What is Financial

Mathematics?

Introduction
Financial Mathematics is a collection of
mathematical techniques that find applications in finance, e.g.
Asset pricing: derivative securities.
Hedging and risk management
Portfolio optimization
Structured products

There are two main approaches:

Partial Differential Equations
Probability and Stochastic Processes

Short History of Financial Mathematics

1900: Bachelier uses Brownian motion as

underlying process to derive option prices.

1973: Black and Scholes publish their

PDE-based option pricing formula.

1980: Harrison and Kreps introduce the

martingale approach into mathematical
finance.

Financial Mathematics has been established as a separate academic discipline

only since the late eighties, with a number of dedicated journals.

Structure of this talk

Preliminary notions: Time value of money,

financial securities, options.

Arbitrage and riskneutral valuation

via a oneperiod, twostate toy model.

Modelling stock price behaviour

Naive stochastic calculus
PDE approach to finance
Martingale approach to finance
Numerical methods
Current Research
4

Preliminary Notions
Discounting and Financial Instruments

Finance may be defined as the study of

how people allocate scarce resources over
time.
The outcomes of financial decisions (costs
and benefits) are
spread over time
not generally known with certainty ahead
of time, i.e. subject to an element of
risk
Decision makers must therefore
be able to compare the values of cashflows at different dates
take a probabilistic view
5

Discounting
The time value of money: R1.00 in the
hand today is worth more than the expectation of receiving R1.00 at some future
date.
Thus borrowing isnt free: the borrower
pays a premium to induce the lender to
part with his/her money. This premium
is the interest.
We shall make the simplifying assumptions that
There is only one interest rate: All
investors can borrow and lend at this
(riskless) rate.
The interest rate is constant over time.
The same rate applies for all maturities.
6

 Let r denote the continuously compounded

interest rate, so that one unit of currency deposited in a (riskless) bank account grows to erT units in time T .

Thus an amount X at time T is the same

as XerT now.

Discounting allows us to compare amounts

of money at different times.

Returns

The return on an investment S is defined

by
S
R = ln T
S0

i.e.

ST = S0eRT

The random variable R is essentially the

interest obtained on the investment,
and may be negative.

Investors attempt to maximize their expected return.

Fundamental relationship in finance:

E[Return] = f (Risk)
where f is an increasing function.

Securities

Securities are contracts for future delivery of goods or money, e.g. shares, bonds
and derivatives.

One distinguishes between underlying (primary) and derivative (secondary) instruments.

Examples of underlying instruments are

shares, bonds, currencies, interest rates,
and indices.

A derivative (or contingent claim) is a

financial instruments whose value is derived from an underlying asset.

Examples of derivatives are forward contracts, futures, options, swaps and bonds.
9

 There are two main reasons for using derivatives: Hedging and Speculation.

Thus derivatives are essentially tools for

transferring risk, and will allow one to
diminish or increase ones exposure to uncertain events.

An option gives the holder the right, but

not the obligation to buy or sell an asset.

A European call option gives the holder

the right to buy an asset S (the underlying) for an agreed amount K (the strike
price) on a specified future date T (maturity).

10

 Thus the payoff at expiry is

max{S(T ) K, 0}

Since the payoff can never be negative,

but is sometimes positive, options arent
free. The premium paid for the option
is related to the risk (probability) that
the share price is greater than the strike
at expiry.

11

Risk-Neutral Valuation
Consider a toy model with just two trading dates t = 0 and t = T , and just two
financial assets
A riskfree bank account A paying
a constant simple rate r = 10% over
the interval [0, T ].
A risky stock S. Todays stock price
is S0 = 10.

At time T , there are only two possible

states of the world, UP and DOWN.

12

 We model this using the tuple

(, P, F , T, F, (At, St)tT)

Here = {Up, Down}, and P is a probability measure on .

13

 Consider a European call option on S

with strike price K = 11 and maturity
T . At maturity the call option has the
following possible values:

How would we find the fair price C0

for this contract at t = 0?

14

 Two possibilities come to mind:

METHOD I. Calculate the expected
value of the future payoff, and discount this to the present.
Thus
1
[P(UP) 11 + P(Down) 0]
1.1
= 10 P(UP)

C0 =

PROBLEM: How do we determine

the measure P?
If we consider both states equally
likely, the value of the call option
will be C(0) = 5
METHOD II. The price of the option
will be determined by the market, in
particular by supply and demand.

15

16

 The correct price can be determined by

an arbitrage argument, as follows:
Consider a portfolio = (0, 1) containing an amount 0 in the bank and a quantity 1 shares. The initial value of the
portfolio is V0() = 0 + 101.

We want to ensure that the portfolio has

the same value as the call option in all
states of the world at expiry.
UP
DOWN

VT () = 1.10 + 221 = 11
VT () = 1.10 + 5.51 = 0

i.e.
10 2
= ,
3 3


2 shares,
and
buy
Thus if you borrow 10
3
3
the resulting portfolio has the same cashflows at maturity as the call option.
17

 To exclude arbitrage, the initial value

of the option must be the same as the
initial value of the portfolio, i.e.
10
2
10
C(0) =
+ 10 =
3
3
3
Arbitrage is the possibility of making a
profit without the possibility of making a
loss.

In the preceding example, if the option

costs less than the portfolio, then
Short the portfolio;
Use the proceeds to buy the option;
And put the remainder in the bank.

18

 Note that the option price using discounted

expected values was 5, which is higher
than 10/3. How can this be?

If we insist on using the probability measure P, then the share itself is priced incorrectly.
Its value ought to have been
1 1
1
S0 =
(22) + (5.5) = 12.5
1.1 2
2


but the real price is S0 = 10.

19

 This reflects the fact that investors are

risk averse. In order to take on the risk
of the share, investors require a risk premium Rp:
1
10 = S0 =
EP[ST ]
1 + r + Rp
1
1
1
=
[ 22 + 5.5]
1.1 + Rp 2
2
Suppose that we now change the probability measure to a new measure Q under which investors are riskneutral, i.e.
under which they do not require a risk
premium.

In this world, the current value of the

share is its discounted expected value.
1
10 =
[Q(UP) 22 + (1 Q(UP)) 5.5]
1.1
1,
which implies that Q(UP) = 3
and Q(DOWN) = 2
3.
20

 If we price the option using the discounted

expected value under the riskneutral measure Q, we get
1 1
2
10
C(0) =
( 11 + 0) =
1.1 3
3
3
and this is CORRECT!!!

Principle of RiskNeutral Valuation:

The t = 0value of an option is its
discounted expected value.
However, the expectation is taken under a riskneutral probability measure, which we can calculate.
And not under the realworld probability measure, which we can never
know.

21

Modelling Stock Prices

Any model of stock price behaviour must
be stochastic, i.e. incorporate the random nature of price behaviour. The simplest such models are random walks.

Partition the interval [0, T ] into subintervals of length t

0 = t0 t1 tN = T

N =

T
t

Let Xtn , n = 1, 2, . . . N be a family of random variables, and let S0 be the stock

price at t = 0. We might (naively) attempt to model the stock price process
by

Stn+1 = Stn + Xtn+1

22

 Thus
St = S0 +

t
X

Xu

u=1

The intuition behind this is that the price

at time t + t equals the price at time t
plus a random shock, modelled by Xt.

We also assume that these shocks are

independent.

Efficient Markets Hypothesis: Stock

price processes are Markov processes.

23

 Fact: If Xn are independent random variables, then

X

var(

Xn) =

var(Xn)

Thus if the Xn are independent, identically distributed, then the variance of

the sum is proportional to the number of
terms.

So the variance of the stock price in our

naive random walk model is proportional
to the elapsed time.

24

 We attempt to build a continuoustime

model of stock price behaviour over an
interval [0, T ]. As a first approximation,
we use Bernoulli shocks every unit time,
i.e. we let
(

Xt =

+S

with probability 0.5

with probability 0.5

Note that
Var(Xt) = S 2
Var(ST ) =

N
X

Var(Xtn )

n=1

= N S 2
S 2
=
T
t

25

 How large should the jumps in stock price

be? To ensure that Var(ST ) goes to neither 0 nor as t 0, we must have

S = o( t)

Note that for differentiable functions f (t),

we have f f 0(t)t, i.e.
f = o(t)

This shows that St cannot be differentiable!

26

 To build a continuous version of our model,

we use the Central Limit Theorem: If
Xn is a largish family of iid random variP
ables, then n Xn is approximately normally distributed.

Thus: After a largish number of shocks,

the stock price in our naive random walk
model will be approximately normally distributed.

We seek a continuous-time version of the

random walk a stochastic process that
is changing because of random shocks at
every instant in time.

27

Brownian motion

Brownian motion is a continuoustime

stochastic process Bt, t 0 with the following properties:
(1) Each change
Bt Bs = (Bs+h Bs ) + (Bs+2h Bs+h )
+ + (Bt Bth )

is normally distributed with mean 0

and variance t s.
(2) Each change Bt Bs is independent
of all the previous values Bu, u s.
(3) Each sample path Bt, t 0 is (a.s.)
continuous, and has B0 = 0.
Brownian motion is a martingale:

EsBt = Bs

st

where Es denotes the expectation at time

s.
28

GBM

For stock prices, the Brownian motion

model is inadequate. We expect the change
in price to be proportional to the current
price.

A better model for share prices is given

by the stochastic differential equation
dSt = St dt + St dBt
Here is the drift, i.e. the rate at which
the share price increases in the absence
of risk. The differential dBt models the
randomness (risk), and the parameter ,
known as the volatility, models how sensitive the share price is to these random
events.

This share price process is called a geometric Brownian motion.

29

Value process

Consider a market with a share St whose

price process is a GBM
dSt = St dt + St dBt

Let the riskfree interest rate be r, i.e.

the riskfree bank account At satisfies
the DE
dAt = rAt dt

At is the riskless asset. It has drift r

and zero volatility.
Given a dynamic portfolio t = (t0, t1),
the value process Vt() is defined by
Vt() = t0 At + t1 St

It satisfies the SDE

dVt = t0 dAt + t1 dSt
= (rt0 At + t1 St) dt + 1 St dBt
30

 The value of the portfolio at time T is

therefore
Z

VT () = V0 () +

Z0T
+

[rt0 At + t1 St] dt
1 St dBt

We now see that we need to be able to

evaluate integrals of the form
Z

f (t, ) dBt()
0

The obvious method would be to regard

the above as a RiemannStieltjes (or
LebesgueStieltjes) integral.

31

Stochastic Calculus
Naive Approach

Let f (x) be a differentiable function on

an interval [a, b]. Partition this interval:

a = x0 < x1 < x2 < xn = b

where xi+1 xi = x
Then by Taylor series expansion, we get
f (xi+1 ) f (xi) = f 0 (xi)x +
+

1 00
f (xi)(x)2
2!

1 000
f (xi)(x)3 + terms involving x4 , x5 , . . .
3!

Thus
f (b) f (a) =

n1
X
i=0
n1
X

[f (xi+1 ) f (xi)]
n1

1 X 00
0
=
f (xi)x +
f (xi)(x)2 + . . .
2 i=0
i=0
32

 As x 0, we get
f (b) f (a) = lim

x0

f 0 (xi)x

X
1
+
lim
f 00 (xi)(x)2 + . . .
2 x0 i
 Z b

Z b
1
=
f 00 (x) (dx)2 + . . .
f 0 (x) dx +
2 a
a

In ordinary calculus, only the first term

counts (by the Fundamental Theorem of
Calculus), and the other terms are zero.
This is because the quadratic variation
of any ordinary function is zero, i.e.
lim

(g)2 = 0

x0

for any ordinary function g.

33

 But Brownian motion is different: Consider B = Bt+t Bt. This is a normally distributed random variable with E[B] =
0 and variance var(B) = t.
Consider next the random variable (B)2.
This has
E[(B)2] = var[B] = t
var[(B)2 ] = E[(B)4 ] (t)2 = 2(t)2 << t

Thus the variance of (B)2 is 0, i.e.

though B is a random variable, (B)2
is a constant (!! I promise that this can be
made precise.)
It follows that
lim
t0

E(B) = lim

t0

t = T

where T is the total elapsed time. Thus

the quadratic variation of Brownian motion is nonzero.
34

 Also
lim
t0

E(B) = 2 lim

(t)2 = 0

t0

because g(t) = t is an ordinary function, with quadratic variation zero.

Hence we cannot ignore the secondorder
term
1
2

f 00 (x) (dx)2

in the case that x = B.

But we can ignore all higherorder terms.

We thus have the following rules for stochastic calculus:

(dBt)2 = dt
dBt dt = (dt)2 = 0

35

 Suppose that f (t, x) is a C 1,2function,

and let Xt = f (t, Bt). Applying these
rules to a second order Taylor series, we
obtain:
Theorem: (Itos Formula)

dXt =

1 2f

f
+
t
2 B 2

dt +

f
dBt
B

Ordinary calculus shows that for a function f (t, x) we have

df =

f
f
dt +
dx
t
x

In stochastic calculus, we get another term,

due to the nonzero quadratic variation
of Brownian motion.

36

 Since Brownian motion has non-zero quadratic

variation, Brownian sample paths are (a.s.)
of unbounded variation.

This means that in general the Ito stochasR

tic integral 0T f dBt cannot be interpreted
as a RiemannStieltjes integral.

Nevertheless, the stochastic integral can

be defined with semimartingale integrators (using an approximation in a L2
space, rather than an (almost) pointwise
limit).
Fact: The Ito integral
Z
Mt =

f (u, Bu ) dBu
0

is a (local) martingale, i.e.

Z

f dBu =

Es
0

f dBu
0

37

Stock price process parameters

Lets have another look at volatility. The

GBM model for stock prices is
dSt = St dt + St dBt
Thus

dS 2
E
= 2 dt
S


and thus 2 dt is the variance of the return of the stock over a small period dt.

It follows that is the standard deviation of the annual return of the stock
S.

This can be measured from market data.

38

 Can we also measure the drift ?

No.

So the correct, real-world dynamics of a

share price are unknowable: We can get
the volatility, but not the drift.

Amazingly, we dont care!!

39

Black-Scholes Model
PDE Approach

Consider again market with a share St

whose price process satisfies the SDE
dSt = St dt + St dBt

Let the riskfree interest rate be r, and

let At be the riskless bank account, with
dynamics
dAt = rAt dt

Let V (t, St) be Europeanstyle derivative

whose value depends on both the share
price and time. Consider a portfolio
which contains 1 derivative, and n shares,
i.e. its value is
t = Vt + nSt
40

 A small amount of time dt later, the share

price has changed. The value of the portfolio changes by
dt = dVt + n dSt
By Itos Formula,
V
V
1 2V
2
dVt =
dt +
dS +
dS
S
2 S 2
t

V
V
V
1 2 2 V
=
dt
+
S
+ S
+ S
dBt
t
S
2
S 2
S

Hence


V
V
1
V
dt =
+ S
+ 2 S 2 2 + nS
t
S
2
S


V
+ n dBt
+ S
S


dt

41

 Now if we take n = V
S (i.e. the portfolio is short V
S shares), then the portfolio is unaffected by a random change
in the stock price:

dt =

V
1
V
+ 2S 2 2
t
2
S


dt

(1)

Thus, for a brief instant, the portfolio

is riskfree. By a noarbitrage argument, it must earn the same return as
the riskfree bank account, i.e.


V
dt = rt dt = r V
S
S


dt

(2)

42

 Equating (1) and (2), we get

V
1 2 2 2V
V
+ S
+ rS
rV = 0
2
t
2
S
S

This is the famous BlackScholes PDE.

It is a secondorder parabolic PDE, i.e.
essentially a heat equation.

It is now clear why we dont care about

the drift of the underlying asset S: It
does not appear in the BS PDE!!

43

BlackScholes Model
RiskNeutral Approach
Since we dont care about the drift rate
of an underlying asset, we may as well
simplify our asset price dynamics by assuming that all assets have the same
drift.

The riskless asset (bank account) has drift

r, which we can actually see. We thus
assume that all assets have the same return, namely the riskfree rate r.
Mathematically, this corresponds to a change
of measure from a real world, unknowable probability measure P to a knowable, riskneutral measure Q. In the
riskneutral world, the dynamics of S are
dSt = rSt dt + S dBt

Thus we change the drift of the asset

from to r.
44

 Mathematically, this is accomplished using the CameronGirsanov Theorem:

Let
dYt = (t, ) dt + (t, ) dBt
be an Ito process in a filtered probability
space (, Ft, P) Suppose that there exists
processes u(t, ) and (t, ) such that
u=
Define a process M by
1 t
||u||2 ds)
Mt = exp( u dBs
2 0
0
and define a measure Q by
Z t

dQ
= MT
dP
Then under Q, Y dynamics are
t
dYt = (t, ) dt + (t, ) dB
t is a QBrownian motion.
where B
Amazingly, a change of measure changes
only the drift and not the volatility.
45

 We can calculate option prices in the risk

neutral world, because the asset price
dynamics/distributions are known.

But: Prices in the real and riskneutral

world are the same! It is just probabilities
that are changed.

Fundamental Theorem of Asset Pricing: There are no arbitrage opportunities

if and only if there exists a riskneutral

measure.

46

PDE = RiskNeutral
Consider a European call option C on a
share S with strike K and maturity T .
The volatility of the underlying share S is
and the riskfree rate is r.
We must solve the following BVP:

V
V
1 2 2 2V
+
rS
+ S
rV = 0
t
2
S 2
S

V (T ) = (ST ) = max{ST K, 0}

Theorem: In the riskneutral world, the

Vt
discounted value process A
= ertVt is
t
a martingale:
rT

Z
VT = V0 +

ertSt dBt

47

 It follows that the expected value of

ertVt at any time is its current value,
and thus the value of the call option with
strike K and maturity T is given by
V0 = E0 [erT VT ] = erT E0 [max{ST K, 0}]

In the same way, the value of any European

style contingent claim V with maturity T
and payoff (boundary condition) V (T, ST ) =
(ST ) is simply
V0 = erT E[(ST )]

This is a version of the FeynmanKac

Theorem, which gives the solution to a
large class of parabolic PDEs as an expectation of a diffusion (here with loss of
mass, represented by discounting).

48

Computational Toolbox
Numerical integration

Optimization techniques

Finite difference methods

Lattice/tree methods

Monte Carlo and quasiMonte Carlo methods

Statistical techniques: Principal component analysis, factor analysis, maximum

entropy

49

 Time series analysis

Numerical solution of SDEs

Dynamic programming

Stochastic control theory

50

Current Research
Altenatives to BlackScholes
Stochastic volatility models.
Jump diffusions.
Levy processes.

Interestrate modelling.

Pricing in incomplete markets.

Pricing/measuring/hedging credit risk.

51

 Capital adequacy based risk measures

Real options

Differential game theory

Entropybased option pricing

Viability theory

Non-standard finance

52