Derivatives (ECONM3017)

Lecture Eleven: Options VI

(Advanced Option Pricing)

Nick Taylor
[email protected]

University of Bristol

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Table of contents

1 Learning Outcomes

2 BSM Alternatives

3 Advanced Numerical Procedures

4 Summary

5 Reading

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Learning Outcomes

At the end of this lecture you will be able to:

1 Motivate use of option pricing models that compete with the BSM model.
2 Understand the underlying assumptions of competing models.
3 Implement a variety of numerical procedures to price options with
non-standard payoffs.

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BSM Alternatives

Motivation
What if stock prices are not log-normally distributed?
Calls:
Distributional shape Out-of-money biases In-the-money biases
Thinner tails BSM overprices BSM overprices
Left thicker BSM overprices BSM underprices
Right thinner
Left thinner BSM underprices BSM overprices
Right thicker
Thicker tails BSM underprices BSM underprices
Consider an out-of-the-money call option. It is the right tail that is
important. If this tail is thicker than expected then its true value will be
greater than that predicted by the BSM model.

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BSM Alternatives (cont.)

Motivation (cont.)
Puts:
Distributional shape Out-of-money biases In-the-money biases
Thinner tails BSM overprices BSM overprices
Left thicker BSM underprices BSM overprices
Right thinner
Left thinner BSM overprices BSM underprices
Right thicker
Thicker tails BSM underprices BSM underprices
Consider an out-of-the-money put option. It is the left tail that is important.
If this tail is thicker than expected then its true value will be greater than
that predicted by the BSM model.

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BSM Alternatives (cont.)

The Constant Elasticity of Variance (CEV) Model

Cox and Ross (1976) introduce is a diffusion model where the risk-neutral
stock price process is given by

dS = (r − q)Sdt + σS α dz,

where r is the risk-free rate, q is the dividend yield, dz is the Wiener

process, σ is a volatility parameter, and α is a positive constant.

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BSM Alternatives (cont.)

The CEV Model (cont.)

Note the following:
When α = 1 it becomes the BSM model.
When α > 1 (α < 1) volatility rises as stock prices rise (fall). This
gives rise to heavier right (α > 1) or heavier left tails (α < 1).
European options can be priced analytically using the above process.

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BSM Alternatives (cont.)

The Mixed Jump-Diffusion Model

Merton (1976) introduces a diffusion model where the risk-neutral stock
price process is given by

dS = (r − q − λk)Sdt + σSdz + Sdp,

where dp is a Poisson process generating the jumps, k is the expected size

of the jump, and λdt is the probability that a jump occurs in the next
interval of length dt.

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BSM Alternatives (cont.)

The Mixed Jump-Diffusion Model (cont.)

Note the following:
The model gives rise to heavier left and right tails than the ones used
in the BSM model.
As in the CEV model, the parameters are chosen by minimising the
sum of the squared differences between model prices and market prices.
Madan, Carr and Chang (1998) introduce a similar model (referred to
as the Variance-Gamma Model), which is based on a process where
small jumps occur frequently and there are occasional large jumps.

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BSM Alternatives (cont.)

Stochastic Volatility Models

Hull and White (1987) consider the following process:
√
dS = (r − q)Sdt + V SdzS ,
dV = a(VL − V )dt + ξV α dzV ,

where a, VL , ξ, and α are constants, V is the asset’s variance rate, and dzS
and dzV are Wiener processes.

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BSM Alternatives (cont.)

Stochastic Volatility Models (cont.)

Note the following:
Hull and White show that when V and S are uncorrelated, a European
option price is the BSM price integrated over the distribution of the
average variance.
When V and S are negatively correlated, a downward sloping volatility
skew occurs similar to that observed in the market for equities.
When V and S are positively correlated, an upward sloping volatility
skew occurs similar to that observed in the market for commodities.

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BSM Alternatives (cont.)

The Implied Volatility Function (IVF) Model

Independently, Derman and Kani (1994), Dupire (1994), and Rubinstein
(1994) introduce the IVF model, which is designed to create a process for
the asset price that exactly matches observed option prices. The assumed
process is given by

dS = (r (t, T ) − q(t, T )) Sdt + σ(S, t, T )Sdz,

where r (t, T ) is the instantaneous forward interest rate at time t for a

contract maturing at time T , q(t, T ) is the dividend yield over the option
life, and σ(S, t, T ) is a function of S, t and T chosen so that the model
prices all European options consistently with the market (an analytical
expression is available).

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Advanced Numerical Procedures

Path-Dependent Options
In general, the following steps are undertaken to price an option:
Step 1: Work forward through the tree calculating the maximum and
minimum values of the path function (i.e., the payoff associated with
each path followed by the asset price) at each node.
Step 2: Choose representative values of the path function that span
the range between the minimum and the maximum (i.e., choose the
minimum, the maximum, and N equally spaced values between them).
Step 3: Work backwards through the tree and carry out calculations for
each of the alternative values of the path function at each node.

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Advanced Numerical Procedures (cont.)

Barrier Options
Trinomial trees work better than binomial trees. When using the former,
define the inner barrier as the barrier formed by nodes just inside the true
barrier (i.e., closer to the centre of the tree), and the outer barrier as the
barrier formed by nodes just outside the true barrier. Then carry out the
following steps:
Step 1: Calculate the derivative price on the assumption that the inner
barrier is the true barrier.
Step 2: Calculate the derivative price on the assumption that the outer
barrier is the true barrier.
Step 3: Interpolate between the two prices.

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Advanced Numerical Procedures (cont.)

American Options via Monte Carlo Simulation

Example
Consider a 3-year American put option where the initial asset price is 1.00, the
strike price is 1.10, and the risk-free rate is 6%. Furthermore, assume that the
option can only be exercised at year one, year two, or year three (it is actually a
Bermudian option). Using these parameters the following sample paths are
generated:
Path t=0 t=1 t=2 t=3
1 1.00 1.09 1.08 1.34
2 1.00 1.16 1.26 1.54
3 1.00 1.22 1.07 1.03
4 1.00 0.93 0.97 0.92
5 1.00 1.11 1.56 1.52
6 1.00 0.76 0.77 0.90
7 1.00 0.92 0.84 1.01
8 1.00 0.88 1.22 1.34
Source: Longstaff and Schwartz (2001), see also Chapter 27, Hull (2015).

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Advanced Numerical Procedures (cont.)

American Options via Monte Carlo Simulation (cont.)

Example (cont.)
Consider prices in year 2. The option is in-the-money for five paths. The
corresponding values of S are 1.08, 1.07, 0.97, 0.77, and 0.84. In turn, the
corresponding continuation values (i.e., discounted payoffs to exercising in year
3) are 0.00, 0.07e −0.06 , 0.18e −0.06 , 0.20e −0.06 , and 0.09e −0.06 .
Using the above values, the least squares approach fits a model of the form:

Vi = a + bSi + cSi2 + i ,

where Vi is the continuation value of the i sample path, Si is the asset price
associated with the i sample path, and i is a suitably defined error term. The
fitted value from this regression represents a conditional expectation of the
continuation value and defines the early exercise decision in year 2.
This process is repeated for year 1, and eventually a price is calculated based on
the discounted payoffs.

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Summary

Motivation
Why the BSM model might not be appropriate.
BSM Alternatives
The CEV model, the mixed jump-diffusion model, stochastic volatility
models, and the IVF model.
Advanced Numerical Procedures
Procedures to price path-dependent options, barrier options, and American
options via Monte Carlo simulation.

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Reading

Essential Reading
Chapter 27 , Hull (2015).
Further Reading
Longstaff, F., and E. Schwartz, 2001, Valuing American options by
simulation: A least squares approach, Review of Financial Studies 14,
113-147.

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