{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

section2 (1)

# section2 (1) - Continuous Time Finance Notes Spring 2004...

This preview shows pages 1–2. Sign up to view the full content.

Continuous Time Finance Notes, Spring 2004 – Section 2, Jan. 28, 2004 Notes by Robert V. Kohn, Courant Institute of Mathematical Sciences. For use in connec- tion with the NYU course Continuous Time Finance. In Section 1 we discussed how Girsanov’s theorem and the martingale representation the- orem tell us how to price and hedge options. This short section makes that discussion concrete by applying it to (a) options on a stock which pays dividends, and (b) options on foreign currency. We close with a brief discussion of Siegel’s paradox. For topics (a) and (b) see also Baxter and Rennie’s sections 4.1 and 4.2 – which are parallel to my discussion, but different enough to be well worth reading and comparing to what’s here. For a discussion of Siegel’s paradox and some related topics, see chapter 1 of the delightful book Puzzles of Finance: Six Practical Problems and their Remarkable Solutions by Mark Kritzman (J. Wiley & Sons, 2000, available as an inexpensive paperback). ******** Options on a stock with dividend yield. You probably already know from Derivative Securities how to price an option on a stock with continuous dividend yield q . If the stock is lognormal with volatility σ and the risk-free rate is (constant) r then the “risk-neutral process” is dS = ( r - q ) S dt + σS dw , and the time-0 value of an option with payoff f ( S T ) and maturity T is e - rT E RN [ f ( S T )]. From the SDE we get dE RN [ S ] /dt = ( r - q ) E RN [ S ], so E RN [ S ]( T ) = e ( r - q ) T S 0 . This is the forward price , i.e. the unique choice of k such that a forward with strike k and maturity T has initial value 0. (Proof: apply the pricing formula to f ( S T ) = S T - k .) When the option is a call, we get an explicit valuation formula using the fact that if X is lognormal with mean E [ X ] = F and volatility s (defined as the standard deviation of log X ), then E [( X - K ) + ] = FN ( d 1 ) - KN ( d 2 ) (1) with d 1 = ln( F/K ) + s 2 / 2 s , d 2 = ln( F/K ) - s 2 / 2 s . There is of course a similar formula for a call (easily deduced by put-call parity). What does it mean that the “risk-neutral process is dS = ( r - q ) S dt + σS dw ?” What happens when the dividends are paid at discrete times? We can clarify these points by using the framework of Section 1. Remember the main points: (a) there is a unique “equivalent martingale measure” Q , obtained by an application of Girsanov’s theorem; and (b) this Q is characterized by the property that the value V t of any tradeable asset satisfies V t /B t = E [ V T /B T | F t ] where B t is the value of a risk-free money-market account, i.e. it solves dB = rB dt with B (0) = 1. Put differently: V/B is a Q -martingale.

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}