Introduction History Revolution Aftermath

Financial derivatives - a brief introduction

Tony Ware

MITACS 6th Annual Conference, May 11 2005

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath

Outline

Introduction

History

Revolution is in the air

A lot has happened since then

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Markets and risk Options

Outline

Introduction
Markets and risk
Options

History

Revolution is in the air

A lot has happened since then

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Markets and risk Options

The Midas formula

V = SN(d+ ) − K e−rT N(d− )

I It appears to be a simple, harmless formula—for the value of

a call option, a simple derivative—but it has been responsible
for the making—and the losing—of unimaginable riches.
I It is a mathematical formula, and the ideas behind it are
subtle. How is it that beautiful mathematics managed to get
mixed up in the business of making money?
I And why aren’t mathematicians doing better out of it?

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Markets and risk Options

Aristotle: 384-322 B.C.

The discussion of [wealth-getting] is

not unworthy of philosophy, but to be
engaged in [it] practically is illiberal
and irksome.

Thales’ call option: he pays a small deposit up front

guaranteeing him the first call on a wine press (at an agreed rent).
If the harvest is bad, he won’t bother to exercise his option. But if
the harvest is good, he does, makes a lot of money, and has his
story told by Aristotle.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Markets and risk Options

Chance and skill

I Aristotle thought that in the making of wealth too much was
down to chance and not enough to human skill.
Play Pause Resume Stop

I But what about the successes of traders who seem to have

enough skill to pick the right stocks and beat the market?

Tony Ware Financial derivatives - a brief introduction

Introduction History Revolution Aftermath Markets and risk Options

Play Pause Resume Stop

Markets are risky!

Tony Ware Financial derivatives - a brief introduction

Introduction History Revolution Aftermath Markets and risk Options

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Markets and risk Options

Risk protection: selling

Suppose you hold a stock and want to sell it in a year’s time. . .
I A put option allows you to ‘lock-in’ a minimum price for your
stock, but to keep the unlimited upside.
I For example: suppose that the stock is currently at $50 and
you protext yourself by purchasing a put option with strike
price $50. When the contract expires, if the stock has risen to
$60, you can sell it for $60. But if it has fallen to $40, you
have the right to sell it for $50.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Markets and risk Options

Risk protection: buying

On the other hand, perhaps you want to invest in the stock. . .
I A call option allows you to guarantee a maximum price you
will have to pay.
I For example: suppose that the stock is currently at $50 and
you protext yourself by purchasing a call option with strike
price $50. When the contract expires, if the stock has risen to
$60, you have the right to buy it for $50. But if it has fallen
to $40, the you will buy it for $50 .

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Markets and risk Options

Payoff diagram for a call option

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Markets and risk Options

Leverage
I Some people trade in options because want to reduce their
exposure to risk. Others, because they want to take on extra
risk and gain an advantage from the increased leverage.
I Here is our example call option struck at $50:

I Suppose the premium for the option is $2.

I If the stock goes up, the payoff is $10 and the profit is $8.
A 400% gain!
I If the stock goes down, the payoff is zero and we get nothing.
A 100% loss!

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Markets and risk Options

Risk transfer
I Financial derivatives come in many varieties
I puts, calls, american/european/asian/bermudan options,
I butterfly spreads, bull/bear spreads, condors,
I digital options, up-and-out/down-and-out options,
I futures, swaptions, passport options, swing options. . .
I They all involve the exchange of risk (or uncertainty).
I The key question we are always trying to answer is:
How much is that uncertainty worth?

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Options trading Bachelier Gaining understanding

Outline

Introduction

History
Options trading
Bachelier
Gaining understanding

Revolution is in the air

A lot has happened since then

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Options trading Bachelier Gaining understanding

A long,disreputable history
I 1600s - Holland. Tulip dealing is big business, and growers
and dealers are trading in options to guarantee prices.
I Soon speculators are joining in and a thriving options market is
born. But the market crashes, many speculators fail to honour
their commitments, and the Dutch economy is brought to its
knees.
I 1700s - London. Options are declared illegal!
I 1934 - USA. Investment act legitimises options. Annual
volume < 300, 000 contracts by 1968.
I April 1973 - Chigaco. The CBOT starts trading listed call
options on 16 stocks, with a first-day volume of 911 contracts.
I 1974 - Chigaco. The daily volume grows from 20,000 to over
200,000 contracts.
So what happened to cause this explosive growth? - Mathematics!

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Options trading Bachelier Gaining understanding

The mathematicians are coming

The search for a mathematical understanding of the behaviour of
the market, and options pricing, has its beginning in the 1900
doctoral thesis of Louis Bachelier on the ‘Théorie de la
Spéculation’.
I He studies the movements of bond prices and associated
options on the Parisian Bourse.
I He derives an analogy between the probability distribution of
prices and the flow of heat.
I His price model is an example of Brownian motion - five years
before Einstein’s work on the subject.
I But his thesis is hardly noticed at the time - his career falters
and his work lies waiting until it is rediscovered more than
fifty years later.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Options trading Bachelier Gaining understanding

Brownian motion
I In 1827 Robert Brown had observed pollen particles floating in
water under the microscope and noted their jittery behaviour.
In order to make sure that the motion was not due to the
pollen being alive he did the same thing with dust particles.
I Bachelier models bond price movements in the same way
Einstein later models the motion of particles under
‘bombardment’.(In fact he derives his results in three different
ways.)
I Between any two points in time (t and t + ∆t), the change in
the bond price is a normally-distributed random
variable—following a ‘bell-curve’ law.
I Any non-overlapping changes are independent.
I For times that are close together, the curve is peaked, and for
longer times it is smeared out.
I This produces random, infinitely-long, but continuous curves.
Tony Ware Financial derivatives - a brief introduction
 Introduction History Revolution Aftermath Options trading Bachelier Gaining understanding

Brownian motion in pictures

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Options trading Bachelier Gaining understanding

Rediscovery and enhancement

I In the 1930s and 40s, A. N. Kolmogorov, Kiyoshi Itô, Paul
Lévy and Norbert Wiener put the mathematical description of
Brownian motion on a much firmer basis, and Itô figures out
how to do calculus on these random functions.
I Brownian motions are now called Wiener processes by the
mathematicians.
I In 1955 Paul Samuelson turns his attention to option pricing.
He and his students discover Bachelier’s thesis. They also
redefine Bachelier’s model so that it refers to the logarithm of
the stock price - this prevents the model from generating
negative stock prices.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Options trading Bachelier Gaining understanding

Geometric Brownian motion

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Options trading Bachelier Gaining understanding

The hunt is on
In the period 1955-1970, people were working very hard indeed to
try to solve the option pricing problem. Perhaps they had an
inkling of how important such a discovery might be.
I Paul Samuelson - almost gets there.
I Guynemer Giguere - figures out ‘boundary conditions’
I Case Sprenkle - his model requires estimates of growth rates
and investors risk-aversion.
I James Boness - translated Bachelier’s thesis, creates an option
model based on a discounted expected payoff.
I Henry McKean - writes a book with Itô, a paper with
Samuelson. He figures out the mathematical formulae.
I Ed Thorp - he’s even closer, building on Boness.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Options trading Bachelier Gaining understanding

Almost there

Play Pause Resume Stop

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Convergence Balance The formula Publication Nobel prizes

Outline

Introduction

History

Revolution is in the air

Convergence
Balance
The formula
Publication
Nobel prizes

A lot has happened since then

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Convergence Balance The formula Publication Nobel prizes

Convergence
I In the late 1965 Fischer Black makes the journey from physics
to finance, joining the consulting firm Arthur D. Little. A
couple of years later, Myron Scholes joins the faculty at MIT,
and meets Black.
I Black and Scholes work on the option pricing problem. They
realise that risk is the key - it is what is at the root of all the
problems others are having, and it is what options are all
about.
I They work on the idea of creating a small portfolio, consisting
of just three items:
I S—the stock.
I B—a risk-free bond (a costless bank account).
I V —the option.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Convergence Balance The formula Publication Nobel prizes

Make it go away. . .
Their idea is to try to balance this porfolio (S, B and V ) so that
the risk goes away. If the worth of the option is independent of
individual preferences, then it just might be possible. . . .
Here’s what you can do.
I Start out by borrowing some money (i.e. a negative B) and
investing it in S and V in some ratio. (Zero net investment.)
I Tomorrow, or when you next come to trade, the values of B,
S and V have all changed. Your portfolio could be worth
anything.
I But. . . if you choose your initial balance to minimise the
uncertainty (the risk), could you get rid of it altogether?
I If you could, then you would know for sure the value of your
portfolio ‘tomorrow’. Given that you invested nothing in it
today, if its value is going to be anything but zero, you have
found a money-making machine.
Tony Ware Financial derivatives - a brief introduction
 Introduction History Revolution Aftermath Convergence Balance The formula Publication Nobel prizes

Easy street?
Your money-making machine is what is known as an arbitrage
opportunity. The problem is that once word gets around,
everybody wants a piece, and the effect of this is to push prices the
other way. The gap closes, and your machine does not work any
more.
Black and Scholes adopted the standard assumptions:
I that the grapevine works perfectly and instantaneously
I that there are no barriers to anyone entering into a trade, no
matter how small or how often.
The result is that these arbitrage opportunities do not exist.
But this means that your perfectly-balanced portfolio
must still be worth nothing tomorrow. This is going to
give you a handle on how the value of your option is
changing with time.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Convergence Balance The formula Publication Nobel prizes

Perfect balance
Consider a simplified model with these ingredients:
I a stock, which is
currently at $50 and can
move up to $60 or down
to $30.
I a call option with strike
price $45.
I a zero interest rate.

I Create a portfolio consisting of buying one stock, selling two

options, and borrowing $30.
I If the stock goes up, the net value is $60 - 2×$15 - $30 = 0.
I If the stock goes down, the net value is $30 - $30 = 0.
I The value at the start must be zero - so V = $10.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Convergence Balance The formula Publication Nobel prizes

In continuous time
In the previous example, we created a portfolio that was perfectly
balanced - in all eventualities its value stayed at zero. Can we do
this with a more realistic model? Well, the answer is ‘no’. Here’s
the best you can do if you rebalance once a day. . .

Tony Ware Financial derivatives - a brief introduction

Introduction History Revolution Aftermath Convergence Balance The formula Publication Nobel prizes

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Convergence Balance The formula Publication Nobel prizes

Trading more often

If turns out that you can do better if you rebalance once an hour. . .

Tony Ware Financial derivatives - a brief introduction

Introduction History Revolution Aftermath Convergence Balance The formula Publication Nobel prizes

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Convergence Balance The formula Publication Nobel prizes

Robert Merton
Merton arrived on the scene in 1968 and brought with him
expertise in Itô calculus, and an understanding of continuous-time
‘stochastic processes’.
He met Scholes in 1969 and it was he who figured out that their
dream of perfect balance could be achieved by continuously
adjusting their portfolio.
Here’s the result of our previous experiment, rebalancing every
minute of the year. . .

Tony Ware Financial derivatives - a brief introduction

Introduction History Revolution Aftermath Convergence Balance The formula Publication Nobel prizes

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Convergence Balance The formula Publication Nobel prizes

The balance equation

Achieving perfect balance tells you that the value of your portfolio
is stable over time, and the no arbitrage principle then forces the
option value to depend on S and B and the time t in a particular
way.
If r is the continuously-compounded rate of interest
earned by B, and σ is a measure of the volatility of S,
then
∂V ∂V σ2 ∂ 2V
+ rS + S 2 2 = rV .
∂t ∂S 2 ∂S
This is what has become known as the Black-Scholes equation. It
had already been solved by McKean, and the solution is the
formula everyone had been looking for.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Convergence Balance The formula Publication Nobel prizes

The formula
The value of a call option on an asset S, expiring at time T , with
strike price K is

V = SN(d+ ) − K e−rT N(d− ),

where N(x) is the cumulative normal distribution function,

S σ2 T


ln K e−rT
± 2
d± = √ ,
σ T
and r is the risk-free interest rate, continuously-compounded, and
σ is the volatility of the asset.
The balance is struck by selling N(d+ ) units of the asset for every
unit option bought. This is known as the delta, or hedge ratio.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Convergence Balance The formula Publication Nobel prizes

The option value surface

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Convergence Balance The formula Publication Nobel prizes

Getting it out
I Black and Scholes had a little trouble getting their paper
published. They had to try three times—the first two times
the paper was rejected without even being reviewed! (The
suspicion is that Black’s non-academic position may have had
something to do with it.)
I Merton had written his own version, more general than Black
and Scholes’, but he graciously delayed the publication of his
until their paper appeared.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Convergence Balance The formula Publication Nobel prizes

Nobel’s for almost all

Myron Scholes Robert C. Merton

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Value Generalizations LTCM

Outline

Introduction

History

Revolution is in the air

A lot has happened since then

Calculating the value
Generalizations of Black-Scholes
LTCM

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Value Generalizations LTCM

Martingale pricing methods

Consider again our simplified model:
I a stock, which is
currently at $50 and can
move up to $60 or down
to $30.
I a call option with strike
price $45.
I a zero interest rate.
I Create a portfolio consisting of buying one stock, selling two
options, and borrowing $30.
I If the stock goes up, the net value is $60 - 2×$15 - $30 = 0.
I If the stock goes down, the net value is $30 - $30 = 0.
I The value at the start must be zero - so V = $10.
I Notice that the option value ($10) is 32 × $15 + 13 × $0.
I If we think of 32 and 13 as the probability of the price going up
Tony Ware Financial derivatives - a brief introduction
 Introduction History Revolution Aftermath Value Generalizations LTCM

Martingale pricing methods

I Martingale pricing methods involve finding an equivalent
martingale (probability) measure.
I Once this is determined, the option value is computed as a
discounted expectation.
I This may involve numerical integration of some form or other.
I Problems:
I there may not be a unique EMM.
I the computation of the discounted expectation may not be
trivial.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Value Generalizations LTCM

Binomial trees
I If we repeat our simple model recursively, we can construct a
binomial tree.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Value Generalizations LTCM

Binomial trees
I Each branch on the tree corresponds to a change from an
asset price S to either uS (up step) or dS (down step) over a
time interval ∆t.
I If Vjm is the option price after n steps of which j are up steps,
then
h i er ∆t − d
Vjm = e−r ∆t pVj+1
m+1
+ (1 − p)Vjm+1 , with p = .
u−d
Here r is the risk-free interest rate.
I The computation starts from the payoff at the final time and
works backwards.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Value Generalizations LTCM

Binomial tree computation of an american option

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Value Generalizations LTCM

Solving the PDE

I The Black-Schole PDE
∂V ∂V σ2 ∂ 2V
+ rS + S 2 2 = rV
∂t ∂S 2 ∂S
is a reverse-time parabolic equation that can be solved by
reducing it to the heat equation.
I Explicit solutions may not exist in more general settings -
numerical solution methods will be needed.
I Finite difference/finite element methods.
I Fourier methods.
I Wavelet-based methods.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Value Generalizations LTCM

Solving the PDE

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Value Generalizations LTCM

Solving the PDE

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Value Generalizations LTCM

Broadening the scope

I Better price process models:
I stochastic volatility.
I mean-reversion.
I jump-diffusion.
I variance-gamma.
I Indifference pricing.
I Transaction costs and other imperfections.
I Exotics:
I structured contracts (energy markets).
I real options.
I Credit derivatives.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Value Generalizations LTCM

Death of a dream
Merton and Scholes wanted to see their ideas in practice. They
teamed up with some of the top investors from Wall Street to form
a new company - Long Term Capital Management.
They raised $3 billion from investors, including many of the major
banks, on the promise of using dynamic hedging (a.k.a. continuous
rebalancing) on a huge scale to form a ‘gigantic vacuum cleaner
sucking up nickels from around the world.’
They were enormously successful - returning 20%, 43% and 41%
to their investors in the first three years.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Value Generalizations LTCM

Death of a dream
But at the tail end of the century things started to go wrong. The
trouble started in asia - markets were collapsing and deviating
significantly from their historical norms. LTCM carried on as
normal, convinced that things would stabilize. When Russia
defaulted, the game was up.
In order to prevent the global economic collapse that would have
resulted from the failure of LTCM, the Federal Reserve had no
choice but to bail them out - to the tune of $3 billion.

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Value Generalizations LTCM

Summing up

I Mathematics plays an unexpectedly significant role in the

operation of financial markets.
I Mathematics provides powerful tools for understanding and
even controlling the nature and effects of uncertainty and risk.
I But some humility is called for!

Tony Ware Financial derivatives - a brief introduction

 Introduction History Revolution Aftermath Value Generalizations LTCM

A video-less version of these slides is available at

finance.math.ucalgary.ca/papers/MitacsShortCourse2005.pdf

Tony Ware Financial derivatives - a brief introduction