Barclays Capital Lecture Series at the

University of Hong Kong

Derivatives Pricing and Hedging

An Introduction

Ken Kwan
Director
Debt Capital Markets / Investment Banking
22 September 2005
What is a Derivative?

A financial instrument whose price depends on the price of
another asset.

Basic examples:

Equity Derivatives: call, put

Interest Rate Derivatives: swap, cap, floor, swaption, bond option

FX options: call, put

Commodities: swap, call, put

Credit Derivatives

2
Option Payout

Call Payout = Max [Final Price – Strike, 0 ]

How much should I pay to buy this call option?

3
Option Valuation: Black-Scholes Model

Assumption: Underlying has a lognormal distribution

Underlying Price

4
Black-Scholes Inputs
Spot Price Interest Volatility Expiry (t) Option
(S) Rate (df) (σ) Strike (K) Type
No. of Years

Forward
Price (F)

Black Scholes
Option Pricing
Formula

Option
Premium

5
Black-Scholes

S = 50

K = 45

σ = 20%

t = 0.25 year

r = 10%
Probability of option
Don’t care being exercised N(d2)
about this area = 0.8944
Probability

d2

d1

45 51.26 Asset Price

6
Black-Scholes Formula

 N(d1) 
Call = N(d2) ×  F × − K  × df
 N(d2) 
F σ
Ln( ) + t
d1 = K 2
σ t
d2 = d1− σ t Inputs:

Forward (F)

Strike (K)

Implied volatility (σ)

Maturity (t)

Discount factor (df)

7
Black-Scholes Formula

 N(d1) 
Call = N(d2) ×  F × − K  × df
 N(d2) 

Probability of Expected Value

Strike Discount Factor
Option Ending of Asset Price if
Price (K) (df)
up in the Money exercised

8
Black-Scholes Formula

 0.9155  1
Call = 0.8944 ×  50 × (1+ 0.1× 0.25)× − 45  ×
 0.8944  1+ (0.1× 0.25)

Probability of Expected Value

Strike Discount Factor
Option Ending of Asset Price if
Price (K) (df)
up in the Money exercised

Call = 6.51

9
Option Hedging in Practice

Delta

Delta neutral on a frequent basis

Transaction costs

Portfolio hedging

Gamma and Vega

Neutrality is done on a less frequent basis

Wider bid / offer spread in the option market

Portfolio hedging

10
Interest Rate Derivatives

Black-Scholes Model

Assumptions: underlying has a lognormal distribution

For cap and floor, the underlying is the short rate e.g. LIBOR or
HIBOR

For swaption, the underlying is the swap rate

Issues
• The above two are not consistent to each other
• This is an one factor model

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More Advanced Models

Two-factor or multi-factor

Volatility Term Structure

Curve shape movement

Correlation of adjacent forward rates

E.g. BGM Model

• Implementation: Calibration and Monte Carlo Simulation

12
Conclusion

Black-Scholes model to price simple and European style derivatives

Advanced model to price more structured or path dependent derivatives

Trader’s job

Manage the trading book w.r.t. delta, gamma and vega etc that come from the trades
that Marketers bring in.

Put on proprietary positions.

Structurer’s job:

Tailor make derivatives products to suit different clients’ risk and reward appetites.

Pricing and Execution

Work with Traders and Marketers.

Clear internal approvals with Legal, Credit and Compliance, if necessary

Marketer’s job:

Interface with the clients direct to understand their needs.

Channel the client requirements to Structurers to identify the right products together

Market the ideas to clients

13
Thank You
 Barclays Capital Lecture Series at the
University of Hong Kong

The Story of CDO

Recent Developments In Credit Derivatives

Tim Cheung
Director
Debt Capital Markets / Investment Banking
22 September 2005
CDO … What CDO?

You are thinking of buying the debt, which is called CDO,
issued by this magic company.
Magic Company
Asset Liability

Loan
Senior

Loss Absorption
Magic
Bond
Transformation
ABS
Mezzanine
CDS

CDO Equity

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CDO and Bank Capital Structure

Looking for similarities.
Special Purpose Vehicle Bank

Asset Liability Liability

Collateral

Loan
Deposit &
Senior Inter-bank
Corp Bond Market

ABS
Tier 1 & 2
Mezzanine
CDS Capital

CDO Equity Equity

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Rate of Return

If you are interested in the Equity piece, what rate of return
will make you happy.

Liability

Senior LIBOR + ???

Loss Absorption

Mezzanine LIBOR + ???

Equity ???

18
The Whole Capital Structure

In the old days, the whole capital structure is sold down and
the arranger earned the net spread.
Special Purpose Company
Asset Liability Pricing driven
Collateral Net Spread by demand
and supply
Loan
Senior
Bond
Tranching Investors
ABS
Mezzanine
CDS

CDO Equity

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The Single Tranche

What happen if you can find buyers for the Mezzanine
tranche only (at a given period of time)?

Liability

What rate of return are you going to

Senior offer?

How are you going to risk manage the

Mezzanine single tranche?
Equity

20
Behaviour of a Single Tranche

A leveraged call spread

100%
Tranche Loss

0%
Portfolio Loss
3% 4% 5% 6%
Attachment Detachment
Point Tranche Width Point

21
Five Years Ago

The answers starts with

this ground breaking
research paper …

22
The Wall Street Journal Reported

Finally get the attention

of Wall Street Journal …

23
Searching for the Perfect Copula

The word copula

originates from the Latin
noun for a "link or tie"
that connects two
different things

In statistics, a copula is a
probability distribution on a
unit cube [0, 1]n for which
every marginal distribution is
uniform on the interval [0, 1].

24
The Answer Depends On

Loss distribution of the collateral portfolio

Probability Equity Mezzanine Senior Super Senior

Bond Pool Loss (%)

Expected Loss

25
Importance of Default Correlation

Default correlation affects the shape of the loss distribution.

Low Correlation High Correlation

80% 80%
70% 70%
60% 60% Extreme
50% 50% Events
Probability

Probability
40% 40%
30% 30%
20% 20%
10% 10%
0% 0%
0% 6% 12% 18% 24% 30% 36% 42% 48% 54% 60% 0% 6% 12% 18% 24% 30% 36% 42% 48% 54% 60%
Portfolio Loss (%) Portfolio Loss (%)

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Default Correlation Estimation
4.0 Default is a Rare Event
3.5

3.0
Default Rate (%)
2.5 Investment Grade
Speculative Grade
2.0

1.5

1.0

0.5

0.0
81 83 85 87 89 91 93 95 97 99 '01 '03

No model independent mathematical relationship to

link default correlation to equity price correlation or
credit spread correlation

27
The Battle Tranches

Senior Troop Equity Troop

28
The Barclays Capital IBD Tranches

General Lai Private Cheung

Senior Tranche Equity Tranche

29
Low Correlation Minefield

Private Cheung
easily get killed

30
High Correlation Minefield

Private Cheung
might find a
safe passage

31
The Barclays Capital IBD Tranches

General Lai Private Cheung

I love low
correlation
I love high
correlation

32
Final Remark

“It is not the perfect model.

There’s not a better one yet”
David Li

33
Quant Genius Wanted

Quant genius who can make sense of relationship between
credit correlation and spread volatility.

Capable of creating models to explain why current index
trades at current inexplicable level.

Create model that eliminate correlation skew.

Make sense of the term structure of correlation.

Put into Black-Scholes framework.

People skills not essential.

34
Thank You