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Derivatives Pricing and Hedging: An Introduction
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
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
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)
8
Black-Scholes Formula
0.9155 1
Call = 0.8944 × 50 × (1+ 0.1× 0.25)× − 45 ×
0.8944 1+ (0.1× 0.25)
Call = 6.51
9
Option Hedging in Practice
Delta
Delta neutral on a frequent basis
Transaction costs
Portfolio hedging
10
Interest Rate Derivatives
Black-Scholes Model
For cap and floor, the underlying is the short rate e.g. LIBOR or
HIBOR
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
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
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
Loan
Deposit &
Senior Inter-bank
Corp Bond Market
ABS
Tier 1 & 2
Mezzanine
CDS Capital
17
Rate of Return
If you are interested in the Equity piece, what rate of return
will make you happy.
Liability
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
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
22
The Wall Street Journal Reported
23
Searching for the Perfect Copula
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
25
Importance of Default Correlation
Default correlation affects the shape of the loss distribution.
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
27
The Battle Tranches
28
The Barclays Capital IBD Tranches
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
I love low
correlation
I love high
correlation
32
Final Remark
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