Probabilistic models in finance

Grégoire Szymanski

September 16, 2024

Probabilistic models in finance 2
Contents

1 Introduction 5
1.1 Financial vocabulary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
1.2 Interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
1.3 Pricing and hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.3.1 Absence of arbitrage and replicating strategies . . . . . . . . . . . 7
1.3.2 Toy example: a single period binary model . . . . . . . . . . . . . 8
1.4 Exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

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Probabilistic models in finance 4
Chapter 1

Introduction

1.1 Financial vocabulary

Definition 1.1.1 (Asset) An asset in a financial market is a tradable entity that has
monetary value.

Definition 1.1.2 (Asset Class) An asset class is a group of financial instruments that
share similar characteristics, behave similarly in the marketplace, and are subject to the
same laws and regulations.

Common asset classes include equities (stocks), fixed income (bonds), real estate,
commodities, and cash equivalents. Each asset class responds di↵erently to market con-
ditions, di↵erent market conventions, etc. However, they can be studied within a unified
financial framework.

Definition 1.1.3 (Derivative) A derivative is a financial contract that derives its value
from the performance of an underlying asset. The price or value of a derivative is the
price which has to be paid (at time 0) to acquire this derivative.

The two most important types of derivatives are the forward contract and option
contracts. Other examples include futures, swaps, exotic options, CDO, CDS.

Definition 1.1.4 (Forward) A forward is financial contract between two parties to buy
or sell an asset at a specified future time at a price agreed on in the contract.

Definition 1.1.5 (Forward price) The forward price of an asset is the price that would
make the initial value of a forward contract null.

Definition 1.1.6 (Option) An option is a financial contract that gives the holder the
right, but not the obligation, to purchase or sell the underlying asset at a specified strike
price up to, or at a prescribed time in the future. This prescribed time is called the
maturity date or expiration date.

According to the date of expiry, two kinds of options can be distinguished:

• American options which can be exercised by its holder at any time before expiry,

• European options which can only be exercised by its holder at the expiration time.

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Probabilistic models in finance 6

Similarly, two kinds of options can be distinguished according to the right to buy or sell:
• Call options which give the holder the right to buy the underlying asset,
• Put options which give the holder the right to sell the underlying asset.

Notation 1.1.7 Typically, the following notations are used:

• St : the price of an asset at time t,
• K: the strike price,
• T : the maturity time,
• F : the forward price.

Using these notations, the cashflow induced by an European call option is pST ´ Kq`
and the cashflow induced by an European put option is pK ´ ST q` .

1.2 Interest rates

Definition 1.2.1 (Interest rate) An interest rate is the percentage charged on the total
amount of a loan or the percentage earned on an investment over a specified period of
time. It represents the cost of borrowing money or the reward for saving or investing
money. The interest rate of the market is usually denoted r

Two types of interest rates can be considered, depending on how interest is accumu-
lated over time:
• Discrete interest rate: This means that interest is applied at regular intervals (for
example, yearly, monthly, or daily). For each unit of time, we need to pay an interest
rate of r. After T units of time, the total amount to reimburse is p1 ` rqT . This
formula assumes that the interest is compounded at discrete intervals, which means
that the interest earned in one period also earns interest in subsequent periods.
• Continuous interest rate: In this case, interest is compounded continuously, mean-
ing that interest is applied and accrued at every instant of time. Money depreciates
continuously over time due to this constant compounding. The amount to reim-
burse after T units of time, when the interest rate is r, is given by the formula
erT . This exponential growth reflects the fact that the interest is being added in an
infinitely small, but continuous, manner.
Because of these interest rates, 1 euro today is not worth 1 euro in the future; people
generally prefer money today rather than in the future. To account for this, future
cashflows must be discounted to calculate their present value.

Definition 1.2.2 (Discount factor) The discount factor is a value that is used to con-
vert future cashflows into their equivalent present value. It depends on the interest rate
and the time period over which the discounting takes place. For a discrete interest rate r
over T time periods, the discount factor is given by:
1
DFpT q “ .
p1 ` rqT
Probabilistic models in finance 7

For a continuous interest rate r, the discount factor is given by:

DFpT q “ e´rT .
This factor represents how much 1 euro received at time T in the future is worth today.
Definition 1.2.3 (Present value) The present value (PV) is the current value of a
future cashflow, discounted using the appropriate discount factor. If CT is the cashflow
expected at time T , the present value is calculated as:
PV “ CT ˆ DF pT q.
For example, if the interest rate is discrete, the present value of a future cashflow is:
CT
PV “ .
p1 ` rqT
In the case of continuous interest, the present value is:
PV “ CT ˆ e´rT .
This concept allows us to compare the value of money received at di↵erent points in time
by bringing all values to a common point: the present.

1.3 Pricing and hedging

1.3.1 Absence of arbitrage and replicating strategies
One of the most fundamental questions in finance is how to compute the price of deriva-
tives. This problem was first addressed by Louis Bachelier in his 1900 PhD thesis titled
Théorie de la spéculation. Despite significant progress over the past century, this issue
remains only partially solved, and many open questions persist in modern finance.
Derivatives, typically sold by banks, are financial instruments that investors purchase
to hedge against various risks. For example, investors might buy a call option to protect
themselves from a potential decline in the price of an underlying asset. This ability to
manage risk makes derivatives a critical tool in financial markets.
On the other side, banks face the critical challenge of determining the correct price
for these derivatives. More importantly, they must ensure that they do not incur losses
in adverse market conditions. This gives rise to two fundamental problems in financial
theory:
• Pricing problem: How to accurately evaluate the value of a derivative at the initial
time, t “ 0.
• Hedging problem: How can the seller of an option construct a risk-free strategy that
guarantees the ability to meet the contractual obligations at the expiration time,
T.
These two questions lie at the core of derivative pricing theory. The solutions are
built upon a fundamental set of assumptions known as the no-arbitrage assumptions.
Essentially, these assumptions imply that it is impossible to ”make money out of nothing.”
Under this framework, the correct price of a derivative is the one that allows for an exact
replication using only traded assets. By replication, we mean constructing a strategy
that guarantees the same cashflow as the derivative at the expiration time.
Probabilistic models in finance 8

1.3.2 Toy example: a single period binary model

Consider an asset S, currently priced at S0 euros. Suppose the (continuous) interest rate
is r. We aim to price a European call option with a strike price K and an expiration
time T . Additionally, assume that at time T , the price of the asset S can only take two
possible values: #
L with probability p,
ST “ (1.1)
U with probability 1 ´ p,
where L † K † U for simplicity. The objective is to determine the fair price C for this
call option.

Approach. The idea consists in building a portfolio, containing a certain amount X

of cash and a certain amount Y of the asset S so that this portfolio is worth exactly
pST ´ Kq` at time T .
The idea is to construct a replicating portfolio consisting of a certain amount X of
cash and Y shares of the asset S, such that the portfolio’s value at time T matches the
payo↵ of the call option, i.e., pST ´ Kq` .

• At Time 0: We receive the payment C for selling the call option and use it to buy
Y shares of the asset. Thus, the initial cashflow is X “ C ´ Y S0 .
– If X • 0, we invest the cash at the risk-free interest rate r.
– If X † 0, we borrow the required amount at the same risk-free rate r.
• At Time T : Each of the Y shares is now worth ST , and the cash position has grown
(or the debt has increased) to XerT . Therefore, the total value of the portfolio at
time T is:
Y ST ` XerT “ Y ST ` pC ´ Y S0 qerT .

Condition for Replication. We need to choose Y and C so that this strategy perfectly
replicates the payo↵ of the call option at time T , i.e.,

Y ST ` pC ´ Y S0 qerT “ pST ´ Kq` .

Since ST can only take two values, L or U , we set up the following system of equations:
#
Y U ` pC ´ Y S0 qerT “ U ´ K,
Y L ` pC ´ Y S0 qerT “ 0.

Solving this system gives the values of Y and C:

U ´K
Y “
U ´L
and
pU ´ KqpS0 ´ e´rT Lq
C“ . (1.2)
U ´L

Remark 1 Since X “ C ´ Y S0 “ ´ pU ´Kq ´rT

pU ´Lq
e L † 0, the replicating strategy requires
borrowing money at time 0.
Probabilistic models in finance 9

Solution of the Pricing and Hedging Problems. In this toy example, we have an
explicit solution for the pricing and hedging problems:
pU ´KqpS0 ´erT Lq
• Pricing: The price of the call should be C “ U ´L
.
pU ´Kq
• Hedging: Buying at time 0 an amount pU ´Lq
of the asset S and borrowing
pU ´Kq ´rT
pU ´Lq
e L.

1.4 Exercises
Exercise 1 (Forward Price) Consider an asset with a current price S0 at time t “ 0.
Derive the forward price F of the asset with maturity T by applying the no-arbitrage
principle. Show that the forward price is given by:
S0
F “
DF pT q

where DF pT q is the discount factor for maturity T .

Exercise 2 (Call-Put Parity) Consider a European Call option and a European Put
option, both with the same strike price K and maturity T . Using the no-arbitrage as-
sumption, derive the relationship known as the Call-Put Parity. Prove that:

C0 ` DF pT qK “ P0 ` S0

where C0 and P0 are the prices of the Call and Put options at time t “ 0, respectively,
and S0 is the current price of the underlying asset.

Exercise 3 In the toy model of Section 1.3.2, what happens when K § L and K ° L.

Exercise 4 In the toy model of Section 1.3.2, how can you build an arbitrage if C ‰
pU ´KqpS0 ´erT Lq
U ´L
.

Exercise 5 1. In the toy model of Section 1.3.2, compute Ere´rT pST ´ Kq` s.

2. Find p such that Ere´rT pST ´ Kq` s “ C, where C is given by (1.2).