on his feet when the gong clanged for the last round.
“Brekfuss narf a minnit,” said Orace.
The Saint was grinning as he dressed. Orace was nearly too good
to be true.
 They were late that morning, and Orace left to fetch Patricia as
soon as he had served “brekfuss.” The girl arrived in half an hour, to
find the Saint spread-eagled in a deck chair outside the Pill Box. He
had managed to unearth another pair of flannel bags and another
shooting-jacket that were nearly as disreputable as the outfit which
had been wrecked in Bittle’s garden the night before, and he looked
very fresh and comfortable, for his shirt, as usual, would have put
snow to shame.
He jumped up and held out both his hands, and she gave him
both of hers.
“I haven’t seen you for ages,” he said. “How are we?”
“Fine,” she told him. “And nothing happened.”
She was cool and slim in white, and he thought he had never seen
anyone half so lovely.
“Something might have,” he said. “And when I was a Boy Scout
they taught me to Be Prepared.”
He rigged a chair for her and adjusted the cushions, and then he
sat down again.
“I know you’re bursting with curiosity,” he said, “so I’ll come
straight to the ’osses.”
And without further ado he started on the long history. He told her
about Fernando, dying out in the jungle with a Tiger Cub’s kris in
him, and he told her Fernando’s story. He told her about the Tiger,
who was for years Chicago’s most brilliant and terrible gang leader.
He told her about some of the Tiger’s exploits, and finally came to
the account of the breaking of the Confederate Bank. Some of the
details Fernando had told him; the rest he had gathered together by
patient investigation; the accumulation worked up into a plot hair-
raising enough to provide the basis of the wildest film serial that was
ever made.
“The Tiger’s very nearly a genius,” he said. “The way he got away
with that mint of money and carted it all the miles to here is just a
sample of his brain.”
Then he told her about the more recent events—the little he had
learned while he had been in Baycombe. How he had been
suspected from the day of his arrival, and how he had done his best
to encourage that suspicion, in the hope that the other side would
give themselves away by trying to dispose of him. Gradually the lie
of the land took shape in her mind, while the Saint talked on, putting
in a touch of character here and there, recalling points that he had
omitted and referring to details that he had not yet given. The story
was not told smoothly—it rattled out, paused, and rattled on again,
decorated with the Saint’s typical racy idiom and humorous egotism.
Nevertheless, it held her, and it was a convincing story, for the Saint
had a gift for graphic description. She saw the scenes at which she
had been present in a new light.
He ended up with a flippant account of the sport chez Bittle after
he had helped her get away.
“And there you have it,” he concluded. “Heard in cold blood, with
the sun shining and all that, it sounds preposterous enough to make
dear old Munchausen look like gospel. But you’ve seen a bit of it
yourself, and perhaps that’ll make it easier for you to believe the
rest. And what it boils down to is that the Tiger is in Baycombe, and
so am I, and so are the pieces of eight; and the Tiger wants my
head on a tin tray, and I want his ill-gotten gains, and we’re both
pretty keen to hang on to our respective possessions. So, taken by
and large, it looks like we shall come to blows and other Wild and
Woolly Western expressions of mutual ill-feeling. And the point is,
Pat, and the reason why I felt you had a right to know all the odds—
is that you’ve gone and cut in on the game. By last night, the Tiger
had to face the risk that I might have talked to you, and the way you
behaved generally won’t have eased his mind any. You might be a
danger or you might not, but he can’t afford to take chances. To be
on the safe side, he’s got to assume that you and I are as thick as
thieves. So you see, old soul, you’re slap in the middle of this here
jamboree, whether you like it or not. You’re cast for second juvenile
lead in the bloodcurdling melodrama now playing, and your name’s
up in red lights all round the Tiger’s den—and the question before
the house is, What Do We Do About It?”
He was leaning forward so that he could see her face, and she
knew that he was desperately serious. She knew, also, instinctively,
that he was not a man to exaggerate the situation, however much
he might play the buffoon in other directions.
“Now, here’s my suggestion,” said the Saint. “I know a bloke called
Terry Mannering, who lives on the other side of Devonshire, and he
can deal with fun and games as well as I can. He has a wife, whom
you’ll love, and a very good line in yachts, being nearly as rich as I
should like to be since his Old Man kicked the bucket. If I took you
over and told Terry that it’d be good for all your healths if you went
cruising off to the West Indies or somewhere else a long way off for
a few months, till the tumult and the shouting dies, so to speak, and
the Tigers and their Cubs depart—well, I know the three of you’d be
on the high seas in no time. And the Tiger and I would be rude to
each other for a bit, and when it was all over and he was decently
buried I’d let you know and you could come back. What about it?”
Patricia studied her shoe; and she said, in a very Saintly way:
“What, indeed?”
“You said?” rapped Simon.
“What about it?” queried Patricia. “It might be rather a good idea
some time, but you can’t rush it like that. Besides, I’m rather
enjoying myself in Baycombe.”
Simon got up.
“Well, I’m not enjoying your enjoyment,” he said bluntly. “That
sort of courage is all very fine when it’s to some purpose—but this
time it isn’t. I’ve never dragged a woman into my little worries yet,
and I’m not starting now. Perhaps you think this is going to be a
picnic. I thought I’d made it plain enough that it isn’t. If you want to
pack a few thrills into your young life, I’ll arrange a big-game
shooting trip, or something else comparatively tame, later. But this
particular spree is not in your line one bit, and you’d better be
sensible and admit it.”
Patricia raised her eyebrows.
“So I gather you propose to kidnap me,” she said calmly. “I believe
‘shanghai’ is the word. Well, I should start planning right away—
because nothing short of that is going to move me.”
“You’re a damned fool,” said the Saint.
 She laughed, standing up to him and laying a hand on his
shoulder.
“Dear man,” she said, “I refuse to lose my temper, because I know
that’s just what you want me to do. You think that if you’re rude
enough I’ll dash off and leave you to stew. And I can promise you I
shan’t do anything of the sort. I know it isn’t going to be a picnic—
but I’m sorry if you think I’m a girl that’s only fit for picnics. I’ve
always fancied myself as the heroine of a hell-for-leather adventure,
and this is probably the only chance I shall ever have. And I’m jolly
well going to see it through!”
Simon held himself in check with an effort. He had a frantic
impulse to take this stubborn slip of a girl across his knee and spank
some sense into her; and coincidently with that he had an equally
importunate desire to hug her and kiss her to death. For there was
no doubt that she was determined to ride on to the kill, however
dangerous the country her obstinate intention led her over. Why she
should be so set on it beat the Saint. He could imagine a high-
spirited girl fancying herself as the heroine of just such an
adventure, but he had never dreamed of meeting a girl who’d go on
fancying herself quite so keenly when it came to the point, and
when she’d had a peek at some of the stern and spiky
disadvantages. But there she was, smiling into his eyes, tranquilly
announcing her resolution to see the shooting-match through with
him, and boldly averring that she was perfectly prepared to eat the
whole cake as well as the icing. She was going to be the blazes of a
nuisance and the mischief of a worry to him—“But, Hell!” swore the
Saint to himself—“I’m darn glad of it!” Wherein he betrayed his
egotism. It would be a gruelling test for her, but he’d have her with
him all the time. And if she came through it with flying colours, well,
maybe after all he’d go the way of most confirmed bachelors. . . .
And since he saw that neither cajoling nor cursing would budge
her, he accepted the situation like a wise man. And even then (with
such an inferiority complex is Love afflicted) the sublime egotist did
not spot the foundation of her determination, though it stuck out a
mile. Nevertheless, in his blindness he was very near to blundering
straight into the heart of the affair. His scowl relaxed, and he took
her hand from his shoulder and held it.
“I’ve known some fool women,” said the Saint, “but I never met
one whose foolishness appealed to me more than yours.”
“Then—it’s a bet?” she asked.
He nodded.
“You said it, partner. And the Lord grant we win. It’s not my fault if
you insist on jazzing into the Tiger’s den, but it’ll be my unforgivable
fault if I don’t yank you out again safely. Shake!”
“Bless you,” said Patricia softly.
 Chapter IX.
Patricia Perseveres
“Well,” remarked Simon Templar, breaking a long silence as lightly
as he could, “where do we go from here, old Pat?”
She disengaged her hand and sat down again; and he shifted his
own chair round so that they were knee to knee. She was chilled by
the definiteness with which he reverted to pure business, though
later she realised that he did so only because he was afraid of letting
himself go, and possibly incurring her displeasure by forcing the
pace.
“I’ve also a story to tell,” she said, “and it came out only last
night.”
And she gave him a full account of Agatha Girton’s confession.
For such a loquacious man, he was an astonishingly attentive
listener. It was a side of his character which she had not seen before
—the Saint concentrating. He did not interrupt her once, sitting back
with his eyes shut and his face so composed that he might well have
been asleep. But when she had finished he was frowning
thoughtfully.
“Curiouser and curiouser,” said the Saint. “So Aunt Aggie is one of
the bhoys? But what in the sacred name of haggis could anyone
blackmail Aunt Aggie with? Speaking quite reverently, I can’t imagine
she was ever ravishing enough, even in her prime, to acquire
anything like a Past.”
“It does seem absurd, but——”
The Saint scratched his head.
“What do you know about her?”
 “Very little, really,” Patricia replied. “I’ve sort of always taken her
for granted. My mother died when I was twelve—my father was
killed hunting three years before that—and she became my
guardian. I never saw much of her until quite recently. She spent
most of her time abroad, on the Riviera. She had a villa at Hyères. I
stayed on at school very late, and I was generally alone here during
the holidays—I mean, she was away, though I usually had school
friends staying with me, or I stayed with them. She didn’t do much
for me, but my bills were paid regularly, and she wrote once a
fortnight.”
“When did she settle down in Baycombe, then?”
“When she came back from South Africa. About six years ago I
had a letter from her from Port Said, saying that she was on her way
to the Cape. She was away a year, and I hardly had a line from her.
Then one day she turned up and said she’d had enough of travelling
and was going to live at the Manor.”
“And did she?”
“She used to go abroad occasionally, but they were quite short
trips.”
“When was the last expedition?”
She pondered.
“About two years ago, or a bit less. I can’t remember the exact
date.”
“Now think,” suggested the Saint—“roughly, you hardly saw her at
all between the time she introduced herself as your guardian, when
you were twelve, until she came back from South Africa, when you
were sixteen or seventeen.”
“Nearer seventeen.”
“And in that time anything might have happened.”
She shrugged.
“I suppose so. But it’s too ridiculous. . . .”
“Of course it is,” agreed Simon blandly. “It’s all too shriekingly
ridiculous for words. It’s ridiculous that our Tiger should have broken
the Confederate Bank of Chicago and lugged the moidores over to
Baycombe to await disposal. It’s ridiculous to think that there are
some hundredweights of twenty-two carat gold hidden somewhere
not two miles from here. But there are. What we’ve got to assume is
that on this joy ride nothing is too ridiculous to be real. Which
reminds me—what do you know about the old houses in Baycombe?
There must be something conspicuously old enough for Fernando to
have thought The Old House was sufficient address.”
He was surprised at her immediate answer.
“There are two that’d fit,” she said. “One is just out of the village,
inland. It used to be an inn, and the name of it was The Old House.
It’s falling to bits now—the proprietor lost his licence in the year Dot,
and nobody took it over. It’s supposed to be haunted. The windows
are all boarded up, and a dozen men could live there without being
seen if they went in and out at night.”
The Saint smashed fist into palm, his eyes lighting up.
“Moonshine and Moses!” he whooped. “Pat, you’re worth a fortune
to this partnership! And I was just thinking we’d come to a standstill.
Why, we haven’t moved yet! . . . What’s the other one?”
“The island just round the point.” She waved her arm to the east.
“The fishermen call it the Old House, but you wouldn’t have noticed
it because it only looks like that from the sea. The sides are very
steep, and on one side it juts right out over the water, like those old
houses where the first floor is bigger than the ground floor.”
Simon jumped up and walked to the edge of the cliff, so that he
could see the island. It was about a mile from the shore—nothing
but an outcrop of rock thickly overgrown with bushes and stunted
trees. He came back jubilant.
“It might be either,” he said exultantly, “or it might be both—the
Tiger may have a home from home in your defunct pub, and he may
have parked the doubloons on the island. Anyway, we’ll draw both
covers and see. Thinking it over, I guess I’ve hit it. The Tiger’d want
to have the gold in some place he could ship it from easily—
remember it’s got to go to Africa. And by the same token . . . Here,
hold on half a sec.”
He disappeared into the Pill Box and came back in a moment with
field-glasses. Then he focused on the horizon and began to sweep it
carefully from west to east. He had covered three-quarters of the arc
when he stopped and stared for a full minute, suddenly rigid.
 “And there she blows,” he muttered.
He handed her the binoculars and pointed north-east.
“See what you make of it.”
“It looks like a couple of masts sticking up.”
“Motor ship—no funnels,” he explained. “The Bristol shipping
passes here, but we’re back in a sort of big bay, and I don’t think
they’d stand in as near as that. But we’ll just make sure.”
He took the glasses from her again and went into the Pill Box, and
she followed. He fossicked about in the kitchen till he found a piece
of board, the remains of a packing-case, and this he settled in one
of the embrasures, truing it up level with little wedges of newspaper.
Then he put the field-glasses on it and took a sight on one of the
masts by means of a couple of pins stuck in the board.
“We’ll give her five minutes.”
She grasped his meaning at once.
“You think they’re waiting to come in after dark?”
“No less. Comrade Bloem hasn’t done all he’d like to with T. T.
Deeps, but he’ll have some weeks’ grace while the stuff’s getting to
the mine. And he daren’t let it lie around here any longer, in case my
luck holds and I don’t get bumped off according to schedule. I’ve
rattled the Tiger!”
He was keeping an eye on his watch, and the minutes ticked away
very slowly.
“Is Dr. Carn a detective?” she asked.
“That’s hit it in one,” affirmed the Saint. “But don’t let on you
know. It wouldn’t be sporting not to give the old boy a fair run.”
“Then aren’t you a detective?” she stammered in bewilderment. “I
thought you were friendly rivals—that was the only explanation I
could work out last night.”
The Saint smiled grimly.
“Rivals—more or less friendly—yes,” he said. “But I’m not a
detective, and never was. I’m playing for my own hand, with an
enormous quantity of ha’pence coming to me if I win, and
everybody’s kicks if I lose. Profession, gentleman adventurer: i.e.,
available for any job involving plenty of money and plenty of trouble,
suitable for a man who doesn’t bother much about the letter of the
law and who’s prepared to take his licking without a yelp if he gets
landed. That’s me. Like this. I happened to find Fernando, and as
soon as I’d got the thing taped out I took a trip to Chicago and saw
the boss of the Confederate. ‘Here’s nearly a year since your strong
room was busted,’ I said, ‘and the dicks haven’t brought you back
one cent of the almighties. Now suppose you let me have a shot.
Terms, twenty per cent. commission if I bring it off. Not a bean if I
don’t. Me to work on my lonesome, without reporting to anybody,
and to take all the blame if I’m run over.’ Well, that put them on
something to nothing, so they bit. And there you are.”
He was looking steadily at her, but she did not change colour. But
the Saint was never a faker, and this was his call to clean the whole
sheet, so that she could take it or leave it as she chose and would
never be able to say he hadn’t played square. He rubbed it in with
brutal directness.
“That’s the way I’ve lived for years. Pretty well, all things
considered, so that if this gamble turns up I’ll be able to retire and
settle down as soon as I like, and not have to stint myself anywhere.
In those years I’ve committed about half the crimes in the Calendar,
at the expense of crooks. It’s a sporting game—man to man, and
devil take the mug: and the police, for obvious reasons, aren’t
invited to interfere by either side. Bloem’s the first to break that rule;
but the Tiger isn’t a sportsman—he’s just a pot-hunter. Still, I doubt
if your friends would appreciate my success in that career. D’you still
want to be a partner in the firm?”
She sighed.
“Saint, you’re an ass,” she said. “And if you exhibit any symptoms
of virulent imbecility I shall fire you and become managing director
myself.”
“Hell’s bells,” ejaculated Simon, unwontedly moved, and swung
away.
Very carefully, so as not to disturb the board, he took another
sight at the ship’s masts; and presently he straightened up with a
light of triumph breaking on his face.
“We’re in luck,” he said. “She hasn’t shifted a millimetre. Rotten
bad navigation. I’d have known the height of my masts to an inch,
and the height of the cliffs here ditto, and I’d have figured out my
position to six places of decimals. . . . But the Tiger’s loss is our
gain!”
“They’ll start to come in at sunset,” she took him up excitedly.
“And——”
“And I’ll be there,” said the Saint. “It’s a moonlight swim for me
to-night. That’s great—to let the Tiger Cubs themselves lead me to
the cache! But the snag is . . . Holy Habbakuk . . . they’ll be waiting
for me.” She stared. “They know I’ll invite myself, bless it!”
“Why?”
“Because they know I’m wise to this Old House joke. I let on, like
a fool. That was a poisonous bad bloomer! I was ragging old Bloem
about Fernando, just seeing how much breeze I could put up him,
and I mentioned the Old House. They’ll think I knew exactly what
and where it was. Oh, crumbs and crutches! D’you mind kicking me
as hard as you can?”
She was as distressed as he was. It was in no half-hearted
manner that she had enlisted in the army of adventurers. A setback
stung her as much as anybody. She bit her lip.
“But they’re coming in,” she insisted.
“Yes—forewarned and forearmed to the teeth. If I happen to have
been a bit slow on the uptake, well and good. If I haven’t, and think
I’ll butt in, they’ll be ready for me. Maybe the Tiger’s patting himself
on the back right now, bucked to death with his dandy little scheme
for getting away with the oof and me too. Well, it’s up to me to hand
him the jar of his life. Sit tight a shake while I think.”
He dropped into a chair and lighted a cigarette, his brain reeling
and humming to encompass this new twist to the problem.
Undoubtedly he had sized it up right—the Tiger was giving himself a
double chance. And that move had got to be baulked somehow. But
how? The Saint had only to breathe a word to Carn, and the Tiger
was dished. But then so was the Saint. That put that out of bounds.
He was fully prepared to swim out to the Old House that night,
with Anna strapped to his arm, and trust to the inspiration of the
moment to show him a way of beating the gang, even if they were
watching and waiting for him. That was an honest toss-up with
sudden death, and Simon took risks of that stamp without turning a
hair. But on the other hand he liked to have at least a shadowy loop-
hole for emergencies—there was no point in chucking the game
away for lack of a little forethought. And how to provide that loop-
hole? The Tiger’s forces were large: the Saint could reckon on only
Orace and the girl, besides himself. And he didn’t want to push a slip
of a girl into the front line, however keen she might be to go. How
to make three people—or nearer two and a half—do the work of a
platoon was a poser worthy of the undivided attention of a great
general. Manifestly, it could not be done by any ordinary means.
Therefore, there must be subtlety.
And the Tiger had the added advantage of being the attacker.
Simon’s cigarette began to smoulder down in his fingers unnoticed.
That was a point! The Tiger was sitting high and dry in his den,
hatching plots and making raids and forays when the spirit moved
him; while the Saint had to sit on the fence with his eyes skinned,
just parrying the Tiger’s thrusts. And it became clear to the Saint
that there was something unfair about that arrangement. True, the
Saint had made one attack—but why let the offensive stop there?
The enemy had an idea that he would come lunging in again that
night: well, so he might, if it looked like a good tussle and he felt in
the mood. But that didn’t imply an armistice until zero hour, by any
manner of means. Quite a lot of skirmishing could take place before
the big battle—and every blow of it would bother the Tiger and help
harrass his organisation for the last rounds. There really was no
earthly reason why the Tiger should have it all his own way.
Where to launch the attack? The other Old House sprang to his
mind at once. They might be expecting him to turn up there, but
they would hardly anticipate his arrival in broad daylight. Which was
just the way he might catch them on the hop. Or the dilapidated inn
might be a false scent—in which case there was nothing but the
state of his own nerves to stop him paying a call on Bloem. The
prospects began to look brighter, and suddenly the Saint sat up with
a broad grin illuminating his face.
“I’ve very nearly got it,” he announced.
“Do let’s hear!”
 She was flushed and eager, eyes sparkling, lips slightly parted, like
a splendid young Diana. She made a picture that in the abstract
would have delighted the pagan Saint, but in the concrete it brought
him up with a jerk. Next thing he knew, she’d be demanding to be
allowed to accompany him on the whole tour.
“Simply the germ of an idea to wallop the Tiger Cubs when they
come in for the spondulicks,” he lied, thinking furiously. “You see,
gold’s shocking weighty stuff, so they’ll have to ferry it to the ship in
small doses. That’ll mean they’ll have about three of the ship’s boats
running in relays—if they tried to take too big a load at once it’d
simply drop through the bottom. And the crew’ll be pretty small. A
motor ship doesn’t take much running, and they’d want to keep the
numbers down in any case, because the seaman who can be relied
on not to gossip in port is a rare bird. If we’re lucky, the skipper’ll be
ashore getting his orders from the Tiger, and that’ll make one less to
tackle. Otherwise, the Tiger’ll go aboard himself, and that’ll be one
more to pip—though the fish’ll be worth the extra trouble of landing.
In any event, the general idea is this: we’re going to have a stab at
pinching that hooker!”
The Saint was capable of surprising himself. That plan of
campaign, rigged out on the spur of the moment to put the girl off
the main trail, caught hold of his imagination even as he improvised
it. He ended on a note of genuine enthusiasm, and found that she
was wringing his hands joyfully.
“That’s really brilliant,” she bubbled. “Oh, Saint, it’s going to be the
most fearfully thrilling thing that ever happened—if we can only
bring it off!”
He gazed sadly down at her. There it was—a tank of mulligatawny
big enough to drown a brontosaurus, and he’d fallen right in before
he knew what was happening. He shook his head.
“Kid,” he said, “piracy on the low seas isn’t part of the curriculum
at Mayfield, is it?”
“I can swim a couple of miles any day of the week.”
“Can you climb eighteen feet of anchor chain at the end of it?”
objected the Saint. “Can you back yourself to put a man to sleep
before he can loose a yell? Can you make yourself unpleasant with a
belaying-pin if it comes to a riot? I hate to have to damp your
ardour, Pat, but a woman can’t be expected to play that game.”
She was up in arms at once.
“Saint, you’re trying to elbow me out again!” she accused.
“Possibly you’ve never met anybody like me before—I flatter myself
I’m a bit out of the ruck in some ways. And I won’t be packed up in
cotton-wool! Whatever you go into, I’m going with you.”
Then he let her have it from the shoulder.
“Finally,” he said in a level voice, “how d’you fancy yourself as a
prisoner on that tub, at the mercy of a bunch like the Tiger’s, if we
happen to lose? We might, you know. Think it over.”
“You needn’t worry,” she said. “I shall carry a gun—and save one
cartridge.”
The Saint’s fists clenched. His mouth had set in a hard line, and
his eyes were blazing. The Saintly pose had dropped from him like
the flimsy mask it was, and for the first and last-but-one time she
saw Simon Templar in a savage fury.
“And—you think—you, my girl, you——” The words dropped from
his tense lips like chips of white-hot steel. “You think I shall let you—
take—that chance?”
“Is there any logical reason, my man, why you shouldn’t?”
“Yes, there is!” he stormed. “And if you aren’t damned careful
you’ll hear it—and I don’t care how you take it!”
She tossed her head.
“Well, what is it?”
“This,” said Simon deliberately—“I love you.”
“But, you dear priceless idiot,” said Patricia, “hasn’t it occurred to
you that the only reason I’m in this at all is because I love you?”
For a space he stared. Then——
“Burn it,” said the Saint shakily, “why couldn’t you say so before?”
But after that there was only one thing to do. For a man so
unversed in the ways of women he did it exceedingly well.
 Chapter X.
The Old House
It was Orace, that stern disciplinarian, who ruthlessly interrupted
the seance in order to lay the table for lunch. That was half an hour
later, though Simon and Pat would both have sworn that the
interlude had lasted no more than a short half-minute. The Saint
moved away to an embrasure and gazed out at the rippling blue sea,
self-conscious for the first time in his life. The girl began to tidy her
hair. But Orace, after one disapproving glance round, brazenly
continued with his task, as though no amount of objections to his
intrusion could stop him enforcing punctuality.
“Lunch narf a minnit,” warned Orace, and returned to the kitchen.
The Saint continued to admire the horizon with mixed feelings. He
was sufficiently hardened in his lawless career to appreciate the
practical disadvantages of Romance with a big R horning in at that
stage of the proceedings. Why in the name of Noah couldn’t the love
and kisses have waited their turn and popped up at the conventional
time, when the ungodly had been duly routed and the scene was all
set for a fade-out on the inevitable embrace? But they hadn’t, and
there it was. The Saint was ready to sing and curse simultaneously.
That the too marvellous Patricia should be in love with him was all
but too good to be true—but the fact that she was, and that he
knew it, quadrupled his responsibility and his anxieties.
It was not until Orace had served lunch and departed again that
they could speak naturally, and by then a difficult obstacle of
shyness had grown up between them to impose a fresh restraint.
 “So you see,” remarked Patricia at last, “you can’t leave me out of
it now.”
“If you cared anything about my feelings,” returned the Saint,
somewhat brusquely, “you’d respect them—and give way.”
She shook her head.
“In anything else in the world,” she said, “but not in this.”
So that was that. Simon had used up all his arguments, and
further effort to combat her resolution would only be tedious. She
won. Short of an appeal to brute strength, he hadn’t a thing left to
do except grin and bear it and do his best to make the going as safe
as ingenuity could. And like many strong men the Saint shrank from
applying cave-man measures.
At that moment he would even have considered throwing up the
sponge, tipping the wink to Carn, and sliding out of the picture.
What stopped him from taking that desperate way out was a shrewd
understanding of the girl’s character. Somehow, out of a normal
education and a simple life in a forgotten country village, she had
acquired the standards of a qualified adventuress—in the clean
sense. And she had a ramrod will to back her up. She felt that it was
only the game to stand by her man in any and every kind of trouble,
and she meant to play the game according to her lights. She would
only despise him if he refused to carry on on her account: she was
determined to prove to him by deeds as well as words that she
wasn’t a clinging vine who was going to cramp his style either before
or after the wedding bells. And it was quite hopeless for the Saint to
try and point out to her that she would only hamper him—as
hopeless as it would have been ungracious, bearing in mind the
uniqueness of a girl of her calibre.
But for one thing Simon could and did thank his stars: he had
successfully put her off the track of the first string of his bow—the
disused inn behind the village. He would be able to tackle the
proposition from that angle without her knowledge before nightfall,
and if the Fates played into his hands he might manage to get a
stranglehold on the Tiger before it was her turn to bat.
“If the mountain won’t budge, Mahomet’ll have to leave it where it
is,” said the Saint disarmingly. “But there are one or two knots that
ought to be untied in the course of the afternoon, and that’s where
you can help. One—it might be a sound plot to see if we can’t get
this Aunt Aggie palaver cleared up a bit.”
“She wouldn’t tell me anything last night.”
“You were hardly on form then, with me loose in the menagerie.
This afternoon you can go back full of beans, with a parting hug
from me to pep you up, and lam into Auntie two-fisted. If you can
only carry it, you’ve got her cold. After all, she admits having tapped
your treasure chest to save herself. It isn’t too stiff a return to ask
her to get a bit off her own chest for your satisfaction. I know she’s
a hefty handful, but she isn’t half the size of some of the things
you’ll have to wire into during the next twenty-four hours, and it’ll
limber you up. If she tries to bully you, remember that there isn’t a
bully swaggering the earth that can’t be bullied himself by someone
with the guts to take on the job. And if she finds she can’t treat you
high-handed, and bursts into tears—don’t let ’em dissolve you. I
can’t take her on myself, so I’ve got to rely on you.”
She nodded.
“If you say so, Saint, I shan’t funk it.”
“Good Scout!” he approved. “The other item is old Lapping. He’s
been lying doggo since the beginning of the piece, but there are so
darn few possible winning numbers in this lottery that I think we
ought to get a line on Lapping. On the face of it, he’s right out of the
running—but then, so’s everyone else in Baycombe. And I’m just
wondering about a lad called Harry the Duke.”
“ ‘Harry the Duke’?” she repeated, mystified. “Whoever’s he?”
“A swell mobsman that Lapping sent down for seven years when
he was a judge. It was a nasty piece of work—I’ll spare you the
details—but Harry escaped six years ago, and he never was a
forgiving man, from all accounts. In fact, knowing what’s said about
Harry at the Yard, I’m surprised he hasn’t taken it out of Lapping
before now. There’s a story that Harry followed the first magistrate
who convicted him half-way round the world—and got him. Since
when there was no other, Harry being miles and miles above the
common run of crooks in brains, until Lapping. It’s a long shot, I
know, but bad men run pretty much to pattern, and the Tiger’s
acknowledged to be an Englishman. And the hunch got me recently
—suppose Harry the Duke is the Tiger?”
“Wouldn’t he have been recognised?”
“Harry’s face is pure plasticine, and he’s forgotten more about
make-up than most actors ever learn. And Harry’s one of the few
men I’d credit with brains enough to wear the Tiger’s hat. . . . It’s all
speculation, and long odds against it on probability, but it’s worth a
flutter. You see, if the Tiger did happen to be Harry the Duke—and
the Tiger started operations not so long after Harry broke gaol—it
accounts for Lapping’s continued health. The Tiger’ll just be waiting
till he’s ready to skedaddle with the swag, since Lapping’s right
where he can lay his hands on him any time, and then he’ll pay off
the old score and sail away.”
She was still puzzled.
“But what do you want me to do?” she asked.
“If you’ve got time and energy left after pasting Auntie, go over
and be sweet and winsome to Sir Mike,” replied Simon. “You know
him quite well—lay it on with a spade. Ask him to advise you about
me. That’s sound! If he happened to be in with the Tiger, it might
put you on safer ground, if you can kid them you’re not in my
confidence after all. If he’s harmless, it can’t hurt us. Talk to him as
the old friend and honorary uncle. Tell him about l’affaire Bittle—
noting how he reacts—and lead from that to my eccentric self. You
might say that you felt attracted, and wondered if it was wise to let
it go any further. The blushing ingenuous maiden act.”
“I’ll do it,” she said, and he leaned across the table and touched
her hand.
“You’re a partner in a million, old Pat.”
After lunch Orace served coffee outside, and they sat and smoked
while they discussed the final arrangements.
“I’ll send Orace over to fetch you after dinner,” he said. “I think it’d
be better if I didn’t appear. Put a bathing costume on under your
frock; and when the time comes I’ll give you a belt and the neatest
waterproof holster, that’ll just carry your fit in guns. But I’ll give you
the shooter now.”
 He took a little automatic from his pocket, slipped the jacket to
bring a cartridge into the chamber, and clicked over the safety catch.
“And it’s not for ornament,” he added. “If the occasion calls for it,
let fly, and apologise to the body. Have you ever handled this sort of
gadget?”
“Often. I used to go and shoot in revolver ranges on piers.”
“Then that’s all to the good. Put it away in your pocket—but don’t
flourish it about unnecessarily, because it belongs to Bloem. I picked
his pocket when I was showing him out last night, thinking it might
be handy to have around the house.”
She rose.
“I’d better be getting along,” she said. “I shall have a lot to do this
afternoon. And we assemble after dinner?”
“Eightish,” he said. “Don’t take any risks till then. I just hate
having to let you out of my sight even for as long as that. You never
know what Tigers are up to. All the help I can give you is, distrust
everybody and everything, keep your head and use it, and don’t go
and walk into the first trap that’s set for you like any fool heroine in
a novel.”
Her arms went round his neck, and he held her close to him for a
while. And then she drew back her head and looked up at him with a
smile, though her eyes were brimming.
“Oh, I’m silly,” she said. “But love’s like that, old boy. What about
me letting you out of my sight for so long?”
“I’m safer than the Bank of England,” he reassured her. “The gipsy
told me I’d die in my bed at the ripe old age of ninety-nine. And
d’you think I’m going to let the Tiger or anyone else book me to
Kingdom Come when I’ve got you waiting for me here? I am not!”
And then there had to be a further delay, which need not be
reported. For those who have lost their hearts know all about these
things, and those who haven’t don’t deserve to be told. . . .
But at last he had to let her go, so he kissed her again and then
took her hand and kissed that. And afterwards he took her shoulders
and squared them up, and drew himself up in front of her.
“Soldier’s wives, Pat!” he commanded. “Cheerio—and the best of
luck!”
 “Cheerio, Saint!” she answered. “God bless you. . . .”
She flung him a brave smile, and turned and walked off down the
hill with Orace ambling behind like a faithful dog. Just before the
path led her round a bend and out of sight she stopped and waved
her handkerchief, and the Saint waved back. Then she was gone,
and he wondered if he would ever see her again.
He went back into the Pill Box, took off his coat, rolled up his left
sleeve, and strapped Anna securely to his forearm. That was for
emergencies; but now that the Tiger knew all about Anna the Saint
had to rummage in his bag for her twin sister, and this dangerous
woman he fixed to his left calf in a similar manner, where it would be
quite likely to be overlooked if he were caught and searched. He
made sure that he had his first-aid cigarette case in his hip pocket,
and as an afterthought added to the kit a telescopic rod of the finest
steel with a claw at one end.
As a final precaution, he sat down and scribbled a note:

If I don’t turn up by seven-thirty look for me at the Old House

—the place behind the village that used to be an inn. Failing
that, try Bloem’s or Bittle’s. Don’t go to Carn till you’ve drawn
blank at all those three places. And BE CAREFUL. If they get me
they’ll be on the look out for you.

This he folded, addressed to Orace, and left in a conspicuous

position in the kitchen, where his man would be sure to find it when
he returned.
Then the Saint went swinging down the track towards the village.
It was a ticklish job he was embarking on. In broad daylight
stealth was out of the question. It would mean walking boldly up to
the enemy fortress and trying to get as far as he wanted in one
dash, before the opposition could collect their wits. And then there
would be ructions—but that would have to take care of itself.
The Saint did not remember the Old House very distinctly, and he
paused at the edge of a spinney lower down the hill to survey the
land. And then he gave thanks once again for the continuance of his
phenomenal luck. There it was—the blessing out of the blue that
he’d never dared to hope or pray for—a long low wall that sprang
from one corner of the Old House and ran north towards the
straggly outskirts of the village, losing itself behind a couple of sheds
belonging to a small farm. Hardly believing his good fortune, the
Saint hurried down the slope and passed through the village. He
worked round the farm outbuildings, and found that he was not
deceived. The wall started there, and it was just high enough to
screen his advance if he bent almost double.
That was not a very difficult feat, and Simon plunged straight on
into his adventure. Stooping down, he trotted rapidly along under
cover of the wall till he had nearly reached the nearest corner of the
Old House. At that point he slowed up and proceeded with more
caution, travelling on his toes and finger-tips, in case there should
be a watcher posted at an upper window. When he actually came to
the Old House itself he flattened down on his stomach and lay prone
for a moment while he planned his entrance.
He could see one wall of the Old House—a dead flat facade of
chipped and mouldering brick, broken only by four symmetrically
placed windows and a door. The door was a godsend. The windows
themselves were roughly boarded up, and to prise off those boards,
though it could be done in a brace of shakes, would be rather too
audible for the Saint’s taste; whereas a mere door could probably be
dealt with, by an expert, almost noiselessly.
The Saint wormed his way forwards, fitting himself as snugly as
he could into the angle between the wall and the ground and taking
infinite pains to make no sound that might betray his approach to a
keen ear within. From the moment he left the shelter of the wall,
however, he was in danger of discovery, for if any sentinel had
elected to peer out of a window the Saint would be lucky to be
overlooked. The watcher would probably scrutinise the nearest
cover, in which case his gaze would pass right above the Saint; but
on the other hand the enemy might be well aware of the possibilities
of that too convenient wall, and in that case anyone who was taking
a peek round would certainly cast an eye downwards, and then the
Saint wouldn’t have an earthly. That salutary realisation made him
wriggle along as fast as he could with safety, and it must be
admitted that his spine was tingling and the short hairs on the scruff
of his neck bristling throughout that dozen yards’ crawl. It is not
pleasant to have visions of a man sticking a gun out of an upper
window and plugging a chunk of lead down into your back.
But his head came on a level with the door at last, and nothing so
disastrous had happened. The Saint crept up into a squatting
position and, tentatively, began to breathe again, while he inspected
the door at close quarters.
He found that the handle had snapped off short—in fact, he
discovered the tarnished brass ball lying under a bush a few yards
away. The lock was rusty, and the door sagged on its hinges. The
Saint scratched his head. Either the Old House was not the goods at
all, or the Tiger Cubs were banking a lot on its reputation of being
haunted. He looked again and more closely at the broken end of the
handle lever protruding from the door, and caught his breath. The
jagged metal was shining—not a trace of the rust that flaked over
the rest of the metal dulled its brilliance. That was a new break!
Even in forty-eight hours the exposed steel would have lost some of
that sheen. Therefore, someone had been there recently. And unless
the village children were less superstitious than their elders, that
meant that the Tiger Cubs had graced the premises.
Simon put his hand on the door and pushed gently. It gave back
smoothly at his touch.
The Saint took his hand away as if the wood had burned it. The
door yielded smoothly! It wasn’t locked, or bolted, or barred, and
there wasn’t a creak anywhere. And the doors of houses that haven’t
been inhabited since the year Dot don’t do things like that—for one
thing, the hinges are so rusted up that it takes a thundering good
push to shift them; but these hinges turned like brand-new ones
freshly oiled. That meant that someone certainly was using the Old
House. And, plus the fact that there was apparently nothing to stop
anyone else using it as well, the complete scenery had a howling
warning scrawled all over it. A tight little smile moved the Saint’s
mouth.
“ ‘Will you walk into my parlour?’ said the spider to the fly,”
murmured the Saint. “Surest thing you know, son—but not exactly
like that sort of boob.”
He drew back to think it over, and cast a thoughtful glance at the
boarded windows. But the same difficulty presented itself: to break
away a plank makes a noise at the best of times, and he could now
see that the planks in question were not simply nailed to the frame
but solidly riveted in place. That seemed to rule out the windows,
which left only the door—with someone waiting for him inside, as
like as not. Well, Simon decided, that had got to be faced, and it was
better to tackle something you had a line on than something you
hadn’t. It wasn’t a time for humming and hawing and eventually
leaving your card and promising to look them up next walk you took
that way. He was more than ever determined to get inside the Old
House that afternoon, and the door was the only way in that
presented itself. Therefore, it must be the door.
The Saint pushed the door a little further. Nothing happened. Then
he slowly edged one eye round at a point where no one within
would expect a man to appear—only a few inches off the ground.
But inside was darkness, and he could distinguish nothing. The Saint
swung the door again, until it was over a foot ajar.
Plop!
Just the noise that a big stone makes falling into a well; and
something nicked the door, breaking a burst of splinters out of the
rotten wood. The Saint looked up at the wound, and saw that it
would have been on a level with his chest if he had been standing
up.
That was enough—ultimatum, declaration of war, and attack, all
together. And it meant also that, whatever was waiting for him
inside, it would probably be healthier to charge right in and take it
on than to stick around in the open where half a dozen Tiger Cubs
could take pot-shots at him from the windows. The Saint gathered
himself for the rush and slid Anna out of her sheath. He tested his
muscles, drew a deep breath, and jumped.
One leap took him well inside the door, and in a flash he had
banged it shut again behind him. That evened things up a bit, for it
stopped him being a target against the light outside for any sniper
hidden in the darkness. Then, almost in the same movement, he had
flung back again against the door, in a corner.
He had half expected to find someone waiting just behind the
door to put him down as he passed, but his groping fingers touched
nothing but dust. First mistake. Well, that meant that anything that
was coming to him would arrive out of the blackness in front.
The Saint stood motionless, listening intently and straining his
eyes to try and locate the gentleman who had fired that single shot
—and had been too surprised at the suddenness of the Saint’s
reaction to loose off another round at the critical instant when the
Saint was silhouetted in the doorway on his way in. It was at least a
comfort to have your back to a wall, and to know that the other man
was literally as much in the dark as you were; but there were such
things as electric torches, and the Saint was tensely prepared for a
beam of light to shoot from the obscurity and pick him out for the
benefit of the man with the gun. Simon had Anna held in his deft
fingers ready to send her whistling through the hand of any man
who turned a spotlight on him, and equally ready to hamstring
anyone who might creep up and jump on him.
Minutes passed without the other side making a move, and Simon
shifted one hand to scratch his head mechanically. Not even his
preternaturally acute hearing could catch the least sound—and in
that silence he would have bet half his worldly goods on being able
to detect the faint rustle of cloth if a man so much as lifted his arm.
He made out the steady beating of his own heart, and even heard
the whisper of his wrist watch ticking, but there was nothing else.
His eyes were gradually becoming accustomed to the gloom, and
at last he began to scowl very thoughtfully, for the passage in front
of him was empty. One by one the details became visible. First, two
doors, opposite each other and about two yards away, both of them
closed. He looked down. The dust lay thick on the floor of the
passage, and there were marks of many feet, both entering and
leaving. Some of the footprints branched off to the door on his right,
but it seemed that nobody had used the room on the left, unless
there was another entrance to it. At the far end of the passage was
a small window, boarded up like the rest, and it was through this
that enough light filtered in for him to be able to see.
It was not long before other features of the landscape showed up.
Further along, to the left, was another door and the footprints
proved that that room had been used fairly recently. And at the end
of the passage, under the window, stood a table with a square box
on it.
The Saint looked long and hard at that box, and suddenly he had
an inspiration. Bending down, he felt along the ground by the door.
Presently he found wires, and a little research disclosed the fact that
they ran up the corridor—towards the table and the square box. A
little more investigation brought him to the metal contacts which
closed the electric circuit. One of them he found screwed to the
inside of the door, low down; the other projected from a terminal
fixed to the floor. On the strength of that, Simon began to tiptoe
down the passage, though he did not relax his vigilance for an
instant. He came to the table and the box, and examined them with
interest. The wires he had found led to terminals on the box, and
from the front of it protruded a shining steel tube.
“Very ingenious, my Tiger,” was the Saint’s unspoken comment.
“When I open the door, I get pipped. And I didn’t, after all. So
sorry!”
However, just in case the arrangement had any more shots left,
and in case he should have to leave hurriedly by the door, he slewed
the box round so that the gun barrel pointed into the wall, and
disconnected the wires. Then he took stock of the position again.
The discovery and circumnavigation of that little booby-trap didn’t
dispose of the possibility of encountering others—in fact, his
estimate of the Tiger forced him to realise that the next step he took
might set some other equally neat little contrivance working. And if
not that, there might still be Tiger Cubs in the building, already
warned of his arrival by Booby Trap Number One going off, and
knowing that it hadn’t functioned quite according to plan. The
amusing thought that they might be in some fear of his fighting
record struck the Saint, and he chuckled quietly. Perhaps they felt
confident of having him safely trapped, and were just biding their
time to strike him down when the operation could be performed
without risk to themselves. Well, it wouldn’t hurt them to keep on
hoping.
But the job looked just as prickly now that he was inside the Old
House as it had been when he was outside. However gingerly he
opened the next door, there might be men inside the room waiting
to open fire as soon as he showed up in the doorway. Yet the Saint
was no piker; and, having got so far, he intended to go the rest of
the journey. And the only course he could see was to repeat the
tactics he had used when entering the building in the first place. So,
without further hesitation, he got on with it.
There was the door with footprints leading to and from it, and that
seemed the most promising. There were also footprints outside the
swing door nearest to him, but they were less encouraging, for at
that point there was only a double set, whereas the other seemed to
have been fairly popular. And the Saint’s philosophy laid down the
law that if you must stroll into the home-sweet-home of a bunch of
cut-throats you might as well do the thing in style. Wherefore the
Saint went down the passage and halted by the most dangerous-
looking door.
There was a handle on that door. He turned it and opened a
couple of inches. Then, keeping well away, he set his toe against the
wood, braced himself, and kicked. The door opened wide, but there
was no muffled report. That short history at least wasn’t going to
repeat itself. And, accordingly, the only thing to do was to march
straight in.
Simon went—in a catlike spring that carried him round the corner
and set his back against the wall again in a flash. But once more
there was no response. Simon had jerked the door shut behind him
as before, and one foot was against it so that nobody could open it
and sneak out without his knowing it. But only stillness answered his
listening, and the room was so dark that he could see nothing. He
cursed himself for not having an electric torch. But it was far too late
to remedy that, and therefore his only hope was to strike a match—
and hope that his concerted speed of eye and brain and hand would
be great enough to overcome the handicap he would have to create
for himself. If there was anyone in the room, he would be able to
see the Saint before the Saint saw him. But the Saint had taken
longer chances than that, and his nerves were getting just a shade
raw. Simon Templar was afraid of nothing that he could see and hit
back at, but this creeping around, seeing no sign of the enemy and
yet continually threatened by him, was turning into a joke that the
Saint didn’t feel inclined to laugh at.
Still gripping Anna, he fished a box of matches out of his pocket
and struck one quickly, holding it behind his head so that the flare of
it would not dazzle him.
And the room was perfectly empty.
The match burned down between his fingers and went out. He
struck another, but even that could not cause a human being to
materialise. Yet there had been men there—their footprints were all
over the floor, and there were three comparatively new-looking beer
bottles in one corner, and scraps of greasy paper were littered about.
“This is getting annoying,” said the Saint.
He struck a third match, and took a couple of steps into the room.
Then he tried to hurl himself back, but he was a fraction of a
second late. The ground dropped away beneath his feet and he felt
himself falling down and down into utter darkness.
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