4

Option Pricing

This Chapter explains basically how should we price an option.

In a first Finance Mathematics course we are thaught the concept of
present value, which consists in discounting by a constant risk free interest
rate some value in the future so that we can find the price of it in the present.
It is correct if we think of loans and bank accounts with fixed interest
rates because we know the evolution of these values, so we can track it and
use it in a reverse way to find the present value, but not in general. For risky
assets we don’t know the evolution of the price so we cannot discount by a
proper rate.
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On the other hand Probability Theory have some answers to solve that
problem. Under some assumptions, if we change properly the measure in which
we take expectations we can think of any discounted portfolio as a risk neutral
one in that measure. That’s why such measures are more usually called Risk
Neutral Measures than Equivalent Martingale Measures. The latter name is
because under that new equivalent measure, the discounted portfolio becomes
a martingale.

4.1
Pricing Formula in the Risk-Neutral Measure
For this section, we follow the chapter 5 in Shreve (41) for the background
and to show the Black-Scholes example.
Rt
Let Dt = e− 0 r(u)du be a discount factor process and Xt be a self-financing
portfolio made of fixed interest investment and risky assets where the amount
invested into risky assets in time t is ∆t . It means that changes in the value
of the portfolio are due to changes in the price of the risk asset and changes
in the safe investment and not for putting more money into this portfolio.
Mathematically we ask that

dXt = ∆t dSt + rt (Xt − ∆t St )dt

Note that according to the Itô product rule, asking for being self-financing
is very restrictive because we lose some terms in the equation above. Suppose
 Risk Neutral Option Pricing under some special GARCH models 30

also that the asset follows

dSt = αt St dt + σt St dWt (4-1)

or as in example 25 of the use of Itô’s Lemma:

Rt Rt
fs +
σdW (r− 21 σ2 )ds
St = S0 e 0 0 (4-2)

By the Itô Lemma, we get first that

Rt
dDt = e− 0 r(u)du
r(t)dt = −Dt rt dt

Then

dXt = ∆t dSt + rt (Xt − ∆t St )dt (4-3)

= ∆t αt St dt + ∆t σt St dWt + rt (Xt − ∆t St )dt (4-4)
= (∆t αt St dt + rt Xt − rt ∆t St )dt + ∆t σt St dWt (4-5)
= (rt Xt + (αt − rt )∆t St )dt + ∆t σt St dWt (4-6)
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= rt Xt dt + σt ∆t St (θt dt + dWt ) (4-7)

ft .
= rt Xt dt + σt ∆t St dW (4-8)

ft is a Brownian Motion by Girsanov’s Theorem and θt =

where W (αt −rt )
.
σt

Proposition 30 Dt Xt is a martingale under Q

Proof : We will proceed as Shreve (41). By the product rule (example 23 of

the use of Itô’s Lemma) we have

d(Dt Xt ) = Xt dDt + Dt dXt + dDt dXt (4-9)

= Xt (−Dt rt )dt + Dt dXt + 0 (4-10)
ft )
= −Xt Dt rt dt + Dt (rt Xt dt + σt ∆t St dW (4-11)
ft .
= Dt σt ∆t St dW (4-12)

The Girsanov’s Theorem garantee us that W ft is a Brownian Motion and

so, as a stochastic integral with respect to a Brownian Motion is a martingale,
Dt Xt is a martingale. 
Let the value of some derivative VT be FT -measurable. We want to know
what is the initial money X0 and which process ∆t are required to be in a
portfolio so that an investor can hedge a position in this derivative, i.e., such
that
XT = VT
 Risk Neutral Option Pricing under some special GARCH models 31

If we can do that, given that Dt Xt is a martingale under Q we have

Dt Xt = EQ [DT XT |Ft ] = EQ [DT VT |Ft ]

Then, Dt Xt is the amount required in t to make the hedge of this

derivative with payoff VT . We can then say that the price of the derivative
in t is Vt where

Dt Vt = EQ [DT VT |Ft ] 0 ≤ t ≤ T (4-13)

or
RT
Vt = EQ [e− t r(u)du
VT |Ft ] 0 ≤ t ≤ T (4-14)

4.2
Black-Scholes-Merton Formula
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The most famous finance formula is the Black-Scholes formula. It is easy

to find in many books the proof that consists in deriving the Black-Scholes
PDE and then turning it in a heat equation problem. Here we present it under
the risk-neutral framework as in Shreve (41).
The Black-Scholes-Merton Model supposes that the interest rate and the
volatility are fixed. For an European Call option, we have the payoff

VT = (ST − K)+ (4-15)

Using the pricing formula just discussed we need to calculate

Vt = EQ [e−r(T −t) (ST − K)+ |Ft ] (4-16)

Let’s think of the formula above as a function of t and St :

C(t, St ) = EQ [e−r(T −t) (ST − K)+ |Ft ] (4-17)

The equation
Rt Rt
fs +
σdW (r− 21 σ2 )ds
St = S0 e 0 0 (4-18)
 Risk Neutral Option Pricing under some special GARCH models 32

can be written as
RT RT
fs +
σdW (r− 21 σ2 )ds
ST = St e t t (4-19)
f f
= St eσ(WT −Wt )+(r− 2 σ )τ
1 2
(4-20)

f f
where τ = T − t. If we further define Y = − W√TT−−t
Wt
we can write

√
τ Y +(r− 12 σ 2 )τ
ST = St e−σ (4-21)
√
τ Y +(r− 12 σ 2 )τ
Then, as St is Ft -measurable and e−σ is independent of Ft :

C(t, x) = EQ [e−rτ (ST − K)+ ] (4-22)

Z ∞
1 √
e−rτ (xe−σ τ Y +(r− 2 σ )τ − K)+ e− 2 y dy
1 2 1 2
= √ (4-23)
2π −∞
√
τ Y +(r− 21 σ 2 )τ
Now, note that (xe−σ − K)+ is positive if and only if
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1 x 1 2
y < d− ≡ √ ln + r− σ τ (4-24)
σ τ K 2

Indeed,
√ √
τ y+(r− 21 σ 2 )τ
e−σ τ y > (K/x)e−(r− 2 σ )τ
1 2
e−σ > K/x ⇐⇒
 
√ 1 2
⇐⇒ −σ τ y > ln(K/x) − r − σ τ
2
     
∗(−1) 1 x 1 2
⇐⇒ y < √ ln + r− σ τ
σ τ K 2

We don’t have to consider the integral when it is zero. This leads us to:
Z d−
1 √
e−rτ (xe−σ τ y+(r− 2 σ )τ − K)e− 2 y dy
1 2 1 2
C(t, x) = √
2π −∞
Z d− Z d−
1 √
− 12 y 2 −σ τ y+(− 21 σ 2 )τ 1 2
= √ xe dy − e−rτ Ke− 2 y dy
2π −∞ −∞
Z d−
1 (y+σ τ )
√ 2

= √ xe− 2 dy − Φ(d− )e−rτ K

2π −∞
√ Z d− +σ√τ
z=y+σ τ 1 (z)2
= x√ e− 2 dz − Φ(d− )e−rτ K
2π −∞
= xΦ(d+ ) − Φ(d− )e−rτ K
 Risk Neutral Option Pricing under some special GARCH models 33

where
√
d+ = d− + σ τ
     
1 x 1 2 √
= √ ln + r− σ τ +σ τ
σ τ K 2
x

1 2


ln K + r − 2 σ τ + σ 2 τ
= √
σ τ



ln Kx + r + 21 σ 2 τ
= √
σ τ

4.3
Put-Call Parity
Now, we will see that who can solve the problem of pricing the European
Call option, can also find the price of an Europena Put Option.
Build a portfolio made of:
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• Buy a stock.
• Buy a put option with this stock bought as the underlying.
• Sell a call option also based in the stock bought.
Then, if we call this portfolio Π, we can write:

Πt = St + Pt − Ct .

But then at time T we will have:

payoffT (Π) = ST + (K − ST )+ − (ST − K)+

(
ST + K − ST , if ST ≤ K
=
ST − (ST − K) , if ST > K
= K.

This portfolio always gives a return K, the exercise price. Then, because
it is a deterministic portfolio, we can think of its present value being that of
K discounted:

Πt = Ke−r(T −t)
 Risk Neutral Option Pricing under some special GARCH models 34

Then we have:

Ke−r(T −t) = St + Pt − Ct ⇒ Pt = Ke−r(T −t) + Ct − St .

4.4
Incomplete Markets
Here we are going to show two well known techniques for pricing in
incomplete markets, viz. the Davis method and the Esscher method.
When we can not find a hedge for some asset in the economy we say
that the market is incomplete and then it is known that there are infinite
equivalent martingale measures. The risk neutral way of pricing do not involve
requirements concerning the risk preferences of the investors, but in order to
justify the choice of one particular risk neutral measure among many, we will
have to think about a reasonable way to select it.
Besides the two methodologies that we are going to discuss briefly here,
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there are other approaches to hedging and pricing in incomplete markets, such
as the quadratic hedging approach. They are mainly interested in minimizing
risk, Maximizing expected utility or minimize loss. For a comprehensible
reading see Bingham and Kiesel (2004)(5).

4.4.1
Davis Method
We start by the method of Davis. Let Φa be the set of all self-financing
strategies (i.e. in which you can not inject money in the portfolio. For details
see (21)and (26)) and write

Ũ (x) = sup E[U (Vϕ,x (T ))]

ϕ∈Φa

for the maximum expected utility of an investor and suppose p is the price of
the asset X.
Let

δ
W (δ, x, p) = sup E[U (Vϕ,x−δ (T ) + X)]
ϕ∈Φa p
be a disturb created for being able to sense the effect of changing the strategy.
If the maximum utility does not get affected by this “tilt”, p̂ is the fair price
for the option.
Under some conditions, p̂ is the unique solution of
 Risk Neutral Option Pricing under some special GARCH models 35

∂W
W (0, p, x) = 0
∂δ
which is the fair price of the option in t = 0. Furthermore, this value is
given by:

E[U ′ (Vϕ∗ ,x (T ))X]

p̂ =
Ũ ′ (x)
For more details see Davis(1994)(13) and Bingham and Kiesel(2004) (5).

4.4.2
Esscher Method
Now let’s see the Esscher method. Let St = S0 eXt be the model for the
asset prices where Xt has independent and stationary increments. Assume that

M (h, t) = M (h, 1)t = E[ehXt ] (4-25)

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Then, having that in mind, let’s define

ehXt hXt −t Sth

Λt = = e M (h, 1) = ; t≥0 (4-26)
E[ehXt ] E[Sth ]

that is a positive martingale and will be used for the change of measure.
Now, by the Baye’s rule,

E[Ψ(Y )ehY ]
E h [Ψ(Y )] = E[Ψ(Y ); h] = (4-27)
E[ehY ]
= E[Λt Ψ(Y )] (4-28)

where Y is a random variable and Ψ is a measurable function. For

example Ψ(Y ) could be the logreturn eXt .
We will call Q the Esscher measure of parameter h = h∗ if {e−rt St }t≥0 is
a martingale.
By the condition on the asset prices we have the following equivalences:
 Risk Neutral Option Pricing under some special GARCH models 36

 
−rt ∗ St ∗
E[e St , h ] = S0 ⇐⇒ E , h = ert (4-29)
S0
⇐⇒ E[eXt , h∗ ] = ert (4-30)
 ∗ 
Xt eh Xt
⇐⇒ E e = ert (4-31)
M (h∗ , 1)t
∗
E[eXt (h +1) ]
⇐⇒ ∗ t
= ert (4-32)
M (h , 1)
M (h∗ + 1, 1)t
⇐⇒ ∗ t
= ert (4-33)
M (h , 1)
 t
M (h∗ + 1, 1)
⇐⇒ = ert (4-34)
M (h∗ , 1)
M (h∗ + 1, 1)
⇐⇒ = er (4-35)
M (h∗ , 1)
(4-36)

The equation
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M (h∗ + 1, 1)
= er (4-37)
M (h∗ , 1)

determines the parameter h∗ uniquely. We will be interested in this

parameter for finding the risk neutral measure to be used in the option pricing.
There is a useful result that we should show here. It is known as the
factorization formula:
Theorem 31 Let g be a measurable function and h, k and t be real values
with t ≥ 0, then

E[Stk g(St ); h] = E[Stk ; h]E[g(St ); k + h]. (4-38)

Proof :

E[Stk g(St ); h] = E[Stk g(St )ehXt M (h, 1)−t ] (4-39)

 
k Sth
= E St g(St ) (4-40)
E[Sth ]
E[Stk+h ]E[Stk+h g(St )]
= (4-41)
E[Sth ]E[Stk+h ]
= E[Stk ; h]E[g(St ); k + h] (4-42)
 Risk Neutral Option Pricing under some special GARCH models 37


For more details see Gerber and Shiu (1994)(31) and Bingham and
Kiesel(2004)(5). Some of the points discussed above will be revisited in the
conditional Esscher Transform section.

4.5
Duan’s breakthrough
In 1995, Duan developped a method for pricing options under GARCH
processes. Although there are economic restrictions and is valid only for
normal noises, it was a milestone in Finance. He also developped some papers
concerning the relationship between the diffusions and the econometric models
and their risk neutral versions. This discussion doesn’t help us in this thesis
and it can be found in Duan(1997)(18). Here we show the main results from
the paper published in 1995 (17).
Consider the model:

Xt p 1
ln = r + λ ht − ht + ξt
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Xt−1 2
where

ξt |φt−1 ∼ N (0, ht ) under mesure P

q p
X X
2
ht = α0 + αi ξt−i + βj ht−j
i=1 j=1

Basically the paper raises the question: What would the risk-neutral
GARCH be?
For answering this question, he defines the concept of Local Risk Neutral
Valuation Relationship hereafter LRNVR, as below:
A measure Q satisfies the LRNVR if:

1 Q is mutually absolutely continuous with respect to measure

P.(Equivalents)
Xt
2 Xt−1
is lognormally distributed (under Q)
3 E Q [ XXt−1
t
|φt−1 ] = er
4 V arQ (ln XXt−1
t
|φt−1 ) = V arP (ln XXt−1
t
|φt−1 ) a.s.

Having in mind this concept we can state the main Theorem of the paper:
Theorem 32 Supposing the LRNVR, under Q we have:

Xt 1
ln = r − ht + ǫt
Xt−1 2
 Risk Neutral Option Pricing under some special GARCH models 38

where:

ǫt |φt−1 ∼ N (0, ht )
q p
X p X
2
ht = α0 + αi (ǫt−i − λ ht−i ) + βj ht−j
i=1 j=1

Xt
Proof : It follows exactly as in Duan (17). Since |φ
Xt−1 t−1
lognormally dis-
tributed under measure Q, it can be written as:

Xt
ln = v t + ǫt ,
Xt−1

where vt is the conditional mean and ǫt is a Q-normal random variable. The

conditional mean of ǫt is zero and its conditional variance is to be determined.
The proof is in two parts.
First we prove that vt = r − h2t . Indeed,
 
Xt ht
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E Q
|φt−1 = E Q [evt +ǫt |φt−1 ] = evt + 2
Xt−1
where ht = V arP [ XXt−1
t
|φt−1 ] = V arQ [ XXt−1
t
|φt−1 ] by the LRNVR.
Since E [ Xt−1 |φt−1 ] = e also by the LRNVR, it follows that vt = r − h2t .
Q Xt r

Now we prove the second part. It remains to prove that ht can indeed
be expressed as stated in the Theorem. By the preceding result and the model
under P:

Xt p ht
ln = r + λ ht − + ξt , (4-43)
Xt−1 2

we have, comparing the logs:

p ht ht
r+λ ht − + ξt = r − + ǫt . (4-44)
2 2
√
so that ξt = ǫt − λ ht . Substituting ǫt into the conditional variance
equation yields the desired result:
q p
X p X
2
ht = α0 + αi (ǫt−i − λ ht−i ) + βj ht−j
i=1 j=1


The result just proved can be found as a particular case of the method
described in the next section. This verification can be found in section 3.1
 Risk Neutral Option Pricing under some special GARCH models 39

in the paper by Siu et al. (2004)(43). The method below doesn’t require the
noises to be normal, they just have to have a moment generation function.
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