An Idiots Guide to Option Pricing

Bruno Dupire
Bloomberg LP
bdupire@bloomberg.net

CRFMS, UCSB
April 26, 2007
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Warm-up
% 30 ] [
% 70 ] [
=
=
Black
Red
P
P

Black if $0
Red if 100 $
Roulette:
A lottery ticket gives:
You can buy it or sell it for $60
Is it cheap or expensive?
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Nave expectation
Buy 60 70 >
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Replication argument
Sell 60 50 <
as if priced with other probabilities
instead of
OUTLINE
1. Risk neutral pricing
2. Stochastic calculus
3. Pricing methods
4. Hedging
5. Volatility
6. Volatility modeling




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Addressing Financial Risks
volume
underlyings
products
models
users
regions
Over the past 20 years, intense development of Derivatives
in terms of:
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$
T
S
K
To buy or not to buy?
Call Option: Right to buy stock at T for K

$
T
S
K
$
T
S
K
TO BUY
NOT TO BUY
CALL
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Vanilla Options
European Call:
Gives the right to buy the underlying at a fixed price (the strike) at
some future time (the maturity)

( )
+
=
T
S K Payoff Put
European Put:
Gives the right to sell the underlying at a fixed strike at some maturity

( ) 0 , max ) ( Payoff Call K S K S
T T
= =
+
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Option prices for one maturity
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Risk Management
Client has risk exposure
Buys a product from a bank to limit its risk
Risk
Not Enough Too Costly Perfect Hedge
Vanilla Hedges
Exotic Hedge
Client transfers risk to the bank which has the technology to handle it
Product fits the risk
Risk Neutral Pricing
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Price as discounted expectation
! ?
Option gives uncertain payoff in the future
Premium: known price today

Resolve the uncertainty by computing expectation:
Transfer future into present by discounting
? !
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Application to option pricing
Risk Neutral Probability
Physical Probability
}

+
=
o
T T T
rT
dS K S S e ) )( ( Price
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Basic Properties
0 ) ( price 0 > > A A
) ( price ) ( price ) ( price B A B A + = +

Price as a function of payoff is:

- Positive:
- Linear:
Price = discounted expectation of payoff
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gives 1 in state
Option A gives
Toy Model
n
s s ,...,
1
i
x
i
s
1 period, n possible states
in state
i
A
i
s

=
= =
i
i i
i
i i
i
i i
x q
A x A A x A
o
) ( price ) ( price
If , 0 in all other states,
where
( ) price(1) price ) ( price = =
i i
A A o
is a discount factor

j
j
i
i
A
A
q
) ( price
) ( price
1 and 0 = >

i
i i
q q
is a probability:
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FTAP
Fundamental Theorem of Asset Pricing

1) NA There exists an equivalent martingale measure

2) NA + complete There exists a unique EMM
Cone of >0 claims
Claims attainable from 0
Separating hyperplanes
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Risk Neutrality Paradox
Risk neutrality: carelessness about uncertainty?








1 A gives either 2 B or .5 B1.25 B
1 B gives either .5 A or 2 A1.25 A
Cannot be RN wrt 2 numeraires with the same probability
Sun: 1 Apple = 2 Bananas
Rain: 1 Banana = 2 Apples
50%
50%
Stochastic Calculus
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Modeling Uncertainty
Main ingredients for spot modeling
Many small shocks: Brownian Motion
(continuous prices)


A few big shocks: Poisson process (jumps)
t
S
t
S
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Brownian Motion
10
100
1000
From discrete to continuous
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Stochastic Differential Equations
t
W
) , 0 ( ~ s t N W W
s t

dW dt dx b a + =
At the limit:

continuous with independent Gaussian increments

SDE:

drift noise
a
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Itos Dilemma
) (x f
dW dt dx b a + =
Classical calculus:

expand to the first order


Stochastic calculus:

should we expand further?
dx x f df ) ( ' =
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Itos Lemma
dt dW =
2
) (
dW b dt a dx + =
dt b x f dx x f
dx x f dx x f
x f dx x f df
2
2
) ( ' '
2
1
) ( '
) ( ) ( ' '
2
1
) ( '
) ( ) (
+ =
+ =
+ =
At the limit
for f(x),
If
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Black-Scholes PDE
Black-Scholes assumption

Apply Itos formula to Call price C(S,t)


Hedged position is riskless, earns interest rate r


Black-Scholes PDE

No drift!
dW dt
S
dS
o + =
dt C
S
C dS C dC
SS t S
)
2
(
2 2
o
+ + =
dt S C C r dS C dC dt C
S
C
S S SS t
) ( )
2
(
2 2
= = +
o
) (
2
2 2
S C C r C
S
C
S SS t
+ =
o
S C C
S

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P&L
S
t t +A
S
t
O
Break-even
points
o At
o At
Option Value
S
t
C
t
C
t t +A
S
Delta
hedge
P&L of a delta hedged option
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Black-Scholes Model
If instantaneous volatility is constant :

dW dt
S
dS
o + =
Then call prices are given by :

)
2
1
) ) / (ln(
1
(
)
2
1
) ) / (ln(
1
(
0
0 0
T rT K S
T
N Ke
T rT K S
T
N S C
rT
BS
o
o
o
o
+
+ + =

No drift in the formula, only the interest rate r due to the

hedging argument.

drift:
noise, SD:
t S
t
o
t S
t
o o
Pricing methods
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Pricing methods

Analytical formulas
Trees/PDE finite difference
Monte Carlo simulations
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Formula via PDE
The Black-Scholes PDE is


Reduces to the Heat Equation

With Fourier methods, Black-Scholes equation:


) (
2
2 2
S C C r C
S
C
S SS t
+ =
o
T d d
T
T r K S
d
d N e K d N S C
rT
BS
o
o
o
=
+ +
=
=

1 2
2
0
1
2 1 0
,
) 2 / ( ) / ln(
) ( ) (
xx
U U
2
1
=
t
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Formula via discounted expectation
Risk neutral dynamics

Ito to ln S:

Integrating:




Same formula



dW dt r
S
dS
o + =
dW dt r S d o
o
+ = )
2
( ln
2
] ) [( ] ) [(
)
2
(
0
2
+
+
+
= = K e S E e K S E e premium
T
W T r
rT
T
rT
o
o
T T
W T r S S o
o
+ + = )
2
( ln ln
2
0
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Finite difference discretization of PDE
Black-Scholes PDE



Partial derivatives discretized as
+
=
+ =
) ( ) , (
) (
2
2 2
K S T S C
S C C r C
S
C
T
S SS t
o
2
) (
) , 1 ( ) , ( 2 ) , 1 (
) , (
2
) , 1 ( ) , 1 (
) , (
) 1 , ( ) , (
) , (
S
n i C n i C n i C
i n C
S
n i C n i C
n i C
t
n i C n i C
n i C
SS
S
t
o
o
o
+ +
=
+
=

=
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Option pricing with Monte Carlo methods
An option price is the
discounted expectation of its
payoff:


Sometimes the expectation
cannot be computed
analytically:
complex product
complex dynamics
Then the integral has to be
computed numerically


( ) ( ) P EP f x x dx
T 0
= =
}
o o
the option price is its discounted payoff
integrated against the risk neutral density of the spot underlying
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Computing expectations
basic example
You play with a biased die

You want to compute the likelihood of getting
Throw the die 10.000 times

Estimate p( ) by the number of over 10.000 runs
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Option pricing = superdie
Each side of the superdie represents a possible state of the
financial market
N final values
in a multi-underlying model
One path
in a path dependent model
Why generating whole paths?
- when the payoff is path dependent
- when the dynamics are complex
running a Monte Carlo path simulation
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Expectation = Integral
Unit hypercube Gaussian coordinates trajectory
Gaussian transform techniques discretisation schemes
A point in the hypercube maps to a spot trajectory
therefore
( )
( )
| |
( )
| |
( )
| |
EP f x S S dx g y dy
N
g x
T t t
d
d d
i
x
i
d
= e =
~
9
e
} }

. Pr ,...,
,1
,1
1
0
0
1
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Generating Scenarios
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Low Discrepancy Sequences
dimensions
1 & 2
Halton Faure Sobol
dimensions
20 & 25
dimensions
51 & 52
Hedging
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To Hedge or Not To Hedge
Daily Position
Daily P&L
Full P&L
Big directional risk

Hedge Delta
Small daily amplitude risk
S o
P&L
Unhedged
0
Hedged
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The Geometry of Hedging
Risk measured as
Target X, hedge H




Risk is an L
2
norm, with general properties of orthogonal
projections
Optimal Hedge:
| |
T
PL SD
t t t
H X PL =
| |

= = H X H X Risk
T T
var
H

H X H X
H
=
H e
inf

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The Geometry of Hedging
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Super-replication
Property:

Let us call:





Which implies:
| |
| | | | E XY E X E Y s
2 2
( )
y x
y x
x y
P P
Y P X P
XY
Y P X P Y X
2
: Portfolio by the dominated is XY so
, 0 , and all For
2 2
2
+
s
>
P X
P Y
x
y
:
:
price today of
price today of
2
2
| | price XY
P P P P
P P
P P
y x x y
x y
x y
s
+
=
2
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A sight of Cauchy-Schwarz
Volatility
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Volatility : some definitions

Historical volatility :
annualized standard deviation of the logreturns; measure of
uncertainty/activity

Implied volatility :
measure of the option price given by the market

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Historical Volatility

Measure of realized moves
annualized SD of logreturns




t
t
t
S
S
x
1
ln
+

( ) |
.
|

\
|
E

=

=
2
1
2
1
252
i i
t
n
i
t
x x
n
o
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Historical volatility
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Implied volatility
Input of the Black-Scholes formula which makes it fit the
market price :
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Market Skews
Dominating fact since 1987 crash: strong negative skew on
Equity Markets


Not a general phenomenon

Gold: FX:



We focus on Equity Markets
K
impl
o
K
impl
o
K
impl
o
A Brief History of Volatility
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Evolution theory of modeling







constant deterministic stochastic nD
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A Brief History of Volatility
: Bachelier 1900


: Black-Scholes 1973


: Merton 1973


: Merton 1976



Q
t t
t
t
dW t dt r
S
dS
) ( o + =
Q
t t
dW dS o =
Q
t
t
t
dW dt r
S
dS
o + =
dq dW dt k r
S
dS
Q
t
t
t
+ + = ) ( o
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Local Volatility Model







Dupire 1993, minimal model to fit current
volatility surface
( )
2
,
2
2
2
2 ,
) , (
K
C
K
K
C
rK
T
C
T K
dW t S dt r
S
dS
T K
Q
t
t
t
c
c
c
c
c
c
o
o
+
=
+ =
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sought diffusion
(obtained by integrating twice
Fokker-Planck equation)
1D
Diffusions
Risk
Neutral
Processes
Compatible
with Smile
The Risk-Neutral Solution
But if drift imposed (by risk-neutrality), uniqueness of the solution
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European
prices
Local
volatilities
Exotic prices
From simple to complex
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Stochastic Volatility Models







Heston 1993, semi-analytical formulae.

+ =
+ =
t t t t
t t
t
t
dZ dt b d
dW dt r
S
dS
) (

2 2 2
|o o o o
o
The End