Download as pdf or txt
Download as pdf or txt
You are on page 1of 35

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

11
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

16
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

17
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

19
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 (%)

26
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

You might also like