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Week 9 Options2-1 PDF
Week 9 Options2-1 PDF
Week 9 Options2-1 PDF
Guanglian Hu
S1, 2020
dSt
= µdt + σdBt
St
where St is the price of the underlying asset at time t, σ is the
volatility parameter, and µ is the drift or the expected return of the
underlying asset.
Future stock price ST is given by
1 2 τ + σ √τ Z
ST = St e µτ − 2 σ
dSt
= rdt + σdBt
St
where St is the price of underlying asset at time t, σ is the volatility
parameter, and r is the risk-free rate.
Note under Q, the stock price is appreciating at a lower rate (µ > r ).
Future stock price ST under the risk-neutral measure is given by
1 2 τ + σ √τ Z
ST = St e r τ − 2 σ
0.025
Physical
Risk neutral
0.02
0.015
0.01
0.005
0
0 50 100 150 200 250 300
Guanglian Hu S1 2020 S1 2020 4 / 19
The BSM Model: pricing formulae
Ct (τ , St , σ, K , r ) = St N (d1 ) − e −r τ KN (d2 )
Pt (τ , St , σ, K , r ) = e −r τ KN (−d2 ) − St N (−d1 )
ln SKt + (r + 21 σ 2 )τ ln SKt + (r − 21 σ 2 )τ
d1 = √ d2 = √ .
σ τ σ τ
N is the cumulative probability function of a standard normal variable
Option price is a function of τ , St , σ, K , r . Note that µ drops out.
Volatility σ is the only unobservable quantity. There is a one-to-one
correspondence between option price and volatility. In practice, option
prices are often quoted with volatility.
Given option price, one can invert the above pricing formulae to
obtain an estimate of volatility, the so-called implied volatility.
Option Greeks are the partial derivatives of option price with respect
to the model parameters
Examples: delta, gamma, vega, theta
Usually traders use the BSM model when calculating partial
derivatives.
BSM Greeks + adjustments
Delta-neutral portfolios
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
0 10 20 30 40 50 60 70 80 90 100
-0.1
-0.2
-0.3
-0.4
-0.5
-0.6
-0.7
-0.8
-0.9
-1
0 10 20 30 40 50 60 70 80 90 100
Vega (ν = ∂O
∂σ ) is the rate of change of option price with respect to
volatility
∂C ∂P √
∂σ = ∂σ = S τ φ(d1 ), φ is the probability density function of a
standard normal variable
Vega is the same for both call and put options and is always positive
Intuition: a high volatility stock has a greater price potential
20
15
10
0
0 50 100 150
2
Gamma (Γ = ∂∂SO2 ) is the rate of change of delta with respect to the
underlying stock price. It is the second partial derivative of option
price with respect to the underlying stock price
∂∆c ∂∆p φ ( d1 )
∂S = ∂S = S τ σ
√
Intuitively gamma measures how option prices respond to a potential jump in stock price
(either upward or downward)
Gamma is the same for both call and put options and is always
positive.
0.05
0.04
0.03
0.02
0.01
0
0 50 100 150
∂O
Theta (Θ = ∂t ) is the rate of change of option price with respect to
the time.
500
450
400
350
300
250
200
150
100
50
0
1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Note: monthly volatility is computed using 5-min returns within the month.
0.2
0.15
0.1
0.05
0
Expected Return
-0.05
-0.1
-0.15
-0.2
-0.25
Data
BSM
-0.3
96 98 100 102 104 106 108
K
Guanglian Hu S1 2020 S1 2020 18 / 19
Comparing average put option returns with those implied
by the BSM model
Average monthly returns of S&P 500 puts, sample period: 1998 to 2015
-0.05
-0.1
-0.15
-0.2
-0.25
Expected Return
-0.3
-0.35
-0.4
-0.45
-0.5 Data
BSM
-0.55
92 94 96 98 100 102 104
K
Guanglian Hu S1 2020 S1 2020 19 / 19