Master Thesis

__________________________________________________________________________
Master Thesis Supervisor:

Elisa Nicolato

Authors:
Sandra Durok
Sherbanu Umar

Pricing barrier options in a stochastic volatility
framework with applications to Structured
Investment Products

Aarhus School of Business, University of Aarhus
September 2009

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Table of Contents
CHAPTER 1: INTCTION ........................................................................................................................... 1
1.1 PROBLEM STATEMENT..................................................................................................................................... 3
1.2 STRUCTURE ....................................................................................................................................................... 4
1.3 DELIMITATIONS ............................................................................................................................................... 5
1.4 NOTATION ......................................................................................................................................................... 6
1.5 DATA ................................................................................................................................................................ 8
FIGURE 1.1 STOCK PRICE OF EUROSTOXX 50 ...................................................................................... 9
CHAPTER 2: THEORETICAL FUNDAMENT ....................................................................................... 10
2.1 CONTINUOUS-TIME STOCHASTIC PROCESS OF THE UNDERLYING ........................................................................ 11
2.2 THE BLACK SCHOLES MODEL........................................................................................................................... 12
2.2.2 Risk Neutral Valuation ............................................................................................................................... 13
2.2.3 Explicit formulas ........................................................................................................................................ 13
CHAPTER 3: EXTENSIONS TO THE BLACK SCHOLES MODEL .................................................... 14
3.1 EMPIRICAL IMPLICATIONS ................................................................................................................................ 15
3.2 MOVING FROM CONSTANT TO STOCHASTIC VOLATILITY .................................................................................... 22
3.2.1 Volatility smile ........................................................................................................................................... 22
3.2.2 Implied Volatility ........................................................................................................................................ 26
3.3 LITERATURE REVIEW OF MODELS ..................................................................................................................... 27
3.4 CONSTRUCTING A PRICING EQUATION UNDER STOCHASTIC VOLATILITY ............................................................ 29
3.5 THE HESTON (1993) STOCHASTIC VOLATILITY MODEL ..................................................................................... 33
CHAPTER 4: INTRODUCTION TO BARRIER OPTIONS ................................................................... 35
4.1 BARRIER OPTIONS ............................................................................................................................................ 36
CHAPTER 5: PRICING IN A MONTE CARLO FRAMEWORK .......................................................... 39
5.1 CHOICE OF MODEL.......................................................................................................................................... 40
5.2 MONTE CARLO SIMULATION ............................................................................................................................ 41
5.2.1 Model improvements .................................................................................................................................. 42
5.2.2 Generating random numbers ..................................................................................................................... 42
5.2.3 Variance Reduction Techniques ................................................................................................................. 43
5.3 MONTE CARLO SIMULATION OF HESTON MODEL .............................................................................................. 45
5.4 INTRODUCTION TO CALIBRATION ..................................................................................................................... 49
5.5 MODEL CALIBRATION ...................................................................................................................................... 50
5.6 MONTE CARLO SIMULATION OF BARRIER OPTIONS ............................................................................................ 53
CHAPTER 6: ANALYSIS OF EUROPEAN AND EXOTIC OPTIONS .................................................. 54
6.1 IMPACTS OF STOCHASTIC VOLATILITY MODEL ON VANILLA OPTIONS ................................................................... 54
6.1.1 Impacts of stochastic volatility & correlation on smile .............................................................................. 61
6.1.2 Sensitivities of stochastic volatility and correlation on barrier options ..................................................... 64
CHAPTER 7: STRUCTURED INVESTMENT PRODUCTS .................................................................. 72
7.1 INTRODUCING STRUCTURED PRODUCTS: AN OVERVIEW ................................................................................... 72
7.1.1 Payoff structure .......................................................................................................................................... 77
7.1.1 Participation Rate ...................................................................................................................................... 77

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7.2 ANALYSIS OF PROSPECTUS AN OVERVIEW ....................................................................................................... 79
7.2.1 Analysis of Danske Dow Jones EURO STOXX 50 Shark Fin-2009 ................................................... 80
7.2.2 Analysis of KommuneKredit Aktietrappe 2012 .................................................................................... 81
7.3 VALUATION OF THE STRUCTURED PRODUCTS ................................................................................................... 84
CHAPTER 8: DISCUSSIONS OF THE HESTON (1993) MODEL ......................................................... 86
CHAPTER 9: CONCLUSION ................................................................................................................... 89

List of Appendices
Appendix 1: Black & Scholes Assumptions
Appendix 2: Derivation of Black & Scholes
Appendix 3: Proof for dV and dV
1
by Itos Lemma
Appendix 4: Results of Calibration
Appendix 5: Explicit formulee for Barriers
Appendix 6: Effects of Volatility of Variance on Barrier
Appendix 7: Effects of Correlation on Barrier
Appendix 8: Participation rates for Garanti Invest
Appendix 9: Prospect for Aktietrappe 2012
Appendix 10: Prospectus for Shark Fin 2009
Appendix 11: Example of Payoff in Aktietrappe 2012
Appendix 12: Implied Volatilities

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Chapter 1: Introduction
Exotic options are far from new to financial markets. When standard options became
better understood in early 80ies the need for more complex structures rose in line with
particular needs. Accordingly, the financial markets have become much more volatile
today due to substantial increase in variation on financial assets. Option contracts
became increasingly popular to reduce the risk associated with the variation.
Consequently, the two prominent economists Fischer Black and Myron Scholes
developed an analytical closed form solution for option pricing in 1973 by means of
arbitrage argument. Their article (Black & Scholes 1973) won at that time great
reputation in the finance theory. The model has advantages that they express the
option price in closed form and is easy to implement. The model is however only
applicable under stringent assumptions - including that the continuously compounded
stock returns are normally distributed with constant mean and variance. Nevertheless,
in financial context it has eventually become a true and known fact that the famous
Black & Scholes model cannot capture observed market prices.

A number of empirical studies point in the direction of time-varying volatility in asset
prices and to the fact that this volatility tends to cluster. Since the crash in 87, the
market implied volatilities of stock index options often have a skewed-like structure,
which is known as the volatility smile that shows implied volatility across
moneyness. This smile is a good example that the Black Scholes model is not a good
model. The market option prices are not exactly consistent with the theoretical prices
derived from the Black Scholes formula. Nonetheless, the success of the Black
Scholes framework led traders to quote a call option market price in terms of the
constant local volatility
imp
which makes the Black Scholes formula value equal to
the observed market price. The markets implied Black-Scholes volatilities for index
options have shown a negative relation between implied volatilities and strike prices;
out-of-the-money puts trade at higher implied volatilities than out-of-the-money calls
(Derman et al. 2004). This phenomenon lead to the fact that the Black-Scholes model
was found to overprice options and that the degree of overpricing increases with time

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to maturity.
1
Had Black Scholes model been a well describing model for observed
market prices the implied volatility would have been constant, which is apparently
not in agreement with reality.

Accordingly, this lead to that many of the advanced models in literature sought to
overcome this restriction by incorporating a volatility that is stochastic and varies
over time. The most popular model in this context is the Steven Heston (1993)
stochastic volatility model for describing the true market-traded option prices. Steven
Heston developed a semi-closed formula for option pricing that fitted market data to a
much higher extend relative to the Black Scholes. Furthermore, it is relatively easy to
implement, hence the reasons for its popularity.

The financial market searched for new derivative products to cover new and
completely different financial market participants needs. Exotic products were
therefore developed with different characteristics according to market demands.
Barrier option is an example of an exotic option where the payoff depends on whether
the underlying assets price reaches a predetermined level (barrier) during a specific
period of time. The advantage of the barrier option is that they are cheaper since the
buyer does not pay for an unlimited upside chance but only to that predetermined
level. According to literature, barrier options are rather sensitive to volatility of the
underlying asset compared to its equivalent vanilla. For this reason barrier options are
particularly of interest in the sense that it is relevant to examine the behavior of
barrier option prices under stochastic volatility.
Steven Heston developed explicit formulas for vanilla options under stochastic
volatility but no such closed form formula exist for barrier options. For this reason it
is therefore necessary to apply numerical techniques to solve this problem. Monte
Carlo simulation is used as this numerical method has advantageous characteristics
which make it applicable for above problem formulation.

1
Hull and White, Pricing of Options on Assets

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On these grounds it is therefore relevant to explore the issue of accounting for the
rather newly introduced financial phenomenon; the stochastic volatility, which will be
elaborated and analyzed. It is both interesting and relevant to analyze how stochastic
volatility affects the option pricing of standard vanilla options and barrier options.
Following section will line up the above problems and challenges associated with
stochastic volatility.

1.1 Problem Statement
As mentioned, the main theme in this thesis will thus be to emphasize the importance
of applying stochastic volatility instead of constant volatility as this has a great effect
on option pricing. This thesis will then deal with stochastic volatilities to see how
prices behave. Thus, this leads to following research questions:
Why do we apply stochastic volatility instead of a constant volatility? (Why is Black-
Scholes model no longer efficient)
What volatility should then be used in practice?
The main points researched in this thesis will therefore also consist of:
To introduce existing models for stochastic volatility with focus on the Heston (1993)
model
Pricing barrier options with Heston model in a Monte Carlo framework
Analyze differences in option prices under the assumptions of Black-Scholes and
under Heston assumptions

Lastly, the thesis will introduce the concept of structured products. The application to
structured products, as will be seen, is due to the barrier options that are embedded.
Structured products have become increasingly popular with Danish investors;
however have also been subject to massive criticism from the Danish Central Bank
(Nationalbanken) and by largely in the media. This is mainly due to the complexity of
the options embedded and the math that lies behind them.

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Thus, this thesis will attempt to uncover, from perspective of investors, the
complexity of pricing these complex financial products. In addition, the thesis will
describe, price and analyze the contents of a recently issued structured product with
barrier options embedded.

1.2 Structure
In order to get a better overview of the structure of the mentioned issues, this section
describes how the thesis is constructed.
The initial chapters of the thesis lay the theoretical fundament for the whole thesis as
it provide an explanation of option pricing under Black Scholes framework. The
Black Scholes model will be introduced and will be used in the rest of the thesis for
comparison purposes. The risk neutral valuation is also introduced in these sections as
this is essential in option pricing theory. Next, chapter 3 introduces the shortages of
the Black Scholes (1973) model with focus on the assumption that the volatility is
constant and known. Empirical evidences of flaws in the model are then presented
and why it is relevant to loosen the rigid Black Scholes (1973) assumption. This is
done by constructing the well known volatility smile. In this connection various
models in literature for evolution of the underlying asset are mentioned with focus on
the Heston (1993) model which then becomes the building block of this thesis. The
Heston model is described and the reason for its popularity in practice is explained.

Chapter 4 introduces barrier options and the different characteristics of contract types
that exist. In this chapter it is also argued why this type of option contract is chosen,
which lays the foundation for the next chapters.

Chapter 5 introduces pricing options with numerical techniques; Monte Carlo
simulation method is introduced since there exist no explicit formulee for barrier
options under stochastic volatility. Monte Carlo simulation method is applied due to
its advantageous characteristics and methods of improvements; variance reduction
techniques are finally also given.

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The next sections of chapter 5 introduce the method of calibration. For the simulation
of option prices the Heston model is calibrated to market option prices written on the
Dow Jones EuroSTOXX index. These parameters that fit the market best will be used
and in this connection the Heston model performance will be examined under Black
Scholes settings. The prices from Black Scholes model will be compared to Hestons
prices and analyzed.
The next part of the paper involves chapter 6 in which the impacts of stochastic
volatility on first plain vanilla options and then barrier options will be examined and
analyzed. Since barriers are sensitive to stochastic volatilities it is analyzed how
option prices behave for different levels of volatility of variances and correlation
between shocks to the stock price and shocks to the variance. Conclusively, price
differences between the Heston model and Black Scholes model are also analyzed.

Chapter 7 introduces the increasingly popular structured product investments and its
function in this thesis. This chapter also gives a thorough description of how they are
constructed. Conclusively, the structured products are analyzed and priced.

Finally, in the concluding chapters of this thesis the performance of the Heston model
will be discussed. The discussion will based on the empirical findings, own analyses
and findings that is made throughout the paper. Final concluding remarks will be
made on the thesis as a whole.

1.3 Delimitations
This thesis is delimited to pricing European vanilla options hence pricing the
American type of options is beyond the scope of this paper. The pricing process will
be based on theoretical aspects and thereby builds on the classic Black Scholes
theory.
The introduction to stochastic volatility leads naturally to introduction to selected
stochastic volatility models while further analysis will be based on the Heston model
(1993) alone. Thereby, this paper delimits to only mention stochastic volatility

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models available in literature and no further explanation or derivations on them will
be made.
Closed form solutions for the Heston model are available but will not be applied or
explained in this thesis since it is not applicable for pricing barrier options. Since it is
not applicable for barrier option pricing, the numerical method Monte Carlo
simulation method is applied. For convenience this numerical method is also used to
price European vanilla options. There exist other numerical methods however this
thesis will not introduce them here as this is not the purpose of the thesis.
The topic of structured products is a large research field in itself and thus a whole
thesis can be dedicated to this specific area. Delimitations had to be made due to lack
of paper size and relevance for this study. Therefore, this chapter is delimited to
description and analyzes of structured products in order to understand their
complexities for pricing purposes.

1.4 Notation
In order to create as much consistency as possible, the thesis includes following
notations:

SDE: Stochastic Differential Equation.
PDE: Partial Differential Equation.
S
t
: Stock price at time t, where S
0
is the current value of the stock.
S
T
: Stock price at expiration.
K or E: Strike price (Exercise price).
t: Running time, that is (T-t) indicates time to maturity.
T: Expiration date.
r
f
: Risk free rate.

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: Volatility of underlying.
: Rate of return of the asset.
: Long level volatility; as t tends to infinity, the expected value of
t
tends to .
: Rate at which
t
reverts to .
: Volatility of variance; as the name suggests, this determines the variance of
t
.
: Correlation between the Brownian motions (i.e. random walks).

S
u
or U: Upper barrier.
S
d
or L: Lower barrier.
V(S,t): Value of the option as a function of variables S and t.
P(S,t): Payoff of the option as a function of variables S and t.
k
i
V : Value of option in the i
th
asset space and the k
th
time space.
i
T
S : Price of underlying at time T for the i
th
simulation.
N: Number of simulations.
dX: Wiener process.
W
1,2
: Standard Brownian Movements
ITM: In-the-money
OTM: Out-of-the-money

MCS: Monte Carlo Simulation
FD: Finite Difference method
VBA: Visual Basics Application (Software integrated in Excel)

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Other comments
When referred to a vanilla option, it is meant by standard put and call options with
European characteristics.
The symbol for volatility on volatility; , will be used in the paper, however since this
symbol is not possible to make in charts, the letter v will be used to denote this
term.
Often the term underlying is used to refer to the underlying asset in question.
All interest rates and volatilities are expressed in annual terms.

1.5 Data
The empirical research in this paper is based on a database which contains all
reported trades and quotes covering EuroSTOXX 50 index options provided by
Danske Bank and Bloomberg from March 2008 through the time up to present time.
In the construction of return analyses data for a period of 28 years from 31.12 1980 to
17.10 2008 is used based on the S&P 500 index. The reason for this was for the ease
to compare it with other empirical findings that is also based on the S&P 500 index,
which is more common that the Dow Jones EuroSTOXX index. The observations are
daily adjusted (for dividends) closing prices, however since there are closing days in
for instance the weekends and other holidays, these will not be included. However,
this will not affect the big picture and the concluding remarks of the analysis. The
performance of the index can be seen in the following

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Figure 1.1 Stock Price of Dow Jones EuroSTOXX 50

It can be seen from figure 1.1 that the index has fallen by 2500 Euros from
approximately 4500 Euros in January 2008 to approximately 2000 in March 2009 as a
consequence of the world wide crisis. Since then the index has risen to a level of
around 2500 Euros in June 2009, which is a rise of 25 %. Data on this performance of
the index can be seen in Excel file Stock Prices SP5E.

The Dow Jones EuroSTOXX 50 is a market index comprised of the 50 largest
European stocks designed by STOXX Ltd, a joint venture of Deutsche Bank Boerse
AG, Dow Jones & Company and SIX SWISS Exchange. The index is chosen on the
grounds of several criteria such as the combination of market value and turnover on
the bourse of the home country.
The index is equally market weighted which means that the weight of the stocks for
any time is proportional to that of the stock price. The Dow Jones EuroSTOXX
family covers
2
Europe, the Eurozone, Eastern Europe, the EU Enlarged reigion, the
Americas and the Asia/Pacific. It provides investors with access to a variety of market
segments on a regional, size, style, sector or theme level.

In analyzing market prices of put and call it was observed that call prices fell outside
the no arbitrage boundaries for calls, while put prices remained inside the boundary.

2
This paragraph is based on prospectus Aktietrappe pg. 17 and the web-site www.Stoxx.com
0
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Stock Price of EuroSTOXX 50

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Hence, it was concluded that put prices performed better. For practical reasons it was
decided to use call prices converted from put prices through the put call parity.

The valuation part will furthermore require dividends, volatility estimates and risk
free interest rates. The dividend was adapted from EuroSTOXX web-page which was
listed as 3.74%.
3
The interest rates were provided by Danske Bank, who provided us
with 1 month-6 month CIBOR and EURIBOR along with the 1-year to 10-year
CIBOR and EURIBOR. For consistency the EURIBOR were used since the
underlying asset as well as all options written on the Dow Jones EuroSTOXX 50
index are all expressed in Euros. The only inconvenience there may be is that the
structured products are expressed in Danish DKK. Had interest rates not been directly
obtainable this thesis would use futures as interest rates are embedded herein. Danske
Bank in co-operation with Bloomberg also provided us with data. Original data
provided by Danske Bank can be found on the enclosed CD in Excel file Raw data.
More organized and cleaned data can be found in Excel file DowJones_data.

Chapter 2: Theoretical Fundament
To establish the fundament for further study and analysis this chapter will outline the
fundamentals of the Black Scholes model and its usability for pricing derivatives.
Comprehensive derivations will not be carried out as these have been done a lot in
previous works and are not the essentials of this thesis. Instead focus will be on
results and concepts which are relevant for the introduction of stochastic volatility.
Central to the theory behind the assumptions of the Black Scholes model is the
definition of the process followed by the underlying asset when pricing options.
Having defined the process for underlying asset the Black Scholes model can be
derived by constructing a self- financed portfolio that consists of a position in a
underlying asset and one position in a risk-free asset. As mentioned, extensive
derivations will not be given but more some of the argumentation in the idea of the
derivation of the Black Scholes formula is given as they will be referred to at later
stages of the thesis.

3
The dividend is for the financial year 2009.

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2.1 Continuous-time stochastic process of the underlying
As starting point when pricing options the process followed by the underlying asset
must be identified. Since the asset prices change over time in an uncertain way it is
said that they follow a stochastic process. It has proved useful to model stock prices
as a continuous stochastic process despite the fact that they cannot be observed in
continuous time.
This chapter will be based on Hull (2006) and Wilmott (2008).
Geometric Brownian motion is a good model for the uncertainty surrounding the
market value of many type of assets, and it has following properties:
Markov: only present value of variable is relevant for predicting the future.
The past history of variable and the way that the present has emerged from the
past is irrelevant.
Martingale: expected value of variable at any future time is equal to its value
today
Finiteness: The process takes finite values. Any other scaling of the increment
would have resulted in either a random walk going to infinity in a finite time,
or a limit in which there is no motion at all
Continuity: The process is continuous
Quadratic variation: If we divide time interval 0 to t into n equally spaced
intervals with partition points t
i
= it/n

=

n
j
j j
t t X t X
1
2
1
)) ( ) ( (
Normality: Over finite time increments t
i-1
to t
i,
the increment is normally
distributed with mean zero and variance equal to the time step .
1
=
i i
t t t
Geometric Brownian motion is defined as:
SdX Sdt dS + =
(2.1)

This model is good in capturing two key aspects of the stock prices. One of them is
that the expected percentage return required by investor from a stock is independent

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of the stock price, while the other is that the variability of the percentage return in a
short period of time, t, is the same regardless of the stock price.
The Black-Scholes model is based on geometric Brownian motion assumption.

2.2 The Black Scholes model
The famous Nobel Prize-winning equation; the Black Scholes Pricing Equation; got
derivatives theory started. The derivation of the Black Scholes model for option
pricing of European vanilla options includes a strategy of holding a portfolio
consisting of one long position in the underlying and one short position in a risk-free
asset.

The idea behind the classic theory of Black & Scholes is that irrespectively of how
the price of the underlying asset evolves in time the final return of the portfolio is
equivalent to the return of the derivative at expiration. This self-financed portfolio
can without obstacles be replicated since the price of the asset and the price of the
derivative are both impacted by the same uncertainty, viz. the uncertainty in the price
evolution of the underlying asset. By dynamically re-balancing the portfolio it is then
possible to maintain a delta-hedged by selling the derivative. This act of delta-
hedging represents an insurance against losses where losses of one position will be
offset by the gains in the other position of that portfolio.

For the model to be valid a range of assumptions on the market is made - see
Appendix 1 for Black Scholes assumptions. Given these assumptions, the Black
Scholes model hereby assumes that the market is complete. The simplest definition of
a complete market is one where all derivatives can be replicated in a self financed
strategies. The derivation of the Black Scholes Pricing Differential Equation is not
given in this thesis but is referred to in the appendix for the sake of reference at later
stages in this thesis. See Appendix 2 for details on the derivations.

From the derived equations it is seen that the price V of any option which only
depends on S and t must satisfy the Black Scholes equation:

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0
2
1
2
2
2 2
=
rV
S
V
S
S
V
S
t
V
(2.2)

which is a linear parabolic, partial, differential equation.
To solve the equation and finally find V, we need to know more about the contract we
are looking at, i.e. we need to have final condition which is given by the payoff of the
contract.

2.2.2 Risk Neutral Valuation
One way to determine the option price is to solve the partial differential equation
(PDE) directly. An alternative way of solving that PDE is to apply the Martingale
Approach or Risk neutral Valuation method. This is possible because that equation
does not involve any variables that are affected by the risk preferences of the investor.
That allows us to choose any preferences, even the one where we claim that all
investors are risk neutral. In the world where investors are risk neutral, the expected
return on all investment asset is the risk free rate of interest, r (Hull 2006).

2.2.3 Explicit formulas
For standard vanilla European put and call options it is known that it is possible to
solve the Black Scholes differential equation explicitly (Hull 2006, pg. 295). The
value of a call option is expressed in a closed-form solution known as the Black
Scholes formula:

) ( ) ( ) , (
2 1 0
d N Ke d N S t S C
rT
= (2.3)
where

T
T r K S
d
) ( ) / ln(
2
0
1
+ +
= (2.4)

T
T r K S
d
) ( ) / ln(
2
0
2
+
=

(2.5)

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The function N(x) is the cumulative probability distribution function for a
standardized normal distribution. In other words it is the probability that the option
will be exercised in a risk neutral world. The price of a put option can be found
analogically to the derivation of the call option or can simply be found via the put-call
parity:

0
) , ( ) , ( S t S P Ke t S C
rT
+ = +

(2.6)

The relationship between a European call and European put suggests that the
portfolios on both hand sides should have the same values given that the strike and
maturity date are the same. If this is not true, i.e. if equation (2.6) does not hold, there
are arbitrage opportunities (amongst others Hull 2006; pg. 212). The price of the put
can now be derived:

rT
t
Ke S t S C t S P

+ = ) , ( ) , ( (2.7)

Chapter 3: Extensions to the Black Scholes model
Having the fundamentals, this chapter reconsiders the Black Scholes model. As far as
concerned the model have the advantage that it yields the option price in closed form
and is easy to implement. Despite the success of Black Scholes and its stability in
theory, its assumptions do not show reliability in practice today. Namely, the strong
assumptions that the continuously compounded stock returns are normally distributed
with constant mean and variance. If a different perspective is taken it is possible, by
means of the volatility smile, to prove that the variation is not constant across
moneyness and time. Here the variation displays a constantly decreasing tendency
across moneyness whilst the smile becomes less significant with increasing time to
maturity. This enlightens discrepancy between the Black Scholes predicted option
prices and market prices wherefore the inadequacies of the Black-Scholes model
indicate that a more realistic and flexible model is required in order to describe the
option market-traded option prices. During the past two decades new improved
models have been derived such to loosen the restrictive assumptions of the Black-

__________________________________________________________________________
15 | P a g e

Scholes model. Among other things the models include stochastic volatility and
interest as well as jumps in the process of the underlying asset where the primary
objective has been to attempt to fit the actual return distribution. The greatest
improvement in the pricing model in relation to Black-Scholes occurs when accepting
that the volatility is stochastic. In practice, the Black Scholes is still widely used due
to the simplicity of the model and traders use volatility smiles to allow for
nonlognormality.
4

The next sections will thus include evidences that the assumption of a constant
volatility does not hold in practice and that the return distribution is non-Gaussian.
These evidences will be based on simple observations and empirical implications
followed up by argumentations for a more market-realistic model which allows
volatility to vary randomly. Next, a literature review of suggested improved models
for describing the market is given followed by an introduction to the Heston (1993)
model. This model will be used in this thesis for pricing purposes and thus for further
analysis.

3.1 Empirical implications
Whether it makes sense to model volatility as a random variable should be clear to the
most casual observer of equity markets. To be convinced of this, one only needs to
recall the stock market crash of October 1987 (Gatheral 2000). In the following this
issue will be clarified.
A number of empirical studies regarding the return distribution show that the basic
Black Scholes assumption that stock prices follows a Geometric Brownian Motion
given in (2.1) and log returns are normally distributed does not hold. The essential
results in this section will be presented based on empirical evidences. In the study of
financial time-series the actual return distribution will be examined relative to the
normal distribution also known as the Gaussian distribution. The normal distribution
is used in studies to describe data or any variable that tends to cluster around the
mean.

4
Hull 2006 pg. 386

__________________________________________________________________________
16 | P a g e

The normal distribution is defined by a skewness of 0 and kurtosis of 3. A skewness
of zero implies that the distribution is symmetrical around its mean. The kurtosis
measures the peakedness of the distribution and as is set to 3 as default.
The Kernel estimator is used to reproduce the conditional probability density of the
continuously compounded spot returns. The Kernel is used in non-parametric
estimation techniques and is given as:
|
|
\
|
=
2
2
2
) (
exp
2
1
) (
h
x
h
x K
(3.1)
where h is the smoothing parameter also called bandwidth, which is given as:

5 / 1
06 . 1

= NoObs h
(3.2)

The study will take its starting point in presenting empirical evidences of time series
of historical volatility followed up by the return distribution of actual returns to see
whether these time series can be explained by a Gaussian distribution and therefore
also whether the assumption in Black Scholes is justified.
In order to see how volatility behaves, one only needs to glance in history. Historical
data collected from Bloomberg shows indications of a time dependent volatility
shown in below figure.

Figure 3.1: Historical Volatility

Source: Bloomberg

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17 | P a g e

From figure 3.1 it is obvious that volatility appears to change with time. The varying
volatility is also observed indirectly through market prices of traded contracts. Since
volatility cannot be directly observed, the relationship between prices of the
derivative and volatility of the underlying is exploited in order to determine the
(implied) volatility from market prices. This is examined in the following:
In table 3.1 are the market prices of European call options with one, three and seven
months until expiry. All have strike prices of 105 and the underlying asset is currently
106.25. The short-term interest rate over this period is about 5.6% (this example is
based on Lewis 2001).

Table 3.1: Market Prices of European call options, and the implied volatilities
Expiry Value Implied vol.
1 month 3,5 21,2%
3 months 5,75 20,5%
7 months 7,97 19,4%
Source: Own contributions

When values are substituted into the Black Scholes call formula it is easily confirmed
that these prices are consistent with volatilities of 21.2%, 20.5% and 19.4% for one-,
three- and seven month options respectively as shown in table 3.1. Had the volatility
been constant during this period these prices would not have been true. Clearly the
simplest adjustment that can be made is to assume that volatility is time dependent
which is in compliance with considerations made by Rouah et al. (2007).

Endless studies carried out by amongst many others; Jackwerth et al (1995), Fama
(1965), Campbell, Lo & MacKinlay (1997), Hol (2003) and Bollerslev et al. (2001)
all show a distinct in distribution of actual asset returns relative to the normal
distribution which was already pointed out in the 60ies by Mandelbrot (1963) and
Fama (1965). They found that the asset return distribution showed tendency of fatter
tails relative to the normal distribution (see figure 3.2.a for visual example). This non-
Gaussian distribution was since then also found in return distributions of different
market data internationally by many other theorists.

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18 | P a g e

Starting with Fama (1965) several statistical investigations revealed that asset returns
does not follow the Gaussian distribution but larger clustering around the mean was
observed. In particular, the asset returns exhibited heavier tails to the normal
wherefore option prices were consequently underestimated. In other words the
distribution showed a positive excess kurtosis and a tendency of a negative skew
(Fama 1965), which gives an indication of a higher probability of higher returns
relative to negative returns.
Bollerslev et al. (2001) did a survey on the Dow Jones Industrial Average and also
came to overall conclusions that the Dow Jones Industrial Average returns have fatter
tails to the normal and majority of the stocks are skewed to the right which is
consistent with Fama (1965) and the rest.
Besides these observations, the studies furthermore gave indications of a time-varying
volatility in asset prices and that this volatility tends to cluster. This was observed by
Rouah et al. (2007)
5
alongside with other theorists.
Finally, a negative correlation between the asset return and its volatility is often
observed which is called the leverage effect. In other words the leverage effect is the
negative correlation between past returns and future volatility. Under the usual Black
Scholes assumptions this does not exist since it is assumed there is no correlation
between the asset returns and its volatility. In the introduction of leverage effect it
was pointed out that investors did not signal a symmetric response on news, which is
also supported by Campbell et al. (1997). Negative shocks to returns; also known as
abnormal returns turned out having greater effect than the positive shocks. I.e.,
investors responded stronger to negative news than to positive news.

In the following figures the actual returns are sketched in contrast to the normal
distribution to point out the distinctions that were empirically proven by additional
theorists.

5
Rouah et al. 2007 pg. 136

__________________________________________________________________________
19 | P a g e

Figure 3.2.a: Actual return distribution versus Normal

Source: Gatheral 2000
Figure 3.1.a shows the frequency distribution of S&P 500 log-returns over an almost
26 year period. Most surveys are based on the S&P500 index as this is the most
common index and is included in the study of Gatheral (2006). It is seen that the
returns follow a distribution that is highly peaked and fat-tailed relatively to the
normal distribution, which is given by the thin line. This non Gaussian distribution is
also called a leptokurtic distribution.
6

Figure 3.2 b: QQ-plot of daily log returns against the normal

Source: Gatheral 2000

6
In terms of shape a leptokurtic distribution has a more acute peak around the mean and fatter tails
relative to the normal distribution. A distribution that has opposite effects; i.e. lower peak and thinner
tails relative to the normal distribution is called a platykurtic distribution.

__________________________________________________________________________
20 | P a g e

Shown more clearly, the QQ-plot in figure 3.2.b shows how extreme the fat tails of
the empirical distribution of returns are to the normal distribution. Had the empirical
distribution of data returns been normally distributed this would have been
represented by a straight line. The observed market data shows a clear distinction
from the normal distribution both in the peakedness and in the tails which Gatheral
(2006) and other empirical studies also points out. The higher peakedness indicates
higher returns around the mean which can be explained by the existence of a higher
volatility. The change in the shape of the curve; i.e. the fat tails together with the
higher peakedness indicate that the kurtosis is higher for this distribution to the
normal distribution that has a kurtosis of 3.
Figure 3.3 shows a plot of the log returns of S&P 500 over a 28 year period. For
this, adjusted closing prices
7
from daily data was used as this is mostly used,
although one may argue for opening prices and highest/lowest prices for that day.
8

Recalling Gatherals (2006) remark on 1987 crash, one can by simply observing the
historical returns see that the volatility is not constant. The figure (3.3) indicates a
time-varying volatility in asset prices and that this volatility tends to cluster which is
as previously mentioned consistent with Rouah et al. (2007).

7
Closing prices are adjusted for dividends and splits (Yahoofinance.com).
8
Hull 2006 pg. 287

__________________________________________________________________________

Figure 3.3: Daily S&P 500 log returns from 1980

Source: Based on data from Yahoo Finance and own calculations

There have been some discussions on the behavior of the volatility in the year 1987.
As the figure shows the volatility in this year is of an extreme value and thus the
long term historical level thus depend on whether the catastrophic day of 19
October 1987 is included or not. According to Jackwerth et al. (1995) this
observation should not be excluded as an outlier and evaluates further that volatility
based on history often underestimates the volatility systematically if the year 1987 is
excluded.
This volatility clustering feature implies that volatility is
returns, which is a consequence of mean reversion of volatility (Gatheral 2000).
That is; high (low) returns are followed up by high (low) return levels in the
standard deviation in accordance with considerations made by Mandelbrot (1963)
and thus has to be modeled accordingly. Moreover, the observed fat tails and the
high central peak show characteristics of mixtures in distributions with different
variances (Gatheral 2000; pg. 2),
modeling.

Based on own findings and arguments in the above, it was shown that the log
distribution of the underlying asset is non Gaussian. The evidence of fat tails and high
peaks (leptokurtic distribution
__________________________________________________________________________
Daily S&P 500 log returns from 1980 -2008
Source: Based on data from Yahoo Finance and own calculations
been some discussions on the behavior of the volatility in the year 1987.
cluded or not. According to Jackwerth et al. (1995) this
y clustering feature implies that volatility is auto-correlated
accordance with considerations made by Mandelbrot (1963)
variances (Gatheral 2000; pg. 2), which again points in the direction of stochastic
own findings and arguments in the above, it was shown that the log
tribution) is also supported by empirical studies. Furthermore, it
__________________________________________________________________________
21 | P a g e
been some discussions on the behavior of the volatility in the year 1987.
th

cluded or not. According to Jackwerth et al. (1995) this
correlated in between
accordance with considerations made by Mandelbrot (1963)
which again points in the direction of stochastic
own findings and arguments in the above, it was shown that the log-return
) is also supported by empirical studies. Furthermore, it

__________________________________________________________________________
22 | P a g e

was seen that there exist empirical studies and economic arguments that suggests
return on equities and implied volatility are negatively correlated; i.e. the leverage
effect. Had the Black Scholes assumptions been correct the correlation between asset
and volatility would have been zero. Conclusively, this departure from the
assumption of normality plagues the Black Scholes model. Consequently, these
implications lead to the next chapter; i.e. to the introduction to stochastic volatility.

3.2 Moving from Constant to Stochastic Volatility
The year 1973 was the year of a large breakthrough in the field of finance where
economists Fischer Black and Myron Scholes finally had their well known pricing
model (Black-Scholes Model) published. It is still used widely today both for
theoretical as well as practical purposes despite its assumptions of constant volatility.
However, it has eventually become a known fact in financial contexts that the Black-
Scholes model can no longer explain the observed market prices well. This chapter
introduces and provides empirical evidences of the existence of the volatility smile

3.2.1 Volatility smile
Rubinstein (1985) and more recently Jackwerth & Rubinstein (1996) and many others
studied the phenomenon of volatility smile for equity options.
9
Prior to the infamous
stock market crash in October 1987 the volatility surface of index options was
somehow flat, but hereafter it took form of a smile or skew (Hull 379-80 & Derman
2003) as observed today. Theorists were challenged by this new phenomenon both in
theory and in business too. According to classic theory, options of all strikes should
have the same volatility independently of its strike and expiration. The surface would
then have been exhibited as flat as shown in figure 3.4.

9
Hull 2006 pg. 379

__________________________________________________________________________

Figure 3.4: Flat volatility surface

However, post October crash showed an entirely different pattern. According to the
observed smile each option reported a different volatility for the same underlier. In
other words, using Black Scholes option pricing model, the volatility of the
underlying can easily be calculated by plugging in the market prices for the options.
Theoretically, for options with the same expiration date, the implied volatility is
expected to be the same regardless the value of the strike price. However, reality
showed different implied volatilities across various strikes. This disparity is known as
the volatility smile, smirk
upturned curve of the lips. For indexes, the
volatilities were anti-correlated with strikes (Derman 2003). Thus
patterns that emerged in the options markets are now known as the
and the term structure of implied volatility

The problem was that, even if the market p
was needed to hedge it, and if Black Scholes couldnt account for implied volatility, it
couldnt produce a reliable hedge (Derman 2003). Notably, if the classic Black
Scholes model had been well
naturally have been constant. Nevertheless, this clearly contradicts what is observed
on the market today.

__________________________________________________________________________
: Flat volatility surface
can easily be calculated by plugging in the market prices for the options.
ent implied volatilities across various strikes. This disparity is known as
or skew because in the currency world it did show a slight
upturned curve of the lips. For indexes, the skew was described as negative
correlated with strikes (Derman 2003). Thus, in general
patterns that emerged in the options markets are now known as the smile,
term structure of implied volatility.
The problem was that, even if the market price of a liquid option was known a model
Scholes model had been well-explaining in real terms then implied volatility would
__________________________________________________________________________
23 | P a g e

can easily be calculated by plugging in the market prices for the options.
ent implied volatilities across various strikes. This disparity is known as
because in the currency world it did show a slight
negative, since
, in general these
smile, the skew
rice of a liquid option was known a model
terms then implied volatility would

__________________________________________________________________________
24 | P a g e

Typical pre- and post crash smiles are shown in figure 3.5 (Adapted from Rubinstein
et. al 2003). The y-axis shows the market implied volatility as a function of
moneyness. This kind of smile phenomenon has spread to almost all volatility
markets including stock options, interest rate options and currency options
(Rubinstein 1994 & Derman 2003). The volatility smile or skew shows the implicit
volatility from the Black Scholes model across moneyness; that is in other words a
plot which shows implied volatility of an option as a function of its strike price.
10

Figure 3.5: Typical pre and post crash smiles

To generalize, the smile is different for financial instruments; for equity options it
tend to be downward sloping meaning that out-of-the money puts and in-the-money
calls tend to have high implied volatilities, and vice versa for out-of-the-money calls
and in-the-money puts tend to have low volatilities (Rouah et al. 2007 & Hull 2006;
pg 386). The latter can be referred to as volatility skew or smirk which is a more
common pattern. The reverse skew (volatility smirk) typically appears for longer term
equity options and for index options. In the reverse skew pattern, in-the-money calls
options and out-the-money puts at the lower strikes trade at lower implied volatilities
than those options with higher strikes.

10
Hull 2006 pg. 375

__________________________________________________________________________

0
0,1
0,2
0,3
0,4
0,5
0,6
0,7
0,8
1900 2100
Figure 3.6: The Volatility Smile and S

Sources: Own contributions

The explanations behind these observable market patterns of the volatility smile are
many. It can be explained by the empirical indications which showed frequency
distribution of market returns displayed higher central peaks and thicker tails as
shown earlier (section 3.1)
likely that higher excessive returns occur
thought to explain the volatility smile (Rouah et al. 2007). Had the returns been
0.26
1.26
0.28
0.38
0.48
0.58
0.68
Time to maturity
I
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
Volatility surface
__________________________________________________________________________
2100 2300 2500 2700 2900
Strike
16-3 imp vol 6_9
16-3 imp vol 12_9
16-3 imp vol 6_10
16-3 imp vol 12_10
: The Volatility Smile and Surface
Sources: Own contributions
behind these observable market patterns of the volatility smile are
shown earlier (section 3.1). This distribution of higher peaks implies that
higher excessive returns occur than under normality. These features are
2.25
0
.
9
6
1
.
0
1
1
.
0
6
1
.
1
1
1
.
1
6
1
.
2
0
1
.
2
5
1
.
3
0
1
.
3
5
1
.
4
0
Time to maturity Moneyness (K/S)
Volatility surface- Market
0.58
0.48
0.38
0.28
__________________________________________________________________________
25 | P a g e
3 imp vol 6_9
3 imp vol 12_9
3 imp vol 6_10
3 imp vol 12_10

behind these observable market patterns of the volatility smile are
higher peaks implies that it is more
than under normality. These features are
0.58-0.68
0.48-0.58
0.38-0.48
0.28-0.38

__________________________________________________________________________
26 | P a g e

normal, then implied volatility would have been constant across moneyness and
maturity. This implies that deep-in-the-money and deep-out-of-the-money options are
more expensive compared to Black Scholes values.

As mentioned, smirks often occurs because returns often show negative skewness
which implies that higher returns are more likely, leading to the fact that in-the-money
calls are traded at higher implied volatilities compared to out-of-the-money calls.
Similarly, out-of-the-money puts are traded at higher volatilities relative to in-the-
money put options. The skewness can be explained by the correlation between the
asset and its volatility, and as will be elaborated later, a negatively skewed
distribution implies a higher frequency of a positive return relative to negative
returns.
An explanation for the existence of the smile has been suggested explainable by the
so-called crash-o-phobia that originated from the crash in 87 (Engle 1990 &
Rubenstein 1994). The phobia was the panic amongst traders making them fearing a
possibility of another crash similar to October 1987, thus options were priced
accordingly.

The volatility surface on Dow Jones EuroSTOXX in figure 3.6 shows that the smile
effect tends to decrease with time to maturity. At the same time it can be observed
that the smile is strongest for short-term options but decreases with time to maturity
where the mispricing between the market prices and the prices produced with the
assumptions behind the Black Scholes model is the least severe. This is consistent
with observations made by Bakshi et. al (1997).

3.2.2 Implied Volatility
In the discussion of Black Scholes model, it was seen that all parameters in the model
could either be observed from the market directly, or else it is specified in option
contracts, with one exception the volatility of the underlying asset. Theory suggests
different approaches of how to assess the volatility which can be found by using

__________________________________________________________________________
27 | P a g e

historical data or by inverting the Black Scholes formula. These volatilities are
known as historical volatility and implied volatility, respectively.
The historical volatility is assessed from daily data of three months, six months, one
or two years, but is different depending on what is used. Therefore, this method can
be difficult as there are no general rules as what to use (Zhang 1998; pg 82). The
volatility that is used will accordingly also have an effect on the option price. More
data generally lead to accuracy but too old data may be irrelevant since volatility
changes over time. As a compromise, Hull (2006) suggests 90 to 180 days of daily
data.
11

An alternative way to assess the volatility is by inversion of the Black Shcoles
formula. This method is by far most used in practice. The market-traded option price
is directly observable and the matched volatility is the input which yields the correct
market price. In other words, the implied volatility is the volatility of the underlying
which when substituted into the Black Scholes formula gives a theoretical price equal
to the market price (Wilmott 2007). The Black Scholes formula in (2.3) cannot be
inverted that is; the implied volatility is expressed in terms S, t, r, K, T and C of and
must be solved for:

KnownValue T K r t S V
BS
= ) , ; , ; , (
0 0

(3.3)

where V
BS
is the Black Scholes formula. Thus, in order to solve for this equation this
thesis uses the method of Newton-Raphson (Wilmott 2007). This method is arguably
one of the best and fastest in convergence, especially if initial value is sufficient near
the true root. The method approximates to the true value as a function of number of
iterations. The code used in this thesis for Newton-Raphson method is given in
Wilmott 2007.

3.3 Literature review of models
According to literature a range of new models were proposed the past two decades by
theorists whose ideas was to loosen the framework of the Black Scholes model just
enough to support a smile (Derman 2003). These include models where the

11
Hull 2006, pg. 287

__________________________________________________________________________
28 | P a g e

assumption of a constant interest rate is replaced by a stochastic interest rate (Merton
1973) and Amin & Jarrow (1992). Other theorists also tried to ease the assumption
that the underlying asset follows a continuous process by deriving processes with
jumps (jump-diffusion models) (Merton 1973), Bates (1991), Madan & Chang (1996)
and Pan (2002). A popular type is the Affine Jump Diffusion (Duffie et al. 2000).
Amongst other models is also the CEV (Constant Elasticity Variance) model as a
better alternative for the GBM model in Black Scholes to describe the development in
the underlying (Cox, Ingersoll and Ross 1976).
12

Finally, some theorists tried to loosen the most restrictive assumption of Black-
Scholes model; namely the assumption of constant volatility and replaced it with
stochastic volatility, amongst these are models by Hull & White (1987), Scott (1987),
Wiggins (1987), Stein & Stein (1991) and Heston (1993). Amongst the popular
models are the 3/2 model, GARCH-diffusion model by Duan (1995) and Heston &
Nandi (2000) and lastly, the Ornstein-Uhlenbeck process (Wilmott 2006; 860-61).
According to Derman (2003), still after 15 years we are still living in a dark period,
there simply exist too many models. The list of models seems by no means
exhaustive, especially when also including combined models with stochastic
volatility and stochastic interest rate by Baileys & Stulz (1989), Amin & Ng (1993),
Bakshi, Cao & Chen (1997) and Scott (1997), and stochastic volatility jump-diffusion
models by Bates (1996) and Scott (1997). The choice of the correct model therefore
seems a complex task.
13
In their analysis Bakshi, Cao & Chen (1997) concluded that
the most important improvement of the Black-Scholes model is by introducing
stochastic volatility. Once this is done, introducing yet other parameters such as
jumps and stochastic interest rates leads only to marginal reductions in option pricing
errors (Rouah et al. 2007).

Unfortunately, commonly for all these models is that they had to introduce some non-
traded source of risk such as jumps, stochastic volatility or transaction costs, thus
loosing completeness (ability to hedge options with underlying asset) of the model.

12
Hull & White 1987

13

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29 | P a g e

Completeness is of the highest value since it allows for arbitrage pricing and hedging
(Dupire, 1994). Thus, challenge for theorists is to find a model that is both compatible
with the smile at all maturities, and maintains the completeness of the model.
Nevertheless, in literature, the Heston (Steven, 1993) model gained acknowledge as
the most accepted model for describing stochastic volatility. The model proposed by
Hull and White (1987) requires solving a differential equation by numerical methods.
There exists no closed form solution since simulations are generalized for nonzero
correlations. While the option price expressed as the average Black Scholes price
over the mean volatility of the asset seems appealing, obtaining option prices is
computationally intensive.
14
In the next section the Heston (1993) model will be
described.

3.4 Constructing a Pricing Equation under Stochastic Volatility
Having the motivation that the variance is a mean reverting random variable the
valuation equation should then be derived. For the derivation similar arguments from
Wilmott (2000) on the derivation of Black Scholes can be used. The methodology in
this chapter is based on Gatheral (2006) and Wilmott (2000).
It is supposed that the stock price S and its variance v satisfy the following SDEs:

1
dW S v dt S dS
t
t
t t t
+ = (3.4)

2
) , ( ) , ( dZ v t v S dt t v S dv
t t t t t t
+ = (3.5)
With dt dW dW =
2 1

Where
t

is the deterministic instantaneous drift of stock price returns; is the
volatility of variance and is the correlation, which will be explained in details later.
The stochastic process in (3.5) followed by the variance is a very general process
noted by the functional forms of ) ( and ) ( . So far nothing specific about these

14

__________________________________________________________________________
30 | P a g e

functional forms is assumed. As can be guessed from (3.5) ) , ( t v S
t t
is a function of
the drift in the volatility and ) , ( t v S
t t
is a function of the volatility of the variance
such that in the case that as 0 ) , ( t v S
t t

the classic theory of Black Scholes with
constant volatility is obtained.
The two Brownian motions
1
dW and
2
dW (i.e. random walks) are correlated with
correlation rate rho; dt dW dW =
2 1
which has to satisfy the following condition:
1 1 . Rho, , is the correlation between the return of the underlying asset and
the volatility of the return. If the two random walks are independent of each other,
they are uncorrelated; i.e. 0 = . On the other hand; if the random walks were
perfectly correlated; i.e. 1 = then both processes are driven by the same risky
random walk.
The Brownian motion
2
dW can be split up into a combination of the Brownian motion
1
dW and some other Brownian motion which will here have notation dZ . It goes as
follows:
dZ dW dW ) 1 (
2
1 2
+ =

(3.6)
In order to derive the pricing differential equation under stochastic volatility the same
procedure from Black Scholes can be used except for a few adjustments. In the
following it is explained why these adjustments are needed.
In the Black Scholes model only one source of randomness exists, the stock price,
which can be hedged with stocks. However, due to the introduction of stochastic
volatility, random changes herein must also be hedged in order to create the riskless
portfolio. This process that includes yet another risky term; the stochastic volatility, is
called a two-dimensional diffusion process. As opposed to Black Scholes it is in case
not possible solely to hedge by means of the underlying asset and the risk-free asset
as volatility is not a traded asset. For this reason it is necessary to include another
asset which in this case is denoted as V
1
(S,,t)
.
This asset could essentially be an

__________________________________________________________________________
31 | P a g e

European or other type of contract with the same payoff function as V(S,,t) with a
different expiration.
In the same way that the derivation of the Black Scholes price differential equation is
set up; the portfolio is constructed. The portfolio containing the option being priced
V(S, ,t), a quantity of the stock and a quantity
1
of the extra asset whose value
V
1
depends on volatility is then given by:
1 1
V S V = (3.7)
Identically to the Black Scholes, idea in the proceeding of constructing a risk-free
portfolio is the same. The change in above portfolio in a time dt is given by:
1 1
dV dS dV d = (3.8)
Next, the change in both dV and dV
1
can now be written by means of Itos lemma in
higher dimensions. The terms are collected according to dt, dS and dvs.
15
See
Appendix 3 for proof.
dt
v
V
v
v S
V
Sv
S
V
vS
t
V
d
(
=
2
2
2 2
2
2
2
2
2
1
2
1

(3.9)

dt
v
V
v
v S
V
vS
S
V
vS
t
V
(

2
1
2
2 2 1
2
2
1
2
2 1
1
2
1
2
1

dv
v
V
v
V
dS
S
V
S
V
(
+
(
+
1
1
1
1

The terms linked to dt are the deterministic terms, whereas the last two terms dS and
dv are the risky terms. In order to make the portfolio instantaneously risk-free the
following must be chosen to eliminate the dS and the dv terms, respectively:
0
1
1
=
S
V
S
V
(3.10)

15
For the sake of simplicity the explicit dependence on t of the state variables S
t
and v
t
and the dependence of
and on the state variables are eliminated.

__________________________________________________________________________
32 | P a g e

0
1
1
=
v
V
v
V
(3.11)

This is done by choosing the right amounts of and
1
:
v
V
v
V
=
1
1
(3.12)
And inserting this in (3.11) following is obtained

S
V
v
V
v
V
S
V
\
|
=
1 1
(3.13)
Obtaining this means that the remaining terms of (3.9) becomes risk-free and
therefore the portfolio, likewise the argumentation in the Black Scholes equation
derivation, must yield the same return as a risk-free asset:
dt
v
V
v
v S
V
Sv
S
V
vS
t
V
d
(
=
2
2
2 2
2
2
2
2
2
1
2
1

(3.14)

dt
v
V
v
v S
V
vS
S
V
vS
t
V
(

2
1
2
2 2 1
2
2
1
2
2 1
1
2
1
2
1

dt r =
dt V S V r ) (
1 1
=
Where is given by (3.7)
By inserting and
1
from (3.12) and (3.13) and collecting all the V terms on the
left-hand side and all V
1
terms on right-hand side following is obtained:

v
V
rV
S
V
rS
v
V
v
v S
V
Sv
S
V
vS
t
V
|
|
\
|
2
2
2 2
2
2
2
2
2
1
2
1

(3.15)

v
V
rV
S
V
rS
v
V
v
v S
V
vS
S
V
vS
t
V
|
|
\
|
=
1
2
1
2
2 2 1
2
2
1
2
2 1
2
1
2
1
(3.16)

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33 | P a g e

According to Gatheral, the left-hand side is a function of V only and the right-hand
side of V
1
only, the only way for this can be is for both sides to equal some function f
that is only dependent on variables S, v and t. The function f cannot be determined
from arbitrage arguments but is determined from the extra asset V
1
. This function is
determined by the market. Without loss of generality the arbitrary function f can be
written as
v
V
v f
= ) ( , where and are drift and volatility functions from

the SDE (3.5) for instantaneous variance. As this function expresses; it is the drift of
the volatility minus the volatility of the volatility multiplied by some quantity, which
is the market price of volatility risk (S,v,t). Once again, this cannot be determined
from arbitrage arguments, it is the market assesses this market price of volatility. The
pricing equation for options under stochastic volatility can now be written as:

0 ) (
2
1
2
1
2
2
2 2
2
2
2
2
=
v
V
v rV
S
V
rS
v
V
v
v S
V
Sv
S
V
vS
t
V
(3.17)
By re-arranging this equation it becomes clearer where the different parts originate
from:
0 ) (
2
1
2
1
2
2
2 2
2
2
2
2
=
4 4 3 4 4 2 1 4 43 4 42 1 4 43 4 42 1 4 4 4 4 4 3 4 4 4 4 4 2 1
e Marketpric process Stochastic n Correlatio lesPDE BlackSchco
v
V
v
v
V
v
v S
V
Sv rV
S
V
rS
S
V
vS
t
V

From the notes above it can be seen that the first part is the Black Scholes PDE (2.2)
the second term comes from the correlation between the process for underlying asset
and the process for volatility. The third term originates from the process driving the
volatility (3.5) and finally the last term is due to the market price of volatility risk.
The unknown function
v
V
v f
= ) ( is the market price of volatility risk which

stems from the extra asset driving the volatility.

3.5 The Heston (1993) Stochastic Volatility Model
As stated above many advanced option pricing models encountered in literature have
sought to overcome the restrictive assumption of constant volatility in the Black-

__________________________________________________________________________
34 | P a g e

Scholes model. In this chapter the Heston (1993) model is presented, a stochastic
volatility model that has become popular and is relatively easy to implement in Visual
Basics. In addition, there appear several other reasons for its popularity. First;
similarly to the Black Scholes model, the Heston 1993 model is an almost closed
formula whereby the value of the option can be calculated without major obstacles.
16

It differs from the BS model in characteristics in compliance with empirical finance.
For instance, Hestons settings accounts for non-lognormal distribution of the asset
returns which means the process of the volatility of underlying asset in the Heston
model is capable of describing empirical observations that represents the evolution of
the true volatility. Furthermore, it accounts for the mean reverting property of
volatility and it remains analytically tractable (Sergei Mikhailov & Ulrich Ngel
2003).

Heston (1993) proposed the following stochastic volatility model which assumes that
the spot asset at time t follows the diffusion:

1
dW S dt S dS
t t t t t
+ = (3.17)

2
2 2 2
) ( dW dt d t t t + = (3.18)
With dt dW dW =
2 1

(3.19)
where { }
0 > t t
S and { }
0 > t t
are the price and volatility processes, respectively. The
parameters in the above equation represent the following:
: the rate of return of the asset.
: the long level volatility; i.e. the mean variance. As t tends to infinity, the expected
value of volatility
t tends
to
.

: the rate at which
t
reverts to : i.e. the mean reversion speed parameter.
: the volatility of variance; as the name suggests, this determines the volatility of
volatility
t
.

16

__________________________________________________________________________
35 | P a g e

: the correlation between the log-returns and the volatility of the asset.

To take into account the leverage effect, Wiener processes W
1
and W
2
(i.e. random
walks) are correlated Brownian motion processes (with correlation rho; )
dt dW dW =
2 1
. The stochastic model { }
0 > t t
in (3.5) for variance is related to the
square-root mean reverting process of and first used by Feller (1951) and Cox,
Ingersoll and Ross (1985),
17
hence the name Hestons square root model. For the
square root process in (3.5) the variance is always positive.
And Mikhailov et al. suggests to restrict by imposing
2
2 > k
;
such that it cannot
reach zero (Mikhailov & Ngel 2003). All parameters, viz. , , , , are time and
state homogenous.

Chapter 4: Introduction to Barrier options
18

Despite their complexities, options of more exotic character emerged on the markets
even before the birth of the Chicago Board of Options Exchange (CBOE) established
in 1973. The trade of these types were however not more visible in daily presses and
popular until late 80ies and early 90ies when standard vanilla options became better
understood and boosting trading volumes. Financial institutions then began to search
for new options types in form of alternatives that could meet particular needs and
increase business this way (Zhang 1998). Today exotics are used by large financial
institutions, companies and private investors and are much more popular than their
equivalent vanillas since they are much more profitable.
Once introducing stochastic volatility it becomes natural to examine the effects of this
on exotic option prices. The choice of exotic lead naturally to barriers since this
option type is somewhat sensitive to changes in volatility (Wilmott 2007 & Gatheral
2006). The introduction the new element can have significant consequences in prices
of barrier options which then lay foundation for analysis in the following sections.

17
Mikhailov & Ngel
18
This section is primarily built on Hull chapter 22: Exotic options and Zang 1998 chapter 1

__________________________________________________________________________
36 | P a g e

In chapter 3 it was shown that markets incorporate stochastic volatility for vanillas
and likewise it is thus expected to be incorporated in market prices for barriers.
However, it is not possible to compare theoretical prices to market prices since most
barriers are traded over-the-counter and thus quoted prices are not accessible. For this
reason, as will be elaborated in chapter 5, structured products will be used as they
have barriers embedded.
This chapter will introduce concepts and information relevant for the introduction of
barrier options. It will define the specifics to barriers and classify them according to
type. Furthermore, it is shown how barriers are incorporated in the earlier explained
Monte Carlo algorithm. Conclusively, the thesis will analyze the differences in prices
based on the Black Scholes model and the Heston model.

4.1 Barrier options
The barrier option is an example of a weakly path dependent option contract. That is
the price depends only on the current level of the asset and the time to expiry
(Wilmott 2007; pg. 265). What is relevant is whether a predetermined level (barrier)
is hit. Different kinds of barrier options are regularly as mentioned traded in the over-
the-counter market, and are specifically attractive to some clients as they are less
expensive to the equivalent vanilla option (with no barriers). The option becomes
cheaper since a barrier option have an upper or lower limit specified, which indicates
that the investor gives up the upside (or downside) potential. As an example of an up-
and-out option, the closer the barrier is to current asset price the greater chance of the
option being knocked out, thus the cheaper the contract. Vice versa, the closer the
underlying gets to the barrier for an in-option, the more expensive the contract
becomes due to increasingly higher probability that the barrier is hit.
The payoff of the standard European option depends only on the price of the
underlying at maturity or expiration date. Essentially, given the final price of the
underlying, the payoff will be the same no matter how the path of underlying takes its
form during the life of the option. Likewise, the upwards or downward movements
are indifferent to the buyer and seller of the option; only the price at the expiration

__________________________________________________________________________
37 | P a g e

date matters. The terminology to describe this kind is called path independence.
Barrier options are exotics that are similar in some ways to vanilla options. That they
become activated if the option is an in-option or, on the contrary, null and void for an
out-option if the underlier reaches a predetermined level. This kind of options is said
to be path dependent.
That is; in this thesis we will look at a simpler case of path dependence in which the
payoff does not only depend on the final price of the underlying asset but also on
whether the underlying asset reaches one or more barriers during the life of the option
(Hull 2006; pg.533). Barrier options are amongst the most used exotic/path dependent
options (Nelken 2000).
Barrier options come in many different types on the market and can roughly be
classified into four different types of options:
Classification of Barriers:
Up-and-out
Down-and-out
Up-and-in
Down-and-in
To summarize; the in/out call or put options can be divided into up/down styles. If the
predetermined barrier is set higher than the initial value of the underlying, the option
is said to have an up characteristics and vice versa. What is common for In options
is that these types of contracts starts worthless and only become active in the event a
predetermined barrier is breached. "Out" options start their lives active and become
null and void in the event a certain knock-out barrier price is breached. If the latter is
the case the option is said to be knocked-out. If the option is not knocked out the
holder of the option receives the vanilla payoff at expiry. On the other hand the in
option only pays off if the barrier is hit and is said to have knocked-in if this occurs
and purchaser receives the vanilla payoff at expiry. In either case, if the option
expires inactive, then there may be a cash rebate paid out which increases the price of
the option. This rebate is normally some fraction of the premium. Since the sum of

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38 | P a g e

the two types in/out options is a vanilla it is sufficient to assess the price of one of the
options while the other can be assessed by applying the in/out relation.

And finally, option payoffs are characterized after usual characteristics; calls, puts in
European, American styles within each category which results in overall 16 different
types of barriers.

Above types of contracts are standard barrier options meanwhile product
development has allowed additional exotic types within barriers; among these are:
19

Double barrier options (predetermined upper and lower barriers; above and below the
current stock price, respectively.) This type of option is priced by Geman & Yor
1996. We will come back to this type of options.
Options with non-linear barriers (for instance the barrier follows an exponential
function.) Kunitomo & Ikeda (1992) are amongst others that investigated and priced
this type of options.
Rainbow barriers (also called outside barriers; Rainbow option is a derivative
exposed to two or more sources of uncertainty as opposed to a simple option. This
type of options are usually calls or puts on the best or worst of n underlying assets, or
options which pay the best or worst of n assets.) Carr (1995) investigated this type of
options.
Parisian options (the barrier becomes active when underlying has been beyond the
barrier level for more than a specified time). This additional feature reduces
possibility of manipulation of the trigger event and makes the dynamic hedging easier
however also increases the dimensionality of the problem (Wilmott 2007; pg. 301).
Partial barriers (the barrier are activated only in predetermined time periods; that is
the option has protective periods in which the payoffs does not change if the barrier
is hit.) This type of options has been researched by Heynen & Kat (1996).

19
http://www.nuclearphynance.com/User%20Files/256/riskpaper.pdf

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39 | P a g e

Bermudan options (also known as Mid-Atlantic, limited exercise or modified
American options.) As the name mid-Atlantic suggests, a mid-Atlantic option is a
hybrid of European option - which allows exercise at maturity and American options
which allows exercise at any time prior to maturity (Zhang 1998; pg. 641). These
types of options can only be exercised at pre-specified discretely-spaced time points
prior to maturity.

Although it may seem interesting to price these types of complex contract types this
thesis will only focus on the vanilla barrier options, i.e. the regular out barriers with
no further complications. This is due to the structured products that were available.
Far most structured products have simple barriers or some barrier feature embedded.
One of the structured products (Aktietrappe 2012), however, has the idea of a
Bermudan option feature embedded. The only difference is that the characteristics of
a Bermudan is that it can be exercised at any pre-specififed discrete time points,
whereas this product, as will be seen, depends on the evolution of value i.e.
Vrdiudvikling as suggested in the prospect. Different from the Bermudan is that
this product cannot be exercised prior to expiry.

Chapter 5: Pricing in a Monte Carlo framework
The purpose of this chapter is to price options under stochastic volatility by means of
Monte Carlo Simulation method. Initially, an explanation of choice of model wil be
given followed up by a more thorough description of the Monte Carlo method and its
improvement techniques which speeds up the computational process and results in a
more precise Monte Carlo estimate. Then an explanation of the Monte Carlo
simulation under stochastic volatility in accordance with Heston model is followed
up. Here a thorough explanation will be given on how to discretize the Heston model
for Monte Carlo simulation.
Finally, the procedure for checking the correctness of implementation of the Heston
model is described such that the price produced under the Heston model matches the
price calculated with Black Scholes explicit formulas.

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40 | P a g e

5.1 Choice of model
In chapter 2 it was shown that the calculation of option values for European put and
call options is relatively easy since explicit solutions exist. That is; if the payoff
structure is very simple it is then possible to find explicit solutions to the partial
differential equation (2.2), however if the payoff is more complex in structure it
becomes necessary to solve the Black-Scholes partial differential numerically.
Literature offers multiple different ways of pricing options numerically, where
examples of these are shown in figure 5.1.
Figure 5.1: Numerical methods

Amongst the most popular are the binomial tree, Finite Difference Method and Monte
Carlo simulation and the best model choice depends on the type of option and type of
contract. The Binomial tree and Finite Difference method works fine when only two
dimensions are introduced. Since a third dimension; the stochastic volatility is
introduced in this thesis it is complicated to work with tree-type models. According to
Wilmott (2007), literature recommends a limit of 3-4 dimensions in Monte Carlo
Simulation method for it to be effective in relative to other methods. This thesis will
therefore use Monte Carlo Simulation as pricing tool. The Monte Carlo is widely
applied and is often used in practice for pricing and hedging path dependent
derivatives (Andersen 2007). The numerical methods are modeled in Visual Basics
integrated in Excel programme. The advantage of Monte Carlo is that it is relatively
easy to implement also in changing the algorithm according to contract type.
Solution of Black Scholes equation for a given payoff
Solve PDE Solve via MCS
Finite Difference
Explicit
Implicit
Crank-Nicolson
Lattice Methods

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41 | P a g e

In the next sections the Monte Carlo procedure under stochastic volatility will be
elaborated.

5.2 Monte Carlo Simulation
Monte Carlo Simulation is a numerical method which is particularly useful when
determining values of strongly path dependent options. The method is based on the
analogy between probability and volume.
The price evolution of the underlying, which follows a risk neutral random walk, is
simulated by means of equation (5.4). This simulation results in a final price
i
T
S , and
payoff P(
i
T
S ) can then be calculated, accordingly. The law of large numbers ensures
that this estimate converges to the correct value as the number of draws increases,
thus this procedure is repeated for a large number of N paths until convergence is
achieved (Paul Glasserman, 2004). Thereafter the average payoff is calculated. With
starting point in Feynman-Kacs equation the option value is now found as the
expected value of the discounted payoff.

After N number of simulations the best result of V(S,t) is expressed as
N
V :

N S P e t S V
N
i
i
T
t T t
N
/ ) ( ) , (
1
) (
(
=

=

(5.1)

The risk neutral random walk, a Brownian motion in which the drift is the risk free
rate, evolves as follows: dS = rSdt + SdX, where dX is the Wiener process. By
applying Itos Lemma it is ascertain that changes in ln(S) are normally distributed and
follows the process below:

(5.2)
|
|
\
|

|
|
\
|
= ) ( ); (
2
ln ln
2
2
t T t T r N S S
t T

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42 | P a g e

(5.3)
0By integrating the differential equation in (5.2) the following expression appears of
how to simulate S
20
:
(Hull 2006.) S(t + t) = S(t) exp ((r-d-0.5
2
) t+ sqr(t) , (5.4)
where is a random number generated from a standard normal distribution. The
advantages here is that the stock prices follow a log-normal probability distribution;
that is the prices can only vary between zero and infinity which also complies with
the definition of the underlying asset in equation (2.1).
The randomly generated number can be generated in various ways however we
will focus on the Marsaglia-Bray method in the programming. A comprehensive
explanation of mentioned various methods will come in the following sections.

5.2.1 Model improvements
As mentioned earlier the Monte Carlo simulation calculation and convergence can be
achieved in two ways. Firstly, it can be improved by applying the Marsaglia-Bray or
Box-Muller method for generating normally distributed N(0,1) random numbers.
Secondly, it can be improved through Variance Reduction Techniques. These issues
will be explained below.

5.2.2 Generating random numbers
A Monte Carlo simulation is based on random numbers, which functions as inputs in
the simulations, thus they have a great influence on the individual shape of paths and
thereby on the Monte Carlo estimate and its error. For this reason comes the
importance of generating random numbers for Monte Carlo simulations.
There are a number of ways to generate Standard Normal Distributed Random
Numbers for Monte Carlo simulation. What characterizes normally distributed

20
The Method of Eulers Approximation is also applicable, however has the disadvantage that the stock
prices are normally distributed; that is they can go negative.

t t r S S
t t t
+
|
|
\
|
=
+
2
ln ln
2

__________________________________________________________________________
43 | P a g e

numbers is that they are standard normal distributed and that there is no serial
correlation between them.
Four most common methods of generating random numbers are the NormSInv(Rnd())
in Excel, the CLT method, Box-Mller and the Marsaglia-Bray. The function
NormSInv(Rnd())
21
is known for being highly inefficient due to high computational
time. Central limit theorem method is more efficient and can be used as an
alternative to generate standard normal random numbers, however it is slower than
the other two methods in test impacting the overall time efficiency of a simulation.
The method of Box-Mller converts two random uniformly distributed numbers x
1
and x
2
as follows:

,

where y
1
and y
2
are independently normally distributed numbers. This method runs
faster than the central limit method, though it should run slightly slower than the
Marsaglia Bray due to calculation of the trigonometric function.
22
This fact was not
proven by the below test. The method of Marsaglia-Bray is used in all simulations
related to this thesis.

5.2.3 Variance Reduction Techniques
In order to improve the accuracy with Monte Carlo method, usually a large number of
simulations are required. This is costly in terms of computational time. There are yet
other ways to improve the efficiency of the Monte Carlo estimate; one which is to
reduce the variance of this, which can be done by applying one or additional Variance
Reduction Techniques.
Antithetic variables method
Variance Reduction Techniques: Control Variate Technique

21
Financial Engineering Lecture Slides: Monte Carlo simulation.
22
Lectures slides Monte Carlo Simulation
( )
2 1 1
2 cos ln 2 x x y =
( )
2 1 2
2 sin ln 2 x x y =

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44 | P a g e

The Antithetic variables methods: In order to achieve a better estimate on the
option value with a fewer number of simulations, one can exploit the symmetry
in the normal distribution. The method calculates two estimates for the option
values using only one set of random numbers, the positive V
1
and negative value V
2
.
In this way we ensure the random numbers used are symmetric
The steps are as follows:
One set of normal random numbers is used to generate one estimate of the option
V
1

Then the set of random numbers is used to generate another estimate V
2

Then V = 0.5(V
1
+V
2
) is set
This procedure is repeated a number of times
This works well because when one value is above the true value, the other tends to be
below, and vice versa (Hull 2006; pg.417).
Due to the fact that one can apply the closed form formula to price an option, it is
possible to further increase the accuracy of the simulation. The Control Variate
Technique is applicable when two similar derivatives exist, A and B. With this
technique it is possible to exploit the fact that the value of the B is similar to the
option value of A, and has an analytic solution available. Two simulations using the
same random number streams and the same delta t are performed parallel to each
other. We first estimate a value for the option with arithmetic average and then for the
geometric average, we will denote these as V
*
A
and V
*
B
. Based on these three values,
the solution of the option value the derivative with arithmetic average can easily be
found. This can be expressed in a form of a formula:

V
A
+ V
*
A
= V
*
B
+ V
B
(Hull 2006; 417)
The idea is that while the option with arithmetic average being under consideration,
the errors in its estimate should equal the error in option value with geometric
average. In the end we solve for V
A
in the equation above.

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45 | P a g e

5.3 Monte Carlo simulation of Heston model
In earlier stages of this thesis it was mentioned that Heston developed explicit
formulee for European vanilla options where two complex integrals has to be solved.
Unfortunately there are no such closed form solutions for exotic options and one must
undertake a Monte Carlo simulation approach. This chapter explains how the Heston
model is applied while still applying the variance reduction techniques as described
earlier. By adjusting the Heston model under Black Scholes settings it is possible by
means of Black Scholes model to control whether the implementation has been done
correctly. Once the correctness of the price estimate and convergence to the true price
is achieved, the Heston algorithm can be applied to barrier options.

Since there is no explicit solution that calculates the price under continuous time
under the Heston model like under Black Scholes, it is therefore necessary to
discretize the Heston model for Monte Carlo simulation in order to simulate the
Heston path.

Despite the fact that the Heston model, and the square root models in general is now
approximately more than 15 years old there has been remarkably little research into
efficient discretization of the continuous-time Heston dynamics wherefore there are
no specific methodology of how to simulate this model in a Monte Carlo framework.
Only in later work from the past years the issue was subject to research in articles by
Andersen and Brotherton-Ratcliffe (2001), Broadie & Kaya (2004), Kahl, C. and P.
Jackel (2005).

In addition, Gatheral (2006) put up suggestions in his book. Amongst these are the
Milstein discretization scheme used by Kahl et al. (2005) and the scheme used by
Broadie & Kaya (2004). Although, preferred by Gatheral (2006), the Milstein scheme
is however criticized in the sense that it is harder to implement and takes more time
per replication relative to the Euler discretization (Broadie & Kaya 2004). Broadie &
Kaya (2004) developed a completely bias-free scheme but has drawbacks that will be
elaborated later.

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46 | P a g e

The simplest solution that appears is the simple Euler discretization of Heston
dynamics. According to Gatheral (2007) the discretization requires a huge number of
time steps to achieve convergence. It is by means of some conditions, possible to
prove that the Euler converges to the true process when the number of time steps is
made smaller.

The idea of the Euler formula is to approximate the paths of the stock price and
variance processes on a discrete time grid. The discretization of the stock price is
given by:
)
`
+ = ) 1 , 0 ( * * )
2
1
( exp * N T V T V r S S
eff
T
eff
T
eff
T T
(5.5)

where the normal N(0,1) is the W
2
and S
eff
and V
eff
are given by:
)
`
+ =
T T t
eff
T
Y X S S
2
2
1
exp * for time t =1,2,3,to T (5.6)
Note that if rho is = 0 then S
eff
is = S
0

T X V
T
eff
T
/ ) 1 (
2
=
(5.7)

And the increments X
T
and Y
T
are given by:
dt X
T
t T

=
0
2

1
0
t
T
t T
dW Y

=
These integrals of the increments are generated

And the Euler discretization of the variance process is given by:
2 1
) ( W t v t v v v v
i i i i
+ =
+

(5.8)

where W
2
is a Brownian motion. To simulate these Brownian increments, the fact that
each increment
) ( ) (
1
j
t
j
t
i i
W W

is independent of others is used. These increments are

normally distributed with mean zero and a standard deviation of t .
There exists however some problems with the Euler discretization of the Heston
model in the variance process. Irrespective of how large a number of simulation is
chosen or how small time step is, the variance may give rise to a negative variance

__________________________________________________________________________
47 | P a g e

(Gatheral 2006). In practice this problem can be solved by restricting boundaries;
such that if variance goes negative; i.e. 0 < v , then 0 = v or v v = . These
approaches are known as the absorbing assumption and the reflecting assumption,
respectively (Gatheral 2006).

This problem of negative variance in the Euler discretization process seems to could
have been eased by instead implementing the Milstein discretization scheme
mentioned earlier that achieves second order convergence for the bias under some
conditions given in Kloeden and Platen (1992). This is done by going one higher
order in the Ito-Taylor expansion of ) ( t t v + which in theory improves the
convergence of the total simulation bias to O(N
-2/5
). However, it was also shown that
since the conditions for convergence are not satisfied by the dynamics of the state
variables, the method on Milstein is not guaranteed to achieve a second order
convergence rate (Broadie & Kaya 2005 and Glasserman (2004). Also Glasserman
(2004) comes up with a suggestion that the problem of negative variance may be
omitted by sampling from the exact transition law process. This method is shown in
detail in Broadie & Kaya (2004) but turns out to be a very complex and time
consuming process as the method involves integration of a characteristic function
expressed in terms of two modified Bessel functions (Gatheral 2006).
Duffie & Glynn (1995) study the optimal computational anomaly between the
number of time steps and the number of simulations trials. The concluding results
show that it is optimal to choose the number of time steps proportional to the square-
root of the number of simulation trials for first order methods. Furthermore, they
show that with their allocation rule, the convergence rate of the error for the Euler
discretization scheme is O(N
1/3
).
Another drawback of the Euler-discretization scheme besides that a high number of
simulations is required is that the variance process can become negative. However,
authors conclude that computational efficiency of the scheme exceeds that of the
more complicated schemes in Broadie & Kaya (2004), Kahl et al. (2005) and
Andersen (2007).

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48 | P a g e

Based on above suggested approaches for simulation of the Heston process, the
simple Euler discretization is used in this thesis. The Euler discretization of the
variance process and the process of the underlying will be described, respectively.

In connection with simulation it is relevant to examine the boundary behavior of
volatility and restrict it accordingly. If the volatility reaches zero or even goes
negative following restriction procedure is imposed in the simulation; if <0

then
impose that
6
10

= E v . This ensures that the minimum variance that the simulation
can accept is not entirely zero but approximates to a value close to zero.

Implementation of the Heston model
In order to compare the Heston price with the Black Scholes price a number of
parameters will be adjusted. Parameters will be set according to Black Scholes
settings.
Volatility of volatility () has to equal 0: Since Black Scholes model assumes
constant volatility, the volatility of volatility is zero.
Correlation (): Finally, this parameter is of no relevance either since as it can be
seen in the formula below, it has no influence on the volatility in the next period.
As far as volatility is concerned, it must be constant according to BS settings. The
formula for volatility in the next period is:

) (
1 1
+ =
t t t

(5.9)

Thus, in order for volatility of next period to remain constant it has to be that:
Long level (): This parameter is set to initial volatility so that the equation will be
1
=
t t
.
Mean reversion level (): Is then of no relevance because of above action.

Once these assumptions are fulfilled, the Heston model yields the equivalent Black
Scholes price in a Monte Carlo framework.

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49 | P a g e

According to Hull (2006) pricing under stochastic volatility starts to show significant
effects for time horizons of more than one year. Maturity period for the selected
products are as known both 3 years which indicates the importance of pricing under
stochastic volatility. According to Gatheral (2006; pg. 39) it is never possible to fit
the term structure of volatility for short expirations. This in return implies that the
best fit is obtained by applying options with longer expirations.
In the next section computation of the parameters: , , , is shown thoroughly.
Furthermore, an introduction and explanation of the tool and concept of calibration is
given.

5.4 Introduction to Calibration
In order for the stochastic volatility model to be applicable in practice it needs to
return parameters corresponding to current market prices of European options. The
Heston model has five parameters that need estimation, viz. , , , and which
must fit into the market implied volatility (Gatheral 2006). Empirical studies have
shown that the implied parameters (i.e. those parameters that produce the correct
option prices) and their time-series estimate counterparts are different (Bakshi, Chao
& Chen 1997). One therefore cannot just use empirical estimates for the parameters.
A common solution is to find those parameters that produce the correct market prices
of vanilla options. This is called the inverse problem as the parameters are solved
indirectly through some implied structure. Some level of error has to be accepted due
to the high number of parameters that has to be estimated and no existing model can
perfectly replicate the observed market prices. The most popular approach to solving
this inverse problem is to minimize the error or discrepancy between model prices
and market prices by adjusting the Heston parameters. No literature exists on
calibration or on how to proceed with the performance of the calibration which makes
it hard for empirics to know how to start. One will have to take starting points in
educated guesses as initial input numbers. It should be noted that a stable calibration
of the model is of paramount importance since an unstable calibration can lead to
significantly wrong prices.

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5.5 Model Calibration
The values of the parameters are obtained by standard problem solver supplied with
Excel. It uses a Generalized Reduced Gradient (GRG) method and hence is a local
optimizer and the calibration results are therefore extremely sensitive to the initial
estimates of the parameters. At the same time, the Excel solver programme was tested
by Mikhailov & Ngel (2003) and proved to be robust and reliable (Mikhailov &
Ngel 2003). However, there may be some problems with this technique, especially if
the minimization technique searches for local minima as opposed to global in case
that there exists no unique solution. For this reason it is important to have initial
values as close to the true parameters as possible.

The root square mean error (RSME) explains the degree of error difference between
the market-traded prices and prices on options. This is squared summed and square
rooted. (Woolridge 2006) shows this in expressional terms:
[ ]
2
1
) , ( ) , ( min ) ( min

=
=
N
i
i i
M
i i i
SV
i
T K C T K C SSE (5.10)

Where is a vector of a set of parameter values,
SV
i
C and
M
i
C are the i
th
option prices
from the model and market, respectively, with strike
i
K

and maturity
i
T . N is the
number of options used for calibration. The set of parameters are defined initially
with educated guesses to ensure that the searching process starts realistic. The error
estimates of the calibrated parameters are then assessed as the difference between the
observed market prices
M
i
C and theoretical prices
M
i
C as shown in (5.10).
When the mean error is minimized in problem solver one obtains the optimal values
of ,

and . The validity and reliability of these value estimates increases as the
number of options included increases. It is recommended to use options with both
short and long maturities as volatility reaches the expected level of option volatility.
The remaining parameters, and can thus be found by minimizing error terms
between market implied volatility and implied volatility calculated from the three
calibrated parameters. This procedure is repeated until the sum of square errors (SSE)

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51 | P a g e

has stabilized and cannot get any closer to zero. Consequently, it is possible to show
how well the Heston model fits observed market prices.
Another error measurement is the average relative percentage error (ARPE) which is
as the name indicates the relative percentage error per observation. This measure
gives a clearer picture of the relative percentage difference between market traded
option prices and the estimated prices. The ARPE is calculated as follows:

=
N
i
i i
M
i
i i
M
i i i
SV
i
T K C
T K C T K C
N
ARPE
1
) , (
, ( ) , (
1
(5.11)

As mentioned earlier, the searching techniques are highly sensitive to initial guesses
therefore becomes necessary to do a careful study in previous work. Furthermore,
these initial guesses are restricted to constraints that they have to fulfill. All five
parameters that have to be calibrated are constraints to strictly positive numbers,
except correlation, rho. The correlation is subject to a constraint in the interval
between 1 and -1.
In literature exist an endless number of studies however most of them uses the S&P
500 index which is a more common index than the Dow Jones EuroSTOXX index. A
careful study is therefore done and a discussion of the initial parameters is then
followed up. The input parameters such as interest rates, the prices of the underlying
asset and time to expiration are given by market and are therefore not estimated in the
model. The study is done on basis of papers written by Bakshi et al. (2003) etc.

Next arise the question what market prices to use in the calibration process as for any
given option there exist a bid and ask price. In examining the behavior of these
options it was seen (see Excel file DowJones_data Sheet named IR16March) that
puts behaved better. Thus, puts prices converted to call prices were used for this case.

Appendix 4 shows the calibrated parameters which can be found in Excel file
Calibration. These parameters represents the best fitted for observed market prices.
The discrepancy error in parameter estimation however still exists, which indicates

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52 | P a g e

that the Heston model does not completely explain observed market prices. The
choice of parameters is thus given:

Table 5.1: Estimated parameters from calibration

Parameter Value
Mean reversion () 1.25
Long level variance () 0.10
Initial variance () 0.35
Volatility of variance () 1.26
Correlation () -0.48

The initial volatility is 0.35 (square root of variance) which will vary around the long
level variance value of 0.10 at a mean reversion speed of 1.25.

As shown in sections of chapter 3 the assessed parameters have a decisive influence
of how far the return distribution will deviate from the normal distribution. A
negative correlation causes a negative skewness and the left tail spreads out. The
relatively high volatility of variance results in a higher peaks and higher kurtosis, thus
fatter tails relative to the normal distribution.
In prolongation with analysis from sections of chapter 3 the estimated negative
correlation (all things held equal) will imply that Heston underprices the option
relative to Black Scholes for out-of-the-money options and overprice in-the-money
options compared to Black Scholes prices. High volatility of variance will (all other
things being equal), according to the theory, result in higher Heston prices for away-
from-the-money options and lower for near-the-money options compared to Black
Scholes values.

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53 | P a g e

5.6 Monte Carlo simulation of barrier options
Under Black Scholes assumptions a number of explicit solutions for barriers exist
which are listed in Appendix 5 and the formula for up-and-out call is implemented in
VBA in Excel file Effects of Rho on Barriers in the function ExplicitUpOutcall on the
enclosed CD. On the contrary, under assumption of stochastic volatility in Heston
settings it was not possible to derive fully closed formulee thus a Monte Carlo
simulation is carried out.
In order to ensure that the implementation is done correctly, the barrier option price is
also calculated under Black Scholes settings. That is the parameters are initially set
such that they match the Black Scholes assumptions. The simulated Heston price can
then be controlled by comparing it to the price from the explicit formula. The
implemented barrier prices under both Black Scholes assumptions and stochastic
volatility are found in Excel file Up and Out Call on the enclosed CD.

Implementing the barriers in the already defined Monte Carlo algorithm for
simulation of the Heston path is relatively easy. This is also one of the advantages of
the numerical techniques.
As mentioned, this thesis seeks to price two individual barrier options embedded in
the structured products issued by Danske Bank and Nordea Bank.
The only actual change that is made in the algorithm is that the entire volatility path is
simulated and that for each time step it must be checked to observe whether the
barrier is hit. Earlier the algorithm of vanilla options under Heston model was shown
and therefore only the main changes in the algorithm with barriers will be shown
here. In general the algorithm for the two structured products goes as follows:
Fin Shark 09:
Stock price and volatility for next time step is simulated based on initial
volatility and spot price.
Then it is checked each (or more times) day whether the barrier is crossed.

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54 | P a g e

Aktietrappe 2012:
The entire path of daily volatility is calculated for a 30-day period.
The stock price on the 30
th
day is simulated.
Check whether index change rose 4 %. If it rose 4 or more per cent then lock
index change at +4 % once a month. Otherwise the actual index change is
calculated.
Same procedure is repeated for the rest 35 months.
Additionally we also have to check whether one of the locked-in levels is
crossed which assures against losses if the index falls.
The price of the barrier option depends on how often the barrier is observed. The
closed form solution for the barrier under Black Scholes assumptions assumes that
the barrier is observed in continuous time. Therefore it is important to choose a
relevant number of time steps in discretized models. This choice will be crucial since
a too large gap in time steps can result in the fact that the barrier is hit in between the
steps. By reducing time steps t it is possible to approximate a continuously
observation of the barrier and thereby minimize the error discrepancy. However, as
mentioned in section 5.3 that there is an anomaly between computing time and errors.
The variance reduction techniques are applied in the calibration process. The
antithetic variables are to ensure high convergence speed and minimize the standard
error of the Monte Carlo estimate.

Chapter 6: Analysis of European and Exotic Options

6.1 Impacts of stochastic volatility model on vanilla options
It is relevant and interesting to analyze the effects of stochastic volatility on European
option prices. More specifically, it is in this section examined how the Heston model
affects the return distribution and how this affects the price differences in option
prices between the Heston and Black Scholes model. In this relation there are many

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55 | P a g e

effects linked to the introduction of the time dependent dynamics of volatility. For
instance, a higher volatility has a positive effect on options as in the Black Scholes
model. The advantage of Heston (1993) model is that it is possible by adjusting its
parameters to manipulate with the skewness and kurtosis of the return distribution,
and thereby fit market data better. The Black Scholes model, on the other hand, is
log-normally distributed and it is for this reason only possible to manipulate with the
mean and variance. The effects of each Heston parameter are given in the following
based on theoretical arguments and on effect of the most important parameters are
shown empirically.
An increase in the long level variance

increases the prices of options, while mean
reversion speed determines the relative weights of the current variance and the long
level variance on option prices. If the mean reversion is positive, the variance has a
steady-state distribution with mean

(Cox, Ingersoll and Ross (1995))
.
In analyzing the effects of the Heston model there are two important parameters rho
and volatility of variance which will play an essential role. Rho represents the
correlation between shocks to the stock price and shocks to the variance, and the
volatility of variance (or volatility of volatility).
For illustration of these effects on option prices the default parameters in table 5.2 is
given in the following
23
:

Table 5.2: Default parameters in the Heston model
Parameter Value
Mean reversion () 2
Long level variance () 0.01
Initial variance () 0.01
Volatility of variance () 0.10
Option maturity (T) 0.5
Interest rate ( r ) 0
Strike price (K) 100

23
These parameters are partly taken from the Heston article (1993)

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56 | P a g e

To compare the differences the Black Scholes model with a matched volatility
parameter (square root of the variance) of the spot return is used. The following sub
sections on impacts of stochastic volatility models on the return distributions is based
on the empirical analysis carried out in the Heston article (1993). The return
distributions graphs is the kernel density estimation which is a non-parametric
method of estimating the probability density function of a random variable. See
computation of the return distribution in excel file Heston_returns_original on the
enclosed CD.

Effects of correlation on return distribution
The correlation parameter rho affects the skewness of spot returns (Heston 1993).
This statement is also indicated in the below figure (6.1) which shows the probability
density distributions for asset returns.
From the left figure of 6.1 it can be seen that the effects of skews results in spreads in
the tails. The figure indicates that a positive correlation ( 0 > ) results in a positive
skew with a fat right tail and a thin left tail. Intuitively, a positive correlation implies
that rising asset prices results in higher variance, which again results in higher asset
prices. Consequently, this implies a wide spread of the right tail of the probability
density distribution. Since the left tail is connected to a low variance (because of low
asset prices) it is not spread out. The reverse of the above statement is true for the
case of a negative rho ( 0 < ).
Figure 6.1: Effects of rho on the return distribution

-16
-14
-12
-10
-8
-6
-4
-2
0
2
4
-0,4 -0,2 0 0,2 0,4
log-scale densities
rho=0.5
rho=-0.5
rho=0
0
1
2
3
4
5
6
7
-0,4 -0,2 0 0,2 0,4
d
e
n
s
i
t
y
Spot Returns
rho=0.5
rho=-0.5
rho=0

__________________________________________________________________________
57 | P a g e

Source: Own contribution
The figure to the right gives a clearer picture of the fatness of the tails. It is seen that for a
positive correlation (blue graph), the left tail is thin whereas the right tail tends to thicken.
For a negative correlation (red graph), the opposite is true. In order to visualize the effects of
a positive and negative correlation on the option prices, this is illustrated in the following for
call options.
Figure 6.2: Price difference for different levels of rho


Figure 6.2 shows option prices from the stochastic volatility model subtracted from
Black Scholes values with matching volatility to option maturity. The difference in
option prices are shown for different levels of spot price. For = - 0.5 and = 0.5
the Black Scholes volatility is 10 %. Calculation of price differences can be found in
Excel file Heston_difference_original.
An examination of the figure will be carried out followed up by an intuitive
argumentation of the observed results.

Comparing to the benchmark (the x-axis) in figure 6.2, the figure indicates that out-
of-the-money options are positively affected by a positive correlation. The price of
out-of-the-money options is higher from the Heston model relative to the Black
Scholes model with comparable volatility. For in-the-money options a positive
-0.150
-0.100
-0.050
0.000
0.050
0.100
0.150
80 90 100 110 120 130
rho=-0.5 rho=0.5

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58 | P a g e

correlation implies that there is a decrease in prices relative to the Black Scholes
model. For a negative correlation the opposite is true. The negative correlation
decreases the price of out-of-the-money options relative to the Black Scholes value
and increases the price of the in-the-money options compared to the Black Scholes.
These observations from the figure will be justified by intuitive argumentation.

For positive correlation it was seen that the right tails are fatter relative to the Black
Scholes. Out-of-the-money call options are sensitive to the fat right tails. In the
following is shown why this is so. Intuitively, this is an indication that returns are
higher and volatility becomes higher, accordingly. In return, the probability of ending
in-the-money is larger. For this reason out-of-the-money options benefits from fatter
tails. Conversely, a negative correlation results in opposite price difference as for the
case of positive correlation. For out-of-the-money options the Heston produces lower
price relative to Black Scholes values since it is less likely that the options end up in-
the-money.
On the contrary in-the-money options are relatively more sensitive to fatter tails on
the left side of the distribution. It is seen in figure 6.1 that fatter tails are produced by
a negative correlation. The fatter left tails in return therefore produces higher Heston
prices relative to the values from Black Scholes for in-the-money options.

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59 | P a g e

Effects of volatility of variance on return distribution
The volatility of the variance assesses the kurtosis of spot returns (Heston 1993). The
higher this parameter is the higher the kurtosis, which will be shown next.

Figure 6.3: Effects of volatility of variance on return distribution

Soruce: Own contributions
In the case where the volatility of variance is zero the volatility is deterministic as
in the case of Black Scholes and the asset returns therefore has a distribution that is
normal. A higher volatility of variance results in fluctuations in the volatility which
then results in larger tendency that stock prices will fluctuate further. This results in
higher peaks and fatter tails as shown in figure 6..3. This observation of a non-normal
distribution was also proven in the empirical studies outlined in section 3.1. Figure
6.3 can be found in Excel file Heston_returns_original.

To see how volatility of variance effect option prices an illustration of the price
difference of the Heston price relative to the Black Scholes value is given:

0
1
2
3
4
5
6
7
8
-0,4 -0,2 0 0,2 0,4
d
e
n
s
i
t
y
Spot Return
v=0.1
v=0.2
v=0.3

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60 | P a g e

Figure 6.4: Price difference for different levels of volatility of variance

As shown in the figure for price differences the higher volatility of variance affects
the Heston prices in different directions. This is due to the higher kurtosis given in
section 3.3. The high kurtosis produces prices that are cheaper for near-the-money
options under Heston model in contrast to the Black Scholes model. Meanwhile, the
fatter tails produces prices more worth under the Heston model compared to the
Black Scholes values away-from-the-money options; i.e. out-of-the-money options
and in-the-money options. Because the correlation effect is not considered in this case
there is very little effect of skewness. This in return implies that the price effects of
out-of-the-money options comparative to in-the-money options are almost
symmetrical. Figure 6.4 can be found in Excel file Heston_difference_original.
In compliance with empirical work, the above examinations show that the stochastic
volatility model has an effect on return distribution and that it can produce a variety
of price effects compared to the Black Scholes model.
The effects illustrated were based on default Heston parameters and variance was
assumed equal to long level variance whereas in practice the variance would evolve
around its long level. Nonetheless, the main conclusions drawn should not be affected
(Heston 1993).
-0.15
-0.10
-0.05
0.00
0.05
0.10
70 75 80 85 90 95 100 105 110 115 120 125 130
v=0.1 v=0.2

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61 | P a g e

6.1.1 Impacts of stochastic volatility & correlation on smile
In order better to understand the Heston model and how it works, this section
examines the Heston parameters and how they, by varying these parameters, affect
the volatility smile. The parameters that are specifically of interest are rho and
volatility of variance as examined in previous section on return distribution.
In order to examine how the Heston model affects the smile this is done by
calculating option prices for a number of strike prices and expiries in the Heston
model. The implicit volatilities are then calculated using option prices as inputs in the
inverted Black Scholes formula.
Figure 6.5: Effects of rho on the volatility smile

In order to better explain the effects of correlation a graph is produced. Figure 6.5
shows different levels of the correlation parameter () on volatility smile across
moneyness. Had there been no correlation (as in the Black Scholes model) the smile
would have exhibited no skew unlike represented by the blue and green line ( < 0
and > 0, respectively). It is seen from the figure that for a rho equal zero; = 0, a
classic symmetric volatility smile is produced (red smile). The effects of skewness
show how market-traded options are priced. As seen; away-from-the-money options
are traded at higher implicit volatilities than those of near-the-money options. This
0.44
0.46
0.48
0.5
0.52
0.54
0.56
0.79 0.84 0.89 0.94 0.99 1.04 1.09
rho = - 0.5 Rho = 0 Rho = 0.5
I
m
p
l
i
e
d
V
o
l
a
t
i
l
i
t
y
Moneyness

__________________________________________________________________________
62 | P a g e

can be explained by the fat tails that were shown and explained in section 3.1. A
negative correlation imply that in-the-money calls has higher implied volatility and
out-of-the-money calls have lower implied volatility. This is consistent with the
smiles that were shown in Dow Jones EuroStoxx 50 options ignoring the shortest
maturity. This indicates that a correlation between the process of the underlying asset
and the process of its variance exist, wherefore an option pricing model must also
account for it to fit the observed smile. As for a positive correlation the skew have an
upward slope as will be seen in the smile based on Dow Jones EuroSTOXX 50 for
options with very short maturity.

Figure 6.6: Volatility Surfaces with correlations; Rho = 0 and Rho = - 0.5

For the ease of visual understanding, the Heston default parameters were used to
produce these surfaces. The volatility surface shown in figure 6.6 shows that the
smile-effect flattens out as time to maturity increases. This is in accordance with the
empirical results given in section 3.1. Because the smile flattens out with maturity the
Heston prices and the Black Scholes prices differs less and less.
Next the effect of volatility of variance is examined in order to see how this affects
the volatility smile. The volatility of variance impacts how clear or significant the
smile or the skew is as shown in the figures below.

0,5
2
0,09
0,095
0,1
0,105
0,11
0,84
0,88
0,92
0,96
1
1,04
1,08
1,12
Time to
maturity
I
m
p
l
i
e
d
v
o
l
a
t
i
l
i
t
y
Moneyness(K/S)
0,5
0,08
0,09
0,1
0,11
0,12
0,84
0,88
0,92
0,96
1
1,04
1,08
1,12
Time to
maturity
I
m
p
l
i
e
d
v
o
l
a
t
i
l
i
t
y
Moneyness (K/S)

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63 | P a g e

Figure 6.7 a: Effects of volatility of variance for = 0

Figure 6.7 b: Effects of volatility of variance for = - 0.5

Figure 6.7 c: Effects of volatility of variance for = 0.5
0,085
0,09
0,095
0,1
0,105
0,11
0,92 0,94 0,96 0,98 1 1,02 1,04 1,06 1,08 1,1
I
m
p
l
i
e
d
v
o
l
a
t
i
l
i
t
y
Moneyness(K/S)
rho=0
v=0.1 v=0.2 v=0.3
0,06
0,07
0,08
0,09
0,1
0,11
0,12
0,13
0,920,940,960,98 1 1,021,041,061,08 1,1 1,121,141,161,18 1,2
I
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
Moneyness(K/S)
rho=-0.5
v=0.1 v=0.2 v=0.4
0,07
0,08
0,09
0,1
0,11
0,12
0,13
0,84 0,86 0,88 0,9 0,92 0,94 0,96 0,98 1 1,02 1,04 1,06 1,08 1,1
I
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
Moneyness(K/S)
rho=0.5
v=0.1 v=0.2 v=0.3

__________________________________________________________________________
64 | P a g e

To better understand how different levels of volatility of variance perform, figures
6.7 a - b shows volatility of variance for different levels of correlation . Taking 6.7
a as an example, it is seen that as volatility of variance tends to zero, the implied
volatility curve tends to flatten and shift upwards, such that at-the-money options
trade at higher implied volatility. Another observation that can be made is that, as
volatility of variance is lowered, the curve tends to flatten and approaches the Black
Scholes model with a zero volatility of variance (i.e. constant volatility). A higher
volatility of variance on the contrary results in significant smile. Intuitively, higher
volatility of volatility deviates further from the Black Scholes. To conclude, the lower
the volatility of variance, the closer the prices of at-the-money options get between
BS and Heston model which is also consistent with theory. Figure 6.7 a,b and c can
be found in the Excel file Effects_of_Rho.

In this chapter we examined the sensitivities of stochastic volatility and correlation
on standard vanilla European options to conclude on the impacts prior to the later
analysis of these sensitivities on barrier options. An important aspect of the analysis
is the distinction in effects of the stochastic volatility and the correlation between the
underlying process and its volatility. It was seen for the non-correlation case that a
higher volatility of variance produces higher kurtosis and not a skew. As a
consequence of higher variance, higher prices were produced for far-from-the-money
options relative to near-the-money options.
On the contrary, it was seen that for positive and negative correlation that is;
correlation different from zero, produced a skew. A negative skew implied that in-
the-money options were overpriced in contrast to out-of-the-money options. And vice
versa for the positive skew. On these grounds the choice of correlation of spot returns
and the volatility of variance should be done with serious consideration.

6.1.2 Sensitivities of stochastic volatility and correlation on barrier options
As seen earlier European vanilla options are affected by stochastic volatility and
correlation effects, thus for this reason barrier options are also believed to be
impacted by stochastic volatility and correlation. This is especially believed since

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65 | P a g e

according to literature, barrier options are more sensitive to stochastic volatility
relative to the equivalent vanilla. It is therefore interesting to examine and analyze the
sensitivities of barrier options under the Heston model. In the following the prices
produced by the Heston model are contrasted with equivalent values produced by the
standard Black Scholes model. The prices are calculated based on 10.000 number of
simulations. The explicit results are given in Appendix 6 and 7. All simulated option
prices are initially at-the-money, that is the strike price is equivalent to the spot;
2050.96 Euros. In order to construct a good visual presentation of option prices, the
spot price of the index is varied.

Figure 6.8 shows the prices of an up-and-out call option with a barrier of 4945.88
Euro. The simulated and exact prices are given in Appendix 6. From the figure it can
be observed that from a spot price of 2100 Euro and to the barrier the Heston model
distinctly exceeds the Black Scholes prices. That is; barrier option prices produced by
Heston model most of the time exceeds the price produced by the Black Scholes
model and especially for around at-the-money options. The biggest price difference of
around 400 Euros occurs around spot price of 3300 Euros. The Black Scholes prices
for far-out-of-the-money options, on the contrary, are bigger.
In order to evaluate the influence of these price differences and to evaluate how the
parameters in the Heston model affects prices an analysis is made by simulating
option prices for different levels of the given parameters. The relevant parameters in
this case are, like in section 6.1.1, the volatility of variance and correlation between
the process of the underlying asset and its volatility. It is relevant to see how changes
in these parameters impacts up-and-out call option prices and thereby the price
differences.

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Figure 6.8: Effects of volatility of variance on up-and-out barrier option


The figure above indicates that a higher volatility of variance affects the price of the
barrier options in a positive direction to a greater magnitude than in the vanilla case,
given that all other parameters are held constant. This is consistent with the
theoretical statement that barriers are more sensitive to volatility of variance than the
equivalent vanilla. Calculations for the Figure 6.8 can be found in Excel file Effects
on Vol on vol on Barrier.
Furthermore, it can be seen that for a high volatility of variance; i.e. the assessed
calibrated value of 1.14, the peak is higher. Here the Heston values falls faster
towards zero, and the level where Black Scholes exceeds Heston prices gets closer to
the strike price.
The procedure for constructing a return distribution is given in section 3.1. Three
different levels of volatility of variances is given here for the sake of simplicity, such
that it is easier to distinguish the graphs.

-100
0
100
200
300
400
500
600
700
800
900
0 1000 2000 3000 4000 5000 6000
V
a
l
u
e
Spot
v=0.1
v=0.4
v=0.7
v=1.14
BS

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67 | P a g e

Figure 6.9: Effects of volatility of variance on the return distribution

As mentioned earlier the volatility of variance affects the kurtosis of the return
distribution. The purple return distribution represents the simulated spot prices with
calibrated parameters. It is positively skewed as the calibrated correlation turned out
negative. Figure 6.9 can be found in Excel file Barrier_returns.
It is of interest to see the price differences under Black Scholes and under Heston for
the different levels of volatility of variance. This is shown in the next figure.
Figure 6.10: Price difference for up-and-out barrier under Black Scholes and Heston

0
0,2
0,4
0,6
0,8
1
1,2
1,4
-2 -1 0 1 2
D
e
n
s
i
t
y
Spot Return
v=0.4
v=0.7
v=1.14
-100
0
100
200
300
400
500
600
0 2000 4000 6000
D
i
f
f
e
r
e
n
c
e
Spot
Bs and v=0.1
Bs and calibrated

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68 | P a g e

The red line shows the difference between the Black Scholes price and the Heston
price with calibrated parameters; i.e. the calibrated volatility of variance is 1.14. The
lower graph shows the difference between the Black Scholes and the Heston model
with a volatility of variance of 0.1. As seen, the figure implies that the level of
volatility of variance has serious impacts on pricing barrier options. For the up-and-
out call option it can be seen that Heston underprices the option relative to the Black
Scholes model price for far-out-of-the-money options only. This is due to the fatter
left tail (which implies larger probability of negative returns) relative to the normal.
For low volatility of variance the thicker right tail imply that far-out-the-money
options have higher probability of ending in-the-money and this is higher than the
probability of being knocked out. The price of far-out-of-the-money is thus higher
under the Black Scholes model relative to the Heston model. Figure 6.10 can be
found in Excel file Effects of Vol on vol on Barrier.

Figure 6.11 once again shows the previously concluded results; the larger the positive
correlation the fatter right tails and the distribution skewed to the left, thereby a larger
probability of higher values of the underlying asset. Positive correlations imply that
the fatter right tails results in higher probability of hitting the barrier. It also implies
that the probability of ending in-the-money is lowered since the peak of the return
distribution is skewed to the left. For the negative correlation the opposite is true. The
lower the correlation the more skewed the return distribution is to the right. This
implies a higher probability of ending in-the-money. This explains the higher price of
the up-and-out barrier option as shown in the figure above.

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Figure 6.11: Effects of correlation on the return distribution

From the graph it can be seen that with the calibrated value of correlation; i.e. = -
0.47 there is a higher probability of ending in-the-money and at the same time the
probability of hitting the barrier is low wherefore the price of the barrier option is
high. On the contrary, For = 0.5, the fatter tails imply that there is a higher
probability of hitting the barrier and the skew imply that ending up in-the-money is
lower, which again implies lower barrier option prices. These conclusions are
consistent with figure 6.12 which shows the differences between barrier option prices
under Heston model and under Black Scholes for the different levels of correlation.
The area under the x-axis shows that Black Scholes price exceeds the prices under
Heston. That is; out-the-money options are overpriced by the Black Scholes model
contrasted to the Heston model and in-the-money options are priced higher under the
Heston model relative to the Black Scholes model. Figure 6.11 can be found in Excel
file Barrier_returns.

0
0,2
0,4
0,6
0,8
1
1,2
1,4
1,6
-2 -1 0 1 2
D
e
n
s
i
t
y
Spot Return
rho=-0.7
rho=-0.46996
rho=0
rho=0.5

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70 | P a g e

Figure 6.12: Difference in up-and-out barrier prices for different correlations

Overall, it can be concluded that for a fixed level of barrier the probability of hitting it
varies with the level of correlation. The effects of the different levels of correlation on
up-and-out barrier option prices can be seen on the following figure. The differences
are calculated and presented in Appendix 7, and can also be found in Excel file
Effects of Rho on Barriers.
Figure 6.13: Effects of correlations on up-and-out barrier option

-200
-100
0
100
200
300
400
500
600
0 2000 4000 6000
D
i
f
f
e
r
e
n
c
e
Spot
BS and rho=-0.46996
BS and rho=0
BS and rho=0.5
-200
0
200
400
600
800
1000
1200
0 1000 2000 3000 4000 5000 6000
V
a
l
u
e
Spot
rho=-0.7
rho=0
rho=0,5
Calibrated
BS

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71 | P a g e

The figure shows that options with even smaller negative correlation has higher prices
which is due to the fact that the probability of ending up in-the-money is higher as
concluded before. It is seen that the prices by far exceeds the prices produced under
Black Scholes model. However, for a correlation of 0.5 it can be seen that the level
where the price under Black Scholes model exceeds Heston moves closer to the
barrier level.

The above analyses can similarly be done for put options, nevertheless, will not be
carried out in this thesis since the same conclusions can be drawn from it.

Overall, it can be concluded that the introduction to stochastic volatility has a
significant impact on pricing barrier options in contrast to the assumption of constant
volatility in the Black Scholes model. As seen in earlier sections it was empirically
proven that volatility is not constant and thereby it can be discussed the extent to
which the Black Scholes can be applied for pricing barrier options in practice. Since
barrier prices are not quoted on the market it was not possible to compare the prices,
wherefore the conclusions have no supports. This leads to next chapter, which
introduces structured products.
From the analysis different facts can be concluded. It was seen that the prices under
the Heston model are sensitive to changes in the calibrated parameters. For this
reason accuracy of parameters is important to overall conclusions. Another decisive
factor is that; irrespective of how the Heston parameters are set there are significant
deviations from the standard Black Scholes model. Especially for the sensitivity in
the level of volatility of variance large effects on the prices was seen wherefore it
enlighten the importance of using models that includes stochastic volatility. Applying
Black Scholes, on the other hand, implies serious consequences for option pricing.

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Chapter 7: Structured Investment Products
It was not possible to find direct quotes on barrier options since derivatives are not
directly observable as they are mostly traded over-the-counter. That is; if an
investor wants to buy or short-sell a derivative, he or she must call the dealer network
that makes the market in that derivative and ask for quotes. This thesis deals with
application of structured products to back out market option prices for the comparison
purposes. The estimated model prices will be compared to prices of barrier options
that are embedded in the structured products. In order to provide an understanding of
structured products, this chapter gives a brief introduction to structured investment
products, what they may look like and uncovers, what may be to an investor,
complexities of these.

7.1 Introducing Structured Products: An overview
The concept of structured products is not new in the financial world. The products
were introduced in the 1980s and experienced a rapid growth since millennium
(Jrgensen et al. 2009). Since their introduction in the Danish market in 1998
24

structured products have increasingly become a popular financial product and as a
consequence the market grew almost exponentially in later years.
25
They have
become so advanced products that the typical investor cannot comprehend all the
mechanisms herein and tell whether the investment is truly attractive. Furthermore, in
some cases the products are so advanced that even financial managers cannot grasps
the structures of these, and thus cannot provide reliable advices to their clients
(Bentow 2006).
Structured investment products are synthetic investment instruments specially created
to meet an investors specific needs that cannot be met from the standardized
financial instruments available in the markets. They appeared attractive to investors

24
One may conclude that the Danish retail investors have been quite familiar with the concept of
structured products for decades. Since most bonds for mortgages contain an imbedded call option that
gives the bond holders a right to retire the bond before maturity, the resemblance to modern structured
products are striking (Das 2001: pg. 31).
25
Lchte Jrgensen et al. 2009 (Article from FinansInvest)

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73 | P a g e

that sought to lock in their principals while leaving the opportunity of an up-side
potential open. The terminology for structured products
26
can best be described as a
product - a mini portfolio - that combines fixed income elements with derivatives
instruments (Das 2001). For instance, its composition consists of a traditional bond
and an option, where most likely the bond will be a zero-coupon bond, and instead of
a fixed coupon rate in the case of a traditional bond the product has an embedded
option.
27
Typically, the bond part of the construction provides a 100% principal
protection; that is investors will in any case receive as a minimum amount the full
principal at maturity. The length of maturity of the bond varies but is often 3-5 years.
It happens that the product is sold above 100 which results in a loss (in terms of costs)
(Jrgensen et al. 2009). In the worst case where investor pays above 100 or even 100
there is also a loss in terms of interest rate alternatives.

The embedded option can be synthetically constructed by one or more option types
and this part varies much more across the products. The variation and creativity is
seen in the degree of complexity (option type) and the underlying asset of the option.
This part is the risky component in this structure and is customized according to the
investor's risk tolerance. Hence, structured products are similar in their overall
structure yet specific in the design of the option-element. Figure 7.1 shows a
categorization of the most applied option types, however because of the many
combination possibilities a precise categorization is difficult. The figure indicates that
above 30 % of options are Basket options. Moreover, 75 % of these include an option
with Asian features of some kind. The next largest option applied is of pure Asian
character on a single index. This is then followed by Barrier options which still
belong to a large group of embedded options; i.e. approximately 15 % of options as
seen in figure 5.1.

26
Terms such as principal protected notes, accelerated return notes, range notes, reverse convertibles,
buffered return notes, or barrier notes are used to describe the numerous individual categories of
structured products. (Das 2001) refers to them as structured notes with different names underlying asset.
The term structured products will be used in this thesis.
27
(Rasmussen 2007: pg. 47)

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74 | P a g e

Figure 7.1: Distribution over frequency of option types

Source: Jrgensen et al. (2009)

The underlying asset is often a stock index as seen in figure 7.2, however the
opportunities are many. A whole variety can be selected as the underlying asset;
currencies, single security or securities, a basket of stocks, interest rates,
commodities, debt issuance and/or combinations of these and a lot more.

Figure 7.2: Frequency distribution of underlying index in categories


The list of indices is also long however as figure 7.3 shows the most used index as
underlying in Denmark is the Dow Jones EuroSTOXX 50 (25 %) followed by Nikkei
225 (17 %).

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75 | P a g e

Figure 7.3: Frequency distribution of Underlying Asset


The embedded option often has features of an exotic option such as barriers
mentioned in section 4.1 or more recently second generation of exotic options such as
power options. The option embedded could be created solely for this purpose which
explains why an identical option may not be available in the market. Due to their
(exotics) complex structures it has proved a difficult task to determine the fair value
of these structured products. According to Jrgensen et al. (2009) the products were
under heavy criticism from amongst others; Brsen (2009), Jyllands-Posten (2009),
Danish National Bank (Rasmussen 2007) as a consequence of lack of transparency
for the private investor (Jrgensen et al. 2009). According to Forbrugerrdet (2008)
such products were banned for sale to private investors in 1998 by Norwegian
authorities.
Despite the mass criticism the characteristics of structured products have made them
very popular amongst private investors. This is backed up by statistics which reveals
that the amount invested in structured products has reached approximately 55 billion
DKK
28
in the Danish market (Rasmussen 2007). As mentioned earlier the product
may seem appealing to the private investor due to the promises of redemption
guarantee of the capital plus the possibility of an upside potential. The sellers assure
the investors that they cannot lose money on the investment although in reality the

28
Based on May 2007 statistics

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76 | P a g e

investor can lose on paying overprice and miss the interest rate on the principal. A
documentation of this was made by Breuer and Perst (2007) who looks at structured
products from a behavioral finance perspective. Issuers of structured products used
this argument in marketing structured products.

The construction of the structured product and its return can be graphically sketched
as in figure 7.4.

Figure: 7.4: Components of a Structured Investment Product

Source: Own constructions.
Note: Due to costs, the value is often above 100, for instance 102,5 or 103.

As suggested by the figure investors product payment can be divided into three
categories. The major part of the investment amount finances the bond purchase
while the smaller part finances the purchase of the option. As will be elaborated
further at a later stage, it is this price of the option that is sought in this thesis.
The sum of these components represents the fair price of the structured product while
the difference
29
is the costs involved with the product. They cover the issuance costs
of the option writer, bond issuer and the intermediaries. The amount size of this can

29
The difference between the fair price and the issuance price that the bond is sold at

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77 | P a g e

be hard for investor to determine. Thus, the investor may consider the greatest part of
the cost as charging overprice since individual component purchases will only have
some transaction costs related.

7.1.1 Payoff structure
The payoff of the embedded option depends on the structured products participation
rate (R) and the development of the underlying asset. In terms of calculations, the
option payoff can be calculated via this formula:
Option payoff = P * R * performance of the underlying (7.1)
In above equation P is the principal amount invested, the participation rate R (also
known as gearing) represents the percentage at which the investor participates in the
appreciation of the underlying asset. The performance of the underlying could be for
example the return of a stock or index, where P*R*performance of the underlying is
called the redemption premium RP.
Hereafter one simply adds (7.1) to the zero-coupon bonds principal amount P in order
to find the payoff of the typical principal protected note:
Payoff = P + P * R * performance of the underlying (7.2)
The major part of (7.2) typically comes from the zero-coupon while the up-side
potential comes from the embedded option depending on the participation rate.

7.1.1 Participation Rate
The participation rate, also known as gearing (R), as mentioned is the decisive factor
ruling how large a share the investor receives from the payoff of the embedded option
provided that it ends up in-the-money. In other words the participation rate can be
described as the number of options per bond (Jrgensen et al. 2009). To exemplify, if
the structured product has a participation rate of 200 % the investor will then receive
twice the option payoff. This makes the participation rate a fine tool to the mediator
in order to attract investors since a high participation rate can yield a high option
payoff despite the small changes in underlying asset. One may be fooled by a high

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78 | P a g e

participation rate however truth is that participation rates cannot be compared across
structured products such that a participation rate of 200 % is better than one of 80 %
in another. The participation rate must be evaluated in coherence with type of option
and character of underlying asset (Jrgensen et al. 2009).

The gearing is normally not set prior to the expiration of issuance period, which is
why this remains unknown until this time and only appears as an estimate in the
prospect. Once settled the participation rate, which can be calculated from (7.3), is
held fixed during the lifetime of the product:

C P
S P
R
Option
*
*
0
= (7.3)
where P
option
is the amount invested in the embedded calculated as in (7.4).
P
option
= Issuance price - zero-coupon bond costs (7.4)
S
0
is the underlying spot price.
P is the principal amount.
C is the price of the embedded option.

From equations (7.3) and (7.4) it can be seen that the participation rate is determined
by a number of variables. The mediator can thus manipulate with these to make the
structured product look attractive for the investor and sell the idea. Apart from those
variables that appear directly in the equations above, the interest rate, the product
lifetime and the volatility of the underlying asset also has its influences on the
participation rate. For instance, high interest rate levels in Denmark results in higher
participation rate and vice versa. Similarly a lower volatility of underlying asset
results in a reduction of option price which again increases participation rate and vice
versa driving the bond price downwards. The construction of the product also has its
effects on the gearing; that is charging overprice (above 100) also drives the
participation rate upwards.
30
Yet another often used method is to use exotic options as

30
Garanti Invest

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79 | P a g e

they are as mentioned in 4.1 cheaper than their equivalent vanillas. Barriers are
especially the case, hence the foundation of this thesis.
The lower option price enables one to buy more options whereby the participation
rate increases. According to appendix 8 participation rates for Garanti Invests active
structured bonds lie in the interval between 73 % and 1.285 % the 16th of June. A
database over all structured products in Denmark shows a range lying in between 27
% and 1.285 % and that far most products have a participation rate of 100%-130%.
31

Both selected structured products for this thesis have the participation rate estimates
of 100 %.

7.2 Analysis of prospectus An overview
Having introduced the structured products investments this section will provide an
overview of the two chosen products Danske Dow Jones EURO STOXX 50 Shark
Fin-2009 and KommuneKredit Aktietrappe 2012 given in Appendix 9 and 10,
respectively, issued by the two of the largest Danish banks; Danske Bank and Nordea
Bank, respectively. Structured products typically include all information as given in
the prospects given in the appendices.
ISIN Code (Fund Code)
Name of the bond
Issue Date
Interest Commencement Date
Expiration Date
Settlement Date
Issuers
Credit rating of issuers
Specified Currency or Currencies
Aggregate Nominal Amount
Specified Denominations
Issue Price

31
Jrgensen et al. (2009)

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Yearly Percentage of Costs
Coupon
Option Type
Underlying Asset
Category of Underlying Asset
Number of Underlying Assets

7.2.1 Analysis of Danske Dow Jones EURO STOXX 50 Shark Fin-2009

Start value of Index: 3704.78 Euros
Barrier: 4945.88 Euros

Product overview
The product Danske Dow Jones EURO STOXX 50 Shark Fin-2009 was issued 6
th

of June, 2008 by Danske Bank under ISIN code: DK0030102280. The product is
composed of a security bond with a maturity of 18 months, and a barrier up-and-out
call option on Dow Jones EURO STOXX 50 index. Barrier is set on 133.5 per cent of
Index Initial. The expiry date of a product is December 7, 2009. The product is issued
at price of 100 per cent of nominal amount, with a redemption rate of 100 per cent. If
the index at or above the barrier a rebate is paid out which is 105 per cent. Until
expiry of the product there will be no coupons from the product. The issuer of the
product is Danske Bank A/S.

Payoff structure
The embedded option in Danske Dow Jones EURO STOXX 50 Shark Fin-2009 is
up-and-out call barrier option on Dow Jones EURO STOXX index, with a barrier set
to 133.5 per cent of Index Initial value. If the Closing Level of the Index on all
Scheduled Trading Days during the period from the Initial Valuation Date to and
including the Final Valuation Date is lower than the barrier, than the payoff will be
following:

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DK 10,000 + DK 10,000 * Participation * MAX [0%; Index Change]
If on the other hand Level of the Index on all Scheduled Trading Days during the
period from the Initial Valuation Date to and including the Final Valuation Date is
higher than the barrier, than the payoff will be following:
DK 10,000 + DK 10,000 * 5%

Risk Factors
The price of Danske Dow Jones EURO STOXX 50 Shark Fin-2009 is issued at
10,000 DKK, with a guaranteed redemption at 10,000 DKK. If the embedded option
expires out of the money investor receives 10,500 and the only loss investor will have
encountered is the opportunity to earn more money if he invested his money
somewhere else.
The risk associated to the bond is connected to the credit rating of the Danske Bank.
Since the Danske Bank at the issuance of the product has an investment grade rating
of Standard & Poors A+
32
or equivalent rating from Moodys Investor Services Inc.
or Fitch Ratings Ltd, the risks associated with the bond element is considered fairly
low.

7.2.2 Analysis of KommuneKredit Aktietrappe 2012
Start value of Index: 2012.15 Euros
Monthly Barrier: 4 per cent

Product overview
The product KommuneKredit Aktietrappe 2012 was issued 20
th
of Marts, 2009 by
KommuneKredit under ISIN code: DK0030164397. The product is composed of a
security bond with a maturity of 3 years, and an option with embedded barrier feature
on Dow Jones EURO STOXX 50 index. The expiry date of the product is 8
th
of April,
2012. The product is issued at price of 102.5 per cent of nominal amount, with a

32
Suorce:Danske bank

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minimum redemption rate of 100 per cent. . Until expiry of the product there will be
no coupons from the product. The issuer of the product is KommuneKredit.

Payoff structure
Bonds return depends on changes in value in underlying index. Monthly Ceiling of 4
per cent sets a maximum limit of how large share of the growth will be included in
the calculations of the return.
At redemption day payoff will be one of the two following:
Rate 100, or
Rate 100 + 100 * Index Supplement which is calculated in following way:
{ }
)
`

36
1
; * 100 ; * 100 ; 0 _ rier MonthlyBar Underlying in Change MIN level in Lock MA

In addition, as shown in the payoff equation above this product contains a locked-in-
level which ensures to lock in the profits from the sum of growth in the underlying.
An example of a hypothetical development of the underlying and how the payoff is
calculated is given in Appendix 11. In each observation period the development in
value (Vrdiudvikling) is given, which is the change in the index given in the first
column. In the second column calculations of the development in value is given
taking the monthly loft into account. The monthly developments in value (with
Monthly Loft) is then summed up which is the final accumulated development in
value. After each period it is then observed whether this accumulated value has
reached a locked-in-level (see Appendix 11). The locked-in-levels are given in the
following table:

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Table 7.1: Locked-in-levels

Source: Aktietrappe 2012 Prospectus

Risk Factors
The price of KommuneKredit Aktietrappe 2012 is issued at the rate 102.5, with a
guaranteed redemption at 100. If the embedded option expires worthlessly the
investor will have encountered a loss of 2.5 plus return on alternative investment.
Alternative investment with the same maturity as KommuneKredits Aktietrappe
2012 in for example government bond in whole investment period would give return
of about 2.62 per cent per anno determined from market conditions on 30
th
of January
2009.
The risk associated to the bond is connected to the credit rating of the
KommuneKredit. Since the KommuneKredit at the issuance of the product has an
investment grade rating of Standard & Poors AAA or equivalent rating from
Moodys Investor Services Inc., the risks associated with the bond element is
considered fairly low.

Locked-in-levels
Lock-in level 1 6 per cent

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Costs
The costs are dependent on the size of the issuance. With an expected issuance
volume of nominal 50,000.00 DKK the costs for KommuneKredit Aktietrappe
2012 can be categorized as:
Issuance provision at 0.61 per cent p.a. of the nominal issuance volume.
Marketing costs, including advertising, brochures and printing of information
material. Approximately 0.07 % of the total issuance.
Broker costs for listing on the OMX Copenhagen Stock Exchange 0.08 % p.a. of the
total issuance.
License fee to owners of the indices implicated in the product 0.05 % p.a.

7.3 Valuation of the structured products
This thesis has analyzed two prospectus and established an algorithm for valuation of
the products with barrier options or alike embedded. The pricing of the structured
products will now be undertaken. The pricing date was on the 20
th
of March; which is
also the issue date of Aktietrappe 2012. The calculation was done as follows:
Theoretical price = 100 + 100 * Payoff
Where the payoffs differ for the two products.

The structured product price in Shark Fin 09 was estimated under stochastic volatility
from 10 000 simulations. The market price of Shark Fin 09 at the 20
th
of March was
DKK 97.35 (can be seen in Excel file Structured product market prices). With 10 000
number of simulations the Monte Carlo valuation method estimated the price of the
product to be 98.36 DKK per nominal value of 100. The payoff for this product was
calculated as follows:
payoff e lprice Theoretica =
) 365 / 262 ( 0178 . 0

Theoretical price = 98.36

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The theoretical price exceeds the market price by only DKK 1.01, which indicates
that the product was fairly priced according to the Heston model. That is; Heston
model is pricing correctly according to the market. Prices for structured product
Shark Fin 09 are calculated in Excel file Shark_Fin.
The second product; Aktietrappe 2012 had a market price of DKK 102.5 on the 20
th

of March (can be seen in Excel file Structured product market prices). Prices are
calculated in Excel file Aktie_trappe. Ignoring the costs of 2.5 the nominal amount is
set to 100. With 10 000 simulations the Monte Carlo valuation method estimated the
price of the product to be DKK 115.57 per nominal value of 100.

payoff e lprice Theoretica =
) 365 / 1093 ( 0178 . 0

Theoretical price = 115.57
Based on the theoretical result for the structured product, the issuer underpriced his
product. There may be different reasons for this. The difference in the theoretical total
value and the issued price would most likely be found in the embedded option. It
could be that issuer used Black Scholes model to price embedded option. The
product would require a higher participation rate to match the lower embedded
theoretical option price. Or, on the other hand, to match the participation rate set in
the prospectus, an implied fair option price would have a higher value.

Had the price been calculated under constant volatility the prices of Shark Fin 09 and
Aktietrappe 2012 would instead have been 99.36 and 102.48 DKK , which is a rise of
1.02 % and a fall of 11.32 %, respectively.( For calculation of price under constant
volatility, calibrated value of implied volatility was used. Calibration procedure can
be found in excel file Calibration_for_BS.) Since Shark Fin 09 has an up and out
barrier embedded, according to findings from previous sections it was expected that
the price difference for at-the-money call between Heston and Black Scholes will be
minimal.

__________________________________________________________________________
86 | P a g e

The option element in Aktietrappe 2012 is quite complicated, wherefore it is hard to
predict expectations of impacts of Heston on the pricing. One of the reasons why the
Heston priced this product higher than the Black Scholes can be as follows: Under
stochastic volatility there is higher probability of fluctuations in the underlying asset,
which further enables stock index changes to reach locked-in-levels each month.
Once locked at for instance 6 per cent the investors can only benefit from more
volatile volatility. Another reason may come from the negative correlation, which
implied that there is higher probability of positive returns. Alternatively, there may
rise other reasons for the significant price difference. There may be uncertainty
associated to the calibration as the variables could have been estimated wrong. The
process is long and the parameters are more or less determined by intuition and
acceptance of the calibrated values.

Chapter 8: Discussions of the Heston (1993) model
In this chapter the Heston (1993) model is reconsidered and a discussion is presented
on how well it performs. This is done by presenting the most essential results and
findings that were achieved in this thesis. A thorough evaluation and discussion of
these results will then be presented.
In empirical results a line of theoretical prices were determined by the Heston Square
root model. The error measurement ARPE was used to observe the price error terms
between market prices and the estimated theoretical prices. It can be seen in
Appendix 4 that the average ARPE of 8.52 % across five days from 16
th
of March to
20
th
of March is still quite large. As mentioned in section 5.4 some level of error have
to be accepted. The reason for this could lie in the insufficient number of simulations
or in the method of Least Squares used in solver. A higher number of simulations
were not possible due to the available equipments and lack of time.

An alternative way to judge the performance of the Heston model and its fit to
empirical implied volatility surface is to compare the two volatility surfaces
graphically. The figure below shows the graphical illustration of the two volatility

__________________________________________________________________________

surfaces where the first is the
graph on the second is the He
12 and can also be found in Excel file

Figure 8.1: Volatility surface of Dow Jones EuroSTOXX 50 implied volatilities

Figure 8.2: Volatility surfac
0
.
2
6
0
.
7
6
1
.
2
6
1
.
7
6
2
.
2
5
2
.
7
5
0.28
0.33
0.38
0.43
0.48
0.53
0.58
0.63
0.68
Time to maturity
I
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
Volatility surface
0.26
1.26
2.25
0.30
0.35
0.40
0.45
0.50
0.55
0
.
9
6
I
m
p
l
i
e
d

v
o
l
a
t
i
l
i
t
y
Volatility surface
__________________________________________________________________________
is the Dow Jones EuroSTOXX 50 volatility surface and the
graph on the second is the Heston fit. The implied volatilities are given in Appendix
and can also be found in Excel file Calibration.
: Volatility surface of Dow Jones EuroSTOXX 50 implied volatilities
: Volatility surface of Heston implied volatilities
2
.
7
5
Moneyness (K/S)
Volatility surface- Market
0.63-
0.58-
0.53-
0.48-
0.43-
0.38-
0.33-
0.28-
1
.
0
1
1
.
0
6
1
.
1
1
1
.
1
6
1
.
2
0
1
.
2
5
1
.
3
0
1
.
3
5
1
.
4
0
Moneyness (K/S)
Volatility surface - Calibrated
0.50-
0.45-
0.40-
0.35-
0.30-
__________________________________________________________________________
87 | P a g e
Dow Jones EuroSTOXX 50 volatility surface and the
lities are given in Appendix
: Volatility surface of Dow Jones EuroSTOXX 50 implied volatilities

-0.68
-0.63
-0.58
-0.53
-0.48
-0.43
-0.38
-0.33
-0.55
-0.50
-0.45
-0.40
-0.35

__________________________________________________________________________
88 | P a g e

From the two views presented here it can be seen that the volatility smile generated
by the Heston model lacks an upward smile relative to the empirical implied volatility
surface. The Heston model seems to produce a surface that is flatter across
moneyness relative to the empirical surface. For longer expirations, however, the
Heston fit performs quite well. It is seen that the Market implied volatilities for longer
maturity is around 0.35 and does not deviate much from the estimated implied
volatilities. As can be seen in figure 8.2 the implied volatilities for longer maturity is
between 0.30 and 0.35.
This is also backed up by Gatherals (2006) empirical tests that show that the Heston
model does not fit the observed implied volatility surface for short expirations but for
longer expirations it works better. Chapter 7 of his book exclaims that all stochastic
volatility models roughly generate the same shape of volatility surface. From this
follows that if one is searching for a model that can better capture market parameters,
one need to go beyond stochastic volatility models (Gatheral 2006).

To conclude, it can be said that the Heston model is not the best model for fitting the
observed implied volatility surface for short expirations while it fits better for longer
expirations.
There may be a number of risks associated to why the empirical results did not come
out successively. These are model risk, calibration risk and simulation risk. The
model risk is the risk associated with the choice of model. The Heston model may not
be the best model to price options and furthermore calibration of the Heston
parameters could also be associated to some level of error. This is where the
calibration risk comes from. Lastly, the parameters from calibration would be
estimated more accurately if much higher number of simulations were carried out.
But due to the high computational time and computers available this was not possible.

__________________________________________________________________________
89 | P a g e

Chapter 9: Conclusion
The financial markets have developed over the past years and have become more
risky today. This is due to the increase in variation of financial derivatives. On this
ground options have become popular to reduce the risk linked to this variation. For
this reason Fischer Black & Myron Scholes came up with a closed form analytical
formula to price options, but did not show reliable for a number of reasons. Among
other reasons it assumes that the log-return follows the normal distribution and the
variance of the underlying process is both constant and known. This assumption
however is rejected by several empirical studies and results given in this thesis.

The log-return showed tendency of a higher probability of returns around the mean. It
also showed fatter tails and a more skewed (negative skew) than the normal
distribution allows. Both of these distributional features are thought to explain smiles
and smirks. Had the returns been normal, the implied volatility would have been
constant across moneyness and maturity. In addition, it was observed that the
volatility in the log-return has a tendency to cluster. These findings were consistent
with empirical evidences put forward by Mandelbrot (1963), Fama (1965) including
amongst others Bollerslev et al. (2001). From the studies it was furthermore observed
a significantly positive correlation between the two Brownian motions driving the
processes for the underlying asset and the process for volatility.

The construction of the volatility smile across moneyness and maturity turned out to
deviate from the assumption of a constant volatility under Black Scholes. Instead it
shows a continuous falling tendency (except for very short maturity it showed an
increasing tendency) across moneyness while at the same time smiles in general are
more pronounced for short-term options and less pronounced for long-term options.
This is also consistent with theory and previous empirical studies. This is synonym to
long-term returns being closer to normally distributed than short-term returns. These
findings indicate that the Black Scholes model is far inadequate in a sense that a more

__________________________________________________________________________
90 | P a g e

realistic and flexible model becomes necessary in order to describe the observed
market option prices.

In the past two decades theorists struggled to come up with a mean reverting model
that could account for the above mentioned problems, and specifically allowing for a
volatility that could vary randomly such that it fulfilled the criteria of post-crash
market structures.

Different models were proposed and among them were models that included
stochastic volatility and interest rates alongside with jump-diffusions in the process of
underlying asset. Empirical studies concluded that introducing stochastic volatility in
a Black Scholes framework was by far most the largest improvement. Introducing
stochastic interest rate and jump diffusions in the model only lead to marginal
reductions in option pricing errors. According to literature, the Heston (1993) model
was the most accepted and popular for pricing options under stochastic volatility. The
reason for its great popularity was due to its ability to capture a stochastic mean
reverting volatility and the correlation between the processes of variance and asset.

The importance of the correlation was seen captured in the skew in the observed
return distribution. In addition, from empirical studies it was seen that the log-return
distribution had higher return around the mean (i.e. higher kurtosis) and fatter tails
compared to the normal distribution, which the Heston model is also able to capture.
Finally, the model is applicable at ease in practice since it is relatively easy to
implement in Visual Basics.

An analysis on vanilla options under Heston model was carried out in order to
compare the actual return distribution to the assumption of normality in the Black
Scholes model. Then the price differences between the Heston model and the Black
Scholes model are presented and analyzed. In this connection the validity and
reliability of Heston model was also assessed. To measure this, the square root mean
error were investigated and analyzed.

__________________________________________________________________________
91 | P a g e

From the analysis of vanilla call options pricing under Heston model it was found that
both volatility of variance and correlation had significant impacts on the price
difference between the Black Scholes model and the Heston model.
Volatility of variance parameter in Heston model affects the kurtosis of the return
distribution. A higher volatility of variance resulted in higher peakedness which was
consistent with empirical evidences on return distribution of assets. From analysis it
was concluded that a higher volatility of variances implied lower prices for near-the-
money options relative to the Black Scholes. On the contrary, the fatter tails implied
higher premiums charged for away-from-the-money options relative to Black Scholes.
Conclusively, on the behalf that the ability of the Heston model to incorporate the
correlation and the volatility of variance it fits the observed empirical volatility smile
and implied volatility surfaces, which were also shown graphically, the Heston model
performs much better than the Black Scholes model.

From the analyses on correlation it was observed that correlation also had a
significant effect on the prices difference between the Black Scholes model and the
Heston model. The level of correlation, rho, positively affected the skewness of
return distributions and intuitively, a positive correlation resulted in a high variance
when spot asset rises, and this spreads the right tail. This was proved correct in the
analysis, which showed that the more positive the correlation the more positively
skewed the return distributions and the fatter the right tails. Conversely, the left tail
was associated with low variance and therefore not spread out. This implied higher
prices for out-of-the-money vanilla options and lower prices for in-the-money vanillas
relative to Black Scholes prices with comparable volatility. For at-the-money calls the
price difference between Heston and Black Scholes did not differ significantly.

Since the Heston model is capable of incorporating stochastic volatility and
correlation it can fit the observed market volatility smile and thereby the surface
better. The fact that the model can fit the empirical observations better implies that
the Heston model is a better pricing model for options as opposed to the simplified
Black Scholes model.

__________________________________________________________________________
92 | P a g e

The purpose of this thesis was to price barrier options under stochastic volatility. For
this task the Heston (1993) square root model was applied. The estimated model
prices could not be compared to market-traded prices as barrier prices are not quoted.
Barrier options were particularly of interest since this type of option is sensitive to
changes in volatility, which makes them interesting to analyze when introducing
stochastic volatility. It was again seen that larger volatility of variances implied
higher peakedness and fatter tails. For the up-and-out call option it was seen that the
price under Black Scholes was higher than under Heston model for far-out-of-the-
money options only. This was due to the fatter left tail relative to the normal. The
higher Heston price was impacted by steeper return distribution and a negative skew
hence thinner right tail. This implied a higher probability of ending up just below the
barrier and thereby in-the-money. In other words; the probability of reaching high
values of the underlying is reduced, thereby the probability of hitting the barrier is
reduced.

The effects of correlation between shocks to the asset and shocks to the variance also
showed to have an impact on the price difference between the Black Scholes model
and the Heston model. It was seen from the negatively skewed return distributions
that the lower the correlation (the more skewed to the right) the higher the probability
of ending in-the-money while the probability of being knocked out is still low. This
resulted in the higher prices of up-and-out barrier options for lower (in the negative
scale) values of correlation. The opposite was true for a positive correlation effects.
Overall, it was concluded that the probability of being knocked out varied with the
level of correlations, for a given level of barrier.
In general, it can be concluded that barrier option values can be very sensitive to
changes to modeling assumptions and that stochastic volatility and correlation are
decisive factors that must be included in the model when pricing these options.

__________________________________________________________________________
93 | P a g e

As mentioned in the paper it is very difficult to find market-quoted barrier prices,
hence the application of the structured product made that had barrier options
embedded it possible to compare the theoretical prices to the market-traded prices.
The market prices of Shark Fin 09 and Aktietrappe 2012 were DKK 97.35 and DKK
102.5, respectively. It was found that the theoretical prices were DKK 98.36 and
DKK 115.57. The price difference that was found in Shark Fin 09 showed that the
Heston model priced the product almost identical to the market price.

Finally a discussion on the Heston model was presented. The findings on volatility
surfaces was that the Heston exhibited a small and fairly flat volatility smile for short
expiration relative to the empirical surface and tended to flatten somewhat out for
longer maturity. This conclusion was true for different levels of correlations, only that
a negative/positive correlation exhibited a curve in the volatility surface. Higher
levels of volatility of variance resulted in more significant smiles.

These points have shown that the Heston model, as opposed to the Black Scholes
model, is much better at reproducing more realistic return distributions and in
capturing smiles/smirk-effects in option prices.

The essential findings based on the analyses and by comparing the volatility surfaces
of market and the estimated surface were that the Heston model performs much better
than the Black Scholes model in the sense that it is capable of capturing the stochastic
volatility and the correlation effects. Also, in general it was found that the
performance of the Heston model works better for longer expirations than for shorter
expirations. It was observed that the model lacked the significant smile for
particularly short time, however, as the smile tended to flatten with maturity the
model also seemed to fit it better.
In order to sum up the conclusions on the Heston performance, the advantages and
disadvantages, respectively, are summarized in table on following page.

__________________________________________________________________________
94 | P a g e

Advantages Disadvantages
Capability of fitting market implied
volatility surface reasonably well.
Estimation of Heston parameters may
not be stable over time.
Capability of including a mean reverting
volatility. Volatility is not directly observed. As a
Allowance of to reproduce more realistic
return distributions (Non-lognormal
probability distribution)
consequence, estimation of the
parameters and the current level of
volatility is not straight forward.
Asymmetry of the distribution can be
incorporated by correlating the noise

For very short maturities good results
are not obtained.
sources.
The smile/smirk effect in option prices is
exhibited in the Heston stochastic
volatility model, where correlation
controls the skew.

The positive aspects of the Heston (1993) model show that the Heston model can be
used in practice under some restrictions. On the other hand there remain some
disadvantages and open questions. Generally, in literature this opinion is shared
amongst theorists; there is no stochastic volatility model that is generally accepted for
fitting the market-traded option prices perfectly, and if a better model is sought, one
must go beyond stochastic volatility models (Forque et al. 2000 & Gatheral 2006).

Appendices:
Appendix 1: Black & Scholes Assumptions.1
Appendix 2: Derivation of Black & Scholes2
1
by Itos Lemma..5
Appendix 4: Results of Calibration..6
Appendix 5: Explicit formulee for Barriers7
Appendix 6: Effects of Volatility of Variance on Barrier.10
Appendix 7: Effects of Correlation on Barrier..12
Appendix 8: Participation rates for Garanti Invest...14
Appendix 9: Example of Payoff in Aktietrappe 2012...15
Appendix10: Heston and Market Implied Volatilities16

2 | P a g e

Appendix 1: Black & Scholes Assumptions
The assumptions used to derive the Black Scholes Merton differention equation are as
follows:
1. The stock price follows the process
1
dW vS dt S dS
t t t t
+ =

with and constant v.
2. The short selling of securities with full use of proceeds is permitted.
3. There are no transactions costs or taxes. All securities are perfectly divisible.
4. There are no dividends during the life of the derivative.
5. There are no riskless arbitrage opportunities.
6. Security trading is continuous.
7. The risk-free rate of interest, r, is constant and the same for all maturities.

Note: some of the assumptions can be relaxed. For instance, v and r can be known
functions of t. Also interest rates can be allowed stochastic provided that the stock
price distribution at maturity of the option is still lognormal.

3 | P a g e

Appendix 2: Derivation of Black & Scholes
33

The assumptions in appendix XX involves that the market is complete. The value of the
option is given as V(S, t; , ; E, T; r) but is for simplicity denoted as V(S, t).
The derivation of the Black Scholes is given in the following:
If assumed that V(S, t) is known at time t a portfolio with value of one long position
and a short position in some quantity (delta) of the underlying:
= V(S, t) S (1.1)
where the first term shows the value of the option and second term is the short position
in the asset.
The change of the value in the portfolio from time t to t + dt partly comes from the
change in the value of the underlying and partly from change in the value of the option.
The change can be written as:
d = dV(S, t) dS (1.2)
From the assumption that the underlying follows a GBM then by Itos lemma we have:
dt
S
V
S dS
S
V
dt
t
V
dV
2
2
2 2
2
1
=
Thus the portfolio (from (1.1)) changes by
dS dt
S
V
S dS
S
V
dt
t
V
d
=
2
2
2 2
2
1
(1.3)
Next, all the deterministic terms and the risky terms are separated:
dS
S
V
dt
S
V
S
t
V
d
|
\
|

+
|
|
\
|
=
2
2
2 2
2
1
(1.4)

33
Based on Wilmott 2007, Hull 2006

4 | P a g e

The idea in the Black Scholes argumentation is now to eliminate the random terms that
represents the risk in the portfolio; i.e. the last term of (1.4). In theory (and almost in
practice) this can be done by choosing the quantity :
S
V
S
V
= |
\
|

(1.5)
This elimination of risk, by exploiting correlation between two instruments (the option
and its underlying), is called delta hedging. The quantity
S
V
, a function of the
continuously changing variables S and t, therefore also changes from one time step to
another. For this reason it is necessary to continuously rebalance the position of the
underlying asset to remain delta hedged. The portfolio held is then risk-free:
dt
S
V
S
t
V
d
|
|
\
|
=
2
2
2 2
2
1
(1.6)
If the change in portfolio in (1.6) is completely riskless then it must be, by the no-
arbitrage principle, that it yields the same amount if the equivalent amount of cash was
invested in a risk-free bearing account:
dt r d = (1.7)
The economic argument is now that if the return on the portfolio were higher than the
risk-free rate then by borrowing money from the bank, paying interest at the rate r,
invest in the risk-free option/stock portfolio and make a profit from this. The reverse
action is performed if the return on the portfolio was lesser. In either case an arbitrage
opportunity exist.
By substituting (1.1), (1.5) and (1.6) into (1.7) following is obtained and rearranged to
(1.8):
dt
S
V
S V r dt
S
V
S
t
V
) (
2
1
2
2
2 2
=
|
|
\
|

0
2
1
2
2
2 2
=
rV
S
V
S
S
V
S
t
V
(1.8)

5 | P a g e

This equation is known as the Black Scholes Pricing Differential Equation (PDE). The
price of any option, depended on S and t, will thus satisfy this equation otherwise, as
mentioned before, arbitrages will arise.

6 | P a g e

1
by Itos Lemma
34

The proof is based on Wilmott 2007 pg. 130 & Gatheral 2006 pg. 4-5.
From section X (constructing) we had that stock price S and its variance v follow SDE processes:
1
dZ S v dt S dS
t t t t t
+ =
2
) , ( ) , ( dZ v t v S dt t v S dv
t t t t t t
+ =
With dt dW dW =
2 1

where rho had to satisfy the condition: 1 1
Using Itos lemma for higher dimension (two dimensional) the evolution of V and V
1
can be
described by:
dt
v
V
v dt
v S
V
v S v dt
S
V
vS dv
v
V
dS
S
V
dt
t
V
dV
2
2
2 2
2
2
2
2
2
1
2
1
=
dt
v
V
v dt
v S
V
v S v dt
S
V
vS dv
v
V
dS
S
V
dt
t
V
dV
2
1
2
2 2 1
2
2
1
2
2 1 1 1
1
2
1
2
1
=
By applying these, the change in the portfolio
1 1
V S V =

following is then obtained:
(
=
dt
v
V
v dt
v S
V
v S v dt
S
V
vS dv
v
V
dS
S
V
dt
t
V
dS dt
v
V
v dt
v S
V
v S v dt
S
V
vS dv
v
V
dS
S
V
dt
t
V
d
2
1
2
2 2 1
2
2
1
2
2 1 1 1
1
2
2
2 2
2
2
2
2
2
1
2
1
2
1
2
1

Rewriting this by separating all the deterministic terms dts from the random terms dSs and the
dvs following is obtained:
dt
v
V
v
v S
V
Sv
S
V
vS
t
V
d
(
=
2
2
2 2
2
2
2
2
2
1
2
1

dt
v
V
v
v S
V
vS
S
V
vS
t
V
(

2
1
2
2 2 1
2
2
1
2
2 1
1
2
1
2
1

dv
v
V
v
V
dS
S
V
S
V
(
+
(
+
1
1
1
1

34
The notation is still the Gatheral notation.

7 | P a g e

Appendix 4: Results of Calibration

Date 16-03-2009 17-03-2009 18-03-2009 19-03-2009 20-03-2009 Average
Spot 2033,72 2012,25 2019,19 2039,58 2050,96
initial volatility 0,354766299 0,344471307 0,338290466 0,34229543 0,348559874 0,345676675
vol on vol 1,203304023 1,119425433 1,142934208 1,418447934 1,432204637 1,263263247
long level 0,077151366 0,085203786 0,099142282 0,135856638 0,105432828 0,10055738
mean reversion 1,588787562 1,259339273 1,26933873 1,072831741 1,070595905 1,252178642
Rho 0,454772902 0,483028318 0,509867004 0,516410974 0,450548856 -0,482925611
Deltat 0,002739726 0,002739726 0,002739726 0,002739726 0,002739726
number of simulations 10000 10000 10000 10000 10000
Dividend 0,0374 0,0374 0,0374 0,0374 0,0374
SSE 21371,68857 21830,69114 58953,26962 138703,8875 18644,8615 51900,87967
ARPE 0,069443756 0,072789947 0,09776004 0,127538095 0,058964145 0,085299196

8 | P a g e

Appendix 5: Explicit formulee for Barriers
In the following N() is used to denote the cumulative distribution function for a
standardized Normal variable, and S
b
is the barrier position (whether S
u
or S
d
is obvious
from the example). The dividend yield on stocks is denoted by q and is zero in this
thesis. The prices of barrier options are then given by the following:
Up-and-out Call:
( ) ( ) )) ( ) ( ( ) ( ) ( )) ( ) ( ( ) ( ) (
7 5 4 2
) (
8 6 3 1
) (
d N d N a d N d N Ke d N d N b d N d N Se
t T r t T q

Up-and-in Call:
( ) ( ) )) ( ) ( ( ) ( )) ( ) ( ( ) (
7 5 4
) (
8 6 1
) (
d N d N a d N Ke d N d N b d N Se
t T r t T q
+ +

Down-and-out Call:
1. K > S
b
:
( ) ( ) )) ( 1 ( ) ( )) ( 1 ( ) (
7 2
) (
8 1
) (
d N a d N Ke d N b d N Se
t T r t T q

2. K < S
b
:
( ) ( ) )) ( 1 ( ) ( )) ( 1 ( ) (
5 4
) (
6 3
) (
d N a d N Ke d N b d N Se
t T r t T q

Down-and-in Call:
1. K > S
b
:
( ) ( ) )) ( 1 ( )) ( 1
7
) (
8
) (
d N a Ke d N b Se
t T r t T q

2. K < S
b
:
( ) ( ) )) ( 1 ( ) ( ) ( )) ( 1 ( ) ( ) (
5 4 2
) (
6 3 1
) (
d N a d N d N Ke d N b d N d N Se
t T r t T q
+ +

Down-and-out put:

9 | P a g e

( ) ( ) )) ( ) ( ( ) ( ) ( ) ( ) ( ( ) ( ) (
5 7 2 4
) (
6 8 1 3
) (
d N d N a d N d N Ke d N d N b d N d N Se
t T r t T q
+

Down-and-in put:
( ) ( ) )) ( ) ( ( ) ( 1 ) ( ) ( ( ) ( 1
5 7 4
) (
6 8 3
) (
d N d N a d N Ke d N d N b d N Se
t T r t T q
+ + +

Up-and-out put:
1. K > S
b
:
( ) ( ) ) ( ) ( 1 ) ( ) ( 1
5 4
) (
6 3
) (
d aN d N Ke d bN d N Se
t T r t T q
+ +

2. K < S
b
:
( ) ( ) ) ( ) ( 1 ) ( ) ( 1
7 2
) (
8 1
) (
d aN d N Ke d bN d N Se
t T r t T q
+

Up-and-in put:
1. K > S
b
:
( ) ( ) ) ( ) ( ) ( ) ( ) ( ) (
5 2 4
) (
6 1 3
) (
d aN d N d N Ke d bN d N d N Se
t T r t T q
+ + +

2. K < S
b
:
( ) ) ( ) (
7
) (
8
) (
d aN Ke d bN Se
t T r t T q
+

Where a and b are given by:
2
) ( 2
1
q r
b
S
S
a

+
|
\
|
=

2
) ( 2
1
q r
b
S
S
b

+
|
\
|
=

and where d
1
to d
8
is given by:
|
|
\
|
+ +
=
) (
) ( ( ) / log(
2
1
t T
t T q r K S
d

10 | P a g e

|
|
\
|
+
=
) (
) ( ( ) / log(
2
2
t T
t T q r K S
d

|
|
\
|
+ +
=
) (
) ( ( ) / log(
2
3
t T
t T q r S S
d
b

|
|
\
|
+
=
) (
) ( ( ) / log(
2
4
t T
t T q r S S
d
b

|
|
\
|

=
) (
) ( ( ) / log(
2
5
t T
t T q r S S
d
b

|
|
\
|
+
=
) (
) ( ( ) / log(
2
6
t T
t T q r S S
d
b

|
|
\
|

=
) (
) ( ( ) / log(
2 2
7
t T
t T q r S SK
d
b

|
|
\
|
+
=
) (
) ( ( ) / log(
2 2
8
t T
t T q r S SK
d
b

11 | P a g e

Appendix 6: Effects of Volatility of Variance on Barrier

=0,1 =0,4 =0,7 =1.14 BS
Difference
btw
v=0.1
and BS
Difference
btw
calibrated
and BS
500 0,00619 0 0 0 0,294132 -0,28794 -0,29413
600 0,098187 0,02135 0,002169 0 1,052581 -0,95439 -1,05258
700 0,618577 0,173891 0,085813 0,100563 2,819379 -2,2008 -2,71882
800 1,956289 0,700661 0,47853 0,507484 6,182374 -4,22608 -5,67489
900 4,594944 2,123711 1,474654 1,466306 11,72552 -7,13058 -10,2592
1000 9,158545 5,295883 3,813346 3,613919 19,93684 -10,7783 -16,3229
1100 16,55185 11,03834 8,14158 7,133478 31,1443 -14,5925 -24,0108
1200 27,50397 20,41694 15,46686 12,87032 45,48453 -17,9806 -32,6142
1300 42,1448 33,9488 26,75325 22,53834 62,89995 -20,7552 -40,3616
1400 62,69032 52,80698 43,17734 33,01096 83,15682 -20,4665 -50,1459
1500 83,7161 75,87847 64,8356 51,03824 105,8759 -22,1598 -54,8377
1600 111,7173 106,3084 93,77473 76,27499 130,569 -18,8517 -54,294
1700 143,6406 140,5342 125,1797 105,8741 156,6763 -13,0357 -50,8021
1800 178,8919 177,3628 165,9407 144,5224 183,6008 -4,70896 -39,0785
1900 212,3297 218,8167 208,9516 184,6686 210,739 1,590713 -26,0704
2000 248,0156 257,1743 251,8702 235,8765 237,5049 10,51071 -1,62836
2100 286,0994 306,4863 307,5947 291,5764 263,3498 22,74962 28,22665
2200 325,8132 352,2912 353,6776 347,6612 287,7755 38,03771 59,88571
2300 362,6435 393,6801 407,5942 409,9202 310,3442 52,29928 99,57606
2400 398,8306 439,5664 462,1098 463,7978 330,6826 68,14798 133,1151
2500 427,2341 476,0616 511,1231 524,505 348,4849 78,74925 176,0201
2600 447,8525 509,6458 552,843 582,6058 363,511 84,3415 219,0948
2700 471,3225 538,8463 599,3266 638,5715 375,5846 95,73787 262,9868
2800 494,4046 566,0479 627,6975 683,3665 384,589 109,8156 298,7775
2900 516,1936 586,5155 658,6329 734,9601 390,4615 125,7321 344,4986
3000 522,772 597,5005 685,4046 771,6726 393,1889 129,5831 378,4838
3100 530,9215 608,1612 702,0805 809,285 392,8006 138,1209 416,4844
3200 528,2517 599,2883 690,348 832,2334 389,3636 138,8881 442,8698
3300 523,9913 597,6863 696,3124 842,4525 382,9764 141,0149 459,4761
3400 528,3695 594,8777 701,9123 841,2372 373,7636 154,6059 467,4736
3500 502,7566 564,2429 675,9495 834,7735 361,871 140,8856 472,9025
3600 490,0865 542,6871 652,4131 830,3054 347,4608 142,6257 482,8446
3700 476,3229 527,7329 623,9801 811,3568 330,7076 145,6153 480,6492
3800 453,5114 495,6872 587,3156 768,9951 311,7944 141,7169 457,2007
3900 427,5272 465,907 552,6615 723,9625 290,9095 136,6176 433,053
4000 393,0581 428,0581 509,2324 668,7746 268,2436 124,8145 400,531

12 | P a g e

4100 365,253 396,3304 455,4596 612,8817 243,9871 121,2659 368,8946
4200 329,5586 355,1669 413,5707 549,7322 218,3284 111,2303 331,4038
4300 290,4881 309,5634 360,679 472,5243 191,4517 99,03646 281,0727
4400 252,7924 273,2125 310,5066 409,7541 163,5359 89,25655 246,2182
4500 211,7515 225,0249 256,6275 334,9282 134,7534 76,9981 200,1748
4600 172,2597 181,2977 204,5818 258,9485 105,269 66,99068 153,6795
4700 127,3962 129,1651 148,3367 194,4131 75,23952 52,15669 119,1736
4800 85,96542 86,59242 96,37305 125,0804 44,81294 41,15248 80,26743
4900 47,43664 48,1775 54,56763 67,18398 14,1284 33,30824 53,05558
5000 19,03118 20,04876 22,57487 27,73394 0 19,03118 27,73394

13 | P a g e

Appendix 7: Effects of Correlation on Barrier

=-0,7 =0 =0.5 =-0.46996 BS
Difference
btw
calibrated
and BS
Difference
btw =0
and BS
Difference
btw =0.5
and BS
500 0 0,71255 2,65752 0 0,294132 -0,29413 0,418418 2,36338854
600 0 1,655432 3,155782 0 1,052581 -1,05258 0,602851 2,10320084
700 0 2,936781 6,363181 0,117196101 2,819379 -2,70218 0,117403 3,54380275
800 0,001001 6,190831 8,997952 0,552207747 6,182374 -5,63017 0,008458 2,81557833
900 0,123715 7,979334 11,79799 1,602562726 11,72552 -10,123 -3,74619 0,072473
1000 0,524455 13,87032 15,98814 3,622772457 19,93684 -16,3141 -6,06652 -3,9486944
1100 1,670474 18,54905 20,67192 7,053566513 31,1443 -24,0907 -12,5953 -10,472383
1200 4,246572 25,57353 28,39427 12,51271515 45,48453 -32,9718 -19,911 -17,09026
1300 8,870869 30,58729 33,63162 20,00854725 62,89995 -42,8914 -32,3127 -29,268329
1400 17,53184 43,78113 43,39301 32,20753309 83,15682 -50,9493 -39,3757 -39,763811
1500 32,22457 59,38444 53,41975 49,97893509 105,8759 -55,897 -46,4915 -52,456161
1600 54,77847 74,91263 65,88038 72,96095766 130,569 -57,6081 -55,6564 -64,688636
1700 87,25052 98,93304 82,99575 103,4153595 156,6763 -53,2609 -57,7432 -73,680524
1800 127,5364 125,4853 100,4325 138,5917395 183,6008 -45,0091 -58,1156 -83,168271
1900 179,1999 154,8867 118,6145 179,817768 210,739 -30,9212 -55,8523 -92,124481
2000 237,826 190,3765 134,666 232,535567 237,5049 -4,96932 -47,1284 -102,83888
2100 299,7311 224,0226 156,3265 286,8309713 263,3498 23,48122 -39,3272 -107,0233
2200 369,3624 266,7306 181 345,4991923 287,7755 57,72365 -21,045 -106,77552
2300 437,0053 310,6093 206,7991 405,5870342 310,3442 95,24286 0,265128 -103,54511
2400 508,8811 353,255 237,7565 465,6250505 330,6826 134,9424 22,57236 -92,926169
2500 581,8959 392,8088 262,2973 522,8341981 348,4849 174,3493 44,32387 -86,187628
2600 653,5972 436,4966 296,4009 579,7976471 363,511 216,2867 72,98564 -67,110132
2700 720,1679 477,5134 332,2499 642,6090377 375,5846 267,0244 101,9288 -43,334729
2800 790,1862 518,13 369,7397 697,7098921 384,589 313,1209 133,5411 -14,849265
2900 847,5155 556,9597 404,2092 742,4578633 390,4615 351,9963 166,4982 13,7476941
3000 911,3845 590,9535 437,503 782,9358623 393,1889 389,747 197,7646 44,314135
3100 948,2576 617,9218 474,5432 828,6305923 392,8006 435,83 225,1212 81,7426569
3200 984,6504 641,8973 495,0592 857,865472 389,3636 468,5019 252,5337 105,695541
3300 1014,709 661,9516 513,1561 865,3909905 382,9764 482,4146 278,9752 130,179712
3400 1015,321 676,1599 541,8158 880,1289296 373,7636 506,3653 302,3963 168,05216
3500 1005,59 690,5011 555,96 876,1731882 361,871 514,3022 328,6301 194,089032
3600 982,3146 689,0286 568,4966 867,3899452 347,4608 519,9291 341,5677 221,035813
3700 942,7849 682,3429 575,1767 838,074694 330,7076 507,3671 351,6353 244,469125
3800 903,2123 676,4743 578,5829 800,9573589 311,7944 489,1629 364,6799 266,788475
3900 827,169 657,9338 573,1384 764,2747127 290,9095 473,3652 367,0243 282,228871
4000 760,3133 628,9092 564,1865 707,8442556 268,2436 439,6007 360,6656 295,942893

14 | P a g e

4100 675,6 594,4957 542,3227 643,9473651 243,9871 399,9602 350,5086 298,335606
4200 585,4648 545,4892 515,0453 583,6451349 218,3284 365,3168 327,1608 296,716948
4300 497,2049 498,9304 482,3095 506,8735776 191,4517 315,4219 307,4788 290,857888
4400 404,5479 446,6158 440,5191 425,258177 163,5359 261,7223 283,0799 276,983256
4500 341,4911 374,9081 388,7015 355,3581752 134,7534 220,6048 240,1547 253,948077
4600 258,8274 302,2788 327,0393 276,4048154 105,269 171,1358 197,0098 221,77029
4700 183,1648 232,3064 259,8863 207,5679524 75,23952 132,3284 157,0669 184,646791
4800 120,3379 160,4209 180,7339 131,0398089 44,81294 86,22687 115,6079 135,921008
4900 64,56859 86,67071 103,4146 71,16302423 14,1284 57,03462 72,54231 89,2861544
5000 22,30301 36,77028 42,90423 27,96437865 0 27,96438 36,77028 42,9042345

15 | P a g e

Appendix 8: Participation rates for Garanti Invest
Tabel A1.1: Deltagelsesgrader for Garanti Invests produkter
Navn/Indekskatagori Deltagelsesgrad
Ejendomsindeks
Tyske Ejendomme 2006-2012 100,00%
Geografisk indeks
Europiske Aktier 2007-2012 100,00%
Asiatiske Aktier 2007-2012 100,00%
Tyske Aktier 2006-2011 100,00%
Danske Aktier II 2006-2011 100,00%
Danske Aktier 2006-2011 100,00%
Europa 2004-2009 105,00%
Japan Super 2004-2008 152,40%
Japan Basis 2004-2008 103,70%
Norden Top30 Super 2004-2009 112,00%
Norden Top30 Basis 2004-2009 83,00%
Kina & Japan Super 2003-2008 98,00%
Kina & Japan Basis 2003-2008 73,00%
Markedsindeks
Bedst-af-3 III 2007-2012 100,00%
Bedst-af-3 II 2006-2011 100,00%
Bedst-af-3 2005-2010 100,00%
Rvareindeks
AGRO 2007-2010 100,00%
Industrimetaller 2007-2009 100,00%
WTI Rolie 2007-2008 *
Renteindeks
FIRST Super 2005-2010 1285,00%
FIRST Basis 2005-2010 825,00%
Valutaindeks
US Dollar Basis 2008-2010 80,00%
US Dollar Extra 2008-2010 120,00%
Hjrente Valuta III 2008-2009 169,00%
BRIK Valuta 2007-2009 100,00%
Bedst-af-3 Valuta Super 2007-2009 245,00%
Bedst-af-3 Valuta Basis 2007-2009 135,00%
Tyrkiske Lira II Super 2006-2009 100,00%
Tyrkiske Lira II Extra 2006-2009 100,00%
Islandske Kroner 2006-2009 100,00%
Latinamerika 2006-2008 100,00%
Brasilianske Real Super 2005-2009 400,00%
Brasilianske Real Extra 2005-2009 100,00%
Tyrkiske Lira Extra 2005-2008 162,00%
Tyrkiske Lira Basis 2005-2008 170,00%
Sektorindeks
Infrastruktur 2007-2011 100,00%
Alternativ Energi 2007-2011
Source: Garanti Invest (2009) and own contribution
Note: The participation rates are collected from the Danish Garanti Invest web-site the 16th of June 2009 and only
include active structured products.

16 | P a g e

Appendix 9: Example of Payoff in Aktietrappe 2012

17 | P a g e

Appendix 10: Heston and Market Implied Volatilities

The Heston and Market implied volatilities are based on 16
th
of March data.

Heston implied volatilities

Time to maturity

Moneyness 0,26 0,76 1,26 1,76 2,25 2,75
0,96 0,537 0,452 0,405 0,380 0,367 0,383
0,98 0,530 0,446 0,400 0,376 0,364 0,380
1,01 0,523 0,440 0,396 0,372 0,361 0,378
1,03 0,517 0,434 0,391 0,369 0,358 0,376
1,06 0,511 0,430 0,388 0,366 0,355 0,373
1,08 0,505 0,425 0,384 0,363 0,353 0,371
1,11 0,501 0,422 0,381 0,360 0,350 0,369
1,13 0,497 0,418 0,379 0,358 0,348 0,367
1,16 0,493 0,415 0,376 0,355 0,346 0,366
1,18 0,490 0,413 0,374 0,353 0,344 0,364
1,20 0,487 0,410 0,372 0,352 0,342 0,362
1,23 0,485 0,409 0,370 0,350 0,341 0,361
1,25 0,483 0,407 0,369 0,349 0,339 0,359
1,28 0,482 0,406 0,368 0,347 0,338 0,358
1,30 0,481 0,406 0,366 0,346 0,337 0,357
1,33 0,480 0,405 0,366 0,345 0,335 0,356
1,35 0,480 0,405 0,365 0,344 0,334 0,355
1,38 0,480 0,406 0,364 0,343 0,333 0,354
1,40 0,479 0,406 0,364 0,342 0,333 0,353

18 | P a g e

Market implied volatilities

Time to maturity
Moneyness 0,26 0,76 1,26 1,76 2,25 2,75
0,96 0,471 0,410 0,388 0,367 0,356 0,343
0,98 0,469 0,406 0,384 0,363 0,352 0,340
1,01 0,469 0,402 0,381 0,360 0,349 0,337
1,03 0,470 0,399 0,378 0,356 0,346 0,334
1,06 0,473 0,397 0,376 0,353 0,343 0,331
1,08 0,477 0,395 0,373 0,350 0,341 0,327
1,11 0,485 0,393 0,371 0,347 0,338 0,325
1,13 0,493 0,393 0,370 0,344 0,336 0,322
1,16 0,504 0,392 0,369 0,341 0,333 0,319
1,18 0,516 0,393 0,368 0,339 0,331 0,316
1,20 0,530 0,395 0,367 0,337 0,329 0,314
1,23 0,544 0,397 0,367 0,335 0,328 0,311
1,25 0,560 0,399 0,368 0,334 0,326 0,309
1,28 0,577 0,403 0,369 0,333 0,324 0,307
1,30 0,595 0,407 0,370 0,332 0,323 0,305
1,33 0,613 0,411 0,372 0,331 0,322 0,303
1,35 0,631 0,416 0,374 0,331 0,321 0,301
1,38 0,650 0,422 0,376 0,331 0,320 0,299
1,40 0,668 0,428 0,379 0,331 0,320 0,298

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= ) ( , where and are drift and volatility functions from

= ) ( is the market price of volatility risk which

is independent of others is used. These increments are

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