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The manager of a proprietary hedge fund studied the German yield curve and noticed that it
used to be quite steep. At the time of the study, the overnight rate was approximately 3%. The
one-month forward on the overnight rate is 3.50%. The proprietary trader had the following
idea. Often at times the market thinks that one month hence the overnight rate is going to go
higher to 3.50%. However, most of the time nothing happens to the overnight rate; it stays at
3%. The proprietary trader wanted to develop a low-premium, high-payout strategy to make
huge profits himself if he was correct. On the other hand, the trader did not want to lose much
in case he was wrong.
The strategy was developed with digital options. The market determines the forward rate
at 3.50%. The trader disagrees with the market and thinks the rate will stay down at 3%.
Consider the following alternatives:1
1. Engage in a short forward transaction. Although this is zero cost, it may be quite expensive
if the trader turns out to be wrong and interest rates increase to 4%.
2. Buy an at-the-money put, struck at 3.50%. If interest rates stay at 3%, the trader is going
to get 50 basis points times the notional amount. Thats a very nice payout. However,
there is a problem with this strategy, as the trader has to pay for an at-the-money European option for which the premium is quite expensive. In our case, the cost of the option
is about 14.20 basis points. So the trader will spend 14 to make 50.
3. To reduce the cost the trader can buy an out-of-the-money option, struck at 3.05%. Since
this is an out-of-the-money put, its going to be a lot cheaper. In our case, the cost of the
out-of-the-money put is about 1.36 basis points. On the other hand, the payout of the
option is going to be much lower. If interest rates are at 3%, the payout will be only 5
basis points. Now the trader has to spend 1.36 to make 5.
4. Buy a digital put option struck at 3.05%. The put pays 50 basis points if interest rates
are lower than 3.05%. This option costs about 4.85 basis points. With the digital, the
trader can spend 4.85 to make 50.
To summarize, the structure is particularly attractive to option writers, for whom the digital
structure means a known and limited loss in the event the option is exercised. For the purchaser, the major advantage of a digital option is that the option payoff is a known constant.
This amount may be related to some fundamental amount related to the underlying hedging
transaction. In addition, it overcomes the problem of a purchaser where the option expires ator slightly in-the-money and where the resultant payoff does not cover the cost of the option
premium paid to purchase the option contract.
1
Calculations for European interest rate options make use of Blacks model, which assumes that the futures
price follows geometric Brownian motion. Under this model, the futures price can be viewed as a security
providing a continuous dividend yield equal to r (i.e., q = r) and the price of a European interest rate put option
is given by
with d2 =
ln(F/K) 2 /2
and d1 = d2 + ,
where F is the forward rate, K the strike price, the time to expiration, r the risk-free rate, and the volatility.
In this numerical example, we assume that the volatility is 35.33%. The reader should return to verify the
price of the digital put option after reading Section 2.
Payoff Profile
The simplest structure for a digital option is path-independent, whereby a call (resp. put)
pays nothing if the underlying asset finishes below (resp. above) the strike price or pays a
predetermined constant amount Q if the underlying asset finishes above (resp. below) the strike
price. These options are also referred to as binary, cash-or-nothing, or all-or-nothing options.
Q
cf.
K
Valuation
The valuation of the digital call option is extremely simple. The valuation formula is the
present value of the area under the lognormal distribution curve to the right of the strike price.
Therefore, the price of the digital call option is
ln(S/K) + (r q 2 /2)
where S is the spot price of the underlying, K the strike price, the time to expiration, r the
risk-free rate, q the dividend yield, and the volatility.
Example: Calculate the value of a derivative that pays off $100 in six months if the S&P
500 index is greater than 500 and zero otherwise. Assume that the current level of the index is
480, the risk-free rate is 8% pa, the dividend yield on the index is 3% pa, and the volatility of
the index is 20%.
Here, Q = 100, S = 480, K = 500, = 0.5, r = 0.08, q = 0.03, and = 0.2. With these
values, we find that d2 = 0.1826, and N (d2 ) = 0.4276. Therefore, the derivative has a value
of 100 0.4108 = $41.08.
2
Hedging
A European option can be approximated by digital options.2 What is more interesting is the
replication of a digital option with European options.
2
It is possible to take a European option and to build steps to the top of the mountain, as illustrated below.
We can have a series of digital options:
One that pays a dollar struck at $100.
We can make the steps as long or as small as we wish, and so we can make the replication as precise as possible.
Along the same line, Pechlt [2] shows how digital options can be used as a means of valuing exotic options and
constructing static hedges, illustrating the ideas with switch and corridor options.
The dealer sells a digital option to a client and now needs to hedge himself. Consider a
digital call option that pays $1 if the underlying is over $100 at expiration. Compare this
digital option with a portfolio consisting of a long position in a call struck at $100 and a short
position in a call struck at $101. Above $101 both positions pay out a dollar. Below $100 both
positions result in zero. Between $100 and $101, the bull spread is not an exact hedge for the
digital option (see diagram).
6 6
$100
$101
An alternative hedge is to be long two European call options struck at $100 and short two
European call options struck at $100.50. This bull spread mirrors the digital option exactly
except for the region between $100 and $100.50. If the trader wants to be really aggressive, he
can go long ten calls at $100 and short ten calls at $100.10. This bull spread mirrors the digital
option exactly except for the small region between $100 and $100.10.
In the general case, the hedge for a digital option struck at K which pays $1 is:
Long 1/ Europeans at point K.
Short 1/ Europeans at point K + .
In the three hedging alternatives examined above, was $1, $0.50, and $0.10 respectively.3
We can find so that the hedge is correct within a certain probability by constructing the
bull spread. Note that:
If S K, we are hedged.
If S K + , we are hedged.
If K < S < K + , we are not exactly hedged.
Hence, we can choose so that
P {K < S < K + } < 1 ,
where is the desired probability of being hedged.
Consider the following directive for exotic options traders:
Digital calls are hedged with a bull spread with a 20-tick difference, unless volatility
is lower than 10%, in which case we move to a 10-tick difference.
3
Digital options are probably one of the very first exotics that a lot of banks step into. A bank sells a digital
and puts it on the books as a very aggressive bull spread, say as long 100 call options struck at $100 and short
100 call options truck at $100.01. Since the bank already has the capability of pricing and hedging European
options, it can replicate the digital with them. The payout of the digital and the bull spread is similar, so is the
pricing. Delta and all other Greeks are pretty much the same too. Thus its the most natural exotic to get into
because the system can almost already handle it.
Besides the static hedging strategy outlined above, the dealer can also hedge his position
dynamically by trading in the underlying asset. With this approach, we need to evaluate the
delta and gamma of a digital (call) option. Assuming Q = 1, we have:
=
C
d2
er n(d2 )
,
= er n(d2 )
=
S
S
S
er d1 n(d2 )
er n0 (d2 ) er n(d2 )
=
S
S 22
(S )
S2
(2)
d 1 = d2 + .
with
(3)
Variations
super share
K1
K2
step structure
K1
K2
For a visual on how the value, delta, and gamma of a digital option vary with the underlying asset price and
time to expiration, numerical examples are provided in Barret [1]. The reader is encouraged to use the analytical
formulas (1), (2), and (3) to reason the illustrated behaviors of those quantities.
5
Rubinstein and Reiner [3] describe a variety of barrier digital options and provide valuation formulas for
these options. The interested reader is referred there.
Summary
Digital options represent a unique class of exotic options which focus on varying the payout
profile of options. This alteration of the payoff pattern of options creates unique transactional
hedging opportunities, since it allows writers a known cost in the event that the option expires
in-the-money. Similarly, it allows option purchasers to nominate a particular payoff related to
underlying hedging requirement. It is not too difficult to price and hedge digital options unless
they are very near expiration and very near the strike.
Digital options have proved to be among the most enduring and popular types of exotic
options and have been incorporated in a variety of securities and derivative transactions. In
addition, the concept of digital options provides the basis of contingent-premium options.6
6
In fact, digital options are rarely used alone. They can also be integrated into structured off-balance sheet
products such as swap with embedded l everage (Spelalso called a range, time, accrual or corridor swap), or in
the form of range notes. These strategies are illustrated in Barret [1].
Problems
1. Calculate the value in dollars of a derivative that pays off 10,000 in one year provided that
the dollar-sterling exchange rate is greater than 1.5000 at that time. The current exchange
rate is 1.4800. The dollar and sterling interest rates are 4% and 8% pa respectively. The
volatility of the exchange rate is 12% pa.
2. In Section 3, we considered the following hedge for a digital call option struck at K which
pays $1:
Long 1/ Europeans at point K.
Short 1/ Europeans at point K + .
(a) In this case, if the bull spread did not match the digital, then it underhedged it.
(i) Construct a more symmetrical hedge for the digital option.
(ii) Construct a bull spread that will assure the dealer of overhedging.
(b) Use the bull spread to show that the digital call option should be priced at C =
er N (d2 ).
3. By considering bull spread hedges similar to Problem 2, or by direct evaluation, or otherwise, show that
(a) the price of a digital put option is P = er N (d2 ).
References
[1] Barret, G. (1995). The Binary Option Mechanism. Corporate Finance Risk Management Yearbook 1995
(May 95), 2429.
[2] Pechlt, A. (1995). Classified Information. Risk, 8 (Jun 95), 5961. Also in Over the Rainbow: Developments
in Exotic Options and Complex Swaps, Chapter 8 (pp 7174).
[3] Rubinstein, M. and E. Reiner (1991). Unscrambling the Binary Code. Risk, 4 (Oct 91), 7583