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Edition L1.

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Rahul Bhattacharya









CFE School, Risk Latte Company Limited, Hong Kong
2011



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Dedicated to my father, Chandranath Bhattacharya






























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What Industry Practitioners have to say about this book?


Rahul Bhattacharya has composed an indispensable collection of notes on Quantitative
Finance with an astonishingly broad coverage. The book familiarizes the reader with a
wide array of models used in the industry with tips on implementation in Excel. Excel
is an excellent pedagogical tool and the material in the book invites the reader to
implement the models. The book also contains an extensive coverage of structures traded
across asset classes and even the most seasoned professional will find something new in it.
This is more than a study aid; this is an excellent reference that should be kept within reach
on any derivatives desk.

Boris Mangal
FX Options Trader
RBC Capital Markets, Tokyo


The Book of Greeks is an amazingly useful compendium. Rahul Bhattacharya has produced
an easy-reference compilation of the main results in quantitative finance, with just enough
write-ups to be able to apply them in practice, and spanning the entire field from basic
stochastic processes to equity, credit, and rates, as well as exotic payoffs and numerical
methods. It distils the key results from an entire library of books, periodicals, and academic
papers into a single short volume that will save practitioners a lot of time and effort.

James de Castro
Former Head of Trading, Asia-Pacific (ex-Japan)
Merrill Lynch, Hong Kong
















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Foreward

The Book of Greeks is an excellent compendium of formulae, models and quantitative
techniques that should be in the repertoire of any derivatives trader, hedge fund manager,
derivatives structurer, academic or student of financial engineering.
Often when we work on trading desks or while structuring derivatives, we wish that we had
a book that had the answers and solutions to the myriad financial products that we have to
price or trade. Well, "The Book of Greeks" is the answer to our prayers. A wonderful, well
compiled book, it offers both the practitioner as well as the academic a one stop source of
mathematical techniques used in the world of financial engineering.
I have enjoyed going through this book and am delighted to be able to recommend it to
anyone who has an interest in quantitative finance and financial engineering.

Rajat Bhatia
CEO, Neural Capital
Former SVP, Citibank Global Asset Management, London
& former VP, Lehman Brothers International, London.


















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First Few Words

This book is a collection of lecture notes that Ive used for my CFE classes over the past 2
years. These notes are intended to help the reader navigate through various formulas,
equations and algorithms that are used in the four modules of our Certificate in Financial
Engineering (CFE) course. Also, these notes will help all those students taking our CFE
Exam to better understand the landscape of the entire subject. However, by no means do
these notes present a comprehensive or an exhaustive list of formulas and equations that are
used in the study of financial engineering and quantitative finance. At best, it is a miniscule
portion of the entire discipline. If anything, these notes aim to provide to the reader a
glimpse of the giant canvas on which the subject of Quantitative Finance is written.

All formulas and equations that are used in these notes are meant to be implemented on an
Excel spreadsheet. In our CFE course, we implement all these formulas and equations in
Excel/VBA and then build quantitative models of financial derivatives and asset portfolio
pricing and risk analysis.

Financial Engineering or Quantitative Finance (and we shall use both these terms
interchangeably) is neither just physics nor applied mathematics, and much more than the
sum total of the two. Quantitative Finance is concerned with the application of all those
physics-like theories and advanced mathematical concepts and methodologies for the
development of mathematical models and algorithms with which financial derivatives and
financial asset portfolios can be traded, valued and their risks can be analyzed. However,
such is not possible unless all those complex and abstract formulas and equations are
transformed into simpler workable format and implemented on a platform. And that
platform has to be something that is very simple to understand and work on.

For our CFE course that platform is the Microsoft Excel spreadsheet.

These notes are exclusively meant for supplementing the knowledge and skills imparted in
the CFE course and helping students take the CFE examination. Other than that, this book
has no other objective or pretense. This book should not be seen as an alternative or
supplement to any textbook on the subject of quantitative finance, a partial list of which is
given at the end in the reference section. There are no substitutes for the great books
written by Jamil Baz, George Chacko, John Hull, Jim Gatheral, Rebonato Riccardo, Paul
Wilmott, to name only a few.



Rahul Bhattacharya



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Contents


Page

Chapter 0
The Journey: From U of Chicago to CBOE 10

0.1 Backgroud
0.2 Two Physics problems
0.3 A Very Brief History of Quant Finance
0.4 Timelines
0.5 Black-Scholes Era
0.6 Heston Era
0.7 Post-Heston Era
0.8 Volatility as a Financial Asset

Chapter M
Applied Mathematics and Numerical Methods in Finance 17

Part A: Matrices & Applications

M.1 Fun with Matrices: From Quantum Mechanics to Quant Finance
M.2 Types of Matrices
M.3 Eigenvalues and Eigenvectors
M.4 Cholesky matrix
M.5 Finding Square Root of Matrix
M.6. Applications in Quantitative Finance

Part B: Probability & Probability Distributions

M.7 Probability and Measure Theory
M.8 Is Call Option price a Probability Measure?
M.9. Expectations and Jensens Inequality
M.10 Moments of a Distribution
M.11 Gaussian distribution
M.12 Skew and Fat Tails
M.13 Change of Measure
M.14 Correlation and Covariance


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Part C: Binomial & Trinomial Trees

M.15 Cox-Ross-Rubinstein (CRR) Tree
M.16 Trinomial Tree
M.17 Trinomial Tree with CRR parameters
M.18 Other kinds of Binomial Trees

Part D: Black-Scholes Diffusion Equaiton & Greens Function

M.19 Valution of Vanilla Options
M.20 Valuation of Exotic Options

Part E: Numerical Integrals & Monte Carlo Integration

M.14 Trapezoidal and other rules for Numerical Integration
M.15 Gaussian Quadrature Methods
M.15 Monte Carlo Integration to value Non-path Dependent Options
M.16 Routine for Implementation in Excel

Part F: Differential Equations & Finite Difference Methods

M.17 Ordinary Differential Equations in Finance
M.18 Stochastic Differential Equations in Finance
M.19 Partial Differential Equations in Finance
M.20 Finite Difference Methods
M.21 Laplace Transform

Chapter S
Stochastic Processes for Asset Price Modeling 84
(Monte Carlo Simulation on Excel spreadsheet)

S.1 Stochastic Process and a Markov Process
S.2 Random Walk
S.3 Geometric Brownian motion
S.4 S.5 Reimann Zeta Function and the Brownian motion
S.6 Girsanovs Theorem
S.7 Brownian motion for the Inverse of the Asset Price
S.8 Brownian motion with default
S.9 Stochastic Process for the Relative Process of Two Assets
S.10 Arithmetic Brownian motion
S.11 Mean Reverting Brownian motion
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S.12 Brownian Bridge Process
S.13 Cox-Ross Square Root Process
S.14 Ornstein-Uhlenbeck Process
S.15 Vasicek Process
S.16 Cox-Ingersoll-Ross Process
S.17 Black Derman Toy (BDT) Process
S.18 Black Karisinski Process
S.19 Poisson Jump Diffusion Process
S.20 Kous Double Exponential Process
S.21 Heston Stochastic Volatility Model
S.22 Double Mean Reverting Process for Variance
S.23 Constant Elasticity of Variance (CEV) Process
S.24 Stochastic Alpha Beta Rho (SABR) Model
S.25 Longstaffs Double Square Root Model
S.26 Stochastic Local Volatility (SLV) Process
S.27 SLV Bloomberg Model
S.28 GARCH Diffusion Process
S.29 Gibson & Schwarz Stochastic Convenience Yield Process
S.30 Stochastic Correlation Process
S.31 Mixture of Normals Process
S.32 Variance Gamma (VG) Process
S.33 Monte Carlo Simulation for VG Process
S.34 Displaced Diffusion Model
S.35 Libor Market Model (LMM)
S.36 Homogenous Poisson Process
S.37 Monte Carlo Simulation for Valuation of Single Asset options
S.38 Multi-asset Stochastic Process
S.39 Cholesky Decompostion
S.40 Eigenvalue decomposition
S.41 Monte Carlo Simulation of Valuation of Multi-asset options
S.42 Cleaning Correlation Matrices
S.43 Quantum Random Walk


Chapter E
Financial Products and Product Engineering (Structuring) 132

E.1 Vanilla Options
E.2 Straddles and zero beta straddles
E.3 Binary Options
E.4.Outperformance Digital options
E.5 Money back options
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E.6 Fixed and Floating Strike Lookback Options
E.7 Arithmetic Average Options
E.8 Chooser Options
E.9 Symmetric and Asymmetric Power Options
E.10 Forward Starting and Cliquet Options
E.11 Reverse Cliquet Options
E.12 Napoleon Options
E.13 Exchange Options
E.14 Amortizing Options
E.15 Pyramid and Madonna Options
E.16 Basket Options
E.17 Best of and Worst of Options
E.18 Himalaya, Altipano and Everest Options
E.19 Capped Bull Note
E.20 Principal Protected Bull Note
E.21 Principal Protected Bear Note
E.22 Principal Protected Mixed Note
E.22 Equity Linked Basket Note
E.23 Note with a Short Put option embedded
E.24 Perpetual Capped Call Note (American style) with no maturity
E.25 Decomposition of Structured Product through Payoff Diagram
E.26 Convertible Bonds and Reverse Convertible Bonds
E.27 Caplet and Snowball options
E.28 Sycurve Options


Chapter V
Volatility and Correlation 166

Part A: Implied Volatility & Volatility Surface

V.1 Numerical Estimation of Implied Volatility
V.2 Lelands Formula
V.3 Brenner-Subrahmanyam Approximations
V.4 Corrado Miller Approximation
V.5 Steven Lis Approximation
V.6 SABR Volatility
V.7 CEV Volatility
V.8 Volatility Skew
V.9 Implied Volatility Surface and Interpolating Implied Volatility
V.10 Vanna Volga Methodology
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V.11 Local Volatility
V.12 Local Volatility in presence of Default

Part A: Historical Volatility

V.13 Historical Volatility using close to close price
V.14 Parkinsons Number
V.15 Garman-Klass Estimator
V.16 EWMA Volatility
V.17 GARCH Process

Part C: Model Free Volatility and Variance Swaps

V.18 Log Contract
V.19 Britten-Jones & Neuberger Model
V.20 Variance Swap
V.21 VIX Index
V.22 Volatility Swap
V.23 Correlation and Implied Correlation
V.24 Correlation Skew
V.25 Dispersion

Chapter O
Options and Financial Derivatives Valuation 195

O.1 Vanilla Options using Black-Scholes Model
O.2 Put-Call Parity and Put-Call Symmetry
O.3 Straddle Options
O.4 Option pricing using Displaced Diffusion model
O.5 Power Option
O.6 Exchange Option
O.7 Binary Option
O.8 Barrier Option
O.9 One Touch Option
O.9 Double Barrier (Binary) Option
O.10 Fixed and Floating Strike Lookback options
O.11 Arithmetic Average option
O.12 Forward Starting option
O.13 Caps and Floors
O.14 Swaption Valuation using Blacks formula
O.15 SYCURVE Options
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O.16 Bond Option pricing using Blacks formula
O.17 Options on Zero Coupon Bond using Vasiceks Model
O.18 Options on Variance

Chapter G
Greeks for Vanilla & Exotic Options 221

G.1 Call and Put Delta
G.2 Call and Put Gamma
G.3 Vega of Options
G.4 Hedging Error due to Volatility Smile
G.5 Theta and Rho of Vanilla options
G.6 Binary Call and Put Delta
G.7 Dirac Delta Function and the Binary
G.8 Binary Gamma and Vega
G.9 Variance Swap Greeks

Chapter P
Portfolio Analysis & Asset Allocation 230

P.1 Sharpe Ratio, Treynor Ration and Jensens Alpha
P.2 Portfolio Volatility
P.3 Expected Return for Stocks and Bonds
P.4 Volatility of Spreads
P.5 Probability of Stocks Outperforming Bonds
P.6 Mean-Variance Optimization for a Total Return Objective
P.7 Mean-Variance Optimization by maximizing Sharpe Ratio
P.8 Sharpes Algorithm for Efficient Frontier
P.9 Portfolio Insurance
P.10 Constant Proportion Portfolio Insurance (CPPI)
P.11 Capital Asset Pricing Model (CAPM)
P.12 Minimization of Risk and MCR Algorithm
P.13 Statistical Arbitrage
P.14 Triangular Arbitrage







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Chapter 0
The Journey
From the University of Chicago to Chicago Board Options Exchange

Background

Before we talk about Quantitative Finance, talk about its brief history and then plunge
ourselves into the thick of this discipline with formulas, equations and theory, it is
worthwhile to understand the background in which this discipline originated some 50 to 60
years ago. That background is physics. The foundations of quant finance were laid based on
theories and models of physics. The twin concepts of equilibrium and linearity which
underlie almost all of early theories and models of quant finance are both borrowed from
physics, as is most of the math and the rationale.

Two Physics problems and the Birth of Quant Finance

I. Albert Einstein and the Random Walk (Diffusion) Problem

Diffusion is one of the fundamental physical processes by which material in nature moves. It
is found in biology, chemistry, geology, engineering, and above all in physics. The process
first originated in physics in the form of Brownian motion and was studied by none other the
famous physicist Albert Einstein in 1905. Diffusion arises due to the constant thermal motion
of atoms, molecules, and particles and causes material to move from areas of high
concentration to low concentration. Therefore, the final outcome of diffusion would be a
state of constant concentration across space. Take a bottle of deodorant or perfume and spray
it heavily inside a small closed room. Eventually the smell spreads across the room and the
entire room starts to smell nice. This is an example of diffusion. Take an iron rod and heat
one end of it. Eventually, the other end becomes hot as well, because heat was transferred
from the hot end to the cold end.

Actually, Albert Einstein had solved the Black-Scholes problem long ago. While studying
Brownian motion of particles to complete his Ph.D. thesis, he realized that the random
motion of the molecules at the microscopic level is ultimately responsible for the process of
diffusion that occurs at the macroscopic level. Physicists had long studied the macroscopic
phenomenon of diffusion and established the governing partial differential equation, PDE,
(see below for more details on what is a PDE). However, it took Einsteins genius to realize
that the constant coefficient of diffusion in the governing PDE of the diffusion process is
actually the same as the volatility parameter, o , of the microscopic random process of the
molecules.

Note: Fischer Black and Myron Scholes, while formulating the option pricing problem in
early 1970s, followed more or less the same rationale and thought process as Einstein. The
math and the physics was exactly the same. Only the context was different and certain broad


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(and sweeping) assumptions were made about the economy and the investors in relating the
problem in physics to that in financial economics.

II. Richard Feynmans Path Integrals and Feynman-Kac Approach

In 1948, Richard Feynman, another eminent physicist of the twentieth century made a simple
and stunning discovery. He found out that the Schrodingers partial differential equation
(another example of a PDE) in quantum mechanics could be solved by some kind of
averaging over the paths. This led to the reformulation of the entire quantum mechanical
theory in physics in terms of what is known as path integrals. Mark Kac, a mathematician
and a colleague of Feynman at Cornell, immediately realized that the concept of averaging
of paths could be applied to the solution of heat equation with boundary conditions and
other kinds of diffusion equations in physics. In short, a diffusive partial differential equation
can be solved as an expectation, under a certain probability measure, of a function that
contains a Brownian motion. This expectation approach has come to be known as the
Feynman-Kac solution.

Note: The expectations approach, developed by latter day quants and still used extensively
by practicing quants in the banks and the academic theorists, to solve the pricing problem for
vanilla and exotic options is exactly like Feynman and Kacs approach. In fact, even quants
call it the Feynman-Kac approach. Everywhere, in finance textbooks, research papers and
other technical documents, youll see the expectation operator, E written as ( ) .
Q
E and inside
the brackets youd see an option payoff. This is nothing but Feynman-Kac approach.

A Very Brief History of Quant Finance

The history of Quantitative Finance is essentially a history of the conquest of "Volatility".
The story is about how a few exceptionally talented men across both sides of the Atlantic
grappled with the concept of volatility and ultimately tamed it. The story starts off in 1952
with volatility being a statistical measure of financial risk and ends in the present day with it
becoming a financial asset. Thats pretty much all there is to quantitative finance. Rest is just
details and an awful lot of very advanced math and computer programming.

It all started in Chicago in 1952 with Harry Markowitz and ended in Chicago sometime
around 2003 when the new VIX was introduced. In that sense we may be living in the post-
historical period.

Timeline

This timeline outlines how Volatility got transformed from being a measure of financial risk
to financial asset. If we were to take a Jurassic Park style tour of Quant Finance then wed be
taken through the following periods:

- Black-Scholes Era (1952 1987)
- Heston Era (1988 2007)
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- Post Heston (2007 Present)

The History tour of Quant Finance

Black-Scholes Era (1952 1987)

Black Scholes era began when in 1952, Harry Markowtiz, during the course of completing
his Ph.D. dissertation realized that volatility is a statistical concept and in fact, is the same as
the concept of standard deviation. And mathematically speaking, this is the proxy for
financial risk.

Constant Volatility

It was in 1973, when Fischer Black and Myron Scholes presented their seminal perhaps,
the most famous paper in all of quantitative finance on option pricing. This could be
considered a formal beginning of the discipline of quant finance.

Here are the defining characteristics and landmarks of this era

- In 1973 Black-Scholes option pricing model was introduced which modeled asset
prices as following a geometric Brownian motion a Gaussian diffusion process
with a fixed volatility parameter and option prices are determined as functions of the
underlying asset price. This fixed volatility parameter was important as this is the
same parameter that appears in the partial diffusion equation (PDE) for the option
price as the coefficient of diffusion.
- The physics of the problem was this: asset price is like the molecule following a
random walk suspended in a medium, where the molecule was the stock (asset) and
the medium was the volatility.
- The fact that volatility is constant is extremely important in a Black-Scholes world,
because it simplifies life enormously. Constant volatility implies and causes the
following:

(i) A market consisting of a stock and an interest-bearing bond is complete, in
the sense that all derivative payoffs can be replicated by a dynamic portfolio
consisting of the stock and the bond only.
(ii) Corollary to the above point is that the principle of no arbitrage leads to a
unique equivalent martingale measure that can be used to price derivatives.
(iii) The Black-Scholes PDE (with boundary conditions) can be solved exactly as a
heat equation and a neat formula for option price can be extracted (this is the
Black-Scholes option pricing formula).

- In 1977 Oldrich Vasicek presented the mean reverting random walk model for asset
price. This has now come to be known as the Vasicek model and over the years this
model has found wide applications in interest rate derivatives valuation.

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- In 1976 John Cox and Steven Ross presented their risk-neutral argument and
intuitively one of the most curious facts of the Black-Scholes model, that is, as to why
the drift term in the asset price equation of random walk drops out of the option
pricing equation and the Black-Scholes formula.
- Cox and Ross also presented the square root diffusion model of asset price which once
again opened up new ways at looking at the option pricing problem. Closely related to
the Cox-Ross model was the Cox-Ingersoll-Ross (CIR) model of asset prices, another
mean reverting, arithmetic Brownian motion model of asset price. This model also
found wide applications in interest rate modeling. More importantly, CIR model would
form the basis for the stochastic volatility model developed by Heston in the early
1990s.

Black-Scholes era came to an end with the stock market crash of 1987 when investors
realized that volatility is not constant. The notion of volatility smile (skew) a varying
implied volatility across strike prices was born and Wall Street started becoming a very
comfortable place for the quants. Strangely, as the physics was getting out of the way of
quantitative finance and making way for something far more complex (at least in terms of
comprehension and conceptualization), more and more physicists started getting hired on
Wall Street.

Heston Era (1988 2007)

In my opimion the Heston era began around the time when John Hull and Alan White
published their one factor stochastic volatility model in 1987. But this was still not a game
changer. The real paradigm shift happened when Steven Heston came up with his two factor
stochastic volatility model. This was the first break with physics like models.

Stochastic Volatility

Here are the defining characteristics and landmarks of this era

- Heston postulated that not only the asset price but volatility associated with that asset
price is stochastic. In other words, both the asset price and the volatility of that asset
price evolve randomly over time. Even though the asset price in Hestons model
follows the same geometric Brownian motion, i.e. a Gaussian diffusion process, as the
Black-Scholes model, the volatility is assumed to follow a square root diffusion
process, more popularly known as the Cox-Ingersoll-Ross (CIR) process. Thus, the
probability distribution of the asset price was Gaussian (Log-normal) but that of the
volatility was not.
- Volatility, which varies stochastically, is also mean reverting;
- And above all, the stochastic processes for the asset and the volatility are correlated.
This is where there was a paradigm shift in the world view. For, there was no parallel
of such a process in physics. Imagine, Einstein thinking about a diffusion process of a
molecule which follows a random walk in a medium which is itself vibrating in a
random manner.
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- Since volatility was not a tradable asset by which we mean, an explicitly tangible
tradable asset a random volatility would give rise to a situation where a riskless
portfolio cannot be constructed to replicate the option price; hence we would end up in
a state where markets would no longer be complete.
- And the PDE for the option got far more complex.
- Fortunately, Hestons model generated a closed form solution a formula, if you will
with which option prices could be calculated.
- And last but certainly not the least, Heston, during the course of his work on stochastic
volatility, introduced the use of Fourier transform into the quant finance domain (this
technique would be later utilized to solve various option pricing problem extensively
by many quants, most notably Peter Carr).

However, ironically, even though Heston introduced a revolutionary way of visualizing
volatility and the option pricing problem and, advertently or inadvertently, made a decisive
break with physics-like models of quant finance, much of the Heston era was dominated by
the other type of volatility models, i.e. the volatility surface and local volatility. It was only
from 2003 onwards that banks started using Hestons model extensively and quants and
traders started recognizing the utility of this model.

In fact, to be precise, both concepts of volatility surface and local volatility do not merit
the addition of the word model after them. Vol surface and Local Vol are not really
models. They are just another way of looking at stochastic volatility.

Anyway, as things stand today Hestons stochastic volatility model has become a very
important and essential tool in the repertoire of most quants and traders in the banks around
the world. This change has come about in the last 8 to 9 years.

Volatility Surface

As noted that with the demise of the Black-Scholes world view after the crash of 1987,
investors and option traders discovered the volatility smile.

- It was observed in the market that implied volatility of options varied across strike
prices for a given maturity. From 1987 onwards, it was observed that at least for
equity index options, almost always, implied volatilities increase with decreasing
strike that is, out-of-the-money puts trade at higher implied volatilities than out-
of-the-money calls. This feature is often referred to as a negative skew, where
skew is just another characterization of smile.
- It was observed that there is a term structure of volatility, i.e. implied volatility
varied across different maturities; another key observation was that long-term
implied volatilities exceed short-term implied volatilities
- From this, the notion of volatility surface was born. This was a surface a two
dimensional matrix where implied volatility was plotted against strike prices
and time to maturity. From this surface, implied volatility of any arbitrary option
can be interpolated.
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Local Volatility in a Stochastic Volatility world

In 1994, Emanuel Derman, Iraz Kani and Bruno Dupire noted that under the condition of risk
neutrality there is a unique diffusion process that is consistent with the distribution of market
prices of the European options. Derman and Kani, then at Goldman Sachs, presented this
argument using a discrete time binomial tree whereas, Dupire, working separately, presented
the continuous time version of the same argument. Their work was based on the earlier work
of Breeden and Litzenberger done in 1978.

The import of their arguments was a simple modification in the way we looked at volatility.
Rather than thinking of volatility as a constant coefficient of a diffusion process, as given by
the Black-Scholes model, they assumed that volatility was now a state dependent function
expressed as: ( ) t S
L
, o o = , where, the subscript L stood for the word local. The volatility
was now a function of S , the asset price and time, t . This shift in the way how volatility was
defined by Dupire, Derman and Kani (DDK), based on what was observed in the market as
well as that of theoretical foundations of Breeden and Litzenbergers work, presented a
complexity. How exactly can we define local volatility? This is a question that many senior
quants and traders in banks will have difficulty answering.

Jim Gatheral has presented a unique interpretation of this concept in his book Volatility and
Correlation. He doubts if the proponents of DDK local volatility model visualized this as a
model of evolution of volatility. In fact, he doesnt believe that local volatility should form
a separate class of models. Gatherals interpretation is that local volatility can be thought
of as an average of all possible instantaneous volatilities in a stochastic volatility world.
Gatheral has actually demonstrated this notion, using sophisticated mathematics, in his book.

As David de Rosa (64) points out it is important to note that even though local volatility is a
function of a stochastic variable, i.e. the asset price, in itself it is not stochastic. This
distinction is important to capture the essence of local volatility. Local volatility isnt some
measure of stochastic volatility, rather, given the existence of vanilla option prices in the
market it is a process through which quants make some simplifying assumptions to price
exotic options that are consistent with the prices of the vanilla options traded in the market.

Post Heston (2007 Present)

One can say that the post-Heston era started with the financial crisis of 2007-2008. During
the ensuing market turmoil the stochastic volatility models more or less broke down. This is a
period that witnessed big spikes in volatility in many FX options market, such as the Dollar-
Yen market, it caused serious problems for traders. What was really troubling, and perhaps
bewildering at the same time, was the observation that somehow volatility has acquired a life
of its own independent of that of the underlying asset. Is such a thing possible? Is it possible
for volatility to have the freedom to rise or fall on its own accord without any change in the
underlying asset, say, the FX rate?


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Enter a new class of models known as the Stochastic Local Volatility (SLV) models. The
most important development came with the publication of a stochastic local volatility model
by Ren, Madan, and Qian in 2007. As we shall see later on in these notes, this model
incorporated an independent stochastic component in the volatility process that would change
the dynamics of the process significantly. Grigore Tataru and Travis Fisher at Bloomberg
also developed an SLV model in 2010 for pricing barrier options. Tataru and Fisher make a
key observation in their paper, which perhaps explains the motivation for the development of
SLV models and what we have argued in the above paragraph. The authors note that prices
of barrier and path dependent options mostly depend on the dynamics of the market. Vanilla
option prices dont matter that much for their pricing. What is important is how the market
behaves and, in particular, how volatility rises and falls with the arrival of information and
passage of time. SLV models try to matching this extra market dimension to obtain good
exotic option prices.

Volatility as a Financial Asset

Right from the onset in early 1970s when option trading began on the Chicago Board,
investors bought or sold options for its value which was captured, mainly, by the volatility of
the underlying asset. Therefore, implicitly at least, investors were buying and selling
volatility via options. But this trade was an imperfect trade in volatility. Volatility in itself
was not a tradable asset. Still, traders and sophisticated investors used various option
strategies to create as perfect a trade as possible to trade only the volatility of the asset.

During the Heston era two fundamental developments happened that would transform
volatility into a nearly tangible asset. The first was the development of variance swaps (and
volatility swaps). In 1994, Anthony Neuberger introduced the Log contract. A key
mathematical ingredient in the variance swap pricing mechanism was this Log contract.
Variance swaps were developed mainly by Derman and his colleagues at Goldman Sachs,
though many others, like Jim Gatheral, contributed to the understanding and development of
the pricing of this product, and other related products such as volatility swaps. Variance
swap was first instrument in the history of quant finance which allowed investors to trade
pure volatility, as if it were an asset.

The second development was the creation of the new VIX index by the Chicago Board
Options Exchange (CBOE) in 2003. The construction of this volatility index would not have
been possible without the introduction of the variance swaps. Through this new VIX index
volatility became an exchange traded commodity and options on this VIX index have now
been developed.

From being just the standard deviation of asset returns to becoming an exchanged traded
asset is the story of volatility; which, as I said before, is pretty much the story of quantitative
finance. From the University of Chicago in 1952, when Harry Markowitz had to defend his
novel concept of risk to Milton Friedman, to the Chicago Board Options Exchange in 2003,
when the new VIX was introduced, is a very short distance. But its been a long and
fascinating journey in time.
19
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Chapter M
Applied Mathematics and
Numerical Methods in Finance

Part A
Matrices & Applications


Fun with Matrices
From Quantum Mechanics to Quantitative Finance - I

Matrices are extremely important in the study of Quantitative Finance and they are
ubiquitous. While studying quant finance we come across Volatility matrix, correlation
matrix, Variance-covariance matrix, etc. Just like quantum mechanics in physics, the study of
quantitative finance would not be possible without matrices. Matrices can be easily handled
and understood and most of the time they are fun to deal with. So what are matrices?

We all know what a matrix is. A 2 x 2 matrix is an arrangement of rows and columns, or in
other words, arrays. A typical 2 x 2 matrix looks like:


|
|
.
|

\
|
=
2 0
1 1
A

The above matrix has 2 rows and 2 columns and hence its dimension is 2 x 2. A typical 3 x 3
matrix will look like:


|
|
|
.
|

\
|

=
6 3 1
4 3 5 . 0
0 0 1
B

The above matrix has 3 rows and 3 columns and hence its dimension is 3 x 3. Matrices can
also have imaginary numbers as its components. For example, a 2 x 2 matrix can look like:


|
|
.
|

\
|
= E
0
0
i
i



In the above is a 2 x 2 matrix i is an imaginary number that appears on the second cell of the
first column and the first cell of the second column. The value of i is 1 = i . The matrix is

20
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designated as E , which is called the sigma (in capital) in Greek. The above matrix forms
part of something very important in quantum mechanics in physics and is known as one of
the Pauli matrices. The above matrices are all square matrices. Why square? That is
because the number of rows is equal to the number of columns. A 2 x 2, 3 x 3, 8 x 8 or an N
x N matrix are all examples of square matrices. In quantitative finance we only deal with
square matrices.

Of course, non-square matrices do exist and they do have applications in other fields of
study, such as Cryptography. But we shall not talk about them here.

The cool thing about matrices and from now on we only mean square matrices is that
they dont commute. What does that mean? Take the numbers 3 and 8. Multiply 3 by 8 and
youll get 24. If instead, you multiply 8 by 3 youd still get 24. It does not matter whether we
multiply 3 by 8 or 8 by 3. The result is the same 24.

24 8 3 3 8 = =

In algebra, if we measure a quantity by x and another by y then:

0 = = yx xy yx xy

If you take y time x and then subtract that quantity from x times y then result would be
zero. Any junior school student would tell you that.

However, this does not happen in the case of matrices. If a quantity is measured by say, a 2 x
2 matrix (such as a correlation matrix for a two asset portfolio or for any two random
variables), P and another quantity is measured by another 2 x 2 matrix, Q then:
0 = QP PQ .

Take any arbitrary square matrices, P and Q.

If
|
|
.
|

\
|
=
0 4
1 3
P and
|
|
.
|

\
|
=
8 0
0 1
Q then if you multiply P with Q, youd get
|
|
.
|

\
|

=
0 4
8 3
PQ .

Now, if you multiply Q with P , youd get:
|
|
.
|

\
|
=
0 32
1 3
QP . Therefore, the value of the
quantity given by PQ is different from the value of the quantity given by QP. How is this
possible? School algebra tell us that x times y is always equal to y times x . Yes, but that is
what we call commutative algebra. Matrices form, what we call, non-commutative algebra.



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It may seem trivial to many of you but this simple, non-commutative property of matrices,
i.e. the fact that 0 = QP PQ gave physicists the first glimpse into the world of Quantum
Mechanics.

Fun with Matrices
From Quantum Mechanics to Quantitative Finance - II

There is a beautiful book perhaps, one of the best in its field titled Quantum Mechanics in
Simple Matrix Form by Thomas F. Jordan. This article is inspired from that book.

Let us consider three special matrices:


|
|
.
|

\
|
=
0 1
1 0
1
o
,
|
|
.
|

\
|

=
0
0
2
i
i
o
,
|
|
.
|

\
|

=
1 0
0 1
3
o


These matrices are known as Pauli matrices in quantum mechanics and form one of the
building blocks of that discipline in physics. But why do we need to know about them? We
dont really have to know about them, except that if we combine the Pauli matrices with an
Identity matrix, I , where
|
|
.
|

\
|
=
1 0
0 1
I , then we can express any arbitrary 2 x 2 matrix using
them. In that sense, we can say that Pauli matrices are the fundamental building blocks of all
2 x 2 matrices in the universe.

Lets take an arbitrary 2 x 2 matrix, A, where A is given by:
|
|
.
|

\
|
=
22 21
12 11
a a
a a
A . Now take four
complex numbers,
0
z ,
1
z ,
2
z and
3
z . In fact, these complex numbers can be thought to be
some sort of unique complex numbers associated with every 2 x 2 matrix.

Now, given the Pauli matrices above and the Identity matrix, I we can write the matrix, A,
as:


|
|
.
|

\
|
+
+
=
|
|
.
|

\
|

|
|
.
|

\
|

+
|
|
.
|

\
|
+
|
|
.
|

\
|
+
|
|
.
|

\
|
=
|
|
.
|

\
|

+ + + =
3 0 2 1
2 1 3 0
22 21
12 11
3 2 1 0
22 21
12 11
3 3 2 2 1 1 0
1 0
0 1
0
0
0 1
1 0
1 0
0 1
z z iz z
iz z z z
a a
a a
z
i
i
z z z
a a
a a
z z z I z A o o o


Therefore, we can express the unique complex numbers as:

( ) ( ) ( ) ( )
22 11 3 12 21 2 12 21 1 22 11 0
2
1
,
2
1
,
2
1
,
2
1
a a z a a i z a a z a a z = = + = + =
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As an example, take a 2 x 2 correlation matrix, M . This could be the correlation between the
returns of two stock indices. Say, one stock index is 70% correlated with the other. Then, M
can be expressed as:



|
|
.
|

\
|
=
1 7 . 0
7 . 0 1
M

Therefore, we can now express this 2 x 2 correlation matrix in terms of the unique complex
numbers associated with it:


1
0
= z 7 . 0
1
= z , 0
2
= z , 0
3
= z

Every correlation matrix can be decomposed into its unique complex numbers derived from
Pauli matrices.

Types of Matrices and their Applications

1. Square Matrix

In a square matrix the number of rows is equal to the number of columns. It is generally
n n m n = written as matrix, where, . A matrix is a square matrix with 3 rows and 3
columns. All matrices used in financial engineering and quantitative finance are square
3 3 matrices. An example of a matrix would be:

|
|
|
.
|

\
|

=
3 2 0
8 4 1
1 0 2
P

An example of a square matrix in finance is the correlation matrix of asset returns. A
covariance matrix of asset returns is also an example of a square matrix.


2. Identity Matrix

I An Identity Matrix, denoted by, , has one on its diagonal and zeros in the off-diagonals.
3 3 It is the equivalent of number 0 in number theory. An example of a identity matrix
is:



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|
|
|
.
|

\
|
=
1 0 0
0 1 0
0 0 1
I



3. Diagonal Matrix

A diagonal matrix is one whose diagonals have non-zero values and the off-diagonals
have zeros. An identity matrix is a special case of a diagonal matrix. An example of a
3 3 diagonal matrix is:


|
|
|
.
|

\
|
=
2 0 0
0 6 0
0 0 3
D



Say, we have a three asset portfolio (1, 2, 3) with asset (return) volatilities of 15%, 10%
and 12%. Then, we can write the volatilities as a diagonal matrix:


|
|
|
.
|

\
|
=
12 . 0 0 0
0 10 . 0 0
0 0 15 . 0
V


4. Triangular Matrices

A triangular matrix is one where all elements above or below the diagonal are zeros. If all
elements above the diagonal are zero then the matrix is known as lower triangular matrix
whereas if all elements below the diagonal are zero then the matrix is known as upper
3 3 triangular. Examples of lower and upper triangular matrices are:

Lower Triangular

|
|
|
.
|

\
|

=
8 2 9
0 1 1
0 0 2
L



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Upper Triangular

|
|
|
.
|

\
|
=
4 0 0
5 3 0
6 8 1
U


5. Symmetric Matrix: Correlation & Variance-Covariance Matrices

A symmetric matrix is one where all elements above the diagonal are mirror images of
n n A the elements below the diagonal. In other words, for any symmetric matrix, , the
T
A transpose of the matrix, , is the matrix itself. The following relationship holds:

A A
T
=

A transpose operation flips the rows of any matrix into columns and columns into rows.

3 3 Consider a correlation matrix of asset returns, which is a symmetric matrix:

|
|
|
.
|

\
|
=
1 25 . 0 55 . 0
25 . 0 1 65 . 0
55 . 0 65 . 0 1
M

M All elements of below the diagonal are mirror images of the elements below the
diagonal. That is obvious in the case of asset correlation matrix. The correlation of asset 1
with that of asset 2 is the same as the correlation of the return of asset 2 with that of asset
12

21
1. If is the correlation of asset 1 with asset 2 then is the correlation of asset 2
21 12
= with asset 1 such that .

M The transpose of the asset correlation matrix, , above is given by:

M M
T
=
|
|
|
.
|

\
|
=
1 25 . 0 55 . 0
25 . 0 1 65 . 0
55 . 0 65 . 0 1



If we have three assets (1, 2, 3) in a portfolio then the symmetric, 3 3 asset correlation
matrix is given by:


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|
|
|
.
|

\
|
=
1
1
1
32 31
23 21
13 12



M


If the volatilities of the three assets (1, 2, 3) are given by
1
o ,
2
o and
3
o respectively
then the symmetric, 3 3 asset covariance matrix is given by:


|
|
|
.
|

\
|
= E
2
3 32 2 3 31 1 3
23 3 2
2
2 21 1 2
13 3 1 12 2 1
2
1
o o o o o
o o o o o
o o o o o



6. Volatility, Correlation and Variance-Covariance (VCV) Matrix of a Portfolio
(Three Asset Case)

1
o
2
o
3
o Given three assets (1, 2 and 3) with volatilities of , and respectively. Then the
volatility matrix can be expressed as a diagonal matrix:

|
|
|
.
|

\
|
=
3
2
1
0 0
0 0
0 0
o
o
o
V

M Given a correlation matrix of these three assets as , where,

|
|
|
.
|

\
|
=
1
1
1
32 31
23 21
13 12



M

M
ji ij
= Where, in the matrix , we have . Then the Variance-Covariance matrix of the
three asset portfolio would be given by:

MV V
T
= E




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|
|
|
.
|

\
|
= E
|
|
|
.
|

\
|
|
|
|
.
|

\
|
|
|
|
.
|

\
|
= E
2
3 23 3 2 13 3 1
23 3 2
2
2 12 2 1
13 3 1 12 2 1
2
1
3
2
1
32 31
23 21
13 12
3
2
1
0 0
0 0
0 0
1
1
1
0 0
0 0
0 0
o o o o o
o o o o o
o o o o o
o
o
o



o
o
o




7. Transpose of a Matrix

As explained above a transpose operation flips the rows of any matrix into columns and
3 3 columns into rows. Consider the following matrix.

|
|
|
.
|

\
|
=
2 . 0 3 0
5 . 0 2 1
0 4 1
B

B The transpose of would be given by

|
|
|
.
|

\
|
=
2 . 0 5 . 0 0
3 2 4
0 1 1
T
B


In Excel, the formula for Transpose is given by =TRANSPOSE(.).

8. Determinant of a Matrix

Determinant symbolizes the area or the volume enclosed by the row vectors of any
matrix. It is a scalar quantity (a single number). Determinants exist only for square
2 2 matrices. Consider a matrix below:

|
|
.
|

\
|

=
3 1
1 2
C


C C C det The determinant of this matrix, , denoted by or is given by:


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( ) 7 ) 1 ( 1 3 2
3 1
1 2
=

= C

3 3 For a matrix the determinant is calculated as:

|
|
|
.
|

\
|

=
2 5 1
2 0 3
1 2 1
E

E The determinant of would be given by:

( ) ( ) ( )
9
15 1 8 2 10 1
5 1
0 3
) 1 (
2 1
2 3
2
2 5
2 0
1
=
+ =
+

= E


Why are determinants important?

(i) They are essential for calculating the inverse of a matrix. In fact, a determinant tells
us if a matrix can be inverted or not.
(ii) They are related to the eigenvalues and eigenvectors of a symmetric matrix
(iii) They measure the area or the volume of shape defined by the row vectors of a
matrix.

Why the Determinant of a VCV or a Correlation Matrix should be Positive?

Interpretation #1

Lets look at a simple 2 x 2 correlation matrix. The geometrical interpretation of
determinant is that in a 2 x 2 framework (2 x 2 matrix) it measures the area that is
spanned by the two column vectors of the 2 x 2 correlation matrix. If both the vectors
are aligned, which means one of the vectors is linearly dependent on the other, then the
determinant is zero. The value of the determinant becomes maximum when the angle
between the vectors is 90 degrees which is equivalent to the area under a rectangle
formed by the two vectors. If the determinant is a measure of the area then how can the
area of a surface outlined by two vectors be negative? Therefore, a negative determinant,
though possible for any arbitrary square matrix, is geometrically incomprehensible for a
symmetric, correlation or covariance matrix.


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Interpretation #2

The determinant of a VCV matrix is a measure of generalized variance, which is in
essence a measure of the spread of the observations in the data set. The determinant for
a 2 x 2 VCV measures the overall information in the matrix, i.e. the total variance of
each variable less whatever correlation (covariance) there is between the variables.
Here again, a negative generalized variance cannot be defined and therefore, if the
value of the determinant of a VCV (or correlation) matrix is negative then we are in the
realm of the nonsense. And a zero variance will only apply to constants, i.e. no spread
in the observations in the data set. Therefore, zero variance is meaningless because this
would mean all observations in the data set are same.

Determinants and Eigenvalues of a Matrix
(For more on eigenvalues and eigenvectors see Chapter S, Part B)

For a symmetric variance-covariance (VCV) or Correlation matrix, the determinant of the
A matrix is equal to the product of the eigenvalues of the matrix. If is a square,
m n n m m n = A symmetric matrix with dimension ( rows and columns, with ), is the
A .... , , ,
3 2 1
n A determinant of and are eigenvalues of then the following
relationship holds:


n
A = ......
3 2 1


Since calculation of the determinant is much easier (and faster) than the estimation of
eigenvalues of a matrix, as a rule of thumb, a quant should always check first if the
determinant of a VCV or a correlation matrix of asset returns is positive. If it is, then the
chances are good that all eigenvalues of the matrix are positive though not necessarily
so and hence there is a good chance that the matrix would be valid and not
nonsensical (i.e. the matrix would be positive semi-definite). Of course, even with a
positive determinant, a correlation matrix can be nonsensical if 2 or 4 or other even
number of eigenvalues is negative.


In Excel, the formula for the determinant of a matrix is given by =MDETERM(.).










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9. Inverse of a Matrix

A
1
A A
1
A The inverse of a matrix, , is defined as where, multiplied by is equal to the
I I AA =
1
identity matrix, . Mathematically, we can write, .The inverse of a matrix is
calculated as:

A
A adj
A =
1


If the determinant of a matrix is zero then the inverse of the matrix will not exist. We say
that the matrix is non-invertible. Such matrices are known as Singular matrices.

In Excel, the formula for the inverse of a matrix is given by =MINVERSE(.).

10. Matrix Multiplication

Two matrices can be multiplied to produce a third matrix. However, two matrices can
only be multiplied if the column of the first matrix is equal to the row of the second
matrix. The dimension of the third matrix, which is the product of the first and the second
matrix, would be the rows of the first matrix and the columns of the second matrix.

2 2 A B If we have two matrices, and given as follows

|
|
.
|

\
|
=
|
|
.
|

\
|
=
22 21
12 11
22 21
12 11
b b
b b
B
a a
a a
A

B A Then the product of the two matrices, is given by

|
|
.
|

\
|
+ +
+ +
=
|
|
.
|

\
|
|
|
.
|

\
|
= =
22 22 12 21 21 22 21 21
22 12 12 11 21 12 11 11
22 21
12 11
22 21
12 11
b a b a b a b a
b a b a b a b a
b b
b b
a a
a a
B A C


Say, we have a three asset portfolio (1, 2, 3) with asset (return) volatilities of 10%, 15%
3 3 and 12% respectively and expressed as a diagonal matrix as:


|
|
|
.
|

\
|
=
12 . 0 0 0
0 15 . 0 0
0 0 10 . 0
V

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3 3 And, if the correlation matrix of asset returns is given by:

|
|
|
.
|

\
|
=
1 25 . 0 55 . 0
25 . 0 1 65 . 0
55 . 0 65 . 0 1
M


Then, we can obtain the 3 3 covariance matrix of asset returns as:



|
|
|
.
|

\
|
=
|
|
|
.
|

\
|
|
|
|
.
|

\
|
|
|
|
.
|

\
|
= = E
0144 . 0 0045 . 0 0066 . 0
0045 . 0 0225 . 0 00975 . 0
0066 . 0 00975 . 0 0100 . 0
12 . 0 0 0
0 15 . 0 0
0 0 10 . 0
1 25 . 0 55 . 0
25 . 0 1 65 . 0
55 . 0 65 . 0 1
12 . 0 0 0
0 15 . 0 0
0 0 10 . 0
T
T
MV V


In Excel, the formula for the multiplication of a matrix is given by =MMULT(.).

11. Trading Covariance Matrix (in Dollars/Share)

Once Price volatility and the correlation between all pairs of stocks are calculated,
algorithmic traders and risk managers estimate the Trading Covariance Matrix.

Given the correlation matrix, M , for all m stocks:


|
|
|
|
|
.
|

\
|
=
1
1
1
2 1
2 21
1 12

m n
m
m
M





And, P , the diagonal matrix of current prices and O as the diagonal matrix of forecast
volatilities:


|
|
|
|
|
.
|

\
|
=
m
p
p
p
P

0 0
0 0
0 0
2
1

|
|
|
|
|
.
|

\
|
= O
m
o
o
o

0 0
0 0
0 0
2
1



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Then, the Trading Covariance matrix in Dollars per share is given by the following
matrix multiplication:


|
|
|
|
|
.
|

\
|

|
|
|
|
|
.
|

\
|

|
|
|
|
|
.
|

\
|

|
|
|
|
|
.
|

\
|

|
|
|
|
|
.
|

\
|
=
O O = E
m
T
m
m n
m
m
m m
T
p
p
p
p
p
p
P M P

0 0
0 0
0 0
0 0
0 0
0 0
1
1
1
0 0
0 0
0 0
0 0
0 0
0 0
2
1
2
1
2 1
2 21
1 12
2
1
2
1
o
o
o



o
o
o



12. Power of a Matrix

One of the problems of matrices is that they cannot be raised to non-integer powers. We
can raise a square matrix to a power of 2, 3, 4.. but we cannot raise a matrix to the
power of 0.5 (half) or 0.75. Thus we cannot find the square root of a matrix. Consider the
3 3 following matrix:


|
|
|
.
|

\
|
=
6 5 1
1 1 3
0 1 2
X



If we want to find the square of the matrix we simply multiply the matrix with itself
(same as raising the matrix to the power of 2).


|
|
|
.
|

\
|


=
|
|
|
.
|

\
|

|
|
|
.
|

\
|
= =
31 36 23
7 1 8
1 3 7
6 5 1
1 1 3
0 1 2
6 5 1
1 1 3
0 1 2
2
S S S


S 3
2
S S Similarly we can raise the matrix to the power of by multiplying with ; and so
S on for higher powers of

S However, if we want to raise the matrix, , to the power of half (0.5), i.e. if we want to
S S find the square root of the matrix , we cannot do it. Square roots of the matrix, exists
but they are very different from the notion of a square root that we have from number
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theory. In fact, a square matrix can have numerous square roots, something that we dont
3 3 see in number theory. The number, has a unique square root given by, .

13. Eigenvalues and Eigenvectors of a Matrix

Let A be an n n square matrix. There exists a number that is said to be the
eigenvalue of A if there exists a non-zero solution vector, W to the linear system of
equations:

W AW =

The solution vector, W , is said to the eigenvector of Acorresponding to the particular
eigenvalue, .

To solve for we set up the characteristic equation as follows:


( ) 0 0
0
= =
=
I A W I A
W AW



Where, I A represents the determinant of ( ) I A . This characteristic equation
yields a closed form real or complex solution for the eigenvalues, . The eigenvalues,
will be the solution of the polynomial (quadratic, cubic, etc.) equation generated by the
characteristic equation above. If A is a 2 2 matrix then there would be 2 values of , (
1
and
2
). If A is a 3 3 matrix then there would be 3 values of , (
1
,
2
and
3
)
and so on. Eigenvalues are scalar quantities and are simply real or complex numbers.

Once the eigenvalues of the matrix, A are determined then the eigenvectors, W are
determined. Except for very rare instances, closed form solutions do not exist for
eigenvectors and the eigenvectors, W , corresponding to each eigenvalue is estimated
iteratively using numerical algorithms.

If A is an n n square matrix (i.e. n rows and n columns) then there would be n
eigenvectors and W would be expressed as an n n square matrix. If A is 2 2 then
even W would be 2 2 in dimension and if Ais 3 3 then even W would be 3 3 in
dimension. The matrix A and W have the same dimensions.







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For any arbitrary square matrix, A given by:


|
|
|
|
|
.
|

\
|
=
nn n n
n
n
a a a
a a a
a a a
A

2 1
2 22 21
1 12 11


We have the corresponding eigenvalues are
n
,...., ,
2 1
= A and the matrix of
eigenvectors W is given as:


|
|
|
|
|
.
|

\
|
=
nn n n
n
n
w w w
w w w
w w w
W

2 1
2 22 21
1 12 11


Here,
|
|
|
|
|
.
|

\
|
=
n
w
w
w
W
1
12
11
1

is the eigenvector corresponding to the eigenvalue


1
,
|
|
|
|
|
.
|

\
|
=
2
22
12
2
n
w
w
w
W

is
the eigenvector corresponding to the eigenvalue
2
and so on.


14. Square Root of a Matrix

K A square matrix can have many square roots. A matrix is said to be the square root of
M M M K 2 2 a matrix, , if the product equals to . For example, consider a matrix B
as given by

|
|
.
|

\
|
=
37 21
28 16
B

This matrix has many square roots. One of the square roots of this matrix is a matrix given
|
|
.
|

\
|
=
5 3
4 2
R B R R = by because, .





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15. Methods of Finding the Square Root of a Matrix
(Please see the Eigenvalues and Eigenvectors of a Matrix to understand this part fully)

th N There are many methods for finding the square root or the root of a square matrix.
One of the most common and robust ways of finding the square root of a matrix is via the
diagonalization method using the eigenvalues and the eigenvectors of the matrix.

X j k W If is a square matrix of dimension given by and is the matrix of the
X j k A eigenvectors of with the same dimension of and is a diagonal matrix of the
X X eigenvalues of then can be decomposed as:

1
A = W W X

th N X Then, the root of the matrix is given by:

1
1


A = W W X
N


A

th N Where, is a diagonal matrix with the diagonal elements being the root of the
k
......., , ,
2 1
3 3 individual eigenvalues, . For a matrix we get the following.

3 3 X
|
|
|
.
|

\
|
=
33 32 31
23 22 21
13 12 11
x x x
x x x
x x x
X If we have a matrix, , given by:

W A And if the matrix of eigenvectors, , and the diagonal matrix of the eigenvalues, , are
given by:

|
|
|
.
|

\
|
=
33 32 31
23 22 21
13 12 11
w w w
w w w
w w w
W
|
|
|
.
|

\
|
= A
3
2
1
0 0
0 0
0 0

and









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16. Cholesky Matrix
(See Part B, Chapter S for more on Cholesky matrix)

Cholesky is a lower triangular matrix that is obtained using the following
M n n A transformation. If is a correlation or a variance-covariance matrix and is
the Cholesky matrix of same dimension then the Cholesky matrix is obtained by:

M AA
T
=

The Cholesky is an important matrix in quantitative finance. A correlation matrix (or a
variance-covariance matrix) of asset returns is valid, i.e. workable and usable, if and
only if the Cholesky of that matrix exists. This is related to the condition of positive
semi-definiteness. A correlation matrix is positive semi-definite if all its eigenvalues
are positive and the Cholesky of that matrix exists. If the Cholesky of a correlation
matrix does not exist then the correlation matrix is commonly known as nonsensical.

17. Solution of a System of Linear Equations using Matrices

Matrices can be used to solve a system of linear equations. Consider the following
system of three linear equations:

2 2
1
0 3
= +
= + +
= +
z y x
z y x
z y x


Using matrices, we can write the above as:

|
|
|
.
|

\
|
=
|
|
|
.
|

\
|
|
|
|
.
|

\
|

2
1
0
2 1 1
1 1 1
1 1 3
z
y
x


B AX = The above can be written as: where,

|
|
|
.
|

\
|
=
|
|
|
.
|

\
|
=
|
|
|
.
|

\
|

=
2
1
0
2 1 1
1 1 1
1 1 3
B
z
y
x
X A



The solution can be obtained using matrix multiplication and using the concept of the
B A X B AX
1
= = inverse of a matrix:

36
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|
|
|
.
|

\
|
=
|
|
|
.
|

\
|
|
|
|
.
|

\
|

=
|
|
|
.
|

\
|
=

8 . 0
1 . 0
3 . 0
2
1
0
2 1 1
1 1 1
1 1 3
1
z
y
x
X

3 . 0 = x 1 . 0 = y 8 . 0 = z Thus, , and


Applications of Matrices in Quantitative Finance

I. Hedging an Option Portfolio

An FX options trader wants to hedge a short position of 100 contracts in an OTC FX
option position that he is running that has a Gamma of 2.12, Vega of 0.1956 and a Volga
of 1.028 such that his overall portfolio (original position plus the hedge) is gamma-vega-
volga neutral. He identifies three traded options in the market with the following greeks:


Option 1 Option 2 Option 3

Gamma 2.56 1.08 2.32

Vega 0.2259 0.3596 0.1862

Volga 0.3122 -0.0024 0.876


How many of each of these three traded options should he buy or sell to make his
portfolio gamma-vega-volga neutral?

For gamma neutrality the equation would be:

12 . 2 32 . 2 08 . 1 56 . 2
3 2 1
= + + w w w

For vega neutrality the equation would be:

1956 . 0 1862 . 0 3596 . 0 2259 . 0
3 2 1
= + + w w w

For volga neutrality the equation would be:

028 . 1 876 . 0 0024 . 0 3122 . 0
3 2 1
= + w w w


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Therefore, to solve for the weights (i.e. the number of options to buy or sell) for making
the portfolio gamma-vega-volga neutral we need to solve the system of three linear
equations given by:

12 . 2 32 . 2 08 . 1 56 . 2
3 2 1
= + + w w w

1956 . 0 1862 . 0 3596 . 0 2259 . 0
3 2 1
= + + w w w

028 . 1 876 . 0 0024 . 0 3122 . 0
3 2 1
= + w w w


The solution is given by:

|
|
|
.
|

\
|

=
|
|
|
.
|

\
|
|
|
|
.
|

\
|
028 . 1
1956 . 0
12 . 2
876 . 0 0024 . 0 3122 . 0
1862 . 0 3596 . 0 2259 . 0
32 . 2 08 . 1 56 . 2
3
2
1
w
w
w


The matrix equation is solved as: B A W B AW
1
= =
Therefore, the number of options to buy or sell is given by:


|
|
|
.
|

\
|

=
|
|
|
.
|

\
|
=
|
|
|
.
|

\
|

|
|
|
.
|

\
|

=
|
|
|
.
|

\
|
=

3257 . 1
1251 . 0
4261 . 0
028 . 1
1956 . 0
12 . 2
876 . 0 0024 . 0 3122 . 0
1862 . 0 3596 . 0 2259 . 0
32 . 2 08 . 1 56 . 2
3
2
1
1
3
2
1
w
w
w
W
w
w
w
W


Since the trader needs to hedge 100 contracts, he needs to buy (long) 42.61 contracts of
option 1, sell (short) 12.51 contracts of option 2 and sell (short) 132.5 contracts of
option 3 to make his portfolio gamma-vega-volga neutral. Of course, this will cause his
delta to change and he needs to re-hedge his delta with FX spot contracts.

II. Estimating the Parametric Value at Risk (VaR)

A Risk Manager wants to estimate the VaR of an FX portfolio of a spot FX trader. The
spot FX positions of the trader with raw USD exposures and respective annualized
volatilities are given by:

Asset Exposure (in USD) Volatility

USD/JPY $2.50 million 8%
USD/CHF $4.56 million 9%
EUR/USD $1.85 million 11%
GBP/USD $3.18 million 7%
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The asset (return) correlation matrix of the above portfolio is given by:

|
|
|
|
|
.
|

\
|
=
1 12 . 0 25 . 0 35 . 0
12 . 0 1 32 . 0 45 . 0
25 . 0 32 . 0 1 67 . 0
35 . 0 45 . 0 67 . 0 1
M

What is the Value at Risk (VaR) of this portfolio?

The VaR with a 66.67% confidence limit is given by:

ME E VaR
T
=

E M In the above formula, is the vector of net exposure, is the correlation matrix and
T
E E is transpose of the vector, . The vector of net exposure is calculated by multiplying
the raw exposures given above with the respective volatilities. For the above portfolio
E the vector of net exposure, , in USD is given by


|
|
|
|
|
.
|

\
|
=
600 , 222
500 , 203
400 , 410
000 , 200
E

The 66.66% Value at Risk of the portfolio is calculates as:

|
|
|
|
|
.
|

\
|
|
|
|
|
|
.
|

\
|
|
|
|
|
|
.
|

\
|
=
600 , 222
500 , 203
400 , 410
000 , 200
1 12 . 0 25 . 0 35 . 0
12 . 0 1 32 . 0 45 . 0
25 . 0 32 . 0 1 67 . 0
35 . 0 45 . 0 67 . 0 1
600 , 222
500 , 203
400 , 410
000 , 200
T
Z

272 , 766 = = Z VaR

Thus, the 66.66% VaR of the FX portfolio is $766,272. This signifies that there is a
66.66% chance that the trader will not lose more than $766,272 in one year provided
that the volatilities and the correlations did not change over this period and the markets
behaved normally.




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III. Portfolio Optimization: Strategic Asset Allocation Problems

Linear equations also appear in portfolio optimization problems (mean-variance
optimization) that appear in strategic asset allocation models used by fund managers to
allocate funds between various asset classes and individual securities within asset
classes.

See Chapter P for more details on this.

IV. Applications in Algorithmic Trading (Minimization of MCR)

Matrices are also used to solve complex mathematical algorithms used by algorithmic
and high frequency traders to buy and sell stocks and other assets. A particular example
is the minimization of the Marginal Contribution of Risk (MCR) to determine the
number of stocks to buy and/or sell in a trade list.

See Chapter P for more details on this.

V. Estimating the Variance-Covariance (VCV) Matrix from Market Data

Quantitative equity analysts, fund managers and risk managers in bank need to have the
variance covariance (VCV) matrix of asset returns almost on a real time basis. How do
we estimate the VCV matrix from market data of stock (asset) prices?

The best, and the easiest way, to extract the VCV matrix from the market data is to
estimate it via excess return. From a time series of stock price data we can calculate the
mean return of the stock and hence determine the excess return for a particular period,

i.e. the return of a particular period less the mean return. Lets say that we have K risky
assets (stocks or stock indices, etc.) and for each of these assets we have price data
(which we can easily obtain in real time from Bloomberg) for N periods (say, 12
months, 52 weeks or 5 years, etc.)

Then, heres the algorithm for obtaining the VCV matrix of the portfolio of K assets:

1. Estimate the return on each of these assets over N periods; ideally, all
percentage asset returns should be annualized
2. Calculate the mean return for each of the assets (stocks);
3. Estimate the excess return matrix; the matrix of excess returns, R

is given by:





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|
|
|
|
|
|
.
|

\
|




=
K NK N N
K
K
K
r r r
r r r
r r r
r r r
R

2 1
3 3 3 32 3 31
2 2 2 22 2 21
1 1 1 12 1 11



Note that the matrix of excess return, R

, will have a dimension of K N and


it will not be a square matrix as N K = . It is mostly likely that we may have
many more periods. N , over which return would be calculated than the
number of assets, K .

4. Calculate the transpose of the matrix of excess returns,
T
R

.
5. Finally, the VCV matrix is given by the following matrix multiplication:


N
R R
VCV
T

= = E

It is quite easy to implement the above algorithm in Excel and we can generate real
time VCV matrices for risk and portfolio analysis.

VI. Estimated Bonds Returns using Transition Matrices

Simon Benninga in his Financial Modelling using Excel, shows how matrices can be
used to estimate the return from coupon paying bonds over multi-periods using the
rating transition matrices. A rating transition matrix, or a probability transition matrix,
shows the probability that a bond that is in a particular rating category, like AAA, AA,
B, etc. will migrate to a new rating category in the next period. This example

Lets consider the return from a bond which pays annual coupon, K over several years
before maturing, whereby it pays off the principal as well. For simplicity, lets say that
in the universe of all the coupon paying bonds, there are only four rating categories, A,
B, C, D and F where, A, B and C show the bond ratings of solvent bonds in decreasing
order of creditworthiness and D represents the default state. The default state is where
the bond is in default for the first time and if this happens then it pays off R , which is
the recovery rate. F represents a state of permanent default, which means that the bond
was in a state of default in the previous period as well and therefore pays off zero in
this period.






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A sample transition matrix is given by:


|
|
|
|
|
|
.
|

\
|
=
1 0 0 0 0
1 0 0 0 0
0
0
0
CD CC CB CA
BD BC BB BA
AD AC AB AA
p p p p
p p p p
p p p p
Q

If the bond in consideration pays a coupon, K and if R denotes the recovery rate should
this bond default then the payoff vector (a column vector, in array notation) of the bond
at any time, t before maturity, T (where, T t < ) and at maturity, T are given by


( )
|
|
|
|
|
|
.
|

\
|
= <
0
R
K
K
K
T t L and ( )
|
|
|
|
|
|
.
|

\
|
+
+
+
= =
0
1
1
1
R
K
K
K
T t L

The state vector (a row vector) of the bond will be defined as the current rating state that
it is in. If A, B, C, D and F are arranged in the decreasing order in a row and if the bond
in consideration is in rating category C then its state vector will be given by:

( ) 0 0 1 0 0 = S

Whereas, if the bond is currently in the rating category A, then its state vector will be
given by:

( ) 0 0 0 0 1 = S

Therefore, the expected payoff of the bond is given by the following row vector:

( ) | | ( ) t L J S t L E
t
=



In the above, S

is the state vector (row) of dimension 1 5,


t
J is the transition matrix
raised to the power of t of dimension 5 5 and ( ) t L is the bond payoff vector (column)
of dimension 5 1. The dimension of ( ) | | t L E is 1 5.

The expected return of the bond can be found out by calculating the Internal Rate of
Return (IRR) using the initial investment of $1 and the expected bond payoff vector
( ) | | t L E .
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VII. Fibonacci Numbers and the Golden Ratio An Eigenvalue problem

Fibonacci Numbers and the Golden Ratio are used quite extensively by technical
analysts to predict stock and currency market moves. However, even though both the
Fibonacci numbers and the Golden Ratio are staple diet for technical analysts in
analyzing stock and currency charts, many would have trouble grasping the relationship
between these two mathematical constructs.

What is the relationship between Fibonacci numbers and the Golden Ratio? As it turns
out Golden Ratio is one of the eigenvalues of a Fibonacci matrix.

A Fibonacci sequence of numbers is given by:

0, 1, 1, 2, 3, 5, 8, 13, 21,

Where, each number, except for zero and one, is the sum of the previous two numbers.
In general they can be written as, with seed values, 0
0
= f and 1
1
= f :


2 1
+ =
k k k
f f f

Golden Ratio is the irrational number 1.6180339. It is generally denoted by the
Greek alphabet (psi) and is an extremely important ratio that is found in mathematics,
nature and the world of arts. Some mathematicians, represent it as:
2
5 1 +
= . And
interestingly, many Renaissance artists believed that the Golden Ratio was a divine
proportion.

We can write a Fibonacci sequence (of two successive Fibonacci numbers) as a 2 x 1
column vector such as:


|
|
.
|

\
|
|
|
.
|

\
|
=
|
|
.
|

\
|
+
=
|
|
.
|

\
|
+
+
+
+
+
k
k
k
k k
k
k
f
f
f
f f
f
f
1
1
1
1
2
0 1
1 1


As can be seen the above equation represents an eigenvalue problem where A is the
Fibonacci matrix.


|
|
.
|

\
|
=
0 1
1 1
A




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It can be easily shown that one of the eigenvalues,
1
, of A is equal to the Golden
Ratio, 1.6180339..

Setting up the characteristic equation as 0 = I A where, is the eigenvalue of A
we get the quadratic equation:

0 1
2
=

Solving the above, we get:
2
5 1
= where:
...... 6180339 . 1
2
5 1
1
=
+
= and ..... 6180339 . 0
2
5 1
2
=

=

Hence, one of the eigenvalues of A,
1
is equal to the irrational number 1.6180339
which is the Golden Ratio.


A whole New Branch of Study

Random Matrices
From Nuclear Physics to Quantitative Finance - I

Matrices are arrays an arrangement of rows and columns of numbers. These numbers
can be real or complex. For example, a 3 x 3 symmetric correlation matrix we have the pair
correlation between two variables. Say, if we have three financial assets, A, B and C
arranged as A, B and C on both rows and columns, and their correlation matrix, M, is given
by:


|
|
|
.
|

\
|
=
1 35 . 0 75 . 0
35 . 0 1 65 . 0
75 . 0 65 . 0 1
M

In the above matrix, all elements are real numbers and each element represents the
correlation between two variables. For example, 0.65 is the correlation between A and B
and 0.35 is the correlation between B and C. The matrix is symmetric because all elements
above the diagonal are equal to all elements below the diagonal (which is how a correlation
matrix should be).

Now say a smart but a lazy quant in a bank wants to estimate the correlation matrix of these
three financial assets. Rather than do historical analysis on the time series of the prices of
A, B and C or try to find out the correlation from the options market, he simply generates a
set of uniform random numbers between 0 and 1 (using Excel spreadsheet or some other
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random number generator) and fills up the off-diagonal elements of the matrix M with
them (of course, he is assuming that all correlations will be either zero or positive). So he
gets a correlation matrix, M, as:


|
|
|
.
|

\
|
=
1 035 . 0 459 . 0
035 . 0 1 425 . 0
459 . 0 425 . 0 1
M

In the above matrix, 0.425, 0.459 and 0.035 are the first three digits of uniform random
numbers between 0 and 1. The elements of the above matrix are all random numbers.

This is an example of a Random matrix.

Generally speaking, a random matrix is a matrix of random numbers drawn from some
probability distribution. More specifically, a random matrix is a symmetric N N matrix
where all elements are random numbers drawn from some probability distribution.

A correlation matrix or a covariance matrix can be a random symmetric matrix. A random
matrix can be generalized as:


|
|
|
|
|
.
|

\
|
=
NN N N
N
N
a a a
a a a
a a a
A

2 1
2 22 21
1 12 11



In the above N N all elements are random numbers and could be drawn from a uniform
distribution, i.e. ( ) 1 , 0 ~ U a
ij
or a Gaussian (Normal) distribution, i.e. ( ) 1 , 0 ~ N a
ij
. They
could be drawn from any other probability distribution.

If the elements of the above matrix are all random numbers drawn from a Gaussian
(Normal) distribution, ( ) 1 , 0 ~ N a
ij
, then it is a special kind of matrix known as Wigner
matrix.

Even though random matrices were discovered in the 1930s, it was nuclear physicist
Eugene Wigner in the early 1950s who made connection between them and the energy
levels of atomic nuclei and thereby unleashed a revolution in the field of applied
mathematics and physics. Wigner conjectured that the excitation energies of heavy nuclei
behave like the eigenvalues of a matrix whose elements are random numbers drawn from a
Gaussian distribution with mean zero and standard deviation of 1.


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Ever since then random matrices and Random Matrix Theory have been applied to various
disciplines including electrical engineering, quantum mechanics, sociology, econometrics
and even quantitative finance.

Random Matrices
From Nuclear Physics to Quantitative Finance - II

Consider a large N N square matrix, A, whose elements are random numbers drawn from
a certain probability distribution, say the Gaussian distribution. Then, for such a matrix, A,
what can be said about the probabilities of a few of the eigenvalues or the eigenvectors of
this matrix? This is the central problem in Random Matrix Theory (RMT) and the answer
to this question has far reaching ramifications, not only in nuclear physics but also in such
diverse areas as quantitative finance, mathematics and mechanical engineering, etc.

Lets see how we can construct a random matrix. Take, a symmetric, N N matrix A, whose
elements are all drawn from a Gaussian (Normal) distribution with mean 0 and standard deviation
of 1, i.e. all elements belong to N(0,1). Then a symmetric matrix, H, is formed as:
( )
T
A A H + =
2
1
. The matrix, H , is known as the Wigner matrix.

For, example, using Excel random number generator we generate the following random matrix,
A:


|
|
|
.
|

\
|

=
134 . 0 440 . 0 462 . 0
815 . 0 302 . 0 674 . 0
914 . 1 748 . 0 228 . 2
A



In the above matrix, ( ) 1 , 0 ~ N a
ij
. Then the symmetric Wigner matrix, H , is given by:


|
|
|
.
|

\
|

=
134 . 0 627 . 0 725 . 0
627 . 0 302 . 0 036 . 0
725 . 0 036 . 0 228 . 2
H

The diagonal elements of H are distributed as i.i.d. N(0,1) and off-diagonal elements are
distributed as i.i.d. N(0,1/2). The eigenvalues of this random matrix, H , will display very
interesting properties. As N , the spacing between the eigenvalues of the matrix like H could
very accurately approximate the spacing between the energy levels of a heavy nuclei. This was
Eugene Wigners insight in the 1950s. Wigner originally explored a real, symmetric N N
random matrix whose diagonal elements are zero and off diagonal elements were 1 with
probability of 2 1 .

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Hows all this relevant to the study of quantitative finance?

Take an example from portfolio analysis and asset allocation. When an equity analyst in a
hedge fund quantitatively analyzes a large portfolio of stocks (or any other asset) she first
and foremost estimates the correlation and/or the covariance matrix of the stock returns.
Lets say that the covariance matrix of stock returns is M and random (symmetric) matrix
of the type described above (with suitable constraints) is H . If the eigenvalues of M are
distributed in a similar fashion as the eigenvalues of H then the analyst will conclude that
the elements of M , the actual, observable covariance matrix, have considerable degree of
randomness. This means that there is a lot of noise in the stock price data that she observes
for all the stocks in her portfolio. Random matrix theory can be used to filter out noise from
a correlation or a covariance matrix in a portfolio of assets. There are many other important
applications of random matrices in quantitative finance.


Part B
Probability and Probability Distributions

Probability and Measure Theory

We consider a quantity that can take certain value, x . This quantity could be the price of
Microsoft stock or the S&P500 index or the temperature of New York City. Lets say that
this quantity given by, x , fluctuates randomly. In other words, x is a random number.
Now, for each possible value of x there exists a number, ( ) x p , between 0 and 1 which we
call the probability. In the simplest possible terms, we can think of ( ) x p as the likelihood
of occurrence of the variable x (though strictly speaking likelihood is not probability).
The number ( ) x p can be best thought of as a measure. Just like the notion of area and
volume which are more general notion of measure, a probability number, ( ) x p , is also a
measure (of events occurring); a probability measure, in fact, tells us the likelihood of
observing any conceivable event in an experiment whose outcome is uncertain. However,
probability measure, ( ) x p , must assign a value 1 to the entire probability space. In fact,
probability satisfies the mathematical definition of a measure which is concerned with
the notion of (a) a space and (b) additivity.

Think of the area of a rectangle, which is equal to length multiplied by width, can be
viewed as a product of two intervals to form a certain space and the area of the rectangle is
the measure of that space. Within this overall space, enclosed by the length and width, we
can think of many smaller rectangles enclosed and the sum of the areas of all those
rectangles will be equal to the area original space enclosed by the rectangle. Similarly,
probability is also concerned with a space, known as the probability space, which can be
thought of as a set of all events. Within that set lies the sub-sets of conceivable events
that can occur and probability measures these conceivable events in such a way that the
sum of the probabilities of all these conceivable events is equal to 1.
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The last line means that the sum of the probabilities of all possible values of x is equal to
one. Therefore, the probability measure satisfies these two properties:

(i) 0 < ( ) x p < 1
(ii) ( ) 1 =

x
x p

The mean or the expected value of x is written as x and is denoted by the Greek letter,
mu, . This mean is given by:

( )

= =
x
x xp x

The uncertainty in the value of x , i.e. how much the value of x is going to differ from the
expected value (mean), x , is usually denoted by the Greek letter o and is given by the
expression:

( )
2
x x = o

This is called the standard deviation of x . The quantity ( )
2
x x measures the
dispersion in the value of x and is known as the variance of x .

Is Call Option Price a Probability Measure?

There is a deep connection between the prices of financial derivatives and probability,
though, within the context of derivatives we usually deal with risk neutral probabilities.
The theory of probability and probability distributions forms the foundation for the study of
financial derivatives. It is well known that the price of a digital (binary) call or a put option
in a Black-Scholes framework is nothing but the discounted value of the probability of the
stock (asset) finishing in the money. It has been shown by Peter Carr and Dilip Madan that
a call or a put option price can symbolize a probability measure under a different measure.

If
T
S is the price of the asset at maturity and K is the strike price then the (undiscounted)
price of a call option is given by:


( ) ( ) ( )
}


= dS S K S K C
T
| 0 , max

In terms of the expectation operator we can write the above price as:

( ) ( ) | | 0 , max K S E K C
T
=
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Where, the above expectation is under a risk neutral probability measure, P .

Now, the value (price) of the asset today,
0
S , can be represented under a suitable
probability measure as:

| |
T
S E S =
0


Therefore, since
0
S is constant, the normalized call price can be written as:


( ) ( ) | |
| |
(

|
|
.
|

\
|
=

=
0 , 1 max

0 , max
0
T
T
T
S
K
E
S E
K S E
S
K C


Here, the modified call price is under a different probability measure E

. This is actually
known as the share measure.

The buyer of a call option can choose to get paid in shares instead of US Dollars and in that
case the claim the payoff from the call option gets valued using the share price tilted
measure. The two measures are equivalent, as in the prices of the claims call option
paid out in US Dollars can be seen as equivalent price measures where the claim is paid out
in shares.

Secondly, the function
( )
0
S
K C
has a minimum value of zero and a maximum value of 1
(one). For various values of
T
S the normalized call price will assign a value of 1 (one) to
the entire space of payoffs. Hence, the normalized call price, ( )
0
S K C is indeed a
probability measure.

Expectation and Derivatives Valuation

The concept of expectation is an important one in quantitative finance. As we have seen
above, expectation is related to the mean of the probability distribution, i.e. the first
moment. When we find the expectation of a function, we essentially estimate the
probability weighted average of that function. While valuing options we estimate the
expection of the payoff function under risk neutral probability measure.


( ) ( ) | |
( ) ( )
}


=
=
dz z N K S
z N K S E Call
T
T
P
0 , max
0 , max


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Where, z is a random normal variable and ( ) 1 , 0 ~ N z . In the above ( ) z N is the measure of
the probability that the stock will finish in the money.

It can be better understood in discrete form, where the integral gets replaced by the
summation sign.

( ) ( )

=
=
i
i T i
z N K S Call 0 , max
,


In a simple binomial model say, that the risk neutral probability of up move is 60% and the
down move is 40% and the current stock price is 100. In an up move the asset will finish at
120 and in a down move the asset will finist at 80. Then what is the value of a 100 strike
call option.

Using the above formula for the call value as an expectation we get:

( ) ( ) 12 4 . 0 0 , 100 80 max 6 . 0 0 , 100 120 max = + = Call

A key point that has to be noted is that when we are estimating the option price using an
expectations approach, we always take the expectation of the option payoff and not the
expection of the asset price. This is because the option payoff is a convex function and
Jensens inequality holds.

Jensens Inequality

Jensens Inequality states that for a convex function, such as the payoff of a call option, the
expected value of the function is greater than or equal to the function of the expected value.
In other words, if ( ) x f is a convex function in x , then

( ) | | ( ) | | x E f x f E >

Paul Wilmott in his Frequently Asked Questions in Quantitative Finance and Spiegeleer
and Schoutens in their The Handbook of Convertible Bonds have shown, how using a
Taylor series expansion on the above expression we can explain the concepts of convexity
and gamma of an option.

Jensens inequality is one of the most important theorems in quantitative finance and it is
the reason why financial derivatives have value embedded in their gammas. Concept of
convexity, Jensens inequality, randomness and volatility of an asset price are intricately
linked. In my opinion, study of financial derivatives should start with an understanding and
the explanation of convex functions and the Jensens inequality.



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More on Jensens Inequality: Explaining Convexity with Numbers

If k is a constant and x is a variable, then what is common between the functions ( )
2
x x f =
and ( ) ( ) 0 , max k x x g = ?

Most of us would immediately recognize the second function as the payoff from a call
option. But what about the first function? That doesnt seem like the payoff of a financial
derivative. Actually, both the above functions share the property of convexity. In other
words, both these functions are convex. And the function, ( )
2
x x f = is as much a payoff of
a financial derivative as the function ( ) ( ) 0 , max k x x f = . One of the chief reasons why
every financial derivative has inherent value (and which sometimes is also known as the
time value) is because all financial derivatives have a convex payoff. Convexity is also
known as gamma in option parlance. It is the same as what mathematicians call
curvature of function (or a graph).

Therefore, for financial derivatives to have value they must have a convex payoff. Every
option, vanilla or exotic, every structured product has to have a convex payoff for it to have
inherent value based on which it can be traded. Without convexity in its payoff, the
financial derivative would just become the underlying asset (equity, FX, interest rate, etc.)

How do we define a convex payoff or a convex function?

If, | , is a small parameter (constant) between 0 and 1 (i.e. 1 0 < <| ) then, for a given
interval | |
2 1
, x x , a convex function has the following property:

( ) ( ) ( ) ( ) ( )
2 1 2 1
1 1 x f x f x x f | | | | + s +

Lets take some numbers to see if the two functions above share the above property.

Lets take 75 . 0 = | and lets take the interval [100, 110]. Applying the above inequality on
the first function, ( )
2
x x f = , we get:


( ) ( ) ( )
( ) ( ) ( )
525 , 10 506 , 10
110 25 . 0 100 75 . 0 5 . 102
110 25 . 0 100 75 . 0 110 * 25 . 0 100 * 75 . 0
s
+ s
+ s +
f f f
f f f


Therefore, the left hand side is less than (or equal to) the right hand side. So, the function is
convex.




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Now, lets take the second function, ( ) ( ) 0 , max k x x g = which is in fact, the payoff
function for a call option. Lets keep the interval the same, i.e. [100, 110] and 75 . 0 = | . We
choose the constant, k (strike) to be 102. In fact, the choice of k doesnt matter at all and
we can choose any value for k . Now, applying the property of convexity to this function
we get:


( ) ( ) ( )
( ) ( ) ( )
( ) ( ) ( )
2 5 . 0
102 110 max * 25 . 0 0 , 102 100 max * 75 . 0 0 , 102 5 . 102 max
110 25 . 0 100 75 . 0 5 . 102
110 25 . 0 100 75 . 0 110 * 25 . 0 100 * 75 . 0
s
+ s
+ s
+ s +
g g g
g g g


Once again we see that the left hand side is less than (or equal to) the right hand side. This
shows that the function for the call option payoff is indeed convex.

In fact, we can take any values for | between 0 and 1 and choose any interval | |
2 1
, x x , the
above property (inequality) for convexity will always hold. We leave it as an exercise for
the readers to choose different values of | in ( ) 1 0 < <| and any arbitrary interval | |
2 1
, x x
to test whether the inequality for convexity holds for both the above functions.

Like the previous example, lets take two functions, ( ) x f and ( ) x g which are given by
( )
2
x x f = and ( ) ( ) 0 , max k x x g = respectively representing the payoff functions of
financial derivatives on the same underlying asset, say, S&P500. Here, we should note that
x is a random variable (drawn from a certain probability distribution). For example, x can
be the price of S&P500 stock index. As again, ( ) x g is the payoff of a call option, say on
SP500, with a constant strike price k . The function ( ) x f would also give the payoff of a
financial financial derivative which is given by the square of x , or in this case, the square
of the final price of S&P500 stock index. Both functions are convex.

In the above context, we should write the Jensens inequality as:

( ) | | ( ) | |
T T
x E f x f E >

The subscript T denotes the final price of the variable (SP500); for example, T could be
equal to one year if the maturity of the derivative is one year.

I will now take a very simple and highly stylized example, using numbers, to prove the
Jensens inequality. Say, S&P500 is currently trading at 100 (normalized value). Now, to
keep things extremely simple lets say that SP500 index can only take 6 (final) values at the
end of one year. The final price of S&P500,
T
x can be any one of these values: 100, 110,
120, 130, 140 and 150.


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The first financial derivative, given by the function, ( )
T
x f , is the square of the final SP500
index values. The expected value of the function is given by:


( ) | |
917 , 15
6
500 , 22 600 , 19 900 , 16 400 , 14 100 , 12 000 , 10
6
2
6 ,
2
5 ,
2
4 ,
2
3 ,
2
2 ,
2
1 ,
=
+ + + + +
=
+ + + + +
=
T T T T T T
T
x x x x x x
x f E


The function of the expected value is given by:


( ) | |
625 , 15
6
2
5 , 4 , 3 , 2 , 1 ,
=
|
|
.
|

\
| + + + +
=
T T T T T
T
x x x x x
x E f


Therefore, from the above we see that ( ) | | ( ) | |
T T
x E f x f E > .

Now consider the second function, ( )
T
x g , which is a one year call option on SP500 index.
Say, the strike price, the constant, k in the function is the same as before, i.e. 102. The
expected value of this function is given by:


( ) | |
( ) ( ) ( )
( ) ( ) ( )
33 . 23
6
0 , 102 150 max .. .......... 0 , 102 110 max 0 , 102 100 max
6
0 , max .... .......... 0 , max 0 , max
6 , 2 , 1 ,
=
+ + +
=
+ + +
=
k x k x k x
x f E
T T T
T


The function of the expected value would be given by:


( ) | |
23
0 , 102
6
150 .......... 110 100
max
0 ,
6
........
max
6 , 2 , 1 ,
=
|
|
.
|

\
|

(

+ + +
=
|
|
.
|

\
|

+ + +
= k
x x x
x E f
T T T
T







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Therefore, once again we see that ( ) | | ( ) | |
T T
x E f x f E > . Hence we observe that given
these values of
T
x (all of which are assumed to be random) both the functions, ( ) x f and
( ) x g satisfy the Jensens inequality.

One can take any values and a large enough set of numerical values for
T
x the Jensens
inequality for both the above functions will hold. We would urge our readers to experiment
with any random set (no matter how large is the set) of numerical values for
T
x to test the
Jensens inequality.

Since, the expected value of the function, ( ) x g , is always greater than the function of the
expected value, a call option on SP500 (or a call option on any other asset that is modeled
as a random walk) will have an inherent, fundamental value at inception (time, t = 0). And
that fundamental value is given by the (discounted) expected value of the function ( )
T
x g .
In our simple and stylized example above we assumed only six possible values for the
variable (SP500)
T
x . In reality, there will a large infinite number of values for
T
x all
drawn from a certain probability distribution (because
T
x is random). Thus, in real life, the
fair value of a call option on SP500 stock index at inception (t = 0) would be given by:

( ) | |
T
Q rT
x f E e Call

=

Where, Qis the probability measure under which the expectation, | | - E (or, in laymans
terms, the averaging) is being carried out. In fact, as Wilmott shows

( ) | | ( ) | | terms order higher x E f x f E
T T
+ =


The higher order terms capture the gamma (convexity) of the option and the variance of
the randomness. All financial derivatives, whether they are given by functions, ( )
T
x f ,
( )
T
x g or any other convex functions (of a random variable) share the above property.
Convexity terms (higher order terms) are added to the expected value (mean) of the
function to give the financial derivative a fundamental fair value at inception (t = 0).

Probability Distribution and the Gaussian

If there is a random variable X which can take all possible values, each of which has a
certain probability of occurrence, such that the sum of all probabilities is 1, then a
probability distribution of X will show how the total value of 1 is distributed over all
possible values. An example of a probability distribution is the famous Normal, or the
Gaussian, probability distribution.



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If z is a normally distributed random variable with mean 0 and standard deviation of 1, the
probability density function (pdf) is given by:

( )
2
2
1
2
1
z
e x f

=
t


The probability associated with this random variable is denoted by ( ) z dP , which will represent the
probability that the random variable z will fall within a small interval of length dz centred around
z . Mathematically, this probability can be written as


( ) ( ) dy e kdz z z kdz z P z dP
kdz z
kdz z
y
}
+

= + < < =
2
2
1
2
1
t


Where, in the above expression, k is a constant that is less than 1. This gives us:


( ) dz e z dP
z
2
2
1
2
1

~
t


We call ( ) z dP a probability measure. ( ) z dP is a function in the probability space, P and it
satisfies all the measure properties (like additivity, etc.).

In more recognizable terms, we can write the following, for a random variable, c , that is drawn
from a Normal (Gaussian) probability distribution, with mean of zero and variance of one:

| | ( ) x N e dx x x prob
x
' = = + s s

2
2
1
2
1
t
c
| | ( ) y N dx e y prob
y
x
= = s
}

2
2
1
2
1
t
c
| | ( ) ( ) y N y N dx e y prob
y
x
= = = >
}

1
2
1
2
2
1
t
c

In Excel the function, ( ) N , is estimated by the formula =NORMSDIST(.)

Radon-Nikodym Derivative: Changing a Probability measure

Now, given the above explanation for a probability measure, ( ) z dP , how can we change this
probability measure?

Lets define a function, ( ) z | , where ( ) 0 > z | , which is given by


( )
( ) 8 4
=
z
e z |
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What happens if we multiply our probability measure, ( ) z dP with this new function, ( ) z | ? We
would get the following result:



( ) ( )
( )
dz e
dz e e z z dP
z z
z
z
|
.
|

\
|
+

=
=
8 4
2
1
8 4
2
1
2
2
2
1
2
1
t
t
|


If we denote, the product of ( ) z dP and ( ) z | as ( ) z dQ , then, using simple algebra on the right
hand side of the above equation, we can write the expression for ( ) z dQ as:


( )
( )
dz e z dQ
z
2
4
2
1
2
1

=
t


It is obvious from the above that ( ) z dQ is a new probability measure. In fact, given the
above expression we can see that ( ) z dQ is the probability associated with a random
variable with a mean of 4 and a standard deviation of 1.


Therefore, by multiplying the original probability measure ( ) z dP by the function ( ) z | we
have transformed the original Normal distribution from N(0,1) to N(4,1). The mean of the
distribution has been shifted.

The function ( ) z | can be alternatively expressed as:

( )
( )
( ) z dP
z dQ
z = |

We can, therefore, think of ( ) z | as mathematical derivative of Qwith respect to P . These
kinds of mathematical derivatives are called Radon-Nikodym derivatives. ( ) z | is a Radon-
Nikodym derivative.


Moments of a Probability Distribution

(i) Mean: The first moment of a probability distribution is known as the Mean or the
expected value. It is usually denoted by . If
i
x is a random variable drawn from a
probability distribution and the sample size is N then its mean is given by:

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=
=
N
i
i
x
N
1
1


(ii) Variance: The second moment of a probability distribution is known as the Variance.
If
i
x is a random variable drawn from a probability distribution and the sample size is
N then its Variance is given by:

( )

=
N
i
i
x
N
1
2 2
1
1
o

The standard deviation, which also measures the historical volatility of assets and is one
of the common measures of financial risk, is given by the square root of the variance:

( )

=
N
i
i
x
N
1
2
1
1
o

In Excel the standard deviation of a time series is calculated by the formula
=STDEV(.)


(iii) Skew: The third moment of a probability distribution is known as the skewness, or
sometimes just skew. If
i
x is a random variable drawn from a probability distribution
and the sample size is N and the first and the second moments are and
2
o then its
Skew is given by:

( )( )

=
|
.
|

\
|

=
N
i
i
x
N N
N
Skewness
1
2
2 1 o


Skew measures the symmetry in the distribution. A Normal (Gaussian) distribution is
supposed to be symmetrical around the mean and hence should ideally display zero
skew. However, in practice that is never the case. In the financial markets, just as in
life, probability distributions are greatly skewed either to the left or the right of the
mean.

The Odd Moment: More on Skewness of Probability Distributions

The notion of skewness, or simply the skew, the measure of the third central moment of
a probability distribution, is fundamental to financial markets and understanding the
behaviour of agents who operate in it. If the distribution is negatively skewed then the
trader will experience frequent small gains and infrequent large losses and the
distribution will exhibit a long tail on the left hand side (relative to the mean) of the
distribution. This happens when you are long options or follow a bleed strategy. A

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trader or a hedge fund manager continuously but steadily buys options, usually out of
the money options, thereby paying a small premium or in other words, bleeding cash.

His book will show frequent small losses. However, once in a while, mostly due to rare
events or one single Black Swan event, there would big gains when the out of the
money options will be in the money. This strategy of trading, which exhibits negative
skew, is known as a bleed strategy. A prime (but an extreme) example is that of
Quantum Fund, the hedge fund run and managed by George Soros and his trader
Stanley Druckenmiller. In September, 1992, these two traders bought large quantities of
out of the money put options in Pound Sterling against the Deutsche Mark. The strike
price of these put options were outside the Government bank (as specified by the then
existing Exchange Rate Mechanism, or the ERM in Europe). During the entire month
they kept on buying these options steadily thereby paying premium. This showed a
steady loss on their books. Since the strike price was outside the ERM government
band most traders working in the banks in London and New York, who sold these
options to Soros and Drukenmiller, thought that their own chances of their making
money was 99% since even 1% chance of Pound Sterling breaking the ERM band
against the Deutsche Mark (thereby making the GBP put options in the money) was
quite remote. However, we all now know that the unthinkable happened. GBP broke
the ERM and Soros and Druckenmiller allegedly made a billion dollars on the trade.

A positive skew on the other hand will create a long tail on the right hand side (relative
to the mean) of the distribution. This is the case with short options strategy. When
traders steadily sell out of the money options to customers they realize immediate
profits. Their estimate is that 99% of the time the options will expire worthless and
hence they stand to make profits on 99% of the short option trades. However, they are
subject to infrequent loss, and sometimes a huge loss due to Black Swan and other rare
events which can wipe out their entire profits and more. The hedge fund LTCM is a
case in point. Another example of a negatively skewed bet is that of banks and
financial institutions that lend money to customers, both corporates and retail. In fact,
banks lend money to countries as well who are considered sovereign clients with very
low default risk. The lending can be in the form of loans or they can buy bonds. The
banks lend money over and above the risk free rate (and their own borrowing costs)
thereby making a nice spread and steadily earning profits. However, there is a default
risk of the customer and when the customer defaults your entire earnings are wiped out.
The banks think that the client is a triple A rated client with very low default risk and
hence makes the loan or gives line of credit (or guarantees). The chance of the customer
defaulting is 1% and 99% of the time the banks make good money. However, when that
1% happens due to some rare event the customer suddenly goes from triple A to
bankruptcy due to severe cash flow problems or due to worsening financial markets
the banks lose all their gains (on the coupon spread) and has to even write off the
principal. When a bank makes a loan to a customer with a credit risk, it is essentially
shorting a spread option (a loan can be thought of as a portfolio of short spread option
and a credit default swap, CDS). As an example, look whats happening in Greece now.

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9 out of 10 people in the financial markets live the life on the positively skewed side
of the probability distribution. They think that this is desirable and safe, unless of
course, an LTCM, a Lehman Brothers collapse or Greece happens. Then they look with

envy to that one guy on the other side of the mean who has lived life on the negatively
skewed side of the distribution all along.

(iv) Kurtosis Kurtosis is the fourth moment of a probability distribution. If
i
x is a random :
variable drawn from a probability distribution with the sample size N and the first and
the second moments are and
2
o then the kurtosis is given by the following
expression:


( )
( )( )( )
( )
( )( ) 3 2
1 3
3 2 1
1
2
4
1


|
.
|

\
|

+
=

=
N N
N x
N N N
N N
Kurtosis
N
i
i
o



This fourth moment measures the peakedness of the distribution and the heaviness of
the tails of the distribution. In the financial markets and option trading parlance it is
related to the notion of fat tails. Heavy tails occur when the distribution exhibits
positive kurtosis. In this case, most of the observations lie towards the extreme end of
the probability distributions and there are only a few observations near the mean. The
distribution therefore has distinct, sharp peak but it falls off very fast around the mean
and make the tails heavy. Negative kurtosis is the opposite of this where most of the
observations are clustered around the mean. Here, the mean is flatter.

Fat Tails in the Markets

One of the vexing issues in the derivatives market is the phenomenon of volatility of
volatility or vvol. Every traders volatility estimate has volatility and he knows that
this is what gives rise to fat tails and the gamma of the gamma, the fourth moment
of a probability distribution. Many seasoned traders will tell you that fat tails the
probability of rare events, like stock markets falling by 10% in a day, happening far
more frequently than what is predicted by the Normal probability distribution dont

have to be necessarily caused by blown out variances. A fat tail can occur even when an
asset has a low volatility but a very high volatility of volatility.

Option traders believe that fat tails are caused due to a variable volatility. In a Black-
Scholes world, where volatility is constant, there would be no fat tails. However, the
fact that volatility is variable (and stochastically so) gives rise to volatility of volatility.
High volatility causes a market to move towards the tail of a probability distribution.
According to many traders one of the main reasons for the higher price of in the money
and out of the money options than the Black-Scholes value is because of the existence
of volatility of volatility which causes the tails of the distribution to become fat.

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Correlation and Covariance

If x and y are two random variables drawn from a probability distribution and
i
x and
i
y are two historical time series of these two random variables then the correlation
between them is given by:

( )( )
( ) ( )
(

= =
=
N
i
N
i
y i x i
N
i
y i x i
y x
y x
y x
1 1
2 2
1
,


Here,
y x,
is known as the correlation coefficient. Within the context of asset prices
this is called the historical or realized correlation.
Correlation coefficient measures the association between the movements of two
random variables, such as the return on securities. If the return on security A moves in
the same direction as the return on seucurity B then
AB
will be positive. The value of
the correlation coefficient lies between +1 and -1. A +1 correlation coefficient signifies
a perfect positive correlation between two random variables whereas a -1 correlation
coefficient signifies a perfect negative correlation between the two random variables.
In Excel the correlation coefficient between two time series is calculated by the
formula =CORREL(.).
Drawbacks of the Correlation measure:

(i) It only measures the linear relationships between variables. For example, if x and
y vary quadratically, via, say an equation like
2
x y = , then even though there is a
perfect co-movement between the two variables the correlation coefficient will fail
to capture that relationship.
(ii) It only measures the direction and the degree of association between the
movements of two random variables but does not take into account the magnitude
of variation in the movements. For that reason Covariance is a better estimate of
co-movement.

Covariance between two random variables, x and y is the product of correlation
coefficient and the standard deviations of variable x and y

( ) ( ) ( ) ( ) y Dev Std x Dev Std y x n Correlatio y x Cov = , ,
Or, we can write the covariance of x and y as
xy
o , using the familiar notations for
correlation and standard deviations as:

y x x xy
o o o =

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Harry Markowitz Introduces Covariance

It is interesting to note that Harry Markowitz introduced the statistical concept of
Covariance in the early 1950s while working on the portfolio selection problem and
the Mean-Variance optimization technique.

Markowitz was the first to think of the statistical concept of variance of a financial
assets returns as the measure of a financial securitys risk, or financial risk. If the
return of the asset prices follows a Gaussian (Normal) distribution then the variance of
these returns, or the standard deviation (volatility) which is the square of the variance,
measured over a historical time period is the measure of that assets risk. However, if
there are two assets, each of whose returns follow a Gaussian distribution, then how do
we measure the portfolio risk? The problem is compounded because besides the two
variances (or standard deviations), one for each asset, there is also the correlation
coefficient which measures the co-movement between them. However, the correlation
coefficient is an imperfect measure of co-movement as it only captures the direction of
co-movement, but not the quantum of variation. Markowtizs insight was that if we are
to simply take the average of the variances of the two assets then we would not be able
to capture the co-movement between them, as the correlation would be left out. By itself
correlation is not sufficient to capture both the direction (co-movement) and the
quantum of movement of each asset. Therefore, the best way to capture portfolio risk
would be to multiply the correlation with the product of each assets variance. This was
the only way in which portfolio risk of two assets can reduce to the risk of a single asset
if one of them were to disappear. The covariance of a financial asset with itself will
simply become the variance of that asset because the correlation coefficient of an asset
with itself is +1.

y x = then ( )
2
1 ,
x x x xy
y x Cov o o o o = = = If, then

Real (Actual) versus Risk Neutral Probability

Real probability measure is the actual probability that cash flows will be large or small
where estimation is done using historical data and other fundamental insights about the
company. It is generally represented as P

In derivatives pricing however, we are concerned not with real or actual probabilities but
with risk neutral probabilities. In an arbitrage free, frictionless market there exists a risk
neutral probability measure which makes the price of any derivative today equal to the
expected value of the payoff, discounted by a risk free rate. In a complete market this
risk neutral probability measure is unique which renders the option price unique. Risk
neutral probability is generally represented as Q



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Other Probability distributions

Binomial distribution
Binomial distribution is used in the construction and analysis of a binomial tree to value
options and financial derivatives. A binomial distribution is a discrete probability
distribution (unlike the Normal distribution, which is a continuous distribution) where
the stochastic (random) variable can take on only two values. Within the context of a
binomial tree (see below more details on binomial tree models of option valuation) these
two values can be denoted as up-value and down-value representing the stock going
up or down respectively. The random variable,
t
S (stock or the asset price) is called a
Bernoulli variable and has two states of existence in the next period.
If the probability of the up state is given by p and that of the down state is given by
) 1 ( p q = then the probability mass function of this distribution is given by:
( ) ( )
( )
( )
( )
( ) m n m m n m
m
n
p p
m n m
n
p p C m P

= = 1
! !
!
1
Where, ( ) m P , denote the probability of the stock (asset) price going up mtimes out of
n trials. The events in a binomial distribution are independent of each other. The above
formula is very useful in creating a binomial tree for the asset price movement and
option valuation using VBA code in Excel.
Poisson distribution
A Poisson distribution is a discrete probability distribution and it gives the probability
that a certain number, m, of a particular event say, the default on a bond are going to
happen when the average occurrence, , of such an event in a given time interval is
already known. The probability of exactly mevents occurring is given by:
( )
! m
e
m P
m


=
The events in a Poisson distribution are independent of each other. Poisson distribution
is quite helpful in modeling extreme events where the frequency of occurrence of the
events is less. This distribution is used in many stochastic models of asset prices which
have jumps in their paths and is associated with Poisson process and the Cox process
(see below).


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Part C
Binomial & Trinomial Trees

In a binomial tree there are two states into which an asset price can move from the
current price level. One is the up state and the other is the down state. There is a
probability of up move and a probability of down move, such that the sum of the
probabilities is equal to one (within a risk neutral pricing framework, the probabilities
are risk neutral probabilities). A binomial tree follows a binomial probability
distribution and in the limiting case, just as the binomial distribution approaches a
Normal (Gaussian) distribution, a binomial tree (model) of the option price approaches
the Black-Scholes option price.

The simplest binomial tree is a Cox-Ross-Rubenstein (CRR) trees which is used to value
equity and FX options. A CRR tree is a recombining tree, meaning that after every
alternative node the up state and the down state converge to the same value as the
starting value of the asset. Not all binomial trees are re-combining trees and many trees
used in interest rate modeling are non re-combining. It is mathematically very
challenging to handle non re-combining trees.

In a trinomial tree there are three states, the up state, the down state and the same
state. The same state is the one where in the next period the asset price remains the
same as it is today. In a trinomial tree there are three corresponding probabilities, one for
each state, and all probabilities sum up to one.

1. Cox-Ross-Rubenstein (CRR) Tree

The quantum of up and down moves is given by:

u
e d move down
e u move up
t
t
1
= = =
= =
A
A
o
o


The drift and the probabilities are given by:

up down
up
t r
p p
d u
d a
p
e a
=

=
=
A
1







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Implementing a CRR Tree in Excel








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2. Jarrow- Rudd (JR) Tree

The quantum of up and down moves is given by:

|
.
|

\
|
=
|
.
|

\
|
+ =
A A
A A
1 1
1 1
2
2
t t r
t t r
e e d
e e u
o
o


The most popular choice for the quantum of up and down moves for a JR tree is:

( )
( )
2
2
1
o |
o |
o |
=
=
=
A A
A + A
r
e d
e u
t t
t t


The probabilities are given by:

2
1
= =
d u
p p

3. Trinomial Tree

Trinomial Tree with CRR Parameters

If a trinomial tree can be constructed with CRR parameters, such that there are three
states: an up move, a down move and a move where the asset (stock) price remains the
same, then the quantum of respective moves will be given by:


t
e u
A
=
2 o

t
e d
A
=
2 o


and the respective risk neutral probabilities will be given by:


( )
2
2 2
2 2
1
|
|
|
.
|

\
|

=
A

A
A
A
t t
t
t q r
up
e e
e e
p
o o
o



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( )
2
2 2
2
1
2
|
|
|
.
|

\
|

=
A

A
A
A
t t
t q r
t
down
e e
e e
p
o o
o



down up same
p p p =1

For more on the above tree see, Espen Gaarder Haugs Derivatives Models on Models.

Another common model of trinomial tree is constructed where the quantum of up move,
down move and the move for remaining at the same level is given by:

( )
( )
t
t t
t t
e m same Stay
e d down
e u up
A
A A
A + A
= =
= =
= =
|
o |
o |
3
3


The respective risk neutral probabilities of the moves are given by:

3
2
6
1
=
= =
m
d u
p
p p




4. Tians Equal Probability Tree

Given the following:


( )
( ) ( ) t q r
t
e L
e B
L L
J
A
A
=
=
+
=
2
4
3
o


The quantum of up and down moves and that of staying the same is given by:






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( )
2
3
2 2
2 2
B L
m
m L L d
m L L u

=
=
+ =

The probabilities are given by:
3
1
= = =
m d u
p p p


5. Kamrad and Ritchken Tree

This tree is used by many quants to value convertible bonds. There is a stretching
parameter which makes the tree recombining. This tree also posits a horizontal jump
which is given by 1 = m

The quantum of up move, down move and staying the same is given by:


( )
( )
1 =
=
=
A
A
m
e d
e u
t
t
o
o


The probabilities are given by:


2
2
2
2
2
1
1
2
2
1
2
1
2
2
1
2
1

o
o

o
o

=
A
|
.
|

\
|

=
A |
.
|

\
|

+ =
m
d
u
p
t q r
p
t q r
p


The value of has to be bigger than one and is taken by many practitioners to be equal
to 2 3 which makes the probability of a horizontal jump equal to 3 1 .




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Part D
Black-Scholes Diffusion Equation
& Greens Function for Valuation of Exotics

Note: This section is due to joint work with Danny Yap, CFE student, Singapore, who
covered this topic in his class presentation which was supervised and guided by me.
Also, this content appeared on Risk Lattes website.

If you believe the stock price process is GBM,

( ) ( ) ( ) dz t t S dt t S t dS o + =

Then Itos formula and a hedging argument, leads to the Black-Scholes partial
differential equation (PDE) for ( ) ( ) t S t X , :

( ) ( ) rX
s
X
t S
s
X
t rS
t
X
=
c
c
+
c
c
+
c
c
2
2
2 2
2
1
o

To get the diffusion equation, make the change of variables,


( ) ( )
( )
( )
( )
( )
( ) ( )
|
.
|

\
|
+

= =

K
t S r
t T
r
z t T
r
e t S t X U
t T r
ln , , ,
2
2
2
2
2
2
2
2 ) (
2
2
2
2
2
2
o
o
o
o
o
o
t

Then the BSE becomes the Diffusion Equation (DE) for ( ) z U , t ,

2
2
z
U U
c
c
=
c
c
t


In 1905, Einstein showed us that the DE arises from the Brownian motion of
microscopic particles. Thus, both the BSE and the DE are based on the same underlying
process. Solutions of the DE with known initial condition ( ) z U , 0 take the form,

( ) ( ) ( ) ( )
( )
t
tt
t t t
4
'
2
4
1
' , , , ' ' , 0 ' , , ,
z z
e z z G dz z U z z G z U


= =
}



( ) ' , , z z G t or Greens Function is called the Fundamental Solution of the DE.




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Option Prices

For a call option, the boundary condition at T t = is,

( ) ( ) ( )( ) ( )

>
<
= =
0 1
0 0
, ,
y
y
y h K S K S h T S T X

where ) ( y h is the Heaviside Step Function. Making the transformation of variables, the
boundary condition on the DE at T t = becomes,

( )
( )
|
|
.
|

\
|

|
|
.
|

\
|

|
|
.
|

\
|

=

1 , 0
2
2
2
2
2
2
o
t o
o
r
Exp K
r
z
h z U
z


We can put ( ) z U , 0 back into the integral, to get Black-Scholes Formula after some
integration


( ) ( )
( )
T d d
T
T q r
K
S
d d N Ke d N e S X
rT qT
o
o
o
=
+ + |
.
|

\
|
= =

1 2
2
0
1 2 1 0
,
ln
,
2


Alternatively, we can solve for ( ) z U , t numerically and then transform back to get X

Initial Conditions for Other Options

( )
( )
( )
( ) K
r
z
h z U Put Binary
K
r
z
h z U Call Binary
r
Exp K
r
z
h z U Put Vanilla
z
|
|
.
|

\
|

=
|
|
.
|

\
|

=
|
|
.
|

\
|
|
|
.
|

\
|

|
|
.
|

\
|

=

2
2
2
2
2
2
2
2
2
2
, 0
, 0
1 , 0
o
o
o
t o
o









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Part E
Numerical Integration Techniques
& Monte Carlo Integration Routine

1. General Numerical Integration routine




2. Rectangle Rule for Numerical Integration



3. Trapezoidal Rule for Numerical Integration

The trapezoidal rule breaks up the area under the curve traced by the function into
trapezoids and evaluates the area of all those trapezoids and sums them up.
Say, we have to integrate a function, ( ) x f , between the limits, a and b :

( )
}
=
=
=
b x
a x
dx x f I

If we divide the curve traced by the function on an xy plane, where x axis is the
abscissa and y axis represents the function, ( ) x f , into small trapezoids then the area
of each trapezoid enclosed between,
i
x and
1 i
x would be given by:


| | ( ) ( ) ( ) | |
( ) ( ) | |
1
1 1 1
2
2
1
,


+
A
=
+ = =
i i
i i i i i i i
x f x f
x
x f x f x x A x x Trapezoid of Area


The integral would then be the entire area contained in the curve, which represents
the sum of the areas of all the small trapezoids.






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( ) ( ) ( ) | |
( ) ( ) | |

=

=

=
+
A
=
+ =
=
= =
b
a i
i i
b
a i
i i i i
b
a i
i
x f x f
x
x f x f x x
A
Trapezoids All of Areas of Sum I Integral
1
1 1
2
2
1


A useful closed form approximation of the integral using the trapezoidal rule is given
by:

( )
( )
( ) ( )
(

+ |
.
|

\
| +
+

=
}
b f
b a
f a f
a b
dx x f
b
a
2
4
6


Implementing Numerical Integrals using trapezoidal rule in Excel







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4. Closed form solution of the Integral of Gaussian Density Function

( )
( )

(
(

= =
}
2 1 2
2 1
2
1
2
1
2
2
1
z erf
dz e z
z t
t t
|


For the Call option valuation in a Monte Carlo Integration routine using an Excel
spreadsheet (or VBA) the limits of integration in the above definite integral would be
from 0 to 6.

6. Gaussian Quadrature Methods

In general, Gaussian Quadrature (GQ) techniques involve evaluation of the area, A,
under the curve traced by the function, ( ) x f , at a set of x values, known as nodes,
using a set of weights,
i
w as given below:

( ) ( )

}
=

= =
N
i
i i
x f w dx x f I
1
1
1


In the GQ methods, the nodes and the weights are determined from certain kinds of
polynomials. One of them is the Legendre polynomials and GQ method using
Legendre polynomials is one of the most common ways of numerically evaluating
integrals.

GQ select the optimal x-values (also known as the nodes or abscissas)
n
x x x ,..., ,
2 1
on
an xy plane along with the function is being integrated. At each of these x-values the

function is evaluated along with a set of weights,
n
w w w ..., , ,
2 1
. The GQ method is
then simply a summation over these abscissas and weights. The function, ( ) x f in the
interval [a, b] is given by:


( ) ( )

}
=
~
n
i
i i
b
a
x f w dx x f
1


In fact, a more accurate expression of all GQ methods is:

( ) ( ) ( ) x P x f w dx x f
n
n
i
i i
b
a
+ =

}
=1



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One of the GQ methods is the Gauss-Legendre quadrature (GLQ) method. GLQ
methods are based on the Legendre polynomials of the first kind. GLQ.

GLQ are constructed for integrals over the range [-1, 1]. However, we can generalize
the intervals by a suitable transformation. With a function, ( ) x f and weighting
coefficients
i
w , GLQ is a summation given by:


( ) ( )

}
=

~
n
i
i i
x f w dx x f
1
1
1


If we want to have a more general limit of integration, say, [a, b], then we use a
transformation:


( ) a b
b a x
z


=
2


With the above transformation the integral becomes:

( )
( ) ( )
dz
a b z a b
f
a b
dx x f I
b
a
} }

|
.
|

\
| + +
= =
1
1
2 2


Using a set of weights,
i
w the above expression in discrete form becomes

( )
( ) ( )
|
.
|

\
| + +

= =

}
=
2 2
1
a b z a b
f w
a b
dx x f I
N
i
i
b
a


In the GLQ method the values of the abscissas,
i
x , and the weights,
i
w , are
determined using Legendre polynomials. The Legendre polynomials, ( ) x P
N
, are a set
of polynomials of degree N and the roots of ( ) x P
N
are distinct in the interval (-1, 1)
and symmetric with respect to the origina. Legendre polynomials for N up to 100 are
already published and freely available. In the GLQ method, increasing N increases
the accuracy of the evaluation process.

When 2 = N (not at all desirable as the accuracy will be quite low) the integral can
be approximated, with a degree of precision 3, as:

( )
|
|
.
|

\
|
+
|
|
.
|

\
|

=
}

3
3
3
3
1
1
f f dx x f


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5. Monte Carlo Integration Routine for Non-path Dependent Options

Monte Carlo integration technique follows the same numerical integral techniques as
mentioned above, with the only difference that the probability distribution has to be
incorporated into the integral. This is because at maturity the call value is an
expectation given by:

( ) | | 0 , max K S E e Call
T
Q rT
=



Where, the above expectation is taken using the risk neutral probability. Following
the expectations approach we know that the above expectation is given by the
following definite integral:

( ) ( )
}

= dz z N K S e Call
T
rT
0 , max
Where, z is a random variable that is drawn from a Normal (Gaussian) distribution
with zero mean and unit standard deviation and ( ) z N is the cumulative probability
distribution function. The above expression is certainly not an ordinary (Newtonian)
integral as we have the stochastic (random) term, z , in it and the integration is over
z . However, if we let z vary deterministically over a certain range then the above
integral can reduce to an ordinary integral.

The same holds for the put option. The value of the put option is given by:

( ) ( )
}

= dz z N S K e Put
T
rT
0 , max

Monte Carlo Integration Routine for Valuation of a Call

If z is a random variable that is drawn from a Normal (Gaussian) distribution with
zero mean and unit standard deviation and if ( ) z N is the cumulative probability
distribution function then the value of a Call is given by:

( ) ( )
}

= dz z N K S e Call
T
rT
0 , max

If
0
S is the asset price at time, 0 = t , then with the familiar constant parameters for
risk free rate, r , dividend yield, q and volatility, o , the asset price at time, T ,
denoted by,
T
S , can be expressed as a stochastic equation for geometric Brownian
motion give by:


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|
|
.
|

\
|
+ |
.
|

\
|

=
z T T q r
T
e S S
o o
2
2
1
0


Therefore, we can write the definite integral for the call option as


( ) ( )
( )
}
}


|
|
.
|

\
|
+ |
.
|

\
|

|
|
.
|

\
|
=
=
dz z N K e S e
dz z N K S e Call
z T T q r
rT
T
rT
0 , max
0 , max
2
2
1
0
o o


Approximating the integral, which is the area under the curve traced by the function,
( ) ( ) 0 , max K S S f
T T
= by summation we can write,

( )

=
|
|
.
|

\
|
+ |
.
|

\
|

|
|
.
|

\
|
=
i
i
z T T q r
rt
z N K e S e Call
i
0 , max
2
2
1
0
o o


The cumulative probability distribution function, ( )
i
z N , can be estimated as the area
under the curve traced by the function ( ) ( ) 0 , max K S S f
T T
= , where,
T
S is given by
the equation above, .

Therefore, the above call valuation summation can be further broken down into:

=
|
|
.
|

\
|
+ |
.
|

\
|

(
(

|
|
.
|

\
|
=
i
i
z T T q r
rt
A K e S e Call
i
0 , max
2 2
2
1
2
1
0
o o


Where,
i
A , is the area under the curve or the sum of areas of all trapezoids contained in the
curve.

Implementation on Excel

Heres the algorithm for implementation on an Excel spreadsheet

(i) Generate the random numbers, z , in a deterministic manner; in most
routines simply generate a sequence of numbers from -5 to +5 with equal
spacing of 0.1. The limits of -5 to +5 is a proxy for the theoretical limits of
to + . Therefore, there would be 101 points on the x axis (or 101
points / cells in a column in Excel). This is the x -axis or the absissca;

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(ii) Estimate the cumulative probability distribution function, ( ) z N for each of
these 101 points, using the Excel function =NORMSDIST( z , 0, 1, 0).
(iii) Now, these ( )
i
z N , generated in step (ii) above, become the x values on the
xy plane and where, we have sliced the entire curve traced by the function,
( ) ( ) 0 , max K S S f
T T
= , into 101 trapezoids. We estimate the area of each
of these trapezoids using the trapezoidal rule for area (shown above);
(iv) Generate the (deterministic) asset price paths for all the 101 points using the
equation
|
|
.
|

\
|
+ |
.
|

\
|

=
z T T q r
T
e S S
o o
2
2
1
0
where, we input, the z values
from step (i)
(v) Then using the value of
T
S generated for each of the 101 points, estimate the
function, ( ) ( ) 0 , max K S S f
T T
= and multiply it with ( )
i
z N generated in
step (iii) above.


Numerical Integration (Monte Carlo Integration) in Excel








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Part F
Differential Equations
&
Finite Difference Methods

A differential equations is an equation, describing the change and rate of change of
variables, that contains terms like
dx
d
,
x c
c
,
2
2
x c
c
,
y xc c
c
2
, etc. which are terms used in the
study of calculus. However, there are two kinds Calculus, in mathematics:

- Newtonian calculus
- Stochastic calculus

Newtonian calculus describes the dynamics of variables that change deterministically,
whereas, Stochastic calculus describes the dynamics of variables that change randomly
(via random numbers). Ordinary differential equations (ODE) and partial differential
equations (PDE) fall in the realm of Newtonian calculus whereas stochastic differential
equations inhabit the world of stochastic calculus.

In Finance, we come across three kinds of differential equations.

- Ordinary differential equations (ODE)
- Partial differential equations (PDE)
- Stochastic differential equations (SDE)

Ordinary Differential Equations in Finance

An ordinary differential equation (ODE) describes the dynamics of a variable that varies
with another variable in a deterministic manner. For example, if there is a variable, y ,
the change of whose value, or the rate of change of whose value, is governed by the


change in the value of another variable, x , then we can describe such a relationship via
an ODE.

Savings Account

An example of ordinary differential equation is the everyday savings account in a bank
that we use. If we deposit M as the amount of money (in Dollars) in a savings account
where the interest paid on the deposit is r (which is constant), then over a period of time,
t , the amount in the account will be given by:


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( ) t r M t M =

Here, the functional form of relationship is: ( ) ( ) t f t M = , where the money deposited in
the savings account is only a function of time elapsed.

The way the money will grow in the account over a time period, t , and t t A + , where,
t A is a very small (infinitesimally small) time interval, will be given by:

( ) ( ) ( ) | | t Mr t t t r M t M t t M A = A + = A +

Writing, the expression, ( ) ( ) t M t t M A + , as ( ) t M A , where, A is the delta representing a
very small (infinitesimally small) change in the value of M , the amount of money in the
account.

Therefore, we can write the above equation for the change in the amount of money in the
savings account as:


rM
t
M
t r
M
M
=
A
A

A =
A


Taking the limit as 0 At , we write the above equation in the familiar differential
calculus form as

rM
dt
dM
=

The above is an example of an ordinary differential equation (ODE). The above ordinary
differential equation can be easily solved.

American Capped Call Option

Another example of an ordinary differential equation is the American style capped call
option. If we consider an American style call option which is capped at a certain level,
then the underlying dynamics of the call option price is described by an ordinary
differential equation as shown below. If
A
C is an American style capped call option, such
that when the cap is hit, the option expires, with no maturity, such that the functional
relationship is mathematically expressed as: ( ) ( ) S f S C
A
= . Here, the call price is only a
function of the underlying asset price, S .

The ODE for a capped American style call option is given by:

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( ) 0
2
1
2
2
2 2
= + r C
dS
C d
S
dS
dC
S q r
A
A
t
A
t
o


Important Note

Almost always, the underlying dynamics for the change of an option price, C with the
underlying asset price, S is a function of both, S and the time, t , i.e. ( ) ( ) t S f t S C , , = . In
such cases, the differential equation describing the change in the option price with both
asset price and time will be described by a partial differential equation (PDE), like the
Black-Scholes PDE, because, the option price is partially dependent on the asset price
and partially on the time. However, in some rare cases a partial differential equation can
reduce to an ordinary differential equation, like when we use the Laplace transforms to
solve derivatives problems as well as like the case above, when the option price is a
function of only one variable, i.e. the asset price.

Stochastic Differential Equation in Finance

A stochastic differential equation (SDE) is a differential equation that describes the
behavior of a dependent variable with respect to an independent variable that changes
randomly. For example, the price of a financial asset (other than cash), like a stock, a
stock index, an FX pair or an interest rate, is assumed to follow a random process
whereby it is a function of time but the evolution of the asset price over tine is random.

An example of a stochastic differential equation is the equation of the famous geometric
Brownian motion, where, the asset price,
t
S , varies in a random manner:


t
t
t
dW dt
S
dS
o + =
It is because of the second term in the above equation,
t
dW , that separates this equation
from an ordinary differential equation because
t
dW varies in a random manner that is
unpredictable. Here,
t
dW varies as: t dW
t t
o c = , where,
t
c is a random number drawn
from a standard Normal distribution.

The key characteristic that separates a stochastic differential equation from an ordinary
differential equation, is the fact that the asset price,
t
S , is not differential with respect to
time. With the risk of oversimplification, one can say that the asset price movement over
a small period of time, say, a day, is indistinguishable from the asset price movement
over a smaller period of time, say, an hour. In other words, the change of asset price with
respect to time,
dt
dS
t
, does not converge.


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Here we follow the arguments of Jamil Baz and George Chacko. Consider an arithmetic
Brownian motion for the asset price,
t
S , given by:


t dt dS
dW dt dS
t
t t
o oc
o
+ =
+ =


Taking, the discrete version of the above equation

t t S
t
A + A = A oc

Dividing the above equation by t A we get


t
t
S
t
A
+ =
A
A oc


Taking the limits as 0 At , i.e. time slice becomes infinitesimally small, we get

( ) ( )
(

A
+ A =
A
A
A
t
t Lim
t
S
t Lim
t
oc
0 0

Hence, the change of asset price with respect to the time goes to plus or minus infinity
(depending on the random variable, c ) as the time interval is made smaller and smaller.
This makes the Brownian motion unpredictable over short intervals of time. This also
shows that the asset price is not differentiable.

Partial Differential Equations (PDEs) in Finance

A partial differential equation (PDE) is an equation which has partial (mathematical)
derivatives in it. If we have a function, y which is dependent on two variables, x , which
is say, a spatial variable and t , which denotes time, such that ( ) t x f y , = then a partial
mathematical derivatives of y are given by:
x
y
c
c
and
t
y
c
c
. The first partial derivative
shows the variation of y with respect to x and the second partial derivative shows the
variation of y with respect to t . We can combine these two partial derivatives and write
an equation as:


2
2
x
y
t
y
c
c
=
c
c


The above is known as a heat equation and is an example of a PDE. This equation has
applications in the field of financial derivatives.
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In quantitative finance, a financial derivative, such as a call option on a stock, is a
function of two variables, the underlying asset, such as the stock, and the time. We can
write the call option on the stock as ( ) ( ) t S C t S f C , , = = which shows that its value
changes with the change in S and t . Therefore, the partial derivatives of a call option can
be written as:


t
C
c
c
= first partial derivative of the call option with respect to time

S
C
c
c
= first partial derivative of the call option with respect to the asset price

2
2
S
C
c
c
= second partial derivative of the call option price with respect to the asset price

All these three partial derivatives can be combined to give a partial differential equation
for the call option price:

rC
S
C
S
S
C
rS
t
C
=
c
c
+
c
c
+
c
c
2
2
2 2
2
1
o


This is the famous Black-Scholes PDE, the solution of which yields the Black-Scholes
call option pricing formula.


It has to be noted that all PDEs that we study in finance are linear in nature.

Partial differential equations (PDE) are divided into three major categories:

- Parabolic
- Elliptic
- Hyperbolic

The parabolic equation, of which diffusion and convection-diffusion equation is a sub
class, is the most used and popular one in the world of derivatives. Black-Scholes PDE,
the solution of which gives the celebrated Black-Scholes option pricing formula, is a
convection-diffusion equation. However, elliptic and hyperbolic (a 2
nd
order hyperbolic
equation is a wave equation) equations are also found in some financial derivatives
applications.

Parabolic PDE

Parabolic PDEs model heat flow (financial derivatives) and fluid flow phenomenon. The
Black-Scholes (PDE) in quantitative finance is a parabolic PDE and is given by:



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( ) ( ) ( )
( ) t S rC
S
t S C
S
S
t S C
rS
t
t S C
,
,
2
1 , ,
2
2
2 2
=
c
c
+
c
c
+
c
c
o

The Black-Scholes PDE, like the heat equation stated above, is a Diffusion equation.

In the above, the Call option price, C is a function of the underlying asset price, S and
the time, t and hence is written as ( ) t S C , . The partial derivatives of the call option price
are:
( )
t
t S C
c
c ,
, which explains the variation of the call price with the time,
( )
S
t S C
c
c ,
which
explains the variation of the call price with the underlying asset (and is related to the delta
of the option) and
( )
2
2
,
S
t S C
c
c
which is a second mathematical derivative of the call price
with respect to the underlying asset and can be thought of as the variation of
( )
S
t S C
c
c ,
with the underlying asset.

Hyperbolic PDE

Hyperbolic partial differential equations model wave phenomenon in physics. Examples
of a hyperbolic PDE in quantitative finance are the PDEs that model deterministic
interest rates.

A wave equation for y , here ( ) t x y y , = , can be written as:


2
2
2
2
2
x
y
c
t
y
c
c
=
c
c
( ) 0 , , > e t x

Elliptic PDE

Elliptic partial differential equations require specification of boundary conditions if a
unique solution is desired. A important example of an elliptic PDE is the Poissons
equation (of which Laplaces equation is a special case) given by:

( ) y x f
y
v
x
v
,
2
2
2
2
=
c
c
+
c
c


Here, ( ) y x v v , = is a function of two variables, x and y . In quantitative finance, an
example of an elliptic PDE would be that of a Bond price in some of the one factor
stochastic interest rate models.



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Categorization of Partial Differential Equations

Generally speaking, all partial differential equations that are used in quantitative finance
can be transformed into algebraic equations, mostly notably, quadratic equations of the
form:

0 2
2
= + + c bx ax

Where a, b, and c are constants and x is a generalized variable. In the case of partial
differential equations we can treat the variable x as a partial derivate of two other
variables. For example we could have a first or second order PDE with terms involving
t
y
c
c
,
2
2
t
y
c
c
and
s
y
c
c
,
2
2
s
y
c
c
and x could be a transformed variable of these.

The roots of the above quadratic equation are:


a
ac b b
x

=
2


The categorization of a PDE into elliptic, parabolic and hyberbolic is due the nature of
the roots of the above quadratic equation as shown below:

- Parabolic PDE: 0
2
= ac b
- Hyperbolic PDE: 0
2
> ac b
- Elliptic PDE: 0
2
< ac b

This is how PDEs are typically classified. Time and resource permitting we shall try to
discuss some more on PDEs and especially the non-parabolic PDEs which are not that
common in financial engineering applications.

Conversion of PDEs to ODEs

Partial differential equations can be (PDE) converted into ordinary differential equations
(ODE) by making use of Laplace transform. PDEs are comparatively much more difficult
to solve than ODEs; therefore, the use of Laplace transforms come very handy while
transforming a PDE into an ODE and finding the solution easily.

Jamil Baz and George Chacko (51) show how to use Laplace transforms to solve PDEs
for derivatives valuation.




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Finite Difference Method

Here we follow the approach of Tung, Lai, Wong and Ng (2010) to set up the finite
difference problem as a system of linear equations and solve it using standard matrix
theory. We find this approach quite elegant and extremely easy to follow.

In a finite difference method, a partial differential equation (PDE) is transformed into a
finite difference equation by converting the partial derivatives into finite difference
expressions. Then using standard matrix method a system of linear equations is solved to
get the range of values for the dependent variable.

If the call option payoff is given by: ( ) ( ) 0 , max , K S T S C = , where, T is the maturity
of the option and K the strike price then the Black-Scholes PDE is given by:


( ) ( ) ( )
( ) t S rC
S
t S C
S
S
t S C
rS
t
t S C
,
,
2
1 , ,
2
2
2 2
=
c
c
+
c
c
+
c
c
o

We first convert the partial differentials into finite difference approximations. To do that
we have not note that an ordinary mathematical derivative of y with respect to x can be
expressed as:


( ) ( )
x
x y x x y
dx
dy
A
A +
=

We set up a two dimensional grid, a sort of ij plane, with the vertical axis, j
representing the asset price with
max
,........, , ,
2 1 0 j
S S S S and the horizontal axis, i
representing time with
max
,........, , ,
2 1 0 i
t t t t . Note that T t
i
=
max
, the maturity of the option
and S j S
j
A = and t i t
i
A = .

We choose an arbitrary interior point inside the grid, representing the point ( )
i j
t S , and at
this point estimate the partial derivatives of the option price as:



( ) ( ) ( )
( ) ( ) ( ) ( )
( )
( ) ( ) ( )
t
t S C t S C
t
t S C
S
t S V t S C t S V
S
t S C
S
t S C t S C
S
t S C
i j i j i j
i j i j i j i j
i j i j i j
A

=
c
c
A
+
=
c
c
A

=
c
c
+
+
+
, , ,
, , 2 , ,
2
, , ,
1
2
1 1
2
2
1 1



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Note that in the above, the partial derivative of the call option with time, t , given by the
third approximation
( )
t
t S C
i j
c
c ,
is a forward difference measure in t A .
Using the above notation the Black-Scholes PDE transforms into a system of linear
equations given by:

( ) ( ) ( ) ( )
i j j i j J i j j i i
t S C t S C t S C t S C , , , ,
1 1 1 + +
+ + = | o



1 ........, , 1 , 0
1 ......., , 2 , 1
max
max
=
=
i i
j j for


Where, the coefficients are given by:


t j t r
t j t r
t j t r
j j
j
j j
A A =
A + A + =
A A =
2 2
2 2
2 2
2
1
2
1
1
2
1
2
1
o
o |
o o


Given the initial inputs for volatility and risk free rate and a suitable choice of t A the
above coefficients can be easily calculated and substituted in the system of linear
equations.

Two more useful transformations that can be introduced here are:



( ) ( )
( ) ( ) t S C t S C
t S C t S C
j J I j
i i
, ,
, ,
max max 1 max
0 0 1 0
|
|
=
=
+
+


1
max
=
j
|

=
A
options style American for
options style European for e
t r
1
0
|

The above system of linear equations can be put in a matrix form as:


( )
( )
( )
( )
( )
( )
( )
( )
|
|
|
|
|
|
.
|

\
|
=
|
|
|
|
|
|
.
|

\
|

+
+
+
+
i j
i j
i
i
i j
i j
i
i
t S C
t S C
t S C
t S C
F
t S C
t S C
t S C
t S C
,
,
,
,
,
,
,
,
max
max
max
max
1
1
0
1
1 1
1 1
1 0


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Where, F is a tridiagonal matrix given by:



|
|
|
|
|
|
|
|
|
|
|
.
|

\
|
=

MAX
J
j j j
F
|
| o
| o
| o
|
0 0
0 0
0
0 0
1 1 1
2 2 2
1 1 1
0
max max max





The above matrix equation is iterating forward in time. However, like the binomial tree,
to solve the Black-Scholes option value, we need to work backwards. This is done by
inverting the tridiagonal matrix, F and solving the difference equations:


( )
( )
( )
( )
( )
( )
( )
( )
|
|
|
|
|
|
.
|

\
|
=
|
|
|
|
|
|
.
|

\
|
+
+
+
+

1
1 1
1 1
1 0
1
1
1
0
,
,
,
,
,
,
,
,
max
max
max
max
i j
i j
i
i
i j
i j
i
i
t S C
t S C
t S C
t S C
F
t S C
t S C
t S C
t S C


The above can be easily implemented on an Excel spreadsheet and solved.

Laplace Transform

Laplace transform method comes handy in many areas of quantitative finance. The
simplest application of Laplace transform is to estimate the time value of money.

Laplace transforms are used to convert time domain relationships to a set of equations
expressed in terms of the Laplace operator s . After the transformation, the solution of the
original problem is arrived at by simple algebraic manipulations in the s (Laplace)
domain rather than the time domain.

But why do we need to do such a transformation? The quick answer is to simplify
mathematical calculations. It is a bit like why we use logarithms in mathematical
calculations. Logarithms simply the math considerably and makes a problem more
tractable. When we take logarithms we transform numbers to the power of 10 or some
other base, say, e , which becomes natural logarithm. What we achieve by this is to

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transform mathematical manipulations and divisions to simple additions and subtractions.
Similarly, Laplace transforms can be applied to linear, differential equations in a way that
the differential equations are transformed into simple algebraic equations which can be
solved easily.

The Laplace Transform of a time variable function, f (t), is defined as:

( ) ( ) | | ( )
}

= =
0
dt t f e t f L s F
st


Now think of the present value problem in Finance. One of the most fundamental and
elementary problems in finance is to estimate the present value of a future cash flow. If
the discount rate (interest rate) is constant and equal to r then the present value of a
future cash flow, ( ) t C , where, ( ) t C is a function of time, t is given by:


( )
( )
( )
( )

=

=
=
+
=
T
t
rt
T
t
t
t C e
r
t C
t p
1 1
1


In the above we have assumed continuous compounding and present value function, ( ) t p
is a function of t. The time is bounded between 0 and some finite quantity, T . In the
limiting case, the summation is replaced by an integral and the above present value
equation can be expressed as:

( ) ( )
}

=
T
rt
dt t C e r p
0

Due to the presence of the integral, the domain of the computation changes from time, t
to rate, r and therefore, the present value becomes a function of the rate, r . However,
the boundary of the integral is still from 0 to some finite quantity, T .

Now, if we change the upper bound to infinity, i.e. T , then the definite integral will
become:

( ) ( )
}

=
0
dt t C e r P
rt

Note, that equation (4) is now an exact replica of equation (1), where the r (rate)
domain acts like the Laplace domain, s . In fact, we can write equation (4) as:

( ) ( ) | | ( )
}

= =
0
dt t C e t p L r P
rt

Therefore, the present value of a future cash flow ( ) r P is the Laplace transform of the
cash flow ( ) t C .

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Of course, one needs to be cognizant of the fact that the bounds of the integral above are
from 0 to infinity. In other words, the Laplace transform equation, (3), exactly translates
into the discrete time present value equation (2) only when we are considering a very
long period of time. If the cash flow is $1 then by equation (4), ( )
r
r P
1
= and if the cash
flow is K (where, K is constant) then equation (4) will yield ( )
r
K
r P = . Actually, this can
be very easily verified using an Excel spreadsheet. Choose any interest rate, say, 5% and
choose a cash flow equal to $100. Then, over say, a 100 year period (100 years is long
enough to be the real life equivalent of infinity) the present value of all the cash flows
(summed up over 100 years) would be equal to $1,985. Using the Laplace transform
result, youd get $2,000.


































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Chapter S
Stochastic Process for Asset Price Modelling
(For Implementing Monte Carlo Simulation in Excel )

A fundamental, and perhaps the most crucial, step in valuation and risk analysis of
financial derivatives is to create a particular math model for the stochastic asset price
process. The following variables and constants are used in the equations in this chapter:

Random Number (from a Normal Distribution) = ( ) 1 , 0 ~ N
t
c
Weiner Process (Random Walk) = t dW
t
o c =

Discrete Weiner Process (Random Walk) = t W
t
A = A c
Poisson Process =
t
P with intensity and Jump size J
Stochastic Asset Price =
t
S

Asset Price today (time, 0 = t ) =
0
S
Constant displacement in Asset price = o
Stochastic Forward price =
t
F
Constant Volatility = o

Stochastic Volatility = t
o
Stochastic Variance =
t
v
Constant rates = r

Stochastic rates = t
r
Constant dividend yield = q
Drift = ( ) q r =
Long term value of rates (constant) =

r

Long term value of rates (stochastic) =

t
r
Long term value of variance (constant) =

v

Long term value of variance (stochastic) =

t
v
Long term mean of the mean reversion parameter,

v =
t
m
Speed of mean reversion = k
Volatility of volatility (constant) = q

Volatility of the mean reversion parameter (constant) =

Correlation =
Long term mean of Correlation (constant) =


Libor at time, ( T t = ) =
T
L
Forward Libor at time ( T t = ) =
F
T
L

Maturity value of a variable is indicated by T t =


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Stochastic Process

Stochastic means Random. A Stochastic process,
t
W , where ( ) { } T t t W W
t
e = , , is
defined as a sequence of random variables, ( ) t W , where the parameter, t denotes time
and flows over an index T . The state space of the stochastic process, is given by the set
of all possible values for the random variables ( ) t W and each of these possible values is
called the state of the process. If T represents a countable set then ( ) t W is a discrete
stochastic process and t will represent discrete time measurements. The process ( ) t W is
a continuous stochastic process if the index T is a finite continuum.

Simply put, a stochastic process is variable who value over a period of time changes in a
random (stochastic) manner. A stock price is a stochastic process, as is the FX rate or the
interest rate. If we measure the random changes in the variable over discrete time
interval, such as one month, one day, one hour, one minute, one second, etc. then it is
known as a discrete time stochastic process. Here we denote the change in the time
interval over which the value of the variable changes randomly as t A . If we measure
the random changes in the variable over infinitesimally small time intervals, such that
0 At , then the process is known as a continuous time stochastic process. An example
of a stochastic process is a Weiner Process or what is popularly known as Random Walk.

Two World Views for Incorporating Stochasticity (Randomness)

In Finance, stochastic processes are generally of two kinds:

- A process where the asset price is stochastic;
- A process where the time is stochastic;

Stochastic Processes of Asset Price and the Levy Process

Most stochastic processes in Finance that are used to describe asset price behavior
belong to the family of Levy processes. A Levy process is a generalized stochastic
process that has three independent components:

(i) Weiner process (i.e. a random walk)
(ii) A deterministic drift
(iii) A pure jump process

Classification of Stochastic Processes for investigating key Risk Factors

Damanio Brigo Damiano Brigo, Antonio Dalessandro, Matthias Neugebauer and Fares
Triki in their excellent tutorial have identified two of the key characteristic features of
asset prices that a stochastic process should incorporate, especially if an investigation is

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made from a risk management point of view. These two features of the asset price are:

- Fat Tails
- Mean Reversion

Consequently, he characterizes the stochastic process of asset prices into following
categories:

- Basic process: Arithmetic Brownian Motion (ABM) and Geometric Brownian
Motion (GBM)

- Fat tails processes: GBM with lognormal jumps, ABM with normal jumps,
GARCH and Variance Gamma (VG)

- Mean Reverting processes: Vasicek, Cox-Ingersoll-Ross (CIR), Exponential
Vasicek

- Mean Reverting processes with Fat Tails: Vasicek with jumps, Exponential
Vasicek with jumps.

However, note that the above categorization is neither exhaustive nor complete. There
are numerous other stochastic processes that describe asset prices, volatility and
correlation that have not been included above. The above classification is only one of
the ways to look at stochastic processes.

Stochastic Processes of Time and the Poisson Process

Stochastic processes where time is a random variable mostly belong to the class of
Poisson processes, which are point processes.

Poisson Process

A Poisson process is an important stochastic process used to model insurance risk and
has wide applications in both finance and insurance. There are three kinds of Poisson
processes that are of interest in the field of financial engineering:

- Homogenous Poisson process
- Non-homogenous Poisson process
- Cox process (Doubly stochastic Poisson process)

In insurance, Poisson processes are used to model claims arrival time. In finance,
Poisson processes (and especially, Cox processes) are used extensively to model default
times, while valuing risky bonds and credit derivatives.

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Stochastic Processes for Modelling Asset Price

1. Markov Process

The stochastic processes that mostly studies in quantitative finance are Markov
Processes. For example, the random walk and the Brownian motion describing equity
(stock) prices and currencies (FX rates) are Markovian processes. A Markov Process is a
stochastic process where on the present value of the variable is relevant in determining
the future values of the variables. In other words, the future evolution of the random path
of a variable in a Markov process is solely dependent on the present state of the variable.

2. Martingale Property of a Stochastic Process

The martingale property of a stochastic process states that the conditional expectation of
the process at any time in the future is just the current value. Suppose you are playing the
coin tossing game with an opponent and every time heads show up in a toss, you win $1
and if tails show up you lose $1. The martingale property of this stochastic process states
that the conditional expectation of your winnings at any future time is just the amount of
dollars you already hold. In terms of probability notation we can write:

( )
i j i
X i j X X E = < ,

3. Random Walk (Weiner Process) and Brownian Motion

All Financial Assets, like stocks, currencies, interest rates, etc. are assumed to follow a
random walk and a Brownian motion. A random walk is a simple, continuous time
Markovian diffusion process, which is stochastic in nature, and is more formally known
as a Weiner Process.

If ( ) t W is a Weiner process, where t is time, then its behaviour can be understood by the
following two properties:

(i) Over an infinitesimally small time interval, t A , the change in ( ) t W , given by ( ) t W A
is given by:

( ) ( ) ( ) t t W t t W t W
t
A = A + = A c

Where,
t
c , is a random number drawn from a Normal (Gaussian) distribution with
zero mean and unit standard deviation. In other words, ( ) 1 , 0 ~ N
t
c . In the limiting
case, when, 0 At the Weiner process is given by:


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( ) t t dW
t
o c =

(ii) For any two values of time, t and s , where, s = t the processes ( ) t W A and ( ) s W A
are independently distributed which makes ( ) t W a Markov process.

If we add a drift to the random walk then we get a Brownian motion. A Brownian motion
is a random walk plus a drift:

Brownian motion = Random Walk + Drift.

Financial assets and securities that follow a Brownian motion have two components to
their price change. The first is the drift and the second is the random walk. The random
walk is tied to the volatility of the asset or the security. An example of drift is the risk
neutral forward rate, i.e. risk free interest rate minus the dividend yield for equities or the
domestic interest rate minus the foreign interest rate for currencies.

Random Walks have these two important properties:

(i) They are Markovian in nature
(ii) They have the Martingale property

4. Geometric Brownian Motion (GBM) with constant volatility

Geometric Brownian motion (GBM) is used to model equity, equity indices, FX rates and
Commodity prices in Finance. A geometric Brownian motion (GBM) models the return
of the stock (price), where the return is expressed as the logarithm of the price relative. In
other words, in a GBM we model the rate of change of the asset price, i.e. the percentage
change. If we assume a lognormal process for the asset price, i.e. if the natural logarithm
of the asset price follows a Normal (Gaussian) probability distribution then the Stochastic
Differential Equation (SDE) for the asset price,
t
S is given by:


t
t
t
dW dt
S
dS
o + =
Here, is a constant and represents the drift of the Brownian motion and o is also a
constant and represents the volatility of the asset. The volatility o is the coefficient of
the diffusion process. In a risk neutral setting, where, r is the risk free rate in the
economy and q is the dividend yield of the asset, the drift can be expressed as: q r = .
Therefore, the GBM for the asset price can be written as:

( )
t
t
t
dW dt q r
S
dS
o + =

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Where, the Weiner process (random walk),
t
dW , is given by t dW
t t
o c = in continuous
time. In discrete time, the Weiner process is given by: t W
t t
A = A c . Here,
t
c is a
random number drawn from a Gaussian (Normal) distribution with mean 0 and variance
of 1.

Transforming the above stochastic differential equation into a stochastic difference
equation (for implementing on an Excel spreadsheet) we get:


( )
( )
( ) ( )
t t t t
t
t
t t
t
t
t
t dt q r S S S
t dt q r
S
S S
dW dt q r
S
S
c o
c o
o
A + + =
A + =

+ =
A

1 1
1
1


In Excel we can draw a random normal number,
t
c (i.e. a random number from a
Normal distribution with zero mean and unit standard deviation) by the library function
=NORMSINV(RAND()).

However, the above stochastic differential equation is not really robust and it actually
breaks down for very high values of o (volatility). Try inputting a value of 800% for the
volatility in the above model and the model will blow up on an Excel spreadsheet by
generating negative asset values. However, for a Geometric Brownian motion given by
the above stochastic differential equation (SDE), an asset value can never be negative. So
why does the SDE blow up? This is because when we transform the stochastic
differential equation into a stochastic difference equation the left hand side actually
becomes the measure of arithmetic return as opposed to a geometric return which a GBM
is supposed to model. GBM models log return and the SDE above also models the log
returns (on the left hand side) and if we take the integral of
t t
S dS we would get ( )
t
S ln
because ( ) x x dx ln =
}
.

The problem arises only when we discretize the SDE into a difference equation using an
Euler discretization scheme. It is then that the left hand side (the return of the asset)
which in continuous form is
t t
S dS becomes, in discrete form,
|
|
.
|

\
|

1
1
t
t t
S
S S
which is a
measure of the arithmetic return. Therefore, it is best to use the integral form of the above
GBM. The Stochastic Integral Equation of the asset return in a GBM is given by:


|
|
.
|

\
|
A + A |
.
|

\
|

=
t
t t q r
t t
e S S
c o o
2
2
1
1


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This is the process that most commercial software in banks and financial institutions use
for simulating a Geometric Brownian motion while using a Monte Carlo simulator to
value financial derivatives. Of course, it must be added that for realistic levels of
volatility (less than 300%) and for large number of iterations the asset price values
generated by both the stochastic differential equation and the stochastic integral equation
will converge. Therefore, one can as easily use a stochastic differential equation as a
stochastic integral equation in a Monte Carlo simulation.The above GBM model is
suitable for equity (stock) and stock indices whereby the drift is given by the difference
between the risk free rate and the dividend yield.

For FX rate, where the drift is the difference between the domestic interest rate and the
foreign interest rate, the Stochastic Differential Equation (SDE) for the GBM is given by:

( )
t f d
t
t
dW dt r r
S
dS
o + =

And, the Stochastic Integral Equation for the GBM for FX rate is given by:


|
|
.
|

\
|
A + A |
.
|

\
|

=
t f d
t t r r
t t
e S S
c o o
2
2
1
1


Where, t dW
t t
o c = in continuous form, and ( ) 1 , 0 ~ N
t
c .

Spurious Paths in Monte Carlo Simulation
Every once in a while the Geometric Brownian motion (GBM) breaks down due to the
problem with Euler discretization scheme in implementing a stochastic differential
equation (SDE). Spurious paths are those Monte Carlo paths which cross zero!

A GBM should never cross zero and in fact should not even come close to zero. But for
some values of random numbers it will. Why?

Take the stochastic differential equation (SDE) of a GBM:


t
t
t
dW dt
S
dS
o + =


In the above, dW is the Weiner Process and
t
S is the stochastic asset price. The Euler
scheme for the above SDE that transforms it into a difference equation is:

( )
t t t t
t t S S S c o A + A + + =

1
1 1


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Here, c is a random normal number, i.e. ( ) 1 , 0 ~ N c . This scheme will converge to the
mathematically correct description of GBM only in the limiting case of t A becoming
infinitesimally small, i.e. 0 At . But if the time slices are finite, i.e. if t A are small, but
finite such as one month, one week, one day, one hour, etc. then depending on the
parameters and o one can always draw a random normal number, c , such that


t
t
A
A +
<
o

c
1


There is a small but a finite probability of the above happening. In fact, if the time slice
is finite, then it is only a matter of time when the above will happen, i.e. the random
normal number, c , drawn will be less than the expression on the right hand side. And if
that happens then the value of
t
S will become negative!

Such a path where the asset price becomes negative is called a spurious path. One can
easily test the above using an Excel spreadsheet and running a very large number of
iterations with sufficiently big time slice, i.e. 4 1 2 1 or t = A and reasonably large
values of drift and volatility.

Is there a connection between the Riemann Zeta function and the Brownian motion of
the asset prices?

Number Theory meets Quantitative Finance
Riemann Zeta Function and the Brownian Motion of Asset Prices

Riemann Zeta function is perhaps the most beautiful formula in Number theory and
certainly ranks at par with Eulers formula as one of the most beautiful formulas in
mathematics. The Riemann Zeta function is simply expressed as:


( )

=
0 n
s
n s


The function is defined 1 Re > s . In the above, definition, s is a complex number. In a
series form the zeta function can be expressed as:

( ) ..........
3
1
2
1
1
1
+ + + =
s s s
s

All this is fine. But what has all this got to with quantitative finance?

Lets see what happens when we take the inverse of the Riemann zeta function

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( )
...... ..........
10
1
9
0
8
0
7
1
6
1
5
1
4
0
3
1
2
1
1
1
s s s s s s s s s
s
+ + + + + =



The numerator of the above series are the values of the Mobius function, ( ) x , which is
zero if x is square free, 1 if x has even number of prime factors and 1 if it has an odd
number of prime factors. If we look at the values of the Mobius function the look like

....... .......... , 1 , 0 , 0 , 1 , 1 , 1 , 0 , 1 , 1 , 1 + + +

This can be thought of as a random walk in which a person who is quite drunk or a
financial asset such as a stock price of an FX pair stays where it is, i.e. 0, or takes one
step forward, i.e. +1 or takes one step backward, i.e. -1.

As David Wells writes in his excellent book, Prime Numbers, this observation was first
made by Von Sternbach in 1896, who also listed the first 150,000 values of the Mobius
function and estimated that the probability that ( ) x was non-zero was around
2
6 t
which is roughly equal to 0.608 with +1 and -1 having approximately equal probabilities
of occurrence.

Therefore, the random walk, i.e. a Weiner process that models the asset price, is hidden
deep within the Riemann zeta function.

Let us look at some more evidence of this.

In 1997, in a seminal paper, Broadie, Glasserman and Kou, professors at Columbia
University and the University of Michigan respectively, proposed a beautiful formula for
the adjustment that needs to be made when we move from a continuous barrier to a
discrete barrier, while valuing a certain kind of financial derivative called the barrier
options. Barrier options are extremely popular amongst sell side traders in the banks and
institutional investors and are embedded in numerous structured products sold to retail
investors as well.

All closed form solution for barrier options (knock-outs or knock-ins) are priced
assuming a continuous monitoring of the barrier, owing to the use of continuous time
stochastic calculus in such mathematical modeling. However, in real life all option
traders observe any barrier a knock-out or a knock-in level of the asset, given a certain
asset price path on a discrete basis, such as daily monitoring, weekly monitoring, etc.
Therefore, adjustment needs to be made to compensate for this fact.

Broadie, Glasserman and Kou showed that if m is denotes monitoring points (number of
days or number of months, etc.), H' is the (theoretical) continuously monitored barrier
level and H is the corresponding (practical) discrete barrier level then the two should be
approximately related by this formula (also, see Chapter O, #18 for this formula).

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m
T
He H
|o
= '


In the above formula, the authors showed that the constant | is related to the Riemann
zeta function by


( )
5826 . 0
2
2 1
~ =
t

|

In the above formula, ( ) s is the value of the Riemann zeta function around 2 1 = s .

The plus and the minus sign in front of the constant | represent an up barrier and a
down barrier option respectively. This beautiful formula is used today by traders to
make adjustments to the barrier level when valuing barrier options and the formula. The
function, ( ) s around 2 1 = s has a special significance. The Riemann hypothesis states
that the zeta function has non-real and non-trivial zeros only on the critical line for
which the real part of s is 2 1 .

The Riemann zeta function and the Riemann hypothesis are both related to the Prime
number theorem and the distribution of prime numbers. Prime numbers are used in many
powerful mathematical algorithms to we generate random numbers. These random
numbers are in turn used to simulate Brownian motion while modeling asset price paths
for the valuation of financial derivatives.

5. GBM and the Log Returns in Continuous Time Finance

In continuous time finance, closely related to the notion of geometric Brownian motion
(GBM) is the concept of log returns for assets. In a continuous time framework, when we
slice time into smaller and smaller intervals, the return of an asset get expressed as
natural logarithm of this periods price divided by the last periods price. In other words,
if
t
S is this periods price (say, today) and
1 t
S is last periods price (say, yesterday) then
we express the return of the asset as
|
|
.
|

\
|
=
t
t
t
S
S
R ln .

It is a moot point and even though the above expression does not make intuitive sense to
the every day investors, traders and quants use this measure all the time in their
calculation. Actually, it comes from applying integral calculus to finance.

Asset return should be measured, as indeed it is by thousands of fund managers and
investors around the world, as todays price less yesterdays price divided by yesterdays
price. This is an arithmetic measure. In other words, if
t
S is this periods asset price
(where the time period is discrete like one year, one month, one week, one day or even
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one minute) and
1 t
S is last periods asset price then (assuming no dividend payments) the
asset return should be equal to:


1
1

=
t
t t
t
S
S S
R

The above formula gives the measure of an arithmetic return something that we are all
familiar with. Now, if we have many periods, say, N, in one time interval (i.e. 12 months
in an interval of one year) then the total return of the entire interval is simply the sum of
all the individual periods returns, i.e.



=

=
|
|
.
|

\
|
= =
N
t t
t t
N
t
t T
S
S S
R R
1 1
1
1


However, what happens if we start to slice time into smaller and smaller intervals. Say,
we start slicing time (one year) into minutes, seconds, nanoseconds and so on until we get
to the mathematical definition of an infinitesimally small interval of time. We are now
talking about the limit when delta t (the smallest measurable unit of time) goes to zero.
Mathematically speaking, we say that 0 At . In the limit, the above expression for
return will reduce to:



= =
A A
|
|
.
|

\
| A
= =
N
t
N
t t
t
t
t
t
T
S
S
Lt R Lt R
1 1
0 0


In the limiting case if 0 At , then dS S A and the summation sign will get replaced
by an integral. Therefore, the expression for the asset return (dropping the subscript for
time) becomes:


}
=
=
=
T
S S
S S
T
S
dS
R
0


And the limits of the integral are chosen in line with the time limits, i.e. at start when
0 = t the asset price is
0
S and at the end of the time interval (maturity), i.e. at T t = , the
asset price is
T
S . From integral calculus, we know that ( ) x
x
dx
ln =
}
and therefore, we
have:

( ) ( ) | |
} |
|
.
|

\
|
= = =
T
S
S
T
T T
S
S
S S
S
dS
R
0
0
0
ln ln ln

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Therefore, in a time interval [0, T], if we assume a continuous time process, i.e. time is
sliced as infinitesimally small intervals, the asset return will be expressed as the natural
logarithm of the final price over the initial price.

6. Girsanovs Theorem and Exotic Options Pricing

One of the fundamental concepts in asset price modeling for valuation of exotic options
is the Girsanovs theorem. It is closely related to the notion of Radon-Nikodym
derivative that we learnt above. Barrier option traders come face to face with both these
concepts quite regularly.

How can we explain Girsanovs theorem?

According to one veteran exotic options trader Girsanovs theorem makes the drift
disappear from an asset (diffusion process) making it a martingale. In other words, a
Brownian motion with drift becomes a drift-less random walk changing the probability
of the asset hitting a barrier. In other words, we look at the problem of a barrier being hit
not under the real (physical) probability measure but a risk neutral one. The real
(physical) probability of the barrier being hit may be too low or immeasurable but under
a risk neutral probability measure the problem becomes tractable.

Another traders refrain was: options can be very easily priced using the difference
between the two reflected processes. Reflection principle helps us in estimating the risk
neutral probability of all random paths that reach a given point without going through a
barrier. Under a real (physical) probability measure the Brownian motion of the asset
price will have drift and hence the two Weiner processes will not be equivalent. The
drift needs to get out of the way for the Weiner processes to be equivalent. Actually, the
probability takes care of the drift.

Say, you are a barrier options trader and you are investigating an asset price diffusion
process given by:

( ) ( ) ( ) ( ) t dW t dt t t dX o + =

Here, ( ) t is the drift of the asset and ( ) t o is the coefficient of diffusion (i.e. volatility).
You are interested in estimating the probability of ( ) t X , the asset price, entering a
certain space, say, B (the region around the barrier) in the time interval | | T , 0 . The only
way to do this is to run Monte Carlo simulations. So you set up an Excel spreadsheet
simulator and start to run simulations.

However, you are quite sure that the probability of this event happening is very small,
say,
5
10

. In other words, youd have to run 100,000 iterations (realizations of asset


price path) to measure this probability.

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Now say, you could somehow change the drift of the asset diffusion process, shown
above, in such a way that the probability of the above event, i.e. asset price, ( ) t X
entering the barrier space, B in the time interval | | T , 0 , becomes significantly larger
than
5
10

. Therefore, youd need a lot less number of iterations (realizations of the asset
price paths) to measure this probability. This is music to a traders ears! Girsanovs
theorem does precisely that.

Two probability measures, Q and P are equivalent if Qis absolutely continuous with P
and P is absolutely continuous with Q. A probability measure Qis absolutely
continuous with P if the Radon-Nikodym derivative, shown below, exists.


dP
dQ
= |

Say we have an Ito diffusion process (such as a Geometric Brownian motion) for an
asset price given by

( ) ( ) ( ) ( ) t dW t dt t t dX o + =

Where, ( ) t W is a Weiner process (a random walk) under a probability measure, P . In
the above equation, ( ) t is the drift and ( ) t o is the coefficient of diffusion (equivalent
to volatility).

Note that ( ) t X is a martingale if the above process is driftless, i.e. the drift, 0 = . That
it, we would need the stochastic differential equation to be of the form ( ) ( ) t dW t dX o = .
How can we do so?

Rewrite the above diffusion equation as:


( ) ( )
( )
( )
( )
( ) ( ) ( ) t W d t t dX
t dW
t
t
t t dX
' =
(

+ =
o
o

o


The resultant equation also looks like a geometric Brownian motion. However, the new
Weiner process, ( ) t W' is given by:


( ) ( )
( )
( )
( ) ( )
( )
( )
}
+ = '
+ = '
t
ds
t
t
t W t W
dt
t
t
t dW t W d
0
o



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Hence, the drift has vanished and the resultant diffusion equation is a martingale.
Girsanovs theorem states that the process ( ) t W' is also a Brownian motion under a
different probability measure.

7. Stochastic Process for the Forward Price

The forward price of asset, at time, t for a contract maturing at t time, T is related to the
spot price by:

( ) ( )
( )( ) t T q r
e t S T t F

= ,

Dropping the subscript, T , from the forward price, we can write:


( )
( )t q r
S
dS
F
dF
e S F
t
t
t
t
t q r
t t
=
=



This shows that:

- There is a relationship between the dynamics of the spot price and the forward
price.

- If the interest rate and the dividend yield are constant then if the spot price
follows a geometric Brownian motion then the forward price will also follow a
geometric Brownian motion.

8. Brownian Motion with Default Risk

If we assume that the asset has default risk and in the event of default the asset (stock)
price goes to zero the stochastic differential equation (SDE) describing the Geometric
Brownian motion of the asset should be modified as:

dQ dW dt
S
dS
t
t
t
+ = o

The drift, can be expressed as ( ) q r = in a risk neutral world, where, r is the risk
free rate and q is the dividend yield. Here, dQ, is a Poisson process, ( ) t Q , where,

=
default No
default
dQ
, 0
, 1



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The Poisson process is related to the default intensity, where the probability that the
value of dQwill be 1 is equal to dt .

9. Geometric Brownian Motion for the Inverse of the Asset Price

This process comes handy in understanding the movements of FX rates (currency pairs).
They can help us to investigate how the process of USD/JPY (Dollar-Yen) differs from
the process for JPY/USD (Yen-Dollar).

Given the Jensens inequality

( ) | | ( ) | | X E f x f E >

The geometric Brownian motion for the inverse of the asset price, S Y 1 = , is given by

( )
t
t
t
dW dt
Y
dY
o o =
2


An example would be, if
t
S is the USD/JPY (Dollar-Yen) price then
t t
S Y 1 = , would be
the JPY/USD (Yen-Dollar) price.

10. Stochastic Process for the Relative Performance of Two Assets

If there are two assets (two stocks or two stock indices),
1
S and
2
S such that their
respective stochastic processes (geometric Brownian motions) are given by:


dt dW dW where
dW dt
S
dS
dW dt
S
dS
t t
t
t
t
t
t
t

o
o
=
+ =
+ =
2 1
2
2 2
, 2
, 2
1
1 1
, 1
, 1
,

Where, the respective Weiner processes are correlated via the correlation coefficient, .
Now, consider a relative process (can be thought of as relative performance) given by:
( )
2
1
2 1
,
S
S
S S R =
It can be shown that this relative process, R , also follows a geometric Brownian motion
given by:
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t R R
t
t
dW dt
R
dR
o + =
Where,
2 1
2
2 2 1
o o o + =
R
and
2 1
2
2
2
1
2 o o o o o + =
R

11. Arithmetic Brownian motion with constant volatility
(See Vasicek and CIR process for Rates Modelling)

Arithmetic Brownian motion (ABM) are primarily used to model short rates (interest
rates). Also, in stochastic volatility models, such as Heston (see below), the variance of
an asset price is assumed to follow a mean-reverting arithmetic Brownian motion.

In an arithmetic Brownian motion (ABM), we model the change in the value of the asset
price and therefore, the value of the asset price can be negative in this model.

( )
t t
dW dt q r dS o + =


12. Geometric Brownian Motion for the Square of the Asset

The GBM for the square of the asset is given by:

( ) ( ) ( ) ( )
t t t t
dW S dt S q r S d
2 2 2 2
2 2 o o + + =


13. Geometric Brownian Motion for the th n Power of the Asset

The GBM for the n th power of the asset is given by:

( ) ( ) ( )
t
N
t
N
t
N
t
dW S N dt S N N q r N S d o o +
)
`

+ =
2
1
2
1

14. Mean Reverting Geometric Brownian Motion


Geman (2005) describes a mean reverting geometric Brownian motion that is quite
popular in modeling commodities such as energy and agricultural commodities. If
t
S is
the asset price and

S is the long term average of the asset price, k is the speed of mean
reversion, o is the volatility of the asset and
t
W is a Weiner process such that
t dW
t t
o c = and ( ) 1 , 0 ~ N
t
c then the stochastic differential equation for the asset price
is given by:

( )
t t
t
t
dW dt S S k
S
dS
o + =

ln
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Making the following transformations:


t t
S G ln =

t
rT
t
G e Y =

and integrating between the limits | | T t, , we get the stochastic integral equation for the
asset price within the time limit | | T t, , where the value
t
Y at time t is observed and is the
starting value and
T
Y is a function of the Weiner process,
t
W .

( )
t
kt kT
kt kT
t T
W
k
e e
e e
k
S Y Y
2 2
2 2 2

+
|
|
.
|

\
|
+ =

o
o


15. Brownian Bridge Process

A Brownian bridge is a tied down Brownian motion. It is used to model Treasury
bonds where the asset redeems at par. In a Brownian bridge the final asset price reverts
back to the par value or the starting price and is therefore known in advance. However,
between 0 = t and maturity, T t = , the process is stochastic.

A Brownian bridge is described by the following process:


( ) ( ) ( )
( ) T t
T W
T
t
t W t B
, 0 e
=


) ( * ) ( ) ( T W t t W t B =

Where, ( ) t W is the corresponding Weiner process. The stochastic integral equation for
the asset (bond), with two known values, the starting price,
0
S , the price at maturity,
T
S ,


|
.
|

\
|
+
|
|
.
|

\
|
=
T t
T
W
T
t
W
T
t
s
S
t
e S S
o
0
ln
0



16. Cox-Ross Square Root Process

A Cox-Ross, square root stochastic process is given by:


t t t t
dW S dt S dS o + =

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Where,
t
dW is a Weiner process given by t dW
t
o c = . This is an extremely useful
process because of the additive property which also makes it a desirable process for
valuation of Asian options. But the most important property of a Cox-Ross process is that
it explains the volatility skew observed in the market. Lets write the above square root

process differently and express the left hand side as a return process (as opposed to a
change in price process).

dz
S
dt
S
dS
t
t
t
o
+ =

It is obvious from the above return process that the instantaneous variance of the return
2
|
|
.
|

\
|
t
t
S
dS
is equal to
t
S
2
o
. This is an inverse function of the equity (asset) price. Thus,
lower the equity (asset) price the higher the variance and vice-versa. This fact is
empirically found to be true. Therefore, the Cox-Ross square root process is a better
process than a geometric Brownian motion (GBM) when it comes to explaining the
volatility skew.

In fact, along with the square root process, Cox and Ross also introduced the Constant
Elasticity of Variance (CEV) stochastic model of asset prices which till this day is
popular amongst many FX option traders. CEV process can be viewed as a more
generalized form of the Cox-Ross process.

17. Ornstein-Uhlenbeck Process

Ornstein-Uhlenbeck (OU) are a class of mean reverting, stochastic processes which find
wide application in the modeling of interest rates and commodities. A generic OU
process can be written as:

( )
t t t
dW dt S k dS o + =

Where,
t
dW is a Weiner process given by t dW
t t
o c = , where, ( ) 1 , 0 ~ N
t
c is a random
number drawn from a Gaussian (Normal) distribution with mean zero and standard
deviation of one.

Discretization of OU process for Monte Carlo Simulation in Excel

( )
t t t t
t t S k S S c o A + A + =
1 1




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A constraint on the above formula is that the time step, t A should be quite small. For
large time steps the simulation often breaks down. A more exact discrete formula for the
stochastic process is given by:


( )
( )
t
t k
t k
t
t k
t
t
t k
t k
t
t k
t
t
k
e
e S e S
dW
k
e
e S e S
c o
o
A

+ + =

+ + =
A
A

A
A
A

A
2
1
1
2
1
1
2
1
2
1



Ornstein-Uhlenbeck Process in Interest Rate Models

Deutsche Bank quants, Marcus Overhaus, Hans Buehler, Ana Bermudez, Andrew
Ferraris, Christopher Jordinson and Aziz Lamnouar in their book Equity Hybrid
Derivatives, have shown that within the context of short rate modeling if the short rate
(one period annualized interest rate),
t
r , is a function of the variable
t
y and its mean,
t
y
such that ( ) t y y f r
t t t
, , = , then the short rate can be expressed as a generalized mean
reverting OU process given by:

t t t t t
dW dt y k dy o + =

This generalized OU process yields most of the well-known single factor short rate
models. For example, if
t t t
y y r + = , we recover the Vasicek or the Hull-White model; if
we let the short rate take exponential form of the type
( )
t t
y y
t
e r
+
= then we recover the
Black-Karasinkski model. And we such an exponential form for short rate, if we make
0 = k then we retrieve the Black-Derman-Toy model.

Further, if we want to have a better grip on the functional relationship between the short
rate and its volatility then a parameter can be introduced by interpolating between a
normal and a lognormal model so that the short rate is expressed as:


( ) ( )

=
+
1
t t
y y
t
e
r


Here, in the limit when 0 = , we recover the Hull-White model and when 1 = , we
retrieve the Black-Karasinski model.





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18. Mean Reverting Vasicek Process for Interest Rates

In 1977 Vasicek introduced a continuous time mean reverting random walk, which was
arithmetic in nature, to model the interest rate. In this model he proposed modelling the
the term structure of rates through the changes in the spot rate. Vasiceks process is an
extremely important stochastic process because it is one of the first models to have laid
the foundations for modeling interest rates as a mean reverting process. The idea of mean
reversion the notion that the underlying variable, the rate, reverts to a long term average
value finds strong acceptance amongst many economists and central bankers who take
the Vasicek model as the classical model for short rates.

The stochastic differential equation for a Vasicek process is given by:

( )
t t t
dW dt r r k dr o + =



In the above stochastic process, the short rate,
t
r is being modeled as a mean reverting
arithmetic Brownian motion (ABM) where,

r is the long term average value of the


short rate and k is the speed of mean reversion. Since the process follows an arithmetic
Brownian motion, the short rate can become negative. This is the biggest drawback of a
Vasicek process.

The discretized process (for implementing it on an Excel spreadsheet) will be given by:


( )
( )
t t t t
t t t
t t r r k r r
t t r r k r
c o
c o
A + A + =
A + A = A

1 1


In a Vasicek model, the following formula gives the probability that the rates will be
negative:


| |
( )
( )
( )
(
(
(
(

+
= <


t s k
t s k
t
s
e
k
e r r r
N r
2
1
2
0 Pr
o










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Oldrich Vasicek

Oldrich Vasicek was one of the first professionals in the field of quantitative finance who
thought that asset prices could follow a process other than a classical geometric Brownian
motion. His revolutionary paper on the dynamics of yield curve appeared in 1977 and for
the first time modeled an asset the short rate as an Ornstein Uhlenbeck process. This
has come to be known as the Vasicek model. He would also probably be one of the
richest academic quant (outside the banking world) alive today. Along with Stephen
Kealhofer, John McQuown, he founded a company called KMV in 1989 which was sold
to Moodys in 2002 reportedly for a sum of US$210 million.


19. Mean Reverting Cox-Ingersoll-Ross (CIR) process for Interest Rates

This is a very important process in quantitative finance. Besides being used in the
valuation of interest rate derivatives, it is also a process which has inspired the stochastic
volatility process of Heston. The process is significant improvement over the Vasicek
process as the possibility of obtaining negative rates is significantly redunced.

( )
t t t t
dW r dt r r dr o + =




20. Hull-White Process

( )
t t t t t
dW dt r r k dr o + =



21. n Dimensional Bessel Process


t
t
t
dW dt
S
n
dS +

=
2
1

22. Black-Derman-Toy (BDT) Process

BDT (1990) is a one factor, mean reverting lognormal model of interest rates where the
speed of mean reversion depends entirely on the volatility function. In practice, a BDT is
implementd in a discrete form using a tree. A continuous version of the BDT stochastic
process can be written as:


( )
( )
t t t t t
t
t
dW r dt r r
dt
d
dr o u
o
+ = ln ln
ln


Fischer Black, Emanuel Derman and William Toy, all three working at Goldman Sachs
& Co. in 1990 explain the key features of this model in their original paper as:
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(i) The fundamental variable of the model is the short rate, the one period annualized
interest rate which drives all security prices. This is the single (and the only) factor
of the model;
(ii) The two key inputs to the model are an array of long term interest rates, i.e. the yield
on zero-coupon Treasury bonds for various maturities, known as the yield curve and
an array of the yield volatilities of these bonds, known as the volatility curve.
(iii)
According to BDT, the model varies an array of means and an array of volatilities
for the future short rate to match the inputs. The future mean reversion changes
with the future volatilities.

Usefulness of BDT Model

Out of all the one factor models of short rate for pricing options, the BDT model has been
the most popular and for the entire decade of 1990s BDT was one of the dominant
models of short rate used by banks. It is still used by some banks. There are three reasons
for its usefulness and popularity:

(i) The model is capable of pricing an arbitrary set of discount bonds that trade in the
market;
(ii) The assumption of log-normal distribution for the short rates which facilitates the
calibration to caplet volatilities;
(iii) Translated into a tree form the model can be very easily implemented.
23. Black-Karisinski (BK) Process

BK is an explicitly mean reverting model of short rate and the dependence on time is via
( ) t k k
t
= , ( ) t
t
u u = and volatility of the short rate, ( ) t
t
o o = . The model is described by
the following stochastic differential equation.

( ) ( )
t t t t t t
dW dt r k r d o u + = ln ln


In the above process the speed of mean reversion,
t
k and the volatility of the short rate,
t
o are independent.
24. Poisson Jump Diffusion Process

A Poisson Jump diffusion process for an FX rate can be written as:


( )
t t d f
t
t
JdP dW dt r r
S
dS
+ = o



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Where, an independent jump factor is introduced to the Brownian motion. The equity
counterpart of this equation will have risk free rate and the dividend yield in the drift
process.
25. Kous Double Exponential Process
(Stochastic Integral Equation)


)
`

+ +
|
.
|

\
|
=

=

) (
1
2
1
) (
2
1
exp
t N
i
i t t
Y t W t r S S o , o

1
1 1
2
2
1
1

+
+

=
q
q
q
q
, q p

, o =
2
2
1
r


1
1 q = Mean size of upward jump

2
1 q = Mean size of downward jump


26. Heston Stochastic Volatility Process

Heston (1993) stochastic volatility is a two factor model whereby, besides the asset price
following a stochastic GBM, the variance of the asset varies stochastically as well, albeit
via a mean reverting Cox-Ingersoll-Ross (CIR) process. Hestons stochastic volatility
model is used to price many exotic equity options, especially those where there is a
forward skew, such as cliquets and reverse cliquets.

Asset Price Process with Stochastic Variance

The asset price,
t
S follows a GBM and the variance of the asset price,
t
v follows a mean
reverting CIR process, with a long term average value of the variance as:

v .


( )
2
1
t t t
t t
t
t
dW dt v v k dv
dW v dt
S
dS
q

+ =
+ =



dt dW dW =
2 1



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Where, the Weiner processes are given by: t dW
t t
o c =
1
and t dW
t
o c
2
2
=

Asset Price Process with Stochastic Volatility

Zhu (2008) has shown that a stochastic process for volatility can be derived from the
stochastic variance process of Heston (1993). Using the relationship:
t t
v = o and
making use of the Taylor Series expansion, Zhu derives the two factor stochastic
volatility process as:


( )
dt dW dW
k
where
dW dt k d
dW v dt
S
dS
t
t t t
t t
t
t

o
q
u
t
q o t o

=
|
|
.
|

\
|

=
+ =
+ =
2 1
2
2
1
4
,

Where, the Weiner processes are given by: t dW
t t
o c =
1
and t dW
t
o c
2
2
=

Finite Difference Discretization of the Variance Process using Euler scheme

( ) c q t v t v v k v v
t t t t
A + A + =

+1


Given the fact that the stochastic variance process in Hestons model follows an
arithmetic random walk, there is a possibility of observing negative variances if we
follow Euler scheme of discretization as given above. In a Monte Carlo simulator, this
situation is often mitigated by using the following rule:


condition reflecting v v then v if
condition absorbing v then v if
t t t
t t
= <
= <
, 0
0 , 0


However, a better discretization process is the Milsteins scheme which follows second
order Ito-Taylor expansion to arrive at the finite difference equations from the
stochastic differential equations.

Finite Difference Discretization of the Variance Process using Milsteins scheme is
given by:



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( ) ( )
( ) t t v v k t v v
t t v t v v k v v
t t t
t t t t
A A +
|
.
|

\
|
A + =
A + A + A + =

+
4 2
1
4
2
2
1
2
2
1
q
c
q
c
q
c q


Main Drawbacks of a Stochastic Volatility Model
(i) The models fit with European option prices is not good
(ii) The volatility of volatility (vvol) is determined using calibration to option prices
and the fit is also not good.
(iii) A stochastic volatility model does not produce accurate deltas for hedging
purposes
(iv) In times of great market stress, a stochastic volatility model mostly fails.
For the above reasons, some experts have proposed a Stochastic Local Volatility
Models (see below).
27. Double Mean Reverting Process for Variance
Given below is the Double Mean Reverting Stochastic Volatility (DMR-SV) model. To
the best of our knowledge, the first DMR-SV model was introduced by Jim Gatheral. In a
more generalized case, a DMR-SV model can be based on Buehlers Variance Curve
Models. In a Double Mean Reverting Stochastic Volatility model (DMR-SV) the short
variance is a mean reverting stochastic process whose mean reversion itself is
stochastic. Such behaviour is quite often seen in the financial markets.

( )
( )
m
t t t
v
t t t t t
v
t t t t t
t t
t
t
dW m dm
dW v v m p dv
dW v dt v v k dv
dB v
S
dS


q
=
+ =
+ =
=



In the above process the Weiner processes are given by


( )
4 2
3 2
,
2
,
2
2 2
1
1
1 1
1
t m t m
m
t
t
v v
t
v v v
t
v
v
t
t v t v
v
t
t t
W B W
W W B W
W B W
W B



+ =
+ + =
+ =
=



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In the above stochastic model, the variance is a CIR process that reverts to a long term
average value,

t
v , which itself varies stochastically. This long term average variance
also follows a mean reverting CIR process and the mean of this process is itself a
stochastic variable.

Link between DMR-SV Model and Buehlers Variance Curve Model
The DMR-SV model is closely related to the concept of Variance Curve models
introduced by Hans Buehler in 2006. The key idea is to get a spot stochastic volatility
model based on observable Variance Swap curves in the market.
A Variance curve the floating leg of a variance swap is observable in the market and
therefore, forward variance is observable from the variance swap curves. This can be
numerically approximated. From forward variance we can get the implied short
variance. By following an approach very similar to the Heath Jarrow Morton (HJM)
approach for modelling the forward interest rates Buehler derives implied spot volatility
from the forward variance. The beauty of Buehlers approach is to show that a
reasonable specification of variance swaps in the market is the key to modelling
stochastic volatility.
In the above DMR-SV model the calibration of the initial states along with both the
mean reversion speeds of the variance, as well as the long term average variance are
done by fitting a double linearly mean reverting variance curve functional to the
observed variance swap market data. This is where Buehlers Variance Curve model and
the techniques to estimate Variance Curve functionals come in.
28. Constant Elasticity of Variance (CEV)
A Constant Elasticity of Variance (CEV) process for an asset,
t
S , with a constant
volatility parameter, o , is given by:

t t t
dW S dt S dS
|
o + =
A parameter, | is important and it determines the nature of the distribution and it varies
from 0 to 1. For 1 = | we get the geometric Brownian motion (GBM), i.e a lognormal
process. For 0 = | we get an arithmetic Brownian motion, i.e. a normal process. For
2 1 = | , we get the Cox-Ross square root process.
29. SABR (Stochastic Alpha Beta Rho) Process
The stochastic alpha beta rho (SABR) model was introduced by Hagan, Kumar,
Lesniewski and Woodward in 2002. This model has mainly been used to model the short
rate and price interest rate derivatives (swaptions, caps, floors). SABR process is
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described by the following stochastic differential equations, one for the forward rate and
the other for the volatility of the rate.

2
1
t
t t t
dW d
dW F dF
qo o
o
|
=
=


dt dW dW
t t
=
2 1


In the above model the forward rate follows a CEV (constant elasticity of variance) type
process; however, the volatility, o , of the forward rate, is now stochastic and has a
volatility of volatility equal to q . Here, t dW
t t
o c = or in discrete form t W
t t
A = A c
The key feature of this model is that via the parameter, | , it can capture and preserve the
downward sloping shape of the volatility smile. Interest rate markets exhibit downward
sloping volatility smile and hence SABR is a good fit for modeling the short rates.

To implement SABR in Monte Carlo, we use Euler Discretization with Backward
Difference Method:


2 1 1 1
1 1 1
c o
c qo o o
t F F F
t
t t t t
t t t
A + =
A + =





30. Longstaffs Double Square Root Model

This model, which was originally proposed by Longstaff in 1989 for rates and by Zhu for
the variance process in 2000, is similar to the Hestons model for variance except that the
drift term has a mean reversion in volatility and not variance.


( )
2
1
t t t
t t
t
t
dW dt v k dv
dW v dt
S
dS
q u

+ =
+ =



dt dW dW =
2 1


Where,

u is the long term value (mean) of volatility of the asset.







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31. Stochastic Local Volatility (SLV) Process

In a Stochastic Local Volatility model we mix stochastic volatility with local volatility
models. In most stochastic local volatility model, volatility has the freedom to rise and
fall independent of the underlying spot.

One form of a stochastic local volatility process is given by:


( )
2
1
,
t t t
t
v
t t L
t
t
dW dt kv dv
dW e S dt
S
dS
t
q
o o
+ =
+ =


In this model, the second equation follows an Ornstein-Uhlenbeck log-variance process.

Ren, Madan and Qian (2007) have introduced a stochastic local volatility process given
by:


( )
( ) ( )
( )
kt
t
t t t t
t t t L
t
t
e
k
v
dW dt Z v k Z d
dW Z t S dt
S
dS
2
2
2
1
1
2
ln ln
,

+ =
+ =
+ =
q
q
o


dt dW dW
t t
=
2 1


In the above model, k is the speed of mean reversion and q is the volatility of volatility.
The long term drift,
t
v of
t
Z is deterministic and due to the last equation for
t
v , the
unconditional expectation of
2
t
Z is unity. The two Brownian motions,
1
t
dW and
2
t
dW are
corrected via the correlation coefficient, . Also, it is assumed that ( ) 1 0 = Z .

Ren, Madan and Qians model is important in one key aspect. In this model, there is an
independent stochastic component,
t
Z ,
t
Z is not the variance process, though it does
depend on the long term average variance,
t
v , which is given by the third equation above.
In this basic form, however, the two Brownian motions are not correlated.

- The asset price process, given by the first stochastic differential equation, almost
makes the asset price a local volatility process;
- The process of
t
Z gives a lot of freedom for volatility to move regardless of the
underlying asset prices move.

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32. Stochastic Local Volatility (SLV) / Bloomberg Model

Grigore Tataru and Travis Fisher at Bloomberg have proposed a model of asset prices
which combines the features of a stochastic volatility process and a local volatility
surface. Tataru and Fishers SLV process is given by:


( ) ( )
( )
dt dW dW
dW V dt V V k dV
dW V t S dt r r
S
dS
t t
t t t t t
t t t L f d
t
t

q
o
=
+ =
+ =

2 1
2
1
.
,


The above model is specifically tailored towards modeling FX rates and valuation of
barrier options. In the above process,
d
r and
f
r are domestic and foreign interest rates.

In the above model the first equation describes the process for the asset price,
t
S and the
second equation describes the process for stochastic volatility,
t
V , where,

t
V is the long
term average of the volatility, k , is the speed of mean reversion, q is the volatility of
volatility and ( ) t S
t L
, o represents the local volatility, which Tataru and Fisher call the
leverage surface. The asset price and the stochastic volatility processes are correlated
via the correlation coefficient, .

Important Aspects of the SLV Model

- In the above SLV model, if we make the volatility of volatility zero, i.e. 0 = q
then SLV model degenerates into a pure local volatility model. On the other hand

making the local volatility (leverage surface) equal to one, i.e. ( ) 1 , = t S
t L
o
recovers a purely stochastic volatility model.
- Since both local volatility and stochastic volatility is present in the model, there is
a mixing fraction, which is controlled by the volatility of volatility parameter, q .

33. GARCH Diffusion Process for Volatility

The GARCH diffusion model is the continuous-time limit of many GARCH-type
processes and in such a process volatility is modeled as a stochastic process given by:

( )
t t t t
dW dt b d qo uo o + =



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Where,
t
dW is a Weiner process given by: t dW
t
o c = and ( ) 1 , 0 ~ N c . The mean
reversion in the volatility process is captured by the constant drift parameters, b and u .
Since,u , has dimensions of inverse time, the parameter u 1 can be thought of as the
half-life of volatility.

Heston-Nandi(1997) has derived a degenerate case for the Heston(1993) stochastic
volatility process as a limiting case for a particular GARCH type process.

34. Mean Reverting Random Walk for Commodity Prices

Geman (2005) describes a mean reverting geometric Brownian motion that is quite
popular in modeling commodities space such as energy and agricultural commodities.
Here, mean reversion is introduced in a geometric Brownian motion (GBM), which is
very different from equity or FX processes. Due to the lognormal evolution the model
does not allow negative values for commodity prices

( ) dW dt S S k
S
dS
t
t
t
o + =

ln

Using the variables
t t
S G ln = and
t
rT
t
G e Y = we get

( )
t
kt kT
kt kT
t T
W
k
e e
e e
k
S Y Y
2 2
2 2 2

+
|
|
.
|

\
|
+ =

o
o



35. Gibson & Schwarz (1990) Stochastic Convenience Yield Process

The forward price of the commodity (Oil), at time, t for a contract maturing at t time, T
is related to the spot price by:

( ) ( )
( )( ) t T y r
e t S T t F

= ,

Where, r is the continuously compounded interest rate prevailing at t , for maturity, T
and y is convenience yield on the commodity. Gibson and Schwarz (1990) present the
following two factor model for pricing of contingent claims on Oil is given by:


( )
2
2
1
1
t t t
t
t
t
dW dt y k dy
dW dt
S
dS
o u
o
+ =
+ =


dt dW dW
t t
=
2 1
.
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The rationale for a stochastic process for convenience yield is the realization, based on
theoretical and empirical findings by the authors, that a key factor impacting the
relationship between the spot and futures commodity prices is the convenience yield.

A Note on Convenience Yield

- Convenience yield can be defined as a benefit that accrues to the owner of the
physical commodity but not to the holder of a forward contract (Kalder(1939)
and Working (1948, 1949)). The analogy here is with the dividend yield which is
paid to the owner of a stock but the owner of a derivative contract on the same
stock does not benefit from it (Geman (2005)).
- Convenience yield can be viewed as an embedded timing option attached to the
commodity since the inventory, like a gas storage facility, gives us the flexibility
to put the commodity in the market depending on whether the prices are high or
low (Geman (2005)).
- In the stochastic models of commodity, the convenience yield is expressed as a
rate. It is defined as the gain on a physical commodity less the cost of storage
(Geman (2005)).

36. Two Factor Model for Oil Prices

Eydeland & Geman (1998) have proposed a Heston type stochastic volatility model for
commodities, especially to model gas or electricity prices. There is mean reversion in the
spot price which follows a GBM. The volatility of the asset (commodity) follows a mean
reverting CIR process (Heston) and is correlated to the underlying commodity price
process.


( )
( )
dt dW dW
dW v v v dv
dW dt S k
S
dS
t t
t t t t
t t t
t
t

q
o u
=
+ =
+ =

2 1
2
2
.
ln


Where, ( ) t
t
o o = and ( ) ( ) | |
2
t t v v
t
o = =

37. Dynamics of Forward Price and Valuation of Commodity Derivatives

Many top banks who are important players in the commodity derivatives market value
these derivatives using a two factor or three factor PCA model. Using Principal
Components Analysis (PCA) which is done using Eigensystem decomposition of a
covariance matrix of forward rates one can identify the most important risk factors that
impact a commodity forward rate.


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Keeping the geometric Brownian motion (GBM) framework assuming a varying
volatility in time t and T many practitioners have proposed a model of the forward rate
as (see 43):


( )
( )
( )
motions Brownian W
factors risk of number N
dW T t
T t F
T t dF
i
t
N
i
i
t i
:
:
,
,
,
1

=
= o


The risk factors are identified through Principal Components Analysis (PCA) of the
forward curve / futures.

Financial Engineering Associates (FEA) Model for PCA

In particular, we look at the model proposed by Carlos Blanco, David Soronow & Paul
Stefiszyn of FEA in 2002.


( )
( )
( )
(
(

+

=
= =
N
j
N
j
j j ij j ij
t c t c
e
t F
t dF
1 1
2
2
1
c o o


The discretized version of the above continuous time stochastic equation is

( ) ( ) ( )
(

A + A = A +
= =
N
j
N
j
j j ij j ij
t c t c t F t t F
1 1
2
2
1
exp c

PCA is done on the covariance matrix of the forward curve / futures. After that the factor
scores and factor loadings are calculated. In the above, s denote the factor scores andc
s denote the factor loadings.Then the forward price is simulated using the continuous
time GBM framework shown above

38. Joint Mean Reverting Model of Spot and Forward for Commodities

In the same paper referenced above (see 63), Carlos Blanco, David Soronow & Paul
Stefiszyn discuss a stochastic process that models the joint mean reverting movements of
the spot and the forward price of a commodity.


( ) ( )
( ) | |
s
t t s
dW dW t dt
F
t S
a
F
t S
Log d
2 1
1 1
1 log o + +
(

=
(

)
`





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Where,


1
F : prompt moth forward price
a : spot mean reverting rate
: correlation between the spot and the prompt month
o : volatility of the spot price at time, t


39. Stochastic Correlation Process

In a stochastic correlation process the correlation between asset returns vary randomly
within the boundary 1 1 < < . The stochastic correlation never crosses the +1 or -1 on
either side of the boundary but within this boundary it varies randomly.

( ) ( )( )
t t t t t
dW dt k d o + + =

1 1



The stochastic correlation is modeled as a Jacobi process which is bounded between two
limits. If
t
X is a random variable that follows a Jacobi process then the process is
described by

( ) ( )
t t t t t
dW X X c dt bX a dX + = 1

Where, a , b , and c are constants and
t
dW is a Weiner process. If we transform
t
X as:

1 2 =
t t
X

Where,
t
is the correlation then we can retrieve the above stochastic correlation
process. However, the process imposes the following constraint for the correlation not to
breach the bounds:

1 1
2 2
> >

k k
o

o


40. Mixture of Normals / Gamma Process


Here, we follow the arguments presented in T.W. Epps. Understanding this process can
be a very good precursor to understanding the Variance Gamma process, explained later.
This process is the mixture of Normals which can also explain excess kurtosis. We
assume that the asset price,
t
S , follows a discrete time stochastic process of the kind
shown below.
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t v S S dS
t
t
t t t
A + = =
+

c
o 1 ln ln
1


If we make a transformation as:
t
t t
v
Z

c = , the above equation will reduce to:


t Z
v
v
S S
t t t
A

+ + =
+
1
ln ln
1
o


Where,
t
c is a Normal variable, that is a random number drawn from a Normal
distribution with mean 0 and unit variance, i.e., ( ) 1 , 0 ~ N
t
c and
t
is i.i.d. gamma
variable (gamma distribution) independent of
t
c . The shape parameter of the gamma
variables is v , with 1 > v and unit scale.

The above formulation gives a symmetric probability distribution for
t
dS with a mean of
and a standard deviation of o . In this model the excess kurtosis the fat tails is
inversely related to the parameter, v . The log of stock price is distributed as
( )
|
|
.
|

\
|
t
v
N

1
,
2
, conditional on
t
. This is a mixture of Normals where the inverse
variance is distributed as gamma distribution.

41. Variance Gamma (VG) Process

Here, we follow the line of reasoning and arguments of Madan, et al (1998) as well as
those of Riccardo Rebonato as outlined in his Volatility and Correlation. We also, follow
the explanation of Damanio Brigo and others in their excellent tutorial A Stochastic
Processes Toolkit for Risk Management and the working paper by Michael C. Fu,
Variance Gamma and Monte Carlo.

Variance Gamma (VG) process as a stochastic stock price model was first proposed by
Dilip Madan and E. Seneta in 1990. A Variance Gamma process is a stochastic process
that is characterized by a drift parameter, a volatility parameter of the Brownian motion,
and a variance parameter of the subordinator.

The VG process, where a Brownian motion is time changed via subordinator (process),
explains the following quite well:

- Fat tails
- Frequent small jumps and infrequent large jumps in the asset price

VG process belongs to the family of Levy processes (see the definition of Levy process
earlier in this chapter). It is a pure jump process
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The Need for a Variance Gamma (VG) Process

It is observed in real life that rather than following a purely diffusive process like a
geometric Brownian motion, asset prices follow a diffusive process which has jumps in
it. It is observed that there are sizable jumps that occur over the path of the asset price.
These jumps are casued due to the arrival of news and information, including financial
news, in the market. Small pieces of news and information arrive quite frequently in the

market causing frequent jumps. Big news and large pieces of information are rare and
therefore they arrive infrequently in the market. This leads to small frequent jumps and
large infrequent jumps in the asset prices over a particular time period. With the
exception of interest rates, this fact is well borne out by almost all other asset markets
such as equity, FX and commodities. Therefore, we need a mathematical model which
can incorporate this fact of life in financial markets.

Another way of looking at the above is to note that perhaps economic time does not
have uniform speed due to the impact of unpredictable news and information which
arrives in market. As we move forward the flow of time accelerates or decelerates in a
random manner. Time change therefore should become a key feature of a stochastic
asset price model.

What is so Unique about a Variance Gamma Process?

In most of the stochastic processes volatility is intricately linked to randomness. In a
GBM or ABM, volatility, even though constant, is tied to the Weiner process, in GARCH
stochastic process, even though conditional volatility is not random, the unconditional
volatility is random; in stochastic volatility model volatility is itself a random process. In
other jump diffusion models, jumps add new source of randomness over and above the
Weiner process. However, in all these processes the flow of time is not changed.

In a VG process, however, financial time is made random via a new process called the
subordinator. Here, the financial time or the market activity time gets randomly
transformed from calendar time.

Concept of the Variance Gamma Process

We start with a standard Brownian motion that explains a pure diffusive process, with
constant or deterministic volatility:

( ) ( ) t W t t B o o + = , ;

Note, that in the above, we have altered the flow of flow of time in a purely deterministic
manner via a constant volatility, o . However, in a Variance Gamma setting we have to
move one step further and specify a time change process that is stochastic. This is

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because of the uncertain arrival of news and information that induces jumps and alters the
flow of time in an uncertain manner. As Rebonato explains, this is accomplished by
introducing the condition that a Brownian motion should be evaluated at a particular time
by a gamma process, , with unit mean rate and a variance equal to v , i.e. ( ) v t
t
, 1 , = .

This gives us a process,
t
X , which is a kind of Levy process given by:


t
W B X
t t t
u + = ' =


This new stochastic process,
t
X , is the Variance Gamma (VG) process. A key
observation to make here is that the stochastic time is present in both the drift term as
well as the stochastic term.

Distinguishing features of a VG Process

The following are the distinguishing features of a VG process

(i) The variance gamma process (VG) is a Lvy process and is characterized by a
random time change.
(ii) There diffusion component in the VG process is absent and it is instead a pure jump
process.
(iii) The increments are independent and follow a Laplace distribution.


Difference between Brownian motion and the Variance Gamma (VG) Process

A Levy process is a kind of a generalized stochastic process which has independent and
stationary increments. These increments are given by independent and identically
distributed random numbers. Both the Brownian motion and the Variance Gamma (VG)
process are Levy Process. In a standard Brownian motion (also known as a Weiner
process), the mean of these stochastic increments is zero and the variance is proportional
to the size of the increment. If ( )
2
,o N denotes a Normal (Gaussian) distribution with
mean, , and standard deviation, o , then we can write a Weiner process as:

( ) ( ) ( ) ( ) t N t W t t W t dW A A + = , 0 ~

In a Gamma process, the stochastic increments are gamma distributed and if ( ) | o, I is a
gamma distribution with mean, o| and variance,
2
o| then the process is given by:

( ) ( ) ( ) ( ) 1 , ~ t t t t t d A I I A + I = I


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Given the above definition of a Gamma process a VG process can be characterized in two
alternative ways:

(i) It can be thought of as a time-changed, subordinated Brownian motion, where
the subordinator is a gamma process.
(ii) A VG process can be thought of as a difference of two gamma processes.


Math Model for VG and Monte Carlo Simulation

Simulating VG as a Stochastic Differential Equation

Following the arguments used by Brigo, et al, if we consider a time changed Brownian
motion with mean, and volatility, o and u another constant then we can write the
stochastic differential equation for an asset price,
t
S , which follows a VG process as:

( ) ( ) ( ) ( ) t g dW t dg dt S d
t
o u log + + =

Where, ( ) . dW is a modified Weiner process. The only way that the above SDE differs
from a standard Brownian motion is that it contains the term ( ) t g , which, in probabilistic
term, is known as a subordinator. This term characterizes the market activity time. The
market activity time, ( ) t g , is a positive increasing random process where
( ) ( ) | | s t s g t g E = . This reconciles the market activity time with the real time between
the time, t and s .

( ) ( ) ( ) ( ) ( ) ( ) ( )
t
s g t g s g W t g W c o o ~

Where,
t
c , is a random normal number drawn from a Normal (Gaussian) distribution
with mean 0 and standard deviation of 1, i.e. ( ) 1 , 0 ~ N
t
c .

Finally, VG model assumes, that the process ( ) t g is related to the Gamma process as
( )
|
.
|

\
|
I v
v
t
t g , ~ , v being the variance of the gamma process. Here, the increments are
independent and stationary random variables drawn from a gamma distribution.

Simulating VG as a Stochastic Integral Equation

Take a Brownian motion,
t
B (which is a Weiner process,
t
W plus a deterministic drift,
) given by:


t t
W t B o + =
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In the above equation, q r = , where, r is the risk free rate and q is the dividend yield
of the asset. Thereafter, we construct VG as Levy process,
t
X , that characterizes a time
changed Brownian motion with three parameters, the drift of the asset , the volatility of
the asset, o and a constant u given by:


t
W B X
t t t
o u + = ' =

Where,
t
, is a gamma process with unit mean and a variance parameter, v . Then the
equation for the asset price,
t
S , with risk free interest rate, r , and dividend yield q , will
be given by


( ) ( )
t
X t q r
t
e S S
+ A +
=
e
0


Where, e , is a constant that makes the discounted asset price a martingle measure and is
related to the characteristic function of the Levy process. This is the equation we would
use to simulate the asset price.

In the above equation, e is given by:


( ) 2 1 ln
1
2
v o uv
v
e =


42. Displaced Diffusion Model

Displaced diffusion model for asset prices was introduced by Rubinstein in 1983.

If
t
S is the asset price at time, t then in a displaced diffusion process, the quantity o +
t
S
follows a geometric Brownian motion, where, o is a constant.


( )
t
t
t
dW
S
S d
o o
o
o
o
+ =
+
+



o
and
o
o are the drift and the volatility of the process, o +
t
S .

Advantages

- Its extremely simple to model
- The process can be made to mimic a Constant Elasticity of Variance (CEV)
process while retaining the analytical properties of a geometric Brownian motion.

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- A closed form solution, similar to the Black-Scholes formula, can be found out
easily.
- A displaced diffusion process may be quite suitable to model inflation and
therefore can find use in valuation of inflation derivatives;

Disadvantages

- Whereas, the quantity o +
t
S , which follows a GBM in guaranteed to be positive,
there is no guarantee that the asset price,
t
S , will be positive. In this process,
t
S ,
is bounded in the range | | + , o .

43. Simplified Libor Market Model
(Single factor with Lognormal interest rates)

We assume that spot LIBOR,
t
L is stochastic and follows a lognormal distribution, i.e. a
geometric Brownian motion of the type:


t L L
t
t
dW dt
L
dL
o + =


However, instead of the above SDE, we use the stochastic integral equation for the GBM
to model stochastic LIBOR. Also, we assume that LIBOR diffuses over the time interval
| | T t, . Therefore,

( )
|
|
.
|

\
|
+ |
.
|

\
|

=
t l L L
t T T T
t T
e L L
c o o
2
2
1


Here,
L
o is the LIBOR volatility which could be calibrated to caplet volatilities and
L
is
the drift of the LIBOR. Also, we assume that the forward LIBOR rates are not correlated
with each other.

Given the fact that LIBOR has a well defined, observable forward curve at all points, the
drift of the LIBOR rate is given by:


|
|
.
|

\
|
=
F
t
F
T
L
L
L


Substituting the above in the equation for LIBOR above and doing some algebraic
manipulation we get the equation for LIBOR as:




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|
.
|

\
|
+
|
|
.
|

\
|
=
t L L
t T
F
t
F
T
t T
e
L
L
L L
c o o
2
2
1

In the above equation,
t
c is a random number drawn from a Normal distribution with
zero mean and unit standard deviation.
44. Homogenous Poisson Process

This is a process for modeling stochastic time. A homogeneous Poisson process is a
continuous-time stochastic process{ } 0 : > t P
t
with an intensity rate), , such that 0 >
with the following conditions:

(i)
t
P is a point process,
(ii) the times between events are i.i.d. (random variables) with an exponential
distribution, i.e. exponential with mean .

1
.

A Poisson process with a parameter, ( 0 > ) can be defined as an integer-valued,
continuous time stochastic process { } 0 : > t P
t
such that the following conditions hold:

(i) ( ) 0 0
0
= = P P ;
(ii) For all values of time,
n
t t t t < < < < ......
2 1 0
, the increments,
t
dP given by
( ) ( )
0 1
t P t P , ( ) ( )
1 2
t P t P , .., are independent random variables;
(iii) For 0 > t , 0 > t and non-negative integers m, the increments have a Poisson
distribution given by: ( ) ( ) | |
( )
!
Pr
m
e t
m P t P
t m

t t

= = +














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How to do Monte Carlo Simulation for Single Asset Options and
Financial Derivatives:

(i) Generate uniform random numbers, ( ) 1 , 0 e u between 0 and 1. In Excel the
library function for u is =RAND()
(ii) Transform these uniform random numbers to random normal numbers,
t
c where
( ) 1 , 0 ~ N
t
c , i.e. random numbers drawn from a Normal (Gaussian) distribution with
zero mean and unit standard deviation. In Excel the library function for
t
c is
=NORMSINV(RAND()).
(iii) Simulate asset price paths using the relevant Stochastic Differential Equations (SDE)
or Stochastic Integral Equations (SIE) for a particular model. Choose the time

interval, t A , as daily or weekly or monthly (as the case may be) and the simulation
will run from 0 = t (today) until T t = (252th trading day, the 12
th
month, end of
year, etc.). If there are n number of iterations (i.e. the number of asset paths) then
the terminal (final) value of the asset for the th i path would be given by
T i
S
,
.
(iv) Since volatility is usually quoted in annualized term, remember to convert the
volatility, o , in the SDE or SIE into the relevant time interval terms. For example if
o is quoted in annualized percentage and if the time interval for the simulation is
daily then we have to multiply o by 252 1 .
(v) For each iteration calculate the payoff of the derivate from that asset price path. The
payoff of the derivative for the th i path ( th i iteration) would be given by
T i
P
,
. For
example, if we are finding the value of a vanilla Call Option whose payoff at
maturity is given by: ( ) 0 , max K S payoff Call
T
= , then for the th i path the
payoff would be: ( ) 0 , max
, ,
K S P
T i T i
= .
(vi) Discount each payoff with the risk free rate, r , from the maturity T to the valuation
date of the derivative, i.e. today (or 0 = t ).
(vii) Take the average of all the discounted payoffs to get the Monte Carlo value. For n
iterations (i.e. n sample asset paths) the Monte Carlo value will be given by:

=
n
i
T i
rT
P e
n
P
1
,
1









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Multi-asset Stochastic Processes
Cholesky and Eigensystem Decomposition

How to factor Correlation in a Monte Carlo Simulation

Given two or more than two stochastic processes (for two more assets in a basket) like the
following:


( )
( )
dt dW dW where
dW dt q r
S
dS
dW dt q r
S
dS
t t
t
t
t
t
t
t

o
o
=
+ =
+ =
2 1
2
2 2 2
, 2
, 2
1
1 1 1
, 1
, 1
,


The correlation, , between the two Weiner processes (assets) can be incorporated in the
model either using the Cholesky decomposition or the Eigensystem decomposition.

Monte Carlo Simulation Algorithm (using Cholesky Decomposition)

1. Generate a set of uncorrelated random numbers, , ( )
k
c c c ......, , ,
2 1
from a Normal
distribution with mean zero and standard deviation of one, where k denotes the
number of assets and ( ) 1 , 0 ~ N
k
c .

2. Given a correlation matrix, M for the asset returns, estimate the Cholesky Matrix, A,
from this correlation matrix.

3. Generated correlated random numbers using the Cholesky matrix as shown below:



|
|
|
.
|

\
|
|
|
|
.
|

\
|
=
|
|
|
.
|

\
|
=
k kk k
k
k
a a
a a
z
z
A Z
c
c
c

1
1
1 11 1


4. If using stochastic differential equations (SDE) to model asset price paths and/or
volatility or variances, then transform these stochastic differential equation (SDE) into
Difference equations;



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5. Use the set of correlated random numbers, ( )
k
z z z ,....., ,
2 1
to generate correlated asset
price paths by inputting them in the stochastic differential equation (SDE) or the
stochastic integral equation for the asset prices and/or the volatility process.

Monte Carlo Simulation Algorithm (using Eigensystem Decomposition)

1. Generate a set of uncorrelated random numbers, , ( )
k
c c c ......, , ,
2 1
from a Normal
distribution with mean zero and standard deviation of one, where k denotes the
number of assets and ( ) 1 , 0 ~ N
k
c .
2. Given a correlation matrix, M for the asset returns, estimate the Eigenvector Matrix,
W of the correlation matrix and the Eigenvalues, , corresponding to the Eigenvector
matrix, .
3. Correlate the random numbers using the Eigensystem transformation


|
|
|
.
|

\
|
|
|
|
|
.
|

\
|
|
|
|
.
|

\
|
=
|
|
|
.
|

\
|

A =
k k kk k
k
k
w w
w w
z
z
W Z
c
c

1 1
1
1 11 1
0
0


4. If using stochastic differential equations (SDE) to model asset price paths and/or
volatility or variances, then transform these stochastic differential equation (SDE) into
Difference equations;
5. Use the set of correlated random numbers, ( )
k
z z z ,....., ,
2 1
to generate correlated asset
price paths by inputting them in the stochastic differential equation (SDE) or the
stochastic integral equation for the asset prices and/or the volatility process.

Explanation of the Special Matrices and Transformations

Given a correlation matrix, M , as follows

Correlation Matrix =
|
|
|
.
|

\
|
=
nn n
N
M

1
1 11


And, the corresponding Cholesky matrix and the Eigensystem of the Correlation matrix as
following:





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Cholesky Matrix =
|
|
|
.
|

\
|
=
nn n
n
a a
a a
A

1
1 11


Eigenvector Matrix =
|
|
|
.
|

\
|
=
nn n
n
w w
w w
W

1
1 11


Eigenvalues (scalar) = ( )
n

1



Lambda Matrix =
|
|
|
.
|

\
|
= A
n

0
0
1

Square Root Lambda Matrix (Diagonal matrix) =
|
|
|
|
.
|

\
|
= A
n

0
0
1


Uncorrelated Random Normal Numbers = ( )
n
c c c
1
=

Correlated Random Normal Numbers = ( )
n
z z Z
1
=


1. Definition of Transpose

For any arbitrary, square matrix (rows equal to columns), Transpose operation flips the
rows into columns and columns into rows. For a square matrix, X , the transpose is
written as
T
X . As an example, the transpose of a 2 2 matrix is shown below



|
|
.
|

\
|

=
|
|
.
|

\
|
=
0 1
1 2
0 1
1 2
T
X X






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2. Cholesky Transformation

If M is an n m square correlation matrix, such that, n m = , and if A is an arbitrary
matrix of same dimension as the correlation matrix then Ais called the Cholesky
matrix if the following relationship is satisfied:

M AA
T
=


Note that M has to be a valid correlation matrix, i.e. it has to be positive semi-definite
for the Cholesky matrix, A, to exist. This means all eigenvalues of M should be
positive.

3. Cholesky transformation

If we have a vector of independent random normal numbers (that is, random numbers
drawn from a Normal distribution with mean 0 and standard deviation 1), given by
1
c ,
2
c , ..,
n
c representing the asset returns and if a correlation matrix, M , of asset
returns exist with a corresponding Cholesky matrix given by, A, then the vector of
correlated random normal numbers,
1
z ,
2
z , ..,
n
z are given by the following
transformation:

c A Z =

Or, writing the above matrix equation in expanded form, we get:


|
|
|
|
|
.
|

\
|
|
|
|
|
|
.
|

\
|
=
|
|
|
|
|
.
|

\
|
n nm n n
m
m
n
a a a
a a a
a a a
z
z
z
c
c
c

2
1
2 1
2 22 21
1 12 11
2
1


For a two asset case, we get a Cholesky transformation as:



2 22 1 21 2
2 12 1 11 1
2
1
22 21
12 11
2
1
c c
c c
c
c
c
a a z
a a z
a a
a a
z
z
A Z
+ =
+ =
|
|
.
|

\
|
|
|
.
|

\
|
=
|
|
.
|

\
|

=


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Closed Form Solution for the 2 2 Cholesky Matrix


|
|
.
|

\
|

=
|
|
.
|

\
|
=
2
22 21
12 11
1
0 1
a a
a a
A

4. Cholesky transformation for 3 (three) assets case

Using the same notations and definitions as above, we get, for a three asset case:


3 33 2 32 1 31 3
3 23 2 22 1 21 2
3 13 2 12 1 11 1
3
2
1
33 32 31
23 22 21
13 12 11
3
2
1
c c c
c c c
c c c
c
c
c
c
a a a z
a a a z
a a a z
a a a
a a a
a a a
z
z
z
A Z
+ + =
+ + =
+ + =
|
|
|
.
|

\
|
|
|
|
.
|

\
|
=
|
|
|
.
|

\
|

=



Closed Form Solution for the 3 3 Cholesky Matrix


( )
|
|
|
|
|
|
|
.
|

\
|

=
|
|
|
.
|

\
|
=
2
12
2
14 12 23 2
13
2
12
13 12 23
13
2
12 12
33 32 31
23 22 21
13 12 11
1
1
1
0 1
0 0 1


a a a
a a a
a a a
A


5. Eigensystem Decomposition

If M is square matrix of correlation of asset returns, W is a square matrix of
eigenvectors of the asset correlation matrix and A is a diagonal matrix where all
elements of the diagonal are the eigenvalues of the correlation matrix then the
following transformation holds:

M W W
T
= A

Note that W and Ahave the same dimension as M
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6. Eigensystem decomposition for Two Asset case

Using the same notation and definition as above we get for a two asset case:


|
|
.
|

\
|
|
|
.
|

\
|
=
|
|
.
|

\
|
|
|
.
|

\
|
|
|
.
|

\
|
=
|
|
.
|

\
|

A =
2
1
2 22 1 21
2 12 1 11
2
1
2
1
22 21
12 11
2
1
0
0
c
c


c
c

c
w w
w w
w w
w w
z
z
W Z


Expanding as a system of linear equations


2 2 22 1 2 21 2
2 2 12 1 1 11 1
c c
c c
w w z
w w z
+ =
+ =


7. Eigensystem decomposition for 3 (three) assets case


|
|
|
.
|

\
|
|
|
|
|
.
|

\
|
=
|
|
|
.
|

\
|

|
|
|
.
|

\
|
|
|
|
|
.
|

\
|
|
|
|
.
|

\
|
=
|
|
|
.
|

\
|

A =
3
2
1
3 33 2 32 1 31
3 23 2 22 1 21
3 13 2 12 1 11
3
2
1
3
2
1
3
2
1
33 32 31
23 22 21
13 12 11
3
2
1
0 0
0 0
0 0
c
c
c



c
c
c

c
w w w
w w w
w w w
z
z
z
w w w
w w w
w w w
z
z
z
W Z


8. Cleaning a Correlation Matrix of Asset Returns

Many a times correlation matrices generated from historical data are nonsensical. What
does this mean? It means that the correlations between a pair of asset returns is unstable,
or is not correct. Sometimes you may hear risk managers talking about spurious
correlations. It is quite likely that the correlations between two return series may have
been drawn from different time periods (dont be surprised!!) so even if the length of the
series is same the exact trading dates could be different. Or some correlations may have
been invented, meaning certain return assumptions have been made to fill in a certain
empty block of dates (where no prices exists).

A nonsensical correlation matrix or an unstable or an invalid correlation matrix
cannot be used in any risk management calculations or multi-asset pricing. Why? Because
the cholesky of the matrix does not exist (if you are using an Excel sheet to get the output
of a cholesky matrix from the original matrix youll see: #Value in the output matrix
cells). This means the correlation matrix is not positive semi-definite and it contains

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negative eigenvalues. A nonsensical correlation matrix needs to be cleaned before it can
be used for either derivatives pricing or risk analysis.

How do we know that a correlation matrix is nonsensical or invalid?

If the cholesky matrix does not exist for any correlation matrix then it is not a valid
correlation matrix. A nonsensical or invalid correlation matrix will have at least one
negative eigenvalue. We say that the correlation matrix is not positive semi-definite. All
workable, valid correlation matrices should be positive semi-definite. A positive semi-
definite matrix has all its eigenvalues as positive. A n x m correlation matrix has 1 x m
vector of eigenvalues. If any one of them is negative then the correlation matrix is invalid.
Alternatively, the cholesky of the correlation will not exist. Moreover, a quick and dirty
way to see if the correlation matrix is going to be valid or not is to check the determinant
of the matrix. If the determinant is negative then the cholesky will not exist and the
correlation matrix will not be positive semi-definite. If the determinant of a correlation
matrix is negative then you are in trouble. Then we need to clean a correlation matrix to
make it a valid one.

How do we make a nonsensical correlation matrix valid?

How do we clean an invalid correlation matrix? Essentially, we need to get a correlation
matrix that is positive semi-definite and if a certain correlation matrix is not positive semi-
definite then we need make it positive semi-definite and we use eigenvectors and
eigenvalues to do that. Here is a brief and approximate (but workable) algorithm to clean a
correlation matrix and make it positive semi definite.

1. After calculating the eigenvalues of the correlation matrix, youll find at least one of
the eigenvalues as negative;
2. Set the negative eigenvalue(s) as zero; This gives a new row vector of eigenvalues;

3. Arrange the new vector of eigenvalues as a diagonal matrix; This is the lambda
matrix;
4. Then perform the following matrix operation using the lambda matrix and the
existing eigenvectors matrix:
1
AW W

Remember that one can retrieve the any correlation matrix M by using the following
matrix transformation:


1
A = W W M
Where, W is the n x m matrix of eigenvectors of the correlation matrix and A is the
diagonal matrix of eigenvalues of the correlation matrix.



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Example:

Say we had a correlation matrix M of four asset returns (a real life example) as follows:


|
|
|
|
|
.
|

\
|




=
1 128 . 0 047 . 0 005 . 0
128 . 0 1 670 . 0 860 . 0
047 . 0 670 . 0 1 990 . 0
005 . 0 860 . 0 990 . 0 1
M


This correlation matrix is not a valid correlation matrix. If you calculate the determinant of
this matrix (we can do that very easily in Excel spreadsheet) it will come out to be -
0.02652. That is 02652 . 0 = A . If we were to estimate the cholesky of this matrix
(which can also be done very easily in Excel spreadsheet, we will get #Values for all the
cells of the decomposed matrix. A quant will save himself a lot of time if he performs this
operation first to check if the correlations are valid or not. Thus using PCA we need to
clean this matrix to make it valid.

The eigenvectors of the above correlation matrix are:


|
|
|
|
|
.
|

\
|


=
981 . 0 187 . 0 014 . 0 023 . 0
139 . 0 777 . 0 286 . 0 542 . 0
117 . 0 585 . 0 560 . 0 574 . 0
050 . 0 132 . 0 777 . 0 613 . 0
W


And the eigenvalues of the correlation matrix are:

( ) 024 . 1 318 . 0 030 . 0 687 . 2

So the second eigenvalue of the correlation matrix is negative. This is what makes the
correlation matrix invalid. Now to clean the correlation matrix and retrieve a valid matrix
we set this second eigenvalue to zero in the above vector. Then the new vector of
eigenvalues will be:

( ) 024 . 1 318 . 0 0 687 . 2

Then create a diagonal matrix of these eigenvalues, lambda matrix, and perform the
following matrix operation:







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1
1
981 . 0 187 . 0 014 . 0 023 . 0
139 . 0 777 . 0 286 . 0 542 . 0
117 . 0 585 . 0 560 . 0 574 . 0
050 . 0 132 . 0 777 . 0 613 . 0
024 . 1 0 0 0
0 318 . 0 0 0
0 0 0 0
0 0 0 687 . 2
981 . 0 187 . 0 014 . 0 023 . 0
139 . 0 777 . 0 286 . 0 542 . 0
117 . 0 585 . 0 560 . 0 574 . 0
050 . 0 132 . 0 777 . 0 613 . 0

|
|
|
|
|
.
|

\
|

|
|
|
|
|
.
|

\
|

|
|
|
|
|
.
|

\
|


= '
A' = '
M
W W M


This gives us the new valid correlation matrix M' as:


|
|
|
|
|
.
|

\
|




= '
1 128 . 0 047 . 0 005 . 0
128 . 0 1 674 . 0 853 . 0
047 . 0 674 . 0 1 977 . 0
005 . 0 853 . 0 977 . 0 1
M


Thus the new (modified) but valid correlation matrix is only slightly different from the
original correlation matrix. This is a coincidence (and an actual real life case). Sometimes,
the difference between the new correlation matrix and the original one could be
significant. If you now calculate the determinant of this matrix youll find it very close to
zero but still retains a positive value (a very small positive value).

Excursions in the Abstract Space
Quantum Random Walk Could this explain a Black Swan?

On 15
th
September 2008 as Lehman Brothers, the 150 years old venerable Wall Street
investment bank, was filing for bankruptcy I sat before a group of market risk quants at
WestLB bank in Tokyo running a Monte Carlo simulation code to value some exotic
equity structured notes. By mistake, one of the trainees had forgotten to multiply the daily
volatility by square root of 252 days to convert it into annualized volatility. He had simply
multiplied it by 252 days (forgotten the square root part) and gotten an absurdly high
annualized volatility of around 100%.

It was then that one of them jokingly of course, about the Lehman Walk, when
absurdly high volatility appeared out of nowhere to cause havoc on a system. And while
the Monte Carlo code kept running to complete a million iterations, we took a wild
excursion in the abstract space and discussed how would such a walk look like?

One of the ideas that we bounced around was: what if the volatility of an asset did not
scale with the square root of time but with time itself? What if the random walk did not
converge to any limiting distributions? What, if via some tunneling mechanism an asset
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reaches a state, say, an absorbing state, at an exponential speed? Unwittingly, and by
accident, we had entered into the space of what is known as a Quantum Random Walk.
A quantum random walk is the equivalent of a classical random walk (Brownian motion
without a drift) in the quantum mechanical space of sub-atomic particles.

In a classical world of finance, asset prices, such as stocks, currencies, commodities,
interest rates, etc. are modeled using a geometric or an arithmetic Brownian motion
which are known as classical random walks very similar to the ones used in statistical
mechanics whereby the Laplacian operator
2
V is the classical diffusion operator
(diffusion equation) which produces a characteristic Brownian motion signature where the
distance, d is proportional to the square root of time: time d .

When the classical random walk hypothesis is applied to financial markets and asset
prices, this translates into a theorem that states that volatility of an asset price scales with
the square root of time. If one day volatility of a stock is 1% then one year (252 days)
volatility will be % 87 . 15 252 * % 1 = . So the classical diffusion process classical
random walk produces the following signature: time volatility .

In 1965 Richard Feynman had introduced a random walk process that was predicated on
Dirac equation in the one dimensional case. However, to this day, this remains a new
theory, even within the sphere of quantum mechanics and quantum computing. But a
quantum random walk displays certain very interesting characteristics and maybe, it is
better suited to describe the properties of asset price diffusion process in the financial
markets.

In relativistic quantum mechanics the Dirac equation uses a different diffusion operator
that produces a signature of distance, d , that is proportional to time: . time d Due to this
property, where the distance traveled by the random variable in a quantum random walk is
proportional to the time, instead of the square root of time as in a classical random walk,
for particular absorbing points quantum walks could become significantly faster than their
classical counterpart.

Applied to financial assets this could mean that volatility scales with time, instead of
square root of time as in a classical walk. Thus time volatility . In this scheme of things
a 1% daily volatility would translate into a 252% annualized volatility: % 252 252 * % 1 = .
A key property of a quantum random walk is that the standard deviation of the random
variable is ) (t O whereas in a classical random walk, the current model being applied to
financial assets, the standard deviation is of order ( ) t O . Therefore, a quantum random
walk propagates quadratically faster. Also, the position probability distribution of a
quantum random walk depends on the initial quantum state as opposed to a classical
random walk.


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In a quantum random walk, a walker say, an asset such as a stock or a currency pair
may be in a superposition of positions and because of quantum interference the walk
may spread significantly faster, or even slower at times, than its classical equivalents.
Further, quantum random walks are unitary and reversible and in a single dimension the
hitting time is quadratically faster; on an n-dimensional hypercube the speed up in the
hitting time is exponential.

Could this then be the appropriate model of financial assets? Should the entire stochastic
framework of asset pricing for financial derivatives then be predicated on Quantum
Random Walk rather than a Classical Random Walk? Perhaps, then it would be easier to
explain a Lehman bankruptcy, a Madoff blowup or any of those seemingly Black Swan
events?

































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Chapter E
Financial Products &
Product Engineering (Structuring)


1. Call Option

A regular call option, also known as the plain vanilla call option, gives the buyer the
right to buy the underlying asset at maturity,
T
S at a pre-determined price, K , known
as the strike price. It is a right and not an obligation. If intrinsic value of the call
option is given by the asset price less the strike price then a call option payoff at
maturity can be expressed as the maximum of the intrinsic value of the option and
zero.

( ) 0 , max K S Call
T
=

2. Put Option

A regular put option, also known as the plain vanilla put option, gives the buyer the
right to sell the underlying asset at maturity,
T
S at a pre-determined price, K , known
as the strike price. It is a right and not an obligation. If the intrinsic value of a put
option is defined as the strike price less the asset price then a put option payoff at
maturity can be expressed as the maximum of the intrinsic value and zero.

( ) 0 , max
T
S K Put =


3. Straddles

A straddle is portfolio of one at the money (ATM) call option and ATM one put
option with the same maturity. At the money (ATM) signifies that the spot is equal to
the strike price. Equal weightings of ATM calls and puts options with same maturity
are used to construct straddles. Straddles are bets on volatility. A long straddle tends
to profit from increasing volatility and a short straddle tends to benefit from falling
volatility.

4. Zero Beta Straddle

An at-the-money (ATM) straddle, which represents a bet on volatility, does not
guarantee zero market exposure. In other words, the beta of the straddle is not zero.
To make a pure bet on volatility while at the same time neutralizing the market
exposure completely a trader needs to trade in zero beta straddles. The idea was first
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fully formalized by Coval and Shumway (2001) who proposed using calls and puts in
proportion to their market betas. Further, Fabrice Douglas Rouah and Gregory
Vainberg (2007) explain this concept in detail. A zero beta straddle is a portfolio of
two components, a proportion w (in terms of the dollar value) in calls and a
proportion ( ) w 1 in puts. By construction, the beta of the straddle must be zero, and
hence:

( ) 0 1 = + =
Put Call STRADDLE
w w | | |

Using an alternative analysis to derive the value of a call option done by Fischer
Black and Myron Scholes in 1973, whereby they use CAPM to derive option prices,
the beta of the call and the put option can be written as:


S Call Call
C
S
| o | =

S Putl Put
P
S
| o | =

Where, S is the asset (stock) price, C and P are call and put option prices,
S
| is the
beta of the stock and ( )
1
d N
Call
= o is the delta of the call option and
Put
o is the delta
of the put option. From the above values of the beta of a call and a put and the
equation for straddle beta, the proportions, w and ( ) w 1 are calculated as follows:


Call Put
Put
C
P
w
o o
o
|
.
|

\
|

=


Put Call
Call
P
C
w
o o
o
|
.
|

\
|

= 1

In the above, w is the proportion of calls used in the straddle but expressed in
Dollars.









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5. Straddle Option


A Straddle option (STO) is a call option on a simple (ATM) Straddle. At maturity,
1
T
the buyer of the straddle option (STO) has the option to buy a straddle with exercise
price
STO
K . If this STO is exercised then the buyer receives a call and a put (with
same strike) with maturity
2
T . In other words, the straddle has a maturity of
2
T and
the STO has a maturity of
1
T where,
1 2
T T > .

6. Capped Call Option

A Capped option has a payoff similar to a vanilla option, except for that the payoff is
capped at a certain value. If the cap level is fixed and given by X the payoff of a
Capped Call option is given by:

( )
| |
( )
| | X S X S T
K X K S Call Capped
> <
+ =
max max
1 1 0 , max

The payoff of a Capped Put option is given by:

( )
| |
( )
| | X S X S T
MIN MIN
X K S K Put Capped
s <
+ = 1 1 0 , max


7. Binary Call Option

A binary call option, also known as a digital call option, is a bet that the asset will
finish at or above a pre-determined price. A binary call option payoff at maturity is
one if the asset finishes at or greater than the pre-determined price, the strike price. If
at maturity the asset finishes below the strike price then the binary call option payoff
is zero.

<
>
=
0 ,
1 ,
K S if
K S if
BC
T
T


8. Binary Put Option

A binary put option, also known as a digital put option, is a bet that the asset will
finish below a pre-determined price. A binary put option payoff at maturity is one if
the asset finishes below the pre-determined price, the strike price. If at maturity the
asset finishes at or above the strike price then the binary call option payoff is zero.



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<
>
=
1 ,
0 ,
K S if
K S if
BP
T
T


Heaviside Function and Binary Payoffs

In quantitative finance, the use of Heaviside function is ubiquitous. Every now and
then, while dealing with option payoffs, especially, binary (digital) option payoffs, we
come across the Heaviside function. For example, if the asset price is S at maturity
and the strike price is K , then the payoff of a binary (digital) call and binary put
options are given by:


( ) ( )
( ) ( ) S K H S BP
K S H S BC
=
=


In the above, ( ) H is the Heaviside function.

If the asset price in the time period | | t t , 1 is given by
1 t
S and
t
S then the payoff of
a binary (digital) cliquet will be given by:


( ) | |
1
=
t t
S S H coupon Cliquet Digital

Where, once again, in the above payoff equation ( ) H is the Heaviside function.
Actually, there is a technical problem with the way the above payoffs are constructed.
Strictly speaking, a Heavisde step function is not defined at the origin, i.e. for the case
when the asset is equal to the strike, K S = . Well talk more of that in a moment.

How does a Binary (Digital) call option payoff look like? If we plot the Binary call
payoff well get something like this:


0
0.2
0.4
0.6
0.8
1
1.2
-65 -70 -75 -80 -85 -90 -95 100 105 110 115 120 125 130 135
Binary (Digital) Call Payoff
BC(S) = H(S - K)
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The binary call payoff looks like a step function.

What is a Heaviside function? Heaviside function is a step function whose value is 0
(zero) when the argument is negative and 1 (one) when the argument is positive.
More formally, Heaviside step function can be defined as:


( )

=
negative is x if
positive is x if
x H
0
1


A plot of Heaviside step function looks like this





The function ( ) x H is discontinuous at the origin, i.e. at zero. The function is not
defined at the origin. At origin, there is indeterminacy. How can we say that?

We can rewrite the Heaviside step function, ( ) x H as:


( )
x
x x
x H
2
+
=


From this definition, it is obvious that at 0 = x , the function ( ) x H is indeterminate or
undefined. This is where the discontinuity occurs.

Therefore, in a binary call or a put option payoff, we have the condition, K S =
included in the K S < , i.e. the binary call payoff, ( ) S BC is given by:

( )

>
s
=
K S if
K S if
S BC
1
0

-0.2
0
0.2
0.4
0.6
0.8
1
1.2
-15 -10 -5 0 5 10 15
Heaviside Function
H(x)
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9. Outperformance Digital Call Option


If at time, 0 = t (today), the price of asset 1 is
0 , 1
S and that of asset 2 is
0 , 2
S , and the
respective dividend yields of the assets are
1
q and
2
q , and the respective volatilities
are
1
o and
2
o then for a maturity, T , then the payoff of an outperformance digital
(OD) option is given by:

>
=
Otherwise
S S if
Payoff OD
T T
0
1
, 2 , 1


It can be also expressed as:


( ) | |
T T
Q rT
T
S S H E e OD
, 2 , 1
> =



Where, ( ) x H is a Heaviside step function or unit step function and Q is a risk neutral
probability measure.

10. Money Back Option

A money back equity option is a financial derivative where the investors buys a
vanilla call option on a stock or a stock index and if at maturity the stock is within a
pre-determined range he gets back the premium he paid for the option. In its most
simple form, a money back option pays the premium back to the investor if the stock
finishes in the money.

The payoff of a money back option is really simple and so is its valuation. There is a
digital option embedded in the money back option. The payoff of a money-back call
is simply a vanilla call plus a digital times the premium that the investor has paid.
From the payoff equation it can be easily seen that the value of the premium the
price of a money back call option at time, t = 0, i.e. at inception, is equal to the price
of the call option divided by one minus the price of the digital option.

The payoff of a money back call option is given by:

( )
0 0
* , 0 max P D S S P
t t
+ =

>
<
=
0
0
, 1
, 0
,
S S
S S
D
where
t
t





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The premium,
0
P of the money back call option can be found by solving the following
equation.

Digital P Call P *
0 0
+ =
11. Pay Later (Contingent Premium) Option

Like the Money Back option, the Pay Later option is another interesting product
containing the digital option in it. In a Pay Later option the investor (buyer) pays the
premium only if the option finishes in the money. The pricing of a Pay Later option is
given in Chapter O.


12. Knock-out (Barrier) Call Option

A knock out (barrier) call option (KO call) is like a regular (vanilla) call option with
the only difference that if the barrier, H , is hit by the asset price then the option
knocks out, i.e. the contract is null and void and all liability of the option seller is
extinguished. On the other hand, if the barrier is never hit during the life of the option
then at maturity the KO call pays off just like a regular (vanilla) call option.



( ) ( )
( )

s =
s =
=
0 ,
0 , max ,
then T t for H t S if
K S then T t for H t S if
KO
T


( ) H t S = means that the asset never touches (hits) the barrier level, H , at any point
in time before the maturity of the option.

A KO call can be up and out or down and out depending on the position of the
barrier vis--vis the current spot. If the barrier is below the current barrier then the
KO will be down and out (DO) call, whereas if the barrier is above the current spot
then the KO will be up and out (UO) call. The payoff of an UO call option can be
written as:



( )
( )
| | H S T
T S
K S Call UO
<
e
=
, 0
max
1 0 , max


13. Knock-out (Barrier) Put Option

A knock out (barrier) put option (KO put) is like a regular (vanilla) put option with
the only difference that if the barrier, H , is hit by the asset price then the option
knocks out, i.e. the contract is null and void and all liability of the option seller is
extinguished. On the other hand, if the barrier is never hit during the life of the option
then at maturity the KO put pays off just like a regular (vanilla) put option.
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( ) ( )
( )

s =
s =
=
0 ,
0 , max ,
then T t for H t S if
S K then T t for H t S if
KO
T


( ) H t S = means that the asset never touches (hits) the barrier level, H , at any point
in time before the maturity of the option.

Just like the KO call, a KO put will also be up and out (UO) or down and out
(DO) depending upon the position of the barrier vis--vis the current level of the spot.

The payoff of DO put for example will be given by:


( )
( )
| | H S T
T S
S K Put DO
>
e
=
, 0
min
1 0 , max


14. Knock-in (Barrier) Call Option

A knock in (barrier) call option (KI call) is like a regular (vanilla) call option with the
only difference that only if the barrier, H , is hit by the asset price then the option
knocks in, i.e. the contract between the buyer and the seller comes into existence and
the payoff at maturity is exactly the same as a regular (vanilla) call option. On the
other hand, if the barrier is never hit during the life of the option then at maturity the
KI call pays nothing.


( )
( ) ( )

< =
< =
=
0 , max ,
0 ,
K S then T t for H t S if
then T t for H t S if
KI
T


( ) H t S = means that the asset never touches (hits) the barrier level, H , at any point
in time before the maturity of the option.

A KI call value can be found out from the barrier parity relationship, i.e. a KI plus a
KO is a vanilla. For example, the value of an up and in (UI) call will be given by:

( ) ( ) ( ) H K Call UO K Call H K Call UI , , =

15. Knock-in (Barrier) Put Option

A knock in (barrier) put option (KI put) is like a regular (vanilla) put option with the
only difference that only if the barrier, H , is hit by the asset price then the option
knocks in, i.e. the contract between the buyer and the seller comes into existence and
the payoff at maturity is exactly the same as a regular (vanilla) put option. On the
other hand, if the barrier is never hit during the life of the option then at maturity the
KI put pays nothing.
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( )
( ) ( )

< =
< =
=
0 , max ,
0 ,
T
S K then T t for H t S if
then T t for H t S if
KI


( ) H t S = means that the asset never touches (hits) the barrier level, H , at any point
in time before the maturity of the option.

A KI put value can be found out from the barrier parity relationship, i.e. a KI plus a
KO is a vanilla.

( ) ( ) ( ) H K Put DO K Put H K Put DI , , =

16. Double Barrier Binary (Range) Option

A very interesting binary option product is the double barrier binary range option,
which can be both knock out and knock in variety.

Knock out Double Barrier Binary

In a knock out double barrier binary range option, the option has two barrier levels,
an upper barrier and a lower barrier, and if neither of these barriers are hit during the
lifetime of the option then the option seller pays a lump sum cash amount to the
option buyer. However, if either of these barriers are hit then the option is knocked
out and nothing is paid out.


( ) ( )
( ) ( )

s = =
s = =
=
0 then T t for H t S or H t S if
A then T t for H t S and H t S if
KO
L U
L U


Why are Double Barrier Binary options popular?

These options, especially the knock out type of double barrier binary options, are
quite popular with the traders in sell side banks. This is because traders in the banks
have to sell volatility all the time and thus they get exposed to negative gamma (via a
short straddle). If the asset price moves dramatically and in big leaps then the trader
who is short gamma (short volatility via a straddle) can lose a lot of money due to the
movement of the underlying asset. A knock out double barrier binary option (which
knocks out if either of the barrier is hit) also allows the trader to go short volatility by
selling this option but in this case the trader only pays a fixed premium. Therefore, it
is a short volatility trade with a fixed payout.




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Knock in Double Barrier Binary


( ) ( )
( ) ( )

s = =
s = =
=
A then T t for H t S or H t S if
then T t for H t S and H t S if
KI
L U
L U
0


17. Fixed Strike Lookback Call Option

In a Lookback call option the underlying asset is the maximum of the asset price
observed during a certain, pre-defined observation period, up to the maturity. The
pre-defined observation could be daily, weekly or monthly. At maturity the payoff of
a lookback call is the maximum of the difference between the maximum of the asset
price (over the predefined observation period) and the strike price and zero. In a fixed
strike lookback call, the strike price is constant and pre-determined.

( ) 0 , max
max
K S Call Lookback =


18. Fixed Strike Lookback Put Option

In a Lookback put option the underlying asset is the minimum of the asset price
observed during a certain, pre-defined observation period, up to the maturity. The
pre-defined observation could be daily, weekly or monthly. At maturity the payoff of
a lookback put is the maximum of the difference between the strike price and the
minimum of the asset price (over the predefined observation period) and zero. In a
fixed strike lookback put, the strike price is constant and pre-determined.

( ) 0 , max
min
S K Put Lookback =

19. Floating Strike Lookback Call Option

In a floating strike lookback call option the underlying is the asset price, like a regular
(vanilla) call, however, the strike price is variable and is the minimum of the asset
price observed over a predefined observation period. At maturity a floating strike
lookback call option has a payoff equal to the maximum of the difference between the
asset price at maturity and the minimum of the asset price observed over the
predefined observation period and zero.

( ) 0 , max
min
S S Call Lookback
T
=


20. Floating Strike Lookback Put Option

In a floating strike lookback put option the underlying is the asset price, like a regular
(vanilla) put, however, the strike price is variable and is the maximum of the asset
price observed over a predefined observation period. At maturity a floating strike
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lookback put option has a payoff equal to the maximum of the difference between the
maximum of asset price observed over the predefined observation period and the
asset price at maturity and zero.

( ) 0 , max
max T
S S Put Lookback =


21. Floating Strike Ladder Call Option

A floating strike ladder call option is a variation of floating strike lookback call
option.

( ) ( ) 0 , , ....., , , min max
2 1 T n T
S L L L S Call Ladder =


22. Floating Strike Ladder Put Option

A floating strike ladder put option is a variation of floating strike lookback put
option.

( ) ( ) 0 , , ....., , , max max
2 1 T T n
S S L L L Put Ladder =


23. Arithmetic Average Call Option

In an arithmetic average call option the underlying asset is the arithmetic average of
the asset price over a predefined observation period (daily, weekly or monthly). At
maturity the payoff is maximum of the difference between the arithmetic average of
the asset price and the strike price and zero.


( ) 0 , max K S AC
Average
=

=
=
N
i
i Average
S
N
S
1
1


24. Arithmetic Average Put Option

In an arithmetic average put option the underlying asset is the arithmetic average of
the asset price over a predefined observation period (daily, weekly or monthly). At
maturity the payoff is maximum of the difference between strike price and the
arithmetic average of the asset price and zero.

( ) 0 , max
Average
S K AP =


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=
=
N
i
i Average
S
N
S
1
1

25. Simple Chooser Option Option

A simple chooser option is the maximum of a call option and a put option with the
same strike price.


( ) ( ) ( ) t t T K P t T K C Chooser ; , , , max =


Where, T t < and t is the time to choose between a call and a put.


26. Asymmetric Power Option (Power of 2)

( ) 0 , max
2 2
K S Payoff
T
=



27. Symmetric Power Option (Power of 2)

( )
2
0 , max K S Payoff
T
=

This can be decomposed, for valuation and hedging purposes, as:

( ) ( ) ( ) K S K K S K S
T T T
= 2
2 2 2


Thus, we get the relationship:

Vanilla K Short Power Asymmetric Long Power Symmetric 2 + =


28. Forward Starting Option


A forward starting option with maturity, T , starts either ATM or proportionally ITM or
OTM after a known amount of time t in the future. The strike price of a such a forward
starting option is set equal to a positive constant | times the asset price S after the
known time t . If 1 = | then both the forward starting call and the put option will start at
the money (ATM).

( ) 0 , max
t T Start Forward
S S Call | =


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( ) 0 , max
T t Start Forward
S S Put = |


29. Cliquet Option

A cliquet option is equivalent to a series of forward-starting at-the-money (ATM)
options, where a single premium is paid upfront. Cliquets allow the buyers to lock in
profits on the underlying asset at predetermined dates when the options strike price is
effectively reset.

|
|
.
|

\
|
=

0 , max
1
K
S
S
Cliquet
t
t


Deconstruction and Risk Analysis of Exotic Cliquets
This section is written by Anshum Bhambri, CFE Graduate, formerly at Deutsche Bank

Equity structured products are interesting in many ways; some more than others on
account of the complex risks embedded in them. The family of forward-starting
options, more commonly referred to as cliquet options, is one such example of
interesting structured products that we will be deconstructing in a multi-part series.
A forward starting option is an option which does not start until the so-called forward
start date. This also means that the strike price of this option is dependent on the
underlying share price at this forward start date. What makes cliquet options unique
is this hard path-dependency in that the strikes of the options are set at future dates.

In this section wed be talking about:

1. Introduction to cliquets
2. Main risks associated with cliquets i.e. volgamma and forward skew
3. Models used to price cliquets
4. Different types of cliquet option payoffs
5. Basic & advanced Greeks; as well as replicating portfolios for cliquet options.

Definition
A cliquet structure is a series of forward starting options i.e. the strikes will be set in
the future


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Example A locally floored cliquet


Evolution of Cliquets
1998: Minimum Coupon Cliquets with no downside risk
1999: ... some downside
2000: ... unlimited downside
2000: Reverse Put cliquets became popular
2002: Annual Minimum Coupon Cliquets (monthly resets)
Minimum Lookback Cliquets (Napoleon)
2003: Cheap Compounding Cliquet structures (Triple C)
2004: Correlation Cliquet structures (MultiPlus, BCB)



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Risks involved in Cliquet trades
Volgamma and Forward Skew
What is the Volgamma?
In order to understand volgamma, we first need to go through the concept of volatility
of volatility and see how it impacts the pricing of cliquets.
If we plot the 250d vol of the VIX on a rolling basis for the past 10 years, we observe
that implied volatility is very volatile itself and the volatility of the implied volatility
of short-dated S&P100 options has historically been between 60% and 140%.
Since most cliquet structures are generally longer-dated than 1-3 months (the maturity
of options used to calculate the VIX), they are normally not exposed to the very high
volatility of the short-dated implied volatility, but rather to a long-term volatility that
is not as volatile. However, we still have to consider changing implied volatilities
during the life of the trades in our pricing.
First, we will demonstrate that the Vega of an ATM Call Option does not change
when volatility changes, i.e. it is not necessary to focus on Volgamma when pricing
an ATM Call Option.

The price of the ATM vanilla call increases linear with increasing volatility. The
slope of the graph on the left shows the Vega, the first derivative of the price of an
ATM Call Option with respect to volatility.
The graph on the right is nothing but the slope of the graph on the left hand side i.e.
the Vega of an ATM Call Option. We can see that the Vega is constant as volatility
changes.

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Since, the Volgamma is defined as the first derivative of the Vega with respect to
volatility; therefore the slope of the graph of the right hand side is the Volgamma.
The Volgamma of an ATM Call Option is equal to 0, as the line is flat. We can also
say that the Volgamma is the second derivative of the price with respect to volatility.
Now, let us focus on the impact of Volgamma on the price of a Minimum Lookback
Cliquet.
Payoff function of a ML Cliquet: max (0%, high coupon + worst monthly performance of the
index)

An increase in the volatility increases the probability that the worst monthly
performance of the index will be negative and thus increases the likelihood that the
high coupon will be reduced; thereby lowering the price of the maximum lookback
cliquet structure.
However, if the volatility is already at a very high level, a further increase in volatility
does not decrease the price that much anymore: the price depreciation is convex.






Price of a long position
(Minimum Lookback Cliquet)
0%
2%
4%
6%
8%
10%
12%
-8% -6% -4% -2% 0% 2% 4% 6% 8%
Volatility shift
P
r
i
c
e
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The above graph shows the Vega of a Maximum Lookback Cliquet. It is nothing but
the slope of the graph of the price (i.e. slope of the first graph). Since the slope of the
Vega is positive, the investor is long Volgamma.

The above graph shows the Volgamma position of a Maximum Lookback Cliquet. It
is nothing but the slope of the graph of the Vega. (i.e. slope of the second graph). The
area under the graph is positive. This further substantiates that the investor is long
Volgamma.
Now, in graph 1, we observed that the price of a Maximum Lookback Cliquet is
convex to volatility. i.e. a 2% change in volatility from 20% to 22% leads to a
decrease in price of the cliquet than a 2% change in volatility from 30% to 32%.
Let us try to understand this convexity to volatility:
Vega of a long position
(Minimum Lookback Cliquet)
-80
-60
-40
-20
0
-5% -3% -1% 1% 3% 5%
Volatility shift
V
e
g
a

(
B
P
s
)
Volgamma of a long position
(Minimum Lookback Cliquet)
0.0
6.0
-6% -4% -2% 0% 2% 4% 6%
Volatility shift
V
o
l
g
a
m
m
a

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The maximum lookback cliquet structures price depends on the probability of
high negative returns of the underlying.
When we are at a high volatility level a further increase in volatility does not
increase the probability of high negative returns as much as when we are at a low
volatility level.
The graph shows the distribution of the returns of the underlying in a standard
Black Scholes model. The returns are normal distributed. A rise in volatility from
20% to 22% increases the probability of high negative returns more than a rise
from 30% to 32%.
Why do we need to charge for the Volgamma?
So why is volgamma important in the pricing of cliquets? In one sentence, when we
hedge the Minimum Lookback Cliquet with vanilla options, if the volatility moves,
the hedge has to be readjusted in a way that always costs money.






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From the above graph, we can see that as the volatility moves, our vanilla hedge is
always worth less than the Minimum Lookback Cliquet. We are always
underhedged.
Another way to look at this is to consider the net Vega of the hedge:

At trade start we hedge the Vega exposure with a vanilla option. We are Vega neutral.
If Volatility increases: The net position becomes Vega short. To be Vega neutral, we
have to buy Vega at this higher level. This is expensive.
If Volatility decreases: The net position becomes Vega long. We have to sell Vega at
this lower level to become Vega neutral again. We lose money.

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Volgamma Surface


This is an example for a Volgamma surface for a 5-year Minimum Lookback
Cliquet. The x-axis represents the volatility, the y-axis the time to maturity.
Characteristics for the Minimum Lookback Cliquet:
a. The Volgamma decreases with increasing volatility
b. The Volgamma decreases with time (because as time goes by coupons are locked
in and we have less optionality)
Skew and Forward Skew
Definition - The Skew describes how the implied volatility is changing as strike
(moneyness) changes.
Challenges - As we will see, many cliquet trades are very skew sensitive. More
precisely they are forward skew sensitive, i.e. the skew of forward starting options
starting at a future date t
i
and ending on a future date t
i+1
.
With our models we have a good control considering spot skew (i.e. skew for options
starting today).
Forward skew is more difficult to observe in the market as spot starting vanilla
options are not exposed to this risk. There exist broker market quotes for some cliquet
options so sometimes it is possible to derive a market view on the forward skew. Our
models have to be adjusted in different ways to deal with forward skew.

1
0
%
1
3
%
1
6
%
1
9
%
2
2
%
2
5
%
2
8
%
3
1
%
3
4
%
3
7
%
4
0
%
4
3
2
1
0
2
4
6
8
10
12
14
V
o
l
G
a
m
m
a
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This graph shows the skew structure of the Eurostoxx 50. Note that the shorter dated
skew is steeper than the longer dated skew.
Two important points to note:
i. Short-dated options are exposed to skew risk to a higher extent than long-dated
options.
ii. The cliquets consists of a strip of forward starting options. The more resets the
structure has (i.e. yearly, quarterly, monthly) the more (forward) skew sensitive
the structure will be.
Impact of Forward Skew on Cliquets
Example of a locally floored and capped cliquet
Consider a 3-year cliquet structure, with a local cap of 10% and a local floor of 10%,
paying out the annual cliquet performances each year (can be negative).
This cliquet consists of a strip of forward starting options.
i. A 1-year 90%-110% call spread, starting today minus the present value of 10%
paid one year from now.
ii. A 1-year 90%-110% call spread, starting one year from now minus the present
value of 10% paid in two years from now.
iii. A 1-year 90%-110% call spread, starting two year from now minus the present
value of 10% paid in three years from now.

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Main Risk - Forward skew
The higher the forward skew the higher the price of the structure
Why adjust pricing for forward skew?


The above chart is divided into two sections. The blue line shows the 1-year 90%-
110% spot skew of the S&P500 since 1994. Note that the skew has only briefly fallen
below 3% over the 10 years between 1994 and 2004.
The right-hand section shows the 90%-110% 1-year implied forward skew (in 2004)
for a series of 1-year call spreads. The red line is the forward skew interpolated
-15%
-10%
-5%
0%
5%
10%
15%
20%
25%
50% 60% 70% 80% 90% 100% 110% 120% 130% 140%
Spot level
P
a
y
o
f
f
S&P500 1-Year (90%-110%) Skew
0%
1%
2%
3%
4%
5%
6%
7%
8%
Jul-94 Jul-95 Jul-96 Jul-97 Jul-98 Jul-99 Jul-00 Jul-01 Jul-02 Jul-03 Jul-04 Jul-05 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10
9
0
%
-
1
1
0
%

S
k
e
w
Historical
Vol Grid Interp
Local Vol Implied
Historical Skew Implied Forward Skew
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directly from the vol-grid. The green line is interpolated from option prices calculated
using a local volatility model.
In comparing the two sections of the chart notice that the implied 1-year forward
skews quickly decay well below the range of levels at which 1-year spot skews have
historically traded.
Pricing cliquet options using a forward skew that is well below any reasonable
expectation for the future spot-skew will result in significant mis-pricing.

30. A capped and floored Cliquet Option


|
|
.
|

\
|
|
|
.
|

\
|
=

C F K
S
S
Cliquet
t
t
Floor Cap
, , max min
1
,


31. Locally Capped, Globally Floored Cliquet

( ) ( )
(
(

)
`

=

=
min
24
1
, 02 . 0 , 02 . 0 , max min max C R Cliquet
i
t


Where,
1
1

=
t
t t
t
S
S S
R and
min
C is a constant and denotes minimum coupon payable.

32. Digital Cliquet

( )
1
=
t t
S S H C Cliquet Digital

Where, C is the coupon and H is the Heaviside function

33. Reverse Cliquets

A reverse cliquet option has a payoff where the investors sell a series of call or put
spreads which exposes the investors to negative stock market returns.

( )
|
|
.
|

\
|
+ =

=
12
1
max
, 0 min , 0 max
i
t reverse
R C Cliquet
Where,
max
C is a constant and denotes maximum coupon payable and
1
1

=
t
t t
t
S
S S
R


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34. Napoleon Option

Napoleon option, a type of cliquet option, was introduced to the market by the quants
at Goldman Sachs around 2002. Goldman Sachs sales pitch was that this innovative
product would allow the investors to sell the volatility skew to the bank. The
Napoleon option pays out the sum of a fixed central coupon plus the worst monthly
performance of a stock index, such as the S&P500, from the previous 12 months, at
the end of each year. Typical maturity of a Napoleon cliquet varies from three to five
years. And, typically, the monthly performance is defined relative to the previous
months return.

( )
t
R C Napoleon

, 0 max
max
+ =

( )
N
t t t t
R R R R ...., , , min

2 1
=

Where,
max
C is the maximum coupon and
t
R

denotes the worst monthly (or any other


periodic) return of a basket of stocks or stock indices

For example, if the maximum coupon,
max
C , is 10% and the worst monthly
performance for year one is +3%, the investor receives a total coupon of 13%. Then
in year two, if the worst monthly performance is -11%, the investor receives a total
coupon of 1%. The payoff is almost always floored at zero so that the minimum total
coupon is 0%. Thus, the skew increases as the probability of a large negative
movement in the level of the index increases.

A clear motivation for Goldman to sell these Napoleon cliquet structures to investors
was the expectation of a more negative worst-performing month going forward, and
therefore it expects to pay a smaller coupon. The bank is therefore long volatility
skew. With the increase in volatility skew the payout of the option that the bank has
written, given by the maximum coupon plus the worst-performing, decreases.

35. Exchange Option

If at maturity, T t = the price of asset 1 is
T
S
, 1
and that of asset 2 is
T
S
, 2
, then the
payoff of an exchange option is given by:

( ) 0 , max
, 2 , 2 T T
S S Payoff =

This is the payoff to exchange asset 1 for asset 2 at maturity.



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36. Two Asset Rainbow Option

( ) 0 , , max
2 , 2 1 , 1
K S K S Call Raibow
T T
=


37. Quanto Option

( ) 0 , max
foreign foreign
T
fixed
o
K S FX Call Quanto =

Where,
foreign
T
S is the stock price at maturity denominated in a foreign currency and
foreign
K is the strike price denominated in the same foreign currency.
fixed
FX
0
is the
fixed FX rate at time, 0 = t .

38. Two Asset Pyramid Option

If there are two assets,
1
S and
2
S with corresponding strike prices
1
K and
2
K
respectively then the payoff of a pyramid call option is given by:

( ) ( ) 0 , max
2 , 2 1 , 1
K K S K S Call Pyramid
T T
+ =

39. Two Asset Madonna Option Call Option

If there are two assets,
1
S and
2
S with corresponding strike prices
1
K and
2
K
respectively and another strike, K then the payoff of a madonna call option is given
by:

( ) ( ) |
.
|

\
|
+ = 0 , max
2
2 , 2
2
1 , 1
K K S K S Call Madonna
T T


40. Exchange Option

( ) 0 , max
2 2 1 1
S n S n Option Exchange =


41. Basket Call Option


A basket call has a payoff similar to a vanilla call, the only difference is that the
underlying asset is a portfolio (basket) of several assets. For example, if we construct
a portfolio (basket) with 3 assets 1, 2, and 3, whose prices at maturity, T , are given
by
T
S
, 1
,
T
S
, 2
and
T
S
, 3
respectively and the strike price of the option is K (in dollar /
price terms) then the basket call option payoff at maturity is:
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( ) K S Payoff Call Basket
T p
=
,
, 0 max
Where,
T T T T p
S w S w S w S
, 3 3 , 2 2 , 1 1 ,
+ + = , represents the price of the portfolio (basket).
Here,
1
w ,
2
w and
3
w are the weights of asset 1, 2 and 3 respectively.

Another way to construct a basket payoff is via the returns of the assets. If we denote
the initial prices of the above three assets as
0 , 1
S ,
0 , 2
S and
0 , 3
S respectively then
another portfolio (basket) call payoff can be written as:

( ) K R Payoff Basket
T p
=
,
, 0 max

Where,
T T T T p
R w R w R w R
, 3 3 , 2 2 , 1 1 ,
+ + = is the return of the portfolio (basket) and
individual returns are given by:

1
0 , 1
, 1
, 1
=
S
S
R
T
T
, 1
0 , 2
, 2
, 2
=
S
S
R
T
T
, 1
0 , 3
, 3
, 3
=
S
S
R
T
T

In the above option payoff the strike price, K , would be in percentage terms to match
with the asset returns.

42. Two Asset Best of Call Option


|
|
.
|

\
|
= 0 , , max
0 , 1
0 , 1 , 1
0 , 2
0 , 2 , 2
S
S S
S
S S
Call of Best
T T


43. Single Asset Best of Call Option
(for Hedge Fund Managers)

If a hedge fund manager wants to invest in a product that gives him the minimum
return on a stock index (asset) or 4% in a certain period maturing at time T then the
payoff of this product will be:


|
|
.
|

\
|
|
|
.
|

\
|
= 04 . 0 , 1 5 . 0 max
0
S
S
Payoff
T


This product can be broken up as:




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( ) 0 , 08 . 1 max
2
1
% 4
04 . 0 5 . 0 , 0 max % 4
04 . 0 , 5 . 0 max 04 . 0 04 . 0
0
0
0
0
0
0
S S
S
P
S
S S
P
S
S S
P Payoff
T
T
T
+ =
|
|
.
|

\
|

|
|
.
|

\
|
+ =
|
|
.
|

\
|
|
|
.
|

\
|
+ = =


Thus, the payoff of the best of product represents a 4% coupon and a call option with
a strike of
0
08 . 1 S and leverage factor of
0
2
1
S
. If the notional of the product is N
then the leverage of the call option would be ( )
0
2S N . This best of product
represents a long zero coupon bond with a coupon of % 4 and a leveraged call option.


44. Best of Options with CMS Floor


|
|
.
|

\
|
=
y
T
T
R
S
S
Payoff
5
0
, 1 max 75 . 0
Where,
y
T
R
5
is the 5 year swap rate.

45. Best of Option with Inflation Floor


|
|
.
|

\
|

|
|
.
|

\
|
= 1 , 1 75 . 0 max
0 0
I
I
S
S
Payoff
T T

Where,
T
I is the retail price index at maturity.

46. FX Power Reverse Dual Currency (PRDC) Option

FX PRDC call options are a series of options embedded in a long term note (typical
maturity would be 20 or 30 years) each maturing at regular intervals.

1 ......., , 3 , 2 , 1 ; , , max min
0
=
|
|
.
|

\
|
|
|
.
|

\
|

|
|
.
|

\
|
= T t F F r
S
S
r Payoff
U L d
t
f

( )
0
0
,
0 , max
S
r
J
r
r S
K
K S J Payoff
f
f
d
t
= =
=

In the above,
d
r is the domestic interest rate and
f
r is the foreign interest rate.

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47. Himalaya Option

The Himalaya option comes in two varieties, the best of Himalaya and the worst of
Himalaya..
Best of Himalaya
If there are N coupon dates and N stocks in a portfolio (basket) and we select return
according to the following algorithm:
- The return of each of the asset (stocks) in the basket is given by
|
|
.
|

\
|
= 1
0
S
S
R
i
t
t
,
where,
i
t t t ,....., ,
2 1
are coupon dates the stock;
- At the end of the first coupon date, the return of all N stocks are observed and the
return of the stock that performs the best is recorded and removed from the
basket;
- At the end of the next coupon date, the return of the remaining, 1 N stocks are
observed and the return of the stock that performs best is recorded and removed
from the basket.
- This process continues until the option maturity.
With the above process in place, the payoff of the Himalaya option is given by:
|
.
|

\
|
=

=
N
i
Best
i
K R
N
P Himalaya of Best
1
0 ,
1
max
Where,
Best
i
R is the return of the best performing stock for the period i and P is the
participation factor. It has to be noted that the returns are not floored at zero and
therefore an investor would adversely affected if any of the returns in the basket is
negative due to poor performance of an asset (stock).
Worst of Himalaya
In the worst of Himalaya the process is the same, the only difference being that the
worst return is chosen in a period instead of the best.
- The return of each of the asset (stocks) in the basket is given by
|
|
.
|

\
|
= 1
0
S
S
R
i
t
t
,
where,
i
t t t ,....., ,
2 1
are coupon dates the stock;
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- At the end of the first coupon date, the return of all N stocks are observed and the
return of the stock that performs the worst is recorded and removed from the
basket;
- At the end of the next coupon date, the return of the remaining, 1 N stocks are
observed and the return of the stock that performs the worst is recorded and
removed from the basket.
- This process continues until the option maturity.
|
.
|

\
|
=

=
N
i
Worst
i
K R
N
P Himalaya of Worst
1
0 ,
1
max
Where,
Worst
i
R is the return of the worst performing stock for the period i and P is the
participation factor.

48. Altipano Option

An altipano option pays a large coupon, F , to the holder of the option provided that
none of the assets (stocks) in a portfolio (basket) has fallen below a pre-determined
level. If there are massets (stocks) in a portfolio (basket), the maturity of the option is
T , the participation factor is P and B is a pre-defined barrier level, then the altipano
payoff is given by:

|
|
.
|

\
|

|
|
.
|

\
|

>
|
|
.
|

\
|
=

=
Otherwise K
S
S
m
B
S
S
S
S
S
S
if F
P Altipano
m
i i
T i
m
T m T T
, 1
1
max
...., , , min
1 0 ,
,
0 ,
,
0 , 2
, 2
0 , 1
, 1

In the above altipano there is only one period, from the start date, 0 = t until maturity,
T t = .
In practice, most banks sell altipanos that have multi-period observations, i.e. the
return of mstocks are observed over, N , periods and based on the returns over these
periods the final payout is made.

|
|
.
|

\
|

|
|
.
|

\
|

>
|
|
.
|

\
|
=

= =
s s s s
Otherwise K
S
S
N m
B
S
S
if F
P Altipano
m
i
N
i j
i j
j
i j
t t t m j
N i
, 1
1
max
min
1 1 0 ,
,
0 ,
,
, 1
1

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In the above,
i j
S
,
is the closing price of stock j over the period i and the relevant
time periods are
N
t t t ,...., ,
2 1
, where, T t
N
= .
49. Capped Bull Note
Payoff and Reverse Engineering


|
|
.
|

\
|
(

|
|
.
|

\
|
+ =
0
0
, min 1
S
S S
C N Payoff
T
o


Where,
T
S is the value of the asset (stock index) at maturity and
0
S is the value of
the asset (stock index) today. In the above payoff, N is the notional amount of the
note, C is a constant denoting the cap and o is also a constant denoting the
participation rate. The payoff of the above capped bull note can be decomposed as:

( )
|
|
.
|

\
|
(

+ + =
|
|
.
|

\
|
(

|
|
.
|

\
|
+ + =
|
|
.
|

\
|
(

|
|
.
|

\
|
+ + =
o
o
o
o
C S
S S
S
C N P
C
S
S S
C C C N P
S
S S
C C C N Payoff
T
T
T
0
0
0
0
0
0
0
, 0 min 1
, min 1
, min 1
( )
(

|
.
|

\
|
+ + =
|
|
.
|

\
|
(

|
.
|

\
|
+ + =
|
|
.
|

\
|
(

|
|
.
|

\
|
|
.
|

\
|
+ + + =
T
T
T
S
C
S
S
N
C N P
S
C
S
S
C N P
C
S S
S
C N P
o
o
o
o
o
o
1 , 0 max 1
1 , 0 max 1
1 , 0 min 1
0
0
0
0
0
0


Thus, the capped bull note can be decomposed as long a coupon bond with a coupon
of C and short a leveraged put option on the asset with a strike price of
|
.
|

\
|
+
o
C
S 1
0
.
In the above algebraic manipulation we have made use of the following
mathematical identity: ( ) ( ) y x y x = , max , min .


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50. Principal Protected Bull Note



Rate ion Participat
Floor F
S
S S
F N Payoff
T
=
=
|
|
.
|

\
|
(

|
|
.
|

\
|
+ =
o
o
0
0
, max 1


The above note can be reverse engineered as:


( )
|
|
.
|

\
|
|
.
|

\
|
+ + + =
|
|
.
|

\
|
(

|
|
.
|

\
|
+ + =
|
|
.
|

\
|
(

|
|
.
|

\
|
+ + =
0 , 1 max 1
, max 1
, max 1
0
0
0
0
0
0
o
o
o
o
F
S S
S
N
F N P
F
S
S S
F F F N P
S
S S
F F F N Payoff
T
T
T


Thus, the above principal protected bull note decomposes as long a coupon bond
with a notional of N and long a leveraged call option on the asset with a strike
price of
|
.
|

\
|
+
o
F
S 1
0
.

51. Principal Protected Bear Note

With pre-defined constants, F and o , a principal protected Bear note has a payoff
given by:


|
|
.
|

\
|
(

|
|
.
|

\
|
+ =
0
0
, max 1
S
S S
F N Payoff
T
o

52. Principal Protected Mixed Note

With pre-defined constants, F and o , a principal protected Mixed note has a payoff
given by:


|
|
.
|

\
|
(

|
|
.
|

\
|
+ =
0
0
0
0
, max , max 1
S
S S
S
S S
F N Payoff
T T
o


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53. Principal Protected Neutral Note

With pre-defined constants, F and o , A principal protected Mixed note has a payoff
given by:


|
|
.
|

\
|
(

|
|
.
|

\
|
+ =
0
0
0
0 max
, max , max 1
S
S S
S
S S
R F N Payoff
T T
o

In the above payoff,
max
R is a constant and denotes the maximum return that the note
will pay.


54. Equity Linked Basket Note

If a portfolio (basket) comprises a collection of 4 stocks,
1
S ,
2
S ,
3
S and
4
S with
corresponding weights as
1
w ,
2
w ,
3
w and
4
w , N o

|
|
.
|

\
|
|
|
.
|

\
|
+ =
i
T
B
B B
N Payoff
0
, 0 max 1 o

T
T
R
B
B B
B
0

=

0 , 4 4 0 , 3 3 0 , 2 2
0
, 1 1 0
S w S w S w S w B + + + =

T T T T T
S w S w S w S w B
, 4 4 , 3 3 , 2 2 , 1 1
+ + + =

| |
| |
Call Basket
B
N
Bond Coupon Zero P
B B
B
N
N P
B B
B
N P Payoff
T
T

|
|
.
|

\
|
+ =

|
|
.
|

\
|
+ =
|
|
.
|

\
|
+ = =
0
0
0
0
0
, 0 max
, 0 max * 1 *
o
o
o





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55. Note with a Short Put option embedded
Reverse Engineering a payoff

< |
.
|

\
|

>
=
K S if
K
S
N
K S if N
Payoff
T
T
T
,


The above payoff can be decomposed as:


|
|
.
|

\
|
|
.
|

\
|
+ =
|
.
|

\
|
=
|
|
.
|

\
|
|
.
|

\
|
= =
K
S
N P
K
S
N P
K
S
N N P Payoff
T
T
T
, 1 min 1 1
, 1 min
, min


( )
( ) K S
K
N
N P
K S
K
N P
S
K S
N P
K
S
N P
K
S
N P
T
T
T
T
T
T
=
|
.
|

\
|
=
|
|
.
|

\
|
|
|
.
|

\
|
+ =
|
|
.
|

\
|
|
.
|

\
|
+ =
|
|
.
|

\
|
|
.
|

\
|
+ =
, 0 max
, 0 max
1
1
, 0 min 1
1 , 1 1 min 1
, 1 min 1 1


Thus, the note decomposes as a long zero coupon bond on a notional of N and short
a leveraged put with strike of K . The leverage factor is ( ) K N .

56. Perpetual Capped Call Note (American style) with no maturity

Concept

The structured note contains an embedded capped call option that is American in
nature. The call lives on for an indefinite period of time which means that there is no
maturity of the option. However, there is a barrier, a cap such that if the barrier is hit
the call option is exercised (terminated). However, neither the buyer nor the seller of
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the option (structured note) can exercise the option voluntarily. The call will be
exercised only when the barrier is hit. If the barrier is not hit then the option goes on
(lives on) indefinitely.

Payoff

The structure of the note is something like this: the buyer of the note (structured
product) gets a fixed coupon of say, 5% per annum, payable semi-annually as long as
the spot (the underlying stock index) trades below the cap. As soon as the cap is hit,
the structure terminates with a payoff from the capped call as the difference between
the cap and the strike.

If C is the cap and K is the strike price, such that K C > and the current spot is
below the cap level, i.e. C S
t
< then the capped call pays K C and terminates as
soon as
t
S hits C . And the option has no maturity, i.e. it can be alive for as long as
the spot remains below the cap. The note payoff will look like:


( )

>
<
=
C S if K C
C S if
Payoff
t
t
0 , max
% 5


Of course, upon exercise, all accrued interest will also be paid to the buyer of the
note. Note that in the above payoff there is no maturity.

Investment Context

Say, an investor holds a portfolio of stocks that mimics an equity index, say the
S&P500. Given the recent sell off in the equity markets, he is under water and losing
a lot of money on the portfolio. However, he is a long term investor and does not
want to liquidate his portfolio. Therefore, he buys the above perpetual capped call
note from a bank with a cap level that well above his breakeven level. For example, if
he holds (long) the index (or the indexed portfolio) at 100 and the index is currently at
70 due to a massive sell off then he puts the cap at 120. The strike price could be 70.
Therefore, as long as the market (index) is below the cap level he continues to get a
fixed coupon from the bank, say 5% per annum payable semi-annually. This will
compensate in some way the (paper) loss that he is sitting on because of a sell off. He

may also have financing costs due to margin calls, etc. which can also be
compensated by this fixed coupon payoff. It depends on the pricing and what is the
appetite of the seller (the bank) but the fixed coupon can be structured to be as high as
possible to benefit the buyer.

As soon as the market rallies back up and goes beyond his breakeven level he is back
in the positive territory. And if the rally is good enough then the cap will be hit and
the option will be terminated with a payoff to the buyer of 120 70 = 50. At this
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point the investor (buyer) no longer needs any protection because his portfolio or the
long index position will be in the positive territory.

57. Amortizing Option

The payoff of an Amortizing call option with strike price, K , is given by:


( )
T
T
S
K S
Call Amortizing

=
max


An amortizing option is an attractive instrument in a high volatility environment.
When the volatility of an asset is quite high a vanilla call (or a put) on the asset will
be quite expensive. However, if the notional of the option declines as the option goes
in the money, then high costs can be mitigated to a great extent.

Gatheral (6) has shown that an amortizing call, with strike, K , can be decomposed
into a long vanilla call with the same strike, K and short an infinite strip of vanilla
calls with increasing strikes from K to infinity.


( ) ( ) ( )
}

=
(


K
T
T
dK
K
K Call
K
K
K Call
S
K S
E
3
2
max



58. Decomposition of Structured Product through Payoff Diagram
(This section is based on analysis done by Neeraj Kumar, Kotak Mahindra Bank,
Mumbai, India as class presentation under my supervision and guidance.This also
appeared on the website of Risk Latte.)

The following example explains how a derivative structure with complex payoff can
be broken down into plain vanilla put, call, digital option and bond. The procedure
can be applied to any structure to arrive at its building blocks.

Lets look at a fairly complex Dollar-Yen FX payoff that is attached to a zero coupon
bond. Well ignore the bond payoff and only analyze the embedded derivative payoff.
The structure was originally done in the late eighties and was a five year structure.

>
< <
<
=
169 0
169 5 . 84 1
169
5 . 84 0
T
T
T
T
FX if
FX if
FX
FX if
Payoff

Where,
T
FX is the USD/JPY foreign exchange rate at maturity.

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However, lets analyze this as a general asset structure and call the final maturity
value of the asset as S.

Derivative Payoff

- If S < 84.5 then payoff = 0
- If S > = 84.5 and S < = 169 then payoff = (169/S) -1
- If S > 169 then payoff = 0

Decomposition

1. Plot the payoff :
The plot of the above payoff will look like (see the next page)
































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2. Break the payoff into parts where the slope of the payoff is 0 and where it has
some value. Thus we can break the above payoff into three parts part 1 and 3
where the slope of the payoff is 0 and part 2 where the slope of the payoff is
negative.

3. First analyze the payoff in part 2 and replicate it through combination of call and
put options.
a. The payoff in part 2 is negative sloping and the minimum is 0. We know
that such payoff can be replicated by long put.
b. But a long put will give payoff even when S < 84.5, thus we have to
negate the payoff on the option for all S < 84.5. This can be done by
shorting a put at 84.5.
c. The combined pay off this is shown below (see the next page). Thus to
create a payoff in part 2 of the structure we are going long one put at strike
of 169 and short one put at strike of 84.5. This is also called a put bear
spread.





84.
5
169
Part 1
Part 2
Part 3
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d. The payoff of the put bear spread shows that its payoff is 0 for S > 169.
Thus this spread also replicates the payoff of part 3.
e. However the put bear spread generates a constant pay of 84.5 (169-
84.5)for all S < 84.5.
f. We know that the structure pays 0 for S < 84.5 but the put bear spread
pays 84.5 for S < 0. Thus now we need to negate this payoff. This payoff
can be negated by going short 84.5 digital puts at strike = 84.5.

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g. Thus now we have three options -
i. One Long put at strike = 169
ii. One Short put at strike = 84.5
iii. 84.5 short digital put at strike = 84.5.
The combined payoff of these three options is shown below. The payoff is
shown by the solid blue line. This payoff exactly replicates the payoff of
the structure. Thus the price of the structure should be equal to the price of
these options.





59. Convertible Bond

A convertible bond (also called a convert or CB in market parlance) is a financial
derivative product combining a standard corporate bond with an option (to buy the
underlying equity of the company). The convertible feature allows the holder of the
bond to convert the bond into a predetermined number of shares of common stock
(known as the conversion ratio). The number of shares of common stock that the
bondholder will receive from exercising the call option of a convertible bond is called
the conversion ratio (CR).

The payoff of a Vanilla Convertible Bond can be thought of as the Investment Value
(IV) of the bond plus a call option on the underlying stock. If, C is the coupon on the

84.5
169
Payoff on digital put
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bond and
T
S is the price of the stock at maturity, T , r is the risk free rate and s is
the spread on the bond then, the CB payoff would be given by:

Call IV CB + =

Where,


s r i
i
Par
i
C
IV
t
T
t
t
+ =
+
+
|
|
.
|

\
|
+
=

=
) 1 ( ) 1 (
1


( ) 0 , max K S Call
T
=

Where,

Strike Price,
CR
IV
K = .

Payoff Decomposition

A convertible bond can be decomposed as:

(i) A bond plus a call option
(ii) Equity (shares) plus a put option

Bond plus a Call option
If the face value of a convertible bond is, F , and if the holder of this convert has a
right to convert this face value for o shares of equity with a price,
T
S , at maturity, T ,
the payoff of the convert can be written as:
( )
T
S F CB o , max =
Here, o is called the conversion ratio. The above payoff can be decomposed as:

( )
( )
( ) F S F
S F F F
S F CB
T
T
T
+ =
+ =
=
o
o
o
, 0 max
, max
, max

Thus the holder of a convert is long a bond with face value (notional) equal to F , and
long a call option on the stock. Note that the above equation can be further simplified
as:
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|
.
|

\
|
+ =
o o
F
S F CB
T
, 0 max
1

Thus the strike price of the call option is given by, o F .

Equity (Shares) plus a Put option

Using Put-Call parity and ignoring the discounting factors, we can write:


Strike Spot Put Call
Strike Spot Put Call
+ =
=


Applying the above relationship to the convert payoff we get:


( )
( )
( )
T T
T T
T
S F S
F S S F F
F S F CB
o o
o o
o
+ =
+ + =
+ =
, 0 max
, 0 max
, 0 max


Therefore, a convert is also equivalent to holding o times shares plus a long put
option.

There are many kinds of converts, including some with very exotic and sometimes
highly toxic payoffs. One such toxic convert is the Death Spiral Convertible Bond.

Death Spiral Convertible Bonds

One highly toxic kind of convertible bond is the death spiral convertible bond, a
product, more or less, banned in the United States for some time now. Death spiral
convertible bonds are technically known as floating rate convertible bonds where the
conversion price is kept floating. A floating rate convertible bond, converts into the
common shares of the underlying company at a deep discount to the share price that
exists at the time of the issuance and at a fixed dollar amount rather than a fixed
number of shares.

Nomura Securities first introduced this product in Japan in 2003, though Nomura
used a rather innocuous name of Multiple Private Offerings (MPOs) to brand these
securities. Investors would have been impervious to the pernicious nature of these
financial derivatives had the events of February 2005, which in a large measure upset
the equilibrium of corporate Japan, not put the spotlight on these securities. Takafumi
Horie, a 32 year, young and brash entrepreneur who owned the budding internet
service provider, Livedoor, acquired 35% stake in Nippon Broadcasting system
(NBS). Hories ultimate objective was the control of Fuji Television, one of the
largest TV networks in Japan. NBS owned 22.5% of Fujis shares. What really
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surprised everybody about this deal was that Livedoor, with revenue of $200 million
and a market capitalization of $2 billion was able to raise $800 million needed for the
acquisition and that too in such a short span of time. Enter, Lehman Brothers and the
death spiral convertibles. Lehman Brothers gave $800 million to Livedoor and bought
death spiral convertible bonds, with zero coupon and warrants attached to them, from
the company in lieu of those funds. Even though there was an initial conversion
price of Yen 450 the term sheet for this convertible bond had a clause that once the
bond is issued, this initial conversion price of the bond shall be modified the next
trading day after every Friday (known as the decision date) to an amount equal to
90% of the trading-volume-weighted-average price of the companys common shares
during the three consecutive trading days preceding the decision date which will
then become the modified conversion price. Of course, there was a floor for the
conversion price; it was Yen 157. The initial conversion price itself was at a very
steep discount to what Livedoors stock was trading at in February 2005. On top of
that, the way the bonds were priced, there was every incentive by the holder of these
bonds to keep shorting the stock so that modified conversion. price fell more and
more towards the minimum, where for the fixed dollar amount, the holder of the
bonds would get more and more common shares of the company.

Livedoor would eventually be delisted from the Tokyo Stock Exchange a year later
and the stock price would fall to Yen 94. Horie would go to jail and Fuji TV would be
shaken up to its bone. That sordid saga is well known and well documented in the
financial press

60. Reverse Convertible Bond

In a Reverse Convertible bond the investor (holder of the bond) gets either a fixed
number, o , of the shares or the face value, F , of the bond. The payoff is:

( )
T
S F Payoff o , min =

Decomposing the above payoff gives:


( )
( )
( )
( )
T
T
T
T
S F F
F S F
S F F F
S F Payoff
o
o
o
o
=
+ =
+ =
=
, 0 max
, 0 min
, max
, min


Where, we have made use of the mathematical identity: ( ) ( ) y x y x = , max , min .
Therefore, a reverse convert is equivalent to a long position in the bond and a short
position in the put option on the stock.



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One variation of a reverse convert is a knock in reverse convert is a long bond plus
a short down and in put option on the asset. .

61. Caplet

A caplet is a single call option on a forward interest rate, ( ) T t F , , where the rate starts
at time t and finishes at time, T . If the option has a strike price of K % and is written
on principal amount, N , and if at time t the fixing of ( ) T t F , is F % then the payoff
of the caplet is given by:

( ) ( ) N t T K F Caplet = 0 , max

The above payoff is paid at time, T . If we adopt an FRA convention then the payoff
of the caplet has to occur at time, t and the payoff would be given by:



( ) ( )
( ) | | T T F
N t T K F
Caplet
+

=
1
0 , max


62. Snowball Option

In a typical snowball option, the first two coupons are fixed and relatively high.
Subsequent coupons are given by a payoff function that is tied to the previous
coupon. A possible snowball option payoff function could be:

( ) ( ) 0 , % 2 25 . 0 max
1 T t t
L C Payoff + =



Where,
1 t
C is the previous coupon and
T
L is 3 month USD Libor.

63. SYCURVE Option

SYCURVE stands for Slope of the Yield Curve. The payoff of a SYCURVE Option
is given by:

( ) 0 , max K Y SYCURVE
T
=

Where,
T
Y is the spread on the yield of two US Treasury bonds, i.e. 2 Year US
Treasury Bond and 30 Year US Treasury xBond and K is the strike spread. The
strike price, K , is quoted in basis points. The yield spread between the two
underlying securities is the only factor that determines the payoff of a SYCURVE
option at expiration. The payoff of a SYCUVE option is unaffected by whether the
general levels of yields have gone up or down during the life of the option. This gives
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rise to an interesting feature: the duration and convexity of SYCURVE put and call
options are roughly zero.

In the late 80s investors realized that OTC call and put options on individual fixed
income securities were totally inadequate to hedge the spread exposure. There was no
way, then, how an investor could replicate an option on a spread, say between 2 yr
US Treasury and 30 yr US Treasury by buying options on the underlying securities,
i.e. 2 yr US Treasury bond and the 30 yr US Treasury bond. Goldman Sachs was the
first to capitalize on this opportunity by responding to the investors needs.

In mid-1989, Goldman Sachs & Co. introduced SYCURVE options It was part of a
large class of fixed income options that Goldman Sachs introduced in the late 1980s
such as, MOTTO options, which were options on the spread between Mortgage and
Treasury securities, ISO options, which were options on the spread between foreign
fixed income securities and U.S. Treasury securities, CROSS options, etc. In the late
1980s institutional investors on Wall Street felt an acute need for appropriate
instruments to hedge different kinds of spread exposures.



























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Chapter V
Volatility and Correlation


Given the following notations:

Current Price of the Asset =
0
S
Strike Price = K
Risk free rate = r
Dividend Yield = q
Volatility = o
Time to Maturity = T
Current price of the Call = C
High of the Stock Price =
H
S
Low of the Stock Price =
L
S
Number of trading days = n
Decay Parameter =

Part A
Implied Volatility & Volatility Surface

1. Numerical Estimation of Implied Volatility

i. Newton Rahpson Method

The Newton-Raphson method solves a one dimensional non-linear equation iteratively:


( )
( )
Vega
C C
C
C C
mkt k
k k
k
mkt k
k k

=
c c

=
+
+
o
o o
o
o
o o
1
1


In the above formula,
mkt
C is the market price of a traded call option and
k
o is the
theoretical volatility (or the implied volatility estimate) of the underlying asset for the
k th iteration,
1 + k
o is the implied volatility estimate for the 1 + k iteration and ( )
k
C o
is the theoretical model dependent price of the call option for the k th iteration. The
Newton-Raphson method is a very efficient numerical algorithm that requires the
knowledge of the vega of the option. Manaster & Koehler have devised a formula for
the Seed Value to start with in a Newton-Raphson algorithm that more or less
guarantees convergence to implied volatility.


T
rT
K
S
seed
2
ln + |
.
|

\
|
= o



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ii. Bisection Method

The Bisection method chooses two initial (seed) values for the estimated implied
volatility, a high value,
H
o , and a low value,
L
o and then linearly interpolates between
these two values to arrive at the correct estimate for the implied volatility:


( )
( )
( )
L H
I H
I mkt I k
C C
o o
o o
o o

+ =
+ 1


The Bisection method is much simpler to use and does not require the knowledge of
the vega of the option.

A Note on the Two Numerical Methods for Implied Volatility Computation

Newton-Raphson method, despite being more complex mathematically, is most
widely used in commercial software used by banks and financial institutions to
estimate implied volatility. This is because Newton-Raphson is a very efficient
mathematical method. In this method one solves for a one dimensional non-linear
equation using an iteration technique and the algorithm is so efficient that within 3 to 4
iterations the theoretically adjusted volatility converges to the implied volatility.
However, one needs to have knowledge about the vega the partial (mathematical)
derivative of the option price with respect to the volatility of the option. Starting
with a seed value of the theoretical volatility (the one that goes as an input in the
Black-Schole formula) and comparing the market price of the option and the
theoretical price of the option (using this seed volatility) one moves to the next value
of the theoretical volatility that brings the convergence of the market value and the
theoretical value closer. And so on with the iteration, till the two values converge. The
iteration takes into account the vega of the option. Manaster and Koehler in 1982
developed an efficient seed value to start with in the Newton-Raphson method that
more or less guarantees convergence for European style options valued using Black-
Scholes formula. Espen Haugs brilliant textbook, The Complete Guide to Option
Pricing Formulas discusses this algorithm.

Bisection method is much simpler than the Newton-Raphson method. Bisection
method does not require the knowledge of vega of the option and hence its
attractiveness. Many exotic options and American style options do not have analytic
formulas for vega (like the one that exists for vanilla call and put options using a
Black-Scholes formula) and therefore Newton-Raphson method cannot be used in
such cases. In a bisection method two initial seed values for the theoretical volatility
are assumed, one a low estimate of implied volatility and the other a high estimate of
the implied volatility. The market price of the option will be between these two values
of the estimated volatility. The exact estimate of the implied volatility is then found
out using a linear interpolation between these two theoretical (estimated) volatility
values. It is a simple method of linear interpolation
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2. Lelands Formula for incorporating Transaction Costs in Volatility

Adjusted Implied Volatility for Long option position


2
1
8
1

|
|
.
|

\
|
A
=
o t
o o
k
t



Adjusted Implied Volatility for Short option position


2
1
8
1

|
|
.
|

\
|
A
+ =
o t
o o
k
t



Where, t A is the frequency of rebalancing and k is the transaction cost in percentage,
taking into account the bid-ask spread. Bid-ask spread is also a measure of liquidity in
the market and one way to define a bid-ask spread is as follows:


Bid-Ask Spread =
( )
bid ask
bid ask
P P
P P
+

2
1


3. Brenner-Subrahmanyam Approximation for ATM Call and the Put

Here the rates are assume to be extremely low, theoretically equal to zero, and the spot
is assumed to equal the discounted strike (
rT
Ke S r

= = , 0 ), i.e. the option is ATM.
This approximation holds only for ATM options with zero rates.


T S
C
S
C
T
Vol
implied ATM
0
0
5 . 2 2
= = =
t
o

If dividends are taken into account then the above formula becomes


T e S
C
e S
C
T
Vol
qT qT
implied ATM


= = =
0 0
5 . 2 2t
o




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4. Improvement on Brenner-Subrahmanyam Approximation for ATM Option
(Steven Lis Approximation)

Once again, rates are assumed to be zero and spot is assumed to be equal to the
discounted strike.


(

|
|
.
|

\
|
=
=
=

32
3
2
2
6
8
1 2 2
1
0
2
o
t
o
o
o
Cos Cos z
S
C
z
z
T
z
T
implied



5. Bharadia, et al Approximation for Near the Money Option

If rates are zero (i.e. spot is equal to discounted strike) but, if the option is not strictly
at the money, but near the money, i.e. the strike does not deviate too far away from the
spot then the implied volatility can be estimated by:



( )
( ) 2
2 2
K S S
K S C
T
implied


=
t
o


6. Corrado and Miller Approximation for Near the Money option

If rates are zero and if the option is near the money, i.e. the strike is not too far away
from the spot, then the implied volatility can be estimated by a more accurate formula
given below:


( )
( ) ( ) ( )
(
(

|
|
.
|

\
|

+

+
=
t
t
o
2
2
2
2 2
1 2 K S K S
C
K S
C
K S T
implied









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7. Implied Volatility Approximation for ITM or OTM Options
(Steven Li Approximation)

Deep in the money or deep out of the money options

For deep in or out of the money options with small volatility and short time to
expiration and zero rates the following formula is quite accurate


( )
T
implied
2
1
1 4

2
2
+

+
=
t
t
o o
o


Where,
|
|
.
|

\
|
+
+
= 1
2
1
2

0
t
t
t
o
S
C
and
K
S
0
= t

Near the Money Option

When the strike does not deviate too far away from the spot and when the following
condition holds
T
1
>>
t
o then the following formula can be used to estimate the
implied volatility



|
|
.
|

\
|
+
+
=
(

|
|
.
|

\
|
=
=

1
2
1
2

32
3

2
6
8
1

2 2
0
1
2
t
t
t
o
o
o
o
S
C
Cos Cos z
z
z
T
z
T
implied












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8. SABR Volatility

A 2-factor SABR model of stochastic volatility for the forward is given by


2
1
dW d
dW F dF
qo o
o
|
=
=


For 1 = | which is mostly the case for FX, the closed form solution for SABR
volatility,
B
o is given by:


( )
( )
( )
|
|
.
|

\
|

+ +
=
|
.
|

\
|
=
(

+
|
.
|

\
|
+ +
|
|
.
|

\
|
=

o
q
q oq

o o
1
2 1
ln
ln
..... 3 2
24
1
4
1
1
2
2 2
z z z
z
K
F
z
T
z
z
B


For 1 = | which is mostly the case for FX, the closed form solution for SABR
volatility,
B
o is given by:



( )
( )
( )
|
|
.
|

\
|

+ +
=
|
.
|

\
|
=
(

+
|
|
.
|

\
|
+ +
|
|
.
|

\
|

o
q
q
o

o o
1
2 1
ln
ln
...
24
3 2
24
1
ln
2
2
2 2
z z z
z
K
F
FK z
T
FK z
z
K F
K F
B


The SABR volatility can be input into the Black-76 formula to estimate the value of the
option. In that sense, this becomes the Black equivalent volatility.







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9. CEV Volatility

A CEV (constant elasticity of variance) model for the is given by

dW F dF
|
o =

The closed for solution for the CEV volatility, o is given by:


( ) ( ) ( )
2
...
24
1
24
2 1
1
2 2
2
2
2
1
K F
f
f
T
f
K F
f
+
=
(
(

+
|
|
.
|

\
| +
+ =
| |
o | | | o
o


This volatility can be input into the Black-76 formula for estimating the option values.
For at the money forward the CEV volatility becomes


|
o
o

=
1

F


In the above formulas, K is the strike price.

10. Forward Interpolation of Implied Volatility

If
1
o is the implied volatility for a maturity | |
1
, 0 T and
2
o is the implied volatility of
the maturity | |
2
, 0 T such that
1 2
T T >

then the forward volatility between
1
T and
2
T is
given by:


( )
1 2
1
2
1 2
2
2
1 2
,
T T
T T
T T

=
o o
o


11. Volatility Skew

Volatility Skew, also known as volatility smile, means that options on a particular asset
with varying strikes but the same maturity will have different implied volatility. The
existence of skew or smile is not possible in a Black-Scholes world. In a volatility
smile the out of the money (OTM) and the in the money (ITM) options on the asset
(with same maturity) have higher implied volatility than the at the money (ATM)
options. Skew is a special case of smile where lower strike options on the asset have
higher implied volatilities than the higher strike options.


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In most common trading parlance, skew means that out of the money puts trade higher
than the at the money puts. If the asset is currently at 100 then a 90 strike put (which is
out of the money) will have higher implied vol, and hence higher price, than a 100
strike (ATM) put. A plausible explanation for this is the market crash theory. When
markets go down the volatility increases and in the event of a very big move or a
market crash the volatility explodes. Given such an event a trader selling out of the
money puts would like to protect himself from losses and hence would be marking the
volatilities higher, and since volatility is a proxy for option price, in such an instance
out of the money puts will trade higher. Investors fearing a market crash would buy
more insurance by buying out of the money puts thereby increasing the demand for
them which would in turn cause the sellers of the puts (mostly traders in sell side
banks) to mark the prices of these options higher.

A slightly more technical explanation can be had using the delta rebalancing theory.
A good explanation of this is provided by Frans De Weert in Exotic Options Trading.
As a result of delta hedging frequently a trader incurs losses on his gamma. When the
markets move downward very quickly a trader who has sold out of the money puts is
faced with two big problems: (a) the gamma on the lower strike options increases and
(b) the realized volatility increases and both these combined compels the trader to
rebalance his delta more frequently which in turn causes bigger losses for the trader.
The trader would therefore want a compensation for this loss and hence would mark the
implied volatilities of the lower strike puts (out of the money) options higher.

12. Implied Volatiltiy Surface

The volatility surface is a two dimensional matrix representing a map of the implied
volatilities quoted by the market for plain vanilla options struck at different levels of
strike price and expiring at different maturities. Implied volatility is the parameter, o ,
that we plug into the Black-Scholes formula to calculate the price of an option.

The volatility surface is built according to three main market conventions amongst
traders:

- the Sticky Strike
- the Sticky Delta
- the Sticky Absolute.

The Sticky Strike rule is used mostly in the equity options market. Here the implied
volatilities are mapped, for each expiry, against the strike prices. The name sticky
strike alludes to the fact that implied volatilities do not to change if the underlying
stocks price changes.

The Sticky Delta rule is used mostly in the FX options market where traders are used
to quoting option prices in terms of delta, rather than the strike. Here, the volatilities are
mapped, for each expiry, with respect to the delta of the option; this rules is based on
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the assumption if options are priced by their their Delta then when the underlying
assets price moves the Delta of the option will also move correspondingly thereby
necessitating a different implied volatility input in the pricing formula.

The Sticky Absolute rule is mostly used in the swaptions and bond options market. It is
a mixture of the above two rules. It generates a surface where the implied volatilities
are mapped, for each expiry, in terms of the absolute distance, measured in some units
of price, from the at-the-money strike. The at the money strike may be set equal to the
forward price of the asset.

13. Interpolating Implied Volatility amongst Strikes

One of the most common and accepted ways of interpolating implied volatility
amongst strikes is via polynomials. Say, we want to find the implied volatility of an
option with a strike K . Lets denote this by,
K
o , the value of which we want to find
out by interpolation. Choose 3 volatilities from the traded options market: (i) an ATM
volatility,
ATM
o with strike,
ATM
K , (ii) the second one an out of the money (OTM) call
volatility,
OTM
C K,
o , with strike,
OTM
C
K , and (iii) the third one an OTM put volatility,
otm
p K,
o , with an OTM strike,
OTM
P
K .

Given the above, we can construct a second degree polynomial as:

( ) ( )
2
ATM ATM K K
K K q K K p
ATM
+ + = | o o o

Where, ( )
OTM OTM
P C
K K p = and
( )
(

+
=
ATM
P K C K
OTM OTM
q o
o o
2
, ,

The values of o , | and can be estimated using standard procedure. It can be shown
(see Iason(2007)) that the above polynomial equation becomes:

( ) ( )
2
16 2
ATM ATM K K
K K q K K p
ATM
+ + =o o

Hence, from using the above polynomial equation and using market quoted volatilities
ATM
o ,
OTM
C K,
o ,
otm
p K,
o and market quoted strikes,
ATM
K ,
OTM
C
K and
OTM
P
K we can
estimate the the implied volatility of the option with strike, K








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14. Interpolating Volatility amongst Maturities

In any options market, a set of options trade with implied volatilities for certain
maturities, i.e. 1 month, 2 months, 3 months, 6 months, 1 year, etc. This forms the term
structure of the implied volatility. How do we interpolate between these maturities to
get the implied volatility of an arbitrary option with a certain maturity? The most
common way is to specify a function for the evolution of volatilities and then fit that
function to the observed maturities.

For the FX options market a Heston type mean reverting function is used. If we assume
that the instantaneous variance, ( )
t
v t v = , starting at
0
v reverts to a long term average
variance,
2

o , with a speed of k , then a Heston type, mean reverting like variance


curve functional, with parameter, t , will be given by:

( )
kt
t
e v v


+ =
2
0
2
o o

This is an example of a linearly mean-reverting variance curve functional. Overhaus,
et al (5) give examples of double linearly mean-reverting and exponential linearly
mean-reverting variance curve functionals as well.

In order to find the implied volatility of an arbitrary option with an arbitrary maturity,
T , one needs to integrate the instantaneous variance, given by the above equation, from
0 to T and then divide the result by T and take the square root.

The implied volatility for a maturity T will be given by:

( ) ( )
kT
e
v T
kT


+ =
1
2
0
2
o o o

As explained in Iason (2007) the above formula does not work well for the interest rate
markets. The term structure of implied volatilities in the rates markets is not explained
properly by the above formula.

There is another method used by practitioners which do not require the use of a
variance curve functional or any form of functional dependence of the instantaneous
variance to interpolate between maturities. This is known as the Total Variance
Interpolation method.

Assuming that we choose two maturities,
j
T and
1 + j
T on either side of an arbitrary
maturity, T , for which we need to find the implied volatility. We have:
1 +
< <
j j
T T T .
The total variance interpolation method gives the implied volatility, ( ) T o as:


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( ) ( ) ( )
j
j
j j
j
j
j
j j
j
T
T
T
T T
T T
T
T
T
T T
T T
T
2
1
1
1
2
1
1
o o o

=
+
+
+
+
+



15. Vanna Volga Methodology for Implied Volatility

This section follows the analysis presented in Antonio Castagna (2010), Castagna and
Mercurio (2005). The Vanna Volga (VV) method is an empirical method to obtain the
implied volatility smile from three market quoted option prices, with strikes
2 1
, K K
and
3
K for a given option maturity, T . Many traders think in terms of vanna volga
overhedge or the vanna volga cost, thereby implying that the hedging costs of a
locally replicating portfolio within the strike boundary | |
3 1
, K K is added to the Black-
Scholes price to produce option values that are consistent with the observed smile. VV
method is consistent with a stochastic volatility world where the volatility changes
randomly together with the asset.

Vanna Volga Approximation - 1

The assumption is a flat strike world where the implied volatilities are constant through
strikes and they change stochastically over time.

The following the algorithm to approximate the Vanna-Volga implied volatility (and
the price) of an option, ( ) K C with strike K . If there are three options in the market,
1
C
2
C and
3
C with respective strike prices
1
K ,
2
K
3
K such that
1
K <
2
K <
3
K and the
implied volatilities of the options are given by
1
o
2
o
3
o then the weights which will
make the resultant portfolio of these three European Calls with maturity T that hedges
the price of the European call, C , with strike K and maturity T , up to the second order
in the price and the volatility (Vanna and Volga) are given by the solution of this
system of linear equations:

Vega =
( )
( )
( )
o o c
c
=
c
c

=
i BS
N
i
i
bs
K C
K w
K C
1

Volga =
( )
( )
( )
2
2
1
2
2
o o c
c
=
c
c

=
i BS
N
i
i
bs
K C
K w
K C

Vanna =
( )
( )
( )
0
2
1 0
2
S
K C
K w
S
K C
i BS
N
i
i
bs
c c
c
=
c c
c

=
o o





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If we write the vega of the call, ( ) K C , as ( ) K v , then the solution of the above system
of equations, given the Black-Scholes expression for Vanna and Volga, gives the
weights as:


( )
( )
|
|
.
|

\
|
|
|
.
|

\
|
|
.
|

\
|
|
.
|

\
|
=
1
3
1
2
3 2
1
1
ln ln
ln ln
K
K
K
K
K
K
K
K
K
K
w
v
v



( )
( )
|
|
.
|

\
|
|
|
.
|

\
|
|
.
|

\
|
|
|
.
|

\
|
=
2
3
1
2
3
1
2
2
ln ln
ln ln
K
K
K
K
K
K
K
K
K
K
w
v
v



( )
( )
|
|
.
|

\
|
|
|
.
|

\
|
|
|
.
|

\
|
|
|
.
|

\
|
=
2
3
1
3
2 1
3
3
ln ln
ln ln
K
K
K
K
K
K
K
K
K
K
w
v
v


The Vanna-Volga call price, ( ) K C
VV
for the call option ( ) K C with strike, K will be
given by:

( ) ( ) ( ) ( ) ( ) ( ) | |

=
+ = =
3
1 i
i BS i MKT i BS VV
K C K C K w K C K C K C

The Vanna-Volga implied volatility of the call option, ( ) K C is given by:

( )
3
2
3
1
3
2 1
2
2
3
1
2
3
1
1
1
3
1
2
3 2
ln ln
ln ln
ln ln
ln ln
ln ln
ln ln
o o o o
|
|
.
|

\
|
|
|
.
|

\
|
|
|
.
|

\
|
|
|
.
|

\
|
+
|
|
.
|

\
|
|
|
.
|

\
|
|
.
|

\
|
|
|
.
|

\
|
+
|
|
.
|

\
|
|
|
.
|

\
|
|
.
|

\
|
|
.
|

\
|
=
K
K
K
K
K
K
K
K
K
K
K
K
K
K
K
K
K
K
K
K
K
K
K
K
K
VV



Vanna Volga Approximation - 2

In the approximation 1, the valuation is quite accurate within the strike boundary,
| |
3 1
, K K but the wings are not valued properly. In fact, the wings get overvalued in the
above approximation. To make the VV approximation asymptotically constant at
196
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extreme strikes, Castagna and Mercurio (2005) have derived a more accurate
approximation for the VV implied volatility.

It is given by:

( )
( ) ( ) ( ) ( ) ( )
( ) ( ) K d K d
K D K D K d K d
K
VV
2 1
2 1 2 2 1
2
2 2
2 2
2 + + +
+ =

o o o
o o

Where,


( ) ( )
( ) ( ) ( )( )
( ) ( )( )
2
2 3 3 2 3 1
2
3
1
3
2 1
2
2 1 1 2 1
1
3
1
2
3 2
2
2 1
ln ln
ln ln
ln ln
ln ln
o o
o o
o

|
|
.
|

\
|
|
|
.
|

\
|
|
|
.
|

\
|
|
|
.
|

\
|
+

|
|
.
|

\
|
|
|
.
|

\
|
|
.
|

\
|
|
.
|

\
|
=
=
K d K d
K
K
K
K
K
K
K
K
K d K d
K
K
K
K
K
K
K
K
K D
K C K D
VV


And, ( )
1
d is the Black-Scholes parameter.

Vanna-Volga Method for FX Options Market

In the FX market, the three strike prices used in the Vanna Volga method are the at the
money strike,
ATM
K , the strike for 25 delta call,
Call
K
o 25
, and the strike for 25 delta put,
Put
K
o 25
.


ATM
K K
2

Call
K K
o 25 1

Put
K K
o 25 1













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( )
( )
|
|
.
|

\
|
|
.
|

\
|
+ +
|
|
.
|

\
|
|
.
|

\
|
+ +
|
.
|

\
|
+
=
=
=
T r r T
Put
T r r T
Call
T r r
ATMl
ATM f d Putl
ATM f d Call
ATM f d
e S K
e S K
e S K
2
25
2
25
2
2
1
0 25
2
1
0 25
2
1
0
o o
o
o o
o
o
o
o


Where,
|
.
|

\
|
=
T r
f
e N
4
1
and ( ) N is the cumulative Normal distribution function.

16. Local Volatility

If there is a unique diffusion process, under risk neutrality, which is consistent with the
distributions of market prices of options then the state dependent coefficient of
diffusion of that process is the local volatility function. This notion builds on the
insight that the risk neutral density of asset prices can be derived from the market
prices of European options. As Jim Gatheral explains, Local Volatility can be thought
of as some kind of average over all possible instantaneous volatilities in a stochastic
volatility world.

Key features relating to the notion of Local Volatility

- Local volatility models do not represent a separate class of models
- Local volatility is an average over instantaneous volatilities

Dupire, Derman and Kani
The concept of Local Volatility was formalized by Bruno Dupire, Emanuel Derman and
Iraz Kani in 1994. Dupire, approach for understanding local volatility was the continuous
time theory and he built upon the work done by Breeden and Litzenberger in 1978.
Derman and Kani, both at Goldman Sachs at that time, on the other hand used the
discrete time binomial tree version. Dupire.

Dupires formula for Local Volatility is given by:

( )
2
2
2
2
2
1
,
K
C
K
T
C
T K
c
c
c
c
= o



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All terms on the right hands side of the above equation can be calculated from observed
European option prices.

17. Local Volatility in the presence of Default

Gatheral (6) has shown that in the presence of default, Dupires formula for the local
volatility gets modified. It is possible to derive a closed form solution for local volatility
in the presence of default. In the presence of default in a Black-Scholes world, the
interest rate get shifted by the hazard rate,

(Mertons model of default).



Following Gatheral it can be shown that in presence of default, the local volatility can be
estimated using the following closed form solution:


( )
( )
2
2 2
2
2
2
2 2
2
2
1
d N
d N
T
K
C
K
K
C
K
local
'
+ =
c
c
c
c
=
o o
o o


Where,
2
d is the Black-Scholes parameter given by:


2
ln
2
T
T
T
K
S
d
o
o

+
|
.
|

\
|
=

And, ( )
2
2
2
1
2
2
1
d
e d N

= '
t
. The parameter, o , is the constant volatility, which is defined
as the coefficient of diffusion for the diffusion PDE in the jump to ruin case (with zero
rates and dividends). As Gatheral explains, in practice, both the constant volatility, o can
be estimated as the best fit parameters of the Merton model, i.e. it would be the value that
would generate option prices closest to the European option prices calculated using
implied volatilities.

It can be further shown that for very low strikes where, 1 << S K we get 0
2
>> d and
( ) 1
2
~ d N therefore, the default adjusted local volatility formula for very low strikes
becomes:


2 2 2
2
2
2 2
d
local
e T t o o o + =



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Estimation of the Hazard Rate

Choose a T period zero coupon bond of the asset for which you are estimating the local
volatility, where the option expiry is also T years. This bond is risky and will have a
credit spread, s . Alternatively, talke the T period credit default swap rate for the asset
and denote it by s . If the recovery rate is R and a hazard rate is for the asset, we have
the following credit relationship:

( )
T T sT
e R e e

+ = 1

Given the value of s , R and T , the hazard rate, can be calculated from the above
formula.


Part B
Historical Volatility


1. Historical Volatility using Close to Close prices

The standard deviation of asset returns is calculated as follows:

(i) Get the asset price data over a certain period (252 days with daily prices, or 12
months with monthly prices, etc.); let us denote the asset price for a period, t , as
t
S .
(ii) Estimate the geometric or log returns from this price data; this is done by taking
the natural logarithm of todays price (this periods price) divided by yesterdays
price (last periods price).


|
|
.
|

\
|
=
1
ln
t
t
t
S
S
R
.
(i) Estimate the mean of the asset returns:

=
=
N
i
t
i
R
N
1
1


(ii) Then compute the asset return volatility (standard deviation of asset returns by) by
the well-known formula for standard deviation:


( )
( )

=
N
I
t
i
R
N N
1
2
1
1
o

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2. Parkinsons Number for Calculating Historical Volatility using High and Low

Parkinsons number captures the variance of asset returns using the high and low of the
asset price during a certain time interval. If the asset prices are log-normally distributed
and the drift is zero then, the underlying stock's realized high and low prices over a
given period provide information regarding the stock's variance, which is captured via
the Parkinson's number, P .


=
)
`

|
|
.
|

\
|
|
|
.
|

\
|

=
N
t
L
H
S
S
N
P
1
2
ln
1
) 2 ln( 4
1


Intuitively, one can understand that volatility of any asset observed through a 24 hour
(or any other) sampling period should be related to the extreme volatilities observed
during the period via the distribution of the maximum and the minimum. Parkinsons
number helps traders in distilling this information and helps them to better understand
the mean reversion in the market and therefore can be a potent trading tool.

If we compare the Parkinsons number with the periodically sampled volatility, o (the
historical volatility using the formula shown in #1 above) then the following holds:

o = 67 . 1 P

If a trader has a knock-out or a knock-in on his book then the above equation shows
that if P is greater than o 67 . 1 , then the likelihood of the barrier hitting is higher. This
will have trading implications. Even for trading vanilla options this relationship is
useful. As Taleb explains in Dynamic Hedging, if P is consistently higher than o 67 . 1 ,
then the hedging of long gamma has to be done more frequently.

3. Garman-Klass Estimator


( )

=

)

|
|
.
|

\
|
|
|
.
|

\
|

|
|
.
|

\
|
|
|
.
|

\
|
|
.
|

\
|
=
n
t C
O
L
H
S
S
S
S
n
P
1
2 2
log 1 ) 2 log( 2 log
2
1 250


4. Rogers-Satchell Estimator

=
)

|
|
.
|

\
|
|
|
.
|

\
|
|
|
.
|

\
|
+
|
|
.
|

\
|
|
|
.
|

\
|
|
|
.
|

\
|
|
.
|

\
|
=
n
t
O
L
C
L
O
H
C
H
S
S
S
S
S
S
S
S
n
RS
1
log log log log
250



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5. Historical Volatility using a Kalman Filter

=
=
=
)
`

|
|
.
|

\
|
=
)
`

|
|
.
|

\
|
= =
n
t L
H t
n
t
t
n
t L
H t
Historical Historical
S
S
S
S
Vol
1
2
1
1
2
ln ) 1 (
ln

o



6. Exponentially Weighted Moving Average (EWMA) Volatility


|
|
.
|

\
|
+ = =

1
2
1 ,
ln ) 1 (
t
t
t EWMA EWMA Historical
S
S
Vol o o

7. GARCH (1,1) Volatility

GARCH stands for Generalized Autoregressing Conditional Heteroskedasticity, which
essentially posits that volatility is not constant but changing. The model assumes that
the asset returns are drawn from a Normal distribution given by:

( )
t t
N R o , ~

Where, the mean is constant and the volatility, the standard deviation of the returns,
changes over time. In a GARCH (1,1) model the future variance of returns at time t ,
given by
2
t
o , is a weighted average of three parameters: (i) its immediate past estimate at
time, 1 t , given by
2
1 t
o , (ii) the most recent estimate of its squared residual, ( )
2

t
R
and (iii) a long run average value of the variance, given by
2
L
o . The weights all sum up to
one. The equation for the variance of the asset at time, t , would be given by:

( )
2
1
2
1
2 2

+ + =
t t L t
R c |o o o o

Where, 0 > a , 0 > b and 0 > c and 1 = + + c b a . This implies that b a c =1

A GARCH(1,1) model has three parameters, the long run average of the variance,
L
V , a
and b . These parameters are estimated via the maximum likelihood method which can be
very easily implemented on an Excel spreadsheet.




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GARCH: In 1982 Engle discovered heteroskedasticity - i.e. changing volatility - in
time series on British inflation. It is an effort to estimate the volatility process using
techniques from time series analysis called autoregressive models. It is assumed that the
future volatility was linked to its past realizations, each realization having its own
weight. Intuitively it can be described as a process that can be forecast using past
volatility data in a decreasing manner (as with filtering technique). "Volatility begets
volatility" as the saying goes. A volatile day is more likely to be followed by volatile
day and quiet one by a quiet one.

GARCH and Volatility of Volatility (VVol)

Vvol, or volatility of volatility, is a statistical concept which means that volatility of a
series of random variables is not constant, but varies. Historical volatility is measured by
the standard deviation of stock price returns around a mean. If this standard deviation
itself has a standard deviation then we say that the stock prices have volatility of
volatility. Statisticians call it by an awful sounding name heteroskedasticity and it is
related to the fourth moment, kurtosis, of a normal distribution. Heteroskedasticity in a
Gaussian (Normal) distribution makes a Normal probability distribution display the
fourth moment, when there should be none. One of the main reasons for
heteroskedasticity or varying volatility is that large difference in the size of observations
in a time series. As my dear friend, philosopher and guide, Justin P., who taught me
option trading, used to say that the only beast that you cannot tame is Statistics.

If the above is too esoteric, then think of a simpler example. Say, you are watching a
plane take off from the nearby airport and trying to measure the distance it travels every
5 seconds. Initially, say, in the first 10 to 20 seconds as you see the plane lift off from
the runway, your measurements will be quite accurate, maybe even to the nearest meter.
Then as the plane starts receding farther and farther away from you, the accuracy of your
measurements will fall. This is because of the increased distance between you and the
plane, the atmospheric distortions, and many other physical reasons. This data, filled
with measurement errors, will be a heteroskedastic.

In the financial markets, the notion of variable volatility, the fact that standard deviation
of stock returns would have a standard deviation, has given rise to what is known as the
paradigm of stochastic volatility or random volatility. In fact, the only way that
volatility of an asset can have volatility is if it were random and behaved in a random
fashion just like the underlying asset itself.







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Part C
Model Free Volatility and Variance Swaps


1. The Log Contract

The Log contract was introduced by Anthony Neuberger in 1994. This was the first step
towards turning volatility into an asset. The log contract is an essential component
that goes into the mathematics of variance swaps.

The Log contract pays the natural logarithm of the asset price (either spot or the
forward).The payoff is given by: S Log Payoff = for spot and for the forward we have
F Log Payoff = , where, F , is the forward contract.

The closed form solution for a Log contract on the spot price of an asset is given by:


( )
( ) t T r
e t T r S Log L

)
`

|
.
|

\
|
=
2
2
1
o



( ) t T F Log L
F
=
2
2
1
o


2. Britten-Jones & Neuberger (2000) Model

Britten Jones and Neuberger have derived a model free volatility estimate from the
entire cross-section of option prices that are traded in the market. This model free
volatility estimate is the foundation for the new VIX computation.

Under the assumption that the underlying asset does not pay any dividend and the risk
free rate is zero, the risk neutral expected sum of the squared returns between any two
future dates,
1
T and
2
T


( ) ( )
dK
K
K T C K T C
S
dS
E
T
T
t
t P
} }


=
(
(

|
|
.
|

\
|
0
2
2 1
2
, ,
2
2
1

In the above formula, we see that the asset return variance (squared volatility),
2
|
|
.
|

\
|
t
t
S
dS
is a function of only the observed traded call option prices at any point in time. The
reason it is called a model free measure of volatility is because we do not need any
quantitative model for the underlying asset price to arrive at this measure of variance or
volatility.
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Jian and Tian (2005) have given us an algorithm to implement the above model free
volatility in practice. In their implementation the no dividends and zero risk free rate
assumptions are relaxed. Assuming that we want to measure model free volatility from
the current date ( ) 0
1
= T and some later date (maturity), T ( ) T T =
2
, the model free
variance (volatility) is given by:


( ) ( )
dK
K
K S K T C
S
dS
E Variance
T
t
t P
mf
} }


=
(
(

|
|
.
|

\
|
=
0
2
0
0
2
0 , max ,
2

( ) ( )
dK
K
K S K T C
S
dS
E Vol
T
t
t P
mf
} }


s
(
(

|
|
.
|

\
|
=
0
2
0
0
2
0 , max ,
2

It can be shown that the model free Variance given above can be expressed in terms of
the observable traded prices of both call and put options. Using put-call parity it can be
shown that the model free variance is given by:



( ) ( )
} }

+ =
0
0
2
0
2
, ,
S
S
mf
dK
K
K T C
dK
K
K T P
Variance

3. Variance Swap

In a variance swap, for a given notional amount, two counter-parties swap (trade) the
future realized variance. The payoff of a variance swap (for the party going long on
it) is given by:

( )
2 2
o
o K N Payoff
R Variance
=

Where,
Variance
N is the variance notional,
R
o is the realized volatility over the
maturity of the swap and
2
o
K is the strike of the variance swap. It has to be noted that
the convention in the market is that volatility is always scaled by 100. Therefore, a
volatility strike of 20% would be expressed as 20. The variance notional gives the
deal size.

The relationship between the Variance notional and Vega notional of a variance swap
is given by:


o
K N N
Variance Vega
= 2




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We can express the payoff of a variance swap in terms of Vega notional:


( )
o
o
o
K
K
N Payoff
R
Vega
2
2 2

=

Fair Value of the Variance Strike

Demeterfi, et al has come up with a rule of thumb formula to estimate the fair value
of the strike of a variance swap. If
ATM
o is the at the money volatility, T is the time
to maturity of the variance swap and b is the slope of the volatility smile, then the
fair value of the variance swap strike is given by (approximation only):

2
3 1 b T K
ATM
+ =o
o

The parameter, b is estimated from the market. If for example, 90 strike put costs 2
volatility points more than the ATM vol, then b = 0.2.
If the volatility skew follows a log-linear relationship with the strike price given by:

( )
|
.
|

\
|
=
F
K
K
ATMF
ln o o , where, ATMF is the at the money forward volatility, F is
the forward price and is the slop of the log skew curve then the fair value of the
variance swap strike can be approximated by:
( )
2 4 2
2
3 2
5 12
4
T T T K
ATMF ATM ATMF ATMF Var
o o

o o + + + =
Stochastic Volatility Model and Variance Swap

In a stochastic volatility model, where the instantaneous variance,
t
v , follows a
mean reverting CIR process, with ( ) 0 0
2
0 0
> = = o v v :


( )
2
1
t t t
t t
t
t
dW dt v v k dv
dW v dt
S
dS
q

+ =
+ =



the expected value of the Realized Variance (RV), is given by:




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| | ( ) T v
k
e
v RV E
kT
t

=
1
2
0
o

( )

= v
kT
e
v
kT
VarSwap
1
2
0
o o


Marked to Market (MTM) of a Variance Swap

If the strike price of a variance swap maturing in T years is
2
o
K and if from the start
date (inception of the swap) a time, t A has elapsed during which the realized
variance has been
2
R
o , then the mark to market (MTM) value of the variance swap is
given by:
( ) ( )|
.
|

\
|

A
+
A
=
A
2 2
,
2 2
o o o
o K K
T
t T
K
T
t
N MTM
T R Variance

Here, the term
2
, T
K
A o
represents the fair value of the strike of a new spot variance
swap that starts after time t A has elapsed. The estimation of
2
, T
K
A o
has to be based
on a new (changed) volatility surface.
Capped Variance Swap

The payoff of a typical capped variance swap is given by:

( )
2 2 2
2 , min
o o
o K K Payoff
R
=
Here, the payoff of the variance swap is capped at 200% of the variance strike, i.e.
o
K . This cap helps limit the downside of the variance swaps seller in the event of a
default or a collapse in the stock price and a corresponding blow up of the
underlying volatility.

Making use of the mathematical identity, ( ) ( ) y x y x = , max , min , the above
payoff can be algebraically manipulated as:






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( )
( ) | |
( ) | |
( ) | |
2 2 2 2
2 2 2 2 2
2 2 2
2 2 2
0 , 2 max 2
2 , max 2 2
2 , max
2 , min
o o o
o o o o
o o
o o
o
o
o
o
K K K P
K K K K P
K K P
K K P Payoff
R
R
R
R
=
=
=
= =


In the above expression, the term ( ) 0 , 2 max
2 2
R
K o
o
is a put option on the realized
variance with a strike price of
2
2
o
K . Now ignoring the discounting factors, Put-Call parity
relationship can be written as:


Strike Spot Call Put
Strike Spot Put Call
+ =
=


Using the above Put-Call parity relationship we can write the payoff as:


( )
( ) ( )
2 2 2 2 2
2 2 2 2 2 2
4 0 , 2 max
2 0 , 2 max 2
o o o
o o o o
o o
o o
K K K P
K K K K P
R R
R R
=
+ =


In the above payoff equation, the term ( ) 0 , 2 max
2 2
o
o K
R
is the payoff of an out of
the money call option on the realized variance with a strike of
2
2
o
K . Thus, the seller
of a capped variance swap is long an out of the money (OTM) call option on the
realized variance.

4. VIX Index

CBOE defines the Volatility Index, VIX, for S&P500 as

( ) ( )
(


A
=

1
1 2
0
2
2
K
F
T
K Q
K
K
T
VIX
i
i
i
i


Where,
i
Q is the price of the out of money option with strike
i
K and
0
K is the
highest strike below the forward price, F .









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5. Volatility Swap

Peter Carr and Roger Lee, in 2009, in a paper titled Volatility Derivatives have very
elegantly derived a closed form solution for the Volatility Swaps rate. Their
derivation is based on the argument, and the common practice, the at-the-money
implied (ATMI) is taken to be as a good forecast of subsequent realized volatility.
Carr and Lee argue that ATMI, although biased, is an efficient forecast of subsequent
realized volatility.

Assumptions:

- a risk-neutral measure exists (hence no frictions and no arbitrage);
- the underlying asset price is positive and continuous over time (hence no
bankruptcy and no price jumps); and
- increments in instantaneous volatility are independent of returns (hence no
leverage effect);
Carr and Lee show that under these assumptions, the initial volatility swap rate is
closely approximated by just the ATMI, which is a single point on the implied
volatility smile curve.

( )
o
o K Payoff Swap Vol =

Where, o , is the random realized volatility at maturity, T and
o
K is the initial ( 0 = t )
volatility swap rate, i.e. the strike price. To get the fair value of the swap, under risk
netural expectiation, we have

( ) | | 0 =
o
o K E
Q


From the above, we get: | | o
o

Q
E K = where, Q is a risk neutral measure. And, the
random realized volatility is given by:


}
=
T
s
ds
T
0
2
1
o o

Given the value of a European Call option on the forward (futures) price of the
underlying asset (for which the vol swap rate is being estimated) as:

( )
|
|
|
|
|
.
|

\
|

|
.
|

\
|

|
|
|
|
|
.
|

\
|
+
|
.
|

\
|
=
2
ln
2
ln
, ,
0 0
0 0
T
T
K
F
KN
T
T
K
F
N F K F C
o
o
o
o
o

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In the above volatility is a deterministic process, but as Carr and Lee argue, o , is the
mean value of deterministic volatility. Now, for ATM condition, K F =
0
and
therefore, the call value becomes:

( )
(
(

|
|
.
|

\
|

|
|
.
|

\
|
= =
2 2
,
0 0
T
N
T
N F K F C
ATM
o o
o

Using Taylor series expansion of the above and ignoring higher order terms, it can be
shown that


(

= T
F
E C
Q
ATM
o
t

2
0


Therefore,

| |
ATM
Q
C
T F
E K = =
0
2

t
o
o



Correlation

If there are mstocks (assets),
1
S ,
2
S , ,
m
S in a basket with corresponding weights
1
w ,
2
w ,
m
w , then the realized basket (index) correlation is given by the weighted average
of the realized correlations of the component stocks (excluding the correlation between a
stock and itself):

<
s < s
=
j i
j i
m j i
ij j i
realized
w w
w w
1


The weights,
1
w ,
2
w ,
m
w , vary from 0 to 1 and all weights sum up to one, i.e. 1
0
=

=
m
i
i
w
In the above formula,
ij
, is the realized correlation between stock i and stock j . A
better way to visualize correlations between various stocks in the basket is via the
correlation matrix:





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|
|
|
|
|
.
|

\
|
=
mm m m
m
m
M


2 1
2 22 21
1 12 11


Where, the diagonal elements, 1 .....
22 11
= = = =
mm
represents the correlation of a
stock (asset) with itself. The off-diagonal elements
12 21
= ,
13 31
= ,..,
ji ij
=
are symmetric, meaning that the correlation of stock 1 with stock 2 is the same as
correlation of stock 2 with stock 1.

Sensitivity of a multi-asset (basket) option to a specific Correlation Pair

To compute the sensitivity of a multi-asset option to a specific correlation pair, say
between asset 5 and asset 6, in a basket:

(i) Increase the correlation between them by 1%
(ii) Check if the correlation matrix is still valid (i.e. it is positive semi-definite)
(iii) Re-price the option to get the difference.

Sensitivity of a multi-asset (basket) option to overall move in Correlation

To compute the sensitivity of a multi-asset option to the overall move in correlation
amongst the assets within the basket:

(i) Increase all correlations (except for the diagonal elements) in the correlation
matrix by 1%
(ii) Check if the correlation matrix is still valid (i.e. it is positive semi-definite)
(iii) Re-price the option to get the difference

A useful measure for the above purpose is the average off-diagonal correlation of the
correlation matrix. This is given by:


( )

< < s

=
m j i
ij Average
m m
1
1
2


Implied Correlation

If we define the variance of a basket comprising massets (stocks)
1
S ,
2
S , ,
m
S , with
respective weights as
1
w ,
2
w ,
m
w , and the respective volatilities as
1
o ,
2
o , .,
m
o
and a correlation matrix, M , as defined above, then the variance of the basket is given
by:
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< < s < s
+ =
m j i
ij j i j i
m i
i i Baslet
w w w
1 1
2 2 2
2 o o o o

Where,
ij j i
o o , is defined as the covariance of asset, i and j . The above formula can
be expressed in a more succinct manner as:

= =
=
m
i
m
j
ij j i Baslet
w w
1 1
2
o

Then, the implied correlation of the basket is defined as


< < s
=

=
m j i
j i j i
m
i
i i Basket
Basket
implied
w w
w
1
1
2 2 2
2 o o
o o


In the above formula,
Basket
o is the implied volatility of the basket (index) and
i
o is the
implied volatility of the i th asset of the basket.

Correlation Skew

Correlation skew arises because individual assets in a basket have implied volatility skew
and the basket itself has implied volatility skew. Vol skew for the basket means that
vanilla option prices on the basket itself for a particular maturity varies across strikes.
Correlation skew means that for a given maturity, for a set of strikes across which the
volatility of the vanilla options on assets in the basket varies (vol skew for assets) and the
implied volatility of the basket also varies, the implied basket correlation, estimated by
the above formula, will vary as well. Using the above formula if we calculate implied
basket correlation for a set of strikes and plot this correlation against the strike, we will
get a curve. This is the correlation smile or the correlation skew.

Dispersion

Dispersion is a trading strategy whereby a trader takes position on the basket volatility
against the volatility of the component stocks (assets) in the basket. More succinctly,
dispersion is going short volatility (sell volatility) on the basket and long volatilities on
the component stocks (assets) in the basket. As De Weert (48) explains, the reason the
above trade is known as a dispersion trade is because this trade will generate profits only
when the component stocks are significantly negatively correlated to each other, i.e. a
move towards a correlation of -1.


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Trading Dispersion

A trader can go long dispersion, i.e. long volatility on the component stocks, in
proportion to their weights in the basket, and short volatility on the basket, by going long
vega on the stocks (assets) in proportion to their weights and going short on vega on the
basket. This can be achieved in two ways:

- The trader can buy vega through buying variance swaps;
- The trader can buy vega through buying vanilla options;




































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Chapter O
Options & Financial Derivatives


Asset price today ( 0 = t ) =
0
S

Forward = f
Strike = K

Alternative Strike =
K'

Volatility = o
Maturity = T
Discrete Barrier = H


Barrier =
H
Risk free rate = r
Dividend Yield = q



1. Forward Price

If
t
S is the spot price at time t of the asset (stock, FX, etc.), the risk free interest rate is
r , the dividend yield is q , then at time, t , the forward contract maturing at time, T , is
given by:


( )
( ) ( )
( )( ) | | t T q r
t
t T q t T r
t t
e S
e e S T t F F


=
= = ,


2. Vanilla Call Option
Black-Scholes Formula for Option Pricing

The value of a Call option today, for realizing a payoff of ( ) K S
T
max , is given by
the following expectation:

( ) | | 0 , max K S E e Call
T
P rT
=



The above expectation is under a risk neutral probability measure, P .

The closed form price (formula) of a vanilla call option, as expressed by the above
expectation, is given by the famous Black-Scholes formula as:

( ) ( )
2 1 0
d N Ke d N e S Call
rT qT
=

Where, the values of
1
d and
2
d are given by




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T d d
T
T q r
K
S
d
o
o
o
=
|
.
|

\
|
+ + |
.
|

\
|
=
1 2
2 0
1
2
1
ln



Where, ( ) y N measures the cumulative normal (Gaussian) probability distribution. It
measures the probability that a normally distributed random variable with a mean of
zero and a unit standard deviation ( ) 1 , 0 N is less than y . In the above formula, ( )
1
d N
and ( )
2
d N are both probability estimates, even though traders prefer to call ( )
1
d N as
the delta, the hedge ratio and ( )
2
d N as the probability of the asset finishing in the
money at maturity. In Excel, ( ) N is given by =NORMSDIST(.). If the current price
of the asset is 100 and the strike price is also 100 (i.e. the call option is at the money,
ATM), the risk free interest rate is 5%, the volatility is 25% and the maturity is 1 year,
then the price of the ATM, one year call option, as given by the above formula is equal
to 12.34.

To see that both ( )
1
d N and ( )
2
d N are both similar (but not same) probability
measures, in the above example make the interest rate to 1% (very low) and volatility to
0.5% (extremely low, almost equal to zero). Then the values of both these probability
measures converge. We see that ( ) ( )
2 1
d N d N = = 0.977.

Is Delta, the hedge ratio, ( )
1
d N , a Probability measure? A Quants Explanation

As Fabrice Douglas Rouah has shown in his paper that both ( )
1
d N and ( )
2
d N are
both probabilities of the call ending up in-the-money, but under dierent measures.
Using a very elegant proof, Douglas Rouah, shows that there are two probability
measures, P and Q. P is the original risk neutral measure under which the stochastic
process of the stock (asset) is a Brownian motion. Using the application of Radon-
Nikodyn derivative from measure theory, the probability measure P can be changed to
a new measure Q. The Black-Scholes call option formula for a call option at any time,
t with a maturity of T , such that T t < can be written as:

( )
( )
( ) K S P Ke K S Q S Call
T
t T r
T t
> > =



In the above ( ) K S P
T
> is the probability of exercise under the original measure P and
( ) K S Q
T
> is the probability of exercise under the new measure, Q. Therefore, in the
Black-Scholes formula, ( )
2
d N is the probability of exercise, i.e. the probability of the
stock (asset) finishing in the money, under the risk neutral probability measure P and
( )
1
d N , the delta or the hedge ratio, is also the probability of exercise but under a
different probability measure, Q.
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Effect of Volatility on the price of a Vanilla Option







3. Vanilla Put Option

We can use the Black-Scholes formula for the call option and the Put-Call Parity
relationship (see below) to derive the closed form price of a Vanilla Put option.


( ) ( )
T d d
T
T q r
K
S
d
d N e S d N Ke Put
qT rT
o
o
o
=
|
.
|

\
|
+ + |
.
|

\
|
=
=

1 2
2 0
1
1 0 2
2
1
ln

4. Adjustment to Black-Scholes Price due to Variable (Stochastic) Volatility

See Chapter G, #7 for more on how to adjust the Black-Scholes option price when the
volatility is not constant but varies stochastically.


5. Put-Call Parity Relationship

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rT qT
Ke e S Put Call

=
0


6. Put-Call Symmetry

Put-Call symmetry is explained in many good textbooks on financial derivatives,
however a very intuitive and concise explanation, at least from traders point of view, is
explained in Nassim Talebs Dynamic Hedging. Put-Call symmetry can be used for
static hedging of barrier options (knock-out and knock-in options) and has applications

If B is a barrier then there are two strikes,
1
K and
2
K on either side of this barrier such
that
2 1
K B K < < , then the following relationship holds


|
|
.
|

\
|
= |
.
|

\
|
2
1
K
B
Log
B
K
Log


2 1
2
2 1
K K B
B K K
=
=




1
2
K
K
Call
Put
=


7. Put-Call Super-symmetry

Put-Call super symmetry is tied to the very interesting (but not so useful) concept of
negative volatility. Given the usual parameters of volatility, o , strike, K , maturity, T
and the risk free rate, r , we have


( ) ( )
( ) ( ) o o
o o
Put Call
T r K S P T r K S C
=
= , , , , , , , ,
0 0

8. Call Option on the Forward

If
t
S is the spot price at time t of the asset (stock, FX, etc.), the risk free interest rate is
r , the dividend yield is q , then at time, t , the call option on the forward contract
maturing at time, T , is given by Blacks formula:


( )
( ) ( ) | |
2 1
d KN d N F e Call
t
t T r
=






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Where,

( )
( )
t T
t T
K
F
d
t T
t T
K
F
d
t
t

|
.
|

\
|
=

+ |
.
|

\
|
=
o
o
o
o
2
2
2
1
2
1
ln
2
1
ln


9. The Put Option on the Forward

If
t
S is the spot price at time t of the asset (stock, FX, etc.), the risk free interest rate is
r , the dividend yield is q , then at time, t , the call option on the forward contract
maturing at time, T , is given by the Blacks formula for the call option on the forward
and the put call-parity for the forward given by:



( )
( ) K F e Put Call
t
t T r
=




10. Brenner-Subrahmanyam Approximation for a Call
(Black-Scholes in your head)

ATM call and put option price, with rates equal to zero ( 0 = r ), and dividend yield
equal to zero ( 0 = q ), thus making the spot is equal to the discounted strike, are given
by


t
o
2
0
T
S Put Call = =


T S Put Call
0
40 . 0 = = o


11. Approximation for a Call and a Put Price

When the rates and the dividend yield are not equal to zero, i.e. 0 = r and 0 = q , the
Call and Put option prices are approximated by the following formulas



( ) ( )
0 0
2 2
1
2
S
T q r T q r T
S Call

+ |
.
|

\
|
=
t
o


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( ) ( )
0 0
2 2
1
2
S
T q r T q r T
S Put

|
.
|

\
|
=
t
o



12. Straddle Option

Brenner, Ou and Zhang (2006) have proposed a closed form formula for valuing STOs
based on the stochastic volatility model of Stein & Stein (1991). We consider the
simple case given in their paper where the volatility is constant. The straddle option
matures at
1
T and the maturity of the straddle is
2
T . Under constant volatility and
Black-Scholes assumptions the price of a Straddle Option (STO) at time, t and a
maturity
1
T such that,
1
0 T t < s

with a strike of
STO
K (on a straddle whose price at
option maturity is
1
T
ST ) is given by:


( ) ( )
1 1
1
2
1
1
2
1
ln
,
1
T
T r
K
S
d
Where
t T d N e K d N S STO
STO
t
rT
STO t
o
o
o
o o
|
.
|

\
|
+ +
|
|
.
|

\
|
=
=


Here, the stock volatility is constant and equal to
1
o between 0 = t and
1
T but may
change to
2
o between
1
T and
2
T . In the above formula, o is the relative value of the
straddle given by:
1
1
T
T
S
ST
= o . Here,
1
T
ST and
1
T
S are the prices of straddle and the
underlying asset (stock) at option maturity,
1
T . If we use the Brenner- Subrahmanyam
(1988) approximation, then o can be approximated as:
( ) ( ) 1 2 2
1
= d N o







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13. Call Option price in a Displaced Diffusion Model



( ) ( ) ( ) ( )
T
T
K
S
d
T
T
K
S
d
d N K d N S C
o
o
o
o
o
o
o o
o
o
o
o
o
o
o
o
o o
2 0
2
2 0
1
2 1 0
2
1
ln
2
1
ln

|
|
.
|

\
|
+
+
=
+
|
|
.
|

\
|
+
+
=
+ + =


o
o
o
o
|
|
.
|

\
|
+
=
0
0
S
S


A more accurate approximation for the Displaced diffusion volatility is given by


T
S
S
T
S
S
2
0
0
2
0
0
24
1
1
24
1
1
|
|
.
|

\
|
+

|
.
|

\
|

|
|
.
|

\
|
+
=
o
o
o
o
o
o
o



14. Power Call Option
(Closed form Solution)

If the Call payoff is ( ) 0 , max
2
K S
T
, the closed form value of the call is given by:


( ) ( )
( ) ( )
T d d
T
T q r
K
S
d
d N Ke d N e S Call Power
rT qT
o
o
o o
2
2
2 2 ln
1 2
2 2 0
1
2 1 0
=
+ + + |
.
|

\
|
=
=





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15. Exchange Option

If at time, 0 = t (today), the price of asset 1 is
0 , 1
S and that of asset 2 is
0 , 2
S , and the
respective dividend yields of the assets are
1
q and
2
q , and the respective volatilities are
1
o and
2
o then for a maturity, T , the price of the exchange option would be given by:

( ) ( )
2 0 , 2 1 0 , 1
2 1
d N e S d N e S Call Exchange
T q T q
=


12 2 1
2
2
2
1
1 2
2
1 2
0 , 2
0 , 1
1
2

ln
o o o o o
o
o
o
+ =
=
|
|
.
|

\
|
+ +
|
|
.
|

\
|
=
T d d
T
T q q
S
S
d



16. Binary (Digital) Call


( )
T d d
T
T q r
K
S
d
d N e BC
rT
o
o
o
=
|
.
|

\
|
+ + |
.
|

\
|
=
=

1 2
2 0
1
2
2
1
ln


17. Binary (Digital) Put


( )
T d d
T
T q r
K
S
d
d N e BP
rT
o
o
o
=
|
.
|

\
|
+ + |
.
|

\
|
=
=

1 2
2 0
1
2
2
1
ln


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18. Put-Call Parity for Binary Options

Put-Call parity relationship for binary option states that a binary (digital) call plus a
binary put is equal to the discount factor. This result should be obvious given the fact
that a binary call option is nothing but the discounted value of the probability of the
asset finishing in the money and the binary put option is the discounted value of the
probability of the asset not finishing in the money. Sum of the probabilities should
always equal to one.


rT
e BP BC

= +


19. Outperformance Digital Call

If at time, 0 = t (today), the price of asset 1 is
0 , 1
S and that of asset 2 is
0 , 2
S , and the
respective dividend yields of the assets are
1
q and
2
q , and the respective volatilities are
1
o and
2
o then for a maturity, T , then the price of an outperformance digital option is
given by:

( ) d N e OD
rT
=

Where,


( )
12 2 1
2
2
2
1
2
2
1
2
2
1 2
0 , 2
0 , 1
2

2
ln
o o o o o
o
o o
+ =
|
|
.
|

\
|

+ +
|
|
.
|

\
|
=
T
T q q
S
S
d


20. Range Accrual Option

If, at maturity, the Stock price closes above the lower strike but below the upper strike
(both strikes included), i.e. if it is within the range of upper and lower strikes at
maturity then the option pays one, else nothing. A RangeAccrual (RA) payoff is
equivalent to a short position in a Binary Call (BC) option with upper strike price and a
Binary Put (BP) option with a lower strike price.

( ) BP BC Accrual Range + =1



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21. Pay Later Option (Contingent Premium Option)

We follow the analysis done by Wystup (2006). A Pay Later option is a vanilla call or a
put option with the difference that the buyer of the option will pay the premium to the
seller at maturity and only if the option is in the money. Otherwise, the buyer pays
nothing.



( )
( )
( )
( )

+
=
= =
=
=
=
put
call
r t T K S Vanilla
d N
e
P
r t T K S Digital
r t T K S Vanilla
P
rT
1
1
, , , 0 , , , *
, , , 0 , , ,
, , , 0 , , ,
2
|
| o
|
| o
| o


22. One Touch (Binary) Option

This valuation model is due to Reiner and Rubinstein (1991) and Wystup (2006). A one
touch (binary) option pays a lump-sum amount, A, if a certain in-strike, i.e. a barrier,
trades (that is, the barrier is hit) during the life of the option. If
0
S is the current spot
and B is the in-strike (barrier) then the price of a one touch (binary) is given by:



( ) ( )
(
(
(

|
|
.
|

\
|
+
|
|
.
|

\
|
=
+

2
0
1
0
wd N
S
B
wd N
S
B
A e C
T r
Touch One
o
| o
o
| o



Where,


( )
( )
d
f d
r
r r
T
T
B
S
d
T
T
B
S
d
o |
o
o
o
o
o|
o
o|
+ =

=
|
.
|

\
|

|
.
|

\
|
=
1 2
2
ln
ln
2
2
1

223
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And, the indicator parameters are, 1 = w for a call (which implies that the spot is
higher than the barrier) and 1 for a put (which implies that the spot is lower than the
barrier). If the payoff of the option is realized at maturity then 1 = , whereas, if the
payoff of the option happens immediately as the in-strike is hit then 0 =


Hedging a One Touch Binary: Replication Argument

If there is no skew in the market then in a Black-Scholes world a one touch (binary)
barrier option has a value of twice that of a corresponding European binary option.

The Math Argument

As Gatheral explains that a one touch binary call, struck at K , can be deconstructed as
a limit of Lookback call spreads (the limit works in making the difference between the
strikes smaller and smaller). However, a lookback call option has the same value as two
European call options and hence a lookback call spread will have the same value as two
European call spreads. Therefore, a one touch binary option is equal to two European
call options.

The Traders Argument

Lets assume that a trader is long a one touch binary put at a strike (barrier) level, K ,
and hes hedged it would be a European binary put option struck at the same strike
(barrier) level paying double the one touch options notional.

If the strike (barrier), K is hit at any time, t , before the expiry of the option then the
European binary option will become at-the-money (ATM) and therefore, assuming zero
interest rates, will have roughly a 50% chance of paying. A 50% chance at double the
payoff for the digital option will have the same value as a 100% chance at the payoff
for the touch option due to the strike (barrier) being hit.

23. Double Barrier (Binary) Option

Knock-Out (KO) Double Binary Range Option

The closed form formula for a Double Barrier Binary option has been derived by Hui
(1996). If
U
H is the upper barrier and
L
H is the lower barrier and A is the lump sum
amount that is paid out to the buyer if neither of these barriers are touched during the
life of the option, then the value of this knock-out binary range option is given by:





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( )
( )
( )
( )
2
2
2
2
1
1
2
2
0 0
2
2
2
1
4
1
1
2
1
ln
,
ln sin
1
2
2
2
o
o
|
o
t
t
o
t
o |
t
o o
q r
k
r
k
k
H
H
M
Where
e
H
S
M
n
M
N
H
S
H
S
M
A n
C
L
U
T
M
n
n U
L
n
U

=
=
=
|
|
.
|

\
|
=
|
|
.
|

\
|
|
|
.
|

\
|
(
(
(
(
(

|
.
|

\
|
+
|
|
.
|

\
|

|
|
.
|

\
|
=
(
(

|
.
|

\
|

=



Where, r is the risk free rate and q is the dividend yield and o is the volatility. For FX
options,
d
r r = and
f
r q = .

If either of the barriers,
U
H and
L
H are hit before the maturity of the option, the option
knocks out and pays nothing to the buyer.

The above closed form solution has a series expansion and in most cases the series
converges quite fast. Hui states that only a few terms are sufficient to approximate the
solution.

Knock-In (KI) Double Binary Range Option

A knock-in Double Binary Range option is equal to a short knock-out double binary
range option (valued above) plus a cash amount equal to
rT
Ae

.

Knock-In Double Binary = Knock-out Double Binary +
rT
Ae



24. Barrier Option Pricing using Barrier symmetry

Knock-out (KO) and Knock-in (KI) options, both puts and calls, can be priced using the
following parity relationship:

Knock-out option + Knock-in option = Vanilla option


225
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Vanilla KI KO = +
25. Barrier options

Given the following identities pertaining to the barrier


( )
( )
|
.
|

\
|
+
|
.
|

\
|
+
|
|
.
|

\
|
=
|
|
.
|

\
|
=
2
2
2
1
0
2
1
0
o
o
q r
q r
S
H
h
S
H
g


T
T q r
H
S
d
T
T q r
K
S
d
T
T q r
K
S
d
o
o
o
o
o
o
|
.
|

\
|
+ + |
.
|

\
|
=
|
.
|

\
|
+ |
.
|

\
|
=
|
.
|

\
|
+ + |
.
|

\
|
=
2 0
3
2 0
2
2 0
1
2
1
ln
2
1
ln
2
1
ln


T
T q r
H
S
d
T
T q r
H
S
d
o
o
o
o
|
.
|

\
|
|
.
|

\
|
=
|
.
|

\
|
+ |
.
|

\
|
=
2 0
5
2 0
4
2
1
ln
2
1
ln



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T
T q r
H
K S
d
T
T q r
H
K S
d
T
T q r
H
S
d
o
o
o
o
o
o
|
.
|

\
|
+ |
.
|

\
|
=
|
.
|

\
|
|
.
|

\
|
=
|
.
|

\
|
+ |
.
|

\
|
=
2
2
0
8
2
2
0
7
2 0
6
2
1
ln
2
1
ln
2
1
ln



Up and Out Call


( ) ( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( ) ( )
7 5 4 2
8 6 3 1 0
d N d N g d N d N Ke
d N d N h d N d N e S CUO
rT
qT

=



Up and In Call


( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( )
7 5 4
8 6 3 0
d N d N g d N Ke
d N d N h d N e S CUI
rT
qT
+
+ =




Down and Out Call


( ) ( ) ( ) ( )
( ) ( ) ( ) ( )
( ) ( ) ( ) ( )
( ) ( ) ( ) ( )
5 4
6 3 0
7 2
8 1 0
1
1
,
1
1
,
d N g d N Ke
d N h d N e S CDO
then H K If
d N g d N Ke
d N h d N e S CDO
then H K If
rT
qT
rT
qT

=
<

=
>







227
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Down and In Call


( ) ( ) ( )
( ) ( ) ( )
( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( )
5 4 2
6 3 1 0
7
8 0
1
1
,
1
1
,
d N g d N d N Ke
d N h d N d N e S CDO
then H K If
d N g Ke
d N h e S CDO
then H K If
rT
qT
rT
qT
+
+ =
<

=
>



Down and Out Put


( ) ( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( ) ( )
5 7 2 4
6 8 1 3 0
d N d N g d N d N Ke
d N d N h d N d N e S PDO
rT
qT
+
=



Down and In Put


( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( )
5 7 4
6 8 3 0
1
1
d N d N g d N Ke
d N d N h d N e S PDI
rT
qT
+ +
+ =




Up and Out Put


( ) ( ) ( )
( ) ( ) ( )
( ) ( ) ( )
( ) ( ) ( )
7 2
8 1 0
5 4
6 3 0
1
1
,
1
1
,
d N g d N Ke
d N h d N e S PUO
then H K If
d N g d N Ke
d N h d N e S PUO
then H K If
rT
qT
rT
qT
+
=
<
+
=
>










228
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Up and In Put


( ) ( ) ( ) ( )
( ) ( ) ( ) ( )
( ) ( )
( ) ( )
7
8 0
5 2 4
6 1 3 0
,
,
d N g Ke
d N h e S PUI
then H K If
d N g d N d N Ke
d N h d N d N e S PUI
then H K If
rT
qT
rT
qT

+
=
<
+ +
=
>



26. Adjustment for Monitoring Discrete Barrier
(Also see Chapter S, #1 for more on this formula).

Approximate Adjustment for up barrier


t
He H
A
~
o 8 . 0




( ) ( )
t
He f H f
A
~
o 8 . 0




More Accurate Adjustment
(Plus sign for up barrier and Minus sign for down barrier)


( ) ( )
m T
He f H f
o 5826 . 0


=
















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Effect of Volatility on the Price of a Barrier Option




As we can see from the above Excel graph, volatility has a non-linear effect on the
price of a barrier option. This point is illustrated and explained very well in Talebs
Dynamic Hedging. For a vanilla option the volatility remains linear but for a barrier
option the volatility becomes non-linear due to the dominance of the barrier. For a
knock out option as the spot comes nearer to the barrier the sheer impact of volatility
causes the barrier to get hit soon. As Taleb explains, this occurs because volatility is
always nonlinear for events that are away from the centre of the distribution (they
affect the out of the money and the in the money options).

A long barrier means a short knock out and a short barrier means a long knock out.















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27. Fixed Strike Lookback Call

If the Lookback is priced at 0 = t then
min max 0
S S S = =


( ) ( )
( )
( )
( )
( )
( )
T d d
T
T q r
K
S
d
d N e T
q r
d N
K
S
q r
e S
d N Ke d N e S Call
then S K If
T q r
q r
rT
rT qT
o
o
o
o
o o
=
|
.
|

\
|
+ + |
.
|

\
|
=
(
(

+ |
.
|

\
|
|
.
|

\
|

+
=
>


1 2
2 0
1
1 1
2
2
0
2 1 0
max
2
1
ln
2
2
,
2



( ) ( ) ( )
( )
( )
( )
( )
( )
T h h
T
T q r
S
S
h
h N e T
q r
h N
S
S
q r
e S
h N e S h N e S K S e Call
S K If
T q r
q r
rT
rT qT rT
o
o
o
o
o
o
=
|
.
|

\
|
+ +
|
|
.
|

\
|
=
(
(
(

+ |
.
|

\
|

|
|
.
|

\
|

+
+ =
s


1 2
2
max
0
1
1 1
2
max
2
0
2 max 1 0 max
max
2
1
ln
2
2
2


Lookback Hedge with Vanilla

Following the arguments presented in Goldman, Sosin and Gatto (1979) and Gatheral
(2006) it can be shown that the value of a lookback option is exactly equal to two
vanilla call option. In other words,

( ) ( ) T K Call T K Call
Lookback
, 2 , =

A trader who is short a lookback call option at K can hedge his position by two vanilla
call option struck at the same price, K

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28. Fixed Strike Lookback Put

If the Lookback is priced at 0 = t then
min max 0
S S S = =



( ) ( )
( )
( )
( )
( )
( )
T d d
T
T q r
K
S
d
d N e T
q r
d N
K
S
q r
e S
d N e S d N Ke Put
then S K If
T q r
q r
rT
qT rT
o
o
o
o
o
o
=
|
.
|

\
|
+ + |
.
|

\
|
=
(
(

+ |
.
|

\
|
+ |
.
|

\
|

+
=
<


1 2
2 0
1
1 1
2
0
2
0
1 0 2
min
2
1
ln
2
2
,
2

( ) ( ) ( )
( )
( )
( )
( )
( )
T h h
T
T q r
S
S
h
h N e T
q r
h N
S
S
q r
e S
h N e S h N e S S K e Put
S K If
T q r
q r
rT
rT qT rT
o
o
o
o
o
o
=
|
.
|

\
|
+ +
|
|
.
|

\
|
=
(
(
(

|
.
|

\
|
+
|
|
.
|

\
|

+
+ =
>


1 2
2
min
0
1
1 1
2
min
2
0
2 min 1 0 min
min
2
1
ln
2
2
2











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29. Floating Strike Lookback Call


( ) ( )
( )
( )
( )
( )
( )
T l l
T
T q r
S
S
l
l N e T
q r
l N
S
S
q r
e S
l N e S l N e S Call
T q r
q r
rT
rT qT
o
o
o
o
o
o
=
|
.
|

\
|
+ +
|
|
.
|

\
|
=
(
(
(

|
.
|

\
|
+
|
|
.
|

\
|

+
=


1 2
2
min
0
1
1 1
2
min
0
2
0
2 min 1 0
2
1
ln
2
2
2



30. Floating Strike Lookback Put


( ) ( )
( )
( )
( )
( )
( )
T l l
T
T q r
S
S
l
l N e T
q r
l N
S
S
q r
e S
l N e S l N e S Put
T q r
q r
rT
qT rT
o
o
o
o
o
o
=
|
.
|

\
|
+ +
|
|
.
|

\
|
=
(
(
(

+ |
.
|

\
|

|
|
.
|

\
|

+
=


1 2
2
max
1
1 1
2
min
2
0
1 0 2 max
2
1
ln
2
2
2



31. Arithmetic Average (Asian) Call
(Turnbull & Wakeman Formula)


( )
( ) ( )
T d d
T
T
K
S
d
d N Ke d N e S Call
A
A
A A
rT r
A
o
o
o

=
|
.
|

\
|
+ + |
.
|

\
|
=
=

1 2
2 0
1
2 1 0
2
1
ln

233
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Where, the averaging parameters are given by:


( )
( )
T
M
T
M
A
A A
1
2
ln
ln
=
=

o


If t is the time to the averaging period then the first two moments,
1
M and
2
M are
given by:


( ) ( )
( )( )
( ) ( )
( ) ( ) ( ) ( )( )
( ) ( )
( )( ) ( )
( )( )
( )
(

+
+
+ +
=


=
+
+

2 2 2
2
2 2 2
2
1
2
1 2
2
2
2
2 2
o o t
t o o
t
t t o
o
t
q r
e
q r T q r
e
T q r q r
e
M
T q r
e e
M
T q r q r
T q r
q r T q r


32. Arithmetic Average (Asian) Put

With all the above parameters in place for the Arithmetic average call, the value of
Arithmetic average put option is given by:


( )
( )
( )
1 0 2
d N e S d N Ke Put
T r rT
A
=



33. American Capped Call with no Maturity

If
A
C is the indefinitely lived American call option,
t
S is the instantaneous spot rate, r ,
q and o are interest rate, dividend yield and volatility respectively then this call option
follows an ordinary differential equation (ODE) given by:


( ) 0
2
1
2
2
2 2
= + r C
dS
C d
S
dS
dC
S q r
A
A
t
A
t
o

.If K is the strike price of this call option and B is the cap, such that K B > , then the
upper boundary condition of the above ODE is

( ) K B K T B C
A
= = , ,
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Then, assuming that K S
t
< initially, the price of the American style capped call option
with no maturity is then given by:


( ) ( )

|
.
|

\
|
= =
B
S
K B B T S C
t
t
, ,


Where, is one of the roots of the solution of the above ODE and is a function of the
volatility, interest rate and the dividend yield of the underlying.


( )
2
2
2
2 2
2 2 2
o
o o o

r q r q r + + +
=



34. Forward Starting Option

Call Option

The value of a forward starting Call option with maturity, T , and a strike price equal to
| times
t
S , where
t
S is the value of the asset at a known period of time, t , where,
T t < , is given by:


( )
( )
( )
( ) | |
( )
t T d d
t T
t T q r
d
d N e d N e Se Call
t T r t T q qT
=

|
.
|

\
|
+ +
|
|
.
|

\
|
=
=

o
o
o
|
|
1 2
2
1
2 1
2
1 1
ln


Where, r is the risk free rate, q is the dividend yield ando is the volatility of the asset.

Put Option

The value of a forward starting Call option with maturity, T , and a strike price equal to
| times
t
S , where
t
S is the value of the asset at a known period of time, t , where,
T t < , is given by


( )
( )
( )
( ) | |
1 2
d N e d N e Se Put
t T q t T r qT
=

|

Where, all parameters are same as above.

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35. Cap and a Caplet

A Caplet is a single call option on the floating interest rate, like LIBOR. A Cap is a
portfolio of Caplets.

=
=
N
i
i
Caplet Cap
1


If the forward rate (interest rate) is given by the function ( ) T t F F , = , where, F % is
the forward rate between time, t and T and K is the strike rate (in percentage) then the
value of the Caplet is given by Blacks model as:


( ) ( ) | |
t T and
t d d and
t
t
K
F
d where
d N K d N F e N Caplet
t
t
t
rT
= A
=
+
|
.
|

\
|
=
A =

,
2
1
ln
,
1 2
2
1
2 1
o
o
o


36. Floor and a Floorlet

A Floor is a single put option on the floating interest rate, like LIBOR. A Floorlet is a
portfolio of Floorlets.

=
=
N
i
i
Floorlet Floor
1


If the forward rate (interest rate) is given by the function ( ) T t F F , = , where, F % is
the forward rate between time, t and T and K is the strike rate (in percentage) then the
value of the Floorlet is given by Blacks model as:



( ) ( ) | |
t T and
t d d and
t
t
K
F
d where
d N F d N K e N Floorlet
t
t
t
rT
= A
=
+
|
.
|

\
|
=
A =

,
2
1
ln
,
1 2
2
1
1 2
o
o
o






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37. Interest Rate Swaps and Cap-Floor Parity

If we define an Interest Rate Swap (IRS) as an agreement to receive floating interest
rate (LIBOR) and pay a fixed rate of interest with periodic frequency (such as semi-
annual, quarterly, etc.) with no exchange of principal then for the same maturity and
frequency of payment then the value of an IRS is equal to the value of a cap minus the
floor.

Interest Rate Swap = Floor Cap

38. Swaption

A Swaption is an option to enter into an interest rate swap at a future point in time.
There are two kinds of Swaptions:

(i) Receiver's swaption (equivalent to a Put): swap entered at a future date to receive
fixed interest rate and pay floating interest rate;
(j) Payers swaption (equivalent to a Call): swap entered at a future date to pay fixed
interest rate and receive floating interest rate;

39. Blacks Formula for Swaption

European style Swaptions are usually valued in closed form using Blacks formula. If
F is the forward swap rate (fixed) and K is the strike rate of the swaption, t is the
tenor of the swap, n is the compounding per year in the swap rate, T is the maturity of
the option in years then:

Payer Swaption (Call) = ( ) ( ) | |
2 1
d N K d N F e k
rT






F
n
F
k
T d d
T
T
K
F
d
n t
|
.
|

\
|
+

=
=
+ |
.
|

\
|
=
1
1
1
2
1
ln
1 2
2
1
o
o
o


Receiver Swaption (Put) = ( ) ( ) | |
2 1
d N K d N F e k
rT




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F
n
F
k
T d d
T
T
K
F
d
n t
|
.
|

\
|
+

=
=
+
|
.
|

\
|
=
1
1
1
2
1
ln
1 2
2
1
o
o
o


In the above formulas, o , is the Swaption volatility given by:


FL L F L F
o o o o o 2
2 2
+ + =

Where,
F
o and
L
o are the volatilities of the fixed and floating side of the swap
respectively and
FL
is the correlation between the fixed and the floating side.


Margrabes Spread Option Formula for Swaptions:

Richard Flavell in Swaps and Other Derivatives presents an interesting alternative
world view of swaptions. He argues that a swaption can be priced using Margrabes
Spread option pricing formula.

Payers Swaption: If
F
V is the present value of the strike rate (the fixed interest rate
leg) and
L
V is the present value of the spot rate (floating interest rate leg) then Flavell
argues that the price of a Payer Swaption can be approximated by the following Spread
option formula:

( ) ( )
F L LF F L
F
L
F L
T d d
T
T
V
V
d
d N V d N V Payer
o o o o o
o
o
o
2
2
1
ln
2 2
1 2
2
0
0
1
2 1
+ =
=
+
|
|
.
|

\
|
=
=





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40. SYCURVE Options

A SYCURVE Option is an option on the slope of an yield curve. A SYCURVE Call
option is a call option on the expected value of the forward yield spread. In practice,
most SYCURVE options are on the spread between 2 yr US Treasury bond and the 30
yr US Treasury bond.

Where,
0
Y is the expected value of the forward yield spread (which is the forward yield
spread itself) between 2 yr US Treasury bond and 30 Year US Treasury Bond and K is
the strike spread (quoted in basis points) then the value of a SYCURVE Call option is
given by:



( ) ( ) ( ) | | x N T x N K Y e C
rT
' + =

o
0



Where, the following holds:


( )
( )
( )
}

=
= '
=
dx e x N
e x N
K Y
T
x
x
x
2
2
2
1
2
1
0
2
1
2
1
1
t
t
o


In Excel, ( ) N is calculated by the function =NORMSDIST(.)

41. Black-76 Formula for Bond Options

Call Option

The value of a call option with strike price, K maturing at time, T , on a zero coupon
bond whose forward price at option expiration is F , is given by:


( ) ( ) | |
T d d
T
T
K
F
d
d N K d N F e Call
rT
o
o
o
=
+
|
.
|

\
|
=
=

1 2
2
1
2 1
2
1
ln


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Here, o is the price volatility of the bond. A key assumption of Black-76 model is that
the variance of the rate of return of the bond grows linearly with time to maturity and
therefore this model should be used only for options with shorter maturity as compared
to the maturity of the underlying bond. The maturity of the option, T should be
significantly less than the maturity of the underlying bond. As Espen Haug points out in
his Option Pricing Formulas, many traders, as a rule of thumb, use the one fifth rule,
i.e. the option maturity should be less than or equal to one-fifth of the time to maturity
of the underlying bond.

Option on Treasury Bond Futures can also be priced using the above formula.

Put Option

With the above parameters the value of a put option with strike price, K maturing at
time, T , on a zero coupon bond whose forward price at option expiration is F , is given
by:

( ) ( ) | |
1 2
d N F d N K e Put
rT
=



42. Options on Zero Coupon Bond using Vasiceks Model


If ( ) t P , 0 is a price of a zero coupon bond, observed at time, 0 = t and that matures at
time, t , k is the speed of mean reversion in rates,

r is the long term average of rates,


( ) 0 r is the rate as observed at 0 = t , then the price is given by:


( ) ( )
( ) ( )
( )
( )
( ) ( )( ) ( )
(
(

=
=
k
t B
k
r k t t B
kt
r t B
e t A
k
e
t B
Where
e t A t P
4
, 0 2 , 0
0 , 0
2 2
2
2 2
, 0
1
, 0
,
, 0 , 0
o o


Call Option on a Zero

The value of a European call option maturity at time T on a zero coupon bond that
matures at time t , is given by:

( ) ( ) ( ) ( ) o' = d N T P K d N t P Call , 0 , 0



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Where,


( )
( )
( )
( )
k
e
t T B
T P
t P
d
kT
2
1
,
2 , 0
, 0
ln
1
2 2

= '
'
+
(

'
=
o
o
o
o


Put Option on a Zero

The value of a European put option maturing at time, T , on a zero coupon bond that
matures at time t , is given by:

( ) ( ) ( ) ( ) d N t P d N T P K Put ' + = , 0 , 0 o



43. Options on Variance

If ( ) t
2
o is the instantaneous variance of an asset price, define a Quadratic Variation
as:

( )
}
=
T
T
dt t y
0
2
o

Now assuming Ln| |
T
y follows a Gaussian distribution with a mean of and a
variance of
2
q , it can be shown that | |
T
y Ln also has a Gaussian distribution with
mean 2 and
2
4q . Following Gatheral, it can be shown that a closed form, Black-
Scholes formula for Call option on Variance would be given by:


( )
( ) ( )
q

q
q
q
+
=
+ +
=
=
+
K
d
K
d
d N K d N e Call
ln
2
1
2 ln
2
1
2
2
1
2 1
2
2


In the above, K , is the strike price of the variance.


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Chapter G
Greeks for Vanilla & Exotic Options

Current Price of the Asset (at 0 = t ) =
0
S
Risk free rate = r
Dividend Yield = q
Volatility = o
Time to Maturity = T
Given the following parameters and identities


T d d
T
T q r
K
S
d
o
o
o
=
|
.
|

\
|
+ + |
.
|

\
|
=
1 2
2 0
1
2
1
ln



( )
( )
2
1
2
2
1
1
2
1
2
1
2
1
d
x
e d N
e x N

= '
= '
t
t


1. Call Delta

( )
1
d N e
S
C
Delta Call
qT
=
c
c
= A =

Approximating Call Delta of an ATM option


1 1
4 . 0
2
1
2
1
2
1
d d
Call ATM
+ = + = A
t


Delta is known as the hedge ratio as option traders use this number to calculate their
hedge against short option positions. If a trader is short a call option on an asset then he
has to go long delta times the asset to create a market neutral hedge. However, such
hedges have to be dynamic as the delta changes all the time with a market move (the
change of delta is captured by gamma). Delta hedging using Black-Scholes delta, as
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given above, in the presence of a volatility smile (varying implied volatility across
various strike prices) gives rise to hedging error. See below as to how to calculate the
hedgng error.

2. Put Delta

( ) ( ) | |
1 1
1 d N e d N e
S
P
Delta Put
qT qT
= =
c
c
=




3. Delta Cash

Delta cash,
cash
A is the asset (stock) delta times the asset (stock) price.


0
S
cash
A = A


4. Gamma of a Call and a Put


( )
T S
d N e
S
P
S
C
Gamma
qT
o
0
1
2
2
2
2
'
=
c
c
=
c
c
=



Approximating the Gamma for an ATM option


T T
ATM
o t o
4 . 0
2
1
= = I

5. Gamma Cash

Gamma cash is the change in delta cash for a 1% move in the asset.


100
2
0
S
cash
I
= I


6. Vega of a Call and a Put


( )
( ) T d N e S
P C
Vega
T d N e S
P C
Vega
qT
qT
1 0
1 0
10 10 10
% ' =
c
c
=
c
c
=
' =
c
c
=
c
c
=

o
o
o
o
o
o o


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Approximating the Vega of the ATM option

T S
T
S V
ATM
= =
0
4 . 0
2t


Hedging Error Due to Volatility Smile

To understand the hedging error due to volatility smile, we follow Emanuel Dermans
arguments on the subject. Lets say trader is long a one year ATM call option on an
index at 1,000 points (assume that the current spot for the index is also at 1,000 points).
The strike price of the index (which is listed and traded) has a spacing of 100 points.
The one year (implied) volatility at strike 1,000 is 15% and at strike 1,100 is 17%. Thus
there is a volatility smile.

The trader happily uses a Black-Scholes delta hedging for his position and ignores the
smile (or is unaware of how to factor it into his hedging). He finds out that even though
he did delta hedge his position according to Black-Scholes model he lost money every
time the spot moved by 10 points. Why?

This used to happen a lot to junior, trainee traders, in the early nineties when they first
started trading equity and index options. The loss was due to the existence of volatility
smile which made the real delta of the option different from the Black-Scholes delta.
Lets take a simple but very workable (and real life) example to see how this happens.

The Black-Scholes delta is given by:


( )
dS
r T K S dC
BS
o , , , ,
= A


In the above, the differential is with respect to the spot with the assumption and this is
the big assumption in BS model that all the parameters, except for the spot
(asset/underlying) within the parenthesis, including volatility, is constant. Now if there
is smile (skew) in the market, as we see in the above example, then it means that
different strikes will have different implied volatilities. And hence the value of sigma
inside the parenthesis will not be constant. Thus the differential will become a partial
differential with the delta being the total differential as shown below:


S
C
S
C
BS
c
c
c
c
+
c
c
= A
o
o


The above equation simply follows from the rules of calculus when a function that is
being differentiated with respect to a variable has two underlying variables in its
argument. However, the above can also be intuitively explained by the dynamics of the
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smile. The smile implies that the implied volatility will vary with respect to strike
(which can be approximated by the underlying) and due to this the value of the call

itself will vary with the volatility; hence the product of two derivatives. The second
term in the above equation is called the hedging error; the quantity that will modify
the theoretical value of the Black-Scholes delta due to varying volatility (with strike) in
the market. In the second term, o c cC represents the vega of the call option.

Coming back to the example mentioned above lets see how the trader will lose out if
he ignores the hedging error. Calculation of the hedging error in our example (assuming
low interest rates) using the above equation:

94 . 398
2
1 * 000 , 1
2
= ~ ~
c
c
t t
o
T S C



( )
( )
0002 . 0
000 , 1 100 , 1
% 15 % 17
~ =

=
c
c
c
c
K S
o o


The vega of the call is approximated using Brenner-Subrahmanyam approximation.
Therefore, the product of the two derivatives above gives us the value of the hedging
error in index points:

0797 . 0 0002 . 0 * 94 . 398 = =
c
c
c
c
S
C o
o
points

Thus for a 10 point move ( 10 = S o ) in the index the trader will lose (due to imperfect
hedge) 0.797 points. And how much does he make from a perfect (Black-Scholes)
hedge? Now, the profit that the trader will earn from perfect (Black-Scholes) delta
hedge when the index moves by 10 points will be his gamma profit and will be given
by:


( ) ( )
333 . 0
2
*
1
2
* &
2 2
= ~ I =
S
T S
S
L P
o
o
o
points

Therefore, you can see that the profit he will earn due to perfect (Black-Scholes) delta
hedge will be completely eaten up by the losses from the hedging error that will be
there in his trade due to a volatility smile.





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7. Vanna of a Call and a Put


( )
o
1 2
d N d e
DdeltaDvol Vanna
qT
'
= =



8. Volga of a Call and a Put

Volga =
( )
o o
2 1 2 1 1 0
d d
Vega
d d d N e T S
DvegaDvol
qT
=
'
=




9. Adjustment to Black-Scholes Price due to Variable (Stochastic) Volatility

If we assume that the volatility, o of the asset is not constant but varies in a stochastic
(random) manner with a certain mean, ( )
0
o o = E and variance, ( ) o V then the adjusted
price of the Call option would be ( ) o C as opposed to the Black-Scholes Call option
price, ( )
0
o C . Here,
0
o , the expected value of the volatility, represents constant Black-
Scholes volatility. Then taking the Taylor Series expansion of the adjusted Call option
price around ( ) o E we get:

( ) ( ) ( )
( )
( )
( )
..........
2
1
2
2
2
0 0 0
+ + + =
o
o
o o
o
o
o o o o
d
C d
d
dC
C C

Taking the expectation of the above Call option price we get:

( ) | | ( ) ( ) + = o o o V C C E
2
1
0
Volga

Dispersion of the adjusted option price is given by:

( ) | | ( ) ( )
2
Vega V C Variance = o o

Observations

- At the money (ATM) options increase linearly with the volatility and they have a
Volga that is very close to zero;
- In the money (ITM) and out of the money (OTM) options are increases with
volatility in a convex manner and they have a positive volga (remember that
volga is the convexity of volatility).



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Option Pricing

- Since ATM options have large vega and zero (or near zero or sometimes even
negative volga) hence they dont need any adjustment to the Black-Scholes price
on account of volatility uncertainty. Therefore, the adjusted price is almost equal
to the Black-Scholes price for ATM options. However, the uncertainty or the
dispersion of this adjusted price is high because for ATM options vega is very
large and the dispersion of the adjusted price depends on the square of vega (as
shown above).
- A deep ITM or OTM option has a large volga but a very small vega. Therefore,
given the above adjustment formula, for pricing deep ITM and OTM options a
trader has to adjust the Black-Scholes price by the volatility of volatility, as given
by ( ) o V , and the Volga. The adjustment is more relevant for options with longer
maturity. However, there is very little uncertainty about this adjusted option price
because the vega of a deep ITM or OTM option is quite small.

10. Theta of a Call


( )
( ) ( )
2 1 0
1 0
2
d N rKe d N e qS
T
d N e S
T
C
Theta Call
rT qT
qT

' +
'
=
c
c
=
o


11. Theta of a Put


( )
( ) ( )
2 1 0
1 0
2
d N rKe d N e qS
T
d N e S
T
P
Theta Put
rT qT
qT
+ '
'
=
c
c
=

o


12. Rho of a Call
(with respect to the rate)


( )
2
d N T Ke
r
C
Call Rho
rT
=
c
c
=

13. Rho of a Put
(with respect to the rate)

( )
2
d N T Ke
r
P
Put Rho
rT
=
c
c
=







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14. Relationship between Delta, Gamma and Theta of Vanilla Options

From the Black-Scholes Partial Differential Equation we can deduce:


rC S rS
rC
S
C
S
S
C
rS
t
C
= + +
=
c
c
+
c
c
+
c
c
o o u
o
2 2
2
2
2 2
2
1
2
1


15. Binary Call Delta


( )
T S
d N e
rT
Call Binary
o
2
'
= A



Dirac Delta Function and the Delta of the Binary


The delta of the binary is actually the derivative of the Heaviside function and therefore
its a Dirac delta function. So the delta can be more or even significantly more than
100%. Consider a rectangle with length " y " and width " y 1 " such that the area is equal
to one (see the figure on the next page). And also consider that nothing exists in the
vicinity of the rectangle, it's a ...void (all measures of area, volume, etc. outside this
rectangle are zero). Now, no matter what the value of y is, the area of the rectangle
will always remain one and everything outside the rectangle will remain in a void,
measuring zero. And all payoffs from the given binary option that can ever happen
(whether you realize / get that payoff or not) happens within this rectangle. Now make
the rectangle stand on its length, such that the length becomes the base and the width
becomes the height on a xy plane as shown below. And then keep decreasing the
value of y , making the base smaller which will cause the height to increase, since
height is inversely proportional to the base. However, no matter how small the base
becomes (i.e. how small " y " becomes") and how spikey or tall the height becomes (i.e.
how large " y 1 " becomes), the area of this rectangle continues to remain one. And
everything outside this rectangle continues to remain in a void.

If we now reduce the base of this rectangle to an infinitesimally small value, making it
almost zero, then the height will become almost infinite - a tall spike reaching up to the
heavens. The rectangle has now collapsed into a gigantically tall spike; simply a line
standing on a point. The rectangle has become the Dirac delta function. Thus the Dirac
delta function is contained within every rectangle in this universe and in every binary
option. In fact, the Dirac delta function is contained within all financial derivatives.


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16. Binary Put Delta


( )
T S
d N e
rT
Put Binary
o
2
'
= A



17. Binary Call Gamma


( )
T S
d N d e
rT
Call Binary
2 2
2 1
o
'
= I




18. Binary Put Gamma


( )
T S
d N d e
rT
Put Binary
2 2
2 1
o
'
= I



19. Binary Call Vega


( )
o
2 1
d N d e
V
rT
Call Binary
'
=






1/y
y
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20. Binary Put Vega


( )
o
2 1
d N d e
V
rT
Put Binary
'
=



21. Delta of a Variance Swap

Under the assumption of zero volatility skew, a Variance swap does not have any
delta; however, it has a skew delta.

22. Gamma of a Variance Swap

If a variance swap is struck at time, t , with a maturity, T , then the gamma of a
variance swap is given by:


2
2
t
S T
= I

The cash gamma of a variance swap is constant through time.


23. Theta of a Variance Swap

If a variance swap is struck at time, t , with a maturity, T , then the theta of a variance
swap is given by:


T
2
o
u =
The time decay, theta, of a variance swap is constant over time.

24. Vega of a Variance Swap

If a variance swap is struck at time, t , with a maturity, T , then the vega of a variance
swap is given by:


( )
T
t T
v

=
o
2





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Chapter P
Portfolio Analysis & Asset Allocation

1. Sharpe Ratio


P
f P
r R
o


=

2. Treynors Ratio


P
f p
r R
T
|

=

3. Jensens Measure (Alpha)

( ) { }
f m P f P
r R r R + = | o


4. Portfolio Volatility
(Two Asset Case)


12 2 1 2 1
2
2
2
2
2
1
2
1
2 o o o o o w w w w
P
+ + =

5. Multi-asset Portfolio Volatility

For 3 (three) or more assets the portfolio volatility formula in algebraic form becomes
very cumbersome and tedious to handle. Matrix notations are used in those cases. Please
see the Part A of Chapter M above for more on this.

6. Expected Return for Stocks

Given the following:

E = Last Periods Earnings
g = Growth rate of Earnings
p
d = Dividend Payout Ratio
k = Equilibrium Price/Earnings multiple
P = Current Stock price




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Then, the expected return for stocks,
t
R for the period | | t , 0 is given by:


( ) ( ) ( ) ( )
P
P k g E d g E
R
p
t
+ + +
=
1 1


7. Expected Return for Bonds

Given the following:

= C Coupon payment
y = Equilibrium yield to maturity
F = Face value of the bond
P = Current bond price
T = Term to maturity (investment horizon)

Then, the expected return for the bond is given by:


( )
P
P
y
y
C
F
y
C
C
R
T
T

+
|
|
.
|

\
|

+ +
=
1


8. Volatility (Standard Deviation) of Spread in Stock and Bond Return


b s b s b s Spread
o o o o o
,
2 2
2 + =


9. Probability of Stocks Outperforming Bonds

If
s
R is the expected return of the stock and
b
R is the expected return of the bond and
Spread
o is the volatility of the spread (of returns), then assuming that the stock and bond
returns are normally distributed, the probability that the stock will outperform the bond is
given by:

| |
|
|
.
|

\
|

= >
Spread
b s
b s
R R
N R R
o
Pr




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10. Mean-Variance Optimization with Total Return
Constrained Optimization (Risk minimization) Problem
(Strategic Asset Allocation Model for Hedge Fund Managers)

A hedge fund manager wants to minimize the risk of his portfolio subject to his expected
(desired) portfolio return.

Here, a two asset problem in strategic asset allocation model entails allocating funds
between two assets based on minimization of risk (volatility or variance) given a certain
expectation of the return. Say, a hedge fund manager has to allocate funds between two
assets, 1 and 2, such that the risk of the portfolio comprising asset 1 and 2 as
measured by the variance or the volatility is minimized given a certain level of portfolio
return (fund managers desired return) that is expected of the portfolio. The problem
differs from the classical strategic asset allocation model in the sense that in a classical
model a long only fund manager (mutual fund manager) minimizes risk, subject to certain
constraints, such as no short selling, etc., but has not desired return expectation. A hedge
fund manager, like a venture capitalist or a private equity investor, on the other hand has
a firm expectation of how much return he or she wants over a certain investment horizon.

Mathematically, this problem reduces to:

( )
) 2 ( .......... .......... .......... 1
) 1 ( ........ .......... :
2 :
2 1
2 2 1 1
12 2 1 2 1
2
2
2
2
2
1
2
1
= +
= +
+ + =
x x
R R x R x to Subject
x x x x V Minimize
P
o o o o


In the above optimization problems, we have used the following notations:

V = Variance of the portfolio
1
R = Return of asset 1
2
R = Return of asset 2
P
R = Overall portfolio return that the fund manager wants to achieve
1
x = Weight of (funds invested) in asset 1
2
x = Weight of (funds invested) in asset 2
1
o = Volatility of asset 1s return
2
o = Volatility of asset 2s return
12
= Correlation between the returns of asset 1 and 2.

We employ Lagrangian multiplier method to solve the above optimization problem. Lets
say that
1
and
2
are two variables (Lagrangian multipliers) that are introduced in the
problem but we are not interested in solving for these variables; they are immaterial to
the problem. Its just a mathematical trick to make the problem tractable.

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Modified Objective Function and the Optimization problem becomes:


( )
( )
( ) 1
2 :
2 1 2
2 2 1 1 1
12 2 1 2 1
2
2
2
2
2
1
2
1
+ +
+ +
+ + =
x x
R R x R x
x x x x Z Minimize
P

o o o o

Essentially, the modified objective function, Z is exactly equal to the original objective
function (variance), V because we have incorporated the two constraints (1) and (2) in the
objective function by using the Lagrangian multipliers,
1
and
2
.

We need to solve for
1
x and
2
x for the given level of
P
R . The hedge fund managers
objective is to find out how much he should invest in asset 1 and asset 2 such that given
his desired return,
P
R and the volatility and correlation of assets 1 and 2, the allocation
will minimize his portfolio variance.

Differentiating the modified objective function with respect to various variables, we get:


0 1
0
0 2 2
0 2 2
2 1
2
2 2 1 1
1
2 2 1 2 1 12 1
2
2 2
2
2 1 1 2 1 12 2
2
1 1
1
= + =
c
c
= + =
c
c
= + + + =
c
c
= + + + =
c
c
x x
Z
R R x R x
Z
R x x
x
Z
R x x
x
Z
P

o o o
o o o


Using matrix notation we can write the above equation as:


|
|
|
|
|
.
|

\
|
=
|
|
|
|
|
.
|

\
|
|
|
|
|
|
.
|

\
|
1
0
0
0 0 1 1
0 0
1 2 2
1 2 2
2
1
2
1
2 1
2
2
2 2 1 12
1 2 1 12
2
1
p
R
x
x
R R
R
R

o o o
o o o








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The Solution of the above matrix equation is given by:


|
|
|
|
|
.
|

\
|
|
|
|
|
|
.
|

\
|
=
|
|
|
|
|
.
|

\
|

1
0
0
0 0 1 1
0 0
1 2 2
1 2 2
1
2 1
2
2
2 2 1 12
1 2 1 12
2
1
2
1
2
1
p
R R R
R
R
x
x
o o o
o o o




For a three asset problem (asset 1, 2 and 3) the above solution will become:


|
|
|
|
|
|
.
|

\
|
|
|
|
|
|
|
.
|

\
|
=
|
|
|
|
|
|
.
|

\
|

1
0
0
0
0 0 1 1 1
0 0
1 2 2 2
1 2 2 2
1 2 2 2
1
3 2 1
3
2
3 3 2 23 3 1 13
2 3 2 23
2
2 2 1 12
1 3 1 13 2 1 12
2
1
2
1
3
2
1
P
R R R R
R
R
R
x
x
x
o o o o o
o o o o o
o o o o o



Similarly, we can extend the solution for 4, 5,.., N assets.

Lets consider a two asset example. A fund manager wants to invest in two assets, asset 1
and asset 2, such that his desired return is 14%. Asset 1 has an expected return of 11%
and volatility of 19% and asset 2 has an expected return of 12% and volatility of 22%.
The correlation between the two asset returns is 0.25. How much should the fund
manager invest in asset 1 and asset 2?

Solution:


|
|
|
|
|
.
|

\
|

=
|
|
|
|
|
.
|

\
|

|
|
|
|
|
.
|

\
|
|
|
|
|
|
.
|

\
|
=
|
|
|
|
|
.
|

\
|

715 . 3
03 . 33
0 . 3
0 . 2
1
14 . 0
0
0
0 0 1 1
0 0 12 . 0 11 . 0
1 12 . 0 0968 . 0 0209 . 0
1 11 . 0 0209 . 0 0722 . 0
2
1
2
1
1
2
1
2
1

x
x
x
x




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Therefore, the fund manager needs to invest -200% in asset 1, i.e. he needs to borrow
money and go short on asset 1 to the extent of 200% and he needs to invest 300% in asset
2, i.e. he needs to go long on asset 2 to the extent of 300%. His total investment is 100%
of his funds.

This example illustrates the use of leverage by hedge fund managers.

11. Mean-Variance Optimization
Maximization of Sharpe Ratio
(Strategic Asset Allocation Model with Short Sales for Mutual Fund Managers)

The mutual fund manager wants to find out how much he should invest in different assets
such that Sharpe ratio of his portfolio is maximized. There are no constraints other than
the one that his total investment in various assets should add up to 100%.

Given the expected return of each asset (security) as
N
R R R ...., , ,
2 1
and their respective
return volatilities as
N
o o o ......., , ,
2 1
. The correlation between asset i and j is given as
ij
with an N N correlation matrix for the portfolio with N assets. The covariance of
asset i and j is given by
j i ij ij
o o o = .

Maximize the objective function:


P
f P
r R
o


=

Subject to:

1
1
=

=
N
i
i
x


Modified Objective function becomes:



( )
2
1
1 1 1
2 2
1
(
(
(

=
=
= =
=
N
i
N
i j
j
ij j i
N
i
i i
N
i
f i i
x x x
r R x
o o



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Taking the first mathematical derivative of with
i
x and equating them to zero:

0 ......, .......... , 0 , 0
2 1
= = =
n
dx
d
dx
d
dx
d


Substituting,
k k
x h z = , where h is an arbitrary constant, we get the following system of
linear equations:


2
2 2 1 1
2
2
2 2 12 1 2
1 12 2
2
1 1 1
...... ..........
...... ..........
...... ..........
N N N N f N
N N f
N N f
z z z r R
z z z r R
z z z r R
o o o
o o o
o o o
+ + + =
+ + + =
+ + + =



Using matrix notation, we can solve the above system of linear equations quite easily. For
a three asset case (asset 1, 2 and 3) we can express the above system of linear equations
as:


|
|
|
.
|

\
|
|
|
|
.
|

\
|
=
|
|
|
.
|

\
|

3
2
1
2
3 3 2 23 3 1 13
3 2 23
2
2 2 1 12
3 1 13 2 1 12
2
1
3
2
1
z
z
z
r R
r R
r R
f
f
f
o o o o o
o o o o o
o o o o o


The solution is:


|
|
|
.
|

\
|

|
|
|
.
|

\
|
=
|
|
|
.
|

\
|

f
f
f
r R
r R
r R
z
z
z
3
2
1
1
2
3 3 2 23 3 1 13
3 2 23
2
2 2 1 12
3 1 13 2 1 12
2
1
3
2
1
o o o o o
o o o o o
o o o o o


After estimating the
k
z (the z values), we can find out the corresponding
k
x (the x
values), i.e. the proportion to invest in each of the asset such that the Sharpe ratio is
maximized using the following formula:

=
=
N
j
j
k
k
z
z
x
1






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An example: a mutual fund manager wants to invest in three assets (securities), asset 1, 2
and 3. Asset 1 has an expected return of 12% and volatility of 15%. Asset 2 has an
expected return of 9% and volatility of 10%; and asset 3 has an expected return of 20%
and volatility of 28%. The risk free rate is 2% and the correlation matrix of asset returns
for the three assets is given below:


|
|
|
.
|

\
|
=
1 02 . 0 25 . 0
02 . 0 1 65 . 0
25 . 0 65 . 0 1
M

Therefore, the algorithm to maximize the Sharpe ratio of the portfolio and find out the
amounts to invest in each of the assets is given by:


|
|
|
.
|

\
|
=
|
|
|
.
|

\
|

|
|
|
.
|

\
|
|
|
|
.
|

\
|
=
|
|
|
.
|

\
|

14519 . 2
09973 . 6
80014 . 0
18 . 0
07 . 0
1 . 0
0784 . 0 00056 . 0 0105 . 0
00056 . 0 01 . 0 00975 . 0
0105 . 0 00975 . 0 0225 . 0
3
2
1
1
3
2
1
z
z
z
z
z
z


Therefore, the proportions to invest in each of the three assets are given by:


% 85 . 8
045 . 9
8001 . 0
1
= = x , % 44 . 67
045 . 9
099 . 6
2
= = x , % 72 . 23
045 . 9
145 . 2
3
= = x



12. Sharpes Algorithm for Estimating Efficient Frontier
(Constrained Optimization: Three Asset Case)

If V is the variance of the portfolio and
P
R is the return of the portfolio then the
objective function if given by:


P
R R x R x R x to Subject
x x
x x x x x x x V Minimize
= + +
+
+ + + + =
3 3 2 2 1 1
23 3 2 3 2
13 3 1 3 1 12 2 1 2 1
2
3
2
3
2
2
2
2
2
1
2
1
:
2
2 2 :
o o
o o o o o o o





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We modify the objective function using a Lagrangian multiplier as:

Z Minimize : , where,


|
|
.
|

\
|
+
+ + + +
+ + =
23 3 2 3 2
13 3 1 3 1 12 2 1 2 1
2
3
2
3
2
2
2
2
2
1
2
1
3 3 2 2 1 1
2
2 2
o o
o o o o o o o

x x
x x x x x x x
R x R x R x Z

Taking the first mathematical derivative of Z with respect to asset weights


( )
( )
( )
2 3 2 23 1 3 1 13 3
2
3 3
2
3 3 2 23 1 2 1 12 2
2
2 2
2
3 3 1 13 2 2 1 12 1
2
1 1
1
2 2 2
2 2 2
2 2 2
x x x R
x
Z
x x x R
x
Z
x x x R
x
Z
o o o o o
o o o o o
o o o o o
+ + =
c
c
+ + =
c
c
+ + =
c
c


Sharpes algorithm follows an iterative procedure whereby we increase the allocation to
the asset that has the highest value for the first mathematical derivative and reduce by
the same amount the allocation to the asset that has the lowest value for the first
mathematical derivative. And we follow this iterative procedure subject to any
constraint that we may wish to impose on the portfolio. When all mathematical
derivatives (with respect to the weights of asset 1, 2 and 3) are equal to each other,
subject to our constraints, the portfolio becomes efficient.

13. Investing and Speculating: Beyond the First Two Moments

There are two kinds of people who inhabit the world of investments:

- Investors (Long term investors may be a better term)
- Speculators

Analyzing an Investors Behaviour

Investors invest money in any asset with the belief that the expected return will be high
and variance of the returns (volatility) will be low. That is, they implicitly believe in a
high first moment and a low second moment of the Normal (Gaussian) probability
distribution (assuming, of course, that asset returns follow a Normal distribution).
Another way to look at it is through Taylor series expansion which will express any
function as a polynomial combination of the moments of an arbitrary probability
distribution.

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An investors utility can be approximated as a polynomial function around a mean
portfolio return
P
R as:


( ) ( )
( )
( )
( )
( )
( )
( )
terms order higher
R R
R
R U
R R
R
R U
R R
R
R U
R U R U
P P P
+

c
c
+
c
c
+
c
c
+ ~
4
4
4
3
3
3
2
2
2
! 4
1
! 3
1
2
1


If we take the expectation of the above equation and ignore the higher order terms as well
as approximate the derivatives of the utility with constants we get:


( ) | | ( ) ( ) | | ( ) | | ( ) | |
( ) | | Kurtosis Skewness Variance Mean R U E
R R E R R E R R E R U R U E
P P P
. . .
3 2 1
4
3
3
2
2
1
o o o
o o o
+ + + ~
+ + + ~


Therefore, the investors expected utility in other words, possible benefit from a
certain investment depends on mean, variance, skewness and kurtosis (the first, second,
third and the fourth moments of the distribution respectively).

Investors want a high (positive) mean and low variance from any investment, but what
about skewness and kurtosis? Taylor series expansion shows that the third and the fourth
terms are also pertinent in impacting the utility of an investor. Classical investment
theory (Modern Portfolio Theory of Markowitz and Sharpe) ignores these two terms and
analyzes the entire investment problem in the light of only the first two moments of the
distribution (hence the model is known as mean-variance optimization).

In reality, however, skewness and kurtosis play an important role in determining an
investments outcome from the market. A high mean should also mean a high (positive)
skewness. But positive skewness means frequent small gains (profits) and infrequent
large losses. This means over the long run if an investor has a positive skew, because of
the fact that he desires high expected return, somewhere along the line, once in a while,
he might suffer huge losses that might perhaps wipe out his entire profits. It is now an
expected norm that under weak assumptions investors desire high odd moments (the
mean and the skewness in the above expansion) and low even moments (the variance and
the kurtosis in the above expansion).

Analyzing a Speculators Behaviour

The above view of investors preferring high odd moments and low even moments is
completely at odds with the behaviour of the speculators. What is the underlying rationale
of speculating? Why does the cab driver buy the lottery ticket religiously every week?
Why does the noodle shop owner put more faith in the horses than her dumplings and
fried rice?


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In the case of a lottery ticket, or any gambling exercise for that matter, the expected
return is very low; in fact it is usually negative. The chances very high that you will lose
all that youve put into the gamble. And obviously by deduction the variance of the return
is very high. If we assume that the Taylor series captures a speculators utility correctly
then we have to say that the second and the third term above, i.e. the skewness and the
kurtosis should play some role in this as well. A low or negative mean certainly means
low or negative skewness (both first and third moments will behave in a similar fashion)
and a high variance will imply a high kurtosis (both the second and the fourth moment
will behave in a similar fashion).

Thus speculators are seeking low mean and negative skew with high positive variance
and kurtosis. In fact, the negative skew trade means that speculators are indeed betting on
the fact that they will keep losing small money periodically and continuously weekly
lottery for the cab driver or bi-weekly horse race for the noodle shop owner but once in
a while, over a certain longer period of time he will make a fortune.

This is at odds with the behaviour of our conventional investor. In that sense speculators
behave like option buyers.

14. Portfolio Insurance

Portfolio Insurance entails investing in a risky asset (stock, stock index) and a risk free
asset (government bond) in such a way that there is a floor to the investment, i.e. the
investor participates in the upside from the risky asset but loses no more than a certain
percentage of his investment by maturity. For example, if an investor invests $100 in a
risky asset (stock) but does not want to lose more than 10% of his investment within a
years time, then he can create a portfolio insurance strategy.

Portfolio Insurance is equivalent to:

(i) replicating an investment in a risky asset, like a stock or a stock index, and a put
option; or
(ii) replicating an investment in a risk free asset and a call option

Portfolio Insurance can be achieved without actually buying put or call options. Rather,
portfolio insurance in its purest form involves synthetically replicating the payoff of a put
option on the risky asset and combining that with the investment in the risky asset.

Now lets see how we can create investment in a risky asset (stock) and a risk free asset
(government bond) by






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I. Investment in Risky Asset (Stock) plus a Synthetic Put Option
(Binomial Model - Portfolio Insurance without Black-Scholes Model)

As mentioned above, Portfolio Insurance in its purest form does not require any
investment in call or put options. Rather, an investor or fund manager replicates payoff
from a call or a put option by synthetically replicating those payoffs.

Suppose we want to invest $100 in a risky asset (say, a stock or a stock index) for one
year and at the same time do not want to lose more than 10% of the value of our
investment at any point in time during the next one year. This means we want to insure
our portfolio. We can get this insured payoff, i.e. investment of $100 and the investment
(portfolio) value not going below $90 at any time, by buying a protective put option
together with the investment. That is, we invest $100 and at the same time buy a
protective put option. This protective put option can be an actual traded put option on
the asset and in that case well have to go to our bank or the broker and buy such a put
option from the market. However, lets say that we do not want to invest in financial
derivatives and would only like to be invested in cash equities and bonds. Then, how do
we value such a protective put option? How much should be invest in such a put
option?

We do not have to buy put options from the market to insure our portfolio. We can buy or
rather create a synthetic put option on this portfolio, which will act like a protective
put. A synthetic put option can be replicated by selling short some fraction of the risky
asset (i.e. the stock or the stock index) and lending money at risk free rate. Let us assume
that the risk free rate is 1%. Also assume that in a years time the stock can either go up
to $130 or go down to $80. Given the payoff of a put option at maturity, i.e. after one
year, is given by ( ) 0 , max
T
S K , where
T
S is the value of the asset after one year and
K is the strike price. In our case, the strike price is $90 and
T
S takes on two possible
values, $130 or $90. Therefore, we solve a system of two linear equations in two
unknown, N and L , where, N is the amount of the risky asset (stock or the stock index)
to sell short and L is the amount to lend at risk free rate. Lending at risk free rate is
tantamount to buying risk free government bonds.


10 01 . 1 90
0 01 . 1 130
= +
= +
L N
L N


Solving the above equation gives the value of N and L as -0.20 and 25.74 respectively.
Therefore, we can replicate the synthetic put option by selling short 20% of the stock and
lending (i.e. buying govt. bonds) $25.74 at 1% risk free rate.





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In case, we are interested in finding the value of the synthetic put option, it would be
given by:


74 . 5
74 . 25 $ 100 * 20 . 0
=
+ =
Put
Put


Thus, the synthetic put options value at the start of the period, i.e. at the time of
investment should be $5.74. The reader can verify for himself that selling short the stock
and lending in these amounts (buying risk free bond) provides the same outcome as an
investment in a put option.

Therefore, to replicate the protective put strategy, we have to invest $100 in the stock and
also sell short the stock for an amount equal to 20% of the investment, i.e. $20 and invest
$25.74 in government bond.

Portfolio Insurance Strategy = 74 . 25 $ 20 $ 100 $ + = $105.74

There is only one problem with the above strategy. The total investment for the Portfolio
Insurance strategy comes out to $105.74, whereas our initial investment outlay is only
$100. The investment in the stock and the synthetic put, i.e. investment in the stock and
the risk free bond should total to $100. How can we do that?

Well, here one has to iteratively find the amounts to invest in stock and bond which will
be equal to the total investment size of $100. The solution, found using Excel Solver,
with the same parameters as above for the stock price up move and down move and 10%
risk free rate of interest, would be to go long (buy) $95.87 worth of stock (risky asset),
short (sell) the stock for 13% of this amount to get a net exposure of $83.82 in the stock
and buy $16.17 in risk free government bond. With these amounts the cost of the
synthetic (protective) put would be $4.13 and therefore, the initial investment of $95.87
plus the cost of the put of $4.13 equals $100, the initial investment outlay.

The portfolio insurance strategy would be:

Portfolio Insurance Strategy = $95.87 - $12.05 + $16.17 = $100

II. Investment in Risk free Asset plus a Call Option on the Risky Asset
(Portfolio Insurance with Black-Scholes Model)

Portfolio Insurance is also equivalent to investing in a risk free asset, such as a
government bond, plus buying a call option on the risky asset (stock). This time lets
value the synthetic put and the call option using the Black-Scholes option pricing
formula. Lets say, that like the above mentioned situation, we have $100 to invest for
one year and we do not want to lose more than 10% of our investment. With this

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objective in mind we want to create a portfolio insurance strategy by investing in a risk
free bond and buying a call option. The following are the parameters of our problem.

Risky Asset = $100
Strike Price = $90
Volatility of asset = 20%
Short term interest rate = 1%
Maturity = 1 year

Using Black-Scholes formula and the Put-Call parity relationship, we get:

( ) 7507 . 0
1
= d N
( ) 6832 . 0
2
= d N
Call = 14.19
Put = 3.29

Thus, we have $100 in investment in risky asset (stock) and $3.29 investment in put
option. Therefore, we are once again faced with the same predicament. We have a total
investment outlay of $100 and our investment in stock and put becomes $103.29. So we
need to iteratively figure out the right proportion to invest in the stock and the option that
totals to $100.

Once again, using Excel Solver we find out, given the above parameters of volatility,
interest rate, etc., the right amount to invest in the risky asset is $95.36 and that gives the
value of the put option $4.63, so that the total adds up to $100. For this calculation we
get: ( )
1
d N = 0.6698, ( )
2
d N = 0.5946, Call = $10.89, Put = $4.63

Now, we need to determine how to replicate this strategy of buying $95.36 in stock and
$4.63 in put option into an investment in a risk free government bond and a call option.
This is done with the help of the hedge ratio, delta, of the call option. The delta, ( )
1
d N , of
the call option, as we can see from our calculations above, is 66.98%. Therefore, we
would invest the delta times the investment in risky asset (stock) $95.36 in risky asset and
balance of the investment outlay in bonds.

Portfolio Insurance Strategy = $95.36 ( )
1
d N + {$100 - $95.36}
= $63.88 + $36.11 = $100


Therefore, we would invest $63.88 in the risky asset (stock) and $36.11 in risk free
government bonds.





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15. Constant Proportion Portfolio Insurance (CPPI)

Constant Proportion Portfolio Insurance (CPPI) is particular kind of Portfolio Insurance
strategy introduced by Andre Perold of Harvard University for fixed income instruments
and Fischer Black and Robert Jones of Goldman Sachs in 1986.

CPPI addresses two major problems that are inherent in classical Portfolio Insurance. As
Mark Kritzman explains in his wonderful text, Asset Allocation for Institutional
Portfolios, portfolio insurance is plagued by two problems:

(i) Portfolio Insurance as a trading strategy is not particularly straightforward;
(ii) Portfolio Insurance is time dependent, i.e. there always a pre-determined investment
horizon and the delta of the synthetic option (the hedge ratio) has a temporal
dependence with the time to maturity (investment horizon). Even though an
investors attitude towards risk does not change as we move from one investment
horizon to the other, the portfolios riskiness changes due to the change in hedge
ratio.

CPPI works like this: If we want to invest $100 in an asset and want a floor at $90 (i.e.
we do not want to lose more than 10% of the investment value) then we simply multiply
the cushion of $10 (= $100 - $90) by a multiple greater than one and allocate that
amount to the risky asset and the balance to the risk free asset. And then we keep on
monitoring the asset price and in between each successive revisions of the asset price. In
between any two consecutive price changes of the risky asset, if the portfolios value
does not decrease by more than the inverse of the multiple the portfolio will never go
below the floor.

Advantages of CPPI, as Mark Kritzman explains, are:

(i) CPPI as a trading strategy is very simply to understand and implement in practice;
(ii) CPPI continues indefinitely and trades are not occasioned by the passage of time.


16. Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM) is an equilibrium model of asset pricing that was
introduced by William Sharpe in 1964. It does not model the rate of return of an asset but
rather focuses on the risk premium. Risk premium is defined as the expected excess
return above the risk free rate and in equilibrium this risk premium a security j is related
to the market risk premium. Mathematically, CAPM equation can be written as:

( )
j f M j j f j
r r r r c | o + + + =


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In the above expression,
j
r is the return of the security (asset) j ,
f
r is the risk free rate,
M
r is the return on the market portfolio (market index),
j
o is the abnormal return (or the
value added by the portfolio manager),
j
| is the sensitivity of the asset to the market risk
and
j
c is a random noise. In a classical CAPM model, both
j
o and
j
c are zero and the
equation for the risk premium becomes:

( )
f M j f j
r r r r = |

In other words, the risk premium of the asset (security) j is related to the market risk
premium via the sensitivity,
j
| .

17. Minimization of Risk and MCR Algorithm

Marginal Contribution of Risk (MCR) is widely used by asset managers to determine a
portfolios overall risk sensitivity to a particular asset and the MCR is used by many
algorithmic traders to determine the number of shares in a trade list to buy and sell at a
particular point in time.

We will use the terms Risk and MCR interchangeably.

Y Y Risk
T
E =

In the above formula, Y is the vector of exposures (the number of stocks in a trade list),
E is the variance-covariance matrix and
T
Y represents the transpose of Y .

As shown by Kissell and Glantz (see Reference below), the minimization of risk (or the
MCR) entails that:

0 =
c
c
Y
Risk
and 0
2
2
<
c
c
Y
Risk


Therefore, we have

0 =
E
E
=
c
c
Y Y
Y
Y
Risk
T
T


The solution of the above in matrix form is given by:

NMY Y =


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Where,


( )
1
1

+ E =
=
E =
A M
D N
of Diagonal D


In terms of the elements of N and M matrix,
ij
n and
ij
m respectively, we can write

=
=
E
=
j i if
j i if
n
ii
ij
0
1


= E
=
=
j i if
j i if
m
ii
ij
0


One has to remember that the matrix solution NMX X = can only be valid for the
execution in a single stock (share). Therefore, the number of shares in a single stock k
that minimizes the residual risk (MCR) is calculated as:

( )NMX k I y
T
k
=
min ,


Where, ( ) k I
T
is the th k of the Identity Matrix. Thus, the total number of shares of stock
k to trade to minimize residual risk is given by:


min , k k k
y Y w =

But since there is a restriction around the number of shares to trade, given the fund
manager / traders holding in the trade list, such that,
k k
Y w s s 0 the following
adjustments need to be made for a buy order and a sell order.

Buy Order:

<
>
s s
=
0 0
0
k
k k k
k k
buy
k
w
Y w Y
Y w w
w

Sell Order:

>
<
> >
=
0 0
0
k
k k k
k k
buy
k
w
Y w Y
Y w w
w

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18. Statistical Arbitrage

If there are two securities, j and k then a relationship between the price level
t j
P
,
and
t k
P
,
can be arrived using the following algorithm:

i. Out of a universe of liquid securities, that trade at least once within the desired
trading frequency (an hour, a day, etc.) we search for two securities, j and k ; the
price difference between two securities is given by:

| | T t P P P
t j t i t ij
, 1
, , ,
e = A


ii. Then by a minimization of the historical differences in returns between every two
securities, we select the pair of security that is most stable and move together. For
every security, j select a security k with the minimum sum of squares as given
below:


( )

=
A
T
t
t jk k j
P
1
2
, ,
min

iii. Next we estimate the basic distributional properties of the difference. In particular,
we test for the mean and standard deviation:

| | | |

=
A = A = A
T
t
t t t
P
T
P P E
1
1


| | ( ) | |

=
A A

= A
T
t
t t t
P P
T
P
1
2
1
1
o

iv. The buy and sell trade are constructed as follows:

At any point in time, t , sell security j and buy security k

( ) ( )
t t t t t
o P P P P P
k j
A + A > = A 2
, ,


At any point in time, t , buy security j and sell security k

( ) ( )
t t t t t
o P P P P P
k j
A A < = A 2
, ,


v. When the gap in the security prices reverses to achieve a desired gain close the
positions. Of course, if the prices move against the prediction then use stop loss.


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An excellent explanation of statistical arbitrage is given in the book High Frequency
Trading by Irene Aldridge.

Morgan Stanley and the Birth of Statistical Arbitrage

Richard Bookstaber, the first market risk manager at Morgan Stanley in the mid-1980s
and the author of the 2006 book, A Demon of Our Own Design, writes that Statistical
arbitrage is now past its prime. In mid-2002 the performance of stat arb strategies began
to wane, and the standard methods have not recovered. Was it pure coincidence or
absolute prescience on part of Bookstaber that in less than a year after the publication of
this book the global financial markets would unravel.

The August 2011 issue of Bloomberg Markets profiles Peter Muller, the star quant trader,
who founded the Process Driven Trading (PDT) group at Morgan Stanley in 1993. Muller
and his PDT group at Morgan Stanley have made most of their money from an
algorithmic (quantitative) trading strategy called Statistical Arbitrage, or Stat Arb. Not
only at Morgan Stanley but at many other investment banks and hedge funds, Statistical
Arbitrage has been a hugely profitable quantitative trading strategy for the past 25 years.

Of course, Statistical Arbitrage is not just a single trading strategy. As things stand today,
it is an umbrella term used for a broad range of quantitative trading strategies that use
sophisticated statistical and mathematical models to analyze price differences and price
patterns between securities to generate a higher than average profit for the traders. The
math concepts used in Statistical Arbitrage range from Time Series Analysis, Principal
Components Analysis (PCA), Co-integration, neural networks and pattern recognition,
covariance matrices and efficient frontier analysis to advanced concepts in particle
physics such as free The genesis of Stat Arb can be traced from a quantitative trading
strategy called pairs trading. And 25 years after its birth, this strategy, which exploits
price discrepancies and correlation between a pair of stocks to buy and sell them and
make money, still lies at the heart of Statistical Arbitrage. It is believed that the notion of
pairs trading had been around for many years prior to 1980; apparently, Paul Wilmott has
claimed that this trading idea was discovered at his shop in 1980. However, the
formalization of the concept of pairs trading and its implementation as an acceptable
quantitative trading strategy happened in Morgan Stanley in 1982-83. There is a bit of a
debate over who exactly discovered pairs trading. Some, including Bookstaber, believe
that it was Gerry Bamberger, who hit upon this idea while working at Morgan Stanley &
Co. in the early eighties. Bamberger, a computer science graduate from Columbia
University, left Morgan Stanley in 1985 and disappeared from Wall Street around 1987.
Others believe that it was Nunzio Tartaglia, a brilliant quan trader, working with a small
group of researchers at Morgan Stanley in 1985 that discovered pairs trading. Putting the
debate to rest, lets just say that it was Gerry Bamberger and Nunzio Tartaglia at Mogran
Stanley who discovered pairs trading in early to mid-1980s. In the early 1980s Morgan
Stanley was assembling a team of computer scientists and traders to work in an
independent, ultra secretive group, which would exploit the discrepancies in the stock
prices to generate abnormal profits. It would be a well-planned assault on the Efficient
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Market Hypothesis (EMH). One of the members of that team was a computer scientist
from Stanford named David Shaw, who would later founded the legendary Wall Street
investment firm D.E.Shaw & Co. Bamberger, Tartaglia and Shaw, all worked as a part of
this ultra-secretive group that was in search of the Holy Grail of trading.

Morgan Stanleys black box was born in 1985 that would earn the firm a lot of money,
and of course, bolster its reputation man on Wall Street. Even though the term Statistical
Arbitrage would only come into prominence in the mid-1990s when Wall Street traders
would embrace a plethora of complex and esoteric mathematical model to exploit market
anomalies, with the introduction of Morgan Stanleys pairs trading black box the war
against the theory of Efficient Markets had begun.

However, with the departure of David Shaw, Gerry Bamberger and many of other
associates of Tartaglia, in the mid to late eighties this quant trading group at Morgan
Stanley would ultimately fall apart in spirit, though traders would continue to use pairs
trading on the firms trading floor. In 1993, the task of resuscitating the group would fall
on the 29 year old Peter Muller, who would be hired by Derek Bandeen, a prop trader at
Morgan Stanley. The group would be anointed with a new name, the Process Driven
Trading (PDT), and Muller would recruit his own army of quants and computer
programmers to work with him. Over the next decade, Mullers PDT would make lots of
money for the firm and establish Morgan Stanley as the leader in the field of Statistical
Arbitrage.

19. Triangular Arbitrage

Triangular arbitrage is done in the foreign exchange markets. This is due to the
triangular relationship between cross currencies. This is based on the definition of a
synthetic price of a cross currency. Take the example of EUR/JPY. The synthetic
EUR/JPY is given by:


JPY
USD
USD
EUR
JPY
EUR
=

If there is a mispricing between the market price of EUR/JPY and the synthetic price of
EUR/JPY, then the strategy creates an arbitrage using the following relationships


bid Market bid Market bid Synthetic
JPY USD USD EUR JPY EUR =


ask Market ask Market ask Synthetic
JPY USD USD EUR JPY EUR =

If the market asking price for EUR/JPY is less than the synthetic bid price for EUR/JPY
then buy market EUR/JPY and sell synthetic EUR/JPY and then reverse the positions
when the market and synthetic prices become aligned. For the strategy to work the
difference in the market asking price and the synthetic bid price should be big enough to
overcome the spreads on EUR/USD and on USD/JPY.
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Ferraris, Christopher Jordinson and Aziz Lamnouar (John Wiley & Sons, Inc. 2007)
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nd
Edition, Paul Wilmott (John
Wiley & Sons, Limited)
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th
Edition, Edwin J.Elton and Martin
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29. Probability of Exercise in the Call Price, Fabrice Douglas Rouah, www.FRouah.com
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53. http://www.nas.ewi.tudelft.nl/people/Piet/CUPbookChapters/PACUP_Poisson.pdf
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Paul Stefiszyn , FEA, September 2002














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About the Author

Rahul Bhattacharya is the CEO of Risk Latte Company Limited. He has taught and conducted
training sessions for traders, quants, structuring and sales professionals and risk managers in top
tier global banks and investments all over the world, such as Goldman Sachs, HSBC, Citigroup,
Barclays Capital, Credit Suisse, RBS, to name only a few. He teaches the CFE course for the
CFE School, which is the education and learning division of Risk Latte Company.

He has more than 15 years experience in options and FX trading, commodity structuring and risk
advisory and analytics and has worked all over the world. He holds an B.Sc. (Hons) in Physics,
an M.Sc. in Nuclear Physics and an MBA in Finance.

He can be reached at rahul.bhattacharya@risklatte.com

CFE School

CFE School is the Education and Learning division of Risk Latte Company in Hong Kong and
conducts the public course Certificate in Financial Engineering (CFE) and other specialized
quantitative finance courses for banking and finance professionals all over the world.

For any queries on the CFE course or other programmes of the school, please send your request
to cfeschool@risklatte.com.

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