Wo boo A> REG Seeeaesee . . 5 Rubinstein on Derivatives Mark Rubinstein University of California at Berkeley RISK) TeensPublished by Risk Books, division of Risk Publications. Haymarket Howse Monadnock Building Suite 252 28-29 Haymarket 53 West Jackson Boulevard London SWTY 42 Chicago T6504 UK Usa “Te: 0171 484 5745 Tel 0013125540556 Fax: 171 484 9758 Fax 01 312 5540558 E-mail books@riskco.uk Home Page: htp:// www siskpublicationscom (© Mark Rubinstein 1999, ISBN 1 999902597 [rtsh Library Cataloguing in Publication Data ‘A catalogue record fr this book is available from the Brieh Library Risk Books Commissioning Editor: Wiliam Fallon Project Editor: Bridie Selley re press Lindsey Hofmeister and Marin Llewellyn Copy-edited and typeset by Special Edition Prepress Services, London Printed ad Bound in Great Beitain by Bookeraft (Bath) Lid, Somerset. Condition of le All ights reserved. 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However, ne responsibilty for loss ocasioned to any person acting ‘or refraining from acting a a result of the material contained inthis publication willbe accepted by Financial Engineering Lid. “Many ofthe product names contained in this publication are registered trade ‘marks, and Risk Books has made every effort to print them with the capitalisation 2nd punctuation used by the trademark owner. For reasons of textual eat, ts ‘not our house style wo use symbols such as, et. However, the absence of such symbols should not be taken to indiate absence of trademark protection: anyone ‘wishing to use prodact names inthe public domain should fst clear such wie ‘with the product owner,About the Author Mark Rubinstein is the Paul Stephens Professor of Applied Investment Analysis at the Haas School of Business at the University of California at Berkeley. He is a graduate of Harvard University, Stanford University and the University of California at Los Angeles. Professor Rubinstein is renowned for his work on the binomial option pricing model (also known as the Cox-Ross- Rubinstein model). His publications include the book Options ‘Markets, as well as more than 50 publications in leading finance and economic journals. He is currently an associate editor of 10 journals in these areas. He has won numerous prizes and awards for his research and writing on derivatives, including International Financial Engineer of the Year for 1995. In 1993 he served as President of the American Finance Association.To Gladys and Sam RubinsteinPreface 1 Assets, Derivatives and Markets 11 Basic concepts 1.2 Underlying assets 13 Classes of derivatives 1.4 Examples of derivatives 1.5: Markets 2 Forwards and Futures 2.1 Asset and cash 222 Valuation and replication 233 Examples of forwards and futures 2.4 Hedging with atures 255 Swaps 5 Introduction to Options 3.1 Basic positions 3.2. Combined positions 33 Valuation 3:4 Replication 4 The Binomial Option Pricing Model 4.1 Single-period model 42. Multiperod model 483. Hedging with options 44 fxersions 45. Options on bonds 5 The Black-Scholes Formula 5.1 Derivation 5.2 Hedging parameters 53 Extensions 6 Volatility 6.1 Realise volatility 62 Implied volatility 7 Dynamic Strategies 711 Dynamic asset allocation 722 Portalio insurance 7.3 Simulation Glossary Bibliography Index Contents 2 28 36 3 n n a 109 1235 131 ut 14 158 es 181 195 199 208 231 238 247 263 263 279 290 299 299 313 323 323 329 342 385 a7Preface Do we really need another book about derivatives? When John Cox and I wrote our book Options Markets about 20 years ago, the best book then available was Gary Gastineau’s The Stock Options Manual. ince our book ‘was the frst child of the modern Black-Scholes er, it did meet an impor- tant need. But today there are, it seems, books beyond counting about derivatives, including very good ones such as John Hull's Options, Futures and Other Derioatices and Paul Wilmott's encyclopaedic Derivatives: The Theory and Practice of Financial Engineering But very few of these newer books examine derivatives with a real attempt to explain the underlying economic theory and its practical limita- tions. True, in other books you will see the mathematics and be taken by the hand through numerous examples, but will you understand at a “gut” level what is really going on? This book tries its best to provide such insight. To take a famous example from another field, Kepler's geometric rules for predicting the motions of planets provide a consistent way of viewing the phenomena, but they don’t have the explanatory power of Newton's law of gravitation. Newton's law looked, as it were, behind Kepler's rules to a more concise and fundamental relation. His law was also universal since it pertained to all matter, predicted slight differences in ‘the motions of planets which were later observed and suggested that other forces besides gravitation could be important in some circumstances. ‘Here's atest for those who have read other books about derivatives: ‘what is the basic economic idea behind modem option pricing theory as distinct, say, from the earlier equilibrium asset pricing theory? It is this under certain conditions you can make up for an incomplete market (ie, a market in which some patterns of returns are not directly available) by revising over time a portfolio ofthe existing securities in the market. ‘The classic example ofthis isthe Black-Scholes strategy of replicating the payoffofacall with its underlying asset and cash. And who first thought of this general proposition? Black and Scholes in 1973? No, it appeared in a paper published 20 years earlier by the economist Kenneth Arrow. In this book, this idea is called the “third fundamental theorem of financial economice”. The first and sacond theorems ~ also more of less discovered by Arrow in the same paper ~ form the basis for the earlier equilibrium asset pricing theory (le, “the capital asset pricing model” developed in part by William Sharpe).Rubinstein on Derivatives is different from most other books on deriva tives in several other ways. Fist its written in a personal and discursive style. Occasionally, you are reminded that the author isa human being and not a robot ‘Second, the book includes « general overview of all kinds of deriva- tives, beginning in Chapter 1 with an example of earthquake insurance, followed by a tour through numerous applications to things you may not have previously considered derivative, followed in turn by a detailed chapteron forwards, futures and swaps. These are developed fist because they are fundamentally special cases of moze complex derivatives known 2s “options. For example, if you have ever wondered why the expected underlying asset return does not enter the Black-Scholes formula for European options, it helps to understand first why financial futures prices cdo not depend directly on expectations of future underlying asset prices. ‘Third, while many other books on options use stochastic calculus or just wave their pages, this book does neither. It relies instead on the ‘binomial option pricing model, even to the point of developing the Black-Scholes formula, hedging parameters like delta and gamme, ‘options on futures and currencies, and provides several bond option ‘models. Such an approach requires only algebra and elementary statistics and reveals the basic economies of option pricing in its most matherati- cally unadorned form. Fourth, key to applying the theory isthe measurement of certain vari- ables, particularly volatility. So there is an entire chapter devoted to the estimation ofthis parameter. Filth, the book emphasises an understanding of the limitations behind the third fundamental theorem (and hence the Black-Scholes formula) ~ that, it relies on “certain conditions”, To the extent that these fail the con- clusions are at best, good approximations or, at worst, can lead to financial disaster if followed slavishly. So the final chapter describes in detail a case study that uses most ofthe concepts developed in the book. This attempts to carry the example to the threshold of current practice and shows what ‘can go wrong with dynamic replication strategies (and how they can be ‘modified to soften the blow). The reader is hereby forewarned: reading this ‘book without the last chapter could be dangerous to your financial health. Sixth, the book includes two unique bibliographies. The first lists in chronological order about 150 articles and books written over the last cen- tury, each with an annotation describing what I believe to be its principal contribution, This can be read from the beginning asa sort of history of the subject, showing how ideas were elaborated and extended. The second bibliography lists about 175 applications of derivatives theory and recom- ‘ends in each case one article to read first. The reader can then use the bibliography given by the authors of the suggested article to dig, deeper into that application. aFinally, the book is accompanied by a free CD with hundreds of megabytes of software expressly designed to supplement it. Ifyou did not request it on your order form, please email books@risk.ca.uk with your details. The CD includes 342 professionally designed PowerPoint slides that can be used to enhance your own learning or instruct others, four computer applications (including MATLAB for Derivatives and portions of Rubinstein’s Options Calculator), many worked numerical examples, computer exercises and other documents, a WinHelp pop-up glossary with over 600 items interlaced with hundreds of Internet URL, and 100 audio ‘mintlectures of 1-12 minutes each taken from live classroom sessions at Berkeley. Itis customary at this point to thank all those who have helped and to ‘swear that without them this wonderful creation would never have come into existence. Since this book is based on Derioutives: A PowerPlus Picture Book (an alternative to classroom instruction published by myself and available at www.in-the-money.com), I will not rethank those who are ‘mentioned there. However, in its current form this book owes its existence Principally to the encouragement of one man, Bill Falloon of Risk Publications, and I would like hereto formally extend my thanks. Mark Rubinstein November 19, 1999 ‘Corte Madera, CaliforniaAssets, Derivatives and Markets To many, “derivatives” is a mysterious word, connoting the dark and seemingly impenetrable world of modern finance. In fact, the basics of erivatives are easy to understand, in part because most people in devel- oped countries, know it or not, own a least one derivative. A derivative is a contract between two parties that specifies conditions ~ in particular, dates and the resulting values of underlying variables — ‘under which payments, or payofis, are to be made between the partis. For example, social security is a derivative which requires a series of ‘payments from an individual to the government before age 65, and payofls after age 65 from the government to the individual as long as the indivi- dual remains alive. In this case, the payotfs occur at predefined dates and, ‘depend on the individual's survival. Anyone who has ever taken out a ‘mortgage with a prepayment privilege has perhaps unwittingly dabbled in Gerivatives. To take @ more dramatic example, earthquake insurance is a derivative in which an individual makes regular annual payments in ‘exchange for a potentially much larger payolf from the insurance company should an earthquake destroy his property. Derivatives are also known as contingent claims since their payoffs are “contingent” on the outcome of an underlying variable. Derivatives have long existed, with specific events or commodity prices as the underlying variables. The big explosion of interest in derivatives, however, occurred only after purely financial derivatives appeared, with stock prices, stock indexes, foreign exchange rates, bond prices and interest rates as the variables determining the size of payoffs, Historians searching for a starting date might look to 1972, the formation of the International ‘Monetary Market (IMM), a division of the Chicago Mercantile Exchange (CME), or April 1973, the opening of the Chicago Board Options Exchange (CBOE), the first modern exchanges to trade financial derivatives. ‘Speaking philosophically (and very much in the spirit of the book), imerpreting something as a derivative depends on one's point of view. For example, itis usual to consider common stack as an asset that might 1Assets, Derivatives and Markets ‘To many, “derivatives” is a mysterious word, connoting the dark and seemingly impenetrable world of modern finance. In fac, the basics of derivatives are easy to understand, in part because most people in devel- ‘oped countries, know it or not, own at least one derivative A derivative is 2 contract between two partes that specifies conditions ~ in particular, dates and the resulting values of underlying variables ~ ‘under which payments, or payofi, are to be made between the partes. For example, social security isa derivative which requires a series of payments from an individual tothe government before age 65, and payotts alter age 65 from the government tothe individual as long as the indivi- ‘ual remains alive. In this case, the payoffs occur at predefined dates and depend on the individual's survival. Anyone who has ever taken out a ‘mortgage witha prepayment privilege has perhaps unwittingly dabbled in. erivatives. To take a more dramatic example, earthquake insurance is a derivative in which an individual makes regular annual payments in ‘exchange fora potentially much larger payoff from the insurance company should an earthquake destroy his property. Derivatives are also known as Contingent claims since their payofls ae “contingent” on the outcome of an underlying variable. Derivatives have long existed, with specific events or commodity prices as the underlying variables. The big explosion of interest in derivatives, however, occurred only after purely financial derivatives appeared, with stock prices, stock indexes, foreign exchange rates, Bond prices and interest rates asthe variables determining the size of payoffs. Historians searching, for a starting date might look to 1972, the formation of the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange (CME), oF April 1973, the opening ofthe Chicago Board Options Exchange (CBOE), the first modern exchanges to trade financial derivatives, Speaking philosophically (and very much in the spirit of the book), interpreting something, as a derivative depends on one's point of view. For example, itis usual to consider common stock as an asset that might 1EARTHQUAKE INSURANCE POLICY Richter scale Damage —_—Payoff (US$) None o Slight 750 ‘Small 10,000 Medium 25,000 Large 50,000 underlie a derivative, but itis not usually regarded as a derivative itself Yet ifthe payotf from stock is considered to be dependent on some other underlying variable, such as the operating income of the associated firm, the stock itself is being interpreted as a derivative. Whether or not it pays to make this interpretation depends on the particular purpose at hand. To takea classic example from another field, for some purposes itis best to think of the sun as fixed in space and the earth as rotating around it, but for others its useful to adopt the Aristotelian perspective ofthe earth fixed in space with the sun rotating about it 1.1 BASIC CONCEPTS Payoff tables and diagrams In a general sense, perhaps the simplest way to describe a particular derivative is by a payoff table. Table 1.1 contains two main columns (but ‘may contain others to provide more details): the value ofthe underlying variable and the corresponding payoff made by either party. In this table we use earthquake insurance as 2 highly simplified example. Here the two parties are the homeowner and the insurance ‘company. The first column defines the event in terms ofthe magnitude of the earthquake as measured on the Richter scale" Each such potential event is generically referred to as a future state ~a description of the relevant aspects of the world, The third column gives the expected payout by the ingurance company, which depends on the size of the earthquake. For example, if there is no earthquake (Richter scale = 0.0) or only a minor earth movement (Richter scale < 5), there is no damage and therefore noHOMEOWNER PAYOFF FROM INSURANCE A) payout by the insurance company. Going up the scale, earthquakes in the range 50-54 are sufficiently small that damage to a home usually amounts to less than USSI,000. Inthe most extreme case, with an earthquake of 7.0 ‘or higher on the Richter scale, the homeowner will probably be very grate- {al to receive USS50,000 to cover a total loss. An altemative way to describe a derivative is through a payoff diagram, as illustrated in Figure 1.1, This is a graph of the underlying variable on the horizontal axis against the corresponding payoff on the vertical axis. (Clearly, this is just another way to portray the information in the payoff table. ‘The payoff diagram illustrates a common property of many derivatives. (Often the asset itself (in this case the house) is not exchanged, but rather only the change in the value of the asset is exchanged. The insurance company does not buy your house but, rather, agrees to pay the home- ‘owner the change in its value should earthquake damage occur, ‘Some derivatives are simple agreements where one party agrees to pay the other whatever change in value occuts. If the change is positive, the fist party pays the second; ifthe change is negative the second party pays the first, Derivatives with such simple payoffs are often called forwards, futures or swaps: and derivatives with more complex payoffs, lke insur- ance, are often called options, chief among which are calls and puts. Subjective probabiit By itself, the payoff table or diagram tells only part ofthe story. Suppose you want to decide whether oF not to purchase the earthquake insuranceRichter scale policy, This clearly depends on what you think is the likelihood of an. ‘earthquake. Ifyou live in the Midwest, you may conclude that the chances of an earthquake are so remote that you don’t need the insurance. If you live in California, you may view earthquake insurance as one ofthe neces- sary costs of living, A systematic way to give consideration to this second dimension of the erivative sto assign subjective probabilities to each possible future state To be considered probabilities, these must be non-negative numbers Which, added up across al states, sum to 1. Fach subjective probability ‘measures an individual's degree of belief ina given outcome. For example, if one subjective probability is twice the sizeof another, i ‘means the individual believes thatthe first outcome is twice as likely to occur as the second, Figure 1.2is an example of a subjective probability diagram for an earthquake, It indicates that the subjective probability of a Richter- scale event of 4.9 oF les is 85% (or 0.85). At the other extreme, the subjective probability of an earthquake registering 7.0 oF more is only 05% (0.008)? [Note that the sum of the probabilities is 0.85 + 0,10 + 003 + 0.015 + 0.00: Occasionally, | will speak as if the market itself established prices as if it used a single set of subjective probabilities. This fiction, while quite ‘convenient, is much more difficult to justify with rigorous argument. Now we are ready to combine the information in the payoff diagram (Figure 1.1) and the subjective probability diagram (Figure 1.2) to calculateASSETS, DERIVATIVES AND MARKETS Payoff from insurance (X,, Xz Q Subjective probabilities (Q,, Q,, E(8) of the same magnitude. Also, becouse the squared difer- ‘ences aré weighted by probabilities, as for expected value, realisations with Iigher probability are given more weight Variance, however, has atleast one significant drawback: expected pay ‘off is denominated in US dollars, but the squaring causes variance to be ‘denominated in units of US dollars squared (USS). As.a result itis cifcult to compare expected values with variance. To overcome this problem itis ‘common to make one last calculation: take the positive square root ofthe variance. Ths is known as the standard deviation, std(X), which converts Variance into USS unis For example, as we will soon show, the expected payoff from the insurance policy is USS1,000 and the standard deviation of this payof is ss4.92 ' final statistical concept measures the extent to which two random variables are related to each other. Suppose that in addition to the realised payoff from the insurance policy, (XX Xj--rX,), we also have the corresponding realised payof from an investment ina diversified portfolio of securities designed to reflect the retums of the market as a whole, Of Yor Yn) $0, is the subjective probability that we wil simul- taneously observe (%,Y)ASSETS, DERIVATIVES AND MARKETS Covariance captures ina single number the extent to which these two variables move together. For each fture state (0) we first calculate the difference between the fist random variable and its expected value: X/~ E00 (2)next we calculate the difference between the second random variable and its expected value: ¥,~ £00); {@) then we multiply these differences together: [X,~ EOXDY,- EO (8) now we weigh this product by its corresponding subjective probability: 1X) ~ ECOIY,- £0) Finally, we add these weighted products across all states to obtain the cov(X.Y) ¥, a[x)-ee0][y,-€00] Cov(X,¥) canbe positive, negative or ero, The covariance wil be pstce iF and ¥ tend to move together; that isin sates when X, > E(R), also tends to be tru that ¥,> (1); and when X,< (3), we tend to see Y, 0, but under others [X)~ EGIIY)~ ECO] 0. Ofcourse, under certainty, when for al states X= E(X) oY, the cov ‘As with variance, a problem with covariance that itis in USS units ‘Apopular way to sale covariance ito divide it by the produc ofthe sta dard deviation ofeach of the random variables, This scaled measure of covariance iscalled the correlation ofthe two variable: nce will also be zero, cov(X,¥) a0) «20 It can be shown that the correlation lies between —1 and +1, and itis nit. less since itis the ratio of USS? to USS*. Table 1.3 shows the exact caleulation of the expected payoff for our example of earthquake insurance. We first multiply the third and fourth columns to give us the fifth, and we then sum the fifth column to get the expected payoff In this example the expected payoff is USS1,000. That is, the insurance ‘company needs to set an annual premium of USSI,000 for it to expect to break even. In practic, the company will charge somewhat more to cover corr(X,Y) =EARTHQUAKE INSURANCE POLICY Payoff Probability Damage (US$) Probability x Payoff (US$) None © 0.850 0 Sight 750 0.100 78 Small 10,000 0.030 300 Medium — 25,000 0.015, 375, Large $0,000 0.005 250 Expected payoff: US $1,000 +Q)) = 0s «0100750 + 0.03010,000) + 0.015125 00 + 0.005:50,000 = 1,00 Time diconte expected pay wth 1.05 rls ret = USS) 007.05 = USSH52.18 its operating expenses and make a profit for its shareholders. Even so, as wwe shall see, the homeowner may stil want to purchase the insurance because of his atitude toward the rsk of an earthquake, That is, he s often willing to pay this higher premium even though itis greater than his expected payoff ‘Another consideration we have ignored isthe timing ofthe payments, In many cases the homeowner will pay the entire premium in advance at the beginning of the year, while the potential benefits from the insurance can occur only after the premium has been paid. If, this will make the insurance policy more attractive to the insurance company since itcan then earn a bonus: the interest from investing the homeowner's premium over the year. To avoid this complication it is best to think ofthe premium as being paid in gradually over the year. ‘Suppose, however, that the homeowner is not so fortunate ~ that he pays the premium fully in advance at the Beginning of a year but is paid for any earthquake damage only at the end of the year even if the damage ‘occurs during the middle of the year. He might say to himself that as an alternative he could have taken his USSI,000 premium and put it in a bank account. In that case, at the end of the year instead of having USS1,000, hhe would have USS1,000 plus interest at, say, 5%. Assuming that the bank does not default, the amount he would have by the end of the year is USS1,000 1.05 = USSI,050. We can regard 1.05 as the riskless return. Therefore, for both the homeowner and the insurance company to break even, and now taking into account the timing ofthe payments, we amend the above calculation by replacing the premium with USS1,000/1.05 =