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- 1.Management- A Study on Financial Derivatives-Dr.D.revathiPandian
- Derivatives
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Price Options

Stochastic Process

Any variable whose value changes over time in an uncertain way is said to follow a

stochastic process

Can be classed as:

o Discrete – value of variable changes only at certain fixed points in time

o Continuous – value of variable can change at any time

Alternatively, a stochastic process can be classified as discrete variable or continuous

variable

Stock price is assumed to follow a continuous-variable and continuous-time stochastic

process

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Stochastic Process

future

and variance =T

proportional to time

changes are functions of time and the

variable being modelled

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o Markov process – stock future value depends on current value only, not past

value

Process:

2. Make assumptions about future value of stock

3. Calculate the upstate and downstate

4. Then, discount payoff to present value

E is randomly selected

E is characterised by

Normal distribution

Mean = 0

Stdev = 1

Not practical as stock price can’t be negative

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process a is fixed at every period

‘Scatter’ of risk component

Not practical as a return cannot be applied for all stocks e.g. compare

initial stock price of 1 and 100

Ito Process Insert formula

a and b are functions of price i.e. this assumption converts constants a

& b into functions

Geometric Brownian Insert formula

Motion Special form of Ito Process

Describes changing price of stocks only

Markov Process

o The history does not matter

Therefore, Expectation of past price = expectation of today’s price only

Changes in value at different time intervals are independent

o The stocks return on day 1 is independent of the stocks return on day 2

As the returns are independent – and thus, uncorrelated – the variances of the stock

return over a period of time are additive

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Technical analysis does not work

Markov Process is consistent with weak-form market efficiency

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Wiener Process has a drift rate of 0 (a=0) and a variance rate of 1 (b=1)

Definitions:

o Drift rate: mean change per unit of time

o Variance rate: variance per unit of time

GWP: drift rate and variance rate are set equal to any chosen constants

The Wiener Process is a special form of GWP

o WP a=0, b=1

WP GWP

∆𝑥 = 𝜀√∆𝑡 → 𝑑𝑧 𝑑𝑥 = 𝑎𝑑𝑡 + 𝑏𝑑𝑧

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Rewatch lec

1) GWP is normally distributed therefore it can become negative

a. However, stock prices cannot be negative therefore a more

reasonable model would assume that continuously compounded

returns are normally distributed

2) If stock prices follow GWP, then the variance of the stocks prices is

constant regardless of price level

a. It is more reasonable to assume returns have a constant variance,

regardless of price level

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Ito Process

In an Ito process:

o Drift rate and variance rates are functions of time and the underlying variable

GWP fails to capture the aspect of stock prices i.e. the expected percentage return

required by investors from a stock price is independent of the stock’s price e.g. if

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investors require a 14% return when the stock price when it is $10, then, ceteris

paribus, they will also require a 14% return when the stock is $1000

o Recap: GWP stock price has a constant expected drift rate and a constant

variance rate

Therefore, the assumption of constant drift rate is not appropriate and needs to be

replaced by the assumption that the expected return (expected drift divided by stock

price) is constant

The Parameters

o Dependent on the risk of the return from the stock and interest rates in the

economy

o Higher interest rates = higher expected returns on any given stock

Note that: the value of the derivative dependent on a stock is generally independent

of u

Sigma is important in discerning the value of derivatives

Ito’s Lemma

Price of a stock option is a function of the underlying stocks price and time

The price of any derivative is a function of the stochastic variables underlying the

derivative and time

Suppose variable x follows Ito’s process

Where,

o dz is a Wiener Process

o a & b are function of x & t

Variable x has a drift rate of a and a variance rate of b2

Page 291 for more information

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Refer to Page 292

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Use Ito’s lemma to derive the process followed by ln(S) when S follows the process

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Summary

o History is irrelevant

Wiener process dz

o Describes normally distributed variable

o Drift rate = 0

o Variance rate = 1

o Thus, if variable value is x0 at time 0, then at time T, it will have:

Mean x0

Stdev √T

Generalised Wiener Process

o Evolution of normally distributed variable with a drift rate of a per unit time

and a variance rate of b2 per unit time where:

a and b are constants

o Thus, if variable value is x0 at time 0, then at time T, it will have:

Mean x0 + aT

Stdev b√T

Ito process

o Drift and variance rate of x can be a function of both x itself and time

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over longer periods of time is likely to be non-normal

It’s Lemma

o Calculates the stochastic process followed by a function of a variable from the

stochastic process followed by the variable itself

Pricing of derivatives

o Key point: Wiener process (dz) underlying the stochastic process for the

variable is the same underlying the stochastic process for the function

underlying the variable

Both are subject to the same underlying source of uncertainty

The stochastic process assumed for a stock price is Geometric Browning motion

(GBM)

o Returns to the holder of the stock in a small period of time is normally

distributed

o And, returns in two non-overlapping periods are independent

The value of a stock price at a future time has a lognormal distribution

The B-S model is based on the GBM assumption

Process Equation

Wiener Process ∆𝑥 = 𝜀√∆𝑡

Generalised Wiener 𝑑𝑥 = 𝑎𝑑𝑡 + 𝑏𝑑𝑧

Process Where a & b are constants

∆𝑥 = 𝑎∆𝑡 + 𝑏𝜀√∆𝑇

∆𝑥 = 𝑎(𝑥, 𝑡)∆𝑡 + 𝑏(𝑥, 𝑡)𝜀√∆𝑡

Geometric Brownian 𝑑𝑆 = 𝜇𝑆 𝑑𝑡 + 𝜎𝑆 𝑑𝑧

Motion: a special

∆𝑆 = 𝜇𝑆∆𝑡 + 𝜎𝑆𝜀√∆𝑡

form of Ito process

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Ito’s lemma

How do we select 𝜀?

Randomly selected

Normally distributed

Mean = 0

GWP Limitations

Returns are reflected differently depending on stock price e.g. $3 return on a stock

price of $3 and $300 reflected as 100% and 1% return

Ito’s process accounts for this limitation

MODEL

CONCEPTS

How volatility can be estimated from

o Historical data

o Or, from option prices

B-M model extending to European Calls and Puts

Pricing American call options on dividend paying-stocks using B-M model

Stock price behaviour used by the B-M model assumes that percentage changes in

stock price within a short time period are normally distributed.

Define:

o u = expected return on stock per year

o o = volatility of stock price per year

Approach Example 14.1 on Page 300

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Variables with lognormal distribution can take any value between 0 and ∞

o Unlike normal distribution, lognormal is skewed so that mean, median and

mode take on different values

Insert lognormal graph

Approach Example 14.2

distribution of the continuously compounded rate of return earned on a stock

between time 0 and T

Refer to example 14.3 to define continuously compounded rate of return

o Stocks riskiness

o Interest rates in the economy

the value of the stock when expressed as a value of the underlying stock does not

depend on u

Approach equations

VOLATILITY

Stock volatility typically ranges between 15% and 60%

The differential equation must be satisfied by the price of any derivative dependent

on a non-dividend paying stock

Arguments applied to B-M differential equation:

o Assume no arbitrage to value binomial stock price movements thereby setting

up a riskless portfolio consisting of a position in the derivative and a position in

the stock

o Given no arbitrage, return from portfolio must be the risk-free interest rate, r

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PRICING DERIVATIVES

o The price of the underlying process

Which follows a stochastic process

o Time

Ito Lemma is used to characterise the behaviour of a function of a stochastic variable

o The derivatives process is described as using the process followed by the

underlying stock

PARAMETERS

µ Stdev

The expected continuously Stock price volatility

compounded return earned by the Interpreted as the stdev change in

stock per year stock price in one year

Value of derivative dependant on a

stock is usually independent of

return

ASSUMPTIONS:

Stock price follows GBM (ds = uSdt + stdev.dz)

Short-selling of securities is permitted

There are no transaction costs or taxes

Securities are perfectly divisible

There are no dividends during the life of an option

There are no arbitrage opportunities

Security trading is continuous

The risk-free rate of interest is constant and the same for all maturities

o r is not stochastic and remains constant

o However, GBM does not capture jumps in stochastic process

E.g. dramatic share price movements due to market news

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Assumes stdev is constant – it is stochastic

Overall, there is a pricing bias

An American call on a dividend-paying stock should be exercised immediately prior to

an ex-dividend date

o i.e. before the price drops due to the dividend payment

Consider exercising before the final dividend:

o If call is exercised before dividend payment

Holder receives intrinsic value = S(tn) – k

o If call is not exercised, the stock price will drop to S(tn) – Dn

NB: call price is bounded above: C(tn+) ≥ S(tn) – Dn – ke-r(T-tn)

o Where RHS is min. value of option when holding a call

If S(tn) – k ≤ S(tn) – Dn – ke-r(T-tn) then the intrinsic value is LESS than the call price

o DO NOT EXERCISE the call and continue to hold it

It may be optimal to exercise immediately prior to an ex-dividend date if:

Where,

Di is dividend

ti is the time right before the stock going ex-dividend

For an American call option on a non-dividend paying stock, the value is the same as

the value of the corresponding Euro call option

For an American call option on a dividend-paying stock, B-S suggests an

approximation procedure

o Calculate the prices of Euro call options that mature at times T and Tn (time

you may consider exercising the option prior to maturity)

o Then, approximate the American price as the greater of the two

Alternatively, the Binomial Model can be utilised

INDEX OPTIONS

o S&P100 Index (OEX and XEO)

o S&P 500 Index (SPX)

o Dow Jones Index times 0.01 (DJX)

o NASDAQ 100 Index (NDX)

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U.S. exchange-traded contracts are on 100 times index & settled in cash

OEX is American

The others are European

In Australia, the S&P/ASX 200 index options gave a multiplier of 10

PORTFOLIO INSURANCE

o On the other hand, hedging limits potential future gains and losses

Portfolio insurance ensures that portfolio value does not fall below a certain level

This is implemented by buying put options directly or using a dynamic replication

strategy with index futures

o i.e. as the market falls, we sell more index futures to account for the changing

delta of the put

Why did this technique contribute towards the 1987 stock market crash?

PROCEDURE

1. How many Put options do we buy?

2. At what Strike price?

3. Verify decision

SUMMARY

The price of any derivative on a non-dividend paying stock must satisfy the differential

equation

Euro options can be valued as if investors were risk neutral as risk premium is not part

of the equation

To value dividend-paying Euro options, adjust the PV of asset

To value American options, use Black’s approximation or binomial trees

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AND CURRENCIES

PORTFOLIO INSURANCE

Portfolio managers use index options to reduce downside risk

Cost of hedging increases as beta of a portfolio increases

o Because more put options are required and have a higher strike price

CURRENCY OPTIONS

Also, actively traded in OTC market

o Large trades are possible in this market, as well as, tailored strike prices,

expiration date and other features

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Alternatively, there are liquid futures options markets for e.g. major currencies vs. the

US dollar

Currency options are utilised by corporations to buy insurance when they have FX

exposure

o It is an alternative to forward contracts

Put Call

can hedge risk by buying put hedge by buying call options that

options on sterling that mature at mature at that time

that time

Strategy ensures that cost of

Hedge strategy guarantees that sterling will not be greater than a

exchange rate applied to sterling certain amount whilst allowing the

will not be less than the strike company to benefit from

price favourable price movements

benefit from favourable exchange-

rate movements

Notes

Forward contracts lock in the exchange rate for a future transaction whereas

option provides insurance

Options require a premium to be paid up front whereas forward contracts cost

nothing to enter into

Forward/Futures Options

Say, we sell FOREX futures/forwards: Say, we buy options on FOREX:

Reduce downside risk Reduce downside risks

Eliminates upside potential Keeps upside open

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RANGE FORWARDS

It is the simultaneous buying and selling of options

o Buy OTM calls and sell OTM puts

Buy/sell strategy may offset cost of options

Range forwards ensure that the exchange rate paid/received will lie within a

certain range

Range forwards:

o Reduce major risk

o Still exposed to little upside and downside risk

The contract is set up so that put price = call price

o No costs when setting up a range forward contract

If company knew it would If company knew it was due to

receive Euro Pounds pay Euro Pounds

Buy Euro put option with strike Sell Euro put option with strike

price K1 price K1

Sell Euro Call Option with strike Buy Euro Call Option with strike

price K2 price K2

Where K1 < forward exchange Where K1 < forward exchange

rate < K2 rate < K2

K1, the put option will be K1, the put option will be

exercised and company can sell exercised against the company

at the exchange rate of K1 who will buy Euro at the

If exchange rate is more than K2, exchange rate of K1

the call option is exercised If exchange rate is more than K2,

against the company the call option is exercised and

If exchange rate lies between K1 the company can buy Euros at K2

and K2, neither option is If exchange rate lies between K1

exercised and the company uses and K2, neither option is

the current exchange rate at T exercised and the company uses

the current exchange rate at T

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As strike prices of call and put in a range forward move closer, the range forward

contract becomes a regular forward

Short range forward contract short forward contract

Long range forward contract long forward contract

Payment of dividend yield, q, causes growth in stock price to be less by q

Stock price grows from So today to ST at time T

There is the same probability distribution for the stock price at Time T in each of the

following cases:

1. The stock price starts at So and provides dividend yield at a rate of q

2. The stock price starts at Soe-qt and pays no dividends

When valuing Euro options lasting for time T on a stock paying a known dividend yield

at a rate of q, we reduce the current stock price from So to Soe-qt and value the option

as though the stock pays no dividends

If the amount and timing of the dividends during the life of a Euro option is known, the B-S

can be used to value the option given that stock price is reduced by the PV of all dividends

during the life of an option

Put-Call Parity

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Pricing Formulas

Differential Equation and Risk-Neutral Evaluation (refer to textbook)

Valuation of European Stock Index Options

Forward Prices

Implied dividend yields

Valuation of Euro Currency Options

Forward Exchange Rates

American Options

Euro calls and puts with the same strike price and time to maturity:

F0 = K + (c-p)ert

1 𝑐−𝑝+𝑘ⅇ −𝑟𝑇

q = − 𝑇 𝑙𝑛 𝑆0

The above formula allows term structures of forward prices and dividend yields to be

estimated

OTC Euro options are valued using forward prices (Estimates of q are not required)

American options require the dividend yield term structure

AMERICAN OPTIONS

It may be optimal to exercise American currency and index options prior to maturity

American currency/index options are worth more than their Euro counterparts

More likely to be exercised before maturity:

o Call options on high-interest currencies

High-interest currency expected to depreciate

o Put options on low-interest currencies

Low-interest currency expected to appreciate

o Call options with high-dividend yields

o Put options with low-dividend yields

SUMMARY

Exercising an index option receive/pay 100 times the amount by which index

exceeds strike price

Index options are used for portfolio insurance:

o If portfolio value mirrors the index – buy one put option contract for each

100S0 dollars in the portfolio

S0 is value of the index

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o If portfolio value does not mirror the index, B put option contracts should be

purchased for every 100So dollars in the portfolio

o Strike price of put options purchased should reflect level of insurance required

Currency options are mostly traded on OTC markets

They can be used to:

o Hedge foreign exchange exposure

Receive sterling at T buying put options maturing at T

Paying sterling at T buying call options maturing at T

o Create a range forward contract

Zero-cost contract to provide downside protection whilst giving up

some upside

The B-S can value:

o Euro options on a non-dividend paying stock

o Euro options on a stock paring a known dividend yield

o Euro options on stock indices and currencies

Why?

o Stock index is comparable to a stock paying dividend yield

Dividend yield is the dividend yield on the stocks that make up the

index

o Foreign currency is comparable to a stock paying dividend yield

Foreign risk-free rate is like that of the dividend yield

Binomial trees can be used to value American options on stick indices and currencies

INTRODUCTION

Futures options: exercise of option gives holder a position in a futures contract

FUTURES OPTION

The right, but not the obligation, to enter into a futures contract at a certain futures

price at a certain date

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Call Futures Option: right to enter into a long futures contract at a certain price and

vice versa for Put Futures

Futures Options are generally American and expires on or a few days before the

earliest delivery date of the underlying futures contract

They are referred to by the maturity month of the underlying futures

o There can be more option chains than Futures per year

When a futures position is closed out immediately:

o Call payoff: max (FT – K; 0)

o Put payoff: max (K-FT; 0)

What happens when you exercise Futures option?

o Note that the difference between last and next settlement will be applied to

the delivered Futures contract

Holder acquires a long position in Holder acquire short position in the

the underlying futures contract underlying futures contract

And, a cash amount = to most recent Cash amount = strike price LESS

settlement futures price LESS strike most recent settlement futures price

price

o More liquid than the underlying asset

o Easier to trade

o Futures price is immediately known from trading on the futures exchange

o Exercising does not lead to delivery of the asset but rather, underlying futures

contract is closed out prior to delivery and therefore eventually settled in cash

Appealing to investors

o Futures and futures options are traded in the same exchange

Facilitates hedging, arbitrage and speculation

More efficient market

o Future options incur lower transactions costs than spot options

As we are trading on one exchange therefore do not have to pay

additional margin costs

Payoff from Euro Call with same strike price on the futures price of the asset is:

Max (FT – K; 0)

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If future contract matures at the same time as the option, then FT = ST and the two

options are equivalent

Likewise, Euro put futures option are worth the same as its spot put option when the

futures contract matures at the same time as the option

In a nutshell: Euro Futures options and Spot options are equal when the futures

contract matures at the same time as the option

It is common to regard Euro Spot options as Euro Future options when they are

valued in the OTC markets

Difference between futures options and stock options is that there are no up-front

costs when a futures contract is entered into

In a risk-neutral world, the asset price grows at r-q rather than at r when there is a

dividend yield at a rate q

Using binomial trees

o Create a risk-free portfolio

Short 1 option

Long delta futures contracts

o Calculate delta and input into the risk-free equation to discern risk-free payoff

o Discount back to PV

Blacks model is used to value Euro options on the spot price of an asset in the OTC

market

o This avoids the needs to estimate income on the asset

Assumption that futures price follows lognormal process

Volatility of futures price is same as the volatility of the underlying asset

Euro futures options and Euro spot options are equal when the option contract

matures at the same time as the futures contract

An American futures call option must be worth more than the corresponding

American spot call option

o American futures option can be exercised earlier greater profit to the

holder

American put futures option must be worth less than corresponding American spot

put option

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If there is an inverted market where futures prices are consistently lower than spot

prices then the reverse is true i.e.

o American Call futures options are worth less than corresponding American

spot call option

o American Put futures options are worth more than their corresponding

American spot put option

These differences still hold even when the American futures options and American

spot options expire at the same time

The later the futures contract expires (compared to the options contract), the greater

the differences will be

Its expected return should be zero in a risk-neutral world

Therefore, the expected growth rate of the futures price is zero

The futures price can be regarded like a stock paying a dividend yield of r

Set q=r ensures that the expected growth of F in a risk-neutral world is zero

Some exchanges trade these in preference to regular futures options

More info on pg 372

SUMMARY

Call Put

Holder acquires a long futures Holder acquires a short futures

position position

Cash amount = excess of futures Cash amount = excess of strike

price over the strike price price over futures price

If the expiration dates for option and futures contracts are the same, a Euro futures

option is equal to its corresponding Euro spot option

However, this is not true for American options

If the futures market is normal:

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o An American call futures is worth more than its corresponding American spot

call option

o An American put futures is worth less than its corresponding American spot

put option

If the market is inverted, the reverse is true

Lecture 12

Binomial Trees

At each time interval, stock price is assumed to move by a proportional amount of u

and d

Parameters p u and d are chosen to give correct values for stock price change mean

and variance in a risk-neutral world

Backwards Induction

Work back through the tree using risk-neutral valuation to calculate value of option at

each node ensuring to test for early exercise

Option

Stock Indices q equals the dividend yield on the index

Foreign Currency (FOREX) q equals the foreign risk-free rate

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Construct a tree for the stock price less the PV(dividends) and adjusted volatility

Create a new tree by adding PV (remaining dividends at) at each node

This ensures that the tree combines and makes assumptions similar to when B-S

model is used for Euro options

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Making r or q as a function of time does not affect the geometry if the tree

o The probabilities the tree become functions of time

We can make sigma a function of time by making the lengths of the time steps

inversely proportional to the variance rate

Binomial Tree assumption is that r, q and sigma, are not stochastic however they

are stochastic variables in reality

o Also known as time variance

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Introduction

1) Trees

a. Binomial

b. Trinomial

2) Monte Carlo Simulation (not examinable)

3) Finite differences (not examinable)

Binomial Trees

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B-S model only provided analytic valuations for Euro options – Not American options

Used to approximate movements in the price of a stock or other asset

o Start with initial stock price

o Solve factors of upstate and downstate

o Find probability of up and down

Binomial tree valuation

o Divide life of option into many small time intervals of length delta t

o Assumption that at each time interval, the price of the underlying asset moves

from initial value of S to either Su or Sd

Parameters p, u and d

P, u and d are chosen so that the tree gives correct values for the mean and variance

of stock price changes during time interval delta t in a risk-neutral world

Risk-Neutral Valuation

Risk-Neutral Valuation states that an option (or other derivative) can be valued on the

assumption that the world is risk neutrala9

o NOTE: The probability of payments is risk-neutral BUT investors are still risk-

averse

Therefore, for valuation purposes; we use the following procedure underlying

binomial trees:

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o Assume expected return from all traded assets is the risk-free interest rate

o Value payoffs from the derivative by calculating their expected values and

discounting at the risk-free rate

Determination of p, u and d

As we are working in a risk-neutral world, the expected return from the asset is the

risk-free interest rate, r

Expected return in form of capital gains is r-q

When delta t is small; Cox, Ross and Rubinstein proposed a solution to these

equations:

Note:

o The value of a differs depending on the options underlying the option

When futures underlie an option, a = 1

Given the assumption that the growth rate of futures should be

0. Therefore, r – q = 0 and a = 1

Forex options: r(d) – r(f)

Which is domestic?

o Consider: how many domestic currencies exchange for

one unit of foreign currency i.e. foreign currency

appears as 1 unit

The tree shows future possible price of underlying assets but what about payoff

values of the options?

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Options are evaluated by starting at the end of the tree and working backward

At the final node, the option value is

Using risk-neutral valuation to calculate the value of the option at each node, we

work back through the tree and test for early exercise when appropriate

With Early

Exercise

Without Early

Exercise

Using the Binomial Tree for Options on Indices, Currencies, and Futures Contracts

o Stock indices – q = dividend yield on the index

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o Futures – q = r

Procedure

1) Construct a tree for the stock price less the PV(dividends) with adjusted volatility σ*

3) This ensures that the tree recombines and makes assumptions to those when the B-S

model is used for Euro Options

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It uses the same tree to calculate the value of an American and Euro option

The B-S value of a Euro option is also calculated

It is assumed that the error from the tree used to price to Euro option is the same as

the error from pricing an American option with the same tree

o Difference between B-S and Binomial Tree = estimation error i.e., error

generated from using the binomial tree

The binomial tree valuation is not fully accurate

Euro option value from B-S model is most accurate

Therefore, the price of an American option is estimated to be:

The CVT involves using the tree to calculate difference between the Euro and

American price

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Forgetting to adjust u, d and p calculations when options differ i.e. using the wrong

formula

Forgetting B-S model adjustments for d (1) and d (2) when options differ

o Changes must be made when depending on the stock

Stock

Index

Forex

Futures

o Account for all changes!

Rather than setting u=1/d, we can set each of the probabilities to 0.5

Refer to page 442

Advantage: Probabilities are always 0.5 regardless of the value of sigma or the

number of the time steps

Disadvantage: more difficult to calculate the Greek letters as the tree is no longer

centred around stock price

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In practiced, these variables are time-dependent and are assumed to be equal to their

forward values

o The geometry of the tree is unaffected when r and q is a function of time

o To make sigma a function of time, the length of time steps should be altered

to be inversely proportional to the variance rate

Binomial tree values eventually converge to the true value of the option as more

steps are introduced into pricing error

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Homework

Chapter 16

16.14 Would you expect the volatility of a stock index to be greater or less than the volatility

of a typical stock?

Stock index risk is diversified away when a portfolio of stocks is created

In CAPM, there is systematic and unsystematic risk in returns of individual

stocks

In stock indices, the idiosyncratic risk has been mostly diversified away and

only systematic risk contributes to the volatility

- 1.Management- A Study on Financial Derivatives-Dr.D.revathiPandianHochgeladen vonImpact Journals
- DerivativesHochgeladen vonmahant_8
- Guidance Note on ActgHochgeladen vonapi-3828505
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