Mathematical Finance Model Modeling and Risk Analysis

Dnyanesh Deshpande Under the guidance of Dr. Anil Kumar J anuary- April 2009

MATHEMATICAL FINANCE MODELING

AND RISK ANALYSIS
By DNYANESH DESHPANDE (2005A4PS16 2G)

Prepared in the partial fulfillment of Study Oriented Project (BITSC 323)

BIRLA INSTITUE OF TECHNOLOGY AND SCIENCE, PILANI GOA CAMPUS

(April 2009)

ACKNOWLEDGMENT
My sincere regards for Dr . A nil Kumar , without whose support and enthusiasm throughout the semester, I could not have completed this project.

My special thanks to Paul Wilmott whose books aroused my interest in the field of finance which culminated in my project.

Contents
1 Derivatives : An introduction.
1.1 1.2 1.3 Denitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Random Behaviour of assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Time Value of Money. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.3.0.1 1.3.0.2 1.4 1.4.1 1.4.2

4
4 5 5 5 6 7 7 7 8 8 8 8 8 8 9

Simple Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Compound interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Derivatives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.4.1.1 1.4.2.1 1.4.2.2 1.4.2.3

Concept of No Arbitrage

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Commodity futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Forex Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Index Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1.5

Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.5.1 1.5.2 1.5.3 1.5.4 1.5.5 1.5.6 European Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . European Put option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Pay-o diagrams of Call and Put options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Writing an option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Value of option before expiry. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 American options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

1.6 1.7

Put-Call parity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Option Strategies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 1.7.1 1.7.2 1.7.3 1.7.4 1.7.5 1.7.6 Bull Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Bear spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Straddle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Strangle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Buttery Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Condor Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

1.8

Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

2 Binomial Model for Option Pricing.

2.1 2.2 2.3 2.4 2.5

21

Assumptions of basic binomial model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Value of the option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 How did I know to short 1/2 of asset for hedging? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 What happens when rate of interest is not zero? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 Risk Neutral World . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 2.5.1 2.5.2 2.5.3 How to calculate Risk Neutral Probability? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Two wrongs make a right ! . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Non-Zero Interest rates in Risk Neutral World . . . . . . . . . . . . . . . . . . . . . . . . . . 26

2.6 2.7

Valuing options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 Constructing the binomial tree. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 2.7.1 2.7.2 2.7.3 Asset tree. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 Option Pay-o tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 Option Price Tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Binomial Tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Asset Tree. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Option price tree. 2.8.3.1 2.8.3.2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Call option tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

2.8

Programming the Binomial Model : A MATLAB implementation. . . . . . . . . . . . . . . . . . . . 31 2.8.1 2.8.2 2.8.3

Put option tree . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

2.9

Early Exercise : American Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

3 Fundamentals of Stochastic Processes

3.1 3.2 3.3 3.4

40

Random Behaviour of assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Wiener Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Widely accepted model for equities,currencies and commodities. . . . . . . . . . . . . . . . . . . . . . 41 Elementary Stochastic Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 3.4.1 3.4.2 Markov property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Martingale property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

3.5 3.6

Brownian Motion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 Ito's Lemma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44

4 Black Scholes Model for option pricing

4.1 4.2 4.3 4.4 4.5 4.6

46

A special portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 Elimination of risk : Delta Hedging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 No arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47 The Black-Scholes equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 Assumptions of the Black-Scholes equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 Final conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 2

4.7 4.8 4.9

Options on dividend paying equities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Currency options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Commodity options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 4.10.1 Forward Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 4.10.2 Future contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

4.10 Forwards and futures

5 Numerical Methods in option pricing

5.1 The greeks 5.1.1 5.1.2 5.1.3 5.2 5.2.1 5.2.2 5.2.3 5.2.4 5.3 5.4 5.5

52

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

Delta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 Gamma . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 Theta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 Approximating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Approximating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Approximating . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

Using Grid for dierentiation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53

Final Conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 Programming the nite dierence method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 MATLAB implementation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 5.5.1 5.5.2 European call/Put option. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 American options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

Chapter 1

Derivatives : An introduction.
1.1 Denitions

1)Stock/Share/Equity : It is a small share in the company. It can be converted to cash only by selling or if you own so much stock so as to take over the company and keep the prots for yourself. Other benets of stocks are dividend payments (not obligatory on the company's part to pay the dividends) and a rise in stock value.
Stocks come with 'CUM' & 'EX' tags.

CUM : Stock bought with the 'CUM' tag entitles the buyer to the next dividend payment. EX : Stock with 'EX' tag doesn't pay dividend to the buyer but to the previous owner.
Around the time the dividends are declared there is a date when 'CUM' stock changes to 'EX' stock. That time the stock price drops and for a buyer of 'EX' stock-this osets the loss of dividend. 2. Commodities : They are raw products,whose prices are unpredicatble. They are usually traded by people who have no need of the raw material but are just speculating. They are usually traded in the form of forward or futures contracts. 3. Currencies : Related to foreign exchange rate or FOREX. Some currencies are pegged to others (mostly to the dollar) while others are free to oat. There should be consistency in pricing.

Example 1$=0.5 pound

1pound=100 yen 25yen=1$ Then if i have 10 dollars = 5 pounds = 500 yen = 20 dollars. This is an example of mispricing. This doesn't exist in real markets.

1.2

Random Behaviour of assets.

The asset maybe stock,commodity,currency all of them have random behaviour. A very simple way to model random behaviour is by using geometric random walk. Suppose the current value of share price is 100 $. Now I toss a coin.If its heads, I multiply the share price with 1.01. If its tails, I multiply the share price with 0.99. I conduct n such tosses. This results in a geometric random walk. To actually implement this I use EXCEL to generate random numbers using rand() function.I lay the following conditions, If the random number 0.5 then it is considered as a tails. Else it is considered as heads. The result is as shown in the g. (for 1000 coin tosses)

Fig(1) Random Geometric Walk of Asset Price

1.3

Time Value of Money.

There are 3 types of interest oered on money:

1.3.0.1

Simple Interest

Interest is oered on the principal amount only. S.I = (PNR)100 where P= Principal amount
5

N= Period in number of years R= Rate of interest in percentage

1.3.0.2

Compound interest

1)Discretely compounded : Oered at discrete intervals of time e.g. quarterly,yearly etc.

A=P(1 + R/100)n where P= Principal amount A= Amount on maturity R= Compound Rate of interest n= Period in years

2)Continuously compounded : Interest oered continuously.

Suppose I have M(t) amount in my account which gets compounded continuously. After a time interval dt, the amount changes to M(t+dt). By taylor series,

M (t + dt) = M (t) + (dM (t)/dt) dt + ...

Thus the interest recieved in dt time =M (t + dt) M (t) = (dM (t)/dt) dt Also, the interest received at any time is directly propotional to M(t), rate of interest and the time step dt. Therefore,

(dM/dt) dt = r M dt
M(t) dM M (0) dt

t 0

rdt

Log(M (t)/M (0)) = r t M (t) = M (0) ert

Conversely if I know what is the amount in the future M(T) and I want to nd its present value M(t),

M (t) = M (T )er(T t)
This is called the time value of money and is an important concept.

1.4
1.4.1

Derivatives
Forwards

They are contracts agreed upon by individuals. The underlying asset can be any commodity/stock or any such instrument. The price of the contract is so adjusted such that it is 0 when the contract is entered into. No money is transferred till maturity of the forward contract. At the time of maturity the value of the contract becomes Value of forward contract = S(T)-F where S(T) = Spot trading price of the underlying asset. F = Delivery Price agreed upon in the contract.
1.4.1.1

Concept of No Arbitrage

This concept states that if you started with 0 investment then your earning in the future should also be 0. Conversely, if future earning is 0,then present value of investment should also be 0. This concept is useful in pricing of forward / futures derivatives. Consider a forward contract that obliges us to pay F at the time of maturity.Simultaneously I short (sell) the underlying asset.By doing this, I get S(t) amount of money. I deposit this in a bank and get risk free rate of interest 'r'.Thus after a time T,I have S(t)er(T t) in my bank account. At the time of maturity of forward contract, I pay the delivery price F. Thus now, I am left with S(t)er(T t) F amount. Since forward contracts do not need any money investment upfront to enter into and neither does selling the underlying asset, it means I started with zero portfolio. Hence my future earnings should also be zero. Thus,

S(t)er(T t) F = 0 F = S(t)er(T t)
where F = Delivery price agreed in the forward contract. S(t) = spot trading price of underlying when the contract was entered into. t = time when contract was entered into. T= time of maturity of forward contract.

Cash Flow in forward contract portfolio.

Holding Forward Contract Underlying asset Cash Total Worth today (t) 0 S(t) S(t) 0 Worth at maturity (T) S(T ) F S(T ) S(t)er(T t) S(t)er(T t) F 7

1.4.2

Futures

They are similar to Forward contracts the dierence being that they are traded on exchanges (eg NSE,BSE etc). Many rules and regulations govern these contracts and so the default risk is minimum. Parties involved in future contracts are required to maintain money in an account with the exchange (called margin account).
1.4.2.1

Commodity futures

In these contracts the underlying asset is a commodity. Here the buyer has to pay the seller 'storage' cost while the seller has to pay the buyer 'convenience' yield. This results in price adjustment of the value of the futures contract.

F = S(t)e(r+sc)(T t)
where

s = storage cost. c = convenience yield.

1.4.2.2

Forex Futures

Here we have to account for the interest received on the foreign currency (interest rate in the foreign country)

F = S(t)e(rrf )(T t)
where

rf = rate of interest on foreign currency.

1.4.2.3

Index Futures

We have to account for dividend payments.

F = S(t)e(rq)(T t)
where

q = dividend yield

1.5
1.5.1

Options.
European Call Option

It is the right to buy an asset at a pre-determined price at a specied time in the future. Time when we can excercise our option is called expiration date (denoted by T) while agreed price in contract is called strike price (denoted by E).
8

When to exercise call option?

A: When the spot price of the underlying is above the strike price. This way we can buy the asset for a lesser price (E) and sell it for a higher price spot trading price(S). Thus the value of the option at maturity is

V alue = max(S E, 0)
max function shows optionality. If spot price is less than strike price then we do not exercise the call option and the option exercises with zero value.

1.5.2

European Put option

It is the right to sell an asset at a pre-determined price at a specied time in the future.

When to exercise put option?

A: When the spot price of the underlying is below the strike price. This way we can sell the asset for a higher price (E) than the spot trading price(S). Thus the value of the option at maturity is

V alue = max(E S, 0)
For the same expiry date, the higher the strike price the more is the cost of the PUT options and the lesser is the cost of CALL options. This is because at higher strike price, selling is more valuable as compared to buying. With respect to CALL options, the higher the strike price lower is the call option value. The longer it takes to mature,the higher is the call option value. With repect to the time aspect, the call option and put option both prices are both directly proportional to the expriry time. This is because when time to expiry is larger the, asset has more room to move, and thus the price can rise by a signicant amount (protable for call) or price may fall by a signicant amount (protable for put).

1.5.3

Pay-o diagrams of Call and Put options.

Call Pay-o

Fig(2) Call option payo with strike price 45$.

F orS 45, P ayof f = 0. F orS > 45, P ayof f = S E.

After the asset price has crossed E then the pay-o increases linearly with no upper bound. Thus, since the option can have a large pay-o the price of the call option is more than the price of the put option.

10

Put Payo

Fig(3) Put option payo with strike price 45$.

F orS 45, P ayof f = S E. F orS > 45, P ayof f = 0.

1.5.4

Writing an option

Holder of a put/call option has the right to sell/buy when the option is exercised. The writer of the option os obligated to sell (CALL option) or buy (PUT option) when the option holder exercises the option. The holder of the option might sell the option to someone else to close his position.But regardless of who owns the option, who has handled the option, the writer has an obligation to sell/buy the asset when the option is exercised.Since writing options is very risky, margin accounts have to be maintained.

1.5.5

Value of option before expiry.

The value of option before expiry depends on two factors : 1)How high is the asset value today ? 2)How long before contract expires ? The higher the asset price is today, the higher we might expect it to be at the time of expiry and so the more valuable a call option will be.By similar reasoning, the PUT option will be cheaper.
11

If the time for maturity is longer the asset gets more room to move.As a general rule this is considered favorable and thus a longer expiring option is costlier. Value of option is the pay-o we get at maturity whereas price of option is the premium we pay upfront for buying the option. Parameters that determine the price of option are 1)Rate of interest 2)Strike Price 3)Volatility

1.5.6

American options

They are similar to european options with the dierence being that the holder has the right to exercise the option before the time of maturity.

1.6

Put-Call parity

Suppose I buy a call option with strike price E and time to expire as T and simultaneously write a PUT option with same strike price and maturity.At the time of maturity, pay-o from the call option is max(S(T)-E,0) and from put option is -max(E-S(T),0) (-ve sign since we have to buy the asset). Therefore, Total payo = max(S(T)-E,0)-max(E-S(T),0) =S(T)-E

How do I get a similar pay-o?

The rst term in the Right Hand side of the above expression is S(T). I can get this payo by buying the asset at time t and holding it till time T. Whatever might be the value of S(T), the method just described will ensure that I have S(T) pay-o at time T. The second term E can be assured by locking in an amount Ee-r(T-t) at time t.

The conclusion is that the pay-o of a long call and short put is the same as long asset and short cash.
Thus, C(t)-P(t) = S(t)-Ee-r(T-t) ....(1) where,

12

C(t)= Price of Call option at time t P(t)=Price of Put option at time t S(t)=Spot Trading price of asset at time t Cash ow table demonstrating PUT-CALL parity
Holding Call Put Asset Cash Total Value at t C(t) -P(t) -S(t) Ee-r(T-t) C(t)-P(t)-S(t)+Ee-r(T-t) Value at expiry T max(S(T)-E,0) -max(E-S(T),0) -S(T) E 0

Since future cash ow is 0,present cash ow too should be 0 (no-arbitrage argument) C(t)-P(t)=S(t)-Ee-r(T-t)

This relationship holds at any time upto maturity and is called PUT-CALL parity. If
this relationship did not hold then there would be riskless arbitrage oppourtunities.Since European Call and Put options are so common they are also called Vanilla Options. The g below illustrates PUT-CALL parity

Fig(4) Figure showing Put-Call Parity

13

1.7

Option Strategies.

They are the strategies using dierent combinations of options and have dierent kinds of pay-os. They are used under dierent market conditions.

1.7.1

Bull Spread

This option strategy is used to have a binary style pay-o by using vanilla options. It is called a spread because it uses a single kind of option i.e. either a call or a put. If I buy a call option with E1 =50 and time T and write another with E2 =70 and same expiry time T. Then the payo varies as follows : P=0 for S<50, P=max(S-E1 ,0) for 50S<70, P=-max(S-E2 ,0)+max(S-E1 ,0) for S>70
=20 for S>70

This is shown in the gure below

Fig(5) Bull Spread Pay-o Diagram As we can clearly see the pay-o for this option strategy is almost binary style i.e. it is either 0 or 20.

14

1.7.2

Bear spread

If I buy a put option with E1 =70 and time T and write another with E2 =50 and same expiry time T. Then the payo varies as follows : P=-max(E2 -S,0)+max(E1 -S,0) =20 for S<50, P=max(E1 -S,0) for 50S<70, P=0 for S>70 This is shown in the gure below

Fig(6)Bear Spread Pay-o Diagram As we can see the pay-o for this option strategy is similar to Bull Spread just the conditions for pay-os are reversed. This strategy is used in a falling market.

15

1.7.3

Straddle

A call and a put option both with same strike price and date of maturity. Call with E1 =50 and Put with E2 =50. Suppose at time of expiry 1)0S<50 then call option won't be exercised while put option will be exercised. 2)S>50 then call option will be exercised while put option will not be exercised. This is shown in the gure below

Fig(7) Pay-o diagram of Straddle Option Strategy This option strategy is exposed to low risk and the returns may depend on the nal asset price. The returns can be high if the asset price is in the call region and limited if the asset price is in the put region.

16

1.7.4

Strangle

It is similar to straddle the only dierence being the strike price of call and put options used are dierent. Call with E1 =70 and Put with E2 =40. Suppose at time of expiry 1)0S40 then call option won't be exercised while put option will be exercised. 2)40S<70 then both call and put options will not be exercised. 3)S>70 then call option will be exercised while put option will not be exercised. This is shown in the gure below

Fig(8) Pay-o diagram for Strangle Option Strategy The pay-o for this option strategy is the same as that for Straddle option strategy. The only dierence is that there is a at portion where none of the options result in any pay-o. This is a low-risk, dependable return strategy just like strangle option strategy

17

1.7.5

Buttery Spread

You enter this position when you know the asset price is going to be stable.The payo from this strategy is not much but these options are relatively cheap and cheap is good in options. Call options with three dierent strike prices : Long call with strike E1 = 20, 2 short calls with strike prices E2 =40 and 1 long call with strike price E3 =60 At expiry date, 1)0S<20 = None of the options are exercised 2)20S<40 = Call option with E1 is exercised 3)40S<60 = Call options with E1 and E2 are exercised 4)S60 = All Call options are exercised. This is shown in the gure below

Fig(9) Pay-o diagram for Buttery Spread option strategy This strategy will result in a maximum pay-o of 20 (for this example) i.e. the pay-o is limited. As a result, these option spreads are cheaper than vanilla (call/ put) option spreads. Cheap is good in option world !

18

1.7.6

Condor Spread

It is the same as buttery spread the only dierence being the two short calls have dierent strike prices instead of same (as is the case with buttery spread). Call options with four dierent strike prices : Long call with strike E1 = 20, 2 short calls with strike prices E2 =30 and E3 =40 and 1 long call with strike price E3 =50 At expiry date, 1)0S<20 = None of the options are exercised 2)20S<30 = Call option with E1 is exercised 3)30S<40 = Call options with E1 and E2 are exercised 4)40S<50 = Call options with E1 ,E2 ,E3 are exercised
5)S50 = All Call options are exercised.

This is shown in the gure below

Fig(10)Pay-o diagram of Condor spread option strategy These option spreads also give limited pay-o as can be clearly seen (10 in this case). So these option spreads are cheaper too, like buttery spread option strategy.

19

1.8

Overview

These are just few of the various option strategies that are used. They can be summarised as follows:

Strategy Call option Put option Bull spread Bear spread Straddle Strangle Buttery Condor

When to use? (Asset Price) Is going to rise by a large amount Is going to fall by a large amount Is going to rise by a moderate amount Is going to fall by a moderate amount Is going to CHANGE by a large amount.It can rise or fall. Is going to CHANGE by a large amount.It can rise or fall. Is NOT going to CHANGE Is NOT going to CHANGE

Pay-o max(S-E,0) max(E-S,0) 0,E2 -E1 E2 -E1 ,0 E1 -S,S-E1 E1 -S,0,S-E2 0,E2 -E1 ,0 0,E2 -E1 ,0

Return High High Moderate Moderate Depends Depends Low Low

Risk High High Moderate Moderate Low Low Low Low

We now know the basics of options and markets, and a few of the simplest trading strategies. We know some of the nancial terms and the reasons why people might want to buy an option. We've also seen another example of no arbitrage in put-call parity. In the next chapter, we are going to see how much these instruments are worth, how they are aected by the price of the underlying, how much risk is involved in the buying or writing of options.

20

Chapter 2

Binomial Model for Option Pricing.

The most 'accessible' method for option pricing is Binomial Model. This model only requires basic mathematics and no stochastic calculus. This model is a good way for explaning the concepts of delta-hedging, no arbitrage and present value of money.

2.1

Assumptions of basic binomial model.

1)We have a stock (or any asset) and a call option on that stock expiring tomorrow. 2)We know that the stock price will either rise or fall by a known amount between today and tomorrow. i.e. We know the two possible prices of stock tomorrow. 3)Interest rates are zero. The following example illustrates this : The stock is worth 100 $ today and it can rise to 101 $ or 99 $ tomorrow.

What is the price of the stock tomorrow? It is entirely random whether the price is 101$ or 99$ the probability of rising to 101$ is 0.6 and the probability of falling to 99$ is 0.4.

21

Now let us introduce a call option on this stock with strike price 100$ and expiry time of 1 day.

If tomorrow, 1)The stock price rises to 101$ the pay-o will be 101-100=1$. 2)The stock price falls to 99$ the pay-o will be 0. Thus the future expected pay-o is 0.6X1+0.4X0=0.6. This is the expected value of the option in the future and hence its present value too should be the same (0.6).This is WRONG!

2.2

Value of the option.

The correct answer to the value of the option in the above described example is 0.5. How can this be? To see how this happens we must rst make a portfolio that consists of one option and short half of the underlying stock.

This portfolio is shown in the above gure

22

The portfolio thus constructed shows that 1)If the stock price rises to 101$ then value of the portfolio will be 1-1/2(101)=-99/2 2)If the stock price falls to 99$ then value of the portfolio will be 0-1/2(99)=-99/2 Thus whether the stock price rises to 101$ or falls to 99$ our pay-o is xed at -99/2. We have constructed a risk-free portfolio. Since the risk free pay-o tomorrow is -99/2 the present value should also be -99/2. (By no arbitrage argument).Therefore, ?-1/2X100=-99/2 ?=option value today=1/2

Thus the option value does not depend on the probability of asset price rising or falling but on the two actual asset prices (possible) tomorrow.

2.3

How did I know to short 1/2 of asset for hedging?

Suppose I didn't know to use 1/2 of the asset for hedging purposes. Let us assume the quantity to be used as .

As before, 1)If the price rises to 101$ then value of portfolio is 1- X101 2)If the price falls to 99$ then value of portfolio is 0- X99 Since we are constructing a risk-free portfolio both these values should be equal. 1- X101=0- X99 or =1/2

23

This is called 'Delta Hedging'.Delta hedging means choosing such that the future value of the portfolio does not depend on the value of the underlying asset. =Range of option pay-os/Range of asset prices Then we use
?-

to nd the price of option today. XS(T1 ) XS(T2 )

Or

XS(t)=payo1 =payo2 -

2.4

What happens when rate of interest is not zero?

We still construct the same delta hedged portfolio the only dierence being we use a discount factor to scale down the future pay-o to present value. Hence, Value today (r=0)=Value tomorrow (r=0)discount factor

2.5

Risk Neutral World

Risk neutral world concept is used in risk neutral pricing method of options. It is a hypothetical concept that simplies pricing of options. Assumptions of Risk Neutral World : 1)We don't care about risk and don't expect any extra return for taking unnecessary risk. 2)We don't need statistics for estimating probabilities of events happening. 3)We believe everything is priced using simple expectations. Considering same example used before,

24

where p1 and p1' are the risk neutral probabilities. Since they are not found using statistics, and both the events of stock rising and falling are equally likely in risk neutral world, p1=p1'=0.5. Also since we have assumed that all pricing is to be done using expectations, Expected payo=0.51+0.50 Expected payo=option price=0.5 This option price is the same as found out earlier.

2.5.1

How to calculate Risk Neutral Probability?

Since we price everything using expectations (in risk neutral world), 100$ must be the present expected value of the asset. p1101+(1-p1)99=100 p1=0.5

2.5.2

Two wrongs make a right !

1)We calculate the probabilities of asset price rising or falling (risk neutral probabilities) using expectations. We assume that the current asset price is calculated from future asset prices using expectations. (see section 2.5.1). This is WRONG since asset prices cannot be based on expectations.
2)We then use the risk neutral probability to nd the expected pay-o in the future (and thus nd

price of option). This too is WRONG since option price depends on the two (possible) prices tomorrow and not on their probabilities. Thus we calculated the option price using risk neutral method by making two wrong assumptions and still ended up getting the right answer!

25

2.5.3
100

Non-Zero Interest rates in Risk Neutral World

=discount factor[101p1+(1-p1)99] (expectation price) (1)

(asset price today) p1=... ?=discount factor[p11+(1-p1)0]

(2)

2.6

Valuing options

Suppose we have one call option whose current value 'V' is not known.We know the value of the underlying after time-step t adn hence know the value of the option after time step t. 1)V+ if asset rises 2)V- if asset falls. We short of the underlying asset. (if rise) (if fall) Portfolio value at t=V- S Portfolio value at T (i.e.t + t)=V+ -u S =V- - vS Hedging : V+ - uS=V- - vS V+ -V- /(u-v)S= Suppose we denote current value of portfolio as .After T,value will be +d. Since we have delta hedged our portfolio the d amount is assured in the future.This amount should therefore be equal to any risk free interest earned on portfolio value at time 't' over the time-step t.

26

d=rt Value at T=+rt But =V- S

=V-(V+ -V- /u-v)

Also,

+d=(1+rt)=V+ - uS
= V- -

if rise if fall

vS

(V-[V+ -V- /u-v])(1+rt)=V+ -(V+ -V- /u-v)

Solving and manipulating for V.

V=1/(1+rt)[p1V+ +(1-p1)V- ]

This equation has the form, V=discount factor expectation where discount factor = 1/(1+rt) expectation = [p1V+ +(1-p1)V- ] and

p1=1/2 + r t/2
Thus it can be seen that the option value at any time t is the present value of risk neutral expectations at time T in the future. This is where risk neutral probability plays an important role in simplifying option pricing.

2.7

Constructing the binomial tree.

Some formulae are stated without explanation so that the concept of binomial tree does not become cumbersome. u=1 + dt v=1 dt p=1/2 + ( dt)/2 p1=1/2 + (r dt)/2

27

2.7.1

Asset tree.

Knowing the starting price S and u and v we can construct the asset price tree for n number of time-steps. For nding v and u, we need to know the time-step and volatility . Once this is known, the asset price for the next time-step will be uS (rise)or vS(fall) respectively. Thus the entire asset price tree can be traced out. Following is an example of asset tree made with S=100, dt=1/12,r=0.1 and =0.2

2.7.2

Option Pay-o tree Option Payo tree

Asset Prices Tree

28

2.7.3

Option Price Tree

While making the option price tree we rst nd the option pay-o for the last step of the asset tree. As shown above,the option pay-o for the last step is 26.42, 12.44, 0, 0, 0 depending on the node we are looking at. Then, using the two daughter nodes, the parent node can be constructed by using the relation
V=1/(1+rt)[p1V+ +(1-p1)V- ]

where V is the value of the option at the parent node. Asset tree Pay-o at last time step.

29

First Step of option tree

Second Step of option tree

Third Step of option tree

Final Step of option tree

Thus the option price today is 6.13 $.

30

2.8
2.8.1

Programming the Binomial Model : A MATLAB implementation.

Binomial Tree

I have used matrices to implement the binomial model in MATLAB. The nodes are represented by 1's and the rest of the matrix is lled with 0's. A binomial tree with 4 time steps would look something like this :
0 0 0 0 A= 1 0 0 0 0 0 0 0 1 0 1 0 0 0 0 0 1 0 1 0 1 0 0 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1 0 1

where the columns represent the dierent time-steps and the rows represent the rise/fall of asset price. My code for MATLAB implementation of binomial tree is as follows: %function to generate binomial tree for 'n' time steps %usage > A=binomialtree(n) function [A]=binomialtree(n) c=n+1;C=1;r=2*n+1;R=n+1; %variable initialization :c=number of columns, C=column counter r=number of rows, R=row counter,A=empty binomial tree A=zeros(2*n+1,n+1); while C<=c A(R,C)=1; C=C+2; end; R=R+1; C=c; while R<=r A(R,:)=A(R-1,:); C=c; while C>1 A(R,C)=A(R,C-1);
31

%Creating central line of binomial tree matrix

%CREATING LOWER HALF OF BINOMIAL TREE %copying previous row into current row

C=C-1; end; A(R,C)=0; R=R+1; end; R=n+1; C=c; while R>1 A(R-1,:)=A(R,:); C=c; R=R-1; while C>1 A(R,C)=A(R,C-1); C=C-1; end; A(R,C)=0; end; end

%shifting column elements of successive rows by 1 to the right and introducing zeros from left

%CREATING UPPER HALF OF BINOMIAL TREE

The usage for this function is A=binomialtree(n) where n is the number of time steps desired.

and columns. Since a time-step is represented in the matrix by the gap between two columns, the number of columns c=n+1. The nodes at the upper half of the matrix (w.r.t central row) represent the dierent stages of rise of stock prices while the nodes at the lower half of the matrix represent the dierent stages of f all of stock prices. Since there can be n rises and n falls for n number of time-steps, then including the central row, the number of rows = r = n+n+1=2n+1. The central row of the matrix is the starting point. The central row vector is constructed such that it has alternating 1's and 0's starting with a 1. Then the lower half of the matrix is created by copying upper row vectors into the current row and then shifting the entire row vector by 1 place to the right and introducing 0's to the left side. Similarly the upper half of the matrix is created.

Logic : First the input n (number of time-steps) is taken. This input decides the number of rows

2.8.2

Asset Tree.

The asset price tree builds on the binomial tree.Asset tree for the above example would look something like this:

32

0 0 0 0 A= 100 0 0 0 0

0 0 0 126.42 0 0 119.22 0 0 112.44 0 112.44 106.04 0 106.04 0 0 100 0 100 94.31 0 94.31 0 0 88.94 0 88.94 0 0 83.88 0 0 0 0 79.10

My code for the MATLAB implementation of asset-tree is as follows : %This function gives asset price binomial tree. %Inputs are:: S=current stock price,dt=time step,n=number of time steps,X=sigma=volatility. %usage > A=assettreevol(S,dt,n,X); function [A]=assettreevol(S,dt,n,X) u=1+X*sqrt(dt)+(1/2)*(X^2)*(dt); v=1-X*sqrt(dt)-(1/2)*(X^2)*(dt); A=binomialtree(n); c=n+1;C=1;r=2*n+1;R=n+1; while C<=c A(R,C)=S; C=C+2; end; R=R+1; C=c; while R<=r C=c; while C>1 A(R,C)=A(R,C-1); C=C-1; zeros from left end; A(R,C)=0; R=R+1; end; R=n+1; C=c;
33

%Creating central line of asset tree matrix

%CREATING LOWER HALF OF asset TREE %copying previous row into current row with multiplier v.

A(R,:)=A((R-1),:).*v;

%shifting column elements of successive rows by 1 to the right and introducing

while R>1 C=c; R=R-1; while C>1

%CREATING UPPER HALF OF asset TREE

A(R-1,:)=A(R,:).*u;

A(R,C)=A(R,C-1); C=C-1; end; A(R,C)=0; end; end The usage for the function is A = assettreevol(S,dt,n,X) where S=Spot trading price of asset at time t. dt=value of time step. n=number of time steps. X=volatility also denoted by .

such that the values at the nodes are either uSx or vSx where Sx is the asset price at the previous node.

Logic : u,v are calculated using the inputs dt and X. The asset tree builds on the binomial tree

2.8.3

Option price tree.

The option price tree builds on the asset price tree.

2.8.3.1 Call option tree

Call Option price tree for the above example would look something like this:
0 0 0 0 26.42 0 0 0 20.05 0 0 0 14.09 0 12.44 0 9.45 0 6.87 0 0 3, 79 0 0 A= 6.13 0 2.09 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

My code for the MATLAB implementation of call option price tree is as follows :
34

%This function creates call option values from asset tree %Inputs are:: S=current stock price,E=strike price,dt=time step,n=number of time steps,rate=risk free rate of %interest,X=sigma=volatility. %usage > A=calloptiontreevol(S,E,dt,n,rate,X); function [A]=calloptiontreevol(S,E,dt,n,rate,X) p1=1/2+((rate-(1/2)*X^2)*sqrt(dt))/(2*X); A=assettreevol(S,dt,n,X); c=n+1;C=c;r=2*n+1;R=r; discfct=exp(-rate*dt); while R>=1 A(R,C)=max(A(R,C)-E,0); R=R-1; end C=C-1; R=1; while C>0 while R<=r if A(R,C)==0 A(R,C)=A(R,C); else A(R,C)=discfct*(p1*A(R-1,C+1)+(1-p1)*A(R+1,C+1)); end R=R+1; end R=1; C=C-1; end end The usage of the function is A=calloptiontreevol(S,E,dt,n,rate,X) where E=strike price of the option contract. rate=risk free rate of interest %Computing backwards down the tree. %Creating Last Column of option prices tree. %Initializing variables.

35

Logic : First, the last column (representing the nal time-step) is constructed using asset prices
tree and the condition that the option pay-o is max(S-E,0). Then using the nodes of the last column, the nodes of the previous column are created using the relation
V=1/(1+rt)[p1V+ +(1-p1)V- ]

p1 is calculated using the inputs rate,dt,X

2.8.3.2

Put option tree

The put option tree is similar to the call option tree with the dierence being that the pay-o is calculated using the function max(E-S,0). For the above discussed example
0 0 0 0 A= 100 0 0 0 0 0 0 0 126.42 0 0 119.22 0 0 112.44 0 112.44 106.04 0 106.04 0 0 100 0 100 94.31 0 94.31 0 0 88.94 0 88.94 0 0 83.88 0 0 0 0 79.10 0 0 0 0 A= 2.9957 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0.9726 0 0 0 0 2.7125 0 0 5.5126 0 5.0559 0 0 9.7723 0 11.5275 0 0 15.9049 0 0 0 0 21.7261

Asset price tree

Put option tree

My code for the MATLAB implementation of put option price tree is as follows : %This function creates put option values from asset tree %Inputs are:: S=current stock price,E=strike price,dt=time step,n=number of time steps,rate=risk free rate of %interest,X=sigma=volatility. %usage > A=putoptiontreevol(S,E,dt,n,rate,X); function [A]=putoptiontreevol(S,E,dt,n,rate,X) p1=1/2+((rate-(1/2)*X^2)*sqrt(dt))/(2*X); A=assettreevol(S,dt,n,X); c=n+1;C=c;r=2*n+1;R=r; discfct=exp(-rate*dt); while R>=1 if A(R,C)==0 A(R,C)=A(R,C); else
36

A(R,C)=max(E-A(R,C),0); end R=R-1; end C=C-1; R=1; while C>0 while R<=r if A(R,C)==0 A(R,C)=A(R,C); else A(R,C)=discfct*(p1*A(R-1,C+1)+(1-p1)*A(R+1,C+1)); end R=R+1; end R=1; C=C-1; end end

2.9

Early Exercise : American Options.

American options give the holder the right to exercise even before expiry. In the case of european options we were concerned with the option pay-os at the last time-step only to construct the option price tree. This is not the case with American options. In American options, arbitrage is possible when the option pay-o becomes more than option price (more output (pay-o) for less input (price)) at earlier time-steps.In this case you will exercise the option immediately. If the option pay-o doesn't become more than the option price then it is sensible to continue holding the option. In either case, Actual option price = max(pay-o,calculated option price) where Actual option price = the entry we make in american option tree calculated option price = entry at the corresponding node in european option tree. It can be shown that american call options are never exercised before expiry because the pay-o is always option price
37

My MATLAB code for american put options is as follows : %This function creates american put option values from asset tree %Inputs are:: S=current stock price,E=strike price,dt=time step,n=number of time steps,rate=risk free rate of %interest,X=sigma=volatility. %usage > [A,P,B]=americanputoptiontreevol(S,E,dt,n,rate,X) P=put option %payo, B= european put option tree,A=american put option tree. function [A,P,B]=americanputoptiontreevol(S,E,dt,n,rate,X) B=putoptiontreevol(S,E,dt,n,rate,X); P=putoptiontreepayo(S,E,dt,n,X); c=n+1;C=c-1;r=2*n+1;R=1; A=B; discfct=exp(-rate*dt); p1=1/2+((rate-(1/2)*X^2)*sqrt(dt))/(2*X); while C>0 while R<=2*n if A(R,C)==0 A(R,C)=A(R,C); else A(R,C)=discfct*(p1*A(R-1,C+1)+(1-p1)*A(R+1,C+1)); if A(R,C)>P(R,C) A(R,C)=A(R,C); else A(R,C)=P(R,C); end end R=R+1; end R=1; C=C-1; end end

38

The output for this program is

0 0 0 0 A= 100 0 0 0 0 0 0 0 126.42 0 0 119.22 0 0 112.44 0 112.44 106.04 0 106.04 0 0 100 0 100 94.31 0 94.31 0 0 88.94 0 88.94 0 0 83.88 0 0 0 0 79.10

asset tree
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0.9726 0 0 0 0 2.7125 0 0 A= 2.9957 0 5.5126 0 5.0559 0 0 0 9.7723 0 11.5275 0 0 0 15.9049 0 0 0 0 0 21.7261

european put option tree

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1.1427 0 0 0 0 2.6053 0 0 A= 3.4815 0 6.4969 0 5.9402 0 0 11.5275 0 11.5275 0 0 0 16.7829 0 0 0 0 0 21.7261

american put option tree

Thus we see that the american options are higher priced than european options.This is because we have the option of early exercise and we can have a higher pay-o than european options. We have so far seen option pricing using discrete time steps.Continuous time model will be introduced in the coming chapter.

39

Chapter 3

Fundamentals of Stochastic Processes

3.1 Random Behaviour of assets
2

Its convenient to model the random behaviour of assets using Normal Distribution. Probability density function = [1/(2)]*e-1/2

Suppose we believe that the returns on an asset can be approximated using normal distribution then,
1 Rm = M

i=M i=1 Ri

where Rm is the mean of the returns series.

The sample standard deviation is

1 M 1

i=M i=1 (Ri

Rm )2

How does the mean and standard deviation of the returns series depend on the time step between measurement of returns? Lets call the time step t. The mean of the return series scales with the time step i.e. the larger the time step the more the asset will have moved, onaverage. I can write mean = t for some which we assume to be constant. This is the same representing the average return or drift. Ignoring randomness our model is simply S i+1S i =t Si Re-arranging we get, Si+1 =Si (1+t) After M time-steps SM =S0 (1+t)M This is just SM =S0 (1+t)M =S0 eM log(1+t) S0 eM t =S0 e Similarly standard deviation can be derived to be,
40

S.D = t1/2 Thus the asset return series becomes Ri = S i+1S i =t+t1/2 Si This can be re-written as Si+1 -Si =tSi +Si t1/2 (3)

This is the dependence of asset return upon the time step t.

3.2

Wiener Process

Wiener Process is an introduction to continuous time model of random behaviour of assets. We use d to represent change in some quantitity. Thus dS is 'the change in the asset price'. But this change is in continuous time model. Thus we go to the limit t=0. The rst t term in the equation (3) becomes dt but the second t1/2 is more complicated. I cannot straight forward right t1/2 as dt1/2 . I am going to write the term t1/2 as dX .

dX can be thought of as a random variable from a normal distribution with mean 0 and variance dt. Thus the important point to be noted here is that we can build up continuous time theory using Wiener processes instead of normal distribution and discrete time-steps.

3.3

Widely accepted model for equities,currencies and commodities.

Our asset price model using Wiener process can be then written as

dS = Sdt + SdX

.....(4)

This is our rst stochastic dierential equation. Its a continuous time model of asset price. It is the most widely accepted model for equities, currencies, commodities and indices, and the foundation of so much nance theory.

3.4

Elementary Stochastic Properties

Stochastic calculus is very important in the mathematical modeling of nancial processes. This is because of the underlying random nature of nancial markets.

3.4.1

Markov property

Lets consider an example to illustrate our point. Toss a coin. Everytime you throw a head, I give you 1$ and everytime you throw a tail, you give me 1$.If I use Ri to represent the random amount (either +1$ or -1$) you make on the ith toss then we have,
41

E[Ri ]=0.51+0.5(-1)
E[Ri ]=0

where E is the expectation

Similarly E[Ri 2 ]=0.512 +0.5(-1)2

E[Ri 2 ]=1
Since the outcome of the (i+1)th toss is not aected by the previous outcomes, E[Ri Rj ]=0 where Rj is the amount earned on the (i-1)th toss

Introduce Si to mean the total amount you have earned upto and including the ith toss. Then Si =
j=i j=1 Rj

If we now calculate expectations of Si it does matter what information we have. If we calculate the expectations of future events when the experiment has actually begun then, E[Si ]=0 and E[Si 2 ]=i On the other hand,suppose if there have been 5 tosses already, can I use this information and what can be said about the 6th toss? This is the conditional expectation. The expectation of the 6th toss conditional on the previous 5 tosses gives E[S6 |R1 ,R2 ...R5 ]=S5 This is a special result. The value of the random variable Si conditional upon all the past events only depends on the previous value Si-1 . This is the Markov property. This property can be generalized to say that given the information about Sj for some value of 1j<i then the only information useful to us in estimating Si is the value of Sj for the largest j for which we have any information. Almost all the nancial models have the Markov property.

42

3.4.2

Martingale property

The coin tossing experiment has another property which is useful in nance. Suppose you know how much money you have won after the fth toss. Your expected winnings after the sixth toss, and indeed after any number of tosses if we keep playing, is just the amount you already hold. That is, the conditional expectation of your winnings at any time in the future is just the amount you already hold: E[Si |Sj ,j<i]=Sj This is the Martingale property.

3.5

Brownian Motion

Lets change the rules of my coin-tossing experiment. Restrict the time allowed for the six tosses to a period t, so each toss will take a time t/6. Second, the size of the bet will not be $1 but t/6. This new experiment clearly still possesses both the Markov and martingale properties,and its quadratic variation measured over the whole experiment is
j=6 2 j=1 (Sj -Sj-1 ) =6(

t 2 ) =t 6

The experiment is set up such that the quadratic variation is just the time taken for the experiment. Lets change the rules again, to speed up the game. We will have n tosses in the allowed time t, with an amount t/n riding on each throw. Again, the Markov and martingale properties are retained and the quadratic variation is still
j=n 2 j=1 (Sj -Sj-1 ) =n(

t 2 ) =t n

Now make n larger and larger. All I am doing with my rule changes is to speed up the game, decreasing the time between tosses, with a smaller amount for each bet. As we approach the limit n =, the resulting random walk stays nite. It has an expectation, conditional on a starting value of zero, of E[S(t)] = 0 E[S(t)
2

and a variance

] = t.

I use S(t) to denote the amount you have won or the value of the random variable after atime t. The limiting process for this random walk as the time steps go to zero is called Brownian motion, and I will denote it by X(t).

43

The important properties of Brownian motion are as follows.

1)Finiteness: Any other scaling of the bet size or 'increments' with time step would have resulted
in either a random walk going to innity in a nite time, or a limit in which there was no motion at all. It is important that the increment scales with the square root of the time step. 2)Continuity: The paths are continuous, there are no discontinuities. Brownian motion is the continuous-time limit of our discrete time random walk. 3)Markov: The conditional distribution of X(t) given information up until ?< t depends only on X( ). 4)Martingale: Given information up until < t the conditional expectation of X(t)is X( ). 5)Quadratic variation: If we divide up the time 0 to t in a partition with n + 1 partition points ti = it/n then
j=n 2 j=1 (X(ti )-X(ti-1 )) t.

6)Normality: Over nite time increments ti-1 to ti , X(ti ) - X(ti-1 ) is Normally distributed with mean zero and variance ti - ti-1 .

3.6

Ito's Lemma

If F = X2 is it true that dF = 2XdX? No. The ordinary rules of calculus do not generally hold in a stochastic environment. Lets derive an important result in stochastic calculus. In the very small timesacle :
t =h n

the function F(X(t + h)) can be approximated by a Taylor series

dF F(X(t+h))-F(X(t))=(X(t + h) -X(t)) dX (X(t)) +

1 2

d (X(t + h) -X(t))2 dXF (X(t)) +...) 2

From this it follows that (F(X(t + h)) - F(X(t))) + (F(X(t + 2h)) - F(X(t + h))) + ... + (F(X(t + nh))-F(X(t + (n 1)h))) = j=n (X(t + jh)-X(t + (j - 1)h)) j=1 - 1)h))2 + ...
dF dX

(X(t + (j - 1)h)) +

1 d2 F (X(t)) 2 dX 2

j=n j=1 (X(t

+ jh) - X(t + (j

With some manipulation it can be shown that F(X(t)) = F(X(0)) +

t dF 0 dX (X(

))dX( ) + 1 2

t d2 F 0 dX 2 (

(X ))d .

This is the integral version of Ito's lemma which is usually written as

dF dF= dX dX+ 1 2 d2 F dt dX 2

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In the above derivation F was a function depending on X alone. In nancial problems we often have functions of one stochastic variable S and a deter-ministic variable t, time:V(S, t). If dS = a(S, t) dt + b(S, t) dX then the increment dV is given by

dV =

V t

V S

+ 1 b2 V dt 2 S 2

Evaluating b, we get b= S where is the volatility of the asset price. The above equation then becomes,

dV =

V t

V S

+ 1 2 S 2 V dt 2 S 2

(1)

With this knowledge, we can now derive the Black Scholes model for option pricing in continuous time model.

45

Chapter 4

Black Scholes Model for option pricing

In Chapter 1, I described some of the characteristics of options and options markets. I introduced the idea of call and put options. The value of a call option is clearly going to be a function of various parameters in the contract, such as the strike price E and the time to expiry T - t, T is the date of expiry, and t is the current time. The value will also depend on properties of the asset itself, such as its price, its drift and its volatility, as well as the risk-free rate of interest. We can write the option value as V(S, t; ,; E, T; r). Notice that the semi-colons separate dierent types of variables and parameters: 1)S and t are variables; 2) and are parameters associated with the asset price; 3) E and T are parameters associated with the details of the particular contract; 4) r is a parameter associated with the currency in which the asset is quoted.

4.1

A special portfolio

Use to denote the value of a portfolio of one long option position and a short position in some quantity , , of the underlying:

= V(S, t) -S

(4.1)

The rst term on the right is the option and the second term is the short asset position. Notice the minus sign in front of the second term. The quantity will for the moment be some constant quantity of our choosing. We will assume that the underlying follows a Weiner process random walk dS = Sdt + SdX.
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How does the value of the portfolio changes from time t to t + dt? The change in the portfolio value is due partly to the change in the option value and partly to the change in the underlying: d = dV-dS. From Ito's we have

dV =

V t

V S

+ 1 2 S 2 V dt 2 S 2

Thus the portfolio changes by d = V + t

V S

+ 1 2 S 2 V dt-dS 2 S 2

4.2

4.2

Elimination of risk : Delta Hedging

The right-hand side of (4.2) contains two types of terms, the deterministic and the random. The deterministic terms are those with the dt, and the random terms are those with the dS.The random terms in (4.2) are
(
V S

-)dS.

If we choose

= V S

4.3

then the randomness is reduced to zero.Any reduction in randomness is generally termed hedging.

4.3

No arbitrage

After choosing the quantity as suggested above, we hold a portfolio whose value changes by the amount : d =( V + 1 2 S 2 V )dt t 2 S 2
2

4.4

This change is completely riskless. If we have a completely risk-free change d in the portfolio value then it must be the same as the growth we would get if we put the equivalent amount of cash in a risk-free interest-bearing account:
47

d = r dt. This is an example of the no-arbitrage principle.

4.5

4.4

The Black-Scholes equation

If we substitute 4.1,4.3,4.4 in 4.5 we get ( V + 1 2 S 2 V )dt=r(V-S V )dt t 2 S 2 S On dividing by dt and re-arranging we get
V t
2

+ 1 2 S 2 V +rS V -rV=0 2 S 2 S

4.6

This is the Black Scholes equation. It is a linear parabolic partial dierential equation.

4.5

Assumptions of the Black-Scholes equation

1)The underlying asset follows a Weiner process random walk. 2)The risk free interest is a known function of time. 3)There are no dividend payments on the underlying. 4)Delta hedging is done continuously. 5)There are no transaction costs on the underlying. 6)There are no arbitrage opportunities.

4.6

Final conditions

The Black-Scholes equation (4.6) knows nothing about what kind of option we are valuing, whether it is a call or a put, nor what is the strike and the expiry. These points are dealt with by the nal condition. We must specify the option value V as a function of the underlying at the expiry date T. That is, we must prescribe V(S, T), the payo. For example, if we have a call option then we know that V(S,T) = max(S-E,0) Similarly for a put option V(S,T) = max(E-S,0)
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4.7

Options on dividend paying equities

One of the assumptions of the B-S equation derived above was that there is no dividend payment on the underlying asset. This can be accounted for by a simple generalization of the Black-Scholes model. To keep things simple let's assume that the asset receives a continuous and constant dividend yield, D. Thus in a time dt each asset receives an amount DS dt. This must be factored into the derivation of the Black-Scholes equation. I take up the Black-Scholes argument at the point where we are looking at the change in the value of the portfolio : d = V + t
V S

+ 1 2 S 2 V dt-dS-Ddt 2 S 2

The last term on the right-hand side is simply the amount of the dividend per asset, DS dt, multiplied by the number of the asset held, . The is still given by the rate of change of the option value with respect to the underlying, but after some simple substitutions we now get
V t

+ 1 2 S 2 V +(r-D)S V -rV=0 2 S 2 S

4.7

4.8

Currency options

Options on currencies are handled in exactly the same way. In holding the foreign currency we receive interest at the foreign rate of interest rf . This is just like receiving a continuous dividend. We get,
V t

+ 1 2 S 2 V +(r-rf )S V -rV=0 2 S 2 S

4.8

4.9

Commodity options

The relevant feature of commodities requiring that we adjust the Black-Scholes equation is that they have a cost of carry. That is, the storage of commodities is not without cost. Let us introduce q as the fraction of the value of a commodity that goes towards paying the cost of carry. This means that just holding the commodity will result in a gradual loss of wealth even if the commodity price remains xed. To be precise, for each unit of the commodity held an amount qS dt will be required during short time dt to nance the holding. This is just like having a negative dividend and so we get
V t

+ 1 2 S 2 V +(r+q)S V -rV=0 2 S 2 S

4.9

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4.10
4.10.1

Forwards and futures

Forward Contracts

Notation rst. V(S, t) will be the value of the forward contract at any time during its life on the underlying asset S, and maturing at time T.Lets assume that the delivery price is known and nd the forward contracts value.Set up the portfolio of one long forward contract and short of the underlying asset:

= V(S, t) -S.
This changes by an amount d = V + t
V S

+ 1 2 S 2 V dt-dS 2 S 2

from t to t+dt. Choose

= V S
to eliminate risk. By applying the no-arbitrage argument we end up with exactly the Black-Scholes partial dierential equation again. The nal condition for the equation is simply the dierence between the asset price S and the xed delivery price E,say.So : V(S,T)=S-E The solution of the B-S equation with this nal condition is simply
V(S,T)=S-Ee-r(T-t)

This is the forward contract's value during its life.

4.10.2

Future contracts

Use F(S, t) to denote the futures price. Remember that the value of the futures contract during its life is always zero because the change in value is settled daily. This cashow must be taken into account in our analysis. Set up a portfolio of one long futures contract and short of the underlying:

50

 =-S.
Since the future contract has no value during its life it doesn't appear in the portfolio valuation equation. How does the portfolio change in value? d = dF -dS. The dF represents the cashow due to the continual settlement. Applying Ito's lemma d = F + t Choose
F S

+ 1 2 S 2 F dt-dS 2 S 2

= V S
to eliminate risk.Set d = r dt. to get
F t

+ 1 2 S 2 F +rS V =0 2 S 2 S

Observe that there are only three terms in this, it is not the same as the Black-Scholes equation. The nal condition is F(S, T) = S, the futures price and the underlying must have the same value at maturity. The solution is just : F(S, t) = Ser(T-t) We've just seen that the forward price and the futures price are the same when interest rates are constant. They are still the same when rates are known functions of time.The only dierence is when the interest rates are stochastic. This is the Black-Scholes model for option pricing.The partial dierential equations are solved using numerical methods which are discussed in the next chapter.
51

Chapter 5

Numerical Methods in option pricing

Before going into the numerical methods, lets dene some of the important parameters used in option pricing.They are delta,gamma and theta, also called as greeks. The greeks are dened as derivatives of the option value with respect to various variables and parameters.

5.1
5.1.1

The greeks
Delta

The delta of an option or a portfolio of options is the sensitivity of the option or portfolio to the underlying. It is the rate of change of value with respect to the asset :

= V S

5.1.2

Gamma

The gamma, , of an option or a portfolio of options is the second derivative of the position with respect to the underlying :

= V S 2

5.1.3

Theta

Theta, , is the rate of change of the option price with time.

= V t
Thus in the terms of the greeks the B-S equation can be written as

= - 1 2 S2 -rS+rV 2

...(5.1)

If we know the value of all the greeks then we nd the value of V from the above equation.
52

5.2

Using Grid for dierentiation

For nite dierences we use grid or mesh for solving partial dierential equations. The nitedierence grid usually has equal time steps, the time between nodes, and either equal S steps or equal log S steps. A grid used for dierentiation is shown in the gure below.

Fig (11) Equal asset steps and time steps for dierentiation grid Lets introduce some notation. The time-step will be t and the asset step S, both of which are constant. Thus the grid is made up of points at asset values S=i S and times t=T-k t where 0<iI and 0<kK. This means that we will be solving for the asset value going from zero up to the asset value I S. Remembering that the Black-Scholes equation is to be solved for 0S< then I S is our approximation to innity. In practice, this upper bound does not have to be too large. Typically it should be three or four times the value of the exercise price.We can write the option values at each of the grid points as Vi K =V(i S,T-k t)

53

so that the superscript is the time variable and the subscript the asset variable. Suppose that we know the option value V at each of the grid points, can we use this information to nd the derivatives of the option value with respect to S and t? That is, can we nd the terms that go into the Black-Scholes equation?

5.2.1

Approximating

The denition of the rst time derivative is simply

V t

=limh->0 V (S,t+h)V (S,t) h

We can approximate the time derivative from our grid of values using
V t

(S,t)

Vik Vik+1 t

...(5.2)

This is our approximation to the option's theta. It uses the option value at the two points marked in following gure.

Fig (12) Points to be used in calculating Theta

54

5.2.2

Approximating

The same idea can be used for approximating the rst S derivative, the delta. But now we have some choices.
k Vi+1 Vik S k Vik Vi1 S k k Vi+1 Vi1 S

They are called forward dierences,backward dierences and central dierences repectively. We will use central dierences because it is a more accurate method. We use the points marked in the following gure to calculate delta.

Fig(13) Points to be used in calculating delta

5.2.3

Approximating

The gamma of an option is the second derivative of the option with respect to the underlying. The natural approximation for this is
V k 2Vik V k 2V (S,t) i+1 S i1 S 2

The points used for calculation of gamma using grid are shown in the following gure.

55

Fig(14)Points to be used in calculating the value of gamma.

5.2.4

Example

then Theta = Delta =

1213 =-10 0.1 1510 =1.25 22 15212+10 =0.25 22

Gamma =

56

5.3

Final Conditions

A useful boundary condition to apply at S = 0 for most contracts (including calls and puts) is that the diusion and drift terms 'switch o.' This means that on S = 0 the payo is guaranteed, resulting in the condition
V t

(0,t)-rV(0,t)=0

Numerically, this becomes

V0k = (1-r t)V0k1

When the option has a payo that is at most linear in the underlying for large values of S then you can use the upper boundary condition
2V (S,t)0 S 2

as S

Almost all common contracts including Calls and Puts have this property. The nite-dierence representation is
k k VIk =2VI1 -Vi2

5.4

Programming the nite dierence method

We have seen that in the terms of the greeks the B-S equation can be written as
1 = - 2 2 S2 -rS+rV

...(5.1)

Imagine we already know the option value as a function of S, at expiry say.Call this VOld(i). The distance between the asset mesh points is deltaS. We can then calculate the greeks as follows. Delta = (VOld(i + 1) - VOld(i - 1))/(2*deltaS), and Gamma = (VOld(i + 1) - 2*VOld(i) + VOld(i -1))/(deltaS*deltaS). So the B-S equation gives us Theta =-0.5 * vol*vol*(i* deltaS)*(i * deltaS)*Gamma-intrate*(i*deltaS)*Delta + intrate *VOld(i) We can now step back to nd the next value for V at the next time step, call this VNew(i),using VNew(i) = VOld(i) -Theta * deltat.

57

5.5
5.5.1

MATLAB implementation.
European call/Put option.

My MATLAB code for the implementation of the nite dierence method for european call/put is as follows: %This is a function for calculating the value of a european call option %using Black scholes model and nite dierence method. function [V]=bsneuro(Sigma,rate,type,strike,expiration,NAS) S=zeros(NAS+1); dS=2*strike/NAS; NTS=round(expiration/dt)+1; dt=expiration/NTS; V=zeros(NTS+1,NAS+1); for i=1:NAS+1 S(i)=i*dS; end for k=2:NTS+1 for i=2:NAS delta=(V(i+1,k-1)-V(i-1,k-1))/2*dS; gamma=(V(i+1,k-1)-2*V(i,k-1)+V(i-1,k-1))/(dS*dS); V(i,k)=V(i,k-1)-dt*theta; end V(1,k)=V(1,k-1)*(1-rate*dt); V(NAS+1,k)=2*V(NAS,k)-V(NAS-1,k); end end %boundary conditions for S=0 and S=innity %caluclating the greeks theta=0.5*Sigma*Sigma*(i*dS)*(i*dS)*gamma-rate*S(i)*delta+rate*V(i,k-1); %building the asset price array V(i,1)=max(type*(S(i)-strike),0); %to ensure that the expiration is integer steps away. %innity is 2 times the strike price %for stability dt=0.9/(Sigma*Sigma*NAS*NAS);

58

Logic :
1)We have used the approximation that innity is twice the asset price.This is an acceptable approximation. 2)We calculate the asset array using S(i)=idS. 3)The variable type decides whether the option is Call or Put.If Call then type=1 else type=-1. Accordingly, V=max(S-E,0) or V=max(E-S,0). 4)Next we calculate the greeks using the central dierence formulae for delta and gamma. Theta is calculated using the Black-Scholes equation in the greeks form 5)Then the whole Value V array is covered except the end points using the formula, V(i,k)=V(i,k-1)-dt*theta 6)Finally the boundary conditions at S=0 and S=innity are applied to complete the V-array.

5.5.2

American options.

My MATLAB implementation for american call/put is as follows: %This is a function for calculating the value of a european call option %using Black scholes model and nite dierence method. function [V]=bsnamerican(Sigma,rate,type,strike,expiration,NAS) S=zeros(NAS+1); Payo=zeros(NAS+1); dS=2*strike/NAS; NTS=round(expiration/dt)+1; dt=expiration/NTS; V=zeros(NTS+1,NAS+1); for i=1:NAS+1 S(i)=i*dS; Payo(i,:)=V(i,1); end for k=2:NTS+1 for i=2:NAS %asset end points treated dierently %caluclating the greeks delta=(V(i+1,k-1)-V(i-1,k-1))/2*dS; gamma=(V(i+1,k-1)-2*V(i,k-1)+V(i-1,k-1))/(dS*dS); theta=0.5*Sigma*Sigma*(i*dS)*(i*dS)*gamma-rate*S(i)*delta+rate*V(i,k-1);
59

%innity is 2 times the strike price %for stability

dt=0.9/(Sigma*Sigma*NAS*NAS);

%to ensure that the expiration is integer steps away.

%building the asset price array %store the value of pay-o

V(i,1)=max(type*(S(i)-strike),0);

V(i,k)=V(i,k-1)-dt*theta; end V(1,k)=V(1,k-1)*(1-rate*dt); V(NAS+1,k)=2*V(NAS,k)-V(NAS-1,k); for i=1:NAS+1 V(i,k)=max(V(i,k),Payo(i,:); end end end %boundary conditions for S=0 and S=innity

Logic:
The logic for american options is the same as that for european options, the dierence being 1)We introduce a pay-o array to store the option pay-o at each of the grid points. 2)We compare the option value and the pay-o value and choose the greater of these as the new option value. V(i,k)=max(V(i,k),Payo(i,:); This is how options are valued using nite dierences implementation of B-S equation.

60

Conclusion
This project is a study meant as an introduction to the world of nance. Through this project we learnt of the various nancial instruments such as stocks, currencies and commodities. We learnt about simple derivatives such as forward and future contracts and more advanced derivatives namely, Options. We learnt some basic yet very important concepts in nance such as Time Value of Money, No arbitrage, Hedging and Risk Neutral Probability. We saw the payo diagrams of calls and puts and how they vary with the asset price. Then we learnt about the dierent option strategies like bear spread, bull spread, butteries and condors etc and the market scenario in which each of them is implemented. We then started o with some serious nance theory by evaluating forward as well as future contracts as well as options (Call and Put), (European and American). These were implemented using MATLAB code. We learnt about two main models for valuating options before expiry :

1)Binomial model : This model is a discrete time model where Asset price follows a tree-path.
The option value at each parent node depends on the value at the two children-nodes from the future time-step. That is we start o with the expiration time value (pay-o) and scale it down the option tree to present time.

Advantages:The binomial model is great for getting intuition about delta hedging and riskneutral pricing. We also build an approximate model for the various future asset prices starting from the current price S(t).

Disadvantages:The binomial model lacks uniformity. The asset price tree gets skewed as the
volatility increases.As such, it is not the best method for real-life option pricing.

2)Black Scholes Model: This model is a continuous time model where Asset price follows a
Wiener process walk (also called lognormal walk). This model is represented by a parabolic partial dierential equation solved using nite dierences method.

Advantages:This model has uniformity since the grid for the Asset steps and the times steps is
uniform. Since it is continuous time model, it is more appealing to use than the discrete time models.

Disadvantages:This model doesn't account for the very rare occurences possible in the random
behaviour of assets. For example, the current sub-prime crisis can be blamed on this model, because it didn't account for the possibility that the price of real estate could also go down. We learnt numerical methods such as nite dierence grids for solving partial dierence equations. This project was meant to be an introductory course and I'm sure that it has attained its purpose.

61

Bibliography
[1] Paul Wilmott ,Paul Wilmott introduces Quantitative Finance,Wiley Publications,2003 [2] Paolo Brandimarte,Numerical Methods in nance,Prentice Hall ,4th Ed,2000 [3] John C Hull,Options,futures and other Derivatives ,Pearson ,6th Ed,2001 [4] www.quantlib.com [5] www.wilmott.com

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