1 182

Econ 455/655 Options and Futures I
Lecture Notes
Professor Man-lui Lau
Forward and Future Contracts
Definition:
A DERIVATIVE (or derivative security) is a financial instrument whose value depends

on the values of other, more basic underlying variables.
Definition:
A FORWARD CONTRACT is an agreement to buy or sell an asset at a certain future

time for a certain price.
The party who assumes a LONG POSITION agrees to buy the underlying asset on a certain specified
future date for a certain specified price.
The other party who assumes a SHORT POSITION agrees to sell the underlying asset on a certain
specified future date for a certain specified price.
Example:
On January 18, 2013, the forward prices for are as follows:
Spot
1-month forward
3-month forward
6-month forward
1.5864
1.5862 delivery price ( K )
1.5858
1.5852
If a person takes a long position of the 1-month forward contract, then she agrees to buy the British
@ $1.5862 one month from January 18, 2013.
If a person takes a short position of the 6-month forward contract, then she agrees to sell the British
@ $1.5852 six months from January 18, 2013.
Example:
On January 18, 2013, the forward prices for are as follows:
Spot
1-month forward
3-month forward
6-month forward
0.01110
0.01110 delivery price ( K )
0.01111
0.01112
If a person takes a long position of the 3-month forward contract, then she agrees to buy the @
$0.01110 three month from January 18, 2013.
If a person takes a short position of 6-month forward contract, then she agrees to sell the @
$0.01112 six month from January 18, 2013.
ECON 455/655 Options and Futures I
Prof. Man-lui Lau
Note: A forward contract is settled at maturity.

The holder of the short position delivers the asset to the holder of the long position in return for
a cash amount equal to the delivery price.
Payoff
Payoff
K: delivery price
ST: price of asset at maturity
+
ST
ST
LONG POSITION
SHORT POSITION
Payoff ST K
Payoff K ST
Example:
Suppose that an investor entered into a long forward contract on January 18, 2013 to buy 1 million in
1 month @ USD 1.5862/.
If the spot exchange rate rises to 1.6500 at the end of one month, then
($1.6500 $1.5862) 1, 000, 000 $63,800
sell
buy
If the spot exchange rate falls to 1.4000 at the end of one month, then
($1.4000 $1.5862) 1, 000, 000 $186, 200
sell
buy
Example:
Suppose that an investor entered into a short forward contract on January 18, 2013 to sell 1 million
in 3 month @ USD $1.5858/.
If the spot exchange rate rises to 1.6500 at the end of three months, then
($1.5858 $1.6500) 1, 000, 000 $64, 200
sell
buy
If the spot exchange rate falls to 1.4000 at the end of three months, then
($1.5858 $1.4000) 1, 000, 000 $185,800
sell
buy
Prof. Man-lui Lau
Definition:
A Futures Contract is a forward contract trading in an exchange. The futures contract

has a fixed contract size with a fixed maturity date.
Example:
Delivery Month
June
September
December
Commodity
Cattle
S&P Composite Index
Exchange
CME
CME
IMM
Contract Size
40000 pounds
$250 Index
12,500,000
Note:
1)
In the case of commodities such as cotton, wheat, orange juice, the quality of the commodity is
specified.
2)
The exchanges set the place and the time for delivery.
3)
The last trading day of a contract is the second Friday of the delivery month.
Specification of the Futures Contract
1.
The asset
2.
Contract size
3.
Delivery arrangement
4.
Delivery months
5.
Price quotes
6.
Daily price movement limits (limit up and limit down)
7.
Position limits
Reasons for trading futures:
1.
Speculation
a)
Suppose an investor believes that the price of gold will go up in the future, instead of buying
spot gold (which is very inconvenient), she can take a long position of gold futures.
Month
Feb 13
Mar 13
Apr 13
Jun 13
Aug 13
1/18/2013
Settlement
1687.00
1688.00
1689.20
1691.30
1693.10
For example, on Jan 18, 2013, she buys a August Gold futures @$1693.10. [i.e. she promises
to buy 100 oz of gold @$1693.10 at closing on the third last business day of August] Once she
has a long position, she can make money in the following two ways:
i)
She can wait until Aug 28, 2013 (third last business day of August). Suppose at the
closing of that day, the spot price of gold is $1800, then she can buy the gold at the
contract price $1693.10 and immediately sell the gold in the spot market for $1800.
She will make ($1800 $1693.10) 100 $10,690 .
Prof. Man-lui Lau
ii)
Suppose on Jan 31, 2013, the August gold futures is trading @1750, then she can sell a
contract (and close her position) and make ($1750 $1693.10) 100 $5, 690 .
Of course if she is wrong, the following may happen.
b)
i)
Suppose at the closing of Aug 28, 2013, the price of the spot gold is $1000, then her
profit is ($1000 $1693.10) 100 $69,310 (loss) .
ii)
Suppose on Jan 31, 2013, the August gold futures is trading @1500, if she sells a
contract (and closes her position), then her profit is
($1500 $1693.10) 100 $19,310 (loss) .
Suppose an investor believes that the is going to depreciate. Instead of shorting in the spot
market, she can take a short position on the futures.
1/18/2013
Month
Settlement
Mar 13
0.011111
Jun 13
0.011121
Sep 13
0.011133
Dec 13
0.011147
Mar 14
0.011165
Jun 14
0.011185
For example, on Jan 18, 2013, she sells a June futures @0.011121. [i.e. she promise to sell
12.5 million @ 0.011121 per at closing on the second business day immediately preceding
the third Wednesday of June]
Once she has a short position, she can make money in the following two ways:
i)
She can wait until June 17, 2013. Suppose at the closing of that day, the spot price of
contract is $0.01. She can buy the in the spot market @$0.01 and then sell the at
the futures contract price of $0.011121.
She will make ($0.011121 $0.01) 12,500,000 $14,012.50 .
ii)
Suppose on January 31, 2013, the June futures is trading @0.009, then she can buy a
contract (and close her position) and make
($0.011121 $0.009) 12,500,000 $26,512.50
Of course if she is wrong, the following may happen.

i)
Suppose at the closing of June 17, 2013, the spot price of is $0.012, then her profit is
($0.011121 $0.012) 12,500,000 $10,987.50 (loss) .
Prof. Man-lui Lau
ii)
Suppose on January 31, 2013, the June contract futures is trading @$0.0125, if she
buys a contract (and closes her position), then her profit is
($0.011121 $0.0125) 12,500,000 $17, 237.50 (loss) .
2.
Hedging
a)
Short Hedge: A company that knows it is due to sell an asset at a particular time in the future
can hedge by taking a short position in the futures market.
i)
If a farmer knows that he will have wheat for sale in September, he can take a short
position in the futures market. Once he takes the short position, he no longer has to
worry about the price that he will get for the wheat in September.
ii)
Suppose a company is going to receive 1 million in September. In order to avoid any

uncertainty about the value of by that time, he can short 16 September futures
(16 62500 1, 000, 000) @1.5827
Current September Futures price $1.5827

September Spot Price
$1.5000
$1.5500
$1.6000
$1.6500
$1.7000
b)
Not Hedged
Will receive
$1,500,000
$1,550,000
$1,600,000
$1,650,000
$1,700,000
Hedged
Will receive
$1,582,700
$1,582,700
$1,582,700
$1,582,700
$1,582,700
Long Hedge: A company that knows it is due to buy an asset at a particular time in the future
can hedge by taking a long position in the futures market.
i)
In order to eliminate the uncertainty in the price of corn, a cereal company can buy corn
in the futures market.
ii)
Suppose a company is going to pay 1 million Can$ in September. In order to avoid any
uncertainty about the value of Can$ by that time, he can long 10 September Can$
futures (10 100000 1,000,000) @1.0019
Current September Futures price $1.0019
September Spot Price

$0.9800
$0.9900
$1.0000
$1.0100
$1.0200
$1.0300
Not Hedged
Will pay
$980,000
$990,000
$1,000,000
$1,010,000
$1,020,000
$1,030,000
Hedged
Will pay
$1,000,190
$1,000,190
$1,000,190
$1,000,190
$1,000,190
$1,000,190
Prof. Man-lui Lau
iii)
If a mutual fund manager knows that there will be inflow of cash into her fund in June,
she can a long position in June Stock Index Futures to fix the purchasing price at the
current level.
Operation of Margins in Trading Futures (marking to the market)

Example:
Day
Future price
($)
400.00
397.00
396.10
398.20
397.10
396.70
393.30
396.30
400.30
405.30
411.30
6/3
6/4
6/5
6/6
6/7
6/10
6/11
6/12
6/13
6/14
Example:
Day
6/1
6/2
6/3
6/4
6/5
6/8
buy 2 December Gold futures @$400/ounce. (100 ounces per contract)

Initial margin requirement:
$2000/contract (non-current)
Maintenance margin requirement: $1500/contract (non-current)
Daily gain
(loss) ($)
Cumulative gain
(loss) ($)
(600)
(180)
420
(220)
(80)
(680)
600
800
1000
1200
(600)
(780) (600) (180)
(360) (780) 420
(580)
(660)
(1340)
(740)
60
1060
2260
Margin account
balance ($)
4000 2 2000
3400 3000
3220 3000
3640 3000
3420 3000
3340 3000
2660 3000
4600
5400
6400
7600
Margin call ($)
1340 4000 2660
sell 1 December Yen futures @$0.009613 ( 12,500,000 per contract)

$2025/contract
Maintenance margin requirement: $1500/contract
Future
price ($)
0.009613
0.009600
0.009650
0.009700
0.009700
0.009600
0.009400
Daily gain
(loss) ($)
Cumulative gain (loss) ($)
162.50
(625.00)
(625.00)
0
1250
2500
162.50
(462.50) 162.50 (625.00)
(1087.50) (462.50) (625.00)
(1087.50)
162.50
2662.50
Margin account
balance ($)
2025
2187.5
1562.50 1500
937.50 1500
2025
3275
5775
Margin call ($)
1087.50 2025 937.5
Prof. Man-lui Lau
Example:
Day
6/1
6/2
6/3
6/4
6/5
6/8
6/9
6/10
6/11
6/12
sell 1 December S&P500 Index futures @1376.40 ($250 Index)

$19687/contract
Maintenance margin requirement: $15750/contract
Future price
($)
1376.40
1350.00
1340.00
1350.00
1390.00
1360.00
1390.00
1400.00
1405.00
1350.00
1300.00
Daily gain (loss)

($)
Cumulative gain
(loss) ($)
6600
2500
(2500)
(10000)
7500
(7500)
(2500)
(1250)
13750
12500
6600
9100
6600
(3400)
4100
(3400)
(5900)
(7150)
6600
19100
Margin account
balance ($)
19687
26287
28787
26287
16287 15750
23787
16287 15750
13787 15750
18437 15750
32187
44687
Margin call ($)
5900 19687 13787
Reasons why hedging using futures contracts works less than perfectly in practice
1.
2.
3.
The asset whose price is to be hedged may not be exactly the same as the asset underlying the
futures contract.
The hedger may be uncertain as to the exact date when the asset will be bought or sold.
The hedge may require the futures contract to be closed out well before its expiration date.
These problems give rise to BASIS RISK.
Prof. Man-lui Lau
Optimal Hedging Ratio
S : change in spot price, S , during a period of time equal to the life of the hedge
F : change in futures price, F , during a period of time equal to the life of the hedge
S : standard deviation of S
F : standard deviation of F
: coefficient of correlation between S and F
Cov(S , F )
S F
h : hedge ratio
Cov(S , F ) E[(Si E (S ))(Fi E (F )]
When the hedger has a long position in the asset and a short position in the futures, the change in the
value of the hedgers position during the life of the hedge is S hF
When the hedger has a short position in the asset and a long position in the futures, the change in the
value of the hedgers position during the life of the hedge is hF S .
Var (S hF ) Var (S ) Var (hF ) 2Cov(S , hF ) S2 h2 F2 2h S F

Problem:
FOC:
min v S2 h2 F2 2h S F
h
S
dv
2h F2 2 S F 0 h*
dh
F
Optimal hedge ratio:
h*
S
F
Note:
If 1 and F S h* 1.0
In this case, the futures price mirrors the spot price perfectly.
If 1 and F 2 S h* 0.5
The futures price always changes by twice as much as the spot price.
Prof. Man-lui Lau
Example:
(Optimal hedge ratio)
A company knows that it will buy 1 million gallons of jet fuels in 3 months. The standard deviation of
the change in the price per gallon of jet fuel over a 3-month period is calculated as 0.032. As there is
no futures contract on jet fuels, the company chooses to hedge by buying futures contracts on heating
oil. The standard deviation of the change in the futures price over a 3-month period is 0.040 and the
coefficient of correlation( ) between the 3-month change in the price of jet fuel and the 3-month
change in the futures price is 0.8.
optimal hedge ratio h*
S
0.032
(0.8)
0.64
F
0.040
One heating oil futures is on 42000 gallons. The company should therefore buy
1000000
(0.64)
15.2 15 contracts
42000
Example:
(Optimal hedge ratio)
The standard deviation of monthly changes in the spot price of live cattle is (in cents per pound) 1.2.
The standard deviation of monthly changes in the futures price of live cattle for the closest contract is
1.4. The correlation between the futures price changes and the spot price changes is 0.7. It is now
October 15. A beef producer is committed to purchasing 200,000 pounds of live cattle on November
15. The producer wants to use the December live cattle futures contracts to hedge its risk. Each
contract is for the delivery of 40,000 pounds of cattle. What strategy should the beef producer follow?
h*
S
1.2
(0.7)
0.6
F
1.4
The beef producer requires a long position in (200,000)(0.6) 120,000 pounds of cattle. The beef
120000
3 contracts
producer should therefore take a long position in
40000
Rolling the hedge forward

If the expiration date of the hedge is later than the delivery dates of all the futures contracts that can be
used, the hedger must then roll the hedge forward.
Example:
A company has to pay 1 million in December 2018.
In March 2014, buy 16 contracts of December 2014 . ( 16 62500 1000000 )
In December 2014, sell 16 contracts of December 2014 and buy 16 contracts of December 2015 .
10
Prof. Man-lui Lau
II
Forward and Futures Prices
Continuous compounding
Principal: A
Interest Rate: r
Compounding frequency
1
2
3
Value at the end of 1 year
A(1 r )
r
A(1 ) 2
2
r
A(1 )3
3
r
A(1 ) m
m
r
lim A(1 ) m Aer
m
m
th
Value at the end of n year
A(1 r )n
r
A(1 ) 2 n
2
r
A(1 )3n
3
r
A(1 ) mn
m
rn
Ae
Example:
Suppose the semi-annual compounding interest rate is 10%. Find the corresponding continuous
compounding interest rate.
10% 2
) erC
rC : continuous compounding interest rate
2
ln(erC ) ln(1.05)2 rC 2ln(1.05) 9.758%
(1
Example:
Suppose the comtinuous compounding interest rate is 10%. Find the corresponding quarterly
compounding interest rate.
e10% (1
r4 4
)
4
r4 : quarterly compounding interest rate
1
1
10% 14
r4
r4
10% 4
10% 4
(1 ) (e ) (e ) 1 r4 4 (e ) 1 10.126%
4
4
11
Prof. Man-lui Lau
Convergence of futures price to spot price

Claim: The futures price equals (or is very close) to the spot price @T
Abritrage: buy low, sell high
Proof:
(I)
Suppose FT ST , this gives rise to an arbitrage opportunity for traders.
i)
short a futures contract @ FT
ii)
buy the asset @ ST
iii)
make delivery
FT ST
These trades will increase the spot price of the asset and decrease the price of the futures
contract, this process will go on until the equality is reached.
(II)
Suppose FT ST , this gives rise to an arbitrage opportunity for traders.

i)
buy a futures contract @ FT
ii)
accept delivery
iii)
sell the asset @ ST
FT ST
These trades will increase the price of the futures contract and decrease the spot price of
the asset, this process will go on until the equality is reached.
spot price
$
futures price
futures price
spot price
time
time
12
Prof. Man-lui Lau
Assumptions:
1.
There are no transaction costs.
2.
All trading profits (net of trading losses) are subject to the same tax rate.
3.
The market participants can borrow money at the same risk-free rate of interest as they can lend
money.
4.
The market participants take advantage of arbitrage opportunities as they occur.
Notation:
T : time when forward contract matures (years)
t : current time (years)

S : price of asset underlying forward contract @ t
ST : price of asset underlying forward contract @T (unknown at the current time)
K : delivery price (the specified price) in forward contract
f : value of a long forward contract @ t
F : forward price @ t
r : risk-free interest rate (per annum) @ t , with continuous compounding for an investment maturing @T
[Note that the forward price @ t is the delivery price that would make the contract have a value 0 .
When a contract is initiated, the delivery price is normally set equal to the forward price so that
F K and f 0 .]
13
Prof. Man-lui Lau
Forward contracts on a security that provides no income (non-dividend-paying stocks and

discount bonds)
rT
Claim: F Se
[The annual compounding interest rate verison of the formula is F S (1 r )T .]

Proof:
rT
(I)
Suppose F Se
An investor can earn a profit by carrying out the following trades:
i)
borrows $S for (time period) T at interest rate r (per annum)
ii)
buys the asset (and pays $S )
iii)
takes a short position in the forward contract (promises to sell the security for $ F @ T )
cash flow @T :
i)
ii)
$F
$Se
rT
(the asset is sold under the terms of the forward contract)

(repays the loan)
F SerT 0 is realized @T
If a lot of traders carry out the above trades, F and S until the equality is restored.
(II)
rT
Suppose F Se

i)
sells short the asset (and collects $S )
ii)
deposits $S for T at interest rate r (per annum)
iii)
takes a long position in the forward contract (promises to buy the security for $ F @ T )
cash flow @T :
i)
ii)
$F
$Se
rT
(accepts delivery under the terms of the forward contract)

(the deposit)
SerT F 0 is realized @T
14
Prof. Man-lui Lau
Example:
Arbitrage opportunity when forward price of a non-dividend-paying stock is too

high.
The forward price of a stock for a contract with delivery date in three months is $43. The 3-month
risk-free interest rate is 5 percent per annum, and the current stock price is $40. No dividends are
expected.
Opportunity:
Note that 43 F SerT 40e
(5%)(
3
)
12
40.50
The forward price is too high relative to the stock price. An arbitrageur can make a profit by
i)
borrowing $40 @ r 5% to buy 1 share, and
ii)
taking a short position in the forward contract (and promised to sell for $43 three months later)
At the end of 3 months, the arbitrageur delivers the share and receives $43. He is required to pay back
the loan of the amount $40e
(5%)
3
12
$40.50 $43 $40.50 $2.50 .
[Note that if F $43 S Fe rT 43e
Example:
(5%)
3
12
$42.47 .]
Arbitrage opportunity when forward price of a non-dividend-paying stock is too low
The forward price of a stock for a contract with a delivery date in three months is $39. The threemonth risk-free interest rate is 5 percent per annum and the current stock price is $40. No dividends
are expected.
Opportunity
Note that 39 F Se
rT
40e
(5%)(
3
)
12
40.50
The forward price is too low relative to the stock price. An arbitrageur can make a profit by
i)
shorting one share and loaning out the $40 received @ r 5% for three months , and
ii)
taking a long position in the forward contract (and promises to buy @$39 three months later).
(5%)(
At the end of three months, the arbitrageur will have a total cash position of 40e 12 $40.50 . He
will accept delivery according to the forward contract and buy 1 share @$39. This share will be used
to cover the short position established initially.
$40.50 $39 $1.50

[Note that if F $39 S Fe rT 39e
(5%)
3
12
$38.52 ]
15
Prof. Man-lui Lau
Forward contracts on a security that provides income (dividend-paying stocks and couponbearing bonds)
I:
the present value (using the risk-free interest rate to discount future incomes) of income to be
received during the life of the forward contract
Claim: F ( S I )erT [Discrete time version: F ( S I )(1 r )T ]

Proof:
(I)
Suppose F ( S I )erT
i)
borrows $S for T at interest rate r (per annum)
ii)
buys the asset (and pay $S )
iii)
takes a short position in the forward contract (promises to sell for $ F @T )
cash flow @T :
i)
ii)
iii)
$F
$Se
$ IerT
rT
the asset is sold under the terms of the forward contract

repays the loan
dividend
F SerT IerT F ( S I )erT 0 is realized @T
(II)
Suppose F ( S I )erT

i)
sells short the asset (and collects $S )
ii)
lends out $S for T at interest rate r (per annum)
iii)
takes a long position in the forward contract (promises to buy for $ F @T )
cash flow @T :
i)
ii)
iii)
$F
$Se
rT
$ IerT
accepts delivery under the terms of the forward contract

gets back the loan
pays the dividend (for the short stock position)
SerT IerT F ( S I )erT F 0 is realized @T
16
Prof. Man-lui Lau
Example
Consider a 10-month forward contract on a stock with a price of $50. We assume that
the risk-free interest rate (continuously compounding) is 8% per annum for all maturities. We also
assume that dividends of $0.75 per share are expected after 3 months, 6 months, and 9 months.
Present value of the dividends:
I 0.75e
(8%)(
3
)
12
0.75e
(8%)(
3 months
6
)
12
0.75e
(8%)(
6 months
F (S I )erT (50 2.162)e
(8%)(
10
)
12
9
)
12
2.162
9 months
$51.14
10 months
Example:
Consider a 13-month contract on a coupon-paying bond. Let S $900 . Coupon
payments of $40 are expected in 6 months and 1 year respectively. Let the 6-month risk-free interest
rate 9% , the 12-month risk-free interest rate 10% , and the 13-month risk-free interest rate 11% .
Present value of the dividends:
I 40e
(9%)(
6
)
12
40e (10%)(1) 74.43
6 months
12 months
F ( S I )e (900 74.43)e
rT
(11%)(
13
)
12
$930.05
13 months
Forward contracts on a security that provides a constant dividend yield

( r q )T
Claim: F Se
Example:
Consider a 6-month forward contract on an investment asset that is expected to provide
a continuous dividend yield of 4% per annum. The risk-free interest rate (with continuous
compounding) is 10% per annum. The spot price of the asset is $25.
F Se( r q )T 25e
(10% 4%)(
6
)
12
$25.76
Note: When the dividend yield is continuous, but varies throughout the life of the forward contract, q
should be set equal to the average dividend yield during the life of the contract.
17
Prof. Man-lui Lau
Stock index futures

Stock indices
1.
Capitalization-weighted index (S&P 500 Index)
Example:
i)
Stock
A
B
C
Price
$30
$90
$50
Float
175,000
50,000
100,000
Total capitalization
Index
Capitalization
$5,250,000
$4,500,000
$5,000,000
$14,750,000
100
Stock
A
B
C
Price
$40
$80
$60
Float
175,000
50,000
100,000
Index
Capitalization
$7,000,000
$4,000,000
$6,000,000
$17,000,000
17000000
100 (
) 115.25
14750000
Stock
A
B
C
Price
$33
$90
$50
Float
175,000
50,000
100,000
Index
Capitalization
$5,775,000
$4,500,000
$5,000,000
$15,275,000
15275000
100 (
) 103.56
14750000
ii)
iii)
Note:
1.
The index value will not be affected by the change in the number of shares floating.
2.
As the prices of the stocks change, the weight will change as well.
18
Prof. Man-lui Lau
2.
Price-weighted index (Dow Jones Industrial Average)
Example:
i)
Stock
A
B
C
Total
Index
Price
$30
$90
$50
$170
100
Stock
A
B
C
Total
Index
Price
$33
$90
$50
$173
173
100(
) 101.76
170
ii)
Note:
1.
The stock with the highest weight is the one with the highest price.
2.
A change in IBMs price will have more effect on a capitalization-weighted index than on a
price-weighted index.
Major indices:
i)
S&P500 index
A capitalization-weighted index ( 250 index )
Make up of a portfolio of the largest 500 companies.
The index accounts for 80% of the market capitalization of all the stocks listed on the NYSE.
ii)
Dow Jones Industrial Average

A price-weighted index.
Make up of a portfolio of 30 stocks.
iii)
NYSE Composite index

A capitalization-weighted index.
Make up of a portfolio of all the stocks listed in NYSE.
iv)
The Major Market Index

A price-weighted index.
Make up of a portfolio of 20 blue-chips stocks listed on NYSE.
19
Prof. Man-lui Lau
Note:
1.
The futures contracts on stock indices are settled in cash, not by delivery of the underlying
asset.
2.
All contracts are marked to market on the last trading day and the positions are considered to be
closed.
3.
For most contracts, the settlement price on the last trading day is set at the closing value of the
index on that day except the S&P500 index.
4.
For the S&P500 index, the settlement price is set as the value of the index based on the opening
prices on the following trading day.
Future Price of Stock Indices

Most indices can be thought of as securities that pay dividends. The security is the portfolio of stocks
underlying the index and the dividends paid by the security are the dividends that would be received by
the holder of the portfolio.
Example
Consider a 3-month futures contract on the S&P500. Suppose that the stocks underlying the index
provide a dividend yield of 3% per annum.
Let S 400 and r 8% .
Then F Se
( r q )T
400e
(8%3%)(
3
)
12
405.03
In practice, q is not constant over time. The average should be used. Or the actual dividend
date can be used.
Example
Consider the following data of S&P500 index:
June
675.80
September
681.50
Calculate the r q . (Assume that the term structure of interest rate is constant.)
Let T be the expiration date of the June contract.
FSep Se( r q )(T 0.25)
FJune Se( r q )T
FSep
Se( r q )(T 0.25)
681.50
681.50
e0.25( r q )
e0.25( r q ) ln(
) 0.25(r q)
( r q )T
FJune
675.80
675.80
Se
1
681.50
rq
ln(
) 3.36%
0.25 675.80
20
Prof. Man-lui Lau
Index Arbitrage
( r q )T
If F Se
, the following profit opportunity arises:
i)
buy the stocks underlying the index,
ii)
sell the future contract.
[This is usually done by a corporation holding short-term money market instruments.]

( r q )T
If F Se
, the following profit opportunity arises:
i)
sell short the stocks underlying the index,
ii)
buy the future contract.
[This is usually done by a pension fund that owns an index portfolio of stocks.]
Note:
1.
In practice, index arbitrage is accomplished by trading a subset of the index stocks.
2.
If it is done by a computer, it is called program trading.
3.
In normal market conditions, F is very close to Se( r q )T .
However on Oct. 19, 1987, futures prices were at a significant discount. [At closing, the spot
S&P500 index was 225.06, but Dec. S&P500 index was 201.50.] The reason is as follows:
In order to take advantage of the arbitrage opportunity, traders need to buy futures and sell
short stocks. However, traders can only sell short stocks when the stocks are in an up-tick
situation. In a down market such as the one on Oct. 19, 1987, it is impossible to find the
opportunity to sell short stocks. Hence even though there is a discrepancy in the futures price
and the spot price, the traders cannot take advantage of it.
21
Prof. Man-lui Lau
Portfolio Analysis
end-of-period wealth beginning-of-period wealth

beginning-of-period wealth
Definition:
Return
Definition:
Expected return on a portfolio of N securities: rp X i ri
i 1
where rp : expected return of the portfolio

X i : the proportion of the portfolio's initial value invested in security i
ri : expected return of security i
N : the number of securities in the portfolio

CALCULATING THE EXPECTED RETURN ON A PORTFOLIO
(a) Security and Portfolio Values
Security Name
Number of
Shares in
Portfolio
A
B
C
100
200
100
Initial Market Price

Per Share
Total Investment
Proportion of Initial
Market Value of Portfolio
$40
$4000
$4000/$17200=23.35%
$35
$7000
$7000/$17200=40.70%
$62
$6200
$6200/$17200=36.05%
Total =
$17200
100%
(b) Calculating The Expected Return for a Portfolio Using End-of-Period Values
Security Name
Number of
Security Expected
Expected EndAggregate Expected
Shares in
Returns
of-Period Value
End-of-Period Value
Portfolio
Per Share
A
100
$46.48
$46.48 100 = $4648
$46.48 $40
16.2%
$40
B
200
$43.61
$43.61 200 = $8722
$43.61 $35
24.6%
$35
C
100
$76.14
$76.14 100 = $7614
$76.14 $62
22.8%
$62
Total = $20984
$20984 $17200
Portfolio Expected Return rp
22.00%
$17200
(c) Calculating the Expected Return for a Portfolio Using Security Expected Returns
Security Name
Proportion of
Security Expected
Contribution to Portfolio Expected
Initial Market
Returns
Return
Value at
Portfolio
A
23.25%
16.2%
23.25% 16.2% = 3.77%
B
40.70%
24.6%
40.70% 24.6% = 10.01%
C
36.05%
22.8%
36.05% 22.8% = 8.22%
Portfolio Expected Return rp 22.00%
22
Prof. Man-lui Lau
The Capital Asset Pricing Model

Assumptions:
1.
Investors evaluate portfolios by looking at the expected returns and standard deviations of the
portfolios over a one-period horizon.
2.
Investors are never satiated, so when given a choice between two otherwise identical portfolios.
they will choose the one with the higher expected return.
3.
Investors are risk-averse, so when given a choice between two otherwise identical portfolios,
they will choose the one with the lower standard deviation.
4.
Individual assets are infinitely divisible, meaning that an investor can buy a fraction of a share
if he or she so desires.
5.
There is a risk free rate at which an investor may wither lend (that is, invest) money or borrow
money.
6.
Taxes and transaction costs are irrelevant.
7.
All investors have the same one-period horizon.
8.
The risk free rate is the same for all investors.
9.
Information is freely and instantly available to all investors.
10.
Investors have homogeneous expectations, meaning that they have the same perceptions in
regard to the expected returns, standard deviations, and covariance of securities.
Major implication of the model:

The expected return of an asset is related to a measure of risk for that asset known as Beta ( ).
Definition:
The Market Portfolio is a portfolio consisting of all securities where the proportion
invested in each security corresponds to its relative market value.
relative market value of a security
aggregate market value of the security

sum of the aggregate market value of all securities
expected return on portfolio risk free interest rate

return on index risk free interest rate
23
Cov( R, RM )
Var ( RM )
Prof. Man-lui Lau
Hedging using index futures

Define as a measure of the responsiveness of a security or portfolio to the market as a whole (in
term of excess return over risk-free interest rate).
When 1.0 , the return on the portfolio tends to mirror the return on the market.
When 2.0 , the return on the portfolio tends to be twice as great as the excess return on the market.
Suppose we wish to hedge against changes in the value of a portfolio during a period of time T .
Define P : current value of the portfolio
A : current value of the stocks underlying one futures contract
N * : optimal number of contracts to short when hedging the portfolio
N*
P
A
Example
A company wishes to hedge a portfolio worth $2100000 over the next three months using an
S&P500 index futures contract with four months to maturity. The current level of the S&P500 index is
900 and the of the portfolio is 1.5.
The value of the assets underlying 1 futures contract is 900 $250 $225000 .
N
P
A
1.5(2100000)
14 (should short 14 contracts)
225000
24
Prof. Man-lui Lau
Example:
S 200
r 10%
q 4% Value of portfolio $2, 000, 000
1.5
Suppose an investor wants to use 4-month futures contract to hedge the value of the portfolio for
3 months.
The value of the stocks underlying 1 futures contract ($250)(200) $50000
P
$2000000
N 1.5
60 (should sell 60 contracts)
A
$50000
F Se( r q )T 200e
(10% 4%)(
4
)
12
200e0.02 204.04
Suppose the index turns out to be 180 3 months later (a 10% drop).
Futures:
F Se
( r q )T
180e
(10% 4%)(
1
)
12
180e0.005 180.90
Gain from the short position 60(204.04 180.90)($250) $347100
Stocks:
index 10%
dividend 1%
4% per annum, or 1% in 3 months
Total return 9%
expected return on portfolio risk free interest rate
return on index risk free interest rate
expected return on portfolio r (return on index r )

2.5% 1.5[9% 2.5%] 2.5% 1.5[11.5%] 14.75%
Expected value of the portfolio (inclusive of dividends) at the end of 3 months

$2000000 (1 14.75%) $1705000
Aggregate position $347100 $1705000 $2, 052,100
25
Prof. Man-lui Lau
Suppose the index turns out to be 190 3 months later (a 5% drop).

Futures:
F Se( r q )T 190e
(10% 4%)(
1
)
12
190e0.005 190.95
Stocks:
index 5%
dividend 1%
Total return 4%
2.5% 1.5[4% 2.5%] 2.5% 1.5[6.5%] 7.25%
$2000000(1 7.25%) $1855000
Suppose the index turns out to be 200 3 months later (a 0% change).

Futures:
F Se
( r q )T
200e
(10% 4%)(
1
)
12
200e0.005 201.00
Stocks:
index 0%
dividend 1%
Total return 1%
2.5% 1.5[1% 2.5%] 2.5% 1.5[1.5%] 0.25%
$2000000(1 0.25%) $2005000
Aggregate position $45600 $2000500 $2, 050, 600
26
Prof. Man-lui Lau
Suppose the index turns out to be 210 3 months later (a 5% increase)

Futures:
F Se( r q )T 210e
(10% 4%)(
1
)
12
210e0.005 211.05
Stocks:
index 5%
dividend 1%
Total return 6%
2.5% 1.5[6% 2.5%] 2.5% 1.5[3.5%] 7.75%
$2000000(1 7.75%) $2155000
Futures:
F Se
( r q )T
220e
(10% 4%)(
1
)
12
220e0.005 221.10
Stocks:
index 10%
dividend 1%
Total return 11%

2.5% 1.5[11% 2.5%] 2.5% 1.5[ 8.5%] 15.25%
$2000000(1 15.25%) $2305000
27
Prof. Man-lui Lau
Value of index in 3 months

Future prices of index in 3 months
Gain on futures position ($'000s)
Value of portfolio (including dividends) in 3
months ($'000s)
Aggregate position in 3 months ($'000s)
Return
180
180.90
$347.1
$1705.0
Performance of Stock Index Hedge (3 months)

190
200
210
190.95
201.00
211.05
$196.35
$45.6
-$105.15
$1855.00
$2005.0
$2155.00
$2052.1
2.605%
28
$2051.35
2.5675%
$2050.6
2.53%
$2049.85
2.4925%
Prof. Man-lui Lau
220
221.10
-$255.9
$2305.0
$2049.1
2.455%
Suppose the index turns out to be 180 4 months later (a 10% drop)
At maturity, F S
Futures:
Stocks:
index 10%
1
1
dividend 1 %
4% per annum, or 1 % in 4 months
3
3
2
Total return 8 %
3
1
2
1
1
2
3 % 1.5[8 % 3 %] 3 % 1.5[12%] 14 %
3
3
3
3
3
2
$2000000(1 14 %) $1706667
3
Suppose the index turns out to be 190 4 months later (a 5% drop)

At maturity, F S
Futures:
Stocks:
index 5%
1
dividend 1 %
3
2
Total return 3 %
3
1
3

1
2
1
1
1
3 % 1.5[3 % 3 %] 3 % 1.5[7%] 7 %
3
3
3
3
6

1
$2000000(1 7 %) $1856667
6
29
Prof. Man-lui Lau
Suppose the index turns out to be 200 4 months later (no change)
At maturity, F S
Futures:
Gain from the short position 60(204.04 200)($250) $60600
Stocks:
index 0%
1
dividend 1 %
3
1
Total return 1 %
3
1
3

1
1
1
1
1
3 % 1.5[1 % 3 %] 3 % 1.5[ 2%] %
3
3
3
3
3
1
$2000000(1 %) $2006667
3

At maturity, F S
Futures:
Stocks:
index 5%
1
1
dividend 1 %
3
3
1
Total return 6 %
3
1
1
1
1
5
3 % 1.5[6 % 3 %] 3 % 1.5[3%] 7 %
3
3
3
3
6
5
$2000000(1 7 %) $2156667
6
30
Prof. Man-lui Lau
At maturity, F S
Futures:
Stocks:
index 10%
1
dividend 1 %
3
1
3
1
Total return 11 %
3

1
1
1
1
1
3 % 1.5[11 % 3 %] 3 % 1.5[8%] 15 %
3
3
3
3
3
1
$2000000(1 15 %) $2306667
3
Value of index in 4 months

Future prices of index in 4 months
Gain on futures position ($'000s)
Value of portfolio (including dividends) in 4
months ($'000s)
Aggregate position in 4 months ($'000s)
Return
180
180
$360.6
$1706.7
Performance of Stock Index Hedge (4 months)

190
200
210
190
200
210
$210.6
$60.6
-$89.4
$1856.7
$2006.7
$2156.7
$2067.3
3.36%
$2067.3
3.36%
$2067.3
3.36%
$2067.3
3.36%
Note:
1.
A stock index hedge, if effective, should result in the hedger's position growing at
approximately the risk-free interest rate.
2.
By hedging, the ( of the portfolios futures position ) becomes 0 .
31
Prof. Man-lui Lau
220
220
-$239.4
$2306.7
$2067.3
3.36%
Why hedging?
1.
The hedger feels that the stocks in the portfolio have been chosen well and the portfolio will
out-perform the market.
2.
The hedger is planning to hold a portfolio for a long period of time and requires short-term
protection in an uncertain market.
3.
Hedging can eliminate "systematic" risk.
Remark:
After hedging his portfolio, if the market actually goes up, the portfolio manager may
be fired!!
Changing
Stock index futures can be used to change the of a portfolio.
In general, to change the of the portfolio from to * .
If * , a short position in ( *)
If * , a long position in ( * )
P
contracts is required.
A
P
contracts is required.
A
32
Prof. Man-lui Lau
Example:
Stock Portfolio Hedge
Scenario:
On January 2, a portfolio manager is concerned about the market over the next four
months. The portfolio has accumulated an impressive profit, which the manager wishes to protect over
the period ending July 27.
Stock
Price (1/2)
A
B
C
D
E
F
G
H
Portfolio
$18.875
$73.500
$50.875
$43.625
$54.250
$47.750
$44.500
$52.875
S&P500 index:
Price on January 2:
Multiple:
Value of 1 contract:
Number of
shares
9000
8000
3500
5400
10500
14400
12500
16600
Market Value
Weight
Beta
$169875
$588000
$178063
$235575
$569625
$687600
$556250
$877725
$3862713
4.4%
15.2%
4.6%
6.1%
14.7%
17.8%
14.4%
22.7%
100%
1.00
0.80
0.50
0.70
1.10
1.10
1.40
1.20
1.06
portfolio w11 ... wn n
1280
$250
($250)(1280) $320000
S&P500 September futures:

Price on January 2: 1300
Optimal number of futures contract: N
P
$3862713
1.06
12.80 (#contracts shorted 13)
A
$320000
Results (July 27):

Stock
A
B
C
D
E
F
G
H
Portfolio
Price (7/27)
$21.625
$81.500
$43.875
$47.125
$45.875
$48.125
$40.000
$50.000
Market Value
$194625
$652000
$153563
$254475
$481688
$693000
$500000
$830000
$3759351
S&P500 September futures contract:

Price on July 27:
1265
Gain on stocks
Gain on futures contract
Aggregate position
$3759351 $3862713
(1300 1265)($250)(13)
33
$103362
$113750
+$10388
Prof. Man-lui Lau
Example:
Anticipatory Hedge of a Takeover
Scenario:
On November 17, a firm has decided to begin buying up shares of ABC Corporation
with the ultimate objective of obtaining controlling interest. The acquisition will be made by
purchasing lots of about 100000 shares until sufficient control is obtained. The first purchase of
100000 shares will take place on December 17. The stock is currently worth $54 and has a beta of
1.35.
Date
November 17
Spot Market
Current price of the stock is $54.
Current cost of shares:
(100000)($54) $5400000
1.35
December 17
Futures Market
March S&P500 is at 465.45.
Price per contract $116362.50
Approximate number of contracts:
$5400000
1.35
62.65
$116362.5
The number of contracts purchased 63
March S&P500 is at 473.95.
The stock is purchased at its

current price of $57.
Cost of shares:
(100000)($57) $5700000
When the 100000 shares are purchased on December 17, they cost $5700000, an additional $300000.
The profit on the futures contract (473.95 465.45)($250)(63) $133875
The hedge eliminated about 44% of the additional cost.
The shares end up effectively costing ($5700000 $133875) /100000 $55.66
34
Prof. Man-lui Lau
Value of a forward contract of a Non-dividend paying stock

Claim: f S Ke rT
Proof:
Consider 2 portfolios.
rT
cash
Portfolio A: 1 long forward contract on the security $ Ke
Portfolio B: 1 unit of the security
In Portfolio A, the cash will grow to [$ Ke rT ]erT $ K @T , which then can be used to buy 1 unit of
the security. Therefore, @T , value of Portfolio A value of Portfolio B.
@ t , value of Portfolio A value of Portfolio B (otherwise, there will be arbitrage opportunity)

f Ke rT S f S Ke rT
Note: When a forward contract is initiated, the forward price equals the delivery price specified in the
rT
rT
contract ( F K ) and is chosen so that f 0 0 S Fe F Se
Example
Consider a long forward contract on a non-dividend-paying stock that matures in 12 months.
Let K $40, r 10%, S $30 , then f S Ke rT 30 40e (10%)(1) $6.19
The owner of the long forward contract is willing to pay up to $6.19 to get rid of the contract.
Note: The short forward contract is worth $6.19 .
Example
Consider a long 6-month forward contract on a 1-year discount bond.
Let r 6%, K $950, S $930 , then f S Ke rT 930 950e
(6%)(
6
)
12
$8.08
The owner of the long forward contract will ask for $8.08 before he is willing to give up the contract.
Note: The value of the short forward contract is $8.08 .
35
Prof. Man-lui Lau
Value of a forward contract of a security paying known dividend

Claim: f S I Ke rT
Proof:
Consider 2 portfolios.
rT
cash
Portfolio A: 1 long forward contract on the security $ Ke
Portfolio B: 1 unit of the security borrowing of $ I at the risk-free interest rate
In Portfolio A, the cash will grow to [$ Ke rT ]erT $ K @T , which then can be used to buy 1 unit of
the security.
In Portfolio B, the investor will use the income from the security to pay back the loan, so that @T ,
the investor will hold 1 unit of the security.
Therefore, @T , the 2 portfolios are the same value of Portfolio A value of Portfolio B.
@ t , value of Portfolio A value of Portfolio B (otherwise, there will be arbitrage opportunity)

f Ke rT S I f S I Ke rT
Note: When a forward contract is initiated, the forward price equals the delivery price specified in the
contract ( F K ) and is chosen so that f 0 0 S I Fe rT F (S I )erT
Example
Consider a long forward contract on a 5-year bond with S $900 has a maturity of 13 months.
Let K $910, 6-month r 9%, 12-month r 10%, 13-month r 11%
Let the coupon payments of $60 are expected after 6 months and 12 months respectively.
Present value of the coupon payments:
I 60e
(9%)(
6
)
12
60e (10%)(1) $111.65
6 months
12 months
Hence f S I Ke rT 900 111.65 910e
(11%)(
13
)
12
$19.42
36
Prof. Man-lui Lau
Value of a forward contract of a security that provides a known dividend yield

f Se qT Ke rT
Example
Consider a 6-month forward contract on a security that is expected to provide a continuous dividend
yield ( q ) of 4% per annum. The 6-month risk-free interest rate (with continuous compounding) is
10% per annum. Let S $25 and K $27 .
f Se qT Ke rT 25e
(4%)(
6
)
12
27e
(10%)(
6
)
12
$1.18
Also F Se( r q )T 25e
(10% 4%)(
6
)
12
$25.76 .
Note:
i)
r q r q 0 e ( r q )T 1 F S
This has nothing to do with whether the investors are optimistic about the future of the
stock or not!!!
ii)
r q r q 0 e ( r q )T 1 F S
37
Prof. Man-lui Lau
A General Result (Valuing Forward Contract)

The value of a forward contract at the time it is first entered into is $0. At a later stage, it may be either
positive or negative.
There is a general result, applicable to all forward contacts, that gives the value of a long forward
contract, f , in terms of the originally negotiated delivery price, K , and the current forward price, F .
Claim: f ( F K )e rT
Proof:
Consider the following portfolio:
1)
short forward contract A: delivery price F @ T
2)
long forward contract B: delivery price K @ T
@T :
security:
Cash flow:
accept the security (the long forward contract) and deliver the security (the short
forward contract)
FK
@t :
Cash flow:
( F K )e rT
Since the value contract A 0 value of contract B ( F K )e rT

Note:
F K 0 f 0
i)
F K 0 f 0
ii)
Example:
Consider a forward contract on a security, which will expire in 5 months with
K $100 . Let r 10% and F $90 .
f ( F K )e rT (90 100)e
(10%)(
5
)
12
$9.59
38
Prof. Man-lui Lau
Note:
1.
If f ( F K )e rT , the following profit opportunity arises.
i)
Take a long position in a forward contract with delivery price F .
ii)
Take a short position in a forward contract with delivery price K .
@ t , the value of the first contract is $0 and the value of the second contract is quoted at f . With a
short position in the second contract, the investor collects $ f
@T , the investor's net cash flow K F the PV of the cash flow ( K F )e rT

(@ today's dollar) f ( K F )e rT f ( F K )e rT 0 .
2.
If f ( F K )e rT , the following profit opportunity arises.

i)
Take a short position in a forward contract with delivery price F .
ii)
Take a long position in a forward contract with delivery price K .
@ t , the value of the first contract is $0 and the value of the second contract is quoted at f . With a
long position in the second contract, the investor pays $ f .
@T , the investor's net cash flow F K the PV of the cash flow ( F K )e rT

(today's dollar) f ( F K )e rT 0 .
Forward Prices versus Futures Prices

1.
When the risk-free interest rate is constant and the same for all maturities, the forward price for
a contract with a certain delivery date is the same as the futures price for a contract with that
delivery date.
2.
When interest rates vary unpredictably, forward and futures prices are in theory no longer the
same. As the life of a futures contract increases, the differences between forward and futures
contracts become more significant.
39
Prof. Man-lui Lau
Forward and Futures Contracts on Currencies
S : the current price in dollars of 1 unit of the foreign currency

K : the delivery price agreed to in the forward contract
rf : the foreign risk-free interest rate with continuous compounding
Note: A foreign country has the property that the holder of the currency can earn interest at the riskfree interest rate prevailing in the foreign country.
(For example, the holder can invest the currency in a foreign currency denominated bond.)
f Se
Value of forward contract:

Note that @ t 0 , f Se
rf T
rf T
KerT
KerT Se
rf T
FerT 0 F Se
( r rf )T
Note:
1.
The "formula" is very similar to the formula for a security with a constant yield.
2.
r rf r rf 0 e
( r r f )T
1 F S
3.
r rf r rf 0 e
( r r f )T
1 F S
Example
Suppose that the 6-month interest rates in the US and Japan are 5% and 1% per annum, respectively.
The current exchange rate is 100/USD. For a 6-month forward contract, we have S 0.01, r 5% ,
and rf 1% .
F Se
( r r f )T
0.01e
(5% 1%)
6
12
0.010202
40
Prof. Man-lui Lau
Example (arbitrage opportuity)

Let the 2 year interest rates in Australia and United States are 5% and 7% respectively.
Let S $0.62/ AUD and F $0.66/ AUD .
Since 0.66 F Se(7%5%)(2) 0.6453 , there is an arbitrage opportunity.
i)
Borrow $1000 at 7% per annum for 2 years, convert to AUD
1000
AUD 1612.90 and invest
0.62
the AUD at 5% per annum.

ii)
Enter in a forward contract to sell AUD 1612.90 e(5%)(2) AUD 1782.53 for
1782.53 $0.66 $1176.47
2 years later
The investor will sell AUD 1782.53 and get $1176.47 (according to the forward contract). The $ will
be used to cover the initial loan of $1000 e(7%)(2) $1150.27
$1176.47 $1150.27 $26.20

Example (arbitrage opportunity)
Let the 2 year interest rates in Australia and United States are 5% and 7% respectively.
Let S $0.62/ AUD and F $0.63/ AUD .
Since Se(7%5%)(2) 0.6453 0.63 F , there is an arbitrage opportunity.
i)
Borrow AUD 1000 at 5% per annum for 2 years, convert to 1000 $0.62 $620 and invest the
USD at 7% per annum.
ii)
Enter in a forward contract to buy AUD 1000 e(5%)(2) 1105.17 for

1105.17 $0.63 $696.26
2 years later
The amount of USD on hand 620 e(7%)(2) $713.17
AUD 1105.17 will be purchased ($696.26 will be paid, according to the forward contract) and the AUD
will be used to cover the initial short AUD position.
$713.17 $696.26 $16.91
41
Prof. Man-lui Lau
Futures on Commodities
Investment Commodities (Gold and Silver)
3 cases:
i)
storage cost 0 (analogous to securities paying no income)
F Se rT
ii)
storage cost 0
storage cost can be treated as negative income

Let U be the PV of all the storage costs that will be incurred during the life of the futures contract.
F ( S U )erT
iii)
storage cost 0 and is proportional to the price of the commodity.
In this case, the storage cost can be treated as negative dividend yield.
Let u be the storage cost per annum as a percentage of the spot price.
F Se( r u )T
Example
Consider a one-year futures contract on gold. Suppose that it costs $2 per ounce per year to store gold,
with the payment being made at the end of the year. Assume that the spot price is $450 and the riskfree interest rate is 7% per annum for all maturities.
We have S 450, r 7%, T 1
U 2e (7%)(1) 1.865
F ( S U )erT (450 1.865)e(7%)(1) $484.63

If F 484.63 , an arbitrageur can make money by buying gold and shorting 1-year gold futures
contracts.
If F 484.63 , an arbitrageur can make money by selling gold and buying 1-year gold futures
contracts.
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Prof. Man-lui Lau
Consumption Commodities
In the case of consumption commodities, because it is difficult to sell short the commodities even if
there is profit opportunity, hence the formulas become:
F Se rT
F ( S U )erT
F Se( r u )T
Convenience yields
The benefits (including the ability to benefit from temporary local shortages or the ability to keep a
production process running) to the owners of the commodities are called convenience yield.
Fe yT Se rT
Fe yT ( S U )erT
Fe yT Se( r u )T
The convenience yield reflects the markets expectations concerning the future availability of the
commodity. The greater the possibility that shortages will occur during the life of the futures contract,
the higher the convenience yield. If users of the commodity have high inventories, there is very little
chance of shortages in the near future and the convenience yields tends to be low. On the other hand,
low inventories tend to lead to high convenience yields.
43
Prof. Man-lui Lau
The Cost of Carry

The relationship between futures prices and spot prices can be summarized in terms of the cost of
carry.
cost of carry storage cost interst that is paid to finance the asset income earned on the asset
non-dividend stock:
cost of carry r
stock index:
cost of carry r q
currency:
cost of carry r rf
commodity with storage cost:
cost of carry r u
Define c cost of carry

For an investment asset, the futures price is F Se cT
For a consumption asset, the futures price is F Se( c y )T where y is the convenience yield.
44
Prof. Man-lui Lau
Contango is a term used in the futures market to describe an upward sloping forward curve (Such a
forward curve is said to be "in contango" (or sometimes "contangoed").
Formally, it is the situation where, and the amount by which, the price of a commodity for future
delivery is higher than the spot price, or a far future delivery price higher than a nearer future
delivery. The opposite market condition to contango is known as backwardation.
A contango is normal for a non-perishable commodity which has a cost of carry. Such costs
include warehousing fees and interest forgone on money tied up, less income from leasing out the
commodity if possible.
The contango should not exceed the cost of carry, because producers and consumers can compare
the futures contract price against the spot price plus storage, and choose the better one. Arbitrageurs
can sell one and buy the other for a theoretically risk-free profit (see rational pricing futures).
If there is a near-term shortage, the price comparison breaks down and contango may be reduced or
perhaps even reverse altogether into a state called backwardation.
If there is lack of shorage space, then the warehouse cost will increase, hence the cost of carry will
go up and contango becomes more visible.
For agriultural products, the forward curve may not be upward sloping even there is cost of carry. It
may reflect the supply and demand condition of the crop in different part of the year.
corn
1/18/2013
Month
Settlement
Mar 13
7274
May 13
7292
July 13
7214
Sep 13
6134
Dec 13
5904
Mar 14
6004
May 14
6074
July 14
6090
July 14
5856
Contract size:
Deliverable grade:
5000 bushels
#2 Yellow at contract Price,
#1 Yellow at a 1.5 cent/bushel premium
#3 Yellow at a 1.5 cent/bushel discount
45
Prof. Man-lui Lau
III.
Options
A CALL OPTION gives the holder the right to buy the underlying asset by a certain date (expiration
date) for a certain price (strike price).
A PUT OPTION gives the holder the right to sell the underlying asset by a certain date (expiration
date) for a certain price (strike price).
An AMERICAN OPTION can be exercised at any time up to the expiration date.
An EUROPEAN OPTION can only be exercised on the expiration date only.
Note:
1.
Most of the options that are traded on exchanges are American options.
2.
European options are generally easier to analyze than American options.
3.
Unlike futures/forwards, the holder is not obligated to buy or sell the underlying asset.
4.
Whereas it costs nothing to enter into a forward or futures contract (except commissions), an
investor must pay to purchase an option contract.
Different Types of Options

1.
Exchange-traded options:
i)
stock options:
American
ii)
currency options:
American and European
iii)
index options:
S&P 500 is European (cash settlements)

S&P100 is American (cash settlements)
iv)
2.
futures options
Over-the-counter options:
traded directly between financial institutions and corporations.
Because of the non-standard features, they are also called Exotic Options.
46
Prof. Man-lui Lau
Trading Options
1.
A trader purchased 5 IBM July11 170 Call @$1.75 on Jan 21, 2011. He closed his position 1
week later @$2.50.
($2.5 $1.75)(100)(5) $375
100 shares per option
2.
# of options
A trader sold 5 IBM July11 170 Call @$1.75 on Jan 21, 2011. He closed his position 1 week
later @$2.50.
($1.75 $2.5)(100)(10) $750
3.
A trader purchased 20 IBM Jan12 145 Put @$8.70 on Jan 21, 2011. He closed his position 1
week later @$9.00.
($9.0 $8.7)(100)(20) $600
4.
A trader sold 50 IBM Jan12 145 Put @$8.70 on Jan 21, 2011. He closed his position 1 week
@$8.00.
($8.7 $8.0)(100)(50) $3500
Note:
i)
Options are traded like stocks.
ii)
Whether a trader makes money or not only depends on the market price of the options, it has
nothing to do with the strike price etc.
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Prof. Man-lui Lau
X : strike price
ST : final price of the underlying asset
p : preium paid (buyer) or preium received (seller)
Long call position (European)
X $40, p $5
Example:
ST
$30
$35
$40
$45
$50
$55
$60
Payoff max( ST X , 0)
Payoff
$0
$0
$0
$5
$10
$15
$20
max( ST X , 0) p
-$5
-$5
-$5
$0
$5
$10
$15
payoff
Expect increase in stock price

Unlimted gain, limited risk
X
0
Xp
ST
Short call position (European)

Example:
X $40, p $5
ST
$30
$35
$40
$45
$50
$55
$60
Payoff
$0
$0
$0
-$5
-$10
-$15
-$20
$5
$5
$5
$0
-$5
-$10
-$15
Payoff max( ST X , 0) min( X ST , 0)
[max( ST X , 0) p] min( X ST , 0) p
Expect no increase in stock price
Limited gain, unlimited risk
Xp
ST
payoff
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Prof. Man-lui Lau
Long put position

X $40, p $5
Example:
ST
$30
$35
$40
$45
$50
$55
$60
Payoff
$10
$5
$0
$0
$0
$0
$0
$5
$0
-$5
-$5
-$5
-$5
-$5
Payoff max( X ST , 0)
max( X ST , 0) p
Xp
Expect decrease in stock price

Unlimited gain, limited loss
Xp
payoff
ST
Short put position

X $40, p $5
Example:
ST
$30
$35
$40
$45
$50
$55
$60
Payoff
-$10
-$5
$0
$0
$0
$0
$0
-$5
$0
$5
$5
$5
$5
$5
Payoff max( X ST , 0) min( ST X , 0)
[max( X ST , 0) p] min(ST X , 0) p
p
Xp
payoff
ST
X p
X
Note:
Expect no decrease in stock price

Limited gain, unlimited loss
X : strike price
CALL OPTIONS
PUT OPTIONS
SX
in the money
SX
SX
at the money
SX
SX
out of money
SX
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Prof. Man-lui Lau
Adjustment due to dividends

Over-the-counter options are usually dividend protected. If a company declares a dividend, the strike
price for options on the companys stock is reduced on the ex-dividend day by the amount of the
dividend.
Exchange-traded options are not usually adjusted for cash-dividends. In other words, when a cash
dividend occurs, there are no adjustments to the terms of option contract.
[Exception is sometimes made for large cash dividends. On May 28, 2003, Gucci Group declared a
cash dividend of 13.50 euros ($15.88) per common share. In this case, the Options Clearing
Corporation (OCC) at the Chicago Board Options Exchange decided to adjust the terms of options. As
a result, exercise of an option contract required the delivery of 100 shares plus 100 15.88 $1588 of
cash.
The holder of a call contract paid 100 times the strike price on exercise and received $1588 of cash in
addition to 100 shares.
The holder of a put contract received 100 times the strike price on exercise and delivered $1588 of
cash in addition to 100 shares.
These adjustments had the effect of reducing the strike price by $15.88.]
Adjustment due to stock split

Exchange-traded options are adjusted for stock splits. Because a stock split does not affect the wealth
of the company, a n-for-m stock split would cause the stock price to go down to m n of its previous
value. (For example, a 3-for-2 split would cause the stock price to go down to 2 3 of its previous
value.) The terms of option contracts are adjusted to reflect expected changes in a stock price arising
from a stock split. After the n-for-m stock split, the strike price is reduced to m n of its previous
value, and the number of shares covered by 1 contract is increased to n m of its previous value. If the
stock price declines in the way expected, the positions of both the writer and the purchaser of a
contract remain unchanged.
Example:
Consider a call option to buy 100 shares of ABC for $30 per share. Suppose that the company makes
for a 2-for-1 stock split. The terms of the option contract are then changed so that it gives the holder
the right to purchase 200 shares for $15 per share.
Adjustment due to stock dividends
A stock dividend involves a company issuing more shares to its existing shareholders. For example, a
20% stock dividend means that investors receive 1 new share for each 5 already owned. This is
effectively a 6-5 split and it should cause the stock price to decline to 5 6 of its previous value.
50
Prof. Man-lui Lau
IV
Trading Strategies Involving Options
Strategies involving a single option and a stock

Long position in stock short position in call (covered write)
long stock
short
put
combined position
ST
ST
S
X
p S c Xe rT
S c p Xe rT
short call
Short position in stock long position in call
long call
ST
ST
long put
SX
combined position
p S c Xe rT
p c S Xe rT
short stock
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Prof. Man-lui Lau
Long position in stock long position in put
long stock
long call
combined position
ST
S
ST
p S c Xe rT
long put
Short position in stock short position in put
short put
ST
ST
S
short call
X
p S c Xe rT
combined position
p S c Xe rT
short stock
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Prof. Man-lui Lau
Spreads
A spread strategy involves taking a position in 2 or more options of the same type.
Bull Spreads (calls)
i)
buy a call with strike price X1 (higher premium)
ii)
sell a call with a higher strike price X 2 X1 (lower premium)
Payoff from a bull spread
Stock price
range
ST X 2
Payoff from long

call position
ST X1
Payoff from short

call position
X 2 ST
Total payoff
Total
X 2 X1
X 2 X 1 (c2 c1 )e rT
X 2 ST X1
ST X1
ST X1
ST X1 (c2 c1 )erT
X1 ST
(c2 c1 )e rT 0
(initial investment)
long call
combined position
X1
X2
short call
Example
Stock price
range
ST 35
35 ST 30
30 ST
c1 $3 (X1 $30),
Payoff from long
call position
ST 30
ST 30
0
time value is ignored
c2 $1 (X 2 $35)
Payoff from short
call position
35 ST
0
0
53
Total payoff
Total
35 30 5
35 30 3 1 $3
ST 30
0
ST 30 3 1 ST 32
3 1 2
Prof. Man-lui Lau
Bull Spreads (puts)

i)
buy a put with strike price X1 (lower premium)
ii)
sell a put with a higher strike price X 2 X1 (higher premium)
Payoff from a bull spread
Stock price
range
ST X 2
Payoff from long

put position
0
Payoff from short

put position
0
Total payoff
Total
( p1 p2 )e rT 0
X 2 ST X1
ST X 2 0
ST X 2 0
ST X 2 ( p1 p2 )erT
X1 ST
X1 ST 0
ST X 2 0
X1 X 2 0
X 1 X 2 ( p1 p2 )e rT
short put
combined position
X1
X2
long put
Note:
An investor who adopts a bull spread strategy is hoping that stock price will go up.
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Prof. Man-lui Lau
Bear Spread (calls)

i)
sell a call with strike price X1 (higher premium)
ii)
buy a call with a higher strike price X 2 X1 (lower premium)
Stock price
Payoff from long Payoff from short
Total payoff
range
call position
call position
ST X 2
ST X 2
X1 ST
X1 X 2 0
Total
X1 X 2 (c1 c2 )erT
X 2 ST X1
X1 ST
X1 ST 0
X1 ST (c1 c2 )erT
X1 ST
(c1 c2 )e rt 0
long call
X1
X2
combined position
short call
Bear Spread (puts)

i)
sell a put with strike price X1 (lower premium)
ii)
buy a put with a higher strike price X 2 X1 (higher premium)
Stock price
Payoff from long Payoff from short Total payoff
range
put position
put position
0
0
0
ST X 2
Total
( p1 p2 )e rT 0
X 2 ST X1
X 2 ST
X 2 ST 0
X 2 ST ( p1 p2 )e rT
X1 ST
X 2 ST
ST X1
X 2 X1 0
X 2 X1 ( p1 p2 )erT
short put
X1
X2
combined position
long put
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Prof. Man-lui Lau
Butterfly Spreads (calls)

i)
buy a call with strike price X1
ii)
buy a call with a higher strike price X 3 X 1
sell 2 calls with a strike price X 2
iii)
X1 X 3
2
(i)
(ii)
ST
X1
X3
X2
combined position
(iii)
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Prof. Man-lui Lau
Butterfly Spreads (puts)

i)
buy a put with strike price X1
ii)
buy a put with a higher strike price X 3 X 1
sell 2 puts with a strike price X 2
iii)
X1 X 3
2
(iii)
(i)
ST
combined position
X1
X3
X2
(ii)
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Prof. Man-lui Lau
Combinations
Bottom Straddle
i)
buy a call with strike price X
ii)
buy a put with strike price X
long call
combined position
ST
long put
Top Straddle
i)
sell a call with strike price X
ii)
sell a put with strike price X
short put
ST
combined position
short call
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Prof. Man-lui Lau
Bottom Strangle
i)
buy a call with strike price X 2
ii)
buy a put with strike price X1
long call
combined position
X1
X2
ST
long put
Top Strangle
i)
sell a call with strike price X 2
ii)
sell a put with strike price X1
short put
ST
X1
X2
combined position
short call
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Prof. Man-lui Lau
Margin requirements
Long CALL and PUT positions
For options with maturities less than 9 months, investors must pay the full amount of the premium.
For options with maturities more than 9 months, investors can borrow up to 25% of the option value.
Writing naked call options
Higher of the followings:
premium received 20% of the value of the underlying stock
i)
the amount by which the option is out of money
ii)
Writing naked put options
Higher of the followings:
i)
the amount by which the option is out of money
premium received 10% of the exercise price
ii)
A calculation similar to the

initial margin requirement is
repeated every day.
Example
Write 4 naked calls X $40, S $38, p $5
($5)(100)(4) (20%)($38)(100)(4) ($2)(100)(4) $4240 (out of money)
i)
ii)
($5)(100)(4) (10%)($38)(100)(4) $3520
Write 4 naked puts X $40, S $38, p $5

($5)(100)(4) (20%)($38)(100)(4) $5040 (in the money)
i)
ii)
($5)(100)(4) (10%)($40)(100)(4) $3600
Suppose S $60
Call:
($5)(100)(4) (20%)($60)(100)(4) ($0)(100)(4) $6800 (in the money)
i)
ii)
($5)(100)(4) (10%)($60)(100)(4) $4400
Put:
i)
ii)
($5)(100)(4) (20%)($60)(100)(4) ($60 $40)(100)(4) $1200 (out of money)

($5)(100)(4) (10%)($40)(100)(4) $3600
Writing covered call

If X S , no additional marginal requirement.
If X S , the maximum amount the investor can borrow on the stock is based on the call's exercise
price rather than on the stock price.
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Prof. Man-lui Lau
Warrants, Executive Stock Options and Convertibles

Usually, when a call option on a stock is exercised, the party with the short position acquires shares
that have already been issued and sells them to the party with the long position for the strike price.
The company whose stock underlies the option is not involved in any way.
Warrants and executive stock options are call options that are written by a company on its own
stock. When they are exercised, the company issues more of its own stock and sells them to the
warrants/options holder for the strike price. The exercise of a warrant or executive stock option leads
to an increase in the number of shares of the company's stock that are outstanding.
A convertible bond is a bond issued by a company that can be converted into equity at certain times
using a predetermined exchange ratio. It is a bind with an embedded call option on the company's
stock.
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Prof. Man-lui Lau
V.
Properties of stock option prices
Factors affecting option prices

Variable
European Call
Stock Price
Strike Price
Time to Expiration
Volatility
Risk-free interest rate
Dividends
S
X
T
European Put
American Call
American Put
Stock price and strike price

Calls: Payoff max(ST X ,0)
S ST likely call value

Puts:
X call value
Payoff max( X ST ,0)
S ST likely put value
X put value
Time to expiration
American Calls and Puts:
The owner of a long-life option has all the exercise opportunities open to the owner of a short-life
option. The long-life option must, therefore, always be worth at least as much as the short-life option.
European Calls and Puts:
These options do not necessarily become more valuable as (T t ) . This is because the owner of a
long-life European option does not have all the exercise opportunities open to the owner of a short-life
European option. The owner of the long-life European option can exercise only at the maturity of that
option. Hence it is possible that the value of a longer-life European option is lower.
Volatility
The volatility of a stock price, , is defined so that t is the standard deviation of the return to
stock in a short length of time, t . As , it is more likely the options will be in the money at
maturity, hence the value of the options .
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Prof. Man-lui Lau
Risk-free interest rate

Calls: Suppose an investor believes that the price of a stock will go up in the future, instead of owning
the stock, an investor can buy a call option. In doing so, the investor can save a lot of money
(interest). Hence as r , the value of a call .
Puts: Suppose an investor believes that the price of a stock will go down in the future, instead of
selling the stock, an investor can buy a put option. However, in doing so, the investor will lose
a lot of interest. Hence as r , the value of a put .
Dividends
Dividends have the effect of reducing the stock price on the ex-dividend date. This is bad news for the
value of call options and good news for the value of put options.
The value of a call option is negatively related to the size of any anticipated dividend.
The value of a put option is positively related to the size of any anticipated dividend.
Assumptions
1.
2.
3.
There are no transaction costs.

All trading profits (net of trading losses) are subject to the same tax rate.
Borrowing and lending at he risk-free interest rate is possible.
Notation:
S : current stock price
X : strike price of option
T : time of expiration of option

t : current time
ST : stock price at time T
r : risk-free interst rate for an investment maturing @T
C : value of American call option (to buy 1 share)
P : value of American put option (to buy 1 share)
c : value of European call option (to buy 1 share)
p : value of European put option (to buy 1 share)
: volatility of stock price
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Prof. Man-lui Lau
Upper and lower bound for option prices

Upper bound
Calls: No matter what happens, the option can never be worth more than the stock.
c S and C S
No matter how low the ST becomes, the option can never be more than X .
European puts:
p X p Xe rT
American puts:
P X
Lower bound for European Calls on a non-dividend-paying stock

Claim: lower bound max( S Xe rT ,0)
Proof:
Portfolio A:
Portfolio B:
1 European Call option $ Xe rT

1 share
@T
Portfolio A:
Cash becomes [$ Xe rT ]erT $ X

If ST X , the call option is exercised. The investor will own 1 share of the stock and it
is worth $ST .
If ST X , the call option is not exercised. The portfolio is worth $X .
Value(A) max($ST ,$ X ) .
Portfolio B:
Value(B) $ST .
Value(A) Value(B) @T
Value(A) Value(B) @ t (so that there is no arbitrage opportunity)
c Xe rT S c S Xe rT
Since the worst possible case for a call option holder is that the option expires worthless
c max( S Xe rT , 0)
Example
Consider an European call option on a non-dividend-paying stock.
Let S $51, X $50, T 0.5, r 12%
Then the lower bound S Xe rT 51 50e (12%)(0.5) $3.91
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Prof. Man-lui Lau
Example
S $20, X $18, r 10%, T 1 lower bound S Xe rT 20 18e (10%)(1) $3.71
Now suppose the call option is quoted at $3.00 in the market.
Then an investor has the following profit opportunity:
i)
buy the call (the call is cheap)
ii)
short the stock (if we do not short the stock, imagine what will happen if the stock price goes
down, then we will lose money on the long call position)
Cash flow now:
Cash flow 1 year later:
$20 $3 $17
$17e(10%)(1) $18.79
At the end of 1 year,

if ST X ( $18) , then the investor will
i)
ii)
exercise the call option for $18, and

close out the short position in stock
$18.79 $18 $0.79
i)
let the option expire,
ii)
iii)
buy a share in the market ST , and

close the short position in stock
$18.79 ST $0.79
No matter what ST is, the investor will always make money!!

Suppose the market price of the call option is larger than $3.71
Suppose the investor adopts the same strategy:
i)
buy the call option @ M $3.71
ii)
short the stock @$20.s
Cash flow now:
Cash flow 1 year later:
$20 $3.71 $16.29

$16.29e(10%)(1) $18
At the end of 1 year,

i)
ii)
exercise the call option for $18, and

close out the short position in stock
$18 $18 $0 (i.e. loss)
i)
let the option expire,
ii)
iii)
buy a share in the market @ ST , and

close the short position in stock
0 $18 ST (i.e. gain)

If the call option is quoted at a price larger than $3.71, then the investor will NOT make money all
the time.
65
Prof. Man-lui Lau
Lower bound for European Puts on a non-dividend-paying stock

Claim: lower bound max( Xe rT S ,0)
Proof:
Portfolio C: 1 European Put option 1 share
Portfolio D: $ Xe rT
@T
Portfolio D:
The investor will have ($ Xe rT )erT $ X
Portfolio C:
If ST X , the put option will not be exercised and the stock is worth $ST .
If ST X , the put option will be exercised and the portfolio is worth $X .
Value(C) max($ X ,$ST )

Value(C) Value(D) @ T
Value(C) Value(D) @t (so that there is no arbitrage opportunity)
p S Xe rT p Xe rT S
Since the worst possible case for a put option holder is that the option expires worthless
p max( Xe rT S ,0)
Example
Consider an European put option on a non-dividend-paying stock.
Let S $38, X $40, T 0.25, r 10%
Then the lower bound Xe rT S 40e (10%)(0.25) 38 $1.01
Example
S $37, X $40, r 5%, T 0.5 lower bound Xe rT S 40e (5%)(0.5) 37 $2.01
Now suppose the put option is quoted @ $1.00 .
The investor has the following profit opportunity:
i)
borrow $1 to buy the put,
ii)
borrow $37 to buy the stock (if we do not long the stock, imagine what will happen if the stock
price goes up, then we will lose money on the long put position)
At the end of 6 months, the investor has to pay back $38e(5%)(0.5) $38.96
If ST X ($40) , then the put option will not be exercised. The investor can sell the stock and
ST $38.96 0
If ST X ($40) , then the investor will exercise the put option and sell the stock @$40 .
$40 $38.96 $1.04 0
66
Prof. Man-lui Lau
Put-Call Parity (Relationship between the prices of Put options and Call options)
European Options (of the same strike price X )
Portfolio A: 1 European Call option $ Xe rT
Portfolio C: 1 European Put option 1 share
@T
Portfolio A:
Cash becomes ($ Xe rT )erT $ X

If ST X , the call option is exercised. The investor will own 1 share of the stock and it
is worth $ST .
If ST X , the call option is not exercised. The portfolio is worth $X .
Value(A) max($ST ,$ X ) .
Portfolio C:
If ST X , the put option is not exercised. The investor will own 1 share of the stock
and it is worth $ST .
If ST X , the put option is exercised. The investor will sell the share for $X .
Value(C) max($ST ,$ X )
Value(A) Value(C) @T Value(A) Value(C) @ t (so that there is no arbitrage opportunity)

c Xe rT p S Put-Call Parity
Example
S $31, X $30, r 10%, T 0.25, c $3, p $2.25
Value(A) c Xe rT 3 30e (10%)(0.25) $32.26

Value(C) p S 2.25 31 $33.25
Value(C) Value(A) i.e. Portfolio C is overpriced relative to Portfolio A
An investor has the following arbitrage opportunity:
i)
buy the securities (i.e. the call) in Portfolio A
ii)
short the securities (i.e. the put and the stock) in Portfolio C
Cash flow now:
p S c $2.25 $31 $3 $30.25
Cash flow in 3 months:
cash flow $30.25e(10%)(0.25) $31.02
3 months later
If ST $30 X , then the call will be exercised and the put will expire worthless.
The stock from the call position will be used to close the short stock position.
Cash $31.02 $30 $1.02
If ST $30 X , then the call will expire worthless and the put will be assigned.
The assigned stock will be used to close the short position in stock.
Cash $31.02 $30 $1.02
67
Prof. Man-lui Lau
Example
S $31, X $30, r 10%, T 0.25, c $3, p $1
Value(A) c Xe rT 3 30e (10%)(0.25) $32.26
Value(C) p S 1 31 $32
Value(A) Value(C)
i.e. Portfolio A is overpriced relative to Portfolio A
An investor has the following arbitrage opportunity:

i)
short the securities (i.e. the call) in Portfolio A
ii)
buy the securities (i.e. the put and the stock) in Portfolio C
Cash flow now:
c p S $3 $1 $31 $29 (i.e. borrow $29)
Cash flow in 3 months:
cash flow $29e(10%)(0.25) $29.73
3 months later
If ST $30 X , then the call will be assigned and the put will expire worthless.
The stock owned will be taken away (the call is assigned) and the cash received will be used to
pay back the loan.
Cash $30 $29.73 $0.27
If ST $30 X , then the call will expire worthless and the put will be exercised.
The stock will be sold (the put is exercised) for $30.
Cash $30 $29.73 $0.27
68
Prof. Man-lui Lau
Early Exercise: Calls on a Non-dividend-paying stock

Claim: It is never optimal to exercise an American Call option on a non-dividend-paying stock early
Let S $50 and X $40 so that the option is deep-in-the-money.
Example:
If the investor wants to own the stock, it will be beneficial for him/her to exercise the call later to save
interest.
If the investor believes that the stock price will go down, he/she should sell the option now as the price
obtained for the option will be greater than its intrinsic value of $10.
Proof:
Portfolio E:
Portfolio F:
1 American call option $ Xe rT

1 share
Portfolio E:
if the call option is exercised @ , value(E) S X Xe rT S (e rT 1)
Value(E) Value(F) if the call option is erercised before expiration
If the call option is held to expiration, its value max(ST , X ) . Since it is possible that ST X , the
investor should never exercise the option pre-maturely.
call option price
Intrinsic value max( S X , 0)
69
Prof. Man-lui Lau
Early Exercise: Puts in a Non-dividend-paying Stock

Claim: It can be optimal to exercise an American Put option on a non-dividend-paying stock early
Proof:
Portfolio G:
1 American put option 1 share
Portfolio H:
$ Xe rT
If the option is exercised at time T , X value(G) value(H) Xe rT

@T
max( X , ST ) value(G) value(H) X

American put option price
intrinsic value
European put option price
X
the put option is worth less
than the intrinsic value
70
Prof. Man-lui Lau
Relationship between American Puts and Call Prices

S Xe r (T t ) C P S X
Effect of Dividends
D : the present value of the dividends during the life of the option
Lower Bound
No dividends
c max( S Xe rT ,0)
With dividends
c max( S D Xe rT , 0)
p max( Xe rT S ,0)
p max( D Xe rT S , 0)
Put-Call Parity
c Xe
rT
c D Xe rT p S
pS
S Xe rT C P S X
S Xe rT C P S D X
Early exercise
It may be optimal to exercise an American Call option immediately prior to an ex-dividend date. This
is because the dividend will induce the stock price to jump down, making the option less attractive.
It is NEVER optimal to exercise a Call at other times!!
Synthetic positions
Creating equity out of cash (synthetic equity position)
long stock short futures cash earning risk-free interest rate
cash earning risk-free interest rate long futures long stock
This strategy will maintain high level of liquidity for the investor.
Creating cash out of equity (synthetic cash position)

long stock short futures cash earning risk-free interest rate
71
Prof. Man-lui Lau
Binomial Trees
One-step Binomial Model
Example:
3-month European call X $21

S $22
Option value $1
S $20
S $18
Option value $0
Portfolio:
long shares of the stock short 1 call option
@ expiration
S $22 :
S $18 :
value of portfolio 22 1
value of portfolio 18
In order to construct a risk-free portfolio, we need the value of the portfolio remains the same in all
circumstances, i.e. 22 1 18
4 1 0.25
If 0.25 , the value of portfolio at expiration 22(0.25) 1 18(0.25) $4.5
Current value of portfolio 20(0.25) f 5 f
value of the call option
A riskless portfolio, in the absence of arbitrage opportunity, earns the risk-free interest rate.
Let r 12% .
(5 f )e(0.25)(12%) 4.5
5 f 4.5e (0.25)(12%)
f 5 4.5e (0.25)(12%) 5 4.367 $0.633
independent of the probability
72
Prof. Man-lui Lau
Example:

S $22
Option value $2
S $20
S $18
Option value $0
Portfolio:
@ expiration
S $22 :
S $18 :
value of portfolio 18
4 2 0.5
If 0.5 , the value of portfolio at expiration 22(0.5) 2 18(0.5) $9
Let r 12% .
(10 f )e(0.25)(12%) 9
10 f 9e (0.25)(12%)
f 10 9e (0.25)(12%) 10 8.734 $1.266
73
Prof. Man-lui Lau
Example:

S $22
Option value $6
S $20
S $18
Option value $2
Portfolio:
@ expiration
S $22 :
S $18 :
circumstances, i.e. 22 6 18 2
4 4 1
If 1 , the value of portfolio at expiration 22(1) 6 18(1) 2 $16
Current value of portfolio 20(1) f 20 f
Let r 12% .
(20 f )e(0.25)(12%) 16
20 f 16e (0.25)(12%)
f 20 16e (0.25)(12%) 20 15.53 $4.47
74
Prof. Man-lui Lau
Example:
3-month European put X $21

S $22
Option value $0
S $20
S $18
Option value $3
Portfolio:
long shares of the stock long 1 put option
@ expiration
S $22 :
S $18 :
4 3 0.75
If 0.75 , the value of portfolio at expiration 22(0.75) 18(0.75) 3 $16.5
value of the put option
Let r 12% .
(15 f )e(0.25)(12%) 16.5

15 f 16.5e (0.25)(12%)
f 16.5e (0.25)(12%) 15 16.012 15 $1.012
75
Prof. Man-lui Lau
Example:

S $22
Option value $0
S $20
S $18
Option value $2
Portfolio:
@ expiration
S $22 :
S $18 :
4 2 0.5
If 0.5 , the value of portfolio at expiration 22(0.5) 18(0.5) 2 $11
Let r 12% .
(10 f )e(0.25)(12%) 11
10 f 11e (0.25)(12%)
f 11e (0.25)(12%) 10 10.675 10 $0.675
76
Prof. Man-lui Lau
Example:

S $22
Option value $0
S $20
S $18
Option value $0
Portfolio:
@ expiration
S $22 :
S $18 :
circumstances, i.e. 22 18
4 0 0
If 0 , the value of portfolio at expiration 22(0) 18(0) $0
Current value of portfolio 20(0) f f
Let r 12% .
fe(0.25)(12%) 0
f $0
77
Prof. Man-lui Lau
Generalization
current
@ expiration
Stock price S u
(u 1)
Derivative value f u
Stock price S
Derivative price f
Stock price S d
( d 1)
Derivative value f d
Portfolio:
long shares of stock short position in 1 derivative
@ expiration:
stock price S u :
value of portfolio Su fu
stock price S d :
value of portfolio Sd f d
circumstances, i.e. Su fu Sd f d
( Su Sd ) fu f d
fu f d
Su Sd
Note that can be positive or negative.

A positive means that it is a long position.
A negative means that it is a short position.
fu f d
, the value of portfolio at expiration
Su Sd
f fd
Sufu Suf d Sufu Sdfu Sdfu Suf d
Su( u
) fu
Su Sd
Su Sd
Su Sd
fu f d
Sdfu Sdf d Suf d Sdf d Sdfu Suf d
or Sd (
) fd
Su Sd
Su Sd
Su Sd
Given
Current value of portfolio S f S (
fu f d
) f
Su Sd
value of the derivative
78
Prof. Man-lui Lau
Therefore (S f )erT Su fu
S f ( Su f u )e rT
f S ( Su f u )e rT
f e rT [ S e rT ( Su f u )]
f e rT [ S (e rT u ) f u ]
fu f d
) fu ]
Su Sd
rT
u )( f u f d )
rT (e
e [
fu ]
ud
e rT f u uf u e rT f d uf d uf u df u
e rT [
]
ud
rT
f u e rT f d uf d df u
rT e
e [
]
ud
e rT d
u e rT
e rT [
fu
fd ]
ud
ud
e rT [ pf u (1 p ) f d ]
f e rT [ S (e rT u )(
f
f
f
f
f
erT d u d erT d u erT

e rT d
where p
and 1 p 1
ud
ud
ud
ud
Example:

S $22
u 1.1
f u $1
d 0.9
S $20
r 12%
T 0.25
S $18
f d $0
erT d e(12%)(0.25) 0.9

p
0.6523
ud
1.1 0.9
f e rT [ pfu (1 p) f d ] e (12%)(0.25) [0.6523 $1 (1 0.6523) $0] $0.633
79
Prof. Man-lui Lau
Risk-Neutral Valuation
e rT d
In f e [ pfu (1 p) f d ] where p
, p can be interpreted as the probability of an up
ud
movement in the stock price.
rT
pfu (1 p) f d can be interpreted as the expected payoff.
f erT [ pfu (1 p) f d ] is the discounted value of the expected payoff

Implication:
Expected stock price @T :
E(ST ) pSu (1 p)Sd

pSu Sd pSd pS (u d ) Sd
erT d
(
) S (u d ) Sd erT S
ud
i.e.
The stock price grows on average at the risk-free rate.
This is consistent with a risk-neutral world where investors do not require compensation for risk.
This is called risk-neutral valuation in option pricing.
Example
In a risk-free world, the expected return on the stock must be
22 p 18(1 p) 20e(12%)(0.25)
4 p 20e3% 18
p 0.6523
At the end of 3 months, the call option has a Probability 0.6523 of being worth $1 and a
Probability 0.3477 of being worth $0.
Expected value 0.6523 $1 0.3477 $0 $0.6523
Discounted option value 0.6523e (12%)(0.25) $0.633
80
Prof. Man-lui Lau
Two-step Binomial Trees

Example:
3 months
3 months
|
D
S $24.20
f $3.20
B
S $22
f $2.0257
E
S $19.80
f $0
A
S $20
C
S $18
f $0
F
S $16.20
f $0
r 12%, T 0.25, u 1.1, d 0.9
@D
@E
@F
f $24.20 $21 $3.20

f $0
f $0
erT d e(12%)(0.25) 0.9
0.6523
ud
1.1 0.9
@B
f erT [ pfu (1 p) f d ] e(12%)(0.25) [0.6523 $3.20 (1 0.6523) $0] $2.0257

@C
f erT [ pfu (1 p) fd ] e(12%)(0.25) [0.6523 $0 (1 0.6523) $0] $0

@A
f erT [ pfu (1 p) f d ] e(12%)(0.25) [0.6523 $2.0257 (1 0.6523) $0] $1.2823
81
Prof. Man-lui Lau
European Put Options

2-Year European Put X $52
Example:
1 Year
1 Year
|
D
S $72
f uu $0
B
S $60
f u $1.4147
E
S $48
f ud $4
A
S $50
f $4.1923
C
S $40
f d $9.4636
F
S $32
f dd $20
r 5%, T 1, u 1.2, d 0.8
erT d e(5%)(1) 0.8

p
0.6282
ud
1.2 0.8
@B
fu erT [ pfuu (1 p) fud ] e(5%)(1) [0.6282 $0 (1 0.6282) $4] $1.4147

@C
fd erT [ pfud (1 p) fdd ] e(5%)(1) [0.6282 $4 (1 0.6282) $20] $9.4636

@A
f erT [ pfu (1 p) fd ] e(5%)(1) [0.6282 $1.4147 (1 0.6282) $9.4636] $4.1923

or
f e2rt [ p2 fuu 2 p(1 p) fud (1 p)2 f dd ]
e2(5%)(1) [0.62822 0 2 0.6282 (1 0.6282) 4 (1 0.6282)2 20] $4.1923
82
Prof. Man-lui Lau
American Put Options

Note: A holder of American Put Options can exercise the options early.
Hence at each node, the value of the option max{erT [ pfu (1 p) fd ], X S}
2-Year American Put X $52

1 Year
|
|
Example:
payoff from early exercise

1 Year
|
D
S $72
f uu $0
B
S $60
f u $1.4147
E
S $48
f ud $4
A
S $50
f $5.0894
C
S $40
f d $12
F
S $32
f dd $20
The Intrinsic Value of the American Put Option is $52 $40 $12 , hence the holder of the Option
will exercise it early @C.
@A
f erT [ pfu (1 p) f d ] e(5%)(1) [0.6282 $1.4147 (1 0.6282) $12] $5.0894
Note that the American Option is worth more than the European Option as there is an
opportunity for early exercise.
83
Prof. Man-lui Lau
Matching Volatility with u and d

In practice, when constructing a binomial tree to represent the movements in a stock, we choose the
parameters u and d to match the volatility of the stock price.
:
:
expected return on a stock

volatility
t : the standard deviation of the stock price in a short time peiord of t

|
|
|
|
t
t
S0 u
1 p
S0 d
S0 u
S0
S0
1 q
S0 d
In the time period t , the stock price either moves up by a proportional amount u or moves down by a
proportional amount d .
q : the probability of an up movement (in the real world)
expected stock price at the end of t S0 et qS0u (1 q)S0 d
qS0 u (1 q) S0 d S0 e
(**)
q(u d ) d e t
e t d
q
ud
Note: i)
ii)
iii)
Var ( X ) E[ X E ( X )]2 E[ X 2 2 XE ( X ) ( E ( X )) 2 ] E ( X 2 ) [ E ( X )]2

E ( X 2 ) qu 2 (1 q)d 2
E ( X ) qu (1 q)d
variance of the return 2 t qu 2 (1 q)d 2 [qu (1 q)d ]2

(**) e t qu (1 q)d
e2 t [qu (1 q)d ]2
Also et (u d ) [qu (1 q)d ](u d ) qu 2 (1 q)ud qud (1 q)d 2 qu 2 ud (1 q )d 2
et (u d ) ud qu 2 (1 q)d 2
(10.10) : 2 t e t (u d ) ud e2 t
84
Prof. Man-lui Lau
Cox, Ross and Rubinstein suggest the following solution:

u e t
d e
1
u
Example
Let 15%, t 1 and r 10% .
Then u e(0.15) 1 1.1618 and d e (0.15) 1 0.8607
er t d e(10%)(1) 0.8607
p
0.8119
ud
1.1618 0.8607
Let S 100
Su 100 1.1618 $116.18
S $100
Sd 100 0.8607 $86.07
Binomial Tree in Practice

When binomial trees are used in practice, the life of the option is typically divided into 30 or more time
steps of length t .
In each time step there is a binomial stock price movement. With 30 time steps this means that 31
terminal stock prices and 230 , or about 1 billion, possible stock price paths are considered.
85
Prof. Man-lui Lau
VII.
A Model of the Behavior of Stock Price
Normal distribution
1
1 x 2
f ( x , 2 )
exp[ (
) ]
2
2
Standard normal distribution
1
x2
f ( x0,1)
exp( )
2
2
Properties of normal distribution:
N ( , 2 ) and Z a bX , then Z N (a b , b2 2 ) .
1
X
1
1
N ( , 2 2 ) N (0,1)
In particular, if b and a , then Z
1.
If X
2.
If
N (0, 1) , and X a b , then X
N (a b 0, b2 1) N (a, b 2 ) or (a, b)
The Markov Property

A Markov Process is a particular type of stochastic process where only the present value of a variable
is relevant for predicting the future.
We assume stock prices follow a Markov Process.
i)
The predictions for the future should not be affected by the price 1 week or 1 month ago; the
only relevant information is the current stock price S .
ii)
The statistical properties of the stock price are useful in determining the characteristics of the
stochastic process followed by the stock price (e.g. volatility).
iii)
Predictions for the future are uncertain and must be expressed in terms of probability
distributions.
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Prof. Man-lui Lau
Continuous-time Stochastic Processes

Wiener Process
We assume models of stock price behavior can be expressed in terms of Wiener Process.
The Wiener Process is used in Physics to describe the motion of a particle that is subject to a large
number of small molecular shocks. (Brownian Motion).
Let z be a variable which follows a Wiener Process.
z t where N (0,1)
Cov(zi , z j ) 0, i j
[ z for any 2 different short intervals of time are independent of each other.]
Property 1
Property 2
Claim: z N (0, t )
Proof:
i)
Since t is a constant,
N z t
ii)
E(Z ) E( t ) t E( ) 0
iii)
Var (z) E[z E(z)]2 E[(z)2 ] E[( t )2 ] tE( 2 ) t 1 t

Note that 1 Var ( ) E[ E ( )]2 E ( 2 )
Claim: z (T ) z (0) N (0, T )

Proof:
T
Let t
N
z (T ) z (0) z (T ) z (T t ) z (T t ) z (T 2t ) z (T 2t ) ... z[T ( N 1)t ] z (0)
z1 z2 ... z N
1 t 2 t ... N t
where i
N (0,1)
z (1)
Since i 's are independently and identically distributed,
z (T ) z (0)
N [0 ... 0, ( t ) 2 (1) ... ( t ) 2 (1)]
N [(0)( N ), ( t ) 2 ( N )] N (0, (t )( N )] N (0, T )

Note:
T Var
i)
ii)
Let t 0, then we can write z t as dz dt
iii)
In this Wiener Process, E (z ) 0 E ( z ) z (0)
We say that the drift rate of the process 0 .
87
Prof. Man-lui Lau
Generalized Wiener Process

Let x be a variable which follows a Generalized Wiener Process.
a : expected drift rate per unit time
x at b t
N (0,1)
noise or variability
or
dx adt b dt
as t 0
Claim: x N (at , b 2 t )
Proof:
i)
Note that x at b t at (b t )
N ( ) x N ( )
ii)
iii)
E(x) E(at ) E[(b t ) ] at b tE( ) at 0 at

Var (x) E[x E (x)]2
E[(a t b t ) (a t )]2
E[b t ]2
b 2 tE ( 2 )
b 2 t 1 b 2 t
Claim: x(T ) x(0) N (aT , b2T ) or (aT , b T )

Proof:
T
Let t
N
x(T ) x(0) x(T ) x(T t ) x(T t ) x(T 2t ) x(T 2t ) ... x[T ( N 1)t ] x(0)
x1 x2 ... xN
x (1)
Since xi 's are independently and identically distributed,
x(T ) x(0)
N (at , b 2 t )
N ( Nat , Nb2 t ) N (aT , b 2T )
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Prof. Man-lui Lau
Example
Suppose the cash position of a company, measures in thousands of dollars, follows a generalized
Wiener Process with a drift of 20 per year and a variance rate of 900 per year. Let the initial cash
position be 50.
900
x 20t 30 t 20t 30 t
x : cash position
At the end of
1 year, x 20 30 x
(20, 30) and the cash position x (50 20, 30) (70, 30) ;
Question: 1 year later, what is P ( x 90) ?

X 90 70
P( X 90) P(
) P( Z 0.67) 1 0.7486 0.2514
30
Question: 10 years later, what is P ( X 200) ?
X 200 250
P( X 200) P(
) P( Z 0.53) 0.2981
9000
Example
A company's cash position, measured in millions of dollars, follows a generalized Wiener Process with
a drift rate of 0.5 per quarter and a variance rate of 4.0 per quarter. How high does the company's
initial cash position have to be for the company to have a less than 5% chance of a negative cash
position by the end of one year?
Solution:
Let X be the company's initial cash position and Y be the company's cash position after 1 year.
The probability distribution of the cash position at the end of 1 year is
x 0.5t 2 t x (0.5 4, 2 4) (2, 4)

Y
( X 2, 4)
X 2
Y 0 ( X 2)
P(Y 0) P
P Z
5%
4
4

X 2
1.645
X 1.645(4) 2 4.58
4
-1.645
5%
89
Prof. Man-lui Lau
The Process for Stock Price

Consider a non-dividend-paying stock.
Assumption: The expected drift, expressed as a proportion of the stock price, is constant.
S
dS
t
or
dt
S
S
Claim: When the variance rate 0, S (t ) S0 e t
Proof:
dS
dt
S
dS
dt
S
ln S t k
eln S e t k e t ek
S (t ) Ce t
where C e k is a constant
When t 0, we have S0 S (0) Ce (0) C C S0
S (t ) S0 e t
When the variance rate is 0, the stock price grows at a continuously compounded rate of per unit
time.
Assumption: The variance of the percentage return in a short period of time, t , is the same
regardless of the stock price.
S
t t
N (0,1)
: expected rate of return
: stock price volatility
S
dS
dt dt
As t 0, we have
S
dS
dt dz
S
dS S dt S dz
S :
instantaneous expected drift rate
S :
instantaneous standard deviation
S 2 2 : instantaneous variance
90
Prof. Man-lui Lau
Example
Consider a non-dividend paying stock, which has a volatility of 30% per annum and provides an
expected return of 15% per annum with continuous compounding.
0.15, 0.30
dS
0.15dt 0.30dz
S
S
or
0.15t 0.3 t
S
N (0,1)
t 0.0192 year (1 week) and S $100
S S (0.15t 0.3 t )
100[(0.15)(0.0192) (0.3)( 0.0192) ] 100(0.00288 0.0416 ) 0.288 4.16
S (0.288, 4.16) or S N (0.288, 17.31)
Question:
P(2 S 2) ?
2 0.288 S 2 0.288
)
4.16
4.16
P(0.55 Z 0.41) 0.6591 0.2912 36.79%
P(2 S 2) P(
Question:
P(10 S 10) ?
10 0.288 S 10 0.288
)
4.16
4.16
P(2.47 Z 2.33) 0.9901 0.0068 98.33%
P(10 S 10) P(
Question:
P(S 2) ?
2 0.288
)
4.16
P( Z 0.41) 1 0.6591 34.09%
P(S 2) P(
91
Prof. Man-lui Lau
t 0.25 year (3 months) and S $50
S S (0.15t 0.3 t )
50[(0.15)(0.25) (0.3)( 0.25) ] 50(0.0375 0.15 ) 1.875 7.5
S (1.875, 7.5) or S N (1.875, 56.25)
Question:
P(2 S 2) ?
2 1.875 S 2 1.875
)
7.5
7.5
P(0.52 Z 0.02) 0.5080 0.3015 20.65%
P(2 S 2) P(
Question:
P(10 S 10) ?
10 1.875 S 10 1.875
)
7.5
7.5
P(1.57 Z 1.08) 0.8599 0.0582 80.17%
P(10 S 10) P(
Question:
P (S 1) ?
P(S 1) P(
1 1.875
)
7.5
P( Z 0.12) 45.22%
92
Prof. Man-lui Lau
Ito's Lemma
Suppose that the value of a variable x follows an Ito process:
dx a( x, t )dt b( x, t )dz
where dz is a Wiener process and

a( x, t ) and b( x, t ) are functions of x and t .
The variable x has a drift rate of a and a variance rate of b 2 .
Ito's Lemma: Let F ( x, t ) be a function of x and t .

F
F 1 2 F 2
F
a
b )dt
b dz
2
x
t 2 x
x
i.e. F also follows an Ito's process.
F 2
F
F 1 2 F 2
(
b) .
It has a drift rate of
and
a
variance
rate
of
a
b
x
x
t 2 x 2
Then dF (
Example:
Application to Stocks
dS S dt S dz
a
If F ( S , t ) is a function, then dF (
F
F 1 2 F 2 2
F
S
S )dt S dz
2
S a
t 2 S
x b
Note that both S and F are affected by the same underlying source of uncertainty, dz .
93
Prof. Man-lui Lau
Example:
Application to Forward Contracts
We are interested in what happens to the forward price as time passes.

Consider a forward contract on a non-dividend-paying stock:
F Se r (T t )
Let dS S dt S dz
a
F
e r (T t ) ,
S
2 F
0,
S 2
F
(r ) Ser (T t )
t
By Itos Lemma, we have
1
dF [er (T t ) S (r ) Ser (T t ) (0) ( S )2 ]dt [er (T t ) S ]dz
2
b
2
a
b
dF [er (T t ) S rSer (T t ) ] dt er (T t ) S dz
Using F Se r (T t ) ,
dF [ F rF ] dt F dz ( r ) F dt F dz
F also follows the geometric Brownian Motion/Generalized Wiener Process.

expected growth rate:
The growth rate in F is the excess return of S over the risk-free interest rate.
94
Prof. Man-lui Lau
Example:
Application to the Logarithm of the Stock Price ( ln S )
Define F ln S and let dS S dt S dz

b
F 1
,
S S
2 F
1
2,
2
S
S
F
0
t

1
1
1
1
dF [ S 0 ( 2 ) ( S ) 2 ]dt [ S ]dz
S a
2 S
S b
2
b
dF d ln( S ) [
2
2
] dt dz dF
[(
2
2
) dt , dt ]
Since and are constant, this indicates ln S follows a Generalized Wiener Process.
It has constant drift rate
F between 0 and T
ln ST ln S
[(
2
2
[(
2
2
and constant variance rate 2 .
2
2
)T , T ]
)T , T ] or N [(
2
2
)T , 2T ]
95
Prof. Man-lui Lau
VIII. The Black-Scholes Analysis

The lognormal property of stock prices
ln ST ln S
ln ST
[(
2
2
[ln S (
)T , T ]
2
2
)T , T ]
ln ST has a normal distribution
ST has a lognormal distribution
symmetric
0
asymmetric
96
Prof. Man-lui Lau
Example
S $40, 16% per annum, (volatility) 20% per annum
Want: Probability distribution of ST in 6 months time (i.e. T 0.5 )
ln ST
0.22
[ln S ( )T , T ] [ln 40 (0.16
)(0.5), 0.2 0.5] (3.759, 0.141)
2
2
Question:
Pr(30 ST 50) ?
Pr(30 ST 50) Pr(ln 30 ln ST ln 50) Pr(3.4012 ln ST 3.9120)

3.4012 3.759 ln ST 3.9120 3.759
)
0.141
0.141
Pr(2.54 Z 1.09) 0.8621 0.0055 85.66%
Pr(
Let us use the formula in the earlier section.

S
t t S S[ t t ] S 40[(0.16)(0.5) 0.2 0.5 ] 3.2 5.656
S
S (3.2,5.656)
Pr(30 ST 50) Pr(10 S 10)
10 3.2 S 10 3.2
)
5.656
5.656
Pr(2.33 Z 1.20)
Pr(
0.9913 0.1151
87.62%
Note that the answers from the two different methods are different. Why?
97
Prof. Man-lui Lau
Want: Pr(39.9 ST 40.1) in 0.0001 year
ln ST
[ln S (
2
2
)T , T ] [ln 40 (0.16
0.22
)(0.0001), 0.2 0.0001] (3.68888, 0.002)
2
Pr(39.9 ST 40.1) Pr(ln 39.9 ln ST ln 40.1)

ln 39.9 3.68888 ln ST ln 40.1 3.68888
)
0.002
0.002
Pr(1.25 Z 1.25) 0.8944 0.1056 78.88%
Pr(
S
t t S S[ t t ] S 40[(0.16)(0.0001) 0.2 0.0001 ] 0.00064 0.08
S
S (0.00064, 0.08)
Pr(39.9 ST 40.1) Pr(0.1 S 0.1)
0.1 0.00064 S 0.1 0.00064
)
0.08
0.08
Pr(1.26 Z 1.24)
Pr(
0.8925 0.1038
78.87%
Note the difference in the results using the 2 different methods is very small!
98
Prof. Man-lui Lau
Properties of Lognormal Distribution

E ( ST ) Se T
1.
2.
Var (ST ) S 2 e2 T [e T 1]
2
Example 13.2
Current price $20
20% per annum and 40% per annum
1 year later
E ( ST ) Se T 20 e(20%)(1) $24.43
Var (ST ) S 2 e2 T [e T 1] 202 e2(20%)(1) [e(40%)

2
(1)
1] 400 e0.4 (e0.16 1) $103.54
SD(ST ) 103.54 10.18

2 years later
E ( ST ) Se T 20 e(20%)(2) $29.84
Var (ST ) S 2 e2 T [e T 1] 202 e2(20%)(2) [e(40%)

2
(2)
1] 400 e0.8 (e0.32 1) $335.73
SD(ST ) 335.73 $18.32
99
Prof. Man-lui Lau
The Distribution of the Rate of Return
: the annualized continuously compounded rate of return between 0 and T

ST SeT
ln ST ln S T
ln ST ln S T

1
1 S
(ln ST ln S ) ln T
T
T
S
[(
Since ln ST ln S
[(
2 T
)
2 T
T
T
)T , T ]
] [
2
2
Consider a stock where 17% per annum and 20% per annum
Example
0.22 0.2
,
] [0.17
,
] in 3 years
2
2
T
3
(0.15, 0.115)
2
Pr[L H ] 95% in 3 years
Question:
L H
] 95% in 3 years
Note that Pr[
L 0.15
1.96 L 7.54%
0.115
H 0.15
1.96 H 37.54%
0.115
Pr[7.54% 37.54%] 95% in 3 years
100
Prof. Man-lui Lau
Why is E ( )
2
2
Consider the following sequence of returns per annum over 4 years (measured using annual
compounding): 10%, -10%, 10%, -10%
The arithmetic mean of the returns is 0%. However, an investor actually will get a return of 1.99%
1110% 90% 110% 90% 98.01%

Consider the following sequence of returns per annum over 4 years (measured using annual
compounding): 20%, -20%, 20%, -20%
The arithmetic mean of the returns is 0%. However, an investor actually will get a return of 7.84%
1120% 80%120% 80% 92.16%

Note that the bigger the volatity, the bigger the loss.
101
Prof. Man-lui Lau
Estimating Volatility From Historical Data

n 1: # of observations
Si :
stock price at the end of the i th interval (i 0,1,..., n)
length of time intervals in years
ui ln(
Si
)
Si 1
i 1, 2,..., n
Si
eui Si Si 1eui
Si 1
ui is the continuously compounded return in the ith interval

standard deviation s
Earlier, we have ui ln(
Si
2
) ln( Si ) ln( Si 1 ) [( ) , ] dt
Si 1
2
the standard deviation of ui is

The variable s is an estimate of .
Claim: i)
ii)
is the estimate of
standard error of
2n
Note:
This analysis assumes that the stock pays no dividend.
For dividend-paying stock, ui ln(
Si D
) for the time interval that incldues an ex-dividend day.
Si 1
However, as tax factors play a part in determining returns around an ex-dividend date. It is probably
best to discard altogether data for intervals that include an ex-dividend date.
102
Prof. Man-lui Lau
Example
Day
Closing Stock Price
Relative Price
Daily Return
Si
Si 1
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
$20.00
$20.10
$19.90
$20.00
$20.50
$20.25
$20.90
$20.90
$20.90
$20.75
$20.75
$21.00
$21.10
$20.90
$20.90
$21.25
$21.40
$21.40
$21.25
$21.75
$22.00
ui ln(
1.00500
0.99005
1.00503
1.02500
0.98780
1.03210
1.00000
1.00000
0.99282
1.00000
1.01205
1.00476
0.99052
1.00000
1.01675
1.00706
1.00000
0.99299
1.02353
1.01149
SD=
0.00499
-0.01000
0.00501
0.02469
-0.01227
0.03159
0.00000
0.00000
-0.00720
0.00000
0.01198
0.00475
-0.00952
0.00000
0.01661
0.00703
0.00000
-0.00703
0.02326
0.01143
0.012159332
Assume that there are 252 trading days per year (i.e.
Estimated volatility per annum:
Standard error of this estimate:
2n
Si
)
Si 1
0.01216
1
252
0.193
2(20)
103
1
)
252
0.193
0.031 (3.1% per annum)
Prof. Man-lui Lau
Derivation of the Black-Scholes-Merton Differential Equation

Assumptions:
S
t t
1.
S
where and are constants
2.
The short selling of securities with full use of proceeds is permitted.
3.
No transaction costs or taxes.
4.
No dividends.
5.
No riskless arbitrage opportunities.
6,
Security trading is continuous.
7.
r is constant and the same for all maturities.
dS S dt S dz
stock price:
price of a derivative: f f ( S , t )
f
f 1 2 f
f
df [
S
( S ) 2 ]dt [
S ]dz
2
S a
t 2 S
S b
2
b
Discrete time version
S S t S z
f [
f
f 1 2 f
f
S
( S ) 2 ]t [
S ]z
2
S a
t 2 S
S b
2
b
Our goal is to choose an appropriate portfolio so that the Wiener Process is eliminated.
104
Prof. Man-lui Lau
Appropriate portfolio:
1 derivative security
f ( S0 , t0 )
shares
S
f
S
S
t later , the value of the portfolio will be adjusted by
f
f
S
S
f
f 1 2 f
f
f
{[
S
( S ) 2 ]t [
S ]z} { S t S z}
2
S
t 2 S
S
S
2
f 1 f 2 2
[
S ]t
NO z
t 2 S 2
Current value of the portfolio f
This portfolio is riskless and should earn the risk-free interest rate.
r t
f 1 2 f 2 2
f
[
S ]t r[ f S ]t
2
t 2 S
S
2
f 1 f 2 2
f

S rf r S
2
t 2 S
S
2
f 1 f 2 2
f
S rS
rf
(13.16)
2
t 2 S
S
Black-Scholes-Merton Differential
Equation
Note:
i)
The Black-Scholes-Merton Differential Equation has many solutions, corresponding to all the
different derivatives that can be defined with S as the underlying variable.
ii)
The particular derivative that is obtained when the equation is solved depends on the boundary
conditions that are used.
These specify the values of the derivative at the boundaries of possible values of S and t .
In the case of a European call option, the boundary condition is
f max( S X , 0) when t T .
In the case of a European put option, the boundary condition is
f max( X S , 0) when t T .
iii)
The portfolio used in the derivation of equation (13.16) is that it is not permanently riskless. It
f
is riskless only for an infinitesimally short period of time. As S and t change,
also
S
changes. To keep the portfolio riskless, it is necessary to frequently change the relative
proportions of the derivative and the stock in the portfolio.
105
Prof. Man-lui Lau
Example
Consider a forward contract in a non-dividend-paying stock. The value of the contract @ t is
f S Ke r (T t ) .
We have
1
LHS of Black-Scholes Merton Differential Equation: ( rKe r (T t ) ) rS (1) 2 S 2 (0) rKe r (T t ) rS
2
r (T t )
RHS of Black-Scholes Merton Differential Equation: rf r (S Ke
) rS rKe r (T t )
LHS RHS and Black-Scholes Merton Differential Equation is satisfied.
The Prices of Tradable Derivatives

1.
Any function f ( S , t ) that is a solution of the Black-Scholes Merton Differential Equation is the
theoretical price of a derivative that could be traded.
2.
If a derivative with that price existed, it could not create any arbitrage opportunities.
Conversely, if a function f ( S , t ) does not satisfy Black-Scholes Merton Differential
Equation:it cannot be the price of a derivative without creating arbitrage opportunities for
traders.
Example:
Consider f ( S , t ) e S
f
f
2 f
0,
eS , 2 eS .
t
S
S
f
f 1 2 2 2 f
rS
S
rf
t
S 2
S 2
Black-Scholes Merton Differential Equation:
f
f 1 2 2 2 f
1
rS
S
0 rSe S 2 S 2 e S re S rf
2
t
S 2
2
S
This cannot be the price of a tradable security.
LHS:
RHS
Example:
e (
f
e( 2 r )(T t ) 2 f 2e( 2 r )(T t )
,
, 2
Consider f ( S , t )
.
S
S
S2
S
S3
f
f 1 2 2 2 f
rS
S
rf
t
S 2
S 2
2
2
2
f
f 1 2 2 2 f ( 2 2r )e( 2 r )(T t )
e( 2 r )(T t ) 1 2 2 2e( 2 r )(T t )
rS
S
rS
S
LHS:
t
S 2
S
2
S 2
S2
S3
2
2
2
2
2
2 e( 2 r )(T t ) 2re( 2 r )(T t ) re( 2 r )(T t ) 2 e( 2 r )( T t ) re( 2 r )( T t )
rf
RHS
S
S
1
Note: It is the price of a derivative that pays off
at time T .
ST
2
2 r )(T t )
f ( 2 2r )e(
t
S
106
2 r )(T t )
Prof. Man-lui Lau
Risk-neutral Valuation
f
f 1 2 2 2 f
rS
S
rf
t
S 2
S 2
1.
The Black-Scholes-Merton formula does not involve the expected return to the stock, .
2.
depends on risk preferences. The higher the level of risk aversion by investors, the higher
will be for any given stock.
3.
The variables that do appear in the equation are the current stock price, time, stock price
volatility, and the risk-free interest rate.
4.
If risk preference do not enter the equation, any set of risk preference can, therefore, be used
when evaluating f . In particular, we can assume that all investors are risk neutral.
5.
In a world where investors are risk neutral, the expected return on all securities is the risk-free
rate of interest. The reason is that risk-neutral investors do not require a premium to induce
them to take risks.
The present value of any cash flow in a risk-neutral world can be obtained by discounting its
expected value at the risk-free rate.
Consider a derivative that provides a payoff at one particular time. It can be valued using risk-neutral
valuation by using the following procedure:
a)
Assume that the expected return from the underlying asset is the risk-free interest rate, r . (i.e.
assume r ).
b)
Calculate the expected payoff from the option at its maturity.
c)
Discount the expected payoff at the risk-free interest rate.
Note:
i)
The risk-neutral assumption is an artificial device for obtaining solutions to the Black-Scholes
differential equation.
ii)
The solutions are valid in all worlds, not just those where investors are risk neutral.
iii)
When we move from a risk-neutral world to a risk-averse world, 2 things happen:

a)
The expected growth rate in the stock price changes and the discount rate that must be
used for any payoffs from the derivative changes.
b)
It happens that these 2 changes always offset each other exactly.
107
Prof. Man-lui Lau
Example:
Application to Forward Contracts on a Stock
Consider a long forward contact that matures at time T with a delivery price, K .
The value of the contract at maturity is ST K where ST is the stock price at time T .
The value of the forward contract at time 0 is its expected value at time T in a risk-neutral world,
discounted to time 0 at the risk-free interest rate.
f be the value of the forward contract at time t and

E denotes expected value in a risk-neutral world.
Let
f e rT E (ST K ) e rT E (ST ) e rT K
(*)
The expected growth rate of the stock price, , becomes r in a risk-neutral world. Hence
E (S ) SeT SerT
(**)
T
(**) (*)
f e rT SerT e rT K S Ke rT
108
Prof. Man-lui Lau
The Black-Scholes Pricing Formula

The expected value of a European Call option at maturity in a risk-neutral world is
E[max(ST X , 0)]
In general, E ( X )
c e rT E [max( ST X , 0)]
xf ( x)dx
c e rT [max( ST X , 0)]g ( ST ) dST e rT ( ST X ) g ( ST ) dST
where f ( x ) is the density function
density function
[ln S (r
r in a risk-neutral world
)T , T ] ,
2
we get the Black-Scholes formula
Using ln ST
c SN (d1 ) XerT N (d2 )

S
2
) ( r )T
X
2
where d1
T
S
2
ln( ) (r
)T
X
2
d2
d1 T
T
ln(
N ( x) is the cumulative probability distribution for a standardized normal variable
Note:
i)
cC
ii)
iii)
p Xe rT N (d 2 ) SN (d1 )
No exact analytic formula for P (American Put option).
109
Prof. Man-lui Lau
Example
6-month options
S $42, X $40, r 10%, 20%, T 0.5
42
20%2
S
2
ln(
)
(10%
)(0.5)
ln( ) (r
)T
ln(1.05) (0.1 0.02)(0.5)
40
2
X
2
d1
0.7693
T
(20%) 0.5
(0.2) 0.5
d2
ln(
42
20%2
S
2
)(0.5)
) (r
)T ln( ) (10%
ln(1.05) (0.1 0.02)(0.5)
40
2
X
2
0.6278
T
(20%) 0.5
(0.2) 0.5
c SN (d1 ) Xe rT N (d 2 ) 42 N (0.7693) 40e (10%)(0.5) N (0.6278) 42 0.7791 40 e 0.05 0.7349

$4.76
p Xe rT N (d 2 ) SN (d1 ) 40e (10%)(0.5) N (0.6278) 42 N (0.7693)
40 e0.05 0.2651 42 0.2209 $0.81
6-month options
d1
d2
ln(
ln(
1
S $42, X $37 , r 10%, 20%, T 0.5
2
42
20%2
S
2
) (10%
)(0.5)
) (r
)T ln(
ln(1.12) (0.1 0.02)(0.5)
37.5
2
X
2
1.2256
T
(20%) 0.5
(0.2) 0.5
42
20%2
S
2
) (10%
)(0.5)
) (r
)T ln(
ln(1.12) (0.1 0.02)(0.5)
37.5
2
X
2
1.0842
T
(20%) 0.5
(0.2) 0.5
c SN (d1 ) Xe rT N (d 2 ) 42 N (1.2256) 37.5e (10%)(0.5) N (1.0842) 42 0.8898 37.5 e 0.05 0.8609

$6.67
p Xe rT N (d 2 ) SN (d1 ) 37.5e (10%)(0.5) N (1.0842) 42 N (1.2256)
37.5 e0.05 0.1391 42 0.1102 $0.34
Put-call Parity
p S c Xe rT
0.34 42 6.67 37.5e (10%)(0.5)
110
Prof. Man-lui Lau
6-month options
d1
ln(
S $42, X $35, r 10%, 20%, T 0.5
42
20%2
S
2
)(0.5)
) (r
)T ln( ) (10%
ln(1.2) (0.1 0.02)(0.5)
35
2
X
2
1.7135
T
(20%) 0.5
(0.2) 0.5
42
20% 2
S
2
)(0.5)
ln( ) (r
)T ln( ) (10%
ln(1.2) (0.1 0.02)(0.5)
35
2
X
2
d2
1.5721
T
(20%) 0.5
(0.2) 0.5
c SN (d1 ) Xe rT N (d 2 ) 42 N (1.7135) 35e (10%)(0.5) N (1.5721) 42 0.9567 35 e 0.05 0.9420

$8.82
p Xe rT N (d 2 ) SN (d1 ) 35e (10%)(0.5) N (1.5721) 42 N (1.7135)
35 e0.05 0.0580 42 0.0433 $0.11
Put-call Parity
p S c Xe rT
0.11 42 8.82 35e (10%)(0.5)
111
Prof. Man-lui Lau
Warrants Issued by a Company on its Own Stock

Consider a company with N outstanding shares and M outstanding European warrants.
Suppose that each warrant entitles the holder to purchase shares from the company at time T at a
price of X per share.
Let VT be the value of the company's equity (including the warrants) at time T and the warrant holders
exercise, the company receives a cash inflow from the payment of the exercise price of $M X and
the value of the company's equity increases to VT M X .
V M X
This share price immediately after exercise becomes T
.
N M
V M X
V
N
X)
( T X)
The payoff to the warrant holder if the warrant is exercised is ( T
N M
N M N
The warrants should be exercised only if this payoff is positive.
V
N
max( T X , 0)
N M
N
V
N
This shows that the value of the warrant is the value of
regular option on
, where V is the
N
N M
company's equity.
The value of V at time 0 is given by V0 NS0 MW where
S 0 : the stock price at time 0
W : the warrant price at that time
V0
M
S0 W
N
N
The payoff to the warrant holder is
Black-Scholes formula
c S0 N (d1 ) XerT N (d2 )
The warrant price can be calculated by the following procedures:
M
1.
The stock price S 0 is replaced by S0 W .
N
2.
The volatility is the volatility of the equity of the company (i.e. it is the volatility of the
value of the shares plus the warrants, not just the shares).
N
3.
The formula is multiplied by
.
N M
Implied Volatilities
We can use the data observed in the market to calculate the markets opinion about the volatility of a
particular stock.
volatility per annum volatility per trading day number of trading days per annum
112
Prof. Man-lui Lau
Dividends
We can use the Black-Scholes formula by subtracting the present value of the dividend for the stock
price.
Example
Consider a 6-month European Call option on a stock when there are ex-dividend dates in 2-month and
5-month.
Dividend $0.50 each date, S $40, X $40, r 9%, T 0.5, 30%

PV of dividend 0.5e
(9%)(
2
)
12
0.5e
(9%)(
5
)
12
$0.9741
Define S ' S PV of dividend 40 0.9741 $39.0259
39.0259
0.32
S'
2
) (0.09
)(0.5)
) (r
)T ln(
40
2
X
2
d1
0.2017
T
0.3 0.5
39.0259
0.32
S'
2
) (0.09
)(0.5)
ln( ) (r
)T ln(
40
2
X
2
d2
0.0104
T
0.3 0.5
ln(
c S ' N (d1 ) Xe rT N (d 2 ) 39.0259 N (0.2017) 40e (9%)(0.5) N (0.0104)

39.0259 0.5799 40 e0.045 0.4959 $3.67
p Xe rT N (d 2 ) S ' N (d1 ) 40e (9%)(0.5) N (0.0104) 39.0259 N (0.2017)
40e0.045 0.5042 39.0259 0.4201 $2.89
For American options, we have to worry about whether it is optimal to exercise the options
before the maturity date.
113
Prof. Man-lui Lau
IX.
Options on Stock Indices, Currencies, and Futures
Options on Stock Paying A Continuous Dividend Yield

Put-call parity:
Non-dividend paying stock:
Dividend paying stock:
Stock paying continuous dividend
c Xe rT p S
c D Xe rT p S
c Xe rT p Se qt
Option Pricing Formulas

c Se qT N (d1 ) Xe rT N (d 2 )
p Xe rT N (d 2 ) Se qT N (d1 )
S
2
) (r q )T
X
2
d1
T
S
2
ln( ) (r q )T
X
2
d2
d1 T
T
ln(
Note: If the dividend yield is not constant during the life of the option, the above equations are still
true, with q equal to the average annualized dividend yield during the life of the option.
Binomial Trees
current
@ expiration
Stock price S u
Stock price S
(u 1)
Derivative price f
Stock price S d
( d 1)
f erT [ pfu (1 p) f d ]
where p
e ( r q )T d
ud
Example
114
Prof. Man-lui Lau
Suppose that the initial stock price is $30 and the stock price will move either up to $36 or down to
$24 during a 6-month period. The 6-month risk-free interest rate is 5%, and the stock is expected to
provide a dividend yield of 3% during the 6-period.
u 1.2, d 0.8, r 5%, q 3%

p
e( r q )T d e(5%3%)(0.5) 0.8
0.5251
ud
1.2 0.8
Consider a 6-month put option on the stock with X $28 .

If ST $36 fu 0 .
If ST $24 f d 4 .
f erT [ pfu (1 p) f d ] e(5%)(0.5) [0.5251 0 0.4741 4] $1.85
Option on Stock Indices

Note:
1.
The options on the S&P500 are European, whereas those on the S&P100 are American. Both
options have maturity dates on the Saturday following the third Friday of the expiration month.
2.
Index options are settled in cash rather than by delivering the securities underlying the index.
Upon exercise of the option, the holder of a call option receives S X in cash and the writer of
the option pays this amount in cash.
The holder of a put option receives X S in cash and the writer of the option pays this amount
in cash.
3.
In addition to the relatively short-dated options, the exchanges trade longer maturity contracts
known as LEAPS ("Long-term Equity anticipation Securities").
4.
CAPs are options in which the payout is capped so that it cannot exceed $30. The options are
European except for the following: A call CAP is automatically exercised on a day when the
index closed at more than $30 above the strike price; a put CAP is automatically exercised on
a day when the index closed at more than $30 below the strike price
115
Prof. Man-lui Lau
Example:
2-month option
S 310, X 300, r 8%, 20%, q 3%

310
20% 2 2
2
S
) (8% 3%
)( )
) (r q
)T ln(
300
2
12 0.5444
X
2
d1
T
2
20%
12
310
20% 2 2
S
2
) (8% 3%
)( )
ln( ) (r q
)T ln(
300
2
12 0.4628
X
2
d2
T
2
20%
12
ln(
c Se qT N (d1 ) Xe rT N (d 2 ) 310e
3%(
2
)
12
p Xe rT N (d 2 ) Se qT N (d1 ) 300e
N (0.5444) 300e
8%(
2
)
12
8%(
2
)
12
N (0.4628) 300e
N (0.4628) 17.28
3%(
2
)
12
N (0.5444) 4.86
Example:
3-month option
X
350
300
250
200
150
S 250, r 10%, 20%, q 4%

Call
0.01
0.52
11.75
52.51
101.22
Put
93.85
45.61
8.06
0.06
0.00
116
Prof. Man-lui Lau
Hedging a portfolio by buying puts (Portfolio Insurance)
# contracts needed
value of portfolio
value of index
Example:
Portfolio:$10000000
r 10%
20%
T 0.25 (3 months)
2
Current index 250
q 4%
# contracts needed
value of portfolio
$10000000
2
800
value of index
($100)(250)
"Level of protection": 250
cost of protection (8.06)($100)(800) $644800

3 months later
Suppose the index 250
Stocks:
index 0%
dividend 1%
Total return 1%
1
1
2 % 2[1% 2 %] 0.5%
2
2

$10000000(1 0.5%) $9950000
Aggregate position(@ T ) $9950000 $644800e
(10%)(
117
3
)
12
$9950000 $661123.2 $9, 288,876.8
Prof. Man-lui Lau

Stocks:
index 10%
dividend 1%
Total return 9%
1
1
2 % 2[9% 2 %] 20.5%
2
2

$10000000(1 20.5%) $7950000
Aggregate position(@T) $7950000 $644800e
(10%)(
3
)
12
(250 225)($100)(800) $9, 288,876.8

Stocks:
index 20%
dividend 1%
Total return 19%

1
1
2 % 2[19% 2 %] 40.5%
2
2

$10000000(1 40.5%) $5950000
10%(
118
3
)
12
(250 200)($100)(800) $9, 288,876.8
Prof. Man-lui Lau

Stocks:
index 30%
dividend 1%
Total return 29%

1
1
2 % 2[29% 2 %] 60.5%
2
2

$10000000(1 60.5%) $3950000
(10%)(
3
)
12
(250 175)($100)(800) $9, 288.876.8

Stocks:
index 20%
dividend 1%
Total return 21%

1
1
2 % 2[21% 2 %] 39.5%
2
2

$10000000(1 39.5%) $13950000
(10%)(
119
3
)
12
$13, 288,876.8
Prof. Man-lui Lau
"Level of protection": 200
value of portfolio
$10000000
2
800
value of index
($100)(250)
cost of protection (0.06)($100)(800) $4800
# contracts needed
3 months later
(10%)(
3
)
12
$13,945,078.5

(10%)(
3
)
12
(10%)(
3
)
12
(10%)(
3
)
12
$9,945,078.5

$7,945,078.5

$5,945,078.5

(10%)(
3
)
12
(200 175)($100)(800) $5,945,078.5
Note: Do not use the put strike price to calculate the # of contracts needed!!!
120
Prof. Man-lui Lau
Suppose we use the put strike price to calculate the # of contracts needed.
10000000
2 1000
200($100)
Aggregate Position
# contracts needed
Index
250
200
175
150
$9950000 6000e
$5950000 6000e
(10%)(
3
)
12
3
(10%)( )
12
$9,943,848.1
$5,943,848.1
$3950000 0.06($100)(1000)e
$1950000 $6000e
(10%)(
3
)
12
(10%)(
3
)
12
(200 175)($100)(1000) $6, 443,848.1
(200 150)($100)(1000) $6,943,848.1
When index 150

index 40%
dividend 1%
_____________
Total 39%
1
1
1
Expected return on portfolio 2 % 2(39% 2 %) 80 %
2
2
2
1
Expected value of portfolio $10000000(1 80 %) $1950000
2
(10%)(
3
)
12
121
(200 150)($100)(1000) $6,943,848.1
Prof. Man-lui Lau
Currency Options
c Se
rf T
N (d1 ) Xe rT N (d 2 )
p Xe rT N (d 2 ) Se
rf T
N (d1 )
S
2
) (r rf )T
X
2
d1
T
S
2
ln( ) (r rf )T
X
2
d2
d1 T
T
ln(
Example
4-month European call option on British Pound
S 1.6000, X 1.6000, rUS 8%, rUK 11%, 14.1%, T
4
12
1.6
0.1412 4
S
2
)( )
) ( r rf
)T ln( ) (0.08 0.11
1.6
2
12 0.0821
X
2
d1
T
4
0.141
12
2
1.6
0.1412 4
S
)( )
ln( ) (r rf
)T ln( ) (0.08 0.11
2
12 0.1635
X
2
d2
1.6
T
4
0.141
12
ln(
c Se
1.6e
1.6e
rf T
N (d1 ) Xe rT N (d 2 )
(0.11)(
4
)
12
4
(0.11)( )
12
N ( 0.0821) 1.6e
0.4673 1.6e
(0.08)(
4
(0.08)( )
12
4
)
12
N ( 0.1635)
0.435
$0.043
p Xe rT N ( d 2 ) Se
1.6e
1.6e
4
(0.08)( )
12
4
(0.08)( )
12
rf T
N ( d1 )
N (0.1635) 1.6e
0.565 1.6e
(0.11)(
4
(0.11)( )
12
4
)
12
N (0.0821)
0.5327
$0.0586
122
Prof. Man-lui Lau
Since F Se
c Se
rf T
N (d1 ) Xe rT N (d 2 )
e rT [ Se rT e
e rT [ Se
( r r f )T
rf T
( r r f )T
N (d1 ) XN (d 2 )]
N (d1 ) XN (d 2 )]
e rT [ FN (d1 ) XN (d 2 )]
p Xe rT N ( d 2 ) Se
rf T
e rT [ XN ( d 2 ) Se rT e
e rT [ XN ( d 2 ) Se
N (d1 )
rf T
( r r f )T
N ( d1 )]
N (d1 )]
e rT [ XN ( d 2 ) FN ( d1 )]
d1
ln(
d2
ln(
Fe
( r r f )T
F
2
) ( r rf
)T ln( ) ( r rf )T ( r rf
)T
2
X
2
T
T
F
2
)
T
X
2
T
ln(
Fe
( r r f )T
) ( r rf
2
2
)T
ln(
F
2
) ( r rf )T ( r rf )T
X
2
T
F
2
ln( )
T
X
2 d T
1
T
123
Prof. Man-lui Lau
Futures Options
Futures options are American style options. The underlying assets of Futures option are futures
contract.
If a call futures option is exercised, the investor with a long call position acquires a long position in
the underlying futures contract at the most recent settlement price and receives a cash amount equal to
the most recent settlement futures price minus the strike price.
If a call futures option is assigned, the investor with a short call position acquires a short position in
the underlying futures contract at the most recent settlement price and pays a cash amount equal to the
most recent settlement futures price minus the strike price.
If a put futures option is exercised, the investor with a long put position acquires a short position in
the underlying futures contract at the most recent settlement price and receives a cash amount equal to
the strike price minus the most recent settlement futures price.
If a put futures option is assigned, the investor with a short put option acquires a long position in the
underlying futures contract at the most recent settlement price and pays a cash amount equal to the
strike price minus the most recent settlement futures price.
Example
Suppose it is August 15 and an investor has a long position of 1 September futures call option
contract on copper with X $0.70 per pound . 1 futures contract is on 25000 pounds of copper.
Suppose that the futures price of copper for delivery in September is currently $0.81, and at the close
of trading on August 14 (the last settlement day) was $0.80 .
If the option is exercised, the investor receives a cash amount of 25000($0.80 $0.70) $2500
plus a long position in a futures contract to buy 25000 pounds of copper @ $0.80 per pound in
September.
the most recent settlement price
[After "receiving" the long position, the investor may choose to keep the long position or close out the
position immediately.
If position in the futures contract is closed out immediately. This would leave the investor with the
$2500 cash payoff plus an amount 25000($0.81 0.80) $250 reflecting the change in the futures
price since the last settlement.
Effectively, the investor has made 25000($0.81 $0.70) $2750 .]
124
Prof. Man-lui Lau
Example
An investor has 1 long position of 1 December futures put option on corn with X $2.00 per
bushel. 1 futures contract is on 5000 bushels of corn. Suppose that the current futures price of corn for
delivery in December is $1.80, and the most recent settlement price is $1.79.
If the option is exercised, the investor receives a cash amount of 5000($2.00 $1.79) $1050
plus a short position in a futures contract to sell 5000 bushels of corn @ 1.79 per bushel in December.
[After "receiving" the short position, the investor may choose to keep the short position or close out the
position immediately.
If the short position in the futures contract is closed out, this would leave the investor with $1050
minus an amount 5000($1.80 $1.79) $50 reflecting the change in the futures price since the last
settlement.
Effectively, the investor has made 5000($2.00 $1.80) $1000 .]
Example
An investor has a short position of 1 August futures call option on with X $1.50 . 1
futures contract is on for delivery in September is $1.5532. The price at the last settlement day is
$1.55.
If the investor is assigned, the investor will have to pay 62500(1.55 1.50) $3125 plus a
short position in 1 September contract to sell 62500 @$1.55.
[Effectively, the investor has lost 62500($1.5532 $1.50) $3325 .]
Example
An investor has a short position of 1 July futures put option on with X $1.70 . 1 futures
contract is on for delivery in September is $1.5532. The price at the last settlement day is $1.55.
If the investor is assigned, the investor will have to pay 62500(1.7 1.55) $9375 plus a long
position in 1 September contract to buy 62500 @$1.55.
[Effectively, the investor has lost 62500($1.7 1.5532) $9175 .]
125
Prof. Man-lui Lau
European Spot and Futures Options

The payoff from a European call option with strike price X on the spot price of an asset is
max( ST X , 0)
where ST :
spot price at the options maturity
The payoff from a European call option with the same strike price X on the futures price of an asset
is max( FT X , 0)
where FT :
futures price at the options maturity
If the futures contract and the options mature at the same time, then FT ST and the 2 options are
equivalent.
Similarly, a European futures put option is worth the same as the spot put option counterpart when the
futures contract matures at the same time as the option.
Put-Call Parity for futures options :
c XerT p F0 erT
Proof:
Consider European call and put futures options, both with strike price X and time expiration T .
We can form the 2 portfolios:
Portfolio A:
Portfolio B:
rT
a European call futures option $ Xe

a European put futures option a long futures contract $ F0 e rT
Let FT be the futures price at the maturity of the option T .
@T
Portfolio A: The cash will grow to $X .
Case 1: FT X
The call option in Portfolio A is exercised. The investor receives a long position @ FT and cash
( FT X ) . Since the futures contract is "purchased" at the current price, hence it is worth $0 . Hence
the value of the portfolio ( FT X ) X FT .
126
Prof. Man-lui Lau
Case 2: FT X
The call option in Portfolio A is not exercised and the Portfolio A is worth $X .
cash
Hence value( A) max( FT , X ) .

Portfolio B: The cash will grow to F0 .
Case 1: FT X
The put option in Portfolio B is not exercised and the futures contract provides a payoff of FT F0 .
Together with the cash, portfolio B is worth ( FT F0 ) F0 FT .
Case 2: FT X
The put option in Portfolio B is` exercised. The investor receives a short position @ FT and receives
cash ( X FT ) .
This short position @ FT will offset the initial long position @ F0 . This generates a profit ( FT F0 ) .
Together with the cash of F0 , portfolio is worth ( X FT ) ( FT F0 ) F0 $ X .
the Portfolio A is worth $X .
Hence value( B) max( FT , X ) .
Because the value of the two portfolios are the same @T , they have to worth the same at any time.
Hence c XerT p F0 erT
Example
Suppose that the price of a European call option on silver futures for delivery in 6 months is
$0.56 per ounce when X 8.50 . Assume that the silver futures price for delivery in 6 months is
currently $8.00 and the risk-free interest rate for an investment that matures in 6 months is 10% per
annum.
p c XerT F0 erT 0.56 8.5e10%(0.5) 8e10%(0.5) $1.04
For American futures, the put-call parity relationship is
F0 erT X C P F0 KerT
127
Prof. Man-lui Lau
Value of Futures Options Using Binomial Trees

current
@ expiration
Futures price F0 u
(u 1)
Futures price F0
Derivative price f
Futures price F0 d
(d 1)
f erT [ pfu (1 p) f d ]
Example:
where p
1 d
ud
call option with X 29 (r 6%, T
1
0.08333)
12
33 ( fu 4 )
30
28 ( f d 0 )
28
0.9333
30
1 d
1 0.9333
p
0.4
u d 1.1 0.9333
u 1.1, d
f e rT [ pfu (1 p) f d ] e
(0.06)(
1
)
12
[0.4 4 0.6 0] $1.592
128
Prof. Man-lui Lau
Black's Model for Valuing Futures Options
Option Pricing (Black-Scholes) Formulas

c Se qT N (d1 ) Xe rT N (d 2 )
p Xe rT N (d 2 ) Se qT N (d1 )
S
2
) (r q )T
X
2
d1
T
S
2
ln( ) (r q )T
X
2
d2
d1 T
T
ln(
Setting q r and S0 F0 , we have
c e rT [ F0 N (d1 ) XN (d 2 )]
p e rT [ XN ( d 2 ) F0 N ( d1 )]
where
F0 2T
)
X
2
d1
T
F
2T
ln( 0 )
X
2 d T
d2
1
T
: the volatility of the futures price
ln(
When the cost of carry and the convenience yield are functions of time, the volatility of the futures
price is the same as the volatility of the underlying asset.
Note that the Black's model does not require the option contract and the futures contract to mature
at the same time.
129
Prof. Man-lui Lau
Example
Consider a 4-month European futures put option on crude oil.
Current futures price F0 20, X 20, r 9%, volatility of futures price 25%, T
4
12
4
(25% 2 )( )
20
F0 2T
12
ln( )
ln( )
20
2
X
2
d1
0.07216
T
4
25%
12
4
(25% 2 )( )
2
20
F
T
12
ln( )
ln( 0 )
20
2
X
2
d2
0.07216
T
4
25%
12
p e rT [ XN (d 2 ) F0 N ( d1 )] e
9%(
4
)
12
[20 N (0.07216) 20 N (0.07216) $1.12
Using Black's Model instaed of Black-Scholes

Example
Consider a 6-month European call option on the spot price of gold, that is, an option to buy 1 ounce of
gold in 6 months. The strike price is $600, the 6 month futures price of gold is $620, the risk-free
interest rate is 5% per annum, and the volatility of the futures price is 20%.
The option is the same as a 6-month European option on the 6-month futures price.
The value of this 6-month call option on the spot price of gold is:
c e rT [ F0 N (d1 ) XN (d 2 )] e 5%0.5 [620 N (0.3026) 600 N (0.1611)] $44.19
where
620 20%2 0.5
F0 2T
ln(
)
)
600
2
X
2
d1
0.3026
T
20% 0.5
620 20%2 0.5
F
2T
ln(
)
ln( 0 )
600
2
X
2
d2
0.1611
T
20% 0.5
ln(
130
Prof. Man-lui Lau
Traders like to use the Blacks model, [Black, F. (1976): The Pricing of Commodity Contracts,
Journal of Financial Economics, 3 (March 1976): 167-79]. rather than the Black-Scholes model to
value European options on a wide range of underlying assets.
The variable F0 in equations (16.9) and (16.10) is set equal to either the futures or the forward price
of the underlying asset for a contract maturing at the same time as the option.
In the case of foreign currency, by working on the futures price instead of the spot price, there will
be no need to estimate the foreign risk-free interest rate explicitly.
In the case of stock index, by working on the futures price instead of the spot price, there will be no
need to estimate the dividend yield explicitly.
131
Prof. Man-lui Lau
X.
The Greek Letters (Chapter 17)
Example
Suppose a financial institution has sold for $300,000 an European call option on 100000 shares
of non-dividend-paying stock.
Let S $49, X $50, r 5%, 20%, T 0.3846 (20 weeks), 13%
c $2.40
"correct" cost of call option $2.40(100000) $240000
The financial institution has sold the option for $6000 more than its theoretical value and is faced with
the problem of hedging its exposure.
Possible strategies:
1.
Do nothing
i)
if after 20 weeks, the ST $50 , the call will not be exercised, the company will make
$300,000.
ii)
If $50 ST 53 , the company will make money, although by less than $300000.
iii)
If ST $53 , the company will lose money
loss (ST 50)(100000) 300000
2.
Adopt a covered position

Buying 100000 shares as soon as the option has been sold.
This strategy works well if the call is exercised. If the price drops a lot, the financial institution
will lose money.
[Put-call parity states that writing a covered call writing a naked put.]
3.
Stop-loss strategy
The hedging scheme involves buying the stock as soon as its price rises above X , and selling
as soon as it falls below X .
The scheme is designed to ensure that the institution owns the stock at time T if the option
closes in the money and that it does not own the stock if the option closes out of the money.
132
Prof. Man-lui Lau
Delta Hedging
Let f be the price of the derivative security and S be the price of the underlying asset.
DELTA ( ) of the derivative security is the rate of change of its price with respect to
the price of the underlying asset.
Definition
option price
slope
Example
of S
S
Since
1 the of the stock itself 1
S
Example
f S Ke rT
of a forward contract of a non-dividend paying stock

f
1
s
Delta of a portfolio
n
portfolio Wi i
i 1
where Wi is the number of security i and i is the delta of security i
Example
Consider a portfolio of 10 calls (i.e. 1000 shares). Each call has a 0.5 .
Then of the portfolio 0.5 100 10 500 (i.e. S $1 portfolio $500 )
Example
Consider a portfolio of 10 calls (i.e. 1000 shares) and 5 puts (i.e. 500 shares). Each call has a 0.5
and each put has a 0.3
Then of the portfolio 0.5 100 10 (0.3) 100 5 500 150 350
(i.e. S $1 portfolio $350 )
133
Prof. Man-lui Lau
Delta hedging
Example
Suppose an investor sold 20 contracts of call options (i.e. 2000 shares) which has a 0.6 .
How can the investor hedge against this position? (i.e. no matter whether S or ?
The investor should long 0.6 100 20 1200 shares of the underlying stock.
Suppose S by $1
Stocks +$1 1200 1200

Calls
offset each other
+$1 0.6 ( 2000) $1200
Suppose S by $1
Stocks $1 1200 1200

Calls
offset each other
$1 0.6 ( 2000) $1200
Note that
i)
before the investor adds the long stock position into the portfolio,
of the portfolio 0.6 100 (20) 1200

short call
ii)
after the investor adds the long stock position into the portfolio,
of the portfolio 0.6 100 (20) 1 (1200) 0
the hedged portfolio has a 0 ( -neutral)

Note: The investors position is -neutral for only a short period of time. This is because of
the call option changes with changes in S and t .
In practice, when -hedging is implemented, the hedge has to be adjusted periodically. This is
called re-balancing.
Dynamic hedging schemes have to be implemented.
Note: The Black-Scholes formula for options are derived from constructing -neutral portfolio.
134
Prof. Man-lui Lau
of European calls of non-dividend-paying stock

c SN (d1 ) Xe rT N (d 2 )
where
S
2
) (r
)T
X
2
d1
T
S
2
ln( ) (r )T
X
2
d2
d1 T
T
ln(
d
d
c
N (d1 ) SN '(d1 ) 1 Xe rT N '(d 2 ) 2
S
S
S
1 2
1
1 2 d1 d1
1 2 ( d1 T )2 d1
N (d1 ) S
e
Xe rT
e
S
S
2
2
N (d1 )
d1
S
1
1
d12
( d1
1
[ Se 2 Xe rT e 2
2
N (d1 )
d1
S
1
1
d12
rT ( d1
1
[ Se 2 Xe 2
2
d
N (d1 ) 1
S
ln(
ln(
) (r
2
2
)T
d1 T
)T d1 T T
2
) (r
X
) (r
X
ln(
) (r
T
S
T )2
1
1
d12
rT d12 d1
1
[ Se 2 Xe 2
2
d2
ln(
T )2
d1 d2
as d2 d1 T
S
S
)T d1 T
)T
T d1 T
1
1
S
d12
rT d12 ln( ) rT
d1 1
2
2
X
N (d1 )
[ Se
Xe
]
S 2
N (d1 )
135
Prof. Man-lui Lau
0.5
0
S
X
S
0
1
in the money
at the money
out of money
time to expiration
0
136
Prof. Man-lui Lau
Dynamic delta hedging

Example (short call position)
Suppose a financial institution has sold for $300,000 an European call option on 100000 shares of nondividend-paying stock.
S $49, X $50, r 5%, 20%, T 0.3846 (20 weeks), 13% , c $2.40

Simulation of Delta Hedging: Option Closes in the Money
ln(
d1
49
) (5%
50
20%
45800 52200 6400
)(0.3846)
0.0542
52200 $49 $2557800
0.2 0.3846
N ( d1 ) N (0.0542) 0.522 NORMSDIST (0.0542)

( 5%)(
100000 0.522 52200 shares

Week
Stock
Price
Delta
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
49.000
48.125
47.375
50.250
51.750
53.125
53.000
51.875
51.375
53.000
49.875
48.500
49.875
50.375
52.125
51.875
52.875
54.875
54.625
55.875
57.250
0.522
0.458
0.400
0.596
0.693
0.774
0.771
0.706
0.674
0.787
0.550
0.413
0.542
0.591
0.768
0.759
0.865
0.978
0.990
1.000
1.000
Stock
position
needed
52200
45800
40000
59600
69300
77400
77100
70600
67400
78700
55000
41300
54200
59100
76800
75900
86500
97800
99000
100000
100000
ACTION
52200
(6400)
(5800)
19600
9700
8100
(300)
(6500)
(3200)
11300
(23700)
(13700)
12900
4900
17700
(900)
10600
11300
1200
1000
0
2557.8e
Cost of
Shares
($000)
2557.8
(308.0)
(274.8)
984.9
502.0
430.3
(15.9)
(337.2)
(164.4)
598.9
(1182.0)
(664.4)
643.4
246.8
922.6
(46.7)
560.5
620.1
65.6
55.9
0.0
1
52
308 2252.3
Cumulative cost
(including
interest in $000)
2557.8
2252.3
1979.7
2966.5
3471.3
3904.9
3892.8
3559.3
3398.4
4000.5
2822.3
2160.6
2806.1
3055.6
3981.2
3938.3
4502.6
5127.0
5197.5
5258.3
5263.4
the short calls position will be assigned

in the money
the shares the investor owns will be sold @$50

cost of hedging $52634000 $50 100000 $263400
$3 100000 $263400 $36000
137
Prof. Man-lui Lau
Simulation of Delta Hedging: Option Closes Out Of Money

56800 52200 4600
ln(
d1
49
) (5%
20%
50
)(0.3846)
0.0542
52200 $49 $2557800
0.2 0.3846
N ( d1 ) N (0.0542) 0.522
( 5%)(
need 100000 0.522 52200 shares

Week
Stock
Price
Delta
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
49.000
49.750
52.000
50.000
48.375
48.250
48.750
49.625
48.250
48.250
51.125
51.50
49.875
49.875
48.750
47.500
48.000
46.250
48.125
46.625
48.125
0.522
0.568
0.705
0.579
0.459
0.443
0.475
0.540
0.420
0.410
0.658
0.692
0.542
0.538
0.400
0.236
0.261
0.062
0.183
0.007
0.000
Stock
Position
needed
52200
56800
70500
57900
45900
44300
47500
54000
42000
41000
65800
69200
54200
53800
40000
23600
26100
6200
18300
700
0
ACTION
52200
4600
13700
(12600)
(12000)
(1600)
3200
6500
(12000)
(1000)
24800
3400
(15000)
(400)
(13800)
(16400)
2500
(19900)
12100
(17600)
(700)
2557.8e
Cost of
Shares
($000)
2557.8
228.9
712.4
(630.0)
(580.5)
(77.2)
156.0
322.6
(579.0)
(48.2)
1267.9
175.1
(748.1)
(20.0)
(672.7)
(779.0)
120.0
(920.4)
582.3
(820.6)
(33.7)
1
52
228.9 2789.1
Cumulative cost
(including
interest in $000)
2557.8
2789.1
3504.2
2877.6
2299.8
2224.8
2383.0
2707.8
2131.4
2085.2
3355.1
3533.5
2788.7
2771.5
2101.4
1324.4
1445.7
526.7
1109.5
290.0
256.6
the short calls position will expire worthless
buy high!!
out of money
sell low!!
cost of hedging $256600

$3 100000 $256600 $43400
138
Prof. Man-lui Lau
of European Puts of non-dividend-paying stock
p
N (d1 ) 1 0
S
A negative means that a long position in a Put option should be hedged with a continuously
changing long position in the underlying asset, and a short position in a Put option should be hedged
with a continuously changing short position in the underlying asset.
Example:
Suppose an investor has short 20 puts (2000 shares). Let 0.5 .
of the short Put position (0.5)(100)(20) 1000

In order to hedge this position, the investor should short 1000 shares.
of the aggregate position 0.5 2000 1 1000 0

neutral
1
For S S*, 1
0.5
S*
139
Prof. Man-lui Lau
Example (short put position)

Suppose a financial institution has sold for $300,000 an European put option on 100000 shares of nondividend-paying stock.
S $49, X $50, r 5%, 20%, T 0.3846 (20 weeks), 13% , c $2.40

p c Xe r (T t ) S 2.4 50e (5%)(0.3846) 49 $2.45
By Put-Call Parity:
Simulation of Delta Hedging: Option Closes in the Money

(43200) (47800) 4600
ln(
d1
49
) (5%
50
20%
)(0.3846)
0.0542
0.2 0.3846
47800 $49 2342200
N ( d1 ) N (0.0542) 0.522
( 5%)(
need 100000 (0.478) 47800 shares
2342200e
Week
Stock
Price
N(d1)
Delta
N(d1)1
Stock
Position
Needed
ACTION
Revenue
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
49.000
49.750
52.000
50.000
48.375
48.250
48.750
49.625
48.250
48.250
51.125
51.50
49.875
49.875
48.750
47.500
48.000
46.250
48.125
46.625
48.125
0.522
0.568
0.705
0.579
0.459
0.443
0.475
0.540
0.420
0.410
0.658
0.692
0.542
0.538
0.400
0.236
0.261
0.062
0.183
0.007
0.000
-0.478
-0.432
-0.295
-0.421
-0.541
-0.557
-0.525
-0.460
-0.580
-0.590
-0.342
-0.308
-0.458
-0.462
-0.600
-0.764
-0.739
-0.938
-0.817
-0.993
-1.000
(47800)
(43200)
(29500)
(42100)
(54100)
(55700)
(52500)
(46000)
(58000)
(59000)
(34200)
(30800)
(45800)
(46200)
(60000)
(76400)
(73900)
(93800)
(81700)
(99300)
(100000)
(47800)
4600
13700
(12600)
(12000)
(1600)
3200
6500
(12000)
(1000)
24800
3400
(15000)
(400)
(13800)
(16400)
2500
(19900)
12100
(17600)
(700)
2342200
(228850)
(712400)
630000
580500
77200
(156000)
(322562)
579000
48250
(1267900)
(175100)
748125
19950
672750
779000
(120000)
920375
(582313)
820600
33688
1
52
228850 2115603
Accumulated
Revenue
(including
interest income)
2342200
2115603
1405238
2036590
2619049
2698769
2545365
2225251
2806392
2857342
1592191
1418622
2168112
2190148
2865005
3646761
3530269
4454040
3876012
4700341
4738550
the short puts position will be assigned
$4738550 $300000 5000000 $38550
140
Prof. Man-lui Lau
Simulation of Delta Hedging: Option Closes out of Money

(54200) (47800) 6400
ln(
d1
49
) (5%
50
20%
)(0.3846)
0.0542
0.2 0.3846
47800 $49 2342200
N ( d1 ) N (0.0542) 0.522
( 5%)(
need 100000 (0.478) 47800 shares
2342200e
Week
Stock
Price
N(d1)
Delta
N(d1)1
Stock
Position
Needed
ACTION
Revenue
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
49.000
48.125
47.375
50.250
51.750
53.125
53.000
51.875
51.375
53.000
49.875
48.500
49.875
50.375
52.125
51.875
52.875
54.875
54.625
55.875
57.250
0.522
0.458
0.400
0.596
0.693
0.774
0.771
0.706
0.674
0.787
0.550
0.413
0.542
0.591
0.768
0.759
0.865
0.978
0.990
1.000
1.000
-0.478
-0.542
-0.600
-0.404
-0.307
-0.226
-0.229
-0.294
-0.326
-0.213
-0.450
-0.587
-0.458
-0.409
-0.232
-0.241
-0.135
-0.022
-0.010
0.000
0.000
(47800)
(54200)
(60000)
(40400)
(30700)
(22600)
(22900)
(29400)
(32600)
(21300)
(45000)
(58700)
(45800)
(40900)
(23200)
(24100)
(13500)
(2200)
(1000)
0
0
(47800)
(6400)
(5800)
19600
9700
8100
(300)
(6500)
(3200)
11300
(23700)
(13700)
12900
4900
17700
(900)
10600
11300
1200
1000
0
2342200
308000
274775
(984900)
(501975)
(430312)
15900
337187
164400
(598900)
1182037
664450
(643388)
(246837)
(922613)
46688
(560475)
(620087)
(65550)
(55875)
0
1
52
308000 2652453
Accumulated
Revenue
(including
interest income)
2342200
2652453
2929780
1947698
1447597
1018677
1035557
1373741
1539462
942043
2124987
2791481
2150779
1906011
985232
1032867
473386
(146246)
(211937)
(268016)
(268274)
the short puts position will expire worthless
$300000 268274 $31736
141
Prof. Man-lui Lau
Note that
i)
when an investor purchases some call options from a market maker, in order to hedge the short
call position [with a () () () ], the market maker has to long an appropriate amount
of stock to hedge its position;
ii)
when an investor sells some call options to a market maker, in order to hedge the long call
position [with a () () () ], the market maker has to short an appropriate amount of
stock to hedge its position;
iii)
when an investor purchases some put options from a market maker, in order to hedge the short
put position [with a () () () ], the market maker has to short an appropriate amount
of stock to hedge its position;
iv)
when an investor sells some put options to a market maker, in order to hedge the long put
position [with a () () () ], the market maker has to long an appropriate amount of
stock to hedge its position.
of stock index paying a dividend yield

European call:
European put:
where
e qT N (d1 )
e qT [ N (d1 ) 1]
d1
ln(
S
2
) (r q )T
X
2
T
of currency
European call:
European put:
where
rf T
N (d1 )
rf T
[ N (d1 ) 1]
S
2
ln( ) (r rf )T
X
2
d1
T
of futures
European call:
European put:
where
e rT N (d1 )
e rT [ N (d1 ) 1]
d1
ln(
F 2
)
T
X
2
T
142
Prof. Man-lui Lau
Example
i)
A bank has written a 6-month European put option of 1,000,000 with X $1.6000 . Suppose
the current exchange rate is $1.6200, rUS 10% per annum, rUK 13%, 15%, and T 0.5 .
How to hedge?
e
rf T
[ N (d1 ) 1] e (13%)(0.5) [ N (0.0287) 1] 0.458
where d1
ln(
put option of a currency
S
2
) (r rf )T
X
2
0.0287
T
The total of the short put options (0.458)(1000000) 458000

In order to hedge the put option, the bank has to short the spot market. The amount needed is
458000.
Total (0.458)(1000000) (1)(458000) 0
Since the writer of the put option will lose money when the price of . Hence in order to hedge
the short put position, the bank has to short .
ii)
Now suppose instead of writing puts, the bank buys a 6-month European call option of
1,000,000 with X $1.6000 .
rf T
N (d1 ) e(13%)(0.5) N (0.0287) 0.4793
call option of a currency
The total of the long call options (0.4793)(1000000) 479300

In order to hedge the long call option, the bank has to short the spot market. The amount needed is
479300.
Total (0.4793)(1000000) (1)(479300) 0
Since the buyer of the call option will lose money when the price of . Hence in order to hedge
the long call position, the bank has to short .
143
Prof. Man-lui Lau
Example:
Suppose S $49, r 5%, 20%, T 20 weeks .
a)
A market maker purchases 100 call options (10000 shares) with X $50 .
How to hedge?
of 1 call option 0.522 of 100 long call options 0.522 100 100 5220
To construct a portfolio with 0 0.522 100 100 1 X 0 X 5220
The market maker should short 5220 shares.
The market maker with a long call position will lose money if P . Hence in order to hedge the
long call position, the market maker has to short stocks.
b)
A market maker writes 50 call options with X $50 .
How to hedge?
of 1 call option 0.522 of 50 short call options 0.522 (50) 100 2610
To construct a portfolio with 0 0.522 (50) 100 1 X 0 X 2610
The market maker should long 2610 shares.
The market maker with a short call position will lose money if P . Hence in order to hedge the
short call position, the market maker has to long stocks.
144
Prof. Man-lui Lau
Using futures to hedge

In practice, delta hedging is often carried out using a position in futures rather than using a position in
the underlying asset.
The contract that is used does not have to mature at the same time as the derivative security.
H A:
maturity of futures contract

required position in asset @ t 0 for delta hedging
HF :
alternative required position in futures contract @ t for delta hedging
T *:
Non-dividend-paying stock
F Se rT * of 1 futures contract erT *

In general, when we hedge a portfolio with delta , we solve for H A and H F in the following
formulas
H A 1 0 H A
H F erT * 0 H F erT *
Together H F e rT * H A
Stock index paying a dividend yield q
F Se( r q )T * e( r q )T *
formulas
H A 1 0 H A
H F e( r q)T * 0 H F e( r q)T *
Together H F e ( r q )T * H A
145
Prof. Man-lui Lau
Currency
F Se
( r r f )T *
( r r f )T *
formulas
H A 1 0 H A
HF e
( r r f )T *
0 H F e
Together H F e
( r rf )T *
( r r f )T *
HA
Example
A bank has written a 6-month European put option of 1,000,000 with X $1.6000 . Suppose the
current exchange rate is $1.6200, rUS 10% per annum, rUK 13%, 15%, and T 0.5 .
How to hedge?
rf T
[ N (d1 ) 1] e(13%)(0.5) [ N (0.0287) 1] 0.458
The total of the short put options (0.458)(1000000) 458000

To hedge the portfolio, the bank needs to construct a neutral portfolio:
(0.458) (1000000) 1 H A 0 H A 458000

Suppose the bank wants to hedge by using the 9-month futures contract.
HF e
( r rf )T *
H A e(10%13%)(0.75) H A 1.0228 (458000) 468442
Since the contract size of the is 62500, hence
468442
7 contracts should be used.
62500
146
Prof. Man-lui Lau
Example
Let r 10%, q 4%, 20%, S 600
i)
A financial institution writes 1000 6-month European call options on S&P500 with X 600 .
How to hedge with futures?
600
0.22
ln(
) (0.1 0.04
)(0.5)
600
2
d1
0.2828
0.2 0.5
of call options e qT N (d1 ) e (4%)(0.5) N (0.2828) 0.5993
of short call position 0.5993 (1000) 599.3

To construct a portfolio with 0 0.5993 (1000) 1 H A 0 H A 599.3
Since there is no index to be purchased, the firm has to rely on the futures market.
Suppose the financial institution uses the 9-month futures contract.
H F e ( r q )T * H A e (10%4%)(0.75) H A e (10%4%)(0.75) 599.3 572.9 573
ii)
A financial institution buys 500 6-month European call options on S&P500 with X 600 .
How to hedge with futures?
of long call position 0.5993 ( 500) 299.65

To construct a portfolio with 0 0.5993 (500) 1 H A 0 H A 299.65
Suppose the financial institution uses the 9-month futures contract.
H F e ( r q )T * H A e (10%4%)(0.75) H A e (10% 4%)(0.75) (299.65) 286.45 286
Futures versus Forwards

Note that the delta of a futures contract is different from the delta of the corresponding forward.
of a forward contract on one unit of non-dividend paying stock 1
[f S Ke rT ]
of a futures contract on one unit of non-dividend paying stock erT
[ F SerT ]
147
Prof. Man-lui Lau
of a portfolio:
portfolio wi i
i 1
Example
Consider a financial institution that has the following position on Euro:
i)
A long position in 100000 call options with X 1.2 and exercise date is 3 months.
The of each option 0.533
ii)
A short position in 200000 call options with X 1.25 and exercise date is 5 months.
iii)
A short position in 50000 put options with X 1.28 and exercise date is 2 months.
portoflio 0.533 100000 0.468 (200000) (0.508) (50000) 14900

How to hedge:
To construct a portfolio with 0 , the financial institution can long
Euro 125000 14900 Euro 1,862,500,000
Suppose the financial institution wants to hedge by using 6-month futures contract.
r 8%, rf 4%, T * 0.5
HF e
( r rf )T *
H A e(8%4%)(0.5) H A e(8%4%)(0.5) (14900) 14605
148
Prof. Man-lui Lau
Theta
where is the value of the portfolio

t
This is referred to as the TIME DECAY of the portfolio.
Definition:
Non-dividend-paying stock:
SN '(d1 )
rXe rT N (d 2 )
European call:
2 T
SN '(d1 )
rXe rT N ( d 2 )
European put:
2 T
2
1 d21
where N '(d1 )
e
2
S
2
ln( ) (r )T
X
2
d1
T
S
2
ln( ) (r )T
X
2
d2
d1 T
T
Stock index paying a dividend at rate q :

European call:
European put:
where N '(d1 )
SN '(d1 ) e qT
2 T
SN '(d1 ) e qT
1
e
2
2 T
qSN (d1 )e qT rXe rT N (d 2 )

qSN (d1 )e qT rXe rT N (d 2 )
d2
1
2
S
2
) (r q )T
X
2
d1
T
S
2
ln( ) (r q )T
X
2
d2
d1 T
T
ln(
149
Prof. Man-lui Lau
Currencies:
European call:
European put:
where N '(d1 )
SN '(d1 ) e
rf T
2 T
r T
SN '(d1 ) e f
2 T
1
e
2
rf SN (d1 )e
rf T
rf SN ( d1 )e
rXe rT N (d 2 )
rf T
rXe rT N ( d 2 )
d2
1
2
S
2
ln( ) (r rf )T
X
2
d1
T
S
2
ln( ) (r rf )T
X
2
d2
d1 T
T
Futures:
European call:
European put:
where N '(d1 )
FN '(d1 ) e rT
2 T
FN '(d1 ) e rT
1
e
2
2 T
rFN (d1 )e rT rXe rT N (d 2 )

rFN (d1 )e rT rXe rT N (d 2 )
d2
1
2
F
2
)
T
X
2
d1
T
F
2
ln( )
T
X
2 d T
d2
1
T
ln(
150
Prof. Man-lui Lau
Variation of of a European Call option with Stock Price
time to expiration
out of money
in the money
at the money
Variation of of a European Call Option with Time to Maturity

Note:
i)
Except for in-the-money European put option on a non-dividend-paying stock or for in-themoney European call option on a currency with a very high r f , is always negative.
i.e.
ii)
as time to maturity , the option tends to be less valuable.
As there is no uncertainty about the passage of time, it does not make sense to hedge against
the effect of the passage of time on an option portfolio.
151
Prof. Man-lui Lau
Example
Consider a 4-month put option on a stock index.
S 305, X 300, q 3%, r 8%, 25%, T
1
3
p
18.15
t
When t 0.01 (2.5 trading days) p 0.01 (18.15) 0.1815
18.15
18.15
18.15
0.0497 per calendar day or
0.0720 per trading day
365
252
152
Prof. Man-lui Lau
Gamma
The Gamma, , of a portfolio of derivative securities on an underlying asset is the rate of change of
the portfolio's with respect to the price of the underlying asset.
2
S S 2
where : value of the portfolio

Call price
hedging error
in delta
hedging
C"
C'
Stock Price
S
S'
The hedging error depends on the curvature of the relationship between the option price and the stock
price.
S : the change i the price of the underlying asset in a small amount of time ( t )
: the corresponding change in the value of the portfolio
Assume the volatility of the underlying asset is constant.

Then ( S , t )
(does not depend on )
By Taylors expansion, we have
1 2
1 2
1 2
2
2
( S 0 , t0 ) t S
( t )
( S )
t S
t
S
2 t 2
2 S 2
2 S t
1 2
1 2
2
( S0 , t0 )
t S
(
t
)
( S ) 2
2
2
t
S
2 t
2 S
1
t S ( S ) 2
2
For a -neutral portfolio and a small t , we have
1 2
1

t
( S ) 2 t ( S ) 2
2
t
2 S
2
153
Prof. Man-lui Lau
Example
Suppose that the of a -neutral portfolio of options on an asset is 10000 . Suppose S 2 or 2
over a short period of time, there will be a change in the value of the portfolio of
1
1
t ( S ) 2 (0) (10000)(2) 2 $20000
2
2
Note:
long stock
short stock
long call
short call
long put
short put
long futures
short futures
f
S
1
+
+
+
2 f
S 2
0
0
+
10000 the portfolio has a net short call and short put position
Making a portfolio -neutral
Why?
It can be regarded as a first correction for the fact that the position in the underlying asset (or the
futures contract on the underlying asset) cannot be changed continuously when -hedging is used.
Because a position in the underlying asset or in a futures contract on the underlying asset has a 0 ,
the only way a financial institution can change the of its portfolio is by taking a position in a traded
option.
154
Prof. Man-lui Lau
Suppose
of a neutral portfolio
of a traded option T
# of traded options added to the portfolio wT
T
[Since the addition of traded options in the portfolio will change the , so the position in the
underlying asset then has to be changed to maintain neutrality.]
-neutal portfolio wT T 0 wT
Note that the portfolio is only -neutal instantaneously. As time passes, -neutrality can be
maintained only if the position in the traded option is adjusted so that it is always equal to
Example
Portfolio:
0,
3000
Traded call options:
T 0.62,
T 1.50
Task: To make the portfolio both -neutral and -neutral

Let X be the number of trade options needed to make the portfolio neutral
3000 X (1.50) 0 X 2000

Note that once 2000 traded options are added to the portfolio, the of the portflio becomes
0 2000(0.62) 1240
In order to make the portfolio -neutral again, we have to add some shares to the portfolio.
Let Y be the number of shares needed to make the portfolio -neutral again.
1240 Y (1) 0 Y 1240
1240 shares have to be sold (or shorted).
155
Prof. Man-lui Lau
.
T
Example:
Option 1:
# 100000,
0.5,
1.0
Option 2:
# 50000,
0.6,
1.5
of the portfolio (100000)(0.5) (50000)(0.6) 50000 30000 80000

of the portfolio (100000)(1.0) (50000)(1.5) 100000 75000 25000
Task: To make the portfolio both -neutral and -neutral with the following traded option is available
Traded call options: T 0.8,
T 4.0
Let X be the number of traded options added to the portfolio

Let Y be the number of shares added to the portfolio
80000 X (0.8) (Y )(1) 0
25000 X (4.0) (Y )(0) 0
X 6250, Y 75000
of a Non-dividend-paying stock
N '( d1 )
European Call/Put:
S T
N '(d1 )
1
2
d2
1
2
d1
ln(
S
2
) (r
)T
X
2
T
of Stock Index Paying a Continuous Dividend at Rate q
European Call/Put:
N '(d1 )e qT
S T
N '(d1 )
1
2
d2
1
2
d1
ln(
S
2
) (r q
)T
X
2
T
Example
4-month Put option on a Stock Index

4
S 305, X 300, r 8%, q 3%, 25%, T
12
qT
N '(d1 )e
0.00866 i.e. index 1 point by 0.00866

S T
156
Prof. Man-lui Lau
Variation of Gamma with

Stock Price for an Option
S
X
A call options Delta and

Gamma are a function of
the price of the underlying
asset relative to the options
strike price
0
out of money
0
in the money
high means the value of the option holders position

is highly sensitive to jumps in the stock price
out of money
at the money
Valuation of Gamma with

Time to Maturity for a Stock
Option
in the money
Time to maturity
0
157
Prof. Man-lui Lau
Currency
European Call/Put:
N '(d1 )e
rf T
S T
N '(d1 )
1
2
d2
1
2
d1
ln(
S
2
) ( r rf
)T
X
2
T
Futures
European Call/Put:
N '(d1 )e rT
S T
N '(d1 )
1
2
d12
d1
ln(
F
2
)
T
X
2
T
Relationship Among , , and
1 2 2 2
rS
S
r
t
S 2
S 2
1
rS 2 S 2 rf
2
or
1
rS 2 S 2 r
2
For a neutral portfolio, 0
Note:
and
1
2 S 2 rf
2
158
Prof. Man-lui Lau
Vega
Definition:
Note:
i)
If is high in absolute term, the portfolios value is very sensitive to small change in volatility.
ii)
If is low in absolute term, the volatility changes have relatively little impact on the value of
the portfolio.
iii)
A position in the underlying asset or in futures contract has a 0 .
Example
Constructing a neutral portfolio
0, 5000, 8000
Portfolio:
0.6, 0.5, 2.0
Traded option:
To construct a -neutral portfolio, we can include the traded options in the portfolio.
8000 2 X 0 X 4000
Note that the of the new portfolio 5000 0.5 (4000) 3000
Constructing a v neutral, neutral and neutral portfolio
Portfolio:
Traded option 1:
Traded option 2:
0, 5000, 8000
0.6, 0.5, 2.0
0.5, 0.8, 1.2
Let X i be the number of trade option i added to the portfolio.

To construct a v neutral and neutral portfolio.
:
5000 0.5 X1 0.8 X 2 0
:
8000 2 X1 1.2 X 2 0
X1 400, X 2 6000
:
0 0.6 (400) 0.5 (6000) 3240
To make the new portfolio neutral, the investor should sell (short) 3240 shares.
159
Prof. Man-lui Lau
S
2
ln( ) (r )T
X
2
Non-dividend-paying stock
SN '(d1 ) T
d1
T
S
2
ln( ) ( r q
)T
X
2
SN '(d1 )e qT T
d1
Stock Index
T
S
2
ln( ) (r rf )T
r T
X
2
d1
Currency
SN '(d1 )e f T
T
S
2
ln( )
T
rT
X
2
d1
Futures
FN '(d1 )e
T
T
Using the formulas implicitly assumes that the price of an option with a variable volatility is the same
as the price of an option with constant volatility.
The v of an option is always positive.
Variation of Vega with

Stock Price for an Option
S
X
Note:
i)
neutrality corrects for the fact that time elapses between hedge re-balancing.
neutrality corrects for a variable .
ii)
Example
put option
S 305, X 300, r 8%, q 3%, 25%, T
66.44 i.e. 1% in (from 25% to 26%) p by 0.6644 0.01 66.44
4
12
When the volatility of the underlying asset is not constant, we have
1 2
1 2
1 2
2
2
( S 0 , t0 , 0 ) t S

(
t
)
S
)
( ) 2
2
2
2
t
S
2 t
2 S
2
2
2
2
1
1
1
t S
t
S
2 t S
2 t
2 S
1
t S ( S ) 2
2
160
Prof. Man-lui Lau
Rho
Definition:
European Call:
XT e rT N (d 2 )
European Put:
XT e rT N (d 2 )
Non-dividend-paying stock:
d2
Stock index
d2
Futures
d2
Currencies ( r )
d2
S
2
) (r )T
X
2
T
S
2
ln( ) (r q )T
X
2
T
S
2
ln( )
T
X
2
T
S
2
ln( ) ( r rf )T
X
2
T
ln(
Currencies ( r f )
European Call:
ST e
European Put:
ST e
d1
ln(
rf T
rf T
N ( d1 )
N ( d1 )
S
2
) ( r rf
)T
X
2
T
Example
4-month stock index put option
S 305, X 300, r 8%, q 3%, 25%
XT e rT N (d 2 ) 42.57
i.e.
a 1% point increase in the risk-free interest rate (from 8% to 9%), the value of the option
decreases by 0.4257.
161
Prof. Man-lui Lau
Scenario Analysis
In addition to monitoring risks such as , , and , option traders often also carry out a scenario
analysis. The analysis involves calculating the gain or loss on their portfolio over a specified period
under a variety of different scenarios.
Consider a bank with a portfolio of options on a foreign currency. There are 2 main variables upon
which the value of the portfolio depends. These are the exchange rate and exchange rate volatility.
Suppose that the exchange rate is currently 1.0000 and its volatility is 10% annum. The bank would
calculate a table, such as Table 14.7, showing the profit or loss experienced during a 2-week period
under different scenarios. This table considers 7 different exchange rates and 3 different volatilities.
Because a 1-standard-derivation move in the exchange rate during a 2-week period is about 0.02, the
exchange rate moves considered are approximately 1, 2, and 3 standard deviations.
Table
Volatility
8%
10%
12%
Profit or Loss Realized in 2 Weeks Under Different Scenarios ($ millions)

0.94
+102
+80
+60
0.96
+55
+40
+25
0.98
+25
+17
+9
Exchange Rate
1.00
+6
+2
-2
162
1.02
-10
-14
-18
1.04
-34
-38
-42
Prof. Man-lui Lau
1.06
-80
-85
-90
Replicating Options with Positions in Stock and Cash1

Suppose we want to replicate a long call option using only stock and cash. To succeed, our replicating
strategy must satisfy 3 conditions:
i)
for small change in the stock price, the initial out-of-pocket investment must give the same
absolute, dollar return as a call;
ii)
to equalize the rate of return, the initial out-of-pocket investment must equal the value of the
call; and
iii)
thereafter, since a call requires no further investment, the replicating strategy must be selffinancing.
Example
Consider a call of a non-dividend-paying stock. Let S $15, c $3 and 0.5
Assume the investor has $3 of cash initially.
i)
Instead of buying the call, the investor can borrow $4.5 and buy 0.5 share of the stock.
ii)
Instead of selling the call, the investor can sell 0.5 share of the stock and keep $10.5.
Example
Consider a put of a non-dividend-paying stock. Let S $15, p $3 and 0.4
Assume the investor has $3 of cash initially.
i)
Instead of buying the put, the investor can sell 0.4 share of the stock and keep $9.
ii)
Instead of selling the put, the investor can borrow $3 and buy 0.4 share.
Note that as time and the price of the underlying asset change, the investor has to re-adjust the
number of shares in the portfolio as changes.
For long call position, S of the long call (example: +0.3 0.4) hold more stock.
For short call position, S of the short call (more negative) (example: 0.3 0.4) sell
more stock.
For long put position, S of the long put (less negative) (example: 0.6 0.5) buy back
some stock.
For short put position, S of the short put (example: +0.6 0.5) sell some stock.
Rubinstein, Mark and Hayne E. Leland (1981): Replicating Options with Positions in Stock and Cash, Financial
Analysts Journal, July/August, p. 63-72.
163
Prof. Man-lui Lau
Portfolio Insurance
Consider a fund manager holding a $90 million portfolio whose value mirrors the value of the S&P500
index. Suppose that the S&P500 is standing at 900 and the manager wishes to insure against the value
of the portfolio dropping below $87 million in the next 6 months.
Methods to insure against the value of the portfolio dropping below a certain level:
1.
Buying put options:
current index
# of options
$100 900 1000 $90, 000, 000
The manager can buy 1000 6-month put option contracts on the S&P500 index with an exercise price
of 870 and a maturity in 6-month. If the index drops below 870, the put options will be in the money
and provide the manager with compensation for the decline in the value of the portfolio.
Consider the case where the index drops to 810 at the end of 6 months. The value of the managers
stock portfolio is likely to be about $81 million. Because each option contract is on 100 times the
index, the total value of the put options is $6 million $100 60 1000 . This brings the value of the
entire holding back up to $87 million (excluding the cost of the options).
2.
Creating put options synthetically:
This strategy involves taking a varying position in the underlying asset (or futures on the underlying
asset) so that the of the position is maintained equal to the of the required option.
[This strategy could be carried one stage further by using traded options to match the and of the
required options.]
The position necessary to create an option synthetically is the reverse of that necessary to hedge it.
This reflects the fact that a procedure for hedging an option involves the creation of an equal and
opposite option synthetically.
Why?
a)
The option markets do not always have the liquidity to absorb the trades that managers of large
fund would like to carry out.
b)
Fund managers often require strike prices and exercise dates that are different from those
available in traded options markets.
164
Prof. Man-lui Lau
Example
A fund manager with a well-diversified portfolio wants to buy a put option on the portfolio with a
strike price of X and an exercise date in T .
S
2
ln( ) ( r q
)T
qT
X
2
of a put e [ N (d1 ) 1]
d1
T
In order to create the put option synthetically, the fund manager would ensure that at any given time a
portfolio e qT [1 N (d1 )] of the stocks in the original portfolio has been sold.
As the value of the original portfolio declines, the of the put becomes more negative and the
proportion of the portfolio sold must be increased.
As the value of the original portfolio increases, the of the put becomes less negative and the
proportion of the portfolio sold must be decreased (i.e. some of the original portfolio must be
repurchased).
Using this strategy to create portfolio insurance means that, at any given time, funds are divided
between the stock portfolio in which insurance is required and the risk-less assets. As the value of the
stock portfolio increases, risk-less assets are sold and the position in the stock portfolio is increased.
As the value of the stock portfolio declines, the position in the stock portfolio is decreased and risk-less
assets are purchased.
The cost of the insurance arises because the portfolio manager is always selling after a decline in the
market and buying after a rise in the market.
Note:
long put position has a negative
short call position also has a negative
Therefore instead of longing puts, an investor can short calls. [The investor just has to choose a
call with the same absolute value.]
165
Prof. Man-lui Lau
Example
Consider a fund manager holding a $100 million portfolio whose value mirrors the value of the
S&P500 index. Suppose the manager wishes to insure against the value of the portfolio dropping
below $85 million in the next 12 months.
Assume that S 1000, X 850, r 6%, q 2%, 20%, and T 1 .
long $100 millions of stock+ loan of $1,437,000
long 1000 put with X 850
the value of the portfolio

will not go below 85
million (excluding the cost
of the long puts position)
of the required put 0.130

100, 000, 000
# of put
1000
100 1000
cost of the put 14.37 $100 1000 $1, 437, 000
Assume the stock index goes down by 1% in 1 day (ignore time value and dividend)
stock $100 million (1%) $1, 000, 000
value of put options $100 points #options $100 (0.13) [(1%)*1000] 1000 $130000
portfolio $1000000 $130000 $870, 000
0.130 This shows that 13% of the portfolio should be sold initially.
long $100 millions of stock short $13 million of stock+ $13 million cash
long $87 million stock $13 million cash
Assume the stock index goes down by 1% in 1 day (ignore time value and dividend)
portfolio stock $87 million (1%) $870, 000
If the value of the portfolio reduces to $98 million soon after this has been done, the
of the required put 0.153 and a further 2.3% should be sold.
[Note that we can similarly assume S 200, X 170 , we will have the same !
In general, since the original portfolio is worth $100 million and we want to make sure the portfolio
S 100
value does not go below $85 million, we just need to take

X
85
Also notice that the cost of the puts will be the same as well.]
Note that S 98, X 85, r 6%, q 2%, 20%, and T 1 0.153 .
166
Prof. Man-lui Lau
Use of Index Futures

H F e ( r q )T * H A e ( r q )T *{e qT [1 N (d1 )]} e rT *eq (T *T ) [1 N (d1 )]
Example
The manager of a $90 million portfolio mirroring the index wishes to create a 6-month put option with
strike price of $87 million.
In this case, S 900, X 870, r 9%, q 3%, 25%, and T 0.5
of the required put e qT [ N (d1 ) 1] 0.322
Hence, if trades in the portfolio are used to create the option, 32.2% of the portfolio, i.e.
32.2% $90 million $28,980, 000 should be sold initially.
If 9-month futures contracts on the S&P500 are used, T * 0.75, so that the number of futures
shares shorted should be
H F e ( r q )T * H A e (9%3%)(0.75) $28,980, 000 $27, 704,807

#contracts shorted
27704807
123.13 123
250 900
Note:
1.
Creating put options on the index synthetically does not work well if the volatility of the index
changes rapidly or if the index exhibits large jumps.
2.
Portfolio insurance will destabilize the stock market.
3.
The strike price for the options created should be the expected level of the market index when
the portfolios value reaches its insured value.
4.
The number of options created is times the number of options that would be required if the
portfolio had a 1.0 .
167
Prof. Man-lui Lau
Flexible Exchange (FLEX) Options

In contrast to conventional options that are listed by exchanges, FLEX options are established through
a special procedure that allows investors to specify the contract terms, such as the options strike price,
exercise style, and expiration date of the listed options. Once the terms of the FLEX options are set, an
investor can then post a request for quote for this customized option.
Once the request for quote is posted and is disseminated to trader screens and the trading floor,
responding quotes can be submitted. The trader requesting the quote can then decide whether to accept
the responding quote, or to revise the terms of the quote. Once the quote is accepted, a trade occurs
and a FLEX option is created. Note that no quotes of the FLEX options are available after they are
created. To trade an established FLEX option, the investor uses the same procedure for creating the
FLEX option.
FLEX options are issued and guaranteed by the Options Clearing Corporation. This effectively
eliminates the counter-party credit risk in the OTC market. .
[Index FLEX options first appeared in 1993 as a way for the option exchanges to compete with the
over-the-counter market.]
Constraints on the types of options eligible for FLEX trading
1)
Equity FLEX options

a)
b)
c)
2)
T 5
minimum size is 250 contracts (25,000 shares)

not all stocks are eligible
Index FLEX options

a)
b)
c)
T 10
minimum size threshold of $10 million in notional value for the underlying index
covered by the requested options
only a few indexes are eligible
168
Prof. Man-lui Lau
XI.
Volatility Smiles
p S c Xe rT
Put-call parity:
This put-call parity must be satisfied, even if the options are mispriced. It implies that if the call is
mispriced, then the put should also be mispriced. It also implies the calls and puts with the same
strike price should have the same implied volatility.
Volatility smile for currency options
implied
volatility
strike price
implied
Both small and large

movements in the
exchange rate are more
likely than with the
lognormal distribution.
lognormal
Table:
Intermediate movements
are less likely.
% of days when daily exchange rate moves are greater than 1, 2, , 6 standard
deviations
>1 SD
>2 SD
>3 SD
>4 SD
>5 SD
>6 SD
Real world
25.04
5.27
1.34
0.29
0.08
0.03
169
Lognormal distribution
31.73
4.55
0.27
0.01
0.00
0.00
Prof. Man-lui Lau
Reasons for the Smile in Foreign Currency Options

1.
The volatility of the asset is not constant.
2.
The price of the asset does not change smoothly, sometimes it exhibits jumps (which may be
induced by government intervention).
Equity options
implied
volatility
strike price
implied
There is a higher
probability that the price
will go down and a
smaller probability that
the price will go up.
lognormal
Reason:
As a companys equity declines in value, the companys leverage increases. As a result the volatility
of its equity increases, making even lower stock prices more likely.
As a companys equity increases in value, leverage decreases. As a result the volatility of its equity
declines, making a higher stock price less likely.
Note that this pattern has begun to happen after the stock market crash of October 1987. Traders are
concerned about the possibility of another crash similar to October 1987, and they price options
accordingly.
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Prof. Man-lui Lau
XII.
Value at Risk (VaR)
The VaR measure

Value at Risk (VaR) is an attempt to provide a single number for senior management summarizing the
total risk in a portfolio of financial assets.
The VaR calculation is aimed at making a statement of the following form:
We are X % certain that we will not lose money more than V dollars in the next N days.
The variable V is the VaR of the portfolio. It depends on the time horizon N, and the confidence
interval X % .
It is the loss level over N days that has a probability of only (100 X )% of being exceeded.
When N days is the time horizon and X % is the confidence interval, VaR is the loss corresponding
to the (100 X ) th percentile of the distribution of the change in the value of the portfolio over the next
N days.
For example, if N 5 and X 97 , VaR is the 3 percentile of the change of the distribution of changes
in the value of the portfolio over the next 5 days.
(100 X )%
VaR
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Prof. Man-lui Lau
How bank regulators use Var

The Basel Committee on Bank Supervision is a committee of the worlds bank regulators that meet
regularly in Basel, Switzerland.
In 1988 it published The 1988 BIS Accord. It is an agreement between the regulators on how the
capital a bank is required to hold for credit risk should be calculated.
In 1996, the Basel Committee published The 1996 Amendment which was implemented in 1998 and
required banks to hold capital for market risk as well as credit risk. The Amendment distinguishes
between a banks trading book and its banking book.
The banking book consists primarily of loans and is usually revalued on a regular basis for
managerial and accounting purposes.
The trading book consists of a portfolio of different instruments that are traded by the bank (stocks,
bonds, swaps, forward contracts, options, etc.) and is normally revalued daily.
The 1996 BIS Amendment calculates capital for the trading book using the VaR measure with
N 10 and X 99 . This means that it focuses on the revaluation loss over a 10-day period that is
expected only 1% of the time.
The capital it requires the bank to hold is k VaR (with an adjustment for the specific risks).
The multiplier k is chosen on a bank-by-bank basis by the regulators and must be 3 .
For a bank with excellent well-tested VaR estimation procedures, it is likely that k will be set equal
to 3.
For other banks, k will be set 3 .
The time horizon
N day VaR 1 day VaR N

As regulators require a banks capital for market risk to be at least 3 times the 10-day 99% VaR.
the capital level 3 10 1-day 99% VaR 9.49 1-day 99% VaR
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Prof. Man-lui Lau
Historical Simulation
In historical simulation, past data are used to predict what might happen in the future.
Suppose we want to calculate VaR for a portfolio using a 1-day time horizon, a 99% confidence level,
and 501 days of data.
Step 1: Identify the market variables affecting the portfolio. These will typically be exchange rates,
equity prices, interest rates and so on.
Step 2: Collect data on the movements in these market variables over the most recent 501 days. This
provides 500 alternative scenarios for what can happen between today and tomorrow.
Scenario 1 is where the % changes in the values of all variables are the same as they were between Day
0 and Day 1.
Scenario 2 is where the % changes in the values of all variables are the same as they were between Day
1 and Day 2.
Scenario i is where the % changes in the values of all variables are the same as they were between Day
i 1 and Day i .
Step 3: For each scenario, we calculate the dollar change in the value of the portfolio between today
and tomorrow.
This defines a probability distribution for daily changes in the value of our portfolio.
Step 4: The fifth-worst daily change is the first percentile of the distribution.
The estimate of Var is the loss at this first percentile point.
Assuming that the last 500 days are a good guide to what would happen the next day, we are 99%
certain that we will not take a loss greater than our VaR estimate.
Table 1
Day
0
1
2
3
498
499
500
Observations of the market variables (for VaR historical simulation calculation)

Market Variable 1
20.33
20.78
21.44
20.97
25.72
25.75
25.85
Market Variable 2
0.1132
0.1159
0.1162
0.1184
0.1312
0.1323
0.1343
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Market Variable N
65.37
64.91
65.02
64.90
62.22
61.99
62.10
Prof. Man-lui Lau
Assume today is Day 500.

The ith scenario assumes that the value of market variable tomorrow (Day 501) is v500
Scenario
1
Variable 1
20.78
25.85
26.42
20.33
21.44
25.85
26.67
20.78
vi
.
vi 1
Variable 2
0.1159
0.1343
0.1375
0.1132
0.1162
0.1343
0.1346
0.1159
Table Scenarios generated for tomorrow (Day 501) using data in Table 1
Scenario
Market
Variable 1
26.42
26.67
25.28
25.88
25.95
1
2
3
499
500
Note:
Market
Variable 2
0.1375
0.1346
0.1368
0.1354
0.1363
Market
Variable N
61.66
62.21
61.99
61.87
62.21
Portfolio Value
($ million)
23.71
23.12
22.94
23.63
22.87
Change
($ million)
+0.21
-0.38
-0.56
+0.13
-0.63
The value of the portfolio today $23.50 million

These changes are ranked.
The fifth-worst loss is the 1-day 99% VaR.
Model-building approach (Variance-covariance approach)

Daily Volatilites
In option pricing, time is usually measured in years and the volatility of an asset is usually quoted as a
volatility per year.
In VaR calculations we usually measure time in days and the volatility of an asset is usually quoted as
a "volatility per day".
day
year
252
or year day 252 so that the daily volatility is about 6% of annual volatility.
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Prof. Man-lui Lau
S
N ( t , 2 t ) t is approximately equal to the SD of the % change in the asset price
S
in time t .
If t 1 , then day is approximately equal to the SD of the % change in the asset price in 1 day.
For the purpose of calculating VaR, we assume exact equality.
Calculation of VaR in Simple Situations

Assumptions:
i)
We are considering a portfolio of assets.
ii)
The changes in the values of the asset prices have a multivariate normal distribution.
An One-Asset Portfolio
Example:
Consider a portfolio consisting of a position worth $10 million in shares of IBM.
Let N 10 and X 99 (so that we are interested in the loss level over 10 days that we are 99%
confident will not be exceeded).
Assume that the daily volatility day 2% (so that year 2% 252 32% ).
day 2% daily change of the portfolio value (2%)($10, 000, 000) $200, 000
Assume that the expected change in the price of a market variable over the time period is 0.
Note that the expected change in the price of a market variable over a short time period is generally
small when compared with the standard deviation of the change.
Assume IBM has an expected return of 13% per annum.
13%
0.05% . ( SD of return 2% )
252
Over a 10-day period, the expected return (0.05%)(10) 0.5% SD of return 10 (2%) 6.3% )
Over a one-day period, the expected return
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Prof. Man-lui Lau
Assume that the change is normally distributed.

Note that Z N (0,1) P( Z 2.33) 1% .
That is, there is a 1% probability that a normal distributed variable will decrease in value by more than
2.33 standard deviation.
Or, we are 99% certain that a normally distributed variable will not decrease by more than 2.33
standard deviations.
X Z Z as Z
N (0,1) and 0
In other words, there is a 1% probability that the value of the portfolio will decrease by more than
Z 2.33 $200000 $466000
The 1-day 99% VaR for this portfolio of $10 million in IBM (2.33)($200000) $466000
The 10-day 99% VaR for this portfolio of $10 million in IBM (2.33)(200000) 10 $1, 473,621
Example:
Consider a portfolio consisting of a $5 million position in AT&T.
Suppose the daily volatility day of AT&T is 1% daily change (1%)($5, 000, 000) $50, 000
Assume the change is normally distributed.
The 1-day 99% VaR for this portfolio of $5 million in AT&T (2.33)($50000) $116500
The 10-day 99% VaR for this portfolio of $5 million in AT&T (2.33)(50000) 10 $368405
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Prof. Man-lui Lau
A Two-Asset Portfolio
Example:
Consider a portfolio of both $10 million of IBM shares and $5 million of AT&T shares.
Suppose that the returns on the 2 shares have a bivariate normal distribution with a correlation
coefficient of 0.7.
Note that X Y X2 Y2 2 X Y
X : IBM Y : AT&T
X 200000,
Y 50000 X Y 2000002 500002 (2)(0.7)(200000)(50000) 220227
The 1-day 99% VaR for this portfolio (2.33)($220227) $513129

The 10-day 99% VaR for this portfolio $513129 10 $1622657
The Benefits of Diversification

The 1-day VaR for the portfolio of IBM shares $466000
The 1-day VaR for the portfolio of AT&T shares $116500
The 1-day VaR for the portfolio of both IBM and AT&T share $513129
Benefit of diversification ($466000 $116500) $513129 $69371
Suppose IBM and AT&T are perfectly correlated.
X 200000,
Y 50000
X Y 2000002 500002 (2)(1)(200000)(50000) (200000 50000)2 250000

The 1-day 99% VaR for this portfolio (2.33)($250000) $582500 $466000 $116500
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Prof. Man-lui Lau
The linear model

Suppose that we have a portfolio worth P consisting of n assets with an amount i being invested in
asset i, (1 i n) .
i : the amount invested in asset i (1 i n) it is not a percentage
n
P i
i 1
xi : the return on asset i in one day

dollar change in the value of the investment in asset i in one day i xi
n
P i xi
where P is the dollar change in the portfolio value in one day
i 1
Example:
1: IBM
2: AT&T
1 10,
2 5 P 10 x1 5 x2
Since the expected return of both IBM and AT&T are 0 the expected return of P 0 .
i : the daily volatility of the ith asset

ij : the coefficient of correlation between returns on asset i and asset j
P : the standard deviation of P
n
P2 iji j i j i2 i2 2 iji j i j
i 1 j 1
i 1
i 1 j i
P N : the standard deviation of the change over N days

The 99% VaR for an N-day time horizon 2.33 P N .
Example:
1 2%, 2 1%, 12 0.3, 1 10, 2 5

P2 (10)2 (2%) 2 (5) 2 (1%) 2 (2)(10)(5)(0.3)(2%)(1%) 0.0485
P 0.220
the standard deviation of the change in the portfolio value per day (in millions of $).
The 10-day 99% VaR (2.33)(0.220)( 10) $1.623 million
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Prof. Man-lui Lau
When the linear model can be used

We can use the linear model when the portfolio does not consist of positions in derivatives in stocks,
bonds, foreign exchange, and commodities. In this case, the change in the value of the portfolio is
linearly dependent on the change in the value of the underlying market variables (stock prices, zerocoupon bond prices, exchange rates and commodity prices) and we can use the equation
n
P2 iji j i j i2 i2 2 iji j i j
i 1 j 1
i 1
i 1 j i
For the purpose of VaR calculation, all asset prices are measured in the domestic currency. Hence the
linear model can accommodate positions in assets such as foreign equities and foreign bonds.
Example:
Consider a forward contract to buy a foreign currency. Suppose the contract matures @T . It can be
regarded as the exchange of a foreign zero-coupon bond maturing @T for a domestic zero-coupon
bond maturing @T . For the purposes of calculating VaR, the forward contract is treated as a long
position in the foreign bond combined with a short position in the domestic bond.
Example:
Consider an interest rate swap. This can be regarded as the exchange of a floating-rate bond for a
fixed-rate bond. The fixed-rate bond is a regular coupon-bearing bond. The floating-rate bond is
worth par just after the next payment date. It can be regarded as a zero-coupon bond with a maturity
date equal to the next reset date. The interest rate swap can be reduced to a bond portfolio.
The linear model and options

The linear model is only an approximation when the portfolio contains options.
Consider a portfolio consisting of a options on a single stock whose current price is S .
P
P S
S
S
Let x
S
P S x
Suppose we have a position in several underlying market variables and includes options.
n
P Si i xi
i 1
where Si : the value of the i th market variable

i : the delta of the portfolio with respect to the i th market variable
n
This is the same as the equation P i xi
where i Si i
i 1
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Prof. Man-lui Lau
Example
Consider a portfolio consisting of options on IBM and AT&T. The options on IBM have a 1000
and the options on AT&T have a 20000 . SIBM $120, S ATT $30 .
n
Hence P Si i xi =(120)(1000) x1 +(30)(20000) x2 =120000 x1 +600000 x2

i 1
where
x1 : proportional change in the prices of IBM

x2 : proportional change in the prices of AT&T
1 2%, 2 1%, 0.3
P (120)2 (0.02)2 (600)2 (0.01)2 2(0.02)(0.01)(0.3)(120)(600) 7.099 (in thoudands of dollars)

The 5-day 99% VaR (2.33)($7099) 5 $36986
The 5-day 95% VaR (1.65)($7099) 5 $26193
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Prof. Man-lui Lau
A Quadratic Model
When a portfolio includes options, the linear model is an approximation. It does not take account of
the gamma of the portfolio.
Probability distribution for value

Probability distribution for value
of portfolio with positive
of portfolio with negative gamma
gamma
The VaR for a portfolio is critically dependent on the left of the probability distribution of P . For
example, when the confidence level used is 99%, the VaR is the value in the left tail below which there
is only 1% of the distribution.
A positive gamma portfolio tends to have a thinner left tail than the normal distribution. If we assume
the distribution is normal, we will tend to calculate a VaR that is too high.
A negative gamma portfolio tends to have a fatter left tail than the normal distribution. If we assume
the distribution is normal, we will tend to calculate a VaR that is too low.
For a more accurate estimate of VaR than that given by the linear model, we can use both the delta and
gamma measures to relate P to the xi 's.
Consider a portfolio dependent on a single asset whose price is S .
1
P S ( S ) 2
2
S
1
P S x S 2 ( x) 2
Setting x
S
2
The variable P is not normal.
Assume that x N (0, ) , then the first 3 moments of P are
1
E ( P ) S 2 2
2
3
E[( P) 2 ] S 2 2 2 S 4 4 2
4
9
15
E[( P)3 ] S 4 2 4 S 6 6 3
2
8
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Prof. Man-lui Lau
Monte Carlo Simulation

We can use Monte Carlo Simulation to generate the probability distribution for P .
Procedure:
1.
Value the portfolio today in the usual way using the current values of market variables.
2.
Sample once from the multivariate normal probability distribution of the xi 's.
3.
Use the values of the xi 's. that are sampled to determine the value of each market variable at
the end of the day.
4.
Reveal the portfolio at the end of the day in the usual way.
5.
Subtract the value calculated in step 1 from the value in step 4 to determine a sample P .
6.
Repeat step 2) to 5) many times to build up a probability distribution for P .
The VaR is calculated as the appropriate percentile of the probability distribution of P .
Suppose that we calculate 5000 different sample values of P in the way just described.
The 1-day 99% VaR is the value of P for the 50th worst outcome (1% of 5000).
The 1-day 95% VaR is the value of P for the 250th worst outcome (5% of 5000).
N -day Var N (1 day Var)
Principal Component Analysis

One approach to handle the risk arising from groups of highly correlated market variables is principal
component analysis. This takes historical data on movements in the market variables and attempts to
define a set of components or factors that explain the movements.
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Prof. Man-lui Lau

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Econ 455/655 Options and Futures I

Professor Man-lui Lau

Forward and Future Contracts

A DERIVATIVE (or derivative security) is a financial instrument whose value depends

A FORWARD CONTRACT is an agreement to buy or sell an asset at a certain future

ECON 455/655 Options and Futures I

Prof. Man-lui Lau

Note: A forward contract is settled at maturity.

ECON 455/655 Options and Futures I

Prof. Man-lui Lau

A Futures Contract is a forward contract trading in an exchange. The futures contract

ECON 455/655 Options and Futures I

Prof. Man-lui Lau

Of course if she is wrong, the following may happen.

($0.011121 $0.009) 12,500,000 $26,512.50

Of course if she is wrong, the following may happen.

ECON 455/655 Options and Futures I

Prof. Man-lui Lau

Suppose a company is going to receive 1 million in September. In order to avoid any

Current September Futures price $1.5827

Current September Futures price $1.0019

September Spot Price

ECON 455/655 Options and Futures I

Prof. Man-lui Lau

Operation of Margins in Trading Futures (marking to the market)

buy 2 December Gold futures @$400/ounce. (100 ounces per contract)

Margin call ($)

1340 4000 2660

sell 1 December Yen futures @$0.009613 ( 12,500,000 per contract)

Cumulative gain (loss) ($)

ECON 455/655 Options and Futures I

Margin call ($)

1087.50 2025 937.5

Prof. Man-lui Lau

sell 1 December S&P500 Index futures @1376.40 ($250 Index)

Daily gain (loss)

Margin call ($)

5900 19687 13787

These problems give rise to BASIS RISK.

ECON 455/655 Options and Futures I

Prof. Man-lui Lau

Optimal Hedging Ratio

Cov(S , F ) E[(Si E (S ))(Fi E (F )]

Var (S hF ) Var (S ) Var (hF ) 2Cov(S , hF ) S2 h2 F2 2h S F

Optimal hedge ratio:

ECON 455/655 Options and Futures I

Prof. Man-lui Lau

Rolling the hedge forward

ECON 455/655 Options and Futures I

Prof. Man-lui Lau

Forward and Futures Prices

Value at the end of 1 year

r4 : quarterly compounding interest rate

ECON 455/655 Options and Futures I

Prof. Man-lui Lau

Convergence of futures price to spot price

Suppose FT ST , this gives rise to an arbitrage opportunity for traders.

ECON 455/655 Options and Futures I

Prof. Man-lui Lau

t : current time (years)

ECON 455/655 Options and Futures I

Prof. Man-lui Lau

Forward contracts on a security that provides no income (non-dividend-paying stocks and