Stochastic Calculus Key Points

Changing probibility measure

Condition

both measure agree on what’s possible and impossible.
P ( w ) > 0 ⇔ P ∗ ( w ) > 0. \mathbb{P}(w)>0 \Leftrightarrow \mathbb{P}^*(w)>0. P(w)>0P(w)>0.

How to do: Radon-Nikodym Derivative

what:
R N = d P d Q RN=\frac{d\mathbb{P}}{d\mathbb{Q}} RN=dQdP

how to work:
E Q [ x ] = E P [ x d Q d P ] \mathbb{E}^{\mathbb{Q}}[x]=\mathbb{E}^{\mathbb{P}}[x\frac{d\mathbb{Q}}{d\mathbb{P}}] EQ[x]=EP[xdPdQ]

meaning:

  • able to get Q \mathbb{Q} Q measure valuation while using P \mathbb{P} P measure parameters.
  • feels like minimum adjusting to existing results( P \mathbb{P} P results).

Relevant Info: Conditional Expectation (not prob)

Terminology:

  • Conditional on no previous information:
    E 0 ∗ [ X ] = E ∗ [ X ] \mathbb{E}^*_0[X]=\mathbb{E}^*[X] E0[X]=E[X]
  • Conditional on N time:
    E N ∗ [ X ] = X \mathbb{E}^*_N[X]=X EN[X]=X

Property:

  • Linearity
    for all constant a a a, b b b
    E n [ a X + b Y ] = a E n [ X ] + b E n [ b ] . \mathbb{E}_n[aX+bY]=a\mathbb{E}_n[X]+b\mathbb{E}_n[b]. En[aX+bY]=aEn[X]+bEn[b].
  • Extracting known variable
    if X X X only depends on the first n n n tosses, then
    E n [ X Y ] = X E n [ Y ] . \mathbb{E}_n[XY]=X\mathbb{E}_n[Y]. En[XY]=XEn[Y].
  • Iterated conditioning
    if 0 ≤ n ≤ m ≤ N 0 \leq n \leq m \leq N 0nmN, then n n n cancel m m m away:
    E n [ E m [ X ] ] = E n [ X ] \mathbb{E}_n[\mathbb{E}_m[X] ] =\mathbb{E}_n[X] En[Em[X]]=En[X]
  • Independence
    if X X X only depends on the ( n + 1 ) t h (n+1)^{th} (n+1)th toss, then
    E n [ X ] = E [ X ] \mathbb{E}_n[X]=\mathbb{E}[X] En[X]=E[X]

Relevant Info: Martingale

what:
M n = E n ∗ [ M n + 1 ] M_n=\mathbb{E}_n^*[M_{n+1}] Mn=En[Mn+1]
E s [ W n ] = W s E_s[W_n]=W_s Es[Wn]=Ws
what’s important:

  • no drift, expectation always goes back to M 0 M_0 M0
  • risk-neutral process follows martingale
  • thus we have no drift makes risk-neutral measure

Derive continuous binomial tree formula from discrete b-tree

normal (r=0)

σ T 2 = σ S 0 2 ∗ T (T time) σ 1   s t e p 2 = σ S 0 2 ∗ T n (total n steps) σ 1   s t e p = σ 2 T n \begin{aligned} \sigma_T^2&=\sigma_{S_0}^2*T\quad \textnormal{(T time)}\\ \sigma_{1\ step}^2&=\frac{\sigma_{S_0}^2*T}{n}\quad \textnormal{(total n steps)}\\ \sigma_{1\ step}&=\sqrt{\frac{\sigma^2 T}{n}}\\ \end{aligned} σT2σ1 step2σ1 step=σS02T(T time)=nσS02T(total n steps)=nσ2T
X X X is 1 or -1(moving up or down), and E ( X ) = 0 E(X)=0 E(X)=0, V ( X ) = 1 V(X)=1 V(X)=1.
X i ∼ N ( 0 , 1 n ) X_i\sim N(0,\frac{1}{n}) XiN(0,n1)
S n = S 0 + ∑ 1 + ∞ X i σ n = S 0 + T n σ ∑ X i apply CLT l e t Z = ∑ X i n ∼ N ( 0 , 1 ) = S 0 + T σ Z \begin{aligned} S_n&=S_0+\sum^{+\infty}_{1} X_i\sigma _n\\ &=S_0+\sqrt{\frac{T}{n}}\sigma \sum X_i \quad \textnormal{apply CLT}\\ &let Z = \frac{\sum X_i}{\sqrt{n}} \sim N(0,1)\\ &=S_0+\sqrt{T}\sigma Z \end{aligned} Sn=S0+1+Xiσn=S0+nT σXiapply CLTletZ=n XiN(0,1)=S0+T σZ

lognormal (r involved)

l o g ( S t ) = l o g ( S t − 1 ) + ( r − 1 2 σ 2 ) Δ t + σ Δ t X t sum all equations l o g ( S t ) = l o g ( S 0 ) + ( r − 1 2 σ 2 ) T + σ T n ∑ X i apply CLT likewise l o g ( S t S 0 = e x p [ ( r − σ 2 2 ) T + σ T Z ] \begin{aligned} log(S_t)&=log(S_{t-1})+(r-\frac{1}{2}\sigma^2)\Delta t+\sigma \sqrt{\Delta t} X_t\\ &\textnormal{sum all equations}\\ log(S_t)&=log(S_0)+(r-\frac{1}{2}\sigma^2)T+\sigma\sqrt{\frac{T}{n}}\sum X_i\\ &\textnormal{apply CLT likewise}\\ log(\frac{S_t}{S_0}&=exp[(r-\frac{\sigma^2}{2})T+\sigma\sqrt{T}Z]\\ \end{aligned} log(St)log(St)log(S0St=log(St1)+(r21σ2)Δt+σΔt Xtsum all equations=log(S0)+(r21σ2)T+σnT Xiapply CLT likewise=exp[(r2σ2)T+σT Z]

Brownian Motion and its Property

Random Walk

random walk process:
S n = ∑ X i , X i = ± 1 S_n=\sum X_i, \quad X_i=\pm 1 Sn=Xi,Xi=±1

Reflection Principle:

up and down have same prob.

some example here:

  • W t W_t Wt is a Brownian process. Conditional on W 1 > 0 W_1>0 W1>0, what is the probability that W 2 < 0 W_2<0 W2<0?
    P ( W 2 < 0 ∣ W 1 > 0 ) = P ( W 2 ↓ ) P ( ∣ W 2 − W 1 ∣ > ∣ W 1 − 0 ∣ ) = 0.5 × 0.5 = 0.25 \begin{aligned} \mathbb{P}(W_2<0|W_1>0)&=\mathbb{P}(W_2 \downarrow)\mathbb{P}(|W_2-W_1|>|W_1-0|)\\ &=0.5\times 0.5=0.25 \end{aligned} P(W2<0W1>0)=P(W2)P(W2W1>W10)=0.5×0.5=0.25

Brownian Motion

Derive from Random Walk:

  • W n ( 0 ) = 0 W_n(0)=0 Wn(0)=0, start from 0.
  • time spacing is 1 n \frac{1}{n} n1.
  • up and dowm jumps equal and of size 1 n \frac{1}{\sqrt{n}} n 1.
  • measure P \mathbb{P} P, given by up and down probabilities everywhere equal to 1 2 \frac{1}{2} 21.
    W n ( i n ) = W n ( i − 1 n ) + X i n , 1 ≤ i W n ( t ) = t ( ∑ i = 1 n t X i n t ) l e t t = i n \begin{aligned} W_n(\frac{i}{n})&=W_n(\frac{i-1}{n})+\frac{X_i}{\sqrt{n}},\quad 1\leq i\\ W_n(t)&=\sqrt{t}(\frac{\sum_{i=1}^{nt} X_i}{\sqrt{nt}})\quad let t=\frac{i}{n} \end{aligned} Wn(ni)Wn(t)=Wn(ni1)+n Xi,1i=t (nt i=1ntXi)lett=ni
    put n → ∞ n \to \infty n, we distribe :
    W t = lim ⁡ n → ∞ W n ( t ) W_t=\lim_{n\to \infty}W_n(t) Wt=nlimWn(t)

Defination (for checking if Brownian):

  • start from 0
  • increments follow N(0,time)
  • increments iid

Feature:

E [ W t ] = 0 E [ W t 2 ] = t E [ W t − W s ] = 0 V [ W t − W s ] = E [ ( W t − W s ) 2 ] = t − s C o v ( W s , W t ) = s , s < t C o r r ( W s , W t ) = s t \begin{aligned} \mathbb{E}[W_t]&=0\\ \mathbb{E}[W_t^2]&=t\\ \mathbb{E}[W_t-W_s]&=0\\ \mathbb{V}[W_t-W_s]&=\mathbb{E}[(W_t-W_s)^2]=t-s\\ Cov(W_s,W_t)&=s,\quad s<t\\ Corr(W_s,W_t)&=\sqrt{\frac{s}{t}}\\ \end{aligned} E[Wt]E[Wt2]E[WtWs]V[WtWs]Cov(Ws,Wt)Corr(Ws,Wt)=0=t=0=E[(WtWs)2]=ts=s,s<t=ts

Property:

  • W t W_t Wt is continuous everywhere, but differentiable nowhere
  • Brownian motion will hit any real value eventually.
  • Once hit a value, hit infinitely often.
  • fractal.

Brownian Martingales:

  • W t W_t Wt
  • W t 2 − t W_t^2-t Wt2t
  • W t 3 W_t^3 Wt3 is not, prove E S [ W t 3 ] ≠ W s 3 E_S[W_t^3]\neq W_s^3 ES[Wt3]=Ws3
  • e σ W t e^{\sigma W_t} eσWt is not
  • exp ⁡ ( σ W t − σ 2 t 2 ) \exp(\sigma W_t - \frac{\sigma^2t}{2}) exp(σWt2σ2t)
  • technique:
    E s [ W t 3 ] = E s [ ( W t − W s + W s ) 3 ] E_s[W_t^3]=E_s[(W_t-W_s+W_s)^3] Es[Wt3]=Es[(WtWs+Ws)3] both add and substract W s W_s Ws

Stochastic Integrals and It o ^ \hat{o} o^ Formula

Models

normal items and a W t W_t Wt which stands for a stochastic process.
S t = S 0 + μ t + σ W t S_t = S_0+\mu t+\sigma W_t St=S0+μt+σWt
intergral form
S t = S 0 + ∫ 0 t μ d u + ∫ 0 t σ d W u S_t = S_0+\int _0^t\mu du+\int_0^t \sigma dW_u St=S0+0tμdu+0tσdWu
differential form
d S t = μ ( t , S t ) d t + σ ( t , S t ) d W t dS_t = \mu(t,S_t) dt+\sigma(t,S_t) dW_t dSt=μ(t,St)dt+σ(t,St)dWt

Stochastic Integral

core: Taylor expansion.
If S t S_t St includes stochastic process W t W_t Wt, then it needs to expand to second moment since V a r ( W t ) = t Var(W_t)=t Var(Wt)=t, d W t 2 = d t dW_t^2 = dt dWt2=dt.

Property of I = ∫ 0 T f ( u ) d W t I=\int^T_0f(u)dW_t I=0Tf(u)dWt:

  • E [ I ] = 0 \mathbb{E}[I]=0 E[I]=0
  • E [ I 2 ] = E [ ( ∫ 0 T f ( u ) d W u ) 2 ] = E [ ∫ 0 T f ( u ) 2 d u ] \mathbb{E}[I^2]=\mathbb{E}[(\int_0^Tf(u)dW_u)^2]=\mathbb{E}[\int_0^Tf(u)^2du] E[I2]=E[(0Tf(u)dWu)2]=E[0Tf(u)2du], Ito’s Isometry
  • E [ ∫ 0 T f ( u ) d W u × ∫ 0 T g ( u ) d W u ] = E [ ∫ 0 T f ( u ) g ( u ) d W u ] \mathbb{E}[\int_0^Tf(u)dW_u\times \int_0^Tg(u)dW_u]=\mathbb{E}[\int_0^Tf(u)g(u)dW_u] E[0Tf(u)dWu×0Tg(u)dWu]=E[0Tf(u)g(u)dWu]
  • If f f f is a deterministic function, then
    I ∼ N ( 0 , ∫ 0 T f ( u ) 2 d u ) I\sim N(0,\int^T_0f(u)^2du) IN(0,0Tf(u)2du)

It o ^ \hat{o} o^ Formula

d X t = μ d t + σ d W t dX_t = \mu dt + \sigma dW_t dXt=μdt+σdWt

Y t = f ( X t ) Y_t=f(X_t) Yt=f(Xt) function of a stochastic process

derive X twice
d Y t = ( μ t f ′ + 1 2 σ t 2 f ′ ′ ) d t + σ t f ′ d W t dY_t = (\mu_tf'+\frac{1}{2}\sigma_t^2f'')dt+\sigma_tf'dW_t dYt=(μtf+21σt2f)dt+σtfdWt

Y t = g ( X t , t ) Y_t=g(X_t,t) Yt=g(Xt,t)function of a stochastic process and time

d Y t = g t d t + ( μ t g x + 1 2 σ t 2 g x x ) d t + σ t g x d W t dY_t = g_tdt+(\mu_tg_x+\frac{1}{2}\sigma_t^2g_{xx})dt+\sigma_tg_xdW_t dYt=gtdt+(μtgx+21σt2gxx)dt+σtgxdWt

Applications

  1. Solve intergrals
    Cal result for
    ∫ 0 T W t d W t \int_0^TW_tdW_t 0TWtdWt
    A:
    let X t = W t 2 X_t=W_t^2 Xt=Wt2, f x = 2 W t , f x x = 2 f_x=2W_t,f_{xx}=2 fx=2Wt,fxx=2
    d X t = f x d W t + 1 2 f x x d t = 2 W t d W t + d t X T − X 0 = ∫ 0 T 2 W t d W t + T ∫ 0 T W t d W t = W T 2 2 − T 2 \begin{aligned} dX_t&=f_xdW_t+\frac{1}{2}f_{xx}dt\\ &=2W_tdW_t+dt\\ X_T-X_0&=\int_0^T 2W_tdW_t+T\\ \int_0^T W_tdW_t&=\frac{W_T^2}{2}-\frac{T}{2} \end{aligned} dXtXTX00TWtdWt=fxdWt+21fxxdt=2WtdWt+dt=0T2WtdWt+T=2WT22T

3 ways to cook e θ W t e^{\theta W_t} eθWt

Solve 1: W t = x , x ∼ N ( 0 , t ) W_t=x, x\sim N(0,\sqrt{t}) Wt=x,xN(0,t )
E [ e θ W t ] = 1 2 π t ∫ e θ x e − x 2 2 t d x \mathbb{E}[e^{\theta W_t}]=\frac{1}{\sqrt{2\pi t}}\int e^{\theta x}e^{-\frac{x^2}{2t}}dx E[eθWt]=2πt 1eθxe2tx2dx
Solve 2: W t ∼ t x , x ∼ N ( 0 , 1 ) W_t \sim \sqrt{t}x, x\sim N(0,1) Wtt x,xN(0,1)
E [ e θ t X ] = 1 2 π ∫ e θ t x e − x 2 2 d x \mathbb{E}[e^{\theta \sqrt{t}X}]=\frac{1}{\sqrt{2\pi}}\int e^{\theta \sqrt{t}x}e^{-\frac{x^2}{2}}dx E[eθt X]=2π 1eθt xe2x2dx
Solve 3: Leibnits
Let X t = e θ W t X_t=e^{\theta W_t} Xt=eθWt, by Ito’s formula we have
d X t = θ X t d W t + 1 2 θ 2 X t d t X t = X 0 + θ ∫ 0 t X u d W u + θ 2 2 ∫ 0 t X u d u E [ X t ] = E [ X 0 ] + 1 2 θ 2 ∫ 0 t E [ X t ] d t d E [ X t ] d t = θ 2 2 E [ X t ] E [ X t ] = E [ e θ W t ] = e θ 2 2 t \begin{aligned} dX_t &= \theta X_t dW_t+\frac{1}{2}\theta ^2 X_tdt\\ X_t&=X_0+\theta \int_0^t X_udW_u+\frac{\theta^2}{2}\int_0^tX_udu\\ \mathbb{E}[X_t]&=\mathbb{E}[X_0]+\frac{1}{2}\theta ^2 \int_0^t \mathbb{E}[X_t]dt\\ \frac{d\mathbb{E}[X_t]}{dt}&=\frac{\theta^2}{2}\mathbb{E}[X_t]\\ \mathbb{E}[X_t]&=\mathbb{E}[e^{\theta W_t}]=e^{\frac{\theta ^2}{2}t} \end{aligned} dXtXtE[Xt]dtdE[Xt]E[Xt]=θXtdWt+21θ2Xtdt=X0+θ0tXudWu+2θ20tXudu=E[X0]+21θ20tE[Xt]dt=2θ2E[Xt]=E[eθWt]=e2θ2t
Conclusion: find Tylor expansion for general format(since can not find solution for exponential W t W_t Wt), take expectation then and use ODE to solve for results.

Rules/ Techniques

Tools:

  • use log to separate X t X_t Xt from d x dx dx terms.
  • Chain rule.
  • Product rule(keep d W t × d W t dW_t\times dW_t dWt×dWt terms).
  • Two different Brownian Motions
    • ρ = 1 : d W t × d W t ′ = d t \rho = 1: dW_t\times dW'_t=dt ρ=1:dWt×dWt=dt
    • ρ = 0 : d W t × d W t ′ = 0 \rho = 0: dW_t\times dW'_t=0 ρ=0:dWt×dWt=0
  • Box calculus rules:
    • only keep d W t dW_t dWt relevant terms.

Stochastic Differential Equations

Bachelier Model

d S t = σ S 0 d W t dS_t = \sigma S_0dW_t dSt=σS0dWt

Black-Scholes Model

d S t = r S t d t + σ S t d W t dS_t=rS_tdt+\sigma S_tdW_t dSt=rStdt+σStdWt

C ( S t , t ) = N ( d 1 ) S t − N ( d 2 ) P V ( K ) d 1 = 1 σ t [ ln ⁡ ( S t K ) + ( r + σ 2 2 ) t ] d 2 = d 1 − σ t \begin{aligned} C(S_{t},t)&=N(d_{1})S_{t}-N(d_{2})PV(K)\\ d_{1}&={\frac {1}{\sigma {\sqrt {t}}}}\left[\ln \left({\frac {S_{t}}{K}}\right)+\left(r+{\frac {\sigma ^{2}}{2}}\right)t\right]\\ d_{2}&=d_{1}-\sigma {\sqrt {t}}\\ \end{aligned} C(St,t)d1d2=N(d1)StN(d2)PV(K)=σt 1[ln(KSt)+(r+2σ2)t]=d1σt

deriving steps:

  1. S t S_t St formula
  2. find payment thershold x ∗ x^* x
  3. V t V_t Vt formula through intergration
  4. Discount to V 0 V_0 V0

Relevant Questions

  1. What’s the K K K if call and put have equal price?
    According to put call parity: 0 = c − p = S 0 − K e − r T 0=c-p=S_0-Ke^{-rT} 0=cp=S0KerT
    K = S 0 e r T K=S_0e^{rT} K=S0erT
  2. Which is more expensive according to BSM? K K K is equal price from last Q.
    1. call @ $K+$10$
    2. put @ $K-$10$
      c>p
      Since stock price is lognormal distribution, thus, moving down would result in a higher area of probability and moving up would cover a smaller areas of probability.
    3. call gives unlimited potential upside, put gives limited potentials downside, why same worth at K K K?

BSM normal return vs log return

NormalLognormal
Mean log ⁡ ( S 0 ) + ( r − σ 2 2 ) T \log (S_0)+(r-\frac{\sigma^2}{2})T log(S0)+(r2σ2)T S 0 e r T S_0e^{rT} S0erT
Median log ⁡ ( S 0 ) + ( r − σ 2 2 ) T \log (S_0)+(r-\frac{\sigma^2}{2})T log(S0)+(r2σ2)T S 0 e ( r − σ 2 2 ) T S_0e^{(r-\frac{\sigma^2}{2})T} S0e(r2σ2)T
Mode log ⁡ ( S 0 ) + ( r − σ 2 2 ) T \log (S_0)+(r-\frac{\sigma^2}{2})T log(S0)+(r2σ2)T S 0 e ( r − 3 σ 2 2 ) T S_0e^{(r-\frac{3\sigma^2}{2})T} S0e(r23σ2)T
Variance σ 2 T \sigma^2T σ2T S 0 2 e 2 r T ( e σ 2 T − 1 ) S_0^2e^{2rT}(e^{\sigma^2T}-1) S02e2rT(eσ2T1)
Range − ∞ < log ⁡ ( S T ) < + ∞ -\infty<\log (S_T)<+\infty <log(ST)<+ 0 < S T < + ∞ 0<S_T<+\infty 0<ST<+

Approx Price

V 0 c = σ S 0 T 2 π V_0^c=\sigma S_0\sqrt{\frac{T}{2\pi}} V0c=σS02πT

Black 76, Forward Pricing Process

let F t = e r ( T − t ) S t F_t=e^{r(T-t)}S_t Ft=er(Tt)St
d F t = σ F t d W t dF_t=\sigma F_tdW_t dFt=σFtdWt

Displaced-Diffusion Model

between lognormal and normal
d F t = σ [ β F t + ( 1 − β ) F 0 ] d W t , β ∈ [ 0 , 1 ] dF_t = \sigma[\beta F_t+(1-\beta)F_0]dW_t, \quad \beta \in [0,1] dFt=σ[βFt+(1β)F0]dWt,β[0,1]
Solving Key:
rewrite formula as d [ F t + ( 1 − β ) β F 0 ] = σ β [ F t + ( 1 − β ) β F 0 ] d W t d[F_t +\frac{(1-\beta)}{\beta}F_0]= \sigma\beta [F_t+\frac{(1-\beta)}{\beta}F_0]dW_t d[Ft+β(1β)F0]=σβ[Ft+β(1β)F0]dWt

forward rate process is allowed to be negative value as the lowerbound to the forward process.

Vasicek Model

an example discribing rates
d r t = κ ( θ − r t ) d t + σ d W t dr_t=\kappa (\theta-r_t)dt+\sigma dW_t drt=κ(θrt)dt+σdWt
Solution Key:
let X t = e κ t r t X_t = e^{\kappa t}r_t Xt=eκtrt

Cox-Ingersoll-Ross

Quit??

S5 Equivalent Martingale Measure (changing measure)

Girsanov

we always want to change the mean of the distrubution to 0 so that it’s a martingale. So that we need to change measure.

d Q d P = exp ⁡ ( − ∫ 0 T κ t W t − 1 2 ∫ 0 T κ t 2 t ) \frac{d\mathbb{Q}}{d\mathbb{P}}=\exp(-\int_0^T\kappa_t W_t-\frac{1}{2}\int_0^T\kappa_t ^2 t) dPdQ=exp(0TκtWt210Tκt2t)

Example:

  1. Consider X t X_t Xt given by
    d X t = μ d t + σ d W t dX_t = \mu dt + \sigma dW_t dXt=μdt+σdWt
    where W W W is a P \mathbb{P} P-Brownian motion. Determine if there’s a measure Q \mathbb{Q} Q such that the drift of the prcess X t X_t Xt under Q \mathbb{Q} Q is v d t vdt vdt instead of μ d t \mu dt μdt?
    d X t = v X t d t + σ X t ( d W t + μ − v σ d t ) = v X t d t + σ X t d W t ~ κ t = μ − v σ \begin{aligned} dX_t&=vX_t dt + \sigma X_t(dW_t + \frac{\mu - v}{\sigma}dt)\\ &= vX_t dt + \sigma X_t d\tilde{W_t}\\ \kappa _t &= \frac{\mu - v}{\sigma} \end{aligned} dXtκt=vXtdt+σXt(dWt+σμvdt)=vXtdt+σXtdWt~=σμv

Dynamic Hedging (deriving BSM)

d S t = μ S t d t + σ S t d W t d B t = r B t d t let  Π = Δ S − C \begin{aligned} dS_t&=\mu S_t dt + \sigma S_t dW_t\\ dB_t&= rB_tdt\\ \textnormal{let }\Pi&=\Delta S-C\\ \end{aligned} dStdBtlet Π=μStdt+σStdWt=rBtdt=ΔSC
in order for dynamic hedging
d Π = Δ d S + S d Δ + d S d Δ − d C \begin{aligned} d\Pi&=\Delta dS+S d\Delta + dSd\Delta -dC\\ \end{aligned} dΠ=ΔdS+SdΔ+dSdΔdC
considering self financing we have S d Δ + d S d Δ = 0 S d\Delta + dSd\Delta=0 SdΔ+dSdΔ=0
d Π = Δ d S − d C d C = ∂ C ∂ S d S + 1 2 ∂ 2 C ∂ S 2 σ 2 S 2 d t + ∂ C ∂ t d t d Π = Δ d S − ( ∂ C ∂ S d S + 1 2 ∂ 2 C ∂ S 2 σ 2 S 2 d t + ∂ C ∂ t d t ) Δ = ∂ C ∂ S d Π = − ( 1 2 ∂ 2 C ∂ S 2 σ 2 S 2 + ∂ C ∂ t ) d t \begin{aligned} d\Pi&=\Delta dS -dC\\ dC&=\frac{\partial C}{\partial S}dS+\frac{1}{2}\frac{\partial^2 C}{\partial S^2}\sigma^2 S^2 dt+\frac{\partial C}{\partial t}dt\\ d\Pi&=\Delta dS -(\frac{\partial C}{\partial S}dS+\frac{1}{2}\frac{\partial^2 C}{\partial S^2}\sigma^2 S^2 dt+\frac{\partial C}{\partial t}dt)\\ \Delta &= \frac{\partial C}{\partial S}\\ d\Pi &= -(\frac{1}{2}\frac{\partial^2 C}{\partial S^2}\sigma^2 S^2 +\frac{\partial C}{\partial t})dt\\ \end{aligned} dΠdCdΠΔdΠ=ΔdSdC=SCdS+21S22Cσ2S2dt+tCdt=ΔdS(SCdS+21S22Cσ2S2dt+tCdt)=SC=(21S22Cσ2S2+tC)dt
Since Π \Pi Π is tradable, and it’s return is determinstic, arbitrage argument tells that it should drift at risk free rate.
r Π d t = − ( 1 2 ∂ 2 C ∂ S 2 σ 2 S 2 + ∂ C ∂ t ) d t r ( Δ S − C ) = − 1 2 ∂ 2 C ∂ S 2 σ 2 S 2 + ∂ C ∂ t r C = ∂ C ∂ S r S t + ∂ C ∂ t + 1 2 ∂ 2 C ∂ S 2 σ 2 S 2 \begin{aligned} r\Pi dt &= -(\frac{1}{2}\frac{\partial^2 C}{\partial S^2}\sigma^2 S^2 +\frac{\partial C}{\partial t})dt\\ r(\Delta S-C)&=-\frac{1}{2}\frac{\partial^2 C}{\partial S^2}\sigma^2 S^2 +\frac{\partial C}{\partial t}\\ rC&= \frac{\partial C}{\partial S}rS_t + \frac{\partial C}{\partial t}+\frac{1}{2}\frac{\partial ^2 C}{\partial S^2}\sigma ^2 S^2 \end{aligned} rΠdtr(ΔSC)rC=(21S22Cσ2S2+tC)dt=21S22Cσ2S2+tC=SCrSt+tC+21S22Cσ2S2
It’s known as Black-Scholes PDE

Numeraire

The only requirement for a particular security to qualify as a numeraire security is that it has to be strictly positive at all times.

Justification:

  • In a complete market, any derivative security is attainable. Since we can hedge a derivative product perfectly, the derivative security loses its randomness and behaves like a risk-less bond.
  • If we hedge according to our risk-neutral valuation framework, then all risk is eliminated, and the hedged portfolio grows at a risk-free rate.
  • Consequently, the hedged portfolio divided by the risk-free rate is a martingale.
  • In other words, if one portfolio is an arbitrage in one measure, then it is an arbitrage in all other equivalent measures.
  • If the option price we determined under the risk-neutral measure is arbitrage-free, then it is arbitrage-free in the real world.
  • If we can express security price processes discounted by a numeraire security as a martingale, then there can be no arbitrage opportunities.
  • Under the risk-neutral probabilities associated to this numeraire security, the option price is also a martingale, and we can therefore determine it’s present value.

How to Do:
Example:

  1. Let X t = S t B t X_t = \frac{S_t}{B_t} Xt=BtSt
  2. Change X t X_t Xt to risk neutral
  3. record d W t n e w = d W t . . . dW_t^{new}=dW_t... dWtnew=dWt...
  4. place d W t n e w dW_t^{new} dWtnew into S t S_t St
  5. apply pricing

3 ways to Derive Blake-Shole Model

Solution 1

S6 Volatility Smile

Binary Options

TypeNumeraire
Cash or nothing I S t > K \mathbb{I}_{S_t>K} ISt>KBond
Asset or nothing S t I S t > K S_t\mathbb{I}_{S_t>K} StISt>KStock

Radon-Nikodym as Numeraire Ratio

E Q N [ G t ] = E Q M [ G t N T / N 0 M T / M 0 ] \mathbb{E}^{\mathbb{Q}^N}[G_t]=\mathbb{E}^{\mathbb{Q}^M}[G_t\frac{N_T/N_0}{M_T/M_0}] EQN[Gt]=EQM[GtMT/M0NT/N0]
d Q N d Q M = N T / N 0 M T / M 0 \frac{d\mathbb{Q}^N}{d\mathbb{Q}^M}=\frac{N_T/N_0}{M_T/M_0} dQMdQN=MT/M0NT/N0
example:

  1. Bound Numeraire, basing on Lognormal stock price:
    d Q N d Q M = N T / N 0 M T / M 0 = S T / S 0 B T / B 0 = e ( r − σ 2 2 ) t + σ W t ∗ e r t = e − σ 2 2 t + σ W t ∗ \begin{aligned} \frac{d\mathbb{Q}^N}{d\mathbb{Q}^M}&=\frac{N_T/N_0}{M_T/M_0}\\ &=\frac{S_T/S_0}{B_T/B_0}\\ &=\frac{e^{(r-\frac{\sigma^2}{2})t+\sigma W_t^*}}{e^{rt}}\\ &=e^{-\frac{\sigma^2}{2}t+\sigma W_t^*} \end{aligned} dQMdQN=MT/M0NT/N0=BT/B0ST/S0=erte(r2σ2)t+σWt=e2σ2t+σWt
  2. Stock Numeraire, Asset or nothing call:
    V 0 = e − r t E Q ∗ [ S t I S t > K ] = e − r t E Q S [ S t I S t > K d Q ∗ Q S ] = e − r t E Q S [ S t I S t > K B t / B 0 S t / S 0 ] = S 0 E Q S [ I S t > K ] \begin{aligned} V_0&=e^{-rt}\mathbb{E}^{\mathbb{Q}^*}[S_t\mathbb{I}_{S_t>K}]\\ &=e^{-rt}\mathbb{E}^{\mathbb{Q}^S}[S_t\mathbb{I}_{S_t>K}\frac{d\mathbb{Q}^*}{\mathbb{Q}^S}]\\ &=e^{-rt}\mathbb{E}^{\mathbb{Q}^S}[S_t\mathbb{I}_{S_t>K}\frac{B_t/B_0}{S_t/S_0}]\\ &=S_0\mathbb{E}^{\mathbb{Q}^S}[\mathbb{I}_{S_t>K}]\\ \end{aligned} V0=ertEQ[StISt>K]=ertEQS[StISt>KQSdQ]=ertEQS[StISt>KSt/S0Bt/B0]=S0EQS[ISt>K]
    Since d Q S d Q ∗ = e − σ 2 2 t + σ W t ∗ \frac{d\mathbb{Q}^S}{d\mathbb{Q}^*}=e^{-\frac{\sigma^2}{2}t+\sigma W_t^*} dQdQS=e2σ2t+σWt, then W t S = W t ∗ + κ t W_t^S=W_t^*+\kappa t WtS=Wt+κt, κ = − σ \kappa = -\sigma κ=σ.
    d W t S = d W t ∗ − σ d t d S t = ( r + σ 2 ) S t d t + σ S t d W t S , S t = S 0 exp ⁡ [ ( r + 1 2 σ 2 ) T + σ W T S ] S t > K \begin{aligned} dW_t^S&=dW_t^*-\sigma dt\\ dS_t&=(r+\sigma ^2)S_tdt+\sigma S_tdW_t^S,\\ S_t&=S_0\exp{[(r+\frac{1}{2}\sigma ^2)T+\sigma W_T^S]}\\ S_t&>K\\ \end{aligned} dWtSdStStSt=dWtσdt=(r+σ2)Stdt+σStdWtS,=S0exp[(r+21σ2)T+σWTS]>K
    then find boundary and intergrat.

Volatility Smile

background: before 1987, the crash, vol is flat. After, people want more protective put, rising the put price and thus give rise to implied vol.

Constant Vol:

try to use origional models to derive σ \sigma σ.

Black 76 lognormal model:

d F t = σ F t d W t ∗ dF_t=\sigma F_tdW_t^* dFt=σFtdWt

Black 76 normal model:

d F t = σ F 0 d W t ∗ dF_t=\sigma F_0dW_t^* dFt=σF0dWt

Black 76 displaced-diffusion model:

d F t = [ β F t + ( 1 − β ) F 0 ] σ d W t ∗ dF_t=[\beta F_t + (1-\beta)F_0]\sigma dW_t^* dFt=[βFt+(1β)F0]σdWt
solving method refer to displaced-diffusion part.

Stochastic Vol

Idea is that volatility is also stochastic!
d σ t = v σ t d W t σ , d\sigma_t = v\sigma _tdW_t^{\sigma}, dσt=vσtdWtσ,
v v v is volatility of volatility(vol of vol)

Heston Model

somehow he uses V t V_t Vt stands for σ \sigma σ
It’s popular among equity desks
d S t = r S t d t + V t S t d W t S d V t = κ ( θ − V t ) d t + v V t d W t V d W t S d W t V = ρ d t \begin{aligned} dS_t&=rS_tdt+\sqrt{V_t}S_tdW_t^S\\ dV_t&=\kappa (\theta - V_t)dt + v\sqrt{V_t}dW_t^V\\ dW_t^SdW_t^V&=\rho dt \end{aligned} dStdVtdWtSdWtV=rStdt+Vt StdWtS=κ(θVt)dt+vVt dWtV=ρdt

SABR (Stochastic Alpha-Beta-Rho)

d F t = α t F t β d W t F d α t = v α t d W t α d W t α d W t F = ρ d t \begin{aligned} dF_t&=\alpha_tF_t^{\beta}dW_t^F\\ d\alpha_t&=v\alpha_t dW_t^{\alpha}\\ dW_t^{\alpha}dW_t^F&=\rho dt \end{aligned} dFtdαtdWtαdWtF=αtFtβdWtF=vαtdWtα=ρdt

Analysis:
β \beta β
determin normal or lognormal the process is.

ρ → \rho \rightarrow ρ skeweness

Impact on stock return distribution:

  1. negative correlated ρ < 0 \rho < 0 ρ<0: S t ↓ ⇔ σ r ↑ S_t \downarrow \Leftrightarrow \sigma_r \uparrow Stσr
  2. fat left tail: as things go bad, sigma (as there’s no drift) gets worse.

Impact on price:

  1. Out-of-money P P P: ↑ \uparrow
  2. Out-of-money C C C: ↓ \downarrow
v v v vol of vol → \rightarrow kurtosis

Impact on stock return distribution:

  1. v > 0 v > 0 v>0: More volatile than before (vol has vol)
  2. high kurtosis on stock return-- fat tails: extreme evnets occure more ofen, same impact on good and bad side

Impact on price:

  1. Near-money options: ↓ \downarrow
  2. Far-from-money options: ↑ \uparrow

Vol-smile Market Overview

Equity: Smerk
FX: Smile
Rates: Smerk with high vov
Commodity: Reverse Smerk, comsumers in market worried more about price rise. Most hold calls.

Greeks and Dynamic Hedging

normally ovserve Greeks with x-axis = stock price, as this is most volatile

Useful tools

K.
d 1 = log ⁡ S 0 K + ( r + σ 2 2 ) T σ T K e − r T = S 0 e σ 2 T 2 − σ T d 1 \begin{aligned} d_1&=\frac{\log \frac{S_0}{K}+(r+\frac{\sigma^2}{2})T}{\sigma\sqrt{T}}\\ Ke^{-rT}&=S_0e^{\frac{\sigma^2T}{2}-\sigma\sqrt{T}d_1}\\ \end{aligned} d1KerT=σT logKS0+(r+2σ2)T=S0e2σ2TσT d1
Since in doing ∂ Φ ( d 1 ) ∂ S 0 \frac{\partial \Phi(d_1)}{\partial S_0} S0Φ(d1) need to substitute K with all residual stuff to cancel terms.

Delta Δ \Delta Δ

Normal CDF alike curve
Long maturity: slowly moving up, which also means that Gamma with low kurtosis

Gamma Γ \Gamma Γ

Bell curve
Angry Gamma traders, trade highly volatile short term options

Vega (Las-vegas)

Bell curve
Elegant Vega traders, trade 1yr+ options, close to maturity deliver to Gamma traders
Long maturity: high vega, smooth.

BS’s Dynamic Hedging

explaining self financing
V t = ϕ t S t + ψ t B t d V t = ϕ t d S t + S t d ϕ t + d S t d ϕ t + ψ t d B t + B t d ψ t + d ϕ t d B t d V t = ϕ t d S t + S t d ϕ t + d S t d ϕ t + ψ t d B t + B t d ψ t \begin{aligned} V_t&=\phi_t S_t + \psi_t B_t\\ dV_t &= \phi_t dS_t + S_t d\phi _t + dS_t d\phi _t + \\ &\quad \psi_t dB_t + B_td\psi_t + d\phi_tdB_t\\ dV_t &= \phi_t dS_t + S_t d\phi _t + dS_t d\phi _t + \psi_t dB_t + B_td\psi_t \end{aligned} VtdVtdVt=ϕtSt+ψtBt=ϕtdSt+Stdϕt+dStdϕt+ψtdBt+Btdψt+dϕtdBt=ϕtdSt+Stdϕt+dStdϕt+ψtdBt+Btdψt
drop one term as d B t dB_t dBt does not have d W t dW_t dWt
self-financing:
d V t = ϕ t d S t + ψ t d B t dV_t=\phi_t dS_t+\psi_t dB_t dVt=ϕtdSt+ψtdBt

BS Dynamic Hedging
Let X t = C t − ϕ t S t − ψ t B t X_t=C_t - \phi_t S_t - \psi_t B_t Xt=CtϕtStψtBt and X 0 = 0 X_0=0 X0=0, aka, a replicating portfolio
apply Ito formula
d X t = d C t − ϕ t d S t − ψ t d B t d C t = ∂ C ∂ S d S t + ( ∂ C ∂ t + 1 2 σ 2 S t 2 ∂ 2 C ∂ S 2 ) d t d B t = r B t d t \begin{aligned} dX_t&=dC_t-\phi_t dS_t-\psi_t dB_t\\ dC_t &= \frac{\partial C}{\partial S}dS_t + (\frac{\partial C}{\partial t}+\frac{1}{2}\sigma^2 S_t^2 \frac{\partial^2 C}{\partial S^2})dt \\ dB_t&=rB_tdt \end{aligned} dXtdCtdBt=dCtϕtdStψtdBt=SCdSt+(tC+21σ2St2S22C)dt=rBtdt
let d S t dS_t dSt cancel out, we have
ϕ t = ∂ C ∂ S d X t = ( ∂ C ∂ t + 1 2 σ 2 S t 2 ∂ 2 C ∂ S 2 − ψ t r B t ) d t \begin{aligned} \phi_t &= \frac{\partial C}{\partial S}\\ dX_t&=(\frac{\partial C}{\partial t}+\frac{1}{2}\sigma^2 S_t^2 \frac{\partial^2 C}{\partial S^2}-\psi_trB_t)dt \\ \end{aligned} ϕtdXt=SC=(tC+21σ2St2S22CψtrBt)dt
Considering the portfolio is tradable, so it should be arbitrage free, thus should drift at riskless rate d X t = r X t d t = 0 dX_t = rX_tdt=0 dXt=rXtdt=0
ψ t = ∂ C ∂ t + 1 2 σ 2 S t 2 ∂ 2 C ∂ S 2 r B t X t = C t − ϕ S t − ψ t B t = X 0 = 0 C t = ∂ C ∂ S S t + ∂ C ∂ t + 1 2 σ 2 S t 2 ∂ 2 C ∂ S 2 r B t B t r C t = ∂ C ∂ S r S t + ∂ C ∂ t + 1 2 σ 2 S t 2 ∂ 2 C ∂ S 2 \begin{aligned} \psi_t&=\frac{\frac{\partial C}{\partial t}+\frac{1}{2}\sigma^2 S_t^2 \frac{\partial^2 C}{\partial S^2}}{rB_t} \\ X_t &= C_t-\phi S_t - \psi_t B_t=X_0=0\\ C_t&=\frac{\partial C}{\partial S}S_t + \frac{\frac{\partial C}{\partial t}+\frac{1}{2}\sigma^2 S_t^2 \frac{\partial^2 C}{\partial S^2}}{rB_t}B_t\\ rC_t&=\frac{\partial C}{\partial S}rS_t + \frac{\partial C}{\partial t}+\frac{1}{2}\sigma^2 S_t^2 \frac{\partial^2 C}{\partial S^2}\\ \end{aligned} ψtXtCtrCt=rBttC+21σ2St2S22C=CtϕStψtBt=X0=0=SCSt+rBttC+21σ2St2S22CBt=SCrSt+tC+21σ2St2S22C
Which is Blake-Schole PDE

Interperatation

replication portfolio consists of Stock and Bond

  1. option price not dependent on drift μ \mu μ.
  2. dynamic hedging strategy enables the seller to hedge against unfavorable market moves by cancelling the amrket trend.(option price stay same in bull or bear market)
  3. dont need to estimate trend μ \mu μ.
  4. risk of price fluctuation exists as σ \sigma σ.
  5. knowing the position to hold for bond and stocks.

Understanding BSM:

Understanding 1: Hedging/Replicating
C = ∂ C ∂ S S t + ∂ C ∂ t + 1 2 σ 2 S t 2 ∂ 2 C ∂ S 2 r \begin{aligned} C &= \frac{\partial C}{\partial S}S_t + \frac{\frac{\partial C}{\partial t}+\frac{1}{2}\sigma^2 S_t^2 \frac{\partial^2 C}{\partial S^2}}{r} \end{aligned} C=SCSt+rtC+21σ2St2S22C

Understanding 2: Digital calls
C = Asset Digital  C − K × Cash Digital  C = E ∗ [ S t I S t > K ] − K e − r t E ∗ [ I S t > K ] \begin{aligned} C &= \textnormal{Asset Digital }C - K \times \textnormal{Cash Digital }C\\ &=\mathbb{E}^*[S_t\mathbb{I}_{S_t>K}] - Ke^{-rt}\mathbb{E}^*[\mathbb{I}_{S_t>K}]\\ \end{aligned} C=Asset Digital CK×Cash Digital C=E[StISt>K]KertE[ISt>K]

Understanding 3: Prob under different measure
C = E ∗ [ S t I S t > K ] − K e − r t E ∗ [ I S t > K ] = S × P S ( S t > K ) − K e − r t × P ∗ ( S t > K ) \begin{aligned} C&=\mathbb{E}^*[S_t\mathbb{I}_{S_t>K}] - Ke^{-rt}\mathbb{E}^*[\mathbb{I}_{S_t>K}]\\ &= S\times \mathbb{P}^S(S_t>K)-Ke^{-rt}\times \mathbb{P}^*(S_t>K) \end{aligned} C=E[StISt>K]KertE[ISt>K]=S×PS(St>K)Kert×P(St>K)

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