Implied Transition Probabilities To develop an initial model we required a stock which was both heavily traded and highly

liquid. GE met these criteria and we investigated the volatility smile to compare our volatility estimations with that of the market. The initial code was altered to be GE specific (refer m file) and a number of discrepancies were noted such as high and negative probability values and distorted option prices which warranted investigation. We initially took four option expiry dates into the future; December, January, February and March and counted the total days in this period to be 124. We then fixed our time step to be 31 days, completed interpolation and ran our models for a variety of strike prices. For later periods we noted large deviations from pricing patterns which we concluded was a result of illiquidity and the use of stale prices. To address this we adopted a shorter period of 32 days to the options expiry date in December and divided this into 4 periods of 8, 16, 24 and 32 days. We then interpolated the values and calculated our option prices at each of these points in time. Results presented had a number of extreme values as highlighted in attachment (see before tab). Transition values by nature must lie be between 0 and 1 and while the sum of these three cells total 1, the extreme nature of their values must be investigated. Should we trade based on the model in its current state we would introduce opportunities for riskless arbitrage to the market. There are two possible causes of this: 1) The forward price at node (n,i) may fall outside range of its daughter nodes (outside the Pu and Pd of one time movement) having the effect of dragging the lower nodes towards the higher and distorting the lattice. It is necessary to ensure that selection of state space does not allow breach of the forward price condition and changes to it can help remedy the problem, otherwise we are again creating arbitrage opportunities for other traders. 2) Volatility levels at each node in the implied tree. The larger the value of an option at a node, the larger the implied volatility at that node. The reason for the distorted price in the tree may be due to a stale price which may not be possible with a probability range between 0 and 1. To address this the option price should be replaced with a more realistic price. We have ran our model and results recorded in attached excel spreadsheet.

Arbitrage Opportunities Taking our model to be correct, we consider arbitrage opportunities to exist where distortions appear on the volatility smile as per figure 1 below. The distortions arise from differences in implied volatilities is causing this which is reflected in the option prices and allows us to undertake transactions to benefit. We have identified two main opportunities in figure 1 (put options are blue line and call options red line): 1) At strike price 14 we consider an appropriate volatility 30% which gives a range of call option values between $1.93 and $1.95. Volatility noted in the market is 16% giving a price of $1.88. These options appear cheap as a result. 2) At strike price 18 an appropriate put option volatility from our model would be 37% giving a price range of $2.19 to $2.21. The market considers volatility to be 41% and an appropriate price to be $2.25. Options appear overpriced.

Substituting these new implied volatility values into the model and running again we obtained and recorded the values (see after tab). Figure 2 represents the volatility smile with substituted values.

We consider the highlighted values in price changes tab to be the arbitrage opportunities. Even though only two volatilities were changed, a number of movements have been noted. This is because other values were interpolated from these two points. Conclusion The impact of dividends must also be taken into account which is not part of our model, where in real world scenario the price of an option takes into account the dividend yield. This could account for part of the discrepancy. As volatility is a curve, the increase in interpolation points will smooth the curve and generate a more accurate volatility gauge when calculating option prices With the above adjustments, an appropriate model can be developed to price options.