Week 1: Introduction to Derivatives

Underlying assets:
1. Equities
2. Currencies
3. Bonds and interest rates
4. Commodities

Payoff structure (vanilla derivatives):

 Forward/future contracts- obligation to buy/sell
 Call options- right to buy
 Put options- right to sell
 Swaps- exchange of cashflows
EXTRA: Exotics- less common and more complicated derivative securities (e.g., lookback options and
compound options).

Uses for derivatives:

Hedging and risk management: remove or reduce risks associated with economic activities or investment
portfolios to get certainty of income.
Making bets/speculation: Gain exposure to certain risks.

Hedging example
You need loads of oil in a year. You are concerned the price of oil will rise. And thus, the cost of the
purchase that you must make.
Strategy:
 Buy an oil forward/future with a maturity equal to 1 year
 The forward obliges you to purchase oil at a price fixed today on the maturity date
 As the forward price is fixed today, your purchase cost is locked in
 It doesn’t matter what the market price of oil does in the future, that doesn’t affect your purchase
price.
Result: you’ve eliminated any risk coming from the need to have to purchase oil.

Speculation example
You think that orange prices are going to increase over the next 3 weeks. You want to bet on this view.
 Buy some call options on oranges with maturity of 3 weeks.
 The option position allows you to purchase an orange, at a price agreed today, precisely 3 weeks
from now
 The option position costs some money today (not given choice to buy for free)
 As the purchase price is fixed today, if the price of oranges rises dramatically, in 3 weeks you can
buy at the agreed price and make some money.
 You make a profit equal to the difference between the market price in three weeks and the purchase
price written into the option, less the amount you have to pay in order to enter the option.
Result: you’ve taken a bet which pays off the price if oranges go up substantially.

Size of derivatives markets- HUGE!!!! THESE MARKETS ARE LARGER THAN UNDERPLYING
MARKETS AND ARE VERY IMPORTANT
250TRILLION EUROS

Exchange traded Vs Over the counter?

Over The Counter fit contract to your needs while ETD might fit badly
Exchange Traded Derivatives will be more liquid because they are standard and publicly traded

Examples

 Future contract: enter into a contract today which obliges you to buy or sell something at a specific
future date for a price that is fixed today.

CME BRITISH POUND FUTURES

o Go long on 1 contract and you're committing to buy GBP 62,500 at today’s futures price in USD
($1.1795 X 62500). With delivery and payment on specific date.

 Option contract: right to buy or sell at or before specific future date, for a price that is fixed today
called the strike price or exercise price. The cost to enter an option that must be paid today is called
the premium.

CME Sep 22 GOLD OPTION CONTRACTS

o Go long on 1 contract and you're purchasing the right to buy 100 ounces of gold on or before end of
Sep 2022 for a specific price called the strike price.

 Swap contract: two parties fix a notional sum and agree to swap monthly interest payments on the
notional for some pre-determined period. One party will pay a fixed interest rate (swap rate). The
other party pays a market determined floating interest rate.
o Why would you want to trade a swap?
Speculation: If you have a strong belief unlike the rest of the market that 3m LIBOR is going up
sharply in the next year or 2, then enter a 2-year interest rate swap where you pay fixed and
receive 3m LIBOR. If you are right, you'll make money.
Hedging: you currently have a 5-year bank loan. You're worried that 3m LIBOR is going up
sharply. Enter into a 5-year swap where you received 3m LIBOR and pay fixed. If LIBOR rises,
your gains on the swap offset your losses due to the increased payments on the loan.
Week 2: Forwards and Futures

Forwards and futures are very similar in terms of payoff. If held to maturity, both deliver a total
payoff equal to the difference between the underlying price at the delivery date and the agreed
delivery price.

Future contract: Obligation to buy or sell the underlying at a specific date and time in the future.
Standardised contracts which are traded in centralised markets. The exchange guarantees payment for
both parties so that counterparty default risk is not a concern (they are liquid). To protect themselves,
exchanges demand initial margin when a trader opens a new position, and additional margin (margins
calls) when they make losses on existing positions. This aims to ensure that traders have already posted
margin greater than their losses, so they have no incentive to default on a loss-making position.

Forward contract: Obligation to buy or sell the underlying at a specific date and time in the future. Non
standardised contracts that are customised based on the requirements of the parties. They are traded over
the counter. Nonexchangeable.

Forwards vs Futures contracts

Forwards Futures
Private contract between two parties (Over the Exchange traded (More liquid)
counter)
Non-standardised Standardised
Client can specify delivery date Limited choice of dates
Settled at the end of contract Settled daily (marking to market)
Some credit risk Virtually no credit risk

Profits from Long and Short positions (same for forward and futures)

Profit from a long forward/futures position

(Buy underlying)

Payoff= ST - F
F= agreed price
T= maturity date
S= Spot price

Profit from a short forward/futures position

(Sell underlying)

Payoff= F- ST
Negative of the payoff for long position
Futures in more detail
Marking to market money changes hands throughout the contract lifetime. The gains/losses are
exchanged daily. It requires the following:
 Margin account: account holding monies deposited by a party to a futures contract
 Initial margin: initial amount the party must deposit in the margin account when the contract is
opened
 Variation: as the market price of the future contract changes, the balance in the margin account is
altered
 Maintenance margin: If the balance in the margin account falls below the maintenance margin, the
party must top up the balance in the account to the initial margin. This is called a margin call.

Example Future price Monthly Change Margin balance Margin

call
Contract size= 100oz
1500 0 2500 0
Future price= $1500 per oz 1498.40 -160 2340 0

Maturity= 5 months 1494.60 -380 1960 +540

Initial margin= $2500 1492.80 -180 2320 0

1487.90 -490 1830 +670
Maintenance margin= $2000
1491.20 +330 2830 0
In one month, the price of the future has
dropped to $1498.40. Given the 100oz contract size, this makes a total loss of (1500x100) -(1498.40x100)
= $160
 The $160 loss is deducted from the speculators margin account and transferred to the seller’s
margin account. The seller makes a profit here as they are selling at a fixed price, higher than the
current underlying price. The speculator makes a loss because they are buying at a higher price
than the market underlying price.
The following month the market price of the future drops to $1494.60 which is a total loss of (1498.40x100)
-(1494.60x100) =$380
 The $380 loss is deducted and now the margin account is less than $2000, thus the investor is
required to top up the balance to the initial margin of $2500.

Speculators total cashflows--> The investor must pay the final futures price of $1491.20 per oz of gold.
Gains= 330
Losses= (540+670) =1210

At maturity pays final futures price of $1491.20 per oz. Thus, total expenditures= 100 x 1491.20 +1210 -
330=$150000

Key advantage of marking to market- by spreading the $150,000 payment over time, the problems
associated with one of the counterparties defaulting on their obligations is reduced. E.g., if the speculator
went bankrupt on the day before delivery, then his counterparty would still have received the gains/losses
due to the margin account.

Arbitrage: an arbitrage opportunity is said to exist when one can construct one of the following:

 A portfolio with zero set-up cost (i.e., a zero-price portfolio) but a chance of positive subsequent
payoffs (and no chance of a negative payoff).
 A portfolio with a negative set-up cost and zero payoffs thereafter.

However, when this occurs, supply and demand change and causes both the prices of the commodity to be
the same.

Example:
> or <
1. When the 4 components are cheaper than the overall price of a happy meal, then there is arbitrage.
We can pretend the 4 components is a replicating portfolio of the happy meal, and we can make a
profit by selling them at the same price of the happy meal.

2. When the 4 components are more expensive than the happy meal, we can buy a happy meal, and
sell each component separately in a different market to make a profit.

Investors= arbitrageurs
 We assume that investors are smart (i.e., greedy) enough to see any arbitrage opportunities and
take them.
 Buy cheap and sell expensive
 This will tend to raise the prices of the cheaper assets and reduce those of the expensive securities
and thus reduce the scope for arbitrage.
 However, they reduce the scope of arbitrage, causing equilibrium.

Pricing by absence of arbitrage:

In practice, we do the following…
 We want to price asset Z
 Form a portfolio of other assets which has identical payoff structure to Z. Crucially, the prices of
these other assets are known. Call this a replicating portfolio
 No-arbitrage says that because the payoffs of Z and the replicating portfolio are the same, their
prices must be the same.
 As we know the price of the replicating portfolio, we can infer the price of Z.

Implications of absence of arbitrage

Law of one price= If 2 portfolios have the same payoffs then they must have the same price
Law of payoff dominance= If portfolio A guarantees a payoff at least as great as portfolio B, then A must
command a greater price than B.

No Cashflow Forward Price

T= time to maturity
S= current price of underlying
ST= underlying price at maturity
F= delivery price
rT= T-period spot rate

1. Construct replication portfolio that replicated payoff from long forward by assuming that T-year zero
coupon bonds exists with face value £1.
2. Replicating portfolio: buy one unit of stock and sell F T -year zero-coupon bonds. The costs and
payoffs of the forward and the replicating portfolio are

Cost of forward at time0 = 0

Cost of replicating at time0 = S- F/(1+rT) ^T

Hence price of replicating portfolio is equal zero too.

No arbitrage forward price on an asset that pays no dividends or coupons is

If the forward price was any different from this value an arbitrage opportunity would be available.

Convergence of futures and spot prices

Result: as we get close to the delivery date for a futures contract, the futures price will converge towards
the underlying price.
Intuition: consider a futures contract with a tiny amount of time to delivery. It is essentially a spot contract
(i.e., a contract for immediate delivery) and so the futures price should equal the spot price.
Mathematical justification: what happens to F as the time to delivery (T) goes to zero in the equation
below?

More formal argument: assume that, just before the delivery period, the futures price (F) is below the spot
price of the asset (S). Then you can;
 Go long the future with delivery price F
 Go short the asset, yielding S.
 At delivery, use the funds from the short sale to settle the future and take delivery of the asset
 This leaves you with cash of S−F
 Take the asset delivered and close out the short position
Thus, if the futures price is below the spot price, you can lock in a profit and the same is true is the futures
price is above the spot price.

Week 3: Advanced futures pricing

Price of forward contract (no-arbitrage):

 This is essentially the future value of the current underlying price.

 A price any other than F means that you are giving arbitrageurs the chance to make money. You
would be exploited by the rest of the world.

Price of forwards vs future if interest rate varies over time:

Assume positive correlation between S and interest rate i.e., Cov (r, S)>0
 When S goes up interest rate is high
 When S goes down interest rate is low

Assume you are long futures contract:

1. In 1 month, S goes up. Cash flows into your margin account, but at the same time interest rates go
up. Therefore, you can invest the money from your margin account at a high rate.
2. In 1 month, S goes down. Cash flows out of margin account, so interest rates go down. This loss
you are making in your margin account you can finance that at a low rate.
Thus, a future is more valuable, in this positive correlation situation, it is valuable to future holder. Negative
Cov (r, S) is damaging to future holder.
The holder of a forward contract doesn’t get any of the above benefits, so the forward price is likely to be
lower than the futures price. This effect is likely to be small for short maturity contract.

Other factors that might causes prices to differ are:

 Liquidity: Futures more liquid
 Default risk: Futures less default risk
 T-costs: Futures contracts lower transaction costs

Pricing forward contract of underlying (stocks and bonds) that pays coupons or dividends
of known income (no arbitrage):
The cashflows affect the no-arbitrage delivery price.
Financial asset with current price S. We want to know the no arbitrage price of a forward contract with T
periods to delivery. The underlying will pay a PV cashflow equal to I.

The no arbitrage delivery price:

 So (S - I) is the underlying price minus the PV of cashflows.

 The income paid to holder of underlying, reduces the delivery price.
 When income is set to 0, we are back to the original formula we saw last week.

Proof of this no arbitrage price (using replicating portfolio):

We wish to replicate the forward contract, which costs nothing to enter and has payoff of ST - F
Replicating portfolio: Buy one unit of the underlying and sell F + I(1+rT) ^T zero coupon bonds with maturity
T (borrow F + I(1+rT)^T amount of money today).

I = PV of cash flows
I(1+rT) ^T= Future value of I at maturity

Example:
We want to compute the no-arbitrage price for a 6 month forward on a coupon bond which has many years
to maturity. The bond will pay a coupon of $50 in 3 months from now and is currently prices at $980.
Assume that the interest rate is 5% annually.

First compute PV of income:

Then compute the delivery price:

Pricing forward contract of underlying (stocks and bonds) that pays coupons or dividends
of unknown income (no arbitrage):
 Need to predict the cash flows
 People can disagree on flows of dividends

Pricing forward contract of underlying (commodities) that cost money to store and
safeguard or have use in production and consumption that gives them value outside of a
speculative value (no arbitrage):
The cashflows affect the no-arbitrage delivery price.

Storage commodities
 U= Storage costs--> inflate the delivery price

Consumption/production commodities
 Has storage costs (U)
 Holders of the commodity are reluctant to sell as they are valuable in productive activities:
o This means holders of the commodity want to hold stock of it to ensure continuity of their
production process.
o We call the value of having physical stock of a commodity on hand the convenience yield.
o The convenience yield will be high if the commodity is predicted to be short in supply and
vice versa.
o Think of the convenience yield as an income stream from holding a commodity, but it doesn’t
arrive as cash.
 Y= convenience yield

The convenience yield balances the equation.

Pricing futures in continuous time (stock index futures):

Compounding and discounting in continuous time--> if r is the continuously compounded discount rate, then
the PV of a cashflow X to be received in T periods is:

Similarly, the future value of a current cashflow Y if it is invested at rate r for S years is:
We assume that dividends are paid at a constant rate across time.
 q= rate at which income is paid, expressed as a percentage of the underlying price
 If q= 0.05 then income yield is 5%

 If q=0 the futures price is a continuously compounded value of the spot price. A positive income
yield reduces the futures price.

Example:

Risk free interest rate= 10% per annum with continuous compounding
Dividend yield= 4% per annum
Index price= 400
Price of future in 4 months= 405

What arbitrage opportunities does this create?

400e^(0.1-0.04) x4/12= $408.08

The 4-month future is $405 which is lower than the no arbitrage price so there is opportunity to make a
profit.

 We can buy the index future (buy at $405) in 4 months by entering into contract today
 And short the underlying index (sell at $408.08) when the contract is settled

The profit is $3.08.

Pricing currency forwards:

When you buy FX, you can put it in a foreign bank account and earn interest.
S= current exchange rate
FT= forward exchange rate with maturity T (domestic currency price of a unit of FX)
rT= T period domestic spot rate
rf, T= T period foreign spot interest rate

How to set up no arbitrage (assume banks are risk free): Construct two portfolios both of which are risk free
and both which cost one unit of domestic currency. For simplicity think of the domestic currency as GBP
and the foreign currency as JPY.
 A: take your GBP 1 and place it in a GBP bank for T periods
 B: take your GBP 1 and convert it to JPY at the spot exchange rate, place the money in a Japanese
bank for T periods, today enter into a forward contract to sell the JPY for GBP T periods in the
future
No arbitrage currency forward price/covered interest rate parity:

Week 4: Futures: Hedging

You can exploit the fact that underlying, and futures price movements are correlated. The correlation allows
you to build a portfolio of underlying and futures that has lower risk than the underlying alone. This is a
hedged position. Correlation doesn’t have to be 'perfect'.

Therefore, spot and future/forwards prices are perfectly correlated

Static hedge (short hedge)
Long a non-income paying stock, X, currently prices at $100. You want to hedge the 3-month price move in
the stock and a futures contract exists with 3 months to maturity. The risk-free rate is currently 1% and so
the no arbitrage futures price is:

Hedging strategy: short the 3-month futures contract and close out the futures contract just before expiry
(so you don’t have to make delivery).

Some scenarios:
Assume that underlying price drops to $80 in 3 months.
 You’ve lost $20 on your stock position
 You’ve gained money on your short futures position (The gain is 100.25-80=20.25)
 Your total gain is -20+20.25=0.25
 The final value of your portfolio is

If the underlying price rises to $125 in 3 months

 You gain $25 on your stock position
 You lose money on your short futures position (The loss is 125-100.25=24.75)
 The total gain is 25-24.75=0.25
 The final value of your portfolio is

Overall: you’ve removed any substantial profit or loss form your position and your final portfolio value is
100.25 in each scenario.
Long hedge
You're going to receive a cash inflow to your fund in 3 months that you will buy stock with. You're
concerned that stock will become more expensive over the next 3 months. The current stock price is $100,
and you have access to a 3-month futures contract.

Again, assume that interest rates are 1% per annum so that the futures price on this stock is $100.25.
Hedging strategy: go long the futures contract, locking in the price at which you can buy stock in 3 months
at the current futures price.

Cross hedges
An airline will purchase jet fuel in 1 month and is concerned that the price of jet fuel will rise. They do not
have access to a jet fuel futures contract, but there is a heating oil future with 1 month maturity.
 They buy the future as a hedge as the underlying is positively correlated
 The effective cashflow in 1 month is:

This tells us that there is an additional dimension of risk here: the difference between prices of heating oil
and jet fuel on delivery date. This means that our hedge is imperfect and large volatility in that price
difference could mean a rather ineffective hedge.

Rolling hedges
You're holding gold at the end of sept 2022 and wish to sell it at the end of July 2023. Gold futures are
available with March, June, Sep, Dec expiries each year. You will use these futures to hedge. Shortest
maturity is the most liquid.

 Often only the nearest expiry contract is liquid enough to trade cheaply. Given this, you decide to
build a rolling hedge.
 As you are long, you hedge by shorting the futures contract.
 Go short the Dec 2022 future immediately.
 Near the end of Dec, close your Dec 22 futures position and open a short Mar 23 position of the
same size.
 Towards the end of June 23 either close your short futures position and short June 23.
 At the end of June 23 either close your futures position altogether or roll the hedge into the Sep
contract (and sell it at the end of July).
Hedging advice
 When you're long the underlying then hedge by shorting the future and vice versa.
 Choose the futures with which to hedge an asset by maximising correlation between changes in the
asset price and changes in the futures price.
 If possible, find a future that is written on the asset itself.
 If you're hedging for a short period, then choose a future with a maturity that is slightly bigger than
the hedge horizon, and close out 1 month before maturity.
 For long term hedges, choose liquid hedging instruments and roll them over if need be.
 Hedges may require cash (through margin calls) so make sure you have some available.

Minimum variance hedging

How to work out the size of a hedge that works in situations of perfect and imperfect hedging.

Setup: We are long an equity portfolio with total investment Vs. To hedge risk in this asset you take position
in FTSE futures contract. Each future has a cash value of VF and we will buy NF contracts. The total profit or
loss of out hedged portfolio over the period of the hedge is:

Where Rs is the return on the asset and RF is the return on the future.
Goal: we wish to choose NF to minimise the risk, measured by the variance of our P&L.

Variance of the profit (Pi)

Interpretation:
 The first term is the ratio of the size of the position of the asset to be hedged to the size of the
futures contract.
 The second term is a slope coefficient from a regression of the asset return on the futures return.
o So, if that slope coefficient was 1.0 then the size of the hedge would be entirely driven by the
relative size of asset position and futures contracts.
o As the slope coefficient moves away from 1.0, then the size of the hedge gets adjusted
upwards or downwards.

Example

Let’s assume that you're hedging a $750,000 portfolio of US equities with S&P 500 futures contract that has
a $125,000 contract size. Assume that you've run the following regression of historical spot returns on
futures returns.

You estimate Beta to be 0.5. So, when the S&P 500 moves by 1% the portfolio tends to move in the same
direction by 0.5% points.

Then as the portfolio tends to make smaller movements than the S&P 500, we want to scale the hedge
position down. This leads to a hedge size of:
Week 5: Option contracts
Call options: Right to buy an asset for a specified price in the future for a strike price K, market price S
and option premium c

If P>K→ option is exercised → Payoff= S – K - c

If P<K → option not exercised → Payoff= -c

If P>K→ option is exercised→ Payoff= x + K - S

If P<K→ option not exercised→ Payoff= c

Put Options: Right (but not the obligation) to sell an asset for a specified price in the future for a strike
price of K, market price of S and option premium of p

If P<K→ option is exercised → Payoff= K - S- p

If P>K→ option not exercised → Payoff= -p

If P<K→ option is exercised→ Payoff= p +S -K

If P>K→ option not exercised→ Payoff= p

Put call parity

Fundamental idea: premia on puts and calls (on the same underlying with the same strike and maturity) are
linked together by no arbitrage.
No-arbitrage implies that the following condition must hold for a put and a call on the same underlying and
with the same strike price (K) and time to maturity (T):

Where S is the current price of the underlying, p is premia of put, c is premia of call and r is the interest
rate.
Consider two portfolios:
 Portfolio A consists of the underlying and a put option with T periods to maturity and strike price K
o The price of this portfolio is S+p
 Portfolio B consists of a call struck at K and with time to maturity T plus cash to the value of K/(1+r) T
o The price of this portfolio is c+ K /(1+r)T
Options leverage and risk
Would you buy a stock for $35 or buy a 7 call options for $5 premia with strike price $30?

Option leverage= you get to take a lot of risk and also get a lot of options, compared to buying the
underlying asset. The option portfolio return can be -100% more often than the stock portfolio, as this only
happens when a company would go bankrupt.

Options payoffs and uses

 Bull and bear spreads
 Butterfly spreads
 Straddles

Bull and bear spreads

Consider an investor with a mildly bullish view who wants a portfolio that’s protected against extreme price
moves. He can choose one of the following option combinations:
 Bull call spread: combine a long position in a call option (buy RTB) with a low strike (K1) and a short
position in a call option (sell a RTB) with a higher strike (K2)
 Bull put spread: combine a long position in a put option (buy RTS) with a low strike (K 1) and a short
position in a put option (sell RTS) with a higher strike (K2).
Both positions yield the desired portfolio payoff profile. An explanation for the payoff profile of the bull call
spread is given below.

Call bull spread: Put bull spread:

Butterfly spread
Consider an investor who believes that volatility in the underlying will be low until maturity.
 Butterfly spread using calls: go long one call with a low exercise price (K1), short two calls with a
medium strike (K2) and long one call with a high exercise price (K3).
 Butterfly spread using puts: go long one put with low exercise price (K1), short two puts with a
medium strike price (K2) and long one put with a high exercise price (K3).

Call butterfly spread:

Straddles
Consider an investor who wants to bet on volatility in the underlying asset i.e., he wants a portfolio that is
valuable both when there is extreme up and down movements in the underlying price.
 Straddle: go long a put and long a call with the same K
 Strangle: go long a put with a low strike price K1 and long a call with a high strike price K2.
Both will pay off when there is extreme up or down moves in the underlying price. The strangle, however,
increases the range of the underlying price where the buyer of the straddle makes no profits.

Long straddle
Week 6: Option pricing

The goal of this lecture is to derive a formula that tells us the no-arbitrage value of an options
premium.

The approach:
 Build a portfolio of the underlying assets and risk-free bonds that replicates the option payoff
 Workout the cost of building that replicating portfolio
 By no-arbitrage, the option premium must be equal to the cost of building the replicating portfolio.

The binomial assumption: in a single period, the underlying price can move from its current level (S) to
only one of two new levels:
o Either the price moves up by factor u, thus reaching level uS, or…
o Price moves down by a factor d to the level dS
o u>d
 u>1+r
 d<1+r

It seems restrictive that prices can only move to one of the two different levels in the next period - but it’s
easy to generalise to many periods. Think of the period length shrinking to cover a matter of seconds so
that the process above starts to resemble something more reasonable.

Once you know uS or dS you can workout the maximum of 0 and then workout the price of the option.

Need a risk-free asset: we assume that there exists a one period zero-coupon bond with a face value of a
£1 and one period sport rate r. You are willing to pay 1/1+r for this bond today which is the present value of
the face value. You can buy a bond that pays you a pound in one year’s time. It will always pay you a
pound because it is risk free.

So, we have three assets: the underlying, the option and the risk-free asset. The underlying and the risk-
free asset will be the replicating portfolio.

 NOTE: Probabilities are irrelevant in these option pricing diagrams.

Replicating portfolio
1. Purchase △ units of underlying (stock)
2. Sell N one-period zero coupon bonds

The payoff profile of this portfolio is:

 Given that cu, cd, u, d and S are known, we can solve this pair of equations for the quantities of
underlying (△) and the risk-free assets (N) in the portfolio. Like a simultaneous equation.

Thus, the no arbitrage call price is:

This is called the replication method!
An alternative formulation:

This makes the no-arbitrage call price more straightforward:

This is called the risk neutral method!

 0<q<1 must hold

 Probability of upstate is q
 Probability of downstate is 1-q
 The section in square brackets is the expected option payoff (average)
 The 1/(1+r) is the discount factor
 So, this is the PV of the expected option payoff
 BUT q and 1-q are artificial probabilities!
 This method works for any derivative, you just have to workout its payoff in the upstate and the
downstate

Example

The risk-free rate is 5%. A stock has current price $20. In one period its price will either rise to $25 or fall to
$16. Price a one-period call option on this stock with exercise price $22.

u= 25/20=1.25 , d= 16/20=0.8

We need to know the call option payoffs in the two states:

To price by replication, compute △ and N:

Finally, the price of the call is:

To price by risk-neutral method, first compute q:

Then the call price is:

Arbitrage and option price bounds
 Lower bounds on call prices
 Upper bounds on call prices
Ruling out values for the option price that you might be quoted, you will know if it is an unreasonable price
and therefore if there is an arbitrage available.

Take a European call option…

1. Lower bound: Price/premia of call option greater than or equal to 0 (c >0) because you're offering
someone a choice.
2. Upper bound: Payoff of call option is always smaller than or equal the terminal stock price therefore
you will never pay more for the option than you will for the underlying (c< S). This implies that
holding the stock is just as good as holding the call.

Therefore: 0<c<S

3. Final bound:

The price of the call is always weakly greater than the current underlying price minus the present value of
the exercise price.

If the bounds are violated, there is arbitrage opportunity and thus risk-free cash to be made.

Using put call parity to derive the final bound formula:

Combination of 3 bounds:

Intrinsic vs time value for an option

Intrinsic value: value option would have if exercised immediately
 max (St - X, 0) where St is current underlying price.
Time value: value option holds due to its time to maturity

Time value= option price- intrinsic value

Week 7: Black Scholes option pricing model:

Two key ingredients:

 Absence of arbitrage
 A model for stock returns based on the normal distribution

Basic pricing approach:

 Use the model proposed to build a portfolio of stock and options that is risk-free
 By absence of arbitrage this portfolio must earn the risk-free rate
 The allows one to tie down the premium/price of the option

Stock + option that replicates the risk-free asset.

We want our model for stock prices to:

 Percentage returns are normally distributed (which isn't true in real world)
 Expected percentage returns are independent of price
 Volatility of percentage returns is roughly constant for a particular stock (which isn't true)
Continuous time: we will build a model for the variation in quantities over vanishingly small intervals of time

Brownian motion: a fundamental part of the process (Z).

So, the change in Z is equal to epsilon x square root of △t.
 Over the change in time, the change in Z is normal with mean=0 and variance=△ t

 Epsilon is the source of the normal distribution assumption

So, take dt (△t), then we denote the △Z as dZ and this is a normal random variable with mean= 0 and var=
dt
 Variance of constant x random variable= constant2

Geometric Brownian motion (model for underlying):

Sigma affects the variance. The larger the sigma the more volatile and vice versa.
If mew is positive, and as time passes the expected return tends to be positive, stock price goes up and
vice versa.
Therefore, the first term is called drift and the second term is called risk and volatility.

Can also write as:

 Think of mew as the expected return on the underlying
 Think of sigma as controlling the volatility of the underlying

Example
Assume an underlying with annual volatility of 25% and a mean annual return of 9%. If we want to know the
distribution of monthly returns (△t = 1/12=0.0833) then we have:

So, over a period of a month, the expected return is 0.75% and the volatility is expected to be 7.22% (as
square root of 0.0052 = 0.00722)

Geometric Brownian motion IMPLIES Lognormal prices are normally distributed

 Log price is normally distributed, price is not

 This means prices are lognormal
 Log prices drift at a rate given by:

 Their volatility rate is the same as returns

 The further forward in time we look, the more volatile log prices are and the greater the drift

"Returns are normal, log prices are normal, prices are lognormal."

The Black-Scholes Pricing

 dc/dS is the sensitivity of the option value to the underlying

Example:
Assume that we know that for every $1 move in the underlying price, a call option value moves in the same
direction by $0.25. In that case:
 dc/dS= 0.25
 The risk-free portfolio contains:
o A long position of 0.25 units of stock
o A short position of 1 call option
 Then, if the stock price moves, say $0.40 downwards, we would expect the short option position to
move 0.25 x $0.40= $0.10 upwards
 Our long-short portfolio should not move at all as the stock position is down by 0.25 x $0.40= $0.10
and the short position is up by $0.10.
Note: this is the same idea as binomial pricing. In that setting one could build a risk-free portfolio from △
units of stock and a short position in a call option.

However: with put options, a long put option position and a long stock position will give you a risk-free
portfolio.

The return on the portfolio must be the risk-free rate.

The Formulae
Call price formula:

T= time to maturity
X= strike price
S= current underlying price
Sigma= volatility
r= interest rate
And:

Finally, the function N is the cumulative normal distribution function. The total probability of drawing a
number equal to or below x.

In the equation:
Put price formula:

Implications of the changes of inputs in the Black-Scholes formula

Increase in S (Call): The payoff in a call option is the amount by which the stock price exceeds the strike
price. Call options therefore become more valuable as the stock price increases. (You want to buy for a
LOW price, so you want the stock price to be HIGH)

Increase in S (Put): The payoff on exercise is the amount by which the strike price exceeds the stock
price. They become less valuable as the stock price increases. (You want to sell for HIGH price, so you
want the stock price to be low)

Increase in X (Call): You want strike price to be as low as possible, so you can buy cheaper and make a
greater profit, therefore an increase makes it less valuable. The payoff is S- X -c.

Increase in X (Put): You want the strike price to be as high as possible so you can sell high, and make a
greater profit, therefore and increase makes it more valuable. The payoff is X-S-p.

Increase in sigma (Call): high volatility is good because it increases the chance you end up with a large
gain, and in the cases when you end up with low underlying price, you don’t care because you have a
limited downside risk because the most the owner can lose is the price of the option.

Increase in sigma (Put): high volatility is also good because you make money on the downside but don't
lose much money on the upside because the owner has limited downside risk. The most the owner can
lose is the price paid for the option.

Time to maturity (both): you have more time to get into the money.

Increase in r (Call): if you exercise the call option you must pay out the strike price. And if the interest rate
is higher, the expected return required by investors increases and the PV of any future cash flow to the
option holder decreases. So that makes the option more valuable.

Increase in r (Put): the higher the interest rates the lower the put option price. This is because if interest
rates are high you will have to hold the asset for a longer time to deliver it under the put option. Simply
selling the asset and using the proceeds to invest at a higher rate would be a better option. This makes the
put option less attractive and hence less costly when interest rates are high.