DEPARTMENT OF ECONOMICS

RESEARCH GROUP BANKING & FINANCE

FINANCIAL RISK MANAGEMENT

Martien Lamers // 16-11-2020
IT’S WOOCLAP TIME

2
TODAY

̶ Last week(s)
̶ Options
‒ Mechanics of markets
‒ Payoff profiles
‒ (Preliminary) pricing

̶ This week
̶ Options
‒ Pricing
‒ Binomial option trees
‒ Black Scholes Merton model

3
RISK MANAGEMENT PROCESS

4
DISCOUNTING CASH FLOWS

̶ Fair value price of any financial instrument equals discounted expected cash flows:

̶ Bond
‒ 𝑃0 = 𝐶1 𝑒 −𝑟∗1 + 𝐶2 𝑒 −𝑟∗2 + ⋯ + (𝐶𝑇 + 𝐹𝑉)𝑒 −𝑟∗𝑇

̶ As well as a price under which no arbitrage is possible

̶ Problem with forwards, futures, options etc. is that the cash flows are uncertain as they are derived
from another asset

̶ Key question today:

How do we value options?

5
PRICING

̶ Two different approaches

1) Binomial option trees

2) Black-Scholes-Merton model

̶ Both approaches start with modeling the price process of the underlying (mostly stocks)

̶ Once you know the value of the underlying, you can infer the value of the call/put
option

6
BINOMIAL OPTION TREES
7
BINOMIAL TREE

̶ ‘Tree’ with two options, an up-state (with probability p) and a down-

state (with probability (1-p)):
Upstate

Today

Downstate

t=0 t=T
8
BINOMIAL TREE - EXAMPLE
̶ Example:

̶ Stock price currently €20

̶ In 3 months it will be either €22 or €18
̶ What is the pay-off for a 3 month call option with strike price €21?
22
1

If we know p, we could
20 price the option!

18
0

t=0 T=0.25
9
BINOMIAL TREE - EXAMPLE

̶ How can we find a value of p?

̶ Key insight
‒ We can set-up a portfolio that has the same pay-off in each
state
‒ The value of the option is the discounted future pay-off, minus
the cost to create the portfolio

10
HEDGING PORTFOLIO

̶ Portfolio:
̶ Δ shares and short 1 call option

̶ In our previous example

̶ In upstate:
‒ Value of share position is 22*Δ
‒ Value of short call is -1

̶ In downstate:
‒ Value of share position is 18*Δ
‒ Value of short call is 0

11
HEDGING PORTFOLIO
̶ Example:

̶ Stock price currently €20

̶ In 3 months it will be either €22 or €18
̶ 3 month call option with strike price €21
22 Share: 22*Δ
1 Short call: -1

20

18 Share: 18*Δ
0 Short call: 0
t=0 T=0.25
12
HEDGING PORTFOLIO
̶ The portfolio has the same pay-off when

̶ 22*Δ-1 = 18*Δ
̶ Δ=0.25

̶ A portfolio with 0.25 shares and 1 short call option has the same value in both upstate and downstate!

̶ In upstate:
‒ 22*0.25 – 1 = €4.5

̶ In downstate:
‒ 18*0.25 – 0 = €4.5

13
HEDGING PORTFOLIO

̶ The value of the hedging portfolio today is then (and risk-free rate is 12%):
̶ 4.5e–0.12×0.25 = €4.367

̶ Remember, the hedging portfolio consists of

̶ 0.25 shares long
̶ 1 short call

̶ Value of shares today: 0.25*20 = €5

̶ Then value of call must be: 5 – c = 4.367, c = 0.633!

14
GENERALIZATION

S0u Portfolio Δ shares and short 1 derivative:

fu ΔS0u - fu

Portfolio is riskless when ΔS0u – fu = ΔS0d - fd

S0
f fu−fd
Δ=
S0u−S0d

S0d Portfolio Δ shares and short 1 derivative:

fd ΔS0d - fd
t=0 T

15
GENERALIZATION

̶ In that case f = S0 Δ – (S0uΔ – fu)e –rT

̶ And substituting value of Δ yields

‒ f = [pfu +(1-p)fd]e–rT
Risk-neutral probabilities of
rT
e −d upstate and downstate
‒ where p =
u−d

16
BINOMIAL TREE - EXAMPLE
̶ Example:

̶ Stock price currently €20

̶ In 3 months it will be either €22 or €18
̶ What is the pay-off for a 3 month call option with strike price €21?
22
1

If we know p, we could
20 price the option!

18
0

t=0 T=0.25
17
BINOMIAL TREE - EXAMPLE
̶ Example:
erT − d
̶ p=
u−d
̶ u is the upward movement (in %), d is the downward movement (in %)
e0.12∗0.25 − 0.9
̶ p= = 0.6523
1.1 − 0.9
22
1

Value of the option:

20
f = [0.6523*1 +0.3477*0]e–0.12*0.25
= 0.633

18
0

t=0 T=0.25
18
MULTIPLE STEPS
̶ Can easily be extended to two (or more) steps:

er∆𝑡− 0.9 e0.12∗0.25 − 0.9

̶ Now T=0.5, ΔT = 0.25, p = = = 0.6523
1.1 − 0.9 1.1 − 0.9

[0.6523*3.2 +0.3477*0]e–0.12*0.25 = 2.0257

24.2
3.2
22
2.0257
20 19.8
1.2823 0
18
0
[0.6523*2.0257 +0.3477*0]e–0.12*0.25 = 1.2823
16.2
0

[0.6523*0 +0.3477*0]e–0.12*0.25 = 0
19
 PUT OPTION
̶ Example:
̶ Stock price currently €50, strike price €52, T=2, two steps so ΔT = 1, risk-free rate is 5%
e0.05∗1 − 0.8
̶ u is 1.2, d is 0.8, such that p = = 0.6282
1.2 − 0.8

[0.6282*0 +0.3718*4]e–0.05*1 = 1.4147

72
0
60
1.4147
50 48
4.1923 4
40
[0.6282*1.4147 +0.3718*9.4636]e–0.05*1 = 4.1923 9.4636
32
20
[0.6282*4 +0.3718*20]e–0.05*1 = 9.4636
20
 PUT OPTION
̶ Example:
̶ What if option is American, so that early exercise is possible?
̶ Early exercise (intrinsic value) is higher than call option value

[0.6282*0 +0.3718*4]e–0.05*1 = 1.4147

72
0
60
1.4147
50 48
5.0894 4
40
[0.6282*1.4147 +0.3718*12]e–0.05*1 = 5.0894 12
32
Option value is: 20
[0.6282*4 +0.3718*20]e–0.05*1 = 9.4636

21
But intrinsic value (K – S0) is 12!
VALUES OF U AND D

̶ Which values to choose for u and d?

̶ Cox, Ross and Rubinstein (1979) show that optimal values of u and d can be calculated
from the volatility of the underlying stock:

‒ 𝑢 = 𝑒𝜎 ∆𝑡

1 −𝜎 ∆𝑡
‒ 𝑑= =𝑒
𝑢

‒ where 𝜎 is the volatility of the underlying, and ∆𝑡 the time-step (in years)

22
BLACK-SCHOLES-MERTON MODEL
23
BLACK-SCHOLES-MERTON

̶ The Black-Scholes-Merton (BSM) model has the same ingredients

̶ Relies on a hedging portfolio

̶ The hedging portfolio has no risk, same pay-off in every state of the world

‒ But where binomial tree has two outcomes and a discrete time-step …
‒ the BSM models the underlying as a continuum of outcomes (log-normal
distribution) in continuous time

‒ Also called Wiener or Ito process

24
BLACK-SCHOLES-MERTON

̶ Stocks have a certain price distribution, which is log-normal, so that

logarithmic returns are normally distributed:
Random component

𝑆𝑡 2
ln = Φ 𝜇Δ𝑡, 𝜎 Δ𝑡
𝑆0
Expected return (drift parameter)

25
BLACK-SCHOLES-MERTON

̶ Similar to the binomial tree, assume that:

̶ The option and stock prices depend on the same underlying source of uncertainty

̶ Form a portfolio consisting of the stock and the option which eliminates this source of
uncertainty (dynamic hedging)
‒ Δ shares, short 1 option

̶ Since the portfolio is riskless and must instantaneously earn the risk-free rate (risk-
neutral valuation)

26
BLACK-SCHOLES-MERTON How the formula came about:
https://www.dailymotion.com/video/x225si7

̶ Using Ito’s lemma (and the assumption of continuous time), the price of an option
is:
−𝑟𝑇
𝑐 = 𝑆0 𝑁(𝑑1 ) − 𝐾 𝑒 𝑁(𝑑2 )

−𝑟𝑇
𝑝=𝐾𝑒 𝑁(−𝑑2 ) − 𝑆0 𝑁(−𝑑1 )

ln( 𝑆0 /𝐾) + (𝑟 + 𝜎 2 /2)𝑇

where 𝑑1 =
𝜎 𝑇
ln( 𝑆0 /𝐾) + (𝑟 − 𝜎 2 /2)𝑇
𝑑2 = = 𝑑1 − 𝜎 𝑇
𝜎 𝑇
27
BLACK-SCHOLES-MERTON

̶ N(x) is the probability that a normally distributed variable with a

mean of zero and a standard deviation of 1 is less than x

̶ Use critical values of standard normal distribution

28
BLACK-SCHOLES-MERTON

29
BLACK-SCHOLES-MERTON

̶ Deconstruct the formula:

−𝑟𝑇
̶ 𝑐 = 𝑆0 𝑁(𝑑1 ) − 𝐾 𝑒 𝑁(𝑑2 )

̶ Based on portfolio of Δ shares and short 1 option

̶ Interpretation:
‒ 𝑁(𝑑1 ) is Δ
‒ 𝑁(𝑑2 ) is probability that option will be exercised

30
BLACK-SCHOLES-MERTON

̶ From put-call parity, the price of the put option is:

̶ 𝑝=𝐾 𝑒 −𝑟𝑇 𝑁 −𝑑2 − 𝑆0 𝑁 −𝑑1

̶ Interpretation:
‒ 𝑁(−𝑑1 ) is -Δ
‒ 𝑁(−𝑑2 ) is probability that option will not be exercised

31
PROPERTIES
̶ Ceteris paribus:

̶ As S0 becomes large
‒ Call price goes up, put price down

̶ As S0 becomes very small

‒ Call price goes down, put price goes up

̶ As volatility becomes very large

‒ Both call and put prices go up

̶ As T becomes very large

‒ Call price goes up, put price down (risk-neutrality)

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IMPLIED VOLATILITY

̶ Using market prices, we can imply the volatility expected by the market

̶ VIX index
̶ Vstoxx

33
BINOMIAL TREES VS BLACK-SCHOLES-MERTON
̶ Both methods rely on hedging strategy

̶ As you increase number of steps in binomial option trees, the option price
converges to the Black-Scholes-Merton price

34
RECAP
35
RECAP
̶ Key question: How do we value options?
̶ Two different methods, namely binomial option trees and the Black-Scholes-Merton model

̶ Similar ingredients in both:

̶ Model the price of the underlying asset
̶ Rely on a hedging portfolio which mitigates risk
‒ Δ shares, short 1 option
‒ The value of the option is the value of the shares minus discounted payoff

̶ Powerful tool
̶ Easy to apply, probabilities can be interpreted
̶ Used in VIX index, credit risk analysis, etc.

36
COURSE MATERIAL

̶ Hull: Chapters 13, 15

37
NEXT WEEK

̶ Exercise session 3
̶ Problem set 3 on Ufora

̶ Thanks for your attention and see you next week!

38
Prof. dr. Martien Lamers

DEPARTMENT OF ECONOMICS Ghent University

@ugent
E martien.lamers@ugent.be Ghent University
T +32 (0)9 264 35 12

www.ugent.be