ST339 Introduction to Mathematical Finance

For Academic Year 2023/24

Lecture notes by David Hobson1

Closely based on notes by Martin Herdegen
Department of Statistics

University of Warwick

This version: October 10, 2023

1
I would like to thank Martin Herdegen for sharing his notes and the students and teaching assistants Shiyao
Bian, Nikolaos Constantinou, Chester Gan, Alia Hajji, Scott Hamilton, Kairav Hirani, Nazem Khan, Kevin
Lam, Rahul Mathur, Noah Prasad, Anthony Shau, Osian Shelley, Haodong Sun, Anastasiya Tsyhanova, and
Ben Windsor for spotting typos in previous versions.
Any remaining mistakes and errors are of course my responsibility.
Contents

0 Introduction and Preliminaries 4

0.1 What is Mathematical Finance? . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

0.2 Fundamental concepts of Probability Theory . . . . . . . . . . . . . . . . . . . . 4

0.3 The Cauchy-Schwarz inequality . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

1 No-Arbitrage and the Fundamental Theorem of Asset Pricing 9

1.1 A mathematical model for a nancial market in one period . . . . . . . . . . . . 9

1.2 Trading strategies and arbitrage opportunities . . . . . . . . . . . . . . . . . . . 10

1.3 Discounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

1.4 Equivalent Martingale Measures . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

1.5 The Fundamental Theorem of Asset Pricing . . . . . . . . . . . . . . . . . . . . 13

2 Mean-Variance Portfolio Selection and the CAPM 17

2.1 The return of an asset and of a portfolio . . . . . . . . . . . . . . . . . . . . . . 17

2.2 Maximising the expected return . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

2.3 The mean-variance problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

2.4 Portfolios in fractions of wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

2.5 The case without a riskless asset . . . . . . . . . . . . . . . . . . . . . . . . . . 22

2.6 The case with a riskless asset . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

2.7 The Markowitz tangency portfolio and the capital market line . . . . . . . . . . 31

2.8 On mean-variance equilibria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

2.9 The Capital Asset Pricing Model (CAPM) . . . . . . . . . . . . . . . . . . . . . 35

2.10 Criticism of mean-variance portfolio selection and the CAPM . . . . . . . . . . 37

2.11 Factor models and CAPM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

3 Utility Theory 39
3.1 Measure theoretic preliminaries . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

3.2 Preferences on lotteries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40

3.3 Von Neumann-Morgenstern representation . . . . . . . . . . . . . . . . . . . . . 41

3.4 Concave functions and Jensen's inequality . . . . . . . . . . . . . . . . . . . . . 42

3.5 Expected utility representation . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

3.6 Measuring risk aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46

3.7 A primer on utility maximisation . . . . . . . . . . . . . . . . . . . . . . . . . . 48

4 Introduction to Risk Measures 53

4.1 Monetary measures of risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

4.2 Value at Risk and Expected Shortfall . . . . . . . . . . . . . . . . . . . . . . . . 55

5 Pricing and Hedging in Finite Discrete Time 58
5.1 Conditional expectations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

5.2 Filtrations and martingales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

5.3 Financial markets in nite discrete time . . . . . . . . . . . . . . . . . . . . . . 63

5.4 Self-nancing strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65

5.5 The Fundamental Theorem of Asset Pricing revisited . . . . . . . . . . . . . . . 68

5.6 Valuation of contingent claims . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72

5.7 Complete markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78

5.8 Pricing and hedging in the binomial model . . . . . . . . . . . . . . . . . . . . . 80

3
1 No-Arbitrage and the Fundamental Theorem of Asset Pricing

In this chapter, we develop a mathematical model for nancial markets in one period, introduce

the key concept of no-arbitrage, and formulate and prove the so-called Fundamental Theorem
of Asset Pricing on the absence of arbitrage in this setting.

1.1 A mathematical model for a nancial market in one period

We consider a nancial market with 1 + d assets. We assume that the assets are priced at two

times, at t=0 (today) and at t=1 (in one year). Asset prices today are known and given
0 1 d
by the (usually positive) constants S0 , S0 , . . . , S0 ∈ R.2 Asset prices in one year, however, are

usually not known today. So we model them as real-valued (usually positive) random variables
S10 (ω), S11 (ω), . . . , S1d (ω) on some probability space (Ω, F, P). Every ω ∈Ω corresponds to a
i
possible state of the world in one year, and S1 (ω) denotes the price of asset i if the state of

the world in one year happens to be ω ∈ Ω.

It is convenient to identify each asset i with the stochastic process S i = (Sti )t∈{0,1} , i.e.,
i
with the collection of the two random variables S0 and S1i (where S0i (ω) := S0i ).
In most nancial markets, not all asset prices in one year are unknown. Usually, there is a

riskless asset, often also called bank account, which will pay a sure amount in one year.
3 We

will assume throughout that S0 is riskless and satises

S00 = 1 and S10 (ω) ≡ 1 + r,

where r > −1 denotes the interest rate.4

In order to distinguish the riskless asset S0 from the risky assets S1, . . . , Sd, we will use

the notation
5

St = (St1 , . . . , Std ) and S t = (St0 , St ), t ∈ {0, 1}

and call the Rd -valued stochastic process S = (St )t∈{0,1} the risky assets.6

Example 1.1 (One-period Binomial model). Assume that d = 1, i.e., there is only one risky

asset, and there are only two states of the world at time 1, i.e., Ω = {ω1 , ω2 }. We assume that

S01 =1 and

S 1 (ω1 ) = 1 + u and S 1 (ω2 ) = 1 + d,

2
Note that some derivative assets such as swaps have zero initial value.
3
Government bonds are usually considered to be riskless in reality, in particular US government bonds.
Notwithstanding the bank account is a somewhat ctitious security, in particular in continuous time where
it denotes the rollover of very short term riskless bonds.
4
Before the nancial crisis of 2008, interest rates tended to be positive (or at least nonnegative).
5 d d 1+d
Note that S0 is an R -valued vector and S1 is an R -valued random vector. Likewise, S 0 is an R -valued
1+d
vector and S 1 is an R -valued random vector.
6 d
R -valued stochastic process here means the collection of the two Rd -valued random vectors S0 and S1
(where S0 (ω) := S0 ).

4
where u > d > −1. Here, u and d are mnemonics for up and down, and it is often assumed

that u > 0. The probabilities for up and down are given by

P[{ω1 }] = p1 and P[{ω2 }] = p2

where p1 , p2 ∈ (0, 1) and p1 + p2 = 1.7 One can nicely illustrate this model by the following

trees, where the numbers beside the branches denote probabilities:

1
S0 : 1 1+r
p1 1+u

S1 : 1
p2 1+d

1.2 Trading strategies and arbitrage opportunities

We shall assume throughout that we have a frictionless market. This means that there are

no transaction costs, i.e., assets can be bought and sold at the same price, and there are no
constraints on the number of assets one holds. In particular, one can hold a negative amount
of some asset, i.e., assets can be shorted and the price paid/received is linear in the quantity

of assets bought/sold. Moreover, we shall assume that asset prices are exogeneously given and

not inuenced by the trading activities of other market participants. Thus agents are views

as price takers. All this is of course an idealisation of reality but one has to start with the

simplest case before building more realistic and therefore more complex models.

Given a nancial market S = (St0 , St )t∈{0,1} as above, a trading strategy, often also called

a portfolio, is a vector
ϑ = (ϑ0 , ϑ) = (ϑ0 , ϑ1 , . . . , ϑd ) ∈ R1+d ,

where ϑi denotes the number of shares held in asset i. The price today for buying the trading

strategy/portfolio ϑ is
d
X
ϑ · S0 = ϑi S0i = ϑ0 + ϑ · S0 .
i=0

In one year, i.e., at t = 1, the value of the trading strategy/portfolio will be

d
X
ϑ · S 1 (ω) = ϑi S1i (ω) = ϑ0 (1 + r) + ϑ · S1 (ω),
i=0

depending on the state of the world ω ∈ Ω.

The following denition is one of the cornerstones of Mathematical Finance:

7
To make the model mathematically rigorous, we also have to specify the σ -algebra F . This is  as standard
in models with nite (or countable) Ω  given by F = 2Ω , so that F = {∅, {ω1 }, {ω2 }, {ω1 , ω2 }}.

5
Denition 1.2. A trading strategy ϑ ∈ R1+d is called an arbitrage opportunity for S if

ϑ · S 0 ≤ 0, ϑ · S 1 ≥ 0 P-a.s. and P[ϑ · S 1 > 0] > 0.

The nancial market S arbitrage-free

is called if there are no arbitrage opportunities. In this

case one also says that S satises NA.

An arbitrage opportunity gives something (a positive chance of strictly positive nal wealth
P[ϑ·S 1 > 0] > 0) out of nothing (zero or negative initial wealth ϑ·S 0 ≤ 0) without risk (almost
sure nonnegative nal wealth ϑ · S 1 ≥ 0 P-a.s.).

Remark 1.3. If the market S admits arbitrage, there always exists an arbitrage opportunity

with ϑ · S 0 = 0. Indeed, if η = (η 0 , η) is an arbitrage opportunity with η · S 0 < 0, set

ϑ := (ϑ0 , ϑ) = (η 0 − η · S 0 , η). Then

ϑ · S 0 = ϑ0 + ϑ · S0 = η 0 − η · S 0 + η · S0 = η 0 − η 0 − η · S0 + η · S0 = 0.

Moreover, as −η · S 0 > 0,

ϑ · S 1 = ϑ0 (1 + r) + ϑ · S1 = η 0 (1 + r) + (−η · S 0 )(1 + r) + η · S1
= η · S 1 + (−η · S 0 )(1 + r) ≥ (−η · S 0 )(1 + r) > 0 P-a.s.

Thus, ϑ is an arbitrage opportunity with ϑ · S 0 = 0.

1.3 Discounting
Our next aim is to give a necessary and sucient condition on the market S to be arbitrage-

free. To this end, we need to introduce two further concepts.

The rst concept is the notion of discounting. Assets are denoted in units of something,

e.g. GBP or EUR. Notwithstanding, it is clear that prices (and values) are relative. So basic

concepts of nancial markets (like being arbitrage-free) should not and do not depend on the

choice of unit. For this reason, we are free to change the unit, in particular if this makes the

mathematics simpler. It turns out that a good choice is a unit which itself is a traded asset,
0
and the canonical choice is to use the risk-free asset S . So we discount with S 0 ortake S 0 as
numéraire, and dene the discounted assets X 0 , X 1 , . . . , X d by

Sti
Xti = , t ∈ {0, 1}, i ∈ {0, 1, . . . , d}.
St0

Then X0 ≡ 1 and X = (X 1 , . . . , X d ) expresses the value of the risky assets in units of the
0
numéraire S .

6
Example 1.4. Consider the one-period Binomial model from Example 1.1. Then the dis-

counted risky asset X1 is given by X01 = 1 and

1+u 1+d
X11 (ω1 ) = and X11 (ω2 ) = .
1+r 1+r

We can reformulate the notion of arbitrage in terms of the discounted risky assets X only.

Proposition 1.5. The following are equivalent:

(a) The market S satises NA.

(b) The discounted risky assets X satisfy NA, i.e., there does not exist8 any ϑ = (ϑ1 , . . . , ϑd ) ∈
Rd such that

ϑ · (X1 − X0 ) ≥ 0 P-a.s. and P[ϑ · (X1 − X0 ) > 0] > 0.

Proof. We only prove the more dicult direction (a) ⇒ (b).

Seeking a contradiction, suppose that there exist an arbitrage opportunity ϑ ∈ Rd for X

satisfying

ϑ · (X1 − X0 ) ≥ 0 P-a.s. and P[ϑ · (X1 − X0 ) > 0] > 0. (1.1)

We aim to extend ϑ to an arbitrage opportunity ϑ for S by choosing ϑ0 in an appropriate

way. Set

ϑ0 := −ϑ · X0 .

Then with ϑ := (ϑ0 , ϑ) and X 0 := (X00 , X0 ) = (1, X), we get

ϑ · X 0 = ϑ0 X00 + ϑ · X0 = ϑ0 + ϑ · X0 = −ϑ · X0 + ϑ · X0 = 0. (1.2)

Multiplying (1.2) by S00 = 1 gives

ϑ · S 0 = 0. (1.3)

Next, as X10 − X00 = 1 − 1 = 0, we note that (1.1) is equivalent to

ϑ · (X 1 − X 0 ) ≥ 0 P-a.s. and P[ϑ · (X 1 − X 0 ) > 0] > 0. (1.4)

Then plugging (1.2) into (1.4) shows that

ϑ · X 1 ≥ 0 P-a.s. and P[ϑ · X 1 > 0] > 0.

Now using that inequalities remain unchanged by multiplying by positive constants (here S10 ),
8
We would call such a ϑ an arbitrage opportunity for X. This is of course a slight abuse of notation, but a
very common one in Mathematical Finance.

7
we obtain

ϑ · S 1 ≥ 0 P-a.s. and P[ϑ · S 1 > 0] > 0.

This together with (1.3) shows that ϑ is an arbitrage opportunity for S, in contradiction to

the hypothesis that S satises NA.

1.4 Equivalent Martingale Measures

The other concept is the notion of an equivalent martingale measure (EMM).

To this end, we need another concept from Probability Theory.

Denition 1.6. Let (Ω, F) be a measurable space. Two probability measures P and Q on

(Ω, F) are called equivalent (notation: P ≈ Q) if, for A ∈ F , Q[A] = 0 if and only if P[A] = 0.

Two probability measures are equivalent, if they agree on which events will not happen,

i.e., have probability zero. But they may still assign dierent probabilities to events that

might happen.

Example 1.7. Let Ω = {ω1 , . . . , ωN } be a nite sample space and F = 2Ω . Let P be a

probability measure on (Ω, F) with P[{ωn }] > 0 for all n ∈ {1, . . . , N }. Then a probability

measure Q on (Ω, F) is equivalent to P if and only if Q[{ωn }] > 0 for all n ∈ {1, . . . , N }.
Indeed, if Q[{ωn }] = 0 for some n ∈ {1, . . . , N }, then Q cannot be equivalent to P. Otherwise,

x A ∈ F. Then P[A], Q[A] > 0 unless A = ∅; and if A = ∅, then trivially P[A] = 0 = Q[A].

We now can dene the concept of an equivalent martingale measure.

Denition 1.8. Let X be discounted risky assets on a probability space (Ω, F, P). A measure

Q on (Ω, F) is called an equivalent martingale measure for X if Q≈ P, each X i is Q-integrable

and

EQ X1i = X0i ,
 
i ∈ {1, . . . , d}.

Remark 1.9. The terminology equivalent martingale measure stems from the fact that the

X i 's are martingales under the equivalent measure Q. Martingales will be studied in some

detail in Chapter 5.

Alternatively, Q is also often called a risk-neutral measure.

1.5 The Fundamental Theorem of Asset Pricing

We have now all the tools to state and prove the so-called Fundamental Theorem of Asset
pricing, giving necessary and sucient conditions for the absence of arbitrage. For multiperiod

models, this was only established in 1990 by Dalang, Morton, and Willinger. For this reason,

it is sometimes also referred to as the Dalang-Morton-Willinger theorem.

Theorem 1.10 (Fundamental Theorem of Asset Pricing) . Let S = (St0 , St )t∈{0,1} be a one-
period nancial market on some probability space (Ω, F, P). The following are equivalent:

8
 (a) The market S satises NA.

(b) There exists an EMM for the discounted risky assets X = S/S 0 .

Proof. We rst establish the easy direction (b) ⇒ (a). So let Q ≈ P be an EMM. By

Proposition 1.5, it suces to show that X satises NA. Seeking a contradiction, suppose there

is ϑ∈ Rd such that

ϑ · (X1 − X0 ) ≥ 0 P-a.s. and P[ϑ · (X1 − X0 ) > 0] > 0.

By the fact that Q is equivalent to P, we have

ϑ · (X1 − X0 ) ≥ 0 Q-a.s. and Q[ϑ · (X1 − X0 ) > 0] > 0.

By monotonicity of the expectation operator (cf. Lemma 0.2 (b)),

EQ [ϑ · (X1 − X0 )] > 0.

But by linearity of the expectation operator (cf. Lemma 0.2 (a)) and the fact that Q is an

EMM,
d
X d
 X
ϑi EQ X1i − X0i = ϑi × 0 = 0,

EQ [ϑ · (X1 − X0 )] =
i=1 i=1

and we arrive at a contradiction.

For the proof of the dicult direction (a) ⇒ (b), we only consider the special case that

Ω = {ω1 , . . . , ωN } is nite, F = 2Ω and P[{ωn }] > 0 for all n ∈ {1, . . . , N }.9 As is the case

with many abstract existence theorems, the proof is not constructive. We are going to identify

a random variable Y on (Ω, F) with the RN -valued vector (Y (ω1 ), . . . , Y (ωN )). First, set

K := {(ϑ · (X1 (ω1 ) − X0 ), · · · , ϑ · (X1 (ωN ) − X0 )) : ϑ ∈ Rd } (1.5)

Then K corresponds to the collection of all random variables of the form ϑ·(X1 −X0 ) for ϑ ∈ Rd .
Mathematically, K is an (at most d-dimensional) vector subspace of RN . By Proposition 1.5,

X satises NA. In terms of K this means that

K ∩ RN
+ = {0}, (1.6)

where RN N
+ = [0, ∞) . Next, dene the standard simplex of dimension N −1 by

 N
X 
∆N −1 := x ∈ RN
+ : xn
= 1 .
n=1
9
For a proof with general Ω and F (which requires more measure theory), we refer to [2, Theorem 1.7].

9
 1
a·x=λ
∆N −1

−1 1

Figure 1: A illustration of the separating hyperplane theorem for N =2

Then ∆N −1 ⊂ RN
+ and / ∆N −1 ,
0∈ so that

K ∩ ∆N −1 = ∅.

As K and ∆N −1 are both nonempty and convex, K is a vector subspace and ∆N −1 is

compact, it follows from the strict separating hyperplane theorem 10 that there exists a vector
a∈ RN \ {0} and λ>0 such that

a·k =0 for all k ∈ K,

a·x≥λ>0 for all x ∈ ∆N −1 .

As ∆N −1 contains all standard unit vectors en in RN , it follows that

a · en = an > 0, n ∈ {1, . . . , N }.

Now dene the probability measure Q on (Ω, F) by

an
Q[{ωn }] = PN > 0.
k=1 ak

Then Q≈P by Example 1.7. Moreover, for i ∈ {1, . . . , d}, set

k i = (ei · (X1 (ω1 ) − X0 ), . . . , ei · (X1 (ωN ) − X0 )) ∈ K,

10
For a proof, we refer to [1, Proposition B.14].

10
where ei denotes the unit vector in Rd . Then

N N
 X 1 X
EQ X1i − X0i = (X1i (ωn ) − X0i )Q[{ωn }] = PN an (X1i (ωn ) − X0i )

n=1 k=1 ak n=1
N
1 X a · ki
an ei · (X1 (ωn ) − X0 ) = PN


= PN = 0,
k=1 ak n=1 k=1 ak

where we have used in the last step that a·k =0 for all k ∈ K.

Example 1.11. Consider the Binomial model from Example 1.1. Using the FTAP, we want

to check when S satises NA. So let Q be a measure on (Ω, F), and set q1 := Q[{ω1 }] and

q2 := Q[{ω2 }]. We know from Example 1.7 that Q ≈ P if and only if q1 > 0 and q2 > 0.
Moreover, Q 1
is an EMM for X if and only if

1+u 1+d
EQ X11 = X01 = 1 q1 X11 (ω1 ) + q2 X11 (ω2 ) = 1
 
⇔ ⇔ q1 + q2 = 1.
1+r 1+r

Rearranging and using that q2 = (1 − q1 ) gives

r−d
q1 (1 + u) + (1 − q1 )(1 + d) = 1 + r ⇔ q1 = .
u−d

and thus
u−r
q2 = 1 − q1 = .
u−d
Clearly, q1 , q2 > 0 if and only if u > r > d.
So S is arbitrage free if and only if u > r > d, in which case the (unique) EMM satises

r−d u−r
q1 = and q2 =
u−d u−d

The condition u>r>d is economically quite intuitive as it says that the risky asset must

oer the chance of a higher return than the interest rate in one state of the world (u > r) but

also have a lower return than the interest rate in another state of the world (d < r). Note

that the EMM Q does not depend on the values of p1 and p2 .

11