Financial Engineering

Introduction

 Futures markets are often used by hedgers to mitigate risks associated with price
fluctuations of assets like oil or exchange rates.
 A perfect hedge, which eliminates risk entirely, is rare; hedging strategies aim to
achieve near-perfect risk reduction using futures contracts.
 This chapter discusses setting up hedges, determining appropriate futures positions,
choosing the right futures contract, and optimizing the size of futures positions.

Basic Principles

 Hedging aims to neutralize risk by taking offsetting positions in futures markets; for
example, a company exposed to commodity price changes can use futures to create
offsetting gains or losses.

Short Hedges

 A short hedge involves a short position in futures contracts and is suitable when the
hedger owns an asset and plans to sell it in the future, or will own an asset in the
future.
 An example involves an oil producer hedging the future market price of oil by
shorting futures contracts to lock in a price close to the current futures price.
 Regardless of whether the spot price increases or decreases, the company ends up
with approximately the locked-in futures price.

Long Hedges

 Long hedges involve taking a long position in a futures contract and are used when a
company knows it will need to purchase an asset in the future.
 An example is provided of a copper fabricator who takes a long position to hedge
against price increases.
 Whether the price of copper increases or decreases, the net cost is approximately the
initial futures price.
Arguments for and Against Hedging

 Hedging allows companies to focus on their core business by mitigating risks from
fluctuating interest rates, exchange rates, and commodity prices.
 One argument against hedging is that shareholders can hedge themselves, but this
overlooks the information asymmetry and transaction costs.
 If competitors do not hedge, a company that hedges can experience profit margin
fluctuations, potentially worsening its position compared to competitors with constant
profit margins.

Hedging Can Lead to a Worse Outcome

 Hedging can result in decreased profits if the price of the hedged asset moves
favourably; conversely, it can increase profits if the price moves unfavourably.
 Treasurers might be reluctant to hedge because, although it reduces risk for the
company, it may increase personal risk if others do not understand the strategy.
 Ideally, hedging strategies should be set by the board and communicated clearly to
management and shareholders.

Basis Risk

 Basis risk arises when the asset being hedged is not identical to the asset underlying
the futures contract, when there's uncertainty about the exact date of purchase or sale,
or when the futures contract is closed out before its delivery month.
 The basis is the difference between the spot price of the asset to be hedged and the
futures price of the contract used; it should be zero at the expiration of the futures
contract if the assets are the same.
 Basis risk is the uncertainty associated with the basis at the time the hedge is closed
out, affecting the effective price obtained for the asset.

Choice of Contract

 Key factors affecting basis risk are the choice of the asset underlying the futures
contract and the choice of the delivery month.
  A contract with a later delivery month than the expiration of the hedge is usually
chosen to avoid erratic prices during the delivery month and the risk of taking
delivery.
 A good rule of thumb is to choose a delivery month that is as close as possible to, but
later than, the expiration of the hedge.

Cross Hedging

 Cross hedging occurs when the asset being hedged differs from the asset underlying
the futures contract, increasing basis risk.
 The hedge ratio is the ratio of the size of the position in futures contracts to the size of
the exposure; for cross hedging, a ratio of 1.0 is not always optimal.

Calculating the Minimum Variance Hedge Ratio

 The minimum variance hedge ratio minimizes the variance of the hedged position and
depends on the relationship between changes in the spot price and changes in the
futures price.
 The minimum variance hedge ratio, h*, equals r * (σS / σF), where r is the correlation
coefficient between changes in spot and futures prices, and σS and σF are their
standard deviations.
 The hedge effectiveness is the proportion of variance eliminated by hedging, equal to
r^2.

Stock Indices

 A stock index tracks changes in the value of a hypothetical portfolio of stocks, with
the weight of a stock reflecting its proportion in the portfolio.
 Examples include the Dow Jones Industrial Average, the Standard & Poor’s 500
(S&P 500) Index, and the Nasdaq-100, each with futures contracts traded on the CME
Group.
 Futures contracts on stock indices are settled in cash, based on the opening or closing
price of the index on the last trading day.

Hedging an Equity Portfolio

  Stock index futures can hedge a diversified equity portfolio; if the portfolio mirrors
the index, the optimal hedge ratio is 1.0, and the number of contracts is VA/VF.
 For portfolios that don't mirror the index, the capital asset pricing model is used, and
the number of contracts is adjusted based on the portfolio's beta (N* = β * VA/VF).
 Hedging an equity portfolio can be justified if the hedger feels that the stocks in the
portfolio have been chosen well.

Stack and Roll

 When the expiration date of the hedge is later than the delivery dates of available
futures contracts, the hedger must roll the hedge forward by closing out one futures
contract and taking the same position in a later contract.
 This process, known as stack and roll, involves a sequence of shorting and closing out
futures contracts with progressively later delivery dates.
 Potential liquidity problems should always be considered when a hedging strategy is
being planned.

Mechanics of Options Markets

 Options give the holder the right, but not the obligation, to buy or sell an asset by a
certain date for a certain price, unlike forward or futures contracts.
 There are two types of options: call options (right to buy) and put options (right to
sell).
 Options can be American (exercisable any time until expiration) or European
(exercisable only at expiration).

Types of Options

 Call options give the holder the right to buy an asset at a strike price by the expiration
date; if the stock price is below the strike price at expiration, the option is not
exercised, resulting in a loss of the initial investment.
 Put options give the holder the right to sell an asset at a strike price by the expiration
date; profit is realized if the stock price is below the strike price at expiration.
  Exchange-traded stock options are usually American, allowing for early exercise
before the expiration date.

Option Positions

 There are four types of option positions: long call, long put, short call, and short put.
 The payoff from a long position in a European call option is max (ST - K, 0),
reflecting exercise only if ST > K.
 Payoffs for short positions in European call options and long/short positions in
European put options are also defined, illustrating gains or losses based on the
relationship between strike price (K) and asset price at maturity (ST).

Underlying Assets

 Options are traded on stocks, exchange-traded products (ETPs) like ETFs, foreign
currencies, stock indices, and futures contracts.
 Stock options on exchanges like CBOE and NYSE Euronext involve contracts to buy
or sell 100 shares.
 Index options, like those on the S&P 500, are settled in cash, with one contract
representing 100 times the index value.

Specification of Stock Options

 Stock options have expiration dates, typically the third Friday of the expiration month,
and follow a January, February, or March cycle.
 Strike prices are set at intervals of 2.50,5, or $10, depending on the stock price.
 Options are categorized as in the money, at the money, or out of the money based on
the relationship between the stock price and strike price; FLEX options allow for
nonstandard terms.

Dividends and Stock Splits

 Exchange-traded options are not usually adjusted for cash dividends, but adjustments
are made for stock splits and stock dividends.
 Stock splits reduce the strike price and increase the number of shares covered by the
contract to reflect the expected change in stock price.
  Position limits and exercise limits are set by the Chicago Board Options Exchange to
prevent market manipulation.

Trading

 Most derivatives exchanges are fully electronic, and market makers facilitate trading
by quoting bid and ask prices.
 Investors can close positions by issuing offsetting orders, and open interest increases
or decreases based on whether new or existing positions are being traded.
 Trading costs include broker fees, per-contract fees, and the market maker’s bid-ask
spread.

Margin Requirements

 Margin is required when selling options to guarantee obligations, and the amount
depends on the trader’s position.
 Naked options require an initial margin based on the proceeds of the sale and a
percentage of the underlying share price, adjusted for whether the option is in or out
of the money.
 Special rules exist for margin requirements when using option trading strategies like
covered calls, where no margin is required on the written option if the shares are
already owned.

The Options Clearing Corporation

 The Options Clearing Corporation (OCC) guarantees options writers' obligations,

keeps records of positions, and ensures trades are cleared through members.
 When an option is exercised, the OCC randomly selects a member with a short
position, who then assigns an investor to fulfil the obligation.
 At expiration, in-the-money options are automatically exercised unless transaction
costs negate the payoff.

Regulation

 Exchange-traded options markets are regulated by the exchange, Options Clearing

Corporation, and federal/state authorities.
  The Securities and Exchange Commission and the Commodity Futures Trading
Commission oversee options markets for various assets.
 Taxation of option trading strategies can be complex, with gains and losses typically
taxed as capital gains or losses; the wash sale rule and constructive sales are important
considerations.

Warrants, Employee Stock Options, and Convertibles

 Warrants are options issued by financial institutions or corporations, often attached to

bond issues.
 Employee stock options are call options issued to employees to align their interests
with shareholders, and convertible bonds are bonds that can be converted into equity.
 Over-the-counter (OTC) options markets have become increasingly important,
offering tailored instruments but with potential credit risk, often mitigated by
collateral.

***Questions***

The main differences between American and European options are:

1. Exercise Timing:

 American Options: Can be exercised at any time before or on the expiration date.
 European Options: Can only be exercised at the expiration date itself.

2. Flexibility:

 American Options: Offer more flexibility for the holder, as they can choose the
optimal time to exercise based on market conditions.
 European Options: Are less flexible due to the restriction on the exercise date.

3. Valuation:

 American Options: Typically have a higher premium than comparable European

options due to the added benefit of exercise flexibility.
  European Options: Generally, less expensive than American options, as they have a
locked exercise date.

4. Market:

 American Options: Mostly traded on stock exchanges in the United States, and are
the most common type of option.
 European Options: Commonly traded in various markets, including those for foreign
currencies and stock indices.

5. Involvement of Company:

 For American options, the underlying company can be affected by early exercise,
especially if it’s tied to dividends; European options do not typically have this
concern since they can only be exercised at expiration.

These differences impact trading strategies, pricing, and risk management in options markets.

How do margin requirements work when trading options?

Margin requirements in options trading are essential to ensure that traders can meet their
obligations, especially when they write (sell) options. Here's how margin requirements
generally work:

1. Purpose of Margin:

 Margin acts as collateral for the brokerage and ensures that options traders can fulfil
their obligations if an option is exercised against them. It provides a guarantee against
the risk of default,

2. Initial Margin Requirements:

 When a trader writes an option, they are required to maintain an initial margin
account. This margin requirement varies based on whether the option is covered or
uncovered (naked):
  Covered Call: No margin is required if the trader owns the underlying shares.
 Naked Call or Put: Requires a margin that depends on the option position and related
factors, calculated based on various formulas that include the option's proceeds,
underlying asset price, and whether the option is in or out of the money. For example,
the margin for a naked put generally is calculated as the greater of certain percentages
of the stock price or option proceeds.

3. Daily Margin Calculations:

 The margin requirements are recalculated daily based on the current market price of
the options and the underlying assets. If the market price indicates that more margin is
required than what is currently in the account, the trader will receive a margin call,
requiring them to deposit more funds.

4. Maintenance Margin:

 Brokers often set a maintenance margin, which is the minimum amount that must be
maintained in the margin account. If the account balance falls below this level, a
margin call occurs.
 The maintenance margin may differ from the initial margin requirement; brokers can
set higher maintenance margin limits based on their risk assessments.

5. Trading Restrictions:

 Some brokers may restrict their clients from writing uncovered options altogether,
requiring all positions to be covered by sufficient assets. Retail traders may face
stricter margin requirements compared to institutional traders.

6. Options Clearing Corporation (OCC):

 The OCC specifies minimum margin requirements. While individual brokers may
require more than these minimums, they cannot require less.

Understanding these margin requirements is vital for managing risk effectively in options
trading and for ensuring compliance with brokerage policies.
Properties of Stock Options

Overview

 Chapter 11 explores factors affecting stock option prices using arbitrage arguments to
relate European/American option prices and stock prices.
 It examines early exercise of American options, finding it's never optimal for calls on
non-dividend stocks but can be for puts.
 Dividends can make early exercise optimal for both calls and puts.

Factors Affecting Option Prices

 Six factors influence stock option prices: current stock price, strike price, time to
expiration, stock price volatility, risk-free interest rate, and expected dividends.
 Call option prices increase with stock price, time to expiration, volatility, and risk-free
rate, while decreasing with strike price and dividends.
 Put option prices increase with strike price, time to expiration, volatility, and
dividends, while decreasing with stock price and risk-free rate.

Assumptions and Notation

 Assumes no transaction costs, uniform tax rates, and risk-free borrowing/lending rates
for market participants to exploit arbitrage.
 Defines notation: S0 (current stock price), K (strike price), T (time to expiration), ST
(stock price at expiration), r (risk-free interest rate), C (American call), P (American
put), c (European call), p (European put).
 Notes that r is the nominal risk-free interest rate, assuming r > 0 based on arbitrage
arguments.

Upper and Lower Bounds for Option Prices

 Establishes upper bounds: call option value cannot exceed stock price (c ≤ S0, C ≤
S0), American put option value cannot exceed strike price (P ≤ K), and European put
option value cannot exceed present value of strike price (p ≤ Ke-rT).
 Derives lower bound for European calls on non-dividend-paying stocks: c ≥ max(S0 -
Ke-rT, 0), demonstrated through arbitrage examples and portfolio construction.
  Derives lower bound for European puts on non-dividend-paying stocks: p ≥ max(Ke-
rT - S0, 0), also shown via arbitrage and portfolio arguments.

Put–Call Parity

 Introduces put–call parity: c + Ke-rT = p + S0, linking European call and put prices
with the same strike price and maturity on non-dividend-paying stocks.
 Demonstrates arbitrage opportunities if put–call parity is violated through
buying/selling portfolios A (call + bond) and C (put + stock).
 Provides inequalities for American options: S0 - K ≤ C - P ≤ S0 - Ke-rT, when there
are no dividends.

Calls on a Non-Dividend-Paying Stock

 Argues it's never optimal to exercise an American call option on a non-dividend-

paying stock early due to time value of money and insurance against price drops.
 Shows that C ≥ S0 - Ke-rT, implying C > S0 - K when T > 0, thus early exercise isn't
optimal.
 States that American calls are equivalent to European calls (C = c) since early
exercise is not optimal, with bounds max(S0 - Ke-rT, 0) ≤ c, C ≤ S0.

Puts on a Non-Dividend-Paying Stock

 Explains that it can be optimal to exercise an American put option on a non-dividend-

paying stock early, especially when deep in the money.
 Notes that early exercise becomes more attractive as S0 decreases, r increases, and
volatility decreases.
 Provides bounds: max(Ke-rT - S0, 0) ≤ p ≤ Ke-rT for European puts; max(K - S0, 0)
≤ P ≤ K for American puts.

Effect of Dividends

 Considers the impact of known dividends (present value D) on option pricing.

 Modifies lower bounds: c ≥ max(S0 - D - Ke-rT, 0) and p ≥ max(D + Ke-rT - S0, 0).
 States that with dividends, early exercise of American calls may be optimal
immediately before an ex-dividend date.
Summary

 Summarizes factors affecting stock option values, noting the impact of each factor on
call and put prices.
 Reiterates lower bounds for European call and put options with and without
dividends.
 Presents put–call parity equations for both non-dividend-paying (c + Ke-rT = p + S0)
and dividend-paying stocks (c + D + Ke-rT = p + S0).

Trading Strategies Involving Options

 This chapter explores trading strategies that combine options with other assets to
achieve specific profit patterns based on market judgments and risk tolerance.
 It covers portfolios consisting of options and zero-coupon bonds, options and the
underlying asset, and multiple options on the same asset.
 Further strategies involving stock indices, risk management with Greek letters, and
exotic options are referenced for later chapters.

Principal-Protected Notes

 Principal-protected notes are designed for risk-averse investors, offering returns based
on asset performance without risking the initial investment.
 These notes can be structured with a zero-coupon bond and a call option, ensuring the
return of principal while allowing participation in potential asset appreciation.
 Banks incorporate a profit margin when creating these notes, and investors bear the
risk of the bank's solvency at maturity.

Trading an Option and the Underlying Asset

 Strategies involve combining a single stock option with the underlying stock.
 Common strategies include writing a covered call, a protective put, and their reverses,
each offering different profit patterns.
 Put-call parity explains the relationships between these strategies and their profit
patterns, linking them to long or short positions in call or put options.
Spreads

 Spread strategies involve positions in two or more options of the same type (calls or
puts).
 Bull spreads aim for profit in rising markets, created by buying a call option with a
lower strike price and selling a call option with a higher strike price.
 Bear spreads target profit in declining markets, using puts or calls with differing strike
prices to capitalize on downward price movement.

Box Spreads

 A box spread combines a bull call spread and a bear put spread with the same strike
prices, offering a constant payoff.
 Arbitrage opportunities exist if the market price deviates from the present value of the
payoff, but these opportunities are only viable with European options.
 Butterfly spreads involve options with three strike prices, profiting if the stock price
remains near the middle strike price.

Calendar Spreads

 Calendar spreads involve options with the same strike price but different expiration
dates.
 These spreads can be created using call or put options and profit if the stock price at
the short-maturity option's expiration is close to the strike price.
 Diagonal spreads combine different strike prices and expiration dates, increasing the
variety of possible profit patterns.

Combinations

 Combinations involve positions in both calls and puts on the same stock.
 A straddle involves buying a call and a put with the same strike price and expiration
date, profiting from large price movements in either direction.
 Strangles involve buying a call and a put with different strike prices, requiring a larger
price move than a straddle to be profitable but with less downside risk.

Other Payoffs
  Options can be combined in numerous ways to create a wide range of payoff profiles.
 Theoretically, any payoff function can be approximated using a combination of
options with various strike prices, such as butterfly spreads.
 Option trading has increased in popularity due to the flexibility it provides in creating
desired risk and reward profiles.

Questions

1.How do principal-protected notes appeal to risk-averse investors?

Principal-protected notes appeal to risk-averse investors because they guarantee the return of
the initial principal invested, regardless of the performance of the underlying risky asset (such
as a stock or stock index). This structure is typically created by combining a zero-coupon
bond with a call option on the underlying asset. The zero-coupon bond ensures that the
principal will be returned at maturity, while the call option allows participation in the
potential upside if the asset’s price increases.

Thus, for a risk-averse investor, the worst-case scenario is limited to earning no interest or
dividends on the invested principal during the life of the note, but without any risk to the
principal itself. This allows investors to take a position in a risky asset without fear of losing
their original investment, aligning well with their low risk tolerance.

However, while principal-protected notes are attractive for their guaranteed principal, the
investor does face risks such as the issuer’s potential failure to make the promised payoff
(credit risk) and possibly lower returns compared to investing directly in the underlying asset
plus a risk-free bond. Despite this, they remain popular among investors seeking a
conservative way to gain exposure to risky assets.

2.What are the differences between bull spreads, reverse butterfly spreads, and
straddles in terms of risk and potential gain?
The differences between bull spreads, reverse butterfly spreads, and straddles in terms of risk
and potential gain are as follows:

1. Bull Spreads:

 Construction: Created by buying a call (or put) with a lower strike price and selling a
call (or put) with a higher strike price.
 Market View: The investor expects the stock price to increase moderately.
 Risk: Limited downside risk equal to the initial investment.
 Potential Gain: Limited upside potential equal to the difference between the two
strike prices minus the net cost of initiating the spread.
 Profit Pattern: Profit increases as the stock price rises up to the higher strike price,
after which it plateaus.
 Risk Profile: More conservative than outright long calls; caps both profit and loss.

2. Reverse Butterfly Spreads:

 Construction: Typically involves selling a butterfly spread, which includes buying

calls (or puts) at low and high strike prices and selling two calls (or puts) at an
intermediate strike price.
 Market View: The investor expects a large price move but is uncertain about the
direction.
 Risk: The investor faces limited potential loss (the net debit paid to establish the
position).
 Potential Gain: Gains are realized when the stock price moves far from the
intermediate strike price in either direction, so it profits from high volatility.
 Profit Pattern: "Small gain if the hunch is correct" with a small loss if incorrect,
implying moderate risk and reward.
 Risk Profile: A limited-risk strategy designed to benefit from significant volatility
without directional bias.

3. Straddles:

 Construction: Buying a call and a put option with the same strike price and
expiration date.
  Market View: The investor expects a significant price move but is unsure of the
direction.
 Risk: The maximum loss is limited to the combined premiums paid for the call and
put.
 Potential Gain: Unlimited potential gain on either side if the price moves
significantly up or down.
 Profit Pattern: Profits when the stock price moves sufficiently far from the strike
price in either direction; losses occur when the price remains near the strike price.
 Risk Profile: Higher potential gain and loss compared to reverse butterfly; more
aggressive volatility play.

Summary:

 Bull spreads are moderately bullish with limited risk and capped gains.
 Reverse butterfly spreads are moderate-risk, volatility-based strategies with gains
from large moves either way but smaller magnitude.
 Straddles are aggressive volatility plays with potentially unlimited gains but higher
initial cost and risk limited to premiums paid.

Binomial Trees

 Binomial trees are a useful technique for pricing options. They represent possible
stock price paths over an option's life, assuming the stock price follows a random
walk with probabilities of moving up or down. In the limit, as the time step decreases,
this model converges to the Black-Scholes-Merton model.
 This chapter explains no-arbitrage arguments used for option valuation and introduces
the binomial tree numerical procedure, widely used for American options. It also
introduces the principle of risk-neutral valuation.
 The chapter's general approach to constructing trees follows the methodology in Cox,
Ross, and Rubinstein's 1979 paper.

13.1 A One-Step Binomial Model and a No-Arbitrage Argument

  A simple example is presented where a stock is currently 20 and will be either 22 or
18 in 3 months, to value a European call option with a strike price of 21.
 The option is priced by setting up a portfolio of stock and options to eliminate
uncertainty and ensure the portfolio earns the risk-free interest rate, thereby
preventing arbitrage. A riskless portfolio consisting of a long position in ∆ shares of
the stock and a short position in one call option can be created.
 The argument is generalized for a stock with price S0 and an option, considering
stock price movements up to S0u or down to S0d at time T, leading to option payoffs
of fu or fd respectively.

13.2 Risk-Neutral Valuation

 The option pricing formula does not depend on the probabilities of stock price
movements, as these are already incorporated into the stock price. This section
introduces the principle of risk-neutral valuation, which allows derivatives to be
priced under the assumption that investors are risk-neutral.
 This valuation simplifies derivative pricing by assuming the expected return on a
stock is the risk-free rate and discounting the expected payoff on an option at the risk-
free rate. The parameter p in equation (13.2) is interpreted as the probability of an up
movement in a risk-neutral world.
 The one-step binomial example is revisited, illustrating that risk-neutral valuation
yields the same result as no-arbitrage arguments. The difference between real-world
and risk-neutral world probabilities is emphasized, showing the need to discount
expected payoffs at the risk-free rate in a risk-neutral world.

13.3 Two-Step Binomial Trees

 The analysis is extended to a two-step binomial tree, calculating option prices at each
node by repeatedly applying established principles.
 The approach is generalized for two time steps, with the stock price moving up or
down during each step, and the notation for option values is introduced. Equations are
presented to show how the option price is calculated based on the probabilities and
payoffs at each node.
  As more steps are added to the binomial tree, the risk-neutral valuation principle
continues to hold; the option price is equal to its expected payoff in a risk-neutral
world discounted at the risk-free interest rate.

13.4 A Put Example

 The procedures can be used to price puts as well as calls, as illustrated with a 2-year
European put option example.
 The risk-neutral probability, p, is calculated, and the possible final stock prices and
option payoffs are determined.
 The value of the put is calculated using equation (13.10) and working back through
the tree one step at a time.

13.5 American Options

 American options are valued using a binomial tree by working backward from the
end, assessing whether early exercise is optimal at each node.
 At each node, the option's value is the greater of the value given by equation (13.5) or
the payoff from early exercise.
 An example illustrates how early exercise affects the option value in an American put
option compared to a European put option.

13.6 Delta

 Delta (∆) of a stock option is introduced as the ratio of the change in the option price
to the change in the stock price; it represents the number of stock units to hold for
each option shorted to create a riskless portfolio.
 Examples show how to calculate delta for call and put options using the values from
binomial trees.
 The examples illustrate that delta changes over time, requiring periodic adjustments to
stock holdings to maintain a riskless hedge.

13.7 Matching Volatility with u and d

  The section discusses matching volatility with the parameters u and d in the binomial
tree, using the volatility of the stock, σ, to define the standard deviation of its return in
a short period of time.
 Formulas for calculating u and d based on volatility and time step are presented,
ensuring that the tree matches the volatility in the risk-neutral world.
 Girsanov's theorem is introduced, explaining that when moving from a risk-neutral
world to the real world, the expected return of the stock price changes, but its
volatility remains the same.

13.8 The Binomial Tree Formulas

 This section consolidates the binomial tree formulas, defining u, d, and p based on
volatility, risk-free rate, and time step.
 These equations define the tree, and an example applies these formulas to an
American put option to calculate its value.
 The result differs from previous calculations due to changes in u and d.

13.9 Increasing the Number of Steps

 The binomial model becomes more realistic as the number of time steps increases; in
practice, 30 or more time steps are typically used.
 As the number of time steps increases, the binomial tree model makes the same
assumptions about stock price behaviour as the Black–Scholes–Merton model.
 When the binomial tree is used to price a European option, the price converges to the
Black–Scholes–Merton price as the number of time steps is increased.

13.10 Using DerivaGem

 The DerivaGem software is a useful tool for working with binomial trees.
 Instructions are provided on how to use DerivaGem to calculate the price of an option
and display the binomial tree.
 By changing the option type to Binomial European, we can use the tree to value a
European option.

13.11 Options on Other Assets

  Binomial trees can be used for options on indices, currencies, and futures contracts in
the same way as for options on stocks, except the equation for p changes.
 For stocks paying a continuous dividend yield, the equation for p is adjusted to
account for the dividend yield rate q.
 For options on stock indices and currencies, adjustments are made to the parameter 'a'
in the binomial tree formulas to reflect dividend yields and foreign risk-free interest
rates. For futures contracts, the futures price should have an expected growth rate of
zero in a risk-neutral world, so 'a' is set to 1.

Summary

 This chapter provides an introduction to valuing options using binomial trees, where
no-arbitrage arguments and risk-neutral valuation lead to the same option prices.
 The delta of a stock option considers the effect of a small change in the stock price on
the option price; delta changes during the life of an option.
 Constructing binomial trees for options on stock indices, currencies, and futures
contracts is similar to valuing options on stocks.

Questions

How does the model ensure no-arbitrage in option pricing?

The binomial tree model ensures no-arbitrage in option pricing through constructing a
riskless portfolio composed of a certain number of shares of the underlying stock and a short
position in the option.

Here's the key reasoning as described:

 Consider a stock price S0 and an option on the stock with current price f. The option
lasts for time T, and during its life, the stock price can move up by a factor u>1 to S0u
or down by a factor d<1 to S0d.
 The option payoff will be fu if the stock moves up and fd if it moves down.
 Construct a portfolio consisting of a long position in Δ shares and a short position in
one option.
  Choose Δ such that the portfolio is riskless; i.e., it has the same value in both up and
down states: S0uΔ−fu=S0dΔ−fd
 Solve for Δ: Δ=S0u−S0dfu−fd
 Because the portfolio is riskless, its return must be equal to the risk-free interest rate
to prevent arbitrage.
 Using this, the present value of the portfolio must grow at the risk-free rate r, allowing
the calculation of the option price of such that no arbitrage opportunities exist.

This approach shows that the option price can be derived without any arbitrage opportunities,
as the riskless portfolio’s return is fixed and known, eliminating possibility of riskless profit.

This no-arbitrage argument is central and fundamental to the binomial tree approach to option
pricing and is explained in detail on pages 1 to 3,

Additionally, adopting risk-neutral valuation, where probabilities are adjusted to reflect a

world where investors are indifferent to risk, further supports this no-arbitrage framework.
The expected payoffs discounted at the risk-free rate yield the correct option price consistent
with no-arbitrage,

In summary, the binomial model ensures no-arbitrage by:

 Constructing a replicating riskless portfolio of stock and option.

 Ensuring the portfolio’s return matches, the risk-free rate.
 Calculating the option price as the present value of expected payoffs under this
riskless hedge.

This framework thereby guarantees consistent, arbitrage-free option pricing.

What makes binomial trees especially useful for American options compared to other
methods?

Binomial trees are especially useful for valuing American options because they naturally
accommodate the possibility of early exercise at each node in the tree. This feature makes the
method particularly well-suited for American options, which can be exercised at any time
before expiration, unlike European options that can only be exercised at maturity.

Specifically:

 At each node of the binomial tree, after computing the value based on expected
payoffs from future nodes, the model checks whether early exercise is optimal by
comparing the immediate payoff from exercising the option to the value of continuing
to hold it.
 The value of the option at that node is then taken as the maximum of the two:

1. The discounted expected value from continuation (holding the option).

2. The payoff from early exercise.

 This backward induction proceeds from the end of the tree to the beginning,
effectively capturing the optimal exercise strategy.

This stepwise testing for early exercise is straightforward in the binomial framework, making
it easier and more intuitive to price American options compared to, for example, the Black–
Scholes–Merton model which is formulated for European-style options and does not provide
a closed-form solution for American options except in special cases.

An example illustrating this is given on page 11, where the binomial approach determines at
each node whether early exercise is optimal by comparing the value from holding versus
exercising, leading to the correct valuation for American options.

In summary, the binomial tree approach is practical and flexible for American options
because:

 It models stock price evolution discretely over multiple time steps.

 It allows straightforward incorporation of early exercise decisions at each node.
 It uses backward induction to find the option value considering the possibility of early
exercise.

Hence, the binomial tree method is widely used in practice for pricing American-style options
where early exercise is key.
Wiener Processes and Itô’s Lemma

 Stochastic processes, which describe uncertain changes over time, are classified as
discrete or continuous time and variable. This chapter focuses on continuous-variable,
continuous-time stochastic processes for asset prices, with Itô's lemma being central
to derivative pricing.
 A Markov process dictates that only the present value is relevant for predicting the
future, consistent with the weak form of market efficiency. Competition ensures this
property holds, as stock prices reflect information in past prices.
 A Wiener process is a Markov stochastic process with a mean change of zero and a
variance rate of 1.0 per year and is used to describe the motion of a particle subject to
small molecular shocks. Uncertainty in Wiener processes is proportional to the square
root of time.

14.2 Continuous-Time Stochastic Processes

 The probability distribution of changes in a variable following a Markov process can

be determined by adding independent normal distributions. The change in the variable
during any time period T is f(0,T).
 A variable z follows a Wiener process if the change in z during a small time period ∆t
is ∆z = P2∆t, where P has a standard normal distribution f(0,1) and the values of ∆z
for any two short time intervals, ∆t, are independent. The Wiener process has a mean
of ∆z = 0, a standard deviation of ∆z = 2∆t, and a variance of ∆z = ∆t.
 The generalized Wiener process for a variable x can be defined as dx = a dt + b dz,
where a and b are constants. The a dt term implies that x has an expected drift rate of
a per unit of time and the b dz term adds noise or variability to the path followed by x.

14.3 The Process for a Stock Price

 An Itô process is a generalized Wiener process where the parameters a and b are
functions of the underlying variable x and time t. In a small time interval between t
and t + ∆t, the variable changes from x to x + ∆x, where ∆x = a(x, t)∆t + b(x, t)P2∆t.
  The expected percentage return required by investors from a stock is independent of
the stock’s price. The expected drift rate in S should be assumed to be mS for some
constant parameter m, where m is the expected rate of return on the stock.
 The most widely used model of stock price behaviour is dS/S = m dt + s dz, where m
is the stock's expected rate of return and s is the volatility. This represents the stock
price process in the real world, and in a risk-neutral world, m equals the risk-free rate
r.

14.3 The Process for a Stock Price

 The discrete-time version of the model of stock price behavior is ∆S/S = m ∆t +

sP2∆t, where P has a standard normal distribution. In other words, ∆S/S - f(m ∆t, s^2
∆t).
 A Monte Carlo simulation of a stochastic process involves sampling random
outcomes to understand the nature of the stock price process. By repeatedly
simulating movements in the stock price, a complete probability distribution of the
stock price at the end of this time is obtained.
 The parameter m is the expected return earned by an investor in a short period of time
and the parameter s, the stock price volatility, is critically important to the
determination of the value of many derivatives. As an approximation, volatility can be
interpreted as the standard deviation of the change in the stock price in 1 year.

14.5 Correlated Processes

 The processes followed by two variables x1 and x2 are dx1 = a1 dt + b1 dz1 and dx2
= a2 dt + b2 dz2, where dz1 and dz2 are Wiener processes. If x1 and x2 have a
nonzero correlation r, then the P1 and P2 that are used to obtain movements in a
particular period of time should be sampled from a bivariate normal distribution.
 To sample standard normal variables P1 and P2 with correlation r, we can set P1 = u
and P2 = ru + 21 - r2v where u and v are sampled as uncorrelated variables with
standard normal distributions. Obtaining samples for uncorrelated standard normal
variables in cells in Excel involves putting the instruction “=NORMSINV(RAND())”
in each of the cells.
  When there are n correlated variables, we have n different Ps and these must be
sampled from an appropriate multivariate normal distribution. The way this is done is
explained in Chapter 21.

14.6 Itô’s Lemma

 Itô’s lemma is a way of calculating the stochastic process followed by a function of a

variable from the stochastic process followed by the variable itself. Suppose that the
value of a variable x follows the Itô process dx = a(x, t) dt + b(x, t) dz, where dz is a
Wiener process and a and b are functions of x and t.
 From Itô’s lemma, it follows that the process followed by a function G of S and t is
dG = (∂G/∂S mS + ∂G/∂t + 1/2 ∂^2G/∂S^2 s^2S^2) dt + ∂G/∂S sS dz. Both S and G
are affected by the same underlying source of uncertainty, dz.
 From equation (5.1), F0 = S0e^(rT), where F0 is the forward price at time zero, S0 is
the spot price at time zero, and T is the time to maturity of the forward contract. Like
S, the forward price F follows geometric Brownian motion and has the same volatility
as S and an expected growth rate of m - r rather than m.

14.7 The Lognormal Property

 Since ∂G/∂S = 1/S, ∂^2G/∂S^2 = -1/S^2, ∂G/∂t = 0, it follows from equation (14.14)
that the process followed by G is dG = (m - s^2/2) dt + s dz. This equation indicates
that G = ln S follows a generalized Wiener process.
 A variable has a lognormal distribution if the natural logarithm of the variable is
normally distributed. The model of stock price behaviour we have developed in this
chapter therefore implies that a stock’s price at time T, given its price today, is log
normally distributed.
 Fractional Brownian motion (also known as fractal Brownian motion) provides a
generalization of Brownian motion and the models involving Wiener processes. It is
used in rough volatility models for valuing derivatives, which are discussed later in
the book.

14.8 Fractional Brownian Motion

  In fractional Brownian motion we assume E[(X(t) - X(s))^2] = s^2(t - s)^(2H) where
H is referred to as the Hurst exponent. When H = 0.5, fractional Brownian motion
becomes regular Brownian motion.
 When H = 0.5, this reduces to our earlier result for Wiener processes: E3X1s2X1t24 =
s^2s. Fractional Brownian motion is non-Markov.
 Simulating fractional Brownian motion involves dividing the time period being
considered into a number of small time steps of length ∆t. In regular Brownian motion
the Ps used for different time steps are uncorrelated and in fractional Brownian
motion we must build in the correlations so that equation (14.20) is satisfied.

Summary

 A Markov process is one where only the present value of the variable is relevant for
predicting the future. The past history of the variable and the way in which the present
has emerged from the past is irrelevant.
 An Itô process is a process where the drift and variance rate of x can be a function of
both x itself and time. The change in x in a very short period of time is, to a good
approximation, normally distributed, but its change over longer periods of time is
liable to be nonnormal.
 The stochastic process usually assumed for a stock price is geometric Brownian
motion and under this process the return to the holder of the stock in a small period of
time is normally distributed and the returns in two nonoverlapping periods are
independent. The Black–Scholes–Merton model, which we cover in the next chapter,
is based on the geometric Brownian motion assumption.

Questions

How does the Markov property simplify modeling stock prices?

The Markov property simplifies modeling stock prices by asserting that only the current
value of the stock price is relevant for predicting its future behavior, and the entire history or
path by which the price arrived at its current value is irrelevant. This means that the future
probability distribution of the stock price depends solely on its current price, not on past
prices.

Specifically, this implies:

 Given the current stock price, predictions for the future price distribution do not
require knowledge of past prices or the path followed to reach the present price.
 This property supports the weak form of market efficiency, where all information
contained in the history of past prices is already incorporated in the current price,
implying that past prices provide no additional predictive power.
 The Markov property allows the stock price modeling to focus on a process where
future increments depend only on the current state, simplifying the stochastic
modeling framework.
 It leads to models like geometric Brownian motion or Itô processes that describe stock
price dynamics based purely on current prices and time, facilitating tractable
mathematical and numerical analysis,

In summary, the Markov property reduces the complexity of modelling stock prices by
allowing the future evolution of prices to be represented as dependent only on the present
price, thereby ignoring the entire past history and focusing on the current state as the
sufficient statistic for future predictions. This underpins many standard models in quantitative
finance.

Why is Itô’s lemma so important for financial derivatives pricing?

Itô’s lemma is crucial for financial derivatives pricing because it provides a way to determine
the stochastic process followed by a function of a stochastic variable, such as the price of a
derivative, based on the stochastic process of the underlying variable (e.g., the stock price).

Key reasons why Itô’s lemma is important include:

1. Linking underlying asset processes to derivative prices: Many derivatives have

payoffs that are functions of underlying assets whose prices follow stochastic
processes like geometric Brownian motion. Itô’s lemma allows one to derive the
 dynamics of the derivative price from the known dynamics of the underlying asset
price process,
2. Incorporating the same source of uncertainty: The Wiener process (Brownian
motion) driving the stochastic process of the underlying asset price also drives the
process of any function of the asset price. Itô’s lemma accounts for this shared source
of uncertainty, ensuring consistency in modelling,
3. Accounting for second-order terms: Unlike ordinary calculus, where second-order
terms (like Δx2) can be ignored as infinitesimals, Itô’s lemma recognizes that such
terms contribute to the drift part of the stochastic differential equation. This correction
is essential in accurately modelling the drift and diffusion terms of the derivative price
process,
4. Foundation of the Black–Scholes–Merton model: The derivation of the famous
Black–Scholes option pricing formula fundamentally relies on Itô’s lemma to
characterize the evolution of option prices, considering the stochastic nature of the
underlying stock prices and ensuring no arbitrage and risk-neutral pricing,
5. General applicability: Itô’s lemma extends standard results of differential calculus to
stochastic calculus, enabling the treatment of a wide range of more complex
derivative securities whose values depend on multiple stochastic variables or on
multiple times.

In summary, Itô’s lemma is essential because it bridges the behaviour of underlying

stochastic variables and their functions, enabling the correct and rigorous construction of
models for derivative pricing, ensuring models correctly incorporate randomness and drift in
continuous time finance frameworks,

The Black–Scholes–Merton Model

  The Black-Scholes-Merton model revolutionized European stock option pricing in the
early 1970s. It became widely adopted by traders for pricing and hedging derivatives.
 The model assumes percentage changes in stock prices over short periods are
normally distributed, implying stock prices follow a lognormal distribution. Volatility,
a key input, can be estimated from historical data.
 The Black-Scholes-Merton differential equation is crucial for pricing derivatives on
non-dividend-paying stocks and is derived by creating a riskless portfolio of the
derivative and the stock. Risk-neutral valuation, stemming from this equation,
simplifies derivative analysis by assuming all investors are risk-neutral.

15.1 Lognormal Property of Stock Prices

 The Black-Scholes-Merton model assumes percentage changes in the stock price in a

very short period of time are normally distributed.
 The model implies that ln S_T - ln S_0 - fc am - s^2/2 bT, s^2 T d
 The lognormal distribution allows for a range of values from zero to infinity and is
characterized by skewness.

15.2 The Distribution of the Rate of Return

 The lognormal property of stock prices provides information on the probability

distribution of the continuously compounded rate of return earned on a stock between
times 0 and T.
 The continuously compounded rate of return per annum is normally distributed with
mean m - s^2/2 and standard deviation s> 1T.
 As T increases, the standard deviation of x declines.

15.3 The Expected Return

 The expected return required by investors from a stock depends on the riskiness of the
stock.
 The model of stock price behavior implies that, in a very short period of time ∆t, the
mean return is m ∆t.
 The continuously compounded return, x, actually realized over a period of time of
length T is given by equation (15.6) as x = 1/T ln(S_T/S_0).
15.4 Volatility

 The volatility, s, of a stock is a measure of our uncertainty about the returns provided
by the stock.
 The volatility of a stock price can be defined as the standard deviation of the return
provided by the stock in 1 year when the return is expressed using continuous
compounding.
 Uncertainty about a future stock price, as measured by its standard deviation,
increases—at least approximately—with the square root of how far ahead we are
looking.

Estimating Volatility from Historical Data

 Empirical volatility estimation involves observing stock prices at fixed intervals. The
usual estimate, s, of the standard deviation of the u_i is given by s = sqrt(1/(n-1) *
sum(u_i - u)^2).
 The prices of actively traded options are not usually calculated from volatilities based
on historical data.
 Volatilities tend to change through time.

Trading Days vs. Calendar Days

 Research shows that volatility is much higher when the exchange is open for trading
than when it is closed.
 As a result, practitioners tend to ignore days when the exchange is closed when
estimating volatility from historical data and when calculating the life of an option.
 The volatility per annum is calculated from the volatility per trading day using the
formula: Volatility per annum = Volatility per trading day * sqrt(Number of trading
days per annum).

15.5 The Idea Underlying the Black–Scholes–Merton Differential Equation

 The Black–Scholes–Merton differential equation must be satisfied by the price of any

derivative dependent on a non-dividend-paying stock.
 They involve setting up a riskless portfolio consisting of a position in the derivative
and a position in the stock.
  In the absence of arbitrage opportunities, the return from the portfolio must be the
risk-free interest rate, r.

15.6 Derivation of the Black–Scholes–Merton Differential Equation

 The assumptions we use to derive the Black–Scholes–Merton differential equation are

as follows: The stock price follows the process developed in Chapter 14 with m and s
constant, short selling is permitted and There are no transaction costs or taxes.
 Suppose that f is the price of a call option or other derivative contingent on S. The
variable f must be some function of S and t.
 This derivation of equation (15.16) is not completely rigorous.

15.7 Risk-Neutral Valuation

 Risk-neutral valuation is a key tool for derivatives analysis, arising from the Black–
Scholes–Merton differential equation's independence from investor risk preferences.
 Risk-neutral valuation simplifies derivative valuation by assuming all investors are
risk-neutral, setting the expected return on all assets to the risk-free rate.
 This approach involves assuming the expected return is the risk-free rate, calculating
the expected payoff, and discounting it at the risk-free rate.

15.8 Black–Scholes–Merton Pricing Formulas

 The Black–Scholes–Merton formulas provide prices for European call (c) and put (p)
options, incorporating factors like stock price (S_0), strike price (K), risk-free rate (r),
volatility (σ), and time to maturity (T).
 One way of deriving the Black–Scholes–Merton formulas is by solving the
differential equation (15.16) subject to the boundary condition mentioned in Section
15.6.
 It is important to appreciate that risk-neutral valuation (or the assumption that all
investors are risk neutral) is merely an artificial device for obtaining solutions to the
Black–Scholes–Merton differential equation.

15.9 Cumulative Normal Distribution Function

  When implementing equations (15.20) and (15.21), it is necessary to evaluate the
cumulative normal distribution function N1x2.
 Tables for N1x2 are provided at the end of this book.
 The NORMSDIST function in Excel also provides a convenient way of calculating
N1x2.

15.10 Warrants and Employee Stock Options

 Exercise of warrants and employee stock options leads to the company issuing more
shares, diluting existing shareholders' interests.
 The stock price will reflect potential dilution from all outstanding warrants and
employee stock options.
 The total cost of the options is M times this and the reduction in the stock price is
M/(N+M) times the value of a regular call option with strike price K and maturity T.

15.11 Implied Volatilities

 Implied volatilities are derived from market option prices and reflect the market's
volatility opinion.
 An iterative search procedure can be used to find the implied s.
 Traders prefer implied volatility over price, as it is less variable and useful for
estimating other options.

The VIX Index

 The CBOE publishes indices of implied volatility.

 The SPX VIX, is an index of the implied volatility of 30-day options on the S&P 500
calculated from a wide range of calls and puts.
 Trading in futures on the VIX started in 2004 and trading in options on the VIX
started in 2006.

15.12 Dividends

 The Black–Scholes–Merton model can be adapted to accommodate dividend-paying

stocks.
  Operationally, this means that the Black–Scholes–Merton formulas can be used
provided that the stock price is reduced by the present value of all the dividends
during the life of the option.
 Chapter 11 showed that in the absence of dividends American options should never be
exercised early.

Black's Approximation

 Black suggests an approximate procedure for taking account of early exercise in call
options.
 This involves calculating, as described earlier in this section, the prices of European
options that mature at times T and t_n, and then setting the American price equal to
the greater of the two.
 This is an approximation because it in effect assumes the option holder has to decide
at time zero whether the option will be exercised at time T or t_n.

Questions

What are the main differences between Black-Scholes and Merton's approaches?

The main differences between Black-Scholes and Merton's approaches in deriving the Black-
Scholes-Merton model stem from their methodologies and underlying assumptions:

1. Methodology:

 Black and Scholes primarily used the capital asset pricing model to establish a
relationship between the market's required return on options and the required return
on stocks. This approach requires knowing the correct discount rate for calculating the
expected payoff from a European option, which can be complex due to its dependency
on stock price and time.
 Merton, on the other hand, developed his approach by creating a riskless portfolio
composed of the option and the underlying stock. He argued that the return on this
portfolio over a short time must equal the risk-free return, a method that allows for
continuous adjustments in the portfolio. Merton's way is considered more general as it
 doesn't rely on the capital asset pricing model and accommodates continuous time
changes.

2. Assumptions:

 Black-Scholes assumed specific market conditions and utilized a more

straightforward analytical approach based on earlier research, focusing on expected
payoffs and their discounting.
 Merton's method adds complexity by accounting for the continuous nature of stock
price changes and the adjustments necessary in pricing derivatives, encapsulating a
broader range of potential market behaviours. This accounts for the dynamic aspect of
risk management and pricing in a more nuanced manner than Black-Scholes.

In summary, the Black-Scholes approach is more reliant on traditional financial models and
established relationships, while Merton's approach innovatively integrates the concept of
dynamic risk management through continuous portfolio adjustments.

How does the model adapt to dividend-paying stocks?

The Black-Scholes-Merton model can be adapted to accommodate dividend-paying stocks by

modifying the stock price to reflect the expected dividends. Here are the key adaptations
made in the model:

1. Adjustment for Dividends: The model treats the stock price as the sum of two
components: a riskless component that covers the present value of the dividends
during the life of the option and a risky component that corresponds to the stock price
itself. Specifically, the stock price is adjusted downwards by the present value of all
expected dividends that will be paid during the option's life. This ensures that the
model reflects the decrease in stock price on the ex-dividend dates.
2. Present Value Calculation: The present value of dividends is calculated by
discounting them from their respective ex-dividend dates to the present value using
the risk-free interest rate. The formula used is structured such that the total dividends
expected to be paid before the option expires are considered, which translates into a
reduced effective stock price in the Black-Scholes formula,
 3. Use of Adjusted Stock Price: When calculating the option price using the Black-
Scholes formula for a dividend-paying stock, the adjusted stock price (i.e., the original
stock price minus the present value of dividends) is used as the input for the model.
This adjustment is crucial because it reflects the stock's value net of dividends that
will be paid out.
4. Different Treatment for Long-Term Options: For options with longer maturities, it
is often more practical to assume a known dividend yield rather than specific dollar
amounts for dividends. In such cases, the model can incorporate a continuous
dividend yield into the pricing.

By implementing these adaptations, the Black-Scholes-Merton model can effectively price

options on dividend-paying stocks, allowing for more accurate assessments of their value in
light of expected dividend pay-outs.

Credit Risk

 Credit risk is a significant concern for financial institutions, arising from potential
borrower defaults.
 This chapter explores methods for estimating default probabilities and the distinction
between risk-neutral and real-world probabilities.
 It also discusses credit risk mitigation strategies in derivatives agreements and the
estimation of credit value at risk.

Credit Ratings

 Rating agencies like Moody’s, S&P, and Fitch provide creditworthiness ratings for
corporate bonds.
 Moody’s uses ratings from Aaa (highest) to C, while S&P and Fitch use AAA to C.
 Bonds rated Baa/BBB or above are considered investment grade, indicating lower
default risk.

Historical Default Probabilities

  Table 24.1 presents average cumulative default rates over a 15-year period for bonds
with different initial ratings.
 The probability of default during a specific year can be calculated from the table by
subtracting cumulative default rates.
 The hazard rate, denoted as λ(t), is defined such that λ(t)Δt is the probability of
default between time t and t + Δt conditional on no earlier default.

Recovery Rates

 Recovery rate is the market value of a bond shortly after default, expressed as a
percentage of its face value.
 Average recovery rates are negatively correlated with default rates due to factors like
economic conditions and increased supply of distressed assets.
 A high default rate year often leads to lower recovery rates, compounding losses for
lenders.

Estimating Default Probabilities from Bond Yield Spreads

 Bond yield spreads, or the excess yield over the risk-free rate, are often considered
compensation for default risk.
 The average hazard rate, λ(T), can be estimated using the formula λ(T) = s(T) / (1 -
R), where s(T) is the yield spread and R is the recovery rate.
 More precise calculations involve matching bond prices by adjusting hazard rates,
similar to the bootstrap method for zero-coupon yield curves.

Comparison of Default Probability Estimates

 Default probabilities from historical data are typically lower than those derived from
bond yield spreads, especially during financial crises.
 Table 24.2 compares historical hazard rates with those implied by bond yields,
showing the latter are significantly higher.
 The difference between real-world and risk-neutral default probabilities is linked to
systematic risk and the non-diversifiable nature of bond defaults.

Using Equity Prices to Estimate Default Probabilities

  Merton's model treats a company’s equity as an option on its assets, where default
occurs if assets fall below debt obligations.
 The Black–Scholes–Merton formula is used to value the equity as a call option,
allowing the estimation of asset value and volatility.
 Equations (24.3) and (24.4) provide simultaneous equations that can be solved for
asset value (V0) and asset volatility (σV).

Credit Risk in Derivatives Transactions

 Credit risk in bilaterally cleared derivatives is governed by ISDA Master Agreements,

defining default events.
 CVA (Credit Valuation Adjustment) is the present value of the expected cost to a
bank from a counterparty's default, while DVA (Debt Valuation Adjustment) is the
cost to the counterparty from the bank's default.
 CVA and DVA are estimated by dividing the time to the longest derivative into
subintervals and calculating the probability and impact of default in each.

Credit Derivatives

 Credit derivatives enable trading of credit risks, allowing financial institutions to

manage their credit portfolios.
 Credit derivatives are categorized as single-name (e.g., credit default swaps) or multi-
name (e.g., collateralized debt obligations).
 The chapter focuses on credit default swaps (CDS), credit indices, basket credit
default swaps, asset-backed securities (ABS), and collateralized debt obligations
(CDOs).

Credit Default Swaps

 A credit default swap (CDS) provides insurance against the risk of default by a
reference entity.
 The buyer of protection makes periodic payments to the seller until the end of the
CDS or a credit event.
  If a credit event occurs, the seller of protection compensates the buyer, typically
through cash settlement based on an auction process to determine the value of the
cheapest deliverable bond.

The Use of Fixed Coupons

 The precise way in which CDS and CDS index transactions work involves the
specification of a coupon and a recovery rate for each underlying and each maturity.
 A price is calculated from the quoted spread using an implied hazard rate, a "duration"
D for the CDS payments, and the formula P = 100 - 100 * D * (s - c), where s is the
spread and c is the coupon.
 When a trader buys protection, they pay 100 - P per $100 of the total remaining
notional, and the seller of protection receives this amount.

Credit Value at Risk

 Credit VaR estimates potential credit losses that are unlikely to be exceeded over a
specific time horizon at a given confidence level.
 The Gaussian copula model is used to assess credit VaR, with losses modeled based
on a common factor affecting defaults.
 The estimated credit VaR is calculated using loan portfolio size, recovery rate, and
worst-case default rate derived from the copula model.

Questions

What are the crucial differences between risk-neutral and real-world probabilities of
default?

The critical differences between risk-neutral and real-world probabilities of default revolve
around their definitions, applications, and implications:

1. Definitions:

 Risk-Neutral Probabilities: These probabilities are derived from market prices of

bonds or credit derivatives and reflect the likelihood of default in a hypothetical
 scenario where investors are indifferent to risk. They usually lead to higher estimates
of default probabilities because they incorporate a risk premium that investors
demand for bearing credit risk,
 Real-World Probabilities: These probabilities are based on historical data and actual
default experiences. They represent the empirical likelihood of defaulting within a
given timeframe and are used in scenario analyses and stress testing,

2. Applications:

 Risk-Neutral Default Probabilities: Primarily used for pricing credit-sensitive

instruments such as derivatives. When calculating the present value of expected future
cash flows, risk-neutral methods assume that investors’ expectations are aligned with
market pricing,
 Real-World Default Probabilities: Utilized for risk assessment, scenario analysis,
and calculating credit value at risk (VaR). These probabilities are essential for
evaluating the actual risk exposure and potential losses associated with credit events,

3. Magnitude:

 Risk-neutral probabilities of default are often significantly higher than real-world

probabilities. This discrepancy arises due to differences in investor behaviour, market
conditions, and the effects of liquidity constraints,

4. Underlying Assumptions:

 The risk-neutral framework assumes that all investors have the same expectations
about future cash flows, focusing purely on returns while neglecting risk attitudes.
Conversely, real-world probabilities account for diverse investor behaviour and the
actual economic environment that influences default risk,

In summary, while risk-neutral probabilities are concerned with pricing and financial
markets, real-world probabilities focus on actual historical data and risk assessments. Risk-
neutral probabilities tend to be higher due to the inclusion of a risk premium in financial
markets compared to the more conservative real-world estimations derived from historical
experience.
How do rating agencies influence investment decisions related to credit risk?

Rating agencies influence investment decisions related to credit risk in several significant
ways:

1. Credit Ratings:

 Rating agencies, such as Moody's, S&P, and Fitch, assign credit ratings that assess the
creditworthiness of borrowers, particularly in bond markets. These ratings range from
high-quality categories (like AAA) to low-quality (like C), indicating the likelihood of
default. Investors rely on these ratings to make informed decisions about which
securities to invest in, as higher-rated bonds are often considered safer investments.

2. Investment Guidelines:

 Many institutional investors and funds, including pension funds, insurance companies,
and mutual funds, have investment mandates that restrict them to holding only certain
grades of investments. For example, they may be required to invest only in bonds
rated Baa or higher (investment grade). Consequently, ratings heavily influence which
securities these investors can buy or sell.

3. Risk Assessment:

 Ratings provide a standardized measure of credit risk, making it easier for investors to
assess and compare the risk profiles of different issuers and securities. This
standardization helps in the portfolio construction process, where investors seek to
balance risk and return.

4. Market Reactions:

 Changes in ratings (e.g., upgrades or downgrades) can lead to immediate market

reactions. When a rating agency downgraded a bond, for instance, it often results in a
drop in the bond's price and yields, affecting the overall market perception of the
issuer and leading to a reassessment of its credit risk.
 5. Pricing of Securities:

 The rating assigned to a bond influences its yield spread over government securities
(risk-free rates). Higher-rated bonds generally offer lower yields because they are
perceived as lower risk, whereas lower-rated bonds must offer higher yields to attract
investors. This relationship affects the cost of borrowing for issuers, influencing their
decisions related to issuing new debt,

6. Regulatory Impact:

 Rating agencies can also have an indirect influence through regulatory requirements
that reference their ratings. For example, capital requirements for banks and insurance
underwriting are often tied to the credit ratings assigned to the securities they hold,
which in turn impacts their investment approaches.

In summary, rating agencies play a crucial role in shaping investor behaviour, market
dynamics, and the overall cost of capital. Their ratings provide essential information that
guides investment strategies and risk assessments across various sectors of financial markets.

Securitization and the Financial Crisis of 2007–8

 Securitization transfers risk by creating securities from loans. It played a significant

role in the 2007-2008 financial crisis.
 Banks initially used securitization to meet mortgage demand, later applying it to
assets like auto loans and credit card receivables.
 ABS CDOs were created from mezzanine tranches of ABSs and these are riskier.

8.1 Securitization

 Traditionally, banks have funded their loans primarily from deposits.

 In the 1960s, U.S. banks found that they could not keep pace with the demand for
residential mortgages with this type of funding.
 These organizations bought portfolios of mortgages from the originating banks and
packaged them as securities that were sold to investors.
ABSs

 A securitization arrangement of the type used during the 2000 to 2007 period (with no
guarantees against default) is known as an asset-backed security or ABS.
 Figure 8.1 is simpler than the structures that were typically created because it has only
three tranches (in practice, many more tranches were used).
 The general way a waterfall works is illustrated in Figure 8.2.

ABS CDOs

 Finding investors to buy the senior AAA-rated tranches of ABSs was usually not
difficult, because the tranches promised returns that were very attractive when
compared with the return on AAA-rated bonds.
 This led to the creation of ABSs of ABSs.
 The resulting structure is known as an ABS CDO or Mezz ABS CDO.

8.2 The U.S. Housing Market

 In about the year 2000, house prices started to rise much faster than they had in the
previous decade.
 The 2000 to 2006 period was characterized by a huge increase in what is termed
subprime mortgage lending.
 A typical teaser rate was about 6% and the interest rate after the end of the teaser rate
period was typically six-month LIBOR plus 6%.

The Bubble Bursts

 In 2007, many mortgage holders found they could no longer afford their mortgages
when the teaser rates ended.
 One of the features of the U.S. housing market is that mortgages are nonrecourse in
many states.
 If the borrower had negative equity, the optimal decision was to exchange the house
for the outstanding principal on the mortgage.

The Losses
  As foreclosures increased, the losses on mortgages also increased.
 The value of the ABS tranches created from subprime mortgages was monitored by a
series of indices known as ABX.
 Many financial institutions had to be rescued with government funds.

Credit Spreads

 The losses on securities backed by residential mortgages led to a severe financial

crisis.
 The capital of banks had been badly eroded by their losses.
 Credit spreads had increased dramatically.

8.3 What Went Wrong

 Many factors contributed to the crisis that started in 2007.

 There was a tendency to assume that a tranche with a particular rating could be
equated to a bond with the that rating.
 Many of the mortgages were originated by banks and it was banks that were the main
investors in the tranches that were created from the mortgages.

Incentives

 One of the lessons from the crisis is the importance of incentives.

 The process by which mortgages were originated, securitized, and sold to investors
was unfortunately riddled with agency costs. -The rating agencies were paid by the
issuers of the securities they rated and about half their income came from structured
products.

8.4 The Aftermath

 OTC derivatives markets are now largely regulated, with standardized derivatives
cleared through central counterparties.
 Bonuses paid by banks have come under more scrutiny.
 The Dodd–Frank Act in the United States and similar legislation in the United
Kingdom and European Union provide for more oversight of financial institutions and
include much new legislation affecting financial institutions.