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COUNTING MONEY

AMBER HABIB
MATHEMATICAL SCIENCES FOUNDATION
NEW DELHI

Lecture at Alpha, Mathematics Society festival,

Hindu College, Delhi – Nov 4, 2009
 Where does Maths come from?
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 Pure Imagination
 Practical Problems
 Accounting → Arithmetic
 Measuring area to estimate tax revenue → Geometry

 Maps → Coordinate & Spherical Geometry

 Interest & Loans → Roots of Polynomials

 Gambling → Probability

 Mechanics → Calculus

 Heat → PDE, Harmonic Analysis, Cardinality,…

 How do we estimate “Value”?
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 What is Value of an item in terms of money?

 One answer: What we will get if we sell it.

 Problem: How do you estimate value without

selling the item?

 This will obviously involve uncertainty and

probability. In fact, a very large chunk of modern
mathematics is now applied to this problem.
 Mathematics of Finance
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 Probability & Statistics

 (Partial) Differential Equations
 Stochastic Differential Equations
 Stochastic Calculus
 Measure Theory
 Functional Analysis
 Optimization
 Numerical Analysis
 Is This Profit?
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 You invest $100 today and get back $120 after

a week.

Is this a profit?

Are you sure?

 Is This Profit?
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 Well, what if you bought the $’s using Rupees,

and the exchange rate changed?

 $100 → $120

Rs 50/$ → Rs 40/$

Rs 5000 → Rs 4800
 What is Profit?
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 The amount and direction of profit depends on

how we measure it.

 The fact of profit is only independent of the

unit of measure when we invest zero (or less)
and get back something positive.
 Certain Profit: An Example
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 Bank A loans money at an annual interest rate

of 10%, while Bank B pays 15% interest
annually on deposits.
A strategy to exploit this situation:
 Borrow 100 from A and deposit in B for a year.

After a year, withdraw 115 from B, use 110 to

pay off A, and pocket a profit of 5 on a zero
investment.
 Can such situations exist?
 Arbitrage
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 Arbitrage is the technical name for certain

profit. Its general definition is:

 An investment strategy is said to lead to

arbitrage if:
 The initial investment is non-positive.
 The final return is certainly non-negative and has
a non-zero probability of being positive. (Note its
precise value doesn’t have to be known.)
 No Arbitrage Principle
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 In an “efficient market” (in which communication

is instantaneous and complete), arbitrage
opportunities will not exist.

(This is an idealized situation – in real life they

should just die out quickly)

 Thus, a “correct” value is one which prevents

the possibility of arbitrage.
 Continuously Compounded Interest
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 Recall that if interest is compounded, the

growth over n periods is given by
A  P(1 r)n

 For convenience, we replace this by

continuous compounding:

A  Pe nr
 Risk-free Rate of Interest
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No Arbitrage Principle ⇒

 Everyone uses same r.

 Suppose a portfolio has current value P and it
is certain that its value after time T will be A.
Then the growth must be at the risk free rate:

A = PerT
 Futures
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 A futures contract (or just futures) is an

agreement between two parties for a future
trade.
 Terminology:
 Underlying Asset: The asset which will be
traded.
 Spot Price: Current price of underlying asset.

 Writer: Who issues the contract.

 Holder: Who acquires the contract.

 Terms of a Futures
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 At time t=0, the holder acquires the futures

from the writer.
 The futures describes the amount of the
underlying asset to be traded, the time T of
delivery (expiration date) and the price X to
be paid (exercise price).
 No money exchanged at t=0.
 At t=T, holder pays X to writer and acquires the
underlying asset.
 Why Futures?
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 A packaged food company and a farmer will

trade in a certain amount of potatoes 3 months
from now, after the harvest.
 If the crop is poor, prices will rise, and the
company will face a loss.
 If there is a bumper crop, prices will fall, and it
will be the farmer who will face a loss.
 Both parties can mutually eliminate their risk
by agreeing now on what price they will trade
in 3 months time.
 Trade in Futures
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 Suppose, as the expiration date T approaches,

the price of the underlying asset rises above X.
Then the holder starts receiving offers to sell
the futures to a new holder.

 What should be the price of the futures? What

factors may be relevant?
 In the same vein, when the contract is being
written, what should be X?
 Futures on Reliance Shares
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 Exercise Price
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 If X > SerT the writer can make an arbitrage

profit:
 She initially borrows S and uses it to buy the
asset.
 At time T she delivers the asset to the holder,
earns X and uses SerT of that to pay off the loan.
 She pockets a riskless profit of X − SerT.

 If X< SerT the holder can earn arbitrage in a

similar fashion.
 So No Arbitrage Principle ⇒ X= SerT
 Futures Price
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 Consider a futures written at time t=0 with

exercise price X and expiration time T.

 Its value V at a later time t depends on the

spot price St at time t:
r(T  t)
V  St  Xe
r(T t)
 Remark: Xe is the present value of X.
 Generalizations
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 This simple formula is valid when interest rates

are fixed and owning the asset implies no
extra income or cost.
 No Arbitrage arguments easily give formulas
for exercise & futures price when:
 Asset generates known income/cost (interest,
rent, storage costs).
 Asset has known dividend yield – income/cost is
proportional to asset value (certain shares, stock
indices, gold loans).
 Options
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 Futures eliminate uncertainty but not the

possibility of a felt loss – depending on the
final price of the asset either holder or writer
may get a very poor deal.

 Options are contracts which allow one party to

withdraw. The one who has this right pays an
initial fee to acquire it.
 European Call Option
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 Like a futures, a European call option is a

contract for a future trade with expiration date
T and exercise price X. However,
 The holder pays an initial call premium C to the
writer.
 At time T the holder may pay X to the writer.

 If the holder makes the payment, the writer must

deliver the asset.
 European Call Option
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 Main Q: How to determine C?

 Depends on at least T, r, X and S.

 In this case, No Arbitrage Principle by itself
gives some loose bounds for C but not an
exact price.
 It becomes necessary to model how the asset
price may fluctuate.
 Binomial Model
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SU
Suppose the price starts at S and
over time T can go up by factor U
or down by factor D.
S
Then the option also has two
SD possible final values.

CU = (SU-X)+
 x, x  0
x 
C  0, x  0
CD = (SD-X)+
t=0 T=T
 Binomial Model
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 Consider a portfolio with 1 unit of asset and h

written calls.
 Final value of the portfolio:
 Upmove: SU-hCU
 Down move: SD-hCD

 We can choose h & make the portfolio risk

free: SU-hCU = SD-hCD or,

S(U  D)
h
CU  CD
 Binomial Model
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 With this value of h, the portfolio must grow at

the risk free rate:
SU-hCU = erT(S-hC)
 Substitute h value and solve for C:

C = e-rT (qCU+(1-q)CD), where

erT  D
q
UD
 Binomial Options Pricing Model
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We make the model realistic by letting the

asset price evolve over many steps:
SU3
SU2
SU2D
SU
SUD
S SUD2
SD
SD2
SD3
 Binomial Options Pricing Model
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 The tree for the call prices:

CUUU=(SU3-X)+
CUU
CUUD =(SU2D-X)+
CU
CUD
C CUDD
CD
CDD
CDDD
 BOPM
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 Working back from the end of the tree to its

root, over n steps of length T/n each, we get:
n
Ce rT

k 0
n k n-k
Ck q (1- q) (SU Dk nk
 X) 

e D rT/n
where q
UD
 The proof is by mathematical induction.
 Features of BOPM
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 What is important is the dispersion of asset

prices (measured by U,D) not their actual
probabilities.
 Yet the form is of an expectation of a future
value, if we think of q as a probability.
 The model therefore treats the final asset
values as having a binomial probability
distribution and then takes the present value of
the expectation of the call prices.
 Risk Neutral Probability
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 What is special about q? If we treat it as the

probability of an up move, then the probability of a
final asset price of SUkDn-k is nCkqk(1-q)n-k.
 So the expectation of the final price is
n


k 0
n
Ck qk (1 q)nk SUkDnk  S(qU  (1 q)D)n

 SerT
 Under q, the expected value grows at the risk free
rate. We call such a probability risk neutral.
 BOPM in Action
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Predicted call premiums by a 10-step BOPM for calls on

Maruti shares (line), compared with actual premia (stars)
over a 1-month period. (Data from NSE)
 Other Derivatives
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The BOPM approach can also be applied to

 European Put Options (Writer buys asset from

holder)
 American Options (Holder can exercise

contract before T)
 Barrier Options (Contract expires if asset price

crosses set barriers)

 Asian Options (Final payoff depends on

average of asset price over [0,T])

 Black-Scholes Model
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 By letting n→∞ we transform BOPM into a

continuous model.
 The binomial distribution becomes normal.
 The BOPM formula becomes
rT
C  S(w)  e X(w  σ T )
where  is the cdf of the standard normal
distribution and w is a known function of r, T, X,
S and .
 Some History
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 Louis Bachelier (1900, Paris) models price

fluctuations using normal distributions; applies
to pricing options on bonds; develops
Brownian motion and connects problem to
heat equation.
 His work inspires development of Markov
processes by Kolmogorov and stochastic
calculus by Ito. (1930s)
 Some History
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 Fischer Black, Myron Scholes & Robert

Merton (1973) correct Bachelier’s work by
replacing real life probability with risk neutral
probability. They use Ito calculus.
 William Sharpe (1978) introduces BOPM as a
tool to simplify exposition of ideas of Black et
al.
 John Cox, Stephen Ross and Mark Rubinstein
(1979) extend BOPM and derive Black-
Scholes from it.
 What Next?
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 Create models which are not restricted by Black-

Scholes’ assumptions:

 Asset prices modeled by Normal distribution

(Symmetric, dies out quickly – so extreme events very
rare). Use general heavy tailed stable distributions
instead.
 Constant volatility () – Models like GARCH allow for
time varying volatility.
 Constant risk free rate (r) – Develop probabilistic
models for interest rates and incorporate them.
 Who Can Do It?
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 Best equipped people for modeling the

modern world of Finance are Maths and
Physics PhDs who can work with stochastic
calculus and numerical analysis.
 These “quants” are the most highly paid
people on Wall Street.
 Two Case Studies
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 Rabindranath Chatterjee

 MSc Physics – IIT Kanpur (1988)

 PhD Physics – Rutgers University, New Jersey,
USA in particle physics. (1995)
 First Job – Morgan Stanley, New York.

 Current – Senior Vice President, Citibank, New

York
 Two Case Studies
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 Samarendra Sinha
 MSc Maths - IIT Kanpur (1989)
 PhD Maths – University of Minnesota (1995) –
algebraic geometry
 Post-Doc at IAS, Princeton (1995-96)

 Asst Prof, Ohio State University (1996-97)

 MA Finance – Wharton (1999)

 Current – “Quant Analyst” at JP Morgan, NY –

numerical PDEs
 Nobel Prizes
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Nobel prizes for work in mathematical finance:

 James Tobin – 1981

 Franco Modigliani – 1985

 Merton Miller, Harry Markowitz, William

Sharpe – 1990
 Robert Merton, Myron Scholes – 1997

 Robert Engle – 2003