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NDEX
Commerzbank ........................................................................................4 1.1 1.2 1.3 Markets in Corporates & Markets ......................................................5 The profit and loss (P&L) ...................................................................8 The Book Open .................................................................................8
Structured Equity Products and the People who buy them ...............9 2.1 What is a structured product?............................................................9 2.1.1 Manufacturing aspects of structured products............................9 2.1.2 Types of structured product ......................................................10 2.2 The market for structured products..................................................11 2.2.1 Intermediaries in the structured product market .......................12 2.3 Summary .........................................................................................13
Derivatives............................................................................................15 3.1 3.2 3.3 3.4 Vanilla options .................................................................................15 Barrier options .................................................................................17 Combining vanilla products..............................................................18 Put / Call parity ................................................................................19 Stochastic Differential Equations (SDEs).........................................20 Lognormal returns for asset prices ..................................................20 The assumption for the Black-Scholes model..................................20 The Black-Scholes equation ............................................................21 Black-Scholes closed formulas........................................................21
5 6
The Forward .........................................................................................22 Correlation............................................................................................23 6.1 6.2 6.3 How to calculate historical correlation..............................................23 Implied correlation ...........................................................................24 Correlation term structure and correlation skew ..............................24 How to calculate historical volatility .................................................26 Implied volatility ...............................................................................27 Basket volatility................................................................................27 How to calculate the volatility of a basket ........................................27 Volatility term structure ....................................................................28 Skew / Smile....................................................................................28
8 9 10
Quanto and Compo Options ...............................................................30 The Greeks ...........................................................................................32 The Hedge ............................................................................................34
Derivatives
11
Sensitivities of Exotic Options ...........................................................35 The Intrinsic Time Value Relationship ..........................................35 The pragmatic approach to estimate sensitivities ............................36
11.1 11.2 12 13
Being long / short ................................................................................37 Swaps, Notes and Certificates............................................................38 Swaps..............................................................................................38 Equity-linked swaps .........................................................................38 Bonds ..............................................................................................39 Equity Notes ....................................................................................39
14.1 The calibration process....................................................................41 14.2 How all derivative pricing models actually work...............................42 14.3 Black Vanilla ....................................................................................45 14.4 Black Diffusion.................................................................................45 14.5 Vskew ..............................................................................................45 14.6 Pskew ..............................................................................................46 14.7 Local Volatility..................................................................................46 14.8 Stochastic volatility ..........................................................................46 14.8.1 The Heston model ....................................................................47 14.8.2 The Hagan model .....................................................................48 14.8.3 The Scott-Chesney model ........................................................48 15 Cliquets.................................................................................................49 15.1 Volga (or Convexity) ........................................................................49 15.2 Types of Cliquets .............................................................................51 15.2.1 Classic cliquet...........................................................................51 15.2.2 Ratchet .....................................................................................52 15.2.3 Reverse cliquet.........................................................................54 15.2.4 Napoleon ..................................................................................57 15.2.5 Accumulator .............................................................................58 15.2.6 Comparing cliquets...................................................................59 16 The Concept of Risk ............................................................................60 Delta Risk ........................................................................................60 Vega risk..........................................................................................60 Correlation risk ................................................................................61 Second order risks...........................................................................61 Digital call option .............................................................................62 Barrier shifts ....................................................................................63 Evaluating the discontinuities ..........................................................64 How to determine options prices .....................................................66 Closed formulas...............................................................................67 Finite difference and Trees ..............................................................67 The Monte Carlo method .................................................................67 16.1 16.2 16.3 16.4 17 17.1 17.2 17.3 18 18.1 18.2 18.3 18.4
Discontinuities .....................................................................................62
Pricing Techniques..............................................................................66
Derivatives
18.4.1 18.4.2 19 20
How does it work? ....................................................................68 Estimate option prices with the MC method .............................70
20.1 Overview..........................................................................................72 20.2 The impact of stochastic IR .............................................................73 20.3 Specific case studies .......................................................................76 20.3.1 Equity Interest Rates linked payoff ........................................76 21 DIVA ......................................................................................................80 Accessing the data in the trading databases ...................................80 DIVA Objects ...................................................................................80 Pricing complex exotic products ......................................................81 Introduction to EasyDIVA.................................................................82 Product Description .........................................................................84 Product Analysis ..............................................................................88 21.1 21.2 21.3 21.4 22 22.1 22.2
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1 Commerzbank
Commerzbank, unlike many other financial institutions, has a relatively simple internal structure. Reporting lines are not as complex as for big US investment banking giants such as Goldman Sachs, Merrill Lynch, JP Morgan for example. The red marked department in Diagram 1.1 is the one involved in the development, sale and hedging stages of derivatives.
Board
Direction
Services
Zentrale Staebe
Zentrale Geschaeftsfelder
Mittelstand
The main internal business areas you will be in contact with during this internship are the following: 1. ZPK (our retail in Germany) : Thomas Timmermann, Andreas Muehleck and Stefan Gotsche 2. ZPB (our private banking in Germany) : Elmar Gehring, Arne Scheehl and David Krentz 3. ComInvest (Our Asset management in Germany) : Thomas Roell, Andreas Muehleck 4. ComDirect (our online broker ) : Philip Lang
Derivatives
Diagram 1.2 shows the internal divisions of the Investment Banking part of Commerzbank Corporates & Markets.
Client
Client
Client
Client
Requests
Issuer
Investment Banking
Sales
Issuer
EMTN
Indicative Prices
Trading price
Structuring
Pricing methodology
Trading
New models
Models development
Risk control
Financial Engineering
Risk management
Model approval
Diagram 1.2 YYYYYYYYYYYYYYYYYYYYYYYYY The trading team is further segmented into different asset class trading desks as can be seen in diagram 1.3. The desk you will be most in contact with are the following:
Derivatives
1. Single stock trading (Thorsten Moos, Carsten Sitter) 2. Exotic stock trading (Bastien Lussault, Nicolas Allano, Frederic Lescaroux) 3. Exotic indices trading (Michel Sibert, Cristoph Hartmann)
Diagram 1.3 YYYYYYYYYYYYYYYYYYYYYYYYY On the sales side, the teams can be dived by client type. The complexity of the products sold is another important factor which characterises a given sales team. They are: 1. 2. 3. 4. 5. 6. Institutional sales ex Germany (Jaime Uribe, Jorge Masalles) Institutional sales Germany (Thomas Roell, Jens Fischer, Frank Mohr) Private Banking sales ex Germany (Guillaume Hellier) Private Banking sales Germany (Elmart Gehring, Arne Scheehl) CBKs internal retail (Thomas Timmermann, Andreas Muehleck) External retail (Michael Moll, Johannes Neulinger, Fabian Behnke)
Derivatives
Derivatives
i being the total number of products sold and j the total positions held by the trading desk.
Derivatives
Derivatives
The issuer of a structured product is the instution which actually issues the bond which constitues the product. In many cases this is Commerzbank, but in a large number of cases Commerzbank will structure and sell a bond which is issued by an external party. The motivation for the issuer of any bond is to finance their business activities. Generally the coupon that they pay on the bond reflects both the markets required level of compensation to take the risk that the issuer of the bond can repay the principal, but the issuer will have preferences on how it pays the coupon for example some issuers will have costs linked to interest rates, and prefer to pay a coupon linked to interest rates, rather than a fixed coupon. In order to be able to use as wide a range of issuers as possible, most structured products are manufactured in the following way:
Commerzbank ZCM Commerzbank pays Equity-linked amount to Bond issuer at maturity / Over bond lifetime Bond issuer pays Commerzbank Coupon stream in format of Issuers choice (frequency, Currency etc.)
Bond Issuer Bond issuer sells bond With desired equityLinked payoff to bond investor Bond investor pays bond issuer 100 EUR for the bond at Inception
Bond investor
Diagram 2.1 YYYYYYYYYYYYYYYYYYYYYYYYY This way, the net position of the bond issuer is that they have issued a bond, and pay the coupon stream of their choice (almost always an amount linked to short-term interest rates), the investor has a bond, issued by the counterparty of their choice, and with the payoff of their choice, and Commerzbank has a net postion in the equity-linked derivative element of the bond which is then managed in the equity derivatives trading portfolio. Often the issuer will be Commerzbanks own treasury department (this is the department of the bank which is responsible for balancing the cashflows arising from the banks many different financing, and deposit-taking activities). However in many cases it is an external institution. In some cases it is actually this external instution who is Commerzbanks client rather than the bond investor; this will be explained in a later section.
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Derivatives
Delta-1 products
These are the simplest structured products of all, and simply replicate the exposure that is gained from holding a security, basket of securities, or index. Often they only replicate the price return of the security, ie the investor does not receive the benefit of dividends. In this case the cashflow stream that comes from the dividends is used to price These products are used for what is known as market access. For example, a particular type of investor may not be able to invest in a particular market, but once the product is legally transformed through a certificate wrapper its new legal nature makes it a permissible investment, or a more efficient investment from the point of view of regulation or tax. Alternatively, an investor may not have the time or money to actually invest in the underlying (for example the S&P 500 index cannot be tracked by an investor who does not have several hundred thousand euros, plus the time and infrastructure to trade in five hundred stocks at once).
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Derivatives
approximately true to say that if somebody has thousands, or tens of thousands of euros to invest, they are a retail investor. In most developed markets, the relationship between banks (and other financial companies) and retail investors is very closely regulated. One step up (in terms of wealth, and also regulation) from retail investors are the so-called high net worth or HNW individuals, who in simple terms have hundreds of thousands, or millions, of euros to invest. There is generally less regulation covering this market, and they can buy much risker and illiquid products. At the top, are the so-called instutional investors. These are professional money managers, who spend all their time looking for investments. They include insurance companies (who need to invest the premium that they receive from selling insurance policies), pension funds (both private and state), family offices (who act on behalf of the super-rich with billions to invest, often called ultra high net worth.), fund managers who are allowed to invest in structured products rather than directly into equities and bonds, and sometimes large corporations, who invest some of the cash that they hold for liquidity purposes to try and get a higher return than they could from simply putting the cash on deposit. Institutional investors are often driven by very specific regulatory, tax, or accounting concerns as much as they are by the actual economics of the product, so the legal form that the product takes may well be its most important feature. In fact many structurers are devoted solely to addressing these types of issues. Different groups of clients are covered by different sales teams at Commerzbank, often with some regional segmentation as well. Coverage is also a little confused by the fact that the same company may be covered by more than one sales team, depending on the capacity in which they are a client.
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Derivatives
Insurance companies also do this, however instead of issuing the product as a bond (although they often do call it a bond) it is issued in the form of a life insurance contract. The insurance company then holds a bond, or a derivative, as a hedge for the liability of the insurance contract. The contract buyer pays a regular premuim to the insurance company. In return, the contract buyer will get back an amount when the policy matures which is linked to equity performance over the policy lifetime. (Additionally, they will get back something if they die during the policy lifetime, which is why it is a life insurance contract. However this is not a significant element of the product, these are almost invariably bought as investment products). Large fund management companies also sell structured funds which are investment funds which have a defined payoff on a specific future date. As mentioned above, these funds are engineered by buying the derivatives which give the specific payoff. The product manufacturer has to take account of the fees paid for fund admnistration, custodians etc. when assembling such a product. Large manufacturer-distributors like large banks, some asset management companies, and insurance companies are the easiest to service, as they only want to trade derivatives, not manufactured products. They are professional market counterparties so the regulatory burden of dealing with them is very low. However, as a consequence of this, they are highly competitive and although they will deal in large size, they will invariably get several competing quotes from rival derivative houses which makes it difficult to make large profits from them. The retail market is also serviced by brokers and financial advisers, who do not manufacture products themselves. They need to have a product which is in a suitable form to be sold directly to retail investors, often including marketing material and other things. They simply offer a network of sales people, and administration systems, which enable product manufacturers to sell their products directly to the public without actually having to deal with the public. However, because they sell finished products, the products that they sell have to be manufactured to a high standard in terms of things like being listed on stock exchanges, having the documentation produced to certain standards, etc. They may also need the ability to execute small trades (for a few thousand euros) efficiently and quickly, and legally binding commitments from product providers to offer secondary market liquidity with defined bid-offer spreads. Moving up the wealth chain, HNWI are generally serviced by a sector of the intermediary market called Private Banks. These are effectively high-powered advisers and brokers, who may have some limited capacity to manufacture products (but normally not), but who can be serviced much more easily than retail brokers because HNWI can be sold products with very much less regulation than retail investors. Some very large financial institutions may well be a client in more than one way. They will hedge equity retail products which they manufacture themselves, they will offfer Commerzbank manufactured products to their wealthiest clients, and they may trade equity derivatives directly to hedge, for example, employee share schemes. This situation occasionally results in confusion when talking about institutional business. In this case it is important to identify exactly who the end-investor is going to be.
2.3 Summary
There are many types of structured product, and many types of client / investor. Structured products fall into one of three broad classes: Simple market-access products Yield enhancement products Capital protected products
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Derivatives
Commerzbank sells these to various classes of investor, both directly and indirectly. Retail investors directly through Commerzbank braches Retail and HNW investors indirectly via intermediaries who sell Commerzbank products Retail investors indirectly via intermediaries who sell their own products which are manufactured partly from derivatives which they buy from Commerzbank, sometimes known as the retail hedge business. Institutional investors who manage assets professionally (who in some cases are the same companies as the intermediaries mentioned above)
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Derivatives
3 Derivatives
The word Derivatives is a general term describing investment products, which derive their payoff therefore called Derivatives - from an underlying asset. The relationship Asset Derivative is rarely linear, meaning that if the value of the asset increases by a given amount, the value of the derivative doesnt vary by the same amount. There is therefore some form of convexity which depends on the volatility of the underlying (this can be seen by analyzing Jensens inequality). We therefore deduce that the concept of volatility is fundamental when dealing with these products.
V (t ) = V ( S (t , , ); K , T ; r )
The semicolons are used here to distinguish between different types of parameters: underlying-dependent parameters, product-dependent parameters and market-dependent parameters. The underlying dependent parameters cant be modified (unless we replace the underlying with another one) because they are part of the asset and define its behavior over time. The second ones can be changed at our discretion in order to fulfill the investors needs. The last ones cant be modified since they are implied market parameters. The parameters are defined like follows: S: the spot of the asset : the volatility of the asset : the drift of the asset K: the strike of the option T: the maturity of the option r: interest rates The payout of a vanilla call at maturity T is:
Max (0, S T K )
Where St is the value of the underlying on maturity date and K is the prefixed strike level. Its graphical representation is:
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Derivatives
Payoff
Max (0, K S T )
And its graphical representation is:
Payoff
S K Diagram 2.2 YYYYYYYYYYYYYYYYYYYYYYYYY As can be seen on the graphs and in the formulation of the payouts, these options always have a non-negative value for their holders. Call holders believe in the increase of the underlying prices, put holders in their decrease. It is important to notice that the maximum gain a call holder can make is unlimited, whereas the maximum gain a put holder can make is equivalent to the strike value.
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Derivatives
Diagram 2.3 YYYYYYYYYYYYYYYYYYYYYYYYY To illustrate these barrier options, we will consider the example of an Up & Out call with strike K and barrier B. Its payoff is the same as that of a vanilla call, but the payment is conditioned by the fact the underlying asset has never traded at or above its barrier level during the lifetime of the product. The following graph shows the payoff of the Up & Out call. Payoff
S K B
Diagram 2.4 YYYYYYYYYYYYYYYYYYYYYYYYY Lets now consider a Down & In put with strike K and with barrier B. The payoff formula of this put is the same as that of the vanilla put. The put will be activated if the underlying asset trades at or below the barrier level B. The following graph illustrates the product payoff:
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Derivatives
Payoff
S B K
S B K
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Derivatives
T = K + CT PT
It is easy to see that the portfolio position corresponds to the value of the underlying asset at time T, and therefore:
T = ST
If we calculate the present value of the portfolio at time 0, we get:
0 = PV ( T ) = PV ( K ) + C0 P0 = S 0
And therefore:
PV ( K ) + C0 = S 0 + P0
This last relation is called the Put / Call parity.
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Derivatives
4 Black-Scholes Model
The Black-Scholes model (BS) is the central in model finance theory. It still remains the most widely used model and represents the starting point for more complex and complete models such as the Local Volatility Model (LVM).
dX = __ dt + __ dW
In finance we find SDE in the form of an Ito process, which can be written as
dX = a( X , t )dt + b( X , t )dW
dS = dt + dWt S
Where
a ( X , t ) = S
and
b( X , t ) = S
The price return of the underlying asset follows a lognormal distribution with constant drift and constant volatility It is possible to short sell the underlying stock. There are no arbitrage opportunities. Trading in the stock is continuous. There are no transaction costs or taxes. All securities are perfectly divisible (e.g. it is possible to buy 1/100th of a share). It is possible to borrow and lend cash at a constant risk-free interest rate.
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Derivatives
V 1 2 2 2V V = S + rS rV 2 t S 2 S
It is notable that the equation does not contain , the drift of the stock.
C ( S , T ) = S (d1 ) Ke rT (d 2 ) P ( S , T ) = Ke rT (d 2 ) S (d1 )
Where
2 S r + ln + 2 K d1 = T
And
d 2 = d1 T
Here is the standard normal cumulative distribution function.
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Derivatives
5 The Forward
A very important concept when pricing an exotic product is the forward of an asset. The forward is the expected value of the underlying at a point in the future. Here we will explain how to evaluate the forward and how it varies over time. Lets consider the lognormal distributes process previously described:
dS = dt + dWt S
If we dont take into account the Brownian term, this equation can be rewritten as:
dS = dt S
And the solution of this simple first order differential equation, where the initial condition is given by S0 for t=0, is:
S (T ) = S 0 e T = S 0 e ( r q )T
Or expressed as a percentage of the initial spot S0
F% (T ) =
S (T ) = e ( r q )T S0
We see that the forward increases as interest rates increases and decreases as dividends increases. This is a very important observation that will be very useful when well have to deal with the optimization problem.
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Derivatives
6 Correlation
The concept of correlation is widely used in finance and statistics to indicate the linear relationship between two random variables or between two time series. In other words a correlation between a random variable X and a random variable Y indicates the probability of X changing in a given direction and in which direction for a given change in Y. Definition: The correlation can be seen as a strength vector between X and Y, which expresses the intensity and the direction of their linear relationship. It is important to notice that the correlation is a static value, meaning that it doesnt tell us anything about the future variation of the relationship. The general definition of the correlation between two random variables X and Y, with mean X and Y and standard deviation X and Y is:
cov( X , Y )
XY
E (( X X )(Y Y ))
X Y
E ( XY ) E ( X ) E (Y ) E ( X 2 ) E 2 ( X ) E (Y 2 ) E 2 (Y )
Where E is the expected value of the variable and cov is its covariance. Since X = E(X), X2 = E(X2) E2(X) and likewise for Y, in order for the correlation to have a mathematical sense the standard deviations have to be different from zero. It can be shown (Cauchy-Schwarz inequality corollary) that the maximum value that the correlation can assume is 1, meaning that for each up movement of X, Y moves up as well and vice versa. Notice that the correlation is not telling us anything about the size of the individual movements. Notice that the correlation is not telling us anything about the intensity of the changes, since this is expressed by the volatility.
N xi yi xi yi
i =1 i =1 i =1
N N xi xi i =1 i =1
N 2
N N y i yi i =1 i =1
N 2
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Derivatives
I ,t = ij ,t ij ,t
i =1 j >i
Where
ij ,t =
wi ,t w j ,t i ,t j ,t
w
i =1 j >i
i ,t
w j ,t i ,t j ,t
The implied correlation is an average correlation value that, if used to calculate the variance of the index I would give the same variance 2.
= (t )
If actual correlation is high compared to historical correlation then it will lower over time resulting in a downward sloping correlation curve; if it low compared to historical correlation then it will be upward sloping, as shown in diagramm XXX.
CORRELATION TERM-STRUCTURE
Correlation
Historical Correlation
Maturity
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Derivatives
Similarly, correlation is not constant for different market levels. In a bearish market, assets move with a correlation close to one, whereas in a bullish market assets move with lower correlation. This is generally defined as correlation skew and therefore the following equation holds:
= (K )
Diagram XX shows how the correlation evolves with different market levels. The correlation is asymptotic to one in a bearish market and to zero in a bulish market. This is true for assets within the same asset class. If assets from different asset classes are taken, corelation might behave in a different way. CORRELATION SKEW
Correlation
Strike
Similar to the volatility, we can represent correlation as a surface function of time and strike and defined as follows:
= (t , K )
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Derivatives
Var ( X ) = E (( X E ( X )) 2 ) = E ( X 2 ) ( E ( X )) 2
And therefore
X = E ( X 2 ) ( E ( X )) 2
The T-period volatility T is defined as
T = T
Therefore the wider the data is spread around the mean the higher will be the volatility.
hist , N Days =
Example
1 N
1 xi N i =1
N
xi i =1
N
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Derivatives
B ,T = wi2 i2,T + 2 ij wi w j i ,T j ,T
i =1 j >i
N 1
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Derivatives
Maturity
Diagram 6.1 YYYYYYYYYYYYYYYYYYYYYYYYY This means that, usually, the market quotes longer term options with a higher volatility than shorter term options. This can be explained if we think of the risk associated to longer maturities compared to shorter maturities.
VOLATILITY SMILE
Implied volatility
Strike
Strike
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Derivatives
This has important repercussions on option prices. Options with different strikes and different expiries tend to trade at different implied volatilities. When implied volatilities for options with the same expiry are plotted, the graph looks like a smile (or a skew), with at-the-money volatility in the middle and in-the-money volatilities gently rising on either side (smile) or only on the downside (skew) There are various explanations for why volatilities exhibit skew. First, lets consider a firm. We know that a firms value is the sum of its debt and its equity. This value is relatively constant over time and thus if the firms equity declines, its debt and consequently risk and volatility will increase. On the other hand, if equity increases, debt will decrease along with risk and volatility. This argument shows that we can expect the volatility of equity to be a decreasing function of price.
Equity
Debt
Diagram 6.3 YYYYYYYYYYYYYYYYYYYYYYYYY Another explanation refers to behavior of equity in market crashes. In a bearish market investors suffer from fears of large losses and, therefore, increase their trading activity. In a bullish market on the other hand investors are confident and tend to hold for longer time their equity position reducing therefore the trading activity.
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Derivatives
ZZ FXfin YY
It is easy to see that the investor incurs two different risks: 1. The risk associated with the equity performance between the buying and the selling date of the J-stock. In case the equity performed negatively (any other parameter remaining the same), the investor would have incurred in a loss. 2. The risk associated with the exchange rate at maturity. In case the yen weakened against the euro, meaning that you need more yen in order to buy euros (any other parameter remaining the same), the investor would have incurred in a loss. Derivatives where the payoff (expressed in foreign currency) is converted back into the domestic currency with the exchange rate at maturity and discounted with the domestic discount factor are called compo options or compo derivatives.
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Derivatives
Not all the investors are ready to take the FX-risk associated with compo derivatives. This problem can be overturned by selling to the bank the embedded foreign exchange risk and conserving only the equity risk. These kinds of options are called quanto options or quanto derivatives. Here the final payoff is first discounted using the foreign discount factor and is then converted into the domestic currency using a fixed exchange rate. The pricing of quanto options is relatively simple and requires the forward to be redefined. Let FXt be the exchange rate at time t, which corresponds to the domestic currency amount for one unit of foreign currency. Lets define rd and rf as the riskless domestic and foreign interest rates. As we know, the exchange rate follows a lognormal distributed stochastic process:
dS t = (r f d )dt + S dWS St
Where S is the volatility of the stock price and dWS is the Wiener process. It is possible to construct a portfolio with the quanto derivative, an amount of foreign currency and a given amount of shares: = V(FX, S, t) FX FX S S FX Where FX FX is the Euro amount of the Yen amount being short and S S FX is the Euro amount of the shares being short. By repeating the same procedure as shown in the chapter 3, it is easy to see that quanto options have to satisfy a similar equation to the Black-Scholes one, where the dividends have to be replaced by: d = rf + d + S FX and the forward can, therefore be rewritten as
S (T ) = S 0 e T = S 0 e ( rd d ')T = S 0 e
Or expressed as a percentage of the initial spot S0
( rd r f d FX S )T
F% (T ) =
S (T ) ( r r d FX S )T =e d f S0
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9 The Greeks
The delta measures sensitivity of the option price V to spot price S.
V S
The gamma measures second order sensitivity of the option price V to spot price S.
2V S 2 .
The speed measures third order sensitivity of the option price V to spot price S.
3V speed = 3 S .
The vega measures sensitivity of the option price V to volatility .
vega =
V .
The theta measures sensitivity of the option price V to the passage of time. With T the amount of time to expiry:
V T .
The rho measures sensitivity of the option price V to the applicable interest rate r.
V r .
The vega gamma or volga or convexity measures second order sensitivity of the option price V to implied volatility .
2V volga = 2 .
The vanna measures cross-sensitivity of option value with respect to change in underlying level and the underlying volatility, which can also be interpreted as the sensitivity of delta to a unit change in volatility.
vanna =
2V S .
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Derivatives
The sensitivity to the skew is also considered like a greek:
slope =
105% 95%
10%
The underlined greeks are the most important for a structuring position. In general, we define a GreekX as the sensitivity of the option price V with respect to the parameter X:
Greek X =
V X
Greek X =
where X 2 X 1 is small.
V V V X 2 V X1 = X X X 2 X1
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10 The Hedge
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Derivatives
S C(T ) = max T K ,0 S 0
In any previous instant t the value of a call option can be decomposed into two components: 1. The intrinsic value It 2. Its time value t The intrinsic value It is the value the option would have if exercised at time t; it corresponds therefore to the payout of the same option but with expiry t. The time value t is the value that takes into account the probability for the call option to be in the money at maturity T. The Intrinsic Time value relationship for a call C at time t expresses the value of the option at that time and can be written as:
S C t = I t + t = max t K ,0 + (t ) S 0
Diagram XX schematises the Intrinsic Time value relationship
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Derivatives
Price
t It K S
Diagram 10.1 YYYYYYYYYYYYYYYYYYYYYYYYY Generally speaking we can say that, for vanilla options, the intrinsic value is directly a function of the forward and therefore will be sensitive to interest rates and dividends and of the strike of the option. The time value on the other side is a function of time and of the volatility. In case of a vanilla call it grows asymptotically to volatility multiplied by square root of time.
The intrinsic value is directly proportional to the forward and therefore as interest rates increase the intrinsic value tends to increase, whereas the opposite effect is observed if dividends increase. On the other hand the intrinsic value will increase if the strike decreases since the option would be in the money already since its issue. Higher volatility and longer maturity have both a positive effect on the time value for an ATM European option since the probability for being in the money at expiration increases.
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Derivatives
Y(t) Y(0)
B
time
Diagram 11.1 YYYYYYYYYYYYYYYYYYYYYYYYY The terms are used even in a more general and wider sense. Y in the previous example was a call option but could in effect also be a market parameter such as volatility, skew, dividends, correlation etc. Definition: Counterparty A is said to be long (respectively short) a derivative or a generic market parameter Y if the increase of Y, at any time t after he first established his long (respectively short) position at time 0, represents a gain (respectively a loss) for A. In the case of the call for example we said that A bought the call and is therefore long the option. A is said also to be long vega since an increase in volatility during the lifetime would increase the time value of the derivative itself. Analyzing further, A is said to be short dividends since the increase in dividends would decrease the intrinsic value of the call option.
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13.1 Swaps
A T-year swap is a derivative contract written between two counterparties where they agree to swap a stream of cash flows at prefixed dates in the future expiring at time T. The simplest form of swap is the interest rate swap where the counterparties agree to exchange a fixed against a floating amount. The floating amount is usually linked to Libor (London Inter Bank Offer Rate).
A
option Libori - X
B
T Diagram 12.1 YYYYYYYYYYYYYYYYYYYYYYYYY Counterparty B pays a floating amount, which corresponds to Libor minus a small fixed amount X called funding, at prefixed intervals to counterparty A. The total amount received from counterparty A is therefore time
( Libor X )
i =1 i i
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Counterparty A on the other hand pays the equity option to counterparty B at maturity T. in order for the payment to be consistent the value of the floating amount leg has to be equal to the value of the equity option (plus the sales margin if any). This means that
Bank
13.3 Bonds
Bonds are special financial instruments which are used to raise capital. It is a debt instrument with maturity T issued by a company or by governments in exchange of a principal amount. The bond issuer has then the obligation to pay back its debt at maturity T by repaying the principal amount. The simplest form of bond doesnt pay any coupon during its lifetime and is called a zero coupon bond. It is easy to understand that the value of a bond varies over time since its value is linked to interest rates. The value of a zero coupon bond which pays X at maturity T is worth today the net present value of X, evaluated with the current levels of interest rates.
Bond
option
B
T time
Diagram 12.2 YYYYYYYYYYYYYYYYYYYYYYYYY If counterparty B wishes to invest an amount X into a 100% capital protected note then he would pay X to counterparty A. We know that in order to have X at maturity T we need to
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invest the net present value of X into the money market, earning interest on it. The remaining amount (i.e. the difference between A and its net present value) is then used to buy an equity option with maturity T plus the margin for counterparty A (and the margin for counterparty B if it will be sold further to a third party). The following equality has therefore to be satisfied:
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B-S Model
Exotic option
OK X
OK
OK OK
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Lets assume that this money has to be borrowed. There is a cost to this borrowing equal to the interest rate paid. The total cost of the hedging strategy is therefore the cost of the share, plus the cost of borrowing the money to buy the share, between the deal inception date and the date on which the share is going to be sold. As an example, assume that the share price is 100 EUR, the term of the contract is 1 year, and the interest rate is 5%. The fair price to sell the share in 1 year will be 105 EUR, which is the current price of the share, plus the cost of borrowing 100 EUR for 1 year. The seller, on the deal date, borrows 100 EUR, and buys the share. In 1 year, they sell the share for 105 EUR, and pay back the borrowing which will have grown to 105 EUR. So their position at the end of the contract is economically identical to their position at the start, irrespective of any changes in the price of the share. If the agreed price for the trade in the future (commonly known as the strikeprice) is different to 105 EUR, some money will need to change hands up front to compensate one counterparty or the other. The important thing here is that the forward price of the share is not defined using some arbitrary formula. The formula comes from somewhere it is the cost of removing the risk on the contract. When it comes to a contract where the party who is buying the share can walk away from the deal with no penalty, the situation is different. The simple strategy described above will not work in the case that the share price is below 105 EUR on the expiry date, because the buyer would be better off buying the share in the market. So they will abandon their side of the contract, leaving the seller holding a share which is worth less than 105 EUR, but with a loan of 105 EUR to repay. So the seller needs to do something else. One possible strategy would be to sell the share immediately should the price fall below the strike price of the contract, and buy it again as soon as the price goes above the strike price. Another would be to smooth the trading, by buying half a share initially, assuming that it is about equally likely that the share is going to go up as down, and buying or selling another half share at some point in the future depending on the way in which the price moves. Consider a very simple world where it is known that the share price is either going to be 90 EUR or 110 EUR at maturity. To further simplify the analysis in this case, assume that interest rates are zero. The strike price of the option is 100 EUR. The seller of the contract buys half a share on the deal date. At expiration, if the price is 110 EUR, the seller will hold half a share worth 55 EUR for which they paid 50 EUR, and will need to buy another half share, at a price of 55 EUR, and deliver the lot to the counterparty for a total price of 100 EUR. The total cost for the seller was 105 EUR, so they will lose 5 EUR in this case. If the share price drops, the seller of the option is left holding half a share, worth 45 EUR, for which they paid 50 EUR. The buyer is not interested in the option because they can buy the share more cheaply in the market than they can from the option seller. So the seller can do nothing other than sell the half-share, for a loss of 5 EUR. The critical point here is that the seller loses 5 EUR in both cases. So if they charge 5 EUR up front for the option, they will break even under all possible scenarios. So the fair value of the option in this very simple model universe is 5 EUR. It is not necessary for the seller to know in advance whether it is more likely that the share go up or down they are completely indifferent to the final price of the share. In the real world, things are clearly a little more complicated and the above model is inadequate. In reality a much wider range of outcomes is possible, and a more complicated model of the world is needed to accurately cover the possible outcomes. An important point about the hedging strategy in the simple world model, is that it involves buying shares at a higher price than they are sold. This is what actually costs money and why the premium for an option is not zero. This, in simple terms, is what all derivative hedging is about, and what all models are about. They will, given a model of how share prices move
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about in the short term, tell you how much you will lose from this process of buying high and selling low. Another important point is that the hedger does not care whether the price of the share goes up or down, they just care that the model covers the potential outcomes regardless of their probabilities. Black and Scholes option pricing is therefore just a complicated way of working out the loss from running a hedging strategy like the one described above, which systematically buys shares at a higher price than they are sold. The model makes assumptions about how the share price behaves in the very short term, and then adds up the effect of these very short term moves, combined with the hedging strategy which specifies how many shares are actually being held at any time, to calculate the losses that result. Also included in the pricing model is the cost of financing the hedge. The Black and Scholes breakthrough was that it represented a simple model of how the market behaves which is reasonably accurate, and also that it incorporates a hedging strategy that, if the market behaves in the way the model describes, will result in an exact outcome for the hedger i.e. the hedger is entirely indifferent to the performance of the share during the options lifetime. Remember that the Black and Scholes model of a share price only describes how the price varies over short periods of time, and does not make any predictions about its long term performance. For shares whose price jumps around a lot, and by large amounts, the losses that result from the buy high / sell low strategy are larger than they will be for a less volatile share. This is why vanilla option prices are linked to volatility. As described above, basic derivative pricing assumes that the price of the underlying jumps around continuously, and the model describes the way that the price moves in the very short term. Approximately speaking, the standard Black and Scholes model assumes that the size of the change of the price of the stock is related to two things: the square root of the length of time over which the change is being moved; and the volatility of the stock, which is a fixed number. Another important aspect of the model is that, on average, the stock price moves down as often, and by as much, as it moves up. The model also assumes that the universe is static, in that the volatility does not change, and there is no time-dependency of the process. This standard model leads to the well-known lognormal distribution of returns, when observed over some long time period (remember that the model of the stock price only describes what happens in the very short term). However when the Black and Scholes equation is solved, it is seen that the price of the option is also equal to the sum, over the possible prices at maturity, of the payoff of the option at each price, multiplied by the probability of ending up at that price. This gives us an alternative way of calculating the price of the option. So the option price that you arrive at, by calculating the loss that results from following the hedging strategy over the lifetime of the option, is the same as the price that you get from calculating the average value of the option, given the final distribution of share prices that you get from the short-term model of how the price of the underlying evolves. Monte-carlo simulation uses this fact of option pricing, to avoid having to simulate the entire path followed by a share price during the lifetime of the option. It simulates a number of single jumps from start to option expiration, so that the distribution of the prices at the end of the jump is the same as the distribution of prices that would result if the share price followed the exact short-term process described in the Black and Scholes equation. For each simulated jump, it calculates the option payoff that would result. Then the option price is simply the average of all of these simulated payoffs (discounted by the appropriate amount). However when option prices are observed in the market, one observes skew and smile. The conclusion is that the simple Black and Scholes model of the short-term evolution of the share price is not quite right. Therefore the distribution of returns over time is not log-normal either. We can acalculate what the implied distribution of long-term returns must look like, using a relatively simple mathematical formula. Note that calculating this implied distribution does not
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actually tell us anything about the short-term process that generates this distribution there are in fact infintely many short-term processes that could in theory produce the same distribution of returns over the longer term. But for Monte-Carlo simulation, we dont have to worry about the short-term process, just the eventual distribution of returns. If you can work out what the eventual distribution of returns is, you can run a Monte-Carlo simulation that takes account of the skew. However, this approach can lead to difficulties when a path-dependent option is priced (that is, an option whose value at expiration is linked to the value of the underlying during the lifetime of the option as well as just the value of the underlying at expiration, for example a barrier option or an asian option).
14.5 Vskew
This model takes account of skew, but suffers from some drawbacks linked to the way it prices path dependent options. As described above, this model takes account of skew by calculating the implied distribution of returns of an option underlying, by examining vanilla option prices. It is simple to price non path-dependent options by simulating returns of the underlying according to the implied distribution of returns at maturity. If we do this, we do not have to worry about what is supposed to be happening to the share price between the start date of the option and the expiry. Imagine now that we have an path-dependent option; i.e. one whose value at maturity is linked to the price on some intermediate date as well as at expiration. We have to run a Monte-Carlo simulation that uses the correct distribution of returns for both of these fixing dates. In a world with no skew, this is not too difficult. We just simulate one jump from the start date to the first fixing date, and another jump from the first fixing date to the second fixing date. This is possible because we know that the same short-term process governing share prices applies equally over both periods of time. The final price of the option for any given path can be calculated by examining the share price on the two fixing dates. Note that with a path-dependent option, we cannot treat the price of the underlying on the two fixing dates as independent things. This is because they are not independent a large drop in the share price between the start date and the first fixing date makes it likely that the share price will also be relatively low on the second fixing date, compared to the situation where the share price is high on the first fixing date. The price on the two fixing dates is correlated.
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However, as mentioned earlier, the distribution of returns on each of these dates might be known, but nothing is known about the process followed by the share price in the short-term. So we know the distribution of returns between today and the first fixing date, and we know the distribution of returns between today and the second fixing date. We do not know anything about the distribution of returns between the two fixing dates.
14.6 Pskew
Pskew attempts to overcome the problems that Vskew has with pricing forward starting options. It does this by generating simulated Monte-Carlo paths by taking each jump in turn, according to a distribution that is calculated by assuming that skew stays the same over each jump. Another way of looking at this is to say that this model assumes that the 1 year skew in 1 years time will be exactly the same as the 1 year skew now. The problem with this model is that when a long-dated vanilla option is priced using this model, where intermediate points in the path are generated (these points do not impact the pricing directly, but the fact that they are calculated will influence the distribution of returns on the expiration date of the option), it does not give the right price. What one can observe is that the model does not produce enough skew in the long-term. This is a direct result of the Central Limit Theorem, that if one takes successive draws from any distribution at all, the overall distribution tends towards a normal distribution. This leads us to the conclusion that there is no simple process of share prices that can lead to the skew that is observed in the market, as all processes tend to produce the normal distribution in the long-term. This lead market practitioners to develop models of the share price process where there is a correlation between the share price and the volatility, and models where the volatility is itself a stochastic process. These are explained later. So Pskew can be used to price simple cliquet options, but not anything else.
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Stochastic volatilty attemps to address the dynamics problem mentioned in the previous paragraph, and also the problem that local vol assumes that the only thing which causes volatility to change is changes in share prices and the passage of time. This is clearly not true, one can observe that there is a random element to volatility. This can be very important in pricing certain types of option which have vega convexity. This means that their sensitivity to implied volatility is not constant, and as implied volatility goes up and down, so will the sensitivity to this parameter. Imagine a situation where an exotic option which has a positive sensitivity to implied volatility is vega-hedged with a vanilla option. If the exotic option has positive convexity of vega, then its sensitivity to implied volatility increases as implied volatility increases. So the total position will no longer be hedged if implied volatility goes up, as the exotic option will have become more sensitive. The hedger will need to sell some more vanilla options in order to have a hedged position again. If implied volatility then drops, the hedger will have to unwind the vanilla option trade. They will make money on this unwind, as they are buying back the vanilla option at a lower level of implied vol compared to the level at which they bought it. So a positive vega convexity position will consistently make the holder money when implied volatility varies itself. The problem arises where an exotic option position has negative vega convexity. The holder of such a position will systematically lose money if implied volatility changes, and it is clear that it does. So they need a model to calculate the cost of these changes, in just the same way that the basic Black and Scholes model calculates the cost of re-heding the delta of an option. Stochastic volatility models generally have five components. The average level of the basic volatility of the share price, the volatility of this volatility, the correlation between the basic volatility and the vol of vol, and the speed to which the basic volatility reverts to its mean level. (This mean reversion is necessary as it is clear that, unlike a share price, implied volatiltiy does not increase without limit. A share price can double, treble, quadruple or even more, whereas volatility cannot feasibly increase above a certain level, except for very short periods.) So stochastic volatility models are used to price options with vega convexity. The classic example of an options with vega convexity are certain types of cliquet option, often called best-of ratchets or reverse cliquets or napoleons. Note that there is a common misconception that it is the forward-starting nature of these options than means they have to be priced with stochastic volatility models. This is not true, it is the fact that they have strong vega convexity. Other types of options, for example simple barrier options, can also have strong vega convexity. It is even possible to construct a portfolio of vanilla options (the butterfly strategy) which has strong convexity. However with the vanilla options, the convexity cost of the strategy is accounted for in the shape of the volatility surface. The mathematical characteristics of stochastic volatility models are the following:
14.8.1
volatility can reach zero stay at zero for some time or stay extremely low or very high for long periods of time.
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14.8.2
the expectation of volatility is constant over time variance of instantaneous volatility grows without limit the most likely value of instantaneous volatility converges to zero.
14.8.3
it requires very high correlation between the spot and the volatility process to calibrate to a pronounced skew the skew is fully deterministic
These features are also shared by all of the above discussed models.
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15 Cliquets
A cliquet, ratchet option or strip of forward start options is a derivative where the strike is reset each observation date at the then current spot level. The profit can be accumulated until final maturity, or paid out at each reset date. Cliquets are complex exotic products where second order effects can significantly affect the pricing. There are two main effects which have to be considered: 1. Volatility of volatility effects (vega convexity) 2. Forward skew effects Not all cliquets are sensitive to volatility of volatility and forward skew. Well see what the impact is on the main types of re-striking options.
C 0 .4 * * T
If we draw the price of this option with respect to the volatility we can see that it is a straight line with positive slope, as shown in Diagram XX. Price
Sigma
It is easy to verify that the vega in this case is equal to a constant value; it is therefore independent from the level of the volatility. The vega is a constant line as shown in diagram XX.
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Price
Sigma
Volga =
2V =0 2
Consequently, vanilla options dont have price convexity. Some exotic derivatives can have a non zero convexity which needs to be hedged like in the case of cliquets. Lets suppose that the price a generic derivative follows a parabolic curve like shown in diagram XXX.
Price
Sigma
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The vega is a linear function of volatility and will therefore change sign around a value * (like shown in diagram 8) Vega
Sigma
As you can see the vega is here not constant with respect to volatility but is a linear function of volatility. We call * the volatility where the vega is equal to zero and changes of sign. If we are buying volatility, the more increases, the shorter the vega is. In order to hedge our position, we need to buy the volatility, therefore we buy the volatility when it increases and we sell it when it decreases. This hedging cost has therefore to be included in the price of the derivative. Finally when the Volga is non zero, we are dealing with the volatility of the volatility, so we need to consider a stochastic volatility.
15.2
Types of Cliquets
There are various types of cliquets options and an extensive list would not be possible. Well present only the main typologies since the effects which have to be taken into account are common to all of them.
15.2.1
Classic cliquet
The classic cliquet is a forward starting option, which fixes its strike at time t (from today) and expires at time T (from today). For a cliquet call option the payoff would be:
S Payoff T = Max 0, T 1 S t
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15.2.1.1
Cliquet behavior
Lets consider an ATM forward starting call option. This derivative would pay at time T the performance of the underlying asset over the time T t if positive, zero otherwise. As we know an ATM call option is not sensitive to skew effect. Similarly a forward starting call option will not exhibit any sensitivity in change in volatility with respect to the strike, meaning that the sensitivity to forward skew is equal to zero. The only parameter that has to been taken into account is the forward starting volatility with maturity T t. This can be evaluated with the simple variance equality:
12 =
2T2 1T1
T12
Diagram XX shows the legs and the volatility considered in the formulas above. S0 St ST
1, T1 2, T2 1*, T12
12, T12
Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY. the price of a european ATM call starting at time t with maturity T12 is therefore the same as the one for a european ATM call starting today and with maturity T12 adjusted by the change in volatility (from 1* to 12) times the volatility sensitivity (because the vega convexity is equal to zero).
15.2.2
Ratchet
A ratchet option is a strip of forward starting options, which fixes their strikes at time i and are evaluated at time i+1. The performances evaluated are thereafter summed together and paid at maturity T. For a call ratchet option the payoff would be:
N S Payoff T = Max 0, i 1 S i =1 i 1
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15.2.2.1
Ratchet behavior
We have seen that classic cliquets are insensitive to forward starting skew. Ratchets are therefore insensitive as well by definition, being the sum of forward starting cliquets. But there are other interesting effects which have to be analyzed. Lets consider a strip of two ATM forward starting call options. This derivative pays at time T the sum of the positive performance between each subsequent period, T1 and T12. As seen before, the only parameter that has to been taken into account is the forward starting volatility between the two fixing date t1 and T. This can be evaluated with the simple variance formula:
12 =
2T2 1T1
T12
In the case of a ratchet the effect of volatility of volatility has to be taken into account. To understand this lets evaluate how the vega position would be at an instant t, between the initial strike date t0 and the first fixing date t1 like shown in Diagram XX.
Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY.
At an instant t, the call with expiry t1 would have a positive vega exposure with respect to the volatility 1. The call with expiry T would have as well a positive vega exposure with respect to the volatility 12, but this volatility decreases if 1 increases, meaning that even if the overall exposure of this call is vega positive, it is in effect vega negative with respect to the volatility corresponding to the previous fixing. This means that at a future instant t the price of the ratchet varies in a non linear way since the first call tends to increase in value if 1 increases, whereas the second call will tend to decrease if 1 increases (assuming that 2 hasnt changed). Diagram XX shows how 12 varies for a 1% increase in 1 considering that 2 is not changing.
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12
Diagram XX YYYYYYYYYYYYYYYYYYYYYYYYYY It is easy to understand that the vega is highly sensitive to the evolution of the volatility term structure: change in the volatility of the volatility have therefore to be taken into account. It is important to highlight that in the case of a volatility surface moving all by the same amount, the vega would have shown a linear behavior.
15.2.3
Reverse cliquet
A reverse cliquet can be generally defined as a globally floored option where the payoff depends on locally capped performances. Usually a reverse cliquet has a maximum payout starting at X which decreases as the sum of forward starting put options increases in value. The payoff would therefore be:
N S Payoff = Max 0, X + Min 0, i 1 S i =1 i 1
The reverse cliquet is sensitive to both the volatility of volatility and the forward skew. In the following section we will show why this is the case.
15.2.3.1
Lets consider how the vega of the reverse cliquet behaves when the volatility varies from small to significant values. If volatility is low the sum of the values of the ATM put options will be very sensitive in volatility changes since a small shift in the surface will be reflected in the change in value of all the single put options and the total vega will therefore be the same as the sum of the individual vegas. If volatility is high, on the other hand, a small change in the volatility surface will not affect the vega since the probability for the puts to be in the money is very high, which in turn is very likely to quickly exceed X. The vega profile can therefore be represented as follows:
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Vega
Sigma
Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY. The reverse cliquet, like several other similar cliquets, can therefore be considered as a put option on volatility as shown in diagram XX. Vega
Sigma
Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY. As we know a put option has a positive sensitivity to vega. It is, therefore, easy to see that if we are using a model which doesnt take into account the volatility of volatility we are in fact pricing a put option without its time value and the price is therefore incorrect. A model which simulates the stochastic behavior of volatility is here needed in order to correctly price the additional optionality. The reverse cliquet is equally sensitive to forward skew, even if its sensitivity is here less important if compared to that of volatility of volatility. To see why this is the case, well analyze * the skew exposure is when we fix the last strike (meaning the fixing before maturity) at time t .
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t0 time N-1 N
Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY. Lets suppose that the following relation is valid at time t
N 1 S X = X + Min 0, i 1 S i =1 i 1
*
[ZZZ]
1-X
Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY.
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The dotted line shows the total position of the holder of the reverse cliquet at time t*, which results in a call spread. It is easy to see that the call one is long is always in-the-money and this results in a positive sensitivity to skew for this call. The call one is short, on the other hand, is always at-the-money and is consequently non sensitive to skew. The total exposure is therefore a positive exposure to skew.
15.2.4
Napoleon
Lets now consider a Napoleon with monthly resets, which pays a yearly coupon expressed by the following formula:
15.2.4.1
Napoleon behavior
The vega is, in this case again, a non-linear function of volatility. Lets consider the case where the volatility of volatility is close to zero. This means that the volatility won't vary significantly from a given fixed value. The individual monthly puts will therefore have a given probability to be in the money and the more valuable of them will have a given probability 1 to assume a value X1. If we increase now the volatility of volatility the probability associated to each monthly put will in general be different and the more valuable of them will have a probability 2 to assume the same a value X, which will be greater than 1. In other words, if we consider stochastic volatility the most valuable monthly put will assume higher values compared to the case where there is no volatility of volatility. If volatility is very high, small shifts of the volatility surface will in general leave unaffected the price of the Napoleon. Increasing the probability for the put being in the money will have no effect on the price since the payoff has an overall floor at zero. The vega is therefore close to zero. This is not the case if volatility is low. In this case increasing the probability will have a significant impact on the options price and this corresponds to a significant vega. The vega profile as a function of volatility is here again similar to the one shown in diagram XXXX. Lets now analyze the sensitivity of the Napoleon with respect to the forward skew. The forward skew has less significant impact if compared to the reverse cliquet. To understand this lets see what the payoff would be at the last strike date (the one before maturity):
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SN 1 = X S N 1
Whereas for the upper strike corresponds to
S Min i 1 S i =[ 0 ,..., N 1] i 1
But we have to distinguish two cases:
15.2.5
Accumulator
N S Payoff = Max 0, Min Cap, Max Floor , i 1 i =1 S i 1
15.2.5.1
Accumulator behavior
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15.2.6
Comparing cliquets
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The value of an option can vary over time because of several market parameters. The trader has always to assume an opposite position in the market (with respect to the issued products) in order to reflect the change in value of the derivative instruments. The main components which have to be hedged away are the so-called first-order risk indicated above (delta, vega and correlation). Once these have been hedged, the trader has still to verify the presence of second order risk like volga or vanna. Usually their effect is negligible for vanilla options and most of the more common exotic options. This is not the case for cliquets and other unusual exotic payoffs.
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Suppose now that after the period t, all the market parameters have not seen any change but the volatility of the underlying (on which the option is written), which has increased. The option is now worth X2 (where X2 is greater than X1 since a call is long vega). In order to be hedged, the trader has, therefore, to buy volatility.
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17 Discontinuities
Discontinuities in the payoff are very common and they need to be analyzed in detail when pricing exotic derivatives. In the following section we describe the dynamic of a digital call option and the issues related to hedging.
Payoff = N I ( St > K )
Diagram 9 shows the payoff profile of a digital call option at maturity. The option pays N if the underlying is above the strike K, it pays 0 otherwise.
Payoff
St
Diagram 18.1 Digital Call option. The black shape in diagram 10 represents the value of the digital call option at time T1 and its corresponding delta profile. As you can see, at time T2 > T1 (and closer to maturity), the value of the option steepens around K and the delta tends to increase consequently.
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Payoff
t = T1
t = T1
St K K
St
Payoff
t = T2>T1
t = T2>T1
St K K
St
Diagram 18.2 Value and delta of a digital option as a function of strike K. a) Shows the value of the digital option with the corresponding delta profile at time T1. b) Shows the value of the digital option with the corresponding delta profile at time T2 > T1. We therefore observe a discontinuity in the payoff at maturity around K. By discontinuity we mean a point where the first derivative of the value of the option tends towards infinity. This is the case of digital options where for the limit of t -> Maturity the delta tends to assume infinite values; in other words close to K and close to maturity the delta, is given by:
=
is a Dirac function.
P S
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Payoff
K Payoff
St
St
St
Diagram 18.3 Barrier shift and the effect on the delta of the option.
(i) C =true = is the intrinsic value of the product if the condition C i is true (i) C =true = is the time value of the product if the condition C i is true (i) C = false = is the intrinsic value of the product if the condition C i is false (i) C = false = is the time value of the product if the condition C i is false
i i
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Example:
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18 Pricing Techniques
Once the model with which one will determine the value of the option has been chosen, it is still necessary to select a pricing method. For sufficiently simple products it is possible to determine closed formulas for option evaluation. This is not the case when dealing with exotic products. In this case more sophisticated techniques have to be used as will be explained in the following sections.
Closed formula (analytical method) Finite difference and Trees (numerical methods) Monte Carlo
Generically we could say that as the dimensionality of the problem increases (and therefore as its complexity increases) the use of a Monte Carlo approach becomes necessary. Schematically this can be seen like in diagram XX
Closed formula
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x 2 3x + 2 = 0
If we want to find the roots of this equation, we can decompose the equation into the product of two members and subsequently evaluate the values for the variable x that satisfies the equation.
( x 1) ( x 2) = 0
It is easy to see that the equation is equal to zero if and only if one of the two members is equal to zero this means:
x 1 = 0 x2=0
The solutions of the equation are therefore x = 1 and x = 2. We used an analytical approach to solve the equation. Closed formula definition: Under some condition a value V of an option with payoff f can be determined via a closed formula. A closed formula is a function f depending from some specific parameters of the underlying like the volatility, the dividends, the interest rates, maturity etc. V can therefore be written as:
V = g(sigma, d, r, T, )
The closed formula solution to the Black and Scholes differential equation has been determined by using an analytical approach. Nevertheless it is very rare that the value of a derivative can be determinate by following this methodology. This is especially the case with more exotic structures where the complexity of the product requires a more powerful evaluation tool. Lets consider, for example, an American call option where the holder has the right to early exercise the option. It is not possible to estimate an American call via a closed formula. The use of Finite difference or Trees becomes, therefore, necessary
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stochastic paths, calculate the average of the payoffs and discount it in order to obtain todays value. Monte Carlo method definition: The Monte Carlo methodology (also called Monte Carlo Integration) is a stochastic technique for obtaining solutions of complex problems by means of random numbers. When we determine the value V of an option with payoff f (and discounted payoff fd) with the MC approach we are effectively calculating the average of the function f on a set of randomly sampled points, each one having a given probability of occurring.
V=
1 M f d ( xi ) M i =1
18.4.1
Lets consider a circle C circumscribed by a square S as illustrated in figure XX. We want to calculate the value of the surface of C via the MC methodology.
Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY
Considering the symmetry of the problem we can also analyze only one quarter of Figure XX. Figure XX shows the arc of circumference and the square S resulting from this operation. Lets discretize S in a finite number of smaller squares by dividing the x and the y axis in M intervals.
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y
i
(x , y )
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Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY
First we randomly extract M pairs of uncorrelated numbers and to associate them with the i i point (x , y ) on S by means of a mapping function F:
F : (x j , y j ) (xi , yi )
Lets count the number of times N the point (xi, yi) falls inside the arc of circle. We can then denote the surface of the arc of circle with A and the surface of the square S with Q. the ratio of these two surfaces will be proportional to the ratio of random extracted points which fell inside and outside the area A:
A N Q M
The ratio on the right hand side tends towards the left ratio for a sufficiently high population of sampling points. We also know that
A=
And that
l2
4
Q = l2
And therefore an estimate for the constant is
N M
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18.4.2
The procedure described in the previous section is very similar to that used to evaluate the price of an option. Lets consider an exotic option with payoff at maturity described by the function f and having only one underlying S, which is lognormally distributed. We want to calculate the value V of this option using the MC method. The procedure can be decomposed as follows: 1. we extract a vector U = [x1, x2, x3, , xN] of N random numbers following a normal probability distribution function 2. we evaluate the values assumed by S for all the different xi, obtaining a vector S = [S1, S2, S3, , SN] 3. we calculate the payoff f corresponding to each Si, which will be as well a vector f = [f1, f2, f3, , fN] 4. we calculate the discounted value of f, called fd = [fd,1, fd,2, fd,3, , fd,N] 5. we calculate the average of all the components of the vector fd, which corresponds to the value V of the option
S S
100%
f t
Diagram XX YYYYYYYYYYYYYYYYYYYYYYYY
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20 Hybrid Products
The term Hybrid usually refers to structured products where the payoff is contingent to more than one asset class, such as equity, foreign exchange, commodities, interest rates, inflation etc. these kinds of products are often, but not always, treated by a specific team within the bank. The reason behind this is that even if some of these underlyings follow the same stochastic process from a pricing point of view which should in theory simplify the pricing the risks involved from a trading point of view are quite different. Risk management tools are very sophisticated for single asset classes but are less flexible and manageable for multi asset classes. Financial institutions are making big efforts to minimise these weaknesses by putting in places dedicated hybrid traders.
20.1 Overview
It is a general mistake to define Hybrids as products where several market parameters have to be taken into account when estimating their fair value. This is obviously not the case since, as we have seen in the initial chapters, the value V of a vanilla option depends on several market variables:
V (t ) = V ( S (t , , ); K , T ; r )
Some of these are pure equity variables, for example the volatility and the forward. Others are non-equity variables such as interest rates and foreign exchange (if quanto or compo). Vanilla options, like many other exotic options, are not pure hybrid products since all the non-equity variables can be hedged away in a static way, whereas equity variable have to be hedged in a dynamic way. Hybrid products can usually categorized into two sub-categories: 1. Payoff involving explicitly more asset classes 2. Payoff involving one asset class which is highly affected by stochastic behavior of other asset classes In both cases a specific model has to be used where each individual asset class is correctly priced (e.g. the vanilla market values have to be matched) and where a correlation between different asset classes has to be taken into account. The steps involved to build a proper hybrid multi-asset model can be listed as follows: 1. 2. 3. 4. Choice of the underlyings (e.g. Equity, FX, Interest Rates commodity etc.) Construction of a single-asset model for each asset class involved Definition of a correlation factor between members of different asset classes Construction of a global multi-asset hybrid model
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Hybrid Model
Market Values
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The dotted line in diagram XXX shows how the surface is afffected.
ATM Diagram 21.2 YYYYYYYYYYYYYYYYYYYYYYYY The reason for this is that the model calibrates to vanilla options. The Black-Scholes volatility (the volatility implied by the Black-Scholes model) cant therefore to be deduced from the local volatility with the known formula
BS ( K ) =
1 ( )d K S S
There is an additional stochastic term coming from the Interest Rates which has to be taken into account. Basically the hybrid model is calibrated in order to match, at each local point, the Black-Scholes volatility for vanilla options if we consider the stochastic behaviour of the rates but the local volatility will in general be different from a non-hybrid model. Lets consider a 10Y lookback certificate, for example, where the client gets at maturity the highest value of the index observed on a monthly basis. This product has the following sensitivities (values are taken as an example)
The sensitivity to the convexity is calculated by bumping the Hagan alpha parameter by 5% in relative value.
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As you can see the sensitivity to the convexity of the volatility surface is quite important. If we increase the convexity the price of the certificate increases by 30 Bps. By pricing this option with the hybrid model and with a non-hybrid equity model, we obtain a substantial difference in the price because of different local volatilities implied by the two models. As we have seen, the hybrid model reduces the convexity of the vol surface. Wed expect, therefore, that the hybrid model will show a cheaper price for a lookback certificate. This is confirmed by the results shown in Table XXX
96.80% 98.30%
Table 21.2 YYYYYYYYYYYYYYYYYYYYYYYY One could suppose that the difference in the price arises from the high vega of the lookback (and therefore from a different deformation of the volatility surface like a parallel shift for example). Lets therefore consider a product which shows no sensitivity (or very small sensitivity) to convexity and skew but with a significant vega. This is the case of a barrier risk reversal 90 110 (the client is short a put strike 90% down and out at 70% and long a call strike 110% up and out at 130%). The sensitivities are shown below:
Table 21.3 YYYYYYYYYYYYYYYYYYYYYYYY If we price this product with a hybrid model and with a non-hybrid equity model, we obtain the following results:
92.69% 92.61%
Table 21.4 YYYYYYYYYYYYYYYYYYYYYYYY The change in price here is very small because of the low sensitvity to the convexity. It is therefore easy to see that the volatility surface is effectively deformed as described above.
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20.3.1
In this section well discuss hybrid products, where the payoff depends on the Equity and on the Interest Rates performance. Usually the interest which is taken into account when dealing with Interest Rates is the CMS rate (Constant Maturity Swap rate). It corresponds to the rate associated to a swap where the maturity remains unchanged throughout the lifetime of the swap. The hybrid options we will analyze in this section are: 1. a strip of CMS10Y digitals on the Eurostoxx50 2. a strip of CMS10Y digitals on the Eurostoxx50 (autocallable if above a barrier) 3. best of between Eurostoxx50 and CMS10Y
20.3.1.1
Lets consider a 3 years product where the client receives, each year, the CMS10Y rate if the Eurostoxx50 performed positively (is above the strike) at the end of that year (since inception); the client receives nothing otherwise. Diagramm XXX shows the CMS10Y linked coupon (red line) if the Eurostoxx50 peforms positively (yellow area) at the end of each year (dottet line), wheras the coupon would be zero if the Eurostoxx 50 performed negatively (grey area). Eurostox50
100%
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E [1 X 1 (1 P(T0 , T1 ))] + E [1 X 2 P(T0 , T1 )(1 P (T1 , T2 ))] + E [1 X 3 P(T0 , T2 )(1 P(T2 , T3 ))]
Where
1 P(Ti 1 , Ti )
P(Ti 2 , Ti 1 )
if Equity if Equity
Table 21.5 YYYYYYYYYYYYYYYYYYYYYYYY The amount of arrows indicates the intensity of the changes if Equity (and therefore Interest Rates) moves up. The product of the discount factor and the individual floating amount increases if equity goes up.
if Equity
Table 21.6 YYYYYYYYYYYYYYYYYYYYYYYY We have now to analyze what happens to the indicator function if Equity moves up. As we have seen previously, when we increase the correlation between Equity and Interest Rates
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we are effectively reducing the equity-skew and therefore we are reducing the probability for the equity being above strike at any observation date. This effects tends to reduce the value of the expections and, therefore, of the whole floating amount. It has, nevetherless, a negligeable effect on the final price. The sensitivity of the individual expectations is summirized in table XXX.
E [o]
if Equity
Table 21.7 YYYYYYYYYYYYYYYYYYYYYYYY The overall sensitivity of the sum of the expectations is directly proportional to the correlation between the two asset classes, as shown in Diagram XXX.
Price
20.3.1.2
Lets consider the same product as in the previous section. The product can be also called, this time, if Equity perofrms particularly well and trades, on any annual observation date, above a barrier B (above the spot price). As we have seen before if we increase the correlation we are effectively increasing the value of the Interest Rate linked coupon whereas the change of the indicator function had no significant impact on the price. In this example the floating coupon is still subject to the same changes if the correlation increases, whereas the effect on the indicator function is not negligeable anymore. As we said before, introducing a correlation between IR and Equity has a significant impact on the Equity-skew. Any autocallable product has a given sensitivity to Equity-skew. If the autocallable barrier is above the spot level then the product has a negative sensitvity (if we increase the Equity-skew, then the price decreases).
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21 DIVA
DIVA is a library of C++ implemented code developed by Commerzbank Corporates & Markets in order to price complex exotic products, which uses Excel as a graphical interface (for more information please refer to Annex 1)
Diva Excel
= av__( )
= feMarket__( )
= X__( )
Database
AVID
Murex
Xenomorph
MDR
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1. take its value from a database (here Murex) = feMarketVol(Index, Strike, Date) 2. create an object containing the previous value = feCreateEquityBlackVolatilityMatrixMarket(Index, Value, Date) 3. repeat this process for all the data in the Market (IR, vols, dividends, ) 4. create an object combining all the data called a MarketDataCollection = feCreateMarketDataCollection( ) Diagram 2 shows how market data are withdrawn form the databases and how different Objects, associated to each Underlying (Indices or Socks) are created in the computer memory as a MarketDataCollection.
rates
volatilities
dividends
Database
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which uses the SPLiFE language to describe the product in details (currency, maturity, underlying, payoff,) b. a Model object with the function =feCreateEquityModel( ) using the object MarketDataCollection as an input for the parameters of the underlyings c. an Implementation object with the function =feCreateImplementation( ) which gives the valuation method 2. use these objects as parameters to get the price with the function = feValueProduct(Product, Model, MonteCarloImplementation) Diagram 3 is a graphical representation of the steps 1.a, 1.b, 1.c and 2.
Product = feCreateSplifeProduct( )
Model = feCreateEquityModel( )
MarketDataCollection
Implementation = feCreateImplementation( )
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Stocks tickers, the type and name of the Model. After the model has been build the user needs to create a SPLiFE product in a separate spreadsheet and use the
= priceproduct( )
function to evaluate the price. Diagram 4 is a schematic representation of EasyDIVAs structure (for more information please refer to annex B).
Product = feCreateSplifeProduct( )
Index/Stock tickers
MonteCarloImplementation = feCreateImplementationMonteCarlo( )
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Example of Payoff Maturity: 3 years Currency: EUR Underlying: Eurostoxx50 (BBG Code: SX5E Index) Observation dates: yearly Barrier: 65% (of initial spot) Annualized amount: 7% p.a. Strike level: 100% (of initial spot) At the end of the first year We observe the underlying on a yearly basis. If the Eurostoxx50 is above issue level (above 100%) then the client gets 7% of the notional invested and the prducts redeems at 100%. This means that if the client invested 100EUR, he would get 107EUR at the end of the first year and the contract between the seller and the buyer is now closed. At the end of the second year If the Eurostoxx50 is below issue level (below 100%), the product continues and we observe the level of the underlying at the end of the second year. If it is above issue level (above 100%), the client gets 14% of the notional invested plus and the product redeems at 100%. This means that if the client invested 100EUR, he would get 114EUR at the end of the second year and the contract between the seller and the buyer is now closed. At the end of the third year If the Eurostoxx50 is below issue level (below 100%), the product continues and we observe the level of the underlying at the end of the third year. If it is above issue level (above 100%), the client gets 21% of the notional invested plus and the product redeems at 100%. In case the Eurostoxx50 is below the strike level (below 100%) but the barrier (65% of initial spot) has never been touched, the product redeems at 100%, otherwise the client is long the underlying at maturity (lets suppose 76% of initial spot as example). This means that if the client invested 100EUR, he would get 121EUR at the end of the third year if the condition is satisfied, 100EUR if the conditin is not satisfied and the barrier never touched, 76EUR otherwise. Advantages and disadvantages Thus, this structure has some downside risk with potential loss of a part of the investment, but it is no more risky than a direct investment in the underlying. The downside has even a protection at maturity up to the trigger
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Besides, if this structure is autocalled, the bonus earned is fixed at the agreement of the deal, so the return could be either more important than a direct investment in the underlying, and the client receives an high bonus coupon, or the underlying could increase highly, and then the return may be less important than a direct investment (which is more risky). Payoff Examples For all the examples, we take the following structures: Maturity: 3 Years Initial Stock Price: 100 Strike Price: At the Money Autocall Bonus: 8% after the first year 16% after the second year 24% after the third year Barrier at maturity: 60% of the Strike First example: at the end of the first year, the underlying stock closed equal to 105 (so to 105% of the initial strike). Then, the product is autocalled and the client will receive 108 which is the notional + the autocall Bonus. So, we see here that the return of this product is higher than a direct investment in the underlying.
Diagram 22.4 YYYYYYYYYYYYYYYYYYYYYYYYY Second example: at the end of the first year, the underlying stock closed equal to 110. So, the product is autocalled, and the client will receive 108 (i.e. the notional + the autocall bonus). This time, the return is less than for a direct investment in the underlying.
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Third example: at the end of the first year, the underlying stock closed equal to 95. The product is not autocalled the first year. Then, the deal continues until the next observation at the end of the second year. Different cases may happen: Closing price at the end of the 2nd year: 120 => Client receives 116 Closing price at the end of the 2nd year: 105 => Client receives 116 Closing price at the end of the 2nd year: 95 => Product is not called after the 2nd year
Diagram 22.4 YYYYYYYYYYYYYYYYYYYYYYYYY Fourth example: the product is called neither in the first year, nor in the second year. The payoff of this derivative will now depend on the closing price at maturity. Closing date at maturity: 105 => Client receives 124 (notional + call bonus at maturity) Closing date at maturity: 80 => Client is protected at maturity and he will receive 100 which is his initial investment Closing date at maturity: 55 => The barrier has been passed at maturity; the client is no more protected, so he will receive 1 share with a 55 notional.
Diagram 22.4 YYYYYYYYYYYYYYYYYYYYYYYYY We can see in those examples that the client is protected on the downside, and that his investment is not more risky than a direct investment in the underlying.
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We must point out here that we have consider for our example an european barrier, but the 100% redemption at maturity if the stock closes below 100% could also be conditioned by an american barrier: If at maturity, so without early redemption, the underlying stock has never quoted below 60% of the strike, the client receives his 100% investment back. Otherwise, the clients receives shares.
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(i) C =true = is the intrinsic value of the product if the condition C i is true (i ) C =true = is the time value of the product if the condition C i is true
i i
(i ) C = false = is the intrinsic value of the product if the condition C i is false (i ) C = false = is the time value of the product if the condition C i is false
i i
On the first year, the condition Ci is whether the closing price of the underlying is below (false) or above (true) the strike price. If we only consider the payoff we expect to receive the day after the first observation, we get the following graph.
108% 100%
100% Diagram 22.4 YYYYYYYYYYYYYYYYYYYYYYYYY On the right side, the product is in the money. So it will pay 108 after this first observation and then the deal is over whereas, on the left side, the product is not called and we have to wait the second observation.
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So, on the right side, the condition Ci is true, the intrinsic value is 108 and the time value is 0 because the deal will be over after this payment. On the other hand, the product on the left side possesses both intrinsic and time value. In our example, if the closing price is above 60, the intrinsic value is the value of receiving the protection (100) within two years, whereas the time value takes into account the probabilities of all possible outcomes of the product life e.g. being autocalled after the second year, or being in the money at maturity, etc. The same reasoning can be applied when the closing price is below the 60% protection, with another intrinsic and temporal value. Thus, if the closing level of the underlying is below 100%, (so the condition Ci is false), we
Ci = false Ci = false . Usually we consider that this value is have a total worth equal to close to 100%, because the probability to receive at least this value whenever the product terminates is quite high.
(i)
+ (i )
This calculation can be computed every year, and the following graph represents the discontinuity each year:
So, each year, this effectively results in an ATM digital, and the discontinuity will increase with the ascending coupon (discontinuity = 8% the first year, 16% the second year and 24% the third year) As a general rule we need to shift the barrier according to the rule: 1% shift per 1 million discontinuity in terms of product notional. So, the shift in the 100% trigger will change every year, and will be ascending like the ascending coupon. However, the value on the left side is not always 100% and depends on the ascending coupon. If this coupon is quite high, this value increases and it can happen that it is more convenient to not be autocalled the first years in order to receive the final high coupon at maturity. This case means that the lefthand value is worth more than the righthand value due to the high coupon we could receive at maturity. In that case, the trigger should be shifted towards the right in order to make the product more expensive. Discontinuity at maturity
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Besides the European discontinuity at 100%, we are also short a put down and in at maturity. This put could be valued according to European observation at maturity, like in our example with the 60% trigger. But a put D&I with a continuous (American) barrier is more frequent. The following graph presents this discontinuity:
100% 60%
If the observation at maturity is European, then the discontinuity at the 60% european barrier is worth 40%, whereas this discontinuity is smaller if the observation is continuous. Sensitivities: Lets try to understand the sensitivities on the most common autocall we have to price: an autocall on the worst performer of a basket with an American barrier at maturity for the 100% redemption. This product is usually: Short Vega: the higher the volatilities, the higher the chance to touch the barrier, and to make the put kick in, so the lower the price. Long correlation: The lower the correlation, the higher the probability for one underlying to touch the down barrier, so the lower the price. Short skew: To understand that, lets consider the following graph which is the payoff at maturity: 124% 100% 60%
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If the skew is higher, the volatility at a stike below 100% is higher, so the probability to touch the barrier is higher and the price decreases. However on the other hand, the higher the skew, the lower the volatility at a strike above 100%, so the higher is the chance to be autocalled and to receive the payoff 100% + coupon, which increases the price. Usually, with the basic structure, the first sensitivity dominates, and the price decreases when the skew increases.
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