Digital options

Daniel Brødsgaard

University of Copenhagen - Department of Economics

21 November 2022
Overview of today

▶ Digital options
Digital options
Digital options
▶ A digital option is the simplest type of exotic... but not really an
exotic. We have seen plain vanilla products so far, which we have
defined as having no dependence on neither skew/smile nor the
model employed.
▶ Digitals does depend on the skew/smile, but has the same price in
all models which are calibrated to the same smile.
▶ And it turns out that digital options can in fact be statically hedged
by trading in European options at two different strikes. So actually
a quite simple product.
▶ A digital caplet (floorlet) pays out 1 if the forward libor rate fixes
above (under) some pre-agreed strike level. Fixed-in-advance and
paid-in-arrears.
▶ In combination with our max/min functions in calls and puts,
digitals can be added in order to create all sorts of pay-off profiles,
and is thus a very common exotic.
▶ From my point-of-view it is mostly interesting due to its theoretical
properties.
Pricing
Digital options depend directly on risk-neutral probabilities.
h RT i
− t r (u)du
Digital(t, K ) = EQ
t e δ1L(T ,T +δ)>K

 

= P(t, T + δ)δQT +δ [L(T , T + δ) > K ] = P(t, T + δ)δ 1 − QT +δ [L(T , T + δ) ≤ K ]

 
| {z }
Distribution function

and furthermore

∂(L(T , T + δ) − K )+
h RT i  R  
− t r (u)du − tT r (u)du
EQ
t e Q
δ1L(T ,T +δ)>K = Et e δ −
∂K
∂ ∂Caplet ′
=− Caplet(t, K , σBS (K )) = − − vega · σBS (K )
∂K ∂K
Note that we can (statically) replicate a digital caplet by buying notional
1
2ϵ caplets at strike K − ϵ and selling same notional of strike K + ϵ
caplets (long call spread) since

∂ Caplet(t, K − ϵ, σBS (K − ϵ)) − Caplet(t, K + ϵ, σBS (K + ϵ))

− Caplet(t, K , σBS (K )) = lim
∂K ϵ→0 2ϵ
Digital greeks

Can you explain intuitively the following greeks? Do you notice

something interesting comparing to swaption (caplet) greeks?

Figure 1: Left: Digital caplet PV. Right: Digital caplet delta.

Digital greeks continued

Figure 2: Left: Digital caplet gamma. Right: Digital caplet vega.