Vanilla Options

Uwe Wystup
Commerzbank Treasury and Financial Products
Neue Mainzer Strasse 32–36
60261 Frankfurt am Main
GERMANY
phone: +49 - 69 - 136 - 41067
fax: +49 - 69 - 136 - 48475
[email protected]
http://www.mathfinance.de

2001-07-05
2 Wystup, U.

1 Model and Payoff

We consider the model geometric Brownian motion

dSt = (rd − rf )St dt + σSt dWt . (1)

The parameters rd , rf and σ are called the domestic interest rate, the foreign
interest rate and the volatility respectively. Applying Ito’s rule to ln St yields
the following solution for the process St
 
1
St = S0 exp (rd − rf − σ 2 )t + σWt , (2)
2

which shows that St is log-normally distributed, more precisely, ln St is normal

with mean ln S0 +(rd −rf − 21 σ 2 )t and variance σ 2 t. Further model assumptions
are

1. There is no arbitrage

2. Trading is frictionless, no transaction cost

3. Any position can be taken at any time, short, long, arbitrary fraction, no
liquidity constraints

The payoff for a vanilla option (European put or call) is given by

F = [φ(ST − K)]+ , (3)

where the contractual parameters are strike K, expiration time T and type φ, a
binary varialbe which takes the value +1 in the case of a call and −1 in the case of
∆ ∆
a put. The symbol x+ denotes the positive part of x, i.e., x+ = max(0, x) = 0∨x.

2 value
In the Black-Scholes model the value of the payoff F at time t if the spot is
at x is denoted by v(t, x) and can be computed either as the solution of the
Black-Scholes partial differential equation

1
vt − rd v + (rd − rf )xvx + σ 2 x2 vxx = 0, (4)
2
v(T, x) = F, (5)

or equivalently (Feynman-Kac-Theorem) as a discounted expected value

v(x, K, T, t, σ, rd , rf , φ) = e−rd τ IE[F ]. (6)

This is why basic financial engineering is mostly concerned with solving partial
differential equations or computing expectations (numerical integration). The
result is the Black–Scholes formula

v(x, K, T, t, σ, rd , rf , φ) = φe−rd τ [f N (φd+ ) − KN (φd− )]. (7)

Vanilla Options 3

2.1 abbreviations
• x: current price of the underlying
∆
• τ =T −t
∆
• f = IE[ST |St = x] = xe(rd −rf )τ : forward price of the underlying
∆ rd −rf σ
• θ± = σ ± 2

x f 2
∆ ln +σθ± τ ln ± σ2 τ
• d± = K √
σ τ
= K√
σ τ

∆ 1 2
• n(t) = √1 e− 2 t = n(−t)
2π

∆ Rx
• N (x) = −∞
n(t) dt = 1 − N (−x)

The Black-Scholes formula can be derived using the integral representation of

Equation (6)

v = e−rd τ IE[F ]
= e−rd τ IE[[φ(ST − K)]+ ]
Z +∞ h  √ i+
1 2
−rd τ
= e φ xe(rd −rf − 2 σ )τ +σ τ y − K n(y) dy. (8)
−∞

Next one has to deal with the positive part and then complete the square to
get the Black-Scholes formula. A derivation based on the partial differential
equation can be done using results about the heat-equation, see, e.g., [9].

2.2 a note on the forward

The forward price f is the strike which makes the time zero value of the forward
contract
F = ST − f (9)
equal to zero. It follows that f = IE[ST ] = xe(rd −rf )T , i.e. the forward price
is the expected price of the underlying at time T in a risk-neutral (drift of the
geometric Brownian motion is equal to cost of carry rd −rf ) setup. The situation
rd > rf is called contango, and the situation rd < rf is called backwardation.
Note that in the Black-Scholes model the class of forward price curves is quite
restricted. For example, no seasonal effects can be included. Note that the value
of the forward contract after time zero is usually different from zero, and since
one of the counterparties is always short, there may be risk of default of the
short party. A futures contract prevents this dangerous affair: it is basically a
forward contract, but the counterparties have to maintain margin accounts to
ensure the amount of cash or commodity owed does not exceed a specified limit.

3 Greeks
Greeks are derivatives of the value function with respect to model and contract
parameters. They are an important information for traders and have become
4 Wystup, U.

standard information supplied by front-office systems. More details on relations

among Greeks will are presented in Chapter ??. For vanilla options we list some
of them now.

(Spot) Delta.

∂v
= φe−rf τ N (φd+ ) (10)
∂x

Forward Delta.
∂v
= φe−rd τ N (φd+ ) (11)
∂f

Driftless Delta.

φN (φd+ ) (12)

Gamma.
∂2v n(d+ )
= e−rf τ √ (13)
∂x2 xσ τ

Speed.

∂3v
 
−rf τ n(d+ ) d+
= −e √ √ +1 (14)
∂x3 x2 σ τ σ τ

Theta.
∂v n(d+ )xσ
= −e−rf τ √
∂t 2 τ
+ φ[rf xe−rf τ N (φd+ ) − rd Ke−rd τ N (φd− )] (15)

Charm.
√
∂2v −rf τ −rf τ 2(rd − rf )τ − d− σ τ
= −φrf e N (φd+ ) + φe n(d+ ) √
∂x∂τ 2τ σ τ
(16)

Color.
√
∂3v
 
n(d+ ) 2(rd − rf )τ − d− σ τ
= −e−rf τ √ 2rf τ + 1 + √ d+
∂x2 ∂τ 2xτ σ τ 2τ σ τ
(17)

Vega.

∂v √
= xe−rf τ τ n(d+ ) (18)
∂σ
Vanilla Options 5

Volga.

∂2v √ d+ d−
2
= xe−rf τ τ n(d+ ) (19)
∂σ σ

Vanna.
∂2v d−
= −e−rf τ n(d+ ) (20)
∂σ∂x σ

Rho.
∂v
= φKτ e−rd τ N (φd− ) (21)
∂rd
∂v
= −φxτ e−rf τ N (φd+ ) (22)
∂rf

Dual Delta.
∂v
= −φe−rd τ N (φd− ) (23)
∂K

Dual Gamma.
∂2v n(d− )
= e−rd τ √ (24)
∂K 2 Kσ τ

Dual Theta.
∂v ∂v
= − (25)
∂T ∂t

4 identities
∂d± d∓
= − (26)
∂σ √σ
∂d± τ
= (27)
∂rd σ
√
∂d± τ
= − (28)
∂rf σ
xe−rf τ n(d+ )= Ke−rd τ n(d− ). (29)
N (φd− ) = IP [φST ≥ φK] (30)
f2
 
N (φd+ ) = IP φST ≤ φ (31)
K

4.1 put-call parity

The put-call-parity is the relationship

v(x, K, T, t, σ, rd , rf , +1) − v(x, K, T, t, σ, rd , rf , −1) = xe−rf τ − Ke−rd τ , (32)

which is just a more complicated way to write the trivial equation x = x+ − x− .

6 Wystup, U.

4.2 put-call delta parity

∂v(x, K, T, t, σ, rd , rf , +1) ∂v(x, K, T, t, σ, rd , rf , −1)
− = e−rf τ (33)
∂x ∂x
In particular, we learn that the absolute value of a put delta and a call delta
are not exactly adding up to one, but only to a positive number e−rf τ . They
add up to one approximately if either the time to expiration τ is short or if the
foreign interest rate rf is close to zero.

4.3 delta-symmetric strike

While the choice K = f produces identical values for call and put, we seek the
strike Ǩ which produces absolutely identical deltas (spot, forward or driftless).
This condition implies d+ = 0 and thus
σ2
T
Ǩ = f e 2 , (34)
in which case the absolute delta is e−rf τ /2. In particular, we learn, that always
Ǩ > f , i.e., there can’t be a put and a call with identical values and deltas.
Note that the strike Ǩ is usually chosen as the middle strike when trading a
σ2
straddle or a butterfly. Similarly the dual-delta-symmetric strike K̂ = f e− 2 T
can be derived from the condition d− = 0.

4.4 space-homogeneity
We may wish to measure the value of the underlying in a different unit. This
will obviously affect the option pricing formula as follows.
av(x, K, T, t, σ, rd , rf , φ) = v(ax, aK, T, t, σ, rd , rf , φ) for all a > 0. (35)
Differentiating both sides with respect to a and then setting a = 1 yields
v = xvx + KvK . (36)
Comparing the coefficients of x and K in equations (7) and (36) leads to sugges-
tive results for the delta vx and dual delta vK . This homogeneity is the reason
behind the simplicity of the delta formulas, whose tedious computation can be
saved this way.

4.5 time-homogeneity
We can perform a similar computation for the time-affected parameters and
obtain the obvious equation
T t √
v(x, K, T, t, σ, rd , rf , φ) = v(x, K,
, , aσ, ard , arf , φ) for all a > 0. (37)
a a
Differentiating both sides with respect to a and then setting a = 1 yields
1
0 = τ vt + σvσ + rd vrd + rf vrf . (38)
2
Of course, this can also be verified by direct computation. The overall use
of such equations is to generate double checking benchmarks when computing
Greeks. These homogeneity methods can easily be extended to other more
complex options.
Vanilla Options 7

4.6 put-call symmetry

By put-call symmetry we understand the relationship (see [2], [3],[5] and [6])

K f2
v(x, K, T, t, σ, rd , rf , +1) = v(x, , T, t, σ, rd , rf , −1). (39)
f K

The strike of the put and the strike of the call result in a geometric mean
equal to the forward f . The forward can be interpreted as a geometric mirror
reflecting a call into a certain number of puts. Note that for at-the-money
options (K = f ) the put-call symmetry coincides with the special case of the
put-call parity where the call and the put have the same value.

4.7 rates symmetry

Direct computation shows that the rates symmetry

∂v ∂v
+ = −τ v (40)
∂rd ∂rf

holds for vanilla options. This relationship, in fact, holds for all European
options and a wide class of path-dependent options as shown in Chapter ??.

4.8 foreign-domestic symmetry

One can directly verify the relationship

1 1 1
v(x, K, T, t, σ, rd , rf , φ) = Kv( , , T, t, σ, rf , rd , −φ). (41)
x x K
This equality can be viewed as one of the faces of put-call symmetry. The
reason is that the value of an option can be computed both in a domestic
as well as in a foreign scenario. We consider the example of St modelling
the exchange rate of EUR/USD. In New York, the call option (ST − K)+
costs v(x, K, T, t, σ, rusd , reur , 1) USD and hence v(x, K, T, t, σ, rusd , reur , 1)/x
EUR. This EUR-call option can also be viewed as a USD-put option with pay-
 +
1
off K K − S1T . This option costs Kv( x1 , K 1
, T, t, σ, reur , rusd , −1) EUR in
Frankfurt, because St and S1t have the same volatility. Of course, the New York
value and the Frankfurt value must agree, which leads to (41).

4.9 Euro related symmetries of value, delta and leverage

Let us now consider the example of St modeling the exchange rate GBP/DEM.
After the currency Euro has been introduced, we need to know how to re-
late options written on GBP/DEM to options on EUR/GBP. W e denote by
E = 1.95583 the fixed exchange rate EUR/DEM. Then E/St serves as model
for EUR/GBP. Combining the foreign-domestic symmetry (41) with the space-
homogeneity (35) we obtain

Kx E E
v(x, K, T, t, σ, rd , rf , φ) = v( , , T, t, σ, rf , rd , −φ). (42)
E x K
8 Wystup, U.

Taking the derivative with respect to x on both sides results in

K E E
vx (x, K, T, t, σ, rd , rf , φ) = v( , , T, t, σ, rf , rd , −φ)
E x K
K E E
− vx ( , , T, t, σ, rf , rd , −φ). (43)
x x K
In particular, the deltas of identical options are not exactly negatives of each
other. This is only approximately correct. The right quantities to compare are
not the deltas, but the dimensionless leverages, because (43) implies
E E E
xvx (x, K, T, t, σ, rd , rf , φ) x vx ( x , K , T, t, σ, rf , rd , −φ)
=1− E E
. (44)
v(x, K, T, t, σ, rd , rf , φ) v( x , K , T, t, σ, rf , rd , −φ)

This means that the leverages of a GBP call and an identical EUR put add
up to one. Note the the factor E could be cancelled on the right hand side to
produce a plain foreign-domestic leverage symmetry.

5 quotation
The value of vanilla option may be quoted in various ways, out of which the
four most used quotation methods are
d value in domestic currency (or in pips of the very same),
% d value in % measured in units of the strike,
f value in foreign currency (or in pips of the very same),
% f value in % of foreign currency.
The Black-Scholes formula quotes d. The others can be computed using the
following instruction.
× 100
x K × x
100x × 1
×xK
d −→ %f −→ %d −→ f −→ d (45)

6 dual Black-Scholes partial differential equa-

tion
The value function for vanilla options can be written as

v(x, K, T, t, σ, rd , rf , φ) = e−rd (T −t) IE[F |St = x]. (46)

Consequently, the process v(t, St )e−rd t = e−rd T IE[F |St ] is a martingale, whence
the dt-coefficient of its differential must vanish. Therefore v(x, K, T, t, σ, rd , rf , φ)
satisfies the Black-Scholes partial differential equation
1
vt − rd v + (rd − rf )xvx + σ 2 x2 vxx = 0. (47)
2
This can easily be remembered by noting that the derivatives have the same
sign.
Vanilla Options 9

Viewing v as a function of T and K, one can verify by direct computation that

the so-called dual Black-Scholes partial differential equation

1
−vT − rf v + (rf − rd )KvK + σ 2 K 2 vKK = 0 (48)
2
also holds. We note that the Black-Scholes equation holds for all options,
whereas its dual is a particularity of put and call options. More details on
this issue can be found in [1] and [10].

7 retrieving the arguments

7.1 implied volatility
Since vσ > 0, the function σ 7→ v(x, K, T, t, σ, rd , rf , φ) is

1. strictly increasing, and also

p
2. concave up for σ ∈ [0, 2| ln f − ln K|/τ ),
p
3. concave down for σ ∈ ( 2| ln f − ln K|/τ , ∞),

and also satisfies

v(x, K, T, t, σ = 0, rd , rf , φ) = [φ(xe−rf τ − Ke−rd τ )]+ , (49)

v(x, K, T, t, σ = ∞, rd , rf , φ = 1) = xe−rf τ , (50)
v(x, K, T, t, σ = ∞, rd , rf , φ = −1) = Ke−rd τ , (51)
√ √
vσ (x, K, T, t, σ = 0, rd , rf , φ) = xe−rf τ τ / 2πII{f =K} . (52)

Consequently, there exists a unique implied volatility σ = σ(v, x, K, T, t, rd , rf , φ)

for a given value v, which can be found by a Newton-Raphson method. How-
ever, the starting guess for employing this method should be chosen with care,
because the mapping σ 7→ v(x, K, T, t, σ, rd , rf , φ) has a saddle point at
r ( r ! s !)!
2 f f K
| ln |, φ xe−rf τ N φ 2τ [ln ]+ − Ke−rd τ N φ 2τ [ln ]+ .
τ K K f
(53)
To ensure convergence of the Newton-Raphson method, we are advised to use
initial guesses for σ on the same side of the saddle point as the desired implied
volatility. The danger is that a large initial guess could lead to a negative
successive guess for σ. Therefore one should start with small initial guesses at or
below the saddle point. For at-the-money options, the saddle point is degenerate
for a zero volatility and small volatilities serve as good initial guesses.

7.2 strike given delta

Since vx = ∆ = φe−rf τ N (φd+ ) we can retrieve the strike as
√
K = x exp −φN −1 (φ∆erf τ )σ τ + σθ+ τ .

(54)
10 Wystup, U.

7.3 volatility given delta

The mapping σ 7→ ∆ = φe−rf τ N (φd+ ) is not one-to-one. Thus using just the
delta to retrieve the volatility of an option is not advisable. The two solutions
are given by
√
 
1
q
−1 rf τ −1 r τ
σ± = √ 2
φN (φ∆e ) ± (N (φ∆e )) − σ τ (d+ + d− ) . (55)
f
τ

8 Greeks in terms of deltas

Foreign Exchange markets have adopted to speak about vanilla options in terms
of deltas and quote prices in terms of volatility. This makes a ten-delta call a
financial object as such independent of spot and strike. This method and the
quotation in volatility makes objects and prices transparent in a very intelligent
and user-friendly way. At this point we list the Greeks in terms of deltas instead
of spot and strike. Let us introduce the quantities
∆
∆+ = φe−rf τ N (φd+ ) spot delta, (56)
∆ −rd τ
∆− = −φe N (φd− ) dual delta, (57)

which we assume to be given. From these we can retrieve

d+ = φN −1 (φerf τ ∆+ ), (58)
d− = φN −1 (−φerd τ ∆− ). (59)

8.1 interpretation of dual delta

The dual delta introduced in (23) as the sensitivity with respect to strike has
another - more practical - interpretation in a foreign exchange setup. We have
seen in Section 4.8 that the domestic value

v(x, K, τ, σ, rd , rf , φ) (60)

corresponds to a foreign value

1 1
v( , , τ, σ, rf , rd , −φ) (61)
x K
up to an adjustment of the nominal amount by the factor xK. From a foreign
viewpoint the delta is thus given by
!
−rd τ ln( K 1 2
x ) + (rf − rd + 2 σ τ )
−φe N −φ √
σ τ
ln( x ) + (rd − rf − 12 σ 2 τ )
 
= −φe−rd τ N φ K √
σ τ
= ∆− , (62)

which means the dual delta is the delta from the foreign viewpoint. We will see
below that foreign rho, vega and gamma do not require to know the dual delta.
We will now state the Greeks in terms of x, ∆+ , ∆− , rd , rf , τ, φ.
Vanilla Options 11

8.2 list of Greeks

Value.
e−rf τ n(d+ )
v(x, ∆+ , ∆− , rd , rf , τ, φ) = x∆+ + x∆− (63)
e−rd τ n(d− )

(Spot) Delta.

∂v
= ∆+ (64)
∂x

Forward Delta.
∂v
= e(rf −rd )τ ∆+ (65)
∂f

Gamma.
∂2v n(d+ )
= e−rf τ (66)
∂x2 x(d+ − d− )

Taking a trader’s gamma (change of delta if spot moves by 1%) addition-

ally removes the spot dependence, because

x ∂2v n(d+ )
Γtrader = = e−rf τ (67)
100 ∂x2 100(d+ − d− )

Speed.

∂3v n(d+ )
= −e−rf τ (2d+ − d− ) (68)
∂x3 x2 (d
+ − d− )
2

Theta.
1 ∂v n(d+ )(d+ − d− )
= −e−rf τ
x ∂t 2τ
e−rf τ n(d+ )
 
+ rf ∆+ + rd ∆− −r τ (69)
e d n(d− )

Charm.
∂2v 2(rd − rf )τ − d− (d+ − d− )
= −φrf e−rf τ N (φd+ ) + φe−rf τ n(d+ )
∂x∂τ 2τ (d+ − d− )
(70)

Color.
∂3v e−rf τ n(d+ )
 
2(rd − rf )τ − d− (d+ − d− )
= − 2rf τ + 1 + d+
∂x2 ∂τ 2xτ (d+ − d− ) 2τ (d+ − d− )
(71)
12 Wystup, U.

Vega.

∂v √
= xe−rf τ τ n(d+ ) (72)
∂σ

Volga.

∂2v d+ d−
2
= xe−rf τ τ n(d+ ) (73)
∂σ d+ − d−

Vanna.
√
∂2v τ d−
= −e−rf τ n(d+ ) (74)
∂σ∂x d+ − d−

Rho.

∂v e−rf τ n(d+ )
= −xτ ∆− (75)
∂rd e−rd τ n(d− )
∂v
= −xτ ∆+ (76)
∂rf

Dual Delta.
∂v
= ∆− (77)
∂K

Dual Gamma.

∂2v ∂2v
= (78)
∂K 2 ∂x2

Dual Theta.
∂v
= −vt (79)
∂T

As an important example we consider vega.

8.3 vega given delta

√
The mapping ∆ 7→ vσ = xe−rf τ τ n(N −1 (erf τ ∆)) is important for trading va-
nilla options. Observe that this function does not depend on rd or σ, just on rf .
Quoting vega in % foreign will additionally remove the spot dependence. This
means that for a moderately stable foreign termstructure curve, traders will be
able to use a moderately stable vega matrix. I.e. for rf = 3% the vega matrix
looks like this.
Vanilla Options 13

Mat/∆ 50% 45% 40% 35% 30% 25% 20% 15% 10% 5%
1D 2 2 2 2 2 2 1 1 1 1
1W 6 5 5 5 5 4 4 3 2 1
1W 8 8 8 7 7 6 5 5 3 2
1M 11 11 11 11 10 9 8 7 5 3
2M 16 16 16 15 14 13 11 9 7 4
3M 20 20 19 18 17 16 14 12 9 5
6M 28 28 27 26 24 22 20 16 12 7
9M 34 34 33 32 30 27 24 20 15 9
1Y 39 39 38 36 34 31 28 23 17 10
2Y 53 53 52 50 48 44 39 32 24 14
3Y 63 63 62 60 57 53 47 39 30 18

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Index
backwardation, 3
Black–Scholes formula, 2
Black-Scholes partial differential equa-
tion, 2

contango, 3

dual Black-Scholes partial differen-

tial equation, 8

foreign-domestic symmetry, 7
forward contract, 3
forward price, 3
futures contract, 3

Greeks for vanilla options, 3

margin accounts, 3

put-call symmetry, 7
put-call-parity, 5

quotation conventions for vanilla op-

tions, 8

rates symmetry, 7

strike in terms of delta, 9

trader’s gamma, 11

vanilla option, 2
vega matrix, 12
volatility, implied, 9

15
16 Wystup, U.

Contents
1 Model and Payoff 2

2 value 2
2.1 abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
2.2 a note on the forward . . . . . . . . . . . . . . . . . . . . . . . . 3

3 Greeks 3

4 identities 5
4.1 put-call parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
4.2 put-call delta parity . . . . . . . . . . . . . . . . . . . . . . . . . 6
4.3 delta-symmetric strike . . . . . . . . . . . . . . . . . . . . . . . . 6
4.4 space-homogeneity . . . . . . . . . . . . . . . . . . . . . . . . . . 6
4.5 time-homogeneity . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
4.6 put-call symmetry . . . . . . . . . . . . . . . . . . . . . . . . . . 7
4.7 rates symmetry . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
4.8 foreign-domestic symmetry . . . . . . . . . . . . . . . . . . . . . 7
4.9 Euro related symmetries of value, delta and leverage . . . . . . . 7

5 quotation 8

6 dual Black-Scholes partial differential equation 8

7 retrieving the arguments 9

7.1 implied volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
7.2 strike given delta . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
7.3 volatility given delta . . . . . . . . . . . . . . . . . . . . . . . . . 10

8 Greeks in terms of deltas 10

8.1 interpretation of dual delta . . . . . . . . . . . . . . . . . . . . . 10
8.2 list of Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
8.3 vega given delta . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12