Class Notes 1

Derivatives
João Amaro de Matos

Faculdade de Economia
Universidade Nova de Lisboa
October 2008
Contents
1 Introduction to Options 5
1.1 Notions and Notation . . . . . . . . . . . . . . . . . . . . . . . 5
1.2 Payoff and Profit of Options . . . . . . . . . . . . . . . . . . . 6
1.3 Strategies with Options . . . . . . . . . . . . . . . . . . . . . . 8
2 Bounds on Option Prices 11

2.1 Bounds on the Value of the Underlying Asset . . . . . . . . . 11
2.2 Bounds on the Exercise Price . . . . . . . . . . . . . . . . . . 12
2.3 Bounds related to Time . . . . . . . . . . . . . . . . . . . . . 14
2.4 Put-Call Parity . . . . . . . . . . . . . . . . . . . . . . . . . . 16
3 The Binomial Option Pricing Model 19

3.1 Trees and One-Period Binomial Trees . . . . . . . . . . . . . . 19
3.2 The Binomial One-Period Model . . . . . . . . . . . . . . . . . 19
3.3 Multiple States with More Time Steps . . . . . . . . . . . . . 21
3.4 General Strategy for Several Periods . . . . . . . . . . . . . . 22
3.5 The Multiple Period Binomial Model . . . . . . . . . . . . . . 24
3.6 The Binomial Formula in Two Periods . . . . . . . . . . . . . 26
4 State Prices and Valuation of Derivatives 30

4.1 States of Nature and Digital Options . . . . . . . . . . . . . . 30
4.2 Expectations . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
4.3 What is a Derivative? . . . . . . . . . . . . . . . . . . . . . . . 34
4.4 Pricing Options and Recovering the Binomial Model . . . . . . 35
4.5 Recovering Digital Options from the Market . . . . . . . . . . 38
4.6 Hedging and State Prices . . . . . . . . . . . . . . . . . . . . . 39
5 Stochastic Volatility and Term Structure of Interest Rates 43

5.1 Valuing Options in the Presence of a Term Structure . . . . . 43
5.2 Valuing Options in the Presence of Time Varying Volatility . . 45
5.3 Valuing Options in the Presence of Stochastic Volatility . . . . 47
5.4 An Example Integrating both Effects . . . . . . . . . . . . . . 49
6 From the Binomial Formula to the Black-Scholes Formula 50

6.1 The Multiperiod Binomial Formula . . . . . . . . . . . . . . . 50
6.2 From volatility to U and D . . . . . . . . . . . . . . . . . . . . 54
6.3 Black-Scholes as a Limit of the Binomial Model . . . . . . . . 57
1
7 Valuing American Options and Options on Dividend-Paying
Assets 60
7.1 Early Exercise of Puts . . . . . . . . . . . . . . . . . . . . . . 60
7.2 Discrete-Time Adjustment for Dividends . . . . . . . . . . . . 62
7.3 Black-Scholes Valuation with Constant Dividend Yield . . . . 65
7.4 Black-Scholes Valuation with Constant Discrete Dividend . . . 67
8 Properties of the Black-Scholes Model 69

8.1 Call Value as a function of the Underlying Asset . . . . . . . . 69
8.2 The Systematic Risk of Options . . . . . . . . . . . . . . . . . 71
8.3 Call Value and the Volatility of the Underlying Asset . . . . . 72
8.4 Other Limiting Behaviors . . . . . . . . . . . . . . . . . . . . 74
8.5 Implied Volatility . . . . . . . . . . . . . . . . . . . . . . . . . 75
9 Pricing Corporate Securities 76

9.1 Equity as an Option . . . . . . . . . . . . . . . . . . . . . . . 76
9.2 Corporate Bonds . . . . . . . . . . . . . . . . . . . . . . . . . 78
9.3 The Risky Part of Corporate Bonds . . . . . . . . . . . . . . . 79
9.4 Decomposition of Risky Bonds . . . . . . . . . . . . . . . . . . 80
9.5 Shareholder Incentives . . . . . . . . . . . . . . . . . . . . . . 81
9.6 Convertible Bonds as a Solution . . . . . . . . . . . . . . . . . 82
9.7 Callable Convertible Bonds . . . . . . . . . . . . . . . . . . . . 84
10 Real Options 87
10.1 Working Example: An option to abandon . . . . . . . . . . . . 88
10.1.1 Options Payoffs . . . . . . . . . . . . . . . . . . . . . . 89
10.1.2 Option Value and adjusting the Discount Rate . . . . . 90
10.2 Types of Real Options . . . . . . . . . . . . . . . . . . . . . . 92
10.3 Growth Options . . . . . . . . . . . . . . . . . . . . . . . . . . 92
10.4 Application: Natural Resource Investment . . . . . . . . . . . 94
10.4.1 Discrete time: does it make any difference? . . . . . . . 95
10.4.2 Probability that Extraction will Proceed . . . . . . . . 96
11 Dynamic Delta Hedging and the Greeks 98

11.1 Hedging Strategies . . . . . . . . . . . . . . . . . . . . . . . . 98
11.2 Dynamic Delta Hedging . . . . . . . . . . . . . . . . . . . . . 100
11.3 The Greeks . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
11.4 Greeks and the Black-Scholes Model . . . . . . . . . . . . . . 106
2
12 Principles of Simulation 108
12.1 From the Binomial Tree to a Continuous-Time Process . . . . 108
12.2 Simulating Paths and Payoffs . . . . . . . . . . . . . . . . . . 109
12.3 Estimating the Value of a Derivative . . . . . . . . . . . . . . 112
12.4 Alternative Processes . . . . . . . . . . . . . . . . . . . . . . . 113
12.5 Simulating the Value of a Derivative on Two Assets . . . . . . 115
13 Exotic Options 118

13.1 Packages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
13.2 Options on Options . . . . . . . . . . . . . . . . . . . . . . . . 119
13.3 Barrier Options . . . . . . . . . . . . . . . . . . . . . . . . . . 120
13.4 Asian Options . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
13.5 Lookback Options . . . . . . . . . . . . . . . . . . . . . . . . . 122
14 Discrete-Time Models for Options on Interest Rates 124

14.1 The Black and Scholes Failure . . . . . . . . . . . . . . . . . . 124
14.2 Models for Interest rates . . . . . . . . . . . . . . . . . . . . . 125
14.3 The Rendleman and Bartter Model . . . . . . . . . . . . . . . 126
14.4 The Ho and Lee model . . . . . . . . . . . . . . . . . . . . . . 128
3
Foreword
This text contains the class notes for a 6-weeks course about derivatives.
Students following this course are assumed to have been exposed to basic
corporate Finance and Investments, being aware of concepts such as the time
value of money, the tradeoff between risk and return, and basic valuation
models of risky cash-flows.
The first three chapters are presented for completeness and revise the
basic concepts of Options, discussing payoffs, basic strategies using options,
no-arbitrage properties of Option prices and the principles of Binomial model
(at least in one and two periods). Students having completed the course
of investments should have been exposed to this material to some extent.
The Derivatives’ class material starts actually in Chapter 4 and goes to the
end. Examples are provided at each chapter, and should be taken as solved
exercises for the benefit of studying.
The course includes quizzes to be completed by the end of each week
(Sundays) and four home works that intend to capture a more practical side
of the taught material.
4
1 Introduction to Options
1.1 Notions and Notation
An option is defined as a contract giving the right to buy or to sell a certain
asset during a certain period of time, for a predefined price K, termed the
exercise price of the option.
The maturity of the option, denoted by T, is the limiting point in time
at which the option can be exercised. If the option can be exercised only at
maturity, the option is said to be European. On the other hand, if the option
can be exercised at any point in time until maturity, the option is said to be
American.
If the option gives the right to buy the asset, it is said to be a call, whereas
if it gives the right to sell it is known as a put option. Who sells (writes) the
option is said to be in a short position, and who buys it is said to go long.
To value an option amounts to value the right underlying that contract.
In fact, such value has a strictly positive value, provided the future uncertain
value of the underlying asset includes the possibility of making some profit.
The natural question is to understand what are the determinants of such
value. If the contract is written at time τ , with maturity T and an exercise
price K, its value depends on
• Sτ ,the value of the underlying asset at τ ;
• T − τ , the time to maturity;
• Volatility σ, measuring the uncertainty of returns of the underlying

asset;
• K, the exercise price;
• interest rate.
The following notation will be used when necessary, to distinguish be-

tween European and American options:
• Ce : value of an European call ;
• Ca : value of an American call ;
• Pe : value of an European put;
5
• Pa : value of an American put.
Clearly, Ca ≥ Ce and Pa ≥ Pe , since the American contracts include more

rights than the European. Another relevant aspect of these contracts is to
know at time τ , how the value of the underlying asset Sτ relates to the exercise
price K. If the exercise of an otherwise similar American instrument were
possible with profit, the instrument is said to be in the money. Otherwise,
the instrument would be out of the money. In case of indifference (or zero
profit), the instrument is said to be at the money. Exemplifying for a call :
Example 1.1 • If Sτ > K a call is said to be in the money;
• If Sτ < K a call is said to be out of the money;
• If Sτ = K a call is said to be at the money.
We can also exemplify the principle in the case of a put,
Example 1.2 • If Sτ < K a put is said to be in the money;
• If Sτ > K a put is said to be out of the money;
• If Sτ = K a put is said to be at the money.
1.2 Payoff and Profit of Options

The payoff of an option is the value obtained from holding that option until
exercise. In the case of a call option, a necessary condition for exercise is
that S > K. In case it is exercised at time τ , its payoff is Sτ − K. If it is not
exercised its payoff is zero. Hence, at the moment of a potential exercise, the
payoff of a call may be written as
max[0, Sτ − K]
as illustrated in the first graphic of figure 1. In the case of a put, the necessary
condition for exercise is that S < K, and if it is to be exercised at time τ ,
its payoff will be K − Sτ . Hence, the payoff of a put may be written as
max[0, K − Sτ ]
6
call’s payoff put’s payoff
6 6
@
@
@
@
@
@
@
K @ K
- Sτ @ - Sτ
Figure 1: Payoff of a call and a put.
call’s profit put’s profit

6 6
@
@
@
@
@
@
@
K - @ K -
Sτ @ Sτ
Figure 2: Profit for a call and for a put.
7
which is depicted in the right side of figure 1.
Notice that a call protects the long side - a potential buyer - from the
risk of unexpected upward movements in the value of the underlying asset.
Similarly, a put option protects the short side - a potential seller - from the
risk of a sudden decrease of that value.
However, the profit on the exercise of the option is always less than the
payoff, since the option has a premium, the value paid for. Hence, the graph-
ics for the profits should look like those in figure 2. Notice that the graphics
are similar to those for the payoffs, except that they are shifted downwards
by an amount equal to the future value of the option.
1.3 Strategies with Options

There are three types of uses for this type of instruments in the financial
markets. The first, and most important, is to cover risk, and is made by
hedgers. For instance, if an agent wants to protect himself from the risk of
the future uncertain value of an asset, he/she may buy an option with a
established exercise price, eliminating that risk.
The second type of use of these instruments is associated with speculation.
If one believes that the value of a stock will increase in the future, a long
position on an at-the-money call may provide good profits, as well as a short
position on an at-the-money put. If, on the contrary, one believes that the
price will drop, the best alternative would be either a short position on an
at-the-money call or a long position on an at-the-money put.
More complicated strategies may be constructed as portfolios of simple
options. For example, if someone wants to protect himself from a high
volatility of an underlying asset, he/she may buy a put option with exercise
price K1 and a call with exercise price K2 > K1 , generating the payoff shown
in figure 3
What you can see immediately from that figure is that if the value of the
underlying at maturity is below K1 the payoff will be positive, the same thing
happening if it is above K2 . Therefore, this strategy protects the investor
against large fluctuations of the underlying asset’s value.
Another type of attitude that would justify this strategy would be to
bet on high volatility. This would be a clear example of speculation. Other
strategies combining the instruments above can be constructed for many
different reasons. Some of the best known are:
8
Portfolio’s Payoff
6
@
@
@
@
@
@ K1 K2
@ - Sτ
Figure 3: Payoff of a portfolio constituted by a call and a put.
• spreads: Combine different types of options of the same class, such as

several calls or several puts. Some examples are:
Example 1.3 • bullish vertical spread: long on a call with exercise price
K1 and short a call with exercise price K2 , with K2 > K1 . The long
position on the first call reflects the expectation that the value of the
underlying ends above K1 ; The short position on the second reflects the
expectation that it is not very likely that the value of the underlying
asset increases more than the threshold K2 . The graphic of the payoff
will show that clearly.
• bearish vertical spread: short on a call with exercise price K1 and long
on a call with exercise price K2 with K2 > K1 .
• butterfly spread: May be seen as a combination of both strategies above.

Go long on two calls, one with exercise price K1 and the second with
exercise price K2 , with K2 > K1 . The position is completed by going
short on two options with intermediate exercise price. Notice that this
strategy is used by people who do not believe in volatility.
• combinations: Combine together calls and puts. Some examples follow:
9
Example 1.4 • bottom straddle: long a call and short a put with the
same exercise price.
• top straddle: short a call and long a put with the same exercise price.
• bottom vertical: long a call and long a put with exercise prices respec-
tively K1 and K2 with K2 > K1 .
• top vertical: short a call and short a put with exercise prices respec-
tively K1 and K2 with K2 > K1 .
In what follows, we leave to the reader the drawing of the payoffs of the
contracts in the examples.
Exercise 1.1 Draw the payoffs of the strategies above (spreads and combi-
nations).
10
2 Bounds on Option Prices
Several bounds for option prices appear naturally from the fact that in equi-
librium, people cannot make money out of nothing.
2.1 Bounds on the Value of the Underlying Asset

The first important bounds are those dependent on the value of the under-
lying asset, S. An example of one such bound is that
C ≤ S, (1)
or the value of a call is always less than the value of the underlying asset.
To see this, notice that if this does not hold, you could sell the option for C,
and you would have more than enough to buy the asset. You could keep the
difference C − S > 0 and still keep the asset, in case the option you sold is
exercised. This type of miracles, called arbitrage opportunities, allows you
to get money with certainty and without any initial investment of yours.
Assuming that such things do not exist in equilibrium financial markets, it
follows that C ≤ S.
Consider now the possibility that the underlying asset pays dividends
with present value D. Of course, being short in an asset that pays dividends
during a certain period of time imply the restitution of the paid dividends.
Also consider that r denotes the interest rate. Then, for a European option,
Ce ≥ max 0, S − Ke−rt − D .

(2)
To see this, notice that if C < 0 you may get a certain profit buying the option
(getting cash for that), and exercising it or not, having always a positive net
result with zero initial cost. Therefore, C > 0, a result known as positivity.
On the other hand, if C < S −Ke−rt −D, you may sell short the asset, re-
ceiving S, from which you should take D out, in order to repay the dividends.
Then, you buy a call option by C and invest Ke−rt in T-bills with the same
maturity as the option. The initial cash-flow is thus S − D − Ke−rt − C > 0.
At maturity the T-bills provide a positive cash-flow of K. In case there is
no exercise, or K − ST > 0, there is a negative cash-flow −ST to cover the
position in the original asset. Together with the T-bills result, this provides
the positive payoff K − ST > 0. In case there is exercise, we use the T-bills
proceed K to pay the exercise of the option and receive the asset to cover the
11
initial short position, generating a null final payoff. In any case, you would
have at zero cost and for sure the positive initial difference, a clear arbitrage
opportunity. Thus, it follows that C ≥ max [0, S − Ke−rt − D] .
If the call is American, an additional bound can be obtained as
Ca ≥ max 0, S − K, S − Ke−rt − D

(3)
To see this, suppose on the contrary that C < S − K. Then, it suffices

to buy the call option and immediately exercise it, realizing a certain profit
C − (S − K) > 0. Again, this would be an arbitrage opportunity, and thus
we must have C ≥ S − K. Since the value of an American option is always
larger or equal to an otherwise identical European option, the other bounds
follow.
The bounds above for call values define a feasible region as a function of
S. Notice that (1) together with (2) imply that
S = 0 ⇒ C = 0,
meaning that the value of a call on a worthless asset is zero.
Exercise 2.1 Suppose that a call option on a stock paying no dividends is

being sold with one-year maturity. The underlying stock is worth 10 euros
today and the exercise price is 7 euros. Assume also that one year from now
there are two states of Nature. The values of the two available digital options,
corresponding to the two different states are Iu = 5/9 and Id = 3/9.
1. If the option is American and is being sold for 2 euros, show that there
is an arbitrage opportunity. How can you make money on that? How
much money would you gain per option?
2. How would your answer above change if the option were European?
2.2 Bounds on the Exercise Price

Similarly, using the same equations with K = 0, it follows that
K = 0 ⇒ C = S,
meaning that an option for which you do not have exercise price is equivalent
to hold the asset itself. Of course, the larger the exercise price, the less
12
valuable will be a call option. In other words, suppose that K1 and K2 are
the exercise prices of two different call options on the same asset and with the
same maturity. Let C(K1 ) and C(K1 ) denote their respective prices. Then,
K1 < K2 ⇒ C(K1 ) ≥ C(K2 ).
This is a very intuitive idea. To see how it works, suppose that C(K1 ) <
C(K2 ). In that case, you can sell the second option by C(K2 ) and buy
the first one by C(K1 ), keeping the positive difference C(K2 ) − C(K1 ) >
0. If the sold option is exercised at any time, you simply have to exercise
simultaneously your long position, providing the asset to deliver plus the
positive cash-flow K2 − K1 > 0. Otherwise, both options are hold until
maturity. In any case, a certain profit at no cost would exist. Assuming that
such arbitrage opportunities are not feasible in equilibrium it then follows
that K1 < K2 implies C(K1 ) ≥ C(K2 ).
Similar reasoning leads to
K1 < K2 ⇒ C(K1 ) − C(K2 ) ≤ K2 − K1 . (4)
and to
K3 − K2 K2 − K 1
K1 < K2 < K3 ⇒ C(K2 ) ≤ C(K1 ) + C(K3 ).
K3 − K1 K3 − K 1
To see this last one, define λ = (K3 −K2 )/(K3 −K1 ) and construct a portfolio
short on one call with K2 , long on λ calls with K1 and long on 1 − λ calls
with K3 , to get an initial cash-flow of
C(K2 ) − λC(K1 ) − (1 − λ)C(K3 ).
If the sold option is exercised at τ < T , it follows that Sτ > K2 and there is a
negative cash-flow K2 − S 0 . If C(Sτ , τ, K1 ) > Sτ − K1 , the calls with exercise
price K1 must be sold, generating a positive cash-flow of λC(S 0 , t0 , K1 ) >
λ(S 0 − K1 ); otherwise they are exercised generating a cash-flow λ(Sτ − K1 ).
Actually, the simultaneous exercise of all options involved generate a total
payoff of zero, since by construction
λ(Sτ − K1 ) + (1 − λ)(Sτ − K3 ) = Sτ − K2 .
The suggested sale of the options may simply add some positive cash-flow,
characterizing an arbitrage opportunity.
13
If the sold option is not exercised before maturity, the portfolio will always
have a positive payoff, whatever the final value of ST is. If this portfolio has
always a positive payoff, its original value C(K2 ) − λC(K1 ) − (1 − λ)C(K3 )
must then be negative, leading to
K3 − K2 K2 − K1
C(K2 ) ≤ C(K1 ) + C(K3 ).
K3 − K1 K3 − K1
Exercise 2.2 Suppose that there are two call options trading with K1 <
K2 ⇒ C(K1 ) − C(K2 )..
2.3 Bounds related to Time

The same type of reasoning may be used for other characterizations of option
prices. In this section we illustrate how the passage of time can impose some
bounds on the value of options.
Example 2.1 For instance, the value of a call must decrease as time goes
by. In fact, the value of an option incorporates a number of possibilities that
may happen in time. As time flows, some of these possibilities become less
likely, diminishing the value of the option.
The example above can be formalized in other words. Consider two iden-
tical American calls, except for the fact that one has maturity T1 and the
other T2 > T1 . Let the values of both options be denoted respectively by
C(T1 ) and C(T2 ). Then
T2 > T1 ⇒ C(T1 ) ≤ C(T2 ).
Suppose that such is not true and we have C(T1 ) > C(T2 ). In that case we
can go short in the first option and long in the second, keeping the initial
strictly positive cash-flow C(T1 ) − C(T2 ) > 0. If the sold call expires without
being exercised, a positive profit is ensured. If the sold option is exercised
at time τ ≤ T1 when the underlying asset is worth Sτ , the total portfolio is
worth C(T2 − τ ) − max[0, Sτ − K]. For an American option we know from
inequality (3) that
Ca (T2 − τ ) > Sτ − K,
whereas for a European option, the bound in (2) gives
K
Ce (T2 − τ ) > Sτ − > Sτ − K.
(1 + r)T
14
Hence, the option in hands may be sold, providing a certain positive cash-
flow. Hence, the assumption that C(T1 ) > C(T2 ) leads to an arbitrage
opportunity, and we must conclude that C(T1 ) ≤ C(T2 ).
A particular argument may be raised for American options, with relation
to the possibility of their early exercise. It is easy to see that the value of
an American call should be greater than S − K between dividend dates. If
not, an arbitrage opportunity exists. To see that, suppose that Ca ≤ S − K
between dividend payments. Build then a portfolio long on a call, short on
the underlying asset and depositing K in the bank. Just before the next
dividend payment, you will have in the bank an amount strictly superior to
K. You can therefore exercise the option, covering your short position on the
asset and keeping a strictly positive, certain and costless profit: an arbitrage
opportunity. We thus infer that, between dividends payments, C > S − K.
This means that, between dividend payments, to hold an American call option
is more valuable than to exercise it.
Notice that if the covering of the short position in the asset were made
after the payment of dividends, the profit would not be sure, since the divi-
dends would have to be additionally paid. It then follows that
Proposition 2.2 (Early Exercise for Calls) An American call option on

an asset paying no dividends is exercised, if at all, only before dividend pay-
ments or at maturity.
The main implication of this fact is that an American call on an asset

paying no dividends will never be rationally exercised before maturity and,
therefore, is worth as much as an otherwise identical European option.
Exercise 2.3 Consider that there are two call options on a risky asset being
transacted, both at-the-money. The first option costs 2.5 euros and has a
one-year maturity. The second option has a two-year maturity and costs
2.35 euros. The price of the risky asset is currently 55 euros.
1. What is the minimum amount of money that you can obtain from that
arbitrage opportunity?
2. Is the arbitrage profit larger if the options are American or smaller (as
compared to the case of European options) ?
15
2.4 Put-Call Parity
Until now, we have talked a lot about European call options as if the rea-
soning for puts were the same. The results for puts, however are slightly
different. However, the absence of arbitrage opportunities allows to relate
the value of a European call to the value of an otherwise identical European
put option. This is known as the put-call parity relationship.
Think of a call and a put European options written on the same asset,
with the same maturity T and exercise price K. Consider now a strategy
where you hold today the call option plus the present value of the exercise
price. Holding that position, you will exercise the call option at maturity if
ST > K, keeping the asset valuing ST , or otherwise will let the option expire
worthless and keep the exercise price K. Your payoff will be
max [ST , K] .
On the other hand, consider the alternative strategy to hold today the put
option together with the asset This implies that, at maturity, you will be
able to choose between what is worth more: the asset valuing ST , in which
case you would not exercise the put option, or the exercise price K, leading
to the same payoff above. The fact that both strategies provide the same
payoff at maturity imply that they should have the same value today.
The Put-Call Parity relation can be thus loosely stated as follows:
Proposition 2.3 (Put-Call Parity) To hold an asset plus the right to sell
it at a given future date is worth as much as to hold the right to buy it at
that point in time together with enough money to do it.
Using our previous notation this reads

K
S + Pe = Ce +
(1 + r)T
To verify this relationship more formally, borrow Ke−rT from the bank at
the rate r. Make this loan with maturity T selling also a call option. With
the money you get, buy a put and buy the underlying asset. The value of
that initial portfolio is thus
K
+ Ce − Pe − S.
(1 + r)T
16
At maturity, if ST ≤ K, the put is exercised, you loose the asset but you
get the exercise price K. The call is not exercised, but since you have to pay
your loan back to the bank and you are left with the net value K − K = 0.
The resulting portfolio is worthless.
If, on the other hand, ST > K at maturity, the put will not be exercised.
However, the call is exercised and you sell your asset for the exercised price
K. Again, you have to pay your loan back to the bank and at the end you
are left with K − K = 0 as before.
Hence, the value of this portfolio is zero, no matter what the final state of
Nature is. Thus, its initial value should also be zero, and the put-call parity
relation follows.
Notice that this result is valid only for European options written on assets
that do not pay dividends. Some of the results can be easily extended.
Example 2.4 If the underlying asset pays dividends, still in the case of Eu-
ropean options, the following holds true:
K
Ce = Pe + S − D − .
(1 + r)T
The proof being similar to the original no-dividend case. In the case
of American options written on assets paying no dividends, the following
bounds can be shown to hold true:
K
Ca − S + K ≥ Pa ≥ Ca − S + .
(1 + r)T
The lower bound follows from inequality (3) together with the fact that Amer-
ican instruments are always more valuable than their European equivalents.
To check the upper bound, build a portfolio shorting a put and one unit of
the underlying asset, and long a call. With a deposit of K at the interest rate
r, this gives an initial value P + S − C − K. If the short put is exercised, you
just have to take K from your bank account, allowing to cover your short
position on the asset. You still have the call plus the remaining cash in the
bank account, clearly positive. Hence, if no arbitrage opportunities exist,
the initial value of the portfolio must be negative, and the original bound
follows.
The Put-Call parity relations allow to translate some of the bounds for
calls above into bounds for puts. An example follows:
17
Example 2.5 For instance, in the case of American options,
K
K ≥ Pa ≥ max[0, K − S, D + − S]
(1 + r)T
This fact follows simply from inequality (3) together with the Parity relation
above.
Example 2.6 Similarly, it follows from expressions such as (4) identical

results for puts that read
K1 < K2 ⇒ 0 ≤ Pe (K2 ) − Pe (K1 ) ≤ K2 − K1 .
We now introduce some exercises with the Put-Call parity relation for
European options.
Exercise 2.4 Show that the value of a call option in-the-money is always
larger than the value on an otherwise identical put.
Exercise 2.5 If a call option at-the-money is worth exactly the same as an

otherwise identical put option and there are no arbitrage opportunities, what
can you say?
Exercise 2.6 IMN share are being transacted for US$45.00. Risk free rates
are at 15% level and you are willing to buy a one-year put option with exercise
price of US$51.75 for hedging purposes. However, in the market you have
only call options. How can you solve your hedging problem? How much would
your strategy above cost?
18
3 The Binomial Option Pricing Model
3.1 Trees and One-Period Binomial Trees
Vu

* V1
*

VH
- V2 V HH
H
HH HH
H HH
HH H
H H
HH
j
H V3
j
H Vd
t=0 t=1
Figure 4: Tree for payoff of a security, given 3 or 2 possible states of Nature
The payoff of a given security is very often represented by a tree, describ-

ing the different possible states of nature, as in Figure 4. Most of the time,
however, we shall limit ourselves to the case of two states per period. This
case generates what is known as a Binomial (because from each nodes there
are two new branches) tree as the one shown in the second part of Figure
4. The two states in a Binomial tree are typically called the up and down
states, leading to the labels used in the figure.
3.2 The Binomial One-Period Model

Consider an economy with two assets and such that uncertainty is represented
by a one-period Binomial tree. We assume that there is a European call
option on an underlying risky asset with exercise price K, leading to the
payoffs Cu = max[0, Su − K] and Cd = max[0, Sd − K], where Su and Sd are
as in the above tree. There is also a risk-free asset that provides a return
r. Let R = 1 + r denote the total risk-free return. Clearly, in equilibrium
R > Sd /S otherwise no agent would invest in the risk-free asset. Likewise,
R < Su /S otherwise there would be no demand for the risky asset. Thus,
Sd Su
<R< . (5)
S S
19
Suppose that we build an independent portfolio constituted of ∆ shares
of the underlying stock and an amount B in the bank that will provide a
risk-free return. The original value of the portfolio is ∆S + B. The total
payoff of the portfolio at maturity will be ∆Su + BR in the up state and
∆Sd + BR in the down state. If we can find values of ∆ and B such that
this portfolio exactly replicates the option’s payoff,
Cu = ∆Su + BR
Cd = ∆Sd + BR,
we then must have C = ∆S +B under the absence of arbitrage opportunities.

To find such values of ∆ and B amounts to solve two unknowns from two
(linear) equations. The solution for this system is
Cu − Cd
∆=
Su − Sd
and
1 Cd Su − Cu Sd
B=
R S u − Sd
leading to

1 RCu − RCd Cd Su − Cu Sd
C = S+
R Su − Sd Su − Sd
1
= [pu Cu + pd Cd ]
R
where
Sd
R− S
pu = Su Sd
S
− S
and
Su
S
−R
pd = Su Sd
.
S
− S
These numbers sum up to one. Since Su /S > R > Sd /S, both pu and pd are
positive. Two positive numbers that sum up to one can be interpreted as
probabilities and the value of the call option can be written as the expected
payoff under this probability measure discounted at the risk-free rate
20
1 p
C= E {max[0, S(t = 1) − K]}.
R
Notice that there is no reason to believe that this probability measure is
the same as the real probability associated to the realization of the states of
Nature. The interpretation of the probability measure used above is inter-
esting. By construction, it is easy to verify that
1
S= [pu Su + pd Sd ],
R
implying that the probability measure used here is the one that agents in
equilibrium would have used in an economy where all the agents were risk
neutral. This can be argued since the present value of the asset is obtained
by discounting at the risk-free rate (therefore without any risk premium in-
corporated). If we assume that the agents are not risk-neutral, the expected
(risky) payoffs of the options should be discounted at a risk premium, using
the real probability of occurrence of the states of Nature. The valuation pro-
cedure just described seem to incorporate two errors that cancel out elegantly,
providing the correct value of the option.
3.3 Multiple States with More Time Steps

One of the more visible limitations of our Binomial trees is that they are
binomial or, in other words, that at each time, it allows only for two possible
states. This is certainly not a very accurate description of what is observed
in reality. Even with a simplified description of future outcomes as we have
done above, it is easy to imagine a situation where more than two future
scenarios are possible.
Things can be made simple if we consider the three-state tree in figure 5.
Notice that, in order to value the asset, we will need three securities
according to the methodology described above. These would generate three
equations to solve for three unknowns. The relevant question is whether we
could price one such asset with only two securities.
To see how this is possible, consider now that there are two possible states
per period, but what is now considered the period is only half of the size of
the former periods.
21
*
S1

SH

- S2
H
HH
H
HH
H
HH
j S3
t=0 t=1
Figure 5: Value of an asset, given 3 possible states of Nature
Example 3.1 Consider the performance of the economy each semester. As-
sume that at the end of each semester the economy may present one of two
possible states: expansion or recession. Hence, after two semesters - or one
year - we may have two consecutive expansions, two consecutive recessions,
or else, a recession and an expansion, not necessarily in this order.
Notice that in this example, both recession followed by expansion and ex-
pansion followed by recession are classified as similar states (stable economies,
in the example). This is not necessarily the general case as figure 6 illus-
trates.1 Hence, with two-state trees, we could construct three final states
by using two time periods. If we wanted four final states, either we do not
recombine the tree assuming that Sud 6= Sdu , or we just had to consider
four-month periods, of course.
3.4 General Strategy for Several Periods

Consider an asset that is supposed to last for a long period of time, with
initial value V (0). A partition of its life period is considered characterizing
a sequence of points in time t = 0, 1, . . .. In order to describe the uncertain
value of the asset during its life, an underlying structure for such uncertainty
over time is required.
For simplicity, the value of the asset will be described as following a
binomial tree. Assume that at each point in time t, future uncertainty is
1
The tree in the example is said to recombine if we assume that Sud = Sdu .
22
*
Suu

Su
H

*
H
HH
j
H Sud
VH

H *
Sdu
HH

j
H
Sd
HH
HH
j
H Sdd
t=0 t=1
Figure 6: Value for the project with two periods.
characterized by the existence of only two possible states of nature at the

subsequent time t + 1. The tree is constituted of nodes and branches.
To establish notation, let each node be characterized by (n, t) , where t
is the point in time and n denotes the number of times that the project
increased value (passed by u states) from time zero until time t (inclusive).
An example of a tree with its nodes is given in figure 7.
The initial node is thus (0, 0). Seen from t = 0, at t = 1 there are two
possible states denoted as (1, 1) and (0, 1), depending on whether the value
of the asset increased or decreased with respect to its initial value. At time
t = 2 there in are principle four possible states, two for each of the possible
states at t = 1. In fact, from state (1, 1), the value of the asset may increase,
leading to state (2, 2) but may also decrease, leading to (1, 2). Similarly, from
state (0, 1) one can achieve either state (1, 2) or (0, 2). Notice that two of
these four states collapse into the same one, leaving only three distinct states
at t = 2. One such tree is said to be recombining.
Finally, markets are taken as complete in the sense that at any point in
time there is a one period risk-free asset besides the asset. Let us assume
that the asset is asset 1 and the risk-free asset is asset 2.
Let j be the number of times up to date t that the value of the asset
23
*
(3,3)

(2,2)
*

HH

(1,1) (2,3)
H
HH
j
*
H *

HH
(1,2)

(0,0)
H

H j
H
H * HH
(0,1) (1,3)
HH HH
j
H j
H
HH *

(0,2)
H
HHj
H
HH
H
j
H (0,3)
Figure 7: Nodes for the three-period tree.
increased. At each node, the value of the asset is denoted by Sj (t). Hence,
1
Sj (t) = [pu Sj+1 (t + 1) + (1 − pu ) Sj (t + 1)] ,
1+r
fully characterizing the value of the asset at any node.
Of course, the value of any asset could be written with the real probabil-
ities p and 1 − p, provided that the discount rate would be suitably adjusted
for its class of risk.
3.5 The Multiple Period Binomial Model

As before, the relationships between value and payoffs of assets characterize
the pricing structure discussed so far, even in multiple periods. The Binomial
model is a further simplification of this structure. In multiple periods it
establishes the existence of rates U and D such that
Sj+1 (t + 1) = U Sj (t) (6)
and
Sj (t + 1) = DSj (t). (7)
for j = 0, 1, . . . , t. Under the assumption that U ≥ D, absence of arbitrage
opportunities implies that U ≥ R ≥ D.
24
*
Suu

Su
H

*
H
HH
j
H Sud
V
H H *
Sdu
HH

j
H
Sd
HH
HH
j
H Sdd
t=0 t=1 t=2
Figure 8: Value of risky asset under with two periods under the Binomial
model.
Let us deal with the case of two periods. In this case we simplify the
notation using S0 (0) = S; S0 (1) = Sd ; S1 (1) = Su ; S0 (2) = Sdd ; S1 (2) =
Sdu ; S2 (2) = Suu , as in Figure 8.
Example 3.2 In the two-period tree above, if S = 90 together with U =

1.3, D = 1.0 and r = 0.10, we have
Su = U V = 1.3 × 90 = 117
Sd = DV = 1.0 × 90 = 90
and
Suu = U Su = U 2 V = 1.3 × 117 = 152.1

Sdd = DSd = D2 V = 1.0 × 90 = 90
Sud = DSu = U Sd = 1.3 × 90 = 117
Clearly, the valuation principles are valid in the sense that

1
Su = [pu Suu + pd Sud ]
R
1
Sd = [pu Sud + pd Sdd ]
R
25
and
1
S = [pu Su + pd Sd ]
R
1 2
pu Suu + 2pu pd Sud + p2d Sdd .

= 2
(8)
R
We can verify this by checking the values of the risk neutral probabilities and
plugging in the formulas. This is illustrated as follows.
Example 3.3 In the example above, it is straightforward to verify that

R−D 1.1 − 1.0 1 2
pu = = = ⇒ pd =
U −D 1.3 − 1.0 3 3
and

1 1 2 1 1 2
Su = Suu + Sud = × 152.1 + × 117 = 117
1.1 3 3 1.1 3 3

1 1 2 1 1 2
Sd = Sud + Sdd = × 117 + × 90 = 90
1.1 3 3 1.1 3 3

1 1 2 1 1 2
S = Su + S d = × 117 + × 90 = 90.
1.1 3 3 1.1 3 3
Exercise 3.1 In the Example above, imagine that we have a two year project
paying at maturity US$9 million in state uu, US$ 111.250 in state ud and a
loss of US$1 million in state dd. How much would you be willing to invest in
that project if the risk free rate is 10% per year?
3.6 The Binomial Formula in Two Periods

Consider the case of a call option with exercise price K on an asset following
the Binomial process defined in equations (6,7). The Binomial formula in
two periods to evaluate a call option is the simple application of equation
(8) to a call option. In this case, the values of the instrument at maturity
should be substituted by the payoff of a call:
Cuu = max [0, Suu − K] = max 0, U 2 V − K

Cdd = max [0, Sdu − K] = max [0, U DV − K]

Cud = max [0, Sdd − K] = max 0, D2 V − K .

26
The value of the call at time t = 1 would be
1
Cu = [pu Cuu + pd Cud ] in state u
R
1
Cd = [pu Cud + pd Cdd ] in state d,
R
and at t = 0 we would have, just as in equation (8),
1
C = [pu Cu + pd Cd ]
R
1 2 2

= p u Cuu + 2p u p d Cud + p d Cdd .
R2
For a put option, a similar procedure leads to
Puu = max 0, K − U 2 V

Pdd = max (0, K − U DV )

Pud = max 0, K − D2 V .

and
1 2 2

P = p u P uu + 2p u p d P dd + p d P ud .
R2
Example 3.4 Assume that the underlying asset is given as in the former
example with S = 90 together with U = 1.3, D = 1.0 and r = 0.10 and
that we have a call option with exercise price K = 100 and two periods to
maturity. In that case
Cuu = max [0, 152.1 − 100] = 52.1
Cdd = max [0, 117 − 100] = 17
Cud = max [0, 90 − 100] = 0
and with pu = 31 ,

1 1 2
Cu = × 52.1 + × 17 = 26.09
1.1 3 3

1 1 2
Cd = × 17 + × 0 = 5.15,
1.1 3 3
leading to
1 1 2
C= Cu + Cd = 11.03.
1.1 3 3
27
* 52.1
* 0

26.09H
0
HH

* H
*
HH HH
j
H j
H
11.03H
17 3.67
HH 0
H *
*

HH HH

j
H
5.15 H

j
H
6.06
HH

H
HH HH
j 0
H j 10
H
t=0 t=1 t=2 t=0 t=1 t=2
Figure 9: Values of a call and a put with two periods under the Binomial
model.
The tree for the values of this call option is given in Figure 9. Similar work
can be done for a put option with two periods to maturity and K = 100. In
that case
Puu = max [0, 100 − 152.1] = 0
Pdd = max [0, 100 − 117] = 0
Pud = max [0, 100 − 90] = 10
and with pu = 31 ,

1 1 2
Pu = ×0+ ×0 =0
1.1 3 3

1 1 2
Pd = ×0+ × 10 = 6.06,
1.1 3 3
leading to
1 1 2
P = Pu + Pd = 3.67.
1.1 3 3
Notice that time to maturity is 2 periods. Hence, the required present amount
to exercise at maturity is
K
= 82.64.
R2
28
Therefore, the put call parity relation reads
K
P +S = C +
R2
3.67 + 90 = 11.03 + 82.64
As an exercise, you can check the validity of this relationship for each possible
state at each time.
This valuation principle is easily extendible to three and more time peri-
ods.
Exercise 3.2 Consider a share with current price £80 and a 2 year Euro-
pean put option with K = 60 written on that share. If the risk free rate is
10% per year and the annual increasing rates for the underlying stock are
U = 1.5 and D = 0.5
1. (a) Please calculate the value of this option.

(b) Please evaluate a call option with the same parameters.
Exercise 3.3 In the following questions consider the following data: U=2,
D=0.5, r=0, the value of the underlying asset is $100 and the exercise price
is also $100.
1. What is the value of a one-period call option on that asset?
2. What is the value of a one-period put option on that asset?
29
4 State Prices and Valuation of Derivatives
We first look at risk-free cash flows at different dates. To find the present
value of a flow X1, X2, . . . , XT at dates t = 1, 2, . . . , T, we use the expression
T
X Xi
V =
t=1
(1 + rt )t
X1 X2 XT
= + 2 + ···
1 + r1 (1 + r2 ) (1 + rT )T
= P1 X1 + P2 X2 + · · · + PT XT ,
where Pt is the present value of one riskless monetary unit to be delivered at

time t. Thus, this present value may be seen as a basket of T goods. If we
are considering a sequence of a risky cash flow Xt at time t with expected
value E (Xt ), its present value will be given by
V = Pβ(t) E (Xt )
where Pβ(t) < Pt , incorporating the risk associated to the cash-flow. Un-
der the assumptions of the CAPM, all economic agents are well diversified
and, therefore, the only component of the risk to be priced is the systematic
risk. As a consequence, the factor Pβ(t) may be calculated as
Pβ(t) = rt + β [E (rm ) − rt ] ,
where
cov X

P
, rm
β= .
σ 2 (rm )
4.1 States of Nature and Digital Options

In the above procedure the risk of the cash-flow was taken into account in the
characterization of the discount rate that defines the value of such cash flow.
In this section we establish how to relate the notion of value of a risky cash
flow to the future uncertainty, without the need for the risk adjustment in the
discount rate, provided enough instruments are transacted in the financial
markets. We shall see that the adjustment for risk is done rather in the
probability measure that characterizes the expected discounted payoff. For
that purpose we need a characterization of risk. Risk is associated with
30
the uncertain realization of unfavorable states of Nature. The description of
uncertainty is made by an enumeration of a set of states of Nature and its
respective probabilities. Each state of Nature describes one of the different
realizations of the world that may happen in the future.
Example 4.1 Suppose that there may be two different possibilities for next
year: either the economy will be in expansion or in recession. In case of
an expansion, the economy is expected to grow by 20%, whereas under a
recession, the economy will have a negative growth of 10%.
In this example, there are two states: expansion (to be called the ‘up’
state) and recession (to be called the ‘down’ state). We shall use the letters
u and d to label the different states.
Consider now a financial instrument that pays 1 monetary unit only if a
certain state occurs, and pays nothing otherwise.
Example 4.2 Since there are two states of Nature, we can imagine two of
such instruments in that case: the first pays 1 if the economy is in expan-
sion one year from now and nothing otherwise, and the other pays the same
amount, but only if the economy is in recession. Let the value of the first
instrument be Iu = 0.40 and the value of the second be Id = 0.50.
These financial instruments are called digital options. They are very
useful since each of them actually provide the present value of a sure unit
received in the given corresponding state and zero units received in any other
state. For that reason, the values of the digital options are often referred to
as state prices. These values can be used to price any other security with
payoffs contingent on the realization of the different states of Nature.
Example 4.3 Consider the following two securities in the market: a risk-
free asset paying 1 unit in whatever state of Nature and a risky asset paying
1.6 in case of expansion but only 0.7 in case of a recession. What is the value
of these securities? To calculate the value of the risk free asset, we just have
to understand that to hold it provides exactly the same payoff as if we were
holding the two different digital options, and thus
risk free price = 0.40 + 0.50 = 0.90.
31
Hence, the risk free rate can be obtained from
1 1
= Iu + Id = 0.9 ⇒ r = − 1 = 1/9 = 11.11%.
1+r Iu + Id
Similarly, we can think of the risky asset as being composed of 1.6 ‘up’ digital
options and 0.7 ‘down’ digital options, leading to the value
risky price = 1.6 × Iu + 0.7 × Id = 0.99.
In general, we may consider a number S of states of Nature. The risk

free rate can be obtained as above by
S
1 X 1
= Is ⇒ r = PS − 1.
1+r s=1 s=1 Is
Exercise 4.1 Consider that one year from now the world economy may be
in expansion, in recession or in a normal state (neither expansion, nor reces-
sion). There are three securities in the market: security A pays 1 monetary
unit in case of a recession or a normal state, zero otherwise, and is worth now
0.65; security B pays 1 monetary unit in case of an expansion or a normal
state, zero otherwise, and is worth now 0.75; security C is a digital option
that pays 1 monetary unit in case of a normal state, zero otherwise, and is
worth now 0.50.
1. You want to issue digital options for the states of expansion and reces-
sion. What should be their fair price?
2. What is the value of a risk free security paying one monetary unit in
either state of Nature?
3. What is the risk free rate?
4.2 Expectations
As we saw in the former section, the digital options can be used in a very
effective way. Consider a number S of states of Nature and a risky security
paying Xs at each state s = 1, 2, . . . , S. Then, if there are digital options
being transacted for each state, the value of the risky security should be
V = I1 X1 + I2 X2 + · · · + IS XS .
32
For convenience, however, we shall write this value in a slightly different way
as
1
V = [I1 (1 + r) X1 + I2 (1 + r) X2 + · · · + IS (1 + r) XS ] .
1+r
Now define ps as
ps = Is (1 + r)
to get
1
V = [p1 X1 + p2 X2 + · · · + ps (1 + r) XS ] .
1+r
Example 4.4 In the example given above we have
10 4
p1 = 0.4 × = = 0.44444
9 9
and
10 5
p2 = 0.5 × = = 0.55555.
9 9
It follows that the value of the risky security given in that example should be
written as
1 4 5
V = × 1.6 + × 0.7 = 0.99
10/9 9 9
It is an evident property that the set of ps sum up to one and that these
are numbers between zero and one. They actually behave as probabilities
and the value of a risky asset may be seen as the expected value (under this
special probability) of its payoffs discounted at the risk free rate
S
1 X
V = ps Xs .
1 + r s=1
It is important to notice two things: first, the set of probabilities ps

do not correspond to the real probabilities of occurrence of the different
states; second, there is no mention to the risk aversion characteristics of any
economic agent up to now.
Exercise 4.2 Consider a risky asset paying 20 euros in case of expansion

and only 5 in case of recession. Expansion happens with 63% probability and
recession with 37% probability. If a risk free asset paying 1 euro in either
state is worth now 0.8 and a digital option for the expansion state is worth
0.5, how much should the risky asset should be worth?
33
4.3 What is a Derivative?
The principle to price a risky cash-flow has already been presented before. In
general a derivative is a security with a risky payoff depending on the risky
cash-flow associated to an asset. In other words, the payoff of a derivative
is a function of the value of the underlying asset. Consider a security that
pays P (Xs ) if state s occurs, where Xs is the value of the underlying asset
in that state of nature. For simplicity consider a Binomial tree for Xs as in
figure 10 with only two states of Nature, u and d. Defining for simplicity
Ps = P (Xs ) , it follows that a derivative pays Pu if state u occurs and pays
Pd if state d occurs.
*

Pu

P H HH
HH
H
HH
H
j
H Pd
Figure 10: Binomial Tree for the payoff of a derivative
The payoff of the derivative is then given by the tree in figure 10 above.
The present value of the risky payoff must therefore be the price of that
security and is given by
P = Iu Pu + Id Pd
Example 4.5 Take again the example 4.3, where Iu = 0.40 and Id = 0.50
and a risky asset paying 1.6 in case of expansion but only 0.7 in case of a
recession. What would be the price of an instrument promising to pay the
double as the risky asset in state u and half of the risky asset in state d?
34
Its value would be simply

1
P = 0.40 × (2 × 1.6) + 0.5 × × 0.7 = 1.455
2
Alternatively, we can define
ps = Is (1 + r)
to get
1
P = [pu Pu + pd Pd ] .
1+r
Example 4.6 Knowing that
1 10 4 5
Iu + Id = = 0.9 ⇒ 1 + r = ⇒ pu = and pd =
1+r 9 9 9
and
4 5 1
P = 0.9 × (2 × 1.6) + × × 0.7 = 1.455
9 9 2
Denoting the expectation under p as E ∗ (x) , we can still rewrite the price
of a derivative as its expected discounted payoff as
1
P = E ∗ (Ps ) .
1+r
Exercise 4.3 Consider an asset that is worth now 100 pounds. If state u
occurs, its value will be 200 pounds; if state d occurs, its value will be only
50 pounds. Both state prices are identical. What is the value of a security
that pays half the value of the underlying asset in state u and the double of
its value in state d?
4.4 Pricing Options and Recovering the Binomial Model

As it should be clear by now, options are simple examples of derivatives. If
the underlying asset is worth S today and its future value is Su in state u
and Sd in state d, we can think of a call option as a derivative with payoff
Cu = max[0, Su − K] (9)
35
in state u or
Cd = max[0, Sd − K] (10)
in state d. The present value of a call is thus
1
C= (pu Cu + pd Cd ) .
1+r
Example 4.7 Using again the example where Iu = 0.40 and Id = 0.50 and a
risky asset paying 1.6 in case of expansion but only 0.7 in case of a recession,
the value of a call option with strike K = 2 is zero, since both Cu and Cd are
zero. A call with K = 1, however, is worth
C = 0.40 × (1.6 − 1) + 0 = 0.24 (11)
Consider now the case of a put option. Here the same principle applies
with
1
P = [pu Pu + pd Pd ] , (12)
1+r
where Pu and Pd denoting the payoffs
Pu = max[0, K − Su ] (13)
in state u or
Pd = max[0, K − Sd ] (14)
in state d.
Exercise 4.4 Consider a risky asset that will be worth 300 euros if state u
occurs, but only 90 euros if state d occurs. If the risk free rate is 30% and
pu = pd ,
1. What is the value of a call at-the-money?
2. What is the value of a put at-the-money?
3. Check the Put-Call Parity.
The Binomial model is a further specification of the structure used so far.

If S denotes the initial value of an asset, this model establishes the existence
of rates U and D such that
Su = U S (15)
36
*

Su = U S

S
H H
HH
H
HH
H
HH
j Sd = DS
Figure 11: Binomial Tree for the prices under the Binomial model.
and
Sd = DS (16)
as illustrated in Figure 11.
Now, let R = 1+r denote the total return at the risk free rate and assume
the equilibrium condition that U ≥ R ≥ D, reflecting the content of equation
(5). In order to recover the Binomial formula, we are left to show that
R−D
pu = .
U −D
The state price probabilities can be calculated in a very simple way. No-
tice that
1
S = [pu Su + pd Sd ]
R
1
= [pu U S + pd DS]
R
implies
R = pu U + pd D.
This, together with pu + pd = 1 leads to
R−D U −R
pu = and pd = . (17)
U −D U −D
37
Since U > R > D, both pu and pd are numbers between 0 and 1, guaranteeing
a safe definition as probabilities.
4.5 Recovering Digital Options from the Market

Clearly, when looking at the markets it is not easy to identify digital op-
tions and the corresponding state prices. However, even if these instruments
do not exist physically, they are implied in the pricing of all the observed
instruments. We shall provide a simple example of how to work that out.
Example 4.8 To illustrate this construction, imagine that there are two as-
sets (asset A and asset B) in the economy, and that there are two possible
states, after each period: state u and state d.
The value of asset A today is S A = U S$20, and the value of asset B is
S B = U S$30. After one period of time, the value of asset A will increase
10%, whatever state occurs. Clearly, asset A is a risk-free asset implying that
r = 0.10 or R = 1.1 and SuA = SdA S A × 0.10 = U S$22.
Asset B will increase by 50% if state u occurs, or decrease by 50% if state
d occurs after one period of time. Asset B is a risky asset with U = 1.5 and
D = 0.5. We have SdB = U S$45 and SuB = U S$15.
It is easily seen that the probability measure in the example above is char-
acterized by
R−D 1.1 − 0.5
pu = = = 0.6 and pd = 0.4.
U −D 1.5 − 0.5
and the values of the (physically non-existing) digital options can be obtained
from the expressions Iu = pu /R = 0.6/1.1 = 0.545 and Id = pd /R =
0.4/1.1 = 0.364.
Exercise 4.5 In the following questions consider the following data: U=2,
D=0.5, r=0, the value of the underlying asset is $100 and the exercise price
is also $100. What is the value of a one-period call option on that asset?
1. (a) $50
(b) $25
(c) $33.33
(d) $16.67
38
Exercise 4.6 What is the value of a one-period put option on that asset?
1. (a) $110
(b) $20
(c) $33.33
(d) $16.67
4.6 Hedging and State Prices

In this section we argue that state prices should be the same for all assets.
If they are not, it is possible to create arbitrage opportunities, i.e., certain
profits at zero cost. In equilibrium markets, such opportunities should not
exist. In order to illustrate how this condition implies that state prices should
be the same for all assets, we first start with an example of a risky asset and
a derivative written on that asset.
Example 4.9 Take again Example 4.5, where Iu = 0.40 and Id = 0.50 and
there is a risky asset paying U S$1.6 in case of expansion but only U S$0.7
in case of a recession. We also considered the existence of an instrument
promising to pay the double as the risky asset in state u and half of the risky
asset in state d. Suppose that this second instrument is transacted by U S$2
in the market place.
From Example 4.3, we know that the original risky asset should cost only
U S$0.99. Hence, we could sell one of these U S$2 instruments and simul-
taneously buy two shares of the risky asset without taking a cent from our
pockets; and we would still be left with U S$0.01, that we could put in a bank
account.
At maturity, there are two possibilities: either we end in the u state, and
the proceeds from our two shares are just enough to cover our short position,
or we end in the d state, earning U S$1.4 from our two shares, more than
enough to cover our short position of U S$0.35. Hence, without spending
any of our resources, in the up state we end with the money deposited in
the bank plus interest, and in the down state we may add to that amount
U S$1.4 − U S$0.35 = U S$1.05. This is an arbitrage opportunity!
In this example, the risk assumed when we sell one of the US$2 instru-
ments is fully covered with the long position on two shares of the risky asset.
39
For that reason we call this portfolio of two shares the hedging portfolio.
Therefore, to construct an arbitrage opportunity amounts to construct a
hedging portfolio that costs, at most, the value of a risky portfolio in hands.
The explanation for this strange “money machine” is that, from Example
4.5, we know that the value of the derivative instrument should be simply

1
P = 0.40 × (2 × 1.6) + 0.5 × × 0.7 = U S$1.455
2
If this were the transaction price, there would have been no arbitrage oppor-
tunities. In the example above, this instrument was selling for US$2, above
its natural (no-arbitrage) price. This can be interpreted as if the derivative
has been priced with implied probabilities different from those implied in the
underlying risky asset.
Example 4.10 Let pD D D

u and pd = 1 − pu be the state prices probabilities
implied in the derivative. Then, and according to Example 4.6 they must
satisfy
D D
1
2 = 0.9 pu × (2 × 1.6) + 1 − pu × × 0.7
2
leading to pD D
u = 0.65692 and pd = 0.34308, quite different from the values
pD D
u = 0.4444 and pd = 0.5555 in Example 4.6.
Therefore, in very simple terms we can say that state prices should be
the same for all assets, otherwise arbitrage opportunities may arise. This
example was made with a risky asset and a derivative written on that asset.
Let us now consider the case of two different risky assets.
Example 4.11 Consider a risky asset being traded currently for SA = £100.
The risk-free rate is 10% and the asset has the following future values, one
period from now: in state up pays £140 and in state down pays £80. This
means that
1 1
pA A A A

£100 = u × 140 + pd × 80 ⇒ pu = pd =
1+r 2
Consider that, at the same time, a different risky asset B is being transacted
for a price SB = £100. Also assume that asset B pays £130 in state up and
40
pays £100 in state down. Using the probabilities above, the correct price of
asset B should be

1 1 1
× £130 + × £100 = £104.55
1+r 2 2
For SB = £100, asset B is, therefore, a very good deal. In fact, an arbitrage
opportunity may arise very simply in the following way: sell two shares of
asset A, getting £200 in that way, borrow £300 from the bank at the risk free
rate and invest those £500 you have got buying five shares of asset B. How
much did you spend from your own money? nothing! How much will you get
back one period from now? In any state, you must pay back to the bank £330.
However, in state up you get 5 × £130 = £650 from your shares of asset B
and have to cover your position in asset A by paying 2 × £140 = £280,
leading thus to a payoff
−£330 − £280 + £650 = +£40.
In state down you get 5 × £100 = £500 from your shares of asset B and have
to cover your position in asset A by paying 2 × £80 = £160, leading thus to
a payoff
−£330 − £160 + £500 = +£10.
In both cases you have generated a strictly positive payoff with zero initial
investment. The hedging portfolio of five shares of asset B fully covers the
risk of your short position, costing exactly the same amount. Again, we have
an example of an arbitrage opportunity. Once more, this can be explained
by the fact that the price SB = £100 incorporates state price probabilities
different from those calculated above:
1 1 2
pB B B
and pB

£100 = u × £140 + pd × £80 ⇒ pu = d = .
1+r 3 3
The arbitrage strategy build above was not by chance. We show now
what is the rational behind this construction. Denote by n the number of
shares of an asset that you buy (n < 0 is interpreted as a selling position). In
particular, let nA and nB denote the number of shares of asset A and asset B,
respectively, in your portfolio. Also, let β > 0 denote the amount of money
(in units of £100) that you lend to the bank at the risk free rate, whereas
β < 0 denotes the amount that you borrow from the bank. The total cost of
41
a portfolio in assets A, B and cash is thus 100nA + 100nB + 100β. If we want
a zero cost portfolio,
100 × nA + 100 × nB + 100 × β = 0.
At maturity we must have a positive payoff at any state:
110 × β + 140 × nA + 130 × nB ≥ 0

110 × β + 80 × nA + 100 × nB ≥ 0.
This system solves for

3
−3nA ≥ nB ≥ − nA ⇒ nA < 0; nB > 0.
2
together with
β = − (nA + nB ) .
Our choice of nA = −2, nB = 5 and β = −3, clearly satisfy the solution
above.
Exercise 4.7 In the last Example, for £2 sold shares of asset A
1. (a) What would the maximum amount of shares of asset B allowed in

a hedging portfolio be?
(b) In that case, what would have been the arbitrage payoffs in each
state of nature?
Exercise 4.8 Suppose that an at-the-money call option on asset A above is

being sold for £15. Please construct an arbitrage opportunity ignoring the
existence of asset B.
42
5 Stochastic Volatility and Term Structure of
Interest Rates
So far, both the Binomial model and the Black-Scholes model have assumed
that both the risk-free rate and the volatility of the underlying asset are con-
stant through the life of the option. This assumption is clearly unsatisfactory
from what we know. We will describe a simple way to adjust the evaluation
procedure in the Binomial context to the presence of a term structure of
interest rates and to variable volatility.
5.1 Valuing Options in the Presence of a Term Struc-

ture
Consider a term structure with a spot rate r1 for the first period and a
forward rate r2 for the second period. The underlying asset has an initial
given value that may grow every period at a rate U or decrease at a rate D.
We will consider a two-period setting and European options to setup ideas.
The tree for the values of the Call option is described in Figure 12.
Cuu

*

Cu H

* HH

j Cud
HH
C HH * Cdu
H
HH
j C
d
HH
H
j Cdd
HH
t=0 t=1 t=2
Figure 12: Value of the Call option with two periods under the Binomial
model.
The main trick in this situation is to realize that the risk-neutral proba-
43
bilities are different in each period of time. In fact, recalling that
R−D
pu =
U −D
and that in the first period the total risk-free return will be R1 = 1 + r1 ,
which is different from the total risk-free return will be R2 = 1 + r2 , it follows
that the risk-neutral probability in the first period will be given by
R1 − D
pu1 =
U −D
and for the second period
R2 − D
pu2 = .
U −D
Otherwise, the procedure value any option will follow the usual backward
process in the Binomial model.
Example 5.1 Consider a term structure with a spot rate of 2% for the first
period and a forward rate of 6% for the second period. The underlying asset
has an initial value of 100 euros and grows every period at a rate U = 1.10
or decreases at a rate D = 0.90. Clearly, Cud = Cdu in our example. We will
value a European Call option at the money in that asset with a two-period
maturity. Noticing that R1 = 1.02 6= R2 = 1.05 we get for the first period
R1 − D 1.02 − 0.90
pu1 = = = 0.6
U −D 1.10 − 0.90
R2 − D 1.06 − 0.90
pu2 = = = 0.8
U −D 1.10 − 0.90
Also we have that
Suu = 100 × U 2 = 100 × 1.102 = 121

Sud = 100 × U 2 = 100 × 1.10 × 0.90 = 99
Sdd = 100 × U 2 = 100 × 0.902 = 81
We thus have Cuu = 21, Cud = Cdd = 0. Using the one period Binomial
formula for the second period we have
44
1 1
Cu = [pu2 Cuu + (1 − pu2 )Cud ] = [0.8 × 21 + 0.2 × 0] = 15.85
R2 1.06
and
1 1
Cd = [pu2 Cdu + (1 − pu2 )Cdd ] = [0.8 × 0 + 0.2 × 0] = 0.
R2 1.06
In order to obtain the initial value of the derivative, we must again use
the one period Binomial formula, this time for the first period and, therefore,
using R1 and pu1 . Thus
1 1
C= [pu1 Cu + (1 − pu1 )Cd ] = [0.6 × 15.85 + 0.4 × 0] = 9.32
R1 1.02
Notice that we could have been tempted to use the closed-form expression
for the two-period Binomial model using the two-period rate in the term
structure satisfying
(1 + r2 )2 = (1.02)(1.06) → r2 = 0.04.
1.04−0.9
However, this would lead to pu = 1.1−0.9
= 0.7 and
1 1
C= 2
[p2u Cuu + 2pu (1 − pu )Cud + (1 − pu )2 Cdd ] = [0.49 × 21] = 9.51
1.04 1.042
clearly a wrong answer. In fact, pricing an option in the way we do, assumes
that it is possible to rebalance the replicating portfolio at each node of the
tree at zero cost, and at times t = 0 and t = 1 replicating portfolios must be
build considering different interest rates at each point in time.
5.2 Valuing Options in the Presence of Time Varying

Volatility
We now turn to the case where interest rates are the same in both periods,
but U and D are different at times t = 0 and t = 1. Again, the risk-neutral
probabilities are different in each period of time. In fact, recalling that
45
R−D
pu =
U −D
and noticing that U and D are different for the first and second periods, we
get for the first period a risk-neutral probability
R − D1
pu1 =
U1 − D1
R − D2
pu2 = .
U2 − D2
The valuation then follows the usual backward procedure using the one-
period Binomial Formula.
Example 5.2 Assume that we have a Call option at the money for the same
asset above, but that in the first period we have U1 = 1.1 and D1 = 0.9 but
that in the second period U2 = 1.05 and D2 = 0.95. Let us assume that the
term structure is flat at the level r = 0.02.For the first period we get therefore
a risk-neutral probability
R − D1 1.02 − 0.90
pu1 = = = 0.6
U1 − D1 1.10 − 1.90
R − D2 1.02 − 0.95
pu2 = = = 0.7.
U2 − D2 1.05 − 0.95
We also have
Suu = 100 × U1 × U2 = 100 × 1.10 × 1.05 = 115.5

Sud = 100 × U1 × D2 = 100 × 1.10 × 0.95 = 104.5
Sdu = 100 × D1 × U2 = 100 × 0.9 × 1.05 = 94.5
Sdd = 100 × D1 × D2 = 100 × 0.90 × 0.95 = 85.5.
Notice that in this case the tree for the values of the Call option as the
one shown in in Figure 12 does not recombine at t = 2, and we then have
Cuu = 15.5, Cud = 4.5, Cdu = Cdd = 0. Using the one period Binomial
formula for the second period we have
46
1 1
Cu = [pu2 Cuu + (1 − pu2 )Cud ] = [0.7 × 15.5 + 0.3 × 4.5] = 11.96
R 1.02
and
1 1
Cd = [pu2 Cdu + (1 − pu2 )Cdd ] = [0.7 × 0 + 0.3 × 0] = 0.
R 1.02
using R and pu1 . Thus
1 1
C= [pu1 Cu + (1 − pu1 )Cd ] = [0.6 × 11.96 + 0.4 × 0] = 7.04
R 1.02
5.3 Valuing Options in the Presence of Stochastic Volatil-

ity
Now we turn to a more delicate problem. Assume that volatility (the set of
values of U and D) depends not only on the point in time, but also on the
state of Nature. In other words, assume that not only U2 and D2 at time
t = 1 are different from U1 and D1 , but also the values of U2 and D2 depend
on whether we arrive at t = 1 in the up node or in the down node. This
makes all the sense, since we know that market volatility changes in time,
but changes differently depending on whether the economy is booming or in
a recession. We thus introduce U2u and D2u for the up node and U2d and
D2d .
Example 5.3 Consider again the example in the former section, but con-
sider that if the economy evolves at t = 1 to the down state, we have
U2d = 1.15 and D2d = 0.95. We then have a Call option at the money
for the same asset above. In the first period we have U1 = 1.1 and D1 = 0.9
but in the second period we have U2u = 1.05 and D2u = 0.95 in the up node
and U2d = 1.15 and D2d = 0.95 in the down node. Let us assume that the
term structure is flat at the level r = 0.02.
Now the risk-neutral probabilities are different not only at each point in
time, but also at each node of the tree. In fact, recalling that U and D are
47
different for the first and second periods, and for the up and down node, we
get for the first period
R − D1 1.02 − 0.90
pu1 = = = 0.6
U1 − D1 1.10 − 1.90
as before, and for the up node
R − D2u 1.02 − 0.95
puu2 = = = 0.7
U2u − D2u 1.05 − 0.95
and for the down node
R − D2d 1.02 − 0.95
pdu2 = = = 0.35
U2d − D2d 1.15 − 0.95
We also have
Suu = 100 × U1 × U2u = 100 × 1.10 × 1.05 = 115.5
Sud = 100 × U1 × D2u = 100 × 1.10 × 0.95 = 104.5
Sdu = 100 × D1 × U2d = 100 × 0.9 × 1.05 = 103.5
Sdd = 100 × D1 × D2d = 100 × 0.90 × 0.95 = 85.5
Again we see that in this case the tree for the values of the Call option as
the one shown in in Figure 12 does not recombine at t = 2 and we then
have Cuu = 15.5, Cud = 4.5, Cdu = 3.5 and Cdd = 0. Using the one period
Binomial formula for the second period we have
1 u 1
Cu = [pu2 Cuu + (1 − puu2 )Cud ] = [0.7 × 15.5 + 0.3 × 4.5] = 11.96
R 1.02
and
1 d 1
Cd = [pu2 Cdu + (1 − pdu2 )Cdd ] = [0.35 × 3.5 + 0.65 × 0] = 1.20.
R 1.02
1 1
C= [pu1 Cu + (1 − pu1 )Cd ] = [0.6 × 11.96 + 0.4 × 1.20] = 7.66
R 1.02
48
5.4 An Example Integrating both Effects
We can now calculate easily the value of a Call option on an asset with
stochastic volatility in the presence of a term structure of interest rates.
Consider the last example, but now assume that there is a term structure
with a spot rate of 2% for the first period and a forward rate of 4% for the
second period. Clearly we would still have have Cuu = 15.5, Cud = 4.5, Cdu =
3.5 and Cdd = 0, but now the risk neutral probabilities and the discount rates
should be adjusted for the different periods. Thus,
R 1 − D1 1.02 − 0.90
pu1 = = = 0.6
U1 − D1 1.10 − 1.90
as before, and for the up node
R2 − D2u 1.04 − 0.95
puu2 = = = 0.9
U2u − D2u 1.05 − 0.95
and for the down node
R2 − D2d 1.04 − 0.95
pdu2 = = = 0.45.
U2d − D2d 1.15 − 0.95
Using the one period Binomial formula for the second period we have
1 u 1
Cu = [pu2 Cuu + (1 − puu2 )Cud ] = [0.9 × 15.5 + 0.1 × 4.5] = 13.85
R2 1.04
and
1 d 1
Cd = [pu2 Cdu + (1 − pdu2 )Cdd ] = [0.45 × 3.5 + 0.55 × 0] = 1.51.
R2 1.04
1 1
C= [pu1 Cu + (1 − pu1 )Cd ] = [0.6 × 13.85 + 0.4 × 1.51] = 8.74
R1 1.02
49
6 From the Binomial Formula to the Black-
Scholes Formula
6.1 The Multiperiod Binomial Formula
Assume that an asset has current value S such that its growth rates are U
and D per period, together with the fact that the risk free total discount
ate R = 1 + r, with U > R > D,. This allows us to write the value of a
one-period Call with strike K as
1
C= [pCu + (1 − p) Cd ]
R
where
R−D
p =
U −D
Cu = max [0, SU − K]
Cd = max [o, SD − K] .
For a two-period call the expression of the value is written as

1 2 2
C= p Cuu + 2p (1 − p) Cud + (1 − p) Cdd
R2
with
Cuu = max 0, SU 2 − K

Cud = max [0, SU D − K]

Cd = max o, SD2 − K .

For an arbitrary number of periods T, we have T + 1 final states and the

value of the Call can be written as
T
1 X T T −j
(1 − p)j max 0, SU T −j Dj − K .

C= T p
R j=0 j
In each term of the sum j denotes the number of times that the stock goes
down within those T periods of time, SU T −jDj is the final value of the stock
at maturity T after going down t times, Tj = (T −j)!j!
T!
counts the number of
50
possible different ways in which this may have happened and pT −j (1 − p)j is
the probability of one such path.
If it was not for the max function, the call value could be written as the
sum of differences, which could be rewritten in a simple way as the difference
of sums. In order to eliminate the max function we consider the following.
If there is a value of j such that SU T −j Dj − K ≤ 0, then the max function
can be ignored for that value of j and all values above that level. Let j ∗ be
defined such that
∗ ∗
SU T −j Dj = K
then
j ∗ K

D D K ln T
SU T = K ⇐⇒ j ∗ ln = ln ⇐⇒ j ∗ = SU
.
U U SU T ln D
U
Example 6.1 Consider a Call option on an asset that is worth $50, with
strike K = 58 and 1 month to maturity. If the daily growth rates are U =
1.011 and D = 0.989 we can easily find that
58

ln 50×1.011 30
j∗ = = 8.37
ln 0.989
1.011
This means that among the final 31 payoffs at maturity (T=30), the nine top
are strictly positive (corresponding to j=0,1,. . . ,8) and all other 22 payoffs
are zero (corresponding to all integers j > 8.37).
Thus, the Call option value can be written as

j∗
1 X T T −j j T −j j

C = p (1 − p) SU D − K
RT j=0 j
j∗ j∗
1 X T T −j j K X T T −j
= T
p (1 − p) SU T −j j
D − T p (1 − p)j
R j=0 j R j=0 j
j∗ T −j j j∗
X T Up D (1 − p) K X T T −j
= S − T p (1 − p)j
j=0
j R R R j=0
j
j∗ j∗
X T T −j j K X T T −j
= S (p0 ) (1 − p0 ) − T p (1 − p)j ,
j=0
j R j=0 j
51
where p0 = URp and can be shown to be a number in [0, 1] (a probability) since
p is defined as above.
Now, define for an arbitrary probability π the Binomial function
∗
j
X T
∗
Φ (π; j ) = π T −j (1 − π)j .
j=0
j
This function measure the probability that the number of the down-moves
after T periods is less that j ∗ if the probability that it goes up in every single
time period is π.
Then, the T -period Call value can simply be written as
K
C = SΦ (p0 ; j ∗ ) − T
Φ (p; j ∗ ) .
R
This can be identified as a functional form similar to that of the Black
and Scholes Formula. Its interpretation is simple. A Call entitles its owner
to receive the stock at maturity, with value ST , in exchange for the exercise
price K. The present value of of the stock is S and the present value of the
exercise price is K/RT . The present value of the payoff is thus S − K/RT if
it were exercised with certainty. Since there is uncertainty about the future
exercise of the option, both terms of the payoff have to be adjusted by the
probabilistic terms Φ (p0 ; j ∗ ) and Φ (p0 ; j ∗ ) .
In the Black-Scholes formula, which is the expression above when the
time intervals of the binomial tree are arbitrarily small, the general Bino-
mial factors Φ (π; j ∗ ) are simply replaced by the cumulative Normal stan-
dard probability, N (z), which gives the probability that a normally standard
distributed random variable is less than z. In particular, for volatility σ,
ln (S/K) + (r + σ 2 /2) T
d1 = √ (18)
σ T
and
√ ln (S/K) + (r − σ 2 /2) T
d2 = d1 − σ T = √ (19)
σ T
we have that
K
C = SN (d1 ) − N (d2 ).
RT
52
Additionally, and because this replacement is valid only for time intervals
that are arbitrarily small, we shall use in this context continuously com-
pounded discount rates and replace the discount factor 1/RT by exp (−rT ) ,
leading to
C = SN (d1 ) − K exp (−rT ) N (d2 ). (20)
Example 6.2 Consider the case of a call option where S = 40; σ = 0.3; T =
10 years; K = 40; r = 0.05. Then
(0.05 + 0.045) × 10
d1 = = 1.0014 ⇒ N (d1 ) = 0.84168
0.3 × 3.16
and
(0.05 + 0.045) × 10
d2 = = 0.0527 ⇒ N (d2 ) = 0.52102
0.3 × 3.16
leading to
C = 40N (d1 ) − 40 exp(−0.05 × 10)N (d2 ) = 21.03.
Now consider the case of the same parameters but a maturity reduced to only
9 months. Hence, T = 0.75 and
d1 = 0, 27424 ⇒ N (d1 ) = 0, 60805
d2 = 0, 01443 ⇒ N (d2 ) = 0, 50576
C = 4, 84.
Thus maturity drastically affects the value of the option. The longer the
maturity the more the option is worth. We now change the interest rate to
0.06.In the case of T = 10 we will have
d1 = 1, 10680 ⇒ N (d1 ) = 0, 86581
d2 = 0, 15811 ⇒ N (d2 ) = 0, 56282
C = 22, 278.
Thus a 1 point increase in the interest rate led to a 5.9% increase in the
option price with T = 10. For the short term maturity (T = 0.75), this
interest rate change would lead to
d1 = 0, 30311 ⇒ N (d1 ) = 0, 61910
d2 = 0, 04330 ⇒ N (d2 ) = 0, 51727
C = 4, 98,
53
leading to an increase of only 2.9% in the call option. The long term option
is much more sensitive to changes in discount rates.
By using the Black-Scholes formula instead of the Binomial model, we

left behind the factors U and D, replacing them somehow by the volatility.
We are left to discuss the relation between U, D and volatility σ.
6.2 From volatility to U and D

When trying to build the binomial tree for a practical case, the most common
problem is to try to get the U and D factors from data. If you deal with
market data, you can obtain easily the expected return of the assets and you
can measure its volatility (the standard deviation of the returns). Let us
understand how these market values can lead you to the U and D factors of
the Binomial model.
Let the one period (say one month) average return as measured by past
data be denoted by E, and let the standard deviation of those returns (for
the same period unit) be denoted by σ. We assume that both E and σ are
right estimates of the expected returns and volatility for the future periods.
If the (real) probability of an up-state in the next period is q, we then have
for the next period of time
1 + E = qU + (1 − q) D.
The variance of returns is calculate as the mean square deviation from the
above expected value:
σ2 = q {U − [qU + (1 − q) D]}2 + (1 − q) {D − [qU + (1 − q) D]}2
= q [(1 − q) U + (1 − q) D]2 + (1 − q) [qD − qU ]2
= q (1 − q)2 (U − D)2 + q 2 (1 − q) (U − D)2
= q (1 − q) (U − D)2
Given E and σ we have two equations with two unknowns (U and D) if we
knew the true probability q of the up state. We do not know. In order to
determine the values of U and D we will maximize our uncertainty about q
by assuming that q = 1/2. We thus have the two equations
2 (1 + E) = U + D
2σ = U − D
54
leading to
U = 1+E+σ
D = 1 + E − σ.
For a period of time of arbitrary length h, however, the values of U and
D will not be the same as for h = 1 month. For h = 12 (1 year) the U
will be much larger and the D will be much smaller than for the 1-month
period. And for h = 1/30 (1 day) both U and D will be very close to one.
We thus take U and D to be functions of h and write U (h) and D (h) to get
the equations
2 [1 + E (h)] = U (h) + D (h)
2σ (h) = U (h) − D (h)
to get
U (h) = 1 + E (h) + σ (h)
D (h) = 1 + E (h) − σ (h) .
We are left to specify the behavior of E (h) and of σ (h) . It is obvious that
1 + E (h) = (1 + E)h
as well as σ (h)2 = hσ 2 . This last equality comes from the fact that whatever
happens in the next periods is assumed not to depend on what happened
in the past. Thus, future returns are independent random variables and the
variance of the future return after h periods is the sum of the variances of
independent variables identically distributed. Thus
√
U (h) = (1 + E)h + hσ
√
D (h) = (1 + E)h − hσ.
In the particular case of a very small time interval (h → 0) we have (1 + E)h '
1 + hE and the expressions above become
√ √
U (h) ' 1 + hE + hσ ' 1 + hσ
√ √
D (h) ' 1 + hE − hσ ' 1 − hσ.
These expressions
√ corresponds to√the Taylor expansion of the well known
U = exp hσ and D = exp − hσ .
55
Example 6.3 Consider a stock for which the average monthly return in the
last two years was 0.5% and respective monthly standard deviation was 6%.
If we are to use a monthly binomial tree to evaluate a six months call (a tree
with 6 periods), we get
U = 1 + 0.005 + 0.06 = 1.065

D = 1 + 0.005 − 0.06 = 0.945.
The usual exponential approximation would have given U = exp (σ) = 1.062
and D = exp (−σ) = 0.942, close to the values obtained for the daily tree, as
you can see. If we are to use a one period binomial tree (h = 6), then
√
U (6) = (1 + 0.005)6 + 6 × 0.06 = 1.177
√
D (6) = (1 + 0.005)6 − 6 × 0.06 = 0.883.
√
Here, the usual exponential approximation would have given U = exp hσ =
√
1, 158 and D = exp − hσ = 0, 863. If a daily tree is used (h = 1/30), we
will have
√
U (1/30) = 1 + hσ = 1.011
√
D (1/30) = 1 − hσ = 0.989.
Finally, the usual exponential

√ approximation would have given the almost
√
perfect values of U = exp hσ = 1.011 and D = exp − hσ = 0.989,
not distinguishable from the values obtained for the daily tree, as you can see.
At this point it is important to stress a difference between the Binomial

model and the Black-Scholes model. Although they have exactly the same
root, as the first section of these notes have made clear, the value of a call
option will coincide in both models only when the time interval h is really
small. In the example below. we show how a daily tree approximates better
the value of a Black-Scholes option than a monthly tree.
Example 6.4 Take the above data and assume that the risk free rate is 1%
per quarter and the initial value of the stock is $50. What is the value of a
package of 100,000 call options with strike K = 58 and 1 month to maturity?
Clearly, under the one-period Binomial tree with U = 1.065 the value of
56
each of the call options is zero since the highest possible value of the stock at
maturity will still provide a zero payoff. As you decrease h from the initial
value h = 1, positive payoffs start showing up (actually that happens for
h < 0.17046, corresponding to periods of approximately 5 days). Under the
daily Binomial tree, however, we know from Example 1 that there will be 9
final states in-the-money. The risk neutral probability can be calculated as
p = 0, 497457661, the monthly discount rate is r = 0, 003322284 and the
expected discounted payoff of each option will be C = 0, 014782047. The
package is thus worth $1, 478.20. Using the Black-Scholes model we have
S = 50; σ = 0.06; T = 1; K = 58 leading to
d1 = −2, 388295352 ⇒ N (d1 ) = 0, 008463366
d2 = −2, 448295352 ⇒ N (d2 ) = 0, 007176697
C = 0, 008300479.
Under this model, the value of the package is thus $830.05, almost 44% below
the daily Binomial tree value. But at least the daily tree captures the value
of the option, what the one-period tree is not able to do.
6.3 Black-Scholes as a Limit of the Binomial Model

We here present a simple heuristic derivation of the continuous-time equiv-
alent of the Binomial model. In order to do that, we take the simple one
period model to write
1
C= [pCu + (1 − p) Cd ] ⇐⇒ pCu + (1 − p) Cd − (1 + r) C = 0
1+r
We thus have to characterize p, Cu and Cd as the time interval h tends to
zero. From the section above, we have U (h), D(h) and r(h) such that the
risk-neutral probabilities may be written as
√
1 + r(h) − D(h) 1 + rh − 1 − hσ 1 r √
p = → √ √ = + h
U (h) − D(h) 1 + hσ − 1 − hσ 2 2σ
U (h) − [1 + r(h)] 1 r √
1−p = → − h
U (h) − D(h) 2 2σ
and equation (6.3) reads
1 r √
(Cu + Cd ) + h (Cu − Cd ) − (1 + rh) C = 0. (21)
2 2σ
57
In order to work out this expression, we assume that the call value C is a
continuous (twice differentiable) function of both the value of the underlying
asset S and also the time t. We thus write C ≡ C (S, t) and let the partial
derivatives be denoted by
∂C ∂2C ∂C
CS ≡ ; CSS ≡ 2
; Ct ≡ .
∂S ∂S ∂t
We use a Taylor expansion to write
1
Cu = C + (Su − S) CS + (Su − S)2 CSS + hCt
2
√ 1 2 2
= C + σS hCS + σ S hCSS + hCt
2
1
Cd = C + (Sd − S) CS + (Sd − S)2 CSS + hCt
2
√ 1 2 2
= C − σS hCS + σ S hCSS + hCt
2
√
where use has been made of the fact that Su = SU (h) = S 1 + hσ and
√
Sd = SD(h) = S 1 − hσ . We may then write
Cu + Cd = 2C + σ 2 S 2 hCSS + 2hCt
√
Cu − Cd = 2σS hCS .
Plugging these expressions in equality (21) above, we obtain
1 r √ √
2C + σ 2 S 2 hCSS + 2hCt +

h 2σS hCS − (1 + rh) C = 0
2 2σ
or still
1 2 2
σ S CSS + rSCS + Ct − rC = 0. (22)
2
Hence, the value of a Call option must be a function C (S, t) of the value of
the underlying asset S and the time t such that its partial derivatives must
satisfy the above equation. Furthermore, we now that, by construction, at
maturity
C (S, T ) = max [0, S − K] . (23)
Also, it must be the case that a call option written on a worthless asset is
worth zero
C (0, t) = 0. (24)
58
Given these two (boundary) conditions, it is possible to prove that the ex-
pression in equation (20) is the unique solution to the partial differential
equation (22).
Exercise 6.1 Please show that the expression in (20) solves the partial dif-
ferential equation (22) and satisfies the boundary conditions in equations (23)
and (24).
A simple application of this approach shows that the continuous-time

limit of the delta-hedging parameter can be obtained as
√
Cu − Cd 2σS h
∆= → √ √ CS = CS .
Su − S d S 1 + hσ − S 1 − hσ
59
7 Valuing American Options and Options on
Dividend-Paying Assets
7.1 Early Exercise of Puts
Up to know, we have been dealing only with European options. However,
the discrete time setting (and in particular the Binomial setting) allows to
value American options in a very natural way. We shall illustrate how this
is done with the example given above.
Example 7.1 Consider that V=90 together with U=1.3, D=1.0 and r=0.10,
and also that we have an American put option on that asset with exercise
price K = 100 and two periods to maturity. The Figure below represents the
tree for the values of the option in the case where the option were European.
Looking at this Figure, it is obvious that if we get at time t = 2, we would
exercise the put option if and only if the state of nature was dd (the underlying
asset did not increase value at any time). Otherwise, the value of the option
is zero.
However, if the option is American, the alternative of early exercise is
open. Consider the situation at t = 1. In that case, we have the following. If
0

*

0
HH

* H
HH
j
0
3.67 HH
H
*
Hj
H 6.06
HH
H
j 10
HH
t=0 t=1 t=2
Figure 13: Values of a put with two periods under the Binomial model.
we are in state u (the underlying asset increased value), the value of the put
60
is zero, but the value of early is negative. In that case, the option is clearly
worthless. However, if we find ourselves in state d, the value of holding the
option one more period is 6.06. The alternative is to exercise the option at
that point in time, getting a payoff of 100 − 90 = 10. What would you prefer?
Of course, to exercise immediately the put option. With those payoffs at
t = 1, the value of holding the option at time zero must be calculated again
as
1 1 2
P = × 0 + × 10 = 6.06,
1.1 3 3
higher than the original 3.67 for the European case. Are we done? Not quite,
because we still have to check for the possibility of exercising at time t = 0.
If we do not exercise, the option will be worth 6.06, but isn’t true that we can
exercise immediately the option and get a payoff of 100 − 90 = 10? Yes, it
is. Hence, one such option would be rationally exercised at time t = 0 and
its value would be Pa = 10, much higher than Pe = 3.67.
What we see from this example is that at each state at every point in
time we must compare the value of exercising early to the value of waiting
one more period. In other words, if the value of a European instrument at
time t was
1
Sj (t) = [pu Sj+1 (t + 1) + pd Sj (t + 1)]
1+r
for any state j = 0, 1, . . . , t, now we have the (American) value SjA (t) defined
as
SjA (t) = max SjA (t), Πj (t) ≥ Sj (t)

where Πj (t) is the payoff of immediate exercise in that state, at that point in
time. As you saw in the example, this makes sense working backwards, from
maturity T to time t = 0. Notice that, at maturity, American and European
instruments are worth exactly the same
SjA (T ) = Πj (T ) = Sj (T ).
On step backward, however, American instruments are worth more:
SjA (T − 1) = max [Sj (T − 1), Πj (T − 1)] ≥ Sj (T − 1).
In the case of a put option written in asset S, what we did reads
Πput
j (t) = max [0, K − Sj (t)] .
61
In the case of a call option,
Πcall
j (t) = max [0, Sj (t) − K] .
Exercise 7.1 Consider a share with current price £80 and a 3 year Ameri-
can put option with K = 60 written on that share. If the risk free rate is 10%
per year and the annual increasing rates for the underlying stock are U = 1.5
and D = 0.5, please calculate the value of this option.
7.2 Discrete-Time Adjustment for Dividends

The Binomial Model can be easily extended to the case where the underlying
asset pays dividends. The tree describing the value of the underlying asset
is just as before, except for the fact that, whenever dividends are paid, the
value of the asset is reduced by the exact amount of dividends paid.
The consequence is that at those points in time, the tree suffers a jump.
Since the reduced price will still increase at the rates U and D as before,
the tree no longer recombine its subsequent nodes. This is best seen in an
example.
Example 7.2 Consider the case of an asset with initial value 100 euros,
U = 1.1 and D = 0.9. If there is a dividend of 10 euros at t = 1, the tree
for the price process is depicted in Figure 14. Notice that, because a dividend
was paid, at time t = 2 we have four different states of nature, instead of the
usual three.
The procedure to evaluate a European option is just the same as before.
We can easily illustrate that with the case of a put option on the asset above.
Example 7.3 Consider the case of a European put with K = 88, written on
the asset above. With r = 0.05, the tree for the value process followed by that
option is depicted in Figure 15. Notice that in this example,
1.05 − 0.9
pu = = 0.75
1.1 − 0.9
and the numbers in the nodes are obtained as before
1
Pud = (0.75 × 0 + 0.25 × 16) = 3.810
1.05
1
Pu = (0.75 × 0 + 0.25 × 3.81) = 0.907
1.05
62
110

110

100 @
@
@
100 @
@
R
@ 90
@
@
88
@
R 90
@
80 @
@
@
@
R 72
@
Figure 14: Values of an asset paying dividend at t=1.
0

0.91 @
@
@
max(0,88-88)=0
@
R 3.81
@
3.81 @
@
@
@
R 88-72=16
@
Figure 15: Values of a European put written on an asset paying a dividend
at t=1.
63
The advantage of this method is that it is easily extended to American
instruments, as we have already discussed. For completeness, we give the
following example.
Example 7.4 Consider now the case of an American put with K = 88,
written on the asset above. With r = 0.05, the tree for the value process
followed by that option is depicted in Figure 16. Still with
1.05 − 0.9
pu = = 0.75
1.1 − 0.9
the numbers in the nodes are obtained as before
Pud = max [88 − 80, 3.810] = 8
1
Pu = (0.75 × 0 + 0.25 × 8) = 1.905
1.05
0

1.90 @
@
@ max(0,88-88)=0
@
R 8
@
8 @
@
@
@
R 88-72=16
@
Figure 16: Values of an American put written on an asset paying a dividend
at t=1.
As an exercise we leave to calculate the value of equivalent call options.
Exercise 7.2 Evaluate an American and a European option, with same ex-
ercise price and maturity on that asset.
64
7.3 Black-Scholes Valuation with Constant Dividend
Yield
Consider a tree in the context of the multi-period Binomial model where at
every period the stock pays a dividend that is a fixed percentage of the value
of the stock. Let that dividend yield be denoted by δ (say δ =5%). At time
t = 1 the stock that would go originally either to U S or to DS now will go to
U S (1 − δ) or to DS (1 − δ) . For fixed δ at all times and all nodes, it is easy
to see that the tree recombines at each point in time, and after T periods
one gets to the same T + 1 final states of Nature. The main difference now is
that where earlier we would have at maturity T the value SU T −j Dj when the
stock has gone down j times, now we will have the value SU T −j Dj (1 − δ)T .
Hence the expressions in the first section are all valid for the case of a
constant dividend yield, provided we replace S by S (1 − δ)T . This leads to
K
C = S (1 − δ)T Φ (p0 ; j ∗ ) − T
Φ (p; j ∗ )
R
with now h i
K
ln S(1−δ)T U T
j∗ = .
ln D

U
In the context of the Black-Scholes model nothing will change in the essence.
Just because we have to put the problem in continuous time, we shall replace
the discrete-time payout factor (1 − δ)T by exp (−δT ) , just as we did with
the continuously compounded discount factor. We thus have for the Black-
Scholes call value on a stock paying a continuous dividend yield:
C = S exp (−δT ) N (d1 ) − K exp (−rT ) N (d2 )
where now
h i
S exp(−δT )
ln K
+ (r + σ 2 /2) T ln (S/K) + (r − δ + σ 2 /2) T
d1 = √ = √
σ T σ T
and similarly
ln (S/K) + (r − δ − σ 2 /2) T
d2 = √ .
σ T
In other words, the value of a call on a stock paying a constant dividend
yield is the same as the value of an otherwise identical call option on another
65
stock with initial value lower than the original one, as if the total proportion
of dividends were paid at the origin. So, instead of staring the process from
S, one would start it from S exp (−δT ) .
Example 7.5 Consider the case of the same call option where S = 40; σ =
0.3; T = 10 years; K = 40; r = 0.05 but now with a dividend yield δ = 0.025.
Then
(0.05 − 0.025 + 0.045) × 10
d1 = = 0, 737864787 ⇒ N (d1 ) = 0, 769701691
0.3 × 3.16
and
(0.05 − 0.025 + 0.045) × 10
d2 = = −0, 210818511 ⇒ N (d2 ) = 0, 416514447
0.3 × 3.16
leading to
C = 40 exp(−0.025 × 10)N (d1 ) − 40 exp(−0.05 × 10)N (d2 ) = 13, 87.
Again, consider now the case of the same parameters but a maturity reduced
to only 9 months. Hence, T = 0.75 and
d1 = 0, 202072594 ⇒ N (d1 ) = 0, 580070014
d2 = −0, 057735027 ⇒ N (d2 ) = 0, 476979846
C = 4, 39.
Thus maturity drastically affects the value of the option. The longer the
maturity the more the option is worth. We now check the effect of a change
in the interest rate to 0.06. In the case of T = 10 we will have
d1 = 0, 843274043 ⇒ N (d1 ) = 0, 800462402
d2 = −0, 105409255 ⇒ N (d2 ) = 0, 458025536
C = 14, 88.
Thus a 1 point increase in the interest rate led to a 7.3% (larger than the
former 5.9% when no dividends were present) increase in the option price
with T = 10. For the short term maturity (T = 0.75), this interest rate
change would lead to
d1 = 0, 230940108 ⇒ N (d1 ) = 0, 591319334
d2 = −0, 028867513 ⇒ N (d2 ) = 0, 488485128
C = 4, 53
66
leading to an increase of only 3.2% (also larger than the former 2.9% when
no dividends were present) in the call option. Again, the long term option is
much more sensitive to changes in discount rates. This sensitivity increases
as the initial value of the stock decreases or, equivalently, as the dividend
yield increases.
7.4 Black-Scholes Valuation with Constant Discrete Div-

idend
Suppose that a corporation pays out dividends at discrete points in time, no
mater what state of Nature has been reached. This is different from the case
above of proportional dividends, of course. Assuming that the volatility of
the underlying asset is not affected by the payout of dividends, a Binomial
tree can easily solve the problem as shown in the Example below:
Example 7.6 Consider the stock above for which the average monthly return
in the last two years was 0.5% and respective monthly standard deviation was
6%. The risk free rate is 1% per quarter. The initial value of the stock is $50
and a dividend of $5 is announced to be paid 3 months from now. If we are
to use a binomial tree to evaluate a six months call at the money, we get for
a two-period tree
√
U (3) = (1 + 0.005)3 + 3 × 0.06 = 1.12
√
D (3) = (1 + 0.005)3 − 3 × 0.06 = 0.91
and
1.01 − 0.91
p= = 0.47619
1.12 − 0.91
The values Su = 50 × 1.12 = 56 and Sd = 50 × 0.91 = 45.5 will have to
be diminished by the dividends, in order to start the second 3-month period
with Su0 = Su − 5 = 51 and Sd0 = Sd − 5 = 40.5. Actually, the only state at
0
maturity that will be in the money is Suu = 51 × 1.12 = 57.12, corresponding
to a payoff of 7.12. The value of the call is easily calculated as
1 2

C= 0.47619 × 7.12 = 1.52.
1.012
It has been shown that an effective way to approximate the value of such
options in a continuous time setting is to discount the present values of the
67
dividends from the initial value of the underlying security and then perform
the option value calculation in a regular tree without dividends. In that case
our example would go like this:
Example 7.7 The present value of the dividends is d = 5/(1.01) = 4.95. If

we start the tree with S = 50 − 4.95 = 45.05, the up-up state will give the
only in the money state for the underlying stock, with value Suu = 56.51,
corresponding to a payoff of 6.51. The call option value will thus be
1 2

C= 0.47619 × 6.51 = 1.45.
1.012
Finally we can use the Black-Scholes expression to evaluate the same call
option, by using the same trick: replace the current value of the stock by the
value of the stock minus the present value of the dividends.
Example 7.8 Using the Black-Scholes formula with S = 45.05, σ = 0.06 per
month, K = 50, r = 0.01 per quarter and T = 6 months. Normalizing all
variables to quarters, we get S = 45.05, σ = 0, 103923, K = 50, r = 0.01 and
T = 2. We then get
d1 = −0, 499764094 ⇒ N (d1 ) = 0, 308620598

d2 = −0, 646733479 ⇒ N (d2 ) = 0, 258902226
C = 1, 21
As explained before, the Black-Scholes is not supposed to give the same

value as the Binomial model, since it is a model that assumes continuous
trading of the underlying security in a market that does not admit any arbi-
trage opportunities.
68
8 Properties of the Black-Scholes Model
8.1 Call Value as a function of the Underlying Asset
The Black-Scholes value of a Call option can be seen to be zero for an un-
derlying asset that is worthless. This can be easily seen directly from the
Black-Scholes formula. Just notice that
lim d1 = lim d2 = −∞
S→0 S→0
implying that
lim N (d1 ) = lim N (d2 ) = 0.

S→0 S→0
Thus
lim C = 0.
S→0
The intuition for this result is simple if we think that the Black-Scholes
formula can be seen as the continuous-time limit of a one period Binomial
model. From a initial value S in the Binomial model, the value of the un-
derlying asset evolves to either U S or DS.If the initial value is S = 0, this
means that in this model the asset will expire worthless and, therefore, any
call option should be worth zero.
A second point is that the Call value converges asymptotically to the
present value of a certain payoff as S increases. This can be seen mathemat-
ically in an easy way, since from equations (18) and (refeq:d2)
lim d1 = lim d2 = +∞
S→+∞ S→+∞
implying that
lim N (d1 ) = lim N (d2 ) = 1.

S→+∞ S→+∞
Thus, from the Black-Scholes formula (20),
lim C = S − K exp −rT .

S→+∞
The intuition of this result is also simple, since in the Binomial model this
arbitrary large value for the underlying asset corresponds to a certain exercise
69
of the option. Hence, the value of the Call corresponds simple to the present
value of the payoff: present value of the underlying minus the present value
of the exercise price.
The first important and more general property of the Black-Scholes model
is that the value of a Call option increases with the value of the underlying
asset, all the rest fixed. In mathematical terms, this means simply that
∂C
> 0.
∂S
This can be simply verified by noticing that
∂C
= N (d1 ).
∂S
By definition this is a positive number, since N (d1 ) is nothing else but the
cumulative standard Normal distribution of the number d1 .
Exercise 8.1 Please show the precedent result deriving it directly from the
Black-Scholes formula.
This result somehow reflects a simple intuition. For a given exercise price,
the higher the initial value of the underlying asset, the more likely it is that
it ends up in the money and with a higher payoff. However, we can say
something else about the qualitative behavior of the value of a Call as a
function of the underlying asset. In fact, noticing that
ln (S/K) + (r + σ 2 /2) T
d1 = √ ,
σ T
it follows that d1 increases with S and, therefore, the derivative of C increases
with the value of the underlying asset, characterizing a positive convexity of
the Call value function. In other words, the second derivative is also positive
∂2C
> 0.
∂S 2
The fact that the derivative grows can be better described. Actually, a)
for very low values of the underlying asset (when the option is deep out-of-
the-money) the Call value function is linear and flat and b) for very high
values of the underlying asset (when the option is deep in-the-money) the
Call value function is linear and with slope tending to 1. The Option value
70
behavior is non-linear (its second derivative is not constant) for values of the
underlying asset that makes it close to at-the-money. This behavior is clear
by looking at the expression of the derivative, N (d1 ).
As described above
lim N (d1 ) = 0,
S→0
confirming part a). On the other hand
lim N (d1 ) = 1,
S→+inf ty
confirming part b).
8.2 The Systematic Risk of Options

We know that a call option can be seen as a portfolio of ∆ shares of the
underlying asset plus an amount B invested in the bank at a risk-free rate.
Thus, its value is written as
C = ∆S + B. (25)
Seen as a portfolio, it has a weight xs = ∆S
C
in the underlying asset (with
systematic risk βs ) and a weight xb = BC
in the risk-free asset (with systematic
risk βb = 0). From portfolio theory it follows that the systematic risk of the
call must be given by
βc = xs βs + xb βb
∆S
= βs
C
∂C S
= βs
∂S C
= Ωβs
where
∂C S
Ω=
∂S C
denotes the elasticity of the call option with respect to the value of the
underlying asset. This result also allows to check easily that Ω is larger than
1. In fact, plugging ∆ = N (d1 ) in equation (25) and comparing with the
Black-Scholes expression, it becomes evident that
71
B = −K exp(−rT )N (d2 ) < 0.
Also notice that, by construction, equation (25) may be rewritten as
B
C = ΩC + B → Ω = 1 − > 1,
C
the last inequality following from the fact that B < 0 and C > 0. This result
implies that the beta of an option is larger than the beta of the underlying
asset. In other words, under the CAPM, the expected return on a call op-
tion is larger than the expected return on the underlying stock, reflecting a
more risky position. This is consistent with the fact that a Call option is a
leveraged position (since B < 0).
Since a Call option can be seen as a portfolio on the underlying stock and
on the risk free asset with a weight larger than one (xs = Ω) in the former
and a negative weight (B < 0) in the latter, in a Markowitz Frontier setting a
Call option is therefore located in a straight line that links the risk free asset
to the stock, but located to the right of the stock, reflecting the leveraged
position.
Exercise 8.2 Please provide a similar result for a European Put option and
interpret the result comparing the expected return on the underlying asset and
the expected return on the Put option.
Exercise 8.3 Show that the above elasticity for a Call option, Ω = ∆S/C,
is positive and larger than 1 even in the context of the one-period Binomial
model. What would be the correspondent statement for the elasticity of an
otherwise similar Put option, and what implications would it have to charac-
terize the systematic risk of a Put option?
8.3 Call Value and the Volatility of the Underlying

Asset
We can establish a number of results describing how the value of a Call option
behaves as a function of the volatility σ, all other factors constant.
The first important fact is that as σ grows without bound, to hold a Call
option is equivalent to hold the underlying asset. We can see this from the
limiting expression
72
lim d1 = ∞ ⇒ lim N (d1 ) = 1
σ→∞ σ→∞
and
lim d2 = −∞ ⇒ lim N (d2 ) = 0
σ→∞ σ→∞
Replacing those to limiting terms in the Black-Scholes formula (20) we get
lim C = S.
σ→∞
As σ goes to zero, the story is quite different. Notice that on one hand,
S < K exp(−rT ) ⇒ ln(S/K) + rT < 0.
Thus,
S < K exp(−rT ) ⇒ lim d1 = lim d2 = −∞
σ→0 σ→0
and
S < K exp(−rT ) ⇒ lim N (d1 ) = lim N (d2 ) = 0
σ→0 σ→0
leading to
lim C = 0.
σ→0
On the other hand
S > K exp(−rT ) ⇒ ln(S/K) + rT > 0.
Thus,
S > K exp(−rT ) ⇒ lim d1 = lim d2 = +∞
σ→0 σ→0
and
S > K exp(−rT ) ⇒ lim N (d1 ) = lim N (d2 ) = 1
σ→0 σ→0
leading to
lim C = S − K exp(−rT ).
σ→0
The interpretation of this result is quite obvious. Zero volatility means

that the value of the underlying asset will not change. If the option starts
out of the money it will expire worthless and its present value should be
zero. If it starts in the money, it will be exercised for sure and the value of
the option should be simply the present value of the asset minus the present
value of the exercise price.
73
8.4 Other Limiting Behaviors
There are more parameters in the Black-Scholes formula, namely the exercise
price K, the time to maturity T and the interest rate r. Most of the limit-
ing behavior of the Black-Scholes formula with respect to these parameters
should be now evident and we leave to show them as exercises.
Exercise 8.4 Please show the following Black-Scholes behavior: as K → ∞,

then C → 0; as K → 0, then C → S.
The intuition is also very clear. On one hand, as the exercise price is too
large, the Call option becomes worthless because exercise will be impossible.
On the other hand, as the exercise price gets closer to zero, this means that
you do not have to pay anything to collect the underlying asset at maturity,
meaning that you will exercise for sure and, therefore, to hold the option
corresponds to hold the asset.
Exercise 8.5 Please show the following Black-Scholes behavior: as r → ∞,

then C → S.
This result is also very intuitive. Effectively, it means that if interest rates
are extraordinarily large, this means that the present value of the exercise
price is close to zero, and we follow in the former case (see exercise above).
Exercise 8.6 Please show the following Black-Scholes behavior: given S <
K: as T → 0, then C → 0; given S > K: as T → 0, then C → S − K as
T → ∞, then C → S;
The intuition for this final result is also simple. For the first one, an option
out of the money to be exercised right now has no value by construction. For
the second result, an option in the money to be exercised right now is worth
the value of the underlying asset minus the cost of exercising that option.
Finally, an option with infinite maturity is exercised with certainty. In fact
enlarging the time to maturity may be seen as equivalent to increase the
volatility of the asset. To see this
√ notice that every σ in the Black-Scholes
formula is multiplied by a term T .
74
8.5 Implied Volatility
One of the most interesting initial applications of he Black-Scholes options
was the possibility of inferring the volatility of the returns of the underlying
asset from prices observed in the options’market. In fact, according to the
Black-Scholes formula (20), options’ values depend on five parameters: the
current value of the underlying asset S, the exercise price K, the interest
rate r, the time to maturity T and the volatility σ. All these parameters are
directly observable from the market, except for one: the volatility.
For a given observed option price, we can therefore extract from the
Black-Scholes formula the (unique) compatible value of the volatility. This
is the so-called implied volatility of the asset.
A curious experience is to fix all the parameters of the option except the
exercise price, and try to observe how the implied volatility varies with K. If
the assumption of the Black-Scholes model are correct, this should be a flat
graphic. However, it has been observed that options deep in the money and
deep out of the money have usually higher volatility than options around the
money. This U-shape graphic of the implied volatility as a function of the
exercise price K is known as the smile effect.
If we try to draw several curves like that, one for each time to maturity,
we get what is termed a term structure of volatility.
75
Payoff to equityholder Payoff to debtholder
6 6
- ST - ST
K K
Figure 17: Payoff of equity holders and debt holders.
9 Pricing Corporate Securities

9.1 Equity as an Option
As you know, a project can be financed with equity and/or debt. Considering
the value of a project, this value must be split between the equity owners
and the debt owners.
Debt owners have a fixed claim on the future value of the firm, corre-
sponding to the future payment of interest and principal. Equity owners
have a residual claim on what is left of the firm value after the payment to
the debt owners.
It is possible, however, that in some states of nature the not have enough
assets to cover the due payments associated to the debt. In that case, we
say that the firm is bankrupt and the owners of the debt take over the assets
of the firm, although their value is not enough to cover their claim. The
liability of equityholders is limited, meaning that in case of a bankrupt firm,
the payoff for equityholders is zero. In other words, they do not have to pay
from their money whatever is missing to pay the debtholders.
If the firm does not go bankrupt, however, the equityholders are entitled
to the remaining value of the firm, after the debtholders are paid. If ST
denotes the value of the firm at debt maturity T and K is the future value
76
of future payment of interest and principal, figure 17 depicts the payoff to
equityholders and to debtholders.
From the pictures it is clear that the sum of both payoffs is ST . It is
also clear that the payoff to equityholders is the payoff of a call option on
the future value of the firm with exercise price K. Let E and B denote
respectively the present value of equity and debt. Using the Put-Call parity
relation, the value of the debt can thus be written as
B = V −E
K
= − P.
(1 + r)T
In other words,the value of debt can be seen as the present value of all debt-
associated payments minus the value of a put on the final value of the firm.
Example 9.1 The Czech-Javanese singer Kant Cing wanted to finance his
new CD. For that purpose he constitutes a firm and borrowed money from
the bank and put the rest from his own pocket. The CD is coming out now.
In one-year time, he will have to pay back to the bank 700 thousand dollars.
If the CD is a success, we expect to generate a value of 1.2 million dollars,
otherwise only 600 thousand dollars. The success state price is 0.5217 and
the annual risk free rate is 15%. How much is this project worth for our
friend Kant? We then have
pu = 0.5217 × (1 + r) = 0.60 ⇒ pd = 1 − pu = 0.40
and
1
E = [pu × max (Su − K, 0) + pd × max (Sd − K, 0)]
(1 + r)
1
[pu × max (1.2 − 0.7, 0) + pd × max (0.6 − 0.7, 0)]
1.15
0.60 × 0.5
= = 0.261
1.15
or 261 thousand dollars. The overall value of the project can also be calculated
as
1
V = [pu × Su + pd × Sd ]
(1 + r)
1
= [0.6 × 1.2 + 0.4 × 0.6] = 0.835
1.15
77
or 835 thousand dollars. The difference, of course, is the present value of
debt:
0.835 − 0.261 = 0.574
or 574 thousand dollars. An alternative way to calculate this number is to
use the same principle as for V :
1
B = [pu × Bu + pd × Bd ]
(1 + r)
1
= [0.6 × 0.7 + 0.4 × 0.6] = 0.574
1.15
Based on this example, we introduce
Exercise 9.1 Kant Cing thought about including or not a new song com-
posed together with his niece, entitled “Kant here it”. This is one of their
favorites tunes of his new (forthcoming) rock opera. He decided not to include
it because it could be very risky: If it were a success, the CD would generate
a final value of 1.5 million dollars, otherwise it would be a big disaster. State
prices would not change and the overall value of the project would not change,
though.
1. What value would be generated in case of a disaster?
2. What would happen with the values of equity and debt?
3. Comment Kant’s decision of not including this song. Was it good or

was it bad? Why?
9.2 Corporate Bonds

In this section we are going to apply the valuation procedure developed so
far to price corporate debt. If a bond promises to pay X1, X2, . . . , XT at dates
t = 1, 2, . . . , T, we use the expression
T
X Xi
B =
t=1
(1 + rt )t
X1 X2 XT
= + 2 + ···
1 + r1 (1 + r2 ) (1 + rT )T
= P1 X1 + P2 X2 + · · · + PT XT ,
78
to value the bond. Here rt is the suitable discount rate taking into account
the risk of default. If the bond is risk free, the discount rates rt should be,
of course, the risk free rate. The issue is to price risky bonds.
9.3 The Risky Part of Corporate Bonds

The risk incorporated in the bonds reflects the probability of default, cor-
responding to the realization of certain states of nature. Since the payoff is
contingent on the realized states of nature, the state price approach seems to
be the more convenient to value corporate bonds. Let B denote the market
value of debt, D be the face value and BT be the payoff to debt-holders at
maturity T.
Example 9.2 In the kingdom of Neuroland, the firm SeeStars is planning

an investment project in a product that will be in the market only for one
year. The initial investment is 3.000 neuros, including the purchase of a
specific machine for this project. The firm expects earnings before interest
and taxes of 10.000 neuros with probability 1 − p, or −1000 with probability
p = 0, 2. In this last case, the firm goes bankrupt and does not pay taxes. The
risk free rate is 10% and SeeStars issued with face value of D = 1000 neuros,
due next period.
In the example above, clearly the value of debt is not the 1000 neuros,
discounted at the risk free rate. In order to value debt, we need the state
price probability. Moreover, notice that this state price probability is not
necessarily the probability of actual realization of the bad state.
Example 9.3 If debt is contracted by B = 850 neuros

1 1.1 × 850
850 = [(1 − pd ) × 1000 + pd × 0] ⇒ pd = 1 − = 0.065,
1.1 1000
the implicit state price bankrupt probability is 6.5%. Notice that a promised
payment of 1000 for a market value of 850 implies a return of 17.65%, well
above the risk free rate r = 10%.
In more abstract terms, if ST denotes the value of the corporation at the

maturity T of a corporate bond with face value D, such bond provides the
payoff
BT = min (D, ST ) .
79
9.4 Decomposition of Risky Bonds
A risky bond can be seen in different ways. It is possible to decompose it as
different portfolios.
On one hand, it can be seen as a portfolio composed of a long position
in a risk free bond and a short position in a put option on the value of the
corporation, with exercise price coinciding with its debt face value. This can
be easily seen since
BT = min (D, ST ) = D + min (0, ST − D) = D − max (0, D − ST )
The last part reflects just the constant value D, independent of the state
of nature, minus the payoff of a put option written on the value of the
corporation with exercise price D. Hence
D
B= − P,
1+r
where D is discounted at the risk free rate (because it is risk free) and P
denotes the value of the European option.
Example 9.4 The value of a put option on SeeStars is
1
P = [0.935 × 0 + 0.065 × (1000 − 0)] = 59.10
1.1
Subtracting this value from
D 1000
= = 909.10
1+r 1.1
we get
D
B= − P = 909.10 − 59.10 = 850.
1+r
A different construction allows to write the payoff of a corporate bond as
the value of the corporation at maturity together with a short position on a
call on that value with exercise price D.
BT = min (D, ST ) = ST + min (0, D − ST ) = ST − max (0, ST − D)

Notice that the call option here is simply the payoff to equity. In other
words, this is simply another way of writing
V = B + E.
80
Example 9.5 In this case, we have that
1
V = [0.935 × 10000 + 0.065 × 0] = 8500
1.1
and
1
E= [0.935 × 9000 + 0.065 × 0] = 7650.
1.1
The difference of these two values is
B = V − E = 8500 − 7650 = 850.
9.5 Shareholder Incentives

When issuing debt, the shareholders of a firm give the debt holders a claim
on at least part of the value of the firm. The point of this section is that
shareholders and bondholders have quite different incentives. This may lead
to the fact that the best interest of shareholders do not coincide with the
best interest of the bondholders. Management may therefore be induced to
make choices that are not aligned with the bondholders, hurting them.
A typical situation is to consider two alternative projects with exactly
the same value, but one is riskier than the other. The riskier project has
a higher payoff in the favorable state and a lower payoff in the bankruptcy
state. Of course, the shareholders do not care about the bankruptcy state
(they do not get anything in either project). Their choice is made strictly
on the basis of the favorable state. Therefore, they clearly prefer the riskier
state. The bondholders, on the other hand, would prefer the project with
higher payoff to them, i.e., the project with higher payoff at the bankruptcy
state. Hence, the bondholders would prefer the less risky project.
Example 9.6 The firm SeeStars has an alternative investment project to

that presented in the former example in a product that will be in the market
only for one year. The initial investment is 3.000 neuros, including the
purchase of a specific machine for this project. The firm expects earnings
before interest and taxes of 9950 neuros with probability 1 − p, or 719.23 with
probability p = 0, 2. The risk free rate is 10% and SeeStars issued with face
value of D = 1000 neuros, due next period. In the case of the down state,
the firm goes bankrupt and does not pay taxes.
This is a typical situation where the shareholders prefer the original project,
since they earn 100 neuros more in the up state, and exactly the same (zero)
81
in the down state. The bondholders prefer this last alternative project since
in case of bankruptcy, they receive at least part of the face value.
The important point is that in either project the values of equity and
debt are different. Equity is worth more with the riskier project and debt is
worth more with the less risky project.
Example 9.7 Let Sa , Ea and Ba denote respectively the value of the alter-
native project for SeeStars, the value of equity and the value of debt under
that alternative project. We then have
1
Sa = [0.935 × 9950 + 0.065 × 719.23] = 8500
1.1
and
1
Ea = [0.935 × 8950 + 0.065 × 0] = 7607.5
1.1
The difference of these two values is
Ba = Sa − Ea = 8500 − 7607.5 = 892.5
Clearly Sa = V, Ea < E and Ba > B.
Notice that, in the above example, Ea < E and Ba > B is sufficient to

make the company reject the alternative project at the expenses of the bond-
holders. That decision does not depend on the fact that Sa = V. Actually, if
the alternative project is rejected with Sa > V, we say the company incurs
an agency cost of debt. This cost is Sa − V.
This is a general feature. Whenever the debt is in place, acting in the in-
terest of shareholders, management will have always the incentive to increase
the risk of the firm, increasing the value of equity at the expense of debt.
9.6 Convertible Bonds as a Solution

There are various solutions for the type of agency problems raised above. A
convertible bond is a debt instrument that allows the bondholder to exchange
the bond for a certain number of shares of equity. In this way, if bondholders
feel hurt at the benefit of shareholders, they can convert their bonds into
shares, profiting from the shareholders’ benefits.
82
Example 9.8 A corporation has issued convertible bonds with a face value
1000. At the discretion of the bondholder, each bond can be converted for 40
shares of newly issued common stock.
The number of shares that are issued per converted bond is termed the
conversion ratio. The price of the underlying stock that equals the value of
the converted bond to the face value of the convertible bond is known as the
conversion price.
Example 9.9 In the example above, the conversion ratio is 1:40 and the
conversion price is
1000
= 25.
40
Issuing new shares of stock implies a dilution of the value per share.
This is a confusing concept, and it is difficult to figure out what the optimal
conversion policies are.
In order to avoid this type of issues, we shall be centered in the case where
there is one outstanding share and one convertible bond, with conversion ratio
1:1. Let us try to characterize the payoff of a convertible bond in this case.
As before, let ST denote the maturity value of the firm. If, at maturity, the
corporation is worth less than the face value of debt, the company defaults
and whatever is left belongs to the bondholders. In other words,
ST ≤ D ⇒ BT = ST .
On the other hand, if the firm is worth more than the face value of debt,
the bondholder can choose between receiving the face value D or one share
corresponding to half of the value of the firm. In other words,

ST D if D ≤ ST ≤ 2D
ST ≥ D ⇒ BT = max D, = ST .
2 2
if 2D ≤ ST
Putting everything together,

 ST if ST ≤ D
BT = D if D ≤ ST ≤ 2D
 ST
2
if 2D ≤ ST
or still
ST
BT = min ST , max D, .
2
83
This is so since max D, S2T ≥ D. The expression above for BT can be

decomposed in many different ways such as

ST
BT = min ST , max D,
2

ST
= min ST , D + max 0, −D
2

ST
= D + min ST − D, max 0, −D
2

ST
= D − max (0, ST − D) + max 0, −D .
2
This corresponds to the payoff of a portfolio constituted by a risk free bond,

a short position on a put on the value of the firm plus a long call on half of
the value of the firm. All options with exercise price coinciding with the face
value of debt.
Hence, since B = R1 E ∗ (BT ) , it follows that
D
B= − P + C,
R
where

1 ∗ 1 ∗ ST
P = E [max (0, ST − D)] and C = E max 0, −D .
R R 2
Exercise 9.2 Draw the payoff of the convertible bond above.
9.7 Callable Convertible Bonds

Many convertible bonds have a special callable feature. This means that the
firm has the right to buy back the issued bond, at a pre-established call price
C̄. When called, bondholders may choose to convert the bond into equity at
that call price, instead of delivering the bond against C̄.
The issue here is to know under what circumstances should the firm call a
convertible bond. The policy should be such that minimizes the value to the
bondholders, maximizing therefore the value of equity, through the relation
E = V − B. This is best illustrated with an example.
84
Example 9.10 Consider the case of a firm which current value is £80 thou-
sand. Its future value follows a Binomial process with U = 1.5 and D = 0.5
and the risk free annual interest rate is 10%. The firm issued a convertible
bond with face value D = 50 to be paid at t = 2. The bond can be called only
at t = 1 for C̄ = 41 , and the conversion ratio is 1:1.
The possible terminal values of the firm are £180, £60 and £20 thousand.
The state price measure is easily seen to be characterized by pu = 0.6 and
pd = 0.4. Checking the payoffs at maturity of the convertible bond, ignoring
the callable feature, and working backwards, it is easy to see that the process
followed by the value of the bond is the one depicted in Figure 18 Notice that
90

*

67.27
HH

*
HH
j
H
46.61 H
50
H *

HH

j
H
27.27
HH
HH
j 0
H
t=0 t=1 t=2
Figure 18: Values of a convertible bond with two periods under the Binomial
model.
in the uu state, the bondholders prefer to convert. At time t = 1, however,

if state u occurs the firm should call back the bond. At that point, the bond-
holders will have to choose between the £41 thousand of the call price or
conversion to stock, in which case they would get £60 thousand. Of course
they prefer the last alternative, leading to a new tree for the values of the
bond, lowering the current value of debt and, therefore, increasing the value
of equity. Notice that in state d there is no point in calling back the bond for
41, since the debt contract is worth only 27.27.
The principle to call back is simple: if, at that point in time, the debt
85
60
*

42.64
HH 50
*

HH
j
H
27.27
HH

HH
j 0
H
t=0 t=1 t=2
Figure 19: Values of a calable convertible bond with two periods under the
Binomial model.
contract is worth more than the call price, the bond must be called.
Exercise 9.3 For what range of values for the face value D would the bond
above be called?
86
10 Real Options
Future cash-flows are uncertain, since they depend on the realization of future
States of Nature. When using the standard technique of Discounted Cash
Flows (DCF), what we do is to aggregate our uncertainty in a sufficiently high
rate to discount the expected cash-flows. However, depending on the realized
state of Nature, the management may have the possibility of intervening in
the processes in order to improve the profile of the business or to cut the
damages that may have occurred. This possibility of action in some specific
states of Nature at the discretion of the management is very often not taken
into account by the usual approach of the DCF. However, when planning
and presenting a Business, most time managers have in the back of their
minds the possibility of different contingent strategies - contingent on the
realization of different states of the World, - designed to improve the project
value, enhancing its value and thus lowering its cost of capital.
The topic to be discussed here is how packages of strategies should be
taken into account in order to properly incorporate them in the cash-flows of
any given project and to adjust its cost of capital, before going through the
valuation process.
Before going further, we should call for a change of mental framework
regarding the cash-flows, using the by now familiar tree-representation.
Standard DCF reflects a one-dimensional cash-flow, following time. If we
are to consider the impact of different states of Nature at each point in time,
we should start thinking of cash-flows as a two-dimensional object, just like
the trees that we use valuing options with the Binomial model.
We shall proceed by constructing different examples that will illustrate
the point.
Example 10.1 A simple and traditional example comes from the natural
resource industry. A company that extracts gold from a mine may decide to
stop the process if the market price of gold follows to levels where it does not
compensate the cost of extraction. This option to abandon the project (or to
temporary stop it) adds value to the project when it is valued ex-ante.
Example 10.2 A similar example can be thought of with oil extraction. Dur-
ing the first Gulf war the oil price went up to levels where it made sense to
start exploiting some wells in the US that have never been economically viable
before due to higher extracting costs.
87
10.1 Working Example: An option to abandon
Consider the case of a clothing industry that is starting a new line of shirts.
This is a 2-years project that requires today a 50 (thousand) investment.
After one year we shall know whether or not the design of the new shirts are
according to the new market trends (we assume that with 70% probability
the line will have success - state G - and with 30% insuccess - state B).
Once this year of initial investment is over, additional 50 are required for the
production process to start, followed by sales in the second year. We expect
the sales year to confirm the tendency of the first year with a probability of
80%.
The payoffs are collected at the end of the second year and described as
follows. For a good sales year after market trend has been recognized as
good, the payoff is 200. For a bad sales year after market trend has been
recognized as good, the payoff is 120. For a good sales year after market
trend has been recognized as bad, the payoff is 90. For a bad sales year after
market trend has been recognized as bad, the payoff is -100. The hurdle
discount rate for this industry is about 10%.
Let Et (P | x) denote the expected payoff at maturity as seen from time t
and conditional in state x, and let Pr (x) denote the probability of state x. If
we are to use standard Discounted cash-flow approach to value this project,
we have that the expected cash-flow at the end of the second year (as seen
from time t = 0) is
E0 (P ) = E1 (P | G) Pr (G) + E1 (P | B) Pr (B)
= (200 × 0.8 + 120 × 0.2) × 0.7 + (90 × 0.2 − 100 × 0.8) × 0.3
= 110.2
and the expected Net Present Value of this project would be
50 110.2
E (N P V ) = −50 − + = −4.37
1.1 (1.1)2
This value should more properly be written as a function of the investment I
at time t = 1 and as a function of the conditional expectations at that point
in time as
E0 (I | G) E0 (I | B)
E (N P V ) = −50 − Pr (G) − Pr (B) (26)
1.1 1.1
E1 (P | G) Pr (G) + E1 (P | B) Pr (B)
+ .
(1.1)2
88
This is so because in this example it is clear that
E0 (I | B) = 50 > 0 and E1 (P | B) = 90 × 0.2 − 100 × 0.8 = −62
and thus, the management has the option to abandon the project if the state
at t = 1 is revealed to be B, investing therefore zero and eliminating the bad
expected payout at time t = 2. In other words, if the management has the
possibility to make an active intervention in state B at t = 1, this affects the
time-zero value of the project, leading to
E0 (I | B) = 0 ⇒ E1 (P | B) = 0.
In that case, the correct E (N P V ) would have to be calculated as
ERO (N P V )
E0 (I | G) E0 (I | B) E1 (P | G) Pr (G)
= −50 − Pr (G) − Pr (B) +
1.1 1.1 (1.1)2
50 (200 × 0.8 + 120 × 0.2) × 0.7
= −50 − × 0.7 + = 24.63
1.1 (1.1)2
Exercise 10.1 When projects are abandoned, typically there are contractual
penalties. We can ask in the above case what would be the maximum penalty
that would make the project still worth pursuing at t = 0 even considering
the alternative of abandoning the project at t = 1.
10.1.1 Options Payoffs

One important problem appears with the approach above. By eliminating
the bad state of Nature, we are saying that we can avoid the losses associated
to those states and thus, we are diminishing the risk of the project. In that
case we should be using a lower discount rate for the project, and not the
10% anymore!
In order to adjust for that we do the following. Consider the value of
the project at time t = 0 under both approaches above and notice that the
89
difference is
ERO (N P V ) − E (N P V )
50 E1 (P | B) Pr (B)
= × 0.3 −
1.1 (1.1)2
50 90 × 0.2 − 100 × 0.8
= × 0.3 − × 0.3
1.1 (1.1)2

Pr (B) E1 (P | B) Pr (G) E1 (P | G)
= max 50 − ,0 + max 50 − ,0
1.1 1.1 1.1 1.1
= 29
In other words, the project with the option to abandon is equivalent to

consider the original project without alternative of abandon, plus the option
to sell the future (t = 2) payout of the project for the value of investment at
t = 1 (the condition to pursue the project for a second period). Notice that
in our example,
E1 (P | B) = 90 × 0.2 − 100 × 0.8 = −62

E1 (P | G) = 200 × 0.8 + 120 × 0.2 = 184
and thus this put option has a positive payoff in the B state, since 50 −
E1 (P |B) |G)
1.1
> 0, but has a zero payoff in the G state, since 50 − E1 (P
1.1
< 0.
As seen from t = 0 then, the value of the project with the possibility of
abandoning can be thus written as
ERO (N P V ) = E (N P V ) + P ut
10.1.2 Option Value and adjusting the Discount Rate

The problem that we refer to above, in the beginning of the former section,
can be seen in a different perspective. Actually, this put option has been
valued using real probabilities and an inadequate discount rate. However,
we know how to value this option assuming that market completeness. We
can easily identify the underlying asset as the present value of the expected
payout at time t = 2, the time to maturity at the option when seen at time
t = 0 is T = 1 and we are left to estimate the growth and decreasing rate U
and D in order to write the option value as a function of the risk free rate
that was not given.
90
Let us start by estimating the growth and decreasing rate U and D. The
underlying asset at time t = 1 is
E1 (P | B) −62
= = −56.36 in state B
1.1 1.1
E1 (P | G) 184
= = 167.27 in state G.
1.1 1.1
At time t = 0, the value of the underlying asset is given by
E1 (P | G) Pr (G) + E1 (P | B) Pr (B) 167.27 × 0.7 − 56.36 × 0.3
2 = = 91.07
(1.1) 1.1
leading to
167.27
U = = 1.835
91.07
56.36
D = − = −0.615
91.07
and the risk neutral probability measure can be written as
1 + rf − D rf + 1.615
p = =
U −D 2.45
U − 1 − rf 0.835 − rf
1−p = =
U −D 2.45
and the correct value of that Put option can be written as

1−p 106.36 0.835 − rf
P ut = [50 + 56.36] =
1 + rf 2.45 1 + rf
and the value of the Put option can be seen as a decreasing function of the
risk free rate rf . For rf = 0.10 the value of the Put is clearly P ut = 29
confirming the result in the former section. But we know that the risk free
rate must be below the hurdle rate of the risky project, 0.10. Let us assume
that rf = 0.05 leading to the result
P ut = 32.48
This means that the value of the project is thus
ERO (N P V ) = E (N P V ) + P ut = −4.38 + 32.48 = 28.105
91
This should be the true value of the project, as opposed to the value of 24.65
found above. Notice that this value is higher, reflecting the fact that the
adjusted discount rate must be lower than the 10% hurdle rate. In fact,
the true discount rate r can be seen as the rate that discounts the cash-flow
associated to the ERO (N P V ) but leading to the new value 28.105. We can
thus write
50 (200 × 0.8 + 120 × 0.2) × 0.7
ERO (N P V ) = −50 − × 0.7 + = 28.105
1+r (1 + r)2
leading to r = 0.0795.
10.2 Types of Real Options

We introduce in this section a simple taxonomy of real options:
1. Input Mix Options or Process Flexibility Options
2. Output Mix Options or Product Flexibility Options
3. Abandonment or Termination Options
4. Temporary Stop or Shutdown Options
5. Operating Scale Options
(a) Option to Expand

(b) Option to Contract
(c) Switching Option
6. Initiation or Deferment Option
7. Growth Options
10.3 Growth Options

The value of a firm may exceed the market value of its projects currently
in place. The firm may have the opportunity to undertake positive NPV
projects in the future. The traditional NPV techniques may value these
92
projects anticipating implementation dates that may not be verified, for ex-
ample, missing different dimensions of management flexibility. The difference
in value between the firm with and without such projects can be seen as the
growth option value of the firm This type of options is particularly important
in infrastructure based or strategic industries, such as the software industry,
and generally speaking high-tech industries, where first-mover advantage is
very important.
Example 10.3 Project Alpha has 2 phases. You may invest in the first
phase, in both or in neither. The first phase requires an initial investment of
100 (thousand euros) today. One year later. Alpha delivers either 120 or 80
with equal probability. At that time (after phase 1 payment has been received),
you may invest additional 100 in phase 2. Phase 2 pays either more 20% or
less 20% than phase 1 with equal probability. The hurdle discount rate in this
industry is typically 10%.
The value of Alpha’s phase 1 is
0.5 × 120 + 0.5 × 80
N P V1α = −100 + = −100 + 90.91 = −9.09 < 0.
1.1
The value of phase 2 if we decide at time zero, once and for all to invest in
the second phase would be
100 0.25 × (144 + 2 × 96 + 64) N P V1α

N P V2α =− + = = −8.26 < 0.
1.1 1.12 1.1
If we consider that there is the choice of undergoing or not the second phase,
the total value of Alpha is thus

α 100 100 0.5 × (144 + 96)
NPV = −100 + + 0.5 × − +
1.1 1.1 1.12
6
= − 2 = −4.96 < 0.
1.1
We may think of the impact of volatility in the value of this projects by
considering an otherwise equal project with a higher volatility.
Exercise 10.2 Project Omega has 2 phases. You may invest in the first
phase, in both or in neither. The first phase requires an initial investment of
100 (thousand euros) today. One year later. Omega delivers either 140 or 60
93
with equal probability. At that time (after phase 1 payment has been received),
you may invest additional 100 in phase 2. Phase 2 pays either more 40% or
less 40% than phase 1 with equal probability. The hurdle discount rate in
this industry is typically 10%. Show that the first two values calculated do
not differ from those in project Alpha (because they do not differ in expected
value), but that the total value of project Omega is quite different since it
incorporates an option and option values depend on volatilities.
The two examples above were build to make clear that the value of the
option is strongly related to the volatility of the payoffs. However, facing
these results one is let to conclude that project Alpha is not interesting
under any circumstances. This is not necessarily true since, as we have seen
before, this approach is valuing the option to expand with the wrong discount
rates. We should reset the problem under the risk neutral probability measure
approach, that will depend on the risk-free discount rate. The question must
be posed therefore in the following way.
Exercise 10.3 For what values of the risk free rate would Project Alpha be
valuable?
10.4 Application: Natural Resource Investment

Suppose that a Resource management company has a 2-year lease over a
small copper deposit. The management has to decide whether or not to
mine the deposit knowing that, at the end of the 2-year period, all the rights
reverse to the local government. The deposit contains an estimated 8 million
pound of copper. Mining implies a one-year development phase at a cost of
1.25 million euros. The company extracts copper at a cost of 0.85 euros per
pound and then may contract to sell it at the spot market price, one year
from now if the development phase is well succeeded. Market prices annual
percent change are expected to grow on average 7% with standard deviation
of 20%, and are assumed to be Normally distributed. Current market price
of copper is 0.95 euros per pound and the risk-free rate is 5% per year.
A naive way to calculate the NPV of the project is
8 × [E (S1 ) − 0.85]
E (N P V ) = −1.25 + = −0.0391,
1.1
where E (S1 ) = S0 (1 + 0.07) = 0.95 × 1.07 = 1.0165.
94
Alternatively,we could have used a continuously compound growth rate
to obtain E (S1 ) = S0 exp (0.07) = 1.0189 ⇒ E (N P V ) = −0.022. Notice
that in either case the NPV is negative and the conclusion would still be not
to undergo this project.
Actually, the problem should be seen as including 8 million call options
to buy one pound of copper one year from now, for a strike price of 0.85,
instead of the payoff [E (S1 ) − 0.85]. The reason is that the management has
the option to undergo or not the extraction or not of the copper one year
from now, depending on the market prices observed at that point in time
and avoiding negative payoffs that are included in the naive approach.
Exercise 10.4 Calculate the correct E (N P V ) of the above project incorpo-

rating the option value and using the Black-Scholes formula.
10.4.1 Discrete time: does it make any difference?

We may use the discrete time approach by using
U = exp (0.2) = 1.2214 and D = exp (−0.20) = 0.818731.
The market prices of copper one year from now will be either 1.16 (in the up-
state) or 0.78 (in the down-state) and the risk-neutral probability measure
would be
1 + rf − D
p= = 0.574337
U −D
leading to
1
C= [p (1.16 − 0.85)] = 0.170
1 + rf
and
E (N P V ) = −1.25 + 8 × 0.170 = +0.11,
and the project still has a positive NPV. As we know, the approximation
used above where U = exp (σ) and D = exp (−σ) are valid only for very
small time intervals. There are alternative ways to evaluate the U and D
rates. The issue is whether it does make any difference in the decision to
invest or not.
Exercise 10.5 Take U = 1 + σ and the corresponding approach for D and

calculate the E (N P V ) of the above project.
95
10.4.2 Probability that Extraction will Proceed
The value of the option is related to the probability that the extraction will
proceed. Clearly, in case that probability is one, the naive approach is valid.
On the other hand, as that probability tends to zero the value of the option
goes to zero and the value of the project tends to -1.25.
In a discrete time setting we may estimate the probability in the following
way. We know that the return (percent change) in the copper price is
S1 − 0.95
r=
0.95
Extraction will not proceed if S1 < 0.85.

x − 0.95
Pr (S1 < x) = Pr r <
0.95
leading to Pr (S1 < 0.85) = Pr (r < −0.10526) = 0.19, where use has been
made that the returns are Normally distributed
r ∼ N 0.07; 0.22 .

The probability that extraction will proceed is thus estimated around 81%.
If returns are considered to be continuously compounded,
Pr (S1 < 0.85) = Pr (ln S1 < ln 0.85) = Pr (ln S1 < −0.1625) ,
where use has been made of the fact that the logarithm is a monotonic
increasing function. How do we get the Probability distribution of ln S from
the distribution of the returns? First notice that
S1 − 0.95 S1
r= = −1
0.95 0.95
and therefore
S1
ln (1 + r) = ln = ln S1 − ln 0.95.
0.95
But from a simple Taylor expansion we know that

1 1 2
ln (1 + r) ' r − r2 ∼ N E(r); σ 2 + N

− σ ;0 .
2 2
96
This means that
ln S1 − ln 0.95 ∼ N 0.07 − 0.02; 0.22

or
ln S1 ∼ ln 0.95 + N 0.07 − 0.02; 0.22 = N 0.00129; 0.22 .

Thus, we can now calculate the required probability as
Pr (ln S1 < −0.1625) = 0.33
leading us to estimate the probability that the extraction will proceed as

being close to 67%.
97
11 Dynamic Delta Hedging and the Greeks
11.1 Hedging Strategies
Whenever we sell or buy derivatives, the underlying question is how to be
safe, regarding the uncertainty with respect to the exercise and payoff of
such derivatives. If we sell a derivative, we would like to sell it at least for
a price that would allow us to invest in the underlying asset and minimize
our lost in case the derivative is exercised by the long position. In case we
buy a derivative, we would like to pay no more than the amount that allows
us to hedge that position minimizing the costs in case the derivative is not
exercised.
Example 11.1 Suppose that we are short in a European call written on

1,000 shares of XYZ with exercise price K = $40 and 6 months to maturity.
The current stock price of XYZ is $42, with σ = 0.2, r = 0.1 and we received
$5,500 for that position. The Black-Scholes value of that call is $4,760.
We shall use the position above to analyze the most commonly used
hedging strategies and consider their advantages and disadvantages.
Example 11.2 Naked strategy. In this case, the strategy is to do nothing.

Clearly if the stock ends below the exercise price, this is a winning strategy.
However, if the stock ends at a high level, say ST = 50 we would have to
buy 1000 shares at the market value, paying $50,000 and would receive only
$40,000 from the exercise of the options. The $10,000 difference would be a
loss.
The naked strategy works well if stock goes down, but is a disaster if the
value of the stock goes up. Alternatively we could use other strategies.
Example 11.3 Covered strategy. In this case, to avoid the possible disasters
of the naked strategy, the short position could buy at the current price the
1,000 shares paying a total value of $42,000. If the stock goes up, the exercise
of the derivative will be covered, but if the stock goes down to, say, $35,
the value of the position in stock generates a loss of $7,000 which is not
compensated by the value of the $5,500 received initially.
98
The covered strategy works well if stock goes up, but it is a disaster
if the value of the stock goes down. The trick must lie in the possibility
of rebalancing the portfolio of stock depends on whether the stock value
increases or decreases.
Example 11.4 Stop-loss strategy. This strategy tries to balance the advan-
tages and disadvantages of both strategies above. The idea is to establish a
threshold above which we buy the 1,000 shares and below which we sell them
at market price. In the case of the option above this threshold would be the
exercise price K = 40. Thus, whenever the option gets in the money, we
would by the stock. Whenever it gets out of the money we sell the stock.
This strategy fails for two reasons. First it does not take into account the
time value of money. Buying and selling at different times does not reflect
the same present value. Second, there are transaction costs. The value at
which we buy is always above the selling price. One such strategy applied
continuously in time could imply very high transaction costs.
Example 11.5 Delta hedging strategy. This is a strategy that refines the
idea behind the stop-loss strategy. The point is that we do not have to buy
the whole package of 1,000 shares at once. As the stock price goes up we can
use the proceeds from the option and borrow money to buy more shares until
we reach the 1,000 level, but as the stock value goes down we may rebalance
the portfolio by selling some of the shares we hold and paying debt back. The
point is to know how many shares should we hold given the stock price’s level.
We know that at any point the value of a call option must coincide with the
value of a portfolio that exactly replicates its future value in any state of
Nature and where the number of shares is ∆ or
C = ∆S + B
where B is the amount borrowed at the risk-free rate. In particular, for the
Black-Scholes model, it is simple to identify ∆ = N (d1 ) whereas for the
Binomial model
Cu − Cd
C=
S(U − D)
. By holding ∆ shares of stock, where ∆ depends on the stock’s price level,
we say that the position is delta-hedged. As ∆ tends to one this means that
the probability of exercise at maturity is one and we should hold 100% of the
1,000 shares.
99
11.2 Dynamic Delta Hedging
As we evolve in time, the value of the underlying asset will change and,
therefore, the value of ∆ will also change. The replicating portfolio must
be then rebalanced at every point in time. This is what we call a dynamic
hedging strategy. We shall illustrate this concept at work with the Example
3.4 used in the valuation of a two-period Binomial option.
Example 11.6 Assume that the underlying asset is given such that S = 90
together with U = 1.3, D = 1.0 and r = 0.10 and that we have a call option
with exercise price K = 100 and two periods to maturity. In that case, with
pu = 13 , we get the following trees for the put and call options shown in Figure
20.
We shall illustrate the hedging principle for the Call at time t = 0 to start
with. We know that the original value of the Call, C = 11.03 mst be equal
to C = ∆0 S + B, where
Cu − Cd 26.09 − 5.15
∆= = = 0.776
Su − Sd 117 − 90
and
B = C − ∆0 S = 11.03 − 0.776 × 90 = −58.77.
In other words, if we receive 11.03 for a call option, we should be able to
hedge our short position in the call by buying 0.776 shares of the underlying
asset, that will cost 69.8 and borrowing the remaining required 58.77 from
the bank at the risk free rate. In that case, at t = 1 we would have two
possibilities.
First we consider the case where we find ourselves at t = 1 in the up state
and the underlying asset is worth 117. Therefore, our 0.776 shares will be
worth
∆0 × Su = 0.776 × 117 = 90.74.
However, we would have to pay back to the bank the amount borrowed plus
interest, or
B(1 + r) = 58.77 × 1.1 = 64.65.
This would let us exactly with 26.09 or the precise value of Cu . At that up
node, we may replicate again the payoffs of the option for t = 2, because we
100
* Cuu = 52.1

Cu = 26.09
H
*
HH
H
j
H
C=11.03
H Cud = 17
HH
*
H
j C = 5.15
H
d
H
HH
j Cdd = 0
H
H
t=0 t=1 t=2
* Cuu = ∆u Suu + Bu R

∆u = 1
* Bu = −111.85
H
HH
H
∆ = 0.776 H
j
H
Cud = ∆u Sud + Bu R = ∆d Sud + Bd R
B = −58.77 HH
*
H
j ∆ = 0.63
H
d
Bd = −51.52 HHH
j Cdd = ∆d Sdd + Bd R
H
H
Figure 20: Trees for the call and replicating portfolios with two periods under
the Binomial model.
101
have already in hands exactly the precise amount corresponding to the value
of the option. We then buy ∆u shares such that
Cuu − Cud 52.1 − 17
∆u = = =1
Suu − Sud 152.1 − 117
and borrow the missing amount
Bu = Cu − ∆u Su = 26.09 − 117 = −90.91.
If the economy goes to the uu state, the shares will be worth 152.1 and we
shall pay back to the bank 90.91 × 1.1 = 100, leaving us with 52.1, precisely
the value of Cuu . If the economy goes to the ud state, the shares will be worth
117 and we shall pay back to the bank the same amount 90.91 × 1.1 = 100,
leaving us with 17, precisely the value of Cud .
Second, we consider the case where we find ourselves at t = 1 in the down
state and the underlying asset is worth 90. Therefore, our 0.776 shares will
be worth
∆0 × Sd = 0.776 × 90 = 69.80.
However, we would have to pay back to the bank the amount borrowed plus
interest, or exactly the same
B(1 + r) = 58.77 × 1.1 = 64.65
as before. This would let us exactly with 5.15, or the precise value of Cd . At
that down node, we may replicate again the payoffs of the option for t = 2,
because we have already in hands exactly the precise amount corresponding
to the value of the option. We then buy ∆d shares such that
Cud − Cdd 17 − 0
∆d = = = 0.63
Sud − Sdd 117 − 90
and borrow the missing amount
Bd = Cd − ∆d Sd = 5.15 − 0.63 × 90 = −51.52.
If the economy goes to the ud state, the 0.63 shares will be worth 0.63×117 =
73.67 and we shall pay back to the bank 51.51 × 1.1 = 56.67, leaving us with
17, precisely the value of Cud . If the economy goes to the dd state, the
0.63 shares will be worth 56.67 and we shall pay back to the bank the same
amount 56.67, leaving us with 0, precisely the value of Cdd .
102
We call this a self-financing trading strategy, since we were able to repli-
cate the payoff of the option, period after period by rebalancing the portfolio,
without putting a cent from our own pocket!
Exercise 11.1 Please replicate the dynamic hedging exercise above for the
otherwise equal Put European option.
11.3 The Greeks

Suppose that a derivative instrument has a price Π. As you know, the Delta
of a derivative instrument reflects the sensitivity of its price to changes in
the value of underlying asset
∂Π
∆= .
∂S
Exercise 11.2 Explain why the delta of a put has the opposite sign of a delta
of a call.
The underlying asset can be seen as a derivative as well. In fact, it can

be seen as a perpetual payout protected American Call with zero exercise
price. We thus have that the ∆ of the underlying asset can be written as
∆ = ∂S/∂S.
If we have a portfolio of two derivative instruments on the same underlying
asset, say n1 units of derivative 1 with value V1 and n2 units of derivative 1
with value V2 , with deltas given respectively by ∆1 an ∆2 , the position value
is
V = n1 V1 + n2 V2
and the delta associated to such position is simply
∂V ∂V1 ∂V2
∆= = n1 + n2 = n1 ∆1 + n2 ∆2 .
∂S ∂S ∂S
The position delta measures how exposed our position value is to changes
in the value of the underlying asset. Given what we know from the hedging
strategies, if the value of the underlying is going up, we would like the delta to
be positive (it bullish position). If we assume that the value of the underlying
is going down, we would like the delta to be negative (it bearish position).
Finally, if we are uncertain of the direction of value change for the underlying,
103
we would like the delta to be zero (neutral position). By construction, a
neutral position implies that
n1 ∆2
n1 ∆1 + n2 ∆2 = 0 ⇒ =− .
n2 ∆1
As the value of the underlying changes and both the value position and
the delta established will change. In fact the ∆ of a European call can be
seen to increase with the value of the underlying asset. In order to control
for that, the Gamma of the derivative is defined as to reflect the sensitivity
of its Delta with respect to changes on the value of the underlying asset. It
is given by
∂2Π ∂∆
Γ= 2
= .
∂S ∂S
Example 11.7 For hedging purposes this parameter is very important to
correct the effect of ∆. If the value of the underlying asset increases by one
unit, by using Delta hedging you might think that the value of the call would
increase by ∆ units. However, since ∆ itself increases, we should correct
the increase in the call option to ∆ + 12 Γ, by making use of a trivial Taylor
expansion.
The position gamma for a portfolio as the one defined above is thus
defined by
∂∆ ∂∆1 ∂∆2
Γ= = n1 + n2 = n1 Γ1 + n2 Γ2 .
∂S ∂S ∂S
The sign of the position gamma, specially for a delta neutral position,
can be very useful. Since in a delta neutral position we do not expect the
value to change, the second derivative (gamma) being negative (top position)
indicates that we will not loose money only if the value of the underlying
remains relatively stable. On the other hand, if gamma is positive (bottom
position), we will make profits only for relatively large movements of the
underlying’s value in either direction. Of course the gamma of a position can
be chosen to be zero, in which case we will have a gamma-neutral position
(in order to distinguish it from a delta-neutral position).
Notice that the value of the underlying asset does not change without
the change of an equally important parameter to value the derivative: the
time to maturity T . The passage of time does clearly affect the value of
the derivative, and neither ∆ nor Γ above do take that change of value into
104
account (note that Greeks are partial derivatives!). We thus need a third
measure of value sensitivity, reflecting the changes in value as time passes
that we shall denote by theta
∂Π
Θ=− .
∂T
Example 11.8 For hedging purposes this parameter is very important to
correct the joint effect of ∆ and Γ. If the value of the underlying asset
increases by one unit after one time unit, by using Delta-Gamma hedging as
above you might think that the value of the call would increase by ∆ + 12 Γ.
However, as time to maturity was reduced, there has been a reduction of the
call option by Θ and the total variation of the call should be adjusted to be
∆ + 21 Γ − Θ.
The position theta for a portfolio as the one defined above is thus defined
by
∂V ∂V1 ∂V2
Θ= = n1 + n2 = n1 Θ1 + n2 Θ2 .
∂T ∂T ∂T
A position with negative theta is said to have a negative time bias, in the
sense that as time to maturity diminishes, the value of the derivative will also
decrease. Likewise, a position with positive theta is said to have a positive
time bias, and a position with zero theta is said to have a neutral time bias.
There are other measures of sensitivity of the value of a derivative with
respect to the parameters on which it depends. The Vega of a Derivative,
for example, reflects its sensitivity with respect to changes in the volatility
of the underlying asset, and it is defined in a similar way as
∂Π
V= ;
∂σS
Finally, the Rho of a derivative reflects its sensitivity with respect to
changes in the risk-free rate, and is defined in as
∂Π
ρ= .
∂r
Exercise 11.3 Assume that a financial institution has the following portfolio
105
of over-the-counter options on sterling:
Type Position Delta Gamma Vega

Call -1000 0,50 2,2 1,8
Call -500 0,80 0,6 0,2
Put -2000 -0,40 1,3 0,7
Call -500 0,70 1,8 1,4
1. A traded option is available with a delta of 0,6, a gamma of 1,5 and a

vega of 0,8. What position in the traded option and in sterling would
make the portfolio both gamma neutral and delta neutral?
2. What position in the traded option and in sterling would make the port-
folio both vega neutral and delta neutral?
3. Suppose now that a second traded option with a delta of 0,1, a gamma
of 0,5, and a vega of 0,6 is available. How could the portfolio be made
simultaneously delta, gamma, and vega neutral?
11.4 Greeks and the Black-Scholes Model

Recall that the value of a call option is obtained under the absence of ar-
bitrage by the value of a hedging portfolio that exactly replicates its payoff
at any state of nature at a subsequent point in time. In the discrete-time
Binomial setting this leads to equation (6.3) that reads
1
C= [pCu + (1 − p) Cd ] ,
1+r
and that translates in continuous time as the Black-Scholes partial differential
equation (22)
1 2 2
σ S CSS + rSCS + Ct − rC = 0.
2
Notice that this valuation process can be interpreted now in terms of the
Greeks in the sense that
1 2 2
σ S Γ + rS∆ + Θ − rC = 0
2
or still
1
Θ = rC − rS∆ − σ 2 S 2 Γ. (27)
2
106
This allows us to relate Θ to C, ∆ and Γ for any option position. In
particular if V > 0, ∆ ≤ 0 and γ ≤ 0, then Θ ≥ 0; and if V < 0, ∆ ≥ 0 and
γ ≥ 0, then Θ ≤ 0.
Furthermore, the value of the Greeks can be exactly obtained in the
Black-Scholes world from the call option formula. In fact,
∆ = N (d1 )
1
exp −d21 /2

Γ = √
Sσ 2πT
Sσ
exp −d21 /2 + K exp(−rT )rN (d2 )

Θ = √
2 2πT
For a call option with K = 0, notice that d1 → ∞ and both Γ and Θ are
zero and ∆ = 1. It then follows from equation (27) that C = S as it should,
because the right of buying some object for nothing in the future corresponds
to a certain exercise. Hence, the current value of that option should exactly
coincide with the present value of the object to be bought.
Exercise 11.4 Please find the expressions for Vega and Rho in the Black-
Scholes setting.
107
12 Principles of Simulation
12.1 From the Binomial Tree to a Continuous-Time
Process
We typically start discussing Options by using a discrete-time setting, ad
only after that we evolve to the continuous-time limit. The idea is, of course,
that price variations happen continuously in time according to some prob-
abilistic rule, but that the discrete-time Binomial setting captures its main
probabilistic structure.
Notice that the random variable return is defined as
S1 − S0 S1
r= ⇒1+r = ,
S0 S0
where S0 is the current (known) price and S1 is the (random) future price.
In that sense, and assuming that returns are Normally distributed and
therefore fully characterized in the mean-variance space (compatible with the
usual Markowitz analysis) we would have for the probability of returns the
distribution
Z b
−(x − µ)2

1
Pr(a < r < b) = √ exp
2π a 2σ 2
where µ is the expected rate of return per time unit and σ 2 is the variance of
returns per time unit. For an infinitesimal time interval dt we have that the
change in value of the underlying may be written as S1 − S0 = dS and the
return reads r = dS/S0 . This equals a random variable y that is Normally
distributed with average µdt and variance σ 2 dt. We denote this as
dS
= y(dt) ∼ N µdt, σ 2 dt .

S
We may standardize the Normal random variable by defining as usual the
new variable
y(dt) − µdt
z= √ ∼ N (0, 1)
σ dt
implying that √
y(dt) = µdt + σz dt.
108
Thus, we arrive to
dS √
= µdt + σz dt
S
or still √
dS = µSdt + σSz dt (28)
where z ∼ N (0, 1). This approach however, has a limitation since it leads to
the fact that for arbitrary large time intervals
−(x − µ)2
Z
1 −1
Pr(r < −1) = √ ∞ exp >0
2π − 2σ 2
meaning that the probability of obtaining it negative future prices is positive.
This is a contradiction that shows that the probabilistic model must be ad-
justed. This is done in the following way. For small returns r (for small time
intervals t, and in particular consistent with the infinitesimal time approach
leading to equation 28) we have by a simple Taylor expansion that
r2 r2
ln(1 + r) ≈ r − ⇒ r ≈ ln(1 + r) +
2 2
and thus we model
r2 St r 2
= y(t) ∼ N µt, σ 2 t .

ln(1 + r) + = ln + (29)
2 S0 2
This is the so called log-Normal model for the returns.
Notice that for small t, the evolution of the random variable r2 /2 is
dominated by the term σ 2 t, since the term in µ will be multiplied by t2 ,
and the expression (29) reads
√
ln St − ln S0 = (µ − σ 2 )dt + σz t
or h √i
2
St = S0 exp (µ − σ )dt + σz t . (30)
12.2 Simulating Paths and Payoffs

In this section we consider two different situations in order to simulate the
payoff of a derivative. First, a situation where we need to simulate the whole
path. Second a simulation where we need to simulate just the final value of
the path at maturity.
109
In the first case, we must use the process described in equation (28). Its
discrete time version for a time interval ∆t is
√
∆St = µSt ∆t + σSt z ∆t.
In other words, given the value of the underlying asset at time t as St , we
have that the (random) increment ∆S to get the value at t + ∆t is given by
the expression above. The equation for discrete time evolution thus reads
√
St+∆t = St + ∆St = St + µSt ∆t + σSt z ∆t.
The procedure to get a sample path goes like this. Given the time to maturity
T
T , we divide it into n = ∆t small intervals. We thus generate n random
variables from the univariate standardize Normal distribution (from Excel,
for example), to get zi , i = 1, . . . , n.
Example 12.1 Suppose we have a year maturity and we want to partition
that year into 12 months in order to generate 12 values of z. From the Excel
spreadsheet we use the function RAND() to generate random numbers uni-
formly distributed in the interval [0,1]. In a first trial we get the numbers
0,027880346 0,686979758 0,681832186 0,09316745 0,959175355 0,882736306
0,062713381 0,349901574 0,524949529 0,321139678 0,5963742 0,733327001.
These numbers are distributed uniformly in the image of the cumulative stan-
dard Normal distribution. By using the Excel function NORMSINV() for
each of them, we will obtain the correspondent random numbers that are dis-
tributed according to a standard Normal density. We then get
z1 = −1, 91290127
z2 = 0, 487307428
z3 = 0, 472828375
z4 = −1, 321499409
z5 = 1, 741195645
z6 = 1, 188777108
z7 = −1, 532387817
z8 = −0, 385586208
z9 = 0, 062580019
z10 = −0, 464514244
z11 = 0, 243973169
z12 = 0, 622906451
110
We then write for the value of the asset at any point in time t = i∆t
Si = Si∆t with
√
S1 = S0 + µS0 ∆t + σS0 z1 ∆t
√
S2 = S1 + µS1 ∆t + σS1 z2 ∆t
√
S3 = S2 + µS2 ∆t + σS2 z3 ∆t
.. .
. = ..
√
Sn = Sn−1 + µSn−1 ∆t + σSn−1 zn ∆t.
For a vector of realized univariate Normal variables Z = (z1 , z2 , . . . , zn ),
the path is the sequence of the values of the asset in time, denoted by the
vector
S(Z) = (S1 , S2 , . . . , ST )
Example 12.2 Assume that we have S0 = 50, σ = 0.2, µ = 0.10 and that
the maturity of the derivative to be considered is one year. By taking monthly
intervals, ∆t = 1/12 and n = 12. From the 12 Normally distributed random
numbers obtained in the former example we get the following asset price path
S1 = 44, 89459635
S2 = 46, 53181432
S3 = 48, 18984023
S4 = 44, 91469144
S5 = 49, 80416362
S6 = 53, 63746118
S7 = 49, 33900232
S8 = 48, 65178418
S9 = 49, 23299749
S10 = 48, 32290539
S11 = 49, 40626293
S12 = 51, 59480495
With a simulated path we can calculate the payoff of any European deriva-
tive. Let us assume that the derivative pays at maturity a value F [S(Z)].
Example 12.3 For a call option at the money the payoff function is
F [S(Z)] = max(0, S(T ) − 50).
111
In the case of the simulated path above the value of the payoff would be 1,59.
For a put option at the money the payoff function is
F [S(Z)] = max(0, 50 − S(T )).
In the case of the simulated path above the value of the payoff would be 0.
For the case of a lookback option (see next section), where the payoff
function is
F [S(Z)] = max(St ),
t
the above simulated path would give the value of the payoff as 53,64.
For the second approach, we could use simply the equation (30) to get
an estimation of ST . Clearly, and as opposed to the first approach, this
approach is interesting only for derivatives with payoffs that depend only on
ST , such as European calls or puts. The advantage is that requires much less
computing time.
Example 12.4 In the example of the former process, we can simulate the
value the terminal value of the asset by using one single random standardized
Normal simulation. Take z = 0, 12308 with ∆t = 1 to get
ST = 50 exp (0, 1 − 0, 22 ) + 0, 2 × 0, 12308 = 55, 51

In that case, the payoff of the call would be 5,51 and the payoff of the put
would also be zero, as before. However, it would not be possible to value the
payoff of the lookback option.
12.3 Estimating the Value of a Derivative

The value of a derivative must be expressed as the expected payoff discounted
at the risk-free rate. The discount is the easy part, once we have the correct
risk-free rate. The expectation must be estimated from a sufficiently large
number of independently simulated payoffs.
Example 12.5 Suppose that we have the same asset as described above. For
an annual risk free rate of 5% and an at the money call, we simulate several
payoffs. Suppose we have the following values: 1.59 5,51 8.1 0.23 9.14 0 2.04
112
0.01 3.42 6.38 This would give an average value of 3.64. Discounted at the
risk free rate, we would have an estimated value for the option of
C = exp(−0.05) × 3.64 = 3.46.
Just to compare with the Black Scholes value, we can calculate d1 = 0.35, d2 =
0.15, N (d1 ) = 0.6368, N (d2 ) = 0.5596 and
C = 50N (d1 ) − 50 exp(−0.05)N (d2 ) = 5.23.
The difference between the estimated value and the exact Black-Scholes
value is due to the fact that we run only ten simulated payoffs. For the
estimated value to converge with higher probability to the Black-Scholes
value, we would need a higher number of simulations.
The simulated value of the derivative can be either above or below the
correct model value. The size of this interval reflects the accuracy of the
simulation procedure. For a perfectly accurate estimation, the size of this
interval should shrink to zero. For a given confidence level, the interval size
where the simulated value can be found is seen to be proportional to the
inverse of the square root of the number of simulated values of the payoff.
Thus, as we increase the number of simulations, the interval size will shrink.
To get an interval of half the size (double the accuracy) we would need four
times more simulation. To multiply the accuracy by ten, we would need 100
times more simulations, and so on.
12.4 Alternative Processes

The Simulation procedure just described can be easily adjusted to accommo-
date different processes for the value of the underlying asset. Provided that
we can describe the process as something like
√
dS = µ(S, t)dt + σ(S, t)z dt
where µ(S, t) is a drift dependent of the price level S and on time, as well as
the volatility.
Example 12.6 The first example that we can think of is the case of the time
varying volatility. In this case
√
dS = Sµdt + Sσ(t)z dt
113
and the same simulation procedures would apply with the subtle difference
that the argument of σ should be taken into account. Thus, we would have
for the sample path
√
S1 = S0 + µS0 ∆t + σ(0)S0 z1 ∆t
√
S2 = S1 + µS1 ∆t + σ(∆t)S1 z2 ∆t
√
S3 = S2 + µS2 ∆t + σ(2∆t)S2 z3 ∆t
.. .
. = ..
√
ST = Sn−1 + µSn−1 ∆t + σ(T − ∆t)Sn−1 zn ∆t.
If we consider the case of stochastic volatility, we then have to imagine

that the volatility changes not only with time but also with the price level
of the underlying asset.
Example 12.7 In the case of stochastic volatility we must have

√
dS = Sµdt + Sσ(S, t)z dt
and the same simulation procedures would apply with the subtle difference
that the argument of σ should be taken into account. Thus, we would have
for the sample path
√
S1 = S0 + µS0 ∆t + σ(S0 , 0)S0 z1 ∆t
√
S2 = S1 + µS1 ∆t + σ(S1 , ∆t)S1 z2 ∆t
√
S3 = S2 + µS2 ∆t + σ(S2 , 2∆t)S2 z3 ∆t
.. .
. = ..
√
ST = Sn−1 + µSn−1 ∆t + σ(Sn−1 , T − ∆t)Sn−1 zn ∆t.
An additional case to illustrate the application of the principle is a process

with mean reversion. This is a process that resembles the Black-Scholes
process except that the more the level of prices are above a certain target,
the more likely it is that they will drop. Also, the more they are below
that same target, the more likely it is that they will increase. This behavior
(typical of interest rates, for instance) is modeled by a type of process with
µ(S) = m(k − S), for some k > 0 such that
√
dS = m(k − S)dt + Sσz dt
114
Notice that if the level of S is too high (above k), the time trend µ(k − S) is
negative and the price has a negative expected growth rate. If the level of S
is too low (below k), the time trend µ(k − S) is positive and the price has a
positive expected growth rate.
Example 12.8 In the case of a process with mean reversion, the argument
of µ should be taken into account. Thus, we would have for the sample path
√
S1 = S0 + m(k − S0 )∆t + σ(S0 , 0)S0 z1 ∆t
√
S2 = S1 + m(k − S1 )∆t + σ(S1 , ∆t)S1 z2 ∆t
√
S3 = S2 + m(k − S2 )∆t + σ(S2 , 2∆t)S2 z3 ∆t
.. .
. = ..
√
ST = Sn−1 + m(k − Sn−1 )∆t + σ(Sn−1 , T − ∆t)Sn−1 zn ∆t.
12.5 Simulating the Value of a Derivative on Two As-

sets
Suppose that we have an option written on two different assets. Assume that
the realization of the Normal random terms associated to the price processes
of both assets are correlated and have a correlation factor ρ. If we simulate
both processes independently, using for each one the procedure described
above, there will be no room for the correlation factor ρ. The question is,
how can we correctly introduce the factor ρ in two generated random price
processes? Here is how we proceed.
First, take a vector Z (1) of Normally generated standard random vari-
ables. Second, take an independent vector Z (2) of Normally generated stan-
dard random variables. We now define the vectors (1) and (2) such that
(1) = Z (1)
p
(2) = ρZ (1) + 1 − ρ2 Z (2) .
In this way, both (1) and (2) will be equally sampled from a standard Normal
distribution and, at the same time, have a correlation equal to ρ. This is the
simplest form of the so-called Cholesky decomposition.
Example 12.9 For the case where we sample Z (1) and Z (2) as the following
115
sequences
(1)
z1 = −0, 067769799
(1)
z2 = 0, 568252052
(1)
z3 = 0, 354000943
(1)
z4 = 0, 289909749
(1)
z5 = −1, 000803195
(1)
z6 = 0, 152944657
(1)
z7 = 0, 217508668
(1)
z8 = 1, 640039586
(1)
z9 = −1, 172677569
(1)
z10 = 0, 849859264
(1)
z11 = −0, 282850425
(1)
z12 = −1, 11497839
and
(2)
z1 = −0, 459378376
(2)
z2 = 0, 608550455
(2)
z3 = −2, 099060111
(2)
z4 = −0, 725984352
(2)
z5 = 1, 009035724
(2)
z6 = −0, 439378688
(2)
z7 = −0, 234987835
(2)
z8 = 0, 106744598
(2)
z9 = −0, 297372999
(2)
z10 = −0, 298457605
(2)
z11 = 1, 681584974
(2)
z12 = 0, 564678965,
we will get a random vector (2) sampled from a Normal distribution and with
116
correlation ρ = 0.5 with Z (1) as
(2) (1)
√ (2)
1 = 0.5 × z1 + 0.75z1 = −0, 431718243
(2) (1)
√ (2)
2 = 0.5 × z2 + 0.75z2 = 0, 811146179
(2) (1)
√ (2)
3 = 0.5 × z3 + 0.75z3 = −1, 640838908
(2) (1)
√ (2)
4 = 0.5 × z4 + 0.75z4 = −0, 483766017
(2) (1)
√ (2)
5 = 0.5 × z5 + 0.75z5 = 0, 373448973
(2) (1)
√ (2)
6 = 0.5 × z6 + 0.75z6 = −0, 304040777
(2) (1)
√ (2)
7 = 0.5 × z7 + 0.75z7 = −0, 094751101
(2) (1)
√ (2)
8 = 0.5 × z8 + 0.75z8 = 0, 912463326
(2) (1)
√ (2)
9 = 0.5 × z9 + 0.75z9 = −0, 843871356
(2) (1)
√ (2)
10 = 0.5 × z10 + 0.75z10 = 0, 166457764
(2) (1)
√ (2)
11 = 0.5 × z11 + 0.75z11 = 1, 314870093
(2) (1)
√ (2)
12 = 0.5 × z12 + 0.75z12 = −0, 068462866.
From the two sampled vectors of Normal distributed variables Z (1) and (2) ,
we can then simulate paths for both assets, using Z (1) for the process of one
asset and using (2) for the process of the second asset. This procedure can
be repeated for as many paths as we wish until we can estimate the value of
the derivative with enough accuracy.
117
13 Exotic Options
The options we have dealt with so far are the most basic types of contracts.
They are calls or puts, either European or American. These are the so-called
vanilla options. Exotic options are more complex products whose payoffs are
designed in a quite different way for different hedging purposes. We shall
describe in this section a few of such products, explaining how some of them
can be priced in the context of the Black-Scholes assumptions.
13.1 Packages
A Package is a derivative that may be decomposed into calls, puts, underlying
asset and cash.
Example 13.1 A first example of a Package is a Collar. This is simply an
instrument that at maturity pays the following: if the value of the underlying
is too high (say above K2 ), the payoff is truncated at K2 ; if the value of the
underlying is too low (say K1 ), then the payoff will be insured as K1 . In
between, the payoff corresponds to the value of the asset itself.
The payoff of a collar can be seen to be
K1 + max(0, ST − K1 ) − max(0, ST − K2 )
and therefore, its present value should be equal to
K1 exp(−rT ) + C(K1 ) − C(K2 )
In other words, this instruments pays the value of the underlying at maturity
with two exceptions. On one hand, if the value is too high, it will not pay
more than K2 ; if on the other hand the value ends up too low, the long
position will be assured of a minimum payoff K1 . Another example of a
package is the following.
Example 13.2 Forward start is a contract that ensures today (at time 0)
that at a fixed time t you will hold an at the money call option that matures
at T > t.
The value of a European call option at the money can be seen to be homoge-
neous of first degree in the asset price (check that from the Binomial model
and also from the Black-Scholes formula):
C(K = St , St , T − t) = St C(K = 1, S = 1, T − t)
118
and therefore is equivalent to hold at time t a number of C(K=1,S=1) shares
of stock. The value of that position at time zero is obviously
S0 C(K = 1, S = 1, T − t) = C(K = S0 , S0 , T − t).
The time zero value of a forward start is thus the value of an at the money
call option with a reduced time to maturity T − t.
13.2 Options on Options

This type of option is a regular option written on another option. In order to
simplify the approach we shall consider only plain vanilla options of European
nature.
Example 13.3 Chooser is an option that at time t allows to choose between

holding a call and a put option with a given exercise price K and a maturity
T > t.
The value of a chooser at time t will be
max(Ct , Pt ) = Ct + max(0, Pt − Ct ) = Ct + max{0, St − K exp[−r(T − t)]},
where use has been made of the Put-Call Parity Relation. Thus, at time t
the chooser is equivalent to holding a call option that matures at time T plus
the payoff of a call option that matures at t with a reduced exercise price
K exp[−r(T − t)]. At time zero, the value of such contract is
C(K, S0 , T ) + C(K exp[−r(T − t)], S0 , t).
Example 13.4 Compound option gives the holder the right to buy (call) or
to sell (put) at time t for an exercise price Kt another option that matures
at time T > t with an exercise price KT .
In the context of the Black-Scholes model we can find closed-form expres-

sions for European options on European options. If the underlying asset has
volatility σ and pays dividend at a constant dividend yield q, the value of a
call option on a call option is
p p
S0 e−qT M (a1 , b1 ; t/T ) − KT e−rT M (a2 , b2 ; t/T ) − e−rt Kt N (a2 )
119
where S ∗ is the asset price at t for which the underlying option at that time
would equal Kt (and therefore would be at the money) and
ln(S0 /S ∗ ) + (r − q + σ 2 /2)t
a1 = √
σ t
√
a2 = a1 − σ t
ln(S0 /KT ) + (r − q + σ 2 /2)T
b1 = √
σ T
√
b2 = b1 − σ T .
The function M (a, b; ρ) is the cumulative bivariate Normal distribution, pro-

viding the probability that the first variable is less than a and that the
second variable is less than b, when the correlation between both variables is
ρ. Likewise, the value of a European put on a European call is
p p
−S0 e−qT M (−a1 , b1 ; − t/T ) + KT e−rT M (−a2 , b2 ; − t/T ) + e−rt Kt N (−a2 ).
The value of a European call on a European put is

p p
−S0 e−qT M (−a1 , −b1 ; t/T ) + KT e−rT M (−a2 , −b2 ; t/T ) − e−rt Kt N (−a2 ).
The value of a European put on a European put is

p p
S0 e−qT M (a1 , −b1 ; − t/T ) − KT e−rT M (a2 , −b2 ; − t/T ) + e−rt Kt N (a2 )
13.3 Barrier Options

An option that exist or ceases to exist only when the underlying asset attains
a pre-specified barrier level. The two different types are called respectively a
knock-in and a knock-out option. If the barrier level H is above the initial
value of the underlying asset S0 , we say that we have an up option. If the
barrier level H is below the initial value of the underlying asset S0 , we say
that we have an down option.
In the context of the Black-Scholes model,, these options have closed-form
values. We will give a couple of examples. If the barrier level H is below the
exercise price K, the value of a down and in call at time zero is
√
Cdi = S0 e−qT (H/S0 )2λ N (y) − Ke−rT (H/S0 )2λ−2 N (y − σ T ),
120
where
r − q + σ 2 /2
λ=
σ2
and
ln[H 2 /(S0 K)] √
y= √ + λσ T .
σ T
Exercise 13.1 Please work out the expression for an otherwise similar down
and out Call option.
If the barrier level H is equal or above the exercise price K, the value of
a up and in put at time zero is
√
Pui = −S0 e−qT (H/S0 )2λ N (−y) + Ke−rT (H/S0 )2λ−2 N (−y + σ T ),
where, as before,
r − q + σ 2 /2
λ=
σ2
and
ln[H 2 /(S0 K)] √
y= √ + λσ T .
σ T
Exercise 13.2 Please work out the expression for an otherwise similar up
and out Put option.
13.4 Asian Options

These are options whose payoffs depend on the average value of the under-
lying asset during a certain period of time. We shall consider Save as the
average value of the underlying asset during the life of the option.
Example 13.5 One simple example of Asian option is an average strike

option. This is a simple European option such that the payoff at maturity is
calculated by replacing the exercise price by Save .
Different types of contracts can be established. The average can be taken

for a limited time interval (not necessarily the full life of the option). The
Option may be American. The average can be geometric or, more usually,
arithmetic. Or anything else...
121
Example 13.6 Another example of Asian option is an average price option.
This is a simple European option such that the payoff at maturity is calculated
by replacing the maturity value of the underlying asset by Save .
If the average is geometric, there is a closed-form solution for an average

price option in the Black-Scholes context. This happens since the geometric
average of log-Normal random variables is also log-Normally distributed. In
this case, for an underlying asset with volatility σ and paying a constant
dividend yield q, the value of the average price option at issuance time can
be calculated
√ by using the usual Black-Scholes formula replacing the volatility
by σ/ 3 and the constant dividend yield by
σ2

1
r+q+ .
2 6
Suppose now that an average price option has been issued at time zero
and that we are at time t. The observed average price until t is S̄ and we
consider Save to be the average from t to maturity T . The payoff of an
average price call will be then

S̄t + Save (T − t) T −t
max 0, − K, 0 = max(0, Save − K ∗ )
T T
where
T t
K∗ = K− S̄.
T −t T −t
13.5 Lookback Options

These are options whose payoffs depend on the maximum or the minimum
value of the underlying asset during the life of the option. The simplest
example is a floating lookback call option, a contract that allows to buy the
underlying asset by the lowest price achieved during the life of the option.
Its payoff at maturity is the difference between the terminal value of the
underlying asset and its minimum value during the life of the option. An
analogous floating lookback contract allows to sell the underlying asset by
the highest price achieved during the life of the option. Its payoff at maturity
is the difference between the maximum value of the underlying asset during
the life of the option and its terminal value.
122
The values of such instruments can be seen to be
σ2 σ 2 Y1

−rT
Cl = S0 N (a1 ) − S0 N (−a1 ) − Smin e N (a2 ) − e N (−a3 ) ,
2r 2r
where
ln(S0 /Smin ) + (r + σ 2 /2)T
a1 = √
σ T
√
a2 = a1 − σ T
ln(S0 /Smin ) + (−r + σ 2 /2)T
a3 = √
σ T
2(r − σ 2 /2) ln(S0 /Smin )
Y1 = −
σ2
and Smin is the minimum value of the underlying asset from time zero until
the point in time where we are valuing the option. If t = 0, clearly Smin = S0 .
In the case of an otherwise identical put, its value would be given by
σ2 σ 2 Y2

−rT
Pl = −S0 N (b2 ) + S0 N (−b2 ) + Smax e N (b1 ) − e N (−b3 ) ,
2r 2r
where
ln(Smax /S0 ) + (−r + σ 2 /2)T
b1 = √
σ T
√
b2 = b1 − σ T
ln(Smax /S0 ) + (r − σ 2 /2)T
b3 = √
σ T
2(r − σ 2 /2) ln(Smax /S0 )
Y2 =
σ2
and Smax is the maximum value of the underlying asset from time zero until
the point in time where we are valuing the option. If t = 0, clearly Smax = S0 .
Exercise 13.3 Consider a non-dividend paying stock with current price 62.
The yearly stock price volatility is 0.20 and the risk free rate is 5%. What is
the value of a newly issued floating lookback call with 6 months to maturity
on that asset? And what is the value of an otherwise identical lookback put?
123
14 Discrete-Time Models for Options on In-
terest Rates
14.1 The Black and Scholes Failure
The simplest model used to value bond options is the Black and Scholes
mode. If no coupon payments are due to be received during th life of the
option, the Black-Scholes model gives the European call and put prices as
C = BN (d1 ) − K exp (−rT ) N (d2 )

P = K exp (−rT ) N (−d2 ) − BN (−d1 )
where B is the current price of the undelying bond, T is the time to maturity
of the option, and the other terms are as usual where
2

ln (B/K) + r − σ2 T
d1 = √
σ T
√
d12 = d1 − σ T
with σ being the volatility of the bond price. If coupon payments are due to
be received during the life of the option, their present value must e subtracted
from B in the equations that price the options above.
Example 14.1 Take a 1-year European call option on a 10-year bond. Sup-
pose that B = 960, the exercise price is 1000, the 1-year risk-free rate is
10%, the volatility of the bond price is 9% and coupon payments of 50 are
expected in 3 and 9 months. Suppose further hat the 3-month and 9-month
risk-free rates are 9% and 9.5% per year respectively. The present value of
the coupons payment is
50 exp (−0.25 × 0.09) + 50 exp (−0.75 × 0.095) = 95.45.
We then have d1 = −0.4611 and d2 = −0.5511 leading to C = 15.60.
There are two obvious problems with the Black and Scholes model when
applying it to bond options.
First, is that it assumes that interest rates are constant at the same time
the the bond price is stochastic. If interest rates are constant, the bond price
124
will be a deterministic function of time and the two assumptions are clearly
inconsistent.
Second, it assumes that the bond price has a constant volatility. As we
know, bond price volatilities decrease with the passage of time because the
value of the bond must converge to its ace value at the bond’s maturity.
14.2 Models for Interest rates

To overcome the difficulties above, it is necessary to construct a model of
the stochastic behavior of interest rates. Such a model generally involves
a number of parameters such as the market price of risk of the short-term
interest rate, its volatility, the speed with which the short-term interest rates
revert to its long-term tendency, and so on.
In the models that we are considering here, the stochastic variable is
usually the instantaneous risk-free interest rate, r. This rate is assumed to
have an expected growth rate m and a market price of risk λ. Its volatility
will be denoted by s. These parameters can be a function of the level of
interest rate r, of time t, but not a function of other stochastic variables.
The value of a derivative with payoff fT at maturity T is thus
E {exp [−r̄(T − t)] fT }
where r̄ is an average discount rate over the time period and the expectation
is with respect to the risk-neutral probability measure. In a risk neutral
world, the growth rate of the interest rate would be m − λs. Let us define
the current value (at time t) of a bond paying one unit at maturity T as
B (t, T ) = E {exp [−r̄(T − t)]} .
If the continuously compounded interest rate for the period to maturity

(T − t) at that time is denoted by R (t, T ) , we then have
B (t, T ) = exp [−R (t, T ) (T − t)]
or
1
R (t, T ) = − ln E {exp [−r̄(T − t)]} .
T −t
This equation allows to obtain the term structure of interest rates from the
given process followed by the term structure risk-free rate.
125
14.3 The Rendleman and Bartter Model
In this model, the risk-free rate follows a Geometric Brownian motion, and
can thus be represented in a recombining tree with up and down factors like
in the binomial model. We will take
√
u = exp s ∆t
√
d = exp −s ∆t
a−d
p =
u−d
where
a = exp [(m − λs) ∆t]
and m, λ and s are defined as in the former section.
Example 14.2 To illustrate this approach, suppose that ∆t = 1 year, m =

0, s = 0.15, λs = −0.05 and we wish to model interest rates over a 5-year
period. It follows that
u = 1.1618
d = 0.8607
a = 1.0513
p = 0.6329
If the initial interest rate r is 10% p.a., a tree for the interest rate can be
easily obtained. The tree for the interest rates is displayed in
The values in the tree are calculated as usual, multiplying the predecessor
by either u or d. For example in the up node when t = 1, denoted as node
(1,0), the value of the interest rate is calculated as
r10 = r00 × u = 0.10 × 1.1618 = 0.11618.
Once we have a model for the evolution of the interest rate, we may
calculate a similar tree for the values of the bond, the true underlying asset
on which the option is written. For that purpose we have the following.
Example 14.3 Consider a 5-year bond that pays an 8% coupon and has a
face value of $1000. The bond is thus worth $1000 at each of the 6 final
126
* 21.17%

*
18.22%
HH
H
15.68% 15.68%
HHj
*
H *

HH
13.5% 13.5%
H
*

HH j
H
*

HH
H
HH
11.62% 11.62% 11.62%
HH
j j
H
*
H *
H *

HH HH

10% 10% 10%
H H

H j
H j
H
H
* HH * HH
8.61%
HH HH HH
8.61% 8.61%
j
H j
H j
H
HH *
HH *

H H
7.41% 7.41%
HH
j HHj
H *
H
HH HH

6.38% 6.38%
H H
j
H
HH j
H
H *

5.49%
HHj
H
HH
4.72%
H
j
H
Figure 21: Tree for the evolution of the short-term interest rate.
nodes of the tree at t = 5. The value of the bond at each node in earlier times
has to be calculated by working backward through the tree. Let rij = ruj di−j
be the value of the interest rate at time i after going up j times and let Bij
denote the value of the bond at that node. Then
Bij = exp (−rij ∆t) [pBi+1,j+1 + (1 − p) Bi+1,j + c]
where c is the coupon paid at the end of each year. Working back the value
of the bond, we find B00 = 870.9.
The next stage is to use the tree for the bond price to characterize the tree
of the option value.
Example 14.4 Assume that we wish to value a 4-year American call option
on the above bond, with an exercise price of $1000. If fij denotes the value
of the option when the interest rate is rij , we have
f4j = max [B4j − 1000, 0]
and when i < 4,
fij = max {Bij − 1000, exp (−rij ∆t) [pfi+1,j+1 + (1 − p) fi+1,j ]}
due to the American nature of the option. The value of the option at t = 0
can be shown to be $1.05.
127
Exercise 14.1 Evaluate a put option on a 6% coupon bond with a face value
of $1000 that matures at the end of year 6. The option is American and
expires at the end of year 4. Assume that coupons are paid at the end of each
year, the exercise price is $900, the initial interest rate is 8%, the volatility
of interest rates is 20%, the drift in interest rate (m) is zero, and the market
price of interest rate risk is -0.4. Use a time interval of a year.
14.4 The Ho and Lee model

The Ho and Lee model is more flexible than the model above, since it allows
for a different term structure of interest rates at each node of the tree, instead
of a single value of interest rate for each period, based on u and d.
The term structure at any given time t can be described by a discount
function D(k). This is the value at time t of a discount bond which lasts for
time k∆t(k = 1, 2, 3, . . .) and pays off $1.
At time i there are i + 1 nodes. Let Dij (k) denote the discount function
at time i and node j (0 ≤ j ≤ i) . The discount function Dij (k) leads to a
discount function Di+1,j+1 (k) if an up movement occurs between times i and
i + 1, and to Di+1,j (k) if a down movement occurs during this time. Under
the absence of arbitrage opportunities Ho and Lee show that term structure
movements imply that
Dij (k + 1)
Di+1,j+1 (k) = h (k)
Dij (1)
Dij (k + 1) ∗
Di+1,j (k) = h (k)
Dij (1)
where
1
h(k) =
p + (1 − p)δ k
δk
h∗ (k) =
p + (1 − p)δ k
and p and δ are constants between 0 and 1. Since the first node on the tree is
the current term structure, this model automatically provides correct values
for the prices of bonds. The parameters p and δ must be estimated from
the values of traded options. It can be shown that the annual volatility of
128
interest rates is approximately
s
p (1 − p) (ln δ)2
.
r2 ∆t3
Example 14.5 To illustrate the model we calculate the value of a 1-year
European put option on a 3-month Treasury bill with a face value of $1000.
The cash exercise price will be assumed to be $980 and the subinterval width
∆t, will be set equal to 3 months. We assume that p and δ have been estimated
as 0.5 and 0.99700, respectively. We also know the current term structure
as being
D00 (1) = 0.98260
D00 (2) = 0.96510
D00 (3) = 0.94740
D00 (4) = 0.92960
D00 (5) = 0.91190
Thus 0.98260 is the value of a bond that pays $1 in 3 months; 0.96510 is the
value of a bond that pays $1 in 6 months; and so on.
Now, from the expressions above we can easily obtain
k = 1 ⇒ h = 1.00150 and h∗ = 0.99850
k = 2 ⇒ h = 1.00300 and h∗ = 0.99700
k = 3 ⇒ h = 1.00451 and h∗ = 0.99549
k = 4 ⇒ h = 1.00601 and h∗ = 0.99399
k = 5 ⇒ h = 1.00751 and h∗ = 0.99249.
This allows to write for the upper node at t = 1 the following term structure:
D00 (2)
D11 (1) = h (1) = 0.98367
D00 (1)
D00 (3)
D11 (2) = h (2) = 0.96707
D00 (1)
D00 (4)
D11 (3) = h (3) = 0.95032
D00 (1)
D00 (5)
D11 (4) = h (4) = 0.93362
D00 (1)
129
and for the lower node:
D00 (2) ∗
D10 (1) = h (1) = 0.98071
D00 (1)
D00 (3) ∗
D10 (2) = h (2) = 0.96128
D00 (1)
D00 (4) ∗
D10 (3) = h (3) = 0.94180
D00 (1)
D00 (5) ∗
D10 (4) = h (4) = 0.92247.
D00 (1)
In a similar way we can calculate
D20 (1) = 0.97871; D20 (2) = 0.95743; D20 (3) = 0.93637

D21 (1) = 0.98165; D21 (2) = 0.96320; D21 (3) = 0.94485
D22 (1) = 0.98461; D22 (2) = 0.96901; D22 (3) = 0.95340
and
D30 (1) = 0.97679; D30 (2) = 0.95387

D31 (1) = 0.97973; D31 (2) = 0.95961
D32 (1) = 0.98268; D32 (2) = 0.96540
D33 (1) = 0.98563; D33 (2) = 0.97122
and
D40 (1) = 0.97506

D41 (1) = 0.97800
D42 (1) = 0.98094
D43 (1) = 0.98389
D44 (1) = 0.98685.
With these term structures (one for each node of the tree) the values of the
option at each node can be calculated by working backward as before. At
maturity, the value of the option is
max [980 − 1000D4j (1) , 0]
130
for j = 0, 1, 2, 3, and 4. The interest rate used to discount at node (i, j) is
Dij (1) . Thus the value at node (2, 0) can be seen to be
(0.5 × 0.98 + 0.5 × 3.39) × 0.97871 = 2.14
The value of the option at t = 0 can be seen to be $0.75.
Exercise 14.2 Suppose that the current term structure with continuous com-
pounding is as follows:
1-year rate = 0.10

2-year rate = 0.11
3-year rate = 0.12
4-year rate = 0.125
5-year rate = 0.13
Suppose further that the parameters in the Ho and Lee model when ∆t = 1
year are δ = 0.965 and p = 0.45. Estimate the value of a security that pays
off
1000 max(0, R − 0.15)
in 4 years where R is the 1-year rate in 4 years time.
131

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Derivatives

João Amaro de Matos

2 Bounds on Option Prices 11

3 The Binomial Option Pricing Model 19

4 State Prices and Valuation of Derivatives 30

5 Stochastic Volatility and Term Structure of Interest Rates 43

6 From the Binomial Formula to the Black-Scholes Formula 50

8 Properties of the Black-Scholes Model 69

9 Pricing Corporate Securities 76

11 Dynamic Delta Hedging and the Greeks 98

13 Exotic Options 118

14 Discrete-Time Models for Options on Interest Rates 124

• Sτ ,the value of the underlying asset at τ ;

• T − τ , the time to maturity;

• Volatility σ, measuring the uncertainty of returns of the underlying

• K, the exercise price;

The following notation will be used when necessary, to distinguish be-

• Ce : value of an European call ;

• Ca : value of an American call ;

• Pe : value of an European put;

Clearly, Ca ≥ Ce and Pa ≥ Pe , since the American contracts include more

Example 1.1 • If Sτ > K a call is said to be in the money;

• If Sτ < K a call is said to be out of the money;

• If Sτ = K a call is said to be at the money.

We can also exemplify the principle in the case of a put,

Example 1.2 • If Sτ < K a put is said to be in the money;

• If Sτ > K a put is said to be out of the money;

• If Sτ = K a put is said to be at the money.

1.2 Payoff and Profit of Options

Figure 1: Payoff of a call and a put.

call’s profit put’s profit

Figure 2: Profit for a call and for a put.

1.3 Strategies with Options

Figure 3: Payoff of a portfolio constituted by a call and a put.

• spreads: Combine different types of options of the same class, such as

• butterfly spread: May be seen as a combination of both strategies above.

• combinations: Combine together calls and puts. Some examples follow:

2.1 Bounds on the Value of the Underlying Asset

To see this, suppose on the contrary that C < S − K. Then, it suffices

meaning that the value of a call on a worthless asset is zero.

Exercise 2.1 Suppose that a call option on a stock paying no dividends is

2.2 Bounds on the Exercise Price

K1 < K2 ⇒ C(K1 ) ≥ C(K2 ).

K1 < K2 ⇒ C(K1 ) − C(K2 ) ≤ K2 − K1 . (4)

C(K2 ) − λC(K1 ) − (1 − λ)C(K3 ).

2.3 Bounds related to Time

Proposition 2.2 (Early Exercise for Calls) An American call option on

The main implication of this fact is that an American call on an asset

Using our previous notation this reads

Example 2.6 Similarly, it follows from expressions such as (4) identical

K1 < K2 ⇒ 0 ≤ Pe (K2 ) − Pe (K1 ) ≤ K2 − K1 .

Exercise 2.5 If a call option at-the-money is worth exactly the same as an

Figure 4: Tree for payoff of a security, given 3 or 2 possible states of Nature

The payoff of a given security is very often represented by a tree, describ-

3.2 The Binomial One-Period Model

we then must have C = ∆S +B under the absence of arbitrage opportunities.

3.3 Multiple States with More Time Steps

Figure 5: Value of an asset, given 3 possible states of Nature

3.4 General Strategy for Several Periods

Figure 6: Value for the project with two periods.

characterized by the existence of only two possible states of nature at the

Figure 7: Nodes for the three-period tree.

3.5 The Multiple Period Binomial Model

t=0 t=1 t=2