in [0 T ]R+. Here r is the interest rate; is the volatility of the underlying assumed fixed parameters.
Asset S and (s) =max(s k ,0) is the contract function. According to the FeynmanKac theorem PDE
solution can represented as an expected value
F(t,s)=e
r(Tt)
  ) , (
,
T s E
s t
where the underlying stock S(t ) follows the dynamics
s(u)=r s(u) u+s(u)
(u,s(u)) W(u)
This price process is called geometric Brownian motion. Here W is a Wiener process
where S starts in s at time 0.
For the purpose of option pricing I thus should assume that the underlying stock follows
this dynamics even if in reality we do not expect the value of the stock to grow with the
interest rate r.
The American version of those two options is the same except that it can be exercised
earlier than exercise date.
15
1.2.4 An American option
gives the owner the right to exercise the option on or before the Expiration date t T
before the expiration, date (also called early exercise).
The holder of an American option needs to decide whether to exercise immediately or to wait.
If the holder decides to exercise at say t T, then he receives (S(t)) where is the appropriate
contract function.
Similarly, this option can also be classified into two basic types:
American call options which give the owner the right to buy an underlying asset for a
given strike price on or before the expiration date, and American put option which gives
the owner the right to sell an underlying asset for a certain strike price on or before the
expiration date.
If the underlying stock pays no dividends, early exercise of an American call option is not
optimal.
On the other hand early exercise of an American put option can be optimal even if the
underlying stock does not pay dividends.
An American option is worth at least as much as an European option. To compare by
examples here are two examples how the two prices compares
For example
Prices of the following options long plain vanilla call option non dividend share for 3
months to expiry date option the two price functions (European and American plain
vanilla option) are plotted here for the same
strikes of 100
current share price 120
16
Risk free rate of 10 %
Volatility of 40.
Figure 1.1 is showing the price function of European option using Black and Scholes
formula .
Figure 1.2 is showing the price function of the American option using Bjerksund &
Stensland approximation.for more details about this approximation see the Bjerksund & Stensland
approximation 2002.
The table used to generate the 3 d graph for the American option using Bjerksund approximation
& Stensland approximation.
Time to maturity days
Asset price 10.00 30.88 51.76 72.65 93.53 114.41 135.29 156.18 177.06 218.82 239.71 260.59 281.47 302.35 323.24 344.12
150.00 50.2736 50.8432 51.4228 52.0323 52.6754 53.3462 54.0368 54.7405 55.4517 56.8819 57.5955 58.3059 59.0117 59.7122 60.4067 61.0947
145.00 45.2736 45.8445 46.4380 47.0762 47.7554 48.4640 49.1912 49.9288 50.6712 52.1546 52.8908 53.6213 54.3452 55.0617 55.7706 56.4715
140.00 40.2736 40.8484 41.4678 42.1490 42.8763 43.6316 44.4018 45.1780 45.9544 47.4945 48.2540 49.0050 49.7469 50.4794 51.2022 51.9154
135.00 35.2736 35.8592 36.5246 37.2678 38.0568 38.8680 39.6871 40.5056 41.3184 42.9168 43.6996 44.4707 45.2300 45.9776 46.7134 47.4379
130.00 30.2737 30.8871 31.6301 32.4580 33.3226 34.1978 35.0704 35.9335 36.7836 38.4395 39.2445 40.0344 40.8097 41.5707 42.3180 43.0522
125.00 25.2742 25.9552 26.8190 27.7556 28.7079 29.6527 30.5807 31.4882 32.3744 34.0837 34.9085 35.7147 36.5033 37.2753 38.0316 38.7729
120.00 20.2792 21.1106 22.1456 23.2106 24.2569 25.2717 26.2528 27.2013 28.1194 29.8737 30.7141 31.5326 32.3307 33.1100 33.8717 34.6170
115.00 15.3132 16.4396 17.6873 18.8874 20.0238 21.1015 22.1277 23.1092 24.0516 25.8369 26.6867 27.5117 28.3141 29.0958 29.8583 30.6032
110.00 10.4857 12.0799 13.5459 14.8645 16.0723 17.1955 18.2514 19.2524 20.2072 22.0037 22.8545 23.6783 24.4780 25.2556 26.0131 26.7521
105.00 6.1194 8.2180 9.8410 11.2294 12.4717 13.6114 14.6736 15.6747 16.6255 18.4066 19.2475 20.0605 20.8486 21.6143 22.3595 23.0861
100.00 2.7763 5.0530 6.6920 8.0687 9.2905 10.4065 11.4440 12.4201 13.3462 15.0793 15.8971 16.6876 17.4538 18.1981 18.9226 19.6289
95.00 0.8696 2.7262 4.1907 5.4529 6.5875 7.6319 8.6080 9.5299 10.4073 12.0549 12.8344 13.5891 14.3215 15.0338 15.7278 16.4051
90.00 0.1638 1.2453 2.3693 3.4191 4.4001 5.3241 6.2009 7.0380 7.8413 9.3633 10.0884 10.7929 11.4787 12.1475 12.8006 13.4392
85.00 0.0159 0.4614 1.1806 1.9564 2.7338 3.4970 4.2412 4.9657 5.6711 7.0287 7.6834 8.3233 8.9495 9.5630 10.1644 10.7546
80.00 0.0007 0.1318 0.5035 1.0009 1.5555 2.1355 2.7253 3.3167 3.9055 5.0661 5.6360 6.1984 6.7530 7.3000 7.8395 8.3716
75.00 0.0000 0.0273 0.1774 0.4466 0.7951 1.1937 1.6237 2.0735 2.5355 3.4779 3.9525 4.4271 4.9005 5.3718 5.8405 6.3061
70.00 0.0000 0.0038 0.0494 0.1684 0.3564 0.5989 0.8823 1.1961 1.5325 2.2510 2.6256 3.0069 3.3929 3.7823 4.1739 4.5667
65.00 0.0000 0.0003 0.0103 0.0516 0.1359 0.2631 0.4283 0.6253 0.8487 1.3560 1.6327 1.9210 2.2189 2.5244 2.8362 3.1530
60.00 0.0000 0.0000 0.0015 0.0122 0.0424 0.0981 0.1807 0.2894 0.4218 0.7477 0.9360 1.1384 1.3529 1.5778 1.8118 2.0535
55.00 0.0000 0.0000 0.0001 0.0021 0.0103 0.0297 0.0640 0.1150 0.1832 0.3692 0.4850 0.6143 0.7560 0.9089 1.0719 1.2439
50.00 0.0000 0.0000 0.0000 0.0002 0.0018 0.0069 0.0182 0.0377 0.0671 0.1586 0.2211 0.2945 0.3785 0.4724 0.5757 0.6878
17
Figure 1.1 European call Figure 1.2 American call Bjerksund
18
A Trinomial tree has been set up for the American option in case of the American option.
A 500 steps trinomial tree is constructed with matrix of underlying price is as follows.
The following diagram shows how the first node is calculated also I will mention here
how we calculate the relevant probabilities of up and down probabilities and here is part
of algorithm
dt is the time step
n is number of steps
v is the volatility
pu is the up probability
Pd is the down probability
dt =T / n
u =Exp(v * Sqr(2 * dt))
d =1 / u
pu =(Exp(r * dt / 2)  Exp(v * Sqr(dt / 2))) ^2 / (Exp(v * Sqr(dt / 2))  Exp(v * Sqr(dt / 2))) ^2
pd =(Exp(v * Sqr(dt / 2))  Exp(r * dt / 2)) ^2 / (Exp(v * Sqr(dt / 2))  Exp(v * Sqr(dt / 2))) ^2
pm =1  pu pd
19
20
Calculations of
table used to
generate 3D
graph
Time to
maturity
in days
Asset
price
10.0
0
30.8
8
51.7
6
72.6
5
93.5
3
114.
41
135.
29
156
.18
177.
06
218.
82
239.
71
260.
59
281.
47
302.
35
323.
24
344.
12 365.00
150.00
50.1
369
50.4
222
50.7
070
50.9
944
51.2
892
51.5
945
51.9
118
52.
240
2
52.5
795
53.2
823
53.6
432
54.0
076
54.3
775
54.7
508
55.1
223
55.5
009
55.87
46
145.00
45.1
369
45.4
222
45.7
080
46.0
003
46.3
059
46.6
269
46.9
632
47.
312
5
47.6
731
48.4
194
48.8
011
49.1
892
49.5
774
49.9
679
50.3
604
50.7
523
51.14
32
140.00
40.1
369
40.4
223
40.7
109
41.0
139
41.3
380
41.6
833
42.0
467
42.
423
8
42.8
114
43.6
126
44.0
208
44.4
286
44.8
404
45.2
512
45.6
630
46.0
700
46.48
26
135.00
35.1
369
35.4
228
35.7
195
36.0
437
36.3
985
36.7
787
37.1
799
37.
592
5
38.0
153
38.8
803
39.3
138
39.7
493
40.1
842
40.6
174
41.0
462
41.4
784
41.90
15
130.00
30.1
369
30.4
252
30.7
427
31.1
069
31.5
107
31.9
414
32.3
874
32.
845
4
33.3
088
34.2
449
34.7
064
35.1
730
35.6
292
36.0
867
36.5
394
36.9
815
37.42
75
125.00
25.1
369
25.4
361
25.8
025
26.2
357
26.7
093
27.2
038
27.7
110
28.
220
6
28.7
273
29.7
378
30.2
338
30.7
226
31.2
095
31.6
831
32.1
547
32.6
227
33.08
01
120.00
20.1
370
20.4
775
20.9
442
21.4
825
22.0
492
22.6
213
23.1
932
23.
760
3
24.3
155
25.3
976
25.9
250
26.4
351
26.9
461
27.4
448
27.9
303
28.4
040
28.88
15
115.00
15.1
404
15.6
142
16.2
555
16.9
340
17.6
075
18.2
652
18.9
042
19.
517
8
20.1
226
21.2
695
21.8
218
22.3
553
22.8
769
23.3
940
23.8
969
24.3
871
24.86
55
110.00
10.1
877
10.9
996
11.8
786
12.7
056
13.4
827
14.2
193
14.9
112
15.
575
0
16.2
035
17.4
033
17.9
707
18.5
184
19.0
487
19.5
710
20.0
822
20.5
802
21.06
61
105.00
5.55
16
6.90
85
8.00
59
8.95
13
9.80
37
10.5
811
11.3
015
11.
988
5
12.6
383
13.8
499
14.4
199
14.9
701
15.5
027
16.0
197
16.5
279
17.0
230
17.50
60
100.00
2.04
77
3.68
63
4.84
87
5.81
61
6.66
89
7.44
38
8.16
12
8.8
337
9.47
00
10.6
569
11.2
155
11.7
547
12.2
767
12.7
835
13.2
763
13.7
566
14.22
54
95.00
0.39
91
1.57
85
2.55
87
3.41
67
4.18
70
4.89
85
5.55
80
6.1
817
6.77
96
7.89
62
8.42
23
8.93
05
9.42
28
9.90
10
10.3
663
10.8
227
11.27
10
90.00
0.03
08
0.50
40
1.13
31
1.76
40
2.37
47
2.95
62
3.52
30
4.0
567
4.58
38
5.57
04
6.04
68
6.51
19
6.96
29
7.40
12
7.82
81
8.24
46
8.658
0
85.00
0.00
07
0.11
03
0.40
00
0.77
75
1.18
66
1.61
33
2.03
99
2.4
694
2.89
24
3.71
81
4.12
53
4.51
95
4.90
93
5.29
91
5.67
91
6.05
03
6.413
2
80.00
0.00
00
0.01
51
0.10
71
0.28
10
0.51
05
0.77
48
1.06
44
1.3
671
1.67
64
2.31
73
2.63
93
2.96
01
3.28
49
3.60
15
3.92
08
4.24
13
4.555
0
75.00
0.00
00
0.00
11
0.02
04
0.07
91
0.18
09
0.31
86
0.48
62
0.6
751
0.88
12
1.32
75
1.56
48
1.80
82
2.05
39
2.30
44
2.55
87
2.80
78
3.068
0
70.00
0.00
00
0.00
00
0.00
25
0.01
66
0.05
09
0.10
85
0.18
84
0.2
895
0.40
69
0.68
76
0.84
64
1.01
26
1.18
56
1.36
87
1.55
26
1.74
59
1.940
6
65.00
0.00
00
0.00
00
0.00
02
0.00
24
0.01
07
0.02
91
0.06
01
0.1
045
0.16
15
0.31
48
0.40
74
0.50
85
0.62
17
0.74
13
0.86
49
0.99
98
1.134
2
0.00 0.00 0.00 0.00 0.00 0.00 0.01 0.0 0.05 0.12 0.17 0.22 0.28 0.35 0.43 0.51 0.603
21
10.00
93.53
177.06
260.59
1
5
0
1
4
5
1
4
0
1
3
5
1
3
0
1
2
5
1
2
0
1
1
5
1
1
0
1
0
5
1
0
0
9
5
9
0
8
5
8
0
7
5
7
0
6
5
6
0
5
5
5
0
0
10
20
30
40
50
60
Time to maturity
Asset price
As we can see here that the trinomial method is value the American option than the
approximation but it will converge as the number of steps increase.
22
1.2.5 Bermudan Option
This type of options lies between American and European. They can be exercised at
certain discrete time points for any discrete time t <t <<t =T.
Therefore the Bermudan options being a hybrid of European and American options, the
value of a Bermudan is greater than or equal to an identical European option but less than
or equal to its equivalent American option .
I will price some of Bermudan type option like equity Cliquet option .
1.2.6 Asian option types
This type of option depends on the average value of the underlying asset over a time,
Therefore, an Asian option is path dependent.
Asian options are cheaper relative to their European and American counterparts because of
their lower volatility feature
The are broadly three categories:
1) Arithmetic average Asians,
2) Geometric average Asians
3) Combination of 1 and 2
The payoff can be averaged on a weighted average basis, whereby a given weights is applied to
each stock being averaged.
This can be useful for attaining an average on a sample with a highly skewed sample
population.
There are no known closed form analytical solutions arithmetic options, due to the a property of
these options under which the lognormal assumptions collapse so it is not possible to
analytically evaluate the sum of the correlated lognormal random variables.
23
A further breakdown of these options concludes that Asians are either based on the average
price of the underlying asset, or alternatively, there is the average strike type.
The payoff of geometric Asian options is given as:
Payoff
Asian call
=max
(
(


.

\

=
X S i
n
n
i
/ 1
1
, 0
Payoff
Asian put
=max
(
(


.

\

=
n
n
i
S i X
/ 1
1
, 0
Kemna & Vorst (1990) put forward a closed form pricing solution to geometric averaging
options by altering the volatility, and cost of carry term.
Geometric averaging options can be priced via a closed form analytic solution because of the
reason that the geometric average of the underlying prices follows a lognormal distribution as
well, whereas with arithmetic average rate options, this condition collapses.
The solutions to the geometric averaging Asian call and puts are given as:
C
G
=S e
(br)(Tt)
N(d
1
)X e
r(Tt)
N(d
2
)
and,
P
G
=X e
r(Tt)
N(d
2
) S e
(br)(Tt)
N(d
1
)
where N(x) is the cumulative normal distribution function of:
d
1
=ln(S/X)+(b+0.5
2
A
)T
A
T
d
2
=ln(S/X)+(b0.5
2
A
)T
A
T
24
The adjusted volatility and dividend yield are given as:
A
/ 3
b=1/2(rD
2
/6)
The payoff of arithmetic Asian options is given as
Payoff
Asian call
=max(0,(
=
n
i
Si
1
/n)X)
Payoff
Asian put=
max(0,X(
=
n
i
Si
1
/n)
Here I will mention one of the approximations to calculate the price of a structured product that
has an Asian structured product .
1) The zero coupon bonds parts are valuated using the relevant spot interest rates.
2)The Asian option for which payments are based on a geometric average are relatively easy
approximations have been developed by Turnbull and Wakeman (1991),
Levy (1992) and Curran (1992).
In Currans model, the value Of an Asian option can be approximated using the following
formula:
25
Here is an example of capital guaranteed structured product that has Asian pay off.
On the FTSE 100 index using Currans model.
Average calculated quarterly and the interest rate used are annual compounded
and volatility is used are annual rate. The main parameters used are as follows
Asset price ( S ) 95.00
Average so far ( SA ) 100.00
Strike price ( X ) 100.00
Time to next average
point (t1) 0.25
Time to maturity ( T ) 5.00
Number of fixings n 4.00
Number of fixings fixed
m 0.00
Riskfree rate ( r ) 4.50%
Cost of carry ( b ) 2.00%
Volatility (
) 26.00%
Value 10.7396
26
10.00
114.41
218.82
323.24
2
0
0
.
0
0
1
8
5
.
0
0
1
7
0
.
0
0
1
5
5
.
0
0
1
4
0
.
0
0
1
2
5
.
0
0
1
1
0
.
0
0
9
5
.
0
0
8
0
.
0
0
6
5
.
0
0
5
0
.
0
0
0.0000
20.0000
40.0000
60.0000
80.0000
100.0000
120.0000
Time to maturity
Asset price
The frequency with which the value of the underlying asset is sampled varies widely from product to
product.
The averages are usually calculated using daily, weekly or monthly values.
Depending on whether an Asian call or put option is embedded, the redemption amount is
calculated using one of the following formulas:
=Zero coupon bond +Asian option value .
27
1.2.7 Cliquet options
Cliquet are option contracts, which provide a guaranteed minimum annual return in
exchange for capping the maximum return earned each year over the life of the contract.
Applications:
Recent turmoil in financial markets has led to a demand for products that reduce risk
while still offering upside potential.
For example, pension plans have been looking at attaching Guarantees to their products
that are linked to equity returns.
Some plans, also in VA life products such as those described.
Pricing Cliquet options
The Pricing framework here will be in the deterministic volatility model .
Cliquet options are essentially a series of forwardstarting atthemoney options with a
single premium determined up front, that lock in any gains on specific dates.
The strike price is then reset at the new level of the underlying asset.
I will use the following form, considering a global cap, global floor and local caps at pre
defined resetting times t
i
(i =1, . . . , n).
P=exp(rt
n
)N.E
Q


.

\



.

\



.

\



.

\



.

\

C F
S
S S i
C F
n
i i
i
i i
, , m i n m a x m a x m i n
1 1
1
,
where N is the notional, C is the global cap, F is the global floor, F
i
, i =1. . . n the local f
floors, C
i
, i =1, . . . , n are the local caps, and S is the asset price following a geometric
Brownian motion, or a jumpdiffusion process.
Under geometric Brownian motion with only fixed deterministic annual rate of interest
28
I can use the binomial method (CRR) binomial tree to price Cliquet option .
This binomial cliquet option valuation model which maintains the important property of
flexibility, can be used to price European and American cliquets.
The settings for this model are the same as those described in the previous section:
I have the CoxRossRubinstein (CRR) binomial tree with
U=e
t
and D =e
t
The adjusted riskneutral probability for the up state is
P = e
t
D
UD
In addition (1p) for the downstate probability.
This time, instead of calculating the probability of each payoff, I use the backward valuation approach
described in Hull (2003), Haug (1997)), adjusting it to Cliquet options with no cap or floor applied.
The adjustment is as follows:
For each node that falls under the reset date m, the new strike price is determined.
If the stock price at m is above the original strike, the put will reset its strike price equal to the then
current stock price.
For call options: if the stock price m is below the original strike, the call will reset its strike price equal
to the thencurrent stock price.
Pricing example
29
Current stock price =100
Exercise price =100
Time to maturity =20 year
Time to reset =10 year
Riskfree interest rate =4,5%
Dividend yield =2%
Sigma =20%.
In addition, here is comparison between plan vanilla European call and European Cliquet option
prices for various stock prices
30
0
10
20
30
40
50
60
70
80
90
100
110
50.00 70.00 90.00 110.00 130.00 150.00 170.00 190.00 210.00 230.00 250.00
cliquet price
Plan vanila CRR
And here is comparison between plan vanilla American call and European Cliquet option prices
for various stock prices
0
10
20
30
40
50
60
70
80
90
100
110
120
130
140
50.00 70.00 90.00 110.00 130.00 150.00 170.00 190.00 210.00 230.00 250.00
cliquet price
CRR vanilla
As you can see from both charts that the price is different only when the stock price is less than 100
strike price for both the American and European option .
31
Chapter 2 interest rate structured products
2.1.1 Floating Rate Notes (FRNs, Floaters)
Floating rate notes does not carry a fixed nominal interest rate.
The coupon payments are linked to the movement in a reference interest rate (frequently money
market rates, such as the LIBOR) to which they are adjusted at specific intervals, typically on each
coupon date for the next coupon period.
A typical product could have the following features:
The initial coupon payment to become due in sixmonths time corresponds to the 6month LIBOR as
at the issue date. After six months the first coupon is paid out and the second coupon payment is
locked in at the then current 6month LIBOR. This procedure is repeated every six months.
The coupon of an FRN is frequently defined as the sum of the reference interest rate and a spread of
x basis points. As they are regularly adjusted to the prevailing money market rates, the volatility of
floating rate notes is very low.
Replication
Floating rate notes may be viewed as zero coupon bonds with a face value equating the sum of the
forthcoming coupon payment and the principal of the FRN. Because their regular interest rate
adjustments guarantee interest payments in line with market condition.
2.2 Options on bonds
Bond options are an example for derivatives depending indirectly (through price movements of the
underlying bond) on the development of interest rates.
It is common to embed bond options into particular bonds when they are issued to make
them more attractive to potential purchasers.
A callable bond, for example, allows the issuing party to buy back the bond at a
predetermined price in the future.
A putable bond, on the other hand, allows the holder to sell the bond back to the issuer at a certain
future time for a specified price.
32
Pricing bond options
The wellknown BlackScholes equation was derived for the pricing of options on stock
prices and it was published in 1973 .
Shortly afterwards, the model has been extended to account for the valuation of options
on commodity contracts such as forward contracts.
In general, this model describes relations for any variable, which is log normally distributed and can
therefore be used for options on interest rates as well.
The main assumption of the Black model for the pricing of options on bonds is that
at time T the value of the underlying asset V
T
follows a lognormal distribution with the
Standard deviation.
S[ln V
T
]=
T
.
Furthermore, the expected value of the underlying at time T must be equal to its forward
price for a contract with maturity T, since otherwise, arbitrage would be possible.
E[V
T
]=F
0
E[max(VK),0]=E[V]N(d1)KN(d2)
E[max(KV),0]=KN(d2)E[V]N(d1)
where the symbols d1 and d2 are
d1
s
=ln (E[V]/K)+s
2
/2
d2=d1 =ln (E[V]/K)s
2
/
s
2 =d1s
This is also the main result of Black's model which, for the first time, allowed an
Analytical approach to the pricing of options on any log normally distributed underlying.
33
The symbol N(x) denotes the cumulative normal distribution.
For a European call option on a zerocoupon bond this leads to the wellknown result for
the value of the option.
The call price is given by
C=P(0,T)(F
0
N(d1)KN(d2))
where the value at time T is discounted to time 0 using P(0;T) as a risk free deflator.
The value of the corresponding put option is
P=P(0,T)( KN(d2) F
0
N(d1)))
Here is pricing example of European bond call option and put option using the Black
model and the following parameter .
Bond Data Term Structure
Time (Yrs) Rate (%)
Principal: 100 Coupon Frequency: 0.5 4.500%
Bond Life (Years): 5 1 5.000%
Coupon Rate (%): 6.000% 2 5.500%
Quoted Bond Price (/100): 98.80303 3 5.800%
4 6.100%
Option Data 5 6.300%
Pricing Model:
Strike Price (/100): 100.00
Option Life (Years): 3.00
Yield Volatility (%): 10.00%
Calculate
Put Call
Quoted Strike
Imply Volatility Black  European
Quarterly
34
This is the graph of the call option price against the strike
0
0.5
1
1.5
2
2.5
3
3.5
4
4.5
95.00 97.00 99.00 101.00 103.00 105.00
St r ike Pr ice
O
p
t
i
o
n
P
r
i
c
e
This is graph of the put option price against the strike
0
1
2
3
4
5
6
7
95.00 97.00 99.00 101.00 103.00 105.00
St r ike Pr ice
O
p
t
i
o
n
P
r
i
c
e
35
2.3 I nterest Rate Caps and Floors
Interest rate caps are options designed to provide hedge against the rate of interest on a floatingrate
note rising above a certain level known as cap rate.
A floating rate note is periodically reset to a reference rate, eg. LIBOR.
If this rate exceeds the cap rate, The cap rate applies instead. The tenor denotes the time between
reset dates. The Individual options of a cap are denoted as caplets.
Note that the interest rate is always set at the beginning of the time period, while the payment must
be made at the end of the period.
In addition to caps, floors and collars can be defined analogously to a cap, a floor Provides a payoff if
the LIBOR rate falls below the floor rate, and the components of a floor are denoted as floorlets.
A collar is a combination of a long position in a cap and a short position in a floor. It is used to insure
against the LIBOR rate leaving an interest rate range between two specific levels.
Consider a cap with expiration T, a principal of L, and a cap rate of RK. The reset dates
are t
1
, t
2
, ., t
n
, and t
n+1
=T.
The LIBOR rate observed at time t
k
is set for the time Period between t
k
and t
k+1
, and the
cap leads to a payoff at time t
k+1
which is
L
k
Max(F
k
R
K
,0)
where
k
=t
k+1
 t
k.
If the LIBOR rate F
k
is assumed lognormal distributed with volatility
k
, each caplet can be valued
separately using the Black formula. The value of a caplet becomes
C=L
k
P(0, t
k+1
) (F
k
N(d1) R
K
N(d2))
36
with
d1=ln(F
k /
R
K
)+ k
2
t
k
/2
tk k
d2=ln(F
k /
R
K
) k
2
t
k
/2
tk k
For the pricing of the whole cap or floor, the values of each caplet or floorlet have to be
discounted back using discount factor as the numeraire: for N number of floorlet and caplets
C
total=
) , (
0
ti t C i P
N
i
=
F
total =
) , (
0
ti t F i P
N
i
=
A Swap is an agreement between two parties to exchange cash flows in the future.
2. I nterest rate swap(IRS)
A company agrees to pay a fixed interest rate on a specific principal for a number of years and, in
return, receives a floating interest rate on the same principal (pay fixed receive floating).
The floating interest rate is usually the LIBOR rate.
Such 'plain vanilla' interest rate swaps are often used to transform floating rate to fixedrate loans or
vice versa.
A swap agreement can be seen as the exchange of a floatingrate (LIBOR) bond with a fixedrate
bond.
The forward swap rate S
,
(t) at time t for the sets of times T and year fractions is the
rate in the fixed leg of the above IRS that makes the IRS a fair contract at the present time.
37
S
,
(t) = P(t;T
) P(t;T
)
+ =
1 i
i
P(t,Ti)
Application
Life insurance companies use the hedge interest rate risk and extend their asset duration in order to
stay matched with their long duration liabilities.
2.5 European payer (receiver) swaption is an option giving the right (and no obligation)
to enter a payer(receiver) IRS at a given future time, the swaption maturity.
Usually the swaption maturity coincides with the first reset date of the underlying IRS.
The underlyingIRS length (T
1
T
2
in our notation) is called the tenor of the swaption.
Sometimes the set of reset and payment dates is called the tenor structure.
I can write the discounted payoff of a payer swaption by considering the value of the underlying payer
IRS at its first reset date T
1,
which is also assumed to be the swaption maturity. Such a value is given
by changing sign in formula .
Blacks model is used frequently to value European swaption,

C=
r T
x m t
e
F
m F
(
1
) / 1 (
1
1
  ) 2 ( ) 1 ( * d X N d N F
P=
r T
x m t
e
F
m F
(
1
) / 1 (
1
1
  ) 1 ( ) 2 ( * d F N d N X
38
d1=ln(F
/
X
)+
2
t
k
/2
T
d2 =d1  T
where F is the strike swap rate and X is the current implied forward swap rate for t
1
which is here the maturity of the option element of the swaption and start time of the
swap and time t
2
is the time when the swap contract terminate
T=t
2
t
1
Pricing and applications
Here is example of pricing receiver swaption that life insurer use to hedge their interest rate exposure
in guaranteed annuity option.
Swap / Cap Data Term Structure
Underlying Type: Time (Yrs) Rate (%)
1 3.961%
Settlement Frequency: 2 3.879%
Principal : 100 3 3.853%
Swap Start (Years): 1.00 4 3.928%
Swap End (Years): 30.00 5 3.992%
Swap Rate (%): 1.82% 6 4.118%
7 4.203%
Pricing Model: 8 4.288%
9 4.406%
10 4.618%
Volatility (%): 15.00% 11 4.586%
12 4.482%
13 4.376%
Price: 1.318E08
DV01 (Per basis point): 1.25E09
Gamma01 (Per %): 1.172E08
Vega (per %): 7.45E08
Swap Option
Black  European
Imply Volatility
Imply Breakeven Rate
Pay Fixed
Rec. Fixed
Calculate
SemiAnnual
39
0
5
10
15
20
25
1.00% 2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00%
Swap Rate
O
p
t
i
o
n
P
r
i
c
e
40
2.6 Callable/Putable Zero Coupon Bonds
Callable (putable) zero coupon bonds differ from zero coupon bonds in that the Issuer has the right
to buy (the investor has the right to sell) the paper prematurely at a specified price. There are three
types of call/put provisions.
European option:
The bond is callable/putable at a predetermined price on one specified day.
American option:
The bond is callable/putable during a specified period.
Bermuda option:
The bond is callable/putable at specified prices on a number of predetermined occasions.
A call provision allows the issuer to repurchase the bond prematurely at a specified price. In effect,
the issuer of a callable bond retains a call option on the bond. The investor is the option seller.
A put provision allows the investor to sell the bond prematurely at a specified price.
In other words, the investor has a put option on the bond. Here, the issuer is the option seller.
Call provision
The issuer has a Bermuda call option which may be exercised at an annually changing strike price.
Replication
This instrument breaks into callable zero coupon bonds down into a zero coupon bond and a call
Option.
callable zero coupon bond = zero coupon bond +call option
41
where
+long position
 Short position
The decomposed zero coupon bond has the same features as the callable zero coupon bond except for
the call provision. The call option can be a European, American or Bermuda option.
Variance swaps
Variance swaps are instruments, which offer investors straightforward and direct exposure to the
volatility of an underlying asset such as a stock or index.
They are swap contracts where the parties agree to exchange a preagreed Variance level for the actual
amount of variance realised over a period.
Variance swaps offer investors a means of achieving direct exposure to realised variance without the
pathdependency issues associated with deltahedged options.
Buying a variance swap is like being long volatility at the strike level; if the market delivers more than
implied by the strike of the option, you are in profit, and if the market delivers less, you are in loss.
Similarly, selling a variance swap is like being short volatility.
However, variance swaps are convex in volatility: a long position profits more from an increase in
volatility than it loses from a corresponding decrease. For this reason variance swaps normally trade
above ATM volatility.
42
Market development
Variance swap contracts were first mentioned in the 1990s, but like vanilla options only really took
off following the development of robust pricing models through replication arguments.
The directness of the exposure to volatility and the relative ease of replication through a static portfolio
of options make variance swaps attractive instruments for investors and marketmakers alike.
The variance swap market has grown steadily in recent years, driven by investor demand to take direct
volatility exposure without the cost and complexity of managing and delta hedging a vanilla options
position.
Although it is possible to achieve variance swap payoffs using a portfolio of options, the variance
swap contract offers a convenient package bundled with the necessary deltahedging.
This will offer investors a simple and direct exposure to volatility, without any of the path dependency
issues associated with delta hedging an option.
Variance swaps initially developed on index underlings. In Europe, variance swaps on the Euro Stoxx
50 index are by far the most liquid, but DAX and FTSE are also frequently traded.
Variance swaps are also tradable on the more liquid stock underlings especially Euro Stoxx 50
constituents, allowing for the construction of variance dispersion trades.
43
Variance swaps are tradable on a range of indices across developed markets and increasingly also on
developing markets.
Bid/offer spreads have come in significantly over recent years and in
Europe they are now typically in the region of 0.5 vegas for indices and vegas for singlestocks
although the latter vary according to liquidity factors.
Example 1: Variance swap p/l
An investor want to gain exposure to the volatility of an underlying index (e.g, Dow
J ones FTSE 100 ) over the next year.
The investor buys a 1year variance swap, and will be delivered the difference between
the realised variance over the next year and the current level of implied variance, multiplied by the
variance notional.
Suppose the trade size is 2,500 variance notional, representing a p/l of 2,500 per point
difference between realised and Implied variance.
If the variance swap strike is 20 (implied variance is 400) and the subsequent variance realised over the
course of the year is(15%)
2
=0.0225 (quoted as 225),
The investor will make a loss because realised variance is below the level bought.
Overall loss to the long =437,500 =2,500 x (400 225).
The short position will profit by the same amount.
1.1: Realised volatility
44
Volatility measures the variability of returns of an underlying asset and in some sense provides a
measure of the risk of holding that underlying.
In this note I am concerned with the volatility of equities and equity indices, although much of the
discussion could apply to the volatility of other underlying assets such as credit, fixedincome, FX and
commodities.
Figure 3 shows the history of realised volatility on the Dow J ones Industrial Average
over the last 100 years. Periods of higher volatility can be observed, e.g. in the early 1930s as a result
of the Great Depression, and to a lesser extent around 2000 with the buildup and unwind of the dot
com bubble. Also noticeable is the effect of the 1987 crash, mostly due to an exceptionally large
single day move, as well as numerous smaller volatility spikes
.
Summary of the equity volatility characteristics
The following are some of the commonly observed properties of (equity market) volatility:
Volatility tends to be anticorrelated with the underlying over short time periods
Volatility can increase suddenly in spikes
Volatility can be observed to experience different regimes
Volatility tends to be mean reverting (within regimes)
45
This list suggests some of the reasons why investors may wish to trade volatility: as a partial hedge
against the underlying .
Especially for a volatility spike caused by a sudden market selloff; as a diversifying asset
class; to take a macro view e.g. or a potential change in volatility regime; for to trade a spread of
volatility between related instruments.
Pricing model and hedging
First let us understand the cash flow structure the following diagram explain the cash flow exchanged
by looking to the following diagram
46
Volatility swaps are series of forward contracts on future realized stock volatility, variance.
Swaps are similar contract on variance, the square of the future volatility.
Both these instruments provide an easy way for investors to gain exposure to the future level of
volatility.
A stock's volatility is the simplest measure of its risk less or uncertainty.
Formally, the volatility
R
(S).
R
(S) is the annualized standard deviation of the Stocks returns during the period of
interest , where the subscript R denotes the observed or "realized" volatility for the stock .
The easy way to trade volatility is to use volatility swaps, sometimes Called realized volatility forward
contracts, because they provide pure exposure To volatility (and only to volatility). A stock volatility
swap is a forward contract on the annualized volatility.
Its payoff at expiration is equal to
N(
2
R
(S)K
var
)
Where
R
(S)) is the realized stock volatility (quoted in annual terms) over the life of the contract.
47
(
2
R
(S) =1/T
T
0
2
(S) ds
K
var
is the delivery price for variance, and N is the notional amount of the swap in dollars per
annualized volatility point squared.
The holder of variance swap at expiration receives N dollars for every point by which the stock's
realized variance has exceeded the variance delivery price K
var
.
Therefore, pricing the variance swap reduces to calculating the realized volatility square.
Valuing a variance forward contract or swap is no different from valuing any other derivative security.
The value of a forward contract P on future realized variance with strike price Kvar is the expected
present value of the Future payoff in the riskneutral world:
P=E(e
rT
(
2
R
(S)K
var
)
where r is the riskfree discount rate corresponding to the expiration date T (Under the
assumption of deterministic risk free rate)and E denotes the expectation.
Thus, for calculating variance swaps we need to know only
E [(
2
R
(S)]
Namely, mean value of the underlying variance.
Approximation (which is used the second order Taylor expansion for function px)
where
E[
2
R
(S)]
) (V E
 Var(V)
48
8 E(V)
3/2
Where V =
2
R
(S)
In addition, Var(V)
8 E(V)
3/2
this the term of the convexity adjustment.
Thus, to calculate volatility swaps ineed the first and the second term
this variance has unbiased estimator namely:
Var
n
(S)=n/(n1)*1/T *
=
n
i 1
log
2
S
t
S
t1
V=Var(S)=lim Var
n
(S)
n
Where we neglected by 1/n
=
n
i 1
log
2
S
t
S
t1
For simplicity reason only. Inote that iuse Heston (1993) model:
Log St
1
=
d t r
t
t
t
) 2 / (
2
1
1
1
+
t
t
t
t
dw
t
1
1
S
t1
1
49
E(var
n
(S))= n
) ( l o g
1 1
1
1
2
t
t
n
t
S
S
E
(n1)T
snd
E( log
2
1 1
1
t
t
S
S
)=
) (
1
1
1
dt r
t
t
t
2 _
) (
1
1
1
dt r
t
t
t
dt E
t
t
t
t
1
2
1
) (
+
4
1
s d E t
t
t
t
t
2 2
1
1
1
1
1 1
E(
dt E
t
t
t
t
1
2
1
) (
t
t
t
t
dw
t
1
1
)+
dt E
t
t
t
t
1
2
1
) (
50
Appendix 1
Variance and Volatility Swaps for Heston
Model of Securities Markets
Stochastic Volatility Model.
Let (;F;F
t
; P) be probability space with filtration Ft; t
[0; T]:
Assume that underlying asset St in the riskneutral world and variance
follow the following model, Heston (1993) model:
ds t
t =
r
t
dt+ dw
t
s
t
d t
2
=K(
2
 t
2
)dt+
dw
t
2
where
rt
is deterministic interest rate,
0 and
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