FIN501 Asset PricingLecture 03 One Period Model: Pricing (1)
LECTURE 3: ONE-PERIOD MODELPRICING
Markus K. Brunnermeier
FIN501 Asset PricingLecture 03 One Period Model: Pricing (2)
Overview: Pricing
1. LOOP, No arbitrage [L2,3]
2. Forwards [McD5]
3. Options: Parity relationship [McD6]
4. No arbitrage and existence of state prices [L2,3,5]
5. Market completeness and uniqueness of state prices
6. Unique ๐โ
7. Four pricing formulas:state prices, SDF, EMM, beta pricing [L2,3,5,6]
8. Recovering state prices from options [DD10.6]
FIN501 Asset PricingLecture 03 One Period Model: Pricing (3)
Vector Notation
โข Notation: ๐ฆ, ๐ฅ โ โ๐
โ ๐ฆ โฅ ๐ฅ โ ๐ฆ๐ โฅ ๐ฅ๐ for each ๐ = 1,โฆ , ๐
โ ๐ฆ > ๐ฅ โ ๐ฆ โฅ ๐ฅ, ๐ฆ โ ๐ฅ
โ ๐ฆ โซ ๐ฅ โ ๐ฆ๐ > ๐ฅ๐ for each ๐ = 1,โฆ , ๐
โข Inner product
โ ๐ฆ โ ๐ฅ = ๐ฆ๐ฅ
โข Matrix multiplication
FIN501 Asset PricingLecture 03 One Period Model: Pricing (4)
Three Forms of No-ARBITRAGE
1. Law of one Price (LOOP) ๐โ = ๐๐ โ ๐ โ โ = ๐ โ ๐
2. No strong arbitrageThere exists no portfolio โ which is a strong arbitrage, that is ๐โ โฅ 0 and ๐ โ โ < 0
3. No arbitrage There exists no strong arbitrage nor portfolio ๐ with ๐๐ > 0 and ๐ โ ๐ โค 0
FIN501 Asset PricingLecture 03 One Period Model: Pricing (5)
Three Forms of No-ARBITRAGE
โข Law of one price is equivalent to every portfolio with zero payoff has zero price.
โข No arbitrage => no strong arbitrage No strong arbitrage => law of one price
FIN501 Asset PricingLecture 03 One Period Model: Pricing (6)
specifyPreferences &
Technology
observe/specifyexisting
Asset Prices
State Prices q(or stochastic discount
factor/Martingale measure)
derivePrice for (new) asset
โข evolution of statesโข risk preferencesโข aggregation
absolute asset pricing
relativeasset pricing
NAC/LOOP
LOOP
NAC/LOOP
Only works as long as market completeness doesnโt change
deriveAsset Prices
FIN501 Asset PricingLecture 03 One Period Model: Pricing (7)
Overview: Pricing
1. LOOP, No arbitrage
2. Forwards
3. Options: Parity relationship
4. No arbitrage and existence of state prices
5. Market completeness and uniqueness of state prices
6. Unique q*
7. Four pricing formulas:state prices, SDF, EMM, beta pricing
8. Recovering state prices from options
FIN501 Asset PricingLecture 03 One Period Model: Pricing (8)
Alternative ways to buy a stockโข Four different payment and receipt timing combinations:
โ Outright purchase: ordinary transaction
โ Fully leveraged purchase: investor borrows the full amount
โ Prepaid forward contract: pay today, receive the share later
โ Forward contract: agree on price now, pay/receive later
โข Payments, receipts, and their timing:
FIN501 Asset PricingLecture 03 One Period Model: Pricing (9)
Pricing prepaid forwards
โข If we can price the prepaid forward (๐น๐), then we can calculate the price for a forward contract:
๐น = Future value of ๐น๐
โข Pricing by analogyโ In the absence of dividends, the timing of delivery is irrelevant
โ Price of the prepaid forward contract same as current stock price
โ ๐น0,๐๐ = ๐0 (where the asset is bought at t = 0, delivered at t = T)
FIN501 Asset PricingLecture 03 One Period Model: Pricing (10)
Pricing prepaid forwards (cont.)
โข Pricing by arbitrageโ If at time ๐ก = 0, the prepaid forward price somehow exceeded the
stock price, i.e., ๐น0,๐๐ > ๐0, an arbitrageur could do the following:
FIN501 Asset PricingLecture 03 One Period Model: Pricing (11)
Pricing prepaid forwards (cont.)
โข What if there are deterministic* dividends? Is ๐น0,๐๐ = ๐0 still valid?
โ No, because the holder of the forward will not receive dividends that will be
paid to the holder of the stock โ ๐น0,๐๐ < ๐0
๐น0,๐๐ = ๐0โ PV(๐๐๐ ๐๐๐ฃ๐๐๐๐๐๐ ๐๐๐๐ ๐๐๐๐ ๐ก = 0 ๐ก๐ ๐ก = ๐)
โ For discrete dividends ๐ท๐ก๐at times ๐ก๐ , ๐ = 1,โฆ , ๐
โข The prepaid forward price: ๐น0,๐๐ = ๐0 โ ๐=1
๐ ๐๐0,๐ ๐ท๐ก๐
(reinvest the dividend at risk-free rate)
โ For continuous dividends with an annualized yield ๐ฟ
โข The prepaid forward price: ๐น0,๐๐ = ๐0๐
โ๐ฟ๐
(reinvest the dividend in this index. One has to invest only ๐0๐โ๐ฟ๐ initially)
โ Forward price is the future value of the prepaid forward: ๐น0,๐ = FV ๐น0,๐๐ = ๐น0,๐
๐ ร ๐๐๐
NB: If dividends are stochastic, we cannot apply the one period model
FIN501 Asset PricingLecture 03 One Period Model: Pricing (12)
Creating a synthetic forwardโข One can offset the risk of a forward by creating a synthetic forward to
offset a position in the actual forward contract
โข How can one do this? (assume continuous dividends at rate ๐ฟ)
โ Recall the long forward payoff at expiration ๐๐ โ ๐น0,๐โ Borrow and purchase shares as follows:
โ Note that the total payoff at expiration is same as forward payoff
โ This leads to: Forward = Stock โ zero-coupon bond
FIN501 Asset PricingLecture 03 One Period Model: Pricing (13)
Other issues in forward pricing
โข Does the forward price predict the future price?
โ According the formula ๐น0,๐ = ๐0๐๐โ๐ฟ ๐ the forward price conveys no
additional information beyond what ๐0, ๐, ๐ฟ provide
โ Moreover, if ๐ < ๐ฟ the forward price underestimates the future stock price
โข Forward pricing formula and cost of carryโ Forward price =
Spot price + Interest to carry the asset โ asset lease rate
Cost of carry ๐ โ ๐ฟ ๐
FIN501 Asset PricingLecture 03 One Period Model: Pricing (14)
Overview: Pricing
1. LOOP, No arbitrage
2. Forwards
3. Options: Parity relationship
4. No arbitrage and existence of state prices
5. Market completeness and uniqueness of state prices
6. Unique q*
7. Four pricing formulas:state prices, SDF, EMM, beta pricing
8. Recovering state prices from options
FIN501 Asset PricingLecture 03 One Period Model: Pricing (15)
Put-Call Parity
โข For European options with the same strike price and time to expiration the parity relationship is:
Call โ Put = PV Forward Px โ Strike Px
๐ถ ๐พ, ๐ โ ๐ ๐พ, ๐ = ๐๐0,๐ ๐น0,๐ โ ๐พ = ๐โ๐๐ ๐น0,๐ โ ๐พ
ice (๐น0,๐ = ๐พ) creates a synthetic forward contract and hence must
โ creates a synthetic forward contract and hence must have a zero price
โ creates a synthetic forward contract and hence must have a zero price
FIN501 Asset PricingLecture 03 One Period Model: Pricing (16)
Parity for Options on Stocks
โข If underlying asset is a stock and Div is the deterministic* dividend stream, we can plug in ๐โ๐๐๐น0,๐ = ๐0 โ ๐๐0,๐ Divthus obtaining:
๐ถ(๐พ, ๐) = ๐(๐พ, ๐) + ๐0 โ ๐๐0,๐ Div โ ๐โ๐๐๐พ
โข For index options, ๐0 โ ๐๐0,๐ Div = ๐0๐โ๐ฟ๐, therefore
๐ถ ๐พ, ๐ = ๐ ๐พ, ๐ + ๐0๐โ๐ฟ๐ โ ๐โ๐๐๐พ
* allows us to stay in one period setting
FIN501 Asset PricingLecture 03 One Period Model: Pricing (17)
Option price boundaries
โข American vs. Europeanโ Since an American option can be exercised at anytime, whereas a
European option can only be exercised at expiration, an American option must always be at least as valuable as an otherwise identical European option:
๐ถ๐ด ๐, ๐พ, ๐ โฅ ๐ถ๐ธ ๐, ๐พ, ๐๐๐ด ๐, ๐พ, ๐ โฅ ๐๐ธ ๐, ๐พ, ๐
โข Option price boundariesโ Call price cannot: be negative, exceed stock price, be less than price
implied by put-call parity using zero for put price:๐ > ๐ถ๐ด ๐, ๐พ, ๐ โฅ ๐ถ๐ธ ๐, ๐พ, ๐ > ๐๐0,๐ ๐น0,๐ โ ๐๐0,๐ ๐พ
+
โ Put price cannot: be negative, exceed strike price, be less than price implied by put-call parity using zero for call price:
๐พ > ๐๐ด ๐, ๐พ, ๐ โฅ ๐๐ธ ๐, ๐พ, ๐ > ๐๐0,๐ ๐พ โ ๐๐0,๐ ๐น0,๐+
FIN501 Asset PricingLecture 03 One Period Model: Pricing (18)
Early exercise of American call
โข Early exercise of American optionsโ A non-dividend paying American call option should not be
exercised early, because:๐ถ๐ด โฅ ๐ถ๐ธ = ๐๐ก โ ๐พ + ๐๐ธ + ๐พ 1 โ ๐โ๐ ๐โ๐ก > ๐๐ก โ ๐พ
โ That means, one would lose money be exercising early instead of selling the option
โข Caveatsโ If there are dividends, it may be optimal to exercise early
โ It may be optimal to exercise a non-dividend paying put option early if the underlying stock price is sufficiently low
FIN501 Asset PricingLecture 03 One Period Model: Pricing (19)
Options: Time to expiration
โข Time to expiration
โ An American option (both put and call) with more time to expiration is at least as valuable as an American option with less time to expiration. This is because the longer option can easily be converted into the shorter option by exercising it early.
โ European call options on dividend-paying stock may be less valuable than an otherwise identical option with less time to expiration.
FIN501 Asset PricingLecture 03 One Period Model: Pricing (20)
Options: Time to expirationโข Time to expiration
โ When the strike price grows at the rate of interest, European call and put prices on a non-dividend paying stock increases with time.
โข Suppose to the contrary ๐ ๐ < ๐(๐ก) for ๐ > ๐ก, then arbitrage.
โ Buy ๐(๐) and sell ๐(๐ก) initially.
โ ๐๐ก < ๐พ๐ก, keep stock and finance ๐พ๐ก, Time ๐ value ๐พ๐ก๐๐ ๐โ๐ก = ๐พ๐
0 t T
๐๐ก < ๐พ๐ก ๐๐ก > ๐พ๐ก ๐๐ก < ๐พ๐ก ๐๐ก > ๐พ๐ก
+๐ ๐ก ๐๐ก โ ๐พ๐ก 0
โ๐๐ก +๐๐
+๐พ๐ก โ๐พ๐
โ๐(๐) max{๐พ๐ โ ๐๐ , 0}
-------------- -------------- -------------- -------------- --------------
> 0 0 0 โฅ 0 โฅ 0
FIN501 Asset PricingLecture 03 One Period Model: Pricing (21)
Options: Strike price
โข Different strike prices (๐พ1 < ๐พ2 < ๐พ3), for both European and American optionsโ A call with a low strike price is at least as valuable as an otherwise
identical call with higher strike price:๐ถ ๐พ1 โฅ ๐ถ(๐พ2)
โ A put with a high strike price is at least as valuable as an otherwise identical put with low strike price:
๐ ๐พ2 โฅ ๐ ๐พ1
โ The premium difference between otherwise identical calls with different strike prices cannot be greater than the difference in strike prices:
๐ถ ๐พ1 โ ๐ถ ๐พ2 โค ๐พ2 โ ๐พ1โข Price of a collar is not greater than its maximum payoff
S
K2 โ K1
FIN501 Asset PricingLecture 03 One Period Model: Pricing (22)
Options: Strike price (cont.)
โข Different strike prices (๐พ1 < ๐พ2 < ๐พ3), for both European and American optionsโ The premium difference between otherwise identical puts with
different strike prices cannot be greater than the difference in strike prices:
๐ ๐พ2 โ ๐ ๐พ1 โค ๐พ2 โ ๐พ1
โ Premiums decline at a decreasing rate for calls with progressively higher strike prices. (Convexity of option price with respect to strike price):
๐ถ ๐พ1 โ ๐ถ ๐พ2
๐พ1 โ ๐พ2<
๐ถ ๐พ2 โ ๐ถ ๐พ3
๐พ2 โ ๐พ3
FIN501 Asset PricingLecture 03 One Period Model: Pricing (23)
Options: Strike price
โข Proof: suppose to the contrary๐ถ ๐พ1 โ ๐ถ ๐พ2
๐พ2 โ ๐พ1โค
๐ถ ๐พ2 โ ๐ถ ๐พ3
๐พ3 โ ๐พ2
โข (Asymmetric) Butterfly spreadโ Price โค 0:
1
๐พ2โ๐พ1๐ถ ๐พ1 โ
1
๐พ2โ๐พ1+
1
๐พ3โ๐พ2๐ถ ๐พ2 +
1
๐พ3โ๐พ2๐ถ ๐พ3 โค 0
โ Payoff > 0: (at least in some states of the world)
โ โ arbitrage ๐พ1 ๐พ2 ๐พ3
FIN501 Asset PricingLecture 03 One Period Model: Pricing (24)
Overview: Pricing - one period model
1. LOOP, No arbitrage
2. Forwards
3. Options: Parity relationship
4. No arbitrage and existence of state prices
5. Market completeness and uniqueness of state prices
6. Unique q*
7. Four pricing formulas:state prices, SDF, EMM, beta pricing
8. Recovering state prices from options
FIN501 Asset PricingLecture 03 One Period Model: Pricing (25)
โฆ back to the big picture
โข State space (evolution of states)
โข (Risk) preferences
โข Aggregation over different agents
โข Security structure โ prices of traded securities
โข Problem:
โ Difficult to observe risk preferences
โ What can we say about existence of state prices without assuming specific utility functions/constraints for all agents in the economy
FIN501 Asset PricingLecture 03 One Period Model: Pricing (26)
specifyPreferences &
Technology
observe/specifyexisting
Asset Prices
State Prices q(or stochastic discount
factor/Martingale measure)
derivePrice for (new) asset
โข evolution of statesโข risk preferencesโข aggregation
absolute asset pricing
relativeasset pricing
NAC/LOOP
LOOP
NAC/LOOP
Only works as long as market completeness doesnโt change
deriveAsset Prices
FIN501 Asset PricingLecture 03 One Period Model: Pricing (27)
Three Forms of No-ARBITRAGE
1. Law of one Price (LOOP) ๐โ = ๐๐ โ ๐ โ โ = ๐ โ ๐
2. No strong arbitrageThere exists no portfolio โ which is a strong arbitrage, that is ๐โ โฅ 0 and ๐ โ โ < 0
3. No arbitrage There exists no strong arbitrage nor portfolio ๐ with ๐๐ > 0 and ๐ โ ๐ โค 0
FIN501 Asset PricingLecture 03 One Period Model: Pricing (28)
Pricing
โข Define for each ๐ง โ ๐๐ฃ ๐ง โ ๐ โ โ: ๐ง = ๐โ
โข If LOOP holds ๐ฃ ๐ง is a linear functionalโ Single-valued, because if hโ and hโ lead to same z, then price
has to be the same
โ Linear on ๐
โ ๐ฃ 0 = 0
โข Conversely, if ๐ฃ is a linear functional defined in ๐ then the law of one price holds.
FIN501 Asset PricingLecture 03 One Period Model: Pricing (29)
Pricing
โข LOOP โ ๐ฃ ๐โ = ๐ โ โ
โข A linear functional ๐ โ โ๐ is a valuation function if
๐ ๐ง = ๐ฃ ๐ง for each ๐ง โ ๐
โข ๐ ๐ง = ๐ โ ๐ง for some ๐ โ โ๐, where ๐๐ = ๐ ๐๐ , and ๐๐ is the vector with ๐๐
๐ = 1 and ๐๐ ๐ = 0 if ๐ โ ๐
โ ๐๐ is an Arrow-Debreu security
โข ๐ is a vector of state prices
โข ๐ extends ๐ฃ on โ๐
FIN501 Asset PricingLecture 03 One Period Model: Pricing (30)
State prices q
โข ๐ is a vector of state prices if ๐ = ๐โฒ๐, that is ๐๐ = ๐ฅ๐ โ ๐ for each ๐ = 1,โฆ , ๐ฝ
โข If ๐ ๐ง = ๐ โ ๐ง is a valuation functional then ๐ is a vector of state prices
โข Suppose ๐ is a vector of state prices and LOOP holds. Then if ๐ง = ๐โ LOOP implies that
๐ฃ ๐ง =
๐
โ๐๐๐
=
๐
๐
๐ฅ๐ ๐๐๐ โ๐ =
๐
๐
๐ฅ๐ ๐โ๐ ๐๐ = ๐ โ ๐ง
โข ๐ ๐ง = ๐ โ ๐ง is a valuation functional โ๐ is a vector of state prices and LOOP holds
FIN501 Asset PricingLecture 03 One Period Model: Pricing (31)
๐ 1,1 = ๐1 + ๐2๐ 2,1 = 2๐1 + ๐2
Value of portfolio (1,2)3๐ 1,1 โ ๐ 2,1 = ๐1 + 2๐2
State prices q
๐ฅ1
๐ฅ2
21
12
FIN501 Asset PricingLecture 03 One Period Model: Pricing (32)
The Fundamental Theorem of Finance
โข Proposition 1. Security prices exclude arbitrage if and only if there exists a valuation functional with ๐ โซ 0
โข Proposition 1โ. Let ๐ be a S ร ๐ฝ matrix, and ๐ โ โ๐ฝ. There is no โ in โ๐ฝ satisfying โ โ ๐ โค 0, ๐โ โฅ 0 and at least one strict inequality โ there exists a vector ๐ โ โ๐ with ๐ โซ 0 and ๐ = ๐โฒ๐
No arbitrage , positive state prices
FIN501 Asset PricingLecture 03 One Period Model: Pricing (33)
Overview: Pricing
1. LOOP, No arbitrage
2. Forwards
3. Options: Parity relationship
4. No arbitrage and existence of state prices
5. Market completeness and uniqueness of state prices
6. Unique ๐โ
7. Four pricing formulas:state prices, SDF, EMM, beta pricing
8. Recovering state prices from options
FIN501 Asset PricingLecture 03 One Period Model: Pricing (34)
Multiple State Prices ๐& Incomplete Markets
๐1
๐2
๐ฅ1
๐ฅ2
๐ 1,1
Payoff space โจ๐โฉ
bond (1,1) only
What state prices are consistent with ๐ 1,1 ?๐ 1,1 = ๐1 + ๐2
One equation โ two unknowns ๐1, ๐2There are (infinitely) many.
e.g. if ๐ 1,1 = .9๐1 = .45, ๐2 = .45,
or ๐1 = .35, ๐2 = .55
FIN501 Asset PricingLecture 03 One Period Model: Pricing (35)
โจ๐โฉ
๐
complete markets
๐ฅ1
๐ฅ2
๐(๐ฅ)
FIN501 Asset PricingLecture 03 One Period Model: Pricing (36)
๐(๐ฅ)
โจ๐โฉ
๐
๐ = ๐โฒ๐
incomplete markets
๐ฅ1
๐ฅ2
FIN501 Asset PricingLecture 03 One Period Model: Pricing (37)
โจ๐โฉ
๐โ
๐ = ๐โฒ๐โ
incomplete markets
๐ฅ1
๐ฅ2
๐(๐ฅ)
FIN501 Asset PricingLecture 03 One Period Model: Pricing (38)
Multiple q in incomplete marketsโจ๐โฉ
๐v
๐โ
๐โ
๐ = ๐โฒ๐
Many possible state price vectors s.t. ๐ = ๐โฒ๐.One is special: ๐โ - it can be replicated as a portfolio.
๐ฅ2
๐ฅ1
FIN501 Asset PricingLecture 03 One Period Model: Pricing (39)
Uniqueness and Completeness
โข Proposition 2. If markets are complete, under no arbitrage there exists a unique valuation functional.
โข If markets are not complete, then there exists ๐ฃ โ โ๐ with 0 = ๐๐ฃ
โข Suppose there is no arbitrage and let ๐ โซ 0 be a vector of state prices. Then ๐ + ๐ผ๐ฃ โซ 0 provided ๐ผ is small enough, and ๐ = ๐ ๐ + ๐ผ๐ฃ . Hence, there are an infinite number of strictly positive state prices.
FIN501 Asset PricingLecture 03 One Period Model: Pricing (40)
Overview: Pricing - one period model
1. LOOP, No arbitrage
2. Forwards
3. Options: Parity relationship
4. No arbitrage and existence of state prices
5. Market completeness and uniqueness of state prices
6. Unique q*
7. Four pricing formulas:state prices, SDF, EMM, beta pricing
8. Recovering state prices from options
FIN501 Asset PricingLecture 03 One Period Model: Pricing (41)
Four Asset Pricing Formulas
1. State prices ๐๐ = ๐ ๐๐ ๐ฅ๐ ๐
2. Stochastic discount factor ๐๐ = ๐ธ ๐๐ฅ๐
3. Martingale measure ๐๐ =1
1+๐๐๐ธ ๐ ๐ฅ๐
(reflect risk aversion by over(under)weighing the โbad(good)โ states!)
4. State-price beta model ๐ธ ๐ ๐ โ ๐ ๐น = ๐ฝ๐๐ธ ๐ โ โ ๐ ๐
(in returns ๐ ๐ โ๐ฅ๐
๐๐)
๐1
๐2
๐3
๐ฅ1๐
๐ฅ2๐
๐ฅ3๐
FIN501 Asset PricingLecture 03 One Period Model: Pricing (42)
1. State Price Model
โข โฆ so far price in terms of Arrow-Debreu (state) prices
๐๐ =
๐
๐๐ ๐ฅ๐ ๐
FIN501 Asset PricingLecture 03 One Period Model: Pricing (43)
2. Stochastic Discount Factor
๐๐ =
๐
๐๐ ๐ฅ๐ ๐=
๐
๐๐
๐๐ ๐๐
๐ฅ๐ ๐
โข That is, stochastic discount factor ๐๐ โ๐๐
๐๐
๐๐ = ๐ธ ๐๐ฅ๐
Now, probability inner product between ๐ and ๐ฅ๐
FIN501 Asset PricingLecture 03 One Period Model: Pricing (44)
โจ๐โฉ
2. Stochastic Discount Factor
shrink axes by factor ๐๐
๐
๐โ
๐2 ๐2
๐1 ๐1
With m: Probability inner product = 0 (โprobability orthogonalโ)
FIN501 Asset PricingLecture 03 One Period Model: Pricing (45)
Risk-adjustment in payoffs
๐ = ๐ธ ๐๐ฅ = ๐ธ ๐ ๐ธ ๐ฅ + cov ๐, ๐ฅ
Since ๐bond = ๐ธ ๐ ร 1 , the risk free rate 1
1+๐๐=
1
๐ ๐ = ๐ธ ๐ .
๐ =๐ฌ ๐
๐น๐+ cov ๐, ๐
Remarks:
(i) If risk-free rate does not exist, ๐ ๐ is the shadow risk free rate
(ii) Typically cov ๐, ๐ฅ < 0, which lowers price and increases return
FIN501 Asset PricingLecture 03 One Period Model: Pricing (46)
3. Equivalent Martingale Measure
โข Price of any asset ๐๐ = ๐ ๐๐ ๐ฅ๐ ๐
โข Price of a bond ๐bond = ๐ ๐๐ =1
1+๐๐
๐๐ =1
1 + ๐๐
๐
๐๐ ๐ โฒ ๐๐ โฒ
๐ฅ๐ ๐=
1
1 + ๐๐๐ธ ๐ ๐ฅ๐
where ๐๐ โ๐๐
๐ โฒ
๐๐ โฒ
FIN501 Asset PricingLecture 03 One Period Model: Pricing (47)
โฆ in Returns: ๐ ๐ =๐ฅ๐
๐๐
๐ธ ๐๐ ๐ = 1, ๐ ๐๐ธ ๐ = 1 โ ๐ธ ๐ ๐ ๐ โ ๐ ๐ = 0
๐ธ ๐ ๐ธ ๐ ๐ โ ๐ ๐ + cov ๐, ๐ ๐ = 0
โ ๐ธ ๐ ๐ โ ๐ ๐ = โcov ๐, ๐ ๐
๐ธ ๐(also holds for portfolios โ)
Note:
โข risk correction depends only on Cov of payoff/return with discount factor.
โข Only compensated for taking on systematic risk not idiosyncratic risk.
FIN501 Asset PricingLecture 03 One Period Model: Pricing (48)
4. State-price BETA Model
๐
๐โ
๐ โ
p=1(priced with m*)
๐ โ = ๐ผ๐โ
let underlying asset be ๐ฅ = 1.2,1
shrink axes by factor ๐๐
โจ๐โฉ
๐2 ๐2
๐1 ๐2
With m: Probability inner product = 0 (โprobability orthogonalโ)
FIN501 Asset PricingLecture 03 One Period Model: Pricing (49)
4. State-price BETA Model
๐ธ ๐ ๐ โ ๐ ๐ = โcov ๐, ๐ ๐
๐ธ ๐(also holds for all portfolios โ,
we can replace m with ๐โ)
Suppose (i) var ๐โ > 0 and (ii) ๐ โ = ๐ผ๐โ with ๐ผ > 0
๐ธ ๐ โ โ ๐ ๐ = โcov ๐ โ, ๐ โ
๐ธ ๐ โ
Define ๐ฝโ โcov ๐ โ,๐ โ
var ๐ โ for any portfolio โ
FIN501 Asset PricingLecture 03 One Period Model: Pricing (50)
4. State-price BETA Model
(2) for ๐ โ: ๐ธ ๐ โ โ ๐ ๐ = โcov ๐ โ,๐ โ
๐ธ ๐ โ = โ๐ฝโ var ๐ โ
๐ธ ๐ โ
(2) for ๐ โ: ๐ธ ๐ โ โ ๐ ๐ = โcov ๐ โ,๐ โ
๐ธ ๐ โ = โvar ๐ โ
๐ธ ๐ โ
Hence,๐ฌ ๐น๐ โ ๐น๐ = ๐ท๐๐ฌ ๐นโ โ ๐น๐
where ๐ท๐ โcov ๐นโ,๐น๐
var ๐นโ
Regression ๐ ๐ โ = ๐ผโ + ๐ฝโ ๐ โ
๐ + ํ๐ with cov ๐ โ, ํ = ๐ธ ํ = 0very general โ but what is R* in reality?
FIN501 Asset PricingLecture 03 One Period Model: Pricing (51)
Four Asset Pricing Formulas
1. State prices ๐๐ = ๐ ๐๐ ๐ฅ๐ ๐
2. Stochastic discount factor ๐๐ = ๐ธ ๐๐ฅ๐
3. Martingale measure ๐๐ =1
1+๐๐๐ธ ๐[๐ฅ๐ ]
(reflect risk aversion by over(under)weighing the โbad(good)โ states!)
4. State-price beta model ๐ธ ๐ ๐ โ ๐ ๐น = ๐ฝ๐๐ธ ๐ โ โ ๐ ๐
(in returns ๐ ๐ โ๐ฅ๐
๐๐)
๐1
๐2
๐3
๐ฅ1๐
๐ฅ2๐
๐ฅ3๐
FIN501 Asset PricingLecture 03 One Period Model: Pricing (52)
What do we know about ๐,๐, ๐, ๐ โ?
โข Main results so far
โ Existence โ no arbitrage
โข Hence, single factor only
โข But doesnโt famous Fama-French factor model have 3 factors?
โข Additional factors are due to time-variation (wait for multi-period model)
โ Uniqueness if markets are complete
FIN501 Asset PricingLecture 03 One Period Model: Pricing (53)
Different Asset Pricing Models
๐๐ก = ๐ธ ๐๐ก+1๐ฅ๐ก+1 โ ๐ธ ๐ โ โ ๐ ๐ = ๐ฝโ๐ธ ๐ โ โ ๐ ๐
where ๐๐ก+1 = ๐ โฆ and ๐ฝโ =cov ๐ โ,๐ โ
var ๐ โ
๐ โฆ = asset pricing modelGeneral Equilibrium
๐ โฆ =MRS๐
Factor Pricing Model๐ + ๐1๐1,๐ก+1 + ๐2๐2,๐ก+1CAPM CAPM
๐ + ๐1๐1,๐ก+1 = ๐ + ๐1๐ ๐ ๐ โ = ๐ ๐ ๐+๐1๐
๐
๐+๐1๐ ๐
where ๐ ๐ is market returnis ๐1 โท 0?
FIN501 Asset PricingLecture 03 One Period Model: Pricing (54)
Different Asset Pricing Models
โข Theoryโ All economics and modeling is determined by
๐๐ก+1 = ๐ + ๐โฒ๐
โ Entire content of model lies in restriction of SDF
โข Empiricsโ ๐โ (which is a portfolio payoff) prices as well as m (which
is e.g. a function of income, investment etc.)
โ measurement error of ๐โ is smaller than for any ๐
โ Run regression on returns (portfolio payoffs)!(e.g. Fama-French three factor model)
FIN501 Asset PricingLecture 03 One Period Model: Pricing (55)
Overview: Pricing - one period model
1. LOOP, No arbitrage
2. Forwards
3. Options: Parity relationship
4. No arbitrage and existence of state prices
5. Market completeness and uniqueness of state prices
6. Unique ๐โ
7. Four pricing formulas:state prices, SDF, EMM, beta pricing
8. Recovering state prices from options
FIN501 Asset PricingLecture 03 One Period Model: Pricing (56)
specifyPreferences &
Technology
observe/specifyexisting
Asset Prices
State Prices q(or stochastic discount
factor/Martingale measure)
derivePrice for (new) asset
โข evolution of statesโข risk preferencesโข aggregation
absolute asset pricing
relativeasset pricing
NAC/LOOP
LOOP
NAC/LOOP
Only works as long as market completeness doesnโt change
deriveAsset Prices
FIN501 Asset PricingLecture 03 One Period Model: Pricing (57)
Recovering State Prices from Option Prices
โข Suppose that ๐๐, the price of the underlying portfolio (we may think of it as a proxy for price of โmarket portfolioโ), assumes a "continuum" of possible values.
โข Suppose there are a โcontinuumโ of call options with different strike/exercise prices โ markets are complete
โข Let us construct the following portfolio: for some small positive number ํ > 0
โ Buy one call with ๐พ = ๐๐ โ๐ฟ
2โ ํ
โ Sell one call with ๐พ = ๐๐ โ๐ฟ
2
โ Sell one call with ๐พ = ๐๐ +๐ฟ
2
โ Buy one call with ๐พ = ๐๐ +๐ฟ
2+ ํ
FIN501 Asset PricingLecture 03 One Period Model: Pricing (58)
Recovering State Prices โฆ (ctd)
ํ
๐๐ โ๐ฟ
2 ๐๐ +
๐ฟ
2 ๐๐ ๐๐ โ
๐ฟ
2โ ํ ๐๐ +
๐ฟ
2+ ํ
Payoff of the portfolio
FIN501 Asset PricingLecture 03 One Period Model: Pricing (59)
โข Let us thus consider buying 1
units of the portfolio.
โข The total payment, when ๐๐ โ๐ฟ
2โค ๐๐ โค ๐๐ +
๐ฟ
2is ํ โ
1= 1, for any ํ
โข Letting ํ โ 0 eliminates payments in the regions ๐๐ โ ๐๐ โ๐ฟ
2โ ํ, ๐๐ โ
๐ฟ
2
and ๐๐ โ ๐๐ +๐ฟ
2, ๐๐ +
๐ฟ
2+ ํ
โข The value of 1
units of this portfolio is1
ํ ๐ถ ๐, ๐พ = ๐๐ โ
๐ฟ
2โ ํ โ ๐ถ ๐, ๐พ = ๐๐ โ
๐ฟ
2
Recovering State Prices โฆ (ctd)
FIN501 Asset PricingLecture 03 One Period Model: Pricing (60)
Recovering State Prices โฆ (ctd)
โข Taking the limit ํ โ 0
= โ limโ0
๐ถ ๐, ๐พ = ๐๐ โ๐ฟ2
โ ๐ถ ๐, ๐พ = ๐๐ โ๐ฟ2โ ํ
ํ+ lim
โ0
๐ถ ๐, ๐พ = ๐๐ +๐ฟ2+ ํ โ ๐ถ ๐, ๐พ = ๐๐ +
๐ฟ2
ํ
= โ๐๐ถ ๐, ๐พ = ๐๐ โ
๐ฟ2
๐๐พ+๐๐ถ ๐, ๐พ = ๐๐ +
๐ฟ2
๐๐พ
as ๐ฟ โ 0 we obtain state price density๐2๐ถ
๐๐พ2
1
๐๐ โ ๐ฟ/2 ๐๐ + ๐ฟ/2 ๐๐
FIN501 Asset PricingLecture 03 One Period Model: Pricing (61)
Recovering State Prices โฆ (ctd.)
โข Evaluate the following cash flow
๐ถ๐น๐ = 0 ๐๐ โ ๐๐ โ
๐ฟ
2, ๐๐ +
๐ฟ
2
50000 ๐๐ โ ๐๐ โ๐ฟ
2, ๐๐ +
๐ฟ
2
โข Value of this cash flow today
50000๐๐ถ
๐๐พ๐, ๐พ = ๐๐ +
๐ฟ
2โ
๐๐ถ
๐๐พ๐, ๐พ = ๐๐ โ
๐ฟ
2
๐ ๐๐1 , ๐๐
2 =๐๐ถ
๐๐พ๐, ๐พ = ๐๐
1 โ๐๐ถ
๐๐พ๐, ๐พ = ๐๐
2
FIN501 Asset PricingLecture 03 One Period Model: Pricing (62)
Table 8.1 Pricing an Arrow-Debreu State Claim
E C(S,E) Cost of position
Payoff if ST =
7 8 9 10 11 12 13 โC โ (โC)= qs
7 3.354
-0.895
8 2.459 0.106
-0.789 9 1.670 +1.670 0 0 0 1 2 3 4 0.164 -0.625
10 1.045 -2.090 0 0 0 0 -2 -4 -6 0.184 -0.441
11 0.604 +0.604 0 0 0 0 0 1 2 0.162 -0.279
12 0.325 0.118 -0.161
13 0.164 0.184 0 0 0 1 0 0 0
Note ฮ๐พ = 1
FIN501 Asset PricingLecture 03 One Period Model: Pricing (63)
specify
Preferences &
Technology
observe/specify
existing
Asset Prices
State Prices q(or stochastic discount
factor/Martingale measure)
derive
Asset Prices
derive
Price for (new) asset
โขevolution of states
โขrisk preferences
โขaggregation
absolute
asset pricing
relative
asset pricing
NAC/LOOP
LOOP
NAC/LOOP
Only works as long as market
completeness doesnโt change