Appunti 1

The most heavily traded assets are futures and options.
November, 2002 p.4/42
Put option:
Call option:

ST
PT

ST

C T
An option is a financial contract which provides the right to buy

(sell) an asset in a future date at a given price.
Options
commodities: gold, cotton, etc.

derivatives
currencies (foreign exchange)
stocks (equity)
bond
Traded assets in financial markets are:
Introduction to finance
Futures are different from forward because of contractual

differences regarding guarantees and the way the payoff is
delivered.
Futures are more liquid than their underlying.
A futures contract gives you the obligation to buy an asset in a

future date. In institutional markets, the counterparts have to pay
a guarantee when signing the contract. Theres no initial price.
Derivatives are financial contracts whose payoff at future dates

depends upon the value of an other asset, called underlying.
Futures
..... than models are very sophisticated.
A lot of data are available......
Derivatives
Dipartimento di Economia Politica, Universit`a di Siena
reno@unisi.it
Roberto Ren`o
Option pricing: the Black & Scholes model
Finance
Finance is a subset of Economics, which is quite peculiar for two

reasons:
Introduction to finance

Money Market Account
r s ds

Lets look the time series of an asset (FIB30 2000-2001, daily

data):
r t B t dt
dS t
St

drift
t S dt

t S
t S dW t
volatility
t S
The price of a financial asset is modeled via a stochastic

differential equation:
Asset pricing
The short rate is the state variable adopted in interest rate models.
short rate, spot rate
dB t
rt
The Money Market account is a model of a riskless asset, whose

payoff is certain
Money Market Account
If r t is constant, it coincides with the yield to maturity.
B 0 exp
Bt
If r t id deterministic, the evolution of B t is deterministic, the

solution of the ordinary differential equation is
FIB30 time series
assets can be short-selled and bought in the desired

quantities
theres no default risk
theres no arbitrage
there are no transaction costs
We will work in market in which:
Perfect market
A market is said to be complete if it is possible to replicate any

derivative with a buy-and-sell strategy accomplished with the
underlying.
We assume that in the market is is not possible to realize a

positive payoff with no risk. Such a contract would be an
arbitrage contract. This assumption is called absence of arbitrage.
Absence of arbitrage and completeness

In the Black and Scholes model there are two assets S and B,
which follow the following dynamics:
The Black and Scholes model
F
s
1 2 2 2 F
S
rF 0
2
S2
F T S
ST
We then found a PDE for the price of any derivative.
0 the portfolio is riskless.
rS
1 we have

If uS
u dW t
V uS

u dt
F
t

V uS
Solving for uS and u , keeping in mind that uS
uS
Now we use the assumption of absence of arbitrage; since the

portfolio is riskless, its drift has to be equal to r.
dV

then:

u t V t
uS t V S t

V t
The value of the portfolio is then given by:
u be the fraction of wealth invested in
Arbitrage and PDE

Consider a portfolio composed by the asset S and the derivative.

Let:
uS be the fraction of wealth invested in S.

t
F
S
F
Arbitrage
This result is still valid if and depend on t S.
This result is valid only if the derivative is actively traded.
Our results depends only on the absence of arbitrage. This is

not astonishing, since the valuation equation for F needs the
dynamics of S to be computed.
Some considerations
1 2 2 2 F
S
2
S2
F
S
S
Portfolio
T.
F
t
The Black and Scholes model can be used to value derivatives.
be the derivative price at time t
B is the riskless asset.

ST
F sSs
Let s

r are constants!
S is the risky asset, tipycally a stock.
For example, for the Call option S T
S t dW t
S t dt
dS t
t dW t
t t dt
d t
rB t dt
Itos lemma allows us to compute the evolution of t S
Contingent claim valuation
dB t
Let us consider the problem of pricing a derivative issued in t

which promises a payoff at T t given by S T .
Contingent claim valuation
Lets look for a probabilistic interpretation of this result.

The Feynman-Kac formula says that the solution of the PDE is
given by:
e r T t EI X T
F t St
t
Risk Neutral valuation

r T s

Such a process is called a martingale, and

equivalent martingale measure.
Ps

EI
T:

is also called
Fundamental theorem of mathematical finance:

In the market, there are no arbitrage opportunities if and only if
there exists a probability which is equivalent to P under which
discounted prices are martingales under .
The market is complete if and only if is unique.

The above reasonings show that the Black and Scholes model is
complete and free of arbitrage.
Pt
F T ST e

The above formula says that, t
PsSs
s 2 ds
The relation we found for the Black and Scholes model is much
more general:
Risk is measured via volatility.
Risk premium: excess return per risk unit.
W t
W t

Let us consider the discounted price:
ST

is called risk neutral probability. Following Girsanovs

theorem, the relation between W and W is:
EI

F t St
r T t
Then, following Feynman-Kac formula, we can write:
1
2
Risk Neutral Probability and arbitrage
We then call the probability under which W is a Brownian

motion. We interpret X as the asset S under the probability .
Risk Neutral Valuation
s dW s
Risk Premium

with respect to P.
exp
Lt
Actually, investors are risk-averse. They take risky positions only

if them promise an excess return.
The only difference in the diffusion of X with respect to S is that

the drift is given by r instead of .
XdWt
dX
X t
Girsanov theorem says that for any process t , then

t
Bt
W t
0 s ds is a Brownian motion under the
probability P with density
Denote by P the probability under which Wt is a Brownian

motion.
Girsanov theorem
r r Xdt
St
where X is the solution of the SDE:
Indeed, investor would equally trade X, which has drift r but is

uncertain, and B, which has drift r and no uncertainity.
If X would be the price of an asset, than investors are risk-neutral
Risk Neutral Valuation

d2
d2
d1
$
%&%&'

1 2 2 2 F
S
2
S2
dt
F
V S dW t
V
Let us denote by u and u0 the fractions of wealth invested, in S

and B respectively:
u u0 1
F
S
The initial wealth invested in the strategy is given by the option

price.
dV t
F
t
We can than use again Itos lemma:

S
The value of the strategy must be given by the option price at any
instant:
F t St
V t
Now we address the following problem: I sold an option, and I

want to realize a strategy, using the underlying and the riskless
asset, which provides me the same payoff at maturity (hedging).
This task can be accomplished if the market is complete: i.e., if I

can replicate any option with a self-financed strategy which is
equivalent to the option itself.
The hedging strategy
Hedging
does not depend on .
&) )&*

In financial market, the Black and Scholes formula is so

widespread that what is quoted is not price, but implied volatility.
2
2
The estimate of obtained plugging the option prices in the Black

and Scholes formula and inverting is called implied volatility.
F
0
there is a one-to-one mapping between price and volatility.
Since
Implied volatility
"
is the cumulative distribution of a Normal 0 1 . The formula
We then verify that S t is exactly the desired solution.
W t
S
K

log

t
r T t

2
t
2
1
T
d1
d1

!

S0 exp
This suggests a method to estimate and using the time series

of prices. An estimate of obtained like that is called historical
volatility.
where:

St

t .
F t S
from which:
dWt
turns out to be Normal
with mean T

St
St
t and variance 2 T
dYt

ST
!
2
dt
2

Conversely, the distribution of
Using the solution we can compute the price of any derivative.

ST
K we
For example, for the Call option, S T
have:
log St and use (only formally!) Itos lemma:
SdWt

S 0 is then Lognormal.

The distribution of S T given S t
The Black and Scholes formula
dS Sdt
S0
S0
Historical volatility
We set Yt
We look for a solution of the SDE:
Solution of the Black and Scholes model

"
1 2 2 2 F
S
2
S2
rF
Now we should ask ourselves if its assumption are respected by

financial markets, and consequently if it can be used safely or not.
The Black and Scholes model is paramountly used, starting from

the early Seventies. It is the natural benchmark for any option
pricing model. It owes its fortune to its simplicity: its the
simplest diffusion model with Normal returns.
Are interest rates constant?

Interest rates vary through time:
Black and Scholes: the empirics
F
S
2 F
S2
F
r
F
t
F
which is the PDE for the option price!
rS
F
t
F
S
1 we have:
u0 t
1 2 2 2 F
S
2
S2
rF
If we ask u0
F
t
The Greeks
The price sensitivity with respect to the parameters is measured

by the so-called Greeks:
ut
F
S
F
we have:
V t u0 t r

u t dt

dV t
V t u t t dW t
Since for the strategy u u0 the portfolio value is given by:
The hedging strategy
Volatility is not constant.
Is volatility constant?
Following that, in the Black and Scholes model hedging is called

hedging.
When we hedge an option in the Black and Scholes model, we

have:
S
u
F
than is exactly the number of stocks S that I have to buy for a
given number of options F, in order to have a riskless portfolio.
hedging
Are returns Normal?
Implied volatility should be tha same for Call option at the money
(S K 1), in the money (S K 1), out of the money (S K 1).
The Black and Scholes formula implies that implied volatility

does not depend on the moneyness S K.
Implied volatility and moneyness
Indeed they are not, the distribution is leptokurtic (fat tails):
Such a result would be an important point made by the Black and

Scholes model, irrespectively of the empirical facts which it
cannot account for.
The ACF of the absolute value of returns shows dependence for

very long periods (1-2 months).
Are returns independent?
Looking at the time series it seems not....
Are returns Normal?
Implied volatility depends on moneyness:
Smile effect
The ACF of returns is null after one day! This is coherent with
the assumptions of independent returns, but...
Are returns independent?

Appunti 1

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Appunti 1

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The most heavily traded assets are futures and options.

November, 2002 p.4/42

November, 2002 p.5/42

November, 2002 p.3/42

November, 2002 p.6/42

An option is a financial contract which provides the right to buy

commodities: gold, cotton, etc.

currencies (foreign exchange)

Traded assets in financial markets are:

Futures are different from forward because of contractual

Futures are more liquid than their underlying.

A futures contract gives you the obligation to buy an asset in a

Derivatives are financial contracts whose payoff at future dates

November, 2002 p.2/42

November, 2002 p.1/42

..... than models are very sophisticated.

A lot of data are available......

Dipartimento di Economia Politica, Universit`a di Siena

Option pricing: the Black & Scholes model

Finance is a subset of Economics, which is quite peculiar for two

Money Market Account

Lets look the time series of an asset (FIB30 2000-2001, daily

November, 2002 p.8/42

November, 2002 p.12/42

The price of a financial asset is modeled via a stochastic

November, 2002 p.9/42

short rate, spot rate

The Money Market account is a model of a riskless asset, whose

Money Market Account

If r t is constant, it coincides with the yield to maturity.

November, 2002 p.10/42

If r t id deterministic, the evolution of B t is deterministic, the

FIB30 time series

assets can be short-selled and bought in the desired

We will work in market in which:

November, 2002 p.7/42

A market is said to be complete if it is possible to replicate any

We assume that in the market is is not possible to realize a

Absence of arbitrage and completeness

The Black and Scholes model

November, 2002 p.16/42

We then found a PDE for the price of any derivative.

0 the portfolio is riskless.

November, 2002 p.17/42

Solving for uS and u , keeping in mind that uS

Now we use the assumption of absence of arbitrage; since the

The value of the portfolio is then given by:

u be the fraction of wealth invested in

Arbitrage and PDE

Consider a portfolio composed by the asset S and the derivative.

November, 2002 p.15/42

This result is still valid if and depend on t S.

November, 2002 p.18/42

This result is valid only if the derivative is actively traded.

Our results depends only on the absence of arbitrage. This is

November, 2002 p.13/42

The Black and Scholes model can be used to value derivatives.

be the derivative price at time t

B is the riskless asset.

For example, for the Call option S T

Itos lemma allows us to compute the evolution of t S

Contingent claim valuation

Let us consider the problem of pricing a derivative issued in t