Python for Finance, 2nd Edition

Chapter 17. Valuation Framework

Compound interest is the greatest mathematical discovery of all time.

Albert Einstein

This chapter provides the framework for the development of the DX library by introducing the most fundamental concepts needed for such an undertaking. It briefly reviews the Fundamental Theorem of Asset Pricing, which provides the theoretical background for the simulation and valuation. It then proceeds by addressing the fundamental concepts of date handling and risk-neutral discounting. This chapter considers only the simplest case of constant short rates for the discounting, but more complex and realistic models can be added to the library quite easily. This chapter also introduces the concept of a market environment—i.e., a collection of constants, lists, and curves needed for the instantiation of almost any other class to come in subsequent chapters.

The chapter comprises the following sections:

“Fundamental Theorem of Asset Pricing”

This section introduces the Fundamental Theorem of Asset Pricing, which provides the theoretical background for the library to be developed.

“Risk-Neutral Discounting”

This section develops a class for the risk-neutral discounting of future payoffs of options and other derivative instruments.

“Market Environments”

This section develops a class to manage market environments for the pricing of single instruments and portfolios composed of multiple instruments.

Fundamental Theorem of Asset Pricing

The Fundamental Theorem ...