Professional Documents
Culture Documents
Price Options
Stochastic Process
Stochastic Process
o Markov process – stock future value depends on current value only, not past
value
Process:
Markov Process
Wiener Process has a drift rate of 0 (a=0) and a variance rate of 1 (b=1)
Definitions:
o Drift rate: mean change per unit of time
o Variance rate: variance per unit of time
GWP: drift rate and variance rate are set equal to any chosen constants
The Wiener Process is a special form of GWP
o WP a=0, b=1
WP GWP
∆𝑥 = 𝜀√∆𝑡 → 𝑑𝑧 𝑑𝑥 = 𝑎𝑑𝑡 + 𝑏𝑑𝑧
Arena Dai
2) If stock prices follow GWP, then the variance of the stocks prices is
constant regardless of price level
a. It is more reasonable to assume returns have a constant variance,
regardless of price level
Arena Dai
Ito Process
In an Ito process:
o Drift rate and variance rates are functions of time and the underlying variable
GWP fails to capture the aspect of stock prices i.e. the expected percentage return
required by investors from a stock price is independent of the stock’s price e.g. if
Arena Dai
investors require a 14% return when the stock price when it is $10, then, ceteris
paribus, they will also require a 14% return when the stock is $1000
o Recap: GWP stock price has a constant expected drift rate and a constant
variance rate
Therefore, the assumption of constant drift rate is not appropriate and needs to be
replaced by the assumption that the expected return (expected drift divided by stock
price) is constant
The Parameters
Ito’s Lemma
Price of a stock option is a function of the underlying stocks price and time
The price of any derivative is a function of the stochastic variables underlying the
derivative and time
Suppose variable x follows Ito’s process
Where,
o dz is a Wiener Process
o a & b are function of x & t
Variable x has a drift rate of a and a variance rate of b2
Page 291 for more information
Arena Dai
Arena Dai
Use Ito’s lemma to derive the process followed by ln(S) when S follows the process
Arena Dai
Arena Dai
Summary
Process Equation
Wiener Process ∆𝑥 = 𝜀√∆𝑡
Generalised Wiener 𝑑𝑥 = 𝑎𝑑𝑡 + 𝑏𝑑𝑧
Process Where a & b are constants
∆𝑥 = 𝑎∆𝑡 + 𝑏𝜀√∆𝑇
Geometric Brownian 𝑑𝑆 = 𝜇𝑆 𝑑𝑡 + 𝜎𝑆 𝑑𝑧
Motion: a special
∆𝑆 = 𝜇𝑆∆𝑡 + 𝜎𝑆𝜀√∆𝑡
form of Ito process
Arena Dai
Ito’s lemma
How do we select 𝜀?
Randomly selected
Normally distributed
Mean = 0
GWP Limitations
Returns are reflected differently depending on stock price e.g. $3 return on a stock
price of $3 and $300 reflected as 100% and 1% return
Ito’s process accounts for this limitation
Stock price behaviour used by the B-M model assumes that percentage changes in
stock price within a short time period are normally distributed.
Define:
o u = expected return on stock per year
o o = volatility of stock price per year
Approach Example 14.1 on Page 300
Arena Dai
Variables with lognormal distribution can take any value between 0 and ∞
o Unlike normal distribution, lognormal is skewed so that mean, median and
mode take on different values
Insert lognormal graph
Approach Example 14.2
VOLATILITY
The differential equation must be satisfied by the price of any derivative dependent
on a non-dividend paying stock
Arguments applied to B-M differential equation:
o Assume no arbitrage to value binomial stock price movements thereby setting
up a riskless portfolio consisting of a position in the derivative and a position in
the stock
o Given no arbitrage, return from portfolio must be the risk-free interest rate, r
Arena Dai
PRICING DERIVATIVES
PARAMETERS
µ Stdev
The expected continuously Stock price volatility
compounded return earned by the Interpreted as the stdev change in
stock per year stock price in one year
Value of derivative dependant on a
stock is usually independent of
return
ASSUMPTIONS:
Stock price follows GBM (ds = uSdt + stdev.dz)
Short-selling of securities is permitted
There are no transaction costs or taxes
Securities are perfectly divisible
There are no dividends during the life of an option
There are no arbitrage opportunities
Security trading is continuous
The risk-free rate of interest is constant and the same for all maturities
o r is not stochastic and remains constant
Where,
Di is dividend
ti is the time right before the stock going ex-dividend
For an American call option on a non-dividend paying stock, the value is the same as
the value of the corresponding Euro call option
For an American call option on a dividend-paying stock, B-S suggests an
approximation procedure
o Calculate the prices of Euro call options that mature at times T and Tn (time
you may consider exercising the option prior to maturity)
o Then, approximate the American price as the greater of the two
Alternatively, the Binomial Model can be utilised
INDEX OPTIONS
U.S. exchange-traded contracts are on 100 times index & settled in cash
OEX is American
The others are European
In Australia, the S&P/ASX 200 index options gave a multiplier of 10
PORTFOLIO INSURANCE
PROCEDURE
1. How many Put options do we buy?
2. At what Strike price?
3. Verify decision
SUMMARY
CURRENCY OPTIONS
Alternatively, there are liquid futures options markets for e.g. major currencies vs. the
US dollar
Currency options are utilised by corporations to buy insurance when they have FX
exposure
o It is an alternative to forward contracts
Put Call
Notes
Forward contracts lock in the exchange rate for a future transaction whereas
option provides insurance
Options require a premium to be paid up front whereas forward contracts cost
nothing to enter into
Forward/Futures Options
Say, we sell FOREX futures/forwards: Say, we buy options on FOREX:
RANGE FORWARDS
As strike prices of call and put in a range forward move closer, the range forward
contract becomes a regular forward
Short range forward contract short forward contract
Long range forward contract long forward contract
If the amount and timing of the dividends during the life of a Euro option is known, the B-S
can be used to value the option given that stock price is reduced by the PV of all dividends
during the life of an option
Pricing Formulas
Differential Equation and Risk-Neutral Evaluation (refer to textbook)
Valuation of European Stock Index Options
Forward Prices
Implied dividend yields
Valuation of Euro Currency Options
Forward Exchange Rates
American Options
Euro calls and puts with the same strike price and time to maturity:
F0 = K + (c-p)ert
1 𝑐−𝑝+𝑘ⅇ −𝑟𝑇
q = − 𝑇 𝑙𝑛 𝑆0
The above formula allows term structures of forward prices and dividend yields to be
estimated
OTC Euro options are valued using forward prices (Estimates of q are not required)
American options require the dividend yield term structure
AMERICAN OPTIONS
It may be optimal to exercise American currency and index options prior to maturity
American currency/index options are worth more than their Euro counterparts
More likely to be exercised before maturity:
o Call options on high-interest currencies
High-interest currency expected to depreciate
o Put options on low-interest currencies
Low-interest currency expected to appreciate
o Call options with high-dividend yields
o Put options with low-dividend yields
SUMMARY
o If portfolio value does not mirror the index, B put option contracts should be
purchased for every 100So dollars in the portfolio
o Strike price of put options purchased should reflect level of insurance required
Currency options are mostly traded on OTC markets
They can be used to:
o Hedge foreign exchange exposure
Receive sterling at T buying put options maturing at T
Paying sterling at T buying call options maturing at T
o Create a range forward contract
Zero-cost contract to provide downside protection whilst giving up
some upside
The B-S can value:
o Euro options on a non-dividend paying stock
o Euro options on a stock paring a known dividend yield
o Euro options on stock indices and currencies
Why?
o Stock index is comparable to a stock paying dividend yield
Dividend yield is the dividend yield on the stocks that make up the
index
o Foreign currency is comparable to a stock paying dividend yield
Foreign risk-free rate is like that of the dividend yield
Binomial trees can be used to value American options on stick indices and currencies
FUTURES OPTION
The right, but not the obligation, to enter into a futures contract at a certain futures
price at a certain date
Arena Dai
Call Futures Option: right to enter into a long futures contract at a certain price and
vice versa for Put Futures
Futures Options are generally American and expires on or a few days before the
earliest delivery date of the underlying futures contract
They are referred to by the maturity month of the underlying futures
o There can be more option chains than Futures per year
When a futures position is closed out immediately:
o Call payoff: max (FT – K; 0)
o Put payoff: max (K-FT; 0)
What happens when you exercise Futures option?
o Note that the difference between last and next settlement will be applied to
the delivered Futures contract
Payoff from Euro Call with same strike price on the futures price of the asset is:
Max (FT – K; 0)
Arena Dai
Difference between futures options and stock options is that there are no up-front
costs when a futures contract is entered into
In a risk-neutral world, the asset price grows at r-q rather than at r when there is a
dividend yield at a rate q
Using binomial trees
o Create a risk-free portfolio
Short 1 option
Long delta futures contracts
o Calculate delta and input into the risk-free equation to discern risk-free payoff
o Discount back to PV
Blacks model is used to value Euro options on the spot price of an asset in the OTC
market
o This avoids the needs to estimate income on the asset
Assumption that futures price follows lognormal process
Volatility of futures price is same as the volatility of the underlying asset
Euro futures options and Euro spot options are equal when the option contract
matures at the same time as the futures contract
An American futures call option must be worth more than the corresponding
American spot call option
o American futures option can be exercised earlier greater profit to the
holder
American put futures option must be worth less than corresponding American spot
put option
Arena Dai
If there is an inverted market where futures prices are consistently lower than spot
prices then the reverse is true i.e.
o American Call futures options are worth less than corresponding American
spot call option
o American Put futures options are worth more than their corresponding
American spot put option
These differences still hold even when the American futures options and American
spot options expire at the same time
The later the futures contract expires (compared to the options contract), the greater
the differences will be
SUMMARY
Call Put
Holder acquires a long futures Holder acquires a short futures
position position
Cash amount = excess of futures Cash amount = excess of strike
price over the strike price price over futures price
If the expiration dates for option and futures contracts are the same, a Euro futures
option is equal to its corresponding Euro spot option
However, this is not true for American options
If the futures market is normal:
Arena Dai
o An American call futures is worth more than its corresponding American spot
call option
o An American put futures is worth less than its corresponding American spot
put option
If the market is inverted, the reverse is true
Lecture 12
Binomial Trees
Backwards Induction
Option
Stock Indices q equals the dividend yield on the index
Foreign Currency (FOREX) q equals the foreign risk-free rate
Arena Dai
Construct a tree for the stock price less the PV(dividends) and adjusted volatility
Create a new tree by adding PV (remaining dividends at) at each node
This ensures that the tree combines and makes assumptions similar to when B-S
model is used for Euro options
Arena Dai
Making r or q as a function of time does not affect the geometry if the tree
o The probabilities the tree become functions of time
We can make sigma a function of time by making the lengths of the time steps
inversely proportional to the variance rate
Binomial Tree assumption is that r, q and sigma, are not stochastic however they
are stochastic variables in reality
o Also known as time variance
Arena Dai
Introduction
1) Trees
a. Binomial
b. Trinomial
2) Monte Carlo Simulation (not examinable)
3) Finite differences (not examinable)
Binomial Trees
B-S model only provided analytic valuations for Euro options – Not American options
Used to approximate movements in the price of a stock or other asset
o Start with initial stock price
o Solve factors of upstate and downstate
o Find probability of up and down
Binomial tree valuation
o Divide life of option into many small time intervals of length delta t
o Assumption that at each time interval, the price of the underlying asset moves
from initial value of S to either Su or Sd
Parameters p, u and d
P, u and d are chosen so that the tree gives correct values for the mean and variance
of stock price changes during time interval delta t in a risk-neutral world
Risk-Neutral Valuation
Risk-Neutral Valuation states that an option (or other derivative) can be valued on the
assumption that the world is risk neutrala9
o NOTE: The probability of payments is risk-neutral BUT investors are still risk-
averse
Therefore, for valuation purposes; we use the following procedure underlying
binomial trees:
Arena Dai
o Assume expected return from all traded assets is the risk-free interest rate
o Value payoffs from the derivative by calculating their expected values and
discounting at the risk-free rate
Determination of p, u and d
As we are working in a risk-neutral world, the expected return from the asset is the
risk-free interest rate, r
Expected return in form of capital gains is r-q
When delta t is small; Cox, Ross and Rubinstein proposed a solution to these
equations:
Note:
The tree shows future possible price of underlying assets but what about payoff
values of the options?
Arena Dai
Options are evaluated by starting at the end of the tree and working backward
At the final node, the option value is
Using risk-neutral valuation to calculate the value of the option at each node, we
work back through the tree and test for early exercise when appropriate
With Early
Exercise
Without Early
Exercise
Using the Binomial Tree for Options on Indices, Currencies, and Futures Contracts
Procedure
1) Construct a tree for the stock price less the PV(dividends) with adjusted volatility σ*
3) This ensures that the tree recombines and makes assumptions to those when the B-S
model is used for Euro Options
The CVT involves using the tree to calculate difference between the Euro and
American price
Arena Dai
Rather than setting u=1/d, we can set each of the probabilities to 0.5
Refer to page 442
Advantage: Probabilities are always 0.5 regardless of the value of sigma or the
number of the time steps
Disadvantage: more difficult to calculate the Greek letters as the tree is no longer
centred around stock price
Arena Dai
Homework
Chapter 16
16.14 Would you expect the volatility of a stock index to be greater or less than the volatility
of a typical stock?