Currency Options

(2): Hedging and

Valuation
P. Sercu,
International
Finance: Theory into
Practice
Overview

Chapter 9

Currency Options (2):

Hedging and Valuation

Overview
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
Overview

The Binomial Logic: One-period pricing

The Replication Approach
The Hedging Approach
The Risk-adjusted Probabilities
Multiperiod Pricing: Assumptions
Notation
Assumptions
Discussion
Stepwise Multiperiod Binomial Option Pricing
Backward Pricing, Dynamic Hedging
What can go wrong?
American-style Options
Towards Black-Merton-Scholes
STP-ing of European Options
Towards the Black-Merton-Scholes Equation
The Delta of an Option

Overview
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
Overview

The Binomial Logic: One-period pricing

The Replication Approach
The Hedging Approach
The Risk-adjusted Probabilities
Multiperiod Pricing: Assumptions
Notation
Assumptions
Discussion
Stepwise Multiperiod Binomial Option Pricing
Backward Pricing, Dynamic Hedging
What can go wrong?
American-style Options
Towards Black-Merton-Scholes
STP-ing of European Options
Towards the Black-Merton-Scholes Equation
The Delta of an Option

Overview
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
Overview

The Binomial Logic: One-period pricing

The Replication Approach
The Hedging Approach
The Risk-adjusted Probabilities
Multiperiod Pricing: Assumptions
Notation
Assumptions
Discussion
Stepwise Multiperiod Binomial Option Pricing
Backward Pricing, Dynamic Hedging
What can go wrong?
American-style Options
Towards Black-Merton-Scholes
STP-ing of European Options
Towards the Black-Merton-Scholes Equation
The Delta of an Option

Overview
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
Overview

The Binomial Logic: One-period pricing

The Replication Approach
The Hedging Approach
The Risk-adjusted Probabilities
Multiperiod Pricing: Assumptions
Notation
Assumptions
Discussion
Stepwise Multiperiod Binomial Option Pricing
Backward Pricing, Dynamic Hedging
What can go wrong?
American-style Options
Towards Black-Merton-Scholes
STP-ing of European Options
Towards the Black-Merton-Scholes Equation
The Delta of an Option

Binomial ModelsWhat & Why?

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

 Binomial Model
B given St , there only two possible values for St+1 , called up and
down.

 Restrictive?Yes, but ...

The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

B the distribution of the total return, after many of these binomial

price changes, becomes bell-shaped
B the binomial option price converges to the BMS price
B the binomial math is much more accessible than the BMS math
B BinMod can be used to value more complex derivatives that
have no closed-form Black-Scholes type solution.

 Ways to explain the modelall very similar:

in spot market
forward

via hedging

via replication

(not here)

(not here)

yes

yes

Binomial ModelsWhat & Why?

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

 Binomial Model
B given St , there only two possible values for St+1 , called up and
down.

 Restrictive?Yes, but ...

The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

B the distribution of the total return, after many of these binomial

price changes, becomes bell-shaped
B the binomial option price converges to the BMS price
B the binomial math is much more accessible than the BMS math
B BinMod can be used to value more complex derivatives that
have no closed-form Black-Scholes type solution.

 Ways to explain the modelall very similar:

in spot market
forward

via hedging

via replication

(not here)

(not here)

yes

yes

Binomial ModelsWhat & Why?

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

 Binomial Model
B given St , there only two possible values for St+1 , called up and
down.

 Restrictive?Yes, but ...

The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

B the distribution of the total return, after many of these binomial

price changes, becomes bell-shaped
B the binomial option price converges to the BMS price
B the binomial math is much more accessible than the BMS math
B BinMod can be used to value more complex derivatives that
have no closed-form Black-Scholes type solution.

 Ways to explain the modelall very similar:

in spot market
forward

via hedging

via replication

(not here)

(not here)

yes

yes

Outline
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
The Replication Approach
The Hedging Approach
The Risk-adjusted Probabilities

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

The Binomial Logic: One-period pricing

The Replication Approach
The Hedging Approach
The Risk-adjusted Probabilities
Multiperiod Pricing: Assumptions
Notation
Assumptions
Discussion
Stepwise Multiperiod Binomial Option Pricing
Backward Pricing, Dynamic Hedging
What can go wrong?
American-style Options
Towards Black-Merton-Scholes
STP-ing of European Options
Towards the Black-Merton-Scholes Equation
The Delta of an Option

Our Example
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
The Replication Approach

 Data
B S0 =

INR / MTL

100, r = 5%p.p.; r = 3.9604%. Hence:

F0,1 = S0

1 + r0,1
1.05
= 100
= 101.

1 + r0,1
1.039604

B S1 is either S1,u = 110 (up) or S1,d = 95 (down).

B 1-period European-style call with X=INR/MTL 105
C1

The Hedging Approach

The Risk-adjusted Probabilities

S1
110

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

C1
5

100
5
95

S1

95

110

B slope of exposure line (exposure):

exposure =

C1,u C1,d
50
=
= 1/3
S1,i S1,d
110 95
S3,3=S0uuu

S =S uu

exposure
line

Our Example
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
The Replication Approach

 Data
B S0 =

INR / MTL

100, r = 5%p.p.; r = 3.9604%. Hence:

F0,1 = S0

1 + r0,1
1.05
= 100
= 101.

1 + r0,1
1.039604

B S1 is either S1,u = 110 (up) or S1,d = 95 (down).

B 1-period European-style call with X=INR/MTL 105
C1

The Hedging Approach

The Risk-adjusted Probabilities

S1
110

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

C1
5

100
5
95

S1

95

110

B slope of exposure line (exposure):

exposure =

C1,u C1,d
50
=
= 1/3
S1,i S1,d
110 95
S3,3=S0uuu

S =S uu

exposure
line

The Replication Approach

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
The Replication Approach

 Step 1 Replicate the payoff from the call[5 if u] and

[0 if d]:
(a) = forward contract
(buy MTL 1/3 at 101)

(b) = deposit,
V1=20

(a)+(b)

S1 = 95

1/3 ( 95 101) = 2

+2

S1 = 110

1/3 (110 101) = +3

+2

The Hedging Approach

The Risk-adjusted Probabilities

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

 Step 2 Time-0 cost of the replicating portfolio:

B forward contract is free
B deposit will cost

INR

2/1.05 =

INR

1.905

 Step 3 Law of One Price: option price = value

portfolio
C0 =

INR

1.905

The Replication Approach

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
The Replication Approach

 Step 1 Replicate the payoff from the call[5 if u] and

[0 if d]:
(a) = forward contract
(buy MTL 1/3 at 101)

(b) = deposit,
V1=20

(a)+(b)

S1 = 95

1/3 ( 95 101) = 2

+2

S1 = 110

1/3 (110 101) = +3

+2

The Hedging Approach

The Risk-adjusted Probabilities

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

 Step 2 Time-0 cost of the replicating portfolio:

B forward contract is free
B deposit will cost

INR

2/1.05 =

INR

1.905

 Step 3 Law of One Price: option price = value

portfolio
C0 =

INR

1.905

The Replication Approach

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
The Replication Approach

 Step 1 Replicate the payoff from the call[5 if u] and

[0 if d]:
(a) = forward contract
(buy MTL 1/3 at 101)

(b) = deposit,
V1=20

(a)+(b)

S1 = 95

1/3 ( 95 101) = 2

+2

S1 = 110

1/3 (110 101) = +3

+2

The Hedging Approach

The Risk-adjusted Probabilities

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

 Step 2 Time-0 cost of the replicating portfolio:

B forward contract is free
B deposit will cost

INR

2/1.05 =

INR

1.905

 Step 3 Law of One Price: option price = value

portfolio
C0 =

INR

1.905

The Hedging Approach

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

Replication:
Hedging:

 Step 1 Hedge the call

(a) = forward hdege
(sell MTL 1/3 at 101)

The Binomial Logic:

One-period pricing
The Replication Approach
The Hedging Approach
The Risk-adjusted Probabilities

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

call = forward position + riskfree deposit

call forward position = riskfree deposit

(b) = call

(a)+(b)

S1 = 95

1/3 (101 95) =

S1 = 110

1/3 (101 110) = 3

 Step 2 time-0 value of the riskfree portfolio

value =

INR 2/1.05

INR 1.905

 Step 3 Law of one price: option price = value

portfolio
C0 + [time-0 value of hedge] =

INR 1.905

C0 =

INR 1.905

... otherwise there are arbitrage possibilities.

The Hedging Approach

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

Replication:
Hedging:

 Step 1 Hedge the call

(a) = forward hdege
(sell MTL 1/3 at 101)

The Binomial Logic:

One-period pricing
The Replication Approach
The Hedging Approach
The Risk-adjusted Probabilities

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

call = forward position + riskfree deposit

call forward position = riskfree deposit

(b) = call

(a)+(b)

S1 = 95

1/3 (101 95) =

S1 = 110

1/3 (101 110) = 3

 Step 2 time-0 value of the riskfree portfolio

value =

INR 2/1.05

INR 1.905

 Step 3 Law of one price: option price = value

portfolio
C0 + [time-0 value of hedge] =

INR 1.905

C0 =

INR 1.905

... otherwise there are arbitrage possibilities.

The Hedging Approach

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

Replication:
Hedging:

 Step 1 Hedge the call

(a) = forward hdege
(sell MTL 1/3 at 101)

The Binomial Logic:

One-period pricing
The Replication Approach
The Hedging Approach
The Risk-adjusted Probabilities

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

call = forward position + riskfree deposit

call forward position = riskfree deposit

(b) = call

(a)+(b)

S1 = 95

1/3 (101 95) =

S1 = 110

1/3 (101 110) = 3

 Step 2 time-0 value of the riskfree portfolio

value =

INR 2/1.05

INR 1.905

 Step 3 Law of one price: option price = value

portfolio
C0 + [time-0 value of hedge] =

INR 1.905

C0 =

INR 1.905

... otherwise there are arbitrage possibilities.

The Risk-adjusted Probabilities

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
The Replication Approach
The Hedging Approach

 Overview: Implicitly, the replication/hedging story ...

B extracts a risk-adjusted probability up from the forward
market,

The Risk-adjusted Probabilities

Multiperiod Pricing:
Assumptions

B uses this probability to compute the calls risk-adjusted

1 ); and
expected payoff, CEQ0 (C

Stepwise Multiperiod
Binomial Pricing

B discounts this risk-adjusted expectation at the riskfree rate.

Towards
BlackMertonScholes

The Risk-adjusted Probabilities

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
The Replication Approach
The Hedging Approach

 Overview: Implicitly, the replication/hedging story ...

B extracts a risk-adjusted probability up from the forward
market,

The Risk-adjusted Probabilities

Multiperiod Pricing:
Assumptions

B uses this probability to compute the calls risk-adjusted

1 ); and
expected payoff, CEQ0 (C

Stepwise Multiperiod
Binomial Pricing

B discounts this risk-adjusted expectation at the riskfree rate.

Towards
BlackMertonScholes

The Risk-adjusted Probabilities

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
The Replication Approach
The Hedging Approach

 Overview: Implicitly, the replication/hedging story ...

B extracts a risk-adjusted probability up from the forward
market,

The Risk-adjusted Probabilities

Multiperiod Pricing:
Assumptions

B uses this probability to compute the calls risk-adjusted

1 ); and
expected payoff, CEQ0 (C

Stepwise Multiperiod
Binomial Pricing

B discounts this risk-adjusted expectation at the riskfree rate.

Towards
BlackMertonScholes

The Risk-adjusted Probabilities

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
The Replication Approach
The Hedging Approach

 Step 1 Extract risk-adjusted probability from F:

E0 (
S1 ) = p 110 + (1 p) 95
B Risk-adjusted expectation: CEQ0 (
S1 ) = q 110 + (1 q) 95
B Ordinary expectation:

B We do not know how/why the market selects q, but q is

revealed by F0,1 (= 101):
101 = 95 + q (110 95) q =

The Risk-adjusted Probabilities

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing

101 95
6
=
= 0.4
110 95
15

 Step 2 CEQ of the calls payoff:

1 ) = (0.4 5) + (1 0.4) 0 = 2
CEQ0 (C

Towards
BlackMertonScholes

 Step 3 Discount at r:
C0 =

1)
CEQ0 (C
2
=
= 1.905
1 + r0,1
1.05

The Risk-adjusted Probabilities

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
The Replication Approach
The Hedging Approach

 Step 1 Extract risk-adjusted probability from F:

E0 (
S1 ) = p 110 + (1 p) 95
B Risk-adjusted expectation: CEQ0 (
S1 ) = q 110 + (1 q) 95
B Ordinary expectation:

B We do not know how/why the market selects q, but q is

revealed by F0,1 (= 101):
101 = 95 + q (110 95) q =

The Risk-adjusted Probabilities

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing

101 95
6
=
= 0.4
110 95
15

 Step 2 CEQ of the calls payoff:

1 ) = (0.4 5) + (1 0.4) 0 = 2
CEQ0 (C

Towards
BlackMertonScholes

 Step 3 Discount at r:
C0 =

1)
CEQ0 (C
2
=
= 1.905
1 + r0,1
1.05

The Risk-adjusted Probabilities

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
The Replication Approach
The Hedging Approach

 Step 1 Extract risk-adjusted probability from F:

E0 (
S1 ) = p 110 + (1 p) 95
B Risk-adjusted expectation: CEQ0 (
S1 ) = q 110 + (1 q) 95
B Ordinary expectation:

B We do not know how/why the market selects q, but q is

revealed by F0,1 (= 101):
101 = 95 + q (110 95) q =

The Risk-adjusted Probabilities

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing

101 95
6
=
= 0.4
110 95
15

 Step 2 CEQ of the calls payoff:

1 ) = (0.4 5) + (1 0.4) 0 = 2
CEQ0 (C

Towards
BlackMertonScholes

 Step 3 Discount at r:
C0 =

1)
CEQ0 (C
2
=
= 1.905
1 + r0,1
1.05

The Risk-adjusted Probabilities

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
The Replication Approach
The Hedging Approach

 Step 1 Extract risk-adjusted probability from F:

E0 (
S1 ) = p 110 + (1 p) 95
B Risk-adjusted expectation: CEQ0 (
S1 ) = q 110 + (1 q) 95
B Ordinary expectation:

B We do not know how/why the market selects q, but q is

revealed by F0,1 (= 101):
101 = 95 + q (110 95) q =

The Risk-adjusted Probabilities

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing

101 95
6
=
= 0.4
110 95
15

 Step 2 CEQ of the calls payoff:

1 ) = (0.4 5) + (1 0.4) 0 = 2
CEQ0 (C

Towards
BlackMertonScholes

 Step 3 Discount at r:
C0 =

1)
CEQ0 (C
2
=
= 1.905
1 + r0,1
1.05

The Risk-adjusted Probabilities

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
The Replication Approach
The Hedging Approach

 Step 1 Extract risk-adjusted probability from F:

E0 (
S1 ) = p 110 + (1 p) 95
B Risk-adjusted expectation: CEQ0 (
S1 ) = q 110 + (1 q) 95
B Ordinary expectation:

B We do not know how/why the market selects q, but q is

revealed by F0,1 (= 101):
101 = 95 + q (110 95) q =

The Risk-adjusted Probabilities

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing

101 95
6
=
= 0.4
110 95
15

 Step 2 CEQ of the calls payoff:

1 ) = (0.4 5) + (1 0.4) 0 = 2
CEQ0 (C

Towards
BlackMertonScholes

 Step 3 Discount at r:
C0 =

1)
CEQ0 (C
2
=
= 1.905
1 + r0,1
1.05

Outline
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions

The Binomial Logic: One-period pricing

The Replication Approach
The Hedging Approach
The Risk-adjusted Probabilities
Multiperiod Pricing: Assumptions
Notation
Assumptions
Discussion

Notation
Assumptions
Discussion

Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

Stepwise Multiperiod Binomial Option Pricing

Backward Pricing, Dynamic Hedging
What can go wrong?
American-style Options
Towards Black-Merton-Scholes
STP-ing of European Options
Towards the Black-Merton-Scholes Equation
The Delta of an Option

Multiperiod Pricing: Notation

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions

 Subscripts: n,j where

B n says how many jumps have been made since time 0
B j says how many of these jumps were up

 General pricing equation:

Ct,j

where qt

Notation
Assumptions
Discussion

Stepwise Multiperiod
Binomial Pricing

Ct+1,u qt + Ct+1,d (1 qt )
,
1 + rt,1period
Ft,t+1 St+1,d
,
St+1,u St+1,d
1+r

Towards
BlackMertonScholes

=
dt

St 1+rt,t+1
St dt

t,t+1

St ut St dt
1+rt,t+1

1+rt,t+1

dt

ut dt

St+1,d
St+1,u
, ut =
.
St
St

(1)

Multiperiod Pricing: Notation

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions

 Subscripts: n,j where

B n says how many jumps have been made since time 0
B j says how many of these jumps were up

 General pricing equation:

Ct,j

where qt

Notation
Assumptions
Discussion

Stepwise Multiperiod
Binomial Pricing

Ct+1,u qt + Ct+1,d (1 qt )
,
1 + rt,1period
Ft,t+1 St+1,d
,
St+1,u St+1,d
1+r

Towards
BlackMertonScholes

=
dt

St 1+rt,t+1
St dt

t,t+1

St ut St dt
1+rt,t+1

1+rt,t+1

dt

ut dt

St+1,d
St+1,u
, ut =
.
St
St

(1)

Assumptions
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions
Notation
Assumptions
Discussion

 A1 (r and r ) : The risk-free one-period rates of return

on both currencies are constant
B denoted by unsubscripted r and r
B Also assumed in Black-Scholes.

 A2 (u and d) : The multiplicative change factors, u

and d, are constant.
Also assumed in Black-Scholes:
B no jumps (sudden de/revaluations) in the exchange rate process, and
B a constant variance of the period-by-period percentage changes in S.

Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

 Implication of A1-A2: qt is a constant.

 A2.01 (no free lunch in F):
d<

1+r
< u St+1,d < Ft < St+1,u 0 < q < 1
1 + r

Q: what would you do if S1 =[95 or 110] while F=90? 115?

Assumptions
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions
Notation
Assumptions
Discussion

 A1 (r and r ) : The risk-free one-period rates of return

on both currencies are constant
B denoted by unsubscripted r and r
B Also assumed in Black-Scholes.

 A2 (u and d) : The multiplicative change factors, u

and d, are constant.
Also assumed in Black-Scholes:
B no jumps (sudden de/revaluations) in the exchange rate process, and
B a constant variance of the period-by-period percentage changes in S.

Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

 Implication of A1-A2: qt is a constant.

 A2.01 (no free lunch in F):
d<

1+r
< u St+1,d < Ft < St+1,u 0 < q < 1
1 + r

Q: what would you do if S1 =[95 or 110] while F=90? 115?

Assumptions
Currency Options
(2): Hedging and
Valuation
P. Sercu,
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The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions
Notation
Assumptions
Discussion

 A1 (r and r ) : The risk-free one-period rates of return

on both currencies are constant
B denoted by unsubscripted r and r
B Also assumed in Black-Scholes.

 A2 (u and d) : The multiplicative change factors, u

and d, are constant.
Also assumed in Black-Scholes:
B no jumps (sudden de/revaluations) in the exchange rate process, and
B a constant variance of the period-by-period percentage changes in S.

Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

 Implication of A1-A2: qt is a constant.

 A2.01 (no free lunch in F):
d<

1+r
< u St+1,d < Ft < St+1,u 0 < q < 1
1 + r

Q: what would you do if S1 =[95 or 110] while F=90? 115?

Assumptions
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions
Notation
Assumptions
Discussion

 A1 (r and r ) : The risk-free one-period rates of return

on both currencies are constant
B denoted by unsubscripted r and r
B Also assumed in Black-Scholes.

 A2 (u and d) : The multiplicative change factors, u

and d, are constant.
Also assumed in Black-Scholes:
B no jumps (sudden de/revaluations) in the exchange rate process, and
B a constant variance of the period-by-period percentage changes in S.

Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

 Implication of A1-A2: qt is a constant.

 A2.01 (no free lunch in F):
d<

1+r
< u St+1,d < Ft < St+1,u 0 < q < 1
1 + r

Q: what would you do if S1 =[95 or 110] while F=90? 115?

95

How such a tree works

95

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

S3,3=S0uuu
S2,2=S 0uu

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions
Notation
Assumptions
Discussion

Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

S1,1=S0u
S0

S3,2=S0uud
S2,1=S0ud

S1,0 =S0d

S3,1=S0udd
S2,0=S0dd
S3.0=S0 ddd

11

The Emerging Bellshape

Currency Options
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4.4 How to model (near-)impredictable spot rates (1)

4. Time-series properties

let p=1/2

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions
Notation
Assumptions
Discussion

Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

1/2
1
1/2

1/4
2/4
1/4

1/8
3/8
3/8
1/8

1/16 n=4, j=4

C = 4!/4!0! = 1

4/16 n=4, j=3

C = 4!/3!1! = 24/6 = 4

6/16 n=4, j=2

C = 4!/2!2! = 24/6 = 6

4/16 n=4, j=1

C = 4!/1!3! = 24/6 = 4

1/16 n=4, j=0

C = 4!/4!0! = 1

The emerging bell-shape

! lnSN is normal ($S lognormal)

What
Emerging
Why multiplicative?
centsBellshape?
vs percents no zero, negative S inverse of S
Constant u and d: corresponds to constant % in BMS
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

additive two oversimplifications:

multiplicative
 Chosing between
additive

100

110
90

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions
Notation
Assumptions

120
100
80

130
110
90

multiplicative

100

110
90

70

121
99
81

133.1!
108.9
89.1
72.9

cents v percent:

we prefer a constant distribution of percentage price changes over a

constant distribution of dollar price changes.

non-negative prices:

with a multiplicative, the exchange rate can never quite reach zero
even if it happens to go down all the time.

Discussion

Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

invertible:

we get a similar multiplicative process for the exchange rate as viewed abroad,
S = 1/S (with d = 1/u, u = 1/d).

 Corresponding Limiting Distributions:

P
t where
= {+10, 10}
additive:
Sn = S0 + nt=1

Sn is normal if n is large (CLT)

Q
multiplicative:
Sn = S0 nt=1 (1 + rt ) where r = {+10%, -10%}
Pn
ln
Sn = ln S0 + t=1 t where = ln(1 + r) = {+0.095, 0.095}
ln
Sn is normal if n is large
Sn is lognormal.

! lnSN is normal ($S lognormal)

What
Emerging
Why multiplicative?
centsBellshape?
vs percents no zero, negative S inverse of S
Constant u and d: corresponds to constant % in BMS
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

additive two oversimplifications:

multiplicative
 Chosing between
additive

100

110
90

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions
Notation
Assumptions

120
100
80

130
110
90

multiplicative

100

110
90

70

121
99
81

133.1!
108.9
89.1
72.9

cents v percent:

we prefer a constant distribution of percentage price changes over a

constant distribution of dollar price changes.

non-negative prices:

with a multiplicative, the exchange rate can never quite reach zero
even if it happens to go down all the time.

Discussion

Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

invertible:

we get a similar multiplicative process for the exchange rate as viewed abroad,
S = 1/S (with d = 1/u, u = 1/d).

 Corresponding Limiting Distributions:

P
t where
= {+10, 10}
additive:
Sn = S0 + nt=1

Sn is normal if n is large (CLT)

Q
multiplicative:
Sn = S0 nt=1 (1 + rt ) where r = {+10%, -10%}
Pn
ln
Sn = ln S0 + t=1 t where = ln(1 + r) = {+0.095, 0.095}
ln
Sn is normal if n is large
Sn is lognormal.

! lnSN is normal ($S lognormal)

What
Emerging
Why multiplicative?
centsBellshape?
vs percents no zero, negative S inverse of S
Constant u and d: corresponds to constant % in BMS
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

additive two oversimplifications:

multiplicative
 Chosing between
additive

100

110
90

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions
Notation
Assumptions

120
100
80

130
110
90

multiplicative

100

110
90

70

121
99
81

133.1!
108.9
89.1
72.9

cents v percent:

we prefer a constant distribution of percentage price changes over a

constant distribution of dollar price changes.

non-negative prices:

with a multiplicative, the exchange rate can never quite reach zero
even if it happens to go down all the time.

Discussion

Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

invertible:

we get a similar multiplicative process for the exchange rate as viewed abroad,
S = 1/S (with d = 1/u, u = 1/d).

 Corresponding Limiting Distributions:

P
t where
= {+10, 10}
additive:
Sn = S0 + nt=1

Sn is normal if n is large (CLT)

Q
multiplicative:
Sn = S0 nt=1 (1 + rt ) where r = {+10%, -10%}
Pn
ln
Sn = ln S0 + t=1 t where = ln(1 + r) = {+0.095, 0.095}
ln
Sn is normal if n is large
Sn is lognormal.

! lnSN is normal ($S lognormal)

What
Emerging
Why multiplicative?
centsBellshape?
vs percents no zero, negative S inverse of S
Constant u and d: corresponds to constant % in BMS
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

additive two oversimplifications:

multiplicative
 Chosing between
additive

100

110
90

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions
Notation
Assumptions

120
100
80

130
110
90

multiplicative

100

110
90

70

121
99
81

133.1!
108.9
89.1
72.9

cents v percent:

we prefer a constant distribution of percentage price changes over a

constant distribution of dollar price changes.

non-negative prices:

with a multiplicative, the exchange rate can never quite reach zero
even if it happens to go down all the time.

Discussion

Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

invertible:

we get a similar multiplicative process for the exchange rate as viewed abroad,
S = 1/S (with d = 1/u, u = 1/d).

 Corresponding Limiting Distributions:

P
t where
= {+10, 10}
additive:
Sn = S0 + nt=1

Sn is normal if n is large (CLT)

Q
multiplicative:
Sn = S0 nt=1 (1 + rt ) where r = {+10%, -10%}
Pn
ln
Sn = ln S0 + t=1 t where = ln(1 + r) = {+0.095, 0.095}
ln
Sn is normal if n is large
Sn is lognormal.

! lnSN is normal ($S lognormal)

What
Emerging
Why multiplicative?
centsBellshape?
vs percents no zero, negative S inverse of S
Constant u and d: corresponds to constant % in BMS
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

additive two oversimplifications:

multiplicative
 Chosing between
additive

100

110
90

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions
Notation
Assumptions

120
100
80

130
110
90

multiplicative

100

110
90

70

121
99
81

133.1!
108.9
89.1
72.9

cents v percent:

we prefer a constant distribution of percentage price changes over a

constant distribution of dollar price changes.

non-negative prices:

with a multiplicative, the exchange rate can never quite reach zero
even if it happens to go down all the time.

Discussion

Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

invertible:

we get a similar multiplicative process for the exchange rate as viewed abroad,
S = 1/S (with d = 1/u, u = 1/d).

 Corresponding Limiting Distributions:

P
t where
= {+10, 10}
additive:
Sn = S0 + nt=1

Sn is normal if n is large (CLT)

Q
multiplicative:
Sn = S0 nt=1 (1 + rt ) where r = {+10%, -10%}
Pn
ln
Sn = ln S0 + t=1 t where = ln(1 + r) = {+0.095, 0.095}
ln
Sn is normal if n is large
Sn is lognormal.

! lnSN is normal ($S lognormal)

What
Emerging
Why multiplicative?
centsBellshape?
vs percents no zero, negative S inverse of S
Constant u and d: corresponds to constant % in BMS
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

additive two oversimplifications:

multiplicative
 Chosing between
additive

100

110
90

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions
Notation
Assumptions

120
100
80

130
110
90

multiplicative

100

110
90

70

121
99
81

133.1!
108.9
89.1
72.9

cents v percent:

we prefer a constant distribution of percentage price changes over a

constant distribution of dollar price changes.

non-negative prices:

with a multiplicative, the exchange rate can never quite reach zero
even if it happens to go down all the time.

Discussion

Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

invertible:

we get a similar multiplicative process for the exchange rate as viewed abroad,
S = 1/S (with d = 1/u, u = 1/d).

 Corresponding Limiting Distributions:

P
t where
= {+10, 10}
additive:
Sn = S0 + nt=1

Sn is normal if n is large (CLT)

Q
multiplicative:
Sn = S0 nt=1 (1 + rt ) where r = {+10%, -10%}
Pn
ln
Sn = ln S0 + t=1 t where = ln(1 + r) = {+0.095, 0.095}
ln
Sn is normal if n is large
Sn is lognormal.

! lnSN is normal ($S lognormal)

What
Emerging
Why multiplicative?
centsBellshape?
vs percents no zero, negative S inverse of S
Constant u and d: corresponds to constant % in BMS
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

additive two oversimplifications:

multiplicative
 Chosing between
additive

100

110
90

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions
Notation
Assumptions

120
100
80

130
110
90

multiplicative

100

110
90

70

121
99
81

133.1!
108.9
89.1
72.9

cents v percent:

we prefer a constant distribution of percentage price changes over a

constant distribution of dollar price changes.

non-negative prices:

with a multiplicative, the exchange rate can never quite reach zero
even if it happens to go down all the time.

Discussion

Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

invertible:

we get a similar multiplicative process for the exchange rate as viewed abroad,
S = 1/S (with d = 1/u, u = 1/d).

 Corresponding Limiting Distributions:

P
t where
= {+10, 10}
additive:
Sn = S0 + nt=1

Sn is normal if n is large (CLT)

Q
multiplicative:
Sn = S0 nt=1 (1 + rt ) where r = {+10%, -10%}
Pn
ln
Sn = ln S0 + t=1 t where = ln(1 + r) = {+0.095, 0.095}
ln
Sn is normal if n is large
Sn is lognormal.

Outline
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Backward Pricing, Dynamic
Hedging
What can go wrong?
American-style Options

The Binomial Logic: One-period pricing

The Replication Approach
The Hedging Approach
The Risk-adjusted Probabilities
Multiperiod Pricing: Assumptions
Notation
Assumptions
Discussion
Stepwise Multiperiod Binomial Option Pricing
Backward Pricing, Dynamic Hedging
What can go wrong?
American-style Options

Towards
BlackMertonScholes

Towards Black-Merton-Scholes
STP-ing of European Options
Towards the Black-Merton-Scholes Equation
The Delta of an Option

An N-period European Call: The Problem

3.2. binomial pricing of European Options
3. pricing European

Currency Options
(2): Hedging and
Valuation
P. Sercu,
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Finance: Theory into
Practice

payoff
S1,1 = 110

S0 = 100

S1,0 = 90

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Backward Pricing, Dynamic
Hedging

S 2,2 = 121

26

S 2,1 = 99

S2,0 = 81

u = 1.1; d = .9; 1+r = 1.05; 1+r* = 1.0294118;

forward factor

What can go wrong?

1+r
= 1.02
1+r*

q =1.02 0.9 = 0.60

1.1 0.9

American-style Options

Towards
BlackMertonScholes

Call:

[cashflow"at"T"if"j""up"s]"! "[risk-adj"prob"of"j""up"s]
C0 A4.
= At any discrete moment in
(1+r)n the model, investors

canj=0trade and adjust their portfolios of HC-FC loans.

2

26"! "(0.6 )"+"4"!

"0.6"! "0.4)"+"0"! "(0.4
Black-Scholes:
trading is"(2"!
continuous
=

1.052

2)

Backward Pricing, Dynamic Hedging

3.2. binomial pricing of European Options
3. pricing European options

payoff

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions

S1,0 = 90

26

S 2,1 = 99

S2,0 = 81

u = 1.1; d = .9; 1+r = 1.05; 1+r* = 1.0294118;

forward factor
n

1+r
= 1.02
1+r*

q =1.02 0.9 = 0.60

1.1 0.9

[cashflow"at"T"if"j""up"s]"! "[risk-adj"prob"of"j""up"s]

Call:
=!
 if we land
inC node
(1,1): (1+r)n
0

j=0

26"! "(0.62)"+"4"! "(2"! "0.6"! "0.4)"+"0"! "(0.42)

1.052

b1,1

C1,1

P. Sercu and R. Uppal

Stepwise Multiperiod
Binomial Pricing
Backward Pricing, Dynamic
Hedging

S1,1 = 110

S0 = 100

S 2,2 = 121

What can go wrong?

26 4
=1
121 99
(26 0.6) + (4 0.4)
= 16.38
1.05
The International Finance Workbook

page 8.16

American-style Options

Towards
BlackMertonScholes

 if we land in node (1,0):

b1,0

C1,0

40
= .222
99 81
(4 0.6) + (0 0.4)
= 2.29
1.05

Backward Pricing, Dynamic Hedging

3.2. binomial pricing of European Options
3. pricing European options

payoff

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions

S1,0 = 90

26

S 2,1 = 99

S2,0 = 81

u = 1.1; d = .9; 1+r = 1.05; 1+r* = 1.0294118;

forward factor
n

1+r
= 1.02
1+r*

q =1.02 0.9 = 0.60

1.1 0.9

[cashflow"at"T"if"j""up"s]"! "[risk-adj"prob"of"j""up"s]

Call:
=!
 if we land
inC node
(1,1): (1+r)n
0

j=0

26"! "(0.62)"+"4"! "(2"! "0.6"! "0.4)"+"0"! "(0.42)

1.052

b1,1

C1,1

P. Sercu and R. Uppal

Stepwise Multiperiod
Binomial Pricing
Backward Pricing, Dynamic
Hedging

S1,1 = 110

S0 = 100

S 2,2 = 121

What can go wrong?

26 4
=1
121 99
(26 0.6) + (4 0.4)
= 16.38
1.05
The International Finance Workbook

page 8.16

American-style Options

Towards
BlackMertonScholes

 if we land in node (1,0):

b1,0

C1,0

40
= .222
99 81
(4 0.6) + (0 0.4)
= 2.29
1.05

Backward Pricing, Dynamic Hedging

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions

C1 =

16.38
2.29

if S1 = 110
if S1 = 90

 at time 0 we do have a two-point problem:

b0

C1,1

16.38 2.29
= 0.704
110 90
(16.38 0.6) + (2.29 0.4)
= 10.23
1.05

Stepwise Multiperiod
Binomial Pricing
Backward Pricing, Dynamic
Hedging
What can go wrong?

Summary:

American-style Options

Towards
BlackMertonScholes

B we hedge dynamically:
start the hedge at time 0 with 0.704 units sold forward.
The time-1 hedge will be to sell forward 1 or 0.222 units of foreign
currency, depending on whether the rate moves up of down.

B we price backward, step by step

Backward Pricing, Dynamic Hedging

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions

C1 =

16.38
2.29

if S1 = 110
if S1 = 90

 at time 0 we do have a two-point problem:

b0

C1,1

16.38 2.29
= 0.704
110 90
(16.38 0.6) + (2.29 0.4)
= 10.23
1.05

Stepwise Multiperiod
Binomial Pricing
Backward Pricing, Dynamic
Hedging
What can go wrong?

Summary:

American-style Options

Towards
BlackMertonScholes

B we hedge dynamically:
start the hedge at time 0 with 0.704 units sold forward.
The time-1 hedge will be to sell forward 1 or 0.222 units of foreign
currency, depending on whether the rate moves up of down.

B we price backward, step by step

Backward Pricing, Dynamic Hedging

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions

C1 =

16.38
2.29

if S1 = 110
if S1 = 90

 at time 0 we do have a two-point problem:

b0

C1,1

16.38 2.29
= 0.704
110 90
(16.38 0.6) + (2.29 0.4)
= 10.23
1.05

Stepwise Multiperiod
Binomial Pricing
Backward Pricing, Dynamic
Hedging
What can go wrong?

Summary:

American-style Options

Towards
BlackMertonScholes

B we hedge dynamically:
start the hedge at time 0 with 0.704 units sold forward.
The time-1 hedge will be to sell forward 1 or 0.222 units of foreign
currency, depending on whether the rate moves up of down.

B we price backward, step by step

Backward Pricing, Dynamic Hedging

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions

C1 =

16.38
2.29

if S1 = 110
if S1 = 90

 at time 0 we do have a two-point problem:

b0

C1,1

16.38 2.29
= 0.704
110 90
(16.38 0.6) + (2.29 0.4)
= 10.23
1.05

Stepwise Multiperiod
Binomial Pricing
Backward Pricing, Dynamic
Hedging
What can go wrong?

Summary:

American-style Options

Towards
BlackMertonScholes

B we hedge dynamically:
start the hedge at time 0 with 0.704 units sold forward.
The time-1 hedge will be to sell forward 1 or 0.222 units of foreign
currency, depending on whether the rate moves up of down.

B we price backward, step by step

Hedging Verified
5. Delta hedging

Currency Options
(2): Hedging and
Valuation

payoff

P. Sercu,
International
Finance: Theory into
Practice

112.2
S1,1 = 110

102
S0 = 100

91.8
S1,0 = 90

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions

Example
B
at time 0:u

What can go wrong?

S 2,1 = 99

S2,0 = 81

at 5%, 1+r*
buy fwd
0.704 762 at 100 1.02 = 102
= 1.1; dinvest
= .9;10.23
1+r129
= 1.05;
=MTL
1.0294118;

1+r 1.05 + 0.704

0.9 =
10.23 129
762 (110
102)
0.60 =
factor
= 1.02 q =1.02
1.1 0.9
1+r*
129 1.05 + 0.704 762 ( 90 102) =
one-period10.23
forward
rates added above spot rates

value if down:
B

American-style Options

Towards
BlackMertonScholes

26

value forward
if up:

Stepwise Multiperiod
Binomial Pricing
Backward Pricing, Dynamic
Hedging

S 2,2 = 121

b1,1

if in node (1,1):

26!!4
= value if up:

2.295 71

invest 16.380 95 at 5%, buy fwd MTL 1 at 100 1.02 = 112.2

(26! 0.6)!+!(4! 0.4)

16.380 95 1.05 +V 1.000

000 (121 112.2) =
1,1 =
1.05
16.380 95 1.05 + 1.000 000 ( 99 112.2) =

121!!99 = 1,
value if down:
4!!0
b1,0 = 99!!81 = .222222,
B

16.380 95

V1,0 =

4! 0.6!+!0!0.4
1.05

26.000 00
= 16.38095
4.000 00

= 2.28571

if in node (1,0):

invest 2.295 71 at 5%, buy fwd MTL 0.222 222 at 90 1.02 = 91.8

value if up:

2.295 71 1.05 + 0.222 222 ( 99 91.8) =

4.000 00

value if down:

2.295 71 1.05 + 0.222 222 ( 81 91.8) =

0.000 00

P. Sercu and R. Uppal

The International Finance Workbook

page 8.21

What can go wrong?

4.4 Note: what could go wrong?

Everything can and will go wrong:

Currency Options
(2): Hedging and
Valuation

Suppose that, unexpectedly,

the risk changes

P. Sercu,
International
Finance: Theory into
Practice in

132

(1,1): u = 1.20, d = 0.80

in (1,0): u = 1.05, d = 0.95

The Binomial Logic:

One-period pricing

Backward Pricing, Dynamic

Hedging

37

110
100
90

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing

4. Multiperiod binomial

94.5
88

0
0

85.5

37 0.55 + 0
V1,1
=
19.36,ifnot
16.38;
Change
of risk:
20%
down,
instead of the current 10%:
1.05 if up,= 5%

0 +=0 37 0.55 + 0 = 19.36, not 16.38,

C1,1
V1,0
= 1.05
= 0, not 2.29
1.05
Towards
0 +00
BlackMertonScholes
19.36
= 0.00, not 2.29,
C
=
to hedge/replicate, we should have1,0used 110 1.05
90 = 0.97?!
What can go wrong?

and

American-style Options

P. Sercu and R. Uppal

You would haveThemishedged:

International Finance Workbook
You would lose, as a writer, in the upstate (risk up)
You would gain, as a writer, in the downstate (risk down)

page 5.16

What can go wrong?

4.4 Note: what could go wrong?

Everything can and will go wrong:

Currency Options
(2): Hedging and
Valuation

Suppose that, unexpectedly,

the risk changes

P. Sercu,
International
Finance: Theory into
Practice in

132

(1,1): u = 1.20, d = 0.80

in (1,0): u = 1.05, d = 0.95

The Binomial Logic:

One-period pricing

Backward Pricing, Dynamic

Hedging

37

110
100
90

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing

4. Multiperiod binomial

94.5
88

0
0

85.5

37 0.55 + 0
V1,1
=
19.36,ifnot
16.38;
Change
of risk:
20%
down,
instead of the current 10%:
1.05 if up,= 5%

0 +=0 37 0.55 + 0 = 19.36, not 16.38,

C1,1
V1,0
= 1.05
= 0, not 2.29
1.05
Towards
0 +00
BlackMertonScholes
19.36
= 0.00, not 2.29,
C
=
to hedge/replicate, we should have1,0used 110 1.05
90 = 0.97?!
What can go wrong?

and

American-style Options

P. Sercu and R. Uppal

You would haveThemishedged:

International Finance Workbook
You would lose, as a writer, in the upstate (risk up)
You would gain, as a writer, in the downstate (risk down)

page 5.16

American-style Options
4. American Options
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

Exchange rate

121

110
100

90

99
81

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Backward Pricing, Dynamic
Hedging
What can go wrong?
American-style Options

Towards
BlackMertonScholes

European Put with

X=100
.381
(0)
3.193
(0)
7.81
(10)

0
1
19

American Put with

0
X=100
.381
(0)
4.03
1
(0)
7.81
(10)
19

u=1.1, d=0.9, r=5%, (1+r)/(1+r*) = 1.02, q=0.60

(0.6! 0)!+!(0.4! 1)
(0.6! 1)!+!(0.4! 19)
 Node (1,1)
European:
P1,1 In
= this node
= 0.38are
, P1,0 =
= 7.81
1.05 the choices
1.05
B PV of later exercise (0 or 1): 0.381
(0.6! 0.381)!+!(0.4
7.81)
B Value of immediate
0 so !we
wait;= V3.193
1,1 = .381
P0 = exercise: 1.05
 Node (1,0)
Nownode
the (except
choicesthe
are
American:
In every
last period, but including time 0): chose between
B
PV
of
later
exercise
(0
or
19):
exercising (" value dead) or postponing7.81
(" Value alive). The value is given by the larger
B Value
of the
two. of immediate exercse: 10 so we exercise; V1,0 = 10 not 7.81

 Node (0) We now choose between

B PV of later exercise (0 or 1 at time 2, or 10 at time 1):

P. Sercu and R. Uppal

The International Finance Workbook

Palive
0

0.381 0.60 + 10 0.40

=
= 4.03
1.05

B Value of immediate exercise: 0 so we wait; V0 = 4.03

page 8.18

American-style Options
4. American Options
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

Exchange rate

121

110
100

90

99
81

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Backward Pricing, Dynamic
Hedging
What can go wrong?
American-style Options

Towards
BlackMertonScholes

European Put with

X=100
.381
(0)
3.193
(0)
7.81
(10)

0
1
19

American Put with

0
X=100
.381
(0)
4.03
1
(0)
7.81
(10)
19

u=1.1, d=0.9, r=5%, (1+r)/(1+r*) = 1.02, q=0.60

(0.6! 0)!+!(0.4! 1)
(0.6! 1)!+!(0.4! 19)
 Node (1,1)
European:
P1,1 In
= this node
= 0.38are
, P1,0 =
= 7.81
1.05 the choices
1.05
B PV of later exercise (0 or 1): 0.381
(0.6! 0.381)!+!(0.4
7.81)
B Value of immediate
0 so !we
wait;= V3.193
1,1 = .381
P0 = exercise: 1.05
 Node (1,0)
Nownode
the (except
choicesthe
are
American:
In every
last period, but including time 0): chose between
B
PV
of
later
exercise
(0
or
19):
exercising (" value dead) or postponing7.81
(" Value alive). The value is given by the larger
B Value
of the
two. of immediate exercse: 10 so we exercise; V1,0 = 10 not 7.81

 Node (0) We now choose between

B PV of later exercise (0 or 1 at time 2, or 10 at time 1):

P. Sercu and R. Uppal

The International Finance Workbook

Palive
0

0.381 0.60 + 10 0.40

=
= 4.03
1.05

B Value of immediate exercise: 0 so we wait; V0 = 4.03

page 8.18

American-style Options
4. American Options
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

Exchange rate

121

110
100

90

99
81

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Backward Pricing, Dynamic
Hedging
What can go wrong?
American-style Options

Towards
BlackMertonScholes

European Put with

X=100
.381
(0)
3.193
(0)
7.81
(10)

0
1
19

American Put with

0
X=100
.381
(0)
4.03
1
(0)
7.81
(10)
19

u=1.1, d=0.9, r=5%, (1+r)/(1+r*) = 1.02, q=0.60

(0.6! 0)!+!(0.4! 1)
(0.6! 1)!+!(0.4! 19)
 Node (1,1)
European:
P1,1 In
= this node
= 0.38are
, P1,0 =
= 7.81
1.05 the choices
1.05
B PV of later exercise (0 or 1): 0.381
(0.6! 0.381)!+!(0.4
7.81)
B Value of immediate
0 so !we
wait;= V3.193
1,1 = .381
P0 = exercise: 1.05
 Node (1,0)
Nownode
the (except
choicesthe
are
American:
In every
last period, but including time 0): chose between
B
PV
of
later
exercise
(0
or
19):
exercising (" value dead) or postponing7.81
(" Value alive). The value is given by the larger
B Value
of the
two. of immediate exercse: 10 so we exercise; V1,0 = 10 not 7.81

 Node (0) We now choose between

B PV of later exercise (0 or 1 at time 2, or 10 at time 1):

P. Sercu and R. Uppal

The International Finance Workbook

Palive
0

0.381 0.60 + 10 0.40

=
= 4.03
1.05

B Value of immediate exercise: 0 so we wait; V0 = 4.03

page 8.18

Outline
Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes
STP-ing of European Options
Towards BlackMertonScholes

The Binomial Logic: One-period pricing

The Replication Approach
The Hedging Approach
The Risk-adjusted Probabilities
Multiperiod Pricing: Assumptions
Notation
Assumptions
Discussion
Stepwise Multiperiod Binomial Option Pricing
Backward Pricing, Dynamic Hedging
What can go wrong?
American-style Options

Options Delta

Towards Black-Merton-Scholes
STP-ing of European Options
Towards the Black-Merton-Scholes Equation
The Delta of an Option

Straight-Through-Pricing a 3-period Put

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

100

110

133.1

121

108.9

99

90

89.1

81

6.68

The long way:

Stepwise Multiperiod
Binomial Pricing

C2,2

Towards
BlackMertonScholes

C2,1

C2,0

C1,1

C1,0

C0

STP-ing of European Options

Towards BlackMertonScholes

1.58

72.9

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions

! 4.21

Options Delta

0.00 0.6 + 0.00 0.4

1.05
0.00 0.6 + 10.9 0.4
1.05
10.0 0.6 + 27.1 0.4

= 0.00,
= 4.152,

= 16.55,
1.05
0.000 0.6 + 4.152 0.4
= 1.582,
1.05
4.152 0.6 + 16.55 0.4
= 8, 678,
1.05
1.582 0.6 + 8, 678 0.4
= 4.210.
1.05

0.00
4,15
16,6

0.00
0.00
10.9
27.1

Straight-Through-Pricing a 3-period Put

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

100

110

133.1

121

108.9

99

90

89.1

81

6.68

The long way:

Stepwise Multiperiod
Binomial Pricing

C2,2

Towards
BlackMertonScholes

C2,1

C2,0

C1,1

C1,0

C0

STP-ing of European Options

Towards BlackMertonScholes

1.58

72.9

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions

! 4.21

Options Delta

0.00 0.6 + 0.00 0.4

1.05
0.00 0.6 + 10.9 0.4
1.05
10.0 0.6 + 27.1 0.4

= 0.00,
= 4.152,

= 16.55,
1.05
0.000 0.6 + 4.152 0.4
= 1.582,
1.05
4.152 0.6 + 16.55 0.4
= 8, 678,
1.05
1.582 0.6 + 8, 678 0.4
= 4.210.
1.05

0.00
4,15
16,6

0.00
0.00
10.9
27.1

Straight-Through-Pricing a 3-period Put

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

100

121

110

The Binomial Logic:

One-period pricing

99

90

81

133.1
108.9

! 4.21

89.1

0.00

1.58

4,15

6.68

16,6

72.9

0.00
0.00
10.9
27.1

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes
STP-ing of European Options
Towards BlackMertonScholes
Options Delta

The fast way:

B pr3 = ...
B pr2 = ...
B pr1 = ...
B pr0 = ...
B The (risk-adjusted) chance of ending in the money is ...
B C0 =

= 4.21.

Straight-Through-Pricing: 2-period Math

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing

C1,1

q C2,2 + (1 q)C2,1
,
1+r

C1,0

q C2,1 + (1 q)C2,0
,
1+r

C0

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes
STP-ing of European Options

Towards BlackMertonScholes

q C1,1 + (1 q)C1,0
,
1+r
h q C +(1q)C i
h q C +(1q)C i
2,2
2,1
2,1
2,0
q
+ (1 q)
1+r
1+r
1+r

Options Delta

q2 C2,2 + 2q (1 q)C2,1 + (1 q)2 C2,0

(1 + r)2

Straight-Through-Pricing: 3-period Math

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

C1,1

q2 C3,3 + 2q (1 q)C3,2 + (1 q)2 C3,1

(1 + r)2

The Binomial Logic:

One-period pricing

C1,0

q2 C3,2 + 2q (1 q)C3,1 + (1 q)2 C3,0

,
(1 + r)2

C0

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes
STP-ing of European Options
Towards BlackMertonScholes

Options Delta

q C1,1 + (1 q)C1,0
,
1+r

q q2 C3,3 + 2q (1 q) C3,2 + (1 q)2 C3,1

2
+ (1 q) q C3,2 + 2q (1 q)C3,1 + (1 q)2 C3,0
(1 + r)3
q3 C3,3 + 3q2 (1 q)C3,2 + 3q(1 q)2 C3,1 + (1 q)3 C3,0
(1 + r)3

Toward BMS 1: two terms

Currency Options
(2): Hedging and
Valuation

(Q)

Let prn,j

P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing

=
=

# of paths with
j ups

and let a

then C0

Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing

j=0

(Q)

prn,j Cn,j

(1 +
PN

prob of such a
path

{j a} {Sn,j X};
PN

Towards
BlackMertonScholes
STP-ing of European Options

risk-adjusted chance of having j ups in n jumps

N
n!
qj (1 q)Nj =
qj (1 q)Nj
j! (n j)!
j
| {z }
{z
}
|

j=0

r)N

N )
CEQ0 (C
,
discounted

(Q)

prn,j (Sn,j X)+

(1 + r)N

Towards BlackMertonScholes

Options Delta

PN
=

j=a

(1 + r)N
PN

(Q)

prn,j (Sn,j X)

j=a

(Q)

prn,j Sn,j

(1 +

r)N

N
X
X
(Q)
pr .
N
(1 + r) j=a n,j

(2)

Toward BMS 2: two probabilities

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice

PN
Recall: C0

j=a

(Q)

prn,j Sn,j

(1 + r)N

N
X

(1 + r)N j=a

(Q)

prn,j .

We can factor out S0 , in the first term, by using

Sn,j = S0 uj dNj .

The Binomial Logic:

One-period pricing

We also use

Multiperiod Pricing:
Assumptions

1
1
=
(1 + r)N
(1 + r )N

Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes
STP-ing of European Options

PN

j=a

(Q)

prn,j Sn,j

(1 + r)N

1 + r
1+r

1 + r
1+r

Nj

N
X
S0
N
1 + r j
1 + r Nj
q
(1

q)
(1 + r )N j=a j
1+r
1+r

N
X
S0
N j
(1 )Nj
(1 + r )N j=a j

:=

Towards BlackMertonScholes
Options Delta

where

1 + r
1 + r
1 = (1 q)
.
1+r
1+r

Towards BMS 3: the limit

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes
STP-ing of European Options
Towards BlackMertonScholes
Options Delta

prob(Q) of
ja

a j a probability-like
expression

z
z }| {
{
! }|
N
N
X
X
X
N j
S0
(Q)
Nj

(1

pr . (3)
C0 =
(1 + r )N j=a j
(1 + r)N j=a n,j
| {z }
| {z }
discounted
strike

price of the
underlying FC PN

 Special case a = 0:
B a = 0 means that ...
B so both probabilities become ...
B and we recognize the value of ...

 In the limit for N (and suitably adjusting u, d, r, r )

B j/N becomes Gaussian, so we get Gaussian probabilities
2
ln(Ft,T /X)+(1/2)t,T
t,T

B first prob typically denoted N(d1 ), d1 =

the effective stdev of ln
ST as seen at time t
B second prob typically denoted N(d2 ), d2 =

, with t,T

2
ln(Ft,T /X)(1/2)t,T
t,T

Towards BMS 3: the limit

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes
STP-ing of European Options
Towards BlackMertonScholes
Options Delta

prob(Q) of
ja

a j a probability-like
expression

z
z }| {
{
! }|
N
N
X
X
X
N j
S0
(Q)
Nj

(1

pr . (3)
C0 =
(1 + r )N j=a j
(1 + r)N j=a n,j
| {z }
| {z }
discounted
strike

price of the
underlying FC PN

 Special case a = 0:
B a = 0 means that ...
B so both probabilities become ...
B and we recognize the value of ...

 In the limit for N (and suitably adjusting u, d, r, r )

B j/N becomes Gaussian, so we get Gaussian probabilities
2
ln(Ft,T /X)+(1/2)t,T
t,T

B first prob typically denoted N(d1 ), d1 =

the effective stdev of ln
ST as seen at time t
B second prob typically denoted N(d2 ), d2 =

, with t,T

2
ln(Ft,T /X)(1/2)t,T
t,T

Towards BMS 3: the limit

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes
STP-ing of European Options
Towards BlackMertonScholes
Options Delta

prob(Q) of
ja

a j a probability-like
expression

z
z }| {
{
! }|
N
N
X
X
X
N j
S0
(Q)
Nj

(1

pr . (3)
C0 =
(1 + r )N j=a j
(1 + r)N j=a n,j
| {z }
| {z }
discounted
strike

price of the
underlying FC PN

 Special case a = 0:
B a = 0 means that ...
B so both probabilities become ...
B and we recognize the value of ...

 In the limit for N (and suitably adjusting u, d, r, r )

B j/N becomes Gaussian, so we get Gaussian probabilities
2
ln(Ft,T /X)+(1/2)t,T
t,T

B first prob typically denoted N(d1 ), d1 =

the effective stdev of ln
ST as seen at time t
B second prob typically denoted N(d2 ), d2 =

, with t,T

2
ln(Ft,T /X)(1/2)t,T
t,T

Towards BMS 3: the limit

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes
STP-ing of European Options
Towards BlackMertonScholes
Options Delta

prob(Q) of
ja

a j a probability-like
expression

z
z }| {
{
! }|
N
N
X
X
X
N j
S0
(Q)
Nj

(1

pr . (3)
C0 =
(1 + r )N j=a j
(1 + r)N j=a n,j
| {z }
| {z }
discounted
strike

price of the
underlying FC PN

 Special case a = 0:
B a = 0 means that ...
B so both probabilities become ...
B and we recognize the value of ...

 In the limit for N (and suitably adjusting u, d, r, r )

B j/N becomes Gaussian, so we get Gaussian probabilities
2
ln(Ft,T /X)+(1/2)t,T
t,T

B first prob typically denoted N(d1 ), d1 =

the effective stdev of ln
ST as seen at time t
B second prob typically denoted N(d2 ), d2 =

, with t,T

2
ln(Ft,T /X)(1/2)t,T
t,T

Towards BMS 3: the limit

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes
STP-ing of European Options
Towards BlackMertonScholes
Options Delta

prob(Q) of
ja

a j a probability-like
expression

z
z }| {
{
! }|
N
N
X
X
X
N j
S0
(Q)
Nj

(1

pr . (3)
C0 =
(1 + r )N j=a j
(1 + r)N j=a n,j
| {z }
| {z }
discounted
strike

price of the
underlying FC PN

 Special case a = 0:
B a = 0 means that ...
B so both probabilities become ...
B and we recognize the value of ...

 In the limit for N (and suitably adjusting u, d, r, r )

B j/N becomes Gaussian, so we get Gaussian probabilities
2
ln(Ft,T /X)+(1/2)t,T
t,T

B first prob typically denoted N(d1 ), d1 =

the effective stdev of ln
ST as seen at time t
B second prob typically denoted N(d2 ), d2 =

, with t,T

2
ln(Ft,T /X)(1/2)t,T
t,T

The Delta of an Option

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

 Replication: in BMS the option formula is still based

on a portfolio that replicates the option (over the short
time period dt):
B a fraction
B a fraction

Pn
Pj=a
n
j=a

j or N(d1 ) of a FC PN with face value unity, and

prj or N(d2 ) of a

HC PN

with face value X.

 Hedge: since hedging is just replication reversed,

you can use the formula to hedge:
version of formula

hedge instrument

unit price

size of position

S0
1+r
0,T

N(d1 )

S0

N(d1 )
1+r
0,T

F0,T

N(d1 )
1+r0,T

STP-ing of European Options

Towards BlackMertonScholes
Options Delta

C0 = 1+r0 N(d1 ) ...

0,T
N(d )

C0 = S0 1+r1 ...
0,T
N(d )

C0 = F0,T 1+r 1 ...

0,T

FC

PN expiring at T

FC

spot deposit

Forward expiring at T

The Delta of an Option

Currency Options
(2): Hedging and
Valuation
P. Sercu,
International
Finance: Theory into
Practice
The Binomial Logic:
One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes

 Replication: in BMS the option formula is still based

on a portfolio that replicates the option (over the short
time period dt):
B a fraction
B a fraction

Pn
Pj=a
n
j=a

j or N(d1 ) of a FC PN with face value unity, and

prj or N(d2 ) of a

HC PN

with face value X.

 Hedge: since hedging is just replication reversed,

you can use the formula to hedge:
version of formula

hedge instrument

unit price

size of position

S0
1+r
0,T

N(d1 )

S0

N(d1 )
1+r
0,T

F0,T

N(d1 )
1+r0,T

STP-ing of European Options

Towards BlackMertonScholes
Options Delta

C0 = 1+r0 N(d1 ) ...

0,T
N(d )

C0 = S0 1+r1 ...
0,T
N(d )

C0 = F0,T 1+r 1 ...

0,T

FC

PN expiring at T

FC

spot deposit

Forward expiring at T

What have we learned in this chapter?

Currency Options
(2): Hedging and
Valuation

 Why binomial?

P. Sercu,
International
Finance: Theory into
Practice

B is much simpler

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes
STP-ing of European Options
Towards BlackMertonScholes
Options Delta

B does basically the same as the BMS pde, but ...

 One-period problems
B hedging/replication gets us the price without knowing the true p and
the required risk correction in the discount rate
B but thats because we implicitly use q instead:
B the price is the discounted risk-adjusted expectation

 Multiperiod models
B basic model assumes constant u, d, r, r
B we can hedge dynamically and price backward
B for American-style options, we also compare to the value dead

 Black-Merton-Scholes
B For European-style options, you can Straight-Through-Price the option
B This gets us a BMS-like model
B BMS itself is a limit case

What have we learned in this chapter?

Currency Options
(2): Hedging and
Valuation

 Why binomial?

P. Sercu,
International
Finance: Theory into
Practice

B is much simpler

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes
STP-ing of European Options
Towards BlackMertonScholes
Options Delta

B does basically the same as the BMS pde, but ...

 One-period problems
B hedging/replication gets us the price without knowing the true p and
the required risk correction in the discount rate
B but thats because we implicitly use q instead:
B the price is the discounted risk-adjusted expectation

 Multiperiod models
B basic model assumes constant u, d, r, r
B we can hedge dynamically and price backward
B for American-style options, we also compare to the value dead

 Black-Merton-Scholes
B For European-style options, you can Straight-Through-Price the option
B This gets us a BMS-like model
B BMS itself is a limit case

What have we learned in this chapter?

Currency Options
(2): Hedging and
Valuation

 Why binomial?

P. Sercu,
International
Finance: Theory into
Practice

B is much simpler

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes
STP-ing of European Options
Towards BlackMertonScholes
Options Delta

B does basically the same as the BMS pde, but ...

 One-period problems
B hedging/replication gets us the price without knowing the true p and
the required risk correction in the discount rate
B but thats because we implicitly use q instead:
B the price is the discounted risk-adjusted expectation

 Multiperiod models
B basic model assumes constant u, d, r, r
B we can hedge dynamically and price backward
B for American-style options, we also compare to the value dead

 Black-Merton-Scholes
B For European-style options, you can Straight-Through-Price the option
B This gets us a BMS-like model
B BMS itself is a limit case

What have we learned in this chapter?

Currency Options
(2): Hedging and
Valuation

 Why binomial?

P. Sercu,
International
Finance: Theory into
Practice

B is much simpler

The Binomial Logic:

One-period pricing
Multiperiod Pricing:
Assumptions
Stepwise Multiperiod
Binomial Pricing
Towards
BlackMertonScholes
STP-ing of European Options
Towards BlackMertonScholes
Options Delta

B does basically the same as the BMS pde, but ...

 One-period problems
B hedging/replication gets us the price without knowing the true p and
the required risk correction in the discount rate
B but thats because we implicitly use q instead:
B the price is the discounted risk-adjusted expectation

 Multiperiod models
B basic model assumes constant u, d, r, r
B we can hedge dynamically and price backward
B for American-style options, we also compare to the value dead

 Black-Merton-Scholes
B For European-style options, you can Straight-Through-Price the option
B This gets us a BMS-like model
B BMS itself is a limit case