Introduction to Options and Futures

Options
Hedging
Financial with…
markets and Interest rates
corporate and Swaps
applications
Pricing…
Forwards
and Futures
¡ Black-Scholes and arbitrage relations
¡ Black-Scholes and binomial pricing
¡ Black-Scholes, risk-neutral pricing, and Monte
Carlo methods
¡ B-S equation is based on no arbitrage
¡ Thus: The B-S option pricing formulas satisfy
the no arbitrage relations we have learnt
earlier on in our classes
¡ That includes the put-call parity
¡ Put-call parity
𝑐 = 𝑝 + 𝑆! − 𝐾𝑒 "#$

¡ B-S option prices

𝑐 = 𝑆! 𝑁 𝑑% − 𝐾𝑒 "#$ 𝑁 𝑑&
𝑝 = 𝐾𝑒 "#$ 𝑁 −𝑑& − 𝑆! 𝑁 −𝑑%
¡ Use the fact that
𝑁 −𝑥 = 1 − 𝑁 𝑥 1.00

1−𝑁 𝑥

¡ Then 0.75

§ 𝑁 −𝑑! = 1 − 𝑁 𝑑!
0.50

0.25

§ 𝑁 −𝑑" = 1 − 𝑁 𝑑" 𝑁 −𝑥
0.00
-4 -3 -2 -1 0 1 2 3 4
¡ Two option pricing methods
1. Binomial trees

2. Black-Scholes

¡ How do we reconcile them?

¡ Set up tree so as to match empirical volatility

𝑢 = exp 𝜎 Δ𝑡 ; 𝑑 = exp 𝜎 Δ𝑡
¡ Set up “high frequency” tree:
§ Let Δ𝑡 = 𝑇/𝑛

§ Let 𝑛 ↑ ∞

§ Your textbook contains a proof; here: illustration

¡ Suppose 𝑆! = $100, 𝜎 = 20%, 𝑇 = 1 year,
𝑟 = 5%. Call option with 𝐾 = $100.
¡ Black-Scholes price:
𝑐 = 𝑆! 𝑁 𝑑% − 𝐾𝑒 "#$ 𝑁 𝑑&
% (! '"
𝑑% = ln + 𝑟+ 𝑇 ; 𝑑& = 𝑑% − 𝜎 𝑇
' $ ) &

𝑐 =?
 ¡ Suppose 𝑆! = $100, 𝜎 = 20%, 𝑇 = 1 year,
𝑟 = 5%. Call option with 𝐾 = $100.
¡ Start with a one-step tree (𝑛 = 1)
𝑢 = exp 𝜎 Δ𝑡 = 𝑒 &!%×% = 1.22 𝑆# = $122
𝑑 = 0.82
𝑆 = $100
#$
∗
𝑒 −𝑑
𝑝 = = 58% 𝑆$ = $82
𝑢−𝑑
¡ Suppose 𝑆! = $100, 𝜎 = 20%, 𝑇 = 1 year,
𝑟 = 5%. Call option with 𝐾 = $100.
¡ Start with a one-step tree (𝑛 = 1) 𝑝∗ = 58%

𝐶# = $22 𝑆# = $122

𝐶 = $𝟏𝟐. 𝟏𝟔 𝑆 = $100

𝐶$ = $0 𝑆$ = $82
¡ Suppose 𝑆! = $100, 𝜎 = 20%, 𝑇 = 1 year,
𝑟 = 5%. Call option with 𝐾 = $100.
¡ Repeat with a two-step tree (𝑛 = 2)
§ Re-calculate 𝑢 and 𝑑
§ Re-calculate 𝑝∗ = 55%
§ Re-value the option: 𝑐 ! = $𝟗. 𝟓𝟒
¡ Suppose 𝑆! = $100, 𝜎 = 20%, 𝑇 = 1 year,
𝑟 = 5%. Call option with 𝐾 = $100.
¡ Repeat for 𝑛 = 3
¡ Repeat for 𝑛 = 4
¡ Repeat for 𝑛 = 5
¡ …
 12.5 18%

Discrepancy between Black-Scholes and binomial prices

12.0 15%

11.5 12%
Option price

11.0 9%

10.5 6%

10.0 3%

9.5 0%
1 2 3 4 5 6 7 8
Number of steps in binomial tree
 12.5 18%

Discrepancy between Black-Scholes and binomial prices

12.0 15%

11.5 12%
Option price

11.0 9%

10.5 6%

10.0 3%

9.5 0%
1 2 3 4 5 6 7 8
Number of steps in binomial tree
 12.5 18%

Discrepancy between Black-Scholes and binomial prices

12.0 15%

11.5 12%
Option price

11.0 9%

10.5 6%

10.0 3%

9.5 0%
1 2 3 4 5 6 7 8
Number of steps in binomial tree
¡ Why do we do risk-neutral pricing?
§ “Quicker” than setting up a hedging or replicating
portfolio

§ “Easier” than solving the Black-Scholes PDE

¡ Solving Black-Scholes PDE for European call
and put: Easy
¡ But consider e.g. Asian call option with payoff
at maturity:
1 $
max 𝐴 0, 𝑇 − 𝐾 , 𝐴 0, 𝑇 = F 𝑆- 𝑑𝑡
𝑇 !
¡ In most cases, most straightforward solution
is: apply the risk-neutral pricing recipe
Price = 𝑒 $%& 𝐸 ∗ Payoff

¡ In some cases, we may not be able to “do the

algebra” for 𝐸 ∗ Payoff (e.g. Asian option)
¡ Solution: Monte Carlo
¡ Technique to estimate the expected value of
any function 𝑓 𝑥 of a random variable 𝑥
1. Generate random numbers drawn from the
)
distribution of 𝑥, 𝑥' '("
2. For each 𝑥' , compute 𝑓 𝑥'
"
3. Average ∑' 𝑓 𝑥' ≈ 𝐸 𝑓 𝑥
)
¡ Solution: Monte Carlo option pricing
¡ Technique to estimate the expected value of
any function 𝑓 𝑆 of stock price 𝑆
1. Generate random numbers drawn from the risk-
)
neutral distribution of 𝑆, 𝑆' '("
2. For each 𝑆' , compute Payoff 𝑆'
"
3. Average ∑' Payoff 𝑆' ≈ 𝐸 ∗ Payoff 𝑆
)
¡ Suppose 𝑆! = $100, 𝜎 = 20%, 𝑇 = 1 year,
𝑟 = 5%. Call option with 𝐾 = $100.
1. Generate 𝜀' ∼ 𝑁 0,1 for 𝑖 = 1, … , 1000

2. Stock value at maturity, for each 𝑖:

𝜎!
𝑆' 𝑇 = 𝑆* exp 𝑟− 𝑇 + 𝜀' 𝜎 𝑇
2

3. Option payoff: 𝐶' 𝑇 = max 𝑆' 𝑇 − 𝐾, 0

0.30

0.25
Distribution of the
simulated 𝑆. 𝑇
0.20

0.15

0.10

0.05

0.00
50 70 90 110 130 150 170 190 210
 12.5 12%

Discrepancy between Black-Scholes and MC prices

12.0 10%

11.5 8%
Option price

11.0 6%

10.5 4%

10.0 2%

9.5 0%
100 200 300 400 500 600 700 800 900 1000
Number of MC replications
 12.5 12%

Discrepancy between Black-Scholes and MC prices

12.0 10%

11.5 8%
Option price

11.0 6%

10.5 4%

10.0 2%

9.5 0%
100 200 300 400 500 600 700 800 900 1000
Number of MC replications
 12.5 12%

Discrepancy between Black-Scholes and MC prices

12.0 10%

11.5 8%
Option price

11.0 6%

10.5 4%

10.0 2%

9.5 0%
100 200 300 400 500 600 700 800 900 1000
Number of MC replications