Derivatives and Risk

Management

Marta Wisniewska
[email protected]

WSB Gdańsk
Derivatives and Risk Management: Introduction Marta Wisniewska

 Module Outline

 Literature

 Grading
Derivatives and Risk Management: Introduction Marta Wisniewska

RISK
MANAGEMENT DERIVATIVES

USE OF DERIVATIVES
& RISK MANAGEMENT
PRICING OF
DERIVATIVES
Derivatives and Risk Management: Introduction Marta Wisniewska

PV Valuation: e.g. DCF, DDM

Value of an asset PV of Cash Flows the asset is producing

Value of a derivative At what price there is no arbitrage?

No Arbitrage Valuation
Derivatives and Risk Management: Introduction Marta Wisniewska

The purpose of this module is to discuss how derivaties can

be used to manage financial risk.

We will be analyzing:
 the impact of using derivaties
 and the pricing of derivaties.
Derivatives and Risk Management: Introduction Marta Wisniewska

Risk…

…something different than expected

Derivatives…

…financial assets whose value depend of value of

underlying asset (the value of an asset is derived from
value of another asset)
 Derivatives and Risk Management: Introduction Marta Wisniewska

DATE TITLE TEXTBOOK

Introduction to Risk Management

24 Sept Bonds, Interest Rates and Swaps ch 1, 4, 7

Futures and Forwards

25 Sept Introduction to Options ch 3, 5-6, 9-11

8 Oct Option Valuation ch 12, 14

The Greeks & Hedging

Value at Risk
9 Oct American Options & Dividends ch 10, 12, 18

Real Options
6 Nov TEST ch 34
Derivatives and Risk Management: Introduction Marta Wisniewska

Hull, J. C. (2012): Options,

Futures and Other
Derivatives, 8th Edition,
Pearson
LECTURE NOTES
or earlier eddition
Available in the liberary and online:
www.witor.biz/drm
Derivatives and Risk Management: Introduction Marta Wisniewska

Grading

TEST: 100%
 Not multiple choice
 You will need perform calculations
 …and interpret the numbers (e.g. hedging)

 Section 1:
 Option Question
 60%

 Section 2:
 Answer 2 out of 3 questions
 40%

see Exam Paper 2015

Derivatives and Risk Management: Introduction Marta Wisniewska

?
Lecture 1:

1. Introduction
2. Bonds, Interest
Rates and Swaps
1. Introduction to
Risk Management
Introduction to Risk Management

DEBT
EQUITY
Financial markets facilitate the
transfer of funds between  Money
borrowers and lenders Market
 Capital
Market

Financial
LENDERS FUNDS FUNDS BORROWERS
Markets

Households Households
Businesses Businesses
Governments Governments
Foreigners Foreigners
To trade time & risk
 Introduction to Risk Management

Participants of the financial markets

 Hedgers reduce risk exposure

 Speculators
increase risk exposure

 Arbitrageurs
 Arbitrage: a trading strategy that allows making profits without any risk of loss
 Possible when instruments generating the same cash flow are sold at 2 different prices at
2 markets

All current methods of pricing derivatives utilize the notion of arbitrage.

Arbitrage pricing methods derive the prices of derivatives from conditions that preclude arbitrage
opportunities.
 Introduction to Risk Management

 Risk and exposure

 Why manage risk?

 Types of risk

 Risk management process

 Risk management instruments

 Misuse of derivatives
 Introduction to Risk Management Risk and exposure

What investors care about when making the investments?

 Return

 Risk

Risk-return trade off: the higher the risk the higher expected rate of return
 Introduction to Risk Management Risk and exposure

What is return (R)?

Income received (Dt) on an investment plus any change in the

market price (Pt – Pt-1), usually expressed as a percent of the
beginning market price of the investment.

𝑫𝒕 + 𝑷𝒕 − 𝑷𝒕−𝟏 simple return

𝑹=
𝑷𝒕−𝟏

𝑫𝒕 + 𝑷𝒕 logarithmic return
𝒐𝒓 𝑹 = 𝐥𝐧
𝑷𝒕−𝟏
additive properties
Introduction to Risk Management Risk and exposure
 Introduction to Risk Management Risk and exposure

What is risk?

In common language risk is viewed as something ‘negative’, as an

“exposure to danger or hazard”.

The Chinese symbols for risk (危機) combines danger and

opportunity.

In Finance Risk is something different than expected:

Traditionally risk measured by standard deviation of returns (σ), and
is referred to as volatility

𝜎= 𝑅𝑖 − 𝑅 2 𝑝𝑖
𝑖=1
 Introduction to Risk Management Risk and exposure

Normal distribution
68, 96, 99.7 rule
+/- 1 σ , +/- 2 σ , +/- 3 σ
What is risk?

Low Variance Investment

Probability
High Variance Investment

NO RISK

Expected Return
 Introduction to Risk Management Risk and exposure

Is volatility the best

measure of risk?

What is risk?

Capital Asset pricing model (CAPM) assumes that investors hold well diversified
portfolios, thus they care only about exposure towards market risk and not the total risk.

Factors unique to a particular company

or industry. For example, the death of a
key executive or loss of a governmental
defense contract.
𝑛
Factors such as changes
STD DEV OF PORTFOLIO RETURN

in nation’s economy, tax 𝑅𝑝 = 𝑅𝑖 𝑤𝑖

reforms, or a change in 𝑖=1
the world situation.
Unsystematic risk
𝑛
Total (Unique risk)
𝜎𝑝2 = 𝜎𝑖2 𝑤𝑖2 + 2 𝑤𝑖 𝑤𝑗 𝜎𝑖 𝜎𝑗 𝜌𝑖𝑗
Risk 𝑖=1 1≤𝑖<𝑗≤𝑛

Systematic risk
(Market risk)

NUMBER OF SECURITIES IN THE PORTFOLIO

This exposure is measure by beta (β)

𝐶𝑜𝑣 𝑅𝑀 , 𝑅𝑖
𝑅𝑖 = 𝑅𝐹 + 𝛽𝑖 𝑅𝑀 − 𝑅𝐹 𝛽𝑖 = 2 𝜎𝑖2 = 𝛽𝑖2 𝜎𝑀
2 2
+ 𝜎𝑟𝑒𝑠𝑖𝑑
𝜎𝑀
 Introduction to Risk Management Risk and exposure

Does CAPM hold?

Testing CAPM 𝑅𝑖 = 𝑅𝐹 + 𝛽𝑖 𝑅𝑀 − 𝑅𝐹

. regress rbar beta sig, robust

Linear regression Number of obs = 101

F( 2, 98) = 2.54
Prob > F = 0.0838
R-squared = 0.1040
Root MSE = .00047

------------------------------------------------------------------------------
| Robust
rbar | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
beta | -.0005175 .0002296 -2.25 0.026 -.0009732 -.0000618
sig | .0327825 .0169871 1.93 0.057 -.000928 .0664929
_cons | .0002485 .0001712 1.45 0.150 -.0000912 .0005881
------------------------------------------------------------------------------
no idiosyncratic risk
 Introduction to Risk Management Risk and exposure

Does CAPM hold?

Testing CAPM NO

. regress rbar beta beta2, robust

Linear regression Number of obs = 101

F( 2, 98) = 2.28
Prob > F = 0.1081
R-squared = 0.0763
Root MSE = .00048

------------------------------------------------------------------------------
| Robust
rbar | Coef. Std. Err. t P>|t| [95% Conf. Interval]
-------------+----------------------------------------------------------------
beta | .0009477 .0004908 1.93 0.056 -.0000264 .0019217
beta2 | -.0004873 .0002336 -2.09 0.040 -.0009509 -.0000236
_cons | .0000256 .0002206 0.12 0.908 -.0004122 .0004634
------------------------------------------------------------------------------
quadratic relation
 Introduction to Risk Management Risk and exposure

Is volatility the best

measure of risk?

What is risk?

Value at Risk (VaR)

‘We are X percent sure there will not be a loss of more than VaR in the next N days’.
Focus on downside.

Example: If N = 5 and X = 97 what is the VaR?

VaR is a 3rd percentile of

the distribution of gain in
the value of the portfolio
p = (100 - X)% = 3% in the next 5 days.
 Introduction to Risk Management Risk and exposure

Exposure: state of having

Exposure Example: no protection from
Investment Appraisal: Sensitivity Analysis something risky

Today you can buy a machine for £350 000.

Thanks to this machine, in the next 10 years, you can produce t-shirts.
Assume that you know the following about cash flows in years t0 - t10:
 Sales volume: 20 000 units per year
 Sales price: £ 8.50 per unit
 Variable cost: £ 3.50 per unit
 Fixed costs: £ 24 875 per year

time t0 t1 t2 … t10
Machine -350 000 0
Cash Flows CF1 CF2 … CF10
Should you buy
the machine?

Is NPV positive?
Under what
assumptions
 Introduction to Risk Management Risk and exposure
Cash Flows in years t1-t10:
 Sales volume: 20 000 units per year
Exposure Example:  Sales price: £ 8.50 per unit
 Variable cost: £ 3.50 per unit
Investment Appraisal: Sensitivity Analysis  Fixed costs: £ 24 875 per year

Cost of capital 15%

time t0 t1 t2 … t10
Machine -350 000 0
Cash Flows CF1 CF2 … CF10

 Since every year we receive constant cash flow (=CF):

𝐶𝐹 = 20 000 × 8.5 − 3.5 − 24 875 = 75 125

 Therefore to calculate the NPV the annuity formula can be used:

75 125 1
NPV = −350 000 + 1− What happens to NPV if there is
0.15 1 + 0.15 10
= 27 035 change in production costs?
 1st derivative of NPV with respect to chosen factor (exposure) tells us how
much NPV will change if the value of chosen factor changes by 1 unit.
𝜕𝑁𝑃𝑉 −20 000 1
= 1− 10
𝜕𝑉𝐶 0.15 1 + 0.15
If variable cost increases by £1, Approx. 12%
= −133 333 × 0.752815 the NPV decreases by £100 change in VC
375.37 to £-73 340, 37 (= 27 035 - leads to
= −100 375.37 100 375.37). negative NPV
 Introduction to Risk Management Risk and exposure

Exposure Example: What are the sources of

Exposure?
Investment Appraisal: Sensitivity Analysis

Today you can buy a machine for £350 000.

Thanks to this machine, in the next 10 years, you can produce t-shirts.
Assume that you know the following about cash flows in years t0 - t10:
 Sales volume: 20 000 units per year
 Sales price: £ 8.50 per unit price of cotton (in USD)
 Variable cost: £ 3.50 per unit USD/GBP exchange rate
 Fixed costs: £ 24 875 per year …

time t0 t1 t2 … t10 time

Machine -350 000 0

Cash Flows CF1 CF2 … CF10

Cost Factors Income

Introduction to Risk Management Why manage risk?

Cotton price
exposure
Introduction to Risk Management Why manage risk?

FX exposure
Currency Risk
Introduction to Risk Management Why manage risk?

Interest Rate exposure

Interest Rate Risk
Introduction to Risk Management Why manage risk?

Interest Rate exposure

Interest Rate Risk
Introduction to Risk Management Why manage risk?

Market exposure
Market Risk
Introduction to Risk Management Why manage risk?

Oil Prices exposure

Oil Prices Risk
 Introduction to Risk Management Why manage risk?

Why manage risk?

Exposure to risk factors can affect:

The valuation of the project
The valuation of the asset
The value of the whole company

Decision not to manage an expose is a speculation

Yet such speculation is not necessary a bad thing!

Always consider your situation vs. your competitors and the industry standard
 Introduction to Risk Management Types of risk

Classification These classifications are

somewhere arbitrary
1. Diversifiability (some risks overlap)
 Systematic
 Unsystematic One company faces
various types of risks,
some more important
2. Event driven definition of risk than others
What can he do?
Business risk Non-business risks

Business decisions Financial risk Other risks

Strategic risk
Market risk, liquidity Reputational
Product, marketing, risk risk
organization
Credit risk Regulatory,
Business environment political risk
Operational risk
Macroeconomics

Competition,
technology
Jorion P.,(2007) Value at Risk
Introduction to Risk Management Risk management process

What is risk Assuring an

management? outcome

Low Variance Investment

Probability
High Variance Investment

NO RISK

Expected Return

How to assure
outcome?
 Introduction to Risk Management Risk management process

How to assure
outcome?

Reduce
 Reduce the probability that the event will occur
 Reduce the impact if the event does occur

Transfer
 Transfer the cost of an undesirable outcome to someone else

Avoid
 Completely avoid potential events thus providing a zero probability that
they will occur

Do Nothing
 Let the risk happen and be ready to bear the consequences
 Introduction to Risk Management Risk management process

Reduce
Price Risk

What Happens to the Distribution When You Have a Floor Price at $40?

40 100 140

Oil producer
 Introduction to Risk Management Risk management process

Reduce
Price Risk

What Happens to the Distribution When you Establish a Short Fence from
$100 to $140 ?

Via use of
How to derivatives
achieve this?
 Introduction to Risk Management Risk management process

Reduce
Production Risk

Risk: of a poor weather event causing the undesirable outcome of lower than
expected yields

wheat yields
95 160 195

Reduce the cost of the risk via spatial location, multiple variety selection,
and other cropping practices.
 Introduction to Risk Management Risk management process

Transfer
Production Risk

Risk: of a poor weather event causing the undesirable outcome of lower than
expected yields

wheat yields
Transfer the cost 95 160 195
of the risk via
crop insurance
 Introduction to Risk Management Risk management process

Transfer
Financial Risk

Risk: higher interest rates causing the undesirable outcome of lower than expected
cash flow

Cash Flow
Transfer the risk
via fixed rate loans
 Introduction to Risk Management Risk management process

Reduce
Financial Risk

Risk: higher interest rates causing the undesirable outcome of lower than expected
cash flow

Cash Flow

Reduce the cost of the

negative impact via
lower debt financing
 Introduction to Risk Management Risk management process

Risk management (RM) is the process by which various risk exposures are

identified,

measured, and

controlled.
 Introduction to Risk Management Risk management process

Phases risk management process:

1. Identify a company’s current risk profile and set a target risk profile.

2. Achieve the target risk profile by coordinating resources and executing

transactions (i.e. reduce, transfer, avoid, do nothing, or some
combination)

3. Evaluate the altered risk profile.

 Introduction to Risk Management Risk management process

RM process – phase 1

 Decompose corporate assets and liabilities into risk pools: interest rate, foreign
exchange, crude oil, etc.

 Develop market scenarios and test the impact of these on the values of the risk
pools and on the value of the company as a whole. This determines the
company’s “value at risk”.

 Develop a target risk profile, which may or may not include a complete elimination
of risk.
 Introduction to Risk Management Risk management process

RM process – phase 2

 This is the implementation phase.

 Many companies centralize their risk management activities.

 This allows for coordination and avoids unnecessary transactions.

Net
exposure
Division 1 Division 2
Exposed long to Polish interest Exposed short to Polish interest
rates. rates.
Has bank account in zloty. Has floating rate loan in zloty.
 Introduction to Risk Management Risk management process

RM process – phase 3

 This is the evaluation phase.

 Key questions to consider:

 Has the firm’s risk profile changed?
 Is the current risk profile still appropriate?
 What new economic and market scenarios should be considered in the next
iteration?
 Introduction to Risk Management Risk management process

Risk prioritization matrix

High
Act if cost Immediate
effective action
Probability of happening

No action Action
Low
required required

Small Catastrophic
Potential impact

Proximity
Introduction to Risk Management Risk management process

M&M

Risk management is an individual decision

R
i
s
k 2

 No one "right" decision R

e
v
en
ue

 The "right" decision depends on the characteristics of the

 operation and
 individual decision-maker
 Introduction to Risk Management Risk management instruments

Approaches/ Actions Instruments

derivatives
Hedge/ Sell
Eliminate/ Avoid

Diversify

Transfer Insure

Set policy
Absorb/ Manage

Hold capital
 Introduction to Risk Management Risk management instruments

A derivative is a financial instrument whose value derives from (depends on) the value of
something else (underlying asset).

 Forward/ Futures contracts

 A forward/futures contract is an agreement between two parties, a buyer and a seller, to exchange
an asset at a later date for a price (delivery/ futures price) agreed to in advance, when the contract is
first entered into
 Forwards OTC
 Futures exchange traded

 Options
 An option gives the buyer the right, but not the obligation, to buy/sell the underlying at a later date
for a price (strike or exercise price) agreed to in advance, when the contract is first entered into.

 Call option: an option to buy the underlying at the strike price

 Put option: an option to sell the underlying at the strike price

 The option buyer pays the seller a sum of money called the option price or premium.
 OTC and exchange traded.

 Swaps
 Swap is an over-the-counter agreement to exchange cash flows in the future.
 Introduction to Risk Management Risk management instruments

EXAMPLE:

Consider a British fund manager with a portfolio of U.S. equities.

 If he buys IBM shares, he is exposed to three risks:

EXPOSURE
 Prices in the U.S. equity market generally.
 The price of IBM stock specifically.
 The dollar/sterling exchange rate.

Believes
 He is bearish about:
 The dollar’s medium-term prospects.
 The overall U.S. stock market.

Action

 To hedge the currency risk, he could sell dollars under the terms of a forward contract

 To hedge the market risk, he could short futures contracts on the S&P 500 index.

 He would be left with exposure to IBM’s share price only.

 Introduction to Risk Management Risk management instruments

 Derivatives allow firms to:

 Separate out the financial risks that they face.
 Remove or neutralize the risk exposures they do not want.
 Retain or possibly increase the risk exposures they want.

Using derivatives, firms can transfer, for a price, any undesirable risk to other parties
who either have risks that offset or want to assume that risk.
 Introduction to Risk Management Risk management instruments

 Derivative markets have a long history.

 Futures markets: date back to the Middle Ages.
 Options markets: date back to 17th century Holland.

 Last 35 years: extraordinary growth worldwide: Derivative markets:

 Increased market volatility. The over-the-counter (OTC) market
 Deregulation of markets. The exchanges
 Globalization of business

M. Wisniewska Derivatives and Financial Risk Management, Spring 2016 55/54

 Introduction to Risk Management Risk management instruments

Leverage

 Leverage is the ability to control large amounts of an underlying asset with a

comparatively small amount of capital.

 As a result, small price changes can lead to large gains or losses.

 Leverage makes derivatives:

 Powerful and efficient
 Potentially dangerous
 Introduction to Risk Management Risk management instruments

EXAMPLE: LEVERAGE WITH OPTIONS

 It is May.

 The price of XYZ stock is £28.30.

 A December call option on XYZ stock with a £29 strike price is selling for £2.80.

 A speculator thinks the stock price will rise.

 To make a profit, the speculator might:

 Buy, say, 100 shares of XYZ stock for £2,830.
 Buy 1,000 options (10 option contracts on 100 shares each) for £2,800,
(roughly the same amount of money).
 Introduction to Risk Management Risk management instruments

EXAMPLE: LEVERAGE WITH OPTIONS Cont

 Suppose the speculator is right. The stock price rises to £33 by December.

Strategy Profit
Buy the stock £33 − £28.3 × 100 = £470
Buy options £33 − £29 × 1000 − £2800
= £1200
 Introduction to Risk Management Risk management instruments

EXAMPLE: LEVERAGE WITH OPTIONS Cont

 Suppose the speculator is wrong. The stock price falls to £27 by December.

Strategy Loss
Buy the stock £28.3 − £27 × 100 = £130
Buy options £2800
 Introduction to Risk Management Misuse of derivatives

Entity Date Instrument Loss ($million)

Orange County, California Dec.1994 Reverse repos 1 810

 Local government fund

 Bob Citron (county treasurer)

 $7.5 million own money + $12.5 borrowed (via reverse repos)

 Invest money in agency notes with average maturity of 4 years
 Short-term funding of mind-term investment
 Works if rates are falling

 Since Feb 1994 rates started to hike

 Margin calls
 Dec 1994 investors tried to pull out money margin
 Fund defaulted on margin payments call
 Orange County declared bankruptcy
 Introduction to Risk Management Misuse of derivatives

Entity Date Instrument Loss ($million)

Metallgesellschaft, Germany Jan. 1994 Oil futures 1 580

 Germany’s 14th largest industrial group

 58 000 employees

 US subsidiary (MG Refinig & Marketing) offered long-term contracts for oil products
 By 1993 180 million barrels of oil sold to be supplied over a period of 10 years
 Short-term futures & rolling hedge
 Long term exposure hedged via series of short-term contracts (3months maturity)

 In 1993 oil prices fell from $20 to $15, leading to billion $ margin calls
 German parent company exchanges the US subsidiary management and closed the
positions at a loss
 Creditor stepped in with $2.4 billion rescue package
 Stock price dropped form 64 to 25 DM margin
call
 Introduction to Risk Management Misuse of derivatives

Entity Date Instrument Loss ($million)

Barings, UK Feb. 1995 Stock index futures 1 330

 233 year old bank

 28-year old trader Nicholas Leeson

 Large exposure to the Japanese stock market (via futures)

 Baring’s position in Nikkei 225 added up to $7 billion
 Jan&Feb 1995 market fell by 15%, which lead to large losses
 Yet the exposure was increased
 23 Feb Nicholas Lesson walked out of his job

 The bank went bankrupt

 Nicholas went to jail (43 months), then worked as an accountant for Galway United
Football Club
 Introduction to Risk Management Misuse of derivatives

Lessons for Derivative users

Define the risk limits

Do not assume you can outguess the market
Do not underestimate the benefits of diversification
Carry out scenario analysis
Monitor traders carefully
Do not ignore liquidity risk
Short-term funding might create liquidity problems
Make sure you understand the trades you are doing
Make sure a hedger doesn't become a speculator
 Introduction to Risk Management

 Risk and exposure

 Why manage risk?

 Types of risk

 Risk management process

 Risk management instruments

 Misuse of the derivatives

2. Bonds Interest
Rates and Swaps
 Bonds, Interest Rates and Swaps

Interest  Various Interest Rates, Risk Free Rate Proxy

Rates  Measuring Interest Rates, Zero Rates

 Zero-coupon bonds and coupon paying bonds

 The yield curve and the term structure of interest
rates
Bonds
 Duration, Convexity
 Interest Rate Risk and Immunisation of Bonds
Portfolios

 Comparative Advantage
Swaps  Swap Design
 Valuation of Swaps
 Bonds, Interest Rates and Swaps Interest Rates

An interest rate quantifies the amount of money borrower pays the lender.

 The interest rate depends on: (a) the credit risk of the borrower, the higher the risk the higher the interest rate.
(b) the time to maturity

 Interest rates change in time.

 Bonds, Interest Rates and Swaps Interest Rates: Various Interest Rates
Defaults:
Various Interest Rates: Russia 1991 Mexico 1982
Argentina 2005
Treasury Rates  interest rates paid on Treasury bills and bonds USA 1862 UK 1932
 usually assumed that the risk of default is zero Sweden 1812 Germany 1948
 used a proxy of risk-free rate Denmark 1813
…and many many more

LIBOR  London Interbank Offered Rate

 quoted by British Bankers’ Association
Ask rate: how much
 for I want
maturities tomonths
up to 12 get from you if
in all major I deposit money with
currencies you
 at what rates banks make large wholesale deposits with each other
 (i.e. at what rate banks loan money to other banks)
LIBID  at what rates banks accept large wholesale deposits from other banks
Bid rate: how
 atmuch
any timeI want
LIBOR to
ratepay to you
> LIBID rate if you deposit money with me

Repo Rates  Repo or repurchase agreement

 Enter a contract where securities are sold and later repurchased at a higher price,
with the difference in price creating the interest rate (called repo rate)

Overnight  Overnight indexed swap is a swap where a fixed rate for a period is exchanged for
Indexed Swap the geometric average of the overnight rates during the period
Rate  The fixed rate is called the overnight indexed swap rate. Geometric average of a, b, c :
3
𝑎∗𝑏∗𝑐
 Bonds, Interest Rates and Swaps Interest Rates: Risk Free Rate Proxies

Risk-free Interest Rate

The rate is used in valuation of assets (eg. CAMP, or valuation of derivatives).

Rates used as a proxy of risk free rate in pricing derivatives

time
Overnight Index Swaps
Treasure Rates LIBOR (OIS)

 Believed to be at  Use Eurodollar futures  what next?

artificially low level and interest rate swaps
because of tax and to extend the risk-free
regulatory issues LIBOR curve beyond
12 months
 Financial crisis:
difficult to borrow
money at interbank
market
 Bonds, Interest Rates and Swaps Interest Rates: Risk Free Rate Proxies

Negative Interest Rate

Recently some central Banks adopted negative interest rates for cash ‘parked’ with them

To put more money into the market

June 2014 Dec 2014 29.01.2016

time

European Central Bank Swiss National Bank Bank of Japan

 Danish Central Bank  Rate on excess

 Swedish Central Bank reserves cut to
minus 0.1%
 Bonds, Interest Rates and Swaps Interest Rates: Measuring Interest Rates

Measuring Interest Rates

If Rc is a rate of interest with continuous compounding and Rm is the equivalent rate with compounding
m times per annum and A is the amount invested for n years, then:
𝑚𝑛
𝑅𝑚
𝐴𝑒𝑥𝑝 𝑅𝑐 𝑛 = 𝐴 1 +
𝑚

𝑅𝑚
thus: 𝑅𝑐 = 𝑚 ln 1 +
𝑚

and 𝑅𝑐
𝑅𝑚 = 𝑚 𝑒𝑥𝑝 −1
𝑚

Example: If semi-annually compounded rate is 10% what is the equivalent continuously compounded rate?
m=2 Rm = 0.1 Rc = ?
0.1
A = 2 ln 1 +
2
A = 0.09758
 Bonds, Interest Rates and Swaps Interest Rates: Zero Rates

Zero Rates

N-year zero-coupon rate is the rate earned on investment that starts today and last for n years,
with no intermediate payments and all the interest and principal realized at the end of n years.

Example: If today you invest £100 and in 5 years time you receive back £128.40 what is the continuously compounded
zero coupon rate (R)?

A 100 𝑒 𝑅∗5 = 128.4

128.4
A 5R = ln
100
= 0.24998

R = 0.049996
 Bonds, Interest Rates and Swaps Bonds: Definitions

Definitions

A bond is a contract that commits the issuer to make a definite sequence of payments until a
specified terminal date.

The payment made each period is known as the coupon.

The amount paid at the terminal date is the maturity value (par value, face value or bond’s principal).

Bonds are an example of fixed-income securities (like savings account) – you deposit money (`pay the price`) in
order to receive a certain stream of income (interest) at some fixed/certain dates.

Notation:
Date today, t
Maturity date, T
Maturity Value, m
Time to maturity: τ = T - t
Coupon, c
Price of bond today: p
The (annual) yield from holding the bond: y

Yield is a single discount rate that applied to all cash flows of the bond gives the price of the bond equal to its market price.
 Bonds, Interest Rates and Swaps Bonds: Zero-coupon Bonds

Zero-coupon bonds

A zero-coupon bond is one that pays m at the maturity date, and nothing else (i.e. c = 0).

Let yτ be the yield to maturity of the zero-coupon bond.

In this section
yτ is the constant annual rate of return that would be received if the bond was held until maturity. assume annual
compounding
Since it costs p to buy the bond today, and m is received after τ time periods, it must be the case that:

𝑝 1 + 𝑦τ τ =𝑚

Rearranging:
𝑚 Negative relationship between yield to
𝑝= τ
1 + 𝑦τ maturity and the bond price.

Restrictive monetary policy which increases

rf must increase y1, which in turn brings
Moreover:
1 about a fall in bond prices.
𝑚 τ
𝑦τ = −1
𝑝
 Bonds, Interest Rates and Swaps Bonds: Zero-coupon Bonds

Note that the curve that shows p as a function of yτ is:

 Negatively sloped (the higher the yield, the lower the price)
 Convex from below (for successive increases in the yield, the smaller are the reductions in price).
 Bonds, Interest Rates and Swaps Bonds: Yield Curve

The yield curve and the term structure of interest rates

Consider the yield to maturity yτ on zero-coupon bonds with different times to maturity τ.

A curve showing the relationship between yτ and τ is known as the yield curve.

The shape of the yield curve represents the term structure of interest rates.

Bootstrapping zero rates

Zero rates can be determined from Treasury bills and coupon-bearing bonds.

Example: What is the 1.5 year zero rate (R) if 0.5 year zero rate is 10.469%; 1 year rate is 10.536% and bond that
pays coupon of 4 every 6 months and lasts for 1.5 year with par of 100, sells for 96?

4𝑒 −0.10469∗0.5 + 4𝑒 −0.10536∗1 + 104𝑒 −𝑅∗1.5 = 96

𝑒 −1.5𝑅 = 0.85196

ln(0.85196)
𝑅=− = 0.10681
1.5
 Bonds, Interest Rates and Swaps Bonds: Yield Curve

Example of yield curve:

Assumptions:
 Linear between bootstrapping points
 Horizontal before the 1st and after the
last bootstrapping point.
 Bonds, Interest Rates and Swaps Bonds: Yield Curve

Example of yield curve:

The most important determinant of the shape of the yield curve is expectations of future movements of interest rates.
This dependence is summed up by the expectations hypothesis.
 Bonds, Interest Rates and Swaps Bonds: Yield Curve

Expectations hypothesis:

 Assume that the market consist of only two (zero-coupon) bonds: one year to maturity (short-term) and two years to
maturity (long-term). Suppose that initially, yields on the two bonds are equal.

 If the one-year yield is expected to rise next year, investors will have a preference for the one-year bonds, since they
will mature in one year, and the proceeds can be invested at one-year bonds commencing next year, at a higher rate.

 This preference would cause investors to sell two-year bonds and buy one-year bonds, bringing about a fall in the price
of two-year bonds, and a rise in the price of one-year bonds.
 In turn this will cause the yield on two-year bonds to rise above that of one-year bonds. The yield curve will have a
positive slope.

Therefore, theory predicts that if investors expect interest rates to rise, the yield curve will be positively sloped

Expectations of future
movements in the
interest rate can
therefore be deduced
from the slope of the
yield curve.

Conversely, if investors expect interest rates to fall, the yield curve will be negatively sloped.

Alternative explanations for the sign of the slope of yield curve:

(i) liquidity preference theory and
(ii) market segmentation theory.
 Bonds, Interest Rates and Swaps Bonds: Coupon-paying Bonds

Coupon-paying Bonds

Consider a bond that promises to pay a coupon of c per year for τ years, plus the maturity value m when the bond
terminates at maturity. Again price of the bond today is given by p.

This is equal to the present value of the future stream of payments arising if the bond is held to maturity:

𝑐 𝑐 𝑐 𝑐+𝑚
𝑝= + 2
+ 3
+ ⋯+
1+𝑦 1+𝑦 1+𝑦 1+𝑦 τ

The yield to maturity of this coupon-paying bond is defined as the value of y that solves the equation above.
 Bonds, Interest Rates and Swaps Bonds: Coupon-paying Bonds

Par Yield

Par yield (cp) for a certain maturity bond is the coupon rate that causes the bond price (p) equal
to its par value (m).

𝑐𝑝 𝑐𝑝 𝑐𝑝 𝑐𝑝 + 𝑚
𝑚= + 2
+ 3
+ ⋯+
1 + 𝑦1 1 + 𝑦2 1 + 𝑦3 1 + 𝑦τ τ
 Bonds, Interest Rates and Swaps Bonds: Coupon-paying Bonds: Duration

𝑐 𝑐 𝑐 𝑐+𝑚
𝑝= + 2
+ 3
+ ⋯+ Y = a + bX
1+𝑦 1+𝑦 1+𝑦 1+𝑦 τ
If X increases by 1 unit, Y
Macaulay Duration increases by b units

As for zero-coupon bonds, the price of a bond is a negative and convex function of its yield to maturity. For coupon-
paying bonds, the nature of this relationship is of considerable interest.

𝑑𝑝 𝑐 2𝑐 3𝑐 τ 𝑐+𝑚
=− − − − ⋯−
𝑑𝑦 1+𝑦 2 1+𝑦 3 1+𝑦 4 1 + 𝑦 τ+1
The above represents the responsiveness of p to y.

However, it is an unsatisfactory measure, because it depends on the units in which the bond is being measured.

We therefore use instead:

1 + 𝑦 𝑑𝑝 1 1 × 𝑐 2×𝑐 3×𝑐 τ× 𝑐+𝑚

𝐷=− = + + + ⋯+
𝑝 𝑑𝑦 𝑝 (1 + 𝑦) 1+𝑦 2 1+𝑦 3 1+𝑦 τ

MACAULAY DURATION An elasticity of price with respect to changes in yield.

𝑛 −𝑦𝜏𝑖
𝑖=1 𝑐𝑖 𝜏𝑖 𝑒
𝐷=
𝑝
We have also changed the sign so that the measure is positive.
 Bonds, Interest Rates and Swaps Bonds: Coupon-paying Bonds: Duration

Example: Suppose that a bond with maturity value m = £100 pays a coupon of c = £5 for two years (τ = 2). If y = 4%,
then the price of the bond is:
5 5 + 100
𝑝= + = 101.886
1 + 0.04 1 + 0.04 2
and the Macauley Duration is:

1 1×5 2 × (5 + 100)
𝐷= + = 1.953
101.886 (1 + 0.04) 1 + 0.04 2

Duration is so-called is because it is interpreted in the time dimension:

In the example, the time to maturity is τ = 2 years, and the Macauley Duration is somewhat less than 2 (i.e. ‘the average
time to payment’ is less than 2 years).

For coupon-paying bonds: For zero-coupon bonds: Duration measures how long on average the
holder of the bond needs to wait before receiving
cash payments.
𝐷<τ 𝐷=τ
D is a weighted average of the times at which
The higher the coupon, ceteris Entire payment is made after payments are received, with weights being equal
paribus, the lower the value of D. τ periods. to the proportion of the bond’s total present value
provided by the cash flow at time t (=1,.., τ).
 Bonds, Interest Rates and Swaps Bonds: Coupon-paying Bonds: Duration

Interest Rate Risk

Buying and selling bonds is not a risk-free activity. One type of risk is interest rate risk.

Interest rate risk reflects the impact of Central Bank monetary policy. If the Central Bank raises the cost of borrowing,
all bond yields are likely to rise, and therefore all bond prices will fall, so holders of bonds will suffer a loss.

Macauley Duration can be used as a measure of interest rate risk.

There is negative relationship between bond price p and bond yield y, that for small changes in y can be described by:

∆𝑝 𝐷∆𝑦
=− 𝑦
𝑝 1+𝑚
if y is expressed with compounding m times a year, or by:

∆𝑝
= −𝐷∆𝑦
𝑝
if y is expressed with continuous compounding.
 Bonds, Interest Rates and Swaps Bonds: Coupon-paying Bonds: Duration

Interest Rate Risk

Example: Bond that pays semi-annually coupon of £5 has 3 years to maturity and face value of £100. The yield to maturity is
0.12. The bond price is 94.213. What happens to the bond price if yield to maturity increases by 10 basis points (i.e. by 0.001)
and the duration is 2.653?

=A2/EXP(B2*$C$1) =(A2*B2)/EXP($C$1*B2)

∆𝑝 = −𝑝𝐷∆𝑦

= −94.213 ∗ 2.653 ∗ 0.001

= −0.24995

So the new bond price is:

=SUM(C2:C7)

94.213 − 0.24995 = 93.9631 =E8/C8

𝑛 −𝑦𝜏𝑖
𝑖=1 𝑐𝑖 𝜏𝑖 𝑒
𝐷=
𝑝
 Bonds, Interest Rates and Swaps Bonds: Coupon-paying Bonds: Duration

Interest Rate Risk

Example: Bond that pays semi-annually coupon of £5 has 3 years to maturity and face value of £100. The yield to maturity is
0.12. The bond price is 94.213. What happens to the bond price if yield to maturity increases by 10 basis points (i.e. by 0.001)
and the duration is 2.653?

Small change Larger change

 Bonds, Interest Rates and Swaps Bonds: Immunisation

Immunisation of Bond Portfolios

Immunisation strategies (a.k.a. neutral hedge strategies) can be used to eliminate interest rate risk.

They are used by organisations that have predictable liabilities, e.g. knowing that they will be paying a client £1m in 5 years
time. The principle of immunisation is:

Choose a bond portfolio that has the same overall Macauley Duration (D) as that of the liabilities.

Duration of the portfolio is a weighted average of duration on the bonds included in the portfolio, with weights being the
proportion of portfolio being allocated to particular bond.

Example: The contract to pay the client £1m in 5 years time clearly has D = 5 years.

The company could immunise by purchasing a zero-coupon bond with time to maturity 5 years and maturity value £1m
(which has the same D of 5 years). However, this assumes that such a bond is available to be purchased.

What the firm therefore needs to do is purchase a portfolio of bonds with overall Macauley Duration of 5 years. If two
bonds are available, bond 1 with D = 3 and bond 2 with D = 6, then the firm could immunise by purchasing a portfolio
consisting of bonds 1 and 2 in the proportion 1:2, since the overall D of this portfolio would be:

1×3+2×6
= 5
3
 Bonds, Interest Rates and Swaps Bonds: Convexity

Convexity

The duration relationship applies only to small changes in yields (it is a

linear measure).

Convexity (C) helps to improve to model the relationship for larger

changes in yields.

Convexity measure the curvature of how the price change as the yield change. Convexity can be measured as:

1 𝑑2𝑝
𝐶=
𝑝 𝑑𝑝2

in case of continuous compounding:

∆𝑝 1 2
= −𝐷∆𝑦 + 𝐶 ∆𝑦
𝑝 2
 Bonds, Interest Rates and Swaps Swaps

Swap is an agreement to exchange cash flows in the future.

 Most popular swaps are plain vanilla interest rate swap (where fixed rate on a given principal is exchanged for a
floating rate on the same principal) and fixed-for-fixed currency swaps.

 In interest rate swap the principle is not being exchanged (thus it’s called notional principle) and at every payment
date one party remits the difference between the two payments to the other side.

 Currency swap usually involves exchanging principle (both at the beginning and at the end of the swap) and
interest payments in one currency for principle and interest payments in the other currency.

 Most swaps are over the counter agreements.

 Bonds, Interest Rates and Swaps Swaps

Comparative advantage

Comparative advantage comes from the lack of constant spread on quotes offered on two products to two parties. One
party will have comparative advantage in one product, the other in the other.

Minimum Labour Hours Required  Portugal produces both products at a lower cost.
for Production  The difference is cost between 2 countries for cloth is
Commodity
10 (hours) and for wine is 40 (hours).
Cloth Wine
Portugal 90 80  Portugal has comparative advantage in Wine.
England 100 120  England has comparative advantage in Cloth.

 England produces 1 Cloth, brings it to Portugal and exchanges it for 1.125(= 1+ 10/80) Wine.
 The Wine is brought back to England…it is worth 1.35 (=(1.125*120)/100) Cloth.
 We are 0.35 Cloth better off.

 Portugal produces 1 Wine, brings it to England and exchanges it for 1.2 (= 1+20/100) Cloth.
 The Cloth is brought back to Portugal…where it is worth 1.35(=(1.2*90)/80) Wine.
 We are 0.35 Wine better off.
 Bonds, Interest Rates and Swaps Swaps

Comparative advantage

Who has a comparative advantage in fixed rate loan?

The difference in the spreads can lead to potential profit that could be exploited by a swap contract.
Total profit from swap: (2.5% - 1%) – (5% - 4%) = 1.5% - 1% = 0.5%

How much of the 0.5% each party gets? Depends on its bargaining power.

For example, each party is 0.25% better off.

5%

Company A Company B
LIBOR + 1% 5%

+ LIBOR + 2.25% LIBOR + 2.25% - LIBOR + 2.25%

- LIBOR + 1% + 5%
- 5% - 5%
Total: (-) 3.75% Total: (-) LIBOR + 2.25%
each company 0.25% better off
 Bonds, Interest Rates and Swaps Swaps

Comparative advantage

Who has a comparative advantage in fixed rate loan?

The difference in the spreads can lead to potential profit that could be exploited by a swap contract.
Total profit from swap: (2.5% - 1%) – (5% - 4%) = 1.5% - 1% = 0.5%

How much of the 0.5% each party gets? Depends on its bargaining power.

alternative design
4%
5%

Company A Company B
LIBOR + 1% 5%

+ LIBOR + 1.25% LIBOR+1.25%

LIBOR + 2.25% - LIBOR + 1.25%
- LIBOR + 1% + 4%
- 4% - 5%
Total: (-) 3.75% Total: (-) LIBOR + 2.25%
each company 0.25% better off
 Bonds, Interest Rates and Swaps Swaps

Comparative advantage

Financial intermediary netting out 0.1% and each company gets only 0.2%.

I
5% N 5%
T
E
LIBOR + 1% Company A R
Company B 5%
M
E
D
I
+ LIBOR + 2.20% LIBOR + LIBOR +
A - LIBOR + 2.30%
- LIBOR + 1% 2.20% 2.30%
R + 5%
- 5% Y - 5%
Total: 3.8% Total: LIBOR + 2.3%

Total: 0.1%
 Bonds, Interest Rates and Swaps Swaps

Valuation of Swaps

When swap is first initiated it is worth zero. The value of swap changes with time.

There are two valuation approaches of swaps:

(1) in terms of bond price or
(2) in terms of Forward Rate Agreements.

 Plain vanilla interest rate swap can be perceived as a difference between two bonds.
Therefore to the floating-rate payer, a swap can be seen as having a long position in a fixed-rate bond and a short
position in a floating rate bond. The value of the swap is determined by:

𝑉𝑠𝑤𝑎𝑝 = 𝐵𝑓𝑖𝑥 − 𝐵𝑓𝑙𝑒𝑥

 Currency swap can be valued as a difference between two bonds (in two different currencies D-domestic
currency, F-foreign currency, S0 spot exchange rate) that were converted to common currency:

𝑉𝑠𝑤𝑎𝑝 = 𝐵𝐷 − 𝑆0 𝐵𝐹

The above mentioned swaps can be also valued as the sum of the Forward Rate Agreements, where each FRA comes
from the exchange of cash-flows during the life of the swap and its maturity.
 Bonds, Interest Rates and Swaps

Interest  Various Interest Rates, Risk Free Rate Proxy

Rates  Measuring Interest Rates, Zero Rates

 Zero-coupon bonds and coupon paying bonds

 The yield curve and the term structure of interest
rates
Bonds
 Duration, Convexity
 Interest Rate Risk and Immunisation of Bonds
Portfolios

 Comparative Advantage
Swaps  Swap Design
 Valuation of Swaps
EXERCISE
Lecture 2:

3. Futures and
Forwards
4. Introduction
to Options
3. Futures and
Forwards
Forwards and Futures

 Definitions

 Payoffs from Forwards Contract

 Forward Prices

 Valuation of Forward Contracts

 Forward Rates

 Hedging
 Forwards and Futures Definitions

Underlying (asset): bond, stock, index, currency,

commodity (gold, oil, wheat)

Forward and future contracts are agreements to buy or sell an asset at a certain future time (the
maturity date) for a certain price (the delivery price).
They can be contrasted with a spot contract, which is an agreement to buy or sell an asset today.

One of the parties to the forward/future contract assumes a long

position and agrees to buy the asset at the future date at the
agreed price.

The other party assumes a short position and agrees to sell the
asset on the same future date at the same agreed price.
Forwards and Futures Definitions
 Forwards and Futures Definitions

FORWARD FUTURES

 Private contract between two parties  Traded on exchange

 Non standardized  Standardized contracts
 Usually one specified delivery date  Range of delivery dates
 Settled at the end of contract  Settled daily
 Delivery or final cash settlement usually  Contract is usually closed out prior to
takes place maturity
 Some credit risk  Virtually no credit risk

Margin Account
Initial Margin
Maintenance Margin
Margin Call

Notice of intention to deliver presented by

seller to exchange
 Forwards and Futures Payoffs

Payoffs from Forward Contract

The payoff from holding a long position in a forward contract on one unit of an asset is:
𝑆𝑇 − 𝐾

where K is the delivery price and ST is the spot price of the asset at maturity of the contract.

Payoff
We are buying for K something
worth ST

K ST

-K
 Forwards and Futures Payoffs

Payoffs from Forward Contract

The payoff from a short position in a forward contract on one unit of an asset is: 𝐾 − 𝑆𝑇

Payoff

We are selling for K something

worth ST

K ST
 Forwards and Futures Forward prices: Short Selling

Short Selling

Short selling = selling an asset that is not owned.

It is done by borrowing the asset from someone who does own it, selling it, and then buying it back at a later date, and
finally returning it to the party from whom it was borrowed.

BUY BACK &

BORROW & SELL PROFIT ?
RETURN

Such a trade is profitable if the price of the asset has fallen over the period between the sale and the repurchase.
 Forwards and Futures Forward prices

Forward Prices
The easiest type of forward contract to value is one written on an asset that provides the holder with no income, such as
non-dividend paying stock or zero-coupon bond.

Consider a long forward contract to purchase a non-dividend paying stock in 3 months.

Assume that the current stock price is £40 and the 3-month risk-free interest rate is 5% per annum.

Assumptions:
 no transaction costs
Suppose that the forward price is relatively high at £43.  borrow/ lend at rf

now in 3 mths time

 deliver the share and

 borrow £40 at rf of 5% pa
receive £43
 buy 1 share for £40,
 pay back loan:
 short forward contract to
40e0.05*(3/12) = 40.50
sell 1 share in 3 mths

Profit:
Arbitrager can lock in risk free £43 - £40.50 = £2.50
profit of £2.50
 Forwards and Futures Forward prices: No income

Suppose that the forward price is relatively low at £39.

now in 3 mths time

 £40 investment grows to:

 short 1 share (& receive £40) 40e0.05*(3/12) = 40.50
 invest £40 at rf  pay £39 and take delivery of 1 share
 take long position in 3 month  use the share to close out the short
forward contract position

Arbitrager can lock in risk free Profit:

profit of £1.50 £40.50 - £39 = £1.50

Under what circumstances do arbitrage opportunities not exist?

Arbitrage opportunities arise whenever the forward price is above £40.50 or below £40.50.

Thus for there to be no arbitrage, the forward price must be exactly £40.50.
 Forwards and Futures Forward prices: No income

General Formula (no income case)

Consider a forward contract on an asset that provides no income.

The current (spot) price of the asset is St, τ is the time to maturity, r is the risk-free rate, Ft is the forward price.

The relationship between the spot price and the forward price is:

𝐹𝑡 = 𝑆𝑡 𝑒 𝑟𝜏

If Ft > Sterτ , arbitrageurs can buy the asset and short forward contracts on the asset.

If Ft < Sterτ , they can short the asset and enter into long forward contracts on it.
Spot
Forward market
market Buy at the market where asset is cheaper…sell at the
market where it’s more expensive
 Forwards and Futures Forward prices: known income

Known income I

EXMPLE: Consider a long forward contract to purchase a stock in 3 months that pays £1 in 1 month time.
Assume that the current stock price is £40 and the 3-month risk-free interest rate is 5% per annum.

PV(£1) = 1e-0.05*(1/12) = £0.996

Suppose that the forward price is relatively high at £42.

now in 3 mths time

in 1 mth

 deliver the share and receive

 borrow £39.00416 (=40 – 0.996) £42
at rf of 5% pa for 3 months  receive £1  pay back loan:
 borrow £0.996 at rf for 1 month dividend 39.00416 e0.05*(3/12) = 39.49477
 buy 1 share for £40,  pay back short
 short forward contract to sell 1 term loan: £1
share in 3 mths

Profit:
£42 - £39.49477 = £2.50523
 Forwards and Futures Forward prices: known income

General Formula (known income I)

Consider forwards contract on an asset that provides an income with a present value of I during the life of a forward
contract.

The relationship between the spot price and the forward price is:

𝐹𝑡 = 𝑆𝑡 − 𝐼 𝑒 𝑟𝜏

In case Ft> (St-I)erτ, we need to borrow PV of (St-I) for

period of τ, and I for period until we receive the I.

If Ft > (St-I)erτ , arbitrageurs can buy the asset and short forward contracts on the asset.

If Ft < (St-I)erτ , they can short the asset and enter into long forward contracts on it.
 Forwards and Futures Forward prices: known yield

Known yield q

Consider a long forward contract to purchase a stock in 3 months. Stock pays a dividend yield of 2%.
Assume that the current stock price is £40 and the 3-month risk-free interest rate is 5% per annum.

Suppose that the forward price is relatively high at £43.

now in 3 mths time

 deliver the share and receive £43

 borrow £40 at rf of 5% pa  receive divided:
 buy 1 share for £40, 40e0.02*(3/12) – 40 = 0.2005
 short forward contract to sell  pay back loan:
1 share in 3 mths 40e0.05*(3/12) = 40.50

Profit:
£43 - £40.50 + £0.2005 =
£2.7005
 Forwards and Futures Forward prices: known yield

General Formula (known yield q)

Consider forwards contract on an asset that provides a known yield q (i.e. income as percentage of the asset’s price at
the time the income is paid is known).

The relationship between the spot price and the forward price is:

𝑟−𝑞 𝜏
𝐹𝑡 = 𝑆𝑡 𝑒

If Ft > Ste(r-q)τ , arbitrageurs can buy the asset and short forward contracts on the asset.

If Ft < Ste(r-q)τ , they can short the asset and enter into long forward contracts on it.
 Forwards and Futures Valuation of Forward Contracts

Valuing Forward Contract

The value of forward contract at the time it was first entered is zero.
At the later date the value can be positive of negative.

If K is the delivery price, τ is the time to maturity, r is the risk-free rate, Ft the forward price that would apply if
contract was negotiated today, the value of the (long) forward today (f) on no income paying asset can be defined as:

𝑓 = (𝐹𝑡 − 𝐾)𝑒 −𝑟τ

= 𝑆𝑡 −𝐾𝑒 −𝑟𝜏

The value of forward on asset that pays I income is:

𝑓 = 𝑆𝑡 − 𝐼 − 𝐾𝑒 −𝑟τ

The value of forward on asset that pays q yield is:

𝑓 = 𝑆𝑡 𝑒 −𝑞τ − 𝐾𝑒 −𝑟τ
 Forwards and Futures Forward Rates

Forward Rates

Forward interest rates are interest rates implied by current zero rates for periods of time in the future.
If R1 and R2 are the zero rates for maturities T1 and T2, RF is the forward interest rate for the period between T1 and T2, then:

𝑅2 𝑇2 − 𝑅1 𝑇1 R1 RF
𝑅𝐹 =
𝑇2 − 𝑇1 R2

𝑅2 𝑇2 − 𝑅2 𝑇1 + 𝑅2 𝑇1 − 𝑅1 𝑇1 𝑒 𝑅1𝑇1+𝑅𝐹 𝑇2 −𝑇1
= 𝑒 𝑅2 𝑇2
=
𝑇2 − 𝑇1
𝑅1 𝑇1 + 𝑅𝐹 𝑇2 − 𝑇1 = 𝑅2 𝑇2

𝑅2 𝑇2 − 𝑇1 + 𝑅2 𝑇1 − 𝑅1 𝑇1
=
𝑇2 − 𝑇1

𝑇1
= 𝑅2 + 𝑅2 − 𝑅1
𝑇2 − 𝑇1

which shows that if the zero curve is upward sloping between T1 and T2, (i.e. R2>R1), then RF>R2.
 Forwards and Futures Forward Rates

Example:

Calculate year-2 forward rate (i.e. a rate of interest for year 2 that combined with 1-year zero interest
provides the same overall interest as the 2-year zero rate), knowing that R1 = 0.03 and R2 = 0.04.

𝑅2 𝑇2 − 𝑅1 𝑇1
𝑅𝐹 =
𝑇2 − 𝑇1

0.04 × 2 − 0.03 × 1
=
2−1

= 0.05
 Forwards and Futures Hedging: Hedging with Futures

Hedging with Futures

Basis risk arise when (i) the asset underlying futures contract is different than the asset whose price is to be hedged.
(ii) hedge require contract to be closed out before its delivery.

The basis (b) is defined as:

𝐵𝑎𝑠𝑖𝑠 = 𝑆𝑝𝑜𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 𝑡𝑜 𝑏𝑒 ℎ𝑒𝑑𝑔𝑒𝑑 − 𝐹𝑢𝑡𝑢𝑟𝑒𝑠 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑢𝑠𝑒𝑑

If the asset to be hedged and the asset underlying the futures is the same, the base is zero at the maturity of futures contract.
 Forwards and Futures Hedging: Cross Hedging

Cross Hedging

When asset underlying the futures contract is different to the asset whose price is being hedged the hedge is referred to
as cross hedging.

Hedge ratio is the ratio of the size of the position taken in futures contracts to the size of the exposure.
When both assets are the same, it is natural to use hedge ratio of 1.
When assets vary it might be optimal to use different ratio.

The hedger should choose the value of the hedge ratio that minimizes the variance of the value of the hedged position.

Define ΔS as the change in the spot price S during the period of time equal to the life of the hedge and ΔF change in
futures price F during a period of time equal to the life of the hedge.

Minimum variance hedge ratio (h*) can be defined as:

𝜎𝑆
ℎ∗ = 𝜌
𝜎𝐹

where σS is the standard deviation of ΔS, σF is the standard deviation of ΔF, and ρ is the correlation coefficient between
ΔS and ΔF.

If ρ = 1 and σF = σS, h* = 1.
 Forwards and Futures Hedging: Cross Hedging

To calculate the optimal number of contracts to be entered (N*) one should multiply the size of the position being
hedged (QA) by minimum variance hedge ratio, and divide the product by the size of one futures contract (Q F):

∗
ℎ∗ 𝑄𝐴
𝑁 =
𝑄𝐹

In practise:
 Choose contract with closes delivery date to the exposure…but later delivery than exposure
 Choose contract on asset whose price is highly correlated with price of exposed asset
Forwards and Futures

 Definitions

 Payoffs from Forwards Contract

 Forward Prices

 Valuation of Forward Contracts

 Forward Rates

 Hedging
EXERCISE
4. Introduction
to Options
Introduction to Options

 European Options

 Pay-off Diagrams,

 Bounds of Option Prices

Introduction to Options
Introduction to Options
 Introduction to Options

Top 10
 Introduction to Options

During 2012 477 Million equity contracts were traded on the CBOE,
representing options on 47.7 billion shares of underlying stock

S&P500 :
(1) total market capitalization (USD) as of 31 Jan 2014: 16 872 585 650 000

(2) average daily volume in 2013 around 3 000 000 000 (shares)
 Introduction to Options European Options

Like forwards and futures, options can be written on a

stock, foreign exchange, market index,....

CALL OPTION PUT OPTION

A Put Option gives the holder the right to sell

A Call Option gives the holder the right to buy
the underlying asset on (or maybe before) a
the underlying asset on (or maybe before) a
certain date (the expiry date) for a certain price
certain date (the expiry date) for a certain price
(the strike price).
(the strike price).

The owner, or holder, of an option – who is said to adopt a long position – acquires the option by paying the option price
(premium) to the writer – who is said to adopt a short position.

If the holder of a call option chooses to exercise the option, he pays the strike price to the writer in exchange for the asset.
If the holder of a put option chooses to exercise the option, he delivers the asset to the writer, who simultaneously pays the
strike price to the holder.

In forwards/ futures the contract creates an obligation to both parties.

The holder of the options has the right to exercise the option, whereas the person writing the option has an
obligation to comply with holder decision.
 Introduction to Options European Options

EUROPEAN CALL EUROPEAN PUT

OPTION OPTION

A security that gives its owner the right, but not A security that gives its owner the right, but
the obligation, to purchase a specified asset for a not the obligation, to sell a specified asset for a
specified price, known as the strike price, at some specified price, known as the strike price, at
date in the future (the expiry date). some date in the future (expiry).

European Options can only be exercised on the expiry date.

American options, in contrast, can be exercised at any time up to the expiry date.

For the time being, we restrict attention to European Options because they are more straightforward to analyse.

Options that expire unexercised are said to die, and are worthless

Notations:
t is the current date T is the expiry date τ = T – t is the time to expiry.
St is the current (underlying) stock price. ST is the stock price at expiry.
K is the strike price. r is the risk-free rate of interest.
ct is the current price (or the current value) of a Call Option
pt is the current price (or the current value) of a Put Option
 Introduction to Options European Options: Pay-off Diagrams

Payoff diagram for a Call Option

If you are the holder of a call option, you want the stock price at expiry to exceed the strike price.
Then, you exercise the option to buy at the strike price, and immediately sell at a profit ST - K.
If the stock price at expiry is less than the strike price, you let the option die.

Long position in a Call Option

Payoff
𝑚𝑎𝑥 0, 𝑆𝑇 − 𝐾 A call option for which the
current stock price St is
above the strike price K is
said to be in the money.
K
A call option for which the
current stock price St is
below the strike price K is
said to be out of the money.

out of the money K ST A call option for which the

current stock price St is
equals the strike price K is
said to be at the money.
at the money
 Introduction to Options European Options: Pay-off Diagrams

Payoff diagram for a Call Option

Short position in a Call Option

Payoff

K ST

-K

Issuer of the option faces pay off or loss, thus he needs to be compensated to be willing to write the option (option premium).
 Introduction to Options European Options: Pay-off Diagrams

Payoff diagram for a Put Option

Long position in a Put Option

𝑚𝑎𝑥 0, 𝐾 − 𝑆𝑇
Payoff

K
at the money

K out of the money

ST
 Introduction to Options European Options: Pay-off Diagrams

Payoff diagram for a Call Option

Short position in a Put Option

Payoff

K ST

-K
 Introduction to Options European Options: Bounds of Option Prices

Bounds of Option Prices

A call gives the right to buy the underlying.

Thus the call payoff is always less that the value of underlying at time T, ST.

Therefore the value of the call at time t must be less or equal to the value of the underlying:

𝑐𝑡 ≤ 𝑆𝑡

For the put the maximum value obtained at expiry is K, thus current value must be:

𝑝𝑡 ≤ 𝐾𝑒𝑥𝑝(−𝑟𝜏)
 Introduction to Options European Options: Bounds of Option Prices

Bounds of Option Prices

Consider portfolio consisting of call option and a sum of money equal to Kexp(-rτ).
At T in case ST > K, this portfolio is worth the same as the underlying. Otherwise it is worth more than the underlying (i.e. K).

Since the cash and option produce a payoff equal to or greater than that of the underlying, thus the value of portfolio must then
equal to or greater than that of the underlying:

𝑐𝑡 + 𝐾𝑒𝑥𝑝(−𝑟𝜏) ≥ 𝑆𝑡
which implies:

𝑐𝑡 ≥ 𝑆𝑡 − 𝐾𝑒𝑥𝑝(−𝑟𝜏)

Similarly, consider portfolio consisting of put and underlying.

At T in case K > ST put is exercised and portfolio is worth K, otherwise put is not exercised and portfolio is worth ST.
Therefore at time T a portfolio of put and underlying when compared to cash currently worth Kexp(-rτ), will be worth at least
the same as the cash:

𝑝𝑡 + 𝑆𝑡 ≥ 𝐾𝑒𝑥𝑝(−𝑟𝜏)

thus:

𝑝𝑡 ≥ 𝐾𝑒𝑥𝑝 −𝑟𝜏 − 𝑆𝑡
Introduction to Options

 European Options

 Pay-off Diagrams,

 Bounds of Option Prices

Lecture 3:

5.Option Valuation
 Option Valuation

 Option Valuation

 Binomial Model

 Black-Scholes Model

 Put-Call Parity
 Option Valuation European Options: Valuation: Binomial Model

Binomial Trees Risk-neutral valuation on

objective probabilities.
Consider an European put option with time to expiry of 1 year, and a strike price of 110.
The current price of the underlying is 100. Divide the time to expiry into two 6-month intervals.
Suppose that in each interval, the price can either rise by 10 or fall by 10, with equal probabilities.
The risk-free rate is 5% per annum, simply compounded. What is the value of the option?

t=0 t=0.5 t=1

120
110 0
4.878 0*0.5+10*0.5=5

100 4.878*0.5+19.512*0.5 100

=12.195 10
11.897

90 10*0.5+30*0.5=20
19.512 80
 The price movements can 30
be represented by a diagram
called a binomial tree.  The value calculation proceeds backwards from T to t. Each step involves:
 An underlying assumption  finding the terminal value of the option;
is that the underlying price  calculating its expected value of the option; and finally
follows a binomial process .  discounting it by the risk-free rate (make sure that you use the right rate).
 Option Valuation European Options: Valuation: Binomial Model

Binomial Trees

Suppose that the probabilities of rise& fall were 40/60 instead of 50/50.
Without doing any further calculation, can you determine how the option price would change?

t=0 t=0.5 t=1

120
0
110 0.4 0.6
4.878
>4.878
0*0.5+10*0.5=5
0.4 0.6
100 4.878*0.5+19.512*0.5 100
>11.897
11.897
=12.195 10
0.4 0.6
90 10*0.5+30*0.5=20
10*0.5+30*0.5=20
19.512
>19.51 80
30
 Option Valuation European Options: Valuation: Binomial Model

Binomial Trees

Now, let’s redo the question above, but assuming an European call option instead.

Suppose that the probabilities of rise & fall were 60/40 instead of 50/50.
Without doing any further calculation, can you determine how the option price would change?

t=0 t=0.5 t=1

120
5exp(-0.05*0.5)=4.878 10
110 10*0.5+0*0.5=5
4.878

100
4.878*0.5+0*0.5=2.439 100
2.3795
0
0*0.5+0*0.5=0
90
0 80
0

What if we don’t know the probabilities? 1. No-Arbitrage Argument Valuation

2. Risk Neutral Valuation with Risk Neutral Probabilities
 Option Valuation European Options: Valuation: Binomial Model: No Arbitrage Argument

No Arbitrage Argument

Consider a stock whose price is S0 and option on the stock whose current price is f.
Option lasts for time T, and in that time the stock price moves to either S0U (where U > 1) or to S0D (where D < 1).

fU is option payoff if stock moved to S0U and fD option payoff is stock moved to S0D.

SS0U
0UΔ - fU
fU
S0Δ - Sf0
f
SS0DDΔ - f
0 D
fD

Consider a portfolio consisting of a long position in Δ shares and a short position in one option.

Calculate Δ that makes the portfolio riskless (i.e. portfolio has the same payoff regardless if the stock price increased or
decreased):
𝑓𝑈 − 𝑓𝐷
𝑆0 𝑈∆ − 𝑓𝑈 = 𝑆0 𝐷∆ − 𝑓𝐷 ∆=
𝑆0 𝑈 − 𝑆0 𝐷
 Option Valuation European Options: Valuation: Binomial Model: No Arbitrage Argument

No Arbitrage Argument

For arbitrage opportunities not to exist the riskless portfolio must earn risk-free interest rate.

If r is the risk-free interest rate, then the present value of the portfolio is:

(𝑆0 𝑈∆ − 𝑓𝑈 )exp(−𝑟𝑇) = (𝑆0 𝐷∆ − 𝑓𝐷 )exp(−𝑟𝑇)

whereas the cost of creating this portfolio today is:

𝑆0 ∆ − 𝑓

Therefore:
𝑆0 ∆ − 𝑓 = (𝑆0 𝑈∆ − 𝑓𝑈 )exp(−𝑟𝑇)

𝑓 = 𝑆0 ∆(1 − 𝑈𝑒𝑥𝑝 −𝑟𝑇 ) + 𝑓𝑈 exp(−𝑟𝑇)

𝑓𝑈 −𝑓𝐷
Let’s substitute for Δ:
𝑆0 𝑈−𝑆0 𝐷

𝑓𝑈 − 𝑓𝐷
𝑓 = 𝑆0 (1 − 𝑈𝑒𝑥𝑝 −𝑟𝑇 ) + 𝑓𝑈 exp(−𝑟𝑇)
𝑆0 𝑈 − 𝑆0 𝐷
 Option Valuation European Options: Valuation: Binomial Model: No Arbitrage Argument

No Arbitrage Argument

𝑓𝑈 − 𝑓𝐷
𝑓 = 𝑆0 (1 − 𝑈𝑒𝑥𝑝 −𝑟𝑇 ) + 𝑓𝑈 exp(−𝑟𝑇)
𝑆0 𝑈 − 𝑆0 𝐷

𝑓𝑈 − 𝑓𝐷 − 𝑈𝑒𝑥𝑝 −𝑟𝑇 𝑓𝑈 + 𝑈𝑒𝑥𝑝 −𝑟𝑇 𝑓𝐷 + 𝑓𝑈 exp −𝑟𝑇 𝑈 − 𝑓𝑈 exp −𝑟𝑇 𝐷

=
𝑈−𝐷

𝑓𝑈 1 − 𝐷𝑒𝑥𝑝(−𝑟𝑇) + 𝑓𝐷 𝑈𝑒𝑥𝑝(−𝑟𝑇) − 1
=
𝑈−𝐷

𝑓𝑈 exp(𝑟𝑇) − 𝐷 + 𝑓𝐷 𝑈 − exp(𝑟𝑇)
= exp(−𝑟𝑇)
𝑈−𝐷

= exp(−𝑟𝑇) 𝑝𝑓𝑈 + (1 − 𝑝)𝑓𝐷 exp(𝑟𝑇) − 𝐷

where: 𝑝=
𝑈−𝐷

The model allows to price an option when stock price movements are given by a one-step binominal tree, under the
assumption there are no arbitrage opportunities in the market.
 Option Valuation European Options: Valuation: Binomial Model: No Arbitrage Argument

No Arbitrage Argument

Example: Stock price today is equal to 20, and in 3 months it will be either 22 or 18.
What is a value of 3 month European call option with a strike price of 21.
The risk free rate is 12% (continuous compounding).

Step 1: Calculate Δ
22
fU =1 22∆ − 1 = 18∆ − 0
20 4∆ = 1
f
18 ∆ = 0.25
fD = 0

Step 2: Calculate portfolio

value at horizon
Step 3: Calculate portfolio value today, and thus calculate f

18∆ − 0 = 18 × 0.25 = 4.5 3

4.5 exp −rT = 20∆ − 𝑓 4.5 exp −0.12 × = 5−𝑓
12
4.367005 = 5 − 𝑓 𝑓 = 0.632995
 Option Valuation European Options: Valuation: Binomial Model: Risk Neutral Valuation

Risk Neutral Valuation

In risk-neutral world, risk-neutral investors do not increase the expected return they require from an investment to compensate for
increased risk.

Utility Function

Utility: in economics it is the fundamental measure of value.

Utility function u(x): tells us the unit of “satisfaction” that x gives us.
in finance, x usually represents the amount of money or profit.
two assumptions are normally required regarding the function u(.) :
1) slope of the function;
2) curvature, i.e. how the function “bends”.

The usual assumptions are that u’(.) > 0 and u”(.) < 0 .
This implies positive but decreasing marginal utility.

When x is random, then u(x) becomes a random variable.

The assumption about the curvature becomes critical as it implies the view towards risks.
In this aspect, we may classify utility functions according to their risk preferences.
 Option Valuation European Options: Valuation: Binomial Model

Risk Neutral Valuation

Risk Preferences

Suppose that an individual holds a lottery that yields $0 or $100 with equal probabilities.
This lottery gives the expected return of $50 = 0.5*$0 + 0.5*$100

Risk-averse individuals prefer receiving the sure sum of $50 to being given a lottery whose expected return is $50.

This may be described as:

𝑢 50 > 0.5 × 𝑢 0 + 0.5 × 𝑢(100)
A general condition for risk
aversion is that u”(.) < 0
(concave).
U(X)
U(E(W)) 𝑢 40 = 0.5 × 𝑢 0 + 0.5 × 𝑢(100)
U(CE)=E(U(W)) RP risk premium
CE certainty equivalent
E(W) expected value of uncertain
RP payment

E(U(W)) expected utility of the

uncertain payment

CE E(W) X U(E(W)) utility of the expected

value of the uncertain payment
40 50
 Option Valuation European Options: Valuation: Binomial Model

Risk Neutral Valuation

Risk Preferences

Risk-loving individuals prefer the lottery to the sure sum of $50.

This is the opposite case of risk aversion, i.e.

𝑢 50 < 0.5 × 𝑢 0 + 0.5 × 𝑢(100)

A general condition for risk
seeking is that u”(.) > 0 (convex).

U(X)

RP risk premium
U(CE)=E(U(W)) CE certainty equivalent
E(W) expected value of uncertain
payment

E(U(W)) expected utility of the

uncertain payment
U(E(W)) RP
U(E(W)) utility of the expected
value of the uncertain payment
E(W) CE X
50 60
 Option Valuation European Options: Valuation: Binomial Model

Risk Neutral Valuation

Risk Preferences

Risk neutral Individuals who are indifferent between the lottery and the sure sum of $50

𝑢 50 = 0.5 × 𝑢 0 + 0.5 × 𝑢(100)

A general condition for risk

neutrality is that u”(.) = 0 (linear).
U(X)

Real-life examples of risk preferences:

 Risk-averse: Individual investors, pension
funds;
 Risk-loving: Hedge funds;
 Risk-neutral: Institutional investors, large
companies – Management being risk-
loving while owners being risk-averse.
X
E(W)=CE
 Option Valuation European Options: Valuation: Binomial Model

Risk Neutral Valuation

Risk neutrality proves very interesting since it implies that investors only care about expected returns, and not risks
associated with the investment.

Suppose there are only two assets in the economy: one risky (‘stock’) and the other riskless (‘bond’).

Risk-neutral investors will hold the stock alone – no matter how risky it is – provided that such
a stock gives a higher expected return than the bond.
If we’re willing to assume that everybody in the world is risk-neutral, then it must be the case that the returns on both
assets must be equal.

A risk-neutral world has two features that facilitate pricing derivatives:

(1) Expected return on stock (or any other instrument) is risk-free
(2) The discount rate used for the expected payoff on an option (or any other instrument) is risk-free rate.

𝑒 𝑟𝜏 −𝐷
Let 𝑝 = be interpreted as the probability of an up movement in a risk-neutral world..
𝑈−𝐷

Thus the expected future payoff from an option in risk neutral world is:

𝑝𝑓𝑈 + (1 − 𝑝)𝑓𝐷
 Option Valuation European Options: Valuation: Binomial Model

𝑒 𝑟𝜏 −𝐷
Risk Neutral Valuation 𝑝= 𝑈−𝐷

Proof: Consider p as the probability of an up movement, the expected stock price E(ST) at time T:

𝐸 𝑆𝑇 = 𝑝𝑆0 𝑈 + (1 − 𝑝)𝑆0 𝐷

= 𝑝𝑆0 𝑈 − 𝑝𝑆0 𝐷 + 𝑆0 𝐷

= 𝑝𝑆0 (𝑈 − 𝐷) + 𝑆0 𝐷

𝑒 𝑟𝜏 − 𝐷
= 𝑆 (𝑈 − 𝐷) + 𝑆0 𝐷
𝑈−𝐷 0

= 𝑆0 𝑒 𝑟𝜏 −𝑆0 𝐷 + 𝑆0 𝐷

= 𝑆0 𝑒 𝑟𝜏

Thus stock price grows at risk free rate if p is the probability of an up movement.
 Option Valuation European Options: Valuation: Binomial Model

Risk Neutral Valuation

22
Example fU = 1
Stock price today is equal to 20, and in 3 months it will be either 22 or 18. 20
What is a value of 3 month European call option with a strike price of 21. f
The risk free rate is 12% (continuous compounding).
18
3
fD = 0
p could be calculated as: 22𝑝 + 18 1 − 𝑝 = 20𝑒 0.12×12
3
4𝑝 = 20𝑒 0.12×
12 − 18 𝑝 = 0.6523

or as: 3
𝑟𝜏 0.12×
𝑒 −𝐷 𝑒 − 0.9
12
𝑝= = = 0.6523
𝑈−𝐷 1.1 − 0.9

3
thus: 𝑓 = 0.6523 × 1 + (1 − 0.6523) × 0 𝑒 −0.12×12
3
= 0.6523𝑒 −0.12×12 Thus non-arbitrage arguments and
risk-neutral valuation give the
same results.
= 0.633
 Option Valuation European Options: Valuation: Binomial Model

In order to calculate the option price at the initial node of the tree, one needs to start
Two-Step Binominal Trees with calculating option price at the final nodes and then working out option price at
the earlier nodes.

Example: Consider 2-year European put option with a strike price of 52, whose stock is currently trading at 50.
There are two 1-year steps. In each step stock price can increase by 20% or decrease by 20%. The risk-free interest rate is 5%.
𝑒0.05∗1 − 0.8
𝑝= = 0.6282
1.2 − 0.8
t=0 t=1 t=2
Is p constant in the whole tree?
72
60 0 A:
A 0.6282*0+0.3718*4=1.4872

1.4872*exp(-0.05)=1.41668
50 48
CC 44 B:
0.6282*4+0.3718*20=9.9488
40
B 9.9488*exp(-0.05)=9.463591
B 32
20
20
C: 0.6282*1.41668+0.3718*9.463591 = 4.40725

4.40725*exp(-0.05) = 4.192306
Option Valuation European Options: Valuation: Binomial Model

n steps

n → ∞

Binomial Model → Black-Scholes Formula

Option Valuation European Options: Valuation: Binomial Model

The more terms the

more similar BM and
BS valuation
 Option Valuation European Options: Put-Call Parity

Put-Call Parity

The put-call parity defines a relationship between the price of a call and a put – both with identical K and t.

It allows us to calculate c from p, and vice versa. The underlying assumption is that there is no arbitrage opportunities.

The parity is given by: 𝑝𝑡 + 𝑆𝑡 = 𝑐𝑡 + 𝐾𝑒 −𝑟𝜏

We can prove this by considering two portfolios which always give the same payoffs at maturity:
(1) A put & a stock
(2) A call & a zero-coupon bond (or cash)

It can be shown that both portfolios give the same payoffs regardless of the terminal stock price.

ST > K ST < K

put 0 K-ST
stock ST ST ST K

= =
call ST-K 0
bond K ST K K

Therefore, their current values must be identical.

 Option Valuation European Options: Put-Call Parity

Put-Call Parity

(1) A put & a stock

(2) A call & a zero-coupon bond (or cash)

𝑝𝑝𝑡𝑡 +
+ 𝑆𝑆𝑡𝑡 =
> 𝑐𝑐𝑡𝑡 + 𝐾𝑒−𝑟𝜏
+ 𝐾𝑒 −𝑟𝜏

Portfolio (1) is overpriced in relation to portfolio (2).

Buy securities in portfolio (2) and (short) sell those in portfolio (1):
Buy the call and short sell both the put and the stock.

This which will generate upfront positive cash flow that should be invested at risk free rate:

𝑝𝑡 + 𝑆𝑡 − 𝑐𝑡 𝑒 𝑟𝜏
If the stock price at the expiration of the option is greater than K, the call will be exercised; if the price is less than K, the put
will be exercised. In either cases the arbitrageur will end up buying one share for K. This share can be used to close the short
position, thus the net profit is equal to:

𝑝𝑡 + 𝑆𝑡 − 𝑐𝑡 𝑒 𝑟𝜏 − 𝐾 >0
 Option Valuation European Options: Put-Call Parity

Put-Call Parity

(1) A put & a stock

(2) A call & a zero-coupon bond (or cash)

𝐾𝑒−𝑟𝜏
𝑝𝑝𝑡𝑡++𝑆𝑆𝑡𝑡 <= 𝑐𝑡𝑐𝑡++𝐾𝑒 −𝑟𝜏

Portfolio (2) is overpriced in relation to portfolio (1).

Buy securities in portfolio (1) and (short) sell those in portfolio (2):
Buy the put and stock and sell the call.

To do this upfront positive cash flow will be needed, that should be borrowed at risk free rate:

− 𝑝𝑡 − 𝑆𝑡 + 𝑐𝑡 𝑒 𝑟𝜏
If the stock price at the expiration of the option is greater than K, the call will be exercised; if the price is less than K, the put
will be exercised. In either cases the arbitrageur will end up selling one share for K. This money will be used to pay back the
loan, thus the net profit is equal to:

− 𝑝𝑡 − 𝑆𝑡 + 𝑐𝑡 𝑒 𝑟𝜏 + 𝐾 >0
 Option Valuation European Options: Valuation: Black Scholes Model

Black-Scholes Formula

The formula for the value of a Call Option is:

t is the current date
T is the expiry date
𝑐𝑡 = 𝑆𝑡 Φ 𝑑1 − exp(−𝑟𝜏)𝐾Φ 𝑑2 is the time to expiry.
St is the current (underlying) stock price.
K is the strike price.
r is the risk-free rate of interest.
σ is the volatility (σ2 is the variance of the
And the formula for the value of a Put Option is: stock return, per unit time*)

𝑝𝑡 = exp −𝑟𝜏 𝐾Φ −𝑑2 − 𝑆𝑡 Φ −𝑑1

where:
𝑆𝑡 𝜎2
𝑙𝑛 + 𝑟+ 𝜏
𝐾 2
𝑑1 =
𝜎 𝜏

𝑆𝑡 𝜎2
𝑙𝑛 + 𝑟− 𝜏
𝐾 2
𝑑2 = = 𝑑1 − 𝜎 𝜏
𝜎 𝜏
 Option Valuation European Options: Valuation: Black Scholes Model

Black-Scholes Formula

The Black-Scholes formula calculates the price of European put and call options.

The model was proposed in 1973 by Fischer Black and Myron Scholes, who was later awarded the 1997 Nobel Prize in Economics
Science (joint with Robert C. Merton).

died in 1995

Fischer Black Myron Scholes Robert C. Merton

Long-Term Capital Management (LTCM)

Option Valuation European Options: Valuation: Black Scholes Model

Long-Term Capital Management (LTCM)

 Option Valuation European Options: Valuation: Black Scholes Model

Long-Term Capital Management (LTCM)

At the beginning of 1998:

equity of $4.72 billion debt to equity ratio of over 25 to 1

borrowed over $124.5 billion

=>assets of around $129 billion.

The total losses by end of 1998 were found to be $4.6 billion

$1.6 bn in swaps
$1.3 bn in equity volatility
$430 mn in Russia and other emerging markets
$371 mn in directional trades in developed countries
$286 mn in Dual-listed company pairs (such as VW, Shell)
$215 mn in yield curve arbitrage
$203 mn in S&P 500 stocks
$100 mn in junk bond arbitrage
 Option Valuation European Options: Valuation: Black Scholes Model

Black-Scholes Formula

The original model involves the methods of stochastic calculus (continuous-time finance) – which we explored earlier
during the module. Here, we will consider a simplified version of the model.

In the Black-Scholes framework, the assumption about the evolution of the Stock price is:

𝑆𝑡+∆𝑡 = 𝑆𝑡 exp 𝜇∆𝑡 + 𝜎 ∆𝑡𝑍

where Z ~ N(0,1), i.e. Z is a standard normal random variable.

70
60
50
40
S

30
Time series resulting from the above
20 assumption, with µ = 0.04, σ = 0.02.
10
0
0 20 40 60 80 100 120
tim e
 Option Valuation European Options: Valuation: Black Scholes Model

Black-Scholes Formula

The price at expiry is:

𝑆𝑇 = 𝑆𝑡+τ = 𝑆𝑡 exp 𝜇𝜏 + 𝜎 𝜏𝑍

It follows that:
Z ~ N(0,1)
𝑆𝑇
= exp 𝜇𝜏 + 𝜎 𝜏𝑍
𝑆𝑡
~ N(𝜇𝜏, 𝜎 2 𝜏)

and therefore:

𝑆𝑇
~𝐿𝑜𝑔𝑛𝑜𝑟𝑚𝑎𝑙 𝜇𝜏, 𝜎 2 𝜏
𝑆𝑡
 Option Valuation European Options: Valuation: Black Scholes Model

Black-Scholes Formula

From the properties of the Lognormal distribution, we know that:

𝑆𝑇 𝜎2 𝜏 𝜎2
𝐸 = 𝑒𝑥𝑝 𝜇𝜏 + = 𝑒𝑥𝑝 𝜇+ 𝜏
𝑆𝑡 2 2

This is a formula for the expected proportional increase in the stock price from the present to expiry.

Another formula for this is:

𝑆𝑇
𝐸 = 𝑒𝑥𝑝 𝑟𝜏
𝑆𝑡

This is because, in a risk-neutral world, the average return of all stocks equals the risk-free return.

For both of these formulae to be correct, it must be the case that:

𝜎2
𝜇+ =𝑟
2
 Option Valuation European Options: Valuation: Black Scholes Model

Black-Scholes Formula

Recall that a Call Option pays:

𝑚𝑎𝑥 0, 𝑆𝑇 − 𝐾
τ periods in the future.

Therefore the current value of a call option (assuming risk-neutrality) is:

𝑐𝑡 = 𝑒 −𝑟𝜏 𝐸 𝑚𝑎𝑥 0, 𝑆𝑇 − 𝐾

We need to evaluate the expectation:

𝐸 𝑚𝑎𝑥 0, 𝑆𝑇 − 𝐾 = 0 × 𝑃 𝑆𝑇 < 𝐾 + 𝐸 𝑆𝑇 − 𝐾 𝑆𝑇 > 𝐾 × 𝑃 𝑆𝑇 > 𝐾

= 𝐸 𝑆𝑇 − 𝐾 𝑆𝑇 > 𝐾 × 𝑃 𝑆𝑇 > 𝐾

= 𝐸 𝑆𝑇 𝑆𝑇 > 𝐾 × 𝑃 𝑆𝑇 > 𝐾 − 𝐾 × 𝑃 𝑆𝑇 > 𝐾

𝑆𝑇 𝑆𝑇 𝐾 𝑆𝑇 𝐾 𝑆𝑇 𝐾
= 𝑆𝑡 × 𝐸 𝑆 𝑆 > 𝑆 × 𝑃 > − 𝐾×𝑃 >
𝑡 𝑡 𝑡 𝑆𝑡 𝑆𝑡 𝑆𝑡 𝑆𝑡
 Option Valuation European Options: Valuation: Black Scholes Model

Black-Scholes Formula

𝑆𝑇
We know that ~𝐿𝑜𝑔𝑛𝑜𝑟𝑚𝑎𝑙 𝜇𝜏, 𝜎 2 𝜏 .
𝑆𝑡

If 𝑌~𝐿𝑜𝑔𝑛𝑜𝑟𝑚𝑎𝑙 𝜇, 𝜎 2 , then: 𝜇 − 𝑙𝑛𝑐

Φ +𝜎 𝜎2
𝜎
𝐸 𝑌| 𝑌 > 𝑐 = 𝑒𝑥𝑝 𝜇 +
𝜇 − 𝑙𝑛𝑐 2
Φ 𝜎

Applying this formula, we obtain:

𝐾
𝜇𝜏 − 𝑙𝑛 𝑆
𝑡
Φ +𝜎 𝜏
𝑆 𝑆𝑇 𝐾 𝜎 𝜏 𝜎 2𝜏
𝐸 𝑆𝑇 𝑆𝑡 > 𝑆𝑡 = 𝑒𝑥𝑝 𝜇𝜏 +
𝑡 𝐾 2
𝜇𝜏 − 𝑙𝑛 𝑆
𝑡
Φ
𝜎 𝜏
 Option Valuation European Options: Valuation: Black Scholes Model

Black-Scholes Formula

We also require:

𝐾 𝐾
𝑆𝑇 𝐾 𝑙𝑛 − 𝜇𝜏 𝜇𝜏 − 𝑙𝑛 𝑆
𝑃 > 𝑆𝑡 𝑡
=𝑃 𝑍> =Φ
𝑆𝑡 𝑆𝑡 𝜎 𝜏 𝜎 𝜏

Substituting to earlier equations, we obtain:

𝐸 𝑚𝑎𝑥 0, 𝑆𝑇 − 𝐾

𝐾 𝐾
𝜇𝜏 − 𝑙𝑛 𝑆 2
𝜎 𝜏 𝜇𝜏 − 𝑙𝑛
𝑡 𝑆𝑡
= 𝑆𝑡 Φ + 𝜎 𝜏 𝑒𝑥𝑝 𝜇𝜏 + − 𝐾Φ
𝜎 𝜏 2 𝜎 𝜏
 Option Valuation European Options: Valuation: Black Scholes Model

Black-Scholes Formula

𝜎2 𝜎2
Since 𝜇 + = 𝑟 , so exp 𝜇 + = exp(𝑟𝜏) :
2 2
𝜎2
Also, since it is desirable to write the formula without the parameter µ, we substitute 𝜇 = 𝑟 − 2
. We obtain:

𝐸 𝑚𝑎𝑥 0, 𝑆𝑇 − 𝐾
𝐾 𝐾
𝜇𝜏 − 𝑙𝑛 𝑆 2
𝜎 𝜏 𝜇𝜏 − 𝑙𝑛
𝑡 𝑆𝑡
= 𝑆𝑡 Φ + 𝜎 𝜏 𝑒𝑥𝑝 𝜇𝜏 + − 𝐾Φ
𝜎 𝜏 2 𝜎 𝜏

𝜎2 𝐾 𝜎2 𝐾
𝑟 − 2 𝜏 − 𝑙𝑛 𝑆 𝑟 − 2 𝜏 − 𝑙𝑛 𝑆
𝑡 𝑡
= 𝑆𝑡 Φ + 𝜎 𝜏 𝑒𝑥𝑝 𝑟𝜏 − 𝐾Φ
𝜎 𝜏 𝜎 𝜏

All that is now needed is the discount factor exp(-rτ).

This completes the formula for the present value of a call option.
 Option Valuation European Options: Valuation: Black Scholes Model

Black-Scholes Formula

𝑐𝑡 = exp(−𝑟𝜏)𝐸 𝑚𝑎𝑥 0, 𝑆𝑇 − 𝐾
𝜎2 𝐾 𝜎2 𝐾
𝑟− 𝜏 − 𝑙𝑛 𝑟− 𝜏 − 𝑙𝑛
2 𝑆𝑡 2 𝑆𝑡
= exp(−𝑟𝜏)𝑆𝑡 Φ + 𝜎 𝜏 𝑒𝑥𝑝 𝑟𝜏 − exp(−𝑟𝜏)𝐾Φ
𝜎 𝜏 𝜎 𝜏
𝜎2 𝐾 𝜎2 𝐾
𝑟− 𝜏 − 𝑙𝑛 𝑟− 𝜏 − 𝑙𝑛
2 𝑆𝑡 2 𝑆𝑡
= 𝑆𝑡 Φ + 𝜎 𝜏 − exp(−𝑟𝜏)𝐾Φ
𝜎 𝜏 𝜎 𝜏
𝜎2 𝐾 𝜎2 𝐾
𝑟− 𝜏 − 𝑙𝑛 + 𝜎 2𝜏 𝑟− 𝜏 − 𝑙𝑛
2 𝑆𝑡 2 𝑆𝑡
= 𝑆𝑡 Φ − exp(−𝑟𝜏)𝐾Φ
𝜎 𝜏 𝜎 𝜏
𝜎2 𝐾 𝜎2 𝐾
𝑟+ 𝜏 − 𝑙𝑛 𝑟− 𝜏 − 𝑙𝑛
2 𝑆𝑡 2 𝑆𝑡
= 𝑆𝑡 Φ − exp(−𝑟𝜏)𝐾Φ
𝜎 𝜏 𝜎 𝜏
d1 d2
𝑆𝑡 𝜎2 𝑆𝑡 𝜎2
𝑙𝑛 + 𝑟+ 𝜏 𝑙𝑛 + 𝑟− 𝜏
𝐾 2 𝐾 2
= 𝑆𝑡 Φ − exp(−𝑟𝜏)𝐾Φ
𝜎 𝜏 𝜎 𝜏

= 𝑆𝑡 Φ 𝑑1 − exp(−𝑟𝜏)𝐾Φ 𝑑2 𝑑2 = 𝑑1 − 𝜎 𝜏
 Option Valuation European Options: Valuation: Black Scholes Model

Black-Scholes Formula

John C. Hull (p.313, formula 14.20) presents the Black-Scholes formula as:

𝑐 = 𝑆0 𝑁 𝑑1 − exp(−𝑟𝜏)𝐾𝑁 𝑑2

𝑆0 𝜎2
𝑙𝑛 + 𝑟+ 𝑇
𝐾 2
𝑑1 =
𝜎 𝑇

𝑆0 𝜎2
𝑙𝑛 + 𝑟− 𝑇
𝐾 2 = 𝑑1 − 𝜎 𝑇
𝑑2 =
𝜎 𝑇

Note that he is using:

S0 for the current stock price (St in our analysis)

T for the time to expiry (τ in our analysis)
N(.) for the standard normal c.d.f. (Φ(.) in our analysis)
 Option Valuation European Options: Valuation: Black Scholes Model

Black-Scholes Formula

Finding the value of a put is very similar to finding the value of a call.

The present value of a European put option is:

𝑝𝑡 = 𝑒 −𝑟𝜏 𝐸 𝑚𝑎𝑥 0, 𝐾 − 𝑆𝑇

We need to evaluate the expectation:

𝐸 𝑚𝑎𝑥 0, 𝐾 − 𝑆𝑇 = 0 × 𝑃 𝑆𝑇 > 𝐾 + 𝐸 𝐾 − 𝑆𝑇 𝑆𝑇 < 𝐾 × 𝑃 𝑆𝑇 < 𝐾

= 𝐸 𝐾 − 𝑆𝑇 𝑆𝑇 < 𝐾 × 𝑃 𝑆𝑇 < 𝐾

= 𝐾 × 𝑃 𝑆𝑇 < 𝐾 − 𝐸 𝑆𝑇 𝑆𝑇 < 𝐾 × 𝑃 𝑆𝑇 < 𝐾

𝑆𝑇 𝐾 𝑆𝑇 𝑆𝑇 𝐾 𝑆𝑇 𝐾
= 𝐾×𝑃 < − 𝑆𝑡 × 𝐸 𝑆 𝑆 < 𝑆 × 𝑃 <
𝑆𝑡 𝑆𝑡 𝑡 𝑡 𝑡 𝑆𝑡 𝑆𝑡
 Option Valuation European Options: Valuation: Black Scholes Model

Black-Scholes Formula

𝑆𝑇
We know that ~𝐿𝑜𝑔𝑛𝑜𝑟𝑚𝑎𝑙 𝜇𝜏, 𝜎 2 𝜏 .
𝑆𝑡

If 𝑌~𝐿𝑜𝑔𝑛𝑜𝑟𝑚𝑎𝑙 𝜇, 𝜎 2 , then: 𝑙𝑛𝑐 − 𝜇

Φ −𝜎 𝜎2
𝜎
𝐸 𝑌| 𝑌 < 𝑐 = 𝑒𝑥𝑝 𝜇 +
𝑙𝑛𝑐 − 𝜇 2
Φ 𝜎

Applying this formula, we obtain:

𝐾
𝑙𝑛 𝑆 − 𝜇𝜏
𝑡
Φ −𝜎 𝜏
𝑆 𝑆𝑇 𝐾 𝜎 𝜏 𝜎 2𝜏
𝐸 𝑆𝑇 𝑆𝑡 < 𝑆𝑡 = 𝑒𝑥𝑝 𝜇𝜏 +
𝑡 𝐾 2
𝑙𝑛 𝑆 − 𝜇𝜏
𝑡
Φ
𝜎 𝜏
 Option Valuation European Options: Valuation: Black Scholes Model

Black-Scholes Formula

We also require:

𝐾 𝐾
𝑆𝑇 𝐾 𝑙𝑛 − 𝜇𝜏 𝑙𝑛 𝑆 − 𝜇𝜏
𝑆𝑡 𝑡
𝑃 < =𝑃 𝑍< =Φ
𝑆𝑡 𝑆𝑡 𝜎 𝜏 𝜎 𝜏

Substituting to earlier equations we obtain:

𝐸 𝑚𝑎𝑥 0, 𝐾 − 𝑆𝑇

𝐾 𝐾
𝑙𝑛 𝑆 − 𝜇𝜏 𝑙𝑛 𝑆 − 𝜇𝜏 𝜎 2𝜏
𝑡 𝑡
= 𝐾Φ − 𝑆𝑡 Φ − 𝜎 𝜏 𝑒𝑥𝑝 𝜇𝜏 +
𝜎 𝜏 𝜎 𝜏 2
 Option Valuation European Options: Valuation: Black Scholes Model

Black-Scholes Formula

𝜎2 𝜎2
Once again since 𝜇 + = 𝑟 , so exp 𝜇 + = exp(𝑟𝜏) :
2 2

𝐸 𝑚𝑎𝑥 0, 𝐾 − 𝑆𝑇

𝐾 𝐾
𝑙𝑛 𝑆 − 𝜇𝜏 𝑙𝑛 𝑆 − 𝜇𝜏 𝜎 2𝜏
𝑡 𝑡
= 𝐾Φ − 𝑆𝑡 Φ − 𝜎 𝜏 𝑒𝑥𝑝 𝜇𝜏 +
𝜎 𝜏 𝜎 𝜏 2

𝐾 𝜎2 𝐾 𝜎2
𝑙𝑛 𝑆 − 𝑟 − 2 𝜏 𝑙𝑛 𝑆 − 𝑟 − 2 𝜏
𝑡 𝑡
= 𝐾Φ − 𝑆𝑡 Φ − 𝜎 𝜏 𝑒𝑥𝑝 𝑟𝜏
𝜎 𝜏 𝜎 𝜏

All that is now needed is the discount factor exp(-rτ).

This completes the formula for the present value of a put option.
 Option Valuation European Options: Valuation: Black Scholes Model

Black-Scholes Formula

𝑝𝑡 = exp(−𝑟𝜏)𝐸 𝑚𝑎𝑥 0, 𝐾 − 𝑆𝑇
𝐾 𝜎2 𝐾 𝜎2
𝑙𝑛 − 𝑟− 𝜏 𝑙𝑛 − 𝑟− 𝜏
𝑆𝑡 2 𝑆𝑡 2
= exp(−𝑟𝜏)𝐾Φ − exp(−𝑟𝜏)𝑆𝑡 Φ − 𝜎 𝜏 𝑒𝑥𝑝 𝑟𝜏
𝜎 𝜏 𝜎 𝜏
𝐾 𝜎2 𝐾 𝜎2
𝑙𝑛 − 𝑟− 𝜏 𝑙𝑛 − 𝑟− 𝜏
𝑆𝑡 2 𝑆𝑡 2
= exp(−𝑟𝜏)𝐾Φ − 𝑆𝑡 Φ −𝜎 𝜏
𝜎 𝜏 𝜎 𝜏
𝐾 𝜎2 𝐾 𝜎2
𝑙𝑛 − 𝑟− 𝜏 𝑙𝑛 − 𝑟− 𝜏 − 𝜎 2𝜏
𝑆𝑡 2 𝑆𝑡 2
= exp(−𝑟𝜏)𝐾Φ − 𝑆𝑡 Φ
𝜎 𝜏 𝜎 𝜏
𝐾 𝜎2 𝐾 𝜎2
𝑙𝑛 − 𝑟− 𝜏 𝑙𝑛 − 𝑟+ 𝜏
𝑆𝑡 2 𝑆𝑡 2
= exp(−𝑟𝜏)𝐾Φ − 𝑆𝑡 Φ
𝜎 𝜏 𝜎 𝜏
𝑆𝑡 𝜎2 𝑆𝑡 𝜎2
−𝑙𝑛 − 𝑟− 𝜏 −𝑙𝑛 − 𝑟+ 𝜏
𝐾 2 𝐾 2
= exp(−𝑟𝜏)𝐾Φ − 𝑆𝑡 Φ
𝜎 𝜏 𝜎 𝜏
𝑆𝑡 𝜎2 𝑆 𝜎2
𝑙𝑛 + 𝑟− 𝜏 𝑙𝑛 𝑡 + 𝑟 + 𝜏
𝐾 2 𝐾 2
= exp(−𝑟𝜏)𝐾Φ − − 𝑆𝑡 Φ −
𝜎 𝜏 𝜎 𝜏
d2 d1
= exp −𝑟𝜏 𝐾Φ −𝑑2 − 𝑆𝑡 Φ −𝑑1
 Option Valuation European Options: Valuation: Black Scholes Model

Put-Call Parity with Black-Scholes

Consider put-call parity

𝑝𝑡 + 𝑆𝑡 = 𝑐𝑡 + 𝐾𝑒 −𝑟𝜏

Let’s verify the put-call parity in the context of the Black-Scholes.

𝐿𝐻𝑆 = 𝑝𝑡 +𝑆𝑡

= exp −𝑟𝜏 𝐾Φ −𝑑2 − 𝑆𝑡 Φ −𝑑1 + 𝑆𝑡

= exp −𝑟𝜏 𝐾 1 − Φ 𝑑2 − 𝑆𝑡 1 − Φ 𝑑1 + 𝑆𝑡

= exp −𝑟𝜏 𝐾 − exp −𝑟𝜏 𝐾Φ 𝑑2 − 𝑆𝑡 + 𝑆𝑡 Φ 𝑑1 + 𝑆𝑡

= exp −𝑟𝜏 𝐾 − exp −𝑟𝜏 𝐾Φ 𝑑2 + 𝑆𝑡 Φ 𝑑1

= exp −𝑟𝜏 𝐾 + 𝑐𝑡

= 𝑅𝐻𝑆
 Option Valuation European Options: Valuation: Black Scholes Model

Working with Black-Scholes Formula

implied volatility
 Option Valuation European Options: Valuation: Black Scholes Model

Working with Black-Scholes Formula

The formula for the value of a Call Option is: 𝑐𝑡 = 𝑆𝑡 Φ 𝑑1 − exp(−𝑟𝜏)𝐾Φ 𝑑2

And the formula for the value of a Put Option is: 𝑝𝑡 = exp −𝑟𝜏 𝐾Φ −𝑑2 − 𝑆𝑡 Φ −𝑑1

Let’s take a close look at the Call formula:

1. It does not depend on the mean return on the underlying stock (µ); only on its current price (St) and volatility (σ).

2. As St becomes very large, both d1 and d2 become large, so both Φ(d1) and Φ(d2) approach 1,

∞ large large
𝑆𝑡 𝜎2 𝑆𝑡 𝜎2
𝑙𝑛 + 𝑟+ 𝜏 𝑙𝑛 + 𝑟− 𝜏
𝐾 2 𝐾 2
𝑑1 = 𝑑2 = = 𝑑1 − 𝜎 𝜏
𝜎 𝜏 𝜎 𝜏

∞
so the Call formula becomes: 𝑐𝑡 = 𝑆𝑡 − exp(−𝑟𝜏)𝐾

In other words, when a Call Option is “deep in the money”, its current value is simply the current price of the stock, less
the discounted strike price (which will certainly be paid at expiry).
 Option Valuation European Options: Valuation: Black Scholes Model

Working with Black-Scholes Formula

The formula for the value of a Call Option is: 𝑐𝑡 = 𝑆𝑡 Φ 𝑑1 − exp(−𝑟𝜏)𝐾Φ 𝑑2

3. If an option is very close to expiry (i.e. when τ is small), both d1 and d2 become large,
so again both Φ(d1) and Φ(d2) approach 1. Also, exp(-rτ) approaches 1

Thus the Call formula becomes:

𝑆𝑡 − 𝐾 𝑖𝑓 𝑆𝑡 > 𝐾
𝑐𝑡 =
0 𝑖𝑓 𝑆𝑡 < 𝐾

In words, if an option is very close to expiry, then if it is “in the money” its value is simply the difference between the
current stock price and the strike price, and if it is “out of the money” its value is zero.
 Option Valuation European Options: Valuation: Black Scholes Model

Working with Black-Scholes Formula

The formula for the value of a Call Option is: 𝑐𝑡 = 𝑆𝑡 Φ 𝑑1 − exp(−𝑟𝜏)𝐾Φ 𝑑2

4. If the volatility (σ) is small, both d1 and d2 become large,

so again both Φ(d1) and Φ(d2) approach 1, and the Call formula becomes:

𝑆𝑡 − exp(−𝑟𝜏)𝐾 𝑖𝑓 𝑆𝑡 > exp(−𝑟𝜏)𝐾

𝑐𝑡 =
0 𝑖𝑓 𝑆𝑡 < exp(−𝑟𝜏)𝐾

In words, if the volatility is small, the price at expiry is known with certainty to be ST = Stexp(rτ).

This certain price at expiry has present value St, the current price.

Therefore the value of the Option is the current Stock price less the present value of the strike price, provided that the
former exceeds the latter, and zero otherwise.
 Option Valuation

 Option Valuation

 Binomial Model

 Black-Scholes Model

 Put-Call Parity
EXERCISE
Lecture 4:

6.The Greeks &

Hedging
7.Value at risk
8.American Options
and Dividends
6. The Greeks and
Hedging
 The Greeks and hedging

 The Greeks

 Delta, Gamma, Theta, Vega, Rho

 Volatility

 Implied Volatility

 Volatility Smiles and Smirks

 Hedging

 Delta Hedge
 The Greeks and hedging The Greeks

The Greeks

A sensitivity is the change in the option value resulting from a ceteris paribus change in one of the model parameters.

𝑐𝑡 = 𝑆𝑡 Φ 𝑑1 − exp(−𝑟𝜏)𝐾Φ 𝑑2 𝑝𝑡 = exp −𝑟𝜏 𝐾Φ −𝑑2 − 𝑆𝑡 Φ −𝑑1

𝑆𝑡 𝜎2
𝑙𝑛 + 𝑟+ 𝜏
𝐾 2 𝑑2 = 𝑑1 − 𝜎 𝜏
𝑑1 =
𝜎 𝜏

The option price depends on five such parameters: τ, St, K, r, σ.

The sensitivities are also known as the “Greeks”, and are named: delta, gamma, theta, vega, and rho.

Thy are calculated as a partial derivative of the option price/ value (V) with respect to parameter whose impact the
sensitivity is capturing.

𝜕𝑉𝑡
𝑆𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑖𝑡𝑦1 =
𝜕𝑃𝑎𝑟𝑎𝑚𝑒𝑡ℎ𝑒𝑟1
 The Greeks and hedging The Greeks: Delta

Sensitivities of Black-Scholes Call Formula:

Name (symbol) Formula Sign

Delta (Δ) 𝜕𝑐𝑡 +
= Φ 𝑑1
𝜕𝑆𝑡

Delta is the rate of change of the option price with respect to the price of the underlying asset.

Example: Δ = 0.6: if the stock price changes by small amount the price of the option changes by 60% of that amount

Delta is the slope of curve that

relates the option price to the
price of underlying asset
The Greeks and hedging The Greeks: Delta
The Greeks and hedging The Greeks: Delta
 The Greeks and hedging The Greeks: Gamma

Sensitivities of Black-Scholes Call Formula:

Name (symbol) Formula Sign

Gamma (Γ) 𝜕2𝑐𝑡 ϕ 𝑑1 +
=
𝜕𝑆𝑡 2 𝜎𝑆𝑡 𝜏

Gamma is the rate of change of the option delta with respect to the price of the underlying asset.

Example: Γ = 0.6: when stock price changes by ΔS, the delta changes by 0.6* ΔS.

Gamma is the second partial

derivative of the portfolio with
respect to the asset price.

It measures the curvature of the

relationship between the option
price and the stock price.
The Greeks and hedging The Greeks: Gamma
 The Greeks and hedging The Greeks: Theta

Sensitivities of Black-Scholes Call Formula:

Name (symbol) Formula Sign

Theta (Θ) 𝜕𝑐𝑡 𝑆𝑡 𝜎ϕ 𝑑1 -
=− − 𝐾𝑟𝑒𝑥𝑝(−𝑟𝜏)Φ 𝑑2
𝜕𝜏 2 𝜏
Theta is the rate of change of the value of the option with respect to the passage of time.

To obtain the change per calendar day’ theta needs to be divided by 365.

Theta is usually negative because as

time passes the option tends to
become less valuable.
 The Greeks and hedging The Greeks: Vega

Sensitivities of Black-Scholes Call Formula:

Name (symbol) Formula Sign

Vega (ν) 𝜕𝑐𝑡 +
= 𝑆𝑡 𝜏ϕ 𝑑1
𝜕𝜎
Vega is the rate of change of the value of the option with respect to the volatility of the underlying asset.

Example: ν = 12: 1% (0.01) increase in volatility (from 20% to 21%) increases the value of the option by
approximately 0.01 * 12= 0.12
 The Greeks and hedging The Greeks: Rho

Sensitivities of Black-Scholes Call Formula:

Name (symbol) Formula Sign

Rho (ρ) 𝜕𝑐𝑡 +
= 𝜏𝐾𝑒𝑥𝑝(−𝑟𝜏) Φ 𝑑2
𝜕𝑟

Rho is the rate of change of the value of the option with respect to the interest rate.

Example: ρ = 5: 1% (0.01) increase in the risk free rate (from 5% to 6%) increases the value of the option by
approximately 0.01* 5 = 0.05
 The Greeks and hedging The Greeks

long
Sensitivities of Black-Scholes Call Formula: position

Name (symbol) Formula Sign

Delta (Δ) 𝜕𝑐𝑡 +
= Φ 𝑑1
𝜕𝑆𝑡
Gamma (Γ) 𝜕2𝑐𝑡 ϕ 𝑑1 +
=
𝜕𝑆𝑡 2 𝜎𝑆𝑡 𝜏
Theta (Θ) 𝜕𝑐𝑡 𝑆𝑡 𝜎ϕ 𝑑1 -
=− − 𝐾𝑟𝑒𝑥𝑝(−𝑟𝜏)Φ 𝑑2
𝜕𝜏 2 𝜏
Vega (ν) 𝜕𝑐𝑡 +
= 𝑆𝑡 𝜏ϕ 𝑑1
𝜕𝜎
Rho (ρ) 𝜕𝑐𝑡 +
= 𝜏𝐾𝑒𝑥𝑝(−𝑟𝜏) Φ 𝑑2
𝜕𝑟

Let us verify the first two of these.

 The Greeks and hedging The Greeks: Delta

Delta (Δ)

The first thing we need to understand is what happens when we differentiate Φ(w) with respect to w. Recall that:

Φ(𝑤) = ϕ 𝑤 𝑑𝑤
−∞
When we differentiate an integral with respect to the upper limit of integration, we obtain the integrand evaluated at that limit.
So:
𝜕Φ(𝑤)
=ϕ 𝑤
𝜕𝑤

The function we are differentiating is the Call formula:

𝑐𝑡 = 𝑆𝑡 Φ 𝑑1 − exp(−𝑟𝜏)𝐾Φ 𝑑2

But we have to remember that d1 and d2 both involve St,

𝑆𝑡 𝜎2
𝑙𝑛 + 𝑟+ 𝜏
𝐾 2 𝑑2 = 𝑑1 − 𝜎 𝜏
𝑑1 =
𝜎 𝜏
 The Greeks and hedging The Greeks: Delta

′
𝑓𝑔 𝑥 = 𝑓 ′ 𝑥 𝑔 𝑥 + 𝑓 𝑥 𝑔′ (𝑥) 𝑓 ′
𝑔(𝑥) = 𝑓 ′ 𝑔 𝑥 × 𝑔′ (𝑥)

So, differentiating 𝑐𝑡 = 𝑆𝑡 Φ 𝑑1 − exp −𝑟𝜏 𝐾Φ 𝑑2 , we obtain:

𝜕𝑐𝑡 𝜕𝑑1 𝜕𝑑2

Δ= = Φ 𝑑1 + 𝑆𝑡 ϕ 𝑑1 − exp −𝑟𝜏 𝐾ϕ 𝑑2
𝜕𝑆𝑡 𝜕𝑆𝑡 𝜕𝑆𝑡
To complete this we need to differentiate d1 and d2.

We note that d1 and d2 are both of the form: 𝑎

𝑙𝑜𝑔 = 𝑙𝑜𝑔𝑎 − 𝑙𝑜𝑔𝑏
𝑏

𝑆𝑡
𝑙𝑛 + 𝑐𝑜𝑛𝑠𝑡 𝑙𝑛 𝑆𝑡 − ln 𝐾 + 𝑐𝑜𝑛𝑠𝑡 𝑙𝑛 𝑆𝑡 + 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡
𝐾 = =
𝜎 𝜏 𝜎 𝜏 𝜎 𝜏

So that:
𝜕𝑑1 𝜕𝑑2 1
= =
𝜕𝑆𝑡 𝜕𝑆𝑡 𝜎 𝜏𝑆𝑡
 The Greeks and hedging The Greeks: Delta

We obtain:

𝜕𝑐𝑡 𝜕𝑑1 𝜕𝑑1

Δ= = Φ 𝑑1 + 𝑆𝑡 ϕ 𝑑1 − exp −𝑟𝜏 𝐾ϕ 𝑑1
𝜕𝑆𝑡 𝜕𝑆𝑡 𝜕𝑆𝑡

ϕ(𝑑1 ) ϕ(𝑑2 )
= Φ 𝑑1 + 𝑆𝑡 ϕ 𝑑1 − exp −𝑟𝜏 𝐾
𝜎 𝜏𝑆𝑡 𝜎 𝜏𝑆𝑡

1 exp −𝑟𝜏 𝐾ϕ(𝑑2 )

= Φ 𝑑1 + ϕ 𝑑1 −
𝜎 𝜏 𝑆𝑡

The next important point is that the quantity in square brackets is zero.

We will not verify this analytically; we will instead verify it at seminar session.

This is highly convenient, because it means that the formula for delta is very simple:

𝜕𝑐𝑡
Δ= = Φ 𝑑1
𝜕𝑆𝑡
 The Greeks and hedging The Greeks: Delta

Note that delta is always positive (for a Call).

deep in the
money
The value of a Call Option always rises when the current stock price rises.

However, note that delta cannot be greater than one.

This means that the value of the option never rise by more than the rise in
the price of the underlying stock.

For a deep in-the-money call, since d1 is high, delta will be close to 1, and therefore the call price will
move penny for penny with the underlying stock.
 The Greeks and hedging The Greeks: Delta

Delta is sometimes called the hedge ratio.

Delta shows how many units of the underlying stock need to be short-sold for each call option
purchased for the position to be perfectly hedged over a short interval of time.

The position is perfectly hedged if losses made on the stock are offset by gains made on the option, or vice versa.

Delta changes over time for two reasons:

1. The stock price (St) changes over time

2. The time to expiry (τ) falls over time (and since d1 involves τ, delta depends on τ).

If you want your position to remain perfectly hedged, you will need to alter continuously the number of stocks held.

This is dynamic hedging. It can be costly.

Gamma tells us how much delta changes when the underlying price changes.
An option with a high gamma is little use for hedging, because the hedge would need to be readjusted constantly.
 The Greeks and hedging The Greeks: Gamma

Gamma (Γ)

Gamma is the second derivative of the Option value with respect to current price. It therefore represents how sensitive
delta is to the current price.

This one is easier. We have already found delta: 𝜕𝑐𝑡

Δ= = Φ 𝑑1
𝜕𝑆𝑡
Differentiating again with respect to St:

𝜕2𝑐𝑡 𝜕𝑑1
Γ= = ϕ 𝑑1
𝜕𝑆𝑡 2 𝜕𝑆𝑡
1
= ϕ 𝑑1
𝜎 𝜏𝑆𝑡

ϕ 𝑑1
=
𝜎𝑆𝑡 𝜏

Hence we obtain the second formula as presented earlier in the table.

Note that gamma is also always positive. This means that the Call value is a convex function of current stock price.
 The Greeks and hedging The Greeks

long
Sensitivities of Black-Scholes Put Formula: position

Name (symbol) Formula

Delta (Δ) 𝜕𝑝𝑡
= −Φ −𝑑1
𝜕𝑆𝑡
Gamma (Γ) 𝜕 2𝑝𝑡 ϕ 𝑑1
=
𝜕𝑆𝑡 2 𝜎𝑆𝑡 𝜏
Theta (Θ) 𝜕𝑝𝑡 𝑆𝑡 𝜎ϕ 𝑑1
=− + 𝐾𝑟𝑒𝑥𝑝(−𝑟𝜏)Φ 𝑑2
𝜕𝜏 2 𝜏
Vega (ν) 𝜕𝑝𝑡
= 𝑆𝑡 𝜏ϕ 𝑑1
𝜕𝜎
Rho (ρ) 𝜕𝑝𝑡
= −𝜏𝐾𝑒𝑥𝑝(−𝑟𝜏)Φ −𝑑2
𝜕𝑟
 The Greeks and hedging Volatility: Implied Volatility

Volatility
𝑆𝑡 𝜎2
𝑙𝑛 + 𝑟+ 𝜏
𝑐𝑡 = 𝑆𝑡 Φ 𝑑1 − exp(−𝑟𝜏)𝐾Φ 𝑑2 𝐾 2
𝑑1 =
𝜎 𝜏

The option price depends on five parameters: τ , St , K, r, σ. Note that all of these are known, except σ.

σ can be estimated using the historical volatility, that is, the (annualised) standard deviation of the last 30 (perhaps) daily returns.
 The implicit assumption is that σ will be the same in the future as it has been in the recent past.
 If you increase the number of days, you attain more accuracy in your estimate, but you are less likely to pick up recent
changes in volatility.
 A better approach is to use ARCH/GARCH.
 These models recognise that volatility changes over time.
 They are estimated using past data and can be used to forecast future volatility

Implied Volatility

Since the market price of an option is known, and all the parameters except σ are known, we can find the value of σ that gives
rise to an option value equal to the market price. This value of σ is the implied volatility of the underlying stock price.

Typically, many different options are available on the same underlying stock.
In theory, we expect the implied volatility to be the same for all of them, since they are measuring the same thing.
In practice, we see that implied volatility varies with the strike price.
 The Greeks and hedging Volatility: Smiles and Smirks

Volatility smiles and smirks

Before 1987, implied volatility was a U-shaped function (known as a “volatility smile”) of the strike price, with minimum
around the current price.

Implied volatility

at the money Strike price

S
This implies that both in-the-money and
out-of-the money options were over-priced
relative to at-the-money options. Implication:
Log-normal distribution understates the probability of
extreme movements in price of underling asset.
 The Greeks and hedging Volatility: Smiles and Smirks

Volatility smiles and smirks

Since 1987, implied volatility has more commonly been a monotonically decreasing function of strike price (hence
“volatility smirk” or “volatility skew”).

Implied volatility

out the
in the at the money money Call
money Call
Strike price
S

This implies (e.g.) that in-the-money Calls

Implied distribution has heavier left tail than lognormal
are over-priced, but out-of-the-money calls
are under-priced.
 The Greeks and hedging Volatility

Question
Suppose that the stock price at time zero is S0 = £90.The continuously compounded risk free
rate is 5%, and European call option written on S with strike price £100 and time to expiry τ
= 1 year has delta of 0.352 and trades for £2.5. Find the implied volatility of the stock to
the nearest 1%.
1 − 0.352 = 0.648
Φ 𝑑1 = 0.352 ⟹ 𝑑1 = −0.38 𝑐𝑡 = 𝑆𝑡 Φ 𝑑1 − exp(−𝑟𝜏)𝐾Φ 𝑑2

𝑑2 = 𝑑1 − 𝜎 𝜏

2.5 = 90 ∗ 0.352 − exp −1 ∗ 0.05 ∗ 100 ∗ Φ −0.38 − 𝑠𝑖𝑔𝑚𝑎

2.5 = 31.68 − 95.123 ∗ Φ −0.38 − 𝑠𝑖𝑔𝑚𝑎

Φ −0.38 − 𝑠𝑖𝑔𝑚𝑎 = 0.306761

−0.38 − 𝑠𝑖𝑔𝑚𝑎 = −0.51

⟹ 𝑠𝑖𝑔𝑚𝑎 = 0.13 = 13%

 The Greeks and hedging Hedging

Hedging

The financial world is divided into speculators and hedgers.

Speculators:
 take a view on the direction of some quantity such as the asset price, or volatility in the asset price, and
implement a strategy (involving purchase or sale of options) in order to profit from this view.
 tend to lose if their view turns out to be incorrect.

Hedgers :
 buy options that they believe to be under-priced, and simultaneously purchase something else that has the
effect of eliminating all of the risk associated with the option trade.

More traditional classification includes: speculator, arbitrageurs and hedgers:

 Speculators use derivatives to bet on the future direction of price movements.
 Arbitrageurs take offsetting positions in two or more instruments to lock in profit.
 Hedgers use derivatives to reduce risk that they face from potential future movements in a market variable.
 The Greeks and hedging Hedging

Example 1: Perfect Hedge: Binomial pricing model with one time-period.

The current price is 100. Between now and expiry, the price either rises to 120, or falls to 90.
The strike price of the call option is 100. If you purchase the option, you either gain 20 at expiry, or you gain 0 at expiry

How do you make sure that the amount you receive at expiry is the same, regardless of the price of the underlying?

120
c=20
c=20
100
90
c=0
c=0

In addition to purchasing the option, you sell w units of the underlying.

What if you do not have any units to sell? You short-sell.
So, for each option that you purchase,
The value of your portfolio at expiry is then: you need to short-sell 0.67 units of the
underlying.
Either 20 – 120w or 0 – 90w
This amounts to a “perfect hedge” since it
You want these values to be the same, so: results in an outcome that is invariant to
20 – 120w = -90w → w = 0.67 the price of the underlying.
 The Greeks and hedging Hedging

Example 2: Speculation: Straddles.

A straddle is a portfolio consisting of a call and a put with the same strike and same expiry date.
The payoff diagram is shown below:

Such a contract might be bought when the current price is in the

Value vicinity of the strike price (both options are At The Money), but the
investor has reason to believe there will soon be a significant change in
call the price, up or down.
put E.g. there will shortly be an Earnings Announcement, and it is hard to
predict whether the news will be good or bad.

Note that in order to buy a Straddle, someone must be willing to sell it.
It would be sold by someone who has the opposite view: someone who
expects the underlying price to remain stable.
K ST

These contracts are traded by those who have a view on the future direction of volatility (think of ARCH/GARCH modelling).
 Investors forecasting a burst of volatility are likely to purchase Straddles.
 Those forecasting a period of calm are likely to sell them.
Note that their view on the direction of the underlying price is irrelevant. For this reason, Straddles are known as volatility trades.

Buying a Straddle is a good way of reducing risk at times of high volatility.

Also, it is a very straightforward strategy which requires “no maintenance”.

However, it is not a “perfect hedge”. You can lose. E.g. if you buy a Straddle and the price doesn’t move.
 The Greeks and hedging Hedging: Delta Hedge

Delta Hedge

You use an Econometric Model (probably ARCH/GARCH) to forecast the

volatility of the underlying stock price.

If this volatility is higher than the implied volatility of the call option, you
conclude that the call option is under-priced, and you purchase it.

You paid an amount C (0.9704) for the call option. But, by your calculations, it is
worth V (1.244902), where V > C.

If the underlying stock price falls tomorrow, value of the call option falls. How should you hedge against this loss?
Sell w units of the underlying stock. What if you don’t have any to sell? Short-sell.

Value of your portfolio:

V – w*S

How do we choose w?
In order to construct a perfect hedge, we need to ensure that the value of the portfolio is always the same whatever happens to
the price of the underlying (S), thus:
V – w*S = k

where k is some constant that does not depend on S.

Let’s differentiate both sides with respect to S.

 The Greeks and hedging Hedging: Delta Hedge

𝑑𝑉 𝑑𝑉
−𝑤 =0 ⇒𝑤= ≡∆
𝑑𝑆 𝑑𝑆

So, the number of units that we need to short-sell in order to create a perfect hedge is given by the option’s “delta”.
Recall that the delta of a vanilla call option is:
𝑆𝑡 𝜎2
𝜕𝑉 𝑙𝑛 + 𝑟+ 𝜏
𝐾 2
Δ= = Φ 𝑑1 𝑑1 =
𝜕𝑆 where:
𝜎 𝜏
This is delta-hedging.

A problem is that delta changes when S changes.

 This means that every time the price of the underlying changes, the portfolio needs to be “re-hedged” in order to
maintain the fixed value of the portfolio.
 Such re-hedging involves either further short-selling of the underlying (if S has risen) or buying back units of the
underlying (if S has fallen).
 How important it is to re-hedge depends on the responsiveness of delta to changes in S. This responsiveness is given
by “gamma”:

𝜕2𝑐𝑡 ϕ 𝑑1
Γ= =
𝜕𝑆𝑡 2 𝜎𝑆𝑡 𝜏
 An option with a high gamma is little use for hedging, because the hedge would need to be readjusted constantly.
 The Greeks and hedging Hedging

Goal: Portfolio Delta = 0

Delta-hedged portfolio:

 You are protected against small movements in the prices of underlying asset

 As the price of underlying asset changes the delta changes as well

=> you need to re-hedge
=> dynamic hedging BTW: what is delta of a stock/
underlying asset?
 Re-hedging usually done once a day 1

Gamma-hedged portfolio: Goal: Portfolio Gamma = 0

 Between rebalancing at the trading times, Delta will drift away from zero as the underlying asset prices move.
If the portfolio is Gamma-hedged at the discrete trading times then the amount of such drift will be small
(comparable to the square of the change in underlying price).

 You are protected against larger movements in the prices of underlying asset

 Since underlying asset has Gamma = 0 ,

=> position in some other instrument that is non linearly depended on underlying asset needs to be taken;
=> this will affect delta, thus position in the underlying needs to be adjusted accordingly
 The Greeks and hedging Hedging

Vega-hedged portfolio: Goal: Portfolio Vega = 0

 The underlying volatilities used in hedging calculations are all estimates.

If these are incorrect then delta hedging may be incorrect, consequently it is appropriate to attempt to immunise a
portfolio against (small) errors in volatility estimates.
Just as in delta hedging, achieving a portfolio Vega of zero achieves this.

 You are protected against miss-specification of the volatility

 Since underlying asset has Vega = 0,

=> position in some other instrument that is non linearly depended on underlying asset needs to be taken;

 In order for portfolio to be both Vega and Gamma neutral position in 2 different instruments needs to be taken
 The Greeks and hedging Hedging

Example:
Consider a delta neutral portfolio, with Gamma of -5000 and Vega of -8000.
Option 1 has Delta = 0.6, Gamma = 0.5 and Vega = 2;
Option 2 has Delta = 0.5, Gamma = 0.8 and Vega = 1.2.

To make portfolio Gamma and Vega neutral both Option 1 and 2 should be used:

−5000 +0.5𝑤1 + 0.8𝑤2 =0

and −8000 +2𝑤1 + 1.2𝑤2 =0

where w1 is quantity of Option 1;

w2 is quantity of Option 2.

𝑤1 = 400 𝑎𝑛𝑑 𝑤2 = 6000

The delta of the portfolio after addition of Option 1 and 2 changes to:

400 × 0.6 + 6000 × 0.5 = 3240

Therefore 3 240 units of the underlying need to be sold to maintain delta neutrality.
 The Greeks and hedging Hedging

Options, when first sold, are usually close to at the money…

so have relatively high Gammas and Vegas….

with time the price of underlying usually changes enough to make option deep in the money or out of money…

thus both Gammas and Vegas are very small…

consequently focus on delta while hedging

 The Greeks and hedging Hedging

Hedging, delta, Value of the Option…and Black-Scholes

Example: We sold for £300 000 European call option on 100 000 shares of
a non-dividend paying stock. We also know that:
S0 = 49, K = 50, r = 0.05, σ = 0.2, τ = 0.3846
The Black- Scholes price of the option is £ 240 000.
Have we just made £60 0000 profit?
Not necessarily…
…there are risks

What can we do?

1. Do nothing: have naked position
 Consequences:
 If ST < K option will not be exercised, we made £300 000
 If ST > K option will be exercised, our cost is 100 000 (ST – K)
e.g. ST = £60, the cost is 10 * 100 000 = 1000 000, which is much greater than £300 000
2. Buy 100 000 shares as soon as we sold the option: covered position
 Consequences:
 If ST < K option will not be exercised, we have lost (S0 – ST)* 100 000 on position in stock
if ST = £40, we lost £900 000 on stock
 If ST > K option will be exercised, we gain (K-S0)*100 000
3. Stop- loss strategy:
 Buy stock if price raise above K, sell if it falls below K
 Can be costly
4. Perfect Hedge would make the cost of option be equal to Black Scholes price…
Dynamic Delta Hedge
Only with dynamic delta hedge we have profit of £60 000
 The Greeks and hedging Hedging

Hedging, delta, Value of the Option…and Black-Scholes

2557.8 + 2.5 – 308 = 2252.3

Simulation of delta hedging.

Option closes in the money.
Cost of hedging £263 300.

Option is exercised

We get 50*100 000 for the

shares we have.
 The Greeks and hedging Hedging

Hedging, delta, Value of the Option…and Black-Scholes

Simulation of delta hedging.

Option closes out of the money.
Cost of hedging £256 600.

The difference in the cost

of hedging the position in
option and Black-Sholes
price come from the
frequency of hedge
rebalancing.

Still even weekly

rebalancing locks us in
profit…
 The Greeks and hedging

 The Greeks

 Delta, Gamma, Theta, Vega, Rho

 Volatility

 Implied Volatility

 Volatility Smiles and Smirks

 Hedging

 Delta Hedge
EXERCISE
Derivatives and Risk Management: The Greeks….. Marta Wisniewska
7. Value at Risk
 Value at Risk

 VaR

 Calculating VaR:

 Historical Simulation;

 Model Building Approach

 VaR of Option Portfolio

 Value at Risk VaR: Introduction

Value at Risk (VaR)

Each of the Greeks (delta, gamma and vega) were describing different aspect of risk of a portfolio.

Value at Risk (VaR) is a measure that attempts to summarize the total risk of a portfolio and evaluates ‘how bad things can get’.
VaR (V) can be best described by following statement:
‘We are X percent sure there will not be a loss of more than V in the next N days’.

Thus, VaR is the loss level (V) over N days that has a probability of only (100 - X)% of being exceeded.

VaR is a function of:

(1) time horizon (N days) and
(2) confidence interval (X%).
VaR is the loss corresponding to the (100 - X)th percentile of the distribution of the gain in the value of the portfolio over the
next N days.

Example: If N = 5 and X = 97 what is the VaR?

VaR is a 3rd percentile of

the distribution of gain in
the value of the portfolio in
the next 5 days.
p = (100 - X)% = 3%

gain over N days

 Value at Risk VaR: Introduction

gain over N days

gain over N days

Two portfolios with different distribution of gains can have the same VaR.

Expected shortfall is the expected loss during an N-day period conditional that an outcome occurs in the (100-X)% left
tail of the distribution.
 Value at Risk VaR: Introduction

Time Horizon
iind: independent identical normal distribution.
In practice N is usually set to 1 and the usual assumption is that:

(𝑁 − 𝑑𝑎𝑦 𝑉𝑎𝑅) = (1 − 𝑑𝑎𝑦𝑉𝑎𝑅) × 𝑁

This formula is true if changes in the value of portfolio have iind (with mean 0), otherwise it is just an approximation.

Example 1: 10-day 99% VaR can be calculated as:

10 = 3.162 𝑡𝑖𝑚𝑒𝑠 𝑡ℎ𝑒 1 − 𝑑𝑎𝑦 99% 𝑉𝑎𝑅

Example 2:
What is the relationship between volatility per year σyear (used in option pricing) and volatility per day σday (used at VaR).

Assuming 252 trading days it is:

𝜎𝑦𝑒𝑎𝑟 = 𝜎𝑑𝑎𝑦 252

Daily volatility is about 6% of annual volatility.

 Value at Risk Calculating VaR: Historical Simulation

Calculating VaR: Historical Simulation

The distribution of daily loss in the value of the portfolio depends on the value of x market variables (v).
Define vi as the value of a market variable on Day i and suppose that today is Day n.
The ith scenario assumes that the value of the market variable tomorrow will be:

𝑣𝑖
𝑣𝑎𝑙𝑢𝑒 𝑢𝑛𝑑𝑒𝑟 𝑖 𝑡ℎ 𝑠𝑐𝑒𝑛𝑎𝑡𝑖𝑜 = 𝑣𝑛
𝑣𝑖−1

Example 1: Calculate 1-day VaR using 99% confidence level on 501 days of data.

First identify the factors affecting the Value of the portfolio.

Next calculate the daily changes in those factors.
You should have 500 such changes.
Create scenarios of the value of the portfolio based on those changes.
Since there are 500 scenarios, the 99th percentile of the distribution is the 5th highest loss.
 Value at Risk Calculating VaR: Historical Simulation

Example 2: Today the value of the portfolio is 10 000USD.

There are 4 assets in the portfolio, and their value is: (1) DJIA: 4 000USD, (2) FTSE 100: 3 000USD, (3)
CAC 40: 1 000USD and Nikkei 225: 2 000USD.
What is the one-day 99% VaR?

Scenario 1: Value of DJIA

11173.59
11022.06 × = 10977.08
11219.38

value today
1st possible
growth rate
 Value at Risk Calculating VaR: Historical Simulation

Scenario 1: Value of the portfolio

10977.08 5180.40 4229.64 12224.10

4000 × + 3000 × + 1000 × + 2000 × = 10014
11022.06 5197 4226.81 12006.53

Thus the portfolio has a gain of 14 USD under Scenario 1.

 Value at Risk Calculating VaR: Historical Simulation

The one-day 99% VaR can be estimated as the 5th worst loss.

This is 253,385.
 Value at Risk Calculating VaR: Model Building Approach

Calculating VaR: Model-Building Approach

Consider portfolio worth P that consist of n assets with an amount αi being invested in each asset i (1 ≤ i ≤ n).
Define Δxi as the return on asset i in one day.
The change in the value of the investment in asset i in one day is αi Δxi and the change in the value of the portfolio in one
day is:
𝑛

∆𝑃 = 𝛼𝑖 ∆𝑥𝑖
𝑖=1

If Δxi are multivariate normal, then ΔP is normally distributed.

Assume that the expected value of Δxi change is zero (in reality it is different than zero, but small in comparison to the
standard deviation), the mean of is zero.
Therefore to calculate VaR one need to calculate the standard deviation of ΔP (σP ):

𝑛 𝑛

𝜎𝑝2 = ρ𝑖𝑗 α𝑖 α𝑗 σ𝑖 σ𝑗
𝑖=1 𝑗=1

where σi is the daily volatility of the ith asset, and ρij is the correlation coefficient between returns on asset i and asset j.
 Value at Risk Calculating VaR: Model Building Approach

Example:
Consider a portfolio consisting of 10 000GBP of shares A, and 5 000GBP of shares B.
The returns on those two shares have bivariate normal distribution with a correlation of 0.3.
The volatility of A is 2% a day and the volatility of B is 1%.
What is 10-day 99% VaR?

Share A over 1-day period has a standard deviation of 200 GBP (= 10 000* 0.02), whereas share B of 50 GBP.
The standard deviation of the portfolio is therefore:

𝜎𝑃 = 2002 + 502 + 2 × 0.3 × 200 × 50 = 220

The mean change is assumed to be zero, and the change in the value of the portfolio is normally distributed.
N(-2.33) = 0.01 means that there is 1% probability that normally distributed variable will decrease in value by more than
2.33 standard deviations.
Therefore 1-day VaR is:

220 × 2.33 = 512.6

Whereas 10- day VaR is:

10 × 512.6 = 1620
 Value at Risk VaR of Option Portfolio

VaR of Option Portfolio

Consider portfolio of options of single stock. Delta of the portfolio is:

Δ𝑃
𝛿=
Δ𝑆
Define Δx as the percentage change in the stock price in 1 day:

Δ𝑆
∆𝑥 =
𝑆
We know that the approximate relationship between ΔP and Δx is:

∆𝑃 = 𝑆δΔ𝑥

If there are several underlying, then approximate relationship between ΔP and Δxi is similar:
𝑛

∆𝑃 = 𝑆𝑖 𝛿𝑖 ∆𝑥𝑖
𝑖=1
Define 𝛼𝑖 = 𝑆𝑖 𝛿𝑖 we have:
𝑛

∆𝑃 = 𝛼𝑖 ∆𝑥𝑖
𝑖=1
 Value at Risk VaR of Option Portfolio

Example:
Portfolio consists of options on stock X and Y.
The option on stock X has delta of 1 and on stock Y of 20.
X trades for 120 and Y for 30.
What is 5 day 95% VaR?

It is approximately true that:

∆𝑃 = 120 × 1 × ∆𝑥1 + 30 × 20 × ∆𝑥2

= 120∆𝑥1 + 600∆𝑥2

The portfolio is assumed to be equivalent to an investment of 120 in X and of 600 in Y.

Assuming that the daily volatility of X is 2% and of Y is 1% (and assuming the correlation is 0.3), the standard deviation of
is:

120 × 0.02 2 + 600 × 0.01 2 + 2 × 120 × 0.02 × 600 × 0.01 × 0.3 = 7.099

Since N(-1.65) = Φ(-1.65) = 0.05, thus 5-day 95% VaR is:

1.65 × 5 × 7.099 = 26.19

 Value at Risk VaR of Option Portfolio

When options are included in portfolio linear model is approximation.

Gamma of the portfolio should be taken into account as well.

When gamma is positive probability distribution of the value of the portfolio is positively skewed.

long call

positive gamma

Tend to have less heavy left tail than the

normal distribution.
If the distribution is assumed to be normal,
then the VaR is overestimated
 Value at Risk VaR of Option Portfolio

When options are included in portfolio linear model is approximation.

Gamma of the portfolio should be taken into account as well.

When gamma is positive probability distribution of the value of the portfolio is positively skewed.
When gamma is negative, it is negative skewed.

short call

negative gamma
Tend to have heavier left tail than the
normal distribution
If the distribution is assumed to be normal,
then the VaR is underestimated.
 Value at Risk VaR of Option Portfolio

Thus both delta and gamma should be used to calculate the change in the value of portfolio.
In portfolio depended on single asset:

1 2
∆𝑃 = δΔ𝑆 + 𝛾 ∆𝑆
2

Using earlier formulas:

1
∆𝑃 = 𝑆δΔ𝑥 + 𝑆 2 𝛾 ∆𝑥 2
2

In portfolios with n underlying market variables, with each individual instrument depended on one market variable (7.18)
becomes:

𝑛 𝑛
1 2 2
∆𝑃 = 𝑆𝑖 𝛿𝑖 ∆𝑥𝑖 + 𝑆 𝛾 ∆𝑥𝑖
2 𝑖 𝑖
𝑖=1 𝑖=1
 Value at Risk

 VaR

 Calculating VaR:

 Historical Simulation;

 Model Building Approach

 VaR of Option Portfolio

EXERCISE
Derivatives and Risk VaR Marta Wisniewska
Derivatives and Risk VaR Marta Wisniewska
8. American Options
& Dividends
American Options and Dividends

 American Options

 Dividends
 American Options and Dividends American Options

American Options

when to exercise? European Option

American Option

t T time
today expiry

American Options are contracts that may be exercised before expiry (“Early Exercise”), whereas
European only on the expiry date
Example: if we buy an American Call option with one year to expiry,
we can pay the strike price for the unit of the underlying at any time in the next year.

The right to early exercise is an advantage – the value of an American Option must be at least as high as a European option with
otherwise the same characteristics.
Value of American option can never fall below the current pay-off.

Example: if the strike is 100, and the current price of underlying is 70, the price of the put option must be at least 30. Why?
Imagine that this condition is not met. Say the price of the option is 25.
You would buy the option for 25, and immediately exercise it, (short) selling the underlying for 100.
You would then buy it back for the current price of 70.
Your net (riskless) profit from your brief ownership of the option would be 5.

In symbols, this constraint is: 𝑉 ≥ 𝑚𝑎𝑥 𝐾 − 𝑆𝑡 , 0

Note that there is also a constraint that the option value cannot be negative.
 American Options and Dividends American Options

American Options

There is a disadvantage:
the holder of an American Option needs to decide WHEN to Exercise;
this is not an easy decision.

Example: American Put Option; Strike = 100; time to expiry 1 year. After 189 days, you are here:

160 160

140 140

120 120

100 100

80 80
60 60
40
40
20
20
0
0 100 200 300 400 0
0 100 200 300 400

The price of the underlying is 58. It would have been better to wait until day 327, when the
If you exercise now (i.e. on day 189), your payoff is 42. price was 40, so payoff would have been 60.

Do you exercise now, or do you wait? But how were you to know this?

You are likely to formulate a rule:

As soon the price reaches S*, exercise the option.
S* will be called the optimal exercise point.
 American Options and Dividends American Options

American Options

American Options with Expiry

We now assume that the option expires at time T, so the time to expiry is τ = T - t.
The easiest way to analyse this problem is in the context of the binomial model.
Example:
Let’s consider an American put option with time to expiry 1 year, and a strike of 100.
The current price of the underlying is 100.
Let us divide the time to expiry into three four-month intervals.
Assume that in any interval, the price can either rise by 10 or fall by 10 with equal probability.
The risk-free rate is 0.06 (continuously compounded).
t=0 t=0.67 t=1
t=0.33 A= 5 * exp(-0.06*0.33)= 4.9
130
120 0 B = 20 * exp(-0.06*0.33)= 19.607
0
110 0 110 C= 2.45 * exp(-0.06*0.33)= 2.4019
0 0 D= 12.45 * exp(-0.06*0.33)= 12.265
C 100
100 E= 7.334 * exp(-0.06*0.33)= 7.225
0 0
A
E 90 90 At each node in the tree, we compare the
10 80 10 pay-off from exercising, with the
D 20 discounted expected pay-off from holding
B 70 on to the option.
30
Whenever the former exceeds the latter,
early exercise is rational.
 American Options and Dividends American Options

American Options

American Options with Expiry

American Call Options
In the absence of dividends, early exercise is never rational on an American call option..

Proof:
 You purchase an American call option with strike K and one year to expiry.
 At some point in the next year (day t say), if the price of the underlying (St) is sufficiently far above K, you might consider
early exercise, pocketing the pay-off of St - K .

 Instead of early exercise, you could do the following:

 Hold on to the option, and short-sell one unit of the underlying, receiving an amount St at time t.
 At expiry (T), either:
a. If ST < K : Buy the short-sold unit back at price ST.
Let the option die.
b. If ST < K : Exercise the option.
That is, pay K for a unit of the underlying.
Under (a), you receive St at t, and then lose an amount less than K at T.
Under (b), you receive St at t, and then lose an amount K at T.

Either way, this is better than exercising at t, with the pay-off St - K .

Hence, the value of an American call option is the same as the value of a European call option with the same strike and expiry date.

No such reasoning can be applied to put options. American puts are ceteris paribus more valuable than European puts.
 American Options and Dividends Dividends

Dividends

Up until now, we have been assuming that no dividends are paid on the underlying stock.
Let’s relax this assumption.

A dividend is paid to the holder of a stock on a particular date – let us call this the dividend date.

Immediately after the dividend date, ceteris paribus, the value of the stock will fall by an amount equal to the dividend payment

[In fact, for tax reasons, the amount by which the share value falls is slightly less than the amount of the dividend, but let us
ignore this complication.]

Example: if a share price is £100 immediately before the dividend is paid, and the dividend is £4,
we will assume that the share price will be £96 on the day after the dividend date.

Didivend: £4

£ 100
£ 96 time
dividend date
 American Options and Dividends Dividends

Dividends

Example: Binomial Model with 2 periods.

 Consider a European call option with time to expiry one year, and strike price 90.
 The current price of the underlying is 100.
 Divide the time to expiry into two six-month intervals, and assume that in each interval, the price can rise by 10 or fall
by 10 with equal probability.
 Further assume that a dividend of 5 is paid at dividend date five months into the life of the option.

Find the value of the option.

t=0 t = 0.5 t=1 A= 15 * exp(-0.06*0.5)= 14.70592

115
110 25 B= 2.5 * exp(-0.06*0.5)= 2.450987
↓
105
C= 8.57 * exp(-0.06*0.5)= 8.3167
A
100 95
C 5
90
↓
The higher the dividend, the lower
85 the value of the call option.
B
75
0
 American Options and Dividends Dividends

Dividends

Example: Binomial Model with 2 periods.

Find the value of the put option, ceteris paribus.

A= 7.5 * exp(-0.06*0.5)= 7.35296

t = 0.5 t=1 B=3.676* exp(-0.06*0.5)= 3.604323

t=0
115
110
↓ 0
105
100 0
95
B
0
90
↓
85
A The higher the dividend, the
higher the value of the put option.
75
15
 American Options and Dividends Dividends

Dividends

Dividends in the Black-Scholes formula

Case 1: Given dividends and dividend dates

If the amounts of the dividends and the dividend dates are given, a simple adjustment needs to be made:

 Compute the present value of the dividend payments, discounted using the risk-free rate.
 Then simply subtract this from the current stock price St.
 Then apply the Black-Scholes formula in the usual way with this downward-adjusted stock price in place of St.

Example: if the current stock price is £100,

dividends of £2 will be paid after 3 months and 9 months,
the option expires in 12 months, and the risk-free rate is 0.08,
then the present value of the two dividend payments is:

2.0 exp −0.08 × 0.25 + 2.0 exp −0.08 × 0.75 = 3.84

We then subtract this amount from the current stock price:

100 − 3.84 = 96.16

We then use the Black-Scholes formula with 96.16 as the current price in place of 100.
 American Options and Dividends Dividends

Dividends

Dividends in the Black-Scholes formula

Case 2: Dividend given as a dividend rate

Sometimes, the dividend is given as an annual dividend rate.

The stock used in the example above paid dividends of £2 every six months, and therefore £4 each year.
Since the current stock price is £100, the dividend rate in this example is 4% (or 0.04).

Let the dividend rate be δ.

The parameter δ enters the Black-Scholes formula in the following way.

As usual, we need to define the two quantities:

𝑆𝑡 𝜎2
𝑙𝑛 + 𝑟−𝛿+ 𝜏
𝐾 2 𝑑2 = 𝑑1 − 𝜎 𝜏
𝑑1 =
𝜎 𝜏

The formula for the value of a Call Option is:

𝑐𝑡 = 𝑆𝑡 exp(−𝛿𝜏)Φ 𝑑1 − exp(−𝑟𝜏)𝐾Φ 𝑑2

And the formula for the value of a Put Option is:

𝑝𝑡 = exp −𝑟𝜏 𝐾Φ −𝑑2 − 𝑆𝑡 exp(−𝛿𝜏)Φ −𝑑1

American Options and Dividends

 American Options

 Dividends
EXERCISE
Derivatives and Risk Management American Options… Marta Wisniewska
Derivatives and Risk Management American Options… Marta Wisniewska
Lecture 5:

9. Real Options

Test
9. Real Options
 Real Options

 Real Options: Introduction

 Market Price of Risk

 Types of Real Options

 Valuation of Real Options: Examples

 Option Pricing in Equity Valuation

 Real Options Introduction

OPTIONS

FINANCIAL Options REAL Options

 The right, but not the obligation, to  The right, but not the obligation to
buy or sell underlying asset. undertake certain business activities,
such as deferring, abandoning,
 Underlying traded on liquid market expanding capital investment.

 Represents decision or choices to be

made during life of investment project
 Deals with capital budgeting or
resource allocation decision

 Underlying can be illiquid, hard to

trade or traded on inefficient market
Real Options Introduction
Real Options Introduction
 Real Options Introduction

Valuation of potential capital investment project

Premium
Underestimates
the value of the
Real should be
Options paid on
NPV project with project
embedded option with
embedded
option (vs
 NPV of a project = PV of expected future NPV)
incremental cash flows
𝐶𝐹1 𝐶𝐹𝑛  Risk-free rate
𝑁𝑃𝑉 = −𝐶𝐹0 + + ⋯+ 𝑛
1+𝑟 1+𝑟  Risk-neutral probabilities
𝑟𝑓 − 𝐷
 CF: Real life probabilities 𝑝=
 Risk-adjusted discount rate (from e.g. CAMP) 𝑈−𝐷

 NPV > 0: undertake the project  Requires market price of risk (λ)
 It creates value to the shareholders for stochastic variables

 Projects usually have options build within 𝜇 − 𝑟𝑓

them λ=
𝜎
 Different risk than the project
 Different discount rate needed
 Real Options Introduction

A bad investment…

+100

100*0.5 + (-120)*0.5
today = -10

-120
 Real Options Introduction

A bad investment… becomes a good one

+80
NPV: expected cashflows from +100
today’s point without considering
other pathways given what
happens in the first year, etc.

+20 30

-70
today 10

-20 Learn at the 1st

stage

The keys to real option

value come from
learning and adaptive -120
behaviour.
 Real Options Introduction

Can the valuation be the same?

Real
NPV Options

If you modified decision tree analysis to:

 Estimate risk-neutral probabilities to estimate an expected value,

 Adjust the expected value for the market risk in the investment and
 Use the riskfree rate to discount cashflows in each branch

… it could yield the same values as option pricing models

 Real Options Market Price of Risk

Suppose that real asset depends on several variables θi (i=1,2,..), where:

𝑑𝜃𝑖
= 𝑚𝑖 𝑑𝑡 + 𝑠𝑖 𝑑𝑊
𝜃𝑖

λi is the market price of risk of θi

Risk-neutral valuation: any asset dependent on θi can be valued by:

 Reducing the expected growth rate of each θi from mi to mi - λisi.
 Discounting cash-flows at the risk free rate

Assume V has lognormal distribution

𝐸 𝑚𝑎𝑥 𝑉 − 𝐾, 0 = 𝐸 𝑉 𝑁 𝑑1 − 𝐾𝑁 𝑑2

𝐸(𝑉) 𝜔2 𝐸(𝑉) 𝜔2
𝑙𝑛 + 𝜏 𝑙𝑛 − 𝜏
𝐾 2 𝐾 2
𝑑1 = 𝑑2 =
𝜔 𝜏 𝜔 𝜏

where ω is the volatility of V

 Real Options Market Price of Risk

Example: Current cost of renting 1m2 is £30. Cost is quoted as amount per 1m2 per year in 5-year
rental agreement. The expected growth rate in the cost is 12% pa, volatility 20% pa, market price of
risk 0.3. What is the value of an opportunity to pay £1m now for option to rent 100 000m2 at £35
for 5 years in 2 years time? Assume 5% risk-free rate pa.
A: annuity factor
Let V be cost per 1m2 in 2 years time. 4.5355

The pay off from the option is: 100 000 × 𝐴 × 𝑚𝑎𝑥(𝑉 − 35, 0) call

Expectations in
The expected pay off in risk neutral world: risk neutral world
𝐸(𝑉) 0.22
𝑙𝑛 + 2 2
100 000 × 4.5355 × 𝐸 𝑚𝑎𝑥(𝑉 − 35, 0) 𝑑1 =
35
0.2 2
= 453 550 × 𝐸 𝑚𝑎𝑥(𝑉 − 35, 0)
𝐸 𝑉 = 30 exp((𝑚𝑖 − 𝜆𝑖𝑠𝑖 ) ∗ 2)
= 453 550 × 𝐸 𝑉 𝑁 𝑑1 − 35𝑁 𝑑2
= 30 exp((0.12 − (0.3 ∗ 0.2)) ∗ 2)
= 1 501 500 = 30 exp(0.06 ∗ 2)
= 33.83
Value of the option:
1 501 500 ∗ exp(−0.05 ∗ 2) = 1 358 600

The opportunity is worth: 1 358 600 − 1 000 000 = 358 600

 Real Options Market Price of Risk

When historical data are available market price of risk can be estimated using:

𝜌
λ= 𝜇 − 𝑟𝑓
𝜎𝑚 𝑚
λ: market price of risk
ρ: instantaneous correlation between the percentage change in the variable and returns on stock
market index
σm: volatility of return on stock market index
μm: expected return on stock market index
rf: short term risk-free rate

Example:
Percentage changes in company’s sale have a correlation of 0.3 with returns on FTSE100 index. The
volatility of FTSE100 returns is 20%pa, the expected excess returns of FTSE100 over risk-free rate
is 5%.

The market price of risk is:

0.3
λ= ∗ 0.05 = 0.075
0.2
 Real Options Types of Real Options

Types of Real Option

Most investment projects involve options. Those options can add substantial value to the project.
Examples of options embedded in the project:

 Option to Abandon
 Option to sell or close down a project.
 It is an American put option on the project’s value with the strike price being the
liquidation (or resale) value less closing- down costs.
 It mitigates impact of poor investment performance.

 Option to Expand
 Option to make further investments if conditions are favourable.
 It is an American call option on the value of additional capacity. The strike price is the cost
of creating this additional capacity discounted to the time of option exercise.
R&D
 The strike price depends on initial investment.
Patent
 Option to Wait/ Delay
Oil exploration
 This is an American call option on the value of the project.

Project can include more than one option.

 Real Options Option Valuation

OPTION Valuation Models

Black-Scholes Binomial Model

 For European option without  Can price American Option

dividend
 Majority of real options are exercised
 Can be adjusted for dividend before maturity (early exercised)

 What about American option?  Often underlying assets are

discontinuous
 American Call Option will never be
exercised prior maturity…  Binomial tree with outcomes at each
node looks like a decision tree from
capital budgeting.

Still getting the inputs to a binomial model can be difficult…

 Real Options Option Valuation: Examples

Valuing product patent as an option

 A patent provides the company with the right to develop and market the product.

 The product will be developed and marketed only if the present value of the expected cash flows
from the product sales (V) exceed the cost of development (I).

 If this does not occur, the patent will not be used and non further cost will be incurred.

 The payoffs from owning a product patent can be written as:

Max ( 0, V – I )
.

Pay-off

I V
 Real Options Option Valuation: Examples

𝑐𝑡 = 𝑆𝑡 exp(−𝛿𝜏)Φ 𝑑1 − exp(−𝑟𝜏)𝐾Φ 𝑑2 𝑆 𝜎2
𝑙𝑛 𝐾𝑡 + 𝑟 − 𝛿 + 2 𝜏
𝑑1 =
𝜎 𝜏

𝑑2 = 𝑑1 − 𝜎 𝜏

Input Estimation Process

St: Value of the Underlying  PV of Cash Flows from taking the project now
Asset

σ2: Variance in value of  Variance in CF of similar asset or firm

underlying  Variance in PV from capital budgeting
simulation
K: Exercise Price on Option  Cost of making investment in the project

τ: Expiration of the Option  Life of the patent

δ: Dividend Yield  Cost of delay

 Each year of delay means less years of CF
 Real Options Option Valuation: Examples

Example:
Company X, a bio-technology company, has a patent on ABC, a drug to treat multiple sclerosis, for the
next 17 years. X plans to produce and sell the drug by itself.

The key inputs on the drug are as follows:

 St: PV of Cash Flows from Introducing the Drug Now = £3.422 billion
 K: PV of Cost of Developing Drug for Commercial Use = £2.875 billion
 τ: Patent Life = 17 years
 r: Riskless Rate = 6.7% (17-year T.Bond rate)
 σ2: Variance in Expected Present Values = 0.224 (Industry average firm variance for bio-tech
companies)
 δ: Expected Cost of Delay = 1/17 = 5.89%

𝑐𝑡 = 𝑆𝑡 exp(−𝛿𝜏)Φ 𝑑1 − exp(−𝑟𝜏)𝐾Φ 𝑑2
Implementing BS model:
d1 = 1.1362 N(d1) = 0.8720
d2 = -0.8512 N(d2) = 0.2076

Call = 3,422*exp(-0.0589*17)*(0.8720) - 2,875*(exp(-0.067*17)*(0.2076)

= £907 million

NPV of this project:

= 3422 – 2875
= £547 million
 Real Options Option Valuation: Examples

Valuing natural resources

 The underlying asset is the resource and the value of the asset is based upon two variables: (1) the
quantity and (2) the price of the resource.
 Usually there is a cost associated with developing the resource, and the difference between the
value of the asset extracted and the cost of the development is the profit to the owner of the
resource.
 Define the cost of development as X, and the estimated value of the resource as V.
 The payoffs from a natural resource option can be written as:
Max ( 0, V – X )

Pay-off

X V
 Real Options Option Valuation: Examples

𝑐𝑡 = 𝑆𝑡 exp(−𝛿𝜏)Φ 𝑑1 − exp(−𝑟𝜏)𝐾Φ 𝑑2 𝑆 𝜎2
𝑙𝑛 𝐾𝑡 + 𝑟 − 𝛿 + 2 𝜏
𝑑1 =
𝜎 𝜏

𝑑2 = 𝑑1 − 𝜎 𝜏

Input Estimation Process

St: Value of Available Reserves  Expert estimates (Geologist)
of the Resource  PV of cash flows from the recourse

σ2: Variance in value of  Based on variability of the price of the resource

underlying and variability of available reserves
K: Cost of Developing Reserve  Past costs and the specifics of the investment

τ: Time to Expiration  Relinquishment Period

 Time to exhaust inventory
δ: Net Production Revenue  Net production revenue every year as per cent of
(Dividend Yield) market value
Development lag  Calculate PV of reserve based upon the lag
Uncertainty about:
Price, Quantity, Costs
 Real Options Option Valuation: Examples

Example:
Consider oil reserve of 50 million barrels, with PV of the development cost $12 per barrel and the
development lag 2 years. Company X has the right to exploit this reserve for the next 20 years. The
marginal value per barrel of oil is $12. Once developed, the net production revenue each year will be
5% of the value of the reserves.
𝑐𝑡 = 𝑆𝑡 exp(−𝛿𝜏)Φ 𝑑1 − exp(−𝑟𝜏)𝐾Φ 𝑑2
The key inputs on the drug are as follows:
 St: Value of developed reserve discounted back the length of development lag at the
dividend yield = $12*50/(1.05)^2= $ 544.22 million
 K: PV of development Costs= $12 * 50 = $ 600 million
 τ: Time to expiration of the option = 20 years
 r: Riskless Rate = 8%
 σ2: Variance in ln(oil prices) = 0.03
 δ: Dividend yield= Net production revenue/Value of reserve = 5%

Implementing BS model:
d1 = 1.0359 N(d1) = 0.8498
d2 = 0.2613 N(d2) = 0.6030

Call = 544 .22 exp(-0.05*20) (0.8498) -600 (exp(-0.08*20) (0.6030))

= $97.08 million

NPV of this project:

= 544.22 – 600
= - $55.78 million
 Real Options Option Pricing in Equity Valuation

Option Pricing in Equity Valuation

 Equity in a troubled company

 Company with high leverage, negative earnings and a significant chance of
bankruptcy
 Equity can be viewed as a call option (option to liquidate the company).

 Natural resource companies

 The undeveloped reserves can be viewed as options on the natural resource.

 Start-ups or high growth companies

 Companies which derive the bulk of their value from the rights to a product or a
service (eg. a patent)

 In late 90s dot.com companies were valued as options to enter e-commerce market
 Huge premiums
 One could invest in Nokia or GE to enter the same market (lack of exclusivity)
 Real Options

 Real Options: Introduction

 Market Price of Risk

 Types of Real Options

 Valuation of Real Options: Examples

 Option Pricing in Equity Valuation

TEST