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Preface xiii PART I DISCRETE-TIME MODELS 1 1. Introduction to StatePricing 3 A. Arbitrage and State Prices 3 B. Risk-Neutral Probabilities 4C. Optimality and Asset Pricing 5 D. Efficiency and Complete Markets 8 E.Optimality and Representative Agents 8 F. State-Price Beta Models 11Exercises 12 Notes 17 2. The Basic Multiperiod Model 21 A. Uncertainty 21B Security Markets 22 C. Arbitrage, State Prices, and Martingales 22 D.Individual Agent Optimality 24 E. Equilibrium and Pareto Optimality 26 F.Equilibrium Asset Pricing 27 G. Arbitrage and Martingale Measures 28 H.Valuation of Redundant Securities 30 I. American Exercise Policies andValuation 31 J. Is Early Exercise Optimal? 35 Exercises 37 Notes 45 3 TheDynamic Programming Approach 49 A. The Bellman Approach 49 B. First-OrderBellman Conditions 50 C. Markov Uncertainty .51 D. Markov Asset Pricing 52E. Security Pricing by Markov Control 52 F. Markov Arbitrage-Free Valuation55 G Early Exercise and Optimal Stopping 56 Exercises 58 Notes 63 4. TheInfinite-Horizon Setting 65 A. Markov Dynamic Programming .65 B. DynamicProgramming and Equilibrium.69 C. Arbitrage and State Prices 70 D.Optimality and State Prices.71 E. Method-of-Moments Estimation .73Exercises 76 Notes 78 PART 11 CONTINUOUS-TIME MODELS 81 5. TheBlack-Scholes Model 83 A. Trading Gains for Brownian Prices 83 B.Martingale Trading Gains 85 C. Ito Prices and Gains 86 D. Ito's Formula 87E. The Black-Scholes Option-Pricing Formula 88 F. Black-Scholes Formula:First Try 90 G. The PDE for Arbitrage-Free Prices 92 H. The Feynman-KacSolution 93 I. The Multidimensional Case 94 Exercises 97 Notes 100 6.State Prices and Equivalent Martingale Measures 101 A. Arbitrage 101 B.Numeraire Invariance 102 C. State Prices and Doubling Strategies 103 D.Expected Rates of Return 106 E. Equivalent Martingale Measures 108 F. StatePrices and Martingale Measures 110 G. Girsanov and Market Prices of Risk 111H. Black-Scholes Again 115 I. Complete Markets 116 J. Redundant SecurityPricing 119 K. Martingale Measures from No Arbitrage 120 L. ArbitragePricing with Dividends 123 M. Lumpy Dividends and Term Structures 125 N.Martingale Measures, Infinite Horizon 127 Exercises 128 Notes 131 7.Term-Structure Models 135 A. The Term Structure 136 B. One-FactorTerm-Structure Models 137 C. The Gaussian Single-Factor Models 139 D. TheCox-Ingersoll-Ross Model 141 E. The Affine Single-Factor Models 142 F.Term-Structure Derivatives 144 G. The Fundamental Solution 146 H.Multifactor Models 148 1. Affine Term-Structure Models 149 J. The HJM Modelof Forward Rates 151 K. Markovian Yield Curves and SPDEs 154 Exercises 155Notes 161 8. Derivative Pricing 167 A. Martingale Measures in a Black Box167 B. Forward Prices 169 C. Futures and Continuous Resettlement 171 D.Arbitrage-Free Futures Prices 172 E. Stochastic Volatility 174 F. OptionValuation by Transform Analysis 178 G. American Security Valuation 182 H.American Exercise Boundaries 186 1. Lookback Options 189 Exercises 191Notes 196 9. Portfolio and Consumption Choice 203 A. Stochastic Control 203B. Merton's Problem 206 C. Solution to Merton's Problem 209 D. TheInfinite-Horizon Case 213 E. The Martingale Formulation 214 F. MartingaleSolution 217 G. A Generalization 220 H. The Utility-Gradient Approach 221Exercises 224 Notes 232 10. Equilibrium 235 A. The Primitives 235 B.Security-Spot Market Equilibrium 236 C. Arrow-Debreu Equilibrium 237 D.Implementing Arrow-Debreu Equilibrium 238 E. Real Security Prices 240 F.Optimality with Additive Utility 241 G. Equilibrium with Additive Utility243 H. The Consumption-Based CAPM 245 I. The CIR Term Structure 246 J. TheCCAPM in Incomplete Markets 249 Exercises 251 Notes 255 11. CorporateSecurities 259 A. The Black-Scholes-Merton Model 259 B. Endogenous DefaultTiming 262 C. Example: Brownian Dividend Growth 264 D. Taxes and BankruptcyCosts 268 E. Endogenous Capital Structure 269 F. Technology Choice 271 G.Other Market Imperfections 272 H. Intensity-Based Modeling of Default 274I. Risk-Neutral Intensity Process 277 J. Zero-Recovery Bond Pricing 278 K.Pricing with Recovery at Default 280 L. Default-Adjusted Short Rate 281Exercises 282 Notes 288 12. Numerical Methods 293 A. Central LimitTheorems 293 B. Binomial to Black-Scholes 294 C. Binomial Convergence forUnbounded Derivative Payoffs 297 D. Discretization of Asset Price Processes297 E. Monte Carlo Simulation 299 F. Efficient SDE Simulation 300 G.Applying Feynman-Kac 302 H. Finite-Difference Methods 302 I. Term-StructureExample 306 J. Finite-Difference Algorithms with Early Exercise Options 309K. The Numerical Solution of State Prices 310 L. Numerical Solution of thePricing Semi-Group 313 M. Fitting the Initial Term Structure 314 Exercises316 Notes 317 APPENDIXES 321 A. Finite-State Probability 323 B.Separating Hyperplanes and Optimality 326 C. Probability 329 D. StochasticIntegration 334 E. SDE, PDE, and Feynman-Kac 340 F. Ito's Formula withjumps 347 G. Utility Gradients 351 H. Ito's Formula for Complex Functions355 I. Counting Processes 357 J. Finite-Difference Code 363 Bibliography373 Symbol Glossary 445 Author Index 447 Subject Index 457