Volatility ::

The Black-Scholes equation requires the knowledge of the spot rate r, the value of the underlying S(t) at time t (which is known at the current time) and most of all the value of the volatility of the underlying . ut of the a!ove, the volatility is the most difficult estimate. ne method is to use past data on the volatility of the underlying to estimate future ones. "mpirically it has !een o!served that the !est estimates are given !y considering historical data in an interval , long as the maturity time T of the option. # !etter approach is to estimate it directly from the market option quotes. This implied volatility is calculated numerically given that the option value $(S,t) is

where

and

%enerally the implied volatility gives a !etter estimate than that o!tained !y historical data. The implied volatility is found to !e a function of !oth strike price and maturity. The longer the time to maturity, the larger the risk taken and thus the larger the implied volatility.

The most common dependence with strike price is given !y a volatility smile (red curve in the figure a!ove), where the volatility is minimum when the strike price is given !y the initial value of the underlying. ther dependences such as volatility frowns (blue curve) and smirks (green) are also o!served.

#nother approach of dealing with volatility is to assume that it follows a Stochastic &ifferential "quation (S&"s). 'e can follow a type of Black Scholes derivation (see article). So we have our usual log normal S&" and one other for the volatility.

The two Brownian motions are correlated such that , where ( is a measures the correlation. #ssuming that the functions p and q are given, how do we form a riskless portfolio) 'e need to hedge our option *(S,t). Since we cannot hedge against , !ecause it is not offered in the market, we need to hedge against another option on the same underlying S. So as usual we create our hedging portfolio .

By +to,

where our notation we have that

denotes a partial derivative of * w.r.t. to time...,etc. -rom the S&"s

'e su!stitute these relations into the a!ove e.pansion for d* and a similar one for . Su!stituting these into the e.pression for the change in portfolio value, given !y

we find that to remove the randomness of the Brownian motion we need to choose

which gives

/ow we can use the no ar!itrage condition to equate investing in a !ank at a fi.ed rate r.

to the riskless return of

'e are then left with a risk neutral partial differential equation (0&") involving partial derivatives of * and . &efining the differential operator such that

the final 0&" can !e e.presses as follows,

The left hand side is a function of * !ut not of , and vice versa for the right hand side. This means that since the two options will in general have different strike price and maturity dates, this equality holds if !oth sides are independent of the contract specifications. 'e can thus equate this to a function of the independent quantities S, and t. -or some ar!itrary function (S, ,t) we have that

is called the risk neutral drift rate of volatility, whilst the function the market price of risk volatility (articles to follow).

is called

Black-Scholes for Dividend Paying Assets

ur previous derivation of the Black-Scholes equation assumes assets to !e non-dividend paying throughout their ownership. +n reality assets do pay dividends,making them attractive investments. The price of the asset is largely reflectant of future and past payouts. # dividend is a share of the operating profits paid out to the shareholders at regular intervals. +f an organisation fails to make a profit, then no dividend payout out is make for that period. The frequency and dates of the dividend payments vary from one organisation to another. &ividends must !e considered in pricing derivatives on dividend paying assets (e.g. shares in a company) since after each dividend payment the price of the asset drops !y the dividend amount. &ividend forcasting is an art in itself and very crucial to pricing derivatives. 'hen including dividend payments in the Black-Scholes treatment we must ask ourselves two question, 1) 2ow large are the payments) 3) #t what date and how often are they paid out) The second of these two points opens the door to a more interesting question from a mathematical perspective. &oes one use a continous or discrete approach) -or practical reasons,most dividend payments are discretised to set intervals. +f the intervals are small enough, one can approach a continous limit. The closest e.ample to a continous dividend paying asset is money earnt on an interest !earing account.

#ssuming our asset to have continous dividend payments, we define the dividend yield as the proportion of asset price S paid out per unit time. Therefore, in time ,a payment of is made. The random walk for the asset price !ecomes

is a constant in this case. This will alter our Black-Scholes 0&" to

ur final conditions remain unchanged,

for a call option,and

for a put option. Boundary conditions for a call option !ecome

as !efore,and

as

/ote, if , then we recover our previous !oundary condition where the option is worth the asset price. Similarly, the !oundary conditions for a put option on a dividend paying asset are

and

as

The Black-Scholes equation for a dividend paying asset is solved the same way as the nondividend paying one, replacing r !y .

Thus,the value of a "uropean call option !ecomes

where

and

is as previously defined).

he !reek "etters - Delta ::

The %reek 4etters or simply the 5%reeks5 are quantities representing the market sensitivities of the options or other derivatives. "ach %reek measures a different aspect of the risk in an option position. Through understanding and managing these %reeks, market makers, traders, financial institutions and portfolio managers can manage their risks appropriately, whether they deal in T$ or e.change-traded options. Delta The delta of an option is defined as the rate of change of the option price w.r.t. the price of the underlying asset. The delta of an option dependent on a single asset S is mathematically e.pressed as,

-or a "uropean call option on a non-dividend-paying underlying, the value of the option is,

-or a "uropean call option on a non-dividend-paying share,

Since

/ow

i.e.

This gives

&eltas for call options are always positive, which means that a long (!uy)call should !e hedged with a short (sell) position in the underlying, and vice versa. Similarly, for a "uropean put option of the same underlying, delta is given !y,

&eltas for put options are always negative, which means that a long putshould !e hedged with a long position in the underlying, and vice versa. &elta is !etween 6 and 71 for calls and !etween 6 and -1 for puts. The delta for the underlying is always 1. # put option with a delta of 6.8 will drop 96.8 in price for each 91 rise in the underlying (i.e. increasingly out-of-the-money), a call option with the same delta will rise 96.8 instead (i.e. increasingly in-the-money).

Delta #edging +f, for e.ample, the share price is 916 and the call option price is 91 and the delta of the call option is 6.8, an investor who has sold 13 call option contracts (options to !uy 1,366 shares) can delta-hedge his:her position !y !uying 6.8 . 1,366 ; <66 shares. # rise in share price will produce a loss of 6.8 . 1,366 ; 9<66 on the call options !ut a gain of 9<66 on the shares. The delta of the portfolio can !e determined !y adding up all his:her positions.The delta of the short option position is -6.8 . 1,366 ; -<66 and delta of the long share position is 1 . <66 ; <66,thus his:her position has a delta of =ero, this is referred as !eing delta neutral. >nfortunately, delta-hedging only works for a short period of time during when delta of the option is fi.ed. The hedge will have to !e read?usted periodically to reflect changes in delta, which could !e affected !y the share price, time to e.piry, risk-free rate of return and volatility of the underlying. Below we show how delta changes with the underlying share price and time to e.piry. Variation of Delta with Share Price *ariation of &elta with share price (S) for "uropean option on a non-dividend-paying share with strike price of @. 2ere one can see that delta for in-the-money options is very close to one and =ero for out-of-the-money options.

Variation of Delta with

ime to $%piry

*ariation of &elta with Time to ".piry (T) for "uropean option on a non-dividend-paying share with strike price of @. &ed, Blue and !reen lines denote out-of-the-money, at-themoney and in-the-money options respectively.