Pricing Financial Derivatives

Bruno Dupire
Bloomberg L.P/NYU

AIMS Day 1

Cape Town, February 17, 2011
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2
Addressing Financial Risks
volume
underlyings
products
models
users
regions
Over the past 20 years, intense development of Derivatives
in terms of:
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3
Vanilla Options
European Call:
Gives the right to buy the underlying at a fixed price (the strike) at
some future time (the maturity)

( )
+
=
T
S K Payoff Put
European Put:
Gives the right to sell the underlying at a fixed strike at some maturity

( ) 0 , max ) ( Payoff Call K S K S
T T
= =
+
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Option prices for one maturity
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Risk Management
Client has risk exposure
Buys a product from a bank to limit its risk
Risk
Not Enough Too Costly Perfect Hedge
Vanilla Hedges
Exotic Hedge
Client transfers risk to the bank which has the technology to handle it
Product fits the risk
OUTLINE
A) Theory
- Risk neutral pricing
- Stochastic calculus
- Pricing methods

B) Volatility
- Definition and estimation
- Volatility modeling
- Volatility arbitrage


A) THEORY
Risk neutral pricing
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Warm-up
% 30 ] [
% 70 ] [
=
=
Black
Red
P
P

Black if $0
Red if 100 $
Roulette:
A lottery ticket gives:
You can buy it or sell it for $60
Is it cheap or expensive?
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2 approaches
Buy 60 70 >
Sell 60 50 <
Nave expectation
Replication Argument
as if priced with other probabilities instead of
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Price as discounted expectation
! ?
Option gives uncertain payoff in the future
Premium: known price today

Resolve the uncertainty by computing expectation:
Transfer future into present by discounting
? !
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Application to option pricing
Risk Neutral Probability
Physical Probability
}

+
=
o
T T T
rT
dS K S S e ) )( ( Price
Stochastic Calculus
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Modeling Uncertainty
Main ingredients for spot modeling
Many small shocks: Brownian Motion
(continuous prices)


A few big shocks: Poisson process (jumps)
t
S
t
S
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Brownian Motion
10
100
1000
From discrete to continuous
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Stochastic Differential Equations
t
W
) , 0 ( ~ s t N W W
s t

dW dt dx b a + =
At the limit:

Continuous with independent Gaussian increments

SDE:

drift noise
a
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Itos Dilemma
) (x f y =
dW dt dx b a + =
Classical calculus:

expand to the first order


Stochastic calculus:

should we expand further?
dx x f dy ) ( ' =
... ) ( ' + = dx x f dy
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Itos Lemma
dt dW =
2
) (
dW b dt a dx + =
dt b x f dx x f
dx x f dx x f
x f dx x f df
2
2
) ( ' '
2
1
) ( '
) ( ) ( ' '
2
1
) ( '
) ( ) (
+ =
+ =
+ =
At the limit
for f(x),
If
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Black-Scholes PDE
Black-Scholes assumption

Apply Itos formula to Call price C(S,t)


Hedged position is riskless, earns interest rate r


Black-Scholes PDE

No drift!
dW dt
S
dS
o + =
dt C
S
C dS C dC
SS t S
)
2
(
2 2
o
+ + =
dt S C C r dS C dC dt C
S
C
S S SS t
) ( )
2
(
2 2
= = +
o
) (
2
2 2
S C C r C
S
C
S SS t
+ =
o
S C C
S

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P&L
S
t t +A
S
t
O
Break-even
points
o At
o At
Option Value
S
t
C
t
C
t t +A
S
Delta
hedge
P&L of a delta hedged option
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Black-Scholes Model
If instantaneous volatility is constant :

dW dt
S
dS
o + =
Then call prices are given by :

)
2
1
)
) exp(
ln(
1
( ) exp(
)
2
1
)
) exp(
ln(
1
(
0
0
0
T
K
rT S
T
N rT K
T
K
rT S
T
N S C
BS
o
o
o
o

+ =
No drift in the formula, only the interest rate r due to the
hedging argument.

drift:
noise, SD:
t S
t
o
t S
t
o o
Pricing methods
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Pricing methods

Analytical formulas
Trees/PDE finite difference
Monte Carlo simulations
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Formula via PDE
The Black-Scholes PDE is


Reduces to the Heat Equation

With Fourier methods, Black-Scholes equation:


) (
2
2 2
S C C r C
S
C
S SS t
+ =
o
T d d
T
T r K S
d
d N e K d N S C
rT
BS
o
o
o
=
+ +
=
=

1 2
2
0
1
2 1 0
,
) 2 / ( ) / ln(
) ( ) (
xx
U U
2
1
=
t
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Formula via discounted expectation
Risk neutral dynamics

Ito to ln S:

Integrating:




Same formula



dW dt r
S
dS
o + =
dW dt r S d o
o
+ = )
2
( ln
2
] ) [( ] ) [(
)
2
(
0
2
+
+
+
= = K e S E e K S E e premium
T
W T r
rT
T
rT
o
o
T T
W T r S S o
o
+ + = )
2
( ln ln
2
0
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Finite difference discretization of PDE
Black-Scholes PDE



Partial derivatives discretized as
+
=
+ =
) ( ) , (
) (
2
2 2
K S T S C
S C C r C
S
C
T
S SS t
o
2
) (
) , 1 ( ) , ( 2 ) , 1 (
) , (
2
) , 1 ( ) , 1 (
) , (
) 1 , ( ) , (
) , (
S
n i C n i C n i C
i n C
S
n i C n i C
n i C
t
n i C n i C
n i C
SS
S
t
o
o
o
+ +
=
+
=

=
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Option pricing with Monte Carlo methods
An option price is the
discounted expectation of its
payoff:


Sometimes the expectation
cannot be computed
analytically:
complex product
complex dynamics
Then the integral has to be
computed numerically


( ) ( ) P EP f x x dx
T 0
= =
}
o o
the option price is its discounted payoff
integrated against the risk neutral density of the spot underlying
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Computing expectations
basic example
You play with a biased die

You want to compute the likelihood of getting
Throw the die 10.000 times

Estimate p( ) by the number of over 10.000 runs
B) VOLATILITY
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Volatility : some definitions

Historical volatility :
annualized standard deviation of the logreturns; measure of
uncertainty/activity

Implied volatility :
measure of the option price given by the market

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Historical volatility
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Historical Volatility

Measure of realized moves
annualized SD of




t
t
t
S
S
x
1
ln
+

( ) |
.
|

\
|
E

=

=
2
1
2
1
252
i i
t
n
i
t
x x
n
o
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Commonly available information: open, close, high, low






Captures valuable volatility information

Parkinson estimate:

Garman-Klass estimate:
Estimates based on High/Low
( )

=
=
n
t
t t P
d u
n
1
2
2
2 ln 4
1
o
( )

= =
=
n
t
t
n
t
t t GK
c
n
d u
n
1
2
1
2
2
39 . 0 5 . 0
o
S ln
open
upper
S
S
u ln =
open
close
S
S
c ln =
open
down
S
S
d ln =
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Move based estimation
Leads to alternative historical vol estimation:



= number of crossings of log-price over [0,T] o
) , ( T L o
T
T L
h
) , (
~
o
o o
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Black-Scholes Model
If instantaneous volatility is constant :

dW dt
S
dS
o + =
Then call prices are given by :

)
2
1
)
) exp(
ln(
1
( ) exp(
)
2
1
)
) exp(
ln(
1
(
0
0
0
T
K
rT S
T
N rT K
T
K
rT S
T
N S C
BS
o
o
o
o

+ =
No drift in the formula, only the interest rate r due to the
hedging argument.

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Implied volatility
Input of the Black-Scholes formula which makes it fit the
market price :
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Market Skews
Dominating fact since 1987 crash: strong negative skew on
Equity Markets


Not a general phenomenon

Gold: FX:



We focus on Equity Markets
K
impl
o
K
impl
o
K
impl
o
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Skews
Volatility Skew: slope of implied volatility as a
function of Strike
Link with Skewness (asymmetry) of the Risk
Neutral density function ?

Moments Statistics Finance

1 Expectation FWD price
2 Variance Level of implied vol
3 Skewness Slope of implied vol
4 Kurtosis Convexity of implied vol
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Why Volatility Skews?
Market prices governed by
a) Anticipated dynamics (future behavior of volatility or jumps)
b) Supply and Demand




To arbitrage European options, estimate a) to capture
risk premium b)
To arbitrage (or correctly price) exotics, find Risk
Neutral dynamics calibrated to the market
K
impl
o
Market Skew
Th. Skew
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Modeling Uncertainty
Main ingredients for spot modeling
Many small shocks: Brownian Motion
(continuous prices)


A few big shocks: Poisson process (jumps)
t
S
t
S
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To obtain downward sloping implied volatilities



a) Negative link between prices and volatility
Deterministic dependency (Local Volatility Model)
Or negative correlation (Stochastic volatility Model)

b) Downward jumps
K
impl
o
2 mechanisms to produce Skews (1)
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2 mechanisms to produce Skews (2)
a) Negative link between prices and volatility




b) Downward jumps


1
S
2
S
1
S
2
S
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Strike dependency
Fair or Break-Even volatility is an average of squared
returns, weighted by the Gammas, which depend on the
strike

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Strike dependency for multiple paths
A Brief History of Volatility
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Evolution Theory







constant deterministic stochastic nD
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A Brief History of Volatility (1)
: Bachelier 1900

: Black-Scholes 1973

: Merton 1973


: Merton 1976



: Hull&White 1987

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

+ =
+ =
t L t
Q
t t
t
t
dZ dt V V a d
dW dt r
S
dS
o
o o
o
) (

2
Q
t
t
t
dW dt r
S
dS
o + =
dq dW dt k r
S
dS
Q
t
t
t
+ + = ) ( o
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A Brief History of Volatility (2)
Dupire 1992, arbitrage model
which fits term structure of
volatility given by log contracts.



Dupire 1993, minimal model
to fit current volatility surface
( )
Q
t
T
t
Q
t t
t
t
dZ dt
T
t L
d
dW
S
dS
2

2
2
2
o o
o
+
c
c
=
=
( )
2
,
2
2
2
2 ,
) , ( ) (
K
C
K
K
C
rK
T
C
T K
dW t S dt t r
S
dS
T K
Q
t
t
t
c
c
c
c
c
c
o
o
+
=
+ =
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A Brief History of Volatility (3)
Heston 1993,
semi-analytical formulae.



Dupire 1996 (UTV),
Derman 1997,
stochastic volatility model
which fits current volatility
surface HJM treatment.

+ =
+ =
t t t t
t t
t
t
dZ dt b d
dW dt r
S
dS
) (

2 2 2
|o o o o
o
K
V
dZ b dt dV
T K
Q
t T K T K T K
=
+ =
T
,
, , ,
S

to l conditiona
variance forward ous instantane :
o
Local Volatility Model
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Black-Scholes:

Merton:

Simplest extension consistent with smile:

o(S,t) is called local volatility
( )
dS
S
t dW
t
= o
( ) dS S t dW
t
= o ,
dS
S
dW
t
= o
The smile model
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European
prices
Local
volatilities
Exotic prices
From simple to complex
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One Single Model
We know that a model with dS = o(S,t)dW
would generate smiles.
Can we find o(S,t) which fits market smiles?
Are there several solutions?

ANSWER: One and only one way to do it.

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sought diffusion
(obtained by integrating twice
Fokker-Planck equation)
Diffusions
Risk
Neutral
Processes
Compatible
with Smile
The Risk-Neutral Solution
But if drift imposed (by risk-neutrality), uniqueness of the solution
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Forward Equation
BWD Equation: price of one option for different


FWD Equation: price of all options for current


Advantage of FWD equation:
If local volatilities known, fast computation of implied volatility
surface,
If current implied volatility surface known, extraction of local
volatilities:
2
2 2
2
) , (
S
C t S b
t
C
c
c
=
c
c
( ) t S,
( )
0 0
, t S ( ) T K C ,
( )
0 0
,T K C
2
2 2
2
) , (
K
C T K b
T
C
c
c
=
c
c
2
2
/ 2 ) , (
K
C
T
C
T K b
c
c
c
c
=
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Summary of LVM Properties
is the initial volatility surface

compatible with local vol

compatible with
(calibrated SVM are noisy versions of LVM)

deterministic function of (S,t) (if no jumps)
future smile = FWD smile from local vol

Extracts the notion of FWD vol (Conditional Instantaneous Forward
Variance)
( ) t S, o
= E o 0
T k,

o
( ) e o | | ) , (
2 2
0
T K K S E
loc T T
o o = = E

0 E
Extracting information
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MEXBOL: Option Prices
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Non parametric fit of implied vols
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Risk Neutral density
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S&P 500: Option Prices

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Non parametric fit of implied vols

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Risk Neutral densities

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Implied Volatilities

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Local Volatilities

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Interest rates evolution

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Fed Funds evolution

Volatility Arbitrages
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Volatility as an Asset Class:
A Rich Playfield
S
C(S)
VIX
RV
C(RV) VS
Index
Vanillas
Variance
Swap
Options on Realized
Variance
Realized
Variance
Futures
Implied
Volatility
Futures
VIX options
Outline
I. Frequency arbitrage
II. Fair Skew
III. Dynamic arbitrage
IV. Volatility derivatives
I. Frequency arbitrage
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Frequencygram
Historical volatility tends to depend on the sampling
frequency: SPX historical vols over last 5 (left) and 2
(right) years, averaged over the starting dates
Can we take advantage of this pattern?
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Historical Vol / Historical Vol Arbitrage
weekly
T
QV
daily
T
QV
If weekly historical vol < daily historical vol :
buy strip of T options, -hedge daily
sell strip of T options, -hedge weekly

Adding up :
do not buy nor sell any option;
play intra-week mean reversion until T;
final P&L :
weekly
T
daily
T
QV QV
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Daily Vol / weekly Vol Arbitrage
-On each leg: always keep $o invested in the index and update every At
-Resulting spot strategy: follow each week a mean reverting strategy
-Keep each day the following exposure:


where is the j-th day of the i-th week
-It amounts to follow an intra-week mean reversion strategy
j i
t
,
)
1 1
.(
1 , , i j i
t t
S S
o
II. Fair Skew
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Market Skews
Dominating fact since 1987 crash: strong negative skew on
Equity Markets


Not a general phenomenon

Gold: FX:



We focus on Equity Markets
K
impl
o
K
impl
o
K
impl
o
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Why Volatility Skews?
Market prices governed by
a) Anticipated dynamics (future behavior of volatility or jumps)
b) Supply and Demand




To arbitrage European options, estimate a) to capture
risk premium b)
To arbitrage (or correctly price) exotics, find Risk
Neutral dynamics calibrated to the market
K
impl
o
Market Skew
Th. Skew
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Theoretical Skew from Prices
Problem : How to compute option prices on an underlying without
options?
For instance : compute 3 month 5% OTM Call from price history only.
1) Discounted average of the historical Intrinsic Values.
Bad : depends on bull/bear, no call/put parity.
2) Generate paths by sampling 1 day return recentered histogram.
Problem : CLT => converges quickly to same volatility for all
strike/maturity; breaks autocorrelation and vol/spot dependency.
?
=>
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Theoretical Skew from Prices (2)
3) Discounted average of the Intrinsic Value from recentered 3 month
histogram.
4) -Hedging : compute the implied volatility which makes the -
hedging a fair game.
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Theoretical Skew
from historical prices (3)
How to get a theoretical Skew just from spot price
history?
Example:
3 month daily data
1 strike
a) price and delta hedge for a given within Black-Scholes
model
b) compute the associated final Profit & Loss:
c) solve for
d) repeat a) b) c) for general time period and average
e) repeat a) b) c) and d) to get the theoretical Skew
1
T
S k K =
o
( ) o PL
( ) ( ) ( ) 0 / = k PL k o o
t
S
1
T
2
T
K
1
T
S
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Theoretical Skew
from historical prices (4)

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Theoretical Skew
from historical prices (5)

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Theoretical Skew
from historical prices (6)

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Theoretical Skew
from historical prices (7)

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EUR/$, 2005

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Gold, 2005

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Intel, 2005

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S&P500, 2005

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JPY/$, 2005

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S&P500, 2002

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S&P500, 2003

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MexBol 2007

III. Dynamic arbitrage
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Arbitraging parallel shifts
Assume every day normal implied vols are flat
Level vary from day to day







Does it lead to arbitrage?
Strikes
Implied vol
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W arbitrage
Buy the wings, sell the ATM
Symmetric Straddle and Strangle have no Delta and no
Vanna
If same maturity, 0 Gamma => 0 Theta, 0 Vega
The W portfolio: has a free Volga
and no other Greek up to the second order

Straddle Strangle PF
Straddle
Strangle
I
I
=
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Cashing in on vol moves
The W Portfolio transforms all vol moves
into profit





Vols should be convex in strike to prevent
this kind of arbitrage
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M arbitrage
K1 K2
S
0

S
+

S
-

=(K1+K2)/2
In a sticky-delta smiley market:
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98
S
0
K

T
1
T
2
t0

Deterministic future smiles
It is not possible to prescribe just any future
smile
If deterministic, one must have

Not satisfied in general

( ) ( ) ( )dS T S C T S t S t S C
T K T K 1 , 1 0 0 0 0 ,
, , , , ,
2 2 }
=
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99
Det. Fut. smiles & no jumps
=> = FWD smile
If

stripped from implied vols at (S,t)

Then, there exists a 2 step arbitrage:
Define

At t0 : Sell

At t:

gives a premium = PLt at t, no loss at T

Conclusion: independent of
from initial smile


( ) ( ) ( ) ( ) T T K K T K T K t S V T K t S
imp
T
K
T K
o o o o
o
o
+ + = -

, , , lim , , / , , ,
2
0
0
2
,
( ) ( ) ( ) ( ) T K t S
K
C
t S V T K PL
T K t
, , , , ,
2
2
,
2
c
c
o
( )
t S t S t
Dig Dig PL
, , c c +

S
t0 t T
S0
K
| | ( )
T K t
T K
K
S S S
,
2
T K,
2
, sell , CS
2
buy , if o o c c + e
( ) ( ) ( ) T K t S V t S
T K
, , ,
2
0 0 ,
o = =
( ) t S V
T K
,
,
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100
Consequence of det. future smiles
Sticky Strike assumption: Each (K,T) has a fixed
independent of (S,t)
Sticky Delta assumption: depends only on
moneyness and residual maturity

In the absence of jumps,
Sticky Strike is arbitrageable
Sticky is (even more) arbitrageable
) , ( T K
impl
o
) , ( T K
impl
o
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101
Each C
K,T
lives in its Black-Scholes ( ) world


P&L of Delta hedge position over dt:

If no jump

Example of arbitrage with Sticky Strike
2 1 , 2 , 1
assume
2 2 1 1
o o >
T K T K
C C C C
!
( ) ( ) ( )
( )
( ) O I
>
I
=
|
|
.
|

\
|
I
I

I =
free , no
0
2
2
2
2
1
2
2
1
1
2
2
2
2
2
1
t S C C PL
t S S C PL
i i i
o o o o
o o o o
) , ( T K
impl
o
1
o
2
o
1
C
2
C
1
1
2
C
I
I
t t
S
o +
t
S
1
1
2
C
I
I
2
C
1
1
2
2
C C
I
I

t
S
t t
S
o +
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102
Arbitrage with Sticky Delta
1
K
2
K
t
S
In the absence of jumps, Sticky-K is arbitrageable and Sticky- even more so.
However, it seems that quiet trending market (no jumps!) are Sticky-.
In trending markets, buy Calls, sell Puts and -hedge.

Example:

1 2
K K
P C PF
2 1
,o o
S



Vega > Vega
2
K
1
K
PF



2 1
,o o
Vega < Vega
2
K
1
K
S



PF



-hedged PF gains
from S induced
volatility moves.
IV. Volatility derivatives
VIX Future Pricing
Bruno Dupire
105
Vanilla Options
Simple product, but complex mix of underlying and volatility:
Call option has :
Sensitivity to S :
Sensitivity to : Vega
These sensitivities vary through time and spot, and vol :
Bruno Dupire
106
Volatility Games
To play pure volatility games (eg bet that S&P vol goes
up, no view on the S&P itself):
Need of constant sensitivity to vol;
Achieved by combining several strikes;
Ideally achieved by a log profile : (variance swaps)
Bruno Dupire
107
Log Profile
T
S
S
E
T
2
0
2
ln
o
=
(

dK
K
K S
dK
K
S K
S
S S
S
S
S
S
} }

+ +

=
0
0
2
0
2
0
0
0
) ( ) (
) ln(
dK
K
C
dK
K
P
Futures
S
T K
S
T K
S
} }


0
0
0
2
,
0
2
,
1
Under BS: dS=S dW, price of
For all S,
The log profile is decomposed as:
In practice, finite number of strikes CBOE definition:

2
0
2
1 1
2
) 1 (
1
) , (
2
2

+
K
F
T
T K X e
K
K K
T
VIX
i
rT
i
i i
t
Put if K
i
<F,
Call otherwise
FWD adjustment
Bruno Dupire
108
Option prices for one maturity
Bruno Dupire
109
Perfect Replication of
2
1
T
VIX
(
(

=
+
1
1
1
ln
2
2
T
T T
t T
S
S
price
T
VIX
o
o
(

=
+
0 0
1 1
ln
2
ln
2
S
S
T S
S
T
price
T T T
t
o
o o
We can buy today a PF which gives VIX
2
T1
at T
1
:
buy T
2
options and sell T
1
options.
| | PF price
t
=
Bruno Dupire
110
Theoretical Pricing of VIX Futures
F
VIX
before launch
F
VIX
t
: price at t of receiving at T
1
.
VIX
T T T
F VIX PF
1 1 1
= =
) ( ] [ ] [ UB Bound Upper PF PF E PF E F
t T t T t
VIX
t
= = s =
The difference between both sides depends on the
variance of PF (vol vol).
Bruno Dupire
111
RV/VarS
The pay-off of an OTC Variance Swap can be replicated
by a string of Realized Variance Futures:






From 12/02/04 to maturity 09/17/05, bid-ask in vol:
15.03/15.33
Spread=.30% in vol, much tighter than the typical 1%
from the OTC market
t T
T
1
T
2
T
3
T
0
T
4

Bruno Dupire
112
RV/VIX
Assume that RV and VIX, with prices RV and F are defined on the
same future period [T
1
,T
2
]
If at T
0
, then buy 1 RV Futures and sell 2 F
0
VIX Futures
at T
1



If sell the PF of options for and Delta hedge in S until
maturity to replicate RV.
In practice, maturity differ: conduct the same approach with a string
of VIX Futures
2
0 0
F RV <
2
0 1
2
1
0 1 0
2
0 1
0 1 0 0 1 1
) (
) ( 2
) ( 2
1
F F F RV
F F F F RV
F F F RV RV PL
+ =
>
=
2
1 1
F RV <
2
1
F
Bruno Dupire
113
Conclusion
Volatility is a complex and important field

It is important to
- understand how to trade it
- see the link between products
- have the tools to read the market
The End