Lecture2 2010 Courseworks

E4718 Spring 2010: Derman: Lecture 2:Dynamic Replication: Realities and Myths of Options Pricing
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Lecture 2: Dynamic Replication: Realities and

Myths of Options Pricing
Summary of Lecture 1.
Focus on understanding, not efficiency.
The smile: appeared after 1987; inconsistent with Black-Scholes; appears in
all global index options markets; flattens at long expirations when plotted
against K S ; has a negative correlation between slope of the smile and volatility level.
Modeling principles: financial engineering is constructive; financial science
is reductive and unfortunately, has only a limited number of useful principles,
mainly the law of one price: portfolios with the same payoff under all circumstances have the same value.
Relative valuation works better than absolute valuation; models take you from
the known prices of liquid securities to the estimated value of illiquid securities
with unknown prices;
relative valuation is for arbitrageurs and manufactures of securities; dynamic
replication is much more difficult than static replication.
Replication is the best valuation strategy; first static, if not dynamic. Dynamic
is subject to many assumptions.
Its hard to test models in finance, partly because of the dual nature of implied
and realized variables.
You cannot really assign probabilities to human events. People remember the
past and are not coin tosses. Distinguish between quantifiable uncertainty
(risk) and true uncertainty.
My job, I believe, is to persuade others that my conclusions are sound. I
will use an array of devices to do this: theory, stylized facts, time-series
data, surveys, appeals to introspection and so on.
In the real world of research, conventional tests of [statistical] significance seem almost worthless.
Fischer Black
The EMH and Brownian motion are a model of reality, not reality itself, not a
fact. Its not clear that there is an accurate model for reality when it involves
human behavior.
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What Well Cover in Lecture 2

No riskless arbitrage.
GBM and models of risky securities
Diluting, diversifying or hedging risk
Derivatives
Theory of dynamic replication.
Black-Scholes equation.
Trading Volatility.
Practical difficulties and limitations: discrete hedging, which hedge ratio,
transactions costs.
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2.1 The Risk of Stocks

A stocks most important feature is the
The evolution of a stocks return
uncertainty of its return. About the
return
simplest model of uncertainty is the
up
risk involved in flipping a coin. The
t + t
figure at right illustrates a similarly
0.5
simple model, a binary tree, for the
evolution of the price of a stock with
mean t
riskless
return volatility over a small instant
0
return zone
of time t. On an up-move the price
increases by t + t , while on an
0.5
t t
equally probable down-move it
down
t
increases by only t t . The volatility is the measure of the stocks
risk, and is the expected return.
According to the principle of no riskless arbitrage, the riskless rate of return r
must lie in the zone between the up- and down-returns. For, if both the up- and
down-returns were greater than the riskless return, you could create a portfolio
that is long $100 of stock and short $100 of a riskless bond with zero price and
a paradoxically positive payoff under all future scenarios. Any model with
such possibilities is in trouble before it leaves the ground. A riskless return in
the riskless zone can be written as a convex combination of the up- and downreturns where the pseudo-probabilities of up and down moves will ultimately
be the no-arbitrage probabilities in the risk-neutral measure used in options
valuation. This means that there is a measure in which the stock evolution is a
martingale.
This apparently naive either-up-or-down model captures much of the inherent
risk of owning a stock and many other securities. Repeated over and over again
for small time steps, it mimics the more-or-less continuous motion of prices in
a reasonable though imperfect way, and leads to a normal distribution of
returns. (Ask yourself whether its believable that real stocks always behave
this simply.)
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2.2 Risk Reduction

Recall the law of one price, or the principle of no riskless arbitrage:
Any two securities with identical future payoffs, no matter how the future turns
out, should have identical current prices.
But what future expected reward justifies a particular present risk? This is the
paramount question of life and finance. If you know the future volatility of a
stock, what rate of return should you expect?
The law of one price tells you how to value securities you can replicate, but
some payoffs cannot be replicated. Certain risk factors are intrinsic and
unavoidable. We can extend the law of one price (identical payoffs have identical prices) to demand that identical risks should have identical expected
returns. But we have to be careful; some risks can be mitigated and you
shouldnt be rewarded for taking them. Therefore, to be more precise, we
demand that
Identical unavoidable risks should have identical expected returns.
We can use this less restrictive version of the law of one price to determine the
relation between risk and return, illustrated in what follows in our binomial
world. The key ideas is that there are three ways to modify risk: (i) by adding a
riskless bond to the portfolio of stocks, (ii) by diversifying, and (iii) by hedging
away a common factor.
2.2.1 Risk Reduction With Riskless Bonds: More Expected

Risk, More Expected Excess Return
We begin by examining the effect of adding a riskless short-term bond to any
risky position.
cash
The binary tree describing a riskless The evolution of a riskless bonds price
bond, shown at right, is degenerate:
return
whether the stock moves up or
up
down, the bond produces a guaran1 + rt
teed return (1 + rt), as shown at
down
right. The returns of the riskless
bond have zero volatility. By adding
t
a riskless bond with zero volatility
to the stock of volatility and
expected return , you commensurately reduce both the risk and return of your
investment.
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Consider a mixture of w% risky stock with volatility and (1 - w)% riskless

bond. The binary tree for this mixture, obtained by combining the two previous
trees, is shown at below.
return
up
w ( t + t ) + ( 1 w )rt
0.5
w * stock + (1 - w) * cash
0.5
w ( t t ) + ( 1 w )rt
down
The expected return for this mixture is wt + ( 1 w )rt . The volatility of

returns is w .
Suppose we chose a different volatility ' and let w = ' . Then the volatility of the mixture is ' and the expected return is ' = r + ( ' ) ( r ) .
Rearranging terms, we see that
' r
r
------------ = ----------- =
'
Eq.2.1
Assuming our invariance principle, all stocks or portfolios of stocks must have
the same Sharpe ratio , and so
r =
Eq.2.2
Excess return is proportional to risk.

In the next class well show that a similar result holds for options values, and is
equivalent to the Black-Scholes equation.
2.2.2 Risk Reduction by Diversification

You can reduce risk by combining a stock with a riskless bond. But you can
also diminish risk by diversifying. If you can accumulate a portfolio of so
many uncorrelated unavoidable risks that their risks cancel in the limit as the
number of stocks become large, so that the portfolios net volatility
approaches zero, then, by the law of one price, it must produce an excess return
of zero for the entire portfolio. But the excess return of the entire portfolio is
the weighted sum of the excess returns of each individual member of the port-
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folio, each of which is proportional to their individual non-zero volatility via

the Sharpe ratio. Hence the Sharpe ratio in the equations above for this portfolio must be zero. But the Sharpe ratio is the same for all portfolios of stocks, so
that = 0 in general. Thus,
= r
each stock in the portfolio must earn the riskless rate too, so that = r and the
Sharpe ratio is zero If all risk factors can be cancelled by diversification,
investors should expect only the riskless return on any single stock.
2.2.3 Risk Reduction by Hedging

Stock markets arent truly amenable to the total diversification we assumed
above. Thats because large financial markets are more than a collection of
individual uncorrelated risk factors. Experienced investors are always trying to
detect patterns in the universe of stock returns. They perceive stocks as belonging to groups that have in common their sensitivity to a particular asset, factor
or set of factors.
Let be the correlation of the returns between any stock S with volatility and
some tradable risky asset M with volatility M . Because of the correlation
between each stocks return and that of M, you can hedge away the M-related
risk of any stock. If you have $100 invested in a stock S, you can short times
as many dollars of the factor M against it, where = ( M ) is the number
of percentage points the stock S is expected to rise when M rises by 1%. This
factor-hedged portfolio, consisting of a $100 long position in the stock combined with times as much of a short position in M, is expected to carry no net
exposure to the price of M, because any increase in the price of the stock will,
on average, be cancelled by a correlated decrease in value of the short position
in M.
The net expected return on this M-neutral stock is proportional to the return of
the stock S less times the return of M, namely M . This portfolios
return is uncorrelated with M, and, assuming there are no other factors influencing the stock, its residual risk is unavoidable. Only the residual risk/volatility of each stock remains.
Now, having hedged away the risk of M, we can combine the resultant M-neutral stock with a riskless bond to obtain any residual volatility. The excess
return of the M-neutral stock must then be proportional to its residual volatility,
as in Equations 2.2. Furthermore, by diversifying over many stocks whose Mrisk has been hedged away, we can show that the Sharpe ratio here is zero too.
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As a result1, assuming the invariance principle,

( r ) = ( M r )
Eq.2.3
This is the Capital Asset Pricing Model or Arbitrage Pricing Theory: in

a world of rational investors, the excess return you can expect from
buying a stock is its times the expected return of its hedgable factor.
Put differently, you can only expect to be rewarded for the unavoidable
factor risk of each stock, since all other risk can be eliminated by diversification.
The rationality of investors and this result above is hotly debated. You
dont have to be a rocket science to see that this cant always be true.
1. Spelled out in more detail in Section 2 of The Perception of Time, Risk and
Return During Periods of Speculation, Quantitative Finance Vol 2 (2002)
282296, or http://www.ederman.com/new/docs/qf-market_bubbles.pdf
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2.2.4 Derivatives Are Not Independent Securities
If you know the price of a simple stock, whose payoff is linear, what is the value of the nonlinear
option? What is the value of curvature?
A stock is straight, an option curved.

stock S
payoff at expiration
A derivative is a contract whose value is determined

by a specified relation between its payoff and that of
a simpler security called its underlyer. Often, the
relation is nonlinear. The most relevant characteristic of a derivative is the curvature of its payoff C(S),
as illustrated for a simple call option at right.
call option C(S),

strike $100
S
$100
In the binary tree model, there are only two possible

states (up and down) for the stock or the option after Binary price trees for a stock S and a $1 investment in a
a time t. These states are spanned by two indepen- riskless bond. The stock and bond can be decomposed
dent securities, the stock itself and a riskless bond.
into a security u that pays off only in the up state and a
You can use linear algebra to decompose the stock
security d that pays off only in the down state.
and bond into a basis of two more elemental securi- _____________________________________
ties u and d , each respectively paying off in only
one of the final states, as shown at right. By creating
SU
a portfolio that is a suitable mixture of these two
1 + rt
one-state securities u and d , you can replicate the
u
S
payoff of any non-linear function C(S) over the next
instant of time t, no matter into which state the
0
SD
decompose
stock evolves. Note that the portfolio consisting of
0
1 + rt
both u and d is riskless and pays out $(1+rt)
and therefore the sum of their present values is 1.
1
The value of the option is therefore the price of the

mixture of stock and bond that replicates it. In the
limit as t becomes infinitesimally small, you can
repeat this replication strategy instant after instant,
so that, if the final payoff C(S) is known, its replication at all earlier times is determined. The value of
the replicating portfolio depends on the difference
between the up-return and the down-return at each
node in the binary tree, that is, on the stocks volatility . If you know the future volatility, you can synthesize an option out of stock and bonds.
1 + rt
1 + rt
You can replicate an options nonlinear payoff over

each instant by suitable investments in the elemental
securities
u and d .
CU
C
CD
(1+rt)C = (CU). u+ (CD). d

The same strategy of dynamic replication can be
extended to more complex and realistic models of
stock evolution, as well as to the replication of derivatives on all sorts of other underlyers.
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2.2.5 The choice-of-currency/numeraire trick

It seems obvious that value of a security in dollars should be independent of
the currency (US dollar, Japanese yen, share of IBM, etc.) you choose for modeling its evolution. A little thought often suggests a natural choice of currency
that can greatly simplify thinking about a problem, and sometimes reduce its
dimensionality. Just as stock analysts find it convenient to use the P/E ratio to
measure a stocks price in units of projected earnings rather than dollars,
thereby making stock comparison easier, so financial modelers can sometimes
cleverly choose a more meaningful currency than the dollar when valuing a
complex security. Convertible bonds, for example, which involve an option to
exchange a bond for stock, can sometimes be fruitfully modeled by choosing a
bond itself as the natural valuation currency.
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2.3 Methods of Replication

2.3.1 Static Replication
If you can create a static hedge or replicating portfolio for your payoff, you
have very little trading or model risk.
Put from a call: Put-Call Parity
Suppose you need a put but you can only buy a call. Then compare the payoffs
at expiration:
call
call S + K
call S
is same as a put
Thus price of put = price of call - price of stock + PV(K).

A collar: A collar is a very popular instrument
for portfolio managers who have made some
gains during the year and now want to make
sure they keep some upside but dont lose too
much downside. The payoff is shown at right.
collar
LB
UB
You can write the payoff as

LB + call ( S, LB ) call ( S, UB )
which is the payoff of a bond plus a call spread. Using put-call parity you can
also write it as
S + put ( S, LB ) call ( S, UB )
which is long the stock, long a protective put and short a call that gives away
the upside. A long position in a put and a short position in a call with a higher
strike is called a collar. Its popularity forces dealers to be short puts and long
calls.
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Generalized payoffs:
Suppose you can approximate the payoff at a fixed single time in the future as
a piecewise-linear payoff function of the terminal stock price S that is defined
by its intercept and successive slopes as in the following payoff diagram:
payoff F(S)
slope
0
intercept I
0
K0
K1
K2
Then the payoff is the payoff of a portfolio consisting of a zero-coupon bond

ZCB(I) with face value I, plus a series of calls C(Ki) with successively higher
strikes Ki:
ZCB ( I ) + 0 S + ( 1 0 )C ( K 0 ) + ( 2 1 )C ( K 1 ) + ...
and the value of this generalized payoff is the value of the bond and the calls in
the market.
You can check that, for example, between K1 and K2, the payoff of the portfolio above is
I + 0 S + ( 1 0 ) ( S K0 ) + ( 2 1 ) ( S K1 )
= I + 0 K0 + 1 ( K1 K0 ) + 2 ( S K1 )
which is the correct intercept and the correct slope.
2.3.2 Static Hedge for a European Down-and-Out Call

Consider a European down-and-out call option with time t to expiration on a
stock with price S and dividend yield d. We denote the strike level by K and the
level of the out-barrier by B. We assume in this particular example that B and K
are equal and that there is no cash rebate when the barrier is hit. There are two
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classes of scenarios for the stock price paths: scenario 1 in which the barrier is
avoided and the option finishes in-the-money; and scenario 2 in which the barrier is hit before expiration and the option expires worthless. These are shown
in Figure 2.1 below.
FIGURE 2.1. A down-and-out European call option with B = K.
scenario 1:
barrier avoided
value = S - K
stock
price
B=K
knockout barrier
scenario 2 :
barrier hit
value = 0
expiration
time
In scenario 1 the call pays out S' K , where S' is the unknown value of the stock
price at expiration. This is the same as the payoff of a forward contract with
delivery price K. This forward has a theoretical value F = Se dt Ke rt ,
where d is the continuously paid dividend yield of the stock. You can replicate
the down-and-out call under all stock price paths in scenario 1 with a long
position in the forward.
For paths in scenario 2, where the stock price hits the barrier at any time t'
before expiration, the down-and-out call immediately expires with zero value.
In that case, the above forward F that replicates the barrier-avoiding scenarios
of type 1 is worth Ke dt' Ke rt' . This matches the option value for all barrierstriking times t' only if r = d. So, if the riskless interest rate equals the dividend
yield (that is, the stock forward is close to spot1), a forward with delivery price
K will exactly replicate a down-and-out call with barrier and strike at the same
level K, no matter what.
When the stock hits the barrier you must sell the forward to end the trade.
1. In late 1993, for example, the S&P dividend yield was close in value to the short-term
interest rate, and so this hedge might have been applicable to short-term down-and-out
S&P options
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2.4 Dynamic Replication and its Consequence:

the Black-Scholes PDE
Classical options theory is based on the insight that, in an idealized and simplified world, options are not an independent asset, and can therefore be replicated perfectly in terms of simpler securities. Assume interest rates are zero
here, to be simple.
2.4.1 The (assumed) stochastic behavior of stock prices: geometric Brownian motion
S + S t
volatility of returns
dS
------ = dZ
S
S S t
t
Therefore, over a small instant of time t, a stock with volatility will generate a move S = S t .
A stock S is a primitive, linear underlying security If you own a stock
worth S, you profit if it goes up, lose if it goes down. You have a linear position
in S.
If you are long an option, you
can profit no matter whether
the stock goes up or down!
Look at a call with the payoff
on the right. The call has curvature, or convexity.
call option
C
S
stock price
You profit on an up-move, lose nothing on a down move. What is the fair price
for C(S,K,t,T)?
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We can do a Taylor series expansion on the unknown price C( ) and examine

how its value changes as time t passes and the stock moves by an amount S:
C ( S + S, t + t ) = C ( S, t ) +
C
t
t +
S, t
C
S
S +
S, t
C
S
2
S, t
( S )
-------------- + . .
2
Eq.2.4
This is a quadratic function of S. The linear term behaves like the stock price
itself, the quadratic terms increases no matter what the sign of the move in S.
If you were long the call C, you could hedge away the linear term in S if you
C
C
by shorting that many shares of the stock. ( =
is
S
S
dimensionless, a number.) The the resultant profit and loss of the hedged
option position looks like this:
knew the derivative
long call
C(S)
short stock
C
=
S
S
long a call and short shares of stock
produces a curved hedged payout.
1
2
P&L --- ( S )
2
positive
curvature
Convexity generates a profit or loss that is quadratic in (S). Positively curved

or convex securities allow you to make a profit irrespective of whether the
stock moves up or down. Similarly, negatively curved or concave securities
generate a loss on any stock price move. To get the benefit of pure curvature
you must delta-hedge away the linear part of the call option which would otherwise swamp it.
What Should You Pay for Convexity?
Suppose we think we know the future volatility of the stock, . Over time t, a
stock with volatility is expected to move an amount S = SZ ( 0, 1 ) t ,
where Z ( 0, 1 ) represents a normal distribution with mean zero and standard
deviation 1. In a binomial approximation to the continuous evolution of the
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stock price, you can represent the stock moves as S = S t with

2
2 2
( S ) = S t .
1
1
2
2 2
Change in value from the movement in stock price --- ( S ) = --- ( S t )
2
2
Change in value from passage of time = ( t ) where =
C
t
Then, from Equation 2.4, the total change in value of the hedged position is
1
2 2
dP&L = d ( C S ) = --- ( S t ) + ( t )
2
There is nothing stochastic about this; all dependence on the uncertain moves
of S have cancelled out to leading order in the Taylor series. If we think we
know the future volatility , then we know exactly how far the stock will move
over time t, even though we dont know its direction. The potential profit and
loss is completely deterministic, irrespective of the direction of the stock price
move.
Since the hedged portfolio is riskless, an investment in it behaves exactly like
an investment in a short-term riskless bond. The principle of no riskless arbitrage dictates that hedged portfolio and the riskless bond should have the same
current value. In this example with zero interest rates, the riskless bond generates no interest, so its final value and initial value are identical. Therefore the
final value of the hedged portfolio must be identical to its initial value, and so
1 2 2
+ --- S = 0
2
Eq.2.5
Written out in full, this is the Black-Scholes equation for zero interest rates:
2
C 1 2 2 C
+ --- S
= 0
2
t 2
S
Eq.2.6
The Black-Scholes equation relates the decay of an options value over time to
its curvature and the expected stock volatility S. The solution is:
C BS ( S, K, , t, T ) = SN ( d 1 ) KN ( d 2 )
2
ln ( S K ) 0.5 ( T t )
d 1, 2 = -------------------------------------------------------- Tt
1
N ( z ) = ---------2
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dy
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By differentiation (note that d 1 is itself a function of S)

BS
C BS
= N ( d1 )
S
Eq.2.8
The options tells you how many shares to short of the stock so as to remove
the linear exposure of the option so you can trade its quadratic part.
When the riskless rate r is non-zero, we will show in a subsequent chapter that
2
C
C 1 2 2 C
+ rS + --- S
= rC
2
t
S 2
S
Eq.2.9
2.4.2 Hedging an Option Means Betting On Volatility

is the implied volatility that we inserted in order to determine how to price
the option based on our expectation of future volatility.
Suppose1 the stock actually evolves with a realized volatility , so that in reality S SZ ( 0, 1 ) t . Then the actual P&L is determined by
1 2 2
--- S t
2
1 2 2
--- S t
2
The gain from curvature is

The loss from time decay t is
The last identity above follows from Equation 2.5.

The net P&L during time t is
1
2
2 2
--- ( )S t .
2
Eq.2.10
This value is path dependent unless S is independent of the stock price,

which is not the case for vanilla options.
After the Black-Scholes PDE and the Black-Scholes formula, Equation 2.10 is
one of the most important equations in options valuation.
1. In these notes we (almost) always use to represent realized volatility and to represent implied volatility.
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Here is an illustration of the contributions to the P&L:
P&L
A hedged position earns the

S2weighted difference between
realized and implied volatility
1 2 2
--- S t
2
2 2
2
1
Net P&L = --- S ( )t
2
stock
shift S
1 2 2
--- S t
2
This illustration describes the bet you are making in taking a long position in a
hedged option. To profit, you need the realized volatility to be greater than the
implied volatility. A short position profits when the opposite is true.
Note: Black-Scholes uses a single unique volatility for all strikes K and expirations T, because the volatility, real or implied, is the volatility of the stock, not
the option. If Black-Scholes is correct, then is independent of K, t, T and S.
2.4.3 An Aside: The Convexity of Bonds

Consider a zero-coupon T-maturity bond at time whose price at time t with
yield to maturity y T is represented by B ( y T, t, T ) . You can think of bonds as
nonlinear derivatives of interest rates.
The graph of bond price B vs. yield to maturity y looks like
B(yT,t,T)
B(y1,t,1)
y0
If you hedge the long bonds price by buying a one-year bond with price
B ( y 1, t, 1 ) whose behavior is approximately linear in the yield (because its
short term), then you again have a convex P&L for the hedged portfolio as a
function of yields, assuming they move simultaneously and in parallel, and
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there are somewhat analogous PDEs for bond pricing that follow from the
principle of no riskless arbitrage.
The tricky part which Im ignoring here is that yields dont have to move in
parallel, and so, at the minimum, you need a model which takes account of all
yield moves in a consistent model, for example a one-factor short-rate model
like Ho-Lee or BDT or Vasiek. In these one-factor models all bond prices
depend on the short rate as the only stochastic variable, and you can hedge any
single bond with another bond of a different maturity, or indeed with an option
on a bond. Of course, these models exclude the possibility of more than one
factor, that is, of different bonds moving in independent ways.
2.4.4 The Two Kinds of Volatility

I will use to denote implied volatility and to denote a stocks actual (realized) volatility.
Realized Volatility. The realized daily volatility d of an index Si over a
period of N days is the square root of the variance of the daily log returns ri:
Si + 1
S i
r i = log ----------- ------- Si
Si
2
1
2
2
2
d = ------------- ( r i r ) = r r
N1
i
Therefore, over an instant of time t, an index with volatility will move

roughly S d S t where t is the time elapsed in units of a fraction of a
day.
The realized volatility of daily returns is d =
The variance of one-year returns is
log return.
rd ( rd ) .
2
= r a ( r a ) , where r a is the annual

2
If the stock evolution follows geometric Brownian motion, then Nd = N d .

As a rough rule of thumb, a year has approximately 252 trading days, and so
a 16 d .
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Implied Volatility is the value of the volatility parameter in the Black-Scholes

equation that makes the value of the option C BS ( S, K, t, T, ) in that model
match the market price C obs of the option:
C BS ( S, K, t, T, ) = C obs
Eq.2.11
If different options imply different implied volatilities, then the implied BlackScholes volatility of a vanilla call or put can in general be a function
( S, t, K, T ) where K is the strike and T the expiration of the option when the
underlyer value is S at time t. If in fact the market prices of vanilla calls and
puts are such that does vary with strike, then we have a volatility smile and
the Black-Scholes model is inconsistent with market prices.
One way to think of implied volatility is as the markets guess at future average
volatility, perhaps modified by a fear factor, supply and demand, and an understanding of how the Black-Scholes model fails to capture all the features of
realized stock returns and their volatility. Implied volatility is often merely a
quoting convention that incorporates into one number everything you need to
know to get the dollar price from the Black-Scholes formula, and is closely
linked to but not equal to expectations about realized volatility.
The value of a call option in the Black-Scholes model can never be worth more
than the stock. If it were, an initial long position in the call and a short position
in one share of stock requires a positive outlay of cash. However, at expiration,
the long-call/short-stock position always has a negative payoff.) As long as a
call price C is worth less than the current stock price S, there always exists a
unique Black-Scholes implied volatility , because C in the Black-Scholes
model is a monotonic function of whose derivative given by
2
d1
-------2
(T t)
C
Se
= --------------------------------
2
Eq.2.12
which is always positive.

There is another way to derive Equation 2.12 that makes use of the way in
which volatility and time are connected in the Black-Scholes partial differential equation. For interest rates set equal to zero, Equation 2.6 specifies that
2
C 1 2 2 C
+ --- S
= 0
2
2
S
where = T t is the options time to expiration.
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For constant volatility you can rewrite this as

C
1 2 C
--- S
= 0
2
2
( ) 2 S
so that, since the partial differential equation depends on time only through
2
the variable ,
2 2
C
C
2 C
= 2
= S
2
2
( )
S
You can differentiate Equation 2.8 easily to show that the RHS of the equation
is equal to the RHS of Equation 2.12.
If the riskless rate r is non-zero, you can change variables in the Black-Scholes
partial differential equation Equation 2.9 by writing the solution C as
C = exp [ r ( T t ) ] X ( F, K, t, T, ) where F = S exp [ r ( T t ) ] .
In terms of these variables, Equation 2.9 reduces to
2 2
X 1 2 2 X
+ --- F
= 0
2
2
F
and so the derivative with respect to is similarly related to the derivative with
2
respect to the total variance .

A question to think about: To trade options efficiently, is it better to model
implied volatility or realized volatility? What if theyre not the same?
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2.5 The Black-Scholes Equation and Sharpe

Ratios
Valuation by perfect replication is the theoretical bedrock on which options
pricing is based. We assume
Continuous stock price movements (one-factor geometric Brownian

motion) with constant volatility; no other sources of randomness; no
jumps.
Ability to hedge continuously by taking on arbitrarily large long or short

positions.
No bid-ask spreads.
No transactions costs.
No forced unwinding of positions.
Consider at time t a stock price St, a riskless bond Bt that earns interest rate rt,
and an option price Ct.
The stochastic evolution of the stock and bond prices are given by
dS t = S S t dt + t S t dZ t
Eq.2.13
dB t = B t r t dt
The option price is a function C ( S t, t ) whose evolution is given by
2
C t
C t
1 Ct
2
dC t =
dt +
dS t + --- 2 ( t S t ) dt
S
t
2S
2
C t
C t C t
1 Ct
2
=
+
S S t + --- 2 ( t S t ) dt +
S dZ
S t t t
S
2 S
t
C C t dt + C C t dZ t
where by definition
2
1 C t C t
1 Ct
2
= -----
+
S + --( S )
Ct t
S S t 2 S 2 t t
C
2/1/10
Eq.2.14
1 C t
= -----
S
C t S t t
Lecture2.2010.fm
Page 22 of 41
We can create a riskless portfolio out of S and C. Define = S + C

Then
d = { S S t dt + t S t dZ t } + { C C t dt + C C t dZ t }
Eq.2.15
= ( S S t + C C t )dt + ( t S t + C C t )dZ t
That the portfolio be riskless necessitates
C C
= ----------S S
Eq.2.16
That no riskless arbitrage is allowed means that a riskless portfolio must earn
the riskless rate, so that d = rdt . From Equation 2.15 this leads to
S S + C C = ( S + C )r
Rearranging the terms we obtain
S ( S r ) = C ( C r )
Substituting for from Equation 2.16 leads to the relation
C r
S r
--------------- = -------------C
S
Eq.2.17
Only if the stock and the option have equal Sharpe ratios, that is equal expected
returns per unit of volatility, will the option and the stock allow no arbitrage.
This is the argument by which Black originally derived the Black-Scholes
equation.
Substituting from Equation 2.14 into Equation 2.17 for C and C we obtain
2
1 Ct
2
1 C t C t
-----
+
S S t + --- 2 ( t S t ) r
S
2S
Ct t
S r
---------------------------------------------------------------------------------------------- = -------------S
1 C t
-----
S t
Ct S t
which leads to
2
C
C 1 2 2 C
+ rS + --- S
= rC
2
t
S 2
S
2/1/10
Black-Scholes equation
Eq.2.18
Lecture2.2010.fm
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Note how the terms involving S cancelled out of the equation, so that there is
no dependence on the drift of the stock price.
Well look at this solution and its derivatives in more details in subsequent lectures. Its good to get very familiar with manipulating this solution, its derivatives or Greeks, and the approximations to it via Taylor expansions when the
option is close to at-the money (i.e. S K ). The solution, the Black-Scholes
formula and its implied volatility, is the quoting currency for trading prices of
vanilla options. You can get a great deal of insight into more complex models
by regarding them as perturbations or mixtures of different Black-Scholes
solutions.
C ( S, K, t, T, r, ) = e
r ( T t )
SF = e
[ S F N ( d 1 ) KN ( d 2 ) ]
r(T t )
S
2
d 1, 2
ln ( S F K ) 0.5 ( T t )
= --------------------------------------------------------- Tt
1
N ( z ) = ---------2
Eq.2.19
y 2
dy
Notice that except for the r ( T t ) term, time to expiration and volatility
2
always appear together in the combination ( T t ) . If you rewrite the formula in terms of the prices of traded securities the present value of the bond
K PV and the stock price S then indeed time and volatility always appear
together:
C ( S, K, t, T, ) = [ SN ( d 1 ) K PV N ( d 2 ) ]
K PV = e
r ( T t )
K
2
d 1, 2
ln ( S K PV ) 0.5 ( T t )
= ------------------------------------------------------------ Tt
1
N ( z ) = ---------2
Eq.2.20
y 2
dy
Note that the time to expiration appears in the formulas in two different combi2
nations, r ( T t ) the discount factor and ( T t ) the total variance. Smart

users of the formula can enter their estimates of the total variance, which on
average may be smaller on weekends than on weekdays, for example.
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Comment: Options traders get very familiar with the behavior of vanilla
option prices and hedge ratios because they watch their movement and deltas
all day long, and so get a feel for how prices vary. Theorists have to do the
same, i.e. get familiar and gain intuition, but they have to do it by playing with
the formula, manipulating, understanding and approximating it.
2.5.1 Some Useful Derivatives of the Black-Scholes Model

2
x 2
e
N' ( x ) = -------------2
SF ( T t )
ln ----- ---------------------1
K
2
N' ( d 1, 2 ) = ---------- exp --------------------------------------------------2
2
2 ( T t )
S 2
ln -----F
2
ln ( S F K )
K
1
( T t )
exp
-----------------------= ---------- exp -----------------------exp
----------------------+
2
8
2
2
2 ( T t )
SF
N' ( d 2 ) = N' ( d 1 ) exp [ ln ( S F K ) ] = -----N' ( d 1 )
K
d 1, 2
1
= ----------------------K
K T t
d 1, 2
SF
1
(T t)
= ------------------------- ln ----- -------------------2
K
2
(T t)
2
d1
-------2
C
Se
(T t)
= --------------------------------
2
C
r ( T t )
= e
N ( d2 )
K
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2.6 Another View: Option Valuation as Consistent Interpolation

Practitioners in the derivatives world tend to regard options models and their
valuation formulas as interpolating functions for hybrid securities. A convertible bond, for example, is part stock, part bond: it becomes indistinguishable
from the underlying stock when the stock price is sufficiently high, and equivalent to a corporate bond when the stock price is sufficiently low. A convertible
bond valuation model provides a rational formula for smoothly interpolating
between these two extremes. In order to provide the correct limits, the model
must be calibrated. A convertible model that didnt produce the market value
of a pure corporate bond at asymptotically low stock prices would be fatally
suspect.
One can view the Black-Scholes formula in a similar light. Assume that a stock
S that pays no dividends has future returns that are lognormal with volatility
. A plausible way to estimate the value at time t of a European call C with
strike K expiring at time T is to calculate its expected discounted value, which
is given by
C ( S, t ) = e
= e
R ( T t )
( E [ S K ]+ )
R ( T t )
{ Se
(T t )
N ( d 1 ) KN ( d 2 ) }
Eq.2.21
where R is the appropriate but unknown discount rate, still unspecified, and
is the unknown expected growth rate for the stock.
The analogous formula for a put P is given by
P ( S, t ) = e
= e
R ( T t )
R ( T t )
( E [ K S ]+ )
{ KN ( d 2 ) Se
(T t)
N ( d1 ) }
Eq.2.22
where
(T t)
(T t)
Se
ln --------------------- ---------------------2
K
= ------------------------------------------------------ Tt
2
d 1, 2
Eq.2.23
We have forced the discount rate R to be identical for both puts and calls,
because we are taking the viewpoint of a dealer or market-maker who, for
practical reasons, wants to use a single average discount rate for all securities
in his portfolio with the same expiration.
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A dealer or market-maker in options, however, has additional consistency constraints. As a manufacturer rather than a consumer of options, the marketmaker must make prices consistent with the value of his raw supplies. He must
notice that a portfolio F = C P consisting of a long position in a call and a
short position in a put with the same strike K has exactly the same payoff as a
forward contract with expiration time T and delivery price K whose fair current
value is
F = S Ke
r ( T t )
Eq.2.24
where r is the true riskless discount rate for time to expiration ( T t ) .

The individual formulas of Equation 2.21 and Equation 2.22 must be consistent with the constraint that when they are combined to value the portfolio F
which statically replicates a forward contract, they should produce the same
value. If they are not calibrated to satisfy this, the market-maker will be valuing his options, stock and forwards inconsistently. What is necessary to satisfy
this?
Combining Equation 2.21 and Equation 2.22 we obtain
F = CP = e
R ( T t )
{ Se
(T t )
K}
Eq.2.25
The requirement that Equation 2.24 and Equation 2.25 be consistent dictates
the appropriate average discount rate R in the options formula be the zero-coupon discount rate r and that the unknown expected growth rate for the stock
be equated to the same value.
In this way the Black-Scholes options formula results from an assumed future
volatility plus an expected- average-discounted-value approach to valuation,
combined with the requirement that valuation be consistent with the static replication of forward contracts by portfolios of options.
A similar interpolation argument can be used to derive the values of more complex derivatives (quantos for example) that are dependent on a larger number
of underlyers by requiring consistency with the values of all tradeable forwards
contracts on those underlyers.
We now proceed to examining the behavior of the profit and loss of dynamic
hedging strategies.
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2.7 The P&L of Hedged Trading Strategies

Consider an initial position at time t0 in an option C that is -hedged with borrowed money which earns
interest r, and then rehedged using in discrete steps at times t i and corresponding stock prices S i . We use
the notation C n = C ( S n, t n )
tn,Sn
t0,S0
Hedging
action
Buy C0,
t2,S2
Share
Value
Dollars Received
From Shares Traded
0 S0
0 S0
none
0 S1
0 S0 e
get short 1
shares by
shorting
1 0
shares
1 S1
none
short 0
shares
t1,S1
No.
Shares
n = ( S n, t n ) .
C0
rt
0 S0 e
rt
C1 0 S1 + 0 S0 e
rt
C1 1 S1 + 0 S0 e
rt
+ ( 1 0 )S 1
1 S2
0 S0 e
get short 2
shares by
shorting
2 1
shares
get short n
shares by
shorting
n n 1
shares
2 S2
0 S0 e
+ ( 1 0 )S 1
2rt
+ ( 1 0 )S 1 e
t2,S2
Net Value of Position:

Option + Stock + Cash
C2 1 S2 + 0 S0 e
rt
2rt
+ ( 1 0 )S 1 e
+ ( 1 0 )S 1 e
C2 2 S2 + 0 S0 e
rt
+ ( 2 1 )S 2
( 1 0 )S 1 e
2rt
rt
2rt
rt
+ ( 2 1 )S 2
etc.
tn,Sn
2/1/10
n Sn
0 S0 e
nrt
Cn n Sn + 0 S0 e
nrt
+ ( 1 0 )S 1 e
( n 1 )rt
+ ( 1 0 )S 1 e
( n 1 )rt
+ ( 2 1 )S 2 e
( n 2 )rt
+ ( 2 1 )S 2 e
( n 2 )rt
... + ( n n 1 )S n
... + ( n n 1 )S n
Lecture2.2010.fm
Page 28 of 41
Looking at the last line of the above table, you can see that the result of buying
the initial call at a price C0, shorting stock to hedge it and then investing the
money in an interest-bearing account leads, after n steps of size t , where
T t = nt , to a final fair value
CT T ST + 0 S0 e
r(T t)
+ e
r(T )
S [ d ] b
where the subscript b at the end of the formula denotes a backwards Ito integral, and the initial value of the hedged portfolio was C 0 . This amount could
have been invested at the riskless interest and would have grown to C 0 e
r(T t)
Therefore, the fair value of C 0 is given by equating these two quantities, so

that
e
r(T t )
C0 = CT T ST + 0 S0 e
r(T t )
+ e
r(T )
S [ d ] b
Eq.2.26
You can write this more transparently as

( C 0 0 S 0 )e
r(T t)
= ( CT T ST ) + e
r(T )
S [ d ] b
Finally, you can integrate Equation 2.26 by parts using the relation
e
r(T )
S [ d ] b = d [ e
r(T )
S ] + re
r(T )
S d e
r(T )
dS
to obtain
T
C0 = CT e
r ( T t )
( S , ) [ dS S r d ]e
r ( T )
Eq.2.27
Eq.2.26 and Eq.2.27 provide a way to calculate the value of the call in terms of
its final payoff and the hedging strategy.
If you hedge perfectly and continuously, Black-Scholes tells you that this value
will be independent of the path the stock takes to expiration.
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2.8
Page 29 of 41
The Effect of Different Hedging Strategies1
In the previous section, we hedge at each intermediate time between inception

and expiration by shorting i shares of stock. How should we have calculated
i using implied volatility or realized volatility? How do the return profiles
depend on the hedging strategy?
Realized (or actual) volatility is noisy, changing from moment to moment.
Implied volatility is a parameter, the markets expected volatility plus some
premium for other unknowns (hedging costs, inability to hedge perfectly,
uncertainty of future volatility, the chance to make a profit, etc.). Implied volatility is usually greater than realized volatility.
2.8.1 Hedging with Realized (Known) Volatility

Consider the idealized case where we know that the future realized volatility
will be greater than current implied volatility . How can we make money as
an options trader? We buy the option at its implied volatility and then hedge it
at the realized volatility (which we hypothetically know) in order to replicate
the option perfectly. Then the final P&L of this traded is
V ( S, , ) V ( S, , )
where V ( S, , ) is the value obtained by perfectly replicating the option at the
actual volatility, is the time to expiration, and for brevity we have suppressed
displaying the dependence of non-essential variables such as interest rates and
dividend yields. We will sometimes write V ( S, , ) as Vr (for realized) and
V ( S, , ) as Vi (for implied).
How Is This Known Profit Realized As The Stock Evolves Through Time?
Assume the stock evolves with actual drift and volatility , so that
dS = Sdt + SdZ .
Eq.2.28
where is not the riskless rate r, and the stock S pays a continuous dividend
yield D.
The Black-Scholes hedge ratio for a realized volatility r is given by
1. Ahmad, R. and Paul Wilmott, Which Free Lunch Would You Like Today, Sir?: Delta
hedging, volatility arbitrage and optimal positions. Wilmott Magazine.
2/1/10
Lecture2.2010.fm
1
N ( x ) = ---------2
y 2
Page 30 of 41
dy
SF r ( T t )
ln ----- -----------------------K
2
d 1, 2 = ----------------------------------------- Tt
= N ( d1 )
Here S F = S exp [ ( r D )t ] is the forward price of the stock, and depends on
the riskless interest rate r and the dividend yield D rather than .
In the table below we use the symbol V for a security with value V. Lets now
figure out our moment-to-moment P&L over time when we borrow money to
finance a long position in the security V and hedge it using the (assumed
known) realized volatility, and show that we eventually capture V r V i .
Table 1: Position Values when Hedging with Realized Volatility
Time
t
t + dt
Option Position, Value
Stock Position, Value
Vi , Vi
r S , r S
V i ( t + dt, S + dS ) ,
r S , r ( S + dS )
V i + dV i
Value of Cash Position
Net Position Value
r S Vi
( r S V i ) ( 1 + rdt )
( V i + dV i r ( S + dS ) )
r DSdt
( r S V i ) ( 1 + rdt )
dividends
paid
interest
received
r DSdt
Thus the change in the P&L in time dt is given by

dP&L = [ V i + dV i r ( S + dS ) ] + ( r S V i ) ( 1 + rdt ) r DSdt
= dV i r dS rdt ( V i r S ) r DSdt
Eq.2.29
But the Black-Scholes equation is equivalent to the statement that if we had

purchased the option at the fair future realized volatility r , then the change in
the value of the P&L while hedging with realized volatility would be zero, so
that replacing the subscript i by r in Equation 2.29 gives
0 = dV r r dS rdt ( V r r S ) r DSdt
which can be rewritten as
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r dS rdt ( r S ) r DSdt = rdtV r dV r
Eq.2.30
Substituting Equation 2.30 into the RHS of Equation 2.29 we obtain the P&L
generated between times t and t + dt:
dP&L = dV i dV r rdt ( V i V r )
rt
= e d[e
rt
( Vi Vr ) ]
The present value of this profit is obtained by discounting to the initial time t0:
dPV(P&L) = e
r ( t t 0 ) rt
e d[e
rt
rt
( Vi Vr ) ] = e 0 d [ e
rt
( Vi Vr ) ]
Eq.2.31
By expressing the change in the P&L above in terms of total differential makes
it easy to integrate over the total life of the option, which leads to
T
PV(P&L) = e
rt 0
d[e
rt
( Vi Vr ) ]
t0
= 0 ( Vi Vr ) = Vr Vi
Eq.2.32
if T is expiration
where the integrand at time T is zero because at expiration the payoff of the
standard option is independent of volatility.
So we see that the final P&L at the expiration of the option is known and deterministic and equal to the difference in value between the option valued at realized and implied volatility, provided that we know the realized volatility and
that we can hedge continuously.
_____
How is this known P&L realized over time? We show below that the P&L,
while in sum total deterministic, has a stochastic component that vanishes only
as we reach expiration. This is somewhat analogous to the value of bond,
whose final payoff at expiration is known but whose present value varies with
interest rates.
We showed in Equation 2.29 that the change in the P&L after hedging with
implied volatility is given by
dP&L = dV i r dS rdt ( V i r S ) r DSdt
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We can use Itos Lemma to expand dV i and the Black-Scholes equation to

simplify the result. Applying Itos Lemma to the above equation for the actual
mark-to-market value of the P&L after a real move dS in time dt yields
2 2
1
dP&L = i dt + i dS + --- i S dt r dS rdt ( V i r S ) r DSdt
2
Eq.2.33
1
2 2
= i + --- i S dt + ( i r )dS rdt ( V i r S ) r DSdt
2
But the Black-Scholes equation for the option V valued at the implied volatility can be written as
1
2 2
i = --- i S + rV i ( r D )S i
2
Substituting for i in Equation 2.33, we obtain
1
2 2
2
dP&L = --- i S ( )dt + ( i r ) { ( r + D )Sdt + SdZ }
2
Eq.2.34
Thus, even though the total integrated P&L is deterministic, the increments in
the P&L when you hedge with random volatility have a random component
dZ . (Note that this is the non-discounted P&L, not its present value obtained
by discounting each increment to the P&L by the appropriate discount factor.
The total present value of the P&L should equal the difference in price between
the option valued at implied volatility and valued at realized volatility.
To illustrate this, here is a plot of the cumulative P&L along ten random stock
paths, each generated with a realized volatility different from that of implied
volatility.
r = 0.3
i = 0.2
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The accuracy with which the P&L converges to the known value depends on
how continuous the hedging is, of course. Our example uses 100 hedging steps
to expiration.
The final P&L is almost (but not quite) path-independent almost, because
100 rehedgings per year is not quite the same continuous hedging.
Here is a similar plot of the cumulative P&L when we rehedge 10,000 times,
i.e. almost continuously; then the final P&L is virtually independent of the
stock path.
2.8.2 Bounds on the P&L When Hedging at the Realized Volatility

Notice the upper and lower bounds that seem to define the boundaries of the
above figure. We can understand them as follows.
From Equation 2.31 the P&L of an option bought at implied volatility and
hedged at realized volatility is given by
dPV(P&L) = e
r ( t t 0 ) rt
e d[ e
rt
rt
( Vi Vr ) ] = e 0 d [ e
rt
( Vi Vr ) ]
We can integrate this from the inception of the position at time t 0 = 0 when
the stock price is S 0 to intermediate time t, stock price S , to obtain
PV ( P&L(t) ) = [ V ( , S, t ) V ( , S, t ) ] e
2/1/10
rt
+ [ V ( , S 0, 0 ) V ( , S, 0 ) ]
Eq.2.35
Lecture2.2010.fm
Page 34 of 41
Suppose, as in the figure above, that > . Then the both terms in the square
brackets in Equation 2.35 are positive, because the standard options prices are
monotonic in volatility. Also, the second term is the value at inception, and
independent of the path. Therefore the upper bound occurs when the first term
is zero, which occurs at S = 0 or S = . The upper bound of the P&L is
therefore the constant value [ V ( , S 0, 0 ) V ( , S, 0 ) ] , corresponding roughly
to the heavy dotted blue line in the figure below.
The lower bound to the P&L is given by differentiating Equation 2.35 w.r.t. S
and setting the derivative equal to zero to find the minimum. It occurs at
S = Ke
bound
( r 0.5 ) ( T t )
Ke
r ( T t )
(assuming zero dividend rate), and leads to a lower
( ) T t
2N --------------------------------- 1 + [ V ( , S 0, 0 ) V ( , S, 0 ) ]
2
That value is represented roughly by the lower dotted blue line on the figure
above.
2.8.3 Hedging with Implied Volatility

When you hedge with implied volatility, the evolution of the P&L has no random dZ component, as we showed in our derivation of the hedged options
P&L in Section 2.4.2. In this case the final value of the P&L depends on the
path taken, and is not deterministic.
Suppose we buy the option at the implied volatility, hedge it at implied volatility, and any cash received in the bank to earn the riskless rate. Lets now figure
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out our moment-to-moment P&L. We denote a security with price V by the

symbol V .
Table 2: Position Values when Hedging with Implied Volatility

Time
t
t + dt
Option Position, Value
Stock Position, Value
Vi , Vi
i S
V i , V i + dV i
i S , i ( S + dS )
Value of Cash Position
Net Position Value
i S Vi
( i S V i ) ( 1 + rdt )
( V i + dV i i ( S + dS ) )
i DSdt
( i S V i ) ( 1 + rdt )
i DSdt
The change in the P&L in time dt is given by

dP&L = [ V i + dV i i ( S + dS ) ] + ( i S V i ) ( 1 + rdt ) i DSdt
= dV i i dS r ( V i i S )dt i DSdt
Eq.2.36
Using Itos lemma for dV i we obtain

1
2 2
dP&L = i dt + i dS + --- i S dt i dS r ( V i i S )dt i DSdt
2
1
2 2
= i + --- i S + ( r D ) i S rV i dt
2
But the Black-Scholes equation for the option valued at implied volatility
states that
1
2 2
i + --- i S + ( r D ) i S rV i = 0
2
Substituting for i from the last equation into the previous one, we obtain
1
2 2
2
dP&L = --- i S ( )dt
2
Eq.2.37
The present value of this profit is obtained by discounting to the initial time t0,
and then integrating, we obtain
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1
2 2
2 r ( t t0 )
P&L = --- i S ( )e
dt
2
Eq.2.38
t0
2
The P&L depends upon the value of i S along the path to expiration, and this
factor, especially i which varies exponentially with ln S K , is highly pathdependent. Although the hedging strategy captures a value proportional to
2
( ) , the coefficient will be close to zero if the option is far in or out of

the money when the proportionality constant is small, and therefore the hedging strategy will be insensitive to volatility in those regions.
Below is a plot of the cumulative P&L along ten random stock paths generated
with a realized volatility different from that of implied volatility. Because we
hedge using implied volatility, the P&L depends upon the path taken. Our
example uses 100 hedging steps to expiration and a stock drift of 10%.
growth = 10%
Here is a similar example where the stock growth rate is much larger (100%);
with this drift the stock price is much more likely to move out of the money,
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with the -factor on average becoming much smaller. The average cumulative
P&L captured is therefore appreciably lower, as displayed on the plot.
growth = 100%
The above hedging strategies, using realized or implied volatilities, are of

course somewhat idealized. In practice, realized volatility isnt know and keeps
changing, and so you cannot hedge at the known realized volatility. A trading
desk would most likely hedge at the constantly varying implied volatility
which would move in synchronization with (but not be exactly equal to) the
recent realized volatility. because, among other reasons, realized volatility is
instantaneous and implied volatility looks far into the future. One could simulate this by making a model of the relation between implieds and their response
to realizeds.
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2.8.4 Hedging at an Arbitrary Constant Volatility

Suppose, for the more general case, we buy an option at an implied volatility
and hedge it to expiration at a volatility h , the chosen hedge volatility, while
realized volatility remains constant at r . The present value of the P&L is then
given by
t
1 r ( t t0 )
2
2
2
PV ( P&L ) = V h V i + --- e
h S ( r h )dt
2
Eq.2.39
t0
Note that when the hedge volatility h is set equal to either the realized volatility r or the implied volatility i , Equation 2.39 reduces to our previous
results.
2.8.5 The Maximum P&L When Hedging With An Arbitrary

Volatility
What can we deduce about the behavior of the P&L in Equation 2.39? For
r > h , the minimum is clearly V h V i . The maximum occurs when the
2
path-dependent term S h is a maximum along the entire path. Now

D
SN' ( d 1 )e
S h = -----------------------------h
2
Eq.2.40
where
2
1 d 2
N' ( d 1 ) = ----------e 1
2
and d 1 depends on h .
The maximum occurs when
D
N' ( d 1 )e
SN' ( d 1 )e
d1
2
( S ) = -------------------------- ------------------------------ ---------------- = 0
S
h
h
S h
or
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d1
ln ( S K ) + ( r D ) + h
1
------------- = ---------
----------------------------------------------------------------2
2
h
h
( h ) ( h )
which has the solution
2
S = Ke
( r D h 2 )
Eq.2.41
This is intuitively sensible. When S forward strike then is a maximum and

so you maximize the P&L from hedging a long gamma position.
At this value of S, in Equation 2.40
r
Ke
S h = ----------------------- h 2
2
Eq.2.42
Taking the path for the evolution of the stock that moves along this value of S ,
we maximize the P&L. By combining Equation 2.39 and Equation 2.42, we
obtain
T
r ( T t )
r ( t t 0 ) Ke
1 2
2
PV ( P&L ) = V h V i + --- ( r h ) e
--------------------------------dt
2
T t 2
t0
2 r ( T t0 )
h )e
Eq.2.43
K ( r
T t0
= V h V i + -------------------------------------------------------------------2 h
2.8.6 Expected Profit after Hedging at Implied Volatility

From Equation 2.38 we have the P&L when hedging at implied volatility:
T
1
2 2
2 r ( t t0 )
P&L = --- i S ( )e
dt
2
t0
where we denote the realized volatility by .

This integral is path-dependent, so lets find the mean P&L over all paths. Its
possible with some difficulty to take this average analytically over all stochastic paths for the stock price; this is similar to valuing a path-dependent option,
for example an option on the average of the stock price. You can write down a
PDE for it and try to solve it, as illustrated in Wilmotts paper.
Its easier, however, to write a Monte-Carlo program to evaluate the average
P&L over all paths. Shown below is the expected P&L (blue line) over all
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paths for an option bought and hedged at an implied volatility of 0.2 when realized volatility is 0.4, for a range of different stock growth rates . The green
line shows the standard deviation of the P&L. You can see, roughly, that the
expected P&L is a maximum when the growth rate is such that the stock is
close to at-the-money at expiration, so that its is largest. From Equation 2.40
2
this occurs when = r D 0.5 i = 0.05 0.5 ( 0.2 ) = 0.03 , which corresponds closely the value of at the maximum in this illustration. The red
line shows the P&L obtained by hedging at realized volatility, and is just equal
to the difference between the price of the option at realized volatility and the
price of the option at implied volatility. This value is fairly close to the maximum expected P&L when the option is hedged at implied volatility.
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Lecture2.2010.fm

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E4718 Spring 2010: Derman: Lecture 2:Dynamic Replication: Realities and Myths of Options Pricing

Lecture 2: Dynamic Replication: Realities and

What Well Cover in Lecture 2

2.1 The Risk of Stocks

2.2 Risk Reduction

2.2.1 Risk Reduction With Riskless Bonds: More Expected

Consider a mixture of w% risky stock with volatility and (1 - w)% riskless

The expected return for this mixture is wt + ( 1 w )rt . The volatility of

Excess return is proportional to risk.

2.2.2 Risk Reduction by Diversification

folio, each of which is proportional to their individual non-zero volatility via

2.2.3 Risk Reduction by Hedging

As a result1, assuming the invariance principle,

This is the Capital Asset Pricing Model or Arbitrage Pricing Theory: in

2.2.4 Derivatives Are Not Independent Securities

A stock is straight, an option curved.

A derivative is a contract whose value is determined

call option C(S),

In the binary tree model, there are only two possible

The value of the option is therefore the price of the

You can replicate an options nonlinear payoff over

(1+rt)C = (CU). u+ (CD). d

2.2.5 The choice-of-currency/numeraire trick

2.3 Methods of Replication

Thus price of put = price of call - price of stock + PV(K).

You can write the payoff as

Then the payoff is the payoff of a portfolio consisting of a zero-coupon bond

2.3.2 Static Hedge for a European Down-and-Out Call

2.4 Dynamic Replication and its Consequence:

We can do a Taylor series expansion on the unknown price C( ) and examine

Convexity generates a profit or loss that is quadratic in (S). Positively curved

stock price, you can represent the stock moves as S = S t with

By differentiation (note that d 1 is itself a function of S)

2.4.2 Hedging an Option Means Betting On Volatility

The gain from curvature is

The last identity above follows from Equation 2.5.

This value is path dependent unless S is independent of the stock price,

Here is an illustration of the contributions to the P&L:

A hedged position earns the

2.4.3 An Aside: The Convexity of Bonds

2.4.4 The Two Kinds of Volatility

Therefore, over an instant of time t, an index with volatility will move

= r a ( r a ) , where r a is the annual

If the stock evolution follows geometric Brownian motion, then Nd = N d .

Implied Volatility is the value of the volatility parameter in the Black-Scholes

which is always positive.

For constant volatility you can rewrite this as

respect to the total variance .

2.5 The Black-Scholes Equation and Sharpe

Continuous stock price movements (one-factor geometric Brownian

Ability to hedge continuously by taking on arbitrarily large long or short

No forced unwinding of positions.

We can create a riskless portfolio out of S and C. Define = S + C

nations, r ( T t ) the discount factor and ( T t ) the total variance. Smart

2.5.1 Some Useful Derivatives of the Black-Scholes Model

2.6 Another View: Option Valuation as Consistent Interpolation

where r is the true riskless discount rate for time to expiration ( T t ) .

2.7 The P&L of Hedged Trading Strategies

Net Value of Position:

Therefore, the fair value of C 0 is given by equating these two quantities, so

You can write this more transparently as

The Effect of Different Hedging Strategies1