Equity Derivatives PDF

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International Derivatives Exhibition

Reech Capital
Advanced Pricing and Risk

Guillaume BLACHER
Management for Equity Derivatives
FOW Frankfurt March 7 - 8th 2000

Outline
Guillaume
➢ Presentation of products most actively studied in BLACHER
Reech
Equity Derivatives
Capital
download at wowebook.info
➢ Evolution in pricing exotics
➢ Choosing a proper diffusion model
➢ Numerical methods: complexity and performance
➢ Generic product description tools

Equity
Derivatives
➢ The Future of quantitative analysis
Slide 2
products most actively studied in

Equity Derivatives
Products
Guillaume
• High variety of products in Equity BLACHER
Derivatives
Reech
• Always new products tailored to: Capital
– new market conditions
– new tax regimes

– new corporate situation
• Among most popular:
– Cliquets
– Structured notes
Equity
– Baskets and multi-underlying products Derivatives
– Hybrid Products
Slide 4
Cliquets
• Pays the equity positive performance each Guillaume
year, defined as: +
BLACHER
æ STi+1 − STi ö
ç Reech
ç ST Capital
è i
• Pricing:
– By Monte-Carlo: most natural but slow
– By Tree/PDE: requires a second dimension for
the strike
• Problems:
– Almost a pure volatility product
Equity
– Strong impact of smile and dividends Derivatives
• Solution: pricing by static replication
Slide 5
Structured notes
Guillaume
• Client gives up risk-free return, dividends BLACHER
and/or x% of capital to get some equity
exposure via embedded option. Reech
Capital
• Often combines many features into one
product:
– Bond features (coupons, redemption)
– Exotic features (digitals, barriers…)
– Swap features (equity swaps)
– Multi-underlying (best of, basket)
– Path dependent features (average) Equity
Derivatives
– American style features (puttable)
Slide 6
Exotics on basket
Guillaume
• Still a lot of business on baskets, mainly with
BLACHER
path-dependent features (asian baskets) and
Reech
capped
Capital
• Example: 5Y basket option of 3 indices, with a
knock-in in the first 2.5Y at 175% to get an extra

25% of gearing.
• Modeling correlation realistically is crucial
• Correlation cannot be hedged on a trade by trade
basis (no exchange traded correlation sensitive
Equity
options): need for creativity to build up a Derivatives
correlation - diversified portfolio
Slide 7
Hybrid products
Guillaume
• More and more products across asset BLACHER
classes:
Reech
– Best of equity / interest rate
Capital
– Interest swaps triggered by equity level
– Debt products with FX components

• Requires
– Combination of skills for modeling
heterogeneous assets together
– Very high structuring and pay-off description
flexibility Equity
– Consistent risk management across all asset Derivatives
classes
Slide 8
Volatility products
Guillaume
• Swaps or options on: BLACHER
– realised volatility from start to maturity
Reech
– Implied volatility
Capital
• Example:
In 6M, option pays the 1M at-the-money implied

volatility.
• Pricing mechanism differs from standard
structure:
– Mix of semi-static option hedge and dynamic
spot hedge Equity
Derivatives
– Several un-hedgeable elements that need to be
taken into account. Slide 9
Pricing Exotics
Pricing components
Guillaume
• Several components in a pricing engine: BLACHER
Reech
Diffusion Numerical Capital
model method
Model
Product
parameters /
Calibration description Equity
Derivatives
Slide 11
Diffusion models (I)

Diffusion models
• All pricings should be consistent with Guillaume
BLACHER
market prices of hedging instruments:
– Current yield Reech
Capital
– Smile
– Credit curve
• The least it should do to achieve this with
deterministic models:
– short term rate: r(time)
– instantaneous volatility σ(spot, time)
– default probability p(spot, time) Equity
Derivatives
• Those functions can be calibrated to
market instruments Slide 13
Example: volatility modeling
• The simplest diffusion consistent with a Guillaume
market skew is: BLACHER
= (r − repo − div )dt + σ (S , t )dWt

dS Reech
S Capital
• Always exists if market prices are not

arbitrageable
• Would be unique if a continuum of prices
were given
• Significant price impact on:
– Barriers Equity
Derivatives
– Cliquets
– Basket options Slide 14
Example
Guillaume
• Pricing with smile can be critical when the BLACHER
right price cannot be reach with Black-
Scholes formula Reech
Capital
Market smile
3
39
37
Up and Out Call option
2.5
35
33
31
Barrier price
29
2
27
25
Black-Scholes price
Strike
Maturity 1.5
Smile price
Flat smile 1
35
33
0.5
31
29
0
27 0% 20% 40% 60% Equity
Derivatives
25
Maturity Black-Scholes volatility

Strike
Slide 15
Hedging
Guillaume
• What if the smile disappears? BLACHER
Black-Scholes assumption would then apply. Our Reech
Capital
mark-to-market position would be showing a
big loss (if we bought the barrier) or a big

profit (if we sell the barrier)
• Only makes sense if a consistent vega

hedge is used.
Equity
Derivatives
Slide 16
Risk Management
Vega analysis
Guillaume
Volatility risk can be measured at 3 levels: BLACHER
Reech
1) Single vega number: Capital
– Parallel shift of the Classic Vega perturbation

2%
whole smile surface

– No protection against 1%
deformations 0%
– Which European
-1%
options to buy as a Strike Maturity Equity

Derivatives
hedge?
Slide 18
Vega analysis (2)
Guillaume
2) Vega buckets: BLACHER
– Parallel shift of the skew at each tenor Reech
– Protection against time deformations only Capital
– Which strike should we buy as a hedge?

Bucket Vega perturbation Vega bucket for an exotic
2%
1%
Vega
0%
Equity
1M 2M 3M 4M 5M 6M 7M
Derivatives
-1%
Strike Maturity Tenor

Slide 19
Vega analysis (3)
Guillaume
3) Superbuckets: BLACHER
– Shift of each individual point on the surface Reech
– Protection against any deformation Capital
– Provides strikes and maturities to hedge with.

Superbucket perturbation Superbucket: Up&Out Call
2%
strike
1%
barrier
Vega
0%
Equity
Derivatives
-1%
Strike Maturity Mat

Strike Slide 20
Global risk management
Guillaume
• Each individual exotic has got its superbucket BLACHER
topography.
Reech
• What is really relevant is the superbucket of the Capital
whole book, aggregating exotics and vanillas on the

same underlying: Portfolio superbucket
Sensitivities to
be hedged out
Vega
(by trading
corresponding
Equity
Europeans)
Derivatives
Mat
Strike
Slide 21
Risk Reports
Classic Report: CORRECT Report: Guillaume
BLACHER
Spot Strike
Reech
Capital
Maturity
Time Vega Vega
Traders will try to flatten the Classic Report where

they should be trying to flatten the Correct Report:
Equity
• Equivalent for European options Derivatives
• Different for Exotics
Slide 22
Global risk management (2)
Guillaume
• This (correct) analysis should be available at BLACHER
portfolio level on all model parameters, whether Reech
they be: Capital
– hedgeable (credit term structure, smile surface)

– un-hedgeable (instantaneous forward correlation)
• It gives today’s hedge but may not be static: need

for readjusting in the future
• Question: if readjusting is necessary, what is the
Equity
cost? Derivatives
Slide 23
Diffusion models (II)

Cost of hedging
Guillaume
Some options exhibit a vega that varies with: BLACHER
• Spot Reech
• Volatility itself Capital
Rebalancing vega hedge will produce systematic

cost/profit that can only be estimated will a
stochastic volatility model.
To price the cost of having... we need to model...
dVega Correlation (Spot, Vol) Equity
dSpot
Derivatives
dVega
Volatility of volatility
dVol Slide 25
Stationarity
Guillaume
• Many different ways to match current smile
BLACHER
• Choosing the wrong model means having non-
Reech
stationary parameters: Capital
– Even when market does not change, model parameters

do
– Forward smiles not realistic
• Although the reason for choosing a model is

consistency and not ability to forecast, the cost of
rehedge will be wrongly estimated Equity
• Conclusion: try to find the model with most stable Derivatives
parameters Slide 26
Model parameters / Calibration

Auto-calibrated models
Guillaume
• Some model can be considered as auto-calibrated:
BLACHER
“calibration” is analytical, quasi-instantaneous and
Reech
happens automatically inside the numerical
Capital
method
• Examples:
– Local volatility in a Black-Scholes framework
– Local volatility in a deterministic volatility model
– Drift of the short term rate in an Heath-Jarrow-Morton
framework
Equity
– Instantaneous default probability if deterministic Derivatives
– etc...
Slide 28
Calibration
• More and more advanced models are not auto- Guillaume
BLACHER
calibrated
Reech
• Calibration is a long process
Capital
• On the other hand, it is done once and for all (until

market conditions change significantly)
• Examples:
– Parameters of stochastic volatility / jump models
– Volatility in interest rate models
• Systems have to be flexible enough to let the Equity

Derivatives
calibration process happen independently from
pricing Slide 29
Numerical methods
Trees
• Just a way to compute an expectation Guillaume
• Binomial trees obsolete (except for quick BLACHER
approximations) Reech
• Trinomial trees do the job, although they are less Capital
efficient than PDEs.

• 2-dimensional trees technology well mastered
S2
spot spot Equity

S1
time time
Derivatives
time
Binomial Trinomial 2D Trinomial Slide 31
PDEs
• Allows for implicit discretisation Guillaume
• More flexibility on the grid BLACHER
• Better performance in general, much better for some
Reech
products (barriers for example)
Capital
• 2-dimensional PDEs technology well mastered
• Provides option price at any time for any spot

Spot
Pay-off for an
Up&Out Call
Price PDE grid
profile
today
Equity
Derivatives
Option Intrinsic value
price Time Slide 32
Monte Carlo
• Low discrepancy series (ex: Sobol) provide very high Guillaume
convergence rate compared to standard Monte Carlo BLACHER
• Unfortunately biased in high dimension
• Dimension reduction techniques have to be used in high Reech
dimension (spectral truncation) Capital
• Several very efficient techniques to price american style

options within simulations
1 1
0.9 0.9
0.8 0.8
0.7 0.7
0.6 0.6
0.5 0.5
0.4 0.4
0.3 0.3
0.2 0.2 Equity

0.1 0.1
Derivatives
0 0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Standard MC sampling Sobol sampling Slide 33

Complexity vs Performance
• More accurate models usually mean greater Guillaume
computation time. BLACHER
• Becomes an issue when thousands of positions Reech

Capital
have to be revalued.
• Better understanding of models and numerical

speed-ups should precede the purchase of high-
end hardware.
• Using those instead of brutal calculation power
needs structural changes in trading systems
architecture. Equity
Derivatives
Slide 34
Product description
Equity Derivatives richness
• Structured products and Derivatives have 3 main Guillaume
BLACHER
properties:
1) Extreme diversity of features Reech
Capital
2) All features have to be priced together
3) Product popularity does not last forever
• This means:
– A lot of work for quants to implement new features in
the library
– Library contain high quantity of obsolete products (or
even products that have never been dealt) Equity
Derivatives
Slide 36
Generic product description
• Quants should: Guillaume
BLACHER
– spend no time implementing new products in a Library
– spend more time modeling the market parameters Reech
Capital
– spend more time improving their numerical methods
• Structurers/Marketers should:
– spend no time waiting for quants to come up with a new
product in the Library
– spend more time studying the risks of the product
– spend more time trying new ideas
Equity
• What’s the solution? Derivatives
A generic product description language
Slide 37
The future of quantitative analysis
• Main challenge: Guillaume

BLACHER
model more sources of risk while maintaining
Reech
reasonable computation speed.
Capital
• How is it possible?
– Better understanding of the products helps identifying
most important factors
– Some risks can be taken into account without increasing
the dimension
Equity
– More advanced numerical methods and numerical Derivatives
speed-ups are to be used
Slide 38

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download at wowebook.

International Derivatives Exhibition

Advanced Pricing and Risk

Management for Equity Derivatives

FOW Frankfurt March 7 - 8th 2000

➢ Evolution in pricing exotics

➢ Choosing a proper diffusion model

➢ Numerical methods: complexity and performance

➢ Generic product description tools

products most actively studied in

– new tax regimes

knock-in in the first 2.5Y at 175% to get an extra

– Debt products with FX components

In 6M, option pays the 1M at-the-money implied

Diffusion models (I)

= (r − repo − div )dt + σ (S , t )dWt

• Always exists if market prices are not

Maturity Black-Scholes volatility

big loss (if we bought the barrier) or a big

• Only makes sense if a consistent vega

– Parallel shift of the Classic Vega perturbation

whole smile surface

options to buy as a Strike Maturity Equity

– Which strike should we buy as a hedge?

Strike Maturity Tenor

– Provides strikes and maturities to hedge with.

Strike Maturity Mat

whole book, aggregating exotics and vanillas on the

Time Vega Vega

Traders will try to flatten the Classic Report where

– hedgeable (credit term structure, smile surface)

• It gives today’s hedge but may not be static: need

Diffusion models (II)

Rebalancing vega hedge will produce systematic

– Even when market does not change, model parameters

• Although the reason for choosing a model is

Model parameters / Calibration

• On the other hand, it is done once and for all (until

• Systems have to be flexible enough to let the Equity

efficient than PDEs.

spot spot Equity

• Provides option price at any time for any spot

• Several very efficient techniques to price american style

0.2 0.2 Equity

Standard MC sampling Sobol sampling Slide 33

• Becomes an issue when thousands of positions Reech

• Better understanding of models and numerical

3) Product popularity does not last forever

• Main challenge: Guillaume

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