Fall 2015 QFI Core Sample Study Manual

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2015 The Infinite Actuary, LLC www.theinfiniteactuary.com

QFI Core Sample

MFD Chapter 2: A Primer on the Arbitrage Theorem . . . . . . . . . . . . . . . . . . . . . 2

PWIQF Chapter 10: How to Delta Hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
FAQ in Quantitative Finance: Q23 (pages 103-105) - Jensens Inequality . . . . . . . . . . . 11

1
QFI Core MFD Chapter 2: A Primer on the Arbitrage Theorem

MFD Chapter 2: A Primer on the Arbitrage Theorem

Arbitrage

Arbitrage - taking simulataneous positions in different assets so that one guarantees a riskless
profit higher than the risk-free rate

No net investment, but future positive profit

Negative net commitment, but nonnegative profits

Utilizations of arbitrage-free prices

Pricing a new product in the market

Risk management
Marking to market (might use arbitrage-free price for illiquid assets)
Comparing with market

S(t) will denote a vector of asset prices. Each entry of this vector is the price of a specific financial
security at some point in time.

S1 ( t )

S2 ( t )
St =
...

Sn ( t )
W represents the possible payouts in the future possible states of the world.

1 ( t )

2 ( t )
W=
...

n ( t )
D will be the matrix containing payoffs. dij will denote the number of units of account paid by one
unit of security i in state j. For now, consider three assets: risk-free T-bill, an underlying asset, and
a call option. Assume that time elapses and there are two possible future states of the world.
Then K = 2 and N = 3:

d11 d12 ... d1K
d21 d22 ... d2K (1 + r) (1 + r)
Dt = = S1 ( t + ) S2 ( t + )

.. .. .. ..
. . . .
C1 (t + ) C2 (t + )
d N1 d N2 . . . d NK
QFI Core MFD Chapter 2: A Primer on the Arbitrage Theorem

The Arbitrage Theorem

Positive constants 1 and 2 can be found such that asset prices satisfy:

1 (1 + r) (1 + r)  
S(t) = S1 (t + ) S2 (t + ) 1
2
C (t) C1 (t + ) C2 (t + )
if and only if there are no-arbitrage possibilities.

Implications of the Arbitrage Theorem

Define the state prices i , which represent how much investors are willing to pay for one
unit of money in state i. If state i is realized, the investor gets one unit of money, otherwise
nothing.
1
This gives us an important equation: i i = v = 1+r . Here, I am using v to denote the PV
of one unit of money in every state.

Can define the risk-neutral probabilities through the state prices. If we normalize the state
prices so they add to one and set Qi = (1 + r )i .

Then i Qi = 1, and by the arbitrage theorem we have the strict inequality 0 < Qi < 1.

Can use these Qi values for risk-neutral pricing.

1 1
For example, C (t) = i i Ci (t + 1) = 1+r i (1 + r )i Ci (t + 1) = 1+r i Qi Ci (t + 1)
1 Q
Thus, C (t) = 1+ r E (C ( t + 1)). We can value assets using their discounted risk-neutral
expected payoff. We used C above, but can also replace with S as well.

Can rearrange to see we are earning the risk-free rate under measure Q in risk-neutral
EQ (C (t+1))
pricing, 1 + r = C (t)
.

Note that these are not neccessarily true probabilities, they are just convenient for pricing.
1 P
We cannot simply say C (t) = 1+ r E (C ( t + 1)), since we have no guarantee of Qi = (1 + r ) i .

c 2014 The Infinite Actuary, LLC Page 3 of 11
QFI Core MFD Chapter 2: A Primer on the Arbitrage Theorem

Martingales and Submartingales

Suppose at time t one has information summarized by It . A random variable Xt that for all s > 0
satisfies the equality

E P [ Xt+s | It ] = Xt

is called a martingale with respect to the probability P.

If instead, we have for all s > 0

EQ [ Xt+s | It ] Xt

then Xt is called a submartingale with respect to the probability Q.

Notes on Martingales

This is important because asset prices are martingales in the risk-neutral world only
St + s
Must define Xt+s as the discounted future asset price (1+r ) s

Example

1 1.1 1.1  
100 = 100 150 1
2
C 0 50

10% interest rate, Stock price is either $100 or $150 in the next time step. Assume we want
to value a call with strike 100.
Two equations with two unknowns and a third equation showing C = 502 . Thus if we
solve for 2 we can get the call premium.
Solving the matrix equality, 1 = .7272 and 2 = .1818.
Thus, C = i i Ci = 502 = 50 .1818 = 9.09. This is the no-arbitrage price of the call.
Note that here there is a unique state price vector.

Binomial Tree Pricing

Project underlying out through binomial tree

Determine the value at expiration using CT = max (0, ST K )
Work backwards in the binomial tree for each time step until the root of the tree is reached

r [ Qup ( St + ) + Qdown ( St )]
1
St = 1+
1 up
Ct = 1+r [ Qup Ct+ + Qdown Ctdown
+ ].
QFI Core MFD Chapter 2: A Primer on the Arbitrage Theorem

Figure 1: MFD - Ch 2

Dividends and Foreign Currencies

Assume that dividends are paid as a percentage of St+

Btu+ Btd+

1  
u u d d 1
St = St + + d t St + St + + d t St +

2
Ct Ctu+ Ctd+

1+ d u
S= 1+r [ S Qup + Sd Qdown ]
1 u
C= 1+r [C Qup + C d Qdown ]

EQ [ StS+ ] = 1+r
1+d 1 + (r d )

EQ [ CtC+ ] = 1 + r

Under risk-neutral expectation, the underlying S grows below the risk free rate at r d
while the call option expected return is r.

This should make intuitive sense the holder of the underlying will receive d in dividends
to compensate for the lower growth rate. The holder of the call option does not receive the
dividends, so the expected return is simply the risk free rate.

Similar idea with foreign currencies replace d with the foreign savings interest rate r f .

Generalizations and Extensions Needed

Continuous time, t [0, )

Possibly uncountable number of states of the world

c 2014 The Infinite Actuary, LLC Page 5 of 11
QFI Core MFD Chapter 2: A Primer on the Arbitrage Theorem

Continuous discounting, er

Risk-Neutral Pricing Summary

Obtain a model to track the dynamics of the underlying

Calculate how the derivative asset price relates to the price of the underlying asset at expiration
or other boundaries

Obtain risk-adjusted probabilities

Calculate expected payoffs of derivatives at expiration using these risk-adjusted probabilties

Discount this expectation using the risk-free return

Appendix: Generalizations of the Arbitrage Theorem

Define a portfolio

1 ( t )

2 ( t )
=
...

n (t)
such that the portfolio value at time t is St0 = in=1 Si (t)i

Definition: is an arbitrage portfolio, or simply an arbitrage, if either one of the following conditions
is satisfied:

1. S0 0 and D 0 > 0 (costs nothing to purchase, guaranteed positive return)

2. S0 < 0 and D 0 0 (negative cost, nonnegative return)

S0 is the purchase price, D 0 gives the payoff.

QFI Core PWIQF Chapter 10: How to Delta Hedge

PWIQF Chapter 10: How to Delta Hedge

Overview

This chapter is titled How to Delta Hedge. In reality, the focus in much narrower. We
will study how to delta hedge a trading strategy when we think that actual volatility and
implied volatility differ

Actual volatility: the amount of noise in the stock price, the coefficient of the Wiener process,
the amount of randomness that actually transpires

Implied volatility: how the market is currently pricing the option

Notation

: actual volatility
h : volatility used for hedging (i.e. what volatility is plugged into Black-Scholes for
delta hedging)
: implied volatility
e

The topic of this chapter is what h to choose if you believe that actual volatility is different
from implied volatility

In the classic Black-Scholes world with no arbitrage, = e

, but in reality this is not the case

Basic Straddle/Strangle Strategy

Suppose, for example, that > e

One strategy would be to buy straddles/strangles

This is risky. Under the law of large numbers, you would make money. But only one stock
price path will be realized

Will start with a strategy like this in the rest of the chapter, but then delta hedge

Without a delta hedge:

q
2( T t )
Expected Profit = e (
)S
q
Standard Deviation of Profit = 1 2 S T t

Note that the standard deviation only depends on and not e . Also, both the expected
value and standard deviation are linear in , which is a lot of risk. Hence the delta hedging
in the following sections

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QFI Core PWIQF Chapter 10: How to Delta Hedge

Hedging with Actual Volatility

This means that when = a is calculated, d1 and d2 will depend on

One time-step marked-to-market profit

1
2 (
2 2 )S2 i dt + (i a )(( r + D )Sdt + SdX )
e

The final profit is guaranteed to be V (S, t; ) V (S, t; e

), but the way that it is achieved is
random because of the dX term

In the case of discrete hedging, the final profit will be slightly different from the difference
in option values

In summary, the one time-step profit depends on dX when we delta hedge.

The total profit is the difference between the true option value using the actual volatility in
Black-Scholes and the market price of the option

However, the day-to-day profits are volatile

Hedging with Implied Volatility

This means that when = i is calculated, d1 and d2 will depend on e

One time-step marked-to-market profit

1
2 (
2 2 )S2 i dt
e

This gives a PV of total profit of

Z T
1
2 (
2 2 )
e er(tt0 ) S2 h dt
t0

Note how there is no dX term. The daily profit is deterministic

Another huge advantage is that we do not need to estimate h = e precisely. We just need
to know if it is larger or smaller than the actual volatility

The above integral is path dependent and is maximized when the option ends up at-the-
money (because is largest then)

Profit from Delta Hedged Portfolio Using Hedged Volatility h

Z T
) + 21 (2 h2 )
PV of Total Profit = V (S, t; h ) V (S, t; e er(tt0 ) S2 h dt
t0

This is a quite general formula. We can derive the two P&L formulas we have seen so far:

Hedging with Actual Volatility: h = P&L = V (S, t; ) V (S, t; e

)
Z T
P&L = 21 (2 e
Hedging with Implied Volatility h = e 2 ) er(tt0 ) S2 h dt
t0
QFI Core PWIQF Chapter 10: How to Delta Hedge

Summary of Hedging Strategies

Hedging with Actual Volatility - local fluctations but global certainty

Hedging with Implied Volatility - global fluctations but local certainty

Pros and Cons of Hedging with Each Volatility

Pros for hedging with actual volatility

Know the exact profit at expiration (assuming continuous hedging)

Most reasonable to use if a market-to-model strategy is allowed
This strategy has more leeway than the implied volatility strategy. If your forecast is
close enough, you will still make money

Cons for hedging with actual volatility

The daily P&L fluctations can be substantial, which introduce some risks
Need to use the value of your volatility forecast for

Pros for hedging with implied volatility

Minimal local fluctations in P&L, continual profit

Do not need a precise estimate of actual volatility, just need to be on the correct side of
the trade
Calculating is easy since implied volatility is directly observable
Most reasonable to use if a market value approach is preferred

Cons for hedging with implied volatility

Do not know the final profit, only that it is positive

How Does Implied Volatility Behave?

As stock prices move up and down, implied volatility often changes

Introduces possible inconsistencies in models we have seen

Sticky Strike

This makes the assumption that for each fixed option, the implied volatility over time
should be roughly constant (even if they are different for different options on the same
underlying)
This is a nice assumption to have because if you are holding an option, then you can
assume the implied volatility is a constant like we have in this chapter (e
(t) = e
)

Sticky Delta

c 2014 The Infinite Actuary, LLC Page 9 of 11
QFI Core PWIQF Chapter 10: How to Delta Hedge

This assumes that options with the same moneyness or delta have the same implied
volatility

Time-Periodic Behavior

Looking at patterns of the VIX, it seems like Monday has much larger average changes
QFI Core FAQ Q23: Jensens Inequality

FAQ in Quantitative Finance: Q23 (pages 103-105) - Jensens Inequality

Definition of Convexity:

A function f is convex on an interval if for every x and y in that interval

f (x + (1 )y) f ( x ) + (1 ) f (y)

for any 0 1.

Jensens Inequality:

If f is a convex function and x is a random variable then

E( f ( x )) f ( E( x ))

Convex functions:

All linear functions

y = x2 , y = x4
Payoff and profit functions for long calls/puts

Not convex functions:

y= x
y = x2

E( f ( x )) f ( E( x )) E( f (S)) = f ( E(S))+ Convexity

Let S = E(S) and S = S + e

E( f (S))

= E( f (S + e))
= E f (S) + e f 0 (S) + 21 e2 f 00 (S) + . . .
 

E f (S) + e f 0 (S) + 21 e2 f 00 (S)

 

= f (S) + E(e f 0 (S)) + E( 12 e2 f 00 (S))

= f (S) + 21 E(e2 ) f 00 (S)
= f ( E(S))+ Convexity
Convexity = 1
2 E ( e2 ) f 00 (S)
| {z } | {z }
randomness function convexity

c 2014 The Infinite Actuary, LLC Page 11 of 11