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Auto Call Able S
Auto Call Able S
Alexander Giese
Outline
1. Introduction to Auto-Callable Structures
2. Requirements for the Pricing Model
3. Black-Scholes & Vasicek++ Model
4. Heston & Vasicek++ and Heston & CIR++ Model
5. Pricing Example
Euro Stoxx 50 = S0
Yes
Early Redemption:
107% of Notional
Yes
Early Redemption:
110% of Notional
Yes
No
...
...
Yes
Early Redemption:
113% of Notional
Redemption:
125% of Notional
Redemption:
100% of Notional
4
There are currently more than 235 auto-callable equity certificates (express
certificates) in the German certificate market.
The open interest (units x market price) in these products is about 4.7 billion
which corresponds to a 9% share of the overall German certificate market.
HVB issued recently its 100th auto-callable equity certificate.
Source: Derivate Forum, Der Deutsche Markt fr Derivative Produkte, Januar 2006.
5
where
V1 = 107 df (T1 ) P * [S (T1 ) K ]
= 107 df (T1 ) N1 (d (K , T1 ))
= 110 df (T2 ) N 2 ( d (K , T1 ), d (K , T2 ), 2 )
...
V7 = 125 df (T7 ) N 7 ( d (K , T1 ),d (K , T2 )..., d (K , T7 ), 7 )
N n (b1 ,..., bn ; ) =
bs
'
'
'
''
''
''
,...,
;
,...,
;
N
b
b
N
b
b
f ( y ) dy
ns
s +1
n
s 1 1 s 1
where 2 s n-1 and f (.) denotes the univariate standard normal density
if the correlatio n matrix = { i, j }has the following structure
i, j =
i
for i < j with i < j .
j
For example :
N 7 (b1 ,..., b7 ; ) =
b4
'
'
'
''
''
''
N
b
,...,
b
;
N
b
,...,
b
;
f ( y ) dy
3 4
7
3 1 3
Fast calibration to standard options in the equity and interest rate world
(calls, puts, caps, swaptions) is required.
10
Euro Stoxx 50 = S0
No
Yes
Early Redemption:
100% of Notional
Redemption at Maturity:
100% of Notional
Assume that we delta hedge the auto-callable structure using the equity
underlying, a 1 year zero bond and a 7 year zero bond.
11
dS (t ) = (r (t ) d ) S(t)dt + S (t ) S (t )dW S (t )
r (t ) = R (t ) + (t )
dR (t ) = R ( R R (t ) )dt + R dW R (t ),
d W S ,W R
= S , R dt.
14
C ( K , T ) = df (T )(F (T ) N ( d1 ) KN (d 2 ) )
F (T ) 1 2
/ v(T )
(
)
d1, 2 = ln
v
T
K 2
T
(u, T) =
1 - e - R (T -u )
Note that in comparison to the standard Black-Scholes formula only the volatility
changes. The total volatility now depends on the equity and interest rate volatility as
well as on the correlation between equity and interest rates.
15
VCall (0, T1 , T2 , K ) = e
0T2 (t )dt
v
1
1 - e - 2 R T1
A(0, T2 )e B (0,T2 )R (0 )
; v = R B (T1 , T2 )
h1/ 2 = ln
T2
t
dt
(
)
2 R
v Ke T1
A(0, T1 )e B (0 ,T1 )R (0 ) 2
(B (t , T ) T + t ) R2 R 0.5 R2 R2 B 2 (t , T )
1 - e - R (T t )
A(t , T ) = exp
; B(t , T ) =
2
4 R
R
R
Through the formula above we can also price caps and floors as well as swaptions.
For details see Brigo and Mercurio (2001).
16
18
Conclusion:
Since the implied volatility skew is an important factor for the price of any
structure with digital risk, we need to look for another model.
19
dS ( t ) = ( r ( t ) d ) S(t)dt +
dW
v ( t ) S ( t ) dW
( t ) + S , R S (t )dW R (t ),
dv ( t ) = v ( v v ( t ) )dt + v v ( t ) dW v ( t ),
S
,W
= S , v dt ,
r ( t ) = R ( t ) + ( t ),
[
d [W
dR ( t ) = R ( R R ( t ) )dt + R dW
d W S ,W
v
,W
] = 0,
] = 0.
( t ),
20
dS ( t ) = ( r ( t ) d ) S(t)dt +
dW
v ( t ) S ( t ) dW
( t ) + S , R R (t ) S (t )dW R (t ),
dv ( t ) = v ( v v ( t ) )dt + v v ( t ) dW v ( t ),
S
,W
= S , v dt ,
r ( t ) = R ( t ) + ( t ),
[
d [W
dR ( t ) = R ( R R ( t ) )dt + R
d W S ,W
v
,W
R
R
] = 0,
] = 0.
R ( t ) dW
( t ),
21
C (K , T , S (0 ), v (0 ), R (0 )) = S (0 )e dT P1 Kdf (T ) P2 , where
1 1
Pj (K , T , S (0 ), v (0 ), R (0 )) = +
2
e i ln K f j
Re
d
i
for j = 1,2.
with
f1 = e C1 (T , )+ D1 (T , )v (0 )+ E1 (T , )R (0 )+ i ln S (0 )
f 2 = e C 2 (T , )+ D2 (T , )v (0 )+ E 2 (T , )R (0 )+ i ln S (0 ) ln df (T )
22
S , R (t ) =
d [S, r ] t
=
d [S ] t d [r ] t
S , R (t ) =
d [S, r ] t
=
d [S ] t d [r ] t
S, R R (t )
v (t ) +
2
S, R
S, R
v (t ) +
2
S, R
R (t )
S, R =
S, R =
S , R (t ) v (t )
R (t ) 1
S , R (t ) v (t )
1
2
S ,R
(t )
2
S ,R
(t )
S, R
S ,R
0 v (t )dt
1 T
2
(
)
E
R
t
dt
1
,R
S
0
T
1
T
0 v (t )dt
S ,R E
S, R
1
T
1-
2
S ,R
1 T
1 T
1 T
(
)
(
)
(
)
E
v
t
dt
E
v
t
dt
Var
v
t
dt
T 0
T 0
T
1 e v
1 T
(v(0) v ) + v
E v(t )dt =
0
vT
T
2 2T
ve
1 T
Var v(t )dt =
3 2
2 T
T 0
(
(
1 T
8 E v(t )dt
T 0
3
2
2 1 + e 2 v T 2e T v T (v(0 ) v )
+ 1 + 4e v T 3e 2 v T + 2e v T T
v
v
Alternatively,
1
1 T
E
v(t )dt =
0
2
T
1
0T v ( t )dt
3/ 2
v ( 0 ) B
T
(
(
)
)
(
)
1
where
f
=
E
e
=
Ae
25
v (0 ) = 0 . 0625 , v = 0 . 4 , v = 0 . 09 , v = 0 . 5 , S, v = 0 . 7
R (0 ) = 0 . 02 , R = 0 . 1, R = 0 . 05 ,
= 0 . 06 , T = 4 years
S, R = 0.3473.
26
1. Calibrate the CIR++/ Vasicek++ interest rate process to the yield curve,
caps and swaptions.
28
29
5. Pricing Example
We consider again the auto-callable equity structure from the introduction:
Start Date
End of 1st year
Euro Stoxx 50 = S0
Euro Stoxx 50 S0?
No
Yes
Early Redemption:
107% of Notional
Yes
Early Redemption:
110% of Notional
Yes
No
...
...
Yes
Early Redemption:
113% of Notional
Redemption:
125% of Notional
Redemption:
100% of Notional
30
5. Pricing Example
After the calibration of all 3 models to market data (Feb 2006) and for different
values of the correlation between equity and interest rate, we obtain the following
prices and price differences:
Model / Correlation
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
BlackScholes &
Vasicek++
96.37
96.49
96.61
96.74
96.84
96.97
97.10
97.25
97.38
-0.47
-0.35
-0.23
-0.10
0.0
0.13
0.26
0.41
0.54
97.90
98.00
98.09
98.18
98.32
98.48
98.68
98.92
99.08
-0.42
-0.32
-0.23
-0.14
0.0
0.16
0.36
0.60
0.76
97.85
97.96
98.07
98.22
98.32
98.45
98.62
98.90
99.04
-0.47
-0.36
-0.25
-0.10
0.0
0.13
0.30
0.58
0.72
31
5. Pricing Example
Conclusion:
Ignoring the implied volatility skew or the correlation between equity and
interest rates leads to significant mispricing.
Heston & CIR++ and Heston & Vasicek++ produce similar results and their
correlation exposure is comparable to the correlation exposure of the
Black-Scholes & Vasicek++ model for moderate correlation values.
32
5. Pricing Example
Remaining Question: Which correlation value should be used?
0.80
EUSA5-SX5E
0.60
corr, return
0.40
0.20
0.00
-0.20
-0.40
100 d corr
100 d corr
-0.60
27922110- 20- 30- 13- 22- 31- 12- 23615- 24819- 31918314- 28615- 29920- 30817112- 21- 29817Jan- Apr- Jun- Sep- Nov- Jan- Mar- Jun- Aug- Oct- Jan- Mar- Jun- Aug- Oct- Jan- Mar- May- Aug- Oct- Jan- Mar- May- Aug- Oct- Dec- Mar- May- Jul- Oct- Dec- Mar- May- Jul- Sep- Dec- Feb99
99
99
99
99
00
00
00
00
00
01
01
01
01
01
02
02
02
02
02
03
03
03
03
03
03
04
04
04
04
04
05
05
05
05
05
06
33
5. Pricing Example
1Y historical Correlation (1990-2002)
EuroStoxx 50 and
Maximum
66%
70%
Average
-10%
-7%
Minimum
-62%
-58%
5. Pricing Example
OTC Quote (February 16, 2006):
1 year correlation swap* between 20 year USD swap rate and S&P 500:
-10
+45
5. Pricing Example
0.80
USSW20-SPX
0.60
corr, return
0.40
0.20
0.00
-0.20
-0.40
100 d corr
100 d corr
-0.60
13- 27311- 22116613- 27318816- 2920- 31- 10- 20- 616- 27- 12- 24- 8617- 28- 10- 20712- 2314- 24- 10- 20- 222- 4May- Aug- Oct- Dec- Mar- May- Aug- Oct- Dec- Mar- May- Jul- Oct- Dec- Mar- May- Jul- Oct- Dec- Mar- May- Jul- Oct- Dec- Mar- May- Jul- Oct- Dec- Mar- May- Jul- Oct- Dec- Mar- May- Jul- Oct- Dec- Feb06
05
05
05
05
05
04
04
04
04
04
03
03
03
03
03
02
02
02
02
02
01
01
01
01
01
00
00
00
00
00
99
99
99
99
99
98
98
98
98
36
References
Bakshi, Cao and Chen (1997): Empirical Performance of Alternative Option Pricing Models, Journal of
Finance, 52, 2003-2049.
Brigo and Mercurio (2001), On Deterministic-Shift Extensions of Short-Rate Models, Working Paper,
Banca IMI.
Chang (2006), Hybrid Products, Derivatives Solutions, Credit Suisse.
Giese (2004), Closed-Form Solutions for Standard Calls in the Heston&Vasicek++ and the
Heston&CIR++ Model, Working Paper, HypoVereinsbank.
Giese, Reder and Zagst (2004), Auto Trigger Structures: Closed-form Solutions and Applications,
Working Paper, HypoVereinsbank.
Kruse (2002), Closed-form Solutions to Option Pricing under the Assumption of Stochastic Interest
Rates, Working Paper, ITWM.
Merton (1973), Theory of Rational Option Pricing, Bell Journal of Economics and Management Science,
4, 141-183.
Schroder (1989), A Reduction Method Applicable to Compound Option Formulas, Management
Science, 35, 823-827
Scott (1997), Pricing Stock Options in a Jump-Diffusion Model with Stochastic Volatility and Interest
Rates: Application of Fourier Inversion Methods, Mathematical Finance, 7, 413-426.
37