scientific article; zbMATH DE number 1548491

Publication date 4 January 2001

Black-Scholes formula exotic options finite difference methods Itô calculus martingale method Monte Carlo methods partial differential equations portfolio optimization portfolio problem pricing of options stochastic control method tree methods

Mathematics Subject Classification ID

Martingales with continuous parameter (60G44) Stochastic integrals (60H05) Applications of stochastic analysis (to PDEs, etc.) (60H30) Applications of statistics to actuarial sciences and financial mathematics (62P05) Research exposition (monographs, survey articles) pertaining to game theory, economics, and finance (91-02) Portfolio theory (91G10) Derivative securities (option pricing, hedging, etc.) (91G20) Numerical methods (including Monte Carlo methods) (91G60) Financial applications of other theories (91G80) Optimal stochastic control (93E20)

Review text

[For a review of the German original (1999) see Zbl 0924.90020).] The financial markets introduced more and more types of derivatives often having very complex structures. For their quantitative valuation it is essential to have a sound knowledge of mathematical models for financial markets and to be able to handle the corresponding mathematical toolbox. Here, the most important tool has become the Itô calculus. One aim of this book is a fast and at the same time rigorous introduction to Itô calculus. This introduction is tailored to applications in financial mathematics. Based on this introduction, the standard diffusion type security market model is built up in Chapter 2 called ``The Continuous-Time Market Model. The first major problem in finance, the pricing of options, is treated in detail in Chapter 3 entitled ``Option Pricing. It starts by introducing the method of option pricing via replication and no arbitrage. This approach is based on the principle that the price of an option should be exactly equal to the amount of money needed to create the option's payments synthetically. The method to price options with partial differential equations which is the original approach taken by Black and Scholes is also presented. It is necessary to mention that R. Merton and M. Scholes were awarded the Nobel Prize in economics for their work contributing to the Black-Scholes formula. In recent years many new types of options, so-called exotic options, appeared at the market and also inspired the research. Numerous examples of such options are presented in this book, some of them with explicit pricing formulas. For obtaining prices for exotic options where an explicit pricing formula cannot be found, numerical methods are needed. Therefore, in Chapter 4 ``Pricing of Exotic Options and Numerical Algorithms, the basics of Monte Carlo methods, tree methods, and finite difference methods, are described. Finally, another problem in finance is to optimize the investment and consumption strategies, the so-called portfolio problem. This subject is treated in Chapter 5 entitled ``Optimal Portfolios, where the martingale method and the stochastic control method for portfolio optimization are described. As a very recent application, a portfolio problem where only trading in options is allowed, is also included. The main parts of this important book are based on probabilistic methods and results because modern financial mathematics is related to various mathematical fields. For understanding most parts of this book a basic course in probability theory is sufficient.

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