Introduction to option pricing theory

Authors Rajeeva L. Karandikar, Gopinath Kallianpur

Publication date 25 January 2000

American options arbitrage asset prices Black-Scholes formula continuous semimartingales continuous-time models option pricing Russian options semimartingales stochastic integration

Mathematics Subject Classification ID

Research exposition (monographs, survey articles) pertaining to probability theory (60-02) Stopping times; optimal stopping problems; gambling theory (60G40) Applications of statistics to actuarial sciences and financial mathematics (62P05) Research exposition (monographs, survey articles) pertaining to game theory, economics, and finance (91-02) Derivative securities (option pricing, hedging, etc.) (91G20)

Review text

This book gives an introduction to option pricing theory in continuous-time models with asset prices modelled by continuous semimartingales. It starts with a thorough but concise exposition of stochastic calculus for continuous processes; this includes stochastic integration with respect to continuous semimartingales, Itô's formula with some applications, the Itô and Kunita-Watanabe representations for square-integrable martingales, stochastic differential equations over Brownian motion with Lipschitz coefficients and the Girsanov theorem. All the results are proved for continuous processes and the corresponding theory for general semimartingales is briefly outlined without proofs. The second third of the book is concerned with arbitrage, completeness and the relation to Equivalent local Martingale Measures (EMMs). After a brief explanation of the main ideas and results in a discrete-time model over a finite probability space, the authors thoroughly discuss the connections between absence of arbitrage and the existence of an EMM. Chapter 8 presents the equivalence results by Levental/Skorokhod and by Stricker, mentions the work by Delbaen/Schachermayer and gives for locally bounded RCLL semimartingales a variant using Orlicz spaces. It also shows how to construct arbitrage in a model driven by fractional Brownian motion with parameter \(H\in({1\over 2},1)\) and extends this to a larger class of Gaussian processes. Chapter 9 then characterizes completeness of an arbitrage-free market by the uniqueness of the EMM, gives a couple of examples and explains how to use completeness to value derivatives by pure arbitrage arguments. A brief presentation of elementary arbitrage bounds in incomplete markets and a discussion on the choice of filtration end this part. The third and final part is a collection of some applications or examples for the previously developed techniques. This includes of course a presentation of the classical Black-Scholes formula, a chapter on approximation via binomial models and the theory for pricing American options in a complete market. In addition, there is a chapter on stochastic volatility models with an asymptotic analysis of option prices if volatility fluctuates on a slower time scale and some results of filtering of the volatility. The final chapter treats Russian options in the classical model of geometric Brownian motion and explains how to value these by solving an optimal stopping problem. Although the main focus of the book is on the theoretical side, it explains the key ideas and concepts in option pricing very well. It provides a solid mathematical background for continuous-time models with continuous processes, and the detailed discussion of the relations between absence of arbitrage and the existence of an EMM is currently not available in any other textbook in the present broadness, clarity and carefulness. The third part is deliberately more episodic than encyclopaedic, but still gives a good insight into a number of diverse and interesting topics. As an advanced-level introduction for mathematicians to option pricing theory, the book does a very good job and has some features that make it a welcome addition to the existing literature. (But I do hope a second edition will contain a decent index).

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