Equity-Based Insurance Guarantees Conference

November 14-15, 2011

Chicago, IL




The Risk-Neutral World

Paul Staneski










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The Risk-Neutral World The Risk-Neutral World
The meaning of risk-neutral valuation and
what it says about risk-neutral scenarios.
P l G St ki Ph D Paul G. Staneski, Ph.D.
Managing Director, Credit Suisse
Chicago, November 14, 2011 (1500 Hrs 1545 Hrs)
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Q ti f SOA M b Question from SOA Member
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Q ti Question
The 3m 185 Call on IBM is priced at $9 Is this The 3m 185 Call on IBM is priced at $9. Is this
A. The risk-neutral price?
B The real world (risk averse) price? B. The real-world (risk-averse) price?
C. Huh? I thought this was a wine-tasting event!
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B t d th B t Beauty and the Beast
The risk-neutral valuation argument for derivatives is The risk neutral valuation argument for derivatives is
both a beautiful and powerful result.
That said its sheer brilliance (like that of the Sun) blinds That said, its sheer brilliance (like that of the Sun) blinds
us to some deeper truths and beauty (like the Suns
Corona).
and often leads us astray as well!
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St k P Stock Process
A stock is priced at 90 and in one year will be either 120 A stock is priced at 90 and in one year will be either 120
or 80, with probabilities p = 70% and 30%, respectively.
120
70%
90
80
30%
Assume interest rates and dividends are both zero.
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O ti P Option Process
Consider the 100 Call option on this stock. We know Consider the 100 Call option on this stock. We know
what this option can be worth in one year
20 (value of 100C if S = 120)
70%
100C
0 (value of 100C if S = 80)
30%
$64k Question: What is the 100C worth today?
0 (value of 100C if S = 80)
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Wh t h d b t thi ? Whats so hard about this?
In one year the 100C has In one year, the 100C has
A 70% chance of being worth 20, and
A 30% chance of being worth 0, so
Expected Value of 100C in one year = 0.70*20 = 14.
Given a positive interest rate, the call value would equal the present
value of 14.
Prior to 1973 or so, the prevailing wisdom was that this
was the correct price! (see Boness [1964] and Samuelson [1965])
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L t t d Lets trade
Ill sell you the 100C for 10 I ll sell you the 100C for 10.
Do you want to buy it?
Of course you do Im selling it cheap !
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M P tf li My Portfolio
I sell you the 100C for 10 and I sell you the 100C for 10, and
I buy share of the stock (cost = 45).
I am short the call and long share of stock.
My net outlay is 35 My net outlay is 35.
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I O Y In One Year
If S = 120 If S 120
I owe you 20 for the option
My share of stock is worth 60
If S 80
Net: my portfolio is worth 40
If S = 80
The option is worthless
My share of stock is worth 40
Net: my portfolio is worth 40
I make 5 no matter what happens!
I spent 35 to get a guaranteed 40.
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O ti V l Option Value
What do you think the option is really worth? What do you think the option is really worth?
Remember, long share of stock (cost = 45) and short
option is worth 40 at expiration option is worth 40 at expiration
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N A bit P i No-Arbitrage Price
The arbitrage-free price of the option is 5 The arbitrage free price of the option is 5.
If I can sell the option for more than 5, I can make the
difference by hedging with a long position in share. difference by hedging with a long position in share.
If I can buy the option for less than 5, I can make the
difference by hedging with a short position in share. difference by hedging with a short position in share.
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Ri k F P tf li Risk-Free Portfolio
A portfolio that is short the option and long share of A portfolio that is short the option and long share of
stock is certain to be worth 40 at expiration
60 20 = 40
Value of portfolio today = 45 C
40 0 40
The value today must = 40 45 C = 40 C = 5.
40 0 = 40
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Wh did th f ? Where did the come from?
Want some fraction of stock k such that Want some fraction of stock k such that
120k 20
90k C
80k
Want these to be equal
120k 20 = 80k k =
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G l C General Case
If stock can go to S
+
or S

and the option to C

+
or C

If stock can go to S or S and the option to C or C

+
+

=
S S
C C
k
What do we usually call k?
+
S S
y
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T A i Ob ti Two Amazing Observations
1 We arrived at the 5 call value without using the 70% 1. We arrived at the 5 call value without using the 70%
probability; in fact, we get 5 regardless of the probability
p that stock goes up!
That is the expected growth rate of the stock is immaterial to the value That is, the expected growth rate of the stock is immaterial to the value
of the option.
2 We also made no appeal to (or use of) the risk 2. We also made no appeal to (or use of) the risk
preferences of the investor.
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Bl k S h l i N t h ll Black-Scholes in a Nutshell
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Wh t t id ! What a great idea!
Ed Thorp (b 1932 Ph D mathematician gambler and Ed Thorp (b. 1932, Ph.D. mathematician, gambler, and
hedge fund manager extraordinaire) first derived this
hedging result in the mid 60s.
See Beat the Market by Thorp & Kassouf (1967)
Read Fortunes Formula by William Poundstone.
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BSM BSM
Robert Merton Fischer Black and Myron Scholes Robert Merton, Fischer Black, and Myron Scholes
derived the call value in the early 70s.
Explicitly made the risk-free rate the appropriate discount rate.
Did not fully appreciate the hedging arguments embedded in their Did not fully appreciate the hedging arguments embedded in their
mathematical result.
Fischer Black and Myron Scholes, The Pricing of Options and Corporate
Liabilities, Journal of Political Economy, 81, (May-June 1973), pp. 637-
659. 659.
Scholes and Merton win 1997 Nobel Prize in Economics (Black died in
1995).
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O ti L d St k Option = Levered Stock (and vice versa)
Consider starting with $45 Consider starting with $45
Buy Share Stock or Buy Option & Invest 40
60 (20 + 40)
45
60 ( of 120)
45
60 (20 + 40)
40 ( of 80)
40 (0 + 40)
Same!!
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Sh R ti Sharpe Ratio
Since the option is just levered stock it must have the Since the option is just levered stock it must have the
same Sharpe Ratio as the stock
Return
Capital Market Line
Slope = Sharpe Ratio p p
(aka Market Price of Risk)

Stock
Option
Volatility
rfr
Stock
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Sh R ti O ti V l Sharpe Ratio Option Value
It is simple enough to solve for the value of the option It is simple enough to solve for the value of the option
that has the same Sharpe Ratio as the stock.
In our example, the Sharpe Ratio of the stock is 0.98.
This implies the 100C must be worth 5.
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R t Returns
+300% ( = 20/5 1)
70%
+33% ( = 120/90 1)
70%
Option = 5
100%
30%
Stock = 90
11%( = 80/90 1)
30%
100% 11% ( = 80/90 1)
Expected Return = 20% Expected Return = 180%
Volatility = 20 37% Volatility = 183 30% Volatility 20.37% Volatility 183.30%
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E l Pi t d Example Pictured
Return
180%
Sharpe Ratio = 0.98
Note: the option return
and volatility are calculated
9:1
20%
y
using the 70% and 30%
real-world probabilities!
Volatility
20.37% 183.30%
rfr = 0
9:1
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Diff t P b biliti Different Probabilities
What if the probabilities were 60% and 40% (instead of What if the probabilities were 60% and 40% (instead of
70 and 30)
120
60%
90
60%
40%
80
0%
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60/40 60/40
Return
140%
Sharpe Ratio = 0.71
Note: the option return
and volatility are calculated
9:1
15.6%
y
using the 60% and 40%.
Volatility
21.77% 195.96%
rfr = 0
9:1
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M W ld Many Worlds
The aforementioned result is true regardless of the slope The aforementioned result is true regardless of the slope
of the CML even if it is flat
Return

Each line is associated

Each line is associated

with a unique p (prob.
of stock going up). The
option is worth 5 in all cases.
Volatility
rfr

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I li ti Implication
Since we know the risk-free rate (rfr) we can find p that Since we know the risk free rate (rfr), we can find p that
makes the stock have this expected return
p) (1 1
80
p 1
120
rfr
(

+
(

= Eqn. 1
And use this p to find the value of the option C so it
has the same expected return
p) (
90
p
90
(

Eqn. 1
has the same expected return
p) (1 1
C
0
p 1
C
20
rfr
(

+
(

=
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S l i f Solving for p
Expected return = rfr E(Spot) = Forward p must Expected return rfr E(Spot) Forward p must
also satisfy F = pS
+
+ (1 p)S

80 90 S F

M t d bb d thi th i k t l b bilit i
0.25
80 120
80 90
S S
S F
p =

=
+
Merton dubbed this p the risk-neutral probability since
the stock will have an expected return equal to the risk-
free rate for a risk-neutral investor.
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Ri k N t l P b bilit Risk-Neutral Probability
The risk-neutral probability is just one of an infinite The risk neutral probability is just one of an infinite
number of choices that can be used to value the option.
Its a convenient choice since we can derive it upon p
observing the risk-free rate.
But it also leads to a deeper observation But it also leads to a deeper observation
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Ri k P i Risk Premium
Look at the stock again
90
120
70%
Look at the stock again
90
80
30%
Expected Value = (0.70)(120) + (0.30)(80) = 108
There is an $18 risk premium here.
Pricing the option at 14 is akin to pricing the stock at 108, which would
eliminate the risk premium.
The option must be worth less than 14 to have a positive risk premium!
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P i d P b biliti Prices and Probabilities
Using the risk-neutral probabilities (25/75) yields the Using the risk neutral probabilities (25/75) yields the
prices (90 and 5) to a risk-averse investor.
Using the real probabilities (70/30) yields the prices (108 Using the real probabilities (70/30) yields the prices (108
and 14) to a risk-neutral investor.
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C ti C Continuous Case
All distributions can be used to
value an option.
S
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A th E l Another Example [chosen with a method to the madness!]
Consider the following stock and option Consider the following stock and option
1.25 0
1.11
0.8333
1 Put
0.1667
Again, assume rates and dividends are zero.
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D lt Delta
The delta of the 1 put is The delta of the 1 put is
= (0 0.1667)/(1.25 0.8333) = 0.40
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P t V l Put Value
Risk-free portfolio: Long Put + Long 0 40 Shares Risk free portfolio: Long Put + Long 0.40 Shares
Stock up: (0.40)(1.25) = 0.50 (put worthless)
Stock down: (0.40)(0.8333) + 0.1667 = 0.50
Equal
Put + (0.40)(1.11) = 0.50 Put = 0.50 0.4444 = 0.0556
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Ri k N t l V l ti f P t Risk-Neutral Valuation of Put
Using the risk-neutral probability Using the risk neutral probability
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2
0.8333 1.25
0.8333 1.11
S S
S F
p =

=
+

0
2/3
1 Put
0.1667
1/3
1 Put = (1/3)(0.1667) = 0.0556
(Of course, exactly as before.)
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Th ll t t lik hi k They all taste like chicken
The use of the terms Call and Put is really just a The use of the terms Call and Put is really just a
convenience, rooted in long-held tradition (especially in
equities).
In fact, every call is a put and vice versa: every option is
a contract to exchange two assets at a fixed ratio.
Thi i t b i i FX This is most obvious in FX.
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Th 100C? O th 1 h P t? The 100C? Or the 1-share Put?
The 100C that we valued can thusly be viewed The 100C that we valued can thusly be viewed
You Market
$100
You Market
1s Stock
You are long a call in one currency and long a put in
another currency.
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Whi h i th d l i ? Which is the underlying?
Which is the currency?
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S t P Spot Processes
We can view the underlying process for each currency We can view the underlying process for each currency
as follows
$120 0.8333s
100/120 = 0.8333
$90
$80
1.11 share
1.2500s
100/80 = 1.2500
100/90 = 1.10
Look familiar?
Underlying is 1 share; Underlying is $100;
Worth of 1s in dollars. Worth of $100 in shares.
(i.e., dollars per share) (i.e., shares per $100)
100/80 1.2500
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O ti P (1 Sh P t) Option Process (1 Share Put)
The process for the 1s put (put $100 for 1 share) is The process for the 1s put (put $100 for 1 share) is
0
1s Put
0.1667s
Weve seen this before too!
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D lit Duality
Option trade: Buy 100 Call Option trade: Buy 100 Call
Hedge: Sell (the underlying) stock & buy dollars
Option trade: Buy 1s Put
Same!
Hedge: Buy (the underlying) dollars & sell stock
In each case you are selling (borrowing) stock and y g ( g)
buying (investing) dollars.
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Ri k F P tf li Risk-Free Portfolio
Recall: for the 100C we had: $45 C = $40 Recall: for the 100C we had: $45 C $40.
[value of -share hedge in dollars] [value of call in dollars] = [value of
portfolio in dollars at expiration]
For the one share put we have: 0.4444s + P = 0.50s.
[value of $40 hedge in shares] + [value of put in shares] = [value of
portfolio in shares at expiration]
$40 buys 40/90 = 0.4444s at $90/s today.
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V l f 1 P t Value of 1s Put
Therefore P = 0 50s 0 4444s = 0 0556s Therefore, P 0.50s 0.4444s 0.0556s
The value of this 1s Put is the same as the value of the
100 Call when we do the currency conversion (1 Share 100 Call when we do the currency conversion (1 Share
= $90): (0.0556)($90) = $5.
They are the same option! They are the same option!
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Ri k N t l P b biliti ? Risk-Neutral Probabilities ?
The risk-neutral probability that 1s = $120 was found to The risk neutral probability that 1s $120 was found to
be 1/4.
The risk neutral probability that $100 = 0 8333s was The risk-neutral probability that $100 = 0.8333s was
found to be 1/3.
But these are exactly the same event!
How can this event have 2 different probabilities?
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P b b(ilit) NOT! Probab(ilit)y NOT!
The risk-neutral probability is not a probability at all in The risk neutral probability is not a probability at all, in
the sense that it describes the probability of some event
in the real world.
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U i Ri k N t l P b biliti Using Risk-Neutral Probabilities
Testing techniques and forecasting ability of FX Options Implied Risk Neutral Densities, Oren
Tapiero, European Central Bank, 2004.
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I li d P b biliti Implied Probabilities
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C ti f I f ti Conservation of Information
The very fact that an option is nothing more than a The very fact that an option is nothing more than a
levered position in the underlying belies the belief that
any information about the future probability distribution of
the underlying can be derived from option prices. y g p p
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W B ff t Warren Buffet
Over the past several years Buffet has sold long-dated Over the past several years, Buffet has sold long dated
(usually 15 years, but some out to 2028) at-the-money
spot puts on the S&P 500 and FTSE indexes, taking in
about $4.8 billion in premium. $ p
See p. 19 of his 2010 shareholder letter.
He has argued (again, see his last few letters) that these
puts are too rich since they are valued in the risk-
neutral world and that the expected gains in the indexes
are far greater than the risk-free rate.
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R ll ? Really?
The 90 Put in our example is valued at 7 50 ( = 0 75 x 10) The 90 Put in our example is valued at 7.50 ( 0.75 x 10)
and has a delta of 0.25 ( = 10/40).
Sell 90P Buy 0.25 Shares
7 50
0 (gain of 7.50)
22 50
30 (gain of 7.50)
7.50
10 (loss of 2.50)
22.50
20 (loss of 2.50)
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C t t I f ti Contact Information
P l G St ki Ph D Paul G. Staneski, Ph.D.
Credit Suisse
Managing Director
212 325 2935 212-325-2935
paul.staneski@credit-suisse.com
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