CHAPTER 1

DERIVATIVES MARKETS

Ms Sarah Nadirah Mohd Johari, 2021

CONTENTS
• An Overview of Financial Markets
• Introduction to Derivatives
• Forwards, Options and Option Basic Strategies
• Financial Forwards, Futures and Swap

Ms Sarah Nadirah Mohd Johari, 2021

CONTENTS
• An Overview of Financial Markets
• Definition of Market
• Different Forms of Markets
• Structure of Malaysian Financial Markets
• Introduction to Derivatives
• What is a Derivative?
• Uses of Derivatives
• Buying and Short-Selling Financial Assets
• Forwards, Options and Option Basic Strategies
• Financial Forwards, Futures and Swap

Ms Sarah Nadirah Mohd Johari, 2021

INTRODUCTION

Ms Sarah Nadirah Mohd Johari, 2021

INTRODUCTION

Ms Sarah Nadirah Mohd Johari, 2021

CASH MARKET VS DERIVATIVE MARKET
CASH MARKET DERIVATIVE MARKET
• Spot or physical market. • Does not require spot
transactions & physical market.
EXAMPLE? EXAMPLE?
Mini-market, supermarket, night Stock market
market
• Underlying asset • Contracts

Ms Sarah Nadirah Mohd Johari, 2021

PHYSICAL ASSET VS FINANCIAL ASSET
PHYSICAL ASSET FINANCIAL ASSET
• Tangible in appearance • Intangible appearance
EXAMPLE? EXAMPLE?
Property, vehicle, fixtures Unit trust, commercial paper,
bonds
• Less liquid • More liquid
Reasons:
(i) Absence of organized market
(ii) Requirement of full disposal of an asset

Ms Sarah Nadirah Mohd Johari, 2021

MONEY MARKET VS CAPITAL MARKET
MONEY MARKET CAPITAL MARKET
• Maturity of less than a year • Maturity more than one year or
without any maturity
• Marketable securities • Fixed-income securities in terms
-treasury bill, bankers acceptance, of fixed interest payment over a
negotiable certificate of deposit, specified number of years and
commercial paper. principal repayment at maturity

Ms Sarah Nadirah Mohd Johari, 2021

PRIMARY MARKET VS SECONDARY MARKET
PRIMARY MARKET SECONDARY MARKET
• Involves transaction between an • Involves trading between
issuing institution and potential buyers and sellers
prospective buyers

• Any proceed from selling • Any proceed from selling

financial instruments will go to securities will go to the pocket
an issuer in the form of new money of a seller, either for a
capital. capital gain or loss.

Ms Sarah Nadirah Mohd Johari, 2021

INITIAL PUBLIC OFFERING (IPO)
• Every company that intends to be listed on the stock exchange
(secondary market) has to go initially to the primary market.
• Securing approval from Securities Commission of Malaysia by
satisfying the listing requirements.
Track record, paid-up capital, size of the issue and the offer price.
• In order to become public, company will appoint merchant bank as an
underwriter or advisor in soliciting with investing public.
• Once listed on KLSE or MESDAQ, the company is known as public
company.

Ms Sarah Nadirah Mohd Johari, 2021

THE STRUCTURE OF THE MALAYSIAN
FINANCIAL MARKETS
Financial
Market

Money Capital
Market Market

Marketable Foreign Cash Derivative

Securities Exchange Market Market

Short-Term Foreign Primary Secondary

Futures Options
Instruments Currencies Market Market

Ms Sarah Nadirah Mohd Johari, 2021

MALAYSIA MARKETABLE SECURITIES
• Short-term investment with maturity less than one year, commonly
mature for 3-months.
• Low risk and low return
• Highly negotiable
• Liquidity is very high.

Ms Sarah Nadirah Mohd Johari, 2021

MALAYSIA MARKETABLE SECURITIES
Treasury Bill Commercial Paper

SECURITIES

Negotiable Certificate/ Bankers’ Acceptance

Instrument of Deposit

Ms Sarah Nadirah Mohd Johari, 2021

MALAYSIAN TRUST FUNDS
• Unit trust: A collective investment scheme where money from many
investors is pooled together for collective investment.
• Managing company, trustee and unit-holders
• Governed by the deed registered with SC of Malaysia.

Ms Sarah Nadirah Mohd Johari, 2021

MALAYSIAN TRUST FUNDS
Opened – End Fund Closed – End Fund

TRUST FUNDS

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 WHAT IS A DERIVATIVE?
Primary or underlying
asset
Difference between other market?
Manual

WHAT IS
DERIVATIVE?

Derivatives contract
Definitions

Ms Sarah Nadirah Mohd Johari, 2021

AN OVERVIEW OF FINANCIAL MARKETS
• Trading of a financial asset involves at least four discrete steps:

A buyer and Ownership

seller must records are
The trade must The trade must
locate one updated
be cleared be settled
another and
agree on a price

Ms Sarah Nadirah Mohd Johari, 2021

AN OVERVIEW OF FINANCIAL MARKETS
• Trading involves striking a deal, clearing, settling and maintaining
records.
• Takes place on organized exchange.
- An organization that provides a venue for trading and sets rules governing
what is traded and how trading occurs.
• After a trade has taken place, a clearinghouse matches the buyers
and sellers, keeping track of their obligations and payments.
- Clearing members: traders who deal directly with a clearinghouse.
• After the trade has cleared and settled, buyer and seller have no
continuing obligations to one another.

Ms Sarah Nadirah Mohd Johari, 2021

AN OVERVIEW OF FINANCIAL MARKETS
• With derivatives trades, one party may have to pay another in the
future.
• Large traders may trade directly with a dealer, bypassing organized
exchanges that occur in the over-the-counter (OTC) market.
• Reasons:
(1) Easier to trade a large quantity directly with another party.
(2) Wish to trade a custom financial claim that is not available on an
exchange.
(3) Wish to trade a number of different financial claims at once.

Ms Sarah Nadirah Mohd Johari, 2021

AN OVERVIEW OF FINANCIAL MARKETS
• 4 different measures of a market and its activity:
(1) Trading volume: counts the number of financial claims that change
hands.
(2) Market value: sum of the market value of the claims that could be
traded without regard to whether they have traded.
(3) Notional value: measure the scale of a position, usually with
reference to some underlying asset.
(4) Open interest: measures the total number of contract for which
counterparties have a future obligation to perform.

Ms Sarah Nadirah Mohd Johari, 2021

ROLE OF FINANCIAL MARKETS
• Insurance companies and individual communities/families have
traditionally helped each other to share risks.
• Markets make risk-sharing more efficient
– Diversifiable risks vanish
– Non-diversifiable risks are reallocated to those most willing to
hold it

Ms Sarah Nadirah Mohd Johari, 2021

WHY USE DERIVATIVES?
• Risk Management: Derivatives are a tool for companies and other
users to reduce risks.
• Pure Speculation: Derivatives can serve as investment vehicles.
• Reducing Transaction Costs: Sometimes derivatives provide a lower
cost way to undertake a particular financial transaction.
• Taxes, Regulation: used to get cash for stock that you own without
selling it immediately, allowing to defer taxes on any gain and avoid
the risk of price changes. Use to get around certain regulatory
restrictions and accounting rules.

Ms Sarah Nadirah Mohd Johari, 2021

PERSPECTIVES ON DERIVATIVES
• End users • Intermediaries • Economic Observers
• Corporations • Market-makers  Regulators
• Investment • Traders
managers  Researchers
• Investors Observers

End Intermediary End

user user

Ms Sarah Nadirah Mohd Johari, 2021

DEVELOPMENT AND USE OF DERIVATIVES
• Can be constructed from other financial products in many different
ways. This process is called financial engineering.
• Can be custom-designed for different end-users by changing the
degree of risk, premiums, payoffs, etc.
• Permits risk-sharing.
• Has grown tremendously.
• Financial companies such as banks use derivatives involving interest
rates, currency exchange and credit to manage their risk.
• Manufacturers use for commodities and currency exchange.

Ms Sarah Nadirah Mohd Johari, 2021

BUYING AND SELLING ASSETS
Buying and selling assets such as stocks and bonds:
• Market-makers: bid-ask (offer) spread.
• Pay commission to a broker for a purchase or sale.

Flat amount COMMISSION Percentage

• Two prices for the shares of any stock:

Bid PRICE Ask/offer

Ms Sarah Nadirah Mohd Johari, 2021

EXAMPLE 1
Suppose XYZ stock is bid at RM49.75 and offered at RM50, and the
commission is RM15.
If you buy 100 shares of the XYZ stock and immediately sell them.
What is your cost of this entire transaction (your round-trip transaction
cost)?
Your cash outflow to buy stock: 100 × 50 + 15 = RM5,015
Your cash inflow from sale of stock: 100 × 49.75 − 15 = RM4,960
Your transaction cost: RM5,015 − RM4,960 = RM55

Ms Sarah Nadirah Mohd Johari, 2021

EXERCISE 1
The bid and ask prices of a certain stock are RM30.25 and RM30.50,
respectively. The broker’s commission is 0.2%.
Abu buys 150 shares and immediately sells them. What is his round-
trip transaction cost?

Ms Sarah Nadirah Mohd Johari, 2021

SHORT-SELLING ASSETS
• Short-sale: Sale of a stock that you do not own.
• Terminology term: Long position and short position
• When price of an asset is expected to fall:
- First: borrow and immediately sell an asset (get $$)
- Then: buy back and return the asset (pay $)
- If price fell in the mean time: Profit $ = $$ – $
- The lender must be compensated for dividends received
(lease-rate)
• No limit to your losses.

Ms Sarah Nadirah Mohd Johari, 2021

SHORT-SELLING ASSETS
• Reason to short-sell:

Speculation REASONS Hedging

Financing

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THE BELLS AND WHISTLES
WHO KEEPS THE PROCEEDS?
• The lender of the stock is concerned about borrower’s credit risk.
• The proceeds are usually held by the lender or by a designated bank
or other institutions.
WHAT’S A HAIRCUT?
• The lender may require an additional collateral from the short-seller
in case the borrower loss double from its original price.
• Investors cannot do unlimited amount of short-selling: they must
have capital to pay the haircuts.

Ms Sarah Nadirah Mohd Johari, 2021

THE BELLS AND WHISTLES
WHAT ABOUT INTEREST?
• Borrower deposited a haircut with the lender and it would only be fair
for the borrower to get interest on the haircut for the period that the
lender holds it.
• The rate of interest depends on the supply and demand. If the
demand by short-sellers were high, the lender would offer a lower
rate of interest than the market rate.
• Source of profit for lender.
• Short rebate: Interest rate paid on the haircut in the stock market
• Repo rate: Interest rate paid on the haircut in the bond market

Ms Sarah Nadirah Mohd Johari, 2021

THE BELLS AND WHISTLES
WHAT ABOUT THE DIVIDENDS?
• Neither the short-seller nor the lender owns the stock during the
period of borrowed and returned, the dividends are paid to someone
else.
• The short-seller must pay the lender any dividends that are declared
during the period.

Ms Sarah Nadirah Mohd Johari, 2021

EXAMPLE 2
The bid and ask prices for a certain stock are as follows:

February 25 August 25
Bid 35.22 39.65
Ask 35.37 39.80
Ali enters into a short sale on February 25 for 100 shares. He covers his
short position on August 25. The broker’s commission is RM10 per
transaction. What is Ali’s profit or loss on the short sale?

Ms Sarah Nadirah Mohd Johari, 2021

 BUYING STOCK IS LIKE LENDING MONEY;
SHORT-SELLING IS LIKE BORROWING MONEY
(1) When buy stock (or any other asset) and later sell it
(2) When lend money

NOW LATER
Purchasing and Sale of Cash outflow to buy Cash inflow from sale of
Stock stock stock
Lending Money Cash outflow to lend Cash inflow from
money repayment of loan

Ms Sarah Nadirah Mohd Johari, 2021

 BUYING STOCK IS LIKE LENDING MONEY;
SHORT-SELLING IS LIKE BORROWING MONEY
(1) When short-sell stock and later cover the short
(2) When borrow money

NOW LATER
Short-selling stock Cash inflow from sale Cash outflow to buy
of stock stock
Borrowing Money Cash inflow from Cash outflow to repay
borrowing money loan

Ms Sarah Nadirah Mohd Johari, 2021

THE LEASE RATE OF AN ASSET
• Lease rate of an asset: any payments that the borrower of an asset
has to make to the lender prior to repaying the asset.

Ms Sarah Nadirah Mohd Johari, 2021

CHAPTER 1
DERIVATIVES MARKETS

Ms Sarah Nadirah Mohd Johari, 2021

CONTENTS
• An Overview of Financial Markets
• Introduction to Derivatives
• Forwards, Options and Option Basic Strategies
• Forward Contracts
• Call Options
• Put Options
• Summary of Forward and Option Positions
• Options Are Insurance
• Basic Insurance Strategies
• Put-Call Parity
• Spreads and Collars
• Speculating on Volatility
• Financial Forwards, Futures and Swap

Ms Sarah Nadirah Mohd Johari, 2021

FORWARD CONTRACTS

Ms Sarah Nadirah Mohd Johari, 2021

FORWARD CONTRACTS
• Obligates one party to sell and the other party to buy a specified
quantity of an asset. The asset on which the contract is based is called
the underlying asset.
• Specifies the date on which the sale will take place and the date is
called expiration date.
• May also specify the time, place, manner of delivery, etc., if
appropriate.
• Specified the price that will be paid on the expiration date and the
price is called as forward price.

Ms Sarah Nadirah Mohd Johari, 2021

LONG AND SHORT OF FORWARD CONTRACTS

LONG FORWARD SHORT FORWARD

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PAYOFF OF FORWARD CONTRACTS
• Value of the contract to one of the parties on a particular date.
• The payoff is the amount that party would have if he/she completely
cashed out.
• Actual market price of an asset on a particular date is known as spot
price on that date.

𝑷𝒂𝒚𝒐𝒇𝒇 𝒕𝒐 𝒍𝒐𝒏𝒈 𝒇𝒐𝒓𝒘𝒂𝒓𝒅 = 𝒔𝒑𝒐𝒕 𝒑𝒓𝒊𝒄𝒆 𝒂𝒕 𝒆𝒙𝒑𝒊𝒓𝒂𝒕𝒊𝒐𝒏 − 𝒇𝒐𝒓𝒘𝒂𝒓𝒅 𝒑𝒓𝒊𝒄𝒆

𝑷𝒂𝒚𝒐𝒇𝒇 𝒕𝒐 𝒔𝒉𝒐𝒓𝒕 𝒇𝒐𝒓𝒘𝒂𝒓𝒅 = 𝒇𝒐𝒓𝒘𝒂𝒓𝒅 𝒑𝒓𝒊𝒄𝒆 − 𝒔𝒑𝒐𝒕 𝒑𝒓𝒊𝒄𝒆 𝒂𝒕 𝒆𝒙𝒑𝒊𝒓𝒂𝒕𝒊𝒐𝒏

Ms Sarah Nadirah Mohd Johari, 2021

EXAMPLE PAYOFF OF FORWARD CONTRACTS
Spot Price of PAYOFF PAYOFF GRAPH FOR FORWARD
Stock in 6 CONTRACTS
Long Forward Short Forward
Months (RM) (Sue) (George) 40
30
74 -30 30 20

84 -20 20 10
0
94 -10 10 -10
74 84 94 104 114 124 134

104 0 0 -20
-30
114 10 -10
-40
124 20 -20 Long Forward (Sue) Short Forward (George)

134 30 -30

Ms Sarah Nadirah Mohd Johari, 2021

EXAMPLE 3
Faris entered into a long forward with a forward price of RM100. Fadlan
entered into a short forward based on a different underlying asset and
having the same expiration date, but with a forward price of RM110.
Fadlan assets have the same spot price at expiration. Faris’s profit on
the expiration date is RM20. What is Fadlan’s payoff on the expiration
date?

Ms Sarah Nadirah Mohd Johari, 2021

EXERCISE 2
You are given the following information about two forward contracts
with expiration dates in 6 months:
Current Spot Price Spot Price in 6 Months Forward Price
Contract A 100 90 105
Contract B 120 145 126
You take a long position under Contract A and a short position under
Contract B. What is your total payoff at the end of 6 months?

Ms Sarah Nadirah Mohd Johari, 2021

A FORWARD CONTRACTS VS IMMEDIATE
PURCHASE
• Two ways of owning a stock 6 months from now:
Method 1: Buy the stock immediately and hold it for 6 months
Method 2: take a long position in a 6-month forward contract

• The current S0 of the stock is 𝑅𝑀100 and 𝐹0 is 𝑅𝑀104.

Method 1: Pay 𝑅𝑀100 now and hold the stock for 6 months
Method 2: Pay 𝐹0 in 6 months.

• Either method, will end up owning the stock in 6 months.

Ms Sarah Nadirah Mohd Johari, 2021

A FORWARD CONTRACTS VS IMMEDIATE
PURCHASE
PAYOFF GRAPH FOR FORWARD CONTRACTS
200

150

100

50

0
4 50 100 150
-50

-100

-150
Payoff on Long Forward Payoff on Immediate Purchase

Ms Sarah Nadirah Mohd Johari, 2021

A FORWARD CONTRACTS VS IMMEDIATE
PURCHASE
• To demonstrate the equivalence of the two methods in a concrete
way:
Method 1: Obligated to buy stock for RM104 in 6-months.
Prefund this obligation by investing RM100 now in a 6-month
zero coupon bond that will mature for RM104.
Method 2: Borrow RM100 to pay for the stock outright. Hence,
cash flow at time 0 is 0 but cash outflow of RM104 in 6 months
to repay the loan.

Ms Sarah Nadirah Mohd Johari, 2021

A FORWARD CONTRACTS VS IMMEDIATE
PURCHASE
PAYOFF GRAPH FOR FORWARD CONTRACTS
200

150

100

50

0
4 50 100 150
-50

-100

-150
Payoff on long forward+bond Payoff on Immediate Purchase Payoff on Bond (RM104)

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CALL OPTIONS

BUYER SELLER
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CALL OPTIONS
• Purchaser: party who pays a premium for the right, but NOT the obligation,
to buy the underlying asset at the strike price.
• Writer: party who charges a premium for the purchaser’s right, but NOT
the obligation, to buy the underlying asset at the strike price. Obligated to
sell the asset at the specified price if the purchaser of the option wants to
buy it.
• Strike/Exercise price: Agreed-upon price for which the purchaser of the call
option can buy the asset.
• Exercising: Purchaser of the call decides to pay the strike price to buy the
underlying asset.
• Expiration date: Agreed-upon date by which the call option must be
exercised. If the purchaser of the option decides not to exercise it, the
option expires.

Ms Sarah Nadirah Mohd Johari, 2021

CALL OPTIONS
• Two style call options:

European-style STYLES American-style

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EXAMPLE 4
The strike price of a 6-month European – style call option is RM100.
Nabilah purchases the option from Atiqah for RM10.35. What is
Nabilah’s payoff at expiration if the spot price of the underlying asset at
that time is
(a) RM115
(b) RM100
(c) RM90

Ms Sarah Nadirah Mohd Johari, 2021

EXERCISE 3
If the effective rate of interest for a 6-month period is 4%, what is
Nabilah’s profit at the end of 6 months for each spot price in Example
3?

Ms Sarah Nadirah Mohd Johari, 2021

CALL CONTRACTS

BUYER SELLER
Ms Sarah Nadirah Mohd Johari, 2021
PURCHASED/LONG CALL
• Payoff on a European – style purchased call:

𝑷𝒂𝒚𝒐𝒇𝒇 𝒐𝒏 𝒑𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒅 𝒄𝒂𝒍𝒍 = 𝒎𝒂𝒙[𝟎, 𝒔𝒑𝒐𝒕 𝒑𝒓𝒊𝒄𝒆 𝒂𝒕 𝒆𝒙𝒑𝒊𝒓𝒂𝒕𝒊𝒐𝒏 − 𝒔𝒕𝒓𝒊𝒌𝒆 𝒑𝒓𝒊𝒄𝒆]

𝑷𝒂𝒚𝒐𝒇𝒇 𝒐𝒏 𝒑𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒅 𝒄𝒂𝒍𝒍 = 𝒎𝒂𝒙 𝟎, 𝑺𝑻 − 𝑲

• Profit on a European – style purchased call:

𝑷𝒓𝒐𝒇𝒊𝒕 𝒐𝒏 𝒑𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒅 𝒄𝒂𝒍𝒍

= 𝒎𝒂𝒙 𝟎, 𝒔𝒑𝒐𝒕 𝒑𝒓𝒊𝒄𝒆 𝒂𝒕 𝒆𝒙𝒑𝒊𝒓𝒂𝒕𝒊𝒐𝒏 − 𝒔𝒕𝒓𝒊𝒌𝒆 𝒑𝒓𝒊𝒄𝒆 − 𝑭𝑽 𝒐𝒇 𝒐𝒑𝒕𝒊𝒐𝒏 𝒑𝒓𝒆𝒎𝒊𝒖𝒎

𝑷𝒓𝒐𝒇𝒊𝒕 𝒐𝒏 𝒑𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒅 𝒄𝒂𝒍𝒍 = 𝒎𝒂𝒙 𝟎, 𝑺𝑻 − 𝑲 − 𝑭𝑽 𝑪

Ms Sarah Nadirah Mohd Johari, 2021

 PURCHASED/LONG CALL

Strike Call
35 6.13
40 2.78
45 0.97

Ms Sarah Nadirah Mohd Johari, 2021

WRITTEN/SHORT CALL
• Payoff on a European – style written call:
𝑷𝒂𝒚𝒐𝒇𝒇 𝒐𝒏 𝒘𝒓𝒊𝒕𝒕𝒆𝒏 𝒄𝒂𝒍𝒍 = −𝒎𝒂𝒙[𝟎, 𝒔𝒑𝒐𝒕 𝒑𝒓𝒊𝒄𝒆 𝒂𝒕 𝒆𝒙𝒑𝒊𝒓𝒂𝒕𝒊𝒐𝒏 − 𝒔𝒕𝒓𝒊𝒌𝒆 𝒑𝒓𝒊𝒄𝒆]

𝑷𝒂𝒚𝒐𝒇𝒇 𝒐𝒏 𝒘𝒓𝒊𝒕𝒕𝒆𝒏 𝒄𝒂𝒍𝒍 = −𝒎𝒂𝒙 𝟎, 𝑺𝑻 − 𝑲

• Profit on a European – style written call:

𝑷𝒓𝒐𝒇𝒊𝒕 𝒐𝒏 𝒘𝒓𝒊𝒕𝒕𝒆𝒏 𝒄𝒂𝒍𝒍
= −𝒎𝒂𝒙 𝟎, 𝒔𝒑𝒐𝒕 𝒑𝒓𝒊𝒄𝒆 𝒂𝒕 𝒆𝒙𝒑𝒊𝒓𝒂𝒕𝒊𝒐𝒏 − 𝒔𝒕𝒓𝒊𝒌𝒆 𝒑𝒓𝒊𝒄𝒆 − 𝑭𝑽 𝒐𝒇 𝒐𝒑𝒕𝒊𝒐𝒏 𝒑𝒓𝒆𝒎𝒊𝒖𝒎

𝑷𝒓𝒐𝒇𝒊𝒕 𝒐𝒏 𝒘𝒓𝒊𝒕𝒕𝒆𝒏 𝒄𝒂𝒍𝒍 = −𝒎𝒂𝒙 𝟎, 𝑺𝑻 − 𝑲 − 𝑭𝑽 𝑪

Ms Sarah Nadirah Mohd Johari, 2021

 WRITTEN/SHORT CALL

Strike Call
35 6.13
40 2.78
45 0.97

Ms Sarah Nadirah Mohd Johari, 2021

PUT OPTIONS

BUYER SELLER
Ms Sarah Nadirah Mohd Johari, 2021
PUT OPTIONS
• Purchaser: party who pays a premium for the right, but NOT the
obligation, to sell the underlying asset at the strike price.
• Writer: party who charges a premium for the purchaser’s right, but
NOT the obligation, to sell the underlying asset at the strike price.
Obligated to buy the asset at the specified price if the purchaser of
the option wants to sell it.
• Purchased put has a short position with respect to the underlying
asset.

Ms Sarah Nadirah Mohd Johari, 2021

PUT OPTIONS

BUYER SELLER
Ms Sarah Nadirah Mohd Johari, 2021
PURCHASED/LONG PUT
• Payoff on a European – style purchased put:
𝑷𝒂𝒚𝒐𝒇𝒇 𝒐𝒏 𝒑𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒅 𝒑𝒖𝒕 = 𝒎𝒂𝒙[𝟎, 𝒔𝒕𝒓𝒊𝒌𝒆 𝒑𝒓𝒊𝒄𝒆 − 𝒔𝒑𝒐𝒕 𝒑𝒓𝒊𝒄𝒆 𝒂𝒕 𝒆𝒙𝒑𝒊𝒓𝒂𝒕𝒊𝒐𝒏]

𝑷𝒂𝒚𝒐𝒇𝒇 𝒐𝒏 𝒑𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒅 𝒑𝒖𝒕 = 𝒎𝒂𝒙 𝟎, 𝑲 − 𝑺𝑻

• Profit on a European – style purchased put:

𝑷𝒓𝒐𝒇𝒊𝒕 𝒐𝒏 𝒑𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒅 𝒑𝒖𝒕
= 𝒎𝒂𝒙 𝟎, 𝒔𝒕𝒓𝒊𝒌𝒆 𝒑𝒓𝒊𝒄𝒆 − 𝒔𝒑𝒐𝒕 𝒑𝒓𝒊𝒄𝒆 𝒂𝒕 𝒆𝒙𝒑𝒊𝒓𝒂𝒕𝒊𝒐𝒏 − 𝑭𝑽 𝒐𝒇 𝒐𝒑𝒕𝒊𝒐𝒏 𝒑𝒓𝒆𝒎𝒊𝒖𝒎

𝑷𝒓𝒐𝒇𝒊𝒕 𝒐𝒏 𝒑𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒅 𝒑𝒖𝒕 = 𝒎𝒂𝒙 𝟎, 𝑲 − 𝑺𝑻 − 𝑭𝑽 𝑪

Ms Sarah Nadirah Mohd Johari, 2021

PURCHASED/LONG PUT

Strike Put
35 0.44
40 1.99
45 5.08

Ms Sarah Nadirah Mohd Johari, 2021

WRITTEN/SHORT PUT
• Payoff on a European – style written put:
𝑷𝒂𝒚𝒐𝒇𝒇 𝒐𝒏 𝒘𝒓𝒊𝒕𝒕𝒆𝒏 𝒑𝒖𝒕 = −𝒎𝒂𝒙[𝟎, 𝒔𝒕𝒓𝒊𝒌𝒆 𝒑𝒓𝒊𝒄𝒆 − 𝒔𝒑𝒐𝒕 𝒑𝒓𝒊𝒄𝒆 𝒂𝒕 𝒆𝒙𝒑𝒊𝒓𝒂𝒕𝒊𝒐𝒏]

𝑷𝒂𝒚𝒐𝒇𝒇 𝒐𝒏 𝒘𝒓𝒊𝒕𝒕𝒆𝒏 𝒑𝒖𝒕 = −𝒎𝒂𝒙 𝟎, 𝑲 − 𝑺𝑻

• Profit on a European – style written put:

𝑷𝒓𝒐𝒇𝒊𝒕 𝒐𝒏 𝒘𝒓𝒊𝒕𝒕𝒆𝒏 𝒑𝒖𝒕
= −𝒎𝒂𝒙 𝟎, 𝒔𝒕𝒓𝒊𝒌𝒆 𝒑𝒓𝒊𝒄𝒆 − 𝒔𝒑𝒐𝒕 𝒑𝒓𝒊𝒄𝒆 𝒂𝒕 𝒆𝒙𝒑𝒊𝒓𝒂𝒕𝒊𝒐𝒏 − 𝑭𝑽 𝒐𝒇 𝒐𝒑𝒕𝒊𝒐𝒏 𝒑𝒓𝒆𝒎𝒊𝒖𝒎

𝑷𝒓𝒐𝒇𝒊𝒕 𝒐𝒏 𝒘𝒓𝒊𝒕𝒕𝒆𝒏 𝒑𝒖𝒕 = −𝒎𝒂𝒙 𝟎, 𝑲 − 𝑺𝑻 − 𝑭𝑽 𝑪

Ms Sarah Nadirah Mohd Johari, 2021

TERMINOLOGY SUMMARY

Term as Used in the Alternative Term Position in the

Field (Based on the Underlying Asset
Position in the Option
Itself)
Long Call Purchased Call Long
Short Call Written Call Short
Long Put Purchased Put Short
Short Put Written Put Long

Ms Sarah Nadirah Mohd Johari, 2021

A PUT OPTION IS INSURANCE; INSURANCE IS A
PUT OPTION

HOW DOES A PUT OPTION IS AN INSURANCE?

Long put provides a form of insurance against a fall in the value of the
asset and that is the reason why the purchaser pays a premium to the
put writer.
HOW DOES AN INSURANCE IS A PUT OPTION?
An insurance policy protects you against a fall in the value of an asset
that you own like car or house.

Ms Sarah Nadirah Mohd Johari, 2021

COMPARING CONTRACTS
IN – THE – MONEY OR OUT – OF – THE - MONEY
• Put or call option that would give you a positive payoff if you
exercised it immediately said to be “in-the-money”
HOW DO WE KNOW IF A PURCHASED CALL IS IN THE MONEY?
HOW DO WE KNOW IF A PURCHASED PUT IS IN THE MONEY?
• Payoff would be negative on immediate exercise said to be “out-of-
the-money
HOW ABOUT IF THE OPTION IS AT – THE – MONEY?

Ms Sarah Nadirah Mohd Johari, 2021

COMPARING CONTRACTS
IN – THE – MONEY OR OUT – OF – THE - MONEY

Ms Sarah Nadirah Mohd Johari, 2021

 COMPARISON OF CONTRACTS BY POSITION
Type of Party Referred to as Position in
Contract Underlying
Asset
Forward Obligated to buy at the forward price Long Forward Long
Obligated to sell at the forward price Short Forward Short
Call Right(but not obligation) to buy at strike Purchased (or Long) Call Long
price
Obligation to sell at strike price if purchaser Written (or Short) Call Short
of call exercises option
Put Right(but not obligation) to sell at strike price Purchased (or Long) Put Short

Obligation to buy at strike price if purchaser Written (or Short) Put Long
of put exercises option

Ms Sarah Nadirah Mohd Johari, 2021

COMPARISON OF CONTRACTS BY MAXIMUM
PROFIT AND LOSS
Position Maximum Loss Maximum Gain
Long Forward -forward price Unlimited
Short Forward Unlimited Forward Price
Long (Purchased) Call - FV of premium Unlimited
Short (Written) Call Unlimited FV of premium
Long (Purchased) Put - FV of premium Strike price – FV of
premium
Short (Written) Put FV of premium – strike price FV of premium

Ms Sarah Nadirah Mohd Johari, 2021

COMPARISON BY “ASSET PRICE
CONTINGENCY”
Position Condition for Buying or Selling the Underlying
Asset (“Asset Price Contingency”)
Long Forward Always
Short Forward Always
Long (Purchased) Call Spot Price > strike price
Short (Written) Call Spot Price > strike price
Long (Purchased) Put Spot Price < strike price
Short (Written) Put Spot Price < strike price

Ms Sarah Nadirah Mohd Johari, 2021

 COMPARISON OF CONTRACTS BY STRATEGY
Derivative Position Position With Respect to Strategy
Underlying Asset
Long Forward Long (buy) Guaranteed price
Short Forward Short (sell) Guaranteed price
Long (Purchased) Call Long (buy) Insures against high price
Short (Written) Call Short (sell) Sells insurance against high price
Long (Purchased) Put Short (sell) Insures against low price
Short (Written) Put Long (buy) Sells insurance against low price

Ms Sarah Nadirah Mohd Johari, 2021

OPTION AND FORWARD POSITIONS: A SUMMARY

Ms Sarah Nadirah Mohd Johari, 2021

CHAPTER 1
DERIVATIVES MARKETS

Ms Sarah Nadirah Mohd Johari, 2021

BASIC INSURANCE STRATEGIES
• Options can be:
- Used to insure long positions (floors)
- Used to insure short positions (caps)
- Written against asset positions (selling insurance)

Ms Sarah Nadirah Mohd Johari, 2021

INSURING A LONG POSITION
Suppose you are about to buy a certain stock with current price of
RM100 and you want to have insurance against the possibility that the
price will decline.

Can you think of anything you could do to protect yourself, using any
of the derivative contracts we have discussed so far?

Ms Sarah Nadirah Mohd Johari, 2021

INSURING A LONG POSITION
Since a purchased put guarantees a minimum price at which an asset
can be sold, the put is also called a FLOOR.

The combined long put – long stock position is often referred to as a

protective put.

Ms Sarah Nadirah Mohd Johari, 2021

INSURING A LONG POSITION
You buy the stock for RM100 and at the same time you purchase a
European 6-month put with a strike price of RM100.

What is the payoff if the spot price at expiration is less than or equal
to RM100?

What is the payoff if the spot price at expiration is more than RM100,
say RM120?

Ms Sarah Nadirah Mohd Johari, 2021

INSURING A LONG POSITION
You buy the stock for RM100 and at the same time you purchase a
European 6-month put with a strike price of RM100.
Spot Price at Expiration PAYOFF
From Stock From Put Combined
70
80
90
100
110
120
130

Ms Sarah Nadirah Mohd Johari, 2021

INSURING A LONG POSITION

Ms Sarah Nadirah Mohd Johari, 2021

INSURING A LONG POSITION
To determine the profit, you should deduct what could be called the
financing cost from the payoff.

The financing cost is the RM100 you paid for the stock and the RM6.59 you
paid for the put at time 0.

We should add interest to determine the financing cost at the end of 6-

months.

Thus, assuming 4% effective for ½ year, the financing cost as of the end of 6
months is (100 + 6.50) (1.04) = 110.76
Ms Sarah Nadirah Mohd Johari, 2021
INSURING A LONG POSITION
Financing cost is shown in the 5th column and 6th column minus this
cost from the payoff to determine the profit.
Spot Price at PAYOFF Cost Profit
Expiration From From Put Combined (including
Stock interest)
70
80
90
100
110
120
130

Ms Sarah Nadirah Mohd Johari, 2021

INSURING A LONG POSITION

Ms Sarah Nadirah Mohd Johari, 2021

EXERCISE 4(i)
You purchase a share of Stock A and a share of Stock B. At the same
time, you purchase two European 6-month put options with Stock A
and Stock B as the underlying assets. You are given the following
information:
Current Spot Price Strike Price Put Premium Spot Price at Expiration
Stock A 60 60 3.90 50
Stock B 75 75 4.88 80

Determine the total payoff from the stocks and the options at the end
of 6 month.

Ms Sarah Nadirah Mohd Johari, 2021

EXERCISE 4(ii)

Current Spot Price Strike Price Put Premium Spot Price at Expiration
Stock A 60 60 3.90 50
Stock B 75 75 4.88 80
If the effective rate of interest is 4% for a ½ year period, determine the
total profit in Example 4(i).

Ms Sarah Nadirah Mohd Johari, 2021

INSURING A SHORT POSITION: CAPS
• A call option is combined with a position in the underlying asset

• Goal: to insure against an increase in the price of the underlying asset

(when one has a short position in that asset)

Ms Sarah Nadirah Mohd Johari, 2021

INSURING A SHORT POSITION
Suppose you have a short position in a stock. You want to have
insurance against price increases.

Can you think of anything you could do to protect yourself, using any
of the derivative contracts we have discussed so far?

Since a purchased call guarantees a maximum price at which an asset

can be purchased, the call is also called a CAP.

Ms Sarah Nadirah Mohd Johari, 2021

INSURING A SHORT POSITION
You short-sold stock for RM100. For insurance, you purchase a
European 6-month call with a strike price of RM100.
Spot Price at Expiration PAYOFF
From Short From Call Combined
70
80
90
100
110
120
130

Ms Sarah Nadirah Mohd Johari, 2021

INSURING A SHORT POSITION
Financing cost is shown in the 5th column and 6th column minus this
cost from the payoff to determine the profit.
Spot Price at PAYOFF Cost Profit
Expiration From From Call Combined (including
Short interest)
70
80
90
100
110
120
130

Ms Sarah Nadirah Mohd Johari, 2021

EXERCISE 5(i)
You sell a share of Stock A and a share of Stock B short. The shorts must
be covered in 6 months. At the same time, you purchase a European 6-
month call option on each stock. You are given the following
information:
Current Spot Price Strike Price Call Premium Spot Price at Expiration
Stock A 60 60 6.21 50
Stock B 75 75 7.86 80

Determine the total payoff from the stocks and the options at the end
of 6 month.

Ms Sarah Nadirah Mohd Johari, 2021

EXERCISE 5(ii)

Current Spot Price Strike Price Call Premium Spot Price at Expiration
Stock A 60 60 6.21 50
Stock B 75 75 7.86 80
If the effective rate of interest is 4% for a ½ year period, determine the
total profit in Example 5(i).

Ms Sarah Nadirah Mohd Johari, 2021

SELLING INSURANCE
• For every insurance buyer there must be
an insurance seller.

• Strategies used to sell insurance:

- Covered writing (option overwriting or selling a covered call) is
writing an option when there is a corresponding long position in the
underlying asset is called covered writing
- Naked writing is writing an option when the writer does not have a
position in the asset

Ms Sarah Nadirah Mohd Johari, 2021

COVERED CALLS
You buy a stock currently priced at RM100. At the same time, you sell a
European call option with a strike price of RM100.
Spot Price at PAYOFF Cost Profit
Expiration From From Combined (including
Stock Written Call interest)
70
80
90
100
110
120
130

Ms Sarah Nadirah Mohd Johari, 2021

COVERED CALLS

Ms Sarah Nadirah Mohd Johari, 2021

COVERED PUTS
• Take a short position in an asset (such by selling it short) and write a
put at the same time.

Try to make up a table of payoffs similar to the table for the covered
call in previous slide.

Ms Sarah Nadirah Mohd Johari, 2021

SYNTHETIC FORWARDS
Suppose you buy a call (premium = RM10.35) and write a put (premium
= RM6.50) on the same underlying asset, with the same strike price of
RM100 and same expiration date in 6 months.

Try sketch the payoff graphs for long call, short put and combined.
What does the combined payoff graph look like?

Calculate the profit with interest of 4% for ½ year.

Ms Sarah Nadirah Mohd Johari, 2021

SYNTHETIC FORWARDS
What is the difference between Synthetic Forward and “true” Forward
Contract?

What should the forward price be so that a forward contract has the
same profit as the combination of a purchased call and written put?

Ms Sarah Nadirah Mohd Johari, 2021

PUT – CALL PARITY
Suppose you want to own a non-dividend paying stock at time 𝑇. These
are many portfolios that could establish today that will result in owning
the stock at time 𝑇:

1) Outright Purchase
2) Forward Contract
3) Long Call ; Call 𝐾, 𝑇 and Short Put; Put 𝐾, 𝑇

Each case will end up owning a share of stock at time 𝑇.

Ms Sarah Nadirah Mohd Johari, 2021
 PUT – CALL PARITY
Table below shows all of the cash flows under the three portfolios and
the resulting net cost at time 0: (Note: cash flows occur only at time 0
and time 𝑇)

PORTFOLIO CASH OUTFLOWS CASH OUTFLOWS NET COSTS AS OF TIME

AT TIME 0 AT TIME T 0
1. Outright Purchase 𝑆0 - 𝑆0
2. Long Forward with Forward Price, 𝐹0,𝑇 - 𝐹0,𝑇 𝑃𝑉(𝐹0,𝑇 )
3. Long Call and Short Put with Strike 𝐶𝑎𝑙𝑙 𝐾, 𝑇 𝐾 𝐶𝑎𝑙𝑙 𝐾, 𝑇 − 𝑃𝑢𝑡 𝐾, 𝑇
Price 𝐾 (Synthetic Forward) − 𝑃𝑢𝑡 (𝐾, 𝑇) + 𝑃𝑉(𝐾)

Ms Sarah Nadirah Mohd Johari, 2021

PUT – CALL PARITY
PORTFOLIOS 1 AND 2:
Setting the net costs of portfolios 1 and 2 equal, we have:
𝑺𝟎 = 𝑷𝑽(𝑭𝟎,𝑻 )
From this, we can express the forward price in terms of the current
price of the stock:
𝑭𝟎,𝑻 = 𝑭𝑽 𝑺𝟎
The forward price for a non-dividend paying stock is simply the current
price of the stock accumulated with interest to time 𝑇 at the risk–free
interest rate

Ms Sarah Nadirah Mohd Johari, 2021

PUT – CALL PARITY
PORTFOLIOS 2 AND 3:
Setting the net costs equal, we have:

𝑷𝑽 𝑭𝟎,𝑻 = 𝑪𝒂𝒍𝒍 𝑲, 𝑻 − 𝑷𝒖𝒕 𝑲, 𝑻 + 𝑷𝑽 𝑲

𝑪𝒂𝒍𝒍 𝑲, 𝑻 − 𝑷𝒖𝒕 𝑲, 𝑻 = 𝑷𝑽 𝑭𝟎,𝑻 − 𝑷𝑽(𝑲)

This relationship is knowns as put – call parity. It derives from net cost
of buying an asset using options = net cost of buying an asset using a
forward contract.

Ms Sarah Nadirah Mohd Johari, 2021

PUT – CALL PARITY
PORTFOLIO 1 AND 3:
Setting the net costs equal, we have:

𝑺𝟎 = 𝑪𝒂𝒍𝒍 𝑲, 𝑻 − 𝑷𝒖𝒕 𝑲, 𝑻 + 𝑷𝑽 𝑲
𝑪𝒂𝒍𝒍 𝑲, 𝑻 − 𝑷𝒖𝒕 𝑲, 𝑻 = 𝑺𝟎 − 𝑷𝑽(𝑲)

This relationship for a non-dividend paying stock derives from net cost
of buying an asset using options must be the same as the net cost of an
outright purchase of the asset

Ms Sarah Nadirah Mohd Johari, 2021

PUT – CALL PARITY
NO – ARBITRAGE PRICING
• Net cost of buying an asset on a future date should be the same,
regardless of the particular arrangement we make for buying the
asset
• If this principle did not hold, there would be different costs for buying
asset using different contracts.
• Make a lot of money by buying the asset at a lower cost and selling it
at a higher cost

Ms Sarah Nadirah Mohd Johari, 2021

EXERCISE 6
A non-dividend-paying stock currently sells for RM90. The risk-free
continuously compounded rate of return is 6%. The premium for an 80-
strik call with an expiration date in 6 months is RM15.00. The premium
for a 100-strike put with the same expiration date is RM12.00.
Determine the excess of the premium for a 100-strike call over the
premium for an 80-strike put with an expiration date in 6 months.

Ms Sarah Nadirah Mohd Johari, 2021

EXERCISE 6
The call premium for a non-dividend-paying stock exceeds the put
premium by RM19.608, where both options have a strike price of K.
The put premium on the same stock exceeds the call premium by
RM29.412, where both options have a strike price that is 5% greater
than K. The effective rate of interest for the period from time 0 to the
expiration date of the options is 2%. Determine K and the current stock
price.

Ms Sarah Nadirah Mohd Johari, 2021

SPREADS AND COLLARS
• An option spread is a position consisting of only calls or only puts, in
which some options are purchased and some written

Bull Bear

SPREADS
Box Ratio

Ms Sarah Nadirah Mohd Johari, 2021

 SPREADS AND COLLARS
• A collar is the purchase of a put option and the sale
of a call option with a higher strike price, with both
options having the same underlying asset and having
the same expiration date
Example: zero-cost collar
• A collar represents a bet that the price of the
underlying asset will decrease and resembles a short
forward
• A zero-cost collar can be created when the
premiums of the call and put exactly offset one
another

Ms Sarah Nadirah Mohd Johari, 2021

SPECULATING ON VOLATILITY
• Options can be used to create positions that are nondirectional with
respect to the underlying asset

Straddles Strangles

EXAMPLES

Butterfly spreads

Ms Sarah Nadirah Mohd Johari, 2021

SPECULATING ON VOLATILITY

• Who would use nondirectional positions?

Investors who do not care whether the stock goes up or down,
but only how much it moves, i.e., who speculate on volatility.

Ms Sarah Nadirah Mohd Johari, 2021

CHAPTER 1
DERIVATIVES MARKETS

Ms Sarah Nadirah Mohd Johari, 2021

CONTENTS
• An Overview of Financial Markets
• Introduction to Derivatives
• Forwards, Options and Option Basic Strategies
• Financial Forwards, Futures and Swap
• Alternative Ways to Buy A Stock
• Prepaid Forward Contracts on Stock
• Forward Contracts on Stock
• Future Contracts
• An Example of a Commodity Swap
• Computing the Swap

Ms Sarah Nadirah Mohd Johari, 2021

ALTERNATIVE WAYS TO BUY A STOCK
(1) Outright purchase: Pay for the stock and receive it immediately.
(2) Forward contract: Pay for the stock on the expiration date and
receive it at that time.
(3) Prepaid forward (prepay) contract: Pay for the stock now and
received it at time 𝑇.
(4) Fully leveraged purchase: Receive the stock now and pay for it at
time 𝑇 . Will do this by borrowing money needed to buy the stock
and repaying the loan at time 𝑇.

Ms Sarah Nadirah Mohd Johari, 2021

 ALTERNATIVE WAYS TO BUY A STOCK
4 different ways to buy a share of stock that has price 𝑆0 at time 0. At
time 0 you agree to a price, which is paid either today or at time 𝑇 . The
shares are received either at 0 or 𝑇. The interest rate is 𝑟.

METHOD OF BUYING STOCK TIME OF PAYMENT TIME STOCK IS AMOUNT OF PAYMENT

RECEIVED
Outright Purchase 0 0 𝑆0
Fully Leverage Purchase 𝑇 0 𝑆0 𝑒 𝑟𝑇
Prepaid forward contract 0 𝑇 To be determined
Forward contract 𝑇 𝑇 To be determined

Ms Sarah Nadirah Mohd Johari, 2021

PREPAID FORWARD CONTRACTS ON STOCK
• Pay for the stock now but do not actually receive it until time 𝑇.
Is there any difference between receiving the stock now and receiving
it at time 𝑻?
Does it matter whether:
the stock is place in a vault until time 𝑻?
the seller of the prepay holds onto the stock until time 𝑻?
the stock is sent to Mars in a spaceship until time 𝑻?

Ms Sarah Nadirah Mohd Johari, 2021

PREPAID FORWARD CONTRACTS ON STOCK
YES, IT DOES MATTER,if dividends are paid on the stock between time
𝟎 and time 𝑻 and you do not get them.
Until you receive the stock, you will not be able to exercise your
voting rights or other control rights as a shareholder.
• Three possible methods to price prepaid forwards:
Pricing by analogy
Pricing by discounted present value
Pricing by arbitrage
• For now, assume that there are no dividends
Ms Sarah Nadirah Mohd Johari, 2021
PREPAID FORWARD CONTRACTS ON STOCK
PRICING BY ANALOGY
• In the absence of dividends, the timing of delivery is irrelevant.
• Price of the prepaid forward contract same as current stock price.
𝑃
𝐹0,𝑇 = 𝑆0
• The asset is bought at 𝑡 = 0, delivered at 𝑡 = 𝑇

Ms Sarah Nadirah Mohd Johari, 2021

PREPAID FORWARD CONTRACTS ON STOCK
PRICING BY DISCOUNTED PRESENT VALUE
• We calculate the expected value of the stock at time 𝑇 and then
discount that value at an appropriate rate of return.
• 𝑆𝑇 is uncertain. Therefore, need to use an appropriate risk-adjusted
rate, 𝛼.
𝑃
𝐹0,𝑇 = 𝐸0 (𝑆𝑇 )𝑒 −𝛼𝑇
𝐸0 𝑆𝑇 = 𝑆0 𝑒 𝛼𝑇

𝑃
𝐹0,𝑇 = 𝑆0 𝑒 𝛼𝑇 𝑒 −𝛼𝑇
𝑃
𝐹0,𝑇 = 𝑆0

Ms Sarah Nadirah Mohd Johari, 2021

PREPAID FORWARD CONTRACTS ON STOCK
PRICING BY ARBITRAGE
• Arbitrage: a situation in which one can generate positive cash flow by
simultaneously buying and selling related assets, with no net
investment and with no risk -> free money!!!
• If at time 𝑡 = 0, the prepaid forward price somehow exceeded the
𝑃
stock price, 𝐹0,𝑇 > 𝑆0 , an arbitrageur will buy low and sell high by
𝑃
buying the stock for 𝑆0 and selling the prepaid forward for 𝐹0,𝑇 .

Ms Sarah Nadirah Mohd Johari, 2021

PREPAID FORWARD CONTRACTS ON STOCK
PRICING BY ARBITRAGE
Cash flows and transactions to undertake arbitrage when the prepaid
𝑃
forward price, 𝐹0,𝑇 > 𝑆0 .
CASH FLOWS
TRANSACTION TIME 0 TIME T (EXPIRATION)
Buy stock @ 𝑆0 −𝑆0 +𝑆𝑇
Sell prepaid forward @ 𝑃 −𝑆𝑇
+𝐹0,𝑇
TOTAL 𝑭𝑷
𝟎,𝑻 − 𝑺𝟎 𝟎

Ms Sarah Nadirah Mohd Johari, 2021

PREPAID FORWARD CONTRACTS ON STOCK
PRICING PREPAID FORWARDS WITH DIVIDENDS
• When a stock pays a dividend, the prepaid forward price is less than
the stock price.
• Owner of stock receives dividends.
• Owner of prepaid forward contract does not.
• Two types of dividends:
𝑃
(i) Discrete Dividends: 𝐹0,𝑇 = 𝑆0 − σ𝑛𝑖=1 𝑃𝑉0,𝑡𝑖 𝐷𝑡𝑖
𝑃
(ii) Continuous Dividends: 𝐹0,𝑇 = 𝑆0 𝑒 −𝛿𝑇

Ms Sarah Nadirah Mohd Johari, 2021

EXAMPLE 5
Suppose XYZ stock costs RM100 today and is expected to pay a RM1.25
quarterly dividend, with the first coming 3 months from today and the
last just prior to the delivery of the stock. Suppose the annual
continuously compounded risk-free rate is 10%. The quarterly
continuously compounded rate is therefore 2.5%. A 1-year prepaid
forward contract for the stock would cost?

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EXAMPLE 6
Suppose that the index is RM125 and the annualized daily
compounded dividend yield is 3%. Find:
(i) The daily dollar
(ii) The prepaid forward price

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FORWARD CONTRACTS ON STOCK
• Difference between prepaid forward contract and a forward contract
is the timing of the payment for the stock which is immediate with a
prepaid forward but deferred with a forward.
• Due to deferred payment, forward contract is initially costless for
both buyer and seller, premium = 0.
• Forward price is the future value of the prepaid forward price.

𝑃
𝐹0,𝑇 = 𝐹𝑉(𝐹0,𝑇 )

𝐹0,𝑇 = 𝑒 𝑟𝑇 𝑆0 𝑒 −𝛿𝑇 𝑜𝑟 𝑆0 𝑒 𝑟− 𝛿 𝑇

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FORWARD CONTRACTS ON STOCK
FORWARD PREMIUM
• The difference between current forward price and stock price.
• Can be used to infer the current stock price from forward price.
• Definition:
Forward premium= 𝐹0,𝑇 /𝑆0

1 𝐹0,𝑇
Annualized forward premium= ln
𝑇 𝑆0

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OTHER ISSUES IN FORWARD PRICING
• Does the forward price predict the future price?
According the formula F0,T = 𝑆0 𝑒 − 𝑟− 𝛿 𝑇 the forward price
conveys no additional information beyond what 𝑆0 , 𝑟, and 𝛿
provides.
Moreover, the forward price underestimates the future stock
price.
• Forward pricing formula and cost of carry:
𝐹𝑜𝑟𝑤𝑎𝑟𝑑 𝑝𝑟𝑖𝑐𝑒
= 𝑆𝑝𝑜𝑡 𝑝𝑟𝑖𝑐𝑒 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑡𝑜 𝑐𝑎𝑟𝑟𝑦 𝑡ℎ𝑒 𝑎𝑠𝑠𝑒𝑡 – 𝑎𝑠𝑠𝑒𝑡 𝑙𝑒𝑎𝑠𝑒 𝑟𝑎𝑡𝑒
Cost of carry, (r-d)S

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FUTURE CONTRACTS
• Are essentially exchange-traded forward contracts.
• Represent a commitment to buy or sell an underlying asset at some
future date.
• They are standardized and have specified delivery dates, locations,
and procedures

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FUTURE CONTRACTS VS FORWARD CONTRACTS
FUTURE CONTRACTS FORWARD CONTRACTS
• An obligation to buy or sell the • Same
underlying asset at a specified
price on the expiration date.
• Standardized as to expiration • Tailored to the needs of each
dates, size, underlying asset or party
index
• Marked-to-market and settled • Not marked-to-market and
daily settlement is made on
expiration date only.

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 FUTURE CONTRACTS VS FORWARD CONTRACTS
FUTURE CONTRACTS FORWARD CONTRACTS
• Liquid. Exchange traded. Marking- • Relatively illiquid. Traded over-the-
to-market allows for daily counter. Handled by dealers or
settlement brokers. Difficult to settle a contract
before expiration date.
• Marking-to-market and daily • Credit risk may be a problem.
settlement minimizes credit risk.
• The exchange imposes price limits. • Price limit are not applicable, since
The rules are complicated. there is no daily marking-to-market
or settlement.
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FUTURE CONTRACTS

BUYER SELLER
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 FUTURE CONTRACTS
MARGIN ACCOUNT WITH NO INTEREST

DAY FUTURES PRICE CREDIT OR DEBIT = BALANCE IN

PRICE CHANGE 𝑹𝑴𝟐𝟓𝟎 × 𝑷𝑹𝑰𝑪𝑬 𝑪𝑯𝑨𝑵𝑮𝑬 MARGIN ACCOUNT
0 1000 25,000
1 1005 +5 +1,250 26,250
2 999 -6 -1,500 24,750
3 1015 +16 +4,000 28,750
4 1014 -1 -250 28,500

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SWAP

BUYER SELLER
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SWAPS
• A contract that covers a stream of payment over a period of time.
• We can say, a forward contract is a single-payment swap.
• Four ways to settle a forward contract:
(i) Physical Settlement
(ii) Financial Settlement
(iii) Broker as a Go-Between (back-to-back or matched-book)
(iv) Broker Contracts Only With Buyer and Hedges Position

Ms Sarah Nadirah Mohd Johari, 2021

SWAPS
Assume a company needs to buy the commodity more than once, say
in one year and in two years from now.

A swap contract is available with a swap price of RM100 in one year

and RM110 in two years.

This contract can pay upfront by paying the present value of these
guaranteed prices at the risk-free interest rate and it is called as a
prepaid swap.

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SWAPS
Risk-free interest rates on zero-coupon bonds are:
TERM TO MATURITY (IN YEARS) YIELD RATE ON ZERO-COUPON BOND
1 4.0%
2 4.5
3 5.0
4 5.5

FIND THE PRESENT VALUE OF THE PREPAID SWAP PRICES.

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SWAPS
Concern from:
(a) Buyer: Will the seller be around to sell the commodity in one year
and in two years at the guaranteed prices?

(b) Seller: After delivering the commodity to you at the end of one
and two years, will the buyer be able to pay for it?

Ms Sarah Nadirah Mohd Johari, 2021

SWAPS
Buyer prefer to pay at the end of the two-year period (postpaid swap)

Way to handle payments on swap is to determine the level annual

payment that is equivalent to the prepaid amount.

Find level annual payment an what can you conclude?

Ms Sarah Nadirah Mohd Johari, 2021

THE MARKET VALUE OF A SWAP CONTRACT
• After the swap is entered into at time 0, the market value of the
contract may change as of a later time T.
• Consider two situations:
(1) There are no changes in the swap prices in contracts being written
at time T, as compared to contracts that were written at time 0.

(2) There are changes in the swap prices in contracts being written at
time T, as compared to contracts that were written at time 0.

Ms Sarah Nadirah Mohd Johari, 2021

 CHAPTER 2
PARITY AND OTHER OPTION RELATIONSHIP

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CONTENTS
• Put – Call Parity
• Generalized Parity and Exchange Options
• Comparing Option with Respect to Style, Maturity and Strike

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PUT – CALL PARITY
Discuss the relationship between the premium of a call and the premium of
a put.

In this entire section, we will deal only with European options, not American
ones.

Suppose you bought a European call option and sold a European put option,
both having the same underlying asset, strike price and time to expiry.

You would then pay 𝐶(𝐾, 𝑇) − 𝑃(𝐾, 𝑇) at time 0. An equivalent result can
be achieved without using options at all!
Ms Sarah Nadirah Mohd Johari, 2021
PUT – CALL PARITY
At time 𝑇, either one of the options is sure to be exercise unless the price of
the asset is exactly equal the strike price, (𝑆𝑇 = 𝐾).Therefore, both options
are worthless.

Whichever options is exercised, you pay 𝐾 and receive the underlying asset:
1. If 𝑆𝑇 > 𝐾, you exercise the call option you bought. You pay 𝐾 and receive
the asset.
2. If 𝐾 > 𝑆𝑇 , the counterparty exercises the put option you sold. You
receive the asset and pay 𝐾.
3. If 𝑆𝑇 = 𝐾, it does not matter whether you have 𝐾 or the underlying
asset.

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PUT – CALL PARITY
Two ways to receive 𝑆𝑇 at time 𝑇 :
1. Buy a call option and sell a put option at time 0 and pay 𝐾 at time 𝑇.
2. Enter a forward agreement to buy 𝑆𝑇 and at time 𝑇 pay 𝐹0,𝑇 , the price of
the forward agreement.

By the no-arbitrage principle, these two methods must cost the same.
Discounting to time 0, this means:
𝐶 𝐾, 𝑇 − 𝑃 𝐾, 𝑇 + 𝐾𝑒 −𝑟𝑇 = 𝐹0,𝑇 𝑒 −𝑟𝑇
Or
𝑪 𝑲, 𝑻 − 𝑷 𝑲, 𝑻 = 𝒆−𝒓𝑻 (𝑭𝟎,𝑻 − 𝑲)

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PUT – CALL PARITY
Suppose you would like to have the maximum of 𝑆𝑇 and 𝐾 at time 𝑇. There are
two choices:
• Buy a time 𝑇 forward on the asset and buy a put option with expiry 𝑇 and
strike price 𝐾. The forward price is 𝐹0,𝑇 , but since you pay at time 0, you pay
𝐹0,𝑇 𝑒 −𝑟𝑇 for the forward.
• Buy a risk-free investment maturing for 𝐾 at time 𝑇 and buy a call option on
the asset with expiry 𝑇 and strike price 𝐾. The cost of the risk-free investment
is 𝐾𝑒 −𝑟𝑇

𝒆−𝒓𝑻 𝑭𝟎,𝑻 + 𝑷 𝑺, 𝑲, 𝑻 = 𝑲𝒆−𝒓𝑻 + 𝑪(𝑺, 𝑲, 𝑻)

Put-Call Parity equation lets you price a put once you know the price of a call.

Ms Sarah Nadirah Mohd Johari, 2021

STOCK PUT – CALL PARITY
For a nondividend paying stock, the forward price is 𝐹0,𝑇 = 𝑆0 𝑒 𝑟𝑇

𝑪 𝑲, 𝑻 − 𝑷 𝑲, 𝑻 = 𝑺𝟎 − 𝑲𝒆−𝒓𝑻

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EXAMPLE 1
A nondividend paying stock has a price of 40. A European call option
allows buying the stock for 45 at the end of 9 months. The continuously
compounded risk-free rate is 5%. The premium of the call option is
2.84.
Determine the premium of a European put option allowing selling the
stock for 45 at the end of 9 months.

𝑪 𝑲, 𝑻 − 𝑷 𝑲, 𝑻 = 𝑺𝟎 − 𝑲𝒆−𝒓𝑻
𝟐. 𝟖𝟒 − 𝑷 𝑲, 𝑻 = 𝟒𝟎 − 𝟒𝟓𝒆− 𝟎.𝟎𝟓 𝟎.𝟕𝟓
𝟐. 𝟖𝟒 − 𝑷 𝑲, 𝑻 = 𝟑. 𝟑𝟒𝟑𝟕𝟓
𝑷 𝑲, 𝑻 = 𝟐. 𝟖𝟒 + 𝟑. 𝟑𝟒𝟑𝟕𝟓 = 𝟔. 𝟏𝟖𝟑𝟕𝟓
Ms Sarah Nadirah Mohd Johari, 2021
STOCK PUT – CALL PARITY
A convenient concept is the prepaid forward. It is the same as a regular
forward except that the payment is made at the time the agreement is
entered, time 𝑡 = 0, rather than at time 𝑇.

𝑃
We use the notation 𝐹𝑡,𝑇 for the value at time 𝑡 of a prepaid forward
𝑃
settling at time 𝑇. Then 𝐹0,𝑇 = 𝑒 −𝑟𝑇 𝐹0,𝑇 .

𝑃
If the forward maturing at time 𝑇 is prepaid at time 𝑡, 𝐹𝑡,𝑇 = 𝑒 −𝑟(𝑇−𝑡) 𝐹𝑡,𝑇

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 STOCK PUT – CALL PARITY
𝑃𝑉𝑡,𝑇 is the PV at time 𝑡 of a payment at time 𝑇.

UNDERLYING ASSET FORWARD PRICE PREPAID FORWARD PRICE

Non-dividend paying 𝑆𝑡 𝑒 𝑟 𝑇−𝑡 𝑆𝑡
stock
Dividend paying stock 𝑆𝑡 𝑒 𝑟 𝑇−𝑡 − 𝐶𝑢𝑚𝑉𝑎𝑙𝑢𝑒 (𝐷𝑖𝑣𝑠) 𝑆𝑡 − 𝑃𝑉𝑡,𝑇 (𝐷𝑖𝑣𝑠)
Stock Index 𝑆𝑡 𝑒 𝑟−𝛿 𝑇−𝑡 𝑆𝑡 𝑒 −𝛿 𝑇−𝑡

𝑟𝑑 −𝑓𝑟 𝑇−𝑡
Currency, denominated 𝑥𝑡 𝑒 𝑥𝑡 𝑒 −𝑟𝑓 𝑇−𝑡

in currency 𝑑 for
delivery of currency 𝑓

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STOCK PUT – CALL PARITY
Using prepaid forwards, put-call parity formula becomes:

𝑪 𝑲, 𝑻 − 𝑷 𝑲, 𝑻 = 𝑭𝑷
𝟎,𝑻 − 𝑲𝒆 −𝒓𝑻

If a stock with discrete dividends at rate 𝛿 , by using prepaid forwards,

put-call parity becomes:

𝑪 𝑲, 𝑻 − 𝑷 𝑲, 𝑻 = 𝑺𝟎 − 𝑷𝑽𝟎,𝑻 (𝑫𝒊𝒗𝒔) − 𝑲𝒆−𝒓𝑻

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EXAMPLE 2
A stock’s price is 45. the stock will pay a dividend of 1 after 2 months. A
European put option with a strike of 42 and an expiry date of 3 months
has a premium of 2.71. The continuously compounded risk-free rate is
5%.
Determine the premium of a European call option on the stock with the
same strike and expiry.
𝑪 𝑲, 𝑻 − 𝑷 𝑲, 𝑻 = 𝑺𝟎 − 𝑷𝑽𝟎,𝑻 𝑫𝒊𝒗𝒔 − 𝑲𝒆−𝒓𝑻
𝑪 𝟒𝟐, 𝟎. 𝟐𝟓 − 𝟐. 𝟕𝟏 = 𝟒𝟓 − 𝟏 𝒆−𝟎.𝟎𝟓/𝟔 − 𝟒𝟐𝒆− 𝟎.𝟎𝟓 𝟎.𝟐𝟓
𝑪 𝟒𝟐, 𝟎. 𝟐𝟓 − 𝟐. 𝟕𝟏 = 𝟐. 𝟓𝟑𝟎𝟎
𝑪 𝟒𝟐, 𝟎. 𝟐𝟓 = 𝟐. 𝟕𝟏 + 𝟐. 𝟓𝟑𝟎𝟎 = 𝟓. 𝟐𝟒𝟎𝟎

Ms Sarah Nadirah Mohd Johari, 2021

STOCK PUT – CALL PARITY
If a stock pays continuous dividends, the formula becomes:

𝑪 𝑲, 𝑻 − 𝑷 𝑲, 𝑻 = 𝑺𝟎 𝒆−𝜹𝑻 − 𝑲𝒆−𝒓𝑻

Ms Sarah Nadirah Mohd Johari, 2021

EXAMPLE 3
You are given:
i. A stock’s price is 40
ii. The continuously compounded risk-free rate is 8%
iii. The stock’s continuous dividend rate is 2%
A European 1-year call option with a strike of 50 costs 2.34. Determine
the premium for a European 1-year put option with a strike of 50.
𝑪 𝑲, 𝑻 − 𝑷 𝑲, 𝑻 = 𝑺𝟎 𝒆−𝜹𝑻 − 𝑲𝒆−𝒓𝑻
𝟐. 𝟑𝟒 − 𝑷 𝑲, 𝑻 = 𝟒𝟎𝒆−𝟎.𝟎𝟐 − 𝟓𝟎𝒆− 𝟎.𝟎𝟖
𝟐. 𝟑𝟒 − 𝑷 𝑲, 𝑻 = 𝟔. 𝟗𝟒𝟕𝟖𝟕
𝑷 𝑲, 𝑻 = 𝟐. 𝟑𝟒 + 𝟔. 𝟗𝟒𝟕𝟖𝟕 = 𝟗. 𝟐𝟖𝟕𝟖𝟕

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SYNTHETIC STOCKS AND TREASURIES
We can create a synthetic stock with an appropriate combination of
options and lending. With continuous dividends, the formula is

𝑪 𝑲, 𝑻 − 𝑷 𝑲, 𝑻 = 𝑺𝟎 𝒆−𝜹𝑻 − 𝑲𝒆−𝒓𝑻
𝑺𝟎 = (𝑪 𝑲, 𝑻 − 𝑷 𝑲, 𝑻 + 𝑲𝒆−𝒓𝑻 )𝒆𝜹𝑻

To create a synthetic Treasury, we rearrange the equation as follows:

𝑪 𝑲, 𝑻 − 𝑷 𝑲, 𝑻 = 𝑺𝟎 𝒆−𝜹𝑻 − 𝑲𝒆−𝒓𝑻
𝑲𝒆−𝒓𝑻 = 𝑺𝟎 𝒆𝜹𝑻 − 𝑪 𝑲, 𝑻 + 𝑷 𝑲, 𝑻

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SYNTHETIC OPTIONS
If an option is mispriced based on put-call parity, you may want to create
an arbitrage.

Suppose the price of a European call based on put-call parity is 𝐶, but the
price it is actually selling at is 𝐶 ′ < 𝐶. You would then buy the underpriced
call option and sell a synthesized call option. Since

𝑪 𝑺, 𝑲, 𝑻 = 𝑺𝟎 𝒆−𝜹𝑻 − 𝑲𝒆−𝒓𝑻 +𝑷 𝑺, 𝑲, 𝑻
You would sell the right hand side of this equation.

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 GENERALIZED PARITY RELATIONSHIP
𝑪 𝑺𝒕 , 𝑸𝒕 , 𝑻 − 𝒕 − 𝑷 𝑺𝒕 , 𝑸𝒕 , 𝑻 − 𝒕 = 𝑭𝑷
𝒕,𝑻 𝑺 − 𝑭 𝑷
𝒕,𝑻 (𝑸)

EXPIRATION
TRANSACTION TIME 0 𝑺𝑻 ≤ 𝑸𝑻 𝑺𝑻 > 𝑸𝑻
Buy call −𝐶 𝑆𝑡 , 𝑄𝑡 , 𝑇 − 𝑡 0 𝑆𝑇 − 𝑄𝑇
Sell put 𝑃 𝑆𝑡 , 𝑄𝑡 , 𝑇 − 𝑡 𝑆𝑇 − 𝑄𝑇 0
Sell prepaid forward on A 𝑃 −𝑆𝑇 −𝑆𝑇
𝐹𝑡,𝑇 (𝑆)
Buy prepaid forward on B 𝑃 𝑄𝑇 𝑄𝑇
−𝐹𝑡,𝑇 𝑄
TOTAL −𝑪 𝑺𝒕 , 𝑸𝒕 , 𝑻 − 𝒕 + 𝑷 𝑺𝒕 , 𝑸𝒕 , 𝑻 − 𝒕 + 𝑭𝑷 𝑷
𝒕,𝑻 𝑺 − 𝑭𝒕,𝑻 (𝑸) 𝟎 0

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COMPARING OPTIONS WITH RESPECT TO
STYLE, MATURITY AND STRIKE
EUROPEAN VS AMERICAN OPTIONS
Since an American option can be exercised at anytime, whereas a
European option can only be exercised at expiration, an American option
must always be at least as valuable as an otherwise identical European
option

𝑪𝑨𝒎𝒆𝒓 𝑺, 𝑲, 𝑻 ≥ 𝑪𝑬𝒖𝒓 (𝑺, 𝑲, 𝑻)

𝑷𝑨𝒎𝒆𝒓 𝑺, 𝑲, 𝑻 ≥ 𝑷𝑬𝒖𝒓 (𝑺, 𝑲, 𝑻)

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COMPARING OPTIONS WITH RESPECT TO
STYLE, MATURITY AND STRIKE
MAXIMUM AND MINIMUM OPTION PRICES
CALL
Call price cannot:
• be negative
• exceed stock price
• be less than price implied by put-call parity using zero
for put price:

𝑺 > 𝑪𝑨𝒎𝒆𝒓 𝑺, 𝑲, 𝑻 ≥ 𝑪𝑬𝒖𝒓 𝑺, 𝑲, 𝑻 ≥ 𝐦𝐚𝐱 𝟎, 𝐏𝐕𝟎,𝐓 𝐅𝟎,𝐓 − 𝐏𝐕𝟎,𝐓 𝐊

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 COMPARING OPTIONS WITH RESPECT TO
STYLE, MATURITY AND STRIKE
MAXIMUM AND MINIMUM OPTION PRICES
PUT
Put price cannot:
• be more than the strike price
• be less than price implied by put-call parity using zero for
put price:

𝑲 > 𝑷𝑨𝒎𝒆𝒓 𝑺, 𝑲, 𝑻 ≥ 𝑷𝑬𝒖𝒓 𝑺, 𝑲, 𝑻 ≥ 𝐦𝐚𝐱 𝟎, 𝐏𝐕𝟎,𝐓 𝐊 − 𝐏𝐕𝟎,𝐓 𝐅𝟎,𝐓

Ms Sarah Nadirah Mohd Johari, 2021

COMPARING OPTIONS WITH RESPECT TO
STYLE, MATURITY AND STRIKE
EARLY EXERCISE FOR AMERICAN OPTIONS
• An American call option on a non-dividend-paying stock should not be
exercised early, because
𝑪𝑨𝒎𝒆𝒓 𝑺, 𝑲, 𝑻 ≥ 𝑪𝑬𝒖𝒓 𝑺, 𝑲, 𝑻 ≥ 𝑺𝑻 − 𝑲
• That means, one would lose money be exercising early instead of selling
the option.
• If there are dividends, it may be optimal to
exercise early, just prior to a dividend
• It may be optimal to exercise a non-dividend-paying put option early if
the underlying stock price is sufficiently low

Ms Sarah Nadirah Mohd Johari, 2021

COMPARING OPTIONS WITH RESPECT TO
STYLE, MATURITY AND STRIKE
TIME TO EXPIRATION
• An American option (both put and call) with more time to expiration is at least
as valuable as an American option with less time to expiration. This is because
the longer option can easily be converted into the shorter option by exercising
it early
• A European call option on a non-dividend-paying stock will be more valuable
than an otherwise identical option with less time to expiration.
• European call options on dividend-paying stock and European puts may be
less valuable than an otherwise identical option with less time to expiration
• When the strike price grows at the rate of interest, European call and put
prices on a non-dividend-paying stock increases with time to maturity

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COMPARING OPTIONS WITH RESPECT TO
STYLE, MATURITY AND STRIKE
DIFFERENT STRIKE PRICES (𝑲𝟏 < 𝑲𝟐 < 𝑲𝟑 ) FOR BOTH EUROPEAN AND
AMERICAN OPTIONS
• A call with a low strike price is at least as valuable as an otherwise identical
call with higher strike price
𝑪(𝑲𝟏 ) ≥ 𝑪(𝑲𝟐 )
• A put with a high strike price is at least as valuable as an otherwise identical
call with low strike price
𝑷(𝑲𝟐 ) ≥ 𝑷(𝑲𝟏 )
• The premium difference between otherwise identical calls with different strike
prices cannot be greater than the difference in strike prices
𝑪 𝑲𝟏 − 𝑪 𝑲𝟐 ≤ 𝑲𝟐 − 𝑲𝟏

Ms Sarah Nadirah Mohd Johari, 2021

COMPARING OPTIONS WITH RESPECT TO
STYLE, MATURITY AND STRIKE
DIFFERENT STRIKE PRICES (𝑲𝟏 < 𝑲𝟐 < 𝑲𝟑 ) FOR BOTH EUROPEAN AND
AMERICAN OPTIONS
• The premium difference between otherwise identical puts with different
strike prices cannot be greater than the difference in strike prices
𝑷 𝑲𝟏 − 𝑷 𝑲𝟐 ≤ 𝑲𝟐 − 𝑲𝟏
• Premiums decline at a decreasing rate for calls with progressively higher
strike prices. (Convexity of option price with respect to strike price)
𝑪 𝑲𝟏 − 𝑪(𝑲𝟐 ) 𝑪 𝑲𝟐 − 𝑪(𝑲𝟑 )
≤
𝑲𝟐 − 𝑲𝟏 𝑲𝟑 − 𝑲𝟐

Ms Sarah Nadirah Mohd Johari, 2021

 CHAPTER 3
BINOMIAL OPTION PRICING MODELS

Ms Sarah Nadirah Mohd Johari, 2021

CONTENTS
• Type of Binomial Option Pricing Model & Arbitrage
• Type of Options, Early Exercise and Risk Neutral Pricing
• The Binomial Tree and Lognormality
• Estimating Volatility

Ms Sarah Nadirah Mohd Johari, 2021

INTRODUCTION TO BINOMIAL OPTION
PRICING
• Previous lecture, discussed on how the price of one option is related
to the price of another but did not explain on how to determine the
price of an option relative to the price of the underlying asset.
• Compute the price of an option, given the characteristics of the stock
or other underlying asset.
• Price of the underlying asset can move up or down only by a specified
amount.
• Often referred to as the Cox-Ross-Rubinstein pricing model.

Ms Sarah Nadirah Mohd Johari, 2021

INTRODUCTION TO BINOMIAL OPTION
PRICING
• Learn two ways to price options:
i. Binomial trees – discrete
ii. Black – Scholes Formula – analytic but requires several assumptions
and cannot be used generally.

• Assume the underlying asset is a nondividend paying stock.

• Binomial tree will have only one period
• The stock can only have one of 2 values at expiry of the option.

Ms Sarah Nadirah Mohd Johari, 2021

A ONE – PERIOD BINOMIAL TREE
EXAMPLE
For a 1-year European call option on a nondividend paying stock:
i. The stock’s price is currently 41
ii. The stock’s price will be either 60 or 30 at the end of the year.
iii. The strike price is 40
iv. The continuously compounded risk-free rate is 8%.
The binomial tree for the stock is:

Ms Sarah Nadirah Mohd Johari, 2021

COMPUTING THE OPTION PRICE
• Consider two portfolios:
Portfolio A: buy one call option
Portfolio B: buy 2/3 shares of XYZ and borrow RM18.462 at the risk-
free rate
• Costs:
Portfolio A: the call premium, which is unknown
Portfolio B: 2/3  RM41– RM18.462 = RM8.871

Ms Sarah Nadirah Mohd Johari, 2021

COMPUTING THE OPTION PRICE
• PAYOFF?
• EXPLAIN YOUR PAYOFF FINDINGS.

Ms Sarah Nadirah Mohd Johari, 2021

THE BINOMIAL SOLUTION
HOW TO REPLICATE PORTFOLIO CONSISTING OF  SHARES OF STOCK
AND A DOLLAR AMOUNT B IN LENDING, SUCH THAT THE PORTFOLIO
IMITATES THE OPTION WHETHER THE STOCK RISES OR FALLS?
Suppose that the stock has a continuous dividend yield of 𝛿, which is
reinvested in the stock. Thus, if you buy one share at time 𝑡, at time 𝑡 +
ℎ you will have e𝛿ℎ shares.
If the length of a period is ℎ , the interest factor per period
is 𝑒 𝑟ℎ
𝑆 be the stock price. 𝑢𝑆 denotes the stock price when the price goes
up, and 𝑑𝑆 denotes the stock price when the price goes down.
Ms Sarah Nadirah Mohd Johari, 2021
THE BINOMIAL SOLUTION

𝑢𝑆 𝐶𝑢
𝑆 𝐶
𝑑𝑆 𝐶𝑑
Value of replicating portfolio at time ℎ, with stock price 𝑆ℎ :

∆𝑺𝒉 𝒆𝜹𝒉 + 𝒆𝒓𝒉 𝑩

Ms Sarah Nadirah Mohd Johari, 2021

THE BINOMIAL SOLUTION
• At the price, 𝑆ℎ = 𝑢𝑆 and 𝑆ℎ = 𝑑𝑆, a successful replicating portfolio will
satisfy:
∆ × 𝑢𝑆 × 𝑒 𝛿ℎ + 𝐵 × 𝑒 𝑟ℎ = 𝐶𝑢

∆ × 𝑑𝑆 × 𝑒 𝛿ℎ + 𝐵 × 𝑒 𝑟ℎ = 𝐶𝑑
Solve for ∆ and 𝐵:
𝐶𝑢 − 𝐶𝑑
∆= 𝑒 −𝛿ℎ
𝑆(𝑢 − 𝑑)

𝑢𝐶𝑑 − 𝑑𝐶𝑢
𝐵= 𝑒 −𝑟ℎ
𝑢−𝑑
Ms Sarah Nadirah Mohd Johari, 2021
THE BINOMIAL SOLUTION
• Cost of creating the option is the net cash flow required to buy the
shares and bonds. Thus, the cost of the option is ∆𝑆 + 𝐵

𝑒 𝑟−𝛿 ℎ
−𝑑 𝑢 − 𝑒 𝑟−𝛿 ℎ
∆𝑆 + 𝐵 = 𝑒 −𝑟ℎ 𝐶𝑢 + 𝐶𝑑
𝑢−𝑑 𝑢−𝑑

• No –arbitrage condition:
𝑢>𝑒 𝑟−𝛿 ℎ >𝑑

Ms Sarah Nadirah Mohd Johari, 2021

ARBITRAGE A MISPRICED OPTION
• If the observed option price differs from its theoretical price,
arbitrage is possible. HOW?
If an option is overpriced, we can sell the option. However, the risk is
that the option will be in the money at expiration, and we will be
required to deliver the stock. To hedge this risk, we can buy
a synthetic option at the same time we sell the actual option
If an option is underpriced, we buy the option. To hedge the risk
associated with the possibility of the stock price falling at expiration,
we sell a synthetic option at the same time

Ms Sarah Nadirah Mohd Johari, 2021

RISK – NEUTRAL PRICING
𝑒 𝑟−𝛿 ℎ −𝑑 𝑢−𝑒 𝑟−𝛿 ℎ
• Interpret the terms and as probabilities.
𝑢−𝑑 𝑢−𝑑
• Let:
𝑒 𝑟−𝛿 ℎ
−𝑑
𝑝∗ =
𝑢−𝑑
Then,
𝑟−𝛿 ℎ
𝑒 −𝑑 𝑢 − 𝑒 𝑟−𝛿 ℎ
∆𝑆 + 𝐵 = 𝑒 −𝑟ℎ 𝐶𝑢 + 𝐶𝑑
𝑢−𝑑 𝑢−𝑑

𝑪 = 𝒆−𝒓𝒉 𝑪𝒖 𝒑∗ + 𝑪𝒅 𝟏 − 𝒑∗

Ms Sarah Nadirah Mohd Johari, 2021

CONSTRUCTING A BINOMIAL TREE
• Model the stock returns 𝑢 and 𝑑 using:

𝑟−𝛿 ℎ+𝜎 ℎ
𝑢=𝑒

𝑟−𝛿 ℎ−𝜎 ℎ
𝑑=𝑒

𝑟 is continuously compounded annual interest rate

𝛿 is continuous dividend yield
𝜎 is annual volatility
ℎ is the length of a binomial period in years

Ms Sarah Nadirah Mohd Johari, 2021

CONSTRUCTING A BINOMIAL TREE
CONTINUOUSLY COMPOUNDED RETURNS
• Logarithmic function computes returns from prices:
𝑆𝑡+ℎ
𝑟𝑡,𝑡+ℎ = ln
𝑆𝑡

• Exponential function computes prices from returns:

𝑆𝑡+ℎ = 𝑆𝑡 𝑒 𝑟𝑡,𝑡+ℎ

• Continuously compounded returns are addictive.

Ms Sarah Nadirah Mohd Johari, 2021

CONSTRUCTING A BINOMIAL TREE
VOLATILITY
• Defined as standard deviation of continuously compounded returns.
• Suppose the continuously compounded return over the month 𝑖 is 𝑟𝑚𝑜𝑛𝑡ℎ𝑙𝑦,𝑗 .
Since returns are addictive, annual return is:
12

𝑟𝑎𝑛𝑛𝑢𝑎𝑙 = ෍ 𝑟𝑚𝑜𝑛𝑡ℎ𝑙𝑦,𝑖
𝑖=1

• Variance of annual return:

12

𝑉𝑎𝑟 𝑟𝑎𝑛𝑛𝑢𝑎𝑙 = 𝑉𝑎𝑟 ෍ 𝑟𝑚𝑜𝑛𝑡ℎ𝑙𝑦,𝑖

𝑖=1

Ms Sarah Nadirah Mohd Johari, 2021

CONSTRUCTING A BINOMIAL TREE
VOLATILITY
• Suppose that returns are uncorrelated over time and that each month
has the same variance of returns. 𝜎 2 denote the annual variance.

2
𝜎 2 = 12 × 𝜎𝑚𝑜𝑛𝑡ℎ𝑙𝑦

𝜎
𝜎𝑚𝑜𝑛𝑡ℎ𝑙𝑦 =
12

Ms Sarah Nadirah Mohd Johari, 2021

CONSTRUCTING A BINOMIAL TREE
VOLATILITY
1
• Split the year into 𝑛 periods of length ℎ ℎ = , standard deviation
𝑛
over the period of length ℎ, 𝜎ℎ :

𝜎ℎ = 𝜎 ℎ

𝜎ℎ
𝜎=
ℎ

Ms Sarah Nadirah Mohd Johari, 2021

CONSTRUCTING A BINOMIAL TREE
CONSTRUCTING 𝒖 AND 𝒅
• In the absence of uncertainty, a stock must appreciate at the risk-free
rate less the dividend yield.
• Therefore, from time 𝑡 to time 𝑡 + ℎ:

𝐹𝑡,𝑡+ℎ = 𝑆𝑡+ℎ = 𝑆𝑡 𝑒 𝑟−𝛿 ℎ

• The stock price next period equals the forward price.

Ms Sarah Nadirah Mohd Johari, 2021

CONSTRUCTING A BINOMIAL TREE
CONSTRUCTING 𝒖 AND 𝒅
• With uncertainty, the stock price evolution:

𝑢𝑆𝑡 = 𝐹𝑡,𝑡+ℎ 𝑒 +𝜎 ℎ

𝑑𝑆𝑡 = 𝐹𝑡,𝑡+ℎ 𝑒 −𝜎 ℎ

• Can rewrite the equation:

𝑢=𝑒 𝑟−𝛿 ℎ+𝜎 ℎ

𝑑=𝑒 𝑟−𝛿 ℎ−𝜎 ℎ

Ms Sarah Nadirah Mohd Johari, 2021

CONSTRUCTING A BINOMIAL TREE
ESTIMATING HISTORICAL VOLATILITY
• Need to decide what value to assign to 𝜎 which we cannot observe
directly
• One possibility is to measure 𝜎 by computing the standard deviation
of continuously compounded historical returns
• Volatility computed from historical stock returns is
historical volatility

Ms Sarah Nadirah Mohd Johari, 2021

ONE PERIOD EXAMPLE WITH A FORWARD
TREE
Consider a European call option on a stock, with a RM40 strike and 1
year to expiration. The stock does not pay dividends, and its current
price is RM41. Suppose the volatility of the stock is 30%. The
continuously compounded risk-free interest rate is 8%. Use these
inputs to:
Calculate the final stock prices

Ms Sarah Nadirah Mohd Johari, 2021

ONE PERIOD EXAMPLE WITH A FORWARD
TREE
Consider a European call option on a stock, with a RM40 strike and 1
year to expiration. The stock does not pay dividends, and its current
price is RM41. Suppose the volatility of the stock is 30%. The
continuously compounded risk-free interest rate is 8%. Use these
inputs to:
Calculate the final option values

Ms Sarah Nadirah Mohd Johari, 2021

ONE PERIOD EXAMPLE WITH A FORWARD
TREE
Consider a European call option on a stock, with a RM40 strike and 1
year to expiration. The stock does not pay dividends, and its current
price is RM41. Suppose the volatility of the stock is 30%. The
continuously compounded risk-free interest rate is 8%. Use these
inputs to:
Calculate ∆ and B

Ms Sarah Nadirah Mohd Johari, 2021

ONE PERIOD EXAMPLE WITH A FORWARD
TREE
Consider a European call option on a stock, with a RM40 strike and 1
year to expiration. The stock does not pay dividends, and its current
price is RM41. Suppose the volatility of the stock is 30%. The
continuously compounded risk-free interest rate is 8%. Use these
inputs to:
Calculate the option price

Ms Sarah Nadirah Mohd Johari, 2021

ONE PERIOD EXAMPLE WITH A FORWARD
TREE
Consider a European call option on a stock, with a RM40 strike and 1
year to expiration. The stock does not pay dividends, and its current
price is RM41. Suppose the volatility of the stock is 30%. The
continuously compounded risk-free interest rate is 8%. Based on the
calculations that you have done, draw the tree diagram.

Ms Sarah Nadirah Mohd Johari, 2021

TWO OR MORE BINOMIAL PERIODS
• Pricing a 2-year call option with a RM40 strike when the current stock
price is RM41 by using a two-period binomial model. The volatility of
the stock is 30%. The continuously compounded risk-free interest rate
is 8%.

Ms Sarah Nadirah Mohd Johari, 2021

 TWO OR MORE BINOMIAL PERIODS
𝑆uu = RM87.669
RM47.669
𝑆u = RM59.954
RM23.029
∆= 1.00
𝐵 = −𝑅𝑀36.925
𝑆 = RM41 𝑆𝑑𝑢 = 𝑆ud = RM48.114
𝑆𝑑 = RM32.903 RM8.114
RM10.737
∆= 0.734 RM3.187
∆= 0.374
𝐵 = −𝑅𝑀19.337 𝐵 = −𝑅𝑀9.111
𝑆𝑑𝑑 = RM26.405
RM0.000

Ms Sarah Nadirah Mohd Johari, 2021

TWO OR MORE BINOMIAL PERIODS
PRICING THE CALL OPTION
• To price an option with two binomial periods, we work backward through
the tree.
• Year 2, Stock Price = RM87.669
Since we are at expiration, the option value:
max 0, 𝑆 − 𝐾 = 𝑅𝑀47.669
• Year 2, Stock Price = RM48.114
option value: max 0, 𝑆 − 𝐾 = 𝑅𝑀8.114
• Year 2, Stock Price = RM26.404
Since the option is out of the money, the value is 0.

Ms Sarah Nadirah Mohd Johari, 2021

TWO OR MORE BINOMIAL PERIODS
PRICING THE CALL OPTION
• Year 1, Stock Price = RM59.954
Compute option value where 𝑢𝑆 = 𝑅𝑀87.669, 𝑑𝑆 = 𝑅𝑀48.114 :
𝑒 𝑟−𝛿 ℎ −𝑑 𝑢−𝑒 𝑟−𝛿 ℎ
∆𝑆 + 𝐵 = 𝑒 −𝑟ℎ 𝐶𝑢 + 𝐶𝑑 = 𝑅𝑀23.029
𝑢−𝑑 𝑢−𝑑
• Year 1, Stock Price = RM32.903
Compute option value by using the same equation above.
• Year 0, Stock Price = RM41
Compute option value by using the same equation above.

Ms Sarah Nadirah Mohd Johari, 2021

MANY BINOMIAL PERIOD
• Dividing the time to expiration into more periods allows us to
generate a more realistic tree with a larger number of different values
at expiration.
Pricing a 1-year call option with a RM40 strike when the current stock
price is RM41 by using a three-period binomial model. The volatility
of the stock is 30%. The continuously compounded risk-free interest
rate is 8%.

Ms Sarah Nadirah Mohd Johari, 2021

PUT OPTIONS
• Compute put option prices using the same stock price tree and in almost
the same way as call option prices
• The only difference with a European put option occurs at expiration
• Instead of computing the price as max(0, 𝑆 − 𝐾), we use max(0, 𝐾 − 𝑆)

Ms Sarah Nadirah Mohd Johari, 2021

PUT OPTIONS
Pricing a 1-year put option with a RM40 strike when the current stock
price is RM41 by using a three-period binomial model. The volatility
of the stock is 30%. The continuously compounded risk-free interest
rate is 8%.

Ms Sarah Nadirah Mohd Johari, 2021

AMERICAN OPTIONS
• The value of the option if it is left “alive” (unexercised) is given by the
value of holding it for another period, equation:

𝑒 𝑟−𝛿 ℎ− 𝑑 𝑢 − 𝑒 𝑟−𝛿 ℎ
∆𝑆 + 𝐵 = 𝑒 −𝑟ℎ 𝐶𝑢 + 𝐶𝑑
𝑢−𝑑 𝑢−𝑑
• The value of the option if it is exercised is given by max 0, 𝑆 − 𝐾 if it is
a call and max(0, 𝐾 − 𝑆) if it is put.
• For an American put, the value of the option at a node is given by

𝑃 𝑆, 𝐾, 𝑡 = 𝑚𝑎 𝑥 𝐾 − 𝑆, 𝑒 −𝑟ℎ 𝑃 𝑢𝑆, 𝐾, 𝑡 + ℎ 𝑝∗ + 𝑃 𝑑𝑆, 𝐾, 𝑡 + ℎ 1 − 𝑝∗

Ms Sarah Nadirah Mohd Johari, 2021

AMERICAN OPTIONS
• The valuation of American options proceeds as follows:
At each node, we check for early exercise.

If the value of the option is greater when exercised, we assign that

value to the node. Otherwise, we the value of the option
unexercised.

We work backward through the tree as usual.

Ms Sarah Nadirah Mohd Johari, 2021

AMERICAN OPTIONS
Pricing a 1-year American put option with a RM40 strike when the
current stock price is RM41 by using a three-period binomial model.
The volatility of the stock is 30%. The continuously compounded risk-
free interest rate is 8%.
Bold italic on the option prices that exercise is optimal on the node.

Ms Sarah Nadirah Mohd Johari, 2021

OPTIONS ON OTHER ASSETS
• The binomial model developed thus far can be modified easily to price options
on underlying assets other than non-dividend-paying stocks.
• The difference for different underlying assets is the construction of the
binomial tree and the risk-neutral probability.
• Can examine options on:
1) Stock indexes
2) Currencies
3) Future contracts
4) Commodities
5) Bonds

Ms Sarah Nadirah Mohd Johari, 2021

 CHAPTER 3
BINOMIAL OPTION PRICING MODELS PART II

Ms Sarah Nadirah Mohd Johari, 2021

CONTENTS
• Type of Binomial Option Pricing Model & Arbitrage
• Type of Options, Early Exercise and Risk Neutral Pricing
• The Binomial Tree and Lognormality
• Estimating Volatility

Ms Sarah Nadirah Mohd Johari, 2021

UNDERSTANDING EARLY EXERCISE
• When call option exercise early, the interest on the strike price lose and
gain dividends on the stock.
• Another effect of early exercise: losing the implicit put option, the ability
not to exercise the call if the stock is below the strike price at expiry.
• Hence, value of put must be less than the net of gained dividends over
lost interest to make exercise optimal.

Ms Sarah Nadirah Mohd Johari, 2021

UNDERSTANDING EARLY EXERCISE
• Interest on strike price is proportional to 𝐾𝑟 and dividends on the stock
are proportional to 𝑆𝛿
• If there were no volatility and the option were always in the money,
early exercise would be optimal for an infinitely-lived option if:
𝑟𝐾 < 𝛿𝑆
or
𝑟𝐾
𝑆>
𝛿

Ms Sarah Nadirah Mohd Johari, 2021

UNDERSTANDING EARLY EXERCISE
EXAMPLE
For an American call option on a stock;
i. The stock price is initially 60
ii. The strike price is 60
iii. 𝑟 = 0.05
iv. 𝛿 = 0.04
There are 3 months to expiry.
If the value of a 3-month put option with strike price 60 is 1 and early exercise
at this point is optimal, what is the lowest possible current value for the stock?

Ms Sarah Nadirah Mohd Johari, 2021

UNDERSTANDING EARLY EXERCISE
• For early exercise of a put option to be optimal, interest on the strike
price must be greater than the sum of stock dividends and the value of
the implicit call.
• The higher the volatility, the less likely early exercise is optimal because
of the increased value of the implicit options.
• The closer to expiry, the more likely early exercise is optimal because lost
interest is lower and the value of the put is lower.

Ms Sarah Nadirah Mohd Johari, 2021

UNDERSTANDING RISK-NEUTRAL PRICING
• A risk-neutral investor is indifferent between a sure thing and a risky bet with
expected payoff equal to the value of the sure thing.
• 𝑝∗ : risk-neutral probability that the stock price will go up.

𝑒 𝑟−𝛿 ℎ
−𝑑
𝑝∗ =
𝑢−𝑑
Then,
𝑟−𝛿 ℎ
𝑒 −𝑑 𝑢 − 𝑒 𝑟−𝛿 ℎ
∆𝑆 + 𝐵 = 𝑒 −𝑟ℎ 𝐶𝑢 + 𝐶𝑑
𝑢−𝑑 𝑢−𝑑

𝑪 = 𝒆−𝒓𝒉 𝑪𝒖 𝒑∗ + 𝑪𝒅 𝟏 − 𝒑∗

Ms Sarah Nadirah Mohd Johari, 2021

UNDERSTANDING RISK-NEUTRAL PRICING
• Option pricing formula can be said to price options as if investors are
risk-neutral
• Not assuming that investors are actually risk-neutral, and that risky
assets are actually expected to earn the risk-free rate of return.

Ms Sarah Nadirah Mohd Johari, 2021

UNDERSTANDING RISK-NEUTRAL PRICING
PRICING AN OPTION USING REAL PROBABILITIES
IS OPTION PRICING CONSISTENT WITH STANDARD DISCOUNTED CASH
FLOW CALCULATIONS?
Suppose that the stock has a continuous dividend yield of 𝛿, which is
reinvested in the stock. Thus, if you buy one share at time 𝑡, at time 𝑡 +
ℎ you will have e𝛿ℎ shares.
If the length of a period is ℎ , the interest factor per period
is 𝑒 𝑟ℎ
𝑆 be the stock price. 𝑢𝑆 denotes the stock price when the price goes
up, and 𝑑𝑆 denotes the stock price when the price goes down.

Ms Sarah Nadirah Mohd Johari, 2021

UNDERSTANDING RISK-NEUTRAL PRICING
PRICING AN OPTION USING REAL PROBABILITIES
• Discussing on how to determine the discounting rate for an option if risk-
neutral pricing is not used.
• In reality, the expected return on a stock is 𝛼 > 𝑟.
• If 𝑝 is the true probability of the stock going up, 𝑝 must be consistent
with 𝑢, 𝑑 and 𝛼
𝑝𝑢𝑆 + 1 − 𝑝 𝑑𝑆 = 𝑒 𝛼ℎ 𝑆

𝑒 𝛼ℎ − 𝑑
𝑝=
𝑢−𝑑

Ms Sarah Nadirah Mohd Johari, 2021

UNDERSTANDING RISK-NEUTRAL PRICING
PRICING AN OPTION USING REAL PROBABILITIES
• By using 𝑝,the actual expected payoff to the option one period:
𝑒 𝛼ℎ − 𝑑 𝑢 − 𝑒^𝛼ℎ
𝑝𝐶𝑢 + 1 − 𝑝 𝐶𝑑 = 𝐶𝑢 + 𝐶𝑑
𝑢−𝑑 𝑢−𝑑

At what rate do we discount this expected payoff?

It is not correct to discount the option at the expected return on the
stock,  because the option is equivalent to a leveraged investment in
the stock and hence is riskier than the stock

Ms Sarah Nadirah Mohd Johari, 2021

UNDERSTANDING RISK-NEUTRAL PRICING
PRICING AN OPTION USING REAL PROBABILITIES
• Let 𝛾 be the discounting rate for the option.
• Must be the same as the discounting rate for the replicating portfolio
which is weighted average of the discounting rates of the two
components of the portfolio.

𝛾ℎ
𝑆∆ 𝛼ℎ
𝐵
𝑒 = 𝑒 + 𝑒 𝑟ℎ
𝑆∆ + 𝐵 𝑆∆ + 𝐵

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UNDERSTANDING RISK-NEUTRAL PRICING
PRICING AN OPTION USING REAL PROBABILITIES
• Then, compute the option premium by taking the expected present
value of the two nodes:
𝐶 = 𝑒 −𝛾ℎ 𝑝𝐶𝑢 + 1 − 𝑝 𝐶𝑑

• Turns out, the result is identical to 𝐶 computed with risk-neutral

probabilities and returns.
• Hence, no need to add the complexity of 𝛼 and 𝛾, unless one is
interested in the discounting rate of the option.

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UNDERSTANDING RISK-NEUTRAL PRICING
PRICING AN OPTION USING REAL PROBABILITIES
• By equating the return on the option to the return on the replicating
portfolio:

𝐶𝑒 𝛾ℎ = 𝑆∆𝑒 𝛼ℎ + 𝐵𝑒 𝑟ℎ

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UNDERSTANDING RISK-NEUTRAL PRICING
EXAMPLE
For an American call option on a stock;
i. The stock price is 52
ii. The stock’s continuously compounded dividend rate is 10%
iii. The option expires in 6 months
iv. The strike price is 53
v. The continuously compounded risk-free rate is 3%
vi. The expected return on the stock is 15.
The option is modeled with a 2-period binomial tree in which 𝑢 = 1.3, 𝑑 = 0.8.
Determine the discount rate for the call option at each node.

Ms Sarah Nadirah Mohd Johari, 2021

UNDERSTANDING RISK-NEUTRAL PRICING
PRICING AN OPTION USING REAL PROBABILITIES
• Alternative method for calculating the rate of return on an option.

𝐶 = 𝑒 −𝛾ℎ 𝑝𝐶𝑢 + 1 − 𝑝 𝐶𝑑 = 𝑒 −𝑟ℎ 𝑝∗ 𝐶𝑢 + 1 − 𝑝∗ 𝐶𝑑

• Thus 𝛾 can be calculated without backing out the replicating portfolio.

When 𝐶𝑑 = 0:
𝑒 −𝛾ℎ 𝑝 = 𝑒 −𝑟ℎ 𝑝∗

Ms Sarah Nadirah Mohd Johari, 2021

UNDERSTANDING RISK-NEUTRAL PRICING
PRICING AN OPTION USING REAL PROBABILITIES
• To calculate the return of an option at a node:
1) Calculate the price of the call at the node using risk-neutral
probabilities:
𝑒 −𝑟ℎ 𝑝∗ 𝐶𝑢 + 1 − 𝑝∗ 𝐶𝑑
2) Calculate the expected payoff of the option at the two branch nodes by
using the true probabilities. The expected payoff:

𝑝𝐶𝑢 + 1 − 𝑝 𝐶𝑑

Ms Sarah Nadirah Mohd Johari, 2021

UNDERSTANDING RISK-NEUTRAL PRICING
PRICING AN OPTION USING REAL PROBABILITIES
3) The quotient of the expected payoff over the call price is the 𝑒 𝛾ℎ , so log
it and divide by ℎ.

Ms Sarah Nadirah Mohd Johari, 2021

EXERCISE 1
A 1-year European put option on a stock is modeled using a 1-period
binomial tree based on forward prices. You are given:
i. The stock price is 43.
ii. The strike price is 45.
iii. r = 0.04
iv. The stock’s continuously compounded annual return is 15%.
v. The stock pays no dividends.
vi. Volatility = 0.3.
Determine the continuously compounded annual return on the option

Ms Sarah Nadirah Mohd Johari, 2021

 CHAPTER 3
BINOMIAL OPTION PRICING MODELS

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THE BINOMIAL TREE AND LOGNORMALITY
• The usefulness of the binomial pricing model hinges on the binomial tree
providing a reasonable representation of the stock price distribution.

• The binomial tree approximates a lognormal distribution.

Ms Sarah Nadirah Mohd Johari, 2021

THE BINOMIAL TREE AND LOGNORMALITY
THE RANDOM WALK MODEL
• It is sometimes said that stock prices follow a random walk.
• Imagine that you flip a coin repeatedly.
After 𝑛 flips, with the 𝑖 𝑡ℎ flip denoted 𝑌𝑖 ,
the total cumulative, 𝑍𝑛 :
𝑛

𝑍𝑛 = ෍ 𝑌𝑖
𝑖=1
• Turns out, the more times you flip, on average the farther you will move
from where you start.

Ms Sarah Nadirah Mohd Johari, 2021

THE BINOMIAL TREE AND LOGNORMALITY
THE RANDOM WALK MODEL
• Another way to represent the process by 𝑍𝑛 in term of the change in 𝑍𝑛 :

𝑍𝑛 − 𝑍𝑛−1 = 𝑌𝑛
Or
𝐻𝑒𝑎𝑑𝑠: 𝑍𝑛 − 𝑍𝑛−1 = +1
𝑇𝑎𝑖𝑙𝑠: 𝑍𝑛 − 𝑍𝑛−1 = −1

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THE BINOMIAL TREE AND LOGNORMALITY
THE RANDOM WALK MODEL
• A random walk, where with heads, the change in 𝑍 is 1, and with tails,
the change in 𝑍 is −1.
• In efficient markets, an asset price should reflect all available
information. In response to new information the price is equally likely
to move up or down, as with the coin flip.
• The price after a period of time is the initial price plus the cumulative up
and down movements due to informational surprises

Ms Sarah Nadirah Mohd Johari, 2021

THE BINOMIAL TREE AND LOGNORMALITY
MODELING STOCK PRICES AS A RANDOM WALK
• Problem with random walk model:
If by chance, will get enough cumulative down movements, the
stock price will become negative.
Magnitude of the move (RM1) should depend upon how quickly the
coin flips occur and the level of the stock price
The stock, on average, should have a positive return. Random walk
model taken literally does not permit this.
• Binomial model is a variant of the random walk model that solves all of
these problems at once.

Ms Sarah Nadirah Mohd Johari, 2021

THE BINOMIAL TREE AND LOGNORMALITY
THE BINOMIAL MODEL
• A random walk is a binomial variable in each unit of time and as the number
of periods go to infinity, the position (the sum of all the movements)
converges to a normal distribution by the Central Limit Theorem.
• Assumes that continuously compounded returns are a random walk with drift.
• 𝜎 of a sum of 𝑛 independent identical random variables is 𝑛𝜎 of each one.
• Hence, if annual volatility of a stock price is 𝜎, then monthly volatility is
𝜎/ 12.

Ms Sarah Nadirah Mohd Johari, 2021

THE BINOMIAL TREE AND LOGNORMALITY
THE BINOMIAL MODEL
• Binomial model:
𝑟−𝛿 ℎ±𝜎 ℎ
𝑆𝑡+ℎ = 𝑆𝑡 𝑒
• Taking logs:
𝑆𝑡+ℎ
ln = 𝑟−𝛿 ℎ±𝜎 ℎ
𝑆𝑡
Since it is multiplying rather than adding moves to model stock prices, the
stock price converges to the exponential of a normal distribution or a
lognormal distribution.

Ms Sarah Nadirah Mohd Johari, 2021

THE BINOMIAL TREE AND LOGNORMALITY
THE BINOMIAL MODEL
• Binomial model:
𝑟−𝛿 ℎ±𝜎 ℎ
𝑆𝑡+ℎ = 𝑆𝑡 𝑒
• Taking logs:
𝑆𝑡+ℎ
ln = 𝑟−𝛿 ℎ±𝜎 ℎ
𝑆𝑡
Since it is multiplying rather than adding moves to model stock prices, the
stock price converges to the exponential of a normal distribution or a
lognormal distribution.

Ms Sarah Nadirah Mohd Johari, 2021

THE BINOMIAL TREE AND LOGNORMALITY
• The lognormal model for stock prices makes the following assumptions:
1) Volatility is constant
2) Stock returns for different time periods are independent
3) Large stock movements do not occur; stock prices do not jump.

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THE BINOMIAL TREE AND LOGNORMALITY
• The binomial model implicitly
assigns probabilities to the
various nodes.

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THE BINOMIAL TREE AND LOGNORMALITY
ALTERNATIVE BINOMIAL TREES
• So far, all the binomial trees are based on forward prices which center
the nodes at 𝑒 𝑟−𝛿 ℎ+𝜎 ℎ and then multiply and divide this by 𝑒 𝜎 ℎ ,
resulting in:
𝑢 = 𝑒 𝑟−𝛿 ℎ+𝜎 ℎ
𝑑 = 𝑒 𝑟−𝛿 ℎ−𝜎 ℎ
• Advantage: Assuring the arbitrage-free requirement that the upper node
higher than the forward price and the lower node be lower.

Ms Sarah Nadirah Mohd Johari, 2021

THE BINOMIAL TREE AND LOGNORMALITY
ALTERNATIVE BINOMIAL TREES
COX-ROSS-RUBINSTEIN TREE
• Center on 1, so that:
𝑢 = 𝑒 +𝜎 ℎ

𝑑 = 𝑒 −𝜎 ℎ

• If 𝑒 𝑟−𝛿 ℎ > 𝑒 𝜎 ℎ , this will violates the arbitrage-free requirement since

both 𝑢 and 𝑑 are less than 𝑒 𝑟−𝛿 ℎ . If ℎ is small enough, this will not
happen.

Ms Sarah Nadirah Mohd Johari, 2021

THE BINOMIAL TREE AND LOGNORMALITY
ALTERNATIVE BINOMIAL TREES
LOGNORMAL TREE
𝑟−𝛿−0.5𝜎 2 ℎ
• Center on 𝑒 , so that:
𝑟−𝛿−0.5𝜎 2 ℎ+𝜎 ℎ
𝑢=𝑒
𝑟−𝛿−0.5𝜎 2 −𝜎 ℎ
𝑑=𝑒
• Also known as Jarrow-Rudd binomial model.
• Subtracting 0.5𝜎 2 is that stock price has a lognormal distribution and the
mean of a lognormal with parameters 𝜇 ℎ and 𝜎 ℎ.

Ms Sarah Nadirah Mohd Johari, 2021

THE BINOMIAL TREE AND LOGNORMALITY
ALTERNATIVE BINOMIAL TREES
LOGNORMAL TREE
• By subtracting 0.5𝜎 2 from 𝑟 − 𝛿 ℎ so that μ = 𝑟 − 𝛿 − 0.5𝜎 2 ℎ, the
stock price will have a mean of e 𝑟−𝛿 ℎ .
• Hence, risk-neutral probabilities will be close to 0.5.
• Subtracting 0.5𝜎 2 is that stock price has a lognormal distribution and the
mean of a lognormal with parameters 𝜇 ℎ and 𝜎 ℎ.

Ms Sarah Nadirah Mohd Johari, 2021

THE BINOMIAL TREE AND LOGNORMALITY
ALTERNATIVE BINOMIAL TREES
• All the trees have:
u
= e2𝜎 ℎ
d
Or
u
ln = 2𝜎 ℎ
d

Ms Sarah Nadirah Mohd Johari, 2021

EXERCISE 2
For 𝑆 = 100, 𝑟 = 0.04, 𝛿 = 0, 𝜎 = 0.5, and ℎ = 0.5, determine 𝑆𝑢𝑑 :
1. Using forward prices
2. Using the Cox-Ross-Rubinstein tree
3. Using the lognormal tree

Ms Sarah Nadirah Mohd Johari, 2021

STOCK PAYING DISCRETE DIVIDENDS
• Suppose that a dividend will be paid between times 𝑡 and 𝑡 + ℎ and that
its future value at time 𝑡 + ℎ is 𝐷
• The time 𝑡 forward price for delivery at 𝑡 + ℎ:
𝐹𝑡,𝑡_ℎ = 𝑆𝑡 𝑒 𝑟ℎ − 𝐷
• Since the stock price at time 𝑡 + ℎ will be ex-dividend, we create the up
and down moves based on the ex-dividend stock price
𝑺𝒖𝒕 = 𝑺𝒕 𝒆𝒓𝒉 − 𝑫 𝒆𝝈 𝒉
𝑺𝒅𝒕 = 𝑺𝒕 𝒆𝒓𝒉 − 𝑫 𝒆−𝝈 𝒉

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STOCK PAYING DISCRETE DIVIDENDS
• When a dividend is paid, we have to account for the fact that the stocks
earns the dividend
𝑆𝑡𝑢 + 𝐷 ∆ + 𝑒 𝑟ℎ 𝐵 = 𝐶𝑢
𝑆𝑡𝑑 + 𝐷 ∆ + 𝑒 𝑟ℎ 𝐵 = 𝐶𝑑
• Solution:
𝐶𝑢 − 𝐶𝑑
∆= 𝑢
𝑆𝑡 − 𝑆𝑡𝑑

𝑆𝑡𝑢 𝐶𝑑 − 𝑆𝑡𝑑 𝐶𝑢
𝐵 = 𝑒 −𝑟ℎ − ∆𝐷𝑒 −𝑟ℎ
𝑆𝑡𝑢 − 𝑆𝑡𝑑

Ms Sarah Nadirah Mohd Johari, 2021

 CHAPTER 4
THE BLACK-SCHOLES FORMULA & EQUATION

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CONTENTS
• Introduction and Application of Black Scholes Formula
• Option Greeks, Profit Diagram and Implied Volatility
• Differential Equations and Valuation under Certainty
• The Black-Scholes Equation
• Risk-Neutral Pricing and Changing the Numeraire
• Option Pricing When the Stock Price Can Jump

Ms Sarah Nadirah Mohd Johari, 2021

INTRODUCTION TO BLACK-SCHOLES FORMULA
• Is a closed-form formula for evaluating the value of a European
option.
• Binomial trees: value of such an option depends purely on the sum of
the product of the probability of reaching a node at the end of the
tree times the value of the option at that ending node.
• Can be seen as the limit of the results of evaluation of binomial trees
as the number of periods goes to infinity.

Ms Sarah Nadirah Mohd Johari, 2021

BLACK-SCHOLES FORMULA
• Price at time 0 of a European call option expiring at time 𝑇 on an
asset 𝑆:
𝐶 𝑆, 𝐾, 𝜎, 𝑟, 𝑇, 𝛿 = 𝐹 𝑝 𝑆 𝑁 𝑑1 − 𝐹 𝑝 𝐾 𝑁(𝑑2 )
where
𝐹 𝑃 (𝑆) 1 2
ln 𝑃 + 𝜎 𝑇
𝐹 (𝐾) 2
𝑑1 =
𝜎 𝑇

𝑑2 = 𝑑1 − 𝜎 𝑇

Ms Sarah Nadirah Mohd Johari, 2021

ASSUMPTIONS OF THE BLACK-SCHOLES
FORMULA
• Continuously compounded returns on the stock are normally
distributed and independent over time
• Continuously compounded returns on the strike asset (the risk-free
rate) are known and constant.
• Volatility is known and constant
• Dividends are known and constant
• There are no transaction costs or taxes
• It is possible to short-sell any amount of stock and to borrow any
amount of money at the risk-free rate.

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BLACK-SCHOLES FORMULA FOR COMMON
STOCK OPTIONS
• For call options on common stock with continuous dividends
𝐹 𝑃 𝑆 = 𝑆𝑒 −𝛿𝑇
𝐹 𝑃 (𝐾) = 𝐾𝑒 −𝑟𝑇

𝐶 𝑆, 𝐾, 𝜎, 𝑟, 𝑇, 𝛿 = 𝑆𝑒 −𝛿𝑇 𝑁 𝑑1 − 𝐾𝑒 −𝑟𝑇 𝑁(𝑑2 )

where
𝑆 1
ln + 𝑟 − 𝛿 + 𝜎2 𝑇
𝑑1 = 𝐾 2
𝜎 𝑇

𝑑2 = 𝑑1 − 𝜎 𝑇

Ms Sarah Nadirah Mohd Johari, 2021

BLACK-SCHOLES FORMULA FOR COMMON
STOCK OPTIONS
• For put options on common stock with continuous dividends

𝑃 𝑆, 𝐾, 𝜎, 𝑟, 𝑇, 𝛿 = 𝐾𝑒 −𝑟𝑇 𝑁 −𝑑2 − 𝑆𝑒 −𝛿𝑇 𝑁 −𝑑1

where
𝑆 1 2
ln + 𝑟−𝛿+ 𝜎 𝑇
𝑑1 = 𝐾 2
𝜎 𝑇

𝑑2 = 𝑑1 − 𝜎 𝑇

Ms Sarah Nadirah Mohd Johari, 2021

EXAMPLE 1
For a 3-month 52-strike European options on a stock, you are given:
i) The stock’s price follows the Black-Scholes framework.
ii) The stock’s price is 50
iii) The stock’s volatility is 0.4
iv) The stock’s continuous dividend rate is 4%
v) The continuously compounded risk-free interest rate is 8%.
Calculate the premiums for call and put options.

Ms Sarah Nadirah Mohd Johari, 2021

DISCRETE DIVIDENDS
𝑆𝑡
• 𝜎 is the volatility of the stock or 𝑉𝑎𝑟 ln
𝑆0
• If 𝑆𝑡 is not continuous because of discrete dividends, it does not
satisfy the hypotheses of the Black-Scholes model.
• Instead, Black-Scholes model must be applied to the prepaid forward
price.
• Thus, 𝜎: volatility of the prepaid forward.
• Prepaid forward price for stock with discrete dividends:
𝑃
𝐹0,𝑇 𝑆 = 𝑆0 − 𝑃𝑉0,𝑇 (𝐷𝑖𝑣)

Ms Sarah Nadirah Mohd Johari, 2021

EXAMPLE 2
A stock has quarterly dividends, paid at the end of 3 months and 6 months
from now. You are given:
i) The stock’s price is 42
ii) Quarterly dividends are 0.75
iii) The volatility of a prepaid forward on the stock is 0.3
iv) A 6-month European put option is written on the stock with strike price
40.
v) The put option, if it is exercise, is exercised on the stock ex-dividend.
vi) The continuously compounded risk-free rate is 0.04
Calculate the put option’s premium with the Black-Scholes formula

Ms Sarah Nadirah Mohd Johari, 2021

BLACK-SCHOLES FORMULA: GREEKS
• Black-Scholes formula:
𝐶 𝑆, 𝐾, 𝜎, 𝑟, 𝑇, 𝛿 = 𝑆𝑒 −𝛿𝑇 𝑁 𝑑1 − 𝐾𝑒 −𝑟𝑇 𝑁(𝑑2 )
• By differentiating 𝐶 with respect to these arguments, we can estimate
the change in value of a call in response to the change in value of one
of these arguments.
• It is useful if one wishes to hedge the option.

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BLACK-SCHOLES FORMULA: GREEKS
• Definition of Greeks:
∆: change in option price when stock price increases by $1
Γ: change in delta when option price increases by $1
Vega: change in option price when volatility increases by 1%
𝜃: change in option price when time to maturity decreases by 1 day
𝜌: change in option price when interest rate increase by 1%
𝜑: change in option price when continuous dividend increases by 1%

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BLACK-SCHOLES FORMULA: GREEKS
DELTA, ∆
• Call option becomes more valuable as the stock price increases but
cannot increase in value more than the stock price. Hence, 0 ≤ ∆≤ 1

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BLACK-SCHOLES FORMULA: GREEKS
DELTA, ∆
• Put option becomes less valuable as the stock price increases but cannot
decrease in value faster than the stock price increases. Hence, −1 ≤ ∆≤ 0

Ms Sarah Nadirah Mohd Johari, 2021

BLACK-SCHOLES FORMULA: GREEKS
DELTA, ∆
• Formulas for call and put delta:
∆𝑐𝑎𝑙𝑙 = 𝑒 −𝛿𝑇 𝑁 𝑑1

∆𝑝𝑢𝑡 = −𝑒 −𝛿𝑇 𝑁 −𝑑1

• A call option can be replicated by buying ∆ shares of stock and borrowing

𝐾𝑒 −𝑟𝑇 𝑁(𝑑2 ).

Ms Sarah Nadirah Mohd Johari, 2021

EXAMPLE 3
For a stock, you are given:
i) The price is 45
ii) Volatility of the stock is 0.2
iii) The continuously compounded risk-free rate is 0.05
iv) The continuous dividend rate of the stock is 0.02
A European put option with strike price 43 expires in 3 month.
Using the Black-Scholes formula, how many shares of stock should be
sold and how much be lent, to replicate the put option?

Ms Sarah Nadirah Mohd Johari, 2021

GREEK MEASURES FOR PORTFOLIOS
• Is a weighted average of Greeks of individual portfolio components.
𝑛

∆𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 = ෍ 𝜔𝑖 ∆𝑖
𝑖=1

Ms Sarah Nadirah Mohd Johari, 2021

EXAMPLE 4
For a stock:
i) The price is 55
ii) Volatility of the stock is 0.2
iii) The continuously compounded risk-free rate is 0.04
iv) The continuous dividend rate of the stock is 0.025
A portfolio has three European call options on this stock.
• The first allows purchase of 100 shares of the stock at the end of 3 months at strike price
55.
• The second allows purchase of 200 shares of the stock at the end of 6 months at strike
price 60.
• The third allows purchase of 200 shares of the stock at the end of a year at strike price
65.
Calculate delta for this portfolio.

Ms Sarah Nadirah Mohd Johari, 2021

ELASTICITY AND RELATED CONCEPTS
ELASTICITY
• Option elasticity is percentage change in the value of an option as a function of
the percentage change in the value of the underlying stock.
• If stock price, 𝑆 changes by 1%, what is the percent change in the value of the
option, 𝐶?
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑝𝑡𝑖𝑜𝑛 𝑝𝑟𝑖𝑐𝑒
Ω=
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒

𝜀∆
𝐶 𝑆∆
𝛺= 𝜀 =
𝐶
𝑆
Ms Sarah Nadirah Mohd Johari, 2021
EXAMPLE 5
For a European 3-month put option, you are given:
i) The price of the underlying stock is 40.
ii) The strike price is 38.
iii) The stock pays no dividends
iv) 𝜎 = 0.1
v) 𝑟 = 0.05
Calculate the elasticity of the put option

Ms Sarah Nadirah Mohd Johari, 2021

ELASTICITY AND RELATED CONCEPTS
RELATED CONCEPTS
• The volatility of an option:
𝜎𝑜𝑝𝑡𝑖𝑜𝑛 = 𝜎𝑠𝑡𝑜𝑐𝑘 × |Ω|
• The risk premium of an option:
𝛾 − 𝑟 = (𝛼 − 𝑟) × Ω
• The Sharpe ratio (ratio of the risk premium over the volatility) of an
option:
Ω(𝛼 − 𝑟) 𝛼 − 𝑟
𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 𝑓𝑜𝑟 𝑐𝑎𝑙𝑙 = = = 𝑆ℎ𝑎𝑟𝑝𝑒 𝑟𝑎𝑡𝑖𝑜 𝑓𝑜𝑟 𝑠𝑡𝑜𝑐𝑘
Ω𝜎 𝜎

Ms Sarah Nadirah Mohd Johari, 2021

EXAMPLE 6
For a stock:
i) The price is 55.
ii) The strike price is 38.
iii) The continuous dividend rate is 0.025
iv) 𝜎 = 0.2
v) 𝑟 = 0.04
A portfolio has 3 European call options on this stock. The first allows
purchase of 100 shares of the stock at the end of 3 months at strike price 55.
The second allows purchase of 200 shares of the stock at the end of 6
months at strike price 60. The third allows purchase of 200 shares of the
stock at the end of a year at strike price 65. Calculate elasticity for this
portfolio.

Ms Sarah Nadirah Mohd Johari, 2021

 CHAPTER 4
THE BLACK-SCHOLES FORMULA & EQUATION

Ms Sarah Nadirah Mohd Johari, 2021

CONTENTS
• Introduction and Application of Black Scholes Formula
• Option Greeks, Profit Diagram and Implied Volatility
• Differential Equations and Valuation under Certainty
• The Black-Scholes Equation
• Risk-Neutral Pricing and Changing the Numeraire
• Option Pricing When the Stock Price Can Jump

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PROFIT DIAGRAMS BEFORE MATURITY
• In previous Chapter, to draw the payoff and profit diagrams for options at
expiration has been introduced.
• Look into drawing the payoff and profit diagrams for options prior to
expiration.
• Illustrate the calculations with two strategies:
1) Buy call option
2) Entering a calendar spread (buy and sell options with different times to
expiration)

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PROFIT DIAGRAMS BEFORE MATURITY
CALL OPTIONS AND BULL SPREADS
• Start by calculating how profit develops on European call option.
• If you purchase a 91-day call and hold it for one day, the profit that you
will make on the options is:
1) Change in call premium: call premium after one day minus the call
premium initially
2) Loss interest: one day’s interest on the call premium
• Let 𝐶91 be the initial premium and 𝐶90 be the premium after one day.
The profit is: 𝐶90 − 𝐶91 𝑒 𝑟/365

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EXAMPLE 7
Given:
i) The price of a stock is 55.
ii) The stock’s continuous dividends proportional to its price at a rate
of 0.01
iii) The volatility of the stock is 0.1
iv) A 182-day European call option has strike price 56
v) The continuously compounded risk-free interest rate is 0.05
Calculate the 10-day holding period profit on the call if the stock’s price
is 56 at the end of 10 days.
Ms Sarah Nadirah Mohd Johari, 2021
PROFIT DIAGRAMS BEFORE MATURITY
CALL OPTIONS AND BULL SPREADS
• The Greeks controlling profit are ∆, Γ and 𝜃.
• ∆ causes a certain % of the increase of 1 in the stock value to be profit.
• Γ is a second order effect of the change in stock value.
• 𝜃 causes time decay which reduces the profit on the option.

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EXAMPLE 8
Given:
i) The price of a stock is 55.
ii) The stock’s continuous dividends proportional to its price at a rate
of 0.01
iii) The volatility of the stock is 0.1
iv) A 182-day European call option has strike price 56
v) The continuously compounded risk-free interest rate is 0.05
Calculate the 10-day holding period profit on the call if the stock’s price
is 55 at the end of 10 days.
Ms Sarah Nadirah Mohd Johari, 2021
PROFIT DIAGRAMS BEFORE MATURITY
CALL OPTIONS AND BULL SPREADS

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EXAMPLE 9
A nondividend paying stock has price 50 and volatility 30%. The
continuously compounded risk-free rate is 10%. You purchase a bull
spread consisting of buying a 90-day European call with strike price 50
and selling a 90-day European call with strike price 55.
1. Calculate ∆ for the spread.
2. Calculate the profit on the bull spread after 30 days if the stock
price is 52 then.

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PROFIT DIAGRAMS BEFORE MATURITY
CALL OPTIONS AND BULL SPREADS

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PROFIT DIAGRAMS BEFORE MATURITY
CALENDAR SPREADS
• Consists of selling a call and buying another call with the same strike
price on the same stock but a later expiry date.
• This is a bet on volatility.
• If the stock price is the same at the end of the first period, the shorter
option expires without value and the longer option, while it has lost
some value, still has value and you gain profit.
• If the stock price declines significantly, the longer option loses more
value than the premium of the shorter option, so you lose money.

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PROFIT DIAGRAMS BEFORE MATURITY
CALENDAR SPREADS
• If the stock price increases significantly, the shorter option goes up in
value more than the longer option, once again causing a loss.

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EXAMPLE 9
For a calendar spread consisting of selling a 30-day European call on a
stock and buying a 90-day European call on the same stock, both with
strike price 45.
i) The initial price of the stock is 50.
ii) 𝜎 = 0.3
iii) 𝑟 = 0.05
iv) 𝛿 = 0
1. Calculate the profit on the 30th day if the stock price is then 50.
2. Calculate the profit on the 30th day if the stock price is then 45.
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PROFIT DIAGRAMS BEFORE MATURITY

CALENDAR SPREADS

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VOLATILITY
• Is the parameter that is not directly observable.
𝑆𝑡+ℎ
𝜎 𝑆𝑡 , 𝑋𝑡 , 𝑡 = lim 𝑉𝑎𝑟 ln /ℎ
ℎ→0 𝑆𝑡
• where 𝑋𝑡 denotes other variables which affect the volatility.
• However, in Black-Scholes formula, it assumes the volatility does not
depend on 𝑆𝑡 , 𝑋𝑡 or 𝑡; in other words, 𝜎 is constant.
• Two methods for estimating volatility:
1) Implied volatility
2) Historical volatility.

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VOLATILITY
IMPLIED VOLATILITY
• Important because:
Allows pricing other options on the same stock for which there may
not be market prices, by using the Black-Scholes formula in
conjunction with traded options on the same stock to back out
volatility.
Quick way to describe option prices
Volatility skew is a measure how good the Black-Scholes model is.

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EXAMPLE 10
For European call options on nondividend paying stock:
i) The stock price is 50
ii) Time to expiry is 𝑡
iii) The strike price is 50𝑒 0.04𝑡
iv) The continuously compounded risk-free rate is 0.04
v) The following prices are observed for various time to expiry:
TIME TO EXPIRY 3 months 1 year 2 years
PRICE 3.98 5.96 7.14
Calculate the implied volatilities of options for these 3 periods using
the Black-Scholes model.

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VOLATILITY
IMPLIED VOLATILITY
• Implied volatility tends to decrease as strike price increases.
• ITM call option has higher volatility than OTM call option, particularly for
lower times to expiry
• ITM put option has lower volatility that OTM put option.
• It is known as volatility skew.
• Implied volatility for European calls and puts on the same stock for the
same strike price and expiration must be close by put-call parity
otherwise arbitrage exist.

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 CHAPTER 4
THE BLACK-SCHOLES FORMULA & EQUATION

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CONTENTS
• Introduction and Application of Black Scholes Formula
• Option Greeks, Profit Diagram and Implied Volatility
• Differential Equations and Valuation under Certainty
• The Black-Scholes Equation
• Risk-Neutral Pricing and Changing the Numeraire
• Option Pricing When the Stock Price Can Jump

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BROWNIAN MOTION
• Study the theoretical background for Black-Scholes pricing.
• In order to price options, need:
1) A model for the price movement of the underlying asset
2) A way to calculate the price movement of a claim on the asset as a
function of the price movement of the asset.
• Brownian motion is a model for price movements.
• Itos Lemma is a way to relate changes in values of functions of assets to
changes in values of assets.

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BROWNIAN MOTION
• Aim: to build a model for stock prices.
• The model will be a stochastic model: it will give probabilities for the
stock price being in a certain range at a certain time.
• A one-dimensional discrete random walk models, somebody starting out
on the 𝑥 axis at the point 0 and then moving left or right at the rate of 1
per unit of time, with the direction being chosen randomly at every
point.
• 𝑋(𝑡) be the position at time 𝑡.

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BROWNIAN MOTION
• For a random walk:
1) 𝑋 0 = 0
𝑘 + 1 𝑤𝑖𝑡ℎ 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 0.5
2) For 𝑡 > 0, if 𝑋 𝑡 − 1 = 𝑘 then 𝑋 𝑡 =
𝑘 − 1 𝑤𝑖𝑡ℎ 𝑝𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 0.5
• To calculate the probability that 𝑋 3 = 1, note that for 𝑋 to move 1 at
time 3, it would have to move up twice and down once from time 0.
• There are 23 = 8 possibilities for 3 movements and of these 8, 3 of them
would end up at 1, since you would need 2 ups and 1. Hence 𝑃(𝑋 3 =
3
1) =
8

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BROWNIAN MOTION
• Things to note about random walks:
1) A random walk has no memory. Given that 𝑋 𝑡 = 𝑘, the probability
that 𝑋 𝑡 + 𝑢 = 𝑙 given that 𝑋 𝑡 = 𝑘 is the same as 𝑃 𝑋 𝑢 = 𝑙 − 𝑘
2) Although 𝑋(𝑡) is random, the distance traversed (in absolute value) is
not random. 𝑋 moves at the rate of 1 per unit of time, although it can
move in any direction. If sum up the squares of the movements, will
get 𝑡.
1
3) 𝑋(𝑡) has a scaled and shifted binomial distributions: (𝑋 𝑡 +
2
1
𝑡)~Binomial t,
2

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BROWNIAN MOTION
• Instead of moving 1 per unit of time, moved ℎ per ℎ units of time and
took the limit as ℎ → 0. Then, will have a continuous random walk.
• Binomial rv → normal rv and the result would be Brownian motion.
• Brownian motion, 𝑍(𝑡) is a random process, a collection of rv indexed by
time 𝑡, defined by the following properties:
1) 𝑍 0 = 0
2) 𝑍 𝑡 + 𝑠 |𝑍 𝑡 ~N Z t , s
3) Increments are independent: 𝑍 𝑡 + 𝑠1 − 𝑍(𝑡) independent of 𝑍 𝑡 −
𝑍(𝑡 − 𝑠2 )

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BROWNIAN MOTION (BM)
4) 𝑍 𝑡 is a continuous in 𝑡.
• BM is an example of a diffusion process and of a martingale which are
defined as follows:
• Diffusion process: A continuous process in which the absolute value of
the rv tends to get larger.
• Martingale: A process 𝑋(𝑡) for which 𝐸 𝑋 𝑡 + 𝑠 𝑋 𝑡 = 𝑋(𝑡). For BM,
this follows from the second property above.

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BROWNIAN MOTION (BM)
• 𝑍 𝑡 ~𝑁𝑜𝑟𝑚𝑎𝑙, can easily make probability statements about its ranges.
• Let 𝑡 be the latest time, 𝑍(𝑡).
• Then 𝑍 𝑡 + 𝑠 |𝑍 𝑡 , 𝑠 > 0 ~𝑁 𝑍 𝑡 , 𝑠

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EXAMPLE 11
Price of a stock follows Brownian motion. The price of the stock at time
3 is 52. Determine the probability that the price of the stock is at least
55 at time 12.

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ARITHMETIC BROWNIAN MOTION (ABM)
• ABM consists of a Brownian motion scaled by multiplication and shifted
by addition
• If 𝑋(𝑡) is an ABM, then:
𝑋 𝑡 = 𝑋 0 + 𝛼𝑡 + 𝜎𝑍(𝑡)
• 𝑋 𝑡 + 𝑠 − 𝑋 𝑡 ~𝑁(𝛼𝑠, 𝜎 2 𝑠) where 𝛼 is called the drift of the process.
• Let 𝑡 be the latest time, X(𝑡).
• Then 𝑋 𝑡 + 𝑠 |𝑋 𝑡 , 𝑠 > 0 ~𝑁 𝑋 𝑡 + 𝛼𝑠, 𝜎 2 𝑠

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EXAMPLE 12
Price of a stock follows Arithmetic Brownian motion of the form 𝑋 𝑡 =
𝑋 0 + 𝑡 + 0.2𝑍(𝑡). The current price of the stock is 40.
Determine the probability that the price of the stock at time 4 is less
than 43.

Ms Sarah Nadirah Mohd Johari, 2021

GEOMETRIC BROWNIAN MOTION (GBM)
• ABM is not a good model for stock price movement because it can go
negative and does not scale with stock price.
• Transform ABM to GBM.
• 𝑋 𝑡 ~𝐺𝐵𝑀 if 𝑙𝑛𝑋 𝑡 ~𝐴𝐵𝑀
• 𝑙𝑛𝑋(𝑡) is a normal random variable, making 𝑋 𝑡 a lognormal rv.
𝑋 𝑡
• If ln ~𝑁 𝜇𝑡, 𝜎 2 𝑡 , then
𝑋 0
𝑋 𝑡 𝜇𝑡+0.5𝜎 2𝑡 2𝜇+𝜎 2𝑡 𝜎 2
~𝐿𝑜𝑔𝑛𝑜𝑟𝑚𝑎𝑙 𝑒 ,𝑒 𝑒 −1
𝑋 0

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GEOMETRIC BROWNIAN MOTION (GBM)
• Model the price of a stock using GBM:
• Let 𝑆(𝑡) be the time 𝑡 price of a stock.
• Suppose volatility of stock is 𝜎. 𝑉𝑎𝑟 ln 𝑆 𝑡 𝑆 0 = 𝜎 2 𝑡.
• The stock pays no dividends.
• The only return from the stock is its capital gains or growth in price.
• Suppose 𝐸 𝑆 𝑡 = 𝑆 0 𝑒 𝛼𝑡 .

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GEOMETRIC BROWNIAN MOTION (GBM)
• Assume the stock pays dividends at a continuously compounded rate of
𝛿. There are two sources of earnings on the stock:
1. The dividends, 𝛿.
2. The capital gains.
• Sum of these returns is 𝛼. The capital gains rate – the rate at which the
stock price increases – is 𝜀 = 𝛼 − 𝛿.

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GEOMETRIC BROWNIAN MOTION (GBM)
• Expected stock price increase:
𝑆 𝑡
𝐸 = 𝑒 𝜀𝑡
𝑆 0

𝑋 𝑡 𝜇+0.5𝜎 2 𝑡
𝐸 =𝑒
𝑋 0
• It follows 𝜀 = 𝜇 + 0.5𝜎 2 .
• From GBM to ABM, subtract 0.5𝜎 2 if you wish to use the normal tables
to look up probabilities or percentiles.

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GEOMETRIC BROWNIAN MOTION (GBM)
• Since 𝜀 = 𝛼 − 𝛿, to calculate probabilities or percentiles for a stock
whose return is 𝛼, which pays dividends of 𝛿, and whose volatility is 𝜎,
set 𝑚 = 𝛼 − 𝛿 − 0.5𝜎 2 𝑡 and 𝑣 = 𝜎 𝑡 and use these parameters to
look up the normal distribution in the table.

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EXAMPLE 13
The time,𝑡 price of a stock is 𝑆(𝑡). The stock price is modelled as
following Geometric Brownian motion. You are given:
i) The stock’s continuously compounded expected rate of return is
0.15
ii) The stock’s continuously compounded dividend yield is 0.04.
iii) The stock’s volatility is 0.3.
iv) 𝑆 0 = 45
v) 𝑆 0.6 = 47
Calculate 𝑃 𝑆 1 < 45 given the above facts.

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DIFFERENTIAL EQUATIONS AND VALUATION
UNDER UNCERTAINTY
• Black and Scholes assumed that stock follows Geometric Brownian
motion (GBM) and used Itos Lemma to describe option price behavior.
• GBM is a useful model for stock prices.
𝑆 𝑡
• If 𝑆 𝑡 ~𝐺𝐵𝑀, then ~𝐿𝑜𝑔𝑛𝑜𝑟𝑚𝑎𝑙
𝑆 0
• It is hard to build a memory-free variable of this nature except by using
calculus: stating the starting value of the variable and stating the rate at
which it changes.
• Need a stochastic calculus, one that allows for a random lognormal term.

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DIFFERENTIAL EQUATIONS AND VALUATION
UNDER UNCERTAINTY
• In ordinary calculus:
𝑦 = 𝑒 𝜀𝑡
𝒅𝒚
=? ?
𝒅𝒕
• This form does not easily allow introduction of an additional component
for 𝑑𝑍(𝑡).
• Multiply both sides by 𝑑𝑡 to obtain a differential expression:
𝑑𝑦 = 𝜀𝑒 𝜀𝑡 𝑑𝑡
𝑑𝑦 = 𝜀𝑦𝑑𝑡

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DIFFERENTIAL EQUATIONS AND VALUATION
UNDER UNCERTAINTY
• Divide by 𝑦 to obtain:
𝑑𝑦
= 𝜀𝑑𝑡
𝑦
• This says that the change of 𝑦 is proportional to 𝜀𝑦 times the change of 𝑡.
• Suppose that there were some uncertainty in this rate of change.
• Add 𝜎𝑑𝑍(𝑡) to the right hand side:
𝑑𝑦
= 𝜀𝑑𝑡 + 𝜎𝑑𝑍(𝑡)
𝑦

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DIFFERENTIAL EQUATIONS AND VALUATION
UNDER UNCERTAINTY
• 𝑑𝑍(𝑡) is the differential of a Brownian motion
• It is the limit, as ℎ → 0 of a random variable equal to ℎ with probability
0.5 and −ℎ with probability 0.5.
• 𝑡 represent time.
• 𝑍(𝑡) is independent of 𝑡 so that partials with respect to one of them do
not include the other.

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DIFFERENTIAL EQUATIONS AND VALUATION
UNDER UNCERTAINTY
EXAMPLE
• Value at time 𝑡 of an arithmetic Brownian motion 𝑋(𝑡) with drift, 𝜇 and
coefficient of 𝑍(𝑡) equal to 𝜎 can be expressed as:
𝑋 𝑡 = 𝑋 0 + 𝜇𝑡 + 𝜎𝑍(𝑡)
• The differential of this arithmetic Brownian motion 𝑋(𝑡):
𝑑𝑋 𝑡 = 𝜇𝑑𝑡 + 𝜎𝑑𝑍(𝑡)
• A small change in 𝑋 equals:
1) 𝜇 times a small change in time or 𝑑𝑡
2) 𝜎 times a small change in a Brownian motion or 𝑑𝑍(𝑡).

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DIFFERENTIAL EQUATIONS AND VALUATION
UNDER UNCERTAINTY
• Brownian motion itself, 𝑍 𝑡 ~Normal (0, t).
• A small change in a Brownian motion is a rv normally distributed with
mean 0 and variance 𝑑𝑡.
• The time value of a GBM, 𝑋 𝑡 can be expressed in terms of its
logarithm:
ln 𝑋 𝑡 = ln 𝑋 0 + 𝜀 − 0.5𝜎 2 𝑡 + 𝜎𝑍(𝑡)
• Differential of this expression:
𝑑 ln 𝑋 𝑡 = 𝜀 − 0.5𝜎 2 𝑑𝑡 + 𝜎𝑑𝑍(𝑡)

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DIFFERENTIAL EQUATIONS AND VALUATION
UNDER UNCERTAINTY
• The same GBM, 𝑋 𝑡 can be expressed directly:
𝜀−0.5𝜎 2 𝑡+𝜎𝑍 𝑡
𝑋 𝑡 = 𝑋(0)𝑒
• Differential of this expression:
𝑑𝑋(𝑡) = 𝜀𝑋(𝑡)𝑑𝑡 + 𝜎𝑋(𝑡)𝑑𝑍(𝑡)
• This form displays the return as a coefficient of 𝑑𝑡; in other forms, must
add 0.5𝜎 2 to get the return.
• Going the other way, must subtract 0.5𝜎 2 from the coefficient of 𝑑𝑡
before looking up a normal table, whereas in the other forms, no
subtraction is done.

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DIFFERENTIAL EQUATIONS AND VALUATION
UNDER UNCERTAINTY
• Any process of the form:
𝑑𝑆 𝑡 = 𝜀 𝑆 𝑡 , 𝑡 𝑑𝑡 + 𝜎 𝑆 𝑡 , 𝑡 𝑑𝑍(𝑡)
• Where 𝜀 𝑆 𝑡 , 𝑡 and 𝜎 𝑆 𝑡 , 𝑡 are functions of 𝑆 an 𝑡 is called an Ito
process.
• 𝑑𝑡 = drift of the process.

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EXAMPLE 14
You are given an Ito process of the form:
𝑑𝑆 𝑡 = 0.25𝑆(𝑡)𝑑𝑡 + 0.10𝑆(𝑡)𝑑𝑍(𝑡)
Calculate the probability that 𝑆(𝑡) is at least 5% higher than 𝑆(0).
1. At time 𝑡 = 0.1
2. At time 𝑡 = 1

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EXAMPLE 15
You are given that 𝑆(𝑡) follows an Ito process of the form:

𝑑𝑆 𝑡
= 0.15𝑑𝑡 + 0.20𝑑𝑍(𝑡)
𝑆 𝑡

Given that 𝑆 9 = 40, calculate the probability that 40 < 𝑆 13 < 50.

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THE LANGUAGE OF BROWNIAN MOTION
• A stock follows and Ito process of the form:
𝑑𝑆
= 𝜀𝑑𝑡 + 𝜎𝑑𝑍(𝑡)
𝑆
• Where both 𝜀 and 𝜎 are constant.
• Immediately translate:
1) Stock follows the Black-Scholes framework
2) Continuous rate of increase in the stock price, ε = 𝛼 − 𝛿
3) Volatility is 𝜎

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THE LANGUAGE OF BROWNIAN MOTION
• To apply Black-Scholes formula, will probably need dividend rate and
risk-free rate.
• Should translate 𝑉𝑎𝑟 ln 𝑆 𝑡 |𝑆(0) = 𝜎 2 𝑡 to the volatility is 𝜎
• Translate 𝑌 𝑡 = ln 𝑆(𝑡) follows and Ito process 𝑑𝑌 𝑡 = 𝜇𝑑𝑡 + 𝜎𝑑𝑍(𝑡)
into GBM for 𝑆(𝑡), remembering to add 0.5𝜎 2 to 𝜇

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EXAMPLE 16
The price of a nondividend paying stock at time t, 𝑆(𝑡) follows an Ito process
of the form:

𝑑𝑆 𝑡
= 𝛼𝑑𝑡 + 𝜎𝑑𝑍(𝑡)
𝑆 𝑡

You are given:

1) 𝑆 0 = 40
2) 𝑉𝑎𝑟 ln 𝑆 𝑡 = 0.25𝑡
3) The continuously compounded risk-free interest rate is 0.04
A European call option on the stock expiring in four years has strike price 50.
Determine the value of this call option.

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ITO’S LEMMA
• An Ito process is a random process 𝑋(𝑡) whose differential can be
expressed as:
𝑑𝑋 𝑡 = 𝜀 𝑡, 𝑋 𝑡 𝑑𝑡 + 𝜎 𝑡, 𝑋 𝑡 𝑑𝑍 𝑡
• It generalizes Arithmetic and Geometric BM.
• For ABM: 𝜀 𝑡, 𝑋 𝑡 = 𝛼 ; 𝜎 𝑡, 𝑋 𝑡 =𝜎
• For GBM: 𝜀 𝑡, 𝑋 𝑡 = 𝜀𝑋(𝑡); 𝜎 𝑡, 𝑋 𝑡 = 𝜎𝑋(𝑡)

Ms Sarah Nadirah Mohd Johari, 2021

ITO’S LEMMA
• An Ito process in which 𝜀 𝑡, 𝑋 𝑡 is not constant is one of the following
form:
𝑑𝑋 𝑡 = λ 𝛼 − 𝑋 𝑡 𝑑𝑡 + 𝜎𝑑𝑍 𝑡
• 𝜀 𝑡, 𝑋 𝑡 is smaller if 𝑋(𝑡) is close to 𝛼 and larger if it is far away.
Moreover, the process drifts towards 𝛼 no matter where it starts.
• It is known as mean reverting process and is called an Ornstein-
Uhlenbeck process, whether or not 𝛼 = 0, λ indicates the speed at which
the process reverts to 𝛼.

Ms Sarah Nadirah Mohd Johari, 2021

ITO’S LEMMA
• Ito’s lemma is a formula for evaluating 𝑑𝐶(𝑆, 𝑡) if 𝐶(𝑆, 𝑡) is a function of
𝑆 and 𝑡.
• It is like ordinary calculus’s chain rule.
• if 𝐶(𝑆, 𝑡) is a function of 𝑆 and 𝑡:
𝑑𝐶 = 𝐶𝑠 𝑑𝑠 + 𝐶𝑡 𝑑𝑡
• Where 𝐶𝑠 = 𝜕𝐶/𝜕𝑆 is the partial derivative of 𝐶 𝑡 with respect to 𝑆(𝑡)
• 𝐶𝑡 = 𝜕𝐶/𝜕𝑡 is the partial derivative of 𝐶𝑡 with respect to 𝑡.
• In ordinary calculus, second order terms such as 𝑑𝑡 2 are zero, but in
stochastic calculus: 𝑑𝑍 𝑡 × 𝑑𝑍 𝑡 = 𝑑𝑡 ≠ 0. Hence, need an extra term.

Ms Sarah Nadirah Mohd Johari, 2021

ITO’S LEMMA
• Ito’s lemma:
𝑑𝐶 = 𝐶𝑠 𝑑𝑆 + 0.5𝐶𝑠𝑠 𝑑𝑆 2 + 𝐶𝑡 𝑑𝑡
• 𝐶𝑠𝑠 = 𝜕 2 𝐶/𝜕𝑆 2 , the second partial derivative of 𝐶(𝑡) with respect to
𝑆(𝑡).
• To multiply differentials, use the following table:
Multiplication table
𝑑𝑡 𝑑𝑍(𝑡)
𝑑𝑡 0 0
𝑑𝑍(𝑡) 0 𝑑𝑡
Ms Sarah Nadirah Mohd Johari, 2021
ITO’S LEMMA
• If 𝑍(𝑡) and 𝑍′(𝑡) are two BM having correlation 𝜌, then 𝑑𝑍 𝑡 ×
𝑑𝑍 ′ 𝑡 = 𝜌𝑑𝑡
• If 𝑑𝑆 𝑡 = 𝛼 𝑡, 𝑆 𝑡 𝑑𝑡 + 𝜎 𝑡, 𝑆 𝑡 𝑑𝑍 𝑡 , the only term that will
2 2
survive when multiplying out 𝑑𝑆 𝑡 = 𝜎 𝑡, 𝑆 𝑡 𝑑𝑡 .
• If 𝐶𝑠𝑠 = 0, Ito’s lemma reduces to the chain rule and the differentiation
looks like ordinary calculus.

Ms Sarah Nadirah Mohd Johari, 2021

EXAMPLE 17
You are given:

𝑋(𝑡) = 𝛼𝑡 + 𝜎𝑍(𝑡)

Calculate 𝑑𝑋(𝑡) using Ito’s lemma.

Ms Sarah Nadirah Mohd Johari, 2021

EXAMPLE 18
You are given:

𝑋(𝑡) = 𝑋 0 𝑒 𝛼−0.5𝜎 2 𝑡+𝜎𝑍(𝑡)

Calculate 𝑑𝑋(𝑡) using Ito’s lemma.

Ms Sarah Nadirah Mohd Johari, 2021

EXAMPLE 19
You are given:

𝑑𝑋 𝑡
= 𝜀𝑑𝑡 + 𝜎𝑑𝑍(𝑡)
𝑋 𝑡
Calculate 𝑑 ln 𝑋 𝑡 using Ito’s lemma.

Ms Sarah Nadirah Mohd Johari, 2021

EXAMPLE 20
You are given:
i) The Ito’s process for 𝑆(𝑡) is 𝑑𝑆 𝑡 = 0.2𝑆 𝑡 𝑑𝑡 + 0.02𝑆 𝑡 𝑑𝑍 𝑡
ii) 𝐶 𝑆, 𝑡 is a claim on 𝑆.
iii) 𝐶 𝑆, 𝑡 = 𝑆 3
Determine the coefficients of 𝑑𝑡 and 𝑑𝑍(𝑡) in the Ito process for
𝐶(𝑆, 𝑡).

Ms Sarah Nadirah Mohd Johari, 2021

MARTINGALES
• An Ito process is a martingale if and only if the coefficient of 𝑑𝑡, the drift,
is identically zero.
• Can use Ito’s Lemma to calculate the coefficient of 𝑑𝑡.

EXAMPLE 21
The process 𝑋 𝑡 = 𝑍 𝑡 3 + 𝑐𝑡𝑍(𝑡) is a martingale.
Determine 𝑐.

Ms Sarah Nadirah Mohd Johari, 2021

THE BLACK-SCHOLES EQUATION
• Is a general non-stochastic partial differential equation for claims on
assets following GBM.
• To value an asset, cancel out the 𝑑𝑍(𝑡) randomness of the asset and
obtain a risk-free portfolio.
• By setting the rate of return equal to the risk-free rate, we obtain a
partial differential equation.

Ms Sarah Nadirah Mohd Johari, 2021

THE BLACK-SCHOLES EQUATION
• To value a claim on an asset:
1) Buy the claim
2) Delta-hedge by selling delta shares of the asset.
3) Lend the net proceeds of the above two at the risk-free rate.
4) The 𝑑 of the first two items plus the dividend of the asset minus
interest at the risk-free rate must equal.

Ms Sarah Nadirah Mohd Johari, 2021

THE BLACK-SCHOLES EQUATION
• Let 𝐶(𝑡) be the value of the claim and 𝑆 𝑡 be the value of the
underlying asset.
• Assume 𝑆 𝑡 follows a geometric Ito process:
𝑑𝑆 𝑡
= 𝛼𝑑𝑡 + 𝜎𝑑𝑍(𝑡)
𝑆 𝑡
• Buying the claim, will get positive 𝐶.
• Delta-hedging by selling shares of the asset, will get negative 𝐶𝑠 𝑆.
• Net proceeds of buying 𝐶 and selling 𝐶𝑠 shares of 𝑆 are 𝐶𝑠 𝑆 − 𝐶, which
we lend and the value of loan in the portfolio is 𝐶𝑠 𝑆 − 𝐶.

Ms Sarah Nadirah Mohd Johari, 2021

THE BLACK-SCHOLES EQUATION
• Let 𝑉 be the value of the portfolio.
𝑑𝑉 = 𝑑𝐶 − 𝐶𝑠 𝑑𝑆 − 𝐶𝑠 𝑆𝛿𝑑𝑡 + 𝐶𝑠 𝑆 − 𝐶 𝑟𝑑𝑡 = 0
1) Subtracted 𝐶𝑠 𝑆𝛿𝑑𝑡 since 𝐶𝑠 shares that were sold earn dividends
2) Multiplied 𝐶𝑠 𝑆 − 𝐶 by 𝑟𝑑𝑡 since the risk-free loan pays at the rate of 𝑟
• Evaluate 𝑑𝐶 by Ito’s lemma:
𝑑𝐶 = 𝐶𝑠 𝑑𝑆 + 0.5𝐶𝑠𝑠 𝑑𝑆 2 + 𝐶𝑡 𝑑𝑡
0.5𝐶𝑠𝑠 𝑑𝑆 2 + 𝐶𝑡 𝑑𝑡 − 𝐶𝑠 𝑆𝛿𝑑𝑡 + 𝐶𝑠 𝑆 − 𝐶 𝑟𝑑𝑡 = 0
• 𝑑𝑆 2 = 𝑆 2 𝜎 2 𝑑𝑡
0.5𝑆 2 𝜎 2 𝐶𝑠𝑠 + 𝐶𝑠 𝑆 𝑟 − 𝛿 + 𝐶𝑡 = 𝑟𝐶

Ms Sarah Nadirah Mohd Johari, 2021

THE BLACK-SCHOLES EQUATION
∆𝑆 𝑟 − 𝛿 + 0.5Γ𝑆 2 𝜎 2 + 𝜃 = 𝑟𝐶

• Black-Scholes equation applies to most options.

• Does not apply to an American option if the option should be exercised
and requires modification for Asian options to take into account the
movement of the average stock price.

Ms Sarah Nadirah Mohd Johari, 2021

THE BLACK-SCHOLES EQUATION

Ms Sarah Nadirah Mohd Johari, 2021

EXAMPLE 22
Assume the Black-Scholes framework. Consider a derivative security of
a stock. You are given:
i) The time-t price of the stock is 𝑆(𝑡)
ii) The time-t price of the derivative security is 𝑆 𝑡 3
iii) The continuously compounded risk-free interest rate is 0.03
iv) The volatility of the stock is 0.3
v) The derivative security does not pay dividends.
Determine the continuously compounded dividend rate of the stock.

Ms Sarah Nadirah Mohd Johari, 2021

EXAMPLE 23
For a call option on a stock, you are given:
i) The stock price is 40
ii) 𝜎 = 0.5
iii) The stock pays no dividends.
iv) 𝑟 = 0.08
v) ∆ for the option is 0.7171
vi) Γ for the option is 0.0098
vii) 𝜃 for the option, per year is -3.0295
Determine the price of the option using the Black-Scholes equation.

Ms Sarah Nadirah Mohd Johari, 2021

RISK-NEUTRAL PRICING
• Investors demand a risk premium to accept risk.
• Risk premium is additional return required and the Sharpe ratio
determines the risk premium based on the volatility.
• In terms of Ito process, if the true Ito process is:
𝑑𝑆 𝑡 = 𝛼 𝑡, 𝑆 𝑡 − 𝛿 𝑡, 𝑆 𝑡 𝑑𝑡 + 𝜎 𝑡, 𝑆 𝑡 𝑑𝑍 𝑡
• Can be translated into the risk-neutral process:
𝑑𝑆 𝑡 = 𝑟 𝑡 𝑆 𝑡 − 𝛿 𝑡, 𝑆 𝑡 𝑑𝑡 + 𝜎 𝑡, 𝑆 𝑡 𝑑𝑍 𝑡

Ms Sarah Nadirah Mohd Johari, 2021

RISK-NEUTRAL PRICING
• If 𝑆 𝑡 ~𝐺𝐵𝑀, 𝛼 𝑡, 𝑆 𝑡 = 𝛼𝑆(𝑡) and 𝜎 𝑡, 𝑆 𝑡 = 𝜎𝑆(𝑡)
• In terms of Ito process, if the true Ito process is:
𝑑𝑆 𝑡 = 𝛼 𝑡, 𝑆 𝑡 − 𝛿 𝑡, 𝑆 𝑡 𝑑𝑡 + 𝜎 𝑡, 𝑆 𝑡 𝑑𝑍 𝑡
• Can be translated into the risk-neutral process:
𝑑𝑆 𝑡 = 𝑟 𝑡 𝑆 𝑡 − 𝛿 𝑡, 𝑆 𝑡 𝑑𝑡 + 𝜎 𝑡, 𝑆 𝑡 𝑑𝑍ҧ 𝑡

Ms Sarah Nadirah Mohd Johari, 2021

DIFFERENCE BETWEEN ITO’S LEMMA, BLAC-
SCHOLES EQUATIONS AND RISK-NEUTRAL PRICING
Ito’s Lemma:
A general formula for computing the process followed by 𝑉 = 𝑓(𝑆)
from the process followed by 𝑆. 𝑆 does not have to follow GBM. 𝑉
does not have to represent the price of an asset. If 𝑉 is the price of
an asset, it may be an asset that must pay dividends.
Black-Scholes equation:
An equation that must be satisfied by a process V(t) an asset
whose price at all times is 𝑉(𝑡). Assume that the underlying 𝑆~𝐺𝐵𝑀

Ms Sarah Nadirah Mohd Johari, 2021

DIFFERENCE BETWEEN ITO’S LEMMA, BLAC-
SCHOLES EQUATIONS AND RISK-NEUTRAL PRICING
Risk-neural pricing:
used to price a payoff 𝑉. 𝑉 is not a process, if a relationship
𝑉 = 𝑓(𝑆) is given, it only holds at time 𝑇. 𝑆 does not follow GBM
although it may be difficult to calculate the risk-neutral expected
value if it does not.

Ms Sarah Nadirah Mohd Johari, 2021

 ASC637
FINANCIAL RISK MANAGEMENT

Chapter 6.1
The Lognormal Distribution
 The Normal Distribution
1 x − 2
1 −  
• Normal distribution (or density) ( x;  ,  )  2  
e
 2
 The Normal Distribution (cont’d)

• Normal density is symmetric: ( + a;  , ) = ( − a;  , )

• If a random variable x is normally distributed with
mean  and standard deviation,  then 2
x ~ N ( ,  )
• Use z to represent a random variable that has a
standard normal distribution:
z ~ N (0,1)
• The value of the cumulative normal distribution
function N(a) equals to the probability P(z<a) of a
number z drawn from the normal distribution to
be less than a.
1
a 1 − x2
N (a )  −  e 2 dx
2
The Normal Distribution (cont’d)
 The Normal Distribution (cont’d)

• The probability that a number drawn from the

standard normal distribution will be between a and
–a:
Prob (z < –a) = N(–a)
Prob (z < a) = N(a)
therefore
Prob (–a < z < a) = N(a) – N(–a) =
N(a) – [1 – N(a)] = 2·N(a) – 1
• Example: Prob (–0.3 < z < 0.3) = 2·0.6179 – 1 =
0.2358
 The Normal Distribution (cont’d)

• Converting a normal random variable to

standard normal
x−
– If x ~ N ( ,  2 ) , then z ~ N (0,1) if z = 
• Converting a standard normal variable to a
normal variable
– If z ~ N (0,1) , then x ~ N ( ,  2 ) if x =  + z

• Example 18.2: Suppose x ~ N (3,5) and z ~ N (0,1)

x−3
then ~ N (0,1) , and 3 + 5  z ~ N (3,25)
5
 The Normal Distribution (cont’d)

• The sum of normal random variables is also

n  n n n 
  i xi ~ N    i  i ,    i  j ij 
i =1  i =1 i =1 j =1 

where xi, i = 1,…,n, are n random variables,

with mean E(xi) = i,

variance Var(xi) =i2,

covariance Cov(xi,xj) = ij = rijij

 The Lognormal Distribution

• A random variable x is lognormally distributed if

ln(x) is normally distributed
– If x is normal, and ln(y) = x (or y = ex), then y is
lognormal
– If continuously compounded stock returns are normal then
the stock price is lognormally distributed

• Product of lognormal variables is lognormal

– If x1 and x2 are normal, then y1=ex1 and y2=ex2 are
lognormal
– The product of y1 and y2: y1 x y2 = ex1 x ex2 = ex1+x2
– Since x1+x2 is normal, ex1+x2 is lognormal
 The Lognormal Distribution
(cont’d)

• The lognormal density function

2
1  ln( y )−m ] 
1 −  
g ( y; m, v)  e 2 v 

yv 2

• If x ~ N(m,v2), then
1
m+ v 2
E (e ) = e
x 2

Var(e ) = e
x 2 m+v 2
( e −1)
v2
The Lognormal Distribution
(cont’d)
 A Lognormal Model of Stock
Prices
• If the stock price St is lognormal, then St / S0 = ex,
where x, the continuously compounded return from
0 to t, is normally distributed
• If R(t, s) is the continuously compounded return
from t to s, and, t0 < t1 < t2, then R(t0, t2) = R(t0,
t1) + R(t1, t2)
• From 0 to T, E[R(0,T)] = nah , and Var[R(0,T)] =
nh2
• If returns are i.i.d., the mean and variance of the
continuously compounded returns are proportional
to time
 A Lognormal Model of
Stock Prices (cont’d)

• If we assume that
ln(St / S0 ) ~ N[(a −  − 0.5 2 )t , 2t ]
then ln( St / S0 ) = (a −  − 12  2 )t +  tZ
(a − −  2 ) t + tZ
1
and therefore St = S0e 2

• If current stock price is S0, the probability

that a call option with strike price K will expire in
the money is 
Prob( St  K ) = N (d 2 )
where the expression contains a, the true expected return
on the stock in place of r, the risk-free rate
 Lognormal Probability
Calculations
• Prices StL and StU such that Prob (StL < St ) = p/2
and Prob (StU > St ) = p/2

1 1
(a − −  2 ) t + t N −1 ( p /2) (a − −  2 ) t − t N −1 ( p /2)
StL = S0e 2
StU = S0e 2
 Lognormal Probability
Calculations (cont’d)

• Given a call option expires in the money,

what is the expected stock price? The
conditional expected price is
N (d1 )
(a − )t
E ( St | St  K ) = Se
N (d2 )
– where the expression contains a, the true
expected return on the stock in place of r, the
risk-free rate

• The Black-Scholes formula—the price of a

call option is
C (S , K , , r, t ,  ) = e− t SN (d1 ) − Ke− rt N (d 2 )
 Estimating the Parameters of a
Lognormal Distribution
• The lognormality assumption has two implications
– Over any time horizon continuously compounded
return is normal
– The mean and variance of returns grow proportionally
with time
 Estimating the Parameters of a
Lognormal Distribution (cont’d)
• Example 18.8: The mean of the second column is
0.006745 and the standard deviation is 0.038208
• Annualized standard deviation

= 0.038208  52 = 0.2755
• Annualized expected return

= 0.006745  52 + 0.5  0.27552 = 0.3877

How Are Asset Prices
Distributed?
How Are Asset Prices
Distributed? (cont’d)
How Are Asset Prices
Distributed? (cont’d)
 ASC637
FINANCIAL RISK MANAGEMENT

Chapter 6.2
Monte Carlo Valuation
 Monte Carlo Valuation

• Simulation of future stock prices and using

these simulated prices to compute the
discounted expected payoff of an option
– Draw random numbers from an appropriate
distribution
– Use risk-neutral probabilities, and therefore risk-
free discount rate
– Generate distribution of payoffs a byproduct
 Monte Carlo Valuation (cont’d)

• Simulation of future stock prices and

using these simulated prices to compute
the discounted expected payoff of an
option (cont'd)
– Pricing of asset claims and assessing the risks
of the asset
– Control variate method increases conversion
speed
– Incorporate jumps by mixing Poisson and
lognormal variables
– Simulated correlated random variables can be
created using Cholesky decomposition
 Computing the Option Price As a
Discounted Expected Value
• Assume a stock price distribution 3 months
from now
• For each stock price drawn from the
distribution compute the payoff of a call
option (repeat many times)
• Discount the average payoff at the risk-free
rate of return
 Computing the Option Price As a
Discounted Expected Value (cont’d)

• In a binomial setting, if there are n binomial

steps, and i down moves of the stock price,
the European Call price is

n
n!
European Call Price = e − rT
 max[0, Su n−i d i − K ]( p*)n−1(1 − p*)i
i =1 (n − i )!i !
Computing the Option Price As a
Discounted Expected Value (cont’d)
Computing the Option Price As a
Discounted Expected Value (cont’d)
 Computing Random Numbers

• There are several ways for generating random

numbers
– Use “RAND” function in Excel to generate random numbers
between 0 and 1 from a uniform distribution U(0,1)
– To generate random numbers from a normal distribution N
(for which an inverse cumulative distribution N–1 can
be computed),
• generate a random number x from U(0,1)
• find z such that N(z) = x, i.e., N–1(x) = z
• Repeat
• This procedure of using the inverse cumulative probability
distribution works for any distribution for which you can
compute the inverse cummulative distribution
 Simulating Lognormal Stock
Prices
• Recall that if Z ~ N(0,1), a lognormal stock price is
1
( − −  2 )T + T Z
ST = S0e 2

• Randomly draw a set of standard normal Z’s and substitute the

results into the equation above. The resulting St’s will be
lognormally distributed random variables at time t.
• To simulate the path taken by S (which is useful in valuing
path-dependent options) split t into n intervals of length h
 Monte Carlo Valuation

• If V(St,t) is the option payoff at time t, then

the time-0 Monte Carlo price V(S0,0) is
1 − rT n
V ( S0 ,0) = e V ( STi , T )
n i =1
1 n
– where ST , … , ST are n randomly drawn time-T
stock prices
i
• For the case of a call option V(ST ,T) =
i
max(0, ST –K)
 Monte Carlo Valuation (cont’d)

• Example 19.1: Value a 3-month European call

where the S0=$40, K=$40, r=8%, =0%, and
=30%
(0.08−0.32 /2)0.25+0.3 0.25 Z
S3 months = S0e
2500x
• For each stock price, compute
Option payoff = max(0, S3 months – $40)
• Average the resulting option payoffs
• Discount the average back 3 months at the risk-
free rate
$2.804 versus $2.78 Black-Scholes price
 Monte Carlo Valuation (cont’d)

• Monte Carlo valuation of American options is not as easy

• Monte Carlo valuation is inefficient
– 500 observations n=$0.180 6.5%
– 2500 observations n=$0.080 2.9%
– 21,000 observations n=$0.028 1.0%

• Monte Carlo valuation of options is especially useful when

– Number of random elements in the valuation problem is too
great to permit direct numerical valuation
– Underlying variables are distributed in such a way that direct
solutions are difficult
– The options are path-dependent, (the payoff depends on the path
of underlying asset price)
 Monte Carlo Valuation (cont’d)

• Monte Carlo valuation of Asian options

– The payoff is based on the average price over
the life of the option
( r − −0.5 2 )T /3+ T /3 Z Z (1)
S1 = 40e
( r − −0.5 2 )T /3+ T /3Z (2)
S2 = 40e
( r − −0.5 2 )T /3+ T /3Z (3)
S3 = 40e
– The value of the Asian option is computed as

CAsian = e− rT E (max[(S1 + S2 + S3 ) / 3 − K ,0])

Monte Carlo Valuation (cont’d)
 Efficient Monte Carlo Valuation
(cont’d)
• Control variate method
– Estimate the error on each trial by using the price of a related
option that does have a pricing formula
– Example: use errors from geometric Asian option to correct the
estimate for the arithmetic Asian option price
• Antithetic variate method
– For every draw also obtain the opposite and equally likely
realizations to reduce variance of the estimate
• Stratified sampling
– Treat each number as a random draw from each percentile of the
uniform distribution
• Other methods
– Importance sampling, low discrepancy sequences
Efficient Monte Carlo Valuation
 The Poisson Distribution

• A discrete probability distribution that counts the

number of events that occur over a period of time
– lh is the probability that one event occurs over the short
interval h
– Over the time period t the probability that the event occurs
exactly m times is given by
e − lt ( l t ) m
p(m, lt ) =
m!
– The cumulative Poisson distribution (the probability that
there are m or fewer events from 0 to t) is

e − l t (l t ) i
m
P(m, lt ) = Pr( x  m; lt ) = 
i =0 i!
 The Poisson Distribution (cont’d)

• The mean of the Poisson distribution is lt

• Given an expected
number of events,
the Poisson distribution
tells us the probability
that we will see a
particular number of
events over a given
period of time
 Simulating Jumps With the
Poisson Distribution
• Stock prices sometimes move (“jump”) more than
what one would expect to see under lognormal
distribution
• The expression for lognormal stock price with m
jumps is
 i =0 W ( i )
m
(ˆ − −l k −0.5 2 ) h+ hZ m ( j −0.5 j )+ j
Sˆt +h = Sˆt e
2

e
where J and J are the mean and standard deviation of the
jump and Z and Wi are random standard normal variables

• To simulate this stock price at time t+h select

– A standard normal Z
– Number of jumps m from the Poisson distribution
– m draws, W(i), i= 1, … , m, from the standard
normal distribution
Simulating Jumps With the
Poisson Distribution (cont’d)
 ASC637
FINANCIAL RISK MANAGEMENT

Chapter 6.1
Brownian Motion and Itô’s Lemma
 Introduction

• Stock and other asset prices are commonly

assumed to follow a stochastic process
called geometric Brownian motion
• Given that an asset price follows geometric
Brownian motion, we want to characterize
the behavior of a claim that has a payoff
dependent upon the asset price
– We will discuss Itô’s Lemma which tells us the
process followed by a claim that is a function of
the stock price
 The Black-Scholes Assumption
About Stock Prices
• The original paper by Black and Scholes begins by assuming
that the price of the underlying asset follows a process like the
following
dS (t )
= ( −  ) dt +  dZ (t )
S (t ) (20.1)
where
– S(t) is the stock price
– dS(t) is the instantaneous change in the stock price
–  is the continuously compounded expected return on the stock
–  is the continuously compounded standard deviation (volatility)
– Z(t) is a normally distributed random variable that follows a
process called Brownian motion
– dZ(t) is the change in Z(t) over a short period of time
 The Black-Scholes Assumption
About Stock Prices (cont’d)
• A stock obeying equation (20.1) is said to follow a
process called geometric Brownian motion
• Expressions like equation (20.1) are called
stochastic differential equations
• There are 2 important implications of equation
(20.1)
– Suppose the stock price now is S(0). If the stock price
follows equation (20.1), the distribution of S(T) is
lognormal, i.e.

ln[ S (T )] ~ N (ln[ S (0)] + [ −  − 0.5 2 ]T ,  2T )

– Geometric Brownian motion allows us to describe the path
the stock price takes in getting to a terminal point
 A Description of Stock Price
Behavior

• The normal distribution provides an

unrealistic description of the stock price.
However, normality can be a plausible
description of continuously compounded
returns
– If the continuously compounded return is R(0,T),
the price is S(0) eR(0,T), which is always positive

• It can be reasonable to assume that over

very short periods of time effective stock
returns, S(t + h)/S(t), are normally
distributed
 Brownian Motion

• Brownian motion is a stochastic process that

evolves in continuous time, with movements
that are continuous
– A random walk can be generated by flipping a
coin each period and moving one step, with the
direction determined by whether the coin is
heads or tails
– To generate Brownian motion, we would flip the
coins infinitely fast and take infinitesimally small
steps at each point
 Brownian Motion (cont’d)

• Brownian motion is a continuous stochastic process,

Z(t), with the following characteristics
– Z(0) = 0
– Z(t + s) – Z (t) is normally distributed with mean 0
and variance s
– Z(t + s1) – Z(t) is independent of Z(t) – Z(t – s2), where
s1, s2 >0. That is, nonoverlapping increments are
independently distributed
– Z(t) is continuous
• Brownian motion is an example of a random walk,
which is a stochastic process with independent
increments
 Brownian Motion (cont’d)

• We can think of Brownian motion being

approximately generated from the sum of
independent binomial draws with mean 0
and variance h
• Let h get arbitrarily small, and rename h as
dt. Denote the change in Z as dZ(t)
 Brownian Motion (cont’d)

• Then
dZ (t ) = Y (t ) dt
(20.4)
where Y(t) is a random draw from a binomial
distribution, such that Y(t) is 1 with probability
50%

• Equation (20.4) says “Over small periods of

time, changes in the value of the process
are normally distributed with a variance that
is proportional to the length of the time
period.”
 Brownian Motion (cont’d)

• Since Z(T) is the sum of individual dZ(t)’s,

we can write T
Z (T ) = Z (0) +  dZ (t )
0

– The integral here is called a stochastic integral

– The process Z(t) is also called a diffusion
process

• Among properties of Brownian motion are

– “infinite-crossing property” and
– “infinite variation”
 Arithmetic Brownian Motion

• With pure Brownian motion, the expected change in

Z is 0, and the variance per unit time is 1. We can
generalize this to allow an arbitrary variance and a
nonzero mean

dX (t ) =  dt +  dZ (t ) (20.8)
• This process is called arithmetic Brownian
motion
–  is the instantaneous mean per unit time
– 2 is the instantaneous variance per unit time
– The variable X(t) is the sum of the individual changes dX.
X(t) is normally distributed, i.e., X(T) – X(0) ~ N (T, 2T)
 Arithmetic Brownian Motion
(cont’d)
• An integral representation of equation (20.8) is
T T
X (T ) = X (0) +   dt +   dZ (t )
0 0
• Here are some properties of the process in equation
(20.8)
– X(t) is normally distributed because it is a scaled Brownian
process
– The random term is multiplied by a scale factor that
enables us to specify the variance of the process
– The dt term introduces a nonrandom drift into
the process
 Arithmetic Brownian Motion
(cont’d)

• Arithmetic Brownian motion has several

drawbacks
– There is nothing to prevent X from becoming
negative, so it is a poor model for stock prices
– The mean and variance of changes in dollar
terms are independent of the level of the stock
price

• Both of these criticisms will be eliminated

with geometric Brownian motion
 The Ornstein-Uhlenbeck Process

• We can incorporate mean reversion by modifying

the drift term
dX (t ) = [a − X (t )] dt +  dZ (t ) (20.9)

• This equation is called an Ornstein-Uhlenbeck

process
– The parameter  measures the speed of the reversion:
If  is large, reversion happens more quickly
– In the long run, we expect X to revert toward 
– As with arithmetic Brownian motion, X can still
become negative
 Geometric Brownian Motion

• An equation, in which the drift and volatility depend

on the stock price, is called an Itô process
– Suppose we modify arithmetic Brownian motion to make
the instantaneous mean and standard deviation
proportional to X(t)

dX (t ) =  X (t ) dt +  X (t )dZ (t )
– This is an Itô process that can also be written

dX (t )
= a dt +  dZ (t ) (20.11)
X (t )
– This process is known as geometric Brownian motion
 Geometric Brownian Motion
(cont’d)

• The percentage change in the asset value is

normally distributed with instantaneous
mean  and instantaneous variance 2

• The integral representation for equation

(20.11) is

T T
X (T ) − X (0) =   X (t )dt +   X (t )dZ (t )
0 0
 Lognormality

• If a variable is distributed in such a way that

instantaneous percentage changes follow
geometric Brownian motion, then over
discrete periods of time, the variable is
lognormally distributed
 Relative Importance of the
Drift and Noise Terms
• Over short periods of time, the character of the
Brownian process is determined almost entirely by
the random component
– Consider the ratio of the per-period standard deviation to
the per-period drift
 h 
=
h  h

– The ratio becomes infinite as h approaches dt

• As the time interval becomes longer, the mean

becomes more important than the standard
deviation
Relative Importance of the
Drift and Noise Terms (cont’d)
 Multiplication Rules

• We can simplify complex terms containing dt and

dZ by using the following “multiplication rules”
dt  dZ = 0 (20.15a)
(dt)2 = 0 (20.15b)
(dZ)2 = dt (20.15c)

– The reasoning behind these multiplication rules is that the

multiplications resulting in powers of dt greater than 1
vanish in the limit
 Modeling Correlated Asset Prices

• Let W1(t) and W2(t) be independent Brownian

motions and define
dZ1 (t ) = dW1 (t )
dZ 2 (t ) =  dW1 (t ) + 1 −  2 dW2 (t )
– This is the Cholesky decomposition

• The correlation between Z1(t) and Z2(t) is

dZ1 (t ) dZ 2 (t ) =  dW1 (t ) 2 + 1 −  2 dW1 (t )dW2 (t ) =  dt
– The second term on the right-hand side is 0 because
dW1(t) and dW2(t) are independent.
 Itô’s Lemma

• Suppose a stock with an expected

instantaneous return of , dividend yield of
, and instantaneous volatility, , can be
functions of the stock price and time. S(t)
follows
dS (t ) = ˆ  S (t ), t  − ˆ  S (t ), t  dt + ˆ  S (t ), t  dZ (t )
• C[S(t), t] is the value of a derivative claim
that is a function of the stock price
• How can we describe the behavior of this
claim in terms of the behavior of S?
 Itô’s Lemma

• Itô’s Lemma (Proposition 20.1)

– If C[S(t), t] is a twice-differentiable function of
S(t), then the change in C is
1
dC ( S , t ) = CS dS + CSS (dS ) 2 + Ct dt
2
 1 
= (ˆ ( S , t ) − ˆ( S , t ))CS + ˆ ( S , t ) 2 CSS + Ct  dt + σ ( S , t )CS dZ
 2 

• where CS = C/S, CSS = 2C/S2, and Ct = C/t

– The terms in square brackets are the expected
change in the option price
 Itô’s Lemma (cont’d)

• The extra term involving the variance is

the Jensen’s inequality correction due to
the uncertainty of the stochastic process
• In the case where S(t) follows geometric
Brownian motion, we have
 1 
dC ( S , t ) = ( −  ) SCS +  2 S 2CSS + Ct  dt + σSCS dZ
 2 
– If there is no uncertainty, that is if  = 0,
then
Itô’s Lemma reduces to the calculation of a
dC(S,t) = C dS + C dt
total derivative
S t
 Multivariate Itô’s Lemma

• A derivative may have a value depending on

more than one price, in which case we can use a
multivariate generalization of Itô’s Lemma
• Multivariate Itô’s Lemma (Proposition
20.2)
– Suppose we have n correlated Itô processes
dSi (t )
=  i dt +  i dzi , i = 1, . . ., n
Si (t )
• Denote the pairwise correlations as
E(dzi  dz j ) = i, j dt
 Multivariate Itô’s Lemma
(cont’d)

• If C(S1, . . ., Sn, t) is a twice-differentiable

function of the Si’s, we have
1 n n
dC ( S1 , . . ., Sn , t ) =  i=1 CSi dSi +  dSi dS jCSi S j + Ct dt
n

2 i =1 j =1

• The expected change in C per unit time is

n
1 1 n n
E[dC ( S1, . . ., Sn , t )] =  i SiCSi +  i j ij Si S jCSi S j + Ct
dt i =1 2 i=1 j =1
 The Sharpe Ratio

• If asset i has expected return i, the risk premium

is defined as
Risk premiumi = i – r
– where r is the risk-free rate
• The Sharpe ratio for asset i is the risk premium, i
– r, per unit of volatility, I

αi − r
Sharpe ratio i = (20.25)
i
 The Sharpe Ratio (cont’d)

• We can use the Sharpe ratio to compare two

perfectly correlated claims, such as a derivative and
its underlying asset
• Two assets that are perfectly correlated must have
the same Sharpe ratio, or else there will be an
arbitrage opportunity
– Consider the processes for two non-dividend paying stocks
dS1 = 1S1dt +  1S1dZ (20.26)
dS =  S dt +  S dZ (20.27)
2 2 2 2 2
– Because the two stock prices are driven by the same dZ, it
must be the case that

(1 − r) /  1 = ( 2 − r) /  2
 Risk-Neutral Valuation

• Suppose the evolution of the stock price in the real

world is
dS (t )
= ( −  )dt +  dZ (t )
S (t )

• The corresponding distribution for the stock is

dS (t )
= (r −  )dt +  dZ * (t ) (20.30)
S (t )
 Valuing a Claim on Sa

• Suppose a stock with an expected

instantaneous return of , dividend yield of
, and instantaneous volatility  follows
geometric Brownian motion
dS(t) = ( −  )S(t)dt +  S(t)dZ(t)
• Now suppose that we also have a claim with
a payoff depending on Sa
– For example, we may have a claim that pays
S(T)2 at time T (i.e., a = 2)
 Valuing a Claim on Sa (cont’d)

• Proposition 20.3:
– Using equation 18.13 to compute the expectation of a
lognormal variable
− rT − rT a [ a ( r − )+0.5 a ( a −1) 2 ]T
e E[ S (T ) ] = e
a
S (0) e
– The value at time 0 of a claim paying S(T)a—the prepaid
forward price—is
1
[ a ( r − ) + a ( a −1) 2 ]T
F0P,T [ S (T ) a ] = e −rT S (0) e a 2
(20.32)
– The forward price for S(T)a is
1
[ a ( r − ) + a ( a −1) 2 ]T
F0,T [ S (T ) a ] = S (0) e a 2
(20.33)
 Valuing a Claim on Sa (cont’d)

• Consider a claim maturing at time T that

pays V[S(T), T] = S(T)a
• We can use Itô’s Lemma to determine the
process followed by Sa

dS a = aS a−1dS + 0.5a(a − 1) S a−2dS 2

a dS
= aS + 0.5a(a − 1) S a 2 dt
S
 Valuing a Claim on Sa (cont’d)

• Dividing by Sa, we get

dS a
a
= 
 a ( r −  ) + 0.5a ( a − 1) 2
 dt + a dZ
S (20.34)
• The solution to this is
a ( r − +0.5 a ( a −1) 2 )T −0.5 a 2 2T + a Z ( t )
S (T ) = S (0) e
a a

• Computing E0*  S (0) a  using this equation

yields equation (20.33)
 Examples

• Claims on S
– Suppose a = 1. Equation (20.32) then gives us
V (0) = S (0)e −T
• This is the prepaid forward price on a stock

• Claims on S0
– If a = 0, the claim does not depend on the stock
price. Since S0 = 1, it is a bond. Setting a = 0
gives us
V (0) = e − rT

• This is the price of a T-period pure discount bond

 Examples (cont’d)

• Claims on S2
– When a = 2, the claim pays S(T)2. From equation
(20.33), the forward price is
−[ − r + 2 − 2 ]T
F0,T ( S ) = e S (0) e
2 rT 2

2 ( r − )T  2T 2  2T
= S (0) e
2
e = [ F0,T ( S )] e
(20.35)
– Thus, the forward price on the squared stock
price is the squared forward price times a
variance term
 Examples (cont’d)

• Claims on 1/S
– If a = –1, the claim pays 1/S. Using equation
(20.33), we get
( − r )T  2T −1  2T
F0,T (1 / S ) = [1 / S (0)]e e =F
0 ,T e
• As with the squared security, the forward price is
increasing in volatility
– The payoffs for both the S2 and 1/S securities
are convex. Therefore, according to Jensen’s
inequality, the price is higher when the asset
price is risky than when it is certain.
 Valuing a Claim on Saqb

• Suppose a claim pays S(T)aQ(T)b, where S and Q

follow the risk-neutral processes

dS
= (r −  S )dt +  S dZ S (20.36)
S
and Q follows
dQ
= (r −  Q )dt +  Q dZQ
Q (20.37)

where dZS dZQ =  dt

 Valuing a Claim on Saqb (cont’d)

• Proposition 20.4
– Suppose that the forward prices for Sa and Qb
are given by Proposition 20.3. Then the forward
price for SaQb is
ab S  Q (T −t )
Ft ,T ( S aQb ) = Ft ,T (S a ) Ft ,T (Qb )e
• The forward price for SaQb is the product of those two
forward prices times a factor that accounts for the
covariance between the two assets

– The variance of SaQb is given by

a 2 S2 + b 2 Q2 + 2ab S Q
 Valuing a Claim on Saqb (cont’d)

• The squared security, S2, is a special case of

Proposition 20.4
– When S = Q, a = b = 1, and  = 1, the
covariance term becomes

ab S Q =  2
S

– This gives us the same result as equation

(20.35) for the forward price for a squared stock
 Valuing a Claim on Saqb (cont’d)

• Proposition 20.4 can be generalized

– Suppose there are n stocks, each of which follows the
process
dSi
= ( i −  i )dt +  i dzi
Si (20.39)
where dzidzj = ijdt. Let n
V (t ) =  Siai
i =1 (20.40)
– The forward price for V is then

 i=1  j=i+1 ij i j ai a jT

n n−1 n

F0,T (V ) =  [ F0,T ( Si )]ai e (20.41)

i =1
 Jumps in the Stock Price

• A practical objection to the Brownian

process as a model of the stock price is that
Brownian paths are continuous—there are
no discrete jumps in the stock price
• In practice, asset prices occasionally seem
to jump (e.g., on October 19, 1987)
• One way to model such jumps is by using
the Poisson distribution mixed with a
standard Brownian process.
 Jumps in the Stock Price (cont’d)

• Let q(t) represent the cumulative jump and dq the

change in the cumulative jump
– When there is no jump, dq = 0
– When there is a jump, we let the random variable Y denote
the magnitude of the jump, and k = E(Y) – 1 is then the
expected percentage change in the stock price

• If  is the expected number of jumps per unit time

over an interval dt, then
Prob(jump) = dt
Prob(no jump) = 1 – dt
 Jumps in the Stock Price (cont’d)

• We can write the stock price process as

dS(t) / S(t) = ( −  k)dt +  dZ + dq (20.42)
where
0 if there is no jump
dq =
Y-1 if there is a jump
and E(dq) = kdt
– When no jump is occurring, the stock price S evolves as
geometric Brownian motion. When the jump occurs, the
new stock price is YS.
 Jumps in the Stock Price (cont’d)

• Proposition 20.5
– Suppose an asset follows equation (20.42). If
C(S, t) is a twice continuously differentiable
function of the stock price, the process followed
by C is
1
dC(S , t ) = CS dS + CSS 2 S 2 dt + Ct dt + EY [C ( SY , t ) − C (S , t )]
2
(20.43)
• The last term in the equation is the expected change in
the option price conditional on the jump times the
probability of the jump.
 ASC637
FINANCIAL RISK MANAGEMENT

Chapter 7
Value at Risk
 Introduction

• Risk assessment is the evaluation of

distributions of possible outcomes, with a
focus on the worst that might happen
– Insurance companies, for example,
assess the likelihood of insured events, and the
resulting possible losses for the insurer
– Financial institutions must understand their
portfolio risks in order to determine the capital
buffer needed to support their business
 Value at Risk

• Value at risk (VaR) is one way to perform

risk assessment for complex portfolios
• In general, computing value at risk means
finding the value of a portfolio such that
there is a specified probability that the
portfolio will be worth at least this much
over a given horizon
– The choice of horizon and probability will depend
on how VaR is to be used
 Value at Risk (Cont’d)

• There are at least three uses of value

at risk
– Regulators can use VaR to compute capital
requirements for financial institutions
– Managers can use VaR as an input in making
risk-taking and risk-management decisions
– Managers can also use VaR to assess the quality
of the bank’s models
 Value at Risk for One Stock

• Suppose ~xh is the dollar return on a portfolio

over the horizon h, and f (x, h) is the
distribution of returns
• Define the value at risk of the portfolio as the
return, xh(c), such that
Pr( xh  xh (c)) = c
• Suppose a portfolio consists of a single stock
and we wish to compute value at risk over the
horizon h
 Value at Risk for One Stock
(cont’d)

• If we pick a stock price S h and the

distribution of the stock price after h
periods, Sh, is lognormal, then
( − −0.5 2 ) h+ hN −1 ( c )
Sh (c) = S0e
(26.5)
 Value at Risk for One Stock
(cont’d)
• In practice, it is common to simplify the VaR
calculation by assuming a normal return rather than
a lognormal return. A normal approximation is
S h = S 0 (1 + h + z h ) (26.7)
• We could further simplify by ignoring the mean
– Mean is hard to estimate precisely
– For short horizons, the mean is less important than the
diffusion term in an Itô process

S h = S 0 (1 + z h ) (26.8)

• Both equations become less reasonable as h grows

 Value at Risk for One Stock
(cont’d)
• Comparison of three models—lognormal, normal
with mean, and normal without mean
 VaR for Two or More Stocks

• When we consider a portfolio having two or

more stocks, the distribution of the future
portfolio value is the sum of lognormally
distributed random variables and is
therefore not lognormal
• Since the distribution is no longer
lognormal, we can use the normal
approximation
 VaR for Two or More Stocks
(cont’d)

• Let the annual mean of the return on stock

i,  i , be i
• The standard deviation of the return on
stock i is i
• The correlation between stocks i and j is ij
• The dollar investment in stock i is Wi
• The value of a portfolio containing n stocks is
n
W = Wi
i =1
 VaR for Two or More Stocks
(cont’d)
• If there are n assets, the VaR calculation requires
that we specify the standard deviation for each
stock, along with all pairwise correlations
– The return on the portfolio over the horizon h, Rh, is
n
1
Rh =
W

i =1
Wi
i ,h

– Assuming normality, the annualized distribution of the

portfolio return is

1 n
1 n n 
Rh ~ N   hW i i, 2  i j ij
   hWW
i j
(26.9)
W i =1 W i =1 j =1 
 Var for Nonlinear Portfolios

• If a portfolio contains options as well as stocks,

it is more complicated to compute the distribution
of returns
– The sum of the lognormally distributed stock prices
is not lognormal
– The option price distribution is complicated

• There are two approaches to handling nonlinearity

– Delta approximation: we can create a linear approximation
to the option price by using the option delta
– Monte Carlo simulation: we can value the option using an
appropriate option pricing formula and then perform Monte
Carlo simulation to obtain the return distribution
 Delta Approximation

~ , we can approximate the

• If the return on stock i is  i
return on the option as  i i , where i is the option delta
~
• The expected return on the stock and option portfolio over
the horizon h is then n
1
Rp =  i Si (i + Ni i )
W i=1 (26.10)
– The term i + Nii measures the exposure to stock i

• The variance of the return is

1 n n
 p = 2  Si S j (i + Ni i )( j + N j  j ) i j ij
2

W i=1 j =1 (26.11)

• With this mean and variance, we can mimic the n-stock

analysis
 Delta Approximation (cont’d)

• Comparison of exact portfolio value with a

delta approximation
 Monte Carlo Simulation

• Monte Carlo simulation works well in situations

where we need a two-tailed approach to VaR (e.g.,
straddle)
– Simulation produces the distribution of portfolio values

• To use Monte Carlo simulation

– We randomly draw a set of stock prices
– Once we have the portfolio values corresponding to each
draw of random prices, we sort the resulting portfolio
values in ascending order
– The 5% lower tail of portfolio values, for example, is used
to compute the 95% value at risk
 Monte Carlo Simulation (cont’d)

• Example 26.6
– Consider the 1-week 95% value at risk of an at-
the-money written straddle on 100,000 shares of
a single stock
– Assume that S = $100, K = $100,  = 30%, r =
8%, T = 30 days, and  = 0
– The initial value of the straddle is −$685,776
 Monte Carlo Simulation (cont’d)

• First, we randomly draw a set of z ~ N(0,1), and

construct the stock price as

( − −0.5 2 ) h + h z
S h = S0e (26.13)

• Next, we compute the Black-Scholes call and put

prices using each stock price, which gives us a
distribution of straddle values
• We then sort the resulting straddle values in
ascending order
• The 5% value is used to compute the 95%
value at risk
 Monte Carlo Simulation (cont’d)

• Histogram of values resulting

from 100,000 random
simulations of the value
of the straddle

• The 95% value at risk is −$943,028 − (−$685,776) =

−$257,252
 Monte Carlo Simulation (cont’d)

• Note that the value of the portfolio never

exceeds about −$597,000
– If a call and put are written on the same stock,
stock price moves can never induce the two to
appreciate together. The same effect limits a loss

• When options are written on different

stocks, it is possible for both to gain or lose
simultaneously. As a result, the distribution
of prices has a greater variance and
increased value at risk
 Monte Carlo Simulation (cont’d)

• Example 26.7: Histogram of values of a portfolio

that contains a written put and call having different,
correlated underlying stocks
 VaR for Bonds

• The risk of a bond and other interest-rate sensitive

claims can be measured as the risk of a portfolio of
zero-coupon bonds
– Suppose a zero-coupon bond matures at time T, has price
P(T), and that the annualized yield volatility of the bond is
T
– For a zero-coupon bond, duration equals maturity. Thus, if
the yield changes by , the percentage change in the bond
price will be approximately T
– Using this linear approximation based on duration, over
the horizon h the bond has a 95% chance of being worth
more than
P(T ) 1 +  TT h  (−1.645) 
 VaR for Bonds (cont’d)

• Now suppose that instead of a single bond

we have a portfolio of zero-
coupon bonds
– As with a portfolio of stocks, we can use the
delta approximation, only instead of correlated
stock returns we have correlated bond yields
 VaR for Bonds (cont’d)

• In general, if we are analyzing the risk of an

instrument with multiple cash flows, the first step is
to find the equivalent portfolio of zero-coupon
bonds
– For example, a 10-year bond with semiannual coupons = a
portfolio of 20 zero-coupon bonds

• Every interest rate claim is decomposed in this way

into interest rate “buckets” containing the claim’s
constituent zero-coupon bonds
• A set of bonds and swaps reduces to a portfolio of
long and short positions in zero-coupon bonds
 VaR for Bonds (cont’d)

• We need volatilities and correlations for all

the bonds
• Volatility and yields are tracked only at
certain benchmark maturities
– The goal is to find an interpolation procedure to
express any hypothetical zero-coupon bond in
terms of the benchmark zero-coupon bonds
– This procedure in which cash flows are allocated
to benchmark claims is called cashflow
mapping
 VaR for Bonds (cont’d)

• Suppose that we wish to assess the risk of a 12-

year zero-coupon bond, given information on the
10-year and 15-year zero-coupon bonds
– We can use simple linear interpolation to obtain the yield
and yield volatility for the 12-year bond from those of the
10-year and 15-year bonds
– If the yield and volatility of the t-year bond are yt and t,
the
y12 = (0.6  y10 ) + (0.4  y15 )
(26.14)
 12 = (0.6   10 ) + (0.4   15 ) (26.15)
– These interpolations enable us to determine the price and
volatility of $1 paid in year 12. Note, however, that they do
not provide correlations between the 12-year zero and the
adjacent benchmark bonds
 VaR for Bonds (cont’d)

• The price is e − y12 12

• To find the combination of the 10- and 15-year zero-coupon
bonds have the same volatility as the hypothetical 12-year
bond, we must solve

 212 = ( 2 210 ) + [(1 −  )2  210 ] + [2 10.15 (1 −  ) 10 15] (26.16)

– where  equals the fraction allocated to the 10-year bond
– Since this is a quadratic equation, there are two solutions for .
Typically, only one of the two solutions will be economically
appealing
– Given the weights, value at risk for the 12-year bond can be
computed in the same way as VaR for a bond portfolio
• Similarly, mapping can be applied to any claim with multiple
cash flows
 Estimating Volatility

• Volatility is the key input in any VaR calculation

• In most examples, return volatility is assumed to
be constant and returns are independent over time
• We require correlation estimates in order to
compute volatilities of portfolios
• Assessing return correlation is complicated
– Over horizons as short as a day, returns may be negatively
correlated due to factors such as bid-ask bounce
– With commodities, return independence is not reasonable
for long horizons due to supply and demand responses
 Bootstrapping Return
Distributions
• It is possible to use observed past returns to create an
empirical probability distribution of returns that can then be
used for simulation. This procedure is called bootstrapping
– The idea of bootstrapping is to sample, with replacement, from
observed historical returns under the assumption that future
returns will be drawn from the same distribution
• Advantages and disadvantages of bootstrapping
– The advantage is that, since bootstrapping is not based on a
particular assumed distribution, it is consistent with any
distribution
of returns
– The disadvantage is that key features of the data might be lost
when the data are reshuffled. There is also the question of how
to bootstrap multiple series in such a way that correlations
are preserved
 Issues With VaR

• One of the problems with VaR is that small

changes in the VaR probability can cause
VaR to change by a large amount
– Suppose you are comparing activity C, which
generates a $1 loss with a 1.1% probability,
with activity D, which generates a $1m loss with
a 0.9% probability
– Any reasonable rule would require more capital
for activity D, but a 1% VaR would be greater for
C than for D
 Issues With VaR (cont’d)

• One approach to improving VaR is to

compute the average loss conditional upon
the VaR loss being exceeded. This is called
the Tail VaR
– The 1% Tail VaR for activity C would be $1, and
the 1% Tail VaR for activity D would be
$900,000 (instead of the VaR of $0)
 Issues With VaR (cont’d)

• It is argued that a reasonable risk measure should

have certain properties, among them
subadditivity
– If (X) is the risk measure associated with activity X, then
 is subadditive if for two activities X and Y
(X + Y )  (X) + (Y )
(26.21)
– This says that the risk measure (i.e., the capital required) for
the two activities combined should be less than for the two
activities separately

• VaR is not subadditive

Chapter 7 FRM
Value at Risk

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Copyright © John C. Hull 2012 1
The Question Being Asked in VaR
“What loss level is such that we are X%
confident it will not be exceeded in N
business days?”

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Copyright © John C. Hull 2012 2
VaR vs. Expected Shortfall
VaR is the loss level that will not be exceeded
with a specified probability
Expected Shortfall (or C-VaR) is the expected
loss given that the loss is greater than the VaR
level
Although expected shortfall is theoretically
more appealing, it is VaR that is used by
regulators in setting bank capital requirements

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Copyright © John C. Hull 2012 3
Advantages of VaR
It captures an important aspect of risk
in a single number
It is easy to understand
It asks the simple question: “How bad can
things get?”

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Copyright © John C. Hull 2012 4
Historical Simulation to Calculate the
One-Day VaR
Create a database of the daily movements in
all market variables.
The first simulation trial assumes that the
percentage changes in all market variables
are as on the first day
The second simulation trial assumes that the
percentage changes in all market variables
are as on the second day
and so on
Options, Futures, and Other Derivatives, 8th Edition,
Copyright © John C. Hull 2012 5
Historical Simulation continued
Suppose we use 501 days of historical data
(Day 0 to Day 500)
Let vi be the value of a variable on day i
There are 500 simulation trials
The ith trial assumes that the value of the
market variable tomorrow is
vi
v500
vi −1
Options, Futures, and Other Derivatives, 8th Edition,
Copyright © John C. Hull 2012 6
Example : Calculation of 1-day, 99%
VaR for a Portfolio on Sept 25, 2008 (Table
21.1, page 475)

Index Value ($000s)

DJIA 4,000
FTSE 100 3,000
CAC 40 1,000
Nikkei 225 2,000

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Data After Adjusting for
Exchange Rates (Table 21.2, page 475)
Day Date DJIA FTSE 100 CAC 40 Nikkei 225
0 Aug 7, 2006 11,219.38 6,026.33 4,345.08 14,023.44
1 Aug 8, 2006 11,173.59 6,007.08 4,347.99 14,300.91
2 Aug 9, 2006 11,076.18 6,055.30 4,413.35 14,467.09
3 Aug 10, 2006 11,124.37 5,964.90 4,333.90 14,413.32
… …… ….. ….. …… ……
499 Sep 24, 2008 10,825.17 5,109.67 4,113.33 12,159.59
500 Sep 25, 2008 11,022.06 5,197.00 4,226.81 12,006.53

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Scenarios Generated (Table 21.3, page 476)
Scenario DJIA FTSE 100 CAC 40 Nikkei 225 Portfolio Loss
Value ($000s) ($000s)

1 10,977.08 5,180.40 4,229.64 12,244.10 10,014.334 −14.334

2 10,925.97 5,238.72 4,290.35 12,146.04 10,027.481 −27.481

3 11,070.01 5,118.64 4,150.71 11,961.91 9,946.736 53.264

… ……. ……. ……. …….. ……. ……..

499 10,831.43 5,079.84 4,125.61 12,115.90 9,857.465 142.535

500 11,222.53 5,285.82 4,343.42 11,855.40 10,126.439 −126.439

11,173.59
Example of Calculation: 11,022.06  = 10,977.08
11,219.38

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Copyright © John C. Hull 2012 9
Ranked Losses (Table 21.4, page 477)
Scenario Number Loss ($000s)
494 477.841
99% one-
339 345.435
day VaR
349 282.204
329 277.041
487 253.385
227 217.974
131 205.256

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The N-day VaR
The N-day VaR for market risk is usually
assumed to be N times the one-day VaR
In our example the 10-day VaR would be
calculated as
10  253,385 = 801,274
This assumption is in theory only perfectly
correct if daily changes are normally
distributed and independent
Options, Futures, and Other Derivatives, 8th Edition,
Copyright © John C. Hull 2012 11
The Model-Building Approach
The main alternative to historical simulation is
to make assumptions about the probability
distributions of the return on the market
variables and calculate the probability
distribution of the change in the value of the
portfolio analytically
This is known as the model building approach
or the variance-covariance approach

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Copyright © John C. Hull 2012 12
Daily Volatilities
In option pricing we measure volatility “per
year”
In VaR calculations we measure volatility “per
day”
 y ear
 day =
252

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Daily Volatility continued
Theoretically, day is the standard deviation of
the continuously compounded return in one
day
In practice we assume that it is the standard
deviation of the percentage change in one
day

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Copyright © John C. Hull 2012 14
Microsoft Example (page 479)
We have a position worth $10 million in
Microsoft shares
The volatility of Microsoft is 2% per day
(about 32% per year)
We use N=10 and X=99

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Microsoft Example continued
The standard deviation of the change in the
portfolio in 1 day is $200,000
The standard deviation of the change in 10
days is
200,000 10 = $632,456

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Microsoft Example continued
We assume that the expected change in the
value of the portfolio is zero (This is OK for
short time periods)
We assume that the change in the value of
the portfolio is normally distributed
Since N(–2.33)=0.01, the VaR is
2.33  632,456 = $1,473,621

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AT&T Example (page 480)
Consider a position of $5 million in AT&T
The daily volatility of AT&T is 1% (approx
16% per year)
The S.D per 10 days is
50,000 10 = $158,144
The VaR is
158,114  2.33 = $368,405

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Portfolio
Now consider a portfolio consisting of both
Microsoft and AT&T
Assume that the returns of AT&T and
Microsoft are bivariate normal
Suppose that the correlation between the
returns

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Copyright © John C. Hull 2012 19
S.D. of Portfolio
A standard result in statistics states that
 X +Y = 2X + Y2 + 2r X  Y

In this case X = 200,000 and Y = 50,000 and

r = 0.3. The standard deviation of the change
in the portfolio value in one day is therefore
220,227

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VaR for Portfolio
The 10-day 99% VaR for the portfolio is
220,227  10  2.33 = $1,622,657
The benefits of diversification are
(1,473,621+368,405)–1,622,657=$219,369
What is the incremental effect of the AT&T
holding on VaR?

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The Linear Model
This assumes
• The daily change in the value of a portfolio is
linearly related to the daily returns from
market variables
• The returns from the market variables are
normally distributed

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Markowitz Result for Variance of
Return on Portfolio
n n
Variance of Portfolio Return =  r
i =1 j =1
ij wi w j  i  j

wi is weight of ith instrument in portfolio

σ i2 is variance of return on ith instrument
in portfolio
ρij is correlatio n between returns of ith
and jth instrument s

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VaR Result for Variance of
Portfolio Value (ai = wiP)
n
P =  a i xi
i =1
n n
 =  r ij a i a j  i  j
2
P
i =1 j =1
n
 2P =  a  i2 + 2 r ij a i a j  i  j
2
i
i =1 i j

 i is the daily volatility of ith instrument (i.e., SD of daily return)

 P is the SD of the change in the portfolio value per day

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Covariance Matrix (vari = covii)

 var1 cov12 cov13  cov1n 

 
 cov21 var2 cov23  cov2 n 
C =  cov31 cov32 var3  cov3n 
 
      
 cov  varn  
 n1 covn 2 covn 3
covij = rij i j where i and j are the SDs of the daily returns
of variables i and j, and rij is the correlation between them
Options, Futures, and Other Derivatives, 8th Edition,
Copyright © John C. Hull 2012 25
Alternative Expressions for P2
pages 482-483

n n
 =  covij a i a j
2
P
i =1 j =1

 2P = α T Cα

where α is the column vector whose ith

element is α i and α T is its transpose

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Copyright © John C. Hull 2012 26
Alternatives for Handling
Interest Rates
Duration approach: Linear relation between
P and y but assumes parallel shifts)
Cash flow mapping: Cash flows are mapped
to standard maturities and variables are zero-
coupon bond prices with the standard
maturities
Principal components analysis: 2 or 3
independent shifts with their own volatilities

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When Linear Model Can be Used
Portfolio of stocks
Portfolio of bonds
Forward contract on foreign currency
Interest-rate swap

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Copyright © John C. Hull 2012 28
The Linear Model and Options

Consider a portfolio of options dependent on

a single stock price, S. If d is the delta of the
option, then it is approximately true that
P
d
S
Define S
x =
S

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Copyright © John C. Hull 2012 29
Linear Model and Options
continued (equations 20.3 and 20.4)
Then
P  d S = Sd x

Similarly when there are many underlying

market variables

P  S d
i
i i xi

where di is the delta of the portfolio with

respect to the ith asset

Options, Futures, and Other Derivatives, 8th Edition,

Copyright © John C. Hull 2012 30
Example
Consider an investment in options on Microsoft and
AT&T. Suppose the stock prices are 120 and 30
respectively and the deltas of the portfolio with
respect to the two stock prices are 1,000 and 20,000
respectively
As an approximation
P = 120 1,000x1 + 30  20,000x2
where x1 and x2 are the percentage changes in the
two stock prices

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But the distribution of the daily return
on an option is not normal

The linear model fails to capture skewness in the

probability distribution of the portfolio value.

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Impact of gamma (Figure 21.4, page
486)

Positive Gamma Negative Gamma

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Translation of Asset Price Change to Price
Change for Long Call (Figure 21.5, page 487)
Long
Call

Asset Price

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Copyright © John C. Hull 2012 34
Translation of Asset Price Change to Price
Change for Short Call (Figure 21.6, page 487)

Asset Price

Short
Call
Options, Futures, and Other Derivatives, 8th Edition,
Copyright © John C. Hull 2012 35
Quadratic Model

For a portfolio dependent on a single stock

price it is approximately true that
1
P = dS +  (S ) 2

2
this becomes
1 2
P = Sd x + S  (x) 2

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Copyright © John C. Hull 2012 36
Quadratic Model continued
With many market variables we get an
expression of the form
n n
1
P =  Si di xi +  Si S j  ij xi x j
i =1 i =1 2
where
P 2
 P
di =  ij =
Si Si S j

But this is much more difficult to work with

than the linear model
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Copyright © John C. Hull 2012 37
Monte Carlo Simulation (page 488-489)
To calculate VaR using MC simulation we
• Value portfolio today
• Sample once from the multivariate distributions
of the xi
• Use the xi to determine market variables at
end of one day
• Revalue the portfolio at the end of day

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Copyright © John C. Hull 2012 38
Monte Carlo Simulation continued
Calculate P
Repeat many times to build up a probability
distribution for P
VaR is the appropriate fractile of the
distribution times square root of N
For example, with 1,000 trial the 1 percentile
is the 10th worst case.

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Copyright © John C. Hull 2012 39
Monte Carlo Simulation
Calculate P
Repeat many times to build up a probability
distribution for P
VaR is the appropriate fractile of the
distribution times square root of N
For example, with 1,000 trial the 1 percentile
is the 10th worst case.

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Speeding Up Monte Carlo
Use the quadratic approximation to calculate
P

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Copyright © John C. Hull 2012 41
Speeding up Calculations with
the Partial Simulation Approach
Use the approximate delta/gamma
relationship between P and the xi to
calculate the change in value of the portfolio
This can also be used to speed up the
historical simulation approach

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Comparison of Approaches
Model building approach assumes normal
distributions for market variables. It tends to
give poor results for low delta portfolios
Historical simulation lets historical data
determine distributions, but is computationally
slower

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Copyright © John C. Hull 2012 43
Stress Testing
This involves testing how well a portfolio
performs under extreme but plausible market
moves
Scenarios can be generated using
Historical data
Analyses carried out by economics group
Senior management

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Copyright © John C. Hull 2012 44
Back-Testing
Tests how well VaR estimates would have
performed in the past
We could ask the question: How often was
the actual 1-day loss greater than the
99%/1- day VaR?

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Copyright © John C. Hull 2012 45
Principal Components Analysis
for Interest Rates
The first factor is a roughly parallel shift
(83.1% of variation explained)
The second factor is a twist (10% of
variation explained)
The third factor is a bowing (2.8% of
variation explained)

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The First Three Principal
Components (Figure 21.7, page 492)

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Standard Deviation of Factor
Scores

PC1 PC2 PC3 PC4 …..

17.49 6.05 3.10 2.17 ….

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Using PCA to Calculate VaR (page
493)

Example: Sensitivity of portfolio to rates ($m)

1 yr 2 yr 3 yr 4 yr 5 yr
+10 +4 -8 -7 +2

Sensitivity to first factor is from factor loadings:

10×0.32 + 4×0.35 − 8×0.36 − 7 ×0.36 +2 ×0.36
= −0.08
Similarly sensitivity to second factor = − 4.40
Options, Futures, and Other Derivatives, 8th Edition,
Copyright © John C. Hull 2012 49
Using PCA to calculate VaR
continued
As an approximation
P = −0.08 f1 − 4.40 f 2
The f1 and f2 are independent
The standard deviation of P (from Table
20.4) is
0.08 2 17.49 2 + 4.40 2  6.05 2 = 26.66
The 1 day 99% VaR is 26.66 × 2.33 = 62.12

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 ASC637
FINANCIAL RISK MANAGEMENT

Chapter 8
Credit Risk

1
Credit Ratings
In the S&P rating system, AAA is the best
rating. After that comes AA, A, BBB, BB, B,
CCC, CC, and C
The corresponding Moody’s ratings are Aaa,
Aa, A, Baa, Ba, B,Caa, Ca, and C
Bonds with ratings of BBB (or Baa) and
above are considered to be “investment
grade”

2
Historical Data
Historical data provided by rating agencies
are also used to estimate the probability of
default

3
Cumulative Ave Default Rates (%)
(1970-2009, Moody’s, Table 23.1, page 522)

1 2 3 4 5 7 10
Aaa 0.000 0.012 0.012 0.037 0.105 0.245 0.497
Aa 0.022 0.059 0.091 0.159 0.234 0.384 0.542
A 0.051 0.165 0.341 0.520 0.717 1.179 2.046
Baa 0.176 0.494 0.912 1.404 1.926 2.996 4.851
Ba 1.166 3.186 5.583 8.123 10.397 14.318 19.964
B 4.546 10.426 16.188 21.256 25.895 34.473 44.377
Caa-C 17.723 29.384 38.682 46.094 52.286 59.771 71.376

4
Interpretation
The table shows the probability of default
for companies starting with a particular
credit rating
A company with an initial credit rating of
Baa has a probability of 0.176% of
defaulting by the end of the first year,
0.494% by the end of the second year, and
so on

5
Do Default Probabilities Increase
with Time?

For a company that starts with a good credit

rating default probabilities tend to increase
with time
For a company that starts with a poor credit
rating default probabilities tend to decrease
with time

6
Hazard Rates vs Unconditional Default
Probabilities (page 522-523)
The hazard rate (also called default intensity) is the
probability of default for a certain time period
conditional on no earlier default
The unconditional default probability is the probability
of default for a certain time period as seen at time
zero
What are the default intensities and unconditional
default probabilities for a Caa rated company in the
third year?

7
Hazard Rate
The hazard rate that is usually quoted is an
instantaneous rate
If V(t) is the probability of a company surviving to time
t
V (t + t ) − V (t ) = −(t )V (t )
This leads to
t

V (t ) = e 0
−  ( t ) dt

The cumulative probability of default by time t is

Q(t ) = 1 − e −  (t )t

8
Recovery Rate
The recovery rate for a bond is usually
defined as the price of the bond immediately
after default as a percent of its face value
Recovery rates tend to decrease as default
rates increase

9
Recovery Rates; Moody’s: 1982 to 2009
Class Mean(%)
1st lien bank loan 65.6

2nd lien bank loan 32.8

Sen Unsec. bank loan 48.7

Senior Secured 49.8

Senior Unsecured 36.6

Senior Subordinated 30.7

Subordinated 31.3

Junior Subordinated 24.7

10
Estimating Default Probabilities

Alternatives:
Use Bond Prices
Use CDS spreads
Use Historical Data
Use Merton’s Model

11
Using Bond Prices (Equation 23.2,
page 524)

Average default intensity over life

of bond is approximately
s
1− R

where s is the spread of the

bond’s yield over the risk-free rate
and R is the recovery rate
12
More Exact Calculation
Assume that a five year corporate bond pays a
coupon of 6% per annum (semiannually). The yield is
7% with continuous compounding and the yield on a
similar risk-free bond is 5% (with continuous
compounding)
Price of risk-free bond is 104.09; price of corporate
bond is 95.34; expected loss from defaults is 8.75
Suppose that the probability of default is Q per year
and that defaults always happen half way through a
year (immediately before a coupon payment.

13
 Calculations (Table 23.3, page 525)
Time Def Recovery Risk-free Loss given Discount PV of Exp
(yrs) Prob Amount Value Default Factor Loss
0.5 Q 40 106.73 66.73 0.9753 65.08Q

1.5 Q 40 105.97 65.97 0.9277 61.20Q

2.5 Q 40 105.17 65.17 0.8825 57.52Q

3.5 Q 40 104.34 64.34 0.8395 54.01Q

4.5 Q 40 103.46 63.46 0.7985 50.67Q

Total 288.48Q

14
Calculations continued
We set 288.48Q = 8.75 to get Q = 3.03%
This analysis can be extended to allow
defaults to take place more frequently
With several bonds we can use more
parameters to describe the default probability
distribution

15
The Risk-Free Rate
The risk-free rate when default probabilities
are estimated is usually assumed to be the
LIBOR/swap zero rate (or sometimes 10 bps
below the LIBOR/swap rate)
Asset swaps provide a direct estimates of the
spread of bond yields over swap rates

16
Real World vs Risk-Neutral Default
Probabilities

The default probabilities backed out of bond

prices or credit default swap spreads are risk-
neutral default probabilities
The default probabilities backed out of
historical data are real-world default
probabilities

17
A Comparison
Calculate 7-year default intensities from the
Moody’s data, 1970-2009, (These are real
world default probabilities)
Use Merrill Lynch data to estimate average 7-
year default intensities from bond prices,
1996 to 2007 (these are risk-neutral default
intensities)
Assume a risk-free rate equal to the 7-year
swap rate minus 10 basis points

18
Data from Moody’s and Merrill Lynch
Cumulative 7-year default Average bond yield spread in bps *
probability (Moody’s: 1970-2009) (Merrill Lynch: 1996 to June 2007)

Aaa 0.245% 35.74

Aa 0.384% 43.67
A 1.179% 58.68
Baa 2.996% 127.53
Ba 14.318% 280.28
B 34.473% 481.04
Caa 59.771% 1103.70

*Thebenchmark risk-free rate for calculating spreads is assumed to be the

swap rate minus 10 basis points. Bonds are corporate bonds with a life of
approximately 7 years.

19
 Real World vs Risk Neutral Hazard
Rates (Table 23.4, page 527)
Rating Historical hazard rate1 Hazard rate from bond Ratio Difference
% per annum prices2 (% per annum)
Aaa 0.04 0.60 17.0 0.56
Aa 0.05 0.73 13.2 0.67
A 0.17 1.15 6.8 0.98
Baa 0.43 2.13 4.9 1.69
Ba 2.21 4.67 2.1 2.46
B 6.04 8.02 1.3 1.98
Caa 13.01 18.39 1.4 5.39

1 Calculated as−[ln(1-d)]/7 where d is the Moody’s 7 yr default rate. For example, in the
case of Aaa companies, d=0.00245 and -ln(0.99755)/7=0.0004 or 4bps. For investment
grade companies the historical hazard rate is approximately d/7.
2 Calculated as s/(1-R) where s is the bond yield spread and R is the recovery rate
(assumed to be 40%).

20
Average Risk Premiums Earned
By Bond Traders
Rating Bond Yield Spread of risk-free Spread to Extra Risk
Spread over rate over Treasuries compensate for Premium
Treasuries (bps)1 historical default (bps)
(bps) rate (bps)2
Aaa 78 42 2 34
Aa 86 42 3 41
A 111 42 10 59
Baa 169 42 26 101
Ba 322 42 132 148
B 523 42 362 119
Caa 1146 42 781 323
1Equals average spread of our benchmark risk-free rate over
Treasuries.
2Equals historical hazard rate times (1-R) where R is the recovery rate.
For example, in the case of Baa, 26bps is 0.6 times 43bps.

21
Possible Reasons for These
Results (The third reason is the most important)
Corporate bonds are relatively illiquid
The subjective default probabilities of bond traders
may be much higher than the estimates from
Moody’s historical data
Bonds do not default independently of each
other. This leads to systematic risk that cannot be
diversified away.
Bond returns are highly skewed with limited upside.
The non-systematic risk is difficult to diversify away
and may be priced by the market

22
Which World Should We Use?
We should use risk-neutral estimates for
valuing credit derivatives and estimating the
present value of the cost of default
We should use real world estimates for
calculating credit VaR and scenario analysis

23
Using Equity Prices: Merton’s
Model (page 530-531)
Merton’s model regards the equity as an
option on the assets of the firm
In a simple situation the equity value is
max(VT −D, 0)
where VT is the value of the firm and D is the
debt repayment required

24
Equity vs. Assets
The Black-Scholes-Merton option pricing
model enables the value of the firm’s equity
today, E0, to be related to the value of its
assets today, V0, and the volatility of its
assets, sV
E 0 = V0 N (d 1 ) − De − rT N (d 2 )
where
ln (V0 D) + (r + sV2 2)T
d1 = ; d 2 = d 1 − sV T
sV T

25
Volatilities
E
s E E0 = sV V0 = N (d1 )sV V0
V

This equation together with the option

pricing relationship enables V0 and sV to
be determined from E0 and sE

26
Example
A company’s equity is $3 million and the
volatility of the equity is 80%
The risk-free rate is 5%, the debt is $10
million and time to debt maturity is 1 year
Solving the two equations yields V0=12.40
and sv=21.23%
The probability of default is N(−d2) or 12.7%

27
The Implementation of Merton’s
Model
Choose time horizon
Calculate cumulative obligations to time horizon. This is
termed by KMV the “default point”. We denote it by D
Use Merton’s model to calculate a theoretical probability
of default
Use historical data or bond data to develop a one-to-one
mapping of theoretical probability into either real-world or
risk-neutral probability of default.

28
Credit Risk in Derivatives
Transactions (page 531-534)
Three cases
Contract always an asset
Contract always a liability
Contract can be an asset or a liability

29
General Result
Assume that default probability is independent of
the value of the derivative
Define
t1, t2,…tn: times when default can occur
qi: default probability at time ti.
fi: The value of the transaction at time ti
R: Recovery rate

30
General Result continued
The expected loss from defaults at time ti is
qi(1−R)E[max(fi,0)].
Defining ui=qi(1−R) and vi as the value of a
derivative that provides a payoff of max(fi,0) at
time ti, the PV of the cost of defaults is
n
Credit Value Adjustmen t (CVA) = u v
i =1
i i

31
Applications
If transaction is always an asset so that fi > 0
then vi = f0 and the cost of defaults
n
is f0 times
the total default probability,  qi times 1−R
i =1
If transaction is always a liability then vi= 0
and the cost of defaults is zero
In other cases we must value the derivative
max(fi,0) for each value of i

32
Using Bond Yields for Instruments
in the First Category
All instruments that promise a (non-negative) payoff at time T
should be reduced in price by the same amount for default risk

f 0* B0*
=
f 0 B0
so that
− ( y * − y )T
f 0* = f0e

where f0 and f0* are the no-default and actual values of the
instrument; B0 and B0* are the no-default and actual values of a
zero-coupon bond maturing at time T; y and y* are the yields on
these zero coupon bonds

33
Example
A 2-year option has a Black-Scholes value of
$3
Assume a 2 year zero coupon bond issued by
the company has a yield of 1.5% greater than
the risk free rate
Value of option is 3e−0.015×2 = 2.91

34
Expected Exposure on Pair of Offsetting
Interest Rate Swaps and a Pair of
Offsetting Currency Swaps
Exposure
Currency
swaps

Interest Rate
Swaps

Maturity

35
Interest Rate vs Currency Swaps
The ui’s are the same for both
The vi’s for an interest rate swap are on
average much less than the vi’s for a currency
swap
The expected cost of defaults on a currency
swap is therefore greater.

36
Credit Risk Mitigation
Netting
Collateralization
Downgrade triggers

37
Netting
Suppose a bank has three transactions worth
of $10 million, $30 million, and −$25 million
Without netting the exposure is $40 million
With netting the exposure is $15 million

38
Collateralization
Transactions are marked to market
periodically (e.g. every day)
If total value of transactions Party A has with
party B is above a specified threshold level it
can ask Party B to post collateral equal to the
excess of the value over the threshold level
After that collateral can be withdrawn or must
be increased by Party B depending on
whether value of transactions to Party A
decreases or increases

39
Downgrade Triggers
A downgrade trigger is a clause stating that a
transaction can be closed out by Party A when
the credit rating of the other side, Party B, falls
below a certain level
In practice Party A will only close out
transactions that have a negative value to Party
B
When there are a large number of downgrade
triggers they are likely to be counterproductive

40
Default Correlation
The credit default correlation between two
companies is a measure of their tendency to
default at about the same time
Default correlation is important in risk
management when analyzing the benefits of
credit risk diversification
It is also important in the valuation of some
credit derivatives, eg a first-to-default CDS
and CDO tranches.

41
Measurement
There is no generally accepted measure of
default correlation
Default correlation is a more complex
phenomenon than the correlation between
two random variables

42
Survival Time Correlation
Define ti as the time to default for company i
and Qi(ti) as the probability distribution for ti
The default correlation between companies i
and j can be defined as the correlation
between ti and tj
But this does not uniquely define the joint
probability distribution of default times

43
Gaussian Copula Model (page 538-540)
• Define a one-to-one correspondence between the
time to default, ti, of company i and a variable xi by
Qi(ti ) = N(xi ) or xi = N-1[Q(ti)]
where N is the cumulative normal distribution
function.
• This is a “percentile to percentile” transformation. The
p percentile point of the Qi distribution is transformed
to the p percentile point of the xi distribution. xi has a
standard normal distribution
• We assume that the xi are multivariate normal. The
default correlation measure, rij between companies i
and j is the correlation between xi and xj

44
Example of Use of Gaussian Copula
(Example 23.3, page 539)

Suppose that we wish to simulate the defaults for

n companies . For each company the cumulative
probabilities of default during the next 1, 2, 3, 4,
and 5 years are 1%, 3%, 6%, 10%, and 15%,
respectively

45
Use of Gaussian Copula continued
We sample from a multivariate normal
distribution to get the xi
Critical values of xi are
N -1(0.01) = -2.33, N -1(0.03) = -1.88,
N -1(0.06) = -1.55, N -1(0.10) = -1.28,
N -1(0.15) = -1.04

46
Use of Gaussian Copula continued
When sample for a company is less than
-2.33, the company defaults in the first year
When sample is between -2.33 and -1.88, the
company defaults in the second year
When sample is between -1.88 and -1.55, the
company defaults in the third year
When sample is between -1,55 and -1.28, the
company defaults in the fourth year
When sample is between -1.28 and -1.04, the
company defaults during the fifth year
When sample is greater than -1.04, there is no
default during the first five years

47
A One-Factor Model for the
Correlation Structure
xi = ai F + 1− ai2 Z i
The correlation between xi and xj is aiaj
The ith company defaults by time T when
xi < N-1[Qi(T)] or
N −1[Qi (T ) − ai F ]
Zi 
1 − ai2

Conditional on F the probability of this is

 N Qi (T ) − ai F 
 −1

Qi (T F ) = N  

 1 − ai
2



48
Credit VaR (page 540-542)

Can be defined analogously to Market Risk

VaR
A T-year credit VaR with an X% confidence is
the loss level that we are X% confident will
not be exceeded over T years

49
Calculation from a Factor-Based
Gaussian Copula Model (equation 23.13, page
540)
Consider a large portfolio of loans, each of which has
a probability of Q(T) of defaulting by time T. Suppose
that all pairwise copula correlations are r so that all
ai’s are r
We are X% certain that F is less than
N−1(1−X) = −N−1(X)
It follows that the VaR is
 N Q(T ) + r N ( X ) 
 −1 −1

V ( X ,T ) = N  

 1 − r 


50
Example (page 541)
A bank has $100 million of retail exposures
1-year probability of default averages 2% and the
recovery rate averages 60%
The copula correlation parameter is 0.1
99.9% worst case default rate is
 N −1 (0.02) + 0.1N −1 (0.999 )  
V (0.999 ,1) = N   = 0.128
 1 − 0.1 
 
The one-year 99.9% credit VaR is therefore
100×0.128×(1-0.6) or $5.13 million

51
CreditMetrics (page 541-542)
Calculates credit VaR by considering possible
rating transitions
A Gaussian copula model is used to define
the correlation between the ratings transitions
of different companies

Options, Futures, and Other Derivatives, 8th Edition,

Copyright © John C. Hull 2012 52