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178 Mathematics for Finance


Theorem 8.3


The expectation of the discounted payoff computed with respect to the risk-
neutral probability is equal to the present value of the derivative security,


D(0) =E∗

(

(1 +r)−^2 f(S(2))

)

Exercise 8.5


LetS(0) = 120 dollars,u=0.2,d=− 0 .1andr=0.1. Consider a call
option with strike priceX= 120 dollars and exercise timeT=2.Find
the option price and the replicating strategy.

Exercise 8.6


Using the data in the previous exercise, find the price of a call and the
replicating strategy if a 15 dollar dividend is paid at time 1.

8.1.3 GeneralN-Step Model ..............................


The extension of the results above to a multi-step model is straightforward.
Beginning with the payoff at the final step, we proceed backwards, solving the
one-step problem repeatedly. Here is the procedure for the three-step model:


D(3) =f(S(3)),

D(2) =

1

1+r

[p∗f(S(2)(1 +u)) + (1−p∗)f(S(2)(1 +d))]
=g(S(2)),

D(1) =

1

1+r

[p∗g(S(1)(1 +u)) + (1−p∗)g(S(1)(1 +d))]
=h(S(1)),

D(0) =

1

1+r[p∗h(S(0)(1 +u)) + (1−p∗)h(S(0)(1 +d))],

where


g(x)=^1
1+r

[p∗f(x(1 +u)) + (1−p∗)f(x(1 +d))],

h(x)=

1

1+r

[p∗g(x(1 +u)) + (1−p∗)g(x(1 +d))].
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