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Option Valuation

Agenda

Lattice methods of valuation Binomial model Black Scholes Model Extensions to Black Scholes

Why Valuation Models?

Only know terminal payoff value Need to know interim value

Risk Management

A model will tell us how sensitive a derivative is to changes in market factors

Option Pricing

Option payoff depends on stock price Need to model stock prices

Binomial models Continuous time models

Option values depend on stock volatility

Binomial Model

Looks at stock price movement over small periods of time t Start with one period, t = 1

It turns out quite easy to determine option price in this case

Then many periods

Ultimately we can model infinite number of up/down movements This is continuous time

Binomial Price Tree

S

Su
Sd

Usual to assume u > 1 > d

One-Period Model Example

S = 100, u = 2, d = 0.5

Su = 200 Sd = 50

Interest rate: 10%

Bond price 100 today, 110 in one period

Suppose call strike price is 100 What is price of call option?

One-Period Model

At Su

Stock worth 200 Option pays 100 Bond worth 110

At Sd

Stock worth 50 Option worth 0 Bond worth 110

One-Period Model

 Up Down Stock 200 50 Bond 110 110 Call 100 0

But look at a portfolio of 0.6667 stocks and -0.30303 bonds: produces the same payoff as the call!

UP:

Down: (0.6667*50) - (0.30303*110) = 0

(0.6667*200) - (0.30303*110) = 100

Replication

The payoff of the call can be replicated

Using the stock and the bond, combined in a portfolio

The call and the portfolio must be worth the same

Because they have the same payoff

So we know the value of the call!

Because we know the value of the replicating portfolio In this case: C = (100*0.6667) - (0.30303*100) = \$36.37

This tells us 2 things:

How to price the call How to “create” the call if it didn’t exist

Replication - General Formula

In general, need to solve:

C u = max{Su-X, 0} = nSu + m B(1 + r f ) C d =max{Sd-X,0} = nSd + m B(1 + r f )

B(1 + r f ) = value of bond at end of period

n = # stocks, m = #bonds

Solution:

n = (C u -C d )/(Su-Sd)

is also called the delta of the option, will see it again

m = [SuC d - SdC u] /[B(1 + r f ) (Su-Sd)]

Risk Neutral Valuation

Define

π

=

(1 + r f ) - d

u - d

Then

S =

πSu + (1- π)Sd

(1 + r f )

C =

πCu + (1- π)Cd

(1 + r f )

Risk Neutral Probability

Interpretation:

π is the risk-neutral probability

S is the NPV of ‘expected’ future stock cash flows C is the NPV of ‘expected’ future option cash flows

Risk-Neutral:

Expected future cash flows are discounted using

the risk-free rate:

DF = 1 / (1 + r f )

This is true in a risk-neutral world, where there is no premium for risk

Two Period Model

Extension of replication idea:

Must replicate dynamically

Work backwards Solve a sequence of 1- period problems

S

 Suu Su Sd Sud Sdd

Delta Hedging

We know how to value options Next: how to manage risk

Option Value & Stock Prices

Option value changes as stock moves:

Up move: call value increases, put value falls Down move: put value increases, call value falls

Delta measures sensitivity of option price to stock movements:

Delta =

(Change in option price)

(Change in stock price)

Rebalancing

Option deltas change as stock price moves

So, position deltas change too

Need to rebalance portfolio periodically to keep it delta neutral Example: Long 10 calls, delta = 5

Hedge this position by selling 5 stocks Now stock move up, and call delta increases to 0.6 Position delta is (10x0.6) - 5 = 1 Need to sell another stock to rebalance to delta neutral

Delta Hedging: General Case

Idea: Replicate an option position using stock and bonds Suppose we have 1 call and sell δ stock Need to solve:

- Su + C u = Br - Sd + C d = Br

Then δ = (C u - C d ) / (Su - Sd)

The Black-Scholes Model

Can be viewed as limit of the binomial model

What happens as the time interval between up/down movements goes to zero.

Take a time period t, divide it into n intervals

Let σ = volatility of the stock

u = exp{σ√t/n}, d = 1/u This value ensures process has correct volatility σ

Black-Scholes Model

In limit, stock price process has the following properties:

a) returns are normally distributed b) returns over different periods are independent c) stock prices over any interval are log-normally distributed

Formally, can be represented by a continuous time stochastic process

Continuous Time Random Walk Model

Stochastic Differential Equation

dS = µ

S

dt

dX

+σ

S is stock price µ is drift factor σ is stock volatility

X is Weiner Process

X = ε(δt) 1/2 ε is standardized Normal random variate

Black-Scholes Equation

Consider delta-hedged option portfolio

Must grow at risk free rate, else arbitrage

V

Theta

t

2

V

S

2

1 σ

2

2

S

+

2

Gamma

+ rS

V

= rV

Delta

S

Black-Scholes Option Pricing

Solution of Black-Scholes equation:

 C = P =

d

1

d

2

=

=

S N ( d

Xe N

1

rt

)

(

Xe N ( d

(

rt

d

2

)

SN

2

)

d

1

)

 ln( S / X ) + ( r + σ 2 / 2) t σ √ t d − σ √ t

1

Properties of the Model

Call prices increase with S, r Put prices decrease S, r Both prices increase with volatility Value depends on time to maturity

Called time decay

Application

IBM Options

S = 107 1/2, strike = 105, Call option Expiration:

Sat after third Fri = July 20 0.137 years

Int rate: use 6.15% Volatility 30%

Option Calculator – Pricing
Implied Volatility

Use quoted option price to back out volatility

Using Newton-Raphson or other iterative method

Volatility estimate implicit in option price

Assuming Black-Scholes model used

Market’s estimate of future volatility

Over the life of the option May be higher or lower than historical volatility

Option “prices” often quoted in terms of implied volatility

Application: Implied Volatility

Sun Microsystems Options

S = 104, strike = 95 Option price \$11.5 Expiration (Aug options):

0.08 years

Int rate: 6.15%

Implied Volatility: 53.29%

Option Calculator - Implied Vol

Black-Scholes Assumptions

Returns are normally distributed

In reality return distributions are non-Normal Can modify model to accommodate other forms of distribution (Student T, Pareto-Levy)

Zero transaction costs

Bid-Offer spreads and other costs can be factored in

Volatility is static

In fact volatility is stochastic Use GARCH & other stochastic volatility models

Limitations of Black Scholes

Stocks

Cannot handle dividends American options

Options on Futures

Assumes underlying is deliverable today

Foreign exchange

Two assets both paying “dividend”

Domestic and foreign risk free rate

Bonds

Bonds prices are constrained, unlike stocks

Validity of Black-Scholes Model

Can be extended quite easily

Asset classes

Dividends Foreign Exchange Futures

More realistic assumptions

E.g. stochastic volatility

Vanilla model is a benchmark

May not use it to value options, but use for reference quotes

Extensions of Black Scholes

Index Options

Options on e.g. the S&P500

European options, but with dividends

Merton’s model

Extension of Black Scholes Underlying asset pays continuous dividends Good approximation for S&P500

not as good for smaller indices

Merton’s Model

qt

rt

C

Se

 N ( d 1 ( − d 2 ) + (

)

Xe

N ( d

=

2

P Xe

=

d

1 =

ln(

rt

N

) Se

r

q

+

rt

N
(
2
2 )
t

d )

1

S / X

σ

σ

t

)

d

2

=

d

1

σ

t

dividend yield

q = r

q:

Futures:

Currencies q = foreign interest rate

Application to Index Options

S&P500 Index 1368.36 Yield: 2% June options (mature June 22) t = 0.06 Risk free rate: 6.15% 1375 call priced at 45.25 Option trading at implied vol. of 34.46%

Option Calculator:

S&P500 Index Options
Foreign Exchange Options

Garman-Kohlhagen model

Identical to Merton’s model q is foreign risk free rate Holding cost

h = r - q

Black’s Model

Simple extension of Black-Scholes

Originally developed for commodity futures Used to value caps and floors Let F = forward price, X = strike price Value of call option:

C =

d =

1

d =

2

 − rt e [ FN ( d 1 ) − XN ( d ln( F / X ) + ( σ 2 / 2) t σ √ t d − σ √ t

1

2

)]

Application to Caps

Example: 1-year cap

NP = notional principal R j = reference rate at reset period j R x = strike rate Then, get NP x Max{R j - R x ,0} in arrears But this is an option on R j , not F j Use F j as an estimator of R j and apply Black’s model to F j

Previously was a forward price, now a forward rate

Black’s Model for Caps

Payments: NP x Max{R j - R x ,0} in arrears

These are a series of options:

One for each R j , the future spot interest rate

Called caplets

Let F j = forward rate from j to j+1 Value of caplet j:

Discount by (1+ F j ) as paid in arrears

C = NP x e -rt [F j N(d 1 ) - R x N(d 2 )] / (1 + F j )

Black’s Model - Example

8% cap on 3-m LIBOR (R x = Strike = 8%)

Capped for period of 3m, in 1-year’s time f = 1-year forward rate for 3m LIBOR is 7% R f = 1-year spot rate is 6.5% Yield volatility is 20% pa

See Excel workbook

Black’s Model - Example

Strike

Term

Fwd Rate Vol

R

f

C/P

E/A

HCost

C = BSOpt (8%, 1, 0, 7%, 20%, 6.5%, 0, 0, 0)

Holding Cost

Hcost = (R f -d) for stocks, 0 for Futures

Convert to %: C% = C x t / (1 + F * t)

0.00211 x 0.25 x 1 / (1 + 7% x 0.25) Cap Premium % = 0.0518% (5.18bp) So cost of capping \$1000,000 loan would be \$518

Black’s Model - Equivalent Formulation in Terms of Price

Cap = Put option on price

Equivalent of call option on rate

Useful if know price volatility rather than yield vol.

F = 1 / (1 + f

x t) is forward price

F = 1 / (1 + 7% x 0.25) = 0.982801

X = 1/(1 + R x x t) is strike price

X = 1 / (1 + 8% x 0.25) = 0.980392

Require price volatility

Other parameters as before

Black’s Model - Price Example

Strike

Term

Fwd

Price

Vol

R

f C/P E/A

C = BSOpt (.980392, 1, 0, 0.982801, 0.3702%, 6.5%, 1, 0, 0)

Cap Premium % = 0.0518% (5.18bp)
HCost
So cost of capping \$1000,000 loan would be \$518
NOTE:
This time we are price a put option

Limitations of Black’s Model

Problems:

Unbiasedness: empirically false

Option on R j not same as option on F j

Discount rate: fixed - but F j variable

Rates both stochastic and fixed!

If applied to prices the additional problem

Assumes prices can be any positive number But can’t exceed value of future cash flows

Time Dependent Volatility

Black-Scholes still valid if σ is function of time

Instead of σ, use: σ(t) =

 1 t ∫ 0 ( σ τ ) 2 d t τ

Fit σ(t) to implied volatilities of options of varying maturities

Stochastic Volatility

dσ = p(S, σ, t)dt + q(S, σ, t)dX

X is a Weiner process

Example: GARCH(1,1) model

σ

2

t + 1

= ω + βσ

2

t

2

+ αε

t

{e t }is a white noise process

Black-Scholes differential equation includes

extra terms:

(

p

λ

q )

V

σ

λ(S, s, t) is market price of volatility risk

Volatility Smiles & Surfaces

Implied volatilities of options with different strikes varies

Inconsistent with Black-Scholes Implies volatilities of OTM options typically greater than ATM options

Smile: Plot IV vs. Strike

Shows “smile” effect

Surface: Plot IV vs. Strike & Maturity

Volatility Smile – Example
Volatility Surface – Example
Lab: YAHOO

Construct implied volatility smile & surface

Solution: YAHOO
73%
73%
72%
72%
71%
71%
70%
95
100
0.57
105
0.32
110
0.15
115
0.07
Solution: YAHOO
73%
73%
72%
72%
71%
71%
95
70%
100
0.57
105
0.32
110
0.15

115

0.07

Non-Normal Models

Significant skewness and excess kurtosis in returns

Increases with sampling frequency Skewness

τ

3

= E [( X µ) ] /σ

3

0 for Normal distribution

Kurtosis

κ

4

= E[( X µ) ] /σ

4

3 for Normal distribution

2.00%
MOT 5-Minute Returns
1.00%
MOT 5-Minute Returns
0.00%
140
120
Kurtosis
= 27.5
100
-1.00%
80
60
-2.00%
40
20
0
Impact on Options

Option Valuation

ATM / OTM options undervalued

Volatility Curve

Volatility curve smiles & skews

Risk Measurment

VaR Option Greeks

Modeling Non-Normality

Extreme value distributions

Models maximum values

Normal mixture models

Simulate market jumps

Extreme Value Distributions

Extreme value M n

M n = Max(X 1 , Standardized:

, X n ) Y n = (M n µ n ) / σ n

Generalized Extreme Value Distn

(

F y

) =

exp

{

(1

exp

+

ξ

y

)

{

1/

e

ξ

y

}

}

if

if

ξ

ξ

= 0

0, (1

+

ξ

y

)

>

0

Extreme Value Distributions

Gumbel: tail index ξ = 0

Positive skew Exponential tails Normal or Lognormal returns

Weibull: tail index ξ = <0

Uniform density in returns

Frechet: tail index ξ = >0

Returns generated by GARCH, Student-t or stable Pareto

Gumbel Density
Gumbel
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
-1.0
-0.6
-0.2
0.2
0.6
1.0
1.4
1.8
2.2
2.6
3.0
3.4
3.8
4.2
4.6
5.0
5.4
Normal Mixtures

Weighted sum of two Normal processes

Low volatility High volatility (“jumps”)

g

(

y

)

= ρφ

1

(

)

y +

(1

ρ φ

)

2

(

y

)

Moments of Normal Mixture

Mean

Weighted sum of means (zero)

Variance - weighted sum of variances
2
σ
=
ρ σ
M
i
i

Skewness – zero

Kurtosis

3

ρ σ

i

4

i

/

{

ρ σ

i

2

i

} 2

Selecting Appropriate Mixtures

Three parameters

ρ, σ 1 and σ 2 Need three equations to solve Match variance, kurtosis and sixth moment of empirical distribution

Applications

Option Pricing

Using MCS

Value at Risk

Improves measure of tail risk

Option Pricing with Kurtosis

Kurtosis will affect option value if present over life of option

Hence typically more relevant to shorter dated option

Option value is weighted sum of price under each density in mixture

P = ρ f

1

(

σ

1

)

+

+ ρ

n

f σ

(

n

)

f(σ i ) is option price assuming normal distribution with volatility σ i NB: NOT price at volatility of mixture distribution

Option Pricing with Normal Mixture

45 day Call option

\$105 strike, \$100 stock

Normal mixture

Vol1 = 15% Vol2 = 30% Probability of jump = 0.5 “Expected” vol 22.5%

Normal Mixture Example

0.1400

0.1200

0.1000

0.0800

0.0600

0.0400

0.0200

0.0000

80
82
84
86
88
90
92
94
96
98
100 102 104 106 108 110 112 114 116 118

Strik e

Jump Diffusion

Brownian Motion with jumps

dS = µ

S

dt

dX

+σ

+ (

J

1)

dq

Poisson process

dq = 0 with probability (1-λ)dt dq = 1 with probability λdt

λ is the inter-arrival time of jumps

Jump Diffusion Example
Jump Diffusion
160
140
120
100
80
60
40
20
0
0.0
0.9
1.7
2.6
3.5
4.3
5.2
6.0
6.9
7.8
8.6
9.5
10.3
11.2
12.1
12.9
13.8
14.6
Ito with Jump Diffusion

Hold portfolio

Option and –of stock Π =V(S,t) - S

⎛ ∂ V

V

2

1

⎛ ∂ V

d Π = ⎜

2

dt + ⎜

t

2

S

2

S

+

σ

S

2

− ∆ dS

+

(

V ( JS , t

)

V ( S , t

)

− ∆

(

J

1)

S ) dq

If dq = 0 then = δV/δS eliminates risk If there is a jump the portfolio changes by an amount that cannot be hedged away

Pricing with Jump Diffusion

Merton (1976):

if jump component is uncorrelated then jump risk should not be priced in

Since diversifiable

Option value is weighted sum of n Black- Scholes values

Weights are probability of n jumps

n = 1

1

e

n !

t

λ

(

λ

t V

)

n

BS

(

S t

,

;

σ

n

,

r

n

)

λ′ = λ(1+ E[ J 1])

Jump Diffusion Option Pricing
Jump Diffusion vs Black-Scholes
60.0
50.0
40.0
BS
30.0
JD
20.0
10.0
0.0
60
70
80
90
100
110
120
130
140
Summary: Option Valuation

Binomial

Option replication

Black-Scholes

Limiting case of binomial

Simple extensions

Merton

Black

More complex extensions

Stochastic Volatility Extreme value Jump models