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Introduction to Risk-Neutral Pricing


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Slides of fin math lectures given at IIT-Delhi, IIT-Bombay and at Morgan Stanley

Published in: Economy & Finance, Business
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Introduction to Risk-Neutral Pricing

  1. 1. Introduction to Risk-Neutral Valuation - Ashwin RaoAug 25, 2010
  2. 2. WHAT ARE DERIVATIVE SECURITIES ? • Fundamental Securities – eg: stocks and bonds • Derivative Securities - Contract between two parties • The contract specifies a contingent future financial claim • Contingent on the value of a fundamental security • The fundamental security is refered to as the underlying asset • A simple example – A binary option • How much would you pay to own this binary option ? • Key question: What is the expected payoff ? • What information is reqd to figure out the expected payoff ?
  3. 3. BINARY OPTION PAYOFF AND UNDERLYING DISTRIBUTION 1.2 0.025 1 0.02 Binary Option 0.8 Payoff 0.015 Underlying DistributionPayoff Distribution 0.6 0.01 0.4 0.005 0.2 0 0 30 40 50 60 70 80 90 100 110 120 130 140 150 Underlying
  4. 4. A CASINO GAME• The game operator tosses a fair coin• You win Rs. 100 if it’s a HEAD and 0 is it’s a TAIL• How much should you pay to play this game ?• Would you rather play a game where you get Rs. 50 for both H & T ?• What if you get Rs. 1 Crore for H and Rs. 0 for T ?• Depends on your risk attitude• Risk-averse or Risk-neutral or Risk-seeking• What is the risk premium for a risk-averse individual ?
  5. 5. LAW OF DIMINISHING MARGINAL UTILITY 50 40 30Satisfaction Marginal Satisfaction 20 Total Satisfaction 10 0 1 2 3 4 5 6 7 8 9 10 Number of chocolate bars eaten -10
  6. 6. LAW OF DIMINISHING MARGINAL UTILITY• Note that the total utility function f(x) is concave• Let x (qty of consumption) be uncertain (some probability distribution)• Then, E[ f(x) ] < f( E[x] ) (Jensen’s inequality)• Expected Utility is less than Utility at Expected Consumption• Consumption y that gives you the expected utility: f(y) = E[ f(x) ]• So, when faced with uncertain consumption x, we will pay y < E[x]
  7. 7. LAW OF DMU RISK-AVERSION• E[x] is called the expected value• y is called the “certainty equivalent”• y – E[x] is called the “risk premium”• y – E[x] depends on the utility concavity and distributionvariance• More concavity means more risk premium and more risk-aversion• So to play a game with an uncertain payoff, people would Generally pay less than the expected payoff
  8. 8. A SIMPLE DERIVATIVE – FORWARD CONTRACT • Contract between two parties X and Y • X promises to deliver an asset to Y at a future point in time t • Y promises to pay X an amount of Rs. F at the same time t • Contract made at time 0 and value of F also established at time 0 • F is called the forward price of the asset • What is the fair value of F ? • Expectation-based pricing to arrive at the value of F is wrong
  9. 9. PAYOFF OF A FORWARD CONTRACT (AT TIME T) 50 Payoff of forward at time t 40 30 20 10 0 0 10 20 30 40 50 60 70 80 90 100 -10 -20 Forward price = 50 -30 -40 -50 Asset price at time t
  10. 10. TIME VALUE OF MONEY• The concept of risk-free interest rate is very important• Deposit Rs. 1 and get back Rs. 1+r at time t (rate r for timet)• So, Rs. X today is worth Rs. X*(1+r) in time t• If I’ll have Rs. Y at time t, it is worth Rs. Y/(1+r) today• So you have to discount future wealth when valuing themtoday• With continuously compound interest, er instead of (1+r)
  11. 11. ARBITRAGE• The concept of arbitrage is also very important• Zero wealth today (at time 0)• Positive wealth in at least one future state of the world (attime t)• Negative wealth in no future state of the world (at time t)• So, starting with 0 wealth, you can guarantee positivewealth• Arbitrage = Riskless profit at zero cost• Fundamental concept: Arbitrage cannot exist in financial
  12. 12. USE THESE CONCEPTS TO VALUE A FORWARD • Contract: At time t, you have to deliver asset A and receive Rs. F • Assume today’s (t = 0) price of asset A = Rs. S • Step 1: At time 0, borrow Rs. S for time t • Step 2: At time 0, buy one unit of asset A • Step 3: At time t, deliver asset A as per contract • Step 4: At time t, receive Rs. F as per contract • Step 5: Use the Rs. F to return Rs. Sert of borrowed money • If F > Sert , you have made riskless money out of nowhere • Make similar arbitrage argument for your counterparty • Arbitrage forces F to be equal to Sert
  13. 13. REPLICATING PORTFOLIO FOR A FORWARD • A Forward can be replicated by fundamental securities • Fundamental Securities are the Asset and Bonds • “Long Forward”: At time t, Receive Asset & Pay Forward Price F • “Long Asset”: Owner of 1 unit of asset • “Long Bond”: Lend money for time t (receiving back Rs.1 at t) • “Short positions” are the other side (opposite) of “Long positions” • “Long Forward” equivalent to [“Long 1 Asset”, “Short F Bonds”] • Because they both have exactly the same payoff at time t • This is called the Replicating Portfolio for a forward
  14. 14. DERIVATIVES: CALL AND PUT OPTIONS• X writes and sells a call option contract to Y at time 0• At time t, Y can buy the underlying asset at a “strike price” of K• Y does not have the obligation to buy at time t (only an “option”)• So if time t price of asset < K, Y can “just ignore the option”• But if time t price > K, Y makes a profit at time t• At time 0, Y pays X Rs. C (the price of the call option)• With put option, Y can sell the asset at a strike price of K• What is the fair value of C (call) and of P (put) ?
  15. 15. PAYOFF OF CALL AND PUT OPTIONS (AT TIME T) 50 45 40 Payoff at time t 35 30 25 Call Payoff 20 Put payoff 15 10 5 0 Strike price K = 50 0 10 20 30 40 50 60 70 80 90 100 Asset price at time t
  16. 16. PRICING OF OPTIONS• Again, it is tempting to do expectation-based pricing• This requires you to know the time t distribution of assetprice• We know expectation-based pricing is not the right price• Note that Call Payoff – Put Payoff = Fwd Payoff when K = F•This is useful but doesn’t help us in figuring out prices C andP• Like forwards, use replication and arbitrage arguments• However, replication is a bit more complicated here• Consider two states of the world at time t
  18. 18. SOLVING, WE GET THE PRICE FORMULA Note that the price formula is independent of p and
  20. 20. WHAT EXACTLY HAVE WE DONE HERE ?• We have altered the time t asset price’s mean to F = Sert• Arbitrage-pricing is equiv to expected payoff with altered mean• Altered mean corresponds to asset price growth at rate r• But bond price also grows at rate r• All derivatives are replicated with underlying asset and a bond• So, all derivatives (in this altered world) grow at rate r• In reality, risky assets must grow at rate > r (Risk-Aversion)• Only in an imaginary “risk-neutral” world, everything will grow atrate r• But magically, arbitrage-pricing is equivalent to: Expectation-based pricing but with “risk-neutrality”assumption
  21. 21. RELAXING SIMPLIFYING ASSUMPTIONS• Model a stochastic process for underlying asset price• For example, Black Scholes: dS = μS dt + σ S dW• Use Girsanov’s Theorem to alter process to “risk-neutralmeasure” Q• Risk-neutral Black Scholes process: dS = r S dt + σ S dWQ•Bond process is: dB = r B dt• Two-state transition works only for infinitesimal time dt• So, expand into a binary (or binomial) tree to extend to time t• Use “backward induction” from time t back to time 0• At every backward induction step, do discounted expectation• But using risk-neutral probabilities (derived from repl.portfolio)
  22. 22. CONTINUOUS-TIME THEORY: MARTINGALE PRICING• One has to assume the replicating portfolio is “self-financing”• Any profits/losses are reinvested into the next step’s repl.portfolio• Underlying asset and its derivatives have a drift rate of r (in Q)• So, discounted (by e-rt ) derivatives processes have no drift(no dt term)• Driftless processes are martingales• So, in the risk-neutral measure, the martingale property isused to