Derivatives Lectures PDF

FNCE 30007
Derivative Securities
Lecture – Introduction to Futures

Outline
 Definition
 Specifications of futures contracts
 How to open and close a position
 Relationship between futures price and spot price
 Margins and marking-to-market
 Price and trading information
 Regulation and price limits
 Forward vs. Futures
Reading: Chapters 1 and 2

Definition
 A contract between two parties
 one party buys something from the other at a later date
 price agreed today
 subject to daily settlement of gains & losses
 guaranteed against the risk that either party might default
 Diagram
 Available on a range of underlying securities e.g
 Bonds
 Shares
 Indices such as the SFE SPI 200
 Exchange traded
 Settled daily
Profit from a Long Forward or Futures Position
 Initially treat futures as a forward and add

complexity as we progress through lecture
Profit
Price of Underlying
at Maturity 𝑆𝑆𝑇𝑇 = 𝐹𝐹𝑇𝑇
Buying price locked in today 𝐹𝐹0

Profit from a Short Forward or Futures Position
Profit
Price of Underlying
at Maturity
𝑆𝑆𝑇𝑇 = 𝐹𝐹𝑇𝑇
Selling price locked in today 𝐹𝐹0
Specifications
 What can be delivered (the asset)
 Most contracts cash settled at expiry.
 Some are deliverable
 e.g 90-day Bank Accepted Bill & some commodities .
 Usually only hedgers take delivery.
 Where it can be delivered (delivery arrangements)

 When it can be delivered (delivery months)
 Most contracts expire quarterly: March, June, Sept, Dec.
 Commodities aligned to harvesting & crop seasons.
 Contract size
 Price quotes, price limits and position limits
 Example: www.cmegroup.com
Opening & Closing a Contract
 To open a position you call your broker or enter into
the contract via online trading account.
 Contracts are referred to by their delivery month.
 e.g “long May oil futures.”
 Most contracts don’t lead to delivery.
 Might be inconvenient (speculators).
 Can be expensive (storage costs, transport).
 To close a position, enter into opposite trade
Long 5 October corn futures Short 5 October corn futures Expiration
June 15 Sept 20 October 31
 If short 5 contracts on June 15, long 5 contracts Sept 20

 Net position is zero and exchange closes position.
Contract not closed out prior to expiration
 Cash settled:
 Exchange closes out the position
 Left with margin account balance.
 Deliverable:
 Settled by delivering the assets underlying the contract at the
settle price at maturity.
 Diagram
 When there are alternatives about what is delivered, where it
is delivered, and when it is delivered, the party with the short
position chooses.
 Soybeans example www.cmegroup.com

Trading the nearby and rollover
 Most participants close out prior to expiration
 What does this mean if you seek to hold a position
over the longer term?
 Rollover strategy required
 Minimises transaction costs as spreads on closest
contract are small and tend to increase with horizon
 Example www.cmegroup.com
 Agricultural positions may not trade the nearest
contract and roll over.
 Tend to take a position that aligns with the
harvest/crop season.
 Minimises basis risk for hedgers (more on this in
lecture 2)
Example: SPI 200 futures
 The SPI 200 futures contract tracks the price
fluctuations of the ASX 200 index.
 Suppose an investor is bullish long futures
 Each point move in the futures contract is worth $25
 Long: contract price increases from 5500 to 5501
$25 profit/contract
 contract decreases from 5500 to 5499 $25 loss/contract
Futures = 5500 points Futures = 5550 points
May 1 May 20 June 30

Long 1 contract Short 1 contract Expiration
Example: SPI 200 futures
 Profit is 50 points x $25/point = $1250
 If the market falls to 5480 the investor loses 20
points x $25/point = $500.
 If the speculator was bearish they would short the

index on May 1.
 If index drops to 5480 profit is $500/contract.
 If index increases to 5550 loss is $1250/contract.
 So why not just speculate on the index through an

ETF?
 Leverage example using SPI200 futures
Convergence of Futures Price to Spot Price
 As futures approaches expiration futures price

converges to the spot price.
 Otherwise there’s an arbitrage opportunity.
Example:
Assume futures is above the spot at maturity FT > ST
 sell overvalued security and buy undervalued one.

 Arbitrageurs sell (short) a futures contract, buy the asset,
and make the delivery.
 Futures price & spot price
 Continue until prices are equal (subject to transaction costs)
Futures Spot Price

Price
Futures
Spot Price Price
Expiration date Expiration date
Time Time
20
15
10
0
1-Apr-94 18-Oct-94 6-May-95 22-Nov-95 9-Jun-96 26-Dec-96 14-Jul-97 30-Jan-98 18-Aug-98
-5
S&P500 futures basis(t) on the nearby = F(t)-S(t)

-10
See: S&P500 10 days combined.xls

Margins
 When two investors enter a trade without an
exchange they are exposed to default risk.
 Role of exchange is to organize trading so that
this risk is minimised.
 A margin is cash or marketable securities deposited
by an investor with his or her broker.
 The balance in the margin account is adjusted to
reflect daily settlement (marking to market).
 Margins minimize the possibility of a loss through a
default on a contract.
 Example: incentive to default minimized via margins
Margins example
 June 15: investor takes long position in 15 October
corn futures contracts
 contract size: 100 bushels
 futures price: US$2.00/bushel
 margin requirement: US$200/contract (US$3,000

in total)
 maintenance margin: US$180/contract
(US$2,700 in total)
Margins example
Day Futures Daily Cumulative Margin Margin
Price Gain Gain Account Call
(Loss) (Loss) Balance
2.00 3,000
15-Jun 2.15 225 225 3,225
16-Jun 2.05 -150 75 3,075

17-Jun 1.95 -150 -75 2,925
18-Jun 1.65 -450 -525 2,475 525 = 3,000
19-Jun 1.42 -345 -870 2,655 345 = 3,000
20-Jun 1.82 600 -270 3,600
Calcs June 15: Profit/contract = 0.15x100bu = $15.

Total profit = 15 contracts x$15=$225
If margin call not met exchange closes your position
Price & trading information
 Open: Price when futures contract starts trading

 High: The highest price during the day
 Low: The lowest price during the day
 Last: The last traded price during the day
 Sett: The daily settlement price declared by the exchange
at which all contracts are marked to market. Usually
midpoint of closing bid & offer - may be different from last
traded price.
Price & trading information
 Settlement Change: difference between yesterday’s &
today’s settlement price.
 Open Interest (stock): Total no of contracts that
haven’t been liquidated by an offsetting transaction or
physical delivery.
no of long positions = no of short positions (STOCK)
 Open Interest Change: number of net new positions
 Volume (flow): during a specified period is
no of purchases = no of sales
Examples at www.cmegroup.com
Questions:
 When a new trade occurs what are the possible effects on
open interest?
 Can the volume of trading in a day be greater than the
open interest?
Regulation
 Regulation is designed to protect the public interest
 Regulators try to prevent questionable trading
practices by individuals on the floor of the exchange
or outside groups
 Australian Regulators
 ASIC: Australian Securities and Investments Commission
 ACCC: Australian Competition and Consumer Commission
 Price limits are one example (next slide)
 Approx 2/3 of exchanges use price limits (mainly on
commodities).
Price Limits – US Soybeans (CME)
 From 4/5/1992 to 26/8/2000
 30cents/bushel
 If limit hit, expanded to $0.45cents next 3 days
 From 27/8/2000
 45cents/bushel with no expansion
 Limit based on volatility of underlying
 A total of 21 limit days (14 lower, 7 upper)
1200
1000
Price - cents/bushel
800
600
400
200
0
5/04/1992
25/11/1992
18/6/1993
1/11/1994
8/04/1994
27/2/1995
20/9/1995
4/12/1996
11/05/1996
29/5/1997
22/12/1997
15/7/1998
2/05/1999
31/8/1999
23/3/2000
16/10/2000
5/09/2001
12/04/2001
27/6/2002
20/1/2003
13/8/2003
3/05/2004
28/9/2004
21/4/2005
14/11/2005
6/07/2006
29/12/2006
Futures Spot
 Price limits partial substitute for margins

 Limits decrease the max loss for a given day, therefore margin
requirements can be decreased.
Forwards v Futures
 A forward is an OTC (over-the-counter)
agreement between two parties for one
party to buy something from the other at a
later date at a price agreed upon today.
 No daily settlement. At the end of the life of
the contract one party buys the asset for
the agreed price from the other party
Forwards v Futures
FNCE 30007
Lecture – Hedging with Futures

Outline
 Short/Long Hedges
 Should companies hedge?
 Basis Risk
 Cross Hedging
 Use of Stock Index Futures
 Hedge Ratio
Reading: Chapter 3
Short and Long Hedges
 Last lecture we saw how futures can be used by
speculators to gain highly levered positions.
 This lecture focuses on the use of futures by hedgers
 Hedgers objective: take a futures position that
minimizes risk as far as possible.
 Short futures hedge when
 sell an asset in the future & want to lock in price
 asset is owned or will be owned
 Long futures hedge when

 purchase an asset in the future & want to lock in
price
 Diagrams illustrating offsetting payoffs
Short and long hedges
 We are going to address hedging using three
approaches
 All provide the same answer
 Each approach provides different insights
 Approach 1: What transactions actually occur
 Approach 2: Emphasizes offsetting payoffs and
assists in the development of the hedge ratio
 Approach 3: Emphasizes the importance of basis risk
(the key risk when hedging)
Short hedge
 April 20: Farmer negotiates to sell 50,000 bu of corn
at the spot price on June 20
 June 20 is futures maturity date – no basis risk (𝑆𝑆𝑇𝑇 = 𝐹𝐹𝑇𝑇 )
 Quotes are given as:
 Spot price of corn: $3.50/bu
 June corn futures price: $3.35/bu (each contract
is for 5,000 bu) Sell corn at spot price
Short 10 June futures Close out futures
Apr 20 June 20
 After futures gains & losses the price received by the

farmer should be $3.35/bu.
Short hedge
Scenario 1: Spot price June 20 $3.10/bu
Approach 1: Actual transactions

Spot: Farmer sells corn at ($3.10)(50,000) = 155,000
Futures: Gain ($3.35 – $3.10)(50,000) = $12,500
Total received: $155,000 + $12,500 = $167,500.
price/bu = $167,500 / 50,000 = $3.35
Approach 2: Offsetting payoffs

Short hedge

Spot: Sell corn at ($3.70)(50,000) = $185,000
Futures: Loss ($3.70 – $3.35)(50,000) = $17,500
Total received: $185,000 – $17,500 = $167,500.
Price/bu = $167,500 / 50,000 = $3.35
Irrespective of what the spot is at maturity

a) The price of $3.35 is locked in
b) The loss from the hedge of $7,500 is locked in
Long hedge
 April 20: Food company negotiates to buy 50,000 bu
of corn at the spot price on June 20
 June 20 is futures maturity date – no basis risk (𝑆𝑆𝑇𝑇 = 𝐹𝐹𝑇𝑇 )
 Quotes are given as:
 Spot price of corn: $3.50/bu
 June corn futures price: $3.35/bu (each contract
is for 5,000 bu) Buy corn at spot price
Long 10 June futures Close out futures
Apr 20 June 20
 After futures gains & losses the price paid by the

company should be $3.35/bu.
Long hedge

Spot: Company buys corn ($3.10)(50,000) = 155,000
Futures: Loss ($3.35 – $3.10)(50,000) = $12,500
Total paid: $155,000 + $12,500 = $167,500.
price/bu = $167,500 / 50,000 = $3.35

Long hedge

Spot: Buy corn at ($3.70)(50,000) = $185,000
Futures: Gain ($3.70 – $3.35)(50,000) = $17,500
Total paid: $185,000 – $17,500 = $167,500.
Price/bu = $167,500 / 50,000 = $3.35
Irrespective of what the spot is at maturity

a) The price of $3.35 is locked in
b) The gain from the hedge of $7,500 is locked in
Question
 Should the food company in the example buy the corn it
needs today in the spot market?
 If company doesn’t need corn until June 20, better not to
buy today.
 A lower price will be paid on June 20 ($3.35 c.f $3.50).
 Storage costs avoided.
 But what if F(t)>S(t)?

 Time value
 Storage costs
 Convenience yield
 Most of the time long hedgers do not take delivery
 close out before the delivery date and buy in the spot.
 partly because delivery arrangements can be very expensive.
Should companies hedge?
 Arguments in favor of hedging
 Companies should focus on the main business they are
in & take steps to minimize risks arising from interest
rates, exchange rates, & other market variables
 Arguments against hedging

 Shareholders are usually well diversified and can make
their own hedging decisions
 It may increase risk to hedge when competitors do not
(e.g gold jewellery manufacturer).
 Explaining a situation where there is a loss on the
hedge and a gain on the underlying can be difficult
Basis risk
 Perfect hedge: completely eliminates risk.
 Previous examples were perfect
 Most hedges are imperfect because:
 hedge requires the futures contract to be closed
out before expiration date
 hedger may not be sure about the exact date the
asset will be bought or sold.
 cross hedge: asset to be hedged not the same as
the asset underlying the futures contract (hedge
jet fuel with oil futures)
Basis risk
 These problems create basis risk.
 Basis(t) = spot price of asset to be hedged(t) – futures price of
contract used(t)
 Basis risk arises because of uncertainty about the basis when the
hedge is closed out
Futures
Price
Spot
Price
Close out
Time
Basis risk: Long hedge
 Approach 3: Emphasizes basis risk
 Suppose that
F0: Initial Futures Price
F1: Final Futures Price
S1: Final Asset Price Unknown at time t=0
 You hedge the future purchase of an asset by entering
into a long futures contract
 Cost of Asset = S1 – (F1 – F0) = F0 + Basis1
Approach 1 Approach 3
Up to now we have closed out at time T
and have therefore assumed Basis1 =0. This
means a perfect hedge was achieved.
Basis risk: Short hedge
 Suppose that
F0 : Initial Futures Price
F1 : Final Futures Price
S1 : Final Asset Price
 You hedge the future sale of an asset by entering
into a short futures contract
 Price Realized=S1+ (F0 – F1) = F0 + Basis1
Approach 1 Approach 3
Up to now we have closed out at time T
and have therefore assumed Basis1 =0. This
means a perfect hedge was achieved.
Basis risk: Example 1
(close out before expiration date)
Time t=0: Spot = $3.50, futures = $3.35.
Time t=1: Spot = $3.30, futures = $3.05.
Basis:
b0 = 3.50 – 3.35 = 0.15
b1 = 3.30 – 3.05 = 0.25
 Short hedger: price rec’d: F0 + b1 = 3.35 + .25 = $3.60

 Long hedger: price paid: F0 + b1 = 3.35 + .25 = $3.60
 b1 is unknown basis risk (F0 is certain)
 Seek to remove spot price risk but introduce basis risk
 Basis risk can improve or a worsen a hedger’s position.

(unsure about close out date)
 It is July 25.
 Company knows it will need to purchase 40,000 bu of
corn some time in September or October.
 Current December corn futures price is $2.55/bu.
 Each corn futures contract is for 5,000 bushels.
 Hedging strategy:
 Long position in 40,000/5,000 = 8 December corn
futures contracts on July 25 at a futures price of
$2.55.
 Close out contract when ready to purchase the corn.
(unsure about close out date)
 Assume company ready to purchase corn on October 15.
 Spot price on October 15 = $2.90
 December futures price on October 15 = $2.80
 Basis on October 15: $2.90 - $2.80 = $0.10
 Net cost of corn:

 Approach 1: Spot price on October 15 - gain on futures
= 2.90 – (2.80 – 2.55) = $2.65
 Approach 3: Futures price on July 25 + basis on
October 15 = 2.55 + (2.90 – 2.80) = $2.65.
Basis risk: cross hedge
 Hedge by taking position in related futures contract.
 no derivatives contract for asset being hedged OR
 futures contract exists but market highly illiquid.
 Success depends on relationship between
 i) asset being hedged and
 ii) asset which underlies the derivatives contract.
 Should cointegrate with fast rate of equilibrium adjustment.
 Basis risk likely to increase. Additional source of uncertainty
F0 + (S*1 - F1) + (S1 - S*1)
 (S*1 - F1) = basis that exists if the asset being hedged were the same
as the asset underlying the futures
 (S1 - S*1) = basis that arises from difference between the two assets.
 Jet fuel cross hedge example
Index futures hedging
 Desire to be out of the market for a

short period of time.
 Hedging may be cheaper than selling
the portfolio & buying it back.
 Desire to hedge systematic risk
 You feel that you have picked stocks
that will outperform the market.
 Seek exposure to idiosyncratic risk only
Index futures hedging
 To hedge the risk in a portfolio the number of
contracts shorted is
# contracts for index fund
VA P0
N β= β
= *
VF F0
V=
A P=
0 current portfolio value
V=
F F=
0 current value of one futures contract
 beta = 1, portfolio return mirrors market return

 beta = 2, portfolio return tends to be twice the market return
 beta = 0.5, portfolio return tends to be half the market return
 Note this is a cross hedge because you are hedging with a futures
contract that is not written against the spot exposure
Example: Index futures hedge
Value of ASX 200 = 5,500
Futures price = 5,600
Size of portfolio = $10 million
Beta of portfolio = 1.2
Risk-free rate = 8% per annum
Dividend yield on the index = 1% per annum
Dividend yield on the portfolio = 4% per annum
One contract is $25 times the futures index points
What position in ASX 200 futures is necessary to hedge the

portfolio for three months?
(1.2)(10million/(25*5,600)) = 85.71~ 86 short contracts

 Suppose the index is 5300 in three months & the
futures price is 5350.
 Approach 2:
 Adjust current value of the position for the hedged gain/loss
 Short futures (gain)
(86)(5,600 – 5,350 )(25) = 537,500
 Index (loss)
(5,500 – 5,300) / 5,500 = 3.64%.
 Assume index pays a dividend of 1% per annum
(0.25% per three months).
 Taking dividends into account loss reduces to
3.64 – 0.25 = 3.39%
 CAPM
ri = rf + Beta(rm –rf)
 Expected (%) portfolio loss during the 3 months

rp = 0.02 + 1.2(-0.0339 – 0.02) = -4.46%
 Expected portfolio value (including dividends):
$10,000,000(1 – 0.0446) = $9,554,000
 Expected value of the hedgers position:
$ 9,554,000 + $537,500 = $10,091,500
Index futures : changing beta
 What position is necessary to reduce the beta of the
portfolio to 0.90? (Assume an initial beta of 1.5)
P 10,000,000
( β − β * ) = (1.5 − 0.9) = 44.86 ~ 45
F (5,350)(25)
 Short 45 contracts
 What position is necessary to increase the beta of the

portfolio to 2.5? (Assume an initial beta of 1.5)
P 10,000,000
( β * − β ) = (2.5 − 1.5) = 74.76 ~ 75
F (5,350)(25)
 Buy 75 contracts
Minimum variance hedge ratio (MVHR)
size of futures position
Hedge ratio (HR) =
size of spot exposure
 Typically measured in quantities (commodity
contracts) and $ values (financial contracts)
 So far we have set the hedge ratio at 1.0

 referred to as the naïve hedge ratio
 A naïve hedge may be sub-optimal with basis risk i.e

 cross hedging and/or
 hedge completion date not same as futures expiration date
 We can derive a minimum variance hedge ratio
 It recognizes the presence of basis risk and so it
seeks to minimize the variation in the hedged
profit/loss.
σ sf σs
=
h *
= ρ
σ 2f sf
σf
h* = optimal hedge ratio
σ sf = covariance between the spot exposure and futures used
σ 2f = futures variance
σ s = spot std deviation
ρ sf = correlation between spot and futures
 Example 1: Hedge S&P500 (S&P500.xls) for index fund
 Calculate variances, covariance and correlations using
continuously compounded returns
100 × [ ln( St ) − ln( St −1 ) ]
rs ,t =
 Calculate the cont compounded hedged returns each day via
rh ,t = rs ,t − h* × rf ,t
 Determining the time period for estimation
 Comparison of alternative methods: naïve v MVHR
 Can calculate the optimal number of contracts via
VA
N =h
* *
VF
 Example 2: Fuel hedge (Fuel hedge.xls)
h * QA
N* =
QF
QA = size of position being hedged (units)
QF = size of one futures contract
N* = optimal number of futures contracts
Minimum variance hedge ratio
 We have just seen
VA
=
VA
N * β=
P
β 0 (1)
N * = h* ( 2)
VF
VF F0
Hull argues that this implies h = β
*

 Equation 1 however assumes that the hedge close

out is close to the maturity of the futures contract.
If this is not the case, h* ≠ β because h also
*

accounts for the risk associated with an early close
out.
FNCE 30007
Lecture – Forward & futures pricing

Outline
 Introduction
 Arbitrage
 Investment v consumption assets
 Short selling
 Investment assets
 Simple relation (no income)
 Known income (bond futures)
 Known yield (stock index futures, currency futures)
 Consumption assets
 Valuation
 Environmental, social and governance movement
 Futures & expected spot prices
Reading: Chapter 5
Introduction: No arbitrage pricing
 Lecture 1 considered speculators, lecture 2 considered

hedgers.
 We now focus on the other major participant –
arbitrageurs
 Arbitrage takes advantage of a price differential between
two or more markets
 No up front payment and a positive cash flow later
 Arbitrage possible if
 Same asset does not trade at the same price on all
markets (the law of one price); or
 2 assets with identical cash flows do not trade at the
same price; or
 An asset with a known price in the future does not
today trade at its future price discounted at the risk-
free interest rate
Introduction: Forward v Futures prices
 Forward and futures prices are usually equal.

 We therefore price futures contracts as if they are
forwards
 Greatly simplifies the problem
 Slight differences may arise from
 Taxes
 Transaction costs
 Margins
 Futures more liquid & have no counterparty risk
Introduction: Investment v Consumption assets
 Investment assets: held by significant numbers of

people purely for investment purposes (gold, silver,
stocks, bonds).
 Can price forwards & futures off spot via
arbitrage.
 Consumption assets: held primarily for consumption
& not usually for investment purposes (copper, oil,
pork bellies, soybeans).
 Not able to price forwards & futures off spot via
arbitrage.
Introduction: Short selling
 Short selling: sell securities you do not own
 Your broker borrows the securities from another
client and sells them in the spot market
 At some stage you buy the securities back & return
them
 If the price falls: sell high, buy low.
 You pay dividends & other benefits to the owner of
the securities.
 Diagram
Introduction: Assumptions & notation
 Assume:
 No transaction costs
 Same tax rate
 Borrowing/lending at risk-free rate
 No-arbitrage opportunities (arbitrage

opportunities taken advantage of immediately).
 S0: Spot price today
 F0: Futures or forward price today
 T: Time until delivery date (years)
 r: Risk-free interest rate for maturity T
(continuously compounded rate p.a).
Investment assets - Simple pricing
 The relationship between F0 and S0 is
F0 = S 0 e rT
 If F0 > S0erT, arbitrageurs buy the asset
and short forward contracts
 If F0 < S0erT, arbitrageurs short the asset
and buy forward contracts.
Investment assets - Example 1
 Suppose:
 The spot price of gold is US$600
 The quoted 1-year futures price of gold is

US$650
 1-year US$ interest rate is 5% p.a
 No income or storage costs for gold
 Is there an arbitrage opportunity?

Investment assets - Example 2
 Suppose:
 The spot price of gold is US$600
 The quoted 1-year futures price of gold is

US$590
 1-year US$ interest rate is 5% p.a
 No income or storage costs for gold
 Is there an arbitrage opportunity?

Short sale constraint
 What if short sales are not possible for all
investment assets?
 Short selling not needed for the forward
price equation.
 Only require that at least some people hold
the asset only for investment purposes.
 If the forward price is low, they sell the asset &
take a long forward position.
Investment assets - known $ income
 Investment asset has income during the life of a

forward contract:
F0 = (S0 – I)erT
where I = present value of the income during life of
forward contract
 If F0 > (S0 – I )erT, arbitrageurs buy the asset and

short the forward contract.
 If F0 < (S0 – I )erT, arbitrageurs short the asset and
buy the forward contract.
Example: known $ income
Consider a long forward contract to buy a coupon
bond with a current price of $900.
-The forward contract has a 9 month maturity & a
coupon payment of $40 in 4 months.
-The continuously compounded 4 and 9 month risk-
free rates are 3% and 4% p.a
 The forward contract price should be $886.60.
 To show why we will consider 2 situations
 i) where the futures is overvalued at $910.
 ii) where the futures is undervalued at $870.

Example: known $ income (i)
 The forward price is $910. Arbitrageur will
 Today:
 Borrow $900. The coupon payment has a present
value of 40e(-0.03)(4/12) = $39.60. So, $39.60 is
borrowed for four months and the rest ($860.40) is
borrowed for nine months (at 4%).
 Buy the bond
 Enter into a forward contract to sell the asset for $910.
 In four months:
 Receive $40 coupon payment
 Use $40 to repay first loan with interest
 In nine months:
 Sell bond & receive $910 under the terms of the
forward contract.
 Use $886.60 to repay second loan with interest.
 Profit: $910 – $886.60 = $23.40
Example: known $ income (ii)
 Forward price is $870. Arbitrageur will
 Today:
 Short the bond ($900)
 Enter into a forward contract to buy the bond for $870
in nine months.
 Of the $900 realized from shorting the bond, $39.60 is
invested for four months at 3% per annum (grows to
$40). The remaining $860.40 is invested for nine
months at 4% per annum (grows to $886.60)
 In four months:
 Receive $40 from four-month investment
 Use $40 to pay coupon on the bond
 In nine months:
 Receive $886.60 from nine-month investment
 Buy the bond for $870 under the terms of the forward
contract
 Close out short position in the bond
 Profit: $886.60 – $870 = $16.60
Investment assets - known yield
 If the asset underlying a forward contract
has a known yield
F0 = S0e(r–q)T
where q = average yield over the life of the contract
 Two examples
 Stock index futures
 Currency futures
Known yield – stock index futures
 Investment asset paying a dividend yield
 The price relationship is
F0 = S0 e(r–q )T
where q = dividend yield (over life of contract) on

the portfolio represented by the index
 Index must represent an investment asset
 changes in the index must correspond to changes
in the value of a tradable portfolio
 F0 > S0e(r-q)T arbitrageur buys the stocks
underlying the index and sells futures
 F0 < S0e(r-q)T an arbitrageur buys futures
and sells the stocks underlying the index
 Index arbitrage involves simultaneous
trades in futures & many different stocks
 Very often computer used to generate
trades
 Lets consider the E-mini S&P500 futures contract
Contract specs reveal expires 3rd

Friday of the month. Therefore
34 trading days prior to expiration
T=34/252
S&P500 close Feb 3/2020

 3225.52
 4 week US T-bill rate 1.53%p.a
 Dividend yield 1.79%p.a
=
 Fo 3225.52 exp [ (0.0153 − 0.0179)
= × 34 252] 3224.39
Known yield – currency
 Foreign currency provides a continuous
yield - the foreign risk-free interest rate rf
( r −rf ) T
F0 = S0e
 Underlying asset is 1 unit of foreign

currency.
Known yield – currency example
 2year interest rates in Australia and the U.S. are 5%
and 7%. Spot exchange rate is 0.62 USD per AUD.
Find the two year forward rate.
 Given that fx rate is 1 unit of foreign currency,
we consider from perspective of US investor.
 Can also redo from the perspective of an
Australian investor.
 Consider when 2year forward rate is 0.63 & 0.66.

Consumption assets
F0 ≤ S0 e(r+u )T
where u is the storage cost per unit time as
a percent of the asset value.
 Alternatively,
F0 ≤ (S0+U )erT
where U = present value of the storage
costs.
Consumption assets - example
 Consider a 1 year copper futures contract.
 Assume no income and that it costs $2 per ounce
per year to store copper, with payment being
made at the end of the year.
 The spot price is $600 and the risk-free rate is
5% p.a for all maturities.
 Find the futures price.
 Consider when futures price is $700 & $610

Consumption assets – convenience yield
 Convenience yield is the benefit from holding

the physical asset.
 Reflects market expectations of future availability
 High inventory expectations low conv yield
 Low inventory expectations high conv yield
 Convenience yield is
F0eyT = (S0+U )erT
 If U is proportional to the spot price
F0eyT = S0e(r + u)T
 Example
Cost of carry
 Cost of carry, c, is the storage cost plus the
interest costs less the income earned
 Investment asset F0 = S0ecT
 Consumption asset F0 ≤ S0ecT
 Convenience yield on consumption asset, y,
is defined so that
F0 = S0 e(c–y )T
Forward valuation
 The value of a futures contract is zero - value reflected in
the margin account.
 K is delivery price in a forward contract entered into
previously. F0 is forward price that would apply to the
contract today.
 Value of a long forward contract, ƒ, is
ƒ = (F0 – K )e–rT
 Value of a short forward contract is
ƒ = (K – F0 )e–rT
 Forwards have a value of zero at the time first entered
into because F0=K.
 As time passes, the forward price and the value of the
contract change.
Forward valuation: example
Consider a long forward contract on a non-dividend
paying stock entered into some time ago that has
5 months left to maturity. The risk-free rate with
continuous compounding is 9% p.a. The current
stock price is $30 and the delivery price is $28.
The value of the contract is:

F0 = 30e(0.09)(5/12) = $31.15
ƒ = (F0 – K )e–rT = (31.15 – 28)e(-0.09)(5/12) = $3.03
or
ƒ = S0 – Ke–rT = 30 - 28e(-0.09)(5/12) = $3.03
Will use this in the BSM lecture

ESG
 Environmental, social and governance (ESG)
movement is now emerging in the derivatives
markets.
 ESG companies typically less exposed to
environmental and regulatory tail risks (Value at
Risk lecture)
 Eurex and Nasdaq have launched ESG futures
 Similar plans for many other markets
 China will soon open an exchange solely dedicated

to the trading of carbon finance futures
ESG
 Eurex
 Futures on the STOXX Europe 600 ESG-X index
 Index screens out companies with low ESG rankings
 Index enables investors to easily switch portfolio to an ESG
compliant benchmark with low cost and tracking error
 Futures on the index now traded
 Futures can be used for hedging and speculative purposes
 This should add liquidity to the underlying index
 Nasdaq
 In October 2019 Nasdaq launched a futures based on the
OMXS30 responsible index
 Also excludes companies with poor ESG standards
Futures Prices & Expected Spot Prices
 So far we have focused on the contemporaneous

relation between F0 and S0.
 What about the relation between F0 and E (ST )?
 If
 F0 = E (ST ) F0 unbiased estimate of ST
 F0<E (ST ) normal backwardation
 F0>E (ST ) contango
FNCE 30007
Lecture – Introduction to Options

Outline
 Option types and positions
 Moneyness, intrinsic and time value
 Factors affecting option prices
 Upper and lower bounds
 Put-call parity
 Early exercise
 The effect of dividends
Reading: Chapter 10
Option types and positions
 Two basic option types
 call: is an option to buy
 put: is an option to sell
 Options can be either

 European: can be exercised only at maturity
 American: can be exercised any time
 There are four option positions

 Long call
 Long put
 Short call
 Short put
Option types & positions: Long Call
 Profit from buying one European call option: option
price = $5, strike price = $100
Payoff
ST = stock price at maturity, K = strike price
0 if ST ≤ K
ST – K if ST > K
Option types & positions: short call
 Profit from writing one European call option: option
Payoff
0 if ST ≤ K
– (ST – K) if ST > K
Option types & positions: long Put
 Profit from buying a European put option: option
Payoff
K – ST if ST < K
0 if ST ≥ K
Option types & positions: short put
 Profit from writing a European put option: option
Payoff
– (K – ST) if ST < K
0 if ST ≥ K
Moneyness & Intrinsic Value
 Moneyness
 In the money if S > K for call (S < K for put)
 Out of the money if S < K for call (S > K for put)
 At the money if S = K for call and put
 European option will be exercised when it is in the

money on the expiration date
 Intrinsic value: the maximum of zero & the value of
the option if exercised immediately
 max(S – K, 0) for a call option
 max(K - S, 0) for a put option

Time value
 Time value: Option value - Intrinsic value
 captures the possibility that the option may
increase in value due to volatility in the
underlying asset
 positive, declines exponentially with time and
reaches zero at maturity
 Usually worthwhile for the holder of American option
to wait rather than exercise immediately
 if exercise receive intrinsic value & lose time
value
 Example: www.asx.com.au
Factors Affecting Option Prices
 current stock price, S0
 strike price, K
 time to expiration, T
 volatility of the underlying asset, σ
 risk-free rate, r
 dividends expected during the life of the option, D
European American
Stock Price
 Call options become more valuable as stock price increases
 Put options become more valuable as stock price decreases
Strike Price
 Call options become more valuable as strike price decreases
 Put options become more valuable as strike price increases
Time to Expiration
 As the time to expiration increases American put and call options
become more valuable
Dividends
 Dividends reduce the stock price
 Value of a call option decreases and a put option increases
Volatility
 Higher volatility increases the chance that the stock
will do very well or very poorly
Risk-free rate
 Call (put) options become more (less) valuable as
. the risk-free rate increases
Upper Bounds (No Dividends)
 Call never worth more than the stock.
c ≤ S0 and C ≤ S0
 American put never worth more than the
exercise price
K = max profit available at any time
P≤K
 European put never worth more than PV
value of the exercise price today
p ≤ Ke-rt
Ke-rt = max profit at maturity
in today’s $
Lower bound for calls (No Dividends)
 Lower bound for a European call option on a non-

dividend-paying stock is
c≥max(S0 - Ke-rt, 0)
 Violation of lower bound arbitrage profits
Example
European call on non-dividend-paying stock with
strike of $25 and maturity in 1 year. The option
premium is $4, stock price is $32 & risk-free rate is
10%p.a Is there an arbitrage opportunity?
S − Ke − rT =−
32 25e −0.1×1 =
9.379
cobs < S − Ke − rT
underpriced = buy overpriced =sell

Lower bound for calls: example
Lower bound for calls: example
Note: profits are identical 5.379e0.1 = 5.95

Formal Derivation
 Consider two portfolios:
 A: 1 European call option (c) + Ke-rt (in cash)

 B: 1 share (S0)
 Cash in A, if invested, will grow to K in time T
 If ST > K, option exercised and A worth ST
 If ST ≤ K, option worthless and A worth K
 Therefore, at T, portfolio A worth max(ST, K)
 B always worth ST at time T

 Thus, portfolio A is always worth as much as, and

sometimes more, than portfolio B at maturity.
c + Ke-rt ≥ S0
or
c ≥ S0 - Ke-rt
 At worst, the call value will be zero. Thus,
c ≥ max(S0 - Ke-rt, 0)
Lower bound for puts (No Dividends)
 Lower bound for a European put

on a non-dividend paying stock is:
p ≥ max(Ke-rt - S0 , 0)
 We can again consider two

portfolios and derive the above
condition
Lower bounds: CBA options Feb 3,2020
r=0.879%p.a
T-bond yield
c ≥ max ( S0 − K e − rT ,=
0 ) max ( 84.490 − 84e −0.00879×7/252 , 0 ) p ≥ max ( K=
e − rT − S0 , 0 ) max ( 84e −0.00879×7/252 − 84.490, 0 )
= max ( 0.5105, 0 ) = max ( −0.5105, 0 )
No lower bound violations

Put-call parity (No Dividends)
 Consider 2 portfolios:
 Portfolio A: European call + PV of strike
in cash
 Portfolio C: European put + stock
 Both worth max(ST , K ) at option maturity

 Must be worth the same today, i.e.
c + Ke -rT = p + S0
Put-call parity example
 Suppose
c = 4, S0 = 35, K = 32, T = 1.00, r = 10%, D = 0
 What are the arbitrage possibilities when p = 3.00 ?
c = p + S0 − Ke − rT
=3 + 35 − 32e −0.1
= 9.045
cobs < p + S0 − Ke − rT
↑ ↑
underpriced=buy overpriced=sell
Note: profits are identical 5.045e = 5.58

0.1
Put-call parity: CBA options Feb 3,2020
Use midpoint between bid and offer
𝑐𝑐 + 𝐾𝐾exp(−𝑟𝑟𝑟𝑟) = 𝑝𝑝 + 𝑆𝑆0
1.41 + 84exp(−0.00879 × 7⁄252) = 0.77 + 84.620
85.39 = 85.39
Put-call parity: American Options
 Put-call parity holds only for European options.
 The following holds for American options (no dividends):
S0 - K ≤ C – P ≤ S0 - Ke -rT
 Not an equality given the possibility of early exercise

 If call is within this range: no arbitrage opportunities
 If outside these bounds: arbitrage opportunities
Early Exercise
 Chance that American option will be exercised early
 Exception is American call on non-dividend paying stock
 Should never be exercised early
 No advantages to exercising early if the investor plans to

hold onto the stock for the remaining life of the option
 Reasons for not exercising American call early
 no income is sacrificed
 delay paying the strike
 call provides insurance against stock price falling below strike
 Lower bound for the option is:

C≥c
or
C ≥ S0 - Ke -rT
Early Exercise: American Puts
 May be optimal to exercise early
Example:
 K = $15, S0= $0, this K - S0 = $15
 Gain from exercise will never >$15, but can be <$15
 Time value of money: receiving $15 now is preferable

to receiving $15 in the future
 Early exercise more attractive as the stock price

decreases, risk-free rate increases, and volatility
decreases
Early Exercise: American Puts
 Remember lower bound for a European put
p ≥ Ke-rt - S0
 For an American put, the above condition is

stronger
P ≥ K - S0
This is the profit from buying a put and selling

underlying immediately. Put must be priced more
than this otherwise arbitrage opportunity
Dividends
 Lower bound for calls and puts
c ≥ S0 – D – Ke-rt
p ≥ D + Ke-rt – S0
 When it is known that dividends are to be paid,
sometimes optimal to exercise American call just prior to
an ex-div date. Most likely when
 i) final ex div date close to T (not foregoing much time value)
 ii) dividend is large (large decrease in S ex div)
 iii) if multiple dividends better to exercise just before last
dividend (see page 321)
 Put-call parity
c + D + Ke -rT = p + S0 (European options)
S0 – D – K ≤ C – P ≤ S0 - Ke –rT (American options)
FNCE 30007
Lecture – Binomial Model (Part 1)

Outline
 Stock price dynamics

 The Key Idea
 The one period model
 The two period model
Stock Price Dynamics
 The value of an option at maturity depends on the price of the
underlying stock at maturity.
 The value of the option today depends on the expected value of
the option at maturity and hence on the expected stock price at
maturity.
 We know the current stock price today, but what is the expected
stock price at maturity?
0 T
Used to denote a
random variable
i.e unknown
S0 Dynamics
ST
C0 Take expectations & present value

CT
 Objective: To specify a mathematical model for the movements

(dynamics) in the price of the underlying stock over time
Stock Price Dynamics - Definitions
 Discrete Random Variable
 A discrete rv is a variable X which is to take on one
value, by chance, from a set of possible values
Ψ ={ x1 , x2 ,..., xn }
 The realisation of a rv represents the value of X that
occurs (X is no longer random).
 Probability and Distribution Functions

 The probabilities associated with a discrete rv X are
given by the probability function
p ( xi ) ≥ 0
Prob ( X i)
= x= p ( xi ) for each xi ∈ Ψ p ( x1 ) + p ( x2 ) + ... + p ( xn ) =
1
 and the distribution function:

Prob ( X ≤ x=
i) ∑ p (=
x)
x ≤ xi
p ( x1 ) + p ( x2 ) + ... + p ( xi )
Stock Price Dynamics - Definitions
 Expectations and Moments
 The expected value of a discrete rv is
n
E [ X ] = ∑ xi p ( xi )
i =1
 If X is a rv and g is a function, then g ( X ) is also a

rv (i.e a function of a rv is also a rv) and
n
E  g ( X )  = ∑ g ( xi ) p ( xi )
i =1
 The mean of X is: E[X ]
The variance of X is: [ X ] E ( X − E [ X ]) 

2
 Var=
Measures dispersion in Ψ
 Expectations and Moments
 Example 1:
 Assume a fair die is rolled once. Let X be the rv
whose value represents the number rolled.
 Calculate:
 i) the probability of rolling less than or equal to
4,
 ii) the expected value of X.
 Stochastic Processes
 A stochastic process is a sequence of related
rv’s over time i.e there is a physical link
between them.
 Let X t be a rv measured over time. Then the
sequence of rv’s X 0 , X 1 , X 2 ,... X T is a discrete time
stochastic process
 Each X t is a rv, the sequence of the X t is the
sp
 The sample path (or realisation) of a sp
represents the sequence of particular values of
each X t that occurs i.e. the process is no
longer random.
 Example 2:
 Assume a fair coin is tossed 3 times
 i) How can we model the cumulative number of
heads over time?
 Let t=0,1,2,3 be the time of each toss

 Let X t be the rv whose value is the no of heads up
to and including time t.
 The sequence X 0 , X 1 , X 2 , X 3 is a discrete time
stochastic process for the number of heads over
time
 ii) Describe the sample path corresponding to the

outcome Heads-Tails-Heads.
 Example 3:
 Let St be the random variable whose
value represents the stock price at time
t
 Then the sequence S0 , S1 ,...., ST is a
discrete time sp for the stock price over
time
 Stochastic Processes - Summary

 To price options we need a model for
the movements in the underlying stock
over time
 We model movements in stock prices
over time by a stochastic process
 There are a number of different
stochastic processes that may be used.
The Key Idea – The Riskless Hedge
 The riskless hedge is the key concept underlying most
standard option pricing models
 Including the binomial model
 Based on the assumption of no arbitrage (NA)
 Assume the current price of a risky non dividend paying
stock is $20. At the end of the period it will be either $22
or $18. Consider a European call on the stock with K=$21
with maturity of one period. Risk free rate is 3%p.a.
 The stock is risky – payoff at the end of the period is
variable/uncertain/random.
 A risk free bond (B) is riskless – payoff at the end of the
period is fixed.
= =
ST 22, BT 103
S0 = 20
B0 = 100 = =
ST 18, BT 103
 The riskless hedge refers to the fact that a combination of
options and stock in the appropriate proportions can be
used to replicate the payoff on a risk free bond
Cash now Cash at end of year
S1 = 18 S1 = 22
Portfolio 1
Buy 1 share
Sell 4 calls
Net
Portfolio 2
Buy risk free bonds
 Riskless hedge because you sell calls and protect yourself

from stock price rise by holding the stock
 If same payoff at maturity, then must have same current
value today
4c − 20 = −17.468
c = 0.633
 The implications of the riskless hedge

approach for option valuation are
 1) An option is risky, but it is not necessary to
determine the risk premium applicable to the
option in order to value it.
 To value a risky asset we would normally need
to know the expected rate of return on the
asset (risk free rate +RP)…..but not here.
 Since the payoff on the portfolio of stock and
options is risk free, the return on the portfolio
is the risk free rate (which we know).
 From here we can work out the value of the
option given the current stock price.
Stock is risky + Option is risky BUT Stock & Option together is riskless
 2) In accordance with the NA assumption, this is
a relative valuation approach – we value the
option relative to the price of the stock.
 We don’t require the stock to be fairly priced
 3) If the observed market price of the option
differs from the NA price - arbitrage opportunity.
 4) We did not need to know the probability that
the stock price will rise or fall.
 5) The riskless hedge is the basis for the BS and
binomial model.
 An alternative approach is the risk neutral valuation
approach (more on this later).
The One Period Model
 Assumptions
 1) European call option on a stock with a strike K,
maturity T years.
 2) The current price of the stock is S and over each
period of length ∆t years, the stock price either
increases by a factor u with probability q or
decreases by a factor d with probability 1-q where
u,d,q are constant.
 3) The stock pays no dividends over the life of the
option
 4) Frictionless market
 5) The nominal risk free rate is constant at r% p.a.
where u > e r t > d
 6) no arbitrage
 7) one time period to maturity
2) and 7), S follows a binomial stochastic process.

The One Period Model
 Value of Option at maturity

 If stock price rises:
= fu max [ 0, uS − K ]
 If stock price falls:

= fd max [ 0, dS − K ]
fT ∈ { f u , f d } is a discrete rv
 Current value of the option
e r t − d
where p = Note: formula does
u−d not contain q
The One period Model – Derivation
 1) At start of the period form a portfolio of long ∆ shares of stock
and short 1 option.
Selling call decreases
 2) The current value of the portfolio is π =∆S − f cost of the portfolio
(it costs −π to form the portfolio)
The value of the portfolio at maturity depends on the stock price at

that time
πu =
∆uS − fu If the stock rises
πd =∆dS − f d If the stock falls
If we choose
fu − f d
∆= then πu = πd
uS − dS
and the value of the portfolio at the end is the same irrespective of
whether the stock price rises or falls. The value of the portfolio is
therefore riskless (not effected by the stock price risk).
The One period Model – Derivation
 3) If the portfolio is riskless then the
(continuously compounded) rate of return
over the period must be the risk free rate
of return (otherwise arbitrage would be
possible) and so
π=
u π=d π e r ∆t
 i.e you earn the risk free rate of r% p.a over a

period of ∆t years.
 Some algebraic manipulation leads to the 1
period pricing formula.
The One period Model – Example
 Assume
 Current stock price = $20
 Stock price changes by +/- 10% each 3
months with equal probability
 European call, strike $21, maturity 3
months
 Constant risk free rate of 12% p.a
 1 time period to maturity
The One Period Model - Notes
 1) The value of the option does not depend on the
expected return of the stock
σ ∆t
 =
Depends on volatility expectations: u e= ,d 1 u
 Eg expect volatility (std dev) at 20% annualised, T=1 year
=
u e0.2=
1
1.221,=
d 1=
u 0.819
 2) f is a relative pricing relationship
 For a given S, this is the correct f.
 3) ∆ is the delta of the option and specifies the number of
shares to be bought for each option sold at the start of
the period
 4) The 1 period formula can be given the following relative
interpretation
pfu + (1 − p ) f d
f =
e r ∆t
Option value at Option value at

Option value at end of period if end of period if
start of period stock rises stock decreases
The 2 period model
 Assumptions
 1) to 6) as before
 8) two periods (of equal length) to
maturity.
 Current value of option
p 2 fuu + 2 p (1 − p ) fud + (1 − p ) f dd
2
f =
e 2 r ∆t
The 2 period model
 Example
 Stock price changes by +/-10% each 3
months
 Constant risk free rate = 12%p.a
 2 time periods (of equal length) to
maturity.
The 2 period model - Derivation
 Consider a 2 period model as a series of 2 x 1 period
models.
 Starting at maturity, work backwards through the tree 1
period at a time and repeatedly apply the principle of a 1
period riskless hedge to each 1 period sub tree.
4 f uu max  0, u 2 S − K 
=  
2
pfuu + (1 − p ) fud
fu =
1 e r ∆t
pf + (1 − p ) f d
5 f
= ud max [ 0, udS − K ]
f = u
e r ∆t
3
pf + (1 − p ) f dd
f d = ud
e r ∆t
= f max 0, d 2 S − K 
Substituting and working through algebra yields 6 dd
p 2 fuu + 2 p (1 − p ) fud + (1 − p ) f dd
2
f =
e 2 r ∆t
Two period model - Notes
 1) Since u and d are the same for each
period, the tree recombines. Non-
recombining trees explode as the number
of periods increases.
 2) the delta of the option changes from
period to period
 Rather than a single ∆ we now have a ∆1 at
node 1, a ∆ 2 at node 2 and a ∆ 3 at node 3.
 The risk neutral hedge needs to be re-balanced
at the start of each period if the hedge is to be
maintained over the life of the option.
References
 Hull (8th edition) Chapter 12 and 18.1
FNCE 30007
Lecture – Binomial Model (Part 2)

Outline
 The n period model

 When early exercise may be optimal
 Hedging strategies
 Risk neutral valuation
The n period model
 Assumptions
 1) to 6) as before
T
 9) n periods (of equal length) to maturity ∆t =
n
 Stock price tree
 Each period starts at time t = 0, ∆t , 2∆t ,..., ( n − 1) ∆t
with maturity of the option at time t = n∆t = T
 At time t = i∆t (after i movements in the stock
price) there are i+1 nodes (possible stock
prices)
 The stock price at the (i,j) node is u j d i − j S
corresponding to j up movements at time t = i∆t
 Let fi , j be the value of the option at the (i,j)
node
The n period model
 Values of the option at maturity (i=n)
n+1 possible stock prices at end
f=
n, j max 0, u j d i − j S − K  for=j 0,1,..., n
stock price at node (n,j)
 Values of the option at intermediate nodes

 At each node prior to maturity, repeated
application of the principle of a one period
riskless hedge gives:
pfi +1, j +1 + (1 − p ) fi +1, j
fi , j =
e r ∆t
The n period model
 Current value of the option
n
n!
∑ p j (1 − p ) f n , j
n− j
j =0 j !( n − j ) !
f =
e nr ∆t
 Example (2 period model)
 Substitute n=2 into the above formula
2
2!
∑ j !( 2 − j )! p (1 − p )
j 2− j
f 2, j
j =0
f =
e 2 r ∆t
 Now expand the numerator for each of j=0, 1
and 2.
The n period model: CBA options Feb 3,2020
The n period model: CBA call & put
Price CBA options from lecture 4

7 days to maturity 7 step model
Delta t = 1/252
When early exercise may be optimal
 Recall
 i) American call on a non div paying stock
should never be exercised early
 If exercise, receive intrinsic value
 If sell, receive intrinsic value + time value
 ii) Time value for American call on a div paying

stock may be zero.
 Exercise may be better than selling
 iii) American put on a non div paying stock

 May be optimal to exercise early
 A simple (analytical) valuation

formula does not exist.
 We use the following methodology
 Start at maturity and work backwards
through the stock price tree node by
node
 Value the option at each node ensuring
you test at each node where early
exercise is possible, whether early
exercise is optimal at that node
 Example: American put on a non

div paying stock
 The value of the option at node (i,j) is:
K − u j d i− j S if exercised (lower bound)
pfi +1, j +1 + (1 − p ) fi +1, j if not exercised

e r ∆t
 pfi +1, j +1 + (1 − p ) fi +1, j 

Therefore
= fi , j max  K − u j d i − j S , r ∆t 
 e 
pfi +1, j +1 + (1 − p ) fi +1, j exercise at node (i,j)

If K − u j d i− j S > r ∆t
e
 Example:
 2 year American put option on a non
div paying stock
 Stock price $50 and changes by +/-
20% p.a
 Strike price $52
 Risk free rate 5% p.a
 i) Value put using a two period model
 ii) Should option be exercised early?
Hedging strategies
 What happens if the market price of an option differs from its
theoretical price/value?
 The one period binomial model is based on the 1 period riskless
hedge portfolio
π =∆S − f
theory
 i.e long $π bonds = long ∆shares + short 1 option
 Rearranging yields
f theory =∆S − π
 i.e long 1 option = long ∆ shares + short $π bonds
 If the observed market price of the option differs from the

theoretical value of the option f theory , then an arbitrage
opportunity exists.
 The riskless hedge portfolio shows us how to lock in an
arbitrage profit.
Hedging strategies
 Example
 Stock changes by +/-10% each 3
months
 Constant risk free rate of 12%p.a
 1 time period to maturity
 Current market price of call is $0.70.
First step: Solve for ∆ and then ∏
Cashflows t=0 t=T

ST = 18 ST = 22
Sell 1 call
Buy ∆ stock
Sell π bonds
Net Cash
Note: If you just sold the overpriced call you are exposed.
Buying stock provides protection and ensures the arbitrage
is riskless
Notes
 1) At the start of each period (time

t) the hedge portfolio is
Theoretical value at
the end of period if
S increases
ft ++1 − ft +−1
long ∆ t = + shares of stock
St +1 − St−+1
short π t =
∆ t St − f t theory in 1 period zero coupon riskless bonds
for each option short.

 2) Applies to both calls and puts
Notes
 3) The positions of the hedge portfolio follows from the
fact that you can hedge a short option with an
equivalent long option.
 i.e. since long ∆ shares + short $π bonds is equivalent to a
long option, it can be used to hedge an equivalent short
option.
 4) Sometimes the hedging strategy calls for a reverse
hedge. Here the above absolute positions are reversed
but the relative positions are the same.
 i.e hedge a long option with short ∆ t stock and long π
bonds with calculated as above
t
∆t π t
 5) The 1 period riskless hedge states that an
appropriate combination of option and stock can be
used to create a riskless portfolio.
 This can be extended to that an appropriate combination
of any two of the securities (option, stock and bonds) can
be used to create a portfolio equal to the third.
Notes
 6) in the n period model, ∆ changes from period to
period.
 The riskless hedge portfolio needs to be rebalanced at the
start of each period.
 7) Since ∆ t π t are node dependent the delta hedging
strategy is path dependent.
 8) The above hedging strategy gives a perfect hedge…
in theory.
 9) If ft obs = ft theory the hedge portfolio can be used to hedge
the option and is called a hedging strategy.
If f ≠ f
t
obs
tthe hedge portfolio can be used to lock in an
theory
arbitrage profit and is called an arbitrage strategy.

Hedging strategies - Example
 Assume
 Stock changes by +/-10% each 3 months with
equal probability
 European call, strike $21, maturity 6 months
 Constant risk free rate of 12%p.a
 2 time periods to maturity
 Current market price of call is $1.50.
 What hedging strategy should be used to
lock in an arbitrage profit assuming the
stock price increases in both periods?
24.20
4
fuu = 3.20
22
2
∆2 ,π 2 19.80
20
5
f1theory = 1.2823 1 fud = 0
∆1 , π 1 18
3
16.20
∆3 , π 3
6
f dd = 0
t =0 t = 0.25 t = 0.5
St = 20 St = 22 St = 24.20
At t = 0
Sell call 1.50 -3.20
Buy stock -10.1280 12.2549
Sell bonds 8.8457 -9.1151
At t = 0.25
Buy stock -4.8598 5.3458
Sell bonds 13.9744 -14.4006
Net cash 0.2177 -0.0005 ≈ 0 0.0001 ≈ 0
Note: each period the bonds have to be repaid at the end of each period
Risk Neutral Valuation
 The binomial model is a special case of a
general approach to valuing options
known as risk neutral valuation
 The current value of an option is equal to the
present value of its expected future payoff in a
risk neutral world using the risk free rate as
the discount rate.
f = e − rT E * [ fT ]
where * represents the expectation in a risk
neutral world.
Why not value options using NPV in the real world?

Risk Neutral valuation - Notes
 1) Risk neutral world – investors do not care
about risk in valuing assets.
 2) In a RNW the expected return on the stock
(and all assets) is the risk free rate.
 3) RNV assumes risk neutrality only for the
purposes of valuing the option, even though most
investors are risk averse. (Done to simplify calcs).
 4) It can be shown that the value of the option
derived in a RNW is the same as the value of the
option in a risk averse world.
 5) This principle extends to valuing other
derivatives as well.
Risk Neutral valuation
 Example – 1 period binomial model

 i) Risk neutral probabilities
 Show that p may be interpreted as the
probability of a stock price increase in a
risk neutral world.
 ii) Derive the value of the option using
the RNV
References
FNCE 30007
Lecture – Black Scholes Merton Model

Introduction
 The binomial model (last two lectures) used a
discrete time SP
 Binomial model was actually published after BSM by
Cox, Ingersoll and Ross in 1979 (JFE)
 Used the binomial model to explain the concepts in the
BSM model to university students
 BSM uses a continuous time SP
 Published in 1973 (JPE)
 Nobel prize in 1997
 Drew on Louis Bachelier who did PhD in 1900
Outline
 Normal and lognormal distributions

 BSM assumptions
 Derivation
 BSM formulae
 Implied volatility
 Link between binomial and BSM
 Hedging errors
Normal & lognormal distributions
 Continuous random variable
 This is a variable X which takes on one value by chance
from a range of possible values. For example
−∞ < X < ∞ 0< X <∞
 The probabilities associated with a continuous RV X are
given by the probability function
b
∫ f ( x)dx
Prob(a ≤ X ≤ b) =
a
where f(x) is the probability density function (pdf) of X

 Graphically Prob( a ≤ X ≤ b) is the area under the pdf
between a & b.
 (Picture of pdf with probability)
 Normal random variables
 Use X ~ Φ (u , σ ) to denote that X is a normal RV with
mean u & std deviation σ
 Note: Φ (u , σ ) corresponds to Φ ( m, s ) in Hull
(2002,2005) but Hull(2008) uses Φ ( m, v ) which
corresponds to Φ (u , σ )
2
 Important features of a normal RV include

 The pdf of X is 1  x −u 
1 − 
σ 
=f ( x) e 2 for − ∞ < x < ∞
σ 2π
 Symmetric about its mean
 Area under curve is one.
 The probability that X takes on a value within one
(two) std deviations of its mean is approx 68% (95%).
 Standard normal random variables
 A function of a RV is a RV
X −u
 If X ~ Φ (u , σ ) and Z = then Z is the
standard normal RV σ
 Important features include
 Z ~ Φ (0,1) .
 Prob(a ≤ Z ≤ b) may be calculated from a
standard normal table which gives the area under
the standard normal (pdf) for a range of Z values
 Total area under curve is one
 Symmetric Prob( − a ≤ Z ≤ −
=b) Prob(b ≤ Z ≤ a )
 Lognormal random variables
 If X is a RV, then natural log of X is also a
RV (function of a RV is also a RV)
 Note: base e, not base 10
 X is a lognormal RV (lognormally
distributed) if lnX is a normal RV
The RV lnX ln X ~ Φ (u , σ )
Picture of f(x)
 Lognormal random variables
 Important features
 x > 0 . Stock prices cannot be zero
 Since lnX is normal
= and Var(ln X ) σ 2
E(ln X ) u=
 The mean of X is  σ2 
 u + 
E( X ) ≠ u
E( X ) = e  2 
 X is positively skewed (not symmetric) – the

probability of X being below its mean is greater
than the probability of X being above the mean
BSM assumptions
 1) European call on a stock, current price S, strike K,
maturity T years.
 2) Log stock price follows a geometric brownian motion
(GBM) with a continuously compounded expected rate of
return of u and a std deviation of the rate of return of σ .
Both u and σ are expressed as per annum rates and are
assumed constant over the life of the option.
E ( ST ) = SeuT
 3) Stock pays no dividends over life of option

 4) Frictionless market (no transaction costs, short selling)
 5) Constant risk free rate of r% p.a.
 6) no arbitrage
 7) securities are traded continuously i.e at every instant
BSM assumptions
 Stock price assumption
 Let St be the stock price at time t
 [
Each (future) St is a RV & the sequence St ; t ∈ 0, T is a ]
continuous time stochastic process for the stock price over
time. i.e there is a stock price for every time t
 Important features
 Stock price is smooth (no jumps)
 (Future) continuously compounded returns on the

stock over any two disjoint time periods are
independent RVs
 Think of GBM as a type of random walk as the length of each
time step 0.
 Stock price picture
BSM assumptions
 Stock price assumption (cont)
 Future continuously compounded returns on the stock are
normally distributed
ST  σ2  
ln ~ Φu −  T ,σ T  Separate density for
each horizon.
St  2  
 ln ( ST St ) is a normal RV
 Std dev increases as T increases. i.e the further ahead we look, the
more uncertainty about ST
 Returns can be positive or negative
 Future stock prices are lognormally distributed
  σ2  
ln ST ~ Φ  ln St +  u −  T ,σ T 
  2  
 To recover stock price take the exponent – this ensures stock price>0
BSM assumptions
 Stock price assumption (cont): Technical note
 The continuously compounded expected return on the
stock is
 E ( ST ) 
ln   = uT
 i.e. u p.a  St 
 The expected continuously compounded return on the

stock is  S   σ2 
E ln T =
 u − T
σ2  St   2 
 i.e. u− p.a.
2
 This “apparent” inconsistence is due to Jensen’s inequality
where
E [ ln( ST ) ] ≠ ln ( E [ ST ])
BSM assumptions
 Stock price assumption (cont)
 Example
 Assume a stock has an initial price of $40 and follows a
GBM with an expected return of 16% p.a and a volatility
(std dev) of 20% p.a.
 i) What is the probability distribution of the stock price
in 6 months time?
 ii) What is the 95% confidence interval for the stock
price in 6 months time?
 iii) What is the probability distribution of the 6 month
(continuously compounded) rate of return on the stock
price?
Outline of derivation of BSM model
 The binomial model is based on the concept of the one
period riskless hedge.
 Assumes that follows a discrete stochastic process (binomial)
 Similarly the BSM model is based on the concept of the
instantaneous riskless hedge
 Assumes follows a continuous stochastic process
 At each time t, a portfolio consisting of a long position in the
stock and a short position in the option is formed such that its
value is riskless for that instant.
 For binomial we do this at the start of each period
 No arbitrage: instantaneous rate of return on the riskless

portfolio is the risk free rate (same as binomial)
 Same principles as binomial, just harder maths (requires
solving PDEs) results in the BSM pricing formula.
BSM formulae
 Call Option
 Current value of the call option is
=Ct St N ( d1 ) − Ke − rT N ( d 2 )
where
ln ( St K ) + ( r + σ 2 2 ) T
d1 =
σ T
d=
2 d1 − σ T
and N(z) is the area under the standard normal from

−∞ to z
BSM formulae
 Getting behind the formula

 i) Binomial model
 ii) BSM payoffs diagram
 iii) BSM formula
  rT  N (d1 )   
 N ( d 2 )  St e   − K  + 0 × 1 − N ( d 2 )  
− rT
ct e
   N (d 2 )   
Expand and simplify
=ct St N ( d1 ) − Ke − rT N ( d 2 )
BSM formulae
 Call Option (cont): Notes
 1) there is a single source of uncertainty – movements in
the stock price. i.e only is random
 2) Ct is perfectly positively correlated with over an
infinitesimally small period of time
 3) it can be shown that note 2) + assumption 7)
(securities traded continuously) instantaneous riskless
hedge may be formed
 4) since the hedge is instantaneous, it needs to be
rebalanced continuously
 (binomial rebalance at start of each period)
 5) formula does not contain u – value of option does not
depend on expected stock return
 (binomial does not contain q)
BSM formulae

Ct
σ
d = 1/ u
BSM formulae
 Call option (cont)
 Example
 Stock price is currently traded at $1.76. Calculate the
price of a European call (strike $1.60, maturity 3 months)
on one share. Assume risk free rate of 10% p.a., stock
price volatility is 30% p.a. and company not expected to
pay any dividends over the next 3 months
BSM: CBA call Feb 3, 2020
BSM: CBA call Feb 3, 2020
 BSM calculations
=
St 84.620,= =
K 84, =
T 7 252, =
r 0.00879, σ 0.19
d1 = 0.25577 Note: no rounding for N(d1) and N(d2).
If rounding applied price is not close
d 2 = 0.2241
Ct 84.620 ( 0.600936 ) − 84e −0.00879×7 252 × 0.588662
=
= 1.416
 Binomial = 1.4258
 Actual midpoint = 1.41
BSM formulae
 Put option
 Current value of an equivalent put (same strike and
maturity) is:
Pt Ke − rT N ( − d 2 ) − St N ( − d1 )
=
Where
ln ( St K ) + ( r + σ 2 2 ) T

d1 =
σ T
d=
2 d1 − σ T
 Derivation uses put call parity + BSM call formula (see
tutorial questions)
Implied volatility
 Cannot directly observe σ so must be estimated
 Most common approaches are historic (see Appendix) &
implied
 Implied volatility estimates
 Recall Ct ( St , K , T , r , σ )
 Given Ct , St , K , T , r, implied volatility is that value of σ
which when substituted in the BSM formula, gives
 theoretical option price = current market price.
 Reflects the markets assessment of future volatility of the
stock over the life of the option.
 Solved iteratively as BSM formula cannot be inverted to
give σ = σ ( St , K , T , r , C )
Implied volatility
 Example
 Assume current value of a 3 month
European call on a non dividend paying
stock is $2.10. If the current stock price
is $21, strike is $20 and risk free rate is
10% p.a., what is the implied volatility of
the option
Volatility smiles and surfaces
 If BSM model was perfect, then all options on the same
stock would generate same implied volatility
 In practice, holding everything else constant, there are
patterns in implied volatility as a function of
 Strike price – volatility smiles (currency), volatility
skew(equity)
 Maturity – volatility term structures
 Strike and maturity – volatility surface
 Graphs for currency and equity against strike
 Reasons
 Either one or more of the assumptions are wrong or
there are one or more features which should be taken
into account. e.g fat tails (from TV vol or jumps),
leverage, crashphobia (skew)
Link between binomial and BSM
 Binomial and BSM forecast a distribution of stock
prices and hence option payoffs at maturity.
 Both models value the option as the PV of the expected
payoff in the risk neutral world
 As number of steps in binomial increases, the
distribution of ln ( ST ) and returns ln ( ST S0 ) converges
to the normal distribution.
 This is consistent with the binomial distribution
being well approximated by the normal if n>20
and p is not near 0 or 1.
Link between binomial and BSM
 u, d and q (binomial parameters) relate to changes in the
stock price over ∆t years
 For an option of fixed maturity T, as n (no of periods)
increases, sensible for u,d,q to be consistent with correct
model of stock price changes (mean and volatility) over
the life of the option. i.e need to link u,d,q, to u , σ (BSM)
 As n → ∞, ∆t → 0 binomial option prices converge to BSM
option price provided:
σ ∆t
=u e= and d e −σ ∆t
 Note u,q do not appear.

 If given u , σ for BSM and asked to use binomial, use the
above formula to get u and d.
Hedging errors
Binomial BSM
Assumptions i) Stock prices change i) Stock prices change
discretely continuously
ii) trading is discrete ii) trading is continuous
Option Dynamic: set hedge now Dynamic: set hedge now and
hedging (start of 1st period) and continuously rebalance over
rebalance at start of each time (i.e at every instant)
subsequent period to
maturity
In theory Delta hedging is perfect Delta hedging is perfect
In practice Perfect hedge only if actual Perfect hedge only if actual
stock prices follow the stock process follow assumed
assumed binomial process GBM process and can
rebalance continuously
Appendix 1: Standard normal table
 The table (next slide) shows the probability that the
random variable Z is between 0 and some positive
value z, where z is determined by reading down the
left column and the top row.
 Examples. What is the probability

 i) 0<Z<1.75 (Ans: 0.4599)
 ii) -1.75<Z<0 (Ans 0.4599)
 iii) -1.75<Z<1.75 (Ans 0.9198)
 iv) Z<-1.75 (Ans 0.0401)
 v) Z>1.75 (Ans 0.0401)
Appendix 1: Standard normal table
z .00 .01 .02 .03 .04 .05 .06 .07 .08 .09
0.0 .0000 .0040 .0080 .0120 .0160 .0199 .0239 .0279 .0319 .0359
0.1 .0398 .0438 .0478 .0517 .0557 .0596 .0636 .0675 .0714 .0753
0.2 .0793 .0832 .0871 .0910 .0948 .0987 .1026 .1064 .1103 .1141
0.3 .1179 .1217 .1255 .1293 .1331 .1368 .1406 .1443 .1480 .1517
0.4 .1554 .1591 .1628 .1664 .1700 .1736 .1772 .1808 .1844 .1879
0.5 .1915 .1950 .1985 .2019 .2054 .2088 .2123 .2157 .2190 .2224
0.6 .2257 .2291 .2324 .2357 .2389 .2422 .2454 .2486 .2517 .2549
0.7 .2580 .2611 .2642 .2673 .2704 .2734 .2764 .2794 .2823 .2852
0.8 .2881 .2910 .2939 .2967 .2995 .3023 .3051 .3078 .3106 .3133
0.9 .3159 .3186 .3212 .3238 .3264 .3289 .3315 .3340 .3365 .3389
1.0 .3413 .3438 .3461 .3485 .3508 .3531 .3554 .3577 .3599 .3621
1.1 .3643 .3665 .3686 .3708 .3729 .3749 .3770 .3790 .3810 .3830
1.2 .3849 .3869 .3888 .3907 .3925 .3944 .3962 .3980 .3997 .4015
1.3 .4032 .4049 .4066 .4082 .4099 .4115 .4131 .4147 .4162 .4177
1.4 .4192 .4207 .4222 .4236 .4251 .4265 .4279 .4292 .4306 .4319
1.5 .4332 .4345 .4357 .4370 .4382 .4394 .4406 .4418 .4429 .4441
1.6 .4452 .4463 .4474 .4484 .4495 .4505 .4515 .4525 .4535 .4545
1.7 .4554 .4564 .4573 .4582 .4591 .4599 .4608 .4616 .4625 .4633
1.8 .4641 .4649 .4656 .4664 .4671 .4678 .4686 .4693 .4699 .4706
1.9 .4713 .4719 .4726 .4732 .4738 .4744 .4750 .4756 .4761 .4767
2.0 .4772 .4778 .4783 .4788 .4793 .4798 .4803 .4808 .4812 .4817
Appendix 2: Historical volatility
 Volatility is a measure of uncertainty of stock returns
 Of the 5 parameters in the BSM model, volatility is the
only one that is unobserved
 Historical volatility, is an estimate of future volatility
based on past actual stock prices
 Consider a sample of n years of stock prices.
 Let Si for i = 0,1, 2,..., n be the actual stock price at the end of each
year. Assume no dividends
Pi
 Continuously compounded return for each year = is ui ln= for i 1, 2,.., n
Pi −1
 Estimate of actual volatility is the sample std deviation
n
1 n
s = ∑ ( ui − u ) ( n − 1) where u = ∑ ui
2
=i 1 = ni1
 Since annual data employed, this is an estimate of annual volatility
 If higher frequency data used (eg daily) then s is an estimate of σ τ
where τ is the length of each period in years
s
is an estimate of σ
τ
Appendix 2: Historical volatility
 Notes:
 1) past prices are not necessarily a good predictor of
future prices
 2) if daily data is used then usual to take τ = 1/ 252
rather than τ = 1/ 365 .
 3) more complicated approaches based on
econometric techniques exist (realised volatilities
based on intraday data)
References
 Hull (8th edition) Chapters 13.1-13.7, 13.9, 19.1-19.3
 Hull (7th edition) Chapters 13.1-13.7, 13.9, 19.1-19.3
 Hull (6th edition) Chapters 12.1-12.8, 17.1-17.3
FNCE 30007
Lecture – Dividends
Outline
 Stock pays a known (certain)

discrete dividend
 Stock pays a known (certain)
continuous dividend
 Options on stock indices
 Binomial trees
Stock pays known discrete dividend
 Impact on stock price

 In a perfectly competitive market (PCM) stock price is
expected to fall on the ex dividend date by the amount of
the dividend
 Let τ = ex-div date
Sτ = stock price at timeτ

Sτ − = stock price immediately before timeτ
D = known dividend paid at timeτ
 Then
=
Sτ Sτ − − D
 Picture of stock price over time
 Impact on stock price (cont)

 Market imperfections (transaction costs, taxes etc)
 drop off may be α D
 Cannot model stock price as a GBM (as it assumes no
jumps)
 Stock price net of the PV of dividends
 Assume
 Frictionless market
 St ; t ∈ [ 0, T ] is the actual stock price process
 It is known with certainty that there is one ex-div date at
time τ < T at when stock pays a div of D which causes stock
price to drop by α D
 Constant risk free rate of r% p.a.
 Stock price net of the PV of dividends (cont’d)
 The stock price net of the PV of dividends is St ; t ∈ [ 0, T ]
PV of price
St = St − α De − r (τ −t ) for 0 ≤ t < τ decrease
= St for τ ≤ t ≤ T
0 Any t T
PV
αD
t St PV of divs St
0 S0 α De− r (τ −0) = α De− rτ S0 − α De − rτ
τ− Sτ − −
α De− r (τ −τ ) = α D Sτ − − α D
τ Sτ - Sτ
T ST - ST
 Stock price net of the PV of dividends (cont’d)
 Key point: St has a jump but St does not.
Model St by a GBM
 Picture of stock prices over time
 Notes:
 1) equivalent to the stock price consisting of a risky and a
riskless component S= S − PV(div)
t t
S=
t St + PV(div) riskless
 2) α likely to be stock specific, but from now we will
assume α =1
 3) can extend to multiple dividends.
 Valuation of European Options
 Assumptions
 1) Standard assumptions (from here)
 Frictionless market
 Constant risk free rate of r% p.a
 No arbitrage
 Securities traded continuously
 2) European call on a stock with strike K, maturity T years
 3) Stock pays one dividend over life of option and the
amount and timing (t = τ ) of the dividend (D) and stock
price drop off (α = 1) is known with certainty
 4) Stock price net of the PV of dividends St ; t ∈ [ 0, T ]
follows a GBM with an expected rate of return of u and a
volatility of σ where u σ are constants and current
price of the stock net of PV of dividends is St
 Valuation of European Options (cont’d)
 The actual stock price process St has a dividend and a
jump, so cannot assume St follows a GBM
 cannot use BSM to price option (Option c )


The adjusted stock price process St has no dividend and
no jump so we can assume St follows a GBM
 can use BSM to price an otherwise equivalent option on St (Option c )
 What is the relation between the price of an option on St
and the price of an otherwise equivalent option on St.
 i.e the relation between c and c
 The current value of the option is approximately
(
C BSM St , K , T )
 i.e reduce the current stock price by the PV of the
dividends (to get St ) and value the option using BSM as
if the stock pays no dividends.
 Does use of St mean that we ignored the dividends?
 No, this recognises that the drop in stock price caused by the dividend,
we are just bringing it forward by using a lower stock price at t=0.
 Example
 Shares currently at $2.00. Calculate value of a European
call on one share with strike $2.10 and maturity 1 year.
Assume risk free rate of 10% p.a, stock price volatility of
30% p.a and a dividend of 10cents per share in 6 months.
 Notes
 1) σ is the volatility of the return on the stock price net of
dividens, but often use σ i.e σ ≈ σ
 2) only dividends that are relevant are those which occur
over life of option
 3) value of option on St equals value of option on St
Payoff Option C Payoff Option C

=CT max ( 0, ST − K ) = (
CT max 0, ST − K )
But ST = ST → CT = CT → Ct = C t
 4) Same approach for European put

 Optimal exercise of American options

 It may be optimal to exercise an American call on a
dividend paying stock just prior to an ex-div date.
 With multiple dividends, in most circumstances need only
consider the last ex-div date
 Valuation of American options
 Black’s(1975) pseudo American option pricing model
 Assumptions 1), 3) 4) as European above plus 5)
American call: strike K, maturity T years
 Treat American call like 2 European calls
 Because only optimal to exercise at 2 points in time – immediately
before goes ex-div and maturity.
 Diagram
 Valuation of American options (cont’d)

 Current value is approximately
{ (
max CBSM ( S , K ,τ ) , CBSM S , K , T )}
 Notes
 1) Shorter maturity option on actual stock price, but
longer maturity option on stock price net of PV of divs
 2) Approximation since the model does not take into
account the probability of early exercise at time τ
 3) Use BSM to value both options, but usually use same σ
 4) More complicated if multiple divs over life of option
 Valuation of American options (cont’d)

 Example
 Shares currently at $2.00. Calculate value of an American
call on one share with strike $2.10 and maturity 1 year.
Assume risk free rate of 10% p.a, stock price volatility of
30% p.a and a dividend of 10cents per share in 6 months.
 Other approaches to valuation

 Roll-Geske-Whaley exact American option pricing model
(takes into account probability of early exercise at time τ )
(not examinable)
 Analytical approximation (not examinable)
 Numerical approximation (monte carlo – Week 11)
 Extensions to binomial to allow for dividends (later)
Stock pays known continuous dividend
 Impact on stock price

 Div yield = p.a rate at which div is paid expressed as a %
of the stock price.
 Discrete div paid price falls on ex-div date
 Continuous div paid price falls continuously over time
 Stream of very small divs paid at each point in time
 None of the divs have a noticeable impact (no jump)
 In sum, the collective impact over time is same as discrete
 If price of non-div paying stock follows a GBM with
constant u & σ
 Tot expected rate of return = capital gains = u
 If stock pays continuous div yield of q% p.a, expected
growth rate in stock price is u − q
 Tot expected rate of return = capital gains + divs
u = u−q+q
 Valuation of European Options

 Merton’s (1973) continuous dividend option pricing model
 Assumptions
 1) Standard assumptions
 2) European call on a stock with strike K, maturity T years
 3) Stock pays known continuous dividend yield of q% p.a
 [ ]
4) Stock price St ; t ∈ 0, T follows a GBM where u , σ , q are
constants.
 Actual stock price process St has no jump, but stock pays
dividend assume St follows a GBM but cannot
assume no div cannot use BSM
 Valuation of European Options (cont)

 Solution
 Just like discrete div case, we reduce the current stock
price by removing the PV of the dividends

 Current stock price reduced from St to St = St e
− qT
and
then value the option as if the stock pays no dividends
(
C BSM St , K , T )
 The stock price process St has no jump and no
dividend and so can assume follows a GBM and price
using BSM

 Example
 Shares currently at $2.00. Calculate value of a
European call on one share with strike $2.10 and
maturity 1 year. Assume risk free rate of 10% p.a,
stock price volatility of 30% p.a and a dividend yield of
4% p.a. (rather than 10cents per share in 6 months).

 1) If St ; t ∈ [ 0, T ] follows a GBM with a constant
expected rate of return of g p.a & the current price
is S0 , then
E [ ST ] = S0 e gT
 2) The probability distribution of ST for the following

stocks is the same
 i) non div paying stock which follows a GBM with
constant u , σ & current price St e − qT (dynamics for
pricing)
 ii) dividend paying stock which follows a GBM
with constant u , σ , q & current price St (actual
dynamics)
 3) Given that 2) holds, the option values are equal

 Notes (cont)
 4) For American options, there is always a positive
probability of early exercise
C American > CEuropean
 Not examinable using continuous time approaches
 Can use a binomial tree with continuous div yield instead
 5) Substantial pricing errors can results around ex-
div date if divs are paid discretely not a good
pricing model for options on individual stocks!
Options on stock indices
 Stock Index definition

 Stock index measures the price of a portfolio (basket)
of stocks
 Price of the portfolio is usually a value or equally
weighted (arithmetic) average of the prices of
underlying stocks
 Pricing
 Can price using the known continuous div yield approach
under following conditions
 i) div paid by each stock in index is very small relative
to the total stocks in the index
 ii) ex div dates are reasonably spread across the year
 Caution: usually some clustering in div payments (half year and year end)
Binomial Trees
 Can be adjusted to value options on div paying stocks
 Discrete dividends
 1) Constant proportion of stock price
 δ
Div paid = times the stock price at time t
 price drops to 1 − δ times the (pre-drop) price on the ex-div date.
 All stocks nodes after and including ex-div date reflect drop
 Tree re-combines
 u,d,q are calculated as though there is no dividends
 2) Constant $ amount
 Div paid = D
 Price drops by D on ex div date
 All stock nodes after and including ex-div date reflect drop
 Tree does not recombine
 Approx is based on a binomial tree for stock price net of PV of
dividends
Binomial Trees
 Continuous div yield
 Stock pays a known continuous div of q% p.a
 Can apply one period model in the normal way but with
following adjusted value of p
e( r − q )∆t − d
p= No div q=0
u−d
..
 Start at St not St
Binomial Trees - dividends
 Example 1: Constant proportion

 Stock price $50, price changes +/-
10% each period, 3 period model,
dividend is 5% of the stock price at end
of 2nd period.
 Example 2: Constant $ amount

 Price an American put using 5 period
model with following
 5 month maturity
 Stock price $52, strike $50
 Risk free rate 10%p.a
 Volatility 40%
 $2.06 dividend paid in 3.5 months time
 Answer $4.44
Summary
 Continuous time
Option type Dividend
Discrete Continuous
• ••
European Call/put S t → use BSM S t → use BSM (Merton)
American Call Black’s pseudo (1 div) Analytical or numerical
Roll-Geske-Whaley (multiple approx. (not examinable)
div – not examinable)
Put Cannot use Black’s pseudo Analytical or numerical

(see tut) approx. (not examinable)
Analytical or numerical
approx. (not examinable)
 In general no analytical solution for American options except

 American call on non div paying stock. This should never be exercised early and so it s priced
equal to a European call
 American call with discrete dividends (see above)
 Discrete time
 Binomial can price any of the above options via 1 period riskless hedge
References
 Hull (8th edition) Chapter 13.10, 15.1, 15.3,15.4, 18.3
 Hull (7th edition) Chapter 13.10, 15.1, 15.3,15.4, 18.3
 Hull (6th edition) Chapter 12.10, 13.1-13.4, 16.3
FNCE 30007
Lecture – Delta hedging

Outline
 Hedging an option
 Delta hedging
 Hedging errors
 Synthetic options
 Rebalancing
Hedging an option
 Risk
 refers to the degree of uncertainty in the future value of
(or change in the value) of a variable – price of a stock (or
some other asset)
 Hedger
 Already has exposure to the future price of a stock and
seeks to reduce this risk – stock price risk
 Hedging reduces or eliminates an exposure
 Perfect hedge = eliminate 100% of the risk
 An option (or other derivative) may be used to hedge an
exposure to a stock
 A stock may be used to hedge an exposure to an option
 Consider a bank that writes an OTC option for a client. Bank wants to
hedge this risk
Hedging an option
 Static hedging
 Simplest way to hedge an option exposure is to take
opposite position and hold to maturity
 eg. Assume you write a call on a stock with strike K
and maturity T
 Diagram
 may not always be available (or may be too

expensive)
 Other ways to hedge an option
 Naked position
 Covered position Don’t work well
 Stop-loss strategy
 Delta hedge
Delta Hedging
 Risk of an option exposure
 Current value of an option on a non-div paying stock is a
function of
f = f (S , K , r, T ,σ )
 A change in any one of these variables change in f.
 K is fixed no need to hedge
 No uncertainty re passing of time no need to hedge
time decay
 BSM assumes only uncertainty affecting option value is
stock price risk, but in practice
 Both r , σ are likely to change over life of option
 Each party exposed to counterparty default
 more than one source of risk

Delta Hedging
 Greeks
 Describe some different dimensions to an options risk
 Measure the sensitivity in option value to changes in value
of each underlying variable
 Delta: change in f due to a change in S
 Rho: change in f due to a change in r
 Vega: change in f due to a change in σ
 Theta: change in f due to a change in T
 Gamma: change in delta due to a change in S
 Each Greek assumes only one variable changed at a time

i.e. all other variable are held constant
 We will focus on delta and gamma
Delta Hedging
 Delta of an option
 Delta is the rate of change of the option price with respect
to the stock price (assuming all other variables are
constant)
∂f
 For small changes in S: ∆ ≈
∂S
 Alternatively: ∂f ≈ ∆∂S
 Technical note: delta is the partial derivative of f with respect to S

 Notation:
 Hull (2002) uses lower case “delta” δ
 Hull (2005,8) uses upper case “delta” ∆

Delta Hedging
 Example
 Consider a call on one Speedy Ltd share.
The option has a delta of 0.6, current price
of $10, and current share price of $100.
 Assume stock price immediately increases by 10
cents.
 Use delta to estimate the price of the option
immediately after the change
Delta Hedging
 Delta of an option as a function of the stock
price
 Long call 0 ≤ ∆ ≤1
 Long put −1 ≤ ∆ ≤ 0
 Diagrams
 Delta of other securities

 Define delta (relative to changes in the stock
price) of any other security (eg futures) in similar
way
∂F
∆ futures =
∂S
Delta Hedging
 Delta of a portfolio
 Portfolio consists of
 n1 units of security 1 (value V1, delta ∆1 )
 n2 units of security 2 (value V2 , delta ∆ 2 )
 Both securities have same source of uncertainty - stock price
 Value of portfolio is
=
V p n1V1 + n2V2
 Delta of portfolio is
∆ p = n1∆1 + n2 ∆ 2
 Long (short) position represented by positive (negative)
values of n1 or n2
Delta Hedging
 Delta Hedging
 Portfolio with a zero delta is delta neutral
 Not affected by stock price risk (or small changes in S)
 Delta hedge an option (or portfolio of securities) by
combining it with the underlying stock so that the delta of
the combined portfolio is zero.
 Required to buy or sell underlying stock
 Required to buy or sell risk less bonds

 Stock purchases funded by selling riskless bonds (borrow
at risk free rate)
 Proceeds from stock sales used to buy riskless bonds
(invest at risk free rate)
 Alternatively, can delta hedge an option/portfolio using
other securities (e.g futures or other options on the
stock)
Delta Hedging
 Delta Hedging (cont’d)
 Example
 Assume you have just written 20 Speedy call options
 i) How can you delta hedge this exposure using the stock?
Security Delta Number
Call 1 0.6 n1 = −20
Stock 2 1 n2 = ?
 ii) Assume you have just delta hedged your exposure and
the stock price immediately increases by 10 cents. Use
the delta to estimate the impact on the value of the
hedged portfolio.
Delta Hedging
 Calculating delta of an option
 Delta is model specific
 If binomial model is being used to price the option, delta
at start of each one period sub-tree is
f − fd
∆= u
uS − dS
 If BSM is being used delta at each instant is Non-div paying stock
=
Call : ∆ N ( d1 ) =
Put : ∆ N ( d1 ) − 1
 If Merton’s model is being used delta at each instant is
Call : ∆ e − qT N ( d1 ) =
Put : ∆ e − qT  N ( d1 ) − 1
..
Calculate d1 using St =
 BSM with discrete div is not examinable.

Delta Hedging
 Gamma
 Is the rate of change of the options delta with respect to
the stock price, assuming all other variables constant.
 For small changes in S:
∂∆
Γ≈ ∂∆ ≈ Γ∂S
∂S
 Technical note: Exact definition is the second partial

derivative of f with respect to S
∂∆ ∂ 2 f
=
Γ =
∂S ∂S 2
Delta Hedging
 Gamma (cont’d)
 Using Merton’s model, the gamma for a call or put at each
instant is: − qT − d 2 /2
e 1
Γ= Γ call =
Γ put > 0
.. Sσ 2π T
St not S t
 The BSM gamma is derived by setting q=0.
 Gamma is greatest when at the money and decreases the
further the option goes either into or out of the money.
Hedging errors
 In theory, delta hedging is perfect
 Binomial & BSM models assume we can form a perfect
riskless hedge
 This assumption is based on assumptions that are unlikely
to hold in practice
 Binomial model assumes stock price can only take on one of
two possible values at the end of each period – many prices
are available.
 BSM assumes
i) can trade & hence hedge continuously – can only trade at
discrete points in time
ii) stock prices change continuously (i.e at any time they
can change by a very small amount) – in reality stock prices
may jump even in the absence of divs
 Delta hedging likely to be imperfect
Hedging errors
 Assume you wish to hedge a call option against an
immediate change in the stock price. Let
∂S = S '− S = actual change in S
∂f = f '− f = actual change in f
 Delta hedging implies that for a small change in S
Actual change in f ∂f ≈ ∆∂S Estimated change in f

 Or equivalently
∂f = ∆∂S + ε1
 i.e the hedging error is
ε1 = ∂f − ∆∂S
Hedging errors
 In a plot of option price versus stock price, delta is the
slope of the tangent to the curve at the current stock price
 Delta hedging assumes that f is a linear function of S,
when it is in fact curved (convex) function of S
 hedging error
 Delta hedging always underestimates the price of a call
after a stock price change
 Underestimates ∂f if stock price increases
 Overestimates ∂f if stock price decreases
 Delta hedging always underestimates the price of a put

after a stock price change and so
 Overestimates ∂f if the stock price increases
 Underestimates ∂f if the stock price decreases

Hedging errors
 Gamma measures some of the curvature between the

option and stock prices
 Taking account of gamma gives better estimate of ∂f
 For a small ∂S
Γ ( ∂S ) Γ ( ∂S )
2 2
∂f ≈ ∆∂S + → ∂f = ∆∂S + + ε2
2 2
Taylor series expansion
 where
Γ ( ∂S )
2
ε 2 = ∂f − ∆∂S − < ε1
2
Positive
Delta hedge error
Synthetic options
 Recall, you hedge an option by taking the opposite
position ( and holding to maturity)
 e.g you hedge a short call by buying a long call
 Key idea behind delta hedging is that rather than buying
(or selling) an option to hedge your exposure, you create
(or replicate) the required option position
 e.g. you hedge a short call by creating a synthetic long call
 Delta hedging creates a synthetic option by trading the
underlying stock and riskless bonds over the life of the
option (also referred to as a “replicating portfolio”)
 Fundamental rule: You create a synthetic option position
in the same way as you would hedge the opposite option
position
 Technical note: It may be better to delta hedge by trading in futures (lower
transaction costs, higher liquidity)
Synthetic options
 Assume you seek to protect the value of a portfolio
(portfolio insurance)
 Buy a put or create a long put synthetically
 Create a long put same way as you would hedge a
short put
f =∆S − π
Sell put Long, but remember ∆<0
π
short ∆S and invest bonds
 Why not just buy a put?

 Option markets may not have enough liquidity to
absorb trades of large funds
 May require strikes & maturity dates that are different
from exchange traded options
Hedging an option
 Example (continued from Binomial Part I)
 Current stock price of a non div paying stock is $20 and at
end of period will be either $22 or $18. Risk free rate is
3% per period and markets are frictionless. Show how to
create a synthetic long European call option on the stock
with a strike of $21 and maturity of one period.
Cash now Cash at end of year

ST = 18 ST = 22
Buy a call
Long 1 call
Create a call
Long 0.25 stock
Short $4.367 bonds
Net
Rebalancing
 Delta hedging is an example of dynamic hedging
 Delta of an option is not constant but changes with
changes in the stock price.
 Option price will also change with time (even if stock price does not
change)
 Delta hedge (delta neutral portfolio) will need to be
rebalanced from time to time to remain delta neutral
 Binomial at the start of each period, BSM each instant
 A measure of importance of rebalancing is the gamma
 Greater the gamma greater the change in delta
for a change in stock price greater potential for
hedging error from not rebalancing
 Gamma is greatest when at the money and therefore
re-balancing is most important here.
Rebalancing
 Example
 Consider a European call with a strike of $80, and
maturity 4 weeks from now on a non div paying stock.
Current stock price $80, risk free rate 5% p.a, stock price
volatility is 25% p.a.
 Assume a bank has just sold this option to a client for $3
and wants to immediately hedge the exposure.
 Describe the dynamic hedging strategy assuming the bank
employs the BSM model, the hedge is rebalanced weekly
and the stock price path is
End of week 0 1 2 3 4
Stock price $80.00 $77.86 $83.10 $83.67 $82.00
Rebalancing
Short position in riskless bonds
(3)
End of Delta # of shares Open Interest Shares Option Close
week bought/sold
St (1) (2) (4) (5) (6)
0 80.00 0.5359 0.5359 0.00 0.00 42.87 42.87

1 77.86 0.3557 -0.1802 42.87 0.04 -14.03 28.88
2 83.10 0.7995 0.4439 28.88 0.03 36.88 65.79
3 83.67 0.9099 0.1103 65.79 0.06 9.23 75.09
4 82.00 -0.9099 75.09 0.07 -74.61 2.00 2.55
Cumulative cost of hedging i.e how much is owed at the end.

If a perfect hedge, PV(2.55) should equal the options fair value.
Rebalancing
 Calculations (previous slide)
 1) Based on BSM (don’t forget to allow for decline in
maturity of option)
 2) Positive (negative) amounts represent stock purchases
(sales)
 3) Positive (negative) amounts represent borrowing
(investing) at risk free rate
 4) Based on opening balance
 5) Positive (negative) amounts represent stock purchases
(sales)
 6) Payoff on short option position at maturity
Rebalancing
 Notes
 1) Closing short position in riskless bonds (end of week 4)
represents the cumulative cost of hedging the option
 2) Difference between the initial fair value of option & the
present value of the cumulative cost of hedging is the
cumulative hedging error over the life of the option
 2.39-2.55exp(-0.05*4/52)
 If a perfect hedge is not possible then the cost of creating an option
will not equal the cost of buying the option
 3) Hedging error depends on the assumed path followed
by the stock over the life of the option
 Different stock paths will have different hedging errors
 Error may be positive or negative
 Could estimate expected error by simulation
Rebalancing
 Notes (cont’d)
 4) A delta hedge is ex-ante perfect only if there is a zero
hedging error for all possible stock price paths
 5) The more frequent you rebalance the lower the
expected hedging error
 In the limit, the BSM assumption of continuous rebalancing leads to a
perfect hedge
 6) In practice, rebalancing involves transaction costs –
increasing the frequency of rebalancing involves a trade-
off between lower expected hedging errors and higher
transaction costs
 7) If stock price falls, then so does the delta
 Delta hedging requires sell (buy) stock when price falls (rises)
 Larger hedging errors if everyone want to rebalance at same time
 e.g. portfolio insurance strategies during 87 crash
 ↓ S →↓ ∆ , synthetic puts needed to re-balance by selling more stock but limited/no
buyers
FNCE30007
Pricing options using simulation

techniques
Outline
 Motivation
 Simulation techniques
 Bootstrapping
 Monte Carlo
 VBA
 User defined functions
 If and ElseIf statements
 Loops
 Option pricing via monte carlo
 Numerical approximation of Greeks
 Antithetic variates
Motivation
 Black-Scholes presents a neat closed form
solution for pricing a European call option.
 The model however is only suitable when
its underlying assumptions hold.
 A European call option
 Stock prices correspond to the lognormal
model with returns  and constant volatility 
(volatility clustering – see S&P500 returns).
 No dividends
 Return independence i.e. i.i.d (autocorrelation
functions are useful here).
Motivation
 Some of these assumptions are not problematic/have
been addressed. e.g
 Put call parity to price European puts.
 Modifications for dividends
 Black’s approximation for an American call when

dividends are paid.
 Variations allow for
 Time varying risk free rate and volatility.
 Non normal returns distributions/prices not

lognormal.
 What if you are required to price a new exotic option with
no historical data?
 Sometimes solving an analytical solution is just too hard!
Motivation
 The model cannot be used to price some of the
more exotic options
 Example 1: An Asian option’s payoff depends upon
the average value (arithmetic) of the underlying,
over the horizon specified.
 Example 2: Cross-currency option. 4 categories
according to payoff.
 Consider European call option on foreign stock. Let
 ST be the stock price at maturity (denominated in foreign
currency
 eT be the fx rate at maturity, e0 a pre-specified fx rate
 K the exercise price in foreign currency.
 Four possible options:
 eTmax[0,ST-K],
 e0max[0,ST-K],
 max[0,e0ST-eTK],
 max[0,eTST-e0K].
Simulation techniques
 Simulation techniques are a powerful and
flexible way of pricing complex derivatives.
 Under the risk neutral valuation method the
option price is calculated in the following
way
1) Simulate prices to the relevant horizon
2) Calculate the payoff at maturity
3) Repeat steps 1) and 2) many times
4) Calculate the current value of the option by
averaging the present value of the payoffs at
maturity (discount rate is the risk free rate)
 So how can we simulate the prices?

 Two types of simulations
 Bootstrapping: requires a time series of
data. It generates data sets by re-
sampling.
 Monte carlo: does not require any data
and artificially generates data sets. This
is what we will be focusing on here.
 Bootstrapping
 Only makes the assumption that returns are i.i.d (no
distributional assumption)
 Say we have 1000 daily return observations and we

seek to simulate prices 100 days into the future.
 Randomly draw with replacement 100 returns
from the return series.
 The 100*1 vector of returns is then used to
create the simulated price series i.e
St 1  exp  Rt 1  ln  St  
 Not useful here as we need to simulate returns so
they have an expected return equal to the risk free
rate. Good for other applications though!
 Monte carlo
 Requires you to assume a particular data generating process
 A law of motion for the prices/returns
 Including a distribution
 You randomly draw values from the assumed distribution and

use this to generate the simulated data sets.
 Assume that the log of the underlying asset price follows a
geometric brownian motion. Applying Ito’s lemma and
discretising, the following asset price relation holds
St 1  St exp  r  q  0.5 2  dt  zt 1 dt 

r  risk free rate
q  div yield We will assume normality
zt  random innovation
dt  change in time
 Monte carlo (cont’d)
 Example (from BSM lecture)
 Stock price is currently traded at $1.76. Calculate the
price of a European call (strike $1.60, maturity 3 months)
on one share. Assume risk free rate of 10% p.a., stock
price volatility is 30% p.a. and company not expected to
pay any dividends over the next 3 months
 Call price per BSM = $0.23.

 We will illustrate the basics via the spreadsheet
“Simulation example.xlsm”.
Note: the average innovation is not equal to zero.

 Monte carlo (cont’d)
 Recall we need to simulate the price path many times
 Option value is the average of the PV of the payoffs at
maturity.
 We can write programs in VBA – the programming
language in excel.
 We will briefly go through the code that employs
 A user defined function
 If and ElseIf statements
 Loops
VBA - User defined functions
 A user defined function is a saved list of instructions
that produces a value (the option price).
 Once defined, the function can then be used in an
excel spreadsheet.
 Programming is performed via the VBA editor.
 Open a new excel file (this must be done first).
 To activate the editor:
 v2007:Office button/Excel
options/Popular/Tick “Show developer tab in
the ribbon”
 V2010: File/Options/Customise
Ribbon/Tick”Developer”
VBA- User defined functions
VBA- User defined functions
Developer tab/visual basic
User defined functions need to be written in a module. Select Insert/Module

Note the creation of the modules directory and Module1

This function can now be used in the existing excel spreadsheet.

Clicking on the fx icon produces the insert function screen. Select user defined and Function1 appears.
Note all the functions already in excel. (Note there is no description or help available)
Selecting Function1 produces the following Clicking on cell B1 produces the above result
VBA - If Statements
If statements control the execution of the function. Execution of the SimpleIf function
If true, one statement is executed, otherwise another produces the above.
statement is executed.
VBA - If ElseIf Statements
Application of the function produces the above

You can have as many ElseIf clauses as you want following
an If, but none can appear after the Else.
VBA - Loops
 Loops repeat repetitive tasks.
 This is vital when performing a simulation –
where you may want to simulate say 50000 price
paths.
 VBA employs a variety of loop commands
including
 For i=1 to 50 Set i=1 and do the commands
written in here. Then set i=2 and
re-perform commands.
This continues until i=50.
 Next i
 You can do loops within loops
VBA - Loops
Sets the indexing at 1
Creates an array with n elements
As go through loop, MyArray

is filled with
1*1, 2*2, .. n*n
Function returns n*n

VBA-Option pricing code
Declares variables/matrices
Variables input into function
Loop generating
stock prices
Outer loop that performs
“nIter” replications
Loop that adds up payoffs

Calculate option payoff
Average payoff
If you get an error, then you have probably exceeded the array size.
Decrease the number of steps and/or the number of iterations
The Greeks
 Simulation can numerically approximate the Greeks.
 Vega. Just repeat the simulation with the same zt
values, but change  . The change in the asset value
due to the change in volatility is the vega risk.
c
Vega 

 Rho. Again repeat the simulation but change the risk
free rate. c
Rho 
rf
 The results for the vega calculation are
c 0.23238  0.22875
  0.363 BSM vega = 0.239
 0.31  0.30
Antithetic Variates
 In the spreadsheet “Simulation example.xlsm” we
saw the average simulated innovation was not zero.
 This introduces sampling error.
 To help minimise this we may employ antithetic
variates (not employed in the code).
*
 Let zt denote a vector of random innovations
 Assume a random draw of
zt*  1.5, 0.8, 0.2,........  2.1
 The technique requires another replication using
zt*  1.5, 0.8, 0.2,........, 2.1
 Ensures the average innovation across all
replications is zero.
 More precise estimates of the option price
Antithetic Variates
 Technical note:
 Procedure relies on the central limit theorem.
 Say we do 10,000 replications, option value is the sample mean
of the PV of the payoffs.
 
We know that the distribution of sample means is X ~ N u,  n 
 Therefore when seeking to estimate u , we know that in the
limit the distribution of X converges to u .
 We are seeking to estimate u (true option price) via its sample
mean X (average of the PV of payoffs)
 The standard error of the estimate for a simulation is  n
 We can therefore improve our estimate (get closer to u ) via
 Increasing the number of replications. To reduce the sampling
variation in the simulation by a factor of 10, we need to
increase the sample size by a factor of 100.
 Antithetic variates decreases the standard error of the
estimate for a given sample size.
FNCE 30007
Lecture – Value at Risk
Introduction
 A number of financial disasters in the early 1990s
could be traced to poor management and
supervision of financial risks eg Orange County,
Barings…
 Financial institutions and regulators turned to
Value at risk (VaR) as a way of quantifying
market risk.
Introduction
 Five types of financial risk
 Market: from movements in the level or volatility
of market prices.
 Credit risk: from counterparties being unable to
fulfil their contractual obligations. Losses can also
occur before default
 Liquidity risk:
 Asset – large position in an illiquid market – a large
transaction can significantly affect prices.
 Funding/cash flow – inability to meet payment
obligations forces early liquidation. eg margin calls
 Operational risk: arises from human and
technical errors. eg. fraud, inadequate
procedures and controls.
 Legal risk: a transaction is unenforceable by law.
Introduction
 VaR provides an aggregate view of a portfolios
risk.
 It accounts for leverage, correlations and current
positions.
 Applies to all financial instruments including
derivatives.
 VaR is now used in three ways
 Passively: measure and communicate financial risks
to management/shareholders. Used for capital
adequacy purposes under the Basel Accord.
 Defensively: used to set position limits for traders
and business units
 Actively: used for risk management. May be used to
allocate capital across traders or business units.
Assists portfolio managers to assess the impact of a
trade on portfolio risk.
Introduction
 VaR measures the worst expected
loss over a given horizon under
normal market conditions at a given
confidence level.
 Example: Daily VaR of a portfolio is
$20M at a 95% level of confidence.
This means that there is a 5%
chance that a loss greater than
$20M will occur.
Introduction
 The VaR is therefore obtained from the pdf of the
future portfolio value f  w 
 Therefore we wish to find the quantile of f  w 
Let c  level of confidence (eg. 95%)
W*
1 c   f  w  w  P  w  W *   p

Area in tail is 1-c, 5%.
W* E W  W
VaR
Introduction
W0  initial investment
Let
u  expected return
W *  lowest portfolio value at given confidence level
 W0 1  R* 
2 types of VaR
Relative VaR  E W   W * Absolute VaR  W0  W *
 W0 1  u   W0 1  R *
  W0  W0 1  R* 
 W0  W0u  W0  W0 R *  W0  W0  W0 R*
 W0  R  u 
*  W0 R*
Conceptually superior. If
horizon short, both methods VaR is all about identifying W / R
* *
comparable.
Introduction
 Assume that the pdf is adequately
represented by the normal distribution.
 A random variable X  N  u,   can be
transformed into the standard normal Z  N  0,1
via x u
z

 You solve for a quantile/percentile via
x  u  z
Introduction
 We can therefore state the following
W* R* 
1 c   f  w w   f  r  r     
  
where   ~ N  0,1
 The quantile can be found via
R*  u  z eg. z=-1.645 for a tail probability of 5%
 u  
using the notation in Jorion (2001)
Introduction
 The VaR can therefore be calculated

as
Relative VaR  W0  R*  u 
 W0  u    u 
 W0
Absolute VaR  W0 R*

 W0  u   
VaR for a single asset
 For illustrative purposes we will use a
weekly data set (VaR calcs.xls).
 Assume a single asset portfolio with an
initial investment of $10M.
 We seek 99% 5 day VaR estimates.
 Important: We are basing our
expectations on historical data. i.e the
historical return distribution will be the
same over the forecast horizon
VaR for a single asset
VaR for a portfolio – Delta normal
 Local valuation method

 The value of the portfolio is measured
at the initial position.
 Assumes normal distributions – the
portfolio return is therefore normal.
 Employs the variance-covariance
matrix and is able to provide closed
form/analytical solutions.
VaR – 2 asset portfolio
 Now consider the VaR for a 2 asset portfolio.
 We consider the portfolio expected return
distribution  N  E ( Rp ),  p 
E ( R p )  w1 E  R1   w2 E  R2 
 p2  w12 12  w22 22  2 w1w2 12 w1  w2  1
R* E ( Rp )
VaRp
VaR – 2 asset portfolio
 Consider a portfolio consisting of AMP and the CBA.
 We consider an equally weighted portfolio and calculate
the 99% 5 day VaR.
If R & R2 are normal so is R p
E ( R p )  w1 E  R1   w2 E  R2 
1
 0.5  (0.11%)  0.5  (0.08%)

 0.10%
 p  2.41% (See spreadsheet – AMP & CBA tab)
VaR p   pW
 2.326  2.41%  $10 M
Diversification benefit:
 $561, 039 =561,039-(0.5*704,237+0.5*549,531)
=-65,863
VaR – N asset portfolio
 This can easily be extended to a portfolio of N assets.
 We need to calculate the mean and standard deviation for
the expected return distribution as
E ( R p )  w1 E  R1   w2 E  R2   .......  wN E  RN 
N N N
  w  
2
p
2
i i
2
 wi w j ij
i 1 i 1 j 1, j  i
 The number of covariance terms requiring calculation is

N(N-1)/2.
 A 3 asset portfolio requires 3(2)/2 = 3 covariances
 A 50 asset portfolio requires 50(49)/2 = 1225 covariances!
Matrix algebra
 Linear algebra is a nightmare if

seeking to calculate the portfolio
variance for a portfolio with a large
number of assets.
 Matrix algebra makes life much
easier for us.
Matrix Algebra
 A matrix is rectangular array of elements arranged in
rows or columns as in
 a11 a12 .... a1n 

 
 a21 a22 .... a2 n 
 .. .. .. 
 
 am1 am 2 .... amn 
 If it has mn elements arranged in m rows and n

columns it is said to be of order m x n.
 The element in the ith rows and jth column is
represented by aij
Matrix Algebra
 A matrix of order 1 x n contains a

single row – is referred to as a row
vector
 b1 b2 ..... bn 
 While a matrix of order m x 1 is a

column vector  c1 
 
 c2 
 .. 
 
 cm 
Matrix Algebra - Rules
 Addition
 If 2 matrices A and B are of the same
order, then we define a new matrix C =
A + B, where C is of the same order.
 2 0  3 6   1 6 
A  B  C  A B   
 5 6  4 1   1 7 
cij  aij  bij for all i, j

Matrix Algebra
 Multiplication
 If Amn and Bn p , then C=AB is defined
to be a matrix of order m x p whose ij th
element is
n
cij   aik bkj
k 1
 To be conformable, the number of

columns in the first should be the same
as the number of rows in the second.
Matrix Algebra
 Multiplication (cont)
 BA is usually different from AB (and may not exist).
 2 1 3 0 7 2 6 3
A  B  AB    BA   
 1 1   1 2  4 2 4 3
 2 1  1 1  1 0
AB  BA  
A  B  
 1 1   1 2   0 1 
2 1 3 0 5   7 2 10 
B    21 28

A  1 1   AB   4 2 5  BA   
1 2 0  4 3 
14 10 15
3 5
Matrix Algebra
 Transposition
 The transpose of A ( AT or A' ) is the
matrix obtained from A by
interchanging rows and columns
5 1
5 8 4  
A  AT   8 3 
 1 3 2  4 2
 
Calculation of the var-cov matrix
 The var-cov matrix can be calculated via
AT  A
 M
where A  Excess return matrix
 r11  r1 .... rn1  rn 
 r  r .... r  r 
=  12 1 n2 n 
.. 
 
 r1M  r1 .... rnM  rn 
n  no of assets
M  no of observations
Calculation of the var-cov matrix
 The expected portfolio return and variance are
 R1 
R  N N N
  w  
2 2 2
 wi w j ij
E  R p    w1w2 ,...wN   2   w' R p
i 1
i i
i 1 j 1, j  i
 .. 
   w ' w
 RN 
 The VaR for a portfolio valued at W is
VaR p   pW
 The VaR for each asset is

VaRi   i Wi

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FNCE 30007

Lecture – Introduction to Futures

Reading: Chapters 1 and 2

 Initially treat futures as a forward and add

Buying price locked in today 𝐹𝐹0

 Some are deliverable

 e.g 90-day Bank Accepted Bill & some commodities .

 Usually only hedgers take delivery.

 Where it can be delivered (delivery arrangements)

 Commodities aligned to harvesting & crop seasons.

Long 5 October corn futures Short 5 October corn futures Expiration

June 15 Sept 20 October 31

 If short 5 contracts on June 15, long 5 contracts Sept 20

Futures = 5500 points Futures = 5550 points

May 1 May 20 June 30

 If the speculator was bearish they would short the

 So why not just speculate on the index through an

 As futures approaches expiration futures price

 sell overvalued security and buy undervalued one.

Futures Spot Price

S&P500 futures basis(t) on the nearby = F(t)-S(t)

See: S&P500 10 days combined.xls

 futures price: US$2.00/bushel

 margin requirement: US$200/contract (US$3,000

16-Jun 2.05 -150 75 3,075

20-Jun 1.82 600 -270 3,600

Calcs June 15: Profit/contract = 0.15x100bu = $15.

 Open: Price when futures contract starts trading

 Price limits partial substitute for margins

Lecture – Hedging with Futures

 asset is owned or will be owned

 Long futures hedge when

 After futures gains & losses the price received by the

Approach 1: Actual transactions

Approach 2: Offsetting payoffs

Approach 1: Actual transactions

Approach 2: Offsetting payoffs

Irrespective of what the spot is at maturity

 After futures gains & losses the price paid by the

Approach 1: Actual transactions

Approach 2: Offsetting payoffs

Approach 1: Actual transactions

Approach 2: Offsetting payoffs

Irrespective of what the spot is at maturity

 Storage costs avoided.

 But what if F(t)>S(t)?

 Arguments against hedging

 Short hedger: price rec’d: F0 + b1 = 3.35 + .25 = $3.60

 Basis risk can improve or a worsen a hedger’s position.

 Each corn futures contract is for 5,000 bushels.

 Net cost of corn:

F0 + (S*1 - F1) + (S1 - S*1)

 Desire to be out of the market for a

 beta = 1, portfolio return mirrors market return

 beta = 0.5, portfolio return tends to be half the market return

What position in ASX 200 futures is necessary to hedge the

(1.2)(10million/(25*5,600)) = 85.71~ 86 short contracts

 Expected (%) portfolio loss during the 3 months

 What position is necessary to increase the beta of the

 So far we have set the hedge ratio at 1.0

 A naïve hedge may be sub-optimal with basis risk i.e

 Example 2: Fuel hedge (Fuel hedge.xls)

 Equation 1 however assumes that the hedge close

F0 + (S1 - F1) + (S1 - S1)