InstitutionalFinance

Lecture10: DynamicArbitragetoReplicate nonlinearPayoffs MarkusK.Brunnermeier

p gBeom Choi Preceptor: Dong

PrincetonUniversity
1

BINOMIALOPTIONPRICING

ConsideraEuropeancalloptionmaturingattimeT with i hstrike ik K: K CT=max(S (STK,0), K 0) nocash hflows fl in i between b Isthereawaytostaticallyreplicatethispayoff?

Notusingjustthe h stock kand drisk kfree f bond b d required dstock k positionchangesforeachperioduntilmaturity(aswewill see) ) Needtodynamicallyhedge comparewithstatichedge suchashedgingaforward,orhedgeusingputcallparity

Replicationstrategydependsonspecifiedrandom processofstockprice needtoknowhowprice evolvesovertime time.Binomial(CoxRubinsteinRoss) modeliscanonical

ASSUMPTIONS

Assumptions:

Stock St kwhich hi hpaysnodividend di id d Overeachperiodoftime,stockpricemovesfromStoeither uS ordS,i.i.d.overtime,sothatfinaldistributionofST is binomial

uS dS S

Supposelengthofperiodishandriskfreerateisgivenby R=erh Noarbitrage:u>R>d Note:simplisticmodel, model butaswewillsee, see withenough periodsbeginstolookmorerealistic

AONEPERIODBINOMIALTREE

Exampleofasingleperiodmodel

S=50,u=2,d=0.5,R=1.25
50

100 25

WhatisvalueofaEuropeancalloptionwithK=50? Optionpayoff:max(STK,0)
50 C=? 0

Usereplicationtoprice

SINGLEPERIODREPLICATION

ConsideralongpositionofinthestockandB dollars d ll in i bond b d Payofffromportfolio:

S+B=50 +B

uS+RB=100 +1.25B dS+RB=25 +1.25B

DefineCu asoptionpayoffinupstateandCd asoption payoffindownstate(Cu=50,Cd=0here) R li i strategymustmatch Replicating hpayoffs: ff Cu=uS+RB Cd=dS+RB

SINGLEPERIODREPLICATION

Solvingtheseequationsyields:
Cu Cd = S (u d ) uCd dCu B= R (u d )

Inprevious I i example, l =2/3 2/3and dB B=13.33, 13 33 sothe h optionvalueis

C = S S+B B = 20

Interpretationof:sensitivityofcallpricetoa change g inthestockprice. p Equivalently, q y,tellsy youhow tohedgeriskofoption

Tohedgealongpositionincall,shortsharesofstock

RISKNEUTRALPROBABILITIES

SubstitutingandBfromintoformulaforC,
C= Cu Cd uC dCu S+ d S (u d ) R (u d )

1 R d uR Cu + = Cd ud R ud

Definep=(Rd)/(ud), d) notethat1p=(uR)/(ud), d) so
C= 1 [ pCu + (1 p )Cd ] R

Interpretationofp:probabilitythestockgoestouS in worldwhereeveryoneisriskneutral

RISKNEUTRALPROBABILITIES

Notethatpistheprobabilitythatwouldjustifythe currentstockpriceSinariskneutralworld: 1 S = [q quS + (1 q)dS ] R Rd =p q= ud Noarbitragerequiresu>R>dasclaimedbefore Note:didntneedtoknowanythingaboutthe objectiveprobabilityofstockgoingupordown(P measure).Justneedamodelofstockpricesto constructQmeasureandpricetheoption.

THEBINOMIALFORMULAINAGRAPH

TWOPERIODBINOMIALTREE

Concatenationofsingleperiodtrees:
u2S uS S dS d2S udS

TWOPERIODBINOMIALTREE

Example:S=50,u=2,d=0.5,R=1.25
200 100 50 25 12 5 12.5 50

Optionpayoff:
Cu C Cd

150 0

TWOPERIODBINOMIALTREE

Topricetheoption,workbackwardsfromfinalperiod.
200 100 50 Cu 0 150

Weknowhowtopricethisfrombefore: R d 1.25 0.5 = = 0.5 p= ud 2 0.5 1 Cu = [ pCuu + (1 p )Cud ] = 60 R Threestep pp procedure:

1.Computeriskneutralprobability,p 2.PlugintoformulaforCateachnodetoforprices,goingbackwards fromthefinalnode. 3.PlugintoformulaforandBateachnodeforreplicatingstrategy, goingbackwardsfromthefinalnode..

TWOPERIODBINOMIALTREE

Generalformulasfortwoperiodtree: p=(Rd)/(ud)
Cu=[pCuu+(1-p)Cud]/R u=(Cuu-C Cud)/(u2S-udS) S udS) Bu=Cu- uS

Cuu

C=[pCu+(1-p)Cd]/R =[p2Cuu+2p(1-p)Cud+(1-p)2Cud]/R =(Cu-Cd)/(uS-dS) Cd=[pCud+(1-p)Cdd]/R B=C- S 2S) =(C ( -C ) )/(udS-d ( ) Bd=Cd- dS

d ud dd

Cud

Syntheticoptionrequiresdynamichedging

Cdd

Mustchangetheportfolioasstockpricemoves

ARBITRAGINGAMISPRICEDOPTION

Considera3periodtreewithS=80,K=80, u=1.5,d=0.5,R=1.1 Impliesp=(Rd)/(ud)=0.6 Candynamicallyreplicatethisoptionusing3 periodbinomialtree. tree Costis$34 $34.08 08 Ifthecallissellingfor$36,howtoarbitrage?

Sell llthe h real lcall ll Buythesyntheticcall CS+B=36 34.08=1.92

Whatdoyougetupfront?

ARBITRAGINGAMISPRICEDOPTION

Supposethatoneperiodgoesby(2periodsfrom expiration),andnowS=120.Ifyoucloseyourposition, whatdoyougetinthefollowingscenarios?

Call C llprice i equals l theoretical h i lvalue, l $60 $60.50. 0 Callpriceislessthan60.50 Callpriceismorethan60.50 60 50 Closingthepositionyieldszeroifcallequalstheoretical Ifcallpriceislessthan60.50,closingpositionyieldsmore thanzerosinceitischeapertobuybackcall. Ifcallpriceismorethan60.50,closingoutpositionyieldsa loss!Whatdoyoudo?(Rebalanceandwait.)

Answer:

TOWARDSBLACKSCHOLES

BlackScholes canbeviewedasthelimitofabinomial treewherethenumberofperiodsn goestoinfinity Takeparameters:

u = e

T /n

, d = 1 / u = e

T /n

Where:

n=numberofperiodsintree T=timetoexpiration(e.g.,measuredinyears) =standarddeviationofcontinuouslycompoundedreturn

Alsotake

R = e rT / n

TOWARDSBLACKSCHOLES

1n n! j n j j n j C = p (1 p ) max(0, u d S K ) R j =0 j! ( n j )!

GeneralbinomialformulaforaEuropeancallonnondividend payingstocknperiodsfromexpiration:

Substituteu, u d d,andRandlettingnbeverylarge(handwaving here),getBlackScholes:

C = SN (d1 ) Ke rT N (d 2 )

T d 2 = d1 T

d1 =

[ln(S / K ) + (r +

/ 2 )T

INTERPRETINGBLACKSCHOLES

NotethatinterpretthetradingstrategyundertheBSformulaas

call = N (d1 )

rT Bcall = Ke N (d 2 ) ll

Priceofaputoption:useputcallparityfornondividendpaying stock P = C S + Ke rT

= Ke rT N ( d 2 ) SN ( d1 )

Reminderofparameters

5parameters S =currentstockprice,K =strike,T =timetomaturity,r =annualized continuouslycompoundedriskfreerate,=annualizedstandarddev.of cont.compoundedrateofreturnonunderlying

INTERPRETINGBLACKSCHOLES

Optionhasintrinsicvalue [max(SK,0)]andtimevalue [Cmax(SK,0)]

50 45 40 35 30 25 20 15 10 5 0 0.001 3 6 9 12 15 18 21 24 27 30 33 36 39 42 45 48 51 54 57 60 63 66 69 72 75 78 Time Value Intrinsic Value

DELTA

Recallthatisthesensitivityofoptionpricetoasmallchangein thestockprice

Numberofsharesneededtomakeasyntheticcall Alsomeasuresriskinessofanoptionposition

Fromtheformulaforacall,

call = N (d1 )

Bcall = Ke rT N (d 2 )

Acallalwayshasdeltabetween0and1. Similarexercise:deltaofaputisbetween1and0. D l of Delta fastock: k 1. 1 D Delta l of fabond: b d 0. 0 Deltaofaportfolio: portfolio = N i i

DELTAHEDGING

Aportfolioisdeltaneutral if

portfolio = N i i = 0

Deltaneutralportfoliosareofinterestbecausetheyareawayto hedgeouttheriskofanoption(orportfolioofoptions) Example:supposeyouwrite1Europeancallwhosedeltais0.61. 0 61 Howcanyoutradetobedeltaneutral?

nc call ll + ns S = 1(0.61) + ns (1) = 0

Soweneedtohold0.61sharesofthestock. Deltahedgingmakesyoudirectionallyneutral ontheposition.

FINALNOTESONBLACKSCHOLES

Deltahedgingisnotaperfecthedgeifyoudonottrade continuously

Deltahedgingisalinearapproximationtotheoptionvalue Butconvexityimpliessecondorderderivativesmatter Hedgeismoreeffectiveforsmallerpricechanges

DeltaGammahedgingreducesthebasisriskofthehedge. BSmodelassumesthatvolatilityisconstantovertime. time Thisisa badassumption

Volatilitysmile BSunderprices outofthemoneyputs(andthusinthemoneycalls) BSoverpricesoutofthemoneycalls(andthusinthemoneyputs) Waysforward:stochasticvolatility

Otherissues:stochastic h interestrates,bid b dask ktransaction

costs,etc.

COLLATERALDEBTOBLIGATIONS(CDO)

CollateralizedDebtObligation g repackage p g cash flowsfromasetofassets Tranches:Seniortrancheisp paidoutfirst, , Mezzaninesecond,juniortrancheispaidoutlast Canadapt p option p pricing p gtheory, y,usefulinp pricing g CDOs:

Tranchescanbepricedusinganaloguesfromoption pricingformulas Estimateimplieddefaultcorrelationsthatpricethe tranchescorrectly correctl