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    MFDC 10 D

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    Tu Shirota
    The key points are: 1) Under no arbitrage, for any non-dividend paying asset B, there exists a probability measure QB such that the ratio of any other asset price to the numeraire asset B is a martingale. 2) This allows expressing the price of an asset S as the expected future value of S/B, discounted by the numeraire asset B. 3) Choosing the risk-free bond as the numeraire gives the traditional risk-neutral pricing formula. Changing the numeraire is useful for pricing interest rate derivatives and stock options

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    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd

    MFDC 10 D

    Uploaded by

    Tu Shirota
    21 views5 pages
    The key points are: 1) Under no arbitrage, for any non-dividend paying asset B, there exists a probability measure QB such that the ratio of any other asset price to the numeraire asset B is a martingale. 2) This allows expressing the price of an asset S as the expected future value of S/B, discounted by the numeraire asset B. 3) Choosing the risk-free bond as the numeraire gives the traditional risk-neutral pricing formula. Changing the numeraire is useful for pricing interest rate derivatives and stock options

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    mfdc10d

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    The key points are: 1) Under no arbitrage, for any non-dividend paying asset B, there exists a probability measure QB such that the ratio of any other asset price to the numeraire asset B is a martingale. 2) This allows expressing the price of an asset S as the expected future value of S/B, discounted by the numeraire asset B. 3) Choosing the risk-free bond as the numeraire gives the traditional risk-neutral pricing formula. Changing the numeraire is useful for pricing interest rate derivatives and stock options

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    21 views5 pages

    MFDC 10 D

    Uploaded by

    Tu Shirota
    The key points are: 1) Under no arbitrage, for any non-dividend paying asset B, there exists a probability measure QB such that the ratio of any other asset price to the numeraire asset B is a martingale. 2) This allows expressing the price of an asset S as the expected future value of S/B, discounted by the numeraire asset B. 3) Choosing the risk-free bond as the numeraire gives the traditional risk-neutral pricing formula. Changing the numeraire is useful for pricing interest rate derivatives and stock options

    Copyright:

    Attribution Non-Commercial (BY-NC)
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    Download as pdf or txt
    of 5

    10.

    Changing the Numraire


    So far we have assumed that the (risk-free)
    interest rate is constant or at least a known
    function of time, of the for,
    r(t) =
    _
    t
    0
    r(s)ds. (1)
    However, in many instances like pricing inter-
    est rate options or, more generally, for longer
    dated contracts, the interest rate must be
    modeled as a stochastic process.
    1
    The no-arbitrage in fact implies:
    If there are no arbitrage opportunities, then for each
    (non-dividend-paying) asset, there exists a probabil-
    ity measure such that the ratio of any other (non-
    dividend-paying) asset price to the numraire asset is
    a martingale.
    2
    Example 10.1. Consider the simple one period model
    with two end states. Suppose that the corresponding
    risk-neutral probabilities are q
    u
    and q
    d
    . Then if C is an
    option with the underlying security S, r is the risk-free
    interest rate, and T is time to maturity, we have
    C = e
    rT
    (q
    u
    C
    u
    +q
    d
    C
    d
    )
    S = e
    rT
    (q
    u
    S
    u
    +q
    d
    S
    d
    )
    1 = q
    u
    +q
    d
    .
    (2)
    Let B denote the risk-free bond, such that that the
    current price is B = 1, B
    u
    = e
    rT
    , and B
    d
    = e
    rT
    (risk-
    free). Then we can write (2) as
    C
    B
    = q
    u
    C
    u
    B
    u
    +q
    d
    C
    d
    B
    d
    S
    B
    = q
    u
    S
    u
    B
    u
    +q
    d
    S
    d
    B
    d
    1 = q
    u
    +q
    d
    .
    (3)
    3
    On the other hand dening
    q

    u
    = q
    u
    S
    u
    e
    rT
    /S
    and
    q

    d
    = q
    d
    S
    d
    e
    rT
    /S,
    then q

    u
    > 0, q

    d
    > 0, and
    C
    S
    = q

    u
    C
    u
    S
    u
    +q

    d
    C
    d
    S
    d
    1 = q

    u
    +q

    d
    B
    S
    = q

    u
    B
    u
    S
    u
    +q

    d
    B
    d
    S
    d
    .
    (4)
    Thus, we observe that qs are new probabilities and
    the ratios are martingales with respect to these new
    probabilities.
    This is an example of changing the numraire (denom-
    inator).
    4
    The result of Example 10.1 can be general-
    ized.
    If there is no arbitrage, then given any (non-
    dividend-paying) asset B there exist a prob-
    ability measure Q
    B
    such that S(t)/B(t) is a
    Q
    B
    -martingale.
    That is,
    S(t)
    B(t)
    = E
    B
    t
    _
    S(T)
    B(T)
    _
    , (5)
    where T t and E
    B
    t
    denotes conditional ex-
    pectation w.r.t Q
    B
    , given information up to
    time point t.
    Thus we have the pricing equation
    S(t) = B(t)E
    B
    t
    _
    S(T)
    B(T)
    _
    . (6)
    5
    Remark 10.2 If we select B(t) = e
    rt
    risk free bond, we
    get the traditional pricing equation
    S(t) = e
    rt
    E
    t
    _
    S(T)
    e
    rT
    _
    = e
    r(Tt)
    E
    t
    [S(T)], (7)
    where the expectation is with respect to the risk-
    neutral martingale measure.
    This change of numraire technique has es-
    pecially applications in pricing interest rate
    derivatives.
    It is also useful in pricing stock options as
    well.
    6
    Example 10.2: (Exchange option) Consider an Euro-
    pean option that allows to exchange an asset U for
    another asset V . The volatilities of U and V are
    U
    and
    V
    , the correlation between the assets is , and
    the expiration day is T.
    If we choose U as the numraire (denominator) in (6),we
    obtain
    V (t) = U(t)E
    U
    t
    _
    V (T)
    U(T)
    _
    . (8)
    The payo function of the option at the expiration is
    C(T) = max [V (T) U(T), 0]. (9)
    Thus,
    C(0) = U(0)E
    U
    _
    max[V (T) U(T), 0]
    U(T)
    _
    (10)
    or
    C(0) = U(0)E
    U
    _
    max
    _
    V (T)
    U(T)
    1, 0
    __
    . (11)
    7
    U and V are both GBM processes (here non-dividend-
    paying), which implies (in the risk-neutral world)
    V (t)
    U(t)
    =
    V (0)
    U(0)
    exp
    _

    1
    2
    (
    2
    V

    2
    U
    )t +
    U
    W
    V
    T

    V
    W
    U
    T
    _
    . (12)
    From this we nd that the volatility of the U/V -process
    is
    =
    _

    2
    U
    +
    2
    V
    2
    U

    V
    . (13)
    From (12) we see that the ratio is again log-normal.
    Thus, using the properties of the log-normal distribu-
    tion, we get
    C(0) = U(0)
    _
    E
    U
    _
    V (T)
    U(T)
    _
    (d
    1
    ) (d
    2
    )
    _
    , (14)
    where
    d
    1
    =
    log(V
    0
    /U
    0
    ) +
    1
    2

    2
    T

    T
    (15)
    and
    d
    2
    = d
    1

    T. (16)
    8
    Because V (T)/U(T) is Q
    U
    -martingale,
    E
    U
    [V (T)/U(T)] = V (0)/U(0)
    and (14) reduces to
    C
    0
    = V
    0
    (d
    1
    ) U
    0
    (d
    2
    ), (17)
    where C
    0
    = C(0), U
    0
    = U(0), and V
    0
    = V (0).
    9

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