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QUANTITATIVE METHODS IN FINANCE

Brian Moore

Nora Ransom

ENGL 415: Written Communications for Engineering

Spring 2011

9:30 MWF

2005 Hunting Ave

Manhattan, KS 66502 April 29, 2011

Chris Bauer, Information Technology Manager Koch Supply & Trading, LP

4111 East 37 th Street North

Wichita, KS 67220

Dear Chris,

I have completed my literature review, Quantitative Methods in Finance, which you

authorized on March 13, 2011. I completed my review on schedule, and I have met all of the

objectives in my proposal.

As technology continues to pervade finance, quantitative techniques are essential to our sustained success. Modern financial firms rely on efficient and accurate data analysis to remain competitive. In fact, companies now place more value on quantitative methods than ever before. This review will provide Koch Supply & Trading (KS&T) with the necessary tools to remain on the cutting edge of quantitative finance.

This literature review discusses applications of quantitative analysis in options pricing and risk management. In options pricing, I begin by laying the groundwork for modeling and simulating stocks. Then, I discuss Black-Scholes theory, the major result of options pricing research. I also cover the applications of random sampling, Monte Carlo methods, and regression analysis to options pricing. In risk management, I cover confidence intervals, Value at Risk analysis, volatility, and risk metrics. In each case, I present the relevant equations and provide figures demonstrating practical use.

I recommend that we immediately implement the quantitative methods in this review.

Quantitative techniques take full advantage of available market data and provide solutions to complex financial problems. They also provide market insight beyond the intuition of even veteran traders. Quantitative methods are intuitive and easy to learn, so we are well-equipped to implement them.

I will gladly answer any questions you have regarding my research. I appreciate the

opportunity to write this review, and I look forward to applying quantitative methods at KS&T. Thank you.

Sincerely,

Brian Moore

QUANTITATIVE METHODS IN FINANCE

SUBMITTED TO:

Chris Bauer Information Technology Manager Koch Supply & Trading, LP 4111 East 37 th Street North Wichita, KS 67220

SUBMITTED BY:

Brian Moore Mathematics Kansas State University

April 29, 2011

TABLE OF CONTENTS

List of Illustrations ………………………………………………………………………

iii

Glossary ………………………………………………………………………………….

iv

Executive Summary ……………………………………………………………………

vii

Introduction ……………………………………………………………………………

1

Options Pricing …………………………………………………………………………

2

Geometric Brownian Motion …………………………………………………….

3

Black-Scholes Theory ……………………………………………………………

4

Random Sampling ……………………………………………………………….

7

Monte Carlo Methods …………………………………………………………

8

Regression ……………………………………………………………………….

12

Linear Least Squares Regression ………………………………………

13

Non-Linear Least Squares Regression ……………………………

……

15

Risk Management ………………………………………………………………………

17

Confidence Intervals …………………………………………………………….

18

VaR Analysis …………………………………………………………………….

20

Volatility …………………………………………………………………………

22

The Greeks ……………………………………………………………………….

23

Delta ……………………………………………………………………

23

Gamma …………………………………………………………………

24

Theta ……………………………………………………………………

25

Vega ……………………………………………………………………

26

Rho ……………………………………………………………………

26

Black-Scholes Greeks ……………………………………………………

26

Conclusions ……………………………………………………………………………

28

References ……………………………………………………………………………….

30

LIST OF ILLUSTRATIONS

Figure 1

Graphical summary of quantitative analysis …………………………….

viii

Figure 2

Simulation of geometric Brownian motion ……………………………

4

Table 1

Tabulation of Φ(z) values ………………………………………………

6

Figure 3

Random sampling of the Gaussian distribution ………………………….

9

Figure 4

Monte Carlo approximation of π ………………………………………

10

Figure 5

Linear least squares regression of a stock price …………………………

14

Figure 6

Non-linear least squares regression of a stock price with n = 1 …………

16

Figure 7

Non-linear least squares regression of a stock price with n = 5 …………

17

Figure 8

Graphical depiction of a 90% confidence interval ………………………

19

Figure 9

Graphical depiction of a 20% confidence interval ………………………

20

Figure 10

Graphical depiction of one-day VaR …………………………………….

21

GLOSSARY

CDF: Cumulative distribution function; a function representing the probability that a random variable is less than a certain value. Mathematically [1],

where F(z) is the CDF of f (x);

f (x) is the PDF of random variable x; and z is the value of interest.

Covariance: A measure of the correlation between two random variables. Mathematically [1],

where cov(x,y) is the covariance of random variables x and y; μ x is the mean of x; μ y is the mean of y; and E[ ] is the expectation function.

Expectation: A weighted average of a random variable. For continuous random variables [1],

where E[x] is the expectation of random variable x; and f(x) is the PDF of x.

For discrete random variables [1],

where E[x] is the expectation of random variable x;

x k is the k th random outcome;

p k is the probability of x k ;

and n is the total number of outcomes.

Mean: The statistical average of a data set. For random variables [1],

where μ is the mean of random variable x; and E[x] is the expectation of x.

For discrete data points [1],

where μ is the mean of the data;

a k is the k th data point;

and n is the total number of data points.

Overdetermined system: A system of linear equations that contains more equations than unknown variables [2].

PDF: Probability density function; a function describing the probability distribution of a random variable. By definition [1],

where f(x) is the PDF of any random variable x.

Random variable: An event whose outcome is governed by a PDF [1].

SDE: Stochastic differential equation; an equation containing derivatives and random processes.

Standard deviation: A measure of the concentration of a data set. Mathematically [1],

where σ is the standard deviation of random variable x; μ is the mean of x; and E[ ] is the expectation function.

Uniform random variable: A random variable with constant PDF. In general, for a uniform random variable [1] over the interval [a,b],

where f(x) is the PDF of random variable x;

a is the smallest possible outcome;

and b is the largest possible outcome.

Vanderbonde matrix: An m x n matrix of the form [2]

where m is the number of rows;

n is the number of columns;

and {α 1 , α 2, … , α m } are real numbers.

VaR: Value at Risk.

Variance: A measure of the self correlation of a random variable. Mathematically [1],

where var(x) is the variance of random variable x; and σ is the standard deviation of x.

White noise: A uniformly distributed random variable [1].

Wiener process: A discrete random process with the property that the next state value is the sum of the current state and a Gaussian random variable with zero mean and variance equal to the step size [3].

EXECUTIVE SUMMARY

Advances in computing and data processing are heavily impacting the financial market. Companies must take advantage of new technologies to remain competitive. In particular, quantitative methods are enjoying great success in the financial market. Quantitative methods process vast amounts of available data and provide insight beyond the intuition of even veteran traders. As advances in computing and information sharing continue, quantitative methods will increase trading profits at Koch Supply & Trading.

My review covers quantitative methods in options pricing and risk management. For options pricing, I discuss five techniques that compose a complete options pricing arsenal:

Brownian motion is a simple and effective method for simulating stock prices.

Black-Scholes theory provides explicit formulas for pricing European options.

Random sampling replaces complicated equations with manageable data.

Monte Carlo methods use random sampling to find approximate solutions to general options pricing formulas.

Regression techniques regain equations from sampled data.

With these five techniques, we can simulate underlying stocks, price options, and identify trends in complex data. In each case, I present and explain all relevant equations. I also simulated each technique to generate figures that demonstrate practical use. With the information in this section, we can immediately implement all five of these techniques.

For risk management, I discuss four tools that measure financial risk:

Confidence intervals attach probabilities to market predictions.

VaR analysis quantifies lower bounds on asset performance.

Volatility quantifies asset randomness.

The Greeks quantify an asset’s underlying sensitivities. Together, they measure the overall health of an asset.

These four tools quantify all aspects of a typical trade. As with options pricing, I present and explain all relevant equations and provide figures that demonstrate practical use. Figure 1 gives a graphical summary of my review.

I recommend that we immediately implement the quantitative methods in this review. Quantitative methods take full advantage of available market data and provide reliable results to complex problems. Quantitative analysis is far superior to qualitative analysis because it is based on mathematical theory. Nonetheless, quantitative methods are intuitive, so they are easy to learn.

In options pricing, Brownian motion and Black-Scholes theory drastically simplify stock/option pricing. Monte Carlo methods are straightforward and provide efficient solutions to large-scale problems. Even for complex data, regression identifies underlying trends and yields convenient market predictions. In risk management, volatility and the Greeks quantify an asset’s stability and growth potential. VaR and confidence intervals quantify the probability of potential outcomes. We can use these techniques to manage the

risk of our portfolio and guarantee profitable investments. Overall, these quantitative methods will improve our efficiency and accuracy in options pricing and risk management. Therefore, they will result in increased profit.

Confidence Brownian Quantitative Analysis Intervals motion Risk Management Options Pricing Greeks Black-Scholes
Confidence
Brownian
Quantitative Analysis
Intervals
motion
Risk Management
Options Pricing
Greeks
Black-Scholes
Theory
Value at Risk
Analysis
Monte Carlo
Regression
Volatility
Methods

Figure 1: Graphical summary of quantitative analysis and the primary methods used in each application.

Adapted from [5].

QUANTITATIVE METHODS IN FINANCE

INTRODUCTION

Technology is forever changing the scope of modern business. Companies of all types must regularly adapt to advances in information sharing and analysis to remain competitive in the market. In particular, technology has heavily influenced the financial sector. Now analysts constantly adapt their methods to take advantage of innovations in computing and data processing [4]. Financial firms have discovered that accurate and efficient data processing provides a significant market edge. In fact, financial companies now place more value on their quantitative tools than ever before [5]. Computing power has also spurred renewed interest in financial research that will lead to further innovation in quantitative technology [4]. Given these market trends, quantitative analysis has great potential profitability for options pricing and risk management at Koch Supply & Trading (KS&T).

Quantitative analysis, also known as computational finance, applies mathematical theories and computational techniques to suggest potential trading strategies [4]. Quantitative analysts often implement simulations and perform optimizations [6]. Computer simulations help quantitative analysts model market trends and predict the behavior of targeted variables like stock prices. Financial optimizations establish trading strategies that maximize return while meeting certain risk restrictions [5]. In either case, quantitative analysts apply computational techniques to obtain market insight beyond the intuition of even veteran traders.

Quantitative techniques are becoming increasingly attractive thanks to advances in processing power [5]. Data mining companies compile a vast amount of financial information every day, and financial firms have easy access to this information [4]. Advances in computing power have also made this data useful in quantitative modeling [7]. For example, one researcher notes that quantitative pricing models are attracting large investments in both technology and personnel [8]. Ambitious companies use quantitative analysis to take advantage of the limitless data in today’s financial market.

Although financial information is readily available, analysts must process it in large quantities to obtain results. In fact, one recent financial simulation considered over twenty million variables and five million test cases [7]. Research also suggests that commonly traded financial objects like stocks and futures have complex probabilistic behavior [8], which justifies the use of simulations in finance. Moreover, thorough research is critical because experts have determined that financial problems of practical interest rarely have closed form solutions [8]. Quantitative analysis takes full advantage of available financial data and offers solutions despite the complexity of the stock market.

This literature review discusses applications of quantitative analysis in options pricing and risk management. In options pricing, I begin by laying the groundwork for modeling and simulating stocks. Then, I discuss Black-Scholes theory, the major result of options pricing research. I also cover the applications of random sampling, Monte Carlo methods, and regression analysis to options pricing. In risk management, I cover confidence intervals, Value at Risk analysis, volatility, and risk metrics. Finally, I present my conclusions and discuss the implementation of quantitative methods at KS&T. For each topic, I present the relevant equations, discuss their importance, and give practical examples. This review should equip experts and technicians with the necessary tools and intuition to immediately implement quantitative analysis at KS&T. Executives should focus on the introduction to each section and my conclusions to understand the benefits of quantitative analysis.

OPTIONS PRICING

Options pricing is one major application of quantitative analysis in finance. A financial option is an agreement between a buyer and seller that guarantees the buyer the chance to trade a certain stock before an expiration date at an agreed upon price, called the strike price. If the agreement involves the sale of a stock, it is a put; if the agreement involves the purchase of a stock, it is a call [8]. Clearly, the market price of a stock can change during the agreement. Accordingly, the value of the option changes, so accurate predictions are important. Because the options market is worth more than one trillion dollars [3], quantitative analysts place great value on developing efficient algorithms for options pricing.

Geometric Brownian Motion

Options derive value from their underlying stocks, so accurate stock simulation is critical in options pricing [8]. Clearly, though, stock prices are difficult to predict. In lieu of insider trading or other illegal activity, quantitative analysts model the behavior of stocks with numerical techniques. Interestingly, Louis Bachelier suggested one of the most popular techniques in the early 1900s, well before the birth of quantitative finance. In his doctoral

thesis, Bachelier developed the concept of Brownian motion and hypothesized that it could predict stock prices [9]. Formally, Bachelier stated that the price of any stock, S, is governed [10] by the SDE

(1)

where μ is the percentage drift of stock S; σ is the percentage volatility of stock S; dS is the differential stock price; dt is the differential time element; and W t is a Wiener process whose differential, dW t , is white noise.

Intuitively, equation (1) indicates that parameters μ and σ, along with small randomness, completely determine the rate of change of a stock price. Once mathematicians develop a differential equation, they solve it to obtain a closed form solution for the variable of interest. In the case of equation (1), solving for S yields a closed form expression for the price of a stock, S(t), over time. The solution [10] is

(2)

where S 0 is the initial price of the stock; t is time; and μ, σ, and W t are defined as in equation (1).

Once quantitative analysts determine μ and σ for a certain stock, they use equation (2) to predict its behavior. Figure 2 applies equation (2) to predict the prices of two hypothetical stocks with an initial price of $1.00 over a 10-day trading period. The stock in red has greater drift and volatility values than the stock in blue. As a result, the price of the stock in red grows to almost twice the value of the stock in blue. Intuitively, this result is reasonable because a stock with higher drift and volatility should exhibit greater growth. Figure 2 resembles the behavior of real stocks; thus, quantitative analysts can reasonably assume that Bachelier’s model is viable. Equation (2) is an essential tool in stock pricing.

The simulated stock prices in Figure 2 follow geometric Brownian motion. In general, mathematicians say that any process that satisfies the SDE in equation (1) follows geometric Brownian motion [10]. In practice, quantitative analysts gain valuable insight into the behavior of stocks by considering them Brownian. Analysts think of geometric Brownian motion as a weighted random growth over time [9]. In the case of stocks, parameters μ and σ are the weights. Thus, quantitative analysts consider a stock to be a random variable where drift and volatility parameters control growth. Quantitative analysts prefer the Brownian view of stocks because it allows them to apply the statistical theory of random variables to stock pricing while maintaining an intuitive grasp of drift and volatility.

Figure 2: Simulation of geometric Brownian motion for two hypothetical stocks with an initial price

Figure 2: Simulation of geometric Brownian motion for two hypothetical stocks with an initial price of $1.00 and different values for μ and σ.

Black-Scholes Theory

Black-Scholes theory, a revolutionary pricing model developed by economists Fischer Black and Myron Scholes in the 1970s, is the primary method for options pricing [3]. Black- Scholes theory is widely important in quantitative finance because it applies to options pricing and general stock pricing [10]. In fact, Black-Scholes theory extends the work of Bachelier into options pricing by modeling underlying stock prices with geometric Brownian motion [9]. Black-Scholes theory only considers European options, which differ from traditional options only in that traders cannot exercise them before the expiration date. The resulting equations, known collectively as the Black-Scholes option pricing formulas, predict the call price, c, and put price, p, of European stock options. The equations [9] for c and p are

where

where and where s is the price of the underlying stock; x is the strike price;

and where s is the price of the underlying stock;

x

is the strike price;

r

is the interest rate;

t

is the time, in years, until expiration;

σ is the volatility of the underlying stock; and Φ(z) is the standard normal CDF.

(3)

(4)

(5)

(6)

Although equations (3)-(6) are somewhat complicated, they allow quantitative analysts to explicitly calculate call and put prices for European stock options. After calculating the expected call or put price of an option, quantitative analysts can then determine whether the option is profitable. Finally, quantitative analysts compile this information for many potential options and recommend optimal trading strategies. Equations (3)-(6) are essential to profitable options pricing.

The only unknown parameter in equations (3)-(6) is Φ(z), the standard normal CDF. Mathematically, Φ(z) is defined [1] as

normal CDF. Mathematically, Φ( z ) is defined [1] as where z is the right bound

where z is the right bound of integration; and x is the variable of integration.

(7)

Unfortunately, explicit evaluation of equation (7) is impossible [1]. Instead, statisticians used numerical techniques to compile Table 1, a set of Φ(z) values at predetermined z values. The figure included with Table 1 shows the graphical interpretation of Φ(z) as the area underneath the standard Gaussian between 0 and z. Use of Table 1 is straightforward. For example, Φ(2.03) = .4788, the entry corresponding to the row labeled 2.0 and the column labeled 0.03. While Table 1 only contains values of Φ(z) from z = 0 to z = 3 in increments of 0.01, quantitative analysts often construct larger tables offering smaller increments and larger ranges for z. Such tables provide greater accuracy, which analysts often require.

Φ(z)
Φ(z)

Table 1: A tabulation of Φ(z), the area underneath the standard normal distribution between 0 and the desired z value. For example, Φ(2.03) = .4788, the entry corresponding to the row labeled 2.0 and the column labeled 0.03.

0

z

z

0.00

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09

0.0

0.0000

0.0040

0.0080

0.0120

0.0160

0.0199

0.0239

0.0279

0.0319

0.0359

0.1

0.0398

0.0438

0.0478

0.0517

0.0557

0.0596

0.0636

0.0675

0.0714

0.0753

0.2

0.0793

0.0832

0.0871

0.0910

0.0948

0.0987

0.1026

0.1064

0.1103

0.1141

0.3

0.1179

0.1217

0.1255

0.1293

0.1331

0.1368

0.1406

0.1443

0.1480

0.1517

0.4

0.1554

0.1591

0.1628

0.1664

0.1700

0.1736

0.1772

0.1808

0.1844

0.1879

0.5

0.1915

0.1950

0.1985

0.2019

0.2054

0.2088

0.2123

0.2157

0.2190

0.2224

0.6

0.2257

0.2291

0.2324

0.2357

0.2389

0.2422

0.2454

0.2486

0.2517

0.2549

0.7

0.2580

0.2611

0.2642

0.2673

0.2704

0.2734

0.2764

0.2794

0.2823

0.2852

0.8

0.2881

0.2910

0.2939

0.2967

0.2995

0.3023

0.3051

0.3078

0.3106

0.3133

0.9

0.3159

0.3186

0.3212

0.3238

0.3264

0.3289

0.3315

0.3340

0.3365

0.3389

1.0

0.3413

0.3438

0.3461

0.3485

0.3508

0.3531

0.3554

0.3577

0.3599

0.3621

1.1

0.3643

0.3665

0.3686

0.3708

0.3729

0.3749

0.3770

0.3790

0.3810

0.3830

1.2

0.3849

0.3869

0.3888

0.3907

0.3925

0.3944

0.3962

0.3980

0.3997

0.4015

1.3

0.4032

0.4049

0.4066

0.4082

0.4099

0.4115

0.4131

0.4147

0.4162

0.4177

1.4

0.4192

0.4207

0.4222

0.4236

0.4251

0.4265

0.4279

0.4292

0.4306

0.4319

1.5

0.4332

0.4345

0.4357

0.4370

0.4382

0.4394

0.4406

0.4418

0.4429

0.4441

1.6

0.4452

0.4463

0.4474

0.4484

0.4495

0.4505

0.4515

0.4525

0.4535

0.4545

1.7

0.4554

0.4564

0.4573

0.4582

0.4591

0.4599

0.4608

0.4616

0.4625

0.4633

1.8

0.4641

0.4649

0.4656

0.4664

0.4671

0.4678

0.4686

0.4693

0.4699

0.4706

1.9

0.4713

0.4719

0.4726

0.4732

0.4738

0.4744

0.4750

0.4756

0.4761

0.4767

2.0

0.4772

0.4778

0.4783

0.4788

0.4793

0.4798

0.4803

0.4808

0.4812

0.4817

2.1

0.4821

0.4826

0.4830

0.4834

0.4838

0.4842

0.4846

0.4850

0.4854

0.4857

2.2

0.4861

0.4864

0.4868

0.4871

0.4875

0.4878

0.4881

0.4884

0.4887

0.4890

2.3

0.4893

0.4896

0.4898

0.4901

0.4904

0.4906

0.4909

0.4911

0.4913

0.4916

2.4

0.4918

0.4920

0.4922

0.4925

0.4927

0.4929

0.4931

0.4932

0.4934

0.4936

2.5

0.4938

0.4940

0.4941

0.4943

0.4945

0.4946

0.4948

0.4949

0.4951

0.4952

2.6

0.4953

0.4955

0.4956

0.4957

0.4959

0.4960

0.4961

0.4962

0.4963

0.4964

2.7

0.4965

0.4966

0.4967

0.4968

0.4969

0.4970

0.4971

0.4972

0.4973

0.4974

2.8

0.4974

0.4975

0.4976

0.4977

0.4977

0.4978

0.4979

0.4979

0.4980

0.4981

2.9

0.4981

0.4982

0.4982

0.4983

0.4984

0.4984

0.4985

0.4985

0.4986

0.4986

Adapted from [1].

Table 1 is indispensable because the Black-Scholes equations require computation of Φ(z), which requires a reference table. Although the Black-Scholes equations consider only European options, quantitative analysts have extended them to price general options [9]. Thus, the Black-Scholes equations and Table 1 are key to profitable options trading and a valuable edge in this multi-trillion dollar industry.

Equation (2) is the starting model for Black-Scholes Theory. Its true value, however, lies in its convenience rather than its applicability [9]. Closed form solutions like equation (2) are convenient because they give analysts a complete prediction of a stock’s behavior. Unfortunately, such solutions are not always possible. Indeed, equation (2) is only valid for European options with constant volatility that do not pay dividends [10]. Clearly, these assumptions limit the practical application of equation (2). Nonetheless, Black-Scholes Theory remains important in quantitative analysis. While equation (2) is not always valid, quantitative analysts can adapt equation (1) to model generic options. In such cases, though, closed form solutions like equation (2) are rare. Thus, quantitative analysts must resort numerical techniques to solve adapted SDEs [10].

Quantitative analysts use many numerical techniques for solving differential equations. While details vary, all such techniques contain a numerical integration method. Unfortunately, many numerical integration methods bear the curse of dimensionality, meaning that their implementations grow unfeasibly complex in large-scale problems [9]. Financial problems like options pricing are large-scale, so quantitative analysts turn to random sampling and Monte Carlo methods for efficient solutions [10].

Random Sampling

Quantitative methods in finance rely heavily on statistical analysis [5]. To identify underlying market trends, quantitative analysts process large quantities of market data from many sources. Analysts refer to the current trend of interest as a random variable and the associated market data as a sampling of the random variable. Thus, quantitative analysts collect data by sampling random variables of interest. Although this terminology seems excessive, it suggests a connection to the Central Limit Theorem, an important theorem in statistics. The Central Limit Theorem states that the average of a large number of random variables has a Gaussian, or bell curve, distribution [1]. Because quantitative analysts collect extensive data, the Central Limit Theorem suggests that market trends will have Gaussian distributions. Thus, the Gaussian distribution is an important tool in quantitative analysis.

Mathematically, the Gaussian distribution [1], G(μ,σ,z), is

the Gaussian distribution [1], G( μ , σ , z) , is where μ is the

where μ is the sample mean; σ is the sample standard deviation; and z is a Gaussian random variable.

(8)

The black curves in Figure 3 represent Gaussian distributions with μ = 4 and σ = 1. The Gaussian distribution is rather complicated, so quantitative analysts avoid direct use of equation (8) in practice. Because the Gaussian distribution is exceedingly common in finance, however, an alternative approach is essential. The series of bar graphs in Figure 3 demonstrate one such approach. Each bar graph represents a random sampling of equation (8) with μ = 4 and σ = 1 grouped into 30 equally spaced intervals. The y-axis of each graph displays the proportion of sampled values that fell within each interval. The upper left graph shows that 100 samples are not sufficient to approximate a Gaussian distribution. However, the lower right graph achieves a close fit by tabulating 100,000 samples. Thus, Figure 3 demonstrates that randomly sampled data will converge to its underlying distribution as sample size increases.

Advances in computing power have made it feasible to process 100,000 samples or more [4]. As such, Figure 3 has huge implications to quantitative analysis. Quantitative analysts use the random sampling procedure demonstrated in Figure 3 to obtain discrete approximations of the Gaussian distribution. Therefore, random sampling allows quantitative analysts to avoid direct use of equation (8), which is too complicated for practical use. Finally, random sampling is easy to implement; I wrote the source code to generate Figure 3 in less than 15 minutes using MATLAB, a popular and widely available software package.

Monte Carlo Methods

A Monte Carlo method is any numerical technique that uses random sampling to compute

solutions. Monte Carlo methods are ideal for large-scale problems because their complexity

does not depend on the size of the problem [11]. In particular, quantitative analysts use Monte Carlo methods to solve problems in options pricing and risk management [5]. Monte

Carlo methods are a natural fit in finance because both rely on probability and randomness.

In general, though, Monte Carlo methods are surprisingly applicable to problems that are not

probabilistic or random [9]. The approximation of π is one such problem.

Mathematicians have proven that π, defined as the ratio of the circumference and diameter of

a circle, is an irrational number; i.e., its decimal representation is never ending. To nine digits

of accuracy,

π ≈ 3. 4 59 65

(9)

Monte Carlo methods are a surprisingly simple way to approximate π. Moreover, this simple example will demonstrate the general Monte Carlo procedure. Figure 4 contains a quarter circle of radius one inscribed in the unit square formed by the x-y axes. From geometry, the equation of the quarter circle is

where x is the horizontal coordinate; and y is the vertical coordinate.

(10)

Figure 3: Approximation of a standard Gaussian distribution using random sampling. Upper left: 100 samples.
Figure 3: Approximation of a standard Gaussian distribution using random sampling. Upper left: 100 samples.
Upper right: 1,000 samples. Lower left: 10,000 samples. Lower right: 100,000 samples.
Figure 4: Example of a Monte Carlo simulation using 2,000 randomly sampled points (represented by

Figure 4: Example of a Monte Carlo simulation using 2,000 randomly sampled points (represented by green dots) to approximate π. The resulting estimation was π ≈ 3.1416.

Furthermore,

4

where A c is the area of the quarter circle; and A s is the area of the unit square.

(11)

Equation (11) indicates that π is exactly four times the ratio of A C to A S . However, calculating A C requires the value of π, so equation (11) is not directly useful. Instead, we will use a Monte Carlo simulation to approximate this ratio. Suppose we generate a large number of random points inside the unit square. Because the ratio of areas of the quarter circle to the square is π/4, we expect the number of random points that fall inside the quarter circle to be proportional to π/4. Mathematically, a point (x,y) falls within our quarter circle whenever

where x is the horizontal coordinate; and y is the vertical coordinate.

(12)

Equation (12) follows directly from equation (10). In conclusion, we can use the following Monte Carlo method to approximate π:

1. Generate a random point (x,y) inside the unit square.

2. If equation (12) holds, increment a variable Y. If not, increment a variable N.

3. Repeat 1-2 for the desired number of samples.

4. Approximate π as

4

(13)

where Y is the total number of points within the quarter circle; and N is the total number of points outside the quarter circle.

Figure 4 realizes the above procedure with 2,000 samples. From equation (13), the resulting approximation was π ≈ 3.1416. Comparison with equation (9) shows that we achieved four digits of accuracy. Moreover, the simulation that generated Figure 4 took less than one second to execute. Thus, we could feasibly generate even more samples and improve our approximation!

The approximation of π is a non-probabilistic application of Monte Carlo methods. Nonetheless, quantitative analysts use similar methods to solve probabilistic problems in finance [9]. In either case, use of random sampling to approximate complex problems with manageable ones is the key to Monte Carlo methods. In the above example, random sampling allowed us to approximate equation (11) with equation (13). Similarly, quantitative analysts apply Monte Carlo methods to approximate integrals that often appear in financial problems. Indeed, consider a generic integral [12]

where Ψ is the unknown value of the integral; f(u ) is any integrable function over (0,1) n ; u is a vector of length n; and n is the dimension.

(14)

Quantitative analysts can transform almost all practical integrals into equation (14) [11]. Thus, quantitative analysts can use the Monte Carlo method for equation (14) to approximate most integrals. To apply the Monte Carlo method, we replace u with a uniform random

variable U over (0,1) n . In doing so, we obtain an expression for Ψ in terms of the expectation of f(u ) over (0,1) n . That is, we have [12]

(15)

where E[f(U )] is the expectation of f(U ) over (0,1) n ; U is a uniform random variable over (0,1) n ; and f(u ) and Ψ are defined as in equation (14).

Intuitively, equation (15) expresses the desired integral as the average of f(u ) over the region of integration. The expectation of a function still involves an integral, however, so we cannot directly apply equation (15). Instead, we can approximate equation (15) by simply calculating the statistical mean of a sample set of f(u ). Mathematically, this means we can approximate [12] Ψ as

(16)

where u [k] is the k th random sample of f(U ); M is the number of samples; and f(u ) and Ψ are defined as in equation (14).

Quantitative analysts call equation (16) the Monte Carlo estimator of Ψ [11]. Equation (16) is valuable for two reasons. First, it calls for samples of f(U ), which we can easily obtain with random sampling. Second, we can increase the number of samples, M, to obtain arbitrarily close approximations of Ψ. Thus, equation (16) is a powerful and effective method for approximating integrals in finance.

The Monte Carlo estimator for Ψ is remarkably similar to equation (13). In both cases, the Monte Carlo method uses random sampling to replace difficult quantities [11]. Then, we increase the sample size until the results converge to the exact solution. Whether the problem of interest is probabilistic or deterministic, Monte Carlo methods remain an important tool for quantitative analysts [9]. In fact, because equation (16) is a general result, quantitative analysts can use it to solve most SDEs in options pricing [11]. Specifically, quantitative analysts can use the Monte Carlo method outlined above to price non-European options that pay dividends. Such options were previously elusive to Black-Scholes theory. Thus, Monte Carlo methods fill the gap between Black-Scholes theory and generalized options pricing.

Regression

When quantitative analysts use Monte Carlo methods, they replace underlying equations with numerical approximations. Without numerical approximations, analysts would be unable to construct financial models. Equations, however, allow analysts to extrapolate results [5].

Because market prediction is vital, analysts often wish to reconstruct equations from numerical models. Analysts rely on regression analysis to accomplish this goal.

Regression analysis is the branch of statistics that seeks to describe the relationship between two variables [1]. Analysts distinguish the variables as controlled or controlling variables. The controlling, or independent, variable is the underlying cause of an event. The controlled, or dependent, variable responds to change in the controlling variable. Thus, regression techniques describe how dependent variables vary with independent variables. Accurate descriptions of these relationships are critical because they lead to accurate market predictions. Least squares methods are the most popular regression techniques in finance [5]. Analysts further distinguish between linear and non-linear least squares methods.

Linear Least Squares Regression

Linear regression techniques find the line of best fit for a given data set [1]. In general, regression techniques use different criteria to define best fit. Least squares is the most common form of linear regression [13]. Liner least squares minimizes the sum of the square error between the line of best fit and the data [1]. Intuitively, the line of best fit travels as close as possible to every data point. The equation of a line has the general form

where y is the dependent variable;

m is the slope;

x is the independent variable; and b is the y-intercept.

(17)

From equation (17), the linear least squares method must find the optimal m and b values. Formally, the optimality criterion [13] for m and b is

where (x k ,y k ) is the k th data point;

N is the number of data points;

and m and b are the linear least squares solutions.

(18)

Equation (18) requires a search of all possible m and b values to find the line that minimizes the square error to our data. Clearly, this is not practical. Quantitative analysts often bypass impractical tasks like solving equation (18) by finding numerical approximations [5]. Fortunately, though, equation (18) has an exact solution. The optimal m and b values [13] are

where x is the independent variable; y is the dependent variable; μ x is the mean of x; μ y is the mean of y; cov(x,y) is the covariance of x and y; and var(x) is the variance of x.

(19)

(20)

Equations (19)-(20) allow analysts to explicitly calculate m and b for any data set. The simplicity of equations (19)-(20) makes linear least squares the standard regression technique in finance [1]. Figure 5 illustrates a practical application of linear least squares regression. I used equations (19)-(20) to calculate m = .32 and b = 4.33 for the stock price data in blue. The resulting line, in red, is the best linear fit to the stock data over the 7 day trading period. Moreover, by extrapolating the line to 10 days, we can predict the behavior of the stock over the next 3 days. The red line quantifies the underlying linear growth of the stock. If market conditions stay constant, the red line is a reasonable predictor of stock price [9]. Thus, quantitative analysts use linear least squares regression to identify linear trends and make linear predictions. While linear trends are often sufficient, analysts turn to non-linear least squares regression to make more accurate predictions.

least squares regression to make more accurate predictions. Figure 5: Linear least squares regression of a

Figure 5: Linear least squares regression of a hypothetical stock.

Non-Linear Least Squares Regression

Non-linear least squares regression finds the polynomial of best fit for a given data set [1]. Like linear least squares, the polynomial of best fit minimizes the sum of the square errors with the data. However, non-linear least squares regression achieves a much closer fit because polynomials are more flexible than lines. A polynomial, p(x), has general form

(21)

where {P n , P n-1 , , P 1 , P 0 } are the polynomial coefficients;

n is the degree of the polynomial;

and x is the independent variable.

From equation (21), the non-linear least squares method seeks the optimal polynomial coefficients for a given data set and polynomial degree. When n = 1, non-linear least squares regression reduces to liner least squares regression. In general, though, increasing the polynomial degree provides a closer fit [1]. To apply non-linear least squares regression, we express our polynomial of best fit in matrix form [2] as

(22)

where (x k , y k ) is the k th data point; {P n , P n-1 , , P 1 , P 0 } are the polynomial coefficients; m is the number of data points; and n is the degree of the polynomial.

Equation (22) requires the polynomial of best fit to travel through every data point. When m > n, this cannot happen; nonetheless, equation (22) will produce the least squares solution. To solve for the polynomial coefficients, we express equation (22) in compact form [2] as

where Y is the vector of dependent data points;

(23)

X is the Vanderbonde matrix of independent data points;

and P is the vector of polynomial coefficients.

Solving equation (23) for P will yield the optimal polynomial coefficients. Equation (23) represents an overdetermined system of linear equations. From linear algebra, the solution [14] to equation (23) is

where X, Y, and P are defined as in equation (24).

(24)

Equation (24) is the explicit formula for P, the coefficients of the non-linear least squares polynomial of degree n [14]. Quantitative analysts vary n to find the best fitting polynomial for a given data set. Figure 6 uses equation (24) to fit a polynomial with n = 1 to a hypothetical stock. The red line is exactly the linear least squares solution. Figure 7, however, uses equation (24) to fit a polynomial with n = 5 to the same stock data. Clearly, the red curve in Figure 7 is a much closer fit. Analysts use non-linear least squares regression to quantify price fluctuation over time [1]. While linear regression identifies fundamental trends, non-linear regression can track multiple peaks and valleys in data.

regression can track multiple peaks and valleys in data. Figure 6: Non-linear least squares regression of

Figure 6: Non-linear least squares regression of a hypothetical stock with n = 1.

Equations (19), (20), and (24) are the main results of least squares regression in finance. Quantitative analysts use these three equations to regain equations from numerical approximations [5]. Then, analysts can extrapolate the results to predict behavior. Linear least squares regression quantifies the linear growth of data over time [1]. Non-liner least squares regression provides a more detailed description of data trends. Understanding relationships between market variables is essential to profitable trading [4]. Regression techniques provide a quantitative measure of such relationships, so they are important tools in finance.

Figure 7: Non-linear least squares regression of the stock from Figure 6 with n =

Figure 7: Non-linear least squares regression of the stock from Figure 6 with n = 5.

RISK MANAGEMENT

Risk management is another key application of quantitative analysis. Formally, risk management refers to the creation of financial strategies that minimize potential losses in a given market [5]. Quantitative analysts break risk management into three basic stages:

identification, measurement, and formulation. During the identification stage, analysts research stocks to identify underlying risks. Then analysts use a variety of techniques to measure and rank inherent risks. Finally, analysts formulate investment strategies that meet the desired risk restrictions [5]. Quantitative analysts focus on the risk measurement and risk formulation stages because these areas require the most mathematics. Stock traders, on the other hand, focus on the identification of risk. Risk management is inherent in all financial ventures because traders always seek profit while trying to reduce risk of loss [7]. Like options pricing, risk management is a broad and important financial concept.

Quantitative analysts are particularly interested in the mathematical approach to risk. Simple investment classifications like aggressive or conservative are not sufficient in quantitative finance. Instead, analysts develop techniques to quantify investment risk so they can guarantee profitable outcomes. Quantitative risk management is a natural extension of stock/options pricing. As established, analysts use Black-Scholes theory and Monte Carlo methods to predict the future price of assets. Then, however, they must determine the risk associated with these predictions. Profitable investment requires prediction and management.

Confidence Intervals

Quantitative analysts are often concerned with the confidence interval of a given investment [11]. Statistically, a confidence interval is a range of defined probabilistic outcome [1]. In practice, quantitative analysts develop confidence intervals for future stock prices to qualify price predictions. For example, suppose a quantitative analyst applies equation (2) to predict the future price of a European option. Clearly, the analyst cannot promise the option will reach the predicted price. This does not imply, however, that the prediction is invalid; it simply means the analyst must qualify the prediction. Instead, the analyst may state that he/she is 90% sure the option price will be between $100 and $150 in 5 days. In this example, the analyst expressed a 90% confidence interval for the 5-day option price. The revised prediction accounts for uncertainty, so the analyst can determine the risk of the prediction.

Quantitative analysts derive confidence intervals from PDFs [1]. For example, suppose that the next-day price of a certain stock has a distribution, G(μ,σ,z), defined by equation (8). To develop a p % confidence interval for the next-day price, analysts calculate the value of α for which [1]

where G(μ,σ,z) is defined by equation (8); p is the desired confidence level, in %; and α is the confidence interval.

(25)

Equation (25) indicates that the confidence interval for the next-day stock price is the width required to encompass p % of the total area under the PDF. As before, quantitative analysts use Table 1 to approximate the integral in equation (25) and calculate α. Mathematically, this equates [1] to finding the value for α such that

(26)

where Φ(z) is defined by equation (8); and p, α, and σ are defined as in equation (25).

Quantitative analysts use equation (26) and Table 1 to directly determine the confidence interval for any next-day stock price with PDF G(μ,σ,z). Suppose we wish to predict the next- day price of a stock described by PDF G(4,1,z). Although $4.00 is the average next-day price, we cannot guarantee this price. Instead, we must calculate confidence intervals. Using equation (26) and Table 1, we determine that the 90% confidence interval is $3.29 and the 20% confidence interval is $0.50. Thus, we are 90% sure the next-day price will fall between $2.36 and $5.64 (the interval of width $3.29 centered at $4.00.) On the other hand, we are

only 20% sure the next-day price will fall between $4.26 and $4.76. 1 Figures 8 and 9 show the graphical interpretation of these confidence intervals as the widths required to reach the desired percentages of the total area under G(4,1,z). From Figure 8, we must accept a wide confidence interval to guarantee 90% prediction accuracy. Figure 9, though, shows that narrowing the confidence interval reduces our prediction accuracy. Thus, confidence level and confidence interval are inversely proportional [1]. In practice, quantitative analysts must decide whether they value confidence level or confidence interval when evaluating stocks.

level or confidence interval when evaluating stocks. Figure 8: Graphical interpretation of a 90% confidence

Figure 8: Graphical interpretation of a 90% confidence interval of a hypothetical stock. The confidence interval is $3.29.

Quantitative analysts also use equation (26) to calculate confidence intervals for other market parameters with PDFs [9]. Thus, confidence intervals allow quantitative analysts to attach probabilities to many financial predictions. In terms of the three stages of risk management, confidence intervals are a risk measurement technique. To formulate investment strategies, quantitative analysts compile numerous confidence intervals and decide which investments yield the best combinations of growth potential and growth confidence. For example, an analyst may select a stock whose share price has a 90% potential for $20 growth over a stock whose share price has a 30% potential for $100 growth.

Risk metrics are another important topic in risk management. As with confidence intervals, risk metrics describe the probabilities of financial predictions [9]. Just as we use the meter to

1 For a general stock with PDF G(μ,σ,z), the next-day price interval is [μ – α/2, μ + α/2].

measure length, quantitative analysts use risk metrics to measure the growth, stability, and reliability of financial assets [9]. By definition, risk metrics are a risk measurement technique. Quantitative analysts use many risk metrics, but VaR analysis, volatility, and the Greeks are most common.

VaR analysis, volatility, and the Greeks are most common. Figure 9: Graphical interpretation of a 20%

Figure 9: Graphical interpretation of a 20% confidence interval for a hypothetical stock. The confidence interval is $0.50.

VaR Analysis

Quantitative analysts use VaR analysis to quantify the risk associated with assets [9]. VaR has many variations, but one-day VaR is representative. One-day VaR quantifies the risk of loss for a particular stock over a one day trading period [9]. For example, consider a stock whose next-day price is given by PDF f(x). Then, the c % one-day VaR, V, of the stock satisfies [9]

(27)

where c is the desired confidence, in %; p 0 is the current stock price; and f(x) is the PDF of the next-day stock price.

Equation (27) indicates that the one-day VaR is the maximum price drop a stock will experience in one day with c % probability. In practice, quantitative analysts use numerical integration to evaluate equation (27) and approximate V [10]. The one-day VaR of a stock is an upper bound on the price drop that it will likely experience. Thus, quantitative analysts use VaR to quantify a stock’s inherent risk of loss.

Figure 10 shows a hypothetical stock with a one-day 86% VaR of $7.42. In words, the stock in Figure 10 has an 86% chance of not losing more than $7.42 over the next day. Graphically, we can also use Figure 10 to visualize the relationship between c and V. As c increases, the blue shaded area decreases and V increases. Intuitively, this suggests a tradeoff between confidence and VaR: lower VaR results in lower confidence. In addition, we can graphically interpret the shape of f(x). In areas where f(x) is concentrated, c has little effect on V. In other words, if the next-day price of a stock is likely to fall in a certain interval, its VaR is largely independent of confidence level. For such stocks, the maximum price drop is predictable, and the resulting risk is low.

VaR = $7.42 Area = 14% p 0
VaR = $7.42
Area = 14%
p 0

Figure 10: Graphical depiction of a hypothetical stock with a one-day 86% VaR of $7.42. The current stock price, p 0 , is assumed to be $27.42. The next-day stock price is described by the PDF in black.

One-day VaR is useful in stock pricing. Quantitative analysts use one-day VaR calculations for a group of stocks to calculate the risk of loss for an entire portfolio [9]. Furthermore, analysts can track trends in one-day VaR to record risk over time. In either case, one-day VaR analysis helps quantitative analysts measure inherent risk in stocks. More generally, quantitative analysts consider VaR periods longer than one day. In these cases, analysts call the time period a time horizon. Analysts often use two-week and one-year time horizons as additional risk metrics for a stock [9]. Fortunately, equation (27) is still applicable to VaR analysis at other time horizons. Quantitative analysts simply replace the next-day PDF with a PDF for the stock price at the desired time horizon. As a result, equation (27) is the key to VaR analysis.

Volatility

Volatility is another important risk metric in finance. Conceptually, volatility quantifies consistency over time [15]. For stocks, high volatility indicates large price deviation, while low volatility indicates small price deviation. Thus, the volatility of a stock describes its inherent unpredictability. This intuitive view of volatility suggests that volatility and risk are related. Indeed, quantitative analysts use volatility to measure the risk of stocks [5]. In practice, quantitative analysts use two types of volatility: statistical volatility and implied volatility. Statistical volatility is based on past stock prices, while implied volatility depends on market growth predictions [15].

Quantitative analysts define statistical volatility as the logarithm standard deviation of a stock price [15]. That is, for a stock, S, we have

(28)

where σ is the statistical volatility of S; μ is the mean price of S over the sample period; S k is the k th price sample of S; and N is the number of samples.

After obtaining N price samples of S, quantitative analysts directly apply equation (28) to calculate σ. The appearance of σ in equation (28) is not a coincidence. Statistical volatility is a standard deviation, so it represents the same σ that appears in equations (1)-(2), (5)-(6), (8) and (25)-(26) [15]. Thus, statistical volatility is necessary for options pricing and confidence interval calculation. With equation (28) at hand, quantitative analysts can measure the statistical volatility of any stock using past market data. Then, because volatility is proportional to uncertainty, analysts can draw conclusions about the risk of a stock.

Unlike statistical volatility, implied volatility does not require stock price data. Instead, quantitative analysts calculate implied volatility by working in reverse. For example, in options pricing, analysts typically apply equations (3)-(6) to calculate expected call/put prices

of options. Equations (3)-(6), however, require prior knowledge of volatility. To work in reverse, quantitative analysts start with a series of past call/put prices. Then, they use these values to back-solve for the associated volatility value. Analysts call volatilities calculated in this manner implied volatilities because they derive from predicted market trends [15]. Implied volatility is important because analysts can use it to replace statistical volatility [5]. Thus, both types of volatility are essential to options pricing and risk management calculations.

Statistical and implied volatility each have advantages and disadvantages [9]. In practice, analysts must decide which version will more accurately predict market risk. Statistical volatility requires actual price data, so it is closely related to recent market trends. However, the data may be outdated and fail to accurately reflect current market trends [9]. Implied volatility is based on current market trends, so it will not become outdated. Unfortunately, research suggests that supply and demand factors can bias implied volatility [9]. Thus, implied volatility can be inaccurate in large-scale options trading. Quantitative analysts must consider the trade-off between these weaknesses when deciding which type of volatility is appropriate. In general, though, analysts prefer implied volatility because it more accurately reflects current market trends [9].

The Greeks

The Greeks are another common risk metric in finance. The Greeks are a set of parameters that measure the health and performance of stocks and options [15]. Quantitative analysts use the Greeks to predict the future performance of stocks and options. As such, the Greeks help analysts determine the risk of potential trading strategies. Because the Greeks are based on current market data, they predict, not guarantee, future performance [15]. Quantitative analysts use five Greeks: delta, gamma, rho, theta, and vega. 2 Each parameter quantifies different market characteristics. Conceptually, each Greek measures the sensitivity of an asset to a specific external factor. Thus, analysts call the Greeks factor sensitivities [9]. Quantitative analysts consider the implications of all five parameters when gauging the risk of stocks and options.

Delta

Price deviation in underlying stocks is the major risk factor in options trading [9]. Therefore, quantitative analysts developed two Greek parameters to quantify the sensitivity of an option to such deviation. First, delta quantifies the linear sensitivity of an option to its underlying stock [15]. Analysts interpret linear sensitivity as the slope of the tangent line of a graph. For delta, the relevant graph plots option price versus underlying stock price. Thus, a large delta value means an option is highly sensitive to change in underlying stock price, while a small delta value means an option price is largely independent of underlying stock price. Formally

[9],

2 By convention, analysts do not use Greek letters when referring to the Greeks. Also, analysts consider vega a Greek despite the fact that it is not a Greek letter [9].

where p is the option price;

s is the underlying stock price;

and

is the partial differential operator.

(29)

Equation (29) indicates that delta is the partial derivative of option price with respect to underlying stock price. Because the derivative measures slope, equation (29) confirms analysts’ interpretation of delta as the slope of the tangent line. In practice, quantitative analysts rarely have explicit functions for p and s. Instead, analysts approximate [9]

where

is a small change in underlying stock price; is the corresponding change in option price.

and

(30)

Analysts call equation (30) the delta approximation [9]. Equation (30) indicates that delta is the ratio between a small change in stock price and the resulting change in option price. Unlike equation (29), equation (30) is easy to evaluate: we need only compute the difference between pairs of option and stock price samples.

Delta quantifies the relationship between an option and its underlying stock. Quantitative analysts use delta values to predict the growth of options based on underlying stock prices [15]. Large delta values warn analysts that an option is unstable and risky, while small delta values predict that an option price is unlikely to change. In either case, delta helps analysts quantify the sensitivity of an option to its underlying stock.

Gamma

The relationship between an option and its underlying stock is important enough to warrant a second Greek. Gamma measures the quadratic sensitivity of an option to its underlying stock [15]. Formally [9],

where p is the option price;

s is the underlying stock price;

and

is the partial differential operator.

(31)

Equation (31) indicates that gamma is the second partial derivative of option price with respect to underlying stock price. While linear sensitivity describes the slope of a tangent line, quadratic sensitivity describes best fit parabolas [9]. Intuitively, a positive gamma value

means an option is trending upwards, while a negative gamma value means an option is trending downwards. As with equation (29), analysts rarely apply equation (31) directly. Instead, analysts developed the delta-gamma approximation [9]

(32)

where

is a small change in underlying stock price;

and

is the corresponding change in option price.

Analysts use equation (32) in two ways. First, they use

gamma. Second, they use

provides analysts with an improved picture of an option’s performance [9]. Equation (32)

extends equation (30) by accounting for second order gamma effects. Thus, the resulting prediction is valid over a wider range of stock prices.

, and delta values to calculate

. In the latter, gamma

, , gamma, and delta values to calculate

Gamma gives analysts an improved measure of the relationship between options and underlying stocks. Delta accounts only for first order trends in an option price. Gamma, however, considers second order effects, which provides a more accurate description of an option price [9]. Analysts consider delta and gamma values when determining the sensitivity of an option.

Theta

Although the relationship between an option and its underlying stock is the most important sensitivity factor, analysts consider other relationships. Theta quantifies the linear sensitivity of an option over time [15]. Like delta and rho, analysts define theta with a partial derivative. In practice, however, analysts use the approximation [9]

where

is a small change in time; is the corresponding change in option price.

and

(33)
(33)

From equation (33), positive theta predicts price increase, while negative theta predicts price decrease. Moreover, a large theta predicts rapid price change, while a small theta predicts little price change. Assuming all other Greeks remain constant, analysts can use theta to predict an option’s future price [9]. Theta values that vary widely over time indicate uncertainty; thus, quantitative analysts use theta to quantify an option’s inherent risk over time.

Vega

Vega quantifies the linear sensitivity of an option to its implied volatility [15]. Like the other Greeks, analysts define vega with a partial derivative. In practice, however, analysts use the approximation [9]

where

is a small change in implied volatility; is the corresponding change in option price.

and

(34)
(34)

Equation (34) indicates that vega behaves similar to delta, rho, and theta. In this case, however, an option with positive vega will increase in price when its implied volatility increases, while an option with negative vega will decrease in price when its implied volatility increases. Research suggests that short term options profit from decreasing implied volatility, while long term options profit from increasing implied volatility [9]. Thus, quantitative analysts use vega to predict the success of short and long term options.

Rho

Rho quantifies the linear sensitivity of an option to interest rate [15]. Like delta, analysts define rho with a partial derivative. In practice, however, analysts use the approximation [9]

where

is a small change in interest rate; is the corresponding change in option price.

and

(35)

Equation (35) indicates that a large rho corresponds to high interest rate sensitivity. In other words, analysts expect options with large rho to have large price changes in response to interest rate deviation. As such, analysts use rho to quantify the risk of options based on current interest rate trends. Research suggests that options are comparatively less sensitive to interest rate than other market factors [9], so rho is a lesser Greek.

Each Greek quantifies the sensitivity of an option to an underlying variable [9]. Together, the Greeks give analysts an understanding of how an option will respond to market trends. Large Greeks indicate extreme sensitivity and imply high risk. Small Greeks indicate resilience and imply low risk. In practice, current market conditions determine the relative importance of each Greek [15]. Regardless, the Greeks are valuable risk metrics in finance.

Black-Scholes Greeks

Not surprisingly, Black and Scholes developed explicit formulas for the Greeks of their options pricing formulas. For a call, the Greeks [9] are

(36) (37) (38) (39) (40) where G(μ,σ,z) is defined by equation (8); and all other
(36)
(37)
(38)
(39)
(40)
where G(μ,σ,z) is defined by equation (8);
and all other parameters are defined as in equations (3)-(6).
For a put, the Greeks [9] are
(41)
(42)
(43)
(44)
(45)

where G(μ,σ,z) is defined by equation (8); and all other parameters are defined as in equations (3)-(6).

Equations (36)-(45) give analysts an understanding of the market sensitivities of European options [9]. Black and Scholes derived equations (36)-(45) from the partial derivative definitions of the Greeks. When analysts use numerical techniques to price options, they cannot find explicit formulas for the Greeks. Black-Scholes theory, however, offers explicit pricing formulas, so equations (36)-(45) exist. Because Black-Scholes theory is widely used in options pricing, equations (36)-(45) are an important tool in options risk management.

CONCLUSIONS

As technology continues to pervade finance, KS&T should take advantage of innovations in quantitative technology to remain competitive. Geometric Brownian motion is a convenient and simple tool for stock modeling. We can use the Brownian model to simulate stocks by estimating only two market parameters. Thus, Brownian motion is an intuitive method for stock simulation.

The Black-Scholes equations provide explicit formulas for call/put prices of European options. Furthermore, we can use the Monte Carlo methods that I presented to extend Black- Scholes theory to general options pricing. Monte Carlo methods use random sampling to replace equations with discrete data. Whenever necessary, however, we can apply regression techniques to regain equations from data.

Linear least squares regression identifies linear data trends, so it is useful in predicting stock behavior. Non-linear least squares regression generates more precise curves. Thus, we can use it to quantify subtle data trends.

Quantitative analysts focus on the mathematical approach to risk. Confidence intervals quantify the probability of market outcomes. We can easily calculate confidence intervals for any quantity with a PDF. In doing so, we can attach probabilities to our market predictions and quantify their inherent risk.

VaR is a standard measure of a stock’s loss potential. We can use the equations that I presented to compile VaR data for potential stocks and quantify their loss potentials over any desired time period. Thus, we can limit the risk of loss in our trading strategies.

Volatility appears in many important equations in options pricing and risk management. We can use past market data to calculate statistical volatility, or we can use market predictions to calculate implied volatility. Implied volatility is generally more accurate because it relies on current data. Therefore, we can substitute implied volatility values into our models to improve results.

The Greeks are a set of parameters that measure stock sensitivities. Together, they provide an overall picture of a stock’s health. We can use the five Greeks that I discussed to quantify sensitivity to specific market variables. Equations (36)-(45) allow explicit calculation of the Greeks for options priced with Black-Scholes theory. Thus, we can also use the Greeks to quantify the market sensitivities of our options.

Options pricing and risk management are valuable and important subjects in finance. This review offers complete coverage of each of these subjects, including necessary equations and figures demonstrating practical use. Quantitative techniques identify market trends that even experienced analysts cannot. Quantitative techniques are also highly efficient and take full advantage of available market data. For these reasons, I recommend that KS&T immediately implement the quantitative techniques in this review.

Furthermore, I recommend that we use MATLAB to implement these techniques. MATLAB is a widely popular numerical computing tool. It is ideal for quantitative finance because it easily handles large data sets and has an intuitive user interface. I used MATLAB to generate all nine graphs in this review. MATLAB can process data and generate figures, so we can use it to conduct complete financial analyses. MATLAB also has a comparatively smaller learning curve than similar numerical tools, so it is an efficient choice.

MATLAB contains built-in functions for most common numerical techniques. For example, many techniques in this review require uniform and normal random variables. MATLAB has built-in functions for both. MATLAB also includes a Brownian motion function, which will make simulating stocks with equation (2) easy. In addition, it has many efficient numerical integration functions, so we can easily calculate VaR and confidence intervals. Finally, we can generate fully customizable graphs in MATLAB with just a few lines of code. MATLAB is a comprehensive tool for implementing quantitative techniques.

By implementing the quantitative methods in this review, we can efficiently and accurately solve large-scale problems in finance. Thus, quantitative analysis will provide KS&T the necessary tools to remain on the cutting edge of quantitative finance.

REFERENCES

[1] A. J. Hayter, Probability and Statistics for Engineers and Scientists. Canada: Thomson Brooks/Cole, 2007.

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