# ARBITRAGE-FREE OPTION PRICING MODELS. Denis Bell. University of North Florida

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1 ARBITRAGE-FREE OPTION PRICING MODELS Denis Bell University of North Florida

2 Modelling Stock Prices Example American Express In mathematical finance, it is customary to model a stock price by an (Ito) stochatic differential equation (SDE) ds t = a(s t )dt + b(s t )dw t where w is a Wiener process. The coefficient function b is called the volatility of the stock.

3 The model is required to be arbitrage-free, i.e. E[S t ] = e rt S 0 (1) where r is the riskless interest rate. Writing (1) as E[e rt S t ] = S 0 (2) we see that condition (1) says that the process e rt S t is a martingale.

4 The Black-Scholes Model ds t = rs t dt + σs t dw t (3) The arbitrage-free properly (2) is immediate from the fact that Ito integrals are martingales. Eq. (3) can be explicitly solved to give S t = S 0 exp [ (r σ2 2 )t + σw ] t. (4) The present value of a European call option with strike price K and maturity time T is V T = e rt E [ (S T K) +]. (5) Using (4), we can compute (5). This results in the famous Black-Scholes formula for option pricing.

5 The Cox-Ross Model Cox & Ross introduced the following fractional version of the B-S model ds t = rs t dt + σ S t dw t. (6) This model arises naturally in financial situations as a limit of jump processes. In contrast to the B-S model, it is impossible to solve (6) in closed form and hence find an elementary option pricing formula for the C-R model analogous to the Black-Scholes formula. Cox & Ross computed the option price V T as an infinite series. A more general version of this problem was recently studied by Delbaen and coworkers using Bessel processes. They found a formula for V T in terms of theta functions.

6 An approach to constructing solvable models (Bell-Stelljes) Assume in the remainder of the talk that if p 1 then p = m/n is a rational with m and n coprime and of different parity (one even and one odd). Consider the Stratonovich equation ds t = µs t dt + σs p t dw t, 1/2 p 1. (7) Since Stratonovich differentials transform in the classical way, Eq. (7) can be solved by elementary ODE techniques to obtain S t = S 0 exp(µt + σw t ), p = 1 (8) S t = e µt [(1 p)σ t 0 eµ(p 1)s dw s +S 1 p 0 ] 1 1 p, p 1. (9)

7 We note that: The assumptions on p ensure that is a fraction with odd denominator so S t in (9) exists 1 p for all time t. 1 The existence/uniqueness theorem for solutions to SDEs does not apply to (7) for p in the range [1/2, 1). However, the validity of the solution (9) can be checked by the Ito formula. Writing (7) in Ito form we obtain ds t = (µs t + pσ2 ) 2 S2p 1 t dt + σst p dw t. The uniqueness question for SDEs of this type has been studied by several authors.

8 Uniqueness Theorems Consider the SDE dx t = b(x t )dt + σx p t dw t, x 0 > 0. (10) where b is locally Lipschitz away from 0. Since both the drift and diffusion coefficients are locally Lipschitz away 0, there will be a unique solution up until the time τ when x t hits 0. The uniqueness issue is therefore closely related to the question of whether this will happen in finite time. Theorem (Delbaen-Shirakawa). For 0 < p < 1, if b = 0 then with probability 1, x t reaches 0 in finite time. Theorem (Yamabe-Watanabe). If 1/2 p 1 and b is Lipschitz at 0 then (10) has a (pathwise) unique solution.

9 Theorem (Lions-Musiela). If 1/2 p 1 and σ 2 2 x2p 2 b(x) x (11) is bounded near x > 0. Then the solution to (10) never reaches 0 in finite time and is thus unique. None of the foregoing hypotheses apply to the equation under consideration ds t = (µs t + pσ2 ) 2 S2p 1 t dt + σst p dw t (12) for p in the range [1/2, 1). (Note that in this case (11) becomes σ 2 2 (1 p)x2p 2 µ. We show that the conclusions of the theorems do not hold for (12) if 1/2 < p < 1.

10 Define Y t t 0 eµ(p 1)s dw s. By the time-change theorem for Ito integrals, we can write Y t = B(τ t ) where B is a Brownian motion and [ ] 1 τ t = e 2µ(p 1)t 1. 2µ(p 1) Note that if µ < 0 then τ t as t while if µ > 0 then τ t is bounded as t. Recall the explicit solution to (12) [ S t = e µt (1 p)σy t + S 1 p 0 ] 1 1 p. Define τ = inf{t/s t = 0}. Since B hits every given level in any given time interval [0, T ], (T > 0) with positive probability, we will have P (τ < ) > 0.

11 Set V t = S t, t τ 0, t > τ. Writing (12) in integral form x t = S 0 + t 0 (µx u + pσ2 ) t 2 x2p 1 u du + σ 0 xp u we see that S and V provide two different solutions to (12). Note that this argument requires the integrand in the Riemann integral above to vanish when x u = 0. This excludes the case p = 1/2 from the discussion.

12 Bell-Stelljes Model (continued) We would like to use the Stratonovich equation (7) ds t = µs t dt + σs p t dw t as a model for stock price. However, unlike Ito integrals, Stratonovich integrals are not martingales. Hence this model has arbitrage. We therefore seek a transformation that converts S t to an arbitrage-free model. Theorem 1. Suppose G(s, t) : [0, ) [0, ] R is C 2 in s and C 1 in t and satisfies the PDE G t + (µs+ pσ2 )G 2 s2p 1 s + σ2 2 s2p G ss = rg (13) Suppose that for all T > 0 there exists n N such that sup 0 t T G s (s, t) s n for large s. (14) Let R t = G(S t, t). Then e rt R t is a martingale, i.e. R t is arbitrage-free.

13 The main purpose of this talk is to explore the class of models that this theorem produces. This involves studying the set of solutions to (13) satisfying (14). A standard method for solving PDEs is separation of variables. Set G(s, t) = F (s)h(t). Substituting this into (10) and separating gives H(t) = e ct (for an arbitrary constant c), and the following differential equation for F σ 2 s 2p 2 F + (µs + pσ2 ) 2 s2p 1 F = (r c)f. (15) According to the theory of linear ODEs there are two linearly independent solutions to (15) valid in the range s (0, ), for every c. The question is which of these solutions are smooth at s = 0?

14 We look at some special cases of (15) where we can find explicit solutions. Note that there are two values of p where the equation has a particularly simple form, p = 1 and p = 1/2.

15 The case p = 1 Here (15) becomes σ 2 s 2 2 F ( σ 2 + µ + 2 ) sf = (r c)f. This is a Cauchy-Euler equation. The solutions are F (s) = s k where k is a root of the quadratic equation σ 2 k 2 /2 + µk + (c r) = 0. Solving for c and evaluating R t = e ct F (S t ) where S t is given by (8), we get R t = R 0 exp [ (r σ 2 k 2 /2)t + σkw t ]. This is the Black-Scholes model with the volatility σ replaced by kσ (if σ is an a-priori unknown parameter, it is essentially just the B-S model).

16 The case p = 1/2 In this case (15) becomes σ 2 s 2 F ( σ 2 ) + µs + F = (r c)f. 4 This equation can be solved by Laplace transforms. Denoting the Laplace transform of F by L we have L(t) = ( t + 2µ σ 2 [ t ( A 0 uα ) t (1+α) u + 2µ σ 2 ) (α+1/2)du + B ] (16) where A and B are an arbitrary constants and α = r c µ

17 If α is a positive integer then the integral in (16) can be evaluated by integration by parts. Furthermore, the inverse transform can be computed and shows that F is as a polynomial of degree α. e.g., if α = 1 then there exists a solution F (s) = s + σ 2 /4µ. This gives rise to the following explicit analogue of the Cox-Ross model R t = e rt [ σ 2 t 0 e µs/2 dw s + R 0 σ 2 /4µ 2 + σ2 4µ e(r µ)t. An option pricing formula based on this model was derived by Bell & Stelljes.

18 Irregular solutions for 1/2 p < 1 If r c has an appropriate value, then Eq. (15): σ 2 s 2p 2 F + (µs + pσ2 ) 2 s2p 1 F = (r c)f has a solution F (s) = s 1 p. Indeed, substituting F (s) = s k and equating the coefficients of like powers of s gives k = 1 p and r c = (1 p)µ. Note that F (s) blows up as s 0 so the hypothesis of Theorem 1 is not satisfied by the corresponding function G. Substituting S t from (9) into R t = e ct F (S t ) we get R t = e rt (1 p)σ t 0 eµ(p 1)s dw s + R o. Because of the presence of the absolute value, e rt S t is not a martingale.

19 This shows the importance of the regularity assumptions on G at s = 0 in Theorem 1. We can use the method of reduction of order to find a second solution F 2 (s) of equation (15) corresonding to F 1 (s) = s 1 p. We obtain F 2 = vf 1 where This implies v (s) = s p 2 exp [ µs 2(1 p) σ 2 (1 p) F 2 (s) s 1, s 0 ]. so F 2 also has singular behavior at s = 0. These examples motivate the following result:

20 A Non-existence Theorem Theorem 2. If 1/2 < p < 1, µ < 0, and c r then (other than the zero function) there is no C 2 solution on [0, ) to the ODE σ 2 s 2p 2 F ( pσ 2 ) + µs + 2 s2p 1 F = (r c)f, satisfying: there exists n N such that F (s) s n, for large s. Recall we have seen that such solutions exist for p = 1/2 and p = 1.

21 Proof. Consider again the SDE ds t = µs t dt + σs p t dw (The value of S 0 will be chosen later). write this equation in Ito form We ds t = (µs t + pσ2 2 S2p 1 t )dt + σst p dw. (17) As we previously observed, the process satisfies (17) where X t = (1 p)σ 1 1 p S t = e µt Xt (18) t 0 eµ(p 1)s dw s + S 1 p 0 We modify (18) as before to get another solution to (17). Let τ = inf{t/x t = 0}. Recall that since µ < 0 we have τ < a.s. Define V t = S t if t τ and V t = 0 if t > τ..

22 Suppose that F is a non-zero function with the properties in the statement of Theorem 2. Choose the initial point S 0 = V 0 in Eq. (17) such that F (V 0 ) 0. Then the function G(s, t) = e ct F (s) satisfies the hypotheses of Theorem 1, so according to the theorem the process e (c r)t F (V t ) is a martingale. In particular e (c r)t E[F (V t )] = F (V 0 ). (19)

23 Hence lim e (c r)t E[F (V t )] = F (V 0 ) 0. (20) t Graph of V If F (0) 0 then this implies the limit in (20) is 0 (if c < r) or (if c > r). In either case we have a contradiction. If F (0) = 0 then, since F (V t ) 0 for t > τ, lim e (c r)t E[F (V t )] = lim E[e (c r)t F (V t )] = 0, t t again resulting in a contradiction. (The case c > r requires some estimates to justify the passage of the limit inside the expectation).

24 Ongoing Work 1, Characterize the solution set to the PDE G t + (µs + pσ2 )G 2 s2p 1 s + σ2 2 s2p G ss = rg. In particular, identify the solutions that are regular at s = 0 (these are the solutions that can be expected to give rise to arbitrage-free option pricing models via the approach of B- Stelljes). 2. Find a natural financial interpretation for the resulting arbtrage-free models, or at least relate these models to concrete financial situations.

25 References F. Black and M. J. Scholes, The pricing of options and corporate liabilities, Journal of Political Economy 81, no. 3 (1973), D. Bell and S. Stelljes, Arbitrage-free option procing models, Journal of the Australian Mathematical Society, to appear. J. C. Cox and S. A. Ross, The valuation of options for alternative stochastic processes, Journal of Financial Economics 3 (1976), F. Delbaen and H. Shirakawa, A note of option pricing for constant elasticity of variance model, preprint No

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